BANKING MANAGEMENT

Why capital Adequacy Norms?

If a company closes down, other steel companies are happy there is at least one less
competitor. If a bank closes down (Barings Banks, Northern Rock in UK, Lemon
Brothers in US, Global Trust Bank in India, etc), other banks are severely affected -
• other banks have dues from that bank. So one, bank collapsing can result in
another bank collapsing and a chair reaction - This is known as systematic
Failure.
• Banking system thrive on confidence of people. If this confidence i.e shattered,
there will be a run on banks i.e. a liquidity crises and a complete break down of
financial system in an economy.

So what should Government do, when the bank is on the verge of failing?
Alternative 1 If Government allows it to tail, there can be systemic crisis.

Alternative 2 If Government bail it out with tax payers money, there would be a
problem of moral hazard i.e bank would take undue risk knowing fully well that
Government is standing to bail them out.

Note : These introductory points helps to communicate two important features of the
Basal III accord -
• The Basal committee will identify Global systematically Important Financial
Institutions (G - SIFI) and domestic regulars such as RBI will identify D-SIFI's.
These institutions shall be subject to stricken prudential guidance in the form of
higher capital adequacy norms and higher capital adequacy norms and higher
level of scrutiny by the regulators.
• The Basel III norms also introduced the concept of Contingent Convertible Bonds
(Coco's). Banks and other FI's can issue Coco's. If capital adequacy of the bank
falls below a certain level (say 5.2%), these bonds will automatically get
converted into common equity. Thus on conversion, capital adequacy ratio
(CAB) will rise and Governments may not be required to bail out the bank.
Credit swiss issued Coco's and is was subscribed eleven times.

3. Let us look at a summarised Balance sheet and Income statement of commercial

bank.

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Balance sheet
Capital 5 Loane 80
Sub-ordinate Investment 5
Debt 10 Cash 5
Deposit 90 Fixed Assets 10
100 100

Income Statement
Net Interest Income 3
(-) loar losses 0.5
(+) other ice - based 0.5
income
(-) other expense 1.8
? Income 1.2

1.2
Pre tax RoE =  100
5
= 24%, which is quite healthy.
In order to further push up ROE Bank may be incurred to buy back equity by raising
deposits say to the extent of 4. Let us assume, that the income statements remains
the same.
1.2
ROE becomes =  100
1
= 120%

This means given a choice and freedom, a commercial bank which is a profit making
entity would like to keep less capital.
Now suppose, loan losses rise to 4% of 100 i.e 4 there is a pretax income - 2.3. The
entire capital of 1 is wiped off and sub-ordinate debt have to bear the remaining 1.3

Comment - In this case, bank is wound up but deposit holders do not suffer. Hence,
sub-ordinate debt is Tier II Capital ( of course with certain condition.)
What if loan issue are 10% of total Assets? The pretax income becomes - 8.3 so in the
balance sheet situation capital suffers 1 subordinate Debt suffers 5 and deposit
holders (1) suffers 0.3 - This unacceptable.
Hence, what do regulators want -

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Tier I capital i.e, care capital should be sufficient enough to obcorb unexpected
losses - The bank continues to be a going concern - it is not wound up.
• In the extreme situation where tier - I capital is wiped off and the bank is wound
up, tier II capital represented by sub-ordinate debt should be sufficient to bear
unexpected losses.
Deposit holder should not suffer.

4. The above discussion provide a solid rationale for Banking Regulation - Nobody will
argue against bank regulation.
Deposit Insurance is one form of Bank Regulation i.e. deposits are insured to a
certain extent by the FDIC (Federal Deposit Insurance Corporation). However this
open the window for another moral hazard - Banks will start taking more risk as
they know that deposits are insured. This is the least outcome that regulator wanted.
Hence, the need for Capital adequacy norms comes.

PART 2 - BASEL I 1988

1. To 1974, bank regulators of the G-Tech countries decide to form a committee know
as the bases committee which would meet regularly at the premises of banks for
International settlements (BIS) at bases in Switzerland. They would discuss and
formulate guideness for ensuring a safe and healthy banking and financial system.

2. Initially they established guidance for minimum capital Total Assets Ratio. Of
course, this is too children and poses a number of problems -
• Banks which follow these guidelines would become less competitive (more
safe) as compared to other banks not following the guidelines.
• Off-Balance sheet exposures such as bankers acceptance, guarantees LC, and
derivative transactions and not captured.

3. In 1988 the Basel committee announced Basel I accord which was accepted by all
OECD (organisation for Economic Cooperation and Development) Nations and even
other several nations including India.

4. The Basal I accord requires Bank to have a capital adequacy Ratio (also known as
Cooke ratio) of at least 8%.

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TierIcapital + TierIIcapital
CAR =  8%
Risk weighted Assets
Tier I Capital - It is the core capital which is readily available to act as a cushion
against unexpected losses. Bank does not have legal liability toward, these. So even
if they are not paid, bank cannot be wound up. Hence we can it going concern
capital.
Example - common-equity paid up, non-cumulative Perpetual preference share, free
reserves, etc.
Tier II Capital - This non-core or supplemental capital. If the bank is indeed
wounded up, this capital acts as a cushion against unexpected losses we may is
GONE capital.
Example - Subordinate debts [i.e. debt which is unsecured fully paid up and
subordinate to the claims of other creditors and having original maturity at least 5
years], certain hybrid instruments etc.
Tier I capital cannot be less than Tier II capital

5. Risk Weighted Assets.

A. On Balance Sheet RWA

Here we follow a bucket - wise approach -
0% Risk weight - cash in hand, Balance with RBI, Exposure to Government
20% Risk weight - Inter bank Exposure.
50% Risk weight - Housing loan
100% Risk weight - Corporate Exposure
150% Risk weight - Venture Capital Exposure

B. Off Balance Sheet RWA

Step (1) Calculate credit equivalent amount by using conversion factor.
Step (2) Now use Risk weights to get RWA

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Exposure Amount CF Credit RW RWA

Equivalent
Guarantee 1000 1 1000 20% 200
issued in
favour of
another
bank
LC issued in 2000 1 2000 100/- 2000
favour of a
corporate
None 0.5 500 100/- 500
issuance
facility
(NIF) 1000
2100

Out of the popular items, NIF is the one which has the conversion factor of 0.5.
For others, take a conversion factor of 1.

C. Derivative Exposure -
Step (1) Calculate current Exposure defined as max [V, 0] This means, bank if
facing current exposure only if it has a positive value right now. (You may refer
to valuation of swap in ?)
Step (2) Potential future Exposure known as add- on = aL
Where L = National principal
'a', is a certain % depending on the nature and tenure of derivative.
For instance suppose a bank is presently having as IRS (Interest Rate swap)
which has a 3 year maturity. Today value of the swap to the bank is -0.6 crore.
Notional principal is 200 cr. Add on factor is 2%
So, we have current Exposure = Max (V, o)
= Max (-0.6, 0)
= 0 (against us)
Potential Exposure
al = 0.02 × 200
= 4 crore.

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Current Potential
Step (3) Credit Equivalent Amt = +
Exposure Exposure
=0+4
= 4 cr.
Step (4) Now apply risk weight - suppose the swap is with a
govt./bank/corporate, accordingly risk weight is 0%/20%/100%
 RWA = 0/0.8cr/4 crore.

6. In the light of development in the derivative market and a few large collapses such
as The Bearing Bank, the simple cookie ratio proposed by Basel I seemed to be naive
• There was no capital charge for market risk and operational risk.
• Credit risk mitigants such as collateral netting, credit derivatives etc used by
a bank were not considered. The simple bucket wise approach did not
capture the true credit risk faced by bank and encouraged regulatory
arbitrage - whether bank gave loan to a AAA corporate or 'BB corporate, risk
weight was same i.e 100% so banks focusing on profitability would
compromise safety by making wan to "BB" corporates.

Part 3 - Basel II - 1998

1. Given the indequacy of Basel - I accord, the basel committee came out with the Basel
II accord in 1998. This accord is based on three pillans-
Pillar 1 - Capital Adequacy Ratio (CAR) where capital is required for a wise
spectrum of risk rather than only credit risk and captures the effect of risk mitigants.

Pillar 2 - Supervisory Review - The pillar gives importance to the role of the
supervisor i.e RBI in India. It uses continuously monitor bank's internal processes
and systems. It may decide to charge higher capital from certain banks. It will also
be proactive in identifying possible banks failures and dissolution such than
contagious effect is contained.

Pillar 3 - Market Discipline - This pillar focuses on adequate disclosure regarding

risk profits and capital adequacy of banks so that there will be market monitering
and problems can be identifies at an early stage.
Basically, the them of Basel - II, was banks are the ones who are most closely
connected with the risks know the risks they are facing so banks should have their
own inner models for finding out capital charge. Of course there a conflict of interest

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we allow banks to have the own internal models - they would obviously like to
weak the models to result in a lower capital charge.
Hence the role of supervisor and market.

2. Pillar - 1
TierI+TierII + TierIII capital
CAR =
Credit RWA + Market RWA + operational RWA

Capital

•
Credit RWA - It does away with the bucket wise approach and incorporates a
reduction in capital charge for the presence of risk mitigates. (if any)
There are three methods of calculating capital charge for credit risk -

Method 1 - Standardised Approach - It is suitable for small, unsophisticated banks

whose internal risk management models are not well developed - Here, risk weights
are based on external ratings by reputed agencies like standard and Poor Mody's etc.
Rating Government Banks Corporates
AAA   
AA   
B   
BBB   
BB   
B   
CCC   
CC   
C   
D   
Unrated   

Method 2 - Foundation Internal Rating Based Approach

Capitalch arg e =
N

 ( WCPD − PD )  LGD  EAD   ( M )

i =1
1 1 1 i i

Set where = i = ith pool

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Bank will through its internal models provide only one input i.e WCPD and PD. All
other inputs will be provides by regulator i.e RBI.

In the above formula, the subscript 'i' refers to the 7th homogeneous pool i.e a pool
of credit exposures which are homogeneous i.e. similar in terms of having the same
PD and LGD, It could be corporate cement sector exposure corporate power sector
exposure Retail housing loan exposure, retail student loan exposure etc.

The inputs used in the above formula are -

Worst Case probability of default i.e downtown P.D. This is calculated at 99.9%
confidence level over a 1 year horizon say 18%
→ PDi - Expected probability of default for the poor say 5%
→ LGDi - Loss given default for the ith pool (say 60%)
→ EADi - Exposure at default for the ith pool. (say 4000)
→ f (Mi) - Maturity Adjustment capturing ageing or teething problems (say 1.2)
 Capital charge for the ith pool = (0.18 - 0.05) × 0.6 × 40000 × 1.2
= 3744 cr.

Credit loss distribution for the ith pool

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Method 3 :
Advance IRB approach - The methodology is same as that of foundation IRB. However,
in this case all inputs are internally generate by the bank subject to supervisor review
and approval.

Note:- If CAR is 8%, the capital charge computed above is multiplied by 12.5 to get
credit RWA.

Market RWA - The biggest charge brought about by Basel - was the differentiation of
bank's exposure into trading book and Banking book.

The trading book will contain market risk exposure namely equity bond, currency and
commodity it has to mark to market daily. There will be a capital charge for market risk
in the trading book.

The banking book will contain credit exposure. It is not mark to market on a daily basis.
There is a capital charge for credit risk in the banking book to be calculated by one of
the three methods discussed earlier.

There are two methods for calculating capital charge for market risk in trading book :-

Method 1
Standardized Approach - This Approach is to be used by less sophisticated banks
whose internal models are not developed. It involves applying a certain percentage on
each type of exposure (equity bond, currency and commodity) and then making
allowances for diversification benefit due to imperfect correction

Method 2
Advanced Approach - This approach is allowed to be used by sophisticated banks with
well-developed internal system. Under this approach-

Capital charge for market risk

General risk charges (GRC) i.e., charge for systematic risk + Specific Risk charge i.e.,
charge for unsystematic risk applicable only for equity and bond exposure

GRC = Max [VARt-i , m  VARavg ]

Where

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VARt-i - is the 10 day, 99% VAR of the trading book calculated the previous day

VARavg - It is the average of the 10-day 99% VAR calculated over the past 60 days

m - multiplier, decided by the supervisor based on the no. of exception reported by the
bank in a Back-Testing exercise.

Note:- Once again if we consider CAR to be 8%

Market RWA = Capital charge for market risk  12.5

Operational RWA - We know that operational risk refers to the risk arising on account
of failure of people, process and systems. Thus, the collapse of Barings Bank on account
of fraud committee by Niklesson clearly exposed the importance of maintaining
Chineese Wall between the front office, middle office and back office of the treasury
department in a bank.

There are three methods of finding out capital charge for operational risk -

Method 1
Basic Indication Approach - Capital charge = 15% of Gross Income.

Method 2
Standardized Approach - Bank has 8 Business lines (B2) such as corporate division,
retail division, treasury division, etc. A separate charge is applied on Gross Income of
each Business line.
8
Capital charge for Bank =   charge  BL 
i =1
i i

Method 3

Loss Distribution Approach or Advanced measurement Approach pioneered by

Deutsche Bank. This approach is based on Business line - event type matrix i.e., what
are the events which can result in operational loss within each business line. There
events can be classified into -

• HFLS - High frequency low severity i.e., happen very often but result in
insignificant losses
• LFHS - low frequency high severity - happen once in a life time but is
catastrophic(fatal)
Event 1 Event 2 Event 3 Event 4

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Bl1
Bl2
Bl3
BL4 Distribution
BL5
BL6
BL7
BL8

So, we generate an operational loss distribution in each cell. Then we aggregate those
distributions by a process caused convolution and generate the operational loss
distribution for the entire bank and calculate the operational VAR at 99% confidence

Note:- Once again, operational RWA = capital charge  12.5

Criticism

Basel II accord is heavily criticized on the following grounds -

• Conclusion of tier III capital i.e., sub supplemental capital is encouraging banks
to take more risk.
• There is credit risk in trading book relating to unsecuritized and securitized bond
- there is no charge for it and banks ar conducting regularly arbitrage. They are
not adopting the traditional "Buy and Hold" approach - instead they are
adopting the originate and distribute model i.e., they are securitizing assets and
then holding securitized instruments in the trading book. So, instead of 99.9% 1
year credit VAR required in the banking book, they are holding just 99% 10 day
VAR in the trading book.

• It has been found that correlation shoots up during crisis and the so called
"benefits of diversification" is not available exactly at the time when it is most
needed. So, market risk measurement needs to be tighten by considering stressed
VAR i.e., the maximum that we can lose in stress circumstances.
• There was no focus on banks liquidity
• There was no focus on bank's liquidity
• There was no focus on ALM(Asset - liability management)
• There was no focus on leverage.

PART 4
BASEL III

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Due to the poor timing of Base III i.e., 2007 it came under heavy criticism during the
2008 credit crisis and various refinements were made. In India, Base III was
implemented from 1st April ,2013.
Basel III reserves the three pillar framework of Base II
• Capital Adequacy Norms
• Supervisory review
• Market Discipline
of course, a number of changes have been made in Base III to counter the drawbacks of
Basel II-

1. Capital Definition and requirement made more stringent

• Tier - III capital is not allowed
• Tier - I capital (6% of RWA)

Common Tier - I Additional Tier - I

At least 4.5% At most 1.5% if RWA
Note: Intangible Assets like G/W are to be deducted from Tier - I

• Tier II capital - Atmost 2% of RWA 5

This makes total capital greater than equal to 8% of RWA

• Capital conservation Buffer - An additional 2.5% is required to be kept as a buffer

to meet unexpected losses. This makes capital requirement 10.5%
• Counter cyclical Buffer - During economic expansions it has been found that
banks become less stringent and start lending aggressively resulting in further
overheating the economy. To prevent this tendency, there will be an extra capital
buffer ranging from 0 to 2.5% - This will be created in good times to safeguard
the banking system during bad times

2. More stringent of stressed VAR -

Capital charge for market Risk =
Max  VAR t −1 max VAR avg  + Max  VAR t −1 m s x VAR avg  + Specific Risk Charge

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• Incremental Risk charge -This is additional charge for credit risk in trading book
relating to non securitized instruments. It includes the charge default risk and
down grade risk.
• Comprehensive Risk charge - This is additional charge for exposure of
securitized instruments in the trade book
3. Limits on leverage - In order to ensure that bank do not get over leveraged-
Capital
 3%
Total Assets

4. Liquidity Requirement -
During the sub-prime crisis, it was found that profitable banks went bankrupt due
to lack of liquidity . Hence, a liquidity ratio was defined as
Liquid funds ( cash and short term securities )

Cash outflow in the next 30 days
5. Asset liability matching-
If the yield curve is upward sloping, banks of the tendency to borrow short term and
lend for long term . This results in higher spreads. However are stuck up. Hence, we
have the requirement of Net Stable Funding Ratio (NSF)
Available stable Funds
NSF=  100%
Re quired Stable funds

Hint: the denomination is the weightage average of the liability site, like -
0% of capital & Reserve + 5% of Fixed Deposit + 80% of saving Deposit + 100% of
current Account Deposit etc.

The numerator is the weighted average of the assets side, like-

100% of cash in hand + 70% of short term invest + 30% of short term advances + 0%
of long-term advances and fixed assets, etc.

6. More Stringent Norm for DSIFI and GSIFI -

7. Provision for Coco Bonds

PART V

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1. Asset Reconstructions Companies-

Refer to law paper for SURFACE ACT and NCLT

2. Asset- liability Management - (Refer to SFM)

Liquidity Currency Interest Rate Risk

Risk Management Risk Management Management

Interest - Maturity GAP (SFM)

Rate - Duration Gap
Risk - simulation
Management -VAR
-Role of securitization

LIQUIDITY RISK MANAGEMENT

Liquidity refer to the ability of a bank in paying off its liabilities as and when they are
due and the bank also being able to make loans and advances whenever there is an
opportunity.

It was found in almost all financial crisis in the past that a major cause of a financial
institution going bankrupt is - poor liquidity risk management. In this regard, we
should remember that there are 2 aspects of liquidity risk-

- Funding liquidity Risk, i.e., the risk that the bank cannot raise funds due to poor
reputation.
- Market liquidity Risk, i.e., the risk that the bank use short term funds to make
long term loan and is therefore stuck up.
To manage the same, ALCO( Asset Liability Management) must keep and tracking the
bank maturity mismatch ???? and adhere to liquidity ratio and NSF ratio prescribed by
Base III

CURRENCY RISK MANAGEMENT

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Bank typically have significant currency exposure

- They buy or sell currencies on behalf of the client (this is not risky)
- They carry out propriety trading in currencies (risky)
- They are market makers i.e., they quote bid ??????? this may not be risky if they
always
Hence, Also should identify and measure all currency exposure, compare the
same to risk tolerance levels and then design appropriate risk mitigating
techniques.

INTEREST RATE RISK MANAGEMENT

There are no other entities which are more affected by interest rate charges than bank
and financial institutions changes in interest rate affects banks in the following two
way-

- Effect on Net Interest Income (NII)

- NII- Interest Income to interest Expenses

Short term assets and liabilities are known as Rate sensitive as they are re-priced
regularly, so, we have- ∆NII - ∆r × (Maturity GAP)

Where, Maturity Gap = RSA -RSL

∆r= Charge in interest rate.

Example
RSA = 4000 cr.
RSL = 3200 cr.

i. If interest rate rises by 60 BP, what will be the charge in NII?

ii. If interest rate falls by 80BP, what will be the change in NII?

iii. If the treasury department of the bank ,if forecasting a 50 BP fall in interest rate,
what is the maximum gap that a bank can maintain? How will the bank more from
the current Gap to the target GAP? Assume that the tolerance leve set by ALCO is a
?????? 10% change in NII and presently
i. solution- maturity GAP = 800 cr

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∆r = 0.6
∆NII = ∆r maturity GAP = 0.006  800= 4.80 cr.

ii. ∆NII = ∆r maturity GAP

= 0.008  800
= 6.40 cr.

iii. We have
∆NII = ∆r GAP
NII
Gap =
r
10% of 140 = 14
0.005 -0.005
=-2800 cr.
So, the bank can maintain negative gap of almost to reach that gap. RSA got to be
reduced and to be increased
However keeping-
Note : Higher RSL exposes the bank to even liquid
- Also should look into that issue
- Effect on Market Value of Equity
The market value of equity is given by = E= A-L
Thus, as interest rate changes, A and L change brings about a change in E. We got to
remember most of the assets and liabilities of a bank are ????? and have bond like cash
flows. Hence, Duration used as a measure of sensitivity.

As, r ↑, A↓ ε l↓, such that the resultant on Equity depends on DA and DL

As, r ↓, A ↑ ε L↑, and the resultant effect on depends on DA and DL

We have , DA  A = DL  L  DE  F
∴ DE = DA  A - DI  L

?????? following market value B/s of the bank

???? ` in cr Duration ` in cr Duration
1 800 NA Assets 500 0.2
1 1200 0.1 A2 1500 1.2
1.2 2000 1.8 A3 2500 2

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1.3 3000 3 A4 1000 4

1.4 1500 4 A5 3000 8
8500 8500

i. Calculate DA DL and DE
ii. What should be done to immunise equity from interest rate charges?

Solution
500  .2 + 1500  1.2 + 2500  2 + 1000  4 + 3000  8
i. DA =
8500
= 4.11
1200  .1 + 2000  1.8 + 3000  3 + 1500  4
DL =
7700
= 2.43
DA  Pi − Dl  L
 DE =
F
.  8500 − 2.43  7700
411
=
800
= 20.28
this means that if r goes up by 1% assets will fall by 4.11%, liability will fall by
2.43% one therefore, equity will fall by 20.28%
ii. To imunise equity we have to set DE = 0,
i.e DA × A = DL × L
DA L
 =
DL A
7700
 = 0.91 : 1
D8500L
In other words we have to reduce DA and increases DL in Bank. BA < DL

→ Simulation
It is an advanced computer based quantitative tool where used random
numbers to generate random values uncertain random variables. ALCO can
use it for generating interest rate paths, currency paths, calculation of stressed
VAR, etc.
E
or, DA − PL = −DL → This only known as Duration Gap.
A

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