Documents needed for verification of various types of clients:

Documents needed for verification of various types of clients:

1. individuals: (a) One certified copy of an 'officially valid document' containing details of his identity
and address One recent photograph and such other documents including in respect of the nature
of business and financial status of the client as may be required by the banking company or the
financial institution or the intermediary. Photograph need not be submitted by a client who does
not have account-based relationship. Officially valid document means the passport, the driving
licence, the Permanent Account Number (PAN) Card, the Voter's Identity Card issued by the
Election Commission of India or any other document as may be required by the banking
company, or financial institution or intermediary. The Narega card and Adhar card issued by
UIDAI will also be officially valid documents.

2. Company: Certificate of incorporation; Memorandum and Articles of Association; A resolution from the
Board of Directors and power of attorney granted to its managers, officers or employees to transact on
its behalf; and an officially valid document in respect of managers, officers or employees holding an
attorney to transact on its behalf.

3. Partnership Firm: Registration certificate; Partnership deed; and an officially valid document in
respect of the person holding an attorney to transact on its behalf.

4. Trust Documents: Registration certificate; Trust deed; and an officially valid document in respect of the
person holding an attorney to transact on its behalf.

5. Association of Persons (ADP) or Body of Individuals (BOI):Resolution of the managing body of such
association or body of individuals; Power of attorney granted to him to transact on its behalf; an
officially valid document in respect of the person holding an attorney to transact on its behalf; and
such information as may be required by the banking company or the financial institution or the
intermediary to collectively establish the legal existence of such an association or body of
individuals.

Customer Identification Requirements – Indicative Guidelines

Trust/Nominee or Fiduciary Accounts
There exists the possibility that trust/nominee or fiduciary accounts can be used to
circumvent the customer identification procedures. The branches should determine whether
the customer is acting on behalf of another person as trustee/nominee or any other
intermediary. If so, branches shall insist on receipt of satisfactory evidence of the identity of
the intermediaries and of the persons on whose behalf they are acting, as also obtain details
of the nature of the trust or other arrangements in place. While opening an account for a
trust, branches should take reasonable precautions to verify the identity of the trustees and
the settlors of trust (including any person settling assets into the trust), grantors, protectors,
beneficiaries and signatories. Beneficiaries should be identified when they are defined. In the
case of a 'foundation', steps should be taken to verify the founder managers/ directors and
the beneficiaries, if defined.

Accounts of companies and firms
Branches need to be vigilant against business entities being used by individuals as a ‘front’ for
maintaining accounts with banks. Branches should examine the control structure of the entity,
determine the source of funds and identify the natural persons who have a controlling
interest and who comprise the management. These requirements may be moderated
according to the risk perception e.g. in the case of a public company it will not be necessary to
identify all the shareholders. But at least promoters, directors and its executives need to be
identified adequately.

Client accounts opened by professional intermediaries
When the branch has knowledge or reason to believe that the client account opened by a
professional intermediary is on behalf of a single client, that client must be identified.
Branches may hold 'pooled' accounts managed by professional intermediaries on behalf of
entities like mutual funds, pension funds or other types of funds. Branches should also
maintain 'pooled' accounts managed by lawyers/chartered accountants or stockbrokers for
funds held 'on deposit' or 'in escrow' for a range of clients. Where funds held by the
intermediaries are not co-mingled at the branch and there are 'sub-accounts', each of them
attributable to a beneficial owner, all the beneficial owners must be identified. Where such
accounts are co-mingled at the branch, the branch should still look through to the beneficial
owners. Where the bank rely on the 'customer due diligence' (CDD) done by an intermediary, it
shall satisfy itself that the intermediary is regulated and supervised and has adequate
systems in place to comply with the KYC requirements.

Accounts of Politically Exposed Persons(PEPs) resident outside India
Politically exposed persons are individuals who are or have been entrusted with prominent
public functions in a foreign country, e.g., Heads of States or of Governments, senior
politicians, senior government/judicial/military officers, senior executives of state-owned
corporations, important political party officials, etc. Branches should gather sufficient
information on any person/customer of this category intending to establish a relationship and
check all the information available on the person in the public domain. Branches should verify
the identify of the person and seek information about the sources of funds before accepting
the PEP as a customer. The branches should seek prior approval of their concerned Zonal
Heads for opening an account in the name of PEP.

Accounts of non-face-to-face customers
With the introduction of telephone and electronic banking, increasingly accounts are being
opened by banks for customers without the need for the customer to visit the bank branch. In
the case of non-face-to-face customers, apart from applying the usual customer identification
procedures, there must be specific and adequate procedures to mitigate the higher risk
involved. Certification of all the documents presented shall be insisted upon and, if necessary,
additional documents may be called for. In such cases, branches may also require the first
payment to be effected through the customer's account if any with another bank which, in
turn, adheres to similar KYC standards. In the case of cross-border customers, there is the
additional difficulty of matching the customer with the documentation and the branches might
have to rely on third party certification/introduction. In such cases, it must be ensured that
the third party is a regulated and supervised entity and has adequate KYC systems in place.
Correspondent Banking
a) Correspondent banking is the provision of banking services by one bank (the
'correspondent bank') to another bank (the 'respondent bank'). These services may include
cash/funds management, international wire transfers, drawing arrangements for demand
drafts and mail transfers, payable-through-accounts, cheques clearing, etc. The bank while
entering into any kind of correspondent banking arrangement shall gather sufficient
information to understand fully the nature of the business of the correspondent/respondent
bank. Information on the other bank’s management, major business activities, level of
AML/CFT compliance, purpose of opening the account, identity of any third party entities that
will use the correspondent banking services, and regulatory/supervisory framework in the
correspondent's/respondent’s country shall be of special relevance. Similarly, the bank shall
also ascertain from publicly available information whether the other bank has been subject to
any money laundering or terrorist financing investigation or regulatory action. Such
relationships shall be established only with the prior approval of the Board. The Board may in
the alternative delegate powers in this regard to a committee headed by the Chairman/CEO of
the bank and lay down clear parameters for approving such relationships. Proposals
approved by the Committee should invariably be put up to the Board at its next meeting for
post facto approval. The responsibilities of each bank with whom correspondent banking
relationship is established should be clearly documented. In the case of payable-through-
accounts, the correspondent bank should be satisfied that the respondent bank has verified
the identity of the customers having direct access to the accounts and is undertaking ongoing
'due diligence' on them. The bank shall also ensure that the respondent bank is able to provide
the relevant customer identification data immediately on request.
b) Bank shall not enter into a correspondent relationship with a 'shell bank'. A Shell bank is a
bank which is incorporated in a country where it has no physical presence and is unaffiliated
to any regulated financial group. “Shell banks” are not permitted to operate in India. Bank
shall also guard against establishing relationships with respondent foreign financial
institutions that permit their accounts to be used by “shell banks”. The Bank shall move
cautiously while continuing relationships with respondent banks located in countries with poor
KYC standards and countries identified as 'non-cooperative' in the fight against money
laundering policies and procedures in place and apply enhanced 'due diligence' procedures for
transactions carried out through the correspondent accounts

Classification of risk under customer acceptance policy

The risk to the customer shall be assigned on the following basis:


 i. Low Risk (Level I):

Individuals (other than High Net Worth) and entities whose identities and sources of wealth can

be easily identified and transactions in whose accounts by and large conform to the known profile

may be categorized as low risk. The illustrative examples of low risk customers could be salaried

employees whose salary structures are well defined, people belonging to lower economic strata of

the society whose accounts show small balances and low turnover, Government Departments andGovernment owned companies, regulators and statutory bodies etc. In such cases, only the basic
requirements of verifying the identity and location of the customer shall be met.


ii. Medium Risk (Level II):
Customers that are likely to pose a higher than average risk to the bank may be categorized as
medium or high risk depending on customer’s background, nature and location of activity, country
of origin, sources of funds and his client profile etc; such as:
a) Persons in business/industry or trading activity where the area of his residence or place of
business has a scope or history of unlawful trading/business activity.
b) Where the client profile of the person/s opening the account, according to the perception of
the branch is uncertain and/or doubtful/dubious.


iii. High Risk (Level III):
The branches may apply enhanced due diligence measures based on the risk assessment, thereby
requiring intensive ‘due diligence’ for higher risk customers, especially those for whom the
sources of funds are not clear. The examples of customers requiring higher due diligence may
include
a) Non Resident Customers,
b) High Net worth individuals
c) Trusts, charities, NGOs and organizations receiving donations,
d) Companies having close family shareholding or beneficial ownership
e) Firms with ‘sleeping partners’
f) Politically Exposed Persons (PEPs) of foreign origin
g) Non-face to face customers, and
h) Those with dubious reputation as per public information available, etc.

Master Circular on Know Your Customer (KYC)

Master Circular on Know Your Customer (KYC) norms/Anti-Money Laundering (AML)
standards/Combating Financing of Terrorism (CFT)/Obligation of banks and financial
institutions under Prevention of Money Laundering Act, (PMLA), 2002.
A. Purpose
Banks and financial institutions (FIs) have been advised to follow certain customer identification
procedure for opening of accounts and monitor transactions of suspicious nature for the purpose
of reporting the same to appropriate authority. These ‘Know Your Customer’ (KYC) guidelines
have been revisited in the context of the recommendations made by the Financial Action Task
Force (FATF) on Anti Money Laundering (AML) standards and on Combating Financing of
Terrorism (CFT). Detailed guidelines based on the recommendations of FATF and the paper
issued on Customer Due Diligence (CDD) for banks by the Basel Committee on Banking
Supervision (BCBS), with suggestions wherever considered necessary, have been issued.
Banks/FIs have been advised to ensure that a proper policy framework on ‘Know Your Customer’
and Anti-Money Laundering measures is formulated and put in place with the approval of their
Boards.
A list of circulars issued from time to time in this regard which are consolidated in this Master
Circular is given in Annex – III
B. Application
(i) The instructions, contained in the Master Circular, are applicable to All India Financial
Institutions, all Scheduled Commercial Banks (including RRBs), Local Area Banks,/ All Primary
(Urban) Co-operative Banks /State and Central Co-operative Banks. (ii) These guidelines are
issued under Section 35A of the Banking Regulation Act, 1949 and Rule 9(14) of Prevention of
Money-Laundering (Maintenance of Records) Rules, 2005. Any contravention thereof or noncompliance
shall attract penalties under Banking Regulation Act. The objective of KYC/AML/CFT
guidelines is to prevent banks/FIs from being used, intentionally or unintentionally, by criminal
elements for money laundering or terrorist financing activities. KYC procedures also enable
banks/FIs to know/understand their customers and their financial dealings better and manage
their risks prudently.
1. Introduction
The objective of KYC/AML/CFT guidelines is to prevent banks/FIs from being used, intentionally
or unintentionally, by criminal elements for money laundering or terrorist financing activities. KYC
procedures also enable banks/FIs to know/understand their customers and their financial dealings
better and manage their risks prudently.
2. Definitions
2.1 Customer
For the purpose of KYC Norms, a ‘Customer’ is defined as a person who is engaged in a financial
transaction or activity with a reporting entity and includes a person on whose behalf the person
who is engaged in the transaction or activity, is acting.
2.2 Designated Director
“Designated Director" means a person designated by the reporting entity (bank, financial
institution, etc.) to ensure overall compliance with the obligations imposed under chapter IV of the
PML Act and the Rules and includes:-
(i) the Managing Director or a whole-time Director duly authorized by the Board of Directors if the
reporting entity is a company,
(ii) the Managing Partner if the reporting entity is a partnership firm,
(iii) the Proprietor if the reporting entity is a proprietorship concern,
(iv) the Managing Trustee if the reporting entity is a trust,
(v) a person or individual, as the case may be, who controls and manages the affairs of the
reporting entity, if the reporting entity is an unincorporated association or a body of individuals,
and
(vi) such other person or class of persons as may be notified by the Government if the reporting
entity does not fall in any of the categories above.
Explanation. - For the purpose of this clause, the terms "Managing Director" and "Whole-time
Director" shall have the meaning assigned to them in the Companies Act
2.3 “Officially valid document” (OVD)
OVD means the passport, the driving licence, the Permanent Account Number (PAN) Card, the
Voter's Identity Card issued by the Election Commission of India, job card issued by NREGA duly
signed by an officer of the State Government, letter issued by the Unique Identification Authority
of India containing details of name, address and Aadhaar number, or any other document as
notified by the Central Government in consultation with the Regulator.
(i) Provided that where ‘simplified measures’ are applied for verifying the identity of the clients the
following documents shall be deemed to be OVD:
a) identity card with applicant’s Photograph issued by Central/ State Government Departments,
Statutory/ Regulatory Authorities, Public Sector Undertakings, Scheduled Commercial Banks, and
Public Financial Institutions; b) Letter issued by a gazetted officer, with a duly attested photograph
of the person.(ii) Provided further that where ‘simplified measures’ are applied for verifying for the
limited purpose of proof of address the following additional documents are deemed to be OVDs :.
a) Utility bill which is not more than two months old of any service provider (electricity, telephone,
post-paid mobile phone, piped gas, water bill);
b) Property or Municipal Tax receipt;
c) Bank account or Post Office savings bank account statement;
d) Pension or family pension payment orders (PPOs) issued to retired employees by Government
Departments or Public Sector Undertakings, if they contain the address;
e) Letter of allotment of accommodation from employer issued by State or Central Government
departments, statutory or regulatory bodies, public sector undertakings, scheduled commercial
banks, financial institutions and listed companies. Similarly, leave and license agreements with
such employers allotting official accommodation; and
f) Documents issued by Government departments of foreign jurisdictions and letter issued by
Foreign Embassy or Mission in India.
2.4 Person
In terms of PML Act a ‘person’ includes:
(i) an individual,
(ii) a Hindu undivided family,
(iii) a company,
(iv) a firm,
(v) an association of persons or a body of individuals, whether
incorporated or not,
(vi) every artificial juridical person, not falling within any one of the above persons (i to v), and
(vii) any agency, office or branch owned or controlled by any of the above persons (i to vi).

Types of risks

Major Types of Risks
Operational Risk human errors, technical faults, infrastructure breakdown, faulty
systems and procedures or lack of internal controls
Operational risk can be controlled by:
a. providing state of art systems and specified contingency
plans,
b. disaster control procedures, and sufficient back-up
arrangements for man and machine,
c. A duplication process at a different site (mirroring).
Exchange Risk on account of fluctuations in exchange rates and/or when
mismatches occur in assets/ liabilities and receivables/payables
Credit Risk arises due to inability or unwillingness of the counter party to meet
the obligations at maturity of the underlying transaction. Credit risk is
further classified into pre-settlement risk and settlement risk.
Pre-settlement risk: failure of the counter party before maturity of
the contract thereby exposing the other party to cover the
transaction at the ongoing market rates. This entails the risk of only
market differences and is not an absolute loss for the bank
Settlement risk: risk of failure of the counter party during the
course of settlement, due to the time zone differences, between the
two currencies to be exchanged.One party to a foreign exchange
transaction could pay out the currency it sold but not received the
currency it bought. This principal risk in the settlement of foreign
exchange transaction is variously called foreign exchange
settlement risk or temporal risk or Herstatt risk( after failure of
Bankhaus Herstat of Germany in 1974)
Methods to mitigate settlement risk are:
a. applying credit lines (limits) to each counter party to reduce
the risk.
b. settlement systems, operating on a single time basis, as also
on real-time gross settlement basis, are put in place.
c. time zone differences could be eliminated, if the global books
are linked to a single time zone, say GMT closing.
Liquidity Risk Potential for liabilities to drain from the bank at a faster rate than
assets. The mismatches in the maturity patterns of assets and
liabilities give rise to liquidity risk.
When a party to a foreign exchange transaction is unable to meet its
funding requirement or execute a transaction at a reasonable price,
it creates Liquidity Risk
It is also the risk of the party not being able to exit or offset positions
quickly at a reasonable price.In a deal of US dollar purchase against rupee, if the party selling US
Dollar is short of funds in the nostro account, then it may not be
possible for him to generate/borrow or buy USD to fund the USD
account. Liquidity risk is said to have arisen.
Liquidity risk mitigation is done by:
a. control the mismatches between maturities of assets and
liabilities
b. fixing limits for maturity mismatches and reduce open
positions
Gap Risk/Interest
Rate Risk
arises due to adverse movement of interest rates or interest rate
differentials
If the purchase and sale take place for different value, while the
bank may
completely stand hedged on exchange front, it creates a mismatch
between its assets and liabilities referred to as GAP
These gaps are to be filled by the bank by paying/receiving
appropriate forward differentials. These forward differentials are in
turn a function of interest rates and any adverse movement in
interest rates would result in adverse movement of forward
differentials thus affecting the cash flows on the underlying open
gaps or mismatches. Therefore, it is the risk arising out of adverse
movements in implied interest rates or actual interest rate
differentials
Interest rate risk also occurs when different bases of interest rates
are applied to assets and corresponding liabilities.
Volatility in interest rates is due to:
a. The increasing capital flows in the global financial markets
b. the economic disparities between nations and the increased
use of interest rates as a regulatory tool for macro- economic
controls
Mitigation of interest rate risk is done by:
a. undertaking appropriate swaps, or
b. matching funding actions or
c. through appropriate risk mitigating interest rate derivatives
Market Risk due to adverse movement of market variables when the players are
unable to exit the positions quickly
Legal Risk On account of non-enforceability of contract against a counter party.Legal risk also includes compliance and regulations related risks,
arising out of non-compliance of prescribed guidelines or breach of
governmental rules, leading to wrong understanding of rules and
penalties by the enforcing agencies.
Systemic Risk possibility of a major bank failing and the resultant losses to counter
parties reverberating into a banking crisis.
Country Risk
/Political Risk
counter party situated in a different country unable to perform its
part of the contractual obligations despite its willingness to do so
due to local government regulations or political or economic
instability in that country.
A country giving very high returns is generally:
a. Faces high country risk
b. Not too many countries or instutions are ready to invest in
that country. Hence they try to attract these institutions by
giving high returns
Sovereign Risk sub-risk in the overall country risk in that certain state-owned entities
themselves quoting their sovereign status claim immunity from any
recovery proceedings of fulfillment of any obligations they had
originally agreed to.
Sovereign risk can be reduced by
a. inserting disclaimer clauses in the documentation
b. making the contracts and the sovereign counter parties
subject to a third country jurisdiction

Risk management very Important Terms

  Risk management very  Important Terms 

Capital Funds

Equity contribution of owners. The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business. Capital is divided into different tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II. 

Tier I Capital

A term used to refer to one of the components of regulatory capital. It consists mainly of share capital and disclosed reserves (minus goodwill, if any). Tier I items are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital. 

Tier II Capital

Refers to one of the components of regulatory capital. Also known as supplementary capital, it consists of certain reserves and certain types of subordinated debt. Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a bank's activities. Tier II's capital loss absorption capacity is lower than that of Tier I capital. 

Revaluation reserves

Revaluation reserves are a part of Tier-II capital. These reserves arise from revaluation of assets that are undervalued on the bank's books, typically bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets and the subsequent deterioration in values under difficult market conditions or in a forced sale. 

Leverage

Ratio of assets to capital. 

Capital reserves

That portion of a company's profits not paid out as dividends to shareholders. They are also known as undistributable reserves and are ploughed back into the business. 

Deferred Tax Assets

Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable income which is considered as timing differences result in deferred tax assets. The deferred Tax Assets are accounted as per the Accounting Standard 22. 

Deferred Tax Liabilities

Deferred tax liabilities have an effect of increasing future year's income tax payments, which indicates that they are accrued income taxes and meet definition of liabilities. 

Subordinated debt

Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid. 

Hybrid debt capital instruments

In this category, fall a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature, which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital. 

BASEL Committee on Banking Supervision

The BASEL Committee is a committee of bank supervisors consisting of members from each of the G10 countries. The Committee is a forum for discussion on the handling of specific supervisory problems. It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks' foreign establishments with the aim of ensuring effective supervision of banks' activities worldwide. 

BASEL Capital accord

The BASEL Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardised risk-based capital requirements for banks across countries. The Accord was replaced with a new capital adequacy framework (BASEL II), published in June 2004. BASEL II is based on three mutually reinforcing pillars hat allow banks and supervisors to evaluate properly the various risks that banks face. These three pillars are:

Minimum capital requirements, which seek to refine the present measurement framework

supervisory review of an institution's capital adequacy and internal assessment process;

market discipline through effective disclosure to encourage safe and sound banking practices 

Risk Weighted Asset

The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number. Risk weight for different assets vary e.g. 0% on a Government Dated Security and 20% on a AAA rated foreign bank etc. 

CRAR(Capital to Risk Weighted Assets Ratio)

Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the CRAR of a bank the better capitalized it is. 

Credit Risk

The risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments. Credit risk can be associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk 

1.standardised approach (SA) - Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets by assigning risk weights based on the rating assigned by the external credit rating agencies.

2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks. The IRB approaches are of two types:

a) Foundation IRB (FIRB):The bank estimates the Probability of Default (PD) associated with each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and Exposure At Default (EAD). 

b) Advanced IRB (AIRB):In addition to Probability of Default (PD), the bank estimates other inputs such as EAD and LGD. The requirements for this approach are more exacting. The adoption of advanced approaches would require the banks to meet minimum requirements relating to internal ratings at the outset and on an ongoing basis such as those relating to the design of the rating system, operations, controls, corporate governance, and estimation and validation of credit risk components, viz., PD for both FIRB and AIRB and LGD and EAD for AIRB. The banks should have, at the minimum, PD data for five years and LGD and EAD data for seven years. In India, banks have been advised to compute capital requirements for credit risk adopting the SA. 

Market risk

Market risk is defined as the risk of loss arising from movements in market prices or rates away from the rates or prices set out in a transaction or agreement. The capital charge for market risk was introduced by the BASEL Committee on Banking Supervision through the Market Risk Amendment of January 1996 to the capital accord of 1988 (BASEL I Framework). There are two methodologies available to estimate the capital requirement to cover market risks: 

1) The Standardised Measurement Method: This method, currently implemented by the Reserve Bank, adopts a 'building block' approach for interest-rate related and equity instruments which differentiate capital requirements for 'specific risk' from those of 'general market risk'. The 'specific risk charge' is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. The 'general market risk charge' is designed to protect against the interest rate risk in the portfolio.

2) The Internal Models Approach (IMA): This method enables banks to use their proprietary in-house method which must meet the qualitative and quantitative criteria set out by the BCBS and is subject to the explicit approval of the supervisory authority. 

Operational Risk

The revised BASEL II framework offers the following three approaches for estimating capital charges for operational risk:

1) The Basic Indicator Approach (BIA): This approach sets a charge for operational risk as a fixed percentage ("alpha factor") of a single indicator, which serves as a proxy for the bank's risk exposure. 

2) The Standardised Approach (SA): This approach requires that the institution separate its operations into eight standard business lines, and the capital charge for each business line is calculated by multiplying gross income of that business line by a factor (denoted beta) assigned to that business line.

3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital requirement will equal the risk measure generated by the banks' internal operational risk measurement system. In India, the banks have been advised to adopt the BIA to estimate the capital charge for operational risk and 15% of average gross income of last three years is taken for calculating capital charge for operational risk. 

Internal Capital Adequacy Assessment Process (ICAAP)

In terms of the guidelines on BASEL II, the banks are required to have a board-approved policy on internal capital adequacy assessment process (ICAAP) to assess the capital requirement as per ICAAP at the solo as well as consolidated level. The ICAAP is required to form an integral part of the management and decision-making culture of a bank. ICAAP document is required to clearly demarcate the quantifiable and qualitatively assessed risks. The ICAAP is also required to include stress tests and scenario analyses, to be conducted periodically, particularly in respect of the bank's material risk exposures, in order to evaluate the potential vulnerability of the bank to some unlikely but plausible events or movements in the market conditions that could have an adverse impact on the bank's capital. 

Supervisory Review Process (SRP)

Supervisory review process envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority. The objective of the SRP is to ensure that the banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks. 

Market Discipline

Market Discipline seeks to achieve increased transparency through expanded disclosure requirements for banks. 

Credit risk mitigation

Techniques used to mitigate the credit risks through exposure being collateralised in whole or in part with cash or securities or guaranteed by a third party. 

Mortgage Back Security

A bond-type security in which the collateral is provided by a pool of mortgages. Income from the underlying mortgages is used to meet interest and principal repayments. 

Derivative

A derivative instrument derives its value from an underlying product. There are basically three derivatives 

a) Forward Contract- A forward contract is an agreement between two parties to buy or sell an agreed amount of a commodity or financial instrument at an agreed price, for delivery on an agreed future date. Future Contract- Is a standardized exchange tradable forward contract executed at an exchange. In contrast to a futures contract, a forward contract is not transferable or exchange tradable, its terms are not standardized and no margin is exchanged. The buyer of the forward contract is said to be long on the contract and the seller is said to be short on the contract.

b) Options- An option is a contract which grants the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset, commodity, currency or financial instrument at an agreed rate (exercise price) on or before an agreed date (expiry or settlement date). The buyer pays the seller an amount called the premium in exchange for this right. This premium is the price of the option.

c) Swaps- Is an agreement to exchange future cash flow at pre-specified Intervals. Typically one cash flow is based on a variable price and other on affixed one. 

Duration

Duration (Macaulay duration) measures the price volatility of fixed income securities. It is often used in the comparison of interest rate risk between securities with different coupons and different maturities. It is defined as the weighted average time to cash flows of a bond where the weights are nothing but the present value of the cash flows themselves. It is expressed in years. The duration of a fixed income security is always shorter than its term to maturity, except in the case of zero coupon securities where they are the same. 

Modified Duration

Modified Duration = Macaulay Duration/ (1+y/m), where 'y' is the yield (%), 'm' is the number of times compounding occurs in a year. For example if interest is paid twice a year m=2. Modified Duration is a measure of the percentage change in price of a bond for a 1% change in yield. 

Non Performing Assets (NPA)

An asset, including a leased asset, becomes non performing when it ceases to generate income for the bank. 

Net NPA

Gross NPA - (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending adjustment + Part payment received and kept in suspense account + Total provisions held). 

Coverage Ratio

Equity minus net NPA divided by total assets minus intangible assets. 

Slippage Ratio

(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the year)*100 

Restructuring

A restructured account is one where the bank, grants to the borrower concessions that the bank would not otherwise consider. Restructuring would normally involve modification of terms of the advances/securities, which would generally include, among others, alteration of repayment period/ repayable amount/ the amount of installments and rate of interest. It is a mechanism to nurture an otherwise viable unit, which has been adversely impacted, back to health. 

Substandard Assets

A substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. Such an asset will have well defined credit weaknesses that jeopardize the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected. 

Doubtful Asset

An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, - on the basis of currently known facts, conditions and values - highly questionable and improbable. 


Loss Asset

A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value. 

Off Balance Sheet Exposure

Off-Balance Sheet exposures refer to the business activities of a bank that generally do not involve booking assets (loans) and taking deposits. Off-balance sheet activities normally generate fees, but produce liabilities or assets that are deferred or contingent and thus, do not appear on the institution's balance sheet until and unless they become actual assets or liabilities. 

Current Exposure Method



The credit equivalent amount of a market related off-balance sheet transaction is calculated using the current exposure method by adding the current credit exposure to the potential future credit exposure of these contracts. Current credit exposure is defined as the sum of the positive mark to market value of a contract. The Current Exposure Method requires periodical calculation of the current credit exposure by marking the contracts to market, thus capturing the current credit exposure. Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts irrespective of whether the contract has a zero, positive or negative mark-to-market value by the relevant add-on factor prescribed by RBI, according to the nature and residual maturity of the instrument.