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Investments: A major asset in banks Why do banks invest in securities???
Safety of Capital Liquidity Yield Diversification of credit risk Managing interest rate risk exposure Meeting pledging requirements
Based on objective of investment, banks divide their security holdings into three categories:
Held to maturity (HTM) : these are securities purchased with the objective of holding till maturity. On the balance sheet, they are carried at amortised cost. The capital gain or losses at the time of maturity will be taken to the income statement. However, during the period they are held, unrealistic gains and losses due to market fluctuations have no impact on the income statement. Held for trading (HFT): these securities are purchased with the intent to sell in the near term. They are carried at market value on the balance sheet and therefore unrealistic gains or losses could impact the income statement. Available for sale (AFS): securities not classified under above two categories will be included here. They too are carried at market value on the balance sheet.
The Treasury Functions
Investment advice and assistance to customers, including other banks, to manage their investment portfolios. Most treasury products are associated with the credit and cash management needs of corporate customers. The treasury can also play an important role in structuring products to hedge the bank‟s own capital. These products-typically derivative contracts-protect the bank‟s capital exposure to a particular currency or to market forces such as changing interest rates and commodity prices. The treasury buys and sells securities on behalf of the customers. Treasuries‟ willingness to buy and sell securities is also called „making the market‟. While making the market, they also make profits on the transactions, by maintaining a positive spread between the bid and ask prices. Large banks are also market makers in options and interest rate swaps.
Banks, as traders, also speculate on short term interest rate movements. Also the treasury could borrow in short term money market and invest in commercial papers. In developed markets, the treasury departments act as risk managers for banks. By using sophisticated internal transfer pricing, the treasury buys and sells funds among the bank‟s client-facing units, thus isolating and removing maturity and interest rate mismatches from corporate and retail business units.
Sources of Treasury Profit Foreign exchange business Buying and selling forex forwards. futures .swaps involving forex Loans and advances in foreign currency • Money market products Repos T-bills Commercial papers Certificate of deposits • Security market products Government securities Bonds Equities .
RETURNS OF INVESTMENT SECURITIES Methods in which bank‟s investments contribute to returns are: Interest income Income from reinvestment Capital gains and losses .
RISKS Interest rate risk Reinvestment risk Credit risk Liquidity risk Inflation risk .
VALUE AT RISK (VaR) VaR is defined as the maximum potential loss in the value of a portfolio due to adverse market movements. for a given probability Reduces the market risk to just one number Summarizes the predicted maximum loss over a target horizon within a given confidence level .
The .100crore in medium-term investments. Assume a bank holds Rs. E.cont. How much could the bank lose in a month? answer would help the bank to decide whether the returns it receives is an appropriate compensation for risk.VaR….g.
VaR PARAMETERS Two quantitative parameters: Horizon Confidence level The parameters can be changed assuming portfolio returns follow a normal distribution using the formula: VaR(n days)=n* VaR(1 day) To convert from one confidence level to another to another. use standard normal tables .
USES OF VaR Summarizes the portfolio‟s exposure to market risk Summarizes the probability of an adverse move Helps investors to decide their degree of comfort for a particular risk level Helps in internal capital allocation .
SHORTCOMINGS OF VaR Fails to measure “event” risks like market crashes Does not readily capture liquidity difference among instruments .
SUMMARY OF VaR Using a probability of x% and a holding period of n days. an entity‟s VaR is the loss that is expected to be exceeded with a probability of only x% during the next nday holding period .
Investment portfolio Permanent investment Current investment RBI stipulations Investment category Government sector Approved sector Permanent 25% 25% Current 75% 75% Shares Debentures/ bonds Subsidiaries / JV‟s Others 100% - 100% 100% 100% .
Portfolio classification Objective - - - of investment decided at the time of acquisition Held to maturity (HTM): intention to hold till maturity Held for trading (HFT): intention to trade by taking advantage of short term movements Available for sale (AFS): securities not falling in above categories .
Loss on sale recognized in the P&L account .Total SLR held in HTM does not exceed 25% of DTL on the last Friday of the 2nd preceding fortnight Profit on sale first to the profit/ loss and then appropriated to the „capital reserve account‟.Excess comprise only of SLR activities .Held to maturity Banks can exceed the limit of 25% of total investment under the following : .
SLR securities upto 25% of DTL as on last Friday of 2nd preceding fortnight .Fresh equity investment in subsidiaries and JV‟s where it holds more than 25% of equity .Fresh recapitalization bonds received from government .RIDF (Rural infrastructure development fund ) / SIDBI deposits . Following securities can be held under HTM category : .Non SLR securities included under .
Debentures/ bonds held under the HTM category must be treated as „advances‟ under following circumstances: .if issue is part of private placement .if issued as part of proposal for working capital finance and tenure is less than 1 year .if bank has a significant stake (10% or more) in the issue .if issued as part of proposal for project finance and tenure is of 3 years and above .
capital positions .Other categories Profit or loss from investments in both categories will be taken to the P&L account Investments classified under the HFT category should be sold within 90 days Bank has freedom to classify the extent of holdings under the 2 categories on the basis of: .basis of intent .tax planning .trading strategies .risk management .
Shifting categories Banks may shift investments to/ from HFT category once a year with the approval of board of directors Banks may shift from AFS to HFT with the approval of board of directors/ investment committee Shifting from HFT to AFS is generally not allowed. except under exceptional circumstances like inability to sell security but only with the approval of board of directors or investment committee .
Valuation HTM .Premium to be amortized over period remaining to maturity . other than temporary in the value of banks investment in subsidiaries or JV‟s should be provided for .Investments carried at acquisition cost .No need of marked-to-market .Any diminution.
Should be marked to market at most frequent intervals .No set offs across categories allowed .Net appreciation should be ignored .Net depreciation to be provided for . AVS .
HFT .Should be marked to market at monthly or frequent intervals .Treatment of depreciation similar to AVS .Book value of securities don‟t change after marking to market .
10% of investment portfolio Should be calculated with reference to investments in the category of HFT & AVS Banks maintaining capital of atleast 9% of RWA for the categories HFT &AVS may transfer the balance in excess of 5% of securities to statutory reserve (part of tier 1 capital) . 5% of the portfolio worth Max.INVESTMENT FLUCTUATION RESERVE To be maintained at min.
State govt.Market value Quoted securities .T bills to be valued at carrying costs . securities of equivalent maturity .Central govt. securities of equivalent maturity .Other approved securities: valued by applying the YTM method by marking it up by 25 bps above central govt. securities: basis of proces and YTM rates published .Market price of security available Unquoted securities . marked up by 25 bps above central govt. securities: valued through YTM methods.
BASEL II Three pillar approach to risk management Pillar 1 – minimum capital requirements Pillar 2 – supervisory review process Pillar 3 – market discipline and disclosures .
loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes.Continued…. INCREASED SOPHISTICATION Risk weights are assigned in slabs STANDARDISED according to the asset class or are based on assessment by external credit APPROACH assessment institutions REDUCED CAPITAL REQUIREMENT . Other risk components are standardized. ADVANCED INTERNAL RATING BASED APPROACH FOUNDATION INTERNAL RATING BASED APPROACH Banks use internal estimations of PD.
PILLAR 1.MINIMUM CAPITAL REQUIREMENT Standardised Approach Internal Rating Based (IRB) Approach Advance IRB Approach .
20%. 50%. . 100% & 150% on the basis of rating assigned by ECAIs. Standardised Approach Risk weights are assigned in slabs of 0%. Claims on Corporates – will be risk weighted in the range of 20-150% and unrated Corporates will be assigned 100% risk weight.
4-key Risk Elements of IRB Probability of Default (PD) It measures the likelihood that the borrower will default over a given timehorizon. Exposure at Default (EAD) It measures the amount of the facility that is likely to be drawn if a default occurs . Loss Given Default (LGD) It measures the proportion of the exposure that will be lost if a default occurs. . Maturity (M) It measures the remaining economic maturity of the exposure .
Minimum requirements to adopt IRB approach Credit risk management Rating dimensions Rating structure Assessment horizon Rating assignments PD for economic cycle Validation Use of credit risk mitigants .
there is no Advanced IRB is applicable to retail foundation IRB (only advanced IRB exposure also. Advance IRB Approach Values for Loss given default (LGD) and exposure at default (EAD) are determined by each bank through internal modeling with a data of 5-7 years. Banks may assess the value of its credit mitigants. where besides PD. For retail exposure.) . Assessment of values of credit mitigants is done by the regulatory authority. the bank concerned will have to estimate LGD & EAD.IRB Approach Values for Loss given default (LGD) and exposure at default (EAD) are provided by the regulatory authority.
PILLAR 2-SUPERVISORY REVIEW PROCESS There are four main areas to be treated as Pillar 2: Credit concentration risk Interest rate risk Business cycle effects .
assessing the capital adequacy to their risk profile Principle 2.monitoring and compliance with regulatory ratios Principle 3.Continued… The four key principles of supervisory review are: Principle 1.risk characteristics of the banks .
PILLAR 3.MARKET DISCIPLINE Disclosures requirements Corporate governance Creation of confidence .
credit facilities to whom is treated as an NPA . Equity shares are valued at Re 1 per company on account of the non-availability of the latest balance sheet.Non-Performing Investments Interest/installment is due and remains unpaid for more than 90 days. Fixed dividend on preference shares is not paid. The bank has invested in securities issued by a borrowing firm.
Non-Performing Investments The investments in debentures/bonds. . would also be subjected to NPI norms as applicable to investments State government guaranteed investments. where interest/principal/maturity proceeds remain unpaid for more than 90 days. in the nature of advances.
.Non-Performing Investments If interest and principal not paid – no income recognition from the securities Appropriate provisions for depreciation Depreciation of NPI cannot be set off against appreciation in other securities.
or a state govt.. . provided interest is serviced regularly and as such is not in arrears. body in its AGM and the owner‟s right to receive payment is established. Divided on shares of corporate bodies. provided dividend on the shares has been declared by the corp.Income Recognition Accrual Basis Securities of corporate bodies/ public sector undertakings in respect of which the payment of interest and repayment of principal have been guaranteed by the central govt.
Income Recognition Income from govt. Cash basis Income from units of MFs . securities and bonds and debentures of corporate bodies. where interest rates on these instruments are predetermined and provided interest is serviced regularly and is not in arrears.
985. Mutual Funds Sub-total TOTALS 100 35.51% State Govt.000 1.670.000 .000 10 10 44.) Number of Securities Total Face Value (Rs. Approved Securities 7.000 237.000 5.000 440.28% GOI 2014 (March) 8.000 4.000 5.000 719.277.000 3.000 16.985.000 677.000 100 50.700 440.000 100.500.000 700. Equity Shares: AB Financial Services Ltd.000 5.035. Securities 9.000 3.000 150.670.000 23.000 5.000.000 10 500. Loan 2016 December Sub Total 100 100 7.000.000 100.) Acquisition Price (Rs.000 3.000 887.167. Subsidiaries AG Caps Sub-total VI.000.000 5.000 3.000 5.000 150.000 4.327.55% 2011 February Sub-total III. Bank G Sub-total IV.000 15.Investment Valuation Investment Portfolio of Bank A at the end of March 2008: Face Value (Rs.000 1.000 II.000.000.000 300.000. Bonds & Debentures 7% 2011 (March) (Taxable) Sub-total V.000 1.000.000 316.000 10 10.) I.500. Govt.000 3.
the investment is valued.) 98.40 lakh. The prices of govt.25% 6.90 102 The shares of Bank G are traded in the market at Rs. and approved securities into current investment category. Since AB Financial Services Ltd.75 .Continued… The Bank classifies the entire govt. NAV of MF is Rs 10. based on the latest audited accounts.10% Maturity 2012 2014 Sale Price (Rs. at Rs 2. 27. Is not a listed firm. securities on the RBI list for sale are: Security 5.
the following YTMs are applicable on 31 March. .17 For valuation of taxable bonds.05 8 5. 08: No.96 7 5.54 3 4.5 2 4.07 10 5.05 9 5. 1% above the applicable YTM rate is to be applied.6 4 4. 18 lakh. securities (central and state). of Years YTM (%) <1 4. For all other govt. Provision made during the previous year stands at Rs.83 No.66 5 4. of Years YTM (%) 6 4.3 1 4.
900 7% bonds – Rs.917 Approved Security 7. Securities 9. 1. 6.55% Feb07 – Rs. 3.064 Equity shares AB Financial Services Ltd – no market quote Bank G – 27*23.75 = Rs.000*10.700 = Rs.28% GOI 2014 – Rs.53.500 .951 8. 37.51% state govt.86.770 Investments in subsidiary – permanent – book value MF – 10. 51.Sale Price = I*n – F[(0.07. 8.39. loan – Rs.72.90.4nr)-I] 0.6nr+I Govt.
951 56.786.000 150.190.327.064 116.500 -489.770 5.000 100.000.) I.000.951 372.786.190.900 879.000.000 639.000 5.064 116.55% 2011 February Sub-total (II) III. Bank G Sub-total (III) IV.600 .917 1.51% State Govt. Equity Shares: AB Financial Services Ltd.670.000 -247.000 3.) Acquisition Value (Rs. Mutual Funds Sub-total (VI) TOTALS (III+VI) 3.500.000 3.000 5.000 5.868 II.000 4.985.000 719.000.770 205.000.868 134.) Change in Value (Rs.917 191.064 440.226.000 300.000 1.000.770 205.000 5.000 887.500.000. Govt.500 -42. Approved Securities 7. Subsidiaries AG Caps Sub-total (V) VI. Securities 9.000.000 4.28% GOI 2014 (March) 8.000 150.000 100.100 5.Face Value (Rs.985. Bonds & Debentures 7% 2011 (March) (Taxable) Sub-total (IV) V.000 5.064 3.000 1.000 316.035. Loan 2016 December Sub Total (I) 700.770 5.000 1.000 853.900 -200.000 440.100 -447.000 5.000 5.000 240.000.000 237.500 -42.000 107.000 3.670.) Market Value (Rs.000 677.500 107.000 3.
LTCM Collapse and Link with VaR 1998 – World‟s largest hedge fund failed and sent shock waves through the world‟s financial system. Derivatives > USD 5 tn. Federal Reserve Bank of New York facilitated a bailout. Capital base – USD 3 mn. . Primary contributory factor to failure – Poor risk management. Assets > USD 10 bn.
LTCM Collapse and Link with VaR Combination of different VaR techniques.1 in 50 years 45% drop in equity value over a course of month – 10 std dev .Aug 98 .1 in 10 months 20% or > .1 in 5 months 10% or > . VaR analysis showed: 5% or > .
USD 100 mn Fourth day of debacle – USD 500 mn Decision to file for bankruptcy followed by bailout .LTCM Collapse and Link with VaR Aug 98 – beyond predictive abilities of VaR models Russian crisis triggered drying up of liquidity in the global financial markets Derivative positions slacked VaR estimate – daily loss < USD 50 mn Actual daily loss – approx.
Lesson learnt too many uncertainties in the future that cannot be predicted by the past. VaR has to be used judiciously.LTCM Collapse and Link with VaR Wrong basic assumption – Historical trends in securities movements were an accurate predictor of future movements.3 bn of equity capital and USD 1 bn excess liquidity. LTCM used USD 2. .
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