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Introduction - What is Risk ?

Word Risk is derived from the Latin word resicum, risicum and riscus which mean cliff or reef. Likewise, Latin word comes from a Greek navigation term rhizikon, rhiza which meant “root, stone, cut off the firm land” and was a metaphor for “difficulty to avoid in the sea” (Riskology 2012).                                          

Risk can be defined as uncertainties resulting in adverse outcomes, adverse in relation to planned objectives or expectations. Financial Risks are uncertainties resulting in adverse variation of profitability or outright losses.

As we are aware that profit and loss of business depends upon the net result of all cash inflows and outflows, uncertainties in cash inflow and cash outflows also create uncertainties in net cash flow or profit. Factors that are responsible for such uncertainties in cash outflows and /or cash outflow are the risk elements.

Uncertainties associated with risk elements impact the net cash flow of any business or investment. These variations in net cash flow can be favorable as well as unfavorable. The possible unfavorable impact is the Risk of the business or investment.

Lower Risk implies lower variation in net cash flow with lower up and downside potential. Higher risk would imply higher upside and downside potential.  

Risk Management or Financial Risk management aims at Trade -off between risk and return according to the Risk Appetite of a firm or investor. 

Capital requirement of a business or revenue model would depend upon the risks associated with the business or revenue models and expected return on the investment would also factor in the risks associated with it . Higher the risks in the business model, greater would be the capital requirement and return expectations. The reverse is also true. This is the linkage between risk, return and capital. 

In financial sector, there are broadly two categories of risks i.e. Systematic Risks & Unsystematic Risk. Systematic Risk also known as Market risk is the risk of losing investment due to macro economic factors which affect the performance of the overall market whereas Unsystematic, also known as specific risk is micro in nature and affects a particular industry or company.

Other form of risks which belongs to both Systematic & Unsystematic risks are: -

1) Credit Risk : Risk that the counterparty will fail to perform or meet the obligation on the agreed terms. 

2) Market Risk : Market Risk is a risk to the bank’s  trading portfolio that could result from adverse movement in market price. 

3) Interest Rate Risk : Interest rate risk refers to potential adverse impact on Net Interest Income or Interest Rate Margin or Market Value of Equity ,caused by changes in market interest rates.

4) Liquidity Risk : Liquidity risk arises in financial companies mainly from funding of long term assets by short term liabilities. Liquidity risk is defined as the inability to obtain funds to meet cash flow obligations at a reasonable rate.

5) Concentration Risk : Concentration risk is a banking term describing the level of risk in a bank's portfolio arising from concentration to a single counterparty, sector or country.

6) Strategic Risk This risk results from a fundamental shift in the economy or political environment. Strategic risks usually affect the entire industry and are much more difficult to protect themselves.

7) Business Risk : These are the risks that the bank willingly assumes to create a competitive advantage and add value to its shareholders. It pertains to the product market in which the bank operates, and includes technological innovations, marketing and product design. A bank with a pulse on the market and driven by technology as well as a high degree of customer focus, could be relatively protected against this risk.

8) Operational Risk arises as a result of failure of the operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc. It arise due to failure of People , Procedure , System and/or External factors

9) Country Risk : The buyers are unable to meet the commitment due to restrictions imposed on transfer of funds by the foreign govt. or regulators. When the transactions are with the foreign govt. The risk is called Sovereign Risk.

11) Technological Risk : Technology risk is any potential for technology failures to disrupt your business such as information security incidents or service outages. There is always a risk of the advent of disrupting technology.

Bank of International settlement ( BIS)

Bank of International Settlement was established in 1930 ,having its Head Office in Basel, Switzerland and is owned by 60 Central Banks representing countries from around the world that together account for about 95 % of world GDP. 

Main focus of BIS is to bring monetary and financial stability and also act as a bank for central banks.

It is mainly involved in 

• fostering discussion and facilitating collaboration among central banks
• supporting dialogue with other authorities that are responsible for promoting financial stability
• carrying out research and policy analysis on issues of relevance for monetary and financial stability
• acting as a prime counterparty for central banks in their financial transactions
• serving as an agent or trustee in connection with international financial operations . 

Legal Status and Organizational structure

The BIS was created by an international treaty signed by governments (The Hague, 20 January 1930), but it has been set up and is exclusively controlled by central banks. At the same time, as a bank, the BIS is a limited liability company incorporated under Swiss law, with an issued share capital. The administration of the BIS is vested in the Board of Directors, 

Herstatt Risk 

It is named after a small German bank (Bankhaus Herstatt) which failed in June 1974 during the period it was supposed to settle a contract after having received the payment from the counterparty. The bank collapsed because of over-trading on the foreign currency markets. On 26 June 1974, German regulators forced the troubled Bank Herstatt into liquidation. That day, a number of banks had released payment of Deutsche Marks (DEM) to Herstatt in Frankfurt in exchange for US dollars (USD) that were to be delivered in New York. The bank was closed at 16:30 German time, which was 10:30 New York time. Because of time zone differences, Herstatt ceased operations between the times of the respective payments. The counterparty banks did not receive their USD payments. That failure caused a string of cascading defaults in a rapid sequence, totalling a loss of $620 million to the international banking sector. 

Thus, Herstatt Risk is also known as a cross country settlement risk that arises where the working hours of interbank fund transfer systems do not overlap due to time zone differences.

Due to occurrence of  Herstatt debacle, the G-10 countries (the G-10 is actually eleven countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States), Luxembourg and Spain formed a standing committee under the auspices of the Bank for International Settlements (BIS). Called the Basel Committee on Banking Supervision, the committee comprises representatives from central banks and regulatory authorities.. 

The failure of Herstatt Bank was a key factor that led to the worldwide implementation of real-time gross settlement (RTGS) systems, which ensure that payments between one bank and another are executed in real-time and are considered final. The work on these issues was coordinated by the Basel Committee on Banking Supervision under the Bank for International Settlements.

Global Banking scenario during Early Eighties

During the seventies (1970s), ten largest banks in the world, based on total assets, were from US, UK, France & Germany except for one, Bank of Japan. The same scenario prevailed till 1981. But thereafter, there was a gradual shift in this position and by 1988, nine out of 10 largest banks in the world were Japanese. In 1974, Bank of America, Citicorp Group and Chase Manhattan were the three largest banks in the world but by 1988, they slipped to the 41st, 11th & 39th position respectively. During these 14 years, assets of the top 300 banks in the world grew nearly seven fold from $2.2 trillion to 15.1 trillion. Interestingly during the same period, the assets of the Japanese banks in this category increased by a factor of greater than 13 whereas the US banks represented amongst this category of 300 banks did not increase even triple. It was further observed during this period that capital ratios of both Japanese and US banks had moved inversely i.e. Japanese banks were growing in assets but declining in capital ratio whereas US, French, British and German banks were declining in assets but growing in capital ratio. At the international level, since there was no benchmark of minimum capital ratio therefore it was difficult to measure the strength of banks and their loss absorbing capacity.

The 1980s also witnessed the greatest crisis in US commercial banking. Faced with both increased competition from open market source of credit and Non-banking intermediation and a series of adverse shocks to loan portfolio, banks in US experienced shrinking profits and a growing likelihood of failure. In fact, there was a sharp increase in failure rate for banks in the US between 1982 & 1991. The largest bank failure was in 1984 of Continental Illinois National Bank and Trust Company, a $40bn bank (at one time the seventh –largest bank in the United States as measured by deposits)

By 1986, regulators in the US were concerned about the failure of primary ratio to differentiate amongst risks and not providing accurate measures of the risk exposure associated with innovative and expanding banking activities, particularly off balance sheet activities of larger institutions.  Regulators in the US began studying the risk based capital requirements of other countries- France, U.K. and West Germany to ascertain the risk based capital standards practiced by these countries. In 1987, the US joined the UK in announcing a bilateral agreement of capital adequacy. Thereafter “International convergence of Capital Measurement and Capital Standards “were published by BCBS in 1988 to introduce a uniform regulation for Internationally active banks.

Basel Committee on Banking Supervision- BCBS

The Basel Committee - initially named the Committee on Banking Regulations and Supervisory Practices - was established by the central bank Governors of the Group of Ten countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets (notably the failure of Bankhaus Herstatt in West Germany as stated above).

The Committee, headquartered at the Bank for International Settlements in Basel, was established to enhance financial stability by improving the quality of banking supervision worldwide, and to serve as a forum for regular cooperation between its member countries on banking supervisory matters. The Committee's first meeting took place in February 1975, and meetings have been held regularly three or four times a year since.

Since its inception, the Basel Committee has expanded its membership from the G10 to 45 institutions from 28 jurisdictions. Starting with the Basel Concordat, first issued in 1975 and revised several times since, the Committee has established a series of international standards for bank regulation, most notably its landmark publications of the accords on capital adequacy which are commonly known as Basel I, Basel II and, most recently, Basel III.

Introduction of Basel Accord –I 

In 1988 , Basel Committee on Banking Supervision, introduced the first set of international risk-based standards for capital adequacy known as Basel – I Accord. 

It sets out the details of the agreed framework for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities represented on the Committee intend to implement in their respective countries. The framework and this standard have been endorsed by the Group of Ten ( G-10) *central-bank Governors. 

Two fundamental objectives lie at the heart of the Committee’s work on regulatory convergence. These are, firstly, that the new framework should serve to strengthen the soundness and stability of the international banking system; and, secondly, that the framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks. The framework allows for a degree of national discretion in the way in which it is applied. The impact of such discrepancies on the overall ratios is likely to be negligible and it is not considered that they will compromise the basic objectives.

Basel Accord I entirely addressed credit risk, the main risk incurred by banks. The document consists of mainly sections, which cover 

1. the definition of capital and 
2. the structure of risks weights

Based on basel norms , in India , RBI also issued similar guidelines on capital adequacy norms for Indian banks. According to the said guidelines of RBI, banks were required to identify their Tier I and Tier II capital and assign risk weights to the assets. With the help of Tier I & Tier II capital and risk weight assets , banks can calculate Capital Adequacy ratio.

Section I     The constituents of capital

Tier -1 Capital ( Core Capital)

• Paid –up Capital
• Statutory Reserves
• Disclosed free reserves
• Capital reserves representing surplus arising out of sale proceeds of asset

Tier- II Capital ( Supplementary Capital)

• Undisclosed reserves and Cumulative Perpetual Preference Shares
• Revaluation reserves
• General provisions/general loan-loss reserves

The risk weights

The framework of weights has been kept as simple as possible and only five weights are used - 0, 10, 20, 50 and 100% according to the category of debtors. There are inevitably some broad-brush judgements in deciding which weight should apply to different types of asset and the weightings should not be regarded as a substitute for commercial judgement for purposes of market pricing of the different instruments.

Categories of risk captured in the framework

Risk exposure (only Credit Risk under Basel I) can be divided into three categories

1) Credit Risk arising from on-balance sheet items (excluding derivatives)

2) Credit Risk arising from off Balance sheet items (excluding derivatives)

3) Credit Risk arising from over the counter derivatives

1) Risk weights by category of on-balance-sheet asset

Off-balance-sheet Exposure

III. A target standard ratio – Capital Adequacy Ratio

In the light of consultations and preliminary testing of the framework, the Committee has agreed that a minimum standard should be set now which international banks generally will be expected to achieve. It is also agreed that this standard should be set at a level that is consistent with the objective of securing over time soundly-based and consistent capital ratios for all international banks. Accordingly, the Committee confirms that the target standard ratio of capital to weighted risk assets should be set at 8% (of which the core capital element will be at least 4%). In India , these targets were 9 % and 6 % respectively

Basel II Norms 

Advantages of Basel I Accord: -

• Substantial increase in in capital adequacy ratios of internationally active banks ;
• Relatively simple structure
• Worldwide adoption among internally active banks
• Greater discipline in managing capital 
• A benchmark for assessment by market participants

Weaknesses of Basel I Accord: - 

• Capital Adequacy depends upon the credit risk, while other risks (e.g. market and operational) are excluded from the analysis. 
• In Credit risk assessment , it was fit for all i.e. there was no difference between credit quality and rating
• Emphasis was on book value and not on market value
• Inadequate assessment of risks and effects of the use of new financial instruments, as well as risk mitigation techniques.

Weaknesses related to market risk were over bridged by the amendment by means of introducing Capital requirement for market risks.

Basel II Accord 

The above listed weaknesses with few other improvements brought in a new Basel Capital Accord  known as Basel II norms in 2004.

On June 26, 2004 , the BCBS released “ International Convergence of Capital Measurement and Capital Standards: a revised Framework”. Basel II aims to build on a solid foundation of prudent capital regulation, supervision and market discipline to enhance risk management framework and financial stability. It Capitalizes on the modern risk management techniques and seeks to establish a more risk responsive linkage between the bank’s operation and their capital requirement. 

The Basel II consists of three mutually reinforcing pillars, popularly known as Pillar I, Pillar II , & Pillar III, A brief description of these pillars is as under:-

Pillar I : It stipulates the Minimum Capital Ratio requirements allocation of regulatory capital not only for credit risk and market risk but additionally for operational risk also. Regulators suggested simplified and advanced approaches to determining capital charge for each of these categories of risk .

Pillar II deals with the Supervisory Review Process. In fact it covers the entire risk domain of the banks. Under this requirement , Banks are required to have their own Internal Capital Adequacy Assessment Process ( ICAAP) which should encompass all such risks which are either not fully captured or not captured at all under the Pillar I. The ICAAP document is subject to supervisory review and if warranted, supervisors can prescribe the higher capital requirement over and above the minimum capital ratio envisaged in Pillar I.

Pillar III : It focuses on Market discipline and recognises the fact that apart from regulators banks are also monitored by the market and the discipline exerted by the market is as powerful as the regulations imposed by regulators. Thus through these disciplines , depending upon their nature , banks can be penalized or rewarded by the market forces.

Capital Adequacy Under Basel II 

Total CRAR = ( Eligible Capital Funds ) / ( Credit RWA* + Market RWA+ Operational RWA)

Tier I CRAR = [Eligible Tier I capital funds]/ [Credit RWA* + Market RWA +

Operational RWA]

• *RWA = Risk weighted assets

Basel II has also recommended at least 8% CRAR and 4% Tier 1 CRAR, whereas RBI has given guidelines for at least 9% CRAR and 6% Tier 1 CRAR.

So calculation of CRAR is dependent on two major factors

1. Eligible Total Capital Funds

2. Risk Weighted Assets

Eligible Total Capital Funds Components

Risk Weighted Assets 

Credit Risk Assessment: Unlike Basel 1, BCBS have devised three

approaches for calculation of credit risk weighted assets:

 Standardized Approach to Credit Risk: The standardized approach has

fixed risk weights corresponding to various risk category based on ratings given by

approved external credit rating agencies. The risk weights vary from 0% to 150%

based on the risk category. Unrated loans have 100% risk weights. Standardized

approach has increased risk sensitivity by considering expanded range of collateral,

guarantees and credit derivatives. The risk weights for residential mortgage exposure

were reduced in comparison to Basel 1 Accord.

Foundation Internal Rating Based Approach: In Internal Rating Based

Approach, credit risk is measured on basis of internal ratings given by the banks

rather than external credit rating agencies. The ratings are based on the risk

characteristics of both the borrower and the specific transaction. Expected loss is

calculated based on probability of default (PD) of borrower, loss given default (LGD),

bank’s exposure at default (EAD) and remaining Maturity (M) of exposure

Probability of default (PD) measures the likelihood that the borrower will default

over a given time horizon.

Loss Given Default (LGD) measures the proportion of the exposure that will be

lost if Default occurs.

Exposure at Default (EAD) is the estimated amount outstanding in a loan commitment if default occurs.

 Maturity (M) measures the remaining economic maturity of the exposure.

There are two types of losses- Expected and Unexpected. 

Expected Loss, which is normal business risk of a bank, is a multiplication of PD, LGD, EAD and M.

Expected Loss= PD X LGD X EAD X M

Unexpected Loss is that part of credit risk that cannot be priced in the product and hence the banks have to provide capital for it by risk weighing their assets.

Unexpected Loss is the upward variation in expected loss over a definite time

horizon. Unexpected Loss (UL) may be expressed as under:

UL = E x LGD x Standard Deviation of PD.

In Foundation IRB, PD is calculated by the bank and the remaining are based on

supervisory values set by Basel Committee or RBI (in India) 2.1.2.1.3 Advanced Internal Rating Based Approach: Advanced IRB is advanced version of foundation IRB. The only difference is that Loss Given Default, Exposure at Default and Maturity are also estimated by the bank based on the historical data.

Capital Charge for Credit Risk under Standardized Approach

Market Risk Assessment: Market risk is potential for loss resulting from adverse movement in market risk factors such as interest rates, forex rates, currency valuations, equity prices and commodity prices. (Bhattacharya, 2008). In Basel 2, risks are divided into two major risks: interest rate risk and volatility risk. Therefore there is a clear distinction between fixed income and other products such as equity, commodity and foreign exchange vehicles. The approaches to calculate market risk in capital charge are:

Standardized Duration Approach: Under the standardized method there are two principal methods of measuring market risk, a “maturity” method and a “duration” method. As the “duration” method is a more accurate method of measuring interest rate risk, RBI has adopted a standardized duration method to arrive at the capital charge. For interest rate risk, depending on the time to maturity/ duration of the fixed income asset, Basel II had recommended banks to hold capital between 0% and 12.5% of an asset’s value to protect against movements in interest rates. To guard against the volatility risk of fixed income assets, Basel II recommends risk weightings tied to the credit risk ratings given to underlying bank assets.

Internal risk management Models Approach: In this methodology banks are encouraged to develop their own internal models to calculate a stock, currency, or commodity’s market risk on a case-by-case basis. In this, banks have to develop their measures to calculate “Value of Risk” (VaR) based on 5 years data on position to position basis. On the basis of the Bank's calculation, capital requirements are predicted. Similar to other advanced measures RBI will supervise this method.

Operational Risk Assessment:

“Risk of direct or indirect loss resulting from inadequate or failed internal control processes, people, systems or from external events” Such breakdowns can lead to financial losses through Error, Fraud, Failure to perform in a timely manner, may cause the interest of the bank to be compromised like exceeding authority, conducting business in an unethical or risky manner.It is the risk of loss arising from the potential that inadequate information system;technology failures, breaches in internal controls, fraud, unforeseen catastrophes, or

other operational problems may result in unexpected losses or reputation problems (BIS, 2006).

The Basel II Accord has 3 methods of calculating risk weighted assets with increase

in sophistication and risk sensitivity

(i) the Basic Indicator Approach (BIA); (ii) the Standardized Approach (TSA); and

(iii) Advanced Measurement Approaches (AMA).

 Basic Indicator Approach: Under this approach banks must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted as alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero, should be excluded from both the numerator and denominator when calculating the average.

The Standardized Approach: In this approach, banks’ activities are divided into eight  business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta-β as 12, 15 and 18) assigned to that business

Advanced Measurement Approach: Under the AMA, the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement system (ORMS). After these criteria have been satisfied, the operational risk capital charge is computed from the unexpected loss of VaR at the 99.9 percent confidence level over one year horizon provided the expected loss is accounted for through provisions.A bank should calculate its regulatory operational risk capital requirement as the sum of expected loss (EL) and unexpected loss (UL). Expected Loss is covered by provisions & pricing and unexpected loss through additional capital.

Basel III

With above development in place BCBS issued guidelines on capital in December ,2010 & then revised it in June 2011June as “ Basel III : A Global Regulatory framework for more Resilient Banks and Banking System ”  and another guidelines on liquidity as “Basel III: International framework for liquidity risk measurement, standards and monitoring” .The objective of both these guidelines is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy . To address the market failures revealed by the crisis, the Committee introduced a number of  fundamental reforms to the international regulatory framework. The reforms strengthen bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress .

The key features of these guidelines are :-

Increased Quantity /Quality of Capital

Under Basel III, a bank’s total capital consists of :

1. Tier 1 equity capital (also known as CET 1 i.e. Core Equity Tier 1)
2. Additional Tier 1 Capital i.e. IPDI & PNCPS
3. Tier 2 capital 

Under Basel II also components of the capital as stated above are same but minimum requirement of each component is different. The table below shows the comparative picture of capital requirement under Basel II & Basel III:-

The component wise comparison as per above table clearly shows that core equity requirement under Basel III has increased sustainably from 2 % to 7 %.  Beside, Total minimum capital requirement under pillar- I has also increased from 8 % to 10.5 %. 

As regards quality of capital, loss absorbing components under Basel II were only core capital in Tier I and provisions in Tier II whereas under Basel III, Tier I & Tier II bonds are also having the feature of loss absorbency which means at the point of non-viability these bonds either can be considered to adjust the losses or can be converted into equity.

Capital Conservation Buffer 

In addition to Core Equity Capital of 4.5 %, Basel III requires a capital conservation buffer in normal times consisting of a further amount of core Tier I equity capital equal to 2.5 % of risk weighted assets. This provision is designed to ensure that banks build up capital during normal times so that it can be run down when losses are incurred during periods of financial difficulties. It is presumed that raising capital during normal circumstances is easier than raising capital during stressed market conditions. There are certain dividend restrictions imposed as per following table:- 

The capital conservation buffer means that the Tier I equity capital required to be kept in normal times is 7 %  of RWA; total Tier Capital is to be 8.5 % of RWA and Total CRAR is required to be 10.5 % of RWA and in India, requirement  is 11.5 % RWA.

This requirement of additional Capital of 2.5 % was phased out in four equal tranches of .625 each starting from Jan 1, 2016 to Jan 1, 2019. In India it started from 1st April 2016 up to 1st April 2019 . Last tranche of .625 has been deferred up to 1st April, 2020.

Countercyclical Buffer

Losses incurred in the banking sector can be extremely large when a downturn is

preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. These interactions highlight the particular importance of the banking sector building up additional capital defences in periods where the risks of system-wide stress are growing markedly.

Another Capital requirement specified under Basel III is Countercyclical buffer. This is similar to the Capital conservation buffer , but the extent to which it is implemented in a particular country is left to the discretion of national authorities. The buffer is intended to provide protection for the cyclicality of bank earnings. The buffer can be set to between 0 % to 2.5 % of total risk weighted assets and must be met with Tier I equity capital..

National authorities will monitor credit growth and other indicators that may signal a

build up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build up of system-wide risk. Based on this assessment they will put in place a countercyclical buffer requirement when circumstances warrant. This requirement will be released when system-wide risk crystallises or dissipates.

Global and Domestic Systemically Important Banks (D-SIBs)

Global and Domestic Systemically Important Banks (D-SIBs), are those banks where failure of any of these banks would have a cascading effect on the whole financial system which in other words mean banks that are considered to be too big to fail.

As per the norms, these banks will have to set aside more capital for their continued operation. 

RBI comes with the list every year since 2015 to announce such banks in India. At present, SBI, ICICI and HDFC banks are DSIB and require additional capital of 0.6, 0.20& 0.20 of their RWA. 

This additional capital has to be in form of Common Equity Tier-I

Global Liquidity Standards 

 Liquidity is a bank’s capacity to fund an increase in assets and meet both expected and unexpected cash and collateral obligations at a reasonable cost. Liquidity risk is the inability of a bank to meet such obligations as they become due, without adversely affecting the bank’s financial condition. Effective liquidity risk management helps ensure a bank’s ability to meet its obligations as they fall due and reduces the probability of an adverse situation developing. This assumes significance on account of the fact that a liquidity crisis, even at a single institution can have systemic implications.

 Liquidity risk for banks mainly manifests on account of the following: 

(i) Funding Liquidity Risk – the risk that a bank will not be able to efficiently meet the expected and unexpected current and future cash flows and collateral needs without affecting either its daily operations or its financial condition. 

(ii) Market Liquidity Risk – the risk that a bank cannot easily offset or eliminate a position at the prevailing market price because of inadequate market depth or market disruption.

The Basel Committee on banking supervision had published its report on Basel III rules text on Liquidity- “Basel III International Framework for liquidity risk measurement, standards and monitoring in 2010”

This committee had suggested two standards namely 

1. Liquidity Coverage Ratio (LCR) and (2) Net Stable Funding Ratio (NSFR) to ensure adequate liquidity with banks and to take care of funding risk. 

 These two ratios are a key component of the Basel III Framework. These are explained as under :

The liquidity coverage ratio (LCR) is introduced with a view to ensure that a bank has an adequate stock of unencumbered high quality liquid assets that consists of cash and near cash assets to meet its liquidity needs in the next 30 calendar days.  This will help a bank to survive until the 30th day of the stress scenario.  

The standard norm of net stable funding ratio is also expected to bring discipline through use of more stable sources of funds to fund long term assets.

(i) The Liquidity Coverage Ratio (LCR) is calculated by using following ratio

                             Stock of high quality liquid assets             

   LCR = --------------------------------------------------------------   x 100

                             Total net cash outflows over the next  30   calendar days

The LCR should be more than or equal to 100 percent at any point of time.  This ratio must be maintained on a continuous basis.  As per the Basel Committee’s recommendations banks having business in overseas countries have to maintain this standard with effect from January 1, 2015.  The time frame within which degree of this standard must be maintained is as follows.