INDEX

Page No
Module – A International Banking
Foreign Exchange 2
Forex Risks and Derivatives 11
Correspondent Banking 13
Letter of Credit 19
Exports 23
Imports 29
Foreign Trade Risks and ECGC 33
Exim Bank 36
Reserve Bank of India , FEMA and FEDAI 37

Module – B Risk Management

Risk and Capital , Capital adequacy Ratio 47
Types of Risks, Tier-I& II Capital & Risk Weighted assets 49
BASEL-I, II & III 52
Credit Risk & Credit Risk Mitigates 56
Operational Risk 66
Market Risk 70
Supervisory Review Process and Market Discipline 73
Risk Weights on NPAs and Off Balance Sheet Items 73
Questions for Practice 74
LCR & NFSR 81
Module – C Treasury Management
Concept of Treasury 86
Treasury Products 89
Funding and Regulatory Aspects 98
Treasury Risk Management 101
Derivative Products 104
Treasury and ALM 108
Module – D Balance Sheet Management
rd
3 Schedule – Bank’s Balance Sheet 111
Asset Classification 115
Liquidity Management 122
Interest Rate Risk Management 124
RAROC 128
Case Studies 130
Module - A

International Banking
Forex, Exports, Imports, DGFT, RBI, LC, FEDAI etc.

2020
 International Banking

Foreign Exchange
Foreign It includes all Currency, deposits, Credits and Balances payable in Foreign
Exchange & currency. It also includes Drafts/TCs, LCs and Bills of Exchange payable in
Foreign Foreign currency. In nut shell, all claims payable abroad is Foreign
Currency Exchange.

On the other hand, Foreign Currency is narrow term which includes hard
currency say Pounds, Dollars etc.
Forex Market It comprises of individuals and entities including banks across the globe
without geographical boundaries. Forex market is dynamic and it operates
round the clock. Exchange rate of major currencies change after about
every 4 seconds (i.e. 15*60*24= 21600 changes per day). It opens from
Monday to Friday except in Middle east countries where it is closed on
Friday and opens on Saturday and Sunday.
Global Forex market handles turnover of approx. 5100 billion USD$ per
day, out of which 2% relates to trade and remaining 98% relates to
investments and speculations.
Exchange Rate When settlement of funds and exchange
mechanism of currency takes place_________
TOD rate or Cash Rate Same day (it is also called ready rate)
TOM Rate Next working day
Spot Rate 2nd working day (48 hours)
Forward Rate After few days/months
 If Next day or 2 day is holiday in either of the two countries, the
nd

settlement will take place on next day. For example Spot deal is
stuck on 23rd Dec. 25th is Christmas Day and 26th is Sunday. Under
such circumstances, value date will be 27th i.e. Monday.
 There are two types of rates- Fixed and Floating. Floating rates are
determined by market forces of Demand and Supply. India
switched to Floating exchange rates regime in 1993.
 Card rates are calculated at beginning of each day based on current
market rates.
Factors Fundamental reasons
determining  Balance of Payment (Surplus leads to stronger home currency)
Exchange rates  GDP rates (High growth rate leads to rise in imports and weaker
home currency).
 Fiscal & Monetary policy (Lower taxes lead to high growth)
 Interest rates (In short run, high interest rates attracts overseas
capital and local currency appreciates).
 Political issues (Political stability leads to Economic growth).
Surplus of Foreign currency makes local currency stronger
 Technical reasons : Freedom on capital movement brings FDI and
local currency becomes stronger.
Speculations: It provides depth and liquidity to the market and sometimes
acts as a cushion. In this way, local currency becomes stronger in
exchange of Foreign currency.

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Buy and Sell If the net result of transaction is incoming of Foreign currency, it is Buy
Maxim transaction otherwise, if foreign exchange outgoes, it is Sell transaction.

Buy Low Sell High (Direct Quotations)

Buy rate is also called Bid Rate and Sell Rate is called Offer Rate.

Buy High Sell Low (Indirect Quotations)

 When Local Currency is fixed, bank will like to have more foreign
currency while buying and give less foreign currency while selling.
Direct and Direct Rates
Indirect Rates Foreign Currency is fixed ---say 1USD = INR 55.70
Indirect Rates
Local currency remains fixed---say Rs. 100 = 1.93 USD.
(The Term Home Currency Quotations are Direct Rates)
At present, following 4 currencies are quoted in Indirect mode:
EURO, GBP, AUD and NZ$
Suppose 1USD = 55.70. Rate changes and now 1USD = 55.80. It means
Dollar has improved and Rupee has become cheaper.
Forward Rates It is required when currency is exchanged after few months/days.
Buy Transactions :
(Premium is Spot Rate (+ ) premium OR ( - ) Discount
always added and ( Lower premium is added OR Higher discount is deducted )
Discount is Sale Transactions:
always deducted Spot Rate (+ )Higher premium OR (-) Lower discount
from Spot Rate to
arrive at Forward (So that currency may become cheaper while buying and dearer while
Rate) selling

In India, Forward Contracts are available for Maximum period

of 12 Months and are decided by market forces of Demand and Supply)

Example of Euro 1 = USD$1.3180/3190

Forward rates Forward differentials:
1M = 15/18, 2M= 30/37, 3M=41/49
(Direct Quotations
when currency is Calculate 2M Bid rate and 3M Offer rate
at premium) 2M Bid rate
( It implies that the we have to quote bid rate of Euro)
Formula of Direct Quote will apply.
2M Bid rate = 1.3180+.0030 = 1.3210 (Lower premium is added in lower
spot rate)

3M Offer Rate
(It implies that we have to quote Sale rate of Euro)
Formula of Direct Quote will apply
3M Offer rate = 1.3190+.0049=1.3239 (Higher premium is added in
higher spot rate)

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 Indirect Quotes
Suppose, in the above example, if situation is like this that we have to
quote Buy Rate of USD (instead of Euro), then this will be indirect
quotation. We will like to buy more USD for 1 Euro. Then Maxim Buy High,
Sell Low will apply i.e. 1Euro = USD 1.3190
Forward Rates Euro 1 = USD$1.3180/3190
when Currency Forward differentials:
is at Discount 1M = 24/19, 2M= 26/20, 3M=33/25 (It implies Discount)

Find out 2 Month Bid rate

2M Bid rate = 1.3180-.0026 = 1.3154 (Higher Discount is deducted in
Lower spot rate)

2M Offer Rate = 1.3190-.0020 = 1.3170 ((Lower Discount is deducted in

Higher spot rate)
Exchange
Margin Exchange margin is deducted while buying and added while selling.
Cross Rates Suppose bank has to Quote GBP against INR, but in India, GBP is not
quoted directly. In India,
It is an exchange 1USD =48.10 and GBP/USD is quoted as 1GBP= USD1.6000.
rate between two Therefore 1 GBP = 48.10X1.6 = 76.96
currencies
computed by An Import bill of GBP 100000 has to be retired. Rates are:
reference to a third 1 GBP=1.5975/85 USD
currency, usually 1USD = 48.14/15 INR
the US dollar TT margin =.20%
Here Cross selling rate of both currencies will apply.

Bank has to remit GBP. GBP/USD Quote is available in International

market whereas USD/Rupee Quote is available in local market. Bank will
sell USD to buy GBP and then GBP will be sold to customer.

While selling USD, bank will Quote Higher Rate i.e. 1 USD = 48.15
While selling GBP, bank will Quote Higher Rate i.e. 1 GBP = 1.5985 USD

1 GBP = 1.5985 USD = 1.5985*48.15 = 76.9675 + Margin@.20% =

77.1214 (say 77.1225)
Per Unit and 100 All currencies are quoted as per unit of currency whereas the following
Unit Quotes currencies are quoted as 100 units of Foreign currency:
 Japanese Yen
 Indonesian Rupiahs
 Kenyan Schilling.
 Belgian Francs
 Spanish Peseta
Intervening Currencies in India
 US Dollar
 British Pound

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What is Bank Formula is :
Spread?
Selling Rate – Buying Rate___ *100
(Selling Rate + Buying Rate)/2

Suppose Equation is 1 USD = 44.57/44.68

44.68 -44.57*100
44.625

= .11/44.625*100 = .2465%

Cross Rates Suppose, In India, 1USD=42.8450/545 and in UK, 1USD=.7587/.7590

where two EURO. The customer intends to remit Euro and he desires to know 1 Euro
markets are = ? INR.
involved and
one of them is We will Sell USD to buy Euro in International Market and then, we will Sell
international Euro to our customer.
market Calculation
Sell rate of 1USD = .42.8545 (Direct Quote)
(Sell High i.e. While selling USD, get more INR)

Sell Rate of Euro (Indirect Quotes)

i.e. 1USD=.7587 (Sell Low Buy High)

.7587Euro = 1USD = INR 42.8545

1 EURO = 42.8545/.7587 = 56.48

In India, there is Full Convertibility of Current Account transactions.

Example Where one currency is bought and another currency is sold
A wants to remit JPY 100.00 million at TT spot with margin @.15%. Given
USD/INR at 48.2500/2600 and in Japan USD/JPY = 90.50/60

Solution:
We will buy Japanese Yen and sell USD and then, JPY will be sold to the
customer. The rate to be applied is:
48.2600/90.50 = .533260 per JPY
Rate per 100 JPY = 53.3260 + Margin @.15%(.0799) = 53.4059 (say
53.4050)

TT Rates and Bill Rates

Following 4 types of buying and selling rates are important:

1. TT Buying rate
2. Bill Buying rate
3. TT Selling rate
4. Bill Selling rate

In Interbank market, exchange rate is quoted up to 4 decimals in multiples of 0.0025. e.g.

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1USD=53.5625/5650

For customers the exchange rate is quoted in two decimal places i.e. Rupees and paisa. E.g. 1
USD =Rs. 55.54.

Amount being paid or received will be rounded off to nearest Rupee.

TT Buying Rate
It is required to calculate when our Nostro account is already credited or
being credited without delay e.g. Receipt of DD, MT, TT or collection of
Foreign bills. This rate is used for cancellation of Forward Sales Contract.
Calculation
Spot Rate – Exchange Margin

Bill Buying Rate Bill Buying rate is applied when bank gives INR to the customer before
receipt of Foreign Exchange in the Nostro account i.e. Nostro account is
credited after the purchase transaction. In such cases.
Examples are:
 Export Bills Purchased/Discounted/Negotiated.
 Cheques/DDs purchased by the bank.
Calculation
Spot Rate + Forward Premium (or deduct forward discount) – Exchange
margin.
TT Selling Rate Any sale transaction where no delay is involved is quoted at TT selling rate.
It is desired in issue of TT, MT or Draft. It is also desired in crystallization of
Export bills and Cancellation of Forward purchase contract.
Calculation
Spot Rate + Exchange Margin
Bill Selling Rate It is applied where handling of documents is involved e.g. Payment against
Import transactions:
Calculation
Spot Rate + Exchange Margin for TT selling + Exchange margin for Bill
Selling

Examples
Q. 1
Bank received MT of USD 5000 on 15th Sep. The Nostro account was already credited. What
amount will be paid to the customer: Spot Rate 34.25/30. Oct Forward Differential is 22/24.
Exchange margin is .80%

Solution
TT buying Rate will be applied
34.25 - .274 = 33.976 Ans.

Q. 2
On 15th July, Customer presented a sight bill for USD 100000 for Purchase under LC. How
much amount will be credited to the account of the Exporter. Transit period is 20 days and
Exchange margin is 0.15%. The spot rate is 34.75/85. Forward differentials:
Aug: .60/.57 Sep:1.00/.97 Oct: 1.40/1.37

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Solution
Bill Buying rate of August will be applied.
Spot Rate----34.75 Less discount .60 = 34.15
Less Exchange Margin O.15% i.e. .0512 =34.0988 Ans.
( Transit period is rounded to next month since currency will be cheaper as it is buy transaction)

Q. 3
Issue of DD on New York for USD 25000. The spot Rate is IUSD = 34.3575/3825 IM forward
rate is 34.7825/8250
Exchange margin: 0.15%

Solution:
TT Selling Rate will Apply
Spot Rate = 34.3825 Add Exchange margin (.15%) i.e. 0.0516
TT Selling Rate = Spot Rate + Exchange Margin = 34.4341 Ans.

Q. 4
On 12th Feb, received Import Bill of USD-10000. The bill has to retired to debit the account of
the customer. Inter-bank spot rate =34.6500/7200. The spot rate for March is 5000/4500. The
exchange margin for TT selling is .15% and Exchange margin for Bill selling is .20%. Quote rate
to be applied.

Solution
Bill Selling Rate will be applied.
Spot Rate + Exchange margin for TT Selling + Exchange margin for Bill selling =
34.7200+.0520+.0695 = 34.8415 Ans.

Forward Contract – Due date and Transit period

(Bill Buying Rates and Bill Selling Rates)
If due date after adding transit period and forward period falls in a particular month

Buy Transactions
Quote rates applicable to lower month (if currency is at premium) and same month (if currency
is at discount) due to the reason that currency becomes cheaper and Buy low and Sell High

Sale Transactions
Quote rates applicable to Same month (if currency is at premium) and lower month (if currency
is at discount) due to the reason that currency becomes dearer and Buy low and Sell High
Forward contracts can be booked by Resident Individuals up to USD1lac.

Buy Spot Rate on 16.07.2012 is 1 USD = 34.6850/7275

Transactions- Spot August = 4000/4200, Spot Sep = 7500/7700, Spot Oct = 1.05/1.07
Currency at Spot Nov =1.40/1.42
Premium Transit Period = 25 days , Exchange Margin = 0.15%

Transit Period is Calculate Forward Buying Rate of 3 M Usance bill.

rounded off to
lower month in Due date of realization of Bill = 16.7.2012 + 3M + 25 days = 9.11.2012
which due date By Rounding Transit period to lower month, Oct Rate will be as under:
falls 34.6850+1.05 - .0536 (exchange margin) = 35.6814

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Buy On 22.7.2013,
Transactions- Spot Rate is 35.6000/6500 Forward 1M=3500/3000 2M=5500/5000
Currency at 3M=8500/8000
Discount Transit Period ----20 days Exchange Margin = 0.15%.
Find Bill Buying Rate & 2 M Forward Buying Rate
Transit Period is
rounded off to Solution
same month in Bill Buying Rate (Ready) : Bill Date +20 days = 11.8.2013
which due date Spot Rate = 35.6000 Less Forward Discount 1M (0.3500) Less Exchange
falls Margin 0.15% (0.529)
i.e. 35.6000-.3500-.0529(0.15% of 35.2500) = 35.1971

2 M Forward Buying Rate: = Transaction date +2M +20 days =11.10.13

3 Month Forward Buying Rate will be applied.
Spot Rate = 35.6000 Less Forward Discount of 3M (.8500) Less Exchange
Margin (.0521)
i.e. 35.6000-.8500-.0521(0.15% of 34.7500) = 34.6979 Ans.

Cancellation of
Deal Cancellation of Buy contract is done at TT selling rate and cancellation of
Sale contract is done at TT buying rate.

Example
A bank purchased export bill of USD 50000 at Rs. 42.66, which was dishonored for non-
payment. How much amount will be recovered from exporter, if Spot rate is 42.2000/3000.
Exchange margin is 0.15%.
Solution
TT selling rate will be applied to recover the amount
TT Selling rate= Spot rate +Exchange margin
=42.3000+0.06345 = 42.36345= 42.3625 (Rounding off to nearest .0025)
Amount to be debited to customers’ account =50000*42.3625 =2118125 --------------Ans.

Value Date It is date on which payment of funds or entry to an account becomes

effective. Under TT transaction, value date is same. In other spot and
forward contracts, Value Date is the date when Nostro Account is actually
credited. Value date is also date when actually settlement takes place.

Arbitrage It consists of purchase of one currency in one center accompanied by

immediate resale against same currency at other center.
Per Cent and Per 1% is on part of 100 whereas per mille is 1 part of thousand
Mille
Authorized Authorized dealers are called Authorized Persons. The categories are as
Dealers under:
AP category 1 -----AD banks, Fis dealing in Forex transactions- all types of
Current Account and Capital account transactions.
AP category 2-----Money changers authorized to sell and purchase
Foreign currency notes, TCs and Handle remittances. These are called
FFMCs (Full Fledged Money Changers). These are Coop. Banks, RRBs.
AP category 3----Only purchase of Foreign currency and Travelers
Cheques. These were earlier called ―Restricted Money Changers.‖

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  At present there are about 90 ADs which include all PSBs, Foreign
Banks, Pvt. Banks and All India Financial institutions.

Forward Point Spot Rate

Calculation Euro 1 = US$1.3180
3 Month Forward Rate
Euro 1 = US$1.3330
Forward Point = 1.3330 – 1.3180 = 150 points

Arbitrage & It consists of purchase of one currency in one center accompanied by

Forward Point immediate resale against same currency at other center.
Calculation Example:
Let us borrow from one center and lend at other center at higher rate. In
USA, rate of interest is 6% whereas in Germany, rate of interest is 3% for
EURO. We will borrow from Germany and lend in USA where
1EURO =1.5 USD

Forward Point Calculation for 3 Months

Spot Rate x Interest rate difference x Forward Period

100 x Nos. of days in a year

= 1.5 x 3 x 90
100*360
=0.01125

3 month swap rate = 1.5 + 0.01125 = 1.5112

Calculation of Interest Differential

Forward Points x Nos. of Days x 100

Forward Period x Spot Rate

= 0.01125 x 360 x 100 =3%

1.5 x 90

Forward Premium or Discount are generally based on Interest Rate

Differentials as well as Demand and Supply of Currency.

Some additional examples

Ex.1
Calculate TT selling rate for GBP/INR, if USD/INR is 43.85/87 & GBP/USD is 1.9345/49. A
margin of 0.15% is to be loaded.
Solution ; TT selling rate of GBP/INR
1 GBP = 1.9349 USD
= (1.9349 *43.87)+Margin 0.15%
=84.8841+.1273=85.0114 INR 85.0114-------------------------Ans.

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Ex.2
A foreign correspondent intends to fund his Vostro Account maintained with Mumbai branch of
SBI. What rate will be quoted if 1 USD = 44.23/27 and margin is 0.08%
Solution : TT buying rate will quoted
44.23-.035 = 44.195 ---------------------------------------Ans.

Ex.3
If Swiss Franc is quoted as USD = CHF 1.2550/54 and in India, USD =INR43.50/52, how much
INR will exporter get for his export bill of CHF 50000.
Solution :
Swiss Franc will be bought from customer and sold for USD in overseas market and USD will be
bought in local market.
Rate will be as under:
1 USD = 1.2554 CHF and 1USD=INR 43.50
1CHF=43.50/1.2554 = 34.6503
Amount as paid to exporter = 34.6503*50000=17,32,515/- ----------------Ans.
Ex.4
If Swiss Franc is quoted as USD = CHF 1.2550/54 and USD =INR43.50/52, how much INR will
Importer pay for his import bill of CHF 50000.
Solution :
Swiss Franc will be sold to the customer after it is bought against USD in overseas market.
For this purpose, we will have to buy USD from local market i.e. Buy rate and Sell the same in
the international market to buy CHF. CHF will then be sold to the customer.

1 USD = 1.2550 CHF and 1USD=INR 43.52

1CHF=43.52/1.2550 = 34.6773
Amount to be received from Importer = 34.6773*50000
=17,33,865/- ----Ans.

Q.5 What rate will be quoted for repatriation of FCNR deposit (spot rate or TT rate)
Ans. No rate as the amount is to be paid in Foreign currency itself.

Q. 6 (Cancellation of Contract)
An Export customer booked 3 M Contract for purchase of 10000 USD @45.60. Owing to 3 days’
delay in realization of export bill, the customer intended to cancel forward contract before due
date and book fresh contract of 1M Forward. How much amount will be paid to the customer
and at what rate, the fresh contract will be booked.
Spot Rate = 45.2000/2200 1M Forward = .0800/.1000
TT Selling and Buying Margin is 0.20%
Solution
1. Contract will be cancelled at TT selling rate i.e. 45.2200+.0904(.20%) = 45.3104
 Amount which should have been paid if original contract is honored
=45.60*10000=456000
 Amount which should have been recovered in the event of cancellation of
contract = 45.3104*10000=453104
 Difference of amount to be paid to customer = 456000 – 453104 = 2896/-

2. Contract will be booked at 1M Forward Buying Rate

Spot Rate + 1M premium – Margin (0.20%)
=45.2000 + .0800 - .0905 = 45.1895

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Forex Dealing It is a service branch which deals Buying and Selling Operations of the
Room bank. It manages Foreign currency Assets and Liabilities and also
operations manages Nostro accounts.

A dealer has to maintain two positions:

1. Funds position
2. Currency Position
Currency position can be Overbought or Oversold. It is called Open
position. Hedging is done to square off the open position.

Mid Office deals with Risk Management.

Back Office takes care of settlement and Reconciliation.

FOREX RISKS AND DERIVATIVES

Foreign  Exchange Risk (Transaction Exposure, Translation Exposure and

Exchange Risks Operational Exposure)
 Settlement Risk
 Liquidity Risk
 Country Risk or Sovereign Risk
 Interest Rate Risk or Gap risk
 Operational Risk
 Legal Risk
 Buyer Risk, Seller Risk and Shipping Risk.
ICG (Internal Overnight Limit Maximum exposure a bank can keep overnight
control Day Light Limit : Maximum exposure a bank can expose at any time during
guidelines of a day.
RBI Gap Limit: Maximum inter-period say a month exposure which a bank can
keep.
Counter party limit
Country limit
Dealer limit
Stop Loss limit
Settlement limit
Deal Size limit
 Net Overnight Open Position Limit (NOOPL) –should not exceed
25% of total capital.
 Day Light limit of Ads is 5 times the Net Overnight Position Limit or
existing Intra Day Open Position limit whichever is higher.
 Aggregate Gap limit (AGL) should not exceed 6% of total capital.
CCIL Clearing Corporation of India Limited is the institution created for clearing
and settlement of Forex deals amongst Primary dealers. It mitigates
settlement Risks.. Both counter parties should be members of CCIL. It
handles USD/INR deal settlements with netted amounts.
Derivatives Instruments which reduce risk to an accepted level by future coverings are
called derivatives. Popular derivatives are:
1. Forward Contracts
2. Futures

11
 3. Options
4. Swaps
Forward It is a derivative product in which seller agrees to deliver goods on some
Contract future date at fix price. The Quantity and delivery date is fixed as per
requirements suited to the party. These are OTC products.
Forward differentials are calculated on the basis of difference in interest
rates of countries of currency.
Currency with lower interest would be at a premium and currency with
higher interest will be at a discount in future.
Futures It is a derivative product that is based on agreement to buy or sell an asset
at certain price in Future.
Futures are standardized contracts with regard to quantity and Delivery
date only. The delivery is not must. Margin is kept each day and it is
adjusted. These Futures are traded in Exchanges,

Difference between Futures and Forward Contracts

Forward Contract Futures
It is OTC (Over the Counter) Product It is Exchange traded product
It can be for any odd amount It is always for Standard amount
It can be for any Odd period It is always for Standard period
Delivery is essential Delivery is not must
Margin is not essential It is based on Margin requirement and
Marked to market
Options Option is Right to buy or sell an agreed quantity of currency or commodity
without obligation to do so. The buyer will exercise the option if market
price is in favor or otherwise option may be allowed to lapse.

Call Option
Right to buy at fixed price on or before fixed date.
Put Option
Right to sell at fixed price on or before fixed date.
 Final day on which it expires is called maturity.
CALL OPTION;
 If Strike price is below the spot price, the option is In the money.
 If Strike price is equal to the spot price, the option is At the money.
 If Strike price is above the spot price, the option is Out of money.
PUT OPTION
 If Strike price is more the spot price, the option is In the money.
 If Strike price is equal to the spot price, the option is At the money.
 If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
Swap Foreign Exchange transactions where one currency is sold and purchased
Transactions - for another simultaneously.
Swap Deal may involve:
1. Simultaneous purchase of spot and sale of forward or vice versa.
2. Simultaneous sale and purchase, both forward but for different
maturities. It is called ―Forward to Forward Swap‖.

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 Conditions of Swap Deal:
 There should be simultaneous buying and selling of same foreign
currency of same value for different maturities.
 The deal should be concluded with the understanding between the
banks that it is Swap Deal.
 Buying and Selling is done at same rate. Only Forward margin
enters into the deal as a Swap difference.
Example:
PNB approaches UCO bank to quote its Swap rate for spot to 3months.
UCO bank has to sell spot and buy forward. Swap deal is at forward
differential of Rs. 1.40/1.35. UCO bank will sell spot and buy forward at a
discount of Rs.1.40 (Higher discount at purchase). Swap Difference will be
at Discount of Rs.1.40.

CORRESPONDENT BANKING

Correspondent Banking

It is a relationship between two banks which have mutual accounts with each other:

Nostro accounts ― Our account with you ―

E.g. SBI Mumbai maintaining USD account with City Bank, New York
(Only AD Cat. & Cat 2 can open Nostro accounts).
Vostro accounts ―Your account with us‖
E.g.. City Bank New York maintains Rupee account with SBI Ludhiana.
Loro account ―His account with them‖
E.g. City bank referring to Rupee account of Bank of America with SBI Mumbai.
Mirror account ---- It is replica of Nostro account to reconcile.

What is Swift?
Society for Worldwide Interbank Financial Telecommunications. There are 11000 members of
the society. Financial messages are sent through Swift. The messages are automatically
authenticated through BKE (Bilateral Key Exchange). It is operational 24 hours and 365 days.
Swift has now introduced new system of authentication system wherein banks are required to
have authentication key exchanged between them through a set format by use of RMA
(Relationship Management Application). This is called BIC or Bank Identifier Code).

CHIPS – New York

Clearing House Inter Bank Payment System.
CHIPS is major payment system in USA with 49 members. The participants use the system
throughout the day for sending and receiving electronic payment instructions. These are netted
at end of the day and net position is debited or credited to Nostro account of Federal Reserve.
It is used for Foreign Exchange Inter bank settlements and Euro Dollar Settlements.

FEDWIRE -USA
It is US payment system being operated by Federal Reserve Bank having membership of more
than 9000. It handles majority of domestic payments. All US banks maintain account with

13
Federal Reserve Bank and are allotted ABA numbers to identify senders and receivers of
payments.

CHAPS – London
Clearing House Automated Payment System
It is UK based Settlement System. It handles receipts and Payments in UK.
It has 20 member banks and 4500 Indirect members.

TARGET
The full form of TARGET is Trans-European Automated Real-Time Gross Settlement Express
Transfer System. It is Euro Payment System which comprises of 20 national RTGS systems
working in EUROPE. At present, name of system is Target2. It process high value payments
across Europe. The name of present system is TARGET2.

RTGS-plus
RTGS plus has over 60 participants. It is a German Hybrid clearing system and operating as a
European oriented RTGS and Payment system. It has over 90 members.

RTGS & NEFT in India

Real Time Gross Settlement is a payment system for Interbank transfer with minimum Rs. 2.00
lakh. This system is managed by IDRBT, Hyderabad, which connects all banks to Central server
maintained by RBI. The network is INFINET (Indian Financial Network)
Timings are: 8:00AM to 8:00PM

NEFT (National Electronic Fund Transfer) is mainly used for low amount transactions. However,
there is no minimum and maximum limit. The timings are: 8:00AM to 7:00PM. There are 23 half
yearly batches daily. The time period is B+2.

Who is Resident A person who resides in India for more than 182 days during preceding
Indian? Who is financial year is Resident Indian. A person who is not resident is Non-
Non- Resident Resident.
Who is NRI? A person who is citizen of India but resides outside India owing to:
 Employment, Business, vocation-------indicating indefinite period of
stay outside.
 Work abroad on assignment with Foreign Govt., UNO, and IMF etc.
 Deputation officially.
 Study abroad.
PIO - Persons of PIO is a person who is citizen of any other country (Except Pakistan and
Indian Origin Bangladesh), but he at any time:
 Held Indian Passport; or
 He or his grand-parents or grand grand-parents were Indian citizens
by virtue of constitution of India or under Indian Citizenship Act,
1955; or
 The person is spouse of Indian Citizen.
OCB – Overseas OCBs are firms, Cos, Society owned directly or indirectly to the extent of at-
Corporate least 60% by NRIs.
Bodies It also includes overseas trusts where at-least 60% irrevocable beneficial
interest is held by non-residents directly or indirectly.

14
NRE Deposit Only non-resident Indians can open following NRE accounts with banks:
Accounts  Fixed Deposits & Recurring Deposits
 SB and CA Deposits

The other features are:

 Deposits are held in Indian currency.
 The Principal and Interest both can be repatriated.
 Account holder bears the risk of fluctuations in currency rates.
 Account will be opened with proceeds from abroad.
 Funds originating in India cannot be deposited.
 No lien is permitted to be marked against SB deposits.
 Joint account with Indians can be opened as Former or
Survivor.
 Cheque book and IBS allowed.
 Nomination in favor of NRI/Resident Indian allowed.
 Interest Income is exempt from Income Tax, Gift Tax or Wealth Tax.
 TOD allowed up to Rs. 50000/- for maximum 2 weeks.
 Account can be operated in India through mandate/P/A basis also.
 Loans against FDR to 3rd parties allowed provided NRI is personally
present for documentation.
 Interest rates Have since been deregulated by RBI..
FCNR- B FCNRB accounts can also be opened by NRIs. The conditions of NRE
accounts deposits as explained above are also applicable on FCNR-B deposits with
the following additional features:
 Only FD 1-5 years tenure can be opened.
 The amount is kept in Foreign Currency and repaid in the Foreign
Currency.
 Account can now be opened in any convertible currency.
 No exchange risk for the customer. The bank bears the risk.
 Interest on the basis of 360 days in a year
 Half yearly intervals of 180 days
 Interest exemptions from I.T.
 Operating by P/A not permitted.
 The amount of Principle and Interest is freely repatriable
 Joint account with Indians can be opened as Former or
Survivor.
 The rate of interest and tenor applicable to these accounts will be
decided by Reserve Bank of India with LIBOR as base.

SNRR SNRR (Special Non-resident Rupee Account)

(Special Non- Any person resident outside India, having business relations in India can
resident Rupee open SNRR account in Indian Rupees with AD for the purpose of putting
Account) proceeds from India.
 CA type and no interest is paid.
 Tenure of account should commensurate with term of contract or
period of operation in India.
 Maximum tenure is 7 years.
 Balance in the account is eligible for repatriation.
 Transfer from NRO to SNRR account is prohibited.

15
  All transactions are subject to taxes payable in India.
 Pakinstan and Bangladesh national require prior approval of RBI.
Rupee Loans Demand Loan or Overdraft is allowed against FDR. There is no maximum
against limit of loan against pledge of FDR . The loan proceeds will be credited to
NRE/FCNRB NRO account. The loan can be availed for :
FDRs  Personal purpose.
 Investment.
 Purchase of property.
The loan can be repaid :
 From proceeds of abroad
 From NRE/FCNR account
 From local resources through NRO account.
NRO accounts Non-Resident Ordinary are Rupee accounts and can be opened:
 By NRIs for deposit of Income earned in India.
An NRO account,  By any person resident outside India (other than a person resident
is a savings, FD, in Nepal and Bhutan). Foreigners coming to India for temporary
RD or current stay can open NRO account, maintain it for 6M and can convert it
account held in
into foreign currency after completion of stay provided no local
India for the NRIs to
manage their funds are credited to the account.
income earned in  Deposit may be held jointly with residents (Former or Survivor)
India. Hence, it is a  Currency of Deposit is Indian Rupees
good way for  Non Repatriable except for the following in the account - 1) Current
account holders to income 2) Up-to USD 1 Million per financial year.
deposit and  Existing accounts of residents are converted to NRO category
manage their
consequent upon their becoming NRIs.
accumulated rupee
funds.  TDS called withholding Tax is applicable at 30% + Service Tax
+Education Cess.
 Prior permission of RBI is required to open NRO account of
Pakistani national. However permission is not required for
opening NRO account of Bangladeshi citizen having valid Visa
and Passport.
 NRO Account of Foreign student can be opened on the basis of
Passport and Visa provided declaration of local address is given
within 30 days and address is verified. Till then, deposit cannot be in
excess of amount equivalent to USD 1000.
 Now, bank can open one NRO account for Citizen of Pakistan
without RBI approval, belonging to minority community in those
countries and residing in India and who have been granted Long
Term Visa by CG.

Non-Resident Non-resident account holder if returns to India for permanent stay, his
returning to NRO/FCNR account is converted either into either Resident account Or
India RFC (Resident Foreign Currency Account).

Resident It has been decided that AD banks may include an NRI close relative
Accounts – (relatives as defined in Section 6 of the Companies Act, 1956) in existing /
Operation Either new resident bank accounts as joint holder with the resident account holder
or Survivor with on ―Either or Survivor‖ basis subject to the following conditions:
non- resident

16
  Such account will be treated as resident bank account
 Cheques, instruments, remittances, cash, card belonging to the NRI
close relative shall not be eligible for credit to this account
 The NRI close relative shall operate such account only for and on
behalf of the resident for domestic payment
Where due to any eventuality, the non-resident account holder becomes
the survivor, it shall be categorized as NRO account.

Investments by NRIs are allowed to invest in India on Repatriation basis as well as on Non-
NRIs in India Repatriation basis. NRI can purchase Equity Shares, Preference shares
and Convertible Debentures in Indian companies subject to conditions
under following categories:
1. Foreign Direct Investments.
2. Portfolio Investment
3. Purchase and Sale of Shares on Non-Repatriation basis.
4. Purchase of other securities of Indian Companies.
5. Exchange Traded Derivatives.
Ceiling of Purchase of shares by NRI/PIO

Any individual NRI/PIO 5% of Paid capital of Co

All NRIs/PIOs taken together 10% of Paid up capital of Co.

Besides above, NRIs are permitted to invest in:

 Units of UTI and Mutual Funds
 Company Deposits – Minimum 3 years’ period.
 Share in Proprietorship firm/partnership firm provided the firm is not
engaged in Agriculture and Plantation activity or Real Estate
business.
 Acquiring of Immovable property not being Agriculture, Plantation
or Farm House.
NRI can acquire IP by way of :
 Purchase out of funds received in India
 By way of gift from resident in India or outside India.
 By way of Inheritance from a person resident outside India.
The Income from the property or sale proceeds of the property can be
repatriated outside India up to monetary limit of USD1 Million per financial
year provided all the applicable taxes are paid.
 NRIs can invest in Govt. securities, treasury bills on non-
repatriation basis.
 However, NRI cannot invest in Small saving Schemes including
PPF.
Loans to NRIs NRI can avail the following loans:
1. Rupee Loans in India
- Up to up to any limit subject to prescribed margin.
- For personal purpose, contribution to Capital in Indian
Companies or for acquisition of property.
- Repayment of loan will be either from inward remittances or
from local resources through NRO accounts.
- Loan cannot be used for relending or for agriculture/plantation
activities.

17
 2. Foreign Currency Loans in India
- Against security of funds in FCNR-B deposits.
- Maturity of loan should not exceed due date of deposits.
- Repayment from Fresh remittances or from maturity proceeds of
deposits.
- Premature withdrawal of deposits not allowed.

3. Loans to 3rd Parties provided

- There is no direct or indirect consideration for NRE depositor
agreeing to pledge his FD.
- Margin, rate of Interest and Purpose of loan shall be as per RBI
guidelines.
- The loan will be utilized for personal purpose or business
purpose and not for re-lending or carrying out
Agriculture/Plantation/Real estate activities.
- Loan documents will be executed personally by the depositor
and Power of attorney is not allowed.

4. Housing Loans to NRIs : HL can be sanctioned to NRIs subject to

following conditions:
- Quantum of loan, Margin and period of Repayment shall be
same as applicable to Indian resident.
- The loan shall not be credited to NRE/FCNR account of the
customer.
- EM of IP is must and lien on assets.
- Repayment from remittance abroad or by debit to NRE/FCNR
account or from rental income derived from property.
Foreign Portfolio Portfolio Investor registered with SEBI is called RFPI (Registered Foreign
Investment Portfolio Investor ) instead of FII and QFI.
Scheme for
RFPIs  Individual investment limits for RFPI is below 10% of paid up capital
of the company or paid up value of each series of convertible
debentures issued by Indian Company.
 Aggregate Investment limit for RFPI is below 24% of paid up capital
of the company or paid up value of each series of convertible
debentures issued by Indian Company.
 The limits are within FDI sectoral caps.
 RFPI can open SNRR (Special Non-resident Rupee account) and
also Foreign Currency account with AD bank.
RFPI can
 Purchase/Sale of shares and debentures
 Purchase of Govt. Securities
 Invest in Exchange traded derivatives
 Through Regd. Brokers
 Amount is routed through designated branch.
 Only delivery based transactions
 Investment on Repatriation basis can be made out of inward
remittances or out of NRE/FCNR deposits.

18
 LETTER OF CREDIT

Documentary LC is a document:
Letters of Credit  Issued by Buyer’s bank at his request.
(LC)  Carrying undertaking to pay to the seller
 Upon presentation of documents evidencing shipping of goods.
 In compliance with terms and conditions.
ILC is Inland Letter of Credit and FLC is Foreign Letter of Credit. The
parties to LC are as under:

Applicant Buyer or Importer

Beneficiary Seller or Exporter
Issuing Bank It is opening Bank which ultimately pays on
behalf of importer in the Importer’s country.
Advising Bank or Bank in Exporter Country through which LC is
Notifying Bank advised. It acts as agent without responsibility to
pay unless it confirms.
Negotiating Bank Bank in Exporter Country which makes payment
or Nominated Bank to exporter or accepts Bill of Exchange.
Confirming Bank In Exporter’s country. It may be advising bank
also if it adds confirmation. This bank will be
responsible for default, if any.
Reimbursing Bank The bank which reimburses the negotiating
bank. (Usually, it is the bank having Nostro
account of Opening Bank.
UCP – 600 It is a publication of ICC (international Chamber of Commerce). ICC is
Uniform Custom situated in Paris. It does not apply by default. There must be special
and Practice of mention in LC about applicability of UCPDC – 600. It has 39 articles. Some
Documentary of the important are here under:
Credit
 Negotiating Bank/Issuing Bank gets Reasonable time for
acceptance/refusal of Documents which is 5 Banking days after
presentation.
 Bank to deal with documents and not with goods. Bank not to check
quality of the goods. However shipping documents must contain the
particulars of commodity shipped which should match with LC.
 Bank is not concerned with underlying contract of buyer and seller.
 Courts refrain from passing injunction on complaint of importer
regarding any discrepancy of goods.
 If word about is written in LC, amount of Bill may differ from LC
amount ±10% (Tolerance limit)
 In such cases, quantity of Bill may differ from LC specification ±5%
(Tolerance limit).
 Documents are original if it carries original signatures, stamp mark
and label of issuer.
 Documents must be presented for negotiation within 21 Calendar
days from date of Shipment. It becomes stale thereafter.
 If the documents are presented after 21 days, banks can handle

19
 without RBI permission, if satisfied with the reasons.
 If expiry of LC falls on Public holiday, under such situations
documents can be submitted on Preceding banking day. It cannot
be extended under any circumstances.
 Term beginning, middle and end of the month means 1-10, 11-20 &
21 to last day of the month.
 DOCDEX (Documentary Credit Dispute resolution Expertise) is one
of the options available to parties of LC to resolve their disputes.
Types of LC LC Type Features
Revocable It is an LC which can be amended or cancelled
without consent of all parties. UCPDC 600 does not
allow issue of such LC.
Irrevocable It is LC which cannot be cancelled or amended
without consent of all parties.
Confirmed LC If confirmed by some bank in exporter country.
Transferable LC It can be transferred in Full or part by advising bank at
the request of issuing bank. ONLY ONCE
Red Clause LC It enables the beneficiary to avail pre-shipment credit
at issuing bank’s Risk by the Corresponding bank
.
Green Clause Besides pre-shipment, Corresponding bank can allow
Letter of Credit advance for storage and shipment.
Revolving LC Where bills are negotiated and LC is automatically
renewed.
Back to Back LC Beneficiary Uses LC to open another LC in favor of
local suppliers.
Standby LC It is issued in lieu of Guarantee. It is substitute of
guarantee and is used in countries like US where
guarantees are not used.
Sight, Sight LC is payable on demand whereas Acceptance
acceptance or LC is payable on due date after usance period. LC
Deferred which is not accompanied by Bill of exchange and is
Payment Credit payable on certain future date is called DP credit.
 If nothing is mentioned, LC will be Irrevocable, non-transferable.

Documents under LC
1. Bill of exchange.
2. Invoice
3. Transport Documents: Bill of Lading & Airway Bill
4. Insurance Documents (Insurance is done at 110% of CIF value)
5. Certificate of Origin

Short Bill of Lading: Which does not carry detailed terms and conditions
Thorough Bill of Lading covers entire voyage with several modes of
transport
Straight Bill of Lading is issued directly in the name of consignee.
Clause Bill of Lading: It bears super imposed clause that declared
defective condition of Goods.
Clean Bill of Lading: It has no such super imposed clause declaring
goods or packaging as defective.

20
Crystallization of It is incumbent upon the issuing bank to make payment immediately.
Foreign In case of sight documents, the issuing bank can hold documents for
currency maximum period of 10 days. In case the bill is not retired or paid within this
Liability period, the issuing bank will crystallize the liability on 10th day at Bill
Selling rate or the rate at which the contract was booked (whichever is
higher)
As per latest directive, this period will be decided by each individual bank
and make policy in this regard

In case of Usance bill, Forex liability will be crystallized on due date into
Indian Rupees at Bill Selling rate or Contracted Rate (which is higher)
Inco Terms Ex-Works
(International Exporter says that goods can be picked up from Factory. Exporter will not
Commercial pay the freight. The transport cost and risk will be borne by the Importer.
Terms)
FCA (Main Freight Paid by Buyer)
Free Carrier means seller hands over the goods to first Carrier.

FAS (Main Freight Paid by Buyer)

Free alongside ship i.e. Goods will be delivered by exporter to shipping co.

FOB (Main Freight Paid by Buyer)

Free on Board (Say FOB Mangalore) means Goods will be loaded on
ship/Aero plane (main carriage still unpaid by the exporter)

DAP: Delivery at Place

DAT: Delivery at terminal

CFR (Cost and Freight Paid by Seller)

Seller will pay cost and freight till destination
CIF (Cost, Insurance and Freight paid by Seller)
The cost, Insurance and Freight will be borne by seller.
Other related  UCPDC does not apply by default. It is required to be mentioned on
guidelines LC.
 Shipping Documents can be dated prior to the date of LC. It means
LC covers the shipping done prior to the issue of letter of credit. But,
the shipping done after expiry of LC is not permitted.
 On or about date means ±5 Calendar days. If it is mentioned on LC
that date of credit is on or about 31.12.2013. This implies that date
of expiry of LC can be after 5 calendar days after 31.12.2013.
 ISBP (International Standard Banking Practice ) for examination of
Documents under LC is ICC publication which provides important
guidance for examination of documents under LC.
 URR-725 (Uniform Rules for Bank to Bank Reimbursement) is also
publication of ICC which prescribes responsibilities of Issuing bank,
claiming bank, re-imbursing bank and other related parties as
incorporated in LC.
 Insurance Policy should be in the same currency as the LC.
Insurance claim is payable in currency of applicant.

21
Case Studies on Case-Study -1
LC ABC Ltd received LC in their favour for exports to UK. The expiry date of
credit is on or about 30th July, 2014. Owing to delay, the exporter
presented shipping documents on 3rd Aug, 2014. What is the position of
Negotiating Bank?
Solution
The documents can be accepted. The reason is that expiry date of LC is on
or about 30th July. As per Article 3 of UCPDC, On or About is interpreted
as that an even can occur during a period of 5 calendar days after the
specified date (both start and end date included). The presentation of
shipping documents is well within stipulated period.

Case Study – 2
Dena Bank issued LC of USD 75000 on 5.1.2014 in favour of XYZ, London.
Last date of shipping is 15.1.14 and last date of negotiation is 31.1.14.
 Goods were shipped on 2.1.14 14
 Documents of shipping were presented with London Bank
(Negotiating bank) on 14.1.2014.
 Documents were negotiated on 16.1.14. The documents were sent
to Dena bank (Issuing bank/Opening bank) for reimbursement by
London Bank,

The opening bank narrated the following deficiencies and returned the
negotiating documents.
1. Date of LC is 5.1.14 whereas the goods were shipped on 2.1.14.
2. Date of Invoice is 3.1.14 whereas date of packing list and inspection
certificate is 31.12.13.
Solution
The return is not justified on the following grounds:
1. As per Article 14 of UCPDC, Documents under LC can be dated
prior to the Issue of LC. But these cannot be dated later than date of
presentation.
2. There is no justification for objection no. 2 raised by the opening
bank.
As such, There is no option with the opening bank except to honor the
commitment and pay the LC.
Case Study – 3
Issuing Bank received documents under LC from Negotiating bank on
22.12.2013. The documents were forwarded to the applicant for
acceptance on next day. On 29.12.2013, applicant pointed out that
insurance policy was in currency different than as mentioned in LC. 25th
Dec was holiday and 27th Dec was Sunday. The opening bank informed the
discrepancies to Negotiating bank and sought directions of exporter. The
Negotiating bank objected that opening bank could have pointed out
discrepancy within 5 days which has already been lapsed and therefore
Opening bank must pay now.
Solution
Article 16 of UCPDC states that Issuing Bank gets 5 banking days to
determine discrepancy, if any. 25th Dec, 26th Dec and 27th Dec has to
excluded and therefore the claim of Negotiating bank is not tenable.

22
 EXPORTS

RBI and DGFT RBI controls Foreign Exchange and DGFT (Directorate General of Foreign
Trade) controls Foreign Trade. Exim Policy as framed in accordance with
FEMA is implemented by DGFT. DGFT functions under direct control of
Ministry of Commerce and Industry. It regulates Imports and Exports
through EXIM Policy.

On the other hand, RBI keeps Forex Reserves, Finances Export trade and
Regulates exchange control. Receipts and Payments of Forex are also
handled by RBI.

IEC - Importer One has to apply for IEC to become eligible for Imports and Exports. DGFT
Exporter Code allots IEC to Exporters and Importers in accordance with RBI guidelines
and FEMA regulations. EXIM Policy is also considered before allotting IEC.

Export All exports (physically or otherwise) shall be declared in the following Form.
Declaration 1. Softex form---meant for export of software.
Form 2. SDF/EDF (Statutory Declaration Form/ Export Declaration Form)----
replaced GR form in order to submit declaration electronically.

EDF is submitted in duplicate with Custom Commissioner who puts its

stamp and hands over obne copy to exporter marked ―Exchange Control
Copy‖ for submission thereof to AD.

Exemptions
 Trade Samples, Personal effects of travelers and Central Govt.
goods and Aircrafts/Engines spare parts for overhauling
 Gift items having value up to Rs. 5.00 lakh per exporter.
 Goods with value not exceeding USD 1000 value to Myanmar.
 Goods imported free of cost on re-export basis
 Goods sent for testing.
 Imported goods found defective for replacement or found surplus

ADs may consider waiver for export of goods free of cost for export
promotion up to 2% of average annual exports of previous 3 years subject
to ceiling of Rs. 1.00 crore for Status Holder Exporters.

As per latest directives, submission of SDF has been dispensed with

only if exports are taking place on EDI ports. . However, mandatory
statutory requirements contained in EDF have been subsumed in
Shipping bill format.

Prescribed Time The time norms for export trade are as under:
limits  Submission of documents with ―Exchange Control Copy‖ to AD
within 21 days from date of shipment.
 Time period for realization of Export proceeds is has been reduced
to 9M for all types of exports including exports to SEZ (Special

23
 economic zones), SHE (Status Holder Exporters) and 100%EOUs.
Previously, the time period was 12Months for SEZs and SHEs.
 For, Exports to Warehouse established outside India, as soon as it
is realized and in any case within fifteen months from the date of
shipment of goods
 After expiry of time limit, extension is sought by Exporter on ETX
Form. The AD can extend the period by 6M.

However, reporting will be made to RBI on XOS Form on half yearly basis
in respect of all overdue bills not realized within due date.

Direct Dispatch AD banks may handle direct dispatch of shipping documents provided
of Shipping  export proceeds are up to USD 1 Million
Documents  the exporter is regular customer of at least 6 months AND
 Full Value of Exports stands received.

Advance Exporters may receive advance payments from their overseas importers
Payments provided:
 Shipment is made within 1 year from receipt of advance.
 Rate of interest payable should not exceed LIBOR+100 bps.
 Documents are routed through AD from which advance was routed.
Refund of Refund of export proceeds can be considered by AD provided the exporter
Export proceeds submits evidence of re-import on account of poor quality, trade dispute etc.
SD must exercise due diligence, verify bonafides and obtain certificate of
DGFT from exporter that no incentives were received from DGFT at the
time of exports or incentives received if any have been surrendered. The
Ad must also obtain certificate that goods will be re-imported within 3
months from date of remittance.
Prescribed Exporter will receive payment though any of the following mode:
Method of  Bank Drafts, TC, Currency, FCNR/NRE deposits, International
payment and Credit Card. But the proceeds can be in Indian Rupees from Nepal
Reduction in and Bhutan.
export proceeds  Export proceeds from ACU countries can be settled in ACU/EURO
or ACU/Dollar. A separate Dollar/Euro account is maintained which
is denominated as ACU Dollar or ACU EURO.

ACU – Asian Clearing Union was formed in Tehran, Iran in 1974 and it
comprises of following 9 countries as members.

India, Bangladesh, Bhutan, Myanmar, Iran, Pak, Srilanka, Nepal and

Maldives.
Exporters may be allowed to reduce the export proceeds with the following:
 Reduction in Invoice value on account of discount for pre-payment
of Usance bills (maximum 25%)
 Agency commission on exports.
 Claims against exports.
 Write off the unrecoverable export dues up to maximum limit of 5%
of export value. SHE can write off up 10% of total exports during
previous calendar year.

24
 The proceeds of exports can be got deposited by exporter in any of the
following account:
1. Overseas Foreign Currency account.
2. Diamond Dollar account.
3. EEFC (Exchange Earners Foreign Currency account)
DDA _ diamond Diamond Dollar account can be opened by traders dealing in Rough and
Dollar accounts Polished diamond or Diamond studded Jewellary with the following
conditions:

1. With track record of 2 years.

2. Average Export turnover of 3 crores or above during preceding 3
licensing years.

DDA account can be opened by the exporter for transacting business in

Foreign Exchange. An exporter can have maximum 5 Diamond Dollar
accounts.
EEFC Exchange Earners Foreign Currency accounts can be opened by exporters.
100% export proceeds can be credited in the account which does not earn
interest but this amount is repatriable outside India for imports (Current
Account transactions).

Pre-shipment Packing credit has the following features:

Finance or
Packing Credit 1. Calculation of FOB value of order/LC amount or Domestic cost of
production (whichever is lower).
2. IEC allotted by DGFT.
3. Exporter should not be on the ―Caution List‖ of RBI.
4. He should not be under ―Specific Approval list‖ of ECGC.
5. There must be valid Export order or LC.
6. Account should be KYC compliant.
7. Normally up to 180 days at concessional rates. Presently, it is
available up to 270 dats.

Liquidation of Pre-shipment credit

 Out of proceeds of the bill.
 Out of negotiation of export documents.
 Out of balances held in EEFC account
 Out of proceeds of Post Shipment credit.

Post Shipment Post shipment finance is made available to exporters on the following
Finance conditions:
 IEC accompanied by prescribed declaration on GR/PP/Softex/SDF
form must be submitted.
 Documents must be submitted by exporter within 21 days of
shipment.
 Payment must be made in approved manner within 6 months.
 Normal Transit Period is 25 days. The margin is NIL normally. But
in any case, it should not exceed 10% if LC is there otherwise it can
be up to 25%.
 Credit can be granted for maximum 9 months (inclusive of NTP) in

25
 case of Usance Bills
 Concessional rate of interest is allowed to the exporter up to
Notional Due Date or Value date whichever is earlier up to
maximum 90 days.
Types of Post Shipment Finance:
 Export Bills Purchased for Sight bills and Discounting for Usance
bills.( These bills are not covered under LC)
 Export bills negotiation. (These bills are covered under LC)
 Advance against bills sent for collection.

Discrepancies of Documents
Late Shipment, LC expired, Late presentation of shipping documents, Bill
of Lading not signed properly, Incomplete Bill of Lading, Clause Bill of
Lading , Short Bill of Lading or Inadequate Insurance.

Advance against Un-drawn Balance

Undrawn balance is the amount less received from Importers. Bank can
finance up to 10% undrawn amount up to maximum period of 90 days.

Advance against Duty Drawback

Duty drawback is the support by Government by way of refund of
Excise/Custom duty in case the domestic cost of the product is higher than
the Price charged from the importer. This is done to boost exports despite
international competition. Bank can make loan to exporter against Duty
Drawback up to maximum period of 90 days.

 Concessional rate of interest is allowed up to NDD (Notional

Due Date) in case of Demand Bill and Usance Bill.

Export Credit in PCFC is pre-shipment credit in Foreign Currency and PSFC is post-
Foreign shipment credit in Foreign Currency. This is additional window for providing
Currency finance in any convertible currency. It is applicable only in cash exports.
GATS Credit can be afforded to exporters of all the 161 services covered under
GATS ―General Agreement on Trade in Services‖. The provisions
applicable to export of goods apply mutatis mutandis to export of services.

Crystallization of Consequent upon non-realization, Conversion of Foreign Exchange liability

Overdue Bills into Rupees is called crystallization. It is done on 30th day from notional
due date at prevailing TT selling rate or Original Bill Buying Rate
(Whichever is higher).

DA Bills
Notional due date is calculated in DA Bill by adding normal period of transit
i.e. 25 days in the Usance period. 30th day is taken from notional due date.
DP Bills
30th day after Normal Transit Period
If 30th day happens to be holiday or Saturday, liability will be
crystallized on the following working day.
 Policy has been liberalized and crystallization period will be decided
by individual banks.

26
Export of Credit can be provided to exporters of all 161 tradable services covered
services under GATS (General Agreement on Trade in services) where payment for
such services is received in Forex. The provisions applicable to export of
goods apply to export of services.

Gold Card All exporters in Small and Medium Sector with good track record are
Scheme eligible to avail Gold Card Scheme. The conditions are :
1. Account should be classified as Standard assets for the last 3
years.
2. Limit is sanctioned for 5 years.
3. There is provision of 20% Standby limit.
4. Packing Credit is allowed in Foreign currency.
5. Concessional rate is allowed for 90 days initially which can be
extended for 360 days.
6. Bank may waive collateral and provide exemption from ECGC
Guarantee schemes.
Star Export As per Foreign Trade Policy, Star Export Houses are exporters who Excel.
Houses Category FOB Value of Exports in USD
One Star Export House 3 million
Two Star Export House 25 million
Three Star Export House 100 million
Four Star Export House 500 million
Five Star Export House 2500 million
Factoring and Factoring is financing and collection of Receivables. The client sells
Forfaiting Receivables at discount to Factor in order to raise finance for Working
Capital. It may be with or without recourse. Factor finances about 80%
and balance of 20% is paid after collection from the borrower. Bill should
carry LR/RR. Maximum Debt period permitted is 150 days inclusive of
grace period of 60 days. Debts are assigned in favour of Factor. There are
2 factors in International Factoring. One is Export Factor and the other is
Import Factor. Importer pays to Import factor who remits the same to Export
Factor.

Forfaiting is Finance of Export Receivables to exporter by the Forfaitor. It

is also called discounting of Trade Receivables such as drafts drawn under
LC, B/E or PN. It is always No Recourse Basis (i.e. without recourse to
exporter). Forfaitor after sending documents to Exporters’ Bank makes
100% payment to exporter after deducting applicable discount. Maximum
period of Advance is 180 days.

Pre-shipment & Post-shipment Finance

Q. 1
Received order of USD 50000(CIF) to Australia on 1.1.11 when USD/INR Bill Buying Rate is
43.50. How much pre-shipment finance will be released considering profit margin of 10% and
Insurance and freight cost@ 12%. Contribution from borrower is 25%.
Solution
FOB Value = CIF – Insurance and Freight – Profit (Calculation at Bill Buying Rate on 1.1.11)
= 50000X43.5 = 2175000 – 261000(12%) – 191400(10% of 1914000) = 1722600
Pre-shipment Finance = FOB value - 25% (Margin) = 1722600-430650=1291950.Ans.

27
Q. 2 :What will be amount of Post-shipment Finance under Foreign Bill Purchased for USD
45000 when Bill Buying rate on 31.3.11 (date of submission of Export documents) is 43.85
Solution
45000X43.85 = 1973250 Ans.
Q. 3: Period for which concessional Rate of Interest is charged on DP bills Solution
25 days .Ans.
Q. 4 If the above said bill remains overdue for 2 months, what will be date of crystallization?
Due Date of Bill will be 31.3.11 + 25 days = 25.4.2011
The bill will be crystallized on 24.5.2011 i.e. on 30th day from due date. Ans.
Q. 5 : On 8th Sep, an exporter tenders a demand bill for USD 100000 drawn on New York. The
USD/INR quote is as under:
Spot---------USD 1 =34.3000/3500
Spot Sep-------------------6000/7000
Spot Oct--------------------8000/9000
Spot Nov------------------10000/11000
Transit Period is 20 days and Exchange margin 0.15%
Calculate Rupee payable to the customer. Customer wants to retain 15% in Dollars
Interest @13% has to be charged on INR liability of the customer.
Solution
Since, the currency is at premium, the transit period will be rounded off to the lower month
(i.e. NIL). And the rate to the customer will be based on Spot Rate. If interest rate is 13%, how
much interest will be recovered from the Exporter
Spot Buying rate = 34.3000
Less Exchange Margin = 0.0515
34.2485 or 34.25 per dollar.
Amount in Indian Rupee = 85000(85% of 100000) x 34.25 = 2911250/-
Interest will be charged on 2911250/- @ 13% for 20 days = 20738/-.
Q. 6
On 26th Aug, an exporter tenders for purchase a bill payable 60 days from sight and drawn on
New York for USD 25650. The dollar rupee rate is as under:
Spot----------------------1USD = 34.6525/6850
Spot Sep--------------------------------1500/1400
Spot Oct---------------------------------2800/2700
Spot Nov--------------------------------4200/4100
Spot Dec--------------------------------5600/5500
Exchange Margin is 0.15%, Transit Period is 20 days. Rate of Interest is 13%. An amount of Rs.
500/- on account of Out of Pocket expenses has to be charged.
What will be the exchange rate payable to the customer and Rupee amount payable?
Solution
Notional due Date = 20+60 days from 26th Aug i.e. 14th Nov. Since, the currency is at discount,
the period will be rounded off to the same month). Obviously, the discount of Nov will be more
and it will make the Buy Rate Lower.
Dollar/Rupee market spot Buying Rate = 34.6525
Less Discount for August to November = 0.4200
34.2325
Less Exchange Margin @.15% .0513
= 34.1812
Rupee Amount payable to exporter = 25650 X 34.18 = 876717-00
Less Interest for 80 days @ 13% = 24980-00
Less out of pocket expenses = 500-00
851237-00

28
 IMPORTS

Imports – Pre- AD1 banks are to ensure that Imports are in accordance with:
requisites  Exim Policy
 RBI Guidelines
 FEMA Rules
 Goods are as per OGL (Open General list).
 Importer is having IEC (Import Export Code) issued by DGFT.
Imports The following are essential elements of Imports:
Formalities & 1. An importer before remitting proceeds exceeding USD 5000 must
Time limit for submit application on Form A-1 to the Authorized Dealer.
import payment
(AS PER LATEST DIRECTIVES OF RBI, FORM A-1 IS NO MORE
REQUIRED NOW)

2. AD banks can issue LC on the basis of License and Exchange

Control Copy.

Remittance against imports should be completed within 6 months from

date of shipment. For Capital goods, period is 3 years.
 Any delay beyond 6 months will be treated as Deferred
Payment arrangement and the same will be treated as
Trade Credit up to 3 years.

 AD Category – I banks can consider granting extension of

time for settlement of import dues up to a period of 6
months at a time (maximum up to the period of three years)
irrespective of the invoice value for delays on account of
disputes about quantity or quality or non-fulfillment of terms
of contract; financial difficulties and cases where importer
has filed suit against the seller.

 While considering extension beyond one year from the date

of remittance, the total outstanding of the importer does not
exceed USD one million or 10 per cent of the average import
remittances during the preceding two financial years,
whichever is lower.

 Cases not covered by the above instructions / beyond the

above limits, may be referred to the concerned Regional
Office of Reserve Bank of India.
Advance AD Banks may remit advance payment of Imports subject to following
Remittances conditions:
 Up to USD 200000 or equivalent after satisfying about nature of
transaction, trade and standing of Supplier. For services, the limit is
USD 500000.
 In excess of 2,00,000 USD, an irrevocable Standby LC or
Guarantee from a bank of international repute or a guarantee from
bank in India, if such guarantee is issued against Counter guarantee

29
 of International bank outside India.
 The requirement of guarantee may not be insisted upon in case of
remittances above USD200000 up to USD 50, 00,000 (5 million)
subject to suitable policy framed by BOD of bank. The AD should be
satisfied with track record of the exporter.
 Approval of RBI is required only if Advance remittance exceeds
USD 50,00 000 or equivalent.
 Advance remittance will be made direct to overseas supplier or his
bank.
 Physical imports must be made within 6 months from date of
Remittance. For Capital goods, the period is 3 years. If it is Non-
Physical Imports, a certificate from CA that Software data has
been received, may be obtained.
Evidence of In case of all imports, irrespective of the value of foreign exchange remitted
Imports / paid for import into India, it is obligatory on the part of the AD Category– I
bank through which the relative remittance was made, to ensure that the
importer submits BoE number, port code and date for marking evidence of
import under IDPMS

AD Category – I bank may accept, in lieu of Exchange Control Copy of Bill

of Entry for home consumption, a certificate from the Chief Executive
Officer (CEO) or auditor of the company that the goods for which
remittance was made have actually been imported into India provided :-

 The amount of foreign exchange remitted is less than USD

1,000,000 or its equivalent and
 The importer is a company listed on a stock exchange in India and
whose net worth is not less than Rs.100 crore as on the date of its
last audited balance sheet, or, the importer is a public sector
company or an undertaking of the Government of India or its
departments.

On operationalization of IDPMS, all outstanding import remittances,

Irrespective of the amount involved, will be reported into the system by
banks and submission of a separate BEF statement would be discontinued
from a date, to be notified separately.
Import Finance Importer can avail finance from banks/FIs in the shape of :
1. Letter of Credit
2. Import Loans against Pledge/Hypothecation of stocks.
3. Trade Credit – Supplier Credit or Buyer Credit.
4.

Trade Credit If the Import proceeds are not remitted, within 6 months, it is treated as
Trade Credit up to the period 3 years. Importer must be resident of India.

There are two types of Trade Credit:

1. Suppliers Credit
2. Buyers Credit

Suppliers’ Credit

30
 It is credit extended by Overseas suppliers to Importer normally beyond 6
months..
 Up to 1 year for Current Account Transactions
 Up to 3 years for Capital Account Transactions

Monetary Limit is USD 20 million (Revised 50 million) per transaction

under Automatic route and beyond 50 million under Approval route. For
Oil/Gas/refinery and Marketing – monetary limit is Rs. 150 million per
transaction.

Buyers’ Credit
It is credit arranged by Importer from Banks/FIs outside countries. Banks
can approve proposals of Buyers’ Credit with period of Maturity:
 Up to 1 year for Current Account Transactions
 Up to 5 years for Capital Account Transactions

All-in Cost The present Ceilings for all-in-cost, including interest for buyers’/suppliers’
Ceiling credit, as fixed by RBI is as under:

Benchmark rate + 250 bps

These ceilings include management fees, arrangement fees etc.

Crystallization of In case the importer fails to make payment,

Foreign Crystallization of Foreign Exchange liability into Indian Rupees is done on
Currency 10th day at Bill selling Rate or Original Bill Selling rate (whichever is
Liability into INR higher)

In case of Retirement of Import Bill

The crystallization is done at current Bill Selling Rate on the following dates
 DP Bill: On 10th Day from date of receipt of Import Bill.
 DA Bill: On Actual Due Date.

Example On 12th Feb, a customer has received an Import bill for USD 10000/-. He
asks you to retire the bill to the debit of the account. Considering Exchange
margin 0.15% for TT sales and 0.20% on Bill Selling Rate. What amount
will be debited to the account? Spot rate is 34.6500/34.7200
Spot march = 5000/4500

Rate applied will be Bill Selling Rate

Spot Rate = 34.7200
Add Margin for TT selling (0.15%) = 0.0520
TT selling Rate = 34.7720
Add margin for Bill selling@ 0.20% = 0.0695
Bill Selling Rate = 34.8415
Customers’ account will be debited with Rs. 348400/- (10000X 34.84) Ans.

IDPMS & EDPMS IDPMS (Import Data Processing and Monitoring System)
It is IT based system of processing all import transactions. And monitoring
thereof. Custom authorities, DGFT, Banks and RBI use this common

31
 platform to monitor all Import transactions.

EDPMS (Export Data Processing and Monitoring System)

It is IT based system of processing all Export transactions. And monitoring
thereof. Custom authorities, DGFT, Banks and RBI use this common
platform to monitor all Import transactions.

RATES TO BE APPLIED IN FOREIGN EXCHANGE TRANSACTIONS

Nature of transaction Rate to be applied
Encashing Foreign currency Currency Buying rate
Encashing Traveler Cheques TC Buying rate
Issue of Draft in Foreign currency TT Selling rate
Payment of draft where Nostro account TT Buying rate
stands credited already
Cancellation of DD TT Buying Rate
Purchase of Export Bill Bill Buying rate
Purchase of Sight Bill i.e. DP under FOBP Bill Buying
Discounting of Usance Bill i.e. DA under Spot rate - Exchange
FUBD Margin + Forward
Premium
Payment of Imports Bill Selling
Repatriation of NRE deposits TT selling
Repatriation of FCNR deposits No rate
Crystallization of Overdue Export Bills on TT Selling rate or
30th day after Notional due date Original Bill buying rate
Whichever is higher
Crystallization of LC liability on 10th day Bill Selling rate or
Contracted rate
Whichever is higher
Retirement of Import Bill Bill Selling rate
Crystallization of Import bill on 10th day If Bill Selling rate or
there is default by the buyer Contracted rate
Whichever is higher
Cancellation of Forward Purchase TT selling rate
Contract on 7th working day after due date
Foreign bill returned Unpaid TT selling rate
Cancellation of Forward Sales Contract TT buying rate
on 3rd Working Day after due date

32
 FOREIGN TRADE RISKS AND ECGC

Risks in Foreign trade risk may be defined as Uncertainty or Unplanned events with
International financial consequences resulting into loss. Types of Risks are as under:
Trade 1. Buyers’ Risk: Non-Acceptance or non-payment
2. Sellers’ Risk: Non- shipping or Shipping of poor quality goods or
delay.
3. Shipping Risk: Mishandling, Goods siphoned off, Strik e by potters or
wrong delivery.
4. Other Risks:
- Credit Risk
- Legal Risk
- Country Risk
- Operational Risk
- Exchange Risk
5. Country Risk
Provision of risk is made if Exposure to one country is 1% or more of total
assets. ECGC has the list of Country Risk Ratings which can be referred to
by the Banks and the banks can make their own country risk policy.
Risk Export Credit and Guarantee Corporation provides guarantee cover for risks
Classification which can be availed by the banks after making payment of Premium.
of Countries ECGC adopts classification of risk. The list is updated and published on
quarterly basis. The latest classification is as under:
1. Insignificant Risks A1
2. Low Risk A2
3. Moderately Low Risk B1
4. Moderate Risk B2
5. Moderately High Risk C1
6. High Risk C2
7. Very High Risk D

15 countries including Afghanistan, Iraq, Lebanon, Libya, Ukraine, Yemen,

Congo, Africa have been placed in ―Restricted Cover Group-1‖ where
revolving limits are approved by ECGC and these are valid for 1 year.

The other 8 countries with D rating (North Korea, Palestine, Sudan, Syria
Venezuela, Western Sahara, South Sudan and Zimbabwe are placed in
―Restricted Cover Group-2‖ where specific approval is given on case to
case basis by ECGC.

The other 217 countries are in open list.

ECGC _ Export ECGC was established in 1964. Export Credit and Guarantee Corporation
Credit and provides guarantee cover for risks which can be availed by the banks after
Guarantee making payment of Premium. Its activities are governed by IRDA.
Corporation The functions of ECGC are 3 fold:
1. It rates the different countries.
2. It issues Insurance Policies.
3. It guarantees proceeds of Exports.
Types of Policies:
1. Standard Policies

33
 It provides 90% cover for exporters for short term exports in case
failure of buyer to make payment due in 4 months.. These cover
Commercial and Political Risks. The different types of Policies are:
- Shipment (Comprehensive Risk) Policy – to cover
commercial and political risks from date of shipment.
- Shipment (Political Risks) Policy- from date of shipment
- Contracts (Comprehensive Risk) Policy for both commercial
and Political risks from date of Contract.
- Contracts (Political Risks) Policy from date of contract.

These policies do not cover risk of exchange rate fluctuation, commercial

disputes regarding fitment and quality of goods, failure of buyer to obtain
import authorisation from authorities and failure of exporter to fulfil terms of
export contract or negligence on his part.

2. Small Exporters’ policy

A small exporter is defined whose anticipated total export turnover
for the period of 12 M is not more than 50 lac. The policy is issued
to cover shipments 24 M ahead.
Coverage is 95% where loss is due to commercial risks.
Coverage is 100% where loss is due to political risks.

The policy provides cover against Commercial risks and Political

risks covering insolvency of the buyer , failure of the borrower to
make payment due within 2 months from due date, borrower’s
failure to accept the goods due to no fault of exporter.
3. Specific Shipment Policy—Short term
It provides cover for both Commercial and political risks – Failure to
pay within 4M. It covers short term credit not exceeding 180 days of
PC & PS credit.. These policies can be obtained by exporters who
are not covered by above said comprehensive risk policies.
4. Exports Specific Buyer Policy
This is buyer wise short term policy which covers both Commercial
risks and political risks involved in export of goods on short term
credit to a particular buyer. Policy can be invoked on failure to pay
within 4M

The other Policies are Buyers’ Exposure Policy, Export Turnover Policy
(exporters who pay minimum 10 lac premium to ECGC are eligible) and
Consignment export Policy, IT enabled Services Policy for Single Customers
& Policy for SME sector.
Financial ECGC issues following types of Guarantees for the benefit of Exporters:
Guarantees Packing Credit Insurance
ECIB (WT-PC) – Exporters Credit Insurance for Banks (whole Turnover
Packing Credit)
This policy is issued to banks to guarantee export risks:
- For all exporters
- Minimum 25 accounts should be there.
- Minimum assured premium is Rs. 5.00 lac.
- Period of cover is 12M.
- The claim is payable if there is default of 4 Months.

34
 - Premium for fresh covers is 7.50 paisa Per Rs. 100 Per month. It is
calculated on average outstanding.
- Percentage of cover ranges from 75% to 90%
- If due date of export proceeds is extended beyond 360 days,
approval of ECGC is required.
- Claim is to be filed within 6M of report of default to ECGC.
ECIB – PC – for individual exporters. The advance should be categorized as
Standard Asset. The period of coverage is 12M and %age of cover is 66-
2/3 %. The premium is 12 paisa% per month on highest outstanding.
- Monthly declaration by banks before 10th.
- Approval of Corporation beyond 360 days PC.
- Report of default within 4M from due date.
- Filing of claim within 6M of the report.
ECIB –(WT- PS) – Whole Turnover Post Shipment Credit Policy
- It is a common policy for all exporters.
- Advances against export bills are covered.
- Premium is 8.5 paisa % per month.
- Cover is usually 75 to 90%
- Filing of claim within 6M of the report
ECIB-PS-- for individual exporters

Export Finance When banks make advance to exporters against export incentives
Guarantee receivables like Duty Drawback etc. The cover available is 75% and the
premium ranges from 7 paisa onwards.
Exchange The cover is available for payment schedule over 12 months up to maximum
Fluctuation period of 15 years. Cover is available for payments specified in USD, GBP,
Risk Cover EURO, JPY, SWF, AUD and it can be extended for other convertible
Scheme currencies.
The contract cover provided a franchise of 2% Loss or gain within range of
2% of reference rate will go to the account of the exporter. If the loss
exceeds 2% , the ECGC will make good the portion of loss in excess of 2%
but not exceeding 35%.
The other guarantees are:
- Export Performance Guarantee
- Export Finance (Overseas Lending) Guarantee.
Transfer guarantee – cover to the confirming bank in India.

Maturity ECGC provides full-fledged Factoring Insurance services. It facilitates

Factoring purchase of account receivables. It provides up to 90% finance against
approved transactions. It follows up collection of sales proceeds. Exporters
of good track record and dealing on DA terms having unexpected bulk
orders are eligible to apply.
Common Notice of Default
Guidelines Notice of default must be served within a period of 4 months from due date
or 1 month from date of recall.
Lodging of Claim
The claim should be filed with ECGC within maximum period of 6 months
from date of lodging of Default Notice.

35
 EXIM BANK

Exim Bank – its Exim Bank (Export/Import Bank) was established in 1981 with the objective
functions of financing Import Export Trade especially on Long term basis. The
functions of Exim bank are as under:
 Offering Finance for Exports at competitive rates.
 Developing alternate financial solution
 Data and Information about new export opportunities.
 Respond to export problems and pursue Policy solutions.
The finance activities of Exim bank consist of :
1. Arranging Suppliers’ credit and Buyers’ credit
2. Consultancy and Technical services for exporters
3. Pre-shipment credit – over 6 months
4. Setting up of EOU in EPZ (Export Processing Zones)
5. Finance for DTA (Domestic Tariff Area) units exporting minimum
25% of annual sales.
6. Finance for Import of Computer System and Development of
Software. Plant and Machinery and Technical up-gradations etc.
7. Services for Overseas Investments.
8. Line of Credit to exporters on the basis of which they receive export
orders.
EXIM Bank performs following functions for Commercial Banks:
 Export Bills Rediscounting – Usance period should not exceed 180
days.
 SSI Export Bills Rediscounting.
 Refinance of Export credit
 Refinance of TL to EOU, Software Capital goods up to 100%
 Participates with banks in Issuance of Guarantees.
Besides above, the EXIM bank arranges Relending facilities for Overseas
Banks, sanctions direct credit to foreign importers and arranges line of
credit for foreign importers.
DPG (Deferred It is normally beyond 6M and meant for SHE (Status Holder Exporters)
Payment only.
Guarantees Banks can approve proposals up to 25 crore.
Above 25 crore up to 100 crore are referred to EXIM bank.
Above 100 crore proposals will be considered by Inter institutional Working
Group consisting of members from RBI, FEDAI, ECGC and EXIM.
Other services Besides above, the EXIM bank provides assistance for :
of EXIM bank 1. Project Exports – export of Engineering goods on Deferred Payment
terms
2. Turnkey Projects- supply of equipment along with related services
like design, detailed engineering etc.
3. Construction Projects
4. Funded facilities.
EXIM Bank is nodal agency designated by GOI to manage Export
Marketing Fund (EMF) which consists of loan made available to India by
World bank to promote International Trade.

36
 RESERVE BANK OF INDIA

RBI controls RBI is empowered to

Foreign  Control and regulate Foreign Exchange Reserves
Exchange  Supervise Foreign Exchange dealings
 Maintain external value of Rupee
FERA was replaced by FEMA in the year 1999.
FEMA The important FEMA guidelines with regard to Foreign exchange are as
provisions under:
1. No drawl of exchange for Nepal and Bhutan
2. If Rupee equivalent exceeds Rs. 50000/-, payment by way of
crossed Cheque.
3. During visit abroad, one can carry foreign currency notes up to USD
3000 or equivalent. For Libya and Iraq, the limit is USD 5000 and
the entire amount for Iran and Russian states.
4. Indian citizens can retain and possess foreign currency up to USD
2000 or its equivalent. (For coins, there is no limit)
5. Unspent currency must be surrendered within a period of 180 days
after arrival in India.
Release of Foreign Exchange for Individuals
Purpose of Visit Previous Present Guidelines
Guidelines
USD or its equivalent Per Financial Year
Personal/Tourism 10000 per fin year USD 250000
Business Purpose 25000 per visit USD 250000
Seminars/conferences 25000 per visit USD 250000
Employment/Immigration 100000 USD 250000
Studies 100000 per USD 250000
academic year
Medical 100000 USD 250000
Donations/Gifts 5000 per donor per USD 250000
year
Consultancy services 100000 per project USD 250000
Debit Credit As per BTQ as USD 250000
above
*AD can release Foreign Exchange 60 days ahead of journey
 Overall limit is USD 250000 if exchange is required for more than
one purposes.
Release of Foreign currency for other than individuals
 Donations per remitter/per donor up to 250000 USD in a financial
year.
 Consultancy services : Maximum USD 10 lac per project for
infrastructure and USD 100000 per project for others.
 One can send Gift to Corporate Clients abroad up to USD 5000 at
one time but not exceeding USD 250000 per financial year.
Form A2 is required if transaction amount is exceeds USD 25000.

Contravention of Fema guidelines may attract penalty of 10000/- with

additional penalty of 2000/- per day if contravention continues.

37
LRS (Liberalized The scheme is meant for Resident Indians individuals (including Minors).
Remittance They can freely remit up USD 250000 per financial year in respect of any
Scheme) current or capital account transaction without prior approval of RBI. The
precondition is that the remitter should have been a customer of the bank
for the last 1 year. PAN is mandatory. Form A2 is required to be submitted
to RBI, If remittance exceeds USD 25000. For remittance up to $25000,
Form A2 can be retained by bank itself.

Not Applicable
 The scheme is not applicable for remittance to Nepal, Bhutan, Pak,
Mauritius or other counties identified by FATF.
 The scheme is not meant for remittance by Corporate.
 Banks should not extend loan facility for capital account
transactions.
 Beneficiary should not be Resident Indian.
Latest Guidelines
 The limit can be used by Residents for acquiring property abroad.
 The limit can be used for opening Foreign Currency accounts
abroad.
 The scheme should not be used for making remittances for any
prohibited or illegal activities such as margin trading, lottery etc., as
hitherto.
 Resident individuals have now been allowed to set up Joint
Ventures (JV) / Wholly Owned Subsidiaries (WOS) outside India for
bonafide business activities outside India within the limit of USD
250000.
 The limit for gift in Rupees by Resident Individuals to NRI close
relatives and loans in Rupees by resident individuals to NRI close
relatives shall accordingly stand modified to USD 250000 per
financial year.
 Resident Individual is permitted to lend to NRI/PIO close relative
subject to the condition that the loan is interest free and with
minimum maturity of 1 year under LRS of 250000 USD per
financial year.
 PAN No. is compulsory for all transactions irrespective of amount.
 Remittance beyond $250000 requires prior permission of RBI.
Remittance of It means remittance of funds out of:
Assets  Bank deposits/Company deposits
 PF Balance/Superannuation of funds
 Insurance claim or Maturity proceeds
 Sale proceeds of Shares
 Sale proceeds of property.
Indian Residents, NRIs and PIOs can remit proceeds of assets out of India
up to USD 1 Million per financial year without approval of RBI. In excess
of USD 1 million, prior approval from RBI is required.
Import and Any person resident in India
Export of Indian a) May take outside India (other than Nepal and Bhutan) currency
Rupees notes up to Rs. 25000/- or
b) May bring into India (from country other than Nepal and Bhutan)

38
 currency notes up to Rs. 25000/-
Any person Resident Outside India (Not being citizen of Pak and
Bangladesh)
a) May take outside India currency up to Rs. 25000/-
b) May bring into India currency notes up to 25000/-
(Previously, the limit was Rs. 10000/-)
Any amount can be taken out while going to Nepal and Bhutan in any
denomination. ( Notes ABOVE 100 denomination up to Rs. 25000/- only
are allowed)
Restrictions  Customer is required to furnish PAN No.
 If rupee equivalent is 50000/- and above, the entire payment has to
be made by way of crossed cheque or DD.
RETURNS TO Following important returns are submitted to RBI
BE SUBMITTED R- Returns Forex Operations (Fortnightly)
TO RBI BAL statement Balance in Nostro/Vostro account
STAT 5 Transactions in FCNR B accounts
(Fortnightly)---Since discontinued
STAT 8 Transactions in NRE/NRO accounts
(Fortnightly) )---Since discontinued
Trade Credit Statement Buyers’ and Suppliers’ Credit
XOS O/S Overdue Export bills
BEF Import Remittance effected but Bill of Entry
not submitted for >3M.
ETX Form Seeking relaxation from RBI after expiry of
9M when export proceeds are not received.
NRDCSR –. Consolidated statement on Non-resident
deposits
IBS International Banking Statistics – Qtly
containtaing all International Assets and
Liabilities.
Statement of Monthly
Remittances under LRS
FEMIS- Daily data on Foreign Exchange Dealing
Room operations.
RFC accounts Resident Foreign Currency account is opened by Indian residents who
were earlier NRIs and Forex is received by them from their overseas dues:
 The accounts can be opened as SB/CA/FD type.
 Proceeds are received from overseas.
 Out of Monetary benefits accruing abroad
 The funds are freely repatriable.
 Minimum amount is USD 5000.
RFC- D accounts Resident Foreign Currency (Domestic) accounts are opened:
 By Indian residents who visit abroad: and
 Bring with them Foreign Exchange;
 As honorarium, gift etc.
 Unspent money can also be deposited.
 These are CA nature accounts and no interest is paid.

39
 FEDAI – Foreign Exchange Dealers Association of India
Foreign Exchange association of India is a non-profit body established in 1958 by RBI. All public
sector banks, Private Banks, Foreign Banks and Cooperative banks are its members. The
functions of FEDAI are:
 Forming uniform rules
 Providing training to bankers; and
 Providing guidance and information from time to time.

Who publishes prime rates for major currencies in India on monthly basis?
Ans. FEDAI
The important rules are:
1. Export Transactions Forex liability must be crystallized into Indian rupees on 30th day
after expiry of NTP at TT selling rate(Notional Transit Period) in case of Sight bills and
on 30th day after notional due date in case of Usance bills. The rule has since been
relaxed and bank can frame its own rule for nos. of days for crystallization.
2. Concessional rate of interest is applied up to Notional due date or up to value date of
realization of export dues (whichever is earlier)
3. Import Transactions: For retirement of Import bills whether under LC or otherwise, Bill
selling rate or Contracted selling rate whichever is higher, will be applied.
 DP Bills (sight) are retired after crystallization on 10th day after receipt.
 DA Bills are retired (crystallized) on Due Date.
4. All Foreign Currency bills under LC, if not retired on receipt, shall be crystallized into
Rupee liability on 10th day after date of receipt of documents at Bill Selling Rate or
contracted rate whichever is higher.
Normal Transit Period is:
-
Export through Bills in Foreign Currencies 25 Days (General)
Exports to Iraq under United Nations 120 Days
Guidelines
Exports to Russia under L/C where 20 Days
reimbursement is provided by RBI
Export Bills drawn in Rupees under Reimbursement provided at centre of
Letters of Credit (L/C) negotiation ----3 Days
Reimbursement in India at centre different
from centre of negotiation—7 days
Reimbursement provided by banks
outside India---20 Days
Export Bills in Rupees not under Letter of 20 Days
Credit
Compensation on Delayed payment:
Authorized dealers will pay or send information to the beneficiary within 2 working days from
date of receipt of credit advice. In case of delay, interest @ 2% over SB rate will be paid to
beneficiary. Bank will also re-imburse amount on account of reverse exchange movement.

In the event of delay in payment of interbank foreign currency funds, interest@2% above Prime
rate of currency to be specified by the bank, shall be paid by defaulting bank.

In the event of delay in payment of Rupee Settlement funds, interest at 2% above NSE MIBOR
ruling on each day will be paid.

40
Forward Contracts
 Exchange contracts will be for definite amount and period.
 Contracts must state first and last date of contracts e.g. from 1-31 Jan or from 17th Jan to
16th Feb.
 For contracts up to 1 month, option period for delivery may be specified.
 In case of extension of contract, previous contract will be cancelled at TT Buying rate or
TT selling rate as the case may be.
 Overdue contracts are liable to be cancelled on 3rd (Third) working day after maturity
date if no instructions are received. The contracts must state first and last date of the
contract.
 Banks can allow resident individuals to book forward contracts up to 100000 USD with
the condition that these are on deliverable basis.
 Banks are now free to fix their own rates of commission and margin etc.
 Hours of Interbank office transactions is 9:00 am to 5:00 PM. However cross currency
transactions are permitted during extended working hours. Saturday will not be treated
as working day. If due date is known holiday (Holiday known before 3 days), contact
will become due on succeeding day. If due date is suddenly declared holiday, contract
will become due on preceding day.
In the event of contravention of FEMA guidelines, RBI may impose upon AP up to 3 times of
contravention amount. If amount is not quantifiable, up to 2.00 lac and up to 5000/- per day is
imposed, if the contravention continues.

ECBs – External Commercial Borrowings

External Commercial Borrowings (ECBs) are loans in India made by non-resident lenders in
foreign currency to Indian borrowers. They are used widely in India to facilitate access to foreign
money by Indian corporations and PSUs (public sector undertakings).

Revised ECB guidelines: The salient features of the new framework are as under:

Merging of Tracks: Now, there will be two tracks as under:

1. Foreign Currency denominated ECB

2. Rupee Denominated ECB

Eligible Borrowers: This has been expanded to include all entities eligible to receive FDI.
Additionally, Port Trusts, Units in SEZ, SIDBI, EXIM Bank, registered entities engaged in micro-
finance activities, viz., registered not for profit companies, registered
societies/trusts/cooperatives and non-government organizations can also borrow under this
framework.

Recognized Lenders: The lender should be resident of FATF or IOSCO compliant country.
Multilateral and Regional Financial Institutions, Individuals and Foreign branches / subsidiaries
of Indian banks can also be lenders.

Forms of ECB
Loans including bank loans, floating/ fixed rate notes/ bonds/ debentures, Trade credits
beyond 3 years; FCCBs; FCEBs and Financial Lease.

41
 Minimum Average Maturity Period (MAMP):
ECBs in general 3 years

ECBs raised from foreign Equity Holders 5 years

and utilized for specific purpose

ECB raised for 10 years

 WC purposes
 Repayment of Rupee loans availed
domestically for purposes other than
capital expenditure
 on-lending by NBFCs for the same
purpose
ECBs up to 50 Million USD per financial 1 Year
year by Mfg. Sector

All in Cost Ceiling

Benchmark rate (6 M LIBOR Rate) + 450 bps

End-uses (Negative list) The negative list, for which the ECB proceeds cannot be utilized,
would include the following
a) Real estate activities.
b) Investment in capital market.
c) Equity investment.
d) Working capital purposes except from foreign equity holder.
e) General corporate purposes except from foreign equity holder.
f) Repayment of Rupee loans except from foreign equity holder.
g) On-lending to entities for the above

Limit and leverage

 All eligible borrowers can raise ECB up to USD 750 million or equivalent
per financial year under auto route.
 Further, in case of FCY denominated ECB raised from direct foreign equity
holder ECB liability-equity ratio for ECBs raised under the automatic route
cannot exceed 7:1. However, this ratio will not be applicable if outstanding
amount of all ECBs, including proposed one, is up to USD 5 million or
equivalent.
 Issuance of Guarantee, etc. by Indian banks and Financial Institutions:
Issuance of any type of guarantee by Indian banks, All India Financial
Institutions and NBFCs relating to ECB is not permitted.
 ECB framework is not applicable in respect of the investment in Non-
Convertible Debentures in India made by Registered Foreign Portfolio
Investors.
 Loan Registration Number (LRN): Any draw-down in respect of an ECB
should happen only after obtaining the LRN from the Reserve Bank.
 AD Category-I banks are permitted to allow Startups to raise ECB under
the automatic route with minimum average maturity period will be 3 years.
The borrowing per Startup will be limited to USD 3 million or equivalent per

42
 financial year either in INR or any convertible foreign currency or a
combination of both.
 In case of FCY denominated ECB, companies are required to mandatorily
hedge 70 per cent of their ECB exposure in case average maturity of ECB is
less than 5 years.
 Borrowings by NBFC permitted for WC and general purposes having MAM up
to 7 years.
 ECM having MAM up to 7 years can be availed by eligible borrowers for
repayment of Rupee loans availed domestically for Capital Expenditure.
 EC ECM can be availed by eligible borrowers for repayment of Rupee loans
availed domestically for Capital Expenditure in Mfg. and Infra structure if
classified as SMA-2 or NPA under any OTS.

FCCB & FCEB FCCB (Foreign Currency Convertible Bonds)

These are special category of bonds issued in different currency from
Company’s domestic currency. It facilitates Foreign currency investment in
home country. These are Quasi debt instruments tradable on stock
exchanges and convertible into shares.
FCEB (Foreign currency Exchangeable Bonds)
FCEBs are exchangeable into equity share of another company, to be
called the Offered Company, in any manner, either wholly, or partly or on
the basis of any equity related warrants attached to debt instruments.
ADRs – American Depository Receipts are Receipts or Certificates issued by US
American Bank representing specified number of shares of non-US Companies.
Depository Defined as under:
Receipts  These are issued in capital market of USA alone.
 These represent securities of companies of other countries.
 These securities are traded in US market.
 The US Bank is depository in this case.
 ADR is the evidence of ownership of the underlying shares.
Unsponsored ADRs
It is the arrangement initiated by US brokers at their own. US Depository
banks create such ADRs. The depository has to Register ADRs with SEC
(Security Exchange Commission).
Sponsored ADRs
Issuing Company initiates the process. It promotes the company’s ADRs in
the USA. It chooses single Depository bank. Registration with SEC is not
compulsory. However, unregistered ADRs are not listed in US exchanges.

GDRs – Global Global Depository Receipt is a Dollar denominated instrument with

Depository following features:
Receipts 1. Mainly traded in Stock exchanges of Europe.
2. Represents shares of other countries.
3. Depository bank in Europe acquires these shares and issues
―Receipts‖ to investors.
4. GDRs do-not carry voting rights.
5. Dividend is paid in local currency and there is no exchange risk for
the issuing company.
6. Issuing Co. collects proceeds in foreign currency which can be used
locally for meeting Foreign exchange requirements of Import.

43
 7. GDRS are normally listed on ―Luxembourg Exchange ― and traded
in OTC market London and private placement in USA.
8. It can be converted in underlying shares.
IDRs – Indian Indian Depository Receipts are traded in local exchanges and represent
Deposits security of Overseas Companies.
Receipts
CDF (Currency CDF is required to be submitted by the person on his arrival to India at the
Declaration Airport to the custom Authorities in the following cases:
Form) 1. If aggregate of Foreign Exchange including foreign currency/TCs
exceeds USD 10000 or its equivalent.
2. If aggregate value of currency notes (cash portion) exceeds
USD 5000 or its equivalent.

Form A1 Form A1 is meant for remittance abroad to settle imports obligations. It is

Form A2 and not required if value of imports is up to USD 5000. Now, as per latest
Form A3 directives of RBI, Form A-1 is not at all required for any kind of imports.

Form A2 is meant for remittance abroad on account of any purpose other

than Imports. It is not required if remittance is up to USD 25000.

Form A3 is meant for remittances abroad in Inter bank Vostro account

within 5 working days. The form is submitted by remitting bank to
beneficiary bank.
LIBOR Rate & London Interbank Offering rate is the rate fixed at 11 am (London time) at
Other Rates which top 16 banks in London offer to lend funds in interbank markets.

MIBOR- Mumbai Inter Bank Offered Rate

MIFOR- Mumbai Interbank Forward Rate
EURIBOR Euro Inter-bank Offered Rate
TIBOR Tokyo Inter-bank Offered Rate
SIBOR Singapore Inter-bank Offered Rate
Interest on Banks are free to decide lending rates on export credit or above MCLR
Export Credit & Interest Equalization Scheme for Rupee Pre-shipment and Post-
Interest shipment Credit
Equalization  Rate of Interest Equalization is 3%.pa.
Scheme  Banks are to pass on benefit upfront
 Eligible exports should meet the criteria of minimum processing of
Goods called ―Originating from India‖ as per Foreign trade policy
2015-2020.
 Benefit of Interest is available up the date of repayment or up date
beyond which export credit becomes overdue.
 The scheme is applicable on export of products covering 416 tariff
items including Merchant Exports.
Interest Equalization Scheme on pre & post shipment Rupee Export Credit,
increased from 3% to 5% in respect of MSME (Manufacturing sector)
only.
Foreign It has been decided to liberalize this facility further.
Currency Accordingly, AD Category - I banks may henceforth borrow funds from
Borrowings by their Head Office, overseas branches and correspondents and overdrafts in
ADs from Nostro accounts up to a limit of 100 per cent of their unimpaired Tier I

44
Overseas capital as at the close of the previous quarter or USD 10 million (or its
equivalent), whichever is higher, as against the existing limit of 50 per cent
(excluding borrowings for financing of export credit in foreign currency and
capital instruments).
 Borrowings can be from Banks/FIs outside India.
 Purpose of borrowings is Packing credit or Post shipment credit.
Borrowings by Resident Individuals may borrow up to USD 250000 or equivalent from
Resident close relatives outside India subject to the following conditions:
Individuals  Minimum maturity period is 1 year.
 Loan is free of interest.
Crystallization of RBI has advised that AD will crystallize i.e. convert foreign currency deposit
Inoperative (with fixed maturity date) into INR, if remains in-operative for 3 years from
Foreign date of maturity.
Currency If a deposit account has not been operated for 10 years, the amount will be
Deposits transferred to DEAF.
Rupee Current Account transactions are payments due in connection with foreign
Convertibility in trade, services and short term banking and credit facilities, interest on loan,
Current Account remittances and expenses in connection with foreign travel, medical care,
& Capital education etc. Rupee is fully convertible in such type of transactions.
Account
Transactions But Rupee is partially Convertible in Capital Account transactions. These
transactions are FDI, ODI, ECBs, Raising Foreign Currency Loans,
Transfer of Property or other Assets outside India, Loans to persons
residing outside India & Maintenance of Foreign Currency Account in India.
In nut shell, if a transactions creates long term liability or asset in India, it is
Capital Account transaction. Rupee is partially convertible in capital
account transactions as there are certain restrictions in capital account
transactions.

Which of the currencies is not freely convertible?

Ans.----Indian Rupees

LOU/LOC - Letter of Undertaking and Letter of Comfort cannot be issued as per RBI
directives dt. 13.3.2018.

NRI working in London remits GBP 100000 for opening account in India:

 He can open any of the three - NRO, NRE or FCNR account.

 Exchange rate will be TT Buying Rate for opening NRE Account.
 If he prefers to place money in Foreign Currency, FCNR account will be opened. Exchange Risk
will be borne by bank.
 He can exercise nomination in favour of NRI or Indian resident in all types of accounts.
 NRI can appoint any indian resident as attorney to operate the account.
 If he return to India for permanent stay, his accounts will be converted either to Resident a/c or
RFC a/c.
 The amount in RFC account can be repatriated abroad provided minimum stay abroad was 1
year.
 He can raise Demand loan when he executes documents personally.

45
Module - B

RISK MANAGEMENT
RISKS and CAPITAL

46
 Risk Management

Risk and Risk is possible unfavorable impact on net cash flow in future due to
Capital uncertainty of happening or non-happening of events. Capital is a
cushion or shock observer required to absorb potential losses in future.
Higher the Risks, high will be the requirement of Capital and there will
be rise in RAROC (Risk Adjusted Return on Capital).
Types of Risks Risk is anticipated at Transaction level as well as at Portfolio level.
Transaction Level
Credit Risk, Market Risk and Operational Risk are transaction level risk
and are managed at Unit level.
Portfolio Level
Liquidity Risk and Interest Rate Risk are also transaction level risks but
are managed at Portfolio level (aggregate level).

Risk Measurement
1. Based on Sensitivity
It is change in Market Value due to 1% change in interest rates. The interest rate gap is
sensitivity of the interest rate margin of Banking book. Duration is sensitivity of Investment
portfolio or Trading book.

2. Based on Volatility:
It is common statistical measure of dispersion around the average of any random variable
such as earnings, Mark to market values, losses due to default etc.

Statistically Volatility is Standard deviation of Value of Variables

Calculation
Example 1 : We have to find volatility of Given Stock price over a given period. Volatility
may be weekly or monthly. Suppose we want to calculate weekly volatility. We will note
down Stock price of nos. of weeks.
Let Mean Price = 123.62 and
Variance (sum of Squared deviation from mean) / Number of options = 82.70 (given)
(extracted from weekly Stock prices). Volatility is nothing else but Standard Deviation.
Volatility i.e. sd = ∫Variance = ∫82.70 = 9.09

Volatility over Time Horizon T = Daily Volatility X ∫T

Example 2
Daily Volatility =1.5%
Monthly Volatility = 1.5 X ∫30 = 1.5 X 5.48 = 8.22

Volatility will be more if Time horizon is more.

3. Downside Potential (Best Method to measure Risk)

It captures only possible losses ignoring profits and risk calculation is done keeping in view
two components:
1. Potential losses 2. Probability of Occurrence.
The measure is more relied upon by banks/FIs/RBI. VaR (Value at Risk) is a downside
Risk Measure. Banks using propriety models must compute VaR daily, using 99th percentile
with time horizon of 10 trading days using historical observation of last one year.

47
Risk Pricing Risk Premium is added in the interest rate because of the following:
 Necessary Capital is to be maintained as per regulatory
requirements.
 Capital is raised with cost.
For example there are 100 loan accounts with Level 2 Risk. It means
there can be average loss of 2% on such type of loan accounts: Risk
Premium of 2% will be added in Rate of Interest.
Pricing includes the following:
1. Cost of Deploying funds 2. Operating Expenses
3.Loss Probabilities 4. Capital Charge
Risk Credit Risk can be mitigated by accepting Collaterals, 3rd party
Calculation guarantees, Diversification of Advances and Credit Derivatives.
Interest rate Risk can be reduced by Derivatives of Interest Rate
Swaps.
Forex Risk can be reduced by entering into Forward Contracts and
Futures etc.
Diversification of Advances
Business Year1 2 3 4 5 Total Mean sd
A
(Cash 10 3 4 8 11 36 7.20 3.26
flow)
Risk = sd/mean = 3.26/7.20 = .45 i.e. 45%
If we make advances to different types of business with different Risk
percentage, the overall risk will be reduced through diversification of
Portfolio.
Banking Book, Banking Book
Trading Book It includes all advances, deposits and borrowings which arise from
and Off Balance Commercial and Retail Banking. These are Held till maturity and
Sheet Items Accrual system of accounting is applied. The Risks involved are:
Liquidity Risk, Interest Rate Risk, Credit Default Risk, and Operational
Risk.
Trading Book
It includes Assets which are traded in market.
 These are not held till maturity.
 The positions are liquidated from time to time.
 These are Mark- to–market i.e. Difference between market
price and book value is taken as profit.
 Trading Book comprises of Equities, Foreign Exchange
Holdings and Commodities etc.
 These also include Derivatives
The Risks involved are Market Risks. However Credit Risks and
Liquidity Risks can also be there.
Off Balance Sheet Exposures
The Off Balance sheet exposures are Contingent Liabilities,
Guarantees, LC and other obligations. It includes Derivatives also.
These may form part of Trading Book or Banking Book after they
become Fund based exposure.

48
 Types of Risks

1. Liquidity Risk
It is inability to obtain funds at reasonable rates for meeting Cash flow obligations.
Liquidity Risk is of following types:
Funding Risk: It is risk of unanticipated withdrawals and non-renewal of FDs which
are raw material for Fund based facilities.
Time Risk: It is risk of non-receipt of expected inflows from loans in time due to
high rate NPAs which will create liquidity crisis.
Call Risk: It is risk of crystallization of contingent liabilities.

2. Interest Rate Risk

Risk of loss due to adverse movement of interest rates. Interest rate risk is of
following types:
Gap or Mismatch Risk: The risk of Gap between maturities of Assets and
Liabilities. Sometimes, Long term loans are funded by short term deposits. After
maturity of deposits, these liabilities are get re-priced and Gap of Interest rates
between Assets and Liabilities may become narrowed thereby reduction of profits.
Basis Risks: Change of Interest rates on Assets and Liabilities may change in
different magnitudes thus creating variation in Net Interest Income.
Yield Curve Risk: Yield is Internal Rate of Return on Securities. Higher Interest
Rate scenario will reduce Yield and thereby reduction in the value of assets.
Adverse movement of yield will certainly affect NII (Net Interest Income).
Embedded Option Risk: Adverse movement of Interest Rate may result into pre-
payment of CC/DL and TL. It may also result into pre-mature withdrawal of
TDs/RDs. This will also result into reduced NII. This is called Embedded Risk.
Re-investment Risk: It is uncertainty with regard to interest rate at which future
cash flows could be re-invested.
3. Market Risk
Market Risk is Risk of Reduction in Mark-to-Market value of Trading portfolio i.e.
equities, commodities and currencies etc. due to adverse market sensex. Market
Risk comprises of:
- Price Risk occurs when assets are sold before maturity. Bond prices and Yield
are inversely related.
- IRR affects the price of the instruments.
- Price of Other commodities like Gold etc,. is also affected by the market trends.
- Forex Risks are also Market Risks.
- Liquidity Risk or Settlement Risk is also present in the market.
4. Credit Risk or Default Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed
terms and conditions. There are two types of credit Risks:
Counter party Risk: This includes non-performance by the borrower due to his
refusal or inability.
Country Risk : When non-performance of the borrower arises due to constrains or
restrictions imposed by a country.
5. Operational Risk
Operation Risk is the risk of loss due to inadequate or Failed Internal procedures,
people and the system. The external factors like dacoity, floods, fire etc. may also

49
 cause operational loss. It includes Frauds Risk, Communication Risk,
Documentation Risk, Regulatory Risk, Compliance Risk and legal risks but
excludes strategic /reputation risks.
Two of these risks are frequently occurred.
Transaction Risk: Risk arising from fraud, failed business processes and inability
to maintain Business Continuity.
Compliance Risk: Failure to comply with applicable laws, regulations, Code of
Conduct may attract penalties and compensation.
Other Risks are:
1. Strategic Risk: Adverse Business Decisions, Lack of Responsiveness to business
changes and no strategy to achieve business goals.
2. Reputation Risk ; Negative public opinions, Decline in Customer base and litigations
etc.
3. Systemic Risks ; Single bank failure may cause collapse of whole Banking System
and result into large scale failure of banks.
4. Settlement Risk: In 1974, closure of HERSTATT Bank in Germany posed a threat
for the entire Banking system. This happened when it could not pay dues in
settlement. This is called Settlement Risk.. Risk of Settlement that arises due to
time zone differences is known as HERSTAT Risk.
Strategic Risk & Reputational risk are equivalent to Operational Risk. Settlement Risk will
lead to Credit Risk.

Case Study (Risk Identification) - Interest Rate Risk

PCR bank has granted a Term Loan of Rs. 2.00 crore to a reputed corporate client for 6
years at BR+2% .

The above said loan is funded by bank with low interest FD of Rs. 2.00 crore @7%
whose maturity is 4 years.

The loan is carrying floating rate of interest whereas FD is carrying Fixed rate of interest.

There are

Q. 1 If rate of interest is reduced on both Loan and FD during first 4 years, which type of
risk, the bank is exposed to:
a) Funding Risk b) Embedded Option Risk c) Basis Risk, Gap or mismatch Risk

Q. 2 Rate of interest at the end of 4 years may be different on Fixed Deposit

a) Re-investment Risk b) Embedded Option Risk c) Basis Risk, Gap or mismatch Risk

Q.3 There is possibility that Company may pre-pay the loan or depositor may withdraw
deposit pre-maturily. Which type of risk, the bank is exposed to:
a) Re-investment Risk b) Embedded Option Risk c) Basis Risk, Gap or mismatch Risk

Q.4 With Quarterly repayment of loan, the repayment amount has to be deployed by the
bank elsewhere at different rate of interest. Due to this bank is exposed to
Re-investment Risk b) Embedded Option Risk c) Basis Risk, Gap or mismatch Risk

50
 Case Study (Risk Identification) - Liquidity Risk
PCR bank has granted a Term Loan of Rs. 20.00 crore to a reputed corporate client for 7
years repayable in 84 Equal monthly installments with moratorium of 12 months.

The above said loan is funded by bank with low interest FD of Rs. 10.00 crore for 5
years, 5 crores for 3 years and 5.00 crore for 2 years. There is also One Bank Guarantee
of 60 lac.

Q. 1 If FD is withdrawn before maturity or is not renewed on maturity, bank will require

new source to fund the loan, which type of risk, the bank is exposed to:
a) Funding Risk b) Call Risk c) Time Risk. D) Gap or mismatch Risk

Q. 2 If loan installment is not paid in time

a) Funding Risk b) Call Risk c) Time Risk d) Gap or mismatch Risk

Q.3 If Bank Guarantee is invoked and borrower is unable to pay.

a) Funding Risk b) Call Risk c) Time Risk d) Gap or mismatch Risk

Q.4 There is maturity mismatch between TL and FD, this can result into:
a) Credit Risk b) Market Risk c) Liquidity Risk d) Operational Risk

Q. 5 If there is default by the borrower in repayment of loan, it will be called

a) Credit Risk b) Market Risk c) Liquidity Risk d) Operational Risk

 Exchanges such as Stock Exchange or Commodity Exchange mitigate Counter-

party Risk.
 Banks impose Penalty of certain % on Prepayment of Loan/limit. This is done to
mitigate Embedded option Risk.
 Sanction of loan by bank, Besides major portion of Credit risk, bank also incurs
Interest Rate risk, Liquidity Risk and Operational Risk.
 Banking Book Assets and Liabilities are NOT exposed to Market Risk.
 Risk of worsening of Credit Rating is called CREDIT SPREAD RISK.
 Which type of Risk is taken care of in RTGS – Settlement Risk.

51
 BASEL-I, II & III

BASEL–I Bank for International Settlements (BIS) is situated at Basel (name of

(back-ground) the city in Switzerland). Moved by collapse of HERSTATT bank, BCBS
– Basel Committee on Banking Supervision consisting of 13 members
of G10 met at Basel and released guidelines on Capital Adequacy in
July 1988. These guidelines were implemented in India by RBI w.e.f.
1.4.1992 on the recommendations of Narsimham Committee. The basic
objective was to strengthen soundness and stability of Banking system
in India in order to win confidence of investors, to create healthy
environment and meet international standards.
BCBS meets 4 times in a year. Presently, there are 28 members.
BCBS does not possess any formal supervisory authority.
BASEL II The Committee on Banking Regulations and Supervisory Practices
released revised version in the year 2004. These guidelines have been
got implemented by RBI in all the banks of India. Parallel run was
started from 1.4.2006. In banks having overseas presence and foreign
banks (except RRBs and local area banks. Complete switchover has
taken place w.e.f. 31.3.2008. In banks with no foreign branch,
switchover took place w.e.f. 31.3.2009.
Distinction
between Basel I Basel – I measures credit risks and market risks only whereas Basel II
and Basel II measures 3 types of risks i.e. Credit Risk, Operational Risk and
Market Risk. Risk weights are allocated on the basis of rating of the
borrower i.e. AAA, AA, A, BBB, BB and B etc. Basel –II also recognized
CRM such as Derivatives, Collaterals etc.

BASEL III BASEL-III was implemented in India w.e.f. 1.4.2013.

Under Basel-III, Capital will include the following:

1. Tier - I Capital (Going concern concept)

2. Tier - II Capital (Gone Concern Concept)

Tier-I Capital consists of:

a) Common Equity Tier - I (CET-I)
b) Additional Capital Tier – I (AT-I )

CET – I (Common Equity Tier-I ) : Core Capital It includes as under:

 Paid up equity capital (Common shares)
 Share Premium (Stock surplus)
 Statutory Reserves
 Capital Reserve
 Other disclosed free reserves
 Investment Fluctuation Reserve (Without ant ceiling)
 Revaluation Reserve at discount of 55%
 Foreign currency transaction reserve at a discount of 25%
 Balance in PL account
 Qtly profit after incremental provision of NPAs
 Common Shares issued by subsidiaries of bank (Minority
interest).

52
 AT-I (Additional Capital) : It includes the following
 Perpetual Non-Cumulative Preference Shares (PNCPS).
 Share premium on instruments issued in AT-I
 Innovative perpetual Debt Instruments (PDI).
.
Amount of PNCPS along with PDI cannot exceed 1.5 % of Risk
Weighted Assets. Beyond this limit, the amount will be included in Tier-
II Capital. Banks can also issue PDI and PNCPS with call option which
be exercised with prior approval of RBI only if the instrument has run for
at least 5 years.

Tier –II Capital consists the following:

 Redeemable Cumulative Preference shares,
 Redeemable non-cumulative Preference shares
 General Provisions & Loss reserves up to 1.25 % of Credit
RWAs, if Standardized approach (0.6 % if IRBA approach)
 Debt Capital instruments
 Stock Surplus resulting into issue of above said securities.

(Under BASEL-II, Tier -2 Capital cannot be more than 50% of total

capital or we can say Tier 2 Capital cannot be more than 100% of
Tier-1 Capital)

Regulatory Adjustments/Deductions: Following adjustments have to

be applied to Regulatory Capital at both solo and consolidated level.

 Goodwill and all intangible assets,

 DTA (Deferred Tax Assets)
 Cash flow Hedge reserve
 Shortfall in stock of provisions for expected losses.
 Gain on related securitization transactions.
 Investment in own shares
 Investment in Capital of Banking, Financial and Insurance
entities.

Calculation of Capital funds ( Tier I & Tier II)

CRAR (Capital --------------------------------------------------------------------------------- X 100
to Risk Credit Risk Weighted Assets + Market RWAs + Operational RWAs
Weighted Asset
Ratio) Minimum requirement of CRAR is as under:
As per BASEL-II recommendations 8%
As per RBI guidelines 9%
Banks undertaking Insurance business +1%
New Private Sector Banks 10%
Local Area banks 15%
.

53
Two ways to 1. By raising more capital. Raising Tier I capital will dilute the equity
improve CRAR stake of existing investors including Govt. Raising Tier II Capital is
definitely a costly affair and it will affect our profits.
2. Reduction of risk weighted assets by implementing Risk mitigation
Policy.

(Parallel run of Basel-II & Basel-III till 31.3.2017)

BASEL –III – Calculation of Capital

Minimum Capital Requirement will be calculated as under:

The below mentioned %age has been fully implemented from 31.3.2019

%age of RWAs AS PER BASEL

Minimum CET-I (Common Equity) 5.5% 4.5%
Max. AT-I (Additional Tier-I) 1.5% 1.5%
Minimum Tier - I Capital 7.00 % 6.00%
Maximum Tier-II Capital 2.00 % 2.00%
Minimum CRAR 9% 8.00%
CCB – Capital Conservative Buffer in 2.5% 2.5%
the form of Common Equity(Tier –I )
Countercyclical Capital Buffer within 0-2.5%of RWAs
range of (Yet to be implemented)
Leverage Ratio (Minimum Standard) 4.5% 4.5%
It is ratio of Outside Liabilities/Net Worth
i.e. Capital & Reserves

Common Equity Tier-1 Capital Ratio = CET-1/ Risk Weighted Assets

Tier-1 Capital Ratio = Tier-1 Capital / Risk Weighted Assets
Total Capital Ratio ( CRAR) = Eligible Total Capital / Risk Weighted Assets
Leverage Ratio = Capital Measure / Exposure Measure

(Risk Weighted Assets = RWAs for Credit, Market and Operational Risk)
 Capital Conservation Buffer in the form of Common Equity Tier-I.
 Countercyclical Capital Buffer within the range of 0-2.5% of RWAs will also be in the
form of Common Equity. It will be implanted as per national requirements.
 Leverage Ratio prescribes minimum standard of 4.5% of Tier – I Capital compared
with Total Exposure. Total Exposure includes Balance Sheet Items and Non-
Balance sheet items as well as 10% of un-availed limits even if there is
unconditional cancellable undertaking.
 D-SIBs (Domestic Systemically Important Banks) are those whose failure can
disrupt the whole system. These are SBI, ICICI & HDFC. These banks need to
provide additional CET-1 @0.6% (SBI) & 0.2% for other banks.

Advances against NSC/KVC/FDs/LIC 0%

Risk Weights Claims on RBI, DICGC, CGTMSE, CGFSEL etc. 0%
on Different Claims on Domestic Sovereign i.e. Central Govt. 0%
Assets/Loans Guarantees & Loans Guaranteed By Central
Govt.

54
 Claims on ECGC 20%
State Govt. Guarantees & Loans Guaranteed By 20%
State Govt.
Balance with other scheduled banks having CRR 20%
at least 9%
Secured loan to staff 20%
Other Staff loans -not covered by retirement dues 75%
Loans upto 1.00 lac against Gold/Silver 50%
Mortgage based securitization of assets 77.5%
Credit Cards/Loan against Shares & Capital 125%
Market Exposure
Personal Loans and Consumer Loans 100%
Claims secured by NBFC-non-deposit taking 100%
(other than AFCs)
Exposure to Corporate AFC, NBFC-IFCs (More 150%
than 200 Crore
Venture Capital 150%
Commercial Real Estates (CRE) 100%
Commercial Real Estate (Residential Housing) 75%
Education Loans 75%
Other Retail Loans 75%
SME Loans 75%
Other loans (Agriculture, Exports) 100%

Risk Weight on Housing Loan

Latest guidelines of RBI are as under:
Loan Category LTV Ratio Risk Weight Provision on
Standard
Asset
Up to 30 lac < 80 35% 0.25 %
>80 < 90 50%

Above 30 up to 75 lac < 80 35%

Above 75 lac LTV < 75 50%

Bank’s Exposure for 3rd House will be treated as CRE
exposure.

Three Pillars of Pillar –I Minimum Capital Requirement

BASEL-II Pillar – II Supervisory Review Process
Pillar –III Market Discipline

55
 Credit Risk

Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms
and conditions. In terms of extant guidelines contained in BASEL-II, there are three
approaches to measure Credit Risk given as under:

1. Standardized approach
2. IRB (Internal Rating Based) Foundation approach
3. IRB (Internal Rating Based) Advanced approach

1. Standardized Approach
RBI has directed all banks to adopt Standardized approach in respect of Credit Risks.
Under standardized approach, risk rating will be done by credit agencies. Following
Agencies are approved for external rating:

1. CARE 2. FITCH India (New name – India Rating.) 3.CRISIL 4. ICRA 5. Credit
Analysis and Research Limited. 6. INFORMERICS 7. Brickwork
8. SMERA (For SME units) and 9. Onicara (also for SME units)
Bank may also use International agencies like Fitch, Moody & Standard and Poor

Risk weights prescribed by RBI are as under:

Long term Rating Risk Weight Short Term Rating

AAA 20% A1+
AA 30% A1
A 50% A2
BBB 100% A3
BB, C & D 150% A4 & D
Unrated 100% Unrated

 External Risk rating is required for total exposure (FB & NFB) Rs 10 crore and
above. It is exempted up to 25 crore for MSME borrowers with aggregate
exposure up to 25 crore provided the same is secured by 75% Cash Collateral.

2. IRBA – Internal rating Based Approach

At present all advances of Rs. 10.00 crore and above are being rated from external
agencies in our bank.
IRBA
IRBA is based on bank‘s internal assessment. It has two variants (Foundation and
advanced). Bank will do its own assessment of risk rating and requirement of Capital will be
calculated on
 Probability of default (PD)- It measures the likelihood that borrower will default.
 Loss given default (LD) – It measures proportion of exposure that will be lost in
case of default
 Exposure of default (ED) – It measures the facility that is likely to be drawn in the
event of default.
 Effective maturity. (M) – It measures the remaining economic maturity of Exposure.

56
Bank has developed its own rating module system to rate the undertaking internally. The
internal rating is being used for the following purposes:

1. Credit decisions
2. Determination of Powers
3. Price fixing

Credit Risk Management Department (CRMD) is responsible for implementing the Risk
Identification and Risk mitigate strategies.

Risk Identification

Credit risk has two components:

1. Default risk
2. Credit Spread Risk or Downgrade risk
Credit Risk at portfolio level is of following two types:
1. Systemic risk
2. Concentration risk – due to non- diversification

Rating Migration
Rating migration is change in the rating of a borrower over a period of time when rated on
the same standard or model.

Rating Migration of loan accounts based on internal rating of HSBC between 31.3.11 &
31.3.12 is as under:
Last Nos. of Present Rating
Rating Accoun
ts
AAA AA+ AA A+ A BBB C
AAA 50 35 8 2 2 1 1 1

Last Nos. of Present Rating

Rating Accoun
ts
AAA AA+ AA A+ BBB C Default
AA+ 50 5 30 7 5 1 1 1

Last Nos. of Present Rating

Rating Accoun
ts
A+ A BBB C Default
A 100 10 80 6 2 2

Last Nos. of Present Rating

Rating Accoun
ts
A+ BBB C Default
BBB 200 10 120 30 40

57
 Last Nos. of Present Rating
Rating Accoun
ts
BBB C Default
C 30 5 20 5

 %age of AAA rated borrowers remained in the same rating:35/50 = 70%

 At the end of observation period, number of AAA rated borrowers = 40
 %age migration of borrowers from A to default category –2%
 %age migration of borrowers from BBB to default category –40/200*100=20%.
 Which rating module the regulator will advise to rigorously follow up ---BBB
(maximum default)
 Number of Default borrowers at the end of period: 1+2+40+5= 48

Altman’s Z Model of Scoring

Altman‘s Z score makes forecast about financial health of the company within 12 months.
This model combines following 5 ratios to predict the financial position:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 +1.0 X5

Here 1= Working Capital / Total Assets Ratio

2=Retained earnings / Total Assets Ratio
3=Earnings before Interest and Tax / Total Assets Ratio
4 = Market Value of Equity / Book Value of Long Term Liabilities Ratio
5=Sales/Total Assets ratio

Higher the value of Z, lower will be default risk. A firm with less than Z score 1.81 should be
classified as High Risk borrower.

JP Morgan’s Credit Metrics- Model of Scoring

JP Morgan developed a portfolio model ―Credit Metrics‖ for evaluating Credit Risks. The
volatility is computing by tracking probability that borrower may migrate from one rating to
another. It focuses on estimating volatility in value of assets caused by variation in quality
of assets.

What is Ripple Effect?

Systemic risk is the risk that a default by one bank will create a RIPPLE EFFECT that leads
to defaults by other Fis and threatens stability of financial system.

What is Cooke Ratio?

CRAR is also known as Cooke Ratio. It is Capital/Risk Weighted Assets. Minimum 9% is
the requirement for Indian banks.

58
Example -1

XYZ bank has provided the following figures in respect of advances:

Rating AAA AA A BBB BB B CCC
3 year .04% .15% .30% 1.10% 6% 25% 40%
5 year .10% .40% .60% 2% 10% 35% 45%

Other Information is as under:

Base Rate of the bank = 11% for AAA category
Load factor = 1% for AA , 2% for A, 3% for BBB and 4% for BB accounts.
Load factor for additional maturity over 3 years = 0.5%

Bank has given loan of Rs. 400 lac to A rated Company for 5 years, out of which 2
year period has already lapsed and there has been no default. Present outstanding is
300 lac.
EAD (Exposure at Default) = 100% and
LGD (Loss Given Default = 50%
Find the expected loss on this account?

Solution:
It will be solved as under:
EAD X Probability of default X LGD =

300,00,000 X .30% X 50% = Rs. 45000 Ans.

Example -2

PLR bank has provided the following figures in respect of advances:

Rating AAA AA A BBB BB B CCC
3 year .05% .20% .40% 1% 5% 20% 50%
5 year .8% .30% .70% 1.8% 8% 40% 60%
Bank has given loan to A category borrower with repayment schedule of 4 years out of
which 1 year has lapsed and there has been no default. O/s 400 lac, EAD 100% and LGD
is 50%. Find Expected loss on this account.

Solution:
Expected Loss = EAD*PD*LGD
= 400*100%*.4%*50%
=80000 ---------Ans

59
How to Calculate RWAs and Capital Charge in respect of Credit risk

1st Step : Calculate Fund Based and Non Fund Based Adjusted Exposure
2nd Step: Deduct Allowable Reduction after applying haircuts
3rd Step : Apply Risk Weights as per Ratings
4th Step: Calculate Risk Weighted Assets
5th Step : Calculate Capital Charge

Ist Step: Calculate Fund Based and Non Fund Based Exposure:

Example:
Fund Based Exposure (Amount in ‗000)
Nature of loan Limit Outstanding Undrawn portion
CC 200 100 100
Bills Purchased 60 30 30
Packing Credit 40 30 10
Term Loan 200 40 160
Total 200
Out of Undrawn portion of TL, 60 is to drawn in a year and balance
beyond 1 year.

Adjusted Exposure:
100% Outstanding(Unrated) = 200
20% of Undrawn CC, BP & PC (140*20/100) = 28
20% of Undrawn TL (1 yr) (60*20/100) = 12
50% of Undrawn TL (>1Yr) (100*50/100) = 50
Exposure FB limits 290

Non Fund Based Exposure (Amount in ‗000)

Type of NBF Exposure CCF Adjusted
Exposure
Financial Guarantees 90 100% 90
Acceptances 80 100% 80
Standby LC 50 100% 50
Clean LC 50 100% 50
Unconditional Take out finance 100 100% 100
Performance Guarantee 80 50% 40
Bid Bonds 20 50% 10
Conditional Take out finance 50 50% 25
Documentary LC 40 20% 8
Exposure FB limits = 453

Total Exposure = 290000+453000 = 7,43,000

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2nd Step: Allowable Reduction after adjusting CRMs (Credit Risk Mitigates)
Reduction from adjusted exposure is made on account of following eligible financial
collaterals:
Eligible Financial Collaterals.
 Deposits being maintained by a borrower under lien.
 Cash (including CDs or FDs), Gold, Govt Securities, KVP, NSC, LIC Policy, Debt
Securities, Mutual Funds‘
Equity and convertible bonds are no more eligible CRMs.

Formula for Deposits under lien: C*(1-Hfx) X Mf

(C=Amount of Deposit; Hfx =0 (if same currency), Hfx = 0.08 (if diff currency) Mf =
Maturity factor).

Formula for Approved Financial collaterals: C*(1-Hc-Hfx) *Mf ) - E*He

Haircuts(He–Haircut for Exposure & Hc-Haircut for Collateral)

Haircut refers to the adjustments made to the amount of exposures to the counter party
and also the value of collateral received to take account of possible future fluctuations in
the value of either, on account of market movements. Standardized Supervisory Haircuts
for collateral /Exposure have been prescribed by RBI and given in the said circular.

Capital Requirement for collateralized transaction

E* = max { 0, [E X (1+He) – C X (1-Hc- Hfx) } ]
E* - exposure value alter risk mitigation
E – Current value of exposure for which coll. Qualifies
C = current value of collateral received
Hfx = Haircut appropriate for currency mismatch between collateral and exposure.
E* will be multiplied by the risk weight of the counter party to obtain RWA amount.

Illustrations clarifying CRM

In the case of exposure of Rs 100 (denominated in USD) having a maturity of 6 years to a
BBB rated (rating by external credit rating agency) corporate borrower secured by collateral
of Rs 100 by way of A+ rated corporate bond with a maturity of 6 years, the exposure
amount after the applicable haircut @ 12%, will be Rs 112 and the volatility adjusted
collateral value would be Rs 80, (after applying haircut @ 12% as per issue rating and 8%
for currency mismatch) for the purpose of arriving at the value of risk weighted asset &
calculating charge on capital.

There is an exposure of Rs 100 to an unrated Corporate (having no rating from any

external agency) having a maturity of 3 years, which is secured by Govt. Securities outside
the main index having a market value of Rs 100. The haircut for exposure as well as
collateral will be 25%. There is no currency mismatch in this case. The volatility adjusted
exposure and collateral after application of haircuts works out to Rs 125 and Rs 75
respectively. Therefore, the net exposure for calculating RWA works out to Rs 50.

There is a demand loan of Rs 100 secured by bank‘s own deposit of Rs 125. The haircuts
for exposure and collateral would be zero. There is no maturity mismatch. Adjusted
exposure and collateral after application of haircuts would be Rs 100 and Rs 125
respectively. Net exposure for the purpose of RWA would be zero

61
Other Examples
No. 1:
1. Exposure----------------------------------------- 100 lac with tenure 3 years
2. Eligible Collateral in A+ Debt Security -----30 lac with Residual maturity 2 years
3. Hair cut on Collateral is 6%
4. Table of Maturity factor shows hair cut as 0.25 for remaining maturity of 2 years.
Calculate Value of Exposure after Risk Mitigation?

Solution:
Value of Exposure after Risk Mitigation =
Current Value of Exposure – Value of adjusted collateral for Hair cut and maturity mismatch

Value of Adjusted Collateral for Hair cut = C*(1-Hc) = 30(1-6%) = 30*94% = 28.20
Value of Adjusted Collateral for Hair cut and Maturity Mismatch = C* (t-0.25)
(T-0.25)
= 28.20*(2-.25)/(3-.25) = 17.95
( Where t = Remaining maturity of Collateral T= Tenure of loan )

Value of Exposure after Risk Mitigation = 100-17.95= 82.05 lac.

No. 2
An exposure of Rs. 100 lac is backed by lien on FD of 30 lac. There is no mismatch of
maturity.

Solution:
Hair Cut for CRM i.e. FDR is zero.
Hence Value of Exposure after Risk Mitigation is 100 lac – 30 lac = 70 lac.

Computation of CRAR
In a bank ; Tier 1 Capital = 1000 crore
Tier II Capital = 1200 crore
RWAs for Credit Risk = 10000 crore
Capital Charge for Market Risk = 500 crore
Capital Charge for Op Risk = 300 crore
Find Tier I CRAR and Total CRAR.

Solution:
RWAs for Credit Risk = 10000 crore
RWAs for Market Risk = 500/.09 = 5556 crore
RWAs for Op Risk = 300/.09 = 3333 crore
Total RWS = 10000+5556+3333 = 18889 crore
Tier I Capital = 1000 crore
Tier II Capital can be up to maximum 1000 crore
Total Capital = 2000 crore
Tier I CRAR = Eligible Tier I Capital /Total RWAs = 1000/18889=5.29%
Total CRAR = Eligible Total Capital /Total RWAs = 2000/18889 = 10.59%

We may conclude that Tier I Capital is less than the required level.

62
 Credit Risk Mitigates
It is a process through which credit Risk is reduced or transferred to counter party. CRM
techniques are adopted at Transaction level as well as at Portfolio level as under:
At Transaction level:
 Obtaining Cash Collaterals
 Obtaining guarantees from Sovereign entities (BIS, IMF, European Cental Bank as
well as from ECGC, CGTMSE, CGTFSEL, banks, PDs with lower RW than the
counterparty.
At portfolio level
 Securitization
 Collateral Loan Obligations and Credit Linked Notes
 Credit Derivatives
What is LRM?
It is Loan Review Mechanism used to evaluate quality of loans and bring improvement in
credit administration.

1. Securitization
It is process/transactions in which financial securities are issued against cash flow
generated from pool of assets. Cash flow arising from receipt of Interest and Principal of
loans are used to pay interest and repayment of securities. SPV (Special Purpose
Vehicle) is created for the said purpose. Originating bank transfers assets to SPV and it
issues financial securities which are called PTC (Pass Through Certificates).

2. Collateral Loan Obligations (CLO) / Collateralized Debt Obligation (CDO)

It is also a form of securitization. Through CLO, bank removes assets from Balance Sheet
and issues tradable securities. They become free from Regulatory Capital.
Collateralized loan obligations (CLOs) are a form of securitization where payments from
multiple middle sized and large business loans are pooled together and passed on to different
classes of owners in various classes.. A CLO is a type of collateralized debt obligation.

It allow banks more often to immediately sell loans to external investor/lenders so as to

facilitate the lending of money to business clients and earn fees with little to no risk to
themselves.

3. Credit Derivatives
It is managing risks without affecting portfolio size. Risk is transferred without transfer of
assets from the Balance Sheet though OTC bilateral contract. These are Off Balance Sheet
Financial Instruments. Credit Insurance and LC are similar to Credit derivatives. Under a
Credit Derivative PB (Protection buyer) enters into an agreement with PS (Protection
seller) for transfer of risks at notional value by making of Premium payments. In case of
delinquencies, default, Foreclosure, prepayments, PS compensates PB for the losses.
Settlement can be Physical or Cash. Under physical settlement, asset is transferred
whereas under Cash settlement, only loss is compensated.

63
Credit Derivatives are generally OTC instruments. ISDA (International Swaps and
Derivatives Association) has come out with documentation evidencing such transaction.
Credit Derivatives are:

1.Credit Default Swaps

2.Total Return Swaps
3.Credit Link Notes

Credit Default Swaps

It is a transaction in which PB pays a premium to PS in return of protection against credit
event experienced on reference obligation. i.e. insolvency, default etc.
Total Return Swaps
In Total Return Swap, PB swaps with PS, total return on an asset by making payment of
premium. It covers both credit risk and market risk. The coupon capital depreciation is also
covered by PS by making premium by PB.
Credit Linked Notes
A credit linked note (CLN) is a form of funded credit derivative. It is structured as
a security with an embedded credit default swap allowing the issuer to transfer a specific
credit risk to credit investors. This eliminates a third-party insurance provider.
 It is issued by a special purpose company or trust, designed to offer investors par
value at maturity unless the referenced entity defaults. In the case of default, the
investors receive a recovery rate.
 The trust will also have entered into a default swap with a dealer. In case of default,
the trust will pay the dealer par minus the recovery rate, in exchange for an annual
fee which is passed on to the investors in the form of a higher yield on their note.
 The purpose of the arrangement is to pass the risk of specific default onto investors
willing to bear that risk in return for the higher yield it makes available. The CLNs
themselves are typically backed by very highly-rated collateral, such as U.S.
Treasury securities.
CLO differs from CLN (Credit link notes in the following manner.
 CLO provide credit Exposure to diverse pool of credit where CLN relates to single
credit.
 CLO result in transfer of ownership whereas CLN do not provide such transfer.
 CLO may enjoy higher credit rating than that of originating bank.

Example:
A bank lends money to a company, XYZ, and at the time of loan issues credit-linked notes bought
by investors. The interest rate on the notes is determined by the credit risk of the company XYZ. The
funds the bank raises by issuing notes to investors are invested in bonds with low probability of
default. If company XYZ is solvent, the bank is obligated to pay the notes in full. If company XYZ
goes bankrupt, the note-holders/investors become the creditor of the company XYZ and receive the
company XYZ loan. The bank in turn gets compensated by the returns on less-risky bond
investments funded by issuing credit linked notes.

64
SPV – Special Purpose Vehicle
It is fund created by Securitization Companies to acquire/purchase non-performing assets.
The Fund manages the assets for the purpose of realization or holds them as investments
till maturity. SPV issues consideration of transfer price to the Originator bank in the form of
cash, debentures, bonds as mutually agreed.

SPV is created by SCRC (Securitization and Reconstruction Companies. These companies

raise resources from QIBs (Qualified Institutional Buyers). Security Receipt is issued to
QIBs by SCRC in lieu of amount contributed by them.

Example:

OBC made loan to a corporate whose particulars are as under:

Loan Repayabl Credit Value of RW to A Hair cut Hair Cut
amount e after Rating Cash category on on
Collateral Collateral Exposur
e
10 crore 3 years A 10 crore 50% 6% 0%

Question Answer
Value of Collateral after Hair cut 10 (1-06) = 9.40 crore
Value of Exposure after Credit Risk 10-9.40 = .60 crore
Mitigation
Value of RWAs .60*50/100 = .30 crore

Risk Weight on Exposures Covered by Guarantees

Credit Risk is reduced, if the exposure is backed by Guarantee of Soverign, DICGC,
ECGC, CGTMSE, CGFSEL and entities with minimum rating AA(-) by approved rating
agencies in India. The guaranteed amount will be adjusted against exposure with
currency mismatch and maturity mismatch as under:

Adjusted Guaranteed amount = G X (1-Hfx) X Mf

The guaranteed portion is to be assigned RW as per rating of guarantor (20% for AAA,
30% for AA)

65
 Operational Risk

Operational Risk is the risk of loss resulting from

 Inadequate or failed internal processes, people and system.
 External events such as dacoity, burglary, fire etc.
It includes legal risks but excludes strategic /reputation risks.
Identification
 Actual Loss Data Base
 RBIA reports
 Risk Control & Self Assessment Survey
 Key Risk indicators
 Scenario analysis
Four ways to manage Risk
 Prevent
 Reduce
 Transfer
 Carry/Accept
Operation Three approaches have been defined to measure Operational Risk at the
al Risk – branches/offices of the bank:
Measurem 1. Basic Indicator approach
ent 2. The Standardized approach
3. AMA i.e. Advanced measurement approach
Basic 15% of Average positive gross annual income of previous 3 years will be
Indicator requirement of capital. To start with banks will have to adopt this
Approach approach and huge capital is required to be maintained.
The All banking activities are to be divided in 8 business lines. 1) Corporate
Standardi finance 2) Trading & Sales 3) Retail Banking 4) Commercial Banking 5)
zed Asset Management 6) Retail brokerage 7) Agency service 8) Payment
approach settlement
– β factor Within each business line, Capital requirement will be calculated as
under:
By multiplying the average gross income generated by a business over
previous 3 years by a factor β ranging from 12 % to 18 % depending
upon industry-wise relationships as under:

Retail Banking, Retail Brokerage and Asset Management-----------12%

Commercial Banking and Agency Services-----------------------------15%
Corporate, Trading and Payment Settlement----------------------------18%
Advanced Capital requirement is calculated by the actual risk measurement system
Measurem devised by bank‘s own internal Operational Risk Measurement methods
ent using quantitative and qualitative criteria. Our bank has started measuring
approach actual losses and estimating future losses. Minimum 5 year data is
required for a bank to switch over to AMA.

How to calculate RWAs for Operational Risk?

RWAs for Operational Risk = Capital Charge (If required CAR is 9%)
.09

66
Operational
Risk Events Cause based
 People oriented – losses due to negligence, incompetence, lack
of awareness etc.
 Process oriented – losses due to business volume, less staff,
organization complexity, lack of supervision etc.
 Technology oriented – failure of system etc.
 External causes: Floods, natural disasters etc.
Effect Based
 Claim cases in court settled against the bank.
 Penalties due to non-compliance
 Tax penalties
 Write off
 Delayed interest
Event Based
 Internal and External Frauds
 Dacoity, Burg alary etc.
 Damage to assets
 Business disruption.
 Employment practices and workplace safety.

Operational It is a term used in measurement of Operational Risk on the basis of

Risk - scenario estimates.
Scenario Banks use scenario analysis based on expert opinion in conjunction
Analysis with external data to evaluate its exposure to high severity events.

In addition, scenario analysis is used to assess impact of deviations

from correlation assumptions in the bank‘s Operational Risk
measurement framework to evaluate potential losses arising from
operational risk loss events.

Operational Insurance cover, if available can reduce the operational risk only when
Risk Mitigation AMA is adopted for estimating capital requirements. The recognition of
insurance mitigation is limited to 20% of total Operational Risk
Capital Charge calculated under AMA.

ORMC (Operational Risk Management Committee) under ORMD

(Operational Risk Management Division) is formed at bank level to
record, report and prevent Operational Risks at Branch level.

Practical Under AMA approach, Estimated level of Operational Risk is calculated

Example –AMA on the basis of:
approach 1. Estimated probability of occurrence
2. Estimated potential financial impact
3. Estimated impact of internal control.

Estimated Probability of Occurrence : This is based on historical

frequency of occurrence and estimated likelihood of future occurrence.
Probability is mapped on scale of 5 as under:
Negligible risk -----1

67
 Low risk-------------2
Medium Risk------3
High Risk--- -----4
Very High Risk----5

For Calculation, following formula is used:

Estimated level of Operational Risk = {Estimated probability of

occurrence x Estimated potential financial impact x Estimated impact of
internal control} ^0.5

^0.5 implies Under root of whole

Example:
Probability of occurrence = 2
Probability of Financial impact = 4
Impact of Financial control = 50%

Solution
[ 2x4x(1-0.5)] ^0.5 = ∫4 = 2 (Low) Ans.

In case financial impact of Internal Control is 20%

Solution would be:
[ 2x4x(1-0.2)] ^0.5 = ∫6.40 = 2.53---------Ans.
AMA – Question: Probability of Occurrence : 4
Estimated Potential Financial impact =4
level of Impact of Internal controls = 0%
Operational
Risk and Solution:
Impact of { Probability of occurrence x Potential financial impact x Impact of
Internal internal controls } ^0.5
Control =(4x4) ^0.5 = ∫16 = 4 Ans.(High Risk)

Example for Balance sheet figures of ABC bank are as under:

calculation of
Capital Charge Ist year (R . in 2nd Year (Rs.
for operational cr res) crores)
Risk Net Profits 120 150
Provisions 240 290
Staff exp nses 280 320
Other operating expenses 160 240

Other Income 320 460

Calculate Capital Charge for Operational Risk and RWAs as per
Basel Norms.
Capital Charge for Operational Risk is calculated as under:
Gross Income *15/100
Gross Income = Net Profit + Provisions + Staff expenses + Other
operating expenses

68
 Ist year = 120+240+280+160= 800 crore
2nd Year = 150+290+320+240=1000 crore

Average Gross Income = (800+1000)/2 = 900 crore

Capital for operational Risk = 900*15/100 = 135 crore

Risk Weighted Assets for Operational Risk =

135/.08 = 1687.50 Crore (as per BASEL norms)
Or 135/.09 = 1500 crore (as per RBI norms)

 For calculation of Capital charge under Basic Indicator approach, Gross income
is defined as net interest income plus net non-interest income. However, it is
gross of provisions, operating expenses, Extra ordinary expenses, Profits/losses
from sale of securities.
 Figures for any year in which annual gross income is negative or zero should be
excluded from both the numerator and denominator when calculating the
average

69
 Market Risk

It is simply risk of losses on Balance sheet and Off Balance sheet items basically in
investments due to movement in market prices.

It is risk of adverse deviation of mark to Market value of trading portfolio during the period.
Any decline in the market value will result into loss.

Market Risk involves the following:

1. Risk Identification
2. Risk Measurement
3. Risk monitoring and control
4. Risk mitigation.

ALCO: Assets Liability Management Committee meets at frequent intervals and takes
decisions in respect of Product pricing, Maturity profiles and mix of incremental assets and
profiles, Interest rate, Funding policy, Transfer pricing and Balance Sheet Management.

Market Risk measurement

Measurement of Market Risk is based on:
1. Sensitivity measurement
2. Downside potential measurement

Sensitivity Measurement
Change in market rate of interest has inverse relation with Value of Bonds. Higher interest
rates lower the value of bond whereas decline in interest rate would result into higher bond
value. Also More liquidity in the market results into enhanced demand of securities and it
will lead to higher price of market instrument. There are two methods of assessment of
Market risk: 1. Basis Point Value 2. Duration method

1. Basis Point Value

This is change in value of security due to 1 basis point change in Market Yield. Higher the
BPV higher will be the risk.

Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10

Difference in Market price = 0.10

Difference Yield = 0.05%
BPV = Diff in Market price/Difference in Yield

BPV = 0.10/0.05 = 2 paisa per Rs. 100 i.e. 2 basis points per Rs. 100/-
If Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/-

Now, if the yield on Bond declines by 8 bps, then it will result into profit of Rs. 16000/-

70
(8x2000). BPV declines as maturity reaches. It will become zero on the date of maturity.

2. Duration method
Duration is the time that a bond holder must wait till nos. of years (Duration)to receive
Present Value of the bond.

e.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7 years. It
means Total Cash Flow of Rs. 130 to be received in 5 years would be discounted with
Present Value which will be equivalent as amount received in 3.7 years. The Duration of
the Bond is 3.7 Years.

Formula of Calculation of McCauley Duration = ∑PV*T

∑PV
Modified Duration = Duration
1+Yield
Approximate % change in price = Modified Duration X Change in Yield

Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is
5 years. What will be the McCauley Duration.

Modified Duration = Duration/ 1+YTM

Duration = Modified Duration x (1+YTM)
= 5 x 1.06 = 5.30 Ans.

Downside Potential measurement

It captures only possible losses ignoring profit potentials. It integrates sensitivity and
volatility with adverse affect of Uncertainty.

This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method
to calculate downside potential.

Value at Risk (VaR)

It means how much can we expect to lose? What is the potential loss?. Banks using
propriory models must compute VaR daily, using 99th percentile with time horizon of 10
trading days using historical observation of last one year. Capital Charge for the bank will
be higher of previous day‘s VaR and 3 times the average of daily VaR of preceding 60
business days.

Let VaR =x. It means we can lose up to maximum of x value over the next period say
week (time horizon). Confidence level of 99% is taken into consideration.

Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is
only one chance in 100 that daily loss will be more than 10 crore under normal conditions.

VaR in days in 1 year based on 250 working days = 1 x 250 == 2.5 days per year.

100

71
Back Testing
It is a process where model based VaR is compared with Actual performance. It tells us
whether results fall within pre-specified confidence bonds as predicted by VaR models.

Stress Testing
It seeks to determine possible change in Market Value of portfolio that could arise due to
non-normal movement in one or more market parameters (such as interest rate, liquidity,
inflation, Exchange rate and Stock price etc.). Four test are applied:
1. Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate ±2%, 4%,6% etc.
2. Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if
possible events occur. It assesses potential consequences for a firm of an extreme.
It is based on historical event or hypothetical event.
3. Maximum loss
The approach assesses the risks of portfolio by identifying most potential
combination of moves of market risks
4. Extreme value theory
The theory is based on behavior of tails (i.e. very high and very low potential
values) of probable distributions.
Risk Management and Control
Market risk is controlled by implementing the business policies and setting of market risk
limits or controlling through economic measures with the objective of attaining higher
RAROC. Risk is managed by the following:
1. Limits and Triggers
2. Risk Monitoring
3. Models of Analyses.

Calculation of Capital Charge of Market Risk

The Basel Committee has two approaches for calculation of Capital Charge on Market
Risk as under:
1. Standardized Duration approach
2. Internal Risk Management approach
Under Standardized approach, there are two methods: Maturity method and duration
method. RBI has decided to adopt Standardization duration method to arrive at capital
charge on the basis of investment rating as under:

Investment rating Capital Required

AAA to AA 0%
A+ to BBB
Residual term to maturity
Up to 6M .28%
Up to 24M 1.14%
More than 24 M 1.80%
Unrated 9.00%
Rated BB and Below 13.5%

How to Calculate RWAs, if Capital Charge is given:

RWAs for Market Risk = Capital Charge (If required CAR is 9%)
.09

72
Pillar – II SRP has two issues:
Supervisory 1. To ensure that bank is having adequate capital.
Review Process 2. To encourage banks to use better techniques to mitigate risks.
(SRP) SRP concentrates on 3 main areas:
 Risks not fully captured under Pillar -1 i.e. Interest Rate Risks,
Credit concentration Risks, Liquidity Risk, Settlement Risks,
Reputational Risks and Strategic Risks.
 Risks not at all taken care of in Pillar -1.
 External Factors.
This pillar ensures that the banks have adequate capital. This process
also ensures that the bank managements develop Internal risk capital
assessment process and set capital targets commensurate with bank‘s
risk profile and capital environment. Central Bank also ensures through
supervisory measures that each bank maintains required CRAR and
components of capital i.e. Tier –I & Tier –II are in accordance with
BASEL-II norms. RBIA and other internal inspection processes are the
important tools of bank‘s supervisory techniques.

Every Bank will prepare ICAAP (Internal Capital Adequacy Assessment

Plan) on solo basis which will comprise of functions of measuring and
identifying Risks, Maintaining appropriate level of Capital and
Developing suitable Risk mitigation techniques. Piller 2 also requires
supervisory authorities to ask bank to prepare Supervisory Review and
Evaluation process (SREP).

Pillar – III Market discipline is complete disclosure and transparency in the

Market balance sheet and all the financial statements of the bank. The
Discipline disclosure is required in respect of the following:

 Capital structure.
 Components of Tier –I and Tier –II Capital
 Bank‘s approach to assess capital adequacy
 Assessment of Credit Risks, Market Risk and Operational Risk.
 Credit Aspects like Asset Classification, Net NPA ratios,
Movement of NPAs and Provisioning.

Frequency of Disclosure
 Banks with Capital funds of Rs. 100 crore or more will make
interim Disclosures on Quantitative aspects on standalone basis
on their respective websites.
 Larger banks with Capital Funds of Rs. 500 crore or more will
disclose Tier-I capital , Total Capital, CAR on Quarterly basis on
website.

73
 Risk Weight on NPAs

a) Risk weight on NPAs net of specific provision will be calculated as under:

When provision is less than 20% of NPA o/s ---- 150%

When provision is at least 20% of NPA o/s ---- 100%
When provision is at least 50% of NPA o/s ---- 50%

Category Provision Rate Criteria Risk Weight

Substandard 15% Provision is less 150%
(Secured) than 20%
Substandard 25% Provision is at-least 100%
(Unsecured) 20%
Doubtful (DI) 25% Provision is at-least 100%
(Secured) 20%
Doubtful (DI) 100% Provision is at-least 50%
(Un-Secured) 50%
Doubtful (D2) 40% Provision is at-least 100%
(Secured) 20%
Doubtful (D3) 100% Provision is at-least 50%
(Secured) 50%
Doubtful (D2) 100% Provision is at-least 50%
(Un-Secured) 50%

Off-balance sheet items

Off-balance sheet items have been bifurcated as follows:

i) Non-market related off-balance sheet items
ii) Market related off-balance sheet items
There is two-step process for the purpose of calculating risk weighted assets in respect of
off-balance sheet items:
a) The notional amount of the transaction is converted into a credit equivalent factor by
multiplying the amount by the specified Credit Conversion Factor (CCF)
b) The resulting credit equivalent amount is then multiplied by the risk weight
applicable to the counter party or to the purpose for which the bank has extended
finance or the type of asset whichever is higher.
Where the off-balance sheet item is secured by eligible collateral or guarantee, the credit
risk mitigation guidelines will be applied.

Non-market related off-balance sheet items:

Off balance sheet items like direct credit substitutes, trade and performance related
contingent items and commitments with certain draw downs are classified under Non-
market related off-balance sheet items. The credit equivalent amount is determined by
multiplying the contracted amount of that particular transaction by the relevant CCF.
Non-market related off-balance sheet items also include undrawn or partially
undrawn fund based and non-fund based facilities, which are not unconditionally
cancellable. The amount of undrawn commitment is to be included in calculating the off-

74
balance sheet items. Non-market related exposure is the maximum unused portion of the
commitment that could be drawn during the remaining period of maturity. In case of term
loan with respect to large project to be drawn in stages, undrawn portion shall be calculated
with respect of the running stage only.

RBI guidelines on CCF (Credit Conversion Factor)

Direct Credit Substitutes CCF

General Guarantees (including Standby LCs), 100%
Acceptances
Transaction related contingent items (Performance 50%
bonds, Bid bonds, Warranties, Indemnities, Standby
LC relating to particular transaction
Short Term LC (Documentary) for Issuing bank as well 20%
as confirming bank

Capital Charge on Un-availed limit

Capital Charge on Undrawn limits is calculated as under:

 20% on Undrawn CC limit

 20% on Undrawn TL limit (which is to be drawn in a year)
 50% on Undrawn TL limit (which is to be drawn beyond a year)

Example
In the case of a cash credit facility for Rs.100 lakh (which is not
unconditionally cancelable) where the availed portion is Rs. 60 lakh, the un-availed
portion of Rs.40 lakh will attract a Credit Conversion Factor (CCF) of 20% (since the
cash credit facility is subject to review / renewal normally once a year). The credit
equivalent amount of Rs.8 lakh (20% of Rs.40 lakh) will be assigned the appropriate
risk weight as applicable to the counterparty / rating to arrive at the risk weighted
asset for the unavailed portion. The availed portion (Rs.60 lakh) will attract a risk
weight as applicable to the counterparty / rating.
In compliance of the new guidelines banks have advised all the branches for:
i) Insertion of Limit Cancellation Clause in loan documents
ii) Levying of Commitment Charges

VaR (Value at Value at Risk is how much can we expect to lose? What is potential
Risk) loss?
We can lose maximum up to VaR (value at Risk) over a given time at a
given confidence level.

Calculation of VaR
Market Factor Sensitivity X Daily Volatility X Probability at given
confidence level

75
 Suppose impact of 1% change of interest rate (Price) = 6000/-
Daily Volatility = 3% : Confidence level is 99%
Probability of occurrence at 99% confidence level is 2.326
Defeasance period = 1 day
VaR = 6000x3x2.326 = 41874/-
Duration and Duration is the time that Bondholder must wait for a number of years
Modified (duration) to receive Present Value of Cash Inflows i.e. period in which
Duration PV of Cash Inflows equals Actual Cash outflows..

Formula of calculating Duration (Macaulay‘s Duration)

∑ ( PV*T) / ∑PV

For example:
5 years bond of Rs. 100 @ 6% Coupan rate and gives Duration of 3.7
years. It means Total Cash flow of Rs. 130/- would be equivalent to
receiving Rs. 130/- at the end of 3.7 years.
Modified Duration = Duration / 1 + Yield
CREDIT RISK Fixed Assets : 500 Crore Govt. Securities : 5000 crore
How to find Standard Assets
Risk Weighted Retail ---3000 crore
Assets? HL (Less than 30 lakh & LTV above 80%) -------2000 crore
Other loans—10000 cr
Sub-Standard Assets
Secured ----500 crore Unsecured -----150 crore
Doubtful (DAI) --------------------------------800 crore

Solution:
Retail----------------3000*75/100 = 2250 crore
HL---------------------2000*50/100=1000 crore
Other loans---------10000*100/100 = 10000 crore
Gsec------------------5000*0/100=0
SS Secured----------500*150/100=750 crore
SS Unsecured ------150*100/100=150 crore
Doubtful D1 --------800*100/100=800 crore
Total RWAs = 2250+1000+10000+750+150+800 = 14950 crore
OPERATIONAL
RISK Ist year 2nd year
How to find Net Profit 120 crore 150 crore
Risk Weighted Provisions 240 crore 290 crore
Assets? Staff Expenses 280 crore 320 crore
Other Oper. 160 crore 240 crore
expenses
Gross Income 800 crore 1000 crore
Average Income 1800/2=900 crore
Capital Charge 900*15/100=135 crore
RWAs (assuming Capital Charge/8% = 135*100/8 =
BASEL rate of 8%) 1687.50 crore

76
Capital Charge LC within Retail portfolio -------------------1000 crore (AAA rated
on Off Balance securities)
Sheet Items Standby LC (As Financial Guarantee)-----500 crore (A rated Co.)
How to find Standby LC –particular transaction-------200 crore (AA rated Co)
Risk Weighted Performance Bonds & Bid bonds---------1000 crore (Unrated Co.)
Assets? Financial Guarantees------------------------400 crore (AA rated Co.)
Confirmed LC for Imports------------------100 crore (AAA rated Co.)
Off Balance Sheet CCF Adjusted RWAs
Exposure Exposure
LC Retail Portfolio 20% 1000*20% = 200 200 *20%
(AAA rated) crore =40 crore

Standby LC (As 100% 500*100% = 500 500*50%

Financial Guarantee) crore =250 crore
(A rated)
Standby LC – 50% 200*50%=100 100*30%
particular transaction crore =30 crore
(AA rated)
Performance Bonds 50% 1000*50%=500 500*100%
& Bid bonds crore =500 crore
(Unrated)
Financial Guarantees 100% 400*100%=400 400*30%
(AA rated) crore =120 crore
Confirmed LC for 20% 100*20%=100 20*20%
Imports crore 4 crore
Total RWAs 40+250+30+500+120+4=944 crore
Capital Required = 944 *9%= 84.96 crore
Tier-I and Tier II RWAs --- Credit Risks = 14000 crore
Capital RWAs ----Market Risk =2000 crore
CRAR RWAs ----Operational Risks = 3000 crore
(As per BASEL- Tier –I Capital
BASEL-II Paid up Capital--------------------------------------------- 100 crore
guidelines) Free Reserves ---------------------------------------------300 crore
Perpetual non-Cumulative Preference Shares -----400 crore

Tier-II Capital
Provisions for contingencies ---------------------------200 crore
Revaluation Reserve--------------------------------------300 crore
Subordinate Debts-----------------------------------------300 crore

Solution
Tier –I Capital = 100+300+400 = 800 crore
Tier-II Capital = Provisions 200 crore (Max 1.25% of Credit RWAs i.e.
175 crore)+ ( Revaluation Reserves @ discount of 55% i.e.
300*45/100) + Subordinate Debts i.e. 300 crore
=175 + 135 + 300 = 610 crore
Total Capital = 800 + 610 = 1410 crore
CAR = 1410/19000*100 = 7.42 %

77
How Tier –I Capital = 100+300+400 + 135 ( 300*45/100) = 935 Crore
calculations will Tier-II Capital = 175 (1.25 % of Credit RWAs or Rs. 200 crore) +300 =
be made under 475 Cr
BASEL-III Total Risk Weighted Assets = 19000
Capital Adequacy Ratio = Tier-I + Tier-II/ RWA = 1410/19000 = 7.42%

Minimum CET-I (5.5% of RWAs) = 19000*5.5% = 1045 Cr

Maximum AT-I (1.5% of RWAs) =19000*1.5% = 285 Cr
Minimum Tier-I Capital Ratio = 19000*7% = 1330 Cr
Maximum Tier-II Capital = 19000*2% = 380 Cr
CCB required in the shape of Tier-I = 19000*2.5%= 475 Cr

Practical Examples
Ex.1
If daily volatility of a Security is 2%, how much will be monthly volatility?
Solution
Monthly volatility = Daily Volatility * ∫30 = 2*∫30 = 2*5.477 = 10.95% Ans
Ex.2
If per annum volatility is 30% and nos. of trading days per annum be 250, how much will be
daily volatility?
Solution
Annual Volatility = Daily Volatility * ∫250 = Daily Volatility * 15.81
30 = Daily Volatility *15.81
Daily volatility = 30/15.81 = 1.90% Ans.
Ex.3
If 1 day VaR of a portfolio is Rs. 50000/- with 97% confidence level. In a period of 1 year of
300 trading days, how many times the loss on the portfolio may exceed Rs. 50000/-.
Solution
97% confidence level means loss may exceed the given level (50000)on 3 days out of
100.
If out of 100 days loss exceeds the given level on days =3
Then out of 300 days, loss exceeds the given level = 3/100*300 =9 days. Ans.
Ex.4
A 5 year 5% Bond has a BPV of Rs. 50/-, how much the bond will gain or lose due to
increase in the yield of bond by 2 bps
Solution
Increase in yield will affect the bond adversely and the bond will lose.
Since BPV of the bond is Rs. 50/-. Increase in yield by 2 bps will result into loss of value of
Bond by 50*2=100.
Ex.5
1 day VaR of a portfolio is Rs. 50000/- with 90% confidence level. In a period of 1 year (250
days) how many times the loss on the portfolio may exceed Rs.50000/-

Ans. 90% confidence level means on 10 days out of 100, the loss will be more than Rs.
50000/-.
Out of 250 days, loss will be more than 50000/- on 25 days Ans. It means, out of 250
days, loss will not exceed on 225 days.

78
Ex.6
Given;
RWAs for Credit and Operational Risks 1200 Cr
RWAs for Market Risks 100 Cr
Common Equity Tier-I Capital 85 Cr
CCB 25 Cr
PNCPS/PDI 35 Cr
Eligible PNCPS/PDI 21.25 Cr
Eligible Tier-I Capital 106.25 Cr
Tier-II Capital available 25 Cr
Tier-II Capital Eligible 28.33 Cr
Excess of AT-I eligible for Tier-II 3.33 Cr.
Total eligible Capital 134.58

Q. Minimum Common Equity CET-I Capital to support Credit and Operational

Risks
Ans. 1200*5.5% = 66 Crore
Q. Max Additional Tier-I (AT-I) capital to support Credit and Operational Risks
Ans. 1200*1.5% = 18 Crore
Q. Maximum Tier-II Capital to Credit and Operational Risks
Ans. 1200*2% = 24 Crore
Q. Total Capital to support Credit and Operational Risks
Ans. 66+18+24 = 108 Crore
Q. Minimum CET-I available to support Market Risks
Ans. 85-66 = 19 Crore
Q. Maximum AT-I to support Market Risks
Ans. 21.25 – 18 = 3.25 Crore
Q. Maximum T-II Capital within total to support market risks
Ans. 28.33 – 24 = 4.33 Crore
Q. Total Eligible Capital to support Market Risks
Ans. 19+3.25+4.33 = 26.58 Crore

Ex.7

PCR Bank has investment in Bonds as on 30.09.2013 as under:

Face Value Yield Price Cost
9% GOI 2000 8.40 107.60 215200
Bonds
11% GOI 2000 8.80 110.50 221000
Bond
Position as on 31.3.2014 is as under:
Face Value Yield Price
9% GOI 2000 8.20 109.80 219600
Bonds
11% GOI 2000 8.60 113.30 226000
Bond

79
 1. Find out change in Basis Point Value of Bond for 1 basis point
change in yield for 9% GOI Bonds

BPV = Difference in Market Price / Difference in Yield

=(109.80-107.60) / (8.40-8.20) = 2.20 / 20 = 11 paisa per Basis Point

2. Find out Price of 9% Bonds, if there is decrease in yield by 100

bps

Change in price for 1 basis point change in yield = 11 paisa

Change in price for 100 basis point change in yield = .11*100 = 11 Rupees---Ans
Price of Bond will increase by Rs. 11/-

3. Profit, if 9% Bonds are sold on 31.3.2014

Market Price – Cost

219600- 215200 = 4200/-

LATEST GUIDELINES
Treatment of Revaluation reserves :
Revaluation reserves arising out of change in the carrying amount of a bank‘s property
consequent upon its revaluation may, at the discretion of banks, be reckoned as CET1
capital at a discount of 55%, instead of as Tier 2 capital

Treatment of deferred tax assets (DTAs)

 Deferred tax assets (DTAs) associated with accumulated losses and other such
assets should be deducted in full from CET1 capital.
 The amount of DTAs which are to be deducted from CET1 capital may be netted
with associated deferred tax liabilities (DTLs) provided that:
 The amount of DTAs which is not deducted from CET1 capital (in terms of para
(ii) above) will be risk weighted at 250% as in the case of significant investments
in common shares not deducted from bank‘s CET1 capital.

80
 LCR & NFSR under Basel-III

Liquidity Coverage Ratio is a new concept adopted under BASEL-III. It aims at

ensuring that banks have sufficient High Quality Liquid Assets to survive an acute stress
scenario lasting for 30 days. LCR will be implemented in a phased manner from
1.1.2015 and its 100% implementation will be up to 1.1.2019.
It will be applicable on Indian banks on standalone basis including foreign branches. In
foreign banks, framework to be applicable for Indian operations only.

HQLA (High Quality Liquid Assets)

These are assets which can be easily converted into cash with no loss or little loss of
value. There are two categories:

1 Level-1 These are included in HQLA without any limit or haircut.

Assets: Following are Level-1 assets:
 Cash including Cash reserves in excess of CRR.

 Govt. securities in excess of minimum SLR requirement.

 Marketable securities issued/guaranteed by foreign

sovereigns with zero risk weight

2 Level 2 Assets These are included in HQLA subject to maximum 40% of

overall stock of HQLA after applying haircut. Level-2 assets are
further divided in 2 parts:
Level-2A assets are included after applying 15% hair cut. The
examples of these assets are:

 Marketable securities guaranteed by sovereigns/PSEs

with 20% Risk Weight.

 Corporate bonds whose valuation is readily available

with AA rating or above

 Commercial Papers not issued by banks/PDs/FIs with

minimum AA rating

3 Level- 2B These are included in HQLA after applying 50% haircut. These
assets should comprise not more that 15% of total HQLA. The
examples of these assets are:
 Marketable securities guaranteed by sovereigns/PSEs
with Risk Weight above 20% up to 50%.

 Common Equity shares not issued by banks/FIs/NBFC/

and included in Nifty/Sensex index

81
How to calculate LCR
Ist. Step—Total Level 1 Assets (100% factor)
2nd step---Total Level 2A Assets (85% factor)
3rd Step---Total Level 2B Assets (50% factor)

HQLA= Level 1 Assets + Level-2A Assets + Level 2B Assets – Adjustment of 15% Cap –
Adjustment of 50% Cap

Total NET Cash flow = Expected Cash Outflow - Expected Cash Inflow for subsequent
30 calendar days.

LCR (Liquidity Coverage Ratio) = Stock of HQLA

Total net cash outflow over next 30 days

> 100%

Concept of Tier – III Capital (Not applicable in India)

Banks may at the discretion of the National Authority, employ 3rd tier of Capital
consisting of short term subordinate debts for the sole purpose of meeting a proportion
of capital requirements for market risks. Tier III capital will be limited to 250% of bank‘s
Tier –I Capital (Minimum of 28.5%) that is required to support market risks.

RATING OF BANKS
Banks are rated on a 5 point scale known as CAMELS as under:
C Capital Adequacy Ratio
A Asset Quality
M Management Effectiveness
E Earnings
L Liquidity
S System and Control

Foreign banks are rated as under:

C Capital Adequacy Ratio
A Asset Quality
L Liquidity
C Compliance
S System and Control

PCA (prompt Corrective Action)

It relates to taking corrective action promptly where bank faces weakness in respect of
CAR, Net worth or profits. Follwing are the Trigger Points:
CAR (Capital Adequcy Ratio) Less than 9%
Non Performing Assets Net NPAs over 10%
Return on Assets Below 0.25%

82
 NSFR (Net Stable Funding Ratio)

It aims at promoting medium to long term structural funding of assets and activities of the
banks. RBI proposes to make this ratio applicable to banks in India from 1.1.2018. The
objective of this ratio is to ensure that banks maintain stable funding profile for their
assets and off balance sheet items.

Available Stable Funding (ASF) X100 = 100% and above

Required Stable Funding (RSF)

Long-term or "structural term assets" means RSF (Required Stable Funding)

Assets with Zero RSF Factors
Assets assigned a 5% RSF factor
Assets assigned a 15% RSF factor
Assets assigned a 50% RSF factor
Assets assigned a 65% RSF factor
Assets assigned an 85% RSF factor
Assets assigned a 100% RSF factor
Cash, Bank Balance and Balance with
RBI
Level 1 assets as defined in LCR
Level 2A assets as defined in LCR
Level 2B assets as defined in LCR
residential mortgages with a residual
maturity of one year or more that would
qualify for a 35% or lower risk weight
Other unencumbered performing loans
that do not qualify for the 35% or lower
risk weight under and have residual
maturities of one year or more.
100% of loans longer than one year

Available Stable Funding (ASF)

Liabilities and capital instruments receiving a 100% ASF

 The total amount of regulatory capital and Total amount of any capital instrument
not included that has an effective residual maturity of one year or more .
 The total amount of secured and unsecured borrowings and liabilities (including
term deposits) with effective residual maturities of one year or more.

Liabilities receiving a 95% ASF factor

 Stable Term deposits with residual maturities of less than one year provided by
retail and small- and medium-sized entity (SME) customers.

Liabilities receiving a 90% ASF factor

 Less Stable Term deposits with residual maturities of less than one year provided
by retail and SME customers.

Liabilities receiving a 50% ASF factor

 Funding (secured and unsecured) with a residual maturity of less than one year
provided by non-financial corporate customers;
 Operational deposits
 Funding with residual maturity of less than one year from sovereigns, public
sector entities (PSEs), and multilateral and national development banks; and

83
  Other funding (secured and unsecured) not included in the categories above with
residual maturity of not less than six months and less than one year, including
funding from central banks and financial institutions.

Net Stable Funding Ratio =

Available Stable Funding (ASF) X100 > 100% i.e. 100% and above
Required Stable Funding (RSF)

84
MODULE - C

Treasury Management

2020
 Treasury

Concept of Treasury
It deals with short term fund flow (i.e. Securities with up to 1 year maturity) except part of SLR
requirement. Previously, Liquidity Management was main function of Treasury. But now, it
includes all Trading and Investment activities in financial markets.

 Treasury has become profit center for all the banks

 It also plays important role in ALM (Asset Liability Management)

Functions of Integrated Treasury

Integrated Treasury refers to integration of the following:

1. Money Market
2. Security Market or Capital Market
3. Forex Market

Why Treasury has become so important

 Rupee is freely convertible on account of Current Account transactions. In Capital

account transactions, it is convertible to a larger extent. Therefore, banks are free to
operate in FDI, ECB and ODI.
 Banks source funds from Global markets and invest in Domestic currency or vice versa.
 Banks invest in Equity and Debt Market.
 Use of Derivatives with reference to forex market as per requirement of our corporate
customers.

Role of Treasury

 Liquidity Management : Managing short term funds besides maintaining CRR and SLR
 Proprietary Positions: Trading in Currencies, Securities and other financial instruments
including Derivatives.
 Risk Management: Bridging Asset Liability mismatches and managing Risks through
Derivative tools.

Treasury Manages 3 books:

1. ALM Book
2. Merchant Book
3. Trading Book

ALM book deals with Internal Risk Management. Merchant Book deals with Client related
Derivatives. Trading Book deals sales and purchase of financial instruments for bank itself.

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Globalization and Growth : Rapid Economic growth is not possible without free capital flows
i.e. Overseas Companies invest in India and Domestic Companies invest outside India.
Exchange of technology and human resources has been made possible only after liberalization
after 1990.

Overseas operations of a bank include Portfolio investment,

 Direct Investment,
 ECB
 Issue of Equity and Debt Capital in Global market
 Mergers and Acquisitions
 Payment of technology, and
 Receipt of Interest, fees and dividend etc.

RBI has permitted large movement of capital though

 Automatic route
 Approval Route

Impact of Globalization

1. Interest rates are influenced by global trends

2. Exchange rates become volatile and affect GDP as well as Markets of Stock and
Commodity.
3. Institutional Structure has changed. SEBI, IRDA, CCIL, NSDL and CIBIL have come up.
4. There is widespread use of Swaps, Forwards and Options.
5. Rupee Derivatives are also available in the market.

Banks can Borrow and Invest Outside India through Overseas Correspondents in Foreign
Currency up to 100% of Tier–1 Capital or USD 10 Million (whichever is higher)

Treasury as Profit Centre Due to following:

1. Inter- bank market is free from Credit risk and requires little capital allocation.
2. Treasury activity is highly leveraged. The risk ranges from 2% to 5%.
3. Operational costs are low.

Sources of Treasury Profit

1. Forex Business
 Buy Low and Sell High
 Position is generally squared on daily basis.
 Stock of currency is not generally kept.
 Overbought and Oversold is called ―Open Position‖

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 2. Money Market
Banks lend surplus funds in Money Market and borrow the same when required. Interest
is earned.
3. Investment in Govt. Securities and Other Securities
Treasury profit is earned by investment in G-sec and other securities in Debt and Equity
Market.
4. Interest Arbitrage
If interest rates are in favour, banks borrow from centers having low rate of interest and
lend at other centers where rate of interest is high. This is called Arbitrage.
5. Trading in market
It is speculative activity. Banks trade in securities and currencies. Swap transactions are
also done to increase profits of the bank.

Organization Structure

In every bank, General Manager is CTO (Chief Transaction Officer) who reports direct to CEO.
There are four sections at HO:

1. Dealing Room : Chief Dealer is Head. There are separate dealers for Forex Operations,
Money market operations and Security Operations. For corporate, separate dealer is
appointed who deals with securities in Secondary as well as Primary market.
2. Mid-Office: It provides MIS, implements Risk Management system and monitors
exposure limits and Stop Loss Limit.
3. Back Office: This office is responsible for verification and settlement of deals,
confirmation of deals with counterparts, book-keeping of all deals and Maintaining
Nostro accounts.
4. Investment Office: This office deals with Primary Issues . Minimum marketable
Investment is Rs. 5.00 crore.

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 Treasury Products

Treasury Products are of 3 types:

 Products of Forex Market

 Products of Money Market
 Products of Security Market

Forex Market Products: It is virtual market without boundaries, highly volatile and liquid and
most transparent. It includes the following products.

1. Spot Trades: Currencies are generally bought and sold at spot rates when payment and
settlement takes place on 2nd working day. Cash and Tom rates are quoted at discount
from Spot rate.
2. Forward Trades : Purchase or sale of currency at future rates. Exchange takes place
after few days/months. Importers and Exporters cover risks by Forward trades. Forward
rates are arrived at on the basis of interest rate differentials of two currencies.
3. Swaps: Foreign Exchange transactions where one currency is sold and purchased for
another simultaneously is called Swap. Swap Deal may involve: Simultaneous purchase
of spot and sale of forward or vice versa. It may also involve Simultaneous sale and
purchase, both forward but for different maturities. It is called ―Forward to Forward
Swap‖.
4. Investment in Foreign Currencies: If forex is surplus with bank, it makes investment.
Surplus arises from profits of treasury business, overseas operations, forex borrowings,
NRE, FCNR and EEFC deposits. Investment can be of following 3 types:
 Interbank loans- normally not more than 1 year
 Short term investments in T-bills and CPs issued by multinational agencies
 Some Correspondent banks offer automatic investment facility in Nostro
Accounts subject to minimum balance.
5. Foreign Currency Loans: Banks extend WC loans in foreign currency and for this
purpose, clearance of Treasury is required.
6. Rediscounting of Foreign Bills : Treasury refinances the Foreign currency bills
purchased/negotiated by another bank. The advance covers Usance period 15-360
days.

Money Market Products : Money market products relate to raising and deploying short
term resources with maturity Maximum 1 year. The money market products are:

1. Call Money: It refers to Overnight placement. It needs to be repaid on Next Working

Day. O/N MIBOR Rate is the indicative rate. Non bank players (FIs/MFs) are not
eligible to participate.

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 2. Notice Money: It is placement of funds beyond overnight up to maximum period of
14 days.
3. Term Money: It deals with placement of funds in excess of 14 days up to 1 year.
1 to 6 month products are very common.

 Banks can borrow in Call Money Market up to 100% of Capital on daily

average basis. But during any day in previous fortnight, the borrowing can be
up to 125%. Banks can lend also in call money market up to 25% of capita
on daily average basis l. On any day, this cap is 50% of Capital funds.
 Cooperative banks can borrow up to 2% of their aggregate deposits. For
Lending, there is no limit.
 PDs are allowed to borrow up to 225% of their Net Owned Funds whereas
lending limit is 25% of Net Owned Funds.

Other Money Market Products:

1. Treasury Bills:
 These are issued by Govt. of India through RBI in denomination of 1.00 lac and
further in multiples.
 Tenure is 91Days, 182 Days and 364 Days.
 These are issued at Discount in auction.
 Banks and PDs participate in the auction.
 The auction is also available to all financial players (FIs/MFs/Corporate).
 Auction takes place on Wednesday every week in case of 91 days bills.
 It takes place on Wednesday every Fortnight in case of 182 D and 364 D bills.

2. Commercial Papers & 3. Certificates of Deposits

CP and CD Commercial Papers – CP:

 CP is issued by Corporate with Net Worth minimum 4
Crore, Rating min. A3 and availing WC limit from any
bank.
 CP is issued with tenure 7 Days to 1 year.
 CP is issued in multiples of Rs. 5.00 lac
 CP is Promissory Note and is Negotiable and also attracts
Stamp Duty.
 It is fairly active in Secondary market.
 It is in Demat form and the price is less than Face Value.
Certificate of Deposit – CD
 CD is issued by banks
 CD is issued with tenure 7 Days to 1 year.
 CD is issued in multiples of Rs. 1.00 lac.
 CD is Promissory Note and is Negotiable and also attracts
Stamp Duty.
 CD is not very active in Secondary market.
Both are Zero Coupon Bonds always issued at discount.

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  CD can be issued by FIs for 1-3 years.

Practical Example: How to calculate Issue price of CP (Face Value Rs. 100) carrying
maturity of 1 year. Rate of return in the market is 10%

Present Value = Future Value / 1+r

= 100/1.10
= 90.90
 What will be annualized yield of a treasury bill with face value of Rs. 1.00 lac with
maturity after 85 days and is being traded at Rs. 98000/-.

Annualized Yield = Face Value – Maket Price *365/85

Market Price

= (100000-98000) *365/85
98000
=2000*365/85 = 0.0876 = 8.76%
98000
3. LAF – Repo and Reverse Repo (Repurchase Option)
It is Lending and Borrowing money for short term period (1 day to 1 year)
Under Repo, RBI purchases securities with commitment to sell at a later date in order to
Inject Liquidity. Presently, Govt. securities are dealt with. All Repo transactions are
routed through CCIL. RBI has permitted Repo in Corporate securities for only ―AA‖ rated
companies. But the market is yet to be activated.
Under Reverse Repo, RBI sells securities with a commitment to buy at a later date in
order to Contain Liquidity.
Repo and Reverse Repo transactions are generally conducted for Overnight period
through Auction Twice Daily. The minimum Bid is Rs. 5.00 crore and its multiples.
Margin is normally 5%. Margin is called Hair cut.

Latest Repo Guidelines as per Monetary policy dt. 3.6.2014

 Cap of Overnight Repo reduced from 0.5 % to 0.25% of NDTL

 Continuation of Term Repo up to 0.75% (cap) of NDTL under 7 days to 14 days
term repos.

4. CBLO : Collateralized Borrowings and Lending Obligations:

It is money market instrument launched by CCIL. Borrower can deposit G-sec with CCIL
and borrow funds from others who have surplus funds subject to re-purchase of
securities. The tenure is 1 day to 1 year.

Borrowing Limits in Money Market

Participant Borrowings up to Lending up to

Scheduled Commercial 125% of Capital funds 50% of Capital funds
Banks (Fortnightly average not to (Fortnightly average not to
exceed 50% of capital funds) exceed 25% of capital funds)

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Co-operative Banks 2% of their aggregate deposits No limit
of March prev. year
Primary Dealers 225% of Net Owned Funds of 25% of Net Owned Funds
March prev. year

CMB (Cash Management Bills)---These are new short term instruments (With maturity less
than 91 days) issued by Govt. to meet short term cash flow mismatches. CMB is just like a
Treasury Bill. The tenure of the bill depends upon short term requirement of Govt. The bills are
issued at a discount through auction through press release. Investment in CBM by SCBs qualify
for statutory requirement of SLR.

Security Market Products

Securities constitute Shares, Debentures, Bonds, and Govt Securities etc. The various types of
securities are:

1. Govt. Securities
 These are issued by PDO (Public Debt Office) of RBI.
 Price is determined in auction
 There is active trading in Secondary market.
 If Yield rate is more than coupon rate, these are issued at a discount.
 Open Market Operations are conducted by GOI to maintain liquidity position.
 SLR requirements are met by banks by investing in HTM securities.
2. Corporate Debt Papers
 These are medium and long term Bonds and Debentures issued by Corporate
and FIs.
 These are non-SLR securities.
 These form part of Tier –II Capital.
 Yield is more than that of Govt. Securities.
3. Debentures and Bonds: Both are Debt instruments and form part of Tier-II Capital.
SEBI has control over issuance and redemption.
Debenture Bond
Issued by Corporate in Private sector Issued by institutions in Public sector
It is Secured by Floating charge It is not secured
Provisions of Company Law applies It is governed by Indian Contract Act
It can be transferred through registration It is negotiable instrument
It can be convertible or non-convertible  Bond, if given option can be
convertible into equity shares.
It can be
Zero Coupon Bond, Perpetual Bond,
Floating Bond, Deep Discount & Converible
Bond
Masala Bonds: IFC issued Masala Bonds in International markets to fund Infrastructure
projects in India in 2014. These are rupee denominated.

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Green Bonds: Exim Bank issued Green Bonds to fund green projects in India in 2015. This
was India’s first Dollar denominated Bond.

4. Equities: It is Share Capital issued by both Private sector and Public sector Companies
to raise funds from public. The people who invest are called Shareholders:
 Bank can invest subject to limit exposure set by RBI for Capital Market
 SEBI has full control and these are traded in Stock Exchanges.
 Derivative products are also available.
 If offered by Company, it is called Primary Market. If purchased through Stock
Exchanges, it is called Secondary market.

Equity Share Preference Share

It is permanent capital and is not It may be redeemable or non-redeemable.
redeemed. It forms part of Tier-I Capital. If redeemable, forms part of Tier-II Capital
Dividend is paid out of profits after making Preference is given while paying dividend.
payment to Preference Share-holders. Unpaid dividend can be carried forward.
This is why these are called Cumulative
Preference shares.
The Company, if liquidated, pays to Equity Preference Shares are given preference
Shares at last. for payment at the time of liquidation.
These carry Voting Rights. These don’t carry Voting rights.
Generally Preference Shares are
Cumulative and Redeemable.
Domestic and Global Markets Rupee is fully convertible on account of Current Account
transactions and partially on account of Capital Account transactions. Interaction between
Domestic and Global markets takes place in respect of following:

1. FII Investments: These are made by way of FDI (Foreign Direct Investments) and
Portfolio Investments. FDI is for Long term Project related investment whereas Portfolio
Investment related to Investment in Equity and Debt Market. In some areas, FDI is 100%
whereas it is up to 74% in other areas.

2. ADR/GDR
American Depository Receipts are Receipts or Certificates issued by US Banks
representing specified number of shares of non-US Companies.

Global Depository Receipt is a Dollar denominated instrument which is traded in

European Markets but represents Securities of non-European Companies.

3. ECB (External Commercial Borrowings

ECBs – External Commercial Borrowings

External Commercial Borrowings (ECBs) are loans in India made by non-resident

lenders in foreign currency to Indian borrowers. They are used widely in India to facilitate
access to foreign money by Indian corporations and PSUs (public sector undertakings).

93
Revised ECB guidelines: The salient features of the new framework are as under:

Merging of Tracks: Now, there will be two tracks as under:

1. Foreign Currency denominated ECB

2. Rupee Denominated ECB

Eligible Borrowers: This has been expanded to include all entities eligible to receive
FDI. Additionally, Port Trusts, Units in SEZ, SIDBI, EXIM Bank, registered entities
engaged in micro-finance activities, viz., registered not for profit companies, registered
societies/trusts/cooperatives and non-government organizations can also borrow under
this framework.

Recognized Lenders: The lender should be resident of FATF or IOSCO compliant

country. Multilateral and Regional Financial Institutions, Individuals and Foreign
branches / subsidiaries of Indian banks can also be lenders.

Forms of ECB
Loans including bank loans, floating/ fixed rate notes/ bonds/ debentures, Trade credits
beyond 3 years; FCCBs; FCEBs and Financial Lease.

Minimum Average Maturity Period (MAMP):

ECBs in general 3 years

ECBs raised from foreign Equity Holders 5 years

and utilized for specific purpose

ECBs up to 50 Million USD per financial year 1 Year

by Mfg. Sector

All in Cost Ceiling

Benchmark rate (6 M LIBOR Rate) + 450 bps

End-uses (Negative list) The negative list, for which the ECB proceeds cannot be
utilized, would include the following
a) Real estate activities.
b) Investment in capital market.
c) Equity investment.
d) Working capital purposes except from foreign equity holder.
e) General corporate purposes except from foreign equity holder.
f) Repayment of Rupee loans except from foreign equity holder.
g) On-lending to entities for the above

Limit and leverage

 All eligible borrowers can raise ECB up to USD 750 million or
equivalent per financial year under auto route.
 Further, in case of FCY denominated ECB raised from direct foreign
equity holder ECB liability-equity ratio for ECBs raised under the
automatic route cannot exceed 7:1. However, this ratio will not be

94
 applicable if outstanding amount of all ECBs, including proposed one,
is up to USD 5 million or equivalent.
 Issuance of Guarantee, etc. by Indian banks and Financial
Institutions: Issuance of any type of guarantee by Indian banks, All
India Financial Institutions and NBFCs relating to ECB is not
permitted.
 ECB framework is not applicable in respect of the investment in
Non-Convertible Debentures in India made by Registered Foreign
Portfolio Investors.
 Loan Registration Number (LRN): Any draw-down in respect of an
ECB should happen only after obtaining the LRN from the Reserve
Bank.
 AD Category-I banks are permitted to allow Startups to raise ECB
under the automatic route with minimum average maturity period will
be 3 years. The borrowing per Startup will be limited to USD 3 million
or equivalent per financial year either in INR or any convertible foreign
currency or a combination of both.
 In case of FCY denominated ECB, companies are required to
mandatorily hedge 70 per cent of their ECB exposure in case average
maturity of ECB is less than 5 years.

4. Foreign Currency Funds of Banks

Banks can use FCNR deposits for the purpose of Investing outside India as well as for
domestic lending in foreign currency. They are also permitted to borrow/invest in
overseas market within a ceiling of 100% of Unimpaired Tier –1 Capital with minimum
USD10 million.
5. ODI (Overseas Direct Investment)
Corporate can invest in Joint Venture/Subsidiary units outside India from Rupee
resources subject to cap of 4 times of Net worth i.e. 400% of Net worth.
This way, Indian Companies can have global presence.

Any financial commitment exceeding 1 billion USD in a financial year would require prior
permission of RBI even within overall limit of 400% of Net Worth.
It has been decided that Proprietorship concerns and Unregistered Partnership firms can
also participate in ODI up to 10% of average export realization of previous 3 years or
200% of Net Owned funds of the firm provided:
1. It is Status Holder Exporter and KYC compliant
2. It has proven track record i.e. exports outstanding does not exceed 10% of average
export realization of previous 3 years.
3. There is no adverse notice of any govt. agency.

LRS (Liberalized Remittance Scheme)

The scheme is meant for Resident Indians individuals. They can freely remit up to USD
250000 per financial year in respect of any current or capital account transaction without
prior approval of RBI. The precondition is that the remitter should have been a customer
of the bank for the last 1 year. PAN is mandatory.
Not Applicable
 The scheme is not applicable for remittance to Nepal, Bhutan, Pak, Mauritius or
other counties identified by FATF.

95
  The scheme is not meant for remittance by Corporate.
Latest Guidelines
 The scheme should not be used for making remittances for any prohibited or
illegal activities such as margin trading, lottery etc., as hitherto.
 Resident individuals have now been allowed to set up Joint Ventures (JV) /
Wholly Owned Subsidiaries (WOS) outside India for bonafide business activities
outside India within the limit of USD 250000
 The limit for gift in Rupees by Resident Individuals to NRI close relatives and
loans in Rupees by resident individuals to NRI close relatives shall accordingly
stand modified to USD 250000 per financial year.
 PAN No. is compulsory for all transactions irrespective of amount.
RBI has clarified that Scheme can now be used for acquisition of IP (Immovable
Property) outside India.
.
MSF – Marginal Standing Facility
The banks will use Marginal Standing Facility to borrow overnight money from RBI only
when they have exhausted all other existing channels like Collateralized Borrowing and
Lending Obligations (CBLO) and Liquidity Adjustment Facility (LAF). The features of the
scheme are as under:
 The eligible entities can avail overnight, up to 2% of their respective
NDTL outstanding at the end of the 2nd preceding fortnight.
 For the intervening holidays, the MSF facility will be for one day except on
Fridays when the facility will be for 3 days or more, maturing on the
following working day.
 The facility is available on all working days in Mumbai, excluding
Saturdays between 3.30 P.M. and 4.30 P.M.
 Requests will be received for a minimum amount of Rs. One Crore and in
multiple of Rs. One Crore thereafter.
 MSF will be undertaken in all SLR-eligible transferable Government of
India dated Securities/Treasury Bills and State Development Loans
(SDL).
A margin of 5% will be applied in respect of GOI dated securities and Treasury Bills. In
respect of SDLs, a margin of 10 per cent will be applied.

FDI (Foreign Direct Investment)

Foreign direct investment (FDI) is a direct investment into production or business in a

country by an individual or company in another country, either by buying a company in
the target country or by expanding operations of an existing business in that country.
Foreign direct investment is in contrast to portfolio investment which is a passive
investment in the securities of another country such as stocks and bonds.

FDI Limits in different sectors are as under:

%age of Net Owned
Capital
Civil Aviation & Domestic Airlines 100%
Railways, Construction, Mining of Gold 100%
and Silver
Retail Single brand 100% by FIPB
Courier Service, Electricity & Power 100%

96
 Foreign Banks in wholly owned 100%
subsidiary
Telecom, Education, RE, NBFC, Films, 100%
Hotel & Tourism Sector
Private Sector banks 74%
Credit Information Companies, Coal, 74%
Airports, Direct to Home, Mining of
Diamond
Retail- Multi brand & Trading 51%
Defense Sector 49%
Insurance Sector 49%
Power Exchanges & Stock Exchanges 49%
Public sector Banks 20%
 A citizen/Entity of Pakistan may participate in FDI with prior approval of
Government.
ODI It has now been decided:
(Overseas
Direct a) To restore ODI up to 400% of Net Worth. Any financial
Investment ) commitment exceeding 1 billion USD in a financial Year would
require prior approval of RBI even within overall limit of 400% of
Net worth.

b) Any ODI in excess of 400% of the net worth shall be considered

under the Approval Route by the Reserve Bank of India.
FPIs FPIs are now allowed access to :
(Foreign  Currency futures
Portfolio  Exchange traded currency options
Investors For the purpose of hedging currency risk arising out of market value of
their exposure to Indian Debt and Security market.

UP TO USD 10 MILLION or equivalent without having to establish

existence of any underlying exposure.

Beyond USD 10 million, FPI will have to establish underlying exposure.

PRESENT RATES AT A GLANCE

Present Rate
w.e.f. 21.2.2019
Repo 5.15 %
Reverse 4.90 %
Repo
MSF 5.40 %
Bank Rate 5.40 %
CRR 4%
SLR * 18.25%

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 Funding and Regulatory Aspects

Broad Money (M3) includes currency in circulation, Demand and Time Liabilities of Banks and
Post Office SB accounts. Narrow money (M1) includes Currency in circulation, Demand
Liabilities of Banks and other deposits with RBI. M3 is 3-4 times than M1.

Money is impounded by RBI to reduce multiplier effect by means of CRR and SLR.

Cash Reserve Ratio (Presently 4% of DTL)

Banks have to maintain cash balance equal to 4% of DTL with RBI.

 There is No minimum and No ceiling limit.
 No interest is paid by RBI.
 Non-maintenance of CRR attracts penalty @ 3% above Bank rate on 1st day and 5%
above bank rate from 2nd day.
 It is calculated as fortnightly average.
 However daily cash balance should not fall below 90% of the amount required.

Statutory Liquidity Ratio (Presently 19.25% of DTL)

Banks have to maintain liquid funds in the form of cash, gold and un-encumbered Govt.
securities @19.25 % of DTL.
 There is no floor limit. However, ceiling limit is 40%.
 Non-compliance attracts penalty @ 3% above Bank rate on Ist day and 5% above bank
rate from 2nd day. It is computed as on last Friday of 2nd preceding fortnight every month.
 RBI will reduce SLR by 0.25% every quarter commencing from 1.1.2019 till it
reaches at 18% from present rate of 19.5%.

What Constitutes DTL?

 Demand deposits (CA, SB, Margin money for LC and Overdue FDs)
 Time Deposits (FD and RD).
 Overseas borrowings
 Foreign outward remittances in transit.
 Accrued Interest and credit balance of Suspense account.
Exemptions
 Capital, Reserves and Surplus
 Net Interbank borrowings, Credit balance in ACU Dollar accounts, Transactions in
CBLO and CCIL
 Refinance from NABARD, SIDBI, NHB and RBI.
 DTL in respect of Off-shore banking units.

Payment and Settlement System

1. RTGS (Real Time Gross Settlement) is a payment system for Interbank transfer
with minimum Rs. 2.00 lac. This system is managed by IDRBT, Hyderabad, which
connects all banks to Central server maintained by RBI. The network is INFINET (Indian
Financial Network). Timings are: 7:00AM to 6:00PM (R41) and 7:00 AM to 7:45 PM (R42).

98
 2. NEFT (National Electronic Fund Transfer) is mainly used for low amount
transactions. However, there is no minimum and maximum limit. The facility is available
24X7 basis on all days in a year. There are 48 half yearly batches daily from 00:30 to 00
Hours. . The time period is B+2.
3. Negotiated Dealing System (NDS): It is an electronic platform which facilitates sale
and purchase of Govt. securities. Auctions are made and trading is done electronically.
Banks, PDs, Insurance Cos., MFs and FIs are members. Improved version of NDS
called OM (Anonymous Order matching system) takes care that identity of counter party
is not disclosed till offer is accepted.
4. FX Clear: It is Forex Dealing system developed by CCIL. CCIL provides straight
through processing (STP) between banks for USD/INR transactions and settlement in
made in Indian Rupees.
5. NSDL and CDSL: National Securities Depository Ltd. (NSDL) and Central Depository
Services India Ltd.(CDSL) provide a settlement platform for shares and other securities
in the Secondary market. These institutions also maintain Demat accounts.

NEW RTGS SYSTEM EFFECTIVE FROM 14.7.2014; Two new features have
been added:

1. Hybrid System
 Offsetting after every 5 minutes.
 The transactions with normal priority would be settled in off-setting mechanism
within maximum 2 attempts.
 Maximum time a transaction would be in normal queue is 10 minutes.
 If transaction with normal priority is unable to be settled on offsetting mode within
10 minutes, it would be automatically converted to Urgent.
2. Future Value Transactions; Value Dated transactions would enable the
customers/participants to initiate RTGS transactions 3 working days in advance for
setting in RTGS on Value Date.

UPI (Unified This is advance version of IMPS which facilitates Interbank/Within bank
Payment Payments/Collections. All accounts with same mobile number are connected.
Interface) Procedure is as under:
 Create Virtual address (VA) e.g. abc@pnb
 VA is communicated to sender and amount is remitted.
 Account Number/IFSC/MMID is not to be disclosed.
 App can be downloaded by non-customers also.
 Service is available on all days 24 hours.
Mobile Banking IMPS Immediate Payment 24 Hours service
Service
Three Types of Payments through IMPS (Max amount allowed Rs. 50000/- per day)
1. P2P (Peer to Peer) ----Interbank transfer of funds using MMID (Mobile Money Identifier)
2. P2A (Peer to Account ) -----Interbank transfer of funds using IFSC
3. P2M (Peer to Merchant) ----For e-commerce transactions
4. P2PM (Peer to Peer Merchant)

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 BHIM (Bharat Interface for Money)
Bharat Interface for Money (BHIM) is an app that lets make simple, easy and quick payment
transactions using Unified Payments Interface (UPI). It enables direct bank to bank payments
instantly and collect money using mobile number and Payment address. The application is
launched by NPCI.

Benefits of BHIM:
 Single App for sending and receiving money and making merchant payments
 Go cashless anywhere anytime
 Added security of Single click 2 factor authentication
 Seamless money collection through single identifiers, reduced risks, real time
 Mobile no. or Name used to create VIRTUAL PAYMENT ADDRESS (VPA)
 Best answer to Cash on Delivery hassle

 Send and collect using VIRTUAL PAYMENT ADDRESS (VPA) or A/c no & IFSC
 Payments through single app in your favourite language.
 24X7, 365 days instantaneous money transfer

Revised Transfer Limits (Sending and Collecting) :

1.Maximum amount is Rs. 25000/- per transaction and Rs. 50000/- per Day.
2. Maximum amount per week is Rs. 200000/- and per month is Rs. 1000000/-.
However minimum amount is Rs. .01
 There is limit of 10 transactions per account per bank.(Send money and Collect money).
 New User can initiate 5 collect requests through all his accounts linked to registered
mobile.
 There is no restriction for P2M and P2PM transactions
 There are no charges for making transaction through BHIM
 Your account need not be enabled for mobile banking to use BHIM. Your mobile
number shall have to be registered with the Bank.
 Currently, BHIM supports linking of one Bank only. At the time of account set-up,
one can link your preferred bank account as the default account. In case you want to
link another bank account, one can go to Main menu, choose Bank Accounts and
select default account.
 Visit Profile option and set virtual payment address (VPA)s (2 virtual payment
address (VPA)s are allowed per user 1. mobno@upi, 2. name@upi)
 QR code feature is available, by using Scan and Pay option send and collect money
anytime.
(Limit of P2P Collect Transaction Value : Max 5000/- per transaction)

100
 Treasury Risk Management
Why Treasury is risky?

Treasury is risky because of the following:

1. High Leverage- Value of transaction is very high say 100 crore and 1% adverse
movement may result into loss of 1.00 crore.
2. There is sole discretion of Treasury Department to sell, buy or keep open position.
3. Transactions are confirmed and irrevocable.

Risks involved in the Treasury are mainly:

 Market Risk – It consists of Liquidity risk, Exchange rate risk, Interest rate risk, Equity
risk and Commodity risk

Take an example:
We borrow from Money market and invest in 5 year G-securities. If Bond prices come
down, we are not willing to sell the bond, but loan has to be repaid. This may lead to
shortage of funds which is called Liquidity Risk.

Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at
higher rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.

Fluctuation of exchange rates due to many domestic and international factors can lead
to Currency Risk.

Risk of fluctuation in market price of Shares and Bonds is called Equity Risk whereas
Risk of Fluctuation in market price of Commodities such as Gold, Silver etc. lead to
Commodity Risk.

 Credit Risk – It is risk of default by counter party due to various reasons such as Buyer
Risk, Seller Risk, Country Risk and Sovereign Risk.

Types of Control are:

1. Organizational Control
Segregation of Front, Back and Mid office for effective monitoring and control.
2. Internal Control
Setting up of limits like Deal Size limit, Open Position limit, Stop loss limit, Day light limit
and Overnight limit

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 3. Exposure Ceiling Limit
Exposure limit of counterparty is fixed on the basis of Credit Rating. Ideally all deals
should take place DVP – Delivery Vs Payment and there is no risk. But ideal position is
not there always.
RBI has imposed a ceiling of 5% of Total Business in a year for Individual broker

Measurement of Risk

There are two methods to measure Risk:

1. Value At Risk (VaR)

2. Duration Approach

1.VaR (Value at Risk) It is statistical measure indicating worse movement of market rate
over given period of time under normal market conditions.

For example: Overnight VaR of 45 bps for USD/INR at 95% confidence level. If spot rate is
46.00, there are only 5% chances that the rate will be worse than 45.55 (46.00-0.45).

Another Example is: If Overnight VaR of 1 year G-Sec is 0.35%, the current yield of 7.75% is
expected to fall/rise not more than 0.35% by tomorrow.

 VaR is based on Volatility.

 Volatility is sd calculated from mean observations over a period of time.
 VaR is suggested for shorter period.

Practical Example:

A bank’s G-Sec portfolio has 100 day VaR at 95% confidence level is 4% based on yield. What
is worst case scenario over 25 days.

Solution:

100 days’ Value at Risk is 4%

100 days’ VaR = 1 day VaR * Square root of 100

4 = One day VaR*10

One day VaR = 4/10 = .40

25 Days’ Value at Risk = .40*√25= 2%

In worst case scenario, yield will increase and Market Value of the Bond will fall. Hence,
Answer is 2% increase in yield in 25 days.

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2. Duration or Macaulay Duration

Duration is the period during which Present Value of Outflows become equal to the Present
Value of Inflows.

Bonds carry coupon rate. If rate of return is higher than coupon rate, Value of Bond falls.
Effective rate of Bond is called Yield.

 Duration is Weighted Average measure of life of Bond where time of receipt of cash is
weighted by Present Value of Cash Flow.
 It is expressed in number of years during which PV of the bond equals the market price.

Formula is :

Duration (Macaulay Duration) =

Modified Duration = Duration

1+ Yield

Another formula is :

%age change in Price of Bond = Modified duration X Yield change

Practical Example:
A bond having duration of 8 years is yielding 10% at present. If yield increases by 0.60%, what would
be impact on price of bond.

Modified Duration = Duration/(1+Yield) = 8/(1.10) = 7.27

%age change in Price of Bond = Modified duration X Yield change
= 7.27 X (0.60%)
= 4.36% (Negative)

Ans. = -4.36% (Bond Price will fall by 4.36%

Q. A zero coupon Bond issued for 5 years. What is its duration?

Ans: 5 years (Because No interest is payable on Zero Coupan Bonds).

Q. A Bond has option to be convertible in 5 Years. What option is this?

Ans. Embedded option

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 Derivative Products

Derivatives don’t have independent value. Their value is derived from the underlying market.
The market may be financial market dealing in forex, bonds and equities as well as commodity
market dealing with underlying commodities like Gold, Silver etc.

Derivatives refer to Future Price based on Spot Market. Two types of Products are as under:

1. OTC Products
These are Over The Counter products which include Forward Contracts and Options.
These are structured and offered by Banks/FIs. These derivatives offer contracts with
date, amount of terms fixed as per requirement of the client. Price is quoted by
banks/FIs after adding margin. Settlement is made by physical delivery. Counterparty
Risk is always present.
2. Exchange Traded products
These include Futures traded on organized exchanges. Size of the contract is
standardized. Price is transparent. The exchanges collect margin based on Mark to
Market price. Physical delivery is not must. There is no counter party risk.

Types of Derivatives
1. Forward Contracts
2. Futures
3. Options
4. Interest Rate Swaps
5. Currency Swaps

Forward Contracts
It is a deal to buy or sell Shares, Commodity or Foreign Exchange at a contracted rate with
desired maturity. Forward rate is the interest rate differentiation of two currencies. If Interest
rate is high in a country, its currency will be cheaper.

Futures
It is Exchange traded product. The seller agrees to deliver a specified security, currency or
commodity on specified date at a fixed price. Currency Futures are traded in EURO, GBP, JPY,
CHF, AUD & CAD.

Forward Contract Futures

It is OTC (Over the Counter) Product It is Exchange traded product
It can be for any odd amount It is always for Standard amount
It can be for any Odd period It is always for Standard period
Delivery is essential Delivery is not must
Margin is not essential It is based on Margin requirement and
Marked to market
 Contract size of USD/INR is USD 1000. The settlement takes place in INR.
 EURO/INR/GBP is traded in cross currency rates.
 Future of INR is allowed with Contract size minimum Rs. 2.00 lac based on 7% synthetic
10 year G-Sec.

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 OPTIONS

Option is a contract to buy or sell currency, bonds or Equity on future date. The party has right
to exercise option but there is no obligation.

Option is Right to buy or sell an agreed quantity of currency or commodity without obligation to
do so. The buyer will exercise the option if market price is in favor or otherwise option may be
allowed to lapse.

There are two types of Option: 1. Call Option 2. Put Option

Call Option Right to buy at fixed price on or before fixed date.

Put Option Right to sell at fixed price on or before fixed date.

Final day on which it expires is called maturity. The pre-fixed rate is called Strike Rate.
CALL OPTION;
If Strike price is below the spot price, the option is In the money (ITM)
If Strike price is equal to the spot price, the option is At the money.(ATM)
If Strike price is above the spot price, the option is Out of money.(OTM)
PUT OPTION
If Strike price is more the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
(In India, only Europian type of options are used)

Plain Vanilla Option

It is an option without any conditions. It is ideal for Hedging.
Zero Cost Option
It does not attract any premium. There is risk of holder i.e. importer to pay higher rate if market
rises beyond certain level.
Embedded Option
The bond holder is given option to convert its debt into equity.

Other features of an Option Contract

 Option is based on Notional amount as only exchange difference is settled.
 Price of Option is much smaller than the Notional Value.
 The premium depends upon Volatility of the underlying product.
 Longer the maturity, costlier will be the option.

Practical Question:
Mr. Naresh purchases a Put option for 300 shares of A with strike price of Rs. 2000/- having
maturity of 2 months at Rs. 50/-. On maturity, shares of A were priced at Rs. 1900/-. What is
profit/loss for the individual transaction:

105
Solution:
Naresh will prefer to exercise option by selling at strike price of Rs. 2000/-. He will receive Rs.
600000/- (2000*300) minus Rs.15000(50*300) i.e. 585000/-
At the same time, naresh can buy from market @1900 i.e. net payment of 300*1900=570000/-
Profit = 585000-570000=15000/-

Interest Rate Swaps (IRS)

It is OTC product. It deals with exchange of Interest flows on an underlying assets and liability.
For Example: A company is paying interest on 5 years Debentures @7%. In market, rate of
interest is declining, company will be losing notionally. But its notional loss can be covered only
if the Interest rate is linked to market rate of interest. The Company enters into Interest rate
swap with bank with the terms that Fixed rate of interest on Debentures will Swap 3M T-bills
@5%. The fixed rate of 7 % on Debentures will be swapped with T+2%. After every 3 months,
bank will pay (notionally) to the company @ T-bills+2%.

Assuming that in the next quarter, 90 days T-bill rate is 4%, the Company will notionally lose
1%. Under such circumstances, company will receive from the bank @1%. This will neutralize
the loss of interest @1% (notional) on account of fall in the market interest rate.

Vice versa, company will pay to the bank @1%.

FRA (Forward Rate Agreement)

It is Forward Interest rate which is an over-the-counter contract between parties that determines
the rate of interest to be paid or received on an obligation beginning at a future start date. The
contract will determine the rates to be used along with the termination date and notional value.
On this type of agreement, it is only the differential that is paid on the notional amount of the
contract.

For a basic example, assume Company A enters into an FRA with Company B in which
Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three years.
In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on
the principal amount. The agreement will be settled in cash in three years.

If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that
Company A pay Company B. This is because the LIBOR is higher than the fixed rate.
Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million
at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net
difference between the two amounts is $5,000, which is paid to Company B.

Currency Swaps

It is exchange of cash flow in one currency with that of another currency. Two types of currency
swaps are there: Currency Only Swap & Principal Only Swap. Currency Swaps are used to
mitigate exchange risks for meeting Principal or Interest obligations.

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Example: An investor in Germany needs INR to Invest in India. On the other hand, Reliance in
India needs Euro to acquire a Co. in France. German Investor will raise Euro funds at low rates
and Reliance India will raise Rupee loans at low rates from India. Two parties will Swap Loans
with Bank as financial intermediary.
 Principal Only Swap allows the borrower to pay interest in USD. But payment of
Principal is made in home currency. As such risk fluctuations in respect of Principal are
eliminated.
 Coupon Only Swap allows the borrower to pay interest in INR. Whereas Principal
amount is hedged by using some other derivative.
 P+I Swap is there when borrower eliminates Currency risks as well as Interest Risk. The
risk is zero. Borrower will pay Principal + Interest in Domestic currency to settle Foreign
Currency borrowings. The swap cost is included in rupee interest rates.

RBI Guidelines on Risk Exposure

1. Banks and Counter parties will sign agreement known as ISDA (International Swap
Derivative Association) – Master Agreement which is standardized by SDA (Swap
Derivative Association). The agreement is cleared by FIMMDA (Fixed Income Money
Market and Derivatives Association) and FEDAI.
2. RBI allowed MIFOR (combination of LIBOR and Forward Premium) for Inter-bank
dealings only.
3. RBI permitted banks under ISDA agreement to opt for dual jurisdiction.
4. Ceiling for Forward Contract for Designated Importers and Exporters is 100% of
previous year’s exports or average of 3 years exports (whichever is higher). The ceiling
is 50% for other Importers and Exporters.
5. Fema allows AD-Categori-I banks to become clearing and trading members of exchange
traded currency option market of recognized stock exchanges, which fulfill the following
prudential requirements:
Minimum Networth-----500 crore; Minimum CRAR -------10%
NPA level maximum---3% Net profits during last 3 years.

6. FBIL (Financial Benchmark India Pvt. Ltd.)---This is independent body set up by

FIMMDA and FEDAI. It provides benchmark rates of the following on daily basis except
on Saturday/Sunday and Public hilodays:
MIBOR for 14 days, 1 month & 3 months ; FC Rupee OptionsVolatilities of 5 tenures
Certificate of Deposits (FBIL-CD); Treasury Bills (FBIL-Tbill)
The rate is announced at 10:45 AM.

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 Treasury and ALM
ALM refers to risk management to avoid mismanagement between Assets and Liabilities. The
risk of Liquidity and Interest rates, if not controlled may result into negative spread and can
cause loss to bank. Therefore ALM manages two risks : 1. Liquidity Risk & 2. Interest Rate Risk.

Liquidity Risk and Interest Rate Risk

We borrow from Money market and invest in 5 year G-securities. If Bond prices come down, we
are not willing to sell the bond, but loan has to be repaid. This may lead to shortage of funds
which is called Liquidity Risk.

Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at higher
rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.

Role of ALM to mitigate Liquidity Risk

Liquidity Gap arises when there is difference between souses and uses of funds. RBI has
prescribed Time bands to measure Liquidity Gaps. These are 10 maturity buckets:

Next Day, 2-7 days, 8-14 days, 15-28 days, 29-90 days, 91-180 days, 181–365 days
1-3 years, 3-5 years, Above 5 years.

(Major portion (around 85%) of SB and CA Balances are kept in 1-3 year bucket for
purpose of maturity profile)

ALM measures the gap between Uses and Sources between above said Time bands.
RBI has also prescribed limits of maximum negative mismatch as under:

Next Day -------5%

2-7 Days------10%
8-14 Days—-15%
15-28 Days--20%

ALM takes steps to meet shortfall as a contingent measure at a reasonable rate.

Interest rate Gap leads to erosion of NII (Net Interest Income) due to difference between
earnings and payments.

ALM has the following role to play:

 Treasury establishes a link between Core banking and market operations to manage
risks.
 Treasury earns profits by managing funds out of mismatches.
 Treasury hedges residual risk in Forex market.
 Treasury monitors exchange rates and interest rate movements in the market.
Use of Derivatives in ALM
Derivatives are used to hedge high value individual transactions.
For Example: Medium Term Loan of 3 Years is funded by Deposit of 3M because 3M deposit is
cheaper and NII is increased.

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  Bank may swap 3M interest rate into fixed rate into Fixed rate for 3 years. Bank may
also swap Fixed interest rate on loan into floating rate linked to T-bill rate. If 3M deposit
rate is T+1% and 3Year interest rate on loan is T+3%, there will be NII@2%.
 Bank may arbitrage Forex. It can buy USD funds at cheaper rate (say 3%) and invest in
rupee loan at 6.5%. The spread can be 3.5%

Risks of Derivatives: Derivatives are not free from risks. Two risks involved in Derivatives are:
1. Residual risk i.e. basis risk.
2. Embedded Option Risk :There are embedded options in certain bank products. E.g. FD
is paid premature or TL is pre-paid. It affects the ALM policy if pre-mature payments are
large.

Treasury and Credit Risk

There are chances of failure on the part of counter party to meet its obligations especially when
Treasury deals in:
1. Debt Market products such as CPs, Bonds, Debentures etc.
2. Securitization of Credit Receivables – when credit receivables are converted into Units
or Bonds which are called PTCs ( Pass-through certificate).
3. SPV –Special Purpose Vehicle enables the banks to securitize the Mortgage loans

Credit Derivatives
1. Credit Default Swaps
2. Total Returns Swap
3. Credit Linked Notes

Transfer Pricing
It is important function of ALM. It relates to:
 Fixing cost of recourses and return on Assets.
 ALM notionally buys and sells deposits and loans of the bank.
 Price is paid for buying deposits and price is received for selling loans. This is called
Transfer Pricing.
 The prices vary according to the tenure or maturity of deposits and loans.
 Deposits are bought by Treasury at a rate arrived at by adjusting hedging cost from rate
of deposit. If bank accepts deposits%7% and cost of hedging is 1%, the deposits will be
bought by Treasury @6%.
 Loans are sold to Treasury at transfer cost. For example, 10% loan may be notionally
sold to Treasury @7%. The balance is denoted as Risk premium.
 Treasury Division, after implementing the Transfer Pricing takes care of Liquidity Risk
and Interest rate risk.

Run on the bank: When customers lose confidence in the bank

Liquefiable securities: Securities that are readily sold for cash in secondary market.
Sensitivity Ratio: Ratio of Rate sensitive assets to Rate sensitive laibilities.
Risk Appetite: Capacity and Willingness to absorb losses of market risk

109
MODULE – D

Balance Sheet Management

intel

2020
110
 Bank’s Balance Sheet
All Banks are governed by Indian Companies Act, 1956 as well as Banking Companies Act,
1949. The Banks include Nationalized Banks, SBI and its subsidiaries, Foreign Banks,
Cooperative banks, RRBs and Private Sector Banks.

Section 5 of Banking Regulation Act stipulates that Banking is accepting of deposits of money
from public for the purpose of lending or investment. The deposits are repayable on demand or
otherwise by cheque, draft or otherwise.

Other Important provisions of Banking Regulation Act

 Section 8 prohibits the banks to engage in trading activities.

 Section 9 restricts the banks to hold Immovable property beyond a period of 7 years
except for own use.
 Section 29 stipulates that Balance Sheet of a Banking Company will be prepared on
―Form A of 3rd schedule‖. Further, Profit and Loss Account will be prepared on ―Form B
of 3rd Schedule.‖
 Section 30 states that Balance sheet must be audited by qualified auditors.
 Section 31 & 32 – 3 copies of Balance Sheet & PL account will be submitted to RBI
within 3 months from end of the period. This period can be extended by another 3
months by RBI.
 Final accounts and Auditor’s report must be published in a newspaper within maximum
period of 6 months.
 Sec 17 states that at-least 20% of profits will be transferred to Statutory Reserve by all
the banks. Presently this limit has been raised to 25% by RBI.

3rd Schedule : Form “A”

Balance Sheet of _____Bank as on _________

Capital and Liabilities Schedule Amount

Capital 1
Reserves and Surplus 2
Deposits 3
Borrowings 4
Other Liabilities and Provisions 5
Assets
Cash and Balance with RBI 6
Balances with Banks and Money at call 7
and shot Notices
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
Total

111
Contingent Liabilities: Schedule 12 These are such type of liabilities which may or may not
arise in future. This figure does not form part of Total of Balance sheet but shown as footnote.
These are also called Off Balance Sheet Items. Such items are as under:

1. LC & LG as well as co-acceptance of bills.

2. Claims against banks not acknowledged as Debts.
3. Liability for partly paid up Investments.
4. Outstanding Forward exchange contracts.
5. Bills Rediscounted.

3rd Schedule : Form “B”

Profit and Loss Account of _____Bank for the year _________

Incomes Schedule Amount

Interest earned: It includes interest on Term 13
Loans, Cash Credit, Demand Loan, OD and
Rebate on Bills Purchased and Discounted
It also includes Income from Investments
Other Income : It includes Commission, 14
Brokerage, Profit on sale or revaluation of assets
and Misc. Income
Expenditure
Interest Expanded 15
Operating Expenses 16
Provisions and Contingencies --
Profit or Loss for the year
Appropriations
Transfer to Statutory Reserves (
Transfer to Other Reserves
Transfer to other Reserves
Proposed Dividend
Balance carried forward to Balance sheet
Total

 Statutory Reserve requirement is minimum 20% of Profits. However RBI has

prescribed that banks will maintain 25% of Profits as Reserve.
(Sec 17 of Banking Regulation Act, 1949)

Schedule 17 – Additional Disclosure

Following additional disclosures are required as foot-note in the Balance sheet:
1. Non-performing Assets
2. Movement of provisions held towards NPA
3. Movement of provisions held towards depreciation on Investments.
4. Asset Classification – Standard Assets, Sub-standard Assets, Doubtful Assets & Loss Assets.
5. Income Recognition and Provisioning
6. Investments – SLR and Non- SLR. Further these are to be classified in 3 categories; Held Till
Maturity, Held for Trading and Available for Sale.
7. Provision for Depreciation
8. Repo and Reverse Repo transactions.
9. CDR Restructuring

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 10. Profit per Employee
11. Maturity pattern and ALM (Asset Liability Management)
12. AS-17 Segment Reporting
13. AS-18 Related Party Disclosure
14. AS-21 Consolidated Financial Statements

ALM (Asset Liability Management

ALM refers to risk management to avoid mismanagement between Assets and Liabilities. The risk of
Liquidity and Interest rates, if not controlled may result into negative spread and can cause loss to bank.
Therefore ALM manages two risks : 1. Liquidity Risk & 2. Interest Rate Risk.

Liquidity Risk and Interest Rate Risk

We borrow from Money market and invest in 5 year G-securities. If Bond prices come down, we
are not willing to sell the bond, but loan has to be repaid. This may lead to shortage of funds
which is called Liquidity Risk.

Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at higher
rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.

Significance of ALM

 Market is Volatile. The rate fluctuations affect the NII and ultimate profits
are affected.

 Rapid innovations of products are taking place. Most products affect risk
profile of the bank.

 Regulatory Environment also expects from banks compliance of Basel

norms which cannot be undertaken without ALM.

 Management also recognises ALM mechanism as innovative job.

Objectives of ALM

Objectives of ALM are two fold

1. Profitability through Price matching

2. Ensuring Liquidity through maturity matching.

ALM techniques are so designed to manage various risks and the parameters are:

1. NII – Net Interest Income

The impact of volatility on short term profit is measured by NII.
NII = Interest Income – Interest Expenditure
2. NIM – Net Interest Margin
It is comparison of NII with Average Total Assets

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 It is calculated as under:
NIM = NII (Net Interest Income)
Average Total Assets
3. Economic Equity Ratio
It is comparison of Shareholders’ Funds with Total Assets.
It is calculated as under:

Shareholders’ Funds
Total Assets

Practical Example

Expenses Incomes
Interest Paid 10 Interest Earned 170
Establishment expenses 35 Other Income - operational 110
Provisions 75
Operating Expenses 120
Gross Profit 40

Total 280 Total 280

 Total Liabilities are 2000 crore out of which Capital is 400 crore

Find NII (Net Interest Income), NIM and Economic Equity Ratio

NII= 170-10 = 160

NIM = NII/ Total Assets = 160/2000= 8%

Economic Equity Ratio = Share Holders’ funds / total assets

= 400/2000= 20%

Find out Capital Charge on Operational Risk and Risk Weighted Assets for Operational
Risk.

Capital Charge on Operational risk is 15% of average gross positive income of previous 3 years.
In the instant case, only 1 year study is given.

Therefore Capital charge for Op risk = 15% of 280 = 42 crores

RWAs for Operational Risk = 42*100/9 = 467 crores

114
 Asset Classification
One of the important recommendations of Narsimham Committee was to adopt International
Accounting Practices and Accounting Standards with an objective of bringing transparency in
the Balance Sheet.

The major source of Income in the banks is in the from Interest on loans, which is booked
initially and recovered later on i.e. on Accrual basis. If the same is not recovered within
reasonable time, the Income should not be recognized as per International Standards.

Narsimham Committee suggested as under:

1. Classification of assets into 4 categories:

 Standard Assets: The loan account which is not NPA.
 Sub-standard Assets: The loan account which is classified as NPA.
 Doubtful assets: The loan account which remains NPA for >1year
 Loss Assets: The loan account in which security is not available.
How and when the account becomes NPA?

Type of Account Period

TL becomes NPA if Interest/Principal remains Overdue More than 90 days
CC/OD becomes NPA if it remains out of order More than 90 days
The account is treated as out of order: if
 Outstanding balance is continuously above DP
 There are no credits in the account for >90 days
 Credit is not enough to cover interest during same period
Bill becomes NPA if it remains Overdue for More than 90 days
Agriculture Loan account becomes NPA if overdue After 2 crop seasons
In case of Long duration crops After 1 crop season

KCC Account will be treated as NPA if it is out of order:. A KCC account will be treated as out
of order in the following circumstances:

 There are no credits in the account continuously for two crop seasons/one crop season
(as the case may be) as on the date of balance sheet.
 The outstanding remains continuously in excess of the limit for two crop seasons/one
crop season (as the case may be) as on the date of balance sheet.
 The credits in the account are not sufficient even to cover the interest debited in respect
of the account for two crop seasons/one crop season (as the case may be).

Asset Classification
Loan Account remains in Sub-standard category for 1 year
Loan becomes Doubtful after remaining 1 year in D1 category for 1 year
Substandard category). D2 category for next 2 years
(The account is transferred to Doubtful category directly if D3 category beyond 3 years after
security loss is 50% or above) it became doubtful
Loan becomes Loss Asset If Loss of security is either 100%
or 90% or more.

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Non- Financial reasons for account becoming NPA
1. Stock Statement not received for 3 Months.
(The outstanding in the account based on drawing power calculated from stock
statements older than three months, would be deemed as irregular. A working capital
borrowal account will become NPA if such irregular drawings are permitted in the
account for a continuous period of 90 days)
2. Limit is overdue for renewal for 6 M.

Up-gradation of NPA into Standard Category

The account is upgraded on same day when the recovery is made.

Implications of Accounts after becoming NPA

1. Interest is not charged and not credited to Income head.
2. Interest accrued and credited to Income account but not recovered during corresponding
previous year will be reversed.
3. Provision is made for NPAs (Bad and Doubtful debts) from the current year’s profits.
Asset Classification – Borrower wise and not Facility wise
It means if one account of the borrower is classified as NPA, other accounts will also be
treated as NPAs even if these are regular.
Advances under Consortium
Each bank will take view of transferring account to NPA category on the basis of its own
recovery.

Takeout Finance: Account is treated as NPA from actual date of it becoming NPA and not from
date of taken over.
Advances under rehabilitation approved by BIFR / TLI: Banks canot upgrade these
accounts for a period of one year. They will continue to be classified as sub-standard/doubtful
as the case may be.

PROVISIONING NORMS

In terms of Monetary policy 2011-12, the revised norms of provisioning are as under:
Standard Assets

Classification Rate of provision

Direct SME and Direct Agriculture & 0.25%
Housing Loans
General including DCCO revised up to 2 0.40%
years
Commercial Real Estate (RH) 0.75%
Commercial Real Estate 1%
Teaser Housing Loans 2%
Restructured accounts classified as 5%
standard advances:

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Non-Performing Assets

Sub-standard Advances:

 Secured Exposures 15%

 Unsecured Exposures (abnitio unsecured) 25%
 Unsecured Exposures in respect of 20%
Infrastructure loan accounts

Doubtful Advances – Unsecured Portion 100%

Doubtful Advances- Secured Portion

 For Doubtful up to 1 year 25%

 For Doubtful>1 year and up to 3 years 40%
 For Doubtful >3 years 100%
Loss Assets : These are identified by auditors 100%
where security is eroded up to 90%

CRILIC (Central Repository of Information on Large Credit): Banks have report credit
information including classification of accounts as SMA on all their borrowings having aggregate
fund-based exposure of 5 crore (50 million) and above. For non-reporting to CRILIC, bank is
subjected to enhanced provisioning norms as under:

Secured SS up to 6M--------------15%, 6-12 M------------25%

Unsecured SS up to 6M----------25%, 6-12 M-----------40%

Secured DB -1-----------------------40% DB2 & DB3---------------100%

(Non- cooperative borrowers are those who make default, do not provide information and obstruct
sale of securities. Qtly reporting has to be made by banks within 21 days of close of quarter)

Fraud Cases: Enrite amount has to be provided for irrespective of security.

Legal Entity Identifier

1. RBI has made mandatory for Corporate borrowers having aggregate exposure of 5.00
crore and above to obtain LEI (Legal Entity Identifier registration and capture the
same in CRILIC.

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Some Important Equations:
1. Net NPAs = Gross NPAs – (Provision +DICGC/ECGC cover).
2. Provisioning Coverage Ratio = NPA Provision X 100
Gross NPAs
3. Provisioning Coverage Ratio should not be less than 70% of Gross NPAs as per bank
guidelines.
4. Amount of ECGC/DICGC guarantee cover must be excluded while calculating provision
in respect of Doubtful assets. But in case of Sub-standard assets, this cover need not to
be deducted.
5. In case of Doubtful Assets, Secured portion and Un-secured portion (Security reduced
subsequently) will be segregated and provision will be calculated accordingly.
6. Advances against NSCs/KVPs/FDs/LIC Policies need not to be classified as NPAs
provided adequate margin is available. However, advances against Gold and Govt.
Securities are not covered under the exemption.

GOVT. GUARANTED ACCOUNTS

 STATE GOVT: It will be declared NPA as in other loan cases.
 CENTRAL GOVT: Continued to be Standard Assets till repudiation of guarantee by the
Central Govt. However interest would not be taken into income unless actually received

Exposure in Weak Accounts

All irregular/weak accounts shall henceforth be classified as Special Mention Assets
(SMA) with sub-categories as under;

Sub-Category Basis for Classification

SMA-0 Principal or interest overdue up to 30 days
SMA-1 Principal or interest overdue between 31-60 days
SMA-2 Principal or interest overdue between 61 days to 90
days

Practical Examples
Ex. 1
Account with Outstanding of Rs. 10.00 lac became Out of order on 22.1.11 and it became NPA
on 22.4.2011. The Value of Security at later stage is Rs. 7.00 lac. Calculate Provision as on
31.3.12.
Solution
It is a Sub-Standard Asset as on 31.3.2012.
Provision is 1000000*15/100 = 150000/-

Ex. 2
A loan account with outstanding of Rs. 10.00 lac and Value of Security Rs. 6.00 lac was Sub-
standard as on 30.3.2008. What will be provision as on 31.3.2012?
Solution
The account will be Doubtful (DI) on 30.3.2009, D2 on 30.9.2010, D3 on 30.3.2012. Provision
will as under:
Secured portion = 6.00*100/100 = 6.00 lac
Un-secured portion = 4.00*100/100 = 4.00 lac
Total Provision = 6+4 = 10.00 lac.

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Ex. 3
A loan became Doubtful on 12.2.2009. The outstanding is 6.00 lac. What will be provision on
31.3.2012.
Solution
The Account will be categorized as Doubtful (D3) as on 12.2.2012. Provision is 100% of 6.00 lac
= 6.00 lac

Ex. 4
D2 category account has outstanding--10.00 lac, DI/SI ----2.00 lac, Value of security ---6.00 lac
Solution
Un- Secured portion = 10-2-6 = 2.00 lac Provision = 2.00 * 100/100 = 2.00 lac
Secured portion = 6.00 * 40/100 = 2.40 lac
Total provision = 2.00 + 2.40 = 4.40 lac

Ex. 5
D2 Category loan is having outstanding 4.00 lac, Value of Security 1.50 lac and ECGC cover
50%. Calculate provision as on 31.3.2012.
Solution
Unsecured portion = 50% of (O/s – VS) = 50% (4.00 – 1.50) = 1.25 lac
Secured portion = 1.50 lac
Provision on Unsecured portion = 1.25*100/100 = 1.25 lac
Provision on Secured portion = 1.50*40/100 = 0.60 lac
Total provision = 1.25 +0.60 = 1.85 lac.
Ex. 6
A D2 category loan is having outstanding Rs. 6.00 lac. The Collateral Security is Rs. 3.00 lac
and Primary Security is Rs. 2.00 lac. There is also Guarantee of Rs. 10.00 lac. Calculate
provision.

Solution
Unsecured portion = O/s – Primary Security – Collateral = 6.00 – 2.00 -3.00 = 1.00 lac
Secured portion = 2.00 + 3.00 = 5.00 lac.
Provision on Unsecured portion = 1.00 *100/100 = 1.00 lac
Provision on Secured portion = 5.00*40/100 = 2.00 lac
Total provision = 1.00 + 2.00 = 3.00 lac.

Ex. 7
Advance portfolio of a bank is as under:
Total advances = 40000 crore, Gross NPAs = 9%, Net NPAs = 2%
Find out 1) Total Provision 2) Provisioning Coverage Ratio
Solution
NPAs = Total Advances *9/100 = 40000*9/100 = 3600 crore
Standard Assets = 40000-3600 = 36400 crore
Provision on Standard Assets = 36400*0.40% = 145.60 crore
Provision on NPAs = 9% - 2% = 7% = 40000*7/100 = 2800 crore
1) Total provision = 145.60 + 2800 = 2945.60 crore
Gross NPAs = 40000*9/100 = 3600 crore
Net NPAs = 40000*2/100 = 800 crore
2) Provision Coverage Ratio = Provision on NPAs / Gross NPAs = 2800/3600 = 77%.

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Ex. 7 Account becomes doubtful on 12th Feb 2008. The Balance is Rs. 6 lac. Value of security is
3 lac. What will be the provision on 31.3.2011?
Solution
 It is D3 Type of account.
 Therefore, provision will be 100% i.e. 6 lac = 6.00 lac Ans.

Ex. 8 NPA o/s : Rs. 10 lac including suspended interest/Derecognized interest Rs. 2 lac.
Security value is Rs. 6 lac. It became NPA on 25th Feb 2008. What would be the provision on
31.3.2011.
 It is D2 category account
 4.40 LAC (10-2-6= 2x100%= 2 lac + 40% on 6 lac i.e. 2.40 lac = 4.40 lac) D2

Ex. 9 A/c became NPA on 2nd January 2008. Balance o/s is 10 lac including Derecognized
interest Rs. 2 lac and ECGC cover of 50%. Value of security is 4 lac. What will be provision on
31.3.2009.

 It is D1 category account.
 10 lac – 2 lac, DI – 4 lac Sec. = 4 lac
 ECGC Cover: 4 lac x 50% = 2 lac
Provision on Unsecured portion
 Unsecured: 4 lac – 2 lac = 2 lac x100% = 2.00 lac
Provision on Secured portion
 Secured: 4 lac x 25% = 1.00 lac
 Total Provision: 2 + 1 = 3.00 lac

Strategic Debt Restructuring (SDR): It is the process of Coverting Debt into Equity in a defauting
Company. Management is changed, if needed and in the meantime, suitable buyer of the company is
found. A time period of 18 months is allowed to bank for finding suitable buyers. It requires approval of
JLF (Joint Lending Forum). The decision should be approved by minimum 75% of creditors by value and
60% by number.

Sustainable Structuring of Stressed Assets (S4A)

It is process of restructuring Large ticket loans with aggregate exposure of all lenders above 500
crore, where the project is up and running. The loan is divided in two parts – Sustainable and
Un-sustainable. Sustainable part should be at-least 50% or moreof the unsustainable debt
portion. Portion of loan which can be serviced through existing cashflow is called sustainable.
Unsustainable portion is converted into equity.

INSOLVENCY AND BANKRUPTCY CODE, 2016 (IBC)

The code passed by Parliament in 2016 allows the creditors to acesss viability of a debtor as a
business decision and agree upon a plan for its revival or speedy liquidation.

Insolvency Resolution Process (IRP) for Companies

 Default should be atleast Rs.100000/-
 IRP can be initiated by financial creditor at NCLT (National Company Law Tribunal).
Defaulting Debtor, its sharelders or employees can also initiate.

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  The code permits banks to push recovery from a company within 180 days with grace
period of 90 days , if 75% of creditors agree. If resolution plan is rejected or Debtor fails
to meet recovery terms, Corporate Debtor is put into compulsory liquidation..
 On NCLT passing order of liquidation, a moratotorium is imposed on all pending legal
proceedings against the debtor.
 Assets of the debtor vest in the estate of liquidator.

Insolvency Resolution Process (IRP) for Individuals & Firms

 Default should be atleast Rs.1000/-
 There are two processes. (a) Automatic fresh start & (b) Insolvency resolution.
 Under automatic fresh start process, Eligible debtors can apply DRT for discharge from
certain debts not exceeding a specified threshold, allowing them to start fresh.
 Under Insolvency resolution process, repayment plan is prepared by debtor for approval
from creditors. If approved, DRT passes an order binding both debtor and creditors
towards repayment plan. If plan is rejected or fails, Debtor and creditors may apply for
bankruptcy order.

Other Important Terms of Act

 Bankrupt individuals would be barred from contesting elections.
 Debtor can be jailed up to 5 years for concealing property or defrauding creditors.
 The entire proceedings will be supervised by Insolvency and Bankruptcy Board of India.
 Wokers’ salary up to 24 months will get first priority for payment.
 Money due to Employees from PPF, gratuity fund will not be included in estate of
company or individual.

Asset Classification for MSMEs

it has now been decided to temporarily allow banks and NBFCs to classify their exposure, as
per the 180 days past due criterion, to all MSMEs, including those not registered under GST, as
a standard asset, provided

 The aggregate exposure does not exceed 25 crore as on 31.5.2018.

 A provision of 5 % shall be made.
 The additional time is being provided for the purpose of asset classification only and not
for income recognition.

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 Liquidity Management

Banks are required to honour withdrawals from Deposits. Also the banks are supposed to
disburse loans in time. Liquidity is needed to meet both these requirements. In other words,
liquidity is the ability to accommodate decrease in liability as well as funding of increase in
assets.

Functions of Liquidity Management:

1. It defines market place of bank.
2. It enables banks to meet prior loan commitments.
3. It enables the banks to avoid unprofitable sale of assets.
4. It lowers size of default risk premium.

Liquidity Mismanage may lead to the following:

 It declines earnings.
 It increases NPAs.
 It results in downgrading of rating.

Factors affecting Liquidity

Liquidity is affected by the following:
1. Less profits leads to less liquidity
2. Rise in NPAs means less liquidity
3. Deposit concentration in Term Deposits may lead to high liquidity
4. More taxes means less liquidity.

Types of Liquidity Risks

1. Funding Risk: Decrease in deposits due of bad reputation or loss of confidence.
2. Time Risk: Instalments of loan are not forthcoming in time.
3. Call Risk: Non-fund based credit facilities converted into Fund based. Crystallization of
Contingent liabilities like LC/LG turning into Fund Based Loans.
4. Embedded Risk: Adverse movement of Interest Rate may result into pre-payment of
CC/DL and TL. It may also result into pre-mature withdrawal of TDs/RDs. This will also
result into reduced NII. This is called Embedded Risk.

How to manage Liquidity Risk?

1. Developing an organizational structure.
2. Setting of Tolerance level limits.
 Limit of cash flow mismatches for tomorrow, next week, next month or next year.
 Limit of Loan to Deposit Ratio
 Limit of Loan to Capital ratio.

Measurement of Liquidity Risks: Liquidity Risk can be measured in any of the two ways:
1. Stock Approach
2. Flow Approach

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Stock Approach
Following ratios are calculated to measure Liquidity Gap:

Better it is from Liquidity Point of view

Ratio of Core Deposits to Total Assets More the ratio, better it is
Net Loans to Total Deposits Lower ratio is better
Time deposits to Total Deposits Higher ratio is better
Volatile Liabilities to Total Assets (Market Lower ratio is better
borrowings are volatile liabilities
Short Term Liabilities to Liquid Assets Lower ratio is better.
Liquid Assets to Total Assets Higher ratio is better.
Short Term Liabilities to Total assets Lower is desirable
Prime Assets to Total Assets (Prime assets Higher is better
are Cash, Balance with banks etc.
Market Liabilities to Total assets (Market Lower is better
liabilities are Money Market borrowings, Repo
and Inter-bank liabilities

Flow Approach: It has 3 major dimensions:

1. Measuring and managing net funding requirements through
 Maturity ladder
 General Market conditions
 Bank specific crisis.
 General Market crisis.
2. Measuring Liquidity over chosen time frames.
3. Contingency Planning

RBI guidelines for maturity Buckets:

All Assets and Liabilities are classified into 10 maturity buckets:
1. Tomorrow
2. 2-7 Days
3. 8-14 Days
4. 15-28 Days
5. 29 Days to 3M
6. 3M to 6M
7. 6m to 1 Year
8. 1-3 Years
9. 3-5 Years
10. Over 5 years

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 Interest Rate Risk Management

There is complete deregulation of Interest rates on Fixed Deposits, Recurring Deposits, and SB
Deposits above Rs. 1.00 lac. Banks are also free to determine Interest rates on NRE Deposit
accounts. This has led to interest rate Volatility resulting into greater Interest Rate Risk.

Adverse movement of Interest rates has direct impact on NII as well as NIM. Market Interest
rate also has impact on Present Value of Bonds and Securities. 1% rise in market rate of return
will cause lesser valuation of securities. Also 1% fall in interest rate will cause higher valuation
of securities resulting into increase in Mark to Market Price.

Types of Interest Rate Risk

Following are various types of Interest Rate Risk:

1. Mismatch or Gap Risk

This is risk of gap between maturities of Assets and Liabilities. Sometimes, Long term
loans are funded by short term deposits. After maturity of deposits, these liabilities are
get re-priced and Gap of Interest rates between Assets and Liabilities may become
narrowed thereby leading to reduction of profits.
2. Basis Risk
Change of Interest rates on Assets and Liabilities may change in different magnitudes
thus creating variation in Net Interest Income. It tries to explain what will be the %age
effect on Earnings due to increase or decrease in interest rates by 1bps.
3. Net Interest Position Risk
If the bank has more assets than the liabilities, 1% decrease in interest rate will result
into less earnings and more expenditure on account of interest. This will directly affect
NII and NIM.
4. Embedded Option Risk
Adverse movement of Interest Rate may result into pre-payment of CC/DL and TL. It
may also result into pre-mature withdrawal of TDs/RDs. This will also result into reduced
NII. This is called Embedded Risk.
5. Yield Curve Risk
Yield is Internal Rate of Return on Securities. Higher Interest Rate scenario will reduce
Yield and thereby reduction in the value of assets. Adverse movement of yield will
certainly affect NII (Net Interest Income).
6. Price Risk
In financial market, when assets are sold before maturity in order to meet liquidity
requirements, loss may occur due to lower selling price.
7. Re-investment Risk
It is uncertainty with regard to interest rate at which future cash flows could be re-
invested.

Effects of Interest Rate Risk

Effect on Earnings.
Effect on Economic value of share
Embedded Losses

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Important Points

 Interest rate Risk is a type of Market Risk

 A bank holds a security that is rated A+. The rating of the security migrates to A. What is
the risk that bank will face: Credit Risk
 Lower is the rating of the company, higher will be the interest rate on its Bonds. Bond
with BBB rating will carry higher interest rate than one with AA rating.

Measurement of Interest Rate Risk

1. Re-pricing Schedules
All Assets and Liabilities are assigned to Re-pricing time bands according to past
judgment and experience of the banks. The schedule distributes Interest Sensitive
Assets, Liabilities and Off Balance Sheet Items into certain number of pre-defined time
bands.
Under this method, steps are as under:
Ist step---------Adjusted Gap is calculated by netting Interest bearing assets and interest
bearing liabilities.
2nd step---------Re pricing of assets is done as per the following example
3rd step---------Standard Gap is calculated after deducting Re pricing liabilities from Re
pricing Assets.

How it is calculated?
A bank has following Assets and Liabilities:
Call Money --------500 crore
Cash Credit—-----400 crore
Cash in hand –---100 crore
SB Deposits-------500 crore
Fixed Deposits----500 crore
Current Deposits-200 crore

There is reduction in interest rates by 0.5% in call money, 1% in CC, 0.1% for SB and
0.8% for FD

Calculate Adjusted Gap

Adjusted Gap = (Call Money +CC) – (SB+FD) = 900 - 1000 = 100 crore Negative
Calculate Re pricing Assets
Re pricing Assets = (500*.5) + (400*1) = 250+400=650 crore
Calculate Re pricing Liabilities
Re pricing Liabilities = (500*.1) + (500*.8) = 50+400 = 450 crore
Calculate Standard Gap
Standard Gap = Re Pricing Assets – Re Pricing Liabilities
= 650 – 450 = 200 crore positive

2. Gap Analysis
Gap is Difference between RSA (Risk Sensitive Assets) and RSL (Risk Sensitive
Liabilities)

If RSA > RSL , it is called Positive Gap or Asset Sensitive Gap.

If RSA < RSL, it is called Negative Gap or Liability Sensitive Gap.

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 3. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration) to receive
Present Value of the bond.

E.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7
years. It means Total Cash Flow of Rs. 130 to be received in 5 years would be
discounted with Present Value which will be equivalent as amount received in 3.7 years.
The Duration of the Bond is 3.7 Years.

Formula of Calculation of McCauley Duration = ∑PV*T

∑PV
Modified Duration = Duration
1+Yield
Approximate % change in price = Modified Duration X Change in Yield

4. Simulation Approach: It involves detailed assessment of potential effects of changes in

interest rates on earnings and economic value by simulating the future path of interest
rates and their impact on cash flows.

Simulation techniques could be

 Static simulation – on the basis of existing Assets and Liabilities
 Dynamic simulation – Detailed assumption about future structure of interest
rate regime.

Measures to Control Interest Rate Risk

1. Reduce Asset Sensitivity

Extend Investment portfolio maturity, Increase of Floating rate Deposits, Increase of
Fixed Rate lending, and Increase of short term borrowings and Long term Lending.

2. Reduce Liability Sensitivity

Reduction of Investment portfolio maturity, Increase of Floating rate lending, Increase of
Long term Deposits and Short term Lending.

3. Control and Supervision

 Board and Senior Management of Oversight Interest Rate Risk.
 Board of Directors must have proper control over Interest rate regime.
 Senior Management should be responsible for implementing policy.
 Lines of Authority and Responsibility must be clearly defined.

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Practical Example:
ABC Bank has following Assets and Liabilities:
SB Deposits 300 crore Cash in Hand------------ 200 crore

FD Deposits 300 crore Call Money -------------- 300 crore

CA Deposits 250 crore CC & TL------------------ 240 crore

RSA (Rate Sensitive Assets) = 300+240 = 540 crore

RSL (Rate Sensitive Liabilities = 300+300 = 600 crore
Adjusted Gap = RSA-RSL = 540-600 = (60) --------Negative
 Suppose Interest rate falls 2% on all assets and liabilities. Liabilities are in excess. Bank
will have to pay less thereby improvement in NII by (60*2/100) i.e. 1.20 Crore
 Now, if Interest Rate rises by 2%, bank will have to pay more. Since Negative gap is 60
crore. Bank’s NII will be reduced by 1.20 Crore.

MODIFIED DURATION GAP (DGAP): Under this section, we have to calculate two things as
under:

1. DGAP = Modified DA – W x Modified DL

2. Modified Duration of Equity = DGAP x Leverage

To calculate above, the following values are given in question:

 Modified DA = Weighted duration of assets (given)

 Modified DL = Weighted duration of liabilities (given)
 W = RSL / RSA
 Leverage = RSA/Equity

Practical example

Given in Question : Net Worth = 1500 Cr., T1+T2 Capital = 3500 Cr., RSA = 22500 Cr.
RSL = 21000 Cr, Modified DA = 1.80, Modified DL = 1.10

W = RSL/RSA = 21000/22500 = .933

DGAP = Modified DA – W*Modified DL = 1.80 - .933*1.10 = 0.77
Leverage Ratio = RSA / (Tier 1 + Tier 2) = 22500 / 3500 = 6.428
Modified duration of Equity = DGAP x Leverage ratio = 0.77*6.428 = 4.949 (Say 4.5)

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 RAROC (Risk Adjusted Return on Capital)
Profit Planning involves Balance Sheet Management. Higher risk will fetch more profits whereas
lower risk is the cause of lesser profits.

Risk and Risk is possible unfavorable impact on net cash flow in future due to
Capital uncertainty of happening or non-happening of events. Capital is a
cushion or shock observer required to absorb potential losses in future.
Higher the Risks, high will be the requirement of Capital and there will
be rise in RAROC (Risk Adjusted Return on Capital).

Bank’s Income comprises of the following 3 components:

1. Interest from Loans as well as from Investments

2. Fee Based Income
3. Treasury Income

Bank’s Expenditure consists of the following:

1. Interest on Demand and Time Deposits

2. Staff Expenses
3. Other Operating Expenses

Motive of the bank is to Expand Income and Reduce Expenditure so that Profit can be
maximized. But, in order to Expand Income, more risks have be incurred which requires higher
Capital.

Example:

Bank has Rs. 1000 crore for Investment in Securities which can be invested under any of the
following alternative using Basel Norms:

Yield Risk Situation 1 Situation 2 Situation 3 Situation 4

Weight
G-sec 6% 0% 1000 400 300 300
AAA Rated 8% 20% 0 600 300 300
AA Rated 10% 50% 0 0 400 200
A Rated 12% 100% 0 0 0 200
Total 1000 1000 1000 1000
Yield 60 24+48 18+24+40 18+24+20+24
=72 82 =86
%age Yield 6% 7.2% 8.2% 8.6%
RWAs 0 120 60+200 60+100+200
=120 =260 =360
8% Capital 9.60 20.80 28.80
Requirement
as per basel

128
  Bank’s policy must be to invest in such a manner that optimum yield can be obtained at
a given level of Capital.
 Bank’s non-interest income can be increased by popularizing 3rd party products and
widening scope of Treasury.
 Bank’s profit can be enhanced through effective management of risks.
 Low Cost Deposits must be increased to enhance Profits.

Risk Aggregation and Capital Allocation

Through RAROC approach, each Risk is measured to determine both expected and
Unexpected losses using VaR (Value at Risk).

 Expected Losses are covered by Reserves and provisions.

 Unexpected losses require capital allocation determined on the Principal of Confidence
level, Time horizon, Diversification and Correlation

How to Calculate RC (Risk Capital) & RAMP (Risk Adjusted Performance Measures?

RC (Risk Capital) = Business Volume * Volatility * Probability

RAPM = Profit
RC

Example:
There are two traders – One is Forex Trader and the other is Bond Trader. Each is having profit
of 10 Million USD last year. The performance of each can be compared as under:

Deals in amount Volatility Probability Table RC (Risk Capital)

at 99% volatility
Forex Trader $100 Million 12% p.a. 2.33 28 Million
Bond Trader $200 Million 4% p.a. 2.33 18.6 Million

Forex Trader
RC (Risk Capital) = 100,000,000 x 0.12 x2.33 = 28 Million USD
RAPM = 10/28 = 0.35

Bond Trader
RC (Risk Capital) = 200,000,000 x 0.04 x2.33 = 18.6 Million USD
RAPM = 10/18.6 = 0.53

Bond Trader has less Risk Capital and Higher Risk Adjusted Performance. Therefore Bond
Trader is performing better.

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 CASE STUDIES – 3rd and 4th Module

Case Study – 1 Interest Rate Risk Management

ABC Bank has following assets and liabilities:

Liabilities
Current Deposits-----------500 Crore Cash In Hand----------------------300 crore
SB Deposits-----------------1000 Crore Call Money------------------------- 400 crore
Term Deposits--------------3000 crore Cash Credit------------------------4000 crore
There is change in interest rates as under:
SB----Increase from 3.5% to 4%
FD---Increase from 7.5% to 8.5%
Call Money------------5 % to 6%
CC ----------------------12% to 12.5%

Calculate Adjusted Gap

Rate Sensitive Assets – Rate Sensitive Liabilities
= 4400-4000 = 400 crore (Positive)
Calculate Re-pricing Liabilities after interest change
SB+FD = (1000*.5) + (3000*1)
= 500 + 3000 = 3500 crore
Calculate Re-pricing Assets after Interest change.
Call Money + Cash Credit
=400*1 +4000*.5 = 400+2000= 2400 Crore
Calculate Standard Gap
Standard Gap = Re pricing Assets – Re pricing Liabilities
=2400 – 3500 = 1100 crore (Negative)

Case Study – 2 ALM (Asset Liability Management)

As per RBI guidelines, Buckets are to be classified as under:

Capital and Reserves Over 5 year Bucket
SB Deposits (10% Volatile) & CA (15% Volatile) 1-14 days Bucket
SB & CA Deposits (Core portion) 1-3 year Bucket
Term Deposits Respective Maturity

A bank has following liabilities:

Capital 4000 crore Reserves 12000 crores
CA 1000 crore SB 4000 crores
FD (1 M) 400 crores FD (1-3 M) 800
FD (3-6 M) 1200 FD (6-12 M) 2000
FD (1-3 years) 1200 FD (3-5 years) 600
FD (Above 5 years) 800 Borrowings from RBI 40
Amount in Less than 14 days bucket
 CA = 1000*15% = 150 crore
 SB = 4000*10% = 400 crore
Amount in 1-3 year Bucket

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  CA = 1000*85%= 850 crore
 SB=4000*90%=3600 crore
 FD = 1200 crore
 Total=850+3600+1200=5650 crore

Case Study – 3 CRR and SLR

Calculation of CRR and NDTL

CRR is calculated @4% of NDTL. It is calculated on the basis of fortnightly average. Minimum
90% has to be kept on each day. The amount is deposited with RBI and no interest is paid by
RBI on this balance. Please see the Liability side of bank’s balance sheet:
Capital and Liabilities
Capital
Reserves and Surplus
Refinance from NABARD,SIDBI, RBI
Deposits with other banks
Claims from DICGC, ECGC
Demand Deposits (SB and CA)
Time Deposits (FD and RD)
Borrowings (Domestic and Foreign)
Other Liabilities and Provisions
What is not to be included while calculating CRR?
1. Capital
2. Reserves
3. Refinance from NABARD, SIDBI, NHB or RBI
4. Deposits with other banks (Maturity 15 days and above)
5. Excess provisions for Income tax
6. Claims received from DICGC, ECGS, CGTMSE
 All other items are included while calculating NDTL.
Example:
Amount in crores
Capital 4400
Reserves 8600
CA Deposits 26000
SB Deposits 82000
Term Deposits (Banks) 5200
Term Deposits (others) 123200
NABARD Refinance 600
Bills Payable 200
Interest Accrued 80
Borrowings from FIs 800
Suspense Account 120
Subordinate Debts 800
Total Liabilities 252000

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 Items not to be included while calculating CRR = 4400+8600+5200+600=18800
 Amount of NDTL for calculation of CRAR = 252000-18800 = 233200
 CRR = 233200*4/100 = 9328/-
 Minimum balance to be kept on each day (90%) = 9328*90/100 = 8395.20 crore
 SLR = 233200*20.5/100 = 47806 crore

How to Calculate Cost of Deposit and Rate of Interest on Advances

Q. A bank having Deposits of Rs. 100/- has to keep CRR @4% and SLR %21%. If average rate
on Deposit (Cost of Deposit ) is 7%.
What should be the interest rate on loans so that bank may break even ?
Solution:
Breakeven means = Cost of Deposit = Return on Loans
Total Funds available in bank -----------------100
Less Deposits without income (4+21)---------25
Funds available for lending--------------------- 75

Cost of Deposits of Rs. 100 = 7

Now if Investable funds are Rs 75, earning is Rs. 7

If Investable funds are Rs. 100, earning is ---------7/75*100 = 9.33 %

It means if funds are deployed @9.33%, only then we cover the cost of funds i.e Break even
point.

Q. 2 : If rate of interest on loans is 12%, what will be the profit.

Yield on Advances = 75*12% = 9.00

Cost of funds = 7.00
Profit = 2.00

Case Study – 4 Earnings Per share (EPS)

It is ratio of PAT(Net Profit After tax) and Nos. of Equity Shares

It is calculated as under:

EPS = PAT (Profit after Depreciation, Interest and Tax)

Nos. of Equity Shares

1. A company earns PBT (Profit Before Tax) of Rs. 20 crores and PAT Rs. 15 crores. Paid
up Capital of a company is Rs. 10 crore divided into 1 crore shares of Rs. 10 each.
Market price of share is 150. Find EPS (Earning Per Share).

EPS = PAT/ Nos. of shares = 15 crores/ 1 crore = 15

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 Case Study – 5 Price Earnings Ratio (PE Ratio)
It is comparison of Market price with Earning per share.
It is calculated as under:
PE= Market price of share
Earnings Per Share
1. In the above example, please find out PE Ratio:

PE ratio = Market Price/EPS

= 150/15=Rs.10----------------------Ans.
2. A company with equity capital of Rs. 15 crore makes PBIT of Rs. 25 crore and PAT of
Rs. 5 crore (face value of share is Rs. 10). If PE ratio is 5, what will be the market price
of share:
EPS = PAT/Nos. of shares = 5 crore / 1.5 crore =5/1.5
PE ratio = Market Price / EPS
5 = MP *1.5/5
MP = 5*5/1.5 = 16.67-----------------Ans.
Another formula is derived i.e. Market Price of Share = PE ratio X EPS

Case Study – 6 Book Value of Share

Book Value is Tangible Net Worth of the Company divided by Nos. of Shares
It is calculated as under:

Equity + Reserves + Profits – Intangible Assets

Nos. of Equity Shares
Question:
Equity Share Capital = 10 crore, PBIDT = 30 crore ( Interest = 5 crore, Depreciation = 5
crore & Tax = 10 crore), Reserves = 30 crore & Long Term Debt = 35 crore.
Company pays 50% dividend and transfers remaining profit to Reserves. Share with Face value
of Rs. 10 is quoted as Rs. 150/- in the market.
Find EPS, Book Value of Share, Return on Net Worth, Debt Equity Ratio & PE ratio & Dividend
Payout Ratio.
Solution:
Earnings Per Share = PAT/No of shares = 30-(5+5+10) crore / 1 crore = 10/1 = Rs. 10
Book Value of Share = Equity + Reserves / Nos. of shares = (10+30+5)/ 1 crore = 45

Return on NW = PAT/NW*100 = 10/45*100 = 22.2%------------------------------Ans.

Debt Equity Ratio = Long Term Liabilities / Net Worth = 35/45 = 7.9-----------Ans.
PE ratio = MP/EPS = 150/10 = 15
Dividend Payout Ratio = Dividend/PAT*100 = 5/10*1=50%

Case Study – 7 Pay Out Ratio

Dividend Payout Ratio = Dividend/PAT*100
Dividend Yield Ratio = Dividend/Market Price*100
i.e.
Dividend
Market Price
A company declares Rs. 2 dividend on the equity share of Face Value of Rs. 5. The share is
quoted in the market at Rs. 80. The dividend yield will be:
2*100/80 = 2.5%.-------------Ans.

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 Case Study – 8 Yield
It is the return calculated on Face value of share in comparison with Market Value.
It is calculated as under:

Yield = Dividend (or Interest) X Face Value

Market Value
1. 8% Govt. of India security is quoted at Rs. 120/-. Find out current Yield
The current yield on the security is:
Coupon*Face Value/Market price = 8*100/120 = 6.7%---------------Ans.
1. Debenture of Rs. 100 carrying 15% coupon rate is quoted in the market at 135. Find
Yield or say Current Yield.
Current Yield = 15*100/135 = 11.11%---------------Ans.

Case Study – 9 How to Find Market Price when Rate of return goes up or Down?

1. 12% GOI Security of Rs. 100 is quoted at 120. If interest rate (Yield) goes down by 1%,
Market Price of Security will be ___?
1st step : Find out Yield
Yield = 12*100/120 = 10%
2nd step : Find out Market Price if yield is 9%
Yield = Dividend*Face Value/Market Price
9 = 12*100*MP
MP = 12*100/9 = 133.33-------Ans.
2. 11% GOI Security of Rs. 100 is quoted at Rs. 110. If interest rate (Yield) goes down by
1%, What will be the Market price of the security?
Yield = 11*100/110 = 10%
MP if Yield is 9% = 11*100/9 = 122.22 ------Ans.

Case Study – 10 Yield on Zero Coupon Bonds and T-bills

Zero Coupon Bond does not carry interest but it is always issued at discount. Calculation of
discount is done as under:

On 31st March 2006, 10 year Zero Coupon bond with Yield 7.5% issued. What price should be
quoted on 31.3.2006?

Face Value = 10000 n=10 years r=7.5% i.e. 0.075

Present Value = Future Value
(1+r)^n = 10000/(1+.075)^10 = 4852

On 31.3.2006, T-bill of Rs. 100000 issued for Rs. 98000/- with maturity date 24.6.2006.
Find out Yield

Yield = Face Value -Price X Nos. of days in a year

Price Period of Bond

= 100000-98000 X 365
98000 85

= 2000/98000* 365/85 = 8.76%---------------Ans.

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 Case Study – 11 Bond Value, Current Yield

Bond-1 Bond-2

Face Value 100 100

Annual Coupon 8% 10%

Term to Maturity 3 yrs 4 yrs

Market Price 80 90

Q. 1 Find Current Yield of Bond 2

Solution
Coupon amount X Face Value = 10/90*100 = 11.11%
Market Value
Q. 2 Find YTM of Bond 1 & 2
YTM of Bond 1 = 17.36%
YTM of Bond 2 = 13.41%

Q. 3 Find McCulay Duration of Bond 1

1.76 years
Q. 4
Find Modified Duration of Bond 2

Solution
McCulay duration/1+yield
=3.46/(1+13.41%) = 3.46/1.1341 = 3.05 yrs.
Q. 5 What is %age change in price of Bond 2 if YTM increases by 1%
Expected %age change in price
=Modified Duration x %age change in yield
=3.05 x 1 = -3.05% (Decrease in price of bond)

Q. 6 What is %age change in price of Bond 2 if YTM decreases by 1%

=3.05 x 1 = 3.05% (Increase in price of bond)
Q.7 As an investor, in which bond would you like to invest.
Ans.
Bond 1 (YTM is more)

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