Risk Management in Financial Institutions

Subject Code: 201, Module: G

Implementation of Basel Capital Framework/Accord

S. M. Mahruf Billah
Joint Director
Bangladesh Bank
E-mail: [email protected]
S. M. Mahruf Billah 1
 Previous year’s Questions
From Module-G
SL AIBB Question Number Given
marks
1. 96th 6(c), 8, 9(c), 10 (c), (d), 46
(g), (h)
2. 97th 5 (a), (b), 8, 10 (b), (e) 40
3. 98th 8, 9, 10 (b) 44
4. 99th 5(b), 6(c), 8, 10 (b), (g) 43

S. M. Mahruf Billah 2
 BASEL, a city of Switzerland
Basel also known as Basle,
is a city in northwestern
Switzerland on the River
Rhine Basel is Switzerland's
third-most-populous city
(after Zurich and Geneva).
The Bank for International
Settlements (BIS) is based
in Basel, Switzerland, with
representative offices in
Hong Kong and Mexico City.

S. M. Mahruf Billah 3
 Bank for International Settlements
 The Bank for International Settlements
(BIS) is an international financial
institution which is owned by member
central banks.
 Its primary goal is to foster international
monetary and financial cooperation while
serving as a bank for central banks.
 With its establishment in 1930, it is the
oldest international financial institution
 The BIS carries out its work through its
meetings, programs and through the Basel
Process, hosting international groups
pursuing global financial stability and
facilitating their interaction.

S. M. Mahruf Billah 4
 The Basel Committee - overview
 The Basel Committee on Banking Supervision (BCBS) is the primary
global standard setter for the prudential regulation of banks and
provides a forum for regular cooperation on banking supervisory
matters. Its 45 members comprise central banks and bank supervisors
from 28 jurisdictions.
 The BCBS is the primary global standard setter for the prudential
regulation of banks and provides a forum for cooperation on banking
supervisory matters. Its mandate is to strengthen the regulation,
supervision and practices of banks worldwide with the purpose of
enhancing financial stability.

S. M. Mahruf Billah 5
 What is the Basel framework?
 Also known as the ‘Basel Accords’, ‘Basel Standards’, ‘Basel
Regulations’, or just plain ‘Basel’, the Basel framework is the
full set of standards for the international banking system.
 Set by the Basel Committee on Banking Supervision (BCBS),
which comprises the world’s top banking regulators, the
standards’ aim is to shore up the global financial system and
set a level playing field for banking regulation.
 At the heart of the framework lies the requirement for banks
to maintain enough capital reserves to meet their obligations
and absorb unexpected losses.
 The first set of standards was the ‘Basel Capital Accord’,
established in 1988. Today, this is known as ‘Basel I’, as there
have been two subsequent sets of revisions — Basel II, issued
in 2004, and Basel III, issued in 2010.
S. M. Mahruf Billah 6
 What is the Basel Agreement?
The Basel Agreement identifies the risk-based
capital ratios agreed upon by the member
countries of the Bank for International
Settlements.
 The ratios are to be implemented for all
commercial banks under their jurisdiction.
 Further, most countries in the world now have
accepted the guidelines of this agreement for
measuring capital adequacy.

S. M. Mahruf Billah 7
 What is Basel III?
 The Basel III accord is a set of financial reforms that was
developed by the Basel Committee on Banking
Supervision (BCBS), with the aim of strengthening
regulation, supervision, and risk management within the
banking industry.
 Due to the impact of the 2008 Global Financial Crisis on
banks, Basel III was introduced to improve the banks’
ability to handle shocks from financial stress and to
strengthen their transparency and disclosure.
 Basel III builds on the previous accords, Basel I and II, and
is part of a continuous process to enhance regulation in
the banking industry.
 The accord aims to prevent banks from hurting the
economy by taking moreS. M.risks than they can handle.
Mahruf Billah 8
Basel-II
Pillar-1 Pillar-2 Pillar-3
Calculation of Regulatory supervisory Requirements on rules for
regulatory minimum review so as to disclosure of capital structure,
capital requirements. complement and risk exposures, and capital
1. Credit risk enforce minimum adequacy so as to increase FI
2. Market risk capital requirements transparency and enhance
3. Operational risk calculated under Pillar 1 market/investor discipline

Basel III
Enhanced minimum Enhanced supervisory Enhanced risk disclosure and
capital and liquidity review for firm wide risk market discipline
requirements management and capital
planning

1. Liquidity risk
S. M. Mahruf Billah 9
 Key features of three pillars of Basel-III framework
Basel III’s 3-Pillar Framework
Pillar 1 Pillar 2 Pillar 3
Minimum Capital Supervisory Review Process Market Discipline
Requirements
Additional/Refined Capital Supervision (Dialogue) Additional/Enhanced
Basis  Firm-wide Corporate Disclosure
 Liquidity Coverage Ratio Governance  Risk management
(LCR)  Managing Risk Concentrations  Market
 Net Stable Funding Ratio  Alignment of LT Incentives  Credit
(NSFR)  Sound compensation  Operational
 OTC Derivatives Charge practices  Regulatory Capital
 Quality and Level of Capital  Supervisory Colleges components
 Leverage Ratio  Capital (ICAAP)  Detailed Reconciliation
 Capital Conservation Buffer  Firm-wide Risk Management of Capital
 Countercyclical Buffer  Valuation Practice, Stress  Regulatory Capital Ratio
 Enhanced Loss Absorption Tests  Securitization
Clause (Write-Off or Debt  Supervisory Review Evaluation Exposures
Conversion) Process (SREP)
 Capital
 Governance

S. M. Mahruf Billah 10
 How does Basel-III differ from Basel-II? Explain.
Key features Basel-II Basel-III
Introduction 2004 Gradual introduction starting from
2010
Focus Enhancing Risk Strengthening financial stability and
Management resilience
Pillars Minimum Capital Enhanced Minimum Capital &
Requirements Liquidity Requirements
Supervisory Review Process Enhanced Supervisory Review Process
for Firm-wide Risk Management and
Capital Planning
Disclosure & Market Enhanced Risk Disclosure & Market
Discipline Discipline
Risk-Weighted Introduced the Concept Further developed Risk-Weighted
Assets
Assets approach
Operational Recognized as a distinct risk Continued recognition with
Risk category refinement in calculating capital for
Operational Risk
S. M. Mahruf Billah 11
 How does Basel-III differ from Basel-II? Explain.
Supervisory Emphasis on Focus extended to overall Bank
review supervisory Oversight Resilience and Risk Management

Market Encouraged Maintained transparency focus but

Discipline transparency introduced additional measures for
Capital Buffers and Liquidity.

Capital Buffers Not Present Introduced multiple Capital Buffers

including Capital Conservation Buffer,
Countercyclical Buffer, SIB

Liquidity Not explicitly Introduced Liquidity Standards like the

Standards addressed Liquidity Coverage Ratio (LCR) and Net
Stable Funding Ratio (NSFR)

Leverage Ratio Not explicitly Introduced a Leverage Ratio to prevent

Addressed excessive borrowing

S. M. Mahruf Billah 12
 Identify and briefly discuss the functions of a Bank’s
Capital?
Capital is supposed to protect a bank from all sorts of
uninsured and unsecured risks apt to turn into losses. This
is where we get to the two principal functions of capital –
i. to absorb losses: Capital is needed to allow a bank
to cover any losses with its own funds.
ii. to build and maintain confidence in a bank:
Depositors and bank creditors have to be convinced
that their bank deposits and assets are safe.
Bank capital has a financing and restrictive function as
well. However, in light of the key importance of the
functions discussed above, these functions are somewhat
secondary.
S. M. Mahruf Billah 13
Why are regulators concerned with the levels of capital held by
an FI compared to a non-financial institution?
 Regulators are concerned with the levels of capital
held by an FI because of its special role in society.
 A failure of an FI can have severe repercussions to
the local or national economy unlike non-financial
institutions.
 Such externalities impose a burden on regulators to
ensure that these failures do not impose major
negative externalities on the economy.
 Higher capital levels will reduce the probability of
such failures.

S. M. Mahruf Billah 14
 Why is Liquidity is important in banking?
 Liquidity is a measure of the money and other assets
a bank has readily available to quickly pay bills and
meet financial obligations in the short term.
 Capital is a measure of the resources available to a
bank to absorb losses.
 When asset values deteriorate and monetary policies
become tighter, it increases liquidity risk for banks.
 Liquidity management is crucial for banks to mitigate
risks and meet short-term financial obligations
promptly and without substantial losses.

S. M. Mahruf Billah 15
 What does it mean by market discipline under Basel framework?
Explain its purpose.
 The third pillar of Basel Framework (Market Discipline) requires
the bank activities to be transparent to the general people.
 It aims to ensure market discipline by making it mandatory to
disclose relevant market information.
 For this, the bank is supposed to release relevant financial data
(financial statements etc.) in a timely fashion to the people, for
example, through its website.
 It is intended to foster greater transparency into the soundness
of a bank's business practices and allow investors and others to
compare banks on equal footing.
 This might enable depositors to better evaluate bank condition
(i.e. bank probability of failure) and diversify their portfolio
accordingly.
S. M. Mahruf Billah 16
 The economic basis of financial intermediation
The economic basis of financial intermediation lies in the economies
of scale in portfolio management and in the law of large numbers:
1) Law of large numbers
 Banks, insurance companies, unit trusts, and all other FIs operate
on the assumption, supported by statistical law of large numbers,
that not all the creditors will put forward their claims for cash at the
same time.
 Add to this the fact that if some creditors are withdrawing cash,
some others (whether old or new) is paying in cash. Besides, FIs
receive regularly interest payments on loans and investments made
and repayments of loans due.
 Fortified by this knowledge, banks keep in cash only a small fraction
of even their demand liabilities and invest or lend the rest.
 FIs can afford to manufacture liabilities (secondary securities) that
are far more liquid than the primary securities they buy as earning
assets. S. M. Mahruf Billah 17
 The economic basis of financial intermediation
2) Economies of Scale in Portfolio Management
The average size of the asset portfolios of banks insurance
companies and other organized-sector FIs is quite large in value.
So these FIs can reap several economies of scale in portfolio
management, which improve significantly their net rates of
return from their asset holdings.
These economies accrue in the following main forms:
a) Reduction of risk through portfolio diversification
b) Professional Management
c) Indivisibilities and market imperfections
d) Other Cost economies

S. M. Mahruf Billah 18
 The key principles of BASEL-III
1) Minimum Capital Requirements:
 Common Equity Tier 1 of at least 4.5% of the total RWA
 Tier 1 capital will be at least 6.0% of the total RWA
 Minimum CRAR of 10% of the total RWA.
 In addition to minimum CRAR, Capital Conservation
Buffer (CCB) of 2.5% of the total RWA is being introduced
which will be maintained in the form of CET1.
2) Leverage Ratio:
 Basel III introduced a non-risk leverage ratio that acts as a
safeguard to the risk-based capital requirements.
 Banks must hold a leverage ratio above 3%. This ratio is
calculated by dividing Tier 1 capital by the average total
consolidated assets of the bank.
S. M. Mahruf Billah 19
 The key principles of BASEL-III
3) Liquidity Requirements:
Basel III introduced usage of 2 liquidity ratios
namely Liquidity Coverage Ratio and Net Stable
Funding Ratio.
Liquidity Coverage Ratio (LCR): Banks must
maintain an adequate level of high-quality liquid
assets (HQLA) that can cover their total net cash
outflows over a 30-day stress period.
Net Stable Funding Ratio: Ensures that banks have
a stable funding profile in relation to their assets
and off-balance-sheet activities, promoting longer-
term stability.
S. M. Mahruf Billah 20
 Guidelines on Risk Based Capital Adequacy
Revised Regulatory Capital Framework for banks in
line with Basel III, Bangladesh Bank, December
2014

S. M. Mahruf Billah 21
 General Instructions on Capital Adequacy Framework
Capital to Risk-weighted Asset Ratio
•

The Capital to Risk-weighted Asset Ratio (CRAR) is

calculated by taking eligible regulatory capital as
numerator and total RWA as denominator.

S. M. Mahruf Billah 22
 Measurement of Risk-weighted Asset
 In order to calculate Capital to Risk-weighted Asset
Ratio (CRAR), banks are required to calculate their
Risk Weighted Assets (RWA) on the basis of credit,
market, and operational risks.
 Total RWA will be determined by multiplying the
amount of capital charge for market risk and
operational risk by the reciprocal of the minimum
CRAR and adding the resulting figures to the sum of
risk weighted assets for credit risk.
 The methodologies to calculate RWA for each of
these risk categories are described in detail in
relevant chapters.
S. M. Mahruf Billah 23
 Constituents of Capital and Minimum Requirement
Components of Capital:
For the purpose of calculating capital under capital
adequacy framework, the capital of banks shall be
classified into two tiers. The total regulatory capital will
consist of sum of the following categories:
1) Tier 1 Capital (going-concern capital)
a) Common Equity Tier 1
b) Additional Tier 1
2) Tier 2 Capital (gone-concern capital)

S. M. Mahruf Billah 24
Components of Capital
Tier 1 Capital:
a) Common Equity Tier 1, b) Additional Tier 1
Common Equity Tier 1 Capital:
For the local banks, Common Equity Tier 1 (CET1) capital shall
consist of sum of the following items:
a) Paid up capital
b) Non-repayable share premium account
c) Statutory reserve
d) General reserve
e) Retained earnings
f) Dividend equalization reserve
g) Minority interest in subsidiaries
Less: Regulatory adjustments applicable on CET1 as mentioned in
paragraph 3.4.
S. M. Mahruf Billah 25
Tier 1 Capital:
a) Common Equity Tier 1, b) Additional Tier 1
Common Equity Tier 1 Capital:
For the foreign banks operating in Bangladesh, Common Equity Tier 1 (CET1)
capital shall consist of sum of the following items:
i. Funds from Head Office for the purpose of meeting the capital
adequacy
ii. Statutory reserves kept in books in Bangladesh
iii. Retained earnings
iv. Actuarial gain/loss kept in books in Bangladesh
v. Non-repatriable interest-free funds from Head Office for the purpose
of acquisition of property and held in a separate account and have the
ability to absorb losses regardless of their source.
Less: Regulatory adjustments applicable on CET1 as mentioned in paragraph
3.4. Eligibility criteria for the inclusion in CET1 capital for local and foreign
banks have been specified in Annex 1.
S. M. Mahruf Billah 26
Tier 1 Capital:
a) Common Equity Tier 1, b) Additional Tier 1
Additional Tier 1 Capital:
•

For the local banks, Additional Tier 1 (AT1) capital shall consist of the
following items:
a) Instruments issued by the banks that meet the qualifying criteria
for AT1 as specified at Annex 4 of Guideline for Risk Based Capital
Adequacy issued by BB.
b) Minority Interest i.e. AT1 issued by consolidated subsidiaries to
third parties (for consolidated reporting only); Refer to Annex 2 of
Guideline for Risk Based Capital Adequacy issued by BB for further
details.
Less: Regulatory adjustments applicable on AT1 Capital as mentioned
in paragraph 3.4.
•
S. M. Mahruf Billah 27
Tier 1 Capital:
a) Common Equity Tier 1, b) Additional Tier 1
Additional Tier 1 Capital:
For the foreign banks operating in Bangladesh, Additional Tier 1
(AT1) capital shall consist of the following items:
i. Head Office borrowings in foreign currency by foreign banks
operating in Bangladesh for inclusion in Additional Tier 1
capital which comply with the regulatory requirements as
specified in Annex 4.
ii. Any other item specifically allowed by BB from time to time
for inclusion in Additional Tier 1 capital.
Less: Regulatory adjustments regulatory adjustments applicable on
AT1 Capital as mentioned in paragraph 3.4.
S. M. Mahruf Billah 28
 Components of Capital
Tier 2 Capital
Tier 2 capital, also called ‘gone-concern capital’, represents other
elements which fall short of some of the characteristics of the
core capital but contribute to the overall strength of a bank.
For the local banks, Tier 2 capital shall consist of the following
items:
a) General Provisions
b) Subordinated debt / Instruments issued by the banks that
meet the qualifying criteria for Tier 2 capital as specified at
Annex 4
c) Minority Interest i.e. Tier 2 issued by consolidated
subsidiaries to third parties as specified at Annex 2
Less: Regulatory adjustments applicable on Tier 2 capital as
mentioned at paragraph 3.4
S. M. Mahruf Billah 29
 Tier 2 Capital
For the foreign banks operating in Bangladesh, Tier 2
capital shall consist of the following items:
i. General Provisions
ii.Head Office (HO) borrowings in foreign currency
received that meet the criteria of Tier 2 debt
capital.
Less: Regulatory adjustments applicable on Tier 2
capital as mentioned at paragraph 3.4

S. M. Mahruf Billah 30
 Recapitulating the main points:
Components of Capital
 From Regulatory capital perspective, Going-concern
capital is the capital which can absorb losses without
triggering bankruptcy of the bank.
 Gone-concern capital is the capital which will absorb
losses only in a situation of liquidation of the bank.
 A minority interest is a stake in a company that is
controlled by a larger parent company.
 A minority interest or non-controlling interest is
ownership or equity interest that consists of less than
50% of an enterprise. Minority interests generally range
between 20% and 30% of the company’s equity,
compared to the majority of over 50%.
S. M. Mahruf Billah 31
 Recapitulating the main points:
Components of Capital
 Tier 1 capital represents the core equity assets of a bank
or financial institution. It is largely composed of disclosed
reserves (also known as retained earnings) and common
stock. It can also include noncumulative, nonredeemable
preferred stock.
 It's important to note that Tier 1 capital doesn't include
depositors' money or other assets the financial institution
has little control over. It's based on shareholders' equity at
the bank and comprises two groups.
 The first is Common Equity Tier 1 (CET1) Capital. CET 1 is
a component of Tier-1 capital and comprises primarily of
common stock held by a bank or other financial
institutions.
S. M. Mahruf Billah 32
 Recapitulating the main points:
Components of Capital
 CET1 includes common shares, stock surplus,
retained earnings, other comprehensive income,
common shares issued by subsidiaries of the
institution, and regulatory adjustments.
 Additional Tier 1 or AT1 consists of capital
instruments that are continuous, in that there is no
fixed maturity including:
Preferred shares.
High contingent convertible securities.
These perpetual instruments must contain no
incentive for the issuer to redeem them.
S. M. Mahruf Billah 33
 Recapitulating the main points:
Components of Capital
 Tier 2 capital is the secondary component of bank
capital, in addition to Tier 1 capital, that makes up a
bank’s required reserves.
 Tier 2 capital comprises instruments seen as riskier; in
the event of financial distress, they are more susceptible
to losing their value.
 Tier 2 capital is designated as supplementary capital,
and is composed of items such as revaluation reserves,
undisclosed reserves, hybrid instruments and
subordinated term debt.
 Tier 2 capital includes hybrid capital instruments, loan-
loss and revaluation reserves as well undisclosed
reserves. S. M. Mahruf Billah 34
 Recapitulating the main points:
Concepts
 In accounting terms, a Claim is what a customer owes your
company for a product or service they have purchased.
 Core capital refers to the tier 1 capital of a bank for regulatory
purposes. Tier 1 or core capital is broadly equity capital or
shareholders funds.
 Subordination, in a legal sense, means ranking one claim behind
another claim regarding priority. The subordinated claim is
referred to as the “junior” claim, while the claim with the
highest priority is referred to as “senior”.
 Subordinated debt is a lax loan or bond that positions below
more senior loans or securities with claims on assets or earnings.
In the case of default, creditors owning a subordinated debt will
not be paid until the senior bondholders are paid in full.
 Common stock is a security that represents ownership in a
corporation. S. M. Mahruf Billah 35
 Limits (Minima and Maxima)
All banks are required to maintain the following ratios on an
ongoing basis:
i. Common Equity Tier 1 of at least 4.5% of the total RWA
ii. Tier 1 capital will be at least 6.0% of the total RWA
iii.Minimum CRAR of 10% of the total RWA
iv.Additional Tier 1 capital can be admitted maximum up to
1.5% of the total RWA or 33.33% of CET1, whichever is
higher
v. Tier 2 capital can be admitted maximum up to 4.0% of the
total RWA or 88.89% of CET1, whichever is higher
vi.In addition to minimum CRAR, Capital Conservation Buffer
(CCB) of 2.5% of the total RWA is being introduced which
will be maintained in the form of CET1.
S. M. Mahruf Billah 36
 Limits (Minima and Maxima)
BASEL II
Tier-1 Capital Tier-2 Capital Total
Minimum Capital 5% (at least) 5% (at best) 10%
Requirement (MCR)

BASEL III
Tier-1 Capital Tier-2 Total
CET 1 (Common AT 1 Capital
Equity Tier 1) (Additional Tier
1)
Minimum Capital 4.5% 1.5% 4% 10%
Requirement (MCR)

Capital Conservation 2.5% ------ ------ 2.5%

Buffer (CCB)

Total (MCR+CCB) 7% 1.5% 4% 12.5%

S. M. Mahruf Billah 37
 Capital Conservation Buffer
 Banks are required to maintain a capital conservation buffer
of 2.5%, comprised of Common Equity Tier 1 capital, above
the regulatory minimum capital requirement of 10%.
 Banks should not distribute capital (i.e. pay dividends or
bonuses in any form) in case capital level falls within this
range. However, they will be able to conduct business as
normal when their capital levels fall into the conservation
range as they experience losses.
 Therefore, the constraints imposed are related to the
distributions only and are not related to the operations of
banks.
 The distribution constraints imposed on banks when their
capital levels fall into the range increase as the banks’
capital levels approach the minimum requirements.
S. M. Mahruf Billah 38
 Calculation of RWA for credit risk
Standardized approach: use of external ratings
 Basel framework states that banks can choose between two broad
methodologies for calculating their risk-based capital requirements for
credit risk.
The first is the Standardized Approach (SA) and
the other is the Internal Ratings-based Approach (IRB).
In following SA, banks may use External Credit Assessment Institution
(ECAI) as suggested by Basel framework.
 Bangladesh Bank has made it mandatory for banks to get their loans
rated by ECAIs. Apart from entity credit ratings, all scheduled banks
are required to nominate BB-recognized ECAI(s) for their own as well
as their counterparty credit rating.
 Bangladesh Bank recognized eight credit rating agencies (CRAs) to
provide rating services in Bangladesh. These CRAs are known as
External Credit Assessment Institutions (ECAIs) both nationally and
internationally.
S. M. Mahruf Billah 39
 Measurement of Risk Weighted Assets: Credit Risk
Credit risk is the potential that a bank  Claims on multilateral development
borrower or counterparty fails to meet its banks.
obligation in accordance with agreed term.  Claims on government/ public sector
Claims: entities (PSE).
 Claims on banks and non-bank financial
Exposures such as deposits (including
foreign currency), placements, institutions (NBFIs).
investments, loans and advances  Claims on corporate.
underlying with counterparties.  Claims categorized as retail portfolio.
 Claims on sovereign and central bank  Consumer finance.
 Claims on other sovereigns and central  Claims secured by residential property.
banks  Claims secured by commercial real
 Claims on the Bank for International estate.
 Past due claims.
Settlements (BIS), the International
Monetary Fund (IMF), European  Capital market exposures
Central Bank and the European  Venture capital.
Community.  All other assets
 Claims on multilateral development
banks (specific).
S. M. Mahruf Billah 40
 Measurement of Risk Weighted Assets: Credit Risk
Methodology
 The capital requirement for credit risk is based on the
risk assessment made by External Credit Assessment
Institutions (ECAIs) recognized by BB for capital
adequacy purposes.
 Banks are required to assign a risk weight to all their on-
balance sheet and off-balance sheet exposures.
 Risk weights are based on external credit rating
(solicited) which mapped with the BB rating grade or a
fixed weight that is specified by BB.

S. M. Mahruf Billah 41
 External Credit Assessment Institutions (ECAIs)
Bangladesh Bank has recognized eight credit rating agencies:
 Credit Rating Agency of Bangladesh (CRAB) Ltd.
 Credit Rating Information and Services Limited (CRISL)
 Emerging Credit Rating Ltd (ECRL)
 National Credit Ratings Ltd. (NCRL)
 ARGUS Credit Rating Services Limited (ACRSL)
 Alpha Credit Rating Limited (ACRL)
 WASO Credit Rating Company (BD) Limited and
 The Bangladesh Rating Agency Limited(BDRAL).
Which met the eligibility criteria of ECAIs guidelines (BRPD Circular no.
35/2010) of BB.
BB has also decided that banks may use the ratings (if available) of the
following international credit rating agencies for the purposes of risk weighting
their exposure at abroad:
a) Fitch,
b) Moody, and
c) Standard & Poor S. M. Mahruf Billah 42
 Mapping of ECAIs Rating Grade
 Rating categories of ECAIs both for corporate and
SME’s are mapped with the rating grades of BB.
 For risk weighting purpose, the rating of a client by
any recognized ECAI is valid for one year.
 Credit rating for one entity within a corporate group
cannot be used to risk weight other entities within
the same group i.e. each entity within a same
corporate group needs to get credit rating
individually.

S. M. Mahruf Billah 43
 ECAI’s Credit Rating Categories Mapped with BB’s Rating Grade
BB Equivalen Equivalen Equivalen Equivalen Equivalen Equivalen Equivalent Equivalent Equivalen
Rating t Rating t Rating t Rating t Rating t Rating t Rating Rating of Rating of t Rating
Grade of S&P of Moody of CRISL of CRAB of NCRL of ECRL ACRSL ACRL of WASO
and Fitch

1. AAA to Aaa to Aa AAA, AA+, AAA, AA1, AAA, AA+, AAA, AA+, AAA, AA+, AAA, AA+, AAA AA1,
AA AA, AA AA2, AA3 AA, AA AA, AA AA, AA AA, AA AA2, AA3
2. A A A+, A, A- A1, A2, A3 A+, A, A- A+, A, A- A+, A, A- A+, A, A- A1, A2, A3

3. BBB Baa BBB+, BBB1, BBB+, BBB+, BBB+, BBB, BBB+, BBB1,
BBB, BBB BBB2, BBB, BBB BBB, BBB- BBB- BBB, BBB- BBB2,
BBB3 BBB3

4. BB to B Ba to B BB+, BB, BB1, BB2, BB+, BB, BB+, BB, BB+, BB, BB+, BB, BB1, BB2,
BB- BB3 BB- BB- BB- BB- BB3
5. B+, B, B-, B1, B2, B+, B, B- B+, B, B- B+, B, B-, B+, B, B-, B1, B2,
CCC+, B3, CCC1, CC+,CC,CC CCC B3, CCC
CCC, CCC2,
CCC-, CC+, CCC3, CC
Below B Below B CC, CC

6. C+, C, C-, C, D C+, C, C-, D C+, C, C-, CC+,CC,C CC1,

D D D C-, C+, C, CC2,
C-, D CC3, C+,
C, C-, D
S. M. Mahruf Billah 44
 Risk weight for balance sheet exposure.
Exposure wise risk weights against different rating grades of BB
SL Exposure Type BB’s Rating Risk Weight
Grade (%)
a. Cash 0
b. Claims on Bangladesh Government (other than PSEs) and BB 0
(denominated in domestic and foreign currency)
c. Claims on other Sovereigns & Central Banks
d. Claims on Bank for International Settlements, International 0
Monetary Fund and European Central Bank
e. Claims on Multilateral Development Banks (MDBs)
i) IBRD , IFC, ADB, ADB, EBRD, IADB, EIB, EIF, NIB, CDB, IDB, CEDB 0

ii) Other MDBs 1 20

2,3 50
4,5 100
6 150
Unrated 50
f. Claims on public sector entities (excluding equity exposure) 1 20
2,3 50
4,5 100
6 150
S. M. Mahruf Billah Unrated 50 45
 Risk weight for balance sheet exposure
g. Claims on Banks and NBFIs (denominated in domestic as well as
foreign currency)

i) Original maturity over 3 months 1 20

2,3 50
4,5 100
6 150
Unrated 100
ii) Original maturity up to 3 months 20
h. Claims on Corporate (excluding equity exposures) 1 20
2 50
3,4 100
5,6 150
Unrated 125
S. M. Mahruf Billah 46
 Risk weight for balance sheet exposure
SL Exposure Type Risk
Weight (%)

Fixed Risk Weight Groups:

i. Claims categorized as retail portfolio (excluding consumer 75

finance and Staff loan)

j. Consumer Finance 100

k. Claims fully secured by residential property (excluding Staff 50

loan/investment)

l. Claims fully secured by commercial real estate 100

S. M. Mahruf Billah 47
 Risk weight for off-balance sheet exposure
The total risk weighted assets for off-balance sheet (OBS)
exposure will be the sum of risk-weighted assets for market
related and non-market related OBS transactions. The risk-
weighted amount of the OBS transaction that gives rise to credit
exposure is generally calculated by means of a two-step process:
a) First, the notional amount of a transaction is converted into a
balance sheet equivalent (i.e. credit equivalent amount or
potential exposure) by multiplying the amount with an
appropriate credit conversion factor (CCF) .
b) Second, the resulting credit equivalent amount will be
multiplied by the risk weight (as per Table 7) associated with
the credit rating of that counterparty.
•

Where OBS item is secured by eligible collateral or guarantee,

the credit risk mitigation facility may
S. M. Mahruf Billahbe applied. 48
 Measurement of Risk Weighted Assets: Market Risk
Market risk is defined as the risk of losses in on and off-balance sheet
positions arising from movements in market prices. The market risk
positions subject to this requirement are:
a) The risks pertaining to interest rate related instruments and
equities in the trading book; and
b) Foreign exchange risk and commodities risk throughout the bank
(both in the banking and in the trading book).
 Trading book consists of positions in financial instruments held with
trading intent or in order to hedge other elements of the trading book.
 A capital charge will be applicable for financial instruments which are
free from any restrictive covenants on tradability, or able to be hedged
completely.
 Generally, investments which are held for trading and readily available
for sale are major parts of the trading book. To be mentioned that all
listed shares have to be included in the trading book.

S. M. Mahruf Billah 49
 Methodology
 In Standardized Approach, the capital requirement
for various market risks (interest rate risk, equity
price risk, commodity price risk, and foreign
exchange risk) is determined separately.
 The total capital requirement in respect of market
risk is the sum of capital requirement calculated for
each of these market risk sub-categories.

S. M. Mahruf Billah 50
 Measurement of Risk Weighted Assets: Operational Risk

Operational Risk is defined as the risk of loss resulting

from inadequate or failed internal processes, people
and systems or from external events. This definition
includes legal risk.
The Measurement methodology:
The framework outlined below presents two methods
for calculating operational risk capital charges in a
continuum of increasing sophistication and risk
sensitivity:
(i) the Basic Indicator Approach; and
(ii) the Standardized Approach.
S. M. Mahruf Billah 51
 The basic indicator approach
Under the Basic Indicator Approach (BIA), the capital charge for operational
risk is a fixed percentage (denoted by alpha, α) of average positive annual
gross income of the bank over the past three years.
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 capital charge may be expressed as follows:

Where,
K = capital charge under the Basic Indicator Approach
GI = only positive annual gross income over the previous three years (i.e.
negative or zero gross income if any shall be excluded)
α = 15%
n = number of the previous three years for which gross income is positive.
Gross Income: Gross Income (GI) is defined as ‘Net interest income’ plus
‘net non-interest income’.

S. M. Mahruf Billah 52
 Sample Calculation
Bank’s Balance Sheet under Basel III (in millions of dollars)
Risk Asset Liabilities/Equities Capital
weight Class
0% Cash $8 Demand deposits $150
Balances due from Fed 13 MMDAs deposits 500
Treasury bills 60 CDs 380
Long-term Treasury securities 50 Fed funds purchased 80
Long-term government agencies 42
(GNMAs)
20% Items in process of collection 10 Convertible bonds 10 Tier II
Long-term government agencies 10 Subordinated bonds 10 Tier II
(FNMAs)
Munis (general obligation) 20
Loans to countries with OECD 55 Perpetual preferred 5 Tier II
CRC rating of 2 stock (nonqualifying)
Loans to foreign banks in country 10 Retained earnings 40 CET I
with OECD CRC rating of 2

S. M. Mahruf Billah 53
 Bank’s Balance Sheet under Basel III (in millions of dollars)
50% University dorm bonds (revenue) 34

Residential 1–4 family mortgages, 308 Common stock 30 CET I

Category 1, loan to-value ratio
between 60% and 80%

Loans to foreign banks in country 75 Noncumulative 10 Addition

with OECD CRC rating of 3 perpetual preferred al Tier I
stock (qualifying)

100% Commercial loans 390

Consumer loans 108
Premises, equipment 22
150% Loans to countries with OECD CRC
rating of 7
N/A Reserve for loan losses (10) Tier II
Total Assets $1,215 Total Liabilities & $1,215
Equities
S. M. Mahruf Billah 54
 Bank’s Balance Sheet under Basel III (in millions of dollars)
Off-Balance-Sheet Items:

$80m in two-year loan commitments to a U.S. corporation

$10m direct credit substitute standby letters of credit issued to a
U.S. corporation
$50m in commercial letters of credit issued to a U.S. corporation

One fixed–floating interest rate swap for four years with

notional dollar value of $100 m and replacement cost of $3 m
One two-year Eurodollar contract for $40 m with a replacement
cost of –$1 m

S. M. Mahruf Billah 55
 Bank’s Balance Sheet under Basel III (in millions of dollars)
EXAMPLE-1: Calculation of On-Balance-Sheet Credit Risk–Adjusted
Assets under Basel III
Consider the bank’s balance sheet in Table-10.7, categorized
according to the risk weights of Basel III. Under Basel III, the credit
risk–adjusted value of the bank’s on-balance-sheet assets would be:

The simple book value of on-balance-sheet assets is $1,215 million;

its credit risk– adjusted value under Basel III is $764.5 million.

S. M. Mahruf Billah 56
 Bank’s Balance Sheet under Basel III (in millions of dollars)
EXAMPLE-2: Calculating Off-Balance-Sheet Contingent or Guaranty Contracts’
Credit Risk–Adjusted Assets
Step-1: Convert OBS Values into On-Balance-Sheet Credit Equivalent Amounts
In the first step, we multiply the dollar amount outstanding of these items to
derive the credit equivalent amounts using the conversion factors (CFs) listed in
the following table:
OBS Item Face Value Conversion Credit Equivalent
Factor Amount
Two-year loan commitment $80m 0.5 = $40m
Standby letter of credit 10m 1.0 = 10m
Commercial letter of credit 50m 0.2 = 10m

Thus, the credit equivalent amounts of loan commitments, standby letters of

credit, and commercial letters of credit are, respectively, $40, $10, and $10
million. These conversion factors convert an OBS item into an equivalent credit or
on-balance-sheet item. S. M. Mahruf Billah 57
 Bank’s Balance Sheet under Basel III (in millions of dollars)
Step-2: Assign the OBS Credit Equivalent Amount to a Risk Category
In the second step, we multiply these credit equivalent amounts by
their appropriate risk weights. In our example, because each of the
contingent guaranty contracts involves a U.S. corporation, each is
assigned a risk weight of 100 percent.
OBS Item Credit Risk Weight Risk-adjusted
Equivalent Wl Amount
Amount

Two-year loan commitment $40m 1.0 = $40m

Standby letter of credit 10m 1.0 = 10m
Commercial letter of credit 10m 1.0 = 10m
60m

Thus, the bank’s credit risk–adjusted asset value of its OBS

contingencies and guarantees is $60 million.
S. M. Mahruf Billah 58
 EXAMPLE-3: Calculating Off-Balance-Sheet Market Contract Credit Risk–
Adjusted Assets
The bank in Examples-1 and 2 has taken one interest rate hedging position in the fixed–floating
interest rate swap market for 4 years with a notional dollar amount of $100 million and one 2-year
forward foreign exchange contract for $40 million .
Step-1: We calculate the credit equivalent amount for each item or contract as:

Potential Exposure + Current Exposure

Type of Notion Potential = Potential Replacement Current = Credit
Contract al Exposure Exposure Cost Exposure Equivalent
(remaining Princip Conversion Amount
maturity) al Factor

Four-year 100m 0.005 = $0.5m $3m $3m = $3.5m

fixed-floating
interest
rate swap

Two-year $40 0.050 = $2 -$1m $0 = $2m

forward
foreign
exchange
contract

$5.5m
S. M. Mahruf Billah 59
Step-2: The next step is to multiply this credit equivalent
amount by the appropriate risk weight. Specifically, to
calculate the risk-adjusted asset value for the bank’s OBS
derivative or market contracts, we multiply the credit
equivalent amount by the appropriate risk weight, which is
generally 1.0, or 100 percent:

Total Credit Risk–Adjusted Assets under Basel III:

•

For this above examples: S. M. Mahruf Billah 60

Example-4: Calculating the Overall Risk-Based Capital Position of a
Bank
After calculating the risk-weighted assets for a depository
institution, the final step is to calculate the Tier I and total risk-
based capital ratios.
From above calculation, the bank’s CET1 capital (common stock and
retained earnings) totals $70 million; additional Tier I capital
(qualifying perpetual preferred stock) totals $10 million; and Tier II
capital (convertible bonds, subordinate bonds, non-qualifying
perpetual preferred stock, and reserve for loan losses) totals $35
million. Total credit risk-adjusted assets are $830m. We can now
calculate our bank’s capital adequacy under the Basel III risk-based
capital requirements as:
•

S. M. Mahruf Billah 61
•
9. Based on the given information below of ‘X’ Bank answer the following 20
questions: 98 th AIBB May 2024
(in crore Taka)
Total Risk Weighted Asset (RWA) 45,500
Paid-up Capital 1,890
Retained Earnings 550
Non-repayable share premium account 150
Statutory Reserve 1,300
General Provision 1,100
General Reserve 300
Perpetual Bond 500

(a) Calculate Minimum Capital Requirement (MCR) with Capital Conservation

Buffer (CCB).
(b) Calculate total Capital to Risk Weighted Asset Ratio (CRAR).
(c) Calculate CET-I, Tier-I and Tier-II Capital Ratio.

(a) Interpret the results above against minimum regulatory requirements of

Bangladesh Bank.

S. M. Mahruf Billah 62
Solution:
Reference: Guidelines on Risk Based Capital Adequacy: Revised
Regulatory Capital Framework for banks in line with Basel III,
Bangladesh Bank, December 2014.
a)

b)

As Per the Basel III accord, the minimum Value of CRAR should
be 10.00%
S. M. Mahruf Billah 63
c)
•

As Per the Basel III accord, the minimum Value of CET-1

Capital Ratio should be 4.5%.
•

As Per the Basel III accord, additional Tier-1 capital can be

admitted maximum up to 1.5%.
•

S. M. Mahruf Billah 64
 •
As per the Basel III accord, the minimum Value of Tier-1 Capital Ratio
should be 6%.
•

As Per the Basel III accord, Tier-2 capital can be admitted maximum up to
4.0%
d)
As Per Basel-III accord, to be adequately capitalized, the minimum value of
CET-1 capital ratio, Tier-1 Capital ratio, CRAR is 4.5%, 6%, 10% respectively.
Additional Tier-1 capital and Tier-2 Capital can be admitted maximum up to
1.5% & 4% respectively. Bank X has more than adequate Capital under all
those requirements.
S. M. Mahruf Billah 65
8. Based on the given information of `A’ bank, answer the following 20
questions: 96 th AIBB May 2023
Paid up Capital : Tk 1,392 Crore
Statutory Reserve : Tk 1,000 Crore
Retained Earnings : Tk 420 Crore
Perpetual Bond : Tk 300 Crore
General Provisions : Tk 650 Crore
Subordinated Bond : Tk 360 Crore
Total Risk-Weighted Assets (RWA) : Tk 30,200 Crore
a) Calculate `A’ bank’s minimum capital requirements.
b) Calculate CET-I and Tier-I capital ratios of the bank.
c) Calculate Tier-II capital ratio of the bank.
d) Calculate total capital to Risk-Weighted Assets Ratio (CRAR) of the
bank.
e) Interpret the results above against minimum regulatory
requirements of Bangladesh Bank.

S. M. Mahruf Billah 66
Solution:
Particulars Amount Capital Class
Paid up Capital : Tk 1,392 Crore CET-I
Statutory Reserve : Tk 1,000 Crore CET-I
Retained Earnings : Tk 420 Crore CET-I
Perpetual Bond : Tk 300 Crore Additional Tier-1
General Provisions : Tk 650 Crore Tier-II
Subordinated Bond : Tk 360 Crore Tier-II

Total Risk-Weighted Assets : Tk 30,200 Crore

(RWA)

(a) `A’ bank’s minimum capital requirement:

`A’ bank’s minimum capital requirement plus capital

conservation buffer =

S. M. Mahruf Billah 67
(b)

(C)

(d)

S. M. Mahruf Billah 68
(e)
To be adequately capitalized, the minimum CET1 risk-based
capital ratio is 4.5 percent, the minimum Tier I capital ratio is 6
percent, and the minimum total risk- based capital ratio required
is 10 percent. Thus, the bank in our example has more than
adequate capital under all three capital requirement formulas.

S. M. Mahruf Billah 69
 Leverage Ratio
In order to avoid building-up excessive on and off-balance
sheet leverage in the banking system, a simple,
transparent, non-risk based leverage ratio has been
introduced. The leverage ratio is calibrated to act as a
credible supplementary measure to the risk based capital
requirements. The leverage ratio is intended to achieve the
following objectives:
a) Constrain the build-up of leverage in the banking sector
which can damage the broader financial system and the
economy.
b) Reinforce the risk based requirements with an easy to
understand and a non-risk based measure.
S. M. Mahruf Billah 70
 Leverage Ratio
A minimum Tier 1 leverage ratio of 3% is being
prescribed both at solo and consolidated level. The
banks will maintain leverage ratio on quarterly basis.
The calculation at the end of each calendar quarter will
be submitted to BB showing the average of the month
end leverage ratios based on the following definition of
capital and total exposure.

The exposure measure for the leverage ratio will

generally follow the accounting measure of exposure.
S. M. Mahruf Billah 71
8. (c) Based on the following information of ‘A’ Bank please calculate the Leverage
Ratio for 2019 and 2020 and make your comment on the adequacy of the
ratios:

(in crore Taka)

Particulars 2019 2020
Tier-1 Capital 3,500 2,750
Total asset 50,000 45,000
Total Leverage Ratio Exposure 65,000 60,000

Solution:
•

As per the BASEL III accord, the minimum value of LR should

be 3%. Bank A fulfills the minimum requirement of LR both
years. LR on 2019 is better position
S. M. Mahruf Billahthan LR on 2020. 72
 Liquidity Coverage Ratio (LCR)
The Basel Committee has developed two standards that have
separate but complementary objectives to use in liquidity risk
supervision.
The first objective is to promote the short-term resilience of the
liquidity risk profile of banks by ensuring that they have sufficient
high-quality liquid assets to survive a significant stress scenario
lasting 30 calendar days. The Committee developed the Liquidity
Coverage Ratio to achieve this objective.

 The minimum acceptable value of this ratio is 100 percent.

 The high-quality liquid assets include only those with a high
potential to be converted easily and quickly into cash.
S. M. Mahruf Billah 73
8. (b) Based on the following information of ‘A’ Bank please
calculate the Liquidity Coverage Ratio (LCR) for 2019
and 2020, and make your comment on the adequacy of
the ratios as per Basel III Accord.

(in crore Taka)

Description 2019 2020

High Quality Liquid Asset 1265 1430

Average Monthly 594 550

Withdrawal
Expected Monthly Net 1100 1320
Outflow in a stress scenario

S. M. Mahruf Billah 74
Solution:
•

As Per the Basel III accord, the minimum Value of LCR

should be 100%.Bank A fulfills the minimum requirement
of LCR both Year. LCR on 2019 is better position than LCR
on 2020.

S. M. Mahruf Billah 75
 Net Stable Funding Ratio
The second objective is to promote resilience over a longer time
horizon by creating additional incentives for banks to fund their
activities with more stable sources of funding on an ongoing
basis. The Committee developed the Net Stable Funding Ratio to
achieve this objective.
The Net Stable Funding Ratio has a time horizon of one year and
has been developed to capture structural issues to provide a
sustainable maturity structure of assets and liabilities.

 NSFR is met if ASF exceeds RSF, that is if ASF/RSF > 1 or 100%.

S. M. Mahruf Billah 76
 Stress testing
 Stress testing is an important risk management tool that provides an
indication of how much capital might be needed to absorb losses in
different stressed situations.
 A rigorous and comprehensive stress-testing program must be in
place. It will measure the vulnerability or exposure to the impacts of
exceptional, rare but potentially occurring events like - interest rate
changes, exchange rate fluctuations, changes in credit rating, events
which influence liquidity, etc.
 The following methods can be employed for measuring the impact of
the above factors in an SRP context:
a) Simple sensitivity tests determine the short-term sensitivity to a
single risk factor.
b) Scenario analyses involve risk parameters (with low but positive
probability) which change along a pre-defined scenario and
examine the impact of these parameters.
S. M. Mahruf Billah 77
 Stress testing
Stress test shall be carried out assuming three different
hypothetical scenarios:
a) Minor level shocks: These represent small shocks to the risk
factors. The level for different risk factors can, however, vary.
b) Moderate level shocks: It envisages medium level of shocks
and the level is defined in each risk factor separately.
c) Major level shocks: It involves big shocks to all the risk factors
and is also defined separately for each risk factor.
The results of the stress test will contribute directly to the
expectation that a bank will operate above the Pillar 1 minimum
regulatory capital ratios. These results should also be portrayed
in the capital plan of the bank.

S. M. Mahruf Billah 78
 Significance of Stress Testing in risk management
 Stress testing is a crucial tool for risk management in
the banking sector. It involves testing the financial
resilience of banks under different scenarios, such as
a severe economic downturn, market turbulence, or
unexpected events like a cyber-attack or a natural
disaster.
 Stress testing helps banks identify vulnerabilities in
their risk management processes and make informed
decisions to manage risks more effectively.

S. M. Mahruf Billah 79
 Shocking events involved in stress test for credit risk assessment

The stress test for credit risk assesses the impact of increase in the level
of non‐performing loans of the bank/FI. This involves six types of shocks:
 The first deals with the increase in the NPLs and the respective
provisioning. The three scenarios shall explain the impact of 1%, 2%
and 3% of the total performing loans directly downgraded to bad/loss
category having 100% provisioning requirement.
 The second deals with the negative shift in the NPLs categories and
hence the increase in respective provisioning. The three scenarios
shall explain the impact of 50%, 80% and 100% downward shift in the
NPLs categories. For example, for the first level of shock 50% of the
SMA shall be categorized under substandard, 50% of the substandard
shall be categorized under doubtful and 50% of the doubtful shall be
added to the bad/loss category.
 The third deals with the fall in the forced sale value (FSV) of mortgaged
collateral. The forced sale values of the collateral shall be given shocks
of 10%, 20% and 40% decline in the forced sale value of mortgaged
collateral for all the three scenarios
S. M. Mahruf respectively.
Billah 80
Shocking events involved in stress test for credit risk assessment
 The fourth deals with the increase of the NPLs in particular 1 or 2
sector i.e. garments & Textiles and the respective provisioning. The
three scenarios shall explain the impact of 5%, 7.5% and 10%
performing loans of particular 1 or 2 sectors directly downgraded to
bad/loss category having 100% provisioning requirement.
 The fifth deals with the increase of the NPLs due to default of Top 10
large borrowers and the respective provisioning. The three scenarios
shall explain the impact of 5%, 7.5% and 10% performing loans of Top
10 large borrowers directly downgraded to bad/loss category having
100% provisioning requirement.
 The sixth deals with extreme events in which due to increase in the
certain percentage of NPLs, the whole capital position of a bank will
be wiped out to offset the increased amount of provision due to cover
respective loan losses. The forced sale value of the collaterals and tax‐
adjusted impact of the additional required provision (if any) will be
calibrated in the CAR for the each scenario under all categories.
S. M. Mahruf Billah 81
 Previous Years Questions
 What are the new capital accords of Basel-III in
Bangladesh?
 How does Basel-III differ from Basel-II? Explain.
 Discuss the capital requirement for a bank as per
Basel-III capital guidelines of Bangladesh Bank.
 Why is Liquidity is important in banking? Which Pillar
of Basel-III discusses about Liquidity Risk?
 How does the adoption of Basel-III capital accord
enhance risk management in Financial Institutions?
 What does it mean by market discipline under Basel
framework? Explain its purpose.

S. M. Mahruf Billah 82
 Previous Years Questions
 What is Market risk? Explain the sources of Market Risk
in the financial institutions.
 What are the liquidity standard/ratio suggested by Basel-
III? Explain.
 Define the leverage ratio. What are the objectives of
maintaining leverage ratio?
 What is stress test? Why it is important in ensuring the
financial stability in the banking sector?
 How to conduct stress testing for a bank? What is its
significance in risk management?
 Briefly describe the shocking events involved in stress
test for credit risk assessment?
 What is stress testing? Explain its significance in Market
Discipline. S. M. Mahruf Billah 83
S. M. Mahruf Billah 84