MODULE D

CAPITAL ADEQUACY AND PROFIT

PLANNING.

A PRESENTATION BY

K.ESWAR MBA (XLRI) CAIIB

ASST. GENERAL MANAGER.
 What is the Basel Committee?

Established at the end of 1974 by Central Bank Governors of

G10 to address cross-border banking issues
Reports to G10 Governors/Heads of Supervision
Members are senior bank supervisors from G10, Luxembourg
and Spain
Work undertaken through several working groups
 From Basel I to Basel II

Basel I :1988 Capital Accord established minimum capital

requirements for banks Capital
Minimum ratio: 8%
Risk weighted assets
Risk Weights were straight jacket nature or “ One size fits
approach “
Eg Sovereigns were given 0% Risk weight, Banks 20% and
corporate 100%.
Lacked in its objectives to strengthen the soundness and stability
of Banks.
BASEL II
In 1998, Committee started revising the 1988 Accord:
International Convergence of capital measurement and capital
standards:
More risk sensitive
More consistent with current best practice in banks’ risk
management
Numerator (definition of capital) remains unchanged.
Basel II provides Banks incentives to Banks invest and
increase sophistication of their internal risk management
capabilities to gain reduction in capital.
Greater Disclosure by Banks.
Follow certain standards of market discipline.
 What are the basic aims of Basel II?

To deliver a prudent amount of capital in relation to risk

To provide the right incentives for sound risk management
To maintain a reasonable level playing field

Basel II is not intended to be neutral between different

banks/different exposures
However, there is a desire not to change the overall amount
of capital in the system
 Three pillars of the Basel II framework

Minimum Capital Supervisory

Market Discipline
Requirements Review Process

– Credit risk – Evaluate Risk Assessment. – Enhanced disclosure

–Bank’s own capital strategy.
– Operational risk – Supervisor’s review. –Core disclosures and
–Ensure soundness and integrity of bank’s internal supplementary disclosures.
– Market risk processes to assess the adequacy of capital.
–Ensure maintenance of minimum capital –
–Prescribe differential capital where internal
 The three pillars

All three pillars together are intended to

achieve a level of capital commensurate
with a bank’s overall risk profile.

Tier I capital and Tier II capital.

Core and supplementary capital.

 Limits on components of capital.

 BANKS TYPICALLY FACE
THREE KINDS OF RISK
Type of Risk Example

 Risk of loss due to unexpected re- Daily price “Stocks”

pricing of assets owned by the change (%)
bank, caused by either
 Exchange rate fluctuation
• Interest rate fluctuations
• Market price of investment
Unexpected
fluctuations
Market price volatility
Time

 Risk of loss due to Default “Loans with credit rating 3”

unexpected borrower rate (%)

default Unexpected
default
Avg. default

Credit
Time

 Risk of loss due to a Monthly change “Business unit A”

sudden reduction in of revenue to cost
(%)
operational margins,
caused by either Unexpected
internal or external low cost
utilization
Operational factors
Time
 Pillar I – Credit Risk

Pillar 1 – Credit Risk stipulates three levels of increasing sophistication. The more
sophisticated approaches allow a bank to use its internal models to calculate its
regulatory capital. Banks who move up the ladder are rewarded by a reduced capital
charge

Advanced
Internal
Ratings Based
Approach

Foundation Internal Banks use internal estimations of

Ratings PD, loss given default (LGD) and
exposure at default (EAD) to
Based Approach calculate risk weights for exposure
classes

Banks use internal estimations of

Standardized probability of default (PD) to calculate risk
Approach weights for exposure classes. Other risk
components are standardized.

Risk weights are based on

assessment by external credit
assessment institutions

Reduce Capital requirements

 Pillar I – Operational Risk

Advanced
Measurement
Approach.

Standardized
approach

.
Basic Indicator
Approach

Reduce Capital requirements

 Pillar I – Market Risk

Internal Models
Method
(VaR based
approaches)

Standardized
Duration
Method.

Reduce Capital requirements

 Advantages of capital

 Provides safety and soundness

 Depositor protection
 Limits leveraging
 Cushion against unexpected
losses
 Brings in discipline in risk taking
Framework
 Claims on corporates

Credit AAA AA A BBB Unrate

assessment and d
by domestic below
rating
agencies
Risk weight 20% 50% 100% 150% 100%
Mapping process – draft guidelines

Short term ratings Risk

weights
CARE CRISIL FITCH ICRA
PR1+ P1+ F1+ A1+ 20%
PR1 P1 F1 A1 30%
PR2 P2 F2 A2 50%
PR3 P3 F3 A3 100%
PR4/PR5 P4/P5 B/C/D AR/A5 150%
UNRATED UNRATED UNRATE UNRATE 100%
D D
 Mapping Long term ratings.
 AAA 20%
 AA 30%
 A 50%
 BBB 100%
 BB AND BELOW: 150%
 UNRATED 100%
 +- SIGN CORROSPONDING MAIN
RATING WILL BE USED.
 Retail Portfolio - Criteria
• Orientation criterion - exposure to individual
person or persons or to a small business.

 Product criterion - revolving credit, line of credit,

personal term loan and lease small business
facilities and commitments.
 Granularity criterion- regulatory retail portfolio is
sufficiently diversified to a degree that reduces the
risk in the portfolio – no aggregate exposure to
one counterpart can exceed 0.2% of the overall
regulatory retail portfolio
 Low value of individual exposures- the maximum
aggregate retail exposure to one counterpart
cannot exceed an absolute threshold of euro 1
million.( Rs. 5 Crores for our Bank)
 Turnover Rs.50 Crores.(AVERAGE FOR LAST 3
 Exclusion in Regulatory Retail.

 Mortgage loans to the extent they qualify for

treatment as claims secured by residential
property: Margin 25% : RW upto Rs.30 lakhs
:50% and Rs.30 lakh and above 75% Margin less
than 25% RW 100%
 Consumer credit, credit card exposure etc.
RW125%
 Capital market exposure and NBFCs RW125%
 Commercial Real Estate : RW 150%
 Staff loans: 20% if covered by superannuation
funds or mortgage.
 Other staff loans : 75% RW
 Past Dues ( NPAs)
 Past due loans
• The unsecured portion of any loan that is past
due for more than 90 days, net of specific
provisions, to be given higher risk weight
• 150% if specific provision <20% o/s
• 100% if provision >or= 20%
• if provision = or > 50% with supervisory
discretion for 50% weight
• 100% if provision > or = 15% if fully secured
 Credit Risk Mitigation

 Simple & comprehensive approaches

 Legal certainty, robust recovery
procedures
 Effects of CRM not to be double
counted
 Should not result in increasing other
risks
 Haircuts to be used in the
comprehensive approach
 Eligible financial
collateral
 Cash EQUIVALENT, CDs, Counter party deposit with
lending Bank.
 Gold – bullion & jewellery (99.99 purity)
 Central & State Govt. securities
 IVP, KVP, NSC, LIC policy
 Debt securities rated by recognised credit rating
agency
• PSEs – at least BB
• Other entities – at least A
• ST debt instruments – at least P2+/A3/PL3/F3
 Equities
 Mutual Fund units – daily NAV to be available on
public domain
 Internal Ratings Based
Approach
• Internal ratings based (IRB) approach
 Foundation
 Advanced
 Goal: Should contain incentives for migration
from standardized to IRB approach

•.
 IRB approach
 Risk components – PD, LGD, EAD,

 Retail – PD, LGD & EAD given by banks

 Differentiation between IRB – Advanced &

Foundation.
 Only PD from Bank in IRB foundation.
 In advanced approach Banks provide their
own PD, LGD, EAD.
 General Market Capital charge
 Captures risk of loss arising from general
changes in market interest rates / other market
variables

 Two Approaches

• Standardized Duration approach.

• Internal risk management models

 RBI adopted Standardized approach.

 Specific charge is similar to credit risk.
Market Risk – Internal Models

BIS requirement:
1. VaR to be calculated daily
2. Confidence level of 99%
3. Holding period 10 days
4. Historical data for at least one year to be
taken and updated at least once in a
quarter .
 Operational Risk
 Explicit charge on capital
 Basic Indicator approach – 15% of
gross income
 Gross income = net interest income
plus net non interest income.
 Gross of any provisions.
 Gross of operating expenses.
 Exclude realized profits/losses from
sales investments from Banking book.
 GROSS INCOME
 GROSS INCOME = NET PFORIT+
PROVISIONS+OPERATING
EXPENSES-PROFIT ON SALE OF
INVSTEMENT-INCOME FROM
INSURANCE-EXTRA ORDINARY ITEM
OF INCOME+ LOSS ON SALE OF
INVESTMENT
 Operational Risk
Standardised Approach- Capital charge is calculated as a
simple summation of capital charges across 8 business lines
Business lines % of gross income

Corporate finance 18
Trading & sales 18
Retail Banking 12
Commercial Banking 15
Payment & Settlement 18
Agency Services 15
Asset Management 12
Retail Brokerage 12
 General Standards to qualify for
sophisticated approaches
 Active involvement of Board and senior
management in oversight of ORM
framework.
 Sound RM system implemented with
integrity.
 Sufficient resources and skill level for use of
the approach.
 Subject to initial monitoring by supervisor.
 Supervisory review.
 Supervisors need to concentrate on
riskNot addressed under pillar I Viz
Concentration risk.
 Factors not addressed in pillar 1 such
strategic risk or interest rate risk in
Banking book.
 Factors external to Bank viz Business
cycles.
 Supervisory Review
 Principle I : Board and senior
management overview on assessing their
capital in relation to risk profile and
strategy.
 Principle II: Supervisory review of Banks
internal capital adequacy systems. On site
/off site/discussions etc.
 Principal III: Operate above minimum
regulatory capital ratios.
 Principal IV: Supervisors to intervene at
early stage.
 MARKET DISCIPLINE
a. Third Pillar to supplement first two pillars namely
minimum capital requirement and supervisory review.
b. The aim of this pillar is o encourage market discipline by
developing a set of disclosure requirements which allows
market participants to assess :
• Scope of application
• Capital
• Risk Exposures
• Risk assessment processes
• Ultimately Capital Adequacy
c. Such disclosures with common framework provides
enhanced comparability.
d. Achieving Appropriate Disclosure
• Market Discipline contributes to safe and
sound banking.
• Non-disclosure attracts penalty including a
financial penalty.
• No direct penalty of additional capital for non-
disclosure but indirectly by way of lower risk
weight under pillar-1 provided certain
disclosures are made etc.
e. Interaction with accounting disclosures :
• Disclosure framework not to conflict with requirements
under accounting standards.
f. Scope and frequency of disclosures
• All banks should provide Pillar-III disclosures both
qualitative and quantitative as on March end each year
along with annual financial statements.
• Banks with capital funds of more than Rs.500 crores and
their significant subsidiaries must disclosure on quarterly
basis.
- Tier – 1 Capital
- Total Capital
- Total required capital
- Total Capital adequacy ratios
 QUESTIONS ON NPA NORMS AND PROVISIONS

 Under Income recognition guidelines income from non performing assets is recognized on:
 Accrual basis.
 When debited to account
 When actually received.
 All of above.


 Income from advance against Term Deposit, NSC, IVP, KVP and LIC Pol may be taken to
income provided:
 Adequate margin is available.
 Cannot be taken to income if not received actually.
 In all cases it can be taken to income
 All of above.


 If Govt guaranteed advance becomes NPA then the interest on such advances
 Can be taken to income.
 Can be taken only when interest has been realized.
 All of above.
 None of above.

 QUESTIONS ON NPA NORMS AND PROVISIONS

 If any advance including bill purchased and discounted becomes NPA as at the end of any
quarter/half year/year, interest accrued and credited to income account in the previous
periods if not realized:
 Need not be reversed.
 To be reversed.
 None of above.
 Both of the above.


 Interest realized in NPA may be taken to income provided the credits towards the interest are
realized not from fresh or addl facilities.
 True
 False.


 Recovery in NPA account should be first appropriated towards

 Interest
 Principal
 In equal proportion.
 None of above.


 Recovery in Suit filed/decreed/compromised cases,recovery should first be appropriated

towards
 a. Interest,
 b. Principal
 c. Principal or as per terms of decree or settlement.
 d. None of above.

 QUESTIONS ON NPA NORMS AND PROVISIONS

 Availability of security/net worth of borrowers or guarantor

 Should be taken into consideration for treating account as NPA
 Should not be taken into consideration do
 None of above.
 Both are true.


 A non performing loan shall be a loan or advance:

 Interest or instalment overdue for more than 90 days.
 Account remains out of order for 90 days in CC OD
 Bill remain over due for more than 90 days for bill purchased or discounted.
 All of above are true.


 In case of agricultural loan it will be treated as NPA if

 a. Installments of principal or interest over due for two crop season if loan is granted for
short duration crops.
 b. Installment or interest over for one crop season if loan is for long duration crop.
 c. Both are true.
 d. Both are wrong.


 In case when bank charges interest monthly, the date of classification of NPA in case of non
service of interest will be
a. 90 days after date of charging monthly interest.
 b. 90 days after the end of quarter in which interest was charged.
 c. none of above.
 d. both are correct.
 QUESTIONS ON NPA NORMS AND PROVISIONS

 In CC account when outstanding balance remains within limit/DP:

 Account can become NPA if no credit for 90 days.
 If credits are not enough to cover the interest debited during the same period.
 Only b is correct.
 Both are correct.


 Sub standard asset is asset which

 Remained as NPA for period less than or equal to 12 months.
 Remained overdue for more than 12 months.
 None of above.


 An asset to be classified as Doubtful asset if it remained :

 Remained as sub standard asset for 12 moths.
 Remained as over for 3 years.
 Remained over due for 4 years.
 None of above.


 Loss asset is an asset which

 Considered un collectable and its continuance as bankable asset is not warranted even if some
salvage value or recovery value.
 Over due for 5 years.
 Over due for 10 years.
 None of above.



 QUESTIONS ON NPA NORMS AND PROVISIONS

 A CC account of borrower is out of order for 90 days. IN his Term Loan installment and interest
regularly served:
 Only CC account is is NPA
 Both CC and TL is NPA
 None of accounts are NPA
 Depends on security and NW of borrower.s


 A OD account of borrower is NPA. Investment made in debenture of same company and

interest is serviced regular.: Debenture of company:


 Need not be classified as NPA

 Need to be classified as NPA.
 Depends on servicing of interest on debenture.
 None of above.


 OD account XYZ Ltd a partnership is NPA . One of partner is having a sole proprietorship
account with same bank and availing CC account and this account is in order:


 This account will also be NPA

 This account will not be NPA
 Depends on out of order position.
 Depend on security.
 QUESTIONS ON NPA NORMS AND PROVISIONS


 TL account of ABC Co. is NPA . It is partnership concern. One of partners A is having a CC

account which is in order:


 This account will also be NPA

 This account will not be NPA.
 Depends on account status.
 Depends on security and NW


 TL account granted to X partner is NPA. CC account of partnership where X is partner even if it

is not out order
 Will be NPA
 Will not be NPA
 Depends on account status.
 Depends on NW.


 In account XYZ Ltd borrower committed fraud. But interest and installment recovered
regularly:
 Account should be classified as DA or Loss account.
 Account can continue as Standard.
 Account will be SSA.
 None of above.


 Erosion in security value i.e realizable value of security is less than 50% and it was
sanctioned just 3 months back:
 Classify account as SA
 Classify account as SSA
 Classify account as DA
 Classify account as LA
 QUESTIONS ON NPA NORMS AND PROVISIONS
 Realizable value of security less than 10%


 Classify account as SA
 Classify account as SSA
 Classify account as DA
 Classify account as LA


 In a CC account the stock statement is not submitted for last 3 months and DP is allowed
against old stock statement:
 Account will be NPA now.
 Account will be NPA if drawings are permitted in such account for 90 days based on such old
stock statement.
 None of above.
 Both are true.


 A CC account not reviewed by branch on due date:



 It will be NPA on due date.

 It will be NPA if not renewed in 180 days from due date.
 If will be NPA if not renewed in 90 days from due date.
 None .

 QUESTIONS ON NPA NORMS AND PROVISIONS


 X Co. is consortium account. No credits came to account for last 90 days. But party remitted
the money to consortium leader SBI in time.
 Account will be NPA treating as non served in the books of this Bank.
 Account will be PA as money received by SBI leader of consortium.
 None of above.
 Both of above.


 FCI given loan by your Bank against Govt Guarantee.

 Loan is over due for more than 90 days.:
 Will be treated as NPA.
 Will be treated as NPA only if guaranteed is invoked and guarantee is not honored.
 Both are true.
 None are true.


 Interest on above loan to FCI can be taken to income

 No as such exemption is not for recognition of income.
 Yes can be taken to income.
 None


 State Govt guaranteed loans and investment in State Govt guaranteed bonds will


 Attract loan provisions and asset classification if over due for 90 days.
 Only loan provisioning required.
 Only asset classification required.
 No need to classify as NPA
 QUESTIONS ON NPA NORMS AND PROVISIONS
 In a account 6 months moratorium is given.


 Account will become NPA only if moratorium is over.

 It will attract NPA provisions even before moratorium for interest servicing.
 None of above.


 Advance granted against security of gold :

 a. Need not be classified as NPA if value of security covers the interest even if interest not
service.
 b. Income recognition guidelines are normally applicable.
 c. Both are true.
 d. None of true.


 Advance granted against security of government security :



 a. Need not be classified as NPA if value of security covers the interest even if interest not
serviced.
 b. Income recognition guidelines are normally applicable.
 c. Both are true.
 d. None of true


 Provision on standard assets:



 .25%
 .25% for SME and agricultural advances and .40% for others.
 .40 for all
 None of above.
 QUESTIONS ON NPA NORMS AND PROVISIONS
 Provision on commercial real estate will attract a provision of
 a. 1%
 b.0.25%
 c.0.40%
 d.None.


 Provisions on fully secured SSA



 10%
 20%
 30%
 40%


Provision on SSA where abninitio bank has sanctioned with security less than 10%


 20%
 30%
 40%
 15%


 The above provision on SSA is made on outstanding in any SSA accounts is net of unrealized
interest and held in CD nominal account and realized securities held in CD nominal account
should be made without making any allowance for ECGC/CGTMSE guarantee cover and
securities available:


 True.
 False.
 Not sure.
 None.



 QUESTIONS ON NPA NORMS AND PROVISIONS


 Provisions on DA secured upto one year of remaining in DA category:

 20%
 30%
 50%
 100%


 Provision on DA secured upto 3 years of remaining in DA category:

 30%
 20%
 50%
 100%


 Provisions on DA secured. Remaining in DA for more than 3 years.



 100%
 50%
 150%
 10%

 QUESTIONS ON NPA NORMS AND PROVISIONS


 Provision on DA unsecured irrespective of age.

 100%
 10%
 50%
 70%


 In case loss assets 100% of the outstanding after adjusting realized value of security held,
claim received , unrealized interest held in nominal account, interest suspense account and
margin held account:


 True.
 False.
 Not sure.
 None.

 Profit Planning.
 Profitability for Banks depends on six
factors:
 Interest Income
 Fee Based Income.
 Trading Income.
 Interest expenses.
 Staff expense.
 Other operating expense.
 Profit Planning.
 Basel committee norms have brought
in standardization in the norms for
capital adequacy and provided
benchmarks.
 Hence Banks have to optimum mix of
assets and liabilities , keep balance
of capital requirement and optimize
profits.
 Out of four scenarios
Which scenario require highest capital
Which scenario gives highest returns

I II III IV

Inv in G.ec yield 6% 1000 400 300 300

AAA corp 8% 0 600 300 300

interest
A corp. interest 0 0 400 200
10%
Lending to BBB+ 0 0 0 200
Corp. Interest 12%
Total 1000 1000 1000 1000
Thank You!