Risks and Risk Management in Banking by edutap rbi course

Risks and Risk Management in the Banking Sector Importance:

1. 1 question of 1 mark of full form of ICAAP 2. 1 question question of o f 1 mark Risk Weighted Average Average Capital 3. 1 question question of 1 mark on Systemic Risk 4. 1 question of 2 marks on Negative Beta 5. 1 question of 2 marks on Risk premium 6. 1 question of 2 marks on Risk Return Trade off

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Contents 1

Defin Definiti ition on of Risk Risk ........... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ... 3

2

Risk Risk in Banki Banking ng Busin Busines ess....... s....... .......... .......... ......... .......... .......... ......... .......... .......... ........... ....... 3

3

Type Type of Risks Risks .......... .......... ........... ........ ........... .......... ........ ........... .......... ......... .......... .......... 3

4

3.1

Liqui Liq uidi dity ty Risk Risk .......... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ... 4

3.2

Interes Interestt Rate Rate Risk Risk .......... .......... ........... ......... .......... .......... ......... .......... .......... ......... ....... 4

3.3

Market Market Risk Risk (Als (Also o kno known wn as Price Price Risk) Risk) ........... .......... .......... ......... .......... .......... ......... ....... 5

3.4

Defaul Defaultt or Credit redit Risk............... Risk............... .......... ......... ........... .......... ......... .......... .......... .......... ...... 5

3.5

Operat Operatio iona nall Risk Risk ......... ........... .......... ......... .......... .......... ......... .......... ........... ........ ......... 6

3.6

Other Other Risks Risks......... ......... .......... ........... ......... .......... .......... ......... .......... ........... ........ .......... ....... 6

Risk Risk Managem Managemen entt Frame Framewo work rkss .......... .......... .......... ......... .......... ........... ........ .......... ........... .... 7 4.1

Role of RBI in Risk Risk Manageme Management nt in Banks Banks.... ........ .... ........ .... ........ .... ........ .... .... ........ .... .... ........ .... ........ .... ........ .... ........ .... ........ .... ...... 7

4.2

Came Camels ls Frame Framewo work.................. rk.................. ........... ........ ........... .......... ......... .......... .......... ......... ....... 7

4.3

Basel Basel No Norm rmss ........... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ... 8

4.3.1

Basel Basel 1 ........... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ... 8

4.3.2

Basel Basel 2 ........... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ... 9

4.3.3

Basel Basel 3 ........... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ..10

4.4

PCA PCA Frame Framewo work rk .......... ........... .......... ......... .......... .......... ......... .......... ........... ........ ........11

5

Some Some Impor Importan tantt Terms Terms......... .......... ........... ........ ........... .......... ......... .......... .......... ......... ......12

6

Beta of an Inves Investme tmen nt or an Asse Assett .......... ........... .......... ......... .......... .......... ......... .......... .........13 6.1

CAPM CAPM Mode Modell .......... .......... .......... ......... .......... ........... ........ .......... ........... ........ ........... ..13

6.1.1

ASSET ASSET BETAS, BETAS, EQUITY EQUITY BETAS BETAS,, AND DEBT BETAS BETAS .... ........ .... ........ .... ........ .... ........ .... .... ........ .... ........ .... ........ .... ........ .... 17

7

Counte ounterr Cycli yclicc Capital apital Buffe Buffers rs .......... .......... .......... ......... ........... .......... ......... .......... .......... .....18

8

MCQ’s (Multiple Choice Questions) ............................ ............................................ ............................... ................................ ...........................1 ..........19 9


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1 Definition of Risk An activity which may give profits or result in loss may be called a risky proposition due to uncertainty or unpredictability of the activity of trade in future. In other words, it can be defined as the possibility of loss. loss. Example- Ram bought a piece of land today assuming he will sell it at higher price 1 year later is a activity which has risk in it because there is no guarantee that prices will increase next year. He might make a loss if prices decline next year As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more money

2 Risk in Banking Business The two most important developments that have made it imperative for Indian commercial banks to give emphasize emphasize on risk management management are discussed discussed below

1. Deregulation : The era of financial sector reforms which started in early 1990s has culminated in deregulation in a phased manner. Deregulation has given banks more autonomy in areas like lending, investment, interest rate structure etc. As a result of these developments, banks are required to manage their own business themselves and at the same time maintain liquidity and profitability. This has made it imperative for banks to pay more attention to risk management 2. Technological innovation: Technological innovations have provided a platform to the banks for creating an environment for efficient customer services as also for designing new products. In fact, it is technological innovation that has helped banks to manage the assets and liabilities in a better way, providing various delivery channels, reducing processing time of transactions, reducing manual intervention in back office functions etc. However, all these developments have also increased the diversity and complexity of risks, which need to be managed professionally professionally so that the opportunities opportunities provided by the technology are not negated. negat ed.

3 Type of Risks The major risks in banking business or ‘banking risks’, as common ly referred, are listed below – 1. 2. 3. 4. 5.

Liquidity Risk Interest Rate Risk Market Risk Credit or Default Risk Operational Risk


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3.1 Liquidity Risk

Liquidity risk arises when bank does not have enough money to pay back to its lenders. For example there is a rumor that t hat PNB does not not have enough money money in its accounts. This woul would d lead to large number number of people withdrawing money the next day which can result in PNB not having money t o pay back.

1. Funding Risk : Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail). The example of PNB above is example ex ample of Funding Funding Risk 2. Time Risk : Time risk arises a rises from the need to compensate compensate for non-receipt of expected inflows of of funds i.e., performing assets turning into non-performing assets. People defaulting on loans can leads to Time risk 3. Call Risk: Any future contingency such as bank losing a legal battle resulting in huge fines to the

bank can result result in outflow of money which is called Call Risk

3.2 Interest Rate Risk Interest Rate Risk arises due to movement in Interest rates Example: Bank has given money for 20 years at 8% Rate but borrowed it for 5 years at 7.5 %. Here the

bank is assuming that after 5 years it would again borrow at 7.5 %. But if after 5 years the borrowing rate is increased to 9%. In such a case bank would make loss due to Interest rate movements


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3.3 Market Risk (Also known as Price Risk) The market risk arises due to unfavorable movement in market prices in the investments done by bank. Suppose bank has invested in Equities (Stock market) but stock market crashes then banks would make a loss. Banks generally invests in products which are related to price of Commodities, Shares, Currency movement (You will learn lea rn this t his concept in Derivatives in detail). So investment investment in such products products can lead to market risk. Interest Inter est rate risk is also a type type of market risk Example of Currency Risk: This is also called Forex Risk. Suppose bank has invested 1000 Dollars in US

bank. When it invested each dollar was of Rs. 60 which means bank invested Rs. 60,000. But after certain certa in days the dollar becomes of Rs. 58 which means bank will get only Rs. 58, 000 on that day. You will learn about currency movements later in the course

3.4 Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with the agreed terms 1. Counterparty Risk : This is a variant of Credit risk and is related to non-performance of the trading partners due to counterparty’s refusal and or inability to per form. It is more or less same as Time Risk in the Liquidity Liquidity Risk section 2. Country Risk : This is also a type of credit risk where non-performance of a borrower or counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of non-performance non-performance is external factors fact ors on which the borrower or the counterparty has no control .

Credit Risk R isk can’t can’ t be avoided but has to be managed by applying various risk mitigating mitiga ting processes

1. Banks should assess the credit worthiness of the borrower before sanctioning loan i.e., credit rating of the borrower should be done beforehand. should be maximum limit exposure for single/ single/ group g roup borrower 2. There should


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3.5 Operational Risk

Operational loss has mainly three exposure classes namely people, processes and systems. In other words in arise due to bad intentions of staff, hacking of systems or wrong systems in place to meet the compliance

1. Transaction Risk : Transaction risk is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and manage information.

2. Compliance Risk : Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, and codes of conduct and standards of good practice. It is also called integrity risk since a bank’s reputation is closely linked to its adherence to

principles of integrity integrit y and fair dealing

3.6 Other Risks 1. Strat Strategic gi c R i sk : Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organization’s strategic goals, the business strategi es developed to achieve those goals, the resources deployed against these goals and the quality of implementation. 2. Reputation Risk : Reputation Risk is the risk arising from negative public opinion. This risk may expose expose the institution to litigation, litigat ion, fina fina ncial loss or decline in customer customer base.

3. Systematic Risk: The risk inherent to the entire market or an entire market segment. Systematic risk, also known as undiversifiable risk. It affects the overall market, not just a particular stock or industry. For example if you invest all you money in equities then there is a risk risk that if equity markets crash, c rash, all your investments will go g o into loss. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated mitiga ted through diversificat diversification, ion, only through hedging or by using using the right rig ht asset allocation allocat ion strategy. strat egy. For example, putting some assets in bonds and other assets in stocks can mitigate mitiga te systemat systematic ic risk because bec ause an a n interest rate rat e shift that t hat makes bonds less valuable will tend to make stocks more valuable, and vice versa, thus limiting the overall change in the portfolio’s value from systematic changes. Interest rate changes, inflation,


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recessions and wars all represent sources of systematic risk because they affect the entire market

4 Risk Management Framewo Frameworks rks 4.1 Role of RBI in Risk Management in Banks There is body called Board for Financial Supervision (BFS) which works under the control of RBI and supervises all the financial institutions except Stock Markets (regulated by SEBI) and Insurance (regulated by IRDA). Following Following are the Risk Management Manag ement Frameworks 1. BFS has been using CAMELS rating to evaluate the financial soundness of the Banks. The

CAMELS Model consists of six components namely Capital Adequacy, Asset Quality, Management, Earnings Quality, Liquidity and Sensitivity to Market risk. This framework

was recommended by Basel Committee on Banking Supervision of the Bank for International Settlements ( BIS ) 2. Basel Ba sel norms (Basel (B asel 1, Basel Ba sel 2 and Basel 3) are being being implemented for Risk Management Manag ement 3. PCA (Prompt Corrective Action) to take corrective actions

We will discuss these frameworks one by one

4.2 Camels Framework The CAMELS rating system is a recognized international rating system that bank supervisory authorities use in order to rate financial institutions according to six factors represented by the acronym "CAMELS." Supervisory authorities assign each bank a score on a scale, and a rating of one is considered the best and the rating of five is considered the worst for each factor. The six factors in Camels framework are Factor

Explanation

C- Capital Adequacy

Examiners assess assess institutions' institutions' capital adequacy through capital capita l trend analysis. To get a high capital adequacy rating, institutions must also comply with interest and dividend rules and practices. Other factors involved in rating and assessing an institution's capital adequacy are its growth plans, economic environment, ability to control risk, and loan and investment concentrations

A – Asset Quality

It determines the quality of loan’s given by the bank. Loan given to people

who are not financially sound may be considered are The appropriateness of investment investment The investment risk factors when structure The effect of fair (market) value investments 

policies a nd practices practic es compared to capital and earnings



of investments vs. book value of



M- Management Manag ement


defaulted by them. The factors

Management Manag ement assessment assessment determines whether an institution is able to properly react to financial stress. This component rating is reflected by the

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E- Earnings

L- Liquidity

S- Sensitivity Sensitivity

management's capability to point out, measure, look after, and control risks of the institution's daily activities. It covers the management's ability to ensure the safe operation of the institution as they comply with the necessary and applicable internal and external regulations An institution's ability to create creat e appropriate returns to be able to expand, expa nd, retain competitiveness, and add capital is a key factor in rating its continued viability. Examiners determine this by assessing the company's growth, stability, valuation allowances, net interest margin, net worth level and the quality of the company's company's existing assets To assess a company's liquidity, liquidity, examiners look at interest rate rat e risk sensitivity, availability of assets which can easily be converted to cash, dependence dependence on short-t short-term erm volatile financial resources Sensitivity Sensitivity covers how particular partic ular risk exposures exposures can affect institutions. institutions. Examiners assess an institution's sensitivity to market risk by monitoring the management of credit concentrations. In this way, examiners are able to see how lending to specific industries affect an institution. These loans include agricultural lending, medical lending, credit card lending, and energy sector lending. Exposure to foreign exchange, commodities, equities and derivatives are also included included in rating the sensitivity of a company company to market risk .

4.3 Basel Norms At the end of 1974, the Central Bank Governors of the Group of Ten countries formed a Committee of banking supervisory authorities. As this Committee usually meets at the Bank of International Settlement (BIS ) in Basel, Switzerland, Switzer land, this Committee came to be known known as the Basel Committee. Committee. The Basel committee has introduced three Basel Norms which are known as Basel Accord. These Basel Norms are called Basel 1, Basel 2, and Basel 3. 4.3.1 Basel 1 Basel I mainly catered to the credit risk that the risk of borrowers defaulting on Loans/Bonds/debt etc.

Basel1 defines Capital Ratio = (Tier 1 Capital + Tier 2 Capital)/Risk Weighted Assets Tier 1 include (equity (e quity capital capit al plus disclosed reserves reserve s minus goodwill) Tier 2 includes (asset revaluation reserves, undisclosed reserves, general loan loss reserves, hybrid

capital capita l instrument and subordinated subordinated term debt). debt). Note: You will understand Tier1 and tier 2 better after learning balance sheets in case you have not

read them till now The denominator of the Basel I formula is the sum of risk-adjusted assets. There are five credit risk weights: 0 per cent, 10 per cent, 20 per cent, 50 per cent and 100 per cent. 1. Risk weight weig ht would be 0 % for government or central bank claims cla ims


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2. 20 % for Organizat Orga nization ion for Economic Cooperation and Development (OECD) inter-bank claims c laims 3. 50 % for residential mortgages 4.

100 % for all commercial and consumer loans.

As per Basel I norms the minimum capital ratio should be 8%. India RBI recommends it to be 9%. So any bank in India having capital ratio of less than 9% is deemed to be risky

Numerical1: For example if a company has the following details then find the Capital Ratio

Equity Capital = 100 Loan Loss Reserves = 50 Loan given to Cons Consumers umers = 1500 Loan given to govt = 300 Solution:

Capital Ratio would be = 100 (tier1 equity capital) + 50 (tier 2 loan loss reserves) / (0% of 300 + 100% of 1500) = 150 / 1500 = 10% Here 0% of 300 is taken because for Govt. Loans the risk weight is supposed to be 0%. 100% of 1500 is taken because because for Loan given to Consum Consumers ers the risk weight is suppos supposed ed to be 100% 4.3.2 Basel 2 Basel 2 norms has 3 pillars   

Pillar 1 - Minimum capital capita l requirements Pillar 2 - Supervisory Supervisory review process Pillar 3 - Market discipline

4.3.2.1 Pillar 1 – Minimum Capital Requirements The capital ratio remain the same i.e. 9% as in Basel 1

However the important changes are 1. Along with Credit Risk Basle 2 also take into account Market Risk and Operational Risk while calculating the minimum capital (The detailed formula is not needed for the exam) 2. The major change is that RWA (risk weighted in the assets) which is the denominator while calculating capital ratio is now calculated differently. In Basel 1 a particular type of asset was http://rbigradeb.wordpress.com

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always given a particular percentage like all Consumer loans were thought to be 100% risky but in Basel2 for each type of asset there is a rating based risk weightage. So if a Consumer loan has rating 1 (good rating) then its risk weightage would be around 50% but if it has a rating of 5 (worst rating) rating ) then is risk risk weightag weig htage e would be 100% or may be more. more.

4.3.2.2 Pillar 2 – Supervisory review process Pillar 2 of the new capital framework recognizes the necessity of exercising effective supervisory review of banks’ internal assessments of t heir overall risks to ensure that bank management is

exercising sound judgment and had set aside adequate capital capita l for these risks. Supervisors will personally go to the banks and evaluate the activities and risk profiles of individual banks to determine whether those organizations should hold higher levels of capital than the minimum requirements in Pillar 1. In case the bank needs additional requirements then they would whether there is any need for remedial actions. This process also takes into account other risks such as interest rate risk which are not not considered considered in capital capita l ratio calculation . An important outcome of pillar 2 is ICAAP. It stands for Internal Capital Adequacy Process. It is an umbrella activity that encompasses the governance, management and control of all risk and capital management functions and the linkages therein. It strengthens the governance and organizational organiz ational effectiveness around a round risk and capital capita l management. This is more of a human intervention in the process. Sometimes banks are able to maintain Capital ratio rat io by finding some loopholes but with wit h supervisory process they would not be able to do so

4.3.2.3

Pillar 3 – Market discipline

This pillar is about effective management such as degree of transparency in banks’ public reporting.

Thus, adequate disclosure of information to public in timely manner brings in market discipline and in the process promotes safety and soundnes soundnesss in the financial system. system. The Committee proposes two types of disclosures namely Core and Supplementary . Core disclosures are those which convey vital information for all institutions while Supplementary disclosures disclosures are those those required for some

4.3.3

Basel 3

Basel III is intended to strengthen bank capital requirements by increasing bank liquidity liquidity and decreasing bank leverage. 1. Capital Ratio: Th The e overall overall capit capital al ratio is unchanged unc hanged at 8% ( RBI recomme re comme nds 9%) 9%) But there are are some new recommendations recommendations Capital Ratio = (Tier 1 Capital + Tier 2 Capital)/Risk Weighted Assets


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Let’s break the above formula Tier 1 Capital/RWA – minimum capital ratio is 6% (Also called Tier 1 Capital Ratio) Tier 2 Capital/RWA – minimum capital ratio is 2% (Also called Tier 2 Capital Ratio)

So Tier1 Capital ratio individually needs to be above 6% and Tier 2 Capital ratio individually needs to be above 2% Note: RBI recommends Tier 1 Capital Ratio of 7% and Tier 2 Capital Ratio of 2%. Hence H ence Overall ratio of 9%

Tier 1 capital is further divided in two parts p arts

Tier 1 Capital /RWA= Common Equity Tier 1 (CET1)/RWA + Additional Tier 1(AT 1)/RWA 6% = 4.5 % + 1.5% Common Capital Ratio ) I.e. minimum of CET 1 capital ratio be 4.5 %. (Also called Tier1 Common And minimum of AT1 capital ratio be 1.5 %. Note: RBI recommends CET1 to be 5.5% and AT1 to be 1.5% CET1 capital includes equity instruments that have discretionary dividends and no maturity AT 1 Capital is the money borrowed by company from lenders who expect to get their money

back. But if bank goes into losses then debt is converted in to equity i.e. lenders are issued shares of the bank and no money is returned to them. So it’s a way of restructuring debt. These

are also called Coco bonds or contingent convertible bonds. These bonds can also be cancelled any time 2. Leverage Ratio: Basel III introduced a minimum "leverage ratio". This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items). The banks are expect ed to maintain a leverage leverage ratio in excess exc ess of 3% under Bas Basel el III III

Tier1 Capital / Total Exposure >= 3% 3. Liquidity Coverage Ratio: The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days. Mathematically it is expressed as follows:

LCR = High H igh Quality Assets/Net Assets/Net Liquidity outflow over over 30 days LCR must be >= 100%

4.4 PCA Framework PCA Framework Framework consists c onsists of following following three parameters parameters

1. Capital to risk weighted assets ratio (CRAR), 2. Net non-performing assets (NPA) and 3. Return on Assets (RoA) The Reserve Reserve Bank B ank tak es some s ome actions and put some restrictions on the bank bank as soon as the value for any one of t hese parameters goes beyond a certain limit. l imit. The PCA framework framework is applicable only


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to commercial banks and not not ext ended ended to co-op co -opera erative tive banks, banks, non-banking non-banking financial financial companies (NBFCs) and FMIs. 1. CRAR a. CRAR le ss than 9%, but equa eq uall or more than 6% - bank - bank to submit capital restoration plan; restrictions on RWA expansion, entering into new lines of business, accessing/renewing cost ly deposits deposits and CDs, CDs, and making dividend dividend payments; payments; order order recapitalizat ion; restrictions restricti ons on borrowing borrowing from inter-bank mark market, et, reduction of stake in subsidiaries, reducing its exposure exposure to sensit ive ive sectors like capital capital market, market, real real estate or investment investment in non-SLR securities, securities , etc. b.

CRAR less than 6%, but equal or more than 3% - in addition to actions in hitting the first trigger point, RBI could take steps t o bring bring in new Management/ Management/ Board, Board, appoint appoint consultants for business/ organizational restructuring, take steps to change ownership, and also take steps to merge the bank if it fails to submit recapitalization plan.

c.

CRAR less than 3% - in - in addition addit ion to act ions in hittin hitti ng the first and second trigger points, points, more close monitoring; steps to merg m erge/amalgama e/amalgamate/liquidate te/liquidate t he bank or impose moratorium moratorium on the bank if its CRAR does not improve beyond 3% within one year or within such extended period as agreed to.

2. Net NPAs 1. Net NPAs over 10% but less than 15% - special drive to reduce NPAs and contain generation of fresh NPAs; review loan policy and take steps to strengthen credit appraisal skills, follow-up of advances and suit-filed/decreed debts, put in place proper credit-risk management policies; reduce loan concentration; restrictions in entering new lines of business, making dividend dividend payments payments and increasing its s take in subsidiaries. 2. Net NPAs 15% and an d above abo ve – In addition to actions on hitting the above trigger point, bank’s Board is called for discussion on corrective plan of action. 3. ROA le ss than 0.25% - rest - restrict rict ions on accessing/renew ac cessing/renewing ing costly deposits and CDs, entering into into new lines of business, bank’s borrowings from inter -bank inter -bank market, market, making dividend dividend payments paym ents and expanding its staff; steps to increase fee-based income; contain administrative expenses; special drive to reduce NPAs and contain generation of fresh NPAs; and restrictions on incurring any capital expenditure other than for technological up gradation and for some emergency situations.

5 Some Important Terms 1. Risk Premium: A risk premium is the return in excess of the t he risk-free rate ra te of return re turn an investment is expected to yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment. For example, a fixed deposit i n reputed bank like SBI is giving you a return of 10% and it’s totally

risk free or vey minimum risk. On the other hand when you invest in fixed deposit with a local bank which is not reputed then you will get a return of 15%. But at the same time the return from local bank is not guaranteed local bank might fail and you might not get anything. So here you are taking a risk to get a return of 15% which is more than fixed return of 10%. The extra return of 5% which you might get is called Risk Premium


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2. Risk Return Trade off : The risk-return tradeoff is is the principle that potential return rises with an increase in risk. Low levels of uncertainty or risk are associated with low potential returns, whereas high levels of uncertainty or risk are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor is willing to accept acce pt the possibility possibility of losses. losses. The appropriate risk-return tradeoff depends on a variety of factors including risk tolerance, years to retirement and time of investment . For example, the t he ability to invest in equities over the long-term provides the potential to recover from the risks of bear markets and participate in bull markets, while a short time frame makes equities a higher hig her risk proposition proposition .

6

Beta of an Investment or an Asset

In finance, In finance, the the beta (β or beta b eta coefficien coefficien t) of an investment an investment indicates whether the investment investment is more or less volatile than the t he market. In general, g eneral, a beta less less than t han 1 indicates that the investment is less volatile than the market, mar ket, while a beta more than 1 indicates that t hat the investment investment is more volatile than the market. A beta below 1 can indicate two things 1. If beta is between 0 and 1 then the investment is less volatile v olatile than the market. An example of the first is a treasury bill: treasury bill: the price does not go up or down a lot even when the market moves, moves, so it has a low beta 2. If beta is less than 0 i.e. Negative Beta Beta then it means mea ns volat volatile ile investment whose whose price movements are not correlated not correlated with the market. market. A negative negat ive beta correlation would mean an investment investment that moves in the opposite opposite direction from the t he stock market. ma rket. When the market rises, rises, then a negative neg ative-bet -beta a investment generally falls. When the market falls, then the negative-beta investment will tend to rise. This is generally g enerally true of gold stocks and gold g old bullion bullion

6.1 CAPM Model CAPM stands for Capital Asset Pricing Model


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Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the investment will be different from the expected return. Investors take the risk of an investment into account when deciding on the return they wish to receive for making the investment. The CAPM is a method of calculating the return required on an investment, based on an assessment of its risk. SYSTEMATIC AND UNSYSTEMATIC UNSYSTEMATIC RIS K

If an investor has a portfolio of investments in the shares of a number of different companies, it might be thought that the risk of the portfolio would be the average of the risks of the individual investments. In fact, it has been found that the risk of the portfolio is less than the average of the risks of the individual investments. By diversifying investments in a portfolio, therefore, an investor can reduce the overall level of risk faced. There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not eliminate risk entirely. The risk which cannot be eliminated by portfolio diversification is called ‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the financial s ystem. The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic risk’, or ‘specific risk’, since it is the risk that is associated with individual companies and the shares they

have issued.

THE CAPITAL CAPIT AL ASSE ASSET T PRICING M OD ODE EL

The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed assumed by the CAPM to want a return r eturn on an investment investment based on its systematic systematic risk alone, rather rat her than on its total risk. The measure of ris k used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk. The form f ormula ula for the CAPM is as follow s:

E (ri) = Rf + βi (E (rm) – Rf) – Rf)

E (ri) = return required on financial asset i Rf = risk-free rate of return βi = beta bet a value for for financial asset i E (rm) = average return on the t he capital market This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium: βi (E (rm) - Rf) – which compensates the investor for the systematic risk of the financial asset.

THE RISKRISK-FREE FREE RAT RATE E OF RE RETUR TURN N

In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free


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asset. In order to have consistency of data, the yield on treasury bills is used as a substitute for the risk-free rate of return when applying the CAPM to assets that are traded on the capital market. Note that it is the yield on treasury bills which is used here, rather than the interest rate. .

THE RISK RISK PREM PREM IUM

Rather than finding the average return on the capital market, E (rm), research has concentrated on finding an appropriate value for (E (rm) - Rf), which is the difference between the average return on the capital market and the risk-free rate of return. This difference is called the risk premium, since it represents the extra ret urn required for for investing in risky assets rather than investing in risk-free assets.

BETA

Beta is an indirect measure which compares the systematic risk associated with a company’s shares with the systematic risk of the capital market as a whole. If the beta value of a company’s shares is 1, the

systematic risk associated with the shares is the same as the systematic risk of the capital market as a whole. Beta can also be described as ‘an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole’. For example, if a share has a beta value of 1, the

return on the share will increase by 10% if the return on the capital market as a whole increases by 10%. If a share has a beta value of 0.5, the return on the share will increase by 5% if the return on the capital market increases increa ses by by 10%, and so on on.

Numerical 2 Calculating the Required Return using the CAPM

Although the concepts of the CAPM can appear complex, the application of the model is straightforward. Consider the following information: Risk-free rate of return r eturn = 4% Equity risk premium = 5% Beta value of of RD Co = 1.2

Solution:

Using the CAPM: E(ri) = Rf + βi (E(rm) - Rf) = 4 + (1.2 x 5) = 10%

The CAPM predicts that the cost of equity of RD Co is 10%. The same answer would have been found if the information had given the return on the market a s 9%, rather rat her than giving the equity risk premium premium as 5%.


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Numerical 3

Consider Consider the following information informat ion and find the Risk Free Rate Rat e of Return Marker Rate of return = 9% Required Rate of Return = 10% Beta value of of RD Co = 1.2 Solution:

Using the CAPM: E(ri) = Rf + βi (E(rm) - Rf) 10 = Rf + 1.2 (9-Rf) 10 = Rf +10.8 -1.2 Rf .2 Rf = .8 Rf = .8/.2 = 4%

Numerical 4

Consider Consider the following information informat ion and find the Return in the Market Required Rate of Return = 12% Risk Free Return = 6% Beta value of RD Co Co = 1.2 Solution:

Using the CAPM: E(ri) = Rf + βi (E(rm) - Rf)

12 = 6 + 1.2 (E (rm)-6) 12-6 = 1.2 E (rm) – 7.2 6 + 7.2 = 1.2 E(rm) E (rm) = 13.2/1.2 = 11%


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6.1.1 ASSET BETAS, BETAS, EQUITY BETAS, AND AND DEBT BETAS BETAS

The asset beta we calculated calculat ed above assumed assumed that there is no debt. The actual act ual asset asset beta formula is as follows: follows:

If a company has no debt, its equity beta is the same as its asset beta. beta . Note from the t he formula that t hat if Vd is zero because because a company has no debt, then βa = βe, as stated earlier. company t akes on debt, debt, it’s it ’s gearing increases and financial risk is added to its business business risk. The When a company ordinary shareholders shareholders of the company company face fa ce an increasing level of risk as gearing gea ring increases and the return they require from the company increases increa ses to compensate compensate for the t he increasing risk. risk. This means that the beta of the company’s shares, called the equity equity beta, increases as gearing increases.

Numerical5

Calculate the asset beta of a company. You have the following information information relating relat ing to RD Co: Co: Equity beta of RD Co (Be) = 1.2 Debt beta of RD Co (Bd) = 0.1 Market value of shares of RD Co (Ve) = $6m Market value of debt of RD Co (Vd) = $1.5m Company Company profit tax ta x rate rat e (T) = 25% After After tax market value of company compan y = 6 + (1.5 x 0.75) = $7.125m β a = [(1.2 x 6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024


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Numerical6

Calculate the asset beta of a company. You have the following information information relating relat ing to RD Co: Co: Equity beta of RD Co (Be) = 1.5 Debt beta of RD Co (Bd) = 0.2 Market value of shares of RD Co (Ve) = $6m Market value of debt of RD Co Co (Vd) = $1.5m Company Company profit tax ta x rate rat e (T) = 25% After After tax market value of company compan y = 6 + (1.5 x 0.75) = $7.125m β a = [(1.5 x 6)/7.125] + [(0.2 x 1.5 x 0.75)/7.125] = 1.294

Numerical7

Calculate the Debt beta of a company. c ompany. You have the following following information relating to RD Co: Equity beta of RD Co (Be) = 1.5 Asset Beta Co ( Ba) = 1.3 Market value of shares of RD Co (Ve) = $6m Market value of debt of RD Co Co (Vd) = $1.5m Company Company profit tax ta x rate rat e (T) = 25% After After tax market value of company compan y = 6 + (1.5 x 0.75) = $7.125m

1.3 = [(1.5 x 6)/7.125] + [(Bdx1.5 x 0.75)/7.125] Bd = 0 .253

7 Counter Cyclic Cycli c Capital Buffers Counter Counter Cyclical Capital Buffers (CCCB) are the Buffers which are maintained mainta ined in opposition opposition to the cycle of the credit growth cycles. In good g ood times bank saves money money in the CCC CCCB B and in tough t ough times bank ba nk takes out money from CCCB CCCB and a nd lend lend it to the outside world. They are ar e a mechanism of Risk Manage Ma nagement ment The aim of the Countercyclic Countercyclical al Capital Buffer B uffer (CCCB) (CCCB) regime is twofold twofold 1. Firstly, it requires r equires banks banks to t o build up a buffer of capital capita l in good times t imes which may may be used to maintain flow of credit to the real sector in difficult times 2. Secondly, Secondly, it achieves the broader macro-prudential goal of restricting restr icting the banking sector from indiscriminate indiscriminate lending in the periods of excess exc ess credit growth that t hat have often been associated with the building up of system-wide system-wide risk The CCCB CCCB may be maintained in in the t he form of Common Equity Tier 1 (CET (CET 1) capital capita l or other fully loss absorbing absorbing capital ca pital only, and the amount of the CCC CCCB B may vary from 0 to 2.5% of total risk weighted assets (RWA) of the banks


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8

MCQ’s (Multiple Choice Questions)

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Risks and Risk Management in Banking by edutap rbi course

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