Ankita Management of Capital by Banks

INTRODUCTION
Capital management refers to implementing measures to maintain sufficient

capital, assessing its internal capital adequacy and calculating the capital adequacy
ratio.
Capital, risk, and strategy are deeply connected in banking. Because capital
management is inherently linked to risk—and a bank's risk appetite influences its
strategic choices—capital management is the way that risk management finds
expression in bank strategy at the highest level.
It is extremely important for a financial institution to calculate the capital

adequacy ratio and secure sufficient capital to cover risks it faces by developing and
establishing a capital management system, from the viewpoint of ensuring the
soundness and appropriateness of the institution’s business. Therefore, the
institution’s management is charged with and responsible for taking the initiative in
developing and establishing such a system.
There are various capital management methods according to corporate

management policies and other factors. In some cases, there may be two or more sets
of policies and internal rules with regard to capital management, and the necessary
tasks may be divided between two or more divisions because of the diversity of the
tasks, including development and implementation of capital plans, assessment of
capital adequacy, calculation of the capital adequacy ratio and capital allocation
processes. In other cases, the Comprehensive Risk Management Division may
concurrently undertake the task of capital management. The purpose of this manual
is not to require the establishment of an independent division in charge of capital
management, or to seek to bar a financial institution from having two or more
divisions conduct capital management operations in accordance with their respective
polices and internal rules as mentioned above. In the case where two or more
divisions engage in capital management in coordination with each other, the
inspector should review whether the policies and internal rules adopted by the
divisions and the tasks undertaken by them are compatible with one another and
MANAGEMENT OF CAPITAL BY BANKS Page 1

whether their respective capital management processes are functioning effectively. In
the case where the Comprehensive Risk Management Division undertakes the task of
internal capital adequacy assessment, review should be conducted by using both the
check items concerning internal capital adequacy assessment as part of the capital
management system and those concerning the comprehensive risk management
system, and any problem with regard to capital adequacy should be examined as the
issue of capital management system.
It is important for the inspector to review whether a financial institution has a

capital management system suited to the levels of complexity and sophistication of
the internal capital adequacy assessment processes used by the institution. It should
be noted that the type and level of the process of internal capital adequacy
assessment to be used by a financial institution should be determined according to
the institution’s corporate management policy, the diversity of its business and the
level of complexity of the risks faced by it, and therefore a complex or sophisticated
process of internal capital adequacy assessment is not necessarily suited to all
financial institutions.
If the institution’s management fails to recognize weaknesses or problems

recognized by the inspector, it is also necessary to explore in particular the possibility
that the Internal Control System is not functioning effectively and review findings
thereof through dialogue.
The inspector should review the status of improvements with regard to the
issues pointed out on the occasion of the last inspection that are not minor and
determine whether or not effective improvement measures have been developed and
implemented.

COMPONENTS OF CAPITAL
TIER 1 CAPITAL
Tier 1 capital is the core measure of a bank's financial strength from a

regulator's point of view. It is composed of core capital, which consists primarily
of common stock and disclosed reserves (or retained earnings), but may also
include non-redeemable non-cumulative preferred stock. The Basel Committee
also observed that banks have used innovative instruments over the years to
generate Tier 1 capital; these are subject to stringent conditions and are limited to a
maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be
phased out during the implementation of Basel III.
Capital in this sense is related to, but different from, the accounting concept
of shareholders' equity. Both Tier 1 and Tier 2 capital were first defined in the
Basel I capital accord and remained substantially the same in the replacement
Basel II accord. Tier 2 capital represents "supplementary capital" such as
undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid
(debt/equity) capital instruments, and subordinated debt.
Each country's banking regulator, however, has some discretion over how
differing financial instruments may count in a capital calculation, because the legal
framework varies in different legal systems.
The theoretical reason for holding capital is that it should provide protection
against unexpected losses. This is not the same as expected losses, which are
covered by provisions, reserves and current year profits. In Basel I agreement, Tier
1 capital is a minimum of 4% ownership equity but investors generally require a
ratio of 10%. Tier 1 capital should be greater than 150% of the minimum
requirement.

TIER 1 CAPITAL RATIO
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its
total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets
held by the bank weighted by credit risk according to a formula determined by the
Regulator (usually the country's central bank). Most central banks follow the
Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae
for asset risk weights. Assets like cash and currency usually have zero risk weight,
while certain loans have a risk weight at 100% of their face value. The BCBS is a
part of the Bank of International Settlements (BIS). Under BCBS guidelines total
RWA is not limited to Credit Risk. It contains components for Market Risk
typically based on value at risk (VAR) and Operational Risk. The BCBS rules for
calculation of the components of total RWA have seen a number of changes
following the Financial crisis of 2007–08.
As an example, assume a bank with $2 of equity lends out $10 to a client.

Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk
weighting of 90%, the bank now holds risk-weighted assets of $9 ($10*90%).
Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or
22%.
There are two conventions for calculating and quoting the Tier 1 capital ratio:
 Tier 1 common capital ratio and

 Tier 1 total capital ratio
Preferred shares and non-controlling interests are included in the Tier 1 total
capital ratio but not the Tier 1 common ratio. As a result, the common ratio will
always be less than or equal to the total capital ratio. In the example above, the
two ratios are the same.

TIER 2 CAPITAL
Tier 2 capital is the secondary component of bank capital, in addition to Tier

1 capital, that makes up a bank's required reserves. Tier 2 capital is designated as
supplementary capital, and is composed of items such as revaluation reserves,
undisclosed reserves, hybrid instruments and subordinated term debt. In the
calculation of a bank's reserve requirements, Tier 2 capital is considered less
secure than Tier 1 capital, and in the United States, the overall bank capital
requirement is partially based on the weighted risk of a bank's assets.
BREAKING DOWN TIER 2 CAPITAL
Laws governing bank capital requirements stem from the international Basel
Accords, a set of recommendations from the Basel Committee on Bank
Supervision. Under the Basel Accords, a bank's capital is divided into Tier 1 core
capital and Tier 2 supplementary capital. The minimum capital ratio reserve
requirement for a bank is set at 8%; 6% must be provided by Tier 1 capital. A
bank's capital ratio is calculated by dividing its capital by its total risk-based
assets.
Tier 2 capital is considered less reliable than Tier 1 capital because it is

more difficult to accurately calculate and is composed of assets that are more
difficult to liquidate. It is commonly split into two levels: upper and lower. Upper-
level Tier 2 capital has the characteristics of being perpetual, and senior to
preferred capital and equity. It also has cumulative, deferrable coupons and
interest and principal that can be written down. Lower-level Tier 2 capital is
characterized by being inexpensive for a bank to issue, having coupons that are
not deferrable without triggering default, and includes subordinated debt with a
minimum five-year maturity.

THE COMPONENTS OF TIER 2 CAPITAL
The first component of Tier 2 capital is revaluation reserves, which are

reserves created by the revaluation of an asset. A typical revaluation reserve is a
building owned by a bank. Over time, the value of the real estate asset tends to
increase and can thus be revalued.
The second component is general provisions. These are losses a bank may
have of an as yet undetermined amount. The total general provision amount
allowed is 1.25% of the bank's risk-weighted assets (RWA).
The third element is hybrid capital instruments, which have mixed

characteristics of both debt and equity instruments. Preferred stock is an example
of hybrid instruments. A bank may include hybrid instruments in its Tier 2 capital
as long as the assets are sufficiently similar to equity so losses can be taken on the
face value of the instrument without triggering liquidation of the bank.
The final component of Tier 2 capital under U.S. regulations is subordinated

term debt with a minimum original term of five years or more. The debt is
subordinated in regard to ordinary bank depositors and other loans and securities
that constitute higher-ranking senior debt.
Most countries, including the United States, do not allow undisclosed

reserves, which are profits not stated in a bank's reserve, to be used to meet
reserve requirements.

TIER 3 CAPITAL
Tier 3 capital is tertiary capital, which many banks hold in order to support
their market risk, commodities risk, and foreign currency risk. Tier 3 capital
includes a greater variety of debt than tier 1 and tier 2 capitals.
BREAKING DOWN 'Tier 3 Capital'
Tier 3 capital debts may include a greater number of subordinated issues,

undisclosed reserves and general loss reserves as compared with tier 2 capital. To
qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1 capital,
be unsecured, subordinated, and have a minimum maturity of two years.
The Origin of Tier 3 Capital
Capital tiers for large financial institutions originated with the Basel
Accords. These are a set of three (Basel I, Basel II, and Basel III) regulations,
which the Basel Committee on Bank Supervision (BCBS) began to roll out in
1988. In general all of the Basel Accords provide recommendations on banking
regulations with respect to capital risk, market risk and operational risk. The goal
account to meet obligations and absorb unexpected losses. While violations of the
Basel Accords bring no legal ramifications, members are responsible for the
implementation of the accords in their home countries.
Basel I required international banks to to maintain a minimum amount (8%)

of capital, based on a percent of risk-weighted assets. Basel I also classified a
bank's assets into five risk categories (0%, 10%, 20%, 50% and 100%), based on
the nature of the debtor (e.g. government debt, development bank debt, private-
sector debt, and more).

In addition to minimum capital requirements, Basel II focused on regulatory
supervision and market discipline. Basel II highlighted the division of eligible
regulatory capital of a bank into three tiers. BCBS published Basel III in 2009,
following the 2008 financial crisis. Basel III sought to improve the banking
sector's ability to deal with financial stress, improve risk management, and
strengthen banks' transparency.

Elements of Tier I Capital
• Paid-up capital (ordinary shares)
• Statutory reserves
• Other disclosed free reserves
• Perpetual non-cumulative preference shares (PNCPS) eligible for inclusion as

Tier I capital – Subject to laws in force from time to time
• Innovative perpetual debt instruments (IPDI) eligible for inclusion as Tier I

capital
• Capital reserves representing surplus arising out of sale proceeds of assets
Elements of Tier II Capital
• Undisclosed reserves
• Revaluation reserves
• General provisions
• Loss reserves
• Hybrid capital instruments
• Subordinated debt
• Investment reserve account

ASSET LIABILITY MANAGEMENT IN THE BANKS
The reform measures heralded several epoch making changes in the

financial sector to make them more competitive. It includes deregulation of
interest rates, reduction of reserve requirements (CRR and SLR), integration of
various segment of financial markets, allowing banks to access capital market for
augmenting capital base to meet their capital adequacy, freedom in operational
matters, greater emphasis on the use of information technology, moving towards
capital account convertibility and so on. These measures emphasize on internal
consolidation of banks and covers organizational restructuring to match with
competitive environment among the important aspects of such re-engineering are
Asset Liability Management (ALM), Risk Management and greater penetration to
technology and strategies management. The aim of these strategies is to improve
efficiency by managing risk properly so as to improve profitability of banks. The
present chapter is devoted to focus on ALM in the bank. It is divided into three
sections. The first section deals with conceptual framework of ALM. It covers,
need, types, guidelines, Basel Accord and RBI guidelines and techniques of risk
management Section two is devoted to identify the necessity of ALM in the
domestic banking system and the final section, three, analyses structural changes
of variables of banking sector during post reform period and changes of average
ranking of PSBs over the years using CRAMEL approach
INTRICACIES OF ALM:
ALM envisages the process of managing net interest margin (NIM)

within the overall risk. The key objective of ALM is that of sustaining
profitability in such a manner as to augment capital resources it calls for an
integrated approach towards simultaneous decision making with regard to type
and size of financial assets and liabilities. The success of banks hinges on its
ability to match its assets with its liabilities in terms of rate and maturity to
optimize the yield. This can be illustrated by the following example:

Suppose a bank that borrows USD 100 MM at 3.00 pc for a year and lends the
same money at 3.20 pc to a highly rated borrower for 5 years. For simplicity,
assume interest rates are annually compounded and all interest accumulates to the
maturity of the respective obligations. The net transaction appears profitable - the
bank is earning a 20 basis point spread - but it entails considerable risk. At the end
of a year, the bank will have to find new financing for the loan, which will have 4
more years before it matures. If interest rates have risen, the bank may have to pay
a higher rate of interest on the new financing than the fixed 3.20 it is earning on
its loan. Suppose, at the end of a year, an applicable 4-years interest rate is 6 00
pc. The bank is in serious trouble. It is going to be earning 3.20 pc on its loan and
paying 6.00 pc on its financing. Accrual accounting does not recognise the
problem. The book value of the loan (the bank's asset) is:
lOOMM (1.032) = 103.2 MM.
The book value of the financing (the bank's liability) is:
1OOMM (1.030) =103.0M.
Based upon accrual accounting, the bank earned USD 2, 00,000 in the first year.
Market value accounting recognizes the bank's predicament. The respective
market values of the bank's asset and liability are:
1OOMM (1.032)5 / (1.060)4 = 92.72MM
1OOMM (1.030) = 103.0MM.
From a market-value accounting standpoint, the bank has lost USD 10.28MM. So
which result offers a better portrayal of the bank' situation, the accrual accounting
profit or the market-value accounting loss? The bank is in trouble, and the market-
value loss reflects this.
Ultimately, accrual accounting will recognize a similar loss. It will accrue the as-
yet unrecognized loss over the 4 remaining years of the position. The problem in

this example was caused by a mismatch between assets and liabilities. Prior to the
1970's such mismatches tended not to be a significant problem.
ALM IN PRACTICAL TERMS INVOLVES:
(a) Conscious decisions - making with regard to assets-liability structure in order

to maximize interest earnings within the frame work of perceived risk and.
(b) Quantification of risk and evolving of suitable risk management techniques

to minimize probable loss. It is therefore evident that Asset/Liability Management
(ALM) is a tool that enables bank management to take business decisions in a
more informed framework. The ALM function informs the manager what the
current market risk profile of the bank is, and the impact that various alternate
business decisions would have on the future risk profile. The manager can then
choose the best course of action, depending on his Board's risk appetite.
Objective of ALM:
A Sound ALM system for the bank should encompass:
 Review of interest rate out-looks.

 Fixation of interest product pricing of both assets and liabilities.
 Review of credit portfolio and credit risk management.
 Review of investment portfolio and risk management.
 Risk management of forex operations.
 Management of liquidity risk.

Need of Risk Management by Banks:
Banks across the world are considered as financial risk takers as they live with
money.
They assume risk because risk is pre-requisite for survival. However, taking
higher risks entail a loss and sometimes become disastrous for the organisation.
'Eddie Cade''' has aptly documented these fact illustrated as under.
 Merrill Lynch lost $377 million trading mortgage-backed securities in an

innovative form in 1987.
 Midland Bank lost a reported pound sterling 116 million by guessing wrong on
interest rate movements in 1989.
 Bank of New England made massive bad debt provisions, suffered a run on
deposits and had to be supported by Government to the tune of some $2 billion in
1991.
 Barclays Bank provided pound sterling 2.5 billion for bad and doubtful debts and
declared the first loss in its history in 1992. Credit Lyonnais succumbed to similar
troubles and registered a net loss of Fr. 6.9 billion in 1993.
 Barings, London's oldest merchant bank, was brought down by losses of pound
sterling 830 million on a speculative proprietary position in Nikkei 22.5 stock
index futures.
 In their financial year to March 1996, the major Japanese banks wrote off a total of
some Japanese Yen 6000 billion of bad debts accumulated from the preceding
boom years.
Risks and its nature:
Risk in general term is defined as possibility of suffering a loss. It is potential for
realization of unwanted negative consequences of an event. Thus, by defining risk
one can measure the probability and severity of adverse effects.

Categories of risks:
In the simplest words, risk may be defined as possibility of loss. It may be financial
loss or loss to the reputation/image. It is difficult to think of a commercial
organization, which does not undertake any risk. Banking is also one of such
commercial organizations. The concept of risk-return trade-off is applicable to all
the business.
However, higher risk may also result into higher losses.
Various risks, to which the banks are exposed, may broadly be
categorized in the following categories :
A. Credit Risk
B. Interest Rate Risk
C. Liquidity Risk
D. Foreign Exchange Risk
E. Operational Risk
(A) CREDIT RISK:
Banks pool assets and loans, which have a possibility of default, and yet
provide the depositors with the assurance of redemption at full face value. Credit
risk, in terms of possibilities of loss to the bank, due to failure of borrows/counter
parties in meeting their commitments, is likely to hamper the capability of the bank
to meet its commitment to the depositors. Credit risk is the most significant risk,
more so in Indian scenario where the NPA level of the banking system is
significantly high. Its importance may be understood from the fact that during
Asian financial crisis, non-peribrming loans in Indonesia, Malaysia, South Korea
and Thailand soared to over 30 pc of total assets of the financial system. The
management of credit risk is thus a prerequisite, for long term sustainability/
profitability of a bank.
Credit risk depends on both internal and external factors. Some of the
important external factors are state of economy, swings in commodity prices
foreign exchange rates & interest rates etc. The internal factors may be deficiencies
in loan policies and administration of loan portfolio covering areas like prudential
exposure limits to various category, appraisal of borrower's financial position,

excessive dependence on collateral, mechanism of review and post sanction
surveillance etc.
Risk is inherent in any business. As such it can't be avoided but has to be
managed by adopting various risk mitigating methods. In banking business, funds
are lent to the borrowers after due appraisal. However, the appraisal is based on
certain assumptions, variation from which may affect the profitability of borrowing
unit and this may ultimately culminate in the default. In most of the cases, default
will not take place suddenly. An alert banker may smell the warning signals and by
his pro-activeness he may take suitable steps in time either to remedy the situation
or to exit from the account. Key issue in managing credit risk is to apply a
consistent evaluation and rating system of all investment opportunities. Prudential
limits need to be laid down on various aspect of credit. Rating may be single point
indicator of diverse risk factors of counter party.
Management of credit delivery and monitoring process:
(a) Appraisal stage:
In addition to following the prescribed guidelines of the bank, the
important point is the appraisal of the man behind the project. For this no rules
can be given. However, the managers may use their own innovativeness and
experience to judge the man. Some of the points that the manager may consider
are as under:
183
 Whether the branch has its own network for obtaining reliable information about
present and prospective borrowers through some well known sources like local
organizations, lead bank offices, other customers etc.
 Whether the credit officers keep an eye on local newspapers for keeping track on
some developments in some units / industries etc.
 Whether marketability of the product is assured beyond reasonable doubt.
 Whether while processing the proposals a list of all the important references made
by the borrowers is kept on record.
 Whether a small map of the location of the location of the unit / residence of
borrowers / guarantors is kept on record.

(b) Disbursement stage:
 Whether the branch ensures creation of assets and whether the disbursement is
made in stages and checked at every stage, wherever possible.
 Whether the payments are directly made to the dealers.
 Whether the branch ensures long term availability of the business premises are on
rent.
(c) Review / Renewal:
 Whether the branch considers review as a ritual or uses the opportunity to review
its credit decision,
 Whether proper follow-up for obtaining financial information is stated in time and
borrowers are properly educated in this regard.
(d) Asset Verification/Inspection/visits:
This is most important aspect of monitoring of a borrowed account. If
done regularly, it gives an opportunity to interact with the borrowers and must be
used to ascertain the problems that the unit is facing / likely to face. Remedial steps
should be initiated at the earliest. If an eye is kept on the activities of the borrower,
there is no reason as to why the account can't be kept healthy.
(e) Credit Rating:
Credit rating is the main tool, which helps in measuring the credit risk
and facilitates pricing the account. It gives vital indications of weaknesses in the
account whenever rating of a particular account has slipped. It also gives triggers
for portfolio management at corporate level.
(B) INTEREST RATE RISK:

Bank fixes and changes interest rates on deposits and advances from
time to time. Generally, changes in interest rates on advance affect the interest
rates of all the advances account. However, in case of deposits, the change affects
rate of interest of new/renewed accounts only. Hence, changes in interest rates can
significantly impact the Net Interest Income (Nil). The risk of an adverse impact
on Nil due to variations of interest rate may be called interest rate risk. For
measuring interest rate risk in case of trading activity - Value at Risk (VaR) is

presently the standard approach. It attempts to assess the potential loss that could
crystallize on trading portfolio due to variations in market interest rates and prices.
In case of other balance sheet exposure, banks rely on "gap reporting system" for
identifying asymmetry in re-pricing of assets and liabilities - commonly known as
gap and putting in place a gap reporting system. Supplemented with balance sheet
simulation models to investigate the effect of interest rate variation on reported
earnings over a medium - term horizon.
(C) FOREIGN EXCHANGE RISK:
Foreign exchange market is volatile. The exchange rates change from
moment to moment. Every bank, which is active in international market, keeps
certain open position in foreign currencies. However, there is inherent risk in
running such open position due to wide variations in exchange rates. Such risks
may be called as foreign exchange risks.
Various limits are key elements of risk management in FOREX
trading, as they are all trading business. Banks with active trading positions are
adopting VaR approach to measure the risk associated with exposure. For the
banks that could not develop VaR, some stress testing is required to evaluate the
potential loss associated with changes in exchange rate. This can be done with
small movements as well as for historical maximum movements.
(D) LIQUIDITY RISK:

This may arise due to funding of long-term assets (advances) by short
term sources (deposits). If fresh short-term deposits are not available or existing
deposits are not renewed, the bank will be put in liquidity problem. Several
traditional ratios are used for measuring liquidity risks, loan to total assets, loans to
core deposits, large liabilities to earning assets, loan losses to net loans etc.
Additionally prudential limits are placed on various liquidity measures like inter-
bank borrowings and core deposits vis-a-vis core assets.

(E) OPERATIONAL RISK:
Basel Committee for Banking Supervision has defined the operational risk
as "the risk of loss, resulting from inadequate or failed internal processes, people
and systems or from external events." The operational loss has mainly three
exposure classes viz. People, processes and systems. The importance of managing
operational risk has increased mainly because of two reasons:
 Higher level of automation and
 Increase in global financial inter-linkages.
Internal control mechanism has to be strengthened for mitigating the operational
risk. For unexpected losses, capital has to be provided for. In the Indian context,
banks should start with an external and independent assessment of operational risk
management in the bank. Based on such assessment they may identify high-risk
areas and draw a phased roadmap towards attaining targeted standards.

THE ASSET - LIABILITY MANAGEMENT COMMITTEE
Once the strategic plan is developed and is in place, the responsibility

for day to day administration of the components that affect the financial
performance passes to the asset liability management committee (ALCO). On the
other hand, the planning committee has a long range perspective and meets
frequently. ALCOs are primarily made of staff members headed usually by the
chief executive officer. The ALCO is responsible for developing, implementing
and managing the banks's annual budget or profit plan and its risk management
programme.
In managing performances, the committee reviews a variety of reports
assessing the banks' performance relative to its profit plans and risk management
objectives. To serve effectively all members of the ALCO should be
knowledgeable about the various facets of asset - liability management. Members
should understand the role and use of financial measures in evaluating the bank's
performance. Timely and accurate data for analysis and reporting, is a must for the
ALCO. The ALCO should consider acquiring a software programme to enable
them in carrying out their functions in an efficient manner. In choosing the
software for supporting the bank's process the ALCO should clearly define the
kinds of information it wants the software to produce and the amount of time
available to work with the software.
The Budget or Profit Plan
A bank's annual budget or profit plan is the tool that keeps the bank on
track towards achieving its strategic financial goals. The ALCO oversees the
development of the budget, recommends its implementation to the board of
directors and monitors the banks performance under the plan. The ALCO also
makes recommendations for modifying the budget when necessary. In developing
the annual budget the committee considers the time covered by the plan, the plan's
level of detail, contingencies that might cause the plan to change, and the action

plans, goals and timetables necessary to see that the plan is effectively
implemented.
The Review System
An established system of reviewing the plan and modifying it where

necessary contributes significantly to the plan's success. When the plan is written,
the bank determines the frequency of its review, the types of performance reporting
and the method to use in modifying the plan. Banks depend on effective plans with
realistic targets. These plans enable the managers to take action consistent with the
bank's short and long range goals.

FRAMEWORK FOR ASSET- LIABILITY FUNCTION
Broadly essential elements in the framework for the asset/liability function are
detailed as under:
Strategic Framework:
The ALM function should be proactive and not reactive The ALM
function should assist the line management in product planning and pricing and
help sensitize the operating people to the ALM implications of their decisions.
The ALM function should not be mere analytical function, but a catalyst for the
formulation of business strategies.
Organizational framework:
All elements of the organization, namely the ALM committee, sub-

committees, and the analytical support group should have clearly defined roles
and responsibilities. The analytical group should be located in the right place of
the organization to promote effective functioning. The membership and size of
each organizational element should reflect business requirements. The ALM
function should have full support of the top management. This includes proper
resource allocation and personal commitment.
Analytical Framework:
The various analytical concepts (gap analysis, simulation, duration,

value at risk, etc.) should be used to obtain appropriate insights. In general heavy
emphasis on cash flows, market values, risk adjusted returns and duration.
Technological Framework:
This deals with utilization of top class software, either purchased or

developed in house. The software package should enable one to perform extensive
analysis, planning and measurement of all the facets of the ALM function.

Operational Framework:
There should be a well documented policy statement (approved by the

Board of Directors) and a detailed ALM proceeds.
Performance Management Framework:
The profitability of the bank comes from three sources. Assets,

Liabilities & ALM. First the bank makes profits on the asset side making loans at
a rate higher than economic cost of return on matched funds. This reflects the
credit spread. A second source of profits arises from the liability side. The bank
accesses fixed at a rate lower than economic cost of risk matched funds. This
reflects the franchise spread. Third, the bank makes profits through market risk
transformation. For example, SBI borrows for three months and lends for six
months. The performance measurement framework should enable the banks to
measure profitability of these three business activities. A system of structured
education and training is necessary so that the top management is sensitised to the
developments in Asset/Liability Management. In a field so volatile and fast
changing as ALM, ongoing training and updating is critical.
Information Reporting Framework:
ALM information should be reported. In such a manner that each level

of management should get information that is relevant to them. The overriding
objective is that the decision-maker is neither burdened with information overload
nor starved of needed information. The information should be concise and easily
understandable. The information should allow the recipient to make or evaluate
decisions.

Regulatory Compliance Framework:
The objective is to ensure compliance with the applicable regulatory

requirements such as those containing to risk based capital ratios, liquidity ratios,
capital adequacy directive and the quality of risk management infrastructure.
Control Framework:
The emphasis should on setting up of a system of checks and balance

to ensure the integrity of data, analysis, reporting and adherence to internal
policies. This should be ensured through regular external/internal reviews of the
function.

EMERGENCE OF ALM PROCESS IN INDIA
In India, the need for ALM is a recent phenomenon. ALM is needed

in the domestic banking as part of the system Memorandum of Understanding
(MoU) by which banks are required to submit a policy statement on their
individual liability management system. In 1995, while relaxing the interest rate
structure of term deposits, the RBI emphasized on proper use of offering interest
rates in various maturities of term deposits. Further it should be ensured that they
do not get locked in excessively long deposit maturities. A careful review should
be undertaken to ensure against overall asset-liability mismatches. Besides, in the
busy season credit policy of October 1997, RBI highlighted the importance of
asset-liability management of banks stating, that the need for monitoring the
maturity and liquidity mismatches, interest rate risks and maintaining them at
acceptable levels could not be over-emphasized and banks should put in place
adequate asset liability management system.
NEED FOR ALM IN INDIA:
In India the movement towards greater use of variable rate pending

indicated an important shift in banking environment. It is no longer the case that
banks will be largely asset-driven and primarily concerned with just adhere to find
resources to finance lending. Banks are improving progressively to the stage of
not only adjusting capabilities in accordance with potential liabilities. More
generally there is a growing realization of how an increasingly variegated balance
sheet at a time of volatile economic conditions adds to the risks facing banks and
takes necessary new techniques of risk management. This has led to a broad re-
assessment of the nature of credit risks and credit standards, and also reduced
banks previous emphasis on balance sheet growth at any cost. The concept of
ALM has become important in India because of the following:

 In order to maximize income with acceptable risk, there is need to emphasize on
interest margin/spread, liquidity and capital which are having desired
maneuverability.
 Since sources of liquidity are distributed across both the assets and liability sides,
as a prudent banker there is imperative need to manage both the sided and integrate
liquidity management with the overall asset liability management.
 In the aftermath of financial sector reforms, interest rates on both deposits and
advances are changing more frequently thereby exposing both assets and liabilities
to volatility risk of interest rate of changes.
 Gradual dismantling of restrictions with regard to foreign exchange transactions has
exposed Indian banks to the vagaries of fluctuations in Forex market.
 With the gradual increase in the ratio of current investment to permanent
investment by RBI, banks are showing greater willingness to value major portion of
their investment as "marked to market". While this will expose the investment
portfolio to potential market risks, steps for countering the adverse impact of
interest rate changes or other market risk variables can be initiated through proper
ALM only.
Overall, the ALM exercise at this introductory stage, would involve the
following:
 Prudential management of funds with respect to size and duration.
 Minimizing undesirable maturity mismatches so as to avoid liquidity problem.
 Reducing the gap between rate sensitive assets and rate sensitive liabilities within
the given risk taking capacity.

CAPITAL STRUCTURE THEORY
Capital structure formulation is one of the critical decisions taken

by the finance manager of a company. As capital structure decision determines the
overall cost of capital and eventually the market value of the firm. It has to be
decided whenever the firm starts its operations or need additional funds to finance
its new projects. The determinants of capital structure provide a significant
indication which a firm has to consider before deciding on its capital structure.
Ultimately, the financial perspective of every firm is to maximize its market value
and minimize its cost of capital, while deciding on its capital structure.
Capital structure mainly consists of debt, common stock and

preferred stock that issued to finance the various long-term projects of the firm. In
other words, the capital structure is primarily a combination of debt and equity.
Equity holders are the owners and have a long-term commitment to the firm
whereas; debt holders are creditors and have no long-term commitment to the firm
as they are more interested in timely repayment of the their principal and interest
amount. Equity holders want regular dividend payments and the firm wants to
have more retained earnings to finance their future capital cash outflows. Hence,
the firm decision on capital structure plays significant impact on the financial
structure of the firm. Financial leverage is measured as the ratio of debt and
equity, which states the relationship between the borrowed and owner’s funds.
Firms with both debt and equity are termed as levered firms, while the firms with
only equity are termed as unlevered firms. Debt financing includes tax deductible
interest expense benefit, associated cost of financial distress and limits the ability
of the firm to raise equity as well as its growth ability by putting the pressure of
timely repayment of debt principal and interest amount.

BREAKING DOWN 'CAPITAL STRUCTURE'
Capital structure can be a mixture of a firm's long-term debt, short-term

debt, common equity and preferred equity. A company's proportion of short- and
long-term debt is considered when analyzing capital structure. When analysts
refer to capital structure, they are most likely referring to a firm's debt-to-equity
(D/E) ratio, which provides insight into how risky a company is. Usually, a
company that is heavily financed by debt has a more aggressive capital structure
and therefore poses greater risk to investors. This risk, however, may be the
primary source of the firm's growth.
DEBT VS EQUITY
Debt is one of the two main ways companies can raise capital in the
capital markets. Companies like to issue debt because of the tax advantages.
Interest payments are tax deductible. Debt also allows a company or business to
retain ownership, unlike equity. Additionally, in times of low interest rates, debt is
abundant and easy to access.
Equity is more expensive than debt, especially when interest rates are low.
However, unlike debt, equity does not need to be paid back if earnings decline. On
the other hand, equity represents a claim on the future earnings of the company as
a part owner.
Debt-to-Equity Ratio as a Measure of Capital Structure
Both debt and equity can be found on the balance sheet. The assets
listed on the balance sheet are purchased with this debt and equity. Companies
that use more debt than equity to finance assets have a high leverage ratio and an
aggressive capital structure. A company that pays for assets with more equity than
debt has a low leverage ratio and a conservative capital structure. That said, a high
leverage ratio and/or an aggressive capital structure can also lead to higher growth
rates, whereas a conservative capital structure can lead to lower growth rates. It is

the goal of company management to find the optimal mix of debt and equity, also
referred to as the optimal capital structure.
Analysts use the D/E ratio to compare capital structure. It is calculated

by dividing debt by equity. Savvy companies have learned to incorporate both
debt and equity into their corporate strategies. At times, however, companies may
rely too heavily on external funding and debt in particular. Investors can monitor a
firm's capital structure by tracking the D/E ratio and comparing it against the
company's peers.
IMPORTANCE OF CAPITAL STRUCTURE:
1. Increase in value of the firm:
A sound capital structure of a company helps to increase the market price of

shares and securities which, in turn, lead to increase in the value of the firm.
2. Utilization of available funds:
A good capital structure enables a business enterprise to utilize the available

funds fully. A properly designed capital structure ensures the determination of the
financial requirements of the firm and raises the funds in such proportions from
various sources for their best possible utilization. A sound capital structure
protects the business enterprise from over-capitalization and under-capitalization.
3. Maximization of return:
A sound capital structure enables management to increase the profits of a

company in the form of higher return to the equity shareholders i.e., increase in
earnings per share. This can be done by the mechanism of trading on equity i.e., it
refers to increase in the proportion of debt capital in the capital structure which is
the cheapest source of capital. If the rate of return on capital employed (i.e.,
shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest paid
to debt-holders, the company is said to be trading on equity.

4. Minimization of cost of capital:
A sound capital structure of any business enterprise maximizes

shareholders’ wealth through minimization of the overall cost of capital. This can
also be done by incorporating long-term debt capital in the capital structure as the
cost of debt capital is lower than the cost of equity or preference share capital
since the interest on debt is tax deductible.
5. Solvency or liquidity position:
A sound capital structure never allows a business enterprise to go for too

much rising of debt capital because, at the time of poor earning, the solvency is
disturbed for compulsory payment of interest to .the debt-supplier.
6. Flexibility:
A sound capital structure provides a room for expansion or reduction of

debt capital so that, according to changing conditions, adjustment of capital can be
made.
7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on
business to be diluted.
8. Minimization of financial risk:
If debt component increases in the capital structure of a company, the

financial risk (i.e., payment of fixed interest charges and repayment of principal
amount of debt in time) will also increase. A sound capital structure protects a
business enterprise from such financial risk through a judicious mix of debt and
equity in the capital structure.

FACTORS DETERMINING CAPITAL STRUCTURE:
1. Risk of cash insolvency:
Risk of cash insolvency arises due to failure to pay fixed interest liabilities.
Generally, the higher proportion of debt in capital structure compels the company
to pay higher rate of interest on debt irrespective of the fact that the fund is
available or not. The non-payment of interest charges and principal amount in
time call for liquidation of the company.
The sudden withdrawal of debt funds from the company can cause cash
insolvency. This risk factor has an important bearing in determining the capital
structure of a company and it can be avoided if the project is financed by issues
equity share capital.
2. Risk in variation of earnings:
The higher the debt content in the capital structure of a company, the higher
will be the risk of variation in the expected earnings available to equity
shareholders. If return on investment on total capital employed (i.e., shareholders’
fund plus long-term debt) exceeds the interest rate, the shareholders get a higher
return.
On the other hand, if interest rate exceeds return on investment, the

shareholders may not get any return at all.
3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of
funds. It is the price paid for using the capital. A business enterprise should
generate enough revenue to meet its cost of capital and finance its future growth.
The finance manager should consider the cost of each source of fund while
designing the capital structure of a company.

4. Control:
The consideration of retaining control of the business is an important factor

in capital structure decisions. If the existing equity shareholders do not like to
dilute the control, they may prefer debt capital to equity capital, as former has no
voting rights.
5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity as
sources of finance is known as trading on equity. It is an arrangement by which
the company aims at increasing the return on equity shares by the use of fixed
interest bearing securities (i.e., debenture, preference shares etc.).
If the existing capital structure of the company consists mainly of the equity
shares, the return on equity shares can be increased by using borrowed capital.
This is so because the interest paid on debentures is a deductible expenditure for
income tax assessment and the after-tax cost of debenture becomes very low.
Any excess earnings over cost of debt will be added up to the equity
shareholders. If the rate of return on total capital employed exceeds the rate of
interest on debt capital or rate of dividend on preference share capital, the
company is said to be trading on equity.
6. Government policies:
Capital structure is influenced by Government policies, rules and

regulations of SEBI and lending policies of financial institutions which change the
financial pattern of the company totally. Monetary and fiscal policies of the
Government will also affect the capital structure decisions.

7. Size of the company:
Availability of funds is greatly influenced by the size of company. A small

company finds it difficult to raise debt capital. The terms of debentures and long-
term loans are less favourable to such enterprises. Small companies have to
depend more on the equity shares and retained earnings.
On the other hand, large companies issue various types of securities despite
the fact that they pay less interest because investors consider large companies less
risky.
8. Needs of the investors:
While deciding capital structure the financial conditions and psychology of

different types of investors will have to be kept in mind. For example, a poor or
middle class investor may only be able to invest in equity or preference shares
which are usually of small denominations, only a financially sound investor can
afford to invest in debentures of higher denominations. A cautious investor who
wants his capital to grow will prefer equity shares.
9. Flexibility:
The capital structures of a company should be such that it can raise funds as
and when required. Flexibility provides room for expansion, both in terms of
lower impact on cost and with no significant rise in risk profile.
10. Period of finance:
The period for which finance is needed also influences the capital structure.
When funds are needed for long-term (say 10 years), it should be raised by
issuing debentures or preference shares. Funds should be raised by the issue of
equity shares when it is needed permanently.

11. Nature of business:
It has great influence in the capital structure of the business, companies

having stable and certain earnings prefer debentures or preference shares and
companies having no assured income depends on internal resources.
12. Legal requirements:
The finance manager should comply with the legal provisions while
designing the capital structure of a company.
13. Purpose of financing:
Capital structure of a company is also affected by the purpose of financing.

If the funds are required for manufacturing purposes, the company may procure it
from the issue of long- term sources. When the funds are required for non-
manufacturing purposes i.e., welfare facilities to workers, like school, hospital etc.
the company may procure it from internal sources.
14. Corporate taxation:
When corporate income is subject to taxes, debt financing is favourable.

This is so because the dividend payable on equity share capital and preference
share capital are not deductible for tax purposes, whereas interest paid on debt is
deductible from income and reduces a firm’s tax liabilities. The tax saving on
interest charges reduces the cost of debt funds.
Moreover, a company has to pay tax on the amount distributed as dividend

to the equity shareholders. Due to this total earnings available for both debt
holders and stockholders is more when debt capital is used in capital structure.
Therefore, if the corporate tax rate is high enough, it is prudent to raise capital by
issuing debentures or taking long-term loans from financial institutions.

15. Cash inflows:
The selection of capital structure is also affected by the capacity of the

business to generate cash inflows. It analyses solvency position and the ability of
the company to meet its charges.
16. Provision for future:
The provision for future requirement of capital is also to be considered

while planning the capital structure of a company.
17. EBIT-EPS analysis:
If the level of EBIT is low from HPS point of view, equity is preferable to
debt. If the EBIT is high from EPS point of view, debt financing is preferable to
equity. If ROI is less than the interest on debt, debt financing decreases ROE.
When the ROI is more than the interest on debt, debt financing increases ROE.

CAPITAL ALLOCATION
Capita allocation is the method that banks use to determine the notional
amount of equity capital needed to support a business. Capital budgeting is the
process of deploying banks’ equity capital to support banks’ strategic objectives.
Banks are improving their capital allocation and budgeting practices to

adjust to the strengthening of the regulatory capital framework in the aftermath of
the financial crisis. Banks are now subject to tougher and a larger number of
regulatory capital metrics. In addition, banks also have to comply with new
liquidity standards and some regulatory constraints on the group holding structure
which may also affect how they measure business performance, but these factors
are not considered here.
This article presents the findings of two PRA reviews on capital

allocation practices used by banks to assess the relative profitability of different
business lines such as retail, commercial or investment banking. It aims to shed
light on a commercial practice that is still not publicly well-known and is
undergoing significant changes following the post crisis overhaul of the banking
regulatory capital framework. And, to flag some questions or issues that could
benefit from further analysis and research by the academic community and
practitioners on the policy implications of these capital allocation approaches.
To assess business performance, banks use a return metric which is the

ratio of profits generated by business lines to the notional equity capital allocated
to them. Although banks may also have different approaches to calculating
profits, this article will concentrate on the denominator of this return metric i.e.
how banks determine the notional allocated equity capital.
In this article we first explain why, in the post crisis environment, banks
face greater challenges in managing their capital resources as far as regulatory
metrics are concerned. We then discuss the role of capital allocation and

budgeting in banks’ strategic management as well as their impact on economic
activities. Finally, we describe banks’ approaches to capital allocation and briefly
discuss their capital budgeting practices. An annex sets out the key elements of
the international post crisis standards for capital requirements. The content of the
first three sections may already be quite familiar to readers with a good conceptual
knowledge of capital allocation. These readers may prefer to go directly to the last
section describing banks’ practices.
ROLE OF CAPITAL ALLOCATION AND CAPITAL BUDGETING IN

BANKS’ STRATEGIC MANAGEMENT
Banks translate their strategic plans into detailed capital budgets. A

bank’s strategic plan sets out the strategy such as where to grow, which businesses
to downsize and where to make strategic investments to secure future, profitable
growth. A capital budgeting process deploys the available equity capital to
business lines consistent with this plan. The deployment of equity capital
resources also needs to be consistent with other strategic management tools such
as a bank’s risk appetite and its limit framework that sets hard limits on balance
sheet and RWAs consumption, among others.
When banks engage in multiple activities, they need to be able to

evaluate their different business lines on a common measurement standard.
Capital allocation allows banks to assess the relative performance across different
business lines against the amount of equity capital allocated. Its outcomes are thus
important for the monitoring of performance against the strategy. Gaps between
the expected and actual performance prompt banks to review their strategies.
Periodic performance reviews are also helpful to keep track of the material
changes in the business environment that may require substantial adjustment to
the business strategy.

RISKS IN BANKS
In the post LPG period, the banking sector has witnessed tremendous
competition not only from the domestic banks but from foreign banks alike. In
fact, competition in the banking sector has emerged due to disintermediation and
deregulation. The liberalized economic scenario of the country has opened various
new avenues for increasing revenues of banks. In order to grab this opportunity,
Indian commercial banks have launched several new and innovated products,
introduced facilities like ATMs, Credit Cards, Mobile banking, Internet banking
etc. Apart from the traditional banking products, it is seen that Mutual Funds,
Insurance etc. are being designed/ upgraded and served to attract more customers
to their fold.
In the backdrop of all these developments i.e., deregulation in the Indian

economy and product/ technological innovation, risk exposure of banks has also
increased considerably. Thus, this has forced banks to focus their attention to risk
management (Sharma, 2003). In fact, the importance of risk management of banks
has been elevated by technological developments, the emergence of new financial
instruments, deregulation and heightened capital market volatility.
In short, the two most important developments that have made it

imperative for Indian commercial banks to give emphasize on risk management
are discussed below –
(a) Deregulation: The era of financial sector reforms which started in early 1990s
has culminated in deregulation in a phased manner. Deregulation has given
banks more autonomy in areas like lending, investment, interest rate structure
etc. As a result of these developments, banks are required to manage their own
business themselves and at the same time maintain liquidity and profitability.
This has made it imperative for banks to pay more attention to risk
management.

(b) Technological innovation: Technological innovations have provided a
platform to the banks for creating an environment for efficient customer
services as also for designing new products. In fact, it is technological
innovation that has helped banks to manage the assets and liabilities in a better
way, providing various delivery channels, reducing processing time of
transactions, reducing manual intervention in back office functions etc.
However, all these developments have also increased the diversity and
complexity of risks, which need to be managed professionally so that the
opportunities provided by the technology are not negated.
TYPES OF RISK IN BANK
Risk may be defined as ‘possibility of loss’, which may be financial loss

or loss to the image or reputation. Banks like any other commercial organisation
also intend to take risk, which is inherent in any business. Higher the risk taken,
higher the gain would be. But higher risks may also result into higher losses.
However, banks are prudent enough to identify measure and price risk, and
maintain appropriate capital to take care of any eventuality. The major risks in
banking business or ‘banking risks’, as commonly referred, are listed below –
 Liquidity Risk
 Interest Rate Risk
 Market Risk
 Credit or Default Risk
 Operational Risk

 LIQUIDITY RISK
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 (Kumar et al., 2005). It can be also defined as the possibility that
an institution may be unable to meet its maturing commitments or may do so only
by borrowing funds at prohibitive costs or by disposing assets at rock bottom
prices. The liquidity risk in banks manifest in different dimensions –
(a) Funding Risk: Funding Liquidity Risk is defined as the inability to obtain
funds to meet cash flow obligations. For banks, funding liquidity risk is crucial.
This arises from the need to replace net outflows due to unanticipated withdrawal/
non-renewal of deposits (wholesale and retail).
(b) Time Risk: Time risk arises from the need to compensate for nonreceipt of
expected inflows of funds i.e., performing assets turning into non-performing
assets.
(c) Call Risk: Call risk arises due to crystallization of contingent liabilities. It
may also arise when a bank may not be able to undertake profitable business
opportunities when it arises.

 INTEREST RATE RISK
Interest Rate Risk arises when the Net Interest Margin or the Market Value
of Equity (MVE) of an institution is affected due to changes in the interest rates.
In other words, the risk of an adverse impact on Net Interest Income (NII) due to
variations of interest rate may be called Interest Rate Risk (Sharma, 2003). It is
the exposure of a Bank’s financial condition to adverse movements in interest
rates.
IRR can be viewed in two ways – its impact is on the earnings of the bank
or its impact on the economic value of the bank’s assets, liabilities and Off-
Balance Sheet (OBS) positions. Interest rate Risk can take different forms. The
following are the types of Interest Rate Risk –
(a) 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 re-pricing dates, thereby creating exposure to unexpected
changes in the level of market interest rates.
(b) Yield Curve Risk: Banks, in a floating interest scenario, may price their
assets and liabilities based on different benchmarks, i.e., treasury bills’ yields,
fixed deposit rates, call market rates, MIBOR etc. In case the banks use two
different instruments maturing at different time horizon for pricing their assets
and liabilities then any non-parallel movements in the yield curves, which is
rather frequent, would affect the NII. Thus, banks should evaluate the movement
in yield curves and the impact of that on the portfolio values and income.

An example would be when a liability raised at a rate linked to say 91 days T
Bill is used to fund an asset linked to 364 days T Bills. In a raising rate scenario
both, 91 days and 364 days T Bills may increase but not identically due to non-
parallel movement of yield curve creating a variation in net interest earned.
(c) Basis Risk: Basis Risk is the risk that arises when the interest rate of different
assets, liabilities and off-balance sheet items may change in different magnitude.
For example, in a rising interest rate scenario, asset interest rate may rise in
different magnitude than the interest rate on corresponding liability, thereby
creating variation in net interest income.
The degree of basis risk is fairly high in respect of banks that create
composite assets out of composite liabilities. The loan book in India is funded out
of a composite liability portfolio and is exposed to a considerable degree of basis
risk. The basis risk is quite visible in volatile interest rate scenarios. When the
variation in market interest rate causes the NII to expand, the banks have
experienced favourable basis shifts and if the interest rate movement causes the
NII to contract, the basis has moved against the banks.
(d) Embedded Option Risk: Significant changes in market interest rates create
the 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 experienced in volatile situations and is
becoming a reality in India. The faster and higher the magnitude of changes in
interest rate, the greater will be the embedded option risk to the banks’ Net
Interest Income. The result is the reduction of projected cash flow and the income
for the bank.

(e) Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with
regard to interest rate at which the future cash flows could be reinvested. Any
mismatches in cash flows i.e., inflow and outflow would expose the banks to
variation in Net Interest Income. This is because market interest received on loan
and to be paid on deposits move in different directions.
(f) Net Interest Position Risk: Net Interest Position Risk arises when the market
interest rates adjust downwards and where banks have more earning assets than
paying liabilities. Such banks will experience a reduction in NII as the market
interest rate declines and the NII increases when interest rate rises. Its impact is on
the earnings of the bank or its impact is on the economic value of the banks’
assets, liabilities and OBS positions.
(d) Embedded Option Risk: Significant changes in market interest rates create
the 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 experienced in volatile situations and is
becoming a reality in India. The faster and higher the magnitude of changes in
interest rate, the greater will be the embedded option risk to the banks’ Net
Interest Income. The result is the reduction of projected cash flow and the income
for the bank.
(e) Reinvested Risk: Reinvestment risk is the risk arising out of uncertainty with
regard to interest rate at which the future cash flows could be reinvested. Any
mismatches in cash flows i.e., inflow and outflow would expose the banks to
variation in Net Interest Income. This is because market interest received on loan
and to be paid on deposits move in different directions.

(f) Net Interest Position Risk: Net Interest Position Risk arises when the market
interest rates adjust downwards and where banks have more earning assets than
paying liabilities. Such banks will experience a reduction in NII as the market
interest rate declines and the NII increases when interest rate rises. Its impact is on
the earnings of the bank or its impact is on the economic value of the banks’
assets, liabilities and OBS positions.
 MARKET RISK
The risk of adverse deviations of the mark-to-market value of the trading
portfolio, due to market movements, during the period required to liquidate the
transactions is termed as Market Risk (Kumar et al., 2005). This risk results from
adverse movements in the level or volatility of the market prices of interest rate
instruments, equities, commodities, and currencies. It is also referred to as Price
Risk.
Price 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.
The term Market risk applies to (i) that part of IRR which affects the price
of interest rate instruments, (ii) Pricing risk for all other assets/ portfolio that are
held in the trading book of the bank and (iii) Foreign Currency Risk.

(a) Forex Risk: Forex risk is the risk that a bank may suffer losses as a result of
adverse exchange rate movements during a period in which it has an open position
either spot or forward, or a combination of the two, in an individual foreign
currency.
(b) Market Liquidity Risk: Market liquidity risk arises when a bank is unable to
conclude a large transaction in a particular instrument near the current market
price.
 DEFAULT OR CREDIT RISK
Credit risk is more simply defined as the potential of a bank borrower or

counterparty to fail to meet its obligations in accordance with the agreed terms. In
other words, credit risk can be defined as the risk that the interest or principal or
both will not be paid as promised and is estimated by observing the proportion of
assets that are below standard. Credit risk is borne by all lenders and will lead to
serious problems, if excessive. For most banks, loans are the largest and most
obvious source of credit risk. It is the most significant risk, more so in the Indian
scenario where the NPA level of the banking system is significantly high. The
Asian Financial crisis, which emerged due to rise in NPAs to over 30% of the
total assets of the financial system of Indonesia, Malaysia, South Korea and
Thailand, highlights the importance of management of credit risk.

There are two variants of credit risk which are discussed below –
(a) Counterparty Risk: This is a variant of Credit risk and is related to non-
performance of the trading partners due to counterparty’s refusal and or
inability to perform. The counterparty risk is generally viewed as a transient
financial risk associated with trading rather than standard credit risk.
(b) Country Risk: This is also a type of credit risk where nonperformance of a
borrower or counterparty arises due to constraints or restrictions imposed by a
country. Here, the reason of nonperformance is external factors on which the
borrower or the counterparty has no control.
Credit Risk depends on both external and internal factors. The internal
factors include –
1. Deficiency in credit policy and administration of loan portfolio.
2. Deficiency in appraising borrower’s financial position prior to lending.
3. Excessive dependence on collaterals.
4. Bank’s failure in post-sanction follow-up, etc.
The major external factors –
1. The state of economy
2. Swings in commodity price, foreign exchange rates and interest rates,etc.
Credit Risk can’t be avoided but has to be managed by applying various risk
mitigating processes –
1. Banks should assess the credit worthiness of the borrower before sanctioning loan
i.e., credit rating of the borrower should be done beforehand. Credit rating is main
tool of measuring credit risk and it also facilitates pricing the loan. By applying a
regular evaluation and rating system of all investment opportunities, banks can
reduce its credit risk as it can get vital information of the inherent weaknesses of
the account.

2. Banks should fix prudential limits on various aspects of credit – benchmarking
Current Ratio, Debt Equity Ratio, Debt Service Coverage Ratio, Profitability
Ratio etc.
3. There should be maximum limit exposure for single/ group borrower.
4. There should be provision for flexibility to allow variations for very special
circumstances.
5. Alertness on the part of operating staff at all stages of credit dispensation –
appraisal, disbursement, review/ renewal, post sanction follow-up can also be
useful for avoiding credit risk.
 OPERATIONAL RISK
Basel Committee for Banking Supervision has defined operational risk as
‘the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events’. Thus, operational loss has mainly three exposure
classes namely people, processes and systems.
Managing operational risk has become important for banks due to the following
reasons –
1. Higher level of automation in rendering banking and financial services
2. Increase in global financial inter-linkages
Scope of operational risk is very wide because of the above mentioned reasons.
Two of the most common operational risks are discussed below –

(a) Transaction Risk: Transaction risk is the risk arising from fraud, both internal
and external, failed business processes and the inability to maintain business
continuity and manage information.
(c) Compliance Risk: Compliance risk is the risk of legal or regulatory sanction,
financial loss or reputation loss that a bank may suffer as a result of its failure
to comply with any or all of the applicable laws, regulations, codes of conduct
and standards of good practice. It is also called integrity risk since a bank’s
reputation is closely linked to its adherence to principles of integrity and fair
dealing.
 OTHER RISKS
Apart from the above mentioned risks, following are the other risks
confronted by Banks in course of their business operations –
(a) Strategic Risk: Strategic Risk is the risk arising from adverse business
decisions, improper implementation of decisions or lack of responsiveness to
industry changes. This risk is a function of the compatibility of an organisation’s
strategic goals, the business strategies developed to achieve those goals, the
resources deployed against these goals and the quality of implementation.
(b) Reputation Risk: Reputation Risk is the risk arising from negative public
opinion. This risk may expose the institution to litigation, financial loss or decline
in customer base.

RISK MANAGEMENT PRACTICES IN INDIA
Risk Management, according to the knowledge theorists, is actually a

combination of management of uncertainty, risk, equivocality and error.
Uncertainty – where outcome cannot be estimated even randomly, arises due to
lack of information and this uncertainty gets transformed into risk (where
estimation of outcome is possible) as information gathering progresses. As
information about markets and knowledge about possible outcomes increases, risk
management provides solution for controlling risk. Equivocality arises due to
conflicting interpretations and the resultant lack of judgment. This happens
despite adequate knowledge of the situation. That is why; banking as well as other
institutions develops control systems to reduce errors, information systems to
reduce uncertainty, incentive system to manage agency problems in risk reward
framework and cultural systems to deal with equivocality.
Initially, the Indian banks have used risk control systems that kept pace with
legal environment and Indian accounting standards. But with the growing pace of
deregulation and associated changes in the customer’s behaviour, banks are
exposed to mark-to-market accounting. Therefore, the challenge of Indian banks
is to establish a coherent framework for measuring and managing risk consistent
with corporate goals and responsive to the developments in the market. As the
market is dynamic, banks should maintain vigil on the convergence of regulatory
frameworks in the country, changes in the international accounting standards and
finally and most importantly changes in the clients’ business practices. Therefore,
the need of the hour is to follow certain risk management norms suggested by the
RBI and BIS.

ROLE OF RBI IN RISK MANAGEMENT IN BANKS
The Reserve Bank of India has been using CAMELS rating to evaluate the
financial soundness of the Banks. The CAMELS Model consists of six
components namely Capital Adequacy, Asset Quality, Management, Earnings
Quality, Liquidity and Sensitivity to Market risk
In 1988, The Basel Committee on Banking Supervision of the Bank for

International Settlements (BIS) has recommended using capital adequacy, assets
quality, management quality, earnings and liquidity (CAMEL) as criteria for
assessing a Financial Institution. The sixth component, sensitivity to market risk
was added to CAMEL in 1997. However, most of the developing countries are
using CAMEL instead of CAMELS in the performance evaluation of the FIs. The
Central Banks in some of the countries like Nepal, Kenya use CAEL instead of
CAMELS. CAMELS framework is a common method for evaluating the
soundness of Financial Institutions.
In India, the focus of the statutory regulation of commercial banks by RBI

until the early 1990s was mainly on licensing, administration of minimum capital
requirements, pricing of services including administration of interest rates on
deposits as well as credit, reserves and liquid asset requirement. In these
circumstances, the supervision had to focus essentially on solvency issues. After
the evolution of the BIS prudential norms in 1988, the RBI took a series of
measures to realign its supervisory and regulatory standards and bring it at par
with international best practices. At the same time, it also took care to keep in
view the socio-economic conditions of the country, the business practices,
payment systems prevalent in the country and the predominantly agrarian nature
of the economy, and ensured that the prudential norms were applied over the
period and across different segments of the financial sector in a phased manner.

Finally, it was in the year 1999 that RBI recognized the need of an
appropriate risk management and issued guidelines to banks regarding assets
liability management, management of credit, market and operational risks. The
entire supervisory mechanism has been realigned since 1994 under the directions
of a newly constituted Board for Financial Supervision (BFS), which functions
under the aegis of the RBI, to suit the demanding needs of a strong and stable
financial system. The supervisory jurisdiction of the BFS now extends to the
entire financial system barring the capital market institutions and the insurance
sector. The periodical on-site inspections, and also the targeted appraisals by the
Reserve Bank, are now supplemented by off-site surveillance which particularly
focuses on the risk profile of the supervised institution. A process of rating of
banks on the basis of CAMELS in respect of Indian banks and CACS (Capital,
Asset Quality, Compliance and Systems & Control) in respect of foreign banks
has been put in place from 1999.
Since then, the RBI has moved towards more stringent capital adequacy
norms and adopted the CAMEL (Capital adequacy, Asset quality, Management,
Earnings, Liquidity) based rating system for evaluating the soundness of Indian
banks. The Reserve Bank’s regulatory and supervisory responsibility has been
widened to include financial institutions and non-banking financial companies. As
a result, considering the changes in the Banking industry, the thrust lies upon Risk
- Based Supervision (RBS). The main supervisory issues addressed by Board for
Financial Supervision (BFS) relate to on-site and off-site supervision of banks.
The on-site supervision system for banks is on an annual cycle and is based
on the ‘CAMEL’ model. It focuses on core assessments in accordance with the
statutory mandate, i.e., solvency, liquidity, operational soundness and
management prudence. Thus, banks are rated on this basis. Moreover, in view of
the recent trends towards financial integration, competition, globalization, it has
become necessary for the BFS to supplement on-site supervision with off-site
surveillance so as to capture ‘early warning signals’ from off-site monitoring that
would be helpful to avert the likes of East Asian financial crisis. The off-site

monitoring system consists of capital adequacy, asset quality, large credit and
concentration, connected lending, earnings and risk exposures viz., currency,
liquidity and interest rate risks. Apart from this, the fundamental and technical
analysis of stock of banks in the secondary market will serve as a supplementary
indicator of financial performance of banks.
Thus, on the basis of RBS, a risk profile of individual Bank will be

prepared. A high-risk sensitive bank will be subjected to more intensive
supervision by shorter periodicity with greater use of supervisory tools aimed on
structural meetings, additional off site surveillance, regular on site inspection etc.
This will be undertaken in order to ensure the stability of the Indian Financial
System.

THE BASEL COMMITTEE
At the end of 1974, the Central Bank Governors of the Group of Ten
countries formed a Committee of banking supervisory authorities. As this
Committee usually meets at the Bank of International Settlement (BIS) in Basel,
Switzerland, this Committee came to be known as the Basel Committee. The
Committee’s members came from Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United
Kingdoms and the United States. Countries are represented by their central banks
and also by the authority with formal responsibility for the prudential supervision
of banking business where this is not the central bank.
The Basel Committee does not possess any formal supra-national

supervisory authority, and its conclusions do not, and were never intended to,
have legal force. Rather, it formulates broad supervisory standards and guidelines
and recommends the statements of best practice in the expectation that individual
authorities will take steps to implement them through detailed arrangements –
statutory or otherwise – which are best suited to their own national systems. In
this way, the Committee encourages convergence towards common approaches
and common standards without attempting detailed harmonization of member
countries’ supervisory techniques.
The Committee reports to the central bank Governors of the Group of Ten
countries and seeks the Governors’ endorsement for its major initiatives. In
addition, however, since the Committee contains representatives from institutions,
which are not central banks, the decision involves the commitment of many
national authorities outside the central banking fraternity. These decisions cover a
very wide range of financial issues.

One important objective of the Committee’s work has been to close gaps in
international supervisory coverage in pursuit of two basic principles – that no
foreign banking establishment should escape supervision and the supervision
should be adequate. To achieve this, the Committee has issued a long series of
documents since 1975.
BASEL I
In 1988, the BASEL Committee decided to introduce a capital

measurement system (BASEL I) commonly referred to as the Basel Capital
Accord. Since 1988, this framework has been progressively introduced not only in
member countries but also in virtually all other countries with active international
banks. Towards the end of 1992, this system provided for the implementation of a
credit risk measurement framework with minimum capital standard of 8%.
The basic achievement of Basel I have been to define bank capital and the
so called bank capital ratio. Basel I is a ratio of capital to risk-weighted assets.
The numerator, Capital, is divided into Tier 1 (equity capital plus disclosed
reserves minus goodwill) and Tier 2 (asset revaluation reserves, undisclosed
reserves, general loan loss reserves, hybrid capital instrument and subordinated
term debt). Tier 1 capital ought to constitute at least 50 per cent of the total capital
base. Subordinated debt (with a minimum fixed term to maturity of five years,
available in the event of liquidation, but not available to participate in the losses of
a bank which is still continuing its activities) is limited to a maximum of 50 per
cent of Tier 1.
The denominator of the Basel I formula is the sum of risk-adjusted assets

plus off-balance sheet items adjusted to risk. There are five credit risk weights: 0
per cent, 10 per cent, 20 per cent, 50 per cent and 100 per cent and equivalent
credit conversion factors for off-balance sheet items. Some of the risk weights are
rather ‘arbitrary’ (for example, 0 % for government or central bank claims, 20 %
for organization for Economic Cooperation and Development (OECD) inter-bank

claims, 50 % for residential mortgages, 100 % for all commercial and consumer
loans). The weights represent a compromise between differing views, and are not
‘stated truths’ about the risk profile of the asset portfolio, but rather the result of
bargaining on the basis of historical data available at that time on loan
performance and judgments about the level of risk of certain parts of counterpart,
guarantor or collateral. The risk weights have created opportunities for regulatory
arbitrage.
Interestingly, there is no strong theory for the ‘target’ ratio 8 per cent of
capital (tier 1 plus tier 2) to risk-adjusted assets plus off-balance sheet items. The
8% figure has been derived based on the median value in existing good practice at
the time (US/UK 1986 Accord): the UK and the USA bank around 7.5 per cent,
Switzerland 10 per cent and France and Japan 3 per cent etc. Basel I was a
simple ratio, despite the rather ‘arbitrary’ nature of the definition of Tier 2 capital,
the risk weights and the 8 % target ratio. It is a standard broadly accepted by the
industry and by the authorities in both developed and developing countries.
BASEL II
Central bank Governors and the heads of bank supervisory authorities in

the Group of Ten (G10) countries endorsed the publication of ‘International
Convergence of Capital Measurement and Capital Standards: a Revised
Framework’, the new capital adequacy framework commonly known as Basel II.
The Committee intends that the revised framework would be implemented by the
end of year 2006.
In principle, the new approach (Basel II) is not intended to raise or lower
the overall level of regulatory capital currently held by banks, but to make it more
risk sensitive. The spirit of the new Accord is to encourage the use of internal
systems for measuring risks and allocating capital. The new Accord also wishes to
align regulatory capital more closely with economic capital. The proposed capital
framework consists of three pillars –

Pillar 1 - Minimum capital requirements
Pillar 2 - Supervisory review process
Pillar 3 - Market discipline
Pillar 1: Minimum Capital Requirements
Pillar 1 of the new capital framework revises the 1988 Accord’s guidelines by
aligning the minimum capital requirements more closely to each bank’s actual risk
of economic loss. The minimum capital adequacy ratio would continue to be 8%
of the risk-weighted assets (as per RBI, it is 9%), which will cover capital
requirements for credit, market and operational risks.
Estimating Capital required for Credit Risks
For estimating the capital required for credit risks, a range of approaches
such as Standardized, Foundation Internal Rating Based (IRB) and Advanced IRB
are suggested.
Under the Standardized Approach, preferential weights ranging from 0% to

150% would be assigned to assets based on the external credit rating agencies,
approved by the national supervisors in accordance with the criteria defined by the
Committee.
Under Internal Rating Based (IRB) Approach, banks would be allowed to

estimate their own Probability of Default (PD) instead of standard percentages
such as 20%, 50%, 100% etc. For this purpose, two approaches namely
Foundation IRB and Advanced IRB are suggested. In case of Foundation IRB
approach, RBI is required to set rules for estimating the value of Loss Given
Default (LGD) and Exposure at Default (EAD), while under Advanced IRB
approach, banks would be allowed to use their own estimates of LGD and EAD.

Estimating Capital required for Market Risks
The Narasimham Committee II on Banking Sector Reforms had

recommended that in order to capture market risk in the investment portfolio, a
risk-weight of 5% should be applied for Government2 and other approved
securities for the purpose of capital adequacy. The Reserve Bank of India has
prescribed 2.5% risk-weight for capital adequacy for market risk on SLR and non-
SLR securities with effect from March 2000 and 2001 respectively, in addition to
appropriate risk-weights for credit risk. Further the banks in India are required to
apply the 2.5% risk-weight for capital charges for market risk for the whole
investment portfolio and 100 % risk-weight on open gold and forex position
limits.
Estimating Capital required for Operational Risks
For operational risk, three approaches namely Basic Indicator, Standardized

and Internal measurement have been provided. Under the Basic Indicator
approach, banks have to hold capital for operational risk equal to the fixed
percentage (Alpha) of average annual gross income over the previous three years.
K BIA = GI x α
Where
K BIA = the capital charge under the Basic Indicator Approach
GI = average annual gross income over the previous three years.
α= fixed percentage

In fact, under the above approach, the additional capital required for
operational risk is 20% of the minimum regulatory capital (i.e., 20 % of 9 % = 1.8
% of the total risk weighted assets)
The standardized approach builds on the basic indicator approach. It divides

the bank’s activities into 8 business lines – corporate finance, trading and sales,
retail banking, commercial banking, payment and settlement, agency services,
asset management and retail brokerage. The capital charge for operational risk is
arrived at based on fixed percentage for each business line.
The Internal measurement approach allows individual banks to use their

own data to determine capital required for operational risk
Thus, under BASEL II, the denominator of the minimum capital ratio will
consist of three parts – the sum of all risk weighted assets for credit risk, plus 12.5
times (reciprocal of 8 % minimum risk based capital ratio) the sum of the capital
charges for market risk and operational risk. The multiplicatory factor of 12.5 has
been introduced in order to enable banks to create a numerical link between the
calculation of capital requirement for credit risk and the capital requirement for
operational and market risks. In case of capital requirement for credit risk,
calculation of capital is based on the risk weighted assets. However, for
calculating capital requirement for operational and market risk, the capital charge
itself is calculated directly.
Regulatory Capital
__________________________________________________________= Desired Capital

Risk weight Asset × 12.5 (Market + Operational Risks) Ratio (CAR)
For Credit Risk
Hence, the regulatory requirements cover three types of risks, credit risk, market
and operational risks.

Pillar 2: Supervisory Review Process
Pillar 2 of the new capital framework recognizes the necessity of

exercising effective supervisory review of banks’ internal assessments of their
overall risks to ensure that bank management is exercising sound judgment and
had set aside adequate capital for these risks. To be more specific –
 Supervisors will evaluate the activities and risk profiles of individual banks to
determine whether those organizations should hold higher levels of capital than
the minimum requirements in Pillar 1 would specify and to see whether there is
any need for remedial actions.
 The committee expects that, when supervisors engage banks in a dialogue about
their internal processes for measuring and managing their risks, they will help to
create implicit incentives for organizations to develop sound control structures
and to improve those processes.
Thus, the supervisory review process is intended not only to ensure that
banks have adequate capital to support all the risks in their business, but also to
encourage banks to develop and use better risk management techniques in
monitoring and managing their risks.
There are three main areas that might be particularly suited to treatment under
Pillar 2.
Risks considered under Pillar 1 that are not fully captured by the Pillar 1
process (e.g. the proposed Operational risk in Pillar 1 may not adequately cover
all the specific risks of any given institution).
 Those factors not taken into account by the Pillar 1 process e.g. interest rate risk
 Factor external to the bank e.g. business cycle effects.

Pillar 3: Market Discipline
Pillar 3 leverages the ability of market discipline to motivate prudent

management by enhancing the degree of transparency in banks’ public reporting.
It sets out the public disclosures that banks must make that lend greater insight
into the adequacy of their capitalization. The Committee believes that, when
market place participants have a sufficient understanding of a bank’s activities and
the controls it has in place to manage its exposures, they are better able to
distinguish between banking organizations so that they can reward those that
manage their risks prudently and penalize those that do not.
Thus, adequate disclosure of information to public brings in market

discipline and in the process promotes safety and soundness in the financial
system. The Committee proposes two types of disclosures namely Core and
Supplementary. Core disclosures are those which convey vital information for all
institutions while Supplementary disclosures are those required for some. The
Committee recommends that all sophisticated internationally active banks should
make the full range of core and supplementary information publicly available. The
Committee also has emphasized the importance of timeliness of information. For
the purpose, it has recommended disclosure on semi-annual basis and for
internationally active banks on a quarterly basis.

GLOBAL FINANCIAL CRISIS AND THE INDIAN
BANKING SECTOR
The impact of the global crisis has been transmitted to the Indian economy
through three distinct channels, viz., the financial sector, exports and exchange
rates. Fortunately, India, like most of the emerging economies, was lucky to avoid
the first round of adverse affects because its banks were not overly exposed to
subprime lending. Only one of the larger private sector banks, the ICICI Bank,
was partly exposed but it managed to counter the crisis through a strong balance
sheet and timely government action. Excellent regulations by RBI and the
decision not to allow investment banking on the US model were the two main
reasons that helped to overcome the adverse situation. Further, RBI has also
enforced the prudential and capital adequacy norms without fear or favour.
RBI regulations are equally applicable to all the Indian Banks, both in the
public and private sector. Indian commercial banks are professionally managed
and proper risk management systems are put in place. In short, it can be said that
strict regulation and conservative policies adopted by the Reserve Bank of India
have ensured that banks in India are relatively insulated from the travails of their
western counterparts. Contrary to the situation in India, in U.S., certain relaxations
were permitted in the case of large banks which were considered ‘too big to fail’
and this relaxation ultimately triggered the crisis. Thus, eventually it was proved
that it is not the size that matters, but prudence and proper risk management
systems. Interestingly, while the developed world, including the U.S, the Euro
Zone and Japan, has plunged into recession, the Indian Economy is being affected
by the spill-over effects of the global financial crisis only.
In fact, the financial sector has emerged without much damage and this
was possible due to our strong regulatory framework and in part on account of
state ownership of most of the banking sector.

Although, Indian banks escaped the contagion because they were highly
regulated at home and not too integrated with the global financial system in terms
of sharing the risks inherent in the trillions of dollars of worthless financial
products, but the global financial crisis and its aftermath forced banks to
introspect about the kind of financial sector architecture India should have in the
years ahead apart from quantification of risk and appropriate risk management
models.
Interestingly, over the years, there were significant developments in the

area of quantification of risk and presently, the focus has shifted to statistical
aspects of risk management – especially to risk modeling and other computational
techniques of risk measurement. Although academic research advocates the use of
VaR for market risk assessment, in respect of credit risk, there is no single ‘best
practice’ model for credit risk capital assessment. The Basel II ‘Internal Rating
Based’ methodology provides a portfolio model for credit risk management but
bank managements will have to focus on the determinants of credit risk factors,
the dependency between risk factors, the integration of credit risk to market risk,
data integrity issues like consistency of data over long periods, accuracy and so
on. Likewise, models for assessing and managing other types of risk in the
banking business need to be developed and simultaneously data availability and
reliability issues with respect to the models need to be resolved.
Although researches are on to develop risk management models that can be

used universally for assessing and managing risk, remarkable headway is yet to be
seen. As far private sector banks are concerned, it was seen that irrational loan
advances, and investments are prominent more than public sector banks.
Therefore, private sector banks need strong and effective risk control systems.
However, the in-built risk control systems that are being followed presently are
equally strong for public and foreign sector banks

SOURCES OF DATA
There are two main sources of data
 Primary Data
 Secondary Data
 PRIMARY DATA:
Consists of original information collected for specific purpose.
Primary data for this research are collected through a visit from banks.
 SECONDARY DATA:
It consists of information that already exists somewhere and has
been collected for some specific purpose in the study. The secondary data for this
study is collected from various sources like books, websites and etc.

FINDINGS
While making the project I found lot of things
 What are the components of Bank’s capital, what are they, what does it includes
and how it perform.
 How do the banks manage their Assets & Liabilities, about their committee and
framework.
 How do the banks manage their capital allocation, capital ratio, risks and etc.
 What is the Role of RBI in Risk Management of Banks.
 Know what is Basel Committee
 Came to know about Global Financial Crisis

CONCLUSION
Banking systems have been with us for as long as people have been using
money. Bank and other financial institutions provide security for individuals,
businesses and governments, alike. Let's recap what has been learned with this
tutorial:
In general, what banks do is pretty easy to figure out. For the average person
banks accept deposits, make loans, provide a safe place for money and valuables,
and act as payment agents between merchants and banks.
Banks are quite important to the economy and are involved in such
economic activities as issuing money, settling payments, credit intermediation,
maturity transformation and money creation in the form of fractional reserve
banking.
To make money, banks use deposits and whole sale deposits, share
equity and fees and interest from debt, loans and consumer lending, such as credit
cards and bank fees.
In addition to fees and loans, banks are also involved in various other
types of lending and operations including, buy/hold securities, non-interest
income, insurance and leasing and payment treasury services.
History has proven banks to be vulnerable to many risks, however,

including credit, liquidity, market, operating, interesting rate and legal risks. Many
global crises have been the result of such vulnerabilities and this has led to the
strict regulation of state and national banks.

However, other financial institutions exist that are not restricted by such
regulations. Such institutions include: savings and loans, credit unions, investment
and merchant banks, shadow banks, Islamic banks and industrial banks.
Risk is indispensable for banking business; proper assessment of risk is an

integral part of a bank’s risk management system. Banks are focusing on the
magnitude of their risk exposure and formulating strategies to tackle those
effectively. In the context of risk management practices, the introduction of Basel
II norms and its subsequent adoption by RBI is a significant measure that
promises to promote sound risk management practices. BASEL II seeks to
enhance the risk sensitivity of capital requirements, promote a comprehensive
coverage of risks, offer a more flexible approach through a menu of options, and
is intended to be applied to banks worldwide.
Moreover, the RBI has adopted a series of steps to ensure that individual
banks tackle risks effectively by setting up risk management cells and also
through internal assessment of their risk exposure. Apart from this, RBI has opted
for on-site and off-site surveillance methods for effective risk management in the
Indian Banking sector, so that systemic risk and financial turmoil can be averted
in the country.
Post crisis reforms have significantly strengthened the regulatory capital

framework for banks by increasing the required level of capital, raising its quality
and introducing complementary solvency based metrics to make the whole
framework more robust to different types of uncertainties.
Regulators may also wish to monitor how banks are evolving their
frameworks over time. For instance, it may be worth monitoring how the weights
attached to different metrics are shifting and, depending on how any such shifts
affect banks’ behaviour, whether there are implications for the intended and
unintended effects ofprudential policies.

The Basel Committee recognizes that there is variation across jurisdictions
related to the scope of authority of supervisors in the area of capital planning.
Accordingly, this paper highlights fundamental components of a sound capital
planning process. The Committee believes that they are broadly applicable to
banking organizations required to implement the Basel III framework.
The Basel Committee views capital planning as a necessary complement to

a robust regulatory framework. Sound capital planning is critical for determining
the prudent amount, type and composition of capital that is consistent with a
longer-term strategy of being able to pursue business objectives, while also
withstanding a stressful event. More broadly, the provision of better capital
planning practices furthers the Basel Committee’s objective of consistently
implementing the Basel III framework as a means of maintaining the resilience of
the global financial system.

BIBLOGRAPHY
 Acosta Smith, J, Grill, M and Lang, J H (2017), ‘The leverage ratio risk‑taking and
bank stability’, ECB Working Paper Series No. 2079.
 Cadamagnani, F, Harimohan, R and Tangri, K (2015), ‘A bank within a bank: how
a commercial bank’s treasury function affects the interest rates set for loans and
deposits’, Bank of England Quarterly Bulletin, 2015 Q2;
www.bankofengland.co.uk/‑/media/boe/files/quarterly‑bulletin/2015/a‑bank‑within‑
a‑bank‑how‑a‑commercial‑banks‑treasury‑function‑affects.pdf.
 https://www.investopedia.com/terms/b/bank-capital.asp
 https://www.db.com/ir/en/capital-management.htm
 file:///C:/Users/107781/Desktop/ANKITA/risk%20managent.pdf
 https://books.google.co.in/books?id=p8Duode_8bkC&printsec=frontcover&dq=cap
ital+management+banking+industry&hl=en&sa=X&ved=0ahUKEwi37biD8aXdA
hVYfCsKHYk8AWMQ6AEIJjAA#v=onepage&q=capital%20management%20ba
nking%20industry&f=false
 https://books.google.co.in/books?id=t3BqQgAACAAJ&dq=capital+management+
banking+industry&hl=en&sa=X&ved=0ahUKEwi37biD8aXdAhVYfCsKHYk8A
WMQ6AEILDAB
 https://books.google.co.in/books?id=n9UbCQAAQBAJ&printsec=frontcover&dq=
capital+management+banking+industry&hl=en&sa=X&ved=0ahUKEwi37biD8aX
dAhVYfCsKHYk8AWMQ6AEITDAH#v=onepage&q=capital%20management%2
0banking%20industry&f=false

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INTRODUCTION

Capital management refers to implementing measures to maintain sufficient

It is extremely important for a financial institution to calculate the capital

There are various capital management methods according to corporate

MANAGEMENT OF CAPITAL BY BANKS Page 1

It is important for the inspector to review whether a financial institution has a

If the institution’s management fails to recognize weaknesses or problems

MANAGEMENT OF CAPITAL BY BANKS Page 2

Tier 1 capital is the core measure of a bank's financial strength from a

MANAGEMENT OF CAPITAL BY BANKS Page 3

As an example, assume a bank with $2 of equity lends out $10 to a client.

 Tier 1 common capital ratio and

MANAGEMENT OF CAPITAL BY BANKS Page 4

Tier 2 capital is the secondary component of bank capital, in addition to Tier

BREAKING DOWN TIER 2 CAPITAL

Tier 2 capital is considered less reliable than Tier 1 capital because it is

MANAGEMENT OF CAPITAL BY BANKS Page 5

The first component of Tier 2 capital is revaluation reserves, which are

The third element is hybrid capital instruments, which have mixed

The final component of Tier 2 capital under U.S. regulations is subordinated

Most countries, including the United States, do not allow undisclosed

MANAGEMENT OF CAPITAL BY BANKS Page 6

BREAKING DOWN 'Tier 3 Capital'

Tier 3 capital debts may include a greater number of subordinated issues,

The Origin of Tier 3 Capital

Basel I required international banks to to maintain a minimum amount (8%)

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• Paid-up capital (ordinary shares)

• Other disclosed free reserves

• Perpetual non-cumulative preference shares (PNCPS) eligible for inclusion as

• Innovative perpetual debt instruments (IPDI) eligible for inclusion as Tier I

• Capital reserves representing surplus arising out of sale proceeds of assets

Elements of Tier II Capital

• Hybrid capital instruments

• Investment reserve account

MANAGEMENT OF CAPITAL BY BANKS Page 9

The reform measures heralded several epoch making changes in the

ALM envisages the process of managing net interest margin (NIM)

MANAGEMENT OF CAPITAL BY BANKS Page 10

lOOMM (1.032) = 103.2 MM.

The book value of the financing (the bank's liability) is:

1OOMM (1.030) =103.0M.

1OOMM (1.032)5 / (1.060)4 = 92.72MM

1OOMM (1.030) = 103.0MM.

MANAGEMENT OF CAPITAL BY BANKS Page 11

ALM IN PRACTICAL TERMS INVOLVES:

(a) Conscious decisions - making with regard to assets-liability structure in order

(b) Quantification of risk and evolving of suitable risk management techniques

A Sound ALM system for the bank should encompass:

 Review of interest rate out-looks.

MANAGEMENT OF CAPITAL BY BANKS Page 12

 Merrill Lynch lost $377 million trading mortgage-backed securities in an

MANAGEMENT OF CAPITAL BY BANKS Page 13

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(B) INTEREST RATE RISK:

MANAGEMENT OF CAPITAL BY BANKS Page 16

(D) LIQUIDITY RISK:

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Once the strategic plan is developed and is in place, the responsibility

The Budget or Profit Plan

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