Introduction to Banking
The core business of any bank is to accept deposits and lending to borrowers after keeping the required reserves as prescribed by regulator. The reserve requirement and any addition or deficit cash flows are managed through treasury activities. Hence the primary return drivers for any bank are the interest rate differential (Interest earned by lending – interest paid to depositor) and the income earned doing treasury activities.
Where the return, there lies some risk. So effectively, for a very basic business model of a bank, the primary risk drivers are the lending done to borrowers and treasury investments made by the banks. The risk with lending is that borrowers will not pay back while the risk with treasury investments is that the market price will fall and bank would lose money on it. Both these risks are called credit and market risks respectively.
The Beginning of Basel
In 1988, BCBS (Basel Committee of Bank Supervision) proposed Basel accord to address credit risk and later incorporated market risks within the same framework. Basel prescribed the rules of keeping minimum capital risk adjusted ratio (CRAR) of 8% against the risk weighted assets (RWA) of the bank. It is a simple ratio of bank’s capital and assets (with risk imbibed) of the bank. The purpose of this ratio is that in case of difficult times, bank should be able to absorb reasonable amount of losses out of their capital itself and there should not be any risk on the depositor’s money.
Let’s understand this ratio for once and all-
The numerator in CRAR is capital of banks, which basically means the amount brought in by the bank’s promoters (Paid up capital) and reserve surplus (Reserves made out of previous year’s profits, other reserves) in the books of the bank. It is further categorized as Tier I and Tier II capital and total of it forms the Capital part of the bank. The denominator is assets of the bank, which made of lending portfolio and investments made through treasury activities. However, here the assets are further provided weights based on the riskiness associated with them (based on predefined buckets) and the exposure taken by the bank. The risk weights which needs to be assigned to each asset is prescribed in Basel accords.
For example, loan provided to a borrower with no history and collateral is considered a risky proposition. The risk weights assigned to such category can be, say 200%. In such case, the entire exposure to such category is multiplied with 200% and the risk weighted assets would be doubled, compared to normal assets. Accordingly, the weightages are provided to all the assets. Higher the risk associated with assets, higher the risk weights assigned to it and higher would be the denominator taking the CRAR down. This ensures that those banks, who invests or lends to less risky borrowers, are asked to keep less capital on account of less risk associated with their assets and vice versa.
Once we have understood the ratio, we can very well grasp the other concepts related to capital charge computations which essentially is based on the same notion. However, oversimplification doesn’t work in financial industry all the time and one needs to consider the increasing complexity of banking business day by day. While the basic return drivers for a retail bank almost remained the same, the risk drivers kept on increasing owing the increasing market complexity, introduction of new product, structuring of products and technological advancement.
Basel II Framework
In June 2004, BCBS released “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”, commonly known as Basel II framework. Apart from the credit and market risk, it incorporated operational risk as well. The Basel 2 accord had three pillars;
- Minimum Capital requirement (For Credit, Market and Operational risk as discussed earlier)
- Supervisory review by Central bank to monitor’s bank’s capital adequacy
- Establishing market discipline by proper disclosure
Identification of Operational risk as key risk was on account of the evolving banking industry and associated risk with systems, people and internal controls. Operational risk covers entire aspects from a fraud committed by internal or external stakeholder, failure of systems to financial losses on account of lost reputation or legal case.
Pillar 1 not only included the third risk (operational risk) but also made the calculation more sensitive to the riskiness associated with the banking assets. Instead of using buckets to arrive at risk weights for different asset classes, various risk weights were identified for different category of assets. For example within the lending portfolios, risk weights were assigned based on the ratings, asset type and collaterals available. Further, Internal rating based model was introduced to assign such risk weights based on bank’s own assessment on probability of default, loss given default and recovery rates. While introduction of these methodologies made the entire risk assessment process more scientific and dynamic, it also brought in the complexity associated with such computation.
Pillar 2 provided the power to regulators to supervise and audit bank’s risk management system. Regulators were provided the guidelines to ask for buffers (Additional capital) from bank’s wherever they found that bank is exposed to more risk than required.
Pillar 3 was targeted at making the disclosure mandatory and standardized. This was introduced for better market discipline.
Post Sub-prime Crisis
Well, the story of Basel accord kept getting exciting, complex and even more daunting for bankers post 2008 crisis as more and more requirements were introduced by BCBS. The subprime crisis originated from the securitization chaos made the Basel 2 requirement ineffective to catch up with the latest innovations and product developments, which led to introduction of numerous concepts related to risk management in past 9 years. Keeping pace with such advancements has become one of the major task for any bank across the globe.
Basel 2.5 and later Basel 3 are evidently far more demanding than the earlier versions and need specialized understanding of risk within banks. Liquidity risk also got significant mention under such framework with introduction of liquidity coverage ratio (LCR) and net stability funding ratio (NSFR) and many residual risks were also identified. With entire industry moving to digital, many other risks are also identified which needs due mention including cyber security. However, it is ever evolving subject which gets driven by the changing dynamics of the industry.