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It refers to the money that a company requires to remain stable.
It is not calculated for regulatory purposes. It is the economic capital measure risk that is used to assess the financial strength of a company.
It is calculated by working out on the amount of capital needed to cover the balance sheet considering the risks which could take place over a specific period.
The amount is used to cover it from possible risks - operational, credit, market, and legal.
The amount is required to get recovery from the worst-case scenario.
Sources of Credit Risk - Credit risk at the bank arises from the following sources:
In the case of direct lending: The principal and/or interest amount may not be repaid.
In case of guarantees, letters of credit and letters of comfort (LoC) issued by the Bank: Inadequate cash flow due to which the constituent is unable to liquidate the crystallized liability.
In the case of treasury operations: The payment or series of payments due from the counterparties under respective contracts such as derivatives, forward contracts, etc., may not be forthcoming.
In case of securities trading businesses: Funds/ securities settlement may not be affected
In case of cross-border exposures: Availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the Sovereign.
In case of Purchase of Market Securities: Risk from deterioration of the value of investments pertaining to the banking book including both Debt and Equity.
In the case of Fixed Assets: Depreciation in the value of fixed assets.
Market Risk is the risk of possible losses in holding, on-balance sheet and off-balance sheet positions, due to movements in market prices.
The market risk positions, for capital purposes, are the risks pertaining to interest rate related instruments and equities in the trading book and Forex risk throughout the bank.
Operational Risk is the possibility of loss resulting from inadequate or failed internal processes, people and systems or external events.
(This does not include strategic and reputational risk)
Major factors of operational risk: Lack of competent management and/or planning and controls, incompetent staff, indiscipline, the involvement of staff in frauds, non-compliance, programming errors, failure of computer systems, deficiency in documents etc.
It consists of a review and evaluation process adopted by the supervisor,
For review and evaluation of the bank’s ICAAP,
Conducting an independent assessment of the bank’s risk profile, and if necessary, taking appropriate prudential measures and other supervisory actions.
Capital management is first and foremost driven by a financial risk which can trigger losses and deplete the capital.
Value maximization is used to find ways to finance firms that are sufficiently profitable after capital consumption.
The current economic capital based decision making is experiencing a revival in the asset management and investment banking systems where several institutions are designing frameworks to improve the existing ones.
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