CAIIB BASEL -II CONCEPTS AND OTHER ASPECTS

Question on  Bank Balance sheet.
1)      What is ICAAP and definition,.
ICAAP  ---  Internal Capital Adequacy Assessment Process (ICAAP)
ICAAP is a new requirement for financial institutions, under Basel II, requiring the following assessments:
Pillar I minimum capital requirements;
The extent of total stockholder funds required to meet a firm’s strategy and maintain minimum capital requirements;
ensuring that material risks of the firm are understood by its board, and that there is sufficient and appropriate risk management.
Four crucial elements in any ICAAP are:
1)      assessment (identification and measurement) of the risks a bank is, or may be, exposed to;
2)      application of mitigation techniques that may help to lower capital requirements;
3)      stress-testing techniques;
4)      role of the board of directors and management.
Requirement under Pillar-II
Pillar II requires that risks are presented to, and discussed by, the board to ensure its acceptance and understanding.
Pillar II also requires a bank to maintain capital ratios and convince the regulator.
Risk models and capital are only part of this.
 A financial institution must also consider any other internal risks that the firm may face which may result in losses such as fraud, rogue trading, or strategy failure.
The preparation of a capital plan should incorporate all risks, and requires the cooperation of, and collaboration with, the finance, treasury, business, and risk departments. Capital plans are usually based on a firm’s forecasts for growth, given the maintenance of a capital ratio.
The ICAAP should be customized for each firm, taking into account the particular risks and information available. The process usually consists of the following stages:
1)      Identifying risks—List all material risks, interview staff in relevant departments, and assess the probability of risks occurring.
2)      Assessing capital—How much capital would a risk require?
3)      Forward capital planning—Assess how the capital calculated from the capital assessment might be altered by its business plan, i.e. perform stress and scenario analyses.
Managers should also consider the following risks:
credit risk;
market risk;
operational risk;
liquidity risk;
insurance risk;
concentration risk;
residual risk;
securitization risk;
business risk;
interest rate risk;
any other risks identified.
ICAAP should provide firms with the best capital buffer required, and the best level of funds from stockholders. Risks are often considered by a bank, yet are not always reflected in strategic options and capital planning. ICAAP requires stress and scenario analysis to demonstrate risks at an enterprise level.
Question No 2
1)      What is Capital Adequacy Ratio.
Capital Adequacy Ratio = Regulatory Capital / Risk Weighted Assets.
2)      What is Risk weighted assets.
The Assets side of the balance sheet has the following.

Sl No
Name / Nature of the Asset
Risk weight as a percentage.
1
Cash
May range from 0% to 150* depending upon the risk associated with the Country  . Country risk is known as Sovereign risk. Depending on the rating of the country

2
Balance with Central Bank of the country /RBI

0% to 150% depending up on the rating of the Country.
3
State Bank of India /Other Bank
20% to 150% again depending on the rating of the Bank
4
Investments in Government Securities
0% to 150% depending on the Sovereign Risk.
5
Investment in other Securities
20% to 150%  depending on rating of the  Corporate
6
Loans to Government
0 % to 150% depending on the Sovereign Risk. 
7
Loans to others
20% to 150% depending on rating of the Corporates
8
Other assets
100%
9
Substandard Assets  (Both Investment and Loans)
150%
10
Doubtful  Assets  (Both investment and Loans)
200%


How  to work out the  Risk Weighted assets.
We have to work out the Risk Weighted Assets  by multiplying the assets value as per the balance sheet with the risk weight. As per working given below.

Assets
Amount  Rs (in Crores)
Risk %
Risk weight
Cash
100
0
0
SBI
200
20
40
Investment  in Government Security
1000
0
0
Investment in High rated investment 
AAA  to  AA+
200
20
40
Investment in Average rate  BB+ to B+ 
500
100
500
Loans to Government
High rated AAA to AA+
200
0
0
Loans to High rated  Corporates AAA to AA+
1000
20
200
Loans to Average rated customer
BB+ to B+
3000
100
3000
Substandard Assets

100
150
150
Other Assets
100
100
100
Total Risk Weighted assets


4030

 In the above case Capital required is 4030 X 9/100 = 362.70*
*As the above takes into account only Credit risk, In order to cover the risk in respect of Market Risk Normally Banks  work out this amount by working out the Market Risk  and operational Risk by taking into consideration the past historical data .  
Suppose in the present case the Bank has the following Capital.

Tier -1

Tier -II

Capital
100
Revaluation Reserve.
Discounted 55%
Rs 100 Crores  discounted @55%
45
Free Reserve  (Statutory )
150
General Provisions for Loans in excess of the required provisions for NPA
10
Revenue Reserve
120
Subordinate Debt – Hybrid Capital
(Maximum that can be  taken as Tier II capital is only 50% of the Tier 1 capital) The full amount of maximum 50% of Tier –I capital can be taken as Tier II capital only if it has a maturity balance period of 5 years or more
Suppose the Subordinate capital raised is Rs50 Crores with maturity of 7 years then)
50
Capital Reserve
10
Hybrid Debts -- Perpetual; Cumulative preference Shares
10
Perpetual  Debt Instruments and Non Convertible Preference Shares.
--


Total
380

115

Tier II capital is not  yet implemented.
Total Capital Tier I+ Tier II = Rs380 +Rs115  = Rs495 Crores
Capital Adequacy Ratio  = Regulatory Capital /Risk Weighted Assets
Capital Adequacy Ratio= 495 /4030+ 10% of 4030 (Approximate risk weight for the Market Risk and operational Risk)
 Capital Adequacy Ratio = 495 / 4030+403 = 495/4433 x100= 11.1%
Question -3
Is CRAR  is Capital Adequacy Ratio
Ans  yes - Both are same.




Para 4 page 461 of Bank Financial  Management
Embedded Option Risk.
Consider a situation in which the Bank raises deposit from public by issuing Certificate of Deposit say @8% for 90 days and disburse the same amount by way of loan for 90 days @10%
In this case the market advance Interest  rate falls to 9% the loan borrower prepays the loan after 30 days. As there is no premature closure charges the Bank  accept the amount and close the loan with out charging a penalty. The amount received by the Bank has to be invested in the market for 60 days  @9% instead of 10%.
The Interest received by the Bank is  10% for 30days  10x30 =300
The Interest received  by the Bank  is 9% for 60 days  9x60 = 540                                                                                   Thus  the Bank is able to earn only 840 points  for 90 days  against 900 for 90 days  envisaged . This is the risk.
Question -4
Para 7 page 462 of Bank Financial  Management
Reinvestment risk.
Here the Bank has agreed with a depositor that  the Bank will double the deposit amount of Rs10,000/ in 7 years . Bank has invested the deposit so received in a bond yielding annually @12% for 7 years.
As per rule 72  the number of years that will be taken  for doubling the amount is 72/rate of Interest
In the present case it will take 7 years to double depositors money  ie 7 = 72/ rate of Interest or Rate of Interest = 72/7 = 10. 28%
Thus it can be seen that the Bank has initially accepted the deposit so that it can make substantial money by investing in 12% bonds and by reinvesting the Interest so obtained every year as and when it fall due. In the present case it is informed that the market rate has fallen to 5% after one year. Although the Bank will continue to receive interest @ 12% on the principal amount for 7 years the interest income that can be made by investing the Interest received say Rs1200/ every year will yield only 5% for the remaining years  instead of 12% anticipated.
1st year Interest of  Rs1200 will earn 5% for 6  year
 2 nd year Interest of  Rs1200 will earn 5% for 5  year 
3 rd  year Interest of  Rs1200 will earn 5% for 4  year
4th year interest  of Rs1200 will earn 5% for 3 years etc.
Thus the total yield will be lower than the original anticipated amount causing loss or lesser income to the Bank.
Question -5
What is RAROC 
Ans : Risk Adjusted Return on Capital
page 484 of Bank Financial  Management
Banks have  to manage many risks . 1)  Credit risk  (is arrived at based on the Credit rating of the borrower or the rate of the Corporate in which Bank has made investment). 2)  Market risk, (Interest rate risk,  liquidity Risk , Exchange Fluctuation Risk , Commodity Risk,  etc) and 3)  Operational Risk . As such a Bank has to aggregate the risks at their Head Office level and find the summation of all the risks and estimate the risks . The commonly used  approach is Risk Adjusted Return on Capital (RAROC) In this technique Banks use the Value at Risk VaR and take into account all type of anticipated risks. Statistical methods and Standard deviation etc is used  for arriving at the correct position.
RAROC is also related to concepts such as shareholder value analysis and Economic Value added. The past performance is measured by yardsticks such as return of assets (ROA) which adjust profit for associated book value of Assets or return on assets.
The expected loss is a measure necessary to guard against future losses. This is some time called Economic Capital. 
RAROC  also belong to Risk adjusted performance measure. (RAMP)
Assume two traders. They are working in a Volatile Market.
1)      Foreign Exchange Traders $100 Million at12%
2)      Bond trader Deals with large amounts of $200Million in a market at4% annum.
The risk capital can be computed as a VaR measure, say at99%
Assuming normal distribution this will  Risk Capital = $100,00,000 x0.9x2.33=$28
2.33 is arrived at based on the volatility of interest rate fluctuation  over the past one year at VaR 99%
RAMP = Profit/Risk Capital
As the bond trader is trading at 4% interest the fluction in interest rate for him will be less and so less Risk Capital.
What is Off Balance sheet item.
All contingent liabilities are Off balance sheet items for eg LG /LC/Forwards Contracts etc.