Risk Profiling: Banking Industry

By: Anal Nayak Ankit Arora Gopal Sharma Gouri Shankar Sharma Pragya Gupta Vishal Gupta

Risks identified
Banking industry is subjected to various risks which are majorly classified into following types: Market Risk Credit Risk Operational Risk

Liquidity Risk
Country Risk

Reputation Risk

Description of risks
Credit risk, market risk, and operational are risk defined in the International Convergence of Capital Measurement and Capital Standards (Basel II, June 2004). Part of Pillar I Minimum Capital Requirements. Liquidity risk defined in International Framework for Liquidity Risk Measurement, Standards and Monitoring (Basel III, December 2010).

Reputation risk is a part of Pillar II Supervisory Review Process of Basel II framework. It includes all the risks that would result in damage to a banks reputation, leading to fines, penalties, and loss of business.
Country risk is a specific category of credit risk in which counterparty default is on account of factors resulting from actions of sovereign entities and government. It includes transfer and convertibility risks.

Banks selected
Following banks have been identified for the purpose of risk profiling: Indian banks ICICI Bank (ICICI) State Bank of India (SBI) Yes Bank (Yes)

Foreign banks JP Morgan Chase & Company (JPMC) HSBC Holdings Plc (HSBC) Deutsche Bank (Deutsche)

Regulatory difference
Risk profile template for Indian banks has been prescribed by Reserve Bank of India vide DBS. No. DBS/CO/89/36.01.03/2002-03 dated July 12, 2002. Various differences in regulations result in difference in risk profiles for Indian banks vis--vis foreign banks: Difference in capital adequacy norms Differences in capital computation methodology Transactions permitted Complex derivatives not permitted in India Banks in India not allowed to trade in commodities Short position on bonds not allowed in India (only in interest rate derivatives, short position are allowed) Due to above reasons which would result in significant difference in risk profile, we have considered foreign banks for our project.

Categorization of risks
The identified risks can be categorized into firm specific risks, industry wide risks, and economy wide risks, in the following manner: Type of risk Credit risk Market risk Operational risk Categorization Firm specific risk Economy wide risk Firm specific risk

Liquidity risk
Country risk Reputation risk

Industry wide risk

Economy wide risk Firm specific risk

Market risk
Market risk is the risk arising out of adverse movements in market factors such as interest rates, exchange rates, equity prices, and commodity prices. Measured for the banking book and trading book of a bank. Market risk for banking book measured through earnings-at-risk (EaR) and duration-of-equity (DoE).

Market risk for trading book measured through Standardized Measurement Method (SMM) or Internal Models Approach (IMA).
Domestic banks apply SMM whereas foreign banks apply IMA.

Market risk (Contd.)

Market risk for the six banks is measured as follows:
Parameters Economic capital Risk weighted assets Earnings at risk ICICI 598.0 3,036.8 3.83% SBI 860.4 6,289.1 7.13% Yes 161.8 884.1 2.12% HSBC 8,846.0 54,944.1 4.69% Deutsche 17,404.2 101,778.9 Below 1% JPMC 17,500.0 114,379.1 4.78%

Duration of equity
Value-at-risk (VaR)

3.23%
NR

4.32%
NR

4.80%
NR

NR
346.1

NR
75.3

NR
152.0

NR: Not Reported All the figures are in USD million.

Market risk (Contd.)

The six banks have been rated as:
Parameters Economic capital / RWA Earnings at risk Weights 0.15 0.10 ICICI 5 3 SBI 3 1 Yes 5 4 HSBC 4 3 Deutsche 4 5 JPMC 4 3

Ratings given above corresponds to the following opinion:

Rating 1 2 3 4 5 Opinion Very bad Bad Average Good Very good

Credit risk
Credit risk is defined as the risk arising due to default of a counterparty to meet its obligations in a contract. In a banks portfolio, default stems due to inability or unwillingness of a customer or a counterparty. Sources of credit risk includes loans, various financial instruments including acceptances, inter-bank transactions, trade financing, forex transactions, financial futures, swaps, bonds, equities, options and in guarantees and settlement of transactions.

Credit risk (Contd.)

Standardized Approach (SA): Risk weights are a function of the counterparties types and integrates external ratings to estimate the risk level. Internal Rating Based Foundation Approach (IRBF): Key risk parameters Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Maturity (M) Asset correlation (P) Confidence Interval (CI) Internal Rating Based Advanced Approach (IRBA): Rules are more flexible, any collateral can be recognised and deducted from the exposure to compute capital requirements, as long as historical data is available for valuation and modelling.

Credit risk (Contd.)

The six banks have been rated as:
Parameters Economic capital / RWA Weights 0.15 ICICI 5 SBI 3 Yes 4 HSBC 4 Deutsche 4 JPMC 5

Credit concentration
Non-performing assets

0.05
0.05

5
3

5
2

2
5

3
2

3
3

5
3

Ratings given above corresponds to the following opinion:

Rating 1 2 3 4 5 Opinion Very bad Bad Average Good Very good

Operational risk
Operational risk is defined as the risk of losses arising out of failed or inadequate internal processes, people, systems, and external events. Major determinants of operational risk are the twin factors of Loss Frequency and Loss Severity. Includes penalties and fines imposed by regulatory authorities as well as amounts in lawsuits settlements.

Operational risk (Contd.)

Capital computation methodologies for operational risk are based on: Basic Indicator Approach (BIA): 15% of last three years average gross revenue. The Standardized Approach (TSA): 12%/15%/18% (depending upon business line) of last three years average gross revenue for each business line.

Advances Measurement Approach (AMA): Statistical model-based approach for capital computation based on historical loss data and scenarios.

Operational risk (Contd.)

Estimated loss calculation
Estimated Loss* 134.1 220.0 212.5 165.1 89.4 238.0 Revenue 8,919.8 76,851.0 66,049.6 22,042.4 1.527.9 108,184. 0 Banks ICICI Bank HSBC Deutsche Bank SBI Yes Bank JP Morgan (USD Million) Capital Charge 506.4 19,700.0 6,592.8 1,735.3 104.6 15,900.0

*Estimated loss is determined on the basis of observed loss for Industrial & Commercial Bank of China (ICBC) after scaling the same as per revenues of respective banks. Reference: J. Shih, A. Samad-Khan, & P. Medapa, Is the size of an operational loss related to firm size, Operational Risk, January, 2000.

Operational risk scores

Weights 0.15 0.05 0.05 ICICI 5 3 4 SBI 5 5 5 Yes 5 4 2 HSBC 5 2 5 Deutsche 5 4 5 JPMC 5 4 5

Parameters Economic capital / RWA Penalties / PAT Estimated loss / Total capital

Liquidity risk
Liquidity risk defined in International Framework for Liquidity Risk Measurement, Standards and Monitoring (Basel III, December 2010). Liquidity risk is the risk that a bank will not have sufficient financial resources to meet their obligations as they fall due or can do so only at excessive cost.

Liquidity risk (Contd.)

Liquidity risk is measured on the basis of following two ratios: Liquidity coverage ratio: This ratio measures whether the bank has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one month.

Net stable funding ratio: This is to ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles.

Liquidity risk - monitoring

Parameters Contractual maturity mismatch SBI ICICI Yes Bank Deutsche HSBC JPMC

Concentration of funding
Available unencumbered assets LCR by significant currency Market-related monitoring tools

Contractual maturity measurement

The contractual maturity mismatch profile identifies the gaps between the contractual inflows and outflows of liquidity for defined time bands

State Bank of India Asset Liability Net Next Day 4.88% 3.09% 2 days to 7 days 0.85% 3.75% 8 days to 14 days 1.57% 2.29% 15 days to 28 days 1.45% 2.49% 29 days to 3 months 6.73% 7.98% over 3 months to 6 months 4.96% 9.84% over 6 months to 12 months 5.10% 12.42% over 1 year to 3 years 35.57% 28.18% over 3 years to 5 years 12.14% 16.44% over 5 years 26.76% 13.52%

ICICI Bank Asset Next Day 2 days to 7 days 8 days to 14 days 15 days to 28 days 29 days to 3 months over 3 months to 6 months over 6 months to 12 months over 1 year to 3 years over 3 years to 5 years over 5 years

Liability Net 1.59% 0.63% 5.16% 4.88% 2.19% 2.75% 3.62% 2.04% 6.54% 8.99% 6.26% 9.86% 9.53% 14.81% 28.96% 15.66% 15.96% 18.06% 20.20% 22.33%

Contractual maturity measurement

Yes Bank Asset Next Day 2 days to 7 days 8 days to 14 days 15 days to 28 days 29 days to 3 months over 3 months to 6 months over 6 months to 12 months over 1 year to 3 years over 3 years to 5 years over 5 years Liability Net 0.25% 0.68% 0.74% 12.25% 0.98% 4.30% 1.12% 5.35% 9.58% 16.38% 6.33% 13.96% 9.21% 23.06% 27.70% 5.72% 16.29% 10.46% 28.04% 7.84%

HSBC Asset
Due less than 1 month Over 1 to 3 months Over 3 months to 6 months Over 6 months to 9 months Over 9 months to 1 year Over 1 year to 2 year Over 2 years to 5 years over 5 years

Liability Net 47.68% 77.53% 6.05% 5.20% 3.75% 2.10% 1.77% 0.82% 4.05% 2.30% 4.87% 1.22% 10.98% 3.62% 20.84% 7.22%

Next Day 2 days to 3 Months over 3 Months to 1 year over 1 year to 5 years over 5 years

Deutsche Bank Asset Liability Net 67.00% 68.01% 10.97% 18.49% 3.32% 3.97% 6.69% 5.03% 12.00% 4.49%

Concentration of funding
Identify those sources of wholesale funding that are of such significance that withdrawal of this funding could trigger liquidity problems
Parameters Term deposits to total deposits (in %) Term deposits to Advances (in %) Demand deposits to Advances (in %) Liquidity Reserve (in USD billions) SBI 55.19 47.66 38.71 NR ICICI 56.54 58.58 42.23 NR Yes Bank Deutsche 84.96 115.47 20.44 NR 52.05 74.95 69.05 232.2 HSBC 53.85 67.85 58.15 181 JPMC 63.26 103.11 59.89 491

NR Not reported

Liquidity risk (Contd.)

On the basis of liquidity risk, the six banks have been rated as:
Parameters Liquidity risk Weights 0.15 ICICI 3 SBI 2 Yes 1 HSBC 4 Deutsche 4 JPMC 3

Country risk
Country risk is the risk arising out of investing or funding in a country and may adversely affect the operating profits or the value of assets in a specific country. Country risk can arise on account of following factors: Financial factors such as currency controls, devaluation, or regulatory changes. Stability factors such as mass riots, civil wars and other potential events contributing to companies operational risk.

Country risk (Contd.)

Elements of country risk are as follows: Economic risk: Evaluation of the state of the domestic economy. Government finance and international transactions. Prospects for growth and stability. Political risk: Comprises of the stability of the government and society. Effectiveness of international diplomatic relationships. Reliability and integrity of legal system and business infrastructure. Financial system risk: Evaluation of a countrys banking system, accounting standards, and government finances. Assessment of vulnerability of financial system to external and internal volatility.

Country risk (Contd.)

Country risk measurement parameters are as follows:

PARAMETERS
Macroeconomic Parameters

Weightage
7% 8% 7% 8%

Economic Risk

a) b) c) d)

GDP GDP per capita Projected GDP growth rate Inflation rate (CIP in %)

External Finance
a) b) c) d) Current account balance (as % of GDP) Short term external debt/ International reserves (%) Foreign exchange reserves (no. of months of import) External Debt (% of GDP) 9% 4% 5% 4% 8% 7%

Financial Risk

Public Finance
a) Central government balance (as % of GDP) b) Public Debt (as % of GDP)

Socio Political issues

Political Risk

a) Political Stability b) Corruption perception index c) Government effectiveness score

10% 9% 6%

Other

Market Perception
a) BICRA score b) CDS spread 4% 4%

Country risk (Contd.)

Country risk ratings are given below:

INDIA BBB+

UK AAA

USA AAA

GERMANY AAA

Country risk (Contd.)

On the basis of country risk, the six banks have been rated as:
Parameters Country risk model (as per ICICI Bank) Weights 0.05 ICICI 2 SBI 2 Yes 2 HSBC 5 Deutsche 5 JPMC 4

Reputation risk
Reputation risk is a part of Pillar II Supervisory Review Process of Basel II framework. It includes all the risks that would result in damage of banks reputation, leading to fines, penalties, and loss of business. Earlier regulators consider operational risk to be important source for reputation risk . Financial statements were focussing on reputational risk arising from the operational losses. Incorporates every single activity which bank does. A corporate reputation is largely influenced by an organization's people, processes and systems.

Reputation risk (Contd.)

Assessment of reputation risk would be carried out through the following: Fines/penalties levied by regulatory authorities (domestic and foreign country). Lawsuits and cases filed in consumer forum. Rating up grade/down grade.

Customer perception.
Market perception.

Reputation risk (Contd.)

Challenges in measurement of reputation risk are: Involvement of third party and technology organisation and customer. has widened gap between

Bank's reputation is increasingly shaped by regulatory agencies, the media and online conversations. Today's customers expect and demand much more. Better complaint management required.

Reputation risk (Contd.)

On the basis of reputation risk, the six banks have been rated as:
Parameters Reputation risk Weights 0.05 ICICI 3 SBI 5 Yes 3 HSBC 4 Deutsche 4 JPMC 4

Summary
On the basis of above factors, these banks have been rated as below for all the risks discussed:
Banks v/s Risks Market Risk Credit Risk Operational Risk Liquidity Risk ICICI SBI Yes JPMC Deutsche HSBC

Country Risk
Reputation Risk

Low Medium High

Risk mitigation
Mitigation of various risks can be carried out in the following manner: Credit risk: Through collateral securities, credit enhancements (guarantee, undertakings), credit insurance/CDS, capital and provision. Market risk: Through use of derivative instruments such as forwards, futures, options, and swaps and maintenance of capital. Operational risk: Through loss data recording, regular process audits, adequate capital, insurance, internal controls, back-up procedures, contingency planning (Business Continuity Process). Liquidity risk: Maintaining adequate reserves of low-yield liquid assets, eliminating assetliability mismatch. Country risk: Capital and provision for sovereign defaults, insurance from Multilateral Investment Guarantee Agency (MIGA). Reputation risk: Banks can successfully manage their reputation risks by renewing their focus on people, processes and systems. reputation risks, need to be continuously assessed and managed . Banks that effectively manage their reputation risks will be able to enhance their credibility and profitability.

Thank you.