What Does Basel I Mean?

A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on percent of risk-weighted assets.

Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, capital banks need to put aside to guard against the types of financial and operational risks banks face while maintaining sufficient consistency.

contd
Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

contd
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk,operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach,Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach".

PILLAR I
A bank will have to determine the proportion of its capital that it must keep in reserve based on calulation Total Capital Credit risk+ market risk+operational risk = bank capital Ratio ie >8%(9%for india)

The second pillar

The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk,strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.. Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords It gives banks a power to review their risk management system

THIRD PILLAR
This pillar aims to complement the the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution.

RISKS
FINANCIAL RISK NON FINANCIAL RISK
POLITICAL RISK

CREDIT RISK

MARKET RISK

OPERATING RISK

HUMAN RISK TECHNOLOGY RISK

TRANSACTION RISK

INTEREST RATE RISK

PORTFOLIO RISK

LIQUIDITY RISK

FOREX RISK

CREDIT RISK
Risk that the counterparty will fail to perform or meet the obligation on the agreed terms .

TYPES OF CREDIT RISKS

Transaction Risk
Risk relating to specific trade transactions, sectors or groups.

Portfolio Risk
Risk arising from lending to sectors non related to the core competencies of the Bank / concentrated credits to a particular sector / lending to a few big borrowers.

MARKET RISK
Market risk is the risk to a banks financial condition that could result from adverse movements in market price.

TYPES OF MARKET RISK Interest Rate Risk

Risk felt, when changes in the interest rate structure put pressure on the net interest margin of the Bank.

Liquidity Risk
Risk arising due to the potential for liabilities to drain from the Bank at a faster rate than assets.

TYPES OF MARKET RISK (continued)

FOREX RISK
This risk can be classified into three types.

Transaction Risk is observed when movements in price of a currency upwards or downwards, result in a loss on a particular transaction. Translation Risk arises due to adverse exchange rate movements and change in the level of investments and borrowings in foreign currency. Country Risk. The buyers are unable to meet the commitment due to restrictions imposed on transfer of funds by the foreign govt. or regulators. When the transactions are with the foreign govt. the risk is called as Sovereign Risk.

Operational Risk
Operational Risk arises as a result of failure of operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc.

Systemic Risk is seen when the failure of one financial institution spreads as chain reaction to threaten the financial stability of the financial system as a whole. Political Risk arises due to introduction of Service tax or increase in income tax, freezing the assets of the bank by the legal authority etc. Human Risk Labour unrest, lack of motivation, inadequate skills, problems faced by the bank after implementation of VRS lead to Human Risk. Technology Risk Obsolescence, mismatches, breakdowns, adoption of latest technology by competitors, etc, come under technology risk

Interrelationship of risk
CREDIT RISK

MARKET RISK

OPERATING RISK

MANAGEMENT OF CREDIT RISK

Measurement through Credit Rating / scoring Quantification through estimate of expected loan losses Pricing on a scientific basis Controlling through Effective loan review mechanism and portfolio management

TOOLS OF CREDIT RISK MANAGEMENT

EXPOSURE CEILINGS :Setting
of prudential norms related to the Banks exposure to a single borrower / group borrowers / sectorial borrowers

REVIEW / RENEWAL :

This involves multi-tier credit approving authority, constitution wise delegation of powers, higher delegated powers for better rated borrowers, discriminatory time for credit review / renewal, hurdle rates / benchmarks for fresh exposures & periodicity for renewal based on risk rating.

COMPREHENSIVE MODELS

RISK

RATING

RISK BASED SCIENTIFIC PRICING:

loan pricing to expected loss

Linking

PORTFOLIO

Stipulate quantitative ceiling on specific rating categories, distribution of borrowers in various industries / business groups , rapid portfolio reviews, on-going system for identification of credit weaknesses well in advance, initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision making process.

MANAGEMENT

TOOLS OF CREDIT RISK MANAGEMENT

LOAN REVIEW MECHANISM : This should be done independent of credit operations & administration and cover all the loans above certain cut-off limit ensuring that at least 30 40% of the portfolio is subjected to LRM in a year.

STATISTICAL TOOLS
The probability of default (also call Expected default frequency) is the likelihood that a loan will not be repaid and will fall into default. PD is calculated for each client who has a loan or for a portfolio of clients with similar attributes (for retail banking). The credit history of the counterparty / portfolio and nature of the investment are taken into account to calculate the PD.

Loss Given Default

The amount of funds that is lost by a bank or other financial institution when a borrower defaults on a loan. Academics suggest that there are several methods for calculating the loss given default, but the most frequently used method compares actual total losses to the total potential exposure at the time of default.

For example
, if Bank X loans Rs 1 million to ABC Company and ABC defaults on the note, Bank X's loss isn't necessarily Rs1 million. This is because Bank X may hold substantial assets as collateral, and/or may use the courts in an effort to be made whole. When all of these variables are factored in, Bank X may have lost substantially less than the original RS 1 million loan. The process of analyzing all of these variables (as well as all of the other loans in Bank X's portfolio) is paramount to determining the loss given default.

Exposure At Default
A total value that a bank is exposed to at the time of default. Each underlying exposure that a bank has is given an EAD value and is identified within the bank's internal system. Using the internal ratings board (IRB) approach, financial institutions will often use their own risk management default models to calculate their respective EAD systems.