The Basel Committee on Banking Supervision introduced stricter Basel III regulations after the 2008 financial crisis to strengthen banks' capital requirements and promote a more resilient banking sector. The key changes included higher minimum capital requirements, a capital conservation buffer, a countercyclical capital buffer, strengthened capital treatment for trading book exposures and securitizations, more stringent counterparty credit risk rules, and the introduction of a non-risk-based leverage ratio. The regulations aimed to reduce systemic risk, improve risk management practices, and promote a safer banking system overall.

1. A PROJECT REPORT ON
OPTIMIZATION OF CAPITAL
IN BANKS TREASURY
AT
STATE BANK OF INDIA
Submitted by:
Ravi Ranjan Kumar Singh
Roll No: 40
Batch 2
In partial fulfilment of the requirement for the degree of
Post Graduate Diploma in Management
XAVIER INSTITUTE OF MANAGEMENT
ANDENTREPRENEURSHIP, KOCHI

2. ACKNOWLEDGEMENT
I thank Almighty God for helping me to complete this project fruitfully.
At the end of summer internship programme I feel obliged and thank everyone who made this
possible. The two months of internship has been an enriching experience, in terms of learning
and application of theory in practice. The real time experience that I have received is
something which cannot be emulated in classroom scenario and will be highly helpful for my
professional growth.
I would like to express my deepest regards & gratitude to my coordinator, Mr Shrinivas
Sharad Narvilkar and my mentors, Mr Om Prakash Shivapriya and Mr Rajesh Kumar
Gupta for their continuous motivation, guidance and support in this process. I would also like
to thank all the other employees of State Bank of India for being supportive, cooperative and
encouraging throughout my journey. This research would not be possible without their
valuable inputs.
I would like to thank my college, XAVIER INSTITUTE OF MANAGEMENT AND
ENTREPRENEURSHIP, for providing me with this opportunity. This endeavour would not
have been possible without the continuous guidance and encouragement by my professors
and my friends.
I would also like to thanks Assistant dean Mr. Amitabh Satapathy, my internal faculty
guide for timely guidance and support.
I acknowledge with profound gratitude and reverence the help and guidance of STATE
BANK OF INDIA and I thank this organisation for providing me with this opportunity of
learning and growth.
Last but not the least; my heartfelt love for my parents, whose constant support and blessings
helped me throughout this project.

3. EXECUTIVE SUMMARY
This paper aims to give a summarized view about all the experts speak about optimization of
capital in banks treasury. It explains the different method used by the banking sector to
mitigate its risk arising from Counterparty Credit Risk (CCR), Credit Value Adjustment
(CVA), Risk-Weighted Assets (RWA), etc. It begins by showing an overall perspective of
risk management and optimization of capital by different ways and then moves on the
guidelines prescribed by the Reserve Bank of India (RBI), Basel Committee on Banking
Supervision (BCBS), Banking for International Settlement (BIS) to save banks risk arising
from Risk-Weighted Assets, liquidity etc. The primary data is collected from State Bank of
India (SBI) regarding their internal regulatory and operational policies on optimization of
capital. The secondary data collected from various articles on the public domain by the
consulting companies which measures banks need to use for capital optimization such as
Standardized Method, Advanced Internal Rating Based Approach Method, and Internal
Model Method etc.
This paper shows how CVA capital charge is optimize by adopting Internal Model Method
and also how the following Advanced IRB approach can give banks clear idea about
“Return on Capital” on particular investment comparable to standardized method.
This paper shows how bank can use operational measure, tactical measure, and strategic
measure to make its day-to-day activity plan, short term plan and long term plan to get a
competitive edge over its competitor. Further its shows the way to overcome from liquidity
problems.
This paper also shows about the importance of reducing derivative transactions and benefits
arising from changing its business model. Further it depicts the importance of room for client
management for achieving customer satisfaction and higher customer life time value.
Towards the end, it shows the active approach can be taken by banks for balance sheet (off
and on) management.

5. 1
1. INTRODUCTION
In the recent times when the service industry is attaining greater importance compared to
manufacturing industry, banking has evolved as a prime sector providing financial
services to growing needs of the economy.
Banking industry has undergone a paradigm shift from providing ordinary banking
services in the past to providing such complicated and crucial services like, merchant
banking, housing finance, bill discounting etc. This sector has become more active with
the entry of new players like private and foreign banks. It has also evolved as a prime
builder of the economy by understanding the needs of the same and encouraging the
development by way of giving loans, providing infrastructure facilities and financing
activities for the promotion of entrepreneurs and other business establishments.
For a fast developing economy like ours, presence of a sound financial system to mobilize
and allocate savings of the public towards productive activities is necessary. Commercial
banks play a crucial role in this regard.
The Banking sector in recent years has incorporated new products in their businesses,
which are helpful for growth. The banks have started to provide fee-based services like,
treasury operations, managing derivatives, options and futures, acting as bankers to the
industry during the public offering, providing consultancy services, acting as an
intermediary between two-business entities etc. At the same time, the banks are reaching
out to other end of customer requirements like, insurance premium payment, tax payment
etc. It has changed itself from transaction type of banking into relationship banking, where
you find friendly and quick service suited to your needs. This is possible with
understanding the customer needs their value to the bank, etc. This is possible with the
help of well-organized staff, computer based network for speedy transactions, products
like credit card, debit card, health-card, ATM etc. These are the present trend of services.
The customers at present ask for convenience of banking transactions, like 24 hours
banking, where they want to utilize the services whenever there is a need. The relationship
banking plays a major and important role in growth, because the customers now have
enough number of opportunities, and they choose according to their satisfaction of
responses and recognition they get. So the banks have to play cautiously, else they may
lose out the place in the market due to competition, where slightest of opportunities are
captured fast.

6. 2
Another major role played by banks is in transnational business, transactions and
networking. Many leading Indian banks have spread out their network to other countries,
which help in currency transfer and earn exchange over it.
Another emerging change happening all over the banking industry is consolidation
through mergers and acquisitions. This helps the banks in strengthening their empire and
expanding their network of business in terms of volume and effectiveness.
If the recent scenario of Greece is taken into consideration, the crisis has forced most of
the economies to opt austerity measures which in turn has increased the importance of
banks, as these economies would now turn to saving rather than investing or spending. In
case of India, the new and stable government has raised the hopes of investors and also the
market sentiment. Also, the Union Budget 2015-16 was considered as a pro-growth
budget. The Corporate tax reduction, repo rate cut, Jan Dhan Yojana, Pension plans and
many more initiatives, all point in the same direction – growth of the banking sector. The
growth of the banking sector is clearly visible if we take a look at the increase in the total
amount of loans and deposits of various banks with a view to expand and withstand the
growing competition. But, this expansion has also lead to a great deal of increase in the
amount of NPAs. The reasons behind this increase could be the rising demand for loans
and improper follow-up.
This entire banking sector scenario portrays a single message – an increase in the business
of a sector for increasing its profits would increase the amount of risk involved in it. The
BASEL Committee on Banking Supervision (BCBS) has issued the BASEL guidelines
with a view to curb these kinds of risks by asking the banks to maintain a certain amount
of minimum capital in proportion with these risks. These guidelines are a type of an
external regulation towards risk management. The internal regulation of such risk is done
through the risk control department of a bank.

7. 3
1.1. THE STRUCTURE OF INDIAN BANKING
1.2. COMPANY PROFILE
Founded in 1806, Bank of Calcutta was the first Bank established in India and over a
period of time evolved into SBI. SBI represents a sterling legacy of over 200 years. It is
the oldest commercial Bank in the Indian subcontinent, strengthening the nation’s trillion-
dollar economy and serving the aspirations of its vast population. The Bank is India’s
largest commercial Bank in terms of assets, deposits, profits, branches, number of
Nationalized
Banks
SBI and its
Associates
Schedule Urban co-
operative Banks
Schedule state co-
operative Banks
Reserve Bank of
India
(Central Bank)
Schedule Banks
Scheduled
Commercial Banks
Scheduled
Cooperative Banks
Public Sector
Banks
Private Sector
Banks
Foreign Banks
Regional Rural
Banks

8. 4
Customers and employees, enjoying the continuing faith of millions of customers across
the social spectrum.
Not only many financial institution in the world today can claim the antiquity and majesty
of the State Bank Of India founded nearly two centuries ago with primarily intent of
imparting stability to the money market, the bank from its inception mobilized funds for
supporting both the public credit of the companies governments in the three presidencies
of British India and the private credit of the European and India merchants from about
1860s when the Indian economy book a significant leap forward under the impulse of
quickened world communications and ingenious method of industrial and agricultural
production the Bank became intimately in valued in the financing of practically and
mining activity of the Sub- Continent Although large European and Indian merchants and
manufacturers were undoubtedly thee principal beneficiaries, the small man never ignored
loans as low as Rs.100 were disbursed in agricultural districts against gold ornaments.
Added to these the bank till the creation of the Reserve Bank in 1935 carried out numerous
Central – Banking functions.
Adaptation world and the needs of the hour has been one of the strengths of the Bank, in
the post-depression. For instance – when business opportunities become extremely
restricted, rules laid down in the book of instructions were relined to ensure that good
business did not go post. Yet seldom did the bank contravenes its value as depart from
sound banking principles to retain as expand its business. An innovative array of office,
unknown to the world then, was devised in the form of branches, sub branches, treasury
pay office, pay office, sub pay office and out students to exploit the opportunities of an
expanding economy. New business strategy was also evaded way back in 1937 to render
the best banking service through prompt and courteous attention to customers.
A highly efficient and experienced management functioning in a well-defined
organizational structure did not take long to place the bank an executed pedestal in the
areas of business, profitability, internal discipline and above all credibility An impeccable
financial status consistent maintenance of the lofty traditions if banking an observation of
a high standard of integrity in its operations helped the bank gain a pre- eminent status. No
wonders the administration for the bank was universal as key functionaries of India
successive finance minister of independent India Resource Bank of governors and
representatives of chamber of commercial showered economics on it.

9. 5
Modern day management techniques were also very much evident in the good old day’s
years before corporate governance had become a puzzled the banks bound functioned with
a high degree of responsibility and concerns for the shareholders. An unbroken records of
profits and a fairly high rate of profit and fairly high rate of dividend all through ensured
satisfaction, prudential management and asset liability management not only protected the
interests of the Bank but also ensured that the obligations to customers were not met. The
traditions of the past continued to be upheld even to this day as the State Bank years itself
to meet the emerging challenges of the millennium.
The bank provides a full range of corporate, commercial and retail banking and treasury
operation services.
1.3. MISSION, VISION AND VALUES
VISION STATEMENT
To retain the Bank’s position as premiere Indian Financial Service Group, with world
class standards and significant global committed to excellence in customer, shareholder
and employee satisfaction and to play a leading role in expanding and diversifying
financial service sectors while containing emphasis on its development banking rule. SBI
also speaks about my SBI, my customer first and first in customer satisfaction.
MISSION STATEMENT
 We will be prompt, polite and proactive with our customers.
 We will speak the language of young India.
 We will create products and services that help our customers achieve their goals.
 We will go beyond the call of duty to make our customers feel valued.
 We will be of service even in the remotest part of our country.
 We will offer excellence in services to those abroad as much as we do in India.
 We will imbibe state-of-the-art technology to drive excellence
VALUES
 Excellence in customer service
 Profit orientation

10. 6
 Belonging commitment to bank
 Fairness in all dealings and relations
 Risk taking and innovative
 Team playing
 Learning and renewal
 Integrity
 Transparency and Discipline in policies and systems.
1.4. CORPORATE CENTRE ORGANIZATIONAL CHART

11. 7
1.5. PRODUCTS AND SERVICES
PRODUCTS
State Bank of India renders varieties of services to customers through the following
products:
 SBI TERM DEPOSITS
 SBI RECURRING DEPOSITS
 SBI HOUSING LOAN
 SBI CAR LOAN
 SBI EDUCATIONAL LOAN
 SBI PERSONAL LOAN
 SBI LOAN FOR PENSIONERS
 LOAN AGAINST MORTGAGE OF PROPERTY
 LOAN AGAINST SHARES & DEBENTURES
SERVICES
 DOMESTIC TREASURY
 SBI VISHWA YATRA FOREIGN TRAVEL CARD
 BROKING SERVICES
 REVISED SERVICE CHARGES
 ATM SERVICES
 INTERNET BANKING
 E-PAY
 E-RAIL
 SAFE DEPOSIT LOCKER
 GIFT CHEQUES
 FOREIGN INWARD REMITTANCES

12. 8
2. LITERATURE REVIEW
A number of articles by the various consultancy group such as Accenture, Cognizant, and
E & Y etc. has made valuable contribution regarding optimization of bank capital
according to Basel III norms. There are also many regulatory frameworks provided by
Banking Committee on Basel Supervision (BCBS), Banking for International Settlement
(BIS), Reserve Bank of India (RBI) to work to optimize Risk-Weighted Assets (RWA)
and calculation of Counterparty Credit Risk (CCR) and Credit Value Adjustment (CVA)
etc.
2.1. BASEL REGULATORY CHANGES
After the financial crisis of 2008, BCBS came with a new accord as BASEL III,
which gave a strong foundation to banking sector to avoid liquidity problems in
stress scenarios and it shows the banking industry a way to avoid pitfall in their
approach for calculation of CCR and CVA.
There are following changes made by BCBS which are explained below;
 Pillar 1 - Quality and level of capital; Greater focus on common equity. The
minimum will be raised to 4.5% of risk-weighted assets, after deductions. Capital
loss absorption at the point of non-viability; contractual terms of capital
instruments will include a clause that allows – at the discretion of the relevant
authority – write-off or conversion to common shares if the bank is judged to be
non-viable. This principle increases the contribution of the private sector to
resolving future banking crises and thereby reduces moral hazard. Capital
conservation buffer; comprising common equity of 2.5% of risk-weighted assets,
bringing the total common equity standard to 7%. Constraint on a bank’s
discretionary distributions will be imposed when banks fall into the buffer range.
Countercyclical buffer; imposed within a range of 0-2.5% comprising common
equity, when authority’s judge credit growth is resulting in an unacceptable build-up
of systematic risk. Securitization; strengthens the capital treatment for certain
complex securitizations. Requires banks to conduct more rigorous credit analyses of
externally rated securitization exposures. Trading book; significantly higher capital
for trading and derivatives activities, as well as complex securitizations held in the
trading book. Introduction of a stressed value-at-risk framework to help mitigate
procyclicality. A capital charge for incremental risk that estimates the default and

13. 9
migration risks of unsecuritised credit products and takes liquidity into account.
Counterparty credit risk; substantial strengthening of the counterparty credit risk
framework. Includes: more stringent requirements for measuring exposure; capital
incentives for banks to use central counterparties for derivatives; and higher capital
for inter-financial sector exposures. Bank exposures to central counterparties
(CCPs); the Committee has proposed that trade exposures to a qualifying CCP will
receive a 2% risk weight and default fund exposures to a qualifying CCP will be
capitalized according to a risk-based method that consistently and simply estimates
risk arising from such default fund. Leverage ratio; a non-risk-based leverage ratio
that includes off-balance sheet exposures will serve as a backstop to the risk-based
capital requirement. Also helps contain system wide build-up of leverage. It should
be more than or equal to 3%.
 Pillar 2 - Supplemental Pillar 2 requirements; Address firm-wide governance
and risk management; capturing the risk of off-balance sheet exposures and
securitization activities; managing risk concentrations; providing incentives for
banks to better manage risk and returns over the long term; sound compensation
practices; valuation practices; stress testing; accounting standards for financial
instruments; corporate governance; and supervisory colleges.
 Pillar 3 – Revised Pillar 3 disclosures requirements; the requirements introduced
relate to securitization exposures and sponsorship of off-balance sheet vehicles.
Enhanced disclosures on the detail of the components of regulatory capital and their
reconciliation to the reported accounts will be required, including a comprehensive
explanation of how a bank calculates its regulatory capital ratios.
 Liquidity – Liquidity coverage ratio; the liquidity coverage ratio (LCR) will
require banks to have sufficient high-quality liquid assets to withstand a 30-day
stressed funding scenario that is specified by supervisors. It should be more than or
equal to 100%. Net stable funding ratio; the net stable funding ratio (NSFR) is a
longer-term structural ratio designed to address liquidity mismatches. It covers the
entire balance sheet and provides incentives for banks to use stable sources of
funding. It should be more than or equal to 100%. Principles for Sound Liquidity
Risk Management and Supervision; the Committee’s 2008 guidance Principles for
Sound Liquidity Risk Management and Supervision takes account of lessons learned

14. 10
during the crisis and is based on a fundamental review of sound practices for
managing liquidity risk in banking organizations. Supervisory monitoring; the
liquidity framework includes a common set of monitoring metrics to assist
supervisors in identifying and analyzing liquidity risk trends at both the bank and
system-wide level.
 Systemically important financial institutions (SIFIs) – In addition to meeting the
Basel III requirements, global systemically important financial institutions
(SIFIs) must have higher loss absorbency capacity to reflect the greater risks that
they pose to the financial system. The Committee has developed a methodology that
includes both quantitative indicators and qualitative elements to identify global
systemically important banks (SIBs). The additional loss absorbency requirements
are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement
ranging from 1% to 2.5%, depending on a bank’s systemic importance. For banks
facing the highest SIB surcharge, an additional loss absorbency of 1% could be
applied as a disincentive to increase materially their global systemic importance in
the future. A consultative document was published in cooperation with the Financial
Stability Board, which is coordinating the overall set of measures to reduce the
moral hazard posed by global SIFIs.

15. 11
2.2. CENTRAL COUNTERPARTY (CCP)
While the financial crisis caused massive fallout on bilateral traded over-the-counter
(OTC) sides, exchange traded and centrally cleared derivatives escaped with barely a
scratch. As 90% of global derivatives volumes are purportedly being conducted in
the OTC markets, it is clear why regulators and governments are concerned.
Buy
Sell
Figure 1: Counterparty Risk – Bilateral Settlement
OTC derivatives: The default of a firm A in OTC derivatives transactions has a
possible contagion effect. It doesn’t only affect firm B, it leaves all connected
trading counterparties from firm A to E potentially at risk.
Figure 2: Counterparty Risk – Central Clearing
Bank A
Bank B
Bank CBank D
Bank E
Bank A Bank B
Bank CBank E
Bank D
CCP

16. 12
In this scenario, the CCP stands between firms A to E in the transactions. If firm D
defaults, positions are closed out or transferred to other members. The effect of
default is contained, but there is no contagion.
In simple term, CCP is an intermediary. In other term we can say that, CCPs place
themselves between the buyer and seller of an original trade, leading to a less
complex web of exposures. CCPs effectively guarantee the obligations under the
contract agreed between the two counterparties, both of which would be participants
of the CCP. If one counterparty fails, the other is protected via the default
management procedures and resources of the CCP. (Or) any position taken on with
one counterparty is always offset by an opposite position taken on with a second
counterparty.
2.2.1. OBJECTIVE OF CENTRAL COUNTERPARTY (CCP)
There are following objectives of CCP which have taken into consideration
after financial crisis to increase market safety and integrity, which are
following;
 Reduce the probability of a counterparty defaulting with help of the
“Novation” Process ( In this process, two new contracts are created between
the CCP and the buyer and the CCP and the seller to replace the single,
original contracts between the two parties thus, transferring counterpart risk to
the clearing house).
 Central clearers have put effective lines of defense in place ensuring multilevel
security. So they are well protected against default.
 Set their margin requirement at levels that are expected to cover estimated
market moves of normal market conditions for the interval between the time of
last collection of margin and transfer (or) close out of positions.
 During the risk management process the CCP nets all offsetting open
derivatives contracts of each trading parties. Such multilateral netting decrease
the gross risk exposure to a much higher degree than in the OTC-derivatives
segments which utilize only bilateral netting. Therefore, the CCPs own risk is
reduced and is manageable by means of appropriate margins and capital

17. 13
deposits to prevent damages which arises as a result of any member’s default
burdening the CCP.
 Participants in a bilateral environment are not able to gain as comprehensive a
picture of their counterparties’ derivatives trading risks as CCPs are, since
their knowledge is limited to their own positions vis-à-vis their counterparties.
The effects of this uncertainty on market confidence in periods of market
turmoil can be devastating. By contrast, CCPs are uniquely poised to swiftly
understand the positions of all market participants which they serve as a
central counterparty and are in a stronger position for managing risks for a
clearing member in distress. This may necessitate increasing collateral and – if
needed – unwinding open positions. Well-established CCP processes for
unwinding the positions of a defaulting member further foster market
confidence.
 The introduction of clearing houses into the mix promises to correct these
asymmetries because only the clearing house knows which counterparty is on
the other side of a trade. This anonymity may encourage increased trading
activity on the part of both buy-side and sell-side users.
 Reduces complexity by reducing the number of counterparty relations and
increases efficiency by establishing minimum financial and operational criteria
as well as margin and collateral requirements for its members, centralizing the
necessary calculations, automatically collecting or paying the respective
amounts and preventing disputes (e.g. over the amount and quality of
collateral).
 CCPs address operational risks by means of adequate auditing procedures (i.e.
compliance with technical infrastructure requirements) that ensure the
necessary operational know-how of their current and potential members.
 Requires less regulatory capital from clearing members due to CCPs’ capacity
to mutualize losses through the use of default funds. Many analyst suggested a
remarkable cost advantage if there is no equity capital cost due to the zero
capital weighting.
 Higher collateral cost results from the precautionary measures taken by CCPs
as compared with typical OTC derivatives trading– such as higher quality

18. 14
requirements for eligible collateral and overall level of collateralization
required. However these are partially offset by equity capital savings.
2.2.2. REQUIREMENT OF CCP FOR CCR
Basel II regulations made requirements related to counterparty risk on market
transactions;
 Capital calculation related to over the counter (OTC) and Securities financing
transactions (SFT) such as asset loans and repo, and reverse repo agreements
with exposures implied by the potential one year horizon counterparty default.
 The assessment of counterparty risks on market transactions is directly linked
to the evaluation of the amount of exposure considered appropriate for a
market transaction. Basel II provided two main approaches to estimate this;
 The fixed price version (current exposure method or CEM) is based on a
market price valuation, offering a hybrid measure between exposure and
volume.
EAD (Exposure at default) = [(RC + add-on) – Volatility adjusted collateral)]
Where, RC = Replacement Cost
Add- on = is the estimated amount of Potential Future Exposure
Volatility adjusted collateral = is the value of collateral as specified
 The “internal models” version was created to enable banks to simulate mark-
to-market future variations, with the objective of using such simulations both
for their internal risk monitoring and for calculating regulatory capital.
 The implementation of IMM is much more demanding in terms of
documentation and approval. IMM approach may help to provide regulatory
capital saving opportunities compared to Credit Exposure Method (CEM).

19. 15
2.2.3. NEW REQUIRED MEASUREMENT FOR CCR
There are following measures introduced related to counterparty credit risk;
 Calibration of diffusion parameters in stressed Effective Expected
Positive Exposure (EEPE) calculations: EEPE measure is completed by a
“stressed” EEPE calculation based on the calibration of diffusion model
parameters over a period of three years including a period of rapid increases in
credit spreads. The parameters are then recalibrated and used in current market
situations for calculating the mark-to-future and stressed EEPE. The risk-
weighted assets (RWA) calculation is made twice, using both non-stressed and
stressed parameters. The final measure appearing in the regulatory report is the
highest one observed between non-stressed RWA and stressed RWA.
 Introduction of an additional capital charge to cover the risk of change in
Credit Value Adjustment (CVA) of a trading portfolio: The adjustment of
CVA materializes the market value of CCR on the market transaction of the
trading portfolio. The CVA charge represents a new capital add-on for
potential mark-to-market losses associated with deterioration in the credit
worthiness of counterparty. Two methods for assessing this charge are
proposed by the Basel Committee on Banking Supervision:
 For portfolio valued using the standard method formula; The only eligible
hedges that can be included in calculating the advanced CVA risk capital
charge are, a) Single-name credit default swaps (CDSs) or other equivalent
hedging instruments referencing the counterparty directly . Index CDSs,
provided that the basis between any individual counterparty spread and the
spreads of index CDS hedges is reflected, to the satisfaction of the competent
authority, in the Value-at-Risk (VaR).
 For portfolios valued using IMM (and in the case of banks already using
an internal model for interest rate VaR), the method is based on applying
the VaR model used for bonds to the regulatory CVA.
 The difference in terms of capital requirements between the standard and the
CVA VaR approach can be very material, thus encouraging many market
players to use the Internal Model Approach. The CVA risk capital can lead to
a significant increase in the risk weighted assets.

20. 16
 As for exceptions, a bank is not required to include in its capital charge the
following: Transactions with a central counterparty (CCP) and a client’s
transaction with a clearing member, when the clearing member is acting as an
intermediary between the client and a qualifying central counterparty and the
trading transactions expose the clearing member to a qualifying central
counterparty and securities financing transactions (SFT), unless the bank’s
supervisor determines that the loss exposures arising from SFT transactions
are material. Details explanation of CVA has given below.
 Specific Wrong Way Risk (WWR): Also called unfavorable correlation. It
quantifies the negative correlation between the risk exposure to counterparty
and its credit quality (for instance a put option purchase on a counterparty
legally bound to the counterparty issuing the underlying instrument).
Transactions carrying specific WWR with unfavorable correlation will have to
be identified, isolated from the overall compensation node of origin and
assigned to a particular computational processing to calculate their
exposure at default (EAD).
 General Wrong Way Risk: Macroeconomic factors. For e.g. Increase in oil
prices will lead to probability of airlines companies as the value of some their
exposures increase. Banks will not have to implement a particular action or a
differentiated capital allocation for this type of risk, but nevertheless would
have to identify such exposures through scenario analysis of market
tensions, in order to identify the risk factors correlated with the credit quality
of the counterparties.
 Increase of the Margin Period of Risk (MPR): The margin period of risk
(MPR) is the time period overseeing the last exchange of collateral used to
cover netting transactions with a defaulting counterpart and the closing out of
the counterparty and the resulting market risk is re-hedged. With this indicator
it is possible to model the change in market value of the collateral exchanged
during a theoretical date of collateral exchange and the calculation date of
subsequent exposure. In some situations, for all “illiquid” netting sets, banks
will have to move from 10 days (the Basel II requirement) to 20 days of the
regulatory threshold (with the possible doubling of this threshold if at least two

21. 17
disputes on the same set of compensation have been observed over the last six
months).
 Collateral Management: Implementation of collateral management.
Monitoring, reporting and analyzing received and paid collateral including
categories of collateralized assets, the amount of margin calls exchanged, and
the concentration, disputes, re-hypothecations and other elements.
 Application of a coefficient of correlation between assets value for large
financial institutions: It requires the use of a correlation factor greater than
1.25 times the one used in calculating the Basel II regulatory capital for
institutions of significant size (e.g., those with a trading book exposure over
$100 billion).
 Central Counterparty Clearing (CCP) houses: A bank is required to use a
minimum risk weighting of 2% of the exposure value of all its trade
exposures with the CCP. These counterparties are to serve as intermediaries
between buyers and sellers of products and thus help reduce counterparty risk.
Cleared derivatives contracts will tend to increase liquidity needs through
initial and variation margins callable by clearing houses.
 Back-testing credit counterparty risk modules: Requires performing initial
and on-going valuation of credit counterparty risk exposure models with a
focus on; a) Carrying out back-testing at , Risk Factor Level, Pricing Model
Level, CCR exposure Module. b) Considering a number of distinct prediction
time horizons out to last one year.
2.2.4. QUALIFYING CENTRAL COUNTERPARTIES (QCCP)
It is an entity that is licensed to operate as a CCP (including a license granted
by way of confirming an exemption), and is permitted by the appropriate
regulator / overseer to operate as such with respect to the products offered.
This is subject to the provision that the CCP is based and prudentially
supervised in a jurisdiction where the relevant regulator/overseer has
established, and publicly indicated that it applies to the CCP on an ongoing
basis, domestic rules and regulations that are consistent with the CPSS-IOSCO
Principles for Financial Market Infrastructures.
In India following four corporations have got status as QCCP:

22. 18
 National Securities Clearing Corporation Limited (NSCCL)
 Indian Clearing Corporation Limited (ICCL)
 MCX-SX Clearing Corporation Limited (MCX-SXCCL)
 Clearing Corporation of India Ltd. (CCIL)
2.2.5. CAPITAL REQUIREMENTS FOR EXPOSURES TO CCPS
Capital requirements will be dependent on the nature of CCPs viz. Qualifying
CCPs (QCCPs) and non-Qualifying CCPs.
 Regardless of whether a CCP is classified as a QCCP or not, a bank retains the
responsibility to ensure that it maintains adequate capital for its exposures.
Bank should consider whether it might need to hold capital in excess of the
minimum capital requirements if, for example, (i) its dealings with a CCP give
rise to more risky exposures or (ii) where, given the context of that bank’s
dealings, it is unclear that the CCP meets the definition of a QCCP.
 Banks may be required to hold additional capital against their exposures to
QCCPs, if in the opinion of RBI, it is necessary to do so.
 Where the bank is acting as a clearing member, the bank should assess through
appropriate scenario analysis and stress testing whether the level of capital
held against exposures to a CCP adequately addresses the inherent risks of
those transactions.
 The trades with a former QCCP may continue to be capitalized as though they
are with a QCCP for a period not exceeding three months from the date it
ceases to qualify as a QCCP. After that time, the bank’s exposures with such a
central counterparty must be capitalized according to rules applicable for non-
QCCP.
2.2.6. EXPOSURES TO QUALIFYING CCPS (QCCPS)
A. Trade Exposures:
 Clearing member exposure to QCCPs:
 Where a bank acts as a clearing member of a QCCP for its own purposes,
risk weight of 2% must be applied to the bank’s trade exposure to the QCCP

23. 19
in respect of OTC derivatives transactions, exchange traded derivatives
transactions and SFTs.
 The exposure amount for such trade exposure will be calculated in accordance
with the Current Exposure Method (CEM) for derivatives and rules as
applicable for capital adequacy for Repo / Reverse Repo-style transactions.
 Clearing member exposures to clients: The clearing member will always
capitalize its exposure (including potential CVA risk exposure) to clients as
bilateral trades, irrespective of whether the clearing member guarantees the
trade or acts as an intermediary between the client and the QCCP. However, to
recognize the shorter close-out period for cleared transactions, clearing
members can capitalize the exposure to their clients by multiplying the EAD
by a scalar which is not less than 0.71(A margin period of risk at least 5 days).
(If a margin period of risk will be 6 days = 0.77, 7 days = 0.84, 8 days = 0.89,
9 days = 0.95, and 10 days = 1)
 Client bank exposures to clearing members: Where a client is not protected
from losses in the case that the clearing member and another client of the
clearing member jointly default or become jointly insolvent, but all other
conditions mentioned above are met and the concerned CCP is a QCCP, risk
weight of 4% will apply to the client’s exposure to the clearing member.
 Treatment of posted collateral: Any assets or collateral posted must, from
the perspective of the bank posting such collateral, receive the risk weights
that otherwise applies to such assets or collateral under the capital adequacy
framework, regardless of the fact that such assets have been posted as
collateral. Thus collateral posted from Banking Book will receive Banking
Book treatment and collateral posted from Trading Book will receive Trading
Book treatment.
 Collateral posted by the clearing member (including cash, securities, other
pledged assets, and excess initial or variation margin, also called over-
collateralization), held by a custodian, and is bankruptcy remote from the

24. 20
QCCP, is not subject to a capital requirement for counterparty credit risk
exposure to such bankruptcy remote custodian.
 Collateral posted by a client, that is held by a custodian, and is bankruptcy
remote from the QCCP, the clearing member and other clients, is not subject to
a capital requirement for counterparty credit risk.
 If the collateral is held at the QCCP on a client’s behalf and is not held on a
bankruptcy remote basis, 2% risk weight will be applied to the collateral.
Risk weight of 4% will be made applicable if a client is not protected from
losses in the case that the clearing member and another client of the clearing
member jointly default or become jointly insolvent.
B. Default Fund Exposures to QCCPs: If default fund is shared between
products or types of business with settlement risk only (e.g. equities and
bonds) and products or types of business which give rise to counterparty credit
risk, all of the default fund contributions will receive the risk weight
determined according to the formulae and methodology, without
apportioning to different classes or types of business or products.
2.2.7. EXPOSURES TO NON-QUALIFYING CCPS
Banks must apply the Standardized Approach for credit risk according to the
category of the counterparty, to their trade exposure to a non-qualifying CCP.
 Banks apply Risk Weight of 1250 % to their default fund to a non-QCCPs.
Default Fund = Funded + Unfunded contribution.
 If liability for unfunded contributions, the national supervisor (In case of India,
its RBI) should determine the amount of unfunded commitments to which
Risk weight of 1250 % should apply to.
 The exposures of banks on account of derivative trading and securities and
financing to CCP including those attached stock exchanges for settlement of
exchange traded derivatives, are assigned zero exposure value for CCR.
 Credit Conversion factor (CCF) of 100% are applied to the securities
posted as collaterals with CCPs. 20% for Clearing Corporation of India
Limited (CCIL), and as per the external ratings for other CCPs.

25. 21
 Deposits kept by banks with the CCPs, 20% Risk Weights for CCIL and as
per the external ratings for other CCPs.
Illustration: A Real Estate Company entering into an IRS contracts via a CCP
Company asks bank to ‘Swap’ its
Floating-rate loan Interest payments
For fixed-rate payments.
Floating-Rate Payments Floating-Rate Payments
Fixed Rate Payments Fixed Rate Payments
Assume if Broker Dealer B defaults before the end of the 3 year contract, and
unable to make obligation to offer fixed rate payments in return for floating
ones. The CCP must manage this exposure. For instance, it may use an auction
process to find another counterparty to take on the swap contract. In this event,
the collateral pledged to the CCP by Broker Dealer B could be used to cover
losses the CCP might incur while arranging this.
2.2.8. DEFAULT WATERFALL (HOW CCPS CAN MANAGE IN CASE OF
DEFAULT)
In taking on the obligations of each side to a transaction, a CCP has equal and
opposite contracts. That is, payments owed by the CCP to a member on one
trade are exactly matched by payments due to the CCP from the member on
the matching trade. But if one member defaults, the CCP needs resources to
draw on to continue meeting its obligations to surviving members. This is
Commercial Bank
A
(Member of CCP)
Real Estate Company
CCP
Broker Dealer B
(Member of
CCP)

26. 22
sometimes achieved through an ‘auction’ of the defaulter’s position among
surviving members. In terms of resources to cover its obligations, CCPs
typically have access to financial resources provided by the defaulting party,
the CCP itself and the other, non-defaulting members of the CCP. The order in
which these are drawn down helps to create appropriate incentives for all
parties (members and CCPs) to manage the risks they take on. These funds are
collectively known as the CCP’s ‘default waterfall’.
Figure 3: Default waterfall
If the collateral posted by the defaulter to the CCP is insufficient to meet the
amount owed, the CCP can then draw on the defaulting party’s contribution to
the CCP’s ‘default fund’. Usually, all members are required to contribute to
this fund in advance of using a CCP. A key feature of CCPs is that losses
exceeding those initial sums provided by the defaulter are effectively shared
(mutualized) across all other members of the CCP.
Before using the default fund contributions of surviving members the CCP
may contribute some of its own equity resources towards the loss (shown in
Defaulting member’s initial margin and default
fund contribution
Surviving members default fund-contributions
Part of CCPs Equity
CCPs remaining equity
Right of assessment
CCP insolvent in the absence of a mechanism to
allocate the residual loss

27. 23
the second row of Figure 3). This incentivizes the CCP to ensure that losses
are, as far as possible, limited to the resources provided by the defaulting
member rather than being passed on to other members.
If the CCP’s own contribution is fully utilized, the CCP then mutualizes
outstanding losses across all the other (non-defaulting) members. First, the
CCP draws on default fund contributions from non-defaulting members (third
row of Figure 3). If these loss-absorbing resources (which up to this point are
all pre-funded) are exhausted, CCPs may call on surviving members to
contribute a further amount, usually up to a pre-determined limit. This is
sometimes termed ‘rights of assessment’ (fourth row in Figure 3).
In the absence of a mechanism to allocate any further losses among its
members, the CCP’s remaining equity then becomes the last resource with
which to absorb losses, though this is often quite a small sum when compared
with initial margin and the default fund. If losses exceed this remaining equity,
the CCP would become insolvent.

28. 24
2.3. CREDIT VALUE ADJUSTMENT (CVA)
CVA is introduced to adjust for the risk that appears for counterparties in derivative
instruments. CVA is defined as the market value of counterparty credit risk. Crisis
such as LTCM (Long Term Capital Management) and collapse of Lehman Brothers
have given birth to CVA charge. In the recent 2008 crisis, counterparty risk losses
resulted from the credit market volatility than from realized defaults. There was
estimation that two thirds of counterparty risk related losses were happened from
CVA volatility and only one third from actual default. During this crisis there was
also implication that banks tend to neglect valuation of counterparty credit risk
because of smaller size of the derivative exposure (or) the high credit rating of the
counterparties (AAA or AA). E.g. If banks were going for any derivative contracts
with smaller companies, the size of contracts was smaller and due to this reason
banks were not focusing on Credit Value Adjustment (CVA). But whatever the
contracts may be there will be exposures. Also if banks were going for contract with
a high credit rating companies like AAA rated companies or AA rated companies,
they had a belief that since they have high credit rating, they will not default (too-
big-to-fail concept). These scenarios resulted in emergence of CVA.
2.3.1. APPROACHES FOR MEASUREMENT OF CVA
There are two approaches to measuring CVA; one is Unilateral and second is
bilateral. Difference between Unilateral and Bilateral CVA has explained
below;
Unilateral Bilateral
Assume that the institution who does
the CVA analysis (Bank) is default
free. E.g. Options
Assume both the counterparty and the
banks have possibility of default.
E.g. Swaps
Gives the current market value of future
losses due to counterparty’s potential
default.
Gives fair value calculation since both
the bank and the counterparty requires
a premium for the counterparty risk.
Table 1: Difference of Unilateral and Bilateral CVA

29. 25
2.3.2. CALCULATION OF CVA CAPITAL REQUIREMENT
There are two approaches and four methods for calculating the CVA capital
requirements;
Standardized Approach Advance Approach
1. Current Exposure Method (CEM)
Advanced Method (AM)
2. Internal Model Method (IMM)
3. Standardized Method (SM)
The problem behind addressing CVA is related to infrastructure, data
management and regulatory reporting. So, Advance method is tough to calculate
on the currently available data and infrastructure.
 The Standardized Approach: Institutions using the standardized approach
can stick on this regulatory formula for the calculation of capital requirements
for CVA;

30. 26
Illustration: On 1 November 201Y, Company X (a large corporate) enters into
a 6 month foreign exchange contract (selling USD= 14 million and buying
Euro= 10 million) with bank Y to hedge its foreign currency risk. Bank Y
enters a back-to-back contract with its parent on the same day that is bank Y
sells USD= 14 million and buys Euro= 10 million forward.
Solution: (Assuming here CVA is not hedged)
Step 1 – Calculating EADi and Mi
Assuming that Bank Y determines the exposure at default for OTC derivatives
by reference to the CCR mark-to-market method,
EADi Amount in EURO
EADcorporate EUR 10mm*1%1
= EUR 1,
00,000
EADparent EUR 10mm*1% = EUR 1,
00,000
The discounted exposure at default is calculated by applying a standardized
discounting factor based on the maturity of the transaction.
The effective maturity of both exchange transactions is 6 month.
Step 2 – Calculating wi
Company X = A-
Credit rating = 0.8% weight.
Parent = AA-
Credit rating = 0.7% weight.
Step 3 – Calculating the capital requirement for CVA and CCR
On 1 November 201Y, the capital requirement for CCR is EUR 5,600 that is;
Company X = EUR 1, 00,000*50 %( External Credit Rating)*8 %( CRAR of
bank Y)
= EUR 4000
And Parent Y = EUR 1, 00,000*20 %( External Credit Rating)*8 %( CRAR of
bank Y)
1
It is noted that 1% is the standardised applied to the notional of a forward foreign currency contract with a
maturity of 12 months (or) less.

31. 27
= EUR 1600
The additional capital requirement arising from CVA on 1 November 201Y,
risk is calculated by reference to above formula and amount to EUR 1,366.
Implications of this, CVA risk requires an approx. additional 25% capital
requirement as compared to the CCR.
 Standardized Method (SM) – Currently very few financial intuition use this
method.
 Current Exposure Method (CEM) – Most common method for calculating
Exposure at default (EAD).
EAD = CE + PFE (Potential future exposure) – C
Where, CE = Current exposure of the transaction,
C = Collateral posted by the counterparty.
The limitations of these two methods are poor support for risk mitigation from
collateral agreements and also these are less risk sensitive.
 Internal Model Method (IMM) – It is a way to compute CVA for firms that
have a regulator approved model for CCR.
EAD under IMM –
E (exposure) = max {V [MTM value of the portfolio] – C [amount of
collateral], 0}
With IMM model, we need to focus on Expected Exposure (EE), Expected
Positive Exposure (EPE), Effective Expected Exposure (EEE), and Effective
Expected Positive Exposure (EEPE).
So, EAD = alpha * EEPE
The alpha multiplier is formally defined as the ratio between economic capital
(as computed with the full IMM) and one calculation carried out with
deterministic exposures set to EPE. The existence of the alpha is meant to
account for wrong way risks (WWRs) and other model issues. To the WWR
errors belong;
 Correlations of exposures across counterparties
 Correlation between exposures and defaults.
Other factors which are meant to be accounted for are;

32. 28
 the exposures' volatility
 model estimation errors
 numerical errors
 Advanced Approach - The advanced method is available for banks that
have an approved IMM as well as a specific interest rate risk VaR model.
These banks calculate the CVA capital charge by simulation. The simulation
involves modelling the credit spread and thereby rating of counterparties in
OTC derivative transactions.
We need to calculate two separate version of CVA. The first calculation is
calibrated using market data from the current one year period. The second is
calibrated for a stressed one year period, with increased credit spreads. The
calculations are then added according to produce the CVA capital charge
amount.

33. 29
Since its time extensive and because of poor infrastructure we are not able to
compute CVA based on the Advance Approach.
2.3.3. COMPARISON OF CEM AND IMM METHOD
Since we have seen CEM and IMM method for computation of CVA. Now
we will stress contracts mainly by changing the counterparty’s rating and time
to maturity of the Contracts.
Also, in all scenarios we are the fixed receiver and the contracts have the same
time-to-maturity of 5 years.
All calculations displayed throughout the examples are executed in Matlab
2013b (8.2.0.701).
Below is an overview of the computations we have performed.
 For Internal model method: Firstly, CVA is computed using the IMM. This
method has a moderate support in Matlabs most recent version of the Financial
Instruments Toolbox.
 Current exposure method: Secondly, CVA is computed using the simpler
CEM.
 The reason to why we are not using the advanced method as benchmark for
regulatory CVA is due to the complexity of the model and difficulty in finding
the needed data.
 An interest rate swap is an agreement between two parties to exchange interest
rate cash flows on specified intervals and over a certain period of time. Interest
swaps are OTC derivative contracts, which is one of the reasons to why we
will consider them here.
 There are a number of different versions of IRS contracts, but the far most
common type, and the one we will consider in this chapter, is the so called
plain vanilla interest rate swap. Under this contract, one of the parties pays a
fixed interest rate, and the other pays a floating rate. The convention is that the
party paying the fixed rate is called the payer, and the party receiving the fixed
rate is called the receiver. The interest rate is paid on a so called notional

34. 30
amount (or notional principal amount or notional value); an imaginary value
which is never exchanged.
Maturity (Months) Rate
3 0.00227
6 0.00341
12 0.00446
24 0.00534
36 0.0071
48 0.0089
60 0.0106
84 0.015
120 0.0199
180 0.0244
240 0.0259
Initial rates used in the calculation of CVA calculation
The following are the setting used in the simulation of CVA under IMM:
Parameter Value
Settlement date 2013-11-05
Principal Amount 1MSEK
Latest floating rate 0:00227
Rate Spread 10 bps
Cash flow frequency once per year
Number of simulation paths 500
Time step 1 month
Compounding continuous
IMM alpha 1.4

35. 31
 Rating Drop -
Counterparty 1 2 3 4
Rating AAA BBB B CCC
Weight 0.7 1 3 10
Time-to-
maturity
5 5 5 5
CVA IMM 60260 86090 258270 860910
CVACEM 122400 174800 524500 1748500
Difference 62140 88710 266230 887590
We can implicate from this table that CEM is always calculating a higher
value than the IMM method.
 Increasing time-to-maturity, fixed rating –
Counterparty 1 2 3 4 5
Rating AA AA AA AA AA
Weight 0.7 0.7 0.7 0.7 0.7
Time-to-
maturity
1 2 3 4 5
CVA IMM 422 4515 12591 29218 60264
CVACEM 8150 16310 24490 32640 122390
Difference 7728 11795 11899 3422 62126
Counterparty 1 2 3 4 5
Rating BBB BBB BBB BBB BBB
Weight 1 1 1 1 1
Time-to-
maturity
1 2 3 4 5
CVA IMM 603 6450 17988 41739 86091
CVACEM 11650 23300 34980 46630 174850
Difference 11047 16850 16992 4891 88759

36. 32
We can implicate from both cases that if we change time-to-maturity and
rating of the counterparty, in both of scenario CEM is calculating a higher
value than IMM.
We can conclude from derivations of the two methods, IMM and CEM that
the IMM method is much more mathematically sophisticated. The difference
would be in implementation of both methods are, IMM is much more
computer intensive.
2.3.4. ISSUES IN CVA COMPUTATION
There are many issues in computing CVA, which are following;
 Options on a portfolio are difficult to price and hedge
 Data is difficult to come by and manage
 Pricing
 Calibration
 Sensitiveness
 Trading Strategy Analysis
 Portfolio Calculation
 VaR.

37. 33
3. RESEARCH METHODOLOGY
The objective of this research is to arrive at the optimization of the capital in bank’s
capital by focusing on important changes done by BCBS on their regulatory framework.
Also, there was more focus on data purity and model refining process to use to save capital
in bank’s treasury by way of adopting many prescribed regulatory framework. For this
purpose there has been use of primary data as well as secondary data.
3.1. QUALITATIVE ANALYSIS
This research is done on more of a qualitative than a quantitative ground as it
requires tremendous research on the available policies by BCBS and national
regulators (In case of India, it is RBI). For a start, I conducted study of the available
literatures on capital adequacy framework and how bank can save itself from risk
arising from day-to-day activity in banking operations. These literatures gave an
overall view about the history of financial crisis and what steps have been taken by
regulators to further avoid any crisis. Further, I studied about measurement and
guidance provided by BCBS to banks to save itself from 30-dyas acute stress
scenario (Liquidity Coverage Ratio) and One year stress scenario (Net Stable
Funding Ratio). Further research is performed on individual related concepts which
could have an impact on optimization of capital.
BCBS committee ensures that banks will not neglect any counterparty credit risk
which can arise by down rating of company (or) any issue related with particular
company. The credit valuation adjustment is mandatory for banks after the crisis of
2008-09 in order to keep a check on CCR. A comparatively study has been made on
the models provided by the BASEL committee and which is currently using by most
of the national and international banks.
3.2. QUANTITATIVE ANALYSIS
For better understanding of how capital charge may be reduced, I have taken many
hypothetical examples and also from various resources and tried to showed that how
changing in model can lead to optimization of capital and save bank from any risk
can occur.

38. 34
4. FINDING, ANALYSIS AND IMPLICATIONS
4.1. OPERATIONAL MEASURES
Operational measures is a very important tool for a financial institutions to save
itself from any risk of loss from inadequate or failed internal processes, people and
systems, or from external events.
During the early part of the decade, much of the focus was on techniques for
measuring and managing market risk. As the decade progressed, this shifted to
techniques of measuring and managing credit risk. By the end of the decade, firms
and regulators were increasingly focusing on risks "other than market and credit
risk." These came to be collectively called risk arising from poor operational
measure. This catch-all category of risks was understood to include,
 employee errors,
 systems failures,
 fire, floods or other losses to physical assets,
 fraud or other criminal activity,
 Data Quality,
 Risky Assets,
 Flexible credit approval processes.
Employee Errors can be eliminated by proper training whereas system failures can
be eliminated by strong infrastructure. Fire, floods or other losses to physical assets
can be saved by properly controlling and better framework. Fraud (or) other criminal
activity can be eliminated by proper research of employee’s background and
monitoring of employees. But the most important part of operational measures
which banks need to focus are optimization of Risk Weighted Assets (RWA),
enhancement of data quality, stricter credit approval processes, reducing credit
exposure, improving liquidity risk management, closer integration of risk and
finance functions. These operational measures are explained below;
4.1.1. RWA OPTIMIZATION
At the heart of global bank regulatory capital standards, known as The Basel
Accord, is the idea that since assets represent a diversity of risk, each should
be risk weighted differently. Numerous bank regulators and bank

39. 35
reform advocates in the last few years have become increasingly vocal in their
displeasure about this framework. Every time that the Basel Committee for
Banking Supervision (BCBS) comments on Risk Weighted Assets (RWAs),
that would restrict the existing flexibility that exists in how market participants
come up with many of the inputs for the regulatory capital calculation.
Until the Basel Committee finds a compromise between risk measurement
methodologies and those that are flexible, banks are currently extremely
focused on optimizing their RWAs in the hopes of some regulatory capital
relief. In almost fifteen years of working with banks and regulators on Basel I
– III, I have observed a variety of ways that banks optimize their RWAs with
varying degrees of success.
Irrespective of a banks size a good place to start RWAs optimization is the
banking book, since those will carry a full RWAs.
But how can banks optimize it RWAs, because the competition between public
sector and private sector is very high. Banks are aggressively expanding its
networks to cover maximum industry, person, and government agency without
taking consideration of loss (arising from credit loss and market loss).
RWAs are an important part of both the micro- and macro-prudential toolkit,
and can (i) provide a common measure for a bank’s risks; (ii) ensure that
capital allocated to assets is commensurate with the risks; and (iii) potentially
highlight where destabilizing asset class bubbles are arising.
We will take a hypothetical scenario of banks investment and we can see that
how investment done by banks only in few categories will charge high RWAs.
Assume book value = 100 (equal weightage investment) in portfolio of bank.
In the given scenario, we will consider banks investment in defaulted entities
guaranteed by State government. While making such investments, banks
doesn’t check such information about entities like are they defaulted entities
(or) not. Banks relay on information like guaranteed by state government or
central government and without proper verification, make its investment on the
available information. After doing investment, banks realised that they have
considered wrong information and now they need to assign 102.5% risk
weight instead of 0% and such mistakes increased RWAs of individual bank.

40. 36
So, how can banks save itself from the present scenario? Banks need to take
into consideration of some important aspects to optimize its RWAs, which
explained below;
Banks need to check all available information about companies where they
will make investment, and do the proper analysis before making any
investment.
 SIDBI/NABARD or investment wherever is mandatory according to RBI
prescribed rule, banks will have to do there without thinking. But instead of
investing more of capital in mandatory areas, it’s better to diversify its
portfolio.
 Reduce positions in illiquid assets (BASEL III accord for Liquidity coverage
ratio, banks needs to keep 100% high quality of liquid asset by 2019).
 Aggressively, banks can reduce the maturities of portfolios. This action may
have impact a bank’s earning in short run, but in the longer run it will be
advantageous for bank and also it will help in achieving higher Capital
Adequacy Ratio.
 Liquid collateral is being used for loans or derivatives.
 A category where it is definitely worthwhile for large banks to spend time
exploring is in the area of derivatives. By requiring collateral from
counterparties in OTC derivatives (or) having trades clear through derivatives
clearing organizations, banks can reduce their credit risk, which can provide
capital relief.
 Netting derivatives transactions and compression are also ways for banks to
reduce their RWAs. (According to BASEL III accord, banks need to use
Central counterparty for OTC derivatives and banks need to assign 2% RWA).
 On the Off-Balance sheet items, BASEL III guidance leaves significant room
for banks to optimize the Credit Conversion Factor (CCF) computation for
multiproduct, multi-counterparty facilities relying on mathematical
calculations.
 On the Off-Balance sheet items, banks can try to reduce its investment in non-
funded exposures to commercial real estate, Guarantees issued on behalf of
stock brokers and market makers, non-funded exposures to NBFC-ND-SI etc.

41. 37
which attracts higher Credit conversion factor and in turns it will lead to higher
RWAs.
 Diversification of portfolio can also save RWAs.
 Assume a bank has made investment in AAA & AA rated (assume 20% risk
weight) bond and simultaneously made investment in BBB rated (assume
100% risk weight) bond. Since the rating is higher, so probability of default is
lower in this scenario. So banks can optimize its RWAs in portfolio by
diversifying as said above with the combination of government issued
instruments (T-bills, bonds, etc.) {Combination of G-Sec + AAA & AA +
BBB}.
Also, banks can diversify its portfolio making investment in AAA & AA rated
and simultaneously can make investment in unrated companies (assume 100%
risk weight but higher risk higher return). Since BBB rated companies
assigned 100% risk weight like unrated companies but probability of default
comparing to unrated is very low in BBB rated. But difference between return
from BBB and unrated companies are far wide. So banks can optimize its
RWAs in portfolio by diversifying as said above with the combination of
government issued instruments (T-bills, bonds, etc.) {Combination of G-Sec
+ AAA & AA + unrated}.
 It is advisable for banks to avoid investment in “D” rated companies, since it
assign 150% RWAs and also probability of default is very high and return is
not higher comparable to unrated companies.
 Banks can use a uniform and strict methodology to check RWA calculation.
Under BASEL III, Basel committee has prescribed many approaches which
bank can use to minimize its RWAs. Basel committee has introduced many
methods such as, IRB method, Standardized approach etc. to reform the
existing RWAs framework.
 Banks can also check Sharpe Ratio, Beta, Regression analysis as a tool to
keep tab on market movement of particularly RWAs before making any
investment.
 Beta analysis will give idea that how much systematic risk a particular asset
has relative to an average asset. Assets with larger Betas have greater
systematic risk.

42. 38
 Sharpe Ratio measures the slope of Capital market Line (Obtained by
combining the market portfolio and the riskless asset). Closer the Sharpe Ratio
is to the slope of Current Market Line, the better the performance of the fund
in terms of return against risk.
 Regression analysis measures the relationship between covariance and
correlation and also it gives an equation, which tells the performance of assets
with respect to the total market return.
 Swapping products to a more efficient mix could have significant impacts in
reducing RWA.
Client
Segment
Product Client
need
Product
Examples
Risk
weight
%
Strategy
Retail Domestic
working
capital
financing
Personal
consumpti
on
Overdraft
Consumer
Credit
Salary
guaranteed
loan
100
75
20-40
Switch
to salary
guarante
ed loan
SME/Corpor
ate
Domestic
working
capital
financing
Need for
liquidity
for
domestic
working
capital
financing
Invoice
discounting
Factoring
100
60
Switch
to
factorin
g
Corporate Equipment
Purchase
Financing
for
equipment
purchase
MLT Loan
Equipment
Leasing
90
70
Switch
to
equipme
nt
leasing
SME Liquidity Temporar
y cash
need
Overdraft
Secured
current
account
100
80
Switch
to
current
account
Table 2: Swapping of products

43. 39
4.1.2. STRICTER CREDIT APPROVAL PROCESS
Credit risk is one of the most significant risk that commercial banks faces.
Nearly 40% of the total revenue of a typical bank is generated by credit-related
assets.
The financial crisis of 2008 exposed the inter-linkages between credit risk,
market risk, and liquidity. Beyond the need to be compliant, a stricter credit
approval process and credit risk management can add significant advantage of
a bank business. It helps establish a framework that define corporate
priorities, loan approval process, credit risk rating system, risk-adjusted
pricing system, loan-review mechanism, and comprehensive reporting system.
The output from stricter credit approval process, which help banks in risk-
based pricing, exposure and concentration limit setting, Risk-Adjusted
Return on Capital (RAROC), managing portfolio return profile, setting loss
reserves, and economic capital calculation.
The major problem what banks are facing now for stricter credit approval
policy is lack of quality of data infrastructure, out-dated IT systems, different
definition of customers (most of the banks have 22 definition for “customer”),
large talent gap (specialized skills lacking) etc.
Still several practices are emerging to help overcome of these challenges;
 Effective credit approval solution spans across the entire lending value chain
– origination, underwriting, portfolio monitoring, regulatory reporting, and
collections.
 Data governance should be centralized across different risk categories
including market risk, regulatory risk, fraud, AML/KYC risks, and
finance/treasury risks.
 Have a single definition for customer covering all aspects. It is difficult but not
impossible.
 Banks can outsource some of its part of business to third party such as, BPO
service provider, which can help banks for risk analytics, data management,
testing of systems and validation of models to quickly scale up given the
several risk works.
 Many time banks provide loan to individual, industry etc. (That is one of the
reason that NPA of banks are higher) but they don’t do proper follow-up. So

44. 40
banks need to avoid this situation and in regular interval (at least quarterly) do
follow-up which covers, frequency of reviews, qualification of review
personnel, scope of reviews, depth of reviews, work-paper and report
distribution etc. Banks need to submit reports which summarize the result of
reviews to the board at least quarterly and findings should be adherence to
internal policies and procedures, and applicable laws and regulations, so that
deficiencies can be remedied in a timely manner.
4.1.3. LIQUIDITY RISK MANAGEMENT
Liquidity is a bank’s capacity to fund increase in assets and meet both
expected and unexpected cash and collateral obligations at reasonable cost and
without incurring unacceptable losses. Liquidity risk is the inability of a bank
to meet such obligations as they become due, without adversely affecting the
bank’s financial condition. Effective liquidity risk management helps ensure a
bank’s ability to meet its obligations as they fall due and reduces the
probability of an adverse situation developing. This assumes significance on
account of the fact that liquidity crisis, even at a single institution, can have
systemic implications.
The liquidity risk is closely linked to other dimensions of the financial
structure of the financial institution, like the interest rate and market risks, its
profitability, and solvency, for example. Having a larger amount of liquid
assets or improving the matching of asset and liability flows reduces the
liquidity risk, but also its profitability.
Liquidity risk can be sub-divided into funding liquidity risk and asset
liquidity risk. Asset liquidity risk designates the exposure to loss consequent
upon being unable to effect a transaction at current market prices due to either
relative position size or a temporary drying up of markets. Having to sell in
such circumstances can result in significant losses. Funding liquidity risk
designates the exposure to loss if an institution is unable to meet its cash
needs. This can create various problems, such as failure to meet margin calls
or capital withdrawal requests, comply with collateral requirements or achieve
rollover of debt.
Table below lists some internal and external factors in banks that may
potentially lead to liquidity risk problems.

45. 41
Internal Banking factors External Banking factors
High off-balance sheet exposures. Very sensitive financial markets
depositors.
The banks rely heavily on the short-
term corporate deposits.
External and internal economic shocks.
A gap in the maturity dates of assets
and liabilities.
Low/slow economic performances.
The bank rapid asset expansions exceed
the available funds on the liability side.
Decreasing depositors trust on the
banking sector.
Concentration of deposits in the short
term tenor.
Non-economic factors.
Less allocation in the liquid
government instruments.
Sudden and massive liquidity
withdrawals from depositors.
Fewer placements of funds in long-
term deposits.
Unplanned termination of government
Deposits.
Table 3: Factors may lead to Liquidity risk problems.
There is also a powerful regulatory imperative: liquidity risk is now included
in the scope of Pillar II ICAAP (Internal Capital Adequacy Assessment
Process), and it requires quantitative measures and reporting, complemented
by improved monitoring and controls. The banks should consider putting in
place certain prudential limits to avoid liquidity crisis:
 Cap on inter-bank borrowings, especially call borrowings
 Purchased funds such as liquid assets
 Core deposits such as Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve
Ratio and Loans
 Duration of liabilities and investment portfolio
 Maximum Cumulative Outflows. Banks should fix cumulative mismatches
across all time bands
 Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign
currency sources.
 Intraday liquidity management can become an integral part of an improved
liquidity risk management. (It can achieve by industry best practice for
intraday cash reporting).
 Industry best practice for collateral reporting for liquidity management.

46. 42
 A central “payment tracker/adviser” platform providing transactional statuses.
 Banks need to establish advanced liquidity management and reporting from
market infrastructure such as, the growth in volume and value of transactions
settled through market infrastructure (high value payment system).
 Banks can develop their own liquidity analytics to focus on transactional data
rather than on balance information.
Information flows
Figure 4: Liquidity Analytics
Banks can increase their liquidity in multiple ways, each of which ordinarily
has a cost, including:
 Shorten asset maturities - This can help in two fundamental ways. First, if
the maturity of some assets is shortened by enough that they mature during the
period of a cash crunch, then there is a direct benefit. Second, shorter
maturity assets generally are more liquid.
 Improve the average liquidity of assets - Assets that will mature beyond the
time horizon of an actual or potential cash crunch can still be important
providers of liquidity, if they can be sold in a timely manner without an
excessive loss. There are many ways that banks can improve asset liquidity.
Securities are normally more liquid than loans and other assets, although some
large loans are now designed to be relatively easy to sell on the wholesale
Dashboard Report
Calculation engine
Dashboard
Transactional data
warehouse
Market Data Customer
Retail
Bank/divisio
ns
Settlement
systems
Correspondent
Banks
Branches

47. 43
markets, so this is a matter of degree and not an absolute statement. Shorter
maturity assets are usually more liquid than longer ones. Securities that are
issued in large volume and by large companies generally have greater
liquidity, as do more creditworthy securities.
 Lengthen liability maturities - The longer-term a liability, the less likely that
it will mature while a bank is still in cash crunch.
 Issue more equity - Common stock is roughly equivalent to a bond with a
perpetual maturity, with the added advantage that no interest or similar
periodic payments have to be made. (Dividends are normally paid only out of
profits and are discretionary.)
 Reduce contingent commitments - Cutting back the volume of lines of
credit and other contingent commitments to pay out cash in the future reduces
the potential outflows, thereby improving the balance of sources and uses of
cash.
 Obtain liquidity protection - A bank can pay another bank or an insurer, or in
some cases a central bank, to guarantee the availability of cash in the future, if
needed. For example, a bank could pay for a line of credit from another bank.
In some countries, banks have assets pre-positioned with their central bank
that can be used as collateral to borrow cash in a crisis.
The BASEL III liquidity frameworks breaks new ground with given the size
and breadth of the potential effects, policy makers have instituted Liquidity
Coverage Ratio (LCR) and Net Stable Funding ratio (NSFR).
LCR was introduced to increase banks resilience to an acute 30-day stress
scenario. The main motive was to shocks similar to 2007-08 financial crises.
The LCR is complemented by a structural funding ratio, the Net Stable
Funding Ratio, which is structured to ensure that long-term assets are funded
with a minimum amount of stable long term funding. The main motive is to
absorb long term contingencies.
4.1.4. INTEGRATION OF SUBSIDIARIES
Integration of subsidiaries can help parent banks in their bad time. A bank can
work on two models to integrate its subsidiaries:

48. 44
 Centralized Model: According to this model, parent bank and subsidiaries are
managed in an integrated manner. Funding, asset allocation, and risk
management are centralized in a manner to maximize their profitability. They
can together raise funds with least risk and they can bear surplus and shortfalls
together, with parent and subsidiaries helping each other.
 Decentralized Model: According to this model, parent bank and subsidiaries
operates differently. Funding, assets allocation and other activities will be
performed in a decentralized manner, i.e. the parent and subsidiary will acts as
two different entities, but risk management system and standards would be
integrated. The benefit from running differentially is; there will be some
investors who would be interested in funding the parent company and there
will be some investors who would be interested in funding subsidiaries. So,
they will have greater funding as compared to the centralized model.
If risk management will be integrated together, during crisis it will be
beneficial for both.
4.2. TACTICAL MEASURES
Tactical measures can play a significant role in improving short term performance of
a bank before going for a long term goal. Banks need to redefine their goals before
making any tactical move.
Banks can apply the following approaches for tactical measures;
4.2.1. SHORT AND LONG TERM FUNDING (LCR AND NSFR)
During the early “liquidity phase” of the financial crisis, many banks -
despite adequate capital levels – still experienced difficulties because they
didn’t manage their liquidity in a prudent manner. In response of this, Basel
committee introduced “Liquidity Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR)”. The objectivity of the LCR is to promote the short-
term resilience of the liquidity risk profiles of banks. It does this by ensuring
that banks to continuously maintain a stock of unencumbered high quality
liquid assets (HQLA) that can be converted easily and immediately in private
markets into cash to meet their liquidity needs for a 30 day calendar day
liquidity stress scenario. Now, the most important question arises that how can
bank achieve HQLA? According to BASEL III accord, banks need to keep
very safe, very liquid assets, including government bonds and cash held at

49. 45
central banks, are considered to be “Level 1 (cash, central bank reserves, and
certain marketable securities backed by sovereigns and central banks)” assets.
Safe and liquid assets of other types, including specified categories of private
securities, are considered to be in “Level 2 {Level 2A assets (certain
government securities, covered bonds and corporate debt securities), and Level
2B assets (lower-rated plain-vanilla senior corporate bonds and certain
residential mortgage-backed securities}” and are subject to haircuts of up to
50% on their value to represent the potential loss in a fire sale during a time of
crisis. “Level 2” assets may constitute no more than 40% of the total HQLA.
Figure 5: Tactical improvement of LCR
Banks can also monitor potential currency mismatch for the calculation of
LCR. Banks can use its assets as collateral during liquidity/funding stress
scenario and they can serve early warning indicators, if they found any
difficulties for liquidity. Banks can also focus on huge withdrawal of funding
because that can lead to liquidity problem.
LCR=
HQLA/TNCO
Possible decrease
of HQLA
Decrease
existing assets
Decrease total
net outflow
Non-
HQLA
Increase
HQLA
Refinancing of
purchased
HQLA
Increase existing
liabilities
Exchange
existing assets
Purchase
additional HQLA
Level 2
Level 1
Sell Repo
Short
Tenor
New
Liabilities
Extend
Tenor

50. 46
The Net stable funding ratio (NSFR) is a more structural measure which
promotes long-run resilience intended to ensure that banks hold sufficient
stable funding (capital and long-term debt instruments, retail deposits and
more than one year maturity wholesale funding) to match their medium and
long-term lending– to be able to survive an extended closure of wholesale
funding markets, banks have to operate with a minimum acceptable amount of
“stable funding” based on the liquidity characteristics of the bank’s assets and
activities over a one-year period. Also, NSFR is the ratio of “available
amount of stable funding (ASF) to required amount of stable funding
(RSF)”. The ASF is the bank’s current liabilities (equity and liabilities) that
are assumed to be available to the bank within one year, whereas the RSF
comprises the bank’s current assets and off balance sheet (OBS) exposures.
The NSFR is intended to deal with a broader problem, to prevent banks from
performing an excessive amount of maturity transformation by making too
many illiquid long-term loans and investments funded with volatile short-term
money. It is considerably more difficult to decide on the right metrics for this
function, since there is no consensus on the right level of maturity
transformation. If the NSFR is viewed as a one-year stress test, its designers
faced the difficult task of evaluating reactions over a one-year period of
liquidity crisis. A 30-day crisis scenario is much easier to construct, because
many of the potential reactions, such as raising equity, changing business
models, or selling units, are difficult to do in that space of time, especially
under adverse conditions. One year gives banks much more room to react and
the authorities a much longer period to work to alter the environment.
4.2.2. SHIFTING TO LESS RISKY SEGMENTS
 Reduction of derivative transactions: Bank participation in derivative
markets has risen sharply in recent years. A major concern facing
policymakers and bank regulators today is the possibility that the rising use of
derivatives has increased the riskiness and profitability of individual banks and
of the banking system as a whole instead of new regulation provided according
to BASEL III. There are three main elements to the costs that will be incurred
by OTC derivatives in future: new margin requirement, new capital charge
for exposures and other compliances costs, mainly resulting from

51. 47
additional reporting requirements. In addition to these cost, there may be
scenario of fall in revenue because of greater transparency. The structure
of derivative markets is set to change as a result of the reforms. Cost increase
will lead dealer bank to review the products they offer and possibly withdraw
from certain asset classes which deemed to be costly (or) look to increase
offering for asset classes where client demand is expected to be higher. This
will lead to a shift in the product mix offered by the dealer banks and as a
result usage, across the market. The increase costs for non-cleared products
could move some end users towards less precise hedges by using
cleared/standardized OTC derivatives in place of more expensive derivative,
leaving them with more risk on their own balance sheet.
Estimated additional
Cost (per euro 1
Million notional
Amount traded)
Additional cost for centrally cleared OTC derivative transactions
Initial margin + contribution to the CCP deafult fund
+ Additional cost arising from requiremnets for CCPs + Euro 10
Clearning fees
Capital charge for centrally cleared OTC derivatives transactions Euro 3
Trade, valuation and collateral reporting + compliance costs Euro 0.60
for trade repositiries + compliances costs for CCPs
Total additional costs Euro 13.60
Additional costs for OTC derivatives transactions that will not need to be
centrally cleared
Initial margin for non centrally cleared OTC derivatives transactions Euro 50
Capital charge for non centrally cleared OTC derivatives Euro 120
Trade, valuation and collateral reporting + compliance costs Euro 0.50
for trade repositiries + other compliances costs
Total additional costs Euro 170.50
Table 4: Overview of incremental costs for centrally cleared and no-centrally
cleared OTC derivatives transactions
We estimate that the proposed reforms for centrally cleared OTC derivatives
will lead to incremental transaction cost of Euro13.60 per Euro 1 million
notional. Assume the average notional for a cleared Euro-dominated interest
rate derivative is 110 million would translate into an average additional cost of
Euro 1,496 per transactions. While in the past, trade exposures to CCPs

52. 48
received a 0% risk weight, mark-to-market and collateral exposures to a CCP,
under new rule be subject to 2% or 4% risk weight. These new and higher
risk weights will apply to clearing members but may also to other financial
institutions under certain conditions, e.g. if they enter into a transactions with a
clearing member and the clearing member will complete an offset transactions
with the CCP. Capital charge for exposures to the CCP default fund will add to
the incremental cost of capital requirements. Capital charge for default fund
contributions will need to calculate either using the risk sensitive
‘hypothetical capital requirements’ approach or alternatively applying a
flat risk weight of 1250% to exposures to CCPs default funds.
In total, we estimates additional cost arising from compliance requirement
(daily valuation to trade repositories, collateral reporting, account segregation
and record keeping) to be fairly small- about Euro 0.60 per Euro 1 million
transactions. But this cost may increase if the size of notional amount will
increase and lead to higher capital cost for a dealer bank. OTC derivatives that
will not need to be centrally cleared will be subject to strengthen risk
management requirements, including the need to collateralize positions,
increased capital charge and additional reporting. We estimate that the
proposed reforms for not centrally cleared OTC derivatives will lead to
incremental transaction cost of Euro170.50 per Euro 1 million notional.
Assume, the average notional for a non-cleared Euro-dominated interest rate
derivative is 90 million would translate into an average additional cost of Euro
15,345 per transactions. Non-cleared OTC derivatives will be subject to a
capital charge to protect against variations in the Credit Valuation
Adjustment (CVA). Under the new requirements, financial institutions are
required to hold capital against potential falls in the market value of
counterparty exposures due to increase in Counterparty Credit Risk (CCR).
In effect, financial institutions need to finance more of their assets in order to
meet higher capital requirements. As a result of this reform, dealer bank may
decide to restructure their product offering and pull back from certain asset
classes which are deemed to be too costly (or) increase offering for assets
classes where client demand is expected to be greater. Also, bank can use
internal models for bilateral transactions could help in mitigate costs from

53. 49
margin requirements. However, this comes with the biggest challenge that
bank will face for non-cleared derivatives; the development of the require
model to calculate initial margin. But bank can develop models by two
approaches. Firstly, banks will look to develop their own internal models for
some product sets and submit them for required regulatory approval. Secondly,
we expect the emergence of market based solutions offering a standardized
model approach for some product sets. Common models have also some
operational benefits such as fewer collateralize disputes. These are new
challenges for banks and also it will lead to increase in capital requirement by
banks. Banks can respond to these challenges in an innovative and competitive
way. The larger dealer banks may opt for more defensive strategies in order to
prevent general erosion of client base and protect higher margin product lines.
The large dealer banks can look for alternative products, for example “future
markets” where margin requirements are low.
 Reduction of Securitization exposure: In India, Banks do investment in only
security receipt which received 13.5 % specific risk capital charge ( equivalent
to 150% risk weight according to new capital adequacy framework guidelines
by RBI). Since the security receipts are by and large illiquid and not traded in
secondary market, there will be no general market risk capital charge on them.
Still, banks need to avoid huge investment in security receipt to avoid risk
arising from it.
4.2.3. RISK SENSITIVE PRICING
Risk is at the core of banking. At the industry’s most fundamental, banks take
on risk, trade risk, price it, manage it, and ultimately generate a return to
investors who take a share in that risk. Similarly, the central function that
banks play in the economy is to provide credit to support the growth and
development of economies and societies.
It is in this context that RWA calculated by risk-sensitive internal models
provide a means to a much-needed end: an efficient mechanism to measure
and allocate credit. Where bank capital is linked to risk in a coherent and
robust way, it will be allocated in an effective manner, allowing economies to
grow in a long term sustainable and stable manner. If this is not done correctly,

54. 50
capital is misallocated across the national and international economy in ways
which will undermine the effective allocation and pricing of credit. In the
reaction to the crisis and the justified scrutiny of the banking industry and its
practices, it is concerning that the value of risk-sensitivity has been discounted.
The potential distortions of capital lacking risk sensitivity can also affect the
shape of banks’ portfolios, creating the risk of adverse selection. If banks hold
a flat level of capital for assets of all credit quality (or even according to a
partially granular measure that has a low sensitivity to risk), there is a risk that
they will progressively shift their portfolios towards the higher-risk sector,
over-pricing credit for well-rated counterparties and under-pricing it for the
more marginal counterparties. Risk-based capital is intended to ensure that risk
is priced realistically, so that the distortions of under-pricing a given category
of risk are minimized. A true risk-based approach requires a firm to price risk
appropriately internally by imposing an objective capital charge that relates to
the risk. By contrast, a non-risk-based approach, or a “simple” approach such
as Basel I, makes arbitrary risk assessments that necessarily under- or over-
price certain risks. Similarly, a “simple” measure such as a leverage ratio
ignores the differences among risks, creating incentives to take on the
maximum allowable risk for a given quantum of capital.
One of the key metrics of bank performance is their “Return on Capital”.
The Return metric is directly sensitive to the measure of capital used in this
calculation, and in particular to whether that is a risk-adjusted measure of
capital. For instance, a measure of the Return on Regulatory Capital under an
Advanced IRB (Internal Rating Based) approach would use capital that is
based on RWA and the bank’s target capital ratio, meaning it is in turn highly
sensitive to the inputs used in the calculation of RWA: PD (Probability of
Default), LGD (Loss Given default), EAD (Exposure at Default) and
Tenor/Maturity. We will take a hypothetical example to consider check risk
based price sensitiveness of loan in bank portfolio.
In each of these examples, the following assumptions have been made within
the Return on Capital calculations:
Target capital ratio equivalent to 10% of RWA
Cost: Income Ratio (or ‘Efficiency Ratio’) of 50%
Tax rate of 30%

55. 51
The implication what we can make by this example is absolutely central to the
concepts of risk-based pricing and effective risk-return performance
measurement. If the measure of capital is not risk-based, some significant
distortions and false incentives are instead created, with a bias towards weaker,
riskier assets. The capital measure with no risk sensitivity is reflective of Basel
I, the Basel II Standardized Approach for entities without external ratings, and
the leverage ratio. If the measure of capital used is not risk-sensitive, the
returns metric will merely reflect the impact of the spread earned (i.e. the
Gross Revenue), encouraging banks and their staff to concentrate their efforts
on weaker-rated borrowers. The Basel II Standardized Approach brings a
very moderate measure of risk-sensitivity into the equation, but without
reflecting the full risk profile, and still with some anomalies given the blunt
nature of the risk-weights applied. However, a risk-sensitive capital view
(with regulatory capital based on IRB or economic capital) reflects the risk-
return equation much more accurately, and supports more appropriate
incentives.
So, it is advisable to bank use Advanced IRB to make out most of its capital.

56. 52
Indicative equivalent
rating
A+ A- BBB BB BB- B+
Risk
Variable
EAD 10,0
00,0
00
10,000,
000
10,000,0
00
10,00
0,000
10,000,
000
10,000,
000
PD 0.05
%
0.10% 0.25% 1.00% 2.50% 4.00%
LGD 50% 50% 50% 50% 50% 50%
Expected
Loss (EL) 0.02
5%
0.050% 0.125% 0.500
%
1.250% 2.000%
Market spreads 1.00
%
1.50% 2.00% 3.50% 4.50% 5.50%
No Risk
Sensitive
Risk -
weight
100.
0%
100.0% 100.0% 100.0
%
100.0% 100.0%
RWA 10,0
00,0
00
10,000,
000
10,000,0
00
10,00
0,000
10,000,
000
10,000,
000
Return on
capital 3.41
%
5.08% 6.56% 10.50
%
11.38% 12.25%
Standard
ized – If
externall
y rated
Risk –
weight
50.0
%
50.0% 100.0% 100.0
%
150.0% 150.0%
RWA 5,00
0,00
0
5,000,0
00
10,000,0
00
10,00
0,000
15,000,
000
15,000,
000
Return on
capital 6.83
%
10.15% 6.56% 10.50
%
7.59% 8.17%
Advance
d IRB
approac
h
Risk –
weight at
commence
ment
40.4
489
%
57.5527
3%
88.98512
%
148.8
57%
184.25
281%
203.89
692%
RWA at
commence
ment
4044
890
575527
3
8898512 14885
700
184252
81
203896
92
Average
risk –
weight
over full
loan life
24.4
81%
36.7564
2%
60.94566
%
112.8
1093
%
148.59
541%
169.43
514%
Ave. RWA
(loan life)
2448
100
367564
2
6094566 11281
093
148595
41
169435
14
Return on
capital
13.9
4%
13.81% 10.77% 9.31% 7.66% 7.23%
Table 5: Corporate Loan pricing

57. 53
4.2.4. SHIFTING TO HIGHER VALUE CLIENT
The regulatory and market changes have led to increased competition among
suppliers of financial service products. Now consumers demand increasingly
higher levels of service quality. For banks, staying competitive in the new
market environment means not only offering products at reasonable prices but
also tailoring these products to meet individual customer’s needs.
Banks can tailor its product according to customer’s need. Assume that AAA
rated company is need of “10 million” working capital to purchase new
machine and it approached bank “X” and bank “Y”. The rating (both internal
and external) of this company is very good and can be profitable for banks
which will lend to this company. Bank “X” is providing loan at the interest of
“K%” and bank “Y” is providing loan at the interest of “K – 0.75%”, which
will suit the company due to less interest rate comparable to bank “Y”
(Assuming bank Y is the biggest bank). Company will borrow from bank “Y”
since company is paying less interest. This is a common example. There are
many products (or) services which bank can tailor according to customer credit
worthiness and customize to get competitive advantage in market.
4.2.5. DIVERSIFICATION OF FUNDING MIX
The regulatory changes are one of the important factors for banks to adjust
their funding mix in recent time. Diversification of funding profile is
depending on terms of investor types, regions, products and instruments is an
important element. Basically, banks can obtain funding using a variety of
instruments: besides issuing bonds on the capital market, banks rely, for
example, on customer deposit, central bank financing, and the interbank
market and equity capital. Long-term debt securities issued on the capital
market include unsecured and secured bank bonds. In general there is no
typical bank funding profile: the decision on which funding instruments to
choose depends on many factors such as the business model, the current
market situation and the individual company situation. Banks are, however,
always actively seeking the optimum funding mix. But bank can increase
source for funding in the area of capital market & equity, retail client and

58. 54
transaction banks because these are the most liquid source of funding.
Introduction of Basel III also affected funding mix of banks and banks need to
reduce the mismatches between the maturity structure of assets and liabilities
in banks “deposit and lending activities”.
4.3. STRATEGIC MEASURES
Achieving its short term goal, banks can plan action for its long term commitment
and can re-define its business plan to differentiate itself from their competitor.
Banks can apply following approaches for strategic measures;
4.3.1. BUSINESS MODEL
A business model embodies nothing less than the organizational and financial
‘architecture’ of a business. It is not a spread sheet or computer model,
although a business model might well become embedded in a business plan
and in income statements and cash flow projections. But, clearly, the notion
refers in the first instance to a conceptual, rather than a financial, model of a
business. It makes implicit assumptions about customers, the behavior of
revenues and costs.
Figure 6: Elements of business model
Select technologies
and features to be
included in the
product/services
Determine benfits to
the customer from
consuming/using
product/services.
Identify market
segements to be
targeted
Confirm available
revenue stream
Review the process
on a frequently basis
and capture the
value

59. 55
Banks can re-address its business model and can provide technologies and
features which can include in the product/services and can enhance banks
performance as well as it will reduce operational cost of banks. There are
many features which bank can provide to customer but we will discuss on a
few factors which can revolutionize banking sector. India's rural economy has
been growing with disposable incomes rising, especially in rural areas where
spending power accounts for 57% of the $780 billion spent annually compared
to 43% in urban areas. However, 60% of India's rural population, compared
with 40% overall, does not have a bank account. In spite of a robust banking
infrastructure and a government aim to include the rural economy into the
mainstream, only 5% of 600,000 villages have a commercial bank branch and
just 2% of people living in rural India have a credit card.
The simplest and most cost-effective way to each out to this huge untapped
market is through ATMs. At present there are only 150,000 ATMs deployed
in the country and are expected to reach 400,000 by 2017. But the cost of
setting up bank branches or ATMs is still too high and there are still a lot of
red tape and conservative attitudes in the banking business itself. Rural India’s
problems are scarcity of power, accessibility is poor, crisp notes are rare and
the languages and dialects vary. So, for this situation banks can reach out to
these unreached rural areas by using solar powered ATMs. Solar powered
ATMs which use only up to 100 watt. It can also function in temperatures up
to 122 degrees Fahrenheit (50 degrees Celsius) with no air-conditioning. It
stacks notes vertically instead of horizontally so cash "fall" out of the machine
rather than dispensed. Its lean design and few moving parts make it less
susceptible to breakdown.
Second, banks can use aggressively tablet banking service. The tablet will be
fully loaded device which has application form, banks videos explaining their
product and services. Under this service, banks sale staff will visit the
customer at their home and using the tablet get complete formalities for
account opening formalities like details of KYC and photographs of applicant.
Banks can also use tablet service for “home loans” and this will provide
convenience and time saving and also it will reduce cost for documents and
customer will account number through SMS/e-mail alerts.

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Third, banks can also provide e-Locker, a virtual online locker for its wealth
customers. The locker is available through its internet banking platform for
customers who want to store electronically scanned copies of important
documents like legal agreements, policy documents, degree certificates and
bank statements in various formats.
4.3.2. COST REDUCTION
The most successful banks are not necessarily those making the deepest cost
cuts. Instead, they focus on optimizing their cost base by not just cutting costs,
but by cutting the right costs. They focus on short-term cost cutting efforts
alongside longer-term strategic cost savings. So how can banks reduce their
cost? There are two approaches that banks can adopt which explained below;
 Rationalization of branch structure: Banks can rationalize its branches by
checking the staff to customer ratios and can shift staffs to those branches
where customer crowd is more comparable to where it is not. Having the right,
strategic staffing model in place will help maximize your staff and reduce
operating costs. Even bank can sale that business unit if it is not generating
target revenue. So, how can bank achieve this? There are few steps which bank
can follow. As a first step, banks need to carry out a detailed customer
demographics analysis to understand their target customer profile, their
banking behavior and profitability per customer. As a second step, banks
should use the information in the demographics analysis to determine the
optimal ratio between the different types of branches needed to achieve a
differentiated branch network. Finally, banks should rationalize the number of
branches based on business parameters such as branch performance, customer
profitability and strategic. Based on this following information, banks can
work accordingly their requirement.
 Rationalization of products: There are thousand types of products/services
which banks are providing to customer. Banks can work Pareto Principle
(80:20 rules), which typically provide implication to bank that 80% of profit
(or) sales coming from the best 20% of the products. This happens because
almost all banks keep adding products to the portfolio without removing worse
performing products and this lead to overloading product operations. Based on

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the result after using this principle, banks can remove those products which are
not generating expected revenues (or) customers are not interested.
4.3.3. ROOM FOR CLIENT MANAGEMENT
While Banks are getting more and more pressure from customer’s increasing
demand, highly competitive market and strict regulations – in the current
environment, understanding customer behavior, attitudes and requirements is
more vital than ever for banks’ strategic thinking, operational planning and
day-to-day customer treatment. So, how can bank overcome from these issues?
Banks can use following steps which may help banks to give more
engagements towards client management.
 Banks need to think beyond ‘one-size-fits-all’ strategy to cater to customer’s
increasing demand. Customers also will leave an institution for another based
on getting the services they want and the best price available for it, so
relationship pricing and product bundling become ever more important.
Banks should look at products and pricing based upon a total customer view
and respond to the value that customers bring to the bank across the spectrum
of rates, fees, features and services.
 Though there are many challenges in integrating cross-lab data like
extracting data from multiple disparate systems, existence of duplicate records
in business applications/ databases and data sharing impediments due to opt-
out policy/other regulatory requirements, it is crucial to have a 360 degree
view of customer which will help to get a holistic picture of a customer’s
demographics, engagement, need and preferences. This knowledge enables
organizations to precisely target products and services to current customers,
acquire more profitable customers, reduce marketing costs, improve customer
satisfaction and maximize lifetime value.
 Sophisticated customer segmentation is the key to cater to individualized
needs and should be based on standard banking metrics – tenure with the bank,
number of accounts, balances of accounts and loans, frequency of interaction
with the bank, channel preferences along with psychographic (values,
attitudes, lifestyles), behavioural (usage rate, price sensitivity, brand loyalty,

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and benefits sought) and demographic variables (occupation, income, and
family-status).
 Banks can use real-time events and deep customer insight to offer cross-
channel marketing campaigns where “moments-of-truth” (wedding, home
purchase/sale, new job, stock transactions, etc.) are acted on as a way to
deepen customer relationships - to determine the next best action, be it an
offer, channel, message, piece of content etc. The more customized
product/service offering, the higher are the barriers to switching banks.
 In today’s hyper-competitive market, banks need to move beyond a “one-size-
fits-all” reward model particularly for the most profitable clients. They need to
design a system which let profitable customers enjoy premium benefits and
redeem rewards points.
 In the digital age, customers demand more self-service options and any-time,
anywhere service. So expanding customer self-service, case management,
dispute management and event-based decision-making can be perceived
as better customer care, while lowering operational costs and increasing
effectiveness. However, banks should continue to make compelling offers as
incentives for customers to use lower cost channels.
 Banks should try to engage consumers through digital channels and advance
its leadership in the digital space as well as expand its social media
engagement on Facebook, Twitter, Pinterest and LinkedIn. Though there
can be several roadblocks and complications – like online account opening is
expensive on per-account bass - however, prices for new delivery channels
always commoditize as usage grows. It is a myth that importance of branches
will diminish as the digital channel usage will increase on the contrary, if
branches are tightly integrated with other channels, that promote and support
them and that quickly finish transactions started there will be more successful
than ever.
 The Big data is the new disruptive technology for changing the game. Big
data capabilities provides banks the ability to understand their clients at a more
granular level and more quickly deliver targeted personalized offers. Being
able to anticipate customer needs and resolve them before they become
problems allows banks to deliver timely, concise and actionable insight to

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contact center agents. This can lead to increased sales, improved customer
satisfaction and a reduction in operating costs. Fighting fraud, financial crimes
and security breaches, in all forms, is among the most costly challenges facing
the finance industry. Big data technologies provide a scalable, integrated,
secure and cost effective platform to more quickly prevent, detect and mitigate
internal and external frauds. Big Data Benefits include: Reduced costs of fraud
screening and monitoring fewer false positives, reduced cost of fraud
investigations, reduced payment fraud losses, real time fraud detection and
mitigation, optimized offers and cross-sell.
 Banks should seek to attract and retain customers with a compelling multi-
channel experience across all touch points (branches, online, mortgage and
investment advisors, etc.). Technology continues to rapidly change the way
consumers behave and interact. Virtual channels are becoming more relevant,
with the increasing penetration of high-speed Internet connectivity and Web-
enabled mobile devices allowing consumers to spend more time online. Bank
customers will not only continue to use a mix of channels, but will use non-
branch channels for increasingly complex banking transactions While retail
branches remain a core banking channel, research shows that customer traffic
is in some cases flat or declining, as customers come to rely more heavily on
digital/phone channels.
 Hip, modern, and fun. That’s exactly the vibe many of the nation’s banks are
trying to achieve as they reimagining their branches and try to lure more
customers into brick-and-mortar offices. Withdrawals and deposits aren’t
attracting customers to brick-and-mortar offices anymore, so banks are turning
to perks like coffee bars and yoga to keep an important gateway open.
4.3.4. ACTIVE APPROACH TO BALANCE SHEET MANAGEMENT
Banks need to actively focus on balance sheet management to optimize its’
capital. Banks can take following steps to have an active approach to balance
sheet management;
 Interest rate risk management: In the banking book, interest rate risk
management is the area that has probably the most attention within banks.
There will be re-pricing risk, basis risk, yield curve risk etc.

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Re-pricing risk is the differences in maturity (Fixed rate) and re-pricing
periods (Float rate) for assets versus liabilities and off balance sheet items.
Yield curve risk arises from differing dispersion of assets, liabilities and off
balance sheet items could leave exposures to twist of yield curve (with no
change in average rates). Basis risk arises from positions with same maturity
but priced off different market indicators rates.
Banks need to use re-pricing gaps to earning (based on a mixture of
contractual pricing) and economic value (duration gap and simulation). Bank
can also use Value at risk techniques to measure interest rate risk.

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 Liquidity risk management: Certainly the painful experiences and losses
throughout the financial crisis have forced the banks to make strategy to
safeguard itself from liquidity problems. Basel committee has already given
detailed guidance for implementation of LCR and NSFR to avoid short and
long stress period scenario.
Figure 7: Liquidity Risk Complexity
LCR and NSFR will ensure that banks will not face liquidity problems. LCR is
in transition period and banks need to implement it completely by 2018.
Banks can also use cash flow forecasts using stressed (or) expected flow
measures for liquidity risk. In measuring liquidity risk, banks can focus on
factors included in liquidity risk such as contractual maturities, effective
maturities, types of products, types of customers,
Idiosyncratic Liquidity Risk Market Liquidity Risk
Limitation of
funding and/or
increase of funding
cost due to a down
rating
Earlier than
expected call of
deposits as well as
drawing of
committed credit
lines
Deferred cash
inflows
Sell/buy of
assets/liabilities
with high discount
or premiums to
close the liquidity
gap
Risk of taking
losses due
insufficient market
liquidity
Call
Risk
Scheduling
Risk
Credit
Spread
Risk
Product
Risk
Market
Liquidity
Funding Risk
Net cash outflows
Liquidity Reserve
Illiquidity/Insolvency

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geographies/countries/regions etc. Also, banks need to strengthen its
collateral management. Banks have to have a clear idea regarding collateral in
order to able to deal effectively with liquidity events that may require using
such assets. It is an area where banks need to improve and apply greater rigour
in knowing precisely which assets can be quickly liquidated and at what price.
Bank can use pre-defined stress testing scenario. In performing stress test
banks can take factors such as repayment, drawdown, non-maturing
product profiles, replicate portfolios, credit events, withdrawal of funding,
contingent liabilities, haircuts etc.
 Capital management: The main activities performed by the capital
management unit are capital planning, capital stress testing, capital allocation
and setting the cost of capital. Banks and its management need to cautious
while doing capital management and always use diversification method to get
a better return (risk and return analysis). Management can use Beta analysis,
Sharpe ratio, Regression analysis etc. before taking into consideration for
allocation of capital. Banks can also check rating, creditworthiness etc. before
making any such investment.
 Fund transfer pricing: The importance of FTP has been highlighted as it
underpins the interest margin and profitability results and, thus, has a
significant impact on business unit performance measurement and business
behaviour. It has been recognised that aspects like pricing for liquidity,
optionality, customer behaviour and trading portfolios require more attention
to ensure that underlying risks are properly reflected within pricing and
performance measurement practices. The factor which can affect FTP rates are
bank deposit rates, bank loan rates, Government bond yield, Interbank money
market/swap rates, funding liquidity, asset liquidity, option pricing, political
adjustment etc. Banks need to keep an eye on these factors and now-a-days
political adjustment keep an important role for affecting FTP rates. So, banks
need to focus on this factor carefully.
 Systems: Banks still tend to operate with a patchwork of legacy systems set up
to manage different aspects of the balance sheet (liquidity risk, interest rate
risk, etc.), but significant changes are needed. With different systems, any kind
of integrated balance sheet management simulation and stress testing is

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virtually impossible. But still banks will need to upgrade to a more integrated
approach, allowing planning and stress scenarios to be carried out across all
aspects of the balance sheet.

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5. CONCLUSIONS
Pre-crisis banks were calculating its capital charge according to Basel II accord. Basel II
which doesn’t indicate worse result can arise from the CCP and CVA hidden charge.
The biggest reason of the crisis was counterparty risk related loss happened from CVA
volatility. Only one third of the loss was actually happened because of the counterparty
default. During that era, banks were tending to neglect counterparty credit risk (CCR)
because of small size of derivative contracts (or) higher rating of the companies (such as
AAA or AA rated).
After the crisis BCBS has come up with a new accord, which is known as BASEL III
accord. Basel III has not only changed the game but also it makes sure that bank will not
repeat those mistakes which have already done by them. It came with a door open for
banks to decide their own strategy for calculation of capital charge with taking into
consideration of factors such as probability of default (PD), Loss Given Default (LGD),
Maturity (M), Exposure at Default (EAD) etc.
Models PD LGD Maturity EAD
Standardized Regulator
determined-
risk weights
Regulator
determined-
risk weights
Regulator
Determined
Regulator
Determined
Foundation-
IRB
Internal Model Regulator
Determined
Regulator
Determined
Regulator
Determined
Advanced-IRB Internal Model Internal Model Formula
Provided
Internal Model
Table 6: Calculating risk weights and EAD under each of the three approaches
It is advisable for banks after the Basel III accords, which have provided more space for
calculation of CCR and CVA charge (For Advanced models banks have to take permission
from regulatory authority). Banks can use any other method which can help them to save
their capital. In section 2, it has shown how bank can save capital for CVA charge
calculation by following IMM method. Also, it implied that CVA is approximately 25%
of CCR as shown in section 2. So, it is better if bank can approach IMM method and try to
reduce this 25% capital to an extent of 20% in initial period and then it can reduce
further after getting more expertise in calculating CVA charge by this method.

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There are also following approaches which bank can adopt to reduce CVA charge which is
given below;
 Geography – Location of business of counterparty. Consider Kerala, we know Kerala is
famous for strike and suppose bank counterparty has business in such places. Business of
your counterparty can affect because of this reason and it can also show in their MtM and
it can lead to high CVA. So banks and financial institutions have to carefully observe all
news related to counterparty and on day-to-day basis.
 Industry – Suppose textile industry is not performing well and you are going for contracts
with a counterparty which belongs from same industry. So it can lead to high CVA charge
because your counterparty would default (Since probability is high so CVA will high),
since that industry is not performing well.
 Macroeconomic factors - Banks and financial institutions have to analyses carefully
about macroeconomic factors before going for a contract with counterparty. Need to check
that particular news related to macroeconomic factor will affect counterparty. If yes, then
it will increase CVA.
Basel III also increased burden for banks in the form of introduction of Capital
Conservation Buffer (CCB), Countercyclical Capital Buffer (CCB) and Global
Systematically Important Banks (G-SIBs). Since it will implement in phase out manner,
banks need to start practicing for these cushion of capitals from now onwards only , unless
it will lead an extra burden on banks treasury and can attract penalty.
BCBS also came with a new approach (LCR & NSFR) to make sure that banks will not
face liquidity problems because of stress scenario which can be for acute 30-days stress
period or over a year time horizon. Since LCR and NSFR are very tactically introduction
by BCBS in regulatory framework, banks need to cautious.
New regulatory framework (Basel III) also introduced additional capital charge for
“Reciprocal Cross Holding” and “Investment in own shares”. Since it will attract
additional capital charges, banks need to reduce its investment in these assets to save
capital.
Also, Basel III made sure that it’s time for banks to improve its data quality. Data quality
is a global issue and not just restricted to any geographical or economic jurisdiction. Data
impurity can lead to time and cost. The basic issue as regards the computerization of the
Indian banking system was that we migrated from the branch banking software to a core
banking solution in which every activity/transaction processing is centralized. At the time

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of migration, since a variety of platforms were used for capturing different business
activities, the data was naturally non-standard and when this data was imported ipso facto,
as part of core banking solution, with a bit of data sprucing, the non-standard data needed
some ‘treatment’ before it could be used across all activities. The problem became more
complex as the banks were migrating to a non-data center environment; without any
business process re-engineering. Since banking business must at all times ensure
accuracy of credit risk exposure calculations. This becomes all the more challenging for
international banks that have global footprints. Several jurisdictions have made it a
requirement to certify the data quality. Banks under certain jurisdictions need to self-
certify the accuracy, completeness, and appropriateness of Basel-critical data.
In the context of Indian banking system, these poor qualities of data lead to higher cost in
banking operations. Additionally the RWA is often influenced by the IT infrastructure,
data availability and data quality. For instance the correct mapping of transactions to
the asset classes or the quality of PD and LGD estimations often depend on the
availability and quality of data.
The requirements of Basel III and the interdependencies among the various matters under
regulation lead also to increased complexity of data requirements, especially in the area of
counterparty credit risk and the new liquidity ratios. Data availability, data
completeness, data quality and data consistency can be critical for a successful
implementation of Basel III. That is the reason banks need to re-engineer its process for
data purity.
The accounting standards may have a material impact on RWA and they may also
explain some of the RWA differences between banks.
There may be chances of Changing of the business model might also affect the
organizational structure, as some units might be reduced or merged with others while new
units are established. Banks can rationalize its branches which are not generating target
revenue and instead of that can open a new section (or) office for CVA and CCR desk
to completely focus for the valuation and pricing for derivatives.
Having a strong regulatory framework, banks have an enough time to work on this
framework. An optimal treasury function can work on these frameworks consistently and
reduce financial risks and financial costs of a bank.

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6. GLOSSARY
 BCBS: Basel Committee on Banking Supervision
 NPA: Non-performing assets; an asset is tagged as non- performing when it ceases to
generate income for the lender
 BASEL guidelines: Recommendations on banking laws and regulations issued by
the BCBS.
 RWA: Risk-weighted asset (also referred to as RWA) is a bank's assets or off-
balance-sheet exposures, weighted according to risk. This sort of asset calculation is
used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a
financial institution.
 NOVATION: the substitution of a new contract in place of an old one.
 EE: Expected Exposures is calculated at each time step as he mean of the potential
positive exposures profiles.
 EPE: Expected Positive Exposures is calculated as an average of EE throughout the
one year horizon.
 EFFECTIVE EE: is calculated at each time step as the maximum of all absorbed EE
at each future time step.
 EFFECTIVE EPE: is calculated as an average of effective EE throughout the one-
year horizon.
 CREDIT CONVERSION FACTOR: Following the new capital adequacy rules for
financial institutions: percentages designed to convert the off-balance sheet items to
credit equivalent assets which are then placed in the respective risk-based categories,
therefore they are converted to on-balance sheet equivalents. Hence, the face value of
item requires to be first multiplied by the relevant conversion factor to arrive at risk-
adjusted value of off-balance sheet item.

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7. BIBLIOGRAPHY/WEBLIOGRAPHY
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Bangalore, I. (1994). Capital Asset pricing model.
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BIS. (2014). Basel III: The Net Stable Funding Ratio.
capgemini. (2013). Basel III: Comaprison of standardized approach and advanced approach.
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financale, I. (2012). Basel III challenges.
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KPMG. (2011). Basel III: Issues and Implications.
Morgan, J. P. (2014). Leveraging the Leverage Ratio.
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Shapiro, P. A. (2012). The Capital Asset Pricing Model (CAPM).
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Swift. (2011). Managing liquidity risk.
Transformation, T. C. (2013). Credit Valuation Adjustment:The Devil is in the Detail.
USA, S. a. (2010). Pricing Counterparty Risk at the Trade Level and CVA allocations.
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