Risks and Risk Management in the Banking Sector

Importance:

1. 1 question of 1 mark of full form of ICAAP

2. 1 question of 1 mark Risk Weighted Average Capital
3. 1 question of 1 mark on Systemic Risk
4. 1 question of 2 marks on Negative Beta
5. 1 question of 2 marks on Risk premium
6. 1 question of 2 marks on Risk Return Trade off

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 Contents
1 Definition of Risk ................................................................................................................ 3
2 Risk in Banking Business....................................................................................................... 3
3 Type of Risks ...................................................................................................................... 3
3.1 Liquidity Risk ............................................................................................................... 4
3.2 Interest Rate Risk ......................................................................................................... 4
3.3 Market Risk (Also known as Price Risk) ............................................................................ 5
3.4 Default or Credit Risk.................................................................................................... 5
3.5 Operational Risk .......................................................................................................... 6
3.6 Other Risks.................................................................................................................. 6
4 Risk Management Frameworks ............................................................................................. 7
4.1 Role of RBI in Risk Management in Banks......................................................................... 7
4.2 Camels Framework....................................................................................................... 7
4.3 Basel Norms ................................................................................................................ 8
4.3.1 Basel 1 ................................................................................................................ 8
4.3.2 Basel 2 ................................................................................................................ 9
4.3.3 Basel 3 ...............................................................................................................10
4.4 PCA Framework ..........................................................................................................11
5 Some Important Terms.......................................................................................................12
6 Beta of an Investment or an Asset ........................................................................................13
6.1 CAPM Model ..............................................................................................................13
6.1.1 ASSET BETAS, EQUITY BETAS, AND DEBT BETAS ........................................................17
7 Counter Cyclic Capital Buffers ..............................................................................................18
8 MCQ’s (Multiple Choice Questions) ......................................................................................19

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 1 Definition of Risk
An activity which may give profits or result in loss may be called a risky proposition due to
uncertainty or unpredictability of the activity of trade in future. In other words, it can be defined as
the possibility of loss.

Example- Ram bought a piece of land today assuming he will sell it at higher price 1 year later is a
activity which has risk in it because there is no guarantee that prices will increase next year. He
might make a loss if prices decline next year

As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more
money

2 Risk in Banking Business

The two most important developments that have made it imperative for Indian commercial banks
to give emphasize on risk management are discussed below

1. Deregulation: The era of financial sector reforms which started in early 1990s has culminated in
deregulation in a phased manner. Deregulation has given banks more autonomy in areas like
lending, investment, interest rate structure etc. As a result of these developments, banks are
required to manage their own business themselves and at the same time maintain liquidity and
profitability. This has made it imperative for banks to pay more attention to risk management

2. Technological innovation: Technological innovations have provided a platform to the banks for
creating an environment for efficient customer services as also for designing new products. In
fact, it is technological innovation that has helped banks to manage the assets and liabilities in a
better way, providing various delivery channels, reducing processing time of transactions,
reducing manual intervention in back office functions etc. However, all these developments
have also increased the diversity and complexity of risks, which need to be managed
professionally so that the opportunities provided by the technology are not negated.

3 Type of Risks
The major risks in banking business or ‘banking risks’, as commonly referred, are listed below –

1. Liquidity Risk
2. Interest Rate Risk
3. Market Risk
4. Credit or Default Risk
5. Operational Risk

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 3.1 Liquidity Risk

Liquidity risk arises when bank does not have enough money to pay back to its lenders. For example
there is a rumor that PNB does not have enough money in its accounts. This would lead to large number
of people withdrawing money the next day which can result in PNB not having money to pay back.

1. Funding Risk: Funding Liquidity Risk is defined as the inability to obtain funds to meet cash
flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to replace
net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail).
The example of PNB above is example of Funding Risk

2. Time Risk: Time risk arises from the need to compensate for non-receipt of expected inflows of
funds i.e., performing assets turning into non-performing assets. People defaulting on loans can
leads to Time risk

3. Call Risk: Any future contingency such as bank losing a legal battle resulting in huge fines to the
bank can result in outflow of money which is called Call Risk

3.2 Interest Rate Risk

Interest Rate Risk arises due to movement in Interest rates

Example: Bank has given money for 20 years at 8% Rate but borrowed it for 5 years at 7.5 %. Here the
bank is assuming that after 5 years it would again borrow at 7.5 %. But if after 5 years the borrowing
rate is increased to 9%. In such a case bank would make loss due to Interest rate movements

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 3.3 Market Risk (Also known as Price Risk)
The market risk arises due to unfavorable movement in market prices in the investments done by bank.
Suppose bank has invested in Equities (Stock market) but stock market crashes then banks would make
a loss.

Banks generally invests in products which are related to price of Commodities, Shares, Currency
movement (You will learn this concept in Derivatives in detail). So investment in such products can lead
to market risk. Interest rate risk is also a type of market risk

Example of Currency Risk: This is also called Forex Risk. Suppose bank has invested 1000 Dollars in US
bank. When it invested each dollar was of Rs. 60 which means bank invested Rs. 60,000. But after
certain days the dollar becomes of Rs. 58 which means bank will get only Rs. 58,000 on that day. You will
learn about currency movements later in the course

3.4 Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to
meet its obligations in accordance with the agreed terms

1. Counterparty Risk: This is a variant of Credit risk and is related to non-performance of the
trading partners due to counterparty’s refusal and or inability to perform. It is more or less
same as Time Risk in the Liquidity Risk section

2. Country Risk: This is also a type of credit risk where non-performance of a borrower or
counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of
non-performance is external factors on which the borrower or the counterparty has no control.

Credit Risk can’t be avoided but has to be managed by applying various risk mitigating processes

1. Banks should assess the credit worthiness of the borrower before sanctioning loan i.e., credit
rating of the borrower should be done beforehand.

2. There should be maximum limit exposure for single/ group borrower

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 3.5 Operational Risk

Operational loss has mainly three exposure classes namely people, processes and systems. In other
words in arise due to bad intentions of staff, hacking of systems or wrong systems in place to meet
the compliance

1. Transaction Risk: Transaction risk is the risk arising from fraud, both internal and external,
failed business processes and the inability to maintain business continuity and manage
information.

2. Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial loss or
reputation loss that a bank may suffer as a result of its failure to comply with any or all of
the applicable laws, regulations, and codes of conduct and standards of good practice. It is
also called integrity risk since a bank’s reputation is closely linked to its adherence to
principles of integrity and fair dealing

3.6 Other Risks

1. Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper
implementation of decisions or lack of responsiveness to industry changes. This risk is a
function of the compatibility of an organization’s strategic goals, the business strategies
developed to achieve those goals, the resources deployed against these goals and the
quality of implementation.

2. Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This risk
may expose the institution to litigation, financial loss or decline in customer base.

3. Systematic Risk : The risk inherent to the entire market or an entire market segment.
Systematic risk, also known as undiversifiable risk. It affects the overall market, not just a
particular stock or industry. For example if you invest all you money in equities then there is
a risk that if equity markets crash, all your investments will go into loss.

This type of risk is both unpredictable and impossible to completely avoid. It cannot be
mitigated through diversification, only through hedging or by using the right asset
allocation strategy. For example, putting some assets in bonds and other assets
in stocks can mitigate systematic risk because an interest rate shift that makes bonds less
valuable will tend to make stocks more valuable, and vice versa, thus limiting the overall
change in the portfolio’s value from systematic changes. Interest rate changes, inflation,

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 recessions and wars all represent sources of systematic risk because they affect the entire
market

4 Risk Management Frameworks

4.1 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

We will discuss these frameworks one by one

4.2 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

Factor Explanation
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

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 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.

4.3 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.

4.3.1 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).

Note: You will understand Tier1 and tier 2 better after learning balance sheets in case you have not
read them till now

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

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 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%

4.3.2 Basel 2
Basel 2 norms has 3 pillars

 Pillar 1 - Minimum capital requirements

 Pillar 2 - Supervisory review process
 Pillar 3 - Market discipline

4.3.2.1 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 (The detailed formula is not needed for the exam)

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

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 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.

4.3.2.2 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 such
as 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 and
capital 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

4.3.2.3 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

4.3.3 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

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 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%

4.4 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

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 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; restrictions
on 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.

5 Some Important Terms

1. Risk Premium: A risk premium is the return in excess of the risk-free rate of return an
investment is expected to yield; an asset's risk premium is a form of compensation for investors
who tolerate the extra risk, compared to that of a risk-free asset, in a given investment.

For example, a fixed deposit in reputed bank like SBI is giving you a return of 10% and it’s totally
risk free or vey minimum risk. On the other hand when you invest in fixed deposit with a local
bank which is not reputed then you will get a return of 15%. But at the same time the return
from local bank is not guaranteed local bank might fail and you might not get anything. So here
you are taking a risk to get a return of 15% which is more than fixed return of 10%. The extra
return of 5% which you might get is called Risk Premium

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 2. Risk Return Trade off: The risk-return tradeoff is the principle that potential return rises with an
increase in risk. Low levels of uncertainty or risk are associated with low potential returns,
whereas high levels of uncertainty or risk are associated with high potential returns. According
to the risk-return tradeoff, invested money can render higher profits only if the investor is
willing to accept the possibility of losses.
The appropriate risk-return tradeoff depends on a variety of factors including risk tolerance,
years to retirement and time of investment. For example, the ability to invest in equities over
the long-term provides the potential to recover from the risks of bear markets and participate
in bull markets, while a short time frame makes equities a higher risk proposition.

6 Beta of an Investment or an Asset

In finance, the beta (β or beta coefficient) of an investment indicates whether the investment is more or
less volatile than the market. In general, a beta less than 1 indicates that the investment is less volatile
than the market, while a beta more than 1 indicates that the investment is more volatile than the
market.

A beta below 1 can indicate two things

1. If beta is between 0 and 1 then the investment is less volatile than the market. An example of the
first is a treasury bill: the price does not go up or down a lot even when the market moves, so it has
a low beta
2. If beta is less than 0 i.e. Negative Beta then it means volatile investment whose price movements
are not correlated with the market. A negative beta correlation would mean an investment that
moves in the opposite direction from the stock market. When the market rises, then a negative-beta
investment generally falls. When the market falls, then the negative-beta investment will tend to
rise. This is generally true of gold stocks and gold bullion

6.1 CAPM Model

CAPM stands for Capital Asset Pricing Model

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 Whenever an investment is made, for example in the shares of a company listed on a stock market,
there is a risk that the actual return on the investment will be different from the expected return.
Investors take the risk of an investment into account when deciding on the return they wish to receive
for making the investment. The CAPM is a method of calculating the return required on an investment,
based on an assessment of its risk.

SYSTEMATIC AND UNSYSTEMATIC RISK

If an investor has a portfolio of investments in the shares of a number of different companies, it might
be thought that the risk of the portfolio would be the average of the risks of the individual investments.
In fact, it has been found that the risk of the portfolio is less than the average of the risks of the
individual investments. By diversifying investments in a portfolio, therefore, an investor can reduce the
overall level of risk faced.

There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not
eliminate risk entirely. The risk which cannot be eliminated by portfolio diversification is called
‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the financial system.
The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic
risk’, or ‘specific risk’, since it is the risk that is associated with individual companies and the shares they
have issued.

THE CAPITAL ASSET PRICING MODEL

The CAPM assumes that investors hold fully diversified portfolios. This means that investors are
assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than
on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of
systematic risk.

The formula for the CAPM is as follow s:

E (ri) = Rf + βi (E (rm) – Rf)

E (ri) = return required on financial asset i

Rf = risk-free rate of return
βi = beta value for financial asset i
E (rm) = average return on the capital market

This formula expresses the required return on a financial asset as the sum of the risk-free rate of return
and a risk premium: βi (E (rm) - Rf) – which compensates the investor for the systematic risk of the
financial asset.

THE RISK-FREE RATE OF RETURN

In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively
safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free

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 asset.

In order to have consistency of data, the yield on treasury bills is used as a substitute for the risk-free
rate of return when applying the CAPM to assets that are traded on the capital market. Note that it is
the yield on treasury bills which is used here, rather than the interest rate.

THE RISK PREMIUM

Rather than finding the average return on the capital market, E (rm), research has concentrated on
finding an appropriate value for (E (rm) - Rf), which is the difference between the average return on the
capital market and the risk-free rate of return. This difference is called the risk premium, since it
represents the extra return required for investing in risky assets rather than investing in risk-free assets.

BETA
Beta is an indirect measure which compares the systematic risk associated with a company’s shares with
the systematic risk of the capital market as a whole. If the beta value of a company’s shares is 1, the
systematic risk associated with the shares is the same as the systematic risk of the capital market as a
whole.

Beta can also be described as ‘an index of responsiveness of the returns on a company’s shares
compared to the returns on the market as a whole’. For example, if a share has a beta value of 1, the
return on the share will increase by 10% if the return on the capital market as a whole increases by 10%.
If a share has a beta value of 0.5, the return on the share will increase by 5% if the return on the capital
market increases by 10%, and so on.

Num erical 2

Calculating the Required Return using the CAPM

Although the concepts of the CAPM can appear complex, the application of the model is
straightforward. Consider the following information:

Risk-free rate of return = 4%

Equity risk premium = 5%
Beta value of RD Co = 1.2

Solution:
Using the CAPM:
E(ri) = Rf + βi (E(rm) - Rf) = 4 + (1.2 x 5) = 10%

The CAPM predicts that the cost of equity of RD Co is 10%. The same answer would have been found if
the information had given the return on the market as 9%, rather than giving the equity risk premium as
5%.

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 Num erical 3

Consider the following information and find the Risk Free Rate of Return

Marker Rate of return = 9%

Required Rate of Return = 10%
Beta value of RD Co = 1.2

Solution:
Using the CAPM:
E(ri) = Rf + βi (E(rm) - Rf)

10 = Rf + 1.2 (9-Rf)

10 = Rf +10.8 -1.2 Rf

.2 Rf = .8

Rf = .8/.2 = 4%

Num erical 4

Consider the following information and find the Return in the Market

Required Rate of Return = 12%

Risk Free Return = 6%
Beta value of RD Co = 1.2

Solution:

Using the CAPM:

E(ri) = Rf + βi (E(rm) - Rf)

12 = 6 + 1.2 (E (rm)-6)

12-6 = 1.2 E (rm) – 7.2

6 + 7.2 = 1.2 E(rm)

E (rm) = 13.2/1.2 = 11%

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 6.1.1 ASSET BETAS, EQUITY BETAS, AND DEBT BETAS

The asset beta we calculated above assumed that there is no debt.

The actual asset beta formula is as follows:

If a company has no debt, its equity beta is the same as its asset beta. Note from the formula that if Vd is
zero because a company has no debt, then βa = βe, as stated earlier.

When a company takes on debt, it’s gearing increases and financial risk is added to its business risk. The
ordinary shareholders of the company face an increasing level of risk as gearing increases and the return
they require from the company increases to compensate for the increasing risk. This means that the
beta of the company’s shares, called the equity beta, increases as gearing increases.

Numerical5
Calculate the asset beta of a company. You have the following information relating to RD Co:
Equity beta of RD Co (Be) = 1.2
Debt beta of RD Co (Bd) = 0.1
Market value of shares of RD Co (Ve) = $6m
Market value of debt of RD Co (Vd) = $1.5m
Company profit tax rate (T) = 25%

After tax market value of company = 6 + (1.5 x 0.75) = $7.125m

β a = [(1.2 x 6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024

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 Numerical6
Calculate the asset beta of a company. You have the following information relating to RD Co:
Equity beta of RD Co (Be) = 1.5
Debt beta of RD Co (Bd) = 0.2
Market value of shares of RD Co (Ve) = $6m
Market value of debt of RD Co (Vd) = $1.5m
Company profit tax rate (T) = 25%

After tax market value of company = 6 + (1.5 x 0.75) = $7.125m

β a = [(1.5 x 6)/7.125] + [(0.2 x 1.5 x 0.75)/7.125] = 1.294

Numerical7
Calculate the Debt beta of a company. You have the following information relating to RD Co:
Equity beta of RD Co (Be) = 1.5
Asset Beta Co (Ba) = 1.3
Market value of shares of RD Co (Ve) = $6m
Market value of debt of RD Co (Vd) = $1.5m
Company profit tax rate (T) = 25%

After tax market value of company = 6 + (1.5 x 0.75) = $7.125m

1.3 = [(1.5 x 6)/7.125] + [(Bdx1.5 x 0.75)/7.125]

Bd = 0 .253

7 Counter Cyclic Capital Buffers

Counter Cyclical Capital Buffers (CCCB) are the Buffers which are maintained in opposition to the cycle of
the credit growth cycles. In good times bank saves money in the CCCB and in tough times bank takes out
money from CCCB and lend it to the outside world. They are a mechanism of Risk Management

The aim of the Countercyclical Capital Buffer (CCCB) regime is twofold

1. Firstly, it requires banks to build up a buffer of capital in good times which may be used to
maintain flow of credit to the real sector in difficult times
2. Secondly, it achieves the broader macro-prudential goal of restricting the banking sector from
indiscriminate lending in the periods of excess credit growth that have often been associated
with the building up of system-wide risk

The CCCB may be maintained in the form of Common Equity Tier 1 (CET 1) capital or other fully loss
absorbing capital only, and the amount of the CCCB may vary from 0 to 2.5% of total risk weighted
assets (RWA) of the banks

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 8 MCQ’s (Multiple Choice Questions)
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