· ISFA CAIIB (REVISED) –PAPER 2 INDEX BANK FINANCIAL MANAGEMENT CHAPTER PAGE NO MODULE A 1. FOREIGN EXCHANGE 2 2. FOREX DERIVATIVES 12 3. LETTER OF CREDITS & UCP

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CAIIB (REVISED) –PAPER 2

INDEX

BANK FINANCIAL MANAGEMENT

CHAPTER PAGE NOMODULE A1. FOREIGN EXCHANGE

2

2. FOREX DERIVATIVES 123. LETTER OF CREDITS & UCPDC 600 234. FACILITIES TO EXPORTER & IMPORTER 315. RISK IN INTERNATIONAL TRADE & ECGC 366. ROLE OF RBI & EXCHANGE CONTROL 387. FEMA,1999 49

MODULE B1. RISK MANAGEMENT – AN OVERVIEW 602. ASSET LIBILITY MANAGEMENT 633. LIQUIDITY RISK MANAGEMENT 664. MARKET RISK 765. CREDIT RISK MANAGEMENT 816. OPERATIONAL RISK 89

MODULE C1. TREASURY MANAGEMENT 962. INTEREST RATE RISK 113

MODULE D1. BANK BALANCE SHEET 1222. PRUDENTIAL NORMS – INCOME & ASSET 1313. BASEL ACCORD & PROVISIONS 142

MULTIPLE OBJECTIVE QUESTION BANK 180

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CAIIB (REVISED) –PAPER 2 BANK FIANACIAL MANAGEMENT

CHAPTER 1 FOREIGN EXCHANGE

1. Global Foreign Exchange Markets24 hour non-stop market:The main feature of this market is that, it is continuous - i.e., open 24 hours a day. The time zones are as follows: The market begins with New York (6 p.m India time) , then Sydney, followed by Tokyo. When we come to work in the morning here in India, Tokyo is at lunch. The Frankfurt market opens at 10 a.m our time; then London (12.30 our time) and we go back full circle to New York again. This means that there is a price available always, anytime and you can transact whenever you want.

2. Introduction to Foreign ExchangeForeign exchange rate is the value of a foreign currency relative to domestic currency. The exchange of currencies is done in the foreign exchange market, which is one of the biggest financial markets. The participants of the market are banks, corporations, exporters, importers etc. A foreign exchange contract typically states the currency pair, the amount of the contract, the agreed rate of exchange etc.A foreign exchange deal is always done in currency pairs, for example, US Dollar – Indian Rupee contract (USD – INR); British Pound – INR (GBP - INR), Japanese Yen – U.S. Dollar (JPYUSD), U.S. Dollar – Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the world are USD, JPY, EURO, GBP, and CHF and some of the liquid currency contracts are on USD-JPY, USD-EURO, EURO-JPY, USD-GBP, and USD-CHF. In a currency pair, the first currency is referred to as the base currency and the second currency is referred to as the ‘counter/terms/quote’ currency. The exchange rate tells the worth of the base currency in terms of the terms currency, i.e. for a buyer, how much of the terms currency must be paid to obtain one unit of the base currency. For example, a USD-INR rate of Rs. 64.0530 implies that Rs. 64.0530 must be paid to obtain one US Dollar. Foreign exchange prices are highly volatile and fluctuate on a real time basis. In foreign exchange contracts, the price fluctuation is expressed as appreciation/depreciation or the strengthening/weakening of a currency relative to the other. A change of USD-INR rate from Rs. 64 to Rs. 64.50 implies that USD has strengthened/ appreciated and the INR has weakened/depreciated, since a buyer of USD will now have to pay more INR to buy 1 USD than before.

3. Brief History: Before there was significant trade between countries, there was little need for foreign exchange, and when there was a need, it was served by gold, since gold was used by most of the major countries. However, as trade expanded, there was a need to exchange currency rather than gold because gold was heavy and difficult to transport. But how could different countries equalize their currency in terms of another currency. This was achieved by equalizing all currencies in terms of the amount of gold that it represented—the gold-exchange standard.Under this system, which prevailed from 1879 to 1934, the value of the major currencies was fixed in terms of how much gold for which they could be exchanged, and thus, they were fixed in terms of every other currency.During the 1930's, the world was in the throes of the Great Depression. Countries started abandoning the gold standard by reducing the amount of gold backing their currency so that they could increase the money supply to stimulate their economies. This deliberate reduction of value is called a devaluation of currency. When some of the countries abandoned the gold standard, then it just collapsed, for it was a system that could not work unless all of the trading countries agreed to it.The leaders of the allied nations met at Bretton Woods, New Hampshire in 1944, to set up a better system of fixed exchange rates. The U.S. dollar was fixed at $35 per ounce of gold and all other currencies were expressed in terms of dollars. This official fixed rate of exchange was known as the par value of currency or par exchange rate.However, to avoid making deleterious macroeconomic adjustments to maintain the exchange rate, the new system provided for an adjustable peg, that allowed the exchange rate to be altered under



specific circumstances. Thus, this Bretton Woods system was also known as the adjustable-peg system. To actuate this new system, the International Monetary Fund (IMF) was created.The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large amounts of U.S. dollars from post World War II aid and sales of their exports in the United States. There were concerns as to whether the U.S. had enough gold to redeem all the dollars.With reserves of gold falling steadily, the situation could not be sustained and the U.S. decided to abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold, so the exchange rate was allowed to float. Because of the central role played by the United States, the Bretton Woods system could not be sustained. By 1973, this action led to the system of managed floating exchange rates that exists today.

4. Broad factors that affect Foreign Exchange Markets :Basically, the Supply and Demand for currency determines ex-rates, market forces, like any commodity or asset. Further the following factor has a weightage on exchange rate :

1. Purchasing Power Parity (PPP): Why is a dollar worth Rs. 65, Pound Rs. 100 etc at some point of time? The answer may that these exchange rates reflect the relative purchasing powers of the currencies, i.e the basket of goods that can be purchased with a dollar in the US will cost Rs. 65 in India and Rs.100 in Britain. Purchasing Power Parity theory focuses on the inflation exchange rate relationship. Assume the current rate between INR and USD is Rs. 65/$1. The inflation rates are 8% in India and 4% in US. Therefore , a basket of goods in India or some goods in India, let us say costing now Rs. 65 will cost one year forward Rs.65 x 1.08 = Rs. 70.20. A similar goods in US, after one year will cost $ 1.04. If Purchasing Power Parity (PPP) holds, the exchange rate between USD and INR , one year hence would be Rs. 70.20 = $ 1.04. This means, the exchange rate would be for $1 = Rs. 70.20/1.04, which will be Rs. 67.20

2. Interest Rate Parity (IRP): Interest rate parity is a theory which states that the size of the forward premium or discount should be equal to the interest rate differential between the two countries. According to this theory, there will be no arbitrage in interest rate differentials between two different currencies and the differential will be reflected in the discount or premium for the forward exchange rate on the foreign exchange.ExampleLet us consider investing € 1000 for 1 year, we'll have two options as investment cases −Case I: Home Investment: In the US, let the spot exchange rate be $1.2245 / €1.So, practically, we get an exchange for our €1000 @ $1.2245 = $1224.50We can invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at the end of the year.Case II: International Investment :We can also invest €1000 in an international market, where the rate of interest is 5.0% for 1 year.So, €1000 @ of 5% for 1 year = €1051.27Let the forward exchange rate be $1.20025 / €1.So, we buy forward 1 year in the future exchange rate at $1.20025/€1 since we need to convert our €1000 back to the domestic currency, i.e., the U.S. Dollar.Then, we can convert € 1051.27 @ $1.20025 = $1261.79

Thus, when there is no arbitrage (means the simultaneous purchase and sale of an asset in order to profit from a difference in the price), the Return on Investment (ROI) is equal in both cases, regardless the choice of investment method.

Other Factors:-I. MACRO - ECONOMIC FUNDAMENTALS:1.GDP Growth : This is the primary indicator of economic growth. This gives a bird’s eye view of the economy and its performance.It is the value of all goods and services produced by the nation's labour and capital inputs. It is broken further into private consumption expenditure, investment expenditure, government consumption expenditure and net trade balance.



2.Balance of Payments: This has three components:-i.Trade Gap (Imports less Exports) ii.Current Account balance (trade gap including invisibles) iii.Capital Flows This gives an indication for future exchange rate policy especially for less developed markets. Currency devaluation assists exports by making them more competitive and at the same discouraging imports by making them more expensive.

3. Industrial production / Capacity Utilisation/Unemployment: This indicates the health of the manufacturing sector of the economy.

4. Structural considerations:i.Reserve Composition ( Short /Long Term liabilities): This indicates the extent of hot money that constitutes your reserves. A higher percentage of short term obligations tends to make the economy more vulnerable to exchange rate volatility and also a degree of uncertainty as regards the ability to renew these short term liabilities.ii.Import elasticity ( Dependence on Oil imports ): Volatility in oil prices brings a greater degree of uncertainty to economies dependent to a large extent on oil imports.iii.Structure of Exports - whether import dependent : This relates to the nature of products exported and their susceptibility to the relative exchange rate.iv.Nature of Inflation ( Demand pull/Cost push): Inflation resulting due to excessive demand factors tends to have more impact on monetary policy than those caused by higher input costs.v.Market Liquidity /yield curve dynamics: This is more relevant in less developed markets. Markets with poor liquidity tend to be more volatile.vi.Strength of the Financial System - (Banking sector Capitalisation , Non Performing Assets ( NPAs ). These factors also tend to influence interest rate policies in many countries.

5. Government Policy :This is again relevant in more controlled markets. The attitude of the government regarding their policy focus - Pro reform v/s greater controls. A case in example is Indonesia. The country had to resort back to capital controls to protect its exchange rate. Expectation against reality - Speed of implementation and Government commitment:This tends to affect sentiment more than anything else. India’s divestment policy is a good case in example where political intent is lacking.

2. Foreign Exchange Rates & Arithmetic Exchange Rate Regime : The exchange rate regime is a method through which a country manages its currency in respect to foreign currencies and the foreign exchange market.

Fixed Exchange Rate: A fixed exchange rate is a type of exchange rate regime in which a currency's value is matched to the value of another single currency or any another measure of value, such as gold. A fixed exchange rate is also known as pegged exchange rate. A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of a fixed exchange rate is a floating exchange rate.

Floating Exchange Rate: A Floating Exchange Rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. A Floating Exchange Rate or a flexible exchange rate and is opposite to the fixed exchange rate.

Linked Exchange Rate: A linked exchange rate system is used to equalize the exchange rate of a currency to another. Linked Exchange Rate system is implemented in Hong Kong to stabilise the exchange rate between the Hong Kong dollar (HKD) and the United States dollar (USD).

QUTOATION STYLE: Various kinds of quotes are described in the following sections.



American vs. European QuoteA quote can be classified as European or American only if one of the currencies is the dollar. An American quote is the number of dollars expressed per unit of any other currency, while a European quote is the number of units of any other currency expressed per dollar. For example, Rs. 48.28/$ is a European quote, while $1.6698/£ is an American quote. In almost all the countries, most of the exchange rates are quoted in European terms. The British pound, the Irish pound and the South African rand are a few examples of currencies quoted in American terms.

Direct vs. Indirect QuoteDirect quote: In this case there is one unit of foreign currency and corresponding units of home currency. Examples of direct quotes in India: 1$ = Rs.46 1£ = Rs.68 1 Euro = Rs.54

Indirect quote: In this case there is one unit of home currency and corresponding units of foreign currency. Examples of indirect quotes in India: Re. 1 = $ 0.0250 Re. 1 = £ 0.0122 Re. 1 = Euro 0.0185

OR Indirect quote = 1 ------------------ Direct quote

Here, the bank would be buying dollars @ $2.1998/Rs.100 and selling dollars @ $2.1978/Rs.100. The corresponding direct quote would be:

$ 1=Rs. 45.4586/45.5000

Here, the bank would be buying dollars @ Rs. 45.4586/$ and selling dollars @ Rs. 45.5000/$.

Before August 2, 1993, the indirect methods of quoting exchange rates used to be followed in India. Since that date, however, the direct quote is being used. In other countries, the concepts of American and European quotes are more popular in comparison to direct and indirect quotes.

Example (A) Example Convert the following direct quotes (in India) into indirect quotes:1$ = Rs.40 1£ = Rs.82 Answer: Indirect quotes (in India) Re. 1 = $ 1/40 i.e. $ 0.0250

Re. 1 = £ 1/82 i.e. £ 0.0122

Example (B) Convert the following indirect quotes (in India) into direct quotes: Re. 1 = $ 0.0222 Re. 1 = £ 0.0122

Answer : Direct quotes (In India) 1$ = Rs.1 / 0.0222 i.e. Rs.45 1£ = Rs.1/ 0.0122 i.e. Rs.82

Bid and Ask RateThe buying rate is also known as the ‘Bid rate’ and selling rate as the ‘offer/Ask‘ rate. The difference between these rates is the gross profit for the bank and is known as the ‘Spread‘.

Principal types of Rates (bank to customer) :In a purchase transaction the bank acquires foreign exchange from the customer and pays him in home currency & vise versa for sale transaction. Depending upon the time of realization of foreign exchange by the bank, two types of buying rates are quoted in India. They are

(i) TT Buying Rate (ii) Bill Buying Rate (this is explained in chapter 6, pg.no.44)

(i) TT Buying Rate (TT stands for Telegraphic Transfer):Some of the purchase transactions result in the bank acquiring foreign exchange immediately, while some involve delay in the acquisition of foreign exchange. For instance, if the bank pays a



demand drawn on it by its correspondent bank, there is no delay because the foreign corresponded bank would already have credited the Nostro account of the paying bank while issuing the demand draft.This is the rate applied when the transaction does not involve any delay in realization of the foreign exchange by the bank. In other words, the Nostro account (An account of Indian Bank with foreign bank at overseas settlement center) of the bank would already have been credited. The rate is calculated by deducting from the interbank buying rate the exchange margin as determined by the bank. Though the name implies telegraphic transfer, it is not necessary that the proceeds of the transaction are received by telegram. Any transaction where no delay is involved in the bank acquiring the foreign exchange will be done at the TT rate. Transaction where TT rate is applied is; 1. Payment of demand drafts, mail transfers, telegraphic transfers, etc drawn on the bank where banks Nostro account is already credited.2. Foreign bills collected. When a foreign bill is taken for collection, the bank pays the exporter only when the his importer at foreign destination pays for the bill by SWIFT and the banks Nostro account abroad is credited.

As relates to selling rates by bank, they are of two types:

(i) TT selling Rates (ii) Bills selling rate (this is explained in chapter 6, pg.no.45)

(i) TT Selling Rate This is the rate to be used for all transactions that do not involve handling of documents by the bank. Transactions for which this rate is quoted are: 1. Issue of demand drafts, mail transfers, telegraphic transfer, etc., other than for retirement of an import bill. 2. Cancellation of foreign exchange purchased earlier.

Margin by bank :-Exchange margin is the extra amount or percentage charged by the bank over and above the rate quoted by bank.When we are given the Spot rate / forward rate with margin for buying rate and margin for selling rate then effective rate will be calculated as:

Deduct margin from buying rate to get desired exchange rate. Hence,Now, buying rate will be = Bid rate – exchange margin Example :- Given $ = Rs. 54.480/.900 and Margin is 0.08% then the Bid rate after margin will be:$ = Rs.54.480 – 0.0435 ( 54.480 *0.08%) OR Rs. 54.480 ( 1-0.0008) = Rs. 54.436

Add margin to selling rate to get the desired rate. Hence,Now, selling rate = Ask rate + exchange margin Example: Given $ = Rs. 54.480/.900 and Margin is 0.08% then the Ask rate after margin will be:$ = Rs.54.900 + 0.0439 ( 54.900 *0.08%) OR Rs. 54.900 ( 1 + 0.0008) = Rs. 54.9439

CROSS CURRENCY RATES Before one currency gets converted into another, in most cases, it first gets converted into US Dollars. However, all those currency conversions that happen in foreign exchange, wherein one currency directly gets converted into the other currency (without converting it first to USD), are called currency cross rates, i.e, EUR (euro) / GBP (Great British pound) or GBP / Yen (Japanese yen) or GBP/Rs., Euro/Rs. etc. Sometimes we may not get a quote from market regarding our currency with foreign currency and hence we need to get by cross currency only.

How to calculate Cross currency rates?



Step 1: Review the five "major" crosses that are used to determine cross currencies. They are:EUR/USD (euro/U.S. dollar)GBP/USD (Great British Pound/U.S. dollar)USD/CHF (U.S. dollar/Swiss franc)USD/JPY (U.S dollar/Japanese Yen)AUD/USD (Australian dollar/U.S. dollar)

Step 2 : Determine the rates for the two currencies you want to calculate a cross currency rate for. Let's say you want to calculate a cross rate for the EUR/CHF and the current quote for EUR and CHF is:EUR/USD = 1.2060USD/CHF = 1.5080

Step 3: Calculate the currency cross. Multiply the first currency in the pair by the second currency in the pair. For instance, the EUR/CHF cross is calculated by multiplying the currency rate for EUR by the currency rate for CHF. The calculation is: 1.2060 x 1.5080 = 1.8186

Example a. 1USD = Rs. 40.00 1USD = CHF 1.40 1 CHF = Rs. ? Answer: 1$ = Rs.40.00 (It is Rs./$) 1$ = CHF 1.40 (It is CHF/$) Re. 1 = $ 0.0250 (It is $/Re) 1CHF = $ 0.71429 (It is $/CHF)

We have to find (Rs./CHF)Rs Rs. $----- = ----- x ----- = 40 x 0.71429 = Rs.28.5714 CHF $ CHF

Example b: Given the following rates, find ‘bid’ and ‘ask’ rates for CY in terms of rupees. 1 USD = 5.7040 – 5.7090 CY 1 USD = 40.30 - 40.50 RupeesAnswer:1$ = CY 5.7040/5.7090 (it is CY/$) 1$ = Rs.40.30/40.50 (it is Rs./$) 1CY = $(1/5.7090) / (1/5.7040 ) (it is $/CY) 1 Re. = $(1/40.50) / (1/40.30) (it is $/ Rs.)

We have to find Rs./CY. Rs. $ Rs./CY = -------- x ------- $ CYRs. / CY (bid ) = (40.30) X (1 /5.7090) = 7.0590 Rs. / CY ( ask) = (40.50) X (1/5.7040) = 7.1003 Rs. / CY = 7.0590 / 7.1003 1 CY = Rs.7.0590 / Rs.7.1003

Cross Rates and Chain Rule (India):In India, buying rates are calculated on the assumption that the foreign exchange acquired is disposed of abroad in the international market and the proceeds realized in US dollars. The US dollars thus acquired would be sold in the local interbank market to realize the rupee. For example, if the bank purchased a CHF 10,000 bill it is assumed that it will sell the Swiss francs at the Singapore market and acquire US dollars there. The US dollars are then sold in the interbank market against Indian rupee. The bank would get the rate for US dollars in terms of Indian rupees in India. This would be the interbank rate for US dollars. It would also get the rate for US dollars interms of Swiss franc at the Singapore market. The bank has to quote the rate to the customer for Swiss franc in terms of Indian rupees. The fixing of rate of exchange between the foreign currency



and Indian rupee through the medium of some other currency is done by a method known as ‘Chain Rule‘. The rate thus obtained is the ‘Cross rate‘ between these currencies.

TRANSACTIONS IN INTERBANK MARKETS :The exchange rates quoted by banks to their customer are based on the rates prevalent in the interbank market. The big banks in the market are known as market makers, as they are willing to buy or sell foreign currencies at the rates quoted by them up to any extent. Depending buy or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a bank may be a market maker in one or few major currencies.

Spot and Forward transactions :The transactions in the interbank market may place for settlement (a) on the same day; or (b) two days later; or (c) some day late; say after a month i.e Forward

Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value today.

The transaction where the exchange of currencies takes place two days after the date of the contact is known as the spot transaction. For instance, if the contract is made on Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on the same day the foreign currency is received.

What is mean by ‘Forward transactions’?The transaction in which the exchange of currencies takes places at a specified future date, subsequent to the spot date, is known as a forward transaction. The forward transaction can be for delivery one month or two months or three months etc. A forward contract for delivery one month means the exchange of currencies will take place after one month from the date of contract. A forward contract for delivery two months means the exchange of currencies will take place after two months and so on. The rates quoted for such transactions are called as ‘Forward rates’.

A forward contract is normally entered into to hedge oneself against exchange risk (i.e., the uncertainty regarding the future movements of the exchange rate). By entering into a forward contract, the customer locks-in the exchange rate at which he will buy or sell the currency.Forward rates can be derived from interest rates of the two currencies. It is basically a function of the interest rate differential between the currencies. Let us take an example :MARKET RATES :3 Month GBP : 4.0 %3 Month USD : 1.0 %Spot GBP / USD : 1.7900Interest Rate Differential --------------------------> Exchange Rate Differential(Spot Rate X Int. Rate Differential)/100 X No. of Months Forward/12 MonthsTo make it more scientific you can take the actual number of days in the month.12 months is taken as 365 for GBP and INR and 360 for other currencies as per market practice.1.7900 * 3 X 3 = 0.0134100 12SPOT RATE USD 1.7900SWAP RATE ( POINTS) 0.0134Therefore, 3 month forward rate (outright rate): USD 1.7766

Discount and Premium :A currency is said to be at premium against another currency if it is more expensive in the forward market than in the spot market. In this case, its forward rate will be higher than its spot rate. This happens when the future spot rate is expected to be higher than the current spot rate. Conversely, a currency is said to be at a discount if it is cheaper in the forward market than in the spot market.



In this case, its forward rate will be lower than its spot rate. This happens when the future spot rate is expected to be lower than the current spot rate. Let us assume the Rs/$ quotes to be:

Rs/$ : 45.42/443-m Rs/$ : 46.62/70

Here, the bank is ready to give only Rs. 45.42 currently in exchange for a dollar, while it is ready to give Rs. 46.62 after 3 months. Similarly, the bank is charging only Rs. 45.44 for selling a dollar now, while it is charging Rs. 46.70 for a delivery 3 months hence. So the dollar is expected to be more expensive in the future, and hence is at a premium against the rupee. On the other hand, the rupee is expected to be cheaper in the future and hence is at a discount against the dollar.

Let us now assume the $/£ quotes to be:$/£ : 1.6721/263-m $/£ : 1.6481/92

Here the dollar is at a premium against the pound, while the pound is at a discount against thedollar. It is possible that a currency may be at a premium against one currency, while being at a discount against another at the same time. It is also possible that a currency be at a premium against another for a particular forward maturity, while being at a discount against the same currency for another forward maturity. E.g., the $/£ quotes may be:

$/£ : 1.6721/262-m $/£ : 1.6726/343-m $/£ : 1.6481/92

Here, the pound is at a premium against the dollar for the 2-month maturity, but at a discount for the 3-month maturity. It is also possible to have such a situation where a currency is at a premium against another for a particular forward maturity, but a discount between two forward maturities. E.g., the $/£ quotes may be:

$/£ : 1.6721/261-m $/£ : 1.6730/372-m $/£ : 1.6726/35

Here, the pound is at a premium against the dollar for both the forward maturities, but at a discount between the one-month and the two-month maturities.

Forward premium/discount is generally calculated as percentage per annum.

= (Forward rate-Spot rate) 12/n. *100 Spot rateWhere ‘n’ indicates the number of months till maturity of the forward contract

Interpretation of Interbank quotations :The market quotation for a currency consists of the spot rate and the forward margin. The outright forward rate has to be calculated by loading the forward margin into the spot rate. For instance, US dollar is quoted as under in the interbank market on 25th January under:

Spot USD 1 = Rs. 68.4000/4200Spot/February 2000/2100Spot / March 3500/3600

The following points should be noted interpreting the above quotations:1. The first Statement is the spot rate for dollars. The quoting bank’s buying rate is 38.4000 and selling rate is Rs 38.4200.



2. The second and third statements are forward margins for forward delivery during the months of February and March respectively. Spot/ February rate is valid for delivery end February. Spot/ March rate is valid for delivery end March. 3. The margin is expressed in points, i e 0.0001 of the currency. Therefore, the forward margin for February is 20 paisa and 21 paise4. We have seen that under direct quotation, the first rate in the spot quotation is for buying and second for selling the foreign currency. Correspondingly, taking the forward margin, the first rate relates to buying and the second to selling. Taking Spot/February as an example, the margin of 20 paise is for purchase and 21 paise is for sale of foreign currency.5. Where the forward margin for a month’s is given in ascending order as in the quotation above, it indicated that the forward currency is at premium. The outright forward rates they arrived at by adding the forward margins to the spot rates.The outright forward rates dollar can be derived from the above quotation as follows. Buying rates selling rate

February March February March Spot rate 68.4000 68.4000 68.4200 68.4200Add: Premium 0.2000 0.3500 0.2100 0.3600Forward Rates 68.6000 68.7500 68.6300 68.7800

From the above calculation we arrive at the following outright rates: Buying rates Selling rateSpot delivery USD 1 = Rs.38.4000 38.4200Forward delivery February 38.6000 38.6300Forward delivery March 38.7500 38.7800

If the forward currency is at discount, it would be indicated by quoting the forward margin in the descending order.

Practice Problems:-Q.1 An exporter customer requests a bank to sell 25,00,000 Singapore Dollar (SGD) . The inter-bank market rates are as follows: Mumbai US$ 1= Rs.45.85/45.90 London Pound 1= USD 1.7840/1.7850 Pound 1= SGD 3.1575/3.1590 The bank wishes to retain an exchange margin of 0.125%. (Calculate rate in multiples of .0001). How many Rupees the exporter will receive?Answer:-1$ = Rs.45.85/45.90……....................... (It is Rs./$)1Re = $(1/45.90) / ( 1/45.85) (It is $/Re)1 £ = $1.7840/1.7850…… ………………… (It is $/£)1 $ = £ ( 1/1.7850) / (1/1.7840)………… ( It is £/$)1 £ = SGD 3.1575/ 3.1590…………...........(It is SGD/£)1SGD = £ (1/3.1590) / ( 1/3.1575)………… .(It is £/SGD)

Computation of SGD rate i.e. Rs/SGD.( The bank will be purchasing SGD, hence we have to calculate ‘bid’ rate.)RS = RS. X $ X £ SGD $ £ SGD Rs. (bid) = 45.85 X 1.7840 X (1/3.1590) = Rs.25.8931307375 SDGTaking bank margin into consideration bid rate per SGD: Rs.25.8931307375(1 -0.00125) i.e. Rs.25.860764324. Total receipt = 6,46,51,911

Q.3. If the spot price for USD/EUR = 0.7395, then this means that 1 USD = .7395 EUR. The interest rate in Europe is currently 3.75%, and the current interest rate in the United States is 5.25%. Calculate the 1year forward rate.



Forward Exchange Rate = S(1+rq)n

─────── (1+rb)

n

S = Spot Price rq = Interest Rate of Quote Currency rb = Interest Rate of Base Currencyn = Number of Compounding Periods = 0.7395(1+0.0375)1

───────────── (1+0.0525)1

= 0.7395 *1.0375 ─────────── 1.0525 = 0.7290Thus, the forward exchange rate is 1 USD = 0.7290 (rounded) Euro, or simply, the forward rate.

Q 4. A person has to pay $ 13750 after three months today. Spot Rate: Re l = $ 0.0275. Rupee is likely to depreciate by 5% over three months. What is likely forward rate? Answer: Rupee is left had currency. It is at discount. Amount of discount should be deducted from right hand currency for estimating the forward rate. Hence forward rate is: Re. 1 = $ 0.0275 - $ 0.0275 (5/100) i.e. 0.026125.

Q.5: Six month T bill have a nominal rate of 7%, while default free Japanese bonds that mature in 6 months have a nominal rate of 5.5%. In spot market, 1$ = Yen 86. If interest rate parity holds, what is the 6 month forward exchange rate?Answer: (1.0275/1.035) x 86 = 85.3768

Q.7 : Dollar is quoted in the interbank market as follows.Spot USD 1 = Rs. 65.3500/65.40001 months forward 2000/30002 months forward 4000/50003 months forward 6000/7000Calculate 1 month, 2 months and 3 months forward rates for dollar.

SolutionBuying 1 months 2 months 3 monthsSpot rate 65.3500 65.3500 65.3500Add: Premium 0.2000 0.4000 0.6000Forward Rates 65.5500 65.7500 65.9500

Selling 1 months 2 months 3 monthsSpot rate 65.4000 65.4000 65.4000Add: Premium 0.3000 0.5000 0.7000Forward Rates 65.7000 65.9000 66.1000

*****



CHAPTER 2FOREX DERIVATIVES

The financial environment today has more risks than earlier. Successful business firms are those that are able to manage these risks effectively. Due to changes in the macroeconomic structures and increasing internationalization of businesses, there has been a dramatic increase in the volatility of economic variables such as interest rates, exchange rates, commodity prices etc. Firms that monitor their risks carefully and manage their risks with judicious policies enjoy a more stable business than those who are unable to identify and manage their risks. There are many risks which are influenced by factors external to the business and therefore suitable mechanisms to manage and reduce such risks need to be adopted. One of the modern day solutions to manage financial risks is ‘hedging’. Before trying to understand hedging as a risk management tool, we need to have a proper understanding of the term ‘risk’ and the various types of risks faced by firms.

What is risk? Risk, in simple terms, may be defined as the uncertainty of returns. Risks arise because of a number of factors, but can be broadly classified into two categories: as business risks and financial risks. Business risks include strategic risk, macroeconomic risk, competition risk and technological innovation risk. Managers should be capable of identifying such risks, adapting themselves to the new environment and maintaining their competitive advantage. Financial risk, on the other hand, is caused due to financial market activities and includes liquidity risk and credit risk.

Risk Management An effective manager should be aware of the various financial instruments available in the market for managing financial risks. There are many tools for the same and a judicious mix of various tools helps in efficient risk management. Since the early 1970s, the world has witnessed dramatic increases in the volatility of interest rates, exchange rates and commodity prices. This is fuelled by increasing internationalization of trade and integration of the world economy, largely due to technological innovations. The risks arising out of this internationalization are significant. They have the capacity to make or break not only businesses but also the economies of nations. However, financial institutions are now equipped with tools and techniques that can be used to measure and manage such financial risks. The most powerful instruments among them are derivatives. Derivatives are financial instruments that are used as risk management tools. They help in transferring risk from the risk averse to the risk taker.

Derivatives are financial contracts whose value is determined from one or more underlying variables, which can be a stock, a bond, an index, an interest rate, an exchange rate etc. The most commonly used derivative contracts are forwards and futures contracts and options. There are other types of derivative contracts such as swaps, options, etc.

Currency derivatives can be described as contracts between the sellers and buyers whose values are derived from the underlying which in this case is the Exchange Rate. Currency derivatives are mostly designed for hedging purposes, although they are also used as instruments for speculation. Currency markets provide various choices to market participants through the spot market or derivatives market. Before explaining the meaning and various types of derivatives contracts, let us present three different choices of a market participant.

The market participant may enter into a spot transaction and exchange the currency at current time. The market participant wants to exchange the currency at a future date. Here the market participant may either: • Enter into a futures/forward contract, whereby he agrees to exchange the currency in the future at a price decided now, or,



• Buy a currency option contract, wherein he commits for a future exchange of currency, with an agreement that the contract will be valid only if the price is favorable to the participant.

Forward Contracts : Forward contracts are agreements to exchange currencies at an agreed rate on a specified future date. The actual settlement date is more than two working days after the deal date. The agreed rate is called forward rate and the difference between the spot rate and the forward rate is called as forward margin. Forward contracts are bilateral contracts (privately negotiated), traded outside a regulated stock exchange and suffer from counter-party risks and liquidity risks. Counter Party risk means that one party in the contract may default on fulfilling its obligations thereby causing loss to the other party.

In the previous chapter we have seen how to calculate the forward rates.

Example: Forward Discount/ PremiumIf the ninety day ¥ / $ forward exchange rate is 109.50 and the spot rate is ¥ / $ = 109.38, then the dollar is considered to be "strong" relative to the yen, as the dollar's forward value exceeds the spot value. The dollar has a premium of 0.12 yen per dollar. The yen would trade at a discount because its forward value in terms of dollars is less than its spot rate.

The annualized rate can be calculated by using the following formula: Formula :-Annualized = Forward Price – Spot Price x 12 x 100%Forward Premium Spot Price # of months

forwardAnswer:So in the case listed above, the premium would be calculated as:Annualized forward premium=

((109.50 – 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%

Similarly, to calculate the discount for the Japanese yen, we first want to calculate the forward and spot rates for the Japanese yen in terms of dollars per yen. Those numbers would be (1/109.50 = 0.0091324) and (1/109.38 = 0.0091424), respectively.

So the annualized forward discount for the Japanese yen, in terms of U.S. dollars, would be: ((0.0091324 – 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%

See Chapter FEDAI rules for more calculations & situations of forward contract.

International Swaps and Derivatives Association - ISDAAn association created by the private negotiated derivatives market that represents participating parties. This association helps to improve the private negotiated derivatives market by identifying and reducing risks in the market.

Futures Contracts (Please also refer more on this in chapter Treasury Products in Module C of this notes)Futures contracts are also agreements to buy or sell an asset for a certain price at a future time. Unlike forward contracts, which are traded in the over-the-counter market with no standard contract size or standard delivery arrangements, futures contracts are exchange traded and are more standardized. They are standardized in terms of contract sizes, trading parameters, settlement procedures and are traded on a regulated exchange. The contract size is fixed and is referred to as lot size. Since futures contracts are traded through exchanges, the settlement of the contract is guaranteed by the exchange or a clearing corporation and hence there is no counter party risk. Exchanges guarantee the execution by holding an amount as security from both the parties. This amount is called as Margin money. Futures contracts provide the flexibility of closing out the



contract prior to the maturity by squaring off the transaction in the market. Table will draws a comparison between a forward contract and a futures contract.

I) Currency Futures in India:-A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures contract”. When the underlying is an exchange rate, the contract is termed a “currency futures contract”. Both parties of the futures contract must fulfill their obligations on the settlement date. Currency futures are a linear product, and calculating profits or losses on these instruments is similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also the “tick” value. A tick is the minimum size of price change. The market price will change only in multiples of the tick. Tick values differ for different currency pairs and different underlyings. For e.g. in the case of the USDINR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. 44.7500. One tick move on this contract will translate to Rs.44.7475 or Rs.44.7525 depending on the direction of market movement. The contract amount (or “market lot”) is the minimum amount that can be traded. Therefore, the profit/loss associated with change of one tick is: tick x contract amount The value of one tick on each USDINR contract is Rupees 2.50 (1000 X 0.0025). So if a trader buys 5 contracts and the price moves up by 4 ticks, he makes Rupees 50.00 (= 5 X 4 X 2.5)(Note: The above examples do not include transaction fees and any other fees, which are essential for calculating final profit and loss).

Futures terminology:-Some of the common terms used in the context of currency futures market are given below:• Spot price: The price at which the underlying asset ($, £, €, ¥ etc.) trades in the spot market. • Futures price: The current price of the specified futures contract.• Contract cycle: The period over which a contract trades. The currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-month expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time. • Value Date/Final Settlement Date: The last business day of the month will be termed as the Value date / Final Settlement date of each contract. The last business day would be taken to be the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by Foreign Exchange Dealers’ Association of India (FEDAI).• Expiry date: Also called Last Trading Day, it is the day on which trading ceases in the contract; and is two working days prior to the final settlement date.• Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. In the case of USDINR it is USD 1000; EURINR it is EUR 1000; GBPINR it is GBP 1000 and in case of JPYINR it is JPY 100,000.

Currency Futures

Exporters/Long on Foreign Currency

Importers/Short on Foreign Currency

Short Currency future hedge Long Currency future hedge



• Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.• Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.

CASE STUDIES:-Example 1: An exporter of garments from India has contracted to export 10,000 pieces of shirt to a large retailer in US. The agreed price was USD 100 per shirt and the payment would be made three months after the shipment. The exporter would take one month to manufacture the shirt. The exporter had used the prevailing spot price of 45 as the budgeted price while signing the export contract. To avoid the FX risk, the exporter sells four month futures at the price of 46. The exporter receives USD well on time and he converts USD to INR in the OTC market at the then prevailing price of 47 and also cancels the futures contract at the same time at the price of 47.20. How much was the effective currency price for the exporter. The effective price would be summation of effect of change in USDINR price on the underlying trade transaction and the effect of change in future price on the currency futures contract.• Underlying trade transaction: Against the budget of 45, the exporter realizes the price of 47 and therefore there is a net positive change of Rs 2• Futures contract: Against the contracted price of 46, the exporter had to settle the contract at 47.2 and therefore resulting in a net negative change of Rs 1.2• Combined effect: The combined effect of change in USDINR spot price and change in future price i.e. (Rs 2) + (- Rs 1.2) = + Rs 0.8• Effective price: Therefore the effective price was 45 (budgeted price) + 0.8 (effect of hedging and underlying trade transaction) i.e. Rs 45.8. In the same example, assume that INR appreciated against USD at time of converting USD to INR the spot was 44 and futures contract’s cancellation rate was 44.2, the effective currency price for the exporter would still be 45.8. This is because there would be a negative change of Rs 1 on underlying trade transaction and a positive change of Rs 1.8 on futures contract. Therefore the net effect will be summation of – 1 and + 1.8 i.e.Rs 0.8. Please notice that because of the futures contract exporter always gets a price of 45.8 irrespective of depreciation or appreciation of INR. However, not using currency futures would have resulted in effective rate of 47 (in the first case when INR depreciated from 45 to 47) and effective rate of 44 (in the second case when INR appreciated from 45 to 44). Thus using currency futures, exporter is able to mitigate the risk of currency movement.

2. Let us take an example where an importer hedges only partial amount of total exposure. This example will also demonstrate the method of computing payoff when hedging is done for partial exposure. An importer of pulses buys 1000 tons of chickpea at the price of USD1600 per ton. On the day of finalizing the contract, USDINR spot price was 45. The importer was not sure about the INR movement in future but he was more biased towards INR appreciation. He decides to hedge half of the total exposure using currency futures and contracted a rate of 45.5 for two month contract. In the next two months, INR depreciated to 46.5 at the time of making import payment. Let us assume that the day of making import payment coincides with expiry of future contract and the settlement price of futures contract was declared as 46.7. What was the effective USDINR for the importer and what would it have been had he hedged the full exposure. The effective price would be summation of final price at which import remittance was made and payoff from the futures contract.• Futures contract: Against the contracted price of 45.5, the importer settled the contract at 46.7, thereby resulting in a net positive change of Rs 1.2. Since importer hedged only half of the total exposure, the net inflow from hedging would be available for half of total exposure. • Effective price computation: Therefore the effective price would be 46.5 (final remittance price) for the unhedged part and 45.3 for the balance half which was hedged. The figure of 45.3 is computed by deducting 1.2 (inflow from hedging) from 46.5. Therefore final effective price would be:(46.5 x 0.5) + (45.3 x 0.5) = 45.9



Please note that since it is import payment and a lower USDINR exchange rate would be positive for the importer, therefore a positive inflow from future contract is reduced from the remittance price to compute effective price for the hedged part. As against the effective price of 45.9, the price would have been 45.3 had the importer decided to hedge the total exposure. Also note that without hedging, the effective price would have been 46.5 i.e., the price at which importer made the import remittance.Did you notice that in the second scenario of full hedging, the effective price (45.3) is different from the contracted price of futures (45.5)? The difference is due to the difference in the final settlement price of futures contract and the price at which remittance was done.

1. Mark to market Case study:On Monday HLL enters into a future contract of purchasing $1,25,000/- at the rate of $ = Rs.44.50. This contract is to mature on Thursday. At the close of trading on Monday, Tuesday & Wednesday, the future prices are Rs.44.42, 44.65 & 44.22. At the close of trading on Thursday, the spot rate in Rs.44.10. What amount the investor receives / pays on different days? Explain the outcome of the contract explaining the theoretical concepts of the different steps. Initial margin is 1.25% of contract amount. That means HLL has to deposit = $ 125000 X Rs.44.50 = Rs.55,62,500 X 1.25% = Rs.69,531/- to exchange for this future contract.

The payoff table on mark to market daily basis will be as follows:

Day Market rate Strike Price

Gain or loss

Total Gain or loss on contract

Margin Account cash flow

Monday 44.42 44.50 - 0.08 - Rs.10,000 Rs.59,531Tuesday 44.50 44.50 0.00 0 Rs.59,531Wednesday 44.65 44.50 0.15 + Rs.15,000 Rs.74,531Thursday 44.90 44.50 0.40 + Rs.40,000 Rs.1,14,531

Here from the above we can conclude that HLL by entering in future contract gained by Rs.15,000+Rs.40,000 – Rs.10,000 = Rs.45,000/-

This can be confirmed :- Margin account bal. Rs.1,14,531 – Initial Margin Rs.69,531 = Rs.45,000/- If the rupee will trade at the premium then HLL will suffer a loss as given in following table

Day Market rate Strike Price

Gain or loss

Total Gain or loss on contract

Margin Account cash flow

Monday 44.58 44.50 0.08 + Rs.10,000 Rs.79,531Tuesday 44.50 44.50 0.00 0 Rs.79,531Wednesday 44.35 44.50 - 0.15 - Rs.15,000 Rs.64,531Thursday 44.10 44.50 - 0.40 - Rs.40,000 Rs.24,531

That means HLL lost Rs.45,000/- by entering future contract due to appreciation of rupee.

2) Currency Option:As the word suggests, option means a choice or an alternative. To explain the concept though an example, take a case where you want to a buy a house and you finalize the house to be bought. On September 1st 2011, you pay a token amount or a security deposit of Rs 20,000 to the house seller to book the house at a price of Rs 15,00,000 and agree to pay the full amount in three months i.e., on November 30th 2011. After making full payment in three months, you get the ownership right of the house. During these three months, if you decide not to buy the house, because of any reasons, your initial token amount paid to the seller will be retained by him.In the above example, at the expiry of three months you have the option of buying or not buying the house and house seller is under obligation to sell it to you. In case during



these three months the house prices drop, you may decide not to buy the house and lose the initial token amount. Similarly if the price of the house rises, you would certainly buy the house. Therefore by paying the initial token amount, you are getting a choice/ option to buy or not to buy the house after three months. The above arrangement between house buyer and house seller is called as option contract. We could define option contract as below:

Option: It is a contract between two parties to buy or sell a given amount of asset at a pre- specified price on or before a given date.

We will now use the above example, to define certain important terms relating to options. • The right to buy the asset is called call option and the right to sell the asset is called put option. • The pre-specified price is called as strike price and the date at which strike price is applicable is called expiration date.• The difference between the date of entering into the contract and the expiration date is called time to maturity. • The party which buys the rights but not obligation and pays premium for buying the right is called as option buyer and the party which sells the right and receives premium for assuming such obligation is called option seller/ writer. • The price which option buyer pays to option seller to acquire the right is called as option price or option premium• The asset which is bought or sold is also called as an underlying or underlying asset.

Buying an option is also called as taking a long position in an option contract and selling is also referred to as taking a short position in an option contract.

There are two types of Currency options i.e CALL & PUT as elucidated below.

For example, a ABC Ltd having a liability in Euro with a view that the Euro/USD rate will be higher on maturity date will buy an Euro call. On the maturity date, he has the option to buy the Euro at the strike price or buy it from the market in case it is cheaper. If the ABC Ltd buys a Call Option with a strike price at 0.9000 and on maturity date, the rate is 0.8700, the ABC Ltd has the right to exercise the option. Since in the example cited, it would be cheaper for the ABC Ltd to by the Euro from the market, the ABC Ltd -will not exercise the option

Style of optionsBased on when the buyer is allowed to exercise the option, options are classified into two types:A. European options: European options can be exercised by the buyer of the option only on theexpiration date. In India, all the currency options in OTC market are of European type.

B. American options: American options can be exercised by the buyer any time on or before the expiration date. Currently American options are not allowed in currencies in India.

Illustration:-Purchased Call option: Corporate buys a USD call option for covering its import transactions from a ABN AMRO bank on 1 June 2011, at a strike rate of 45.50. The expiry date is 3 months i.e. 31st August 2011. The premium is 30 paise on the call. Gain or loss at various levels of exchange rate are demonstrated below vide pay off table

Market Exercise Rate call Premium paid Gain/Loss

Currency options

Call Options(Right to buy but no obligation to buy)

Put Option(Right to sale but no obligation to sale)



Rate @ 45.5043.00 0.00 0.30 -0.3043.50 0.00 0.30 -0.3044.00 0.00 0.30 -0.3044.50 0.00 0.30 -0.3046.00 0.50 0.30 0.2046.50 1.00 0.30 0.7047.00 1.50 0.30 1.20

When spot exchange rate rises above the strike price, there are gains, when it falls below the strike price there are losses, which are maximum to the extent of premium paid.That means it is always advisable to exercise Call Option when the spot rate is more and strike price is lower.

Illustration:-Buying Put Option : A leading garment exporter sold Put option in which USD shall be purchased at 45.50, Premium paid for buying put option is 30 paise. Gain or loss at various levels of exchange rate are shown above vide pay off table is given below.

Market Rate

Exercise Rate @ 45.50 Premium paid Gain/Loss

44.00 1.00 0.30 0.7045.00 - 0.50 0.30 0.3046.00 0.00 0.30 0.3046.50 0.00 0.30 0.3047.00 0.00 0.30 0.30

When spot exchange rate rises above the strike price, the put option will not give any profit but when it falls below the strike price there are profits.That means it is always advisable to exercise Put Option when the spot rate is less and strike price is higher.

Selling Put Option : A leading garment exporter sold Put option in which USD shall be purchased at 45.50, Premium paid for buying put option is 30 paise. Gain or loss at various levels of exchange rate are shown above vide pay off table is given below.

Market Rate

Exercise Rate selling put @ 45.50

Premium Received

Gain/Loss

45.00 - 0.50 0.30 - 0.2046.00 0.00 0.30 0.3046.50 0.00 0.30 0.3047.00 0.00 0.30 0.3047.50 0.00 0.30 0.30

When spot exchange rate rises above the strike price, there are gains, when it falls below the strike price there are losses, which are maximum to the extent of premium received.That means it is always advisable to exercise Put Option when the spot rate is more and strike price is lower.

From above three illustrations one must conclude that the strategy will depend on the following factors:

1. Who is a party to options i.e Importer or Exporter2. Perception of exchange rate movement i.e At premium or at Discount3. Premium to paid/received



What is meant by the terminology that an option is in the money, at the money, or out-of-the-money? Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money.

If St ≅ E the option is trading at-the-money.

If St < E (E < St) the call (put) option is trading out-of-the money.

St = Strike PriceE = Exercise Price

CASE STUDIES:-1. An American manufacturer ABC plc. Ltd purchases Japanese goods worth 90 million Yens, credit terms 1 month. i.e. the manufacturer has to pay ,after one month, the Japanese company 90 million Yen no matter what happens to the Yen-Dollar rate. That means the American co. is at risk if the rate is not favorable. Here ABC plc. Ltd can hedge this risk by entering into option contract. The co can buy a foreign currency option which gives him the right but not the obligation to buy 90 million yen at 110 Yens per Dollar. The option carries a premium or cost of US $ 0.02 million. Now there can be Three Possibilities as regards this call option:-a. If Yen Falls: Say 120 yens per US $ then ABC plc. Ltd will purchase Yens from the market instead of going for option as he will need to pay only 0.75 million US $ to spot market. The Co. will benefit even if they lost the premium on call option.

b. If Yen is Stable: ABC plc. Ltd purchases 90 million Yens either from the market or under his option. He has to pay US $ 1.0909 million. Cost is $0.02 million, i.e. premium for purchasing option.

c. If Yen Rises or will be at premium: Suppose after three months, yen rises to 100 Yen per US $. If ABC plc. Ltd purchases Yens from the market, he has to pay 90 million / 100. i.e., 0.90 million US $. That means co. can purchase yen by paying $ 9,00,000.

Whereas if Co. exercises the option, he can purchase 90 million Yens for at 110 yens per dollar or 90million/110 i.e 0.818 million US $. Or co. can purchase yen by paying $ 8,18,182. That means a savings of $ 81818.00 over spot market.

And therefore Co. should exercise the option as the Net saving is $ 81,818 – Premium paid $20,000 = $ 61,818

2. An American firm has just bought merchandise from a British firm for £50,000 on terms of net 90 days. The U.S. company has purchased a 3-month call option of 50,000 pounds at a strike of $1.7 per pound and premium cost of $0.02 per pound. On the day the option matures, the spot exchange rate is $1.8 per pound. Should the U.S. company exercise the option at that time or buy British pounds in the spot market?

A. exercise the option B. buys British pound spotC. does not make any difference D. cannot tellE. none of the above

Answer:- A… Explanation for answer:-Here since American Firm is an importer and therefore need pounds to be delivered. Hence will go for call option for to hedge position of purchase of £.

The contract in $ terms will beCall option = £50,000 x $1.7 = $85,000, that means in this option the American firm can get £50,000 by giving $85000.



Now since this contract is of 3 months, on the maturity the American firm has decide what to do with this contract either to exercise or leave it. If the rate favours the American firm then they will go with exercising the option under the contract. That means they will purchase the £ by giving $.

On maturity the spot rate is $1.8 which means if the American Firm not exercised the call option they need to have spend in Spot transaction = £50,000 x $1.8 = $90,000.

Here, it is now very much clear that Spot transaction is not beneficial to firm and hence, the U.S. company should exercise the call option which will save $5,000 over the spot transaction.

3. An American firm has just bought merchandise from a British firm for £50,000 on terms of net 90 days. The U.S. company has purchased a 3-month call option on 50,000 pounds at a strike price of $1.7 per pound and a premium cost of $0.02 per pound. On the day the option matures, the spot exchange rate is $1.8 per pound. What will be the approximate value of the pound payable in U.S. dollars if the U.S. company exercises the option at that time?

A. $91,000 B. $90,000 C.$86,000 D. $85,000 E. $81,000

Answer :- D :- Call option = £50,000 x $1.7 = $85,000

4. Assume that on 1st December 2011, USD-INR spot was at 45, premium for January 2012 maturity put option at strike of 45.5 is INR 0.54/0.55 and premium for January 2011 maturity call option at strike of 45 is INR 0.71/0.72. A client executes a trade wherein, client has entered sales put (i.e he will be put writer) at a strike of 45.5 and a call at a strike of 45. On expiry the RBI reference rate is 46.07. How much net profit/loss did the client make per USD?(a) Loss of INR 0.2 (b) Profit of INR 0.15 (c) Profit of INR 0.91 (d) Loss of INR 0.96

Answer:- (c) …. Sale Put at strike price of Rs.45.5 and he must have received premium of Rs.0.55.Call at Strike price of Rs.45.00 and he must have paid premium of Rs.0.71.

Now rate at the maturity is Rs.46.07, here the put buyer will not exercise the put option at strike price of Rs.45.50 (as the strike price is lower than RBI reference rate) and therefore the client as put writer will retain the premium.

However since he has in the money for call option (strike price is less than reference rate) he will benefit as 46.07 – 45 = 1.07

Now, Net payoff on this option strategy is = Rs.1.07 + 0.55- 0.71 = Profit of Rs.0.91

5. Assume today’s closing price on a NSE futures contract is $0.9716/EUR. You have a short (future sale) position in one contract with strike price today’s closing. Your margin accountcurrently has a balance of $1,700. The next three days’ settlement prices are $0.9702, $0.9709, and $0.9762. Calculate the changes in the margin account from daily marking-to-market and the balance of the margin account after the third day. Contract of € 1,25,000.Solution:$1,700 + [($0.9716 – $0.9702) + ($0.9716 – $0.9709) + ($0.9716 – $0.9722)] x €125,000 = Or $ 1,700 + [$0.0014 + $0.0007 - $0.0006 ] X € 125000= $1,887.50.

6. Mr. Martin enters into one contract of purchasing futures of GBP on January 27, 2011 at a price of £ = 1.50 USD. The standard size of one future contract is £1,00,000. Using rates of £ = $ on different date: find gain /loss of Mr. Martin at this closing of each of above mentioned dates. January 27 $ 1.38, January 28 $ 1.56, January 29 $ 1.63, January 30 $ 1.28, January 31 $ 1.81.



If the initial margin if $ 5,000 per contract and maintenance margin is $ 3,000 per contract, show Mr. Martin’s margin account (also called as equity account) and the additional deposits to be made (assume no withdrawals).

Date Market rate£ = $

Difference = strike & closing

Adjustment in margin + / - Additional Deposit required above $ 8000

27.01 1.38 - 0.12 100000 x -0.12 = $ -12,000 $ 4,00028.01 1.56 + 0.06 100000 x 0.06 = $ 6,000 029.01 1.63 + 0.13 100000 x 0.13 = $ 13,000 030.01 1.28 - 0.22 100000 x -0.22 = $ - 22,000 $ 10,00031.01 1.81 + 0.31 100000 x 0.31 = $ 33,000 0

7. A Singapore based firm exported goods to an Australian firm, invoice Australian dollars 4,00,000 on 2nd April, 2011, the payment is due on 25thJune 2011. On 18thApril, 2011, the finance manager of the Singapore firm got an indication that the Singapore Dollar (SGD) will appreciate against Australian Dollar (AUD). The following foreign exchange rates are quoted on 18th April, 2011 : Spot SGD/AD = 1.4760 & Dec. 2011 futures contract SGD/AUD = 1.4835. The standard size of the futures contract is AUD 1,00,000. a. Suggest the hedging Strategy? Assuming that the finance manager follows your suggestion, find net cash inflow on 25th June, 2011 assuming that on that day the following rates were prevailed in the market:Spot SGD/AUD = 1.4275 Dec. 2007 futures contract SGD/AUD = 1.3998.

b. In Singapore, the forward price on SGD for delivery in 60 days is quoted at 1.60 per USD. The futures market price for a similar contract is 0.65. Is there some arbitrage opportunity? Answer:-

a. For hedging a firm need to buy future sale contract at a strike price of SGD = 1.4845.The pay off at the date of cash flow i.e 25th June,2011, will be as follows:4 contracts of AUD 1,00,000 will have to be entered.Now on 25th June the strike 1.4845 and spot is 1.4275 and hence we will gain 1.4845 – 1.4275 = AUD 0.057 x 4,00,000 = AUD 22,800.So there is profit in going with futures.

b. Forward price: 1 $ = 1.60SGD. Future prices are in indirect quotations. Hence direct quote for future price: 1SGD = 0.65$ means 1 / $0.65= 1$ = 1.5385 SGD Arbitrage opportunity is there. Buy $ in futures market @ 1.5385 SGD.

8. Mihan Ltd has purchased a 3-months call option of € with an exercise price of Rs.71. Determine the value of Call option at expiration if the Euro price at expiration turns out to be either 67 or 74.Answer: Spot price on maturity Value call option € 67 0 € 74 Rs.3

9. A US importer has decided to buy German goods worth € 105,000 and must settle the account in a month’s time. At the moment, the spot exchange rate is US $0.7284/€. He runs the risk that the euro will appreciate against the dollar, pushing up his dollar costs. One solution would be to buy a euro contract on the CME (each contract is worth €125,000) at the futures rate of US $0.7458. In a month’s time, the spot rate might move to US $0.7444 and the futures price to US $0.7430. If he chose to go ahead with future what will be gain or loss:Answer:



So the rise in the cost of the goods would be (US $0.7444 – US $0.7284) x €125,000 = US $2,000 if not going ahead with futures.However, he can close out the futures position at a profit of US $ 350:(US $0.7458 – US $0.7430) x €125,000. Thus, despite the fact that the contract size exactly matched his exposure, the hedger still actually lost out slightly. This is because the cash and futures markets did not move exactly in tandem. If rates had not moved in his favour, the exporter would have lost money on the futures position but gained on the post transaction.The short hedge would work in the same way. An exporter contracted to sell US goods for a fixed sum in deutschmarks runs the risk that the deutschmark will decline against the dollar. He would sell the appropriate number of contracts to hedge this risk.

10. An IT professional buys a house for INR 500,000 for which payment has to be made after three months. As he is expecting to receive USD 10,000 in three months, he executes 10 USDINR futures contracts to hedge currency risk at a price of 50. When he received the payment, he converted USD into INR with his bank at a price of 51 for making the payment for the house and also settles the contract at a price of 49. Given this situation, would he have sold/ bought USDINR futures and would the effective price for house be lower than or higher than USD 10,000?(a) Bought, Higher (b) Sold, Higher (c) Bought, Lower (d) Sold, Lower

11. A trader executes following currency futures trade: buys one lot of USD/INR, sells one lot of JPY/INR. What view has he executed?(a) JPY strengthening against USD (b) JPY weakening against USD (c) INR strengthening against USD (d) INR weakening against JPY

Unsloved:Q:1 An oil-importing firm - ABC Co. is expected to make future payments of USD 100000 after 3 months (in USD) for payment against oil imports. Suppose the current 3-month futures rate is Rs. 60. ABC Co. can go ____ in the futures contract to hedge itself. (a) Short (b) Long

Q:2 A speculator buys 107 USD-INR contracts @ Rs. 49.00 per contract and sells them @ Rs. 50.00 per contract. Assuming 1 contract = 1000 USD, the total profit made by the speculator is Rs. ______ (a) 107000 (b) 109000 (c) 1070 (d) 10700

Q:3 A speculator buys 65 USD-INR contracts @ Rs. 41.00 per contract and sells them @ Rs. 42.00 per contract. Assuming 1 contract = 1000 USD, the speculator ends up with a _____. (a) loss (b) profit (c) no profit no loss Q:4 A speculator sells 65 USD-INR contracts @ Rs. 41.00 per contract and buys them @ Rs. 40.00 per contract. Assuming 1 contract = 1000 USD, the speculator ends up with a _____. (a) loss (b) profit (c) no profit no loss

Q.5 A person has invested USD 100,000 in US equities with a view of appreciation of US stock market. In next one year, his investments in US equities appreciated in value to USD120,000. The investor decided to sell off his portfolio and repatriate the capital and profits to India. At the time of investing abroad the exchange rate was 44.5 and at the time of converting USD back into INR, he received an exchange rate of 46. How much is the return on investment in USD and in INR respectively?(a) 20%, 16% (b) 20%, 24% (c) 20%, 20% (d) 20%, 18%

***END****



CHAPTER 3LC & UPCDC 600

IntroductionLetter of Credit L/c also known as Documentary Credit is a widely used term to make payment secure in domestic and international trade. The document is issued by a financial organization at the buyer request. Buyer also provide the necessary instructions in preparing the document. The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for Documentary Credit (UCPDC) defines L/C as: "An arrangement, however named or described, whereby a bank (the Issuing bank) acting at the request and on the instructions of a customer (the Applicant) or on its own behalf :

1. Is to make a payment to or to the order third party (the beneficiary) or is to accept bills of exchange (drafts) drawn by the beneficiary.

2. Authorised another bank to effect such payments or to accept and pay such bills of exchange (draft).

3. Authorised another bank to negotiate against stipulated documents provided that the terms are complied with.

A key principle underlying letter of credit (L/C) is that banks deal only in documents and not in goods. The decision to pay under a letter of credit will be based entirely on whether the documents presented to the bank appear on their face to be in accordance with the terms and conditions of the letter of credit.

Parties to Letters of Credit Applicant (Opener): Applicant which is also referred to as account party is normally a buyer

or customer of the goods, who has to make payment to beneficiary. LC is initiated and issued at his request and on the basis of his instructions.

Issuing Bank (Opening Bank) : The issuing bank is the one which create a letter of credit and takes the responsibility to make the payments on receipt of the documents from the beneficiary or through their banker. The payments has to be made to the beneficiary within seven working days from the date of receipt of documents at their end, provided the documents are in accordance with the terms and conditions of the letter of credit. If the documents are discrepant one, the rejection thereof to be communicated within seven working days from the date of of receipt of documents at their end.

Beneficiary : Beneficiary is normally stands for a seller of the goods, who has to receive payment from the applicant. A credit is issued in his favour to enable him or his agent to obtain payment on surrender of stipulated document and comply with the term and conditions of the L/c.

If L/c is a transferable one and he transfers the credit to another party, then he is referred to as the first or original beneficiary.

Advising Bank : An Advising Bank provides advice to the beneficiary and takes the responsibility for sending the documents to the issuing bank and is normally located in the country of the beneficiary.

Confirming Bank : Confirming bank adds its guarantee to the credit opened by another bank, thereby undertaking the responsibility of payment/negotiation acceptance under the credit, in additional to that of the issuing bank. Confirming bank play an important role where the exporter is not satisfied with the undertaking of only the issuing bank.

Negotiating Bank: The Negotiating Bank is the bank who negotiates the documents submitted to them by the beneficiary under the credit either advised through them or restricted to them for negotiation. On negotiation of the documents they will claim the reimbursement under the credit and makes the payment to the beneficiary provided the documents submitted are in accordance with the terms and conditions of the letters of credit.

Reimbursing Bank : Reimbursing Bank is the bank authorized to honor the reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating bank. It is normally the bank with which issuing bank has an account from which payment has to be made.



Second Beneficiary : Second Beneficiary is the person who represent the first or original Beneficiary of credit in his absence. In this case, the credits belonging to the original beneficiary is transferable. The rights of the transferee are subject to terms of transfer.

Process involved in Letter of Credits.

The following is a step-by-step description of a typical Letter of Credit transaction:

1. An Importer (Buyer) and Exporter (Seller) agree on a purchase and sale of goods where payment is made by Letter of Credit.

2. The Importer completes an application requesting its bank (Issuing Bank) to issue a Letter of Credit in favor of the Exporter. Note that the Importer must have a line of credit with the Issuing Bank in order to request that a Letter of Credit be issued.

3. The Issuing Bank issues the Letter of Credit and sends it to the Advising Bank by telecommunication or registered mail in accordance with the Importer’s instructions. A request may be included for the Advising Bank to add its confirmation. The Advising Bank is typically located in the country where the Exporter carries on business and may be the Exporter’s bank but it does not have to be.

4. The Advising Bank will verify the Letter of Credit for authenticity and send a copy to the Exporter.

5. The Exporter examines the Letter of Credit to ensure:a. It corresponds to the terms and conditions in the purchase and sale agreement;

b. Documents stipulated in the Letter of Credit can be produced; and

c. The terms and conditions of the Letter of Credit may be fulfilled.6. If the Exporter is unable to comply with any term or condition of the Letter of Credit or if the Letter of Credit differs from the purchase and sale agreement, the Exporter should immediately notify the Importer and request an amendment to the Letter of Credit.



7. When all parties agree to the amendments, they are incorporated into the terms of the Letter of Credit and advised to the Exporter through the Advising Bank. It is recommended that the Exporter does not make any shipments against the Letter of Credit until the required amendments have been received.

8. The Exporter arranges for shipment of the goods, prepares and/or obtains the documents specified in the Letter of Credit and makes demand under the Letter of Credit by presenting the documents within the stated period and before the expiry date to the “available with” Bank. This may be the Advising/Confirming Bank. That bank checks the documents against the Letter of Credit and forwards them to the Issuing Bank. The drawing is negotiated, paid or accepted as the case may be.

9. The Issuing Bank examines the documents to ensure they comply with the Letter of Credit terms and conditions. The Issuing Bank obtains payment from the Importer for payment already made to the “available with” or the Confirming Bank.

10. Documents are delivered to the Importer to allow them to take possession of the goods from the transport company. The trade cycle is complete as the Importer has received its goods and the Exporter has obtained payment.

Types of Letter of Credit :1. Revocable Letter of Credit L/cA revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. It is rarely used in international trade and not considered satisfactory for the exporters but has an advantage over that of the importers and the issuing bank.There is no provision for confirming revocable credits as per terms of UCPDC, Hence they cannot be confirmed. It should be indicated in LC that the credit is revocable. if there is no such indication the credit will be deemed as irrevocable.2. Irrevocable Letter of CreditL/c In this case it is not possible to revoked or amended a credit without the agreement of the issuing bank, the confirming bank, and the beneficiary. Form an exporters point of view it is believed to be more beneficial. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are complied with, payment will be made. 3. Confirmed Letter of Credit L/cConfirmed Letter of Credit is a special type of L/c in which another bank apart from the issuing bank has added its guarantee. Although, the cost of confirming by two banks makes it costlier, this type of L/c is more beneficial for the beneficiary as it doubles the guarantee. 4. Sight Credit and Usance Credit L/cSight credit states that the payments would be made by the issuing bank at sight, on demand or on presentation. In case of usance credit, draft are drawn on the issuing bank or the correspondent bank at specified usance period. The credit will indicate whether the usance draft are to be drawn on the issuing bank or in the case of confirmed credit on the confirming bank.5. Back to Back Letter of Credit L/cBack to Back Letter of Credit is also termed as Countervailing Credit. A credit is known as backtoback credit when a L/c is opened with security of another L/c. A backtoback credit which can also be referred as credit and countercredit is actually a method of financing both sides of a transaction in which a middleman buys goods from one customer and sells them to another.The parties to a BacktoBack Letter of Credit are: 1.The buyer and his bank as the issuer of the original Letter of Credit. 2. The seller/manufacturer and his bank, 3. The manufacturer's subcontractor and his bank.

The practical use of this Credit is seen when L/c is opened by the ultimate buyer in favour of a particular beneficiary, who may not be the actual supplier/ manufacturer offering the main credit



with near identical terms in favour as security and will be able to obtain reimbursement by presenting the documents received under back to back credit under the main L/c.

6. Transferable Letter of Credit L/cA transferable documentary credit is a type of credit under which the first beneficiary which is usually a middleman may request the nominated bank to transfer credit in whole or in part to the second beneficiary. The L/c does state clearly mentions the margins of the first beneficiary and unless it is specified the L/c cannot be treated as transferable. It can only be used when the company is selling the product of a third party and the proper care has to be taken about the exit policy for the money transactions that take place. This type of L/c is used in the companies that act as a middle man during the transaction but don’t have large limit. In the transferable L/c there is a right to substitute the invoice and the whole value can be transferred to a second beneficiary.

7. Standby Letter of Credit L/cInitially used by the banks in the United States, the standby letter of credit is very much similar in nature to a bank guarantee. The main objective of issuing such a credit is to secure bank loans. Standby credits are usually issued by the applicant’s bank in the applicant’s country and advised to the beneficiary by a bank in the beneficiary’s country.Unlike a traditional letter of credit where the beneficiary obtains payment against documents evidencing performance, the standby letter of credit allow a beneficiary to obtains payment from a bank even when the applicant for the credit has failed to perform as per bond.A standby letter of credit is subject to "Uniform Customs and Practice for Documentary Credit" (UCP), International Chamber of Commerce Publication No 500, 1993 Revision, or "International Standby Practices" (ISP), International Chamber of Commerce Publication No 590, 1998.

"Red Clause" LC :-In the case of a red clause letter of credit (documentary credit with advance payment) the seller can request that the correspondent bank pay an agreed amount in advance (defined in the terms and conditions of the documentary credit). The advance is basically intended to finance the production or purchase of the goods to be delivered under the documentary credit. The advance is normally paid against receipt and commitment in writing from the beneficiary to subsequently deliver the transportation documents by an agreed date.IF in the LC this clause is permitted then it will be printed in RED INK.

"Green Clause"In the case of a green clause letter of credit (documentary credit with advance payment) the beneficiary can request that the correspondent bank pay an agreed amount in advance (defined in the terms and conditions of the letter of credit). The advance is basically intended to finance the production or purchase of the goods to be delivered under the documentary credit. Unlike the red clause letter of credit, the advance is paid only against receipt of an additional document providing proof that the goods to be shipped have been warehoused, as well as against receipt and written commitment from the beneficiary to subsequently deliver the transportation documents by an agreed date.IF in the LC this clause is permitted then it will be printed in GREEN INK.

Amendments to a Letter of Credit:After issuance of a Letter of Credit, changes can be done through amendments subject to acceptance by the Exporter. Amendments to the Letter of Credit will be required when either the Importer or the Exporter is unable to comply with the terms of the sale agreement or the agreement has been changed. For example, an Exporter will ask for an amendment to extend the expiry date and the latest shipping date if they are unable to manufacture the merchandise according to the agreed upon time. An Importer may request an amendment to increase the value of the Letter of Credit if they subsequently decide to purchase a higher quantity of merchandise. The Importer must complete an amendment application listing all required changes and forward the request to



the respective Global Trade Finance office via the same route the original application was sent. Amendment requests will be processed subject to credit approval by the Issuing Bank where necessary. Any amendments to the Letter of Credit must be accepted by the Exporter and where more than one change is included in an amendment, they must be accepted as a whole as opposed to accepting or rejecting individual items within the amendment.

Fees And Reimbursements:The different charges/fees payable under import L/c is briefly as followsThe issuing bank charges the applicant fees for opening the letter of credit. The fee charged depends on the credit of the applicant, and primarily comprises of :(a) Opening Charges This would comprise commitment charges and usance charged to be charged upfront for the period of the L/c. The fee charged by the L/c opening bank during the commitment period is referred to as commitment fees. Commitment period is the period from the opening of the letter of credit until the last date of negotiation of documents under the L/c or the expiry of the L/c, whichever is later.Usance is the credit period agreed between the buyer and the seller under the letter of credit. This may vary from 7 days usance (sight) to 90/180 days. The fee charged by bank for the usance period is referred to as usance charges.

(b)Retirement Charges1. This would be payable at the time of retirement of LCs. LC opening bank scrutinizes the

bills under the LCs according to UCPDC guidelines , and levies charges based on value of goods.

2. The advising bank charges an advising fee to the beneficiary unless stated otherwise The fees could vary depending on the country of the beneficiary. The advising bank charges may be eventually borne by the issuing bank or reimbursed from the applicant.

3. The applicant is bounded and liable to indemnify banks against all obligations and responsibilities imposed by foreign laws and usage.

4. The confirming bank's fee depends on the credit of the issuing bank and would be borne by the beneficiary or the issuing bank (applicant eventually) depending on the terms of contract.

5. The reimbursing bank charges are to the account of the issuing bank.

Export operations under L/cExport Letter of Credit is issued in for a trader for his native country for the purchase of goods and services. Such letters of credit may be received for following purpose:

1. For physical export of goods and services from India to a Foreign Country.2. For execution of projects outside India by Indian exporters by supply of goods and services

from Indian or partly from India and partly from outside India.3. Towards deemed exports where there is no physical movements of goods from outside

India. But the supplies are being made to a project financed in foreign exchange by multilateral agencies, organization or project being executed in India with the aid of external agencies.

4. For sale of goods by Indian exporters with total procurement and supply from outside India. In all the above cases there would be earning of Foreign Exchange or conservation of Foreign Exchange.

Banks in India associated themselves with the export letters of credit in various capacities such as advising bank, confirming bank, transferring bank and reimbursing bank.

In every case the bank will be rendering services not only to the Issuing Bank as its agent correspondent bank but also to the exporter in advising and financing his export activity.

1. Advising an Export L/cThe basic responsibility of an advising bank is to advise the credit received from its overseas branch after checking the apparent genuineness of the credit recognized by the issuing bank.



It is also necessary for the advising bank to go through the letter of credit, try to understand the underlying transaction, terms and conditions of the credit and advice the beneficiary in the matter.The main features of advising export LCs are:1. There are no credit risks as the bank receives a onetime commission for the advising

service. 2. There are no capital adequacy needs for the advising function.

2. Advising of Amendments to L/CsAmendment of LCs is done for various reasons and it is necessary to fallow all the necessary the procedures outlined for advising. In the process of advising the amendments the Issuing bank serializes the amendment number and also ensures that no previous amendment is missing from the list. Only on receipt of satisfactory information/ clarification the amendment may be advised.

3. Confirmation of Export Letters of CreditIt constitutes a definite undertaking of the confirming bank, in addition to that of the issuing bank, which undertakes the sight payment, deferred payment, acceptance or negotiation.Banks in India have the facility of covering the credit confirmation risks with ECGC under their “Transfer Guarantee” scheme and include both the commercial and political risk involved.

4. Discounting/Negotiation of Export LCsWhen the exporter requires funds before due date then he can discount or negotiate the LCs with the negotiating bank. Once the issuing bank nominates the negotiating bank, it can take the credit risk on the issuing bank or confirming bank.However, in such a situation, the negotiating bank bears the risk associated with the document that sometimes arises when the issuing bank discover discrepancies in the documents and refuses to honor its commitment on the due date.

5. Reimbursement of Export LCs Sometimes reimbursing bank, on the recommendation of issuing bank allows the negotiating bank to collect the money from the reimbursing bank once the goods have been shipped. It is quite similar to a cheque facility provided by a bank.In return, the reimbursement bank earns a commission per transaction and enjoys float income without getting involve in the checking the transaction documents.Reimbursement bank play an important role in payment on the due date ( for usance LCs) or the days on which the negotiating bank demands the same (for sight LCs).

UCPDC GuidelinesUniform Customs and Practice for Documentary Credit (UCPDC) is a set of predefined rules established by the International Chamber of Commerce (ICC) on Letters of Credit. The UCPDC is used by bankers and commercial parties in more than 200 countries including India to facilitate trade and payment through LC.UCPDC was first published in 1933 and subsequently updating it throughout the years. In 1994, UCPDC 500 was released with only 7 chapters containing in all 49 articles. . The latest revision was approved by the Banking Commission of the ICC at its meeting in Paris on 25 October 2006. This latest version, called the UCPDC600, formally commenced on 1 July 2007. It contains a total of about 39 articles covering the following areas, which can be classified as 8 sections according to their functions and operational procedures.Serial No. Article Area Consisting

1. 1 to 3 GeneralApplication, Definition andInterpretations

2. 4 to 12 ObligationsCredit vs. Contracts, Documentsvs. Goods

3. 13 to 16 Liabilities and Reimbursement, Examination of



responsibilities. Documents, Complying,Presentation, HandlingDiscrepant Documents

4. 17 to 28 Documents

Bill of Lading, Chapter Party Bill of Lading, Air Documents, Road Railetc. Documents, Courier , Postal etc.Receipt. On board, Shippers' count,Clean Documents, Insurance documents

5. 29 to 33MiscellaneousProvisions

Extension of dates, Tolerance inCredits, Partial Shipment and Drawings. House of Presentation

6 34 to 37 Disclaimer

Effectiveness of DocumentTransmission and TranslationForce Majeure Acts of an Instructed Party

7 38 & 39 OthersTransferable Credits Assignment of Proceeds

CASE STUDY:

I. A LC has mentioned that as per Article 20 (UPCDC 600) indication of port of loading, port of discharge, and that the goods have been loaded on board ‘a named vessel’ is required while negotiating the LC. When documents came for negotiation, the Bill of lading evidencing Bangkok as the port of loading with addition of the words “via Singapore" to indicate that there will be a transshipment in Singapore, Rotterdam as the port of discharge, "vessel Y" as the ocean vessel. Negotiating bank refused to accept the documents and returned by mentioning reason a bill of lading is required covering a port to port shipment from Bangkok to Rotterdam and thus violated Article 20.

1. Whether the negotiating bank is right in action?a. Yes b. No. c. Can’t say

2. Is the transshipment is also to be considered in the light of Article 23 even if not mentioned in LC.a. Yes b. No. c. Can’t say

II. Mr. Prakash Kumar –Branch Manager LPBC bank, Camp branch, Pune, was approached by their client Mr.Suresh Chandra with a request to open an Import LC. The LC was sanctioned by an appropriate authority and the importer Mr.Suresh Chandra required some time to comply with the sanction conditions like depositing of margin money etc. The importer Mr. Suresh Chandra requested Mr.Prakash Kumar –Branch Manager LPBC bank, Pune Camp branch that though the bank can not open LC until sanction terms are compiled with , the bank should send a pre-advice of LC by SWIFT message as under:-“Opened LC No.185/2008 on 24th April, 2008 for US$ 500000.00 Applicant: Sharmila Enterprises Pvt. Ltd. Beneficiary: Clarisa INC, New York, USA Covering: Titanium Plates

1. Whether the above Pre advice will act as LC and negotiation is possiblea. Yes b. No.

2. What should be further words in Pre advice to written as per UCP600 so that Pre advice does not become LC under UCP 600a. Pre advice b. Only consent of opening c. Details to follow d. No words are required.



III. A sight payment L/C is issued for the amount of (not exceeding) $50,000, allowing partial shipment, the beneficiary presented his first shipping docs for the amount of $ 30,000 and was paid due to complying presentation. 2 days before expiry date, the issuing bank received a second shipping docs for an amount of $30,000 for payment (approval basis) due to overdrawing.

The applicant waived the discrepancy and instructed the issuing bank to notice the nominated bank and the beneficiary with the following i.e agreed for amendment in LC:- Documents of the second shipment are accepted.- L/C amount to be increased to $80,000- Latest shipment date and expiry date are extended (where a third shipment can be made).

After this amendment, the beneficiary presented his 3rd shipping docs for an amount of $25,000, during the new L/C validity. As no discrepancies were found the nominated bank took them in compliance and sent them to the issuing bank after debiting the account of the issuing bank for payment.

The issuing bank rejected the claim saying that the LC is overdrawn. What is the amount of LC overdrawn according to issuing bank:

a. $30000 b. $25000 c. $15000 d. $10000

IV. ABC Bank opens an L/C calls for shipment of :1. 100mt ("About") of "X" product2. 200mt ( "About") of "Y" product

Total LC value : not to exceed USD1,000,000. Partial shipments allowed.

Documents presented in one drawing for full LC value of USD1,000,000 but as separate sets of documents relating to each item, represented by invoices as follows :1. 120mt of "X" at unit price of USD5,000 per mt = USD600,0002. 160mt of "Y" at unit price of USD2,500 per mt = USD400,000

A. Should the issuing bank reject the claim for the documents presented:1. Yes 2. No.

B. Suppose the issuing bank rejected the claim by giving reason1. Quantity of product "X" overshipped2. Quantity of product "Y" undershipped

Then, do you agree with the issuing bank for a. First reason is correct b. Second reason is wrong c. Both are wrong d. first is wrong

, second is correct

C. According to UCPDC 600 the tolerance is allowed to the extent of +/- 5% and since the LC is not overdrawn then do you found that still issuing bank correct :1. Yes 2. No

Ans: I.1 a, 2 a II. 1. B 2.c III. c Iv. A. Yes B. b C. 1

*****



CHAPTER 4FACILITIES AVAILABLE TO EXPORTERS AND IMPORTERS

I) To Exporters:-* Exporters are provided timely and adequate credit to meet the exports commitments.* Exporters are allowed pre and post-shipment credit at competitive interest rates.* Export Credit is made available both in Indian Rupee and Foreign Currency as well.

II) To Importers:-* Bank provides import loan at attractive rates to importers of imported inputs and capital goods.* Import loan is allowed in Indian Rupee and in Foreign Currency.* To enable importers avail of credit for their purchases, we also issue Documentary Credits (Letter of Credit and Standby Letter of Credit) favouring overseas supplier.* Import LCs are issued and transmitted by fastest electronic means using ‘SWIFT’ systems.* "Trade Credit" is arranged for importers in line with RBI guidelines. We arrange ‘Buyers’ Credit’ and ‘Suppliers’ Credit’. Issue of Letter of Credit, Letter of Comfort, Letter of Undertaking to facilitate importer arrange for ‘Trade Credit’ at better rates.

I) Types of Facilities for Exportsa) Rupee Export Credit (pre-shipment and post-shipment):The bank provides both pre and post shipment credit to the Indian exporters through Rupee Denominated Loans as well as foreign currency loans in India. Credit facilities are sanctioned to exporters who satisfy credit exposure norms of the bank. Exporters having firm export orders or confirmed L/C from a bank are eligible to avail the export credit facilities. Rupee Export Credit is available generally for a period of 180 days from the date of first disbursement. In deserving cases extension may be permitted within the guidelines of RBI. The corporate may also book forward contracts with the bank in respect of future export credit drawls, if required, as per the guidelines/directives provided by RBI.

b) Pre-shipment Credit in Foreign Currency (PCFC):The bank offers PCFC in the foreign currency to the exporters enabling them to fund their procurement, manufacturing/processing and packing requirements. These loans are available at very competitive international interest rates covering the cost of both domestic as well as import content of the exports.The corporate /exporters with a good track record can avail a running account facility with The bank for PCFC. PCFC is generally available for a period of 180 days from date of first disbursement. In deserving cases extension may be permitted within the guidelines of RBI.

c) Negotiation of Bills under L/CThe bank's Authorised Forex Branches are active in negotiation/discounting of sight/usance international export bills under L/Cs opened by foreign banks as well as branches of Indian banks abroad. The bank offers the most competitive rates. These transactions are undertaken by our branches within The bank/Country Exposure ceilings prescribed by The bank.

d) Export Bill Rediscounting:The bank provides financing of export by way of discounting of export bills, as a post shipment finance to the exporters at competitive international rate of interest. This facility is available in four currencies i.e. US$, Pound Sterling, Euro and JPY.The export bills (both Sight and Usance) drawn in compliance of FEMA can be purchased/ discounted.Exporters can avail this facility from The bank to cover the bills drawn under L/C as well as other export bills.

e) Bank Guarantees: The bank, on behalf of exporter constituents, issues guarantees in favour of beneficiaries abroad. The guarantees may be Performance and Financial. For Indian exporters, guarantees are issued in compliance to RBI guidelines.



II) Types of Facilities for Importers:-a. Collection of Import Bills:The banks has correspondent relationship with reputed International banks throughout the world and can thus provide valuable services to importers who may be importing from any part of the Globe. The import bills are collected by Authorised Forex Branches at very competitive rates. The import bills drawn on customers of other branches are also collected through these branches.b) Letter of Credit:L/Cs of the banks is well accepted in the International market. For any special requirement the banks can get the L/C confirmed by the top international banks.Thus the bank's L/C facility for the purchase of goods/services etc. fulfills the requirements of all importers to arrange a reliable supply. The bank offers this facility to importers in India within the ambit of FEMA and Exim policy of Govt. of India. The bank uses state of the art SWIFT network to transmit L/Cs and with a worldwide network of correspondents and our overseas branches facilitates prompt & efficient services to the importers.L/C facility is granted to the importers on satisfying credit exposure norms of the bank.c) Financing of importUsance L/C facility:- The bank's Usance L/C facility provides the importer an opportunity to avail credit from their supplier/supplier's bank.d) Deferred Payment Guarantee/Standby LC:- The bank's Deferred Payment Guarantee/Standby LC facility also provides the importer an opportunity to avail credit from their supplier/supplier's bank.e) Rupee finance:- The bank also offers to Indian importers Rupee finance for payment of goods and services imported from abroad under its various Rupee credit facilities on satisfying credit exposure norms of The bank.d) Foreign Currency Loans:-Short term External Commercial Borrowings or Trade Credits for less than three years as permitted by RBI for imports into India is allowed by our overseas branches to Indian importers at very competitive rates. These are generally backed by L/Cs opened by importer's bank. Indian importers can also avail this facility from our overseas branches as roll-over credit on their bank agreeing to extend the L/C in favour of our overseas branches.e) Bank Guarantees:The bank, on behalf of importer constituents or other customers, issues guarantees in favour of beneficiaries abroad. The guarantees may be both Performance and Financial.

5. REMITTANCESThe banks, through its worldwide network of correspondents, Indian branches and overseas branches, offers prompt inward and outward foreign remittance facilities at very competitive rates. The use of SWIFT network adds to reliability and efficient handling.The remittances are handled by our Authorised Forex Branches. The outward remittances of customers of other branches are also remitted through these branches. Through our well-spread network of branches in India, inward remittances reach every nook & corner in India. The bank has tie-up arrangements with Western Union Money Transfer.

Important RBI Guidelines on Rupee/Foreign Export Credit: Preshipment Rupee Export Credit:-01. Rupee Pre-shipment Credit/Packing Credit• ‘Pre-shipment/Packing Credit is the working capital finance granted to an exporter for purchase, processing, manufacturing or packing of goods prior to shipment/working capital expenses towards rendering of services against LCs or confirmed/irrevocable order or any other evidence of an order for export. • The period of advance is to be decided by the Banks based on relevant factors. However, if the finance is not adjusted by submission of export documents within 360 days from the date of advance, it ceases to qualify for concessional rate of interest ab initio. Refinance from RBI is available for a period of 180 days.• The facility may be released in one lump sum or in stages as per the requirement for executing the orders / LC. Stage wise release accounts may be maintained depending upon the types of goods/services to be exported. Banks should also keep a close watch on the end-use of the funds,



besides monitoring the progress of execution of the orders.• Liquidation of the export credit facility may be out of the proceeds of the bills drawn thereby converting the pre-shipment into post-shipment credit. It can also be liquidated out of the balances in the Exchange Earners Foreign Currency A/c (EEFC A/c) as also from rupee resources of the exporter to the extent exports have actually taken place. If not so liquidated/ repaid, banks are free to decide the rate of interest from the date of advance.• Banks would provide operational flexibility for repayment/liquidation of EPC with export documentsrelating to other export order for the same or other commodity exported or the existing packing credit may also be marked-off with proceeds of export documents against which no packing credit has been drawn by the exporter to clients who have a good track record. These relaxations should not be extended to transactions of sister / associate / group concerns.

1.1‘Running Account’ Facility• Pre-shipment export credit facility in respect of any commodity without insisting lodgement of LC or export orders which should be produced within a reasonable period of time to be decided by the banks. This facility is being extended only to those exporters whose track record has been goodas also to EOUs/ Units in Free Trade Zones / EPZs and SEZs. Running account facility should not be granted to sub suppliers.

1.2 Rupee Pre-shipment Credit to Specific Sectors/Segments• Banks are permitted to grant Rupee Export Packing Credit to Manufacturer Suppliers for Exports Routed through STC/MMTC/Other Export Houses, Agencies etc. Such advances will be eligible for refinance subject to some conditions including obtaining a letter from the export house setting the details of the export order, etc.

1.3 Rupee Export Packing Credit to Sub-Suppliers• Packing credit can be shared between an Export Order Holder (EOH) and sub-supplier of raw materials, components etc. of the exported goods as in the case of EOH and manufacturer suppliers, subject to the condition that it cannot be made available to Running Account facility.• The scheme will cover the L/C or export order received in favour of Export Houses/Trading Houses/Star Trading Houses etc. or manufacturer exporters only. The scheme should be made available to the exporters with good track record. Banks may approach the ECGC for availing suitable cover in respect of such advances.

1.4 Rupee Pre-shipment Credit to Construction Contractors • The Packing Credit facility can be granted to the construction contractors to meet their initial working capital requirements (preliminary expenses) for execution of contracts abroad on the basis of a firm contract secured from abroad, in a separate account.• The advances should be adjusted within 365 days of the date of advance by negotiation of bills relating to the contract or by remittances received from abroad in respect of the contract executed abroad. To the extent the outstanding in the account are not adjusted in the stipulated manner, banks may charge normal rate of interest on such advance.

1.5 Export of Services • Pre-shipment and post-shipment finance may be provided to exporters of all the 161 tradable services covered under the General Agreement on Trade in Services (GATS). All provisions of the circular shall apply mutatis mutandis to export of services as they apply to export of goods unless otherwise specified. • Exporters of services qualify for working capital export credit (pre and post shipment) for consumables, wages, supplies etc. 1.6 Export Credit to Processors/Exporters-Agri-Export Zones • Export processing units set up in Agri- Export Zones may be provided packing credit for the purpose of procuring and supplying inputs to the farmers so that quality inputs are available to them which in turn will ensure that only good quality crops are raised, besides advantages of economics of scale.



1.7 Export Credit Insurance Whole Turnover Packing Credit (ECIB-WTPC) • Banks are eligible to obtain Whole-Turnover Packing Credit (ECIB-WTPC) for all its packing credit accounts on payment nominal guarantee fee which is to be borne by the exporters. The period of cover is for 12 months. It gives protection to the banks against losses that may be incurred in extending packing credit advances due to protracted default or insolvency of the exporter-client. The coverage is available for banks taking the cover for the first time is 75% upto Grade Percentage limit fixed and 65% beyond (For others varies from 55% to 75% depending on claim premium ratio of the bank). For small exporters/SSIU, it is 90%. Banks are required to submit Monthly declaration along with premium amount. Any extension of due date beyond 360 days should be approved by the ECGC.

02. Post shipment Rupee Export Credit• 'Post-shipment Credit' is the working capital facility granted or any other credit provided by a bank to an exporter of goods / services from the date of extending credit after shipment of goods / rendering of services to the date of realization of export proceeds. As per the extant instructions, the period prescribed for realization of export proceeds is 12 months from the date of shipment. • Post-shipment advance are made available in the form of - (i) Export bills purchased/discounted/negotiated. (ii) Advances against bills for collection. (iii) Advances against duty drawback receivable from Government. • Post-shipment credit is to be liquidated by the proceeds of export bills received from abroad in respect of goods exported / services rendered. It can also be repaid / prepaid out of balances in Exchange Earners Foreign Currency Account (EEFC A/C) as also from proceeds of any other unfinanced (collection) bills.

2.1 Rupee Post shipment Export Credit:Nature of bill Period of AdvanceDemand Bills Normal Transit Period (NTP)*Usance Bills Max. 365 days from the date of

shipment (incl. of NTP)Overdue bill – Demand billUsance Bill

Not paid within NTP plus grace period Not paid on due date

* Average period involved from date of negotiation/purchase/discount till the receipt of proceeds in the Nostro account of the Bank.

2.2 Advances against Undrawn Balances on Export Bills • Banks are permitted to grant advances against the undrawn balances at concessional rate for a maximum period of 90 days provided such remittances are received within 180 days after expiry of NTP in case of demand bills and due date in case of usance bills. For the period beyond 90 days, the rate of interest specified for the category 'ECNOS' (Export Credit Not Otherwise Specified) at post-shipment stage may be charged.

2.3 Advances against Retention Money • Banks may consider granting advance against retention money based on the nature of the export order like turnkey projects, etc. Such finance are subject to some guidelines as set out by RBI and listed in the M. Circular dt. 01.07.2011. No advances to be granted against retention money relating to services portion of the contract.

2.4 Export on Consignment Basis• Export on consignment basis should be at par with exports on outright sale basis on cash terms in matters regarding the rate of interest to be charged by banks on post-shipment credit.• For pre-shipment finance against the exports of precious and semi-precious stones on consignment exports, is adjusted as soon as export takes place, by transfer of the outstanding balance to a special (post-shipment) account which in turn, should be adjusted as soon as the relative proceeds are received from abroad but not later than 365 days from the date of export or such extended period as may be permitted by Foreign Exchange Department, RBI. Balance in the special (post-shipment) account will not be eligible for refinance from RBI.



• RBI (FED) permits on case to case basis longer period up to 12 months from the date of shipment for realization of proceeds of exports in case of Consignments Exports to CIS and East European Countries, Consignment exports to Russian Federation against repayment of State Credit in rupees, Exporters who have been certified as 'Status Holder' in terms of Foreign Trade Policy, and Cent percent EOU and units set up under Electronic Hardware Technology Park, Software Technology Park and Bio-Technology Park Schemes. In case of Exports through the Warehouse–cum-Display Centers abroad realization of export proceeds has been fixed upto 15 months from the date of shipment.

2.5 Export of goods for Exhibition and Sale • Export of goods for exhibition and sale are eligible for export finance both pre and post shipment stages.

03. INTERST ON RUPEE EXPORT CREDIT : Interest Equalisation Scheme on Pre and Post Shipment Rupee Export Credit :The Government of India has announced the Interest Equalisation Scheme on Pre and Post Shipment Rupee Export Credit to eligible exporters. The scheme is effective from April 1, 2015. The rate of interest equalisation @ 3% per annum will be available on Pre Shipment Rupee Export Credit and Post Shipment Rupee Export Credit. The scheme would be applicable w.e.f 01.04.2015 for 5 years.Government, however, Government reserves the right to modify/amend the Scheme at any time. The scheme will be available to all exports under 416 tariff lines [at ITC (HS) code of 4 digit]as per Annexure A and exports made by Micro, Small & Medium Enterprises (MSMEs) across all ITC(HS) codes. However, scheme would not be available to merchant exporters. Banks are required to completely pass on the benefit of interest equalisation, as applicable, to the eligible exporters upfront and submit the claims to RBI for reimbursement, duly certified by the external auditor. From the month of December 2015 onwards, banks shall reduce the interest rate charged to the eligible exporters as per RBI extant guidelines on interest rates on advances by the rate of interest equalisation provided by Government of India. The interest equalisation benefit will be available from the date of disbursement up to the date of repayment or up to the date beyond which the outstanding export credit becomes overdue. However, the interest equalisation will be available to the eligible exporters only during the period the scheme is in force.Note: Government of India has increased w.e.f. November 02, 2018 Interest Equalisation rate from 3% to 5% in respect of exports by the Micro, Small & Medium Enterprises (MSME) sector manufacturers under the Interest Equalisation Scheme on Pre and Post Shipment Rupee Export Credit.

3.1 ECNOS • Banks are free to decide the rate of interest keeping in view of BPLR and spread guidelines in respect of Export Credit Not Otherwise Specified (ECNOS). No penal interest to be charged on ECNOS.

Period within which export value of goods/software to be realised :- Foreign Exchange Management (Export of Goods & Services) (Amendment) Regulations, 2014:The amount representing the full export value of goods or software exported shall be realised and repatriated to India within Nine months from the date of export.Provided that where the goods are exported to a warehouse established outside India with the permission of the RBI, it will be as soon as it is realised and in any case within fifteen months from the date of shipment of goods; Provided further that the RBI, or subject to the directions issued by that Bank in this behalf, the authorised dealer may, for a sufficient and reasonable cause shown, extend the said period of Nine months or fifteen months, as the case may be.

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CHATPER 5Risk in international trade

International trade is exchange of capital, goods, and services across international borders or territories.. In most countries, it represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance has been on the rise in recent centuries.Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their own borders.Companies doing business across international borders face many of the same risks as would normally be evident in strictly domestic transactions. For example,

Buyer insolvency (purchaser cannot pay); Non-acceptance (buyer rejects goods as different from the agreed upon specifications); Credit risk (allowing the buyer to take possession of goods prior to payment); Regulatory risk (e.g., a change in rules that prevents the transaction); Intervention (governmental action to prevent a transaction being completed); Political risk (change in leadership interfering with transactions or prices); and War and other uncontrollable events.

In addition, international trade also faces the risk of unfavorable exchange rate movements (and, the potential benefit of favorable movements)

ECGCA. What is ECGC? Export Credit Guarantee Corporation of India Limited, was established in the year 1957 by the Government of India to strengthen the export promotion drive by covering the risk of exporting on credit.Being essentially an export promotion organization, it functions under the administrative control of the Ministry of Commerce & Industry, Department of Commerce, Government of India. It is managed by a Board of Directors comprising representatives of the Government, Reserve Bank of India, banking, insurance and exporting community.

ECGC is the fifth largest credit insurer of the world in terms of coverage of national exports. The present paid-up capital of the company is Rs.800 crores and authorized capital Rs.1000 crores.

B. What does ECGC does?1.Offers insurance protection to exporters against payment risks2.Provides guidance in export-related activities3.Makes available information on different countries with its own credit ratings4.Makes it easy to obtain export finance from banks/financial institutions5.Assists exporters in recovering bad debts6.Provides information on credit-worthiness of overseas buyers

C. What is the Need for export credit insurance?

Payments for exports are open to risks even at the best of times. The risks have assumed large proportions today due to the far-reaching political and economic changes that are sweeping the world. An outbreak of war or civil war may block or delay payment for goods exported. A coup or an insurrection may also bring about the same result. Economic difficulties or balance of payment problems may lead a country to impose restrictions on either import of certain goods or on transfer of payments for goods imported. In addition, the exporters have to face commercial risks of insolvency or protracted default of buyers. The commercial risks of a foreign buyer going bankrupt or losing his capacity to pay are aggravated due to the political and economic uncertainties. Export credit insurance is designed to protect exporters from the consequences of the payment risks, both political and commercial, and to enable them to expand their overseas



business without fear of loss.

To protect such exporters, ECGC has the following types of covers.

Supply contracts and turnkey projects: For covering supply contracts and turnkey projects, specific contract/shipments policy can be taken. This policy can be for covering only political risks or for covering comprehensive risks i.e. both commercial and political risks.

Construction contract: For covering construction contract, a Construction Works policy can be obtained. This policy can be for either political risk alone or for comprehensive risk. The Comprehensive Risks Policy provides protection against commercial risks such as insolvency of buyer, protracted default, non-acceptance of goods shipped in addition to covering political risk of war, civil war, exchange transfer delay etc. The political risk policy, on the other hand, provides protection against the Political Risks Policy. Under the various export credit insurance policies, ECGC generally covers loss up to 90 per cent.

Services Contract: For covering services contract, which involves only technical and/or professional services, a Services Policy can be obtained. This also can be either for political or comprehensive risks.

Overseas Investment Insurance:-OII provides cover for the investments made by Indian corporates abroad in a joint venture or their wholly owned subsidiary (WOS) either in the form of equity or loan. The Government of India or RBI should approve the JV. The basic principle is that the investment should emanate from India and benefit of dividend/interest therefrom should accrue to India. The investment should not in any way conflict with the policy of both our government and the overseas government. Normally, there should be a bilateral agreement between India and the host country for promotion and protection of Indian investment. In case there is no such agreement the Corporation should be satisfied that the existing laws of the host country adequately safeguard Indian investment.

In addition to the policy covers, which are issued to exporters, ECGC also extends its guarantee support to banks in India against both funded and non-funded facilities extended to project exporters. The types of guarantees issued by Indian banks are:

Funded:* Packing Credit * Post Shipment * Overdraft * Rupee Loan Non-Funded* Bid Bond * Advance payment * Performance guarantee * Retention Money guarantee * Overseas Lending Finance guarantee

Export Credit Insurance Covers to Banks from ECGC Covers for working capital granted by commercial banks to Exporters at Pre

shipment and Post shipment stages Covers available on exporter wise, bank branch wise and bank wise Losses due to protracted default / Insolvency of exporters covered Cover varies from 60% to 95% depending on the type of cover

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CHAPTER 6Role of RBI & Exchange Control

Custodian of Foreign Exchange Reserves:It is the responsibility of the Reserve bank to stabilize the external value of the national currency. The Reserve Bank keeps golds and foreign currencies as reserves against note issue and also meets adverse balance of payments with other counties. It also manages foreign currency in accordance with the controls imposed by the government.

As far as the external sector is concerned, the task of the RBI has the following dimensions: To administer the foreign Exchange Control; To choose, the exchange rate system and fix or manages the exchange rate between the

rupee and other currencies; To manage exchange reserves; To interact or negotiate with the monetary authorities of the Sterling Area, Asian Clearing

Union, and other countries, and with International financial institutions such as the IMF, World Bank, and Asian Development Bank.

The RBI is the custodian of the country’s foreign exchange reserves, id it is vested with the responsibility of managing the investment and utilization of the reserves in the most advantageous manner. The RBI achieves this through buying and selling of foreign exchange market, from and to schedule banks, which, are the authorized dealers in the Indian, foreign exchange market. The Bank manages the investment of reserves in gold counts abroad’ and the shares and securities issued by foreign governments and international banks or financial institutions.

Before going ahead with FEDAI Rules, let us see about Nostro, Vostro & Loro accounts maintained by Authorised dealers:The Foreign Exchange (FX) Market is one of the biggest and most liquid markets in which currencies are traded over the counter (OTC) involving players like central banks, corporate majors, hedge funds, investment banks, commercial banks etc. It aids activities such as cross-border trade, mergers & acquisitions, tourism etc. In order to deal in the Foreign Exchange Market and transact in foreign currencies, banks maintain accounts with other banks globally. This is known as a Nostro Account. For instance, consider two banks: ABC Bank, New York and XYZ Bank, Mumbai. For XYZ Bank, its account in ABC Bank is a ‘Nostro Account’ (My account with you) and ABC Bank’s account with it is a ‘Vostro Account’ (your account with me). ‘Nostro’ and ‘Vostro’ are Italian words for “Our” and “Your” respectively. Reconciliation of these accounts is called Nostro Account Reconciliation or simply Nostro Reconciliation. In India only Scheduled Commercial Banks (SCB) can maintain a Nostro Account, and three types of branches are permitted to deal in them. The A category branch owns, maintains and funds this account. After the Nostro Reconciliation, they submit the statutory returns to the appropriate authorities. The B category branch can operate the account maintained by A category branches and the C category branches are the remaining Scheduled Commercial Bank branches dealing through B or A category branches for their forex transactions.

Nostro debits may arise due to:• Honoring the payment messages sent by the bank/payment of draft issued by the bank• Charges debited in the Nostro accounts• Reimbursement to negotiating bank, under Letters of Credit transactions• Payments on account of interbank deals

Nostro credit may arise due to:• Inward remittances received on behalf of customers• Interest amount credited • Receipts from interbank deals• Realization of bills sent for collection• Reimbursement of negotiated bills



Points to be remember:a. The purchase/sale of currency may be spot or forwardb. Indian bank do not remit foreign currency in Nostro account from India. All receipt in FX and all payment/remittances in FX will be made through Nostro account maintained with foreign bank.c. Forward Purchase/Sale of FX do not affect Nostro A/C because there is no delivery of currency as on date of entering such contract.d. Spot purchase/Sales of CHF affects both exchange position as well as Nostro A/C (Cash Position)

Loro account is an account wherein a bank remits funds in foreign currency to another bank for credit to an account of a third bank. e.g . Canara Bank wants to utilize a NOSTRO account of, Say PNB, at NY, with Bank of America. This arrangement is called as LORO account.

Example for Nostro transactions:Example No. 1 - A bank in India want to send a payment in GBP let's say the bank name is ABC Bank. This bank has a Nostro Acoount (in GBP) with a bank in UK e.g. XYZ Bank. However the beneficiary has an account with some other bank e.g. QWE Bank. This is possible with the use of Nostro account and swift messages. In the first swift message, ABC Bank will be the sender, XYZ bank will be the receiver and QWE bank will be in loop (Account with institution). In the second message XYZ bank will be the sender QWE bank will be the receiver and ABC bank will be in loop (Ordering institution).

Example No. 2 - Cover method can be used when a bank (e.g. ABC Bank) has RMA (Relationship Management Application) with another bank (e.g. XYZ Bank) but do no maintain a Nostro Account. Here ABC can send message to XYZ Bank informing (Sender's Correspondent) that the funds will come from another bank (e.g. QWE Bank). This Sender's Correspondent could be a common correspondent of both the banks. ABC Bank will have to send one more message. ABC Bank will have to send this message to QWE Bank.

FEDAI RulesRole of FEDAIEstablished in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks that deals in foreign exchange in India as a self regulatory body under the Section 25 of the Indian Company Act (1956).The role and responsibilities of FEDAI are as follows:

Formulations of FEDAI guidelines and FEDAI rules for Forex business. Training of bank personnel in the areas of Foreign Exchange Business. Accreditation of Forex Brokers. Advising/Assisting member banks in settling issues/matters in their dealings. Represent member banks on Government/Reserve Bank of India and other bodies. Rules of FEDAI also include announcement of daily and periodical rates to its member

banks.FEDAI guidelines play an important role in the functioning of the markets and work in close coordination with Reserve Bank of India (RBI), other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India and various other market participants.

FEDAI Rules-1-Hours-Of-Business FEDAI Rules-2-Export-Transactions FEDAI Rules-3-Import-Transactions FEDAI Rules-4-Merchanting-Tradeing FEDAI Rules-5-Clean-Instruments FEDAI Rules-6-Guarantees FEDAI Rules-7-Exchange-Contracts FEDAI Rules-8-Early Delivery Extension-And-Cancellation-Of-Forward -Contracts FEDAI Rules-9-Schedule-Of-Charges FEDAI Rules-10-Business-Through-Exchange-Brokers



FEDAI Rules-11-Inter-Bank-TT-Settlement-And-Dispatch FEDAI Rules-12-Inter-Bank-TT-Settlement-Of-Inter-Bank-TTs-And-Despatch Fedai FEDAI Rules-13-Abolition-Of-Sterling-Rates-Schedule FEDAI Rules-14-Clarification-Explanatory-Notes-Certain-Other-Important-Information

FEDAI Rules - General Guidelines/Instructions1. The directives issued by the Reserve Bank of India in respect of Interest rates on Export & Import Finance shall be adhered to by the Authorised Dealers.2. The member banks are totally free to determine their own charges for various types of forex transactions, keeping in view the advice of RBI that such charges are not out of line with the average cost of providing services.3. Authorised Dealers shall ordinarily not be parties to any guarantees for an unlimited amount and/or an unlimited period. Authorised Dealers shall ensure to include a specific clause in all the guarantees stating the exact period within which claims must be made under the guarantee besides the expiry date for the guarantee.4. With a view to simplifying and liberalising import, authorised dealers are permitted to open standby letters of credit on behalf of their importer constituents for importing goods into India permissible under Foreign Trade Policy. RBI vide its AP (Dir Series) Circular No. 84 dated 3rd March 2003 advised the authorised dealers to open standby letters of credit subject to adherence to the guidelines issued by FEDAI. The detailed guidelines were issued by FEDAI vide Special Circular No. SPL-16/Standby LC/2003 dated 1st April 2003.5. Guidelines for calculation of Merchant Rate have been deleted from the Rule Book as the procedure for calculating the rate for Merchant transactions have been left for our member banks to decide.

Rule 1 Hours of business

Each Authorised Dealer will establish its business hours for various types of foreign exchange transactions at each centre where its branches undertake forex business. Authorised dealers are permitted to undertake forex business on behalf of the bank during extended hours subject to the condition that the Management in each bank lays down the working hours of the dealers.RBI Foreign Department have advised that exchange trading hours for inter-bank market would be from 9AM to 4PM.

Rule 2 Export Transactions

Authorised Dealers will purchase only Approved Bills and the decision as to what is an approved bill lies solely with Authorised Dealers. This includes bills tendered under forward contracts, letters of credit, letters of guarantee, letters of authority, orders to negotiate, orders for payment and any other type of document of similar nature.Export Bills purchased/discounted/negotiated: Application of rate = Authorised Dealers’ current bill buying rate or at the contracted rate. Interest for the normal transit period, and usance period shall be recovered simultaneously.Crystallisation and Recovery :-Exporters are liable for the repatriation of proceeds of the export bills negotiated/purchased/discounted or sent for collection by the AD's within time allowed for it. Considering risk in it AD's should transfer the exchange risk to the exporter by crystallising the foreign currency liability into rupee liability.AD's to decide on the period for crystallisation which may be linked to risk factors like credit perception of different types of exporter clients, operational aspects etc.



Rate applicable for crystallisation: AD's TT selling rate on the date of crystallisation. Exchange difference arising out of crystallisation to be recovered from or passed on to the customer, as the case may be. Interest shall be recovered on the date of crystallisation for the period from the date of expiry of the normal transit period/notional due date to the date of crystallisation at the appropriate rate of interest as per the guidelines issued by RBI from time to time.

Realisation of Bills after crystallization :- AD's will adjust the Rupee liability on the bill crystallised as above by applying the TT buying rate of exchange or the contracted rate. Any difference shall be recovered from/paid to the customer. Interest - From the date of crystallisation to the date of realisation of the bill shall be recovered from the customer at the appropriate rate of interest for overdue export bills as permitted by Reserve Bank of India.Dishonour of Bills:- The bank shall recover from the customer : a. The Rupee equivalent at the current ready TT selling rate. b. All foreign currency charges at the ruling ready TT selling rate. c. Interest at appropriate rate as per the guidelines issued by RBI.

Interest At the applicable rate taking into consideration of Normal Transit period.Normal Transit Period

Normal transit period comprises the average period normally involved from the date of negotiation/purchase/discount till the receipt of bill proceeds in the Nostro account of the bank. Normal Transit Period is not to be confused with the time taken for the arrival of the goods at the destination.Normal Transit Period for purposes of all bills in Foreign Currencies 25 days

Exports to Iraq :- 120 days from the date of shipment under UN certificate

Normal Transit Period for purposes of bills drawn in Rupees: In the case of bills drawn under letters of credit where reimbursement is provided at the centre of negotiation: 3 days or else it will be 7 days.In case of export usance bills (foreign currency and rupee bills): Since due dates are reckoned from date of shipment or date of bill of exchange etc. no Normal Transit Period shall be applicable, since the actual due date is known.TT Reimbursement under letter of credit : Reimbursement by cable/SWIFT/Telex or other electronic means - 5 days

Overdue Interest

To be recovered from the customer in case payment is not received on or before the expiry date of Normal Transit Period in case of demand bills, and on or before the notional due date/actual due date as the case may be in case of usance bills as per RBI directives.

In Early realisation

Proportionate interest shall be refunded from the date of realisation i.e., by credit to nostro account in case of a foreign currency bill, and by debit to vostro account in case of a Rupee bill, upto the last date of normal transit period in the case of demand bill and upto the notional due date in case of usance bill.

Export bills sent for collection

Application of rates :- TT buying rate ruling on the date of payment of proceeds or the forward contract rate as the case may be.

Bill Buying Rate

Bill buying Rate is the rate to be applied when a foreign bill is purchased. When a bill is purchased, the proceed will be realized by the bank after the bill is presented to the drawee at the overseas centre. In the case of



a usance bill the proceed will be realized on the due date of the bill which includes the transit period and the usance period of the bill.

If the sight bill on London Is purchased, the realization will be after a period about 20days (transfer period) the bank would be able to dispose of the foreign exchange only after this period. Therefore, the rate quoted to the customer would be based not on the spot rate in the interbank rate for 20 days forward. Likewise if the bill purchased is 30 days usance bill. Then the bill will realize after about 50 days (20 days transit plus 30 day’s usance bill, period) Therefore bank would be able to dispose of foreign exchange only after 50 days the rate to the customer would be based on the interbank rate for 50 days forward.

Rule 3 Import Transactions

“Bills” shall include all documentary/clean bills received under letter/s of credit, standby letter's of credit, letter/s of guarantee, letter's of authority, order's to negotiate, order/s for payment and other document's or undertaking's of a similar nature or on collection basis covering imports into India.

Application of rates for retirement of import bills : Bills selling rate ruling on the date of retirement or the forward sale contract rate as the case may be.

Application of interest :- Bills negotiated under import letters of credit shall carry commercial rate of interest as applicable to banks’ domestic advances.To be recovered from the date of debit to the AD’s Nostro account to the date of crystallisation/retirement whichever is earlier.Crystallisation of Import Bills under Letters of Credit: All foreign currency import bills drawn under letters of credit, in the event of non-retirement shall be crystallised into Rupee liability on the 10th day after the date of receipt of documents at the letter of credit opening branch of the bank, in case of demand bills and on due date in case of usance bills at Bills Selling Rate/contracted rate as the case may be. In case the 10th day or the due date falls on a holiday or Saturday, the importer’s liability shall be crystallised into Rupee liability on the next working day.Import bill under the Forward Exchange Contract results in early/late delivery, the bank shall recover swap cost and interest, if any.

Bill selling Rate

This rate is to be used for all transactions which involve handling of documents by the bank, e.g. payment against import bill. The bill selling rate is calculated by adding exchange margin to the TT selling rate.

Rule 5 Clean Instruments

Encashment of Inward foreign currency travellers cheques and currency notes will be at AD’s option at the rates ruling on the date of such encashment. Outward remittances shall be effected at the TT selling rate of the bank ruling on the date of such remittance or at the forward contract rate.All foreign currency inward remittances up to an equivalent of USD 5000 shall be immediately converted into Indian Rupees. Beneficiary has the option of presenting the relative instrument for payment within the maximum period prescribed under FEMA, 1999 for remittances in excess of equivalent of USD 5000.

Saturday may continue to be treated as working day except for transactions involving conversion at confirmed exchange rate (other than travel related transactions like issue/encashment of foreign currency travellers’ cheques, foreign currency notes etc.).



Rule 7 Foreign Exchange Contracts

Exchange contracts shall be for definite amounts and periods.

Unless date of delivery is fixed, option period of not more than one month be specified at the discretion of the customer. If the fixed date of delivery or the last date of delivery option is a holiday/declared a holiday the delivery shall be effected/delivery option exercised on the preceding working day.“Ready” or “Cash” merchant contract shall be deliverable on the same day.A spot contract shall be deliverable on second succeeding business day. Merchant quotations:- The exchange rate shall be quoted in direct terms i.e., so many Rupees and Paise for 1 unit of foreign currency or 100 units of foreign currencies.

Rule 8 Early Delivery, Extension and Cancellation of Foreign Exchange Contracts

Allowed at the request of the customer. It is optional for a bank unless stated to the contrary in the provisions of FEMA, 1999, a. Accept or give early delivery. b. Extend the contract.

Early delivery:- If a bank accepts or gives early delivery, the bank shall recover/pay swap difference, if any.In all cases of early delivery of purchase or sale contracts, swap cost shall be recovered from customers irrespective of whether an actual swap is made or not. In case of outlay of fund (loss to bank) due to extension/cancellation, Interest at not below the prime lending rate of the respective AD will be charged to customer in addition to the swap cost .Extension: If extension is sought by the customers the contract shall be cancelled (at appropriate Selling or Buying Rate as on the date of cancellation) and rebooked simultaneously only at current rate of exchange. The difference between the contracted rate and the rate at which the contract is cancelled shall be recovered from/paid to the customer at the time of extension. Such request for extension shall be made on or before the maturity date of the contract.Cancellation:- Here, the AD shall recover/pay, as the case may be, the difference between the contracted rate and the rate at which the cancellation is effected.

Rate at for cancellation: a. Purchase contracts - Spot T.T. selling rate b. Sale contracts- Spot T.T. buying rate c.Where the contract is cancelled before maturity -appropriate forward T.T. rate

In the absence of any instructions from the customer contracts which have matured shall be automatically cancelled on the 15th day after maturity date. In case 15th day falls on a Saturday or holiday, the contract shall be cancelled on the next succeeding working day. Here no gain will be transferred to the customer but swap cost can be recovered.Please refer to the illustration on the above points given after these rules..



Rule 10

Business through Exchange Brokers

Authorised Dealers make contracts through brokers such contracts shall only be made through accredited exchange brokers.No brokerage or other form of remuneration shall be paid by the Authorised Dealers to other bank employees on contracts made in respect of any foreign exchange business.

Any accredited broker who knowingly concludes any exchange business contrary to the rules of this Association may have his recognition withdrawn and no Authorised Dealer shall transact business with him thereafter.

Rule 11

Interbank TT-Settlement and Despatch

It is absolutely necessary for AD's to reconcile all dealing items within a period of 24/48 hours by demanding cable/telex/SWIFT confirmation regarding receipt of expected credits in “Nostro” accounts from the correspondents maintaining those accounts within a maximum period of 15 days. Notices of non-receipt of funds in the Nostro account must be followed up by cable, telex, SWIFT etc. with defaulting counterparty banks who should immediately take up the matter with their correspondents.

In case the seller-bank is unable to substantiate to the buyer-bank that it had intended to effect proper delivery on the settlement day, thereby amounting to ‘deliberate’ non-delivery of funds, the seller-bank shall pay to the buyer-bank a penalty as decided by the Managing Committee of the FEDAI or any other Sub-Committee specially appointed for the purpose by the Managing Committee. The penalty as stated above shall be in addition to the interest claim of the buyer-bank.Timings:- Written instructions of buyer-banks to seller-banks regarding their take-up of interbank TT transactions, not later than one hour before the close of the general banking hours of the latter.Settlement of interest claims on the delayed delivery of Foreign Currency Funds: In the event of late delivery of foreign currency amount of an interbank TT at the stated overseas centre, if it is London, interest for the overdue period is to be paid by the seller-bank in India at 2% over the “Barclays Bank’s Base Rate” ruling on the day the remittance should have been received in London in the buyer-bank’s nostro account. Further, the buyer-bank has to lodge the interest claim within 30 days from the day on which the amount should have been received. In case the buyer-bank lodges the claim after expiry of the said period of 30 days, interest at the applicable rate shall be paid for a maximum period of 60 days only or for the actual overdue period whichever is less.In the event of late delivery at centres other than London, interest for the number of days of the delay shall be paid in India at two per cent over the prime rate of the banks specified below at the respective centres, ruling on the day the delivery should have been made provided the buyer-bank lodges the claim for interest within 30 days from the day the delivery should have been received abroad : U.S.A. Citibank N.A.Canada Bank of Nova ScotiaJapan Bank of Tokyo-Mitsubishi Ltd.Switzerland Swiss Bank CorporationEURO ABN Amro BankIn case the buyer-bank lodges the claim for interest after expiry of the aforesaid period of 30 days, interest at the applicable rate shall be paid for a maximum period of 60 days only or the actual period, whichever is less.



No interest claims shall be entertained if claims are preferred after 90 days from the date on which the foreign currency funds should have been received by the buyer bank.

Non-delivery of Foreign Currency Funds: The seller bank shall deliver foreign currency funds within 48 hours of the receipt of the notification from the buyer-bank. Such notification shall be sent by the buyer-bank not later than 15 days from the contracted date of delivery.

Delay in payment of Rupee equivalent of interbank TTs in foreign currencies :The buyer bank shall pay interest for each day of delay at 2% over the NSE-MIBOR rate ruling on each such day of delay. In case the seller-bank fails to lodge the claim within the said period of 15 days, the seller-bank shall be entitled to receive interest for the maximum period of 30 days only. No interest claims shall be entertained if claims are preferred after 90 days from the date on which the rupee funds should have been received by the seller bank.

Period for settlement of interest claims in Rupees:- When a bank is served with the notice of interest claim, it must settle the claim within 21 days of receipt thereof by making proper enquiry into its books and investigating its records.

Payment of interest claim cannot be withheld for more than 21 days on the plea that enquiries are being made in the matter of the interest claim.

Rule 2 : Some illustration for explanation:Illustration:- A Ltd has exported certain material to US for $ 2,00,000 on 05.01.2012 and got it discounted with X bank on 10.01.2012. The bill is usance bill for 60 days from the date of presentation of bill. The rate as quoted in spot at the time of discounting is Rs.55.128/.340. The X bank charges Rs.1000 per bill as presentation and also charges 0.150% as margin. On the basis of the above information answer the following questions:1. What is the due date for the billa. 04th March,2012 b. 5th March ,2012 c. 29th March,2012 d. 3rd April, 2012

2. What is the amount that is will be paid to customer, if RBI states the interest rate of 9%.a.Rs.1,07,78,915 b.Rs.1,07,77,915 c.1,08,10,223 d.1,10,51,398Ans:- b. $ = Rs.55.128 – 0.150% margin = Rs. 55.045 * $2,00,000 = 1,10,09,000 – Rs.1000 = 1,10,08,000 – 9% Intt for 85 days ( 60 days + 25 days normal transit period) Rs.2,30,085 = Rs.1,07,77,915

3. If this bill got dishonoured then what will be the amount of crystallization of this bill, if the rate is $ 55.320/.440a. 1,10,64,000 b. 1,10,88,000 c.1,11,04,600 d.1,10,47,400Ans: c : Refer Rule 2. And also consider the margin charged by bank.

SOME PROBLEMS ON FORWARD CONTRACT :- The following situations are considered for explanation of Rule 8.

Cancellation of Forward Contract: In the absence of any instructions from the customer, contracts which have matured are automatically cancelled on the fifteenth day from the date of maturity. In case the fifteenth day falls on a Saturday or holiday, the contract is cancelled on the next working day. Exchange loss, if any, is recovered from the customer under advice to him. The customer is not paid any gains out of such cancellations.Cancellation of forward contracts can be studied in two parts:-I. Cancellation at the request of customers II. Automatic cancellation by bank on the fifteenth day from date of maturity.



I. Cancellation at the request of customersSituation :- Cancellation before the date of maturity: - The bank enters into an opposite contract with the customer, the new contract will have same maturity date as of old contract. That means bank will cancelled the old contract and will enter in new with same maturity date.

For example, on 10 April, 2012, a bank entered into a forward purchase contract for 1,00,000 $ @ Rs.40 maturing on 10Th June 2012. On 10 th May, 200 the customer requests the bank to cancel the contract. Suppose, on 10th May 2012, the following rates are there : Spot : 1$ = Rs.40.00/40.10 1 month forward : 1$ =Rs.40.50/40.60 For this purpose, the bank will enter into a new forward sale contract, @ Rs.40.60, with the customer maturing 10th June, 2012. The bank recovers the difference.

Illustration:- ABC Ltd., with whom the Bank had entered into 2 months’ forward purchase contract for € 5,000 @ Rs.69.50 comes to bank after 1 months and requests for cancellation of the contract. On this date, the prevailing rates are: Spot € = Rs. 69.60 /.70 One month forward € = Rs. 69.90 / 70.04

What is the loss or gain to ABC Ltd on cancellation? Answer:- On the day the ABC Ltd comes to the bank for cancellation, the bank will enter into a forward contract ( same maturity date as that of the original ) under which bank will sell 5,000 € @ Rs.70.04. On maturity, bank will sell 5,000 € to ABC Ltd (@ Rs.70.04) for Rs.3,50,200 ( under the new contract) and purchase 5,000 € from the ABC Ltd (@ Rs.69.50) for Rs.3,47,500 ( under the original contract ). Loss to the ABC Ltd Rs.2,700. (This loss will be recovered from the ABC Ltd)

Illustration II:- As on November 15, an exporter has booked a sell contract of US$50,000 to be delivered two months forward at a rate Rs. 48.25. The delivery date is January 15. As on December 15, he wanted to cancel the contract. The Bank charges an exchange margin of 0.15% and flat cancellation charges of Rs.250. Estimate the cash flow, with the given information as at December 15:Interbank spot as at December 15: 47.40- 47.421-Month Forward: 15/30 Prime Lending Rate: 11.50% p.a

Answer:- One month before the due date the customer is cancelling the forward contract. Hence, effectively the bank can cover its position by buying one month forward. Cancellation of forward sell contract can be done by one month forward TT selling rate. December Spot US$ Purchase rate: Rs.47.40 1-Month Forward Premium: 0.15 Rs. 47.62 Exchange Margin: 0.15%

Amount to be paid to the customer: {(Rs.48.25 – Rs.47.62)*US$ 50,000 } = Rs.39,000/This payment is due on January 15. Since the settlement is made one month before, the PLR of 11.50% would be used for discounting the January 15 so as to pay it on December 15 and the amount would be Rs. 38376/-

Situation:- Forward contract Cancellation on the date of maturity: The bank does opposite action on spot basis i.e. if under original contract the bank was to sell a currency to ABC Ltd, the bank will purchase that currency from the ABC Ltd on spot basis . The bank recovers/ pays the difference.

Illustration:- Wealthy Bank has booked a forward purchase contract for USD 1,00,000 due 14th

August, 2012 @ Rs. 56.25. On maturity, the customer fails to deliver the Dollars and requests for cancellation of the contract. Spot rate on 14th August, 2012: USD = Rs. 56.652 /.732.



What amount of gain / loss will be payable to / receivable from customer? Answer:- On 14th August, the Bank will sell $ 1,00,000 on spot ( @ Rs.56.732 per $ ) for Rs. 56,73,200, the bank will purchase $ 1,00,000 (@ Rs. 56.25 per $ ) for Rs. 56,25,000 under the original ( forward) contract . Loss to the customer Rs.48,200. This loss will be recovered from the customer. Situation:- Forward contract Cancellation ‘after the date of maturity’ but ‘before fifteenth day after the date of maturity’: The bank does opposite action on spot basis . Exchange loss , if any, is recovered from the customer under advice to him. The customer is not paid any gains out of such cancellations.

Illustration:- Bank of Hydrabad has booked a forward sale contract for USD 1,00,000 @ 54.45 due 10th June, 2012. The customer did not contact the bank on due date. However, on June 16, 2012, the customer requests the bank to cancel the contract. On this date, spot rate is Rs. 54.20 /.29. What amount of gain / loss will be payable to / receivable from customer?Answer :- On 16th June, the Bank will sell 1,00,000 $ on under the original (forward) contract (@ Rs. 54.45 per $) for Rs. 54,45,000 the bank will purchase 1,00,000 $ (@ Rs. 54.20 per $ ) for Rs. 54,20,000 on spot. . Gain to the customer Rs.25,000. This gain won’t be given to the customer, it will be retained by the bank.

Extension of Forward contract:-Extension is permissible, at the customer’s request, only before maturity. The bank takes two steps; (i) Cancels the original contract i.e. the bank will take all the steps required for cancellation of the contract before the date of maturity. (ii) The bank will enter into a new forward contract maturing on the date requested by the customer. The FEDAI guidelines summarize this situation as: Cancel and Rebook. The amount of loss / gain is received from / paid to customer at the time of the customer approaches the bank for extension.

Illustration:- On 15 June, X a customer of “Y” bank booked a forward sale contact (For bank it’s a FX purchase contract) for USD 2,50,000 due July 30 @ Rs. 58.35. On 30th July. the customer requests the bank to extend the forward contact for 30th August. Foreign Exchange rates on 30th July are: Spot 58.458/.667 Forward 30th July 57.662/.717 Forward 30th August 57.442/.537 Bank PLR rate is 12.50% p.a.

What amount of loss / gain will be receivable from / payable to customer?Answer: On 15th June on entering into contract with customer “X”, the bank enters into simutanous contract of Forward sale in the market at a higher price than the forward price of the customer. On maturity the banks will purchase it at Rs.58.35 and will sale at higher price in forward sale contract e.g say at Rs.58.40 But, On 30th July, the customer has requested to extend the contract to 30th August. So now on 30th July, the bank will have to the bank will cancel the contract with the following calculations:$ 2,50,000 X spot TT selling 58.667= Rs. 1,46,66,750 ( that is bank has to purchase from spot and have to honour the commitment of its own other Forward sale contract)$ 2,50,000 X 58.350 = Rs.1,45,87,500 ( this is the amt of bank commitment towards the customer)

And hence here the bank suffers a loss of Rs. 1,46,66,750 – 1,45,87,500 = Rs.79,250/-Hence, this loss of Rs.79,250 is recoverable from the customer and also recover the interest at the rate of 12.50% for 30 days = Rs.79,250*12.50% =9,906/365*30 = Rs.814/-

Early Delivery :-The steps of early delivery can be divided into 3 parts: (I)



(a) Take delivery on spot basis and (b) make provisional payment on the original forward contract rate basis. The net effect of these two steps is that there will be either debit or credit balance in the customer’s account. This will be settled at the time of maturity of the original contract (i.e. at the time of final settlement) along with interest. If there is credit balance in the customer’s account the bank will pay interest at the rate of fixed deposit interest rate; if there is debit balance the bank will charge the customer interest at the rate of its Prime Lending Rate (PLR).

(II) A fresh contract for the cancellation of the original contract: Generally bank enters into an opposite forward contract with the market after the forward contract with the customer, and hence in case of early delivery bank is required to reverse the contract as entered in original contract after the early delivery. The new contract will have same maturity date as that of old contract (which is to be cancelled).

(III) On maturity : The bank will execute both the forward contracts (original contract as well as the contract entered on the date of early delivery). Under the original contract the bank will purchase the foreign currency and under the new contract (entered on the date of early delivery) the bank will sell the foreign currency. Illustration:-Suppose, a ABC Bank has originally entered a 3 month forward purchase of $ 1,00,000 currency at a rate of Rs.54 maturing on 31st August. On 30th June customer received $ 100,000 from US company and hence he approached bank with $ 1,00,000 to exchange in Rupee (when spot rate is Rs. 54.28/.33 and forward rate is Rs.54.80/.89 for due date after 2 months) against forward contract. How much amount will be payable to customer? Answer:-To settle this transaction, bank will do two things: (i) the bank has to enter into another forward purchase contract maturing on 31st August, i.e.due date of original contract. Because bank at the time of entering contract of purchase of $ from customer ,has entered reversed contract of Forward sale maturing on 31st August. Now this new forward purchase bank needs to entered at Rs.54.89 maturing on 31st August. Here bank will suffer a loss to the extent of Rs.54.89 – Spot sale of Rs.54.28 = Rs.0.61 * $1,00,000 = Rs.61,000/- i.e outflow of fund i.e it will be treated as swap difference and hence bank will recover this amount from customer.

II) Bank has to Purchase $ 1,00,000 at agreed rate Rs.54.35 and has to give Rs. 54,35,000 to customer. However, here bank is not earning i.e its a outflow of fund for bank because bank is selling in interbank market at 54.28 and paying to customer at Rs.54.35. And hence, the bank will charge interest on Rs.7,000 (54,35,000 paid – 54,28,000 received) treating as outlay. Interest will be either as mentioned in Forward contract or may be MCLR or may be as specified.

ROLL OVER FORWARD CONTRACT: Another application of swaps is in the “roll-over forward contracts”. In some countries, forward contracts do not exist beyond certain maturities. Like, in India, it is available for maximum maturities of 6 months. Exposures with longer terms are required to be hedged by roll-over forward contracts. Under these contracts, the exchange rate protection is provided for the entire period of the contract and the customer has to bear the roll over charges (swap charges), if any, at every roll over date. Essentially, at every rollover date, the customer does a swap, sell spot and buy forward, or vice-versa.

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CHAPTER 7FOREIGN EXCHANGE MANAGEMENT ACT, 1999

BASICSThe Foreign Exchange Management Act, 1999 (FEMA) deals with cross border investments, foreign exchange transactions and transactions between residents and non-residents. It has replaced the erstwhile Foreign Exchange Regulation Act, 1973 (FERA) with effect from June 1, 2000.The operation of FEMA is akin to any other commercial law. However as compared to most other commercial laws FEMA is one of the smallest, having only 49 Sections. If guidelines, rules, etc. are followed, the person can undertake the transaction without any approvals. If proposed transactions fall outside the guidelines, one will have to take necessary approvals. The consequence of any violation is a penalty. If penalty is not paid, then there can be prosecution.FEMA extends to the whole of India. It also applies to all branches, offices and agencies outside India, which are owned or controlled by a person resident in India.

IMPORTANT TERMS UNDER FEMA – Section 21. Capital Account Transaction means a transaction which: –• Alters foreign assets and foreign liabilities (including contingent liabilities) of Indian residents.• Alters Indian assets and Indian liabilities of Non-residents.• Is a Specified transaction listed in section 6(3).Essentially this is an economic definition and not an accounting or legal definition. It is intended to cover cross border investments, cross border loans and transfer of wealth across borders. RBI has been empowered to regulate capital account transactions. Unless the transaction is permitted as per regulations, Foreign Exchange (FX) cannot be drawn for the same.Capital account transactions though freed to a great extent, continue to be regulated by RBI. Unless RBI permits by way of rules or specific approvals, transactions cannot be undertaken. But there are two very important purposes for which RBI cannot impose any restrictions viz. drawing of foreign exchange for the repayment of any loans and for replenishing depreciation of direct investments in the ordinary course of business. (Section 6)

2. Current Account Transaction means all transactions, which are not capital account transactions. Specifically it includes:–• Business transactions between residents and non-residents.• Short-term banking and credit facilities in the ordinary course of business.• Payments towards interest on loans and by way of income from investments.• Payment of expenses of parents, spouse or children living abroad or expenses on their foreign travel, medical and education.• Scholarships/Chairs.Primarily there are no restrictions on current account transactions. A person may sell or draw foreign exchange freely for his current account transactions, except in a few cases where limits have been prescribed (Section 5). The Central Government has the power to regulate current account transactions. Unless the transaction is restricted, FX can be drawn for the same.

3. Person includes:– (a) an individual (b) a Hindu Undivided Family (HUF) (c) a company (d) a firm (e) an association of persons or body of individuals, whether incorporated or not(f) every artificial judicial person not falling in any of the above sub-clauses(g) any agency, office or branch owned or controlled by such person.

4. Resident/Non-Resident:– If an individual stays in India for more than 182 days during the course of the preceding financial year, he will be treated as a person resident in India. There are a few exceptions as under:

If a person goes/stays outside India for (a) taking up employment, or (b) carrying on business or vocation, or (c) for any other purpose for an uncertain period; he will be treated as a person resident outside India (non-resident). (It has been clarified that students going abroad for further studies will be regarded as non-residents.)



If a person who is residing abroad comes to/stays in India only for (a) taking up employment, or (b) carrying on business or vocation, or (c) for any other purpose for an uncertain period; he will be treated as a person resident in India.

The term financial year means a twelve-month period beginning from April 1 and ending on March 31 next. Following persons (other than individuals) will be treated as person resident in India:

Person or body corporate which is registered or incorporated in India. An office, branch or agency in India, even if it is owned or controlled by a person resident

outside India. An office, branch or agency outside India, if it is owned or controlled by a person resident in

India.The definition is however inadequate to define residential status of a firm, an HUF, a trust or any entity which does not have to be registered. Conversely, a non-resident means a person who is not a resident in India.

IMPORTANT FEATURES :1. All dealings in foreign exchange or foreign security can be done only through an authorized person if permitted by FEMA, rules & regulations framed there under, or by general or special permission of the RBI. Further no payments can be made by a resident to a non-resident unless permitted under FEMA (section 3).

2. Residents have been allowed to maintain foreign currency accounts in India as under:A. EEFC ACCOUNTA person is permitted to credit the under mentioned amounts out of his foreign exchange earnings to his EEFC Account: -

Entity or person Limit in %1 Status Holder Exporter (as defined in the EXIM Policy in force) 1002 Individual professionals ** 1003 100% EOU Unit in EPZ/STP/EHTP 1004 Any other person 100

** Professionals mean Director on Board of overseas company; Scientist /Professor in Indian University/Institution; Economist; Lawyer; Doctor; Architect; Engineer; Artist; Cost/Chartered Account; Any other person rendering professional services in his individual capacity, as may be specified by the Reserve Bank from time to time. Professional earnings including director's fees, consultancy fees, lecture fees, honorarium and similar other earnings received by a professional by rendering services in his individual capacity.However, amounts received to meet specific obligations of the account holder cannot be credited (e.g. equity investment from a non-resident investor). The balances do not earn any interest. These funds can be used for several current account purposes. For many transactions, where there are restrictions under the current account rules, funds in EEFC account can be used without restrictions.Units in SEZ are permitted to open, hold and maintain a Foreign Currency Account with an authorized dealer in India.

B. By Other persons i.e NRI ( Non resident Indian’s)Particulars Foreign Currency (Non-

Resident) Account (Banks) Scheme (FCNR(B) Account

Non-Resident (External)Rupee Account Scheme (NRE

Account)

Non-Resident Ordinary Rupee Account Scheme

(NRO AccountWho can open an account

NRIs (individuals / entities of Pakistan nationality/ownershiprequire prior approval of RBI)

NRIs(individuals / entities of

Pakistan nationality/ownershiprequire prior approval of RBI)

Any person resident outside India (other than a person resident in Nepal and Bhutan). (individuals / entities of Bangladesh / Pakistan nationality /



ownership as well as erstwhile OCBs require prior approval of RBI)

Joint account

Non-Resident Indian (NRI), are permitted to open FCNR(B) account jointly with their resident close relative (relative as defined in Section 2 of the Companies Act, 2013) with operational instructions ‘former or survivor’, where NRI is ‘Former’.

Non-Resident Indians (NRIs), are permitted to open NRE / account jointly with their resident close relative (relative as defined in Section 2 of the Companies Act, 2013) with operational instructions ‘former or survivor’, where NRI is ‘Former’.

May be held jointly with residents

Nomination Permitted Permitted PermittedCurrency in which account is denominated

Pound Sterling, US Dollar, Japanese Yen, Euro, Canadian Dollar and Australian Dollar

Indian Rupees Indian Rupees

Whether Repatriable

Repatriable Repatriable Not repatriable except for the following in the account - 1) current income 2) up to USD 1 million per financial year (April- March), for any bonafide purpose out of the balances in the account / sale proceeds of assets in India acquired by way of inheritance / legacy inclusive of assets acquired out of settlement subject to certain conditions

Type of Account

Term Deposit only Savings, Current, Recurring, Fixed Deposit

Savings, Current, Recurring, Fixed Deposit

Period for fixed deposits

For terms not less than 1 year and not more than 5 years.

At the discretion of the bank As applicable toresident accounts

Rate of Interest

From 01.03.2014Maturity Period:1 year to less than 3 years:LIBOR/Swap plus 200 basis points3 - 5 years: LIBOR/ SWAP plus 300 basis points

Banks are free to determine interest rates for term depositsw.e.f 14.08.13

Banks are free to determine interest rates for term deposits w.e.f 14.08.13

Operations by Power of Attorney in favour of a resident by the non-resident

Operations on the account in terms of Power of Attorney is restricted to withdrawals forpermissible local payments or remittance to the account holder himself through normal banking channels.

Operations on the account in terms of Power of Attorney is restricted to withdrawals for permissible local payments or remittance to the account holder himself through normal banking channels

Operations on the account in terms of Power of Attorney is restricted to withdrawals for permissible local payments or



account holder

remittance to the account holder himself through normal banking channels

a. When a person resident in India leaves India for Nepal and Bhutan for taking up employment or for carrying on business or vocation or for any other purpose indicating his intention to stay in Nepal and Bhutan for an uncertain period, his existing account will continue as a resident account. Such account should not be designated as Non-resident (Ordinary) Rupee Account (NRO).b. ADs may open and maintain NRE / FCNR (B) Accounts of persons resident in Nepal and Bhutan who are citizens of India or of Indian origin, provided the funds for opening these accounts are remitted in free foreign exchange, Interest earned in NRE / FCNR (B) accounts can be remitted only in Indian rupees to NRIs and PIO resident in Nepal and Bhutan. c. In terms of Regulation 4(4) of the Notification No.FEMA.5/2000-RB dated May 3, 2000, ADs may open and maintain Rupee accounts for a person resident in Nepal / Bhutan.

Change of Status:When a resident proceeds to foreign country for stay for uncertain period, the existing ordinary rupee account will be converted as NRO account. Fresh NRE account should be opened with remittance from abroad. On his return back to India for stay for uncertain period / permanent settlement, all the Non Resident running accounts will be converted as resident accounts immediately and Term Deposits will be allowed to continue till maturity.

Bank account outside India of employees of foreign companies on deputation in indiaEmployees of foreign companies (either foreign nationals or Indian nationals) who are on deputation in India are permitted to open, hold and maintain a foreign currency account outside India and receive salary due to them as under:–(a) The amount of salary to be credited to such account should not exceed 75% of the salary accrued or received by the employee from the foreign company.(b) The remaining salary shall be paid in Rupees in India.(c) The tax on the whole salary has been paid.

Note:'Non-Resident Indian (NRI)' means a person resident outside India who is a citizen of India or is a person of Indian origin;‘Person of Indian Origin (PIO)’ means a person resident outside India who is a citizen of any country other than Bangladesh or Pakistan or such other country as may be specified by the Central Government, satisfying the following conditions:a. Who was a citizen of India by virtue of the Constitution of India or the Citizenship Act, 1955 (57 of 1955); orb. Who belonged to a territory that became part of India after the 15th day of August, 1947; orc. Who is a child or a grandchild or a great grandchild of a citizen of India or of a person referred to in clause (a) or (b); ord. Who is a spouse of foreign origin of a citizen of India or spouse of foreign origin of a person referred to in clause (a) or (b) or (c)Explanation: for the purpose of this sub-regulation, the expression ‘Person of Indian Origin’ includes an ‘Overseas Citizen of India’ cardholder within the meaning of Section 7(A) of the Citizenship Act, 1955.

Diamond Dollar Account (DDA) :Under the scheme of Government of India, firms and companies dealing in purchase / sale of rough or cut and polished diamonds / precious metal jewellery plain, minakari and / or studded with / without diamond and / or other stones, with a track record of at least 3 years in import / export of diamonds / coloured gemstones / diamond and coloured gemstones studded jewellery / plain gold jewellery and having an average annual turnover of Rs. 5 crores or above during the preceding



three licensing years (licensing year is from April to March) are permitted to transact their business through Diamond Dollar Accounts.They may be allowed to open not more than five Diamond Dollar Accounts with their banks.

3. CONTRAVENTION, PENALTIES & APPEALS – Sections 13 To 351. Penalties for contraventions under FEMA are per se monetary in nature. If any person contravenes any provisions, rules, regulations, etc. the penalty imposed may be 3 times the amount involved in contravention; and if the amount of contravention is not ascertainable, penalty can be up to Rs. 200,000. If the contravention is a continuing one, a penalty up to Rs. 5,000 per day may be imposed for every day after the 1st day during which the contravention continues.2. The adjudicating officer may also confiscate any currency, security or property in addition to imposing penalty.3. If a person does not pay up the penalty within 90 days, he is liable for civil imprisonment.4. There is a right to appeal given at every stage and an appeal against an order of the Adjudicating Authority can be made to the Special Director (Appeal). An appeal against the order of the Special Director (Appeals) can be made to the Appellate Tribunal. An appeal, on questions of Law, against the order of the Appellate Tribunal can be made to the High Court.5. A person preferring an appeal to the Special Director (Appeals) or the Appellate Tribunal can take assistance of a Chartered Accountant or Legal Practitioner.

4. DIRECTORATE OF ENFORCEMENT – SECTIONS 36 TO 381. The officers of the Directorate have powers to investigate contraventions referred to in section 13.2. The powers and limitations of these officers are the same as those conferred on Income-tax Authorities under the Income-Tax Act, 1961.

5. COMPOUNDING OF CONTRAVENTIONSPowers for compounding of offences – RBI has been given powers for compounding all cases of contraventions other than cases under section 3(a) of FEMA. Cases of contravention under section 3(a) relate to dealing in or transfer of foreign exchange and foreign security to any person other than an authorised dealer. For these, Enforcement Directorate will be responsible. Powers of compounding with RBI should give confidence to public.Depending on the amount involved, various officers have been designated to look into applications for compounding. The compounding authority can call for any information, record or any other documents relevant to the compounding proceedings. The compounding authority is required to pass an order within 180 days from the date of application. The sum for which the contravention is compounded has to be paid within 15 days from the date of order of compounding.

6. TRANSACTIONS BY RESIDENTS :The details of restrictions on Current Account Transactions are as follows:A. Payments or withdrawal of FX for following purposes are totally prohibited:-1. Travel to Nepal and Bhutan. 2. Transaction with a person resident in Nepal and Bhutan.3. Remittance out of lottery winnings. 4. Remittance of income from racing/riding, etc. or any other hobby.5. Remittance for purchase of lottery tickets, banned/ proscribed magazines, football pools, sweepstakes, etc.6. Payment of commission on exports made towards equity investment in Joint Ventures/Wholly Owned Subsidiaries abroad of Indian companies.7. Payment of commission on exports under Rupee State Credit Route, except commission up to 10% of invoice value of exports of tea and tobacco.8. Payment related to “Call Back Services” of telephones.9. Remittance of interest income on funds held in NRSR Scheme Account.10. Remittance towards participation in lottery schemes involving money circulation or for securing prize money / awards, etc.7.2 Investments Abroad by Indian Residents :7.2.1 Joint ventures & wholly owned subsidiaries.



Purpose Set up of Joint ventures wholly owned subsidiaries (WOS) Automatic route (No permission required)

Investment made upto 400% (w.e.f 14.08.2013 – 100%) of the Net worth as per the last balance sheet. Investment over 100% of net worth requires permission.

Who can set up JVs& WOS Indian Companies & Registered Partnership firms only. Registered Trust/ Society operating hospitals in India, can invest in same sector abroad.

Prohibited activity for Investment in JVs & WOS

Portfolio Investment & Investment in banking & real estate

Way of Investment Equity, loans or by way of guarantees.

Other Investments Options:-Portfolio Investment (Automatic Route)Who can invest & upto what amount a. Listed Indian company upto 50% of list net worth

as per last audited Balance sheets.b. Indian MF registered with SEBI upto US$ 7 billion. c. Indian VC registered with SEBI - Upto to US$ 500 million in equity/ Equity linked investment of off shore VC after SEBI approved.

Agriculture operations overseasWho can invest& upto what amount.

Indian Company & registered partnership upto 400% of its Net worth.

Investment by regional Star Exporters. Proprietory Concern/unregistered Partnership firm, who exports for more than 15cr pa. KYC compiled & exports outstanding not exceeding 10% of average export realization of last 3 yrs, can invest max of avg. 3 yrs export realization of 200/- of their net owned Funds, whichever is lower.

7.2.2 Remittance under the Us $ 2,50,000 Scheme (Monetary Policy Review’ in February, 2015,)An individual resident in India is permitted to remit up to US $ 2,50,000 per calendar year for any legal and lawful purpose without obtaining prior permission of RBI. The individual can use said facility for any current account transaction, acquisition of any movable and/or immovable property, remittance towards gift and donation, investment in overseas companies or opening of a bank account outside India. However, remittances cannot be made to Bhutan, Nepal, Mauritius or Pakistan or countries identified as “non co-operative countries and territories” by the Financial Action Task Force. Currently (i.e., as per list updated as on February 17, 2006), the countries where investment cannot be made are Myanmar, Nigeria. The updated list can be seen at the website of FATF - http://www.fatf-gafi.org. An application cum declaration form is required to be filed with the A. D.

7.2.3 Borrowings from Non-residents: w.e.f 30/11.2015 & subsequent amendments in Nov’18.

External Commercial Borrowings(ECB)Who can borrow?Track I (Medium term foreign currency denominated ECB with Minimum Average Maturity (MAM) of 3/5 years.)

- Companies in manufacturing, and software development sectors.- Shipping and airlines companies.- Small Industries Development Bank of India (SIDBI).- Units in Special Economic Zones (SEZs).-Housing Finance Companies, regulated by the National Housing Bank -Port Trusts constituted under the Major Port Trusts Act, 1963 or Indian Ports Act, 1908,-Companies engaged in the business of Maintenance, Repair and Overhaul and freight- Export Import Bank of India (Exim Bank) (only under the approval route)- Companies in infrastructure sector, Non-Banking Financial Companies Infrastructure Finance Companies (NBFCIFCs), NBFCs-Asset Finance Companies (NBFC-AFCs), Holding Companies and Core Investment Companies (CICs).



Track II (Long term foreign currency denominated ECB with MAM of 10 years.)

- All entities listed under Track I.- Companies in infrastructure sector.- Holding companies.- Core Investment Companies (CICs).- Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (INVITs) coming under the regulatory framework of the Securities and Exchange Board of India (SEBI).

Track III (Indian Rupee denominated ECB with MAM of 3/5 years)

- All entities listed under Track II.- All Non-Banking Financial Companies (NBFCs) coming under the regulatory purview of the Reserve Bank.- NBFCs-Micro Finance Institutions (NBFCs-MFIs), Not for Profit companies registered under the Companies Act, 1956/2013, Societies, trusts and cooperatives (registered under the Societies Registration Act, 1860, Indian Trust Act, 1882 and State-level Cooperative Acts/Multi-level Cooperative Act/State-level mutually aided Cooperative Acts respectively), Non-Government Organisations (NGOs) which are engaged in micro finance activities1.- Companies engaged in miscellaneous services viz. research and development (R&D), training (other than educational institutes), companies supporting infrastructure, companies providing logistics services. - Developers of Special Economic Zones (SEZs)/ National Manufacturing and Investment Zones (NMIZs)

Note: ECBs in the infrastructure space can borrow with MAM of 3 years w.e.f 6.11.2018Purpose for which they can borrow?

Track I,II & III 1. Except for the prohibited activities, ECBs can be used for any bonafide business requirement such as import of capital goods, new projects, modernization / expansion of existing production units, etc. Overseas direct investment in Joint ventures (JV)/ Wholly owned subsidiaries (WOS), Refinancing of existing ECB provided the residual maturity is not reduced2. SIDBI can raise ECB only for the purpose of on lending to the borrowers in the Micro, Small and Medium Enterprises (MSME sector)3. Units of SEZs can raise ECB only for their own requirements.4. Shipping and airlines companies can raise ECB only for import of vessels and aircrafts respectively. 5. ECB proceeds can be used for general corporate purpose (including working capital) provided the ECB is raised from the direct / indirect equity holder or from a group company for a minimum average maturity of 5 years.W.e.f 3.10.2018, public sector Oil Marketing Companies (OMCs) can also raise money for working capital purposes with minimum maturity of 3/5 years.6. ECBs for the following purposes will be considered under the approval route:a.Import of second hand goods as per the Director General of Foreign Trade (DGFT) guidelines;b. On-lending by Exim Bank.

Negative List for use The ECB proceeds can be used for all purposes excluding the following:Real estate activities, Investing in capital market, Using the proceeds for equity investment domestically; On-lending to other entities with any of the above objectives; Purchase of land.Holding companies can also use ECB proceeds for providing loans to their infrastructure SPVs. Additionally for Tracks I and III, the following negative end uses will also apply except when raised from Direct and Indirect equity holders or from a Group company, and provided the loan is for a minimum average maturity of five years: d. Working capital purposes.



e. General corporate purposes. f. Repayment of Rupee loans.

Limit upto which ECB can be raised?

A. Automatic Route- Upto USD 750 million or equivalent for the companies in infrastructure and manufacturing sectors, Non-Banking Financial Companies -Infrastructure Finance Companies (NBFC-IFCs), NBFCs-Asset Finance Companies (NBFCAFCs), Holding Companies and Core Investment Companies; - OMC’s can raise upto USD 10 billion or equivalent (for working capital).- Upto USD 200 million or equivalent for companies in software development sector;- Upto USD 100 million or equivalent for entities engaged in micro finance activities; and- Upto 500 million or equivalent for remaining entities.B. Approval Route:Limit above the automatic route will be considered on case by case basis.Minimum Average Maturity Period

Track I & Track III i. 3 years for ECB upto USD 50 million or its equivalent.(However borrowers who are into manufacturing sector can raise it with minimum maturity of 1 year).ii. 5 years for ECB beyond USD 50 million or its equivalent.iii. 5 years for eligible borrowers (Companies in infrastructure sector, Non-Banking Financial Companies Infrastructure Finance Companies (NBFCIFCs), NBFCs-Asset Finance Companies (NBFC-AFCs), Holding Companies and Core Investment Companies (CICs)) irrespective of the amount of borrowing, subject to 100 per cent hedging.iv. 5 years for Foreign Currency Convertible Bonds (FCCBs)/ Foreign Currency Exchangeable Bonds (FCEBs) irrespective of the amount of borrowing. The call and put option, if any, for FCCBs shall not be exercisable prior to 5 years.

Track II 10 years irrespective of the amount.All-in-Cost (AIC)

Track I & IIAverage Maturity in years

450 basis points over 6 months LIBOR or applicable bench mark for the respective currency.Penal interest, if any, for default or breach of covenants should not be more than 2 per cent over and above the contracted rate of interest.

Track III Prevailing yield of the Government of India securities of corresponding maturityThe term ‘All-in-Cost’ includes rate of interest, other fees, expenses, charges, guarantee fees whether paid in foreign currency or Indian Rupees (INR) but will not include commitment fees, pre-payment fees / charges, withholding tax payable in INR. In the case of fixed rate loans, the swap cost plus spread should be equivalent of the floating rate plus the applicable spread.

7.3.1 Borrowings through Loans / DepositsIndian Companies, other Body Corporates, Indian Proprietary Concerns and Firms can accept fresh deposits from NRI only if the deposit is by way of debit to the NRO account of the lender and the amount deposited does not represent inward remittances or transfer from NRE/FCNR (B) Accounts into the NRO Account of the lender. However, they are permitted to hold and renew on maturity existing deposits received by them on repatriation as well as non-repatriation basis.Resident Individuals are permitted to avail of interest free loans up to US $ 250,000 from their NRI / PIO relatives subject to certain conditions.Special permission of the RBI will be required in case where deposits / loans do not fulfil the specified criteria or where the deposits/loans are on repatriation basis in the case of proprietary concerns and firms.

8. PERMISSIBLE TRANSACTIONS BY NON-RESIDENTS:



8.1 Foreign Direct Investment (FDI) in India is : FDI( Foreign Direct Investment): Undertaken in accordance with the FDI Policy which is formulated and announced by the

Government of India. The Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India issues a “Consolidated FDI Policy Circular ” on an yearly basis on March 31 of each year (since 2010) elaborating the policy and the process in respect of FDI in India. The latest “Consolidated FDI Policy Circular” dated April 5, 2013 is available in public domain and can be downloaded from the website of Ministry of Commerce and Industry, Department of Industrial Policy and Promotion –

http://www.dipp.nic.in/English/Policies/FDI_Circular_01_2013.pdf governed by the provisions of the Foreign Exchange Management Act (FEMA), 1999. FEMA Regulations which prescribe amongst other things the mode of investments i.e. issue or acquisition of shares / convertible debentures and preference shares, manner of receipt of funds, pricing guidelines and reporting of the investments to the Reserve Bank. The Reserve Bank has issued Notification No. FEMA 20 /2000-RB dated May 3, 2000 which contains the Regulations in this regard. This Notification has been amended from time to time.

Foreign Direct Investment Entry routes for investments in India

investments can be made in shares, mandatorily and fully convertible debentures and mandatorily and fully convertible preference shares of an Indian company by non-residents through two routes:a. Automatic Route: Under the Automatic Route, the foreign investor or the Indian company does not require any approval from the Reserve Bank or Government of India for the investment.b. Government Route: Under the Government Route, the foreign investor or the Indian company should obtain prior approval of the Government of India(Foreign Investment Promotion Board (FIPB), Department of Economic Affairs (DEA), Ministry of Finance or Department of Industrial Policy & Promotion, as the case may be) for the investment.

List of activities or items in which FDI is prohibited

(i) Foreign investment in any form is prohibited in a company or a partnership firm or a proprietary concern or any entity, whether incorporated or not (such as, Trusts) which is engaged or proposes to engage in the following activities:

a. Business of chit fund, orb. Nidhi company, orc. Agricultural or plantation activities, ord. Real estate business, or construction of farm houses, or e. Trading in Transferable Development Rights (TDRs).

(ii) It is clarified that “real estate business” means dealing in land and immovable property with a view to earning profit or earning income there from and does not include development of townships, construction of residential / commercial premises, roads or bridges, educational institutions, recreational facilities, city and regional level infrastructure, townships.It is further clarified that partnership firms /proprietorship concerns having investments as per FEMA regulations are not allowed to engage in print media sector.(iii) In addition to the above, Foreign investment in the form of FDI is also prohibited in certain sectors such as(a) Lottery Business including Government /private lottery, online lotteries, etc. (b) Gambling and Betting including casinos etc. (c) Business of Chit funds (d) Nidhi company (e) Trading in Transferable Development Rights (TDRs) (f) Real Estate Business or Construction of Farm Houses (g) Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes (h) Activities / sectors not open to private sector investment e.g. Atomic Energy and Railway Transport (other than Mass Rapid Transport Systems).Note: Foreign technology collaboration in any form including licensing for franchise, trademark, brand name, management contract is also prohibited for Lottery Business and Gambling and Betting activities.



Eligibility for Investment in India

(i) A person resident outside India or an entity incorporated outside India, can invest in India, subject to the FDI Policy of the Government of India. A person who is a citizen of Bangladesh or an entity incorporated in Bangladesh can invest in India under the FDI Scheme, with the prior approval of the FIPB. Further, a person who is a citizen of Pakistan or an entity incorporated in Pakistan, may, with the prior approval of the FIPB, can invest in an Indian company under FDI Scheme, subject to the prohibitions applicable to all foreign investors and the Indian company, receiving such foreign direct investment, should not be engaged in sectors / activities pertaining to defence, space and atomic energy.(ii) NRIs, resident in Nepal and Bhutan as well as citizens of Nepal and Bhutan are permitted to invest in shares and convertible debentures of Indian companies under FDI Scheme on repatriation basis, subject to the condition that the amount of consideration for such investment shall be paid only by way of inward remittance in free foreign exchange through normal banking channels.

Investment Limits

a) Foreign Investment LimitsThe details of the entry route applicable and the maximum permissible foreign investment / sectoral cap in an Indian Company are determined by the sector in which it is operating. The details of the entry route applicable along with the sectoral cap for foreign investment in various sectors are given in sectoral investment guidelines.b) Investments in Micro and Small Enterprise (MSE)A company which is reckoned as Micro and Small Enterprise (MSE) (earlier Small Scale Industrial Unit) in terms of the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006, including an Export Oriented Unit or a Unit in Free Trade Zone or in Export Processing Zone or in a Software Technology Park or in an Electronic Hardware Technology Park, may issue shares or convertible debentures to a person resident outside India (other than a resident of Pakistan and to a resident of Bangladesh under approval route), subject to the prescribed limits as per FDI Policy, in accordance with the Entry Routes and the provision of Foreign Direct Investment Policy, as notified by the Ministry of Commerce & Industry, Government of India, from time to time.Any Industrial undertaking, with or without FDI, which is not an MSE, having an industrial license under the provisions of the Industries (Development & Regulation) Act, 1951 for manufacturing items reserved for the MSE sector may issue shares to persons resident outside India (other than a resident/entity of Pakistan and to a resident/entity of Bangladesh with prior approval FIPB), to the extent of 24 per cent of its paid-up capital or sectoral cap whichever is lower. Foreign investments under Portfolio Investment Scheme (PIS)

Investment instruments

Purchase of shares and convertible debentures issued by Indian companies under the Portfolio Investment Scheme (PIS).

Who can invest Foreign Institutional Investors (FIIs) registered with SEBI, NRIs, SEBI approved sub accounts of FIIs (sub accounts),

Limits of Investment

A. FIIs(a) An Individual FII/ SEBI approved sub accounts of FIIs can invest up to a maximum of 10 per cent of the total paid-up capital or 10 per cent of the paid-up value of each series of convertible debentures issued by the Indian company. The 10 per cent limit would include shares held by SEBI registered FII/ SEBI approved sub accounts of FII under the PIS (by way of purchases made through a registered broker on a recognized stock exchange in India or by way of offer/private placement) as well as shares acquired by SEBI registered FII under the FDI scheme.(b) Total holdings of all FIIs / SEBI approved sub accounts of FIIs put together shall not exceed 24 per cent of the paid-up capital or paid-up value of each series of convertible debentures. This limit of 24 per cent can be increased to the sectoral cap / statutory limit, as applicable to the Indian company concerned, by passing of a resolution by its Board of Directors, followed by a special resolution to that effect by its General Body which should necessarily be intimated to the Reserve Bank of India immediately as hitherto, along with certificate from the



Company Secretary stating that all the relevant provisions of the extant Foreign Exchange Management Act, 1999 regulations and the Foreign Direct Investment Policy, as amended from time to to time have been complied with.B. NRIs(a) NRIs are allowed to invest in shares of listed Indian companies in recognised Stock Exchanges under the PIS.(b) NRIs can invest through designated ADs, on repatriation and non-repatriation basis under PIS route up to 5 per cent of the paid- up capital / paid-up value of each series of debentures of listed Indian companies.(c) The aggregate paid-up value of shares / convertible debentures purchased by all NRIs cannot exceed 10 per cent of the paid-up capital of the company / paid-up value of each series of debentures of the company. The aggregate ceiling of 10 per cent can be raised to 24 per cent by passing of a resolution by its Board of Directors followed by a special resolution to that effect by its General Body which should necessarily be intimated to the Reserve Bank of India immediately as hitherto, along with Certificate from the Company Secretary stating that all the relevant provisions of the extant Foreign Exchange Management Act, 1999 regulations and the Foreign Direct Investment Policy, as amended from time to time have been complied with.

Prohibition forinvestments by FIIs and NRIs

• FIIs are not permitted to invest in the capital of an Asset Reconstruction Company.• Both FIIs and NRIs are not allowed to invest in any company which is engaged or proposes to engage in the following activities:

i. Business of chit fund, orii. Nidhi company, oriii. Agricultural or plantation activities, oriv. Real estate business* or construction of farm houses, or v. Trading in Transferable Development Rights (TDRs).

* Real estate business" does not include construction of housing / commercial premises, educational institutions, recreational facilities, city and regional level infrastructure, townships.Investment in Partnership Firm / Proprietary Concern

Who can invest A Non-Resident Indian (NRI) or a Person of Indian Origin (PIO) resident outside India can invest by way of contribution to the capital of a firm or a proprietary concern in India on non-repatriation basis provided:

i. Amount is invested by inward remittance or out of NRE / FCNR(B) / NRO account maintained with Authorised Dealers / Authorised banks.

ii. The firm or proprietary concern is not engaged in any agricultural / plantation or real estate business (i.e. dealing in land and immovable property with a view to earning profit or earning income there from) or print media sector.

iii. Amount invested shall not be eligible for repatriation outside India.Investments with repatriation benefitsNRIs / PIO may seek prior permission of Reserve Bank for investment in sole proprietorship concerns / partnership firms with repatriation benefits. The application will be decided in consultation with the Government of India.

Investment by non-residents other than NRIs / PIO

A person resident outside India other than NRIs / PIO may make an application and seek prior approval of Reserve Bank, for making investment by way of contribution to the capital of a firm or a proprietorship concern or any association of persons in India. The application will be decided in consultation with the Government of India.

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HERE IN AFTER MODULE B RISK MANAGEMENT



CHAPTER 1 RISK MANAGEMENT: AN OVERVIEW

Structure1.1 Introduction1.2 Risk Management1.3 Categories of Risk1.4 Steps in Risk Management1.5 Integration of Risks leading to Enterprise-wise Risk Management System

1.1 INTRODUCTIONThe business of banking today is synonymous with active risk management than it was ever before. The success and failure of a banking institution heavily depends on the strength of the risk management system in the current environment. To diversify other than just lending, banks entered into a host of fee based services such as cash management, funds transfer etc., capital market activities such as merchant banking, public issue management, private placement of issues and advisory services to diversity from fund- based to fee-based activities. It results in rapid growth in the size of investment portfolio of banks over a period of time at the cost of advances portfolio. Over the period of time, the income from the businesses of lending, investments and fee based services have come down due to competition both from within and outside the industry. To counter this, the latest in the array of new products is the provision of specialized services by structuring products to meet the unique requirements of corporate customers and also to high networth individual clients for improving fee income. The scope of the business of structuring products has widened to a significant level with the introduction of derivative products in the markets. The net result of all the above developments is a metamorphic change in the risk and return profile compared to the past. This will continue in future with more and more of derivatives entering into the various segments of the market. While the complexities have increased tremendously, tools to manage the complexities have to be in place to manage the complexities.

1.2 RISK MANAGEMENTMeaning and ScopeThough the term risk has got different connotations from different angles, it can be defined as the potential that events, expected or unexpected may have an adverse impact on a bank’s earnings or capital or both. Both the risks having high probability low impact and low probability high impact are covered under the definition. This working definition would be useful throughout the discussion. It is useful to recall at this stage that risk and expected return are positively related; higher the risk, higher the expected return and vice versa. The scope of risk management function in any organization is to ensure that systems and processes are set up in accordance with the risk management policy of the institution.

ObjectivesThe very basic objective of risk management system is to put in place and operate a systematic process to give a reasonable degree of assurance to the top management that the ultimate corporate goals that are vigorously pursued by it would be achieved in the most efficient manner. In this way, all the risks that come in the way of the institution achieving the goals it has set for itself would be managed properly by the risk management system. In the absence of such a system, no institution can exist in the long-run without fulfilling the objectives for which it was set up.

1.3 CATEGORIES OF RISKBanking risks can be broadly categorized as under:a) Credit Risk b) Interest Rate Risk c) Market Risk d) Liquidity Riske) Operational Risk

a) Credit Risk: Credit risk is the oldest risk among the various types of risks in the financial system, especially in banks and financial institutions due to the process of intermediation. Managing credit risk has formed the core of the expertise of these institutions. While the risk is



well known, growth in the markets, disintermediation, and introduction of a number of innovative products and practices has changed the way. Credit risk is measured and managed in today’s environment. Credit risk arises from all activities where success depends on counterparty, issuer or borrower performance”. Credit risk enters the books of a bank the moment the funds are lent, deployed, invested or committed in any form to counterparty whether the transaction is on or off the balance sheet.b) Interest Rate Risk: Interest Rate Risk (IRR) arises as a result of change in interest rates on rate earning assets and rate paying liabilities of a bank. The scope of IRR management is to cover the measurement, control and management of IRR in the banking book. With the deregulation of interest rates, the volatility of the interest rates has risen considerably. This has transformed the business of banking forever in our country from a mere volume driven business to a business of carefully planning and choosing assets and liabilities to be entered into to achieve targets of profitability.There are two basic approaches to IRR. They are: a) Earnings Approach, and a) Economic Value Approach.c) Market Risk: Traditionally, credit risk management was the primary challenge for banks. With progressive deregulation, market risk arising from adverse changes in market variables, such as interest rate, foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks.Market risk takes the form of: a) Liquidity Risk, b) Interest Rate Risk, c) Foreign Exchange Rate (Forex) Risk, d) Commodity Price Risk, and e) Equity Price Riskd) Liquidity Risk: Liquidity risk is defined as the possibility that the bank would not be able to meet the commitments in the form of cash outflows with the available cash inflows. This risk arises as a result of inadequacy of cash available and near cash item including drawing rights to meet current and potential liabilities. Liquidity risk is categorized into two types; a) Trading Liquidity Risk; and b) Funding Liquidity Risk.Trading liquidity risk arises as a result of illiquidity of securities in the trading portfolio of the bank. Funding liquidity risk arises as a result of the cash flow mismatch and is an outcome of difference in balance sheet strategies pursued by different institutions in the same industry. It is perfectly possible for a few banks to have excess funding liquidity while other banks may suffer shortage ofliquidity.e) Operational Risk: Operational risk is emerging as one of the important risks financial institutions worldwide are concerned with. Unlike other categories of risks, such as credit and market risks, the definition and scope of operational risk is not fully clear. A number of diverse professions such as internal control and audit, statistical quality control and quality assurance, facilities management and contingency planning, etc., have approached the subject of operational risk thereby bringing in different perspectives to the concept. While studies carried out on bank failures in the U.S. show that operational risk has accounted for an insignificant proportion of large bank failures so far, it is widely acknowledged that most of the new, unknown risks are under the category of operational risk. According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events. This definition includes legal risk, but excludes strategic and reputation risk” (The New Basel Capital Accord, Consultative Document released in April 2003). There can be different classifications depending on the purpose.

1.4 STEPS IN RISK MANAGEMENT1) Risk Identification: It is crucial that all the risks have to be identified first. The methodology normally followed is the risk matrix approach which appears as under:

Risk Matrix ( Indicative)Products Credit Risk Interest Rate

RiskMarket Risk Liquidity

RiskOperational Risk

Loans & Advances YES YES NO YES YESInvestments YES YES YES YES YESCash Management & Payment services

NO NO NO NO YES

Deposits NO YES NO YES YES



The matrix above has been prepared for main products. The matrix can be detailed to go down to individual product level risks for better identification of risks present.

2) Risk Measurement: This step is the most crucial of all. Having identified the risks, tools for measurement of each one of the risks need to be put in place to measure each one of the risks in a numerical form. The most challenging task is the selection of an appropriate tool or methodology for quantification of risks. The measures of quantification range from simple to highly complex. What is important is to use an appropriate quantification method or tool suitable for the bank3) Risk Control and Monitoring: Risk control and monitoring deal with setting up of limits to each one of the risks and monitoring them to ensure that the actual exposure to each one of the risks defined is within the limits prescribed in the risk management policy. Any violation of limits needs to be thoroughly investigated to ascertain the reasons for violation and to avoid such violations in future.4) Capital Allocation: Under this step, activities of a bank would be broken down to various major businesses, such as retail banking, corporate banking, government business, proprietary trading etc. as each one of these businesses have become highly focused and require specialization to manage them, unlike in the past when the entire banking business was viewed as a single business requiring little or no specialization at all. Each one can be viewed as a Strategic Business Unit (SBU) with targets of return performance. Each one of the SBUs is allocated a portion of the bank’s equity capital. The allocation of capital is based on the contribution of each SBU to various risks of the bank. Higher the contribution of an SBU to the risk of the bank, higher will be the capital allocated5) Risk-adjusted Performance Measurement: Having allocated capital to each SBU commensurate with its contribution to the overall risk of the bank, a target return on the capital allocated needs to be set. If the SBU is able to earn a return higher than the target, then it is adding value to the bank, if the return earned is lower than the target set, then the value gets reduced. The value is maintained if the actual return is equal to the target set.

1.5 REQUIREMENTS FOR AN EFFECTIVE RISK MANAGEMENT SYSTEMThe Basle committee has set out the requirements for an effective risk management system as under:

Well informed Board of Directors and Oversight of Board, Capable Management, Adequate Risk Management Policies and Processes, High quality MIS for Risk Management, and Appropriate Staffing of the Risk Management Function.

The job of the Board is to establish bank’s strategic direction and define risk tolerances for various types of risk. The risk management policies and standards need to be approved by the Board. The senior management of the bank is responsible for implementation, integrity and maintenance of the risk management system.

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CHAPTER 2 ASSET LIABILITY MANAGEMENT

Structure2.1 Introduction2.2 Nature of ALM Risks and its organisation2.3 Balance Sheet Structure: Implications for ALM2.4 Liquidity Risk- Measurement & Management

2.1 INTRODUCTIONAs indicated in the previous chapter on risk management, risks can have an impact on either the accounting earnings which are periodically reported and or Value of equity which is relatively a new dimension. The Asset Liability Management (ALM) function involves planning, directing, and controlling the flow, level, mix and rates on the bank assets and liabilities. The ALM responsibilities are fully aligned to the overall objectives at the bank level. There was no need for an elaborate ALM function till the interest rates were guided by the regulator and the business of banking was purely volume driven. Deregulation of interest rates, interest rate volatility and increasing competition in the financial market place has made the ALM function a significantly important function in today’s environment.

Categorisation of Bank Balance SheetAt this juncture, it is important to understand how the assets & liabilities in the balance sheet of a bank are classified into Banking Book and Trading Book. The following are the points distinguishing one from the other:Held-till-maturity vs. Short-term holding periodThe intention of the bank in case of banking books is to hold the assets and liabilities till maturity whereas in case of trading book the holding period is extremely short and may vary between a few hours (or minutes in some cases) to a maximum of 90 days (as per the RBI’s stipulation of holding period).Accrual Income vs. Price ChangeThe assets & liabilities in the banking book accrue income and expenses respectively over time. The target variable in case of the banking book is the net accrual income. In case of the trading book, price appreciation (or depreciation) due to fluctuation in market price is the main target variable as the holding period is very shortHistorical cost vs. Mark-to-market ValueThe assets & liabilities in the banking book are valued at historical cost. Change in the values of assets and liabilities are not recognized in the P&L account. The norm in case of trading book is periodic valuation (mark-to-market) and reflection of the market value of the assets and liabilities in the balance sheet. Any appreciation or depreciation with reference to the value prior to valuation would pass through the P&L account as profit or loss.

Examples:Banking Book includes; Deposits, Borrowings, Loans and AdvancesTrading Book comprises of securities such as bonds and equity, various currency positions and commodity positions specifically identified by the bank as part of the trading book. Derivative contracts which are used as a hedge for the trading book or forming part of proprietary trading position would also be part of trading book Scope of ALMALM is a part of overall risk management of a bank which addresses the following risks:

Liquidity Risk: Risk arising out of unexpected fluctuation in cash flows from the assets and liabilities – both in banking and trading books.

Interest Rate Risk: Risk arising out of fluctuations in the interest rates on assets and liabilities in the banking book.

Market Risk: Risk of price fluctuations due to market factors causing changes in the value of the trading portfolio.



2.2 NATURE OF ALM RISKS AND ITS ORGANISATIONThe nature of risks addressed by ALM is the ones which need to be and are centralized at the bank treasury level for efficient management. In other words, interest rate and liquidity risks may be created by branches of a bank in the process of their intermediation between depositors and borrowers, but these risks need to be pooled at the highest level and managed. This is because these risks arising at a branch is not relevant as they need to be offset by exactly opposite positions in some other branch of the same bank. Hence, what is significant to be managed is the net position arising at the bank treasury level rather than individual positions arising at a number of branches. In other words, branch heads do not have anything to with the management of interest rate and liquidity risks at their own level. Their job at present is restricted to providing accurate and timely data for the assessment of the risks which are centralized. By its very nature, as the trading portfolio is managed at the treasury level, no further centralization is warranted.Like in many countries, the RBI has entrusted the job of ALM in each bank to the Asset-Liability Committee (ALCO) to be set up in each bank. ALCO, consisting of senior executives of a bank, is the apex decision making unit responsible for managing all the three risks that come under the purview of ALM in an integrated manner. As per RBI requirements, the ALCO is required to meet periodically to assess the bank’s position in terms of the risks and provide strategic guidance to achieve the overall targets and objectives set. With the above introduction, the concentration of the following section is on the three risks that the ALCO is supposed to address. The typical organizational structure for Risk Management with specific reference to ALM defined by the RBI is as under:

2.3 BALANCE SHEET STRUCTURE: IMPLICATIONS FOR ALMAs the entire subject of ALM is about balance sheet and its management, it is useful at this stage to understand the typical structure of an Indian commercial bank in terms of both rate earning assets and rate paying liability products. Other assets and liabilities, which are not very significant, are



excluded.Balance Sheet Structure: Assetsa. Advances- A significant portion linked to Prime Lending Rate (PLR) in the form of CC/OD, Demand loan & term loans- PLR linked loans – Absence of reset dates (future dates on which the rates would be reset is unknown)- Pattern of repayment based on behavioural studies- Unavailed portion of CC/OD – Uncertainty of utilisation- Borrower Option to prepay in case of Fixed Rate Term loansb. Investments- Major portion Fixed Rate- Medium to long duration portfolio- Illiquidity of a significant portion of the portfolio – no or very low flexibility for reshuffling (altering the structure)

Balance Sheet Structure: Liabilitiesa. Deposits – Savings and Current- Non-maturity – No date of maturity- High volatility of balances in case of current account- Customer Option to freely introduce or withdraw money at any time- Administered interest rates unrelated to market interest ratesb. Term Deposits: Cumulative, Non-Cumulative and Recurring - Overwhelming majority in Fixed Rates- Customer Option (put option valuable when interest rates go above the contractual fixed rate)- The reinvestment risk in case of cumulative deposits- Uncertain installment payments in case of recurring deposits- Floating Rate (a recent development)c. Borrowings- Fixed or Floating Rate- Various tenor- Usually no options, hence no uncertainty about the termIt can be understood from the above structure that a significant portion of liabilities in the form of term deposits have a fixed-rate meaning that the rates would remain unchanged till the maturity or till the deposit remains with the bank. ‘Borrowings’ which is a smaller portfolio in the liabilities are at market related rates.A significant portion of loans and advances portfolio is linked to PLR, which is a floating rate. The meaning of floating rate here is an asset or liability rate linked to a reference or index such as the Treasury bill rate, Government of India security yield, bank rate, money market rate, etc., are the rates reset at predetermined frequencies with reference to the reference rate. The problem that the PLR of banks suffer from is the uncertainty caused by the absence of any predetermined reset dates for the loans and advances linked to PLR. This implies that whenever PLR changes, the rate on the loans & advances would change instantly without any time lag. Contrast this with a hypothetical asset linked to a reference rate, say treasury bill rate with a 3-month reset, we know very clearly that the rate once set for the asset can change only after 3 months and not before that.An overwhelming majority of the investment portfolio is in the form of fixed-rate Government and other securities.Having discussed the balance sheet structure which determines the exposure of a bank to ALM risks, the risks can be taken up for a detailed discussion.

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CHAPTER 3 LIQUIDITY RISK MANAGEMENT

Introduction:Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompasses the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defence mechanism from losses on fire sale of assets.

The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.

I. TYPES:The liquidity risk in banks manifest in different dimensions:i) Funding Risk need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);ii) Time Risk need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; andiii) Call Risk due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

II. Liquidity ManagementThe first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia, should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting /reviewing, etc.Following steps are necessary for managing liquidity risk in banks:

1. Developing a structure for managing liquidity risk.2. Setting tolerance level and limit for liquidity risk.3. Measuring and managing liquidity risk.

1. Developing a structure for managing liquidity risk:Sound liquidity risk management involves setting a strategy for the bank ensuring effective board and senior management oversight as well as operating under a sound process for measuring, monitoring and controlling liquidity risk. Virtually every financial transaction or commitment has implications for a bank’s liquidity. Moreover, the transformation of illiquid into more liquid ones is a key activity of banks. Thus, a bank’s liquidity policies and liquidity management approach should form key elements of bank’s general business strategy. Understanding the context of liquidity management involves examining a banks managerial approach to funding and liquidity operations and its liquidity planning under alternative scenarios.

Treatment of Foreign Currencies : For banks with an international presence, the treatment of assets and liabilities in multiple currencies adds a layer of complexity to liquidity management for two reasons. First, banks are often less well known to liability holders in foreign currency markets. In the event of market concerns, these liability holders may not be able to distinguish rumours from fact as well or as quickly as domestic currency customers.Second, in the event of a disturbance, a bank may not always be able to mobilize domestic liquidity to meet foreign currency funding requirements.Hence, when a bank conducts its business in multiple currencies, its management must make two key decisions.The first decision concerns management structure. A bank with funding requirements in foreign currencies will generally use one of three approaches.

It may completely centralize liquidity management (the head office managing liquidity for the whole bank in every currency )



Alternatively, it may decentralize by assigning operating divisions responsibility for their own liquidity, but subject to limits imposed by the head office or frequent, routine reporting to the head office. For example, a non- European bank might assign its European operations in all currencies,

As a third Approach, a bank may assign responsibility for liquidity in the home currency and for overall coordination to the home office, and responsibility for the bank’s global liquidity in each major foreign currency to the management of the foreign office in the country in the country issuing that currency. For example, the treasurer in the Tokyo office of a non- Japanese bank could be responsible for the bank’s global liquidity needs in yen. All of these approaches, however, provide head office management with the opportunity to monitor and control worldwide liquidity

2. Setting tolerance level and limit for liquidity risk:Bank’s management should set limit to ensure liquidity and these limits should be reviewed by supervisors. Alternatively supervisors may set the limits. Limits could be set on the following:

1. The cumulative cash flow mismatches (i.e. the cumulative net funding requirement as a percentage of total liabilities) over particular periods – Next day, next week, next fortnight, next month, next year. These mismatches should be calculated by taking a conservative view of marketability of liquid assets, with a discount to cover price volatility and any drop in price in the event of a forced sale, and should include likely outflows as a result of draw-down of commitments, etc.

2. Liquid assets as a percentage of short- term liabilities. The assets included in this category should be those which are highly liquid, i.e. only those which are judged to be having a ready market even in periods of stress.

3. A limit on loan to deposit ratio.4. A limit loan to capital radio.5. A general limit on the relationship between anticipated funding needs and available sources

for meeting those needs. 6. Primary sources for meeting those needs. 7. Flexible limits on the percentage reliance on a particular liability category.

(e.g. certificate of deposits should not account for more than certain per cent total Liabilities)8. Limits on the dependence on individual customers or market segments for funds in

liquidity position calculation.9. Flexible limits on the minimum/ maximum average maturity of different categories of

liabilities.10.Minimum liquidity provision to be maintained to sustain operations.

An example of an setting tolerance level for a bank:1.To manage the mismatch levels so as to avert wide liquidity gaps- The residual maturity profile of assets and liabilities will be such that mismatch level for time bucket of 1-14 days and 15-28 days remains around 20% of cash outflows in each time bucket.2. To mange liquidity and remain solvent by maintaining short- term cumulative gap up to one year (short-term liabilities-short –term )at 15% of total out flow of funds.

3. Measuring and Managing Liquidity Risk:-Liquidity measurement is quite a difficult task and can be measured through a. Stock approachb. Flow (cash) approach.

a. Stock Approach:- Stock approach is based on the level of assets and liabilities as well as Off balance sheet exposures on particular date. The key ratios, adopted across the banking system are:i) Ratio of Core deposit to total assets:- More the ratio better it is because core deposits are treated to be the stable source of liquidity. ii) Net loans to total deposit ratio:- It reflects the ratio of loans to public deposits or core deposits. Loan is treated to be less liquid assets and therefore lower the ratio better is the case.



iii) Ratio of time deposit to total deposits:- Time deposit provide stable level of liquidity and negligible volatility. Therefore, higher the ratio always better.iv) Ratio of volatile liabilities to total assets:- Volatile liabilities like market borrowings are to be assessed and compared with the total assets. Higher portion of volatile assets will cause higher problems of liquidity. Therefore, lower ratio is desirable.v) Ratio of Short term liabilities to liquid assets:- Short term liabilities are required to be redeemed at the earliest. Therefore, they will require ready liquid assets to meet the liability. It is expected to be lower in the interest of liquidity.vi) Ratio of liquid assets to total assets:- Higher level of liquid assests in total assets will ensure better liquidity. Therefore higher the ratio is better.vii) Ratio of market liabilities to total assets:- Market liabilities may include money market borrowings , inter bank liabilities repayable within a short period.

b. Flow Approach:- While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches.For measuring and managing net funding requirements, the use of a. maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on future behaviour of assets, liabilities and off-balance sheet items. In other words, banks should have to analyse the behavioural maturity profile of various components of on/ off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance analysis, at least, once in six months to validate the assumptions. The assumptions should be fine-tuned over a period which facilitate near reality predictions about future behaviour of on/off-balance sheet items. Apart from the above cash flows, banks should also track the impact of prepayments of loans, premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallised.The difference between cash inflows and outflows in each time period, the excess or deficit of funds, becomes a starting point for a measure of a bank’s future liquidity surplus or deficit, at a series of points of time.

b.1 Liquidity Gap Analysis or Maturity LaddarLiquidity gap report/maturity laddar which is useful for measuring short-term liquidity risk is prepared by placing assets and liabilities into various time buckets on the basis of timing of cash inflows from the assets and the timing of cash outflows from the liabilities. The cash flows from assets and liabilities include both principal and interest cash flows. For the purpose of regulatory reporting of liquidity mismatches, the RBI has prescribed a liquidity gap report. The following Table is the summary of a real-life liquidity gap report of a commercial bank which would be used for our discussion this point onwards.

Particulars 1-14D 2-28D 29-3M 3-6M 6-12M 1-3 Y 3-5 Y Over 5Y Total

Term deposits 851 613 1835 1858 2372 6601 3729 1172 19030A. Total Outflows 3414 849 2806 3099 2799 18798 4092 4903 40758B. Total Inflows 3440 752 2105 2636 2630 8036 4481 16501 40581 Net Gap (B-A) 26 -96 -702 -462 -170 -10761 389 11598 -177Cumulative Gap 26 -70 -772 -1234 -1404 - 12165 -11776 -177



As reflected in the gap summary, total outflows (A) denotes expected cash outflows from liabilities including term deposits, and the total inflows (B) denotes expected cash inflows from assets as on a particular reporting date. The net gap (C) is the difference between outflows and inflows, i.e., (B)-(A). The net gap figure reflects the net liquidity mismatch, i.e., either the excess of cash outflows over inflows or the excess of cash inflows over outflows for each time bucket. It can be seen from the summary report above that while the bank has a little surplus liquidity in the shortest bucket (1 -14 days), the other buckets up to 1 -3 years show significant shortage of liquidity. The cumulative gap which is a successive summation of net gaps in each bucket can be used to ascertain the mismatch for a period longer than reflected in the short-term buckets. If the bank intends to ascertain its liquidity position for the next three month period, then from the summary above, it can be said that there would be shortage of liquidity to the extent of Rs. 772 crores which is the cumulative gap upto he 3-month bucket.

b.2 Managing market accessThe banks should also consider putting in place certain prudential limits to avoid liquidity crisis: 1) Cap on inter-bank borrowings, especially call borrowings;2) Purchased funds vis-à-vis liquid assets;3) Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and Loans;4) Duration of liabilities and investment portfolio;5) Maximum Cumulative Outflows. Banks should fix cumulative mismatches across all time bands;6) Commitment Ratio – track the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure;7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc.The liquidity profile of the banks could be analysed on a static basis, wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern and the sensitivity of these items to changes in market interest rates and environment are duly accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to:1) Seasonal pattern of deposits/loans;2) Potential liquidity needs for meeting new loan demands, unavailed credit limits, loan policy,potential deposit losses, investment obligations, statutory obligations, etc.

b.3 Alternative ScenariosThe liquidity profile of banks depends on the market conditions, which influence the cash flow behaviour. Thus, banks should evaluate liquidity profile under different conditions, viz. normal situation, bank specific crisis and market crisis scenario. The banks should establish benchmark for normal situation, cash flow profile of on / off balance sheet items and manages net funding requirements.Estimating liquidity under bank specific crisis should provide a worst-case benchmark. It should be assumed that the purchased funds could not be easily rolled over; some of the core deposits could be prematurely closed; a substantial share of assets have turned into non-performing and thus become totally illiquid. These developments would lead to rating down grades and high cost of liquidity. The banks should evolve contingency plans to overcome such situations.The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank, general perception about risk profile of the banking system, severe market disruptions, failure of one or more of major players in the market, financial crisis, contagion, etc. Under this scenario, the rollover of high value customer deposits and



purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. The banks could also sell their investment with huge discounts, entailing severe capital loss.

III. Assumptions and issues in determine cash flows:While the concept of liquidity gap is extremely simple to understand and use, there are a few issues which need to be addressed to be able to use the gap approach.The issues are:1) Non-maturity Items in the Balance Sheet: A sizeable portion of deposits of the Indian banking industry is in the form of current and savings deposits which do not have any specific maturity. Similarly, advances in the form of cash credit & over draft do not have any specific maturity. These items can result in a cash flow at any time. Absence of specific maturity dates in case of these ‘non- maturity’ items makes it difficult to place them in a definite bucket on the basis of cash flows. As prescribed by the RBI, as these items do not have contractual maturity, their behavioural maturity need to be ascertained on the basis of statistical analysis for placing them in appropriate buckets. In the absence of such analysis, the approach suggested by the RBI for non-maturity deposits may be used as an alternative2) Renewal Assumptions in Case of Maturing Term Deposits: Though the term deposits are expected to result in cash out flow on maturity, it has been observed that a sizeable chunk of the maturing term deposits are actually renewed in the same branch. Such renewals prevent the outflow of cash thereby reducing the net gap. While the renewal behaviour is positive, it is difficult to predict perfectly the percentage of maturing deposits renewed period after period as the depositor behaviour may vary from time to time depending on a number of factors. If a certain percent of renewal of deposits, say 60% is assumed for the preparation of the gap reports and the actual renewal is only say 40% for a period, this would create an unexpected deficit of liquidity which is serious given the nature of banking business which is heavily dependent upon public confidence. The public confidence in a bank is the function of its ability to meet all its commitments to the depositors. Surplus of liquidity would be the result when the actual renewal is higher than the expected renewal of deposits. While surplus is viewed favorably from the point of view of the bank’s ability to meet the cash out flows, expected return may suffer as deploying unexpected surplus may diminish expected return.3) Assumptions Relating to Unavailed Portion of Cash Credit, Overdraft: A sizeable portion of the advances portfolio of the Indian banking industry is in the form of cash credit, overdraft etc. In case of CC/OD etc., a limit is sanctioned for each borrower and the right to borrow upto the limit is vested with the borrower. While this has given a lot of flexibility to the borrowers to utilize the limit sanctioned to the extent it is required for meeting business commitments, banks pay a price in the form of uncertainty of timing of utilization by the borrowers of the unutilized limits as they may be utilized at any time without prior notice. As a result of the uncertainty, banks can neither keep the unutilized portion idle as returns may suffer, nor can deploy it in other assets as the requirement may arise at any time unexpectedly. The assumptions relating to unavailed portion need to be thoroughly validated on the basis of behavioral analysis and experience of the bank over a period of time for proper handling of the same.4) Assumptions Relating to off-balance Sheet Items: Guarantees provided in favour of customers by banks in various forms, Letters of Credit etc. are off-balance sheet in nature as the nature of liabilities are contingent upon events For example a financial or performance guarantee is a non-funded commitment till the time it is invoked by the party in whose favour the guarantee was issued by the bank. Analysis of the timing and magnitude of crystallization of a non-funded commitment into a funded commitment is extremely important to assess the impact of such crystallization on the liquidity position of the bank.5) Embedded Options: As indicated earlier, a number of asset and liability products offered by banks to customers have options embedded in them. The simplest example is the fixed rate term deposit in the deposits portfolio. The term deposit holder has the right but not an obligation to prematurely terminate the term deposit at any time during the currency of the deposit. This behavior of the depositors increases whenever interest rate applicable for the deposit goes up in the market and the new rate happens to be higher than original rate contacted at the time of opening of the deposit. This leads to flight of deposits from a bank to its competitor causing an impact on the liquidity position of the bank. Similarly, the term loan borrowers may exercise their



option to prepay the loan fully or partially when interest rates go down as they would be in a position to get the advantage of lower rates elsewhere. It is important to understand here that the customer exercising options either on the liability side or the asset side need not necessarily have an impact on the existing liquidity position when the liability or asset is rebooked with the same institution at new rates. 6) Static Nature of the Gap Report: The time taken to compile the report determines whether it is useful for decision making or not. If time taken is fairly long, then the first few buckets of information would be useless as the period for which the gaps are calculated would have simply elapsed. Even if the time delay is considerably reduced, the dynamic nature of the business of banking in which a lot of assets and liabilities are contracted on an ongoing basis would make the figures less relevant in the light of new business, changing behaviour of customers, etc. These call for the consideration of new business in the form of expected assets and liabilities in future and the behavioural pattern of customers to take into account the dynamic nature of the balance sheet. Unless the dynamic nature of positions and behavioural analysis as indicated in the previous points are incorporated into the analysis of gaps, preparation of a meaningful liquidity report would not be possible.

b.4 Contingency PlanBanks should prepare Contingency Plans to measure their ability to withstand bank-specific or market crisis scenario. The blue-print for asset sales, market access, capacity to restructure the maturity and composition of assets and liabilities should be clearly documented and alternative options of funding in the event of bank’s failure to raise liquidity from existing source/s could be clearly articulated. Liquidity from the Reserve Bank, arising out of its refinance window and interim liquidity adjustment facility or as lender of last resort should not be reckoned for contingency plans. Availability of back-up liquidity support in the form of committed lines of credit, reciprocal arrangements, liquidity support from other external sources, liquidity of assets, etc. should also be clearly established.

RBI circular on Liquidity Mangement:As stated above RBI vide its circular has given detail ALM process to be followed by bank and as also gudience for Measuring and managing liquidity needs. Accordingly, Banks are required to submit Statement of Structural Liquidity is given in Annexure I. The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under: i) 1 to 14 days ii) 15 to 28 days iii) 29 days and upto 3 monthsiv) Over 3 months and upto 6 months v) Over 6 months and upto 12 monthsvi) Over 1 year and upto 2 years vii) Over 2 years and upto 5 yearsviii) Over 5 years

Further circular also says that the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz., next day , 2-7 days and 8-14 days. In the annexure to this circular, RBI has also given the itemized time buckets related to Outflow & Inflows. These are given below in brief:

A. OutflowsCapital, Reserves and Surplus : Over 5 years bucket.Demand Deposits (Current and Savings Bank Deposits): Savings Bank and Current Deposits may be classified into volatile and core portions. Savings Bank (10%) and Current (15%) Deposits are generally withdrawable on demand. This portion may be treated as volatile. While volatile portion can be placed in the Day 1 time bucket, the core portion may be placed in over 1- 3 years bucket.Term Deposits: Respective maturity buckets.Other Liabilities: Respective maturity buckets.

B. Inflows



Cash : Day 1 bucket.Balances with RBI: While the excess balance over the required CRR/SLR may be shown under Day 1 bucket, the Statutory Balances may be distributed amongst various time buckets corresponding to the maturity profile of DTL with a time-lag of 14 days.Balances with other banks- Current Account : Non-withdrawable portion on account of stipulations of minimum balances may be shown under over 1-3 years bucket and the remaining balances may be shown under Day 1 bucket.Securities in the Trading Book: Day 1, 2-7 days, 8-14 days, 15-28 days and 29-90 days according to defeasance periods(i.e. the time taken to liquidate the ‘position’ on the basis of liquidity in the secondary market) NPAs (Net of provisions, interest suspense and claims received from ECGC/DICGC ): Sub-standard: Over 3-5 years bucket. Doubtful and Loss: Over 5 years bucket.Fixed Assets/ Assets on lease : Over 5 years bucketRest of the Assets including Advances : Respective maturity buckets.

Financing of Gap :In case the net cumulative negative mismatches during the Day 1, 2-7 days, 8-14 days and 15-28 days buckets exceed the prudential limit of 5 % ,10%, 15 % and 20% of the cumulative cash outflows in the respective time buckets the bank may show by way of a foot note as to how it proposes to finance the gap to bring the mismatch within the prescribed limits. The gap can be financed from market borrowings (call / term), Bills Rediscounting, Repos and deployment of foreign currency resources after conversion into rupees ( unswapped foreign currency funds ), etc.

Basel III Framework on Liquidity Standards, Liquidity Coverage Ratio (LCR), Liquidity Risk Monitoring Tools and LCR Disclosure StandardsIn ‘First Bi-monthly Monetary Policy Statement, 2014-15’ announced on April 1, 2014, RBIproposed to issue guidelines relating to Basel III LCR and Liquidity Risk Monitoring tools by end-May 2014, as the liquidity coverage ratio (LCR) stipulated by the Basel Committee becomes a standard with effect from January 1, 2015. Accordingly, the final guidelines on the LCR, Liquidity Risk Monitoring Tools and LCR Disclosure Standards are pronounced by RBI. The LCR will be introduced in a phased manner starting with a minimum requirement of 60% from January 1, 2015 and reaching minimum 100% on January 1, 2019. Two minimum standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) for funding liquidity were prescribed by the Basel Committee for achieving two separate but complementary objectives.The LCR promotes short-term resilience of banks to potential liquidity disruptions by ensuring that they have sufficient high quality liquid assets (HQLAs) to survive an acute stress scenario lasting for 30 days. The NSFR promotes resilience over longer-term time horizons by requiring banks to fund their activities with more stable sources of funding on an ongoing basis. In addition, a set of five monitoring tools to be used for monitoring the liquidity risk exposures of banks was also prescribed in the said document.

Definition of LCRStock of high quality liquid assets (HQLAs)________ 100% Total net cash outflows over the next 30 calendar days

The LCR requirement would be binding on banks from January 1, 2015; with a view to provide a transition time for banks, the requirement would be minimum 60% for the calendar year 2015 i.e. with effect from January 1, 2015, and rise in equal steps to reach the minimum required level of 100% on January 1, 2019, as per the time-line given below:

Jan’1 2015 Jan’1 2016 Jan’1 2017 Jan’1 2018 Jan’1 2019 Minimum LCR 60% 70% 80% 90% 100%

High Quality Liquid Assets:



Liquid assets comprise of high quality assets that can be readily sold or used as collateral to obtain funds in a range of stress scenarios. They should be unencumbered i.e. without legal, regulatory or operational impediments. Assets are considered to be high quality liquid assets if they can be easily and immediately converted into cash at little or no loss of value.There are two categories of assets which can be included in the stock of HQLAs, viz. Level 1 and Level 2 assets. Level 2 assets are sub-divided into Level 2A and Level 2B assets on the basis of their price-volatility.

Level 1 assets of banks would comprise of the following and these assets can be included in the stock of liquid assets without any limit as also without applying any haircut: i. Cash including cash reserves in excess of required CRR. ii. Government securities in excess of the minimum SLR requirement. iii. Within the mandatory SLR requirement, Government securities to the extent allowed by RBI under Marginal Standing Facility (MSF), [presently 2 per cent of the bank’s NDTL], and under Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) [presently 9 per cent of the bank’s NDTL+ 2% w.e.f 15.06.2018 = 11%]. iv. Reserves held with foreign Central Banks in excess of the reserve requirement, where a foreign sovereign has been assigned a 0% risk weight as per rating by an international rating agency.v. Reserves held with foreign Central Banks in excess of the reserve requirement, to the extent these balances cover the bank’s stressed net cash outflows in that specific currency, in cases where a foreign sovereign has been assigned a non-0% risk weight as per rating by an international rating agency, but a 0% risk weight has been assigned at national discretion under Basevi. Marketable securities issued or guaranteed by foreign sovereigns satisfying all the following conditions: (a) assigned a 0% risk weight under the Basel II standardized approach for credit risk; (b) Traded in large, deep and active repo or cash markets characterised by a low level of concentration; and proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions. (c) not issued by a bank/financial institution/NBFC or any of its affiliated entities.

Level 2 assets (comprising Level 2A assets and Level 2B assets) can be included in the stock of liquid assets, subject to the requirement that they comprise no more than 40% of the overall stockof HQLAs after haircuts have been applied. The portfolio of Level 2 assets held by the bank should be well diversified in terms of type of assets, type of issuers and specific counterparty or issuer. Level 2A and Level 2B assets would comprise of the following:

(a) Level 2A Assets: A minimum 15% haircut should be applied to the current market value of each Level 2A asset held in the stock. Level 2A assets are limited to the following: i. Marketable securities representing claims on or claims guaranteed by sovereigns, Public Sector Entities (PSEs) or multilateral development banks that are assigned a 20% risk weight under the Basel II Standardised Approach for credit risk and provided that they are not issued by a bank/financial institution/NBFC or any of its affiliated entities. ii. Corporate bonds, not issued by a bank/financial institution/NBFC or any of its affiliated entities, which have been rated AA- or above by an Eligible Credit Rating Agency.ii. Commercial Papers not issued by a bank/PD/financial institution or any of its affiliated entities, which have a short-term rating equivalent to the long-term rating of AA- or above by an Eligible Credit Rating Agency

(b) Level 2B Assets : A minimum 50% haircut should be applied to the current market value of each Level 2B asset held in the stock. Further, Level 2B assets should comprise no more than 15% of the total stock of HQLA. They must also be included within the overall Level 2 assets. Level 2B assets are limited to the following: i. Marketable securities representing claims on or claims guaranteed by sovereigns having risk weights higher than 20% but not higher than 50%, i.e., they should have a credit rating not lower than BBB- as per our Master Circular on ‘Basel III – Capital Regulations’.



ii. With effect from February 1, 2016, Corporate debt securities (including commercial paper), meeting the following conditions: • not issued by a bank, financial institution, PD, NBFC or any of its affiliated entities; • have a long-term credit rating from an Eligible Credit Rating Agency between A+ and BBB- or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; • traded in large, deep and active repo or cash markets characterised by a low level of concentration; and • have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, i.e. a maximum decline of price not exceeding 20% or increase in haircut over a 30-day period not exceeding 20 percentage points during a relevant period of significant liquidity stress.

iii. Common Equity Shares which satisfy all of the following conditions: a) not issued by a bank/financial institution/NBFC or any of its affiliated entities; b) included in NSE CNX Nifty index and/or S&P BSE Sensex index.

Calculation of Total net cash outflows: The total net cash outflows is defined as the total expected cash outflows minus total expected cash inflows for the subsequent 30 calendar days. Total expected cash outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down. Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables by the rates at which they are expected to flow in up to an aggregate cap of 75% of total expected cash outflows. In other words, Total net cash outflows over the next 30 days = Outflows - Min (inflows; 75% of outflows). The various items of assets (inflow) and liabilities (outflow) along with their respective run-off rates and the inflow rates are specified in the format of Basel III Liquidity Return-1 (BLR-1) of this Framework.

The formula for the calculation of the stock of HQLA is as follows: Stock of HQLA = Level 1 + Level 2A + Level 2B – Adjustment for 15% cap – Adjustment for 40% cap Where: Adjustment for 15% cap = Max [{Level 2B – 15/85*(Adjusted Level 1 + Adjusted Level 2A)}, {Level 2B - 15/60*Adjusted Level 1}, 0]

Adjustment for 40% cap = Max {(Adjusted Level 2A + Level 2B – Adjustment for 15% cap -2/3*Adjusted Level 1 assets), 0}

Liquidity Risk Monitoring ToolsIn addition to the two liquidity standards, the Basel III framework also prescribes five monitoring tools / metrics for better monitoring a bank's liquidity position. While some of these monitoring tools/metrics have been in use by banks in the past in the form of various regulatory returns on their liquidity position, certain additional returns under Basel III Liquidity Framework have been prescribed. These metrics along with their objective and the prescribed returns are detailed below:a. Contractual Maturity Mismatchb. Concentration of Fundingc. Available Unencumbered Assetsd. LCR by Significant Currencye. Market-related Monitoring Tools

Basel III Liquidity Returns: The Bank is required to file the following returns to RBI as per the frequency mentioned:Name of the Basel III Liquidity Return (BLR) Frequency

of submission

Time period by which required to be

reported



Statement on Liquidity Coverage Ratio (LCR)- BLR-1 Monthly within 15 daysStatement of Funding Concentration - BLR Monthly within 15 daysStatement of Available Unencumbered Assets - BLR-3 Quarterly within a monthLCR by Significant Currency - BLR-4 Monthly within 15 daysStatement on Other Information on Liquidity - BLR-5 Monthly within 15 days

LCR Disclosure Standards Banks are required to disclose information on their LCR in their annual financial statements underNotes to Accounts, starting with the financial year ending March 31, 2015.

Illustrations on Liquidity Risk:1. Suppose PVB Bank's liquidity manager estimates that the bank will experience a Rs.375 million liquidity deficit next month with a probability of 10 percent, Rs.200million liquidity deficit with a probability of 40 percent, Rs.100 million liquidity surplus with a probability of 30 percent, and a Rs.250 million liquidity surplus bearing a probability of 20 percent. What is this savings bank’s expected liquidity requirement? Solution:Liquidity Deficits or Surpluses Associated Probabilities :Deficit Rs.375 million 10%, Rs.200 million deficit 40%, Rs.100million surplus 30%, Rs.250 millionsurplus 20% and hence the bank's expected liquidity requirement is:Expected Liquidity Requirement = 0.10*(- Rs.375 million) + 0.40* (- Rs.200 million)+0.30* (+Rs.100 million) + 0.20 * (+Rs.250 million)= - Rs.37.5 million - Rs.80 million + Rs.30 million + Rs.50 million= - Rs.37.5 million

2. Madurai Bank estimates that over the next 24 hours the following cash inflow and outflows will occur (all figures in millions of Rs.):Deposit withdrawals 98, Scheduled loan repayments 89,Sales of bank assets 40, Stockholder dividend payments150,Deposit inflows 87, Revenues from sale of non deposit services 95,Acceptable loan requests 56, Repayments of bank borrowings 60,Borrowings from the money market 75, Operating expenses 45, What is this bank’s projected net liquidity position in the next 24 hours? From what sources can the bank cover its liquidity needs?

Solution: (all figures in millions of Rs.):Deposit withdrawals Rs.98 -Deposit inflows Rs.87 +Scheduled loan repayments Rs.89 +Acceptable loan requests Rs.56 -Borrowings from the money market Rs.75 +Sales of bank assets Rs.40 + Stockholder dividend payments Rs.150 -Revenues from sale of nondepositservices Rs.95 +Repayment of bank borrowings Rs.60 -Operating expenses Rs.45 -

= + [Rs.87+ Rs.89+ Rs.75+ Rs.40+ Rs.95] - [Rs.98+ Rs.56+ Rs.150+ Rs.60+ Rs.45]= - Rs.23 million

Faced with an expected liquidity deficit Madurai Bank could arrange to increase its money market borrowings from other institutions or sell some of its assets or do some of both.

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CHAPTER 4 MARKET RISK

1) Introduction2) Market risk management3) Tools for Measurement of Market risk4) Stress Testing

1 Introduction:- Market Risk arises as a result of volatility in price of assets (and liabilities) due to changes in:

Interest Rates Currency Prices Commodity Prices, and Equity Prices

Price risk of the assets in the trading book is the prime decision point in market risk management. Of the above, the most significant exposure is to the interest rates in the form of a sizeable portfolio of Government and other securities. Hence the major concentration would be on interest rates.

2 MARKET RISK MANAGEMENTManagement of market risk should be the major concern of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. The Asset- Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. The Middle Office should comprise of experts in market risk management, economists, statisticians and general bankers and may be functionally placed directly under the ALCO. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management of Treasury. The Middle Office should apprise the top management / ALCO / Treasury about adherence to prudential / risk parameters and also aggregate the total market risk exposures assumed by the bank at any point of time.

3 Tools for Measurement of Market RiskMeasures for market risk are broadly categorized as under:a. Factor Sensitivity Measuresb. Volatility Based Measures

a. Factor Sensitivity Measures: Factor sensitivity measures assess the impact of change in the major factors (which determine the market value of the positions) on the market value of the portfolio. The most prominent factor sensitivity measure is the modified duration. Modified duration is the direct measure of sensitivity in value of a security or a portfolio of bonds for a change in interest rates. The modified duration concept rests on a number of assumptions which are unrealistic in today’s environment. Though a number of refinements to the original concept have been suggested to make it applicable in the current environment, a number of issues remain unattended. Important among them are the relevance of the tool in an environment of non-parallel shifts in the yield curve and adequacy of the concept for bonds embedded options in the form of calls, puts, caps, floors etc. The most significant application of the factor sensitivity measures is to use them for setting limits at portfolio level. For example, a bank may set the maximum modified duration of its bond portfolio as (say) 7. This means that the price sensitivity that the bank is willing to accept in case of the bond portfolio is maximum 7% of the value of the portfolio for 1% change in the interest rates. Any loss higher than 7% would not be tolerated by the bank.

b. Volatility Based Measures: While factor sensitivity measures are still very popular in our



country and are practiced widely, in the recent past, volatility based measure popularly known as Value-at-Risk (VAR). The greatest advantage of VAR is its uniformity in measuring trading risk across various positions such as interest rates, currency, equity and commodity, which is the weakest thing as far as factor sensitivity measures are concerned. As a result of this uniformity of measurement, it is possible to aggregate risk across completely different positions, compare and contrast among various positions to assess the relative riskiness and so on. Apart from this, VAR has revolutionized the risk communication from trading desk to top management as the measure is extremely simple to understand unlike the factor sensitivity measures which make sense only to the respective trading and risk management community that uses them. It is important to recognize here that unless the risk reports are understood and acted upon by the top management, there would always be a possibility of a misalignment between what is perceived as acceptable risk by the top management and others who are in operating lines. An example of VAR is as under:

Type of the portfolio: GOI Bond Trading PortfolioMarket Value: Rs. 200 croresVAR = Rs. 5 croresConfidence Level used for VAR computation: 99%Holding Period used for VAR computation (days): 1The above information can be interpreted easily with a little knowledge of probability.

The exact interpretation of VAR of Rs. 5 crores for a Rs.200 crore GOI Bond portfolio is: the maximum loss that the bank will suffer on a single trading day (as holding period used is 1 day) would not exceed Rs.5 crores on 99% of the trading days (as the confidence level used for VAR computation is 99%). Only on 1% of the trading days, the loss would exceed the VAR of Rs. 5 crores. If we assume 100 trading days in a period, the above interpretation means that 99 trading days out of 100 days would have losses less than Rs. 5 crores. Only on 1 day out of 100 days, the losses would exceed the VAR number computed. Please note that the concept of VAR concentrates on only the possible losses.

We can calculate estimated daily volatility of security as follows :1. Calculation of VaR :Suppose impact of 1% change of interest rate results change in Price of bond by Rs. 8000/-, daily Volatility = 3% : Confidence level is 99% (that means, probability of occurrence at 99% confidence level is 2.326), Defeasance period = 1 daySolution: Market Factor Sensitivity X Daily Volatility X Probability at given confidence levelVaR = Rs. 8000 x 3 x 2.326 = 55824/-

2. If the volatility per annum is 25% and the number of trading days per annum is 252, find the volatility per day.a.1.58% b. 15.8% c. 158% d. 0.10 Solution:Daily volatility of security = ATotal trading days is always to required to be taken at 252, and formula is A = 25 x √1/252A = 1.58% 3. Daily volatility of a security is 1%. What is its 16 days volatility approximately?a. 3% b. 10% c. 1% d. 4%Solution:Wherein trading days has not been given then we have to assume it as 260 days in a year. Accordingly, 16 days volatility = ‘X’Daily volatility = 1% or 0.01So formula will be : 0.01 = X √16/260

0.01 = X 0.2480



0.01/0.2480 = XOR X = 0.040i.e X = 4%

There are at least three broad methods to computing VAR:

1. Historical Simulation: The approach relies heavily on past data of prices to estimate VAR. The basic assumption of the method is that the past trends and volatilities in prices would repeat in future also. This method does not require the use of any statistical distribution and tools, hence it is non-parametric.

2. Analytical or Variance Covariance VAR: This is the most accepted and practiced method at present popularized by the investment bank J.P.Morgan in the 90s. This approach is parametric as it assumes the prices to follow normal distribution and uses statistical concepts such as standard deviation, correlation, covariance etc. for the estimation of VAR.

3. Monte Carlo VAR: The term montecarlo denotes a popular approach to simulating random numbers based on a specified statistical distribution. This approach does not make any assumption of distributional properties of asset prices but involves empirical estimation of the statistical distribution from the prices which is then used to simulate the prices leading to the estimation of VAR.

Increasingly it has been found out that the VAR as a method for market risk measurement is suitable for only normal market environment. Stress testing should be used to complement the computed VAR to assess the performance of the portfolio in an environment of abnormal market movements which remain outside the standard VAR models as of date. This is attempted to be accomplished by modeling extreme price movements using Extreme Value Theory and other similar approaches.

4. Stress Testing :- "Stress testing" has been adopted as a generic term describing various techniques used by banks to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing addresses the large moves in key market variables of that kind that lie beyond day to day risk monitoring but that could potentially occur. The process of stress testing, therefore, involves first identifying these potential movements, including which market variables to stress, how much to stress them by, and what time frame to run the stress analysis over. Once these market movements and underlying assumptions are decided upon, shocks are applied to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market movement has on the value of the portfolio and the overall Profit and Loss. Stress test reports can be constructed that summarise the effects of different shocks of different magnitudes. Normally, then there is some kind of reporting procedure and follow up with traders and management to determine whether any action need to be taken in response.

Stress testing and value-at-risk*

Stress tests supplement value-at-risk (VaR). VaR is thought to be a critical tool for tracking the riskiness of a firm’s portfolio on a day-to-day level, and for assessing the risk-adjusted performance of individual business units. However, VaR has been found to be of limited use in measuring firms’ exposures to extreme market events. This is because, by definition, such events occur too rarely to be captured by empirically driven statistical models. Furthermore, observed correlation patterns between various financial prices (and thus the correlations that would be estimated using data from ordinary times) tend to change when the price movements themselves are large. Stress tests offer a way of measuring and monitoring the portfolio consequences of extreme price movements of this type.



Stress Testing Techniques: Stress testing covers many different techniques. The four discussed here are listed in the Table below along with the information typically referred to as the "result" of that type of a stress test.

Stress Testing Techniques #

Technique What is the "stress test result"

Simple Sensitivity Test Change in portfolio value for one or more shocks to a single risk factor

Scenario Analysis (hypothetical or historical) Change in portfolio value if the scenario were to occur

Maximum loss Sum of individual trading units’ worst-case scenarios

Extreme value theory Probability distribution of extreme losses

A simple sensitivity test isolates the short-term impact on a portfolio’s value of a series of predefined moves in a particular market risk factor. For example, if the risk factor were an exchange rate, the shocks might be exchange rate changes of +/_ 2 percent, 4 percent, 6 percent and 10 percent.

A scenario analysis specifies the shocks that might plausibly affect a number of market risk factors simultaneously if an extreme, but possible, event occurs. It seeks to assess the potential consequences for a firm of an extreme, but possible, state of the world. A scenario analysis can be based on an historical event or a hypothetical event. Historical scenarios employ shocks that occurred in specific historical episodes. Hypothetical scenarios use a structure of shocks thought to be plausible in some foreseeable, but unlikely circumstances for which there is no exact parallel in recent history. Scenario analysis is currently the leading stress testing technique.

A maximum loss approach assesses the riskiness of a business unit’s portfolio by identifying the most potentially damaging combination of moves of market risk factors. Interviewed risk managers who use such "maximum loss" approaches find the output of such exercises to be instructive but they tend not to rely on the results of such exercises in the setting of exposure limits in any systematic manner, an implicit recognition of the arbitrary character of the combination of shocks captured by such a measure.

Extreme value theory (EVT) is a means to better capture the risk of loss in extreme, but possible, circumstances. EVT is the statistical theory on the behaviour of the "tails" (i.e., the very high and low potential values) of probability distributions. Because it focuses only on the tail of a probability distribution, the method can be more flexible. For example, it can accommodate skewed and fat-tailed distributions. A problem with the extreme value approach is adapting it to a situation where many risk factors drive the underlying return distribution. Moreover, the usually unstated assumption that extreme events are not correlated through time is questionable. Despite these drawbacks, EVT is notable for being the only stress test technique that attempts to attach a probability to stress test results.

What Makes a good Stress Test:- A good stress test should be relevant to the current position consider changes in all relevant market rates examine potential regime shifts (whether the current risk parameters will hold or break

down) spur discussion consider market illiquidity, and



consider the interplay of market and credit risk

How should risk managers use stress tests: Stress tests produce information summarising the firm’s exposure to extreme, but possible, circumstances. The role of risk managers in the bank should be assembling and summarising information to enable senior management to understand the strategic relationship between the firm’s risk-taking (such as the extent and character of financial leverage employed) and risk appetite. Typically, the results of a small number of stress scenarios should be computed on a regular basis and monitored over time. Some of the specific ways stress tests are used to influence decision-making are to:

manage funding risk provide a check on modelling assumptions set limits for traders determine capital charges on trading desks’ positions

Manage funding risk: Senior managers use stress tests to help them make decisions regarding funding risk. Managers have come to accept the need to manage risk exposures in anticipation of unfavourable circumstances. The significance of such information will vary according to a bank’s exposure to funding or liquidity risk. Provide a check on modelling assumptions: Scenario analysis is also used to highlight the role of particular correlation and volatility assumptions in the construction of banks’ portfolios of market risk exposures. In this case, scenario analysis can be thought of as a means through which banks check on the portfolio’s sensitivity to assumptions about the extent of effective portfolio diversification.Set limits for traders: Stress tests are also used to set limits. Simple sensitivity tests may be used to put hard limits on bank’s market risk exposures.

Determine capital charges on trading desks’ positions: Banks may also initiate capital charges based on hypothetical losses under certain stress scenarios. The capital charges are deducted from each business unit’s bonus pool. This procedure may be designed to provide each business unit with an economic incentive to reduce the risk of extreme losses.

Limitations of Stress Tests:- Stress testing can appear to be a straightforward technique. In practice, however, stress tests are often neither transparent nor straightforward. They are based on a large number of practitioner choices as to what risk factors to stress, how to combine factors stressed, what range of values to consider, and what time frame to analyse. Even after such choices are made, a risk manager is faced with the considerable tasks of sifting through results and identifying what implications, if any, the stress test results might have for how the firm should manage its risk-taking activities. A well-understood limitation of stress testing is that there are no probabilities attached to the outcomes. Stress tests help answer the question "How much could be lost?" The lack of probability measures exacerbates the issue of transparency and the seeming arbitrariness of stress test design. Systems incompatibilities across business units make frequent stress testing costly for some firms, reflecting the limited role that stress testing had played in influencing the firm’s prior investments in information technology.

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CHAPTER 5 CREDIT RISK MANAGEMENT

4.1 Definition and Scope of Credit Risk4.2 Organisational Structure4.3 Significance Of Credit Risk:- Measurement And Management4.4 Risk Identification4.5 Approaches To Credit Risk Measurement: Intrinsic Risk4.6 Approaches For Portfolio Concentration Risk4.7 Tools of Credit Risk Management4.8 Credit Risk Mitigation

5.1 DEFINITION AND SCOPE OF CREDIT RISKSimon Hills (2004) of the British Bankers Association defines credit risk “is the risk to a bank’s earnings or capital base arising from a borrower’s failure to meet the terms of any contractual or other agreement it has with the bank. Credit risk arises from all activities where success depends on counterparty, issuer or borrower performance”. Credit risk enters the books of a bank the moment the funds are lent, deployed, invested or committed in any form to counterparty whether the transaction is on or off the balance sheet.The nature, nomenclature and the quantum of credit risk may vary depending on a number of factors. The internal organization of credit risk management should recognize this for effective credit risk management.

5.2 Organisational StructureSound organizational structure is sine qua non for successful implementation of an effective credit risk management system. The organizational structure for credit risk management should have the following basic features:The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. The Risk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit risk. For this purpose, this Committee should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee and other risk committees of the bank, if any. It is imperative that the independence of this Committee is preserved. The Board should, therefore, ensure that this is not compromised at any cost. In the event of the Board not accepting any recommendation of this Committee, systems should be put in place to spell out the rationale for such an action and should be properly documented. This document should be made available to the internal and external auditors for their scrutiny and comments. The credit risk strategy and policies adopted by the committee should be effectively communicated throughout the organisation.

5.2.1 Each bank may, depending on the size of the organization or loan/investment book, constitute a high level Credit Risk Management Committee (CRMC). The Committee should be headed by the Chairman/CEO/ED, and should comprise of heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The functions of the Credit Risk Management Committee should be as under:a. Be responsible for the implementation of the credit risk policy/strategy approved by the Board.b. Monitor credit risk on a bank wide basis and ensure compliance with limits approved by the Board.c. Recommend to the Board, for its approval, clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks,d. Decide delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.



5.2.2 Concurrently, each bank should also set up Credit Risk Management Department (CRMD), independent of the Credit Administration Department. The CRMD should:a. Measure, control and manage credit risk on a bank-wide basis within the limits set by the Board/ CRMCb. Enforce compliance with the risk parameters and prudential limits set by the Board/ CRMC.c. Lay down risk assessment systems, develop MIS, monitor quality of loan/investment portfolio, identify problems, correct deficiencies and undertake loan review/audit. Large banks could consider separate set up for loan review/audit.d. Be accountable for protecting the quality of the entire loan/ investment portfolio.

The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio.

Credit Risk officer (CRO):- As per RBI circular, dated 20th April’2017, appointment of the CRO shall be for a fixed tenure with the approval of the Board of Directors of the banks, that means BOD will decide the tenure. The CRO may be transferred/removed from his post before completion of the tenure only with the approval of the Board and such premature transfer/removal shall be reported to the Department of Banking Supervision, Reserve Bank of India, Mumbai. CRO shall be a senior official in the banks’ hierarchy and shall have the necessary and adequate professional qualification/experience in the areas of risk management. The CRO shall have direct reporting lines to the MD & CEO / Risk Management Committee (RMC) of the Board. In case the CRO reports to the MD & CEO, the RMC shall meet the CRO on one-to-one basis, without the presence of the MD & CEO, at least on a quarterly basis. There shall not be any ‘dual hatting’ i.e. the CRO shall not be given the responsibility of Chief Executive Officer, Chief Operating Officer, Chief Financial Officer, Chief of the internal audit function or any other function.In case the CRO is associated with the credit sanction process, it shall be clearly enunciated whether the CRO’s role would be that of an adviser or a decision maker. The policy shall include the necessary safeguards to ensure the independence of the CRO.In banks that follow committee approach in credit sanction process for high value proposals, if the CRO is one of the decision makers in the credit sanction process, he shall have voting power and all members who are part of the credit sanction process, shall individually and severally be liable for all the aspects, including risk perspective related to the credit proposal. If the CRO is not a part of the credit sanction process, his role will be limited to that of an adviser.

5.3 RISK IDENTIFICATION:-Credit Risk and DefaultCredit Risk is the risk of loss to the Bank in the event of Default.Default arises due to counterparty's inability and/or unwillingness to meet commitments in relation to lending.Credit risk is the potential loss that a bank borrower or counter party will fail to meet its obligation in accordance with the agreed terms.

TYPES OF THE CREDIT RISKA) Transaction risk B) Portfolio riska) Grade risk a) concentration riskb) default risk b) intrinsic risk

1) non payment2) delayed payment

Credit risk may be in the following forms:* In case of the direct lending* In case of the guarantees and the letter of the credit* In case of the treasury operations* In case of the securities trading businesses* In case of the cross border exposure



Traditionally credit risk has 2 componentsa) Solvency aspects of the credit risk-the risk borrower is unable to payb) Liquidity aspects of the risk-the risk that arise due to the delay in the repayment by the borrower leading to the cash flow problems for the leader

Credit risk can be segmented into two major segments viz. Systematic or intrinsic and portfolio (or concentration) credit risks. The focus of the intrinsic risk is measurement of risk at individual loan level. This is carried out at lending unit level. Portfolio credit risk arises as a result of concentration of the portfolio to a particular sector, geographic area, industry, type of facility, type of borrowers, similar rating, etc. Concentration risk is managed at the bank level as it is more relevant at that level.

5.4 APPROACHES TO CREDIT RISK MEASUREMENT: INTRINSIC RISKThere are three basic approaches to credit risk measurement at individual loan intrinsic level that are used for various types of loans such as commercial loans, project and infrastructure finance, consumer and retail loans. They are:

Expert Systems, Credit Rating, and Credit Scoring.

Expert Systems: In an expert system, the decision to lend is taken by the lending officer who is expected to possess expert knowledge of assessing the credit worthiness of the customer. Accordingly the success or failure very much depends on the expertise, judgment and the ability to consider relevant factors in the decision to lend. One of the most common expert systems is the five “Cs” of credit. The five ‘C’ are as under :a. Character: Measure of reputation of the firm, its willingness to repay and the repayment history.b. Capital: The adequacy of equity capital of the owners so that the owner’s interest remains in the business. Higher the equity capital better the creditworthiness.c. Capacity: The ability to repay is measured by the expected volatility in the sources of funds intended to be used by the borrower for the repayment of loan along with interest. Higher the volatility of this source, higher the risk and vice versa.d. Collateral: Availability of collateral is important for mitigating credit risk. Higher the value of the collateral, lower would be the risk and vice versa.e. Cycle or (economic) Conditions: The state of the business cycle is an important element in determining credit risk exposure. Some industries are highly dependent on the economic condition while the others are less dependent or independent. Higher the dependence, higher the risk as during recessionary period of the economy, the cyclic industries would suffer and vice versa. Industries such as FMCG, pharmaceuticals, etc. are less dependent on economic cycles than industries such as consumer durable, steel, etc. The expert view on the above would finally influence the decision to lend or not.Although many banks still use expert systems as part of their credit decision process, these systems face two main problems :a. Consistency: There may not be a consistent approach followed for different types of borrowers and industries. Thereby the system would be person dependentb. Subjectivity: As weights applied to different factors are subjective, comparability across time may not be possible.

Credit Rating: Credit Rating is the most popular method at present among banks. Rating is the process by which an alphabetic or numerical rating is assigned to a credit facility extended by a bank to a borrower based on a detailed analysis of his character and matching it with the characteristics of facility that is extended to him. The rating carried out by a bank is very much similar to the credit rating carried out by external rating agencies such as CRISIL, ICRA, etc. The only difference is that while the rating by the external agency is available in the public domain for any one to use, the internal ratings carried out by a bank is confidential and is used for specific



purpose only. Moreover, the internal ratings of banks are usually finer than the ratings of rating agencies. This is to facilitate better distinction between credit qualities and pricing of loan in an accurate manner.

Credit Scoring: A major disadvantage of a rating model is the subjectivity of weight to be applied to different segments in the rating exercise. This drawback can be avoided in a scoring model which is based on rigorous statistical techniques. This approach combines a number of ratios into a single numerical score which is used to determine the credit quality or default. The basic assumption of the method is that combination of a number of ratios explains the success (no default) or failure (default) of a facility extended to a borrower. Starting with the historical data with known outcome of success or failure, a set of ratios that differentiate the successful cases from the failed ones along with the weights to be applied for each ratio is arrived at by multiple discriminant analysis. The most popular among the models is the one by Altman’s (1968) Z-score model, which is a classificatory model for corporate borrowers. Based on a matched sample (by year, size and industry) of failed and solvent firms, and using linear discriminant analysis, the best fitting scoring model for commercial loans took the following form:

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5

WhereZ = Altman’s Z score of a commercial loanX1 = working capital/total assets ratioX2 = retained earnings/total assets ratioX3 = earnings before interest and taxes/total assets ratioX4 = market value of equity/book value of total liabilitiesX5 = Sales/total assets ratio

As indicated, each one of the ratios in the equation is weighted by weight empirically arrived at on the basis of past experience with similar type of loans.

Here are the rules for interpreting the Altman Z score.When Z is >= 3.0, the firm is most likely safe based on the financial data.When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years.When Z is <= 1.8, the company is highly likely to be bankrupt.

Illustration: Calculate the Altman’s Z score from the following information:Current Assets: Rs. 10,00,000, Total Assets: Rs. 40,00,000, Current Liabilities: Rs. 9,00,000 Total Liabilities: Rs. 20,00,000, Retained Earnings: Rs. 1,500,000, Sales: Rs. 12,00,000 EBIT (Earnings Before Interest and Taxes): Rs.240,000, Share Price:Rs.6.36 Shares Outstanding: 500,000Answer:X1 = CA Rs.10,00,000 - CL Rs.9,00,000= Rs.1,00,000/Total Assets Rs.40,00,000 = 0.025X2 = Retained Earnings: Rs. 15,00,000/Total Assets Rs.40,00,000 = 0.375X3 = EBIT: Rs. 240,000/Total Assets Rs.40,00,000 = 0.060X4 = Share Price:Rs.6.36 x Shares Outstanding: 500000 / Total Liabilities:Rs.20,00,000 = 1.59X5 = Sales: Rs.12,00,000/ Total Assets: Rs. 40,00,000 = 0.30

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5

Z = 1.2 (0.025) + 1.4 (0.375) + 3.3 (0.060) + 0.6 (1.59) + 0.999 (0.30)Z = 2.0067

Regulatory framework prescribed for measuring credit risk by the BASEL II & III:

The term standardized approach (or standardised approach) refers to a set of credit riskmeasurement techniques proposed under Basel II capital adequacy rules for banking institutions.Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. For a standardized approach bank, general risk weights are



prescribed for every type of exposure under the Final Rule to determine the credit risk RWA amount. Standardized approach banks are required to determine exposure amounts for each on-balance sheet exposure.

The Basel Accord also permits the bank other alternative for measurement of credit risk based on internal ratings. It will be called as “Internal Ratings Based Approach”.

For illustrations on calculations of credit risk by these method, please refer chapter BASEL III.

5.5 APPROACHES FOR PORTFOLIO CONCENTRATION RISKThe credit risk analysis described above is based on the notion that each loan should be made against some norm. Concentration risk was generally addressed by limiting the size of exposures to individual borrowers. Such an approach has proved inadequate to the task of limiting credit risk as supposedly distinct borrowers in particular sectors have experienced similar problems at the same time. For example: real estate, energy and shipping and loans to developing countries in the 80s and 90s of the U.S banks which led to huge losses despite religiously following a limit on exposure to individual borrowers. On a loan by loan basis these areas offer better opportunities than are available elsewhere.

5.6 Tools of Credit Risk Management.The instruments and tools, through which credit risk management is carried out, are detailed below:a) Exposure Ceilings: Prudential Limit is linked to Capital Funds – say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times).b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated.c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss.d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework.e) Portfolio Management The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector orindustry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-making process.f) Loan Review Mechanism This should be done independent of credit operations. It is also referred as Credit Audit covering review of sanction process, compliance status, review of risk rating, pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked. This is done to bring about qualitative improvement in credit administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be broadened from account level to overall portfolio level. Regular, proper & prompt reporting to Top Management should be ensured. Credit Audit is conducted on site, i.e. at the branch that has



appraised the advance and where the main operative limits are made available. However, it is not required to visit borrowers factory/office premises.

5.7 Credit Risk MitigationCRM is an essential part of credit risk management. This refers to the process through which credit risk is reduced or it is transferred to a counter party. Stratergies for risk reduction at transaction level differ from that at portfolio level. At transaction level banks use a number of techniques to mitigate the credit risk to which they are exposed. They are more traditional techniques e.g exposures collateralized by first priority claims, either in whole or in part, with cash or securities, or an exposure guaranteed by a third party.At portfolio level, asset securitisation, credit derivatives etc., are used to mitigate risks in the portfolio.

A. Securitisation TransactionMeaning :One of the most prominent developments in international finance in recent decades and the one that is likely to assume even greater importance in future, is securitisation. Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors. The process leads to the creation of financial instruments that represent ownership interest in, or are secured by a segregated income producing asset or pool of assets. The pool of assets collateralises securities. These assets are generally secured by personal or real property (e.g. automobiles, real estate, or equipment loans), but in some cases are unsecured (e.g. credit card debt, consumer loans).There are four steps in a securitisation: (i) SPV is created to hold title to assets underlyingsecurities; (ii) the originator or holder of assets sells the assets (existing or future) to the SPV; (iii) the SPV, with the help of an investment banker, issues securities which are distributed to investors; and (iv) the SPV pays the originator for the assets with the proceeds from the sale of securities.

B Credit derivatives:Credit derivatives are privately negotiated bilateral contracts that allow users to manage their exposure to credit risk. For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books. This mechanism can be used for any debt instrument or a basket of instruments for which an objective default price can be determined. In this process, buyers and sellers of the credit risk can achieve various objectives, including reduction of risk concentrations in their portfolios, and access to a portfolio without actually making the loans. Credit derivatives offer a flexible way of managing credit risk and provide opportunities to enhance yields by purchasing credit synthetically.

Example:- Consider Bank A that has lent to the steel industry. Suppose this bank wants to reduce its credit risk. Bank B wants to lend to the steel industry but cannot do so because of locational disadvantage. So, Bank A and Bank B enter into an agreement. The agreement is that if, say, Steel Company X defaults on its loan payments, Bank B will pay Bank A the defaulted amount. If not, Bank B will not pay any money. For providing this facility, Bank B will receive a premium from Bank A. This simple agreement is one of the many credit derivatives available in the international market. Notice that the agreement works like a term assurance contract. You pay a yearly premium to the life insurance company. If you die, the insurance company pays a death benefit. If not, your premiums are not refundable. Credit derivatives are also useful in diversifying loan portfolio. In the above example, by selling (writing) a credit protection, Bank B has taken exposure to the steel sector. How? It will receive premiums just as it receives interest on loans. Bank B will also be exposed to losses if the steel company defaults.

I. Credit default swapThe credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market.



A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity (i.e borrower of any bank): this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfill certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.

The relevant credit events specified in a transaction will usually be selected from amongst the following: a) the bankruptcy of the reference entity;b) its failure to pay in relation to a covered obligation; c) it defaulting on an obligation or that obligation being accelerated; d) it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.

If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle.The seller of the credit default swap is said to sell protection. The seller collects the periodic fee and profits if the credit of the reference entity remains stable or improves while the swap is outstanding. Selling protection has a similar credit risk position to owning a bond or loan, or “going long risk.”

Example:-As shown in Exhibit 2.1, Bank B (herein after Investor B), the buyer of protection, pays Bank S (herein after Investor S), the seller of protection, a periodic fee (usually on the 20th of March, June, September, and December) for a specified time frame. To calculate this fee on an annualized basis, the two parties multiply the notional amount of the swap, or the amount of risk being exchanged, by the market price of the credit default swap (the market price of a CDS is also called the spread or fixed rate). CDS market prices are quoted in basis points (bp) paid annually, and are a measure of the reference entity’s credit risk (the higher the spread the greater the credit risk).

If credit event happened then: Settlement following credit events :- Physical settlement:-Following a credit event, the buyer of protection delivers to the seller of protection defaulted bonds and/or loans with a face amount equal to the notional amount of the credit default swap contract. The seller of protection (long risk) then delivers the notional amount on the CDS contract in cash to the buyer of protection. Note that the buyer of protection pays the accrued spread from the last coupon payment date up to the day of the credit event, then the coupon payments stop. The buyer



can deliver any bond issued by the reference entity meeting certain criteria that is pari passu, or of the same level of seniority, as the specific bond referenced in the contract. Thus the protection buyer has a “cheapest to deliver option,” as she can deliver the lowest price bond to settle the contract. This type of settlement is known as “physical settlement”. See Exhibit 2.2Generally, the legal framework of a CDS – that is, the documentation evidencing the transaction –is based on a confirmation document and legal definitions set forth by the International Swaps and Derivatives Association, Inc. (ISDA).

Exhibit 2.2: If the Reference Entity has a credit event, the CDS Buyer delivers a bond or loan issued by the reference entity to the Seller. The Seller then delivers the Notional value of the CDS contract to the Buyer. Rs.100 face value of Bond or Loan

Notional ( Rs.100/- cash)Cash settlement:A CDS may specify that on occurrence of a credit event the protection seller shall pay difference between the nominal value of the reference obligation and its market value at the time of credit event. This type of settlement is known as “cash settlement”. This type of settlement is also known as payment of par less recovery. A calculation agent plays an important role in the process of settlement.

II Total return swapA total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets.

III Credit linked notesA credit linked note is a synthetic security, typically issued by a special purpose vehicle (SPV) that trades like a bond issued by the reference entity but with the economics of the credit default swap. For this security, the buyer of protection sells the note. The buyer of protection (note seller) will pay periodic payments and profit if the reference entity defaults. Unlike the swap, the buyer of protection in a credit linked note will receive money at the time of transaction from the sale of the note, and will return this money at the contract’s maturity if no credit event occurs.

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CHAPTER 6 OPERATIONAL RISK

5.1 Introduction5.2 Definition5.3 Significance of operational risk5.4 Objectives of operational risk5.5 Developing appropriate environment5.6 Methodologies for measurement of operational risk

5.1 INTRODUCTIONOperational risk is emerging as one of the important risks financial institutions worldwide are concerned with. Unlike other categories of risks, such as credit and market risks, the definition and scope of operational risk is not fully clear. A number of diverse professions such as internal control and audit, statistical quality control and quality assurance, facilities management and contingency planning, etc., have approached the subject of operational risk thereby bringing in different perspectives to the concept. While studies carried out on bank failures in the U.S. show that operational risk has accounted for an insignificant proportion of large bank failures so far, it is widely acknowledged that most of the new, unknown risks are under the category of operational risk. This necessitates the need for an understanding of the operational risks in financial services in general and banking in particular.

5.2 DEFINITION OF OPERATIONAL RISKAccording to the Basel Committee, Operational risk is defined as “the risk of loss resulting from inadequate or failed processes, people and systems or external events. This definition includes legal risk, but excludes strategic and reputational risk” (The New Basel Capital Accord, Consultative Document released in April 2003. Bankers Trust (now a part of Deutsche Bank) asked a very simple question way back in 1992 to understand the nature of operational risk: what risks were not being addressed by market and credit risk models and functions? Answering the question led the bank to identify risks associated with the bank’s exposures as under:Primary operational risk/exposure classes are:

A. Cause basedRelationship RisksNon-proprietary losses caused to a firm and generated through the relationship or contact that a firm has with its clients, shareholders, third parties or regulators (e.g. accommodations/reimbursements to clients, settlements or penalties paid, etc).

People/Human Capital RisksThe risk of loss caused intentionally or unintentionally by an employee (i.e. an employee error, employee misdeed, etc.) or involving employees, such as in the area of employment disputes, intellectual capital, etc.

Technology and Processing RisksThe risk of loss caused by a piracy, theft, failure, breakdown or other disruption in technology, data or information; also includes technology that fails to meet the intended business needs.

Physical RisksThe risk of loss through damage of bank-owned properties or loss to physical property or assets for which the firm is responsible.

B. Effect based1. Legal Liabilility2. Regulatory, compliance and taxation penalities3. Loss or dame to assests4. Restituion



5. Write downs

C. Event Based1. Internal Fraud2. External Fraud3. Employment practices and workplace safety4. Clients, products and business practices.5. Execution, delivery and process management.

5.3 SIGNIFICANCE OF OPERATIONAL RISKThere are number of reasons why operational risks need to be managed properly:a. Increasing Complexity of Activities: The complexity of activities have grown over increasing the probability of errors, intentional or otherwise. This is especially true as the activities of banks in the financial markets have grown considerably, exposing them to operational risks apart from other risks.b. Adoption of Technology: While the adoption of technology helps in reducing ac number of errors committed by human beings, technology absorption has created a number of new risks which need to be managed. If not managed properly, the losses could be very large and may threaten the existence of the institution.c. Regulatory Requirement: As discussed elsewhere, the old capital accord concentrated only on credit risk. The new capital accord, apart from fine-tuning capital requirements for credit risk, proposed for the first time a minimum capital to be maintained for operational risksd. New Products and Services: To effectively compete in the market place, many new products and services are offered in the banking industry. The recent entry of a number of banks into the business of insurance, either as agents or otherwise is a recent example. The introduction of new products comes with its own risks which may or may not be detected. With a view to gain market share, the time taken to introduce new products in the market is considerably shortened in some cases leading to improper assessment of operational risks. Risks arising out of change in the features of existing products to make it more attractive tocustomers also fall in the same category.e. Capital Allocation and Performance Management: As indicated in a previous unit, each one of the risks needs allocation of capital commensurate with the quantum of risks. The return on allocated capital is the performance to be evaluated against benchmarks to performance measurement and management. Operational risks are very much a part of the various types of risks included in arriving at performance at business unit level. With growing activism of the shareholders to realize their expected return and the highly competitive market for capital, capital allocation and performance management are important steps at various levels.

5.4 OBJECTIVES OF OPERATIONAL RISK MANAGEMENTOperational Risk is managed with the following objectives:i. To ensure that the Board of Directors and top management are suitably informed in the form of reports to undertake appropriate monitoring of operational risks and set controls for them on an ongoing basis.ii. To ensure that there is a system of operational risk management to identify measure and control operational risks as laid out in the operational risk policy.iii. To make sure that operational risks, like other risks are considered at all stages in decision making. This would enable proper pricing of products offered to customers.iv. To generate a broader understanding of operational risk issues at all levels.v. To put in place an effective system to demonstrate to the regulators the adequacy of the system for the operational risks.

5.5 DEVELOPING AN APPROPRIATE RISK MANAGEMENT ENVIRONMENTFailure to understand and manage operational risk, which is present in virtually all bank transactions and activities, may greatly increase the likelihood that some risks will go unrecognised and uncontrolled. Both the board and senior management are responsible for creating an organisational culture that places high priority on effective operational risk management and



adherence to sound operating controls. Operational risk management is most effective where a bank’s culture emphasises high standards of ethical behaviour at all levels of the bank. The board and senior management should promote an organisational culture which establishes through both actions and words the expectations of integrity for all employees in conducting the business of the bank.

Principle 1: The board of directors4 should be aware of the major aspects of the bank’s operational risks as a distinct risk category that should be managed, and it should approve and periodically review the bank’s operational risk management framework.The framework should provide a firm-wide definition of operational risk and lay down the principles of how operational risk is to be identified, assessed, monitored, and controlled/mitigated.

Principle 2: The board of directors should ensure that the bank’s operational risk management framework is subject to effective and comprehensive internal audit by operationally independent, appropriately trained and competent staff. The internal audit function should not be directly responsible for operational risk management.

Principle 3: Senior management should have responsibility for implementing the operational risk management framework approved by the board of directors. The framework should be consistently implemented throughout the whole banking organisation, and all levels of staff should understand their responsibilities with respect to operational risk management. Senior management should also have responsibility for developing policies, processes and procedures for managing operational risk in all of the bank’s material products, activities, processes and systems.

Risk Management: Identification, Assessment, Monitoring, and Mitigation/ControlPrinciple 4: Banks should identify and assess the operational risk inherent in all material products, activities, processes and systems. Banks should also ensure that before new products, activities, processes and systems are introduced or undertaken, the operational risk inherent in them is subject to adequate assessment procedures.

Principle 5: Banks should implement a process to regularly monitor operational risk profiles and material exposures to losses. There should be regular reporting of pertinent information to senior management and the board of directors that supports the proactive management of operational risk.

Principle 6: Banks should have policies, processes and procedures to control and/or mitigate material operational risks. Banks should periodically review their risk limitation and control strategies and should adjust their operational risk profile accordingly using appropriate strategies, in light of their overall risk appetite and profile.

Principle 7: Banks should have in place contingency and business continuity plans to ensure their ability to operate on an ongoing basis and limit losses in the event of severe business disruption.

5.6 METHODOLOGIES FOR MEASUREMENT OF OPERATIONAL RISKSThe Basle committee has outlined three methodologies for measurement of operational risks. They are:a. The Basic Indicator Approach,b. The Standardized Approach, andc. The Advanced Measurement Approaches.

a. The Basic Indicator ApproachA fixed percentage (denoted alpha) of average annual gross income over the previous three years is the capital required to be maintained by banks under this approach. It is expressed as:KBIA= GI × aWhereKBIA = The Capital charge under the Basic Indicator Approach



GI = Average annual Gross Income over the previous three years*a = 15% which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator. Gross income for the purpose of the above approach is defined as net interest income plus net non-interest income. It is intended that this measure should:Gross income = Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16) {(OR) Net interest income plus net non-interest income)}(-) profit on sale of HTM investments (-) income from insurance(-) extraordinary / irregular item of income(+) loss on sale of HTM investments

*Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.

Illustration:From the following information calculate operational risk of Xis Bank Ltd for 31.03.2018. Rs. in lakhs

31.03.16 31.03.17 31.03.18Net Profit 2511.00 2860.00 3240.00Reserves created for contingency 28.20 36.25 41.50Provisions on NPA 85.00 112.00 78.00Provisions on standard assets 12.00 16.00 28.00Profit on sale of Trading investments

28.00 54.00 67.00

Loss on sale of HTM investments -14.50 0 0Profit on sale of HTM Investments 0 21.00 34.00Operation Expenses 3455.00 3968.00 4294.00

Answer: Ascertain the Gross income on yearly basis for these 3 years: Rs. in lakhs

31.03.16 31.03.17 31.03.18Net Profit 2511.00 2860.00 3240.00Add:Reserves created for contingency 28.20 36.25 41.50Provisions on NPA 85.00 112.00 78.00Provisions on standard assets 12.00 16.00 28.00Operation Expenses 3455.00 3968.00 4294.00Loss on sale of HTM investments 14.50 0 0

Total 6105.70 6992.25 7681.50Less:Profit on sale of HTM Investments 0 21.00 34.00

Gross Income 6105.70 6971.25 7647.50 No adjustment required for Profit on sale of Trading investments

Total Gross Income for 3 years = 6105.70 + 6971.25 + 7647.50 = 20,724.45GI = Average annual Gross Income over the previous three years = 20724.45 = 6908.15 lakhs 3Operational Risk KBIA= GI × a = 6908.15 x 15% = 1036.22 lakhs

b. The Standardized Approach



Under this approach, activities of the banks are divided into eight business lines:1. Corporate Finance,2 Trading and Sales,3 Retail Banking,4 Commercial Banking,5 Payment and Settlement,6 Agency Services,7 Asset Management, and8 Retail Brokerage.

Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. It is to be appreciated that the gross income is measured for each business line, not for the whole institution as in the case of basic indicator approach.The total capital required for operational risk then, is the simple summation of the capital required across each of the eight business lines. This is expressed as under:KTSA = S(GI1-8 × b1-8)Where:KTSA = the capital charge under the Standardised ApproachGI1-8 = the average annual level of Gross Income over the past three years, as defined above in the Basic Indicator Approach, for each of the eight business linesb1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level of the gross income for each of the eight business lines.The values of the betas are detailed below:

Business Lines Beta FactorsCorporate finance (b1) 18%Trading & Sales (b2) 18%Retail Banking (b3) 12%Commercial Banking (b4) 15%Payment & settlement (b5) 18%Agency services (b6) 15%Asset management (b7) 12%Retail Brokerage (b8) 12%

Supplementary Business Line Mapping GuidelinesThere are a variety of valid approaches that banks can use to map their activities to the eightbusiness lines, provided the approach used meets the business line mapping principles.The following is an example of one possible approach that could be used by a bank to map its gross income:

1. Gross income for retail banking consists of net interest income on loans and advances to retail customers and SMEs treated as retail, plus fees related to traditional retail activities, net income from swaps and derivatives held to hedge the retail banking book, and income on purchased retail receivables. To calculate net interest income for retail banking, a bank takes the interest earned on its loans and advances to retail customers less the weighted average cost of funding of the loans (from whatever source).

2. Similarly, gross income for commercial banking consists of the net interest income on loans and advances to corporate (plus SMEs treated as corporate), interbank and sovereign customers and income on purchased corporate receivables, plus fees related to traditional commercial banking



activities including commitments, guarantees, bills of exchange, net income (e.g. from coupons and dividends) on securities held in the banking book, and profits/losses on swaps and derivatives held to hedge the commercial banking book. Again, the calculation of net interest income is based on interest earned on loans and advances to corporate, interbank and sovereign customers less the weighted average cost of funding for these loans (from whatever source).

3. For trading and sales, gross income consists of profits/losses on instruments held for trading purposes (i.e. in the mark-to-market book), net of funding cost, plus fees from wholesale broking.

4. For the other five business lines, gross income consists primarily of the net fees/commissions earned in each of these businesses. Payment and settlement consists of fees to cover provision of payment/settlement facilities for wholesale counterparties. Asset management is management of assets on behalf of others.

Illustration:From the following information calculate operational risk of Xis Bank Ltd by standardized approach for 31.03.2018. Rs. in lakhs

31.03.16 31.03.17 31.03.18Corporate finance (b1 ) – Beta Factor – 18%Interest received 255.10 320.18 387.90Weighted average cost of funding 192.14 268.70 310.22Non interest income 22.00 18.00 27.00Retail Banking (b3) – Beta Factor – 12%Interest received 458.90 520.11 670.90Net income from derivatives 0 0 27.80Fees & commission 32.20 44.78 69.34Weighted average cost of funding 356.00 427.45 578.16Commercial Banking (b4) – Beta Factor -15%Net interest income 78.24 126.10 156.08BG/LC Fees & commission 56.78 92.24 103.12Net income on securities held in the banking book

109.12 98.70 124.56

Weighted average cost of funding 348.24 448.12 512.30

Answer: Ascertain the Gross income on yearly basis for these 3 years for each line of business: Rs. in lakhs

31.03.16 31.03.17 31.03.18Corporate finance (b1 ) – Beta Factor – 18%Interest received 255.10 320.18 387.90Add: Non interest income 22.00 18.00 27.00

Total 277.10 338.18 414.90Less: Weighted average cost of funding 192.14 268.70 310.22

Gross income from corporate finance 84.96 69.48 104.68

Retail Banking (b3) – Beta Factor – 12%Interest received 458.90 520.11 670.90Add: Net income from derivatives 0 0 27.80 Fees & commission 32.20 44.78 69.34

Total 491.10 564.89 768.04Less: Weighted average cost of funding 356.00 427.45 578.16

Gross income from retail banking 135.10 137.44 189.88

Commercial Banking (b4) – Beta Factor -15%



Net interest income 78.24 126.10 156.08Add: BG/LC Fees & commission 56.78 92.24 103.12 Net income on securities held in the banking book

109.12 98.70 124.56

Gross income from commercial banking 244.14 317.04 383.76Note: We will not deduct Weighted average cost of funding as here Net Interest income is given i.e the same is already deducted and hence no need to deduct it again.

Total Gross Income for 3 years for each line of business will be :

31.03.16 31.03.17 31.03.18 Total Avg. Income

Gross income from corporate finance 84.96 69.48 104.68 259.12 86.37Gross income from retail banking 135.10 137.44 189.88 462.42 154.14Gross income from commercial banking

244.14 317.04 383.76 944.94 314.98

Operational Risk now will be: Taking it on the basis of average income of last 3 years :

KTSA = S(GI × b)

Amount Beta factor

Operational Risk

Gross income from corporate finance 86.37 18% 15.54Gross income from retail banking 154.14 12% 18.49Gross income from commercial banking 314.98 15% 47.25

Total 81.28

C. Advanced Measurement Approaches (AMA)A number of approaches which are internally developed by banks using the quantitative and qualitative criteria for the measurement of operational risks are categorized under AMA. While banks are free to internally develop systems for the measurement of operational risks under AMA, only after obtaining the approval of the local supervisor, the internal models can be put to use. Very few banks in India would really be in a position to even think of AMA at present as it involves the creation of database of losses and its drivers business line-wise. The internal model developed must be able to measure variety of operational risks. It is important that the model developed must be able to reflect both the dimensions of operational risks, i.e., the probability of loss and the severity of loss. While high probability – low impact losses such as human errors, minor frauds, etc., are not very severe and the institution must be in a position to absorb the losses in the normal course of business, the low probability – high impact losses such as break-down of well laid out internal control systems owing to connivance leading to unauthorized dealings in securities and consequent large losses can threaten the very existence of the institution.The approaches that banks are currently developing fall under three broad categories. These are the Internal Measurement Approaches (IMA), Loss Distribution Approaches (LDA), and Scorecard Approaches.

****

HERE IN AFTER

MODULE C

TREASURY



CHAPTER 1 TREASURY MANGEMENT

1 Treasury Management – An Overview2 Functions of Treasury Department In Banks3 Organisational Structure of Treasury4 Objectives of The Treasury Management 5 Elements of Treasury Management6 Functions of a Treasurer7 Nature of Treasury Assets And Liabilities8 List of Bank’s Treasury Products

1 TREASURY MANAGEMENT: AN OVERVIEWWebster defines treasury as "a place where stores of treasures are kept; the place of deposit, care, and disbursement of collected funds." Moreover, if one considers the treasury functions in ones own organization; this definition would most likely broadly describe it. Treasury and its responsibilities fall under the scope of the Chief Financial Officer. In many organizations, the Treasurer will be responsible for the treasury function and also holds the position of Chief Financial Officer. The CFO's responsibilities usually include capital management, risk management, strategic planning, investor relations and financial reporting. In larger organizations, these responsibilities are usually separated between accounting and treasury, with the controller and the treasurer each leading a functional area. Generally accepted accounting principles and generally accepted auditing standards recommend the division of responsibilities in areas of cash control and processing. The specific tasks of a typical treasury function include cash management, risk management, hedging and insurance management, accounts receivable management, accounts payable management, bank relations and investor relations. A successful treasury function has the same attributes as any other function within the organization that is considered successful. These qualities are: * Teamwork * Respect for Organization * Forward Thinking * Global Thinking * Technological Advancement * Customer Focused * Finance/Accounting Knowledge * Legal Knowledge * Reliability

The treasury function must work with all operations within the organization. The operational functions they are working with should consider treasury to be an internal consultant, with expertise in risk and finance. Treasury is an exciting and interesting function of the organization that gets involved in many diverse areas of the business that most other positions in the company do not get the opportunity to be involved in. It is a natural progression in the career of many who start out in credit management.

2 FUNCTIONS OF TREASURY DEPARTMENT IN BANKSSince 1990s, the prime movers of financial intermediaries and services have been the policies of globalization and reforms. All players and regulators had been actively participating, only with variation of the degree of participation, to globalize the economy. With burgeoning forex reserves, Indian banks and Financial Institutions have no alternative but to be directly affected by global happenings and trades. This is where; integrated treasury operations have emerged as a basic tool for key financial performance.A treasury department of a bank is concerned with the following functions:(a) Reserve Management & Investment: It involves (i) meeting CRR/SLR obligations, (ii) having an

appropriate mix of investment portfolio to optimise yield and duration. Duration is the weighted average ‘life’ of a debt instrument over which investment in that instrument is recouped. Duration Analysis is used as a tool to monitor the price sensitivity of an investment instrument to interest rate charges.

(b) Liquidity & Funds Management: It involves (i) analysis of major cash flows arising out of asset-liability transactions (ii) providing a balanced and well-diversified liability base to fund the various assets in the balance sheet of the bank (iii) providing policy inputs to strategic planning



group of the bank on funding mix (currency, tenor & cost) and yield expected in credit and investment.

(c) Asset Liability Management & Term Money: ALM calls for determining the optimal size and growth rate of the balance sheet and also prices the Assets and liabilities in accordance with prescribed guidelines. Successive reduction in CRR rates and ALM practices by banks increase the demand for funds for tenor of above 15 days (Term Money) to match duration of their assets.

(d) Risk Management: integrated treasury manages all market risks associated with a bank’s liabilities and assets. The market risk of liabilities pertains to floating interest rate risk for assets & liability mismatches. The market risk for assets can arise from (i) unfavorable change in interest rates (ii) increasing levels of disintermediation (iii) securitization of assets (iv) emergence of credit derivates etc. while the credit risk assessment continues to rest with Credit Department, the Treasury would monitor the cash inflow impact from changes in assets prices due to interest rate changes by adhering to prudential exposure limits.

(e) Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed optimally, without sacrificing yield or liquidity. An integrated Treasury unit has as idea of the bank’s overall funding needs as well as direct access to various market ( like money market, capital market, forex market, credit market). Hence, ideally treasury should provide benchmark rates, after assuming market risk, to various business groups and product categories about the correct business strategy to adopt.

(f) Derivative Products: Treasury can develop Interest Rate Swap (IRS) and other Rupee based/ cross- currency derivative products for hedging Bank’s own exposures and also sell such products to customers/other banks.

(g) Arbitrage: Treasury units of banks undertake this by simultaneous buying and selling of the same type of assets in two different markets to make risk-less profits.

(h) Capital Adequacy: This function focuses on quality of assets, with Return on Assets (ROA) being a key criterion for measuring the efficiency of deployed funds. An integrated treasury is a major profit centre. It has its own P&L measurement. It undertakes exposures through proprietary trading (deals done to make profits out of movements in market interest/ exchange rates) that may not be required for general banking.

(i) Coordination: Banks do operate at more than one money market centers. All the centers undertake similar transactions with differing volumes. There is a need to coordinate the activities of these centers so that aberrations are avoided (situations where one center is lending and the other one is borrowing at the same time). The task of coordination of foreign exchanges positions is no different.

(j) Control and Development: Treasury operates as the focal point of dealing operations. Dealing operations could include cash/spot, forward, futures, options, interest and currency liability swaps, forward rate agreements and the like. Treasury is the sole owner and performer of these transactions.

(k) Fraud Protection: The decade of nineties has witnessed more frauds in trading than banking books. The amount and variety of such embezzlements have been directly relatable to the operational level. The ground level task of this kind is to be undertaken at the treasury. All the aforesaid activities are funds management functions in a banking environment.

3 ORGANISATIONAL STRUCTURE OF TREASURYThere is no standard structure for treasury department of a bank. Depending on the responsibilities assigned and power delegated, it can be aptly structured. Typically, banks maintain three independent tiers at the functional/operational level-Tier I – Dealing Desk (Front Office): The dealers and traders in different markets- money, stock, debt, commodity, derivatives and forex- operate in their respective areas. They are the first point if interface with other participants in the market. The number of dealers depends on the size and frequency of the operations. In case of larger in each bank, operations would be carried out by separate and independent set of dealers in each market. But, for a relatively smaller treasury, operations would be done by one or more dealers jointly in all the markets.



Tier II – Settlement Desk (Back Office): Once the deals are concluded, it is for the back office to process and settle the deals. Indeed, the back office undertakes settlement and reconciliation operations.

Tier III – Accounting, Monitoring and Reporting Office (Audit group): This department looks after the activities relating to accounting, auditing and reporting. Accountants’ record all deals in the books of accounts, while auditors and inspectors closely monitor all deals and transactions done by the front and the back office, and send regular reports to authorities concerned. This department independently inspects daily operations in the treasury department to ensure internal/regulatory system and procedures.

The three departments should be compartmentalized and they act independently. The heads of each section reports directly to the Head of the Treasury. A treasury can have more functional desk depending on the size and structure of the bank, and activities undertaken by the bank. For example, the treasury may have separate individuals/managers for monitoring funds movement, for monitoring of risks, developing and marketing innovative instruments/products.

4 OBJECTIVES OF THE TREASURY MANAGEMENTTreasury of a commercial bank undertakes various operations in fulfillment of the following objectives: To take advantage of the attractive trading and arbitrage opportunities in the bond and forex

markets. To deploy and invest the deposit liabilities, internal generation and cash flows from maturing

assets for maximum return on a current and forward basis consistent with the bank’s risk policies/appetite.

To fund the balance sheet on current and forward basis as cheaply as possible taking into account the marginal impact of these actions.

To effectively manage the forex assets and liabilities of the bank. To manage and contain the treasury risks of the bank within the approved and prudential

norms of the bank and regulatory authorities.

Head of Treasury

Chief Dealer Mkt. Intelligence Research and analysis

Head of Settlements

Head of AccountingMonitoring and

Reporting

Manager-Funds/Reserve

Manager

Settlements

Manager-Settlements

Accounts/Monitoring

Audit/Reporting

Dealer- Rupee.M.Mkt. dept.

Dealer- Forex.Currency/Invest.

Dealer- Corpo.Merchant/Service



To assess, advise and manage the financial risks associated with the non-treasury assets and liabilities of the bank

To adopt the best practices in dealing, clearing, settlement and risk management in treasury operations.

To maintain statutory reserves- CRR and SLR- as mandated by the RBI on current and forward planning basis.

To deploy profitably and without compromising liquidity the clearing surpluses of the bank To identify and borrow on the best terms from the market to meet the clearing deficits of the

bank To offer comprehensive value-added treasury and related services to the bank’s customers To act as profit center for the bank.

5. NATURE OF TREASURY ASSETS AND LIABILITIESBank’s balance sheet consists of treasury assets and liabilities on the one hand and non- treasury assets and liabilities on the other. There is a clear distinction between the two groups. In general, ifa specific assets or liability is created through a transaction in the inter-bank market and/or can be assigned or negotiated, it becomes a part of the treasury portfolio of the bank.Treasury assets are marketable or tradable subject to meeting legal obligations such as payment of applicable stamp duty, etc. another characteristic of treasury assets is that they can (and often are required to be marked to market. An example of treasury asset/liability which is created by corporate/treasury actions/decisions on funding/deployment but is not tradable, is the Inter-bank Participation Certificate.Loans and advances are specific contractual agreements between the bank and its borrowers, and do not form a part of the treasury assets, although these are obligations to bank. (They can however, be securitized and sold in the market. If a bank were to take a position in such securitized debts, it would become part of treasury activity). On the other hand, an investment in G-Secs can be traded in the market. It is, therefore, a treasury asset.Treasury liabilities are distinguished from other liabilities by the fact that they are borrowings from the money (or bond) market. Deposits (current and savings accounts and fixed deposits) are not treasury liabilities, as they are not created by market borrowing.

6. ELEMENTS OF TREASURY MANAGEMENT1. Cash Reserve Ratio/Statutory Liquidity Ratio Management: CRR, or cash reserve ratio,

refers to the portion of deposits that banks have to maintain with RBI. This serves two purposes. First, it ensures that a portion of bank deposits is totally risk-free. Second, it enables RBI control liquidity in the system, and thereby, inflation. Besides CRR, banks are required to invest a portion (8.25 per cent now) of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they have a ready secondary market.

2. Dated Government Securities: The Government securities comprise dated securities issued by the Government of India and state governments. The date of maturity is specified in the securities therefore it is known as dated government securities.a) The Government borrows funds through the issue of long term-dated securities, the lowest risk category instruments in the economy. These securities are issued through auctions conducted by RBI, where the central bank decides the coupon or discount rate based on the response received. Most of these securities are issued as fixed interest bearing securities, though the government sometimes issues zero coupon instruments and floating rate securities also. In one of its first moves to deregulate interest rates in the economy, RBI adopted the market driven auction method in FY 1991-92. Since then, the interest in government securities has gone up tremendously and trading in these securities has been quite active. They are not generally in the form of securities but in the form of entries in RBI's Subsidiary General Ledger (SGL).



b) The investors in government securities are mainly banks, FIs, insurance companies, provident funds and trusts. These investors are required to hold a certain part of their investments or liabilities in government paper. Foreign institutional investors can also invest in these securities up to 100% of funds-in case of dedicated debt funds and 49% in case of equity funds.c) Till recently, a few of the domestic players used to trade in these securities with a majority investing in these instruments for the full term. This has been changing of late, with a good number of banks setting up active treasuries to trade in these securities. Perhaps the most liquid of the long term instruments, liquidity in gilts is also aided by the primary dealer network set up by RBI and RBI's own open market operations.

1. Money Market Operations: The bank engages into a number of instruments that are available in the Indian money market for the purpose of enhancing liquidity as well as profitability. Some of these instruments are as follows:

A. Call Money MarketCall/Notice money is an amount borrowed or lent on demand for a very short period. If the period is more than one day and up to 14 days it is called 'Notice money' otherwise the amount is known as Call money'. Intervening holidays and/or Sundays are excluded for this purpose. No collateral security is required to cover these transactions.

B. Treasury Bills MarketIn the short term, the lowest risk category instruments are the treasury bills. RBI issues these at a prefixed day and a fixed amount.

There are four types of treasury bills:- 91-day T-bill - maturity is in 91 days. Its auction is on every Wednesday of every week.

The notified amount for this auction is Rs. 100 cr. 182-day T-bill - maturity is in 182 days. Its auction is on every alternate Wednesday

(which is not a reporting week). The notified amount for this auction is Rs. 100 cr. 364-Day T-bill - maturity is in 364 days. Its auction is on every alternate Wednesday

(which is a reporting week). The notified amount for this auction is Rs. 500 cr.

C. Inter-Bank Term MoneyInter bank market for deposits of maturity beyond 14 days and up to three months is referred to as the term money market. The specified entities are not allowed to lend beyond 14 days. The market in this segment is presently not very deep. The declining spread in lending operations, the volatility in the call money market with accompanying risks in running asset/liability mismatches, the growing desire for fixed interest rate borrowing by corporate, the move towards fuller integration between forex and money markets, etc. are all the driving forces for the development of the term money market. These, coupled with the proposals for Nationalization of reserve requirements and stringent guidelines by regulators/managements of institutions, in the asset/liability and interest rate risk management, should stimulate the evolution of term money market sooner than later. The DFHI, as a major player in the market, is putting in all efforts to activate this market.

The development of the term money market is inevitable due to the following reasons Declining spread in lending operations Volatility in the call money market Growing desire for fixed interest rates borrowing by corporate Move towards fuller integration between forex and money market Stringent guidelines by regulators/management of the institutions

D. Certificates of DepositsCertificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note against funds deposited at a bank or other eligible financial institution for a specified time period.



Eligibility : CDs can be issued by (i) scheduled commercial banks {excluding Regional Rural Banks and Local Area Banks}; and (ii) select All-India Financial Institutions (FIs) that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.Aggregate Amount : Banks have the freedom to issue CDs depending on their funding requirements.Minimum Size of Issue and Denominations :Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs.1 lakh, and in multiples of Rs. 1 lakh thereafter.Investors :CDs can be issued to individuals, corporations, companies (including banks and PDs), trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on non-repatriable basis, which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market.Maturity : The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, from the date of issue.Discount / Coupon Rate :CDs may be issued at a discount on face value.

E. Commercial Paper (CP)Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.Companies, PDs and FIs are permitted to raise short term resources through CP. Individuals, banks, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-Resident Indians and Foreign Institutional Investors (FIIs) shall be eligible to invest in CP.A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the banking system and (c) the borrower account of the company is classified as a Standard Asset by the financing bank/s.Some important points related to CP:a. CP shall be issued in the form of a promissory note (as specified in Annex III to this Direction)and held in physical form or in a dematerialized form through any of the depositories approved by and registered with SEBI, provided that all RBI regulated entities can deal in and hold CP only in dematerialised form through such depositories.b. Fresh investments by all RBI-regulated entities shall be only in dematerialised form.c. CP shall be issued in denominations of Rs. 5 lakh and multiples thereof. The amount invested by a single investor should not be less than Rs. 5 lakh (face value).d. CP shall be issued at a discount to face value as may be determined by the issuer.e. CP shall be issued for maturities between a minimum of 7 days and a maximum of up to one year from the date of issue.f. Eligible participants/issuers shall obtain credit rating for issuance of CP from any one of the SEBI registered CRAs. Theminimum credit ratingshall be ‘A3’ as per rating symbol and definition prescribed by SEBI. The issuers shall ensure at the time of issuance of the CP that the rating so obtained is current and has not fallen due for review.

F. Ready Forward ContractsIt is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction.

G. Commercial Bills



Bills of exchange are negotiable instruments drawn by the seller (drawer) of the goods on the buyer (drawee) of the goods for the value of the goods delivered. These bills are called trade bills. These trade bills are called commercial bills when they are accepted by commercial banks. If the bill is payable at a future date and the seller needs money during the currency of the bill then he may approach his bank for discounting the bill. The maturity proceeds or face value of discounted bill, from the drawee, will be received by the bank. If the bank needs fund during the currency of the bill then it can rediscount the bill already discounted by it in the commercial bill rediscount market at the market related discount rate.

8. TREASURY PRODUCTS & SERVICES

1. Forward Contract: It is a contract between the bank and its customers in which the exchange/conversion of currencies would take place at future date at a rate of exchange in advance under the contract. The essential idea of entering into a forward contract is to peg the price and thereby avoid the pricerisk. Forward Rates = Spot rate +/ Premium/Discount

2. Forward Rate Agreement (FRA): An FRA is an agreement between the Bank and a Customer to pay or receive the difference (called settlement money) between an agreed fixed rate (FRA rate) and the interest rate prevailing on stipulated future date (the fixing date) based on a notional amount for an agreed period (the contract period). In short, this is a contract whereby interest rate is fixed now for a future period. The basic purpose of the FRA is to hedge the interest rate risk. For example, if a borrower is going to borrow FC loan for 6 months at LIBOR rate after 3 months, he can buy an FRA whereby he can fix interest rate for the loan.

3. Interest Rate Swap(IRS) : What is an interest rate swap?An interest rate swap is an over-the-counter (OTC) derivative instrument available in the currency market where counter parties can exchange a floating payment for a fixed payment and vice-versa related to an interest rate.Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell.Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.

How does it work?In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counter party. The fixed or floating rate is multiplied by a notional principal amount (say, 1 million).This notional amount is generally not exchanged between counter parties, but is used only for calculating the size of cash flows to be exchanged.The most common interest rate swap is one where one counter party A pays a fixed rate (the swap rate) to counter party B while receiving a floating rate (usually pegged to a reference rate such as LIBOR — London Inter Bank Offered Rate).

A pays fixed rate to B (A receives floating rate)

B pays floating rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 3.784%, in exchange for periodic floating interest rate payments of LIBOR + 70 bps (0.70%). There is no exchange of the principal amount and that the interest rates are on a notional principal amount.The interest payments are settled in net. The fixed rate (3.784% in this example) is referred to as the swap rate.



By convention, a fixed-rate payer is designated as the buyer of the swap, while the floating-rate payer is the seller of the swap.

In most cases an interest rate swap is structured so that both the fixed and floating payments are not actually paid. Rather, the difference between the two amounts is paid by the counterparty who faces the net shortfall at each payment date.

Users and Uses of Interest Rate Swaps Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:1. To obtain lower cost funding2. To hedge interest rate exposure3. To obtain higher yielding investment assets4. To create types of investment asset not otherwise obtainable5. To implement overall asset or liability management strategies6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.

Swap Example:-Consider XYZ corp a manufacturing firm which wants to raise 5 year fixed rate dollar funding for this expansion programme. It finds that will have to pay 2% over 5 year TBill which are currently yielding 9%. In floating rate market it can issue 5 year FRNs at a margin of 0.75% over the prime rate. On the other hand, ABC Inc. a large bank looking for floating rate fundings finds that it will have to pay prime rate while in the fixed rate market it can raise 5-year funs at 50bp(0.50%) above T-bills due to its AAA ratings.

XYZ Corp ABC IncRequirement Fixed rate Floating rateCost (fixed) 11% 9.5%Cost (floating) Prime +0.75% Prime

ABC has an absolute advantage over the XYZ in both the markets but XYZ has a comparative advantage in the floating rate market. Both can achieve cost savings by each borrowing in the market where it has a comparative advantage and then doing a fixed-to-floating interest rate swap.

9.75% fixed 9.50% fixed

Prime = 25bps Prime = 25bps

↓ Prime + 75bp 9.50 To Floating rate Lenders To fixed rate lenders

SWAP BANK

XYZ CORP

ABC Inco.



ABC borrows at 9.5% fixed. XYZ borrows at Prime +0.75 floating rate. ABC pays the swap bank (prime – 0.25T) and swap bank passes this on to ZYZ. XYZ pays the swap bank 9.75% and swap bank pays ABC 9.5%. The key result is that both the parties have achieved their objectives with some cost savings.

XYZ Corp: 9.75% + [prime +0.75 – (prime – 0.25)] % = 10.75% fixed 25bps below its own cost of fixed rate funds.ABC Inc: 9.5% – 9.5% + prime – 0.25% = prime – 0.25%, 25bps below its own cot of floating rate. The swap bank earns a margin of 25bps.

ILLUSTRATION:-Company A can borrow at 8% in USD markets and at 9% in AUD markets. Company B can borrow at 9% in USD markets and at 9.5% in AUD markets. Company A wants to borrow in AUD and company B wants to borrow in USD markets. If these companies enter a swap in which a dealer gets 10 basis points, what is the net cost of borrowing to Company B? a. 9% in USD.b. 8.8% in AUD.c. 8.75% in USD.d. 8.8% in USD.

e. None of the above.

4. Currency Swap: It is an agreement between two parties to exchange obligations in different currencies at the beginning, during the tenure and at the end of the transaction. At the start, initial principal is exchanged, though not obligatory. Periodic interest payments (either fixed or floating) are exchanged through out the life of the contract. The principal is exchanged invariably on termination at the exchange rate decided at the start of the transaction. By means of currency swap, the counterparties can reduce the cost of funding.

ILLUSTRATION:-Current spot exchange rate is 1.6237 CAD/Euro. Assume that risk-free rates are 4% and 7% in Canada and Europe, respectively. The Euro is selling for 1.6300 CAD/Euro forward in a three-month contract. a. Is there arbitrage? b. If yes, briefly describe the strategy to exploit it.

Answer: a. F0 = 1.6237e(.04 - .07).25 = 1.6116 CAD/Euro < 1.6300 => Arbitrage.

b. Today sell the forward, buy the Euros with borrowed CADs at 4% and invest the Euros at 7% in Europe.

a. Forward rate for 1-year horizon is F1 = /$66762.105.1

03.1*7000.1 £.

b.Forward rate for 2-year horizon is F2 = /$63585.105.1

03.1*7000.1

2

£.

The swap for the institution is equivalent to two exchanges: paying $0.85mil and receiving £0.4 mil in one year and paying $17.85mil and receiving £10.4 mil in two years. The swap value to the financial institution is the sum of the values of the one- and two-year forward exchanges.

Value of swap = 96673.0$03.1

)85.1763585.1*4.10(

03.1

)85.066762.1*4.0(2

mil

CASE LET on Currency Swaps:A UK firm is to advance a 3 years loan of £ 1,00,000 to its Japanese subsidiary. A Japanese firm is to advance a 3 years loan of ¥ 2,00,00,000 to its UK subsidiary. Both the firms are brought to a



negotiation table by a finance corporation and a deal is negotiated. Under the deal, the UK firm will advance £ 1,00,000 to UK Subsidiary of the Japanese firm at interest of 8 % p.a. compounded annually payable on maturity, the Japanese firm will advance a loan of ¥ 2,00,00,000 to Japanese subsidiary of UK firm at interest of 7 % p.a. compounded annually payable on maturity. The current exchange rate is 1£ = 200 Yens. However, the £ is expected to decline by 4 Yens per £ over 3 next years. Compare the £ value of receivables of each of the two firms at the end of 3 years. Answer: • UK firm will get £ 1,25,971 from UK subsidiary of the Japanese firm. 1st year: £ 1,00,000 x 8% p.a = £8,0002nd year: £ 1,08,000 x 8% p.a = £8,6403rd year: £ 1,16,640 x 8% p.a = £9,331

That means total will be £ 1,00,000 + Intt £ 25971

• The Japanese firm will get Yens 2,66,20,000 from the Japanese subsidiary of the UK firm:the £ value of this receivable is expected to be 2,45,00,860 / 188 i.e. £ 1,30,323. 1st year: ¥ 2,00,00,000 x 7% p.a = ¥ 14,00,0002nd year: ¥ 2,14,00,000 x 7% p.a = ¥ 14,98,0003rd year: ¥ 2,28,98,000 x 7% p.a = ¥ 16,02,860That means total will be ¥ 2,00,00,000 + Intt.¥ 45,00,860

5. Currency Derivatives:- Already seen in Chapter 1 of Module AThere are two types of currency derivatives to hedge the risk on currency rates fluctuations: 1. Forward 2. Futures & options

CASE LET on Interest Swaps:Case 1: ABC Company just entered into an interest rate swap agreement with another company. ABC has agreed to make semi-annual payments at a fixed rate of 7.6% per year. The counterparty, on the other hand, has agreed to make variable payments at a rate of LIBOR + 1. With a notional principal of $15 million, which of the following statements would hold true for the first payment in six months if LIBOR were 6.1% today and 6.9% in six months? A) ABC would receive a net payment of $37,500. B) ABC would receive a net payment of $22,500. C) ABC would have to make a net payment of $22,500.D) ABC would have to make a net payment of $37,500

Explanation:

(7.6% / 2 ) of 15m = 5,70,000

( 6.1% + 1%) of 15m = 5,32,500 2 Net = 37,500

Note 1:- Since the fixed payer owes more than the float payer, only the fixed payer would make one net payment of $37,500. 2:- We use semi annual rates by dividing the annual rate by 2. 3:- To determine the float payment we use the LIBOR rate at the beginning of the period, even though the payment is made at the end of the period

Case 2: Two parties enter into a three-year interest rate swap, which involves the exchange of LIBOR+1 for a fixed rate of 12% on a $100 million notional amount. The LIBOR rate today is 11%, but is expected to increase to 15% in one year and fall back down to 8% in the following year.

Fixed payer:ABC

Float payer:Counterparty



Which of the following statements accurately depicts the flow of net cash flows between the two counterparties? (a) The fixed rate payer would receive a payment of $4 million at the end of year two, while the variable rate payer would receive $3 million at the end of year three. (b) The fixed rate payer will have to pay $4 million at the end of the second year and $3 million at the end of the third year. (c) The fixed rate payer will have to pay $1 million at the end of the first year. (d) The variable rate payer would receive a payment of $4 million at the end of year two, while the fixed rate payer would receive $3 million at the end of year three.

Explanation:-End of Yr 1:- Fixed pays ( $ 100 million x 12% ) $ 12 million Variable pays (100 million x 12%) $ 12 million = Net cash flow received by fixed payer NIL

End of Yr 2:- Fixed pays ( $ 100 million x 12% ) $ 12 million Variable pays (100 million x 16%) $ 16 million = Net cash flow received by fixed payer $ 4 million End of Yr 2:- Fixed pays ( $ 100 million x 12% ) $ 12 million Variable pays (100 million x 9 %) $ 9 million = Net cash flow paid by fixed payer $ 3 million

Problems on T- Bill:-

1. Assume an investor purchased a six-month T-bill with a Rs.10,000 par value for Rs.9,000 and sold it ninety days later for Rs.9,700. What is the yield?ANSWER:

YPar PP

PP

365

n

10,000 9 7 00

9,700

365

90

12.54%

D

2. Newly issued three-month T-bills with a par value of Rs.10,000 sold for Rs.9,700. Compute the T-bill discount.ANSWER:

YPar PP

Par

365

n

10,000 9 7 00

10,000

365

90

12.16%

D

3. Assume an investor purchased six-month commercial paper with a face value of Rs.1,000,000

for Rs.940,000. What is the yield?ANSWER:

Y 1,000,000 940,000

940,000

365

180

12.94%

cp



4. The Treasury is selling 91-day T-bills with a face value of Rs.10,000 for Rs.8,800. If the investor holds them until maturity, calculate the yield.

ANSWER:YT = (SP – PP/ PP) (365 / n)YT = (10,000 – 8,800 / 8,800) (365 / 91) = 54.69%

Computation of DTLLiabilities of a bank may be in the form of demand or time deposits or borrowings or other miscellaneous items of liabilities. As defined under Section 42 of the RBI Act, 1934, liabilities of a bank may be towards the banking system or towards others in the form of demand and time deposits or borrowings or other miscellaneous items of liabilities.

I. Liabilities in India to the Banking System (excluding any loan taken by a Regional Rural Bank from its sponsor Bank) : The following are to considered as part of it: Demand Liabilities :1. Current deposits 2. Demand liabilities portion of savings bank deposits, 3. Margins held against letters of credit/guarantees, 4. Balances in overdue fixed deposits, 5. Cash certificates and cumulative/recurring deposits, 6. Outstanding Telegraphic Transfers (TTs), Mail Transfers (MTs), Demand Drafts (DDs), 7. Unclaimed deposits, 8. Credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. 9. Money at Call and Short Notice from outside the Banking System should be shown against liability to others.

Time Liabilities1. Fixed deposits, 2. Cash certificates, cumulative and recurring deposits, 3. Time liabilities portion of savings bank deposits, 4. Staff security deposits, 5. Margin held against letters of credit, if not payable on demand, 6. Deposits held as securities for advances which are not payable on demand 7. Gold deposits.

II. Liabilities in India to others (excluding borrowings from the Reserve Bank, Export-Import Bank of India and National Bank for Agriculture and Rural Development) Borrowings from abroad by banks in India: Loans/borrowings from abroad by banks in India will be considered as 'liabilities to others' and will be subject to reserve requirements. Upper Tier II instruments raised and maintained abroad shall be reckoned as liability for the computation of DTL for the purpose of reserve requirements.

Other Demand and Time Liabilities (ODTL)1. Interest accrued on deposits, 2. Bills payable & unpaid dividends, 3. Suspense account balances representing amounts due to other banks or public,4. Net credit balances in branch adjustment account, 5. Any amounts due to the banking system which are not in the nature of deposits or borrowing. Such liabilities may arise due to items like (i) collection of bills on behalf of other banks, (ii) interest due to other banks and so on. 6. Participation Certificates issued to other banks, 7. The balances outstanding in the blocked account pertaining to segregated outstanding credit entries for more than 5 years in inter-branch adjustment account, 8. The margin money on bills purchased / discounted and gold borrowed by banks from abroad,



9. Cash collaterals received under collateralized derivative transactions should be included in the bank’s DTL/NDTL for the purpose of reserve requirements as these are in the nature of ‘outside liabilities’.10. Loans/borrowings from abroad by banks in India11. Arrangements with Correspondent Banks for Remittance Facilities : When a bank accepts funds from a client under its remittance facilities scheme, it becomes a liability (liability to others) in its books. The liability of the bank accepting funds will extinguish only when the correspondent bank honours the drafts issued by the accepting bank to its customers. As such, the balance amount in respect of the drafts issued by the accepting bank on its correspondent bank under the remittance facilities scheme and remaining unpaid should be reflected in the accepting bank's books as liability under the head ' Liability to others in India' and the same should also be taken into account for computation of DTL for CRR/SLR purpose.

III. Assets with the Banking System:(a) Balances in current account with (i) The State Bank of India, subsidiary banks and corresponding new banks. (ii) Other banks and Notified financial Institutions (b) Balances in other accounts with banks and notified financial institutions (c) Money at call and short notice (d) Advances to banks (i.e. dues from banks) (e) Other assets

How to compute NDTL?Net liabilities for the purpose of section 18 and 24 of the Banking Regulation Act, 1949

= Net liabilities to the Banking System+ Other demand and time liabilities

= (I-III)+II if (I-III) is a plus figure

OR

II only if (I-III) is a minus figure

Important Point:SCBs are exempted from maintaining CRR on the following liabilities:i. Liabilities to the banking system in India as computed under clause (d) of the explanation to Section 42(1) of the RBI Act, 1934; (As per this section, mostly liabilities towards SBI & subsidiaries, towards banks formed under 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970); Section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980);],a banking company as defined in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of 1949); a co-operative Bank; or any other financial institution notified by the Central Government in this behalf)ii. Credit balances in ACU (US$) Accounts; andiii. Demand and Time Liabilities in respect of their Offshore Banking Units (OBU).

Maintenance of CRR on Daily Basis : With a view to providing flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra fortnight cash flows, all SCBs are required to maintain minimum CRR balances up to 90 per cent of the average daily required reserves for a reporting fortnight on all days of the fortnight with effect from the fortnight beginning April 16, 2016.However, the actual CRR and SLR maintenance happens with a lag of one fortnight.

Liabilities not to be included in DTL / NDTL calculationThe following liabilities are not be included in the DTL calculation for purposes of maintaining CRR and SLR



- Paid up capital, reserves;- Any credit balance in the Profit & Loss Account of the bank;- Amount of any loan taken from the RBI;- Amount of refinance taken from Exim Bank, NHB, NABARD, SIDBI;- Net income tax provision;- Amount received from Deposit Insurance and Credit Guarantee Corporation (DICGC) towards claims and held by banks pending adjustments thereof;- Amount received from ECGC by invoking the guarantee;- Amount received from insurance company on ad-hoc settlement of claims pending judgment of the Court;- Amount received from the Court Receiver;- The liabilities arising on account of utilization of limits under Bankers Acceptance Facility (BAF);- District Rural Development Agency (DRDA) subsidy of Rs.10, 000/- kept in Subsidy Reserve Fund account in the name of Self Help Groups;- Subsidy released by NABARD under Investment Subsidy Scheme for construction/renovation/expansion of Rural Godowns - Net unrealized gain/loss arising from derivatives transaction under trading portfolio;- Income flows received in advance such as annual fees and other charges which are not refundable;- Bill rediscounted by a bank with eligible financial institutions as approved by RBI;- Provision not being a specific liability arising from contracting additional liability and created from profit and loss account.- The eligible amount of incremental FCNR (B) and NRE deposits of maturities of three years and above from the base date of July 26, 2013, and outstanding as on March 7, 2014, till their maturities/pre-mature withdrawals.

Illustration: CRR calculation:From the following information calculate NDTL for CRR for the reporting Friday as mentioned:

04/09/2016CAPITAL (Issued Paid up and subscribed) 58,96,149RESERVES & SURPLUS 8,14,78,362

DEPOSITS:A) Demand Depositsi) Total Credit Balances in Current a/cs maintained with Co-operative bank by SBI, SUB, banks a

0.00

ii) Total of Other Demand Liabilities to the Banking System 27,095.00iii) Demand Liabilities in India to Others 1,37,701.30

B) Time Deposits i) Time Liabilities in India to Others 31,443.63Time Liabilities of the Banking System 3.057.00

BORROWINGS: From Reserve Bank of India 6,39,600From Public 70,202

OTHER LIABILITIES:Bills payable 64,935Interest accrued 23,809

CASH IN HAND 820A. BALANCES IN CURRENT A/C WITHa) Reserve Bank of India 710b) State Co-op bank of the State 652



c) District Central Co-op Bank 4Total of (a+b+c) 1,366B. Balances of all other types witha) State Co-op bank of the State 0.00b) District Central Co-op bank 0.00Total of (a+b) 0.00C. Assets in India with the Banking systema) Total of Credit Balances in current a/cs maintained with SBI & corresponding new banks

123

b) Total of Other Assets with Banking system, viz. 7,391i) Balance on all Accounts 368i) Money at Call & Short Notice 0.00ii) Advances 0.00v) Any Other Assets 7,025Total of (a + b (i+ii+iii+iv) ) 14,907

INVESTMENTS 45,35,662

ADVANCES 1,07,64,420

Answer: 04/09/2016

CAPITAL (Issued Paid up and subscribed) 0RESERVES & SURPLUS 0

I. DEPOSITS:A) Demand Depositsi) Total Credit Balances in Current a/cs maintained with Co-operative bank by SBI, SUB, banks a

0.00

ii) Total of Other Demand Liabilities to the Banking System 27,095iii) Demand Liabilities in India to Others 1,37,701 Total A ( i + ii + iii ) 1,64,796B) Time DepositsTime Liabilities in India to Others 31,443Time Liabilities of the Banking System 3,057Total B ( i + ii ) 34,500Total I ( A + B ) 1,99,296

II. Liabilities in India to othersBORROWINGS: From Reserve Bank of India (Not to a TL) 00.00From Public (To be considered as liabilities to others) 70,202

OTHER LIABILITIES:Bills payable (To be considered as Other liabilities) 64,935Interest accrued (To be considered as Other liabilities) 23,809Total II 1,58,946

CASH IN HAND ( Not to be considered ) 0

III. Assets with the Banking SystemA. BALANCES IN CURRENT A/C WITH a) Reserve Bank of India ( Not to be considered ) 0b) State Co-op bank of the State (To be considered ) 652c) District Central Co-op Bank (To be considered ) 4



Total of (a+b+c) 656

B. Balances of all other types witha) State Co-op bank of the State 0.00b) District Central Co-op bank 0.00Total of (a+b) 0.00

C. Assets in India with the Banking systema) Total of Credit Balances in current a/cs maintained with SBI & corresponding new banks (To be considered )

123

b) Total of Other Assets with Banking system, viz. (To be considered ) 7,391i) Balance on all Accounts (To be considered ) 368i) Money at Call & Short Notice 0.00iii) Advances 0.00iv) Any Other Assets (To be considered ) 7,025Total of (a + b (i+ii+iii+iv) ) 14,907Total of III ( A + B + C) 15,563INVESTMENTS ( Not a part of NDTL) 0

ADVANCES ( Not a part of NDTL) 0

Total (Net) Demand and Time Liabilities for the purpose of section 18 & 24 (I – III) + II (1,99,296 - 15,563 + 1,58,946 ) 3,42,679CRR to calculated on this figure…

Procedure for Computation of SLRThe procedure to compute total NDTL for the purpose of SLR under Section 24 (2A) of Banking Regulation Act, 1949 is broadly similar to the procedure followed for CRR. The liabilities mentioned above for calculation of CRR, will not form part of liabilities for the purpose of SLR also. Scheduled Commercial Banks (SCB) are required to include inter-bank term deposits / term borrowing liabilities of all maturities in 'Liabilities to the Banking System'. Similarly, banks should include their inter-bank assets of term deposits and term lending of all maturities in 'Assets with the Banking System' for computation of NDTL for SLR purpose.

Maintenance of Statutory Liquidity Ratio (SLR) : Every SCB shall continue to maintain SLR in India assets as detailed below:(a) Cash or (b) Gold valued at a price not exceeding the current market price, or (c) Investment in the following instruments which will be referred to as "Statutory Liquidity Ratio (SLR) securities":(i) Treasury Bills of the Government of India;(ii) Dated securities of the Government of India issued from time to time under the market borrowing programme and the Market Stabilization Scheme;(iii) State Development Loans (SDLs) of the State Governments issued from time to time under the market borrowing programme; and(iv) Any other instrument as may be notified by the Reserve Bank of India.

LAF (Liquidity Adjustment factor) : Liquidity adjustment facility (LAF) is a monetary policy tool used by RBI to manage market liquidity and money supply targets. LAF was introduced in June 2000 and conducted daily on overnight basis. LAF consist of Repo and Reverse Repo transactions.Corridor’ for LAF (Liquidity Adjustment factor) is the difference between repo and reverse repo rates. It is so called as call rates should move between these two rates.

REPO & Reverse REPO Transactions:



Repo rate or repurchase rate is the rate at which banks borrow money from the central bank (read RBI for India) for short period by selling excess Non SLR securities (mostly government bonds or treasury bills) to the central bank with an agreement to repurchase it at a future date at predetermined price. It is similar to borrowing money from anybody by selling him something with a promise to buying it back later at a pre-fixed price ( fixed at the time of borrowing itself). E.g, A bank is having Non SLR securities of Rs.300 cr. They don’t have much of the liquidity due to asset mismatch and hence they will sell these securities to RBI with promise to purchase it within next 15 days. For 15 days they need pay interest prevailing at that time, currently rate is 7.25%. Hence the calculations are Rs.300cr X 7.25% = Rs.21.75 cr p.a. and for 15 days it comes to 89 lakhs. This amount will be adjusted in repurchase price, that mean while repurchasing the securities bank will pay 300 cr + 89 lakhs = 389 cr.

Illustration:Security offered under Repo 11.43% 2026 Coupon payment dates 7 August and 7 February Market Price of the security offered under Repo(i.e. price of the security in the first leg)

Rs.113.00 (1)

Date of the Repo 19 January, 2014 Repo interest rate 7.75% Tenor of the repo 3 days Broken period interest for the first leg* 11.43% x162/360 x100 = 5.1435 (2)Cash consideration for the first leg (1) + (2) = 118.1435 (3)Repo interest** 118.1435 x 7.75% x 3/365 =0.0753 (4)Broken period interest for the second leg 11.43% x 165/360x100=5.2388 (5)Price for the second leg (3)+(4)-(5) = 118.1435 + 0.0753-5.2388 = 112.98 (6)Cash consideration for the second leg (5)+(6) = 112.98 + 5.2388 = 118.2188 (7)

* Computation of days based on 30/360 day count convention ** Computation of days based on Actual/365 day count convention applicable to money market instruments

Reverse Repo RateReverse repo transaction is exactly the opposite of Repo transaction. Here RBI is selling the securities to Banks with a promise to purchase it back at predetermined rate. It the rate of interest at which the RBI borrows funds from other banks for a short duration (by means of selling the securities to banks). The banks deposit their short term excess funds with the central bank and earn interest on it. Reverse Repo Rate is used by the central bank to absorb liquidity from the economy. When it feels that there is too much money floating in the market, it increases the reverse repo rate, meaning that the central bank will pay a higher rate of interest to the banks for depositing money with it.

Both these rates are determined by the RBI based on the demand and supply of money in the economy.

Marginal Standing Facility (MSF) :MSF was introduced by RBI in2011, where banks can borrow from RBI when there is a Considerable shortfall of liquidity. Under MSF, banks can borrow from RBI up to 1 % of NDTL and can pledge securities within the SLR unlike under LAF where has to be above the SLR . RBI recently restricted borrowing under LAF to 1 % of NDTL or approximately 75000cr.

NOTE: PLEASE REFER CHAPTER BOND VALUATION & RATIO ANALYSIS FROM ADVANCED BANK MANAGEMENT, AS SOME QUESTIONS HAVE ASKED IN THE BFM PAPER FROM THESE CHAPTERS ALSO.

****



CHAPTER 2 INTEREST RATE RISK

2.1 Introduction2.2 Types of Interest Rate Risk2.3 Measuring Interest Rate Risk2.4 Trading Book2.5 Banking Book2.6 Approaches to IRR2.7 Interest rate risk measurement techniques

2.1 IntroductionInterest Rate Risk (IRR) arises as a result of change in interest rates on rate earning assets and rate paying liabilities of a bank. The scope of IRR management is to cover the measurement, control and management of IRR in the banking book. As indicated elsewhere, with the deregulation of interest rates, the volatility of the interest rates have risen considerably. This has transformed the business of banking forever in our country from a mere volume driven business (as volume would take care of profitability in a regulated environment) to a business of careful planning and to achieve targets of profitability by choosing the appropriate assets and liabilities to be employed.To take an example at this stage, a bank funding a three year fixed rate loan with a six month fixed rate deposit is exposed to interest rate risk as the timing of repricing of assets and liabilities is different. The asset has a repricing period of three years while the repricing period of the liability is six months. The concept of repricing is extremely important in IRR management which reflects the time remaining for interest rate to change on assets and liabilities. This concept would be expanded further to cover finer aspects of repricing in a subsequent section. If the interest rates go up in six months from now, the impact of the interest rate would hit the bank in the form of reduction in the spread, where the spread is the difference between the yield on assets and the cost of liabilities. This is because the asset rate would remain the same as it is a fixed rate and the liability rate has gone up at a time when existing liability matured and a fresh liability is taken to continue the funding of the assets in the balance sheet. Any fall in the interest rate would have led to positive impact on the spread as liability rate falls while the asset rate remaining the same. This is typically how the interest rate exposure of an institution is arrived at and analysed.

2.2 Types of Interest Rate Risk2.2.1 Gap or Mismatch Risk:A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.

2.2.2 Basis RiskBPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books. BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.How does it work? Let’s suppose you own a Rs. 10million bond that has a price of 100, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by: A. Using the current market price from a dealer quote, or B. Discounting the individual bond cash flows in order to find the sum of the present values. (Refer Bond Valuation chapter in Paper 1 of CAIIB (Revised) Let’s assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon



methodology). For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of Rs.10,000,000. We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of Rs.9,995,671.72. There is a difference of Rs.4,328.28. It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost Rs.4,328.28 on a mark-to-market basis. This is the BPV of the bond.

How do risk managers use this? BPV is an estimate of the interest rate risk you have. You can therefore use it to manage interest rate exposure. Some firms do this by giving traders a maximum BPV that they are permitted torun. For example, a limit where the portfolio BPV must not exceed Rs.2,00,000. The more interest rate risk you are prepared to let dealers take the higher the limit.

2.2.3 Embedded Option RiskSignificant changes in market interest rates create another source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. The embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks’ NII. Thus, banks should evolve scientific techniques to estimate the probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to realistically estimate the risk profiles in their balance sheet. Banks should also endeavour for stipulating appropriate penalties based on opportunity costs to stem the exercise of options, which is always to the disadvantage of banks.

2.2.4 Yield Curve RiskThe yield curve describes the relationship between short- and long-term interest rates (i.e., the "term structure"), and is often represented as a graph showing the duration of investment on the x-axis and the annualized interest rate on the y-axis.The yield curve is important because long-term interest rates are usually higher than short term interest rates, reflecting the fact that long term loans tie up money and make it inaccessible for longer periods of time. Many banks and financial institutions' profits are tied to the difference between short-term and long-term interest rates, as they make money on a "borrow short, lend long" strategy, rather than whether interest rates themselves are nominally low or high. In this strategy, banks borrow money from their depositors and pay these depositors short-term interest (such as in a savings account). Banks will then aggregate these deposits and lend them out in long-term loans (such as mortgages) that will not be paid back for many years, but which pay higher interest.In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curves would affect the NII. The movements in yield curve are rather frequent when the economy moves through business cycles. Thus, banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income.

2.2.5 Price RiskPrice risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks which have an active trading book should, therefore, formulate policies to limit the portfolio size, holding period, duration, defeasance period, stop loss limits, marking to market, etc.

2.2.6 Reinvestment RiskUncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as



the market interest rates move in different directions.

2.2.7 Net Interest Position RiskThe size of nonpaying liabilities is one of the significant factors contributing towards profitability of banks. When banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rates adjust downwards. Thus, banks with positive net interest positions will experience a reduction in NII as the market interest rate declines and increases when interest rate rises. Thus, large float is a natural hedge against the variations in interest rates.

2.3 Measuring Interest Rate Risk2.3.1 Before interest rate risk could be managed, they should be identified and quantified. Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to measure the degree of risks to which banks are exposed. It is also equally impossible to develop effective risk management strategies/hedging techniques without being able to understand the correct risk position of banks. The IRR measurement system should address all material sources of interest rate risk including gap or mismatch, basis, embedded option, yield curve, price, reinvestment and net interest position risks exposures. The IRR measurement system should also take into account the specific characteristics of each individual interest rate sensitive position and should capture in detail the full range of potential movements in interest rates. 2.3.2 There are different techniques for measurement of interest rate risk, ranging from the traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings), Duration (to measure interest rate sensitivity of capital), Simulation and Value at Risk. While these methods highlight different facets of interest rate risk, many banks use them in combination, or use hybrid methods that combine features of all the techniques.2.3.3 Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Investment or Banking Books. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic value changes are the main focus of banking book.

2.4 Trading BookThe top management of banks should lay down policies with regard to volume, maximum maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for classifying securities in the trading book. While the securities held in the trading book should ideally be marked to market on a daily basis, the potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models. The VaR method is employed to assess potential loss that could crystalise on trading position or portfolio due to variations in market interest rates and prices, using a given confidence level, usually 95% to 99%, within a defined period of time. The VaR method should incorporate the market factors against which the market value of the trading position is exposed. The top management should put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions, derivative products, etc.) which is then disaggregated across different desks and departments. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. The potential loss in Present Value Basis Points should be matched by the Middle Office on a daily basis vis-à-vis the prudential limits set by the Board. The advantage of using VaR is that it is comparable across products, desks and Departments and it can be validated through ‘back testing’. However, VaR models require the use of extensive historical data to estimate future volatility. VaR model also may not give good results in extreme volatile conditions or outlier events and stress test has to be employed to complement VaR. The stress tests provide management a view on the potential impact of large size market movements and also attempt to estimate the size of potential losses due to stress events, which occur in the ’tails’ of the loss distribution. Banks may also undertake scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical, simultaneous and



related changes in multiple risk factors present in the trading portfolio to determine the impact of moves on the rest of the portfolio. VaR models could also be modified to reflect liquidity risk differences observed across assets over time. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-statistical concepts such as stop loss and gross/net positions can be used.

2.6 Banking BookThe changes in market interest rates have earnings and economic value impacts on the banks’ banking book. Thus, given the complexity and range of balance sheet products, banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. The variety of techniques ranges from simple maturity (fixed rate) and repricing (floating rate) to static simulation, based on current on-and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk, embedded option risk, yield curve risk, etc.

BCBS Paper on “Principles for the Management and Supervision of Interest Rate Risk" state the following :The main components of the approach prescribed in the above mentioned supporting document are as under: a) The assessment should take into account both the earnings perspective and economic value perspective of interest rate risk. b) The impact on income or the economic value of equity should be calculated by applying a notional interest rate shock of 200 basis points. c) The usual methods followed in measuring the interest rate risk are :1. Earnings Approach: Gap Analysis, simulation techniques and Internal Models based on VaR2. Economic Value Approach : Gap analysis combined with duration gap analysis, simulation techniques and Internal Models based on VaR

2.7.1 Earnings Approach to IRR: Gap Analysis:-The earnings approach is otherwise known as accounting approach. The main focus of the approach is on the impact of interest rate changes on assets and liabilities on the Net Interest Income (NII). NII is an important top-line performance indicator of a bank and is computed as under:NII = Interest Income – Interest Expenses .............................................1

The following example illustrated how term deposits similar in all respects but differing only in terms of type of interest payment – fixed rate or floating rate has to be treated in the rate sensitive gap report. Further discussion of the earnings approach would be enabled with the help of a real-life interest rate sensitivity summary report as under:

Rate Sensitive Gap SummaryParticulars 0-1M 1-3M 3-6M 6-12M 1-3Y 3-5 Y over 5 Y Non

sensitive Total

Term deposits 1464 1835 1858 2372 6601 3729 1172 19030A total liabilities 2099 2593 10930 2730 6601 3972 1172 10342 40258Total Assets 2162 1480 10651 1425 2986 3893 12378 5605 40581 Net Group (B-A) 63 -1113 -280 -1305 -3614 102 11206 -4737 323Cumulative Gap 63 -1049 -1329 -2634 -6248 - 6146 5060 323

As seen above, the gap is positive in the first repricing bucket and is negative in all other buckets except the last two repricing buckets of 3-5 years and over 5 years.

What is the impact of the gaps on the NII of the bank? The formula for NII impact analysis is as under:Impact on NII = Gap × Interest Rate Change



The above formula assumes the impact is for a one year period and the interest rate change is per annum. Computation of impact for shorter periods can be carried out by suitably adjusting both the period of impact and the rate to reflect the period. To illustrate, what is the annual impact of the positive gap in the first repricing bucket when interest rate is expected to go up by 1%? To answer this, we need to make an assumption of timing of rate change within the first bucket as assets and liabilities having different repricing periods upto 1 month are clubbed together for the sake of convenience. The usual assumption is that the rate change takes place at the mid-point of the bucket, i.e., 15 days from today, i.e., 0.5 month. Observe the following arising from the above:

Timing of change in rate = mid-point of the first bucket = (0+1)/2 = 0.5 monthAnnual impact would be for a period of = 11.5 months (i.e., 12 – 0.5)Rate change per annum = 1%Gap in the first bucket = Rs. 63 croresNII impact for the first bucket = Gap × Periodicity of annual impact × Rate Change = 63 × 11.5 × (1%/12) = 0.60375

Hence, the annual impact of interest rate going up in case of the first repricing bucket is Rs.0.6037 crores. As the impact is positive, the NII would go up. What is the annual impact for the second repricing bucket for the same interest rate change?

Timing of change in rate = (1+3)/2 = 2 monthsAnnual impact would be for a period of = 10 months (i.e. 12 – 2)Rate change per annum = 1%Gap in the second bucket = -1113 croresNII impact for the second bucket = -1113 × 10 × (1%/12) = -9.275

While the NII impact of the gap in the first bucket was positive, the impact of the negative gap in the second bucket is negative to the extent of 9.275 crores. This gives an indication that the NII would suffer to an extent of 9.275 crores for the second bucket. The approach described above can be used to arrive at the impact for each bucket and then aggregate bucket-wise impact to arrive at quarterly, semi-annual and annual impact on NII. In the numerical analysis above, the reason for difference in impact between the first and second buckets is simple. The gap in the first bucket is an asset sensitive gap as more assets are repricing than the liabilities. An asset sensitive gap with an increase in interest rates would produce positive impact on NII. That is what we observed in case of the first bucket. The gap in the second bucket is liability sensitive as more liabilities are repricing than assets in the bucket. A liability sensitive position with an increase in interest rates would produce a negative impact that we observed in case of the second bucket. The following table summarises the NII impact given the sign of the gaps and the sign of change in interest rates

Repricing Gap (assets and liab.) Interest Rate view impact on NII Positive

(RSA> RSL)Up Positive

Positive(RSA> RSL)

down Negative

Negative(RSA<RSL)

Up Negative

Negative(RSA<RSL)

Down Positive

Zero(RSA=RSL)

Up or Down Zero

*RSA=Rate Sensitive Assets. RSL=Rate Sensitive Liabilities

Illustration 1:A Bank has Rs.20 million in cash and Rs.180 million loan portfolio. The assets are funded with demand deposits of Rs.18 million, Rs.162 million bonds, and Rs.20 million in equity. The loan



portfolio has a maturity of 2 years, earns interest at the annual rate of 7 percent, and is amortized monthly. The bank pays 7 percent annual interest on the bonds, but the principal will not be paid until the bonds matures at the end of 2 years. What is the maturity gap for Bank?Solution:MA = [0*Rs.20 + 2*Rs.180]/Rs.200 = 1.80 years ML = [0*Rs.18 + 2*Rs.162]/Rs.180 = 1.80 years MGAP = 1.80 – 1.80 = 0 years.

Illustration 2:The balance sheet for GBI bank, is presented below (Rs. millions): Assets Liabilities and EquityCash 30 Core deposits 20 364 days T bill (5.60%) 20 Repo 50 Loans (floating) 105 Bonds (10 yrs) 130 Loans (fixed) 65 Equity 20Total assets 220 Total liabilities & equity 220

Notes to the balance sheet: The Repo funds rate is 6.5%, the floating loan rate is LIBOR + 3 %, and currently LIBOR is 8%. Fixed rate loans have five-year maturities, are priced at par, and pay 12% annual interest. The principal is repaid at maturity. Core deposits are fixed rate for a year at 8% paid annually. The principal is repaid at maturity. Bonds are at 8%.a. What is the banks NIIb. What is the banks NII marginc. If interest rates decline by 60 basis points, what will be effect on NII.Solution: (a)Interest Income = ( 20 x 5.60% + 105 x 11% + 65 x 12%) = 20.47 Interest Expense = ( 20 x 8% + 50 x 6.5% + 130 x 8%) = 15.25 So NII will be = 20.47 – 15.25 = 5.22 million

(b) NII margin = NII_____ x 100 Earnings Assets = 15.25 x 100 = 8.03% 190.00(c) If interest rates decline by 60 basis points, then effect will be only on RSA and RSL and not on other non sensitive assets or liabilities that are on fixed rates.So now the gap of RSA & RSL is :RSA = 364 days T bill (5.60%) 20 + Loans (floating) 105 = 125RSL = Core deposits 20 + Repo 50 = 70Gap = RSA – RSL = 125 – 70 = 55Now refer to table on pg. no. and since the gap is positive and rates are declining by 60 bps the NII will go down by 55 million x 0.60% = 0.33 million.

2.7.2 Economic Value Approach of IRREarnings approach of IRR has a short-term focus and covers only an initial part of the life of assets & liabilities in the balance sheet. It does not cover the long-term impact of the exposure to the changes in interest rates. The Economic Value Approach, which is known by many names such as Market Value Approach, Net Portfolio Value Approach etc. considers the long-term impact of interest rate changes by covering the entire life of all the assets and liabilities. Under the economic value approach, the impact of interest rate changes are studied on an important variable called Economic Value of Equity (EVE). It is known by many names such as Net Portfolio Value, Market Value of Equity, Market Value of Portfolio Equity etc. The EVE is:

EVE = Economic Value of Assets – Economic Value of Outsider Liabilities ............ 5

The economic value of assets and economic value of outsider liabilities represent the fair value of assets and the fair value of liabilities except equity respectively. The essence of the equation



reflects the residuary nature of the claims of the equity shareholders who are the owners. This approach recognises the fact that changes in interest rates not only change the NII but also the economic value of assets and liabilities, which in turn is reflected in the value of equity. The approach to the valuation is the well known ‘present value of future cash flows’, which is a basic foundation for the subject of finance. The economic value approach has gained prominence as the NII impact and EVE impact for a given change in interest rates on assets and liabilities need not have to be in the same direction. It is perfectly possible for a bank to substantially gain in NII terms when interest rates go up, but end up with a reduction in EVE and vice versa.

Sensitivity of Economic Value: Duration as a Measure of Elasticity of ValueApart from the valuation of assets and liabilities using the principle of valuation, there is also a need to use well known measures of interest rate sensitivity to understand the interest rate elasticity of each asset & liability in the balance sheet and for arriving at the net sensitivity, which would ultimately impact the EVE as per equation 5. The well known measures of interest rate sensitivity are the duration family measures which are used extensively in IRR in the current environment. The following illustration would be used to explain the concept of valuation and measures of interest rate sensitivity

Valuation and Computation of Duration Measures for a Term Deposit:

Principal and outstanding balance 10,000Opening Date of Deposit 01/01/2013Current Date 01/01/2014Date of Maturity of Deposit 31/12/2018Contractual Rate of Interest 9%Freq. of Intt. Payment p.a. 1Current Rate of Interest 8%Residual Maturity (Years) 5

Time period (t) in yrs Cash Flow Present of Cash flow Duration Segment1 900 833.3333 0.08012 900 771.6049 0.14843 900 714.4490 0.20614 900 661.5269 0.25455 10,900 7,418.357 3.5668

Value of Deposit 10,399.270 4.2559 3.9406 Modified Duration

The valuation carried out for the term deposit reveals that the economic value of the deposit is Rs.10399.27 while the book value of the same is Rs.10000. As explained, a higher economic value than book value for a liability is a negative impact on EVE. This can be interpreted as hinting at deterioration in the future earning potential for the bank, which is reflected by a reduction in EVE. This explanation would be crystal clear if the contractual interest rate and the current interest rate are compared to draw conclusions on future earning potential. The comparison of interest rates show that the bank has been incurring and will continue to incur till the deposit matures a cost of 9% while the current interest rate on similar deposit has fallen to 8%. The bank is not able to reduce the interest rate on the deposit as the deposit carries a fixed rate. The EVE reduction to the tune of Rs.399.27 (i.e., the current book value of Rs.10000 – the economic value of Rs. 13399.27) is nothing but the present value of future losses that the bank is going to suffer in the next 5 years of the life of deposit as it is compelled to pay a rate 1% higher than current interest rate on similar deposits. This interpretation is as of the current date, which may change in future depending on interest rate on the deposit. Here, the modified duration number of 3.9406 can be interpreted as a measure of interest rate sensitivity. This interpretation suggests that for 1% change in the interest rate on the deposit, the value of the deposit would change in the opposite direction of the interest rate change by 3.9406%. This is the direct measure of interest rate sensitivity of the deposit.



Subject to the limitations of the duration family measures, this measure of sensitivity can be used both in case of assets and liabilities. The process explained above has to be followed for each asset & liability in the balance sheet to arrive at aggregate duration at asset and liability level. Consider the following example:Duration of Assets = 5Value of Asset = 100Duration of Liabilities = 3.5Value of Liabilities = 90Economic Value of Equity = 10 (100 – 90)

A comparison of asset and liability durations reveals that the assets are more interest rate sensitive than the liabilities of the bank. If interest rate goes up by 1% for both the asset and liability, there would be a greater fall in the value of assets than the liabilities. As a result of higher fall in asset value than liability value, the economic value of equity would fall from its present level of Rs.10. The economic value of equity would increase to the same extent when the interest rate falls.

3. Duration Gap Analysis:Matching the duration of assets and liabilities, instead of matching the maturity or repricing dates is the most effective way to protect the economic values of banks from exposure to IRR than the simple gap model. Duration gap model focuses on managing economic value of banks by recognising the change in the market value of assets, liabilities and off-balance sheet (OBS) items. When weighted assets and liabilities and OBS duration are matched, market interest rate movements would have almost same impact on assets, liabilities and OBS, thereby protecting the bank’s total equity or net worth. Duration is a measure of the percentage change in the economic value of a position that will occur given a small change in the level of interest rates. The difference between duration of assets (DA) and liabilities (DL) is bank’s net duration. If the net duration is positive (DA>DL), a decrease in market interest rates will increase the market value of equity of the bank. When the duration gap is negative (DL> DA), the MVE increases when the interest rate increases but decreases when the rate declines. Thus, the Duration Gap shows the impact of the movements in market interest rates on the MVE through influencing the market value of assets, liabilities and OBS.Formula for calculating sensitivity of change in interest rates is:

where % ∆ P (Pt+ 1 - Pt)/Pt = percent change in market value of the securityDUR = duration, i = interest rate, ∆ = Change

Illustration:The bank manager wants to know what happens when interest rates rise from 10% to 11%. The total asset value is Rs. 100 million with duration of 2.70, and the total liability value is Rs. 95 million, with duration of 1.03. Use Equation to calculate the change in the market value of the assets and liabilities.Solution: Assets:DUR= duration = 2.70, ∆i = change in interest rate 0.11 - 0.10 = 0.01, i = interest rate = 0.10% ∆ P ≈ - 2.70 x 0.01 = - 0.025 = -2.5% 1 + 0.11Thus, with a total asset value of Rs. 100 million, the market value of assets falls by Rs. 2.5 million (100 million x 0.025 = 2.5 million).Liabilities: DUR= duration = 1.03, ∆i = change in interest rate 0.11 - 0.10 = 0.01, i = interest rate = 0.10% ∆ P ≈ - 1.03 x 0.01 = - 0.009 = -0.9% 1 + 0.11Thus, with total liabilities of Rs. 95 million, the market value of liabilities falls by Rs. 0.9 million (Rs. 95 million x 0.009= Rs.0.9 million).The result is that the net worth of the bank would decline by Rs. 1.6 million (- Rs. 2.5 million - (- Rs.



0.9 million) = - Rs. 2.5 million + Rs. 0.9 million = - Rs. 1.6 million).

INEREST RATE DERIVATIES:Let us proceed to a discussion in some detail the first exchange traded derivatives on interest rates in India, namely the ‘interest rate futures’ or IRF. Prior to December 5, 2013, in Indian IRF was required to be settled physically that means a compulsory delivery was required. The following are the features for physically settled contract specificiation.

IRF: Contract Specifications Symbol 10YGS7Market Type Normal Instrument type FUTIRDUnit of trading 1 lot - 1 lot is equal to national bonds of FV Rs. 2 lacs. Underlying 10 Year Notional Coupon bearing Government of India (GOI) security.

(Notional Coupon 7% with semiannual compounding.) Tick size Rs. 0.0025 or 0.25 paise. Trading hours Monday to Friday (On all business days) 9.00 a.m to 5.00 pm. Contract trading cycle Four fixed quarterly contracts for entire year, expiring in March, June,

September and December.

Last trading day Two business days preceding the last business day of the delivery month.

Delivery day Last business day of delivery month. Settlement Daily settlement – marked to market daily

Final settlement – physical settlement in the delivery month.

Introduction of cash settled IRF:As per RBI circular No. :RBI/2013-14/402 IDMD.PCD. 08/14.03.01/2013-14, The Interest Rate Futures deriving value from the following underlying are permitted on the recognised stock exchanges:(i) 91-Day Treasury Bill issued by the Government of India.;(ii) 2-year, 5-year and 10-year coupon bearing notional Government of India security, and(iii) Coupon bearing Government of India security.

All these contracts shall be cash-settled in Indian rupees

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HERE AFTER

MODULE D

BANK BALANCE SHEET



CHAPTER 1BANKS BALANCESHEET

The Banking Regulation act, 1949 prescribes formats of preparing final accounts of the Banking companies. The third schedule of section 29 gives forms ‘A’ for the balance sheet and Form ‘B’ for Profit and loss account. The balance sheet consists of total 12 schedules. Schedule 1 to schedule 5 depicts capital and liabilities and schedule 6 to schedule 11 shows Assets of the bank and schedule 12 shows contingent liabilities and there is no specific schedule prescribes for bills for collection.

Form ABalance Sheet As on 31st March ____

Capital and Liabilities Schedule As on 31.3 (Current Year)

As on 31.3 (previous Year)

Rs. Rs.

Capital 1

Reverse and Surplus 2

Deposits 3

Borrowing 4

Other liabilities & Provisions 5

Total

Assets

Cash & Balances with Reserve Bank of India, 6

Balances with banks and money At Call & Short Notice 7

Investments 8

Advances 9

Fixed Asset 10

Other Asset 11

Total

Contingent Liabilities and Bills for Collection 12

Schedule 1 : CapitalAs on 31.3 (Current Year)


Rs. Rs.I. For Nationalised Bank

(Fully owned by Central Government)

II. For Banks incorporated outside India

Capital

i. (The amount brought in by banks by way of start-up

Capital as prescribed by RBI should be shown under

this head)

ii. Amount of deposit kept with RBI u/s 11 (2) of

Banking Regulation Act,1949.

III. For other Banks

I Authorized Capital



______ Share of Rs.______ each

II. Issued Capital

_____________ shares of Rs___________ each.

III. Subscribed Capital

_____________ shares of Rs___________ each.

IV. Called up Capital:-

_____________ shares of Rs___________ each.

Less : Calls Unpaid

Add : Forfeited Shares

Total

Schedule 2 : Reverse and SurplusAs on 31.3 (Current Year)


Rs. Rs.I. Statutory Reserve

a. Opening Balance

b. additions during the year

c. Deductions during the year

II .Capital Reserve

a. Opening balance

b. Additions during the year

c. Deductions during this year

III Share Premium

a. Opening Balance

b. Additions during the year

c. Deductions during the year

IV Balance in Profit & Loss A/c

(Total (I, II, III and IV)

Schedule 3 : DepositsAs on 31.3 (Current Year)


Rs. Rs.I. Demand Deposits:-

i. From Individuals

ii. From others

II. Savings Bank Deposit

III. Term Deposits

From Banks.

From others

Total (I, II and III)

B. i. Deposits of Branches in India

ii. Deposits of Branches outside India



Total ( I and II )

Schedule 4:- BorrowingAs on 31.3 (Current Year)


Rs. Rs.I. Borrowings in India

i. From the Reserve Bank of India

ii. From other Banks

iii. Other Institutions & Agencies

II. Borrowings outside India

Total ( I and II )

Secured Borrowings are included in I & II

Schedule 5:- Other liabilities and provisionsAs on 31.3 (Current Year)


Rs. Rs.

I. Bills payable

II. Inter- office adjustment (net)

III. Interest accrued

IV. Other (including provisions)

Total (I, II , III and IV)

Schedule 6 : Cash and Balances with Reverse Bank of India As on 31.3

(Current Year)


Rs. Rs.

I Cash in Hand

II Balances with Reserve Bank of India

a) In correct Account

b) In other accounts

Total (I and II)

Schedule 7 Balances with banks and money At Call & Short Notice As on 31.3

(Current Year)


Rs. Rs.

I. Balance with Banks & money at Call & Short Notice

i. Balance with Banks:-

a. Current deposits

b. other deposit Accounts

ii. Money at Call and Short Notice

a. With Banks

b. With other institutions



Total (i and ii)

II. Outside India

i. In Current Accounts

ii. In other deposits account

iii. Money at call & short notice

Total (i, ii and iii)

Total (I and II)Schedule 8:- Investments

As on 31.3 (Current Year)


Rs. Rs.

I. Investments in India

a. In Central Government Securities

b. In other Approved Securities

c. Shares

d. In debentures and bonds

e. Subsidiaries and/or Joint ventures

f. Other (To be specified)

Total

II. Investments in outside India

a. Government Securities (including local authorities)

b. Subsidiaries and/or Joint ventures

c. Other (To be specified)

Total

Total (I and II)

Schedule 9 : Advances As on 31.3 (Current Year)


Rs. Rs.

A.

i) Bills purchased & discounted

ii) Cash Credits, overdrafts& loans repayable on demand

iii) Term Loan

Total

B.

i) Secured by tangible assets

ii) Secured by bank/ government guarantees

iii) Unsecured

Total

C.

I. Advances in India

a. Priority sector

b. Public sector

c. Bank

d. Others

II. Advances outside India



a. Dues from Banks

b. Dues from others

i. Bills purchased & discounted

ii. Syndicated Loans

iii. Others

Total (C -I + II)

Schedule 10 : Fixed AssetsAs on 31.3 (Current Year)


Rs. Rs.

I. Premises

a) At cost as on 31st March of the preceedings year

b) Additions

c) Deductions during the year

d) Total (Cost a and b minus c)

e) Less: Depreciation to date

f) Total (d minus e)

II. Other Fixed Assets (including furniture & fixture)

a) At cost as on 31st March of the preceedings year

b) Additions

c) Deductions during the year

d) Total (Cost a and b minus c)

e) Less: Depreciation to date

f) Total (d minus e)

Schedule 11 : Other assetsAs on 31.3 (Current Year)


Rs. Rs.

I. Inter-office adjustment (net)

II. Interest accured

III. Tax Paid in Advance/Tax deducted at source

Iv. Stationary and stampsV. Non-banking assets acquired in satisfaction of claims

V. Others @

Total (I, II, III, IV, and V)@ In case there is any unadjusted balance of loss, is the same may be shown under this item with appropriate footnote.

Schedule 12 : Contingent Liabilities and bliss for collection:- As on 31.3

(Current Year)


Rs. Rs.

I. Claims against the bank not acknowledgement as debts



II. Liability for partly paid investments

III. Liability on account of outstanding forward exchange contractsIV. Guarantees given on behalf of constituents

a. In Indiab. Outside India

V. Acceptance, endorsements and other obligations (including bills for collection)

VI. Other Items for which the bank is contingently liable

Total (I, II III, IV, V and VI)

Form BProfit & Loss Account for the year ended on 31st

March _______________

Schedule As on 31.3 (Current Year)

As on 31.3 (previous Yr)

Rs. Rs.

I Income

Interest earned 13

Other income 14

Total

II. Expenditure

Interest expended 15

Operating expenses 16

Provisions& contingencies

Total

III. Profit/ Loss

Net Profit/ Loss (-) for the year

Profit/ Loss (-) brought forward

Total

IV. Appropriations

Transfer to statutory reserves

Transfer to other reserves(To be specified)

Tr. To Govt./Proposed Dividend

Balance carried to Balance Sheet

Total

Schedule 13 : Interest Earned As on 31.3 (Current Year)


Rs. Rs.

I. Interest/ discount on advances/ bills

II. Income on investments

III. Interest on balances with reserve Bank of India and other inter bank funds

IV. Others

Total



Schedule 14 : Other income As on 31.3 (Current Year)


Rs. Rs.

I. Commission, exchange and brokerage

II. Profit on sale of investments

Less: loss on sale of investments

III. Profit on Revaluation of investments

Less:- Loss on revaluation of investments

IV. Profit on sale of land, buildings and other assets.

Less:- Loss on sale of land, buildings and other assets

V. Profit on exchange transactions.

Less:- Loss on exchange transactionsVI. Income earned by way dividends etc. from subsidiaries/companies and/or joint ventures aboard/in India

VII. Miscellaneous Income

Under I to V loss figures may be shown in bracket

Total

Schedule 15: Interest Expended As on 31.3 (Current Year)


Rs. Rs.

I. Interest on Deposit

II. Interest on RBI/Interbank borrowings

III. Others

Total

Schedule- 16: Operating Expenses As on 31.3 (Current Year)


Rs. Rs.

I. Payments to and provisions for employees

II. Rent, taxes, and lighting

III. Printing and stationery

IV. Advertisement and publicity

V. Depreciation on bank’s property

VI. Director’s fees, allowance and expensesVII. Auditors’ fees and expenses (including branch auditors)

VIII. Law charges

IX. Postage, Telegrams, Telephone, etc.

X. Repairs and maintenance

XI. Insurance

XII. Other expenditure

Total



IMPORTANT GUIDELINES ON DISCLOSURE IN FINANCIAL STATEMENTS *1. PURPOSE • The financial statements are required to provide the information about the financial position and performance of the bank in making economic decisions by the users. They are interested in the bank’s liquidity and solvency and the risks related to the assets and liabilities recognized on its balance sheet and to it’s off balance sheet items. This useful information can be provided by way of ‘Notes’ to the financial statements, being supplementary information for market discipline. Market discipline has been given due importance under Basel II framework on capital adequacy by recognizing it as one of its three Pillars.

2. DISCLOSURE REQUIREMENT • In this direction, RBI has, over the years, developed a set of disclosure requirements which allow the market participants to assess key pieces of information on capital adequacy, risk exposures, risk assessment processes and key business parameters which provide a consistent and understandable disclosure framework that enhances comparability. Banks are also required to comply with the Accounting Standard – 1 (AS -1) on disclosure issued by ICAI. This can be achieved through revision of Balance Sheet and P & L Account of banks and enlarging the scope of disclosures in “Notes to Accounts”.

3. ADDITIONAL/SUPPLEMENTARY INFORMATION “Notes to Accounts” may contain the supplementary information such as:-a) Capital (Current & Previous year) with breakup including CRAR – Tier I/II capital (%), % of share holding of GOI, amount of subordinated debt raised as Tier II capital, etc.b) Investments including details of Repo transactions, Non-SLR investment Portfolio, and Sales & transfers to/from HTM category.c) Derivatives with breakup of Forward Rate Agreement/Interest Rate Swap, Exchange Traded Interest Rate Derivatives, and Disclosures on risk exposure in derivatives.d) Asset Quality with details such as Non-Performing Assets, Particulars of Accounts Restructured, Details of financial assets sold to Securitization / Reconstruction Company for Assets Reconstruction, Details of Non-Performing financial assets purchased, Details of Non-Performing Assets sold, and Provisions on Standard Assets.e) Business Ratios giving Interest Income as a % to Working Funds, Non-interest income as a % to working funds, Operating Profit as a % to working funds, etc.f) Asset Liability Management giving the maturity pattern of certain items of assets and liabilities such as deposits, advances, investments, borrowings, foreign current assets, and foreign currency liabilities.g) Exposures giving the segment wise breakup on Exposure to Real Estate Sector, Exposure to Capital Market, Risk Category wise Country Exposure, Details of Single Borrower Limit (SGL)/Group Borrower Limit (GBL) exceeded by the bank, and Unsecured Advances.h) Miscellaneous relating to Amount of Provisions made for Income Tax during the year, and Disclosure of Penalties imposed by RBI.

4. Disclosure Requirements as per Accounting Standards where RBI has issued guidelines in respect of disclosure items for “Notes to Accounts”a) AS-5 – relating to Net Profit or Loss for the period, prior period items and changes in accounting policies.b) AS -9 – Revenue Recognition giving the reasons for postponement of revenue recognition.c) AS – 15 – Employee Benefitsd) AS – 17 – Segment Reporting such as Treasury, Corporate/wholesale Banking, Retails Banking, ‘Other Banking Operations’ and Domestic and International segments, etc.e) AS – 18 – Related Party Disclosuresf) AS – 21 – Consolidated Financial Statements (CFS)g) AS – 22 – Accounting for Tax & Income – Adoption of AS – 22 entails creation of Deferred Tax Assets (DTL) and Deferred Tax Liabilities (DTL) which have a bearing on the computation of capital adequacy ratio and banks’ ability to declare dividends. DTA represents unabsorbed depreciation and carry forward losses which can set-off against Assets future taxable income which is



considered as timing difference. DTL has an effect of decreasing future income tax payments which indicates that they are prepaid income taxes and meet the definition of assets. It is created by credit to opening balance of Revenue Reserves on the first day of application of AS – 22 or P & L Account for the current year. DTA should be deducted from Tier I capital.Deferred Tax Liability (DTL) is created by debit to opening balance of Revenue Reserves on the first day of application of AS-22 or P & L Account for the current year and will not be eligible for inclusion in Tier I and Tier II capital for capital adequacy purpose. DTL have an effect of increasing the future year’s income tax payments which indicates that they are accrued taxes and meet the definition of liabilities.h) AS – 23 – Accounting for investments in Associates in Consolidated Financial Statements. It relates to the effects of the investments in associates on the financial position and operating results of a groupi) AS – 24 – Discontinuing Operations – resulted in shedding of liability and realization of the assets by the bank, etc.j ) AS – 25 – Interim Financial Reporting – Half yearly reporting.k) Other Accounting Standards Banks are required to comply with the disclosure norms stipulated under the various Accounting Standards issued by ICAI.

5. Additional Disclosures a) Provisions and contingencies – Banks are required to disclose in the “Notes to Accounts” the information on all Provisions and Contingencies giving Provision for depreciation on Investment, Provision towards NPA, Provision towards Standard Assets, Provision made towards Income Tax, and Other Provision and contingencies.b) Floating Provisions - comprehensive disclosures on floating provisions.c) Draw Down from Reserves - Details of draw down of reserves are to be disclosed.d) Complaints - Brief details on ABC Ltd Complaints and Awards passed by the Banking Ombudsman.e) Letters of Comfort (LOC) issued by banks - Details of all the Letters of Comfort (LoCs) issued during the year, including their assessed financial impact, etc. f) Provision Coverage Ratio (PCR) - ratio of provisioning to gross non-performing assetsg) Bancassurance Business - Details of fees/remuneration received, etc.

6. Concentration of Deposits, Advances, Exposures, and NPAs a) Concentration of deposits – Total deposits of 20 large depositors and percentage of the deposits to total deposits of the bank.b) Concentration of Advances - Total advances to 20 largest borrowers and percentage of the advance to total advances of the bank.c) Concentration of Exposures - Total Exposure to 20 largest borrowers/ABC Ltds and percentage of the exposures to total exposure of the bank on borrowers/ABC Ltds.d) Concentration of NPAs - Total exposure to top 4 NPA accounts

7. Sector-wise NPAs - Details of sector-wise NPAs such as Agriculture & Allied Activities, Industry (Micro & Small, Medium and Large), Services, and Personal Loans.8. Movement of NPAs - Additions, Recoveries, Upgradation, Write-offs, etc. from Gross NPAs and the final position as on the date of the Financial Statement.9. Overseas Assets, NPAs, and Revenue -Giving the Total assets, Total NPAs, and Total Revenue.10. Off-balance sheet SPVs sponsored - (consolidated) giving Domestic and Overseas SPVs sponsored.

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CHAPTER 2Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances

1.INTRODUCTION1.1.In line with the international practices and as per the recommendations made by the Committee on the Financial System (Chairman Shri M. Narasimham), the Reserve Bank of India has introduced, in a phased manner, prudential norms for income recognition, asset classification and provisioning for the advances portfolio of the banks so as to move towards greater consistency and transparency in the published accounts.1.2. The policy of income recognition should be objective and based on record of recovery rather than on any subjective considerations. Likewise, the classification of assets of banks has to be done on the basis of objective criteria which would ensure a uniform and consistent application of the norms. Also, the provisioning should be made on the basis of the classification of assets based on the period for which the asset has remained nonperforming and the availability of security and the realisable value thereof.

2. NPA:- MEANING2.1 Non performing Assets2.1.1 An asset, including a leased asset, becomes non performing when it ceases to generate income for the bank.2.1.2 A non performing asset (NPA) is a loan or an advance where;i.interest and/ or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan,ii.the account remains ‘out of order’ as indicated at paragraph 2.2 below, in respect of an Overdraft/Cash Credit (OD/CC),iii.the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted, iv. the instalment of principal or interest thereon remains overdue for two crop seasons for short duration crops, v. the instalment of principal or interest thereon remains overdue for one crop season for long duration crops,vi. the amount of liquidity facility remains outstanding for more than 90 days, in respect of a securitisation transaction undertaken in terms of guidelines on securitisation dated February 1, 2006.vii. in respect of derivative transactions, the overdue receivables representing positive mark-to-market value of a derivative contract, if these remain unpaid for a period of 90 days from the specified due date for payment.2.1.3 Banks should, classify an account as NPA only if the interest due and charged during any quarter is not serviced fully within 90 days from the end of the quarter.

2.2 ‘Out of Order’ statusAn account should be treated as 'out of order' if the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to cover the interest debited during the same period, these accounts should be treated as 'out of order'.

2.3 ‘Overdue’ Any amount due to the bank under any credit facility is ‘overdue’ if it is not paid on the due date fixed by the bank.

3. INCOME RECOGNITION3.1 Income Recognition Policy 3.1.1 The policy of income recognition has to be objective and based on the record of recovery. Internationally income from nonperforming assets (NPA) is not recognised on accrual basis but



is booked as income only when it is actually received. Therefore, the banks should not charge and take to income account interest on any NPA. 3.1.2 However, interest on advances against term deposits, NSCs, IVPs, KVPs and Life policies may be taken to income account on the due date, provided adequate margin is available in the accounts. 3.1.3 Fees and commissions earned by the banks as a result of renegotiations or rescheduling of outstanding debts should be recognised on an accrual basis over the period of time covered by the renegotiated or rescheduled extension of credit.3.1.4 If Government guaranteed advances become NPA, the interest on such advances should not be taken to income account unless the interest has been realised.

3.2 Reversal of income 3.2.1 If any advance, including bills purchased and discounted, becomes NPA as at the close of any year, the entire interest accrued and credited to income account in the past periods, should be reversed or provided for if the same is not realised. This will apply to Government guaranteed accounts also.3.2.2 In respect of NPAs, fees, commission and similar income that have accrued should cease to accrue in the current period and should be reversed or provided for with respect to past periods, if uncollected.

3.2.3 Leased AssetsThe finance charge component of finance income [as defined in ‘AS 19 Leases’ issued by the Council of the Institute of Chartered Accountants of India (ICAI)] on the leased asset which has accrued and was credited to income account before the asset became nonperforming, and remaining unrealised, should be reversed or provided for in the current accounting period.

3.3 Appropriation of recovery in NPAs 3.3.1 Interest realised on NPAs may be taken to income account provided the credits in the accounts towards interest are not out of fresh/ additional credit facilities sanctioned to the borrower concerned. 3.3.2 In the absence of a clear agreement between the bank and the borrower for the purpose of appropriation of recoveries in NPAs (i.e. towards principal or interest due), banks should adopt an accounting principle and exercise the right of appropriation of recoveries in a uniform and consistent manner.

3.4 Interest Application There is no objection to the banks using their own discretion in debiting interest to an NPA account taking the same to Interest Suspense Account or maintaining only a record of such interest inproforma accounts.

3.5 Computation of NPA levelsBanks should deduct the following items from the Gross Advances and Gross NPAs to arrive at the Net advances and Net NPAs respectively:i) Balance in Interest Suspense Account ii) DICGC/ECGC claims received and held, pending adjustmentiii) Part payment received and kept in suspense accountiv) Total provisions held (excluding amount of technical write off and provision on standard assets)For the purpose, the amount of gross advances should exclude the amount of Technical Write off but would include all outstanding loans and advances; including the advances for which refinance has been availed but excluding the amount of rediscounted bills. The level of gross and net NPAs will be arrived at in percentage terms by dividing the amount of gross and net NPAs by gross and net advances, computed as above, respectively.

Projects under implementation (Classification of NPA) • Project Loans are classified into 2 categories viz. Project Loans for infrastructure sector and Project Loans for non-infrastructure sector.



• An infrastructure project loan would be classified as NPA before the date of commencement of commercial operations (DCCO) as per record of recovery (90 days) unless it is restructured and eligible for classification as standard asset.• An infrastructure project would be classified as NPA if it fails to commence commercial operations within 2 years from the original DCCO.• If a project loan classified as standard asset is restructured any time during the period up to two years from the original date of DCCO, it can be retained as a standard asset if the fresh DCCO is fixed and the account continues to be serviced as per the restructured terms subject to the application for restructuring should be received before the expiry of period of two years from the original DCCO and when the account is still standard as per record of recovery.• Delay in infrastructure projects involving court cases and projects in other than court cases, extension of DCCO up to another 2 years (beyond the existing extended period of 2 years i.e. total extension of 4 years) and up to another 1 year (beyond the existing extended period of 2 years i.e. total extension of 3 years) respectively is considered for treating them as NPA.• A loan for a non-infrastructure project will be classified as NPA during any time before commencement of commercial operations as per record of recovery (90 days overdue).• If the non-infrastructure project fails to commence commercial operations within 6 months from the original DCCO, it is to be treated as NPA, etc.

Take out Finance• Under Take out Finance, possibility of default, in view of the time-lag involved in taking-over, cannot be ruled out. The norms of asset classification will have to be followed by the concerned lending bank/financial institution and they should not recognize income on accrual basis, but only on actual receipt. Bank/FI should also make suitable provision pending the takeover by other institution. Upon takeover of the account, the provision could be reversed. But the taking over institution is required to make provision in its books treating it as NPA from the actual date of becoming NPA even though the account was not in its books as on that date.

Post-shipment Supplier's Credit • Post shipment Supplier’s Credit under the EXIM Bank Guarantee-cum-refinance programme, the extent payment has been received from the EXIM Bank, may not be treated as a non-performing asset for asset classification and provisioning purposes. Export Project Finance • In the event of the export proceeds in respect of export project finance is held up due to political developments in the importer’s country, the asset classification may be made after a period of one year from the date the amount was deposited by the importer in the bank abroad.

Advances under rehabilitation approved by BIFR/ TLI • In case of a unit under rehabilitation package approved by BIFR/Term Lending Institution, the existing credit facilities continue to be classified as substandard or doubtful as the case may be. Asset classification norms would be applicable in respect of additional facilities sanctioned under the package after a period of one year from the date of disbursement.

4. ASSET CLASSIFICATION 4.1 Categories of NPAs Banks are required to classify nonperforming assets further into the following three categories based on the period for which the asset has remained nonperforming and the realisability of the dues:I. Substandard AssetsII. Doubtful Assetsiii. Loss Assets

4.1.1 Substandard AssetsWith effect from 31 March 2005, a substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. In such cases, the current net worth of the borrower/ guarantor or the current market value of the security charged is not enough to ensure recovery of



the dues to the banks in full. In other words, such an asset will have well defined credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.

4.1.2. Doubtful Assets With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, – on the basis of currently known facts, conditions and values – highly questionable and improbable.

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

4.2 Guidelines for classification of assets4.2.1 Broadly speaking, classification of assets into above categories should be done taking into account the degree of well-defined credit weaknesses and the extent of dependence on collateral security for realisation of dues.4.2.2 Banks should establish appropriate internal systems to eliminate the tendency to delay or postpone the identification of NPAs, especially in respect of high value accounts. The banks may fix a minimum cut off point to decide what would constitute a high value account depending upon their respective business levels. The cut off point should be valid for the entire accounting year. Responsibility and validation levels for ensuring proper asset classification may be fixed by the banks. The system should ensure that doubts in asset classification due to any reason are settled through specified internal channels within one month from the date on which the account would have been classified as NPA as per extant guidelines.4.2.3 Availability of security / net worth of borrower/ guarantorThe availability of security or net worth of borrower/ guarantor should not be taken into account for the purpose of treating an advance as NPA or otherwise, except to the extent provided in Para 4. 2.9, as income recognition is based on record of recovery.

4.2.4 Accounts with temporary deficienciesThe classification of an asset as NPA should be based on the record of recovery. Bank should not classify an advance account as NPA merely due to the existence of some deficiencies which are temporary in nature such as non-availability of adequate drawing power based on the latest available stock statement, balance outstanding exceeding the limit temporarily, non-submission of stock statements and non-renewal of the limits on the due date, etc. In the matter of classification of accounts with such deficiencies banks may follow the following guidelines:

i) Banks should ensure that drawings in the working capital accounts are covered by the adequacy of current assets, since current assets are first appropriated in times of distress. Drawing power is required to be arrived at based on the stock statement which is current. However, considering the difficulties of large borrowers, stock statements relied upon by the banks for determining drawing power should not be older than three months. The outstanding in the account based on drawing power calculated from stock statements older than three months, would be deemed as irregular.A working capital borrowal account will become NPA if such irregular drawings are permitted in the account for a continuous period of 90 days even though the unit may be working or the borrower's financial position is satisfactory. ii) Regular and ad hoc credit limits need to be reviewed/ regularised not later than three months from the due date/date of ad hoc sanction. In case of constraints such as non-availability of financial statements and other data from the borrowers, the branch should furnish evidence to show that renewal/ review of credit limits is already on and would be completed soon. In any case,



delay beyond six months is not considered desirable as a general discipline. Hence, an account where the regular/ ad hoc credit limits have not been reviewed/ renewed within 180 days from the due date/ date of ad hoc sanction will be treated as NPA.

4.2.5 Upgradation of loan accounts classified as NPAsIf arrears of interest and principal are paid by the borrower in the case of loan accounts classified as NPAs, the account should no longer be treated as nonperforming and may be classified as ‘standard’ accounts.

4.2.6 Accounts regularised near about the balance sheet dateThe asset classification of borrowal accounts where a solitary or a few credits are recorded before the balance sheet date should be handled with care and without scope for subjectivity. Where the account indicates inherent weakness on the basis of the data available, the account should be deemed as a NPA. In other genuine cases, the banks must furnish satisfactory evidence to the Statutory Auditors/Inspecting Officers about the manner of regularisation of the account to eliminate doubts on their performing status.

4.2.7 Asset Classification to be borrower-wise and not facility-wisei) It is difficult to envisage a situation when only one facility to a borrower/one investment in any of the securities issued by the borrower becomes a problem credit/investment and not others. Therefore, all the facilities granted by a bank to a borrower and investment in all the securities issued by the borrower will have to be treated as NPA/NPI and not the particular facility/investment or part thereof which has become irregular.ii) If the debits arising out of devolvement of letters of credit or invoked guarantees are parked in a separate account, the balance outstanding in that account also should be treated as a part of the borrower’s principal operating account for the purpose of application of prudential norms on income recognition, asset classification and provisioning.iii) The bills discounted under LC favouring a borrower may not be classified as a Non-performing advance (NPA), when any other facility granted to the borrower is classified as NPA. However, in case documents under LC are not accepted on presentation or the payment under the LC is not made on the due date by the LC issuing bank for any reason and the borrower does not immediately make good the amount disbursed as a result of discounting of concerned bills, the outstanding bills discounted will immediately be classified as NPA with effect from the date when the other facilities had been classified as NPA.iv) The overdue receivables representing positive mark-to-market value of a derivative contract will be treated as a non-performing asset, if these remain unpaid for 90 days or more. In case the overdues arising from forward contracts and plain vanilla swaps and options become NPAs, all other funded facilities granted to the client shall also be classified as non-performing asset following the principle of borrower-wise classification as per the existing asset classification norms. Accordingly, any amount, representing positive mark-to-market value of the foreign exchange derivative contracts (other than forward contract and plain vanilla swaps and options) that were entered into during the period April 2007 to June 2008, which has already crystallised or might crystallise in future and is / becomes receivable from the client, should be parked in a separate account maintained in the name of the client / counterparty. This amount, even if overdue for a period of 90 days or more, will not make other funded facilities provided to the client, NPA on account of the principle of borrower-wise asset classification, though such receivable overdue for 90 days or more shall itself be classified as NPA, as per the extant IRAC norms. The classification of all other assets of such clients will, however, continue to be governed by the extant IRAC norms.v) If the client concerned is also a borrower of the bank enjoying a Cash Credit or Overdraft facility from the bank, the receivables mentioned at item (iv) above may be debited to that account on due date and the impact of its non-payment would be reflected in the cash credit / overdraft facility account. The principle of borrower-wise asset classification would be applicable here also, as per extant norms.vi) In cases where the contract provides for settlement of the current mark-to-market value of a derivative contract before its maturity, only the current credit exposure (not the potential future exposure) will be classified as a non-performing asset after an overdue period of 90 days.



vii) As the overdue receivables mentioned above would represent unrealised income already booked by the bank on accrual basis, after 90 days of overdue period, the amount already taken to 'Profit and Loss a/c' should be reversed and held in a 'Suspense a/c' in the same manner as is done in the case of overdue advances.

4.2.8 Advances under consortium arrangementsAsset classification of accounts under consortium should be based on the record of recovery of the individual member banks and other aspects having a bearing on the recoverability of the advances. Where the remittances by the borrower under consortium lending arrangements are pooled with one bank and/or where the bank receiving remittances is not parting with the share of other member banks, the account will be treated as not serviced in the books of the other member banks and therefore, be treated as NPA. The banks participating in the consortium should, therefore, arrange to get their share of recovery transferred from the lead bank or get an express consent from the lead bank for the transfer of their share of recovery, to ensure proper asset classification in their respective books.

4.2.9 Accounts where there is erosion in the value of security/frauds committed by borrowersIn respect of accounts where there are potential threats for recovery on account of erosion in the value of security or non-availability of security and existence of other factors such as frauds committed by borrowers it will not be prudent that such accounts should go through various stages of asset classification. In cases of such serious credit impairment the asset should be straightaway classified as doubtful or loss asset as appropriate:i. Erosion in the value of security can be reckoned as significant when the realisable value of the security is less than 50 per cent of the value assessed by the bank or accepted by RBI at the time of last inspection, as the case may be. Such NPAs may be straightaway classified under doubtful category and provisioning should be made as applicable to doubtful assets.ii. If the realisable value of the security, as assessed by the bank/ approved valuers/ RBI is less than 10 per cent of the outstanding in the borrowal accounts, the existence of security should be ignored and the asset should be straightaway classified as loss asset. It may be either written off or fully provided for by the bank.

4.2.10 Advances against Term Deposits, NSCs, KVP/IVP, etcAdvances against term deposits, NSCs eligible for surrender, IVPs, KVPs and life policies need not be treated as NPAs, provided adequate margin is available in the accounts. Advances against gold ornaments, government securities and all other securities are not covered by this exemption.

4.2.11 Loans with moratorium for payment of interesti. In the case of bank finance given for industrial projects or for agricultural plantations etc. where moratorium is available for payment of interest, payment of interest becomes 'due' only after the moratorium or gestation period is over. Therefore, such amounts of interest do not become overdue and hence do not become NPA, with reference to the date of debit of interest. They become overdue after due date for payment of interest, if uncollected. ii. In the case of housing loan or similar advances granted to staff members where interest is payable after recovery of principal, interest need not be considered as overdue from the first quarter onwards. Such loans/advances should be classified as NPA only when there is a default in repayment of instalment of principal or payment of interest on the respective due dates.

5. PROVISIONING NORMS 5.1 General5.1.1 The primary responsibility for making adequate provisions for any diminution in the value of loan assets, investment or other assets is that of the bank managements and the statutory auditors. The assessment made by the inspecting officer of the RBI is furnished to the bank to assist the bank management and the statutory auditors in taking a decision in regard to making adequate and necessary provisions in terms of prudential guidelines. 5.1.2 In conformity with the prudential norms, provisions should be made on the nonperforming assets on the basis of classification of assets into prescribed categories as detailed in paragraphs 4



supra. Taking into account the time lag between an account becoming doubtful of recovery, its recognition as such, the realisation of the security and the erosion over time in the value of security charged to the bank, the banks should make provision against substandard assets, doubtful assets and loss assets as below:

5.2 Loss assetsLoss assets should be written off. If loss assets are permitted to remain in the books for any reason, 100 percent of the outstanding should be provided for.

5.3 Doubtful assetsi. 100 percent of the extent to which the advance is not covered by the realisable value of the security to which the bank has a valid recourse and the realisable value is estimated on a realistic basis. ii. In regard to the secured portion, provision may be made on the following basis, at the rates ranging from 25 percent to 100 percent of the secured portion depending upon the period for which the asset has remained doubtful:

Period for which the advance hasremained in ‘doubtful’ category

Provision requirement (%)

Up to one year 25

One to three years40

More than three years100

iii. Banks are permitted to phase the additional provisioning consequent upon the reduction in the transition period from substandard to doubtful asset from 18 to 12 months over a four year period commencing from the year ending March 31, 2005, with a minimum of 20 % each year.Note: Valuation of Security for provisioning purposesWith a view to bringing down divergence arising out of difference in assessment of the value of security, in cases of NPAs with balance of Rs. 5 crore and above stock audit at annual intervals by external agencies appointed as per the guidelines approved by the Board would be mandatory in order to enhance the reliability on stock valuation. Collaterals such as immovable properties charged in favour of the bank should be got valued once in three years by valuers appointed as per the guidelines approved by the Board of Directors.

5.4 Substandard assets(i) A general provision of 15% on total outstanding should be made without making any allowance for ECGC guarantee cover and securities available.(ii) The ‘unsecured exposures’ which are identified as ‘substandard’ would attract additional provision of 10 per cent, i.e., a total of 25 per cent on the outstanding balance. The provisioning requirement for unsecured ‘doubtful’ assets is 100 per cent. Unsecured exposure is defined as an exposure where the realisable value of the security, as assessed by the bank/approved valuers/Reserve Bank’s inspecting officers, is not more than 10 percent, ab-initio, of the outstanding exposure. ‘Exposure’ shall include all funded and non-funded exposures (including underwriting and similar commitments). ‘Security’ will mean tangible security properly discharged to the bank and will not include intangible securities like guarantees (including State government guarantees), comfort letters etc.Note:- However, “unsecured exposures” in respect of Infrastructure loan accounts classified as sub-standard, in case of which certain safeguards such as escrow accounts are available as indicated in RBI circular DBOD.No.BP.BC.96/08.12.014/2009-10 dated April 23, 2010, will attract an additional provision of 5 per cent only i.e. a total of 20 per cent as against the existing 15 per cent(iii) In order to enhance transparency and ensure correct reflection of the unsecured advances in Schedule 9 of the banks' balance sheet, it is advised that the following would be applicable from the financial year 2009-10 onwards :



a) For determining the amount of unsecured advances for reflecting in schedule 9 of the published balance sheet, the rights, licenses, authorisations, etc., charged to the banks as collateral in respect of projects (including infrastructure projects) financed by them, should not be reckoned as tangible security. Hence such advances shall be reckoned as unsecured.b) Banks should also disclose the total amount of advances for which intangible securities such as charge over the rights, licenses, authority, etc. has been taken as also the estimated value of such intangible collateral. The disclosure may be made under a separate head in ';Notes to Accounts';. This would differentiate such loans from other entirely unsecured loans.

Restructured Accounts:-

Category of Advances Rate (%)

Restructured accounts classified as standard advances (In respect of new restructured standard accounts (flow) with effect from June 1, 2013)- with effect from March 31, 2014 (spread over the four quarters of 2013-14)- with effect from March 31, 2015 (spread over the four quarters of 2014-15)- with effect from March 31, 2016 (spread over the fourquarters of 2015-16)

3.50

4.25

5.00

5.5 Standard assets(i) As a countercyclical measure, the provisioning requirements for all types of standard assets stands amended as below. Banks should make general provision for standard assets at the following rates for the funded outstanding on global loan portfolio basis:(a) direct advances to agricultural and SME sectors at 0.25 per cent; (b) advances to Commercial Real Estate (CRE) Sector at 1.00 per cent;(c) advances to Commercial Real Estate Residential housing (CRE-RH) Sector at 0.75%(d) Individual Housing loans 0.25% ( w.e.f all sanctions after 07.6.2017)(e) all other loans and advances at 0.40 per cent

(ii) The revised norms would be effective prospectively but the provisions held at present should not be reversed. However, in future, if by applying the revised provisioning norms, any provisions are required over and above the level of provisions currently held for the standard category assets, these should be duly provided for.(iii) While the provisions on individual portfolios are required to be calculated at the rates applicable to them, the excess or shortfall in the provisioning, vis-a-vis the position as on any previous date, should be determined on an aggregate basis. If the provisions on an aggregate basis required to be held are less than the provisions already held, the provisions rendered surplus should not be reversed to P&L and should continue to be maintained at the existing level. In case of shortfall determined on aggregate basis, the balance should be provided for by debit to P&L.(iv) The provisions on standard assets should not be reckoned for arriving at net NPAs.(v) The provisions towards Standard Assets need not be netted from gross advances but shown separately as 'Contingent Provisions against Standard Assets' under 'Other Liabilities and Provisions Others' in Schedule 5 of the balance sheet.

NOTE:- Additional Provisions for NPAs at higher than prescribed ratesThe regulatory norms for provisioning represent the minimum requirement. A bank may voluntarily make specific provisions for advances at rates which are higher than the rates prescribed under existing regulations, to provide for estimated actual loss in collectible amount, provided such higher rates are approved by the Board of Directors and consistently adopted from year to year. Such additional provisions are not to be considered



as floating provisions. The additional provisions for NPAs, like the minimum regulatory provision on NPAs, may be netted off from gross NPAs to arrive at the net NPAs.

SALE OF FINANCIAL ASSETS TO SC/RC • Under the SARFAESI Act 2002, banks/FIs are permitted to sell financial assets to Securitization Companies (SC) and Reconstruction Companies (RC). A financial asset which can be sold to the SC/RC by any bank/ FI is:-a) A NPA, including a non-performing bond/ debenture, andb) A Standard Asset where: i) The asset is under consortium/multiple banking arrangements; ii) At least 75% of value of the asset is classified as NPA in the books of other banks/FIs; and ii i) At least 75% (by value) of the banks/FIs who are under the consortium/multiple banking arrangements agree to the sale of the asset to SC/RC.• The prudential guidelines have been grouped under various heads as under:-a) Financial assets which can be sold.b) Procedure for sale of banks’/ FIs’ financial assets to SC/ RC, including valuation and pricing aspects.c) Prudential norms, in the following areas, for banks/ FIs for sale of their financial assets to SC/ RC and for investing in bonds/debentures/ security receipts and any other securities offered by the SC/RC as compensation consequent upon sale of financial assets:i) Provisioning / Valuation norms ii) Capital adequacy norms ii i) Exposure normsd) Disclosure requirements

6. WRITE OFF OF NPAs • In terms of Section 43(D) of the Income Tax Act 1961, interest income of NPAs shall be chargeable to tax in the previous year in which it is credited to the bank’s profit and loss account or received, whichever is earlier. Banks may either make full provision as per the guidelines or write off such advances or claim such tax benefits as are applicable. Recoveries made in such accounts should be offered for tax purposes as per the rules.

7. PRUDENTIAL GUIDELINES ON RESTRUCTURING OF ADVANCES :• A restructured account is one where the bank grants concessions, which would not otherwise consider, taking into account the borrower’s financial difficulty. Restructuring involves modification of terms of advance/securities, which would generally include, among others, alteration of repayment period / repayable amount/ the amount of instalments / rate of interest, etc.• Specified Period means a period of one year from the date when the first payment of interest or instalment of principal falls due under the terms of restructuring package.

The guidelines on restructuring issued by RBI are grouped in four categories as under:-i) Restructuring of advances extended to industrial units.ii) Restructuring of advances extended to industrial units under the Corporate Debt Restructuring (CDR) Mechanismiii) Restructuring of advances extended to Small and Medium Enterprises (SME)iv) Restructuring of all other advances.

Eligibility• Accounts classified under ‘Standard’, ‘Substandard’ and ‘doubtful’ categories. • Banks cannot reschedule / restructure / renegotiate borrowal accounts with retrospective effect. While a restructuring proposal is under consideration, the usual asset classification norms would continue to apply. • No account is taken up for restructuring by the banks unless the financial viability is established and there is a reasonable certainty of repayment from the borrower, as per the terms of restructuring package.• Borrowers indulged in frauds and malfeasance is ineligible for restructuring. • BIFR cases are not eligible for restructuring without their express approval. CDR Core Group in the case of advances restructured under CDR Mechanism / the lead bank in the case of SME Debt Restructuring Mechanism and the individual banks in other cases,



may consider the proposals for restructuring in such cases, after ensuring that all the formalities in seeking the approval from BIFR are completed before implementing the package.

Asset classification normsRestructuring of advances could take place in the following stages: (a)Before commencement of commercial production / operation;(b)After commencement of commercial production / operation but before the asset has been classified as 'sub-standard'; (c) After commencement of commercial production / operation and the asset has been classified as 'sub-standard' or 'doubtful'.

Upon restructuring:-• 'Standard assets' should be reclassified as 'sub-standard assets'• NPAs would continue asset classification as prior to restructuring and may slip into further lower asset classification categories with reference to the prerestructuring repayment schedule. • All NPA accounts would be eligible for being reclassified as ‘standard’ category after observation of satisfactory performance during the ‘specified’ period. Thereafter, the account would be governed as per the existing prudential norms with reference to repayment schedule.• Additional finance considered may be treated as ‘standard asset’ during the ‘specified period. ’Any Interest income should be recognized only on cash basis in respect of accounts classified as ‘substandard’ or ‘doubtful’ at pre-restructuring stage. • A restructured standard asset is subjected to restructuring on a subsequent occasion; it should be classified as substandard. Similarly, a sub-standard or a doubtful restructured asset which is subjected to restructuring on a subsequent occasion, its asset classification will be reckoned from the date when it became NPA on the first occasion. • Interest income in respect of restructured standard asset can be recognized on accrual basis • In case part of the outstanding principal amount is converted into debt or equity instruments as per the restructuring package, the asset so created will be classified in the same asset classification category in which the restructured advance has been classified. • The FITL / debt or equity instrument created by conversion of unpaid interest will be classified in the same asset classification category in which the restructured advance has been classified.Banks will hold provision in respect of restructured assets as per existing provisioning normsAsset classification benefits are available to banks subject to:-• The dues of the banks are fully secured except SSI borrowers where the outstanding is upto Rs.25 Lakh• Infrastructure projects provided the cash flows generated from these projects are adequate for repayment of the advance, escrow mechanism for the cash flows available, and banks have a clear and legal first claim on these cash flows. • The unit becomes viable in 10 years, if it is engaged in infrastructure activities, and in 7 years in the case of other units. • The repayment period of the restructured advance including the moratorium, if any, does not exceed 15 years in the case of infrastructure advances and 10 years in the case of other advances other than restructured home loans.• Promoters' sacrifice (contribution) and additional funds brought by them should be a minimum of 15% of banks' sacrifice upfront. However, if the banks are convinced that the promoters face genuine difficulty in bringing the share of sacrifice immediately, the promoters could be allowed to bring in 50% of their sacrifice i.e. 50% of 15% upfront and the balance within a period of one year.

OBJECTIVE OF RESTRUCTURINGIt may be observed that the basic objective of restructuring is to preserve economic value of units and not ever greening of problem accounts. This can be achieved by banks and the borrowers only by careful assessment of the viability, quick detection of weaknesses in accounts and a time-bound implementation of restructuring packages.

Question:1(a) From the following information, compute the amount of provisions to be made in the Profit



and Loss Account of a Commercial bank:Assets Rs. in lakhs

(i) Standard (Value of security Rs.6,000 lakhs) 7,000

(ii) Sub-standard 3,000

(iii) Doubtful

(a)Doubtful for less than one year(Realisable value of security Rs.500 lakhs)

1,000

(b)Doubtful for more than one year, but less than 3 years(Realisable value of security Rs.300 lakhs)

500

(c)Doubtful for more than 3 years (No security) 300Answer (a) Asset Amount % of provision Provision

Rs. in lakhs Rs. in lakhs

Standard 7,000 0.40 28Sub-standard 3,000 15 450Doubtful (less than one year)On secured portion 500 25 125On unsecured portion 500 100 500Doubtful (more than one year but less than three years)On secured portion 300 40 120On unsecured portion 200 100 200Doubtful Unsecured (more than three years)

300 100 300

Total provision 1,723

Example 2:Outstanding Balance Rs. 4 lakhs

ECGC Cover 50 percent

Period for which the advance has remained doubtful

More than 2 years remained doubtful(say as on March 31, 2014)

Value of security held Rs. 1.50 lakhs

Provision required to be madeOutstanding balance Rs. 4.00 lakhs

Less: Value of security held Rs. 1.50 lakhs

Unrealised balance Rs. 2.50 lakhs

Less: ECGC Cover(50% of unrealisable balance)

Rs. 1.25 lakhs

Net unsecured balance Rs. 1.25 lakhs

Provision for unsecured portion of advance

Rs. 1.25 lakhs(@ 100 percent of unsecured portion)

Provision for secured portion of advance(as on March 31, 2014)

Rs.0.60 lakhs(@ 40 per cent of the secured portion)

Total provision to be made Rs.1.85 lakhs (as on March 31, 2014)

****



CHAPTER 3BASEL ACCORD & PROVISIONS

Brief History:The Basel Committee on Banking Supervision has its origins in the financial market turmoil that followed the breakdown of the Bretton Woods system of managed exchange rates in 1973. After the collapse of Bretton Woods, many banks incurred large foreign currency losses. On 26 June 1974, West Germany’s Federal Banking Supervisory Office withdrew Bankhaus Herstatt’s banking licence after finding that the bank’s foreign exchange exposures amounted to three times its capital. Banks outside Germany took heavy losses on their unsettled trades with Herstatt, adding an international dimension to the turmoil. In October the same year, the Franklin National Bank of New York also closed its doors after incurring large foreign exchange losses. In response to these and other disruptions in the international financial markets, the central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices at the end of 1974. Later renamed the Basel Committee on Banking Supervision, the Committee was designed as a forum for regular cooperation between its member countries on banking supervisory matters. Its aim was and is to enhance financial stability by improving supervisory knowhow and the quality of banking supervision worldwide. The Committee seeks to achieve its aims by setting minimum standards for the regulation and supervision of banks; by sharing supervisory issues, approaches and techniques to promote common understanding and to improve cross-border cooperation; and by exchanging information on developments in the banking sector and financial markets to help identify current or emerging risks for the global financial system. Also, to engage with the challenges presented by diversified financial conglomerates, the Committee also works with other standard-setting bodies.In October 1996, the Committee released a report on The supervision of cross-border banking,drawn up by a joint working group that included supervisors from non-G10 jurisdictions and offshore centres. The document presented proposals for overcoming the impediments to effective consolidated supervision of the cross-border operations of international banks. Subsequently endorsed by supervisors from 140 countries, the report helped to forge relationships between supervisors in home and host countries. The involvement of non-G10 supervisors also played a vital part in the formulation of the Committee’s Core principles for effective banking supervision in the following year. The impetus for this document came from a 1996 report by the G7 finance ministers that called for effective supervision in all important financial marketplaces, including those of emerging economies. When first published in September 1997, the paper set out 25 basic principles that the Basel Committee believed should be in place for a supervisory system to be effective. After several revisions, most recently in September 2012, the document now embraces 29 principles, covering supervisory powers, the need for early intervention and timely supervisory actions, supervisory expectations of banks, and compliance with supervisory standards.

Basel I: the Basel Capital Accord With the foundations for supervision of internationally active banks laid, capital adequacy soon became the main focus of the Committee’s activities. In the early 1980s, the onset of the Latin American debt crisis heightened the Committee’s concerns that the capital ratios of the main international banks were deteriorating at a time of growing international risks. Backed by the G10 Governors, Committee members resolved to halt the erosion of capital standards in their banking systems and to work towards greater convergence in the measurement of capital adequacy. This resulted in a broad consensus on a weighted approach to the measurement of risk, both on and off banks’ balance sheets. There was strong recognition within the Committee of the overriding need for a multinational accord to strengthen the stability of the international banking system and to remove a source of competitive inequality arising from differences in national capital requirements. Following comments on a consultative paper published in December 1987, a capital measurement system commonly referred to as the Basel Capital Accord (1988 Accord) was approved by the G10 Governors and released to banks in July 1988.



The 1988 Accord called for a minimum capital ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992. Ultimately, this framework was introduced not only in member countries but also in virtually all other countries with active international banks. In September 1993, the Committee issued a statement confirming that G10 countries’ banks with material international banking business were meeting the minimum requirements set out in the Accord. The Accord was always intended to evolve over time. It was amended first in November 1991. The 1991 amendment gave greater precision to the definition of general provisions or general loan-loss reserves that could be included in the capital adequacy calculation. In April 1995, the Committee issued an amendment, to take effect at end-1995, to recognise the effects of bilateral netting of banks’ credit exposures in derivative products and to expand the matrix of add-on factors. In April 1996, another document was issued explaining how Committee members intended to recognise the effects of multilateral netting. The Committee also refined the framework to address risks other than credit risk, which was the focus of the 1988 Accord. In January 1996, following two consultative processes, the Committee issued the so-called Market Risk Amendment to the Capital Accord (or Market Risk Amendment), to take effect at the end of 1997. This was designed to incorporate within the Accord a capital requirement for the market risks arising from banks’ exposures to foreign exchange, traded debt securities, equities, commodities and options. An important aspect of the Market Risk Amendment was that banks were, for the first time, allowed to use internal models (value-at-risk models) as a basis for measuring their market risk capital requirements, subject to strict quantitative and qualitative standards. Much of the preparatory work for the market risk package was undertaken jointly with securities regulators.

Basel II: the new capital framework In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace the 1988 Accord. This led to the release of the Revised Capital Framework in June 2004. Generally known as ‟Basel II”, the revised framework comprised three pillars, namely: I. Minimum capital requirements, which sought to develop and expand the standardized rules set out in the 1988 Accord; II. Supervisory review of an institution’s capital adequacy and internal assessment process; and III. effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices.

The new framework was designed to improve the way regulatory capital requirements reflect underlying risks and to better address the financial innovation that had occurred in recent years. The changes aimed at rewarding and encouraging continued improvements in risk measurement and control.

Basel II Provisions:In India, various groups of banks are at present subject to different minimum capital requirements as prescribed in the statutes under which they have been set-up and operate. The foreign banks operating in India should have foreign funds deployed in Indian business equivalent to 3.5% of their deposits as at the end of each year. Further there are prescriptions regarding maintenance of statutory reserves.As per the new formula, every bank should maintain a minimum capital adequacy ratio based on capital funds and risk assets. As per the prudential norms, all Indian scheduled commercial banks (excluding regional rural banks) as well as foreign banks operating in India are required to maintain capital adequacy ratio (or capital to Risk Weighted Assets Ratio) which is specified by RBI from time to time. At present capital adequacy ratio is 9%.*The capital adequacy ratio is worked out as below :

DEFINITION OF CAPITAL FUNDS



The Basle Committee has defined capital in two tiers - Tier-I and Tier-II. While Tier- I capital, otherwise known as core capital, provides the most permanent and readily available support to a bank against unexpected losses, Tier-II capital contains elements that are less permanent in nature or less readily available. Norms have been established by the RBI identifying Tier-I and Tier-II capital for Indian banks and foreign banks.

TIER-I AND TIER-II CAPITAL FOR INDIAN BANKSTier I capital (also known are core capital) provides the most permanent and readily available support to a bank against unexpected losses.

Tier I capital comprises: The aggregate of paid-up capital, statutory reserves; and other disclosed free reserves including share premium and capital reserves arising out of surplus on sale of assets As reduced by :a. intangible assets

b. current and brought forward losses.

c. The DTA (Deferred tax asset) computed as under should be deducted from Tier I capital:

i) DTA associated with accumulated losses; and

ii) The DTA (excluding DTA associated with accumulated losses), net of DTL. Where the DTL is in excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be adjusted against item (i) nor added to Tier I capital.

Tier II capital comprises elements that are less permanent in nature or are less readily available than those comprising Tier I capital. The elements comprising Tier II capital are as follows :(a) Undisclosed reserves and cumulative perpetual preference assets(b) Revaluation reserves - These reserves are taken at a discount of 55% (effective from 1st April, 1994) while determining their value for inclusion in Tier-II capital. (c) General provisions and loss reserves - General provisions and loss reserves (including general provision on standard assets) may be taken only up to a maximum of 1.25 per cent of weighted risk assets.(d) Hybrid Debt Capital instruments(e) Subordinated Debt - These often carry a fixed maturity and as they approach maturity, they should be subjected to progressive discount for inclusion in Tier-II capital. Instrument with an initial maturity of less than five years or with a remaining maturity of one year should not be included as part of Tier-II capital. Subordinated debt instrument will be limited to 50% of Tier-I capital.

Ratio of Tier II capital to Tier I capitalThe quantum of Tier II capital is limited to a maximum of 100% of Tier I Capital. This seeks to ensure that the capital funds of a bank predominantly comprise of core capital rather than items of a less permanent nature. It may be clarified that the Tier II capital of a bank can exceed its Tier I capital; however, in such a case, the excess will be ignored for the purpose of computing the capital adequacy ratio.

BASEL III Provisions:The provisions of Basel III include:a) The Basel III capital regulation has been implemented from April 1, 2013 in India in phases. b) To ensure smooth transition to Basel III, appropriate transitional arrangements have been provided for meeting the minimum Basel III capital ratios, full regulatory adjustments to the components of capital etc. Consequently, Basel III capital regulations would be fully implemented as on March 31, 2019.c) Banks are required to maintain a minimum Pillar 1 Capital to Risk-weighted Assets Ratio (CRAR) of 9% on an on-going basis (other than capital conservation buffer and Countercyclical capital buffer etc.).



d) Capital requirements for the implementation of Basel III guidelines are lower in the initial periods and higher in later years.e) Banks are required to disclose the capital ratios computed under Basel III capital adequacy framework from the quarter ending 30.06.2013.f) The RBI may consider prescribing a higher level of minimum capital ratio for each bank under Pillar 2 framework on the basis of their respective risk profiles and their risk management systems.g) Banks are required to comply with the capital adequacy ratio at two levels viz. consolidated (Group) and standalone (Solo) level. At consolidated level, the capital adequacy ratio requirements of a bank measure the capital adequacy of a bank based on its capital strength and risk profile after consolidating the assets and liabilities of its subsidiaries/joint ventures/associates, etc. except those engaged in insurance and any non-financial activities. The standalone level capital adequacy ratio requirements measure the capital adequacy of a bank based on its standalone capital strength and risk profile. The overseas operations of a bank through its branches will be covered in both the above scenarios. For the purpose of these guidelines, the subsidiary is an enterprise that is controlled by another enterprise (known as the parent), etc.

Under the Basel II framework, the total regulatory capital comprises of Tier I (core capital) and Tier 2 capital (supplementary capital). In order to improve the quality and quality of regulatory capital, capital will predominantly consist of Common Equity under Basel III. Non-equity Tier 1 and Tier 2 capital would continue to form part of regulatory capital subject to eligibility criteria as laid down in Basel III. Banks have to comply with the regulatory limits and minima as prescribed under Basel III capital regulations, on an ongoing basis. To ensure smooth transition to Basel III, appropriate transitional arrangements have been provided for meeting the minimum Basel III capital ratios, full regulatory adjustments to the components of capital etc. Consequently, Basel III capital regulations would be fully implemented as on March 31, 2018. In view of the gradual phase-in of regulatory adjustments to the Common Equity component of Tier 1 capital under Basel III, certain specific prescriptions of Basel II capital adequacy framework (e.g. rules relating to deductions from regulatory capital, risk weighting of investments in other financial entities etc.) will also continue to apply till March 31, 2017.

Pillar I : Minimum Capital Requirement:As in the current accord, the new accord will have the same provisions relating to the regulatory capital requirement: 9%. However, the difference is in the method of calculating bank risk, which would, in turn, affect capital requirement.

Regulatory Capital / Risk weighted assets > 9%

Risk weighted assets = {Capital requirements for Market Risk + (Capital requirements for Operational Risk} + (Risk weighted assets for credit risk )

The accord covers three risks:1. Credit Risk: The potential that a bank borrower or counter party fails to meet the financial obligations on the agreed terms.

External Rating Based Internal Ratings Based

Foundation IRB Advanced IRB Calibrated on the basis of External Ratings Functions provided by

BASEL CommitteeFunctions provided by BASEL Committee

2. Operational Risk: The risk loss arising from the various types of human or technical error,failed internal process, fraud or the legal hurdles.

Basic Indicator Standardized Advance MeasurementCapital Charge =15% of three years average gross income.

Capital Charge= 12%-18% of the gross income per regularity business line

Capital Charge = Internally generated data on internal& External loss data, Scenario analysis business



environment & Internal Control.

3. Market Risk:-The standardized approach which specifies the standards in five categories1. Interest Rate risk2. Equity Position Risk3. Foreign Exchange risk4. Commodities Risk5. Options risk

The second approach to deal in the market risk is based on the internal assessments of the banks. The bank needs to consider following five elements in calculating the internal model based risk structure.1. General criteria, where the approval from the supervisory authority of the bankis mandatory.2. Qualitative standards regarding the maintenance of the Risk management unit3. Specification of Market Risk Factors4. Quantitative standards5. Stress testing to identify the events that could impact the banks.6. External Validation by External auditors and Supervisory authorities

Pillar II : Supervisory Review Process (SRP):The supervisory review process of the framework is intended not only to ensure that banks have adequate capital to support all the risks in their business but also to encourage the banks to develop and use better risk management techniques. Here in this Pillar, banks were required to have a Board-approved policy on Internal Capital Adequacy Assessment Process (ICAAP) and to assess the capital requirement as per ICAAP. The objective of the SRP is to ensure that banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks. This in turn would require a well-defined internal assessment process within banks through which they assure the RBI that adequate capital is indeed held towards the various risks to which they are exposed. The process of assurance could also involve an active dialogue between the bank and the RBI so that, when warranted, appropriate intervention could be made to either reduce the risk exposure of the bank or augment / restore its capital. Thus, ICAAP is an important component of the SRP. The main aspects to be addressed under the SRP, and therefore, under the ICAAP, would include: (a) the risks that are not fully captured by the minimum capital ratio prescribed under Pillar 1; (b) the risks that are not at all taken into account by the Pillar 1; and (c) the factors external to the bank. Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is only the regulatory minimum level, addressing only the three specified risks (viz., credit, market and operational risks), holding additional capital might be necessary for banks, on account of both – the possibility of some under-estimation of risks under the Pillar 1 and the actual risk exposure of a bank vis-à-vis the quality of its risk management architecture. Illustratively, some of the risks that the banks are generally exposed to but which are not captured or not fully captured in the regulatory CRAR would include: (a) Interest rate risk in the banking book; (b) Credit concentration risk; (c) Liquidity risk; (d) Settlement risk; (e) Reputational risk; (f) Strategic risk; (g) Risk of under-estimation of credit risk under the Standardised approach; (h) Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches; (i) Risk of weakness in the credit-risk mitigants; (j) Residual risk of securitisation, etc. It is, therefore, only appropriate that the banks make their own assessment of their various risk exposures, through a well-defined internal process, and maintain an adequate capital cushion for such risks. Banks were advised to develop and put in place, with the approval of their Boards, an ICAAP commensurate with their size, level of complexity, risk profile and scope of operations. The ICAAP document should, inter alia, include the capital adequacy assessment and projections of



capital requirement for the ensuing year, along with the plans and strategies for meeting the capital requirement.

Pillar III :Market Discipline:The purpose of Market discipline is to complement the minimum capital requirements (detailedunder Pillar 1) and the supervisory review process (detailed under Pillar 2). The aim is to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes and hence, the capital adequacy of the institution.

In principle, banks’ disclosures should be consistent with how senior management and the Board of Directors assess and manage the risks of the bank. Under Pillar 1, banks use specified approaches / methodologies for measuring the various risks they face and the resulting capital requirements. It is believed that providing disclosures that are based on a common framework is an effective means of informing the market about a bank’s exposure to those risks and provides a consistent and comprehensive disclosure framework that enhances comparability. Market discipline can contribute to a safe and sound banking environment. Hence, non-compliance with the prescribed disclosure requirements would attract a penalty, including financial penalty.

Banks should have a formal disclosure policy approved by the Board of directors that addresses the bank’s approach for determining what disclosures it will make and the internal controls over the disclosure process. In addition, banks should implement a process for assessing the appropriateness of their disclosures, including validation and frequency.

Banks are required to make Pillar 3 disclosures at least on a half yearly basis, irrespective of whether financial statements are audited, with the exception of following disclosures: (i) Table DF-2: Capital Adequacy; (ii) Table DF-3: Credit Risk: General Disclosures for All Banks; and (iii) Table DF-4: Credit Risk: Disclosures for Portfolios Subject to the Standardised Approach. The disclosures as indicated at (i), (ii) and (iii) above will be made at least on a quarterly basis by banks. All disclosures must either be included in a bank’s published financial results / statements or, at a minimum, must be disclosed on bank’s website.

Implementation of the BASEL:The framework is applicable to wide range of the banking system of G-10 countries. In respect of other countries Basel committee provides that supervisors of the nation should strengthen the supervisory system and then develop the road map for due implementation, through proper planning to switch over to BASEL. There are some benefits of proper compliance with the provisions of Basel II. If banks and financial institutions develop sophisticated internal risk-measurement processes and can show them to be sufficiently accurate, they will be allowed to use these to calculate the capital they must hold against their exposures Improved credit rating systems and improved management of operational risk will also be of benefit. Organisations that address compliance effectively will see the up-side to Basel II to be significant improvements in ABC Ltd service, risk management, decision-making, operational efficiency and cost reduction. All such improvements build consumer confidence and enhance brand and reputation.The liability cost of non-compliance will be high, but there is equally a potential cost of attaining compliance in the wrong way, and there are no prizes for over compliance. Instead over compliance can create barriers to your ABC Ltds and so the key will be to identify best business practice and implement rigorously.

Composition of Regulatory Capital Under Basel III (Pillar I ):Banks are required to maintain a minimum Pillar 1 Capital to Risk- weighted Assets Ratio (CRAR) of 9% on an on-going basis (other than capital conservation buffer and countercyclical capital buffer etc.). The RBI will take into account the relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by a bank is commensurate



with the bank’s overall risk profile. This would include, among others, the effectiveness of the bank’s risk management systems in identifying, assessing / measuring, monitoring and managing various risks including interest rate risk in the banking book, liquidity risk, concentration risk and residual risk. Accordingly, RBI will consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk management systems. Further, in terms of the Pillar 2 requirements, banks are expected to operate at a level well above the minimum requirement.The total regulatory capital fund will consist of the sum of the following categories:-

(i) Tier 1 Capital (going-concern capital*): comprises of:(a) Common Equity Tier 1 capital (b) Additional Tier 1 capital

(ii) Tier 2 Capital (gone-concern capital*)(*From regulatory capital perspective, going-concern capital is the capital which can absorb losses without triggering bankruptcy of the bank. Gone-concern capital is the capital which will absorb losses only in a situation of liquidation of the bank).

Banks are required to compute the Basel III capital ratios in the following manner:-

Common Equity Tier 1 Capital Ratio =

Common Equity Tier 1 Capital_____________ Credit Risk RWA* + Market Risk RWA + Operational Risk RWA

Tier 1 Capital Ratio = Eligible Tier 1 Capital_____________ Credit Risk RWA* + Market Risk RWA + Operational Risk RWA

Total Capital (CRAR) ( 9%) = Eligible Total Capital (CET 1+ Additional Tier I + Tier II)____ Credit Risk RWA* + Market Risk RWA + Operational Risk RWA

DEFINITION OF CAPITAL FUNDSCommon Equity TIER-I, Additional Tier I AND TIER-II CAPITAL FOR INDIAN BANKS:Common Equity TIER-I (also known are core capital) provides the most permanent and readily available support to a bank against unexpected losses.

Common Equity TIER-I capital comprises: i) Common shares (All common shares should ideally be the voting shares as detailed in RBI M. Cir., mostly equity share capital & Perpetual Non-Cumulative Preference Shares) Note: While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit, Perpetual Non-Cumulative Preference Shares (PNCPS) together with Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital, more than 1.5% of risk weighted assets. However, once this minimum total Tier 1 capital has been complied with, any additional PNCPS and PDI issued by the bank can be included in Total Tier 1 capital reported. Excess PNCPS and PDI can be reckoned to comply with Tier 2 capital if the latter is less than 2% of RWAs. PNCPS shall not be issued with a 'put option'.

ii) Stock surplus (share premium) resulting from the issue of common shares; iii) Statutory reservesiv) Capital reserves representing surplus arising out of sale proceeds of assets v) Other disclosed free reserves, if any vi) Balance in Profit & Loss Account at the end of previous year vii) Revaluation reserves at a discount of 55% (that means only 45% to be included) subject to meeting the following conditions:



• bank is able to sell the property readily at its own will and there is no legal impediment in selling the property; • the revaluation reserves are shown under Schedule 2: Reserves & Surplus in the Balance Sheet of the bank; • revaluations are realistic, in accordance with Indian Accounting Standards. • valuations are obtained, from two independent valuers, at least once in every 3 years; where the value of the property has been substantially impaired by any event, these are to be immediately revalued and appropriately factored into capital adequacy computations;• the external auditors of the bank have not expressed a qualified opinion on the revaluation of the property;

viii) Banks may, at their discretion, reckon foreign currency translation reserve arising due to translation of financial statements of their foreign operations in terms of Accounting Standard (AS) 11 as CET1 capital at a discount of 25% subject to meeting the following conditions: • the FCTR are shown under Schedule 2: Reserves & Surplus in the Balance Sheet of the bank; • the external auditors of the bank have not expressed a qualified opinion on the FCTR.

ix) Profit for current year calculated on quarterly basis provided the incremental provisions made for non-performing assets at the end of any of the four quarters of the previous financial year have not deviated more than 25% from the average of the four quarters. The amount which can be reckoned would be arrived at by using the following formula: EPt = {NPt – 0.25*D*t} Where; EPt = Eligible profit up to the quarter ‘t’ of the current financial year; t varies from 1 to 4 NPt = Net profit up to the quarter ‘t’,D= average annual dividend paid during last three years

Elements of Additional Tier 1 Capital – Indian Schedule Banks:Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital consists of the sum of the following elements: (i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory requirements specified as under:Note: While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit, Perpetual Non-Cumulative Preference Shares (PNCPS) together with Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital, more than 1.5% of risk weighted assets. However, once this minimum total Tier 1 capital has been complied with, any additional PNCPS and PDI issued by the bank can be included in Total Tier 1 capital reported. Excess PNCPS and PDI can be reckoned to comply with Tier 2 capital if the latter is less than 2% of RWAs.

(ii) Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital;

(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with the regulatory requirements specified as under:A bank cannot admit Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital, together withPerpetual Non-Cumulative Preference Shares (PNCPS), more than 1.5% of risk weighted assets. However, once this minimum total Tier 1 capital has been complied with, any additional PNCPS and PDI issued by the bank can be included in Total Tier 1 capital reported. Excess PNCPS and PDI can be reckoned to comply with Tier 2 capital if the latter is less than 2% of RWAs. PDI shall not be issued with a 'put option'.

(iv) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Additional Tier 1 capital;

(v) While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Additional Tier 1 capital as specified; and



Tier 2 : Elements of Tier 2 Capital - Indian Schedule Banks (i) General Provisions and Loss Reserves a. Provisions or loan-loss reserves held against future, presently unidentified losses, which are freely available to meet losses which subsequently materialize, will qualify for inclusion within Tier 2 capital. Accordingly, General Provisions on Standard Assets, Floating Provisions, Provisions held for Country Exposures, Investment Reserve Account, excess provisions which arise on account of sale of NPAs and ‘countercyclical provisioning buffer’ will qualify for inclusion in Tier 2 capital. However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25% of the total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based (IRB) approach, where the total expected loss amount is less than total eligible provisions, banks may recognise the difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted assets calculated under the IRB approach. b. Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether individual or grouped should be excluded. Accordingly, for instance, specific provisions on NPAs, both at individual account or at portfolio level, provisions in lieu of diminution in the fair value of assets in the case of restructured advances, provisions against depreciation in the value of investments will be excluded.

(ii) Debt Capital Instruments (as bonds / debentures) issued by the banks; (These debt instruments should have a minimum maturity of 10 years and there are no step-ups or other incentives to redeem.)The debt instruments shall not have any ‘put option’. Further, the debt instruments shall be subjected to a progressive discount for capital adequacy purposes. As they approach maturity these instruments should be subjected to progressive discount as indicated in the table below for being eligible for inclusion in Tier 2 capital.

Remaining Maturity of Instruments Rate of Discount (%)

Less than one year 100One year and more but less than two years 80Two years and more but less than three years 60Three years and more but less than four years 40Four years and more but less than five years 20

(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) / Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference Shares (RCPS)] issued by the banks;

(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital;

(v) While calculating capital adequacy at the consolidated level (i.e Banks along with subsidiaries), Tier 2 capital instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Tier 2 capital;

(vi) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 2 capital; and

REGULATORY ADJUSTMENTS/ DEDUCTIONSa. Goodwill & Intangible assetsIn terms of Basel III, goodwill and other intangibles should be deducted from the Common Equity component of Tier 1.

b. The DTA (Deferred tax asset) computed as under should be deducted from Common Equity component of Tier 1:

i) DTA associated with accumulated losses; and



ii) The DTA (excluding DTA associated with accumulated losses), net of DTL. Where the DTL is in excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be adjusted against item (i) nor added to Tier I capital.

iii) DTAs which relate to timing differences (other than those related to accumulated losses) may, instead of full deduction from CET1 capital, be recognised in the CET1 capital up to 10% of a bank’s CET1 capital, at the discretion of banks [after the application of all regulatory adjustments

c. Cash Flow Hedge Reserve (i) The amount of the cash flow hedge reserve which relates to the hedging of items that are not fair valued on the balance sheet (including projected cash flows) should be derecognised in the calculation of Common Equity Tier 1. This means that positive amounts should be deducted and negative amounts should be added back.

d. Shortfall of the Stock of Provisions to Expected Losses The deduction from capital in respect of a shortfall of the stock of provisions to expected losses under the Internal Ratings Based (IRB) approach should be made in the calculation of Common Equity Tier 1. The full amount is to be deducted and should not be reduced by any tax effects that could be expected to occur if provisions were to rise to the level of expected losses.

e. Any gain-on-sale arising at the time of securitisation, if recognised, should be deducted entirely from Common equity Tier I capital. In terms of guidelines on securitisation of standard assets, banks are allowed to amortise the profit over the period of the securities issued by the SPV. The amount of profits thus recognised in the profit and loss account through the amortisation process need not be deducted.

f. Deduction for Defined Benefit Pension Fund Assets and Liabilities: Under Basel III, defined benefit pension fund liabilities, as included on the balance sheet, must be fully recognised in the calculation of Common Equity Tier 1 capital (i.e. Common Equity Tier 1 capital cannot be increased through derecognising these liabilities or cannot be added to calculated CET 1). For each defined benefit pension fund that is an asset on the balance sheet, the asset should be deducted in the calculation of Common Equity Tier 1 net of any associated deferred tax liability which would be extinguished if the asset should become impaired or derecognized under the relevant accounting standards.

g. Investment in a bank’s own shares, etc. is to be deducted appropriately from Common Equity Tier 1 capital.

h. The investment of banks in the regulatory capital instruments of other financial entities contributes to the inter-connectedness amongst the financial institutions and hence it should be deducted from the respective tiers of regulatory capital so as to avoid double counting of capital in the financial system.

i. Reciprocal cross holdings of capital might result in artificially inflating the capital position of banks and hence such holdings of capital has to be fully deducted from component of capital (Common Equity, Additional Tier 1 and Tier 2 capital) for which the capital would qualify if it was issued by the bank itself,

j. Capital instruments which no longer qualify as non-common equity Tier 1 capital or Tier 2 capital (e.g. IPDI and Tier 2 debt instruments with step-ups) are to be phased out beginning 01.01.2013.

Transitional ArrangementsAs per Basel III terms, in order to ensure smooth migration without any near stress, appropriate transitional arrangements for capital ratios have been made which commenced as on 01.04.2013. Capital ratios and deductions from Common Equity will be fully phased-in and implemented as on



31.03.2019 and accordingly the phase-in arrangements for Schedule Commercial Bank operating in India are drawn as under w.e.f March 27, 2014:-

Transitional Arrangements (Excl. Local area bank and RRBs)Minimum Capital Ratio

01.4.13 31.3.14 31.3.15 31.3.16 31.3.17 31.3.18 31.03.2019

Common Equity Tier I

4.50% 5.00% 5.50% 5.50% 5.50% 5.50% 5.50%

Additional Tier I 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50%Minimum Tier I 6.00% 6.50% 7.00% 7.00% 7.00% 7.00% 7.00%Tier II 3.00% 2.50% 2.00% 2.00% 2.00% 2.00% 2.00%Minimum TotalCapital

9.00% 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%

Capital conservation buffer*

- - - 0.625% 1.25% 1.875% 2.50%

Minimum TotalCapital + CCB

9.00% 9.00% 9.00% 9.625% 10.25% 10.875% 11.50%

Phase-in of all deductions from CET 1

20% 40% 60% 80% 100% 100% 100%

The regulatory adjustments (i.e. deductions and prudential filters) would be fully deducted from Common Equity Tier 1 only by March 31, 2017. During this transition period, the remainder not deducted from Common Equity Tier 1 / Additional Tier 1 /Tier 2 capital will continue to be subject to treatments given under Basel II capital adequacy framework.

*The capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers during normal times (i.e. outside periods of stress) which can be drawn down as losses incurred during a stressed period. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements. Outside the period of stress, banks should hold buffers of capital above the regulatory minimum.

Illustration 1:From the following information of ALL Banks Ltd., calculate the minimum capital requirement of the bank for year ending on 31.03.2018 as per Basel III norms.RWA (in Rs. Cr) : 2,13,163.90Solution: As per Transitional arrangement, Minimum capital as per Basel III for 31.03.2016 will be :CET 1: 5.5%, Additional Tier 1 : 1.50%, Tier II : 2% Accordingly, the following capital is required:CET 1 : 2,13,163.90 x 5.50% = 11,724.01Additional Tier I : 2,13,163.90 x 1.50% = 3,197.45Tier II : 2,13,163.90 x 2% = 4,263.27Total Minimum required = 11,724.01 + 3,197.45 + 4,263.27 = 19,184.73

Illustration 2:From the following particulars calculate CET1, Additional Tier I and Tier II for SSB Bank Ltd.

Particulars Amt in Millions Amount in MillionsPaid up Capital 4,435.60Reserves & Surplus:Statutory reserve 91,876.28Capital reserve 20,695.39Share premium 90,187.42Special Reserve u/s 36(I)(VIII) of I.T. act

44,322.06

Revenue & other reserve 1,42,119.76 3,89,200.91



Borrowings:From banks 24,328.53Other institutions and agencies 2,142.75Repo transaction- 4 days 19,117.00Capital instrument issued as bonds – Tier II – 2015 -15 yrs

50,000.00

Subordinated Bonds 51,900.00 1,47,488.28

Other liabilities & provisions:Bills Payable 21,908.81Inter Office Adjustment (Net) 7,527.12Provision against Standard Advances

29,818.04

Other (including provision) 1,49,079.27 2,08,333.24Total 7,49,458.03

Note : Capital Reserves include Revaluation Reserves of Rs. 10,003.80Solution: Please refer to definition of Capital Funds as given on page no. of notes to know what is required to be included.

Particulars Amt in Millions Amt in MillionsCommon Equity Tier IPaid up Capital 4,435.60Share premium 90,187.42Reserves & Surplus:Statutory reserve 91,876.28Special Reserve u/s 36(I)(VIII) of I.T. act E

44,322.06

Capital reserve (including Revaluation Reserves- ( 55% discount)

15,193.30

Revenue & other reserve 1,42,119.76 3,88,134.42

Additional Tier IBorrowings:Subordinated Bonds issued for Compliance of Add.Tier I

51,900.00 51,900.00

Tier II

Borrowings:Capital instrument issued as bonds –Tier II – 2015 -15 yrs

50,000.00

Other liabilities & provisions:Provision against Standard Advances 29,818.04 79,818.04

Total 5,19,852.46

Illustration 3: The following figures has been drawn from BBR Bank Ltd. (Rs. in Million)Credit Risk – RWA : 10,02,851.08Minimum capital required for Market Risk : 7266.56Minimum capital required for Operational Risk : 8283.81If the total eligible capital is Rs. 1,53,063.15, how much is the CRAR/CAR for the bank, including Capital conservation buffer on 31.03.2018.

Solution: The formula for calculation of CAR is

Total eligible capital______________________ x 100RWA for Credit Risk + RWA for Market Risk + RWA for Operational Risk



Here, we have given figure of total eligible capital is Rs. 1,53,063.15 and also we have RWA for Credit Risk, but not the RWA for Market & operational risk. To calculate the RWA for Market & operational risk, we have to do the following calculation:

We know that total minimum capital requirement in % including CCB for 31.03.2016 is = 10.875%,

Minimum capital for Market risk is given as Rs. 7266.56, Now if we divide Rs. 7266.56, by 10.875%, then we will get the RWA for Market Risk = Rs. 66,818.94

Same way, Minimum capital for Operational risk is given as Rs. 8283.81, Now if we divide Rs. 8283.81, by 10.875%, thenwe will get the RWA for Operational Risk = Rs. 76,172.96

Now, we can put these figures in the formula : 1,53,063.15__ __ x 100 = _1,53,063.15_ x 100 = 13.35%10,02,851.08 + 66,818.94 + 76,172.96 11,45,842.98

CRAR/CAR for the bank, including Capital conservation buffer on 31.03.2018 = 13.25%

Illustration 4:ZT Bank has the following position as on 31.03.2018. You are required to calculate CAR, CET 1, Additional Tier 1, Tier II capital. (Figures in ‘000)Paid-up Capital 6459.60Reserves & Surplus:STATUTORY RESERVE 151816.28CAPITAL RESERVE (Incl. Revaluation Reserves 9003.80) 20695.39SHARE PREMIUM 80486.42Special Reserve u/s 36(I)(VIII) of I.T. act 4812.06Revenue & other reserve 123129.76Investment reserve account 1304.63Borrowings:From banks 24328.53Subordinated Bonds ( Directly issued for Add. Tier I) 23381.19Subordinated Bonds (Remaining maturity 4 yrs. initial maturity was 10 yrs) 35,618.10Other liabilities & provisions:Bills Payable 21908.81Interest Accrued 47810.64

Total credit risk weighted assets 3500359.71Total market risk weighted assets 209246.58Total operational risk weighted assets 251873.17

Solution:Calculation of CET -1Paid-up Capital 6459.60SHARE PREMIUM 80486.42Reserves & Surplus:STATUTORY RESERVE 151816.28Special Reserve u/s 36(I)(VIII) of I.T. act 4812.06Revenue & other reserve 123129.76CAPITAL RESERVE (including Revaluation Reserves- ( 55% discount) 15743.30 Total Common Equity Tier 1 capital (a) 382447.42

Additional Tier 1 capitalSubordinated Bonds ( Directly issued for Add. Tier I) 23381.19



Total Additional Tier 1 capital (b) 23381.19

Tier 2 CalculationsSubordinated Bonds ( Remaining maturity 4 yrs – 20% discount) 28,494.48General Provisions & Loss Reserves: Investment reserve account 1,304.63 Total Tier 2 capital (c ) 29,799.11

Total Eligible capital for CAR is (a+b+c) 435627.72

Total credit risk weighted assets 3500359.71Total market risk weighted assets 209246.58Total operational risk weighted assets 251873.17 Total Risk weighted assets 3961479.46

Capital Adequacy Ratio = 4,35,62739,61,479 x 100 10.99%

Common Equity Tier 1 Ratio =3,82,447.42

39,61,479.46 x 100 9.65%

Additional Tier 1 Ratio =23,381.19

39,61,479.46 x 100 0.59%

Tier 2 capital Ratio =29,799.11

39,61,479.46 x 100 0.75%

Illustration 5:From the following information relating to DSW Bank Ltd., calculate the Tier 1, Additional Tier 1 capital and Tier 2 capital as on 31st March, 2018. Rs. in lakhsCapital & Liabilities Amount AmountPaid up capital A1 5,544.00Reserves & Surplus 4,39,170.50Statutory Reserve B1 11736.50Special Reserve B2 48,848.70( Out of which created out of last current profit) - 236.00 B3Securities premium B4 114957.70Unrealised Investment reserves B5

4.90Capital reserve B6 2,417.90Foreign currency translation reserve B7 34984.50Reserve fund B8 50.90( Out of which created out of last current profit) - 1.20 B9Revenue and other reserves B10 59636.30( Out of which created out of last current profit) - 898.00 B11Balance in Profit & Loss account B12 166533.10( Out of which created out of last current profit) - 53,312.90 B13Employees stock option outstanding C1 55.30Borrowings: 10,18,425.42 From RBI D1 61,048.50 From banks D2 583036.30 From other institutions & agencies D3 152041.20 Borrowings in the form of bonds & debentures D4 222299.42 Tier II Bonds 10yrs to maturity - 150000.00 Bonds are having 4 years to maturity - 42949.32 Debentures are of 2 years to maturity - 29350.10

D5D6D7

Capital instruments D8 2,28,655.20 Perpetual Non cumulative Preference shares D9 3870.00 Securities Premium D10 277.00



Perpetual debt instruments D11 224508.20Total 16,91,850.42

Total Risk weighted assets 74,62,912.80 Note: Provisions made for non-performing assets at the end of any of the four quarters of the previous financial year has not deviated more than 25% from the average of the four quarters. Average dividend paid for last 3 years is 1,316.00

Answer:We will first calculate Common Equity Tier 1 from the above:Paid up capital + B4 ( Securities Premium) 1,20,501.70Reserves & Surplus(B1+B2+B5+B6+B7+B8+B10+B12) 3,24,212.80– ( B3+B9+B11+B13) 54,448.10 2,69,764.70Profits of current year eligible for inclusionEPt= {NPt – 0.25*D*t}Profit for the year = ( B3+B9+B11+B13) 54,448.10 = ( 54,448.10 – 0.25 x 1,316.00 x 4) 53,132.10Common Equity Tier 1 (Before regulatory deductions) 4,43,398.50Less:- Regulatory deductions ( no such deduction given) -Common Equity Tier 1 4,43,398.50CET 1 Ratio = 443398.50 = 443398.50 x 100 Risk weighted assets 7462912.80

5.94%

Calculation of Additional Tier 1 capital:For Additional Tier 1 = D9 + D10 + D11 2,28,655.20(Subject to condition that a bank cannot admit Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital, together with Perpetual Non-Cumulative Preference Shares (PNCPS), more than 1.5% of risk weighted assets - Risk weighted assets 7462912.80 x 1.5%

1,11,943.69

So Additional Tier I capital will be lower of two above 1,11,943.69Add.Tier 1 Ratio = 111943.69 = 111943.69 x 100 Risk weighted assets 7462912.80

1.50%

Total Tier I capital will be Common Equity Tier 1 4,43,398.50Additional Tier I capital 1,11,943.69

Tier I capital (Before regulatory deductions) 5,55,342.19Less:- Regulatory deductions ( no such deduction given) -

Tier I capital 5,55,342.19Tier I capital Ratio will be Tier 1 Ratio = 555342.19 = 555342.19 x 100 Risk weighted assets 7462912.80

7.44%

Tier 2 capital will be:Borrowings in the form of bonds & debentures = D4 (Subject to maturity discount – refer page no.)D5 = Tier II Bonds 10yrs to maturity - 150000.00 - discount @ 0% 1,50,000.00D6 =Bonds are having 4 years to maturity - 42949.32 - discount @ 20% 34,359.46D7 =Debentures are of 2 years to maturity - 29350.10 - discount @ 60% 11,740.04

So D4 eligible to be included in Tier 2 is 1,96,099.55Capital instruments (D9+D10+D11) can be included in Tier 2 if Perpetual Debt Instruments (PDI) & Perpetual Non-Cumulative Preference Shares (PNCPS) is less than 2% of RWAs. 2% of RWA (7462912.80) is

-



1,49,258.25 and hence (D9+D10+D11) is more than it. So no excess can be included in Tire 2.

Tier 2 capital (Before regulatory deductions) 1,96,099.55Less:- Regulatory deductions ( no such deduction given) -

Tier 2 capital 1,96,099.55Tier 2 capital Ratio will beCET 1 Ratio = 196099.55 = 196099.55 x 100 Risk weighted assets 7462912.80

2.62%

Total CRAR for bank as on 31st March 2018 is:Common Equity Tier 1 4,43,398.50Additional Tier I capital 1,11,943.69Tier 2 capital 1,96,099.55Total eligible funds for capital adequacy 7,51,441.74CRAR = 7,51,441.74 = 7,51,441,74 x 100 Risk weighted assets 74,62,912.80

10.06%

Illustration 6:In Illustration 5 if regulatory deductions is adjusted then the calculations of CET1 will change. It will be subject to transitional arrangements. The following regulatory deduction is given as on 31st

March,2018. Rs. in lakhsPrudential valuation adjustments 187.10Goodwill (net of related tax liability) 62.70Other intangibles 1.80Cash-flow hedge reserve 22.60Securitisation gain on sale (Recognised) 14.50Deferred tax assets 222.30Reciprocal cross-holdings 70.10

Solution: CET 1 & deduction:Common Equity Tier 1 4,43,398.50Less: DeductionsPrudential valuation adjustments 187.10Goodwill (net of related tax liability) 62.70Other intangibles 1.80Cash-flow hedge reserve 22.60Securitisation gain on sale 14.50Deferred tax assets 222.30Reciprocal cross-holdings 70.10 Total of deduction 581.10Deduction will be 581.10Common Equity Tier 1 (After regulatory deductions) 4,42,817.40

DISCLOSURE REQUIREMENTS:1. In order to ensure adequate disclosure of details of the components of capital which aims at improving transparency of regulatory capital reporting as well as improving market discipline, banks are required to disclose the following: (i) a full reconciliation of all regulatory capital elements back to the balance sheet in the audited financial statements; (ii) separate disclosure of all regulatory adjustments and the items not deducted from Common Equity Tier 1 (iii) a description of all limits and minima, identifying the positive and negative elements of capital to which the limits and minima apply; (iv) a description of the main features of capital instruments issued; and



(v) banks which disclose ratios involving components of regulatory capital (e.g. “Equity Tier 1”, “Core Tier 1” or “Tangible Common Equity” ratios) must accompany such disclosures with a comprehensive explanation of how these ratios are calculated. 2. Banks are also required to make available on their websites the full terms and conditions of all instruments included in regulatory capital. The Basel Committee will issue more detailed Pillar 3 disclosure shortly, based on which appropriate disclosure norms under Pillar 3 will be issued by RBI. 3. During the transition phase banks are required to disclose the specific components of capital, including capital instruments and regulatory adjustments which are benefiting from the transitional provisions.

→How to calculate Risk weightage assets (RWA):-In order to calculate the Risk weigtage assets one has to go by taking elements into consideration of 3 risks as identified by BASEL- II.

I) Credit Risk:-Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may fail to meet its obligations in accordance with agreed terms. It is the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a ABC Ltd or a counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio arising from actual or perceived deterioration in credit quality.For most banks, loans are the largest and the most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off balance sheet. Banks increasingly face credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, inter-bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options and in guarantees and settlement of transactions.The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio, as well as, the risk in the individual credits or transactions. Banks should have a keen awareness of the need to identify measure, monitor and control credit risk, as well as, to determine that they hold adequate capital against these risks and they are adequately compensated for risks incurred.Under Basel II, the credit risk measurement techniques proposed under capital adequacy rules can be classified under:

a. Standardized Approach: This approach uses a simplistic categorization of obligors, without considering their actual credit risks; external credit ratings are used

b. Internal Ratings-Based (IRB) Approach: In this approach, banks that meet certain criteria are permitted to use their own estimated risk parameters to calculate regulatory capital required for credit risk.

The IRB approach can be further classified into:1. Foundation - IRB : Banks are allowed to calculate the probability of default (PD) for each asset; while the regulator will determine Loss Given Default (LGD) and Exposure at Default (EAD). Maturity (M) can be assigned by either.

2. Advanced - IRB : Banks are allowed to use their internal models to calculate PD, LGD, EAD, and M.The primary objective of employing these models is to arrive at the total risk weighted assets (RWA), which is used to calculate the regulatory capital. The RWA calculation is based on either Standardized or IRB approach.



Risk factor for credit riskUnder the Standardised Approach, the rating assigned by the eligible external credit rating agencies will largely support the measure of credit risk. The Reserve Bank has identified the external credit rating agencies that meet the eligibility criteria specified under the revised Framework. Banks may rely upon the ratings assigned by the external credit rating agencies chosen by the Reserve Bank for assigning risk weights for capital adequacy purposes as per the mapping furnished in these guidelines.

1. Claims on Domestic SovereignsBoth fund based and non fund based claims on the central government 0%Central Government guaranteed claims 0%Direct loan / credit / overdraft exposure, if any, of banks to the State Governments and the investment in State Government securities

0%

State Government guaranteed claims 20%claims on central government exposures will also apply to the claims on the Reserve Bank of India, DICGC, Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), and Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH)

0%

claims on ECGC 20%*The above risk weights for both direct claims and guarantee claims will be applicable as long as they are classified as ‘standard’/ performing assets

Non-performing assets (NPAs)The unsecured portion of NPA, net of specific provisions (including partial write-offs), will be risk-weighted as followsa. when specific provisions are less than 20 per cent of the outstanding amount of the NPA

150%

b. when specific provisions are at least 20 per cent of the outstanding amount of the NPA 100%c. when specific provisions are at least 50 per cent of the outstanding amount of the NPA 50%NPA is fully secured , thenBy collateral not recognized for credit mitigation purposes (net of specific provisions), when provision reach at 15% of outstanding amount

100 %

Claims secured by residential property, (net of specific provisions) 100% - If the specific provisions on loans are between 20%-50% 75% - If the specific provisions on loans is more than 50% then 50%

2. Claims on Foreign SovereignsS&P*/Fetch ratings.

AAA to AA A BBB BB to B Below B unrated

Moody’s rating Aaa to AA A Baa Ba to B Below B unrated

Risk weight 0% 20% 50% 100% 150% 100%

*standard & Poor’s

3. Claims on public sector entities (PSEs)Domestic PSE :- Will be risk weighted in a manner similar to claims on Corporate.

Foreign PSE :-S&P/ Fetch Ratings

AAA to AA A BBB to BB” Below B unrated

Moody’s Ratings

Aaa to Aa A Bbb to Bb Below Ba Unrated

RW (%) 20 50 100 150 100

4.Claims on MDBs, BIS and IMF



Assigned a uniform 20% risk weight : for a) World Bank Group: IBRD and IFC, b) Asian Development Bank, c) African Development Bank, d) European Bank for econstruction &Development, e) Inter-American Development Bank, f) European Investment Bank, g) European Investment Fund, h) Nordic Investment Bank, i) Caribbean Development Bank, j) Islamic Development Bank and k) Council of Europe Development Bank. Similarly, claims on the International Finance Facility for Immunization (IFFIm) will also attract a 20% risk weight.

5.Claims on corporates:- Claims on corporates will include all fund based and non fund based exposures other than those which qualify for inclusion under ‘sovereign’, ‘bank’, ‘regulatory retail’, ‘residential mortgage’, ‘non performing assets’, specified category addressed separately in these guidelines.Claims on corporates, including the exposures on Asset Finance companies and Non-Banking Finance Companies-Infrastructure Finance Companies (NBFC-IFC), shall be risk weighted as per the ratings assigned by the rating agencies registered with the SEBI and chosen by the Reserve Bank of India.a. Long term claims on corporateDomestic ratings agencies

AAA AA A BBB BB & Below Unrated

Risk weight 20% 30% 50% 100% 150% 100

b. Short Term Claims on Corporate

CARE CRISILIndia’s Ratings Research and private limited (India Ratings

ICRA BrickworkSME Ratings agencies of India LTD

SMERA(12)

(%)

CARE A1+

CRISIL A1+ IND A1+ ICRA A1+ Brickwork A+1

SMERA A1+ 20

CARE A1 CRISILA1 INDA1 ICRA A1 Brickwork A1

SMERA A1 30

CAREA2 CRISIL A2 IND A2 ICRA A2 Brickwork A2

SMERA A2 50

CARE A3 CRISIL A3 IND A3 ICRA A3 Brickwork A3

SMERA A3SMERA A4&D

100

CAREA4&D

CRISIL A4&D

IND A4 ICRA A4&D

Brickwork A4 &D

unrated 150

unrated unrated unrated unrated unrated 100

Note: According to RBI notification dated August 25, 2016, with effect from June 30, 2017, all unrated claims on Corporates, AFCs, and NBFC-IFCs having aggregate exposure from banking system of more than INR 200 crore will attract a risk weight of 150%.

However, claims on Corporates, AFCs, and NBFC-IFCs having aggregate exposure from banking system of more than INR 100 crore which were rated earlier and subsequently have become unrated will attract a risk weight of 150% with immediate effect.

6.Claims included in the regulatory retail portfolios:- Claims (include both fund-based and non-fund based) that meet all the four criteria listed below may be considered as retail claims for regulatory capital purposes and included in a regulatory retail portfolio. Claims included in this portfolio shall be assigned a risk-weight of 75%.The following claims, both fund based and non-fund based, shall be excluded from the regulatory retail portfolio: (a) Exposures by way of investments in securities (such as bonds and equities), whether listed or not;



(b) Mortgage Loans to the extent that they qualify for treatment as claims secured by residential property or claims secured by commercial real estate;

(c) Loans and Advances to bank’s own staff which are fully covered by superannuation benefits and / or mortgage of flat/ house;

(d) Consumer Credit, including Personal Loans and credit card receivables;

(e) Capital Market Exposures;

(f) Venture Capital Funds.

Four criteria :(i) Orientation criterion - The exposure (both fund-based and non fund-based) is to an individual person or persons or to a small business; Person under this clause would mean any legal person capable of entering into contracts and would include but not be restricted to individual, HUF, partnership firm, trust, private limited companies, public limited companies, co-operative societies etc. Small business is one where the total average annual turnover is less than Rs. 50 crore. The turnover criterion will be linked to the average of the last three years in the case of existing entities; projected turnover in the case of new entities; and both actual and projected turnover for entities which are yet to complete three years.

(ii) Product criterion - The exposure (both fund-based and non fund-based) takes the form of any of the following: revolving credits and lines of credit (including overdrafts), term loans and leases (e.g. instalment loans and leases, student and educational loans) and small business facilities and commitments.

(iii) Granularity criterion - Banks must ensure that the regulatory retail portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio, warranting the 75 per cent risk weight. One way of achieving this is that no aggregate exposure to one counterpart should exceed 0.2 per cent of the overall regulatory retail portfolio. ‘Aggregate exposure’ means gross amount (i.e. not taking any benefit for credit risk mitigation into account) of all forms of debt exposures (e.g. loans or commitments) that individually satisfy the three other criteria. In addition, ‘one counterpart’ means one or several entities that may be considered as a single beneficiary (e.g. in the case of a small business that is affiliated to another small business, the limit would apply to the bank's aggregated exposure on both businesses). While banks may appropriately use the group exposure concept for computing aggregate exposures, they should evolve adequate systems to ensure strict adherence with this criterion. NPAs under retail loans are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion for risk-weighting purposes.

(iv) Low value of individual exposures - The maximum aggregated retail exposure to one counterpart should not exceed the absolute threshold limit of Rs. 5 crore.

7.Claims secured by residential property: w.e.f 07.06.2017Lending to individuals meant for acquiring residential property which are fully secured by mortgages on the residential property that is or will be occupied by the borrower, or that is rented, shall be risk weighted as indicated below, based on Board approved valuation policy. LTV ratio should be computed as a percentage with total outstanding in the account (viz. “principal + accrued interest + other charges pertaining to the loan” without any netting) in the numerator and the realisable value of the residential property mortgaged to the bank in the denominator.

Category of Loan LTV Ratio Risk Weight %(a) Individual Housing Loans (i) Up to Rs. 30 lakh

a. Less than or equal to 80% 35b. Above 80% to less than or equal

to 90%50

(ii) Above Rs. 30 lakh and up to 75 lakh Less than or equal to 80% 35(iii) Above Rs. 75 lakh Less than or equal to 75% 50



(b) Commercial Real Estate – Residential Housing (CRE-RH)

N A 75

(c) Commercial Real Estate (CRE) N A 100 Note: 1. Restructured housing loans should be risk weighted with an additional risk weight of 25 per cent to the risk weights prescribed above. 2. The LTV ratio should not exceed the prescribed ceiling in all fresh cases of sanction. In case the LTV ratio is currently above the ceiling prescribed for any reasons, efforts shall be made to bring it within limits. 3. CRE-RH means integrated housing projects comprising of some commercial space (e.g. shopping complex, school, etc.) can also be classified under CRE-RH, provided that the commercial area in the residential housing project does not exceed 10% of the total Floor Space Index (FSI) of the project. In case the FSI of the commercial area in the predominantly residential housing complex exceeds the ceiling of 10%, the project loans should be classified as CRE and not CRE-RH.

8. Other Assets :-1. Consumer credit, including personal loans and credit card receivables but excluding educational loans, will attract a higher risk weight of 125 per cent or higher, if warranted by the external rating (or, the lack of it) of the counterparty.2. Loans and advances to bank’s own staff which are fully covered by superannuation benefits and/or mortgage of flat/ house will attract a 20 per cent risk weight. Since flat / house is not an eligible collateral and since banks normally recover the dues by adjusting the superannuation benefits only at the time of cessation from service, the concessional risk weight shall be applied without any adjustment of the outstanding amount. In case a bank is holding eligible collateral in respect of amounts due from a staff member, the outstanding amount in respect of that staff member may be adjusted to the extent permissible. 3. Other loans and advances to bank’s own staff will be eligible for inclusion under regulatory retail portfolio and will therefore attract a 75 per cent risk weight. 4. All other assets will attract a uniform risk weight of 100 per cent

Illustration:ABC bank has the following assets. Calculate the risk weighted assets as per prescribed Basel II norms: Rs. in cr.

Educational Loan Rs.50 Retail loan portfolio(consumer finance) Rs.80 Credit card receivables Rs.35 Staff Advance ( secured by residential property) Rs.25 Housing loanUpto 30 lakhs (LTV 90%) Rs.35Above 75 lakhs (LTV 75%) Rs.10CRE- H Rs.20CRE Rs.25Premises (Bank) Rs.10

Ans:Particulars Exposure Classification Risk

weightCapitalcharge

Educational Loan Rs.50 Retail 75% 37.50Retail loan portfolio(consumer finance) Rs.80 Retail 75% 60.00Credit card receivables Rs.35 Other asset 125% 43.75Staff Advance (secured by residential property)

Rs.25 Other asset 20% 5.00

Housing loan Claim secured by

Upto 30 lakhs (LTV 90%) Rs.35 Residential 50% 17.50



PropertyAbove 75 lakhs (LTV 75%) Rs.10 --“-- 50% 5.00CRE- H Rs.20 --“-- 75% 15.00CRE Rs.25 --“-- 100% 25.00Premises (Bank) Rs.10 Other asset 0 0.00

Total 208.75Off-balance sheet exposures:The risk-weighted amount of an off-balance sheet item that gives rise to credit exposure is generally calculated by means of a two-step process: (a) the notional amount of the transaction is converted into a credit equivalent amount, by multiplying the amount by the specified credit conversion factor or by applying the current exposure method, and (b) the resulting credit equivalent amount is multiplied by the risk weight applicable to the counterparty or to the purpose for which the bank has extended finance or the type of asset, whichever is higher. The credit equivalent amount in relation to a non-market related off-balance sheet item like, direct credit substitutes, trade and performance related contingent items and commitments with certain drawdown, other commitments, etc. will be determined by multiplying the contracted amount of that particular transaction by the relevant credit conversion factor (CCF). Where the non-market related off-balance sheet item is an undrawn or partially undrawn fund-based facility, the amount of undrawn commitment to be included in calculating the off-balance sheet non-market related credit exposures is the maximum unused portion of the commitment that could be drawn during the remaining period to maturity. Any drawn portion of a commitment forms a part of bank's on-balance sheet credit exposure.

Credit conversion Factor (CCF):Sr. No. Instruments Credit

Conversion Factor (%)

1. Direct credit substitutes e.g. general guarantees of indebtedness (including standby L/Cs serving as financial guarantees for loans and securities, credit enhancements, liquidity facilities for securitisation transactions), and acceptances (including endorsements with the character of acceptance). (i.e., the risk of loss depends on the credit worthiness of the counterparty or the party against whom a potential claim is acquired)

100

2. Certain transaction-related contingent items (e.g. performance bonds, bid bonds, warranties, indemnities and standby letters of credit related to particular transaction).

50

3. Short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralised by the underlying shipment) for both issuing bank and confirming bank.

20

4. Sale and repurchase agreement and asset sales with recourse, where the credit risk remains with the bank. (These items are to be risk weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into.)

100

5. Forward asset purchases, forward deposits and partly paid shares and securities, which represent commitments with certain drawdown. (These items are to be risk weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into.)

100

6 Lending of banks’ securities or posting of securities as collateral by banks, including instances where these arise out of repo style transactions (i.e., repurchase / reverse repurchase and securities lending / securities borrowing transactions)

100

7. Note issuance facilities and revolving / non-revolving underwriting facilities. 50



8 Commitments with certain drawdown 100 9. Other commitments (e.g., formal standby facilities and credit lines) with an

original maturity of a) up to one year b) over one year Similar commitments that are unconditionally cancellable at any time by the bank without prior notice or that effectively provide for automatic cancellation due to deterioration in a borrower’s credit worthiness

20 50 0

10. Take-out Finance in the books of taking-over institution (i) Unconditional take-out finance 100 (ii) Conditional take-out finance 50

For classification of banks guarantees viz. direct credit substitutes and transaction-related contingent items etc. (Sr. No. 1 and 2 of Table above), the following principles should be kept in view for the application of CCFs: (a) Financial guarantees are direct credit substitutes wherein a bank irrevocably undertakes to guarantee the repayment of a contractual financial obligation. Financial guarantees essentially carry the same credit risk as a direct extension of credit i.e., the risk of loss is directly linked to the creditworthiness of the counterparty against whom a potential claim is acquired. An indicative list of financial guarantees, attracting a CCF of 100 per cent is as under: i. Guarantees for credit facilities; ii. Guarantees in lieu of repayment of financial securities; iii. Guarantees in lieu of margin requirements of exchanges; iv. Guarantees for mobilisation advance, advance money before the commencement of a project and for money to be received in various stages of project implementation; v. Guarantees towards revenue dues, taxes, duties, levies etc. in favour of Tax/ Customs / Port / Excise Authorities and for disputed liabilities for litigation pending at courts; vi. Credit Enhancements; vii. Liquidity facilities for securitisation transactions; viii. Acceptances (including endorsements with the character of acceptance); ix. Deferred payment guarantees.

(b) Performance guarantees are essentially transaction-related contingencies that involve an irrevocable undertaking to pay a third party in the event the counterparty fails to fulfil or perform a contractual non- financial obligation. In such transactions, the risk of loss depends on the event which need not necessarily be related to the creditworthiness of the counterparty involved. Anindicative list of performance guarantees, attracting a CCF of 50 per cent is as under: (i) Bid bonds; (ii) Performance bonds and export performance guarantees; (iii) Guarantees in lieu of security deposits / earnest money deposits (EMD) for participating in tenders; (iv)Retention money guarantees; (v) Warranties, indemnities and standby letters of credit related to particular transaction.

Market related Off-Balance Sheet ItemsMarket related off-balance sheet items would include: a) interest rate contracts – including single currency interest rate swaps, basis swaps, forward rate agreements, and interest rate futures; b) foreign exchange contracts, including contracts involving gold, – includes cross currency swaps (including cross currency interest rate swaps), forward foreign exchange contracts, currency futures, currency options; c) any other market related contracts specifically allowed by the Reserve Bank which give rise to credit risk.Exemption from capital requirements is permitted for :a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.The credit equivalent amount of a market related off-balance sheet item, whether held in the banking book or trading book must be determined by the current exposure method.



Current Exposure Method (i) The credit equivalent amount of a market related off-balance sheet transaction calculated using the current exposure method is the sum of current credit exposure and potential future credit exposure of these contracts. While computing the credit exposure banks may exclude ‘sold options’, provided the entire premium / fee or any other form of income is received / realised.

(ii) Current credit exposure is defined as the sum of the positive mark-to-market value of these contracts. The Current Exposure Method requires periodical calculation of the current credit exposure by marking these contracts to market, thus capturing the current credit exposure.

(iii) Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts irrespective of whether the contract has a zero, positive or negative mark-to-market value by the relevant add-on factor indicated below according to the nature and residual maturity of the instrument.

Credit Conversion Factors for Market-Related Off-Balance Sheet ItemsCredit conversion Factor (%)

Interest rate contracts

Exchange rate contracts & Gold

One year or less 0.50 2.00Over one year to five years 1.00 10.00Over five years 3.00 15.00

Illustration:Find out from the following information risk weighted asset for non market related off balance sheet item:In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally cancellable) where the drawn portion is Rs. 60 lakh, the undrawn portion of Rs. 40 lakh, credit rating being A2+ for the said customer. Another customer having credit rating of A+ has been sanctioned TL of Rs. 700 cr is sanctioned for a large project which can be drawn down in stages over a three year period. The terms of sanction allow draw down in three stages – Rs. 150 cr in Stage I, Rs. 200 cr in Stage II and Rs. 350 cr in Stage III, where the borrower needs the bank’s explicit approval for draw down under Stages II and III after completion of certain formalities. If the borrower has drawn already Rs. 50 cr under Stage I.Answer:Off balance sheet items Amt. . Credit conversion

factorCredit after conversion

Amt.

Risk weight(refer claims on corporate)

Risk weighted asset,Amt.

a. Undrawn CC Rs.40 lakhs

20% (CCF table item 3 pg.no 162)

Rs.8.00 lakhs 50% Rs.4.00 lakhs

b. Undrawn TL within 1 year*

Rs.100cr.

20% (CCF table item 9 pg.no 162))

Rs.20.00 Cr 50% Rs.10.00 cr

Total Rs.10.04 cr* If Stage I is scheduled to be completed within one year, the CCF will be 20% and if it is more than one year then the applicable CCF will be 50 %.

II. Credit Risk Mitigation:Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised in whole or in part by cash or securities, deposits from the same counterparty, guarantee of a third party, etc. The revised approach to credit risk mitigation allows a wider range of credit risk mitigants to be recognised for regulatory capital purposes than is permitted under the 1988 Framework provided these techniques meet the requirements for legal certainty.



Credit risk mitigation approach as detailed in this section is applicable to the banking book exposures.

1.Credit risk mitigation techniques - Collateralised transactionsA collateralised transaction is one in which: (i) banks have a credit exposure and that credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. Here, “counterparty” is used to denote a party to whom a bank has an on- or off-balance sheet credit exposure. (ii) banks have a specific lien on the collateral and the requirements of legal certainty are met.

i) The comprehensive approach In the comprehensive approach, when taking collateral, banks will need to calculate their adjusted exposure to a counterparty for capital adequacy purposes in order to take account of the effects of that collateral. Banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either, occasioned by market movements. These adjustments are referred to as ‘haircuts’. The application of haircuts will produce volatility adjusted amounts for both exposure and collateral. The volatility adjusted amount for the exposure will be higher than the exposure and the volatility adjusted amount for the collateral will be lower than the collateral, unless either side of the transaction is cash. In other words, the ‘haircut’ for the exposure will be a premium factor and the ‘haircut’ for the collateral will be a discount factor. It may be noted that the purpose underlying the application of haircut is to capture the market-related volatility inherent in the value of exposures as well as of the eligible financial collaterals. Since the value of credit exposures acquired by the banks in the course of their banking operations, would not be subject to market volatility, (since the loan disbursal / investment would be a “cash” transaction) though the value of eligible financial collateral would be, the haircut stipulated in Table-14 would apply in respect of credit transactions only to the eligible collateral but not to the credit exposure of the bank. ii) Additionally where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.

iii) Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral amount (including any further adjustment for foreign exchange risk), banks shall calculate their risk-weighted assets as the difference between the two multiplied by the risk weight of the counterparty.

2. Eligible financial collateral The following collateral instruments are eligible for recognition in the comprehensive approach:(i) Cash (as well as certificates of deposit or comparable instruments, including fixed deposit receipts, issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure. (ii) Gold: Gold would include both bullion and jewellery. However, the value of the collateralised jewellery should be arrived at after notionally converting these to 99.99 purity. (iii) Securities issued by Central and State Governments (iv) Kisan Vikas Patra and National Savings Certificates provided no lock-in period is operational and if they can be encashed within the holding period. (v) Life insurance policies with a declared surrender value of an insurance company which is regulated by an insurance sector regulator. (vi) Debt securities rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are either: a) Attracting 100 per cent or lesser risk weight i.e., rated at least BBB(-) when issued by public sector entities and other entities (including banks and Primary Dealers); or b) Attracting 100 per cent or lesser risk weight i.e., rated at least CARE A3/ CRISIL A3/IND A3/ICRA A3/Brickwork A3/ SMERA A3for short-term debt instruments.



vii) Debt securities not rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are: a) issued by a bank; and b) listed on a recognised exchange; and c) classified as senior debt; and d) all rated issues of the same seniority by the issuing bank are rated at least BBB(-) or CARE A3/ CRISIL A3/IND A3/ICRA A3/Brickwork A3/ SMERA A3by a chosen Credit Rating Agency; and e) the bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB(-) or BBB(-) or CARE A3/ CRISIL A3/IND A3/ICRA A3/Brickwork A3/ SMERA A3 (as applicable) and; f) Banks should be sufficiently confident about the market liquidity of the security.

viii) Units of Mutual Funds regulated by the securities regulator of the jurisdiction of the bank’s operation mutual funds where: a) a price for the units is publicly quoted daily i.e., where the daily NAV is available in public domain; and b) Mutual fund is limited to investing in the instruments listed in this paragraph.

ix) Re-securitisations, irrespective of any credit ratings, are not eligible financial collateral.

3. Calculation of capital requirement For a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:

E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx )]} Where: E* = the exposure value after risk mitigation E = current value of the exposure for which the collateral qualifies as a risk MitigantHe = haircut appropriate to the exposure C = the current value of the collateral received Hc = haircut appropriate to the collateral Hfx = haircut appropriate for currency mismatch between the collateral and exposure

Standard Supervisory Haircuts for Sovereign and other securities whichconstitute Exposure and Collateral

Sl. No. Issue Rating by accredited ECAIs (CARE/ CRISIL/ India Ratings/ ICRA/ Brickwork/SMERA) for Debt securities

Residual Maturity(in years)

Haircut (in percentage)

A Securities issued / guaranteed by the Government of India and issued by the State Governments (Sovereign securities)

i Rating not applicable – as Government securities are not currently rated in India

< or = 1 year 0.5

> 1 year and < or = 5 years

2

> 5 years 4

B Domestic debt securities other than those indicated at Item No. A above including the securities guaranteed by Indian State Governmentsii. AAA to AA PR1/P1/F1/A1

< or = 1 year 1


4

> 5 years 8

iii. A to BBBPR2 / P2 / F2 /A2;

PR3 /P3 / F3 / A3 and unrated bank

< or = 1 year 2


6



securities as specified in paragraph 7.3.5 (vii) of the circular

> 5 years 12

iv. Units of Mutual Funds Highest haircut applicable to any of

the above securities, in which the eligible

mutual fund can invest

C Cash in the same currency 0D Gold 15E Securitisation Exposures

ii. AAA to AA < or = 1 year 2> 1 year and < or = 5

years8

> 5 years 16iii. A to BBB

and unrated bank securities as specified in paragraph 7.3.5 (vii) of

the circular

< or = 1 year 4


12

> 5 years 24

Credit Risk Mitigation Techniques - Guarantees Where guarantees are direct, explicit, irrevocable and unconditional banks may take account of such credit protection in calculating capital requirements. A range of guarantors are recognised. Only guarantees issued by entities with a lower risk weight than the counterparty will lead to reduced capital charges since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor, whereas the uncovered portion retains the risk weight of the underlying counterparty. For e.g. If Bank A has credit rating of AA and the guarantee issued to PSU has rating of AAA, then only credit risk mitigation is possible here and not otherwise.Range of Eligible Guarantors (Counter-Guarantors) Credit protection given by the following entities will be recognised: (i) Sovereigns, sovereign entities (including BIS, IMF, European Central Bank and European Community as well as MDBs, ECGC and CGTMSE), banks and primary dealers with a lower risk weight than the counterparty; (ii) Other entities that are externally rated except when credit protection is provided to a securitisation exposure. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.(iii) when credit protection is provided to a securitisation exposure, other entities that currently are externally rated BBB- or better and that were externally rated A- or better at the time the credit protection was provided. This would include credit protection provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor.

Risk Weights: The protected portion is assigned the risk weight of the protection provider. Exposures covered by State Government guarantees will attract a risk weight of 20 per cent. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.

Illustration:ABC bank has the following exposure to Corporate sector secured by financial assets. Find out the credit risk weighted asset for these assets: INR in Cr.

Party Amount in INR Maturity of exposure & also of collateral

Collateral Value of collateral

ExposureRating



S Ltd 15.00 2 Mutual Fund( AA) 15.00 AAY Ltd 10.00 3 Sovereign Bond 10.00 BBBZ Ltd 25.00 6 Gold 26.00 A

Answer:Party S Ltd Y Ltd Z LtdExposure 15.00 10.00 25.00Rating of Exposure AA BBB ARisk Weight ( see pg no.158) 30% 100% 50%Hair cut for exposure 0 0 0Collateral value 15.00 10.00 26.00Collateral Mutual

Fund( AA)Sovereign Bond

Gold

Maturity of collateral 2 3 6Hair cut for collateral(see p.no.166) 4% 2% 15%

Applying the credit risk mitigation formula on the above:

E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx )]} where: E* = the exposure value after risk mitigation E = current value of the exposure for which the collateral qualifies as a risk MitigantHe = haircut appropriate to the exposure C = the current value of the collateral received Hc = haircut appropriate to the collateral Hfx = haircut appropriate for currency mismatch between the collateral and exposure

For S Ltd:E* = max {0, [15 x (1 + 0) - 15 x (1 – 0.04 - 0 )]} = max of 0 or [0.60]Means the collateral value after mitigation is 15-0.60 = 14.40So the net exposure is 15 – 14.40 = 0.60RWA = 0.60 x Risk weight of exposure which is 30% = 0.18 Cr.

For Y Ltd:E* = max {0, [10 x (1 + 0) - 10 x (1 – 0.02 - 0 )]} = max of 0 or [0.20]Means the collateral value after mitigation is 10-0.20 = 9.80So the net exposure is 10 – 9.80 = 0.20RWA = 0.20 x Risk weight of exposure which is 100% = 0.20 Cr.

For Z Ltd:E* = max {0, [25 x (1 + 0) - 26 x (1 – 0.15 - 0 )]} = max of 0 or [2.90]Means the collateral value after mitigation is 26-2.90 = 23.10So the net exposure is 25 – 23.10 = 1.90RWA = 1.90 x Risk weight of exposure which is 50% = 0.95 Cr.

Credit Risk Measurement by Internal Ratings Based Approach:In this approach, banks that meet certain criteria are permitted to use their own estimated risk parameters to calculate regulatory capital required for credit risk. Here, the credit risk will be calculated on the basis of probability of default (PD) for each asset, while the regulator will determine Loss Given Default (LGD), and Exposure at Default (EAD) as also the Recovery Rate (RR).



Probability of default (PD) means, the likelihood that the borrower will fail to make full and timely repayment of its financial obligations; LGD means the amount of the loss if there is a default, expressed as a percentage of the EAD, Exposure at Default (EAD), the expected value of the loan at the time of default.Credit Risk will be calculated with the following formula under IRB:

Expected Loss = (1-PD) x PD x LGD x EAD = PD x LGD x EAD

Illustration:AU Bank Ltd has a exposure to one entity to the tune of Rs.78 cr @ 11.5% p.a. The loan tenure is 7 yrs. The exposure is currently valued at Rs.52cr. The bank is assessing its position on this advance and wants to know the expected loss on this exposure if, probability of default is 40%. The given loss if exposure is at default is 22% of exposure. What is the expected loss to the bank?Solution:Probability of default (PD) : 40%, Exposure at Default (EAD) 52cr & Loss Given Default (LGD) is 22%Expected Loss = PD x LGD x EAD = 0.40 x 52cr x 0.22 = 4.58cr

(3) Capital charge for Market Risk Introduction: Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are: (i) The risks pertaining to interest rate related instruments and equities in the trading book; and (ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

Scope and coverage of capital charge for Market Risks: These guidelines seek to address the issues involved in computing capital charges for interest rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and other precious metals) in both trading and banking books. Trading book for the purpose of capital adequacy will include: (i) Securities included under the Held for Trading category (ii) Securities included under the Available for Sale category (iii) Open gold position limits (iv) Open foreign exchange position limits (v) Trading positions in derivatives, and (vi) Derivatives entered into for hedging trading book exposures.

(i) Interest rate related Instruments (Trading book):The minimum capital requirement is expressed in terms of two separately calculated charges, (a) "specific risk" charge for each security, which is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer, both for short (short position is not allowed in India except in derivatives and Central Government Securities) and long positions, and (b) "general market risk" charge towards interest rate risk in the portfolio, where long and short positions (which is not allowed in India except in derivatives) in different securities or instruments can be offset.

(a) Specific Risk: The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. The specific risk charges for various kinds of exposures would be applied as given in RBI circular.

(b) General market Risk: The Basle Committee has suggested two broad methodologies for computation of capital charge for general market risks. One is the standardised method and the other is the banks’ internal risk management models method. As banks in India are still in a nascent stage of developing internal risk management models, it has been decided that, to start



with, banks may adopt the standardised method. Under the standardised method there are two principal methods of measuring market risk, a “maturity” method and a “duration” method. As “duration” method is a more accurate method of measuring interest rate risk, it has been decided to adopt standardised duration method to arrive at the capital charge. Accordingly, banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately. Under this method, the mechanics are as follows: (i) first calculate the price sensitivity (modified duration) of each instrument;(ii) next apply the assumed change in yield to the modified duration of each instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument (see Table attached with RBI circular); (iii) slot the resulting capital charge measures into a maturity ladder with the fifteen time bands as set out in Table attached with RBI circular;

(iv) subject long and short positions (short position is not allowed in India except in derivatives) in each time band to a 5 per cent vertical disallowance designed to capture basis risk; and (v) carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in Table attached with RBI circular.

(ii)Equities in Trading books:Specific and general market risk :Capital charge for specific risk (akin to credit risk) will be 11.25%or capital charge in accordance with the risk warranted by external rating of the counterparty, whichever is higher and specific risk is computed on banks' gross equity positions (i.e. the sum of all long and all short equity positions - short equity position is, however, not allowed for banks in India). Specific Risk Capital Charge for banks’ investment in Security Receipts will be 13.5% (equivalent to 150 per cent risk weight). Since the Security Receipts are by and large illiquid and not traded in the secondary market, there will be no General Market Risk Capital Charge on them.The general market risk charge will also be 9 per cent on the gross equity positions. Capital charges for specific risk and general market risk are to be computed separately before aggregation. For computing the total capital charge for market risks, the calculations may be plotted in the following table: Proforma

Risk category Capital ChargeI. Interest Rate a + b a. General market risk

i) Net position (parallel shift) ii) Horizontal disallowance (curvature)iii)Vertical disallowances basis iv)Optionsb) Specific Risk

II. Equity A+Ba. General market risk b. Specific risk

III. Foreign Exchange and gold IV. Total capital charge for market Risk (I+ II+ III)

3. Measurement of capital charge for foreign exchange risk The bank’s net open position in each currency should be calculated by summing:

The net spot position (i.e. all asset items less all liability items, including accrued interest, denominated in the currency in question);

The net forward position (i.e. all amounts to be received less all amounts to be paid under forward foreign exchange transactions, including currency futures and the principal on currency swaps not included in the spot position);

Guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable;



Net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting bank);

Depending on particular accounting conventions in different countries, any other item representing a profit or loss in foreign currencies;

The net delta-based equivalent of the total book of foreign currency options

Foreign exchange open positions and gold open positions are at present risk-weighted at 100 per cent. Thus, capital charge for market risks in foreign exchange and gold open position is 9 per cent. These open positions, limits or actual whichever is higher, would continue to attract capital charge at 9 per cent. This capital charge is in addition to the capital charge for credit risk on the on-balance sheet and off-balance sheet items pertaining to foreign exchange and gold transactions.

III. Capital Charge for Operational risk:-Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.The New Capital Adequacy Framework provides that internationally active banks and banks with significant operational risk exposures are expected to use an approach that is more sophisticated than the Basic Indicator Approach and that is appropriate for the risk profile of the institution. However, to begin with, banks in India shall compute the capital requirements for operational risk under the Basic Indicator Approach. Reserve Bank will review the capital requirement produced by the Basic Indicator Approach for general credibility, especially in relation to a bank’s peers and in the event that credibility is lacking, appropriate supervisory action under Pillar 2 will be considered.For details refer chapter 5 Module B

►How to calculate the general market risk & credit risk: Illustration 1:Market Risk:- General RiskSuppose a bank has invested in AAA rated bond in trading book with HFT category for Rs.100cr. The bond carries coupon rate of 8% and currently traded at Rs.104/- and having maturity period of 2 years. Interest payments are semiannual. To calculate the capital charge for market risk the following steps has to be followed:

Step 1:- calculate the current yield of the bond :- Rs. 8 cr = 7.70% Rs. 104That means 0.077

Step 2 :- Calculate the duration of the above bond

Time period ( Interest receipts) 0.5 1 1.5 2( A)Inflow ( Intt + Maturity- last yr) 4 cr 4 cr 4 cr 104 cr (B)PV at yield 7.70% 4/(1+0.077/2)1 + 4/(1+0.077/2)2 + 4/(1+0.077/2)3 + 104/(1+0.077/2)4 (C) = 4/1.038 + 4/1.078 + 4/1.120 + 104/1.163 = 3.85 cr + 3.71 + 3.57 + 89.42PV* Time ( C*A) = 1.92 + 3.71 + 5.35 + 178.84Total Time weighted PV = 189.82 Cr.

Macaulay Duration in Years = Total Time weighted PV / Current market price of bond = 189.82/104 = 1.82 yearsStep 3 :- Calculate modified duration : Modified duration measures the percent change in a bond’s price for a 1% change in its yield to maturity;



Modified Duration = Duration / { 1 + (Yield /no. of interest period in a year)} = 1.82 / { 1+ (0.077/2)} = 1.82/1.038 = 1.75 yearsNote :- If you want to know that how much bond price will change if there is a change in yield by one basis point ( 1% means 100 Bps), then use the following formula= Modified Duration* ( Market Price/Face value of Bond)Here, 1.75/(104/100) =1.68 and in Rs. terms it will be 0.016 paisa.

Step 4:- Apply the assumed change in yield to the modified duration according to classification given in Table 17 (master circular)

Here, the modified duration is 1.51 and table value is Zone 2 – 0.90That means the risk value will have to be applied to 90 basis points to the portfolio. = 1.51 x 0.90% = 0.013

Step 5 :-Since security is in HFT we will multiply the factor 1.26 to market value of security which is 104 cr. = 104.00 cr * 0.013 = Rs.1.35 cr.Therefore total capital charge for general market risk is = Rs. 1.35 cr

Illustration 2:Reno Bank has a repo transaction. The details of it has been given under. Calculate total capital charge for a repo transaction comprising the capital charge for CCR and Credit/Market risk for the underlying security, under Basel-II.

Type of the Security GOI securityResidual Maturity 5 yearsCoupon 6%Current Market Value Rs.1050Cash borrowed Rs.1000Modified Duration of the security 4.5 yearsAssumed frequency of margining DailyHaircut for security (adjusted for minimum holding period) 1.4 % Haircut on cash ZeroMinimum holding period 5 business-days

Change in yield for computing the capital charge for general market risk 0.7 % p.a.

Answer:Sr. No. Items Particulars Amount

A. Capital Charge for CCR1 Exposure MV of the security 1050.002 CCF for Exposure 100 %3 On-Balance Sheet Credit Equivalent 1050 * 100 % 1050.004 Haircut 1.4 % 5 Exposure adjusted for haircut 1050 * 1.014 1064.706 Collateral for the security lent Cash 1000.007 Haircut for exposure 0 %8 Collateral adjusted for haircut 1000 * 1.00 1000.009 Net Exposure ( 5- 8) 1064.70 - 1000 64.7010 Risk weight (for a Scheduled CRAR-

compliant bank)20 %

11 Risk weighted assets for CCR (9 x 10) 64.70 * 20 % 12.9412 Capital Charge for CCR (11 x 9%) 12.94 * 0.09 1.16B. Capital for Credit/ market Risk of the

security1 Capital for credit risk

(if the security is held under HTM)Credit risk Zero (Being

Govt. security)



2 Capital for market risk (if the security is held under AFS / HFT)

Specific Risk Zero (Being Govt. security)

General Market Risk (4.5 * 0.7 % * 1050) {Modified duration *

assumed yield change (%) * market

value ofsecurity}

33.07

Total capital required (for CCR + credit risk + specific risk + general market risk)

34.23

Credit Risk capital charge:-The ‘Rich Bank’ has the following exposure in the banking book and would like to know the capital charge for credit risk according to Basel II norms . Refer RBI master circular for your calculations:-

Particulars Amount of Exposure ( Rs. Cr)

Rating Security ProvidedCollateral

(A) Corporate Loan(10 yrs)TL to Cement giant Rs.60.00 AA Immovable propertyTL to Textile firm Rs.20.00 BB - --“---(Turnover of these firms is above Rs.50 cr.)

(B) Retail LoanLoan to small business

Rs. 10.00 -- Commercial real estate

Housing Loan to Individual

Rs. 10.00

( Out of Above )- Loan upto 30 lakhs(LTV is 80% to 90%)

Rs. 6.00 Residential House Property

- Loan above 75 lakhs Rs. 4.00 --“ ---(C) Credit card & personal Loan

Rs.5.00 --- No security

(D) Corporate LoanLoan to I.T companies Rs.20.00 A FDR :- Rs. 8.00 cr

GOI Bonds- Rs.12 cr( Maturity 3 years)

(E) NPA – corporate Loan

Rs.3.00(Provision made for 18%)

-- Unsecured Portion 50%

Rs 5.00(Provision made for 50%)

-- ---“----

Solution :-According to Master circular, we need to know the risk weightage according to class of loans and security. We have to go through this circular in entirety to know the different assets & exposure of any bank.

Particulars Exposure Risk weight

RWA

(A) Corporate LoanLoan to Cement giant Rs.60.00 30% Rs.18.00



Loan to Textile firm Rs.20.00 150% Rs.30.00(Turnover of these firms is above Rs.50 cr.)

(B) Retail LoanLoan to small business (20 accounts) Rs. 10.00 75% Rs.7.50Housing Loan to Individual Rs. 10.00( Out of Above ) - Loan upto 30 lakhs Rs. 6.00 50% Rs.3.00 - Loan above 75 lakhs Rs. 4.00 75% Rs.3.00

(C) Credit card & personal Loan Rs.5.00 125% Rs.6.25

(D) Corporate LoanLoan to I.T companies ( credit rating “A”) Rs.20.00 50%Secured - FDR (I) GOI Bonds (II) (Maturity 4 years)

Rs. 8.00Rs.12.00

Haircut as applicable to be deducted from security amount For ( I) Rs.0.00 0% For (II) Rs.2.40 2%Security after Haircut Rs.17.60Now apply risk weight on above Rs.17.60 50% Rs.8.80

( E) NPA – corporate Loan - Rs.3.00Unsecured 50% - 18% provisions ---150%Secured 50% --- more than 15% ---100%

Rs.1.50

Rs.1.50

150%

100%

Rs.2.25

Rs.1.50

corporate Loan - Rs.5.00Unsecured 50% - Atleast 50% provisions --- 50%Secured 50% --- more than 15% ---100%

Rs.2.50

Rs. 2.50

50%

100%

Rs.1.25

Rs.1.25

RWA Rs.82.80

Question 2: From the following information calculate the CRAR of the National Bank Ltd on 31.03.2016 Rs. in Cr.

Liabilities Amount AmountShareholders Fund:Ordinary equity capital 15.00Redeemable Pref. share 10.00Retained Earnings 6.00Share Premium 5.00Revaluation Reserves 3.00 39.00Perpetual Non-Cumulative Preference Shares

5.00

Share Premium on (PNCPS) 2.50Borrowings:Unsecured Tier II Bonds 4.00Deposits 263.00 267.00Other Liabilities & Provisions 52.50

Total 366.00

Assets Amount AmountCash 25.00Money at call & notice 5.00 30.00



Investments:Subsidiary capital 8.00SLR 12.00Non SLR 14.00 34.00Advances:Corporate loan 95.00Housing Loan 95.00Retail Loan 90.00 280.00Fixed Assets 22.00

Total 366.00Note: Off balance sheet exposure of the bank is as follows:Contingent liability (BG & LC) Secured by immovable property : Rs.20.00 cr(Corporate rating : Brickwork A2)

Other Information:1. Corporate loan portfolio will have the following constituents:Long Term Loans (AA) :25.00Long Term Loans (A) : 15.00Short term loan (CARE A1): 35.00Short term loan (ICRA A2): 20.00

2. Housing Loan details:Above 75 lakhs : 25.00Between 20 lakhs to 75 lakhs: 52.00Below 50 lakhs : 18.00

3. Retail loans details:Small business (Turnover below 50 cr) : 75.00Credit card receivables: 10.00Other consumer loans : 10.00

4. SLR investments: Sovereign securities :Maturity : 2 yrs : 1.00 (HFT) (Modified duration 1.5 yrs, change in assumed yield 0.90, MV: 1.20)Maturity : 10 yrs : 4.00 (Modified duration 7.5 yrs, change in assumed yield 0.60, MV 4.00)Maturity : 15 yrs: 7.00 (Modified duration 11.5 yrs, change in assumed yield 0.60, MV 7.05)

5. Non SLR investments:Public sector enterprise bonds –(AAA)- HFT – Maturity 6 months & less: 5.00 (Table 16:Capital charge 0.28%) (Modified duration 2 months, change in assumed yield 1.00, MV: 5.18)AFS – Corporate BBB bonds: 9.00 (Table 16:Capital charge 9%)(Modified duration 6 months, change in assumed yield 1.00, MV: 9.20)

6. Gross income of the bank for last 3 years is as follows:Year 1 : 80.00, Year 2: 45.00, Year 3 : 45.00

Answer: To calculate CRAR the following formula is applicable Total Eligible funds (Common Equity Tier 1 + Additional Tier 1 + Tier 2) RWA for Credit risk + RWA for Market Risk+ RWA for operational Risk

Now we will first calculate Common Equity Tier 1 & Tier II capital from the information given:

Common Equity Tier 1 : Equity capital 15.00 + Retained Earnings 6.00 + Share Premium 5.00 +Revaluation Reserves : Discount to 55%: 1.65 = 27.60Additional Tier 1 capital:



Perpetual Non-Cumulative Preference Shares (PNCPS) = 5.00Securities Premium on above = 2.50 7.50

Tier 2: Unsecured Tier II bonds: Subordinate debt : 4.00 (Assuming recently issued for 10yrs)

Total Eligible funds: CET 1, Additional Tier 1 & Tier 2 - 39.15 Cr

Calculation of RWA for credit Risk:1. Corporate loan portfolio will have the following constituents:Long Term Loans (AA) :25.00 @ 30% = 7.50Long Term Loans (A) : 15.00 @ 50% = 7.50Short term loan (CARE A1) : 35.00 @ 30% = 10.50Short term loan (ICRA A2) : 20.00 @ 50% = 10.00 35.502. Housing Loan details:Above 75 lakhs : 25.00 @ 75% = 18.75 Between 20 lakhs to 75 lakhs: 52.00 @ 50% = 26.00Below 50 lakhs : 18.00 @ 50% = 9.00 53.753. Retail loans details:Small business (Turnover below 50 cr) : 75.00 @ 75% = 56.25Credit card receivables : 10.00 @125% = 12.50Other consumer loans : 10.00 @ 75% = 7.50 76.25

4. SLR investments: This investments will call both Credit risk & Market risk, we will calculate Credit Risk first & then market risk: Sovereign securities :Maturity : 2 yrs : 1.00 (HFT) (Modified duration 1.5 yrs, change in assumed yield 0.90, MV: 1.20)Maturity : 10 yrs : 4.00 (Modified duration 7.5 yrs, change in assumed yield 0.60, MV 4.00)Maturity : 15 yrs: 7.00 (Modified duration 11.5 yrs, change in assumed yield 0.60, MV 7.05)

Since Domestic Sovereign carries 0% risk weight only market risk is required to calculated..

5. Non SLR investments:Public sector enterprise bonds –HFT (AAA) – Maturity 6 months & less: 5.00 (Table 16:Capital charge 0.28%) (Modified duration 2 months, change in assumed yield 1.00, MV: 5.18)Public sector enterprise bonds –HFT (AAA) : 5.00 @ 20% = 1.00

AFS – Corporate BBB bonds: 9.00 (Table 16: Capital charge 9%) (Modified duration 6 months, change in assumed yield 1.00, MV: 9.20)Corporate BBB bonds: 9.00 @ 100% = 9.00Therefore total credit risk = 1.00 + 9.00 = 10.00

6. Fixed assets : Credit risk 100% = 22.00

7. Credit risk for off balance sheet items:Contingent liability (BG & LC): Secured by immovable property : Rs.20.00 crThe above will fall in Short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralised by the underlying shipment) for both issuing bank and confirming bank and hence credit risk conversion factor will be 20%So applying CCF = 20.00 x 20% = 4.00Since rating for such exposure is Brickwork A2, the risk weight is 50%, therefore



Capital charge = 2.00

Total RWA for credit risk (Adding 1 to 7) = 199.50Market Risk for Trading & Non trading interest bearing assets:

SLR investments: Sovereign securities :Maturity : 2 yrs : 1.00 (HFT) (Modified duration 1.5 yrs, change in assumed yield 0.90, MV: 1.20)Maturity : 10 yrs : 4.00 (Modified duration 7.5 yrs, change in assumed yield 0.60, MV 4.00)Maturity : 15 yrs: 7.00 (Modified duration 11.5 yrs, change in assumed yield 0.60, MV 7.05)

Specific Risk: Zero for all being Sovereign Security.General Market Risk: Maturity : 2 yrs : 1.00 (HFT) (Modified duration 1.5 yrs, change in assumed yield 0.90, MV: 1.20)=1.5 X0.90%x1.20 = 0.016Maturity : 10 yrs : 4.00 (Modified duration 7.5 yrs, change in assumed yield 0.60, MV 4.00)=7.5 x 0.60% x 4.00 = 0.18Maturity : 15 yrs: 7.00 (Modified duration 11.5 yrs, change in assumed yield 0.60, MV 7.05)= 11.5 x 0.60% x 7.05 = 0.49Total General market risk charge = 0.69

5. Non SLR investments:Public sector enterprise bonds –HFT (AAA) – Maturity 6 months & less: 5.00 (Table 16:Capital charge 0.28%) (Modified duration 2 months, change in assumed yield 1.00, MV: 5.18)Specific Risk:0.02%Public sector enterprise bonds –HFT (AAA) : 5.00 @ 0.28% = 0.014General market risk: 0.20 x 1% x 5.18 = 0.010Total market risk = 0.014 + 0.010 = 0.024

AFS – Corporate BBB bonds: 9.00 (Table 16: Capital charge 9%) (Modified duration 6 months, change in assumed yield 1.00, MV: 9.20)Specific Risk:1.4%Corporate BBB bonds: 9.00 @ 1.4% = 0.12General market risk: 0.6 x 1% x 5.18 = 0.031Total market risk = 0.031+ 0.12= 0.15Capital charge for Market risk =0.69+ 0.024 +0.015=0.73

Capital charge for operational risk:Average of preceding 3 years income x alpha 15%= 80.00 + 45.00 + 45.00= 170/3 = 56.66= 56.66 x 15% = 8.49

So total Capital charge = RWA for credit risk 199.50

Capital charge for Market risk 0.73Capital charge for operational Risk 8.49 9.22RWA for all Market risk & operational risk(Capital required for CAR to be 9%) = 9.22/0.09 = 102.44

So total RWA = 199.50 + 102.44 = 301.94

CRAR = Total Eligible Funds 39.15 RWA 301.94



CRAR = 12.96%

****END*****

We have taken some important issues (which we thought important from the point of examination) on Basel III for the preparation of this study material. The RBI circular has taken detail view on all items of bank balance sheet and hence we recommend you to look for that circular to have more insight on Basel III.



MULTIPLE OBJECTIVE QUESTIONS

The following multiple choice questions are for practice purpose, we don’t guarantee that these questions will appear in examination. The intention for providing these MCQ’s is a concept clearance and practice. WE also request you that these are available only for students of ISFA and not available for sharing to non ISFA students. Copying, reproducing or sharing on any media, social networking or any website is considered to be illegal.

Module A: International Banking(In study material we have given enough practice problems for this section and hence we are giving some more which we thought that is useful to you)

1. The current price of the specified future contract is a. spot price b. market price c. option price d. future price

2. The last trading day in case of foreign exchange future contract is ----- is prior to the final settlement date. a. one day b. three days c. four days d. two days

3. In case of forward contract the difference between sport rate and forward rate is called as ---- a. backward margin b. forward margin c. spot margin d. past margin

4. Rate applied for a foreign exchange transaction which involves immediate conversion of currency is known as (a) ready rate (b) forward rate (c) merchant rate (d) long rate

5. A quotation in which the home currency unit is the standard unit and the rate is expressed in variable units of foreign currency is called (a) direct rate (b) spot rate (c) indirect rate (d) forward rate

6. When conversion/exchange of currencies takes place at some future date at a rate of exchange agreed upon now, such a transaction is known as (a) spot transaction (b) cover transaction (c) cash transaction (d) forward transaction

7. The maxim applied in respect of Direct Quotation is (a) buy low, sell low (b) buy low, sell high (c) buy high, sell low (d) buy high, sell high

8. A rate of exchange established between any two currencies on the basis of the respective quotation of each currency in terms of a third currency is known as (a) cross rate (b) merchant rate (c) wash rate (d) composite rate

9. Payments for retirement of bills against imports into India must be received by (a) Directly by exporter (b) Directly by importer (c) Authorised Dealer (d) RBI

10. The rate quoted for issue of Drafts/TTs is (a) Bill Selling rate (b) Inter-Office rate (c) Forward rate (d) TT Selling rate

11. The rate applicable for an export bill tendered for negotiation is (a) bill buying rate (b) bill selling rate (c) composite rate (d) TT buying rate

12. The rate quoted for inward remittances by TT/DD, where the cover fund has already been credited to our Nostro a/c is (a) TT buying rate (b) DD buying rate (c) Inter-Office rate (d) Cross rate



13. The transactions of the Bank undertaken to sell the surplus and buy the required foreign currencies in order to keep its position ‘square’ are known as (a) cover operations (b) merchant transactions (c) exchange transactions (d) forward transactions

14. The rate quoted for clean instruments returned unpaid is (a) TT selling rate (b) DD buying rate (c) Inter-Office rate (d) TT buying rate

15. In case of loans/overdrafts against FCNR deposit the margin requirement should be calculated on the rupee equivalent at ______ rate. (a) TT selling rate (b) Bill selling rate (c) Others (d) Notional rate

16. Interest Rates on FCNR Deposit, withdrawn prematurely will be as follows : (a) At the contracted rate, without levy of penalty (b) Two percent below the rate applicable to the period the deposit remained with the Bank (c) One percent below the rate applicable for the period the deposit remained with the Bank. (d) At contracted rate, but subject to penalty, at the discretion of bank to recovery of swap cost.

17. The ceiling for repatriation of funds from NRE/FCNR accounts is : (a) Rs.25 lacs (b) $ 1 million (c) Rs.100 lacs (d) No ceiling

18. Loans/OD granted against FCNR/NRE TDRs/STDRs may be liquidated (a) by Indian rupee remittance (b) by Foreign inward remittance (c) by adjustment against TDR/STDR proceeds (d) by any method mentioned above

19. Mr. Kumar, officer of State Bank of India is posted as IBO to one of our Foreign Offices. Heleaves India on 1st April 2010. What will be his residential status? (a) Non-Resident (b) Resident (c) PIO (d) OCI

20. What would be the case, if Mr. Kumar proceeded abroad not because of a foreign posting but for medical treatment extending for a period of one year? (a) Non-Resident (b) Resident (c) PIO (d) OCI

21. Mr. Gerard, a German (of non-Indian Origin) sets up a proprietary concern in India during June 2012 for carrying on business. What will be his residential status for the financial Year 2012-2013? (a) Non-Resident (b) Resident (c) PIO (d) OCI

22. A foreign citizen of Indian origin who is having NRE STDR for Rs.20.00 lacs with you asks for a loan of Rs.12.00 lacs against STDR to buy a house (a) the loan can be granted. (b) the loan cannot be granted as the loan amount exceeds the limit of Rs.5.00 lacs (c) prior permission from controllers necessary (d) none of the above

23. Can NRE accounts be opened by power of attorney holders in India?a) Yes b)No

24. Can an FCNR deposit in one currency be converted to a deposit in another currency?a) Yes b)No

25. In which type of accounts of NRI, joint account can be opened with resident?: a. FCNR b. NRE c. NRO

26. In FCNR (B) exchange risk is borne by: a. Customer b. Banks

27. Number of days for Nostro and Vostro account credited (cooling period): a.10 days b. 7 days c. 5 days d. 15 days



28. Liberalised Remittance Scheme for Resident Individuals of USD 75,000 per financial year is permissible for a) Any permissible current or capital account transactions or a combination of both. b) Acquire and hold immovable property or any other assets outside India. c) Investment in Overseas Companies listed on a recognized stock exchange abroad. d) Gift and Donation. e) All the above.

29. When the foreign nationals employed in India maintain resident accounts with an Authorised Dealer Category - I (AD Category-I) bank in India, what should the bank do when such foreign national leave the country? a) The bank must close the resident accounts of such foreign national on their leaving the country and transfer their assets to their accounts maintained abroad. b) AD Category-I banks may, permit such foreign nationals to re-designate their resident account maintained in India as NRO account on leaving the country after their employment to enable them to receive their pending bonafide dues. c) The bank may continue the account as it is to enable them to receive their pending bonafide dues. d) None of these

30.From the following information for WBC bank’s nostro account, calculate the balance as on 30.09.2013, maintained at Singapore Bank Ltd. Mirror account has been maintained at WBC’s Singapore branch.

Balance as per mirror account (Dr), on 30.09.2013 $ 25,00,0000Debit for charges in mirror account not accounted $ 2,500Debit for Purchases unreconciled for nostro $ 12,50,000Interest collected in mirror account not accounted $ 3,000Export bill collected in nostro now reported by SBL $ 14,50,000

a. $25,00,500 b. $23,00,500 c. $ 23,03,500 d. $27,00,500

31. Permissible debits in EEFC account a) Advance payments to overseas suppliers under the merchanting trade transactions subject to compliance with the terms and conditions as applicable. b) Payment of freight on imports into India/exports from India by the account holder to shipping/airline companies or their agents operating in India. c) Payment of Customs duty in accordance with provisions of Exim Policy of Government of India. d) Payments to residents in India in consideration of supply of goods/services including payments for air fare and hotel expenditure. (The resident beneficiaries of foreign exchange in such cases will not be eligible for EEFC facility). e) All the above.

32. Mr. Kiran has taken up employment with DS corporation Pts London On 16th of May 1982. He got married with Kerry a UK resident in 1984. From them a son Joy took birth in 1986. Mr Kiran took divorce from Kerry in year 1990. Mr Joy has done an MBA and wants to settle in India. He wants to open up a bank account in joint with his mother. whether he can open an account? Which account he can open? a. No he cannot open any account b. He can open FCNR & NRE only c. He can open NRO account only d. He can open NRE account only

33. In a LC transaction, which Bank is authorized to honour the payment claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating bank? (a) Reimbursing Bank (b) Opening Bank (c) Advising Bank (d) Foreign Bank

34. In documentary credit transactions



(a) all parties deal with documents and not goods (b) all parties deal in documents and goods as well (c) buyer and seller deal in goods and banks in documents (d) all parties deal in goods only

35. When the Advising Bank, at the request of the issuing Bank, adds its confirmation which would constitute a definite undertaking by the former the L/C is known as a / an (a) Irrevocable L/C (b) Transferable L/C (c) Confirmed L/C (d) Revolving L/C

36. An irrevocable LC which authorises the advising bank to extend preshipment /packing credit upto a certain amount to the beneficiary to enable him to meet preshipment expenses is known as a / an (a) Irrevocable LC (b) Transferable LC (c) Revolving LC (d) Red Clause LC

37. All demand bills in foreign currency drawn under and import LC will be crystalised into Rupee liability on ____th day from the date of receipt of document. (a) 10 (b) 7 (c) 15 (d) 30

38. If on an LC alongwith date of shipment “on or about” is written, shipment can be made up to what time?: a. 5 days before or 5 days after the date mentioned in LCb. 2 days before or 2 days after the date mentioned in LCc. 15 days before or 15 days after the date mentioned in LCd. At the time given on Bill of Lading

39. Post-shipment finance can be provided upto how much value of the goods covered? (a) 75 % (b) 50 % (c) 100 % (d) 30 %

40. How many days are allowed to issuing bank and negotiating bank for checking that documents as per LC? a. 5 banking days b. 4 working days c. 10 working days d. 15 banking days

41. Insurance document for Import letter of credits should be opened _____: a.100% of FOB b. 110 % of CIF value c. 100% of CIF d. Value given by customer

42. A bank financed an exporter by discounted foreign bills but, customers did not pay amount on due date. Bank wanted reverse the transaction. What rate bank will apply? a) TT selling b) TT buying c) Bill selling rate d) Bills buying rate e) Bank rate

43. A customer is a need of export finance for his export order worth $ 2 million CIF. The insurance is of 2% of FOB and freight is $ 3,000. How much amount you will give to your customer as packing credit, if the bank margin is 15%.a. $16,64,116 b. $17,00,000 c. $16,63,450 d. None of these

44. A customer has approached you for finance against his retention in export contract. The export order was of $ 1 million ( retention of 20%) and its turnkey project where in 25% amount is for services. How much amount you will sanction to your customer.a. Max of $ 1 million b. Max of 0.75 million c. Max of 0.20 million d. Max of 0.15 million

45. Post Shipment export credit can be liquidated a) Out of balances held in EEFC account b) Proceeds of any other un-financed export bill c) Proceeds of the export bill received d) Rupee resources, when the export bill is overdue for payment e) All the above.

46. Delinking (Crystallisation) of Export bills should be done a) Sight bills remaining unpaid beyond 15 days from the expiry of normal transit period and usance bills remaining unpaid beyond a period of 15 days from the due date should be delinked.



b) Sight bills remaining unpaid beyond 30 days from the expiry of normal transit period and usance bills remaining unpaid beyond a period of 30 days from the due date should be delinked. c) Sight bills remaining unpaid beyond 21 days from the expiry of normal transit period and usance bills remaining unpaid beyond a period of 21 days from the due date should be delinked. d) AD is free to decide the period based on risk perception of the exporter.

47. A customer of your bank has approached you for export bill discounted on 16th July 2013 against a bill of £0.2 million. You have discounted it for £ 0.19 million with a maturity on 18th sept 2013. On 18th sept the bill got dishonoured. The rate on that day was £= Rs 84.221/.228. How much will be the amount to be recovered from customer for such dishonor, if charges for dishonor is 0.025% and RBI interest rate is 8% p.a.a.Rs.1,62,34,020 b.1,62,29,963 c. Rs.1,62,35,313 d. $ 1,62,31,369

48. You are a dealer and the following is your position in $ with NSB Bank of Newyork. Find out the balance in Nostro account.

Opening balance 30,000Opening position (short) 8,000Purchased a TT 2,25,000Issued a travelers cheque 15,000Purchased and export bill payable at Washington 1,00,000Forward sales 3,00,000Export bill realized 2,50,000closing position (overbought) 35,000

a. $ 3,25,000 b.$ 3,60,000 c. $ 3,33,000 d. $4,90,000

49.M/s. Gary International offers your Pune branch a sight bill for USD 258000 on 28.01.2016drawn under a letter of credit established by Amas Bank, Geneva. Assuming the following, what INR amount will you credit exporters account?Interbank USD = Rs. 63.5850/60 Transit period 10 days. Interest Rate 11% Exchange Margin 0.15% Exporter being valuable client 0.50 Ps for Rs.100 better rate.a. Rs.1,63,40,309 b. Rs.1,64,28,063 c. 1,63,80,003 d. Rs. 1,63,17,550 e.Rs. 1,63,43,270

50. Mr. Jayesh Arya bought a Life Insurance Policy GBP 20,000 for 12 years on January 2003, while in service at London. On his return to Pune he requests your Pune branch to remit GBP 891 towards annual premium payment due value date 02.02.2013. Whether Mr. Jaya’s request can be accepted under FEMA 1999? a. Yes b. No.

51.LC says "Shipment must be made in two lots. 2nd shipment must be made within 30 days after the first shipment." If the first shipment is made on 1st January, which of the following is correct?*a. 2nd shipment must be made on 30th January b. 2nd shipment must be made on 31st January c. Latest date for 2nd shipment is 30th January d. Latest date for 2nd shipment is 31st January

52. A Letter of Credit was issued in favor of SM International on 12th December 2007. The LC shows the latest shipment date as "on or before 15th January". Which of the following is the shipment date under this LC?a. 10th to 20th January b. 11th to 19th January c. Anytime before 15th January* d. None of these

53. The issuing bank wants to cancel a letter of credit before it has been advised to the beneficiary by the advising bank. What is the option available to the issuing bank? a. The issuing bank may cancel the LC anytime b. The issuing bank must obtain the consent of the beneficiary*[ Correct Answer ]c. The issuing bank must recall the LC from the advising bank d. The issuing bank should seek permission from the advising bank



54. If the CIF or CIP value cannot be determined from the documents, a nominated bank will accept an insurance document, which covers: 1. 110% of the gross amount of the invoice. 2. 100% of the gross amount of the invoice. 3. 110% of the documentary credit amount. 4. 110% of the amount for which payment, acceptance or negotiation is requested under the credit. a. 1 and 3 only b. 2 and 4 only c. 1, 2 and 4 only d. 1, 3 and 4 only

55. We issued the L/C as follows: L/C expired: Dec 27, 2012 at beneficiary’s countryLatest shipment date: Dec 06, 2012Period of presentation: documents to be presented within 21 days after date of shipment but withinthe validity of credit, state documents acceptable. Which of the following is acceptable?a. B/L on board date: Dec 01, 2012, all documents presented on Dec 25, 2012 b. B/L on board date: Dec 01, 2012, all documents presented on Dec 31, 2012 c. B/L on board date: Dec 10, 2012, all documents presented on Dec 25, 2012 d. B/L on board date: Dec 01, 2012, all documents presented on Dec 15, 2012

Module B: Risk management1. Which of the following statements are true?a. A bank’s assets are its sources of funds. b. A bank’s liabilities are its uses of funds.c. A bank’s balance sheet shows that total assets equal total liabilities plus equity capital.d. Each of the above.

2. When Rs. 1 million is deposited at a bank, the required reserves ratio is 20 percent (SLR), andthe bank chooses not to hold any reserves but makes loans instead, then, in the bank’s finalbalance sheet,a. the assets at the bank increase by Rs.200,000 b. the liabilities of the bank increase by Rs.200,000c. SLR reserves increase by Rs. 200,000.d. each of the above occurs.

3. If a bank has Rs.1 million of deposits, a required reserve ratio of 20 percent, and Rs.300,000 in reserves, it need not rearrange its balance sheet if there is a deposit outflow ofa. Rs.50,000 b. Rs.75,000 c. Rs.150,000 d. either (A) or (B) of the above.

4. If a bank has Rs.100,000 of deposits, a required reserve ratio of 25 percent, and Rs.50,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet isa. Rs.30,000 b. Rs.25,000 c. Rs.20,000 d. Rs.10,000

5. In the process of A.L.M., price matching is used to assess whether an institution is in a position to benefit by raising interest rates through "Positive Gap". Positive Gap means:a. Assets more than liabilities. b. Liabilities more than assets. c. Either a or bd. None of the above

6. Risk of having to compensate for non-receipt of expected cash flows by a Bank is called……..a. Call risk b. Funding risk c. Time risk d .Credit risk

7. In the raising interest rate scenario, a prudent and aggressive banker would follow the following strategy……a. Reprice assets more frequently b. Reprice liabilities more frequentlyc. Match assets and liabilities closely d. All of the above

8. Certain risks in banking business are managed at transaction level and aggregate level; whereas few risks are managed at aggregate level only. Identify the risks managed at aggregate level only?a. Credit risk b. Operational risk c. Market risk d. Liquidity risk



9. As per principle of credit pricing based on credit rating, a borrower rated B shall be charged more interest compared to another borrower rated A is due to:a. Regulatory requirement. b. Industry practice. c. Higher probability of default.d. All of the above.

10.The probability of a company entering bankruptcy within next 12 months period is measured by the following technique……a. Credit metrics b. Credit risks c. Credit maps d. All man's Z score

11. Risk arising out of mismatch in maturity payment in assets and liability is known as…….a. Credit b. Operational transactions c. Liquidity d. None of the above.

12. The parameters that are important in ALM are:a. NIM b. Net Interest Income c. Economic Equity Ratio d. All of the above

13. Liquidity is ensured by grouping assets and liabilities based on their…..a. Pricing b. Maturity c. Risk Weight d. None of the above

14. The liquidity of the Bank is determined by:a. Ability to accommodate decrease in liabilities b. Abilities to fund increase in assetsc. Converting assets to cash quickly and at good costs d. All of the above

15. Price of liquidity is determined by……a. Market conditions b. Nature of convertible assets on handc. Market perception of risks d. All of the above

16. Ratio of liquid assets to total assets is one of the nine ratios used in……a. Flow approach b. Stock approach c. Balance Sheet analysis d. All of the above

17. ‘HLM Bank’ is encouraging its home loan borrowers to shift to a floating rate option. We can conclude that the bank is:a. Trying to maximize interest income from home loans.b. Expecting home loan rates to go down in near future.c. Trying to imitate the international best practices in interest rates.d. Reduce asset sensitivity to interest rates in home loan segment.

18. Which of the following is correct? Collateral is that element of a credit assessment which deals with: a. the security available when credit is extended. b. the knock-on effects that credit problems have with the lender. c. the increased rate applied to a loan to reflect credit quality. d. none of the above.

19. What is meant by ‘concentration risk’ in the context of credit risk management? a. The risk that a large number of counterparties default at the same time.b. The risk that a large number of counterparties share common risk characteristics. c. There is a strong positive correlation in the historical behaviour of credit-sensitive assets in a portfolio. d. All of a, b, and c.

20. A bank that specializes in granting loans to firms in a specific line of business: a. May decrease its operating cost and decrease its credit risk. b. May increase both its operating cost and its credit risk. c. May increase its operating cost and decrease its credit risk. d. May decrease its operating costs and increase its credit risk.



21. The fact that a bank's assets tend to be long-term while its liabilities are short term creates: a. Interest rate risk. b. Credit risk. c. Lower risk for the bank, this is why they follow this strategy. d. Trading risk.

22. The fact that a bank's assets tend to be long-term while its liabilities are short term creates the following situation when interest rates rise? a. The value of assets increases by more than the value of liabilities. b. The value of assets will decrease by more than the value of liabilities. c. The value of assets increases and the value of liabilities decreases. d. The value of assets decreases and the value of liabilities increases.

23. What are the basic parameters required for stabilising ALM of Banks? a. Net Interest Income b. Net Interest Margin c. Economic Equity Ratio d. All these

24. What are the features of Net Interest Income? a. It is a tool for measuring the impact of volatility on the short term profit. b. This indicates difference between interest income and interest c. Short term profits can be stabilised by minimising fluctuations in Net Interest Income. d. All the above.

25. The Net Interest Margin signifies: a. It is the result of Net Interest Income divided by average total Assets. b. It can be viewed as spread on earning Assets. c. The higher the spread. more will be the Net Interest Margin. d. All the above.

26.Which of the following combinations is important to meet funding needs of a Bank? a. Increase short term Borrowings. b. Minimise holding of less liquid Assets. c. Increase Capital Funds. d. All the above.

27. The extent of cumulative cash flow mismatches could be arrived as under a. Taking a conservative view of marketability of liquid Assets. b. Provision for discount to cover price volatility c. Expected outflows as a result of draw down of commitments. d. All the above.

28. A limit can be fixed for the following for managing liquidity Risk: a. Extent of dependence on individual customer. b. Flexible limits on average maturity of different liabilities. c. Minimum liquidity provision. d. Any or all of the above.

29. For every Rs.100 in assets, a bank has Rs.40 in interest rate sensitive assets, and the other Rs.60 in non-interest rate sensitive assets. The same bank has Rs.50 for every Rs.100 in liabilities in interest sensitive liabilities, the other Rs.50 are in liabilities that are not interest rate sensitive. If the interest rate on assets increases from 5 to 6 percent, and the interest rate on liabilities increases from 3 to 4, percent the impact on the bank's profits per Rs.100 of assets will be: a. An increase of Rs.0.10 b. A decrease of Rs.0.10 c. A reduction of Rs.1.00 d. Constant since the interest rates on assets and liabilities increased by the same amount.

30. A bank that makes most of its long term loans at adjustable interest rates is: a. Reducing both interest rate and credit risk. b. Increasing credit risk and reducing interest rate risk. c. Reducing credit risk and increasing interest rate risk. d. Increasing both interest rate and credit risk.



31. From the following information calculate the effect on NIM of the bank if the rate of interest has changed in upward direction to the extent of 50 bps. (Rs. in Cr)

Deposit – demand 30.00 Investment – Non SLR-HTM 10.00Deposit – term Borrowing from RBI- Repo

25.005.00

Advances – fixed Advances – floating

30.0020.00

Borrowing in call market 2.00 Cash in hand 5.00

a. Decrease by 0.05 cr b. Increase by 0.05cr c. Decrease by 0.27 cr d. Increase by 0.27cr

32. From the following one of the event is a credit event for credit default swap.a. restructuring of advance b. payment of advance in full c. take over by other bankd. none of these

33. The seller of protection incase of CDS is going ______ risk.a. short b. narrow c. long d. near

34. The settlement of CDS in which protection by a delivers wants of reference entity is called as a. cash settlement b. credit settlement c. default settlement d. physical settlement

35. On occurrence of a credit event the protection seller shall pay difference between nominal value of the reference obligation and its market value at the time of credit event is called as a. cash settlement b. credit settlement c. default settlement d. physical settlement

36. From the following information calculate operational risk.Profit for last two years Year 1 Rs 300 cr, Year 2 Rs 380 cr. the bank has provided provisions for unpaid interest in the year 2 Rs 30 cr. In year 1 the bank has sold out certain securities in the banking book and booked the profit of Rs 10 cr. a. Rs.30cr b. Rs.49.50cr c. Rs.33.99cr d. Rs.52.50cr

37. In the following activities one activities is not to be considered under standardize approach for measurement of operational risk.a. corporate finance b. retail banking c. asset management d. non fund based finance.

38. In case of money market operation fourteen day treasury bill will be auction on every ______ week.a. Thursday b. Friday c. Monday d. Tuesday

39. A late night news report says the President of a local bank is about to be arrested for embezzling money from the bank he works at. This causes most of the depositors to line up in front of the bank the next morning wanting to withdraw their deposits. This is an example of: a. Liquidity risk b. Operational risk c. Interest rate risk d. Credit risk

40. If Bank A sells some its loans to Bank B for cash, everything else equal: a. Bank A's assets decrease and Bank B's assets increase. b. Bank A becomes less liquid while Bank B becomes more liquid. c. Banks A' total assets do not change, but Bank A is more liquid. d. Bank A's liabilities decrease by the amount of the loans that are sold.

41. Which of the following statement is incorrect regarding credit default swaps?a. A CDS is in effect an insurance policy on the default risk of a corporate bond.b. CDS were designed to allow lenders to buy protection against losses on sizable loans.c. CDS are designed to transfer the credit exposure of variable income products between parties.d. The swap buyer pays an annual premium to the swap seller in exchange, receives a payoff if a credit instrument goes into default.



42. Which of the following procedures is essential in validating the VaR estimates.a. Back Testing b. Scenario Analysis c. Stress Testing d. Once approved by regulators no further validation is required.

43. A Bank reports a one-week VaR of $1M at the 95% confidence level. Which of the following statements is most likely to be true?a. The daily return on the company portfolio follows a normal distribution so that a one-week VaR could be computed.b. The one week VaR at the 99% confidence level is $5Mc. With probability 95%, the company will not experience a loss greater than $95M in one week.d. With probability 5%, the company will loose $1M or more in one week.

44. If the default probability for an “A”-rated company over a three year period is 0.30%, then the most likely probability of default for the same company over a six year period is:a. 0.30% b. Between 0.30% and 0.60% c. 0.60% d. Greater than 0.60%

45. Counter party risk is embedded mainly in………a. Forex transactions b. Credit transactions c. Liquidity management systemsd. All of the above

46. A dealer has a $200 million open position. He finds that his VaR for a one day period with a one percent probability is $1000,000. Which of the following is true?a) This means that the dealer can expect to lose at least $1000,000 in any given day about one percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days). b)This means that the dealer can expect to lose at least $1000,000 in any given day about 99 percent of the time, or in other words, 247.5 times in a year (assuming 250 trading days).c) This means that the dealer can expect to lose at least $2,000,000 in any given day about one percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days). d)This means that the dealer can expect to lose at least $ 4000,000 in any given day about one percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days).

47. Under standardized approach for measurement of operational risk, beta factor for retail banking is…..a.12% b.15% c.18% d.20%

48. 3. Answer the following questions based on RBI circular on Liquidity management using the following information: Capital — Rs.1540cr, Reserves — Rs.9800cr, Current account — Rs.1870cr, Saving Bank—Rs.5620cr, Term deposits1 month maturity bucket — Rs. 600cr, 1 to less than 3months maturity bucket Rs. 900cr, 3 months to less than 6months maturity bucket — Rs. 1400cr, 6 months to less than 12 maturity bucket Rs. 2400cr, 1year to less than 3 years maturity bucket—Rs.1800cr,3 years to less than 5 years maturity bucket—Rs.700cr and above 5 years maturity bucket—Rs.950 cr.Borrowing from RBI—Rs.600cr. 1. What is the amount of current account deposit that can be placed in 14 days bucket:a) Rs. 187 cr b) Rs. 280 cr c) Rs. 374 cr d) None

2. What is the amount of saving bank deposit that can be placed in 14 days bucket: a) Rs. 843 cr b) Rs. 1124 cr c) Rs. 562 cr d) Rs. 281 cr

3. What is the amount of current account deposit that can be placed in 1-3 years bucket: a) Rs. 1590 cr b) Rs. 1683 cr c) Rs. 1496 cr d) Rs. 900 cr



4. What is the total of amount of term deposit that will be placed in various maturity buckets up to less than 12 months;a) Rs. 1500 cr b) Rs. 2900 cr c) Rs. 5300 cr d) Rs. 2400 cr

Module C: Treasury1. A swap transaction involves a) purchase of currency b) sale of currency c) purchase of currency against sale or forward sale of the currency. d) simultaneous purchase and sale of one currency against another for different settlement dates.

2. If you purchase a Rs.100,000 interest-rate futures contract for 105, and the price of the Treasury securities on the expiration date is 108 a) your profit is Rs.3000. b) your loss is Rs.3000. c) your profit is Rs.8000. d) your loss is Rs.8000. e) your profit is Rs.5000.

3. If you sell a Rs.100,000 interest-rate futures contract for 110, and the price of the Treasury securities on the expiration date is 106 a) your profit is Rs.4000. b) your loss is Rs.4000. c) your profit is Rs.6000. d) your loss is Rs.6000. e) your profit is Rs.10,000.

4. To hedge the interest rate risk on Rs. 4 million of Treasury bonds with Rs.100,000 futures contracts, you would need to purchase a) 4 contracts. b) 20 contracts. c) 25 contracts. d) 40 contracts. e) 400 contracts.

5. The number of futures contracts outstanding is called a) liquidity. b) volume. c) float. d) open interest. e) turnover.

6. If a bank manager wants to protect the bank against losses that would be incurred on its portfolio of treasury securities should interest rates rise, he could a) buy put options on financial futures. b) buy call options on financial futures. c) sell put options on financial futures. d) sell call options on financial futures.

7. A swap that involves the exchange of a set of payments in one currency for a set of payments in another currency is ana) interest rate swap. b) currency swap. c) swap options. d) national swap.

8. If Second National Bank has more rate-sensitive assets than rate-sensitive liabilities, it can reduce interest rate risk with a swap that requires Second National to a) pay fixed rate while receiving floating rate. b) receive fixed rate while paying floating rate. c) both receive and pay fixed rate. d) both receive and pay floating rate.

9. If the RBI announces that it has done repos of Rs. 3000 crore, what does this imply? a. RBI has lent securities worth Rs. 3000 crore through the repo markets to the participants. b. RBI has reversed the repo deals of participants who entered into a repo with RBI. c. RBI has inducted funds amounting to Rs. 3000 crores into the market. d. RBI has borrowed securities from the banking system, and lent them onward in the repo markets.

10. A 3-day repo is entered into on July 10, 2013, on an 11.99% 2022 security, maturing on April 7, 2022. The face value of the transaction is Rs. 3,00,00,000. The price of the security is Rs. 116.42. If the repo rate is 7%,



I. What is the settlement amount on July 10, 2013 (transaction value for repo)? Consider Face value of security Rs.100/- & number of days from last coupon is 93 days.a. Rs. 3,58,55,225 b. Rs.3,00,17,500 c. Rs.3,00,03,331 d. Rs.3,49,29,331

II. What is the amount to be settled against borrowing in repo?a. Rs.3,00,17,260 b. Rs. 3,58,75,854 c. Rs.3,00,59,128 d. None of these

11. A bank has having following figures in 1- 3 months bucket. You are required to calculate impact on NII if interest rates goes up by 0.50%. Total liabilities Rs 3123 cr, Total assets Rs 2106cr.a. + 5.08 cr b. - 4.16cr c. – 5.08cr d. + 4.16 cr

12. With regard to a swap bank acting as a dealer in swap transactions, interest rate risk refers toa. The risk that arises from the situation in which the floating-rates of the two counterparties are not pegged to the same index.b. The risk that interest rates changing unfavorably before the swap bank can lay off to an opposing counterparty on the other side of an interest rate swap entered into with the first counterparty.c. The risk the swap bank faces from fluctuating exchange rates during the time it takes for the bank to lay off a swap it undertakes with one counterparty with an opposing transaction.d. The risk that a counterparty will default.

13. Use the following information to calculate the quality spread differential (QSD):Fixed Rate Borrowing cost

Floating rate borrowing cost

Company X 10% LIBORCompany Y 12% LIBOR + 1.5%

a. 0.50% b. 1.00% c. 1.50% d. 2.00%

14. The term interest rate swapa. refers to a "single-currency interest rate swap" shortened to "interest rate swap"b. involves "counterparties" who make a contractual agreement to exchange cash flows at periodic intervalsc. can be "fixed-for-floating rate" or "fixed-for-fixed rate"d. All of the above

15. Which of the following is an agreement to exchange two currencies on one date and to reversethe transaction at a future date?a. Interest rate swap b. Foreign currency swap c. Total return swap d. Credit default swap

16. What will be the impact on EVE if interest rates goes up by 1% a. increase b. decrease c. no change d. decreases by 1%

17. In case of interest rate future contract the underlined bond is ------a. notional 10 yr 7% bond b. 7% bond 5 yrs maturity c. 7.5% bond for more than 15 yr maturity d. none of these

18. The minimum lots size for interest rate future is a. 100 bonds b. 200 bonds c. 1,000 bonds d.2,000 bonds

19. The last trading day incase of IRF is ------ before the expiry date.a. 2 business days b. 3 business days c.1 business days d. 4 business days.

20. The final settlement in case of IRF involves ----- of the bond. a. cash settlement b. physical delivery c. non-delivery d. difference between sell and by price



21. Which of the following is not a characteristic of money market instruments?a. short-term to maturity b. small denomination c. low default risk d. high marketability

22. Which of the following market securities is usually not found on a commercial bank’s balance sheet? a. commercial paper b. treasury bills c. certificate of deposit d. banker’s acceptance

23. Banks invest in government securities for a variety of reasons except:a. income b. safety c. acceptable for collateral d. high relative yield

24. The bank discount rate (ask) on a 91-day T-bill is 5.35%. What is the price of the Rs.1000 T-bill?a. Rs.976.40 b. Rs.986.48 c. Rs.981.20 d. Rs.989.45

25. In a portfolio of a bank, Bond A has duration of 5.6 while bond B has duration of 6.0. Bond B:a. will have greater price variability, given a change in interest rates, relative to bond Ab. will have a shorter maturity than bond Ac. will have a higher coupon rate than bond Ad. will have less price variability, given a change in interest rates, relative to bond A

26. Interest rate risk isa. durationb. the extent that coupon rates vary with timec. the potential variability in the realized rate of return caused by a change in market interest ratesd. the potential variability in the realized rate of return caused by a changing discount rates.

27. Balance Sheet for Hamara Bank is as follows:Assets Yield Liabilities Cost

Rate sensitive Rs. 500 8.0% Rs. 600 4.0%Fixed rate Rs. 350 11.0% Rs. 220 6.0%Non earning Rs. 150 Rs. 100

Rs. 920 EquityRs. 80

Total Rs. 1,000 Rs. 1,000

I. Calculate NII from ita. -41.3 b. 41.3 c. 35.30 d. 68.80

II. How much is the NIMa. 4.13% b. 4.48% c. 5.03% d. 4.86%

III. Calculate the GAPa. -100 b. 100 c. 80 d. -20

IV. What is the effect on NIM if the spread is decrease by 1%a. NIM increases b. NIM decreases c. NIM remains the same in % points

V. If the all assets and liabilities has been doubled what is effect on NIMa. NIM will increase by 100% b. NIM decreases by 100% c. NIM remains the same in % points d. NIM will increase/decrease according to gap

VI. RSAs increase to Rs.540, while fixed-rate assets decrease to Rs.310 and RSLs decrease to Rs.560 while fixed-rate liabilities increase to Rs.260, what is the effect on gap & NIIa. Gap increase, NII lower b. Gap Decrease, NII higher c. Both decreases d. Both increases



28. To Reduce asset sensitivity, what the bank is required to do:a. Shorten loan maturities b. Make more loans on a floating-rate basisc. Move from floating-rate loans to term loans d. Increase the non fund based loans

29. To Increase liability sensitivity, what the bank is required to do:a. Issue long-term subordinated debt b. Shorten loan maturitiesc. Reduce the short term deposit rate d. Increase short-term deposit rates

30. Excel Bank enters into an Interest rate swap with ABC Ltd on the following terms:

Principal Amount Rs. 100crores

Corporate to Pay 6.50% Fixed

Corporate to Receive 3 month NSE MIBOR

Start date 25-4-12

Tenor 6 months

Termination date 25-10-12

Interest Payment Dates 25th July & 25th Oct

First Fixing 6.10%

In the above case, which of the following is correct in respect of net interest amount payable/receivable on 25th July 2012? a. ABC Ltd to pay Rs.986301 b. ABC Ltd to receive Rs.986301 c. ABC Ltd to pay Rs. 1972602 d. ABC Ltd to receive Rs.1972602

31. General Ledger Balance of Modern Bank as on 12-10-2012 Rs. In 000’s

Liabilities Rs Assets Rs

Paid up capital 10,000 Building 10,000

Current Account 180,000 Car 20,000

SB 450,000 Cash Credit 10,00,000

Fixed Deposit 600,000 Term Loan 8,00,000

Interest accrued 10,000

Margin on LCs 2,000 Suspense Account 10,000

TT Payable 1,000 Branch Adjustment Account 20,000

CBLO(Colaterised Borrowing & Lending Obligations)

600,000

ECGC Claims 7,000

Total 18,60,000 Total 18,60,000

1. Demand Liabilities in the above case works out to ……………a. 632000 b. 638000 c. 1238000 d. None of the above

2. Time Liabilities is equal to ………………………..a. 120000 b. 600000 c. 127000 d. None of the above

3. Which of the following can be included for DTL/NDTL computation



a. Amount received from DICGC Claims b. Amount received from Insurance company on ad hoc settlement of claimsc. Amount received from the court receiverd. Amount held as margin against LC

4. Other demand and time Liabilities amounts to ……………………a. 10000 b.17000 c. 18000 d. None of the above

32. Which set of the following statements is true in respect of Commercial Paper (CP): 1, Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note 2. CP can be issued by Corporate, primary dealers (PDs) and the all-India financial institutions (FIs) 3. A corporate would be eligible to issue CP provided the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs.4 crore; 4. The minimum credit rating shall be P-1 of CRISIL or such equivalent rating by other agencies. 5. CP can be issued for maturities between a minimum of 7 days and a maximum up to six months from the date of issue. 6. Amount invested by a single investor should not be less than Rs.15 lakh .

a.1,2 & 4 b.1,2 & 3 c.1,4 & 5 d.1,4 & 6

33. The issuer of loans pooled and securitized is often:a. A Liquidity enhancement b. A Credit Enhancement c. A Trusteed. A credit rating agency

Module D: Bank Balancesheet & Basel1. Examples of off-balance-sheet activities includea. loan sales b. foreign exchange market transactions c. trading in financial futuresd. all of the above e. only A) and B) of the above.

2. If a bank sells off all of its assets and pays all of its liabilities, the amount remaining would be: A) Net profit. B) Reserves. C) Net worth. D) Excess reserves.

3. A bank's loan loss reserves are: a. The amount of loans that have defaulted in the past twelve months. b. The same as equity capital. c. An amount the bank sets aside to cover potential losses from defaulted loans. d. A liability of the bank since it is a source of funds.

4. For a bank, off balance sheet activities usually: a. Increase both assets and liabilities while reducing net income. b. Increase net income but do not change assets or liabilities. c. Increases a bank's liabilities but not their assets. d. Income earned from activities not associated with banking.

5. Acceptances, endorsements and guarantees are shown as-----a. other assets b. contingent liabilities c. advances d. other liabilities and provisions

6. Choose the wrong pair from the following. The information given in the pair is pertaining to banking companiesa. Reserves & surplus - Share premium b. Time deposits - Matured time depositsc. Borrowings in India - Refinance from NABARD d. Other Liabilities & Provisions - Inter office/branch adjustments(net)



7. Choose the wrong pair from the following. The information given in the pair is pertaining to banking companiesa. Demand Deposits - Compulsory deposits under excise rules b. rebate on bills discounted - unexpired discountc. Operating Expenses Schedule 14d. Other Income - Profit on sale of investments less loss on sale of investments

8. Account when becomes NPA, if principal and interest not serviced beyond 90 days from which date: a. From end of month in which it become NPAb. From the date of application during defaulting quarterc. From 91st day of becoming NPAd. None of these

9. If an account is doubtful for more than 3 years what is percentage of provision on secured portion? a. 40% on secured & 100% on unsecured b. 25% on secured & 100% on unsecuredc. 100% Provision both on secured and unsecured. d. 15% on secured & 100% on unsecured

10. “Prudential Write Off” meansa) An NPA account which is written off at H.O level even though the account is outstanding in the book of the bank. However the required provision as per the classification should have been made. b) A fully provided account written off at branch level but maintained at H.O. c) An N.P.A. account transferred to A.R.M. Branch d) None of the above.

11. The provision on Standard Asset is kept in the Balance Sheet as part of: a. Schedule 11 advances b. Deduct from Sch. 13 other assetsc. Deduct from Sch. 4 Deposit d. Other liability and provision.

12. From the following information calculate Net NPA:NPAs Gross : Opening balance 3,152.50 Additions during the year 3,443.31 Reductions during the year 2,131.06Movement of provisions for NPAs excluding provisions on standard assets:Opening balance 2,361.62Provisions made during the year 1,836.42Write-off/ write-back of excess provisions 1,276.93

a.3905.26 b. 1,543.64 c.6,266.88 d.2628.33

13. Upon restricting of any NPA account it will be classified as a. Standard assets b. Doubtful asset c. Sub-standard asset d. loss assets

14. X Co. is consortium account. No credits came to account for last 90 days. But party remitted the money to consortium leader SBI in time, who in turns not shared with member bank.a. Account will be NPA treating as non served in the books of this Bank.b. Account will be PA as money received by SBI leader of consortium.c. None of above. d. Both of above.

15. Given loan by your Bank against Govt Guarantee to Govt company. Loan is over due for more than 90 days.:a. Will be treated as NPA. b. Will be treated as NPA only if guaranteed is invoked and guarantee is not honoured.c. Both are true. d. None are true.



16. Interest on above loan to Govt company can be taken to incomea. No, as such exemption is not for recognition of income. b. Yes can be taken to incomec. None

17. State Govt guaranteed loans and investment in State Govt guaranteed bonds will a. Attract loan provisions and asset classification if over due for 90 daysb. Only loan provisioning required c. Only asset classification requiredd. No need to classify as NPA

18. In a account 6 months moratorium is given.a. Account will become NPA only if moratorium is over.b. It will attract NPA provisions even before moratorium for interest servicing.c. None of above.

19. Provision on standard assets:a. 0.25% b. 0.25% for SME and agricultural advances and .40% for others.c. 0.40 for all d. None of above.

20. Erosion in security value to 50% or more and it was sanctioned just 3 months back:a. Classify account as SA b. Classify account as SSAc. Classify account as DA d. Classify account as LA

21. Erosion in security value leaving value at 10% or less.a. Classify account as SA b. Classify account as SSAc. Classify account as DA d. Classify account as LA

22. In a CC account the stock statement is not submitted for last 3 months and DP is allowed against old stock statement:a. Account will be NPA now.b. Account will be NPA if drawings are permitted in such account for 90 days based on such old stock statement.c. None of above. d. Both are true.

23. If any advance including bill purchased and discounted becomes NPA as at the end of any quarter/half year/year, interest accrued and credited to income account in the previous periods if not realized:a. Need not be reversed b. To be reversed c. None of above d. Both of the above

24. From the following information find out the amount of provisions required to be made in the Profit & Loss Account of a commercial bank for the year ended 31st March, 2015:Packing credit outstanding from Food Processors Rs 60 lakhs against which the bank holds securities worth Rs 15 lakhs. 40% of the above advance is covered by ECGC. The above advances has remained doubtful more than 3 years.Other advances:

Asset classification Rs in lakhsstandard 3,000Sub-standard (Secured 75%) 2,200Doubtful (Full secured)For one year 900For two year 600For three years 400For more than 3 years 300Loss assets than 600

a. 45 lakhs & 1997.50lakhs b. 51 lakhs & 1765lakhs c. 60 lakhs & 1997.50



d. 42 lakhs & 2162 lakhs

25. Bidisha Bank ltd. had extended the following credit lines to a Small & Micro Industry which had not paid any interest since March, 2009. How much provision is required for 31.03.2015.

Term Loan Export CreditBalance outstanding on 31.3.2015

Rs 70 lakhs Rs 60 lakhs

CGTMS/ECGC cover 50% 40%Securities held Rs 30 lakhs Rs 25 lakhRealisable value of securities Rs 20 lakhs Rs 15 lakhs

a. TL 40 lakhs & EC 35 lakhs b. TL 35 lakhs & EC 36 lakhs c. TL 15 & EC 21 lakhs d. TL 45 lakhs & EC 42 lakh

26. From the following information, compute the amount of provisions to be made in the Profit and Loss Account of a Commercial bank:

Assets Rs in lakhsStandard (Value of security Rs 6,000 lakhs) 7,000Sub-standard 3,000doubtfula. Doubtful for less than one year (realizable value of security Rs 500 lakhs) 1,000b. Doubtful for more than one year, but less than 3 years (Realisable value of security Rs 300 lakhs)

500

c. Doubtful for more than 3 years (No security) 300a. 1319 lakhs b. 898 lakhs c. 1478 lakhs d. 2023 lakhs

27 Find out the income to be recongnised at Good Bank Limited for the year ended 31.3.2013 in respect of Interest on advances ( Rs in lakhs) as detailed below:-

Performing Assets NPAInterest Interestearned received

Interest Interest earned received

Term loan 240 160 150 10

Cash credits and overdraft 1500 1240 300 24

Bills purchased and discounted 300 300 100 40

a. Intt on TL 240, Intt on CC & OD 1500, Intt on Bill Purch.& disc. 300b. Intt on TL 160, Intt on CC & OD 1240, Intt on Bill Purch.& disc. 300c. Intt on TL 250, Intt on CC & OD 1524, Intt on Bill Purch.& disc. 340d. Intt on TL 310, Intt on CC & OD 1540, Intt on Bill Purch.& disc. 400

28.From the following details, what will be the closing balance for collection Account: On 1.4.2012, Bills for collection were 51,00,000During the year 2012-13 Bills received for collection amounted to 75,00,000Bill collected during the year 2012-13 98, 47,000Bills dishonoured and returned during the year 27,10,000

a. 47,37,000 b. 3,10,000 c. 43,000 d. 27,53,000

29. Investment Fluctuation Reserve is part of which type of capital: a. Common Equity Tier 1 b. Additional Tier 1 c. Tier 2 d. None of these

30. Revaluation Reserves are taken as part of Tier I capital at a discount of :a.50% b.45% c. 55 % d. No discount



31. Under BASEL-III, what is the Risk Weightage on the Loans and advances given to Staff of the bank: a. 75% b. 30% c. 45% d. 20%

32. Which of the following does not come under Tier 2 capital? a) General Provisions & Loss reserves b) Debt capital instuments c) revaluation reserves d) Non cumulative perpetual shares.

33. Sundry Assets attracts …………… % risk weight for Capital Adequacy Ratio a) 25 b) 50 c) 75 d) 100

34. From the following information calculate CET 1 and Tier II capital according to basel IIIrequirements:

Paid up Share capital 12.54Share Premium 43.37Statutory Reserves 112.25Capital Reserves 7.80Special Reserve 36 (i) viii) 3.99Revaluation Reserves 18.69Investment Reserve 0.74Special Reserve (Swap) 0.51Other reserves (disclosed) 82.437 years non convertible bonds ( 4 years to maturity) 92.80Provision for Standard Assets 19.21Deferred Tax Assets and Other Intangible Assets 30.24

a. CET 1 Rs.232.14, Tier II Rs.123.54 b. CET 1 Rs.241.91, Tier II Rs.19.95c. CET 1 Rs.229.40, Tier II Rs.122.29 d. CET 1 Rs.119.89, Tier II Rs.119.89

35. The credit portfolio of ABC Bank has undergone a uniform downgrade as on 31-3- 2014 after an economic downturn. The position prior to the downgrade is given below: The minimum capital required after downgrade is …………..

Rating Scale Risk Weight (%) ExposureRs. In crores

Extent of downgrade

AAA 20 200 AA

AA 30 200 A

A 50 100 BBB

BBB 100 200 BB

BB& Below 150 100

800

Minimum capital under Basel III Rs.48.60 Cr

a. 63.9 crores b. 58.6 crores c. 60.6 crores d. 52.6 crores

36. A Capital debt instrument which is part of Tier II capital has a remaining maturity of more than 1 year but less than 2 years. At what rate of discount it will be taken for Tier II capital: a. 50% discount b. 80% discount c. 75% discount d. 55% discount

37. Which of the following is a part of Additional Tier 1 capital? a. Floating provisions b. Provision for Standard asset c. disclosed free reserves. d. Perpetual Non-Cumulative Preference Shares (PNCPS)



38. You are working as a Middle Level Executive with ‘Strong Bank Ltd.,’ The MIS Department has submitted the following Statistics from which you are required to estimate the likely Capital Funds required by the Bank as of March,31st, 2014 taking into account the Basel III implementation compliance.i) Risk-Weighted Assets for Credit Risk likely to be Rs.53,889.50 croresii) Capital Allocation for Market Risk to be Rs.100/- croresiii) For Operational Risk following Data available. The bank is required to calculate Capital Charge for Operational Risk by Basic Indicator Approach. (Amount in Crore)Year 31-03-2011 31-03-2012 31-03-2013Gross Income 2600.00 3000.00 3400.00

I. Based on the Gross Income given above, the likely Capital Charge for Strong Bank Ltd., as on March 31, 2014 to cover Operational Risk under Basic Indicator Approach shall bea. 375 crores b. 540 crores c. 450 crores d. 360 crores

II. The Strog Bank Ltd., will require total Capital Funds for covering Credit Risk. As on March31,2014 to comply Basel III norms of Rs.________crores.a. 5400 crore b. 4850 crores c. 4800 crores d. 4311.16 crores

39. Using the following data, calculated capital charge for borrower A & B under Basel III after credit risk mitigation

Borrower- A Ltd Borrower- B Ltd

Exposure Rs.100 crore Rs.100 crore

Maturity of exposure(years) 6 2

Nature of exposure Corporate Corporate

Currency USD INR

Rating of Exposure BBB UNRATED

Haircut for exposure 12% 25%

Value of collateral after haircut Rs.88crore Rs75 crore

Risk weight 100% 100%

a. Rs.24 crore and Rs 50 crore respectively b. Rs.172.50 crore and Rs.53 crore respectively c. Rs.18 crore and Rs.12 crore respectively d. Rs.150 crore and Rs.75 crore respectively

40. The maximum amount of General provisions and loss reserves should be taken for Tier IIa. 1.50 % of RWA b. 2.75% of RWA c. 5% of RWA d. 1.25% of RWA

41. “Netting” is a method of aggregating two or more obligations to achieving a reduced net obligation. The benefits accrues from “Netting” is:a. Reduced Credit Risk b. Liquidity Risk c. Systemic Risk d. All of the above

42. The debt instruments (bonds/debenture) issued by bank for inclusion in Tier II should be issued withouta. Call option b. Put option c. Setup option d. None of these

43. Under transitional arrangements for Basel III implementation, the regulatory deductions to the extent of _____% is required to be taken for CRAR calculation on 31st March,2014 a. 100 b. 60 c. 20 d. 40



44. Specific Risk Capital Charge for banks’ investment in Security Receipts will be _____a. 100% b. 75% c. 150% d. 0%

45. A Collateralised Transaction is one in whicha. A bank is having general lien and right for set offb. bank has hedge the position in the marketc. banks have a specific lien on the collateral and the requirements of legal certainty are met.d. All of the above

46. Gone concern capital meansa. Capital to protect bank without triggering bankruptcy of the bankb. Special capital build up for absorbing abnormal losses to bankc. Capital which RBI has to build by issuing bondsd. Capital to absorb losses only in a situation of liquidation of the bank

47. Going concern capital meansa. Capital to protect bank without triggering bankruptcy of the bankb. Special capital build up for absorbing abnormal losses to bankc. Capital which RBI has to build by issuing bondsd. Capital to absorb losses only in a situation of liquidation of the bank

48. While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit, Perpetual Non-Cumulative Preference Shares (PNCPS) together with Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital more than ____% of RWAa. 2% b. 3% c. 4.5% d. 1.5%

49. Under transitional arrangements Additional tier 1 ratio on 31st March, 2014 should bea. 2% b. 1.5% c. 7% d. 2.50%

50. Capital conservation buffer means capital buffers build up ina. Stress period b. Normal times c. Contagion times d. Catasphoric times

*****************************************************************************************************************Keys:

Module A: International Banking1 d 2 d 3 b 4 a 5 c6 d 7 b 8 b 9 c 10 d11 a 12 a 13 a 14 a 15 d16 d 17 d 18 d 19 a 20 b21 b 22 a 23 b 24 a 25 c26 b 27 d 28 e 29 b 30 d31 e 32 b 33 a 34 a 35 c36 d 37 c 38 a 39 a 40 a41 b 42 a 43 a 44 d 45 e46 d 47 c 48 d 49** e 50 a51 d 52 c 53 b 54 d 55 d

49.** Ans. Spot Rate USD 1 = 63.5850 (-) Margin 0.15% 00.0953 —————— = 63.4897 Rounded off to 63.4875 (In multiples to 0.0025) Better rate 0.50 Ps. = 63.4875 + 0.050 = 63.5375USD 258000 = 258000 x 63.5375 = Rs.1,63,92,675.00



Recover Interest @ 11% for 10days on Rs.1,63,92,675.00 = Rs.49,402Net payable = Rs. 1,63,92,675.00 - Rs.49,402 = 1,63,43,273 or Say 1,63,43,270

Module B: Risk management1 c 2 c 3 d 4 b 5 a6 c 7 a 8 d 9 c 10 d11 c 12 d 13 b 14 d 15 d16 b 17 d 18 a 19 a 20 d21 a 22 b 23 c 24 d 25 d26 d 27 d 28 d 29 b 30 b31 a 32 a 33 c 34 d 35 a36 d 37 d 38 b 39 a 40 c41 c 42 a 43 d 44 d 45 b46 a 47 a 48 (1) b 48 (2) c 48 (3) a48 (4) d

Module C: Treasury1 d 2 a 3 a 4 d 5 d6 a 7 b 8 b 9 c 10 (I)** a10 (II)* b 11 b 12 b 13** a 14 d15 b 16 a 17 a 18 d 19 a20 b 21 b 22 d 23 d 24 b25 a 26 c 27 - I b 27 - II d 27 - III a27 -IV b 27 -V c 27 VI c 28 c 29 d30** a 31 – 1** a 31- 2 b 31 - 3 d 31 - 4 a32 b 33 1

10.** Answer: I.Settlement amount on July 10, 2013 is the transaction value for the securities plus accrued interest. Transaction Value: 3,00,00,000*116.42/100= Rs.3,49,26,000 Accrued Interest: The security’s maturity date is April 7, 2022. The number of days is 93 from the last coupon date. Accrued interest=3,00,00,000 * 11.99%* 93/360 = Rs. 9,29,225.00 Therefore, the settlement amount is: Rs. 3,49,26,000 + Rs. 9,29,225.00= Rs. 3,58,55,225.00 II.Interest on the Amount borrowed: = 35855225 * .07 * 3/365 = Rs. 20629.03 Amount to be settled: 35855225 + 20629.03 = Rs. 35875854.03

14.** The QSD = (12% - 10%) - (LIBOR + 1.5% - LIBOR) = 0.50%

30.** 1000000000*90*.4 ------------------------- 3650031.** Explanation:Demand and Time Liabilities: Main components of DTL are:Demand deposits (held in current and savings accounts, margin money for LCs, overdue fixed deposits etc.)Time deposits (in fixed deposits, recurring deposits, reinvestment deposits etc.)Overseas borrowingsForeign outward remittances in transit (FC liabilities net of FC assets)Other demand and time liabilities (accrued interest, credit balances in suspense account etc.)

Module D: Bank Balancesheet & Basel1 d 2 c 3 c 4 b 5 b6 b 7 c 8 b 9 c 10 a11 d 12 b 13 c 14 a 15 b16 a 17 a 18 a 19 b 20 c



21 d 22 b 23 b 24** d 25 d26 d 27 c 28 c 29 a 30 c31 d 32 d 33 d 34** b 35** a36 b 37 d 38 - I c 38 - II b 39 a40 d 41 a 42 b 43 d 44 c45 c 46 d 47 a 48 d 49 b50 b

24.** Note: In the case of advances classified as doubtful and guaranteed by ECGC, provision should be made after deducting realizable of value of security and the amount guaranteed by the Corporation. Further, while arriving at the provision required to be made for doubtful assets, realisable value of the securities should first be deducted from the outstanding balance in respect of the amount guaranteed by the Corporation and then provision will be made.

34.** CET 1 calculationPaid up Share capital 12.54Share Premium 43.37Statutory Reserves 112.25Capital Reserves 7.80Special Reserve 36 (i) viii) 3.99Other reserves (disclosed) 82.43Revaluation Reserves (Discount of 55%) 10.28Total 272.66Less: Deferred Tax Assets and Other Intangible Assets 30.24Less: Special Reserve (Swap) – Cash flow hedge reserves 0.51

Total CET1 241.91

Tier 2Investment Reserve 0.747 years non convertible bonds – Not to be included as initial minimum maturity is less than 10 years

0

Provision for Standard Assets 19.21Total Tier 2 19.95

35.**

Rating Scale Risk Weight

Exposure Risk weight after downgrade

RWA AFTER DOWNGRADE

AAA 20% 200 30% 60

AA 30% 200 50% 100

A 50% 100 100% 100

BBB 100% 200 150% 300

BB & below 150% 100 - 150

710

WISH YOU ALL THE BESTFromISFA