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BFM MODULE - B [Link] for Risk Management

Chapter 11: RISK AND BASIC RISK • The Board of Directors

• The Risk Management Committee of the Board
MANAGEMENT FRAMEWORK
• The Committee of senior-level executives, also
WHAT IS RISK? called as Sub-Groups:

The word, 'Risk' is derived from the early Italian 1. Asset-Liability Committee (ALCO)
language 'Risi care' which means 'to dare', means
2. Credit Risk Management Committee (CRMC)
to take on challenge. Factors that are responsible
for creating uncertainties in cash outflows and 3. Operational Risk Management Committee
cash inflows are the risk elements. (ORMC)
Warren Buffet maintained, 'Risk comes from not • The Risk management support
knowing what you are doing'. group/department
Risk-adjusted return on capital (RAROC). [Link] Identification
RAROC plays an important role by measuring Risk identification consists of identifying various
performances against the amount of risk risks associated with the risk taking at the
undertaken by the branches or departments or the transaction level and examining their impact on
business units. The higher the RAROC, the higher is the portfolio and on capital requirement.
the reward to investors/shareholders and more
preferable such investment would be to the [Link] Measurement
market.
Risk management relies on the quantitative
BASIC RISK MANAGEMENT FRAMEWORK: measures of risk. The risk measures seek to
capture variations in earnings, market value,
Risk management framework in an organization losses due to default, etc., (referred to as target
that has well-articulated processes covering the variables), arising out of uncertainties associated
following areas: with various risk elements. Quantitative measures
of risks can be classified into three categories.
• Organization for Risk Management
• Risk Identification • Based on Sensitivity
• Risk Measurement • Based on Volatility
• Risk Pricing • Based on Downside Potential
• Risk Monitoring and Control
• Risk Mitigation a. Sensitivity: Sensitivity captures deviation of a
target variable due to unit movement of a single
market parameter.
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b. Volatility: The volatility characterizes the [Link] Mitigation
stability or instability of any random variable.
Risk reduction is achieved by adopting strategies
c. Downside Potential: Downside potential is the that eliminate or reduce the uncertainties
most comprehensive measure of risk as it associated with the risk elements. This is called
integrates sensitivity and volatility with the 'Risk Mitigation'. Risk mitigation strategies help in
adverse effect of uncertainty. reducing adverse impact on the business
(probability of getting losses), it limits upside
4. Risk Pricing
potential as well, i.e., chances of getting super
Risk pricing implies factoring risks into pricing profit would also be limited.
through capital charge and loss probabilities.
Clearing Corporation of India (CCIL)
Pricing, therefore, should take into account the
following: CCIL is a Central Counterparty (CCP) which was set
up in April 2001 to provide clearing and settlement
1. Cost of Deployable Funds
for transactions in Government securities, foreign
2. Operating Expenses exchange and money markets in the country. CCIL
acts as a central counterparty in various segments
3. Loss Probabilities of the financial markets regulated by the RBI viz.
the government securities segment i.e., outright,
4. Capital Charge
market repo and triparty repo, USD-INR and forex
5. Profit Margin or Return on Net worth forward segments.

[Link] Monitoring and control Enterprise-Wide Risk Management (EWRM)

This requires the following: EWRM can be defined as a continuous and

structured process of listing the objectives of the
1. Strong Management Information System for
organization; identifying all external and internal
reporting, monitoring and controlling risk.
risk-factors that could impact the achievement of
2. Well, laid out procedures, effective control and the objectives and organization’s business and
comprehensive risk reporting framework. financial targets; prioritizing the risk-factors;
exploring alternatives for mitigating the risks; and
3. Separate risk management framework controlling and monitoring such risks.
4. Periodical review and evaluation.

5. A robust audit system to find out the

divergence.
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Steps involves in EWRM 2. Formulation of a road map for the
implementation plan that seeks to bridge the gaps
1. Evaluation of the existing risk management
in risk management practices vis-à-vis EWRM.
systems involving
a. Review of the internal environment with a view The ERM Framework is structured around:
to assess the risk philosophy and risk culture
b. Review of the process of setting objectives Enterprise risk management (ERM) helps in
c. Assessment of the existing mechanism of identifying and selecting among alternative risk
identifying risk-factors that can affect responses - risk avoidance, reduction, transfer,
achievement of the desired objectives and acceptance. It helps to ensure effective
d. Evaluation of the existing process of assessing reporting and compliance with laws and
risks regulations, and avoid damage to the entity's
e. Assessment of the process of responding to reputation and associated consequences.
identified risks
f. Evaluation of the adequacy of existing control The ERM Framework is structured around:
processes
(i) Eight key components viz Internal Environment,
g. Assessment of the adequacy of existing
management information system (MIS) Objective setting, Risk Assessment, Risk response,
h. Review of the process of monitoring risks Control Activities, Information & Communication,
Monitoring

(ii) Four key objectives of business viz. strategic,

operations, reporting and compliance.
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BFM MODULE - B

Chapter 12: RISKS IN BANKING BUSINESS

BANKING RISKS – DEFINITIONS:

The major risks in banking business or 'Banking

Risks'. They are listed as follows:

• Liquidity Risk
• Interest Rate Risk
• Market Risk
• Default or Credit Risk
• Operational Risk
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[Link] risk inflows/outflows) because of fluctuations in
interest rates.
The liquidity risk of banks arises mainly from
funding of long-term assets by short-term [Link] risk
liabilities, thereby making the liabilities subject to
Market risk is the risk of adverse deviations of the
rollover or refinancing risk.
mark-to-market value of the trading portfolio, due
The liquidity risk in banks may be of the following to market movements, during the period of
types: holding. The Market risk in banks may be of the
following types:
➢ Funding Risk : This arises from the need to
replace net outflows due to unanticipated ➢ Yield Curve Risky : Yield curve risk is a type of
withdrawal/non-renewal of deposits (wholesale basis risk and this arises with respect to
and retail)/premature closure of term deposits; different maturity benchmarks to which
➢ Time Risk :This arises from the need to liabilities and assets are linked.
compensate for non-receipt of expected inflows ➢ Embedded Option Risk : The faster and higher
of funds the magnitude of changes in interest rate, the
➢ Call Risk: This arises due to crystallization of greater will be the embedded option risk to
contingent liabilities since customers are not the banks'NII.
meeting their commitments on due dates. ➢ Net Interest Position Risk : Where banks have
➢ Gap or Mismatch Risk: A gap of mismatch risk more earning assets than paying liabilities,
arises from holding assets and liabilities and interest rate risk arises when the market
off-balance sheet items with different principal interest rates adjust downwards.
amounts, maturity dates or repricing dates. ➢ Forex Risk: Forex risk, also termed as Exchange
➢ Basis Risk: The risk that the interest rate of Risk, is the risk that a bank may suffer losses as
different assets, liabilities and off-balance sheet a result of adverse exchange rate movements
items may change in different magnitude is during a period in which it has an open
termed as basis risk. position, either spot or forward, or a
➢ Reinvestment Risk: Uncertainty with regard to combination of the two, in an individual
interest rate at which the future cash flows foreign currency.
could be reinvested is called reinvestment risk. ➢ Liquidity Risk: liquidity risk arises when a
bank is unable to conclude a large transaction
2. Interest rate risk
in a particular instrument near the current
Interest Rate Risk (IRR) is the exposure of a Bank's market price.
revenue to adverse movements in interest rates. It
may be defined as the risk of changes in the
financial value of assets or liabilities (or
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[Link] or Credit Risk Other Risk

Credit Risk is most simply defined as the potential ➢ Strategic Risk: Strategic Risk is the risk arising
of a bank borrower or counterparty fail to meet its from adverse business decisions, improper
obligations in accordance with agreed terms. The implementation of decisions, or lack of
Default or Credit risk in banks may be of the responsiveness to industry changes.
following types: ➢ Reputational Risk: Reputational Risk is the risk
arising from negative public opinion. This risk
➢ Counterparty Risk: This is a variant of credit
may expose the institution to litigation,
risk and is related to non-performance of the
financial loss, or a decline in customer base.
trading partners due to counterparty's refusal
➢ Model Risk: Models are designed to predict
and or inability to perform.
values of variables for which it is specifically
➢ Country Risk: This is also a type of credit risk
designed. Model risk is defined as the gap
where non-performance by a borrower or
between value predicted through model and
counter-party arises due to constraints or
the value actually observed.
restrictions imposed by a country.
➢ Climate Risk Climate-related risks refer to the
[Link] Risk potential risks that may arise from climate
change or from efforts to mitigate climate
Operational risk is the risk of loss resulting from change, their related impact, and the economic
inadequate or failed internal processes, people and financial consequences.
and systems or from external events.

Two of these risks, viz. transaction and compliance

risk which are frequently used are;

➢ Transaction Risk: Transaction risk is the risk

arising from fraud, both internal and external,
failed business processes and the inability to
maintain business continuity and manage
information.
➢ Compliance Risk: Compliance risk is the risk of
legal or regulatory sanction, financial loss or
reputation loss that a bank may suffer as a
result of its failure to comply with any or all of
the applicable laws, regulations, and codes of
conduct and standards of good practice.
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BFM MODULE - B

Chapter 13: RISK REGULATIONS IN BANKING INDUSTRY

REGULATION OF BANKING INDUSTRIES-NECESSITIES AND GOALS:

BULLET POINT

Regulations have several goals. They are: (c) Basel Consultative Group

1. Improving the safety of the banking industry, by (d) Macro prudential Supervision Group
imposing capital requirements in line with bank's
(e) Accounting Experts Group
risks.
The five Committee groups report directly to the
2. Levelling the competitive playing field of banks
BCBS Chairman and form part of its permanent
through setting common benchmarks for all
internal structure.
players.
BASEL I: THE BASEL CAPITAL ACCORD:
3. Promoting sound business and supervisory
practices. In 1988, the Basel Committee published a set of
minimal capital requirements for banks, known as
4. Controlling and monitoring 'Systemic Risk'.
the 1988 Basel Accord. The 1988 Basel Accord
5. Protecting interest of depositors as depositors primarily sought to put in place a framework for
cannot impose a real market discipline on banks. minimum capital requirement for banks that was
linked to credit exposure. The 1988 Accord called
THE NEED FOR RISK BASED REGULATION IN A for a minimum ratio of capital to risk-weighted
CHANGED WORLD ENVIRONMENT: assets of 8% and in present minimum as
A regulatory framework, on a cross- country basis, prescribed by RBI is 9% (excluding Capital
Conservation Buffer).The accord provided a
for reconciling risk control and yet maintaining a
detailed definition of capital.
level playing field for fair competition became
necessary. The Basel Committee on Banking Tier 1 or core capital, which includes equity and
Supervision (BCBS) undertook this. disclosed reserves, and Tier 2 or supplementary
capital, which could include undisclosed reserves,
The Basel Committee has the following five
asset revaluation reserves (which is part of Tier 1
groups:
capital in India), general provisions and loan-loss
(a) Policy Development Group reserves, hybrid (debt/equity) and debt capital
instruments.
(b) Supervision and Implementation Group
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The Cooke Ratio Pillar 1 - Minimum Capital Requirement

A relationship of risk-weighted assets to capital 1. Capital for Credit Risk

was put in place. In India Banks are required to
(a) Standardized Approach
maintain minimum 9% CRAR.
(b) Internal Ratings Based (IRB) Foundation
CRAR=Capital/Risk Weighted Assets
Approach
In calculating the Cooke ratio, both on-balance-
(c) Internal Ratings Based (IRB) Advanced
sheet and off-balance-sheet items are considered.
Approach
BASEL-II ACCORD:
2. Capital for Market Risk
BASEL-II framework was designed to improve the
(a) Standardized Approach (Maturity Method)
way regulatory capital requirements reflect
underlying risks and to better address the financial (b) Standardized Approach (Duration Method)
innovation that had occurred in recent years.
(c) Internal Models Method
Structure of Basel-II:
3. Capital for Operational Risk
Basel-II recognized all the three risks namely
(a) Basic Indicator Approach
1. Credit Risk
(b) Standardized Approach
2. Market Risk
(c) Advanced Measurement Approach
3. Operational Risk
Pillar 2-Supervisory Review Process

1. Evaluate risk assessment.

2. Ensure soundness and integrity of banks'

internal process to assess the adequacy of capital.

3. Ensure maintenance of minimum capital - with

PCA (Prompt Corrective Action) for shortfall.

4. Prescribe differential capital, where necessary –

i.e., where the internal processes are slack.
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Pillar 3- Market Discipline. • A countercyclical capital buffer, which
places restrictions on participation by
1. Enhance disclosure
banks in system-wide credit booms with
2. Core disclosures and supplementary disclosures the aim of reducing their losses in credit
busts.
3. Timely - semi annual
• a leverage ratio - a minimum amount of
TOWARDS BASEL-III: loss-absorbing capital relative to all of a
The Group of Governors and Heads of Supervision bank's assets and off-balance sheet
(GHOS) announced higher global minimum capital exposures regardless of risk weighting.
standards for commercial banks. The overall • Liquidity requirements - a minimum
design of the capital and liquidity reform package, liquidity ratio, the Liquidity Coverage Ratio
now referred to as "Basel III". The enhanced Basel (LCR), intended to provide enough cash to
III framework revised and strengthened the three cover funding needs over a 30-day period
pillars established by Basel II. of stress; and a longer-term ratio, the Net
Improvement of Three-Pillar System Stable Funding Ratio (NSFR), intended to
address maturity mismatches over the
entire balance sheet.

• Additional proposals for systemically

important banks, including requirements
for supplementary capital, augmented
contingent capital and strengthened
arrangements for cross-border supervision
and resolution.

Turning to the minimum capital requirements, the

higher minimums for Common Equity and Tier 1
capital were phased in from 2013, and became
effective at the beginning of 2015. The schedule
was as follows:
• An additional layer of common equity - the
capital conservation buffer - that, when ➢ The minimum common equity and Tier 1
this layer is breached, restricts payouts to requirements increased from 2% and 4% to
help meet the minimum common equity 3.5% and 4.5%, respectively, at the beginning
requirement. of 2013.
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➢ The minimum common equity and Tier 1 Banks are required to maintain a minimum Pillar 1
requirements rose to 4% and 5.5%, Capital to Risk-weighted Assets Ratio (CRAR) of 9%
respectively, at the beginning of 2014. on an on-going basis (other than capital
conservation buffer). A bank should compute
➢ The final requirements for common equity and
Basel III capital ratios in the following manner:
Tier 1 capital were set at 4.5% and 6%,
respectively, at the beginning of 2015.

Composition of Regulatory Capital

Common Equity = 𝑪𝒐𝒎𝒎𝒐𝒏 𝑬𝒒𝒖𝒊𝒕𝒚 𝑻𝒊𝒆𝒓 𝟏 𝑪𝒂𝒑𝒊𝒕𝒂𝒍

𝑪𝒓𝒆𝒅𝒊𝒕 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨 ∗ + 𝑴𝒂𝒓𝒌𝒆𝒕 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨 + 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨
Tier 1 capital ratio

(𝑬𝒍𝒊𝒈𝒊𝒃𝒍𝒆 𝑬𝒒𝒖𝒊𝒕𝒚 𝑻𝒊𝒆𝒓 𝟏 𝑪𝒂𝒑𝒊𝒕𝒂𝒍)/(𝑪𝒓𝒆𝒅𝒊𝒕 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨

Tier 1 capital ratio = + 𝑴𝒂𝒓𝒌𝒆𝒕 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨 + 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨 )
(CET1 + AT1)

𝑬𝒍𝒊𝒈𝒊𝒃𝒍𝒆 𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒑𝒊𝒕𝒂𝒍

𝑪𝒓𝒆𝒅𝒊𝒕 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨 + 𝑴𝒂𝒓𝒌𝒆𝒕 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨 + 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑹𝒊𝒔𝒌 𝑹𝑾𝑨
Total Capital =

(CRAR)#

(ii) Tier 2 Capital (gone-concern capital)

* RWA = Risk weighted Assets; Limits and Minima

# Capital to Risk Weighted Asset Ratio With full implementation of capital ratios and CCB
the capital requirements as on 1st October, 2021
Components of Capital
will be as follows:
Total regulatory capital will consist of the sum of
S. No. Regulatory Capital As % to
the following categories:
RWAS
(i) Tier 1 Capital (going-concern capital)
(i) Minimum Common Equity Tier 5.5
(a) Common Equity Tier 1 1 Ratio

(b) Additional Tier 1

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(ii) Capital Conservation Buffer 2.5 (f) Claims on Primary Dealers
(comprised of Common Equity)
(g) Claims on Corporates, Asset Finance Companies
(iii) Minimum Common Equity Tier 8.0 and Non-Banking Finance Companies-
1 Ratio plus Capital Infrastructure Finance Companies
Conservation Buffer [(i)+(ii)]
(h) Claims included in the Regulatory Retail
(iv) Additional Tier 1 Capital 1.5 Portfolios

(v) Minimum Tier 1 Capital Ratio 7.0 (i) Claims secured by Residential Property
[(i)+(iv)]
(j) Claims Classified as Commercial Real Estate
(vi) Tier 2 Capital 2.0 Exposure

(vii) Minimum Total Capital Ratio 9.0 (k) Non-Performing Assets (NPAs)
(MTC) [(v)+(vi)]
(l) Specified Categories Venture Capital Funds
(viii) Minimum Total Capital Ratio 11.5
(m) Other Assets like loans and advances to banks
plus Capital Conservation
own staff
Buffer [(vii)+(ii)]
(n) Off-Balance Sheet Items

(0) Securitization Exposures

CAPITAL CHARGE FOR CREDIT RISK:
(p) Capital Adequacy Requirement for Credit
The Circular issued by the Reserve Bank of India Default Swap (CDS) Positions in the Banking Book
has laid down detailed guidelines on the capital
adequacy requirements and the risk weights to be Eligible Credit Rating Agencies
applied in case of the following claims:
The Reserve Bank of India has decided that banks
(a) Claims on Domestic Sovereigns may use the ratings of the following
national/international credit rating agencies
(b) Claims on Foreign Sovereigns (arranged in alphabetical order) for the purposes
(c) Claims on Public Sector Entities (PSES) of risk weighting their claims for capital adequacy
purposes where specified:
(d) Claims on Multilateral Development Banks,
Bank for International Settlements and the NATIONAL;
International Monetary Fund (a) Credit Analysis and Research Limited (CARE);
(e) Claims on Banks (Exposure to capital (b) CRISIL Limited;
instruments)
(c) ICRA Limited;
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(d) India Ratings and Research Private Limited Credit Risk Mitigation Techniques - Collateralized
(India Ratings); and (e) Acuite Ratings and Transactions
Research Limited (earlier SMERA Ratings Limited)
A Collateralized Transaction is one in which:
(f) INFOMERICS Valuation and Rating Pvt. Ltd
(i) banks have a credit exposure and that credit
(from June, 2017)
exposure is hedged in whole or in part by
INTERNATIONAL; collateral posted by a counterparty or by a third
party on behalf of the counterparty.
(a) Fitch;
(ii) Banks have a specific lien on the collateral and
(b) Moody's; and
the requirements of legal certainty are met.
(c) Standard & Poor's
The Comprehensive Approach
CREDIT RISK MITIGATION:
In the comprehensive approach, when taking
The general principles applicable to use of credit collateral, banks will need to calculate their
risk mitigation techniques is as under: adjusted exposure to a counterparty for capital
adequacy purposes in order to take account of the
(i) No transaction in which Credit Risk Mitigation effects of that collateral. If the exposure and
(CRM) techniques are used should receive a higher collateral are held in Different currencies an
capital requirement than an otherwise identical additional downwards adjustment must be made
transaction where such techniques are not used. to the volatility adjusted collateral amount to take
account of possible future fluctuations in
(ii) The effects of CRM will not be double counted.
exchange rates.
(iii) Principal-only ratings will not be allowed
Credit Risk Mitigation Techniques - On-Balance
within the CRM framework.
Sheet Netting
(iv) While the use of CRM techniques reduces or
On-balance sheet netting is confined to
transfers credit risk, it simultaneously may
loans/advances and deposits, where banks have
increase other risks (residual risks). Residual risks
legally enforceable netting arrangements,
include legal, operational, liquidity and market
involving specific lien with proof of
risks. Therefore, it is imperative that banks employ
documentation. They may calculate capital
robust procedures and processes to control these
requirements on the basis of net credit exposures.
risks.
Credit risk mitigation techniques – guarantees

Where guarantees are direct, explicit, irrevocable

and unconditional, banks may take account of
such credit protection in calculating capital
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requirements. Guarantees issued by entities with risk capital charges in a continuum of increasing
a lower risk weight than the counterparty will lead sophistication and risk sensitivity:
to reduced capital charges since the protected
(i) The Basic Indicator Approach (BIA)
portion of the counterparty exposure is assigned
the risk weight of the guarantor, whereas the (ii) The Standardized Approach (TSA)
uncovered portion retains the risk weight of the
underlying counterparty. (iii) Advanced Measurement Approaches (AMA)

CAPITAL CHARGE FOR MARKET RISK: PILLAR 2 - SUPERVISORY REVIEW PROCESS:

The market risk positions subject to capital charge The objective of the SRP is to ensure that banks
requirement are: have adequate capital to support all the risks in
their business as also to encourage them to
(i) The risks pertaining to interest rate related develop and use better risk management
instruments and equities in the trading book; and techniques for monitoring and managing their
risks.
(ii) Foreign exchange risk (including open position
in precious metals) throughout the bank (both The main aspects to be addressed under the SRP,
banking and trading books). and therefore, under the ICAAP, would
The minimum capital requirement is expressed in (a) The risks that are not fully captured by the
terms of two separately calculated charges, minimum capital ratio prescribed under Pillar 1;
(i) "Specific risk”; Charge for each security, which (b) The risks that are not at all taken into account
is designed to protect against an adverse by the Pillar 1; and
movement in the price of an individual security
owing to factors related to the individual issuer, (c) The factors external to the bank.
both for short (short position is not allowed in
Guidelines for the SREP of the RBI and the ICAAP
India except in derivatives and Central
of Banks
Government Securities) and long positions, and
The Basel capital adequacy framework rests on the
(ii) "General market risk” ; Charge towards interest
following three mutually – reinforcing pillars:
rate risk in the portfolio, where long and short
positions (which is not allowed in India except in Pillar 1: Minimum Capital Requirements -
derivatives and Central Government Securities) in which prescribes a risk-sensitive calculation of
different securities or instruments can be offset. capital requirements that, for the first time,
explicitly includes operational risk in addition
CAPITAL CHARGE FOR OPERATIONAL RISK:
to market and credit risk.
The New Capital Adequacy Framework (NCAF)
Pillar 2: Supervisory Review Process (SRP) -
outlines three methods for calculating operational
which envisages the establishment of suitable
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risk management systems in banks and their Features of a Sound risk management System
review by the supervisory authority.
(a) Active board and senior management
Pillar 3: Market Discipline - which seeks to oversight;
achieve increased transparency through
(b) Appropriate policies, procedures and limits;
expanded disclosure requirements for banks.
(c) Comprehensive and timely identification,
The Basel Committee also lays down the following
measurement, mitigation, controlling, monitoring
four key principles in regard to the SRP envisaged
and reporting of risks;
under Pillar 2:
(d) Appropriate management information systems
Principle 1: Banks should have a process for
(MIS) at the business and firm-wide level; and
assessing their overall capital adequacy in
relation to their risk profile and a strategy for (e) Comprehensive internal controls.
maintaining their capital levels.
PILLAR 3 - MARKET DISCIPLINE:
Principle 2: Supervisors should review and
evaluate banks' internal capital adequacy The purpose of Market discipline is to complement
assessments and strategies, as well as their the minimum capital requirements (detailed under
ability to monitor and ensure their compliance Pillar 1) and the supervisory review process
with the regulatory capital ratios. (detailed under Pillar 2). Pillar 3 applies at the top
consolidated level of the banking group to which
Principle 3: Supervisors should expect banks to the Capital Adequacy Framework applies.
operate above the minimum regulatory capital
ratios and should have the ability to require Banks are required to make Pillar 3 disclosures as
banks to hold capital in excess of the per RBI Guidelines at least on a half yearly basis,
minimum. irrespective of whether financial statements are
audited, with the exception of following
Principle 4: Supervisors should seek to disclosures:
intervene at an early stage to prevent capital
from falling below the minimum levels (i) Table DF-2: Capital Adequacy;
required to support the risk characteristics of a
(ii) Table DF-3: Credit Risk: General Disclosures for
particular bank and should require rapid
All Banks; and (iii) Table DF-4: Credit Risk:
remedial action if capital is not maintained or
Disclosures for Portfolios Subject to the
restored.
Standardized Approach.
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CAPITAL CONSERVATION BUFFER: credit growth that have often been associated
with the building up of system-wide risk.
➢ The capital conservation buffer (CCB) is
designed to ensure that banks build up capital SYSTEMATICALLY IMPORTANT FINANCIAL
buffers during normal times (i.e., outside INSTITUTIONS (SIFIS):
periods of stress) which can be drawn down as
Systemically Important Banks (SIBS) are those
losses are incurred during a stressed period.
banks that are 'Too Big to Fail (TBTF)'. These banks
➢ The requirement is based on simple capital when they fail would create greatest havoc for the
conservation rules designed to avoid breaches country and would negatively impact the real
of minimum capital requirements. economy. The BCBS further required all member
countries to have a regulatory framework to deal
➢ The capital conservation buffer can be drawn
with Domestic Systemically Important Banks (D-
down only when a bank faces a systemic or
SIBS).
idiosyncratic (Bank specific) stress.
Presently, there are three banks that are D-SIBS in
LEVERAGE RATIO:
India. These are:
The Basel III leverage ratio is defined as the capital
• State Bank of India- Bucket 3
measure (the numerator) divided by the exposure
measure (the denominator), with this ratio • ICICI Bank-Bucket 1
expressed as a percentage
• HDFC Bank- Bucket 1.
Leverage ratio = Capital Measure/Exposure
Measure RISK BASED SUPERVISION (RBS):

BCBS has subsequently finalized that bank must ➢ The primary objective of RBS is to not only
meet a minimum 3% LR requirement at all times. protect the depositors' interests but also
promote financial stability.
COUNTERCYCLICAL CAPITAL BUFFER:
➢ RBS includes both Off-site Supervision and On-
The aim of the Countercyclical Capital Buffer Site Supervision.
(CCCB) regime is twofold.
➢ It includes Supervisory Process which involves
1. It requires banks to build up a buffer of capital six key steps:
in good times which may be used to maintain
flow of credit to the real/needy sector in 1. Understanding the bank (Bank Profile),
difficult times. 2. Assessing risks faced by the bank for
2. It achieves the broader macro-prudential goal supervisory purpose (Risk Assessment/Matrix)
of restricting the banking sector from
indiscriminate lending in the periods of excess
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3. Scheduling and Planning Supervisory Activities (j) Equity investments in non-financial subsidiaries
(Planning for supervisory actions / interventions)
(k) Intra Group Transactions and Exposures
[Link] Examination Activities, on-site reviews
Counterparty Credit Risk (CCR)
and on-going monitoring (Onsite Inspection -
objective, scope), ➢ Counterparty Credit Risk (CCR) is the risk that
the counterparty to a transaction could default
5. Inspection Procedure (Onsite Inspection,
before the final settlement of the transaction's
conduct of SREP, offsite continuous supervision)
cash flows.
6. Reporting findings and recommendations and
➢ An economic loss would occur if the
follow-up (Inspection Reports, Updating of the
transactions or portfolio of transactions with
bank Profile)
the counterparty has a positive economic value
Regulatory Adjustments/Deductions at the time of default.

The regulatory adjustments/deductions applied to ➢ CCR creates a bilateral risk of loss: the market
regulatory capital both at solo and consolidated value of the transaction can be positive or
level are as under: negative to either counterparty to the
transaction.
(a) Goodwill and all Other Intangible Assets
Securities Financing Transactions (SFTs) are
(b) Deferred Tax Assets (DTAs)
transactions such as repurchase agreements,
(c) Cash Flow Hedge Reserve reverse repurchase agreements, security
lending and borrowing, collateralized
(d) Shortfall of the Stock of Provisions to Expected borrowing and lending (CBLO) and margin
Losses lending transactions, where the value of the
transactions depends on market valuations
(e) Gain on Sale Related to Securitization
and the transactions are often subject to
Transactions
margin agreements.
(f) Cumulative Gains and Losses due to Changes in
Hedging Set is a group of risk positions from
Own Credit Risk on Fair Valued Financial Liabilities
the transactions within a single netting set for
(g) Defined Benefit Pension Fund Assets and which only their balance is relevant for
Liabilities determining the exposure amount or EAD
under the CCR standardized method.
(h) Investments in Own Shares (Treasury Stock)

(i) Investments in the Capital of Banking, Financial

and Insurance Entities
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Current Exposure is the larger of zero, or the A qualifying central counterparty (QCCP) is an
market value of a transaction or portfolio of entity that is licensed to operate as a CCP
transactions within a netting set with a (including a license granted by way of
counterparty that would be lost upon the default confirming an exemption), and is permitted by
of the counterparty, assuming no recovery on the the appropriate regulator overseer to operate
value of those transactions in bankruptcy. Current as such with respect to the products offered.
exposure is often also called Replacement Cost.
A clearing member is a member of, or a direct
Credit Valuation Adjustment is an adjustment participant in, a CCP that is entitled to enter
to the mid-market valuation of the portfolio of into a transaction with the CCP, regardless of
trades with a counterparty. This adjustment whether it enters into trades with a CCP for its
reflects the market value of the credit risk due own hedging. Investment or speculative
to any failure to perform on contractual purposes or whether it also enters into trades
agreements with a counterparty. as a financial intermediary between ne CCP
and other market participants.
One-Sided Credit Valuation Adjustment is a
credit valuation adjustment that reflects the Offsetting transaction means the transaction
market value of the credit risk of the leg between the clearing member and the CCP
counterparty to the firm, but does not reflect when the clearing member acts on behalf of a
the market value of the credit risk of the bank client (e.g. when a clearing member clears or
to the counterparty. novates a client's trade).

A central counterparty (CCP) is a clearing

house that interposes itself between
counterparties to contracts traded in one or
more financial markets, becoming the buyer to
every seller and the seller to every buyer and
thereby ensuring the future performance of
open contracts.
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BFM MODULE - B

Chapter 14: MARKET RISK

BULLET POINT
market and it affects trading liquidity adversely
and market becomes shallow.
MARKET RISK IN BANKS:

A bank's trading book exposure has the following 3. Credit and Counterparty Risks : Credit and
risks; Counterparty risk may arise either on account of
1. Market Risk default of the issuer/borrower or because of
rating downward migration.
2. Liquidity Risk
MARKET RISK MANAGEMENT FRAMEWORK:
(a) Asset Liquidity Risk
(b) Market Liquidity Risk An effective market risk management framework
in a bank comprises;
3. Credit and Counterparty risks
1. Risk Identification
1. Market Risk: Market risk is the risk of adverse
deviations of the mark-to-market value of the 2. Risk Measurement
trading portfolio, due to market movements, 3. Risk Monitoring and Control
during the period required to liquidate the
transactions. 4. Risk Mitigation

2. Trading Liquidity Risk: Trading liquidity means ORGANISATION STRUCTURE:

the ability to freely transact in markets at
Market Risk Management organization would
reasonable prices. Liquidation involves asset and
consist:
market liquidity risks.
• The Board of Directors
➢ Asset liquidation risk refers to a situation
• The Risk Management Committee
where a specific asset faces lack of trading
• The Asset-Liability Management Committee
liquidity, though there is good liquidity.
(ALCO)
➢ Market liquidation risk refers to a situation
when there is a general liquidity crunch in the • The ALM Support Group/Market Risk Group
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• The Middle Office measure that is most relied upon by banking and
financial service industry as also the regulators.
RISK IDENTIFICATION:
Value at Risk (VaR)
➢ Usually all standard products would have
'Product Programmed' for each of them. All ➢ VaR is defined as the predicted worst-case loss
Risk- Taking Units operate within an approved at a specific confidence level over a certain
'Product Programmed'. period of time assuming Normal Trading
➢ Product programmer defines procedures, limits Conditions'.
and controls for all aspects of the product. ➢ VaR measures the potential loss in market
➢ New products or non-standard products may value under normal circumstances of a
operate under a 'Product Transaction portfolio using estimated volatility (rate or
Memorandum' on a temporary basis while a price move) and correlations (how rates or
full Market Risk Product programmer is being prices move in relation to each other), for a
prepared. given horizon (longer the time horizon, more is
the VaR) measured with a given confidence
RISK MEASUREMENT:
interval.
Market risk measures are based on –
Why VaR is Useful?
• Sensitivity 1. Good tool for all banks, financial institutions,
• Downside Potential multinationals, and fund managers for protection
1. Sensitivity of customers, shareholders, employees and overall
franchise of the business.
Sensitivity is measured as change in market value
due to unit change in the variable. 2. Translates portfolio exposures into potential
impact on Profit and Loss.
For example, where the market value of a
portfolio changes by Rs. 1, 00,000 for 1% change in 3. Aggregates and reports multi-product, multi-
the rate of interest, the interest rate sensitivity of market exposures into one number.
the portfolio is Rs. 1, 00,000. 4. Meets external risk management disclosure and
This gives us a measure of risk associated with the expectations.
portfolio vis-à-vis change in rate of interest. 5. A vital component of current best practices in
[Link] Potential risk measurement.

Downside risk is the most comprehensive measure 6. Embraced by practitioners, regulators and
of risk as it integrates sensitivity and volatility with academicians.
the adverse effect of uncertainty. This is the
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7. Valuable as a probabilistic measure of potential • Examine potential regime shifts (whether the
losses. current risk parameters will hold or
breakdown)
Limitation of VaR
• Consider market illiquidity
➢ VaR is not worst-case scenario. • Consider the interplay of all risks and more
➢ It does not measure losses under any particularly market and credit risk
particular market conditions.
➢ VaR by itself is not sufficient for risk
measurement.

Back Testing Limitations of Stress Tests

➢ Back testing is a process where model based • There are no probabilities attached to the
VaR is compared with the actual performance outcomes.
of the portfolio. • The lack of probability measures exacerbates
➢ This is carried out for evaluating a new model the issue of transparency and the seeming
or to assess the accuracy of the existing arbitrariness of stress test design.
models. • Systems incompatibilities across business units
➢ Back testing for evaluating a new model make frequent stress testing costly for some
requires comparison with the actual banks, reflecting the limited role that stress
performance on a continuous basis for a given testing had played in influencing the bank's
period. prior investments in information technology.
Stress Testing RISK MONITORING AND CONTROL:
➢ Stress testing essentially seeks to determine Risk monitoring and control calls for
possible changes in the market value of a implementation of risk and business policies
portfolio that could arise due to non-normal simultaneously. This is achieved through the
movement in one or more market parameters. following:
➢ It is applied on the portfolio to assess the
impact on it. 1. Policy guidelines limiting roles and authority

What Makes a Good Stress Test? 2. Limit structure and approval process

A good stress test should - 3. System and procedures to unbundle products

and transactions to capture all risks
• Be relevant to the current position
• Consider changes in all relevant market rates 4. Guidelines on portfolio size and mix

5. System for estimating portfolio risk under

normal and stressed situations
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6. Defined policy for mark-to-market In order of importance, senior management
reports should be -
7. Limit monitoring and reporting
• Regular and in time
8. Performance Measurement and Resource
• Reasonably accurate
Allocation
• highlights of portfolio risk concentrations &
Risk Monitoring exceptional events
• Containing written commentary
• Ensure that all transactions are executed and
• Concise.
revalued at the prevailing market rates.
• Financial Models used for revaluations for MANAGING TRADING LIQUIDITY:
income recognition purposes or to measure or
Risk of trading liquidity is managed by avoiding -
monitor Price Risk must be independently
tested and certified. • Large market share in any given type of asset
• Stress tests must be performed preferably • Infrequently traded instruments
quarterly with predetermined changes in the • Instruments with unusual tenors
underlying assumptions of the model/market • One-sided liquidity in the market
conditions.
RISK MITIGATION: Risk mitigation in market risk,
Models of Analysis i.e., reduction in market risk is achieved by
adopting strategies that eliminate or reduce the
• Appropriate and duly approved (usually by
volatility of the portfolio.
Risk Policy Committee) model control and
certification policy. Risk Mitigation Strategies
• Fully documented financial models.
• Duly validated by the designated person, to 1. Strategies Using Sensitivity Measures
ensure that the algorithm employed is 2. Strategies Using Correlation Measures
appropriate and accurate.
• No unauthorized or unintended changes 3. Strategies Using Market Instruments
should be made in models.
• The models should also be subject to model
assumption review on a periodic basis.

RISK REPORTING:

Risk report should enhance risk communication

across different levels of the bank, from the
trading desk to the CEO.
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BFM MODULE - B

Chapter 15: CREDIT RISK

BULLET POINT

Credit risk arises from lending activities of a bank. • The Board of Directors
It arises when a borrower does not pay interest • The Risk Management Committee
and/or instalments as and when it falls due or in • Credit Policy Committee (CPC) or Credit Risk
case where a loan is repayable on demand, the Management Committee (CRMC)
borrower fails to make the payment as and when • Credit Risk Management Department
demanded.
RISK IDENTIFICATION:
CREDIT RISK MANAGEMENT FRAMEWORK:
It has two components:
Credit risk management processes are sub-divided
1. Default risk
into following four parts;
2. Credit spread risk.
1. Credit Risk Identification
1. Default Risk
2. Credit Risk Measurement
Default risk is driven by the potential failure of a
3. Credit Risk Monitoring and Control borrower to make promised payments, either
partly or wholly.
4. Credit Risk Mitigation
2. Credit Spread Risk or Downgrade Risk
ORGANISATION STRUCTURE:
If a borrower does not default, there is still risk
Credit Risk Management organization would due to worsening in credit quality. This results in
consist of: the possible widening of the credit-spread. This is
Credit-spread risk. Usually this is reflected through
rating Downgrade.
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RISK MEASUREMENT: • Develop and maintain necessary data on defaults

of borrowers rating category, wise, i.e., 'Rating
Measurement of credit risk consists of:
Migration'.
(a) Measurement of risk through credit
CREDIT RISK POLICIES AND GUIDELINES AT
rating/scoring;
TRANSACTION LEVEL:
(b) Quantifying the risk through estimating
The instruments of Credit Risk Management at
expected loan losses,
transaction level are:
Credit Rating - Why is it necessary?
• Credit Appraisal Process
A Credit Rating depicts the credit quality of the • Risk Analysis Process
borrower and depicts his default. • Credit Audit and Loan Review Mechanism
• Monitoring Process
A credit rating process normally would consist of
the following parameters: CREDIT CONTROL AND MONITORING AT
PORTFOLIO LEVEL:
• Financial Parameter.
• Management Parameter. The activities include:
• Industry Parameter.
• Identification of portfolio credit weakness in
• Business Parameter.
advance - through credit quality migrations.
Credit Rating - Approach to it • Moving from measuring obligor specific risk
associated with individual credit exposures to
In order to develop our capability to actively measuring concentration effects on the
manage our credit portfolio, one must have in portfolio as a whole.
place the following:
• Evaluating exposure distribution over rating
• Credit Rating Model (or models for different categories and stipulating quantitative ceilings
categories of loans and advances) on aggregate exposure in specified rating
categories.
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• Evaluating rating-wise distribution in various • To evaluate portfolio quality and isolate
industries and setting corresponding exposure potential problem areas.
limits to contain concentration risk. • To provide information for determining
• Moving towards Credit Portfolio Value at Risk adequacy of loan loss provision.
Models. • To assess the adequacy of and adherence to,
loan policies and procedures, and to monitor
ACTIVE CREDIT PORTFOLIO MANAGEMENT:
compliance with relevant laws and regulations.
Motivation for active credit portfolio management • To provide top management with information
comes from changing demand of traditional on credit administration, including credit
products and new business opportunities. sanction process, risk evaluation and post-
sanction follow up.
Change in demand of traditional products has
arisen due to Loan Review Policy should address the following
issues:
• Less demand due to disintermediation
• More supply due to capital mobility ➢ Qualification and Independence
• Lower returns and increased importance of risk ➢ Frequency and Scope of Reviews
➢ Depth of Reviews
The motivation for active credit portfolio ➢ Review of Small value Retail Loan Accounts
management also comes from new
opportunities in the economy, such as: CREDIT RISK MITIGATION:

• Pass through certificates in case of ➢ This refers to the process through which credit
securitization transactions risk is reduced or it is transferred to another
• Syndicated lending counterparty.
• Project/structured finance ➢ Strategies for risk reduction at transaction level
differ from the risk that is prevailing at
CONTROLLING CREDIT RISK THROUGH LOAN portfolio level.
REVIEW MECHANISM (LRM): ➢ At transaction level, banks use a number of
techniques to mitigate the credit risks to which
LRM is also called as Credit Audit. LRM an effective
they are exposed.
tool for constantly evaluating the quality of loan
➢ At portfolio level, asset securitization, credit
book and to bring about qualitative improvements
derivatives, etc., are used to mitigate risks in
in credit administration.
the portfolio.
The main objectives of LRM are:
SECURITISATION:
• To promptly identify loans, which develop
➢ The process by which Banks convert their ill-
credit weaknesses and initiate timely corrective
liquid long-term loans into short-term tradable
action.
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bonds using the services of a Special Purpose Collateralized Loan Obligations
Vehicle (SPV) or Special Purpose Entity (SPE).
CLOs differ from credit-linked notes in several
➢ The tradable bonds are called Pass-through
ways:
Certificates (PTCs).
➢ Securitization exposures include asset-backed • A CLO will provide credit exposure to a diverse
securities, mortgage-backed securities, credit pool of credits whereas most credit-linked
enhancements, liquidity facilities, interest rate notes are linked to a single credit.
or currency swaps, credit derivatives and • CLOS may provide a true transfer of ownership
trenched cover. of underlying assets, whereas credit-linked
➢ Underlying instruments in the pool being notes typically do not provide such a transfer.
securitized may include loans, commitments, • CLOS may enjoy a higher credit rating than that
asset-backed and mortgage- backed securities, of the originating institution, whereas the
corporate bonds, equity securities, and private rating of credit linked notes are effectively
equity investments. capped to the issuer level.\
Minimum Retention Requirement (MRR)

The MRR is primarily designed to ensure that the

originators have a continuing stake in the CREDIT DERIVATIVES (CDs):
performance of securitized assets so as to ensure A credit derivative (CD) is an over-the-counter
that they carry out proper due diligence of loans bilateral contract between two or more
to be securitized. counterparties that provide for transfer of risks in
The originators should adhere to the MRR as a credit asset or credit portfolio without
detailed below: necessarily transferring the underlying asset from
the books of the originator.
a. For underlying loans with original maturity of 24
months or less, the MRR shall be 5% of the book Reasons for entering into credit derivatives are:
value of the loans being securitized. Motives for Protection Buyers:
b. For underlying loans with original maturity of • Transferring credit risk without transferring the
more than 24 months as well as loans with bullet credit asset.
repayments, as mentioned in proviso to Clause 6,
• Hedging against credit risks.
the MRR shall be 10% of the book value of the
• Relief in regulatory capital required for credit
loans being securitized.
assets, which can be used for further business
[Link] the case of residential mortgage-backed purpose.
securities, the MRR for the originator shall be 5% • Better portfolio management by reducing
of the book value of the loans being securitized, concentration in market, i.e. diversification.
irrespective of the original maturity.
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Motives for Protection Sellers: Credit Linked Notes (CLN)

• Yield Enhancement. Credit linked notes are on-balance sheet

• Speculation. equivalents of CDS, which combine credit
• Arbitrage in case the credit derivative derivatives with normal bond instruments and
instruments are inefficiently priced. thus convert credit derivatives (generally an OTC
• Diversification of credit risk. instrument) into capital market instruments.
• Credit derivatives initially were used only for
➢ The credit risk delivered to a credit linked note
hedging.
investor is a dual risk;

(a) The risk faced by the credit linked note issuer

Credit default Swaps (CDS)
(normally highly rated)
A Credit default swap is a transaction in which a
(b) The reference obligation of the embedded
credit hedger (Protection Buyer-PB) pays a
credit derivative.
periodic premium to an investor (Protection Seller-
PS) in return for protection against a credit event Credit Spread Options
experienced on a reference obligation, (i.e., the
underlying credit that is being hedged). ➢ Credit Spread options enable credit hedgers to
acquire protection from an unfavourable
Total Return Swaps (TRS) migration or Credit spread risk of an asset, as
measured by a widening of its credit spread.
➢ In a TRS, the protection seller is able to
➢ Credit spread options transfer credit spread risk
synthetically create an exposure to the
from the credit spread PB to an investor (PS), in
reference asset without actually lending to it.
return for an upfront or periodic payment of
➢ A total return swap represents an off-balance
premium.
sheet replication of a financial asset such as a
➢ The option may be cash settled or physically
loan or bond.
settled into an asset swap.
Formula to arrive at the TRS is: -
• Interest Flows + (Final Value of the underlying Hedging Pitfalls in Practice
exposures minus Original Value of the
underlying exposures). Transaction Origination
• The underlying reference asset can be any of Successful credit derivatives dealers endeavor to:
the below mentioned Reference Assets:
• Bond, Loan, Index such as BSE/NSE, Equity • Establish client/product suitability.
shares of a particular company, Commodity • Identify and fully appreciate end-user
etc. motivations and portfolio.
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• Provide end users with useful feedback and Transactions Documentation
help manage expectations about the timing of
A successful documentation process includes:
transactions.
• Understand that transaction terms are generally • Presentation by credit derivatives trading team
indicative and not firm. to documentation of a transaction term sheet
• Appreciate that dealers may have limits on their should be achieved by setting out terms and
appetite for certain credits. conditions correctly in an unambiguous manner.
• Good communication between all members of
Transactions Structuring the credit hedging team.
• An appreciation of transaction objectives and
This stage, include: goals.
• Problem-solving approach with the credit
• All settlement methods are agreed and market
derivatives trading desk, the end-users and other
disruption clauses have been considered.
internal partners.
• The hedging strategy employed is the most
• A well thought-out transaction template or use of
efficient vehicle in terms of funding,
ISDA-sponsored transaction confirmation.
relationship issues and capital treatment.
• If the reference asset and the underlying credit
risk are one and the same, no residual basis risk
remains (or, if it does, is identified and priced
accordingly).
• The assignability of the unvented underlying
assets is established (otherwise alternative
settlement techniques need to be established).
• The parties have a thorough understanding of
any materiality tests requirements, especially in
the case of non-investment grade credits.
• If a credit-linked note is being issued by a
founder, it must confirm that credit events in
the credit default swap confirmation are
mirrored in the credit-linked note pricing
supplement.
• Credit events are appropriate for the situation.
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BFM MODULE - B

Chapter 16: OPERATIONAL RISK AND INTEGRATION RISK MANAGEMENT

BULLET POINT

OPERATIONAL RISK – GENERAL: 4. Technology oriented causes - Poor technology

and telecom, obsolete applications, information
The Basel Committee has defined Operational
system complexity, poor design, development and
Risk' as follows:
testing.
"The risk of loss resulting from inadequate or
5. External causes- Natural disasters, operation
failed internal processes, people and systems, or
failures of a third party, deteriorated social or
from external events". Operational risk would
political context.
arise due to deviations from normal and planned
functioning of systems, procedures, technology ➢ Effect-based
and human failures of omission and commission.
1. Legal liability
OPERATIONAL RISK – CLASSIFICATION:
2. Regulatory, compliance and taxation penalties
Basel II suggested classification of operational
3. Loss or damage to assets
risks based on the 'Causes' and 'Effects'.
4. Restitution
➢ Cause-based
5. Loss of recourse
1. People oriented causes - Negligence,
incompetence, insufficient training, integrity, key 6. Write-downs
man.
OPERATIONAL RISK MANAGEMENT PRACTICES:
2. Process oriented (Transaction based) causes-
Business volume fluctuation, organizational Fundamental Principles of Operational Risk
complexity, product complexity, and major Management
changes.
➢ Principle I: It is the responsibility of the board
3. Process oriented (Operational control based) of directors to ensure that a strong
causes - Inadequate segregation of duties, lack of operational risk management culture exists
throughout the whole organization.
management supervision, inadequate procedures.
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➢ Principle 2: The Framework for operational
risk management chosen by an individual ➢ Principle 9: Banks should have a strong control
bank will depend on a range of factors, environment that utilizes policies, processes
including its nature, size, complexity and risk and systems; appropriate internal controls;
profile. and appropriate risk mitigation and/or
transfer strategies.
➢ Principle 3: The board of directors should
oversee senior management to ensure that ➢ Principle 10: Banks should have business
the policies, processes and systems are resiliency and continuity plans in place to
implemented effectively at all decision levels. ensure an ability to operate on an ongoing
➢ Principle 4: The board of directors should basis and limit losses in the event of severe
approve and review a risk appetite and business disruption.
tolerance statement for operational risk that
articulates the nature, types, and levels of
➢ Principle 11: A bank's public disclosures
operational risk that the bank is willing to
should allow stakeholders to assess its
assume.
approach to operational risk management.
➢ Principle 5: Senior management should
MANAGEMENT OVERVIEW AND
develop for approval by the board of directors
a clear, effective and robust governance ORGANISATIONAL STRUCTURE:
structure with well defined, transparent and ➢ Role of Board: The board of directors takes
consistent lines of responsibility. overall responsibility to manage and
implement the operational risk framework.
➢ Principle 6: Senior management should ensure ➢ Role of Operational Risk Management
the identification and assessment of the Committee: The operational risk management
operational risk inherent in all material committee should identify the operational
products, activities, processes and systems to risks to which the bank is exposed to,
make sure the inherent risks and incentives formulate policies and procedures for
are well understood. operational risk management, set clear
guidelines on risk assessment/measurement
➢ Principle 7: Senior management should ensure and ensure adequacy of risk mitigating
that there is an approval process for all new controls.
products, activities, processes and systems
➢ Role of Operational Risk Management
that fully assesses operational risk.
Department: The operational risk management
department is the nodal department for
➢ Principle 8: Senior management should
implement a process to regularly monitor identifying, managing and quantifying
operational risk profiles and material operational risks.
exposures to losses. ➢ Role of Internal Audit/Business Functions: The
internal audit function should be operationally
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independent and should not be directly 2. The Standardized Approach (TSA)
responsible for operational risk management. 3. Advanced Measurement Approaches (AMA)

PROCESSES AND FRAMEWORK: [Link] Basic Indicator Approach

• Mapping of Processes and Identification of ➢ Banks using the Basic Indicator Approach must
Risks/Control. hold capital for operational risk equal to the
• The key business processes in the bank must average over the previous three years of a
be mapped into sub-processes. fixed percentage (15%) of positive annual gross
• Implementation of a Qualitative Approach to income.
Aggregating and Assessing Operational Risks. ➢ Gross Income of the bank can be arrived at
• A system to qualitatively analyses the using three formulae given below:
operational risk profile using a scorecard ❖ Formula No.1:
approach should be implemented.
• Gross Income = Net Profit + Provisions &
• Implementation of a Quantitative Approach to
Contingencies + Expenditure incurred under
Assessing Operational Risks in New Product
Schedule 16- minus profit on HTM and irregular
Processes.
/ non-banking transactions income/ income
RISK MONITORING AND CONTROL PRACTICES: non-banking transactions (such as insurance
etc.).
• Collection of Operational Risk Data (incident
❖ Formula No. 2:
reporting framework).
• Gross Income Operating Profit + Expenditure
• Regular monitoring and feedback mechanism
incurred under Schedule 16- minus profit on
in place for monitoring any deterioration in the
HTM and irregular / non-banking transactions
operational risk profile.
income /income from non-banking transactions
• Collation of incident reporting data to assess
(such as insurance etc.)
frequency and probability of occurrence of
• Operating Profit = Net Profit + Provisions &
operational risk events.
Contingences.
• Monitoring and control of management of
❖ Formula No.3:
large exposures.
• Gross Income is defined as the net interest
The modalities to be prescribed in the Loan
income plus non-interest income.
Policy document.
• Non-Interest income excludes the
profits/losses arising out of the following:
OPERATIONAL RISK QUANTIFICATION: • HTM transactions.
Basel II has provided options in the measurement • Income from Insurance business
of operational risk for the purpose of capital • Any irregular / non-banking transactions.
allocation purposes. They are: [Link] Standardized Approach (TSA)
1. The Basic Indicator Approach (BIA)
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➢ In the Standardized Approach, banks' activities 3. Scenario Analysis.
are divided into eight business lines: Corporate
4. Business environment and Internal Control
finance, trading and sales, retail banking,
factors.
commercial banking, payment and settlement,
agency services, asset management, and retail OPERATIONAL RISK MITIGATION:
brokerage.
➢ The capital charge for each business line is ➢ The mitigation of operational risk basically lies
calculated by multiplying gross income by a in the qualitative approach in operational risk
factor (denoted beta) assigned to that business framework adopted and its implementation.
line (Beta Factors). ➢ Under the AMA, a bank will be allowed to
recognize the risk mitigating impact of
Eight Business Lines Beta Factors insurance in the measures of operational risk
used for regulatory minimum capital
1. Corporate finance (high risk factor): 18%
requirements.
2. Trading and Sales (high risk factor: 18% ➢ The recognition of insurance mitigation will be
limited to 20% of the total operational risk
3. Retail banking (low risk factor): 12%
capital charge calculated under the AMA.
4. Commercial Banking (moderate risk factor): 15% ➢ A bank's ability to take advantage of such risk
mitigation will depend on compliance with the
5. Payment and Settlement (high risk factor): 18% criteria laid down in the guidelines.
6. Agency Services (moderate risk factor): 15% Risk and Control Self-Assessment (RCSA) :
7. Asset Management (low risk factor): 12% ➢ This process involves bank's assessment of its
operations and activities against already listed
8. Retail Brokerage (low risk factor): 12%.
menu of potential operational risk weaknesses.
[Link] Measurement Approach (AMA) ➢ RCSA is used to identify gaps between risks and
existing controls, and effectiveness of controls.
➢ Under the AMA, the regulatory capital
requirement will equal the risk measure Key Risk Indicators (KRIS):
generated by the bank's internal operational
➢ KRIS are one of the most common ways of
risk measurement system using the
measuring the actual values of risk causes, the
quantitative and qualitative criteria for the
risk events and their risk consequences.
AMA discussed below.
➢ Capital Charge under AMA is calculated based • Examples of KRIs are: Inadequate staffing, Too
on: many suspicion in the operations, Too many
customers complaints.
1. Internal loss data of the Bank.

2. External loss data of the Banking Industry.

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INTEGRATED RISK MANAGEMENT: INTEGRATED RISK MANAGEMENT – APPROACH:
consists of;
Integrated risk management is managing all risks
that are associated with all the activities ❖ Strategy: Integration of risk management as a
undertaken across the entire organization. key corporate strategy.

THE NECESSITY OF INTEGRATED RISK ❖ Organization: Banks should appoint a Chief

MANAGEMENT: Risk Officer.
• Aligns the strategic aspects of risk with day-to- • Banks should lay down a Board-approved
day operational activities. policy clearly defining the role and
• Facilitates greater transparency for investors responsibilities of the CRO.
and regulators. • CRO has to control and co-ordinate the
• Enhances revenue and earnings growth. functions of the Risk Management Department
• Controls downside risk potential. of the Bank and report directly to the MD or
CEO of the Bank.
INTEGRATED RISK MANAGEMENT – CHALLENGES:
❖ Process: The process of identifying, assessing,
➢ Real-Time Concern
controlling and financing risk must be common
➢ Business Challenge
across the whole enterprise.
➢ Cultural Issues
❖ Systems: Risk management systems must be
developed to provide information and
analytical tools to support the Enterprise Risk
Management functions.
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BFM MODULE - B
Chapter 17: LIQUIDITY RISK MANAGEMANT
BULLET POINT

INTRODUCTION:

Liquidity risk management is the management of ➢ Issues that need to be kept in view while
liquidity by raising sufficient funds either by managing liquidity include:
increasing liabilities or by converting assets
(i) The extent of operational liquidity, reserve
promptly and at a reasonable cost.
liquidity and contingency liquidity that are
LIQUIDITY RISK MANAGEMENT - NEED & required.
IMPORTANCE:
(ii) The impact of changes in the market or
➢ A bank is said to be solvent if its net worth is
economic condition on the liquidity needs.
not negative.
➢ Effective liquidity management crucial for (iii) The availability, accessibility and cost of
increasing the profitability as also the long- liquidity.
term viability/solvency of a bank.
➢ This also highlights the importance of the need (iv) The existence of early warning systems to
of having the best Liquidity Risk Management facilitate prompt action prior to surfacing of the
practices in place in Banks. problem.
➢ Any bank, however, strong it may be, would
(v) The efficacy of the processes in place to ensure
not be able to survive if all the depositors
successful execution of the solutions in times of
queue up demanding their money back.
need.
➢ Banks play a significant role as liquidity
providers in the financial system and to play it POTENTIAL LIQUIDITY RISK DRIVERS:
effectively they need to have sound liquidity
risk management systems in place. The internal and external factors in banks that
➢ The repercussions of liquidity disturbances in may potentially lead to liquidity risk problems in
one financial system could cause ripples in Banks are as under:
others, leading to happening of systemic risk.
➢ Liquidity Risk Management is of critical
importance not only to bankers but to the
regulators as well.
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Internal Banking Factors External Banking Factors

High off-balance sheet exposures. Very sensitive financial market depositors.

The banks rely heavily on the short-term External and internal economic shocks.
corporate Deposits/wholesale deposits.

A negative gap (liability is more than the asset) Low/slow economic performances.
in the maturity dates of assets and liabilities.

The banks' rapid asset expansions exceed the Decreasing depositors' trust on the banking
available funds on the liability side. sector.

Concentration of deposits in the short-term Non-economic factors

Tenor.

Less allocation in the liquid government Sudden and massive liquidity withdrawals from
instruct- ment. depositors.

Fewer placements of funds in long-term Unplanned termination of government

deposits. deposits.

TYPES OF LIQUIDITY RISK:

(i) Funding Liquidity Risk - The risk that a bank will

not be able to meet efficiently the expected and
unexpected current and future cash flows and
collateral needs without affecting either its daily
operations or its financial condition.

(ii) Market Liquidity Risk - The risk that a bank

cannot easily offset or eliminate a position at the
prevailing market price because of inadequate
market depth or market disruption.
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PRINCIPLES FOR SOUND LIQUIDITY RISK MANAGEMENT:

BCBS's Fundamental principle for the management and supervision of liquidity risk

Principle 1 A bank is responsible for the sound management of liquidity risk.

A bank should establish a robust liquidity risk management framework

that ensures it maintains sufficient liquidity, including a cushion of
unencumbered, high quality liquid assets, to withstand a range of stress
events, including those involving the loss or impairment of both
unsecured and secured funding sources.

Supervisors should assess the adequacy of both a bank's liquidity risk

management framework and its liquidity position and should take prompt
action if a bank is deficient in either area in order to protect depositors
and to limit potential damage to the financial system.

Governance of liquidity risk management

Principle 2 A bank should clearly articulate a liquidity risk tolerance that is

appropriate for its business strategy and its role in the financial system.

Principle 3 Senior management should develop a strategy, policies and practices to

manage liquidity risk in accordance with the risk tolerance and to ensure
that the bank maintains sufficient liquidity.

Senior management should continuously review information on the

bank's liquidity developments and report to the board of directors on a
regular basis.

A bank's board of directors should review and approve the strategy,

policies and practices related tothe management of liquidity at least
annually and ensure that senior management manages liquidity risk
effectively.

Principle 4 A bank should incorporate liquidity costs, benefits and risks in the internal
pricing, performance measurement and new product approval process for
all significant business activities (both on- and off-balance sheet), thereby
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aligning the risk-taking incentives of individual business lines with the
liquidity risk exposures and their activities created for the banks a whole.

Measurement and management of liquidity risk

Principle 5 A bank should have a sound process for identifying, measuring, and
monitoring and con- trolling liquidity risk.

This process should include a robust framework for comprehensively

projecting cash flows arising from assets, liabilities and off-balance sheet
items over an appropriate set of time horizons.

Principle 6 A bank should actively monitor and control liquidity risk exposures and
funding needs within and across legal entities, business lines and
currencies, taking into account legal, regulatory and operational
limitations to the transferability of liquidity.

Principle 7 A bank should establish a funding strategy that provides effective

diversification in the sources and tenor of funding.

It should maintain an ongoing presence in its chosen funding markets and

strong relationships with funds providers to promote effective
diversification of funding sources.

A bank should regularly gauge its capacity to raise funds quickly from each
source.

It should identify the main factors that affect its ability to raise funds and
monitor those factors closely to ensure that estimates of fund-raising
capacity remain valid.

Principle 8 A bank should actively manage its intraday liquidity positions and risks to
meet payment and settlement obligations on a timely basis under both
normal and stressed conditions and thus contribute to the smooth
functioning of payment and settlement systems.

Principle 9 A bank should actively manage its collateral positions, differentiating

between encumbered and unencumbered assets.

A bank should monitor the legal entity and physical location where
collateral is held and how it may be mobilized in a timely manner.
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Principle 10 A bank should conduct stress tests on a regular basis for a variety of short-
term and protracted institution-specific and market-wide stress scenarios
(individually and in combination) to identify sources of potential liquidity
strain and to ensure that current exposures remain in accordance with a
bank's established liquidity risk tolerance.

A bank should use stress test outcomes to adjust its liquidity risk
management strategies, policies, and positions and to develop effective
contingency plans.

Principle 11 A bank should have a formal contingency funding plan (CFP) that clearly
sets out the strategies for addressing liquidity shortfalls in emergency
situations. A CFP should out- line policies to manage a range of stress
environments, establish clear lines of responsibility, include clear
invocation and escalation procedures and be regularly tested and updated
to ensure that it is operationally robust.

Principle 12 A bank should maintain a cushion of unencumbered, high quality liquid

assets to be held as insurance against a range of liquidity stress scenarios,
including those that involve the loss or impairment of unsecured and
typically available secured funding sources. There should be no legal,
regulatory or operational impediment to using these assets to obtain
funding.

Public disclosure

Principle 13 A bank should publicly disclose information on a regular basis that

enables market participants to make an informed judgment about the
soundness of its liquidity risk management framework and liquidity
position.

GOVERNANCE OF LIQUIDITY RISK MANAGEMENT: C. The Asset-Liability Management Committee

(ALCO)
The organizational set up for liquidity risk
management should be as under: D. The Asset Liability Management (ALM) Support
Group
A. The Board of Directors (BOD)

B. The Risk Management Committee

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LIQUIDITY RISK MANAGEMENT POLICY, ➢ Strategy for Managing Liquidity Risk
STRATEGIES AND PRACTICES:
The Board of Directors or its delegated committee ➢ The strategy for managing liquidity risk should
of Board members should oversee the be appropriate for the nature, scale and
establishment and approval of policies, strategies complexity of a bank's activities.
and procedures to manage liquidity risk, and ➢ In formulating the strategy, banks/banking
groups should take into consideration its legal
review them at least annually.
structures, key business lines, the breadth and
➢ Liquidity Risk Tolerance diversity of markets, products, jurisdictions in
which they operate and home and host
➢ Banks should have an explicit liquidity risk country regulatory requirements, etc.
tolerance set by the Board of Directors. ➢ Strategies should identify primary sources of
funding for meeting daily operating cash
➢ The risk tolerance should define the level of outflows, as well as expected and unexpected
liquidity risk that the bank is willing to assume, cash flow fluctuations.
and should reflect the bank's financial condition
and funding capacity.

➢ The tolerance should ensure that the bank

manages its liquidity in normal times in such a
way that it is able to withstand a prolonged
period of, both institution specific and market
wide stress events.

➢ Risk tolerance may also be expressed in terms

of minimum survival horizons (without Central
Bank or Government intervention) under a
range of severe but plausible stress scenarios,
chosen to reflect the particular vulnerabilities
of the bank.
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RATIOS IN RESPECT OF LIQUIDITY RISK
MANAGEMENT:
Sl. No. Ratio Significance Industry Average (in %)

1. (Volatile liabilities - Measures the extent to which volatile 40

Temporary Assets)/ (Earning money supports bank's basic earning
Assets - Temporary Assets) assets. Since the numerator
represents short-term, interest
sensitive funds, a high and positive
number implies some risk of illiquidity.

2. Core deposits/Total Assets Measures the extent to which assets 50

are funded through stable deposit
base.

3. (Loans + mandatory SLR + Loans including mandatory cash 80

mandatory CRR + Fixed reserves and statutory liquidity
Assets)/ Total Assets investments are least liquid and hence
a high ratio signifies the degree of
'illiquidity' embedded in the balance
sheet.

4. (Loans + mandatory SLR Measure the extent to which illiquid 150

+mandatory CRR + Fixed assets are financed out of core
Assets)/Core Deposits deposits.

5. Temporary Assets/Total Measures the extent of available 40

Assets liquid assets. A higher ratio could
impinge on the asset utilization of
banking system in terms of
opportunity cost of holding liquidity.

6. Temporary Assets/Volatile Measures the cover of liquid 60

Liabilities investments relative to volatile
liabilities. A ratio of less than 1
indicates the possibility of a liquidity
problem.

7. Volatile Liabilities/Total Measures the extent to which volatile 60

Assets liabilities fund the balance sheet.
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IMPORTANT FACTS CONTINGENCY FUNDING PLAN:
➢ A bank should formulate a contingency funding
[Link] Liabilities: (Deposits + borrowings and
plan (CFP) for responding to severe disruptions
bills payable up to 1 year). Letters of credit-fill up
which might affect the bank's ability to fund
to one year. Current deposits (CA) and Savings some or all of its activities in a timely manner
deposits (SA) i.e. (CASA) deposits reported by the and at a reasonable cost.
banks as payable within one year (as reported in ➢ Contingency plans should contain details of
structural liquidity statement) are included under available/potential contingency funding
volatile liabilities. Borrowings include from RBI, sources and the amount/estimated amount
call, other institutions and refinance. which can be drawn from these sources, clear
escalation/ prioritization procedures detailing
[Link] assets = Cash + Excess CRR balances
when and how each of the actions can and
with RBI + Balances with banks + Bills purchased
should be activated and the lead time needed
discounted up to 1 year + Investments up to one to tap additional funds from each of the
year + Swap funds (sell/buy) up to one year. contingency sources.
[Link] Assets = Total assets - (Fixed assets + ➢ Contingency plans must be tested regularly to
Balances in current accounts with other banks + ensure their effectiveness and operational
feasibility and should be reviewed by the
other assets excluding leasing + Intangible assets).
Board at least on an annual basis.
[Link] deposits = All deposits (including CASA)
BROAD NORMS IN RESPECT OF LIQUIDITY
above 1 year (as reported in structural liquidity
MANAGEMENT:
statement) + net worth.
(i) Banks should not normally assume voluntary
STRESS TESTING: risk exposures extending beyond a period of ten
➢ Stress testing should form an integral part of years.
the overall governance and liquidity risk
(ii) Banks should endeavor to broaden their base
management culture in banks.
➢ The stress test results and the action taken of long-term resources and funding capabilities
should be documented by banks and made consistent with their long-term assets and
available to the Reserve Bank/Inspecting commitments.
Officers as and when required. (iii) The limits on maturity mismatches shall be
➢ If the stress test results indicate any
established within the following tolerance levels:
vulnerability, these should be reported to the
Board and a plan of action charted out (a) Long term resources should not fall below 70%
immediately. of long-term assets; and

(b) long- and medium-term resources together

should not fall below 80% of the long- and
medium-term assets.
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(iv) The monitoring system should be centralized information periodically to the Board and
in the International Division (ID) of the bank for ALCO, both under normal and stress situations.
controlling the mismatch in asset-liability ➢ The MIS should cover liquidity positions in all
structure of the overseas sector on a consolidated currencies in which the bank conducts its
basis, currency-wise. business - both on a subsidiary/branch basis (in
LIQUIDITY ACROSS CURRENCIES: all countries in which the bank is active) and on
an aggregate group basis.
➢ For assessing the liquidity mismatch in foreign
➢ It should capture all sources of liquidity risk,
currencies, as far as domestic operations are
including contingent risks and those arising
concerned, banks are required to prepare
from new activities, and have the ability to
Maturity and Position (MAP) statements
furnish more granular and time sensitive
according to the extant instructions.
information during stress events.
➢ A bank should also undertake separate analysis
of its strategy for each major currency REPORTING TO THE RESERVE BANK OF INDIA:
individually by taking into account the outcome Banks are required to submit the liquidity return,
of stress testing. as per the prescribed format to the Chief General
MANAGEMENT INFORMATION SYSTEM (MIS): Manager-in-Charge, Department of Banking
➢ A bank should have a reliable MIS designed to Supervision, Reserve Bank of India, Central Office,
provide timely and forward-looking World Trade Centre, Mumbai as detailed below:
information on the liquidity position of the
Statement of Structural Liquidity:
bank and the ALM Group should place this

SI. Name of the Liquidity Return (LR) Periodicity Time period by which
No. required to be reported

Structural Liquidity Statement Fortnightly* within a week from the

reporting date
Part Al Statement of Structural Liquidity -
Domestic Currency, Indian Operations
(i)

(ii) Part A2 - Statement of Structural Liquidity - do do

Foreign Currency, Indian Operations

(iii) Part A3 - Statement of Structural Liquidity - do do

Combined Indian Operations

Part B - Statement of Structural Liquidity Monthly# within 15 days from the

(iv) for Overseas Operations reporting date
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(v) Part C Statement of Structural Liquidity- For Quarterly# within a month from the
Consolidated Bank Operations reporting date

INTERNAL CONTROLS:
➢ A bank should have appropriate internal
controls, systems and procedures to ensure
adherence to liquidity risk management
policies and procedure as also adequacy of
liquidity risk management functioning.
➢ A Bank's Management should ensure that an
independent party regularly reviews and
evaluates the various components of the
bank's liquidity risk management process.
➢ The independent review process should report
key issues requiring immediate attention,
including instances of non-compliance to
various guidance/limits for prompt corrective
action consistent with the Board approved
policy.
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BFM MODULE – B

Chapter: 18 BASEL-III FRAMEWORKS ON LIQUIDITY STANDARDS

BULLET POINT

INTRODUCTION: (b) Reinforce the risk-based requirements with a

simple, non-risk based "backstop” measure.
Since Basel II norms could not help save the
financial institutions or avoid occurrence of sub- 4. Introduction of new liquidity ratios such as
prime crisis, BCBS perforce has to come out with Liquidity Coverage Ratio (LCR) and Net Stable
next standards, Basel III guidelines in the year Funding Ratio (NSFR).
2010. Basel-III has tried sincerely to plug the
loopholes of Basel-II guidelines in four different
LIQUIDITY COVERAGE RATIO (LCR)
ways.
The Liquidity Coverage ratio is computed as under:
1. It has mandated a higher capital adequacy ratio
𝐒𝐭𝐨𝐜𝐤 𝐨𝐟 𝐇𝐢𝐠𝐡−𝐐𝐮𝐚𝐥𝐢𝐭𝐲 𝐋𝐢𝐪𝐮𝐢𝐝 𝐀𝐬𝐬𝐞𝐭𝐬
(CAR) to absorb potential losses originating in both ≥
𝐓𝐨𝐭𝐚𝐥 𝐍𝐞𝐭 𝐂𝐚𝐬𝐡 𝐎𝐮𝐭𝐟𝐥𝐨𝐰𝐬 𝐨𝐯𝐞𝐫 𝐭𝐡𝐞 𝐧𝐞𝐱𝐭 𝟑𝟎 𝐜𝐚𝐥𝐞𝐧𝐝𝐚𝐫 𝐝𝐚𝐲𝐬
trading and banking books, including additional 100%
capital conservation buffers.
High Quality Liquid Assets
2. It has taken steps to reduce the variability of the
risk weighted assets by limiting the discretion of ➢ Liquid assets comprise of high-quality assets
banks. that can be readily sold or used as collateral to
obtain funds in a range of stress scenarios.
3. Brought-in is introduction of leverage ratio. ➢ They should be unencumbered i.e., without
legal, regulatory or operational impediments.
The leverage ratio is calibrated to act as a credible
➢ There are two categories of assets which can
supplementary measure to the risk-based capital
be included in the stock of HQLAs, viz. Level 1
requirements and is intended to achieve the
(includes Cash and near cash equivalents and
following objectives:-
hence no haircut applied on these assets) and
(a) Constrain the build-up of leverage in the Level 2 assets.
banking sector to avoid destabilizing deleveraging ➢ Level 2 assets (comprising Level 2A assets and
processes which can damage the broader financial Level 2B assets) can be included in the stock of
system and the economy; and liquid assets, subject to the requirement that
they comprise no more than 40% of the overall
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stock of HQLAS after haircuts have been (a) Contractual Maturity Mismatch
applied.
The contractual maturity mismatch profile
➢ Level 2B assets should comprise no more than
identifies the gaps between the contractual
15% of the total stock of HQLA.
inflows and outflows of liquidity for defined time
Facility to Avail Liquidity for Liquidity Coverage bands.
Ratio' (FALLCR), essential features of which are
(b) Concentration of Funding
given below:
This metric is meant to identify those sources of
(i) Eligibility: Availing of liquidity against such
funding that are of such significance, the
securities would be permitted to banks only under
withdrawal of which could trigger liquidity
the conditions of stress as described under
problems.
paragraph 4.3 and after utilization of all other
HQLAs (including securities permitted under MSF). (c) Available Unencumbered Assets
(ii) Tenor: This facility can be availed/rolled over This metric provides supervisors with data on the
up to a maximum period of 90 days. quantity and key characteristics of banks' available
unencumbered assets.
(iii) Haircut: Liquidity against securities under
FALLCR will be available after applying haircuts as (d) LCR by Significant Currency
stipulated for MSF.
While the LCR standard is required to be met in
(iv) Facility rate: Rate of interest on the funds one single currency, in order to better capture
availed under this facility will be 200 bps above potential currency mismatches, the LCR in each
the prevailing LAF repo rate, up to a period of 90 significant currency needs to be monitored.
days, or as decided by the RBI from time to time.
(e) Market-related Monitoring Tools
Calculation of LCR
This includes high frequency market data that can
It is a ratio of two factors, viz. the Stock of HQLA serve as early warning indicators in monitoring
and the Net Cash Outflows over the next 30 potential liquidity difficulties at banks.
calendar days. Therefore, computation of LCR of a
bank will require calculations of the numerator
and denominator of the ratio, as detailed in the
RBI Circular.

LIQUIDITY RISK MONITORING TOOLS:

Basel III framework also prescribes five monitoring
tools/ metrics for better monitoring a bank's
liquidity position;
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Basel III Liquidity Returns

S. No. Name of the Basel III Liquidity Return (BLR) Frequency of Time period by which
Submission Required to be Reported

1. Statement on Liquidity Coverage Ratio (LCR)-BLR-1 Monthly within 15 days

2. Statement of Funding Concentration - BLR-2 Monthly within 15 days

3. Statement of Available Unencumbered Assets - BLR-3 Quarterly within a month

4. LCR by Significant Currency - BLR-4 Monthly within a month

5. Statement on Other Information on Liquidity - BLR-5 Monthly within 15 days

LCR Disclosure Standards Definition and Computation of Available Stable

Funding
➢ Banks are required to disclose information on
their LCR in their annual financial statements ➢ The amount of ASF is measured, based on the
under Notes to Accounts broad characteristics of the relative stability of
➢ Starting with the financial year ending March an institution's funding sources, including the
31, 2015, for which the LCR related information contractual maturity of its liabilities and the
needs to be furnished only for the quarter differences in the propensity of different types
ending March 31, 2015. of funding providers to withdraw their funding.
➢ In subsequent annual financial statements, the ➢ The amount of ASF is calculated by first
disclosure should cover all the four quarters of assigning the carrying value of an institution's
the relevant financial year. capital and liabilities to one of five categories
as presented below.
NET STABLE FUNDING RATIO (NSFR) ➢ The amount assigned to each category is then
The NSFR is defined as the amount of available multiplied by an ASF factor, and the total ASF is
stable funding relative to the amount of required the sum of the weighted amounts.
stable funding. ➢ Carrying value represents the amount at which
a liability or equity instrument is recorded
𝐀𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐬𝐭𝐚𝐛𝐥𝐞 𝐟𝐮𝐧𝐝𝐢𝐧𝐠 (𝐀𝐒𝐅)
NSFR =𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐬𝐭𝐚𝐛𝐥𝐞 𝐟𝐮𝐧𝐝𝐢𝐧𝐠 (𝐑𝐒𝐅) ≥ 𝟏𝟎𝟎% before the application of any regulatory
deductions, filters or other adjustments.
The above ratio should be equal to at least 100%
on an ongoing basis.
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Sr. No. Components of ASF category (liability categories) Associated
ASF factor

(i) • Total regulatory capital (excluding Tier 2 instruments with residual maturity 100%
of less than one year)

• Other capital instruments with effective residual maturity of one year or

more

• Other liabilities with effective residual maturity of one year or more

(ii) • Stable non-maturity (demand) deposits and term deposits with residual 95%
maturity of less than one year provided by retail and small business
customers

(iii) • Less stable non-maturity deposits and term deposits with residual maturity 90%
of less than one year provided by retail and small business customers

(iv) • Funding with residual maturity of less than one year provided by non- 50%
financial corporate customers

• Operational deposits

• Funding with residual maturity of less than one year from sovereigns, PSEs,
and multilateral and national development banks

• Other funding with residual maturity between six months and less than one
year not included in the above categories, including funding provided by
central banks and financial institutions

(v) • All other liabilities and equity not included in the above categories, 0%
including liabilities without a stated maturity (with a specific treatment for
deferred tax liabilities and minority interests)

• NSFR derivative liabilities net of NSFR derivative assets if NSFR derivative

liabilities are greater than NSFR derivative assets

• "Trade date" payables arising from purchases of financial instruments,

foreign currencies and commodities.
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Definition and Computation of Required Stable ➢ The amount of required stable funding is
Funding (RSF) calculated by first assigning the carrying value
of an institution's assets to the categories
➢ The amount of required stable funding is
listed below.
measured based on the broad characteristics of
the liquidity risk profile of an institution's
assets and OBS exposures.
Sr. Components of RSF category Associated
No. RSF factor

(i) • Coins and banknotes

• Cash Reserve Ratio (CRR) including excess CRR

All claims on RBI with residual maturities of less than six months

• "Trade date" receivables arising from sales of financial

(ii) • Unencumbered Level 1 assets, excluding coins, banknotes and CRR 5%

• Unencumbered SLR Securities

(iii) • Unencumbered loans to financial institutions with residual maturities of less than 10%
six months, where the loan is secured against Level 1 assets as defined in LCR
circular dated June 9, 2014 and updated from time to time, and where the bank
has the ability to freely re-hypothecate the received collateral for the life of the
loan

(iv) • All other 'standard' unencumbered loans to financial institutions with residual 15%
maturities of less than six months not included in the above categories

• Unencumbered Level 2A assets

(v) • Unencumbered Level 2B assets 50%

• HQLA encumbered for a period of six months or more and less than one year

• 'Standard' Loans to financial institutions and central banks with residual

maturities between six months and less than one year

• Deposits held at other financial institutions for operational purposes

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• All other assets not included in the above categories with residual maturity of
less than one year, including 'standard' loans to non-financial corporate clients, to
retail and small business customers, and 'standard' loans to sovereigns and PSES

• Unencumbered 'standard' residential mortgages with a residual maturity of one 65%

(vi) year or more and with the minimum risk weight permitted under the Standardized
Approach 7

• Other unencumbered 'standard' loans not included in the above categories,

excluding loans to financial institutions, with a residual maturity of one year or
more and with a risk weight of less than or equal to 35% under the Standardized
Approach

(vii) • Cash, securities or other assets posted as initial margin for derivative contracts 85%
and cash or other assets provided to contribute to the default fund of a CCP

• Other unencumbered performing loans with risk weights greater than 35% under
the Standardized Approach and residual maturities of one year or more, excluding
loans to financial institutions

• Unencumbered securities that are not in default and do not qualify as HQLA/SLR
with a remaining maturity of one year or more and exchange-traded equities

• Physical traded commodities, including gold

(viii) • All assets that are encumbered for a period of one year or more 100%

• NSFR derivative assets net of NSFR derivative liabilities if NSFR derivative assets
are greater than NSFR derivative liabilities

• 5% of derivative liabilities as calculated according to para 8.1

• All other assets not included in the above categories, including non-performing
loans, loans to financial institutions with a residual maturity of one year or more,
non-exchange-traded equities, fixed assets, items deducted from regulatory
capital, retained interest, insurance assets, subsidiary interests and defaulted
securities

• All restructured 'standard' loans which attract higher risk weight and additional
provision
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Sr: NO Off-balance Sheet Items which require stable Funding Associated RSF factor

(i) Irrevocable and conditionally revocable credit and liquidity 5% of the currently
facilities to any client undrawn portion

(ii) Other contingent funding obligations, including products and

instruments such as:

• Unconditionally revocable credit and liquidity facilities 5% of the currently

undrawn portion

• Non-contractual obligations such as:

-potential requests for debt repurchase of the bank's own

debt or that of related conduits, securities investment
vehicles and other such financing facilities

- structured products where customers anticipate ready

marketability, such as adjustable-rate notes and variable rate
demand notes (VRDNs)

-managed funds that are marketed with the objective of

maintaining a stable value

(iii) • Trade finance-related obligations (including guarantees 3% of the currently

and letters of credit) undrawn portion

• Guarantees and letters of credit unrelated to trade finance

obligations