Risk Management Frameworks in Banking Sector

In the last article, we talked about various types of risks in the banking sector. To ensure the soundness of an economy, we need to minimise the effects of risk and hence a central agency is needed for supervision, RBI in our case. Various risk management frameworks are hence defined to act as guidelines for supervision.

Risk management frameworks

RBI has two main functions – financial regulation and supervision. Both are much sophisticated and effort taking functions. For financial regulation, RBI uses various quantitative and qualitative tools such as defining various policy rates, doing open market operation etc.

For supervisory function, Board of financial supervision has been constituted under RBI which is an autonomous body and supervises all financial institutions except SEBI monitored stock market and IRDAI regulated insurance market.

Following are the risk management frameworks:

1. CAMELS rating to ensure financial soundness of the bank
2. Basel norms (Basel I, II and III) for risk management
3. PCA (Prompt Corrective Action) to take corrective actions

CAMELS rating:

The main instrument of supervision in India is the periodical on-site inspection of banks that is supplemented by off-site monitoring and surveillance. On-site inspections are based on CAMELS (Capital adequacy, asset quality, management, earnings, liquidity, and sensitivity) model and aim at achieving the set objectives.

• C – Capital adequacy
  • The capital adequacy measures the bank’s capacity to handle the losses and meets all its obligations towards the customers without ceasing its operations. This can be met only on the basis of an amount and the quality of capital, a bank can access. A ratio of Capital to Risk Weighted Assets determines the bank’s capital adequacy.
  • The high rating is given when interest and dividend rules are complied. (interest and dividend rules differentiate interest and dividend earning Capitals and define taxations on them)
• A – Asset Quality
  • An asset represents all the assets of the bank, Viz. Current and fixed, loans, investments, real estates and all the off-balance sheet transactions. Through this indicator, the performance of an asset can be evaluated. The ratio of Gross Non-Performing Loans to Gross Advances is one of the criteria to evaluate the effectiveness of credit decisions made by the banker.
• M – Management
  • The board of directors and top-level managers are the key persons who are responsible for the successful functioning of the banking operations.
    Management assessment determines whether an institute is able to react properly to financial stress, depending upon the ability of its management.
• E – Earnings
  • Income from all the operations, non-traditional and extraordinary sources constitute the earnings of a bank. Through this parameter, the bank’s efficiency is checked with respect to its capital adequacy to cover all the potential losses and the ability to pay off the dividends. Return on Assets Ratio measures the earnings of the banks.
• L – Liquidity
  • The bank’s ability to convert assets into cash is called as liquidity. The ratio of cash maintained by Banks and Balance with the Central Bank to Total Assets determines the liquidity of the bank.
• S – Sensitivity
  • Through this parameter, the bank’s sensitivity towards the changing market conditions is checked, i.e. how adverse changes in the interest rates, foreign exchange rates, commodity prices, fixed assets will affect the bank and its operations.

In CAMELS rating, supervisory authority assigns each bank a score from 1 to 5 for each factor mentioned, where 1 is for best and 5 is for worst rating.

The domestic banks are rated on CAMELS model while foreign banks are rated on CALCS model (capital adequacy, assets quality, liquidity, compliance, and systems). The frequency of inspections is generally annual, which can be increased/reduced depending on the financial position, methods of operation and compliance record of the bank.

Basel Norms:

At end of 1974, central bank governors of the group of ten countries formed a committee of banking supervisory authorities. This committee usually meet at Bank of International Settlement (BIS), Basel, Switzerland, hence popular by the name ‘Basel committee’.

BASEL I: The Basel-I defines two tiers of the Capital in the banks to provide a point of view to the regulators. The Tier-I Capital is the core capital while the Tier-II capital can be said to be subordinate capitals. It mainly caters to credit risk (borrowers defaulting).

• Tier 1 capital =
  • Paid up Capital
  • Statutory Reserves
  • Other disclosed free reserves
  • Capital Reserves which represent surplus arising out of the sale proceeds of the assets.
  • Investment Fluctuation Reserves
  • Innovative Perpetual Debt Instruments (IPDIs)
  • Perpetual Noncumulative Preference Shares.

Minus:

• Equity Investment in subsidiaries.
• Intangible assets such as goodwill
• Losses (Current period + past carried forward)

• Tier 2 capital =
  • Undisclosed reserves and cumulative perpetual preference shares.
  • Revaluation Reserves
  • General Provisions and loss reserves
  • Hybrid debt capital instruments such as bonds.
  • Long term unsecured loans
  • Debt Capital Instruments.
  • Redeemable cumulative Preference shares
  • Perpetual cumulative preference shares.

• Risk adjusted assets:
• 0% – government and central bank claims
• 20% – OECD inter-bank claims
• 50% – residential mortgages
• 100% – all commercial and consumer loans

As per Basel norms, the capital ratio should be greater than or equal to 8%. As per RBI, the flour is 9%. Hence any bank in India with CR less than 9% is deemed to be risky.

BASEL II:

Basel II norms have three pillars:

1. Pillar 1 – Minimum capital requirement –

The capital ratio remains same as Basel I. But the calculation of CR is taken in a slightly different manner.

Important changes –

1. Along with credit risk, market risk and operational risks are also taken into account while calculating minimum capital.
2. RWA are now calculated differently. Each type of asset is not given the pre-fixed weight but is assigned as per rating based system. For example, if consumer loan of a type of rating 1 then it may be assigned risk weight around 50% (contrary to Basel I where it was assigned 100% risk).
3. Pillar 2 – Supervisory review process –

There is a necessity of effective supervisory review of banks’ internal assessment of their overall risks to ensure that bank management in exercising social judgment and set aside adequate capital for these risks. Supervisors go to banks for evaluation of activities and risk profiles. This process also takes into account other risks such as interest rate risks.

An important outcome of pillar 2 is ICAAP – Internal Capital Adequacy Assessment Process. It is an umbrella activity that encompasses the governance, management, and control of all risks and capital management functions.

1. Pillar 3 – Market discipline –

It is about effective management such as transparency in banks’ public reporting. Thus adequate disclosure of information in a timely manner brings in market discipline and in the process promotes safety and soundness in the financial system.

Disclosures are either core or supplementary. Core disclosures are those who convey the vital information for all institutions and are important to the basic operation of market discipline. Supplementary disclosures are important for any particular institution, but it should not be treated as secondary or optional.

BASEL III:

It is intended to strengthen banks’ capital requirement by increasing bank liquidity and decreasing bank leverage.

1. Capital ratio – We know that

AT1: This is the money borrowed by the company and expected back by the lenders. But in case of loss, debt is converted into equity i.e. shares of the same price are issued to lenders and no money is returned. So this is a way of debt restructuring debts. These are also called CoCo bonds or contingent convertible bonds. These bonds can also be canceled anytime.

PCA (Prompt Corrective Action) Framework:

PCA framework has been revised and is effective from April 1, 2017. New PCA framework has following parameters, breach of any of which threshold will trigger disciplinary action against that particular bank:

1. Capital to risk-weighted asset ratio (CRAR)/Common Equity Tier I ratio to measure capital – CRAR is defined as Capital ratio + capital conservation buffer (CCB). CET1 ratio is defined as per Basel III norms. CCB is the buffer made by banks during profit periods so that it can be used during loss periods.
2. Net NPA ratio to measure asset quality – Net NPA ratio is defined as the percentage of net NPAs to net advances
3. Return on Assets (RoA) to measure profitability – it is defined as the percentage of profit after tax to average total assets.
4. Leverage ratio (Additional, it wasn’t included in the old PCA) – It is defined same as in Basel norms.

Note – CCB would be 1.875% and 2.5% as on March 31, 2018 and March 31, 2019 respectively.

Following are the actions taken if breaching of any risk threshold takes place.

Common menu for selection of discretionary corrective actions

1. Special Supervisory interactions – Special supervisory monitoring meetings/ inspection/audit of the bank
2. Strategy related actions – Special short term/medium term strategy as advised by RBI to bank’s board
3. Governance related actions – RBI to restructure banks board which contain removal/addition of any managerial person and take other actions as per Banking Regulation Act 1949.
4. Capital related actions – RBI may restrict the bank to expand high-risk weighted assets and from exposure to high-risk sectors, etc.
5. Credit risk related actions – Preparation of time bound plan and commitment for reduction of stock of NPAs, reduction of risk assets, the sale of assets, etc.
6. Market risk related actions – reduction in borrowings from different markets, interbank markets, etc.
7. HR related actions – Reduction in staff expansion or reduce expansion on training etc
8. Profitability related actions- Restrictions on capital expenditure, other than for technological up gradation.
9. Operations related actions – Restrictions on branch expansion plans, Reduction in business etc.

So these are the different risk management frameworks used in the present economic scenario, to effectively tackle the stress period of the economy.

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