Traditionally, banks used to have two separate track approach for credit risks and market risks. The Asset –Liability Management Committee (ALCO) of the bank used to deal with various types of market risks whereas the Credit Policy Committee (CPC) continued taking care of credit/counterparty and country risks. However, in the recent years, as a result of economic crisis in some of the countries, all international banks and banking their regulators have realized a strong co-relation between un-hedged market and credit risk. They have understood that the risks are highly interdependent and the risk at one area may have ramifications on other categories of risks. Thus, the concept of integrated risk management is evolved in banking sector to deal with various types of risks confronted by the bank at one place. Integrated risk management is the comprehensive risk taking methodology which includes structure of prudential limit, strong MIS for reporting, monitoring and controlling risks and periodical review and evaluations. It encompasses with broader business strategies, capital strength, management expertise and overall willingness to assume risk which is approved by the Board of the bank.
Internal scoring and or external credit rating are the methodology used by the banks both for risk weighting and risk management purposes. Except for some specified types of loans the lending decisions and credit pricing decisions of the banks mostly depends upon the assessment of credit risk weighting, which is grasped through the methodology of internal scorings/ external ratings. The Basel II accord emphasizes aligning the capital requirements of banks with risk sensitivity. Therefore, for the purpose of declaration of capital adequacy, banks ought to use the ratings assigned by any one of the domestic or international credit agencies recognised by the Reserve Bank. However, banks have the options to select credit rating agencies of their own choice.
The following are the agencies identified by the RBI which can be entrusted with external credit assignment. a) Analysis and Research Limited(CARE); b) CRISIL Limited; c) FITCH India; d) ICRA Limited; e) Brickwork Ratings India Pvt. Limited (Brickwork). Reserve Bank of India also permitted banks in India to use ratings of following international credit rating agencies for their claims for capital adequacy purpose. a). Fitch; b). Moody’s; c).Standard & Poor’s.
Risk Weighted Assets (RWA)
The RWA is measured on the risk component of the assets. For example Cash held by bank is an asset with zero risk, whereas other assets of the bank such as loans and advances, guarantees etc., are vulnerable to risk of default. Thus, based on risk exposure inputs and compliance to prudential risk parameters reported by their middle offices, the Risk Management Department assesses the probable risk and the potential value losses in each type of assets held by the bank and accordingly make provisions on those potential value losses.
Loan Review Mechanism (LRM)
To check the slippage of advances from good to bad, banks have implemented Loan Review Mechanism (LRM) for their large value accounts. The Loan reviews are designed to evaluate the effectiveness of sanction process and status of post sanction position of the accounts. Usually first of such reviews takes place within 3 months of a sanction/renewal of limit for the accounts enjoying credit limits beyond a cut-off credit limit fixed by the bank. In addition to advances beyond the cut-off limits, about 5-10% of randomly selected proposals from the rest of the portfolio and accounts of sister/ associate concerns of the groups that present elevated risk characteristics are also chosen for reviews. As per RBI guidelines at least 30-40% of the portfolio should be subjected to LRM in a year so as to ensure that all the major credit risks embedded in balance-sheet has been pursued. The frequency of review of accounts take place depending upon to the magnitude of risk assigned to the accounts viz. high risk, average risk, and low risk accounts (say once in a 3 /6/12 months). However, the loan reviews may take place more frequently than 3 months when factors indicate a potential for the deterioration of the credit quality. Timely credit grading is another primary of the LRM. The credit grading involves verification of compliance of conditions of the sanction in terms of laid down policies, regulatory compliance and adequacy of documentation. Reviewing of credit rating awarded by Credit Administration Department, Investment Portfolio (Quasi Credit) and suggesting various measures for improvements including reduction in portfolio concentration on specific category of portfolio are also the important functions of LRM.
Risk-return pricing is a fundamental tenet of risk management. The pricing of loans (interest rate on loans) normally linked to risk rating or credit quality. For determination of pricing of loan banks assess credit quality, portfolio /industrial exposure, business potential, external ratings/internal scoring, value of the collateral, market forces, the probability provisioning requirement etc. The probability of expected default is measured from past experience of a specific loan portfolio based on historical data available with the bank. The advance classified under high risk category in terms of probability of default will be priced high. The lending banks need to allocate enough capital for the purpose of provisioning commensurate with expected default rates assessed by them.
The ‘Market risk’ is an umbrella term used for multiple types of risk associated with adverse changes in market variables that includes Liquidity Risk, Interest rate risk, Foreign exchange rate risk and equity price risk. The Market risk is measured on the basis of value-at-risk (VAR) analysis which is a statistical technique to quantify the maximum possible level of loss in an investment portfolio over a specific time frame (holding period). It means under VaR estimation, maximum percentage of change in value or return of the portfolio shall not be allowed to exceed given probability of confidence level (example: Say 96%) at a future time horizon. Thus the Risk Manager’s job is to make sure that the risks are not taken beyond the level at which bank cannot absorb the losses which may occur due to market swings/crisis. The VaR number (‘probable loss numeric) for a portfolio is useful in determining regulatory requirement of capital to bank’s exposure to risks.
Credit Valuation Adjustment (CVA)
From the studies on past financial crisis in some of the countries, the researchers noticed that the two third of counter party credit losses during the crisis period were mainly due to credit market volatility and not because of counterparty defaults. Therefore, the Basel Committee has introduced a new capital charge in Basel III called Credit Valuation Adjustment (CVA) charges which essentially increases the required capital for OTC (over-the-counter) derivative trading activities. CVA measures the difference between the true value and market value of a portfolio and captures the risk of mark-to-market losses due to deterioration in the credit worthiness of counterparty. The CVA charges also aims at resilience against potential counterpartys’ default.
Risk capital is the minimum amount of capital a bank requires to maintain for its exposure to risks. Higher capital requirement makes the banks to take risk on their own fund instead of depositor’s money. The new capital adequacy norms under Basel III capture all the major risks menacing the operation of the banks. It recommends for higher capital requirement in the form of Tier 1 capital which predominantly consist of Common Equity. Thus in addition to suitable steps to monitor and control the likely risk the banks should have sufficient capital to provide a stable reserve to absorb any losses arising from credit risks, market risks and operation risks etc. It is estimated that banks in India will need to raise around Rs.4.50 lakh Crore in tier I capital including Rs.2.40 lakh Crore in equity capital by March 2018 under Basel III norms.
Capital conservative buffer.
Under the framework of Basel III, Bankers are required to hold Capital Conservative Buffer of 2.5% of RWA (Risk Weighted Assets) in the form of common equity. The capital conservative buffer is planned to ensure a safety net that banks build up capital buffer during normal times (outside period of stress) which can be drawn down during stressed period to cover the losses. The capital conservative buffer in the form of common equity will be phased-in over a period of four years in a uniform manner of 0.625% per year commencing from January 1, 2016.
Risk Management Department
The risk management department (RMD) set up in a bank is independent of other operational departments of the bank. The assessment of probable risks for a bank is done by RMD through various methods of analysis and approaches viz. Credit rating/scoring, Risk weighted assets, LRM, Risk Pricing, VAR analysis and Credit Valuation Adjustment (CVA) etc. The main job of risk management department of the bank is to coordinate with the branches of the bank to find out the solutions for the unresolved deficiencies within a specified time frame. RMD would guide the branch management in the matter of corrective actions against probable risks and also appraise the situations of slippages in large value accounts of the bank to the top management of the Bank from time to time.