Requirements for Managing Banking Risks Example for Free

Risks are inherent in banking business and they cannot be avoided. To absorb losses associated with these risks, the minimum amount of capital required to be kept by the bank should be assessed. Banking risks like credit risk, market risk and operational risk are taken into account while determining minimum capital requirement. Capital reduces the risk of failure by providing protection against unexpected losses. Capital requirement plays an important role in the supervision and regulation of banks. The Basel Committee on Banking Supervision is the committee which sets standards for calculating capital requirement. It proposes differentiated approaches to calculate capital for all the banking risks. In India, the capital ratios of banks observed were generally low and some banks were seriously undercapitalized. Reserve Bank of India adopted the Basel framework prescribing 9% of capital to risk weighted assets for all banks operating in India.

TABLE OF CONTENTS

Introduction

Banking is one of the most regulated industries globally and the rules governing bank capital are one of the most important aspects of such regulation. There are 2 reasons why the banks should be regulated - first, the risk of systemic crisis and second, the inability of depositors to monitor banks. So, bank failures are triggered by inability of banks to honour repayment commitments to their creditors on time. Capital reduces this risk of failure by providing protection against unexpected losses. Greater the bank's capital funds, greater the amount of assets that can default before bank gets insolvent and lower the risk of bank. Apart from absorbing losses, capital can also serve other purpose of banks. When any bank has adequate capital, investors look upon it as a safe investment option and so bank has ready access to the financial market. Thus regulating the amount of capital that a bank should hold is focused at reducing the risk of banks taking undue risks or expanding beyond their ability. There are various types of banking risks:

Credit Risk:

It refers to the consequences related to defaults or non-fulfillment of contracts.

Market Risk:

It refers to risks that result from changes in the money price and capital markets.

Operational Risk:

It refers to the risk of loss resulting from failed or inadequate internal people, processes and systems. The amount of capital which is considered necessary by banks to absorb the potential losses associated with banking risks - credit, market, operational, and other risks - is defined as Economic Capital. One aspect of bank regulation is to ensure that depositors who do not need to withdraw at present are given enough assurance that they will be paid in the future. This assurance can be provided in 3 ways - adequate bank capital, deposit insurance and subordinated debt. Capital adequacy is essential for the long term stability of the banks. Banks need to assess carefully the internal and future requirements of capital on the basis of the risks taken during their operation. Basel Committee on Banking Supervision (BCBS) is the committee which began thinking in terms of setting capital standards for banks and published Basel Accords. It sets a framework on how depository institutions and banks must calculate their capital. The Committee established a capital measurement system known as Basel I in 1988. Under Basel I, banks were required to hold capital for credit and market risk. The 2 principal objectives of Basel I were - To ensure adequate level of capital in international banking system and To no longer build volumes of business without adequate capital backing. When the BCBS Committee decided to revise the original Basel accord (Basel I) in 1998, it had hopes for an international standard for regulation of capital. The Committee claimed that the new accord would remove and cure the defects in the existing regulatory and notably improve the soundness and safety of the international banking system. In 2004, Basel I was replaced by Basel II. Under Basel II, banks were also required to compute capital charge for operational risk. Basel II consists of 3 pillars: Pillar 1: Minimum capital requirement The first pillar mainly deals with the maintenance of regulatory capital which is calculated for 3 major risk components that a bank faces - credit risk, market risk and operational risk. Pillar 2: Supervisory review process The second pillar basically deals with the first pillar's regulatory response, giving regulators improved tools over those which were available under Basel I. It mainly provides a framework to deal with the other risks any bank may face, like reputational risk, systemic risk, concentration risk, pension risk, strategic risk, legal risk and liquidity risk. Pillar 3: Market discipline The third pillar requires institutions to disclose details on capital, risk exposures, risk assessment processes and capital adequacy of institutions. Under US's Federal Bank regulatory agency definitions, to be adequately capitalized, a bank must have a Tier1 capital ratio of greater than 4%, a combined Tier1 and Tier2 capital ratio of greater than 8% and a leverage ratio of greater than 4%. According to Reserve Bank of India (RBI) norms for banks in India, banks must have common equity of 3.6%, Tier1 requirement of 6% and Total Capital of 9 % of risk weighted assets. Risk based regulatory capital standard uses 2 levels of bank capital - Tier1 and Tier2. Tier1 capital is the core measure of financial strength of a bank from point of view of a regulator. It is composed of core capital that consists of common stock and retained earnings but may also include non-cumulative non-redeemable preferred stock. Tier2 capital is also known as supplementary capital. It includes a number of important constituents of capital base of a bank. Leverage ratio is any ratio which is used to calculate financial leverage of a bank so as to get an idea of the methods of financing of bank or to measure bank's ability to meet financial obligations. The Capital ratio is the percentage of capital of a bank to its risk weighted assets. Basel II requires the capital ratio to not to be lower than 8%. Basel III was developed in response to deficiencies revealed in late 2000s financial crisis. Under Basel III, banks will be required to hold common equity of 4.5% and Tier1 capital of risk-weighted assets of 6%. Basel III also introduces the additional buffers of capital 2.5% of mandatory capital conservation buffer 2.5% of discretionary countercyclical buffer capital during high credit growth period Basel III also introduces a minimum of 3% leverage ratio and 2 required liquidity ratios which are required by a bank to hold sufficient high quality liquid assets so as to cover its net cash flow over 30 days.

Problem Statement

Determination of total minimum capital requirement by banks to absorb losses associated with credit, market and operational risks and its impact on Indian Banking System.

Purpose of Study

Market values of bank assets are more volatile than those of the manufacturing firm. Bank assets bear the credit risk i.e. borrower defaults, market risk i.e. interest rate fluctuations, and operational risk i.e. failure of internal systems or people. Also, the bank needs liquidity so as to pay off its creditors with whom they have entered into contracts at various points in time. If banks have to increase capital relative to the risk of the assets they hold, the adequate capital required by banks to run the business to stay viable and survive should be determined.

Significance of Study

Risk is inherent in business of banking and banks cannot survive by avoiding risk. If banks have low risk assets, they can remain safe. However, in practice, banking assets are risky. Therefore, banks must increase capital relative to the risks of the assets that they hold. In the US mortgage crisis 2007-2009, it was evident that the banks were not holding enough capital to support the risky mortgage activities. Capital regulation for banks intends to discipline banks and to promote financial stability.

Methodology

Qualitative method is used to carry out this research as this method helps in gaining indepth information on Basel implementation and its impact from bank employees in form of questionnaires. This approach represents true picture and allows exploring the process effectively. The open ended nature of this project is another reason why this method is used for analysis.

Literature Review

Regulation of capital is required to reduce the risks faced by banks. These risks may be Credit risk, Operational risk or Market risk. So to absorb such risks the amount of capital necessary is to be maintained. This ensures long term stability of banks. Capital which needs to be maintained by banks to absorb unexpected loss and risks is regulated through Basel norms. Basel norms define the amount of capital to be set aside using various models. To improve the supervision of banks worldwide, Basel Committee on Banking Supervision (BCBS) constituting Central Bank Governors, was formed in 1974. This committee published a set of requirements on minimum capital to be maintained by banks mainly focussing on credit risk in 1988 known as Basel I. It was adopted by India in 1999. In 2004, a new set of guidelines were passed known as Basel II which were to be implemented by Indians banks from the year 2007. This deadline was extended later to 2008-09. Due to various issues faced by banks in this period, new guidelines known as Basel III were released in 2010. Basel III is to be implemented in India from 2013.

This paper deals with:

How much capital needs to be maintained by banks, how Basel norms help banks in maintaining capital adequacy and its effectiveness on workings of banks. This paper discusses various norms set for capital adequacy, its evolution and its impact on Indian banking system. That is, this paper discusses the impact of Basel II, need of Basel III and impact of proposed Basel III on Indian Banking system. This paper also suggests few modifications which are required to be made in the new accord (Basel III) on the basis of evaluation of its impact on banking industry. Basel I did not take into account the risk of mortgages. It considers every mortgage activity in the same category of risk and regardless of the creditworthiness of the borrowers. Basel II treated mortgage activities depending on the risk associated with the loan and required banks to establish models appropriate to estimate risk based capital that they need to hold so as to cover unexpected losses. The minimum capital requirement takes into account credit risk which can be determined by two approaches. First, mapping ratings of given by external credit rating agencies to capital requirements (Standardized Approach). Second, mapping bank's internal ratings to default probabilities (Internal Rating Based Approach). The increased importance of trading activities at many banking companies has highlighted the exposure of bank to market risk that is risk of loss from undesirable movements in financial market prices. The capital requirement for market risk is based on the internal value-at-risk model of the bank. A value-at-risk model makes an estimate of the maximum amount that any bank can lose on the portfolio over a certain holding period with a known degree of statistical confidence. Under Basel I, there was no reference made to capital requirement associated to operational risk. There were 3 methods presented to calculate the operational risk capital charge - Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach. It was investigated whether capital regulations have an effect on bank risk-taking and it was observed that Bank with high capital buffer position would adjust risk-taking and the capital adequacy ratio in the same direction and Bank with low capital buffer position would adjust the capital faster than the bank with high capital buffer. Capital Ratio is calculated to maintain the minimum requirement of greater than 8% of bank's capital to risk-weighted assets. Multiplying the capital requirements for operational and market risk by 12.5 (which is the reciprocal of 8% i.e. the minimum capital ratio) and adding the result to the sum of risk weighted assets for credit risk to determine total risk-weighted assets. Capital (Credit Risk + Market Risk + Operational Risk) In India, RBI requires banks to maintain at the minimum 9% of capital to risk weighted assets ratio (CRAR). Banks in India follow Standardized approach for credit risk, Basic indicator approach for operational risk and Standardized approach for market risk. Basel I did not require banks to hold sufficient capital to support the mortgage lending activities. Basel II was intended to solve this problem. However, the Basel II models were very complex and costly to implement. Basel II capital varies across the model and segmentation schemes which provide banks with options to choose the approach which results in making them hold least required capital. Basel II was introduced because it was more risk sensitive. The introduction of Basel II norms required recapitalization of bank's balance sheet. As a result, Capital Adequacy Ratio (CAR) in most Indian banks is above 12%. The Basel II Accord for bank capital regulation was designed to align regulatory capital to the risks which were underlying, by encouraging better systematic risk management practices, mainly in the area of credit risk. An overview of the objectives, main features and analytical foundations of the Accord was provided. The impact of the new bank regulation on the global banking system was analyzed through possible changes in bank behaviour. Also set of issues around analytics of risk such as correlations and portfolio aggregation, model validation, operational risk metrics and summary statistics of a bank's risk profile were studied. Issues brought about by Pillar 2 i.e. supervisory review and Pillar 3 i.e. public disclosure were also studied. In the research done till now, the possible effects of Basel II rules on the pricing of bank loans have also been analyzed. Basel II failed to live up to the expectations and so the reasons of its failure were studied. The failure of Basel II was the result of regulatory capture. The rules of international capital regulation were transformed by a small group of international banks to maximize the profits. The financial distress in 2007 raised so many doubts about the adequacy of regulations. So an academic discussion on Basel II took place on technical issues concerning the Pillar 1 methodology for calculating capital requirements and its implications. Only a range of resources, actors, and institutions which shape the decision making outcomes in the Basel Committee were understood. Basel II was aimed to address few weaknesses of Basel I framework of capital adequacy for banks. Basel II incorporated more detailed calibration (credit risk) and required pricing of other forms of risks. Regulators allow large banks to use risk assessment (with sophisticated risk management systems) based on their own models to determine the min. amount of capital which they are required to hold as buffer against unexpected losses (by the regulators), under Basel II framework. However, 2007-2008 crisis challenged the usefulness of few important elements in Basel II accord. Recapitalization of banks reveal that internal risk models of few banks performed very poorly and also greatly under estimated risk exposure which forced banks for reassessment and repricing of credit risk. This, to some extent, reflects the difficulties for low probability but large events of accounting.

Problems with Basel II:

Problem with Pillar 1: No concentration Penalty No country specific risk Unclear and inconsistent definition of capital Problem with Pillar 2 and Pillar 3: Supervisors cannot be forward looking Inefficient markets A more basic problem with Basel II is that it creates bad incentives to miscalculate credit risk. As banks are allowed their own models to use to assess risk and also to determine the amount of regulatory capital but they might have been tempted about their risk exposure, to be over optimistic in order to minimise required regulatory capital and maximise return on equity (ROE).

Basel III:

New norms aim to improve quality and quantity of capital. The major components of capital are retained earnings and common equity. Also, deferred tax assets, investments in financial institutions and mortgage servicing rights should constitute less than or equal to 15% of common equity.

Figure: Regulatory Capital Adequacy Levels

New norms focus on financial stability of the whole system rather than an individual bank. Basel III Reform Proposal: To raise consistency, transparency and quality of capital base Improvement in the definition of capital Enhance risk coverage by capturing on balance sheet and off balance sheet risks Introduction of leverage ratio Forward looking provisioning Holding buffers of capital

Figure: Macrofinancial Stability Framework

Basel III requires banks to have core capital percentage higher than other means. Core capital includes equity and reserves. This involves raising Tier 1 capital to 9.5% from 6% currently. This means increasing equity requirement to 8% from 4%.

Figure: Basel III Reform Programme Implementation

Figure: Basel III Capital Ratio

Methodology

This section of the research covers the methods used for collection of data and its analysis. The analysis is done on the basis of literature review. Both primary and secondary data are used for proper analysis.

Research Design

Research design lays a foundation to conduct the research project. This research explores the literature review on Basel norms and the impact on Indian banking system. Primary research questions were answered on the basis of the information collected from bank's employees. Information was also collected from BIS website and other journals.

Procedures

The procedure carried out involves defining the problem, forming an approach, designing the research, collecting data, analysing the data and representing the analysis in the form of a report. The research method chosen for the project is Qualitative as explained earlier.

Primary Data:

It is collected in the form of questionnaire relating to advantages and disadvantages of implementing Basel II and the impact of implementing Basel III.

Secondary Data:

It is collected from journal articles and other publications relating to Basel norms.

Participants

Information is collected from bank's employees covering few public, private and foreign banks (in total 30) in India. The employees were clearly and fully informed about the research before collecting answers from them.

Instrumentation

Questionnaire was used to collect information relevant to the research. A set of questions were prepared and asked from various bank's employees. This questionnaire was based on the literature review and other secondary data collected on Basel norms and their impact. It consisted of all closed ended questions. For reliability and validity purposes, the questionnaire was pilot tested so as to check if any rephrasing needs to be done.

Analysis and Findings

The analysis is done on the basis of information obtained from bank's employees in the form of questionnaire. The results are reviewed each question at a time and a conclusion is given on the basis of findings.

What is the main objective of Basel Accord?

According to private banks, it will make the banks compete globally. According to foreign banks and nationalized banks, it will bring stability and soundness in banking system. And according to most other bank respondents, it will reduce bank failures by maintaining capital adequacy ratio.

With introduction of Basel II, did Indian Banking system improve?

Definitely introduction of Basel II improved Indian banking system. It provided the banks with a competitive edge and stakeholders with better pricing of services.

What is Capital Adequacy Requirement in Basel III?

50% employees, majorly from private and foreign banks, said 8%. 30% banks maintain 9%. Others didn't know about that.

Do you think new Basel Accord will help improve the banking system?

75% said yes but they also thought that it will be a tough job to maintain the requirement. Few said that Basel II was better. Few didn't know what impact Basel III will have on banking system.

Do you think increase in capital reserve is required to manage banking risks as per Basel norms?

Increase in capital has its own advantages and disadvantages. So 90% said that increase is required whereas 10% said that other ways can be used to manage bank risks.

Whether new Basel accord requires new skills?

Since Basel III is similar to Basel II, it does not require new people. So all respondents said that if required they can train their existing staff.

What will be the impact of Basel III on Indian banks?

Majority replied stability of system. While two of the respondents mentioned that it might lead to further problems and maybe another crisis.

Summary, Conclusion and Recommendations

Summary

From the above analysis, it can be said that Indian banks are on their way to adopt Basel III. We can note various viewpoints of various banks. Few banks feel that Basel II was successful in managing banking risks and there is no need for Basel III but others feel that Basel III implementation would be more helpful in managing bank risks. They also feel that implementing Basel III is a big challenge but at the same time they realize that to compete with other banks, to expand globally and to meet international standards, implementation of Basel III is very much required. Thus Basel III should be implemented by Indian banks as fast as possible. There are various Impacts of implementing Basel III on Indian Banking System as per the opinion of the employees, which are: Positive Impacts: It could strengthen the credit and capital profile of Indian banks. It will enhance capitalization. It will improve risk adjusted capital ratios of banks. It will solve solvency issues. Negative Impacts: It poses significant dilution risk. It might moderate return on equity of banks i.e. by 1% for private sector banks and by 2% to 3% for PSU banks and so make it difficult to retain investor. It will make hard for banks to grow.

Figure: Impact of Deductions from Capital

Conclusion

Though Basel II was a bold step towards managing bank risks, it took a long time to put it all together and as we can see it is still not completely implemented. Now, Basel III is much more of a job in rush. Basel III's effective implementation will lead to strong, stable and sound Indian bank. It would lead to efficient management of capital and will improve bank's profitability. Basel III mitigates the risky behaviour of banks and changes banks approach towards risk management. Around 15 PSBs (as of December 31, 2011) have core Tier I capital less than 8% and 8 of them have less than 7%. So when banks with low Tier I increase their capital (to 9%), their ROE could drop. Large bank could compensate the decrease in ROE by raising lending yields and small banks might also try the same. However, few banks (with core capital less than 7%) might have to bear the loss in ROE. Private Banks are already well capitalised so implementing Basel III might not significantly impact their earnings. In fact, Private bank's competitive position might improve when PSBs increase their lending yields. Limiting the upside potential for private banks could be limited by the higher minimum core capital requirement. PSBs would require government support as they will fall short of capital adequacy requirement. Basel III is a new layer over Basel II and therefore inherits few problems of Basel II. Basel III is very good for reducing foreseeable risks but not for unforeseeable risks. Challenges that might be face on implementing Basel III: Functional Challenges Functional specification of new regulatory requirements (e.g. stress testing, limit system, risk quantification) Functional integration of new regulatory requirements into existing capital and risk management Technical Challenges Technical implementation of new regulatory requirements Data availability and quality Technical integration into existing risk management systems (e.g. interfaces) Organizational Challenges Coordination of different units as well as within the group Responsibilities within implementation and beyond Availability of resources

Recommendations

Basel III is required to be implemented in India for betterment but Basel III does not take into consideration few aspects and so improvements in the norm are required. Following are some of the problems with Basel norm which are required to be improved upon: Difference in regulatory risk weights assigned by different banks due to difference in methods used by these banks to assess risk weights. Risk weights are assigned on the basis of riskiness of securities in the past and so same weights are assigned to such securities for the future. Basel does not make adjustment for institute specific diversification and concentration. Basel III would encourage banks to find low risk weight asset with return. This would mean that banks would increase their lending to sovereign. And since sovereign default is possible, this might lead to next crisis. Bankruptcy laws should be focussed in detail. Basel III also does not deal with another regulatory problem that is banks try to minimize their capital costs by shifting buckets of risk using Credit Default Swaps (CDS). No concentration penalty fixed.

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