Risk Management in Banks: Regulatory Issues and Capital Adequacy

Individual banks risks create Systematic risk, i.e., the risk that the whole banking system fails. Systematic risk results from the high interrelations between banks through mutual lending and borrowing commitments. The failure of single institution generates a risk of failure for all banks that have ongoing commitments with the defaulting bank. Systematic Risk is a major challenge for the regulator.

A number of rules, aimed at limiting risks in a simple manner, have been in force for a long time. For instance, certain ratios are subject to minimum values, say Capital Adequacy Ratio, certain caps are placed viz., Single Borrowers etc., so as to limit the risks.

The main enforcement of such regulations is Capital Adequacy. That is by enforcing a capital level in a level in a line with risks, regulators focus on pre-emptive (in-anticipation) actions limiting the risk of failure. Guidelines are defined by a group of regulators in Basel at the bank for International Settlements (BIS), Switzerland (hence the name Basel Accord). The process attempts to reach a consensus on the feasibility of implementing new guidelines by interacting with the industry. Basel guidelines are subject to some implementation variations from one country to another according to the view of local supervisors (RBI in case of our country).

However, Capital Adequacy requirements are primarily to meet the following objectives:

  • To ensure survival of the institution to protect it against the risk of insolvency.
  • To absorb unanticipated losses with enough margin to inspire stakeholders confidence and enable the institution to continue as a going concern.
  • To protect depositors, bondholders, creditors in the event of insolvency and lquidation.

The first Accord (1998) known as Basel I, focused on Credit Risk, with the famous Cookie Ratio. The Cookie Ratio sets up the minimum required capital as a fixed percentage of assets weighted according to their nature. The scope of regulations extended progressively later. The extension to market risk was in 1996 by way of an amendment. The proposed New Basel Accord to be known as Basel II considerably enhances the previous credit risk regulations. The New Accord is under finalization.

The major strength of cookie ratio is its simplicity, while of its major drawbacks are :-

  • There is no differentiation between the different risks in lending activity. An 8% ratio applied for “AAA” rated large corporate exposure and also for a small business with a lesser rating. That is, it was not risk sensitive.
  • In the CRAR computation, the capital charges are added. But, summing arithmetically the capital charges of all transactions does not capture diversification effects. By diversification we mean, that the entire portfolio may not move unidirectional, but may compensate and adjust in view of different co-relation among assets within the exposure/portfolio. That is to say, there is an embedded diversification in the 8% (CRAR), but the same ratio applies to all portfolios, whatever their degree of diversification.

The proposed New Basel Accord is the of consultative documents that describe recommended rules for enhancing credit risk measures, extending the scope of capital requirements to operational risk, providing various enhancements to the existing accord and detailing the supervision and market discipline.

The new accord comprises of 3 pillars:

  • Pillar 1 – Minimum Capital Requirements.
  • Pillar 2 – Supervisory Review Process.
  • Pillar 3 – Market Discipline.

The New Basel Accord appears to be a major step forward. On the quantitative side of risk measurements, the accord offers a choice between the Standardised, the Foundation and Advanced approaches and provides remedies for several critical issues/draw backs of the existing system. The new sets of ratios are called the Mc Donough Ratios. Weighs are based on credit risk components allowing a much improved differentiate of risks. The accord is likely to also extend the scope of capital requirements to Operational Risk.

As New Basel Capital Accord is based around three complementary elements viz (i) to reinforce minimum capital standards, (ii) to have the supervisory review process, and (iii) to promote safety and soundness in banks and financial systems. Market Discipline imposes strong incentives to banks to conduct their business in safe, sound and efficient manner, including an incentive to maintain a strong capital base as a cushion against potential future losses arising from risk exposures. The Basel Committee is already working on the scope of application of the Accord, capital and capital adequacy, and risk exposure and assessment. The Risk Management has come at the central stage in the new Basel Capital Accord.