CASE STUDIES ON DOCUMENTARY CREDITS AND UCP600

CASE STUDIES ON DOCUMENTARY CREDITS AND UCP600
CASE STUDY 1
Banks have a practice of calling for the original LC at the time of presentation of documents and
endorse any drawings on its reverse.
LC's may be made available by Acceptance / Defferred Payment / Negotiation and to be freely
available with any bank.
Is it mandatory to endorse the original LC on its reverse?
Analysis
Most LCs contain a clause indicating such a requirement.
The practice is required by SWIFT standards cat.7, for freely negotiable credits, available with any
bank.
Conclusion
What is the problem?
CASE STUDY 2
If a nominated bank does not incur a deffered payment undertaking on presentation of complying
documents and forwards them to the Issuing Bank.
Subsequently can it a purchases a deferred payment undertaking from the issuing bank and seek
protection under UCP600?
Articles 7c. UCP600
CASE STUDY 3
If a LC is confirmed and is available with the Confirming Bank and the beneficiary chooses to
present the document directly to the Issuing Bank and the Issuing Bank wrongfully dishonors.
Should the confirming bank honor the presentation given that the LC has meanwhile expired?
Article 8a. UCP600
CASE STUDY 4
A documentary credit requires all documents must to be issued in English language.
The presentation includes a Certificate of Origin bearing a Stamp / Legalisation done in another
language
Is this a discrepancy?
Issued in?
CASE STUDY 5
As per Article 38 of UCP 600, A LC can be transferred to more than one second beneficiary. This
can be done preferably when the Partial Shipments are allowed under the LC.
If the first Beneficiary is certain that he would be able to comply with article 31(b) of UCP600 (re
partial shipments – submission of multiple BLs on the same voyage), can a LC be transferred to
more than one second beneficiary even if the LC states Partial Shipment is prohibited provided
Article 38.d. UCP600
CASE STUDY 6
If the nominated bank does not accept a bill of exchange drawn on them by the beneficiary, can the
same bill of exchange be presented to the issuing bank or should they present a fresh bill of
exchange drawn on the Issuing Bank
UCP Article 7a (iv)
CASE STUDY 7

INTERNATIONALCOMMERCIAL TERMS (INCOTERMS)

INTERNATIONALCOMMERCIAL TERMS (INCOTERMS)

The Incoterms 2010 rules

The Incoterms 2010 rules are standard sets of trading terms and conditions designed to assist traders when goods are sold and transported. INCOTERMS are generally used in both International trade and Domestic Trade . INCO terms are a series of international sales terms, published by International Chamber Of Commerce

(ICC) and widely used in international commercial transactions. These are accepted by governments, legal

authorities and practitioners worldwide for the interpretation of most commonly used terms in international

trade. This reduces or removes altogether, uncertainties arising from different interpretation of such terms

in different countries. They closely correspond to the U.N. Convention on contracts for the international

sale of goods. The first version of INCO terms was introduced in 1936. INCO terms 2010 (8th edition) were

published on Sept 27, 2010 and these came into effect wef Jan 1, 2011.

Main changes in  INCOTERMS 2010

1. Removal of 4 terms (DAF, DES, DEQ and

DDU) and introduction of 2 new terms (DAP - Delivered at Place and DAT - Delivered at

Terminal). As a result, there are a total of 11

terms instead of 13 (2 additions, DAP and DAT and 4 deletions, DAF, DDU, DEQ and DES).

2. Creation of 2 classes of INCOTERMS - (1)

rules for any mode or modes of transport and (2) rules for sea and inland waterway [INCOTERMS 2000

had 4 categories namely E (covering departure), F (covering main carriage unpaid), C (covering main carriage paid) and D (covering arrival)

Each Incoterms rule specifies:

*the obligations of each party (e.g. who is responsible for services such as transport; import and export clearance etc)

*the point in the journey where risk transfers from the seller to the buyer

So by agreeing on an Incoterms rule and incorporating it into the sales contract, the buyer and seller can achieve a precise understanding of what each party is obliged to do, and where responsibility lies in event of loss, damage or other mishap.

The Incoterms rules are created and published by the International Chamber of Commerce (ICC) and are revised from time to time. The most recent revision is Incoterms 2010 which came into force on 1st January 2011.

The definitive publication on the Incoterms 2010 rules is the ICC publication number 715, which is available from various national bookshops.

This is essential reading for those with responsibility for setting a corporate policy or negotiating contracts with trading partners or service providers.

The logic of the Incoterms 2010 rules

The eleven rules are divided into two main groups

Rules for any transport mode

• Ex Works EXW

• Free Carrier FCA

• Carriage Paid To CPT

• Carriage & Insurance Paid to CIP

• Delivered At Terminal DAT

• Delivered At Place DAP

• Delivered Duty Paid DDP   

Rules for sea & inland waterway only

• Free Alongside Ship FAS

• Free On Board FOB

• Cost and Freight CFR

• Cost Insurance and Freight CIF



In general the “transport by sea or inland waterway only” rules should only be used for bulk cargos (e.g. oil, coal etc) and non-containerised goods, where the exporter can load the goods directly onto the vessel. Where the goods are containerised, the “any transport mode” rules are more appropriate.A critical difference between the rules in these two groups is the point at which risk transfers from seller to buyer. For example, the “Free on Board” (FOB) rule specifies that risk transfers when the goods have been loaded on board the vessel. However the “Free Carrier” (FCA) rule specifies that risk transfers when the goods have been taken in charge by the carrier.

Another useful way of classifying the rules is by considering:

Who is responsible for the main carriage – the buyer or the seller?

If the seller is responsible for the main carriage, where does the risk pass from the seller to the buyer – before the main carriage, or after it?

This gives us these four groups:



Buyer responsible for all carriage – EXW

Buyer arranges main carriage – FAS; FOB; FCA

Seller arranges main carriage, risk passes after main carriage – DAT; DAP; DDP

Seller arranges main carriage, but risk passes before main carriage – CFR; CIF; CPT; CIP

Eleven terms



Group-1 INCO terms

1. EXW means that a seller has the goods ready for collection at his premises (works, factory,

warehouse, plant) on the date agreed upon. The buyer pays transportation costs and bears the risks for

bringing the goods to their final destination. This term places the greatest responsibility on the buyer and

minimum obligations on the seller.

2.FCA — Free Carrier (named places) : The seller hands over the goods, cleared for export, into the

custody of the first carrier (named by the buyer) at the named place. This term is suitable for all modes of

transport, including carriage by air, rail, road, and containerized / multi-modal sea transport.

3. CPT — Carriage Paid To (named place of destination): (The general/containerized/multimodal

equivalent of CFR) The seller pays for carriage to the named point of destination, but risk passes when

the goods are handed over to the first carrier.

4. CIP — Carriage and Insurance Paid (To) (named

place of destination): The containerized transport/multimodal equivalent of CIF. Seller pays for carriage

and insurance to the named destination point, but risk passes when the goods are handed over to the first

carrier,

5. DAP : delivered at place

6. DAT I. delivered at terminal

7. DDP — Delivered Duty Paid (named destination place): This term means that the seller pays for all

transportation costs and bears all risk until the goods have been delivered and pays the duty. Also used

interchangeably with the term "Free Domicile". It is the most comprehensive term for the buyer. In most of

the importing countries, taxes such as (but not limited to) VAT and excises should not be considered

prepaid being handled as a "refundable" tax. Therefore VAT and excise usually are not representing a

direct cost for the importer since they will be recovered against the sales on the local (domestic) market.



Group-2 INCO terms



8. FAS — Free Alongside Ship (named loading port): The seller must place the goods alongside the ship

at the named port. The seller must clear the goods for export. Suitable for maritime transport only but NOT

for multimodal sea transport in containers. This term is typically used for heavy-lift or bulk cargo.

9. FOB — Free on board (named loading 'port): The seller must themselves load the goods on board the

ship nominated by the buyer, cost and risk being divided at ship's rail. The buyer must instruct the seller

the details of the vessel and port where the goods are to be loaded, and there is no reference to, or

provision for, the use of a carrier or forwarder.

10.CFR or CNF — Cost and Freight (named destination port): Seller must pay the costs and freight to

bring the goods to the port of destination. The risk is transferred to the buyer once the goods have

crossed the ship's rail. Maritime transport only and Insurance for the goods is NOT included. Insurance is

at the Cost of the Buyer.

11.CIF — Cost, Insurance and Freight (named destination port): Exactly the same as CFR except that theseller must in addition procure and pay for insurance for the buyer (Maritime transport only).







Ten common mistakes in using the Incoterms rules



Here are some of the most common mistakes made by importers and exporters:

•           Use of a traditional “sea and inland waterway only” rule such as FOB or CIF for containerised goods, instead of the “all transport modes” rule e.g. FCA or CIP. This exposes the exporter to unnecessary risks. A dramatic recent example was the Japanese tsunami in March 2011, which wrecked the Sendai container terminal. Many hundreds of consignments awaiting despatch were damaged. Exporters who were using the wrong rule found themselves responsible for losses that could have been avoided!

•           Making assumptions about passing of title to the goods, based on the Incoterms rule in use. The Incoterms rules are silent on when title passes from seller to buyer; this needs to be defined separately in the sales contract

•           Failure to specify the port/place with sufficient precision, e.g. “FCA Chicago”, which could refer to many places within a wide area

•           Attempting to use DDP without thinking through whether the seller can undertake all the necessary formalities in the buyer’s country, e.g. paying GST or VAT

•           Attempting to use EXW without thinking through the implications of the buyer being required to complete export procedures – in many countries it will be necessary for the exporter to communicate with the authorities in a number of different ways

•           Use of CIP or CIF without checking whether the level of insurance in force matches the requirements of the commercial contract – these Incoterms rules only require a minimal level of cover, which may be inadequate.

•           Where there is more than one carrier, failure to think through the implications of the risk transferring on taking in charge by the first carrier – from the buyer’s perspective, this may turn out to be a small haulage company in another country, so redress may be difficult in the event of loss or damage

•           Failure to establish how terminal handling charges (THC) are going to be treated at the point of arrival. Carriers’ practices vary a good deal here. Some carriers absorb THC’s and include them in their freight charges; however others do not.

•           Where payment is with a letter of credit or a documentary collection, failure to align the Incoterms rule with the security requirements or the requirements of the banks.


•           When DAT or DAP is used with a “post-clearance” delivery point, failure to think through the liaison required between the carrier and the customs authorities – can lead to delays and extra costs

Major Types of Risks

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

DIFFERENT KINDS OF RISKS RELATED TO FOREX TRANSACTIONS

DIFFERENT KINDS OF RISKS RELATED TO FOREX TRANSACTIONS
Foreign exchange operations face large no. of different type of risk due to a variety of reasons such as location of forex
markets without any single location, markets existing in different time zones, frequent fluctuations in the foreign currency
rates, effect of policies of the government and central banks of the related country etc.
Foreign exchange exposure: The exposure can be classified into 3 categories:
1. Transaction exposure : This arises on account of normal business operation. A transaction in foreign exchange can
exposure a firm to currency risk, when compared to the value in home currency.
2. Translation exposure : It arises on valuation of assts and liabilities created through foreign exchange and receivables or
payable in home currency, at the end of accounting period. These are notional and not actual.
3. Operating exposure : These are the factor external to a firm such as change in competition, reduction in import duty,
reduction in prices by other country exporters etc.
Exchange rate risk : Even the major currencies may experience substantial exchange rate movements over relatively short
periods of time. These can alter the balance sheet of a bank if the bank has assets or liabilities domiciled in those currencies.
An adverse movement of the rate can alter the value of the foreign exchange holdings, if not covered properly. The dealers
have to cover the position immediately.
Positions in a foreign currency : When the assets and the outstanding contracts to purchase that currency are more than the
liabilities plus and the outstanding contracts to sell that currency.
 Long or overbought position : When the purchases (and outstanding contracts to purchase) are more than the sale (the
outstanding contracts to sell).
 Short position or oversold position : When the purchases (and outstanding contracts to
purchase) are less than the sale (the outstanding contracts to sell).
Overbought or oversold position : It is called open position
Covering of position risk : The position is covered by fixing suitable limits (such as daylight position limit, overnight position limit,
single deal limit, gap-for-ward mismatch limits).
Prudent limit prescribed by RBI for open position : RBI has given discretion to bank Boards to fix their own open position limits
according to their own requirement, expertise and other related considerations.
Pre-settlement risk : It is the risk of failure of the counter party, due to bankruptcy or closure or other risk, before maturity of the
contract. This may force the bank to cover the contract at the ongoing market rates resulting into loss due to difference prevailing
between the contracted rate and rate at which the contract covered.
Settlement risk: Payment/delivery of one currency and received of other currency by both the parties. Settlement risk is the
risk of failure of the counter party during the course of settlement due to time zone differences between the two currencies
which are to be exchanged. For example, if a bank in the earlier time zone (say in Australia) performs its obligation and
delivers the currency and a bank in a later time zone (say USA) fails to deliver or delivers with delay, the loss may be caused to
the bank in the earlier time zone.
Foreign exchange settlement risk is also called temporal risk or Herstatt risk (named after failure of Bankhaus Herstatt in Germany)
The settlement risk can be taken care of by operating the system on a single time basis and also on real time gross settlement
(RTGS) basis.
Liquidity risk: The liquidity risk is where a market does not have the capacity to handle, at least without significant adverse
impact on the price, the volume of whatever the borrower buys or sells at the time he want to deal. Inability to meet debt
when they fall due could be another form of such risk.
For example, if there is deal of UK Pound purchase against the rupee and the party selling the UK Pound is short of pound in its
NOSTRO account, it may default in payment or it may meet its commitment by borrowing at a very high cost.
Country risk: It is the risk that arises when a counter party abroad, is unable to fulfill its obligation due to reasons other than the

normal risk related to lending or investment.
For example, a counter party is willing and capable to meet its obligation but due to restrictions imposed by the govt. of the
country or change in the polices of the govt., say on remittances etc. is unable to meet its repayment / remittance capacity.
Country risk can be very high in case of those countries that are having foreign exchange reserve problem.
Banks control country risk by putting restrictions on overall exposure, country exposure.
Country risk is in addition to normal credit risk. While the normal credit risk is due to failure on meeting obligation on the part of
counterparty on its own, the country risk arises due to actions initiated by the Govt. of that country due to which counterparty is not
able to perform its part.
Sovereign risk : It is larger than country risk. It arises when the counterparty is a foreign govt. or its agency and enjoys sovereign
immunity under law of that country. Due to this reason, legal action cannot be taken against that counterparty. This risk can be
reduced through disclaimers and by imposing 3,d country jurisdictions.
Interest rate risk: The potential cost of adverse movement of interest rates that the bank faces on its deposits and other
liabilities or currency swaps, forward contracts etc. is called interest rate risk. This risk arises on account of adverse
movement of interest rates or due to interest rate differentials. The bank may face adverse cost on its deposit or adverse
earning impact on its lending and investments due to such change in interest rates.
Interest rate can be managed by determining the interest rate scenario, undertaking appropriate sensitivity exercise to estimate the
potential profit or losses based on interest rate projections.
Gap risk : Banks on certain occasions are not able to match their forward purchase and sales, borrowing and lending which
creates a mismatch position, which is called gap risk. The gaps are required to be filled by paying or receiving the forward
differential. These differentials are the function of interest rates.
The gap risk can be managed by using derivative products such as interest rate swaps, currency
swaps, forward rate agreements.
Fledging risk: This occurs when one fails to achieve a satisfactory hedge for one's exposure, either because it could not be
arranged or as the result of an error. One may also be exposed to basic risk where the available hedging instrument closely
matches but does not exactly mirror or track the risk being hedged.
Operational risk : It is a potential catch that includes human errors or defalcations, loss of documents and records, ineffective
systems or controls and security breaches, how often do one consider the disaster scenario.
Legal, jurisdiction, litigation and documentation risks including netting agreements and cross border insolvency. Which country's
laws regulate individual contracts and the arbitration of disputes ? Could a plaintiff take action against a borrower in an
overseas court where they have better prospects of success or of higher awards ? There is a growing and widespread belief
that, whatever goes wrong, someone else must pay. The compensation culture whatever its justification or cause, is becoming
a big problem for many businesses.

DERIVATIVES

DERIVATIVES
In India, different derivatives instruments are permitted and regulated by various regulators, like Reserve Bank of India (RBI),
Securities and Exchange Board of India (SEBI) and Forward Markets Commission (FMC). Broadly, RBI is empowered to regulate
the interest rate derivatives, foreign currency derivatives and credit derivatives.
Definition : A derivative is a financial instrument:
(a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign
exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the 'underlying');
(b) that requires no initial net investment or little initial net investment relative to other types of contracts that have a
similar response to changes in market conditions; and
(c) that is settled at a future date.
For regulatory purposes, derivatives have been defined in the Reserve Bank of India Act, as "an instrument, to be settled at a
future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of
securities (also called "underlying"), or a combination of more than one of them and includes interest rate swaps, forward
rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee
options or such other instruments as may be specified by the Bank from time to time.
Derivatives Markets
There are two distinct groups of derivative contracts:
Over-the-counter (OTC) derivatives: Contracts that are traded directly between two eligible parties, with or without the use
of an intermediary and without going through an exchange.
Exchange-traded derivatives: Derivative products that are traded on an exchange.
Participants : Participants of this market can broadly be classified into two functional categories, namely, (a) users (who
participates in the derivatives market to manage an underlying risk) and (b) the market-maker who provides continuous bid
and offer prices to users and other market-makers. A market-maker need not have an underlying risk.
Purpose : Derivatives serve a useful risk-management purpose for both financial and nonfinancial firms. It enables transfer of
various financial risks to entities who are more willing or better suited to take or manage them.
Users can undertake derivative transactions to hedge - specifically reduce or extinguish an existing identified risk on an
ongoing

Documentary Letters of Credit

Documentary Letters of Credit
A Letter of Credit/Documentary Credit is a very common and familiar instrument, used for trade settlements across the globe. It is a
link between buyers and sellers, reinforcing the buyer's integrity by adding to it, his banker's undertaking to pay, while sellers need
to make shipments of goods specified and present shipping documents to banks, before getting the payment. Thus, for 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.
In order to bring uniformity in matters pertaining to letters of credit documents and transactions, International Chambers of
Commerce (ICC), established in 1919 and headquartered in Paris, has framed uniform rules and procedures for issuance and handling
of transactions under letters of credit, so that parties to letters of credit transactions uniformly interpret various terms and are
bound by a common rule. These rules and procedures are called Uniform Customs and Practices for Documentary Credits (UCPDC).
The UCPDC was first brought out in 1933, and has been revised from time to time in 1951, 1962, 1974, 1983, 1993 with the last
revision in 2007. The current update of UCPDC is the publication No. 600 of ICC, which has been implemented with effect from
1.7.2007.
DEFINITION OF LETTER OF CREDIT
A documentary credit or/and letter of credit, ( DC or LC) can 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.
An LC can also be defined as an undertaking issued by the bank, on behalf of the importer or the buyer, in favour of the exporter or
the seller, that, if the specified documents, showing that a shipment has taken place, or a service has been supplied, are presented
to the issuing bank or its nominated bank, within the stipulated time, the exporter/seller will be paid the amount specified.
Thus, in an LC transaction, following parties are involved:
(i) The buyers/importers or the applicant—on whose behalf LC is opened,
(ii) The sellers/exporters or the beneficiary of the LC,
(iii) The opening bank (buyers bank), who establishes the LC
(iv) The advising bank (bank in sellers country), who acts as an agent of the issuing bank and authenticates the LC.
(v) The confirming bank— who undertakes to pay on behalf of the issuing bank,
(vi) The negotiating bank (sellers bank or bank nominated by the opening bank),
(vii) Reimbursing bank— who reimburses the negotiating or confirming bank.
The advising bank, confirming bank and the negotiating bank could be the same
Operation of letter of credit
1. Buyer and seller enters into a contract for sale of goods or providing of services. The transaction is covered by LC.
2. On request of the buyer i.e. applicant, LC is issued by Opening Bank in favour of Beneficiary and sent to advising bank instead
of sending directly to beneficiary.
3. After authentication of LC, the advising bank sends the LC to beneficiary.
4. After receiving LC, the beneficiary manufacturers the goods and makes shipment and prepares documents, as mentioned in
LC.
5. Documents are presented by beneficiary to nominated bank for negotiation. Negotiating bank
makes payment against these documents and claims payment on due date from opening bank.
6. Opening bank makes payment to negotiating bank and recovers the payment from applicant.

TYPES OF LETTERS OF CREDITS

TYPES OF LETTERS OF CREDITS

Documents against
Payment LC or Si ght
LC
DP LCs or Sight LCs are those where the payment is made against documents on presentation.
(DA = Documents against payment, DP=Documents against acceptance)
Documents against
acceptance or
us ance

DA LCs or Acceptance LCs are those, where the payment is to be made on the maturity date in terms
of the credit. The documents of title to goods are delivered to applicant merely on acceptance of
documents for payment. (DA = Documents against payment, DP=Documents against acceptance)
Deferred Payment LC It is similar to Usance LC but there is no bill of exchange or draft. It is payable on a future date if
documents as per LC are submitted.

Irrevocable and
revocable credits
The issuing bank can amend or cancel the undertaking if the beneficiary consents.
A revocable credit is one that can be cancelled or amended at any time without the prior knowledge
of the seller. If the negotiating bank makes a payment to the seller prior to receiving notice of
cancellation or amendment, the issuing bank must honour the liability.
With or without recourse
Where the beneficiary holds himself liable to the holder of the bill if dishonoured, is
considered to be with-recourse. Where he does not hold Himself liable, the credit is said to be
without-recourse. As per RBI directive dated Jan 23, 2003, banks should not open LCs and purchase /
discount / negotiate bills bearing the 'without recourse' clause.
Restricted LCs A restricted LC is one wherein a specified bank is designated to pay, accept or negotiate.
Confirmed Credits A credit to which the advising or other hank at the request of the issuing bank adds confirmation that
payment will be made. By such additions, the confirming bank steps into the shoes of the issuing
bank and thus the confirming bank negotiates documents if tendered by the beneficiary.
Transferable Credits The beneficiary is entitled to request the paying, accepting or negotiating bank to make available in
whole or part, the credit Cu one or more other parties (Article 48 of UCPDC). For partial transfer to
one or more second beneficiary/ies the credit must provide for partial shipment.

Back to back
credits
A back to back credit is one where an exporter received a documentary credit opened by a buyer in
his favour. He tenders the same to the bank in his country as a cover for opening another LC in
favour of his local suppliers. The terms of such credit would be identical except that the price may
be lower and validity earlier.
Red Clause
Credits
A red clause credit also referred to a packing or anticipatory credit has a clause permitting the
correspondent bank in the exporter's country to grant advance to beneficiary at issuing bank's
responsibility. These advances are adjusted from proceeds of the bills negotiated.

Green Clause
Credits
A green clause LC permits the advances for storage of goods in a warehouse in addition to preshipment
advance
.
Stand-by
Credits
Standby credits is similar to performance bond or guarantee, but issued in the form of LC. The
beneficiary can submit his claim by means of a draft accompanied by the requisite documentary
evidence of performance, as stipulated in the credit.

Documentary or clean
credits
When LC specifies that the bills drawn under LC must accompany documents of title to goods such as
RRs or MTRs or Bills of lading etc. it is termed as Documentary Credit. If any such documents are not
called, the credit is said to be Clean Credit.

Revolving Credits These provide that the amount of drawings made thereunder would be reinstated and made
available to the beneficiary again and again for further drawings during the currency of credit.
Instahnent credit It is a letter of credit for the full value of goods but requires shipments of specific quantities of
goods within nominated period and allows for part-shipment. In case any instalment of shipment is
missed, credit will not be available for that and subsequent instalment unless of LC permits the

VARIOUS DOCUMENTS UNDER LETTER OF CREDIT

VARIOUS DOCUMENTS UNDER LETTER OF CREDIT
Liability of an opening bank in a letter of credit arises, when the beneficiary delivers the documents strictly drawn as per terms of
the letter of credit. There documents include the following:
Bill of exchange This is the basic document which requires to be discharged by making the payment. It is defined u/s
5 of NI Act. The right to draw this document is available to beneficiary and the amount, tenor etc.
has to be in terms of the credit.
Invoice This document provides relevant details of the sale transaction, which is made in the name of the
applicant, by the beneficiary. The details regarding, quantity, price, specification etc. should be
same as mentioned in the letter of credit.
Transport Documents This is a document which evidences the despatch of the goods by the beneficiary, by handing over
the goods to the agent of the applicant, which may be a ship, railways or a transport operator, who
issues documents such as such as bill of lading, railway receipt, transport receipt. Other documents
could be Airway Bill or Postal or courier receipt.
Insurance documents The despatched goods are required to be insured for transit period. Insurance policy or insurance
certificate should be signed by the company or underwriter or their agent. Amount, kinds of risk etc.
should be same as mentioned in the letter of credit.

Other documents The letter of credit may also specify other documents to be presented along with the above
documents which may include certificate of origin, certificate from health authorities etc.
DIFFERENT TYPES KINDS OF BILL OF LADING
 Received for shipment Bill of lading: It is an acknowledgment that the goods have been received by the ship owners for
shipment. It is not considered safe document for negotiation.
 On-board Bill of lading : It acknowledges that the goods have been put on board of the shipment. This is considered safe for
negotiation purpose.
 Short form bill of lading : Where the terms and conditions of carriage are not printed on the bill of lading and a reference to
another document containing terms and conditions is made on the bill.
 Long form bill of lading : Where all terms and conditions of carriage are given on the document itself.
 Clean bill of lading : Which bears no superimposed clause or notation that expressly declares the defective condition of goods
or packaging. This is considered safe for negotiation purpose.
 Claused bill of lading : Which bears superimposed clause or notation that expressly declares the defective condition of goods
or packaging. Ship owner can disclaim his liability on loss to goods in case of such BL. Hence it is not considered safe.
 Through Bill of lading : That covers the entire voyage covering several modes of transport. There is no guarantee of the carriers
for safe carriage of goods.
 Straight bill of lading BL that is issued directly in the name of the consignee, where the goods will be delivered to the
consignee.
Chartered party bill of lading : Issued to a Chartered party who has hired the space in the vessel. Liability of Issuing Bank
As per UCPDC, an irrevocable Credit constitutes an definite undertaking of the Issuing Bank. Hence:
i. if the Credit provides for sight payment—to pay at sight,
ii. if the Credit provides for deferred payment — to pay on the maturity date(s) determinable in accordance with the
stipulations of the Credit,
iii. if the Credit provides for acceptance to accept Draft(s) drawn by the Beneficiary on the Issuing Bank and pay at maturity, or
iv. if the Credit provides for negotiation — to pay without recourse to drawers and/or bona fide holders, Draft(s) drawn by the
Beneficiary and/or document(s) presented under the Credit. A Credit should not be issued available by Draft(s) on the Applicant.
The Credit nevertheless calls for Draft(s) on the Applicant, banks will consider such Draft(s) as an additional document(s).
Advising Bank's Liability
As per UCPDC, a credit may be advised to a Beneficiary through another bank (the 'Advising Bank') without engagement on the
part of the Advising Bank. If that bank, elects to advise the Credit, shall take reasonable care to check the apparent authenticity of
the Credit which it advises. If the bank elects not to advise the Credit, it must so inform the Issuing Bank without delay. If the
Advising Bank cannot 'establish such apparent authenticity it must inform, without delay, the bank from which the instructions
appear to have been received that it has been unable to establish the authenticity of the Credit and if it elects nonetheless to
advise the Credit it must inform the Beneficiary that it has not been able to establish the authenticity of the Credit.
Liability of the Confirming Bank
A confirmation of an Irrevocable Credit by another hank (the 'Confirming Bank') upon the authorisation or request of the Issuing
Bank, constitutes a definite undertaking of the Confirming Bank, in addition to that of the Issuing Bank. Hence:
i. if the Credit provides for sight payment—to pay at sight,
ii. if the Credit provides for deferred payment — to pay on the maturity date(s) determinable in accordance with stipulations of
the Credit.
iii. if the Credit provides for acceptance to accept Draft(s) drawn by the Beneficiary on the Confirming Bank and pay them at
maturity,
iv. if the Credit provides for negotiation — to negotiate without recourse to drawers and/or bona fide holders, Draft(s) drawn by
the Beneficiary and/or document(s) presented under the Credit. A Credit should not be issued available by Draft(s) on the
Applicant. If the Credit nevertheless calls for Draft(s on the Applicant, banks will Consider such Draft(s) as an additional
document(s).
Examination of Documents
As per UCPDC, a Banks must examine all documents stipulated in the Credit with reasonable care to ascertain whether or not they
appear, on their face, to be in compliance with the terms and conditions of the Credit. Documents, which appear on their face to
be inconsistent with one another, will be considered as not appearing on their face to be in compliance with the terms and
conditions of the Credit. Documents not stipulated in the Credit will not be examined by banks. If they receive such documents,
they shall return them to the presenter or pass them on without responsibility.
Time for scrutiny of documents: The Issuing Bank, the Confirming Bank, if any, or a Nominated Bank acting on their behalf, shall
each have a reasonable time, not to exceed 5 banking days following the day of receipt of the documents, to examine the
documents and determine whether to take up or refuse the documents and to inform the party from which it received the

Insurance Documents
As per UCPDC, the:
A Insurance documents must appear on their face to be issued and signed by insurance companies or underwriters or their
agents.
B If the insurance document indicates that it has been issued in more than one original, all the originals must be presented unless
otherwise authorised in the Credit.
C Cover notes issued by brokers will not be accepted, unless specifically authorised in the Credit.
D Unless otherwise stipulated in the Credit, banks will accept an insurance certificate or a declaration under an open cover presigned
by insurance companies or underwriters or their agents. If a Credit specifically calls for an insurance certificate or a
declaration under an open cover, banks will accept, in
lieu of thereof, an insurance policy.
E Unless otherwise stipulated in the Credit, or unless it appears from the insurance document that the cover is effective at the
latest from the date of loading on board or dispatch or taking in charge of the goods, banks will not accept an insurance
document which bears a date of issuance later than the date of loading on board or dispatch or taking in charge as indicated in
such transport document.
F: i. Unless otherwise stipulated in the Credit, the insurance document must be expressed in the same currency as the Credit.
ii. Unless otherwise stipulated in the Credit, the minimum amount for which the insurance document must indicate the insurance
cover to have been effected is the CIF (cost insurance and freight (...'named port of destination')) or CIP
(carriage and insurance paid to (...'named place of destination')) value of the goods, as the case may be, plus 10%, but only when
the CIF or CIP value can be determined from the documents on their face. Otherwise, banks will accept as such minimum amount
110% of the amount for which payment, acceptance or negotiation is requested under the Credit, or 110% of the gross amount
of the invoice, whichever is the greater.
Commercial Invoices
As per UCPDC:
A Unless otherwise stipulated in the Credit, commercial invoices
i. must appear on their face to be issued by the Beneficiary named in the Credit, and
ii. must be made out in the name of the Applicant, and
iii. need not be signed.
B Unless otherwise stipulated in the Credit, banks may refuse commercial invoices issued or amounts in excess of the amount
permitted by the Credit. Nevertheless, if a bank authorised to pay, incur a deferred payment undertaking, accept Draft(s), or
negotiate under a Credit accepts such invoices, its decision will be binding upon all parties, provided that such bank has not
paid, incurred a deferred payment undertaking, accepted Draft(s) or negotiated for an amount in excess of that permitted by
the Credit.
C The description of the goods in the commercial invoice must correspond with the description in the Credit. In all other
documents, the goods may be described in general terms not inconsistent with the description of the goods in the Credit.
Bank-to-Bank Reimbursement Arrangements as per UCPDC
As per UCPDC: A If an Issuing Bank intends that the reimbursement to which a paying, accepting or negotiating bank is entitled, shall
be obtained by such bank (the 'Claiming Bank'), claiming on another party (the `Reimbursing Bank'), it shall provide such
Reimbursing Bank in good time with the proper instructions or authorisation to honour such reimbursement claims.
B Issuing Banks shall not require a Claiming Bank to supply a certificate of compliance with the terms and conditions of the Credit
to the Reimbursing Bank.
C An Issuing Bank shall not be relieved from any of its obligations to provide reimbursement if and when reimbursement is not
received by the Claiming Bank from the Reimbursing Bank.
D The Issuing Bank shall be responsible to the Claiming Bank for any loss of interest if reimbursement is not provided by the
Reimbursement Bank on first demand, or as otherwise specified in the Credit, or mutually agreed, as the case may be.
E The Reimbursing Bank's charges should be for the account of the Issuing Bank. However, in cases where the charges are for
the account of another party, it is the responsibility of the Issuing Bank to so indicate in the Original Credit and in the
reimbursement authorisation. In cases where the Reimbursing Bank's charges are for the account of another party they shall
be collected from the Claiming Bank when the Credit is drawn under. In cases where the Credit is not drawn under, the
Reimbursing Bank's charges remain the obligation of the Issuing Bank.
UNIFORMCUSTOMS AND PRACTICES FOR DOCUMENTARY CREDITS UCPDC-600
Uniform Customs and Practices for Documentary Credits - 600 (referred to as UCP-600), prepared by
ICC, Paris by revising the UCPDC-500, is being implemented wef July 01, 2007. It is 6th revision of
the Rules since first promulgation in 1933. The new document has 39 Articles (against 49 of UCPDC500) with supplement for
Electronic Presentation covering 12 eArticles. UCPDC-600, shall be applicable to LCs that expressly indicate that these are subject
to UCPDC-600.

Basel capital adequacy framework pillers

The Basel capital adequacy framework rests on the following three mutually- reinforcing pillars:

Pillar 1: 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.

The Basel Committee also lays down the following four key principles in regard to the SRP envisaged under Pillar 2:

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with the regulatory capital ratios. Supervisors should
take appropriate supervisory action if they are not satisfied with the result of this process.
Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

 It would be seen that the principles 1 and 3 relate to the supervisory expectations from banks while the principles 2 and 4 deal with the role of the supervisors under Pillar 2. Pillar 2 (Supervisory Review Process - SRP) requires banks to implement an internal process, called the Internal Capital Adequacy Assessment Process (ICAAP), for assessing their capital adequacy in relation to their risk profiles as well as a strategy for maintaining their capital levels. Pillar 2 also requires the supervisory authorities to subject all banks to an evaluation process, hereafter called Supervisory Review and Evaluation Process (SREP), and to initiate such supervisory measures on that basis, as might be considered necessary. An analysis of the foregoing principles indicates that the following broad responsibilities have been cast on banks and the supervisors:

Banks’ responsibilities:
(a)Banks should have in place a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels (Principle 1)
(b)Banks should operate above the minimum regulatory capital ratios (Principle 3)
Supervisors’ responsibilities
(a) Supervisors should review and evaluate a bank’s ICAAP. (Principle 2)
(b) Supervisors should take appropriate action if they are not satisfied with the results of this process. (Principle 2)
(c) Supervisors should review and evaluate a bank’s compliance with the regulatory capital ratios. (Principle 2)
(d) Supervisors should have the ability to require banks to hold capital in excess of the minimum. (Principle 3)
(e) Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels. (Principle 4)
(f) Supervisors should require rapid remedial action if capital is not maintained or restored. (Principle 4)

Thus, the ICAAP and SREP are the two important components of Pillar 2

and could be broadly defined as follows:
The ICAAP comprises a bank’s procedures and measures designed to ensure the following:
(a) An appropriate identification and measurement of risks;
(b) An appropriate level of internal capital in relation to the bank’s risk profile; and
(c) Application and further development of suitable risk management systems in the bank.
The SREP consists of a review and evaluation process adopted by the supervisor, which covers all the processes and measures defined in the principles listed above. Essentially, these include the review and evaluation of the bank’s ICAAP, conducting an independent assessment of the bank’s risk profile, and if necessary, taking appropriate prudential measures and other supervisory actions.
These guidelines seek to provide broad guidance to banks by outlining the manner in which the SREP would be carried out by the RBI, the expected scope and design of their ICAAP, and the expectations of the RBI from banks in regard to implementation of the ICAAP.

Loans to NRIs

Loans to NRIs NRI can avail the following loans:
1. Rupee Loans in India
- Up to up to any limit subject to prescribed margin. - For personal purpose, contribution to Capital in Indian
Companies or for acquisition of property. - Repayment of loan will be either from inward remittances or
from local resources through NRO accounts. 2. Foreign Currency Loans in India
- Against security of funds in FCNR-B deposits. - Maturity of loan should not exceed due date of deposits. - Repayment from Fresh remittances or from maturity proceeds of
deposits. 3. Loans to 3
rd Parties provided
- There is no direct or indirect consideration for NRE depositor
agreeing to pledge his FD. - Margin, rate of Interest and Purpose of loan shall be as per RBI
guidelines. - The loan will be utilized for personal purpose or business
purpose and not for re-lending or carrying out
Agriculture/Plantation/Real estate activities. - Loan documents will be executed personally by the depositor
and Power of attorney is not allowed. 4. Housing Loans to NRIs : HL can be sanctioned to NRIs subject to
following conditions: - Quantum of loan, Margin and period of Repayment shall be
same as applicable to Indian resident. - The loan shall not be credited to NRE/FCNR account of the
customer. - EM of IP is must and lien on assets. - Repayment from remittance abroad or by debit to NRE/FCNR
account or from rental income derived from property.

Liquidity Risk Management

1.     Liquidity Risk Management - Need & Importance:

A bank is said to be solvent if it's net worth is not negative. To put it differently, a bank is solvent if the total realizable value of its assets is more than its outside liabilities (i.e. other than it's equity/owned funds). As such, at any point in time, a bank could be (i) both solvent and liquid or (ii) liquid but not solvent or (iii) solvent but not liquid or (iv) neither solvent nor liquid. The need to stay both solvent and liquid therefore, makes effective liquidity management crucial for increasing the profitability as also the long-term viability/solvency of a bank.  This also highlights the importance of the need of having the best Liquid Risk Management practices in place in Banks.

We can very well imagine what could happen to a bank if a depositor wanting to withdraw his deposit is told to do so later or the next day in view of non-availability of cash. The consequences could be severe and may even sound the death knell of the bank. Any bank, however, strong  it may be, would not be able to survive if all the depositors queue up demanding their money back.

A Liquidity problem in a bank could be the first symptom of  financial trouble brewing and shall need to be assessed and addressed on an enterprise-wide basis quickly and effectively, as such problems can not only cause significant disruptions on either side of a bank's balance sheet but can also transcend individual banks to cause systemic disruptions. Banks play a significant role as liquidity providers in the financial system and to play it effectively they need to have sound liquidity risk management systems in place. With greater opening up of the world economies and easier cross border flows of funds, the repercussions of liquidity disturbances in one financial system could cause ripples in others. The recent sub-prime crisis in the US and its impact on others, stands ample testimony to this reality. Liquidity Risk Management, thus, is of critical importance not only to bankers but to the regulators as well.

Some Key Considerations in LRM include

(i)             Availability of liquid assets,

(ii)            Extent of volatility of the deposits,

(iii)           Degree of reliance on volatile sources of funding,

(iv)          Level of diversification of funding sources,

(v)           Historical trend of stability of deposits,

(vi)          Quality of maturing assets,

(vii)         Market reputation,

(viii)        Availability of undrawn standbys,

(ix)          Impact of off balance sheet exposures on the balance sheet, and

(x)           Contingency plans.

Some of the issues that need to be kept in view while managing liquidity include

(i)             The extent of operational liquidity, reserve liquidity and contingency liquidity that are required

(ii)            The impact of changes in the market or economic condition on the liquidity needs

(iii)           The availability, accessibility and cost of liquidity

(iv)          The existence of early warning systems to facilitate prompt action prior to surfacing of the problem and

(v)           The efficacy of the processes in place to ensure successful execution of the solutions in times of need.

2.     Potential Liquidity Risk Drivers:

The internal and external factors in banks that may potentially lead to liquidity risk problems in Banks are as under:

Internal Banking Factors	External Banking Factors
High off-balance sheet exposures.	Very sensitive financial markets depositors.
The banks rely heavily on the short-term corporate deposits.	External and internal economic shocks.
A gap in the maturity dates of assets and liabilities.	Low/slow economic performances.
The banks’ rapid asset expansions exceed the available funds on the liability side	Decreasing depositors’ trust on the banking sector.
Concentration of deposits in the short term Tenor	Non-economic factors
Less allocation in the liquid government instruments.	Sudden and massive liquidity withdrawals from depositors.
Fewer placements of funds in long-term deposits.	Unplanned termination of government deposits.

3.     Types of Liquidity Risk:

Banks face the following types of liquidity risk:

(i)     Funding Liquidity Risk – the risk that a bank will not be able to meet efficiently the expected and unexpected current and future cash flows and collateral needs without affecting either its daily operations or its financial condition.

(ii)    Market Liquidity Risk – the risk that a bank cannot easily offset or eliminate a position at the prevailing market price because of inadequate market depth or market disruption.

4.     Principles for Sound Liquidity Risk Management:

After the global financial crisis, in recognition of the need for banks to improve their liquidity risk management, the Basel Committee on Banking Supervision (BCBS) published “Principles for Sound Liquidity Risk Management and Supervision” in September 2008. The broad principles for sound liquidity risk management by banks as envisaged by BCBS are as under:

Fundamental principle for the management and supervision of liquidity risk
Principle 1	A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank’s liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system.
Governance of liquidity risk management
Principle 2	A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.
Principle 3	Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. Senior management should continuously review information on the bank’s liquidity developments and report to the board of directors on a regular basis. A bank’s board of directors should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively.
Principle 4	A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.
Measurement and management of liquidity risk
Principle 5	A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.
Principle 6	A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.
Principle 7	A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.
Principle 8	A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.
Principle 9	A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner.
Principle 10	A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s established liquidity risk tolerance. A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans.
Principle 11	A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.
Principle 12	A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding.
Public disclosure
Principle 13	A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.

Thus, a sound liquidity risk management system would envisage that:

i) A bank should establish a robust liquidity risk management framework.

ii) The Board of Directors (BoD) of a bank should be responsible for sound management of liquidity risk and should clearly articulate a liquidity risk tolerance appropriate for its business strategy and its role in the financial system.

iii) The BoD should develop strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and ensure that the bank maintains sufficient liquidity. The BoD should review the strategy, policies and practices at least annually.

iv) Top management/ALCO should continuously review information on bank’s liquidity developments and report to the BoD on a regular basis.

v) A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk, including a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate time horizon.

vi) A bank’s liquidity management process should be sufficient to meet its funding needs and cover both expected and unexpected deviations from normal operations.

vii) A bank should incorporate liquidity costs, benefits and risks in internal pricing, performance measurement and new product approval process for all significant business activities.

viii) A bank should actively monitor and manage liquidity risk exposure and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to transferability of liquidity.

ix) A bank should establish a funding strategy that provides effective diversification in the source and tenor of funding, and maintain ongoing presence in its chosen funding markets and counterparties, and address inhibiting factors in this regard.

x) Senior management should ensure that market access is being actively managed, monitored, and tested by the appropriate staff.

xi) A bank should identify alternate sources of funding that strengthen its capacity to withstand a variety of severe bank specific and market-wide liquidity shocks.

xii) A bank should actively manage its intra-day liquidity positions and risks.

xiii) A bank should actively manage its collateral positions.

xiv) A bank should conduct stress tests on a regular basis for short-term and protracted institution-specific and market-wide stress scenarios and use stress test outcomes to adjust its liquidity risk management strategies, policies and position and develop effective contingency plans.

xv) Senior management of banks should monitor for potential liquidity stress events by using early warning indicators and event triggers. Early warning signals may include, but are not limited to, negative publicity concerning an asset class owned by the bank, increased potential for deterioration in the bank’s financial condition, widening debt or credit default swap spreads, and increased concerns over the funding of off- balance sheet items.

xvi) To mitigate the potential for reputation contagion, a bank should have a system of effective communication with counterparties, credit rating agencies, and other stakeholders when liquidity problems arise.

xvii) A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should delineate policies to manage a range of stress environments, establish clear lines of responsibility, and articulate clear implementation and escalation procedures.

xviii) A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios.

xix) A bank should publicly disclose its liquidity information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.

5.     Governance of Liquidity Risk Management:

The Reserve Bank had issued guidelines on Asset Liability Management (ALM) system, covering inter alia liquidity risk management system, in February 1999 and October 2007. Successful implementation of any risk management process has to emanate from the top management in the bank with the demonstration of its strong commitment to integrate basic operations and strategic decision making with risk management. Ideally, the organisational set up for liquidity risk management should be as under:

A.    The Board of Directors (BoD):

The BoD should have the overall responsibility for management of liquidity risk. The Board should decide the strategy, policies and procedures of the bank to manage liquidity risk in accordance with the liquidity risk tolerance/limits as detailed in paragraph 14. The risk tolerance should be clearly understood at all levels of management. The Board should also ensure that it understands the nature of the liquidity risk of the bank including liquidity risk profile of all branches, subsidiaries and associates (both domestic and overseas), periodically reviews information necessary to maintain this understanding, establishes executive-level lines of authority and responsibility for managing the bank’s liquidity risk, enforces management’s duties to identify, measure, monitor, and manage liquidity risk and formulates/reviews the contingent funding plan.

B.    The Risk Management Committee:

The Risk Management Committee, which reports to the Board, consisting of Chief Executive Officer (CEO)/Chairman and Managing Director (CMD) and heads of credit, market and operational risk management committee should be responsible for evaluating the overall risks faced by the bank including liquidity risk. The potential interaction of liquidity risk with other risks should also be included in the risks addressed by the risk management committee.

C.    The Asset-Liability Management Committee (ALCO):

The Asset-Liability Management Committee (ALCO) consisting of the bank’s top management should be responsible for ensuring adherence to the risk tolerance/limits set by the Board as well as implementing the liquidity risk management strategy of the bank in line with bank’s decided risk management objectives and risk tolerance.

D.    The Asset Liability Management (ALM) Support Group:

The ALM Support Group consisting of operating staff should be responsible for analysing, monitoring and reporting the liquidity risk profile to the ALCO. The group should also prepare forecasts (simulations) showing the effect of various possible changes in market conditions on the bank’s liquidity position and recommend action needed to be taken to maintain the liquidity position/adhere to bank’s internal limits.

6.     Liquidity Risk Management Policy, Strategies and Practices:

The first step towards liquidity management is to put in place an effective liquidity risk management policy, which inter alia, should spell out the liquidity risk tolerance, funding strategies, prudential limits, system for measuring, assessing and reporting / reviewing liquidity, framework for stress testing, liquidity planning under alternative scenarios/formal contingent funding plan, nature and frequency of management reporting, periodical review of assumptions used in liquidity projection, etc. The policy should also address liquidity separately for individual currencies, legal entities like subsidiaries, joint ventures and associates, and business lines, when appropriate and material, and should place limits on transfer of liquidity keeping in view the regulatory, legal and operational constraints.

The BoD or its delegated committee of board members should oversee the establishment and approval of policies, strategies and procedures to manage liquidity risk, and review them at least annually.

6.1          Liquidity Risk Tolerance:

 Banks should have an explicit liquidity risk tolerance set by the Board of Directors. The risk tolerance should define the level of liquidity risk that the bank is willing to assume, and should reflect the bank’s financial condition and funding capacity. The tolerance should ensure that the bank manages its liquidity in normal times in such a way that it is able to withstand a prolonged period of, both institution specific and market wide stress events. The risk tolerance articulation by a bank should be explicit, comprehensive and appropriate as per its complexity, business mix, liquidity risk profile and systemic significance. They may also be subject to sensitivity analysis. The risk tolerance could be specified by way of fixing the tolerance levels for various maturities under flow approach depending upon the bank’s liquidity risk profile as also for various ratios under stock approach. Risk tolerance may also be expressed in terms of minimum survival horizons (without Central Bank or Government intervention) under a range of severe but plausible stress scenarios, chosen to reflect the particular vulnerabilities of the bank. The key assumptions may be subject to a periodic review by the Board.

6.2          Strategy for Managing Liquidity Risk:

The strategy for managing liquidity risk should be appropriate for the nature, scale and complexity of a bank’s activities. In formulating the strategy, banks/banking groups should take into consideration its legal structures, key business lines, the breadth and diversity of markets, products, jurisdictions in which they operate and home and host country regulatory requirements, etc. Strategies should identify primary sources of funding for meeting daily operating cash outflows, as well as expected and unexpected cash flow fluctuations.

7.     Management of Liquidity Risk:

A bank should have a sound process for identifying, measuring, monitoring and mitigating liquidity risk as enumerated below:

8.1  Identification:

A bank should define and identify the liquidity risk to which it is exposed for each major on and off-balance sheet position, including the effect of embedded options and other contingent exposures that may affect the bank’s sources and uses of funds and for all currencies in which a bank is active.

8.2          Measurement of Liquidity Risk:

There are two simple ways of measuring liquidity; one is the stock approach and the other, flow approach. The stock approach is the first step in evaluating liquidity. Under this method, certain ratios, like liquid assets to short term total liabilities, purchased funds to total assets, core deposits to total assets, loan to deposit ratio, etc. are calculated and compared to the benchmarks that a bank has set for itself. While the stock approach helps up in looking at liquidity from one angle, it does not reveal the intrinsic liquidity profile of a bank.

The flow approach, on the other hand, forecasts liquidity at different points of time. It looks at the liquidity requirements of today, tomorrow, the day thereafter, in the next seven to 14 days and so on. The maturity ladder, thus, constructed helps in tracking the cash flow mismatches over a series of specified time periods. The liquidity controls, apart from being fixed maturity-bucket wise, should also encompass maximum cumulative mismatches across the various time bands.

8.     Ratios in respect of Liquidity Risk Management:

Certain critical ratios in respect of liquidity risk management and their significance for banks are given below. Banks may monitor these ratios by putting in place an internally defined limit approved by the Board for these ratios. The industry averages for these ratios are given for information of banks. They may fix their own limits, based on their liquidity risk management capabilities, experience and profile. The stock ratios are meant for monitoring the liquidity risk at the solo bank level. Banks may also apply these ratios for monitoring liquidity risk in major currencies, viz. US Dollar, Pound Sterling, Euro and Japanese Yen at the solo bank level.

Sl. No.	Ratio	Significance	Industry Average (in %)
1.	(Volatile liabilities – Temporary Assets) /(Earning Assets – Temporary Assets)	Measures the extent to which volatile money supports bank’s basic earning assets. Since the numerator represents short-term, interest sensitive funds, a high and positive number implies some risk of illiquidity.	40
2.	Core deposits/Total Assets	Measures the extent to which assets are funded through stable deposit base.	50
3.	(Loans + mandatory SLR + mandatory CRR + Fixed Assets)/Total Assets	Loans including mandatory cash reserves and statutory liquidity investments are least liquid and hence a high ratio signifies the degree of ‘illiquidity’ embedded in the balance sheet.	80
4.	(Loans + mandatory SLR + mandatory CRR + Fixed Assets) / Core Deposits	Measure the extent to which illiquid assets are financed out of core deposits.	150
5.	Temporary Assets/Total Assets	Measures the extent of available liquid assets. A higher ratio could impinge on the asset utilisation of banking system in terms of opportunity cost of holding liquidity.	40
6.	Temporary Assets/ Volatile Liabilities	Measures the cover of liquid investments relative to volatile liabilities. A ratio of less than 1 indicates the possibility of a liquidity problem.	60
7.	Volatile Liabilities/Total Assets	Measures the extent to which volatile liabilities fund the balance sheet.	60

Volatile Liabilities: (Deposits + borrowings and bills payable up to 1 year). Letters of credit – full outstanding. Component-wise CCF of other contingent credit and commitments. Swap funds (buy/ sell) up to one year. Current deposits (CA) and Savings deposits (SA) i.e. (CASA) deposits reported by the banks as payable within one year (as reported in structural liquidity statement) are included under volatile liabilities. Borrowings include from RBI, call, other institutions and refinance.

Temporary assets =Cash + Excess CRR balances with RBI + Balances with banks + Bills purchased/discounted up to 1 year + Investments up to one year + Swap funds (sell/ buy) up to one year.

 Earning Assets = Total assets – (Fixed assets + Balances in current accounts with other banks + Other assets excluding leasing + Intangible assets)

 Core deposits = All deposits (including CASA) above 1 year (as reported in structural liquidity statement)+ net worth

The above stock ratios are only illustrative and banks could also use other measures / ratios. For example to identify unstable liabilities and liquid asset coverage ratios banks may include ratios of wholesale funding to total liabilities, potentially volatile retail (e.g. high cost or out of market) deposits to total deposits, and other liability dependency measures, such as short term borrowings

9.     Stress Testing:

Stress testing should form an integral part of the overall governance and liquidity risk management culture in banks. A bank should conduct stress tests on a regular basis for a variety of short term and protracted bank specific and market wide stress scenarios (individually and in combination). In designing liquidity stress scenarios, the nature of the bank’s business, activities and vulnerabilities should be taken into consideration so that the scenarios incorporate the major funding and market liquidity risks to which the bank is exposed. These include risks associated with its business activities, products (including complex financial instruments and off-balance sheet items) and funding sources. The defined scenarios should allow the bank to evaluate the potential adverse impact these factors can have on its liquidity position. While historical events may serve as a guide, a bank’s judgment also plays an important role in the design of stress tests.

 Stress tests outcomes should be used to identify and quantify sources of potential liquidity strain and to analyse possible impacts on the bank’s cash flows, liquidity position, profitability and solvency. The results of stress tests should be discussed thoroughly by ALCO. Remedial or mitigating actions should be identified and taken to limit the bank’s exposures, to build up a liquidity cushion and to adjust the liquidity profile to fit the risk tolerance. The results should also play a key role in shaping the bank’s contingent funding planning and in determining the strategy and tactics to deal with events of liquidity stress.

The stress test results and the action taken should be documented by banks and made available to the Reserve Bank / Inspecting Officers as and when required. If the stress test results indicate any vulnerability, these should be reported to the Board and a plan of action charted out immediately. The Department of Banking Supervision, Central Office, Reserve Bank of India should also be kept informed immediately in such cases.

10.  Contingency Funding Plan:

A bank should formulate a contingency funding plan (CFP) for responding to severe disruptions which might affect the bank’s ability to fund some or all of its activities in a timely manner and at a reasonable cost. CFPs should prepare the bank to manage a range of scenarios of severe liquidity stress that include both bank specific and market-wide stress and should be commensurate with a bank’s complexity, risk profile, scope of operations. Contingency plans should contain details of available / potential contingency funding sources and the amount / estimated amount which can be drawn from these sources, clear escalation / prioritisation procedures detailing when and how each of the actions can and should be activated and the lead time needed to tap additional funds from each of the contingency sources.

Contingency plans must be tested regularly to ensure their effectiveness and operational feasibility and should be reviewed by the Board at least on an annual basis.

11.  Overseas Operations of the Indian Banks’ Branches and Subsidiaries and Branches of Foreign banks in India:

A bank’s liquidity policy and procedures should also provide detailed procedures and guidelines for their overseas branches/subsidiaries to manage their operational liquidity on an ongoing basis. Similarly, foreign banks operating in India should also be self reliant with respect to liquidity maintenance and management.

12.  BROAD NORMS IN RESPECT OF LIQUIDITY MANAGEMENT:

Some of the broad norms in respect of liquidity management are as follows:

      i.        Banks should not normally assume voluntary risk exposures extending beyond a period of ten years.

     ii.        Banks should endeavour to broaden their base of long- term resources and funding capabilities consistent with their long term assets and commitments.

    iii.        The limits on maturity mismatches shall be established within the following tolerance levels: (a) long term resources should not fall below 70% of long term assets; and (b) long and medium term resources together should not fall below 80% of the long and medium term assets. These controls should be undertaken currency-wise, and in respect of all such currencies which individually constitute 10% or more of a bank’s consolidated overseas balance sheet. Netting of inter-currency positions and maturity gaps is not allowed. For the purpose of these limits, short term, medium term and long term are defined as under:

Short-term:	those maturing within 6 months
Medium-term:	those maturing in 6 months and longer but within 3 years
Long-term:	those maturing in 3 years and longer