Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 1: Estimation of Portfolio Credit Risk

Dr Arindam Bandyopadhyay

Objective

After studying the chapter and the relevant reading, you should be able to
understand:
 Difference between Expected Loss and Unexpected Loss
 Methods for estimation of Portfolio Unexpected Loss, Risk Contributions
 Related risk contribution to portfolio loss
 Importance of correlation in a credit portfolio
 Portfolio composition
 Benefits of portfolio diversification

Structure:

1.1. Introduction
1.2. Estimation of Credit Loss-Expected Credit Loss (ECL or EL)
1.3. Estimation of Credit Loss-Unexpected Credit Loss (UL)
1.4. Portfolio Expected Loss (ELP)
1.5. Portfolio Unexpected Loss (ULP)
1.6. Marginal Risk Contribution (MRC)
1.7. Estimation of Portfolio Credit Risk-Numerical Illustrations
1.8. Role of Correlation in Portfolio Diversification

1.1. Introduction

For proper management of credit risk, a bank will have asses risk of an individual
assets as well understand its linkage with the portfolio risk. Actually a bank’s loan
portfolio contains many assets and hence it holds portfolio credit risk. The Basel
Committee of Banking Supervision has also recognized the critical nature of

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

portfolio credit risks. During the global financial crisis, many US banks have suffered
losses due to concentration of sub-prime and sub-prime linked assets in their credit
portfolio. Globally, financial institutions have suffered due to joint default or
incidents of clustered defaults. It is in this context, understanding of portfolio risks
is inevitable for proper management of credit risk.

Actually bank’s loan portfolio contains many risky assets that are subject to credit
risk owing to the probable occurrence of default. A bank will not be able to manage a
credit portfolio efficiently unless the dynamics of portfolio credit risks are known. A
prudent portfolio management requires detailed knowledge of individual borrower
credit risk as well as portfolio specific risks. Accordingly, senior management should
have a portfolio perspective that allows the credit risk management to take a top-
down approach and understand they key drivers impacting the portfolio risk profile.
Such portfolio view should be taken at industry level/region level/product level.

In view of this, it is essential for banks to quantify the expected as well as

unexpected loss in a credit portfolio. This has to be done at individual asset level as
well as at portfolio level.

First, we have to assess the credit risk of individual assets. Risks are of two types:
expected and unexpected. Expected credit risk will enable a bank to understand the
average losses and make provisions to cover such losses in advance. However, the
real risk is the unexpected loss which is uncertain in nature. Capital is needed to
protect a bank from this uncertain loss. A credit risk officer will have to know the
pattern of EL as well UL for each individual assets and also at a portfolio level.

1.2. Estimation of Credit Loss-Expected Credit Loss (ECL or EL)

Expected Loss (EL) is the anticipated average loss over a defined period of time.
Expected losses represent a cost of doing business and are generally expected to be
absorbed by operating income. In the case of loan losses, for example, the expected
loss should be priced into the yield and an appropriate charge included in the
allowance for loan and lease losses.

After arriving PD and LGD values for individual assets, one can estimate the
expected loss (EL). Expected loss is intended to be used to set reserve requirements
for doubtful accounts, calculation of credit spread and risk adjusted return on
capital. Since the EL is part of the cost of doing business, the credit pricing must
absorb the EL. Hence, the higher the EL of a loan, the higher should be the pricing.

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The EL of a loan is estimated using the following formula:

EL=EAD×PD×LGD Equation 1.1

1.3. Estimation of Credit Loss-Unexpected Credit Loss (UL)

Losses above expected levels are usually referred to as unexpected loss (UL).
Unexpected loan losses occur due to sudden actual defaults. Capital cushion is
needed for covering unexpected losses. Hence, the risk weights specified under
Basel II/III standardized approach basically capture the unexpected loss part. In
Basel internal rating based approach (IRB), the banks are only required to hold
capital against the unexpected loss. In statistical terms, this is the standard
deviation of the loss distribution.

UL  EAD PD   LGD
2
 LGD2   PD
2
Equation 1.2
2 2
Where LGD is the variance of LGD and PD is the variance of PD; Variance of
PD (  PD ) = PD × (1-PD); this is because of the assumption of Binomail Distribution.
2

The above formula considers that both PD and LGD are volatile. However, if we
2
assume LGD is a constant number and has no uncertainty, then LGD =0 & the
formula shown in Equation 7.2 boils down to a simpler expression:

𝑈𝐿 = 𝐸𝐴𝐷 × 𝐿𝐺𝐷 × √𝑃𝐷 × (1 − 𝑃𝐷) Equation 1.2a

For example, if PD of a Rs. 100 crore loan is 2% and LGD is 50%, the unexpected loss
of the loan would be =100×50%×√2% × (1 − 2%)
=100×50%×14%=Rs. 7 Crore.
The expected loss of the loan would be: EL=100×2%×50%
=1 Crore
Note that the unexpected loss is higher than the expected loss. That is why banks
will have to hold capital to absorb the future unexpected loss of the loan.

The aim of credit risk analysis is to know whether a new credit is to be extended or
whether the current set of credit facilities given to a customer must be withdrawn.

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The following Chart 1.1 exhibits the pattern of a credit loss series. Notice that the
expected loss is the average loss over time (years). However, the actual risk in the
credit portfolio can be measured through the unexpected loss. Which is the standard
deviation of loss over and above the expected loss. The nature of loss pattern has
also been captured in a distribution form in the right side of the panel. Notice that
actually the loss distribution is positively skewed and has a tail longer than normal
distribution.

Chart 1.1
Expected and Unexpected Loss

Source: BCBS (2006)

1.4. Portfolio Expected Loss (ELP)

Portfolio consists of many assets. Portfolio expected loss is the sum of expected loss
of individual facility or borrower.

ELP   ELi
i Equation 1.3

where i is the number of facilities (assuming bank has n number of risky assets).

If there are two risky assets A and B, mathematically, we write the aggregate
expected loss for the two assets as :

ELP=ELA+ELB Equation 1.4

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

1.5. Portfolio Unexpected Loss (ULP)

Portfolio unexpected loss is the unexpected loss of the portfolio as a whole (at
aggregate level). Portfolio Risk is that loss which arises due to holding two or more
assets in the portfolio.

Although Expected Loss of a Portfolio (EL P) is the algebraic sum of the Expected
Losses of the individual credits (linear). However, Unexpected Loss of a Portfolio
(ULP) is not the algebraic sum of the Unexpected Losses of the individual credits.

For N risky assets indexed by i = 1,2,…,N, it can be shown that the portfolio
unexpected loss, denoted by ULP and denominated in Rs. (or $) terms, is given by :

ULP    UL UL
ij i j
i j
Equation 1.5

The sign  denotes the algebraic sum. Where ij is the default correlation between
asset i and asset j. Double summation comes because i and j assets are different (e.g.
1 & 2). Here the entire portfolio of a bank is considered and there are “n” number of
assets in the portfolio.

If we expand the above formula we get :

ULP  UL1UL2 11  UL1UL2 12  UL1UL3 13  ... UL1ULn 1n  UL2UL1  21
 UL2UL2  22  ... UL2ULn  2 n  ... ULnUL1  n1  ULnUL2  n 2  ...ULnULn  nn

Equation 1.6

Note that when default correlation becomes very significant (or prominent), the
probability very bad events increases substantially. When two or more borrowers
default simultaneously, the NPA problem and subsequent losses are more severe.
Since the credit risk managers focus a lot on tail measures of credit risk such as
value at risk, correlations are of crucial importance.

In order to better understand the above expression, let's simplify the case and take
example of a portfolio consists of two assets 1 and 2.
Therefore, Unexpected Loss of the Portfolio would be:

ULP  UL12  UL22  212UL1UL2 Equation 1.6a

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

This means that the portfolio unexpected loss is not equal to the linear sum of the
individual unexpected losses of the risky assets that make up the aggregate
portfolio. Due to the presence of correlation, it can be proved that:
UL P   ULi
i

Hence, the aggregation of all borrower credit risks in a portfolio does not equal
portfolio unexpected loss. In fact, proper risk management can reduce the portfolio
risk below the total or average of borrower credit risk.

Because of diversification effects, the portfolio unexpected loss is very much smaller
than the sum of the individual unexpected losses:
UL P   ULi
i

This implies that only a portion of each asset's unexpected loss (or volatility of loss)
actually contributes to the portfolio's total risk of loss (or overall volatility of the
portfolio). This portion is called the risk contribution.

Correlation (credit quality correlation or correlation of default) is an important

driver of portfolio credit risk. It is a highly useful tool understand the dimension
portfolio credit risk. The knowledge of correlation is useful in designing a credit
portfolio. The higher the correlation of default, the greater is the concentration risk
of the portfolio. The lower the correlation of default, more diversified the portfolio.
Correlation studies can be split into different categories depending upon the
requirement of the banks; for instance, rating wise default correlation, industry wise
default correlation etc.

1.6. Marginal Risk Contribution (MRC)

Marginal Risk contribution (MRC) is that measure which can help the bank to
understand the extent of diversification in their credit portfolios and help them in
their strategic purpose. It just tells how much incremental risk a single risky asset
contributes to the portfolio as a whole.

In fact, for portfolio management, Risk Contribution is the single most important
risk measure for assessing credit risk.

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

The marginal risk contribution of a risky asset, denoted by RCi to the portfolio
unexpected loss is defined as the incremental risk that the exposure of a single asset
contributes to the portfolio's risk.

Mathematically, we write the risk contribution of asset i as:

UL P
RC i  ULi
ULi
Equation 1.7
Observe that the risk contribution of asset i is measured in terms of the units of
unexpected loss of asset i, or ULi.

The above equation shows risk contribution of asset i, RCi, is a sensitivity measure,
as represented by the partial derivatives (shows partial changes), of the portfolio
unexpected loss with respect to the unexpected loss of asset i.
By performing the partial differentiation calculus on equation 1.5 & following
equation 1.7, it can be easily shown that:
ULi UL j ij
RCi 
j

ULP
Equation 1.8
This is the equation that is used in practice. However, in the presence of many
industry groupings one has to incorporate industry indices (See Michael Ong's book
on Internal Credit Risk Models: Capital Allocation and Performance Measurement,
RISK, Appendix C, Chapter 6).
For a two assets portfolio case, equation (1.8) can be written as:
UL1( UL1  12UL2 )
RC1 
UL P

This is the risk contribution of first asset.

Similarly, the risk contribution of the second asset would be:
UL 2 ( UL 2   21UL1 )
RC 2 
UL P

12   21   is the default correlation between two assets.

It can be shown that:

UL P  RC1  RC2 Equation 1.9
Thus portfolio unexpected loss (ULP) is the sum of all the risk contributions from all
the assets in the portfolio.

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Note that if the correlation is same across assets in a portfolio, the marginal risk
contribution or unexpected loss contribution of an asset in the same loan pool
would be:

RC=√𝜌 × 𝑈𝐿𝑖 Equation 1.10

1.7. Estimation of Portfolio Credit Risk-Numerical Illustrations-Three Assets

Case

Volatility of portfolio loss is driven by two factors: concentration and correlation.

Concentration describes the lumpiness of the portfolio (specific risk); correlation
describes the sensitivity of the portfolio to changes in underlying macroeconomic
factors (systematic risk). These are two important risk elements need to be
measured and managed properly in a credit portfolio.

The entire portfolio risk assessment exercises has been numerically illustrated
using a very simple two assets case as given below:

Let’s consider that a credit officer in a bank is dealing with three corporate loans:
borrower i, borrower j and borrower k.

Borrower i got sanction of a non-amortizing term loan of Rs. 100

crore
- for 1 year
- at 15% rate of interest (annual)
- Credit Exposure (Ei) = 100 Crore
- Loss Given Default (LGDj) = 40%
- Credit Rating of Borrower = AA (say)
- Associated Default Probability (PDi) = 0.50%

To Calculate the Expected and Unexpected Loss of the

loan

ELi = PDi * LGDi * Ei

= 0.2 Crore

Ei * LGDi * SQRT{PDi * (1
ULi = - PDi)}
= 2.82 Crore

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Borrower j received a non-amortizing term loan of Rs. 50 crore

- for 1 year
- at 13% rate of interest (annual)
- Credit Exposure (Ej) = 100 Crore
- Loss Given Default (LGDj) = 60%
- Credit Rating of Borrower = A (say)
- Associated Default Probability (PDj) = 1.00%

To Calculate the Expected and Unexpected Loss of the

loan

ELj = PDj * LGDj * Ej

= 0.6 Crore

Ei * LGDj * SQRT{PDj * (1
ULj = – PDj)}
= 5.97 Crore

Borrower k sanctioned a non-amortizing term loan of Rs. 50

crore
- for 1 year
- at 13% rate of interest (annual)
- Credit Exposure (Ek) = 50 Crore
- Loss Given Default (LGDk) = 25%
- Credit Rating of Borrower = AAA (say)
- Associated Default Probability (PDk) = 0.10%

To Calculate the Expected and Unexpected Loss of the

loan

ELk = PDk * LGDk * Ek

= 0.0125 Crore

Ek * LGDk * SQRT{PDi * (1
ULk = – PDk)}
= 0.40 Crore

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One can notice that the unexpected loss in all three loan categories is significantly
higher than the expected loss. This is why, capital is needed as a cushion against
unexpected loss which can be met through provisions.

As a next level, we have to now assess the portfolio losses. Note that this loan
portfolio now consists of three loans. First we estimate portfolio loss for two assets
and then we extend the analysis for 3 assets. The entire computation has been
shown in the following box:

Say Default Correlation between Borrower i and Borrower j is given

by
CORij = 0.36

ELp = ELi + ELj

= 0.8 Crore

ULp = SQRT(ULi 2 + ULj 2 + 2 CORij * ULi * ULj)

= 7.47 Crore

< 8.79 crore

ULi*(ULi+CORij*ULj)/ULp
Risk Contribution of Borrower
X = 1.88 Crore
ULj*(ULj+CORij*ULi)/ULp
Risk Contribution of Borrower
Y = 5.59 Crore

sum of Risk Contribution of X &

Y 7.47

Note that the sum of risk contributions is equal to portfolio unexpected loss of Rs.
7.47 crore. Also notice that the risk contribution for each borrower is markedly
lower than their unexpected losses. This is happening because of correlation benefit
that provides room for diversification. The risk contribution of each borrower
measures their incremental or marginal contribution to portfolio risk. Accordingly,
because of correlation benefit, the unexpected loss charge of an asset will be much
lower. This has important implications on risk based loan pricing. Actually, the

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

unexpected loss charge is much lower due to diversification benefit. A bank cannot
practically implement risk based pricing unless correlation effect is estimated.

The portfolio diversification effect will be more pronounced when we actually

consider the three assets case:

Say Default Correlation between Borrower i and Borrower k is

given by
CORij = 0.3
Say Default Correlation between Borrower j and Borrower k is
given by
CORik = 0.2

ELp = ELi + ELj + ELk

= 0.8125 Crore

=SQRT(ULi2+ULj2+ULk2+
ULp 2 CORij*ULi*ULj+2CORjk*ULj*ULk+2CORik*ULi*ULk)
= 7.58 Crore

< 9.19 crore

Notice that the portfolio unexpected loss ULp amount in Rs. crore is much lower that
the sub portfolio level individual asset wise unexpected losses (UL i, ULj and ULk).
Moreover, the portfolio loss volatility (i.e. UL p) is significantly lower than the sum of
unexpected losses of assets (ULi+ULj+ULk).

It is important to note that if we estimate expected and unexpected losses from

average and loss deviations in percentage term, then we have to adjust the portfolio
expected and unexpected losses with exposure shares or weights (w i).

For example, in a two assets portfolio (N=2), the portfolio risk calculation formula
would be:

𝜎𝑃 = 𝑈𝐿𝑃 = √ 𝑤𝑖2 𝑈𝐿2𝑖 + 𝑤𝑗2 𝑈𝐿𝑗2 + 2𝑤𝑖 𝑤𝑗 𝐶𝑂𝑅𝑖𝑗 𝑈𝐿𝑖 𝑈𝐿𝑗

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Note that correlation CORij is the default correlation between asset i and asset j. It is
also denoted by Greek symbol "𝜌", termed as “rho”.

Here, wi is the exposure share of first borrower to the total portfolio & say it is equal
to 40%. Accordingly, the 2nd borrower exposure share in the same portfolio of two
assets would be 60%.

A bank choose different portfolio mix to understand the effect of correlation on

portfolio unexpected loss.

1.8. Role of Correlation in Portfolio Diversification

Practically, a commercial bank holds many assets in their credit portfolio with
different degrees of risks. Therefore, finding those many asset wise correlations is a
challenge for the bank. This why, assets are finally grouped into various sub-pools
depending upon their common risk characteristics. For example, a bank can create
rating grade wise pool, industry pool, loan to value ratio wise pools, region wise
pools (zone wise or Rural, Urban, Semi-Urban) and can estimate default
correlations. The method for estimation of such correlations are explained in
subsequent chapter.

It is quite clear from the above examples the role of correlation and risk
contributions in a portfolio. As you diversify your portfolio, the portfolio risk
reduces depending upon the correlation of portfolio components. The lower the
correlation, greater is the diversification and the lower the portfolio risk.
Accordingly, while constructing or managing a portfolio, correlation analysis is
required to create a relatively shockproof credit portfolio. Combining the credit
assets with lower correlations tend to reduce the overall portfolio risk.

References
1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,
Cambridge University Press. Chapter 6.
2. Marrison, C. (2002), “The Fundamentals of Risk Measurement”, Tata
McGraw-Hill Edition, Chapter 20.

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 2: Measurement of Default and Asset Correlation

Dr Arindam Bandyopadhyay

Objective

After studying the chapter and the relevant reading, you should be able to
understand:
 Importance of Default Correlation in Portfolio Risk Analysis
 Joint Dependence between Assets
 Method for Estimation of Default Correlation
 Difference between Joint Default Probability and PD
 Proxy Method for Estimation of Industry Default Correlation
 Range of Default Correlation Estimates

Structure

1. Introduction
2. Estimation of Default Correlation
3. Benefits of Estimation of Default Correlation
4. Other Methods for Estimation of Default Correlation
5. Default Correlation for Retail Pools
6. Importance of Default Correlation
7. Difference between Default Correlation and Asset Correlation
8. Factors influence Default Correlation

1. Introduction

Default correlation or the pairwise correlation between two assets is very important
when assessing the totality of portfolio risk (ULP). The glue that ties the risk
contribution of a risky asset to the totality of the portfolio is "default correlation".
This relationship we have seen in the previous chapter when we have computed
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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

portfolio unexpected loss and risk contributions. The strength of the correlation is
determined by macroeconomic, industrial, geographic, and temporal factors. In turn,
an aggregate of risk contributions from several risky assets indicate the level of
concentration risk in the portfolio. Finally, the level of concentration risk decides on
the degree of diversification in the portfolio. The correlation effects need to be
considered carefully in the risk management and measurement of credit portfolios.
However, measuring default correlation is very difficult.

Estimation default correlation is critical for assessment of portfolio unexpected loss

and economic capital. Note that study of default correlation, estimation of marginal
risk capital and economic capital enables the top management to adopt
diversification strategy and limit setting to prevent concentration in loan portfolio.

In this chapter, we will know the methods for computation of default correlation.

2. Estimation of Default Correlation

Here we explain a rating based methodology for determining default correlations

which is based on the approach developed by Lucas (1995), Nagpal and Bahar
(2001) and De Servigny and Renault (2002, 2003) of Standard and Poor (S&P) and
Bandyopadhyay (2007).

As a first step, we have done mortality rate analysis of ten one-year cohorts of
companies to find the number of firms in each rating class in each cohort moving
towards default category (D). Each cohort comprises of all the companies which
have a rating outstanding at the start of the cohort year. From these cohorts, we
calculate year-wise default probabilities for different rating grades and for different
industries. Say there are Ti,D number of firms migrating to Default category out of Ni
number of firms in the ith rating grade (or industry) over a one-year period, where
the subscript i represents the rating grade (or industry) at the start of the period
and the subscript D represents Default. The one-year probability (PD) of the ith
Ti ,D
Ni
rating grade (or industry) is estimated by counting the frequencies : .

The average one-year default probability for the ith rating grade or industry (PDi) is
obtained by weighted average, where the weights are the number of firms in the ith
rating class (or industry) in a particular year divided by the total number of firms in
all the years.
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n
Ti t,D
PDi   wit
t 1 Nit Equation 2.1
where is the weight representing the relative importance of a given year :
N it
wit  n

N i
s

s 1 Equation 2.1a
In the second step, we compare the pairs of defaulting firms at the end of the period
with the total number of pairs of firms at the start of the period to count the joint
default frequency for each year from our data. Here we first consider the joint
migration of two obligors from the same rating grade (say AAA rating) to default D.
Say there are Ti,D number of firms migrating to Default category out of Ni number of
firms in the ith rating grade, where the subscript i represents the rating grade at the
start of the period and the subscript D represents Default. The one-year within-
Ti ,D 2
grade joint default probability would be: Ni  . If obligors are moving from
2

different rating grades (say AA and B) towards default (D), we should be interested
in pairs of number of firms Ti,D and Tj,D migrating respectively to category D. The
one-year between grade joint default probability (JDP) in such a case would be:
Ti ,D 2
Ni 2 . The one-year joint default probabilities are arrived at by assuming that the
defaulting pair of bonds is drawn with replacement. This assumption is important to
ensure that we avoid spurious negative default correlations in cases where only one
default event is observed for a particular rating category (or industry).

The next step is to calculate the average joint default probabilities (JDP) over time.
For joint default migrations of firms within the same starting rating grade, the
following equation is used:
n
( Ti t,D )2
JDPi ,i   wit
t 1 ( N it )2 Equation 2.2
wit
where is the weight representing the relative importance of a given year :
t
N
wit  n
i

N i
s

s 1 Equation 2.2a
For joint default migration of firms from different starting rating grades, we use the
following equation:

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n Ti t,DT jt,D
JDPi , j   w t
ij
N it N tj
t 1
Equation 2.3
Where, the weight is given as:
𝑁𝑖𝑡 𝑁𝑗𝑡
𝑤𝑖𝑗𝑡 =
∑𝑇𝑡=1 𝑁𝑖𝑡 𝑁𝑗𝑡
Equation 2.3a
Where T=total number of years (say 10 years) and t=every year (say year 1, 2, ..10).

Once we obtain the estimates of average joint default probabilities (JDP) and
average default probabilities (PD), we can calculate the one-year expected default
correlations using the following formula:
JDPi , j  PDi PDj
iD, j,D 
PDi ( 1  PDi )PDj ( 1  PDj )
Equation 2.4
The above formula (equation 3.4) is based on the assumption that there is a
constant probability of default (as given by the expected default probability) for a
firm or an industry over time and a constant joint default probability (as given by
the average joint default probability) over time. However, this does not imply that
default probabilities or joint default probabilities are time invariant. It is the
limitation of this method.

For example, if the joint default probability between two borrowers rated A and
BBB is estimated as 0.06%, and probability of default of A is 0.70% and BBB is 2%;
one can derive their default correlation using equation 8.4. The estimated value of
the default correlation coefficient would be=(0.06%-0.70%*2%)/SQRT(0.70%*(1-
0.70%)*2%×(1-2%))=3.94%. Note that * denotes multiplier symbol “×”.

Based on the above methodology, we have obtained the rating wise default
correlation coefficients presented in the table 2.1 below:

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Table 2.1-One-Year Default Correlations Across Indian Corporate Rating

Classes (1995-96 to 2004-05)
(Figures in %)
Year 2
Year 1 AA A BBB BB B C
AA 1.222
(0.45,1336)
A 1.71 2.68
(0.63,1357) (1.00,1378)
BBB 2.38 2.93 7.93***
(0.73,939) (0.77,690) (1.85,542)
BB 3.10 3.10 7.25** 13.06***
(0.87,789) (0.88,810) (1.44,392) (2.04,242)
B -2.51 -6.65*** 0.32 -8.79 24.55***
(-0.66,695) (-1.78,716) (0.055,298) (-1.07,148) (1.83,54)
C -0.19 -2.79 -2.08 -6.96 -7.43 16.537**
(-0.051,711) (-0.75,732) (-0.37,314) (-0.89,164) (-0.61,70) (1.54,86)
Note : *** denotes the significance level at 5% or better, ** denotes significance at
5%-10%.
The figures in the parentheses are the t-values and the number of
observations respectively.

For validation purpose, we have done statistical significance tests of our empirically
derived correlation coefficients. The correlation figures presented above captures
the pairwise default correlations per class of rating.

We also present the international estimates for comparison purpose:

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Table 2.2
One-Year Global Corporate Default Correlations Across All Countries and All Industries:
1981-2002
(×100)
Year 2
Year 1 AA A BBB BB B CCC
AA 0.16
A 0.02 0.12
BBB -0.03 0.03 0.33
BB 0.00 0.19 0.35 0.94
B 0.10 0.22 0.30 0.84 1.55
CCC 0.06 0.26 0.89 1.45 1.67 8.97
Note : As reported by De Servigny and Renault (2004), Measuring and Managing
Credit Risk,
Chapter 5, Standard & Poor's, McGraw-Hill Companies, Inc, pp. 188. Source :
Standard & Poor's CreditPro

The following Table 2.3 documents the default correlation estimates across
investment grades:

Table 2.3
One-Year Default Correlations : 1970-1993
(×100)
Year 2
Year 1 Aaa Aa A Baa Ba B
Aaa 0%
Aa 0% 0%
A 0% 0% 0%
Baa 0% 0% 0% 0%
Ba 0% 0% 0% 0% 2%
B 0% 1% 0% 1% 4% 7%
Note : As reported by Lucas (1995).
Source : Moody's Investors Service Ratings of all Non-Municipal Issuers.

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From all these results, we can see that default correlation tends to increase
substantially as the rating deteriorates. Further, the highest default correlations can
be observed in the diagonal, i.e., within the grades.
Similarly, one can also estimate industry wise default correlations as well.

3. Benefits of Estimation of Default Correlation

The portfolio perspective and estimation of default correlation allows the credit risk
manager to adopt a top-down approach and understand the key drivers impacting
the portfolio credit risk profile. The study of default correlation enables bank to
identify which are the correlated sectors within the portfolio, whether there is any
concentration risk in the portfolio and if so, how can it be managed down. Further, it
also tells us which are the risky areas in the portfolio (identify the industries that
are more vulnerable to industry cyclicality).

4. Other Methods for Estimation of Default Correlation

One can easily understand that the banks need good set of internal data to estimate
the default correlation. Where banks do not have enough time series data on
borrower default, they may use external rating agency data (like S&P or CRISIL) to
estimate the default correlation. Even if rating agency data is not readily available,
bank can take equity industry index returns correlation as a proxy for default
correlation. However, these correlations need to be properly weighted in terms of
bank’s actual credit exposures to these industries. The movement of equity prices
on the public stock exchange is also used as a crude proxy for measuring default
correlation. Sometimes it is also termed as asset correlation (AC). Generally it uses
factor model of credit risk.

5. Default Correlation for Retail Pools

Like the commercial loans, banks that have greater focus on retail portfolios must
take special care to identify any common risk factor that might drive their retail
credit risk. The banks can estimate correlations using actual loan default data from
their internal database. For most banks, a region level breakdown is appropriate.
Similarly, for each region, it is possible to estimate default correlation between
rural, semi-urban and urban areas. Some past global studies have found that the
highest default correlations appear in states that are relatively small and in states
where the economy is cycle sensitive due to industry concentrations. The

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correlation analysis will enable a bank compare economic capital to understand

how much they can gain in terms of capital through diversification.

6. Importance of Default Correlation

Default correlation is very crucial for estimation of portfolio unexpected loss and
economic capital. Capturing simultaneous defaulting events and estimation of
correlation enables a risk manager to understand portfolio concentration and
diversification. Correlation of joint credit quality movement has significant influence
on the market value of a credit portfolio.

7. Difference between Default Correlation and Asset Correlation

Default correlation focuses on joint defaults, where asset correlation measures

association between asset returns. Both have the same sign. The higher the asset
correlation, the higher is the default correlation. Default correlations are generally
low although they increase as ratings deteriorate. Default correlations among highly
rated borrowers are very small since defaults for these obligors are low. As default
probability increases, default correlation also increases for a given level of asset
correlation. Lower-rated obligors on the cusp of default are more susceptible to
downturns in the economy and are more likely to default together in line with shifts
in the state of the general economy.

Default correlation (DC) is used for estimation of portfolio unexpected loss and
economic capital (EC). On the other hand, Basel IRB regulatory capital formula as
proposed by the BCBS prescribes to use Asset correlation (AC) to estimate
regulatory capital (RC).

It has been historically observed that there is inverse relationship between PD and
asset correlation (AC) for a given level of default correlation. This has been
considered in the Basel regulatory capital formula as well. Generally, Asset
Correlation is much higher than the Default Correlation coefficients.

8. Factors influence Default Correlation

Default correlation or default dependencies arises because of three types of reasons:

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Industry-specific reasons-Entire sectors may get hit by common shocks (fall in

commodity price or sharp increase in the prices of raw materials etc.) due to
industry dependence.
General macroeconomic conditions-Growth and recession, interest rate changes
and commodity prices affect all firms to various degrees.
Regional dependence-Entire region sometimes knockout due to crop failure,
recession, price crash, labor strike due to regional common dependence etc.

Macroeconomic, regional and industry specific shocks do lead to increases in the

default rates of entire segments of the economy and push up correlations.

Learning Questions:

1. Identify the difference between Probability of Default (PD) and Default

Correlation (DC)
2. Why correlation analysis is important for a risk manager?
3. Explain the factors influence default correlation

References
1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,
Cambridge University Press. Chapter 6.
2. De Servigny, A., and O. Renault (2004), “Measuring and Managing Credit
Risk”, McGraw-Hill, Chapter 5.

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Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 3: Portfolio Concentration and Risk Diversification

Dr Arindam Bandyopadhyay

Objectives

After studying the chapter and the relevant reading, you should be able to
understand:
 Portfolio Concentration Risk
 Concept of Credit Portfolio Mix
 Measures of Credit Concentration Risk
 Importance of Portfolio Diversification
 Risk Diversification Strategies

Structure

1. Introduction
2. What are the Drivers of Portfolio Credit Risk?
3. Credit Portfolio Mix
4. Credit Concentration Risk
5. Management of Credit Concentration Risk

1. Introduction

Banks are, by their very nature, in the business of risk; and banks do conduct risk
management. Assuming that value creation is the ultimate objective of banks, the
fact that optimal internal risk management can create value makes the need for it all
the more important. Banks can increase their value through risk management by
decreasing the total risk costs (of both the systematic risks and idiosyncratic risks
inherent in their portfolios). Capital budgeting rules should, therefore, take into
consideration these risk costs to ensure optimal allocation of capital.

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Banks will not be able to manage their loan portfolios efficiently unless the
underlying portfolio credit risks are known. It requires detailed knowledge not only
on individual borrower risk but also portfolio specific risks. Analysis of credit
portfolio risk focuses on a broader approach to credit risk and examines the
common credit risk behavior of homogenous groups of borrowers. This involves
study of industry wise, rating wise, region wise, and product specific sub-portfolio
level concentration. The portfolio perspective allows the top management to
understand the key drivers that are impacting the portfolio risk profile.

2. What are the Drivers of Portfolio Credit Risk?

Portfolio Credit Risk is the risk of changes in the market value of the portfolio over a
specified time horizon as a result of changes in credit quality due to:
Credit Migration (Upgrades/Downgrades)
Default
Simultaneous Default (or Default Correlation)
The first two drivers define the portfolio quality or portfolio mix. The third driver is
very important since it addresses simultaneous defaults. The joint or cluster
defaults may produce large losses and therefore the hidden layers of correlation in a
portfolio needs to be well understood. Therefore, a portfolio manager will have to
constantly monitor the asset quality movement over time through transition matrix
analysis and track joint movement of assets. A credit portfolio mix (or quality) may
change due to unexpected change in macroeconomic conditions.

Chart 3.1 summarizes the important drivers of portfolio credit risk. Note that
besides PD and LGD, correlation is an important component of portfolio risk. It
actually links each and every asset to a portfolio.

Chart 3.1-Portfolio Dimension of Credit Risk

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Chart 3.2 demonstrates the relationship between diversifiable ad systematic risks.

The total portfolio risk=unsystematic (diversifiable) risk + systematic (un-
diversifiable) risk.

Chart 3.2- Systematic Risk vs. Diversifiable Risk

Source: Author’s own illustrations adapted from various concepts on portfolio

theorem

Note that the systematic risk cannot be eliminated through diversification. However,
the sector specific idiosyncratic risk or non-systematic risk or specific risk may be
eliminated by holding a large well diversified credit portfolio. This means, as
number of credit assets goes up, the portfolio credit risk will come down. This has
also been recognized by the Basel Committee in IRB credit risk regulatory capital
estimation formula. The Basel IRB formula assumes that bank maintains a perfectly
granular and well diversified portfolio.

A portfolio approach is essential to identify specific and vulnerable sectors and

credit asset categories which may face systematic/cyclical impact severely.
Empirical evidence suggests that low quality portfolio collapses first due to
systematic risk. Some cases, regulator also identifies stress sectors that may cause
large systematic risk in a bank’s portfolio. These are also termed as cyclical or stress
sectors. A portfolio approach is essential to identify such specific and vulnerable
sectors and credit asset categories, which may face systematic impact under
macroeconomic stress situations. Banks also need to perform stress testing to
understand the potential impact of systematic risks on credit portfolio risks and
accordingly design appropriate policies to protect and enhance the quality of the
portfolio.

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It is worthwhile to mention that a proper diversified credit portfolio should have a

large number of credit assets. Hence, it is important to create various sub-pools
based on some common risk characteristics (say rating/score based, LTV based,
industry or product based pools). After, diversifying all nonsystematic risks away
(which is a challenging task), a portfolio manager will have to address the
correlation (the common systematic factor) and assess its impact on portfolio
unexpected loss and economic capital through a value at risk analysis (VaR). Even a
systematic shock can be absorbed by the bank with a well-diversified portfolio.

3. Credit Portfolio Mix

To derive a better insight about the inherent risk characteristics in a portfolio, it is

necessary to understand the dynamics of changing portfolio quality. The following
table 3.1 depicts the change in the rating distribution of Indian corporates from
2008 to 2017. These rating-wise distribution patter is published by CRISIL. Notice
that the corporate portfolio mix has changed considerably with a time gap of every
four years. To better understand the importance of portfolio quality shift, we have to
assess its impact in terms of risk capital. For instance, if we consider that banks are
under the Basel Standardized Approach and relate the risk sensitivity to risk
weighted assets, then we will notice that there is an increase in credit risk due to
deterioration of the asset quality in FY 2012 and in FY 2017. The Basel II/III
standardized approach and regulatory capital estimation for corporate credit
exposures has been already discussed in the previous lecture note. For example, if
loan exposure shifts downward from AAA to AA, then risk weight will increase from
20% to 30% for those segments. Similarly, a deterioration will be more pronounced
if many borrowers are downgraded to BB and B segment since the risk weights are
as high as 150% in those segments. Notice that in FY 2017, the borrower % share is
highest in high risk segment (BB & below). Thus, at system level, there is a shift in
the corporate credit risk profile in India. Consequently, the median rating of around
14,000 ratings in FY 2017 is at “BB” category which is significantly lower than “AA”
category median that was in FY 2008. Note that a deterioration in credit quality
increases the credit risk weighted assets.

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Table 3.1-Agency Rating Distribution

% Share of Borrowers
Grades FY2008 FY2012 FY2017
AAA 34.90% 1.25% 1.05%
AA 35.64% 2.95% 2.00%
A 16.25% 6.25% 4.38%
BBB 7.50% 20.00% 16.32%
BB 2.65% 32.00% 35.10%
B 0.38% 25.45% 34.00%
CCC/D 2.68% 12.10% 7.15%
Total 100.00% 100.00% 100.00%
Source: CRISIL’s Ratings Round-Up, Fiscal 2017

This change in systematic risk profile of corporates will have adverse impact on
capital adequacy of banks. However, the impact may vary from bank to bank
depending upon their actual distribution of assets in the above rating categories.

The risk weight sensitivity will be higher if banks are under IRB approach. This has
been discussed in great detail in Basel Credit Risk section.

4. Credit Concentration Risk

Concentration in credit portfolios is a critical aspect of portfolio credit risk. Portfolio

concentration determine the magnitude of problems a financial institution would
suffer under adverse economic conditions. Concentration may happen due to
geographic preference or excessive exposure to few borrowers or few industries.
An ideal credit portfolio out to be properly balanced, with a mix of different rating
categories and industries. Diversification can be achieved through scientific
determination of the type and extent of diversification required in the portfolio.
This can be achieved through correlation analysis and estimation of economic
capital. Further, bank can also classify the sectors/portfolios based on riskiness and
limit their exposures based on their risk appetite.

A bank can estimate sectoral betas to gauge a portfolio’s volatility due to external
risk. For example they run a regression on loss rate or write off rate in corporate
sector (CL) and use bank’s aggregate loss (BL) as independent variable.

𝐶𝐿 = 𝛼 + 𝛽 × 𝐵𝐿 Equation 3.1
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Portfolio beta will be relatively high for a portfolio with higher level of
concentration. This means the rate of loss of this portfolio would be higher than a
well-diversified portfolio. Some banks use Herfindahl-Hirschman Index (HHI) to
gauge portfolio concentration risk.

The HHI is calculated by summing the squares of the portfolio share of each
individual contributor (a borrower/sector/region etc.). For example, an equal
allocation of loans in each of 100 companies would lead to a diversified HHI of 0.01.
In contrast, if the firms are divided amongst five sectors in the ratio 5:2:1:1:1, then
the implied HHI by sector is 0.32, indicating a significant concentration. On the other
hand, a lower value of HHI (<0.18 or 1,800 in 100×100 unit point) indicates greater
diversification in the loan portfolio.

5. Management of Credit Concentration Risk

Some banks manage concentration risk by closely managing their top 20 borrowers
with extra care. More diligence is exerted in operations involving large accounts,
and involvement of senior management in monitoring such accounts. In India, banks
prudential limits for individual borrowers (15% of capital funds), project finance
(20% of capital funds), group borrower exposures (40% of capital funds) and
substantial exposure limits (aggregate SEL of 800% of bank’s capital funds) on a
quarterly basis to management concentration risk. Most of the banks have internal
limits to prevent themselves from getting over exposed to certain sector that does
not match their risk appetites.

A more prudent approach would be to estimate the default correlation across assets
which has been already shown in the previous chapter.

A risk focused management uses rating transition matrix to monitor the rating
slippage of big accounts across business or regions or industries.

Learning Questions

1. Explain credit concentration risk. Why it is important for credit portfolio

management?
2. How to measure concentration risk?
3. How transition matrix helps a bank to manage loan concentration?
4. What is portfolio mix? What happens to risk if credit quality deteriorates?

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5. Using regression analysis on the sectoral historical losses, a large commercial

bank gets the following sectoral betas:
XLCL=0.008+1.50BL & XRetail=0.002+0.70BL where XLCL=the loss rate in large
corporate credit and BL=the aggregate loss rate for the bank’s entire loan
portfolio & XRetail=loss rate in the retail portfolio.
If the bank’s total loss rate increases by 20 percent, the expected loss rate
increase in the large corporate segment and in retail sector will be:
i) <20% in LCL and >20% in Retail
ii) <20% in LCL and <20% in Retail
iii) >20% in LCL and >20% in Retail
iv) >20% in LCL and <20% in Retail
v) None of the above

References

1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,

Cambridge University Press. Chapter 6.
2. Joseph, C. (2013), “Advanced Credit Risk Analysis and Management”, Wiley
Finance, Chapter 14.

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Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 4: Credit VaR and Economic Capital

Dr Arindam Bandyopadhyay

Objectives

After studying the chapter and the relevant reading, you should be able to
understand:
 Meaning of Economic Capital
 Difference between Economic and Regulatory Capital
 Estimation of Credit VaR
 Link between bank rating and Economic Capital
 Concept of capital multiplier
 Drivers of Economic Capital

Structure:

1. Introduction
2. Concept of Economic Capital and Credit VaR
3. The Role of Economic Capital
4. Measurement of Economic Capital-Credit VaR Approach
5. The drivers of capital levels

1. Introduction.

Banks are, by their very nature, in the business of risk; and banks do conduct risk
management. Assuming that value creation is the ultimate objective of banks, the
fact that optimal internal risk management can create value makes the need for it all
the more important. Banks can increase their value through risk management by
decreasing the total risk costs (of both the systematic risks and idiosyncratic risks
inherent in their portfolios). Capital budgeting rules should, therefore, take into
consideration these risk costs to ensure optimal allocation of capital.

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Banks will not be able to manage their loan portfolios efficiently unless the
underlying portfolio credit risks are known. It requires detailed knowledge not only
on individual borrower risk but also portfolio specific risks. Analysis of credit
portfolio risk focuses on a broader approach to credit risk and examines the
common credit risk behavior of homogenous groups of borrowers. This involves
study of industry wise, rating wise, region wise, and product specific sub-portfolio
level concentration. The portfolio perspective allows the top management to
understand the key drivers that are impacting the portfolio risk profile.

In view of this, it is essential for banks to quantify the inherent risk in their credit
portfolio. This has to be done at individual asset level as well as at portfolio level.

2. Concept of Economic Capital and Credit VaR

Economic capital is typically defined as the difference between some given

percentile of a loss distribution and the expected loss. It is sometimes referred to as
"unexpected loss at the confidence level."

The confidence level is established by bank management and can be viewed as the
risk of insolvency during a defined time period at which management has chosen to
operate. The higher the confidence level selected, the lower the probability of
insolvency. For example, if management establishes a 99.9% confidence level that
means it is accepting a 3 in 10,000 probability of the bank becoming insolvent
during the next 1 year. The Basel Committee on Banking Supervision (BCBS) has set
a confidence level of 99.9% that may correspond to global S&P BBB rating for banks.
Many globally best practiced banks using economic capital models have selected a
confidence level of 99.98%, equivalent to the solvency rate expected for an AA or Aa
credit rating.

3. The Role of Economic Capital

The primary value of economic capital, and the reason that banks have already
adopted such methodologies, is its application to decision-making and risk
management. Specifically, the use of such models can:

Contribute to a more comprehensive pricing system that covers expected losses.

Assist in the evaluation of the adequacy of capital in relation to the bank's
overall risk profile.

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Develop risk-adjusted performance measures that provide for better evaluation

of returns and the volatility of returns.
Enhance risk management efforts by providing a common currency for risk.
Economic capital represents actual risk inherent in the credit portfolio. Unlike
regulatory capital, Economic capital is voluntary in nature and is notional. The
credit risk manager as well as top management must aware of the amount of risk
actually faced by the bank. Economic capital tries to answer whether the available
capital equal or exceed the capital necessary to ensure our survival with a given
level of confidence.

At the sub portfolio level, hard limits can be placed on notional exposure such that
the economic capital as a percentage of exposure does not exceed a certain
threshold

4. Measurement of Economic Capital: Credit VaR Approach

The amount of capital needed to buffer against the bank becoming insolvent due to
default risk is a multiple of the bank's portfolio's unexpected loss (UL P). This capital
is called the risk capital or economic capital. To achieve the proper capitalization for
any line of business, it is necessary for the bank to identify a confidence level that is
consistent with the bank's desired credit rating. This is because a desired debt
rating for the bank corresponds to a given probability of capital exhaustion.

The distribution that determines the probability of loss is important because it

determines the number of standard deviations of the unexpected losses necessary
to achieve, say, a 99.9% confidence level for a desired BBB rating.

Economic Capital can be computed through Credit VaR or Capital at Risk Approach.
A Credit VaR measure is a metric measuring the uncertainty of portfolio loss. Several
risk measures are defined for portfolio loss. The most important risk measures are :
Expected Loss (ELP) : The mean of the portfolio loss distribution.

Unexpected Loss (ULP) : The standard deviation of the portfolio loss

distribution
Value at Risk (VaR) or Economic Capital (EC); where EC is defined as :
99.9%×VaR – ELP

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= N-1 (99.9%) x ULP – ELP

= 3 × ULP – ELP

Note that 3 is the capital multiplier (k). Generally, credit loss is not normally
distributed; hence, if a bank targets to achieve higher rating, should set a higher
capital multiplier in the CVaR analysis. The popular non normal distributions
that are used in the simulation and CVaR analysis are: beta distribution and log
normal distribution which have positive skewedness and moderate level of
kurtosis. The capital multiplier (k) can be decided by the bank through Monte
Carlo simulation and back-testing exercise. It may also depend on the risk
appetite of the bank which is set by the top management.
Chart 4.1
Credit Loss Allocation (at Portfolio Level)

Source: Author’s own illustration

Note : Economic Capital= VaR (X)-Expected Loss;

VaR=The value at risk at a particular confidence interval (multiplier);
Expected shortfall (ES) is the average loss conditional on the loss being above
the VaR level.

Chart 4.1 demonstrates the credit VaR analysis. Once the definition of loss and the
planning horizon (say 1 year) have been selected, the Credit VaR model generates a
distribution – a probability density function (PDF) – of future losses that can be used
to calculate the losses associated with any given percentile of the distribution. In
practice, banks concentrate on two such loss figures: expected loss and unexpected
loss.

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Expected loss is the mean of the above loss distribution and represents the amount
that a bank expects to lose on average on its credit portfolio. Unexpected loss, in
contrast, is a measure of the variability in credit losses, or the credit risk inherent in
the portfolio. It is measured by standard deviation. The Credit VaR, which is the
maximum deviation over and above the mean loss is computed as the losses
associated with some high percentile of the loss distribution (for example, the
99.9th percentile) minus expected loss (EL). A high percentile of the distribution is
chosen so that the resulting risk estimates will cover all but the most extreme
events. Accordingly the capital multiplier will be high. Note that the difference
between EL and UL will vary according to nature of loss distribution. For example,
the gap will be higher for a corporate credit loss portfolio. However, in case of credit
card loans, EL becomes larger relative to UL. Portfolios of lower-quality loans (e.g.,
credit cards) have a higher ratio of EL to UL. This will determine the nature of loss
distribution (normality).

The maximum probable loss is the point in the tail of the loss distribution where
there is a very low probability that losses will exceed that point. This critical point is
also called VaR threshold. The very low probability is chosen to match the bank’s
desired credit rating.

Note that under the economic capital approach, globally a 99.98 percentile
threshold is used as a confidence level by banks who wants to achieve a “AA” rating
by rating agency. It means bank would require around 0.02% of probability in the
tail. It is expected that Eco-cap/RWA would be higher than Tier I% if the bank
targets a better solvency rating. Note that median tier I% in AA rated US Banks is:
9.2%.

Instead of simply multiplying by the k, the best approach is to develop a simulation

model and by simulating the potential outcomes in terms of loss, build up an
accurate picture of the loss distribution and VaR threshold. For this risk experts
uses Beta or Log normal distribution to fit credit loss data and estimates CVaR
through Monte Carlo simulation. A bank can also use the covariance model with
industry or ratings default correlations to derive a portfolio VaR.

It is worthwhile to mention that the CVaR based Economic Capital method will also
assist a bank to measure the degree of concentration risk in the credit portfolio. Risk
experts recommend to formulate a concentration index based CVaR with correlation
effect and the absolute loss without any correlation benefit. This way, at various
sub-portfolio level, concentration index (CI=CVaR divided by absolute unexpected
loss) can be estimated and compared. Finally, a scatter plot of Concentration Index

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across various size of portfolio exposure thresholds will enable a risk manager to
compare the positions. For example, a CI>1 adds concentration risk to the portfolio
while those with a CI<1 add diversification to the portfolio. For further details of this
method, refer Reynolds (2009), Analyzing Concentration Risk, Algorithmics. .

5. The drivers of capital levels

The level of capital affects the return required by shareholders. A bank with a lower
capital requirement would be able to price its products more finely, as its threshold
return would be lower. There is no magic formula to determine the appropriate
level of capital for any bank. Management must weigh the following factors:
The level of capital, which the management of the bank thinks, is appropriate,
supported by an internal assessment of the Capital at Risk or Economic Capital.
The regulatory minimum as predicted by business plans, over the normal
planning horizon. A margin for error needs to be built into this plan, as
regulatory capital shortfall can have very serious consequences.
Against these must be set the target return on capital which management wishes to
achieve. This will be driven by the market's expectations of returns; exceeding the
market's expectations will result in an increase in shareholder value, whereas failing
to meet those expectations will result in a destruction of value. The higher the
amount of capital which a bank maintains, the higher the profit it will have to earn
in order to make the target return.

A bank can surely optimize the relationship between return and capital by either of
two means:
increasing the amount of return earned per rupee of capital, and
decreasing the capital required per rupee of return.

Learning Questions

1. How is the economic capital requirements of the 99.9 percent VaR calculated for a
credit portfolio?
2. What is the difference between economic capital and regulatory capital?
3. What is the difference between loss provision and economic capital?
4. Do you think credit loss follows a normal distribution?
5. What is the difference between C-VaR and Expected Shortfall?

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References

1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,

Cambridge University Press. Chapter 6.
2. Marrison, C. (2005), “The Fundamentals of Risk Measurement”, Chapter 20.

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Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 5: Credit Risk under Basel II Standardized Approach

Dr Arindam Bandyopadhyay

Objective

After studying the chapter and the relevant reading, you should be able to
understand:
 Basel II/III framework
 The concept of Capital to Risk Weighted Assets Ratio, Tier 1 vs. Tier 2 capital
 Basel II Standardized Approach and Risk Weights for Different Exposure
Categories
 Risk weight rules for different exposures
 Basel III Capital Arrangements.

Structure

1. Introduction
2. Evolution of Basel Regulatory Capital Framework
3. Basel II/III Regulatory Pillars
4. Basel Capital Adequacy Ratios
5. Basel Capital Charge for Credit Risk
6. The Standardized Approach
7. Risk weights for different exposure categories
8. Basel III
9. Proposed Revision in the Standardized Approach

1. Introduction.

Risk taking is a natural part of banking transactions, the regulatory agency is

responsible for creating a sound financial environment by setting the regulatory
framework where the supervisory agency monitors the financial viability of banks

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and checks compliance with regulations. Bank capital is considered as the cushion
that protects the liability holders of a bank (depositors, creditors and shareholders).
In order to ensure banks remain solvent, the banking regulators (in India, RBI)
regularly monitor the lending activities and inherent credit risks of the banks they
supervise. The main purpose of the new Basel framework is to ensure that minimum
levels of capital held by internationally active banks against their exposures to
credit, operational and market risks.

The basic objective of this section is to provide an overview of the changes in the
calculation of minimum regulatory capital requirements for credit risk that have
been drafted by the Basel Committee on Banking Supervision (Basel II, 2006) and
subsequently adopted in India through RBI guideline for Implementation of the New
Capital Adequacy Framework (NCAF, April 2007 & later modified and updated in
NCAF, July 1, 2015). In this section, only the standardized approach and regulatory
capital rules for credit risk will be discussed with examples.

2. Evolution of Basel Regulatory Capital Framework

Earlier, Basel I (published in 1988) has been a successful and widely-implemented

standard in banking regulation. Basel I norms (1988) were adopted in India in 1996.
However, financial market architecture, activities, and instruments have evolved
dramatically over the past two decades. Many major international banks and
financial institutions have, over time, developed and adopted more complex
methods of managing and measuring risk widening the gap between the simple risk
framework of Basel I and the actual practice of some banks. In response, the Basel
Committee, through five years of development and consultation, developed a new
capital adequacy framework. In June 2006, the Basel Committee released the Basel
II Capital Framework otherwise known as Basel II. The Basel Committee on Banking
Supervision (BCBS) is a committee comprising of senior bank supervisory authority
and central bank representatives from the G-10 (now G-20) countries. The
committee formulates board supervisory standards and promotes best practices in
the expectation that each country will implement them in ways most appropriate to
its circumstances. The Reserve Bank of India (RBI) follows the Basel norms and are
often more stringent than the BCBS. Now RBI is a member of G20. In response to the
US subprime crisis, the Basel norms were further revised to Basel III in 2010. Our
banks in India started their Basel III journey from 2013 onwards.

While Basel I introduced risk-based capital requirements for banks, Basel II builds
significantly on Basel I by increasing the sensitivity of capital to key bank risks. In
addition, Basel II recognizes that banks can face a multitude of risks, ranging from

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the traditional risks associated with financial intermediation, to the day-to-day risks
of operating a business, to the risks associated with the ups and downs of the local
and international economies. As a result, the new framework more explicitly
associates capital requirements with the particular categories of material risks that
banks face.

The new capital framework also recognizes that large, usually internationally active
banks have developed approaches to risk measurement and management based on
statistical inference rather than judgment alone. The entire Basel structure has been
summarized in the chart 5.1 below:

Chart 5.1: Basel II/III Framework

Pillar 1 Pillar 2 Pillar 3

Minimum Capital Supervisory

Supervisory Review
Review Market
Requirements Process
Process Discipline

Definition of Weighted
Capital Assets

Market Credit Operational

Risk Risk Risk

Standardized IRB Basic Standardized Advanced

Approach Approach Indicator Approach Measurement
Approach Approach (AMA)
now SMA is
Foundation Advanced proposed
Approach Approach

Source: Author’s own illustration

Broadly speaking, the objectives of Basel II&III are to encourage better and more
systematic risk management practices, especially in the area of core risks (credit,
market and operational), and to provide improved measures of capital adequacy for
the benefit of supervisors and the marketplace more generally.

3. Basel II/III Regulatory Pillars-

The Basel II framework incorporates three complementary 'pillars' that draw on the
range of approaches to help ensure banks are adequately capitalized. These

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mutually related pillars are : (a) Minimum capital requirements for ensuring bank
solvency, (b) Supervisory review process to ensure that the banks have adequate
capital to support all of the material risks in their business, and (c) Market discipline
for ensuring banks are adequately capitalized and to encourage banks to behave
prudently.

Pillar 1 – Minimum Capital Requirements: specifies how banks should determine

the capital requirements they should meet for the major risks that they face. These
risks include credit risk, traded market risk, securitization risk, and operational risk
(here, our focus is mainly addressing credit risk only). Based on these risks, specific
risk weights are assigned and the asset values are adjusted as per the risk weight.
Note that the risk weight for different asset category varies depending upon its
rating. For example, in credit risk weight calculation, only 20% risk weight is
assigned for a AAA rated borrower. But if the borrower rating is below BBB, a
highest 150% risk weightage is given to prevent the banks from taking higher risk.

Pillar 2 – supervisory review process (SREP): recognizes that banks are ultimately
responsible for managing their risks. However, supervisors can play a role in
assessing banks' risk management practices, and ensure that the negative
externalities that can arise from the failure of a bank are minimized and managed
and also there is least chance of capital arbitrage. The board approved internal
capital adequacy process (ICAAP) is expected to address SREP.

Pillar 3 – Market Discipline: recognizes the role played by market participants in

'regulating' bank behaviour, and promotes market discipline through the use of
disclosure requirements.

In developing the Basel II framework, the Basel Committee decided to incorporate a

greater role for market discipline by introducing capital adequacy-related public
disclosure requirements for banks.

The objectives of market disciplines are reasonably straightforward. In a well-

functioning market, financial institutions with poorly developed risk management
structures tend to be penalized by the market through higher funding costs because
the banks' counterparties assess the institution as more risky, while those with
prudent risk management structures tend to be rewarded. A key component in
promoting market discipline in this context is ensuring that bank customers,
institutions, and other market participants have ready access to the appropriate
information that allows them to monitor bank performance and risk-taking.

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4. Basel Capital Adequacy Ratios-

The RBI has also shown how a bank should compute Tier 1 CRAR and Total CRAR in
the following manner:
Eligible Tier1 Capital Funds
Tier1 CRAR 
Credit Risk RWA  Market Risk RWA  Operational Risk RWA

Eligible Tier 1  Tier 2 Cap ital Funds

Total CRAR 
Credit Risk RWA  Market Risk RWA  Operational Risk RWA

Note that RWA means Risk Weighted Assets; CRAR means Capital to Risk-weighted
Assets Ratio.
The minimum ratio of regulatory capital to risk weighted assets (RWA) has been set
at 8% by BCBS. In India, the Reserve Bank of India has stipulated it at 9%, which
internationally active banks would be required to maintain. In Basel III, more
emphasis has been given on the numerator part, i.e. quality of capital.
Tier 1 Capital-Pure form of capital consists mainly equity capital, retained earnings
and reserves. This is also termed as core capital.
For Indian banks, Tier 1 capital has the following elements:
 Paid-up equity capital
 Share premium resulting from the issue of equity capital
 Statutory reserves & other disclosed reserves (if any)
 Capital reserves representing surplus arising out of sales proceeds of assets
(or retained profit).
There will be additional tier 1 capital (AT1) in the forms of:
 Innovative perpetual debt instruments are eligible for inclusion in Tier 1
capital which comply with the regulatory requirements.
 Perpetual Non-Cumulative Preference Shares (PNCPs) and share premium on
this.
 Any other type of instrument generally notified by the Reserve Bank from
time to time for inclusion of Tier 1 capital.
Elements of Tier 2 Capital-This is known as supplementary capital consists of
mainly borrowed funds. Tier 2’s loss absorption capacity is lower that Tier 1 but can
act as cushion against unexpected loss. These are of following forms:
– Revaluation reserves-less permanent in nature but can often serve as a cushion
against unexpected loss.
– General provisions and loss reserves.

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– Hybrid debt capital instruments (combine certain characteristics of debt and

equity) like Perpetual Cumulative Preference Shares (PCPS), Redeemable
Cumulative Preference Shares (RCPS) etc.
– Subordinated debt instruments (fully paid up, unsecured, subordinated to the
claims of other creditors, free of restrictive clauses, and should not be
redeemable at the initiative of the holder or without the consent of the Reserve
Bank of India).
– Any other type of instrument generally notified by the Reserve Bank from time
to time for inclusion in Tier 2 capital.
Note: For more details see page 7-14, Revised Draft Guidelines for Implementation
of the New Capital Adequacy Framework (NCAF), July 1, 2015.

Basel III has emphasized that the Indian banks will have to maintain at least 5.5
percent minimum common equity tier 1 (CET1) from 2015 onwards. CET1 ratio is
the ratio between common equity tier 1 (core capital) capital and total risk
weighted assets. CET1 is more restrictive than CRAR in terms of quality of capital.

Our main focus in this lesson to cover the credit risk element in Basel committee’s
regulatory capital prescription. The following section provides detail
description of Capital charges for various credit exposures.

5. Basel II/III Capital Charge for Credit Risk

In this Section, we will mainly focus on the credit risk portion only to make our
discussion more specific to the topic. There are two basic approaches to measuring
credit risk exposure offered : (a) The Standardized Approach : A revision of Basel I
intended for less complex and sophisticated banks, and (b) The Internal Ratings
Based (IRB) Approach : For more sophisticated and complex banks it includes both
the Foundation and Advanced versions.

6. The Standardized Approach

The standardized approach is conceptually the same as the present Accord, but is
more risk sensitive. The bank allocates a risk-weight to each of its assets and off-
balance sheet positions and produces a sum of risk-weighted asset values. The risk-
weights are assigned based on external credit agency ratings of borrowers (ECAIs)
as given by the regulator.

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A risk-weight of 100% means that an exposure is included in the calculation of risk-

weighted assets at its full value, which translates into a capital charge equal to 8% of
that value (in India it is 9%). Similarly, a risk-weight of 20% results in a capital
charge of 1.6% (i.e. one-fifth of 8%).

Individual risk-weights currently depend on the broad category of borrower (i.e.

sovereigns, banks or corporates).

Under Basel II/III, the risk-weights are to be refined by reference to a rating

provided by an external credit assessment institution (such as a rating agency) that
meets strict standards. For example, for corporate lending, the existing Accord
provides only one risk-weight category of 100% but the new Accord will provide
four categories (20%, 50%, 100% and 150%).

As per the Basel II/III Standardized Approach prescribed by RBI,

Amount of loan × Risk-weight × 9% = the capital required to be held against any

given loan.

Equation 5.1

Or, we can write that the minimum regulatory capital per unit of loan exposure is:

K = EAD×Risk Weight×9% Equation 5.2

At first glance it seems an anomaly of the new system that unrated borrowers are
given a lower risk-weighting than borrowers rated below B- (or BB- in the case of
corporates). But as the unrated class covers a wide spectrum of companies, the
effect is to average the risk.

A major difference in the new Standardized Approach for credit risk is that it uses
rating agency grades to determine risk buckets for claims, instead of the current
regulatory buckets of sovereign, bank, residential real estate, and corporate. Also
new in the Standardized Approach are capital requirements for repo liabilities and
undrawn commitments of one year and under in maturity. And the Standardized
Approach gives retail exposures and claims backed by residential real estate lower
risk-weightings.

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6. Risk Weights for Difference Exposure Categories under the Standardized

Approach

Important Features under standardized approach as prescribed by RBI are:

(a) Sovereign Exposure-0% RW for domestic, 20% for state govt., claims on
foreign depends on rating: According to rating: AAA to AA=0%, A=10%,
BBB=50%, BB-B=100%, <B=150%.
(b) Exposure to Banks-For scheduled banks in India with min CRAR, RW=20%;
non-scheduled=100% with min CRAR, for others, RW depends on capital
adequacy positions. For foreign banks, risk weights are based External Credit
Rating Agencies ratings (e.g. S&P, Moody’s & FITCH rating). For example, if
rating is AAA to AA, RW=20%; for A & BBB claims, RW=50%; BB to B,
RW=100% & below B is 150%.
(c) Corporate Exposures-According to external rating (by CRISIL or ICRA or
Fitch etc.): AAA= 20%, AA=30%, A=50%, BBB=100%, <BB=150% & Unrated
= 150% risk weight.
(d) Commercial Real Estate; capital market exposure-100% risk weight,
125% risk weight & standard provisions 1%.
(e) Retail: residential Mortgage- under the Standardized Approach, lending
fully secured by mortgages on residential property that is or will be occupied
by the borrower, or that is rented, will be assigned risk weights depending
upon the size of the loan and loan to value ratio (LTV). It has been grouped in
the following order:
35% RW for housing loan exposures<Rs.30 Lac sanctioned to individual
against the mortgage of residential housing property having LTV<=80% &
for exposures >Rs.30 Lac but <Rs. 75 Lac & LTV<=80%; 50% RW for
exposures <Rs.30 Lac & 80%<LTV<=90% and for exposures >Rs.75 Lac with
LTV<=75%.
(f) Regulatory Retail: A 75% risk-weight for retail exposures subject to four
criteria: 1) loan to individual, 2) small business-SME, turnover<Rs. 50 crore,
3) granularity-no single exposure should be more than 0.2% of the total pool
exposure & 4) each loan exposure size should be <Rs. 5 lakh. It also includes
Education loan.
(g) Retail-Consumer Credit-Personal Loans and Credit Card: 125% risk
weight; Educational Loan: 100%; 50% for Loans <= Rs. 1 Lakh against gold &
silver ornaments.

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(h) Loans Past Due 90 days or more (Defaulted Loans)- 150% risk weight for
unsecured portions if specific provisions < 20% of outstanding amount of
NPA, 100% when >=20% but <50%; & RW 50% if >=50%.

Currently, all the commercial banks operating in India are following Basel II/III
standardized approach and uses the above risk weights for computation of
regulatory capital. For example, suppose a bank intends to derive its credit risk
weighted assets for a A rated (by credit rating agency) corporate loan outstanding of
Rs. 500 crore. As per the Basel II standardized approach, the regulatory risk weight
prescribed for an unsecured BBB rated borrower is 50%. Accordingly, the risk
weighted assets (RWA)=50%×500=Rs. 250 crore. The required regulatory capital
is=9%×250=Rs. 22.5 crore.

This way, following the above risk weights rule the total credit risk weighted assets
for different exposure need to be estimated. Finally, the total credit risk weighted
assets need to be added to the market and operational risk weighted assets and
compared with available Tier 1 and Tier 2 capital of the bank. This will enable a
bank to assess its total capital adequacy position. Note that the non-fund based
exposures need to be adjusted with the applicable credit conversion factor and for
loans with collateral securities will have to use applicable hair-cuts to estimate the
total credit risk weighted assets.

7. Basel III:

RBI in May 02, 2012 had released its guidelines on implementation of Basel III
capital regulation in India. The global financial crisis has highlighted linkages of the
main types of risks, especially credit, market and liquidity risks, and since then the
need for strengthening the capital regime has emerged prominently. The Basel III
guidelines became effective from April 1, 2013 in India in a phased manner. It is
expected that the Basel III capital regulation will be fully implemented as on March
31, 2019.

The Reserve Bank of India has given the following implementation schedule for
transitional arrangements to achieve minimum capital adequacy of 11.5% including
capital conservation buffer by 31st March 2019. The minimum CRAR prescribed by
RBI for SCBs in India is 9 percent plus 2.5 percent Capital Conservation Buffer (CCB)
in 2019. The capital conservation buffer (CCB) will ensure that banks maintain a
capital buffer that can be used to absorb losses during periods of financial and
economic stress.

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Table 5.1: Basel III Transitional Arrangements for Scheduled Commercial

Banks in India

(% of RWAs)
Minimum Capital 1
st st
31 31
st
31
st
31
st
31
st
31
st

Ratios: Apr- Mar- Mar- Mar- Mar- Mar- Mar-

2013 2014 2015 2016 2017 2018 2019
Minimum Common 4.5 5 5.5 5.5 5.5 5.5 5.5
Equity Tier 1 (CET1)
Additional Tier 1 1.50 1.50 1.50 1.50 1.50 1.50 1.50
Minimum Tier 1 Capital 6 6.5 7 7 7 7 7
Capital Conservation 0 0 0 0.625 1.25 1.875 2.5
Buffer (CCB)
Minimum CET 1 + CCB 4.5 5 5.5 6.125 6.75 7.375 8
Minimum Tier 1+ CCB 6 6.5 7 7.625 8.25 8.875 9.50
Tier 2 3 2.50 2 2 2 2 2
Minimum Total Capital 9 9 9 9 9 9 9
Minimum Total Capital + 9 9 9 9.625 10.25 10.875 11.5
CCB
Phase-in of all 20 40 60 80 100 100 100
Deductions from CET1
(in %)
Note: Basel III guidelines of RBI

8. Proposed Revision in the Standardized Approach

Basel Committee is undertaking Fundamental review of the standardized approach.

The BCBS has released the 2 nd consultative document published in December 2015.
This is termed as Revised Standardized Approach (RSA). In some countries it is also
termed as Basel IV. The Final Standard is yet to be published.

The main objectives are-

 Ensure that the SA is appropriately calibrated to reflect the riskiness of
exposures
 Increase comparability of capital requirements
 Reduce reliance on external ratings by providing alternate measures for risk
assessment, where possible.

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The salient features of the RSA has been outlined below:

– ECR will be subject to internal Due Diligence of Banks (avoidance of

total dependence on ECR). Need to ensure ECR reflects appropriate
and conservative assessment of credit risk.
– If required , Banks may be required to allocate higher capital
– Proposed treatment for unrated exposures and for jurisdictions
where credit rating is not accepted for regulatory purposes
– Introduction of new RW proposed for Corporate SME exposures
(85%)
– LTV based RWs for real estate exposures

Learning Questions

1. What is regulatory capital arbitrage?

2. Why Basel II capital norm is more risk sensitive?
3. What is the difference between Tier 1 and Tier 2 ratio?
4. What is the Basel III capital adequacy requirement in 2019?
5. What are the risk weights for Housing Loans of different sizes and of different LTV
ratios?
6. Why there is a proposed revision in the Standardized Approach?
7. As reported by PSBs in their Basel 3 disclosures,
a. Credit Risk Capital>Operational Risk Capital>Market Risk Capital
b. Credit Risk Capital>Market Risk Capital>Operational Risk Capital
c. Operational Risk Capital>Credit Risk Capital>Market Risk Capital
d. Operational Risk>Market Risk>Credit Risk

References:

1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,

Cambridge University Press. Chapter 8.
2. BCBS (2006), International Convergence of Capital Measurement and Capital
Standards, June.
3. Michael Ong (2007), “The Basel Handbook”, 2nd edition (edited), Chapter 3.
4. RBI (2011), Implementation of the Internal Rating Based (IRB) Approaches
for Calculation of Capital Charge for Credit Risk, December 22, 2011.
5. RBI (2014), Master Circular-Basel III Capital Regulations, July 1.
6. RBI (2015), Master Circular-Prudential Guidelines on Capital Adequacy and
Market Discipline-New Capital Adequacy Framework (NCAF), July 1.

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Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 6: Basel Internal Rating Based (IRB) Approach

Dr Arindam Bandyopadhyay

Objectives

After studying the chapter and the relevant reading, you should be able to
understand:
 Difference between FIRB and AIRB requirements
 Regulatory Capital Formula & Risk weights computation under IRB
 Role of PD and LGD in IRB capital Formula
 Exposure Classifications under IRB framework
 Asset Correlation Rule
 Risk sensitivity in IRB Approach
 Difference between Size Adjustment and Maturity Adjustment in Capital
Formula
 Future of IRB

Structure

6.1. Introduction
6.2. Foundation IRB
6.3. Advanced IRB
6.4. Maturity Adjustment
6.5. Size Adjustment
6.6. Basel II/III IRB Approach: Retail Exposure
6.7. Risk-Weight Function for Retail Exposures under the IRB Approach
6.8. Illustrative IRB Risk Weight Computation Examples
6.9. IRB Requirements
6.10. Proposed Regulatory Changes under IRB
6.11. Key Learning Outcomes
6.12. Key Learning Questions

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6.1. Introduction.

Under the IRB approach, banks will be allowed to use their internal assessment of
borrower creditworthiness to establish credit risk in their portfolios subject to strict
system and disclosure controls. Under the IRB approach the range of risk-
weightings will be far more diverse than those in the standardized approach,
resulting in greater risk sensitivity.

The Basel II Capital Accord seeks to improve on the existing rules by aligning
regulatory capital requirements more closely to the underlying risks that banks face.
One of the risk types described in the Capital Accord is credit risk. Banks need to
hold capital to cover the credit risk on their credit portfolio. The focus of this section
lies on the analysis of the Internal Ratings Based (IRB) Capital Requirements
function for credit risk. On the basis of the work of Merton and Vasicek (or KMV
model) the Basel Committee on Banking Supervision (BCBS) decided to adopt the
assumptions of a normal distribution for the systematic and idiosyncratic risk
factors of a credit portfolio. Note that KMV model assess the relevant market net-
worth of a company through estimation of market value of asset (MVA) and asset
volatility. If the companies asset value is high and stable (low volatility), its distance
from the default point (book value of liability) will be higher and expected default
frequency (EDF) will be lower. In KMV model (now of Moody’s), probability of
default of a company or EDF is Prob(VT<DP); where VT is asset value and DP is the
default point. The distance to default (DD) is defined as:

DD=(MVA-DP)/(Asset volatility×MVA) Equation 6.1

Higher the distance to default (DD), lower is the probability of default or EDF of a
borrower.

The model behind the capital requirements function is called an Asymptotic Single
Risk Factor (ASRF) model. The Basel Committee had as important requirement that
the capital requirements function should be portfolio invariant. Michael Gordy has
shown that essentially only ASRF models are portfolio invariant, therefore, the Basel
Committee has chosen for an ASRF model. The risk weight function has been built
on a Value at Risk (VaR) analysis on a global perfectly granular portfolio. Note that
in a very granular portfolio, the influence of a borrower risk to the entire portfolio
will be very insignificant.

The internal rating based approach has two stages:

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6.2. Foundation IRB

The term "Foundation IRB" or "F-IRB" is an abbreviation of "Foundation Internal

Rating Based Approach" and it refers to a set of credit risk measurement techniques
proposed under Basel II capital adequacy rules for banking institutions.

Under this approach the banks are allowed to develop their own empirical model to
estimate the PD (Probability of Default) for individual clients or groups of clients.
Banks can use this approach only subject to approval from their local regulators.

Under F-IRB banks are required to use regulator's prescribed LGD (Loss Given
Default) and other parameters required for calculating the RWA (Risk-Weighted
Asset). Then total required capital is calculated as a fixed percentage of the
estimated RWA.

6.3. Advanced IRB

The term "Advanced IRB" or "A-IRB" is an abbreviation of "Advanced Internal
Rating Based Approach" and it refers to a set of credit risk measurement techniques
proposed under Basel II/III capital adequacy rules for banking institutions.

Under this approach the banks are allowed to develop their own empirical model to
quantify required capital for credit risk. Banks can use this approach only subject to
approval from their local regulators.

Under A-IRB banks are supposed to use their own quantitative models to estimate
PD (Probability of Default), EAD (Exposure at Default), LGD (Loss Given Default) and
other parameters required for calculating the RWA (Risk-Weighted Asset). Then
total required capital is calculated as a fixed percentage of the estimated RWA.

Chart 6.1 summarizes the formulae for some banks' major products: corporates,
small and medium enterprises (SME), residential mortgage and qualifying revolving
retail exposure.
________________________________________________________________________
Chart 6.1
IRB Risk Weight Formula
I. Corporate exposure

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Correlation (R) = 0.12×(1-EXP(-50×PD))/(1-EXP(-50))+0.24× [1-(1-EXP(-50×PD))/

(1-EXP(-50))]
Maturity adjustment (b) = (0.11852-0.05478×ln(PD))^2
ln is the natural log function
Capital requirement (K) = [LGD×N{(1-R)^-0.5xG(PD)+(R/(1-R))^0.5×G(0.999)}-
PD×LGD] ×(1-1.5×b)^-1×(1+(M-2.5)×b)
Risk-weighted assets (RWA) = K×12.5×EAD
12.5 is the inverse of 8%

II. Corporate exposure adjustment for SME

Correlation (R)=0.12× (1-EXP(-50×PD))/(1-EXP(-50))+0.24× [1-(1-EXP(-
50×PD))/(1-EXP(-50))]-0.04× (1-(S-5)/45)
Where S is the size adjustment: Turnover (by Basel) and Exposure (by RBI)

III. Residential mortgage exposure

Correlation (R) = 0.15
Capital requirement (K) = [LGD×N{(1-R)^-0.5×G(PD)+(R/(1-R))^0.5×G(0.999)}-
PD×LGD]
Risk-weighted assets (RWA) = K×12.5×EAD

IV. Qualifying revolving retail exposure (credit card products)

Correlation (R) = 0.04
Capital requirement (K) = [LGD×N{(1-R)^-0.5×G(PD)+(R/(1-R))^0.5×G(0.999)}-
PD×LGD]
Risk-weighted assets (RWA) = K×12.5×EAD

Finally, Regulatory capital is estimated using the following formula:

Regulatory Capital=Total RWA of all assets×9%

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Notes: PD = the probability of default; LGD = loss given default; EAD =

exposure at default; M = effective maturity; R=Asset correlation; G=normal inverse
function (N-1).
Source: In Basel II: International Convergence of Capital Measurement and Capital
Standards: a Revised Framework (BCBS) (June 2006) & IRB Guidelines released by
RBI, Dec 22, 2011.
________________________________________________________________________

Basel committee also encourages banks to initiate internal ratings based approach
for measuring credit risks. Banks are expected to be more capable of adopting more
sophisticated techniques in credit risk management.

Banks can determine their own estimation for some components of risk measure:
the probability of default (PD), exposure at default (EAD) and effective maturity (M).
Then, the risk-weights for individual exposures are calculated based on the function
provided by BCBS or RBI.
6.4. Maturity Adjustment (M)
Under Basel II, default-only capital is scaled by the maturity adjustment given in the
Chart 2. The maturity adjustment accounts for the credit migration risk of the
counterparties and affects only the exposure that extend beyond the one-year
horizon. The average effective maturity is taken as 2.5 years. Otherwise, maturity
adjustment factor can be estimated form the cash-flows.

Maturity adjustment factor is present in estimating Corporate, Sovereign and Bank

Exposure capital charges (check corporate formula in Chat 2).

6.5. Size Adjustment

Firm size adjustment in the capital formula is present for SME loans. RBI uses more
conservative firm size adjustment: adjustment: (S-5)/20 where S=total exposure to
the entity. Maturity adjustment (M) is still there in SME capital formula.

6.6. Basel II/III IRB Approach: Retail Exposure

Definition of Retail Exposures

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The definition of retail exposures under the IRB Approach for regulatory capital
purposes is given as an exposure is categorized as a retail exposure if it meets all of
the following criteria:

Nature of borrower or low value of individual exposures to individuals – such as

revolving credits and lines of credit (e.g. credit cards, overdrafts, and retail facilities
secured by financial instruments) as well as personal term loans and leases (e.g.
installment loans, auto loans and leases, student and educational loans, personal
finance, and other exposures with similar characteristics) – are generally eligible for
retail treatment regardless of exposure size, although supervisors may wish to
establish exposure thresholds to distinguish between retail and corporate
exposures.

Residential mortgage loans (including first and subsequent liens, term loans and
revolving home equity lines of credit) are eligible for retail treatment regardless of
exposure size so long as the credit is extended to an individual that is an owner-
occupier of the property (with the understanding that supervisors exercise
reasonable flexibility regarding buildings containing only a few rental units
otherwise they are treated as corporate). Loans secured by a single or small number
of condominium or cooperative residential housing units in a single building or
complex also fall within the scope of the residential mortgage category. National
supervisors may set limits on the maximum number of housing units per exposure.

Loans extended to small businesses and managed as retail exposures are eligible for
retail treatment provided the total exposure of the banking group to a small
business borrower (on a consolidated basis where applicable) is less than £ 1
million. Small business loans extended through or guaranteed by an individual are
subject to the same exposure threshold.

Large Number of Exposures: The exposure must be one of a large pool of

exposures, which are managed by the bank on a pooled basis. Supervisors may
choose to set a minimum number of exposures within a pool for exposures in that
pool to be treated as retail.

Small business exposures 1 million Euro or less (approximately Rs. 5 crores

threshold given by RBI) may be treated as retail exposures if the bank treats such
exposures in its internal risk management systems consistently over time and in the
same manner as other retail exposures. This requires that such an exposure be
originated in a similar manner to other retail exposures. Furthermore, it must not be

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managed individually in a way comparable to corporate exposures, but rather as

part of a portfolio segment or pool of exposures with similar risk characteristics for
purposes of risk assessment and quantification. However, this does not preclude
retail exposures from being treated individually at some stages of the risk
management process. The fact that an exposure is rated individually does not by
itself deny the eligibility as a retail exposure.

Within the retail asset class category, banks are required to identify separately three
sub-classes of exposures: (a) exposures secured by residential properties as defined
above, (b) qualifying revolving retail exposures, as defined below, and (c) all other
retail exposures.

Definition of qualifying revolving retail exposures

All of the following criteria must be satisfied for a sub-portfolio to be treated as a

qualifying revolving retail exposure (QRRE). These criteria must be applied at a sub-
portfolio level consistent with the bank's segmentation of its retail activities
generally.
(a) The exposures are revolving, unsecured, and uncommitted (both contractually
and in practice). In this context, revolving exposures are defined as those where
customers' outstanding balances are permitted to fluctuate based on their
decisions to borrow and repay, up to a limit established by the bank.

(b) The exposures are to individuals.

(c) The maximum exposure to a single individual in the sub-portfolio is 1 million

Euro or less (RBI: Rs. 5 crore).

(d) Because the asset correlation assumptions for the QRRE risk-weight function are
markedly below those for the other retail risk-weight

function at low PD values, banks must demonstrate that the use of the QRRE risk-
weight function is constrained to portfolios that have exhibited low volatility of
loss rates, relative to their average level of loss rates, especially within the low
PD bands.

(e) Data on loss rates for the sub-portfolio must be retained in order to allow
analysis of the volatility of loss rates.

(f) The supervisor must concur that treatment as a qualifying revolving retail
exposure is consistent with the underlying risk characteristics of the sub-portfolio.

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6.7. Risk-Weight Function for Retail Exposures under the IRB Approach

For retail exposures, banks must provide their own estimates of PD, LGD and EAD.
There is no distinction between a foundation and advanced approach for this asset
class. The following Section presents in detail the method of calculating the
Unexpected Loss Capital Requirements for retail exposures; three risk-weight
functions provided – one for residential mortgage exposures, a second for qualifying
revolving retail exposures, and a third for other retail exposures.

Risk-weighted assets for retail exposures

There are three separate risk-weight functions for retail exposures. Risk-weights for
retail exposures are based on separate assessments of PD and LGD as inputs to the
risk-weight functions. None of the three retail risk-weight functions contains an
explicit maturity adjustment. Throughout this section, PD and LGD are measured as
decimals, and EAD is measured as currency (Rupees).

Risk-Weight Function for residential mortgage exposures

For residential mortgage exposures defined earlier, that are not in default and are
secured or partly secured by residential mortgages, risk-weights will be assigned
based on the following formula:

Correlation (R) = 0.15

Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R/(1 – R))^0.5 ×

G(0.999)] – PD × LGD

Risk-weighted assets = K × 12.5 × EAD

The capital requirement (K) for a defaulted exposure is equal to the greater of zero
and the difference between its LGD and the bank's best estimate of expected loss.
The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5,
and the EAD.

Risk-Weight Function for Qualifying Revolving Retail Exposures

For qualifying revolving retail exposures as defined earlier that are not in default,
risk- weights are defined based on the following formula:

Correlation (R) = 0.04

Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R/(1 – R))^0.5 ×

G(0.999)] – PD × LGD
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Risk-weighted assets = K × 12.5 × EAD

The capital requirement (K) for a defaulted exposure is equal to the greater of zero
and the difference between its LGD and the bank's best estimate of expected loss.
The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5,
and the EAD.

Risk-Weight Function for Other Retail Exposures

For all other retail exposures that are not in default, risk-weights are assigned based
on the following function, which also allows correlation to vary with PD :

Correlation (R) = 0.03 × (1 – EXP(-35 × PD))/(1 – EXP(-35)) + 0.16 ×

[1 – (1 – EXP(-35 × PD))/(1 – EXP(-35))]

Capital requirement (K) = LGD × N[(1 – R)^-0.5 × G(PD) + (R/(1 – R))^0.5 ×

G(0.999)] – PD × LGD

Risk-weighted assets = K × 12.5 × EAD

The capital requirement (K) for a defaulted exposure is equal to the greater of zero
and the difference between its LGD and the bank's best estimate of expected loss.
The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5,
and the EAD.

For defaulted assets, the capital requirement (K) formula is:

K= exposure=Max (0, LGD-EL)

RWA= K×12.5×EAD

6.8. Illustrative IRB Risk Weight Computation Examples

Assume that the bank has a Housing Loans Portfolio (Residential Mortgage
Exposures) with the following characteristics:

(a) Balance Outstanding as on 31-03-2005 (EAD) = Rs. 1500.00 crore

(b) Pooled PD of the Housing Loans Portfolio = 0.10%
(c) Pooled LGD of the Housing Loans Portfolio = 45.00%
The table given below demonstrates the Risk Weighted Assets of the Housing Loans
Portfolio as per the IRB Approach.

Risk-Weighted Assets of Retail Residential Mortgage/Housing Loans Portfolio

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Housing Loans Pooled PD 0.10% (estimated by the bank)

Housing Loans LGD 45.00% (estimated by the bank)
EAD (Rs. crore) 1500 (taken as balance outstanding as on date
of estimation)
Correlation (R) 0.15 (given under the IRB Approach)
K (per Rs.) 0.86% (derived using the Capital
Requirement Formula)
Risk-Weight (%) 10.69% = K × 12.5
Risk-Weighted Assets (Rs. crore)160.34 (product of risk-weight and EAD)

Although the Basel II Capital Accord is a clear improvement of the Basel I Capital
Accord, it still has some clear weaknesses. For example, the assumption of portfolio
invariance made by the Basel Committee ignores the existence of concentration risk.

6.9. IRB Requirements:

In its sophistication in measuring credit risk, IRB is a potential improvement over

the standardized approach. In order to graduate towards more sophisticated
version of credit risk capital estimation system, banks need at least five years of PD,
seven years of EAD and LGD data and two years of minimum use. Banks will be
required to demonstrate the regulator that the estimates they are using as IRB
inputs are reliable and provide a meaningful differentiation of risk. Moreover, they
will have to continuously upgrade the rating system, more granularly, two tier
rating system. Banks must have a robust system in place to capture these
information and validate the accuracy and consistency of rating systems, processes
and the estimation of all relevant risk components. Banks should be able to
regularly compare the realized values of PD, LGD and EAD with predicted values.
Such comparisons must make use of historical data over a long period. Moreover,
they will also have to pass through the use test principles set by the supervisor.

6.10. Proposed Regulatory Changes under IRB

Basel Committee has undertaken fundamental review of IRB Approach as well-Refer

to IRB Consultative Document-March 2016.

The major objectives for proposed change are:

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– Removing excess variability in IRB RWA

– Increasing consistency and comparability in IRB RWA calculations by
banks
– Reducing complexity in IRB models especially in low default portfolios

In order to achieve the above objectives, BCBS has proposed to put some constraints
on the IRB risk parameters-PD, EAD and LGD under both FIRB and AIRB. These
floors are applicable for portfolios that remain eligible for the use of IRB
approaches. This has been summarized in the following table:

Source: BCBS Consultation on constraints on IRB approach, March 2016, page 6.

However, BCBS has acknowledged that the IRB framework has proven its validity as
a risk sensitive way of measuring capital requirements.

Furthermore, under IRB and all policy standards in future, in general, the thrust is
shifting towards simplicity and comparability.

Learning Questions

1. Why IRB capital rule is more risk sensitive than the Basel Standardized
Approach?
2. What is Portfolio Granularity?
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3. What is exposure classification under IRB?

4. Is there any diversification benefit for SME exposure category under IRB?
5. What are the key requirements for graduating towards IRB?
6. In the Basel IRB Capital formula, asset correlation is highest for

a. Corporate Exposures
b. Corporate SME Exposures
c. Mortgages
d. QRRE

7. Under the Basel IRB Capital Formula, Maturity Adjustment is Present in the
following exposures
a. QRRE
b. Other Retail
c. Mortgages
d. Corporate

References:

1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,

Cambridge University Press. Chapter 8.
2. BCBS (2006), International Convergence of Capital Measurement and Capital
Standards, June.
3. Michael Ong (2007), “The Basel Handbook”, 2nd edition (edited), Chapter 3.
4. RBI (2011), Implementation of the Internal Rating Based (IRB) Approaches
for Calculation of Capital Charge for Credit Risk, December 22, 2011.
5. RBI (2014), Master Circular-Basel III Capital Regulations, July 1.
6. RBI (2015), Master Circular-Prudential Guidelines on Capital Adequacy and
Market Discipline-New Capital Adequacy Framework (NCAF), July 1.

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Module III: Management of Risk in Bank Portfolios

Section A: Credit Risk

Chapter 7: Risk Adjusted Performance Measures: RAROC & EVA

Dr Arindam Bandyopadhyay

Objectives

After studying the chapter and the relevant reading, you should be able to
understand:
 Concept of Risk Adjusted Performance
 Definition of RAROC
 Role of RAROC in capital allocation
 RAROC vs. Hurdle Rate
 Usefulness of RAROC metric
 Risk based pricing

Structure

1. Introduction
2. Concept of RAROC
3. Definition of RAROC Metric
4. The importance of RAROC in Banks
5. Estimating RAROC for the Bank as a Whole
6. Estimating the Cost of Equity Capital (Hurdle Rate) for the Bank
7. Estimating RAROC for a Business Unit/Product Line
8. Estimating RAROC for a Credit Customer
9. The Benefits of RAROC Based Evaluation

1. Introduction

Capital allocation and performance measurement skills in the banking industry lag
way behind those employed in manufacturing companies as well as in other
branches of the service sector. This is partly due to the fact that banks and financial
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institutions have a unique form of balance sheet. While an industrial company uses a
mixture of debt and equity to provide operational finance, a bank's source of finance
cannot be seen as external funding of the business: it is part of the business itself.
The problem is further complicated by the fact that banks are required to maintain
levels of equity that they do not strictly need to finance their operations; these
requirements are imposed by the market, or by regulations.

The problem of efficient resource allocations faced by banks is a direct result of the
increasing competitive pressures resulting from deregulation. RAROC attempts to
address the issue of capital allocation from the perspective of improving
performance – measured from both inside the bank as well from the outside. By
improving the capital allocation process – even simply by realizing the need for one
in the first place – it is argued that managers can improve returns earned on that
capital. The use of RAROC as a performance measurement tool helps management
maximize the return for shareholders by bringing risk considerations in the
calculation of return and choosing business strategy on the basis of risk adjusted
returns.

2. Concept of RAROC

RAROC is a powerful risk measurement tool that assists banks and financial
institutions both in measuring solvency and evaluating performance of different
business activities. The increased interest in measuring risk is partly a response to
the greater regulatory emphasis on capital adequacy that has come with the
implementation of the Basel risk-based capital requirements. More importantly,
there have been fundamental changes in the business of banking which has driven
the interest in risk measurement tools. As the progressive deregulation of the
banking industry continues, banks are choosing to provide an increasingly diverse
set of products and services. The real innovation in these new performance
evaluation tools lies in their ability to allocate banks' capital among their expanding
array of non-traditional, fee-based activities – many of which do not involve any use
of capital for funding purposes but create a contingent liability for the bank.

Thus, the ultimate goal of a risk-based capital allocation system like RAROC is to
provide a uniform measure of performance. Management can use this measure to
evaluate performance for capital budgeting and as an input to the compensation
system. The term 'allocation' of capital refers to the process whereby a notional or
proforma calculation of the amount of capital underpinning a business is made.

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Before turning to the question of how much capital banks really need, and how to
allocate it across different businesses or activities, a clear understanding of the exact
definition and role of capital in the banking industry is required. There are many
definitions of capital, starting from a very narrow based 'equity plus stated reserves'
through to something that encompasses subordinated debt. The RBI guidelines use
a two-tier concept.

3. Definition of RAROC Metric

The risk adjusted return on capital compares risk adjusted net income with
economic capital.
Where the numerator is :
Risk Adjusted Net Income (in absolute rupee terms) =
+ Expected Revenues (Gross Interest Income + Other Revenues e.g. Fees)
– Cost of Funds
– Non-Interest Operating Expenses
+ Other Transfer Pricing Allocations
– Expected Credit Losses

The formulation of the numerator assumes that the Expected Risk Adjusted Net
Income is a good proxy for the free cash flows to the shareholders at the end of the
period.

The denominator is :

Economic Capital (in absolute rupee or dollar terms)

= amount of risk capital required for the bank as a whole/business/product line/

customer/transaction

This economic capital equals the notional equity investment in the bank. It has to be
distinguished from the actual equity capital in physical and monetary assets of a
business unit/product line. In banking and financial services firms, the fixed
infrastructure costs are not the sole determinants of capital investment. Growth in
working funds, that is, liabilities transformed into assets through the process of
intermediation too require capital backing. The banking regulator prescribes a
minimum capital adequacy requirement as a percentage of risk weighted assets (in
India, this is 9%). This regulatory capital comprises of Tier I Capital and Tier II
Capital, the components of which are well defined by RBI norms. Economic capital
on the other hand is purely notional and does not involve flow of funds or a charge

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against P&L. In fact, economic capital fluctuates from time to time with risks
assumed and this measure is completely bank specific.

Given that RAROC is a single period measure calculated at the one-year horizon, it is
also often re-written in economic profit or residual earnings form in the spirit of
Shareholder Value concepts :

Economic Profit = Risk Adjusted Net Income – Cost of Economic Capital

Where
Cost of Economic Capital = Economic Capital × Hurdle Rate
Hurdle Rate = Appropriate rate of return for the investment as
determined for example by the CAPM and required by
the equity investors

Thus, economic profits are neither accounting profits nor cash flows. They rather
represent the contribution of a business or transaction to the value of the firm by
considering the opportunity cost of the capital that finances the business or
transaction. If the economic profit is positive, shareholder value is enhanced by the
business. If the economic profit is negative, shareholder value is eroded by the
business.

It is easy to show, by rearranging terms that, in order to find out whether a

business/transaction creates or destroys value, it is sufficient to compare the
calculated RAROC with the hurdle rate. As long as the RAROC of a transaction
exceeds the shareholders' minimum required rate of return (that is, the cost of
equity or hurdle rate), the business/transaction is judged to create value for the
bank, else it will destroy value.

4. The Importance of RAROC in Banks

There are many competing measures of internal business performance used by

banks that attempt to measure risk. RAROC has become one of the most widely
accepted from an economic perspective. It is distinctive because it explicitly uses
economic capital as a measure of risk. The philosophy behind RAROC is straight
forward: the cost of risk is the expected loss and the capital charge. Because
expected losses can be anticipated, they should be regarded as a cost of doing
business and not as a financial risk. To get adequately paid for expected losses banks
must levy a risk charge that reflects the historical charge-off behavior of discrete
loan segments directly in the loan price. Another charge that must be incorporated
is the cost of capital needed to protect the bank against the risk of unexpected loss.

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In order to get paid for unexpected loss banks need to know how much economic
capital (EC) the deal requires.

RAROC is typically used as a tool to choose between competing internal projects in

terms of cost and the amount of allocated economic capital. RAROC is of great
importance in financial institutions (banks or insurance companies) because capital
is required to support risk, and risk is conceptually more difficult to define and
quantify. In industrial organizations capital is relatively easy to grasp because it is
largely used to finance plant and equipment. RAROC should identify where capital is
being employed and whether value is being created or destroyed. RAROC is a tool to
help senior management to maximize shareholder value in addressing key strategic
issues:

the overall level of capital required to support the business risks;

whether the group is over or undercapitalized;

whether individual businesses are creating or destroying value;

growth opportunities within the group; and

how to manage the business in line with regulatory and rating agency capital
guidelines so that the bank maintains a good credit rating in the market.

5. Estimating RAROC for the Bank as a Whole

The RAROC approach enables a bank in evaluating past performance and compare
its position vis-à-vis others on a risk adjusted basis. Following table summarizes the
top-down approach of measuring Bank level or region level RAROC.

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Table 7.5a
Components of Risk Adjusted Return (Numerator of RAROC)
Item Components Source
1. Expected Interest Earned on Advances, Discount of Bank's
Projected
Revenues Bills, Investments, Balances with RBI and P& L
Statement
other inter-bank Funds, Other Interest Income
Fees, Commissions, Brokerage
Net Profit on Sale of Investments, on Revaluation
of Investments, on Exchange Transactions
Income from Dividend and Income from
Leasing/Hire Purchase
2. Expected Interest Expended on Deposits, RBI & Other Bank's
Projected
Cost of Inter-bank Borrowings P& L
Statement
Funds Interest paid on Others
3. Expected Operating Expenses Bank's
Projected
Non-Interest Provisions and Contingencies other than P& L
Statement
Operating Loan Loss Provisions (Provisions for NPA and
Costs Standard Assets)
4. Expected Estimated Value of the Expected Credit Loss Estimated
from
Credit Loss on Total Advances of the Bank historical data
of the
bank on
incremental
Gross NPA and
Recovery Rates

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Table 7.5b
Components of Capital (Denominator of RAROC)
No. Item Components
Source
1. Economic The Economic Capital of the bank as opposed to
Model
Capital the book equity capital or the regulatory equity
Estimate
capital is the estimated value of the unexpected
credit loss on bank's portfolio. In the absence of
the basic information requirements for modeling
the same, we use regulatory definition of
Tier I Capital as a proxy for Economic Capital
2. Tier I Capital Retained Profits
Bank's
Authorized and Paid up Equity Capital
Balance
Free Reserves
Sheet

Note that the Economic capital ultimately benchmarked with a bank’s core Tier I
capital. Finally, the estimated RAROC should be compared with Hurdle Rate. The
hurdle rate actually reflects the bank’s cost of funds or the opportunity cost of
stockholders in holding equity in the bank.

6. Estimating the Cost of Equity Capital (Hurdle Rate) for the Bank
Using the Capital Asset Pricing Model (CAPM) Approach, the cost of equity capital
(hurdle rate) for any firm is given by the formula :
E(r) = [rf + betarm x {E(m) – rf}]

Where,
E(r) = The Cost of Equity Capital/Hurdle Rate
rf = The expected return on a default risk free asset

betarm = Beta coefficient of bank stocks is calculated by time series regression of

the Bank's stock returns and the returns on the equity index selected.

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The regression analysis used is the Ordinary Least Squares

(OLS)
= Covariance(r,m)/Variance(m)
E(m) = The expected return on a market equity index. We can choose anybroad
based market index like S & P CNX Nifty or SENSEX and calculate the
long run average (long run is usually 5 to 10 years) annualized return
on the index

If the RAROC of a bank is higher than the Hurdle rate, we say the Economic Profit of
X Bank for the financial year 2017 is positive. This implies that the Bank's total
business has added value to shareholder expectations. On the other hand, if the
Economic Profit becomes negative, implying that shareholder value will be eroded.

7. Estimating RAROC for a Business Unit/Product Line

The methodology for estimating RAROC for a Business Unit (for example,
Treasury/Credit Operations) or a particular Product Line (for example, Retail Credit
Products/Wholesale Credit Products) is exactly the same as outlined for the bank as
a whole. The first step would be to estimate the Risk Adjusted Returns for the
Business Unit/Product Line. This will entail the allocation of Revenues, Cost of
Funds and Operating Costs to the Business Unit/Product Line. It would also require
the estimation of the Expected Credit Loss pertaining to the Business Unit/Product
Line using a similar approach as outlined for the bank as a whole. The next step
would be to internally allocate Tier I Capital to the Business Unit/Product Line. This
can be done by first estimating the Risk Adjusted Assets of the Business Unit (by
considering market risk, operational risk and credit risk) as a proportion of the
Total Risk Adjusted Assets of the bank. Tier I capital can be allocated in the same
proportion.

To better understand the RAROC metric, let’s consider a simple case of a one-year
bullet loan. The average yield of the loan is 9.5%. The average cost of funds and cost
of operations of the loan are 5.5% & 2%.

Thus, the pre-tax net income of the loan is=Yield+Fees-Provision-Cost of Funds

Let’s consider that the provision of the loan is 1%.

Therefore, pre-tax income=9%+0%-1%-5.5%-2%=0.50%.

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In the second set of analysis, the bank has estimated the loan’s expected loss
(EL=PD×LGD)=0.80% & Economic Capital=4%.

Thus, the estimated post tax RAROC of the loan would be:

{𝑃𝑟𝑒𝑇𝑎𝑥 + 𝑃𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛 − 𝐸𝐿} × (1 − 𝑇𝑎𝑥)

𝑅𝐴𝑅𝑂𝐶 =
𝐸𝐶
Thus,

{0.50% + 1% − 0.8%} × (1 − 34%)

𝑅𝐴𝑅𝑂𝐶 =
4%

Therefore, the estimated RAROC for the loan is=11.55%

Next, it is compared with the Hurdle Rate. Assume the Hurdle Rate worked out by
the bank for this entire loan pool is 10%. This may be the cost of raising capital from
the market in case bank loses it due to unexpected risk.

In this case, the economic profit or economic value addition (EVA) of the loan would
be=
11.55%-10%=1.55%.
Here, we can conclude that since RAROC is higher than the Hurdle Rate, the loan is
adding value to the shareholders.

The ratio of the Risk Adjusted Assets to the Allocated Tier I Capital would give the
RAROC for the Business Unit/Product Line. RAROC can be then compared to the
Hurdle Rate estimated for the Bank as a whole to determine whether the business or
product adds to shareholder value or not. The Capital Budgeting rule would be to
increase capital allocation to those Business Units/Product Lines where the RAROC
exceeds the Hurdle Rate.

The following chart summarizes the components of RAROC computation and

compares risk adjusted performance position of two credit portfolios X & Y:

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Source: Own illustration

It is quite evident that Portfolio Y is yielding greater economic profit than X.

Economic profit is also termed as Economic Value added.

There is a link between RAROC and EVA. In the context of lending, EVA requires a
loan be made only if it adds to the economic value of the company from the
shareholders’ perspective. The EVA per Rs. loan is positive if RAROC>Hurdle Rate.

8. Estimating RAROC for a Credit Customer

For a credit customer of the bank, RAROC calculations become very important in the
light of pricing the underlying loan products to the customer. To ensure that a loan
to a credit customer adds value to the bank, the loan should be priced such that the
RAROC as estimated for the customer is at least not below the Hurdle Rate of the
bank. Pricing a credit customer of the bank as per the RAROC framework would
ensure that each credit asset of the bank would at least not erode shareholder value
at the margin and that the economic profit generated by the credit asset would be
non-negative.

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9. The Benefits of RAROC Based Evaluation

RAROC helps us to determine if a financial entity has the right balance between
capital, returns and risk. The RAROC approach to evaluating performance of the
bank, its business units, products lines, customers and transactions is well accepted
and implemented by many globally best practiced banks. It is important for the
banks’ top management to be conscious and cautious about the RAROC values at any
point of time. It is possible that a bank may not be able to overnight implement the
RAROC methodology for evaluating its business or transactions since this would put
tremendous pressure on its volume growth and acquisition strategy. However, in
the long-run, the bank should think of adopting the RAROC methodology for internal
capital allocation and risk based loan pricing. Economic capital provides us a risk
adjusted common currency of risk so that banks can compare the risk adjusted
profitability of different activities to see more clearly which are more deserving of
future investment. This way, it supports a bank to take strategic decisions.

The RAROC calculation permits a bank to determine not only whether it is pricing an
individual loan correctly, but whether it’s overall portfolio of loans is priced
correctly or if it is carrying too much risk.

A RAROC based economic capital approach also allows a bank to explain to the
regulator how they assess the effect of their regional and product level loan
concentrations on their capital adequacy. Besides prudential limits, a CVaR based
limits can be set at product level or region level or industry level to prevent a bank
from taking excessive concentration risk. Economic capital analysis is designed to
relate a bank’s entire portfolio of risk to the amount of capital the bank must hold if
it is to achieve a particular solvency target.

Learning Questions

1. How economic capital is factor in RAROC calculation?

2. What are the key elements in RAROC metric? Why it is important in credit risk
management?
3. How RAROC is linked to loan pricing?
4. Why RAROC estimate needs to be compared with a Hurdle rate?
5. Why bank RAROC and loan RAROC are different?
6. What is CAPM?
7. What is EVA?

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8. A one year term loan has an average yield of 9.5%. The average cost of funds and
cost of operations are worked out to be 6% and 2% respectively. The credit risk
analyst has estimated the loan’s expected loss as 1% and economic capital as
5.50%.The RAROC of the loan would be:
a. <5%
b. 5%-10%
c. 10%-15%
d. >15%

References:

1. Bandyopadhyay, A. (2016), “Managing Portfolio Credit Risk in Banks”,

Cambridge University Press. Chapter 7.
2. Marrison, C. (2002), “The Fundamentals of Risk Measurement”, TATA
McGRAW-HILL, Chapter 22.
3. Saunders, A., and Cornett, M. M. (2015), 7th Edition, Financial Institutions
Management, McGrawHill Education, Chapter 11.

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Module III: Management of Risk in Bank Portfolios

Section B: Market Risk

Chapter 1: Overview of Asset-Liability Management

Prof. Sanjay Basu

Objectives

After studying this chapter, you will understand

i. The definition of ALM and its features

ii. The scope of ALM strategies
iii. The scope and goals of ALM policy
iv. Focus of ALM

Structure
1. Introduction
2. Definition of ALM
2.1. Benefits of ALM
3. Scope of ALM strategies
3.1. Objectives of ALM Policy
4. Elements of ALM
4.1. Interest rate risk
4.2. Liquidity risk
4.3. Fund transfer pricing methods
4.4. Derivatives for ALM
5. Conclusion

1. Introduction

The global crisis has shown once again how challenging Asset-Liability Management
(ALM) in volatile, competitive markets. With focus on wholesale liabilities and
illiquid assets, for short-term profit maximization, banks and financial institutions
became extremely vulnerable to sudden interest rate shocks and liquidity crunch.

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To pre-empt such problems, the Basel Committee has introduced stringent

guidelines on liquidity and interest rate risk management in the recent past. ALM
has also become critical for Indian banks today because of the same reasons - higher
volatility in interest rates and liquidity positions, intense competition in asset and
liability markets, a sharp squeeze in spreads and a proactive regulatory
environment.

The Reserve Bank of India has urged banks to focus on internal estimates of interest
rate risk and liquidity risk in the banking book, in normal and stressed markets,
through a series of directives. While demanding shareholders are forcing banks to
adopt risk-adjusted performance measures, in their quest for higher returns, the
vigilant BIS and RBI are making them ready for mark-to-market valuation and
capital charges, even for banking book risks, in the near future. Therefore, it has
become essential to identify, measure, monitor and manage a bank’s exposure to
various forms of interest rate, liquidity and currency risks, in the banking book, on a
consistent and continuous basis.

This chapter is organized as follows. Section I defines ALM and discusses its
essential elements. Section II covers the main aspects of ALM strategy and policy.
Section III addresses the main areas of ALM. Section IV concludes.

2. Definition of ALM

This section begins with a definition of ALM, which highlights its holistic approach
to analyzing the impact of interest rate and liquidity fluctuations on both bank
assets and liabilities. ALM is the coordinated management of a bank’s balance
sheet to allow for different interest rate, liquidity and optionality shocks.
These shocks are often interrelated. For instance, a sharp rise in market rates could
tempt some customers to withdraw their current and savings deposits, in search of
higher returns. This is a choice or ‘option’ which they are free to exercise. However,
it could put banks under liquidity pressure and force them to borrow from the
market or raise term deposits at higher cost. Such pressure might also make them
sell tradable assets like long-term bonds and shares at huge losses. Therefore,
liability-side events could distort the volume, composition and returns on the asset
side as well. As a result, business strategies need to consider the joint impact of
possible shocks on the asset and liability sides of the balance sheet.

The discipline of risk management has focused mainly on the asset side. Market Risk
management studies the volatility of traded assets, Credit Risk management
analyzes the quality and concentration of borrowers and Operational Risk

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management discusses the quality of business lines. It is ALM which reminds us that,
in a bank, the asset side exists primarily to service the liability side. It takes us back
to the three main challenges in banking:

1. Ensure an adequate volume of assets to pay off liabilities as and when they fall due –
This combines both Liquidity and Credit Risk Management. Liquidity Risk
Management ensures that there is enough cash or near cash assets to repay
maturing liabilities on time. Credit Risk Management ascertains that, despite some
defaults and delayed payment, the overall quality of maturing assets is good enough
to pay down liabilities as scheduled.

2. Ensure that assets earn high enough returns to meet shareholder expectations and
cost of outside funds on a continuous basis – This is the goal of Earnings Management.
With fluctuations in interest rates, both Net Interest Income and Other Income (fees,
trading P/L, commissions) are affected. Therefore, a bank must have a view on
future rate shocks and the extent to which assets and liabilities are affected by such
events. It has to maintain a high rate of growth in total income not only to pay
market rates on borrowed funds, in line with its rivals, but also to leave enough
residual income for shareholders.

3. Ensure that unexpected losses do not hurt depositors under normal business
conditions – This is the objective of Capital Management. Many strategies might
increase short-term income (by worsening the maturity mismatch or credit risk
profile), at the cost of a sharp erosion in future Net Worth. It is essential to forecast
the size of such losses, so that a buffer can be created before they hit a bank. It is
also crucial to strike a balance between short-term gains and potential losses, when
choosing the mix of assets and liabilities.

At the heart of ALM lies the key function of qualitative asset transformation or
maturity transformation. For many centuries, banks have funded relatively long-
term assets with short-term liabilities and earned the spread between them. Since
individual transaction needs are dispersed, under normal conditions, not all
providers of short-term funds are likely to withdraw together. But, once in a while, a
bank might face a liquidity crunch or a sharp drop in NII, when markets deteriorate.
This is when a bank needs sound ALM. It is a systematic approach to protect a
bank from the mismatch risk inherent in financial intermediation. It provides a
framework to define, measure, monitor, modify and manage the impact of mismatch
risk on (i) Net Interest Income (ii) Net Worth and (iii) liquidity positions.

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2.1 Benefits of ALM

The benefits of a good ALM system, to the bank, are manifold. These are listed
below:
• Awareness of various risks in the banking book, beyond credit and market
risks: Risk appetite for the banking book and at the portfolio level is clearly defined
once hidden risks are known to the bank. It becomes conscious of the entire
spectrum of risks facing its non-traded portfolio of assets and liabilities. It has a
better idea of the incremental risk it has to assume, if it tries to increase the returns
from the banking book.
• Strategies to manage or mitigate intermediation risks: Once the banking
book risks are well understood and estimated, ALM also suggests how to deal with
them. For instance, it might allocate additional capital to cover some of the risks and
hedge the rest with linear (futures and swaps) or nonlinear (options) derivatives.
• Pricing of loan and deposit products: Banks might price out the embedded
optionality in loan and deposit products, which contributes to liquidity and interest
rate risks. In this context, ALM might recommend the use of sophisticated yield
curve models, to capture the impact of interest rate uncertainty on future cashflows
from banking book assets and liabilities with embedded options. ALM can also
suggest the use of an appropriate Funds Transfer Pricing (FTP) method, to
centralize liquidity and interest rate risks and provide important signals for pricing
loan and deposit products with and without embedded options.
• Enhancement of net worth: The limits fixed by the ALM system should be
based on a careful risk/return trade-off. Once all banking book risks are identified,
measured and ranked, much larger low-risk positions can be assumed, by a
conservative bank, with the guidance of an ALM system. Entry into lucrative high-
risk businesses is also possible, if they are weakly correlated with the existing
portfolio. A thorough evaluation of the risks and returns from existing businesses, as
well as potential growth areas, can be made only with a good ALM system. Such an
analysis not only preserves existing businesses but also enhances the rewards from
new ventures. The upshot is that, because of a well-designed ALM system, the bank
knows which business (loan or deposit) it wants and which it does not.

3. Scope of ALM strategies

ALM covers the entire gamut of strategies from risk awareness to shareholder value
maximization. This means that the first task of ALM is to (i) identify the possible
shocks to banking book assets and liabilities (ii) investigate their sources or ‘drivers’
(iii) estimate the interdependence and severity of the shocks and (iv) measure their
impact on target variables like liquidity deficits, Net Interest Income (NII) and

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Economic Value of Equity (EVE), on a periodic basis (e.g. one year). Once the risk
(i.e. potential loss) is estimated, ALM tries to mitigate or manage it in terms of the
following strategies:

 On balance-sheet match between reset and/or maturity dates of assets and

liabilities, to manage interest rate and liquidity risks. The standard remedy is to
match the reset dates, so that interest impact on the assets and liabilities is similar.
Alternatively cash flows from some assets can be dedicated to liability outflows, as
and when they fall due.
 Off balance sheet hedges (with derivatives or short positions) of on-balance sheet
losses. If the bank decides not to touch the on-balance sheet items, it might enter into
derivative contracts for hedging the risks in the banking book. Such contracts create
assets and liabilities outside the balance sheet. The ultimate aim is to create a
portfolio of assets and liabilities – taking the on and off-balance sheet items together
– which generates the highest possible risk-adjusted returns for the bank.
 Securitization, to remove risks from balance sheet. By converting illiquid loans
into bonds and selling them to an outside firm, a bank earns cash which may be
deployed at going market rates, to increase interest income. Such liquid assets may
also be used to meet obligations from depositors and other creditors, as and when
they fall due.
 Alignment of branch level targets with the broader goals of the bank: ALM
decisions are made at the Head Office but the balance sheet of a bank is built up
through its branch network. The branches may not have any incentive to take those
deposits and make those loans which the Asset-Liability Committee (ALCO) prefers.
Instead, they could focus on items which increase their own profitability. As a result,
the bank’s balance sheet grows rather by chance, than by choice. It is the
responsibility of ALM to ensure that the targets set by the Head Office are in the best
interests of the branches.
 Centralization of liquidity and interest rate risks. Branches, zonal and regional
offices have a partial view of the bank’s portfolio – they have no idea of the kind of
loans and deposits at the bank, in other parts of the country. Only the ALM
Department has a complete view of the portfolio, its weaknesses and the sources of
possible diversification benefits. Nor do branches and regional offices set customer
rates or use hedge products, which are available only to the Head Office. Hence, both
interest rate and liquidity risks should be managed only by the head office and
lower-level units should not be affected.

This means that ALM strategies try to affect the volume, composition or maturities
of both assets and liabilities for a bank. A clear statement of the strategies and

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instruments for banking book risk management and return optimization is given by
the ALM policy of a bank.

3.1 Objectives of ALM Policy

The Core objective of ALM policy is to ensure planned and profitable growth in
business through appropriate management of liquidity risk, interest rate risk and
currency risk. This is an important step towards the ultimate goal of Shareholder
Value Maximization. The key components of such an ALM policy are:
1. Management of interest rate risk: To ensure that interest rate movements do not
erode the net interest income (NII) or net worth of a bank. As we see later, NII is the
largest component of a bank’s total income. A sudden decline in current and future
NII (net worth) may be difficult for banks to manage.
2. Liquidity risk management and contingency funding plans: The maturity
structure of the asset portfolio has to be aligned to the volatility of key liability
items, to pre-empt sudden liquidity requirements. Strategies have to be devised to
raise liquidity from different sources, under normal conditions, and mitigate funding
pressure in chaotic markets
3. Management of currency risk: To ensure that FX rate movements do not erode
the earnings and net worth of banks. Borrowing and lending in different currencies
may lead to unsustainable FX mismatches, which have led to many banking crises in
the past.
4. Establishment of appropriate limits for liquidity risk, interest rate risk and
currency risk: Maximization of short-term earnings may often lead to
overinvestment in illiquid assets, dependence on volatile liabilities and exposure to
FX risk. A balance has to be struck between return targets and erosion of future NII
and net worth.
5. Putting in place an appropriate Funds Transfer Pricing (FTP) system: Funds
transfer rates refer to the prices at which loans and deposits are transferred
between the branches and the treasury. By paying higher (lower) rates on some
deposits bought from branches and charging higher (lower) rates on some loans
sold, the treasury can persuade the branches to choose those products which the
ALCO wants. Such Head Office (HO) rates also help the bank determine the
contribution of deposit and lending units to its overall Net Interest Margin (NIM).
6. Use of derivatives for ALM: Such contracts are mirror images of balance sheet
positions. They help offset losses on balance sheet assets and liabilities. The ALCO
should decide whether losses should be hedged at a transactional, product or
portfolio level. The dangers with derivative products should also be well recognized.

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4. Elements of ALM

This section examines the main elements of ALM. While the discussion on interest
rate risk and liquidity risk management is brief, the coverage of Funds Transfer
Pricing methods and applications of derivatives is more detailed. This is intended to
give the reader an overview of these two issues, which will not be explored in later
chapters.

4.1 Interest Rate Risk

It refers to the impact of unexpected movements in interest rates on the NII and Net
Worth of banks. As we know, NII constitutes the largest component of a bank’s total
income. Sudden losses in NII can threaten its survival and force it to take
unwarranted risks. For instance, banks have often made credit risky loans to
increase their interest income and funded those with short-term, wholesale,
deposits, in order to reduce interest cost. As a result, interest rate risk has led to
credit risk on the asset side and liquidity risk on the liability side. Therefore,
Interest Rate Risk in the Banking Book (IRRBB) has become a vital element of ALM
in recent years and was sought to be included under Pillar I of Basel guidelines.
However, for the time being, it remains under Pillar II

IRR affects NII and net worth through both on and off-balance sheet assets and
liabilities. For a given change in rates (e.g. 1 per cent), IRR also includes the effect of
shifts in volume and composition of assets and liabilities. Regulators and
commercial banks split IRR into two components, viz. traded IRR and non-traded
IRR. Though both refer to the potential adverse effects of market rate movements,
the difference lies in the point of impact; ‘traded IRR’ affects MTM values of items in
the trading book while ‘non-traded IRR’ covers all assets and liabilities in the
banking (accrual) book.

Earnings or Accounting Approach: It is a short-term analysis of rate shocks on

accrual or reported earnings. It is generally restricted to the accounting cycle and
covers only an initial part of the lives of assets and liabilities in the balance sheet. In
this approach, assets and liabilities are recorded at historical cost. It is important
because outright losses or decline in earnings, from a rate shock, can threaten
capital adequacy and undermine market confidence. The main focus of the earnings
approach is on the quarterly, semi-annual and annual impact of interest rate
changes on Net Interest Income (NII).

While the earnings approach is popular due to its simplicity and ease of
implementation, it has two serious weaknesses. First, it does not capture the

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interest rate impact on assets and liabilities that mature or rest beyond one year.
Most fixed-rate bonds and deposits, that comprise a sizeable portion of a bank’s
balance sheet, generate cash flows for many years. Ignoring these items makes the
analysis incomplete. Moreover, the NII forecasts are bank-specific. They do not
show how other institutions have fared under the same scenarios. In other words,
they do not indicate how the bank has done vis-à-vis the rest of the market.
Shareholders, bulk depositors, bondholders and regulators may be concerned with a
comparative, rather than an absolute, perspective on banks.

Economic Value Approach: The focus here is on the long-term impact of rate changes
on assets and liabilities till they reset or mature. It recognizes that rate shocks affect
the opportunity costs and gains of future cash flows as well. The Economic Value of
Equity (EVE) is the present value of assets minus present value of liabilities. As rates
rise, a bank gets less on assets, and pays less on liabilities, than the market. But, an
EVE loss indicates that the gain on the cost of liabilities is less than the loss on asset
returns. Similarly, when rates fall, the bank gets more on existing assets, and pays
more on existing liabilities, than the market. A decline in EVE shows that the loss
from higher-cost liabilities is greater than the gain on assets. In both cases, returns
to shareholders will fall. As EVE is the present value of net expected cash flows, it
reflects future earning potential. In the short-run, since it is difficult to judge the
effect of internal decisions on market capitalization, many banks analyze their EVE
impact to gauge market reactions. A sharp EVE decline is also a powerful early
warning signal for future bankruptcy.

4.2 Liquidity risk

There are two types of liquidity risk. These are as follows:

i. Asset or Market Liquidity Risk: Inability to sell assets at normal market

prices because the size of the trade is much larger than normal trading
lots. This means that the market is unable to absorb such large volumes at
quoted prices.
ii. Funding or cash-flow liquidity risk: Inability to meet payment obligations.
This means that the bank is unable to pay either (i) depositors on demand
or (ii) OBS loan commitments and guarantees on demand.

Although liquidity risk is one of the most common in the banking book, its
measurement and management are easier said than done This is not only because
liquidity conditions change very fast, but also due to strong interdependence with
other factors like interest rate risk. In order to capture the whipsaw movement from

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comfortable to turbulent liquidity scenarios and to study the correlations between

liquidity problems and other risks, Basel II had placed Liquidity Risk Management
under Pillar 2. However, since the global financial crisis exposed serious
weaknesses, due to negligence and inadequacy of liquidity risk management, Basel
III introduced two mandatory Liquidity standards – the Liquidity Coverage Ratio
(LCR) and the Net Stable Funding Ratio (NSFR).

Such recent events also suggest why, with financial liberalization, liquidity risk
management has become such a vital challenge for Indian banks. High interest rate
volatility has increased the risk of sudden erosion in current and savings account
deposits, premature withdrawal of term deposits and utilization of the unavailed
portion of credit lines. The intermittent collapse of bond prices and sharp spikes in
money market rates have aggravated funding problems for banks. The subprime
crisis has also shown us how quickly liquidity can vanish from interbank markets.
Hence, there is renewed focus on liquidity risk assessment under normal conditions,
stress testing and scenario analyses and formulation of contingency funding plans,
under Basel III.

4.3 Funds Transfer Pricing (FTP) Methods

FTP is a management accounting technique used to calculate the true net interest
income component of business units, products, market segments and business units.
FTP helps build the income statement by calculating the cost of funding assets and
the credit for funds provided as deposits. A good FTP system helps the treasury to:

• Allocate funds within the bank.

• Transfer liquidity and interest rate risks to the ALM unit to make the
performance of business lines (e.g. branches) independent of risks that are beyond
their control.
• Divide the total interest earned into different components attributable to various
businesses within the bank so that the contribution, from distinct business lines to
bank level margins, is given proper consideration.
• Define economic benchmarks for pricing and performance measurement.
• Drive pricing policies of the business units in line with market prices.
• Provide incentives or penalties to trigger expected performance from business
units to align them with commercial policy.

In short, in an environment of high volatility in interest rates and bank liquidity,

maturity and reset mismatches (leading to interest rate and liquidity risks) can be
risky for banks to sustain. The rates on loans and deposits should respond to these

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mismatches, by making customers choose those maturity segments which the bank
wants them to. However, in the process, a business unit (e.g. branch) which does not
control these risks (or determine the bank’s appetite for them) should not be
penalized. A good FTP method serves both the objectives.

FTP methods (in increasing order of sophistication)

Single Pool: The FTP rate used for pricing all balance sheet items is a single rate.
The same pool is used for funding the assets and rewarding the sources. The rate
represents the theoretical pool of funds with which each asset is funded and into
which each liability is invested. While it enables the computation of NII at any level,
it does not remove IRR from business lines. Given a single FTP rate, branches have
an incentive to make longest tenor loans and take shortest tenor deposits, to
maximize their own profits.

Split pool: More than one pool is used, typically one for the assets and the other for
liabilities. The total cost of funds, expressed in percentage points, is used as the
funding rate for assets and the total yield on earning assets expressed as a rate as
the sourcing rate for deposits. The disadvantage of not being able to remove IRR
from any business line remains as in the case of single pool method.

Multiple pools: This takes into account the maturity and repricing characteristics of
groups of assets and liabilities. Assets and liabilities are classified into short-term,
medium term and long-term. Short-term assets are funded with short-term pool
rates while long-term assets are funded with long-term pool rates. Many pools can
be created and used to arrive at funding rates for assets and sourcing rates for
liabilities. This can partially remove the interest rate risk from the business line.

Matched Maturity FTP (MMFTP): In this method, a yield curve is used instead of
pools. The yield curve is based on the contractual or behavioural maturity of assets
and liabilities. If the reset date is before the maturity date, transfer pricing is done
on the basis of term-to-reset. For instance, an interest paying fixed-rate 3-year term
deposit would be credited with a 3-year rate from the yield curve chosen on the date
of opening of the deposit and the transfer rate would stay with the account till its
maturity. However, a 5-year floating-rate term loan with 3-month reset would be
given a 3 month rate on the date of disbursement of the loan. This rate would be
revised on the basis of FTP rates prevailing on each reset date till the maturity of the
loan.

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Selecting a funding curve or benchmark curve is important for MMFTP

implementation. The curve should be selected according to a bank’s accessible
alternative source or use of funds. For instance, a bank might choose the treasury
yield curve as its funding curve. Such a curve is readily available and widely
recognized as the market rate. However, the problem is that the bank might be
unable to borrow at treasury rates. Alternatively, the bank might choose the cost of
wholesale funds as the funding rate. While this is relevant to the bank and
theoretically accurate as well, it requires the estimation of borrowing rates for all
term-to-maturities and for all historical dates of originating an asset. For instance, if
a loan was originated in 1990, the funding rates in 1990 need to be obtained.
Moreover, business line managers may not be familiar with these rates and might
not be able to understand them. Therefore, many banks use the treasury curve, with
a spread to reflect their own credit qualities. Or, they might consider the interest
rate swap curve, at which they convert overnight funding to fixed rate funding and
eliminate their interest rate risk. In any case, the funding rate has to be adjusted for
credit risk and basis risk.

The FTP method chosen by a bank should be in line with the complexity of its
portfolio and its skill levels. However, at a minimum, the bank should implement the
multiple pools method and graduate to the MMFTP approach at the earliest possible.
This will not only align branch objectives with the goals of the head office, but also
help measure the risk-adjusted performance of the business units.

4.4 Derivatives for ALM

Derivatives are contracts between two parties whose values or profits and losses
(payoffs) depend on other things such as assets, indices or events called underlying
variables. The underlying for a derivative includes, but is not limited to, the
following: (i) Foreign Exchange (ii) Equities (iii) Bonds and Interest Rates (iv)
Energy Products (v) Precious Metals (vi) Agricultural Products (vii) Credit Events.
There are two types of derivatives – the first group consisting of swaps, futures and
forwards and the second group consisting of options. In India, RBI allows only the
first type of contracts for hedging interest rate risk on their balance sheets.
However, banks are allowed to use both currency swaps and options for managing
their currency risk.

Swaps, futures and forwards contracts have two features. They are linear, i.e. their
payoffs vary in proportion to the shocks. They are also symmetric, i.e. if forecasts
about the shocks are mistaken, the gain on the balance sheet will be eroded by
losses in swaps and futures. This is because they confer a right to receive as a well as

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an obligation to make payments. The right to receive benefits them when forecasts
are correct, while the obligation hurts them when they are mistaken. In contrast,
options have asymmetric payoffs – only a right to benefit in future, the obligation
being limited to an upfront premium. So, while swaps, futures and forwards do not
involve any transfer of cash flows when the contract is initiated, options are more
expensive because of the premium.

Such premium is the seller’s fair compensation for promised reduction of downside
risks, but not upside gains, in future. The bank has to compare the cost of the
premium with the potential losses on linear contracts. If it is reasonably certain of
its projections, the shock is assumed to be moderate and exposure is short-term,
then it will prefer linear contracts. If interest or currency rates are highly
unpredictable, the shock is assumed to be large and the exposure is long-term, then
it might prefer costlier options.

Ideally, the bank should use its derivative portfolio for macro hedging its balance
sheet. For instance, the bank might use derivative contracts to hedge the overall
balance sheet maturity gap. A macro hedge takes a portfolio view and allows
individual asset or liability maturity or reset profiles, or long and short positions, to
net each other out. If it wants to hedge item by item, the balance sheet might be
overhedged. A portfolio approach reduces the cost of hedging, because it makes use
of natural diversification benefits in the balance sheet. As a result, the need for
external hedges is reduced.

Conclusion
For many decades, if not centuries, crises after crises have shown the damage
caused by interactions between liquidity risk, interest rate risk and credit risk,
leading to the collapse of banking systems. However, the benign neglect of ALM
continued well into the early years of the 21st century, till the global financial crisis
struck. This prompted a reassessment of extant regulations and more stringent
directives for interest rate and liquidity risk management were introduced. It is in
this light that we study the chapters to follow.

References
[Link], J (2010): Risk Management in Banking, 3rd Edition, John Wiley & Sons, New
York.
[Link], A and Cornett, M. M. (2006): Financial Institutions Management – A Risk
Management Approach, McGraw Hill, New York.
[Link], J. (2002): Commercial Bank Financial Management, Prentice Hall, New
Jersey.

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Module III: Management of Risk in Bank Portfolios

Section B: Market Risk

Chapter 2: Interest Rate Risk in the Banking Book (IRRBB) -

The Earnings Approach

Prof. Sanjay Basu

Objectives

After studying this chapter, you will understand

i. The scope of IRRBB
ii. The features of NII approach
iii. Computing NII impact
iv. The merits and demerits of NII approach

Structure

1. Introduction
2. Definition and sources
3. The NII approach
3.1. Determinants of rate sensitivity
3.2. Shortcomings of NII approach
4. Conclusions

1. Introduction

The birth of modern ALM was with interest rate risk mismanagement. There was a
spike in short-term deposit rates in the US, after the deregulation of interest rates
with the collapse of the Bretton Woods agreement in 1971 and the oil price shock of
1973. This led to a sharp squeeze in NII for many banks, called Savings and Loan
Associations, which were created to make long-term, fixed rate home loans. Their
cost of funds shot up but yields on assets were not affected. Since NII is the most
important source of income for banks, they tried to increase margins by making
credit riskier loans. This caused large defaults by the late 1980s. Hence, interest rate
risk led to widespread credit risk.

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The same story was repeated by Orange County, a borough near LA, before its
collapse in 1994. It depended on short-term, money market borrowing to fund
investments in long-term, fixed-rate, bonds from the late 1980s onwards. As rates
hardened in 1994, cost of funding increased but asset yields remained the same. The
focus on low-quality loans before the subprime crisis (and the NPA crisis in India)
can also be traced to stiff banking competition and sustained squeeze in Net Interest
Margins (NIM) for the banking industry. In other words, a deterioration in NII may
lead to many other fatal forms of risk.

The upshot is that, in an era of stiff banking competition, IRRBB has become more
likely. Hence, there is a greater need to anticipate, monitor and guard against
adverse rate shocks now than ever before. They may add to the pressure on thin
margins and lead banks astray. That is why IRRBB management is vital. In this
chapter, we begin with the Earnings or the Net Interest Income (NII) Approach,
which analyses the short-term impact of rate shocks on a bank’s NII, at most up to
one year.

The chapter is organized as follows. In Section I, we define IRR and explain the
various forms it can assume. In section II, the salient features of the NII approach
are presented. In section III, we discuss the strengths and weaknesses of the
approach. Section IV concludes.

We start the discussion with a snapshot of the volatility of NII as a ratio of total
income, for Indian banks. For this analysis, the banking sector is split into three
major groups, i.e. SBI and its associates, other Public Sector Banks and New Private
Sector banks. Since the purpose is to understand the behaviour of NII, rather than
study the behavior of each bank group, we have masked their identities, by naming
them A, B and C. Group A need not refer to SBI and associates, and so on. For each
group, we have calculated the NII every year and computed the proportion of NII to
total income (i.e. NII/(NII+Other Income)).

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
A 68.89% 65.68% 63.05% 63.30% 68.99% 75.33% 74.35% 73.50% 71.51% 68.11% 63.73%
B 75.46% 67.82% 67.45% 68.05% 76.78% 76.17% 75.52% 74.30% 73.20% 72.32% 64.06%
C 53.36% 54.62% 59.38% 59.32% 63.49% 63.73% 64.83% 64.69% 64.94% 65.21% 63.29%
Table 1: NII as a ratio of total income (Source: IBA website)

We can make two observations, from Table 1. First, the NII shares of all groups (at
least since 2011) exceeds 60%. In other words, NII contributes the largest chunk to
total income, even in an age of increasing range of products which generate non-

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interest income. Therefore, even small changes in NII (due to unexpected interest
rate shocks) can lead to large losses in total income. This is why interest rate risk
management is so important. Secondly, the NII shares of Groups A and B have
steadily fallen between 2012 and 2017. The decline has been the sharpest between
2016 and 2017. We need to understand the reasons for such a slump. Is it due to (i)
credit risk that has led to NPAs and loss of interest income (ii) sharp decline in NII
due to sudden rate shocks or (iii) spike in other income? Without deeper analysis,
we do not know. But, keeping aside credit risk issues and role of other income, we
investigate the impact of rate shocks on NII, in the following sections.

2. Definition and Sources

IRR refers to the effect of interest fluctuations on rate-earning assets and rate-
paying liabilities. For a given change in rates (e.g. 1 per cent), IRR also captures the
changes in the size and nature of assets and liabilities. For instance, when rates rise,
balances may be transferred from savings accounts to fixed deposit accounts. Or,
banks may offer their premium customers a facility to sweep their CASA balances,
beyond a certain threshold, to FDs of their choice. In both cases, the liquidity
position of the bank will remain unchanged, but the interest cost will increase.
Therefore, interest rate risk may occur even without liquidity risk.

As already noted, IRR arises from interest rate volatility. Therefore, the first step in
IRR management is to forecast the (i) direction and (ii) size of the rate shock. One
possible option is to estimate future rate shocks, on the basis of historical
fluctuations, since these are more relevant to the Indian market. The risk analyst can
also add to the forecast, on the basis of his experience and judgment. But, depending
on the complexity of the portfolio and its expertise, the bank might begin with rate
shocks prescribed by the regulator, with a clear understanding that it may graduate
to an internal estimation of rate shocks, relevant to its portfolio, at the earliest.
Therefore, the IRR policy of the bank should specify (i) all possible sources of
interest rate risk (ii) the methods for estimating rate shocks and capturing the
effects on earnings and net-worth (iii) the instruments used for hedging the IRR and
(iv) procedures for setting IRR limits.

Rate forecasting is extremely important for ALM. The analysis of Earnings-at-Risk (

EaR, or earnings volatility), or fixation of limits on Net Interest Income (NII), will be
useless if the size of the underlying interest rate shocks, the items which they affect
and the interval for which they persist, are not known. The bank will not be able ot
act upon the EaR results. Once this is done, the bank can proceed to estimate the
impact of the rate shocks on future earnings and net-worth. There are four main

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sources (types) of banking book IRR. These are: (i) Repricing Risk (ii) Yield Curve
Risk (iii) Basis Risk and (iv) Options Risk.

Repricing Risk arises from differences in the maturity (fixed-rate) or reset

(floating-rate) dates for bank assets, liabilities and off-balance sheet (OBS) items.
For instance, a bank funding a 10-year fixed-rate bond with a 6 month fixed deposit
is exposed to repricing risk. Since the rate on the fixed deposit is adjusted earlier, a
uniform rise in market rates after six months reduces the spread between yields on
assets and costs of liabilities. Similarly, if the loan resets after 6 months while the
deposit resets after one year, a fall in short-term rates may reduce interest income
before interest costs fall. Here, even a parallel shift of the rates can reduce spreads
and erode net worth.

Yield Curve Risk refers to the effect of non-parallel shifts of yield curve segments,
on assets and liabilities across different time buckets. Even if the cumulative (over
all buckets) gap between rate-sensitive assets and liabilities is small, different rate
shocks in different buckets could sharply reduce the NII or networth. For instance, if
one-year loans are financed by six-month deposits, the bank’s spread might fall
sharply when the yield curve flattens. In other words, if there are less liabilities than
assets in the one –year bucket, and less assets than liabilities in the 6m bucket, then
a sharper rise in 6m rates than 1 yr rates will result in a higher cost of funding in the
six-month bucket than the rise in interest income in the 1-year bucket. This will
reduce margins and net worth. It might not be affected much by a parallel shift of
the yield curve.

Basis Risk refers to the impact of imperfect correlation between the indices
underlying asset and liability rates, e.g. between deposit rates and BPLR-linked
loans, with otherwise similar reset frequency. Even if six-month PLR-linked loans
are funded by six-month deposits, there is no guarantee that a 1 per cent change in
deposit rates will imply a 1 per cent change in BPLR. In other words, if the spread
between asset and liability rates changes suddenly, earnings and networth might fall
even when they reset or mature in the same time band.

This problem had indeed occurred during the BPLR regime. Research at NIBM
suggests that for every 100 basis point change in deposit rates, the corresponding
change in asset yields was only 30 basis points. This means that while banks could
be required to pay 100 basis points more on their deposits, in a rising rate regime,
they would earn only 30 bps on their assets. This would erode their NII and net
worth. As much as 70% of bank loans during this period was sub-PLR. This
prompted the RBI to shift to the base rate regime from July 2010 – in which any

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change in the cost of funds would have to be reflected in a similar change in yield on
assets. In order to attract both depositors and borrowers, if banks increased cost of
funds more than their yield on advances, not only would their own margins suffer,
but they would also trigger systemic risk. Hence the RBI scrapped the BPLR regime
and introduced the base-rate system.

Options Risk refers to the effect of options embedded in bank assets, liabilities and
off-balance sheet items. Such options provide the holder the right, but not the
obligation, to alter the cash flows of these instruments. For instance, depositors
have the right to withdraw their savings, current or term deposits at any point. They
are likely to exercise such rights, when market rates rise. Similarly, borrowers can
also prepay their term loans. This can trigger a sharp decline in cash flows for banks,
reduce their reinvestment incomes, increase their refinancing costs and reduce net
worth. In other words, when market rates rise and term deposits are prematurely
withdrawn, the bank loses low-cost deposits before their due date. In order to
replace or rebook these deposits and keep the balance sheet size constant, it may
have to incur higher costs.

RBI and BIS have been extremely worried about the threat of premature
withdrawal, primarily due to their adverse impact on liquidity risks. However, when
deposits are rebooked or CASA balances are transferred to FD accounts (with or
without sweep facilities), interest costs may rise without affecting the liquidity
position of a bank. .

3. The NII Approach

It captures the short-term impact of different types of rate shocks (as already
explained) on future NII. Change in NII reflects the projected change in net
reinvestment income on assets, or refinancing cost of liabilities, with an estimated
change in future rates. The analysis is restricted to all assets and liabilities that reset
or mature within one year. Since current balance sheet structure has already frozen
the rates that a bank earns and pays (i.e. current NII), the only point of interest is the
degree to which future rate shocks change the NII, as assets and liabilities are
affected. The NII impact shows the future earnings potential of a bank, with changes
in market rates. Shareholders, regulators, bulk depositors and other stakeholders
observe short-term changes in NII with keen interest, to analyze whether the
surplus over interest cost is likely to rise or fall. In case it trends to rise, the bank
will add to its stock of Tier I capital and shareholder value will be created.

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In order to conduct NII analysis, a bank needs three inputs: the volume of assets
which may reset or mature within a time horizon, the volume of liabilities which
may reset or mature within the same horizon and the rate shock for the interval. All
these are estimates – it is impossible to know for sure how much of assets and
liabilities will reset or mature over a horizon and what the exact rate shock will be.
The assets are referred to as Rate-Sensitive Assets (RSA) and the liabilities as Rate
Sensitive Liabilities (RSL). The gap between the RSA and RSL within a given time
band is known as the repricing gap – the term repricing captures both reset and
maturity.

NII analysis is based on Interest Rate Sensitivity (IRS) Statements which classify all
RSA and RSL into different repricing buckets, depending on the earliest date when
they are likely to reset or mature. At such a point, they can be reinvested or
refinanced at current market rates. The earliest RBI circular on ALM (issued in
February 1999) considered seven time buckets, from less than 1 month to beyond 5
years. The draft guidelines in April 2006 and the final version in November 2010
created the following structure for the IRS statements – the purpose is to
understand better the IRR in longer-term buckets beyond 5 years. Banks may create
smaller buckets for internal IRR assessment, but bigger bands are not allowed.

IRS statements -_ RBI Time Buckets

1 day - 28 days
29 day - 3 months.
3 months - 6 months.
6 month - 12 months.
1yr. - 3 yrs.
3yrs. - 5yrs.
5-7 years.
7-10 years.
10-15 years.
Above 15 years

3.1 Determinants of Rate Sensitivity

• At Maturity: Any asset or liability that matures will be repriced because the bank
must reinvest the asset proceeds and/or replace deposits and other liabilities at
prevailing rates. In order words, maturing assets may be reinvested and maturing
liabilities refinanced at going market rates.

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• Interim Principal/ coupon: If management expects to receive/make payments

during the time interval, the treatment will be exactly like a maturing asset or
liability. It can be repriced at prevailing rates. The size of the cash flow does not
matter – whether a large amount is received/paid at maturity or a much smaller
instalment arrives in between is irrelevant.
• Contractual Change: Interest rate on outstanding principal changes
contractually, during the period. These could refer to teaser loans on which banks
used to charge different fixed rates at different points of time. For instance, after
one year, the fixed rate on a loan may increase from 7.5% to 8% p.a. Therefore, a
contractual shock of 50 bps will be applicable to the outstanding principal after
one year. Alternatively, step-up bonds which were issued by banks, as Innovative
Perpetual Debt Instruments (IPDI), may offer 100 bps more after 10 years if they
are not called back. Therefore, after 10 years, the outstanding principal has to be
refinanced at 100 bps more, as mentioned in the bond contract.
• Exogenous rate/ index changes: The underlying base rate/MCLR changes and
customer rates may be affected. Therefore, the bank has to forecast the size and
timing of changes in policy rates like repo rates, which drive changes in such
internal indices. The relevant exogenous rate/index in this case is the repo rate.
The bank needs to decide whether repo rates are likely to change during a given
time bucket (say within 1m – 3m). If it feels that the shock is significant enough
for banks to change their base rates or MCLR, then all floating-rate loans linked to
the base rate or MCLR will be slotted to the 1m – 3m bucket. Therefore,
prediction of the likely severity and date of change in repo rates is of utmost
importance in IRR management.

A sample Interest Rate Sensitivity (IRS) statement is given below:

Particulars 0-1M 1-3M 3-6M 6 - 12 M 1y-3y 3y – 5y > 5y

A. Total
liabilities 1431.41 2270.72 2501.69 4062.82 4751.73 902.54 659.68
B. Total
assets 2652.54 1062.87 7804.27 990.30 3215.68 2791.02 9626.22
- - -
Net gap (b-a) 1221.13 1207.85 5302.58 3072.52 1536.05 1888.48 8966.54
Cumulative
gap 1221.13 13.28 5315.86 2243.34 707.29 2595.77 11562.31
Table 2: Interest Rate Sensitivity Statement for Bank X as on 31…….

There are more RSAs than RSLs in the first and third buckets, while the opposite is
true for the second and fourth buckets. In other words, repricing gaps are positive in

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the first and third buckets, and negative in the other two. The NII impact of a
uniform 0.5% rise in interest rates is shown in Table 3:

0-1M 1-3M 3-6M 6 - 12 M Total Impact

Quarterly Impact 1.27 -0.50 0.77
Semi-annual Impact 2.80 -2.01 3.31 4.10
Annual Impact 5.85 -5.03 16.57 -3.84 13.55
Table 3: NII Impact analysis for 0.5% rate hike across all buckets

The interpretation of Table 3 is quite simple. For instance, let us understand what
the quarterly impact in the 0-1 month bucket (Rs. 1.27 crores) means. If rates
increase by 50 bps and a surplus of Rs. 1221.13 crores of assets (as in Table 2) can
be reinvested after 15 days, the additional interest income for 2.5 months is Rs. 1.27
crores. We assume that all assets and liabilities are repriced at the midpoint of a
bucket. They can be repriced at any point of time with equal probability during the
interval; on an average, they are repriced at the midpoint. So, in the 0-1 month
bucket, they will be reinvested or refinanced after 15 days. If the bank chooses a
quarterly horizon to calculate the impact of the rate shock, the surplus will be
reinvested for 2.5 months (=3m-0.5m). Similarly, if the same surplus is reinvested
for 11.5 months (to estimate the annual impact), net interest income will increase
by Rs. 5.85 crores, for a uniform rate hike of 50 bps.

The next table summarizes the impact of rate shocks on NII, given the nature of the
repricing gap, in the bucket. For instance, if rates tend to decline for a bucket with a
negative repricing gap, the impact is good. This is because interest cost on RSLs falls
more than interest revenue from RSAs, for the same rate shocks. The cost saved on
RSLs exceeds the fall in revenue on RSAs, resulting in higher NII for the bank.

Intt view NII Impact Remark

RSA >RSL Up Positive Inc >Exp
RSA >RSL Down Negative Inc < Exp
RSA<RSL Up Negative Inc < Exp
RSA<RSL Down Positive Inc >Exp
RSA=RSL Up/Dn Zero Inc=Exp
Table 4: NII impact and Repricing Gaps

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3.2 Shortcomings of the NII approach

Banks have traditionally tried to minimize the impact of rate shocks on NII. This
reflects the high share of NII in their earnings. This approach is also preferred
because it is easy to understand, use and communicate. But, gradually, they began to
look beyond NII, for three reasons. First of all, it does not estimate the impact of
changes in interest rates, on NII, for those RSAs and RSLs which generate cash flows
beyond one year. This would rule out most HTM bonds and fixed-rate deposits. At
most, it computes the annual impact of expected changes in rates.

Secondly, it also ignores market value effects of rate shocks. This means that the NII
approach does not compare between contractual and market rates on banking book
assets and liabilities. Hence, it neglects the opportunity costs of holding the existing
portfolio. For instance, it does not tell us how much is being lost on account of fixed-
rate loans and investments and how much is being saved on fixed-rate deposits,
made in the past, when rates rise. This information is vital for the shareholder, who
needs to know whether the bank is paying more than the market on its liabilities or
earning less than the market on its assets. The shareholder has a number of
alternative investment opportunities to choose from – therefore his perspective is
comparative. However, the NII analysis, as described, is absolute – it does not tell us
how the bank has fared vis-à-vis other peer institutions. A bank may have lost NII
due to rate shocks, but if the market has done worse, then iyt is relatively better off.

A related point is that NII analysis does not indicate whether the maturity structure
of the balance sheet is optimal in the current rate environment. When assets and
liabilities were contracted, the portfolio structure and asset/liability rates may have
been aligned to the market. However, with the passage of time and change in market
rates, the portfolio may have to be rebalanced to meet shareholder expectations.
Since it throws no light on the performance or the maturity structure of the existing
balance sheet, it does not tell us how to change the nature and composition of assets
and liabilities.

Thirdly, since the NII approach looks only at rate-earning assets and rate-paying
liabilities, it also ignores items that do not pay interest. For instance, under earlier
RBI guidelines, current account deposits and non-interest paying portion of savings
deposits are placed in non-sensitive buckets. However, when interest rates rise, the
opportunity costs of these funds go up and balances are drawn down. Therefore, the
non-interest paying portion should rather be regarded as highly volatile. But, since
market value effects are not estimated, NII analysis fails to capture the rate
sensitivity of non-interest paying items altogether.

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Moreover, the NII approach cannot justify the popular demand for stable CASA in
the banking industry. Whether CASA stays with the bank for three months or three
years, the interest cost is the same. But the opportunity costs are very different. For
instance, if a large chunk of the CASA for Bank A remains for five years, the bank
need not source costlier five-year FDs to fund assets in the same bucket. In contrast,
if the same bank has CASA balances that continue only up to one year, it can replace
at most one –year FDs with such items. Assuming a positively sloped yield curve, i.e.
long–term rates are more than short-term rates, stable (i.e. 5-year) CASA saves
higher FD costs and is more desirable. This perspective is missing in the NII
approach.

4. Conclusions

IRR is so dangerous because it is hidden and can affect many other risks. The most
popular tool to estimate IRRBB is the Earnings approach, which captures the short-
term impact of a rate shock on NII, up to one year. Though it is simple, it fails to
estimate long-term impact or capture opportunity costs. That is why, with the
passage of time, banks migrated to the Economic Value of Equity Approach, which is
discussed in the next chapter.

References

1. Bessis, J. (2010): Risk Management in Banking, 3rd Edition, John Wiley & Sons, New
York.
2. Koch, T and S. Scott McDonald (2015): Bank Management, 8th Edition, Cengage
Learning
3. Saunders, A. and Cornett, M. M. (2006): Financial Institutions Management – A Risk
Management Approach, McGraw Hill, New York.
4. Sinkey, J. (2002): Commercial Bank Financial Management, Prentice Hall, New
Jersey.

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Module III: Management of Risk in Bank Portfolios

Section B: Market Risk

Chapter 3: Interest Rate Risk in the Banking Book (IRRBB) -

The Economic Value of Equity (EVE) Approach

Prof. Sanjay Basu

Learning objectives
After studying this chapter, you will understand
 The scope of EVE approach
 The features of Duration Gap analysis
 Duration Gap limits and implications
 The merits and demerits of Duration Gap approach

Structure
1. Introduction
2. Economic value approach
3. Duration gap model
3.1. Fixation of limits for controlling IRR
4. Strengths and weaknesses
5. Conclusion

1. Introduction
The Earnings approach analyzes the gains and losses in NII after RSAs and RSLs
have matured or reset. However, till such time, if market rates differ from what
banks earn or pay, there are opportunity gains or losses to the organization and its
shareholders. They may get more or less than what they would earn from the
market (i.e. other firms). This would make banks redesign their assets and liabilities,
to maximize shareholder value. Hence, the pricing of loans and deposits, which add
to shareholder value, may have to be changed. Therefore, in order to meet market
expectations, banks must take those deposits and make those loans, which add to
shareholder value. This is the goal of the Economic Value of Equity (EVE) Approach.
It ensures that bank balance sheets grow by choice, and not by chance or default.

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EVE analysis also tells us that non-traded assets and liabilities have opportunity
costs. They may have paid or earned market rates, at the time of origination. But,
with the passage of time, as interest rates change, can these products compete with
fresh deposits and loans? If not, how should bank portfolios be restructured, to
make them attractive to shareholders? These are some questions we discuss later.
This chapter is organized as follows. Section I discusses the Economic Value
Approach. In section II, we describe the Duration Gap model. Section III presents the
strengths and weaknesses of the analysis. We conclude in Section IV, by indicating
some extensions.

2. Economic value approach

In the Economic or Market Value Approach, the focus is on present valuation of all
future principal and interest receipts and payments. The original Basel II guidelines
in 2006, as adopted by the RBI in November 2010, considered only the book values
of the principal amounts for estimation of EVE impact. In contrast, the revised Basel
directives in April 2016, as adopted by RBI in February 2017, recommended present
valuation of all cash flows and inclusion of interest components. The logic is that the
comparison of contractual and market rates will help banks understand their
competitiveness. This should be done on every date at which the contractual cash
flows are due (either as principal or interest). In order to get a complete picture, the
analysis should be conducted for all cash flows till the maturity dates of on and off-
balance sheet assets and liabilities. Therefore, another important difference
between the Earnings and the Economic Value Approaches is that the focus of the
latter is on the entire stream of cash flows, till maturity, rather than only up to one
year.

The reason for present valuation of cash flows from non-traded assets and liabilities
is very simple. Assume that a fresh 2-year FD of a bank pays 7% p.a. as on 1.1.2018.
On 1.1.2019, the residual maturity of this FD will be exactly one year. Therefore, the
bank will compare the rate on the old 1-year deposit (with an original maturity of 2
years) with that on a fresh 1-year deposit, issued on 1st January 2019. If the fresh
deposit pays 6% p.a., the bank loses 100 basis points by holding the old deposit. It
pays more than the market rate on a fresh 1-year deposit. If it has a large number of
old, high-cost, deposits, it will pay 100 basis points more on each of them than the
fresh ones. As it pays more to the depositors, it leaves less for the shareholder.
Therefore, with the passage of time, even if deposits are non-traded, the bank and
the shareholder lose at the expense of depositors.

Similarly, the bank may earn 10% p.a. on an HTM G-sec, which has a residual
maturity of five years. Assume that the market rate on a fresh 5-year bond is 12%

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p.a. By holding on to the old five-year bond till maturity, the bank will lose 2% p.a.
Since the bond is non-traded, its price may not decline, but the loss cannot be
ignored. The shareholder loses, in this case, because the bank earns less than the
market rate.

Therefore, Market or Economic Value refers only to the comparison of contractual

and market rates, not the liquidation of the products. In the case of the depositor
who earns 7%, instead of 6%, the value of his asset increases with a fall in market
rates. But his asset is the bank’s liability. Hence, the Market Value of Liability (MVL)
increases for a bank, as rates fall, leading to losses for the shareholder. Similarly, as
rates rise and the bank earns 2% p.a. less on the HTM bond, than what the market
pays, its Market Value of Asset (MVA) falls. It creates and leaves less for the
shareholder.

The upshot is that, the purpose of discounting for present valuation of cash flows is
to compare how well banks perform, vis-à-vis their peers, as rates change. This
comparison is with identical securities – with the same tenor and cash flows. We try
to understand what the next best alternative is, in terms of asset returns or cost of
funds. If the alternative asset yield is lower, we make an opportunity gain and MVA
rises. If the alternative (or opportunity) cost of funds is higher, we make a gain and
the MVL falls. Since shareholder equity is a residual item, the impact on EVE is the
difference between the effect on MVA and MVL.
EVE=MVA – MVL………(1)
Change in EVE = Change in MVA – Change in MVL…………(2)
Once again, equation (2) shows that a rise in MVA and/or a fall in MVL add to
shareholder value. The former creates and earns more for the bank and
shareholder, vis-à-vis the market while the latter pays to depositors and other
creditors less than the market, leaving more surplus for the shareholder.

At this stage, the natural focus is on the relevant discount rates for assets and
liabilities. Risk-free assets have to be valued at risk-free rates, while an appropriate
credit risk premium needs to be loaded for discounting defaultable cash flows. In
particular, the bank’s own credit rating (and risk premium) should be considered
while valuing bonds issued by it. The details, as given by RBI guidelines, are
provided below.

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Yields for Liabilities

• Volatile portion of CASA: 15-d TD Rate

• Core portion of CASA: 2-year TD Rate/TD Rate as per behavioural analysis.
• Tier I/Tier II bonds: Relevant FIMMDA yields.
• Term Deposits: Current card rates.
• Refinance: Refinance Rates as per source.
• FX Swaps and maturing forwards: Going MIFOR Rates.
• IRS: Going MIBOR/OIS/INBMK Rates.
Table 1: Liability yields as per RBI (2010) guidelines

A brief explanation is in order. Let us start with CASA deposits. The volatile portion
of CASA is assumed to reprice within a month. Assuming that all items reprice at the
midpoint of a bucket, as before, the relevant date is the fourteenth day. Therefore,
the opportunity cost of volatile CASA is the 14-day term deposit rate. The logic is
that, if the volatile CASA was not available, the bank would have to raise 14-day
term deposits to fund itself. There is an opportunity gain even on volatile CASA
deposits, since the bank saves the cost of 14-day FDs. Likewise, if banks are able to
estimate the outflow patterns of CASA deposits, they may classify them in other
buckets based on behavioural maturity. The relevant FD rates would not have to be
paid, if the bank is funded by CASA deposits in these buckets. Since market (i.e. FD)
rates are higher than CASA rates, there is a fall in MVL and an opportunity gain on
CASA deposits. However, if banks are not sophisticated enough to conduct
behavioural analysis of CASA deposits, the RBI allows them to allot the stable
portion in the 1y-3y bucket. In such a case, the opportunity gain for the bank and
shareholder will be w.r.t 2 year FD (midpoint of 1y and 3y) rates.

Similarly, for term deposits, the relevant yield will be the going card rates for the
relevant tenors. If, as already explained, the card rates are less (more) than
contractual rates, MVL rises (falls) and the shareholder loses (gains) at the
depositor’s expense. The same analysis applies to all refinance items (from SIDBI,
NABARD or NHB), for which the current and contractual refinance rates are
compared. The nature of the swap (IRS/ Forex) will determine its yield. For all
bonds issued by the bank, FIMMDA yields corresponding to the latest credit ratings
of these securities are used. If the rating of a bond (and the bank) has improved,
then the contractual rates may be higher than the discount rates – the bank paid
more when it had a lower rating. Since its creditworthiness has improved, current

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yields suggest that it should pay less, which it cannot. Hence, the legacy of lower
(higher) credit ratings results in a loss (gain) for the bank, on the liability side.

Yields for Assets

• Balances with RBI: Non-sensitive.

• Money at Call: Call rates.
• Inter-bank Term Deposits: Card rates of other banks.
• Investments: Risk-free rates for SLR and FIMMDA yields for Non-SLR.
• Loans and Advances: Risk-free rates + spread as per average rating.
• FX Swaps and maturing forwards: Going MIFOR Rates.
• IRS: Going MIBOR/OIS/INBMK Rates.
Table 2: Asset yields as per RBI (2010) guidelines

The treatment of assets is similar. Since balances with RBI do not earn any interest,
they are treated as non-sensitive. However, a counterargument here is that since
they do not earn any interest, the opportunity loss for the bank is the highest,
especially because maintenance of such balances is mandatory. Therefore, such
balances may be discounted at risk-free rates for the appropriate tenors (e.g. 91 day
T-Bill rates). However, as it stands, such amounts need not be discounted under
existing guidelines.

The treatment of SLR and non –SLR investments is also similar. The former should
be valued at risk-free rates while the latter should be discounted at relevant risky
yields, depending on the ratings of the securities. The most interesting item is the
portfolio of loans and advances. Since different banks follow different credit
scoring/rating systems, a loan may not be given the same rating by everyone. A
uniform or common discount rate will then be hard to obtain. Therefore, from the
average (or product-level) ratings given by a bank, the corresponding external
ratings should be obtained. This is common to all banks in the industry. The
appropriate FIMMDA spreads, for such ratings, should be added to the risk-free
yields, to compute the discount rates on loans and advances. In short, the loan is
treated as a bond (with the same rating) bought by the bank. The question is: if the
loan was not available, which bond would the bank invest in and what would its
rating and yield be? The treatment of derivatives follows the same principle as that
of liabilities – the yields should be from the market to which the products belong.

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3. Duration gap model

It is clear that the opportunity gain or loss (and hence the change in MVA and MVL)
are related to the tenor or reset date of the product. For instance, when interest
rates rise and the bank continues to pay (earn) the same deposit (bond) coupon
rate, its opportunity gains (losses) are more over five years, than for one-year
instruments. In other words, the focus of EVE on present values leads naturally to
duration analysis along the lines of bonds (as discussed in Module II). Specifically,
EVE impact is calculated in terms of leverage adjusted duration gap, where duration
is the sensitivity of an asset or liability to a percentage change in rates. If assets have
higher duration than liabilities, their prices fall more when rates rise. Therefore,
banks with high-duration assets and low-duration liabilities (a positive duration
gap) are exposed to EVE losses, with a rise in rates.

The Duration Gap approach estimates possible changes in EVE in the following
steps:
i. It determines tenor-specific discount rates for each rate-sensitive asset and
liability.
ii. It estimates market values of the assets and liabilities, using these discount rates,
and calculates EVE as the difference between MVA and MVL in a Market Value
Statement. The essential steps from IRS statements to market value statements are:
a. Calculate the MV of each A&L, in each bucket, by dividing each book value by
(1+Relevant Discount Rate)^(Midpoint of bucket).
b. Calculate the weighted average yield within each bucket, for each A&L, by
using the MV share of each A (or L) as the weight for its discount rate.
c. Calculate the weighted average Rate, for all A (or L), by multiplying the rates
found in step 2, with the MV shares of A (or L) across buckets. This is just an
approximation. The true portfolio yield is the rate which equates the PV of the
portfolio cash flows to the market value of the portfolio.
d. Calculate the portfolio yield (common to both A&L) by multiplying the
weighted average A&L rates, found in Step 3, with the MV proportions of Total
Assets and Liabilities.
iii. It estimates durations for the asset (DA) and liability (DL) portfolios.
iv. Using a common yield R and a common rate shock R for all assets and liabilities,
it computes the EVE loss as: (MVA×DA - MVL×DL) ×R/(1+R) – the erosion in market
value of assets less the erosion in market value of liabilities. Rearranging this gives
the famous Leverage Adjusted Duration Gap method.
EVE = - (DA – (MVL/ MVA) ×DL) ×MVA ×R/(1+R)
= - (DA – kDL) ×MVA ×R/(1+R). .................(3)

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A pro-forma market value statement is illustrated below in Table 3.

Total 0-1M 1-3M 3-6M 6 - 12M 1y-3y 3y– 5y > 5y
Asset rate 6.20% 6.31% 6.38% 6.59% 7.41% 7.85% 8.34%
Liability
Rate 4.75% 5.50% 6.00% 6.50% 7.00% 7.00% 7.25%
Rate Shock
Assumed 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%
Bucket Mid-
point 0.04 0.17 0.38 0.75 2.00 4.00 10.00
BVA 17869.31 9421.74 619.17 701.10 322.34 648.92 721.55 5434.49
BVL 15469.19 894.21 1152.81 8108.70 2212.42 2637.00 271.79 192.26
MVA 14538.46 9398.15 612.89 685.03 307.27 562.47 533.32 2439.33
MVL 14684.93 892.48 1142.57 7933.44 2110.35 2303.26 207.35 95.48
DA 1.97 0.03 0.01 0.02 0.02 0.08 0.15 1.68
DL 0.76 0.00 0.01 0.20 0.11 0.31 0.06 0.07
Leverage 1.01
LDGap 1.20
EVE Loss -164.05
Table 3: Market Value Statement and Duration Gap analysis

The bucket mid-points are all converted into years. For instance, half a month is
equal to 0.04 years, two months can be written as 0.17 years, and so on. At this
point, a brief recapitulation of the formula for Duration is in order. Let us recall that
Duration is the weighted average time to maturity for a product or a portfolio, in
which the weights are the shares of the market values of cash flows that mature or
reset on various dates.
MVt
T
(1  y ) t
D   twt and wt  …………..(3)
MVt
1
 (1  y) t
A positive duration gap implies that assets reprice later than liabilities. This means
that, if interest rates go up uniformly across all buckets, the loss on assets will be
more than the gain on liabilities. As rates go up, the bank does not incur a higher
cost till its existing liabilities reprice. In our example, since liability duration is 0.76
years, on an average the bank can save itself the higher cost for such a length of
time. Conversely, since the asset duration is 1.96 years, the bank has to wait much
longer before it can reinvest these assets at higher rates. It has to suffer a much
larger opportunity loss on assets than the cost saved on liabilities. There is a fall in
long-term NII, after taking into account all opportunity costs and gains from the
existing portfolio. This decline in NII erodes the EVE or market value of net worth.

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Since MVL falls (i.e. the bank saves cost of liabilities) in proportion to liability
duration, a high leverage ratio (k = (MVL/MVA)) indicates that the bank is saving
more compared to its loss on MVA, as interest rates rise. For instance, if the leverage
ratio is 0.77, the bank loses on 100% of its MVA in proportion to asset duration and
saves costs on 77% of MVA (since MVL is 77% of MVA) in proportion to liability
duration. If the leverage falls to 58%, the bank saves costs on only 58% of MVA. High
leverage reduces the net impact on the asset portfolio and the loss to EVE.

The foregoing discussion brings out a potential conflict between NII and EVE
management, since duration is also a proxy for residual time-to-maturity. Since
long-duration (long-term) assets might carry much higher rates than short-duration
(short-term) liabilities, a bank might try to maximize NII by increasing the duration
gap. This could expose its EVE to a rise in rates. Hence, even if the bank management
wants to focus on NII, regulators might not allow a sharp decline in EVE, for a given
change in rates. They perceive EVE as a proxy for capital adequacy, in market value
terms, and might force a bank to adhere to strict NII limits.

Conversely, if rates are expected to fall, a negative duration gap may create
problems. This is often the case with insurance companies, provident and pension
funds with long-term liabilities and short-term assets. As market rates decline, the
periodic premiums and other contributions are invested at lower rates while the
promised rates on liabilities do not fall till these products mature at a much later
date. Hence, there is a decline in future NII and net worth.

3.1. Fixation of limits for controlling IRR

In general, banks fix limits on negative NII gaps across all buckets, in line with the
earnings perspective. However, large positive gaps in longer-term buckets (e.g.
beyond one year) indicate that long-term RSAs are much more than long-term RSLs.
Hence, the bank might face a sharp decline in EVE, owing to repricing risk or
steepening of the yield curve. The net-worth, of the banking book, is vulnerable to a
rise in market rates. The same rate shocks which lead to an increase in NII might
cause erosion in EVE. In order to minimize the conflict between the earnings and
economic value approaches, the bank should fix limits on positive NII gaps as well in
longer (i.e. beyond 1 year) buckets. To start with, these limits can be based on the
wisdom and judgment of the risk manager. Over time, they have to be based on
more scientific methods, as discussed below.

The actual limits should be obtained from a portfolio optimization exercise by the
bank. On the one hand, the bank wants to maximize its NII. On the other, it should not

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allow the ratio of EVE to market value of assets (capital adequacy in market value
terms) to fall below a floor of (say) 9%. Therefore, it should choose the duration gap
between assets and liabilities in such a manner that NII is reasonably high but EVE is
not too low. This would impose restrictions on the volume of RSAs and RSLs in various
buckets. As a result, there will be limits on (positive and negative) gaps in these
buckets.

As already discussed, a key component of limit fixation is the forecast about (i) size
and (ii) direction of rate shocks. While a sophisticated bank might use its own
forecasts, an ordinary bank might use the shocks prescribed by either RBI or BIS.

What are the strategic implications of setting Duration Gap limits? What kind of
assets and liabilities will the bank choose, as the duration gap shrinks? Going back to
our example, if the EVE loss is to be curtailed from Rs. 164 cr. to Rs. 100 Cr., to align
it with the amount of Pillar II capital available or planned for IRRBB, the duration
gap will be squeezed to 0.73 years. This implies that the bank will be forced to invest
in shorter-term assets (or assets with earlier reset dates), which respond earlier to a
projected rise in rates. Or, the bank may securitize a fraction of its long-term loans
and adavances – invest the cash at higher rates as it arrives.

The problem becomes more complicated on the liability side. If the bank attracts
longer-term deposits, at higher rates, in view of a rate hike, it may be faced with
some premature withdrawal under rising rates. In other words, the extension in
liability duration, which was anticipated while issuing longer-term deposits, may
not materialize to the fullest extent. Moreover, if the market rates fall, contrary to
expectations, the bank is saddled with long-term high-cost deposits and bonds
which drag its future NII downwards.

Therefore, much of EVE and Duration Gap management may boil down to
accumulation and maintenance of stable CASA. If interest rates rise, the cost of
stable CASA will still be frozen at a low level. If rates decline, the loss will be limited
to the cost of stable CASA, which is very low. But, this is easier said than done. It may
come from successful financial inclusion. As banks reach out to the farthest corners
of the country, at some cost, they may have access to large volumes of cheap, stable
deposits since savers have no other investment alternatives. As the technology cost
of bank outreach declines, financial inclusion will make both duration gap and
liquidity risk management easier.

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4. Strengths and weaknesses

The EVE approach makes banks aware that even non-traded items have opportunity
costs. It reminds them that meeting shareholder expectations is a continuous
process. When assets and liabilities are originated, at a point of time, they may be
aligned to market rates. However, with the passage of time, or changes in interest
rates, banks may earn less or pay more than the market. This will result in
shareholder losses. Duration Gap analysis provides a compact and concise method
to estimate such losses, due to a variety of rate shocks, and helps banks remain
prepared with a menu of strategies, to deal with the problem well before it arises.
The pricing of loans, deposits and other on and off-balance sheet products may have
to be adjusted to target specific products and meet shareholder objectives.

But, the Duration Gap approach cannot estimate EVE losses from yield curve risk
and basis risk. Options risks can be analyzed by making ad-hoc assumptions about
prepayment and premature withdrawal, which affect asset or liability durations.
There are two possible ways to incorporate yield curve and basis risks. The risk
manager can use arbitrary rate shocks, within and across repricing buckets, to
capture these risks. Or they can conduct behavioural analysis and simulations, to
incorporate yield curve twists, changes in spreads between asset and liability rates
or exercise of banking book options. This is where a sophisticated bank, with good
MIS, can use its own estimates of rate shocks and optionality for the banking book,
rather than the regulatory prescriptions. These simulations can also be used to
measure VaR for the banking book. This is an estimate of the worst loss, with a pre-
specified probability, and takes into account all kinds of IRR. Therefore, it is a better
metric for banking book IRR, than NII or duration. VaR-based limits, for the banking
book, not only incorporate all material and realistic IRR but also consider
diversification benefits or ‘natural hedges’ among rate-sensitive instruments. This
will reduce risk-based capital, below regulatory capital.

The second problem is that duration is a dynamic concept – it changes as new

products are added, old ones drop out and both balance sheet and off-balance sheet
items move towards their maturity dates. But, this should be a familiar issue – it
should be common knowledge that shareholder value maximization is a continuous
process and needs constant monitoring of asset and liability durations.

Duration Gap management can also be hampered by credit risk events. If a cash flow
is not received on its due date, profitable investment opportunities may be foregone.
In recognition of this problem, RBI guidelines advise that sub-standard assets
should be slotted in the 1y – 3y bucket, while doubtful and loss assets should be

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allotted to the 3y - 5y bucket. There will be a significant erosion in PV of such cash

flows, due to delay in recovery. This shows how higher credit risk can worsen
IRRBB.

5. Conclusion
Benign neglect of the opportunity costs on assets and liabilities has often led to
banking crises. There are two aspects of such negligence: (i) the impact of rate
shocks on all cash flows were not considered, because of exclusive focus on the
Earnings Approach and (ii) the relative performance of banks was not taken into
account. As long as short-term NII seemed to be comfortable, weaker banks did not
appreciate their decline in performance, compared to their peers. As a result,
duration gap management and EVE analysis became very popular in the late 1980s
and early 1990s. It served as an early warning signal of future insolvency and
helped banks improve their asset and liability portfolios, to meet shareholder
expectations. However, with the advent of better Risk Management theories and
computing technology, the weaknesses of duration gap models were brought to
light. Some of these issues will be discussed, in the context of stress testing for ALM,
in a later chapter.

References
1. BIS (2006): International Convergence of Capital Measurement and Capital
Standards: A Revised Framework, Comprehensive Version, June, Bank for
International Settlements.
2. BIS (2016): Interest Rate Risk in the Banking Book, April, Bank for International
Settlements.
3. Bessis, J. (2010): Risk Management in Banking, 3rd Edition, John Wiley & Sons, New
York.
4. Koch, T and S. Scott McDonald (2015): Bank Management, 8th Edition, Cengage
Learning.
5. Saunders, A. and Cornett, M. M. (2006): Financial Institutions Management – A Risk
Management Approach, McGraw Hill, New York.
6. Sinkey, J. (2002): Commercial Bank Financial Management, Prentice Hall, New
Jersey.
7. RBI (2010): Guidelines on Banks’ Asset Liability Management Framework – Interest
Rate Risk, RBI/2010-11/263, DBOD. No. BP. BC. 59 / 21.04.098/ 2010-11,
November.
8. RBI (2017): Draft Guidelines on governance, measurement and management of
Interest Rate Risk in Banking Book, RBI/2016-17/ [Link]…/21.07.005/2016-
17, February.

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Module III: Management of Risk in Bank Portfolios

Section B: Market Risk

Chapter 4: Liquidity Risk Management

Prof. Sanjay Basu

Objectives

After studying this chapter, you will understand

 The scope of liquidity risk management
 The features and concerns of liquidity risk management
 Structural liquidity statements – static and dynamic
 Liquidity risk limits

Structure
1. Introduction
2. Basics
3. Liquidity risk management
4. Liquidity risk limit
5. Conclusion

1. Introduction

Liquidity risk management has been at the heart of banking ever since its inception.
As banks funded long-term assets with short-term liabilities, to increase net interest
margins, they were exposed to liquidity risk. The possibility of sudden withdrawal
of short-term deposits and other borrowings threatened the solvency of even
reputed banks. This was the single most important reason for bank failures across
centuries. However, though the Basel Committee planned to introduce both capital
and liquidity standards together, only capital adequacy guidelines were issued
under Basel I.

After the East Asian and Russian crises of the late 1990s resulted in the collapse of
large banks and financial institutions like LTCM, liquidity risk management was

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introduced as a Pillar II item under Basel II. However, not much attention was paid
in developed countries to the creation of internal models to capture liquidity risk. It
was assumed that funds would always be available at reasonable cost, provided
asset quality was good, and assets could be sold without a sharp decline in prices.
Hence, there were few attempts to reduce exposure to long-term, illiquid, assets or
short-term, volatile, liabilities. This culminated in the global financial crisis and the
subsequent introduction of mandatory liquidity standards under Basel III, viz.
Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). These
stringent guidelines have shifted the focus to liquidity risk assessment, pricing,
hedging and transfer strategies.

This chapter is organized as follows. In section I, we discuss the basic issues in

liquidity risk management. Section II presents the Structural Liquidity Statement
(SLS) and its applications. In section III, we analyze liquidity risk limits. Section IV
concludes.

2. Basics

In this chapter, we are concerned with funding liquidity risk, i.e. the inability to meet
depositor and borrower cash obligations on demand. The objectives of liquidity risk
management should be to:

 Ensure adequate liquidity at all times.

 Comply with regulations.
 Set and follow liquidity risk limits.
 Monitor the gap profile and the sources of funding.
 Monitor the pattern of short-term outflows and their coverage by liquid
assets.
 Ensure a sufficient reserve of liquid assets, which can be used as collateral,
and its efficient usage.

As before, the first step in measuring and managing liquidity risk is the
identification of the most important sources of risk. In the Indian context,
unexpected fluctuations in liquidity are driven by the following items:

i. Behaviour of non-maturity deposits: A large fraction of deposits, at Indian

banks, consists of low-cost current and savings deposits which do not have
any contractual maturity. Moreover, the depositor has the option to
introduce or withdraw funds at any point of time. This makes the analysis of

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future cash inflows and outflows quite difficult. However, it is extremely

crucial because the main reason for the closure of banks has been the
inability to pay depositors on sudden demand. Therefore, the bank needs to
know how much of these deposits is volatile, i.e. likely to flow out at short
notice and how much is core or stable, i.e. unlikely to leave the bank. In the
absence of contractual maturity, the bank needs to analyze the behavioural
maturity of these deposits.

ii. Renewal patterns of term deposits: If the actual proportion of renewal is

more than what the bank expects, it is left with surplus funds which might
have to be reinvested at lower rates. If the actual fraction is less than
anticipated, the bank faces a liquidity deficit, which might entail higher
financing costs. Therefore, the bank needs to carry out a detailed roll-in and
roll-out analysis of the term deposits. It should estimate the probability
distribution of net deposit changes, preferably on a daily basis. If the
distribution is positively skewed, the bank should look for investment
opportunities for its surplus funds. If it is negatively skewed, the bank should
consider how to finance the net deposit drain.

iii. Undrawn portion of credit lines: The bank should estimate how much of its
advances portfolio consists of CC/OD, in which the borrower has the right to
utilize up to the limit, on demand. This is because some large clients might
keep the limit unutilized when the borrowing costs are much lower in the
money markets. They will revert to the bank, for sudden utilization, when
borrowing costs are higher in the market. As a result, the bank can neither
keep the unutilized funds idle nor deploy them in long-term, illiquid assets. It
may also have to borrow at higher costs, from the market, when sudden
drawdown occurs. Estimating the volatility and utilization pattern of CC/OD,
through behavioural analysis, is extremely important for the bank.

iv. Off-balance sheet commitments: At the time when off-balance sheet

acceptances, guarantees and commitments are invoked, the bank might
suffer a sharp liquidity shock. It should carefully monitor the pattern and
impact of exercising these non-funded commitments, in order to minimize
unexpected liquidity outflows.

v. Embedded options in term loans and deposits: When interest rates rise,
depositors might prefer to prematurely withdraw their deposit balances,
rather than continuing at the lower contractual rates. This not only increases
the financing cost of the bank, but also results in a sharp liquidity outflow.

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Similarly, sudden prepayment of term loans, in a falling rate environment,

might saddle the bank with surplus liquidity. As a result, the bank needs to
study the behavioural pattern of premature withdrawal and repayment, to
minimize the impact of sudden liquidity shocks.

vi. Credit Risky assets: The bank might expect the cash inflows from different
assets to arrive in full and on time. In such an ideal case, it can plan how to
meet its expected cash outflows at different intervals. The problem arises
when some of its assets make delayed or partial payments. It might then run
into a funding deficit, whereby depositors, CC/OD and other off-balance sheet
commitments cannot be paid on demand. To project and guard against the
shock, the bank needs to study the historical pattern of cash inflows as per
rating categories.

vii. However, the sources of risk mentioned above are very generic. The Liquidity
Risk Management policy of a bank should be customized. It should be
governed by the size, composition and complexity of its balance sheet.
Depending on the mix of products, two banks in the same market can have
very different liquidity positions. One bank might have surplus liquidity
while the other has a liquidity deficit. Therefore, the Liquidity Risk
Management Policy of a bank should be based on its own risk appetite, skill
level, goals and priorities. Moreover, as the nature of its business, risk
management expertise, risk tolerance and the external environment change,
the policy should also change to capture these new developments.

3. Liquidity Risk Measurement

Liquidity Risk is generally measured in two ways. The first is Liquidity Gap analysis
and the second is Structural Ratio analysis. We will focus on Liquidity Gap analysis.

Liquidity Gap or Structural Liquidity statements (SLS)

This is prepared on the basis of a maturity ladder approach. It is based on the

residual maturity of assets and liabilities. The future is divided into several time
intervals or time buckets. Cash inflows are ranked by future dates or intervals when
assets are repaid or credit lines can be drawn down. Cash outflows are ranked by
future dates on which liabilities fall due. These inflows and outflows are then placed
in appropriate buckets. Trading portfolios can be placed in earlier buckets to
indicate the ease with which they can be liquidated. The difference between
expected cash inflows and outflows (gap) in each bucket captures the excess or

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deficit of liquidity within a specific future interval. Banks reliant on short-term

funding will actively monitor the first few buckets.

On the other hand, monitoring longer-term gaps will allow a bank to frame
strategies that alter product maturities. If there are too many long-term assets and
too few long-term liabilities, there is a reinvestment risk from the deployment of
surplus liquidity in future. Similarly, there is a (long-term) refinancing and funding
liquidity risk with too many long-term liabilities and few long-term assets. A bank
might want to encourage loans and deposits, with particular maturities, to close the
gaps in specific buckets. In order to implement such a strategy, liquidity gap limits
will have to be imposed.

In its first ALM guidelines, issued in February 1999, RBI had introduced eight
buckets in the SLS, as shown below in Table 1. In October 2007, it inserted three
additional buckets, viz. next day, 2-7 days and 8-14 days. This was meant to make
banks conduct a more granular analysis of short-term liquidity fluctuations. In
March 2016, the 1m – 3m bucket was further decomposed into two time bands, i.e.
31 day – 2m and 2m – 3m slots. This was done to ensure that, with their focus on
strict liquidity risk management up to 30 days (as mandated by Basel III and RBI
guidelines), banks do not accumulate short-term liabilities just outside the one-
month window. Dependence on short-term deposits and borrowings, which mature
just beyond one month, may help them meet the twin goals of regulatory
compliance and cost optimization. But this strategy would only defer liquidity
pressure, not manage or resolve it. In short, the latest SLS, prepared as per RBI
guidelines, would appear with the following buckets:
Next day.
2 days - 7 days.
8 days – 14 days.
15 days – 30 days.
31 day - 2 months.
2 months – 3 months.
3 months - 6 months.
6 month - 12 months.
1yr. - 3 yrs.
3yrs. - 5yrs.
Over 5 years.

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The difference between the aims of the Interest Rate Sensitivity Statement (IRS) and
SLS is clear. As we saw in Chapter II, the IRS focuses more on long-term buckets
while the thrust of SLS is on short-term intervals. The reason is that the opportunity
losses and gains on rate-sensitive assets and liabilities increase with the tenor of the
products. This is what the duration gap model also captures. However, liquidity risk
management, or arrangement of enough funds to repay volatile liabilities, is a short-
term problem. That is why RBI has a daily Liquidity Adjustment Facility (LAF) in
place.

The gist of an SLS is illustrated below in Table 1.

2 to 7 8 to 14 29
Next days days 15-28 days 3 to 6 6 to 12 1 to 3 3 to 5 Over
to 3
day days mths mths mths years years 5 years
Outflow 6,370 3,485 2,908 4,910 12,380 8,641 27,731 58,688 14,840 22,557
Inflow 13,385 7,151 2,729 3,780 10,060 11,446 10,536 42,636 15,634 38,285
Gap 7,015 3,666 -180 -1,130 -2,320 2,805 -17,194 -16,052 794 15,728
Cumulative Gap 7,015 10,681 10,501 9,371 7,051 9,856 -7,339 -23,390 -22,596 -6,868
Cumulative
Outflow 6,370 9,855 12,763 17,673 30,054 38,695 66,426 1,25,113 1,39,953 1,62,510
Table 1: Structural Liquidity Statement for Bank X as on ………….

The bank has a comfortable liquidity surplus (positive cumulative gap) up to one
month, but large negative gaps in the 29d - 3m and 6m – 12m buckets. It may be
trying to comply with stringent regulatory limits, up to one month, and build up
short-term liabilities thereafter in order to reduce its cost of funds. However, in such
a case, it only defers liquidity problems, does not solve them. As a result, the SLS
should be used to monitor the trends in maturity patterns of key balance sheet
items over time. A bank may meet its immediate liquidity requirements, but be
vulnerable to adverse shocks in the not too-distant future. This issue will be
discussed in some detail over the next two chapters.

While preparing the SLS, it must be understood that all inflows and outflows are not
completely predictable. Liquidity gap estimates may have to be monitored and
revised in line with the behaviour of these items with uncertain cash flow patterns.
The following matrix might be useful in classifying cash inflows and outflows for
liquidity gap analysis:

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

Cashflow amount
Cashflow timing Deterministic Stochastic
Deterministic Fixed Rate Loans, Floating-rate loans and
bonds, term deposits, bonds, floating leg of
fixed leg of IRS. IRS, European options
Stochastic Traveller’s cheques CA, S/B, American
options

All the items noted above, which drive liquidity risk in Indian banks, can be placed
in one of the cells of the matrix. Bucketing is the easiest when both the amount and
timing of cashflows are deterministic. It is the most difficult (and based on
behavioural analysis) when both are stochastic. There may be a large difference
between actual and estimated liquidity gaps, if the actual inflow/outflow pattern of
the probabilistic items does not match the behavioural forecasts.

A major problem with the structural liquidity statement is that it is static, i.e. based
on existing businesses. With changes in customer profile, product and industry
composition and behavioural patterns, on a regular basis, the actual gaps might be
very different from projected gaps. Therefore, along with static liquidity reports, the
bank should also prepare dynamic liquidity reports to better capture the effect of
changes in the market and balance sheet, on its liquidity profile. Moreover, if it takes
too long to prepare these reports, then the projections in the first few buckets are
useless because these intervals will elapse by the time the reports are generated.
Therefore, granularity and sophistication in gap analysis has to be supported by
better MIS.

Dynamic Liquidity Statements

Liquidity inflows and outflows are affected by interest rate fluctuations. When
designing possible scenarios for supplementing traditional gap analysis, the
underlying assumptions about interest rate fluctuations must be made explicit.
These scenarios (hypothetical and historical) must capture both normal and stress
conditions. For example, a stress scenario should not only specify the quantum of
premature deposit withdrawal, or erosion of savings and current account balances
or utilization of CC/OD limits, but also the size of the underlying interest rate
fluctuations across different time intervals. To the extent possible, the probabilities
of such rate shocks and consequent impact on liquidity gaps should also be

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indicated. This allows the bank to monitor rate movements and elicit early warning
signals for future liquidity shocks.

When this procedure is repeated for dynamic gap analysis, the interdependence
between business scenarios and interest rate shocks must also be taken into
account. For instance, what is the joint probability of (i) non-maturity deposits
(NMDs) increasing by Rs. 100 and (ii) short-term rates being 6.5%, within the next 6
months? Or, what is the joint probability of NMDs rising by Rs. 50 and short term
rates being 7.8%, within the next 6 months? In this simple case, the summary matrix
of joint probabilities and liquidity gaps would appear as follows:

Rate=6.5% Rate=7.8%
NMD rises by 100 (p1, gap1) (p2, gap2)
NMD rises by 50 (p3, gap3) (p4, gap4)

In this case, p1, p2, p3 and p4 indicate the respective joint probabilities. The general
matrix of business scenarios and interest rate scenarios will appear as under:

Rate scenario 1 Rate scenario 2

Business scenario 1 (p1, gap1) (p2, gap2)
Business scenario 2 (p3, gap3) (p4, gap4)

Therefore, the ALM policy should clearly specify that, while preparing dynamic
liquidity gap statements, the bank should not only consider potential business
scenarios but also possible interest rate scenarios and the interdependence (i.e.
joint probabilities) between rate scenarios and business scenarios.

4. Liquidity Risk Limits

A liquidity risk limit is an important tool for prudent risk management. Risk limits
are the most popular means of risk control. They ensure that the bank’s external
rating does not fall below a critical threshold. They allow banks to retain sufficient
liquidity and preserve their creditworthiness to depositors and other borrowers.
With good risk limits, a bank is clearly able to communicate to its senior and top
management the degree of comfort or concern with the current level of risk
exposure. For instance, the board of directors will be happy to know that the gaps in
all buckets are within tolerance limits.

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As with NII gap limits, the tolerance limits for liquidity gaps should not be arbitrary.
They should depend on the following factors:

i. Risk appetite: Some banks are conservative – they do not want to assume
higher liquidity risk for extra returns. Others might be comfortable with
more liquidity risk. The limits set by a bank must recognize its risk
psychology.
ii. The level of capital and earnings: A well-capitalized bank is deemed
creditworthy and is not expected to face sudden withdrawal by depositors
and other lenders. Likewise, a bank with a high level of earnings is unlikely to
gamble for higher returns. Less healthy banks have traditionally
overinvested in risky assets like junk bonds which not only carry high credit
risk (i.e. prone to liquidity deficits from sudden default) but also become
highly illiquid in troubled markets. The limits need to be more stringent for
such banks.
iii. The level of cash capital: In a liquidity crisis, external funding might not be
easily available. Therefore, the bank should fix its liquidity risk exposure (i.e.
limits on potential cash outflows) with respect to its available cash capital,
which captures the amount of funds it can generate in a crisis. The available
cash capital, in this regard, can be defined as the sum of (i) shareholder
equity (ii) core deposits and other borrowing that will not mature in the next
twelve months (iii) the collateral value of assets in the balance sheet and (iv)
committed unsecured credit lines. A bank with a higher level of cash capital
can quickly convert stand-by liquidity sources into cash. Hence, it can assume
higher liquidity risk exposure.
iv. Possible scenarios: Liquidity risk limits will be impractical if they do not
consider a variety of normal and stress scenarios. These should include a
sharp rise in demand for loans, a sudden increase in loan commitment usage,
sudden deposit withdrawal, slower deposit growth and the inability to obtain
or retain funds at a short notice. Based on the results, the limits should vary
across banks and across scenarios.

In 1999, the first RBI guidelines stated that the (negative gap/outflow) ratio should
be below 20% in the 1d-14d and 15d-28d buckets. This means that the liquidity
deficits in each of the first two buckets were not allowed to exceed 20% of outflows.
However, this implied that banks were not allowed to use surplus cash in the 1d-
14d bucket to absorb liquidity shortfalls in the 15d-28d buckets. In October 2007,
after much persuasion, RBI allowed banks to set limits as per cumulative gaps and
cumulative outflows. In particular, the ratio of cumulative gap to cumulative
outflows should be within 5%, 10%, 15% and 20% in the first four buckets.

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This means that

(i) A surplus in the first bucket (next day) may be used to reduce the deficit in the 2d
-7d bucket, and restrict it to regulatory thresholds. As a result, banks need not
maintain as much of short-term assets (or long-term liabilities) to remain within
gap limits in each bucket, as before. This measure would allow them to improve
their NIM, while being conscious of liquidity risk management.
(ii) Since cumulative outflows must be higher for longer-term buckets, the
permissible gaps are also higher. For example, the cumulative outflow in the second
bucket may be Rs. 1000 Cr., while that in the third bucket could be Rs. 1500 Cr. In
such a case, the limit on cumulative liquidity deficit in the second bucket (10%) is
Rs. 100 Cr. and that in the third bucket (15%) is Rs. 225 cr. It is clear that the
cumulative gap, in the third bucket, would have been higher even if the limit was at
10%, as in the second bucket, since cumulative outflows are higher in the 8d-14d
bucket than in the 2d-7d bucket. In short, by setting limits on cumulative outflows,
rather than bucketwise outflows, RBI allowed banks to maintain larger liquidity
deficits, which would reduce their cost of funding, improver their asset yields and
strike a balance between higher profitability and liquidity risk management.

In the liquidity risk management guidelines issued in 2012, RBI also wants banks to
monitor a few vital structural ratios. These include items like (i) Core Deposits:
Illiquid Assets and (ii) Temporary assets: Volatile liabilities. The goal of the former
is to ensure that illiquid assets (like mandatory CRR, mandatory SLR, long-term
loans and fixed assets) are funded primarily by stable deposits, which stay with
banks beyond one year. The objective of the latter is to ensure that short-term
liabilities (up to one year) are repaid with liquid assets of assets. In both cases,
sound liquidity risk management needs that the ratios should be as high as possible.
As it stands, Indian banks have some way to go in that direction. Of course, it’s a
trade-off between financial stability and return optimization as well.

5. Conclusions

After decades of benign neglect, liquidity risk management has received regulatory
and industry attention in the recent past. Banks and financial institutions are more
conscious of short-term liquidity concerns, management of liquidity gap limits and
pricing of loan and deposit products for adherence to such targets. In this context,
the structural liquidity statement may provide a ready summary of short-term
liquidity deficits, trends in asset and liability maturity patterns and impact of

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business growth and market scenarios on liquidity positions. It also helps banks
monitor whether they adhere to liquidity gap limits on an ongoing basis. If not, the
problem items and buckets can be easily identified.

However, the SLS is prepared to capture liquidity profiles under normal conditions.
In chaotic markets, sharp and sudden premature deposit withdrawal, drawdown of
committed credit lines and delay in scheduled inflows from assets may result in
short-term liquidity pressure. The next chapter shows how Basel III seeks to
address such issues, by altering the asset-liability profiles, through global
implementation of two key proposals: (i) the Liquidity Coverage Ratio (LCR) and (ii)
the Net Stable Funding Ratio (NSFR). The consequences of these guidelines are
likely to be far-reaching as well.

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

Module III: Management of Risk in Bank Portfolios

Section B: Market Risk

Chapter V: Stress Testing for ALM

Prof. Sanjay Basu

Objectives

After studying this chapter, you will understand

 The rationale for stress tests

 Stress Tests for Interest Rate Risk management
 Stress Tests for Liquidity Risk management
 Contingency Funding Plans

Structure
1. Introduction
2. Importance of stress tests

1. Introduction
The traditional Pillar I capital charges, under the Basel Accords, measure
unexpected losses under normal conditions. In contrast, stress tests are designed to
capture extreme losses in chaotic financial markets. Therefore, stress testing
complements standard tools of risk management by painting a broader picture of
risk. The global financial crisis has shown how liquidity crunch, credit migration and
large MTM losses due to sharp spikes in interest rates can collude to bring down
reputed banks and financial institutions. As a result, many recent regulatory
guidelines have been issued in several countries, including India, to improve stress
testing practices in the financial sector.

The reason why stress testing may be difficult is that, by definition, market crashes
are rare events. Therefore, as good times roll on longer, it becomes harder to believe
or justify that very large losses may occur in the near future. It may not only be
tough to formulate but also implement stress testing policies, under such conditions.
This may lead to undue optimism and overexposure to high-risk assets and
liabilities. The balance sheet becomes vulnerable to minor shocks. The history of

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crises has shown us that good (business) cycles do not slow down in general – they
come to sudden stops which destroy the financial sector and paralyze the real
sector. However, after the global meltdown and the Eurozone crisis, regulators
across the world have become more aware of the need to create capital and liquidity
buffers when markets are buoyant and not frozen. Hence, stress testing policies
should be designed under normal conditions, to execute possible strategies well in
advance.

2. Importance of Stress Tests

Stress tests are used to estimate tail losses, which are not only rare but can also lead
to large-scale bankruptcy or insolvency. They were included under Pillar II of Basel
II. However, as we saw in Module II, after the global financial crisis, the idea of stress
capital charges gained much currency. Banks under the Internal Models’ Approach
were asked to estimate capital charges using both normal and stress VaR. Under
Basel III, they were asked to maintain a capital conservation buffer, equal to 2.5% of
Risk Weighted Assets (RWA), for general market and idiosyncratic stress events.
Hence, both Basel II and Basel III now include Stress Capital Charges under Pillar I.
RBI has also issued stress testing guidelines in December 2013, to cover a wide
range of risks.

A robust stress testing framework can help banks and financial institutions in many
ways. First, the key risk drivers (liquidity and interest rate shocks) can be calibrated
to different degrees of stress. This will enable banks to build internal models that
estimate stressed capital and liquidity requirements. Secondly, probabilistic stress
tests can be conducted by combining forward-looking and historical shocks.
Futuristic scenarios will allow banks to capture losses from Black Swan (i.e.
unforeseen) events. Innumerable crisis episodes have shown that (i) historical data
may be misleading, while predicting the likelihood of future episodes (ii) past events
may be much less severe than impending shocks. However, since subjective
scenarios may appear to be ad-hoc, they need to be combined with historical data.
The implication is that historical patterns may repeat themselves much, but not all,
of the time.

Thirdly, stress tests can highlight risk concentration and interactions, in volatile
markets, which might otherwise be overlooked. As a result, banks and financial
institutions are in a better position to create and manage their capital and liquidity
buffers on a regular basis. For instance, if liquidity crises occur due to interest rate
shocks and credit events, the combined impact will be larger in those segments to
which the bank has greater exposures. Fourthly, stress tests enable a bank to detect
the weak points in its portfolio and estimate losses when extreme shocks hit such

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segments. The losses may be very large, relative to the exposures, owing to the flaws
in the structure and composition of the portfolio. Fifthly, stress tests can tell a bank
whether potential losses, in earnings and net worth, exceed its risk tolerance limits.
It can decide whether to hedge, raise capital, cut exposures, exit businesses, reduce
dividends or share buybacks.

There are two approaches to stress testing of bank portfolios. The first is Top Down,
i.e. driven by senior management. For instance, the board may wish to know how
much its bank could lose if a stress event (e.g. the NPA crisis) occurs? This would
force the risk management committee to analyse the impact of the episode on
lending, investments, deposits and borrowings. It will help the bank attribute the
aggregate losses to key risk drivers, which can be monitored and managed in time.
The second approach is the Bottom Up one, in which the bank may want to identify
those shocks which make it lose more than a given threshold amount. It will have to
apply large shocks to position-specific risk factors, like interest rates, equity prices
and exchange rates, to examine their correlated impact on assets and liabilities.

Stress tests can also be of two types. The first is scenario analysis – the design and
application of historical or hypothetical events to assets and liabilities. They capture
the effect of relevant shocks on a number of risk factors. The stressed loss combines
the impact of simultaneous movement in a number of risk factors. Historical
scenarios use data from actual stress events. They involve less judgment, but could
be outdated or irrelevant. Hypothetical scenarios are potentially more appropriate
to the risk profile of a bank, but they also require more effort. The second type
covers sensitivity tests. These capture the portfolio impact of shocks to a single risk
factor. The stressed loss is the marginal contribution of a single risk factor.
Multifactor stress tests, for a given position, can be treated as a combination of
sensitivity analysis with a number of risk factors.

3. Section II
Under Basel II (2004), only repricing risk was captured. As a result, NII and EVE
impact was computed only for parallel shifts (i.e. by (+/-) 200 bps) of the yield
curve. However, this ignores the impact of (i) unequal rate shocks across different
tenors (yield curve risk) (ii) dissimilar rate shocks across assets and liabilities (basis
risk) and (iii) loan prepayment or premature deposit withdrawal, on NII and Net
worth. After the global financial crisis, there was a global effort to include such risks
under Pillar I, through draft BIS guidelines in June 2015. However, though the
importance of nonparallel yield curve shifts was recognized, the final guidelines in
April 2016 restricted these items to Pillar II. RBI adopted such guidelines, in its draft
circular, in February 2017. Since these guidelines are quite technical, we wish to

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capture the gist of various stress rate shocks, through a simple illustration with the
Earnings Approach. We start with a simple IRS statement, which has been discussed
in Chapters II and III, in table 1.

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6m- Non-
Particulars 0m - 1m 1m - 3m 3m - 6m 12m 1y – 3y 3y-5y > 5y Sensitive Total
Term Deposits (Fixed
Rate) 1464.07 1834.69 1858.47 2371.86 6600.50 3728.58 1171.83 19030.00
A. TOTAL LIABILITIES 2099.07 2592.69 10930.47 2729.86 6600.50 3791.58 1171.83 10342.00 40258.00
B. TOTAL ASSETS 2162.15 1480.17 10650.60 1425.08 2986.38 3893.42 12378.22 5605.00 40581.02
- - -
NET GAP (B-A) 63.08 1112.52 -279.87 1304.78 3614.12 101.84 11206.39 -4737.00 323.02
- - - -
CUMULATIVE GAP 63.08 1049.44 -1329.31 2634.09 6248.21 6146.37 5060.02 323.02
Table 1: Interest Rate Sensitivity Statement for Bank X as on ……

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The following rate shock scenarios are then applied to the bank’s portfolio, as
shown in Table 2. While repricing risk refers to a flat 100 bp rate shock across all
buckets and products, the rationale for the yield curve and basis risk scenarios is
explained below.

Input Data 0m - 1m 1m - 3m 3m - 6m 6m-12m

1. Rate shock -
Repricing 1% 1% 1% 1%
2. Rate shock – Yield
Curve 1.00% 1.25% 1.50% 1.75%
3. Rate shock Liab -
Basis 1.00% 1.00% 1.00% 1.00%
Rate Shock Assets -
Basis 0.30% 0.30% 0.30% 0.30%
4, Depositor Option Ex. 15.00% 15.00% 15.00%
Term Deposits 2373.82 1559.49 1579.70 2016.08
Total Liabilities 3008.82 2317.49 10651.70 2374.08
Total Assets 2162.15 1480.17 10650.60 1425.08
Table 2: Rate Shock scenarios for Bank X as on ……

The stress (yield curve, basis and option risk) scenarios need to be explained. Since
the bank has a small positive repricing gap in the first bucket and negative gaps in
the next three (i.e. up to one year), its losses increase if rate shocks are higher across
buckets, compared to the repricing risk scenario. As the yield curve steepens – i.e.
the rate shocks increase from 100 bps in the first to 175 bps in the fourth bucket –
its NII losses mount vis-à-vis repricing risk. If the bank had negative gaps in the first
few and positive gaps in the later buckets, the converse would have been true.
Hence, the rate shock scenarios must be relevant to the bank’s balance sheet.

Similarly, if liability rates go up by 100 bps and asset rates increase only by 30 bps,
there is a double whammy due to basis risk. As it is, with negative repricing gaps,
the interest cost on RSLs was higher than the additional income on RSAs, even if the
rate shocks are equal. In addition, if liability rates rise more than asset rates, the loss
will increase further. This is how basis risk reduced future NII under the BPLR
regime. Finally, in a rising rate environment, 15% of all deposits beyond one month
are assumed to be prematurely withdrawn. If we suppose, for simplicity, that all
such deposits are taken out during the first month itself, we find a sharp increase in
rate-sensitive deposits and RSLs, in the first bucket itself. This wipes out the small

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positive repricing gap, which existed in the first bucket. Hence, the NII loss in other
buckets, due to a rate hike, is reinforced by the NII loss in the first bucket due to
options risk. The results are shown in Table 3. Similar examples can be created for
falling rate scenarios as well.

6m- Total
0m - 1m 1m - 3m 3m - 6m 12m Impact
Repricing Risk 0.13 -0.93 -0.80
Yield Curve Risk 0.13 -1.16 -1.03
Basis Risk -3.02 -1.79 -4.81
Options Risk -7.06 -1.12 -8.18
Table 3: Quarterly NII impact for Bank X as on ……

The interpretation of Table 3 is quite simple. For instance, let us understand what
the quarterly impact in the 0-1 month bucket (Rs. 13 lakhs), for repricing risk,
means. If rates increase by 100 bps and a surplus of Rs. 63 crores (as in Table 1) can
be reinvested after 15 days, the additional interest income for 2.5 months is Rs. 13
lakhs. As in Chapter II, we assume that all assets and liabilities are repriced at the
midpoint of a bucket. By the same logic, NII falls by Rs. 93 lakhs (for a reinvestment
horizon of one month) in the 1m-3m bucket. This loss increases to Rs. 1.16 cr., with
yield curve risk, as the shock in the second bucket increases to 125 (instead of 100)
bps. With basis risk, for every 100 bps of additional interest cost, the additional
revenue is only 30 bp. Hence, NII declines even in the first bucket. Finally, under
options risk, there are large negative repricing gaps in all buckets. Hence, the decline
in future NII is the sharpest. Therefore, as we move from repricing risk to more
realistic rate shock scenarios, the potential NII loss may increase.

The foregoing analysis may be improved in three ways. First, we may incorporate
the rate shocks proposed by RBI in 2013 and 2017, in the same framework, to
enrich the menu of scenarios. Secondly, we may consider the EVE impact of the rate
shocks to capture the erosion in net worth as well. Finally, the rate shocks may be
probabilistic – a combination of historical and subjective scenarios – to capture
better the impact of stress scenarios after prolonged calmness in financial markets.

4. Stress scenarios

Many recent crises have been triggered by liquidity distress. As short-term liabilities
became due, long-term illiquid assets had to be sold off at large losses or fresh
borrowing was made at high cost. This led to erosion in capital adequacy as well.

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Therefore, the global banking community has focused on the development of

forward-looking liquidity shock scenarios, for both assets and liabilities, which may
hurt NII and Net Worth.

On the liability side, these scenarios should capture premature withdrawal rates of
retail and bulk deposits. The former items are generally insured and likely to be
more stable. The latter products are uninsured and more vulnerable to market
swings. The renewal rates for deposits, at maturity, may also be much lower during
stress periods. On the asset side, such scenarios may capture a sharp drawdown in
committed credit lines, a large discount on distress sale of assets and delay in
scheduled inflows. The stress testing guidelines issued by RBI in 2013 suggest three
types of scenarios: baseline, medium and severe. These are illustrated in Table 4.

Baseline Medium Severe

Outflows
Partial Loss of retail/wholesale
deposits
Stable - insured and transactional 5% 10% 20%
Unstable 10% 20% 40%
Drawdown on committed lines
Credit facilities
Retail & Small business customers 5% 10% 20%
Non-financial corporates, PSEs and
MDBs 10% 20% 40%
Banks under prudential supervision 40% 70% 100%
Other Financial Institutions (OFIs) 40% 80% 100%
Liquidity Facilities
Non-financial corporates, PSEs and
MDBs 100% 100% 100%
OFIs 30% 60% 100%
Inflows
Bonds with rating AA-or higher 15% 30% 60%
Bonds with rating b/w A+ and BBB- 50% 75% 100%
Securitized Assets 25% 50% 100%
Equity shares 50% 100% 100%
Table 4: Runoff factors and haircuts under liquidity stress

The run-off factors for deposits capture the extent of premature withdrawal. Hence,
a scenario of 20% means that 20% of the deposits may be withdrawn before

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schedule, maybe over the next month, under medium stress. When they are insured
and linked to many transactions, deposit balances become stickier. However, high-
value deposits are more volatile and exhibit higher rates of outflows, ranging from
10% to 40%, depending on the degree of stress. The only issue with the guidelines is
that bulk deposits should be more unstable than retail products, since large
corporates and high-net worth individuals have easier access to attractive
investment opportunities. In other words, the run-off factors for bulk deposits
should be more than that of retail ones, just as Basel III suggests.

The other run-off factors pertain to the degree of utilization of loan commitments.
The higher the rate, the greater the demand for short-term liquidity. For instance, all
of a sudden, 10% - 40% of the undrawn limits given to non-financial corporates,
public sector enterprises (PSEs) and multilateral development banks (MDBs) may
be utilized. Since all banks and FIs are likely to face similar funding pressure, at the
same time, they are expected to draw down their limits with each other faster – to
meet such obligations. Hence, the run-off factors are higher for banks and OFIs. Off-
balance sheet commitments to the corporate sector may trigger contagious failure of
the financial industry. This is a problem which made many banks in the US and UK
collapse and forced the Fed Reserve and Bank of England to offer direct loans to the
corporate sector, when the Commercial Paper (CP) market froze from August 2007
onwards.

The haircuts on inflows capture the discount at which high to investment-grade

corporate bonds may be sold in illiquid markets. Again, the extent of MTM loss
increases with the fall in credit quality of the asset. Bigger haircuts on equities
simply reflect the residual nature of shareholder income and higher volatility of the
stock market. Finally, in the wake of the global financial crisis, securitized assets
also carry steep discounts.

A simple example on liquidity stress testing, based on the structural liquidity

statement (SLS), shows how such regulatory scenarios may be used. The SLS is
taken from the original stress testing guidelines of RBI, in June 2007. The initial
distribution of inflows and outflows, across maturity buckets, is given in Table 5.

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1d-14d 15d- 29d- 3m- 6m-1y 1y-3y 3y-5y > 5y Total

28d 3m 6m
Wholesale 30 40 50 40 50 10 10 0 230
deposits
Retail Deposits 90 140 200 310 300 190 140 200 1570
A. Outflows 120 180 250 350 350 200 150 200 1800
B. Inflows 100.00 150.00 200.00 200.00 300.00 350.00 250.00 250.00 1800.00
C. NET GAP (B- -
A) -20.00 -30.00 -50.00 150.00 -50.00 150.00 100.00 50.00
D. CUMULATIVE - - - -
GAP -20.00 -50.00 100.00 250.00 300.00 150.00 -50.00 0.00
Table 5: SLS for Bank X as on 31.3…..
We wish to examine the impact of a medium stress scenario, i.e. 20% premature withdrawal of retail deposits and 30%
haircuts on high-grade corporate bonds. We also assume that inflows in the first two buckets are only from sale of high-grade
(i.e. AA- or above) corporate bonds. The results of the stress test are shown in Table 6.

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1d- 15d- 29d- 3m- 6m-1y 1y-3y 3y-5y > 5y Total

14d 28d 3m 6m
Wholesale 30.0 40.0 50.0 40.0 50.0 10.0 10.0 0.0 230.0
deposits
Runoff for RD 0.2 0.2 0.2 0.2 0.2 0.2 0.2
RD withdrawal 28.0 40.0 62.0 60.0 38.0 28.0 40.0 296.0
Retail Deposits 386.0 112.0 160.0 248.0 240.0 152.0 112.0 160.0 1570.0
A. Stressed 416.0 152.0 210.0 288.0 290.0 162.0 122.0 160.0 1800.0
Outflows
Haircut on Inflows 0.30 0.30
B. Stressed 70.00 105.00 200.00 200.00 300.00 350.00 250.00 250.00 1725.00
Inflows
-
C. NET GAP (B-A) 346.00 -47.00 -10.00 -88.00 10.00 188.00 128.00 90.00
D. CUMULATIVE - - - - - - -
GAP 346.00 393.00 403.00 491.00 481.00 293.00 165.00 -75.00
Table 6: SLS for Bank X, under medium stress scenario, as on 31.3…..

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

Since we capture premature (i.e. before schedule) withdrawal, all deposits maturing
after the first bucket (i.e. 1 day – 14days) will be hit. From the second bucket
onwards, 20% of all retail deposits will flow out before time. For simplicity, let us
assume that all such jittery deposits are withdrawn during the next fortnight itself.
This adds up to Rs. 296 crores across all buckets. Therefore, the total outflow in the
1d-14d bucket is Rs. 90 cr. (i.e. the amount due as per table 3) plus Rs. 296 Cr.
worth of premature withdrawal. Hence, with 20% run-off, Rs. 386 Cr. worth of retail
deposits will flow out over the next 1 day – 14 days.

The analysis of stressed inflows is easier. Since the haircut on high-grade bonds is
30%, the resale (or market) value will only be 70% of face value, in the first two
buckets. In other words, inflows in the first two buckets are only 70% of what is
expected under normal conditions. As a result of higher outflows and lower inflows,
in stressed markets, the liquidity deficit (negative gap) is much higher in the first
bucket. This has to be reduced through creation of more short-term assets and/or
long-term liabilities. Such strategies will restrict the deficit(s) to board-approved
liquidity gap limits.

The previous example has three weaknesses. First, it assumes that liquidity stress
shocks are one-shot episodes. i.e. there will be premature withdrawal or distress
sales only once. However, liquidity disruption is often sustained, stretching over
months. Secondly, the probability of such severe shocks should be indicated – else
these scenarios may not be used in practice. Third, the reasons for large outflows
and reduced inflows, under normal and stressed conditions, should be investigated.
In other words, the underlying risk drivers - which may act as early warning signals
- should be identified. More advanced stress tests should consider such
improvements.

5. Contingency funding plan

A Contingency Funding Plan (CFP) is a cash flow projection of funding sources and
needs under various scenarios with liquidity disruption. It has to be prepared and
executed when the liquidity position is comfortable, so that enough liquidity may be
arranged. The benefits of a good CFP are as follows:
 Information flows are timely, uninterrupted and precise during a stress
event: If the indicators or risk drivers are well-defined, the weaknesses can be
managed better. The bank knows what may go wrong – there should be few surprise
elements.
 Division of responsibility is clear, so that concerned personnel know in
advance what is expected of them in a stress event: The senior and top management

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

can allocate responsibility for key actions themselves. Some of them may try to
persuade large creditors of the bank to roll over their liabilities, some may approach
large investors to infuse capital while others may attempt private placement or
issuance of bonds. There is no co-ordination failure even during severe stress
events.
 Strategies for altering asset and liability behaviour during stress, including
identification of assets which can be marketed more aggressively during liquidity
strain: Ad-hoc asset liquidation or market borrowing may lead to large MTM losses
or higher funding costs or both. If assets and liabilities are identified in advance,
panic will not set in, when liquidity tends to dry up.
 Relationships with liability holders, borrowers and counterparties, to source
funds better during a liquidity or credit event: These relationships must be
maintained and refined in the wake of financial crises, since even sanctioned lines of
credit may not be disbursed. There is enough evidence to suggest that large banks
and financial institutions, including those in India, could not obtain committed
credit lines during financial distress.

A good CFP should specify a number of triggers which indicate a situation of

abnormal liquidity in the near future, though there might not be any current funding
problems. These are like early warning signals for banks. For instance, the CFP can
be activated when six out of ten triggers are hit. The triggers can be both
quantitative and qualitative in nature. The following is a selective list of triggers for
the bank to consider as early warning signals for a CFP:

Bank-specific liquidity risk

These signals are for individual organizations.
1. Increase in spread on uninsured deposits, borrowed funds or asset
securitization: This shows that wholesale creditors and investors want a higher risk
premium. This may lead to less than expected renewal, premature withdrawal or a
sharp rise in funding cost.
2. Downgrade by a rating agency: This is often confirmation of bad news. It
makes the market question the ability of the bank to repay on time and may squeeze
the supply of liquidity.
3. Reduction in tenors lenders are willing to accept: Lenders may not be sure of
the bank’s long-run or medium-term ability to repay on time. They want their
money back earlier.
4. A decline in earnings: It may signal a future slowdown in growth of Tier I
capital, which erodes the buffer for uninsured depositors. This may prompt a future
withdrawal of such deposits.

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5. An increase in the level of NPAs or loan losses: Credit risk is the most
important source of long-term liquidity risk. If interest or principal is not received
on time, the bank cannot pay its depositors and other creditors as per schedule.
6. A decline in the bank’s stock price relative to the stock prices of similar
banks: If shareholder value is eroded, bank capital adequacy may be threatened.
This may expose uninsured depositors and other creditors to large losses.
7. Significant asset growth or acquisitions: It is often funded by excessive
borrowing and leads to sharp growth in low-quality assets. As these assets collapse,
the bank may fail to meet its massive debt obligations.

Systemic liquidity risk

These factors pertain to the entire banking sector.
 Significant volatility in exchange rates: May rule out cheaper borrowing from
foreign markets.
 An unexpected shift to a tight monetary policy: May lead to a sharp increase
in market rates and funding cost.
 Changes in macroeconomic variables like growth or unemployment rates,
which indicate prolonged recessions: May lead to dip in business activity and
escalation in future NPAs.
 Indications that an asset bubble might burst: May not only spike
industrywide NPAs but also reduce collateral value for the banking sector as a
whole.
 Preference for safest, most liquid assets in capital markets: Difficulty in
selling securities that are normally liquid, reduced availability of interbank funds
and system-wide increase in loan demand.
 Political instability and large-scale interference in lending and bank
supervision: May lead to deterioration in asset quality and future credit and
liquidity crises.

CFP Action Plans in a liquidity crisis

Bank-specific crisis:
In case the early warning signals indicate liquidity distress for a particular bank, it
can try to sell liquid securities in active markets at reasonable prices or raise long-
term funds at affordable rates. Since it is a bank-specific problem, market prices and
rates should not be affected.
 Use of stored liquidity in trading and other investment securities: Liquid G-
secs and corporate bonds may be sold.

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 Use of unutilized limits with NABARD, RBI and other institutions: Long-term
funds may be sourced from refinance institutions.
 Freezing of unutilized limits to borrowers: This is a rare step, taken in
extreme circumstances. May lead to reputation risk.
 Borrowing against collateral eligible in the repo market: If securities markets
are active, repo transactions with other banks (market repo) should be able to raise
sufficient cash, to tide over imminent problems.
 Arrangement of lines of credit with banks and other financial institutions: If
the bank is perceived to be solvent, other banks and FIs should be willing to lend
due to its good asset quality. Advance contracts should ensure a comfortable stock
of liquidity.
 Asset Securitisation: Similar to asset sales. The haircuts should be low, if the
markets are still active.

Systemic crisis:
If all banks have liquidity shortages, price of tradable securities could be low and
funding costs may rise. Individual organizations may not be able to help each other.
The strategies should be different, in such cases. This is where timing of the CFP
execution becomes very important. If a bank anticipates systemic trouble ahead of
others, it can still raise funds from liquid markets.

 Full use of refinance facility from RBI: Since market repo or borrowing is
difficult, the central bank should be approached as a lender of last resort.
 Deposit acceptance at differential rates of interest (DRI): This strategy may
be effective only if a few banks adopt it. If there is competitive pressure on liability
rates, individual banks may not benefit much.
 Incentives for prepayment of advances: This may be difficult to implement,
since borrowers may have to refinance themselves at higher rates.

6. Conclusion

A series of financial crises have led to more emphasis on stress testing practices,
especially for the neglected domain of ALM. However, the biggest threat to these
tests is psychological, rather than methodological or technological. It is often
assumed that past benign trends will continue forever, till crises strike. The need of
the hour is to conduct these tests and prepare for the unforeseen. The capital and
liquidity buffers create during good times will support the banks when markets
freeze. It may be too late, for unprepared banks, to protect themselves against large
shocks as and when they occur.

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

Module III: Management of Risk in Bank Portfolios

Section C: Operational Risk

Chapter 1: Loss Data Collection

Dr. Richa Verma Bajaj

Objective:

The objective of this chapter is to familiarize the participants with issue and challenges in
implementation of event and loss data collection program in banks.

Structure

1. Introduction
2. Internal Loss Data Collection programme
3. Definition of Material Losses
4. Important consideration for Loss Data Collection
5. Minimum loss threshold
6. Loss profiling
7. Grouped losses
8. Issues with internal loss data collection
9. External loss data
10. Sources of external loss data
11. Challenges with external loss data
12. Idiosyncrasies: An issue with operational loss data
13. Adjustments to external loss data
14. Loss Distribution Approach (LDA)
15. Challenges in data driven approach to managing operational risk
16. Multiple Choice Questions

1. Introduction
As the name suggests, internal loss data is the internal loss experience of a bank. It provides
insight into what has already happened in the bank and can help to predict where there
might be future losses. It determines when and in which part of the bank, what kind of loss
event has occurred, with what financial consequences. The database records and classify
loss events with High Frequency and Low [Link] ties operational risk measurement to

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

bank’s actual loss experience. It is collected by bank/financial services firm itself. Big
organizations use intranet based solutions ensuring the decentralized, but uniform input of
loss data. For this reason, they have documented procedures for assessing the relevance of
historical loss data. When a firm designs an appropriate loss data collection program, it is
important that the purpose of the program is understood as this will affect the approach
taken for management of operational risk.

2. Internal Loss Data Collection Programme

Which types of loss events to record must first be defined? Any event that meets the
definition "loss resulting from failed or inadequate people, process, systems and
external events" should be included in a loss database. When a bank determines what
should be included in loss reporting, it may include not only financial losses, but also it
would benefit from collecting information on gains, near-misses or losses that have a non-
financial impact (reputation impact) only. It is up to the bank to determine whether the
collection of such events meets the purpose of its operational risk event program. Many
firms have taken this broader approach to loss data collection and have, therefore, named
this program ‘Operational Risk Event Capture’ rather than loss data capture. The term
'calculation data set' can be used to identify the part of the institution’s internal
operational risk data that is to be used for the generation of regulatory operational risk
estimates and measures. Para 673 of Basel text broadly consider the following to qualify for
regulatory capital purposes, a bank's internal loss collection processes must meet the
following standards:

 Every event must be mapped to one of the seven Basel II level one categories.
 There must be documented, objective criteria for allocating losses to specified business
lines and event types.
 The loss data program must be comprehensive and capture all material activities and
exposures from all appropriate sub-systems and geographic locations.
 It must include all material losses (Direct losses and provisions should be recorded
completely) that are above a de minimis gross loss threshold, for example, €10,000, as
per RBI, not less than Rs 50000/-.
 Each loss data entry must include the following data: Loss amount, Date of the event,
any recoveries of gross loss amounts, Descriptive information about the drivers or
causes of the loss event.
 There must be specific criteria for assigning loss data that arises from an event in a
centralized function (e.g., an information technology department) or an activity that
spans more than one business line, as well as from related events over time.
 Credit risk-related events and market risk-related events should be collected and
flagged as boundary events. When using loss data as an input into a capital calculation,

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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune

credit risk boundary events can be excluded from the calculation, but market risk
events must be included.

3. Definition of Material Losses

As mentioned above the material losses are: (i) ‘rapidly recovered loss event’ to identify
an operational risk event that leads to a loss that is completely recovered in a short period,
(ii) 'near miss event’ to identify an operational risk event that does not lead to a loss, (iii)
'operational risk gain event’ to identify an operational risk event that generates a gain,
(iv)'multiple time losses' to identify a group of subsequent losses occurring in different
periods of time, but relating to the same operational risk event. An example of multiple
time losses is a large number of mispriced transactions arising from a single incorrect piece
of reference data or from a scheme to defraud using many small transactions. Multiple time
losses should be aggregated into a single loss before inclusion in the calculation data set.
(v) 'multiple effect losses' to identify a group of associated losses affecting different
entities or business lines, units, etc., but relating to the same root [Link] effect
losses should also be aggregated into a single loss before inclusion in the calculation data
set; possible exceptions should be documented by institutions and properly addressed to
prevent undue reduction of the capital figures.

4. Important consideration for Loss Data Collection

Thus, when collecting loss data it is important for the bank to consider following:
Who should report?

As operational risk-related losses can occur anywhere and at any time in the firm, it is
important that each bank defines clearand consistent responsibility for reporting such
losses. For the collection of loss data, all employees of the bank must be effectively
informed about regulatory definitions and in particular trained concerning their duties in
relation to the discovery and reporting of operational risk losses.

When to report?

It is clearly mentioned in Basel Text (Para 672), that, Internally generated operational risk
measures used for regulatory capital purposes must be based on a minimum five-year
observation period of internal loss data, whether the internal loss data is used directly to build
the loss measure or to validate it. When the bank first moves to the AMA, a three-year
historical data window is acceptable. That is why, it is appropriate to have a policy that
requires immediate reporting of an event to build the data base as suggested in Basel/RBI
guidelines. A bank can maintain an event database instead of loss database and they should
have a policy that identifies when a loss or an event recorded in the internal loss events

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database is considered for calculation data set or for risk management. This policy should
provide a consistent treatment of loss data across the bank/institution.

Where to record?

Most firms started their operational risk event capture programs in spreadsheets, and then
quickly realized that a more sophisticated and robust system is required for data capture.
However, many firms have determined that they need to build in-house systems to meet
their unique requirements. The majority of operational risk events leading to losses affect
the cost side of profit-and-loss account are principally to be found in the financial
institution’s documentation, in particular in the form of expense booking. Further sources
of information on losses from operational risk are: internal audit reports, minutes of board
meetings, complaints databases and so on.
Why to collect?
The purpose of an operational risk event collection program must be clear, and must be
part of awareness program in bank. The purpose of the data collection program is:
 Reveal weakness in internal controls and show where risk mitigation is needed
 Analyze and understand the causes of the largest losses
 Used to perform trend analysis
 Used in capital calculations

What?

A Basel II firm that pursues an advanced measurement approach, however, must adhere to
minimum requirements as mentioned in the accord. These requirements are a good
standard for any event/loss data collection program. The data points required for
operational risk measurement and management are: Organisational/Businesss
unit/process, Risk category, Date (Frequency) and Amount of loss (Severity) etc. As
guidelines clearly suggests that “A bank's internal loss data must be comprehensive in that it
captures all material activities and exposures from all appropriate sub-systems and
geographic locations”. The Data Fields considered here are:

• Population/Branch Size/Facility
• Risk Event Category
• Loss Event Category
• Date (Loss events occurrence, discovery, entry into the books, settlement)
• Business line
• Severity of Loss: Gross/Net, Recovery (Cash & Insurance)
• Boundary Issues
• Data Puddling Issues
• Threshold

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• Correlation
• Value adjustments: provisions, write-offs (date & amount)
• Data ‘puddles’ occur when the loss event being analyzed can be correctly classified
into more than one risk category. Example: The Officer breached the control limits
related to portfolio, sector or borrower unit. This event can be correctly mapped
into more than one event type i.e. Internal Fraud/ CPBP. But it has to be recorded
under one event type category for reporting purpose. So, if this is done intentionally,
the said event will be reported under Internal Fraud, otherwise as CPBP, as process
failure.

5. Minimum Loss Thresholds

Para 673 of the Basel text present that a bank must have an appropriate de minimis gross loss
threshold for internal loss data collection, for example €10,000. The appropriate threshold
may vary somewhat between banks and within a bank across business lines and/or event
types. However, particular thresholds should be broadly consistent with those used by peer
banks (para 673). For institutions just beginning the collection process, it is better to collect
everything initially and during the modeling phase a threshold can be determined. Thus, a
bank can have different threshold for data collection and capital measurement. This way
the threshold can be different for each unit of measure (i.e. event-wise or line of business)
and the choice can be [Link] data should be collected above a specified threshold
and stored with a certain confidentiality [Link] may be a threshold over which
reporting is mandatory, for example, $10,000, or a zero threshold might be adopted, which
require all events to be recorded. The details that are required for each loss data entry will
be driven by the purpose of the loss data program. Thresholds are the minimum loss
amount recorded above a level. The points considered while defining the threshold are:
 Meant to reflect regular and expected losses
 Typically range from $500 to $100,000, Not more than Rs 50,000 (RBI)
 Impact to regulatory capital must be accounted for
 Impact mainly on EL (expected losses) rather than UL (unexpected losses)
 Reflects to certain extent the internal control
 Some FIs may aggregate (grouping) the losses below the threshold regularly for
ORM
 Threshold for business line with large no of small losses should be lower
 Better to have Low threshold for Risk Management
The threshold fixed by the bank may be broadly consistent with those used by the peer
banks and it should be fixed in such a way that the bank collects detailed information
relating to at least top 95% of the operational losses of the bank. (TSA Guidelines, 2010).

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6. Loss Profiling

It is possible for the banks to do loss profiling according to regulatory requirements (BLET
matrix), or bank-specific requirements like according to branch type, size, event category,
product wise etc for internal control purposes. This is detailed as below:

 To meet the Regulatory Requirement: To study Losses per Business Lines across
Event Types (56 – BL*ET) ( Profile of Business Line and Event Type-wise Losses)

Exhibit: Business lines and Event Type Matrix

Loss Event Internal External Employment Clients, Damage Business Execution
fraud fraud practices & products to disruption delivery and
Workplace and physical and process
Business Line Safety business assets system management
practices failure
Corporate finance
Trading and sales
Retail banking
Commercial
banking
Payment and
settlement
Agency services
Asset management
Retail brokerage

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 Profile of Operational losses in accordance with the Branches of various Size &
Location: For example: Profile of Losses in branches of various Size & Population
Category

BRANCH SIZE

Category ELB VLB Large Medium Small Total

Year 1
Year 2
Metro Year 3

Year 1
Year 2
Urban Year 3

Year 1
Year 2
Semi-Urban Year 3

Year 1
Year 2
Rural Year 3

Year 1
Year 2
Total Year 3

Profile of Losses on the basis of Basel Assets Class

• Under Basel II, risk weights vary depending upon Assets Class. The broad
classification is ‘Wholesale Banking’ and ‘Retail Banking’. RBI guidelines suggests
that the mapping of activities into business lines for operational risk capital
purposes must be consistent with the definitions of business lines used for
regulatory capital calculations in other risk categories, i.e. credit and market risk.

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Loss Data Collection Exercise, 2008

60
50
40
30
20
10
0
Corporate Finance

Agency Services
Retail Banking

Retail Brokerage
Commercial Banking

Assets Management
Payment and Settlement

Unallocated
Trading and Sales

Frequency (%) Severity (%)

7. Grouped Losses

A bank must be able to justify that any activity and exposure that is excluded from the
database, would not have a material impact on the overall risk estimates. Thus, it is better
for the bank to group small losses below the threshold for ORM. The question of concern
here is how to treat the losses Caused by Common OR Event. Between Date of First Loss
and Latest date, which date to consider. The experience suggests that latest date is a better
representative of risk profile in such [Link]: A Natural disaster causes losses in
multiple locations and/or an extended time period

• For the Losses with no causal relationship, but with common features(Basel
guidelines, AMA)

Example 1: Credit card fraud-related losses discovered during a given period are grouped
together and recorded in the loss database (total number and total amount of losses are
recorded).

Example: A natural disaster hits its three branches over a week and damages each of them,
resulting in an €8,000 loss for each. However, each branch did not report its loss because
its damage was below the €10,000 threshold. As a result, the loss that would have
amounted to €24,000 in sum was not used in their risk calculation, although the bank has
the policy of using all the losses that are greater than €10,000.

8. Issues with Internal Loss Data Collection

The losses are about past. The question of interest here is: How many years of OLD LOSSES
should the bank consider in capital measurement? As old losses tend to be less
representative over time as the risk profile of a bank changes, and thus, their risk and

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control environment, therefore, some banks phase out the old losses in capital
measurement. Same was pointed out by Deutsche Bank’s through their paper LDA at Work.

Though, the experience suggests that internal loss data is not available in sufficient
quantities in most banks to permit a reasonable assessment of exposure, particularly in
terms of assessing the risk of extreme losses. Therefore, The Basel text present that the
weaknesses surrounding internal loss data can be addressed by integrating the other data
elements (external loss data, scenario analysis and BEICFs).

9. External Loss Data (ELD)

The internal loss data collection is by definition only a small sample of the universe of
possible losses. Major losses are typically rare but are important for determining potential
risks or losses. ELD provides information on potential areas of risk exposure or control
failures based on other banks/industry loss experience. The bank’s operational risk
measurement system should use relevant external data, when there is reason to believe
that the bank/institutionsare exposed to infrequent, yet potentially severe losses. That is
why; ELD is used for collection of Low Frequency and High Severity Events (LF/HS). ELD is
needed to understand the tails of OR loss distribution to adequately quantify unexpected
losses/potential losses not reflected in internal data in terms of: areas of loss and extent
of losses. This is how ELD adds value for operational risk management purposes?

Events that occur outside a firm can provide insight into risks that a firm faces, and can
provide valuable input. External events are often of great interest to senior managers. Bad
things that have happened to other people can generate healthy discussion about the
operational risk exposures that exist in a firm, and so these should be included in regular
reporting. For example, operational risk events that have occurred in a certain industry
may provide examples for a firm's scenario analysis and risk and control self-assessment
programs.. As with internal events, when designing an appropriate external loss data
program for a firm, it is important to understand the purpose of the program as this will
affect the approach taken. Under AMA, external losses can be used as a direct input into a
capital model for a Basel II firm.

10. Sources of External Loss Data

Basically there are two possible sources of external operational risk event data:
- Consortium Data (Data Sharing)
- Public Data (Outside vendors)

10.1. Consortium Data (Data Sharing)

External loss data, i.e. an operational losses experienced by other banks, are collected by
data consortium. It covers all losses, not all firms. Consortium initiatives are generally set up
by Banks or joint venture between banks. This data sharing initiatives bring together the

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collected loss data of member banks in standardized, anonymous and quality assured form.
The Banks’ should provide data which are classified in a homogeneous manner and contain
information which is comprehensive and [Link] data is often collected and
distributed, through extranet, above thresholds established internally by the member
banks. This requires, in addition to defining the scope of loss data, agreement on a common
structure (organizational units and risk categorization). The internal data of each bank
must be translated into this [Link] information, thus, obtained through consortium
initiatives can be considered an appropriate external data source for capital calculation
purposes, particularly when Banks have limited internal loss data, e.g. on new businesses.

Example of data consortium

Following competing data consortia with different approaches are worthy of mention as
examples:
(i) the Global Operational Risk Loss Database (GOLD), in Great Britain, is an attempt
initiated by the British Bankers’ Association to bring together a rather large
number of banks, the majority of which are British, with consciously low
qualitative standards and at low cost. The reporting threshold is USD 50,000.
(ii) The Operational Risk Data exchange (ORX), in Switzerland, is an international
association, made up of a number of large banks was set up in 2001 and has 22
members (12 founding members with a similar number of members having
joined in the meantime) with high quality standards. The reporting threshold is
EUR 20,000.
(iii) Database Italiano delle Perdite Operative (DIPO) in Italy. It is founded by Italian
Banking Association Associazione Bancaria Italiana (ABI) in the year 2000. It
included 32 banks and banks group at the end of 2003. The reporting threshold
is EUR 5,000.
(iv) Others are: in Germany (Verband offentlicher Banken – VOB), Luxembourg
(Association des Banques et Banquiers de Luxemburg – ABBL) and Italy
(Associazione Bancari Italia – ABI) etc.
(v) In India, CORDEX by IBA.
The exchange of external loss data permits benchmarking operational risk event data with
comparable member banks (peer group). In addition to their utilization in quantitative
analyses and modelling, external data may also provide food for thought by raising, for
example, the question whether existing controls would provide effective protection against
certain events or whether reporting mechanisms are sufficient to detect such events. Thus,
external data may also contribute to improving qualitative risk management.

Consortium- Requirement

• Confidentiality relating to data among the member banks and strictly anonymous
information

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• Consistency of the data recording is important. Input data on comparable loss

events, data fields name should be easily understood
• Consortium to haveflexible structure to incorporate future developments such as
change in categories or amendments due to new risks.

10.2. Public Data

The second source of data is external public data. Where external data from consortium are
insufficient for obtaining information on severe tail events, especially on their causes,
public sources could provide useful additional [Link] covers all firms, not all
[Link] captures most extreme losses, with low frequency but high severity. It contains
more descriptive information on loss events, underlying causes, and control failures. This
involves systematically seeking out publicly known losses in online or print media
(journals and newspapers) and recording them in a standardized [Link], losses of
about €1 million and upwards are recorded in such databases. This can either be searched
for by each institution itself or purchased from commercial suppliers. In addition, there are
several providers of operational risk event information, which include SAS and
Algorithmics Fitch First, that offer fee-based operational risk event data [Link],
external public losses represent only a small part of the losses that have actually occurred.
Not all categories of risk are equally well represented, since some types of loss reach the
public more easily than others. Since the information is not first-hand, the loss amounts
notified also tend to be unreliable.
10.3. Insurance Data

Additionally, databases with information about insurance settlements for operational risk
events are on offer. It represents losses that have been submitted as claims to insurance
companies. These data are captured only in risk class where the insurance company has
offered insurance coverage. Aon is the only vendor and maintains confidentiality relating
to identity of the firm.

11. Challenges with external loss data

There are following challenges with external data:

 External loss data ignores relevant characteristics (size, thresholds, Business lines
etc) of the firm.
 Large losses are easily available in public domain than the smaller ones, such as
large scale frauds, with less coverage on less salacious events, such as systems
outages.
 It is difficult to integrate internal and external risk data, since these capture
different risk characteristics of losses.

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12. Idiosyncrasies: An Issue with Operational Loss Data

Internal loss data appear insufficient and external loss data is affected by reporting biases
and numerous idiosyncratic factors. Thus it is important for an operational risk manager to
answer: How can external loss data be relevant to the his bank in the presence of following
idiosyncrasies or inherent bias?

 Scale (Size) Bias – Operational riskdepends on the size of the bank, i.e. the scale of
operations. Larger Banks (and businesses) are likely to experience more losses than
smaller Banks, in case there controls are weak. In Deutsche bank case, no such
relationship was observed
 Control Bias – Banks with weak controls are more likely to be represented in the
database because they experience more losses. These Banks are likely to experience
more large losses.
 Truncation bias: banks collect data above [Link] thresholds varies
depending upon bank’s loss experience and expert judgement.
 Institutional Culture Bias – More aggressive Banks (and businesses) are likely
toexperience more losses (large losses) than less aggressive Banks.
 Infrastructure/Technology Bias – Less technologically advanced Banks (and
businesses) are likely to experience more losses than more advanced Banks.
 Legal Environment Bias – The legal system in certain countries may lead to more
frequentand/or larger losses.
 Data capture bias: particularly in case of publicly available data.
Thus, the above mentioned problems relating to the use of external data are their logical
classification and scaling is required while using external loss data. A loss that can be easily
borne by one bank may threaten the life of another bank.

13. Adjustments to External Loss Data

Differences in the size of banks or other institution specific factors should be taken into
account when incorporating external data in the measurement system, for example by
making assumptions as to which external loss events are considered relevant depending
upon bank’s business size and nature and on whatlevel the data should be scaled or
otherwise adjusted. Different factors may be used for Scaling, e.g. balance sheet total
(assets size), expenditure or income (sales, revenue), with different factors being relevant
for different business lines or Scrubbing i.e. deleting data points that overlap with internal
data. However, since suitable data are only available to a certain extent, pragmatic
solutions are needed in this context for quality output. For example, in Deutsche
Bundesbank – German Banks/Institutions use those losses that have occurred in business
lines that they also have at their banks.

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14. Loss Distribution Approach (LDA)

After the loss data is collected, the capital (Operational Value at Risk – OpVaR) is computed
using LDA approach. Following steps are involved in capital charge calculation:

1. Emphasis on computation of regulatory capital on historical loss data

2. Modeling the distribution of ‘Frequency of events’

3. Modeling the distribution of ‘Severity of loss’ experience when an event occur

4. Combining the frequency and severity information to derive an aggregate loss

distribution (Monte Carlo Simulation)

5. More risk sensitive, as bank can select their own distribution to estimate UL

However, LDA does not indicate causes of underlying risk, thus, BEICFs are considered as
an important input providers to understand causes.

15. Challenges in data driven approach to managing operational risk

 Bank officials are reluctant to disclose losses and especially near misses, to avoid
any action. Thus, this clearly impedes the ability of the banks to collect such data.
 Infrequent events are hard to estimate since by their very nature it is hard to collect
much data about them.

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Module III: Management of Risk in Bank Portfolios

Section C: Operational Risk

Chapter2. Risk and Control Self-Assessment

Dr. Richa Verma Bajaj

Objective

The objective of this chapter is to view the framework of implementation of RCSA program
in banks.

Structure

1. Introduction
2. Benefits of RCSA to firms
3. Framework of Self-Assessment
3.1. Risk assessment
3.2. Control assessment
3.3. Net risk assessment
3.4. Self assessment is quantitative or qualitative
3.5. Scope of self assessment
3.6. Impact evaluation
3.7. Number of levels for risk assessment
3.8. Structuring a self assessment
4. Requirements for self-assessment
5. Summary

1. Introduction

Risk Control Self-Assessment (RCSA) is risk assessments and internal control evaluations
conducted by operational employees or manager who work in the area (product/business
line/organization) being evaluated. It is also called as self-assessment, control self-
assessment etc. the objective of self-assessment is to identify, measure and monitor the risk
and control, the firm is subject to. Self-Assessment covers:

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(i) Risk assessment, the process of identifying (through questionnaire and

workshops) and assessing risk within a business unit. It is done through
assessment templates, which, assesses frequency and severity of loss,
(ii) Control assessment evaluates the effectiveness of controls that are in place to
manage these risks. It is done through assessment templates (design and
performance) to understand the residual risk profile of unit.

The Institute of Internal Auditors (IIA) defines CSA as a process through which internal
control effectiveness is examined with the objective of providing reasonable assurance that
all business objectives are met. The basis of CSA is that the employees and line managers
have the best view on the effectiveness of controls and the risks of circumventing control.
Therefore, CSA is completed by them, not by the auditors. CSA are typically carried out via
questionnaires or by facilitated meetings or interviews. RCSA can be qualitative and
quantitative. A qualitative assessment will be based on judgement such as high, medium or
low risk. In contrast, quantitative RCSA will assess the risk identified through actual
numbers, such as likelihood or probability in percentage and impact or severity in
monetary values.

2. Benefits of RCSA to firms

The benefits of RCSA are as follows:

a) Clearer understanding of Bank’s overall Operational Risk Profile
b) Accurate information regarding level of risks the business is exposed to
c) Identification of potential risk and control failures
d) Communication of firms risk profile through heat maps
e) Proper documentation of risk and controls failures for required action plan and
for use of external stakeholders like regulators

3. Framework of Self-Assessment

3.1. Risk Assessment

It is a tool that helps identification and, to a limited extent, even quantification of

operational risk. Risk assessment picks up where loss data collection leaves off. Indeed, it
helps fill the knowledge gap left by backward looking and often sparse loss data and
attempts to establish risk-sensitive and forward-looking identification of operational risk.
Risk assessment provides banks with a qualitative, quantitative or both approaches to
identifying potential risks of a primarily severe nature by conducting structured scenarios
with representatives of all business units. The resulting risk profile presents a high-level
overview of risk areas which endanger the survival of the bank or business unit graphically.

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Present high level overview of risk areas: Risk Profile

Impact Catastrophic
Very High
High
Moderate
Minor
Remote Unlikely Possible Likely Frequent
Likelihood

3.2 Control Assessment

Controls have been developed to facilitate action to reduce either the likelihood or impact
of a risk event. The effectiveness and efficiency of internal controls is a key concern in
managing operational risk. Controls are evaluated in terms of its design and performance.
The design of a control is reflection of the systems or processes underpinning that control
(KYC guidelines is a control that is design), whereas, the performance of a control
(implementation of KYC guidelines) is often about the people operating the control. Control
assessment expands risk assessments by highlighting existing or additionally required
controls for mitigating the key risks [Link] failure of the risk management system
is, in itself, an operational risk. Effective internal controls should include:
 Clear reporting standards
 Segregation of duties
 Detailed operational procedures
 Penalties for non-compliance
 Rapid response to problems and potential risks.
Managersworking in the area (product/business line/organization) are responsible for
reviewing and assessing their own department’s compliance (performance) with
operational risk management procedures (design). The knowledge gained from self-
assessments can be used in conjunction with internal and external audits to identify,
analyze, and correct deficiencies in the risk management system. If control gaps exists, the
RCSA workshops (discussed later in chapter) may develop suitable measures and action
[Link] Cause-Event-Effects/consequences linkage (Refer chapter-1), Cause and
Effects provide risk mitigation strategies.

3.3 Net Risk Assessment

Net or residual risks are those risks whose occurrence is measured taking into account all
existing and relevant risk mitigating measures or controls. They represent a consciously
realistic evaluation of the current risk potential, taking into account all existing risk

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management measures. These can include process inherent, preventive (system checks to
prevent limits being exceeded) or detective controls (frauds monitoring or reconciliation
and monitoring of accounting enteries), or risk mitigation on a higher level such as
insurance or business continuity management. More elaborate risk assessments differ
among risk categories, inherent and residual risk and aim to assess the quality of risk-
mitigating measures. It determine Net Risk (Inherent Risk (L/I) – Controls (D/P)) of a
process, business lines or activity.

3.4 Self-Assessment is Qualitative or Quantitative

Risk assessment describes a method or programme aimed at the qualitative assessment

(Low, Medium and High) and quantitative assessment or evaluation of operational risk.
Even though the result may be numeric, the assessment is based on subjective estimates by
individuals or groups. The result cannot be objectively observed, measured or derived,
unlike loss data or indicators. Generally, Scorecards are used for translating the qualitative
evaluation obtained in a self-assessment into quantitative parametersfor assessing loss
frequency and severity in order to rank the risks and identify the key risks. Following
shows the qualitative and quantitative ways of conducting self assessment. It is on the bank
to decide which methodology they are comfortable to:

Example : 1:Home Loan- Self Assessment

Category Risk Drivers Significant/ Risk* Impact** Risk

Insignificant Score
People Inadequate Staff 2 3 6
Knowledge
Process Not following 3 4 12
System/Procedures
Pre-sanction Fake ITR/Salary Slip Fake 2 3 6
Documentation KYC document/ID proof 2 4 8
Fake allotment letter 2 4 8
Over valuation from Valuer 1 5 5
Incorrect Opinion Report 1 5 5
Post Sanction Documents Inadequate 1 4 4
Documentation Multiple Financing 3 4 12
*Risk: (1-VL, 2-L, 3-M, 4-H, 5-VH)
**Impact: (1-VL, 2-L, 3-M, 4-H, 5-VH)

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Example :2:Branch Banking

Probability (Frequency): L: 0-10%, M: 10-60%, H: 60-100%

Severity (Impact): L: 0-1 Lakh, H: 1-5 Lakh

Control Effectiveness: Effective, Poor

Inherent Control Residual

Risk Effectiveness Risk

P I P I
1. Account opened with forged KYC document M H E L M
2. Due diligence not followed at Branch Level M L E L L
3. Misselling by manager M L P H L
4. Cash Shortage at time of disbursement (Cash not tallied) M H E L H
5. Intention Transfer (Account to Account Transfer, M H E L H
inoperative account)

3.5. Object/Scope of Self-Assessment

RCSA aims to capture the risk and controls of a firm at appropriate level. Thus, the objects
of an assessment should be selected in such a way that the assessment includes all relevant
or key areas (processes, product and organizational units as a whole) of a bank to be
examined. The comparison of different risk assessments are as below:

Object and Suitable for Used by which bank

Scope

Processes Strongly process-oriented Bank which have sufficient experience to

organizations with few core conduct self-assessment at each process
processes or many similar processes level (more granular in nature)
capable of being standardized
Products Strongly product-driven Helps to link process level self-
organizations with few support units assessment into product level, which
or processes with small risk content leads to business line-wise self-
assessment in line of regulatory
compliance

Organizational Conventionally structured banks Best choice, if the bank is new to conduct
units with business lines, central self-assessment exercise (less granular,
management areas and service areas top-down way of conducting assessment)

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3.6. Impact Evaluation or Risk Aggregation in Absolute value/range

Absolute value means defining risk in absolute numbers for various business lines (in
terms of size of loss) in following ways:

Value

BL1 (small, Retail Banking) BL2 (large, Trading and Sales)

>500000 >50000000

250000≤500000 10000000≤50000000

50000≤250000 1000000≤10000000

10000≤50000 100000≤1000000

<10000 <100000

Whereas, relative values involves qualitative assessment of risk, i.e. classification of risk of
various business lines, in terms, of: low, moderate, high, very high, and catastrophic.

When it comes to aggregation of risk at bank level. The experience suggests that absolute
value presents a better picture at bank level, by differentiating risk of one business line
(treasury) from another (Retail) in terms of operational risk exposure of respective
business line. Relative ranges (L, M, H, VH, C) at business line level doesn’t differentiate the
risks of two business line properly. For example, if the risk level is Very high (VH) for both
business lines. Actually, Very High risk in Treasury is big operational risk in bank in
comparison to very high risk in Retail.

3.7. No of level or ranges for risk assessment

The risk evaluation can be performed in one or two dimensions. In the case of gross and net
risks, usually impact and likelihood will be assessed. Evaluation of control quality either
takes place in one single dimension or with simultaneous evaluation of their efficiency
and/or effectiveness or through design/performance. Both risks and controls are usually
evaluated in discrete form using multilevel scales with ranges. Banks normally consider 10
levels to assess the risk level, whereas 5 levels are considered manageable. In addition,it is
advisable to use even ranges than odd ranges to get quality response.

3.8. Structuring a Self-assessment: Forms/Instruments of Self-Assessment

 Structured Questionnaire
- Distributed through intranet
- Easy data recording

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Illustrations
Risks ( Level III Loss Events ) Significant
Risks in record maintenance
Causal factor: negligence pressure of work or lack of knowledge YES NO
In/ out register for record with proper acknowledgement not maintained
Destruction of obsolete documents/ drafts/ cheque books not carried out
Missing / Loss of vouchers
Improper filing of vouchers

A survey is carried out before workshop, so that workshop may concentrate on

significant risks, controls and processes

 Workshops
- Enables the sharing and discussion of risks relating to a particular business units or
processes. The team involved in the workshop is able to spend time agreeing on the
risk and debating the impact and likelihood of each risk.
- Contributes to raising awareness and communicating risks across different
organizational units
- Identify and evaluate processes and very important when new products are
introduced and organizational changes takes place.
- The major drawback of workshop is that it requires coordination among all
members

 Interviews: These depends upon corporate culture and participation of senior

management. They are efficient in the use of time required initially as each person
usually able to assess the relevant risks quickly. However, a second round of
interview is often required in order to combine risk assessment with each
[Link] rounds of interview are a time-consuming task.

Whatever way (among above three), the organization conducts self-assessment, it is

important for us to understand that these assessment aresusceptible to various forms of
bias, either in the question being asked, the experience of participants, the seniority of
participants etc.

4. Requirements for self-assessment

 Participants in workshop or interview should be familiarized with the operational

risk definition adopted by the bank and bank’s operational risk management
framework.

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 Self-assessment should be performed at regular intervals (Large banks- once a year

and small banks – at least when major changes takes place like restructuring or
taking the new business lines)
 Danger of Fatigue Effect. This can be avoided by changing the membership of the
group and by inviting the employees who can contribute a new perspective in self-
assessment.

5. Summary
RCSA is an important concept of impact and likelihood assessments, which can deliver
quick benefits to risk owners. It helps in identifying the appropriate risk and controls, as
highlighted below and discussed thoroughly in chapter.

Illustration

Risk Source Risk Control

Incorrect Cash Position Daily Cash Reconciliation

Failure to Follow up claims Proper Monitoring Procedure

Failure to safeguard data secrecy Reporting through secure means

Know your client failures Proper ‘KYC’ check should be made

In general, this is how RCSA format looks like

Risk Level Risk Risk Mitigation Risk Impact

Trend

High Increasing Strong Significant

Moderate Stable Acceptable Limited

Low Decreasing Weak Nominal

For the results of RCSA to be effective and consistent, it is important for RCSA to be linked
with objective at each level of business processes or [Link] needs to be clarity
about the level of both risks and controls and especially about whether the things being
assessed is cause, event or effect. Normally, cause and effects are considered for control of
an operational risk event. RCSA are normally used in conjunction with other operational
risk elements i.e. loss data, risk indicator and scenario analysis.

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Module III: Management of Risk in Bank Portfolios

Section C: Operational Risk

Chapter 3: Key Risk Indicator

Dr. Richa Verma Bajaj

Structure
1. Introduction
2. Sources and Characteristics of Effective Key Risk Indicators
3. Types of Indicators
4. Framework for Key Risk Indicators (KRIs) Identification
5. Conclusion

1. Introduction

More recently, the banking industry has begun to devote attention to improving tools used
in hands-on management of risks and, as part of that effort, more importance has been given
to ‘indicators’ of areas of higher risks and losses i.e. Key Risk Indicators (KRIs). KRIs can act
as indicators, which can be predictive regarding changes in the risk profile of a business (for
example, staff turnover). This enables timely action to be taken to deal with issues arising.
This is what, is the central task of operational risk management, to recognize the changes in
the risk potential that can lead to losses and to take measures that prevent the occurrence of
losses with a high degree of probability. Every bank should assess operational risk based on
KRIs that may provide early warning signals on systems, processes, products, people and
broader environment. KRIs needs to give a direct measure of the extent or likelihood of
failure in one or more resource/driver. Like loss data, KRIs are based on existing data, such
as certain ratios. KRIs are ratios that are capable of providing information about factors that
determine risk. The most important criterion for the suitability of ratios as risk indicators is
their early warning character. For example, a count of pending lawsuits is useful only when
an increase in this count is accompanied by an increase in the number of actual losses.

A key requirement of such risk indicators is the provision of ex ante information (warning
concerning future losses) instead of ex post information on losses that have already occurred
(such as is gathered by the collection of loss data). Unlike loss data, KRIs do not look at the
“face value” of information (assuming history may be repeated), but seek to predict certain
future behavior (for example, staff turnover – not representing actual losses but potential

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future losses, should certain key personnel and knowledge be lost). Identifying relevant KRIs
can be a complex endeavour, as the assumed correlation with actual exposure can only be
determined over time using internal loss data. Banks may need to combine several primary
or directly available indicators to achieve the desired early warning information. The key
features of KRIs are that they:

 Highlight the level of current risk of the bank by providing a measure of the status of
an identified risk and the effectiveness of its control.
 Highlight something observed or calculated: Kris have the ability to express an
identified operational risk factor or dimension in a numerical time series and used to
identify a condition or trends and changes in risk level by monitoring changes in
RCSA;
 provide early warning signals something such as a “light, sign, or pointer”:
through predictive risk indicators, before they result in loss. These indicator helps the
bank in proper risk rating to aid effective decision making
 enable actions that prevent or minimise material loss or incident by prompting
timely action on early warning signals;

Overall, KRIs are measures which indicate the level of and changes in an organisation’s
risk profile. This is achieved by focusing KRIs on the root causes of potentially significant
risk events and exposures, called as Causal indicators. These indicators are metrics that are
aligned with root causes of the risk event, such as system down [Link] is why; RCSA
output is an important input for identifying key risks in a bank.

2. Sources and Characteristics of Effective Key Risk Indicators

The development of effective KRIs is a key challenge for most Banks. Financial institutions
usually have an abundance of credit risk and market risk indicators, but they are challenged
in aggregating this data as well as developing operational risk indicators. The following (non-
exhaustive list) provides some sources of information that can help to identify significant
risks and aid in KRI identification:

 Regulatory inspection findings - Policies and regulations: These KRIs may

include risk exposures against limits or compliance with regulatory requirements
and standards.
 Strategies and objectives: The corporate and business strategies established by
senior management. KRIs should be designed to measure downside risk or volatility
of performance.
 Historical internal loss events and incidents: Many companies have compiled
loss/event databases that capture historical losses and incidents. These databases

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can provide useful input on what processes or events can cause financial or
reputational loss. KRIs can then be developed for these processes and events.
 Risk and control self-assessment results: Risk assessments performed by the
company--including audit assessments and control self-assessments can provide
valuable input on the business entities, processes, or risks where KRIs are needed.
In addition, Internal/external audit findings and Workshops/discussions with business
functions e.g. Human resources (including staff turnover statistics) are important
sources of KRIs.

3. Types of Indicators

3.1 Leading Indicators/ Likelihood Indicators

- These indicators are able to show when risks are more likely to occur

- They can give early warning signals before risks happen

- Examples
- No of credit facility application approved based on financial reports older then
threshold,

- No of Portfolios without guidelines

3.2 Lagging Indicators

- Indicators about the impact of a risk event

- Tell about the effect of the risk when it has happened,i.e. likely size of the impact

- Examples
- Total number of frauds at branches
- No of stolen card reported

4. Framework for Key Risk Indicators (KRIs) Identification

• KRIs are Ex ante

Loss data is ex post, whereas, KRIs are ex ante or forward looking. For identifying
suitable indicators, it is better to take help of knowledge of the employee involved in
the processes in the individual business lines. Brainstorming the possible
determinants of the various risk categories in a small group has proven useful.

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• Frequency of indicator collection

Regular collection is necessary for the implementation of a risk-indicator system.

Some banks rely on at least semi-annual (and mostly monthly, daily in the case of
Treasury) collection process by which part of the information is collected from
supplier systems by appropriate database queries, further processed in spreadsheets
if required and entered into a suitable software tool. Depending on the degree of
granularity, collection in a centralized or decentralized manner makes sense.

• KRI thresholds: One sided/two sided

The next step is to determine which values of the risk indicator are uncritical, from
which threshold, a warning signal should be triggered that should lead to a review of
the situation. When determining such thresholds, the risk appetite of the individual
decision maker is important, in addition to the experience of the experts involved.
“Traffic-light” systems have proved useful in this context. For this purpose, the
deviation of the actual value of a risk indicator from the fixed threshold values can be
evaluated mathematically. It is on the firm to decide whether they want KRIs
threshold to be one sided or two sided. Each is explained with the help of an example:

- Example- KRI’s for Staff Turnover- One Band

Tolerance thresholds

- Below 15 percent – No Risk

- 15 % to 25 % - Potential Risk
- Above 25 percent – Significant Risk

Heat Map

Thresholds (%) Risk Level

Below 15

15 to 25

Above 25

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Bands on Both the sides- Loss of key staff

Red Amber Green Amber Red

Under 5 % 5% - 9% 10%-15 % 16% - 20% Over 20%

This indicates that if the turnover is above 20 percent, the bank is losing their talent and in
case the staff turnover is below 5 percent, the bank is not getting fresh talent. Thus, two band
indicates the risk at a more granular level.

• KRI Reporting

Finally, a reporting system should ensure that the relevant decision makers are
supplied with suitable information for deducing corresponding measures. It seems
thereby advisable to depict, in addition to the relevant current values, the historical
development – both for individual indicators and for an aggregated view – so that
trends can be recognized. For example, trend from green zone to amber zone. KRIs
can be useful, only if, they are directionally correct most of the time, rising, falling and
staying steady with the risks and losses there track. Today, KRIs are defined
differently among banks. If the relevant KRIs are periodically and routinely tracked,
the resulting data can be used to estimate the probability of an event. This will
ultimately help in capital calculations.

• Test of Effectiveness of Risk Indicator

Risk indicator systems need to be examined regularly so as to their suitability against

the background of accumulated experience. It may be necessary to replace or adjust
individual risk indicators or to modify the threshold values associated therewith over
a period of time by the risk manager. Ideally, a test of the effectiveness of the risk
indicator system should be made by analyzing its correlation with losses incurred.
Assuming that adequate measures were introduced on reaching red or amber traffic
lights, it should be possible to observe a reduction in the number of losses incurred.

As discussed in previous chapter on RCSA, about self-assessment for Home loan and Branch
Banking, this chapter provides information about the risk indicator (illustrative) for the two.

Home Loan-KRIs

• No of Frauds in Housing Loan Reported

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• No of instances system and procedures not followed by staff as identified in Audit

Report

• Attrition Rate

• Disciplinary cases against staff

• Rapid growth-Teaser Home Loan

Branch Banking

• No of cases rejected by bank of breach of forged document (90/100) = 90%

• No of times transactions not tallying each day

5. Conclusion
An important objective of key risk indicators is to provide a measure of risk causes in
addition to the effects of risk, so aiding robust risk management and enabling timely action.
Key risk indicators play an important role in: Risk management –help identify process
and/or control weaknesses and thus enable action to be taken to strengthen controls and
resolve issues. It also helps the bank in Risk appetite setting, i.e. risk is within the defined
threshold or it requires more management focus to be in manageable limits. The banks need
to identify KRIs for Regulatory compliance. Under AMA, BEICFs are studied through RCSA
and KRIs. So, it is important for the banks to identify KRIs not only for compliance but also
for monitoring and control of operational risk. BEICFs are inputted in AMA capital. Thus, if
KRIs are identifiable and properly manageable, they results in less losses and low capital
charge under AMA. Few KRIs for Retail lending are highlighted as below:
Source: The “Best” Retail Lending KRIs, The RMA Journal February 2008

Risk Category KRI

Account Number of open items beyond threshold
Reconciliation Risk Reconciliation difference: Total gross value of open items beyond
threshold
Change Risk Substantial Volume increase or decrease by product
Number of regulatory changes within a specific period
Compliance Risk External Audit points: number open, overdue or raised
No of new products or substantial changes to existing products per
defined period
No of compliance related complaints
Compliance Issues: No raised by external professional bodies
Policies and procedures: no not reviewed within established
threshold

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Disbursement Risk No of new risk that have loan/security documentation out of order
Fraud Risk No of exceptions to lending policy
Percentage of loan that default early
Percentage of applications originating from outside
No of sales lender or units that exceed sales target by a predefined
percentage
Information No of third parties/vendor who are dealing with high materiality,
Security Risk sensitive customer information
No of attacks reported to information security desk
Percentage of third party/vendor relationships where there are
information security exceptions or concerns
Access rights to applications by staff: no of reviews beyond threshold

References

• Tony Blunden and John Thirlwell. Mastering Operational Risk.

 Thomas Kaiser and Marc Kohne (2006), An Introduction to Operational Risk,

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Module III: Management of Risk in Bank Portfolios

Section C: Operational Risk

Chapter 4: Scenario Analysis

Dr. Richa Verma Bajaj

Objective

To detail out the issue and challenges in designing the framework for scenario analysis.

Structure
1. Introduction
2. Salient Features of Scenario Analysis?
3. Type of Stress Testing or Scenario Analysis
4. Requirements
5. Steps in Scenario Analysis/Generation
6. Integration with other data elements and sources
7. Scenario templates using a standardised format
8. Key elements of Scenario Analysis
9. Ways to Build Scenarios
9.1. Illustration: Scenario Analysis through RCSA data
10. Conclusion

1. Introduction

During the past few years the financial services industry has witnessed severe events that
resulted in enormous financial loss and reputation damage to banks and financial
institutions. Stress testing is a tool to study the impact of these severe events on bank. Stress
testing can be defined as “the examination of the potential effects on a bank’s financial
condition of a set of specified changes in risk factors, corresponding to exceptional but
plausible events.” Scenario Analysis is a type of stress testing. It impart forward looking
(low frequency and high severity events) element to the process of estimation of operational
risk capital charges under advanced approach.

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The scarcity of historical data for operational losses among banks, and the difficulty in
aggregating external data of some banking institutions, has led to an increased tendency for
banks to focus on scenario modelling for computation of capital charge for operational risk.
Thus, it is an important element under consideration for those banks who do not have
sufficient and robust estimate of losses from other data element. Scenario Analysis has
proven to be a key tool in the identification and management of unexpected losses under
operational risk. Unexpected losses are the major determinant of the capital charge
(economic capital) for operational risk. Federal Register on December 7, 2007, defines
scenario analysis as “a systematic process of obtaining expert opinions from business
managers and risk management experts to derive reasoned assessments of the likelihood
and loss impact of plausible high‐severity operational losses.” It is a sequence of possible
events and the description of possible developments leading up to these events. It tries to
answer:
(i) How likely are certain scenarios to happen? - Frequency
(ii) What is the potential loss severity? - Severity/Impact

2. Salient Features of Scenario Analysis?

It utilizes relevant internal and external loss data, business environment and internal control
factors and other relevant data, such as knowledge of the future plans of the firm (forward
looking). It uses such data in an objective way, considering knowledge of experienced
business line managers and risk management expert, to determine its relevance. This is a
top-down scenario analysis approach, which ensures that all material risks are identified. It
is easier to adapt and adjust to changing circumstances. The features of scenario analysis are
as follows:
 Basel has suggested banks to use scenarios with external data. “What-if” questions
asked in a scenario analysis shift the focus of risk assessment to the future.
 It identifies frequency and severity of plausible high severity losses that have not
occurred to date and that are not reflected in internal or external loss database of a
bank.
 They focus on identifying influencing factors and interrelated effects (correlation
among various factors).
 Scenarios may be developed along organizational units (Business Lines) and risk
factors (IT, processes) being of different relevance for each organizational unit.
 Extreme events that occurred at other banks, may be used for generating scenarios.

3. Type of Stress Testing or Scenario Analysis

The scenarios can be divided into two groups based on the type of event they define.
- Historical events: Through Internal Loss Data

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- Hypothetical events: Through External Loss Data

4. Requirements

 In order to generate credible and reliable data, the Bank’s should ensure a high level
of repeatability of the process for generating scenario data, through consistent
preparation and consistent application of the quantitative (loss data) and qualitative
(expert opinion) results.
 The Bank’s should ensure that the process by which the scenarios are determined is
designed to reduce as much as possible subjectivity and biases. In particular:
(i) The assumptions used in the scenarios should be based as much as possible
on empirical evidence. Relevant internal (historical scenarios) and external
data (hypothetical scenarios) available should be used in building the
scenario;
(ii) In choosing the number of scenario to apply, institutions should be able to
explain the rationale behind the level at which scenarios are studied and/or
the units in which they are studied;
(iii) The assumptions for generating scenario analyses and the process by which
the scenario is built should be well documented.

5. Steps in Scenario Analysis/Generation

1. A first step in scenario analysis can be the brainstorming of situations in which

significant risks are presumed (e.g. the breakdown of critical systems, unavailability
of a large number of employees, terrorist attack). It covers, categorization of events
that serve as a helpful starting point for such investigations. The internal and external
loss data and near miss events can be used as sources of information.
2. The next step is concerned with specifying the situation to such an extent that an
expert judgement can be made as to the likelihood of occurrence (Frequency) and the
size of potential losses (Severity). It is better to filter irrelevant situations beforehand,
so as to ensure the adequacy of scenario analysis in reflecting the operational risk
profile of bank.
3. The scenarios are subsequently evaluated – an analysis is made of the frequency of
occurrence and an estimate of the size of loss associated with the occurrence. An
institution will create a number of scenarios with a discrete number of frequencies
and severities of losses assigned to each scenario. These scenarios are then modelled
in much the same way as real loss data are to create a capital charge commensurate
with the appropriate confidence level.
4. Finally, the scenarios and their evaluation must be validated, or at least made
plausible. To do this, a panel of experts who did not participate in specifying and
evaluating the scenarios could undertake an independent evaluation, eg, the subject
of their investigation is both the completeness and relevance of the scenarios

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selected. In addition to the estimation of frequency and the size of individual loss
events described above, the interdependence (correlation) of the occurrence of
different loss events could be the subject of scenario analysis. Thus, correlation
assumptions plays a very important role in the quantification of operational risk
(What if, system is down and employee is on leave, how much operational loss bank
is expected to experience and is there any correlation between these two
incidences?).

6. Integration with other data elements and sources

The most important aspect is how banks validate and augment the conclusions they reach
through the scenario process. Scenarios should be validated and reassessed through
comparison to actual loss experience to ensure reasonableness. In addition, guidance from
independent parts of the bank (such as internal audit) to ensure that changes in responses
to the scenario from one year to the next make sense and are supported by objective
evidence. Also of great importance will be the review by independent members of the bank,
who nonetheless have knowledge of the larger risks the bank faces, to ascertain whether the
data created by the department is materially reliable in its own right and relative to data
created by other departments of the bank. It is important for every Bank to investigate and
review the sensitivity of the overall capital charge to moderate changes in the scenario
creation. This could include, but is not limited to, stress‐testing some key scenario results.

7. Scenario templates using a standardised format

• Description of scenario risk
• Description of primary controls mitigating the risk
• Summary of internal and relevant external loss experience related to the scenario
• Description of any relevant BE&ICFs affecting scenario risk or control environment
• Other relevant information – e.g. insurance cover
• Assumptions used to determine parameter assumptions
• Summary of scenario parameters (frequency and severity)

Illustration

Scenario risk event 1

Name of Scenario Mismarking of position by trader
Source of Identification External
Scenario Assessment Period One year
Units Impacted Treasury
Basel Business Line Trading and Sales (T&S)
Loss Event Type (Level I) Internal Fraud
Loss Event Type (Level II) Unauthorized Activity

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Description Trader created bogus/ false equity trades to hide

losses and size of Positions
Causes Mismarking of position
Preventive Controls Enhanced supervision of traders
Trade surveillance
Parameters Independent monitoring of trader limits
Monitoring overall bank trading limit and P&L
Trades not confirmed with counterparties
Internal loss data and external
data summaries
BEICF factors Trends of KRI score for Number of cases where
trader specific stop loss trading limits were
breached.
Scores of RCSA for process of MTM valuation and
Limit breaches

Assumption for scenario Monitoring of trader limits and lack of supervisory

control to input while defining scenarios
Results of scenario assessment
Frequency
Lower 1
Upper 7
Average 4
Severity Depending upon bank’s experience
Lower 700000
Upper 25000000
Average 9500000
Narrative Lack of appreciation of risks associated with trading
strategy; failure to implement audit and
supervisory recommendations.
Inadequate staffing; lack of experience; insufficient
process testing.
Trader compensation scheme directly related to net
trading profit
Trader allowed to trade on vacations, at home and
at night

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8. Key elements of Scenario Analysis

 Manner in which scenarios are generated
 Assumption used, should be based on empirical evidence or expert opinions
 Frequency with which scenarios are updated
 Scope and coverage of OR loss event they are intended to reflect
 Scenarios should capture all material losses (all Business unit and geography)

9. Ways to Build Scenarios

i. Deterministic Method: Use of RCSA data in building up scenario.

ii. Probabilistic Method: Through Monte Carlo simulation

9.1. Illustration: Scenario Analysis through RCSA data

• Step I: Start with the original baseline RCSA and derive a gross loss figure, i.e. before
the interaction of controls: The maximum or average impact for each risk which
occurs in scenario needs to be considered while computing the gross loss figure.

• Step II: Calculate the strength of the control environment

- It is important to examine, how effective controls are. For this purpose, proportion of
the control effectiveness score (1 to 4 for design and performance) as fraction of the
maximum potential (4*4=16) needs to be considered
- To compute the effectiveness score, multiply the design and performance score
together, sum them and then divide by maximum (16*no of controls)
• Step III: Use control effectiveness to calculate a net loss
Net Impact = Gross Impact – (Control Factor * Gross Impact)

• Step IV: Deriving a total value for the net baseline RCSA
• Step V: Assessing control failures for the scenario RCSA
- Analyze which controls have failed (7 of 12) in order to allow the scenario to occur
- Compute Scenario Gross Loss (same as Baseline RCSA gross loss)

• Step VI: Calculate the new control effectiveness factor

- Compute new control effectiveness factor after certain controls have failed.
- Thus, failed control have zero contribution to the effectiveness.
- Like, for Risk 1, failed control 1 and 3
- The new effectiveness score for Risk 1 is (0+4+0+16)/64
• Step VII: The adjusted baseline scenario with new improved control
Make improvement in weaker controls and reassess the control scores considering
the baseline RCSA

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Impact Scale (I)

1 0 500000
2 500000 1000000
3 1000000 1500000
4 15000000 2000000

Total Control
Severity Effectiv
(Maximum) eness Scenario I Scenario II
R I L C D P D*P Fail P D*P Improved P D*P
1 4 4 1 3 2 6 2000000 0.50 Yes 0 0 0.31 Yes 4 12 0.67
2 2 2 4 2 4 Yes 3 6
3 3 2 6 Yes 0 0 Yes 3 9
4 4 4 16 4 16 4 16
2 2 4 1 3 4 12 1000000 0.58 Yes 0 0 0.083 4 12 0.67
2 4 3 12 Yes 0 0 Yes 4 16
3 2 2 4 2 4 2 4
3 3 2 1 3 2 6 1500000 0.54 Yes 0 0 0.31 Yes 4 12 0.69
2 2 3 6 Yes 0 0 3 6
3 3 2 6 Yes 0 0 Yes 4 12
4 4 4 16 4 16 4 16
5 3 3 9 3 9 3 9
211041
4500000 7 3322917 1458333

R = Risk C = Controls to mitigate the risk 1, 2, and 3

I = Impact D= Design
L = Liklihood P =Performanc

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10. Conclusion

In general, the use of scenario analysis is not restricted to evaluating exposures to high
severity events. Banks can use scenarios to provide information on the institution’s overall
operational risk exposure. It is an important component of a bank’s early warning system
and strategic development.

Reference

Mastering Operational Risk, Book by Tony Blunden and John Thirlwell.

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Module III: Management of Risk in Bank Portfolios

Section C: Operational Risk

Chapter 5: Operational Risk under Basel III

Dr. Richa Verma Bajaj

Objective

The objective of this chapter is to introduce the new approach “Standardised Approach” to
readers issued recently under Basel III.

Structure

1. Introduction
2. Introduction of Standardised Measurement Approach (SMA) of Operational Risk
3. Standardized Approach of Operational Risk Capital Charge: Computation under
Basel III

1. Introduction
The Operational Risk Analytical Framework, as discussed in previous chapters, provides an
estimate of bank’s operational risk exposure in various business lines from various event
types, which is an aggregate of operational losses that it faces over a one year period at a
soundness standard consistent with a 99.9 percent confidence [Link], various
processes in Operational Risk Management (ORM) framework are:

- Risk mapping of Business lines and Event Types (using internally developed
flowcharts, and control/quality diagrams);
- Risk Identification and assessment through Risk and control self-assessment (use of
audit information)
- Monitoring of data through Key-risk-indicator definition (capture of KRIs)
- Loss data collection (use of operational, exception reports to generate loss or near
miss data), and
- Use of measurement analytics (Building of Scenarios)
All above processes are heavily data driven in producing the needed operational risk
outputs (i.e. loss distributions, operational risk capital charge calculations, ORM reporting
through dashboard etc.), however, banks consider that the capital saving provided by
advanced approach i.e. AMA, relative to TSA, is insufficient, given the cost of implementing

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Loss Data Collection System in a bank. Still, some internationally active banks have taken
advantage of strong risk management systems in reducing their capital charge under
advanced approaches in line with regulatory guidelines. Following table shows a quick look
at the major qualitative and quantitative requirements under Basel II of three approaches
detailed in earlier chapters:

Approaches under Basel II for the calculation of the Regulatory Capital for
Operational Risk
Basic Indicator The Standardized Approach Advanced Measurement
Approach Approach
Implementation of -Board of directors and senior -Board of directors and senior
Sound Practice Paper management must be management must be involved
involved - Independent OR function for
- Clear responsibilities for OR OR methods and policies
management function (OR - Regular, systematic OR
policies) reporting integrated into day-
- OR assessment and to-day management
collection of OR losses - Collection of OR losses
- Regular and systematic OR (History≥5 years, initially 3
reporting years)
- Regular independent - Scenario assessment
monitoring of OR - Economic capital (1 year,
- Business Line Mapping 99.9%) and OR expected loss
- Regular independent review
by internal and external
auditors
- Recognition of Insurance (20
percent of Operational Risk
Capital Charge)

2. Introduction of Standardised Measurement Approach (SMA) of Operational

Risk (consultative document issued in March 2016)

The experience of International active banks suggests that AMA involves diverse range of
internal modelling, subject to supervisory approval and provides significant degree of
flexibility to banks. In reality, Basel Committee’s expectations failed to materialize as far as
implementation of advanced approach is concerned. As, AMA is complex and banks have
varied internal modelling practices to compute the capital charges. That is why; committee
determined the withdrawal of internal modelling approaches and introduced SMA
(consultative document, March 2016).

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The SMA addresses a number of weaknesses in the current framework:

• The SMA will replace the three existing top-down approaches for calculating
operational risk capital as well as the Advanced Measurement Approach (AMA),
thus significantly simplifying the regulatory framework;

• The revised methodology combines a financial statement-based measure of

operational risk - the "Business Indicator" (BI) - with an individual firm's past
operational losses collected internally. This results in a risk-sensitive framework,
while also promoting consistency in the calculation of operational risk capital
requirements across banks and jurisdictions; and

• The option to use an internal model-based approach for measuring operational risk
- the "Advanced Measurement Approaches" (AMA) - has been removed from the
operational risk framework. As, the Committee believes that existing approach of
modelling of operational risk for regulatory capital purposes is unduly complex and
that the AMA has resulted in excessive variability in risk-weighted assets and
insufficient levels of capital for some internationally active banks.
3. Standardized Approach (SA) of Operational Risk Capital Charge Computation
under Basel III
BCBS published “Basel III: Finalising post-crisis reforms” on December 7. The revised
approach for Operational risk under Basel III is called as Standardised Appraoch. The SA
for measuring minimum operational risk capital requirements replaces all existing top-
down (BIA, TSA, ASA) and Bottom-up (AMA) methods. This approach is applicable to
internationally active banks at a consolidated level, but supervisors retain discretion to
apply SA framework to non-internationally active banks. RBI has not issued any guidelines
on operational risk Standardised approach as yet. Though, Implementation date for SA is
1.1.2022 as mentioned in Basel document.

3.1 Components of Standardized Approach

The standardised approach methodology is based on the following components:

(i) the Business Indicator (BI) which is a financial-statement-based proxy for
operational risk;
(ii) the Business Indicator Component (BIC), which is calculated by multiplying
the BI by a set of regulatory determined marginal coefficients (αi); and
(iii) the Internal Loss Multiplier (ILM), which is a scaling factor that is based on a
bank’s average historical losses and the BIC.

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3.1.1. Business Indicator

The Income from banking operations are grouped into three categories for computation of
BI(Business Indicator). It is computed as:

[the ILDC (Interest, Leases and Dividend) component] + [the SC (Services Component)]
+ [the FI (Financial Component)]

- Under Interest, Lease and Dividend Income (ILDC) component (interest income
restricted to 2.25% of Interest Earning Assets)
- Under Services Component (Maximum of other operating income/expense, Max of
fee income/expense
- Financial Component (Absolute net P&L trading book, Absolute net P&L banking
book
In the formula below, a bar above a term indicates that it is calculated as the average over
three years: t, t-1 and t-2,

BI Components: definition

BI P & Lor balance Description

Component sheet items
Interest, Interest income Interest income from all financial assets and other interest
Lease and income
Dividend (includes interest income from financial and operating leases
and profits from leased assets)
Interest expenses Interest expenses from all financial liabilities and other interest
expenses
(includes interest expense from financial and operating leases,
losses, depreciation and impairment of operating leased assets)
Interest earning Total gross outstanding loans, advances, interest bearing
assets (balance securities (including government bonds), and lease assets
sheet item) measured at the end of each financial year

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Dividend income Dividend income from investments in stocks and funds not
consolidated in the bank’s financial statements, including
dividend income from non-consolidated subsidiaries,
associates and joint ventures.
Services Fee and Income received from providing advice and services. Includes
commission income received by the bank as an outsourcer of financial
income services.

Fee and Expenses paid for receiving advice and services. Includes
commission outsourcing fees paid by bank for supply of financial services,
expenses but not outsourcing fees paid for supply of non-financial
services
Other Operating Income from ordinary banking operations not included in other
Income BI items but of similar nature
(income from operating leases should be excluded
Other operating Expenses and losses from ordinary banking operations not
expenses included in other BI items but of similar nature and from
operational loss events (expenses from operating leases should
be excluded)
Financial Net profit (loss) • Net profit/loss on trading assets and trading liabilities
on the trading (derivatives, debt securities, equity securities, loans and
book advances, short positions, other assets and liabilities)
• Net profit/loss from hedge accounting
• Net profit/loss from exchange differences
Net profit (loss) Net profit/loss on financial assets and liabilities measured at
on the banking fair value through profit and loss
book • Realized gains/losses on financial assets and liabilities not
measured at fair value through profit and loss (loans and
advances, assets available for sale, assets held to maturity,
financial liabilities measured at amortized cost)
• Net profit/loss from hedge accounting
• Net profit/loss from exchange differences
Source: Basel III guidelines on Operational Risk

3.1.2. The Business Indicator Component

Business Indicator is grouped under three different buckets on the basis of size in euros. At
each bucket a differential coefficient is applied to arrive at the BI component. To calculate
the BIC, the BI is multiplied by the marginal coefficients (αi). The marginal coefficients
increase with the size of the BI as shown in Table 1.

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The Sum of the BI components at different buckets will be adjusted with loss data multiplier

3.1.3. Computation of Internal Loss Multiplier

A bank’s internal operational risk loss experience affects the calculation of operational risk
capital through the Internal Loss Multiplier (ILM). ILM is a function of the BIC and the Loss
Component (LC), where the latter is equal to 15 times a bank’s average historical
operational risk losses over preceding 10 years. The ILM is defined as:

The ILM is equal to one where the loss and business indicator components are equal.
Where the LC is greater than the BIC, the ILM is greater than one. That is, a bank with losses
that are high relative to its BIC is required to hold higher capital due to the incorporation of
internal losses into the calculation methodology. Conversely, where the LC is lower than
the BIC, the ILM is less than one. That is, a bank with losses that are low relative to its BIC is
required to hold lower capital due to the incorporation of internal losses into the
calculation methodology. At national discretion, supervisors may set the value of ILM equal to
one for all banks in their jurisdiction. Under Basel III, the Minimum standards for use of loss
data have been prescribed.

3.1.4 Formula for Calculation of SA Capital

Minimum “Operational Risk Capital” = (BIC) * (ILM)
Where:
BIC= Business Indicator Component
ILM= Internal Loss Multiplier

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