In the process of financial intermediation, banks mobilize deposits and deploy them in loans and investments in tune with the Central Bank guidelines to create assets.
Apart from assets in balance sheet, there are contractual obligations forming part of off-balance sheet items which also carry risk. But all types of loans and forms of investments does not carry same risk. They carry different risksand are prone to seek diversified mitigation techniques. Some are less risky while others are more risky.
Therefore, it is very difficult to precisely identify types of risks and their weightage in the asset portfolio. Keeping these differentiated uniqueness of risks inherent in various range of assets, Basel – I framework brought out in 1988 by Bank for International Settlement (BIS) had provided model to assign risk weights to each balance sheet item to arrive at total risk weighted assets on which capital is to be maintained.
Accordingly, Central Banks guide banks to assign risk weights to assets according to the risk that it perceives. Thus assignment of risk weights is an effort to determine the riskiness of assets and take them into account in maintaining Capital Adequacy Ratio (CAR). Higher risk has higher weightage.
Both on funded assets and non-funded, off-balance sheet exposures that carry different risk weights. In order to institutionalize process of assessment of risks and accordingly facilitating assigning of risk weights, banks should have an Internal Capital Adequacy Assessment Process (ICAAP) Policy to enable banks to maintain capital on the basis of Risk Weighted Assets (RWAs) and not on numerical value of assets in the balance sheet.
As a result, capital is not determined on the face value of assets as they appear in balance sheet of a bank. Like many Central Banks across the world, Central Bank of Sri Lanka too had issued guidelines to all licensed commercial banks (LCBs) and licensed specialized banks (LSBs) to have ICAAPin line with international standards.
ICAAP policy should take into consideration the past trends, events and Central Bank guidelines in determining the risk weights for different kinds of assets.Every LCB and LSB shall develop and implement a sound ICAAP in accordance with the requirements specified in Central Bank’s regulatory framework on supervisory review process. Banks should ensure that banks use ICAAP in more general business decisions and budgets, in more specific decisions such as allocating capital to business units and when evaluating individual credit decision process. This will ensure appropriate use of the scarce capital resource.
Risk weighted assets
In order to arrive at risk weight to be assigned to various kinds of assets to take care of their inherent risks such as (i) Credit Risk (ii) Market risk and (iii) Operational risk. It is necessary to build a matrix of Probability of default (PD) and Loss Given Default (LGD) based on past asset behavior to track future trends. Banks should develop a robust internal credit-risk grading system that serves as a single point indicator of diverse risk factors of counterparty and for taking credit decisions in a consistent manner while communicating the default risk associated with an exposure. The risk rating, in short, should: a) reflect the underlying credit risk of the loan book and b) be drawn up in a structured manner, incorporating both quantitative (financial ratios) and qualitative standards (industry, payment history, credit reports, management, purpose of the loan, quality of financial information, facility characteristics etc.
Thus the total risk-weighted assets are determined based on riskiness to arrive at the capital requirements where the ICAAP Policy applies a scaling factor to broadly maintain the aggregate level of minimum capital requirements. ICAAP should also providing incentives to adopt the more advanced risk-sensitive approaches of the Framework to move towards more sophisticated risk management approaches.
Computation of risk weighted assets
Every bank normally shall develop and maintain a rigorous and well-documented ICAAP in consonance with its operations and risk profile and consistent with prudential requirements. Accordingly, a scaling factor is applied to the risk weighted asset to reflect the precise riskiness under various risk assessment approaches.
In investment portfolio risk weights ranging from ‘0’ to ‘100’ are assigned. Globally sovereign bonds subscribed by banks which are known as risk free due to sovereign guarantee are assigned ‘0’ weightage and corporate bonds carry the maximum ‘100’ as risk weight. Under the present standardized credit risk management approach all unrated loan assets and other than non-sovereign bonds in balance sheet carry a normal risk weight of ‘100’ till banks migrate to advanced approaches when risk weights will be aligned to the rating of borrower.
Similarly, off balance sheet items such as guarantees, Letters of credit issued by banks carry different risk weights as per perceived risks. After assigning risk weights, the unit of asset corresponding to it will be multiplied with risk weight and aggregate risk weighted assets will be arrived at to compute capital adequacy ratio. The capital is divided with sum total of risk weighted assets (Capital/RWAs) in balance sheet to arrive at CAR.
Thus bank’s ICAAP shall identify all material risks, which are arising from both on balance sheet and off-balance sheet exposures, faced by the bank and measure these risks that can be reliably quantified under both normal and stressed conditions. ICAAP shall, therefore, address credit, market and operational risks.
Risks not fully captured such as concentration risk (credit risk) based on extent of exposure, interest rate risk, rate of return risk in the banking book (market risk) shall also be factored. Other types of risks such as liquidity risk, reputational risk, compliance risk, strategic and business risk, residual risk are also factored to arrive at the aggregate risks built in the portfolio.
Banks will have to take into account other external risk factors that may arise from the regulatory, economic or business environment. In addition, adequate corporate governance and proper risk management including internal control arrangements constitute the foundation of an effective ICAAP. The risk measurement systems shall be sufficiently comprehensive and rigorous to capture the nature and magnitude of the risks faced by the bank. Further the risks that are not easily quantifiable shall be evaluated using qualitative assessment and management judgment.
Therefore factoring all forms of risks and assigning risk weights to each asset class shall enable bank to arrive at the aggregate risk weighted assets so that a comprehensive view can be taken. Therefore line management in banks should be mindful of the implications of creating an asset on the balance sheet of the bank by evaluating its risk and risk weighted assets. The likely risk adjusted yield on the asset should be assessed only after taking into account its precise risk weight implications. Hence assigning risk weighted assets to assets will be critical in calibrating the size of the risk weighted asset that determines the strength of the balance sheet.
(The author is Director, National Institute of Banking Studies and Corporate Management – NIBSCOM, Noida, National Capital Region, Delhi, India. The views are his own)