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Questions on Banks Balance Sheet

1) What is ICAAP and definition,.


ICAAP --- Internal Capital Adequacy Assessment Process (ICAAP)
ICAAP is a new requirement for financial institutions, under Basel II,
requiring the following assessments:
Pillar I minimum capital requirements;
The extent of total stockholder funds required to meet a firms strategy and
maintain minimum capital requirements;
ensuring that material risks of the firm are understood by its board, and that
there is sufficient and appropriate risk management.
Four crucial elements in any ICAAP are:
1) assessment (identification and measurement) of the risks a bank is,
or may be, exposed to;
2) application of mitigation techniques that may help to lower capital
requirements;
3) stress-testing techniques;
4) role of the board of directors and management.
Requirement under Pillar-II
Pillar II requires that risks are presented to, and discussed by, the board to
ensure its acceptance and understanding.
Pillar II also requires a bank to maintain capital ratios and convince the
regulator.
Risk models and capital are only part of this.
A financial institution must also consider any other internal risks that the
firm may face which may result in losses such as fraud, rogue trading, or
strategy failure.
The preparation of a capital plan should incorporate all risks, and requires
the cooperation of, and collaboration with, the finance, treasury, business,

and risk departments. Capital plans are usually based on a firms forecasts
for growth, given the maintenance of a capital ratio.
The ICAAP should be customized for each firm, taking into account
the particular risks and information available. The process usually
consists of the following stages:
1) Identifying risksList all material risks, interview staff in relevant
departments, and assess the probability of risks occurring.
2) Assessing capitalHow much capital would a risk require?
3) Forward capital planningAssess how the capital calculated from
the capital assessment might be altered by its business plan, i.e.
perform stress and scenario analyses.
Managers should also consider the following risks:
credit risk;
market risk;
operational risk;
liquidity risk;
insurance risk;
concentration risk;
residual risk;
securitization risk;
business risk;
interest rate risk;
any other risks identified.
ICAAP should provide firms with the best capital buffer required, and the best
level of funds from stockholders. Risks are often considered by a bank, yet
are not always reflected in strategic options and capital planning. ICAAP
requires stress and scenario analysis to demonstrate risks at an enterprise
level.
Question No 2
1) What is Capital Adequacy Ratio.

Capital Adequacy Ratio = Regulatory Capital / Risk Weighted Assets.


2) What is Risk weighted assets.
The Assets side of the balance sheet has the following.
Sl No

Name / Nature of the Asset

Cash

Balance with Central Bank of the country 0% to 150% depending


/RBI
up on the rating of the
Country.
State Bank of India /Other Bank
20% to 150% again
depending on the rating
of the Bank
Investments in Government Securities
0% to 150% depending
on the Sovereign Risk.
Investment in other Securities
20%
to
150%
depending on rating of
the Corporate
Loans to Government
0 % to 150% depending
on the Sovereign Risk.
Loans to others
20% to 150% depending
on
rating
of
the
Corporates
Other assets
100%
Substandard Assets (Both Investment 150%
and Loans)
Doubtful Assets (Both investment and 200%
Loans)

3
4
5
6
7
8
9
10

Risk
weight
as
a
percentage.
May range from 0% to
150* depending upon
the risk associated with
the Country . Country
risk
is
known
as
Sovereign
risk.
Depending on the rating
of the country

How to work out the Risk Weighted assets.


We have to work out the Risk Weighted Assets by multiplying the assets
value as per the balance sheet with the risk weight. As per working given
below.

Assets

Amount
Crores)
100
200
in 1000

Cash
SBI
Investment
Government
Security
Investment
in
High
rated
investment
AAA to AA+
Investment
in
Average
rate
BB+ to B+
Loans
to
Government
High rated AAA to
AA+
Loans to High
rated Corporates
AAA to AA+
Loans to Average
rated customer
BB+ to B+
Substandard
Assets

Rs (in Risk %

Risk weight

0
20
0

0
40
0

200

20

40

500

100

500

200

1000

20

200

3000

100

3000

100

150

150

Other Assets
100
100
100
Total
Risk
4030
Weighted assets
In the above case Capital required is 4030 X 9/100 = 362.70*
*As the above takes into account only Credit risk, In order to cover the risk in
respect of Market Risk Normally Banks work out this amount by working out
the Market Risk and operational Risk by taking into consideration the past
historical data .
Suppose in the present case the Bank has the following Capital.
Tier -1
Capital
Free
(Statutory )

100
Reserve 150

Tier -II
Revaluation Reserve.
45
Discounted 55%
Rs 100 Crores discounted @55%
General Provisions for Loans in 10
excess of the required provisions for

Revenue Reserve

120

Capital Reserve

10

NPA
Subordinate Debt Hybrid Capital
50
(Maximum that can be taken as
Tier II capital is only 50% of the Tier
1 capital) The full amount of
maximum 50% of Tier I capital can
be taken as Tier II capital only if it
has a maturity balance period of 5
years or more
Suppose the Subordinate capital
raised is Rs50 Crores with maturity
of 7 years then)
Hybrid
Debts
-Perpetual; 10
Cumulative preference Shares

Perpetual
Debt -Instruments and Non
Convertible
Preference Shares.
Total
380
Tier III capital is not yet implemented.

115

Total Capital Tier I+ Tier II = Rs380 +Rs115 = Rs495 Crores


Capital Adequacy Ratio = Regulatory Capital /Risk Weighted Assets
Capital Adequacy Ratio= 495 /4030+ 10% of 4030 (Approximate risk weight
for the Market Risk and operational Risk)
Capital Adequacy Ratio = 495 / 4030+403 = 495/4433 x100= 11.1%
Question -3
Is CRAR is Capital Adequacy Ratio
Ans yes - Both are same.
Para 4 page 461 of Bank Financial Management
Embedded Option Risk.
Consider a situation in which the Bank raises deposit from public by issuing
Certificate of Deposit say @8% for 90 days and disburse the same amount
by way of loan for 90 days @10%
In this case the market advance Interest rate falls to 9% the loan borrower
prepays the loan after 30 days. As there is no premature closure charges the

Bank accept the amount and close the loan with out charging a penalty. The
amount received by the Bank has to be invested in the market for 60 days
@9% instead of 10%.
The Interest received by the Bank is 10% for 30days 10x30 =300
The Interest received by the Bank is 9% for 60 days 9x60 = 540
Thus the Bank is able to earn only 840 points for 90 days against 900 for
90 days envisaged . This is the risk.
Question -4
Para 7 page 462 of Bank Financial Management
Reinvestment risk.
Here the Bank has agreed with a depositor that the Bank will double the
deposit amount of Rs10,000/ in 7 years . Bank has invested the deposit so
received in a bond yielding annually @12% for 7 years.
As per rule 72 the number of years that will be taken
amount is 72/rate of Interest

for doubling the

In the present case it will take 7 years to double depositors money ie 7 = 72/
rate of Interest or Rate of Interest = 72/7 = 10. 28%
Thus it can be seen that the Bank has initially accepted the deposit so that it
can make substantial money by investing in 12% bonds and by reinvesting
the Interest so obtained every year as and when it fall due. In the present
case it is informed that the market rate has fallen to 5% after one year.
Although the Bank will continue to receive interest @ 12% on the principal
amount for 7 years the interest income that can be made by investing the
Interest received say Rs1200/ every year will yield only 5% for the remaining
years instead of 12% anticipated.
1st year Interest of Rs1200 will earn 5% for 6 year
2 nd year Interest of Rs1200 will earn 5% for 5 year
3 rd year Interest of Rs1200 will earn 5% for 4 year
4th year interest of Rs1200 will earn 5% for 3 years etc.
Thus the total yield will be lower than the original anticipated amount
causing loss or lesser income to the Bank.

Question -5
What is RAROC
Ans : Risk Adjusted Return on Capital
page 484 of Bank Financial Management
Banks have to manage many risks . 1) Credit risk (is arrived at based on
the Credit rating of the borrower or the rate of the Corporate in which Bank
has made investment). 2) Market risk, (Interest rate risk, liquidity Risk ,
Exchange Fluctuation Risk , Commodity Risk, etc) and 3) Operational Risk .
As such a Bank has to aggregate the risks at their Head Office level and find
the summation of all the risks and estimate the risks . The commonly used
approach is Risk Adjusted Return on Capital (RAROC) In this technique Banks
use the Value at Risk VaR and take into account all type of anticipated risks.
Statistical methods and Standard deviation etc is used for arriving at the
correct position.
RAROC is also related to concepts such as shareholder value analysis and
Economic Value added. The past performance is measured by yardsticks
such as return of assets (ROA) which adjust profit for associated book value
of Assets or return on assets.
The expected loss is a measure necessary to guard against future losses.
This is some time called Economic Capital.
RAROC also belong to Risk adjusted performance measure. (RAMP)
Assume two traders. They are working in a Volatile Market.
1) Foreign Exchange Traders $100 Million at12%
2) Bond trader Deals with large amounts of $200Million in a market at4%
annum.
The risk capital can be computed as a VaR measure, say at99%
Assuming normal distribution this will
x0.9x2.33=$28

Risk Capital = $100,00,000

2.33 is arrived at based on the volatility of interest rate fluctuation over


the past one year at VaR 99%
RAMP = Profit/Risk Capital

As the bond trader is trading at 4% interest the fluction in interest rate for
him will be less and so less Risk Capital.
What is Off Balance sheet item.
All contingent liabilities are Off balance sheet items for eg LG
/LC/Forwards Contracts etc.