Basel Capital Accord &

Risk Management in Banks

Presentation at Dr.D.Y.Patil Institute of
Management & Research

On 09.02.2011

Shri. V E Dalvi
General Manager
Bank of Maharashtra
Integrated Risk Management
 What is Bank Capital
• A bank balance sheet gives the financial conditions
of the bank.
• It consists of Assets and Liabilities
• Assets such as Loans which are income producing
items.
• Liabilities such as deposits which are what it owes
or sources of funds for Bank
• Capital:-It is defined as assets minus liabilities

Bank Balance Sheet

Assets Liabilities & Capital
Loans 1000 Deposits 900
Capital 100
Total 1000 Total 1000 2
 Why Bank Need Capital
• Bank needs capital for protection in case of losses on
loans or other assets
• Suppose borrower defaults on loan of Rs 50, After
Loan loss capital falls by amount of loss
• The Bank still owes depositor Rs 900
• If capital falls below zero
• Bank's assets are no longer enough to cover what it
owes depositors. It is insolvent and must cease
operations Its share holders lose every thing they have
invested.
Balance Sheet of the bank
Assets Liab & Capital
Loans 950 Deposits 900
Capital 50
Total 950 950 3
 More leverage Means More Risk
• A Bank with less capital in Balance Sheet of a
relation to its assets is said to
have higher leverage
Bank
• High Leverage puts a bank at Assets Lia & Capital
greater risk of insolvency. Loans 1000 Deposit 500
Capital 500
• The low leverage bank could
survive up to Rs. 500 loan Total 1000 1000
Losses
• The Higher Leverage bank Loans 1000 Deposit 900
would become insolvent after Capital 100
just Rs. 100 loan losses. Total 1000 1000

4
 But More Leverage means Higher Returns
• More leverage means higher risk, but also
higher returns for shareholders if the bank
remains solvent
• Assume interest received from Loans to be 10%
and interest paid on deposits to be 8%.
• In first case income will be Rs 100 and Cost of
Deposit will be Rs 40 so profit will be Rs 60. so
return on capital of Rs 500 is 12%
• In second case income will be Rs 100 and Cost
of Deposit will be Rs 72 so profit will be Rs 28.
so return on capital of Rs 100 is 28%
5
 Who Regulates Bank Capital
• Bank Regulators of individual countries (RBI) do
not act alone in setting rules for bank capital.
They coordinate their capital regulation through
the Basel Committee on Banking Supervision
(BCBS)

• The Committee meets at the Bank for

International Settlement (BIS), an international
organization, founded in 1930, that fosters
monetary and financial cooperation and acts as
a bank for central banks
6
 The Basel Accords
• The Basel Committee periodically issues ”Accords” that
set out international standards for bank capital as well as
other bank regulations.
• The first Basel Accord, now called Basel I were issued in
1988.
• RBI implemented in India w.e.f. 1992 with introduction of
IRAC norms and provisions for loan losses.
• Basel I Accord replaced by a new set of standards ,
Basel II , in 2004.
• In India, it was implemented w.e.f 31.03.2008 to Foreign
Banks having branches in India and Indian Banks having
International Presence and w.e.f 31.03.2009 for all other
commercial Banks in India.

7
 Basel I vis-à-vis Basel II

Basel I Basel II
Focus on single risk More emphasis on banks’ own
measure internal risk management
methodologies, supervision
review and market discipline.

‘One size fits all’ & More risk sensitive approach,

‘Broad Brush Flexibility, capital incentives for
Approach’ better risk management.
Centered around Operational Risk addressed
Credit Risk & Market
Risk
8
 CRAR
• Capital to Risk weighted Asset Ratio
(CRAR)

• CRAR = Capital (Tier I +Tier II)

Risk Weighted Assets CR, MR OR
• Minimum As per Basel II 8%
• As per RBI 9% Why? (as cushion)

9
 Elements of Capital
 Tier I
– Paid up equity, statutory reserves
– Capital reserves
– Innovative perpetual debt instruments (IPDI)
– (max 15% of Tier I)
– Other instruments notified by RBI
 Tier II
– Revaluation reserves
– General provisions and loss reserves
– (max 1.25% of RWA)
– Hybrid debt capital instruments (Upper Tier II)
– Subordinated debt (Lower Tier II)
– Surplus innovative perpetual debt Instruments
(IPDI) in excess of 15% taken in Tier I
10
 Basel II Pillars
Basel II framework rests on 3 mutually reinforcing
pillars which are :

• Pillar I -Sets out minimum capital requirements

• Pillar II -Supervisory Review of Capital Adequacy
• Pillar III -Market Discipline

– The II & III Pillars are complementary to Pillar I

– Regulatory Capital Charge for risk
• Credit, Market & Operational Risks
– Evolutionary in Risk Sensitivity to Capital Regime
– Transparency in Public Reporting
11
Pillar 1- Methods for assessment of capital
adequacy
Credit Risk Market Risk Operational
Risk
Standardized Standardized Basic Indicator
Approach Approach Approach
Foundation IRB Standardized
Approach Internal Models Approach
Advanced IRB Approach Advanced
Approach Measurement
Approach
12
Basel-II Framework

13
 Capital Charge : Credit Risk STD Approach
 RW for Domestic Sovereign - Central Govt. DICGC = 0%
State Govt. and ECGC cover = 20%
 RW for Claims on Corporate /PSEs
Short term Rating P1+ P1 P2 P3 P4 & P5 UR
Domestic Long AAA AA A BBB BB & UR
Term Rating Below
Risk Weight 20 % 30 % 50 % 100 % 150 % 100%
 RW for Regulatory Retail 75%
 RW for Banks: Linked to CRAR if <9% 20%
 Housing Loans 50% to 125% LTV > or <=75% and
amount of Loan is <Rs.30 lakh, < 30lakh to 75 Lakh and <75 lakh
 Consumer Loans, Capital Market Exposure= 125%
 Staff Loans 20%
14
 What is Risk Management
Basic Elements of the Risk Management
• Identifying the Risk
• Quantifying/Measuring the Risk
• Controlling the Risk &
• Managing the Risk.

15
 Types of Risk &
Risk profile of Bank/FI
Various Types Of
Risks
Other Risks
Op. Risk
• Credit Risk Liq. Risk

• Market Risk
Mkt. Risk Credit Risk
• Liquidity Risk
• Operational Risk

16
 Objectives of Risk
Management
 TO optimize the Risk Adjusted Returns
and not to minimize the absolute Risk.

 Taking the Risk with prudential

safeguards and not to avoid or
eliminate the Risk.

17
 What is Credit Risk?
• Credit risk is a risk resulting from uncertainty
in a counterparty’s ability or willingness to
meet its contractual obligations.
• Credit risk is the probability of losses
associated with changes in the credit quality
of borrowers or counterparties.
• These losses could arise due to outright
default by counterparties or due to
deterioration in credit quality even when
default has not taken place
18
Why should Banks be concerned
with Credit Risk?
Nature of Loan Returns
Borrower A has been sanctioned a term loan of Rs
10 crore, for 1 year at 10% rate of interest (annual)
Upside gain
• If A does not default
 Rs 11.00 lcrore at the end of 1 year
is limited

• If A does default Downside loss

 Rs 0 under extreme circumstances
 Rs 50 lac if we can recover 50% is large

of the principal

19
Why should Banks be concerned
with Credit Risk
Skewed nature of loan returns
• Loan returns are highly asymmetric since there is limited
upside
• If borrower’s credit quality improves - no benefit to
lending bank since the borrower can refinance his loan
at a lower rate
• If borrower’s credit quality declines - bank is not
compensated for taking the additional risk since loan
price is not revised
• If borrower defaults - accrued interest is reversed and
any new payments are towards principal
• If borrower becomes NPA - minimal recovery
20
 Risk Identification
Elements of Credit Risk

Credit Risk

Portfolio Risk Individual Risk

Concentration Intrinsic Downgrade Default

Risk Risk Risk Risk
Recovery
Risk 21
 Why Manage Credit Risk?
Market Realities
• structural increase in non performing assets
• higher concentrations in loan portfolios
• increasing competition leading to lower spreads
• Volatility in values of Collateral
• growth of off-balance sheet credit products (as a
consequence of enhancing non-interest income)
Changing Regulatory environment
• Basel II implementation
Risk Vision
• Capital is a scarce resource – need for optimal
utilization
22
 Credit Risk Management - Tools

 Credit Approving Authority

 Prudential Limits
 Credit Risk Rating
 Risk Pricing
 Controlling the risk through effective
Portfolio Management Loan Review
Mechanism and.
 Estimation of Expected loan losses
 Estimation of Unexpected loan losses
23
 Prudential limits
For individuals Borrowers including NBFC-AFC:
Excl. Infrastructure 15 % of Total of Tier I and Tier II Capital as
Finance on 31.03.2007 (Rs. 449.74 crore).
Infrastructure 20% of Total of Tier I and Tier II Capital as on
finance 31.03.2007 (Rs. 599.65 crore).
For Group Borrowers including NBFC-AFC:
Excl. Infrastructure 40 % of Total of Tier I and Tier II Capital as
Finance on 31.03.2007 (Rs. 1199.31 crore).
Infrastructure 50 % of Total of Tier I and Tier II Capital as
finance on 31.03.2007 (Rs. 1499.14 crore).
INDIVIDUAL NBFC
Excl. Infrastructure 10% of Total Tier I and Tier II capital as on
31.03.2007 (Rs. 299.82 crore)
For Infrastructure 15% of Total Tier I and Tier II capital as on
31.03.2007 (Rs. 449.74 crore) 24
 Exposure Norms
• Policy on Very Large Exposure:

Entry Level sub ceiling for

– Individual/ Proprietary concerns - Rs. 5.00 crore
– Partnership / Private / Public Ltd. Co. - 10% of Bank’s net
worth as of 31st March 2007. (This ceiling excludes
PSUs, State Govt. owned companies, State Govt. Bodies)

Entry Level exposure beyond above ceiling will be

treated as very large exposure. The very large exposure
shall be taken only under Consortium/ Multiple Banking
Arrangements, where minimum credit risk rating shall be
“A”.

• Substantial Exposure Limit:

Threshold limit - 10% of the total capital funds as on
31.03.2007 Substantial exposure limit- 7.5 times of the
Bank’s capital funds as on 31.03.2007.

25
 Exposure ceilings - Sectors
No Particulars Exposure not to exceed
1. Real Estate Sector- 30% of Gross Credit
of which
a) Housing Loans to Individuals 12.5% of Gross Credit
b) Comm. Real Estate 7.5% of Gross Credit
c) Indirect Real Estate 10% of Gross Credit
2 Shares, Debentures and Bonds 10% of Net Worth
3 Advances to Stock brokers 10% of Net Worth
4 Advances to NBFCs /NBFIs 20% of Gross Credit
of which
Housing Finance Companies 10% of Gross Credit
NBFC – ND - SI 2% of Gross Credit
All Other ( NBFC- D, AFC, 8% of Gross Credit
Factoring and other activities) 26
 Exposure ceilings - Sectors
No Particulars Exposure not to exceed
5 Infrastructure 25% of Gross Credit
of which
a) Power Sector 10% of Gross Credit
b) Roads incl. Highways 5% of Gross Credit
c) Telecommunication 3% of Gross Credit
d) Residual Infrastructure 7% of Gross Credit
Activities
6 Any other sector 10% of Gross Credit
7 Non Fund Business 30% of Gross Credit
8 Unsecured Exposure 35% of Gross Credit
(excluding Food Credit and
Staff Schematic advances) 27
 Exposure ceilings - Industries
No Particulars Exposure not to exceed
1 Sugar Industry 2% of the Gross Credit
2 Advances to Film Industry 1% of the Gross credit
(Cinema Theatre etc.)

3 Software/ IT Industry 5% of Gross Credit

4 Auto and Auto Ancillary 10% of Gross Credit
5 Any other Industry 10% of Gross Credit

Exposure ceilings:
Indian Joint ventures/wholly owned subsidiaries abroad:
Not to exceed 20% of unimpaired capital funds
(Tier I and Tier II capital).

28
 What is Credit Risk Rating

Rating is an assessment/ evaluation of a person,

property, project against a specific yardstick /
benchmark.
Objective of Credit Rating
• Assess a particular credit proposition (incl.
investment) on the basis of certain parameters
• Outcome of rating - Degree of reliability & risk

29
 Credit Risk Rating
It helps in-
• Evaluation of borrower on the basis of certain
parameters (Outcome: Degree of reliability & risk)
• Credit selection / rejection (Entry level rating –
Benchmark rating)
• Activity-wise/ sector-wise portfolio study keeping in
view the macro-level position.
• Estimating concentration risk within a portfolio
• Deciding concentration limit and exposure limit
• Deciding exit point of syndicated loans

30
 Credit Risk Rating Models

The model should provides for

assessment of risks under various
components: such as
•Financial Risk
•Account Operating risk
•Management Risk
•Industrial Risk
•Business Risk &
•Project Risk
31
 Credit Risk Rating Model

Within each risk component, risk parameters

and Risk factors have to be identified
Each risk factor should be assigned weight
according to its Importance
Scoring Norms should be developed for
assigning scores to each risk factor

32
 CRR Model - Risk parameters

• Financial Risk
– Assessment of Financial Statements
– Past Financial Performance
– Future risk
– Cash Flow adequacy (Projected)
• Account Operating Risk
– Security Coverage
– Conduct of the account
– Observance of financial discipline
– Maturity risk
33
 CRR Model - Risk parameters

• Management Risk
– Ownership Experience & Competence
– Track record
– Corporate Governance
• Industry Risk
– Industry Characteristics
– Competitive forces within the industry
– Industry financials

34
 CRR Model - Risk parameters
• Business Risk
– Market Position
– Operating Efficiency
– Growth
• Project Risk (For Project Loan only)
– Timeliness in completion of the project
– Cost escalation of the project
– Funding arrangement for cost escalation
– Achievement of production target
– Deficiency in management of the project
– Repayment period of loan (Excluding Moratorium
Period)
35
 Rating Migration
During the period of 12 months
Rating AAA AA A BBB BB B C Default Total

AAA 900 50 40 10 1000

AA 200 1500 200 50 50 2000

A 300 450 1800 300 50 50 50 3000

BBB 200 200 300 700 100 50 50 100 1700

BB 50 50 100 100 200 50 100 50 700

B 20 20 40 20 50 50 80 70 350

C -- -- 25 25 25 25 300 200 600

36
 Probability of rating Migration
During 12 months period
Rating AAA AA A BBB BB B C Default
% % % % % % % %

AAA 90% 5% 4% 1%

AA 10% 75% 10% 2.5% 2.5%

A 10% 15% 60% 10% 1.6% 1.6% 1.6%

BBB 12% 12% 17% 42% 6% 3% 3% 5%

BB 7% 7% 14% 14% 28% 7% 14% 9%

B 6% 6% 12% 6% 14% 14% 22% 20%

C 4.2% 4.2% 4.3% 4.3% 50% 33%

37
 Measuring credit Risk
Formulation of Credit risk models
• Probability of default(PD)
• PD is the probability of a particular credit
facility defaulting within a given time horizon
(usually 12 months)

• PD is the primary output of a credit risk model

• Estimation of PD is based on rating migration

in 1 year time horizon over a period of time

38
 Measuring credit Risk
Formulation of Credit risk models

Loss Given Default (LGD)

• LGD is the percentage of exposure lost
when default occurs (1- recovery rate).
• It is related risk measure to PD.
• LGD data sources are: bank’s own
historical data by risk segment, trade
association data, published regulatory
reports and rating agency reports.

39
 Measuring credit Risk
Formulation of Credit risk models

Estimation of Expected Loss (EL)

• EL= PD x LGD x EAD
• EL is average loss expectation– will vary
from year to year
• EL shows the amount of credit loss a bank
would expect on its credit portfolio over
the chosen time horizon.
• To begin with RBI introduced IRAC Norms
(Standard, Sub Standard, Doubtful and Loss
Assets and Provision of 10%, 30 to 50% and
100%).
40
 Measuring credit Risk
Formulation of Credit risk models
Credit exposure (Rs. in crore)
Amount Initial PD (%) LGD(%) Expected
of EAD Rating Loss
1000 AAA 0 0.5 0
1000 AA 0 0.5 0
800 A 0.06 0.5 0.24
600 BBB 0.18 0.5 0.54
400 BB 1.06 0.5 2.12
500 B 5.20 0.5 13.00
200 C 19.79 0.5 19.79
4500 Total 35.69
41
 Measuring credit Risk
Formulation of Credit risk models
• Estimation of Unexpected Loss (UL)
• UL is the amount by which actual
losses exceed the expected loss.

• UL is impacted by many things,

particularly volatility.

42
 What is Market Risk
• Market Risk is the possibility of loss to
the bank caused by changes in market
variables such as Interest Rate, FEX
Rate, Equity Price and Commodity
price
Loss arises in two ways
• Loss to the earnings and
• Decline in the economic value of the
assets.

43
 Market Risk Management
• Market risk involves management of
risk in following areas as under
Liquidity Risk
• Interest Rate Risk
• Foreign Exchange Risk
• Equity Price Risk &
• Commodity Price Risk

44
 Liquidity Risk
Liquidity means
• Ability of bank to honor the
commitments as and when it falls
due.
• Bank’s inability to honor the
commitments to meet the liquidity is
called Liquidity Risk
45
 Types of Liquidity risks

• Funding Risk
Need to replace net outflows due to unanticipated
withdrawal/non-renewal of deposits
• Time Risk
Need to compensate for non-receipt of expected
inflows of funds- NPAs
• Call Risk
Due to crystallisation of contingent liabilities &
needs of new business
46
 Liquidity Risk Management
• Liquidity Risk is measured through
Structural Liquidity Statement and Short
Term Dynamic Statement.
• Liquidity Risk is managed through Asset
Liability Management.
• ALCO is the Committee who monitored
and managed liquidity by deciding on the
requirement of funds by changing interest
rates on assets and liabilities.
47
 Structural Liquidity Statement
Outflow Day 2 to 7 8-14 15-28 29d 3-6 6-12 1 -3 3-5 total
1 days days days -3m mt mths yr yr

Dep 5 10 15 20 30 20 100 100 100 400

Borrowin 2 3 5 10
Total 7 13 20 20 30 20 100 100 100 410

Inflow
Loans 2 8 10 15 25 10 50 80 100 300

Invest 2 3 5 10 10 5 10 50 50 145

Total 4 11 15 25 35 10 70 130 150 450

Gap -3 -2 -5 -5 -5 10 30 -30 -50

As per RBI Negative Cumulative Mismatch for First 4 time

48
Buckets should not be > than 5%,10%, 15% and 20%.
 Interest Rate Risk
Why there is Interest Rate Risk?
• On account of Banks core business being
financial intermediation and asset
transformation
• Due to periodical renewal of assets and
liabilities
• Due to mismatches between
maturity/repricing dates as well as maturity
amounts between Assets and Liabilities
• Since depositors and borrowers can pre-
close their accounts
49
 Interest Rate Risk

Rising interest rate scenario

• Deposits rates are Fixed
Interest expenses will be same
• Loans Rates are Floating
Interest income will increase resulting
into increase in NII

50
 Interest Rate Risk

Falling Interest rate scenario

• Deposits Rates are fixed

Interest expenses will be same

• Loans Rates are Floating

Interest income will be less

• NII will reduced.

51
 Types of Interest Rate Risk
• Gap or Mismatch Risk
• Basis Risk
• Embedded Option Risk
• Price Risk
• Reinvestment Risk
• Revaluation Risk/Regulatory Risk

52
 Interest Rate Risk
Gap/Mismatch Risk
• It arises on account of holding rate
sensitive assets and liabilities with different
principal amounts, maturity/repricing rates
• Even though maturity dates are same, if
there is a mismatch between amount of
assets and liabilities it causes interest rate
risk and affects NII

53
 Interest Rate Risk
Gap Report

1. RSA > RSL = POSITIVE GAP

2. RSL > RSA = NEGATIVE GAP

3. RSA = RSL = NEUTRAL GAP

54
Interest Rate Risk
Basis Risk
• Basis risk occurs when interest rates of
different assets and liabilities move in
different magnitudes

• there will be interest rate risk due to

movement of interest rates in different
magnitudes for different types of
assets and liabilities
55
 Interest Rate Risk
Embedded Option Risk
• Pre-payment of loans in case of falling
interest rates
• Premature withdrawal of deposits in
case of rising interest rates
• In both the cases bank’s actual NII is
less than the anticipated NII

56
 Interest Rate Risk
Price Risk

Bond prices and interest rates are

inversely related

57
 Interest Rate Risk
Reinvestment Risk
• It is difficult to correctly predict the
interest rates at which future cash
flows will be invested. This uncertainty
causes reinvestment risk

• If interest rates declines, reinvestment

will be at lower rate
58
 Interest Rate Risk
• Revaluation Risk/Regulatory Risk
• Occurs when revaluation of assets are
to be done as per regulatory
prescriptions
• When regulators change the norms the
assets may have to be re-valued as per
the changed norms and this may
reduce the value of total assets
59
 Interest Rate Risk
• Measures of IRR
• Maturity Gap Analysis – to measure
interest rate sensitivity of earnings or
NII
• Duration Gap Analysis – to measure
interest rate sensitivity of equity
• Simulation
• Value at Risk
60
 IRR Management - Falling
Interest Rate Scenario

 Increase maturities of investment

portfolio
 Increase fixed rate loans
• Increase short-term deposits /
borrowings (reduce maturity of
liabilities)
• Increase floating rate deposits

61
 IRR Management - Rising
Interest Rate Scenario
• Reduce investment portfolio maturities
• Increase floating rate assets
• Increase short-term assets
• Increase long-term
deposits/borrowings
• Sell fixed rate assets

62
 Operational Risk
• WHAT if suddenly ATMs stopped vending
crisp notes, bank branches closed for few
days, the data centre of major banks shut
down, busy operations in dealing rooms of
major banks come to a halt and banking
personnel don't reach their offices.

• This is not a doomsday scenario but what

actually happened during the Mumbai floods.
Uncertainty has crept into our lives. In
technical parlance, we can call the risk
involved in running daily operations
"operational risk",

63
 What is Operational Risk?
Basel II has defined operational risk as “
the risk of loss resulting from inadequate
or failed internal processes, people and
systems or from external events”. Basel II
has clarified that OR includes legal risk
but specifically excludes strategic and
reputational risks.

64
 Definition of Operational Risk
Causal Categories:
Employee Behaviour
Potential or Corporate Behaviour
Forward looking Information
Technology
External Environment

The risk of loss resulting from inadequate or failed

or
external events
internal processes,
people & systems Inadequate collateral
management
External Fraud, Unenforceable documentation
Fire, Flood,
“People and systems” in Legal action,
the regulatory definition Tax,
are captured in internal Regulations,
process Terrorism
65
 Scope of Operational Risks

• Op-risk is as old as banking itself.

• Present in virtually all bank transactions
and activities

• Clear appreciation and understanding by

banks of OR is crucial to effective
management and control thereof

66
 Basel II definition-
Analysing specific risks: People Risk
• Employee fraud ( collusion, embezzlement, theft,
programming fraud)
• Unauthorized activity ( insider trading, misuse of
privileged information, limit breach, incorrect models-
intentional, aggressive selling tactics, ignoring/short
circuiting procedures ( deliberate)
• Employment practices and workplace
safety-(employee turnover, loss of key personnel,
motivation, leave /absence from work, wrongful termination,
discrimination/harassment, non-adherence to employment
laws, workforce disruption, lack of suitable personnel)

67
 Basel II definition-
Analysing specific risks: Process Risk
• Transaction risk- Payment/settlement /delivery risk- failure
of /inadequate payment/settlement processes, losses through
reconciliation failure, delivery errors

• Documentation risk- document not designed properly,

inadequate clauses/contract terms, inappropriate contract
terms, failure of due diligence;

• valuation/pricing ( model risk);

• Internal/external reporting ( inadequate financial reporting,

inadequate regulatory reporting, inadequate stock exchange
reporting), compliance ( failure of internal/external compliance
procedures);

• Selling risks ( product complexity, poor advice) 68

 Basel II definition-Analysing specific
risks: Systems Risk
Technology risk
# System failure
# Security breaches
#Communications failure
# Backup & disaster recovery

69
 Basel II definition-Analysing specific risks:
Risk from External Events
• Legal liability- breach of law, misrepresentation,
etc.
• Criminal activities- external frauds, robberies,
money laundering, physical damage to property
caused by vandalism, arson
• Outsourcing risk- inadequate contract, delivery
failure( ontime, quality service), inadequate mgt of
service providers, bankruptcy of supplier, misuse of
confidential data, etc.
• Disasters - earthquakes, floods, fire, transport
failure, energy failure, external telecommunication
failure, etc.
70
 Benefits of Operational Risk
Management
• Improve operating efficiency
• Reduce earning volatility
• Improve reputation
• Advance the external rating
• Enhance the performance measurement by linkage to
risk sensitivity
• Proper Capital Allocation

71
ORM framework under Basel II

 All the three pillars of the New Capital Accord play an

important role in OR capital framework

 3 methods of calculation of OR in a continuum of increasing

sophistication and risk sensitivity:

1) Basic Indicator Approach

2) Standardized Approach

3) Advanced Measurement Approach

72
 Basel II - 3 methodologies for estimation of
Minimum Capital Requirement

From 31.03. 2009 BIA has been adopted by all banks in India

Basic Indicator Approach (the alpha)

Capital = *gross income ( =15%)
Standardised Approach (the betas)
Capital = *gross income, by business lines ( 12%, 15% or
18% depending on business line)

Advanced Measurement Approach (AMA)

Capital = firm specific calculation 73
 Computation of Capital Charge for
OP Risk as per BIA
Capital Charge = 15% of Avg Gross Income for
Last 3 years.
Gross Income = Net Profit
+ Provisions & Contingencies
+ Operating Expenses
- Profit on sale of HTM Investment
-One time Income (Insurance Income)
-Profit on sale of Immovable/Movable
assets.
• If there is Loss in any year, it should be excluded.
74
 Operational Risk capital:
Standardised Approach
Business Lines Beta Factors

1.Corporate finance 18%

2.Trading and sales 18%
3.Retail banking 12%
4.Commercial banking 15%
5.Payment and settlement 18%
6.Agency services 15%
7.Asset management 12%
8. Retail brokerage 12%
75