COMMERCIAL BANKING

Syllabus
Understanding various risks faced by banks and how bank managers manage these risks Understanding profitability drivers of banks Understanding balance sheet Understanding capital adequacy ratio

Banking that is not Investment banking Understanding Financial statements Understanding Risks and Risk Management in Banks

RISK & RISK MANAGEMENT .

higher the growth in business RISK MGT IS THE PRO-ACTIVE ACTION IN THE PRESENT FOR THE FUTURE . hence little or no risk taking NOW: Risk intermediary instead of financial intermediary Higher the risk.RISK Uncertainty or Financial loss Reflected by way of charge on the fundamental/basic Risks can be inter-dependent Each transaction changes risk profile of bank THEN: Banks were regulated.

RISK Risk is greatest when probability of occurrence of nonoccurrence is equal Potentiality of expected and unexpected events having adverse impact on banks capital and earnings † † EXPECTED LOSS: borne by borrower. taken care by risk premium (pricing) UNEXPECTED LOSS: borne by bank. taken care by capital .

Credit Risk Market Risk Operational risk . 2.TYPES OF RISKS RBI identified three major risks 1. 3.

CREDIT RISK .

CREDIT RISK Potential that a bank borrower fails to meet obligation on agreed terms Inherent to banking business 2 components of risk: o/s loan balance † Quality of risk: probability of default † Quantity Thus. risk † Exposure risk † Default .

Default is not an abrupt process. default/migration statistics. recovery data . its an extreme event of credit migration Use of Portfolio analysis in identifying concentration of credit risk.

Pricing on a scientific basis Controlling through loan review mechanism and portfolio mgt.Management of credit risk Measurement through credit rating/scoring Quanitification through estimate of expected loan losses. .

Loan review mechanism . Exposure ceilings Review/renewal Risk rating model Risk based scientific pricing Portfolio mgt.TOOLS OF CREDIT RISK MGT.

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MARKET RISK .

MARKET RISK Possibility of loss caused by the changes in market variables Risk to the bank·s earnings and capital Comprises of risk † Interest rate risk † Forex risk † Country risk † Liquidity Mitigated by scenario analysis and stress testing of future changes in economic conditions † Periodic review of assumptions † Identification .

LIQUIDITY RISK Liquidity is a bank·s ability to generate cash quickly and at a reasonable cost LR is the risk that the bank may not be able to fund increases in assets or meet liability obligations as they fall due without incurring unacceptable losses .

FACTORS THAT CAN INFLUENCE BANK·S LIQUIDITY Access to financial markets Financial health of the bank: Asset Quality Balance sheet structure: Liquidity v/s Profitability Timing of funds flow: Asset Liability mis-match Exposures to off-balance sheet activity Impact of other risks .

3. 2. Funding risk: Unexpected withdrawals: O/F Time risk: Compensate for non-receipt of expected inflows: I/F Call risk: Crystalisation of contingent liabilities: O/F .LIQUIDITY RISK Mismatch 1.

.ALM ALM is an integral part of the financial management process of any bank ALM is concerned with strategic balance sheet management involving risks caused by changes in the interest rates. exchange rates and the liquidity position of the bank.

WHAT IS ALM? 20 An attempt to match: Assets and Liabilities In terms of: Maturities and Interest Rates Sensitivities To minimize: Interest Rate Risk and Liquidity Risk .

earning power.Asset Liability Management 21 ALM can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. liabilities. and degree of willingness to take on debt and hence is also known as Surplus Management ALM 2008 Com Bkg 2008 . It takes into consideration interest rates.

ASSET LIABILITY MANAGEMENT Examines all assets and liabilities simultaneously on a continuous basis with a view of ensuring a proper balance between funds mobilisaion and their deployment w.t. Track the impact of pre-payment of loans and premature closure of deposits . liabilities and off-balance sheet items.r. to: Maturity profiles † Cost † Yield † Risk exposure † Cash flows are placed in different time buckets based on future likely behaviour of assets.

Liquidity Risk Profile of a Bank (Rs in crores) 23 ALM 2008 Com Bkg 2008 .

GAP Analysis 24 One way to measure the direction and extent of asset-liability mismatch is by using gap analysis. The analysis derives its name from the ´gapµ which is the difference between the amounts of Rate Sensitive Asset (RSA) and Rate Sensitive Liabilities (RSL). .

A. Deregulation of Interest Rates Interest Rate Risk Liquidity Risk Credit Risk ALM 2008 Com Bkg 2008 .HISTORY OF ALM 25 Mid 1970s in the U.S.

earning power and degree of willingness to take on debt. stability and growth of a system through the dynamic balances of its assets and liabilities. ALM 2008 Com Bkg 2008 .managementµ. It is also called surplus.µ The text book definition of ALM is ´a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates. ´the process of decision ² making to control risks of existence.Definition of ALM 26 ALM is defined as.

SUCCESS OF ALM PROCESS The ALM process rests on Three Pillars: 1. ALM Organisation 3. ALM Information Systems 2. ALM Process .

ALM INFORMATION SYSTEM Decision Support and Reporting Tool Comparison between different Branches Product Analysis Duration Gap Analysis Risk Planning and Management Flexible Design Strategic Planning of the Asset-Liability Mix Simulation Analysis Transfer.1.Pricing Mechanism .

ALM ORGANISATION Strong Commitment of Senior Management ALCO should comprise the Senior Management ( including the CEO) A Support Group of Operational Staff .2.

Board of Directors Management Committee Asset Liability Committee (ALCO) Asset Liability Management Cell Finance Planning Department Credit Analysis Department Credit Risk Management Department Treasury 30 ALM 2008 Com Bkg 2008 Investment and Loan Departments .

31 ALM 2008 Com Bkg 2008 .

32 ALM 2008 Com Bkg 2008 .

ALM PROCESS The scope of ALM function can be described as follows: † Liquidity Risk Management † Management † Trading † Funding † Profit of Market Risks Risk Management and Capital Planning Planning and Growth Projection .3.

75* 100 8. cr.75* 100 13.5* 100 .Price Matching (Rs.75* Assets Amount Rate (%) 10 5 15 10 30 10 20 100 0 12 12 15 15 15 18 13.) * Average cost/return on liabilities/assets.5* Spread (%) 0 12 7 10 3 2 5 4. Table 1 Table 1 (Rearranged) Liabilities Amount Rate (%) 15 25 30 30 0 5 12 13 Assets Amount Rate (%) 10 20 50 20 0 12 15 18 Liabilities Amount Rate (%) 10 5 15 10 30 10 20 0 0 5 5 12 13 13 8.

cr.) Table II (Rearranged) Liabiliti es Maturing within (months) Assets Maturing within (months) 15 10 5 10 30 10 20 100 <1 3 6 12 24 36 >36 Liabilit ies Assets Gap Cumulative Gap 10 5 8 4 45 20 8 100 1 3 6 12 24 36 >36 10 5 8 4 45 20 8 100 15 10 5 10 30 10 20 100 -5 -5 3 -6 15 10 -12 -5 -10 -7 -13 2 12 0 .Maturity Matching Table II (Rs.

MANAGEMENT OF LIQUIDITY RISK 36 Construction of time buckets: 1 to 30/31 days Over 1 month and upto 2 months Over 2 months and upto 3 months Over 3 months and upto 6 months Over 6 months and upto 1 year Over 1 year and upto 3 years Over 3 years and upto 5 years Over 5 years .

special sanction from the Board Statement of Structural Liquidity (maturity ladder) ALM 2008 Com Bkg 2008 .MANAGEMENT OF LIQUIDITY RISK Main focus on Short Term mismatches Mismatches during 1-30 days < 20 % of cash outflows in the same bucket For higher limits.

Risks in ALM 38 Interest Rate Risk: It is the risk of having a negative impact on a bank·s future earnings and on the market value of its equity due to changes in interest rates. Forex Risk: It is the risk of having losses in foreign exchange assets and liabilities due to exchanges in exchange rates among multi-currencies under consideration. Liquidity Risk: It is the risk of having insufficient liquid assets to meet the liabilities at a given time. ALM 2008 Com Bkg 2008 .

INTEREST RATE RISK Potential negative impact on the Net Interest income Vulnerability of institution·s financial condition to the movement in interest rates. Measured from † Earnings  perspective: value perspective: impact on reported earnings † Economic  impact on balancesheet  Arises from long term interest rate gaps .

and re-pricing date that IR of A & L change in different magnitude assets are sold before maturities wrt IR at which the future cash flows could be Basis risk: † Risk Re-price risk † When Reinvestment risk † Uncertainity reinvested . maturity dates.Types of INTEREST RATE RISK Gap/Mismatch risk: † Arises from holding Assets and liablities with different Principal amounts.

† Measures wors expected loss over given time interval at a certain confidence level † Assesses Simulation .INTEREST RATE RISK MGT. Gap analysis Value at Risk: market risk using std statistical techniques.

FOREX RISK Risk on account of adverse exchange rate movement pattern of forward contracts † Settlement risk: default of counter party † Maturity Currency risk .

COUNTRY RISK Risk arising on account of cross border transactions Comprises of risk † Sovereign risk † Political risk † Currency risk † Transfer Foreign branches Disclosure norms in Annual reports .

OPERATIONAL RISK .

natural disaster Global financial interlinkages Mitigation through Control and internal audit † Insurance cover † Risk education at all levels † Corporate Governance practices † Internal . financial fraud. people and systems or from external events.OPERATIONAL RISK Risk of loss arising from inadequate or failed internal processes. Arises out of human error.

coz it can be measured.OR is interwined with MR / CR. has evolved over time. hence difficult to isolate & CR Mgt. monitored and analysed † Most financial scams and losses on account of OR † MR 12-20% of charge on Capital funds earmarked for OR .

REGULATORY RISK Multiple regulatory agencies Inhibits free growth Compliances are drain on time and energy .

ENVIRONMENTAL RISK LPG. leads to exposure to Env risk Therefore delivery channel † Reach customers † Innovate products † Improve . Technological advancement etc.

BASEL·S CAPITAL ACCORD .

CAPITAL ACCORD Bankers· for internationa Settlement (BIS) At Basel Developing standards and establishment of framework for bank supervision towards strengthening financial stability through out the world. .

Focused on total amount of bank capital so as to reduce the risk of bank solvency at the potential cost of bank·s failure for the depositors Basel standards require Banks to have a capital adequacy ratio of 8% RBI has mandated 9% CAR Govt infused funds in PSU Banks making it unviable .

5 times Asset creation multiple in case of new banks .CAPITAL ADEQUACY Prior to LPG. PSU banks· capitalisation was not given much importance For a given capital how much assets can be created Maximum asset creation multiple of 12.

etc Functional departments should also be enabled for risk monitoring Strong MIS.CONCLUSION Committee approach † Risk mgt. data warehousing . credit policy C. networking. C. ALCO.

UNDERSTANDING FINANCIAL STATEMENTS .

00.BALANCE SHEET OF A COMPANY LIABILITIES Net worth Borrowings Current Liab & Provision Amount ASSETS 400000 Fixed Assets 400000 Investments 200000 Current Assets 10.00.000 .000 Amount 400000 250000 350000 10.

BALANCE SHEET OF A BANK LIABILITIES Deposits Short term Long term Borrowings Capital & Surplus Amount ASSETS Cash Amount 5000 30000 25000 40000 2000 100000 65000 Loans & Adv 20000 Short term 5000 Long term 10000 Investments Fixed Assets 100000 .

Key differences Financial leverage Fixed Assets Sources of funds are primarily short term Uses of funds short to medium term .

BANK BALANCESHEET
LIABILITIES Net worth Deposits Borrowings Other Liab Contingent Liabilities ASSETS Investments Loans and Advances Fixed Assets Other Assets

BALANCE SHEET

BALANCE SHEET ITEMS: Liabilities
CAPITAL
200 cr upto 300 cr in 3 yrs † Maintain atleast 300 cr thereon
† Min

RESERVES AND SURPLUS
reserve: > 20% of distributable profits † Capital reserve: POSA, LOSA † Share premium † Investment Fluctuation Reserve:
† Statutory

Atleast 5% of Inv portfolio ¶held for trading· & ¶Available for Trading·  Transfer from POSA 

RD. Reinv D. TD due not paid  No int paid on these balances † Savings  deposits Household savings  Payable on demand † Time  deposit FD.  NRI accounts . CD etc.BALANCE SHEET ITEMS : Liabilities DEPOSIT † Demand  deposit: current a/c.

SIDBI and other apex bodies  Money market † Outside India OTHER LIABILITIES AND PROVISIONS office adjustments † Interset accrued † Others † Inter .BALANCE SHEET ITEMS : Liabilities BORROWINGS † In  india Refinancing: RBI.

BALANCE SHEET ITEMS: ASSETS CASH AND BANK BALANCES WITH RBI In hand and in vault † Bal with RBI for statutory requirements † BALANCES WITH BANKS & MONEY AT CALL AND SHORT NOTICE † Additional line of defence to CRR and SLR requirement INVESTMENTS Govt securities † Approved Securities † Shares † Debentures and bonds † Subsidiaries and JV † Other Investment † .

OD. Term loan Tangible security Bank/govt guarantee Unsecured advances Priority Public sector adv Banks others  By security arrangements     By sector     .BALANCE SHEET ITEMS: ASSETS LOANS AND ADVANCES † Classification     by: Nature of credit facility: Bills CC.

BALANCE SHEET ITEMS: ASSETS FIXED ASSETS † Premises † OFA † Assets on lease OTHER ASSETS accrued † Inter office adjustments † Stamp papers. stationery † others † Interest .

CONTINGENT LIABILITY Claims agnst banks not ack as debt o/s forward contracts Guarantees Acceptance. obligations etc Others .

INCOME STATEMENT .

INCOME STATEMENT High revenue from interest on adv and investments Shift towards fee based services i.e. Spread Interest Income < Ohd cost BURDEN † Non . NON INTEREST INCOME NET INTEREST INCOME † Net Interest Income.

INCOME Income from interest on advances Non interest income POSA EXPENSES Interest Paid On Advances Overhead expenses Provisions on Assets/Adv LOSA .

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