Financial risk management:2

Mohan Manohar January 23, 2013
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While “supervisory review” relates to the effective ways of supervision of banks by the Regulator and “market discipline” deals with strengthening of disclosures by banks and safe and sound banking practices, the concept of “Economic Capital” seeks to further refine and sophisticate the system of assessing various risks faced by banks and maintaining adequate capital in relation to the totality of the risks assessed. The third and final consultative document enshrining the New Capital accord was released by the Basel Committee for comments on April 29, 2003. The new accord is to be finalised by the end of the current year whereafter it will be implemented by internationally banks by December 2006.

As against the broad-brush approach in the existing Accord, the New Accord contains the following suggestions:

The Economic Capital will be calculated for financial risks as well as operational risks because operational risks will mostly turn into financial losses. The risks arise mainly on account of the following: –

Exposures on account of lending operations.
Exposures on account of market operations viz. investment and trading in securities and operations in forex markets.
Exposures on account of general banking operations, where any failure on account of internal process, people, systems or technology or external events may result in substantial financial losses (as well as other losses e.g. reputation loss)

Capital Adequacy will be measured as follows:-

Total capital/( Credit Risk  + Market Risk + Operational Risk) > 8%

Risk quantification is not just a regulatory requirement. Banks should put in place a system to understand, measure and manage/control their exposures to developments in the market and to counter-parties. From a psychological angle also, their ‘response’ will be more appropriate and need-driven when banks know their situation. The approach to measuring each type of risk is to assess both the expected loss and unexpected losses using appropriate analytical methods/models and empirical data-bases or Monte-Carlo simulation. Unlike the existing Accord under which banks have to provide adequate capital only for counter-party risks, now banks will have to provide capital to cover all possible losses and calculated in a more rational and data-based manner.

Calculating Credit Risk Capital

For calculation of regulatory capital for credit risks, the Basel Committee has suggested the following approaches which may be implemented by banks in a phased manner.

a. The Standardised Approach 

      Under this approach, the counter-parties are to be grouped into Sovereigns, Banks and Corporates and instead of assigning a uniform risk weight to all the borrowers, differential risk weights will be assigned to them on the basis of external risk assessments by the credit rating agencies

      For Sovereigns, the risk weights will range from 0% to 100% and for Banks and Corporates, the range will be from 20% to 150%. This approach will ensure that a bank knows the quality of its exposures to strengthen its capital base according to the risks it takes. It will also be a tool for the bank to review its exposure and if it finds that its exposures are leaning towards risky areas, it can make timely corrections.

b. Internal Ratings Based (IRB) Approaches

In comparison to the Standardised Approach, the internal ratings based approach is more sophisticated because in respect of each exposure, banks are asked to foresee the possibility of a shift in the asset quality over a period of time. This can be done by working out the probability of default, the probability of loss in the event of default and the exposure at default,  for individual credit exposures as well as the portfolio, with correlations between different exposures in the portfolio duly accounted for.

Probability of default (PD): Banks have to calculate the movement of asset quality over a period of time and work out the likelihood of default. Computation of the PD will give an indication as to how the assets will behave in future for a given a set of specific conditions and whether they are likely to gain or lose quality over a given time horizon. This will enable the banks to predict the behavioural pattern of assets and accordingly, they can redistribute their assets to avoid or mitigate future losses.
Loss Given Default (LGD): Loss given default or loss in the event of default (LIED) is a measure of the probability of loss. The quantum of loss in the event of default is calculated after taking into account the security available etc. This will provide a tool to the banks to make an assessment of loss that may occur in the event of the default taking place. In this process, banks are to carry out the analysis taking into account factors such as recoveries expected until the default as well as the realisable value of the security that would be available at the time of default, which are the two main factors which must be considered. This will help them review their portfolio and also their own financial decision making strategies.

Exposure at Default (EAD): The exposure in the books in the event of default is calculated. This enables the banks to quantify the exposure which may be at default, as distinct from the exposure which will not pose any problem of recovery.

The capital to be maintained will be arrived at after taking into account all the three factors. For calculating the quantum of risk capital required to meet unexpected losses, banks need to develop models and build a database for a minimum period of seven years. The Basel Committee has also suggested that the IRB approach can be either the “basic” approach or an “advanced” approach. Under the basic approach, while each bank can have its own model for calculating PD, the Central Bank of the country will stipulate models for calculating LGD and EAD uniformly for all the banks. Under the advanced approach, each bank can have its own models for PD, LGD and EAD, subject to the Central Bank satisfying itself as to the correctness and accuracy of the model.

Calculating Market Risk Capital

Besides credit exposures, Banks also take financial exposure by way of investments and trading in securities and money market and forex market operations. These operations, if not properly regulated, have the potential of turning into loss events for the banks. To take care of /manage such risks, the Committee has suggested the implementation of “Asset-Liability Management” (ALM). Also, prudential norms for each exposure, fixing position limits for taking open position in any particular exposure over a time horizon, and cut loss limits to ensure that actual loss does not go beyond a point in the hope of making up the losses, have been suggested by the Committee for implementation.

In India, RBI has already introduced most of the risk management measures indicated by the Basel Committee, as Indian Banking Sector has to align itself with the international best practices.

The objective of market risk management is not only to get maximum benefit from market operations but also to build safeguards to contain losses resulting from adverse interest rate and price movements.

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Mohan Manohar

Mohan Manohar is a blogger from India who founded Ittech back in 2007. He is passionate about all things tech and knows the Internet and computers like the back of his hand.

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