Role of RBI in Risk Management in Banks
There is body called Board for Financial Supervision (BFS) which works under the control of RBI and supervises all the financial institutions except Stock Markets (regulated by SEBI) and Insurance (regulated by IRDA).
Following are the Risk Management Frameworks
1. BFS has been using CAMELS rating to evaluate the financial soundness of the Banks. The CAMELS Model consists of six components namely Capital Adequacy, Asset Quality, Management, Earnings Quality, Liquidity and Sensitivity to Market risk. This framework was recommended by Basel Committee on Banking Supervision of the Bank for International Settlements (BIS).
2. Basel norms (Basel 1, Basel 2 and Basel 3) are being implemented for Risk Management.
3. PCA (Prompt Corrective Action) to take corrective actions.

Camels Framework
The CAMELS rating system is a recognized international rating system that bank supervisory authorities use in order to rate financial institutions according to six factors represented by the acronym "CAMELS." Supervisory authorities assign each bank a score on a scale, and a rating of one is considered the best and the rating of five is considered the worst for each factor. The six factors in Camels framework are:
C- Capital Adequacy: Examiners assess institutions' capital adequacy through capital trend analysis. To get a high capital adequacy rating, institutions must also comply with interest and dividend rules and practices. Other factors involved in rating and assessing an institution's capital adequacy are its growth plans, economic environment, ability to control risk, and loan and investment concentrations.
A – Asset Quality It determines the quality of loan’s given by the bank. Loan given to people who are not financially sound may be defaulted by them. The factors considered are:
-The appropriateness of investment policies and practices
-The investment risk factors when compared to capital and earnings structure
-The effect of fair (market) value of investments vs. book value of investments
M- Management: Management assessment determines whether an institution is able to properly react to financial stress. This component rating is reflected by the management's capability to point out, measure, look after, and control risks of the institution's daily activities. It covers the management's ability to ensure the safe operation of the institution as they comply with the necessary and applicable internal and external regulations.
E- Earnings: An institution's ability to create appropriate returns to be able to expand, retain competitiveness, and add capital is a key factor in rating its continued viability. Examiners determine this by assessing the company's growth, stability, valuation allowances, net interest margin, net worth level and the quality of the company's existing assets
L- Liquidity: To assess a company's liquidity, examiners look at interest rate risk sensitivity, availability of assets which can easily be converted to cash, dependence on short-term volatile financial resources.
S- Sensitivity: Sensitivity covers how particular risk exposures can affect institutions. Examiners assess an institution's sensitivity to market risk by monitoring the management of credit concentrations. In this way, examiners are able to see how lending to specific industries affect an institution. These loans include agricultural lending, medical lending, credit card lending, and energy sector lending. Exposure to foreign exchange, commodities, equities and derivatives are also included in rating the sensitivity of a company to market risk.

Basel Norms
At the end of 1974, the Central Bank Governors of the Group of Ten countries formed a Committee of banking supervisory authorities. As this Committee usually meets at the Bank of International Settlement (BIS) in Basel, Switzerland, this Committee came to be known as the Basel Committee. The Basel committee has introduced three Basel Norms which are known as Basel Accord. These Basel Norms are called Basel 1, Basel 2, and Basel 3.

Basel 1
Basel I mainly catered to the credit risk that the risk of borrowers defaulting on Loans/Bonds/debt etc.
Basel1 defines Capital Ratio = (Tier 1 Capital + Tier 2 Capital)/Risk Weighted Assets.
Tier 1 include (equity capital plus disclosed reserves minus goodwill).
Tier 2 includes (asset revaluation reserves, undisclosed reserves, general loan loss reserves, hybrid capital instrument and subordinated term debt).
The denominator of the Basel I formula is the sum of risk-adjusted assets. There are five credit risk weights: 0 per cent, 10 per cent, 20 per cent, 50 per cent and 100 per cent.
1. Risk weight would be 0 % for government or central bank claims.
2. 20 % for Organization for Economic Cooperation and Development (OECD) inter-bank claims
3. 50 % for residential mortgages
4. 100 % for all commercial and consumer loans.
As per Basel I norms the minimum capital ratio should be 8%. India RBI recommends it to be 9%. So any bank in India having capital ratio of less than 9% is deemed to be risky.
Numerical1: For example if a company has the following details then find the Capital Ratio
Equity Capital = 100
Loan Loss Reserves = 50
Loan given to Consumers = 1500
Loan given to govt = 300
Solution:
Capital Ratio would be = 100 (tier1 equity capital) + 50 (tier 2 loan loss reserves) / (0% of 300 + 100% of 1500) = 150 / 1500 = 10%
Here 0% of 300 is taken because for Govt. Loans the risk weight is supposed to be 0%. 100% of 1500 is taken because for Loan given to Consumers the risk weight is supposed to be 100%.

Basel 2
Basel 2 norms has 3 pillars
- Pillar 1 - Minimum capital requirements
- Pillar 2 - Supervisory review process
- Pillar 3 - Market discipline
Pillar 1 – Minimum Capital Requirements
The capital ratio remain the same i.e. 9% as in Basel 1 However the important changes are
1. Along with Credit Risk Basle 2 also take into account Market Risk and Operational Risk while calculating the minimum capital.
2. The major change is that RWA (risk weighted in the assets) which is the denominator while calculating capital ratio is now calculated differently. In Basel 1 a particular type of asset was always given a particular percentage like all Consumer loans were thought to be 100% risky but in Basel2 for each type of asset there is a rating based risk weightage. So if a Consumer loan has rating 1 (good rating) then its risk weightage would be around 50% but if it has a rating of 5 (worst rating) then is risk weightage would be 100% or may be more.

Pillar 2 – Supervisory review process
Pillar 2 of the new capital framework recognizes the necessity of exercising effective supervisory review of banks’ internal assessments of their overall risks to ensure that bank management is exercising sound judgment and had set aside adequate capital for these risks. Supervisors will personally go to the banks and evaluate the activities and risk profiles of individual banks to determine whether those organizations should hold higher levels of capital than the minimum requirements in Pillar 1.
In case the bank needs additional requirements then they would whether there is any need for remedial actions. This process also takes into account other risks suchas interest rate risk which are not considered in capital ratio calculation. An important outcome of pillar 2 is ICAAP. It stands for Internal Capital Adequacy Process. It is an umbrella activity that encompasses the governance, management and control of all risk andcapital management functions and the linkages therein.
It strengthens the governance and organizational effectiveness around risk and capital management. This is more of a human intervention in the process. Sometimes banks are able to maintain Capital ratio by finding some loopholes but with supervisory process they would not be able to do so.

Pillar 3 – Market discipline
This pillar is about effective management such as degree of transparency in banks’ public reporting. Thus, adequate disclosure of information to public in timely manner brings in market discipline and in the process promotes safety and soundness in the financial system. The Committee proposes two types of disclosures namely Core and Supplementary. Core disclosures are those which convey vital information for all institutions while Supplementary disclosures are those required for some.

Basel 3
Basel III is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
1. Capital Ratio: The overall capital ratio is unchanged at 8% (RBI recommends 9%)
But there are some new recommendations:
Capital Ratio = (Tier 1 Capital + Tier 2 Capital)/Risk Weighted Assets.
Let’s break the above formula
Tier 1 Capital/RWA – minimum capital ratio is 6% (Also called Tier 1 Capital Ratio)
Tier 2 Capital/RWA – minimum capital ratio is 2% (Also called Tier 2 Capital Ratio)
So Tier1 Capital ratio individually needs to be above 6% and Tier 2 Capital ratio individually needs to be above 2%
Note: RBI recommends Tier 1 Capital Ratio of 7% and Tier 2 Capital Ratio of 2%. Hence Overall ratio of 9%.
Tier 1 capital is further divided in two parts
Tier 1 Capital /RWA= Common Equity Tier 1 (CET1)/RWA + Additional Tier 1(AT 1)/RWA 6% = 4.5 % + 1.5%
I.e. minimum of CET 1 capital ratio be 4.5 %. (Also called Tier1 Common Capital Ratio) And minimum of AT1 capital ratio be 1.5 %.
Note: RBI recommends CET1 to be 5.5% and AT1 to be 1.5%
CET1 capital includes equity instruments that have discretionary dividends and no maturity.AT 1 Capital is the money borrowed by company from lenders who expect to get their money back. But if bank goes into losses then debt is converted in to equity i.e. lenders are issued
shares of the bank and no money is returned to them. So it’s a way of restructuring debt. These are also called Coco bonds or contingent convertible bonds. These bonds can also be cancelled any time.

2. Leverage Ratio: Basel III introduced a minimum "leverage ratio". This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items). The banks are expected to maintain a leverage ratio in excess of 3% under Basel III Tier1 Capital / Total Exposure >= 3%

3. Liquidity Coverage Ratio: The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days. Mathematically it is expressed as follows:
LCR = High Quality Assets/Net Liquidity outflow over 30 days.
LCR must be >= 100%.

PCA Framework
PCA Framework consists of following three parameters:
1. Capital to risk weighted assets ratio (CRAR),
2. Net non-performing assets (NPA) and
3. Return on Assets (RoA)
The Reserve Bank takes some actions and put some restrictions on the bank as soon as the value for any one of these parameters goes beyond a certain limit. The PCA framework is applicable only to commercial banks and not extended to co-operative banks, non-banking financial companies (NBFCs) and FMIs.
1. CRAR
a. CRAR less than 9%, but equal or more than 6% - bank to submit capital restoration plan; restrictions on RWA expansion, entering into new lines of business, accessing/renewing costly deposits and CDs, and making dividend payments; order recapitalization; restrictionson borrowing from inter-bank market, reduction of stake in subsidiaries, reducing its exposure to sensitive sectors like capital market, real estate or investment in non-SLR securities, etc.
b. CRAR less than 6%, but equal or more than 3% - in addition to actions in hitting the first trigger point, RBI could take steps to bring in new Management/ Board, appoint consultants for business/ organizational restructuring, take steps to change ownership, and also take steps to merge the bank if it fails to submit recapitalization plan.
c. CRAR less than 3% - in addition to actions in hitting the first and second trigger points, more close monitoring; steps to merge/amalgamate/liquidate the bank or impose moratorium on the bank if its CRAR does not improve beyond 3% within one year or within such extended period as agreed to.
2. Net NPAs
1. Net NPAs over 10% but less than 15% - special drive to reduce NPAs and contain generation of fresh NPAs; review loan policy and take steps to strengthen credit appraisal skills, follow-up of advances and suit-filed/decreed debts, put in place proper credit-risk management policies; reduce loan concentration; restrictions in entering new lines of business, making dividend payments and increasing its stake in subsidiaries.
2. Net NPAs 15% and above – In addition to actions on hitting the above trigger point, bank’s Board is called for discussion on corrective plan of action.
3. ROA less than 0.25% - restrictions on accessing/renewing costly deposits and CDs, entering into new lines of business, bank’s borrowings from inter-bank market, making dividend payments and expanding its staff; steps to increase fee-based income; contain administrative expenses; special drive to reduce NPAs and contain generation of fresh NPAs; and restrictions on incurring any capital expenditure other than for technological up gradation and for some emergency situations.