CAIIB – BFM (BANK FINANCIAL MANAGEMENT)

CAIIB - Bank Financial Management - Mod - A : International Banking
EXCHANGE RATES AND FOREX BUSINESS
1. Foreign Exchange: Conversion of currencies from the currency of invoice to the home
currency of the exporters is called as Foreign Exchange.
2. Foreign Exchange Management Act (FEMA),1999 defines Foreign Exchange as o “ All
deposits, credits and balances payable in foreign currency and any drafts, traveler’s Cheques,
LCs and Bills of Exchange, expressed or drawn in Indian Currency and payable in any foreign
currency.”
Any instrument payable at the option of the drawee or holder, thereof or any other party thereto,
either in Indian Currency or in foreign currency, or partly in one and partly in the other.
3. A Foreign Exchange transaction is a contract to exchange funds in one currency for funds in
another currency at an agreed rate and arranged basis.
4. Exchange Rate means the price or the ratio or the value at which one currency is exchanged
for another currency.
5. Foreign Exchange markets participants are
# Central Banks
# Commercial Banks
# Investment Funds/Banks
# Forex Brokers
# Corporations
# Individuals
6. The Forex Markets are highly dynamic, that on an average the exchange rates of major
currencies fluctuate every 4 Seconds, which effectively means it registers 21,600 changes in a
day (15X60X24)
7. Forex markets usually operate from “Monday to Friday” globally, except for the Middle East
or other Islamic Countries which function on Saturday and Sunday with restrictions, to cater to
the local needs, but are closed on Friday.
8. The bulk of the Forex markets are OTC (Over the Counter).
9. Factors Determining Exchange Rates:
a) Fundamental Reasons
# Balance of Payment
# Economic Growth rate
# Fiscal policy
# Monetary Policy
# Interest Rates
# Political Issues
b) Technical Reasons
- Government Control can lead to unrealistic value.
- Free flow of Capital from lower interest rate to higher interest rates
c) Speculative - higher the speculation higher the volatility in rates
10. Due to vastness of the market, operating in different time zones, most of the Forex deals in
general are done on SPOT basis.
11. The delivery of FX deals can be settled in one or more of the following ways:
# Ready or Cash
# TOM
# Spot
# Forward
# Spot and Forward
12. Ready or Cash: Settlement of funds takes place on the same day (date of Deal)
13. TOM: Settlement of funds takes place on the next working day of the deal. If the settlement
day Is holiday in any of the 2 countries, the settlement date will be next working day in both the
countries.
14. Spot : Settlement of funds takes place on the second working day after/following the date of
Contract/deal. If the settlement day is holiday in any of the 2 countries, the settlement date will
be next working day in both the countries.
15. Forward: Delivery of funds takes place on any day after SPOT date.
16. Spot and Forward Rates: On the other hand, when the delivery of the currencies is to take
place at a date beyond the Spot date, it is Forward Transaction and rate applied is called Forward
Rate.
17. Forward Rates are derived from Spot Rates and are function of the spot rates and forward
premium or discount of the currency, being quoted.
18. Forward Rate = Spot Rte + Premium or – Discount
19. If the value of the currency is more than being quoted for Spot, then it is said to be at a
premium.
20. If the currency is cheaper at a later date than Spot, then it is called at a Discount.
21. The forward premium and discount are generally based on the interest rate differentials of
the two currencies involved.
Basics of Forex Derivates
1. Derivatives are the instruments to the exposure for neutralize or alter to acceptable levels, the
uncertainty profile of the exposure. E.g: Forward contracts, options, swaps, forward rate
agreements and futures.
2. A risk can be defined as an unplanned event with financial consequences resulting in loss or
reduced earnings.
3. Some of the very common risks faced in forex operations
i. Exchange Risk
ii. Settlement Risk/ Temporal Risk/ Herstatt Risk (Named after the 1974 failure of the Bankhaus
Herstatt in Germany)
iii. Liquidity Risk
iv. Country Risk
v. Sovereign risk
vi. Intrest Rate Risk
vii. Operational Risk
4. Movement in exchange rates may result in loss for the dealer’s open position.
5. In case of excess of assets over the liabilities, the dealer will have long position
6. Country risk is a dynamic risk and can be controlled by fixing country limit.
7. Sovereign risk can be managed by suitable disclaimer clauses in the documentation and
also by subjecting such sovereign entities to third jurisdiction.
8. Operational risk can be controlled by putting in place state of art system, specified
contingencies.
9. RBI has issued Internal Control Guidelines (ICG) for Foreign Exchange Business.
10. Various Dealing Limits are as follows:
a. Overnight Limit: Maximum amount of open position or exposure, a bank can keep overnight,
when markets in its time zone are closed.
b. Daylight Limit: Maximum amount of open position or exposure, the bank can expose itself at
any time during the day, to meet customers’ needs or
for its trading operations
c. Gap Limits: Maximum inter period/month exposures which a bank can keep, are called gap
limits
d. Counter Party Limit: Maximum amount that a bank can expose itself to a particular counter
party.
e. Country Risk: Maximum exposure on a single country
f. Dealer Limits: Maximum amount a dealer can keep exposure during the operating hours.
g. Stop-Loss Limit: Maximum movement of rate against the position held, so as to trigger the
limit or say maximum loss limit for adverse movement of rates.
h. Settlement Loss Limit: Maximum amount of exposure to any entity, maturing on a single
day.
i. Deal Size Limit: Highest amount for which a deal can be entered. The limits are fixed to
restrict the operational risk on large deals.
11. CCIL (Clearing Corporation of India Ltd) takes over the Settlement Risk, for which it
creates a large pool of resources, called settlement Guarantee Fund, which is used to cover
outstanding of any participant.
12. The Clearing Corporation of India Ltd. (CCIL) was set up in April, 2001 for providing
exclusive clearing and settlement for transactions in Money, GSecs and Foreign Exchange.
February 15, 2002 Negotiated Dealing System (NDS)
November 2002 settlement of Forex transactions
January 2003 Collateralized Borrowing and Lending Obligation (CBLO), a money market
product
based on Gilts as collaterals
August 7, 2003. Forex trading platform “FX-CLEAR”
April 6, 2005. settlement of cross-currency deals through the CLS Bank
13. Six 'core promoters' for CCIL - State Bank of India (SBI), Industrial Development Bank of
India (IDBI), ICICI Ltd., LIC (Life Insurance Corporation of India), Bank of Baroda, and HDFC
Bank.
14. Derivatives: A security whose price is dependent upon or derived from one or more
underlying assets. The derivative itself is merely a contract between two or more parties. Its
value is determined by fluctuations in the underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market indexes. Most
derivatives are characterized by high leverage.
15. In early 1970s, the Chicago Mercantile Exchange introduced world’s first Exchange
traded currency future contract.
Correspondent Banking and NRI Accounts
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.
19. 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.
20. 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.
21. 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.
22. NRE Accounts – Rupee and Foreign Currency Accounts
23. 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 re-designated 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.
Documentary Letters of Credit
1. In international trade, where buyers and sellers are far apart in two different countries, or even
continents, the Letter of Credit acts as a most convenient instrument, giving assurance to the
sellers of goods for payment and to the buyers for shipping documents, as called for under the
Credit.
2. In order to bring an uniformity in matters pertains to LC Documents and Transactions,
International Chamber of Commerce formed rules and procedures. Those are called as Uniform
Customs and Practices for Documentary Credits (UCPDC).
3. The International Chamber of Commerce (ICC)was established in 1919 headquartered at
Paris.
4. The first UCPDC published in 1933 and has been revised from time to time in 1951,
1962,1974,1983,1993 and recently in 2007.
5. The updated UCPDC in 2007 is called as UCPDC 600. And it has been implemented w.e.f 1-
7-2007.
6. Documentary Credit/Letter of Credit: LC/DC cane be defined as a signed or an
authenticated instrument issued by the buyer’s Banker, embodying an undertaking to pay to the
seller a certain amount of money, upon presentation of documents, evidencing shipment of
goods, as specified, and compliance of other terms and conditions..
7. IN an LC Parties are as follows:
a. The buyers/Importers or the applicant – on whose behalf LC is opened.
b. The Sellers/Exporters or the Beneficary of the LC
c. The opening Bank (Buyer’s Bank), who establishes the LC
d. The advising bank (Bank in sellers country), who acts as an agent of the issuing bank and
authenticates the LC.
e. The confirming Bank- Who undertakes to pay on behalf of the issuing bank.
f. The negotiating Bank ( Seller’s bank or Bank nominated by the opening Bank)
g. Reimbursing Bank – Who reimburses the negotiating or confirming bank.
For example, in a hypothetical Situation given below:
Mr Ram, (Banking with Dhanlaxmi Bank) an agriculture entrepreneur growing vegetables in
green house technology in Khammam wants to update his farm house with modern machinery.
He is importing the same from a Chinese manufacturer M/s Zuanch LLC, Beijing who are
banking with China Development Bank for total cost of US$ 4500. M/s Zaunch LLC has issued
an invoice stating the sale transaction must be backed by LC. As such, Mr Ram approaches
Dhanlaxmi Bank for opening of Letter of Credit (Foreign) in FCY USD. Dhanlaxmi Bank’s
China Foreign Correspondent Bank is Bank of China, Beijing.
Applicant of LC - Mr Ram, Khammam
Beneficiary of LC - M/s Zaunch LLC
LC Opening/ Issuing Bank - Dhanlaxmi Bank
Advising Bank /Confirming Bank - Bank of China
Negotiating bank China - Development Bank
Reimbursing Bank - Bank of China in China
8. Types of Letters of Credit
a. Revocable LC
b. Irrevocable LC
c. Irrevocable Confirmed LC
d. Transferable LC
e. Red Clause LC
f. Sight/Acceptance, Deferred Payment, or Negotiation LC
g. Back to Back LC
9. Revocable LC can be amended or cancelled at any moment by the issuing bank without the
consent of any other party, as long as the LC has not been drawn or documents taken up.
10. In case the Negotiating Bank has taken up the documents under revocable LC, prior to
receipt of cancellation notice, the issuing bank is liable to compensate/reimburse the same to the
negotiating bank.
11. Irrevocable LC which holds a commitment by the issuing bank to pay or reimburse the
negotiating bank, provided conditions of the LC are complied with.
12. Irrevocable LC cannot be amended or cancelled without the consent of all parties
concerned.
13. The irrevocable LC is an unconditional undertaking by the issuing bank to make payment
on submission of documents conforming to the terms and conditions of the LC
14. All LCs issued, unless and otherwise specified, are irrevocable Letter of Credits.
15. Irrevocable confirmed LC is an L/c which has been confirmed by a bank, other than the
issuing a bank, usually situated in the country of the exporter, thereby taking an additional
undertaking to pay on receipt of documents conforming to the terms & conditions of the LC
16. The Conforming Bank can be advising Bank, which on receipt of request from the issuing
bank takes this additional responsibility.
17. The conforming bank steps into the shoes of the issuing bank and performs all functions of
the issuing bank.
18. Transferrable LC is available for transfer in full or in part, in favour of any party other than
beneficiary, by the advising bank at the request of the issuing bank.
19. Red Clause LC enables the beneficiary to avail pre-shipment credit from the
nominated/advising bank. The LC bears a clause in “RED Letter” authorizing the nominated
bank to grant advance to the beneficiary, prior to shipment of goods, payment of which is
guaranteed by the Opening Bank, in case of nay default or failure of the beneficiary to submit
shipment documents.
20. Under a Sight LC, the beneficiary is able to get the payment on presentation of documents
conforming to the terms and conditions of the LC at the nominated bank’s countries.
21. Under the Acceptance Credit, the bill of exchange or drafts are drawn with certain Usance
period and are payable upon acceptance, at a future date, subject to receipt of documents
conforming to the terms and condition of the LC.
22. A Deferred Payment Credit is similar to Acceptance Credit, except that there is no bill of
exchange or draft drawn and is payable on certain future date, subject to submission of credit
confirmed documents. The due date is generally mentioned in the LC
23. A Negotiation Credit, the issuing Bank undertakes to make payment to the Bank, which has
negotiated the documents.
24. In a Negotiation LC, LC may be freely negotiable or may be restricted to any bank
nominated by the LC issuing Bank.
25. Back to Back LC: when an exporter arranges to issue an LC in favour of Local supplier to
procure goods on the strength of export LC received in his favour, it is known as Back to Back
LC.
26. UCP 600 come into force w.e.f. 01/07/2007.
27. Important Changes in the Articles of UCP 600 and their implication for the Banks:-
# A reduction in the number of articles from 49 to 39
# New articles on "Definitions" and "Interpretations" providing more clarity and precision in
the rules
# A definitive description of negotiation as "purchase" of drafts of documents
# The replacement of the phrase "reasonable time" for acceptance or refusal of documents by
a maximum period of five banking days
# New provisions allow for the discounting of deferred payment credits
# Banks can now accept an insurance document that contains reference to any exclusion clause
28. UCP 600 does not apply by default to letters of credit issued after July 1st 2007. A
statement needs to be incorporated into the credit (LC), and preferably also into the sales
contract that expressly states it is subject to these rules.
29. Revocable Credits (Article 2): One of the most important changes in UCP 600 is the
exclusion of any verbiage regarding revocable letters of credit, which can be amended or
canceled at any time without notice to the seller. .Actually, Article 2 explicitly defines a credit as
"any arrangement, however named or described, that is irrevocable and thereby constitutes a
definite undertaking of the issuing bank to honour a complying presentation."
30. Article 3 states that "A credit is irrevocable even if there is no indication to that effect."
and Article 10 makes it clear that "a credit can neither be amended nor cancelled without the
agreement of the issuing bank, the confirming bank, if any, and the beneficiary"
(seller).Therefore, it is prudent for the seller to stipulate in the sales contract that the "buyer will
open an irrevocable letter of credit", and to check that the buyer's credit does, in fact, either
describe itself as "irrevocable" or state that it incorporates UCP 600 (without exclusion).
Facilities for Exporters and Importers
Exports
RBI and DGFT RBI controls Foreign Exchange and 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.
On the other hand, 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.
Prescribed Time limits
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.
Risks in Foreign Trade - Role of ECGC
Risks in International Trade
Foreign trade risk may be defined as Uncertainty or Unplanned events with financial
consequences resulting into loss. Types of Risks are as under:
Buyers’ Risk: Non-Acceptance or non-payment
Sellers’ Risk: Non- shipping or Shipping of poor quality goods or delay.
Shipping Risk: Mishandling, Goods siphoned off, Strike by potters or wrong delivery.
Other Risks:
Credit Risk
Legal Risk
Country Risk
Operational Risk
Exchange Risk
Country Risk
Provision of risk is made if Exposure to one country is 1% or more of total assets. ECGC has the
list of Country Risk Ratings which can be referred to by the Banks and the banks can make their
own country risk policy.
Risk Classification of Countries
Export Credit and Guarantee Corporation provides guarantee cover for risks which can be
availed by the banks after making payment of Premium. ECGC adopts 7 fold classification
covering 204 countries. The list is updated and published on quarterly basis. The latest
classification is as under:
Insignificant Risks A1
Low Risk A2
Moderately Low Risk B1
Moderate Risk B2
Moderately High Risk C1
High Risk C2
Very High Risk D
Besides above, 20 countries have been placed in “Restricted Cover Group-1” where revolving
limits are approved by ECGC and these are valid for 1 year.
The other 13 countries are placed in “Restricted Cover Group-2” where specific approval is
given on case to case basis by ECGC.
ECGC ECGC was established in 1964. Export Credit and Guarantee Corporation provides
guarantee cover for risks which can be availed by the banks after making payment of Premium.
Its activities are governed by IRDA. The functions of ECGC are 3 fold:
It rates the different countries.
It issues Insurance Policies.
It guarantees proceeds of Exports.
Types of Policies:
Standard Policies
It provides cover for exporters for short term exports. These cover Commercial and Political
Risks.
The different types of Policies are:
Shipment (Comprehensive Risk) Policy – to cover commercial and political risks from date of
shipment. Default of 4 months.
Shipment (Political Risks) Policy.
Contracts (Comprehensive Risk) Policy for both commercial and Political risks.
Contracts (Political Risks) Policy
Small Exporters’ policy
A small exporter is defined whose anticipated total export turnover for the period of 12 M is not
more than 50 lac. The policy is issued to cover shipments 24 M ahead.
The policy provides cover against Commercial risks and Political risks covering insolvency of
the buyer, failure of the borrower to make payment due within 2 months from due date,
borrower’s failure to accept the goods due to no fault of exporter.
Specific Shipment Policy
Commercial risks – Failure to pay within 4M. It covers short term credit not exceeding 180 days
Exports Specific Buyer Policy
Commercial risks – Failure to pay within 4M and Political Risks
The other Policies are Exports (specific buyers’ Policy), Buyers’ Exposure Policy, Export
Turnover Policy (exporters who pay minimum 10 lac premium to ECGC are eligible) and
Consignment export Policy.
Role of Exim Bank, Reserve Bank of India, Exchange Control in India - FEMA and FEDAI
and Others
Exim Bank – its functions
Exim Bank (Export/Import Bank) was established in 1981 with the objective of financing Import
Export Trade specially on Long term basis. The functions of Exim bank are as under:
Offering Finance for Exports at competitive rates.
Developing alternate financial solution
Data and Information about new export opportunities.
Respond to export problems and pursue Policy solutions.
The finance activities of Exim bank consist of :
Arranging Suppliers’ credit and Buyers’ credit
Consultancy and Technical services for exporters
Pre-shipment credit – over 6 months
Setting up of EOU in EPZ (Export Processing Zones)
Finance for DTA (Domestic Tariff Area) units exporting minimum 25% of annual sales.
Finance for Import of Computer System and Development of Software. Plant and Machinery
and Technical up-gradations etc.
Services for Overseas Investments.
Line of Credit to exporters on the basis of which they receive export orders.
EXIM Bank performs following functions for Commercial Banks:
Export Bills Rediscounting – Usance period should not exceed 180 days.
SSI Export Bills Rediscounting.
Refinance of Export credit
Refinance of TL to EOU, Software Capital goods up to 100%
Participates with banks in Issuance of Guarantees.
Besides above, the EXIM bank arranges Relending facilities for Overseas Banks, sanctions direct
credit to foreign importers and arranges line of credit for foreign importers.
DPG (Deferred Payment Guarantees)
It is normally beyond 6M and meant for SHE (Status Holder Exporters) only.
Banks can approve proposals up to 25 crore.
Above 25 crore up to 100 crore are referred to EXIM bank.
Above 100 crore proposals will be considered by Inter institutional Working Group consisting of
members from RBI, FEDAI, ECGC and EXIM.
Other services of EXIM bank
Besides above, the EXIM bank provides assistance for :
Project Exports – export of Engineering goods on Deferred Payment terms
Turnkey Projects- supply of equipment along with related services like design, detailed
engineering etc.
Construction Projects
Funded facilities.
EXIM Bank is nodal agency designated by GOI to manage Export Marketing Fund (EMF) which
consists of loan made available to India by World bank to promote International Trade.
Reserve Bank of India
RBI controls Foreign Exchange
RBI is empowered to
Control and regulate Foreign Exchange Reserves
Supervise Foreign Exchange dealings
Maintain external value of Rupee
FERA was replaced by FEMA in the year 1999.
FEMA provisions The important FEMA guidelines with regard to Foreign exchange are as
under:
No drawl of exchange for Nepal and Bhutan
If Rupee equivalent exceeds Rs. 50000/-, payment by way of crossed cheque.
During visit abroad, one can carry Foreign currency notes up to USD 3000 or equivalent. For
Libya and Iraq, the limit is USD5000 and the entire amount for Iran and Russian states.
Indian citizens can retain and possess Foreign currency up to USD 2000 or its equivalent.
Unspent currency must be surrendered within a period of 180 days after arrival in India.
Basic Travel Quota (BTQ)
Purpose of Visit Up to USD or equivalent
Personal/Tourism - 10000 per Financial year
Business Purpose - 25000 per visit
Seminars/conferences - 25000 per visit
Employment/Immigration - 100000
Studies - 100000 per academic year
Donations/Gifts - 5000 per donor per year
Consultancy services - 100000 per project
Debit Credit/Credit Card - As per BTQ as above
*AD can release Foreign Exchange 60 days ahead of journey
LRS (Liberalized Remittance Scheme
The scheme is meant for Resident Indians individuals. They can freely remit up to USD 200000
per financial year in respect of any current or capital account transaction (e.g. to acquire property
outside India) without prior approval of RBI. The precondition is that the remitter should have
been a customer of the bank for the last 1 year. PAN is mandatory.
Not Applicable
The scheme is not applicable for remittance to Nepal, Bhutan, Pak, Mauritius or other counties
identified by FATF.
The scheme is not meant for remittance by Corporate.
Import and Export of Indian Rupees
Limit is Rs. 7500/- while leaving India and while coming to India.
RETURNS TO BE SUBMITTED TO RBI
Following important returns are submitted to RBI
R- Returns - Forex Operations (Fortnightly)
BAL statement - Balance in Nostro/Vostro account
STAT 5 - Transactions in FCNR B accounts
STAT 8 - Transactions in NRE/NRO accounts
LRS Statement - UP to USD 200000 (monthly)
Trade Credit Statement - Buyers’ and Suppliers’ Credit
XOS O/S - Overdue Export bills
BEF - Import Remittance effected but Bill of Entry not submitted for >3M.
ETX Form - Seeking relaxation from RBI after expiry of 12M when export proceeds are not
received.
RFC accounts Resident Foreign Currency account is opened by Indian residents who were
earlier NRIs and forex is received by them from their overseas dues:
The accounts can be opened as SB/CA/FD type.
Proceeds are received from overseas.
Out of Monetary benefits accruing abroad
The funds are freely repatriable.
Minimum amount is USD 5000.
RFC- D accounts Resident Foreign Currency (Domestic) accounts are opened:
By Indian residents who visit abroad: and
Bring with them Foreign Exchange;
As honorarium, gift etc.
Unspent money can also be deposited.
These are CA nature accounts and no interest is paid.
CAIIB - Bank Financial Management - Mod - B : Risk Management
Risk Management
Risk and Capital
Risk is possible unfavorable impact on net cash flow in future due to uncertainty of happening or
non-happening of events. Capital is a cushion or shock observer required to absorb potential
losses in future. Higher the Risks, high will be the requirement of Capital and there will be rise in
RAROC (Risk Adjusted Return on Capital).
Types of Risks
Risk is anticipated at Transaction level as well as at Portfolio level.
Transaction Level
Credit Risk, Market Risk and Operational Risk are transaction level risk and are managed at Unit
level.
Portfolio Level
Liquidity Risk and Interest Rate Risk are also transaction level risks but are managed at Portfolio
level.
Risk Measurement
Based on Sensitivity
It is change in Market Value due to 1% change in interest rates. The interest rate gap is
sensitivity of the interest rate margin of Banking book. Duration is sensitivity of Investment
portfolio or Trading book.
Based on Volatility:
It is common statistical measure of dispersion around the average of any random variable such as
earnings, Markto market values, losses due to default etc.
Statistically Volatility is Standard deviation of Value of Variables
Calculation
Example 1 : We have to find volatility of Given Stock price over a given period. Volatility may
be weekly or monthly. Suppose we want to calculate weekly volatility. We will note down Stock
price of nos. of weeks.
Mean Price = 123.62 and
Variance (sum of Squared deviation from mean) is 82.70
(extracted from weekly Stock prices)
Volatility i.e. sd = ∫Variance = ∫82.70 = 9.09
Volatility over Time Horizon T = Daily Volatility X ∫T
Example 2
Daily Volatility =1.5%
Monthly Volatility = 1.5 X ∫30 = 1.5 X 5.48 = 8.22
Volatility will be more if Time horizon is more.
Downside Potential
It captures only possible losses ignoring profits and risk calculation is done keeping in view two
components:
1. Potential losses
2. Probability of Occurrence.
The measure is more relied upon by banks/FIs/RBI. VaR (Value at Risk is a downside Risk
Measure.)
Risk Pricing Risk Premium is added in the interest rate because of the following:
• Necessary Capital is to be maintained as per regulatory requirements.
• Capital is raised with cost.
For example there are 100 loan accounts with Level 2 Risk. It means there can be average loss of
2% on such type of loan accounts: Risk Premium of 2% will be added in Rate of Interest.
Pricing includes the following:
1. Cost of Deploying funds
2. Operating Expenses
3. Loss Probabilities
4. Capital Charge
Risk Mitigation
Credit Risk can be mitigated by accepting Collaterals, 3rd party guarantees, Diversification of
Advances and Credit Derivatives.
Interest rate Risk can be reduced by Derivatives of Interest Rate Swaps.
Forex Risk can be reduced by entering into Forward Contracts and Futures etc.
If we make advances to different types of business with different Risk percentage, the overall
risk will be reduced through diversification of Portfolio.
Banking Book, Trading Book and Off Balance Sheet Items
Banking Book
It includes all advances, deposits and borrowings which arise from Commercial and Retail
Banking. These are Held till maturity and Accrual system of accounting is applied. The Risks
involved are: Liquidity Risk, Interest Rate Risk, Credit Default Risk, Market Risk and
Operational Risk.
Trading Book
It includes Assets which are traded in market.
• These are not held till maturity.
• The positions are liquidated from time to time.
• These are Mark- to–market i.e. Difference between market price and book value is taken as
profit.
• Trading Book comprises of Equities, Foreign Exchange Holdings and Commodities etc.
• These also include Derivatives
The Risks involved are Market Risks. However Credit Risks and Liquidity Risks can also be
there.
Off Balance Sheet Exposures
The Off Balance sheet exposures are Contingent Liabilities, Guarantees, LC and other
obligations. It includes Derivatives also. These may form part of Trading Book or Banking Book
after they become Fund based exposure.
Types of Risks
1. Liquidity Risk
It is inability to obtain funds at reasonable rates for meeting Cash flow obligations. Liquidity
Risk is of following types:
Funding Risk: It is risk of unanticipated withdrawals and non-renewal of FDs which are raw
material for Fund based facilities.
Time Risk: It is risk of non-receipt of expected inflows from loans in time due to high rate
NPAs which will create liquidity crisis.
Call Risk: It is risk of crystallization of contingent liabilities.
2. Interest Rate Risk
Risk of loss due to adverse movement of interest rates. Interest rate risk is of following types:
Gap or Mismatch Risk: The risk of Gap between maturities of Assets and Liabilities.
Sometimes, Long term loans are funded by short term deposits. After maturity of deposits, these
liabilities are get repriced and Gap of Interest rates between Assets and Liabilities may become
narrowed thereby reduction of profits.
Basis Risks: Change of Interest rates on Assets and Liabilities may change in different
magnitudes thus creating variation in Net Interest Income.
Yield Curve Risk: Yield is Internal Rate of Return on Securities. Higher Interest Rate scenario
will reduce Yield and thereby reduction in the value of assets. Adverse movement of yield will
certainly affect NII (Net Interest Income).
Embedded Option Risk : Adverse movement of Interest Rate may result into pre-payment of
CC/DL and TL. It may also result into pre-mature withdrawal of TDs/RDs. This will also result
into reduced NII. This is called Embedded Risk.
Re-investment Risk: It is uncertainty with regard to interest rate at which future cash flows
could be reinvested.
3. Market Risk
Market Risk is Risk of Reduction in Mark-to-Market value of Trading portfolio i.e. equities,
commodities and currencies etc. due to adverse market sensex. Market Risk comprises of:
- Price Risk occurs when assets are sold before maturity. Bond prices and Yield are inversely
related.
- IRR affects the price of the instruments.
- Price of Other commodities like Gold etc,. is also affected by the market trends.
- Forex Risks are also Market Risks.
- Liquidity Risk or Settlement Risk is also present in the market.
4. Credit Risk or Default Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms and
conditions. There are two types of credit Risks:
Counter party Risk: This includes non-performance by the borrower due to his refusal or
inability.
Country Risk : When non-performance of the borrower arises due to constrains or restrictions
imposed by a country.
5. Operational Risk
Operation Risk is the risk of loss due to inadequate or Failed Internal procedures, people and the
system. The external factors like dacoity, floods, fire etc. may also cause operational loss. It
includes Frauds Risk, Communication Risk, Documentation Risk, Regulatory Risk, Compliance
Risk and legal risks but excludes strategic /reputation risks.
Two of these risks are frequently occurred.
Transaction Risk: Risk arising from fraud, failed business processes and inability to maintain
Business Continuity.
Compliance Risk: Failure to comply with applicable laws, regulations, Code of Conduct may
attract penalties and compensation.
Other Risks are:
1. Strategic Risk: Adverse Business Decisions, Lack of Responsiveness to business changes and
no strategy to achieve business goals.
2. Reputation Risk ; Negative public opinions, Decline in Customer base and litigations etc.
3. Systemic Risks ; Single bank failure may cause collapse of whole Banking System and result
into large scale failure of banks.
In 1974, closure of HERSTATT Bank in Germany posed a threat for the entire Banking system
BASEL–I
Bank for International Settlements (BIS) is situated at Basel (name of the city in Switzerland).
Moved by collapse of HERSTATT bank, BCBS – Basel Committee on Banking Supervision
consisting of 13 members of G10 met at Basel and released guidelines on Capital Adequacy in
July 1988. These guidelines were implemented in India by RBI w.e.f. 1.4.1992 on the
recommendations of Narsimham Committee. The basic objective was to strengthen soundness
and stability of Banking system in India in order to win confidence of investors, to create healthy
environment and meet international standards.
BCBS meets 4 times in a year. Presently, there are 27 members.
BCBS does not possess any formal supervisory authority.
1996 Amendment
• Allowed banks to use Internal Risk Rating Model.
• Computation of VaR daily using 99th percentile.
• Use of back-testing
• Allowing banks to issue short term subordinate debts with lock-in clause.
Calculation of CRAR (Capital to Risk Weighted Asset Ratio)
Basel – I requires measurement of Capital Adequacy in respect of Credit risks and Market
Risks only as per the following method:
Capital funds(Tier I & Tier II)/(Credit Risk Weighted Assets + Market RWAs + Operational
RWAs) X 100
Minimum requirement of CRAR is as under:
As per BASEL-II recommendations 8%
As per RBI guidelines 9%
Banks undertaking Insurance business 10%
New Private Sector Banks 10%
Local Area banks 15%
For dividend declaration by the banks (during previous 2 years and current year) 9%
Tier I & Tier II Capital
Tier –I Capital
Tier –I Capital includes:
• Paid up capital, Statutory reserves, Other disclosed free reserves, Capital Reserve representing
surplus out of sale proceeds of assets.
• Investment fluctuation reserve without ceiling.
• Innovative perpetual Debt instruments (Max. 15% of Tier I capital)
• Perpetual non-cumulative Preference shares
Less Intangible assets & Losses.
• Sum total of Innovative Perpetual Instruments and Preference shares as stated above should not
exceed 40% of Tier I capital. Rest amount will be treated as Tier II capital.
Tier –II Capital
It includes:
• Redeemable Cumulative Preference shares, Redeemable non-cumulative Preference shares &
Perpetual cumulative Preference shares,
• Revaluation reserves at a discount of 55%,
• General Provisions & Loss reserves up to 1.25 % of RWAs
• Hybrid debts (say bonds) & Subordinate debts (Long term Unsecured loans) limited to 50% of
Tier –I Capital.
Tier – III Capital
Banks may at the discretion of the National Authority, employ 3rd tier of Capital consisting of
short term subordinate debts for the sole purpose of meeting a proportion of capital requirements
for market risks. Tier III capital will be limited to 250% of bank’s Tier –I Capital (Minimum of
28.5%) that is required to support market risks.
Tier – II capital should not be more than 50% of Total Capital.
Capital adequacy in RRBs
The committee on financial sector assessment has suggested introducing CRAR in RRBs also in
a phased manner.
Two ways to improve CRAR
1. By raising more capital. Raising Tier I capital will dilute the equity stake of existing investors
including Govt. Raising Tier II Capital is definitely a costly affair and it will affect our profits.
2. Reduction of risk weighted assets by implementing Risk mitigation Policy.
Risk Weights on different Assets
Cash and Bank Balance 0%
Advances against NSC/KVC/FDs/LIC 0%
Govt. guaranteed Advances 0%
Central Govt. Guarantees 0%
State Govt. Guarantees 20%
Govt. approved securities 2.5%
Balance with other scheduled banks having CRR at least 9% 20%
Other banks having CRR at least 9% 100%
Secured loan to staff 20%
Other Staff loans -not covered by retirement dues 75%
Loans upto 1.00 lac against Gold/Silver 50%
Residential Housing Loans O/S above 30 lac 75%
Residential Housing loans O/S upto 30 lac 50%
Residential property if LTV ratio is above 75% 100%
Residential Housing Loans O/S above 75 lac 125%
Mortgage based securitization of assets 77.5%
Consumer Credit / Credit Cards/Shares loan 125%
Claims secured by NBFC-non-deposit taking (other than AFCs) 100%
Venture Capital 150%
Commercial Real Estates 100%
Education Loans (Basel –II -75%) 100%
Other loans (Agriculture, Exports) 100%
Indian Banks having overseas presence and Foreign banks will be on parallel run (Basel -I) and
Basel-II for 3 years commencing from 31.3.2010 up to 31.3.2013. These banks will ensure that :
Basel-II minimum capital requirement continues to be higher than 80% of Basel-I minimum
capital requirement for credit Risk and Market Risk.”
Further, Tier –I CRAR should be at-least 6% up to 31.3.2010 and 8% up to 31.3.2011
BASEL II
The Committee on Banking Regulations and Supervisory Practices released revised version in
the year 2004. These guidelines have been got implemented by RBI in all the banks of India.
Parallel run was started from 1.4.2006. In banks having overseas presence and foreign banks
(except RRBs and local area banks. Complete switchover has taken place w.e.f. 31.3.2008. In
banks with no foreign branch, switchover will took place w.e.f. 31.3.2009.
Distinction between Basel I and Basel II
Basel – I measures credit risks and market risks only whereas Basel II measures 3 types of risks
i.e. Credit Risk, Operational Risk and Market Risk. Risk weights are allocated on the basis of
rating of the borrower i.e. AAA, AA, A, BBB, BB and B etc. Basel –II also recognized CRM
such as Derivatives, Collaterals etc.
Three Pillars of BASEL-II
Pillar –I Minimum Capital Requirement
Pillar – II Supervisory Review Process
Pillar –III Market Discipline
Pillar - I – Minimum Capital Requirement
CRAR will be calculated by adopting same method as discussed above under Basel – I with the
only difference that Denominator will be arrived at by adding 3 types of risks i.e. Credit Risks,
Market Risks and Operational Risks.
Credit Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms and
conditions. In terms of extant guidelines contained in BASEL-II, there are three approaches to
measure Credit Risk given as under:
1. Standardized approach
2. IRB (Internal Rating Based) Foundation approach
3. IRB (Internal Rating Based) Advanced approach
1. Standardized Approach
RBI has directed all banks to adopt Standardized approach in respect of Credit Risks.
Under standardized approach, risk rating will be done by credit agencies. Four Agencies are
approved for external rating:
1. CARE 2. FITCH India 3.CRISIL 4. ICRA
Risk weights prescribed by RBI are as under:
Rated Corporate
Rating & Risk Percentage
AAA 20%
AA 30%
A 50%
BBB 100%
BB & below 150%
Education Loans 75%
Retail portfolio and SME portfolio 75%
Housing loans secured by mortgage 50 to 75%
Commercial Real Estates 100%
Unrated Exposure 100%
2. IRBA – Internal rating Based Approach
At present all advances of Rs. 5.00 crore and above are being rated from external agencies in our
bank. IRBA is based on bank’s internal assessment. It has two variants (Foundation and
advanced). Bank will do its own assessment of risk rating and requirement of Capital will be
calculated on
• Probability of default (PD)
• Loss given default (LD)
• Exposure of default (ED)
• Effective maturity. (M)
Bank has developed its own rating module system to rate the undertaking internally. The internal
rating is being used for the following purposes:
1. Credit decisions
2. Determination of Powers
3. Price fixing
Rating by Outside Agencies
The risk weights corresponding to the newly assigned rating symbols are as under:
Table : PART A – Long term Claims on Corporate – Risk Weights
Long Term Ratings
CARE CRISIL Fitch ICRA Risk Weights (%)
CARE AAA CRISIL AAA Fitch AAA ICRA AAA 20
CARE AA CRISIL AA Fitch AA ICRA AA 30
CARE A CRISIL A Fitch A ICRA A 50
CARE BBB CRISIL BBB Fitch BBB ICRA BBB 100
CARE BB & below CRISIL BB & below Fitch BB & below ICRA BB & below 150
Unrated Unrated Unrated Unrated 100
How to Calculate RWAs and Capital Charge in respect of Credit risk
Ist Step : Calculate Fund Based and Non Fund Based Exposure
2nd Step: Allowable Reduction
3rd Step : Apply Risk Weights as per Ratings
4th Step: Calculate Risk Weighted Assets
5th Step : Calculate Capital Charge
Ist Step: Calculate Fund Based and Non Fund Based Exposure:
Example:
Fund Based Exposure (Amount in ‘000)
Nature of loan Limit Outstanding Undrawn portion
CC 200 100 100
Bills Purchased 60 30 30
Packing Credit 40 30 10
Term Loan 200 40 160
Total Outstanding 200
Out of Undrawn portion of TL, 60 is to drawn in a year and balance beyond 1 year.
Adjusted Exposure:
100% Outstanding(Unrated) = 200
20% of Undrawn CC, BP & PC (140*20/100) = 28
20% of Undrawn TL (1 yr) (60*20/100) = 12
50% of Undrawn TL (>1Yr) (100*50/100) = 50
Total Adjusted Exposure FB limits 290
Non Fund Based Exposure (Amount in ‘000)
Type of NBF Exposure CCF Adjusted Exposure
Financial Guarantees 90 100% 90
Acceptances 80 100% 80
Standby LC 50 100% 50
Clean LC 50 100% 50
Unconditional Take out finance 100 100% 100
Performance Guarantee 80 50% 40
Bid Bonds 20 50% 10
Conditional Take out finance 50 50% 25
Documentary LC 40 20% 8
Total Adjusted Exposure FB limits = 453
Total Adjusted Exposure = 290000+453000 = 7,43,000
2nd Step: Allowable Reduction after adjusting CRMs (Credit Risk Mitigates)
Reduction from adjusted exposure is made on account of following eligible financial collaterals:
Eligible Financial Collaterals .
• Deposits being maintained by a borrower under lien.
• Cash (including CDs or FDs), Gold, Govt Securities, KVP, NSC, LIC Policy, Debt Securities,
Mutual Funds’
• Equity and convertible bonds are no more eligible CRMs.
Formula for Deposits under lien: C*(1-Hfx) X Mf
(C=Amount of Deposit; Hfx =0 (if same currency), Hfx = 0.08 (if diff currency) Mf = Maturity
factor).
Formula for Approved Financial collaterals: C*(1-Hc-Hfx) *Mf ) - E*He
Haircuts(He–Haircut for Exposure & Hc-Haircut for Collateral)
Haircut refers to the adjustments made to the amount of exposures to the counter party and also
the value of collateral received to take account of possible future fluctuations in the value of
either, on account of market movements. Standardized Supervisory Haircuts for collateral
/Exposure have been prescribed by RBI and given in the said circular.
Capital Requirement for collateralized transaction
E* = max { 0, [E X (1+He) – C X (1-Hc- Hfx) } ]
E* - exposure value alter risk mitigation
E – Current value of exposure for which coll. Qualifies
C = current value of collateral received
Hfx = Haircut appropriate for currency mismatch between collateral and exposure.
E* will be multiplied by the risk weight of the counter party to obtain RWA amount.
Illustrations clarifying CRM
In the case of exposure of Rs 100 (denominated in USD) having a maturity of 6 years to a BBB
rated (rating by external credit rating agency) corporate borrower secured by collateral of Rs 100
by way of A+ rated corporate bond with a maturity of 6 years, the exposure amount after the
applicable haircut @ 12%, will be Rs 112 and the volatility adjusted collateral value would be Rs
80, (after applying haircut @ 12% as per issue rating and 8% for currency mismatch) for the
purpose of arriving at the value of risk weighted asset & calculating charge on capital.
There is an exposure of Rs 100 to an unrated Corporate (having no rating from any external
agency) having a maturity of 3 years, which is secured by Equity shares outside the main index
having a market value of Rs 100.
The haircut for exposure as well as collateral will be 25%. There is no currency mismatch in this
case. The volatility adjusted exposure and collateral after application of haircuts works out to Rs
125 and Rs 75 respectively. Therefore, the net exposure for calculating RWA works out to Rs
50.
There is a demand loan of Rs 100 secured by bank’s own deposit of Rs 125. The haircuts for
exposure and collateral would be zero. There is no maturity mismatch. Adjusted exposure and
collateral after application of haircuts would be Rs 100 and Rs 125 respectively. Net exposure
for the purpose of RWA would be zero
Other Examples
No. 1:
1. Exposure----------------------------------------- 100 lac with tenure 3 years
2. Eligible Collateral in A+ Debt Security -----30 lac with Residual maturity 2 years
3. Hair cut on Collateral is 6%
4. Table of Maturity factor shows hair cut as 25% for remaining maturity of 2 years/
Calculate Value of Exposure after Risk Mitigation:
Solution:
Value of Exposure after Risk Mitigation =
Current Value of Exposure – Value of adjusted collateral for Hair cut and maturity mismatch
Value of Adjusted Collateral for Hair cut = C*(1-Hc) = 30(1-6%) = 30*94% = 28.20
Value of Adjusted Collateral for Hair cut and Maturity Mismatch = C*(t-0.25) / (T-0.25)
= 28.20*(2-.25)/(3-.25) = 17.95
(Where t = Remaining maturity of Collateral T= Tenure of loan )
Value of Exposure after Risk Mitigation = 100-17.95= 82.05 lac.
No. 2
An exposure of Rs. 100 lac is backed by lien on FD of 30 lac. There is no mismatch of maturity.
Solution:
Hair Cut for CRM i.e. FDR is zero.
Hence Value of Exposure after Risk Mitigation is 100 lac – 30 lac = 70 lac
Computation of CRAR
In a bank ; Tier 1 Capital = 1000 crore
Tier II Capital = 1200 crore
RWAs for Credit Risk = 10000 crore
Capital Charge for Market Risk = 500 crore
Capital Charge for Op Risk = 300 crore
Find Tier I CRAR and Total CRAR.
Solution:
RWAs for Credit Risk = 10000 crore
RWAs for Market Risk = 500/.09 = 5556 crore
RWAs for Op Risk = 300/.09 = 3333 crore
Total RWS = 10000+5556+3333 = 18889 crore
Tier I Capital = 1000 crore
Tier II Capital can be up to maximum 1000 crore
Total Capital = 2000 crore
Tier I CRAR = Eligible Tier I Capital /Total RWAs = 1000/18889=5.29%
Total CRAR = Eligible Total Capital /Total RWAs = 2000/18889 = 10.59%
We may conclude that Tier I Capital is less than the required level.
Credit Risk Mitigates
It is a process through which credit Risk is reduced or transferred to counter party. CRM
techniques are adopted at Transaction level as well as at Portfolio level as under:
At Transaction level:
• Obtaining Cash Collaterals
• Obtaining guarantees
At portfolio level
• Securitization
• Collateral Loan Obligations and Collateral Loan Notes
• Credit Derivatives
1. Securitization
It is process/transactions in which financial securities are issued against cash flow generated
from pool of assets.
Cash flow arising from receipt of Interest and Principal of loans are used to pay interest and
repayment of securities. SPV (Special Purpose Vehicle) is created for the said purpose.
Originating bank transfers assets to SPV and it issues financial securities.
2. Collateral Loan Obligations (CLO) and Credit Linked Notes (CLN)
It is also a form of securitization. Through CLO, bank removes assets from Balance Sheet and
issues tradable securities. They become free from Regulatory Capital.
CLO differs from CLN (Credit link notes in the following manner.
• CLO provide credit Exposure to diverse pool of credit where CLN relates to single credit.
• CLO result in transfer of ownership whereas CLN do not provide such transfer.
• CLO may enjoy higher credit rating than that of originating bank.
3. Credit Derivatives
It is managing risks without affecting portfolio size. Risk is transferred without transfer of assets
from the Balance Sheet though OTC bilateral contract. These are Off Balance Sheet Financial
Instruments. Credit Insurance and LC are similar to Credit derivatives. Under a Credit Derivative
PB (Prospective buyer) enter into an agreement with PS (Prospective seller) for transfer of risks
at notional value by making of Premium payments. In case of delinquencies, default,
Foreclosure, prepayments, PS compensates PB for the losses. Settlement can be Physical or
Cash. Under physical settlement, asset is transferred whereas under Cash settlement, only loss is
compensated.
Credit Derivatives are generally OTC instruments. ISDA (International Swaps and Derivatives
Association) has come out with documentation evidencing such transaction. Credit Derivatives
are:
1. Credit Default Swaps
2. Total Return Swaps
3. Credit Linked Notes
4. Credit Spread Options
Operational Risk
Operational Risk is the risk of loss resulting from
• Inadequate or failed internal processes, people and system.
• External events such as dacoity, burglary, fire etc.
It includes legal risks but excludes strategic /reputation risks.
Identification
• Actual Loss Data Base
• RBIA reports
• Risk Control & Self Assessment Survey
• Key Risk indicators
• Scenario analysis
Four ways to manage Risk
• Prevent
• Reduce
• Transfer
• Carry/Accept
Operational Risk – Measurement
Three approaches have been defined to measure Operational Risk at the bank:
1. Basic Indicator approach
2. Standardized approach
3. AMA i.e. Advanced measurement approach
Basic Indicator Approach
15% of Average positive gross annual income of previous 3 years will be requirement of capital.
To start with banks will have to adopt this approach and huge capital is required to be
maintained. In our bank, estimated requirement of capital will be about Rs. 1000 crore.
The Standardized Approach
All banking activities are to be divided in 8 business lines. 1) Corporate finance 2) Trading &
Sales 3) Retail Banking 4) Commercial Banking 5) Asset Management 6) Retail brokerage 7)
Agency service 8) Payment settlement
Within each business line, Capital requirement will be calculated as under:
By multiplying the average gross income generated by a business over previous 3 years by a
factor β ranging from 12 % to 18 % depending upon industry-wise relationships as under:
Retail Banking, Retail Brokerage and Asset Management-----------12%
Commercial Banking and Agency Services---------------------------15%
Corporate, Trading and Payment Settlement------------------------18%
Advanced Measurement Approach
Capital requirement is calculated by the actual risk measurement system devised by bank’s own
internal Operational Risk Measurement methods using quantitative and qualitative criteria. Our
bank has started measuring actual losses and estimating future losses by introducing statement of
Operational Risk Loss data w.e.f. 1.4.2005. Minimum 5 year data is required for a bank to switch
over to AMA.
How to calculate RWAs for Operational Risk?
RWAs for Operational Risk = Capital Charge / 0.09% (If required CAR is 9%)
Operational Risk – Scenario Analysis
It is a term used in measurement of Operational Risk on the basis of scenario estimates.
Banks use scenario analysis based on expert opinion in conjunction with external data to evaluate
its exposure to high severity events.
In addition, scenario analysis is used to assess impact of deviations from correlation assumptions
in the bank’s Operational Risk measurement framework to evaluate potential losses arising from
operational risk loss events.
Operational Risk Mitigation
Insurance cover, if available can reduce the operational risk only when AMA is adopted for
estimating capital requirements. The recognition of insurance mitigation is limited to 20% of
total Operational Risk Capital Charge calculated under AMA.
Practical Example - AMA approach
Under AMA approach, Estimated level of Operational Risk is calculated on the basis of:
1. Estimated probability of occurrence
2. Estimated potential financial impact
3. Estimated impact of internal control.
Estimated Probability of Occurrence: This is based on historical frequency of occurrence &
estimated likelihood of future occurrence. Probability is mapped on scale of 5 as under:
Negligible risk -----1
Low risk-------------2
Medium Risk--------3
High Risk------------4
Very High Risk------5
For Calculation, following formula is used:
Estimated level of Operational Risk = {Estimated probability of occurrence x Estimated
potential financial impact x Estimated impact of internal control} ^0.5
^0.5 implies Under root of whole
Example:
Probability of occurrence = 2 (medium)
Probability of Financial impact = 4 (very high)
Impact of Financial control = 50%
Solution
[ 2x4x(1-0.5)] ^0.5 = ∫4 = 2 (Low)
Market Risk
It is simply risk of losses on Balance sheet and Off Balance sheet items basically in investments
due to
movement in market prices. It is risk of adverse deviation of mark to Market value of trading
portfolio during the period. Any decline in the market value will result into loss.
Market Risk involves the following:
1. Risk Identification
2. Risk Measurement
3. Risk monitoring and control
4. Risk mitigation.
ALCO: Assets Liability Committee meets at frequent intervals and takes decisions in respect of
Product pricing, Maturity profiles and mix of incremental assets and profiles, Interest rate,
Funding policy, Transfer pricing and Balance Sheet Management.
Market Risk measurement
Measurement of Market Risk is based on:
1. Sensitivity
2. Downside potential
Sensitivity Measurement
Change in market rate of interest has inverse relation with Value of Bonds. Higher interest rates
lower the value of bond whereas decline in interest rate would result into higher bond value.
Also More liquidity in the market results into enhanced demand of securities and it will lead to
higher price of market instrument. There are two methods of assessment of Market risk:
1. Basis Point Value
2. Duration method
1. Basis Point Value
This is change in value of security due to 1 basis point change in Market Yield. Higher the BPV
higher will be the risk.
Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10
Difference Yield = 0.5%
Difference in Market price = 0.10
BPV = 0.10/0.05 = 2 i.e. 2 basis points.
Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/- (1,00,00,000*.02/100)
Now, if the yield on Bond with BPV 2000 declines by 8 bps, then it will result into profit of Rs.
16000/- (8x2000).
BPV declines as maturity reaches. It will become zero on the date of maturity.
2. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration) to receive Present
Value of the bond. e.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley
Duration 3.7 years. It means Total Cash Flow of Rs. 130 to be received in 5 years would be
discounted with Present Value which will be equivalent as amount received in 3.7 years. The
Duration of the Bond is 3.7 Years.
Formula of Calculation of McCauley Duration = ΣPV*T / ΣPV
Modified Duration = Duration / 1+Yield
Approximate % change in price = Modified Duration X Change in Yield
Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is 5
years. What will be the McCauley Duration.
Modified Duration = Duration/ 1+YTM
Duration = Modified Duration x (1+YTM)
= 5 x 1.06 = 5.30
3. Downside Potential
It captures only possible losses ignoring profit potentials. It integrates sensitivity and volatility
with adverse affect of Uncertainty.
This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method to
calculate downside potential.
Value at Risk (VaR)
It means how much can we expect to lose? What is the potential loss?
Let VaR =x. It means we can lose up to maximum of x value over the next period say week (time
horizon).
Confidence level of 99% is taken into consideration.
Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is only
one chance in 100 that daily loss will be more than 10 crore under normal conditions.
VaR in days in 1 year based on 250 working days = 1 x 250 / 100 == 2.5 days per year.
Back Testing
It is a process where model based VaR is compared with Actual performance. It tells us whether
results fall within pre-specified confidence bonds as predicted by VaR models.
Stress Testing
It seeks to determine possible change in Market Value of portfolio that could arise due to nonnormal
movement in one or more market parameters (such as interest rate, liquidity, inflation,
Exchange rate and Stock price etc.).
Four test are applied:
1. Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate +2%, 4%,6% etc.
2. Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if possible events
occur. It assesses potential consequences for a firm of an extreme. It is based on historical event
or hypothetical event.
3. Maximum loss
The approach assesses the risks of portfolio by identifying most potential combination of moves
of market risks
4. Extreme value theory
The theory is based on behavior of tails (i.e. very high and very low potential values) of probable
distributions.
RBI guidelines on CCF (Credit Conversion Factor)
Direct Credit Substitutes CCF
General Guarantees (including Standby LCs), Acceptances - 100%
Transaction related contingent items (Performance bonds, Bid bonds, - 50%
Warranties, Indemnities, Standby LC relating to particular transaction
Short Term LC (Documentary) for Issuing bank as well as confirming bank - 20%
Capital Charge on Un-availed limit
Capital Charge on Undrawn limits is calculated as under:
• 20% on Undrawn CC limit
• 20% on Undrawn TL limit (which is to be drawn in a year)
• 50% on Undrawn TL limit (which is to be drawn beyond a year)
Example
In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally cancelable)
where the
availed portion is Rs. 60 lakh, the un-availed portion of Rs.40 lakh will attract a Credit
Conversion Factor (CCF) of 20% (since the cash credit facility is subject to review / renewal
normally once a year). The credit equivalent amount of Rs.8 lakh (20% of Rs.40 lakh) will be
assigned the appropriate risk weight as applicable to the counterparty / rating to arrive at the risk
weighted asset for the unavailed portion. The availed portion (Rs.60 lakh) will attract a risk
weight as applicable to the counterparty / rating.
In compliance of the new guidelines banks have advised all the branches for:
i) Insertion of Limit Cancellation Clause in loan documents
ii) Levying of Commitment Charges
Time frame for application of different approaches
Application to RBI by Approval by RBI by
IRB approach for Credit Risk 01.04.2012 31.3.2014
AMA approach for Operational Risk 01.04.2012 31.3.2014
Internal Model approach for
Market Risk 01.04.2010 31.3.2011
BASEL -III Basel III covers Liquidity Risk in addition to Basel II.
It is planned to implement BASEL-III w.e.f. 1.1.2013. The propose reforms are as under:
Capital Common Equity Tier –I Total Capital
Minimum 4.5% 6% 8%
+ Conservative Buffer 2.5% 2.5% 2.5%
Transition Arrangement
As on 1.1.2013, the banks will meet new minimum requirement in relation to Risk Weighted
Assets as under:
3.5% of Common Equity + 4.5% of Tier –I Capital = .8% of Total Capital /Risk Weighted
Assets.
VaR (Value at Risk)
Value at Risk is how much can we expect to lose? What is potential loss?
We can lose maximum up to VaR (value at Risk) over a given time at a given confidence level.
Calculation of VaR
Market Factor Sensitivity X Daily Volatility X Probability at given confidence level
Suppose impact of 1% change of interest rate (Price) = 6000/-
Daily Volatility = 3% : Confidence level is 99%
Probability of occurrence at 99% confidence level is 2.326
Defeasance period = 1 day
VaR = 6000x3x2.326 = 41874/-
Duration and Modified Duration
Duration is the time that Bondholder must wait for a number of years (duration) to receive
Present Value of Cash Inflows i.e. PV of Cash Inflows equals Actual Cash Inflows.
Formula of calculating Duration (Macaulay’s Duration)
Σ ( PV*T) / ΣPV
For example:
5 years bond of Rs. 100 @ 6% gives Duration of 3.7 years. It means Total Cash flow of Rs. 130/-
would be equivalent to receiving Rs. 130/- at the end of 3.7 years.
Modified Duration = Duration / 1 + Yield
Risk Management and Control
Market risk is controlled by implementing the business policies and setting of market risk limits
or controlling through economic measures with the objective of attaining higher RAROC. Risk is
managed by the following:
1. Limits and Triggers
2. Risk Monitoring
3. Models of Analyses.
Calculation of Capital Charge of Market Risk
The Basel Committee has two approaches for calculation of Capital Charge on Market Risk as
under:
1. Standardized approach
2. Internal Risk Management approach
Under Standardized approach, there are two methods: Maturity method and duration method.
RBI has decided to adopt Standardization duration method to arrive at capital charge on the
basis of investment rating as under:
Investment rating Capital Required
AAA to AA 0%
A+ to BBB (Residual term to maturity)
Less than 6 M 0.25%
Less than 24M 1.00%
More than 24 M 1.60%
Other Investments 8.00%
How to Calculate RWAs, if Capital Charge is given:
RWAs for Market Risk = Capital Charge / 0.09 (If required CAR is 9%)
Other Risks and Capital Requirement
Other Risks like Liquidity Risks, Interest Rate Risk, Strategic Risk, Reputational Risks and
Systemic Risks are not taken care of while calculating Capital Adequacy in banks.
Pillar – II – Supervisory Review Process (SRP)
SRP has two issues:
1. To ensure that bank is having adequate capital.
2. To encourage banks to use better techniques to mitigate risks.
SRP concentrates on 3 main areas:
• Risks not fully captured under Pillar -1 i.e. Interest Rate Risks, Credit concentration Risks,
Liquidity Risk, Settlement Risks, Reputational Risks and Strategic Risks.
• Risks not at all taken care of in Pillar -1.
• External Factors.
This pillar ensures that the banks have adequate capital. This process also ensures that the bank
managements develop Internal risk capital assessment process and set capital targets
commensurate with bank’s risk profile and capital environment. Central Bank also ensures
through supervisory measures that each bank maintains required CRAR and components of
capital i.e. Tier –I & Tier –II are in accordance with BASEL-II norms. RBIA and other internal
inspection processes are the important tools of bank’s supervisory techniques.
Every Bank will prepare ICAAP (Internal Credit Adequacy Assessment Plan) on solo basis
which will comprise of functions of measuring and identifying Risks, Maintaining appropriate
level of Capital and Developing suitable Risk mitigation techniques.
Pillar – III – Market Discipline
Market discipline is complete disclosure and transparency in the balance sheet and all the
financial statements of the bank. The disclosure is required in respect of the following:
• Capital structure.
• Components of Tier –I and Tier –II Capital
• Bank’s approach to assess capital adequacy
• Assessment of Credit Risks, Market Risk and Operational Risk.
• Credit Aspects like Asset Classification, Net NPA ratios, Movement of NPAs and
Provisioning.
Frequency of Disclosure
• Banks with Capital funds of Rs. 100 crore or more will make interim Disclosures on
Quantitative aspects on standalone basis on their respective websites.
• Larger banks with Capital Funds of Rs. 500 crore or more will disclose Tier-I capital, Total
Capital, CAR on Quarterly basis on website.
Risk Weight on NPAs
a) Risk weight on NPAs net of specific provision will be calculated as under:
When provision is less than 20% of NPA o/s ---- 150%
When provision is at least 20% of NPA o/s ---- 100%
When provision is at least 50% of NPA o/s ---- 50%
Category Provision Rate Risk Weight
Substandard (Secured) 15% 150%
Substandard (Unsecured) 25% 100%
Doubtful (DI) (Secured) 25% 100%
Doubtful (DI) (Un-Secured) 100% 50%
Doubtful (D2) (Secured) 40% 100%
Doubtful (D3) (Secured) 100% 50%
Doubtful (D2)(Un-Secured) 100% 50%
Off-balance sheet items
Off-balance sheet items have been bifurcated as follows:
i) Non-market related off-balance sheet items
ii) Market related off-balance sheet items
There is two-step process for the purpose of calculating risk weighted assets in respect of offbalance
sheet items:
a) The notional amount of the transaction is converted into a credit equivalent factor by
multiplying the amount by the specified Credit Conversion Factor (CCF)
b) The resulting credit equivalent amount is then multiplied by the risk weight applicable to the
counter party or to the purpose for which the bank has extended finance or the type of asset
whichever is higher.
Where the off-balance sheet item is secured by eligible collateral or guarantee, the credit risk
mitigation guidelines will be applied.
Non-market related off-balance sheet items:
Off balance sheet items like direct credit substitutes, trade and performance related contingent
items and commitments with certain draw downs are classified under Non-market related offbalance
sheet items. The credit equivalent amount is determined by multiplying the contracted
amount of that particular transaction by the relevant CCF.
Non-market related off-balance sheet items also include undrawn or partially undrawn fund
based and non-fund based facilities, which are not unconditionally cancellable. The amount of
undrawn commitment is to be included in calculating the off-balance sheet items. Non-market
related exposure is the maximum unused portion of the commitment that could be drawn during
the remaining period of maturity. In case of term loan with respect to large project to be drawn in
stages, undrawn portion shall be calculated with respect of the running stage only.
CREDIT RISK
How to find Risk Weighted Assets?
Fixed Assets : 500 Crore
Govt. Securities : 5000 crore
Standard Assets
Retail ---3000 crore
HL -------2000 crore
Other loans—10000 cr
Sub-Standard Assets
Secured ----500 crore
Unsecured -----150 crore
Doubtful (DAI) -----800 crore
Solution:
Retail----------------3000*75/100 = 2250 crore
HL---------------------2000*50/100=1000 crore
Other loans---------10000*100/100 = 10000 crore
Gsec------------------5000*0/100=0
SS Secured----------500*150/100=750 crore
SS Unsecured ------150*100/100=150 crore
Doubtful D1 --------800*100/100=800 crore
Total RWAs = 2250+1000+750+150+800 = 4950 crore
OPERATIONAL RISK
How to find Risk Weighted Assets?
Ist year 2nd year
Net Profit 120 crore 150 crore
Provisions 240 crore 290 crore
Staff Expenses 280 crore 320 crore
Other Oper.
Expenses 160 crore 240 crore
Gross Income 800 crore 1000 crore
Average Income 1800/2=900 crore
Capital Charge 900*15/100=135 crore
RWAs (assuming BASEL rate of 8%)
Capital Charge/8% = 135*100/8 = 1687.50 crore
Tier-I and Tier II Capital
CRAR
RWAs --- Credit and Operational Risks = 10000 crore
RWAs ----Market Risk =4000 crore
Tier –I Capital
Paid up Capital--------------------------------------------- 100 crore
Free Reserves --------------------------------------------- 300 crore
Perpetual non-Cumulative Preference Shares -----400 crore
Tier-II Capital
Provisions for contingencies ---------------------------200 crore
Revaluation Reserve--------------------------------------300 crore
Subordinate Debts----------------------------------------300 crore
Solution
Tier –I Capital = 100+300+400 = 800 crore
Tier-II Capital = ( 300*45/100) + 300 + 1.25 % of RWAs (or Rs. 200 crore)
=135 + 300 + 175 = 610 crore
Total Capital = 800 + 610 = 1410 crore
Minimum Capital Required and Capital to Support Market Risks
In the above example:
CAR = 1410/14000*100 = 10.07%
Minimum Capital Required to support Credit and Operational Risks = 10000*9/100 = 900 crore
Minimum Tier –I Capital Required to support Credit and Operational Risks = 900*50=450 crore
Minimum Tier –I I Capital Required to support Credit and Operational Risks =900-450=450
crore
Amount of Tier –I Capital to support Market Risks = 800-450 = 350 crore
Amount of Tier –II Capital to support Market Risks = 610-450 = 160 crore
Volatility with time horizon & Bond Value
Ex.1
If daily volatility of a Security is 2%, how much will be monthly volatility?
Solution
Monthly volatility = Daily Volatility * ∫30 = 2*∫30 = 2*5.477 = 10.95%
Ex.2
If per annum volatility is 30% and nos. of trading days per annum be 250, how much will be
daily volatility?
Solution
Annual Volatility = Daily Volatility * ∫250 = Daily Volatility * 15.81
30 = Daily Volatility *15.81
Daily volatility = 30/15.81 = 1.90%
Ex.3
If 1 day VaR of a portfolio is Rs. 50000/- with 97% confidence level. In a period of 1 year of 300
trading days, how many times the loss on the portfolio may exceed Rs. 50000/-.
Solution
97% confidence level means loss may exceed the given level (50000)on 3 days out of 100.
If out of 100 days loss exceeds the given level on days =3
Then out of 300 days, loss exceeds the given level = 3/100*300 =9 days.
Ex.4
A 5 year 5% Bond has a BPV of Rs. 50/-, how much the bond will gain or lose due to increase in
the yield of bond by 2 bps
Solution
Increase in yield will affect the bond adversely and the bond will lose.
Since BPV of the bond is Rs. 50/-. Increase in yield by 2 bps will result into loss of value of
Bond by 50*2=100.
Ex.5
1 day VaR of a portfolio is Rs. 50000/- with 90% confidence level. In a period of 1 year (250
days) how many times the loss on the portfolio may not exceed Rs.50000/-
Ans. 90% confidence level means on 10 days out of 100, the loss will be more than Rs. 50000/-.
Out of 250 days, loss will be more than 50000/- on 25 days Ans.
Bond Value, Current Yield
Bond-1 Bond-2
Face Value 100 100
Annual Coupon 8% 10%
Term to Maturity 3 yrs 4 yrs
Market Price 80 90
Ex. 1 Find Current Yield of Bond 2
Solution
Coupon amount X100 = 10/90*100 = 11.11%
Market Value
Ex. 2 Find YTM of Bond 1 & 2
YTM of Bond 1 = 17.07%
YTM of Bond 2 = 13.41%
Ex. 3 Find McCauley Duration of Bond 1
2.76 years
Ex. 4
Find Modified Duration of Bond 2
Solution
McCauley duration/1+yield
=3.46/(1+13.41%) = 3.46/1.1341 = 3.05 yrs.
Ex. 5 What is %age change in price of Bond 2 if YTM increases by 1%
Expected %age change in price
=Modified Duration x %age change in yield
=3.5 x 1 = -3.05% (Decrease in price of bond)
Ex. 5 What is %age change in price of Bond 2 if YTM decreases by 1%
=3.5 x 1 = 3.05% (Increase in price of bond)
Ex.6 As an investor, in which bond would you like to invest.
Bond 1 (YTM is more)
AMA – Estimated level of Operational Risk and Impact of Internal Control
Question: Probability of Occurrence : 4
Potential Financial impact =4
Impact of Internal controls = 0%
Solution:
{ Probability of occurrence x Potential financial impact x Impact of internal controls } ^0.5
=(4x4) ^0.5 = ∫16 = 4 Ans.(High Risk)
CAIIB - Bank Financial Management - Mod - C : Treasury Management
TREASURY MANAGEMENT
1. Fund management has been the primary activity of treasury, but treasury is also responsible
for Risk Management & plays an active part in ALM.
2. D-mat accounts are maintained by depository participants to hold securities in electronic
form.
3. In present scenario treasury function is liquidity management and it is considered as a service
center.
4. From an organizational point of view treasury was considered as a service center but due to
economic reforms & deregulation of markets treasury has evolved as a profit center.
5. Treasury connects core activity of the bank with the financial markets.
6. Investment in securities & Foreign Exchange business are part of integrated treasury.
7. Integrated treasury refers to integration of money market, Securities market and Foreign
Exchange operations.
8. Banks have been allowed large limits in proportion of their net worth for overseas borrowings
and investment.
9. Banks can also source funds in global markets and Swap the funds into domestic currency or
vice versa.
10. The treasury’s transactions with customers is known as merchant business.
11. The treasury encompasses funds management, Investment and Trading in a multy currency
environment.
12. Globalization refers to integration between domestic and global markets.
13. RBI has been progressively relaxing the Exchange Controls.
14. The Exchange Control Department of RBI has been renamed as Foreign Exchange
Department with effect from January 2004.
15. Though treasury trades with narrow spreads, the profits are generated due to high volume of
business.
16. Foreign currency position at the end of the day is known as open position.
17. Open position is also called Proprietary position or Trading position.
18. Treasury sells Foreign Exchange services, various risk management products & structured
loans to corporates.
19. Forward Rate Agreement (FRA) is entered to fix interest rates in future.
20. SWAP is offered to convert one currency into another currency.
21. Allocation of costs to various departments or branches of the bank on a rational basis is
called transfer pricing.
22. The treasury functions with a degree of autonomy and headed by senior management person.
23. The treasury may be divided into three main divisions 1) Dealing room 2) Back office and 3)
Middle office.
24. Securities market is divided into two parts, primary & secondary markets.
25. The security dealers deals only with secondary market.
26. The back office is responsible for verification & settlement of the deals concluded by the
dealers.
27. Middle office monitors exposure limits and stop loss limits of treasury and reports to the
management on key parameters of performance.
28. Minimum marketable investment is Rs. 5.00 Crores.
---------------------------------------------------------------------------------------------
1. The driving force of integrated treasury are:
A) Integrated cash flow management B) Interest arbitrage C) Investment opportunities D) Risk
Management..
2. The functions of Integrated Treasury are:
A) Meeting Reserve requirements B) Efficient Merchant services C) Global cash management
D) Optimizing profit by exploiting market opportunities in Forex market, Money market and
Securities market E) Risk management F) Assisting bank management in ALM.
3) The immediate impact of globalization is three fold A) Interest rate B) New institutional
structure C) Derivatives were allowed.
4) RBI is allowing banks to borrow and invest through their overseas correspondents, in foreign
currency upto 25% of their Tier – I capital or USD 10Million which amounts higher.
5) Treasury products have become more attractive for two reasons 1) Treasury operations are
almost free of credit risk and require very little capital allocation and 2) Operation coats are low
as compared to branching banking.
6. Treasury generates profits from under noted businesses.
1. Conventional A) Foreign exchange business and B) Money market deals.
2. Investment activities e.g. SLR, non – SLR & investment in Subsidiaries.
3. Interest Arbitrage.
4. Trading is a speculative activity, where profits arise out of favorable price movements
during the interval between buying and selling.
7. ARBITRAGE: is the benefit accruing to traders, who play in different markets
simultaneously.
8. DERIVATIVES are financial contracts to buy or sell or to exchange a cash flow in any
manner at a future date, the price of which is based on market price of an underlying assets
which may be financial or a real asset with or with out an obligation to exercise the contract.
9. EMERGING MARKET COUNTRIES are countries with a fast developing economy,
which are largely market driven.
10. D-MAT ACCOUNTS are maintained by depository participants to hold securities in
electronic form, so that transfer of securities can be affected by debit or credit to the respective
account holders without any physical document.
TREASURY PRODUCTS
1. In Foreign Exchange market free currencies can be bought and sold readily.
2. Free Currencies belong to those countries whose markets are highly developed and where
exchange controls are practically dispensed with.
3. Foreign Exchange market is most transparent & it is virtual market.
4. Foreign Exchange market may be called near perfect with an efficient price discovery system.
5. Spot settlement takes place two working days from the trade date i.e. on third day.
6. Customers expecting Foreign Currency transactions cover their risk by entering forward
contracts.
7. Treasury enters into Forward Contract for making profits out of price movements.
8. Forward exchange rates are arrived at on the basis of interest rates differentials of two
currencies.
9. A combination of Spot and Forward transactions is called Swap.
10. The Swap route is used extensively to convert cash flows from one currency to another
currency.
11. Inter bank loans, Short term investments and Nostro accounts are the avenues for
investment of Forex surpluses.
12. Nostro accounts are current accounts maintained in Foreign Currency by the banks with their
correspondent banks in the home currency of the country.
13. Balance held in Nostro accounts do not earn any interest.
14. Rediscounting of Foreign Bills is an inter bank advance.
15. RBI has allowed banks to include rediscounting of bills in their credit portfolio
16. Money market refers to raising and developing short term resources.
17. Inter bank market is subdivided into Call Money, Notice Money & Term Money.
18. Call Money refers to overnight placement.
19. Notice Money refers to placement beyond overnight for periods not exceeding 14 days.
20. Term Money refers placement beyond 14 days but not exceeding one year.
21. RBI pays interest on CRR balance in excess of 3% at Reverse Repo Rate.
22. Inter bank market carries lowest risk next to Sovereign risk.
23. The interest on treasury bills is by way of discount i.e. Bills are priced below face value, this
is known as implicit yielding.
24. Each issue of 91 days T-bills is for Rs.500 Crores and auction is conducted on Weekly basis
I.e. on every Wednesday.
25. Each issue of 364 days T-bills is Rs.1000 Crores and auction is conducted on Fortnightly
basis i.e. on alternate Wednesday.
26. The payment of T-bills is made and received through Clearing Corporation of India Limited
( CCIL )
27. Commercial paper is short term debt market paper.
28. The Commercial Paper issuing company should have minimum P2 credit rating.
29. Banks can invest in Commercial Paper only if it is issued in D-mat form.
30. Certificate of Deposit attracts stamp duty.
31. Repo is used for lending and borrowing money market funds.
32. Repo refers to sale of securities with a commitment to repurchase the same securities at a
later date.
33. Presently only Govt. securities are being dealt with under Repo transaction.
34. Repo is used extensively by RBI as an instrument to control liquidity in the inter bank
market.
35. Infusion of liquidity is effected through lending to banks under Repo transactions.
36. Absorption of liquidity is done by accepting deposits from banks known as Reverse Repo.
37. Banks may submit their bids to RBI either for Repo or for Reverse Repo.
38. The Repo would set upper rate of interest and Reverse Repo would set floor for the money
market.
39. Investment business is composed of buying and selling products available in securities
market.
40. To satisfy SLR banks can also invest in priority sector bonds of SDBI & NABARD.
41. State Government also issue State Development Bonds through RBI.
42. Corporate Debt papers includes medium and long term bonds & debentures issued by
corporates and Financial Institutions.
43. Debentures and bonds are debt instruments issued by corporate bodies with or without
security.
44. In India debentures are issued by corporates in private sector and bonds are issued by
institutions in Public Sector.
45. Debentures are governed by relevant company law and transferable only by registration.
But bonds are negotiable instruments governed by law of contracts.
46. If the bond holders are given an option to convert the debt into equity on a fixed date or
during a fixed period , these bonds are called Convertible bonds.
47. Banks are permitted to invest in equities subject to a ceiling presently 5% of its total assets.
48. Foreign Institutional Investors are now allowed to invest in debt market subject to an overall
ceiling currently USD 1.75 Billion.
49. Index Futures, Index Options, Stock futures and Stock Options etc. are the Derivative
products recently introduce.
50. The Derivative Products are highly popular for Risk Management as well as for speculation.
51. Banks are also permitted to borrow or invest in overseas markets with in a ceiling subject to
guidelines issued by RBI presently 25% of Tier – I capital or minimum USD 10 Million.
52. The treasury operates in exchange market, Money market and Securities market.
53. Foreign Exchange transaction includes Spot, Forward and Swap trades.
54. Money market is used for deployment of surplus funds and also to raise short term funds to
bridge gaps in the cash flow of bank.
55. Money market products include T-bills, Commercial paper, Certificate of Deposit and Repo.
56. Under EEFC exporters are allowed to hold a portion of the export proceeds in current
account with the bank.
57. GILTS are securities issued by Government which do not have any risk.
58. SGL accounts are maintained by Public Debt Office of RBI in electronic form.
59. FCNR deposit is denominated in four major currencies maintained by NRIs.
FUNDING AND REGULATORY ASPECTS
1. Cheques and Credit Cards etc are near money and also add to money supply.
2. The money in circulation is indicated by Broad Money or M3.
3. The cash component is just 15% of money supply or M3.
4. The monetary policy of RBI is aimed at controlling the inflation and ensuring stability of
financial markets.
5. Liquidity refers to surplus funds available with banks.
6. An excess of liquidity leads to inflation while shortage of liquidity may result in high interest
rates and depreciation of rupee exchange rate.
7. CRR is to be calculated on the basis of DTL with a lag of one fortnight.
8. The interest on CRR is paid at the reverse repo rate of RBI ( presently 6.25% P.A.)
9. SLR is to be maintained in the form of Cash, Gold and approved securities.
10. Liquidity adjustment facility (LAF) is the principal operating instrument of RBI’s monetary
policy.
11. LAF is used to day to day liquidity in the market.
12. LAF refers to RBI lending funds to banking sector through Repo instrument.
13. RBI also accepts deposits from banks under Reverse Repo.
14. RBI purchases securities from banks with an agreement to sell back the securities after a
fixed period is called Repo.
15. The Repo rate is 7.25% on par with bank rate and Reverse Repo rate is 6.25%.
16. The objective of RBI policy is the money market rates should normally move with in the
corridor of Repo rates and Reverse Repo rates.
17. Banks can borrow and lend overnight upto maximum of 100% and 25% respectively of their
net worth.
18. The securities clearing against assured payment is handled by CCLI.
19. CCIL is a specialized institution promoted by major banks.
20. RTGS has been fully activated by RBI from Oct – 2004.
21. All inter bank payments and high value customer payments are settled instantly under
RTGS.
22. Banks accounts with all the branch offices of RBI are also integrated under RTGS.
23. The INFINET has helped introduction of SFMS.
24. The SFMS facilitates domestic transfer of funds and authenticated messages similar to
SWIFT used by banks for international messaging.
25. All security dealings are done through NDS and settled by CCIL.
TREASURY RISK MANAGEMENT
1. The organizational controls refer to the checks and balanced within system.
2. In Treasury business front office is called Dealing Room.
3. Exposure limits protect the bank from Credit Risk.
4. The Counter party Risk is bankruptcy or inability of counter party to complete the transaction
at their end.
5. The exposure limits are fixed on the basis of the counter party’s net worth, market reputation
and track record.
6. RBI has imposed a ceiling of 5% of total business in a year with individual branches.
7. Limits imposed are preventive measures to avoid or contain losses in adverse market
conditions.
8. Trading limits are of three kinds, they are 1) Limits on deal size 2) Limits on open positions
and 3) Stop loss limits.
9. Open position refers to the trading positions, where the buy / sell positions are not matched.
10. All the forward contracts are revalued periodically ( Every month )
11. The stop loss limits prevent the dealer from waiting indefinitely and limit the losses to a
level which is acceptable to the management.
12. The Stop loss limits are prescribed per deal, per day, per month as also an aggregate loss
limit per year.
13. Two main components of market risk are Liquidity risk and Interest rate risk.
14. Liquidity risk implies cash flow gaps which could not be bridged.
15. Liquidity risk and Interest rate risk are like two sides of a coin.
16. The Interest rate risk refers to rise in interest costs eroding the business profits or resulting in
fall in assets prices.
17. The interest rate risk is present where ever there is mismatch in assets and liabilities.
18. If the currency is convertible, the exchange rate and interest rate changes play greater role in
attracting foreign investment inflows into the secondary market.
19. Marker Risk is a confluence of liquidity risk, interest rate risk, Exchange rate risk, Equity
risk and Commodity risk.
20. BIS defines Market Risk as, “ The Risk that the value of on- or – off Balance Sheet positions
will be adversely affected by movements in equity and interest rate markets, Currency exchange
rates and Commodity prices”
21. The Market Risk is closely connected with ALM.
22. The Market Risk is also known as Price Risk.
23. Two important measures of risk are Value at Risk and Duration method.
24. Value at Risk (VAR) at 95% confidence level implies a 5% probability of incurring the loss.
25. VAR is an estimate of potential loss always for a given period at a confidence level.
26. There are three approaches to calculate the AVR i.e. Parametric Approach, Monte Carlo
Approach and Historical Data.
27. VAR is derived from a statistical formulae based on volatility of the market.
28. Parametric Approach is based on sensitivity of various Risk components.
29. Under Monte Carlo model a number of scenarios are generated at random and their impact
on the subject is studied.
30. Duration is widely used in investment business.
31. The rate at which the present value equals the market price of a bond is known as YTM.
32. Yield & price of a bond moves in inverse proportion.
33. Duration is weighted average measure of life of a bond, where the time of receipt of a cash
flow is weighted by the present value of the cash flow.
34. Duration method is also known as Mecalay Duration, its originator is Frederic Mecalay.
35. Longer the duration, greater is the sensitivity of bond price to changes in interest rate.
36. A proportionate change in prices corresponding to the change in yields is possible, only
when the yield curve is linear.
37. Derivatives are used to protect treasury transactions from Market Risk.
38. Derivatives are also useful in managing Balance Sheet risk in ALM.
39. Treasury transactions are of high value & relatively need low capital.
40. Market movements are mainly due speculation.
41. VAR is the maximum loss that may take place with in a time horizon at a given confidence
level.
42. Leverage is Capital Adequacy Ratio incase of companies it is expressed as Debt / Equity
Ratio.
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1. Treasury Risk is sensitive because 1) The Risk of loosing capital is much higher than the risk
in the credit business 2) Large size of transactions done at the discretion of treasurer 3) Losses in
treasury business materialize in very short term and the transactions once confirmed are
irrevocable.
2. The conventional control and supervisory measures of treasury can be divided in to three parts
1) Organizational controls 2) Exposure ceiling and 3) Limits on trading portions and stop loss
limits.
DERIVATIVE PRODUCTS
1. Treasury uses derivatives to manage risk including ATL, to cater needs of corporate
customers and to trade.
2. The value of a Derivative is derived from on underlying market.
3. Derivatives always refer to future price.
4. The Derivatives that can be directly negotiated and obtained from banks and investment
institutions are known as over the counter (OTC) products.
5. Derivatives are of two types OTC products and Exchange traded products.
6. The value of trade in OTC products is much larger than that of Exchange traded products.
7. Derivative products can be broadly categorized into Options, Futures & Swaps.
8. Options refer to contracts where the buyer of an Option has a right but no obligation to
exercise the contract.
9. Put Option gives a right to the holder to buy an underlying product at a pre-fixed rate on a
specified date.
10. Call option gives a right to the holder to sell the underlying product at a pre-fixed rate on a
specified date or during a specified period.
11. The pre-fixed rate is known as Strike Rate.
12. Options are two types, an American type option can be executed at any time before expiry
date and European type option can be exercised only on expiry date. In India we use only
European type of Option.
13. A Dollar put Option gives right to the holder to sell Dollars.
14. If the strike price is same as the spot price, it is known as at the money.
15. The option is in the money (ITM), if the strike price is less than the forward rate in case of a
Call Option or strike price is more than the forward rate in case of a put option.
16. The Option is out of Money (OTM) if the strike price is more than the forward rate in case
of call option or if the strike price is less than forward rate in case of a put Option.
17. In the context of Options spot rate is the rate prevailing on the date of maturity.
18. The profit potential of buyer of an option is unlimited .
19. The option seller’s potential loss is unlimited.
20. Payment of differences between strike price & market price on expiry is known as cash
settlement.
21. The buyer of an option pays premium to the seller for purchase of Option.
22. The option premium is paid upfront.
23. A USD put Option on TJY is right to sell USD against JPY at ‘X’ price.
24. A stock option is the right to buy or sell equity of a company at the strike price.
25. Options are used to hedge against price fluctuations.
26. A convertible option may be the bond holder option of converting the debt into equity on
specified terms.
27. A bond with call option gives right to the issuer to prepay the debt on specified date.
28. Futures are forward contracts.
29. Under Futures contract the seller agrees to deliver to the buyer specified security / Currency
or commodity on a specified date.
30. Future Contracts are of standard size with prefixed settlement dates.
31. A distinct feature of Futures is the contracts are marked to market daily and members are
required to pay margin equivalent to daily loss if any.
32. In case of Futures the exchange guarantees all trades roughted through its members and in
case of default or insolvency of any member the exchange will meet the payment out of its trade
protection fund.
33. Currency Futures serve the same purpose as Forward Contracts, conventionally issued by
banks in foreign exchange business.
34. Futures are standardized and traded on exchanges but Forward Contracts are customized
OTC Contracts.
35. The Futures can be bought only for fixed amounts and fixed periods.
36. A Swap is an exchange of cash flow.
37. An interest rate Swap is an exchange of interest flows on an underlying asset or liability.
38. The cash flows representing the interest payments during the Swap period are exchanged.
39. For USD the bench mark rates are generally LIBOR ( London Inter Bank Offer Rate)
40. MIBOR is announced daily at 9.50 A.M by NSE.
41. MIBOR is used as a base rate for short term and Medium Term lending.
42. Interest rate Swap is shifting of interest rate calculation from fixed rate to floating or floating
rate to fixed rate or floating rate to floating rate.
43. A Floating to Floating rate Swap involves change of bench mark.
44. Quanto Swaps refer to paying interest in home currency at rate s applicable to foreign
currency.
45. Coupon Swaps refer to floating rate in one currency exchanged to fixed rate in another
currency.
46. In Indian Rupee market only plain vanilla type Swaps are permitted.
47. A Currency Swap is an exchange of cash flow in one currency with that of another currency.
48. The need for Currency Swap arises when loan raised in one currency is actually required to
be used in another currency.
49. The Interest rate Swaps (IRS) and Forward rate agreements (FRA) were first allowed by
RBI in 1998.
50. Banks and counter parties need to execute ISDA master agreement before entering into any
derivative contracts.
51. A right to buy is Call Option and a right to Sell is Put Option.
52. Swaps are used to minimize cost of borrowings and also to benefit from arbitrage in two
currencies.
53. Currency and interest rate Swaps with basic structure without in built positions or knock-out
levels are plain vanills type Swaps.
TREASURY AND ASSET LIABILITY MANAGEMENT
1. The risks arise out of mismatch of Assets and Liabilities of the Bank.
2. ALM is defined as protection of net worth of the Bank.
3. Liquidity Risk translates into interest rate risk when the bank has to recycle the deposit funds
or role over a credit on market determined terms.
4. Liquidity implies a positive cash flow.
5. The difference between sources and uses of funds in specific time band is known as Liquidity
Gap which may be positive or negative.
6. Interest rate risk is measured by the gap between interest rate sensitive asset and interest rate
sensitive liability in a given time band.
7. The Assets & Liabilities are rate sensitive when their value changes in reverse direction
corresponding to a change in market rate of interest.
8. The Gap management is only way of monitoring ALM.
9. The Duration and Simulation methods are used to make ALM more effective.
10. Derivatives are useful in reducing the Liquidity & Interest rate Risk.
11. Derivatives replicate market movements.
12. Derivatives can be used to hedge high value individual transactions.
13. The Derivative transaction is independent of the banking transaction.
14. Treasury products such as Bonds & Commercial papers are subject to credit risk.
15. Credit Risk in a loan & bond are similar, unlike a loan bond is tradable and hence it is more
liquid asset.
16. Now a days the conventional credit is converted into tradable treasury product through
Securitisation process by issue of PTC.
17. Securitisation infuses liquidity into the issuing bank & frees blocked capital.
18. Transfer pricing refers to fixing the cost of resources and return on Assets of the bank in a
rational manner.
19. In a multi branch transfer pricing is particularly useful to assess the branch profitability.
20. ALM policy prescribes composition of ALCO & operational assets of ALM.
21. Liquidity policy prescribes minimum liquidity to be maintained.
22. Modern banking may be defined as Risk Intermediation.
23. Market Risk comprises of Liquidity and interest rate risk.
24. Banks are highly sensitive to liquidity risk as they can not afford to default or delay in
meeting their obligations to depositors and other lenders.
25. Liquidity & interest rate sensitivity gap are measured in specified time bands.
26. Treasury connects core banking activity with financial markets.
27. Derivatives and Options are used in managing the mismatches in bank’s Balance Sheet.
28. Treasury is also responsible for transfer pricing.
29. A situation where depositors of a bank lose confidence in the bank and withdraws their
balances immediately is known as Run on the Bank.
30. Securities that can be readily sold for cash in secondary markets are Liquefiable securities.
31. Ratio of interest rate sensitive assets to rate sensitive liabilities is Sensitive Ratio.
32. Capacity and willingness to absorb losses on account of market risk is Risk Appetite.
CAIIB - Bank Financial Management - Mod - D : Balance Sheet Management
COMPONENTS OF ASSETS & LIABILITIES IN BANK’S BALANCE SHEET
 At macro-level. Asset Liability Management involves the formulation of critical business
policies, efficient allocation of capital and designing of products with appropriate pricing
strategies.
 At micro-level the Asset Liability Management aims at achieving profitability through
price matching while ensuring liquidity by means of maturity matching.
 ALM is therefore, the management of the Net Interest Margin (NIM) to ensure that its
level and riskiness are compatible with risk/return objectives of the bank.
 The strategy of actively managing the composition and mix of assets and liabilities
portfolios is called balance sheet restructuring.
 The impact of volatility on the short-term profit is measured by Net Interest Income.Net
Interest Income = Interest Income - Interest Expenses.
 Minimizing fluctuations in NII stabilizes the short term profits of the banks.
 Net Interest Margin is defined as net interest income divided by average total assets. Net
Interest Margin (NIM) = Net Interest Income/Average total Assets.
 Net Interest Margin can be viewed as the 'Spread' on earning assets. The higher the
spread the more will be the NIM
 The ratio of the shareholders funds to the total assets(Economic Equity Ratio) measures
the shifts in the ratio of owned funds to total funds. This fact assesses the sustenance
capacity of the bank.
 Price Matching basically aims to maintain spreads by ensuring that deployment of
liabilities will be at a rate higher than the costs.
 Liquidity is ensured by grouping the assets/liabilities based on their maturing profiles.
The gap is then assessed to identify future financing requirements
 Profit = Interest Income - Interest expense - provision for loan loss + non-interest revenue
- non-interest expense - taxes
Banking Regulation and Capital
 Systemic risk is the risk that a default by one financial institution will create a 'ripple
effect' that leads to defaults by other financial instigations and threatens the stability of
the financial system.
 In calculating the Cooke ratio both on-balance-sheet and off-balance-sheet items are
considered. They are used to calculate bank's total risk-weighted assets. It is a measure of
the bank's total credit exposure. CRAR = Capital/Risk Weighted Assets.
 Tier-I capital consists mainly of share capital and disclosed reserves and it is a bank's
highest quality capital because it is fully available to cover losses.
 Tier-II capital on the other hand consists of certain reserves and certain types of
subordinated debt. The loss absorption capacity of Tier-II capital is lower than that of
Tier-I capital.
 The elements of Tier-I capital include Paid-up capital (ordinary shares), statutory
reserves, and other disclosed free reserves.
Capital Adequacy - The Basel-II Overview
 The Basel Committee provided the framework for capital adequacy in 1988, which is
known as the Basel-I accord.The Basel-I accord provided global standards for minimum
capital requirements for banks.
 The Revised Framework consists of three-mutually reinforcing pillars, viz., minimum
capital requirements, supervisory review of capital adequacy, and market discipline.
 The Framework offers three distinct options for computing capital requirement for credit
risk and three other options for computing capital requirement for operational risk.
 The options available for computing capital for credit risk are Standardised Approach,
Foundation Internal Rating Based Approach and Advanced Internal Rating Based
Approach.
 The options available for computing Market risk is standardized approach (based on
maturity ladder and duration baSed) and advanced approach, i.e., internal models such as
VAR
 The options available for computing capital for operational risk are Basic Indicator
Approach, Standardised Approach and Advanced Measurement Approach.

 The revised capital adequacy norms shall be applicable uniformly to all Commercial
Banks (except Local Area Banks and Regional Rural Banks).
 A Consolidated bank is defined as a group of entities where a licensed bank is the
controlling entity.
 All commercial banks in Indiashall adopt Standardised Approach (SA) for credit risk and
Basic Indicator Approach (BIA) for operational risk.
 Banks shall continue to apply the Standardised Duration Approach (SDA) for computing
capital requirement for market risks.
 The term capital would include Tier-I or core capital, Tier-II or supplemental capital, and
Tier-Ill capital
 Core capital consists of paid up capital, free reserves and unallocated surpluses, less
specified deductions.
 Supplementary capital comprises subordinated debt of more than five years' maturity,
loan loss reserves, revaluation reserves, investment fluctuation reserves, and limited life
preference shares.
 Tier-II capital is restricted to 100% of Tier-I capital as before and long-term subordinated
debt may not exceed 50% of Tier-I capital.
 Tier-Ill capital will be limited to 250% of a bank's Tier-1 capital that is required to
support market risk. This means that a minimum of about 28.5% of market risk needs to
be supported by Tier-I capital. Any capital requirement arising in respect of credit and
counter-party risk needs to be met by Tier-I and Tier-II capital.
 Capital adequacy ratio(C) = Regulatory capital(R)/Total risk weighted assets(T).
 Regulatory Capital ‘R’=C*T and Total Risk weighted Assets ‘T’= R/C
 Total Risk weighted assets =(Risk weighted assets for credit risk) +(12.5*Capital
requirement for market risk)+(12.5*Capital requirement for operational risk)
Supervisory Review
 Pillar I: Minimum Capital Requirements - which prescribes a risk-sensitive calculation of
capital requirements that, for the first time, explicitly includes operational risk in addition
to market and credit risk.
 Pillar 2: Supervisory Review Process (SRP) - which envisages the establishment of
suitable risk management systems in banks and their review by the supervisory authority.
 Pillar 3: Market Discipline - which seeks to achieve increased transparency through
expanded disclosure requirements for banks.
Pillar 3-Market Discipline
 Market Discipline is to compliment the minimum capital requirements (Pillar 1) and the
supervisory review process (Pillar 2). Pillar 3 provides disclosure requirements for banks
using Basel-II framework.
 Information would be regarded as material if its omission or misstatement could change
or influence the assessment or decision of a user relying on that information for the
purpose of making economic decisions.
Asset Classification and Provisioning Norms
 Banks should classify an account as NPA only if the interest charged during any quarter
is not serviced fully within 90 days from the end of the quarter
 An account should be treated as 'out of order' if the outstanding balance remains
continuously in excess of the sanctioned limit/drawing power In cases where the
outstanding balance in the principal operating account is less than the sanctioned
limit/drawing power, but there are no credits continuously for 90 days as on the date of
Balance Sheet or credits are not enough to cover the interest debited during the same
period, these accounts should be treated as 'out of order'.
 Any amount due to the bank under any credit facility is 'overdue' if it is not paid on the
due date fixed by the bank.
 Interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may be
taken to income account on the due date, provided adequate margin is available in the
accounts.
 A substandard asset would be one, which has remained NPA for a period less than or
equal to 12 months. a substandard asset would be one, which has remained NPA for a
period less than or equal to 12 months.
 If arrears of interest and principal are paid by the borrower in the case of loan accounts
classified as NPAs, the account should no longer be treated as nonperforming and may be
classified as 'standard' accounts.
 Advances against Term Deposits, NSCs, KVP/IVP, etc, need not be treated as NPAs.
Advances against gold ornaments, Government securities and all other securities are not
covered by this exemption.
Liquidity Management
 Bank's liquidity management is the process of generating funds to meet contractual or
relationship at reasonable prices at all times.
 Good management information systems, central liquidity control, analysis of net funding
requirements under alternative scenarios, diversification of funding sources, and
contingency planning are crucial elements of strong liquidity management at a bank of
any size or scope of operations.
 The residual maturity profile of assets and liabilities will be such that mismatch level for
time bucket of 1-14 days and 15-88 days remains around 80% of cash outflows in each
time bucket.
 Flow approach is the basic approach being followed by Indian banks. It is called gap
method of measuring and managing liquidity
 Stock approach is based on the level of assets and liabilities as well as off-balance sheet
exposures on a particular date.
 Ratio of Core Deposit to Total Assets: - Core Deposit/Total Assets: More the ratio, better
it is.
 Net Loans to Totals Deposits Ratio:- Net Loans/Total Deposits: It reflects the ratio of
loans to public deposits or core deposits. Loan is treated to be less liquid asset and
therefore lower the ratio, better it is.
 Ratio of Time Deposits to Total Deposits:-Time deposits provide stable level of liquidity
and negligible volatility. Therefore, higher the ratio better it is.
 Ratio of Volatile Liabilities to Total Assets:- Higher portion of volatile assets will pose
higher problems of liquidity. Therefore, lower the ratio better it is.
 Ratio of Short-Term Liabilities to Liquid Assets:- Short-term liabilities are required to be
redeemed at the earliest. It is expected to be lower in the interest of liquidity.
 Ratio of Liquid Assets to Total Assets:-Higher level of liquid assets in total assets will
ensure better liquidity. Therefore, higher the ratio, better it is.
 Liquid assets may include bank balances, money at call and short notice, inter bank
placements due within one month, securities held for trading and available for sale having
ready market.
 Ratio of Short-Term Liabilities to Total Assets:-A lower ratio is desirable
 Short-term liabilities may include balances in current account, volatile portion of savings
accounts leaving behind core portion of saving which is constantly maintained. Maturing
deposits within a short period of one month.
 Ratio of Prime Asset to Total Asset - Prime Asset/Total Assets:-More or higher the, ratio
better it is.
 Prime assets may include cash balances with the bank and balances with banks including
central bank which can be withdrawn at any time without any notice.
 Ratio of Market Liabilities to Total Assets:-Lower the ratio, better it is.
 Market liabilities may include money market borrowings, inter-bank liabilities repayable
within a short period.
 A maturity ladder should be used to compare a bank's future cash inflows to its future
cash outflows over a series of specified time periods.
 The need to replace net outflows due to unanticipated withdrawal of deposits is known as
Funding risk.
 The need to compensate for non-receipt of expected inflows of funds is classified as Time
Risk
 Call risk arises due to crystallisation of Contingent liabilities
 Maturity ladders enables the bank to estimate the difference between Cash inflows and
Cash Outflows in predetermined periods.
 Liquidity management methodology of evaluating whether a bank has sufficient liquid
funds based on the behaviour of cash flows under the different 'what if scenarios is
known as Alternative Scenarios
 The capability of bank to withstand a net funding requirement in a bank specific or
general market liquidity crisis is denoted as Contingency planning
Interest Rate Risk Management
 Interest rate risk is the exposure of a bank's financial condition to adverse movements in
interest rates.
 Gap: The gap is the difference between the amount of assets and liabilities on which the
interest rates are reset during a given period.
 Interest rate risk refers to volatility in Net Interest Income (NiI) or in variations in Net
Interest Margin (NIM)
 The degree of basis risk is fairly high in respect of banks that create composite assets out
of composite liabilities.
 The risk that the interest rate of different assets and liabilities may change in different
magnitudes is called basis risk.
 When assets and liabilities fall due to repricing in different periods, they can create a
mismatch. Such a mismatch or gap may lead to gain or loss depending upon how interest
rate in the market tend to move.
 The degree of basis risk is fairly high in respect of banks that create composite assets out
of composite liabilities
 When the variation in market interest rate causes the Nil to expand, the banks have
experienced a favourable basis shift and if the interest rate movement causes the Nil to
contract, the basis has moved against the bank.
 An yield curve is a line on a graph plotting the yield of all maturities of a particular
instrument
 Price risk occurs when assets are sold before their maturity dates.
 The price risk is closely associated with the trading book which is created for making
profit out of short-term movements in interest rates.
 Uncertainty with regard to interest rate at which the future cash flows can be reinvested is
called reinvestment risk.
 When the interest rate goes up, the bonds price decreases
 When the interest rate declines the bond price increases resulting in a capital gain but the
realised compound yield decreases because of lower coupon reinvestment income.
 Duration is a measure of the percentage change in the economic value of a position that
will occur, given a small change in the level of interest rates.
 Higher duration implies that a given change in the level of interest rates will have a larger
impact on economic value.
 Interest Rate Sensitive Gap: Interest Rate Sensitive Assets(RSA) - Interest Rate Sensitive
Liabilities (RSL).
 Positive Gap or Asset Sensitive Gap - RSA - RSL > 0 & Negative Gap or Liability
Sensitive - RSA - RSL < 0
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