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.
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