Risk Based Capital Management for Banks Compiled By

Risk Based Capital Management for Banks Compiled By Janata Bank Staff College Dhaka.

Risk Related to Banking Activities § Risk is nothing but possibility of losing assets through some activity i. e. , in case of banking credit activity, market activity, operational activity etc. § Risk inherent with banking activities are ü Credit risk ü Market Risk ü Operational risk ü Supervisory risk

Why is Capital so Important? § Bank is a highly leveraged institution § Capital performs several unique and indispensable jobs in banks - Cushion against bank’s business loss. - Promote public confidence - Organization’s growth - Sets limit to risk exposure - A measure of soundness and stability

Capital Adequacy Rule § The capital adequacy rules is to ensure that the institution has enough capital in relation to the risks with their entity’s activities. § Enough capital means the amount of capital sufficient to meet any unforeseen loss. § Capital Adequacy is defined as the level of capital which is required to protect a bank from portfolio losses. § The Basel Committee, designed Capital Regulation, which is known as the Basel Accord.

Objectives of Basel Accord § To strengthen the soundness and stability of the international banking system and § To obtain a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks.

What is the Basel Committee § A Committee of central banks and bank supervisor and regulators from the major industrialized countries (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, U. K and U. S. A) that meets every three months at the BIS in Basel.

Basel-I Capital Requirement § Adopted in 1988 § Capital is linked with risk assets/credit risk. § Banks should calculate Risk Weighted Assets (RWA) and this to be calculated dividing assets into four risk group i. e. 0%, 20%, 50% & 100%. § Capital is divided between: § Tier-1 or Core Capital § Tier-2 or Supplementary Capital § Tier-2 cannot exceed 100% of Tier-1 § Minimum capital requirement is 8% of RWA

Basel-I Capital Standered § Focus only on Credit or Default Risk § Market Risk exposure (Changing interest rates, exchange rates) added later. § Limitations: § Same Set of risk weights § Same required Minimum CAR for all banks. § Operational Risk, gradually turning critical, ignored. § Need for Revised Capital Standard § BASEL-II

Capital Adequacy: Bangladesh Scenario § Before 1991 – No Capital Adequacy Standard § Bank Company Act-1991 – Cap. Adequacy Linked to Liabilities (6% of total demand time liabilities) § However, disregards the asset quality of bank § January, 1996: Capital Adequacy Linked to RWA (8%) in line with BASEL-I § Risk to OBS item also considered

Criticism of Basel-I Accord § Exclusive focus on credit risk. § Inadequate differentiation of credit risk/one size fits all approach is not appropriate. § No recognition for risks related to term structure of credit portfolio. § Dose not recognize portfolio diversification effect of credit risk § Dose not recognize credit risk mitigation techniques and role of collateral. § Dose not levy any capital charge for operational risk.

Risk Based Capital Basel-II § This framework was finalized in 2004. § Basel-II states that bank should maintain capital not only covering credit risk but also covering market & operational risk. § RWA should be calculated covering Market & Operational risk along with credit risk, § In addition to calculation MCR (Pillar-1) banks should have a robust review process on risk and capital planning as stated in pillar-2 of Basel-II. § Again in addition to pillar-1 & pillar-2 banks should disclose their performance as explained in pillar-3 for the sake of establishing Market Discipline. So, that all the stakeholders of banks will be able to know the position of banks success.

Pillar-I Minimum Capital Requirement Credit Risk Standardized Approach Market Risk Standardized Approach Basic Indicator Approach Pillar-III Supervisory Review Market Discipline Internal Capital Adequacy Assessment Process (ICAAP) Standardized Approach Foundation IRB Approach Advanced IRB Approach Operational Risk Pillar-II Internal Model Approach Advanced Measuremen t Approach Supervisory Evaluation Process Core and Supervisory Disclosure

The Guideline is Structured Around Following Three aspects: § Minimum Capital Requirements to be maintained by a bank against credit, market and operational risk. § Assessing Overall Capital Adequacy in relation to bank’s risk profile and a strategy for maintaining capital at an adequate level. § Disclosure of Information on Bank’s Risk Profile, Capital Adequacy and Risk Management.

Capital Base § Tier-1 or Core Capital § § § § Paid up capital Non-repayable share premium account Statutory Reserve General Reserve Retained Earnings Minority Interest in subsidiaries Non-Cumulative irredeemable Preference Share Dividend Equalization Accounts § Tier-2 or Supplementary Capital § General Provision § Revaluation Reserves § Revaluation Reserve for fixed assets § Revaluation Reserve for securities § Revaluation Reserve for equity instrument § All other Preference Share § Subordinated debt § Tier-3 or Additional Supplementary Capital § Short-term subordinated debt (Maturity max. 5 yr. –min 2 yr. )

Condition for Maintaining Regulatory Capital § The amount of T-2 capital will be limited to 100% of the amount of T-1 capital. § 50% of revaluation reserves for fixed assets and securities shall be eligible for T-2 capital. § 10% of revaluation reserves for equity instruments shall be eligible for T-2 capital. § Subordinated debt (T-2) shall be limited to a maximum of 30% of the amount of T-1 capital. § A minimum of about 28. 5% of market risk needs to be supported by T-1 capital. Supporting of market risk from T-3 capital shall be limited up to maximum of 250% of T-1 after meeting credit risk.

Minimum Capital Requirement §

Minimum Capital Requirement (MCR) (Credit + Market + Operational Risk) Risk weighted Amount Cr. Tk. For Credit Risk = ………. For Market Risk ………… x 10 = ……… For Operational Risk ………… x 10 = ……… Total : RWA Minimum Capital Requirement (MCR) ………… 10% of RWA = ……… x 10% = ………

Basel-III: Global Capital Framework for Resilient Banking System § To strengthen global capital and liquidity rules with the goal of promoting a more resilient banking sector, BCBS issued “Basel-III : A Global Regulatory Framework for Resilient Banks and Banking System” in December 2010. § The Objective of the reforms was to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy. § Though its reform package, BCBS also aim to improve risk management and governance as well as strengthen bank’s transparency and disclosures.

Basel-III: Introduction § Gradual erosion of the level and quality of the capital was observed in the last financial crisis. § At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses. § During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institution. § The weakness in the banking sector were rapidly transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability.

The Basel Committee Introduced a Number of Fundamental Reforms § Strengthening the Capital Framework § Supplementing the Risk Based Capital Requirement with a Leverage Ratio. § Reducing Procyclicality and Promoting Countercyclical Buffers. § Addressing Systemic Risk and Interconnectedness. § Introducing Global Liquidity Standard.

What Basel-III is mainly about? Risk Management not the Crisis Management. Risk Based Capital Management (Quality, Quantity and Liquidity)

Key Features of Basel-III To improve banking sector’s ability to absorb shocks arising from financial and economic stress Reducing the risk of spillover from the financial sector to the real economy. To improve risk management and governance as well as strengthen bank’s transparency and disclosures instead of crisis management.

Roadmap of Basel-III by BB § Issuance of Guideline by December 2014 § Draft Guideline Issued : 19 august 2014 § Final Guideline Issues : Through BRPD Circular # 18, dated 21. 12. 2014 § Capacity Building of Bank & BB Officials : January 2015 to December 2019. § Commencement of Basel-III Implementation process : January 2015 § Initiation of Full Implementation of Basel-III : January 2020

Basel-II and Basel-III: Status of Three Pillars Basel-III Pillar-III Minimum Capital Requirements Supervisory Review Process Disclosure & Market Discipline Pillar-I Enhanced Minimum Capital & Liquidity Requirements Pillar-II Enhanced Supervisory Review process for Firm wide Risk Management and Capital planning Pillar-III Enhanced Risk Disclosure & Market Discipline

Phase-in Arrangements for Basel-III Implementation in Bangladesh Particulars 2016 2017 2018 2019 4. 50% - 0. 625% 1. 875% 2. 50% Minimum CET-1 Plus Capital Conservation Buffer 4. 50% 5. 125% 5. 75% 6. 375% 7. 00% Minimum T-1 Capital Ratio 5. 50% 6. 00% Minimum Total Capital Ratio 10. 00% Minimum Total Capital plus Capital Conservation Buffer 10. 00% 10. 625% 11. 875% 12. 50% 20% 40% 60% 80% 100% 3% Migration to pillar 1 Minimum Common Equity Tier-1 (CET) Capital Ratio Capital Conservation Buffer 2015 Phase-in deductions from CET-1 Excess Investment over 10% of a bank’s equity in the equity banking, financial and insurance entities/ Phase-in deductions from Tier-2 Revaluation Reserve (RR) RR from Fixed Assets, Securities and Equity Securities Leverage Ratio Readjustment Liquidity Coverage Ratio ≥ 100% (From sep) ≥ 100% Net Stable Funding Ratio ≥ 100% (From Sep) ≥ 100%

Basel-III: Changes in Capital Framework Particulars Basel-III Basel-II Components of Capital Tier-1 Capital Going Concern Capital : ü Common Equity Tier-1 ü Additional Tier-1 Core Capital Tier-2 Capital Gone Concern Capital Supplementary Capital Tier-3 Capital Abolished in Basel-III Additional Supplementary Capital a) Paid up Capital Components of Tier-1 Capital/Common Equity b) Non-repayable share premium Account Tier-1 c) d) e) f) g) Statutory reserve General reserve Retain earnings Minority Interest in subsidiaries Dividend Equalization account a) Paid up Capital b) Non-repayable share premium Account c) Statutory reserve d) General reserve e) Retain earnings f) Minority Interest in subsidiaries g) Non-cumulative irredeemable preference shares h) Dividend Equalization account

Basel-III: Changes in Capital Framework Particulars Basel-III Deduction/ regulatory adjustments from Tier-1 Capital a) Shortfall in provisions required against classified assets. b) Goodwill and all other intangible Assets c) Deferred tax assets (DTA) d) Defined benefit pension fund assets. e) Gain on sale related to securitization transactions f) Investment in own shares g) Investments in the capital of banking, Financial and Insurance Entities. Basel-II a) b) c) d) e) f) g) Intangible asset e. g. , book value of goodwill and value of any contingent assets. Shortfall in provisions required against classified assets. Shortfall in provisions required against investment in share. Remaining deficit on account of revaluation of investments in securities after netting off any other surplus on the securities Reciprocal/crossholdings of bank’s capital/subordinated debt artificially intended to inflate the capital position of banks. Holding of equity shares in any form exceeding the approved limit under section 26(2) of Bank Company Act, 1991. The additional/unauthorized amount of holdings will be deducted at 50% from Tier 1 capital and 50% from Tier-2 capital. Investment in subsidiaries which are not consolidated.

Basel-III: Changes in Capital Framework Particulars Basel-III Additional Tier-1 Capital a) Instrument issued by banks that meet the qualifying criteria for AT 1 as specified. b) Minority Interest i. e. AT 1 issued by consolidated subsidiaries to third parties (for consolidated reporting only) No such capital was in Basel-II Deduction/ regulatory adjustments from Additional Tier-1 Capital a) No such capital deduction was in Basel-II previously. b) c) d) e) f) g) Shortfall in provisions required against classified assets. Goodwill and all other intangible Assets Deferred tax assets (DTA) Defined benefit pension fund assets. Gain on sale related to securitization transactions Investment in own shares Investments in the capital of banking, Financial and Insurance Entities. Basel-II

Basel-III: Changes in Capital Framework Particulars Basel-III Basel-II Components of Tier-2 Capital a) General Provisions b) Subordinated debt/ Instruments issued by the banks that meet the qualifying criteria for Tier-2 capital. c) Minority Interest i. e. Tier-2 issued by consolidated subsidiaries to third parties a) General Provisions b) Revaluation reserve for fixed assets. Revaluation reserve for securities. Deduction/ regulatory adjustments from Tier-2 Capital As applicable of the areas as specified in deduction for AT-1 above. No such deduction was applicable. Components of Tier-3 Capital Abolished in Basel-III Consisting of short-term subordinated Debt (maturity less than or equal to five years, solely for the purpose of meeting a portion of the capital requirements for market risk. Revaluation reserve for equity instrument. c) All Other preference shares d) Subordinate debt

Basel-III: Changes in Capital Framework Particulars Basel-III Basel-II Capital Conservation Buffer (CCB) Banks are required to maintain a capital conservation buffer of 2. 5%, comprised of common equity Tier 1 capital, above the regulatory minimum capital requirement of 10% No such concept was in Basel-II Constraint on capital distributions No such concept was in Basel-II when a bank’s CET 1 level falls between 4. 5% and 7% of its RWAs. If a bank does not have positive earnings and has a common Equity Tier 1 ratio less than 7%, it should not make positive net distributions.

Limits of Capital Framework § Common Equity Tier 1 of at least 4. 5% of the total RWA § Tier 1 capital will be at least 6. 0% of the total RWA. § Minimum CRAR of 10% of the total RWA. § Additional Tier 1 capital can be admitted maximum up to 1. 5% of the total RWA or 33. 33% of CET 1, whichever is higher. § Tier 2 capital can be admitted maximum up to 4. 0% of the total RWA or 88. 89% of CET 1, whichever is higher. § In addition to minimum CRAR , Capital Conservation Buffer (CCB) of 2. 5% of the total RWA is being introduced which will be maintained in the form of CET 1.

Basel-III: Leverage Ratio Particulars Basel-III Basel-II Leverage Ratio Newly added in Basel-III No such concept was in Basel-II Issues Covered In order to avoid building up excessive on and off-balance No such concept sheet leverage in the banking system, a simple, was in Basel-II transparent, non-risk based leverage ratio has been introduced. The leverage ratio is intended to achieve the following objectives: a) Constrain the build-up of leverage in the banking sector which can be damage the broader financial system and the economy, and b) Reinforce the risk based requirements with an easy to understand a non-risk based measure. Formula Tier 1 Capital (after related deduction) / Total Exposure (after related deduction) Reporting The parallel run period for leverage ratio will commence from January, 2015 and run until December 2016. Bank level disclosure of the leverage ratio and its components will start from January 1, 2015. However, banks should report their Tier 1 leverage ratio to the BB along with CRAR report from the quarter ending March, 2015. No such concept was in Basel-II

Basel-III: Liquidity Coverage Ratio Particulars Basel-III Basel-II Liquidity Coverage Ratio (LCR) Newly added in Basel-III No such concept was in Basel-II Issues Covered Developed to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one Month (30 days) No such concept was in Basel-II Formula (Stock of HQLAs/ Net cash outflow over the next 30 calendar days) ≥ 100% No such concept was in Basel-II

Basel-III: Supervisory Review Process Particulars Basel-III Basel-II ICAAP Reporting Yearly reporting mandatory No such instruction was in Basel-II Risks Covered Basel-III Covers 10(ten) risks: Ø Residual risk Ø Concentration risk Ø Interest rate risk in the banking book Ø Liquidity risk Ø Reputation risk Ø Strategic risk Ø Settlement risk Ø Appraisal of core risk management practice Ø Environmental and climate change risk Ø Other material risks Basel- II Covers 11(eleven) risks: Ø Residual risk Ø Securitization risk Ø Credit Concentration risk Ø Interest rate risk in the banking book Ø Liquidity risk Ø Reputation risk Ø Strategic risk Ø Settlement risk Ø Evaluation of core risk management Ø Environmental risk Ø Other material risks Measures to supplement the supervisory review process Increased emphasis on firm wide support and a number of specific risk management topics, including risk concentrations. The process was run as adhoc basis where some of the technical issues were not specified and justified in terms of banking practices in the respective areas.

Basel-III: Market Discipline Particulars Basel-III Basel-II Web page title of Market Disclosure “Disclosures on Risk Based Capital (Basel-III)” “Disclosures on Risk Based Capital (Basel-II)” Disclosure requirements to improve market discipline Within the Qualitative & Quantitative disclosures, the following issues have been included: v Reconciliation of regulatory capital with audited financial statement. v Information on regulatory adjustments v Description of limits and minimum requirements identifying all elements of capital to which these apply. v Description of the main features of capital instruments issued v Comprehensive explanation of how the ratios are calculated when banks publish ratios that include components of regulatory capital § Qualitative Information § Quantitative Information (As per Central Bank provided formats)

Basel-III: Positive Impacts § Fewer bank failures, fewer taxpayer bailouts- banks hold more and better quality capital to withstand future shocks. § Stronger banking system in the long run. § Greater confidence in the stability of the financial system once implementation commences. § Longer implementation period : § Would aid the current fledging recovery worldwide. § Allow banks to adapt by retaining earning, issuing equity. § Profits rise as bad loans decline. § Bank share prices improve as they engage in acquisitions

Basel-III: Negative Impacts § Reduction in credit üDecreased availability and increased borrowing cost üFewer borrowers have access to funding üSignificantly more onerous conditions § Banks not meeting the ratio requirements cannot pay out dividends, bonuses, share buybacks üRaise investor concerns over dividends § Banks may have to come up sizeable amounts of : ü New equity ü Retained earnings, or ü Dispose of assets to meet the new capital ratios.

Preparatory Course of Action Common Equity / Core Capital has to be increased by earning expected profit Asset-Liability Management should make stronger to ensure liquidity coverage Investment monitoring systems should be structured and effective to ensure asset quality Assessment of capital under revised directions should be performed to determined bank’s status in the respective compliance areas Improvement of human resources quality should be ensure to cope up Basel-III norms, etc.

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