Welcome to Banking Quest

Introduction

• Supervisory Review Process
• ICAAP
• Stress Testing
• Value at Risk
• Stop Loss Limit
• Brief on Internal Control Guidelines

 Supervisory Review Process (SREP)

SREP falls under Pillar 2 of Basel II and III guidelines. 

• Pillar 2 : Supervisory Review Process (SRP) — which envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.
• The Basel norms of the Basel Committee also lays down the following four key principles in regard to the SREP envisaged under Pillar 2: 
• Principle 1 :  Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. 
• Principle 2 :  Supervisors should review and evaluate the banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with the regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. 
• Principle 3 :  Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum.
• Principle 4 :  Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

 ICAAP

• It would be seen that the principles 1 and 3 relate to the supervisory expectations from the banks.
• Principles 2 and 4 deal with the role of the supervisors under Pillar 2. 
• The Pillar 2 (Supervisory Review Process - SRP) requires banks to implement an internal process, called the Internal Capital Adequacy Assessment Process (ICAAP), for assessing their capital adequacy in relation to their risk profiles as well as a strategy for maintaining their capital levels.

Banks’ responsibilities:

• Banks should have in place a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels (Principle 1)  & 
• Banks should operate above the minimum regulatory capital ratios (Principle 3)

Supervisors’ responsibilities:

a) Supervisors should review and evaluate a bank’s ICAAP. (Principle 2) 

b) Supervisors should take appropriate action if they are not satisfied with the results of this process. (Principle 2)

c) Supervisors should review and evaluate a bank’s compliance with the regulatory capital ratios. (Principle 2)

d) Supervisors should have the ability to require banks to hold capital in excess of the minimum. (Principle 3) 

e) Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels. (Principle 4) 

f) Supervisors should require rapid remedial action if capital is not maintained or restored. (Principle 4)

 ICAAP & SREP

• Thus, the ICAAP and SREP are the two important components of Pillar 2 and could be broadly defined as follows:  
• The ICAAP of the Bank should be board mandated one and  comprises a bank’s procedures and measures designed to ensure the following: 

A) An appropriate identification and measurement of risks; 

B) An appropriate level of internal capital in relation to the bank’s risk profile; and 

C) Application and further development of suitable risk management systems in the bank. 

• The SREP consists of a review and evaluation process adopted by the supervisor, which covers all the processes and measures defined in the principles discussed already. 
• Essentially, these include the review and evaluation of the bank’s ICAAP, conducting an independent assessment of the bank’s risk profile, and if necessary, taking appropriate prudential measures and other supervisory actions.

 Main Scope of SREP

• The main aspects to be addressed under the SRP, and therefore, under the Internal Capital Adequacy Assessment Process (ICAAP), would include: 

(a) the risks that are not fully captured by the minimum capital ratio prescribed under Pillar 1 

(b) the risks that are not at all taken into account by the Pillar 1 

(c) the factors external to the bank, that is, new arising risks not covered under Basel norms

• Illustratively, some of the risks that the banks are generally exposed to, but which are not captured or not fully captured in the regulatory CRAR , that is, under Pillar 1, would include: 

(a) Interest rate risk in the banking book, which is part of market risk. 

(b) Credit concentration risk, which is normally part of credit risk. 

(c) Liquidity risk, for convenience sake included as part of market risk. 

(d) Settlement risk, which is also called counterparty risk and is part of credit risk. 

(e) Reputational risk, which is equivalent to operational risk. 

(f) Strategic risk, which is equivalent to operational risk. 

(g) Risk of under-estimation of credit risk under the Standardized approach – Credit risk. 

(h) “Model risk” i.e., the risk of under-estimation of credit risk under the IRB approaches – Credit risk. 

(i) Risk of weakness in the credit-risk mitigants – Credit risk. 

(j) Residual risk of securitization, etc. – can be part of Credit and Market risk

 ICAAP to include Stress Testing

• As part of the ICAAP, the management of a bank shall, as a minimum, conduct relevant stress tests periodically, particularly in respect of the bank’s material risk exposures, in order to evaluate the potential vulnerability of the bank to some unlikely but plausible events or movements in the market conditions that could have an adverse impact on the bank. 
• The use of a stress testing framework can provide a bank’s management a better understanding of the bank’s likely exposure in extreme circumstances. 
• In this context, the attention is also invited to the RBI circular DBOD.No.BP.BC.101/21.04.103/2006-07 dated June 26, 2007 on stress testing wherein the banks were advised to put in place appropriate stress testing policies and stress test frameworks, incorporating “sensitivity tests” and “scenario tests”, for the various risk factors, by September 30, 2007, on a trial / pilot basis and to operationalize formal stress testing frameworks from March 31, 2008. 
• The banks are urged to take necessary measures for implementing an appropriate formal stress testing framework by the date specified which would also meet the stress testing requirements under the ICAAP of the banks. 

 Stress Testing Book by Geithner

• Timothy F. Geithner, the then Treasury Secretary, has written and published a book on Stress Testing, which serves as the basis as to how Banks and financial institutions should conduct Stress Testing and how Supervisors have to review the same. 
• As president of the Federal Reserve Bank of New York and then as President Barack Obama’s secretary of the Treasury, Timothy F. Geithner helped the United States navigate the worst financial crisis since the Great Depression, from boom to bust to rescue to recovery. 
• In a candid, riveting, and historically illuminating memoir, he takes readers behind the scenes of the crisis, explaining the hard choices and politically unpalatable decisions he made to repair a broken financial system and prevent the collapse of the Main Street economy. 
• This is the inside story of how a small group of policy makers—in a thick fog of uncertainty, with unimaginably high stakes—helped avoid a second depression as a fall out of the Subprime crisis. 
• This book ‘Stress Test’  is also a valuable guide to how governments can better manage financial crises, because this one won’t be the last.

 Example of ICAAP

• When the risk increases for the Bank, it is captured as a risk weight.
• That is why the formula for arriving at CRAR is:
• (Total Capital of the Bank)/ (Total Risk weighted assets arising out of Credit, Market & Operational Risks).
• The above CRAR of the Banks under Basel-III regime should not fall below 11.50%.
• At the same time, Basel norms also stipulates that Banks should operate above the minimum regulatory capital ratios (Principle 3) – Why?
• Let us take an example to prove this point.
• The total Capital of the Bank is assumed to be Rs. 18,000 crores. 
• The total risk weighted assets (TRWAs) are assumed to be Rs. 1,30,000 crores.
• So, CRAR of the Bank under Pillar 1 would be:
• (18,000/ 1,30,000) x 100 = 13.85%
• Let us assume that while carrying out the ICAAP exercise, the Bank has found that some risks are omitted to be covered and hence its TRWA has to go up by Rs. 10,000 crores. 
• Now the revised CRAR after applying ICAAP would be:
• (18,000/ 1,40,000) x 100 = 12.86%
• By conducting the Stress Testing, it is found out that the bank’s risk in some areas are expected to go up and by this TRWA is expected to go up by Rs. 15,000 crores. 
• Now the revised CRAR after as per Pillar 1 + ICAAP + Stress Testing would be:
• (18,000/ 1,55,000) x 100 = 11.61%.
• That is the main reason, Supervisors under Basel Norms expect that the Banks should operate above the minimum regulatory capital ratios.
• What the Supervisors expect is that after applying the shock notionally by adding the risks arising out of ICAAP and Stress Testing, Banks minimum CRAR is above 11.50%, then these banks are considered very robust and have capacity to withstand the shocks. 
• Finally, this is the moral of the SREP process.  

 Value At Risk (VaR)

Measuring the risk based on downside potential:

• In this approach, we are going to ignore the positive cash flows and concentrate only on negative cash flows. 
• In measuring the risk under this approach, we are going to use a statistical model called ‘Value at Risk’ or VaR.

Definition of VaR:

• VaR is the risk measurement under the approach Downside Potential and it measures the maximum potential loss one can incur on an investment or on a portfolio of investments subject to having a holding period and confidence level under normal trading circumstances. 
• Limitations of the definition:
  • The only limitation is that this VaR will work only under normal trading circumstances.  It means, it will not work under abnormal trading circumstances. 
• Measuring the risk based on downside potential:
• Under VaR, there are three methods:
  • Historic Simulation Method. 
  • Correlation Method. This is also called the Parametric method or Variance-Covariance Method.
  • Monte Carlo Simulation Method.

Historical Simulation Method: The historical simulation approach calculates the change in the value of a position using the actual historical movements of the underlying asset(s), but starting from the current value of the asset. It does not need a variance/covariance matrix. The length of the historical period chosen does impact the results because if the period is too short, it may not capture the full variety of events and relationships between the various assets and within each asset class, and if it is too long, may be too stale to predict the future. The advantage of this method is that it does not require the user to make any explicit assumptions about correlations and the dynamics of the risk factors because the simulation follows every historical move.

Correlation Method: Under the correlation method, the change in the value of the position is calculated by combining the sensitivity of each component to price changes in the underlying asset(s), with a variance/covariance matrix of the various components’ volatilities and correlation. It is a deterministic approach. 

• This approach assumes the volatility of the data or population falls within a normal distribution curve. 

Correlation Method: By doing a problem, we can understand this method:

• • As a dealer, he has purchased 100 shares of Rs. 1,000/- today. He has to sell the shares before the close of the day. He is working under a confidence level of 95%. The historical volatility of the scrip is 2% and the expected volatility of the scrip is 3%. From these inputs, arrive at the maximum loss he can incur on this trading position?
  • 100 shares x Rs. 1,000 = Rs. 1,00,000/-
  • Expected Volatility 3%, he may lose 3% on Rs. 1,00,000/- = Rs. 3,000/-
  • He is working under a confidence level of 95% which is equivalent to 1.65 standard deviation. 
  • Rs. 3,000 x 1.65 = Rs. 4,950/- is the maximum loss the dealer can incur.

The Monte Carlo simulation method: This calculates the change in the value of a portfolio using a sample of randomly generated price scenarios. Here the user has to make certain assumptions about market structures, correlations between risk factors and the volatility of these factors. 

• He is essentially imposing his views and experience as opposed to the basic approach of the historical simulation method. 
• At the heart, all three methods are statistical models. The closer the models fit economic reality, the more accurate the estimated VaR numbers and therefore the better they will be at predicting the true VaR of the firm. However, there is no guarantee that the numbers returned by each VaR method will be anywhere near each other.

Is VaR the only best methodology available in the world presently?

• VaR is superior to risk measurement when compared to other methodologies like measuring risk using Volatility and Sensitivity. 
• Hence, VaR is a superior methodology till the sub-prime crisis took place. 
• Now, risk experts have come out with one more methodology called Conditional VaR or Expected Shortfall method.

In case VaR is considered as superior methodology when compared to Volatility and Sensitivity, is there a limitation for VaR methodology?

• Yes, VaR has a limitation because VaR can be computed perfectly well and for this it has to be supported by two arms and they are:
  • Back Testing
  • Stress Testing. 

What is backtesting?

• In VaR methodology, we are normally factoring the expected volatility.
• Once the future period is over, we have to again check whether the expected volatility factors have come correctly or not.  For example:
• You are working VaR limit for 10 days.
• Today is 10th January, 2022.
• On 10th January, you have factored a future volatility 2%.
• After 10 days, the due date will be 21st January, 2022. 
• On 21st January, 2022, you will get the actual volatility and this  actual volatility is called realized volatility. 
• In case, the realized volatility is not the same as factored under expected volatility, your estimated loss will go wrong.
• Then we must question the difference in the volatilities and factor the mistakes committed in arriving at the estimated volatility. 
• So, back testing is not a one time exercise.  As long as you are interested in trading, you must keep on perfecting the exercise and this exercise is called Back Testing. 

Stress Testing: 

• Combination of positives and negatives make life.
• When you are on the positive side, make provision for a future negative thing, it may come to you. 
• When you are on the negative side, make use of the provision made during the positive period and wait patiently for the positive thing to take place.

In stress testing, there are four scenarios:

1. Take any one of the above parameters, and stress the BSE Sensex and find out where the Sensex will fall. This scenario is called Sensitivity test. 
2. Take all the above parameters and stress the BSE Sensex and find out where the Sensex will fall.  This Scenario is called Scenario analysis. 
3. Among the factors, only important ones are taken and minor factors are omitted. For example, any factor, which has a weightage of 20% and above is the major concern.  So only these factors are put into the model and stressed to find out the maximum potential loss.   This approach is called the Maximum Loss approach.
4. The last approach is called Extreme Value Theory (EVT): We don't have any such factors above. We must take one or two worst scenarios in the past. Find what was the fall in Sensex. For example, on the Sensex on 24/02/2022, Sessex has fallen by 2,702 points, the biggest fall in almost 2 years. We have to replicate the same scenario today and see where the Sensex will fall. 

The VaR supported by Back-testing and Stress Testing is a very good risk measurement as of today when compared to other risk measures such as Volatility and Sensitivity approaches. 

 Significance of Stop Loss Limit

• A stop-loss limit is a tool used by dealers, traders and investors to limit losses and reduce risk exposure. With a stop-loss limit, a  dealer enters an order to exit a trading position that he holds if the price of his investment moves to a certain level that represents a specified amount of loss in the trade, say 10% of the exposure taken. 
• By using a stop-loss limit, a dealer limits his risk in the trade to a set amount in the event that the market moves against him.
• More particularly for Banks, any investment or loan is funded out of depositors' money and hence Banking is a leveraged business. 
• Hence, dealers have no right to use depositors money to expose themselves to limitless losses. Therefore, stop loss limits are fixed for the dealers to bring them under discipline, which they have to respect and obey.

 Internal Control Guidelines

• RBI has in the year 2011 came out with a revised Guidelines for “Internal Control over Foreign Exchange Business”.
• First framed in 1981, the Internal Control Guidelines (ICG) were revised in December, 1996. The need to revise them once again was felt in the context of rapid pace of evolution of the forex markets in India and abroad as also, developments in information technology and its progressive usage in banks. 
• A Group comprising officials from the Reserve Bank of India, Foreign Exchange Dealers’ Association of India, Fixed Income Money Market and Derivatives Association of India, State Bank of India, ICICI Bank and Standard Chartered Bank looked into the updation of the Internal Control Guidelines to make them contemporary and benchmark document.
• Besides RBI, FEDAI is also coming out with its instructions. Dealers have to observe these internal control guidelines with letter and spirit.

 Parting Suggestions

• Mrs. Indra Nooyi, the then Chairperson, PepsiCo addressed a forum in November, 2011 in Chennai, India.  The brief of her speech is worth mentioning:
• The only certainty is that the world is uncertain, said Nooyi. Her solution: the creative adaptability of the company. 
• Nooyi’s five pointers for the leaders in the audience to explain this solution were:

1. Recognize we live in a new reality. Volatility is our normal life, companies must start thinking about their next plan while ink on the old one is still drying out. 

2. Leaders and corporations have to lead for today and tomorrow at the same time. Companies with long term missions will thrive, especially those with a vision for their role in society. Companies need speed and agility to be able to do this. 

3. Leaders have to be ambitious and make big changes to big things. Innovation is about rethinking and reframing the products and services offering. 

4. Attract and develop the right talent – the most important leadership task of today. New leaders need to have courage, confidence, perseverance, openness to new ideas, and adaptability to change. Retrain to allow experience to adapt to reality – allow cross pollination of ideas from west to east, give young leaders experience across geographies, bring in new blood. 

5. Leaders have to be super visible in the organization and outside world – everyone needs to know how a company is moving forward.

• ‘Risk Management Departments are springing up in many companies. They categorize and analyze risk to the company before it happens, and in most cases, they create systems and processes to prevent risks.  But the reality is that all hazards cannot be predicted or avoided.  Instead of simply staving off risk, focus on building resilience so that when the unthinkable happens, you are better prepared to face it.  Look at all risks you face and play out what you would do if any of them were to come to bear.  Having systems in place to respond could save your valuable time, money and resources’.
• Management Tip from Harvard University Business Review.