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Financial Market A market where financial assets are
exchanged Financial Assets are created and traded in
financial markets Financial assets are intangible
Represent a claim to future cash flow Issuer
The entity that has agreed to make future cash payment
Investor The holder of a financial asset
Flow of Funds : Direct Transfer
Users of Funds(Corporations)
Suppliers of Funds
(Households)
Financial Claims(Equity and debt
instruments)
Cash
Example: A firm sells shares directly to investors without goingthrough a financial institution
Flow of Funds : Indirect transfer
Users of Funds
FI(Asset
transformers)
Suppliers of Funds
Financial Claims(Equity and debt securities)
Financial Claims(Deposits and Insurance policies)
Role of Financial Institutions Maturity Intermediation
Investors/lender are willing to invest/lend for short term
Issuers/borrowers want funds for long term FI are able to offer more choices to both
Denomination Intermediation Allow small investors to overcome constraints
imposed to buying assets imposed by large minimum denomination size
Diversification Transforming more risky asset into less risky
asset through diversification
Role of Financial Institutions Reduced Cost
Information processing and contracting cost
Payment Mechanism Cheque/ Debit Card/ Credit Card
Type of Banking Activities Commercial Banking
Intermediation and liquidity via deposits and loans Payment system
Investment Banking Trading – equity and fixed income securities Underwriting Stockbroking Corporate advisory Merger & Acquisition Fund Management Insurance
Universal Banking Combination of Commercial Banking and Investment
Banking under one legal entity
Central Banking Monetary Control
Open Market Operations Buying and Selling of securities in market Repo and Reverse Repo
Reserve Ratios Cash Reserve Ratio Statutory Liquidity Ratio
Bank Rate Prudential Control
Supervision Lender of Last Resort
Government Debt Placement Raising debt for the Government at reasonable cost
How do banks make money Interest Income
Banks are deposit accepting institutions Accept Deposit (Interest Paid) Lend Money (Interest Income) Spread (Interest Income – Interest Paid)
Non interest income Fee based income
Loan Syndication Fee Letter of Credit Fee Credit Cards
Income from Investment Interest/ Dividend Trading Income
How do the Banks Operate
Channels Multiple interface with the customer
Branches ATM Corporate electronic banking Internet Phone Mail Tied sales force
Customer Relations Management
Customer Static Master information about the customer Single location vs. multiple location
Contact Management To bring together the entire customer
“contacts” and “events” at one place Customer Risk
Group wide view of customer risk
Engines Back office staff and complex computer
systems to set up and maintain the particular product or service for a customer Core Banking Assets Finance Wealth Management Insurance Cards Mortgages Capital Market
Core Banking Activities of a typical commercial
bank that has both personal and business customers; deposits and savings accounts personal and commercial lending payment services including direct debits,
cheques, cash, High Value payments and currency payments
Trade products such as Letters of Credit and international Bonds and Guarantees
Core Banking Corporate/ Wholesale Banking
Services corporations and governments Current Account Payment mechanism Cash Management Services Commercial loans Loan Syndication Guarantees
Retail Banking Individuals and small businesses
Saving accounts Loans – personal, mortgages
Insurance Areas of personal and commercial
insurance broking and underwriting Life Assurance House Insurance Motor Insurance Health Insurance Commercial Insurance Loan Protector Insurance Specialised Insurance (Marine, Aviation, etc)
Assets Financing Services such as leasing, vehicle finance,
debt factoring etc. Quite distinct back office processes and
supporting IT. Lease
Assets are bought by the bank Possession is given to the user Ownership is retained by the Bank The borrower pays in installments Each installment is broken into principle and
interest
Assets Financing Hire Purchase
Assets are bought by the bank Possession is given to the user Ownership is retained by the Bank The borrower pays in installments Each installment is broken into principle
and interest The ownership is transferred to the
borrower upon payment of all the installments
Factoring Transfer of collection of receivables and related book-
keeping functions to a financial intermediary. Factor usually extends an advance and may assume
the risk of non-recovery
Factor
Client Customer
2
5423
6
1
Factoring1 : Credit sale 2 : Client sells the customer’s account to
factor and notifies the customer3 : Factor makes a part payment to client after
adjusting commission and interest4 : Factor maintains customer’s account and
follows up for payment5 : Customer remits the amount due to the
factor6 : Factor makes the final payment to the
client
Forms of FactoringRecourse Factoring
loss of bad debts to be borne by the clientNon-recourse Factoring
risk is borne by the factorFactor participate in the credit granting process
Maturity Factoring/Collection FactoringPayment to the client on the date of collection of
guaranteed payment day Advance Factoring
Advance upto 75-85% of receivableBalance on collection/guaranteed payment day
Factor’s FeesAdministrative Services – CommissionFinancing
Discount (if deducted upfront)Interest (if charged subsequently)For the Period between the date of advance
payment and the date of collection/guaranteed payment date
Risk of bad debts – del credere commission
Banker’s Acceptance / Forfeiting
To finance deferred credit transactions
Exporter Importer
Avalling BankForfailter
1
2
45 6
73 9
8
Banker’s Acceptance /Forfeiting1 : Export transaction2 : Promissory Note sent for co-acceptance (avalization)3 :Avalled notes returned to importer4: Avalled notes sent to exporter5 :Avalled notes sold at a discount to farfaiter on a non-
recourse basis6: Exporter obtains finance 7 : Forfaiter presents the notes to the avalling bank on
maturity8: Avalling bank makes payment to the forfaiter9: Avalling bank gets payment from the Importer
Wealth Management Managing funds on customers’ behalf,
- retail or institutional Active or passive funds management
managed Other services like custody
Cards Key credit and debit card processes:
Card issuing, to both individuals and companies
Merchant acquisition Credit and Debit Card payment
processing
Capital Market Wholesale market in money,
currency, bonds, securities and the derivatives
Distinct back office requirements
Gateways Interaction with counter parties for the provision of a
service to a customer Often highly automated and use industry standard
Gateways. SWIFT CHAPS SWITCH SOLO Bankers Automated Clearing Service (BACS) VISA /MASTERCARD CHEQUE CLEARING CURRENCY CHEQUE CLEARING Continuous Linked Settlement (CLS) LINK
Management Information Deriving information from the activities in the other
parts External
Government Tax Authorities - Information on customer tax withheld and country of residence of customers
Government Security Services - Information on Suspected Terrorists, Money Laundering and Fraud
Central Bank and Financial Services Regulators - Information on credit exposures, capital adequacy and liquidity
Internal Analyzing assets, liabilities, costs and income as well
as non-financial data for a variety of marketing and other management needs.
Accounting in Banks A number of stakeholders Accounting statements meet their information
requirements
GAAP / Accounting Standards Accounting is not an exact science To bring about uniformity in
accounting practices `good accounting practices’ called GAAP evolved over a period of time
GAAP are formalized in the form of Accounting Standards
Move towards harmonization of accounting standards
GAAP Money Measurement Concept
Only those transaction that can be expressed in terms of money is the subject matter of accounting
Money is the common unit of measurement The Entity Concept
Business is a separate accounting entity for which accounts are kept
Business and the businessman are separate entities
GAAP The Going Concern Concept
The business will continue to operate indefinitely Unless there are reasons to believe otherwise The business neither has the intention nor the
necessity to discontinue operations The Cost Concept
Assets are recorded in the accounts at its cost Subsequent changes in the value are normally
not recorded in the accounts Cost is however systematically reduced over the
useful life of the asset
GAAP The Dual Aspect Concept
Each accounting transaction effects at-least two accounts in such a way that
Assets = Liabilities + Owner’s Equity This system of accounting is called double-entry
system Accounting Period Concept
Income is measured for a specified interval of time – accounting period A period of 12 months
Makes comparison easier
GAAP Accrual Concept
Timing when income or expenses should be recorded
Income and expenses are recorded when `accrued’ and not when received or paid Income recorded when earned Expenses recorded when incurred
The Matching Concept Expenses should be matched against the
revenue generated to ascertain profit
GAAP The Conservatism Concept
Anticipate no profit but anticipate all losses Recognise gains only when they are reasonable
certain Recognise losses even if they are reasonably
probable The Consistency Concept
Accounting methods once chosen must be applied consistently period after period unless there is strong reasons to change
Makes inter-period comparison possible
GAAP The Materiality Concept
Insignificant details should be avoided but all important information must be disclosed
Any information that may influence the decision of the user of the financial statement
The level of details to be maintained
Basic Financial Statements To answer the two basic questions
How much profit was generated by the business over a particular period?
What is the accumulated wealth of the business at the end of a particular period?
Financial Statements Profit & Loss Account Balance Sheet
Financial Statements Sources of Funds Shareholders’ Funds
Share Capital Reserve and Surplus
Securities Premium Account Reserves P&L Account (Credit Balance)
Borrowed Funds Deposits Borrowing from other banks Other Liabilities
Application of Fund Cash in hand Cash with other banks Money at call and short notice Investments Loans and Advances to customers Other Assets
Interest Income Less: Interest Expenditure Net Interest Income Other Income Less: Other Expenses Less: Depreciation and
Amortization Profit Before Tax Less: Taxes Profit After Tax Less : Appropriations Dividend Reserves Retained Earnings
Liabilities Shareholders’ Funds
Share Capital Reserve and Surplus
Securities Premium Account Reserves P&L Account (Credit Balance)
Borrowed Funds Deposits Borrowing from other banks Other Liabilities
Assets Cash in hand Cash with other banks Money at call and short notice Investments Loans and Advances to customers Other Assets
Liabilities Deposits
Current accounts: Cheque operated accounts maintained for mainly business purposes. No limits are fixed by banks on the number of transactions permitted in the Account. Banks generally insist on a higher minimum
balance banks generally levy certain service charges for
operating a Current account. Banks do not pay any interest on the balances
maintained in current accounts.
Liabilities Savings deposits
A Savings bank account is the most common operating account for individuals and others for non-commercial transactions. Banks generally put some ceilings on the total
number of withdrawals permitted during specific time periods.
Banks also stipulate certain minimum balance to be maintained in savings accounts.
Banks pay nominal interest on saving accounts
Liabilities Time deposits/Fixed deposits
Time deposits are deposits accepted by banks for a specified period of time. Interest rates are to be determined by respective
banks.
Liabilities Borrowing from other banks
Inter bank borrowings in case of liquidity crunch.
Liabilities Other liabilities
Bills payable Accrued interest Dividends declared but yet to be paid Provisions for loan loss
Provisions made against doubtful asset A bank specific parameter
Net Demand and Time Liabilities (NDTL)
Demand liabilities Payable on demand Current deposits, savings deposits, Demand
drafts etc. Does not include money at call and short notice.
Time liabilities Payable otherwise than on demand Fixed deposits, Gold deposits etc.
A sum of DLs and TLs is termed as NDTL Banks are required to maintain CRR and
SLR with reference to the NDTL as of the reporting day.
Assets Cash in hand
Actual cash held by the bank in its vault for daily use
Acts as the first line of defense in case of insolvency.
Cash with other bank Banks (usually small banks) open current
account with other banks. Banks also keep cash with central bank’s
current account.
Assets Money at call and short notice
Short term investments by banks which can be called back immediately
Call money transactions Investments
Held Till Maturity Held for Trading Available for Sale
Assets Loans and Advances to customers
Commercial & Industrial Term Loan Working Capital Loan Cash Credit/ Overdraft Bill Discounted
Retail Personal Loan Mortgage Educational Loan
Commercial & Industrial Loan Term Loan
Long term loan to finance capital expenditure Interest is charged on Loan Generally secured against the fixed assets of the
company Working Capital Loan
To finance the day to day operating requirements
Interest is charged on the amount sanctioned Generally secured by the hypothecation of
inventories and receivables
Commercial & Industrial Loan Cash Credit/ Overdraft
To finance the day to day operating requirements
Interest is charged on the amount actually utilized
Generally secured by the hypothecation of inventories and receivables
Commitment fees on the amount sanctioned and/or amount unutilized
Commercial & Industrial Loan Bills Discounting
Discounting of trade bills by the bank A bill arises as a consequence of a trade
transaction The seller of goods on credit discounts
the bill from the bank The bank deducts the discount upfront
Mode of Security Hypothecation
Security of moveable property Assets pledged continue to be in possession of the
borrower Lender has a right to attach the property in case of
default Pledge
Physical possession is given to the lender Lender must take reasonable care of the property
pledged Mortgage
Transfer of legal/equitable interest in specific immovable property to the lender
Mortgage Deed
Assets Property and Other Assets
Land & Buildings Furniture and Fixtures Computer Systems Vehicles
Income Statement Interest Income Less: Interest Expenditure Net Interest Income Other Income Less: Other Expenses Less: Depreciation and Amortisation Profit Before Tax Less: Taxes Profit After Tax Less : Appropriations Dividend Reserves Retained Earnings
Income Statement Interest income
Loans Interest
Interest expenses Interest paid on time deposits Interest on other deposits Interest expenses due to repo transaction Interest on bonds and debentures issued by the
bank Investment income
Securities, bonds, debentures etc.
Income Statement Non-interest income
Advisory activity Service charges on deposits Commissions and fees Foreign exchange trading gains and losses
Other expenses Overhead expenses – salaries, employee
benefits etc Expense of premise and fixed assets Provision for loan loss Depreciation
Income Statement Provision for Tax Profit After Tax Appropriations
Reserves Dividend
Retained Earnings (Reserve and Surplus)
Off-Balance Sheet Items Most off-balance sheet activities are
commitments based on a contingent claim. A contingent claim is an obligation by a bank to provide funds if a contingency is realized.
Off-Balance Sheet Items Letters of credit
letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
Off-Balance Sheet Items Commercial LCs
Indian importer German exporter
1Orders $10 million of machinery
Bank XYZ in India
2$10 million LC issued
3Goods shipped
Off-Balance Sheet Items Standby LCs
SLCs perform an insurance function similar to that of commercial letters of credit. However, the structure and the type of risk covered are different (potentially more severe) Default guarantees to back an issue of commercial
papers Completion guarantee of a project others
Off-Balance Sheet Items Loan Commitments
A loan commitment agreement is a contractual commitment by a bank to a firm certain maximum amount of loan at a given interest rate.
The agreement also defines the length of time over which the borrower has the option to take down the loan.
The bank may charge an up-front fee which is termed as loan commitment fee.
Bank may also charge a back-end fee on the unused component of a loan commitment.
Financial Performance Indicators
CapitalEquity TotalIncome Net
Assets TotalIncome Net
Return on Equity =
Return on Assets =
Profit Margin = Income Operating TotalIncome Net
Financial Performance Indicators
LeasesandLoansNetSecuritiesInvestmentInterestInterestNet
ExpensesInterest - Income
Assets EarningIncome
sLiabilitie Bearing
Expense Assets EarningIncome
InterestInterestInterest
Net Interest Margin =
Spread =
Interest Income Ratio =
Non-Interest Income Ratio =Assets Income
TotalInterest
Assets Income
TotalInterestNon
Financial Performance Indicators
Income Operating Expense
TotalInterestNon
Income Operating LossesLoan for Pr
Totalovision
Interest Expense Ratio =
Non-Interest Income Ratio =
Provision for Loan Loss Ratio =
Income Operating Expense
TotalInterest
Risks faced by banks Credit Risk
An asset or loan become irrecoverable or experiences a delay in servicing
Counterparty Risk On traded financial instruments
Liquidity Risk Bank’s inability to fund its day to day
operations `Funding short lending long’
Risk Market Risk / Price Risk
Due to fluctuations in the market price of instruments held by bank
Systematic Risk vs Unsystematic Risk Operational Risk
Due to failed internal processes, people and systems or external events
Interest Rate Risk Due to movement in risk rate
Gearing Risk Due to high financial leverage
Derivatives
Derivates – A closer look Assets whose value is determined by
some other underlying securities – hence termed as derivatives.
The underlying Stock Interest rate (bonds) Currency Bank loan Whether etc.
Forwards Negotiated privately between two
parties to buy and sell a specific quantity of a commodity, foreign currency or financial instrument at a specified price, with delivery and/or settlement at a specified future date.
A forward contract is not formally regulated by an organized exchange, each party to the contract is subject to the default of the other party.
Futures Futures and forwards are almost
similar in all respects except the following Futures are exchange traded
standardized products and hence default risk is essentially eliminated.
Futures, being standardized products are not as flexible as forwards are.
Options Options are the financial derivatives
that provides the right but not the obligation to buy or sell the underlying asset on a specified date and a specified price.
Broadly, exchange traded products with few exceptions.
Swaps A swap is an agreement to exchange
cash flows at specified future times according to certain specified rules
Interest Rate Swap Converting a liability from
fixed rate to floating rate floating rate to fixed rate
Converting an investment from fixed rate to
floating rate floating rate to
fixed rate
Swap - Example Company A has borrowed $100m @
9%, wants to covert the borrowing at floating rate
Company B has borrowed $100m @ Floating Rate, wants to covert the borrowing at fixed rate
Can they swap?
Swap
Company A
Company B
9%
Floating Rate
Floating Rate
9%
Swap
Company A
Company B
Floating RateSwap Dealer
FR FR
9.05%8.95%
9%
Clearing System Process of settlement of cheques
lodged with a bank Out-clearing: Processing of cheques
for a bank where it has been lodged In-Clearing : Processing of cheques for
a bank on which the cheque has been drawn
Adjusted by a system of debits and credit
Process Cheque lodged with bank A Cheque are sorted bank-wise Send cheques to the clearing house Cheques for out-clearing and in-clearing are
exchanged Net position of the bank is determined by
the clearing house Debit / Credit is given to the respective
customer with the net credit to the account being maintained with the Central Bank
Net vs. Gross Settlement Clearing
Based upon the principle of netting Real Time Gross Settlement (RTGS)
Transactions are settled on Gross Basis
Netting-Example Same Bank/ Same Branch
A draws a cheque in favour of B. B lodges the cheque in his account with the same branch.
Same Bank / Different Branch A draws a cheque in favour of B. B
lodges the cheque in his account with the same bank in another branch.
Netting-Example Bank 1
Cheques lodged by Customers Out In Net A : Rs.50,000 (P2) B : Rs..30,000 (Q2) 90,000 73,000 17,000 C : Rs..10,000 (R3)
Bank 2 Cheques lodged by Customers D : Rs.15,000 (S1) E : Rs..45,000 (T3) 145,000 90,500 54,500 F : Rs..85,000 (U3)
Bank 3 Cheques lodged by Customers G : Rs.17,500 (V1) H : Rs..40,500 (U1) 68,500 140,000 (71,500) I : Rs..10,500 (W2)
Netting-Example Bank 1
S 15000 (Dr.) V 17500 (Dr.) U 40500 (Dr.) CH 17000 (Dr.) A 50000 (Cr.) B 30000 (Cr.) C 10000 (Cr.)
Bank 2 P 50000 (Dr.) Q 30000 (Dr.) W 10500 (Dr.) CH 54500 (Dr.) D 15000 (Cr.) E 45000 (Cr.) F 85000 (Cr.)
Netting-Example Bank 3
R 10000 (Dr.) T 45000 (Dr.) U 85000 (Dr.) CH 71500 (Cr.) G 17500 (Cr.) H 40500 (Cr.) I 10500 (Cr.)
Central Bank Bank 3 71500 (Dr.) Bank 1 17000 (Cr.) Bank 2 54500 (Cr.)
Faster Payments Float – time gap between the
initiation of payment and the recipient getting the funds Often a period of 3 days
Faster payment – new same day payment capability Real Time based approach Inter-bank transactions several times day
Payment Systems APACS – Association for Payment Clearing
Services BACS Limited – Bankers Automated
Clearing System - Automated clearing house for non-paper based bulk clearing e.g. standing orders, direct debits and direct credits
CCCL – Cheques and Credit Clearing Company Limited – paper based clearing
CHAPS – Clearing House Automated Payment System - RTGS for high value payments
Banking Regulations
Types of Regulations Diversify Assets
Avoid concentration to one company/ sector Money Laundering
Customer Acceptance Policy Customer Identification Procedure Monitoring of transactions
Capital Adequacy To protect against the risk of insolvency
Liquidity Requirements Cash Reserve Ratio Statutory Liquidity Ratio
Guarantee Funds Monitoring and Surveillance
UK Regulatory StructureType of Institution Regulator LegislationBanks Bank of England Banking Act’87Money Mkt Institution
Bank of England Financial Services Act’ 86
Securities Firm Securities & Investments Board
Financial Services Act’ 86
Fund Managers Securities & Investments Board
Financial Services Act’ 86
Building Societies Building Societies Commission
Building Societies Act’95
Insurance Companies
Department Of Trade & Industry
Insurance Companies Act’82
UK Regulatory StructureType of Institution Regulator LegislationBanks Financial Services
AuthorityFinancial Services & Markets Act’ 2000
Money Mkt Institution
FSA FSMA’2000
Securities Firm FSA FSMA’2000Fund Managers FSA FSMA’2000Building Societies FSA FSMA’2000Insurance Companies
FSA FSMA’2000
UK Regulations Risk Based Approach to Regulation
Risk to Our Objectives (RTO) Computing an Impact Score for each firm
Impact of the problem x Probability of problem arising
A highest score; D lowest 85% of the firm – D High Impact firms – large bank, insurance firms,
broker dealers, stock exchanges
UK Regulations Criteria for licensing of banks EU’s Large Exposure Directive FSA must be satisfied with the banks’ procedure for
taking, monitoring and controlling risk Banks may be asked to supply regular information on
asset quality Each bank must be externally audited and have a
system of internal audits. The FSA or external auditors can examine the
internal audits External Auditors must inform FSA any concern they
might have
UK Regulations Onsite examinations
For high impact firms FSA supervisors may be supported by risk
management specialists Low impact firm will be supervised off-site
through key ratios Appoint a money laundering reporting
officer approved by FSA In addition to Basel, FSA sets an individual
capital ratio for each bank based upon risk profile.
Money LaunderingMoney Laundering
Money Laundering
The process by which the proceeds
of crime are converted into assets
which appear to have a legitimate
origin.
It’s no longer just drugs...
Drugs moneyTerrorist financingTax evasionAll crimes
The Traditional Process
Dirty to cleanplacementlayeringintegration
PlacementGetting dirty money into the system
often in emerging markets overseasor use a “useful” business
Bureaux de Changecar, boat, art, antique dealersprecious metal dealersestate agentstravel agents cash intensive businessesfriends / relatives
LayeringMoving money around to confuse its
originsoffshore banks, weak controlscompany formation agentsTrusts / professionalstrade related activities
Characterised bycomplexitylack of commercial rationalenominee accounts
Integration
Into legitimate economypurchase of an income generating asset
Dirty to cleanmay be most difficult to spot
Money LaunderingMoney LaunderingAreas affected in a bank
Retail bankingInvestment bankingPrivate banking (asset management)Investment in real propertyInsurance sectors
STAKES AND RISKS
The involvement of a bank in a money laundering exposes it to a number of different kinds of risks:
Reputational risk: bank may find its image damaged significantly and it may sustain significant and lasting negative business impacts
Legal risk: the discovery of money laundering operations may lead to disciplinary sanctions
Criminal liability risk: for senior management personnel and staff
Prevention
Select customersSelect customers to deny access to the services of the bank to individuals and legal entities associated with money laundering
Monitor operations Monitor operations to prevent the use of bank for illegal operations
In the event of suspicious activities:Report suspicions to the responsible authoritiesReport suspicions to the responsible authoritiesFreeze assets Freeze assets Terminate business relationsTerminate business relations
Manage
alerts
Know Your Customer
Accounts surveillanceAnalysis of
customer behavior
Transactions surveillance
COMBATING MONEY
LAUNDERING
Capital Adequacy – Basel II
Risk Based Capital Standard Why do banks need to hold capital in order
to do business? Provides a cushion against unexpected loss that
may arise due to credit/market/operational risk. Capital that needs to be maintained as a
proportion of risk based assets is termed as risk based capital – otherwise termed as capital adequacy ratio (CAR). e.g., bank does not maintain any capital
towards credit risk component of Government bonds as it is non-existent.
Banking Risk: An Overview Credit risk
Risk arising due to default or deterioration of the credit quality of the obligor/ borrower
Market risk Risk arising due to market movement of
different benchmark rates. Operational risk
Loss resulting due to errors instructing payments or setting transactions.
Operational Risk Component Operational risk is the risk of loss resulting
from inadequate or failed internal processes, people and systems or from external events. Internal fraud External fraud Employment practices & workplace safety Clients, products & business practices Damage to physical assets Business disruption & system failures Execution, delivery & process management
Operational Risk Component Internal process
Losses from failed transactions, settlements, e.g., data entry error/Unapproved access/Vendor disputes etc.
People Losses caused by an employee, e.g.,
unauthorized trading, internal fraud, harassment etc.
Operational Risk Component Systems
Losses arising from disruption of business or system failure, e.g., hardware or software breakdown, telecommunication failure, programming error, computer virus etc.
External events Losses from the actions of third parties,
e.g., natural disaster, terrorism, credit card fraud, etc.
Evolution of Capital Standard Originated in July 1988 under the auspices
of Bank for International Settlement (BIS) in Basle, Switzerland – popularly termed as Basle Committee. Basel I defines a common measure of solvency,
called the Cooke ratio which covers only credit risk – one size fits all policy.
Specifies 8% capital charge on all exposures. Exposures being defined by respective risk
weights 1988 accord is termed as Basel – I.
A Closer Look into Basel I Capital in regulatory context
Tier 1 Capital Shareholders’ equity and disclosed reserves
Tier 2 Capital (Supplementary) Perpetual securities, unrealized gains on
investment securities, hybrid capital instruments, long term subordinated debt and hidden reserves.
Total of tier 2 capital is limited to a maximum of 100% of the total tier 1 capital.
Basel I requires tier 1 and tie 2 capital to be at least 8% of the total risk weighted assets.
Example – Basel ILiabilities Amount ($
bn)Assets Amount ($ bn)
Equity 15 Cash 2(0)Reserves 2 Govt. Bonds 30(0)Subordinated Debt
5 Inter-bank Loan 20(.20)
Deposits 180 Mortgages 50(.5)Loan Loss Reserve
3 Loans 103(1)
Total 205 205
Risk Weighted Assets = 2*0+30*0+20*.2+50*.5+103*1 = 132 bn
Capital = 15 + 2 + 5 + 3 = 25
Capital Adequacy = 25/132 = 18.9%
Problems with Basel I Does not distinguish among different
credit exposures Both AAA and BBB assets attract the
same capital charge. Does not allow any capital charge for
operational risk.
The New Basel Capital AccordPILLAR I
Minimum capital requirements
Credit riskMarket riskOperational risk
PILLAR IISupervisory
ReviewReview of the institution’s capital adequacyReview of the internal risk assessment processes
PILLAR IIIMarket
Discipline
Enhancing transparency through rigorous disclosure norms.
Summary of ApproachesCredit Risk Operational
RiskMarket Risk
Standardized Approach
Basic Indicator Approach
Standardized Approach
Foundation IRB Approach
Standardized Approach
Internal Model
Advanced IRB Approach
Advanced Measurement Approaches
Impact on capital to be maintained
Advanced approaches are based upon more sophisticated risk management processes and require more information Requirement of capital to be maintained
also goes down
Pillar II – Supervisory review
Four key principles of supervisory review Principle 1: Banks should have process for assessing overall capital adequacy in
relation to risk profile and strategy for maintaining capital levels. Five main features of rigorous process:
Board and senior management oversight Sound capital assessment Comprehensive risk analysis (credit risk, operational risk, market risk,
interest rate risk in banking book, liquidity risk, other risk) Monitoring and reporting Internal control review
Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied.
Principle 3: Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum
Principle 4: Supervisors should seek to intervene at early stage and require rapid remedial action
Pillar III - Market Discipline Comprehensive disclosure is essential for
market participants to understand the relationship between risk profile and capital of an institution.
Includes the disclosure of Capital structure Capital adequacy Method for computing capital requirements Risk exposure such as market, credit and
operational Risk Mitigation
The Sarbanes-Oxley Act 2002
Possible factors that prompted the Oxley Act
.COM Meltdown Enron/ Anderson WorldCom Stock Market Meltdown Loss of Investor Confidence in Financial
Statements of Public Companies and their “Independent” Auditors
All these corporate scandals in late 90’s and early 2000’s provided impetus for the Congress to act quickly
It is created by US Senator Paul Sarbanes and US It is created by US Senator Paul Sarbanes and US Congressman Michael Oxley.Congressman Michael Oxley.
It is passed by the Senate On July 25 2002.It is passed by the Senate On July 25 2002. President Bush signed it into Law on July 30 2002 and President Bush signed it into Law on July 30 2002 and
we get Sarbanes-Oxley Act, 2002.we get Sarbanes-Oxley Act, 2002.
Sarbanes-Oxley ActYes 522No 3Not voting 9
Appreciate the ‘importance and criticality’ Appreciate the ‘importance and criticality’ of Sarbanes-Oxley Act as given by of Sarbanes-Oxley Act as given by Americans!!! Americans!!!
“Americans will always do the right
thing…..
after they have exhausted all other
options.”
Sir Winston Churchill
What does the Sarbanes-Oxley Act seek….?
The Sarbanes-Oxley Act seeks to: Restore the public confidence in both
public accounting and publicly traded securities
Assure ethical business practices through heightened levels of executive awareness and accountability
Increase the confidence of the investors in the financial statements of a company
At what does the Sarbanes-Oxley Act aim…..?
The Act aims to: Improve reporting/disclosures
Strengthen corporate governance
Expand insider accountability
Increase oversight
Broaden sanctions/penalties
Heighten auditor independence
To whom it is applicable?
All those companies which are
registered with Securities Exchange
Commission (SEC), US; except those
which are non-profit companies; and
it is a part of listing agreement.
The Sarbanes-Oxley Act has 11 titles!!!!
I. Public Company Accounting Oversight BoardII. Auditor IndependenceIII. Corporate ResponsibilityIV. Enhanced Financial DisclosuresV. Analyst Conflicts of InterestVI. Commission Resources and AuthorityVII. Studies and ReportsVIII. Corporate and Criminal Fraud AccountabilityIX. White Collar Crime PenaltyX. Corporate Tax ReturnsXI. Corporate Fraud and Accountability
TITLE I – PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
Creation of the Public Company Oversight Board (the Board)
Created as a non-profit organization, the Board will oversee audits of public companies; it is under the authority of the SEC but above other professional accounting organizations such as the AICPA
The Board is comprised of 5 members (appointees), with a maximum of two CPA’s
Among its duties are registering existing public accounting firms which prepare audits for publicly traded companies (issuers), reviewing registered public accounting firms (auditing the auditors), establishing and amending rules and standards (in cooperation with other standard setters), and in the event of non-compliance by registered public accounting firms, to try such firms (and/or any related associate(s)) and penalize
TITLE II – AUDITOR INDEPENDENCE Prohibits registered public accounting firms (RPAFs) who audit an issuer
from performing specific non-audit services for that issuer, including but not limited to: bookkeeping, financial information systems design, appraisal services, actuarial services, internal audit outsourcing services, management/human resource functions, broker/dealer, legal/expert services outside the scope of the audit
In addition to these limitations, audit functions and all other non-audit functions provided to the audit client must be pre-approved by the Board (such as tax services)
Audit Partner rotation – Lead partner on 5 years, off 5 years; other partners on 7 years, off 2
RPAFs performing audits to issuers must report to issuer’s audit committees about: (1) critical accounting policies to be used in the audit, (2) any written communication with management, and (3) any deviations from GAAP in financial reporting
TITLE II (cont.) A conflict of interest arises and an RPAF may not perform audit
services for any issuer employing – in the capacity of CEO, controller, CFO or any other equivalent title – a former audit engagement team member – there is a “cooling-off period” for one year
i.e., an employee of an RPAF who works on an audit of an issuer may not turn around and directly go to work for that issuer – they must wait one year
Currently under investigation is the possibility of mandatory rotations of audit clients among registered public accounting firms
TITLE III – CORPORATE RESPONSIBILITY Audit Committee (committees established by the board of a company for the
purpose of overseeing financial reporting) Independence
Establishes minimum independence standards for audit committees
Independence of the audit committee crucial in that it must (1) oversee and compensate RPAF to perform audit, and (2) establish procedures for addressing complaints by the issuer regarding accounting, internal control, etc. (this lays the foundation for anonymous whistleblowing)
CEOs and CFOs must certify in any periodic report the truthfulness and accurateness of that report – creates liability
Under certain conditions of re-statement of financials due to material non-compliance, CEOs and CFOs will be required to forfeit certain bonuses and profits paid to them as a result of material mis-information
TITLE IV – ENHANCED FINANCIAL DISCLOSURES Issuers must disclose “off-balance sheet transactions” in periodic
reports
No issuer shall make, extend, modify or renew any personal loan to CEOs, CFOs (limited exceptions include company credit cards)
Annual reports will contain internal control reports which state the responsibility of management for establishing such controls and their assessment of the effectiveness of such controls – which must be attested to by the auditor
In periodic reports filed, the issuer must disclose its code of ethics for senior financial officers, and if the issuer has not adopted such a policy, must disclose why not
Issuer must disclose whether or not its audit committee is comprised of at least one financial expert, and if not, why
Financial Disclosures Member considered financial expert if they have an understanding
of GAAP, experience in preparing/auditing financials, experience with internal controls, and an understanding of audit committee functions
SEC must review disclosures (in financials) made by any issuer at least once every three years (similar to Board review of registered public accounting firms)
Issuers must disclose in real time any additional information concerning material changes in the financial condition or operations of the issuer
TITLE V – ANALYST CONFLICTS OF INTEREST National Securities Exchanges and registered securities
associations must adopt rules designed to address conflicts of interest that can arise when securities analysts recommend securities in research reports
To improve objectivity of research and provide investors with useful and reliable information
TITLE VI – COMMISSION RESOURCES AND AUTHORITY Increase 2003 appropriations for the SEC to $780 million, $98
million to be used to hire an additional 200 employees for enhanced oversight of auditors and audit services
SEC will establish rules setting minimum standards for profession conduct for attorneys practicing before it
SEC to conduct investigations of any security professional who has violated a security law
May censure, temporarily bar or deny right to practice
TITLE VII – STUDIES AND REPORTS The Comptroller General of the US shall conduct a study regarding the
consolidation of public accounting firms (e.g. Coopers & Lybrand/Price Waterhouse combine to become PriceWaterhouseCoopers; ToucheRoss/DeloitteHaskins merge to become Deloitte & Touche) since 1989, analyze the past, present and future impact of the consolidations, and create solutions to problems discovered caused by such consolidations
The Comptroller General and/or SEC will also explore such issues as (1) the role and function of credit rating agencies in the operation of the securities market, (2) the number of securities professionals (public accountants, investment bankers, attorneys) who have been found to have aided and abetted a violation of securities law and who have not been disciplined, (3) all enforcement actions by the SEC regarding re-statements, violations of reporting requirements, etc., for the five year period prior to the date the Act is passed, and (4) whether investment banks and financial advisers assisted public companies in manipulating their earnings (specifically Enron and WorldCom)
TITLE VIII – CORPORATE AND CRIMINAL FRAUD ACCOUNTABILITY
To knowingly destroy, create, manipulate documents and/or impede or obstruct federal investigations is considered felony, and violators will be subject to fines or up to 20 years imprisonment, or both
All audit report or related workpapers must be kept by the auditor for at least 5 years
Whistleblower protection – employees of either public companies or public accounting firms are protected from employers taking actions against them, and are granted certain fees and awards (such as Attorney fees)
TITLE IX – WHITE-COLLAR CRIME PENALTY ENHANCEMENTS Financial statements filed with the SEC by any public company
must be certified by CEOs and CFOs; all financials must fairly present the true condition of the issuer and comply with SEC regulations
Violations will result in fines less than or equal to $5 million and /or a maximum of 20 years imprisonment
Mail fraud/wire fraud convictions carry 20 year sentences (previously 5 year sentences)
Anyone convicted of securities fraud may be banned by SEC from holding officer/director positions in public companies
TITLE X – CORPORATE TAX RETURNS Federal income tax returns must be signed by the CEO of an
issuer
TITLE XI – CORPORATE FRAUD ACCOUNTABILITY Destroying or altering a document or record with the intent
to impair the object’s integrity for the intended use in a securities violation proceeding, or otherwise obstructing that proceeding, will be subject to a fine and/or up to 20 years imprisonment
The SEC has the authority to freeze payments to any individual involved in an investigation of a possible security violation
Any retaliatory act against whistleblowers or other informants is subject to fine and/or 10 year imprisonment
The most important concern of the Sarbanes-Oxley Act is …
Disclosures
The Act Imposes Important Reporting Requirements on ManagementSection 302 (and related SEC rule) (Civil)– CEO/CFO Must
Certify Quarterly and Annually that:SEC report being filed has been reviewedReport does not contain any untrue statements or omit any
material facts necessary to make the statements made not misleading
Financial statements fairly present, in all material respects, the financial position, results of operations and cash flows
He/she is responsible for and has designed, established, and maintained Disclosure Controls & Procedures (“DC&P”), as well as evaluated and reported on the effectiveness of those controls and procedures within 90 days of the report filing date
Reporting Requirements Deficiencies and material weaknesses in
internal control have been disclosed to Audit Committee and auditors, as well as any fraud (material or not) involving anyone with a significant role in internal control
Significant changes in internal control affecting controls for periods beyond review have been reported in the certification, including any corrective actions with regard to significant deficiencies and material weaknesses
Internal ControlsSection 404 – Management Must Assess Internal Controls Annually Internal control report states management’s responsibility for
establishing and maintaining adequate internal control structure and procedures for financial reporting
Management must assess effectiveness of internal control structure and procedures for financial reporting as of the end of the most recent fiscal year
Attestation by external auditor (Section 404 and 103) Section 906 (Criminal) – CEO/CFO Must Certify that
Periodic Financial Reports Fully comply with various Acts and information fairly presents
financial condition and results of operations
Impact One Time; there is an initial one off
description of lots of processes so that they are understandable by the auditors. Examples might be human related such as
Change control processes and their key measures/control points
systems related Interest calculation and posting algorithms.
Ongoing; every year there will be an exercise driven by both internal and external auditors of sampling key controls from key processes and analyzing whether these controls are effective
Time Value of Money
What is Time Value of Money? Relationship between Re.1 today and
Re.1 in the future. Two methods for accounting for time
value of money Compounding
Finding the future value of a present sum of money
Discounting Finding the present value of a future sum of
money
What is Time Value of Money?
nrCFV )1(
nrCPV
)1(
Future Value (FV) Value of a sum after
investing over one or more periods.
Present Value (PV) Value of a sum
today which is received after one year or more periods.
C = Sum invested todayr = Interest rate
C= Sum received n year hencer = Interest rate
Future Value and Compounding The general formula for the future value of an
investment over many periods can be written as:FV = C0×(1 + r)n
where C0 is cash flow at date 0, r is the appropriate interest rate, and n is the number of periods over which the cash is
invested. (1 + r)n = Future Value Interest Factor
(FVIFr,n)
Present Value and Discounting Present value of a future sum can be written as
where, PV = Present value of the future sum Cn
n = number of years until the payment will be received
r = annual discount (or interest) rate 1/(1+r)n is termed as Present Value Interest
Factor (PVIFr,n)
nn rCPV
)1(1
Annuities: A Level Stream An annuity is defined as a level
stream of regular payments that lasts for a fixed number of periods. Regular Annuity – cash flow at the end of
each period Annuity Due – cash flow at the beginning
of each period
Future Value of an Annuity Future value of an annuity can be written as
whereFVn = Future value of the annuity at the end of the
periodr = The annual rate of interestn = number of years for which annuity lasts{(1+r)n-1}/r = Future Value Interest Factor of an
Annuity (FVIFAr,n)
rrAFVn
n11
Present Value of an Annuity
rrrCPV n
n
n )1(11
The formula for the present value of an annuity is:
wherePV = Present value of a regular annuityC = Annual Contribution at the end of each periodr = The annual rate of discountn = number of years for which annuity lasts
Capital Recovery Factor
Capital Recovery Factor helps in computing: Loan installment to liquidate a loan Amount that can be withdrawn periodically when
a particular amount is invested now.The Capital Recovery Factor is the inverse of
PVIFA CRF = 1/ PVIFA
Happy Learning……………
