Risk Management and Basel II

Risk Management Division Bank Alfalah Limited

What is Risk?
Risk, in traditional terms, is viewed as a negative. Websters dictionary, for instance, defines risk as exposing to danger or hazard. The Chinese give a much better description of risk >The first is the symbol for danger, while >the second is the symbol for opportunity, making risk a mix of danger and opportunity.

Risk Management
Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behavior in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.

Credit Risk Management

Enable bank to proactively manage loan portfolios in order to minimize losses and earn an acceptable level of return.

Basic Credit Principles

1. Ascertain the customers character for integrity& willingness to repay

2. Only lend what the Customer has the capacity and ability to repay

Basic Credit Principles

3. Contingency Planning for Possible default 4. Only extend credit if your bank can sufficiently understand and manage the risk 5. Build portfolio. & Maintain a diversified

Basic Credit Principles

6. Purpose to be in line with the customers occupation / nature of business 7. The purpose of facility (the assets to be financed) should be held as security. 8.Funds must be utilized for productive purposes and not for speculative, undesirable activities such as hoarding.

Basic Credit Principles

9. The security (primary / collateral) offered to cover the finance should posses the following features Readily realizable and of steady / increasing value. Marketability / storability of goods offered as security. Durability of assets charged to the bank Bank has unhindered access to Security.

Risk Management
.

Risk Management activities are taking place simultaneously

RM performed by Senior management and Board of Directors

Middle management or unit devoted to risk reviews

Strategic

Macro

Micro Level

On-line risk performed by individual who on behalf of bank take calculated risk and manages it at their best, eg front office or loan originators.
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Risk Management at Various Levels

Micro Level: Identify industry and clients that represent good credit risk. Understand customer needs and evaluate opportunities to cater to them while ensuring that minimum risk is undertaken while doing so. Prepares loan application considering all the basic credit principles and lending guidelines laid down by the management. Provide input to senior management during planning process. Macro Level: Performs tasks including: Reviewing proposals recommended by RMs. Ensure a diversified loan portfolio Establishing and monitoring of caps on the basis of industry, business unit, single or group entity, tenor of financing. Strategic Level responsible for: Establish guidelines identifying the business development priorities, and the terms and conditions that should be adhered to in order for loans to be approved. Review and approve exposures of significant amount.

Credit Risk
Credit risk refers to the risk that a counter party or borrower may default on contractual obligations or agreements

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Credit Risk is the risk that the other party to a transaction involving a financial instrument will fail to perform according to the terms & conditions of the contract.

Credit Risk

It is the function of obligors willingness & ability to perform the obligation.

Market Risk

Operational Risk

Counter Party Risk

Pure Credit Risk
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Credit Risk is irrespective of the line of business or geographical location

Credit Risk

Collateral Transaction Risk Monitoring of Credits

Facility Matching/ Rating

Credit Risk By Counterparty

Risk & Return

Rating By Instrument Market scenario Performance simulation

Prudent credit risk management framework for bank ensures strategic fit between business targets, laid-down policy and environment with a view to improve quality of credit decisions & subsequent monitoring of risk assets.
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Causes of Credit Risk

The underlying causes of the credit risk include the performance health of counterparties or borrowers. Unanticipated changes in economic fundamentals. Changes in regulatory measures Changes in fiscal and monetary policies and in political conditions.
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Capital Allocation and Risk Adjusted Performance Measure (RAPM)

The role of the capital in financial institutions and the different type of capital. The key concepts and objective behind regulatory capital. The main calculations principles in the Basel II the current Basel II Accord. The definition and mechanics of economic capital. The use of economic capital as a management tool for risk aggregation, risk-adjusted performance measurement and optimal decision making through capital allocation.
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Role of Capital in Financial Institution

Absorb large unexpected losses Protect depositors and other claim holders Provide enough confidence to external investors and rating agencies on the financial heath and viability of the institution.

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Type of Capital
Economic Capital (EC) or Risk Capital.

estimate of the level of capital that a firm requires to operate its business Regulatory Capital (RC).
capital that a bank is required to hold by regulators in order to operate Bank Capital (BC)

An

The

The actual capital of the bank

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CAPITAL

Bank Capital

Economic Capital

Regulatory Capital

Economic Capital is the amount of capital that the firm has put at risk to cover potential losses* under extreme market conditions
* Arising from all kind of risks

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Balance Sheet Strength V/s Risk Types

CAPITAL
Unexpected Losses

PROVISIONS
Expected / Known Losses

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Economic Capital
Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution. EC is set at a confidence level that is less than 100% since it would be too costly to operate at the 100% level.

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Risk Measurement: Expected & Unexpected Loss

The Expected Loss (EL) and Unexpected Loss (UL) framework may be used to measure economic capital Expected Loss: the mean loss due to a specific event or combination of events over a specified period Unexpected Loss: loss that is not budgeted for (expected) and is absorbed by an attributed amount of economic capital
Determined by confidence level associated with targeted rating Losses so remote that capital is not provided to cover them.

Probability

EL
Cost

UL
Economic Capital = Difference 2,000

500 Expected Loss, Reserves

2,500
Total Loss incurred at x% confidence level
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Risk Appetite

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Minimum Capital Requirements

Basel II And Risk Management

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Comparison

Basel I
Focus on a single risk measure

Basel 2
More emphasis on banks internal methodologies, supervisory review and market discipline Flexibility, menu of approaches. Provides incentives for better risk management Introduces approaches for Credit risk and Operational risk in addition to Market risk introduced earlier. More risk sensitivity
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One size fits all

Operational risk not considered

Broad brush structure

Objectives
The objective of the New Basel Capital accord (Basel II) is:
1.

2. 3.
4. 5.

To promote safety and soundness in the financial system To continue to enhance complete equality To constitute a more comprehensive approach to addressing risks To render capital adequacy more risk-sensitive To provide incentives for banks to enhance their risk measurement capabilities
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MINIMUM CAPITAL REQUREMENTS FOR BANKS

(SBP Circular of October 2010)

Criteria Minimum Paid Up Capital Requirements for New Entrants/Setting up a new Commercial Bank* Minimum Paid Up Capital Requirement for Foreign Banks commencing business in branch mode with 5 branches Minimum Paid Up Capital Requirement for Foreign Banks commencing business in branch mode with 6 to 50 branches

Requirement

PKR 10 Billion

PKR 3 Billion

PKR 6 Billion PKR 10 Billion by December 2013 To be raised in the following manner PKR 7 Billion by Dec 2010 PKR 8 Billion by December 2011 PKR 9 Billion by December 2012 PKR 10 Billion by December 2013
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Minimum Paid Up Capital Requirements for banks with more than 50 branches

MINIMUM CAPITAL REQUREMENTS FOR BANKS

(SBP Circular September 2008)

CAMELS-S

Required CAR effective from

31.12.2008

31.12.2009

1&2 3 4 5

10% 10% 11% 12%

10% 12% 14% 15%

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Overview of Basel II Pillars

The New Basel Accord is comprised of three pillars

Pillar I
Minimum Capital Requirements
Establishes minimum standards for management of capital on a more risk sensitive basis: Credit Risk Operational Risk Market Risk

Pillar II
Supervisory Review Process
Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: Evaluate Banks Capital Adequacy Strategies Certify Internal Models Level of capital charge Proactive monitoring of capital levels and ensuring remedial action

Pillar III
Market Discipline

Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks. Expands the content and improves the transparency of financial disclosures to the market.

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Development of a Revised Capital Adequacy Framework Components of Basel II

The three pillars of Basel II and their principles
Basel II
Minimum capital requirements
How is capital adequacy measured particularly for Advanced approaches?

Objectives
Continue to promote safety and soundness in the banking system

Supervisory review process

How will supervisory bodies assess, monitor and ensure capital adequacy?

Market disclosure
What and how should banks disclose to external parties?

Issue

Better align regulatory capital with economic risk Evolutionary approach to assessing credit risk - Standardised (external factors) - Foundation Internal Ratings Based (IRB) - Advanced IRB Evolutionary approach to operational risk - Basic indicator - Standardised - Adv. Measurement

Internal process for assessing capital in relation to risk profile Supervisors to review and evaluate banks internal processes Supervisors to require banks to hold capital in excess of minimum to cover other risks, e.g. strategic risk Supervisors seek to intervene and ensure compliance

Effective disclosure of: - Banks risk profiles - Adequacy of capital positions Specific qualitative and quantitative disclosures - Scope of application - Composition of capital - Risk exposure assessment - Capital adequacy

Ensure capital adequacy is sensitive to the level of risks borne by banks

Principle

Constitute a more comprehensive approach to addressing risks

Continue to enhance competitive equality

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Pillar 1

Pillar 2

Pillar 3

Overview of Basel II Approaches (Pillar I)

Basic Indicator Approach

Operational Risk Capital

Score Card
Standardized Approach Advanced Measurement Approach (AMA)

Loss Distribution Internal Modeling

Total Regulatory Capital

Credit Risk Capital

Standardized Approach

Foundation
Internal Ratings Based (IRB)

Advanced

Market Risk Capital

Standard Model

Internal Model

Approaches that can be followed in determination of Regulatory Capital under Basel II

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Basel II analysis Credit Risk via four Parameters

Probability of Default
Loss Given Default (LGD) Exposure at Default (EAD)
Probability of default of the borrowers in each risk grade (rating) on a one year time horizon

Loss after the event of a default

Outstanding amount at time of default

Maturity (M)

Remaining effective maturity of the EAD

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Portfolio Structure according to Basel II

Corporate
Sovereigns
Specialized lending

Public Sector Entities

Classification into six classes

Banks

Mortgage

Retail

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Basel II Borrower Types

Sovereign Portfolio Central government, provincial government or the central bank of any country

Bank Portfolio
Retail Portfolio

Commercial banks and DFIs

Exposure to individual, small business in the form of revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities. To be eligible the total exposure to a single person should not be more than Rs 75 million in case of consumer loans and small business loans. Mortgage loans are not included in this category.
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Basel II Borrower Types

Public Sector Entities Corporate Portfolio
Owned or controlled by central or provincial government or any entity categorized as PSE by SBP
Proprietorship, partnership or limited company, insurance companies that is neither a PSE, bank, DFI, nor included in retail exposures. All Public limited companies incorporated under Companies Ordinance, 1984 or any other statute will not fall under the definition of Retail, regardless of their exposure. Consumer loans and small business loans above Rs 75 million will be a part of corporate portfolio and will not remain in retail.
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Basel II Borrower Types

Mortgages

Loans to individuals for the purchase or construction of residential house / apartment or making improvements in house / apartment / land irrespective of the amount of finance Staff housing finance qualifying as Residential Mortgage Finance be treated as residential mortgage. Other staff loans shall be treated as Retail or in any other categories provided respective requirements are fulfilled.
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Staff Finance

Commitments
The New Regulations require Bank should be able to determine the amount of loan committed by the bank to be disbursed The amount of such committed exposure not yet disbursed by the bank at any cut off date Example may include Running finance line approved for Rs 10 million but current outstanding is Rs 4 million and therefore Rs 6 million is banks commitment not yet disbursed by the bank.
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Commitments
Limit amount Outstanding Un-utilized

Commitment
No commitment

Conditions where un-utilized will not be a commitment Where the bank can unconditionally cancel the limit at any time without notice
Where the limit is automatically cancelable due to deterioration in a borrowers creditworthiness In cases where the above conditions are not present, the un-utilized amount will represent commitment.
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Basel II Credit Risk Approaches

Measure credit risk pursuant to fixed risk weights based on external credit
Standardised

assessments (ratings) Least sophisticated capital calculations; generally highest capital burden

Measure credit risk using sophisticated formulas using internally

Foundation IRB

determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M). More risk sensitive capital requirements inputs of PD, LGD, EAD and M Most risk-sensitive (although not always lowest) capital requirements management systems and data

Measure credit risk using sophisticated formulas and internally determined

Advanced IRB

Transition to Advanced IRB status only with robust internal risk

Under Basel II, banks have strong incentive to move to IRB status and reduce capital charges by improving risk management systems
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The Standardised Approach

The most unsophisticated approach for measuring risk, this approach is likely to be used by the majority of smaller, regional banks

The minimum capital requirement calculation first Basel Accord, however Credit Risk determined by reference to the public borrower: Min. Capital Requirement = 10% (CAR % Loan amount x credit risk weighting
AA rated corporate risk weighting = 20% CCC rated corporate risk weighting = 150% Unrated corporate risk weighting = 100%

is similar to the is now to be rating of the requirement) x

Risk weightings are non-linear between rating levels, e.g.:

Defining the required Regulatory Capital is objective based solely on the criteria within the Accord

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Standardized Approach (Credit Risk)

The Banks are required to use rating from External Credit Rating
Agencies (ECAIS).
SBP Rating Grade
1

(Long Term) PACRA

AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ and below
Unrated

ECA Scores
0,1

JCR-VIS
AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ and below
Unrated

Risk Weight (Corporate)

20%

50%

100%

100%

5,6

150%

6
Unrated

7
Unrated

150%
100%

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Short-Term Rating Grade Mapping and Risk Weight

External grade (short term claim on banks and corporate)

SBP Rating Grade

PACRA

JCRVIS

Risk Weight

1 2 3 4

S1 S2 S3 S4

A-1 A-2 A-3 Other

A-1 A-2 A-3 Other

20% 50% 100% 150%

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Short-Term Rating
Short term rating may only be used for short term claim. Short term issue specific rating cannot be used to riskweight any other claim.

e.g. If there are two short term claims on the same counterparty. 1. Claim-1 is rated as S2 2. Claim-2 is unrated
Claim-1 rated as S2 Claim-2 unrated

Risk -weight

50%

100%
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Short-Term Rating (Continue)

e.g. If there are two short term claims on the same counterparty.

1. Claim-1 is rated as S4 2. Claim-2 is unrated

Claim-1 rated as S4 Risk -weight 150% Claim-2 unrated

150%

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Basel I v/s Basel II

Basel: No Risk Differentiation Capital Adequacy Ratio = Regulatory Capital / RWAs (Credit + Market) 8% = Regulatory Capital / RWAs RWAs (Credit Risk) = Risk Weight Amount RWAs = 100 % * Total Credit Outstanding * 100 M = 100 M

8%

= Regulatory Capital / 100 M

Basel II: Risk Sensitive Framework RWA (PSO) = Risk Weight * Total Exposure Amount = 20 % * 10 M =2M 100 % * 10 M = 10 M =12 M
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RWA (ABC Textile) = Total RWAs =

2 M + 10 M

RWA & Capital Adequacy Calculation

(In Million)

Customer Title
PAKISTAN STATE OIL DEWAN SALMAN FIBRE LIMITED

Rating
AAA A

Outstanding Balance
100 100 100 100

Risk Weight
20% 50% 100% 150%

RWA = RW * Total Capital CAR (%) Outstanding Required

20 50 100 150 10% 10% 10% 10% 2.0 5.0 10.0 15.0

RELIANCE WEAVING MILLS (PVT) LTD BBB+ RUPALI POLYESTER LIMITED B

Total:

400

320

32.0

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Basel II Eligible Security/ Collateral

Basel II regulations have clearly spelled out the security/ collaterals which are eligible for taking benefit for the purpose of CAR calculation. These include : Cash on deposit including certificates of deposits (TDR, etc) Gold Debt and equity securities (conditions apply) Units of mutual funds Guarantees (conditions apply)

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Basel II Eligible Security/ Collateral

In order to recognise CRM, banks must meet a set of minimum requirements, including: legal certainty of collateral clear and robust procedures for liquidation of collateral

guarantees and credit derivatives must represent a direct claim on the provider
Legal certainty requires: enforceable in all the relevant jurisdictions binding on all the parties

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Credit Risk Mitigation (CRM)

Where a transaction is secured by eligible collateral. Meets the eligibility requirements. criteria and Minimum

Banks are allowed to reduce their exposure under that particular transaction by taking into account the risk mitigating effect of the collateral.
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Adjustment for Collateral:

There are two approaches:

1. Simple Approach 2. Comprehensive Approach

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Simple Approach (S.A)

Under the S. A. the risk weight of the counterparty is replaced by the risk weight of the collateral for the part of the exposure covered by the collateral. For the exposure not covered by the collateral, the risk weight of the counterparty is used. Collateral must be revalued at least every six months. Collateral must be pledged for at least the life of the exposure.
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Comprehensive Approach (C.A)

Under the comprehensive approach, banks adjust the size of their exposure upward to allow for possible increases. And adjust the value of collateral downwards to allow for possible decreases in the value of the collateral. A new exposure equal to the excess of the adjusted exposure over the adjusted value of the collateral. counterparty's risk weight is applied to the new exposure.
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e.g.

Suppose that a Rs 80 M exposure to a particular counterparty is secured by collateral worth Rs 70 M. The collateral consists of bonds issued by an Arated company. The counterparty has a rating of B+. The risk weight for the

counterparty is 150% and the risk weight for the collateral is 50%.

The risk-weighted assets applicable to the exposure using the simple approach is therefore: Risk Adjusted Exposure: (10M*150) +(70M*50%) = 50M
Comprehensive Approach: Assume that the adjustment to exposure to allow for possible future increases in the exposure is +10% and the adjustment to the collateral to allow for possible future decreases in its value is -15%. The new exposure is: 1.1 X 80 (50%*85%* 70) = 58.25 million A risk weight of 150% is applied to this exposure: Risk-adjusted assets = 58.25 X 1.5 =87.375M
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