CHAPTER-1

INTRODUCTION

1. INTRODUCTION TO THE TOPIC:

The Indian Banking industry has drastically changed due to the liberalization
and deregulation process that started in 1991. The financial system is the lifeline of the
economy. The changes in the economy are mirrored in the performance of the banking
industry. To strengthen the performance of the banking sector, it is adopting
international best practices with its vision. Rising global competition, increasing
deregulation, introduction of innovative products and delivery channels have given rise
to risk in the banking sector.
The success of risk management lies in the ability to gauge the risks and take
appropriate measures. Several prudential and provisioning norms have been introduced.
Under the Basel II accord, capital allocation will be based on the risk inherent in the
asset. Banks generally face various risks such as credit risk, market risk, operational
risk, liquidity risk, etc. Of all the types of risks, credit risk is the most important one.
Credit risk is all about loans and their defaults, and loan transactions account for more
than 50.00 percent of all banking activities. Credit risk management is a structured
approach to managing uncertainties through risk assessment, developing strategies to
manage it, and mitigation of risk using managerial resources.
The strategies include transferring to another party, avoiding the risk, reducing
the negative effects of the risk, and accepting some or all the consequences of a
particular risk. The NPA concept was introduced in India by the Reserve Bank of India
with effect from 1st April 1992 and prudential norms were issued regarding the methods
of identifying NPAs, classification, and income recognition. The NPAs work out a ratio
of non-performing credit to total credit. Bankers are now required to recognize such
loans faster and then classify them as problem assets. The basic factor to determine
whether an account is NPA or not is the record of recovery and not the availability of
security. Before making further analysis of NPAs and their causative factor, an
understanding of how banks classify their advances is necessary.

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1.1 RISK STRUCTURE:

The word ‘risk’ is derived from the Italian word ‘resicare’ which means ‘to
dare.’ It means risk is more a ‘choice’ than a ‘fate.’ An extension of this analogy reveals
risk is a possibility of loss or injury perils and the degree of uncertainty in return. Banks
in the process of financial intermediation are faced with one or more of the following
risk categories.
• Credit Risk
• Market Risk
• Operational Risk
A strong banking sector is important for a flourishing economy. The failure of
the banking sector may hurt other sectors. Non-Performing Asset (NPA) is one of the
major concerns for banks in India. NPAs reflect the performance of banks. A high level
of NPAs suggests a high probability of many credit defaults that affect the profitability
and net worth of banks and erode the value of the asset. The NPA growth involves the
necessity of provisions, which reduces the overall profits and shareholders’ value.
Assets that generate periodical income are called performing assets. Assets that do not
generate periodical income are called non-performing assets. NPAs are further
classified into sub-standard, doubtful, and loss assets based on the criteria stipulated by
RBI. An asset, including a leased asset, becomes nonperforming when it ceases to
generate income for the bank for a specified time.
The quality of Indian bank's assets is likely to deteriorate over the next two
years. This will be driven by the slowdown in the economy and by the aging of loans
made in recent years. The NPAs are considered an important parameter to judge the
performance and the financial health of banks. The level of NPAs is one of the drivers
of financial stability and growth of the banking sector. Financial companies and
institutions are nowadays facing a major problem of managing Non-Performing Assets
(NPAs) as these assets are proving to become a major setback for the growth of the
economy. NPAs in simple words may be defined as the borrower does not pay principal
and interest for 180 days. However, it is taken into consideration now that default status
would be given to a borrower if dues are not paid for 90 days.

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 In banking business evaluation of capital position, a bank must consider both
the static and dynamic costs. The static costs and perhaps the dynamic costs depend in
part on the penalties regulators impose for inadequate capital ratio. The levels and
changes in capital position variety of non-regulatory costs have been associated. During
the seventies, there were no regulations that specified minimum capital ratios.
Regulators were dissatisfied with many banks' capital ratios, at the beginning of the
eighties. In 1981 U.S. regulators specified minimum capital-to-asset ratios for all banks.
As a result, in 1983, banks were required to raise their capital-to-asset ratios to some
pre-specified minimum. Subsequently, other counties followed.
The Basel Committee on Banking Supervision (BIS) was formed in response to
the messy liquidation of a Frankfurt bank in New York. Under the auspices of the Bank
for International Settlement (BIS) Basel I refers to a round of deliberations by central
banks from around the world. During 1988 BIS published a set of minimal capital
requirements for banks. This is also known as the 1988 Basel Accord. In 1992 this was
enforced by law in (G-10) countries. In India, the Capital Adequacy Ratio (CAR) was
introduced in April 1992.

1.1.1 THE BASEL I NORMS:

India began implementing the Basel I in April 1992. The standards are almost
entirely addressed to credit risk, the main risk incurred by banks. The document consists
of two main sections, which cover.
a. The definition of capital; and
b. The structure of risk weights.
Based on the Basel norms, the RBI also issued similar capital adequacy norms
for the Indian banks. According to these guidelines, the banks will have to identify their
Tier-I and Tier-II capital and assign risk weights to the assets. Having done this, they
will have to assess the Capital to Risk Weighted Assets Ratio (CRAR). Banks in India

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have been making efforts to reduce their NPAs post-Basel I implementation and
thereafter.

Tier-I Capital
• Paid-up capital
• Statutory Reserves
• Disclosed free reserves
• Capital reserves representing surplus arising out of sale proceeds of assets
Equity investments in subsidiaries, intangible assets, and losses in the current period
and those brought forward from previous periods will be deducted from Tier I capital.

Tier-II Capital
• Undisclosed Reserves and Cumulative Perpetual Preference Shares
• Revaluation Reserves
• General Provisions and Loss Reserves

1.1.2 THE BASEL II NORMS:

Basel II is the second of the Basel Accords recommended for banking laws and
regulations issued by the BCBS and BIS. The focus of Basel II is on risk determination
and quantification of credit, market, and operational risks faced by banks. With this
objective, on June 26, 2004, The Basel Committee on Banking Supervision released
“International Convergence of Capital Measurement and Capital Standards: A Revised
Framework”, which is commonly known as the Basel II Accord was introduced. Basel
1 initially had Credit Risk and afterward included- Market Risk. In Basel II, apart from
Credit & Market Risk; Operational Risk was considered in the Capital Adequacy Ratio
calculation.
Basel II norms consist of three pillars. The first pillar, minimum capital
requirements, develops and expands on the standardized 1988 rules. The risk weighting
system describes and replaces the earlier system by using external credit ratings. The
second pillar is the supervisory review of capital adequacy which seeks to ensure that

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the bank’s position is consistent with its overall risk profile and strategy, and as such
encourages early supervisory intervention. Supervisors want the ability to require banks
that show a greater degree of risk to hold a minimum capital of over 8.00 percent.
The third pillar, market discipline, encourages high disclosure standards and
enhances the role of market participants in encouraging banks to hold adequate capital.

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 CHAPTER-2
RESEARCH METHODOLOGY

2.1 OBJECTIVES:
1. To assess the current risk management framework.
2. To analyze technological integration in risk management.
3. To examine regulatory compliance and adherence.
4. To identify types of risk and challenges.
5. To compare risk management practices across different banking institutes.

2.2 SCOPE OF STUDY:

1. Introduction to Risk Management in Banking:
This section will provide an overview of risk management in the banking sector,
its significance, and the evolving regulatory landscape. It will delve into the types of
risks prevalent in banking, such as credit risk, market risk, liquidity risk, operational
risk, and compliance risk.
2. Regulatory Framework and Compliance Requirement:
Discuss the regulatory bodies overseeing banking operations, including Basel
Committee on Banking Supervision (BCBS) guidelines, Dodd-Frank Act, and other
regional regulatory standards. Analyze the impact of compliance requirements on risk
management practices within banks.
3. Risk Identification and Assessments:
Investigate methodologies and tools employed by banks for identifying,
measuring, and assessing various risks. This may involve discussing quantitative
models, stress testing, scenario analysis, and risk ranking techniques used to evaluate
the magnitude and likelihood of risks.
4. Credit Risk Management:
Explore how banks manage credit risk associated with lending activities.
Analyze credit risk assessment techniques, loan portfolio diversification strategies,
credit scoring models, and provisioning norms to mitigate credit-related losses.

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5. Market Risk Management:
Examine how banks handle market risks arising from fluctuations in interest
rates, foreign exchange rates, and asset prices. Discuss hedging strategies, value-at-risk
(VaR) models, and stress-testing methods used to manage and mitigate market risks.
6. Liquidity Risk Management:
Investigate how banks ensure they have enough liquid assets to meet short-term
obligations. Discuss liquidity risk measurement tools, stress testing for liquidity shocks,
and contingency funding plans to manage liquidity risk effectively.
7. Operational Risk Management:
Explore methods employed by banks to identify, assess, and mitigate
operational risks related to internal processes, systems, people, and external events.
Discuss the role of technology, internal controls, and business continuity plans in
managing operational risks.

2.3 HYPOTHESIS:
The main objective of the study is to find the bank’s risk management practices
with the risk management process of the banks. Therefore, the following hypothesis
was developed to meet the objective of the study.

H1: There is a positive relationship between risk management practices and

understanding risk and risk management, risk identification, risk assessments and
analysis, risk monitoring, and credit risk.

2.4 LIMITATIONS OF THE STUDY:

2.4.1: Despite the significance of the study, it is not free from limitations. The
first limitation is for data collection. The researcher could not find more reliable data
because the limited availability of high-quality historical data can hinder accurate risk
modeling and forecasting.

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 2.4.2: Risk management heavily relies on quantitative models and assumptions.
However, these models might not fully capture the complexity of real-world scenarios,
leading to model risk. Assumptions made in these models might not hold during times
of extreme market volatility or unforeseen events.
2.4.3: Constantly evolving regulatory requirements can pose challenges for
banks in maintaining compliance. Meeting these regulations often requires substantial
resources and may sometimes conflict with the flexibility needed for effective risk
management strategies.
2.4.4: Banks often have separate risk management departments for different
types of risks (credit, market, operational). Integrating these siloed risk functions and
achieving an enterprise-wide risk management approach can be challenging, leading to
inefficiencies and information gaps.

2.5 DATA COLLECTION & SAMPLE COLLECTION:

1. Primary Information: Personal Interview/Questionnaire.

2. Secondary Information: Through the Internet, Manuals, Journals, Books,
Audit/Annual Reports.

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 CHAPTER-3
LITERATURE REVIEW

Risk management (RM) in general is said to be a good practice of the

corporation that can be used to minimize the identified risk and which is an opportunity
for the organizations. Therefore, risk management plays a vital role in any business. It
is a contemporary requirement of this changing competitive environment. Risk
management is a forward-looking process that involves decision-making on an ongoing
basis. There have been a larger number of studies about risk management where the
empirical studies on risk management practices in the banking industry are found to be
insignificant. This section is thus an attempt to summarize the main conclusion from
selected studies.
According to Awojoni and others (2010), bank failures happen due to more
emphasis on short-term goals over the bank’s long-term goal. However, long-term
sustainability is the key for a bank to set its objectives in today’s context. Many banks
have a contradiction the short-term profits and long-term survival which are highly
impacted by the risk management practice by the banks. Therefore, the risk is an
important aspect that the banks should consider while achieving profitability. Most of
the banks have failed with the risk management, moreover the management of credit
and liquidity risk.
(Raghavan, 2003), As the financial intermediary banks should play a big role
in controlling and keeping stable the financial sector. In that case, they are more
exposed to risk due to the nature of their business. “Banks are exposed to severe
competition and hence are compelled to encounter various types of financial and non-
financial risks. Risks and uncertainties form an integral part of banking which by nature
entails taking risks”.

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 According to Awojobi et al. (2010), the primary aim of risk management in
banks is to avert a situation of insolvency. Therefore, the solvency will be implied
through the efficiency in risk management. According to Raghavan, there are three
main risk categories that a bank should be concerned about. Such as credit risk, Market
Risk, and Operational Risk.
Al Tamimi and Al-Mazrooei (2007), found that the three main risk categories
that Indian banks face are foreign exchange risk, credit risk, and operating risk. They
used the questionnaire-based study to find the risk management practices and the
techniques used by the 157 Indian banks covering branches and head offices of Indian
national and foreign banks in the year 2004.
For all types of organizations, there is a need to understand the risks being taken
when seeking to achieve objectives and attain the desired level of reward. Organizations
need to understand the overall level of risk embedded within their processes and
activities. Organizations need to recognize and prioritize significant risks and identify
the weakest critical controls. When setting out to improve risk management
performance, the expected benefits of the risk management initiative should be
established in advance. The outputs from successful risk management include
compliance, assurance, and enhanced decision-making. These outputs will provide
benefits by way of improvements in the efficiency of operations, the effectiveness of
tactics (change projects), and the efficacy of the strategy of the organization.
According to Del-Porto and Clerk M (2007), the understanding of risk and
risk management in India is good and indicates future risk management efficiency.
Further, they have investigated that the Indian banks are efficient in risk management
to a certain extent. Risk identification, risk assessment, and analysis have been
identified as the most influencing variables in risk management practices. They also
found that there is a significant difference in national and foreign banks' risk
management practices in India Risk management is a central part of the strategic
management of any organization. It is the process whereby organizations methodically
address the risks attached to their activities. A successful risk management initiative
should be proportionate to the level of risk in the organization, aligned with other
corporate activities, comprehensive in its scope, embedded into routine activities, and
dynamic by being responsive to changing circumstances.

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 The focus of risk management is the assessment of significant risks and the
implementation of suitable risk responses. The objective is to achieve maximum
sustainable value from all the activities of the organization. Risk management enhances
the understanding of the potential upside and downside of the factors that can affect an
organization. It increases the probability of success and reduces both the probability of
failure and the level of uncertainty associated with achieving the objectives of the
organization.
According to Richard, there are two main positive aspects of risk management.
Firstly, it will add value to the organizations because of the clear connection between
risk management and risk managers in economic activities. Since risk management will
affect the human, physical, and financial resources of the organizations, secondly it will
improve the visibility of risk management and managers in economic entities. (Richard,
2004)
N.C Chandrashekhar (2002) has investigated the techniques used by Indian
banks to respond to the different types of risks. He has found that the main risk they
face is the credit risk. Further, he has identified the investigation by the risk managers
and the branch managers are the main technique they used to identify the risks of the
banks. Techniques such as the establishment of standards, creditworthiness, risk
ratings, and collateral have been identified as the other techniques of risk management.
Several studies have been conducted to find the relationship between risk management
practices with financial performance (Smith, 1995; Schroeck, 2002, Mohsen and
Khan, 2008).
These studies have found that sound risk management practices enhance the
bank’s performance. The main areas they have been considered are risk management
environment, policies and procedures, risk measurement, risk mitigation, risk
monitoring, and internal control to measure the risk management practices.
Headly and Peter found the importance of board directors to approve the overall
policies to manage the risk and it is important to communicate the overall objectives
within the organization.

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 CHAPTER-4
DATA ANALYSIS, INTERPRETATION AND PRESENTATION

4.1: FRAMEWORK OF DIFFERENT TYPES OF RISKS IN THE

BANKING SECTOR:

4.1.1 INTRODUCTION:

Basel I Accord: The Basel Committee on Banking Supervision, which came into
existence in 1974, volunteered to develop a framework for sound banking practices
internationally. In 1988 the full set of recommendations was documented and given to
the Central banks of the countries for implementation to suit their national systems.
This is called the Basel Capital Accord or Basel I Accord. It provided a level playing
field by stipulating the amount of capital that needs to be maintained by internationally
active banks.

Basel II Accord: Banking has changed dramatically since the Basel I document of
1988. Advances in risk management and the increasing complexity of financial
activities/instruments (like options, hybrid securities, etc.) prompted international
supervisors to review the appropriateness of regulatory capital standards under Basel I.
To meet this requirement, the Basel I Accord was amended and refined, which came
out as the Basel II Accord.

The new proposal is based on three mutually reinforcing pillars that allow banks and
supervisors to evaluate properly the various risks that banks have to face and realign
regulatory capital more closely with underlying risks. Each of these three pillars has
risk mitigation as its central board. The new risk-sensitive approach seeks to strengthen
the safety and soundness of the industry by focusing on:

● Risk-based capital (Pillar 1)

● Risk-based supervision (Pillar 2)
● Risk disclosure to enforce market discipline (Pillar 3)

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4.1.2 BASEL II FRAMEWORK:

The new proposal is based on three mutually reinforcing pillars that allow banks
and supervisors to evaluate properly the various risks that banks face and realign
regulatory capital more closely with underlying risks.

Basel II
Framework

Pillar I Pillar II Pillar III

Minimum Capital Supervisory Market

Requirements Review Process Discipline

4.1.2.1 THE FIRST PILLAR – MINIMUM CAPITAL

REQUIREMENTS:

The first pillar sets out the minimum capital requirement for the bank. The new
framework maintains a minimum capital requirement of 8% of risk assets.
Basel II focuses on improvement in the measurement of risks. The revised credit risk
measurement methods are more elaborate than the current accord. It proposes for the
first time, a measure for operational risk, while the market risk measure remains
unchanged.

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4.1.2.2 THE SECOND PILLAR - THE SUPERVISORY REVIEW
PROCESS:

A supervisory review process has been introduced to ensure not only that banks
have adequate capital to support all the risks, but also to encourage them to develop and
use better risk management techniques in monitoring and managing their risks. The
process has four key principles-
a) Banks should have a process for assessing their overall capital adequacy about their
risk profile and a strategy for monitoring their capital levels.

b) Supervisors should review and evaluate the bank’s internal capital adequacy
assessment and strategies, as well as their ability to monitor and ensure their compliance
with regulatory capital ratios.

c) Supervisors should expect banks to operate above the minimum regulatory capital
ratios and should have the ability to require banks to hold capital over the minimum.

d) Supervisors should seek to intervene at an early stage to prevent capital from

decreasing below the minimum level and should require rapid remedial action if capital
is not mentioned or restored.

4.1.2.3 THE THIRD PILLAR – MARKET DISCIPLINE:

Market discipline imposes strong incentives on banks to conduct their business

in a safe, sound, and effective manner. It is proposed to be affected through a series of
disclosure requirements on capital, risk exposure, etc. so that market participants can
assess a bank’s capital adequacy. These disclosures should be made at least semi-
annually and more frequently if appropriate. Qualitative disclosures such as risk
management objectives and policies, definitions, etc. may be published annually.

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4.1.3 TYPES OF RISKS:

When we use the term “Risk”, we all mean financial risk or unexpected financial
loss. If we consider risk in terms of probability or occur frequently, we measure risk on
a scale, with certainty of occurrence at one end and certainty of non-occurrence at the
other end. Risk is the greatest phenomenon where the probability of occurrence or non-
occurrence is equal. As per the Reserve
Bank of India guidelines issued in Oct.
1999, there are three major types of
risks encountered by the banks these are
Credit Risk, Market Risk & and
Operational Risk. Further after eliciting
views of banks on the draft guidelines
on Credit Risk Management and market
risk management, the RBI has issued
the final guidelines and advised some of the large PSU banks to implement to gauge
the impact. Risk is the potentiality that both the expected and unexpected events may
hurt the bank’s capital or its earnings. The expected loss is to be borne by the borrower
and hence is taken care of by adequately pricing the products through risk premiums
and reserves created out of the earnings. It is the amount expected to be lost due to
changes in credit quality resulting in default. Whereas, the unexpected loss on account
of the individual exposure and the whole portfolio is entirely borne by the bank itself
and hence care should be taken. Thus, the expected losses are covered by
reserves/provisions and the unexpected losses require capital allocation.

4.1.3.1 CREDIT RISK:

In the context of Basel II, the risk that the obligor (borrower or counterparty) in
respect of a particular asset will default in full or in part on the obligation to the bank
about the asset is termed Credit Risk.
Credit Risk is defined as “The risk of loss arising from outright default due to
inability or unwillingness of the customer or counterparty to meet commitments about

15
lending, trading, hedging, settlement and other financial transactions of the customer or
counterparty to meet commitments”.
Credit Risk is also defined, “as the potential that a borrower or counterparty will
fail to meet its obligations by agreed terms.”

16
4.1.3.2 MARKET RISK:

It is defined as “the possibility of loss caused by changes in the market variables

such as interest rate, foreign exchange rate, equity price, and commodity price”. It is
the risk of losses in, various balance sheet positions arising from movements in market
prices.
RBI has defined market risk as
the possibility of loss to a bank caused
by changes in the market rates/ prices.
RBI Guidance Note focuses on the
management of liquidity Risk and
Market Risk, further categorized into
interest rate risk, foreign exchange risk,
commodity price risk, and equity price
risk.
Market risk includes the risk of the degree of volatility of market prices of
bonds, securities, equities, commodities, foreign exchange rates, etc., which will
change daily profit and loss over time; it is the risk of unexpected changes in prices or
rates. It also addresses the issues of a bank's ability to meet its obligation as and when
due, in other words, liquidity risk.

4.1.3.3 OPERATIONAL RISK:

Operational risk is the risk associated with the operations of an organization. It

is defined as “risk of loss resulting from inadequate or failed internal process, people
and systems or from external events.”
It includes legal risk. It excludes strategic and reputational risks, as the same are
not quantifiable.
Operational risk includes the risk of loss arising from fraud, system failures,
trading errors, and many other internal organizational risks as well as risk due to
external events such as fire, flood, etc. The losses due to operation risk can be direct as

17
well as indirect. Direct loss means the financial losses resulting directly from an
incident or an event.
E.g. forgery, fraud, etc. indirect loss means the loss incurred due to the impact
of an incident.

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4.1.3.4 REGULATORY RISK:

The owned funds alone are managed by an entity, it is natural that very few
regulators operate and supervise them. However, as banks accept deposits from the
public better governance is expected from them. This entails a multiplicity of regulatory
controls. Many Banks, having already gone for public issues, have a greater
responsibility and accountability in this regard. As banks deal with public funds and
money, they are subject to various regulations. The various regulators include the
Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI), Department
of Company Affairs (DCA), etc. Moreover, banks should ensure compliance with the
applicable provisions of The Banking Regulation Act, The Companies Act, etc. Thus,
all the banks run the risk of multiple regulatory risks which inhibit the free growth of
businesses as focus on compliance with too many regulations leaves little energy scope,
and time for developing new business. Banks should learn the art of playing their
business activities within the regulatory controls.

4.1.3.5 ENVIRONMENTAL RISK:

As the years roll technological advancement takes place, and expectations of

the customers change and enlarge. With economic liberalization and globalization,
more national and international players are operating the financial markets, particularly
in the banking field. This provides the platform for environmental change and exposure
of the bank to environmental risk. Thus, unless the banks improve their delivery

19
channels, reach customers, and innovate their products that are service-oriented; they
are exposed to environmental risk.

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4.1.4 BASEL’S NEW CAPITAL ACCORD:

Bankers for International Settlement (BIS) meet at Basel situated in Switzerland

to address the common issues concerning bankers all over the world. The Basel
Committee on Banking Supervision (BCBS) is a committee of banking supervisory
authorities of G-10 countries and has been developing standards and establishing a
framework for bank supervision towards strengthening financial stability throughout
the world. In consultation with the supervisory authorities of a few non-G-10 countries
including India, core principles for effective banking supervision in the form of
minimum requirements to strengthen the current supervisory regime, were mooted. The
1988 Capital Accord essentially provided only one option for measuring the appropriate
capital of the risk-weighted assets of the financial institution. It focused on the total
amount of bank capital to reduce the risk of bank solvency at the potential cost of the
bank’s failure for the depositors. As an improvement on the above, the New Capital
Accord was published in 2001 by the Basel Committee of Banking Supervision. It
provides a spectrum of approaches for the measurement of credit, market, and
operational risks to determine the capital required. The spread and nature of the
ownership structure are important as they impinge on the propensity to induct additional
capital. While getting support from a large body of shareholders is a difficult
proposition when the bank’s performance is adverse, a smaller shareholder base
constrains the ability of the bank to garner funds. Tier I capital is not owed to anyone
and is available to cover possible unexpected losses. It has no maturity or repayment
requirement and is expected to remain a permanent component of the core capital of
the counterparty. While Basel standards currently require banks to have a capital
adequacy ratio of 8% with Tier I not less than 4%, RBI has mandated the banks to
maintain a CAR of 9%. The maintenance of the capital adequacy ratio is like aiming at
a moving target as the composition of risk-weighted assets gets changed now and then
on account of fluctuations in the risk profile of a bank. Tier I capital is known as the
core capital providing permanent and readily available support to the bank to meet the
unexpected losses. In the recent past, owners of PSU banks, and the government
provided adequate capital to weaker banks to ease the burden. In doing so, the
government was not acting as a prudent investor as return on such capital was never a
consideration.

21
 Further, capital infusion did not result in any cash flow to the receiver, as all the
capital was required to be reinvested in government securities yielding low returns.
Receipt of capital was just a book entry with the only advantage of income from the
securities.

4.1.5 CAPITAL ADEQUACY:

After the nationalization of banks, capitalization in banks was not given due
importance as it was felt necessary because the ownership of the banks rested with the
government, creating the required confidence in the minds of the public. Combined
forces of globalization and liberalization compelled the public sector banks, hitherto
shielded from the vagaries of market forces, to come by the condition of terms market
realities, where certain minimum capital adequacy must be maintained in the face of
stiff norms in respect to income recognition, asset classification, and provisioning. A
multi-pronged approach would be required to meet the challenges of maintaining
capital at adequate levels in the face of mounting risks in the banking sector. In banks,
asset creation is an event happening after capital formation and deposit mobilization.

4.1.6 RISK AGGREGATION & CAPITAL ALLOCATION:

Capital Adequacy about economic risk is a necessary condition for the long-
term soundness of banks. Aggregate risk exposure is estimated through the Risk-
Adjusted Return on Capital (RAROC) and Earnings at Risk (EaR) method. Former is
used by banks with international presence and the RAROC process estimates the cost
of Economic Capital & and expected losses that may prevail in the worst-case scenario
and then equates the capital cushion to be provided for the potential loss. RAROC is
the first step towards examining the institution’s entire balance sheet on a mark-to-
market basis if only to understand the risk-return trade-offs that have been made. As
banks carry on the business on a wide area network basis, they must be able to
continuously monitor the exposures across the entire organization and aggregate the
risks so that an integrated view can be taken. The Economic Capital is the amount of
capital (besides the Regulatory Capital) that the firm has to put at risk to cover the
potential loss under extreme market conditions. In other words, it is the difference in

22
the mark-to-market value of assets over liabilities that the bank should aim at or target.
As against this, the regulatory capital is the actual Capital Funds held by the bank
against the Risk-Weighted Assets. After measuring the economic capital of the bank,
the bank’s actual capital must be allocated to individual business units based on various
types of risks. This process can be continued till capital is allocated at the
transaction/customer level.

4.1.7 RISK-BASED SUPERVISION (RBS):

The Reserve Bank of India presently has its supervisory mechanism by way of
on-site inspection and off-site monitoring based on the audited balance sheet of a bank.
To enhance the supervisory mechanism, the RBI has decided to put in place, a system
of Risk Based Supervision. Under risk-based supervision, supervisors are expected to
concentrate their efforts on ensuring that financial institutions use the process
necessarily to identify measure, and control risk exposure. The RBS is expected to focus
supervisory attention on the risk profile of the bank. The RBI has already structured the
risk profile templates to enable the bank to make a self-assessment of its risk profile. It
is designed to ensure continuous monitoring and evaluation of the risk profile of the
institution through a risk matrix. This may optimize the utilization of the supervisory
resources of the RBI to minimize the impact of a crisis in the financial system. The
transaction-based audit and supervision is getting shifted to risk-focused audit. Risk-
based supervision approach is an attempt to overcome the deficiencies in the traditional
point-in-time, transaction- validation and value-based supervisory system. It is forward
looking enabling the supervisors to differentiate between banks to focus attention on
those having high-risk profiles. The implementation of risk-based auditing would imply
that greater emphasis is placed on the internal auditor’s role in mitigating risks. By
focusing on effective risk management, the internal auditor would not only offer
remedial measures for current trouble-prone areas but also anticipate problems to play
an active role in protecting the bank from risk hazards.

23
4.2: DIFFERENT TYPES OF RISK MANAGEMENT: KEYS FOR
EFFECTIVE RISK MANAGEMENT:

• To direct risk behavior & and influence the shape of a firm’s risk profile,
management should use all available options. Using financial incentives and
penalties to influence risk-taking behavior is an effective management tool.

• Sharing of information by keeping confidentiality intact is also helpful to find

out different ways for controlling the risk as valuable inputs may be received
through this sharing. Even information on the creditworthiness of counterparties
that are known to take substantial risk can also help.

• Diversification is extremely important. It lowers the variance in investor

portfolios, improves corporate ability to raise debt, reduces employment risks,
& and heightens operating efficiency.

• Governance should never be ignored. Careful structuring of the alliance in

advance of the deal and continual adjustment thereafter help to build a
constructive relationship.

• One should not trust while in business. Personal chemistry is good but is no
substitute for monitoring mechanisms, cooperation incentives, & and
organizational alignment.

• Without a support system within the organization itself, external alliances are
doomed to fail.

24
4.2.1 MARKET RISK MANAGEMENT:

We may believe that there are limited tools available to mitigate this risk, but
this is not so. Future, option, and derivatives trading and its many sub-types are some
of the tools that help investors protect their investments or minimize their exposure to
market risk. In the case of derivatives in a broader sense derivatives are used to hedge
against market risk, but they can be used to mitigate various other types of risks, like
credit risk, and operational risk.
The importance of managing market risk has now been well understood by
financial institutions and corporations across the world. Market risk has made global
financial conditions uncertain and unsettled and still recovery of the problem is not
visible in the near time.

4.2.2 CREDIT RISK MANAGEMENT:

Credit risk management is the practice of mitigating losses by assessing
borrowers' credit risk – including payment behavior and affordability.
Tools of Credit Risk Management: The instruments and tools, through which
credit risk is managed are: Exposure Ceilings, Review/Renewal, Risk Rating Model,
Risk-based scientific pricing, Portfolio Management, and Loan Review Mechanism.

25
4.2.3 OPERATIONAL RISK MANAGEMENT:

This risk can be reduced largely by effectively controlling the organization by

taking certain steps, like assuring that designed processes are carried out carefully &
and with the help of experts, and are followed in the desired way.

26
4.3: METHODOLOGIES FOR RISK ASSESSMENT &
APPROACHES TO HANDLE THE RISK:

4.3.1 CREDIT RISK APPROACHES:

Credit Risk

Standardized approach Advanced Approach

Foundation IRB

A. Standardized Approach: The Basel Committee as well as RBI provides a simple

methodology for risk assessment and calculating capital requirements for credit risk
called Standardized approach. This approach is divided into the following broad topics
for simpler and easier understanding
1. Assignment of Risk Weights: all the exposures are first classified into various
customer types defined by the Basel Committee or RBI. Thereafter, the assignment of
standard risk weights is done, either based on customer type or based on the asset
quality as determined by the rating of the asset, for calculating risk-weighted assets.

2. External Credit Assessments: the regulator or RBI recognizes certain risk rating
agencies and external credit assessment institutions (ECAIs) and ratings assigned by
these ECAIs, to the borrowers may be taken as a basis for assigning risk weights to the
borrowers. A better rating means better quality of assets and lesser risk weights and
hence lesser requirement of capital allocation.

3. Credit Risk Mitigation: Basel recognized Collaterals and Basel recognized

Guarantees are two securities that banks obtain for loans/advances to cover credit risk,
which is termed “Credit Risk Mitigants”

B. Advanced Approach: The Basel II framework also provides for advanced

approaches to calculate capital requirements for credit risk. These approaches rely

27
 heavily on a bank's internal assessment of its borrowers and exposures. These advanced
approaches are based on the internal ratings of the bank and are popularly known as
Internal Rating Based (IRB) approaches. Under Advanced Approaches, the banks will
have 2 options:
a) Foundation Internal Rating Based (FIRB) Approaches.
b) Advanced Internal Rating Based (AIRB) Approaches.

The differences between foundation IRB and advanced IRB have been captured in the
following table: The differences between foundation IRB and advanced IRB.

Data Input Foundation IRB Advanced IRB

Probability of Default Provided by the bank Provided by the bank based

based on its estimates on its estimates.

Loss Given Default Supervisory values set by Provided by the bank based
the Committee on its estimates.

Exposure at Default Supervisory values set by Provided by the bank based

the Committee on its estimates.

Effective Maturity Supervisory values set by Provided by the bank based

the Committee on its estimates or at the
national discretion, provided
by the bank based on its
estimates.

28
4.3.2 MARKET RISK APPROACHES:

Market Risk

Standardized Internal
Approach Model

Maturity Duration
Based Based

RBI issued detailed guidelines for the computation of capital charges on Market
Risk in June 2004. The guidelines seek to address the issues involved in computing
capital charges for interest rate-related instruments in the trading book, equities in the
trading book, and foreign exchange risk (including gold and precious metals) in both
trading and banking books. The trading book will include:
• Securities included under the Held for Trading category
• Securities included under the Available for Sale category
• Open gold position limits
• Open foreign exchange position limits
• Trading position in derivatives and derivatives entered for hedging trading book
exposures.

29
4.3.3 OPERATIONAL RISK APPROACHES:

Operational
Risk

Basic Indicator Standardized Advanced

Approach Approach Approach

Basic Indicator Approach: Under the basic indicator approach, Banks are required to
hold capital for operational risk equal to the average over the previous three years of a
fixed percentage (15% - denoted as alpha) of annual gross income. Gross income is
defined as net interest income plus net non-interest income, excluding realized
profit/losses from the sale of securities in the banking book and extraordinary and
irregular items.

Standardized Approach: Under the standardized approach, banks' activities are

divided into eight business lines. Within each business line, gross income is considered
a broad indicator of the likely scale of operational risk. The capital charge for each
business line is calculated by multiplying gross income by a factor (denoted beta)
assigned to that business line. The total capital charge is calculated as the three-year
average of the simple summations of the regulatory capital across each of the business
lines in each year.

Advanced Measurement Approach: Under the advanced measurement approach, the

regulatory capital will be equal to the risk measures generated by the bank’s internal
risk measurement system using the prescribed quantitative and qualitative criteria.

30
4.4: ANALYSIS OF BASEL II & ITS FRAMEWORK IN BANKING
SYSTEM:

4.4.1 BENEFITS OF BASEL-II:

1. Better allocation of capital and reduced impact of moral hazard through a

reduction in the scope for regulatory arbitrage: By assessing the amount of capital
required for each exposure or pool of exposures, the advanced approach does away with
the simplistic risk buckets of current capital rules.

2. Improved signal quality of capital as an indicator of solvency: the proposed rule

is designed to align regulatory capital more accurately with risk, which will improve
the quality of capital as an indicator of solvency.

3. Encourages banking organizations to improve credit risk management: One of

the principal objectives of the proposed rule is to align capital charges and risk more
closely. For any type of credit, risk increases as either the probability of default or the
loss given default increases.

4. More efficient use of required bank capital: Increased risk sensitivity and
improvements in risk measurement will allow prudential objectives to be achieved more
efficiently.

5. Incorporates and encourages advances in risk measurement and risk

management: The proposed rule seeks to improve upon existing capital regulations by
incorporating advances in risk measurement and risk management made over the past
15 years.

6. Recognizes new developments and accommodates continuing innovation in

financial products by focusing on risk: The proposed rule also has the benefit of
facilitating recognition of new developments in financial products by focusing on the
fundamentals behind risk rather than on static product categories.

31
7. Better alignment of capital and operational risk and encourages banking
organizations to mitigate operational risk: Introducing an explicit capital calculation
for operational risk eliminates the implicit and imprecise “buffer” that covers
operational risk under current capital rules.

8. Enhanced supervisory feedback: all three pillars of the proposed rule aim to
enhance supervisory feedback from federal banking agencies to managers of banks and
thrifts. Enhanced feedback could further strengthen the safety and soundness of the
banking system.

9. Enhanced disclosure promotes market discipline: The proposed rule seeks to aid
market discipline through the regulatory framework by requiring specific disclosures
relating to risk measurement and risk management.

10. Preserves the benefits of international consistency and coordination achieved

with the 1988 Basel Accord: An important objective of the 1988 Accord was
competitive consistency of capital requirements for banking organizations competing
in global markets. Basel II continues to pursue this objective.

4.4.2 LIMITATIONS OF BASEL II:

1. Lack of sufficient public knowledge: knowledge about banks’ portfolios and their
future risk weight, since this will also depend on whether banks will use the
standardized or IRB approaches.

2. Lack of precise knowledge: as to how operational risk costs will be charged. The
banks are expected to benefit from sharpening up some aspects of their risk
management practices preparation and for the introduction of the operational risk
charge.

3. Lack of consistency: at least at this stage, as to how insurance activities will be

accounted for. One treatment outlined in the Capital Accord is that banks deduct equity
and other regulatory capital investments in insurance subsidiaries and significant

32
minority investments in insurance entities. An alternative to this treatment is to apply
a risk weightage to insurance investments.

4.2.3 CHALLENGES FOR THE INDIAN BANKING SYSTEM

UNDER BASEL II:

• Costly Database Creation and Maintenance Process: The most obvious impact
of BASEL II is the need for improved risk management and measurement. It aims
to give impetus to the use of internal rating systems by the international banks.

• Additional Capital Requirement: Here is a worrying aspect that some of the

banks will not be able to put up the additional capital to comply with the new
regulation and they may be isolated from the global banking system.

• Large Proportion of NPAs: Many Indian banks have a significant proportion of

NPAs in their assets. Along with that, a large proportion of loans from banks are of
poor quality. There is a danger that many banks will not be able to restructure and
survive in the new environment. This may lead to forced mergers of many defunct
banks with the existing ones and a loss of capital to the banking system.

• Increased Pro-Cyclicality: The increased importance of credit ratings under Basel

II could imply that the minimum requirements could become pro-cyclical as banks
are required to raise capital levels for loans in times of economic crises.

• Low Degree of Corporate Rating Penetration: India has as few as three

established rating agencies and the level of rating penetration is not very significant
as, so far, ratings are restricted to issues and not issuers. While Basel II gives some
scope to extend the rating of issues to issuers, this would only be an approximation
and it would be necessary for the system to move to ratings of issuers. Encouraging
ratings of issuers would be a challenge.

33
• Cross Border Issues for Foreign Banks: In India, foreign banks are statutorily
required to maintain local capital, and the following issues are required to be
resolved;
1. Validation of the internal models approved by their head offices and home country
supervisor adopted by the Indian branches of foreign banks.
2. The date history maintained and used by the bank should be distinct for the Indian
branches compared to the global data used by the head office.
3. Capital for operational risk should be maintained separately for the Indian
branches in India.

4.4.4 IMPACT OF BASEL II IMPLEMENTATION ON THE

INDIAN BANKING INDUSTRY:

1. Changes in Capital Risk Weighted Assets Ratio (CRAR): Most of the banks are
already adhering to the Basel II guidelines. However, the Government has indicated
that a cushion should be maintained by the public sector banks and therefore their
CRAR should be above 12%. Basel, I focused largely on credit risk, whereas Basel II
has 3 risks to be considered, viz., credit risk, operational risk, and market risks. As Basel
II considers all these 3 risks, there are chances of a decline in the Capital Adequacy
Ratio.

2. High costs for up-gradation of technology: Full implementation of the Basel II

framework would require up-gradation of the bank-wide information systems through
better branch connectivity, which would entail huge costs and may raise IT-security
issues. The implementation of Basel II can also raise issues relating to the development
of HR skills and database management. Small and medium-sized banks may have to
incur enormous costs to acquire the required technology, as well as to train staff in
terms of risk management activities. There will be a need for technological gradation
and access to information like historical data etc.

3. Rating risks: Problems embedded in Basel II norms include rating of risks by rating
agencies. Whether the country has an adequate number of rating agencies to discharge

34
the functions in a Basel II-compliant banking system, is a question for consideration.
Further, to what extent the rating agencies can be relied upon is also a matter of debate.
Entry norms for recognition of rating agencies should be stricter. Only firms with
international experience or background in ratings business should be allowed to enter.
This is necessary given that the Indian rating industry is in its growth phase, especially
with the implementation of new Basel II capital norms that encourage companies to get
rated.

4. Improved Risk Management & Capital Adequacy: One aspect that holds back the
critics of Basel II is the fact that it will tighten the risk management process, improve
capital adequacy, and strengthen the banking system.

5. Curtailment of Credit to Infrastructure Projects: The norms require a higher

weightage for project finance, curtailing credit to this is a very crucial sector. The long-
term impacts of this could be disastrous.

6. Preference for Mortgage Credit to Consumer Credit Lower Risk Weights to

Mortgage Credit: Preference for Mortgage Credit to Consumer Credit Lower Risk
Weights to Mortgage credit would accentuate bankers’ preference towards it vis-à-vis
consumer credit.

7. Basel II-Advantage Big Banks: It would be far easier for the larger banks to
implement the norms, raising their quality of risk management and capital adequacy.
This combined with the higher cost of capital for smaller players would queer the pitch
in favor of the former. The larger banks would also have a distinct advantage in raising
capital in equity markets. Emerging Market Banks can turn this challenge into an
advantage by active implementation and expanding their horizons outside the country.

8. IT spending: Advantage to Indian IT companies: On the flip side, Indian IT

companies, which have considerable expertise in the BFSI segment, stand to gain.
Major Indian IT companies such as I-flex and Infosys already have the products, which
could help them develop an edge over their rivals from the developed countries.

35
4.5: DATA ANALYSIS, INTERPRETATION & OBSERVATION:

4.5.1: QUESTIONNAIRES ABOUT AWARENESS OF

REGULATIONS:

Source: All the below analysis and interpretation is done from the survey
conducted in Banks and with Related Persons.

1. What is your assessment of your readiness for the new Basel proposals concerning
capital requirements?
Table 4.5.1.1: Readiness for the new Basel proposal
CREDIT MARKET OPERATIONAL
RISK RISK RISK
FULLY PREPARED 8 9 9

PARTIALLY 2 1 1
PREPARED
NOT YET PREPARED 0 0 0

OPERATIONAL CREDT RISK, 8

CREDT RISK
RISK, 9
MARKET RISK
OPERATIONAL RISK

MARKET RISK,
9

Figure 4.5.1.1: Readiness for the new Basel proposal

36
2. Have you done a gap analysis between current risk management practice and new
capital requirements?
Table 4.5.1.2: Gap analysis
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 8 5 9

NO 1 5 1

CAN’T 1 0 0
SAY

YES,
OPERATIONAL CREDT RISK
YES, CREDT
RISK, 9, 39%
RISK, 9, 39%
MARKET RISK
OPERATIONAL RISK

YES, MARKET
RISK, 5, 22%

Figure 4.5.1.2: Gap analysis

37
3. What degree of priority do you address to the new Basel regulatory framework?
Table 4.5.1.3: Priority to new Basel regulatory framework
CREDIT MARKET OPERATIONAL
RISK RISK RISK
VERY 9 9 10
IMPORTANT
IMPORTANT 1 1 2
NOT IMPORTANT 0 0 0

VERY VERY
IMPORTANT, IMPORTANT,
OPERATIONAL
CREDT RISK, 9,
RISK, 10, 36% CREDT RISK
32%
MARKET RISK
OPERATIONAL RISK

VERY
IMPORTANT,
MARKET RISK,
9, 32%

Figure 4.5.1.3: Priority to new Basel regulatory framework

38
4. How do you view Basel II regulation: as an opportunity to enhance the risk
management process, or as a regulatory constraint?
Table 4.5.1.4: View of Basel II regulation
CREDIT MARKET OPERATIONAL
RISK RISK RISK
OPPORTUNITY 10 8 10

CONSTRAINT 0 2 0

OPPORTUNITY
,
OPERATIONAL
RISK, 10, 36%
OPPORTUNITY
, CREDT RISK,
10, 36%
CREDT RISK
MARKET RISK
OPERATIONAL RISK

OPPORTUNITY
, MARKET
RISK, 8, 28%

Figure 4.5.1.4: View of Basel II regulation

OBSERVATIONS

• The majority of banks consider themselves to be fully prepared.

• A majority of banks have performed a gap analysis between their current risk
management practice and the new capital requirements.
• Only one bank does not view Basel II implementation as a high-priority project.
• The banks largely believe that Basel II will provide them an opportunity to
enhance risk management.

39
INTERPRETATION

• Although the Basel II regulations are considered important to very important by

a strong majority of banks, some are only partly prepared for implementation.
• The banks aim to look beyond the regulatory aspects and to benefit from the new
regulations to enhance risk management.

40
4.5.2 QUESTIONNAIRES ABOUT ORGANIZATIONAL
STRUCTURE:

1. Do you have an assigned Credit risk, Market risk, and Operational risk manager in
your bank?
Table 4.5.2.1: Assignment of Risk Manager
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 10 9 9
NO 0 1 1

12

10

0
CREDT RISK MARKET RISK OPERATIONAL RISK
YES NO

Figure 4.5.2.1: Assignment of risk manager

41
2. To whom does the Risk manager report?
Table 4.5.2.2: To whom does the risk manager report
CREDIT MARKET OPERATIONAL
RISK RISK RISK
CHIEF EXECUTIVE OFFICER 4 6 6
CHIEF FINANCIAL OFFICER 0 0 0
ASSETS AND LIABILITY 2 1 1
MANAGER
CREDIT RISK OFFICER 4 2 2
OTHER SPECIFY 0 0 0

0
CREDT RISK MARKET RISK OPERATIONAL RISK

CHIEF EXECUTIVE OFFICER CHIEF FINANCIAL OFFICER

ASSETS AND LIABLITY MANAGER CREDIT RISK OFFICER
OTHER SPECIFY

Figure 4.5.2.2: Whom does the risk manager report?

42
3. What is the assigned manager’s time dedicated to this activity?
Table 4.5.2.3: Time dedication
CREDIT MARKET OPERATIONAL
RISK RISK RISK

0-20% 2 4 2
20-50% 2 1 2
>50% 6 5 6

4
0-20%
20-50%
3
>50%

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.2.3: Time dedication

43
4. How many people work in these departments?
Table 4.5.2.4: Number of people work
CREDIT MARKET OPERATIONAL
RISK RISK RISK

1-3 2 4 1

6 4 5
3-5
5- 10 1 1 1
> 10 1 1 3

4 1-3
3-5

3 5- 10
> 10

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.2.4: Number of people who work

44
5. Do you have a Risk Committee?
Table 4.5.2.5: Risk Committee
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 6 5 6
NO 4 5 4

4
YES
3 NO

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.2.5: Risk Committee

OBSERVATIONS

• Almost all the participating banks have a risk management department.

• Most of the industry’s risk managers report to the Chief Executive Officer, Asset
and liability manager, and Chief Risk Officer accounting for the balance in equal
proportions.
• Slightly more attention is paid to credit and operational risk than to Market risk,
as 40 % of the banks operating do not have risk committees.

45
INTERPRETATION

• Despite the relatively small size of banks, they are generally aware of the risk
management function, and for this purpose, risk managers spend over half their
time performing these functions.
• All the banks have separate officers to handle the different types of risk that can
be cached in the bank.

46
4.5.3 QUESTIONNAIRES ABOUT REPORTING ABILITY:

1. Are you producing reporting for

Table 4.5.3.1: Reports produced for
CREDIT MARKET OPERATIONAL
RISK RISK RISK
REGULATORY PURPOSE 3 4 4
MONITORING 7 8 8
DECISION-MAKING 7 4 4
PURPOSE

REGULATORY PURPOSE MONITORING

DECISION MAKING PURPOSE

9

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.3.1: Reports produced for

47
2. Does external reporting drive your internal reporting?
Table 4.5.3.2: External reporting drives internal reporting
CREDIT MARKET OPERATIONAL
RISK RISK RISK
VERY 4 5 4
SIGNIFICANTLY
SIGNIFICANTLY 5 4 5
NOT AT ALL 1 1 1
SIGNIFICANTLY

VERY SIGNIFICANTLY

3
SIGNIFICANTLY

NOT AT ALL
SIGNIFICANTLY
2

0
CREDT RISK MARKET RISK OPERATIONAL
RISK

Figure 4.5.3.2: External reporting drives internal reporting

48
3. Does external reporting affect your decision-making process?
Table 4.5.3.3: External reporting affects the decision-making process
CREDIT MARKET OPERATIONAL
RISK RISK RISK
VERY 3 3 3
SIGNIFICANTLY
SIGNIFICANTLY 6 5 6
NOT AT ALL 1 2 1
SIGNIFICANTLY

4 VERY SIGNIFICANTLY

SIGNIFICANTLY
3

NOT AT ALL
SIGNIFICANTLY
2

0
CREDT RISK MARKET RISK OPERATIONAL
RISK

Figure 4.5.3.3: External reporting affects the decision-making process

49
4. How frequent is your internal reporting?
Table 4.5.3.4: Frequency of internal reporting
CREDIT MARKET OPERATIONAL
RISK RISK RISK

Daily 1 0 1
Weekly 0 1 1
Monthly 8 8 7
Annually 1 1 1

5 Daily
Weekly
4 Monthly
Annually
3

0
CREDT RISK MARKET RISK OPERATIONAL
RISK

Figure 4.5.3.4: Frequency of internal reporting

50
5. Will you produce specific internal reporting for Credit, Market, and Operational
Risk?
Table 4.5.3.5: Production of specific internal reporting
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 10 10 10

NO 0 0 0

YES NO

12

10

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.3.5: Production of specific internal reporting

51
OBSERVATIONS

• All risk reporting is compiled largely for monitoring and Decision-making

purposes rather than Regulatory purposes.
• All the Banks produce internal reports.
• Most of the Banks produce Internal Reports monthly.
• Most of the banks said External reporting affects their decision-making process.

INTERPRETATION

• Reporting for all risks still needs to be developed.

• Increase in the frequency of monthly reports.

52
4.5.4 QUESTIONNAIRES ABOUT COMPLIANCE WITH BASEL
II:

1. Which approach will best suit your organization?

Table 4.5.4.1: Approach that best suit organization
CREDIT MARKET OPERATIONAL
RISK RISK RISK
STANDARD 8 9 7
FOUNDATION 0 0 0
ADVANCED 2 1 3
DON’T KNOW 0 0 0

STANDARD FOUNDATION ADVANCED DON’T KNOW

10

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.4.1: Approach that best suits the organization

53
2. Have you performed a Cost/Benefit analysis for each approach proposed by Basel
II?
Table 4.5.4.2: Cost/Benefit Analysis
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 10 8 9
NO 0 2 1

12

10

6 YES
NO

0
CREDT RISK MARKET RISK OPERATIONAL RISK

Figure 4.5.4.2: Cost/Benefit Analysis

54
3. In your situation, could regulatory capital consumption be a motivation for:
Table 4.5.4.3: Regulatory capital consumption is a motivation
CREDIT MARKET OPERATIONAL
RISK RISK RISK
STOPPING 2 1 2
ACTIVITIES
DEVELOPING 5 7 6
ACTIVITIES
ACQUIRING 1 0 0
ACTIVITIES
NONE 1 1 1

STOPPING
5
ACTIVITIES
DEVEOPLING
4 ACTIVITIES
ACQUIRING
3 ACTIVITIES
NONE
2

0
CREDT RISK MARKET RISK OPERATIONAL
RISK

Figure 4.5.4.3: Regulatory capital consumption is a motivation

OBSERVATIONS

• Most of the banks believe that the standard approach is most appropriate for their
purposes.
• Overall, a cost/benefit analysis has been done for each approach. It appears that
the banks have completed their cost/benefit analysis only for their elected
approach.

55
 • Regulatory capital consumption is motivated for developing activities.

INTERPRETATION

• Most of the banks would prefer to adopt the standard approach, but only a few
of those who would like to implement the advanced approach will implement it.
• The banks that would prefer to adopt the standard approach should try to adopt
an advanced approach.

56
4.5.5 QUESTIONNAIRES ABOUT CAPITAL ALLOCATION:

1. Have you estimated the regulatory capital consumption for each of your businesses?
Table 4.5.5.1: Estimation of the regulatory capital consumption
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 10 9 10

NO 0 1 0

OPERATIONAL RISK 10

MARKET RISK 9 1

CREDT RISK 10

84% 86% 88% 90% 92% 94% 96% 98% 100%

YES NO

Figure 4.5.5.1: Estimation of the regulatory capital consumption

57
2. Will you outsource activities with high capital consumption?
Table 4.5.5.2: Outsource activities for high capital consumption

CREDIT MARKET OPERATIONAL

RISK RISK RISK

YES 4 3 5

NO 6 7 7

OPERATIONAL RISK 5 7

MARKET RISK 3 7

CREDT RISK 4 6

0% 20% 40% 60% 80% 100%

YES NO

Figure 4.5.5.2: Outsource activities for high capital consumption

58
3. Will you insure selected Risk?
Table 4.5.5.3: Insure Risk
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 7 5 6
NO 3 5 4

OPERATIONAL RISK 6 4

MARKET RISK 5 5

CREDT RISK 7 3

0% 20% 40% 60% 80% 100%

YES NO

Figure 4.5.5.3: Insure Risk

59
4. Do you intend to allocate economic capital by Business lines?
Table 4.5.5.4: Allocation of economic capital
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 8 7 8
NO 1 2 1

OPERATIONAL RISK 8 1

MARKET RISK 7 2

CREDT RISK 8 1

0% 20% 40% 60% 80% 100%

YES NO

Figure 4.5.5.4: Allocation of economic capital

60
5. Will you make use of Basel II requirements to implement an economic capital
allocation throughout your business lines?
Table 4.5.5.5: Use of Basel II requirements

CREDIT MARKET OPERATIONAL

RISK RISK RISK

YES 9 8 8
NO 1 1

OPERATIONAL RISK 8 1

MARKET RISK 8 1

CREDT RISK 9

82% 84% 86% 88% 90% 92% 94% 96% 98% 100%

YES NO

Figure 4.5.5.5: Use of Basel II requirements

OBSERVATIONS

• Most of the banks do not outsource activities with high capital consumption.
• Half of the banks insure selected Risk.
• Banks with less sophisticated approaches are likely to use regulatory capital as
the basis for internal capital allocation.

61
INTERPRETATION

• Very few banks plan to outsource activities with high capital consumption, but
the majority will ensure their credit risks, while nearly half will plan to insure
their market and operational risks.
• A strong majority of local banks will allocate economic capital according to
business lines, while a stronger majority will use the Basel II requirements to
implement that capital allocation process.

62
4.5.6 QUESTIONNAIRES ABOUT THE BASEL II ACTION PLAN:

1. Have you established an action plan to achieve the Basel II requirements?

Table 4.5.6.1: Establishment of action plan

CREDIT MARKET OPERATIONAL

RISK RISK RISK

YES 10 10 10
NO 0 0 0

10
9
8
7
6 10 10 10
5
4
3
2
1
0
CREDT RISK MARKET RISK OPERATIONAL
RISK

YES NO

Figure 4.5.6.1: Establishment of action plan

63
2. How will you execute this action plan?
Table 4.5.6.2: Execution of action plan
CREDIT MARKET OPERATIONAL
RISK RISK RISK
INTERNAL 7 5 8
RESOURCES

EXTERNAL 1 4 1
RESOURCES

BOTH 4 3 3

12
3 3
4
10
1

8 1
4

8
4 7
5

0
CREDT RISK MARKET RISK OPERATIONAL
RISK

INTERNAL RESOURCES EXTERNAL RESOURCES BOTH

Figure 4.5.6.2: Execution of action plan

64
3. What will the largest spending area be?
Table 4.5.6.3: Largest spending area
CREDIT MARKET OPERATIONAL
RISK RISK RISK
TECHNOLOGY 8 7 8

COMMUNICATION 1 4 1
OTHER (SPECIFY) 0 0 0
DON’T KNOW 0 0 0

12

10
4
1 1

8 8
4 7

0
CREDT RISK MARKET RISK OPERATIONAL
RISK

TECHNOLOGY COMMUNICATION OTHER (SPECIFY) DON’T KNOW

Figure 4.5.6.3: Largest spending area

65
4. How far are you in the implementation of your action plan?
Table 4.5.6.4: Current progress
CREDIT MARKET OPERATIONAL
RISK RISK RISK
NOT REALISED 0 0 0

PARTIALLY 5 7 5
REALISED

FULLY 5 3 5
REALISED

10
9 3
8 5 5
7
6
5
4 7
3 5 5
2
1
0
CREDT RISK MARKET RISK OPERATIONAL
RISK

NOT REALLISED PARTIALLY REALLISED FULLY REALLISED

Figure 4.5.6.4: Current progress

OBSERVATIONS

• All the banks established an action plan to achieve the Basel II requirements.
• Most of the banks execute the action plan with internal resources rather than
external resources.
• The largest spending area is technology.
• Half of the bank’s implementation of the action plan is partially realized and
half is fully realized.

66
INTERPRETATION

• The banks have generally determined an action plan to help them to meet Basel
II requirements. They have partially completed the actions required and will
continue with these action plans.
• Those banks that have not yet begun implementation tend to be the smaller
banks, with simpler business models, which require less time and resources to
meet the Basel II requirements.

67
4.5.7 QUESTIONNAIRES ABOUT TECHNOLOGY
INFRASTRUCTURE:

1. Does your current IT infrastructure allow you to meet the Basel II requirements?
Table 4.5.7.1: IT infrastructure
CREDIT MARKET OPERATIONAL
RISK RISK RISK
YES 10 8 9
NO 0 2 1

12

YES, CREDT
10
RISK, 10
YES,
OPERATIONAL
RISK, 9
YES, MARKET
8
RISK, 8

NO, MARKET
2
RISK, 2
NO,
OPERATIONAL
RISK, 1
0
CREDT RISK MARKET RISK OPERATIONAL RISK

YES NO

Figure 4.5.7.1: IT infrastructure

68
2. Will you develop an IT solution for Risk management?
Table 4.5.7.2: IT solution for Risk management
CREDIT MARKET OPERATIONAL
RISK RISK RISK

YES 7 7 7
NO 3 3 3

Chart Title
8

YES,
YES, CREDT YES, MARKET
7 OPERATIONAL
RISK, 7 RISK, 7
RISK, 7

NO,
NO, CREDT NO, MARKET
3 OPERATIONAL
RISK, 3 RISK, 3
RISK, 3

0
CREDT RISK MARKET RISK OPERATIONAL RISK

YES NO

Figure 4.5.7.2: IT solution for Risk management

69
3. Have you completed a review of potential IT solutions available?
Table 4.5.7.3: Review of potential IT solutions available

CREDIT MARKET OPERATIONAL

RISK RISK RISK

TECHNOLOGY 5 3 4

CONSULTING 4 6 5

CONSULTING,
6 MARKET RISK,
6

CONSULTING,
TECHNOLOGY,
5 OPERATIONAL
CREDT RISK, 5
RISK, 5

TECHNOLOGY,
CONSULTING,
4 OPERATIONAL
CREDT RISK, 4
RISK, 4

TECHNOLOGY,
3 MARKET RISK,
3

0
CREDT RISK MARKET RISK OPERATIONAL RISK

TECHNOLOGY CONSULTING

Figure 4.5.7.3: Review of potential IT solutions available

70
4. What difficulties do you foresee?
Table 4.5.7.4: Difficulties that you foresee
CREDIT MARKET OPERATIONAL
RISK RISK RISK
INTEGRATION 3 1 1
CAPABILITIES
DATABASE DESIGN 1 1 2
MODELS 1 0 1
BUDGET 0 0 1
DATA GATHERING 4 6 4
HUMAN RESOURCE 3 3 3

OTHER (SPECIFY) 0 0 0

7
6
6

5
4 4
4
3 3 3
3

2
1 1 1
1

0
CREDT RISK MARKET RISK OPERATIONAL RISK

INTEGRATION CAPABILITIES DATABASE DESIGN

MODELS BUDGET
DATA GATHERING HUMAN RESOURCE
OTHER (SPECIFY)

Figure 4.5.7.4: Difficulties that you foresee

71
OBSERVATIONS

• Many organizations are using technology-based models to manage the upcoming

risk.
• They have well-equipped structural risk models.
• Many of the firms are unable to find accurate data from history.
• They have good IT Infrastructure for risk management.

INTERPRETATION

• Firms have managed to get some up-to-date historical data from past resources
but still they must get more accurate and effective data to tackle more risk-
related problems in the future.
• They are getting an equal number of risk-related solutions from both
departments i.e. IT and Consulting.

72