0710 - Mfi 2

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Question Paper
Management of Financial Institutions – II (MSF3L4) : October 2007
Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 - 5.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.
Case Study
Read the case carefully and answer the following questions:
1. Compute the relevant ratios to evaluate the bank’s performance in the following areas: < Answer >
i. Liquidity.
ii. Deployment.
iii. Profitability.
iv. Productivity.
(10 marks)
2. Comment on the performance of the bank based on the ratios computed above. < Answer >
(8 marks)
3. Comment on the risk profile of the bank based on: < Answer >
i. CAR
ii. Average Risk Weight
iii. Gross NPAs to Gross Advances
iv. Net NPAs to Net Advances and
v. ENPA.
(12 marks)
4. What are the facilities extended by the banker under non-fund based limits? Explain how it helps to improve the < Answer >
income and business of a bank.
(10 marks)
5. a. What is Investment Fluctuations Reserve? How does it affect the profit of a bank? < Answer >
b. What is the right to pay less tax or an obligation to pay more tax in the future as a result of transactions
or events that have occurred by the balance sheet date? How such assets and liabilities are recognized/
considered in the balance sheet?
(5 + 5 = 10 marks)
Balance Sheet of a Public sector Bank as at 31st March, 2007
(Rs. in crores)
Particulars Schedule 31.3.2007 31.3.2006
I. CAPITAL AND LIABILITIES
Capital 1 485.00 485.00
Reserves & Surplus 2 2671.32 2408.92
Deposits 3 41454.01 33922.39
Borrowings 4 733.52 758.47
Other Liabilities and Provisions 5 2197.15 3094.48
TOTAL 47541.00 40669.26
II. ASSETS
Cash and balances with the Reserve Bank of India 6 2949.05 3860.70
Balances with Banks and money at call and short notice 7 1075.10 1278.66
Investments 8 14300.67 11444.12
Advances 9 27889.05 22100.41
Fixed Assets 10 192.34 192.74
Other Assets 11 1134.79 1792.63
TOTAL 47541.00 40669.26
Contingent Liabilities 12 20598.28 23418.16
Bills for Collection 3350.91 2890.86
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31.03.2007

(Rs.in ‘crores)
http://206.223.65.215/suggested/MSF3L4-1007.htm (1 of 16) [29/Oct/07 1:14:00 AM]

Year Ended Year Ended

Particulars Schedule No
31.03.2007 31.03.2006
INCOME
INTEREST EARNED 13 3315.31 2675.10
OTHER INCOME 14 446.86 391.52
TOTAL 3762.17 3066.62
EXPENDITURE
INTEREST EXPENDED 15 1897.78 1506.15
OPERATING EXPENSES 16 933.12 857.93
PROVISIONS AND CONTINGENCIES 393.34 217.09
TOTAL 3224.24 2581.17
NET PROFIT 537.93 485.45
PROFIT BROUGHT FORWARD 76.19 75.47
TOTAL 614.12 560.92
APPROPRIATIONS
Transfer to Statutory Reserve 134.48 121.38
Transfer to Revenue & Other Reserves 190.64 169.83
Proposed Dividend 184.32 169.75
Tax on Dividend 28.45 23.77
Balance carried over to Balance Sheet 76.23 76.19
TOTAL 614.12 560.92
Earning per share 11.09 11.78
Significant Account Policies 17
Notes on Accounts 18
SCHEDULES TO THE BALANCE SHEET

(Rs. in crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE – 1 : CAPITAL
AUTHORIZED CAPITAL
150,00,00,000 Equity Shares of Rs.10/- each 1500.00 1500.00
ISSUED, SUBSCRIBED CALLED AND PAID-UP CAPITAL
48,50,00,000 Equity Shaes of Rs.10/- each
(includes 25,00,00,000 equity shares of Rs.10/- each held by central
government). 485.00 485.00
TOTAL 485.00 485.00
(Rs. in crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE – 2
RESERVES AND SURPLUS
I. Statutory reserves
Opening Balance 669.19 547.81
Additions 134.48 121.38
TOTAL 803.67 669.19
II. Capital Reserves
Additions /Deduction 0 (10.58)
TOTAL 137.59 137.59
III. Share Premium 680.00 680.00
IV. Revenue And Other Reserves
Revenue reserves
Less Adjusment 0.04
Additions 141.75 461.41
SUB-TOTAL 924.83 783.12
Other Reserves
Investment Functuation Reserve
Opening Balance 0 313.00
Amount Transferred To Revenue And Othert Reserves 0 313.00
Additions
SUB-TOTAL 0 0
Special Revenue Reserve-AB Homes 14.82 14.82
Special Reserve U/S 36(1) of IT Act 48.00 16.00
Additions 49.00 32.00

Deductions 62.82 0
SUB-TOTAL 49.00 62.82
TOTAL 973.83 845.95
V. Balance in Profit & Los Account 76.23 76.19
TOTAL (I, II, III, IV & V) 2671.32 2408.92
(Rs. in Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE -3 : DEPOSITS
I. Demand Deposits:
i. From Banks 59.71 178.13
ii. From Others 3602.14 2906.68
TOTAL 3661.85 3084.81
II. Savings Bank Deposits 10651.70 9232.38
III. Term Deposits:
i. From Banks 42.31 29.32
ii. From Others 27098.15 21575.88
TOTAL 27140.46 21605.20
TOTAL (I, II and III) 41454.01 33922.39
i. Deposits of Branches in India 41454.01 33922.39
ii. Deposits of Branches Outside India 0 0
TOTAL 41454.01 33922.39
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 4 : BORROWINGS
I. Borrowing in India:
i. Reserve Bank of India 290.00 0
ii Other Banks 5.10 30.35
iii. Other Institutions and Agencies 208.03 348.90
II. Borrowings outside India 230.39 379.22
TOTAL 733.52 758.47
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 5 : OTHER LIABILITEIS AND PROVISIONS
I. Bills Payable 730.77 683.31
II. Inter office adjusments (Net) 0 0
III. Interest Accured 138.35 153.31
IV. Contingent Provisions Against Standard Assets 125.00 79.00
V. Subordinated Debts(Privetly placed to augment tier II capital)
a. 13.6% 87 months Bonds 0 150.00
b. 11.1% 87 months Bonds 65.00 65.00
c. 9.7% 87 months Bonds 75.00 75.00
d. 7.75% 87 months Bonds 140.00 140.00
e. 7.25% 111 months Bonds 200.00 200.00
VI. Others(including provisions) 723.03 1548.86
TOTAL 2197.15 3094.48
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE -6 : CASH AND BALANCES WITH RESERVE BANK OF INDIA
I. Cash in hand (including foreign currency notes) 391.83 326.80
II. Balance with Reserve Bank of India:
i. In Current Account 2557.22 3533.90
ii. In Other Accounts 0 0

TOTAL 2949.05 3860.70
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE-7 : BALANCES WITH BANKS AND
MONEY AT CALL AND SHORT NOTICE
I. In India:
i. Balance with Banks
a. in Current Accounts 248.94 199.29
b. in Other Deposit Accounts 270.68 563.27
ii. Money at call and short notice
a. With banks 151.14 455.00
b. With other institutions 25.00 7.96
TOTAL 695.76 1225.52
II. Outside India:
i. In Current Accounts 61.97 31.14
ii. In Other Deposit Accounts 317.37 22.00
iii. Money at call and short notice 0 0
TOTAL 379.34 53.14
TOTAL (I and II) 1075.10 1278.66
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE -8 : INVESTMENTS
A. Investment in India
i. Government Securities 11357.01 9749.26
ii. Other approved Securities 148.54 153.14
iii. Shares 216.28 133.95
iv. Debentures and Bonds 947.46 924.46
v. Subsidiaries And /Or joint ventures 9.30 9.30
vi. Others (IDBI Deposits,Indira Vikas Patra, Units of UTI, Mutual
Funds and RIDF) 1622.08 474.01
TOTAL 14300.67 11444.12
B. Investments outside India 0 0
TOTAL 0 0
GRAND TOTAL 14300.67 11444.12
Gross Investments 14406.29 11508.41
Less Depreciation 105.62 64.29
Net Investements 14300.67 11444.12
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 9 : ADVANCES
A. i) Bills Purchased and discounted 1628.19 1314.44
ii) Cash Credits, Overdrafts and Loans repayable on demand 14273.73 11564.54
iii) Term Loans 11987.13 9221.43
TOTAL 27889.05 22100.41
B. i) Secured by tangible assets* 21364.55 17842.44
ii) Covered by Bank/Government Guarantees 1073.92 669.78
iii) Unsecured 5450.58 3588.19
TOTAL 27889.05 22100.41
C. I. Advances in India
i) Priority Sector 10454.54 8235.10
ii) Public Sector 2443.78 1939.42
iii) Banks 251.39 0
iv) Others 14739.34 11925.89
TOTAL 27889.05 22100.41
II. Advances outside India 0 0
TOTAL (C I and II) 27889.05 22100.41
(Rs. in Crores)

Particulars 31-03-2007 31-03-2006

SCHEDULE - 10 : FIXED ASSETS
A Premises
At cost as on 31st March of the preceding year 64.84 59.45
Additions 1.00 5.39
Deductions 0.06 0
Depreciation to Date 18.49 16.46
TOTAL 47.29 48.38
B Other Fixed Assets (including Furniture and Fixtures)
At cost as on 31st March of the preceding year 433.05 391.39
Additions 51.34 60.99
Deductions 4.54 12.39
Depreciation to Date 334.80 295.63
TOTAL 145.05 144.36
GRAND TOTAL 192.34 192.74
(Rs. in Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 11 : OTHER ASSETS
I. Inter Office Adjustnments (NET) 29.55 849.12
II. Interest Accured 325.04 240.44
III. Tax Paid In Advance/Tax Deducted At Source 313.20 225.23
IV. Stationary And Stamps 5.41 4.58
V. Deferred Tax Asset - Net 8.66 16.75
VI. Others 452.93 456.51
TOTAL 1134.79 1792.63
(Rs. in Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 12 : CONTINGENT LIABILITIES
I. Claims against the Bank not acknowledged as debts 144.52 127.61
II. Liability For Partly Paid Investments 0 0
III. Capital Commitments 0 0
IV. Liability on account of outstanding forward exchange contracts 15446.84 18644.98
V. Guarantees given on behalf of Constituents
a. In India 2714.09 2308.95
b. Out side India 231.30 295.71
VI. Acceptances, endorsements and other balances 1411.16 1237.01
VII. Other items for which the Bank is contingently liable 650.37 803.90
TOTAL 20598.28 23418.16
(Rs. in Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 13 : INTEREST EARNED
I. Interest/Discount on advances/bills 2303.39 1763.37
II. Income on Investments 896.43 790.59
III. Interest on balances with Reserve Bank of India and
other inter-bank funds 104.80 115.84
IV. Others 10.69 5.30
TOTAL 3315.31 2675.10
(Rs. in Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 14 : OTHER INCOME
I. Commission, exchange and brokerage 181.56 169.70
II. Profit on sale of Investments 55.70 77.14
III. Profit / (Loss) on revaluation of investments-net (75.57) (72.82)
IV. Profit on sale of building and other assets (net) 0.36 0.46
V. Profit on exchange transactions (net) 32.27 27.70
VI. Income Earned by Way of Dividend etc.From Subsidiaries/Companies and /
or Joint Venturies in India 5.94 8.41
VII. Miscellaneous Income 246.60 180.93
TOTAL 446.86 391.52

(Rs. in Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 15 : INTEREST EXPENDED
I. Interest on Deposits 1810.78 1388.61
II. Interest on Reserve Bank of India / Inter-bank borrowings 40.21 57.20
III. Others 46.79 60.34
TOTAL 1897.78 1506.15
(Rs. in
Crores)
Particulars 31-03-2007 31-03-2006
SCHEDULE - 16 : OPERATING EXPENSES
I. Payments and provisions for employees 548.80 492.88
II. Rent, Taxes and Lighting 93.74 81.89
III. Printing and Stationery 12.65 11.18
IV. Advertisement and Publicity 12.39 11.30
V. Depreciation on Bank’s property 55.72 64.79
VI. Directors’ fees, allowances and expenses 0.59 0.35
VII. Auditors’ fees and expenses (including bank auditors) 10.10 8.30
VIII. Law charges 1.51 1.76
IX. Postage, Telegrams, Telephones, etc. 14.18 15.40
X. Repairs and Maintenance 32.60 29.34
XI. Insurance 37.71 34.10
XII. Other Expenditure 113.13 106.64
TOTAL 933.12 857.93
SCHEDULE-17 SIGNIFICANT ACCOUNTING POLICIES (Intentionally removed)

SCHEDULE 18 - NOTES ON ACCOUNTS
1. Reconciliation of Inter-branch and Inter-bank transactions has been done up to 31.03.2007.
2. Legal formalities with regard to the registration of property in favour of Bank are yet to be completed in respect of one property
valued at Rs. 0.06 crores(previous year-one property valued at Rs. 0.06 crores)
3. a. No provision is considered necessary towards disputed tax demand of Rs.44.69 crores (previous year Rs 56.47
crores) in view of judicial pronouncements in similar cases.
b. Deferred Income Tax
Pursuant to Accounting Standard 22, "Accounting for taxes on income," issued by The Institute of Chartered
Accountants of India necessary deferred tax liability (DTL) and deferred tax asset (DTA) has been recognized. The major
components as on 31.03.2007 are as follows:
(Amount Rupees in crores)
Timing Difference 31.03.2007 31.03.2006
DTA DTL DTA DTL
Provision created in books but not 25.56 0 20.69 0
Claimed in Income Tax
Excess depreciation claimed as Per IT 0 0.41 0 3.94
Act 1961
DTL on Special Reserve created under 0 16.49 0 0
Section 36(1) (viii) of I T Act 1961
Total 25.56 16.90 20.69 3.94
c. Provision for Income Tax has been made on the basis of the applicable laws and various judicial pronouncements in
this regard.
d. Fringe Benefit Tax:
i. In view of the legal opinion obtained by the bank, no provision has been made towards Fringe Benefit Tax
amounting to Rs. 25.10 crores in respect of Pension Contribution amounting to Rs. 75.25 Crores upto 31st March, 2006,
since the management is of the view that the said contribution is in lieu of Provident Fund and is in the nature of statutory
obligation for which no provision is required in this regard.
ii. In view of the actuarial valuation, no provision has been considered necessary towards Fringe Benefit Tax as the
Pension Fund contribution is not exceeding Rs.1.00 lakh per employee in respect of the employees who have opted for
pension for the year 2006-07.

4. Investments include Rs. 8.26 crores invested in Regional Rural Banks as Share Capital Deposit pursuant to a letter by
Government of India. Since RRBs are not companies there is no requirement for issue of shares in certificate form.
5. The expenditure on the Public Offer of shares during the year 2005-06 was Rs. 18.20 crores, out of which Rs.9.10 crores was
charged to the Profit and Loss account in that year. The balance amount has been written off during the current year treating it as
deferred revenue expenditure, in terms of the Notification issued by Government of India, Ministry of Finance, vide their
reference F. No. 11/24/2005-BOA dated 7th December,2005 pursuant to section 15 (1) of the Banking Regulation Act, 1949.
6. Additional Provision of Rs. 167.47 crores (Previous year Rs.104.65 crores), includes Rs. 62.82 crores made out of draw down
from Special Reserve created in earlier years under Section 36(1) (viii) of Income Tax 1961, is held as at 31.03.2007 in respect
of gross non performing advances over and above the minimum prescribed as per RBI guidelines with a view to strengthening the
financial stability of the Bank. Such additional provision is netted off from Advances.
Items 2006-07 2005-06
CRAR(%) 11.33 14.00
Number of employees 12,993 13,157
Investments (Rs.in cores)

Items 2006-07 2005-06
1. Value of Investments
i. Gross Value of Investments In India
Outside India, 14406.30 11509.03
0.00 0.00
ii. Provisions for Depreciation In India
Outside India, 105.58 64.26
0.00 0.00
iii.Net Value of Investments 14300.72 11444.77 0.00
In India 0.00
Outside India.
2. Movement of provisions held towards depreciation on
investments.
i. Opening balance 64.26 29.34
ii. Add: Provisions made during the year 46.47 35.12
iii. Less: Write-off/(write-back) of excess provisions During the year 5.15 0.20
iv. Closing balance 105.58 64.26
Asset Quality
Non-Performing Asset
(Rupees in Crores)
Items 2006-07 2005-06
i. Movement of NPAs (Gross)
a. Opening Balance 436.91 440.93
b. Additions during the year 243.66 153.26
c. Reductions during the year 283.56 157.28
d. Closing Balance 397.01 436.91
ii. Movement of Net NPAs
iii. Movement of provisions for NPA’s
Provisions on Standard Asset

(Rupees in crores)
Particulars 2006-07 2005-06
Provisions towards Standard Assets 125.00 79.00
Amount Provisions for taxes for the year:

(Rupees in crores)

2006- 2005-
07 06
Provision for Income Tax 233.00 75.00
Fringe Benefit Tax & Wealth tax 5.91 5.00
Deferred Tax 8.09 (-)
8.07
PROVISIONS AND CONTINGENCIES :

(Rupees in crores)
Breakup of" Provisions and Contingencies" shown under the head
2006-07 2005-06
Expenditure in Profit and Loss Account
i. Depreciation in value of Investments 61.62 65.29
ii. Non Performing Assets 92.59 40.00
(including floating provision)
iii. Standard Assets 46.00 39.87
iv. Taxes 238.91 80.00
v. Deferred Tax 8.09 (8.07)
vi. Withdrawals from Special Reserve (62.82) -
vii. Provision for Assets sold to ARCIL 4.90 -
viii. Other provisions & contingencies
a. Sacrifice on Restructured Investments 1.21 0
b. Country Risk Exposure (1.09) 0
c. Restructured advances 3.92 0
TOTAL 393.33 217.09
FLOATING PROVISIONS:
(Rupees in crores)
Particulars 2006-07 2005-06
Opening balance 104.65 136.81
Additions during the year ( Quantum of floating provisions made) 62.82 0.00
Reduction during the year ( Purpose and amount drawdown made) 0.00 32.16
Closing balance 167.47 104.65
END OF SECTION D
Section E : Caselets (50 Marks)

• This section consists of questions with serial number 6 - 11.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.
Caselet 1
Read the caselet carefully and answer the following questions:
6.As a part of this change, the yuan was allowed to appreciate slightly about 2% against the dollar. The Chinese < Answer
Central Bank called this regime a 'Managed Roal' and the first step toward a floating exchange rate in the >
future. In this regard discuss what prompted China for a 'Managed Roal'?
(8 marks)
7.What do you think will be the global effect of currency changes in China? Discuss. < Answer
(10 marks) >
On Friday, May 18, 2007, the People's Bank of China (PBoC) announced that the Yuan would trade more freely against the dollar.
The Chinese currency is Renminbi (REM) which means people's currency and yuan is the unit of account. This was the second step in the
long pressing need for yuan revaluation. The yuan had been pegged to the US dollar till July 2005, an arrangement that had been in place
since 1994. In a historical move, China de-pegged the yuan from the dollar in 2005 and tied it to a basket of currencies. The currencies in
this basket were not immediately revealed but were most likely to include dollars, euro, yen and possibly a few other trading
partners' currencies. As a part of this change, the yuan was allowed to appreciate slightly about 2% against the dollar. The Chinese
Central Bank called this regime a 'Managed Roal' and the first step toward a floating exchange rate in the future. The new system was
similar to Singapore's managed 'basket, band and crawl' model in which currency floats within a set policy band.

The May 2007 announcement stated that yuan will now be permitted to rise or fall by 0.5% each day up from a 0.3% margin.
This announcement was made just days before the 2nd Strategic Economic Dialogue between China and America on May 22, and 23, 2007
in Washington and hence was politically significant. These measures were aimed to satisfy the US Congress who argued consistently that
the yuan was highly under-valued thus increasing the competitiveness of Chinese exports.
Along with the widening of the band, the PBoC announced monetary tightening moves. The Central Bank raised its one-year lending rate
by 0.18% and one-year deposit rate by 0.27%. This resulted in the one-year deposit rate to be 3.06% and the one-year benchmark lending
rate to be 6.57%. In addition, reserve requirements by the Commercial Banks have been increased by 0.5% from June 5, 2007.
It may be noted that interest rates have increased four times since April 2006 and cash reserve ratio has increased eight times since June
2006. By raising deposit rates more than lending rates, the Chinese monetary authorities made it clear that bad loans have now become
history in the Chinese banking system.
The PBoC was under immense pressure from the US for an appreciation of the currency. This widening was only a small step in that
direction. Given the small value of the widening, there is very little change expected. The yuan has never moved the maximum range under
the previous limit of 0.3% as the biggest change this year was a 0.22% gain on May 11, 2007. However, continued widening of the band
may be expected in the future.
One may say that the band widening is only a small step towards a more flexible exchange rate. The Chinese do have a long-term plan
of moving the currency to a free-floating status. There is still need for more yuan appreciation. Following the widening of the band,
Goldman Sachs predicted that the Yuan’s rate of appreciation could reach 9% in the coming year.
For the present, we can call this change a signal of the government's determination in addressing the fundamental macroeconomic
problem with the Chinese economy - excessive liquidity matched by an inflexible currency. In the meantime, US should concentrate on
other issues related to its own conomy rather than pass the blame entirely on the rigid Yuan.
END OF CASELET 1
Caselet 2
8. Credit risk, one of the biggest risks of the financial system, poses a great challenge to banks and bond investors at times when < Answer >
the borrower is in default. In this regard, discuss how do the credit derivatives help to mitigate credit risk.
(8 marks)
9. Inspite of having so many advantages, credit derivatives have their own limitations. What are the limitations of these credit < Answer >
derivatives? Explain
(8 marks)
Credit risk, one of the biggest risks of the financial system, poses a great challenge to banks and bond investors at times when the borrower
is in default. Nevertheless, an effective management of credit risk largely aids in enhancing the efficiency and resilience of the
financial system of any economy. To serve this very purpose, credit derivatives have globally emerged as a potential risk management tool
for banks, financial institutions and bondholders.
According to the International Swaps and Derivatives Association (ISDA)'s report, the global market for credit derivatives has more
than doubled in size for the third consecutive year. The notional amounts outstanding at the end of 2006 grew by leaps and bounds from
a meager $632 bn in 2001 to $34.5 tn in 2006. After witnessing the phenomenal success of credit derivatives globally, RBI has
recently proposed to introduce them in India also, albeit in a calibrated manner. The move, which will help banks and primary dealers to
hedge against loan defaults, is poised to largely reduce the risk of default in the Indian financial system.
Though credit derivatives have been in existence since the beginning of 1990s, they became popular only in the late 1990s during the
Asian and Russian financial crises when some smart banks demonstrated these instruments' ability to shed the risk. Interestingly,
credit derivative is the latest among the raft of financial innovations after the loan sales of the 1980s and securitization of the 1990s.
However, it has emerged as the fastest growing financial instrument in the world.
Although the RBI framed the draft guidelines for the introduction of credit derivatives in March 2003, absolutely nothing much happened
after that. Nonetheless, after gazing at the explosive growth of these instruments globally, India has made another attempt to open its door
to credit derivatives. Again in May 2007, the RBI put up draft guidelines for public comments.
Industry experts feel that the RBI is allowing credit derivatives at a right time when the lending is soaring. Also, the credit growth rate
is soaring significantly at 30% per annum as the Indian economy is growing at a rate of 9% per annum. Moreover, since corporate India
is planning to invest $500 bn in the coming three years, banks are gearing up to increase their lending capacity to meet this prospective rise
in capital expenditure. However, at the same time, they do need an avenue to offload the associated risk. It's here the credit derivatives
serve the purpose by effectively shedding the risk.
Keeping the valuation, risk management and accounting complexities of the credit derivatives in view, the RBI has decided to allow them in
a calibrated manner. Therefore, it has initially allowed only the plain vanilla Credit Default Swaps (CDS) which provides protection to a
single borrower rather than many. Also, the guidelines allow only local banks and primary dealers to transact in CDSs. The objective of a
CDS should be to hedge against the credit risk. However, as the banks don't have to take on the credit risk through this way, it
definitely enhances the lending capacity of conservative banks who usually hesitate to lend to a single borrower beyond a point.
END OF CASELET 2
Caselet 3

10. What is sub-prime lending and why is it risky? How this sub-prime lending turned out to be the biggest crisis faced by the < Answer >
global financial markets?
(8 marks)
11. How do you think this crisis will affect the US interest rates and the global financial markets? < Answer >
(8 marks)
World stocks tumbled after BNP Paribas became the latest bank to be hit by mortgage credit problems and shortage of cash in money
markets prompted the European Central Bank (ECB) to add emergency liquidity. The French bank froze more than $2 billion worth of
funds as problems in US subprime mortgages — riskiest property loans, often extended to people who have payment difficulties or a
bad credit history — and diminishing liquidity prevented it from calculating their value.
The news sent shivers through markets — including India — already nervous that troubles in US mortgages would spread globally,
hitting banks and the broader financial system. Investors rushed to buy safe-haven bonds and the low-yielding yen to preserve capital.
The BSE Sensex witnessed an intra-day fall of over 400 points.
The FTSE-100 of the UK fell by 102 points to 6,291. Reversing a three-day winning streak, the Dow Jones industrial average of the US
was down 183.56 points, or 1.34 per cent, at 13,474.30. As many of the Asian markets closed by the time the BNP news spread, they
escaped the selling wave.
“The BNP Paribas news has really come at a very bad time. It clearly shows that we are not out of the woods yet so far the credit problems
are concerned,” said analyst Deepak Singh. “When a sharp bounce back doesn’t sustain for long, then even die-hard bulls start to
liquidate their positions and that’s what we witnessed today. The market is going to be extremely volatile with a downward bias in the
short-term,” he said.
On August 1, the Sensex had crashed by 615 points as the US housing loan worries hit global markets. Investors fear that tighter
credit conditions would hurt corporate takeovers and share buybacks, two forces behind the market’s steady advance up until the
recent turbulence. Overnight euro and dollar deposit rates hit six-year peaks at one point with concerns growing there could be more
subprime-related problems from financial institutions. Rates fell after the ECB injected liquidity. “There appears to be a dash for cash both
in dollars and in euros,” said Nick Parsons, head of market strategy at nabCapital.
French bank BNP Paribas suspended three of its funds today as problems in the US subprime mortgage sector are preventing it
from calculating their value. BNP Paribas Investment Partners said in a statement that the decision affected its Parvest Dynamic ABS,
BNP Paribas ABS Euribor and BNP Paribas ABS Eonia funds.
It said the valuation of funds would resume as soon as liquidity returned and added that in the continued absence of liquidity,
additional information on the envisaged measures would be communicated to investors within a month. “The complete evaporation of
liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of
their quality or credit rating,” it said.
“In order to protect the interests and ensure the equal treatment of investors, during these exceptional times, BNP Paribas’s
Investment Partners have decided to temporarily suspend the calculation of the net asset value as well as subscriptions/ redemptions, in
strict compliance with regulations, for these funds,” it added.
As per Jim Rogers one of the US fund managers, “You can't believe how bad it's going to get. It's going to be a disaster for many people
who don't have a clue about what happens when a real estate bubble pops. Real estate prices will go down 40-50% in bubble areas. There
will be massive defaults. And it'll be worse this time because we haven't had this kind of speculative buying in U.S. history.”
Then he added ominously, “When markets turn from bubble to reality, a lot of people get burned”.
END OF CASELET 3
END OF SECTION E
END OF QUESTION PAPER
Suggested Answers
Management of Financial Institutions – II (MSF3L4) : October 2007
Section D : Case Study

1.a. Liquidity < TOP >

(Rs. in crore)
Particulars 2007 2006
Cash in hand 391.83 326.80
Balance with banks 519.62 762.56
Call money 176.14 462.96
Cash & Balance with banks including call money 1087.59 1552.32
Demand Deposits 3661.85 3084.81
Total Deposits 41454.01 33922.39
Total assets 47540.87 40669.21
Ratios
Cash and balance with banks including call money/Demand Deposits 29.7% 50.32%
Cash and balance with banks including call money/Total Deposits 2.62% 4.58%
Cash and balance with banks including call money/Total Assets 2.29% 3.82%
b. Deployment
(Rs. in crore)
Credit 27889.04 22100.41
Investment 14300.67 11444.12
Deposits 41454.01 33922.39
Total assets 47540.87 40669.219
Ratios
Credit/Deposits 67.28% 65.15%
Investment/Deposits 34.50% 33.74%
Credit + Investment / Deposits 101.77% 98.89%
Credit + Investment / Total assets 88.74% 82.48%
c. Profitability
(Rs. in crore)
Interest earned 3315.31 2675.10
Less: interest expended 1897.78 1506.13
Net interest income (NII) 1417.53 1168.97
Net Profit for the year 537.93 485.45
Add: provisions and contingencies 393.34 217.09
Operating profit 931.27 702.54
Total assets 47540.87 40669.21
Net worth (Capital + Reserves) 3156.32 2893.92
Ratios
Net interest margin (NIM) = NII / Total assets 2.98% 2.87%
ROA = Net Profit / Total assets 1.13% 1.19%
ROE = Net Profit / Net worth 17.04% 16.77%
Operating profit / Total assets 1.96% 1.73%
d. Liability Mix
(Rs. in crore)
Business (Deposits + Advances) (41454.01+ (33922.39
27889.05) +22100.41)
69343.06 56022.8
Net profit for the year 537.9 485.45
Number of employees (actual) 12,993 13,157
Business per employee 5.34 4.26
Net profit per employee 0.041 0.037

2. Liquidity < TOP >

All the liquidity ratios have decreased from the previous year’s level. Cash and bank balances with bank as a
percentage of demand deposits decreased from 50.32% to 29.7%. Cash management by the bank during the period
under review appears to be good. Cash and bank balances as a percentage of total deposits and total assets also
decreased. This indicates that the bank has foregone liquidity for higher profitability.
Deployment
The bank’s credit portfolio grew by a healthy 26.19% during the year 2006-07. Credit deposit ratio increased slightly
from 65.15 to 67.28%. The other ratios also namely investment to deposits has increased indicating investments have
increased and deposits also have gone up, credit plus investment to deposits has gone up indicating increase in credit
and investments and credit plus investments to total assets increased indicating more percentage increase in credit plus
investments in comparison with increase in total assets.
Profitability
Interest income registered a growth of 23.93%. Interest expended also increased to 26.01%.
The net interest margin has improved marginally from 2.87% to 2.98%. There is a slight increase in profit to the extent
of 52.41.
Productivity
Employer productivity in terms of business per employee has decreased from Rs.13,157 cr to Rs12,993 cr. Net profit
per employee has increased from Rs.0.037 cr to Rs.0.041 cr due to increase in the net profit.
3.Capital provides a cushion to absorb possible losses so that entities or individuals dealing with banks are protected all < TOP >
the time. To assess the adequacy of capital based on the quality of assets, the capital to Risk Weighted Assets Ratio
(CAR) is computed.
The change in the average risk weighted assets (ARWAs) should be ascertained, to comment on the risk profile of the
bank
ARWAs = RWAs =
Tier I Capital = Paid up capital + Statutory reserves + general reserve + Amalgamation reserve
+ share premium reserves +capital reserves +/-Balance in the profit and loss + Innovative perpetual
debt– Intangible assets- Equity investment in subsidiaries – Deferred tax asset (net).
Tier II Capital = 45% of revaluation reserves + Provision for standard assets + provision for
country risk + Floating provision + Subordinated debt + Revenue reserves+ Investment fluctuation
reserve + Special reserve.
(in crores)
31. 3. 2007 31. 3. 2006
Tier-I capital 485.00+803.67+0+0+680.00+137.59+76.23 485.00+669.19+0+0+680.00+137.59+76.19+49
+0-0-9.30-8.66=2164.53 +0-0-9.30-16.75=2021.92
Tier-II capital 0+125.00+0+167.47+480.00+924.83+0+49 0+79.00+0+104.65+480+783.12+0
=1746.3 +62.82=1509.59
Total capital (Tier I 3910.83 3531.51
+II)
CAR 11.33 14.00
RWAs 34,517.48 25,225.07
ARW = (RWAs /TA) 34,517.48/47,540.87 = 72.61% 25,225.07/40669.21=62.02%
Incremental RWAs / Incremental TA = 9292.41/6,871.66=135.23%
Average risk weight, which was 62.02% in 2006, has increased to 72.61% in 2007. Incremental RWAs / Incremental
TA ratio of 135.23% shows that the bank has followed a aggressive asset deployment policy.
(Rs. in crores)
31. 3. 2007 31. 3. 2006
Gross NPAs 397.01 436.91
Net NPAs 47.25 52.46
Provision for NPAs 343.49 381.00
Net advances 27,889.04 22,100.41
Gross advances (Provi for NPAs
28,232.53 22,481.41
+Net advances)
Net NPAs as % of Net advances 0.17% 0.24%
Gross NPAs as % of gross
1.41% 1.94%
advances
PBT for the year 537.93+233.0 = 770.93 485.49+75.0 = 560.45
ENPA = 770.93/47.25 = 1631.59% 560.45/52.46 = 1068.34%
Gross NPAs as percentage of gross advances decreased from 1.94% to 1.41% indicating a better NPA management.
The higher the ENPA level the better it would be for the bank as it indicates lower credit risk. To achieve a higher
level of ENPA, bank has to increase its profitability and reduce its NPA level. The ENPA level has remained same.
We can say that the increase in the PBT is offset by almost same percentage increase in the NPAs.

4.A contingent liability is a facility given by the banker under non-fund based limits and in the bank’s balance sheet, it is < TOP >
reflected on both the sides as asset and liability. At the time of providing the non-fund based facility to the customers,
the banker believes that the customer is competent enough to keep up his promise or performance or obligation. The
banker earns commission, processing fee etc. for such facilities. If for any reason the customer fails to keep up
promise or performance or obligation it becomes a real liability in future and the facility is crystallized in to a liability
on one hand and it is recovered with interest immediately on the other hand. The objective of providing the non-fund
based limits is to earn more fee-based income without exposing the bank’s resources to any risk. Contingent liability
arises on account of LCs (Inland and Foreign), guarantees including deferred payment basis, forward contracts, and co-
acceptance of bills etc.
A significant component of the bank’s balance sheet is the contingent liability. Banks undertake certain fee-based
activities without directly affecting their balance sheets. Non fund based services extended by the banks are in the
nature of
i. Guarantees
ii. Letters of credit (Inland and Foreign)
iii. Co-acceptance of bills on behalf of its customers.
Other contingent liabilities include claims against the bank not acknowledged as debts, liability for partly paid up
investments, liability on account of outstanding forward foreign exchange contracts, underwriting commitments bills
rediscounted etc. The guarantees can be classified under financial and performance guarantees. Guarantees are issued
for capital goods/project exports on DP (deferred payment) terms. Usually banks collect cash margin ranging from
20% to 100% for LCs and guarantees. For the unsecured portion, collateral securities to the extent of 200% by way of
mortgages are insisted. These activities provide ample scope to earn income in the form of commission, exchange.
Further the cash margins collected by the bank will become resources for the bank to lend which in turn increases the
interest income. Thus some non-fund based services come under the head ‘contingent liability’. The contingent
liability may become a real liability or actual liability if the portfolio of guarantees or LCs is not handled with adequate
care. It is in this backdrop, bank has to take up these facilities by studying the credit worthiness and other financial
indicators of the clients. Banks also issue solvency certificates for their clients with a condition that they do not accept
any responsibility or liability for such certificates.
5. a. In January 2002, RBI advised banks to build up Investment Fluctuation Reserve (IFR) to a minimum of 5% < TOP >
of their investment portfolio under the “held for trading” (HFT) and available for sale (AFS) categories, by
transferring the gains realized on sale of investments within a period of 5 years.
Investment fluctuation reserve account is maintained to reflect the market value of investments. In balance sheet
the value of the investments is shown at the market value and the balance is shown in the investment fluctuation
reserve account on the liabilities side. Securities are marked-to-market to reflect their market values and any
profit due to marked-to-market is credited in this reserve account.
All losses arising due to marked-to-market are normally written-off in the profit and loss account. But profits
arising due to marked-to- market are credited to investment fluctuation reserve account. As long as there is some
balance in the reserve account subsequent losses are debited to the reserve account, thus it doesn't affect the profit
and loss account. Thus investment fluctuation reserve account reduces the volatility of profit of banks due to the
fluctuation in the value of investments.
Bankers opine that all of them would be in a position to meet the 5% deadline will before the prescribed date.
RBI has told banks that while the Investment Fluctuation Reserve (IFR) would continue to be treated as Tier II
capital, it would not be subject to the ceiling of 1.25% of the total risk weighted assets. Further RBI has said that
for the purpose of compliance with the capital adequacy norms, Tier-II capital including IFR would be considered
up to a maximum of 100% of Tier-I capital.
b. Deferred taxes represent the right to pay less tax or an obligation to pay more tax in the future as a result of
transactions or events that have occurred by the balance sheet date. These transactions and events give rise to
timing differences between the recognition of gains and losses in the financial statements in accordance with
accounting rules and their recognition in the tax computations in accordance with tax rules.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences
between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases
and operating loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. Deferred tax assets are recognised for all deductible
timing differences, carry forward of unused tax assets and unused tax losses only if there is virtual certainty that
such deferred tax assets can be realised against future liabilities. The carrying amount of deferred tax assets is
reviewed at each balance sheet date and reduced to the extent that it is no longer probable that sufficient taxable
profit will be available to allow all or part of the deferred tax asset to be utilized.
Section E: Caselets
Caselet 1

6.There are several reasons why China has widened the band. < TOP>
• The US Congress legislations have been threatening to impose sanctions. Recently, in March 2007
taxes were imposed on coated paper, which although had little effect, but seemed a warning for future.
The Bush administration is under immense pressure from Congress to declare China as a currency
manipulator. The Schumer-Graham bill which was withdrawn last year proposed a 27.5% tariff on
Chinese products. China's trade surplus with the US accounts for almost 30% of America's total deficit.
• Yet this was not the only reason. Along with the pressures of a revaluation, Chinese Government
have to manage an overheated economy, a stock market boom and inflation. It was always doubted if the
Chinese would ever allow a free-floating currency given the still weak banking sector. However, the IPO
by four major banks and solid growth have given greater confidence to the policy makers. In fact, by
pegging the Yuan to the dollar, the Chinese have not been able to increase its interest rates. The lending
rates even after the new reforms are too low. Unless the Yuan is allowed to float more freely, independent
monetary policy can hardly be adopted.
• Chinese stock market: Consistent low rates have led to stock market bubbles. Hence to control
overheating there is a need to divert money from the stock markets via higher interest rates. The Chinese
benchmark of CSI 300 has increased by 85% this year. Alan Greenspan had recently warned of a bubble
in the Chinese stock market. On May 23, 2006 he publicly declared that Chinese stocks may face a
dramatic contraction. What is interesting about the bubble is that there is sufficient waming about it unlike
the dotcom bubble or the housing bubble in the US.
7.China has faced political pressures to revalue its currency from Europe, Japan and US. These countries have < TOP >
already imposed marginal tariffs on Chinese imports. However, China will certainly not go in for a dramatic
appreciation of the yuan. A moderate revaluation will not affect the competitiveness of Chinese exports or
reduce the outsourcing possibilities that China provides. However, much of the country's ability to manage its
currency depends on control of speculation. A free float of RMB is not likely as it will severely affect the
competitiveness of Chinese exports. With unemployment in the range of around 15% and still rising China
cannot afford the risk to the manufacturing sector. The Chinese authorities think that a sharp appreciation will
threaten the social stability. Two-thirds of the population lives in rural areas and if exports of food crops are
affected due to revaluation, it will result in rural unemployment. It may also be noted that a big reason for huge
reserves has been a decline in imports of machinery, aluminum, chemicals, etc., by China. In fact, annual real
growth rate in imports is much lower in 2006 than in 2004.
A free float will also hurt the US Government. The Chinese Government holds a large amount of US treasuries
next only to Japan. Hence, the demand for US treasuries keeps interest rates low in the US. If China floats its
currency, there will be no need to hold any treasuries which will severely affect the US bond market. Higher
lending rates make it difficult to allow further appreciation. In order to manage the exchange rate despite the
$1.3 tn forex reserves, the Central Bank of China issues bonds. The central banks buy US treasuries which
have a higher return than domestic bond. The difference in interest covers the losses. Widening the band will
certainly continue the demand for US treasuries in the China reserve fund, thereby suppressing the yield in the
long end of the yield curve. This will add to the sentiment that given the US slowdown, the Fed may actually
reduce the rates at the end of the year.
The widening will also cause a pressure on Japan. The Japanese currency is also undervalued and there is
expectation that the currency will strengthen. The global stock markets will also react. Companies importing
from China will have increased costs and hence a cut in profits. Comparatively companies who compete
against China will benefit. Commodity markets will benefit as raw materials will become cheaper for Chinese
manufacturers. There will be increased demand and capacity expansion, thus causing higher prices in
commodity market However, the Chinese revaluation is not the solution for US. If revaluation takes place,
American goods cannot replace the Chinese goods. This implies that Chinese goods wiIl only be replaced by
goods from other Asian economies. The textile industry which accounted for 72% of China's trade surplus
loses 8.2 bn yuan for every percentage point of currency appreciation. On the other hand, even the US suffers
due to revaluation. In fact, the cheap Chinese products have contributed to consumption by the middle class in
the US.
Caselet 2
8. A credit derivative, typically, is a contract where the lender (default protection buyer) repackages and transfers the < TOP >
credit risk to another party (default protection seller) in exchange for regular periodic premium payments. In the event
of the borrower's default, the protection seller has to compensate the protection buyer for the remaining interest and
principal payments. Essentially, it works on the lines of the concept of insurance where the insured pays regular
premiums to the insurance company which will, in turn, make the payment good when the insured event happens.
Globally, these instruments are, by and large, used by banks, broker-dealers, institutional investors, insurers,
reinsurers, money managers, hedge funds, and corporate treasurers to hedge and diversify their credit risk. Though a
host of exotic credit derivatives, such as total return swaps, credit spread options, credit-linked options, Collateralized
Debt Obligations (CDOs), Collateralized Loan Obligations (CLOs), floating Collateralized Mortgage Obligations
(CMOs), swaptions, etc., are available in the market, the plain vanilla Credit Default Swaps (CDSs) are the most
popular and largely traded instruments. Indeed, in recent times, global banks are more inclined to use them as trading
instruments rather than hedging instruments.
Credit derivatives also makes it possible to divide up credit risks into small parts and to trade these parts at a low cost.

This is not possible with traditional credit insurances. As the trade is so extensive, the pricing of credit risk becomes
much improved.
From the economy’s point of view, it is essentially positive that the credit risk is spread to institutions outside of the
bank system. Although the banks are specialists in assessing credit risk, they are also sensitive to shocks. Deposits are
liquid, while loans are in practice often tied for long periods. If the depositors suddenly want to withdraw their money,
it may be difficult as the bank cannot as quickly call in all its loans for payment. In addition, the banks are of vital
importance for ensuring that payments in the economy function. The fact that credit risks are spread to other
institutions with significant equity, such as insurance companies, may thus reduce the risks in the financial system.
9. There are a number of advantages with credit derivatives and described their remarkable growth. But at the same time, < TOP >
they have brought with them a number of risks. These are mainly related to the market being new and relatively
untested. The four major causes of concern with regard to the credit derivatives market.
Operational And Legal Risks
The most concrete source of concern is how the trade is conducted in practice. The existing infrastructure in the
market has not managed to keep up with the rapid development. Because of the explosive increase in the number of
contracts, routines and handling procedures have lagged behind. The back-office functions at the largest counterparties
have not been able to confirm all of the deals in time. This has entailed a risk of problems if "large” credit events were
to suddenly occur. In these situations there could be confusion as to which deals have been completed and which
positions are actually held, and these paves the way for legal disputes. The large number of outstanding contracts also
makes the settlement process particularly sensitive. If many contracts have to be settled at the same time, there may be
disruptions. The credit risk in one and the same bond may have been resold through a large number of derivative
contracts. Problems can arise in this type of chain, particularly if the underlying bonds need to be delivered physically.
On the legal side, there is always the fear of disputes. Will the person taking over the credit risk actually pay when a
credit event occurs? It is not unusual for major disputes to arise in the insurance market regarding the interpretation of
policy terms. But the problems of unclear rules and practice that existed when the market was new now seem to have
been resolved for the most part. This is because they use almost exclusively international, standardised contracts.
However, the possibilities for completely standardised solutions are still limited. There are so many different types of
more or less complex credit derivatives. According to the market participants themselves, the legal risks in credit
derivative trading have not been completely removed.
Counterparty Risks
The second source of concern is risk management. A bank that buys credit protection through credit derivatives will
get rid of the credit risk, but instead expose itself to counterparty risk, that is, the risk that the party selling the credit
protection cannot pay. Counterparty risks exist in most financial agreements, but as the credit derivatives market is so
young and growth is so rapid, there is particular reason to be aware of them. There is insufficient statistical data
available and it is difficult to assess where the risks will end up.
Liquidity Risks
Thirdly, there is reason to be aware of possible liquidity risks. Problems may arise if the market actors rely on the
market always being liquid and assume this when making their deals. What would happen, for instance, if several
credit events were to occur simultaneously? Perhaps there would suddenly be only sellers and no buyers in the market.
Then prices will plummet. A crisis of this nature risks spreading rapidly to other financial markets and possibly
threatening the lending banks.
Risk Of Mispricing
Finally, the risk of mispricing, a risk that in many respects is closely related to the liquidity risk. During the same
period as the volumes of credit derivative have grown most, interest rates have gradually fallen and credits have
increased. There have been unusually few bankruptcies. The interest rate differences between high-risk and low-risk
bonds have therefore declined, that is, credit spreads have shrunk. The price of credit derivatives has fallen
correspondingly. The compensation for risk has thus reached a level far below the historical average.
The question is what will happen when economic activity shows a downswing and the number of bankruptcies begins
to increase again. If investors have in general underestimated the credit risk, we may see a substantial adjustment in
risk premiums. This will also lead to a fall in prices of corporate bonds and credit derivatives. In this situation,
individual actors with large net exposures in credit risks may be affected by significant losses.
Caselet 3
10.Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for < TOP >
market interest rates because of problems with their credit history or the ability to prove that they have enough income
to support the monthly payment on the loan for which they are applying. Subprime loans or mortgages are risky for
both creditors and debtors because of the combination of high interest rates, bad credit history, and murky financial
situations often associated with subprime applicants.In this residential mortgage business in the US, a homeowner
selects a mortgage lender who gives the loan after checking the borrower’s creditworthiness and the property that
serves as collateral for the loan.
After the loan is disbursed, most mortgage lenders resell these loans to investors or Wall Street firms, often through
multiple intermediaries.
Wall Street firms in turn bundle thousands of mortgage loans from different lenders into mortgage – backed securities.
These mortgage- backed securities are, in turn, of-ten sliced and diced into different structures, for example, a
Collateralised Debt Obligation (CDO)
Many borrowers bought a home they could not afford but hoped that prices would continue rising and that they could

re-sell their homes for a profit. Un-fortunately, prices went in the wrong direction. Many borrowers, in the sub-prime
sector, lied about their income, their assets or their jobs in their greed to make money from the housing boom.
For the US mortgage industry, 2003 was a phenomenal year with mortgages chalking $3.8 trillion, almost double any
other year in mortgage history. Loans slowed some what in 2005 and 2006, but to hold aloft their market share, many
lenders relaxed their credit norms.
In addition, given that most mortgage lenders in the US sell their loans within a month or two, their primary
motivation was to generate as many loans as they could and then sell them quick. This was yet another reason they
lacked strong incentives for credit checks.
The defaults on sub-prime mortgages were much more than expected, with approximately 17 percent of loans
defaulting so far. Over two million American homes are expected to enter foreclosure with losses amounting to more
than $200 billion. It is the worst housing market scene in the US since the Great Depression of the 1930s.
To compound the situation, securities backed by sub-prime mortgages started showing up in unexpected portfolios
leading to staggering losses. So for, losses have been reported from France, Germany, China, Australia, Japan and
England in addition to the US. And this is just the tip of the iceberg. There are likely to be many more casualties over
the next two years.
Given this uncertainty, banks decided to stop lending – not just housing loans but other forms of debt as well. This led
to liquidity crunch, which in turn hit the markets worldwide.
11.All of the major investment firms are heavily invested in the $6.5 trillion mortgage securities market. The sudden < TOP >
decline in the sub prime market is shutting down the funding sources for low income people while increasing home
inventories. It is also boosting unemployment, putting pressure on the banks, and thrusting the country towards
recession.
As the housing market continues to languish, home equity loans (which amounted to $600 billion in 2006) will shrivel
reducing consumer spending and GDP accordingly. That means that the Federal Reserve will be forced to lower
interest rates and remove the last crumbling cinder block propping up the greenback.
When Bernanke lowers interest rates, foreign investment in US Treasuries and dollar-based securities will drop off, the
dollar will fall and we will undergo a painful cycle of hyperinflation. These are the inescapable consequences of
Greenspan's policies.
Equity bubbles are an expression of class interest. They are a way of shifting wealth from working class people--
whose hourly wages or fixed-incomes can't keep pace with a hyperinflationary monetary policy—to the wealthy and
powerful, who benefit from overheated markets and rampant speculation. The investor class are the only ones who
profit from interest rate manipulation and increases in the money supply. For everyone else, inflation is just a hidden
tax.
A substantial dip in securities could trigger a liquidity crisis which would traumatize our credit-dependent society. If
consumer spending slows down, the economy will grind to a halt and living standards will sharply decline. The sub
primes are just the first domino.
These are some of the things that Fed chief Bernanke will have to consider before resetting interest rates: Does he keep
rates where they are and turn away foreign investment or lower rates and try to salvage the faltering housing market?
Either choice will result in a certain amount of pain.
A cloud of uncertainty has descended on the over-leveraged United States of Foreclosure. The storm is just ahead. The
stewards of the system--Paulson, Bush, Bernanke--could care less about the public welfare. All their energy is devoted
to building a lifeboat for themselves and their fat-cat buddies. Once, they've robbed the last farthing from the public
till they'll be gone, and we'll still be marching along the path to national calamity.
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Suggested Answers with Examiner's Feedback

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31.03.2007

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Year Ended Year Ended

SCHEDULES TO THE BALANCE SHEET

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TOTAL 2949.05 3860.70

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Particulars 31-03-2007 31-03-2006

TOTAL 20598.28 23418.16

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SCHEDULE-17 SIGNIFICANT ACCOUNTING POLICIES (Intentionally removed)

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Investments (Rs.in cores)

Provisions on Standard Asset

Amount Provisions for taxes for the year:

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PROVISIONS AND CONTINGENCIES :

Section E : Caselets (50 Marks)

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END OF QUESTION PAPER

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1.a. Liquidity < TOP >

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2. Liquidity < TOP >

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