Basel III...10 questions we should know answers to

What was the paradigm shift from Basel I to Basel II?
The paradigm shift was that while Basel I had a ‘one-size-fits-all’ approach, Basel II introduced risk sensitive capital regulation. The main charge against Basel II is that it is precisely this risk sensitivity that made it blatantly procyclical. In good times, when banks are doing well, and the market is willing to invest capital in them, Basel II does not impose significant additional capital requirement on banks. On the other hand, in stressed times, when banks require additional capital and markets are wary of supplying that capital, Basel II requires banks to bring in more of it. As we saw during the crisis, it was the failure to bring in capital when under pressure that forced major international banks into a vicious cycle of deleveraging, thereby hurtling global financial markets into seizure and economies around the world into recession.
The second charge against Basel II was that even as it made capital regulation more risk sensitive, it did not bring in corresponding changes in the definition and composition of regulatory capital to reflect the changing market dynamics. The market risk models failed, in particular, to factor in the risk from the complex derivative products that were coming on to the market in a big way. These models demanded less capital against trading book exposures on the premise that trading book exposures could be readily sold, and positions rapidly unwound. This gave a perverse incentive for banks to park banking book exposures in the trading book to optimize capital. And as we now know, much of the toxic assets and their securitized derivatives, which were the epicenter of the crisis were parked in the trading book.
So, the second charge against Basel II was that even as it was supposedly risk sensitive, it failed to promote modelling frameworks for accurate measurement of risk and to demand sufficient loss absorbing capital to mitigate that risk.
The third charge against Basel II concerns leverage. Note that Basel II did not have any explicit regulation governing leverage. It assumed that its risk based capital requirement would automatically mitigate the risk of excessive leverage. This assumption, as it turned out, was flawed as excessive leverage of banks was one of the prime causes of the crisis. Similarly, Basel II did not explicitly cover liquidity risk. Since liquidity risk, if left unaddressed, could cascade into a solvency risk, this proved to be the undoing of virtually every bank that came under stress in the depth of the crisis.
Finally, Basel II was also seen to be guilty of focusing exclusively on individual financial institutions, ignoring the systemic risk arising from the interconnectedness across institutions
which, as we now know with the benefit of hindsight, was the culprit for ferociously spreading the crisis across financial markets.
Is all this criticism against Basel II valid? As I said before, only partly valid. Note that Basel II, which became operational in June 2006, was still largely work in progress as the crisis began unfolding in August 2007. It is possible that the failure of the market risk framework underlying Basel II may have abetted the crisis, but to claim that the risk sensitivity of Basel II caused the crisis would be extreme.
2nd Question: How is Basel III an improvement over Basel II?
Basel III represents an effort to fix the gaps and lacunae in Basel II that came to light during the crisis as also to reflect other lessons of the crisis. What is important though is that Basel III does not jettison Basel II; on the contrary, it builds on the essence of Basel II - the link between the risk profiles and capital requirements of individual banks. In that sense, Basel III is not a negation, but an enhancement of Basel II.
The enhancements of Basel III over Basel II come primarily in four areas: (i) augmentation in the level and quality of capital; (ii) introduction of liquidity standards; (iii) modifications in provisioning norms; and (iv) better and more comprehensive disclosures. Let me discuss each of these briefly.
Higher Capital Requirement
Table 1: Capital Requirements Under Basel II and Basel III
As a percentage of risk weighted assets
BaselII
Basel III (as on January 1, 2019)
A = (B+D)
Minimum Total Capital
8.0
8.0
B
Minimum Tier 1 Capital
4.0
6.0
C
of which: Minimum Common Equity Tier 1 Capital
2.02
4.5
D
Maximum Tier 2 Capital (within Total Capital)
4.0
2.0
E
Capital Conservation Buffer (CCB)
-
2.5
F = C+E
Minimum Common Equity Tier 1 Capital + CCB
2.0
7.0
G = A+E
Minimum Total Capital + CCB
8.0
10.5
As can be seen from the comparative data in aqbove Table, Basel III requires higher and better quality capital. The minimum total capital remains unchanged at 8 per cent of risk weighted assets (RWA). However, Basel III introduces a capital conservation buffer of 2.5 per cent of RWA over and above the minimum capital requirement, raising the total capital requirement to 10.5 per cent against 8.0 per cent under Basel II. This buffer is intended to ensure that banks are able to absorb losses without breaching the minimum capital requirement, and are able to carry on business even in a downturn without deleveraging. This buffer is not part of the regulatory minimum; however, the level of the buffer will determine the dividend distributed to shareholders and the bonus paid to staff.
There are also other prescriptions regarding the quality of capital within the minimum total so that capital is able to absorb losses, and calling upon taxpayers to bear the burden of bail out becomes absolutely the last resort.
In addition to the capital conservation buffer, Basel III introduces another capital buffer - the countercyclical capital buffer - in the range of 0 - 2.5 per cent of RWA which could be imposed on banks during periods of excess credit growth. Also, there is a provision for a higher capital surcharge on systemically important banks.
To mitigate the risk of banks building up excess leverage as happened under Basel II, Basel III institutes a leverage ratio as a backstop to the risk based capital requirement. The Basel Committee is contemplating a minimum Tier 1 leverage ratio of 3 per cent (33.3 times) which will eventually become a Pillar 1 requirement as of January 1, 2018.
As we noted earlier, Basel II failed to demand adequate loss absorbing capital to cover market risk. To remedy this, Basel III strengthens the counterparty credit risk framework in market risk instruments. This includes the use of stressed input parameters to determine the capital requirement for counterparty credit default risk. Besides, there is a new capital requirement known as CVA (credit valuation adjustment) risk capital charge for OTC derivatives to protect banks against the risk of decline in the credit quality of the counterparty.
To mitigate liquidity risk, Basel III addresses both potential short-term liquidity stress and longer-term structural liquidity mismatches in banks’ balance sheets (Table - 2). To cover short-term liquidity stress, banks will be required to maintain sufficient high-quality unencumbered liquid assets to withstand any stressed funding scenario over a 30-day horizon as measured by the liquidity coverage ratio (LCR). To mitigate liquidity mismatches in the longer term, banks will be mandated to maintain a net stable funding ratio (NSFR). The NSFR mandates a minimum amount of stable sources of funding relative to the liquidity profile of the assets, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments over a one-year horizon. In essence, the NSFR is aimed at encouraging banks to exploit stable sources of funding.
Liquidity Standards
Table 2: Liquidity Standards
Ratio
Basel II
Basel III
Liquidity Coverage Ratio (LCR) (to be introduced as on January 1, 2015)
-
Stock of high-quality liquid assets = 100% Total net cash outflows over the next 30 calendar days
Net Stable Funding Ratio (NSFR) (to be introduced as on January 1, 2018)
-
Available amount of stable funding > 100% Required amount of stable funding
Provisioning Norms
The Basel Committee is supporting the proposal for adoption of an “expected loss” based measure of provisioning which captures actual losses more transparently and is also less
procyclical than the current “incurred loss” approach. The expected loss approach for provisioning will make financial reporting more useful for all stakeholders, including regulators and supervisors.
Disclosure Requirements
The disclosures made by banks are important for market participants to make informed decisions. One of the lessons of the crisis is that the disclosures made by banks on their risky exposures and on regulatory capital were neither appropriate nor sufficiently transparent to afford any comparative analysis. To remedy this, Basel III requires banks to disclose all relevant details, including any regulatory adjustments, as regards the composition of the regulatory capital of the bank.
3rd Question: What is the additional capital that Indian banks have to mobilize to conform to Basel III? What are the options for, and challenges in, raising this size of capital?
Admittedly, Indian banks already meet the minimum capital requirements of Basel III at an aggregate level, even though some individual banks may have to top up. But capital adequacy today does not mean capital adequacy going forward. Currently, the bank credit - GDP ratio in India is around 55 per cent. If we want growth to accelerate, this ratio will have to go up as a necessary pre-condition. Besides, as our economy goes through a structural transformation, as it should, the share of the industry sector will increase and the credit-GDP ratio will rise even further. What this means is that Indian banks would have been required to raise additional capital even in the absence of Basel III. In estimating the net additional burden on account of Basel III, we have to take this factor into account.
What is the size of the additional capital required to be raised by Indian banks? It depends on the assumption made, and there are various estimates floating around.
The Reserve bank has made some quick estimates based on the following two conservative assumptions covering the period to March 31, 2018: (i) risk weighted assets of individual banks will increase by 20 per cent per annum; and (ii) internal accruals will be of the order of 1 per cent of risk weighted assets.
Reserve Bank’s estimates project an additional capital requirement of Rs. 5 trillion, of which non-equity capital will be of the order of `3.25 trillion while equity capital will be of the order of `1.75 trillion (Table - 3).
Table 3: Additional Common Equity Requirements of Indian Banks under Basel III
(Rs. billion)
Public Sector Banks
Private Sector Banks
Total
A
Additional Equity Capital Requirements under Basel III
1400-1500
200-250
1600-1750
B
Additional Equity Capital Requirements under Basel II
650-700
20-25
670-725
C
Net Equity Capital Requirements under Basel III (A-B)
750-800
180-225
930-1025
D
Of Additional Equity Capital Requirements under Basel III for Public Sector Banks (A)
Government Share (if present shareholding pattern is maintained)
880-910
-
-
Government Share (if shareholding is brought down to 51 per cent)
660-690
-
-
Market Share (if the Government’s shareholding pattern is maintained at present level)
520-590
-
-
The additional equity capital requirement of the order of Rs. 1.75 trillion raises two questions. First, can the market provide capital of this size? Second, what will be the burden on the Government in capitalizing public sector banks (PSBs) and what are its options?
Let us turn to the first question, whether the market will be able to provide equity capital of this size. The amount the market will have to provide will depend on how much of the recapitalization burden of PSBs the Government will meet. Data in Table - 3 indicate that the amount that the market will have to provide will be in the range of Rs. 700 billion - Rs. 1 trillion depending on how much the Government will provide. Over the last five years, banks have revised equity capital to the tune of Rs. 520 billion through the primary markets.
Raising an additional Rs. 700 billion - Rs. 1 trillion over the next five years from the market should therefore not be an insurmountable problem. The extended period of full Basel III implementation spread over five years gives sufficient time to banks to plan the time-table of their capital rising over this period.
Moving on to the second question of the burden on the Government which owns 70 per cent of the banking system. If the Government opts to maintain its shareholding at the current level, the burden of recapitalization will be of the order of Rs. 900 billion; on the other hand, if it decides to reduce its shareholding in every bank to a minimum of 51 per cent, the burden reduces to under Rs. 700 billion.
Clearly, providing equity capital of this size in the face of fiscal constraints poses significant challenges. A tempting option for the Government would be to issue recapitalization bonds against common equity infusion. But this will militate against fiscal transparency. In the alternative, would the Government be open to reducing its shareholding in PSBs to below 51 per cent? If the Government decides to pursue this option, an additional consideration is whether it will amend the statute to protect its majority voting rights.
4th Question: Will Basel III hurt growth?
One major criticism against Basel III has been that it will hurt growth. Even though we do not have a precise quantitative estimate of the impact on growth, the main concern is that the higher capital requirements under Basel III will kick in at a time when credit demand in the economy will be on the rise.
In a structurally transforming economy with rapid upward mobility, credit demand will expand faster than GDP for several reasons. First, India will shift increasingly from services to manufactures, and the credit intensity of manufacturing is higher per unit of GDP than that for services. Second, we need to at least double our investment in infrastructure which will place enormous demands on credit. Finally, financial inclusion, which both the Government and the Reserve Bank are driving, will bring millions of low income households into the formal financial system with almost all of them needing credit.
What all this means is that we are going to have to impose higher capital requirements on banks as per Basel III at a time when credit demand is going to expand rapidly. A crucial question is this. Will this raise the cost of credit and hence militate against growth? Put differently, how much growth are we willing to sacrifice in order to buy insurance against financial instability? At its core, this boils down to the tension between short-term compulsions and long term growth prospects. Comfortingly, empirical research by BIS economists shows that even if Basel III may impose some costs in the short-term, it will secure medium to long term growth prospects.
5th Question: How will Basel III affect the profitability of banks? Will it alter their incentive structure?
Let me attempt an answer. As we noted, Basel III requires higher and better quality capital. Admittedly, the cost of equity capital is high. It is also likely that the loss absorbency requirements on the non-equity regulatory capital will increase its cost.
The average Return on Equity (RoE) of the Indian banking system for the last three years has been approximately 15 per cent. Implementation of Basel III is expected to result in a decline in Indian banks’ RoE in the short-term. However, the expected benefits arising out of a more stable and stronger banking system will largely offset the negative impact of a lower RoE in the medium to long term. It is also fair to assume that investors will perceive the benefits of having less risky and more stable banks, and will therefore be willing to trade in higher returns for lower risks.
A related question is whether banks will bear the increased cost of capital themselves or pass it to their depositors and borrowers. This trade off has to be assessed in the context of the relatively higher level of net interest margins (NIMs) of Indian banks, of approximately 3 per cent. This higher NIM suggests that there is scope for banks to improve their efficiency, bring down the cost of intermediation and ensure that returns are not overly compromised even as the cost of capital may increase.
Having dealt with capital requirements, let us now turn to the Liquidity Standards under Basel III. Will the mandate to maintain a higher quantum of liquid assets encourage banks to resort to the passive option of lending to the Government, thereby crowding out credit to the private sector? Hopefully, this question will resolve itself as the savings rate of the economy improves and the fiscal deficit comes down.
A related question is about the extent banks’ holding of government securities that should be taken into account for assessing compliance with liquidity standards. One view is that since the Statutory Liquidity Ratio (SLR) securities are required to be held on an ongoing basis, they should not be reckoned for calculating liquidity requirements under Basel III. An alternate view is that since the Reserve Bank is expected to provide liquidity against these securities under stressed conditions as part of its lender of last resort (LoLR) obligation, at least a pre-specified portion of these securities should be taken into account for assessing compliance with Basel III’s Liquidity Standards. The Reserve Bank will take a view on this in due course.
So, the answer to the question of whether Basel III will affect the profitability of banks and alter their incentive structure is that the competitive dimensions of our banking sector should ensure that banks are able to deliver efficient financial intermediation without compromising the interests of depositors and borrowers.
6th Question: Does India really need Basel III? Don’t the costs outweigh the benefits?
The last three questions, if you noticed, dealt with the putative negative consequence of Basel III - the burden of raising additional capital and the costs of complying with the new liquidity standards, their impact on banks’ profitability, and on the overall growth prospects of the economy.
One view, although not explicitly spelt out in that form, is that India need not adopt Basel III, or should adopt only a diluted version of it, so as to balance the benefits against the putative costs. To buttress this view, it is argued that Basel III is designed as a corrective for advanced economy banks which had gone astray, oftentimes taking advantage of regulatory gaps and regulatory looseness, and that Indian banks which remained sound through the crisis should not be burdened with the ‘onerous’ obligations of Basel III.
The Reserve Bank does not agree with this view. Our position is that India should transit to Basel III because of several reasons. By far the most important reason is that as India integrates with the rest of the world, as increasingly Indian banks go abroad and foreign banks come on to our shores, we cannot afford to have a regulatory deviation from global standards. Any deviation will hurt us both by way of perception and also in actual practice.
The ‘perception’ of a lower standard regulatory regime will put Indian banks at a disadvantage in global competition, especially because the implementation of Basel III is subject to a ‘peer group’ review whose findings will be in the public domain.
Deviation from Basel III will also hurt us in actual practice. We have to recognize that Basel III provides for improved risk management systems in banks. It is important that Indian banks have the cushion afforded by these risk management systems to withstand shocks from external systems, especially as they deepen their links with the global financial system going forward.
I must also add, as I complete my answer to this question, that some of the prescriptions of Basel III have already been in existence in India, and the net additional burden will be lower than we tend to imagine.
7th Question: The Reserve Bank has already rolled out the implementation of Basel III even as many countries are yet to do so. Why did you have to frontrun and why are some of your regulations more onerous than required under Basel III?
The Reserve Bank issued final guidelines on Basel III capital regulation in May 2012 to be implemented from January 1, 2013 to March 31, 2018 even as many other jurisdictions have yet to do so. We have been criticized for being unduly proactive in this regard. Let me respond to this criticism.
First, on the start and end dates. We have not advanced the start date. It is the same as the internationally agreed date of January 1, 2013. However, we have advanced the end date from the internationally agreed date of December 31, 2018 by nine months to March 31, 2018. We did this to align our date with the close of the Indian fiscal year, which is March 31. We could have gone up to March 31, 2019, but that would have overshot the Basel III prescription by three months and would have attracted adverse notice. Our assessment is that the cost of that adverse notice will far exceed the marginal burden of a slightly earlier close date. So, we settled for March 31, 2018.
Third, major global banks often engage themselves in the Basel Committee’s consultative process which is not the case with Indian banks. We moved early since we had completed the consultative process, and thought that we must give our banks a head start in transiting to Basel III.
47. Let me then move to the more weighty question of why the Reserve Bank has prescribed higher capital and leverage norms for Indian banks than the Basel III minimum. Table-4 summarises the Basel III (international) prescriptions alongside the current requirements in India under Basel II, and as required under Basel III when fully implemented.
Table 4: Minimum Regulatory Capital Prescriptions (as percentage of risk weighted assets) Basel III (as on January 1, 2019) Reserve Bank’s Prescriptions Current (Basel II) Basel III (as on March 31, 2018)
A = (B+D)
Minimum Total Capital
8.0
9.0
9.0
B
Minimum Tier 1 capital
6.0
6.0
7.0
C
of which: Minimum Common Equity Tier 1 capital
4.5
3.6
5.5
D
Maximum Tier 2 capital (within Total Capital)
2.0
3.0
2.0
E
Capital Conservation Buffer (CCB)
2.5
-
2.5
F = C+E
Minimum Common Equity Tier 1 capital + CCB
7.0
3.6
8.0
G = A+E
Minimum Total Capital + CCB
10.5
-
11.5
H
Leverage Ratio (ratio to total assets)
3.0
-
4.5
What is the rationale for our more ‘onerous’ capital standards? Note that banks in India follow the Standardised Approaches under Basel II. The higher prescription is intended to address any judgemental error in capital adequacy viz. wrong application of standardised risk weights, misclassification of asset quality etc. Also, while advanced approaches under Basel II have been strengthened, the calibration of standardised risk weights is yet to be comprehensively effected. And more importantly, Indian banks have not so far been subjected to Pillar 2 capital requirement under Basel II. Thus, the higher prescription addresses any potential concerns relating to undercapitalisation of risky exposures. It should also be noted in this context that even under the Basel I and Basel II regimes, the Reserve Bank’s prescriptions were a percentage point higher than the international norms. Experience shows that this prudence on our part had been helpful and was positive on the cost-benefit calculus.
Please note that India has not been an outlier in prescribing higher capital standards. Several other jurisdictions, particularly Asian countries, have proposed higher capital adequacy ratios under Basel III as may be seen from Table-5 below.
Table 5: Sample of Countries with Higher Capital Adequacy Norms Than India Country Minimum Common Equity Ratio (including capital conservation buffer) (percentage) Minimum Total Capital Ratio (percentage)
Basel III
7.0
10.5
India
8.0
11.5
Philippines
8.5
12.5
Singapore
9.0
12.5
China
7.5
10.5
South Africa
9.0
12.5
Similarly, a question has been raised about why the Reserve Bank prescribed a higher leverage ratio, 4.5 per cent, against the Basel III norm of 3 per cent.It is a matter of supervisory comfort that the Indian banking system is only moderately leveraged on an aggregate basis (22 times of Tier 1 capital approximately). We thought it prudent not to dilute this ‘comfortable’ position during the parallel run period of the leverage ratio. The Basel Committee is monitoring and analysing the potential impact of the leverage ratio. As indicated in our Basel III framework, we will finalize the leverage ratio requirement taking into account the final proposal of the Basel Committee.
8th Question: What are the potential challenges in implementing the countercyclical capital buffer?
As we noted earlier, a critical component of the Basel III package is a countercyclical capital buffer which mandates banks to build up a higher level of capital in good times that could be run down in times of economic contraction, consistent with safety and soundness considerations. This is conceptually neat, but is challenging in operational terms, as indeed evidenced by Spain’s recent experience. The foremost challenge is identifying the inflexion point in an economic cycle which should trigger the release of the buffer. It is quite evident
that both tightening too early or too late can be costly in macroeconomic terms. The identification of the inflexion point therefore needs to be based on objective and observable criteria. It also needs long series data on economic cycles. So, what we need is both a better database and more refined statistical skills in analyzing economic cycles.
The countercyclical capital buffer as prescribed in Basel III was initially based on the credit / GDP metric. Is this a good economic indicator from the Indian perspective? A study undertaken by the Reserve Bank shows that the credit to GDP ratio has not historically been a good indicator of buildup of systemic risk in our banking system.
Furthermore, some economic sectors such as real estate, housing, micro finance and consumer credit are relatively new in India, and banks have only recently begun financing them in a big way. The risk build up in such sectors cannot accurately be captured by the aggregate credit to GDP ratio. The Reserve Bank has so far calibrated countercyclical policies at the sectoral level, and I believe we need to continue to use that approach. The Basel Committee also has now recognized that no single variable can fully capture the dynamics of the economic cycle. Appropriate calibration of the buffer requires country specific judgement backed by a broad range of other simple indicators used in financial stability assessments.
9th Question: What are D-SIBs? Will any Indian bank be classified as a D-SIB?
The moral hazard relating to too-big-to-fail institutions which encourages risky behaviour by larger banks has been a huge issue on the post-crisis reform agenda. Basel III seeks to mitigate this externality by identifying global systemically important banks (G-SIBs) and mandating them to maintain a higher level of capital dependent on their level of systemic importance. The list of G-SIBs is to be reviewed annually. Currently, no Indian bank appears in the list of G–SIBs.
Separately, the Basel Committee is working on establishing a minimum set of principles for domestic systemically important banks (D-SIBs), and also on the norms for prescribing higher loss absorbency (HLA) capital standards for them. Besides, it is also necessary to evolve a sound resolution mechanism for D-SIBs.
The moral hazard issue of too big to fail and the regulatory endeavour to address that raise a question about the optimal size of a G-SIB, and the optimal size of a D-SIB relative to the size of the economy. Admittedly, larger banks offer certain benefits such as economies of scale in operation and capacity to finance large infrastructure projects which are typically considered more risky. In India, we also need large banks with potential capacity to become significant global players. Nevertheless, we have to balance the benefits that large banks extend with the moral hazard costs they entail.
10th Question: What sort of capacity building is required in the implementation of Basel III, especially in the area of risk management? What should banks do and what should the Reserve Bank do in this regard?
There are no two views about the need for building capacity within the banks, and also in the Reserve Bank which is the regulator, to efficiently implement Basel III.
By far the most important reform is that there should be a radical change in banks’ approach to risk management. Banks in India are currently operating on the Standardized Approaches of Basel II. The larger banks need to migrate to the Advanced Approaches, especially as they expand their overseas presence. The adoption of advanced approaches to risk management will enable banks to manage their capital more efficiently and improve their profitability.
This graduation to Advanced Approaches requires three things. First and most importantly, a change in perception from looking upon the capital framework as a compliance function to seeing it as a necessary pre-requisite for keeping the bank sound, stable, and therefore profitable; second, deeper and more broad based capacity in risk management; and finally adequate and good quality data.

Daily Concepts - Basel III

CAIIB (CERTIFIED ASSOCIATE OF INDIAN INSTITUTE BANKING)
Daily Concepts - Basel III
Basel III Capital Regulations are being implemented in India with effect from April 1, 2013 in
a phased manner.
I request all of you to go through the Amended Master Circular - Basel III (01 July 2015) here
:
"https://rbidocs.rbi.org.in/rdocs/notification/PDFs/58BS09C403D06BC14726AB61783180628D
39.PDF"
Revised Framework for Leverage Ratio for Implementation of Basel III Capital Regulations in
India can be better explained under the following headings.
Rationale and Objective
Definition, Minimum Requirement and Scope of Application of the Leverage Ratio
Capital Measure
Exposure Measure
Transitional arrangements
Disclosure requirements
They can be better understood in detail by going through "http://icmai.in/upload/pd/RBICircular-
09012015.pdf". We can also discuss in details if members wants to.
Just a recollection of Basel III developments till
now :
Basel III released in December, 2010 is the third in the series of Basel Accords. These
accords deal with risk management aspects for the banking sector. In a nut shell we can say
that Basel III is the global regulatory standard (agreed upon by the members of the Basel
Committee on Banking Supervision) on bank capital adequacy, stress testing and market
liquidity risk. (Basel I and Basel II are the earlier versions of the same, and were less
stringent)
According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of
reform measures, developed by the Basel Committee on Banking Supervision, to strengthen
the regulation, supervision and risk management of the banking sector".
Thus, we can say that Basel III is only a continuation of effort initiated by the Basel
Committee on Banking Supervision to enhance the banking regulatory framework under Basel
I and Basel II. This latest Accord now seeks to improve the banking sector's ability to deal
with financial and economic stress, improve risk management and strengthen the banks'
transparency.
Objectives / aims of the Basel III measures
Basel III measures aim to:
→ improve the banking sector's ability to absorb shocks arising from financial and economic
stress, whatever the source
→ improve risk management and governance
→ strengthen banks' transparency and disclosures.
Thus we can say that Basel III guidelines are aimed at to improve the ability of banks to
withstand periods of economic and financial stress as the new guidelines are more stringent
than the earlier requirements for capital and liquidity in the banking sector.
How Does Basel III Requirements Will Affect Indian Banks :
The Basel III which is to be implemented by banks in India as per the guidelines issued by
RBI from time to time, will be challenging task not only for the banks but also for GOI. It is
estimated that Indian banks will be required to rais Rs 6,00,000 crores in external capital in
next nine years or so i.e. by 2020 (The estimates vary from organisation to organisation).
Expansion of capital to this extent will affect the returns on the equity of these banks specially
public sector banks. However, only consolation for Indian banks is the fact that historically
they have maintained their core and overall capital well in excess of the regulatory minimum.
The basic structure of Basel III remains unchanged with three mutually
reinforcing pillars.
Pillar 1 : Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) :
Maintaining capital calculated through credit, market and operational risk areas.
Pillar 2 : Supervisory Review Process : Regulating tools and frameworks for dealing with
peripheral risks that banks face.
Pillar 3: Market Discipline : Increasing the disclosures that banks must provide to increase
the transparency of banks
Major Changes Proposed in Basel III over earlier Accords i.e. Basel I and Basel II
(a) Better Capital Quality : One of the key elements of Basel 3 is the introduction of
much stricter definition of capital. Better quality capital means the higher loss-absorbing
capacity. This in turn will mean that banks will be stronger, allowing them to better
withstand periods of stress.
(b) Capital Conservation Buffer: Another key feature of Basel iii is that now banks will
be required to hold a capital conservation buffer of 2.5%. The aim of asking to build
conservation buffer is to ensure that banks maintain a cushion of capital that can be used to
absorb losses during periods of financial and economic stress.
(c) Countercyclical Buffer: This is also one of the key elements of Basel III. The
countercyclical buffer has been introduced with the objective to increase capital requirements
in good times and decrease the same in bad times. The buffer will slow banking activity
when it overheats and will encourage lending when times are tough i.e. in bad times. The
buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing
capital.
(d) Minimum Common Equity and Tier 1 Capital Requirements : The minimum
requirement for common equity, the highest form of loss-absorbing capital, has been raised
under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital
requirement, consisting of not only common equity but also other qualifying financial
instruments, will also increase from the current minimum of 4% to 6%. Although the
minimum total capital requirement will remain at the current 8% level, yet the required total
capital will increase to 10.5% when combined with the conservation buffer.
(e) Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of
many assets fell quicker than assumed from historical experience. Thus, now Basel III rules
include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of
capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in
the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a
mandatory leverage ratio is introduced in January 2018.
(f) Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be
created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be
introduced in 2015 and 2018, respectively.
(g) Systemically Important Financial Institutions (SIFI) : As part of the macroprudential
framework, systemically important banks will be expected to have loss-absorbing
capability beyond the Basel III requirements. Options for implementation include capital
surcharges, contingent capital and bail-in-debt.
-----------------------------------------
Basel III is a comprehensive set of reform measures, developed by the Basel Committee on
Banking Supervision, to strengthen the regulation, supervision and risk of the banking sector.
The Basel Committee is the primary global standard-setter for the prudential regulation of
banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to
strengthen the regulation, supervision and practices of banks worldwide with the purpose of
enhancing financial stability.
The Committee reports to the Group of Governors and Heads of Supervision (GHOS). The
Committee seeks the endorsement of GHOS for its major decisions and its work programme.
The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China,
European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea,
Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain,
Sweden, Switzerland, Turkey, the United Kingdom and the United States.
The Basel III reform measures aim to:
 Improve the banking sector's ability to absorb shocks arising from financial and economic stress,
whatever the source
 Improve risk management and governance
 Strengthen banks' transparency and disclosures.
The reforms target:
a. Bank-level, or microprudential, regulation, which will help raise the resilience of individual
banking institutions to periods of stress.
b. Macroprudential, system wide risks that can build up across the banking sector as well as
the procyclical amplification of these risks over time.
These two approaches to supervision are complementary as greater resilience at the
individual bank level reduces the risk of system wide shocks.
From 1993 to 2008 the total assets of a sample of what we call global systemically important
banks saw a twelve-fold increase (increasing from $2.6 trillion to just over $30 trillion). But
the capital funding these assets only increased seven-fold, (from $125 billion to $890 billion).
Put differently, the average risk weight declined from 70% to below 40%.
The problem was that this reduction did not represent a genuine reduction in risk in the
banking system.
One of the main reasons the economic and financial crisis became so severe was that the
banking sectors of many countries had built up excessive on and off-balance sheet leverage.
This was accompanied by a gradual erosion of the level and quality of the capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic trading and credit
losses nor could it cope with the reintermediation of large off-balance sheet exposures that
had built up in the shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the
interconnectedness of systemic institutions through an array of complex transactions.
During the most severe episode of the crisis, the market lost confidence in the solvency and
liquidity of many banking institutions. The weaknesses in the banking sector were rapidly
transmitted to the rest of the financial system and the real economy, resulting in a massive
contraction of liquidity and credit availability.
Ultimately the public sector had to step in with unprecedented injections of liquidity, capital
support and guarantees, exposing taxpayers to large losses.
The effect on banks, financial systems and economies at the epicentre of the crisis was
immediate. However, the crisis also spread to a wider circle of countries around the globe. For
these countries the transmission channels were less direct, resulting from a severe contraction
in global liquidity, cross-border credit availability and demand for exports.
Given the scope and speed with which the recent and previous crises have been transmitted
around the globe as well as the unpredictable nature of future crises, it is critical that all
countries raise the resilience of their banking sectors to both internal and external shocks.
The G20 Leaders at the Seoul Summit endorsed the Basel III framework and the Financial
Stability Board’s (FSB) policy framework for reducing the moral hazard of systemically
important financial institutions (SIFIs), including the work processes and timelines set out in
the report submitted to the Summit.
SIFIs are financial institutions whose disorderly failure, because of their size, complexity and
systemic interconnectedness, would cause significant disruption to the wider financial system
and economic activity.
We read in the final G20 Communique:
"We endorsed the landmark agreement reached by the Basel Committee on the new bank
capital and liquidity framework, which increases the resilience of the global banking system by
raising the quality, quantity and international consistency of bank capital and liquidity,
constrains the build-up of leverage and maturity mismatches, and introduces capital buffers
above the minimum requirements that can be drawn upon in bad times.
The framework includes an internationally harmonized leverage ratio to serve as a backstop to
the risk-based capital measures.
With this, we have achieved far-reaching reform of the global banking system.
The new standards will markedly reduce banks' incentive to take excessive risks, lower the
likelihood and severity of future crises, and enable banks to withstand - without extraordinary
government support - stresses of a magnitude associated with the recent financial crisis.
This will result in a banking system that can better support stable economic growth.
We are committed to adopt and implement fully these standards within the agreed timeframe
that is consistent with economic recovery and financial stability.
The new framework will be translated into our national laws and regulations, and will be
implemented starting on January 1, 2013 and fully phased in by January 1, 2019."
To ensure visibility of the implementation of reforms, the Basel Committee has been regularly
publishing information about members’ adoption of Basel III to keep all stakeholders and the
markets informed, and to maintain peer pressure where necessary.
It is especially important that jurisdictions that are home to global systemically important
banks (G-SIBs) make every effort to issue final regulations at the earliest possible
opportunity.
But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for:
full, timely and consistent implementation of Basel III. In response to this call, in 2012 the
Committee initiated what has become known as the Regulatory Consistency Assessment
Programme (RCAP).
The regular progress reports are simply one part of this programme, which assesses domestic
regulations’ compliance with the Basel standards, and examines the outcomes at individual
banks.
The RCAP process will be fundamental to ensuring confidence in regulatory ratios and
promoting a level playing field for internationally-operating banks.
It is inevitable that, as the Committee begins to review aspects of the regulatory framework in
far more detail than it (or anyone else) has ever done in the past, there will be aspects of
implementation that do not meet the G20’s aspiration: full, timely and consistent.
The financial crisis identified that, like the standards themselves, implementation of global
standards was not as robust as it should have been.
This could be classed as a failure by global standard setters.
To some extent, the criticism can be justified – not enough has been done in the past to
ensure global agreements have been truly implemented by national authorities.
However, just as the Committee has been determined to revise the Basel framework to fix the
problems that emerged from the lessons of the crisis, the RCAP should be seen as
demonstrating the Committee’s determination to also find implementation problems and fix
them.
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Basel III is divided in two main areas:
Regulatory capital
Asset and liability management
AREA 1: Regulatory Capital
Banks shall progressively reach a minimum solvency ratio of 7% as of 2019:
Solvency ratio = (Regulatory Capital) / (Risk-Weighted Assets). [RWA = Risk-Weighted
Assets]
The minimum requirement used to be 2% prior to Basel 3, with many national banking
authorities requiring much more leading to that most banks used to have a Tier 1 ratio
exceeding 7%
According to the Basel III impact study, at the end of 2009, the average solvency ratio (Core
Tier One) of large banks was 11.1%
So, what is the problem, if banks already exceed the minimum solvency ratio set by Basel III?
The devil is in the details and here is where we find the problems caused to the corporate
sector:
The definitions of the Regulatory Capital and the RWA have changed:
Calculated according to the Basel III definitions, the Core Tier One ratio would have been
5.7% instead of 11.1% according to the old definitions
The 87 “large banks” who answered the impact study would have been short of €600bn of
equity at the end of 2009. New stress tests are disclosed regularly and the shortcomings
differ, but they are still there. This means that banks will either/or have to raise more capital
or decrease its present lending, which will create a crowding out of capital in the financial
markets either way.
There are new definitions of core equity leading to that it is reduced with up to 40% for large
banks increased the crowding out effects even further. Major changes in the definition:
Some financial instruments are not any longer eligible as Regulatory Capital
Intangibles and deferred tax assets shall be deducted from the Regulatory Capital
There are changes in how RWA is calculated in average increasing it with 23%. Major
changes include:
Sharp increase of RWA amounts from trading activities (stress tests on value at risk,
securitisations…) leading to many banks decreasing the trading leading to fewer banks
quoting prices. This has already led to reduced liquidity and increased costs and risks for
corporates in managing its financial exposure from import and export etc
This encourages particularly banks to perform their swaps through clearing houses
This may weight on complex derivatives businesses
Loan portfolios require being marked-to-market even though it is not required by accounting
standards. This increases pro-cyclicality
Basel III introduces a “Leverage Ratio” such that the amounts of assets and commitments
should not represent more than 33 times the Regulatory Capital, regardless of the level of
their risk-weighting and of the credit commitments being drawn down or not
The Financial Stability Board recommended in July 2011 that the 29 identified systemically
important financial institutions have a Core Tier 1 ratio increased between 1% and 2.5%. Of
course these “SIFIs” are the main large corporates’ banking counterparts. This provision has
been “enacted” by the G20 in November 2011.
The European Commission has added:
Minimum solvency ratio shall be 9% for the EU banks (instead of 7%)
The EU banks shall comply with this level in June 2012 (instead of 2019)
AREA 2: Assets and liabilities management
Banks will have to comply with two new ratios:
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
LCR: high-quality highly-liquid assets available must exceed the net cash outflows of the next
30 days:
High-quality highly-liquid assets:
Level 1 assets: Recognized at 100%: cash, sovereign debt of countries weighted at 0%
(which include the PIIGS as they are part of the Eurozone), deposit at central bank. Level 1
assets shall account for at least 60% of the “high-quality highly liquid assets”
Level 2A assets: Recognized at 85% and must not represent more than 40% of the assets:
sovereign debt weighted at 20% (countries rated below AA-), corporate bonds and covered
bonds rated at least AALevel
2B assets (introduced Jan, 2013): non-financial corporate bonds rated between BBBand
A+, with a hair cut of 50%; certain unencumbered equities, with a hair cut of 50%; and
certain residential mortgage-backed securities (RMBS), with a hair cut of 25%.
The Level 2B assets will not be eligible for more than 15% of the “high-quality highly liquid
assets” and a total level 2 assets will not be eligible for more than 40% of the “high-quality
highly liquid assets”
Changes from January 2013 provide:
To some extent, lesser cost of carry for banks on “high-quality highly-liquid assets” but still
limited because of the 50% hair cut and 15% limitation
Improvement for the financing of investment graded companies (BBB and above) by banks
through bonds, which will remain in competition with residential mortgage-backed securities
(RBMS) with lesser hair cut and whose markets is restored with these new provisions
Level 1 assets remain at least 60% of the “high-quality highly-liquid assets”, which means
that concentration risks and cost of carry remain.
Net cash outflows = cash outflows – cash inflows
NSFR: long-term financial resources must exceed long-term commitments (long term = and
more than 1 year):
Stable funding:
equity and any liability maturing after one year
90% of retail deposits
50% of deposits from non-financial corporates and public entities
Long-term uses:
5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach riskweighting
(see comment above for LCR) with a residual maturity above 1 year
20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity
above 1 year
50% of non-financial corporate or covered bonds at least rated between A- and A+ with a
residual maturity above 1 year
50% of loans to non-financial corporates or public sector
65% of residential mortgage with a residual maturity above 1 year
5% of undrawn credit and liquidity facilities
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RBI Guidelines for Implementation of Basel III
Guidelines
Back Ground for Basel III :
Earlier guidelines were known as Basel I and Basel II accords. Later on the committee was
expanded to include members from nearly 30 countries , including India. Inspite of
implementation of Basel I and II guidelines, the financial world saw the worst crisis in early
2008 and whole financial markets tumbled. One of the major debacles was the fall of Lehman
Brothers. One of the interesting comments on the Balance Sheet of Lehman Brothers read :
“Whatever was on the left-hand side (liabilities) was not right and whatever was on the righthand
side (assets) was not left.” Thus, it became necessary to re-visit Basel II and plug the
loopholes and make Basel norms more stringent and wider in scope.
BCBS, through Basel III, put forward norms aimed at strengthening both sides of balance
sheets of banks viz.
(a) enhancing the quantum of common equity;
(b) improving the quality of capital base;
(c) creation of capital buffers to absorb shocks;
(d) improving liquidity of assets;
(e) optimising the leverage through Leverage Ratio;
(f) creating more space for banking supervision by regulators under Pillar II; and
(g) bringing further transparency and market discipline under Pillar III.
Thus, Basel III norms were released by BCBS and individual central banks were asked to
implement these in a phased manner. RBI (India's central bank) too issued draft guidelines in
the initial stage and then came up with the final guidelines.
Over View f the RBI Guidelines for Implementation of Basel III guidelines :
The final guidelines have been issued by Reserve Bank of India for implementation of Basel 3
guidelines on 2nd May, 2012. Full detailed guidelines can be downloaded from RBI website,
by clicking on the following link : Implementation of Base III Guidelines. Major features of
these guidelines are :
(a) These guidelines would become effective from January 1, 2013 in a phased manner. This
means that as at the close of business on January 1, 2013, banks must be able to declare or
disclose capital ratios computed under the amended guidelinesThe Basel III capital ratios will
be fully implemented as on March 31, 2018
(b) The capital requirements for the implementation of Basel III guidelines may be lower
during the initial periods and higher during the later years. Banks needs to keep this in view
while Capital Planning;
(c) Guidelines on operational aspects of implementation of the Countercyclical Capital Buffer.
Guidance to banks on this will be issued in due course as RBI is still working on these.
Moreover, some other proposals viz. ‘Definition of Capital Disclosure Requirements’,
‘Capitalisation of Bank Exposures to Central Counterparties’ etc., are also engaging the
attention of the Basel Committee at present. Therefore, the final proposals of the Basel
Committee on these aspects will be considered for implementation, to the extent applicable,
in future.
(d) For the financial year ending March 31, 2013, banks will have to disclose the capital ratios
computed under the existing guidelines (Basel II) on capital adequacy as well as those
computed under the Basel III capital adequacy framework.
(e) The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against
8% (international) prescribed by the Basel Committee of Total Risk Weighted assets. This
has been decided by Indian regulator as a matter of prudence. Thus, it requirement in this
regard remained at the same level. However, banks will need to raise more money than
under Basel II as several items are excluded under the new definition.
(f) of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs;
(g) In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international
standards require these to be only at 4.5%) banks are also required to maintain a Capital
Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital.
CCB is designed to ensure that banks build up capital buffers during normal times (i.e. outside
periods of stress) which can be drawn down as losses are incurred during a stressed period.
In case such buffers have been drawn down, the banks have to rebuild them through reduced
discretionary distribution of earnings. This could include reducing dividend payments, share
buybacks and staff bonus.
(h) Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been
raised to 7% under Basel III. Moreover, certain instruments, including some with the
characteristics of debts, will not be now included for arriving at Tier 1 capital;
(i) The new norms do not allow banks to use the consolidated capital of any insurance or non
financial subsidiaries for calculating capital adequacy.
(j) Leverage Ratio : Under the new set of guidelines, RBI has set the leverage ratio at 4.5%
(3% under Basel III). Leverage ratio has been introduced in Basel 3 to regulate banks which
have huge trading book and off balance sheet derivative positions. However, In India, most
of banks do not have large derivative activities so as to arrange enhanced cover for
counterparty credit risk. Hence, the pressure on banks should be minimal on this count.
(k) Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold
enough unencumbered liquid assets to cover expected net outflows during a 30-day stress
period. In India, the burden from LCR stipulation will depend on how much of CRR and SLR
can be offset against LCR. Under present guidelines, Indian banks already follow the norms
set by RBI for the statutory liquidity ratio (SLR) – and cash reserve ratio (CRR), which are
liquidity buffers. The SLR is mainly government securities while the CRR is mainly cash.
Thus, for this aspect also Indian banks are better placed over many of their overseas
counterparts.
(l) Countercyclical Buffer: Economic activity moves in cycles and banking system is inherently
pro-cyclic. During upswings, carried away by the boom, banks end up in excessive lending
and unchecked risk build-up, which carry the seeds of a disastrous downturn. The regulation
to create additional capital buffers to lend further would act as a break on unbridled banklending.
The detailed guidelines for these are likely to be issued by RBI only at a later stage.
On the day of release of these guidelines, analysts felt that India may need at least $30 billion
(i.e. around Rs 1.6 trillion) to $40 billion as capital over the next six years to comply with the
new norms. It was also felt that this would impose a heavy financial burden on the
government, as it will need to infuse capital in case it wants to continue its hold on these PS
Banks. RBI Deputy Governor, Mr Anand Sinha viewed that the implementation of Basel II may
have a negative impact on India's growth story. In FY 2012-13, Government of India is
expected to provide Rs 15888 crores to recapitalize the banks. as to maintain capital
adequacy of 8% under old Basel II norms.
Some Major Developments after 2nd May 2012 (i.e. the date when RBI issued Basel III
guidelines) :
(a) On 30th October 2012, RBI in its Second Quarter Review of Monetary Policy 2012-13 has
declared as follows :
(i) "Basel III Disclosure Requirements on Regulatory Capital Composition
The Basel Committee on Banking Supervision (BCBS) has finalised proposals on disclosure
requirements in respect of the composition of regulatory capital, aimed at improving
transparency of regulatory capital reporting as well as market discipline. As these disclosures
have to be given effect by national authorities by June 30, 2013, it has been decided:
to issue draft guidelines on composition of capital disclosure requirements by end-December
2012.
(ii) Banks’ Exposures to Central Counterparties (CCP)
The BCBS has also issued an interim framework for determining capital requirements for bank
exposures to CCPs. This framework is being introduced as an amendment to the existing
Basel II capital adequacy framework and is intended to create incentives to increase the use
of CCPs. These standards will come into effect on January 1, 2013. Accordingly, it has been
decided:
to issue draft guidelines on capital requirements for bank exposures to central counterparties,
based on the interim framework of the BCBS, by mid-November 2012.
(iii) Core Principles for Effective Banking Supervision
The Basel Committee has issued a revised version of the Core Principles in September 2012 to
reflect the lessons learned during the recent global financial crisis. In this context, it is
proposed:
to carry out a self-assessment of the existing regulatory and supervisory practices based on
the revised Core Principles and to initiate steps to further strengthen the regulatory and
supervisory mechanism.
(b) On 7th November, 2012 : RBI has issued final guidelines in respect of Liquidity Risk
Management by Banks
On September 1, 2014 : RBI revised some of its rules governing instruments that qualify as
bank capital under Basel-III
Revised rules make instruments more attractive and broaden the base for AT-1 bonds to
include retail investors
Moodys says the amended rules will also allow banks to have a higher proportion of AT-1 in
their Tier-1 capital
The major benefit is expected to accrue to public sector banks
Low capital levels are a key credit weakness for many Indian banks, particularly PSBs
Daily Concepts - Telegraphic Transfer (TT) Buying/Selling Rate &
Bills Buying/Selling Rate
Understanding Telegraphic Transfer (TT) Buying/Selling Rate & Bills
Buying/Selling Rate
TT Buying/Selling Rate & Bills Buying/Selling Rate are rather called as Merchant
exchange rate.
Merchant rates are lower than the spot rate definitely and somewhat around the
interbank rate which is one of the lowest rate in the market. At merchant rate high
volume export import transaction take place, because the volume of transaction of the
exporter importers may be millions of dollar, and they get a comparable rate generally
favourable to them. So, authorized dealer those who are providing exchange rate to
merchant compete among each other to give what is called a low, lowest rate to the
merchant. And the authorized dealers charge very low profit for merchant transaction
because the transaction is huge, any marginal level of profit can give them huge amount
of profit.
The types of merchant rates are telegraphic transfer rate, what you called TT rates, and
bills rate.
There are two types of T Rates - one is called TT buying rate, another is called TT selling
rate. When as a customer, I go to a bank and ask to remit some money to a person in
US, I purchase what is called TT selling, I sale a TT. When as a exporter, I got export
transaction in the form of foreign currency, I want to convert the foreign currency into
domestic currency, the rate applicable to is called TT buying rate. So, TT selling rate is
nothing but outward transaction, TT buying rate nothing but inward remittances.
TT Buying Rate
If you want to convert the foreign currency into domestic money, you have to buy a TT,
the TT buying rate inward remittances applicable to them. Telegraphic transfer, money
transfer, demand draft, which are generally denominated in foreign currency converted
into Indian currency or domestic currency. So, we have to purchase what is called TT
buying. Conversion of proceeds of instrument, many export oriented instruments, many
foreign bills, those who are denominated in foreign currency converts into domestic
currency through TT buying rate.
Similarly, if you want to cancel outward remittances, suppose you have booked a foreign
DD, foreign currency DD, but you want to convert into Indian currency or cancel it, then
you have to purchase what is called a TT buying rate. So, TT buying rates applicable to
inward remittances, foreign currency demand draft, foreign currency money transfer,
conversion of proceeds of foreign currency denominated instrument, cancellation of
outward remittances in the form of DD, TT, MT.
TT selling rate
If you want to send foreign currency to outside that is from domestic economy, the
foreign currencies are going outward to other country, then you have to sale a TT. So, if
I want to send US dollar to any US citizen in US, then I have to convert the domestic
rupee into US dollar, that time I have to sell a TT. So, all outward remittances
transaction which are generally converted by paying domestic money into foreign
currency are called TT selling rate.
So, outward remittances, telegraphic transfer, money transfer, foreign currency
denominates DD that is demand draft, conversion of proceeds of instrument that is any
instrument in domestic money converted into a foreign currency, cancellation of inward
remittances, if you want to convert any foreign domestic DD, TT, MT into foreign
currency, then TT selling rate applicable. If you want to import something, then you
have to sell TT. TT selling rate applicable to all outward transaction in which any foreign
currency purchased by paying domestic currency.
Bills Buying Rate/Bills Selling Rate
Bills are export import proceeds. Bills buying rate is nothing but inward remittances, bill
selling rate nothing but outward remittances. Foreign currency converted into domestic
currency through bills buying rate; domestic currency converted into foreign currency
through bill selling rate. Here bills are export import bill, and any other kind of foreign,
foreign currency denominated instruments.
TT/Bills Buying/Selling Examples:
1. Inflow of USD 200,000.00 by TT for credit to your exporter's account, being advance
payment for exports (credit received in Nostro statement received from New York
correspondent). What rate you will take to quote to the customer, if the market is
55.21/25?
Explanation :
It will be a purchase of USD from customer for which USD will have to be sold in the
market. Say when USD/Rs is being quoted as 55.21/25, meaning that market buys USD
at Rs 55.21 and sells at Rs 55. 25. We shall have to quote rate to the customer on the
basis of market buying rate, i.e. 55.21, less our margin, as applicable, to arrive at the TT
Buying Rate applicable for the customer transaction.
2. Retirement of import bill for GBP 100,000.00 by TT Margin 0.20%, ignore cash
discount/premium, GBP/USD 1.3965/75, USD/INR 55.16/18. Compute Rate for
Customer.
Explanation :
For retirement of import bill in GBP, we need to buy GBP, to buy GBP we need to give
USD and to get USD, we need to buy USD against Rupee, i.e. sell Rupee.
At the given rates, GBP can be bought at 1.3975 USD, while USD can be bought at
55.18. The GBP/INR rate would be 77.1140. (1.3975 x 55.18), at which we can get GBP
at market rates. Thus the interbank rate for the transaction can be taken as 77.1140.
Add Margin 0.20% 0.1542.
Rate would be 77.1140 + 0.1542 = 77.2682 for effecting import payment. (Bill Selling
Rate).
Daily Concepts - Letter of Credit (LC)
Letter Of Credit
A letter from a bank guaranteeing that a buyer's payment to a seller will be received on
time and for the correct amount. In the event that the buyer is unable to make payment
on the purchase, the bank will be required to cover the full or remaining amount of the
purchase. Now in simple words, If LC opened on your name as beneficiary, you will
receive amount though the buyer’s bank (opening bank) on the agreed time. All Letters
of Credit for export import trade is handled under the guidelines of Uniform Customs and
Practice of Documentary Credit of International Chamber of Commerce (UCP 600).
Letters of credit are often used in international transactions to ensure that payment will
be received. Due to the nature of international dealings including factors such as
distance, differing laws in each country and difficulty in knowing each party personally,
the use of letters of credit has become a very important aspect of international trade.
The bank also acts on behalf of the buyer (holder of letter of credit) by ensuring that the
supplier will not be paid until the bank receives a confirmation that the goods have been
shipped.
There are various types of letters of credit like Revocable, Irrevocable, Confirmed,
Unconfirmed, Clean & Documentary, Fixed, Revolving, Transferable, Back to Back etc.
Most common and safe LC is Irrevocable Letter of Credit for both buyer and seller.
Procedures to get money under Letter of Credit at sight.
Opening a Letter of Credit at sight is common practice in the export business. Under
sight LC, the payment of export proceeds sent to seller’s bank by buyer’s bank
immediately up on receipt of original shipping documents as per the terms and
conditions mentioned on LC.
Once after completion of export customs clearance procedures, the exporter prepares all
required documents as per the terms and conditions of letter of credit. These documents
will be submitted with exporter’s bank, along with the original LC. Bank verifies all
documents and make sure, the documentation is in order as per LC conditions. These
documents will be sent to buyer’s bank and in turn to the buyer after necessary approval
in documentation by seller’s bank. Once the buyer’s bank receives the documents, the
export sales amount as per the said documents will be sent to exporter’s bank.
However, the documentation of each consignment must be as per the conditions of LC at
sight and the buyer’s bank has the right to reject payment on any violation of such
documentation. This is the procedures under letter of credit at sight.
How long is the Credit period under Letter of Credit:
The credit period of LC can be determined my mutually agreed terms and condition by
buyer and seller before sales takes place.
Some time, the foreign buyer may demand credit period of 30 days, 60 days, 90 days,
120 days etc. However as per government regulation, the total period of credit should
not exceed more than 180 days.
Normally the credit period is calculated from the date of shipment. The date of shipment
is determined on the basis of date of bill of lading or airway bill.
Who is a ‘prime banker’ ?
As per the details of assets and liabilities based on the annual financial report of each
bank all over the world, the authorities related to banking prepares prime bankers list.
The prime banks are the banks that hold strong financial background with sound assets
and have been serving people with best service. The prime banker’s data base are
available with all major reputed banks all over world. One can check this data with your
bank or your bank may help you to whom to be approached to get the said data.
So a Letter of Credit issued by a Prime Bank is safe for an exporter always.
How to check authenticity of letter of credit (LC)?
There are many banks all over world. Now days, after the introduction of globalization of
trade, a number of banks and financial institutions have been introduced all over world
with least restrictions within the country. Some of them have been working without any
regulations by government also. These banks work under Society’s Registration Act, but
name as “Bank”. You can approach your bank with the copy of letter of credit to verify
the authenticity and check whether the said LC has been opened by a prime bank.
We can classify mainly eight main parties involved in a Letter of Credit.
Applicant of Letter of Credit.
Applicant is the party who opens Letter of Credit. Normally, buyer of goods is the
Applicant who opens letter of credit. Letter of credit is opened as per his instruction and
necessary payment is arranged to open Letter of credit with his bank. The applicant
arranges to open letter of credit with his bank as per the terms and conditions of
Purchase order and business contract between buyer and seller. So Applicant is one of
the major parties involved in a Letter of credit.
LC Issuing Bank
Issuing Bank is the bank who opens letter of credit. Letter of credit is created by issuing
bank who takes responsibility to pay amount on receipt of documents from supplier of
goods (beneficiary under LC).
Beneficiary party
Beneficiary of Letter of credit gets the benefit under Letter of credit. Beneficiary is the
party under letter of credit who receives amount under letter of credit. The LC is opened
on Beneficiary party’s favor. Beneficiary party under letter of credit submits all required
documents with is bank in accordance with the terms and conditions under LC.
Advising Bank
Advising bank, as a part of letter of credit takes responsibility to communicate with
necessary parties under letter of credit and other required authorities. The advising bank
is the party who sends documents under Letter of Credit to opening bank.
Confirming Bank
Confirming bank as a party of letter of credit confirms and guarantee to undertake the
responsibility of payment or negotiation acceptance under the credit.
Negotiating Bank
Negotiating Bank, who negotiates documents delivered to bank by beneficiary of LC.
Negotiating bank is the bank who verifies documents and confirms the terms and
conditions under LC on behalf of beneficiary to avoid discrepancies
Reimbursing Bank
Reimbursing bank is the party who authorized to honor the the reimbursement claim of
negotiation/ payment/ acceptance.
Second Beneficiary
Second beneficiary who represent the first beneficiary or original beneficiary in their
absence, where in the credits belongs to original beneficiary is transferable as per terms.
Some more notes for clear understanding of LC
Letters of credit used in international transactions are governed by the International
Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The
general provisions and definitions of the International Chamber of Commerce are binding
on all parties. Domestic collections in the United States are governed by the Uniform
Commercial Code.
A commercial letter of credit is a contractual agreement between a bank, known as the
issuing bank, on behalf of one of its customers, authorizing another bank, known as the
advising or confirming bank, to make payment to the beneficiary. The issuing bank, on
the request of its customer, opens the letter of credit. The issuing bank makes a
commitment to honor drawings made under the credit. The beneficiary is normally the
provider of goods and/or services. Essentially, the issuing bank replaces the bank's
customer as the payor.
Elements of a Letter of Credit
A payment undertaking given by a bank (issuing bank)
On behalf of a buyer (applicant)
To pay a seller (beneficiary) for a given amount of money
On presentation of specified documents representing the supply of goods
Within specified time limits
Documents must conform to terms and conditions set out in the letter of credit
Documents to be presented at a specified place
Letter of Credit Characteristics
Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the
beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are
passed freely from one party to another almost in the same way as money. To be
negotiable, the letter of credit must include an unconditional promise to pay, on demand
or at a definite time. The nominated bank becomes a holder in due course. As a holder
in due course, the holder takes the letter of credit for value, in good faith, without notice
of any claims against it. A holder in due course is treated favorably under the UCC.
The transaction is considered a straight negotiation if the issuing bank's payment
obligation extends only to the beneficiary of the credit. If a letter of credit is a straight
negotiation it is referenced on its face by "we engage with you" or "available with
ourselves". Under these conditions the promise does not pass to a purchaser of the draft
as a holder in due course.
Revocability
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may
be revoked or modified for any reason, at any time by the issuing bank without
notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is
engaged in a transaction that involves a revocable letter of credit, it serves as the
advising bank.
Once the documents have been presented and meet the terms and conditions in the
letter of credit, and the draft is honored, the letter of credit cannot be revoked. The
revocable letter of credit is not a commonly used instrument. It is generally used to
provide guidelines for shipment. If a letter of credit is revocable it would be referenced
on its face.
The irrevocable letter of credit may not be revoked or amended without the agreement
of the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of
credit from the issuing bank insures the beneficiary that if the required documents are
presented and the terms and conditions are complied with, payment will be made. If a
letter of credit is irrevocable it is referenced on its face.
Transfer and Assignment
The beneficiary has the right to transfer or assign the right to draw, under a credit only
when the credit states that it is transferable or assignable. Credits governed by the
Uniform Commercial Code (Domestic) maybe transferred an unlimited number of times.
Under the Uniform Customs Practice for Documentary Credits (International) the credit
may be transferred only once. However, even if the credit specifies that it is
nontransferable or nonassignable, the beneficiary may transfer their rights prior to
performance of conditions of the credit.
Sight and Time Drafts
All letters of credit require the beneficiary to present a draft and specified documents in
order to receive payment. A draft is a written order by which the party creating it, orders
another party to pay money to a third party. A draft is also called a bill of exchange.
There are two types of drafts: sight and time. A sight draft is payable as soon as it is
presented for payment. The bank is allowed a reasonable time to review the documents
before making payment.
A time draft is not payable until the lapse of a particular time period stated on the draft.
The bank is required to accept the draft as soon as the documents comply with credit
terms. The issuing bank has a reasonable time to examine those documents. The issuing
bank is obligated to accept drafts and pay them at maturity.
Standby Letter of Credit
The standby letter of credit serves a different function than the commercial letter of
credit. The commercial letter of credit is the primary payment mechanism for a
transaction. The standby letter of credit serves as a secondary payment mechanism. A
bank will issue a standby letter of credit on behalf of a customer to provide assurances
of his ability to perform under the terms of a contract between the beneficiary. The
parties involved with the transaction do not expect that the letter of credit will ever be
drawn upon.
The standby letter of credit assures the beneficiary of the performance of the customer's
obligation. The beneficiary is able to draw under the credit by presenting a draft, copies
of invoices, with evidence that the customer has not performed its obligation. The bank
is obligated to make payment if the documents presented comply with the terms of the
letter of credit.
Standby letters of credit are issued by banks to stand behind monetary obligations, to
insure the refund of advance payment, to
support performance and bid obligations, and to insure the completion of a sales
contract. The credit has an expiration date. The standby letter of credit is often used to
guarantee performance or to strengthen the credit worthiness of a customer. In the
above example, the letter of credit is issued by the bank and held by the supplier. The
customer is provided open account terms. If payments are made in accordance with the
suppliers' terms, the letter of credit would not be drawn on. The seller pursues the
customer for payment directly. If the customer is unable to pay, the seller presents a
draft and copies of invoices to the bank for payment.
The domestic standby letter of credit is governed by the Uniform Commercial Code.
Under these provisions, the bank is given until the close of the third banking day after
receipt of the documents to honor the draft.
Procedures for Using the Tool
The following procedures include a flow of events that follow the decision to use a
Commercial Letter of Credit. Procedures required to execute a Standby Letter of Credit
are less rigorous. The standby credit is a domestic transaction. It does not require a
correspondent bank (advising or confirming). The documentation requirements are also
less tedious.
Step-by-step process:
Buyer and seller agree to conduct business. The seller wants a letter of credit to
guarantee payment.
Buyer applies to his bank for a letter of credit in favor of the seller.
Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its
correspondent bank (advising or confirming). The correspondent bank is usually located
in the same geographical location as the seller (beneficiary).
Advising bank will authenticate the credit and forward the original credit to the seller
(beneficiary).
Seller (beneficiary) ships the goods, then verifies and develops the documentary
requirements to support the letter of credit.
Documentary requirements may vary greatly depending on the perceived risk involved in
dealing with a particular company.
Seller presents the required documents to the advising or confirming bank to be
processed for payment.
Advising or confirming bank examines the documents for compliance with the terms and
conditions of the letter of credit.
If the documents are correct, the advising or confirming bank will claim the funds by:
Debiting the account of the issuing bank.
Waiting until the issuing bank remits, after receiving the documents.
Reimburse on another bank as required in the credit.
Advising or confirming bank will forward the documents to the issuing bank.
Issuing bank will examine the documents for compliance. If they are in order, the issuing
bank will debit the buyer's account.
Issuing bank then forwards the documents to the buyer.
Standard Forms of Documentation
When making payment for product on behalf of its customer, the issuing bank must
verify that all documents and drafts conform precisely to the terms and conditions of the
letter of credit. Although the credit can require an array of documents, the most
common documents that must accompany the draft include:
Commercial Invoice
The billing for the goods and services. It includes a description of merchandise, price,
FOB origin, and name and address of buyer and seller. The buyer and seller information
must correspond exactly to the description in the letter of credit. Unless the letter of
credit specifically states otherwise, a generic description of the merchandise is usually
acceptable in the other accompanying documents.
Bill of Lading
A document evidencing the receipt of goods for shipment and issued by a freight carrier
engaged in the business of forwarding or transporting goods. The documents evidence
control of goods. They also serve as a receipt for the merchandise shipped and as
evidence of the carrier's obligation to transport the goods to their proper destination.
Warranty of Title
A warranty given by a seller to a buyer of goods that states that the title being conveyed
is good and that the transfer is rightful.
This is a method of certifying clear title to product transfer. It is generally issued to the
purchaser and issuing bank expressing an agreement to indemnify and hold both parties
harmless.
Letter of Indemnity
Specifically indemnifies the purchaser against a certain stated circumstance.
Indemnification is generally used to guaranty that shipping documents will be provided
in good order when available.
Common Defects in Documentation
About half of all drawings presented contain discrepancies. A discrepancy is an
irregularity in the documents that causes them to be in non-compliance to the letter of
credit. Requirements set forth in the letter of credit cannot be waived or altered by the
issuing bank without the express consent of the customer. The beneficiary should
prepare and examine all documents carefully before presentation to the paying bank to
avoid any delay in receipt of payment. Commonly found discrepancies between the letter
of credit and supporting documents include:
Letter of Credit has expired prior to presentation of draft.
Bill of Lading evidences delivery prior to or after the date range stated in the credit.
Stale dated documents.
Changes included in the invoice not authorized in the credit.
Inconsistent description of goods.
Insurance document errors.
Invoice amount not equal to draft amount.
Ports of loading and destination not as specified in the credit.
Description of merchandise is not as stated in credit.
A document required by the credit is not presented.
Documents are inconsistent as to general information such as volume, quality, etc.
Names of documents not exact as described in the credit. Beneficiary information must
be exact.
Invoice or statement is not signed as stipulated in the letter of credit.
When a discrepancy is detected by the negotiating bank, a correction to the document
may be allowed if it can be done quickly while remaining in the control of the bank. If
time is not a factor, the exporter should request that the negotiating bank return the
documents for corrections.
If there is not enough time to make corrections, the exporter should request that the
negotiating bank send the documents to the issuing bank on an approval basis or notify
the issuing bank by wire, outline the discrepancies, and request authority to pay.
Payment cannot be made until all parties have agreed to jointly waive the discrepancy.
Tips for Exporters
Communicate with your customers in detail before they apply for letters of credit.
Consider whether a confirmed letter of credit is needed.
Ask for a copy of the application to be fax to you, so you can check for terms or
conditions that may cause you problems in compliance.
Upon first advice of the letter of credit, check that all its terms and conditions can be
complied with within the prescribed time limits.
Many presentations of documents run into problems with time-limits. You must be aware
of at least three time constraints - the expiration date of the credit, the latest shipping
date and the maximum time allowed between dispatch and presentation.
If the letter of credit calls for documents supplied by third parties, make reasonable
allowance for the time this may take to complete.
After dispatch of the goods, check all the documents both against the terms of the credit
and against each other for internal consistency.
Daily Concepts - Commercial Paper (CP)
Commercial Paper (CP)
Commercial Paper (CP) is an unsecured money market instrument issued in the form of
a promissory note.
It was introduced in India in 1990. It was introduced in India in 1990 with a view to
enabling highly rated corporate borrowers to diversify their sources of short-term
borrowings and to provide an additional instrument to investors. Subsequently, primary
dealers and all-India financial institutions were also permitted to issue CP to enable them
to meet their short-term funding requirements for their operations.
Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are
eligible to issue CP.
A corporate would be eligible to issue CP provided –
a. the tangible net worth of the company, as per the latest audited balance sheet, is not
less than Rs. 4 crore
b. company has been sanctioned working capital limit by bank/s or all-India financial
institution/s; and
c. the borrowal account of the company is classified as a Standard Asset by the financing
bank/s/ institution/s.
All eligible participants shall obtain the credit rating for issuance of Commercial Paper
either from Credit Rating Information Services of India Ltd. (CRISIL) or the Investment
Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and
Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other credit rating
agency (CRA) as may be specified by the Reserve Bank of India from time to time, for
the purpose.
Issue of CP – Credit enhancement, limits, etc.
a. CP shall be issued as a ‘stand alone’ product. Further, it would not be obligatory in any
manner on the part of the banks and FIs to provide stand-by facility to the issuers of CP.
b. Banks and FIs may, based on their commercial judgement, subject to the prudential
norms as applicable to them, with the specific approval of their respective Boards,
choose to provide stand-by assistance/credit, back-stop facility etc. by way of credit
enhancement for a CP issue.
c. Non-bank entities (including corporates) may provide unconditional and irrevocable
guarantee for credit enhancement for CP issue provided:
1. the issuer fulfils the eligibility criteria prescribed for issuance of CP;
2. the guarantor has a credit rating at least one notch higher than the issuer given by an approved
CRA; and
3. the offer document for CP properly discloses the net worth of the guarantor company, the names
of the companies to which the guarantor has issued similar guarantees, the extent of the
guarantees offered by the guarantor company, and the conditions under which the guarantee will
be invoked.
d. The aggregate amount of CP that can be issued by an issuer shall at all times be
within the limit as approved by its Board of Directors or the quantum indicated by the
CRA for the specified rating, whichever is lower.
e. Banks and FIs shall have the flexibility to fix working capital limits, duly taking into
account the resource pattern of company’s financing, including CP.
f. An issue of CP by an FI shall be within the overall umbrella limit prescribed in the
Master Circular on Resource Raising Norms for FIs, issued by the Reserve Bank of India,
Department of Banking Operations and Development, as prescribed/ updated from timeto-
time.
g. The total amount of CP proposed to be issued should be raised within a period of two
weeks from the date on which the issuer opens the issue for subscription. CP may be
issued on a single date or in parts on different dates provided that in the latter case,
each CP shall have the same maturity date.
h. Every issue of CP, and every renewal of a CP, shall be treated as a fresh issue.
Eligibility for Investment in CP
1. Individuals, banks, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, Non-Resident Indians and Foreign Institutional Investors (FIIs) shall be
eligible to invest in CP.
2. FIIs shall be eligible to invest in CPs subject to (i) such conditions as may be set for them by
Securities Exchange Board of India (SEBI) and (ii) compliance with the provisions of the
Foreign Exchange Management Act, 1999, the Foreign Exchange (Deposit) Regulations, 2000
and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident
Outside India) Regulations, 2000, as amended from time to time.
Form of the Instrument, mode of issuance and redemption
1. CP shall be issued in the form of a promissory note (as specified in Schedule I to these
Guidelines) and held in physical form or in a dematerialized form through any of the
depositories approved by and registered with SEBI, provided that all RBI regulated entities can
deal in and hold CP only in dematerialised form through such depositories.
2. Fresh investments by all RBI-regulated entities shall be only in dematerialised form.
3. CP shall be issued in denominations of ` 5 lakh and multiples thereof. The amount invested by a
single investor should not be less than ` 5 lakh (face value).
4. CP shall be issued at a discount to face value as may be determined by the issuer.
5. No issuer shall have the issue of CP underwritten or co-accepted.
6. Options (call/put) are not permitted on CP.
Tenor
1. CP shall be issued for maturities between a minimum of 7 days and a maximum of up to one
year from the date of issue.
2. The maturity date of the CP shall not go beyond the date up to which the credit rating of the
issuer is valid.
Procedure for Issuance
1. Every issuer must appoint an IPA for issuance of CP.
2. The issuer should disclose to the potential investors, its latest financial position as per the
standard market practice.
3. After the exchange of confirmation of the deal between the investor and the issuer, the issuer
shall arrange for crediting the CP to the Demat account of the investor with the depository
through the IPA.
4. The issuer shall give to the investor a copy of IPA certificate to the effect that the issuer has a
valid agreement with the IPA and documents are in order (Schedule II).
Rating Requirement
Eligible participants/issuers shall obtain credit rating for issuance of CP from any one of
the SEBI registered CRAs. The minimum credit rating shall be ‘A3’ as per rating symbol
and definition prescribed by SEBI. The issuers shall ensure at the time of issuance of the
CP that the rating so obtained is current and has not fallen due for review.
Investment / Redemption
1. The investor in CP (primary subscriber) shall pay the discounted value of the CP to the account
of the issuer through the IPA.
2. The investor holding the CP in physical form shall, on maturity, present the instrument for
payment to the issuer through the IPA.
3. The holder of a CP in dematerialised form shall get the CP redeemed and receive payment
through the IPA.
The aggregate amount of CP from an issuer shall be within the limit as approved by its
Board of Directors or the quantum indicated by the Credit Rating Agency for the
specified rating, whichever is lower.
As regards FIs, they can issue CP within the overall umbrella limit prescribed in the
Master Circular on Resource Raising Norms for FIs, issued by DBOD and updated from
time-to-time.
The total amount of CP proposed to be issued should be raised within a period of two
weeks from the date on which the issuer opens the issue for subscription.
CP may be issued on a single date or in parts on different dates provided that in the
latter case, each CP shall have the same maturity date. Further, every issue of CP,
including renewal, shall be treated as a fresh issue.
Only a scheduled bank can act as an Issuing and Paying Agent (IPA) for issuance of
CP.
Individuals, banking companies, other corporate bodies (registered or incorporated in
India) and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional
Investors (FIIs) etc. can invest in CPs. However, investment by FIIs would be within the
limits set for them by Securities and Exchange Board of India (SEBI) from time-to-time.
CP can be issued either in the form of a promissory note (Schedule I given in the Master
Circular-Guidelines for Issue of Commercial Paper dated July 1, 2011 and updated from
time –to-time) or in a dematerialised form through any of the depositories approved by
and registered with SEBI. Banks, FIs and PDs can hold CP only in dematerialised form.
CP will be issued at a discount to face value as may be determined by the issuer.
No issuer shall have the issue of Commercial Paper underwritten or co-accepted.
CPs are actively traded in the OTC market. Such transactions, however, are to be
reported on the FIMMDA reporting platform within 15 minutes of the trade for
dissemination of trade information to market participation thereby ensuring market
transparency.
Mode of redemption
Initially the investor in CP is required to pay only the discounted value of the CP by
means of a crossed account payee cheque to the account of the issuer through IPA. On
maturity of CP,
(a) when the CP is held in physical form, the holder of the CP shall present the
instrument for payment to the issuer through the IPA.
(b) when the CP is held in demat form, the holder of the CP will have to get it redeemed
through the depository and receive payment from the IPA.
CP being a `stand alone’ product, it would not be obligatory in any manner on the part
of banks and FIs to provide stand-by facility to the issuers of CP.
However, Banks and FIs have the flexibility to provide for a CP issue, credit
enhancement by way of stand-by assistance/credit backstop facility, etc., based on their
commercial judgement and as per terms prescribed by them. This will be subjected to
prudential norms as applicable and subject to specific approval of the Board.
Non-bank entities including corporates can provide unconditional and irrevocable
guarantee for credit enhancement for CP issue provided :
a. the issuer fulfils the eligibility criteria prescribed for issuance of CP;
b. the guarantor has a credit rating at least one notch higher than the issuer by an
approved credit rating agency and
c. the offer document for CP properly discloses: the networth of the guarantor company,
the names of the companies to which the guarantor has issued similar guarantees, the
extent of the guarantees offered by the guarantor company, and the conditions under
which the guarantee will be invoked.
Procedure for Buyback of CP:
1. Issuers may buyback the CP, issued by them to the investors, before maturity.
2. Buyback of CP shall be through the secondary market and at prevailing market price.
3. The CP shall not be bought back before a minimum period of 7 days from the date of issue.
4. Issuer shall intimate the IPA of the buyback undertaken.
5. Buyback of CPs should be undertaken after taking approval from the Board of Directors.
Role and responsibilities of the Issuer/Issuing and Paying Agent and Credit
Rating Agency.
Issuer:
a. Every issuer must appoint an IPA for issuance of CP.
b. The issuer should disclose to the potential investors its financial position as per the
standard market practice.
c. After the exchange of deal confirmation between the investor and the issuer, issuing
company shall issue physical certificates to the investor or arrange for crediting the CP to
the investor's account with a depository.
Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid
agreement with the IPA and documents are in order (Schedule II given in the Master
Circular-Guidelines for Issue of Commercial Paper dated July 1, 2011 and updated from
time –to-time).
Issuing and Paying Agent
a. IPA would ensure that issuer has the minimum credit rating as stipulated by the RBI
and amount mobilised through issuance of CP is within the quantum indicated by CRA
for the specified rating or as approved by its Board of Directors, whichever is lower.
b. IPA has to verify all the documents submitted by the issuer viz., copy of board
resolution, signatures of authorised executants (when CP in physical form) and issue a
certificate that documents are in order. It should also certify that it has a valid
agreement with the issuer (Schedule II given in the Master Circular-Guidelines for Issue
of Commercial Paper dated July 1, 2011 and updated from time –to-time).
c. Certified copies of original documents verified by the IPA should be held in the custody
of IPA.
Credit Rating Agency
a. Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of capital
market instruments shall be applicable to them (CRAs) for rating CP.
b. Further, the credit rating agencies have the discretion to determine the validity period
of the rating depending upon its perception about the strength of the issuer.
Accordingly, CRA shall at the time of rating, clearly indicate the date when the rating is
due for review.
c. While the CRAs can decide the validity period of credit rating, CRAs would have to
closely monitor the rating assigned to issuers vis-a-vis their track record at regular
intervals and would be required to make its revision in the ratings public through its
publications and website
Fixed Income Money Market and Derivatives Association of India (FIMMDA), may
prescribe, in consultation with the RBI, any standardised procedure and documentation
for operational flexibility and smooth functioning of CP market. Issuers / IPAs may refer
to the detailed guidelines issued by FIMMDA on July 5, 2001 in this regard, and updated
from time-to-time.
Every CP issue should be reported to the Chief General Manager, Reserve Bank of India,
Financial Markets Department, Central Office, Fort, Mumbai through the Issuing and
Paying Agent (IPA) within three days from the date of completion of the issue,
incorporating details as per Schedule III given in the Master Circular-Guidelines for Issue
of Commercial Paper dated July 1, 2011 and updated from time-to-time.
Daily Concepts - Facilities for Exporters and Importers
Facilities for Exporters and Importers
Highlights of the Foreign Trade Policy 2015-20:
Increase exports to $900 billion by 2019-20, from $466 billion in 2013-14
Raise India's share in world exports from 2% to 3.5%.
Merchandise Export from India Scheme (MEIS) and Service Exports from India Scheme
(SEIS) launched.
Higher level of rewards under MEIS for export items with High domestic content and
value addition.
Chapter-3 incentives extended to units located in SEZs.
Export obligation under EPCG scheme reduced to 75% to Promote domestic capital
goods manufacturing.
FTP to be aligned to Make in India, Digital India and Skills India initiatives.
Duty credit scrips made freely transferable and usable For payment of custom duty,
excise duty and service tax.
Export promotion mission to take on board state Governments
Unlike annual reviews, FTP will be reviewed after two-and-Half years.
Higher level of support for export of defence, farm Produce and eco-friendly products.
You can go through the full details here http://dgft.gov.in/exim/2000/ftp2015-20E.pdf
RBI controls Foreign Exchange
DGFT (Directorate General of Foreign Trade) controls Foreign Trade.
Exim Policy as framed in accordance with FEMA is implemented by DGFT.
DGFT functions under direct control of Ministry of Commerce and Industry.
It regulates Imports and Exports through EXIM Policy.
RBI keeps Forex Reserves, Finances Export trade and Regulates exchange control.
Receipts and Payments of Forex are also handled by RBI.
IEC – Importer Exporter Code
One has to apply for IEC to become eligible for Imports and Exports.
DGFT allots IEC to Exporters and Importers in accordance with RBI guidelines and FEMA
regulations. EXIM Policy is also considered before allotting IEC.
Export Declaration Form
All exports (physically or otherwise) shall be declared in the following Form.
GR form--- meant for exports made otherwise than by post.
PP Form---meant for exports by post parcel.
Softex form---meant for export of software.
SDF (Statutory Declaration Form)----replaced GR form in order to submit declaration
electronically.
SDF is submitted in duplicate with Custom Commissioned who puts its stamp and hands
over the same to exporter marked “Exchange Control Copy” for submission thereof to
AD.
Exceptions
Trade Samples, Personal effects and Central Govt. goods.
Up to USD 25000 (value) – Goods or services as declared by exporter.
Gift items having value up to Rs. 5.00 lac.
Goods with value not exceeding USD 1000 value to Mynmar.
Goods imported free of cost for re-export.
Goods sent for testing.
The time norms for export trade are as under:
Submission of documents with “Exchange Control Copy” to AD within 21 days from date
of shipment.
Time period for realisation of Export proceeds is 12 M or 365 days from date of
shipment.
No time limit for SEZ (Special economic zones) and SHE(Status Holder Exporters) and
100 EOUs.
After expiry of time lime limit, extension is sought by Exporter on ETX Form.
The AD can extend the period by 6M. However, reporting will be made to RBI on XOS
Form on half yearly basis in respect of all overdue bills.
Direct Dispatch of Shipping Documents
AD banks may handle direct dispatch of shipping documents provided export proceeds
are up to USD 1 Million and the exporter is regular customer of at least 6 months.
Prescribed Method of payment and Reduction in export proceeds
Exporter will receive payment though any of the following mode:
Bank Drafts, TC, Currency, FCNR/NRE deposits, International Credit Card. But the
proceeds can be in Indian Rupees from Nepal.
Export proceeds from ACU countries (Bangladesh, Burma, Mynmar, Iran, Pak, Srilanka,
Nepal and Maldivis can be settled in ACUEURO or USD. A separate Dollar/Euro account is
maintained.
Exports may be allowed to reduce the export proceeds with the following:
Reduction in Invoice value on account of discount for pre-payment of Usance bills
(maximum 25%)
Agency commission on exports.
Claims against exports.
Write off the unrecoverable export dues up to maximum limit of 10% of export value.
The proceeds of exports can be got deposited by exporter in any of the following
account:
Overseas Foreign Currency account.
Diamond Dollar account.
EEFC (Exchange Earners Foreign Currency account)
DDA - Diamond Dollar Accounts
Diamond Dollar account can be opened by traders dealing in Rough and Polished
diamond or Diamond studded Jewellary with the following conditions:
With track record of 2 years.
Average Export turnover of 3 crore or above during preceding 3 licensing years.
DDA account can be opened by the exporter for transacting business in Foreign
Exchange. An exporter can have maximum 5 Diamond Dollar accounts.
EEFC Exchange Earners Foreign Currency accounts can be opened by exporters. 100%
export proceeds can be credited in the account which do not earn interest but this
amount is repatriable outside India for imports (Current Account transactions).
Pre-shipment Finance or Packing Credit
Packing credit has the following features:
Calculation of FOB value of order/LC amount or Domestic cost of production (whichever
is lower).
IEC allotted by DGFT.
Exporter should not be on the “Caution List” of RBI.
He should not be under “Specific Approval list” of ECGC.
There must be valid Export order or LC.
Account should be KYC compliance.
Liquidation of Pre-shipment credit
Out of proceeds of the bill.
Out of negotiation of export documents.
Out of balances held in EEFC account
Out of proceeds of Post Shipment credit.
Concessional rate of interest is allowed on Packing Credit up to 270 days. Previously, the
period was 180 days. Running facility can also be allowed to good customers.
Post Shipment Finance
Post shipment finance is made available to exporters on the following conditions:
IEC accompanied by prescribed declaration on GR/PP/Softex/SDF form must be
submitted.
Documents must be submitted by exporter within 21 days of shipment.
Payment must be made in approved manner within 6 months.
Normal Transit Period is 25 days.
The margin is NIL normally. But in any case, it should not exceed 10% if LC is there
otherwise it can be up to 25%.
Types of Post Shipment Finance:
Export Bills Purchased for sights bills and Discounting for Usance bills.
Export bills negotiation.
Pre-shipment & Post-shipment Finance
Q. 1. Received order of USD 50000(CIF) to Australia on 1.1.2015 when USD/INR Bill
Buying Rate is 63.50. How much preshipment finance will be released considering profit
margin of 10% and Insurance and freight cost@ 12%.
Solution
FOB Value = CIF – Insurance and Freight – Profit (Calculation at Bill Buying Rate on
1.1.2015)
= 50000X63.5 = 3175000 – 381000(12%) – 279400(10% of 2794000) = 2514600
Pre-shipment Finance = FOB value -25%(Margin) = 2514600-628650=1885950.
Q. 2. What will be amount of Post-shipment Finance under Foreign Bill Purchased for
USD 45000 when Bill Buying rate on 31.3.2015 (date of submission of Export
documents) is 63.50
Solution
45000X63. 05 = 2857500 Ans.
Daily Concepts - NRI - NRE/NRO
NRI: (Non- resident Indian) definition: As per FEMA 1999
A person resident outside India who is a citizen of India i.e.
a) Indian Citizen who proceed abroad for employment or for carrying on any business or
vocation or for any other purpose in cirucumstances indicating indefinite period of stay
outside India.
b) Indian Citizens working abroad on assignment with Foreign government, government
agencies or International MNC
c) Officials of Central and State Governments and Public Sector Undertaking deputed
abroad on assignments with Foreign Govt Agencies/ organization or posted to their own
offices including Indian Diplomatic Missions abroad.
NRI is a Person of Indian Nationality or Origin, who resides abroad for business or
vocation or employment, or intention of employment or vocation, and the period of stay
abroad is indefinite. And a person is of Indian origin if he has held an Indian passport, or
he/she or any of his/hers parents or grandparents was a citizen of India.
A spouse , who is a foreign citizen, of an India citizen or PIO, is also treated at a
PIO, for the purpose of opening of Bank Account, and other facilities granted for
investments into India, provided such accounts or investments are in the joint names of
spouse.
NRE Accounts – Rupee and Foreign Currency Accounts
NRI has provided with various schemes to open Bank A/cs an invest in India.
1) Non Resident (External) Rupee Account (NRE);
2) Non- Resident (Ordinary) Rupee Account (NRO);
3)Foreign Currency (Non-Resident) Account (Banks) {FCNR(B)}
When resident becomes NRI, his/her domestic rupee account, has to be redesignated
as an NRO account.
For NRE – Rupee A/cs , w.e.f 15-3-2005 an attorney can withdraw for local payments
or remittance to the account holder himself through normal banking channels.
NRI wants to repatriate overseas earned money back to India and/or NRI wants to keep
India based earnings in India. NRI has the option of opening a Non Resident Rupee
(NRE) account and/or a Non Resident Ordinary Rupee (NRO) account. An NRO account
can also be opened by a Person of Indian Origin (PIO) and an Overseas citizen of India
(OCI).
Similarities between NRE and NRO accounts:
Both accounts can be opened as Savings as well as current accounts and are Indian
Rupee accounts. One needs to maintain an average monthly balance of Rs 75000 in both
NRE and NRO accounts.
The Differences between NRE and NRO accounts:
Repatriation: Repatriation is defined as sending or bringing money back to the foreign
country. You can easily repatriate funds from an NRE account including the interest
earned in that account. However, RBI has made some restrictions on NRO accounts.
You can remit only up to USD 1 million in a financial year (April to March). In addition,
you will need a chartered accountant to complete the paperwork for you.
Taxation Laws: NRE accounts are tax exempted. Therefore, income taxes, wealth
taxes, and gift taxes do not apply in India. Interest earned from these accounts is also
exempt from taxes. But as per Indian Income tax laws, NRO accounts are taxable;
income taxes, wealth taxes, and gift taxes do apply. Interest earned on an NRO account
as also subject to taxation. However, reduced tax benefit is availed under Double
Taxation Avoidance Agreement (DTAA).
Deposit and Withdrawal of Funds: You can deposit funds from a foreign country (in
foreign currency) in both NRE and NRO accounts, but funds originating from India (in
Indian rupees) can only be deposited in an NRO account and cannot be deposited in an
NRE account. Withdrawals from both NRE and NRO accounts can only be made in INR.
Flow of Funds: In an NRE account, repatriation is allowed outside India in any
currency.
Transfer: An NRE account allows you to transfer funds to another NRE account as well
as to an NRO account. You can transfer funds from an NRO to another NRO account, but
you cannot transfer funds from an NRO account to an NRE account.
Joint Accounts: Two NRIs can open both an NRE joint account or an NRO joint
account. However, you cannot open an NRE joint account with a resident Indian. This
facility is available only with an NRO joint account.
Motive or Purpose: An NRE account helps you transfer funds to India earned abroad
and maintain them. While NRO accounts helps maintain regular flow of income earned in
the form of rent, pensions, or dividends from India.
Effect of Exchange Rate Fluctuations: NRE accounts are exposed to two kinds of
exchange loss, namely day-to-day fluctuations in the value of INR and conversion loss.
NRO accounts are not at such risk.
Choose NRE accounts if you:
want to park your overseas earnings remitted to India converted to Indian Rupees;
want to maintain savings in Rupee but keep them liquid; want to make a joint account
with another NRI;
want Rupee savings to be freely repatriable
Choose NRO account if you:
want to park India based earnings in Rupees in India;
want account to deposit income earned in India such as rent, dividends etc;
want to open account with resident Indian (close relative)
Daily Concepts - Correspondent Banking
Correspondent Banking
A correspondent account is an account (often called a nostro or vostro account)
established by a banking institution to receive deposits from, make payments on behalf
of, or handle other financial transactions for another financial institution. Correspondent
accounts are established through bilateral agreements between the two banks.
Commonly, correspondent accounts are the accounts of foreign banks that require the
ability to pay and receive the domestic currency. The accounts allow them to pay others
from the account or receive money from others into the account. This allows the bank to
offer various services to their customers such as foreign exchange and foreign currency
denominated loans and deposits, despite their not having a bank licence for the foreign
country in that country's currency.
Such accounts are necessary for international trade that requires people and businesses
to pay for things in a currency other than their own. It is impractical to transport large
amounts of currency around the world and physically exchange domestic currency for
the currency that a customer/supplier demands. Instead, money is taken out of an
account at a local bank (which is in local currency) and an equivalent amount of money
is put in the customer's or supplier's account at their local bank (in a foreign currency).
The money from the buyer's account goes to an internal account of your bank. The
money to the customer or supplier comes from an account the buyer's local bank holds
with a bank in the supplier's country—the buyer's bank's correspondent account, at their
correspondent bank.
A correspondent bank is a financial institution that provides services on behalf of
another, equal or unequal, financial institution. It bank can conduct business
transactions, accept deposits and gather documents on behalf of the other financial
institution. Correspondent banks are more likely to be used to conduct business in
foreign countries, and act as a domestic bank's agent abroad.
Correspondent banks are used by domestic banks in order to service transactions
originating in foreign countries, and act as a domestic bank's agent abroad. This is done
because the domestic bank may have limited access to foreign financial markets, and
cannot service its client accounts without opening up a branch in another country.
1. Corresponding Banking is the relationship between two banks which have mutual
accounts with each other, r one of them having account with the other.
2. Functions of Corresponding Banks:
A. Account Services
i. Clearing House Functions
ii. Collections
iii. Payments
iv. Overdraft and loan facility
v. Investment Services
B. Other Services
i. Letter of Credit Advising
ii. LC confirmation
iii. Bankers Acceptance
iv. Issuance of Guarantees – Bid-bond, Performance
v. Foreign Exchange services, including derivative products
vi. Custodial Services etc.
3. Types of Bank Accounts: The foreign account maintained by a Bank, with another
bank is classified as Nostro, Vostro, and Loro Accounts.
4. Nostro Account: “Our Account with you”. DLB maintains an US $ account with Bank
of Wachovia, New York is Nostro Account in the books of DLB, Mumbai.
5. Vostro Account: “Your account with us”. Say American Express Bank maintain a
Indian Rupee account with SBI is Vostro Account in the books of American Express bank
6. Loro Account: It refers to accounts of other banks i.e. His account with them. E.g.
Citi Bank referring to Rupee account of American Express Bank, with SBI Mumbai or
some other bank referring to the USD account of SBI, Mumbai with Citi Bank, New York.
7. Mirror Account: While a Bank maintains Nostro Account with a foreign Bank, (Mostly
in foreign currency), it has to keep an account of the same in its books. The mirror
account is maintained in two currencies, one in foreign currency and one in Home
currency.
8. Electronic Modes of transmission/ payment gateways
SWIFT, CHIPS, CHAPPS, RTGS, NEFT
9. SWIFT: Society for Worldwide Interbank Financial Telecommunications.
10. SWIFT has introduced new system of authentication of messages between banks by
use of Relationship Management Application (RMA) also called as SWIFT BIC i.e.Bank
Identification Code.
11. CHIPS: (Clearing House Interbank Payment System) is a major payment
system in USA since 1970. It is established by New York Clearing House. Present
membership is 48. CHIPS are operative only in New York.
12. FEDWIRE: This is payment system of Federal Reserve Bank, operated all over the
US since 1918. Used for domestic payments.
13. All US banks maintain accounts with Federal Reserve Bank and are allotted
an “ABA number” to identify senders and receivers of payment
What Does ABA Transit Number Mean?
A unique number assigned by the American Bankers Association (ABA) that identifies a
specific federal or state chartered bank or savings institution. In order to qualify for an
ABA transit number, the financial institution must be eligible to hold an account at a
Federal Reserve Bank. ABA transit numbers are also known as ABA routing numbers, and
are used to identify which bank will facilitate the payment of the check.
14. CHAPS: Clearing House Automated Payments system is British Equivalent to CHIPS,
handling receipts and payments in LONDON
15. TARGET: Trans-European Automated Real Time Gross Settlement Express Transfer
System is a EURO payment system working in Europe. And facilitates fund transfers in
Euro Zone.
16. RTGS + and EBA: RTGS+ is Euro German Based hybrid Clearing System. RTGS+
has 60 participants.
17. EBA-Euro 1 is a cross Border Euro Payments
18. RTGS/NEFT in India: The RTGS system is managed by IDRBT- Hyderabad. Real
Time Gross Settlement takes place in RTGS. NEFT settlement takes place in batches.
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