Lecture 6b: An Introduction

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• Lecture 6b An Introduction
• The Basel I Basel II

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• Knowledge has to be improved, challenged and
  increased constantly or it vanishes Peter
  Drucker
• Risk Management and Basel II
• Risk Management DivisionBank Alfalah Limited
• Javed H. Siddiqi

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Managing Risk Effectively Three Critical
Challenges
GLOBALISM
TECHNOLOGY

• Management Challenges for the 21st Century

CHANGE
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Agenda

• What is Risk ?
• Types of Capital and Role of Capital in Financial
  Institution
• Capital Allocation and RAPM
• Expected and Unexpected Loss
• Minimum Capital Requirements and Basel II Pillars
• Understanding of Value of Risk-VaR
• Basel II approach to Operational Risk management
• Basel II approach to Credit Risk management
• Credit Risk Mitigation-CRM, Simple and
  Comprehensive approach.
• The Causes of Credit Risk
• Best Practices in Credit Risk Management
• Correlation and Credit Risk Management.
• Credit Rating and Transition matrix.
• Issues and Challenges
• Summary

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• What is Risk?
• Risk, in traditional terms, is viewed as a
  negative. Websters
• dictionary, for instance, defines risk as
  exposing to danger or hazard.
• The Chinese give a much better description of
  risk
• gtThe first is the symbol for danger, while
• gtthe second is the symbol for opportunity,
  making risk a mix of danger and opportunity.

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Risk Management Risk management is present in
all aspects of life It is about the everyday
trade-off between an expected reward an a
potential danger. We, in the business world,
often associate risk with some variability in
financial outcomes. However, the notion of risk
is much larger. It is universal, in the sense
that it refers to human behaviour in the decision
making process. Risk management is an attempt to
identify, to measure, to monitor and to manage
uncertainty.
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Capital Allocation and RAPM

• The role of the capital in financial institutions
  and the different type of capital.
• The key concepts and objective behind regulatory
  capital.
• The main calculations principles in the Basel II
  the current Basel II Accord.
• The definition and mechanics of economic capital.
• The use of economic capital as a management tool
  for risk aggregation, risk-adjusted performance
  measurement and optimal decision making through
  capital allocation.

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Role of Capital in Financial Institution

• Absorb large unexpected losses
• Protect depositors and other claim holders
• Provide enough confidence to external investors
  and rating agencies on the financial heath and
  viability of the institution.

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Type of Capital

• Economic Capital (EC) or Risk Capital.
• An estimate of the level of capital that a
  firm requires to operate its business.
• Regulatory Capital (RC).
• The capital that a bank is required to hold by
  regulators in order to operate.
• Bank Capital (BC)
• The actual physical capital held

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Economic Capital

• Economic capital acts as a buffer that provides
  protection against all the credit, market,
  operational and business risks faced by an
  institution.
• EC is set at a confidence level that is less than
  100 (e.g. 99.9), since it would be too costly
  to operate at the 100 level.

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Risk Measurement- Expected and Unexpected Loss

• The Expected Loss (EL) and Unexpected Loss (UL)
  framework may be used to measure economic capital
• Expected Loss the mean loss due to a specific
  event or combination of events over a specified
  period
• Unexpected Loss loss that is not budgeted for
  (expected) and is absorbed by an attributed
  amount of economic capital

Losses so remote that capital is not provided to
cover them.
Determined by confidence level associated with
targeted rating
Probability
EL
UL
Cost
2,500
0
Economic Capital Difference 2,000
500 Expected Loss, Reserves
Total Loss incurred at x confidence level

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Minimum Capital Requirements

• Basel II
• And
• Risk Management

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History
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Comparison
Basel I Basel 2
Focus on a single risk measure More emphasis on banks internal methodologies, supervisory review and market discipline
One size fits all Flexibility, menu of approaches. Provides incentives for better risk management
Operational risk not considered Introduces approaches for Credit risk and Operational risk in addition to Market risk introduced earlier.
Broad brush structure More risk sensitivity
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Objectives

• The objective of the New Basel Capital accord
  (Basel II) is
• To promote safety and soundness in the financial
  system
• To continue to enhance completive equality
• To constitute a more comprehensive approach to
  addressing risks
• To render capital adequacy more risk-sensitive
• To provide incentives for banks to enhance their
  risk measurement capabilities

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MINIMUM CAPITAL REQUREMENTS FOR BANKS (SBP
Circular no 6 of 2005)
IRAF Rating Required CAR effective from Required CAR effective from
Institutional Risk Assessment Framework (IRAF) 31st Dec. 2005 31st Dec., 2006 and onwards
1 2 8 8
3 9 10
4 10 12
5 12 14
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Overview of Basel II Pillars
The new Basel Accord is comprised of three
pillars
Pillar I
Pillar II
Pillar III

• Minimum Capital Requirements
• Establishes minimum standards for management of
  capital on a more risk sensitive basis
• Credit Risk
• Operational Risk
• Market Risk

• Supervisory Review Process
• Increases the responsibilities and levels of
  discretion for supervisory reviews and controls
  covering
• Evaluate Banks Capital Adequacy Strategies
• Certify Internal Models
• Level of capital charge
• Proactive monitoring of capital levels and
  ensuring remedial action

Market Discipline Bank will be required to
increase their information disclosure, especially
on the measurement of credit and operational
risks. Expands the content and improves the
transparency of financial disclosures to the
market.
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Development of a revised capital adequacy
framework Components of Basel II
Objectives
The three pillars of Basel II and their principles

• Continue to promote safety and soundness in the
  banking system
• Ensure capital adequacy is sensitive to the level
  of risks borne by banks
• Constitute a more comprehensive approach to
  addressing risks
• Continue to enhance competitive equality

Basel II
Pillar 1
Pillar 2
Pillar 3
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Overview of Basel II Approaches (Pillar I)
Approaches that can
be followed in determination of Regulatory
Capital under Basel II
Basic Indicator Approach
Score Card
Operational Risk Capital
Standardized Approach
Loss Distribution
Advanced Measurement Approach (AMA)
Internal Modeling
Total Regulatory Capital
Credit Risk Capital
Standardized Approach
Foundation
Internal Ratings Based (IRB)
Advanced
Standard Model
Market Risk Capital
Internal Model