Risk Management Financial Institution

Question: Discuss about theRisk Managementfor Financial Institution. Answer: Introduction Capital requirement is an important aspect for a bank or any financial institution. Capital requirement refers to the amount of money or capital that a bank or a financial organization needs to hold as per the rules and regulations of the financial regulators. This capital requirement is expressed as equity or capital adequacy ratio that must be obtained as the percentage of risks. This is a crucial factor for all the banking as well as financial organizations (Morris and Shin 2016). As discussed earlier, there is a need for a minimum credit risk capital for the banking and financial organizations. There were different rules and regulations regarding the requirement of this credit risk capital as per Basel (bis.org 2017). It has been seen that the rules and regulations about the credit risk capital has been changed a lot from Basel Accord to Basel II to Basel III. It can be observed that there are many variables in the process of assessing the credit risks in the banks and other fina ncial institutes as they used to use the process of risk-weighted to measure the risks of the organization (pstat.ucsb.edu 2017). This is because there are several portfolios with similar risk profiles. There were many drawbacks in that credit risk capital measure. This is the reason the committee decided to come up with a more reliable and standardized approach. The committee has proposed a more standardized approach that would define the credit risk capital requirements for the banks and the financial organizations. The main aim of this proposal was to minimize the variation in the risk-weighted methods. Another major aim of these changes is to minimize the exposure of credit capital risks for the banks and other financial organizations. The major concern about the current Basel approach is that current standardized approach is not sufficiently sensitive of risks. The current standardized approach of credit risk capital requirement is unable to consider many important issues. These are some of the loopholes of this process. Some national discretion has been seen in this current process as they are incompletely defined; there are some cases where they are not defined at all. On the other hand, there is not enough clarity in this process. Some specific changes have been made in the recent credit risk capital requirement process. In the current credit risk capital requirement process, the internal estimates have been included. On the other hand, the credit risk mitigation framework approach has bee n adopted. The present committee has identified that to allay level-playing-field concerns, the amount of risks and national discretion in the credit risk capital requirement must be removed. The current committee has made some important recommendations for the new credit risk capital requirement. It is recommended to the banks and financial organizations to use higher counterparty risk weight. This is how the credit risk capital requirement is changed (Mariathasan and Merrouche 2014). Some major changes can be seen from Basel II to Basel III. In the Basel III norms, more risks are taken into consideration for the banking and other financial institutions. Because of this, the banks need to increase the minimum requirement of capital. In addition, as per the Basel III norms, the amount of debt that a bank can own has decreased. In order to avoid the crisis of capital at the time of emergency, Basel III act has instructed the banks and other financila organizations to hold a minimum amount of cash in their hands. This can be measured as the Liquidity Coverage Ratio (LQR) that is the liquid money to total assets. As per Basel II, credit risks can be calculated with the help of three approaches. They are standardized approach, the IRB approach and the advanced IRB approach. The banks and the other financial organizations can chose their risk calculation process from these three approaches based on their sophistication. Many similarities can be seen between the standardized approach and the Basel I approach. However, the main difference is the process for the calculation of risks weights. In this process of standardization approach, the capital requirement is determined based on the external ratings (Vallascas and Hagendorff 2013). In the process of the Internal Rating Bases approach, the capital requirement is calculated based on the one-year value at risk. In this process, the capital requirement is calculated with the formula of Value at risk-the expected loss. In this process of internal rating approach, the banks and the other organizations use to supply their own calculations of probabili ty of default (McNeil, Frey and Embrechts 2015). Lastly, in case of advanced internal rating based approach, the banks and the other financial organizations use to supply the process of the estimation of probability, the default exposure, and the default of loss and the maturity of the exposure. These are the main differences among these three major approaches. From the above discussion, it can be seen that there are major differences between the standardized approach and the internal rating based approach. However, there are little differences between the internal rating based approach and the advanced internal rating based approach. It can be said that the advanced internal rating based approach is an improved version of the internal rating based approach. References Approaches to Credit Risk in the New Basel Capital Accord. (2017). [online] pstat.ucsb.edu. Available at: https://www.pstat.ucsb.edu/research/papers/benzin_trueck.pdf [Accessed 23 Feb. 2017]. Basel Committee on Banking Supervision. (2017). [online] bis.org. Available at: https://www.bis.org/bcbs/publ/d307.pdf [Accessed 23 Feb. 2017]. Mariathasan, M. and Merrouche, O., 2014. The manipulation of basel risk-weights.Journal of Financial Intermediation,23(3), pp.300-321. McNeil, A.J., Frey, R. and Embrechts, P., 2015. Quantitative risk management. Morris, S. and Shin, H.S., 2016. Illiquidity component of credit risk.International Economic Review,57(4), pp.1135-1148. Vallascas, F. and Hagendorff, J., 2013. The risk sensitivity of capital requirements: Evidence from an international sample of large banks.Review of Finance,17(6), pp.1947-1988.