- Credit risk is the possibility of losses associated with the reduction in the credit quality of borrowers or counterparties.
Credit risk forms – direct lending, Bank Guarantee, Letter of Credit, treasury operations, securities trading businesses, cross border exposure, etc.
- Market risk arises from adverse changes in market variables. Market risk forms – liquidity risk, interest rate risk, foreign exchange rate (forex) risk, commodity price risk, equity price risk, etc.
- Operational risk (aka legal risk, administrative risk, settlement or payment risk) arises from human or technical errors.
- Under the Basel I accord, only the credit risk element was considered and the minimum capital requirement of capital funds was fixed at 8 % of the total risk weighted assets.
- In India, banks are required to maintain a minimum capital to risk weighted asset ratio (CRAR) of Basel II has 3 pillars –
- minimum capital requirements
- supervisory review process
- market discipline
- The capital base of the bank consists of the following 3 types of capital requirements: Tier 1, Tier 2 and Tier 3.
- The total of Tier 2 (supplementary) elements will be limited to a maximum of 100 % of the total of Tier 1 capital.
- Subordinated term debt will be limited to a maximum of 50 % of Tier 1 capital.
- Tier 3 capital will be limited to 250 % of a bank’s Tier 1 capital that is required to support market
- Shareholder’s equity and retained earning consists of Tier 1 capital while supplementary refers to Tier 2 capital.
- The sum of total of Tier 2 and Tier 3 capital should not exceed the total of Tier 1 capital.