Risk Management

BY – RAJENDRA MOHANTY
TARGET GROUP –CAIIB

Certified training institute for IIBF flagship certification courses, such as DB&F, JAIIB, CAIIB, CCP, Forex etc.
What is Risk?
• Risk is a possible outcome of
a negative result of our
action.
• Risk is an uncertainty which
may result in negative
deviation of our planned
objective or target.
What is Risk?
• Two factors are responsible for
Risk:
• Uncertainties
• External factors
What is Financial Risk?
• Financial Risk – uncertainties in adverse variations of
profitability or outright losses.
• Financial Risk is the probability that the realized return
would be different from the anticipated or expected
return on the investment made.
What is Financial Risk?
• Profit or Loss in a business depends on the net of cash
inflows & cash outflows.
• Net Cash Flow = Cash Inflow – Cash Outflow
• Cash Inflow > Cash Outflow = Profit
• Cash Outflow > Cash Inflow = Loss
• Uncertainties in both cash inflow and outflow would eventually
result in net cash inflow i.e. either profit or loss.
 Tomato Yesterday Today Tomorrow

Sale Volume 80 kg 100 Kg 50 Kg

Sale Unit price Rs.12/kg Rs.15/kg Rs.10/kg

Inflow Rs.960 Rs.1500 Rs.500

Variation in Sales volume and unit price realisation would create uncertainties in
cash inflows.
Tomato Yesterday Today Tomorrow
Purchase Volume 80 kg 100 kg 50 kg
Purchase Unit Price Rs.12/kg Rs.8/kg Rs.15/kg
Transport cost Rs.200 Rs.250 Rs.100
Admin Exp. Rs.200 Rs.200 Rs.200
Outflow Rs.1360 Rs.1250 Rs.1050

Similarly due variations in purchases and administrative or transportation

costs would also create uncertainties in cash outflows.
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What is Financial Risk?
• The possible adverse impact is Risk in
business.
• The factors that are responsible for
creating uncertainties in cash inflow or
cash outflow are called the Risk
Elements.
• What is high risk business?
• Higher risk would imply higher upside and
downside potential.
• What is low risk business?
• Lower risk implies lower variability in net
cash inflow with lower upside or downside
potential
Risk-Free or Zero-Risk
• It implies that there would be no variations in net cashflow.
• Example: Someone invests Rs.1 Lakh in a Bank FD or Govt.
Bond for 5 years, where the agreed rate of interest is say @6.5%
p.a. which is payable half-yearly.
• He or she would be receiving interest of Rs.3250 every half year
for 5 year period, and finally will get back the principal amount
on maturity.
• Here the cashflow does not vary, i.e. there is no uncertainty at
all. These are called risk-free or zero-risk investments.
• Return on Zero Risk investments would be always low as
compared to other opportunities available in the market.
Example
Cash Year 1 Year 2 Year 3 Year 4 Year 5 (Total)
Flow (000)
Invst. 1 10 10 10 10 10 50
Invst. 2 9 10 13 -3 21 50

Cash Year 1 Year 2 Year 3 Year 4 Year 5 (Total)

Flow (000)
Invst. 3 14 -4 23 -3 24 54

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Linkage between Risk, Capital & Return
• Minimum Capital Required for a business should be such that
it is able to meet the maximum loss that may rise from the
business which would avoid bankruptcy.
• Capital Requirement for high-risk business will be higher, and
that of low-risk business would be lower – This is the basic
linkage between Risk & Capital.
• As regards profit or loss:
• High-risk business => either higher profits or higher losses.
• Low-risk business => either lower profits or lower losses.
• So, when the risk in a business or investment is netted against
the return from it, then it is called: Risk Adjusted Return on
the Investment, or Risk Adjusted Return on Capital.
Linkage between Risk, Capital & Return
• Risk Adjusted Return on Investment or Capital is popularly known
as RAROC.
• RAROC is the key factor in the investment decisions of an
investor.
• Higher the RAROC => Higher would be the reward, and vice
versa.
• The key driver in managing any business is seeking
enhancement in RAROC.
Case Study 1 Project A Project B
Exposure ₹20 Lakh ₹45 Lakh
Expected Total Revenue ₹1 Lakh ₹2 Lakh
Expected Total Expenditure ₹0.50 Lakh ₹1 Lakh
Risk Weight of exposure 20% 20%
Case Study 2
• There are 3 borrowers P, Q, R who have approached you for a loan of
₹1 Lakh each. AS per their respective Credit Ratings, the applicable
RW of the borrowers are 150%, 75% & 50%. If the expected return
from each of them is ₹12000, ₹9000 and ₹8000 respectively. Then
find out to which borrower you will inclined to sanction the loan,
when the cost of capital is 13%.
Why Risk Management?
• Impact of uncertainties – variation in cash flows
• Unfavourable impact i.e. Risk in the business is not constant
• If cashflows are badly affected => High losses => Capital erosion =>
Total wipe out of Capital => Bankruptcy
• To save from bankruptcy -> the loss potential of the business to be
controlled => Risk needs to be managed.
• These loss potentials are the cost of the business.
• Loss potential of a business is correlated to the risks in
the business, which has to be managed efficiently.
Risk Management
• RM is the process of assessing the actual or
potential dangers of a particular situation.
• Measures of loss potential is critical as it helps to
arrive at how much capital is required for the
business.
• Loss assessment due to risks to be accounted for by
treating risks as the cost of business.
Risk Management Framework in Bank
• Top Management’s main concern
• Risk Limits setting based on economic measures of risk
• To ensure the best risk adjusted return is achieved
• Risk Management requires special skills to manage the risk in any
business
• What is the hierarchy of this framework in Banks?
• What are their roles?
Hierarchy of a Risk Management Portfolio

[Link] of Directors
[Link] Management Committee of the Board
[Link] of Senior-Level Executives
i. ALCO – Asset Liability Committee
ii. CRMC – Credit Risk Management Committee
iii. ORMC - Operational Risk Management Committee
[Link] Management Department/Support Group
Steps in Risk Management
[Link] Identification
[Link] Measurement
[Link] Pricing
[Link] Monitoring & Control
[Link] Mitigation
Risk Identification
• It consists of identifying various risks associated with
risk taking at the transaction level and examining its
impact on the portfolio and capital requirement.
Banking Risks
LIQUIDITY INTEREST RATE RISK MARKET RISK CREDIT RISK OPERATIONAL
RISK RISK
Funding Risk Gap/Mismatch Risk Interest Risk Default Risk Transaction Risk

Time Risk Basis Risk Market Liquidity Counterparty Risk Compliance Risk
Risk
Call Risk Reinvestment Risk Forex Risk Country Risk Reputation Risk

Embedded Option Strategic Risk

Risk
Banking Risks
LIQUIDITY INTEREST RATE RISK MARKET RISK CREDIT RISK OPERATIONAL
RISK RISK
Funding Risk Gap/Mismatch Risk Interest Risk Default Risk Transaction Risk

Time Risk Basis Risk Market Liquidity Counterparty Risk Compliance Risk
Risk
Call Risk Reinvestment Risk Forex Risk Country Risk Reputation Risk

Embedded Option Strategic Risk

Risk
Risk Measurement
• Banking Book
• Trading Book
• Off-Balance Sheet

• Quantitative Measurement of Risk

• (a) To measure variations in earnings
• (b) To measure variations in market
value
• (c) To measure losses due to default
Risk Measurement
• Sensitivity
• Mac Duration
• Modified Duration
• Volatility
• BPV
• VaR
Sensitivity
• Sensitivity captures or measures the deviation of a
target variable due to change in single market
parameter.
• Market Parameters:
• Interest Rate
• Exchange Rate
• Stock Price
• Demand-Supply position
Sensitivity
▪ The interest rate gap is the sensitivity of the
interest rate margin of the Banking book.

▪ Duration is the sensitivity of investment portfolio

or Trading book.

• Sensitivity has two significant drawbacks

 Mac Duration & Modified Duration
• Mac Duration describes a bond’s price sensitivity to the change in its yield.
• Example – A 3 year Bond – Face Value ₹1000 with annual coupon rate 4%
payable annually - Current Market interest rate being 4.5%. (i) Find the present
market price of the bond, and (ii) If market rate changes by 1% what would be
the price of the bond?
Volatility
▪ Volatility is about the stability or instability of any
random variable.

▪ Random variables are

▪ Earnings,
▪ Mark-to-market values,
▪ Market Value,
▪ Loss due to Default etc.
• Volatility is captured as the standard deviation of
these values, where the Standard deviation is the
square root of the variance of the random variable.
Example of Volatility – Working out the σ (sigma) –
Standard Deviation
n Month Share Price (p) Mean (m) Deviation (p-m) Square of Deviation
1 March 100 114 - 14 196
2 April 110 114 - 04 16
3 May 90 114 - 24 576
4 June 120 114 +6 36
5 July 150 114 + 36 1296
Total 2120
Average of sum of square root of Deviations i.e. 2120/(n-1) = 2120/4 530
So, Standard Deviation (σ) = √ 530 = 23.02 23
Volatility - BPV – Basis Point Value
• BPV is a method to measure interest rate risk.
• BPV is the change in value of an investment due to 1 basis point
(0.01%) change in market yield.
• It tells how much money your position will gain or lose for a 0.01%
movement in the yield.
• Higher the BPV of a Bond, higher is the risk associated with it.
• Example : A 5 year 6% semi-annual bond @ market yield of 8% has a
price of Rs.92, which raises to Rs.92.10 at a yield of 7.95%.
Volatility - VaR
• VaR describes how much we can lose in a portfolio, i.e. what is the loss
potential?
• VaR will have - (i) time horizon, (ii) confidence level and (iii) maximum loss
potential.
• A bank having 1 day VaR of Rs.10 crore with 99% confidence interval means
that there is only 1 day in 100 days (or 2.5 days per year based on 250
working days in a year) where the daily loss will be more than Rs.10 crore
under normal trading conditions.
• Question – 1 day VaR of a portfolio of Rs.5 Lakh with 95% of confidence
level. In a period of 6 months, how many times the loss on the portfolio
may exceed Rs.5 Lakh?
Volatility - VaR
• Question – 1 day VaR of a portfolio is Rs.5 Lakh with 97% confidence
level, then in a period of 1 year (assuming a year is 250 working days),
in how many days the loss on the portfolio may exceed Rs.5 Lakh?
Volatility - VaR
• Question – 1 day VaR of a portfolio is Rs.5 Lakh with 90% confidence
level, then in a period of 1 year (assuming a year is 250 working days),
in how many days the loss on the portfolio may not exceed Rs.5
Lakh?
VaR - Problem
• Mr. X has invested ₹1 Crore in equity shares of ABC Ltd. Co. The
market price standard deviation of the shares he is holding is 2% per
day. Assuming 252 trading days in a year, determine the maximum
loss Mr.X likely to suffer in a period of 10 days with a confidence level
of 99% (Z Score 2.33)
Risk Pricing
• Risk has to be accounted for in all transactions.
• There are two important things for which risk needs to be
accounted for.
• Maintaining the necessary Capital
• To cover for the Probability of Loss due to default.
• Risk pricing means factoring risks into pricing through capital
charge and loss probabilities.
• This is apart from the actual costs incurred in the transaction
such as cost of funds, cost of providing service etc.
Risk Pricing
• Pricing should therefore be undertaken after taking into account :
1. Cost of Deployable Funds
2. Operating Expenses
3. Loss Probability
4. Capital charge
5. Repo Adjustment
6. Negative carry on CRR
7. Profit Margin
• Pricing is transaction based. For which the entire risk management process is
done at transaction level.
Risk Mitigation
Mitigation – It means to reduce the severity or
painfulness of something through some means.

Credit Risk – Collaterals with Cash, Securities or landed

properties, Third party guarantees. Credit Derivatives
etc.
Interest rate Risk (Market Risk) – Interest rate
swaps, Forward rate agreements etc.
Forex Risks – Forward Contracts, Options or Futures
etc.
Operational Risk – Insurance
Mitigation through Diversification & Portfolio Risk
(Rupees in ‘000s)

Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Total Mean S/D SD/Mean %

Business A 10 3 4 8 11 36 7.20 3.56 0.49

▪ There are variations in cash flows hence variations in risks too.

▪ The ratio of Standard Deviation to Mean is the measure of comparing risks

associated with similar cash flows which is 0.49 for Business A.

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 Mitigation through Diversification & Portfolio Risk
(Rupees in ‘000s)

Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Total Mean S/D SD/Mean %
Business A 10 3 4 8 11 36 7.20 3.56 0.49

Business B 3 8 1 6 4 22 4.40 2.70 0.61

Business C 12 8 9 2 4 35 7.00 4.00 0.57

Business D 6 9 2 3 5 25 5.00 2.74 0.55

Business E 7 12 5 8 6 38 7.60 2.70 0.36

Total Portfolio 38 40 21 27 30 156 31.20 7.85 0.25

▪ Ratio of SD to Mean is different for different Business portfolio

▪ Maximum being 0.61% and Minimum being 0.36%
▪ In case of Total Portfolio taken together the SD to Mean comes to 0.25% - which is less than
compared to the minimum observed in case of individual businesses
▪ Cash Flow in the Year 2 for business A and C has decreased over year 1, while it has increased for
business B, D and E.
▪ As a result the variation in net cash flow of the portfolio has been less.
▪ This process is diversification of risks.
▪ For this reason, risk associated with a portfolio is always less than the weighted average of risks of
individual line of business in the portfolio.
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Need for Risk-based Regulation - Why BCBS?
• The Herstatt Risk incident.
• It prompted G-10 countries to form Basel
Committee on Banking Supervision (BCBS) under the
patronage of Bank of International Settlements (BIS).
• Basel I – Basel Capital Accord (1988) – MCR for
Credit exposures.
• 1996 – Market Risk was introduced.
• Basel II – 2008-09 – Introduction of Operational Risk.
• Basel III – 2013 – More stringent guidelines
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 Three pillars of the Basel framework
I II III

Minimum Capital Supervisory

Market Discipline
Requirements Review Process

– Credit risk – Bank’s own capital strategy – Enhanced disclosure

– Operational risk – Supervisor’s review
– Market risk
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Pillar I
Risk Approaches
Credit Risk 1. Standardised Approach
2. IRB Foundation Approach
3. IRB Advanced Approach
Market Risk 1. Standardised (Maturity Method) Approach
2. Standardised (Duration Method) Approach
3. Internal Models Method
Operational Risk 1. Basic indicator Approach
2. Standardised Approach
3. Advanced Measurement Approach
New Standardized Approach - from April 2023
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 Requirement of Regulatory Capital As % of RWA
Under Basel III

1 Min Common Equity Tier I Capital 5.5

2 Additional Tier I Capital 1.5

3 Minimum Tier I Capital (1+2) 7.0

4 Tier II Capital 2.0
5 Minimum Capital Requirement [MCR] ( 3 + 4) 9.0
6 Capital Conservation Buffer (Common equity) 2.5
7 MCR + CCB (5+6) 11.5

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Elements of Common Equity Tier 1 Capital in Basel III
Common shares (Paid-up Equity Capital)
Stock surplus (Share Premium) resulting from the issue of common shares
Statutory Reserves
Capital Reserves representing surplus arising out of sale proceeds of assets
Other disclosed free reserves, if any
Credit Balance in Profit & Loss Account at the end of the previous financial year
Revaluation Reserves At a discount of 55%

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Elements of Additional Tier 1 Capital
Perpetual Non-Cumulative Preference Shares (PNCPS)
Stock Surplus (Share Premium)
Debt Capital Instruments – Perpetual Debt Instruments (PDI)
Any other type of instrument generally notified by the Reserve Bank from time to
time for inclusion in Additional Tier 1 capital.

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Elements of Tier II Capital in Basel III
General Provisions – Provisions on Standard 1. Maximum upto 1.25% of the Total
Assets, Floating Provisions, Incremental Credit RWA under Standardised
Provisions against unhedged Foreign Currency approach.
exposures, Provisions for country exposures,
Investment Reserve Account, Excess provision
retained after sale of NPA and Countercyclical
Buffer provision

Debt Capital Instruments issued by the banks, Perpetual Cumulative Preference Shares
(PCPS) , RNCPS (Redeemable NCPS), RCPS issued by Banks
Share Premium resulting from the issue of Tier II capital instruments
Any other type of instruments notified by RBI from time to time.

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 Credit Risk Capital

Exposures are divided into 5 categories because of

different risk characteristics.

[Link] SOVEREIGNS (Govt.)

[Link]
[Link]
[Link] PORTFOLIOS
[Link]
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 Ris Weight of Govt Exposures -
Exceptions
Exposure RW
1 State Govt. Guaranteed Claims 20%
2 Claims on ECGC Guaranteed Exposures 20%

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 RISK WEIGHTS ON EXPOSURE TO
BANKS

1. Claims on Scheduled Banks, which comply with the 20%

minimum CRAR prescription of RBI

2. Claims on Non-Scheduled Banks which comply with the 100%

minimum CRAR prescription of RBI

3. Claims on other Scheduled and Non-Scheduled Banks would be as per the

following table

CRAR (%) RISK WEIGHT

Scheduled Others
6 to < 9% 50% 150%
3 to < 6% 100% 250%
0 to <3% 150% 350%
Negative 625% 625%
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 Risk Weights for Corporate Exposure
Standardized Approach - Rating assigned by the eligible external credit rating agencies will support the
measure of credit Risk.
At present there are 7 Domestic Credit Rating Agencies as approved by RBI to conduct the external ratings
of Corporate.
1. CARE 2. CRISIL 3. INFORMERICS 4. ICRA 5. BRICKWORK 6. INDIA RATINGS 7. Acuite Ratings

RATINGS RW
AAA 20%

AA 30%
A 50%
BBB 100%
BB & Below 150%
Unrated # 100%

#If the aggregate exposure exceeds ₹200 crore RW would be 150% for
Unrated category for new exposures.
#If the aggregate exposures exceeds ₹100 crore which were earlier rated and
subsequently have become unrated will have 150% RW.

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Risk Weight of Retail Exposures
Retail Category - The maximum aggregated Retail exposure to one counterpart
should not exceed the absolute threshold limit of Rs. 7.5 Crore. (Oct 2020)

 No Rating is required
 A flat rate of 75% Risk Weight will be applicable.

With following EXCEPTIONS – (The following will have different RW)

1. Real Estate Exposure
2. Mortgage Loans i.e. Housing Loan
3. Consumer Credit, NBFC and IPO Finance
4. Staff Loans
5. Exposure by way of investment in Securities (bonds & equities)
6. Capital Market Exposure
7. Venture Capital Funds
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 RETAIL CATEGORY Amt. Threshold LTV* RW (%)
1 Commercial REAL ESTATE N/A 100%
2 CRE – Residential Housing N/A 75%
3 HOUSING LOAN Upto Rs.30 Lakh Less than or equals 80% 35%
(with minimum margin of 25%) *LTV Upto Rs.30 Lakh > 80 upto 90 50%
Above Rs.30 lakh to Rs. 75 lakh Upto 80 35%
Above Rs.75 lakh Upto 75 50%
4 CONSUMER CREDIT 125%
5 CREDIT CARD RECEIVABLES 150%
6 BANK CREDIT TO NBFC RW as per Credit Rating + 25 percentage points
7 IPO FINANCE/Capital Market Exposures 125%
8 STAFF LOANS Fully covered by Superannuation
benefits and/or Mortgage of 20%
Flat/House.
Restructured housing loans should be risk weighted with an additional risk weight of 25% to the risk weights prescribed. If the RW
of a standard Housing Loan is 50%, and the loan is restructured, the new RW would be.50%+25% of 50 = 50+12.50 = 62.50%

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 RISK WEIGHTS OF NON PERFORMING ASSETS

RW

When Specific Less than 20% of the outstanding 150%

Provision are amount of NPA
Equal to or more than 20% but 100%
less than 50% of the outstanding
amount of NPA
Equal to or more that 50% of the 50%
outstanding amount of NPA
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 OFF-BALANCE-SHEET EXPOSURE

Instruments CCF
1 Financial Bank Guarantees (includes 100%
standby LC serving as Financial
Guarantee)
2 Performance Bonds/Guarantees, 50%
Bid Bonds, Indemnities, Standby LC
serving as Performance Guarantee
3 Letter of Documentary Credit (LC) 20%

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Credit Risk – For Funded Exposure
• Two Steps to be followed for determining the Net Exposure for
Capital charge of Credit Risk
1. Adjusted Exposure
2. Allowable Reduction

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• Allowable Reduction:
• (i) Haircut adjustment of Collateral
• (ii) Haircut adjustment of Exposure
• (iii) Haircut adjustment of Currency Mismatch
• (iv) Haircut adjustment of Tenure Mismatch

Net Exposure Calculation Formula

E* = E(1+He) - C(1-Hc-Hfx) x (t-0.25/T-0.25)

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 Haircut Adjustment Problem 1
• An exposure of Rs.500 is secured with Financial collateral of A+ debt security of Rs.150
issued by others with haircut of 6%. The tenure of exposure is 3 years and the residual
maturity of the financial collateral is 2 years. Find the Net Exposure.
 Haircut Adjustment Problem 2
• An exposure of US $50 million is secured with Financial collateral of A+ debt security of
₹200 million issued by others with haircut of 4%. The tenure of exposure is 3 years and
the residual maturity of the financial collateral is also 3 years. The exposure has an
haircut of 2%. Find the Net Exposure.(Assume 1 US$ = ₹85).
Functions of Expected Loss
• Probability of Default (PD) – It is a measure to find out the
likelihood that the borrower will default on loan
repayment over a given time horizon.
• Loss Given Default – It measures the proportion of the
exposure that will be lost if a default occurs.
• Exposure at Default – It measures the amount of the
facility that is likely to be drawn in the event of the default.
i.e. the amount of loan outstanding at the time of default.

• Expected Loss (EL) = EAD x PD x LGD

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Operational Risk
• The risk which brings in loss resulting from inadequate or
failed internal processes, people and systems, or from
impact of external events which are not under our control.
• Scope of Operational Risk is very wide.

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 Capital Charge for OPR risk
Basic Indicator Approach Standardised Approach Advance Measurement App
15% of average gross income Avg. gross income segregated into 8 Capital Charge equals internally
over 3 (profitable) years business lines. generated measure based on:

Retail, Retail Brokerage and Asset Internal Loss Data

Mgmt – capital charge of 12% External Loss Data
Scenario Analysis
Commercial Banking and Agency Business Environment and
Services @ 15% Internal control factors
Risk mitigation upto 20% allowed
Corp Fin, Trading & Sales, Payment & (Insurance is the main mitigation
Settlement @18% process.)
Total Capital Charge is the sum of Measurement integrated into day-
capital charges across business lines to-day risk management

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Standardised Approach – Operational Risk – Business
Lines
Business Line Activities
Corp Finance M&A, Underwriting, Securitization, Debt, Equity, IPO, Syndication etc.
Sales and Trading Forex, Commodities, Lending, Brokerage, Fixed Income Securities etc.
Retail Banking Deposits, Retail Lending, Banking Services, Trusts & Estates etc.
Private Lending & Deposits, Private Banking Services, Investment Advices.
Various Card Services etc.
Commercial Banking Project Finance, Real Estate, Export Finance, Trade Finance, Factoring, Leasing,
Guarantees etc.
Payments & Settlements Collections & Payments, Fund Transfers, Clearing & Settlement of funds
Agency Services Depository, Escrow. Securities Lending, Corporate Agency Services, Corporate
Trusts
Asset Management All Fund Management – retail, corporate, institutional, private equity etc.
Retail Brokerage Brokerage services
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Base III New Standardised Approach - OR
• Basel III SA (Operational Risk) calculation methodology is based on
the following components:
(i)Business Indicator (BI)
(ii) Business Indicator Component (BIC)
(iii) Internal Loss Multiplier (ILM)
Operational Risk Capital = BIC x ILM
Base III New Standardised Approach - OR
• Business Indicator (BI) = ILDC + SC + FC

ILDC Interest Income Interest Expenses Dividend

SC Fee & Commission Income Fee & Commission Operating Income
Expenses & Expenses
FC Net profit (loss) on the Net profit (loss) on the
Trading Book Banking Book
Base III New Standardised Approach - OR
• Business Indicator (BI) = ILDC + SC + FC
• ILDC = Min[Abs(Interest Income – Interest Expense); 2.25% x
(Interest Earning Assets)] + Dividend Income
• SC = Max[Other Operating Income; Other Operating
Expense] + Max[Fee Income, Fee expense]
• FC = Abs(Net P&L of Trading Book) + Abs(Net P&L of
Banking Book)
Base III New Standardised Approach - OR
• Business Indicator Components (BIC) = BI x αi
• where ‘αi’ is the marginal coefficient, which increases with
the size of BI, as per the table below:
Range of BIs and the applicable marginal coefficient (αi)
Bucket Range of BI in ₹Crore BI Marginal
Coefficient (αi)
1 ≤ 8,000 12%
2 8,000 to ≤ 2,40,000 15%
3 > 2,40,000 18%
Base III New Standardised Approach - OR
• Internal Loss Multiplier : ILM = լn {exp (1) – 1 + [LC/BIC]0.08}
• Operational Risk Capital to be calculated in the following ways:
Banks Operational Risk Capital Applicable Buckets
Charge
Having less than 5 years loss ORC = BIC For all 3 buckets
data
Having more than 5 years loss ORC = BIC x ILM For bucket 2 & 3
data
Having less than 5 years loss ORC = BIC x ILM For buckets 2 & 3
data but their ILM is greater
than 1
 How items of BI-sub components shall be averaged
over three years?
• Suppose, for a particular bank the values of items of BI sub-
components for 3-years period are as under:
Year Interest Income Interest Expense Abs(Intt. Income – Intt.
Expense)
Jan 2018-Dec 2018 3000 3500 500
Jan 2019-Dec 2019 3500 3200 300
Jan 2020-Dec 2020 4000 3600 400
Average of Absolute value of the above BI sub- (500+300+400)/3 = 400
components
Capital Charge for Market Risk

• It is required for compensating the abnormal losses

which may arise on account of adverse movement
in market prices.
• Which again depends on adverse movement in
interest rates and adverse changes in the factors
related to individual issuer.

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Capital Charge for Market Risk
• RBI guidelines – Banks are required to manage the
market risks in their books on an ongoing basis and
ensure that the capital requirement for market risks
are maintained on a continuous basis i.e. at the close
of each business day. ( Mark-to-Market concept)

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Capital Charge for Market Risk

• Capital for Market risk has two basic components :

• One accounting for movement in interest rates –
Capital for General Market Risk
• Other accounting for factors relating to individual
issuer – Capital for Specific Market Risk.

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Capital Charge – Specific Risk
• It depends on:
• Issuer
• Type of Security
• Remaining maturity of the security
• The capital charge varies from 0% to 100% based on the above
parameters. Capital charge for various investments are
prescribed by RBI in their guidelines for market risk.

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Capital Charge – General Risk
• This is computed under Standardised Duration Method.
• Capital = Modified Duration of Security x Market Value of
Security x Assumed change in the Yield.
• Assumed Change in the yield is provided by the Regulator, which
varies from 60 to 100 basis points depending on the remaining
maturity of the security.

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Capital Charge for General Market Risk
• Capital requirement for General Market Risk is to cover the risk of loss from changes in
market interest rates. The total capital requirement is arrived at the as below: (Under
Standardized Duration Method):
• Calculate the price sensitivity (Modified Duration) of each security
• Next apply the assumed change in the yield to the Modified Duration of each security
(between 60% & 100% depending on the maturity of security as prescribed by RBI)
• Then, slot the resulting capital into a maturity ladder with 15 time bands as prescribed by
RBI
• Subject the long and short positions in same time band to a 5% Vertical Disallowance
designed to capture Basis Risk
• Then, carry forward the net positions in each time band for Horizontal Disallowance as
per the prescribed %
• Sum the capital charges.
HORIZONTAL DISALLOWANCE
ZONES TIME BAND WITHIN ZONE BETWEEN ADJACENT ZONES BEYWEEN FAR
(1&2 - 2 &3) ZONE (1&3)
1 Upto 1 month
1 to 3 months
>3m to 6 m 40%
>6m to 1 Y
2 >1Y to 1.9 Y 40%
>1.9Y to 2.8 Y 30%
>2.8Y to 3.6 Y
100%
3 >3.6Y to 4.3 Y
>4.3Y to 5.7 Y
>5.7Y to 7.3 Y 40%
>7.3Y to 9.3 Y
>9.3Y to 10.6 Y 30%
>10.6Y to 12 Y
>12Y to 20 Y
>20 Years
Case Study
a. Long Position in securities with remaining maturity of 2 years having General
Market risk capital charge of ₹100 Crores.
b. Long position in securities with remaining maturity of 5 years having General
Market Risk capital charge of ₹450 Crores.
c. Short position due to Derivatives with remaining maturity of 6 months having
General Market Risk capital charge of ₹100 Crores
d. Short position due to Derivatives with remaining maturity of 2 years having
General Market Risk capital charge of ₹50 Crores.

Find out the total Capital Charge for General Market Risk for the above.
Vertical Disallowance computation (within the same time bands)
Time Band Long (+) Short (-) Offset amt Net amt Capital = Offset amt x 5%
(Lower between the two) (Long + short)

2 years 100 50 50 +50 50 x 5% = 2.50

Additional capital required as per Vertical Disallowance 2.50

Horizontal Disallowance computation (within same zone and across zones – after carrying forward the net amount after adjustment of vertical disallowance
Time Bands in Zone 1 & 2 Long (+) Short (-) Offset amt Net amt Capital = Offset amt x 40%
(Lower between the two) (Long + short)

Up to 6 months (Zone 1) 100

Up to 2 years (Zone 2) 50
50 100 50 -50 50 x 40% = 20
Additional capital required as per Horizontal Disallowance Zone 1 & 2 20

Horizontal Disallowance computation (across zones – after carrying forward the net amount)
Time Bands in Zone 1 & 3 Long (+) Short (-) Offset amt Net amt Capital = Offset amt x 100%
(Lower between the two) (Long + short)

Up to 6 months (Zone 1) 50
Up to 5 years (Zone 3) 450
450 50 50 400 50 x 100% = 50
Additional capital required as per Horizontal Disallowance Zone 1 & 3 50
 Altman Z Score
• X1 = Working Capital/Total Assets
• X2 = Retained Earnings/Total Assets
• X3 = EBIT/Total Assets
• X4 = Market Value of Equity/Book Value of
Liabilities
• X5 = Total Sales/Total Assets

• Z Score = (1.2*X1) + (1.4*X2) + (3.3*X3)

+ (0.6*X4) + (1*X5)

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 Altman Z Score
• After you arrive at the final Z Score, it is compared with
the benchmark.

• A Z-Score of less than 1.81 – Distressed Zone – The

Company may likely to go bankrupt within 1 year time.

• A Z-Score of 1.81 to 2.99 – Gray Zone – Company

could go either way

• A Z-Score of > 2.99 – Safe Zone – not likely at risk of

bankruptcy
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Altman Z -Score
Ratio Code Weight ABC Co. XYZ Co. PQR Co.
WC/TA X1 1.2 0.45 0.39 0.28
RE/TA X2 1.4 0.14 0.18 0.13
EBIT/TA X3 3.3 0.20 0.15 0.09
MvE/BvL X4 0.6 1.34 1.15 0.76
S/TA X5 1.0 0.98 0.81 0.43
ABC Co. 1.2x0.45+1.4x0.14+3.3x0.2+1x0.98+0.6x1.34= 3.18
XYZ Co. 1.2x0.36+1.4x0.18+3.3x0.15+1x0.81+0.6x1.15= 2.71
PQR Co. 1.70

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Liquidity Coverage Ratio - LCR

Stock of High-Quality Liquid Assets (HQLA)

LCR = ---------------------------------------------------------------- > or = 100%
Total net cash outflow over next 30 calendar days
HQLA – High Quality Liquid Assets
LEVEL 1 LEVEL 2A LEVEL 2B
Cash (Cash Reserve kept above CRR) Marketable Securities issued or Marketable Securities issued or
guaranteed by Indian Govt. PSU guaranteed by Indian Govt. PSU
having 20% RW. having more than 20% but upto
50% RW

Govt. Sec. (Excess of SLR Corporate Bonds not issued by Marketable securities rate above
requirement) Banks or NBFC with minimum rating BBB
of AA
Govt. Sec under MSF Commercial Papers not issued by Common Equity Shares not issued
Banks or Fis, with minimum rating by Banks or Fis, that are listed in
of AA BSE, NIFTY or S&P
Marketable Securities issued or
guaranteed by Foreign Govts having
0% RW.
Net Stable Funding Ratio

NSFR % = (ASF/RSF) x 100, that should be equal to or more than 100%

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