FIN 6002 – Session 1- 4

Pradeepta Sethi
TAPMI
 Market Frictions

• The Market for Lemons – George Akerlof (1970)

• Information Asymmetry

• Information is not the same for both the buyer and seller

• Adverse Selection

• Occurs when one side of the market has better information than the other
side and so there is a selection of only high cost or low value being bought or
sold

• Moral Hazard

• Under certain circumstances (Guaranteed of protection) individual will alter

their behavior and take more risks

• Too big to fail

 Market Frictions

• In the presence of information asymmetry

• Adverse selection occurs before the transaction
• The people who are the most undesirable (less credit worthy) from the bank’s
point of view are the ones who are most likely to engage in the financial
transaction.
• Basic idea: presence of “bad" cars (lemons) makes it hard to sell “good" cars
(peaches) because buyers can't distinguish between the two types.
• Moral hazard happens after the transaction
• The risk (hazard) that the borrower might engage in activities that are
undesirable (immoral) from the lender’s point of view.
• Now there are not two types of firms, but two types of projects a firm can
undertake once given funding.
• Basic idea: once you give the firm funding, you can't control what it does with it.
 Banks and Information Asymmetry

• Banks become experts in evaluating  firm types and credit risk (adverse
selection).

• Banks engage in monitoring to ensure firms are using the funds in the most
desirable way and can impose covenants and loan restrictions (moral
hazard).

• Household does not have resources to do either of these things on his or

her own.
 Why we need banks ?

Market Frictions – (Information, Transaction)

Financial Systems

Financial Functions

Channels: Capital Accumulation & TFP

Economic Growth
Source: Levine, R. (1997). " Financial Development and Economic Growth: Views and Agenda." Journal of Economic Literature, 35(2)
 Evolution of banks

¢ 3,900 B.C. - Egypt adopted a banking service utilizing cows as units of exchange

¢ Money lending activity in India could be traced back to the Vedic period, i.e., 2000
to 1400 BC.

¢ Kautilya’s Arthashastra dating back to 400 BC contained references to creditors,

lenders and lending rates.

¢ Modern Banking has European origin.

¢ The word ‘Bank’ is derived either from Old Italian Banca or Middle
French Banque – both meaning a table or bench

¢ A bench for keeping, lending, and exchanging of money or coins in the market
place by money lenders and money changers.

¢ Oldest surviving bank - Monte dei Paschi di Siena - origins in1472 in the Tuscan
city
 History of banking in India

Bank of Hindostan (1770 - 1832)

General Bank of India (1786 - 1791)

Bank of Calcutta (1806) - Bank of Bengal (1809)

Bank of Bombay (1840), Bank of Madras (1843)

Imperial Bank of India (1921)

Reserve Bank of India (1935)

Bank Nationalization (1969)

Entry of Private Banks (1995)

Small Finance & Payment Bank (2014)

 Definition of banks

• “Banking as accepting for the purpose of lending or investment, of deposits

of money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order otherwise.”

- The banking regulation act 1949 Sec 5(b)

• 3 primary activities of a commercial bank

• maintaining deposit accounts including current accounts,

• issue and pay cheques, &

• collect cheques for the bank's customers

 Primary functions of banks
• Accepting deposits

• Current account, Savings account and Fixed deposits

• Advancing loans

• Cash credit, Term loan, Demand loan, Overdraft, Bill discounting

• Creation of credit

• Clearing of cheques

• Financing (foreign) trade

• Letters of Credit, EPC, PCFC

• Remittance of funds
 Creation of credit – Fractional reserve banking
• Assume you deposit ₹10,00,000 in Axis Bank. Axis Bank
must maintain statutory reserve requirement of ₹2,10,000
and rest ₹7,90,000 it can lend to individuals, corporates etc.

• Your friend got a loan of ₹7,90,000 from Axis Bank for

buying a car. The car dealer is maintaining his account with
Canara Bank, so he deposits ₹7,90,000 in Canara Bank.

• Canara Bank must set aside 21% of ₹7,90,000 and rest

(₹6,24,100) it can lend to individuals, corporates etc.

• Your friend’s brother took a personal loan of ₹6,00,000 and

deposits it in his ICICI bank account. So now ICICI bank has
₹6,00,000 by setting aside 21% it can lend further.

• This process will continue till the summation of all the

reserves is equal to the initial deposit amount. In this
process, all the intermediaries are lending from the initial
₹10,00,000.

• This process is known creation of credit – Fractional reserve

banking.
BANK DEPOSIT RESERVE LOAN
A 100.00 20.00 80.00
B 80.00 16.00 64.00
C 64.00 12.80 51.20
D 51.20 10.24 40.96
E 40.96 8.19 32.77
F 32.77 6.55 26.21
G 26.21 5.24 20.97
H 20.97 4.19 16.78
I 16.78 3.36 13.42
J 13.42 2.68 10.74
K 10.74 10.74 -
457.05 100.00 357.05
 Maturity Transformation

• Maturity transformation is a key function of banking.

• Borrowing short term and lending long term

• Banks are still called to transfer funds from agents in

surplus demanding short-term deposits to agents in deficit
with long-term financing needs (Hicks, 1946).
 • Households have a preference to hold
liquid assets as they may not be sure
when they will need to spend the
wealth.

• Many investment projects undertaken

by firms are highly illiquid.
Liquidity
• For this reason, households may not
Transformation want to directly investment in firms.

• Liquidity transformation is the process

by which banks simultaneously invest
in illiquid projects but provide
households with liquid assets (i.e.,
deposits).
 Commercial Banks

¢ Both scheduled and nonscheduled commercial banks are regulated

under Banking Regulation Act, 1949.

¢ Operate on a ‘for profit’ basis.

¢ Primarily engage in the acceptance of deposit and extend loans to the

general public, businesses and the government.
 Types of Commercial Banks
• Scheduled Commercial Banks (SCBs)

• State Bank of India (SBI) – 1 (PSBs)

• Nationalized banks – 11 (PSBs)

• Private sector banks – 22

• Foreign banks – 46

• Regional rural banks (RRBs) – 43

• Small finance banks – 10

• Payment banks – 2

• Nonscheduled Commercial Banks

 Scheduled Banks

¢ A bank which is listed in the 2nd Schedule of the Reserve Bank of India Act,
1934.

¢ Eligible for loans from the Reserve Bank of India at bank rate & are also given
membership to clearing houses.

¢ Paid up capital and reserves not less than ₹ 5 lakhs - ₹ 25 lakhs. Now as per
Basel –III requirements.

¢ The list includes State Bank of India (minimum 55% shareholding by central
government), Nationalized banks (minimum 51% shareholding by central
government), Private banks, Foreign banks, Regional Rural banks & Other
Scheduled Commercial banks.
 Non-Scheduled Banks

¢ Banks not under the 2nd schedule of R.B.I Act of 1934.

¢ They are not entitled to borrow from the RBI for normal banking purposes,
except, in emergency or “abnormal circumstances”.

¢ Paid up capital and reserves less than ₹ 5 lakhs – ₹ 25 lakhs.

¢ Non–scheduled state cooperative banks e.g., Delhi State Cooperative Bank

Ltd.

¢ Non-scheduled urban cooperative banks e.g., Akhand Anand Cooperative

Bank Ltd., Surat.
 Cooperative Banks

¢ The Banking Regulation Act, 1949 was made applicable to primary co-
operative banks commonly known as Urban Co-operative Banks (UCBs) w.e.f.
March 1, 1966.

¢ These are also registered under the Cooperative Societies Act, 1912.

¢ Play a vital role in mobilizing deposits and purveying credit to people of small
means.

¢ An important vehicle for financial inclusion and facilitate payment and

settlement.

¢ These banks run by an elected managing committee with provisions of

members’ rights and a set of “communally developed and approved by laws
and amendments.

¢ Work on “no profit, no loss” basis – do not pursue the goal of profit
maximization.
 Cooperative Banks – Post PMC
¢ Dual control - Registrar of Cooperative Societies and RBI.
¢ Role of registrar of cooperative societies includes incorporation, registration,
management, audit, supersession of board and liquidation.
¢ RBI is responsible for regulatory functions such maintaining cash reserve and capital
adequacy etc.
¢ Banking Regulation (Amendment) Bill, 2020 gives RBI greater supervisory and
regulatory powers over urban cooperative banks, tightened norms for appointment of
top management and boards at these lenders and put in place tougher risk and
reporting standards.
¢ RBI now can restructure/frame a revival plan for urban cooperative banks which are
struggling without putting restrictions on depositors.
¢ 1482 urban cooperatives banks and 58 multi-state cooperative banks - Depositor
base of 8.6 crore, amounting to ₹4.84 lakh crore.
¢ Enables cooperative banks to raise money via public issue and private placement, of
equity or preference shares and unsecured debentures.
 Regional Rural Banks (RRBs)

¢ RRBs were established under the RRB Act, 1976 with a view to develop the
rural economy.

¢ Serve the rural areas and agricultural sectors with basic banking and adequate
financial services.

¢ RRBs were set up to eliminate other unorganized financial institutions like

money lenders and supplement the efforts of co-operative banks.

¢ The capital base is held by the central government, respective state

government, and the commercial bank that sponsors them in the ratio 50:15:35
respectively.

¢ Commercial banks sponsor RRBs e.g., Maharashtra Gramin Bank (sponsored

by the Bank of Maharashtra).

¢ Multiple controlling authorities – RBI (regulator) & NABARD (supervisor).

 Small Finance Banks

¢ Setup with the objective to further financial inclusion - licensed under Section 22 of
the Banking Regulation Act, 1949.
¢ The small finance bank shall primarily undertake basic banking activities of
acceptance of deposits and lending to unserved and underserved sections including
small business units, small and marginal farmers, micro and small industries and
unorganized sector entities.
¢ The minimum paid-up equity capital for small finance banks is ₹ 200 crores.
¢ 75% of their adjusted net bank credit (ANBC) will go towards priority sector lending
and 50% of the loan portfolio will constitute loans up to ₹ 25 lakh.
¢ The promoter's minimum initial contribution to the paid-up equity capital shall at least
be 40%.
¢ Listing of SFBs will be mandatory within three years after the bank reaches a net
worth of ₹ 500 crores for the first time.
¢ Individual banks can decide upon the type of membership to the clearing house –
direct or through sub-member route.
 Payments Banks
¢ Setup with the objective to further financial inclusion by providing small savings
accounts and payments/remittance services to migrant labour workforce, low-
income households, small businesses, other unorganized sector entities and
other user.

¢ Licensed under Section 22 of the Banking Regulation Act, 1949.

¢ Acceptance of demand deposits - restricted to holding a maximum balance of ₹

200,000 per individual customer. Issuance of ATM/debit cards. No credit card

¢ Payments bank cannot undertake lending activities.

¢ It is required to invest minimum 75% of its "demand deposit balances" in SLR

eligible Government securities/treasury bills with maturity up to one year.

¢ The minimum paid-up equity capital is ₹ 100 crore.

¢ The promoter's minimum initial contribution to the paid-up equity shall be at least
be 40% for the first five years from the commencement of its business.
 Proposed Four tiers of banking system

¢ First tier - International Banks - 3 - 4 large Indian banks with domestic

and international presence along with branches of foreign banks in India.

¢ Second tier – National Banks - PSBs, New private sector banks, mid-
sized banking institutions including niche banks with economy-wide
presence.

¢ Third tier - Regional Banks - Old private sector banks, RRBs, and
multi state Urban Cooperative Banks

¢ Fourth tier – Local banks - Small private local banks & cooperative
banks.
 Banking system || Types of bank

• Commercial bank || Investment bank

• Universal bank || Differentiated banking

• Branch banking || Unit banking

• Retail banking || Wholesale banking

 Shadow banking

• Coined by Paul McCulley in 2007 to describe the legal structures used by big
Western banks before the financial crisis to keep opaque and complicated
securitized loans off their balance-sheets.

• Financial Stability Board (FSB) broadly describes shadow banking as credit

intermediation involving entities and activities outside the regular banking system.

• Shadow banks are financial firms that perform similar functions and assume
similar risks to banks.

• Being outside the formal banking sector generally means they lack a strong safety
net, such as publicly guaranteed deposit insurance or lender of last resort facilities
from central banks.

• Operate with a different, and usually lesser, level of prudential regulatory

standards and regulatory oversight.
 Shadow banking

• Shadow banking is more of a catch-all than a category - encompassing a very broad

range of heterogeneous activities.

• Help spur economic growth by making financial services more widely available.

• Broaden access to financial services by enhancing competition and diversification of

the financial sector - complement banks.

• In India these are known as Non-Banking Financial Company (NBFC).

• NBFCs are under RBI’s regulation since 1964 after the insertion of Chapter III-B in RBI
Act.
• No company can carry out NBFC business without obtaining Certificate of Registration
from RBI.
• Niche area of business - Investment and credit, micro-financing, factoring,
infrastructure financing, infrastructure debt fund, mortgage guarantee, housing finance,
account aggregators
 Non-Banking Financial Company

• Broadly 2 categories - Non-deposit accepting NBFCs with asset size of less

than ₹500 crore (NBFCs-ND)

• Non-deposit accepting NBFCs with assets of ₹500 crore and above (NBFCs-
ND-SI) and deposit accepting NBFCs (NBFCs-D).

• NBFC should have a minimum net owned fund of ₹ 2 crores.

• NBFC cannot accept demand deposits.

• NBFCs do not form part of the payment and settlement system and cannot
issue cheques drawn on itself.

• Deposit insurance facility of Deposit Insurance and Credit Guarantee

Corporation is not available to depositors of NBFCs, unlike in case of banks.
FIN 6002 – Session 5 - 6

Pradeepta Sethi
TAPMI
Source: Kjeldsen, K. (2004). The Role of Capital in Banks. Danmarks National bank Monetary Review, 57-69
Source: Admati A. R. (2012), Bank Capital How much is “Enough?” Federal Reserve Bank of Chicago 48th Annual Conference on Bank Structure and
Competition
Source: Ghosh, S. and Chatterjee, G.(2015), Capital Structure, Ownership and Crisis: How Different Are Banks? RBI WPS (DEPR): 06/2015
Traditional balance sheet

Assets Liabilities

Reserves Deposit
Short-term loans Short-term debt
Long-term loans Long-term debt
Other investments

Share holder equity

 Financial statements of bank
¢ Preparation and finalization of financial statements of a bank are governed by Banking
Regulation Act 1949.

¢ RBI devised a format for preparing balance sheet and each bank must follow the same
format.

¢ Section 29 - Every bank must publish the balance sheet as on last working day of March
every year on the prescribed Form “A” & profit and loss account on Form “B” as per the 3rd
schedule of this Act.

¢ Section 30 - Balance sheet is to be audited from qualified auditors.

¢ Section 31 - Each bank is required to submit balance sheet and auditor’s report within three
months from the end of period.

¢ Rule 15 - Banking Regulation Act 1949 prescribes that accounts and auditors' report shall
be published in the news paper.

¢ The RBI has powers to modify and suggest certain changes in the financial reporting format
from time to time.
 Balance sheet
¢ Bank’s ‘sources of funds’ on one side (liabilities and capital) and its ‘use of funds’ (assets) on
the other side.

¢ Banks fund their activities by a mixture of borrowed funds (‘liabilities’) and their own funds
(‘capital’).

¢ Liabilities — retail deposits from households and firms, such as current, savings
accounts, fixed deposits, wholesale funding: borrowing funds from institutional investors,
borrowing from other banks.

¢ Assets — loans to households, business, lending to wholesale market, interbank market

& investments

¢ Investments are classified into three categories – Held to Maturity (HTM – Need not be mark
to market [MTM]), Available for Sale (AFS – MTM Quarterly) and Held for Trading (HFT –
MTM monthly).

¢ Instruments for investment - Government securities, Other approved securities, Shares,

Bonds & Debentures, Subsidiaries & Joint Ventures; other (CP, MFs etc.)
 As on (Current As on (Previous
Items Schedule No
year) ₹ in crore year) ₹ in crore
CAPITAL AND LIABILITIES:
Capital 1
Reserves & Surplus 2
Deposits 3
Borrowings 4
Other Liabilities & Provisions 5
ASSETS:
Cash and balances with R.B.I 6
Balances with banks & Money
7
at call and short notice
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
TOTAL
Contingent liabilities 12
Bills for collection
 Capital

¢ For PSUs –

• Capital owned by Central Government (major portion).

¢ Other Indian banks –

• Authorized, Subscribed, and Paid-up capital should be given

separately.

¢ Banking Companies incorporated outside India –

• operate on wholly-owned subsidiary (WOS) model with initial

minimum paid-up capital of ₹500 crores.
 Capital

¢ For supervisory purposes capital is split into two categories.

¢ Tier – I Capital
l Capital which is first readily available to protect the unexpected losses.
l Tier I items are deemed to be of the highest quality.
l Hence it is also known as Core Capital.

l It consists mainly of paid up capital, statutory reserves & capital reserves.

¢ Tier – II Capital
l Capital which is second readily available to protect the unexpected losses.
l The loss absorption capacity of Tier II capital is lower than that of Tier I capital.
l Hence, it is known as Supplementary Capital.
l Tier II capital consists subordinated debt, undisclosed reserves, perpetual preferred
shares & general provisions and loan-loss reserves.
 Reserves

¢ Statutory Reserve
¢ Reserve created in terms of section 17(1) section of Banking Regulation Act, 1949.
¢ Every banking company incorporated in India shall transfer a sum not less than 20% of
the profit of each year before declaring a dividend.
¢ Capital Reserve
l Surplus on revaluation or sale of fixed assets should be treated as capital reserves.
l That portion of a bank's profits not paid out as dividends to shareholders.
¢ Share Premium
l Premium on issue of share capital may be shown separately under this head.
¢ Revenue Reserve
l Any reserve other than capital reserve, other than those separately classified.
¢ Investment Fluctuation Reserve
l To guard against any possible reversal of interest rate environment in future banks are
required to maintain a minimum reserve of 5% of the investment portfolio.
Item Schedule Coverage
Interest earned 13 I. Interest /discount on advances/bills.
II. Income on investments
III Interest on balances with Reserve Bank of India and other interbank funds
Other income 14 I. Commission, Exchange & brokerage
II. Profit / (Loss) on sale of investments (Net)
III. Profit / (Loss) on revaluation of investments (Net)
IV. Profit / (Loss) on sale of land, building and other assets (Net)
V. Profit / (Loss) on exchange transactions (Net)
VI. Income earned by way of dividends, etc. from subsidiaries/companies
and/or joint ventures abroad/in India
VII. Miscellaneous Income
Interest
15 I. Interest on deposits
expended
II. Interest on RBI/ Inter-Bank borrowings & III. Others
Operating
16 I. Payments to and provisions for employees II. Rent, Taxes & Lighting
expenses
III. Printing & Stationery IV. Advertisement and Publicity
V. Depreciation on Banks’ property, VI. Directors’ fees, allowances and
expenses VII. Auditors’ fees & expenses (including branch auditors)
VIII. Law charges IX. Legal and other expenses debited in respect of PB
Accounts X. Postage, Telegram, Telephones, etc. XI. Repairs & Maintenance,
XII. Insurance XIII. Other Expenditure
Provisions & Provisions & Contingencies made for i) Income Tax ii) Other Taxes iii) NPAs iv)
Contingencies Investments v) Others
I. Transfer to Statutory Reserves II. Transfer to Capital
 Bank earnings

¢ Principal source of banks’ earning –

l Net Interest Income (NII) = Interest income – Interest expense
¢ It accounts for at least 70% of bank’s income.
¢ Net Interest Margin (NIM)
l Net Interest Income / total average interest earnings assets over the period
¢ NIM is measured as the excess of interest income over interest expense scaled by
total asset.
¢ This indicates as to how effectively the banks deploy their funds to generate income
from credit and investment operations.
¢ At bank level, the bank with high NIM is considered more efficient as compared to a
bank with low NIM.
¢ The net interest margin (NIM) is driven by the volume and composition of the
balance sheet and by the interest rates applicable to the individual asset and liability
accounts.
 Interest Income to Total Income
100.00%

95.00%

90.00%

85.00%

80.00%

75.00%

70.00%
05
06
07
08
09
10
11
12
13
14
15
16
17
18
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
SBI HDFC ICICI AXIS BoB PNB

Author's own calculations, Data Source: R.B.I

 Why bank earnings are important?

¢ Burden is defined as the difference between non-interest Income and non-

interest expenses.
¢ The burden ratio is the measure of the difference between non-interest Income
and non-interest expenses expressed as a ratio to average assets.
¢ The burden ratio measures how the net asset yield (net interest income/average
assets) will be burdened by the net expenses of the institution.
¢ Banks earnings provide for internal capital formation.
¢ Healthy profits are needed to absorb loan losses and to build adequate
provisions.
¢ A consistent earnings performance builds public confidence in the bank - attract
new investor capital.
¢ Public confidence - is the most valuable banking asset - it allows to minimize
funding costs and provides access to the best borrowers.
FIN 6002 – Session 7

Pradeepta Sethi
TAPMI
 Funds Transfer Pricing (FTP)

• Funds surplus branches - Provider of funds - mobilize more deposits but

extend lesser amount of loan.

• Funds deficit branches -– User of funds - more potential for extending loans
and advances

• Surplus bank branches supply to the deficit branches.

• The supplier branch is compensated by way of interest payments by the

deficit branch.

• The interest at which the supplier branch is compensated is known as

transfer price.
Source : Grant, J. (2011), Liquidity transfer pricing: a guide to better practice, BIS Occasional Paper
 Funds Transfer Pricing (FTP)

¢ Traditionally, banks have viewed their branches, particularly those with

surplus deposits as the cost generators and their loan extending branches
as the profit makers.
¢ FTP is an internal allocation and measurement mechanism for determining
the pricing of incremental loans/investments/deposits and for determining the
profit contribution of various lending and borrowing units of a bank.
¢ A transfer price is an internal rate of interest used to calculate transfer
income or cost due to an internal flow of funds in a bank.
¢ It is like actual rate of interest paid or received on a bank product, since it
concerns the same transaction balance that the actual rate of interest does.
¢ The interest margin is the difference between interest rate and a transfer
price, and it allows calculating the internal interest profit on a transaction.
 Funds Transfer Pricing (FTP)

¢ Without funds transfer pricing system

l Net funds users would receive credit for interest income without being
charged for the full amount of associated interest expense.

l While net funds providers would be charged with interest expense

without being credited for the full amount of assisted interest income.

l Net funds users have the advantage because all interest income is
associated with assets and all interest expense is associated with
liabilities. So, the net users appear more profitable than the net providers.
 Transfer Pricing Mechanism

¢ This is done by the controlling office of the bank mainly under the Asset-
liability Management (ALM) system.

¢ Segregation of interest income into various segments.

¢ Transferring interest rate risk to ALM unit.

¢ Pricing funds to branches with economic benchmarks, using economic

transfer prices and other methods.

¢ ALM unit aims to maintain interest rate risk within prescribed limits while
minimizing the cost of funds or optimizing the return on investments.

¢ Transferring funds between branches.

 Systemic Risk

• Risk of a large-scale failure of a financial system

• Risk spreads from unhealthy institutions to otherwise healthy institutions

through a transmission mechanism.

• Providers of capital (depositors, investors, and capital markets) lose trust in

either the users of capital (banks, borrowers, leveraged investors, etc.), or in
a given medium of exchange (the US dollar, Japanese yen, pound sterling,
gold, etc.).

¢ Contagion - When a crisis in one financial market | one country causes a

crisis in another financial market | another country.
 CAMELS Approach

¢ Why a system of regulation & supervision? - Depositor protection and systemic

risk.
¢ 1980s - the US supervisory authorities, by the CAMEL rating system introduced
ratings for on-site examinations of banking institutions to classify a bank's overall
condition – point in time assessment.
¢ The component of bank condition that are assessed
l Capital adequacy
l Asset quality
l Management capability
l Earnings
l Liquidity
l Sensitivity (sensitivity to market risk, especially interest rate risk)
 CAMELS Approach

¢ Each of the component factors is rated on a scale of 1 (best) to 5 (worst).

¢ A composite rating is assigned as an abridgement of the component ratings and is

taken as the prime indicator of a bank’s current financial condition.

¢ The composite rating ranges between 1 (best) and 5 (worst).

¢ The CAMELS ratings are normally assessed every year.

¢ Objective of supervision - Protection of depositors’ interests and ensuring

financial health of individual banks/FIs.

¢ S. Padmanabhan committee (1995) - six rating factors - Capital Adequacy, Asset

Quality, Management, Earnings, Liquidity, Systems and Controls (i.e. CAMELS)
for Indian banks.

¢ Foreign banks, five rating factors - Capital Adequacy, Asset Quality, Liquidity,
Compliance, Systems and Controls (i.e. CALCS).
 CAMELS Approach

¢ Each of the components of CAMELS is rated on a scale of 1-100 in ascending

order of performance.

¢ The score of each CAMELS element is arrived by aggregating (by assigning

proportionate weights) the scores of various sub-parameters that constitute the
individual CAMELS parameter.

¢ Each parameter is awarded a rating A-D (A-Good, B–Satisfactory, C-

Unsatisfactory, and D-Poor).

¢ The composite “CAMELS rating” is arrived by aggregating each of the component

weights.

¢ Further the overall composite score is adjusted downwards for poor performance
in one or more components.
Rating Symbol Rating symbol indicates
A+, A, A- Good
B+, B, B- Satisfactory
C+, C, C- Unsatisfactory
D Poor
Weights of various parameters under the CAMELS/CALCS Model
CAMELS CALCS
Capital Adequacy 18 18
Asset Quality 18 18
Management 18 --
Earnings 10 --
Liquidity 18 18
Compliance -- 26
System & Control 18 20
 Limitations of CAMELS Approach

¢ It does not incorporate any forward-looking elements thereby not reflecting the
true market standing of the entity.

¢ The factors influencing the rating awarded to the bank and the implications of the
awarded rating are not shared with the banks.

¢ Moreover, it’s a stock approach (focus on the financial position of the supervised
entities at a given point in time).

¢ Chakrabarty committee (2012) – Risk based supervision

Banking stability map and indicator

Source:Mishra R.N., Majumdar, S. and Bhandia, D (2013). Banking Stability - A Precursor to Financial Stability, RBI WPS (DEPR)
FIN 6002 – Session 9

Pradeepta Sethi
TAPMI
 Do banks need to be regulated?
A. The systemic risk argument
• Banks provide liquidity services (deposits).This liquidity
services leave banks exposed to bank runs – situation in a
balance sheet where the liquidation value of its assets is
less than the value of liquid deposits

• In a bank run, the value of the deposits depend on

depositor's place in line at the time of withdrawal because of
the first come, first served rule.
• This run can occur due to depositors panic and/or due to
information asymmetry.

• If each bank’s investment in the short–term asset were

publicly observable then depositors could be fully insured
against the liquidity risk.
• But the existence of asymmetry of information about the
banks’ assets makes them susceptible to an additional
source of runs.
• It may trigger contagion runs, which may culminate in a
system failure.
 Do banks need to be regulated?
B. Deposit insurance and moral hazard
• Government deposit insurance (safety net) has proven
very successful in protecting banks from runs, but at a
cost because it leads to moral hazard.
• By offering a guarantee that depositors are not subject to
loss, the provider of deposit insurance bears the risk.
• As a result, it diminishes depositors’ incentive to monitor
banks and to demand an interest payment commensurate
with the risk of the bank.
• When the insurance scheme charges the bank a flat rate
premium, the bank does not internalise the full cost of risk
and therefore it has an incentive to take on more risk.
• The moral hazard caused by deposit insurance can be
dealt by charging banks risk–related insurance premiums
and to regulate their capital structure.

• Asymmetry of information make the computation of fair

premiums impossible or undesirable from a welfare point
of view.
 What is bank capital?
¢ Capital can be considered as a bank’s ‘own funds’, rather
than borrowed money such as deposits.
¢ A bank’s own funds are items such as its ordinary share
capital and retained earnings — in other words, not money
lent to the bank that has to be repaid — no associated
contractual commitment for repayment.
¢ Taken together, these own funds are equivalent to the
difference between the value of total assets and liabilities.
¢ Capital appears alongside liabilities as a source of funding
— one that can absorb losses that could otherwise
threaten a bank’s solvency.
¢ It provide funds to finance fixed investments — investment
in building, land, equipment, to finance growth and
expansion etc.
¢ During a bank’s life, it generates new capital from its
profits. Profits not distributed to shareholders are allocated
to other components of shareholders’ equity, resulting in a
permanent increase.
¢ Capital growth is a source of additional funds used to
finance new assets.
 buying with a ₹30,000 down-payments (initial equity)
Year end house-price % change Loan amount Final equity ROE
3,45,000 15 2,70,000 75,000 150
3,15,000 5 2,70,000 45,000 50
3,00,000 0 2,70,000 30,000 0
2,85,000 -5 2,70,000 15,000 -50
2,55,000 -15 2,70,000 0 -150
buying with a ₹60,000 down-payments (initial equity)
Year end house-price % change Loan amount Final equity ROE

3,45,000 15 2,40,000 1,05,000 75

3,15,000 5 2,40,000 75,000 25
3,00,000 0 2,40,000 60,000 0
2,85,000 -5 2,40,000 45,000 -25
2,55,000 -15 2,40,000 15,000 -75
• Misleading to think of capital as
‘held’ or ‘set aside’ by banks.

• Capital is not an asset.

• It’s a form of funding.

• reserve requirement ≠ capital

requirement
Key characteristics of Capital

¢ It represents a bank’s ability to absorb losses

while it remains a ‘going concern’ — keeps it
‘balance-sheet solvent’.

¢ Unlike a bank’s liabilities, it is perpetual: as long

as it continues in business, the bank is not
obligated to repay the original investment to
capital investors.

¢ Typically, distributions to capital investors

(dividends to shareholders) are not obligatory and
usually vary over time, depending on the bank’s
profitability.
Why capital is so important?

• Capital as Incentive

• Skin in the game

• Capital as a Buffer

• Going concern

• Capital for Intervention

• Gone concern
Source : Quarterly Bulletins, Bank of England
 What is liquidity risk?
• Liquid assets (such as cash, central bank reserves
or government bonds) appear on asset side of the
balance sheet as a use of funding.

• A bank holds a buffer of liquid assets to mitigate

against the risk of liquidity crises caused where other
sources of funding dry up.

• Liquidity risk — It is the risk that a large number of

depositors and investors may withdraw their savings
— that is, the bank’s funding — at once, leaving the
bank short of funds.

• Such situations can force banks to sell off assets —

most likely at an unfavorably low price.

• Broadly two types of liquidity risk - Funding liquidity

risk & Market liquidity risk.
 Funding liquidity risk
¢ The risk that a bank does not have
sufficient cash or collateral to make
payments to its counterparties and
customers as they fall due (or can only
do so by liquidating assets at excessive
cost).

¢ In this case the bank has defaulted.

This is sometimes referred to as the
bank having become ‘cash-flow
insolvent’.

¢ A bank ‘run’ is an acute crystallization

of funding liquidity risk.

¢ Balance sheet insolvency is another

trigger for bank run.
 Market liquidity risk
¢ This is the risk that an asset cannot be
sold in the market quickly, or, if its sale is
executed very rapidly, it can only be
achieved at a heavily discounted price.

¢ It is primarily a function of the market for

an asset, and not the circumstances of an
individual bank.

¢ Market liquidity risk can soon result in the

bank facing a funding liquidity crisis.

¢ Alternatively, with a fire sale (selling at a

heavily discounted price), it may result in
the bank suffering losses which deplete
its capital.
 ¢ Credit risk - The risk of a borrower being
unable to repay what he or she owes to a
bank.

¢ This causes the bank to make a loss.

Balance ¢ This is reflected in a reduction in the size

of the bank’s assets shown on its balance
sheet sheet: the loan is wiped out, and an
equivalent reduction must also be made to
insolvency the other side of the balance sheet, by a
reduction in the bank’s capital.

¢ If a bank’s capital is entirely depleted by

such losses, then the bank becomes
‘balance sheet insolvent’.
 Expected and Unexpected loss
¢ Losses of interest and principal occur all the time -
there are always some borrowers that default on
their obligations.

¢ While it is never possible to know in advance the

losses a bank will suffer in a particular year, a bank
can forecast the average level of credit losses it can
reasonably expect to experience. These losses are
referred to as Expected Losses (EL).

¢ Financial institutions view Expected Losses as a

cost component of doing business.

¢ They manage them through the pricing of credit

exposures and through provisioning.

¢ One of the functions of bank capital is to provide a

buffer to protect a bank’s debt holders against peak
losses that exceed expected levels.
 Expected and Unexpected loss

¢ Peak losses do not occur every year, but when they

occur, they can potentially be very large.

¢ Losses above expected levels are usually referred

to as Unexpected Losses (UL).

¢ Interest rates, including risk premia, charged on

credit exposures may absorb some components of
unexpected losses, but the market will not support
prices sufficient to cover all unexpected losses.

¢ Capital is needed to cover the risks of such peak

losses, and therefore it has a loss-absorbing
function.
Source: Basel Committee on Banking Supervision (2005)
Covered by provisions Covered by capital
& write-offs
Source: Basel Committee on Banking Supervision (2005)
Bank Capital How much is “Enough?”

¢ Banks have an incentive to minimize the capital they

maintain, because reducing capital frees up
economic resources that can be directed to
profitable investments.

¢ On the other hand, the less capital a bank

maintains, the greater is the likelihood that it will not
be able to meet its own debt obligations, i.e., that
losses in a given year will not be covered by profit
plus available capital, and that the bank will become
insolvent.

¢ Thus, banks and their supervisors must carefully

balance the risks and rewards of maintaining capital.
FIN 6002 – Session 11

Pradeepta Sethi
TAPMI
 Capital regulations

¢ Bank capital regulations were introduced in order to redress the natural

tendency of banks to maintain insufficient capital and ward off moral
hazard behavior.

¢ The Basel capital adequacy regime dates back to the Basel Accord of
1988, which led to the introduction of Basel I.

¢ Has its origins in the financial market turmoil that followed the breakdown
of the Bretton Woods system of managed exchange rates in 1973.

¢ After the collapse of Bretton Woods, many banks incurred large foreign
currency losses.
 Origins of Capital regulations

¢ On 26th June 1974, West Germany’s Federal Banking Supervisory Office

withdrew Bankhaus Herstatt’s banking license after finding that the bank’s
foreign exchange exposures amounted to three times its capital.

¢ Banks outside Germany took heavy losses on their unsettled trades with
Herstatt, adding an international dimension to the turmoil. In October the
Franklin National Bank of New York also closed its doors after incurring
large foreign exchange losses.

¢ The central bank governors of the G10 countries established a Committee

on Banking Regulations and Supervisory Practices at the end of 1974.
Later renamed it as Basel Committee on Banking Supervision (BCBS).
 Basel Committee

¢ Committee was designed as a forum for regular cooperation between its

member countries on banking supervisory matters.

¢ Its aim is to enhance financial stability by improving supervisory know

how and the quality of banking supervision worldwide.

¢ Currently there are 28 member countries.

¢ Countries are represented on the Committee by their central bank and

also by the authority for the prudential supervision of banking business.
 Basel I

¢ Capital adequacy became the main focus of the Committee’s activities.

¢ Capital measurement system – ‘International Convergence of Capital

Measurements and Capital Standards’ commonly referred to as the Basel
Capital Accord (1988 Accord) was approved by the G10 Governors and
released to banks in July 1988.

¢ The 1988 Accord called for a minimum capital ratio of capital to risk-
weighted assets of 8% to be implemented by the end of 1992.

¢ Focused mainly on the assessment of the quantity of credit risk - created

a cushion against credit risk.
 Basel – I : Four Pillars

Constituents of capital

Risk weighting

Target standard ratio

Transitional & implementing arrangements

 ¢ Capital as per Basel accord, better known
as regulatory capital, is sum of Tier I and
Tier II capital.

¢ Tier I capital or core capital consists of

BASEL - I
elements that are more permanent in nature
and as a result, have high capacity to
absorb losses.

Pillar I: l This comprises of equity capital and

disclosed reserves.
Constituents of
Capital l Equity capital includes fully paid ordinary
equity/common shares and perpetual non-
cumulative preference capital.

l Disclosed/published reserves include post-

tax retained earnings.

l The accord requires Tier I capital to

constitute at least 50 percent of the total
capital base of the banking institution.
 ¢ Tier II capital is ambiguously defined as it may
also arise from difference in accounting
treatment in different countries.

¢ Tier II capital (supplementary capital) is made up

BASEL - I of a broad mix of near equity components and
hybrid (capital/debt) instruments.

l Upper Tier II comprises of items closer to

Pillar I: common equity, like perpetual subordinated
debt;
Constituents of
Capital l Lower Tier II comprises of items closer to
debt than of equity.

¢ The total of Tier II capital is limited to 100 per

cent of Tier I capital.

¢ Tier III capital (additional supplementary capital)

was added in 1996 and can only be used to
meet capital requirements for market risk.
 ¢ Some assets (i.e. loans) are riskier than others.
Each asset class can be assigned a risk weight
according to how risky it is judged to be.

¢ These weights are then applied to the bank’s

BASEL - I assets, resulting in risk-weighted assets (RWAs).

¢ Capital Adequacy Ratio (CAR) = Capital-to-risk

weighted assets ratio (CRAR) — measure of a
bank’s capital — It is the ratio of a bank's capital
in relation to its risk weighted assets.
Pillar II: Risk
e.g. Assuming a home mortgage has 50% of risk
Weighting ¢
weights. So if a bank has a portfolio of ₹100
crores home mortgage, then RWA for home
mortgage is ₹50 crores and if CAR IS 8%, then
the bank needs 50×.08= ₹4 crores as capital for
the home mortgage portfolio.

¢ The framework of weights was kept simple with

five weights used for on-balance sheet assets.
The risk weights include 0, 10, 20, 50 & 100% as
weights.
 Categories of assets Risk Weights

BASEL - I
Cash and Government bonds 0%

Claims on domestic public

10%
sector entities
Pillar II: Risk
Weighting
Inter-bank loans 20%

Home mortgages 50%

Other loans 100%

 ¢ Off-balance sheet elements - contingent
BASEL - I liabilities such as letters of credit,
guarantees and commitments, and Over-
The-Counter (OTC) derivative
instruments, were to be first converted to
a credit equivalent by multiplying the
Pillar II: Risk nominal principal amounts by a credit
Weighting conversion factor (CCF).

¢ The resulting amounts then being

weighted according to the nature of the
counterparty.
Instruments Credit Conversion
Factors (%)

Commitments with an original maturity of up to one year, or which can

0
be unconditionally cancelled at any time
Short-term self-liquidating trade-related contingencies (such as
shipments documentary credits collateralized by the underlying 20
shipments)
• Certain transaction-related contingent items (for example,
performance bonds, bid bonds, warranties and standby letters of
credit related to particular transactions)
50
• Note issuance facilities and revolving underwriting facilities
• Other commitments (for example, formal standby facilities and
credit lines) with an original maturity of over one year
• Direct credit substitutes, for example, general guarantees of
indebtedness (including standby letters of credit serving as
financial guarantees for loans and securities) and acceptances
(including endorsements with the character of acceptances)
• Sale and repurchase agreements and asset sales with recourse, 100
where the credit risk remains with the bank
• Forward asset purchases, forward deposits and partly-paid
shares and securities, which represent commitments with certain
drawdown
 ¢ The risk weighted method is favored over
a simple gearing ratio method due to the
following benefits:
BASEL - I
¢ provides for a fair basis of comparison
between international banks with different
capital structures;

Pillar II: Risk ¢ enables accountability of off-balance

Weighting sheet elements;

¢ does not deter banks to hold liquid and

low risk assets to manage capital
adequacy.
 ¢ Banks to meet two minimum capital
BASEL - I ratios, both computed as a percentage of
the risk-weighted (both on- and off-
balance sheet) assets.

The minimum Tier I ratio was 4 per cent

Pillar III: Target ¢
of risk-weighted assets.
Standard Ratio
¢ Total capital (Tiers I & II) had to exceed 8
per cent of risk-weighted assets.
 BASEL - I ¢ Sets different stages of implementation of
the norms in a phased manner.

¢ Due to widespread undercapitalization of

Pillar IV: the banking sector during that time, a
Transitional & phased manner of implementation was
Implementing agreed upon, wherein a target of 7.25
Arrangement percent was to be achieved by the end of
1990 and 8 percent by the end of 1992.
 Major principles of Basel Accord

¢ A bank must maintain equity capital to at least 8 per cent of its risk-
weighted credit exposures as well as capital to cover market risks in the
bank’s trading account.

¢ When capital falls below this minimum requirement shareholders may be

permitted to retain control, provided that they recapitalize the bank to
meet the minimum capital ratio.

¢ If the shareholders fail to do so, the bank’s regulatory agency is

empowered to sell or liquidate the bank.
 Amendment in 1996

¢ Amended in January 1996 for providing an additional buffer for risk due to
fluctuations in prices, on account of trading activities carried out by the banks.

¢ Banks were permitted to use internal models to determine the additional quantum
of capital to be provided.

¢ Banks had to estimate value-at-risk (VAR) on account of its trading activities that
is the maximum quantum of loss the portfolio could suffer over the holding tenure
at a certain probability.

¢ The capital requirement is then set on the basis of higher of the following
estimate.

l Previous day’s Value-at-risk; or,

l Three times the average of the daily value-at-risk of the preceding sixty
business days
 Criticism of Basel I

¢ Basel I standards stems from the fact that they attempt to define and measure
bank portfolio risk categorically by placing different types of bank exposures into
separate ‘buckets’.

¢ Banks are then required to maintain minimum capital proportional to a weighted

sum of the amounts of assets in the various risk buckets.

¢ That approach incorrectly assumes that risks are identical within each bucket and
that the overall risk of a bank’s portfolio is equal to the sum of the risks across the
various buckets.

¢ Standards have not been able to meet one of the central objectives, viz., to make
the competitive playing field more even for international banks.

¢ ’One-size-fits-all’ – imposing same rules on all banks even within a country.

FIN 6002 – Session 12 – 13

Pradeepta Sethi
TAPMI
 Transition to Basel II

• The banking crises of the 1990s

• Criticism of Basel I

• A Revised Framework on International Convergence

of Capital Measurement and Capital Standards
(Basel II) - 1999 (started) – 2004 (Final version)
 Basel – II: Three Pillars

Pillar I

• Minimum capital requirement

Pillar II

• Supervisory review

Pillar III

• Market discipline
C
a
p
i Operational
t Credit Risk Market Risk
a
Risk
l
Standardized Basic Indicator Standardized
r Approach Approach Approach
e
q
Foundation-
u Standardized Internal Model
Internal Ratings
Approach Approach
i Based Approach
r
e Advanced Advance
m Internal Ratings Measurement
Based Approach Approach
e
n
t
 ¢ Basel II measures the risk-weighted
assets (RWAs) of a bank more
carefully.
¢ 3 methodologies to determine the
risk rating of a bank’s assets –
B
l The Standardized Approach &
A
Pillar I: Minimum l Two Internal Ratings Based
S Approaches (IRB approaches) –
capital requirements
E • The Foundation IRB (F-IRB)
L • The Advanced IRB (A-IRB)
Credit Risk
¢ The standardized approach makes
use of ratings from external credit
I rating agencies to compute capital
I requirements commensurate with
the level of credit risk.
¢ There are 13 categories of (counter
parties) individual assets specifically
named in the Basel II accord with
risk-weighting norms.
 1. Claims on Domestic Sovereigns
2. Claims on Foreign Sovereigns
3. Claims on Public Sector Entities
4. Claims on MDBs, BIS and IMF
B
5. Claims on Banks
A
6. Claims on Primary Dealers
S Pillar I: Minimum
capital requirements 7. Claims on Corporates
E 8. Claims included in the Regulatory
Retail Portfolios
L
Credit Risk 9. Claims secured by Residential
Property
I 10. Claims secured by Commercial
Real Estate
I
11. Non-Performing Assets
12. Specified Categories
13. Other Assets
14. Off-Balance Sheet Items
 Risk Weights

Source : Master Circular - Prudential Guidelines on Capital Adequacy and Market Discipline , RBI
 Risk Weights

Source : Master Circular - Prudential Guidelines on Capital Adequacy and Market Discipline , RBI
Source: RBI, Notification dated June 7, 2017, on Individual Housing Loans: Rationalisation of Risk-Weights and Loan to Value
(LTV) Ratios
Source: RBI, Notification dated October 16, 2020, on Individual Housing Loans: Rationalisation of Risk-Weights and Loan to
Value (LTV) Ratios
 Internal Rating Based (IRB)
approach
¢ Classification of exposures into six
broad categories - corporates,
sovereigns, banks, retail, project
B finance, and equity.
A ¢ India – corporates, sovereigns,
S Pillar I: Minimum banks, retail, equity and others.
capital requirements
E ¢ The capital charge for the six
L exposures discussed above will
then depend on a specific set of risk
Credit Risk - IRB components, or inputs – Probability
of Default (PD) , Loss Given Default
I (LGD), Exposure At Default (EAD)
I and some cases Maturity (M).
These inputs provide risk weights.

¢ To calculate risk-weighted assets,

the bank will multiply the risk
weights by a measure of exposure –
EAD.
 Internal Rating Based (IRB)
approach

¢ Corporate exposures - a specific

B rating to each borrower or loan
A based on a combination of objective
and subjective criteria. The rating is
S Pillar I: Minimum oriented to the risk.
capital requirements
E
¢ For retail loans - banks commonly
L divide the portfolio into segments
Credit Risk - IRB made up of exposures with similar
risk characteristics.
I
¢ Banks then assess risk and quantify
I loss characteristics (PD, LGD, EL,
and EAD) at the segment level
rather than at the individual
exposure level.
 Internal Rating Based (IRB)
approach

¢ Expected Losses (EL) - A bank can

B expect to lose, on average, a
A certain amount of money over a
Pillar I: Minimum predetermined period of time when
S extending credits to its customers.
capital requirements
E
¢ These losses should, therefore, not
L come as a surprise to the bank, and
Credit Risk - IRB a prudent bank should set aside a
certain amount of money (often
I called loan loss reserves to cover
these losses that occur during the
I normal course of their credit
business.

¢ EL must be treated as the

foreseeable cost of doing business
in lending markets.
 ¢ EL is determined by three components
¢ The probability of default (PD) - is the
probability that a borrower will default
before the end of a predetermined
period (the estimation horizon typically
B chosen is one year) or at anytime
before the maturity of the loan -
A Underlying minimum historical
S Pillar I: Minimum observation period is five years.
capital requirements
E ¢ For both foundation and advanced
approaches, the bank has to calculate
L the PD on its own.
Credit Risk - IRB ¢ The exposure amount (EA) of the loan
at the time of default (EAD)
I
¢ The loss rate (LR) - that is, the fraction
I of the exposure amount that is lost in
the event of default, meaning the
amount that is not recovered after the
sale of the collateral (LGD) – Facility
specific
¢ 𝐸𝐿 = 𝐸𝐴×𝑃𝐷×𝐿𝑅
 ¢ EL does not itself constitute risk.

¢ If losses always equaled their

expected levels, there would be no
uncertainty, and there would be no
B economic rationale to maintain
A capital against credit risk.

S Pillar I: Minimum
capital requirements ¢ Risk arises from the variation in loss
E levels—which for credit risk is due
to unexpected losses (UL).
L
Credit Risk - IRB ¢ Unexpected loss is the standard
deviation of credit losses
I
I ¢ EL is calculated as the mean of a
distribution, UL is calculated as the
standard deviation of the same
distribution.

¢ 𝑈𝐿 = 𝐸𝐴× 𝑃𝐷×𝜎 ! "# + 𝐿𝑅 ! ×𝜎 ! $%

Source: Michale K. Ong (2006), Risk Management A modern perspective
 ¢ Foundation IRB (F-IRB) gives banks
the freedom to develop their own
models to ascertain risk weights for
their assets. These are, however,
B subject to the approval of the
banking regulator.
A
S Pillar I: Minimum ¢ A-IRB is same as F-IRB except that
capital requirements banks are free to use their own
E assumptions (LR, EA).
L ¢ By design, the IRB approaches are
Credit Risk - IRB ‘self-regulating mechanisms’.
I ¢ IRB approaches yield merits for both
I bankers and regulators.

¢ Lower risk weights imply lower

capital requirements, and in-turn
higher profitability for the bank.
 Economic capital could be viewed as the optimal
amount of shareholders' equity within the bank's
overall liability structure which is required for the
banking business.

The principal aim of regulatory capital is to provide a

loss-absorbing buffer to protect depositors, or their
Economic insurer, from the possibility of loss due to bank failure.

Capital
________ 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.”
Regulatory
The confidence level is established by bank
Capital management.

Other things being equal, therefore, one might expect

that the banks' own economic capital numbers for
credit risk and operational risk would be significantly
greater than their minimum regulatory capital
requirements.
FIN 6002 – Session 15

Pradeepta Sethi
TAPMI
 Operational Risk

¢ Risk of loss resulting from

inadequate or failed internal
process, people and systems or
B from external events.

A ¢ Internal fraud – intentional

S Pillar I: Minimum misreporting of positions, employee
capital requirements theft, and insider trading on an
E employee’s own account.
L ¢ External fraud – robbery, forgery,
Operational Risk cheque kiting, and damage from
computer hacking.
I
I ¢ Employment practices and
workplace safety – workers
compensation claims, violation of
employee health and safety rules,
organized labour activities,
discrimination claims, and general
liability.
 ¢ Clients, products and business
practices – fiduciary breaches,
misuse of confidential customer
information, improper trading
activities on the bank’s account,
money laundering, and sale of
B unauthorised products.
A ¢ Damage to physical assets – For
S Pillar I: Minimum example, terrorism, vandalism,
capital requirements earthquakes, fires and floods.
E
¢ Business disruption and system
L failures – hardware and software
Operational Risk failures, telecommunication
problems, and utility outages.
I
¢ Execution, delivery and process
I management – data entry errors,
collateral management failures,
incomplete legal documentation,
and unauthorized access given to
client accounts, non-client
counterparty mis performance, and
vendor disputes.
B
A ¢ Unlike some other risk types,
S Pillar I: Minimum not all operational risk events
capital requirements lead to banks incurring losses.
E
L ¢ Operational failures can result in
Operational Risk no loss to a bank, a near miss,
or even lead to a bank making a
I profit, a gain event.
I
Source: Richard Apostolik, Christopher Donohue (2015) Foundations of Financial Risk
B ¢ 3 methods for measurement of
A operational risk–

S Pillar I: Minimum
¢ Basic Indicator Approach (BIA)
capital requirements
E
¢ The Standardized Approach
L (TSA) / The Alternative
Operational Risk Standardized Approach (ASA)
I
¢ Advanced Measurement
I Approach (AMA)
 Basic Indicator Approach (BIA)
¢ Under BIA, banks have to maintain
capital to a fixed percentage (alpha)
of a single indicator.

B ¢ This indicator is ’gross income’.

A ¢ 𝐾!"# = ∑(𝐺𝐼×𝛼) /𝑛, 𝐾!"# = capital

charge under BIA, 𝐺𝐼 = Gross
S Pillar I: Minimum
income, 𝛼 = fixed percentage, n=
capital requirements number of previous 3 years where
E
GI is positive.
L
Operational Risk - BIA ¢ Gross Income = Net profit +
Provisions & contingencies +
Operating expenses – Profit on sale
I of HTM investments – Income of
I insurance – Extraordinary/irregular
item of income + loss on sale of
HTM investments.
¢ Banks to maintain capital at 15% of
their average annual gross income
(over the past three years).
 The Standardized Approach (TSA)
¢ Bank’s activities are divided into
eight business lines.

B ¢ Against each business line a broad

indicator is specified (GI) to reflect
A the size or volume of banks’
S Pillar I: Minimum activities in that area.
capital requirements Within each business line, the
E ¢
capital charge is calculated by a
L factor (beta) assigned to that
Operational Risk - TSA business line.
¢ The idea is that business lines with
I lower operational risk (e.g., asset
I management) would translate into
lower reserve requirements.
¢ 𝐾$%# =
{∑ 1 − 3 𝑦𝑒𝑎𝑟𝑠 max(∑ (𝐺𝐼&'( ×
𝛽&'( ), 0}1/3
 Business Line Indicator Beta
Factor(%)
Corporate finance Gross Income 18
Trading and sales Gross Income 18

The Retail banking Gross Income 12

Commercial banking Gross Income 15
Standardized Payment and 18
Gross Income
Approach settlement
Agency services Gross Income 15
Asset management Gross Income 12
Retail brokerage Gross Income 12
 Alternative Standardized Approach
(ASA)

¢ Under the ASA, the operational risk

capital charge/methodology is the
same as for the Standardised
B Approach except for two business
lines – retail banking and commercial
A banking.
S Pillar I: Minimum
capital requirements ¢ For these business lines, loans and
E advances – multiplied by a fixed factor
‘m’ – replaces gross income as the
L exposure indicator.
Operational Risk - ASA
¢ The betas for retail and commercial
banking are unchanged from the
I Standardised Approach
I ¢ 𝐾𝑅𝐵 = 𝛽𝑅𝐵×𝑚×LARB
¢ KRB – Capital required for retail
banking unit, βRB is the beta for the
retail banking business line, m is
0.035, LARB is total outstanding retail
loans and advances.
 Advance Measurement
Approach (AMA)

¢ Based on an estimation of
operational risk derived from bank’s
internal Operational Risk
B Measurement System (ORMS).
A ¢ Use of both quantitative and
S Pillar I: Minimum qualitative criteria for calculation of
capital requirements capital charge.
E
¢ Qualitative Criteria
L
Operational Risk - AMA ¢ The bank must have an
independent Operational Risk
I Management Framework (ORMF).

I ¢ Rigorous procedures for the

development, implementation and
review of the ORMF.
¢ Use of the output from the AMA
model in its day-to-day operational
risk management and integrated
with credit and market risk.
 ¢ Quantitative Criteria

B ¢ Mapping the Operational Risk

Categories (ORCs) i.e., various
A combinations of loss event types
S Pillar I: Minimum and business lines.
capital requirements
E ¢ Preparing the loss distribution -
L distribution of losses is generated
Operational Risk - AMA for each recognized combination of
business line and loss event type.
I
¢ This is aggregated to compute the
I enterprise level operational risk VaR
for the purpose of obtaining the
operational risk capital charge.