RISK MANAGEMENT MODULE E QUIZ 1

Banks take deposits, provide payment services and transform maturities and liquidity. Their distress can harm depositors and spread through interconnected financial markets, so regulation aims to protect financial stability, depositors and the payment system while limiting excessive risk-taking.

Prudential supervision assesses the safety and soundness of banks, including capital, asset quality, governance, liquidity and risk management. It seeks to reduce the likelihood and impact of failure, rather than guaranteeing that failure is impossible.

The Reserve Bank of India (RBI) is India‘s central bank and the principal regulator and supervisor of commercial banks under the applicable legal framework. Other authorities also have roles in areas such as deposit insurance, securities markets and resolution, but they do not replace RBI‘s core banking supervisory role.

The BCBS develops international standards and guidance for banking regulation and supervision. Its standards are not automatically domestic law; national authorities implement them through local laws, regulations and supervisory requirements.

Basel standards provide internationally agreed minimum standards and supervisory guidance. They become enforceable for banks through domestic implementation by the relevant jurisdiction; national rules may specify local requirements and implementation details.

Basel I introduced a risk-weighted capital framework with a minimum total capital ratio of 8% of risk-weighted assets, subject to the framework‘s definitions and implementation. Domestic supervisors may require higher ratios or additional buffers.

Basel I used relatively broad, standardised risk-weight categories for exposures, rather than the more granular approaches and internal-rating-based methods later developed under Basel II. The original framework primarily focused on credit risk, with market risk added later through an amendment.

The 1996 amendment introduced an explicit capital charge for market risks, including trading-book interest-rate risk and foreign-exchange risk, and permitted qualifying banks to use internal models subject to supervisory requirements. It expanded the earlier credit-risk-focused framework.

Basel II is structured around Pillar 1 minimum capital requirements, Pillar 2 supervisory review, and Pillar 3 market discipline through disclosure. The pillars are complementary and collectively support risk-sensitive capital and stronger supervision.

Basel II‘s Pillar 1 covers minimum capital requirements for credit risk, market risk and operational risk. Operational risk includes loss arising from inadequate or failed internal processes, people and systems or external events, subject to the applicable definition and exclusions.

The crisis highlighted insufficient high-quality capital, excessive leverage, procyclical lending, weak liquidity resilience and interconnectedness. Basel III strengthened capital quality and quantity and introduced additional buffers, leverage and liquidity standards to improve resilience.

Common Equity Tier 1 (CET1) is the highest-quality capital because it is available to absorb losses on a going-concern basis. It generally includes qualifying common shares and retained earnings, subject to regulatory adjustments and deductions.

The Capital Conservation Buffer is designed to ensure banks build up an additional layer of capital that can be drawn down in periods of stress. Restrictions on distributions, such as dividends and certain bonuses, apply when capital falls into the buffer range under the relevant rules.

The Countercyclical Capital Buffer is designed to build resilience during periods of excessive credit growth and can be released when systemic stress materialises. Its calibration and activation are jurisdiction-specific and depend on the applicable supervisory framework.

Total capital ratio = eligible regulatory capital ÷ risk-weighted assets × 100 = ₹12 crore ÷ ₹100 crore × 100 = 12%. Whether the bank meets its requirement depends on the applicable minimums, buffers and supervisory add-ons.

RWA reflect the risk weights or regulatory risk measures applied to different exposures, not simply their accounting size. Differences in asset composition, credit quality, collateral, guarantees, counterparty exposure and applicable calculation approaches can produce different RWA for equal total assets.

The standardised approach applies prescribed regulatory risk weights to exposure classes, with treatment influenced by factors such as counterparty type, external credit assessments where recognised, collateral and guarantees. The exact rules depend on the jurisdiction‘s implemented framework.

Off-balance-sheet items are commonly converted to credit-equivalent amounts using applicable credit conversion factors, then assigned the relevant risk weight. The precise conversion factor depends on the type and terms of the commitment, guarantee or contingent exposure under applicable rules.

Eligible collateral, guarantees, credit derivatives or other recognised techniques may reduce the capital-relevant credit exposure when all regulatory eligibility and operational requirements are met. The mitigant does not eliminate the need to manage residual, legal, market and concentration risks.

Under the IRB approach, qualifying banks use approved internal estimates of specified risk parameters, such as PD and, depending on the IRB variant, LGD and EAD, subject to supervisory approval, minimum requirements and validation. It is not unrestricted use of a bank‘s own preferred numbers.