Caiib BFM Study Notes PDF

BANK FINANCIAL MANAGEMENT
CHAPTER PAGE NO
MODULE A 2
1. FOREIGN EXCHANGE
2. FOREX DERIVATIVES 12
3. LETTER OF CREDITS & UCPDC 600 23
4. FACILITIES TO EXPORTER & IMPORTER 31
5. RISK IN INTERNATIONAL TRADE & ECGC 36
6. ROLE OF RBI & EXCHANGE CONTROL 38
7. FEMA,1999 49
MODULE B
1. RISK MANAGEMENT – AN OVERVIEW 60
2. ASSET LIBILITY MANAGEMENT 63
3. LIQUIDITY RISK MANAGEMENT 66
4. MARKET RISK 76
5. CREDIT RISK MANAGEMENT 81
6. OPERATIONAL RISK 89
MODULE C
1. TREASURY MANAGEMENT 96
2. INTEREST RATE RISK 113
MODULE D
1. BANK BALANCE SHEET 122
2. PRUDENTIAL NORMS – INCOME & ASSET 131
3. BASEL ACCORD & PROVISIONS 142
MULTIPLE OBJECTIVE QUESTION BANK 178
CAIIB (REVISED) –PAPER2

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CHAPTER 1
FOREIGN EXCHANGE
1. GlobalForeign Exchange Markets

24 hour non-stop market:
The main feature of this market is that, it is continuous - i.e., open 24 hours a day. The time zones
are as follows: The market begins with New York (6 p.m India time) , then Sydney, followed by
Tokyo. When we come to work in the morning here in India, Tokyo is at lunch. The Frankfurt
market opens at 10 a.m our time; then London (12.30 our time) and we go back full circle to New
York again. This means that there is a price available always, anytime and you can transact
whenever you want.
2. Introduction to Foreign Exchange

Foreign exchange rate is the value of a foreign currency relative to domestic currency. The
exchange of currencies is done in the foreign exchange market, which is one of the biggest
financial markets. The participants of the market are banks, corporations, exporters, importers etc.
A foreign exchange contract typically states the currency pair, the amount of the contract, the
agreed rate of exchange etc.
A foreign exchange deal is always done in currency pairs, for example, US Dollar – Indian Rupee
contract (USD – INR); British Pound – INR (GBP - INR), Japanese Yen – U.S. Dollar (JPYUSD),
U.S. Dollar – Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the world are USD,
JPY, EURO, GBP, and CHF and some of the liquid currency contracts are on USD-JPY, USD-
EURO, EURO-JPY, USD-GBP, and USD-CHF.
In a currency pair, the first currency is referred to as the base currency and the second currency is
referred to as the ‘counter/terms/quote’ currency. The exchange rate tells the worth of the base
currency in terms of the terms currency, i.e. for a buyer, how much of the terms currency must be
paid to obtain one unit of the base currency. For example, a USD-INR rate of Rs. 64.0530 implies
that Rs. 64.0530 must be paid to obtain one US Dollar. Foreign exchange prices are highly volatile
and fluctuate on a real time basis. In foreign exchange contracts, the price fluctuation is expressed
as appreciation/depreciation or the strengthening/weakening of a currency relative to the other. A
change of USD-INR rate from Rs. 64 to Rs. 64.50 implies that USD has strengthened/ appreciated
and the INR has weakened/depreciated, since a buyer of USD will now have to pay more INR to
buy 1 USD than before.
3. Brief History:
Before there was significant trade between countries, there was little need for foreign exchange,
and when there was a need, it was served by gold, since gold was used by most of the major
countries. However, as trade expanded, there was a need to exchange currency rather than gold
because gold was heavy and difficult to transport. But how could different countries equalize their
currency in terms of another currency. This was achieved by equalizing all currencies in terms of
the amount of gold that it represented—the gold-exchange standard.
Under this system, which prevailed from 1879 to 1934, the value of the major currencies was fixed
in terms of how much gold for which they could be exchanged, and thus, they were fixed in terms of
every other currency.
During the 1930's, the world was in the throes of the Great Depression. Countries started
abandoning the gold standard by reducing the amount of gold backing their currency so that they
could increase the money supply to stimulate their economies. This deliberate reduction of value is
called a devaluation of currency. When some of the countries abandoned the gold standard, then it
just collapsed, for it was a system that could not work unless all of the trading countries agreed to
it.
The leaders of the allied nations met at Bretton Woods, New Hampshire in 1944, to set up a better
system of fixed exchange rates. The U.S. dollar was fixed at $35 per ounce of gold and all other
currencies were expressed in terms of dollars. This official fixed rate of exchange was known as
the par value of currency or par exchange rate.
However, to avoid making deleterious macroeconomic adjustments to maintain the exchange rate,
the new system provided for an adjustable peg, that allowed the exchange rate to be altered under
CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

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specific circumstances. Thus, this Bretton Woods system was also known as the adjustable-peg
system. To actuate this new system, the International Monetary Fund (IMF) was created.
The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large
amounts of U.S. dollars from post World War II aid and sales of their exports in the United States.
There were concerns as to whether the U.S. had enough gold to redeem all the dollars.
With reserves of gold falling steadily, the situation could not be sustained and the U .S. decided to
abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be
convertible into gold, so the exchange rate was allowed to float. Because of the central role played
by the United States, the Bretton Woods system could not be sustained. By 1973, this action led to
the system of managed floating exchange rates that exists today.
4. Broad factors that affect Foreign Exchange Markets :

Basically, the Supply and Demand for currency determines ex-rates, market forces, like any
commodity or asset. Further the following factor has a weightage on exchange rate :
1. Purchasing Power Parity (PPP): Why is a dollar worth Rs. 65, Pound Rs. 100 etc at some point
of time? The answer may that these exchange rates reflect the relative p urchasing powers of the
currencies, i.e the basket of goods that can be purchased with a dollar in the US will cost Rs. 65 in
India and Rs.100 in Britain.
Purchasing Power Parity theory focuses on the inflation exchange rate relationship. Assume the
current rate between INR and USD is Rs. 65/$1. The inflation rates are 8% in India and 4% in US.
Therefore , a basket of goods in India or some goods in India, let us say costing now Rs. 65 will
cost one year forward Rs.65 x 1.08 = Rs. 70.20. A similar goods in US, after one year will cost $
1.04. If Purchasing Power Parity (PPP) holds, the exchange rate between USD and INR , one year
hence would be Rs. 70.20 = $ 1.04. This means, the exchange rate would be for $1 = Rs.
70.20/1.04, which will be Rs. 67.20
2. Interest Rate Parity (IRP): Interest rate parity is a theory which states that the size of the forward
premium or discount should be equal to the interest rate differential between the two countries.
According to this theory, there will be no arbitrage in interest rate differentials between two different
currencies and the differential will be reflected in the discount or premium for the forward exchange
rate on the foreign exchange.
Example
Let us consider investing € 1000 for 1 year, we'll have two options as investment cases −
Case I: Home Investment: In the US, let the spot exchange rate be $1.2245 / €1.
So, practically, we get an exchange for our €1000 @ $1.2245 = $1224.50
We can invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at the end of
the year.
Case II: International Investment :We can also invest €1000 in an international market, where the
rate of interest is 5.0% for 1 year.
So, €1000 @ of 5% for 1 year = €1051.27
Let the forward exchange rate be $1.20025 / €1.
So, we buy forward 1 year in the future exchange rate at $1.20025/€1 since we need to convert our
€1000 back to the domestic currency, i.e., the U.S. Dollar.
Then, we can convert € 1051.27 @ $1.20025 = $1261.79
Thus, when there is no arbitrage (means the simultaneous purchase and sale of an asset in order
to profit from a difference in the price), the Return on Investment (ROI) is equal in both cases,
regardless the choice of investment method.
Other Factors:-
I. MACRO - ECONOMIC FUNDAMENTALS:
1. GDP Growth : This is the primary indicator of economic growth. This gives a bird’s eye view of
the economy and its performance.It is the value of all goods and services produced by the nation's
labour and capital inputs. It is broken further into private consumption expenditure, investment
expenditure, government consumption expenditure and net trade balance.

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2. Balance of Payments: This has three components:-

i.Trade Gap (Imports less Exports)
ii.Current Account balance (trade gap including invisibles)
iii.Capital Flows
This gives an indication for future exchange rate policy especially for less developed markets.
Currency devaluation assists exports by making them more competitive and at the same
discouraging imports by making them more expensive.
3. Industrial production / Capacity Utilisation/Unemployment: This indicates the health of the

manufacturing sector of the economy.
4. Structural considerations:
i. Reserve Composition ( Short /Long Term liabilities): This indicates the extent of hot money that
constitutes your reserves. A higher percentage of short term obligations tends to make the
economy more vulnerable to exchange rate volatility and also a degree of uncertainty as regards
the ability to renew these short term liabilities.
ii. Import elasticity ( Dependence on Oil imports ): Volatility in oil prices brings a greater degree of
uncertainty to economies dependent to a large extent on oil imports.
iii. Structure of Exports - whether import dependent : This relates to the nature of products exported
and their susceptibility to the relative exchange rate.
iv. Nature of Inflation ( Demand pull/Cost push): Inflation resulting due to excessive demand factors
tends to have more impact on monetary policy than those caused by higher input costs.
v. Market Liquidity /yield curve dynamics: This is more relevant in less developed markets. Markets with
poor liquidity tend to be more volatile.
vi. Strength of the Financial System - (Banking sector Capitalisation , Non Performing Assets (
NPAs ). These factors also tend to influence interest rate policies in many countries.
5. Government Policy :
This is again relevant in more controlled markets. The attitude of the government regarding their
policy focus - Pro reform v/s greater controls. A case in example is Indonesia. The country had to
resort back to capital controls to protect its exchange rate.
Expectation against reality - Speed of implementation and Government commitment:
This tends to affect sentiment more than anything else. India’s divestment policy is a good case in
example where political intent is lacking.
2. Foreign Exchange Rates & Arithmetic

Exchange Rate Regime : The exchange rate regime is a method through which a country manages
its currency in respect to foreign currencies and the foreign exchange market.
Fixed Exchange Rate: A fixed exchange rate is a type of exchange rate regime in which a
currency's value is matched to the value of another single currency or any another measure of
value, such as gold. A fixed exchange rate is also known as pegged exchange rate. A currency that
uses a fixed exchange rate is known as a fixed currency. The opposite of a fixed exchange rate is a
floating exchange rate.
Floating Exchange Rate: A Floating Exchange Rate is a type of exchange rate regime wherein a
currency's value is allowed to fluctuate according to the foreign exchange market. A currency that
uses a floating exchange rate is known as a floating currency. A Floating Exchange Rate or a
flexible exchange rate and is opposite to the fixed exchange rate.
Linked Exchange Rate: A linked exchange rate system is used to equalize the exchange rate of a
currency to another. Linked Exchange Rate system is implemented in Hong Kong to stabilise the
exchange rate between the Hong Kong dollar (HKD) and the United States dollar (USD).
QUTOATION STYLE: Various kinds of quotes are described in the following sections.

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American vs. European Quote

A quote can be classified as European or American only if one of the currencies is the dollar. An
American quote is the number of dollars expressed per unit of any other currenc y, while a
European quote is the number of units of any other currency expressed per dollar. For example,
Rs. 48.28/$ is a European quote, while $1.6698/£ is an American quote. In almost all the countries,
most of the exchange rates are quoted in European terms. The British pound, the Irish pound and
the South African rand are a few examples of currencies quoted in American terms.
Direct vs. Indirect Quote

Direct quote: In this case there is one unit of foreign currency and corresponding units of home
currency. Examples of direct quotes in India:
1$ = Rs.46 1£ = Rs.68 1 Euro = Rs.54
Indirect quote: In this case there is one unit of home currency and corresponding units of foreign
currency. Examples of indirect quotes in India:
Re. 1 = $ 0.0250 Re. 1 = £ 0.0122 Re. 1 = Euro 0.0185
OR Indirect quote = 1
------------------
Direct quote
Here, the bank would be buying dollars @ $2.1998/Rs.100 and selling dollars @ $2.1978/Rs.100.
The corresponding direct quote would be:
$ 1=Rs. 45.4586/45.5000
Here, the bank would be buying dollars @ Rs. 45.4586/$ and selling dollars @ Rs. 45.5000/$.
Before August 2, 1993, the indirect methods of quoting exchange rates used to be followed in India.
Since that date, however, the direct quote is being used. In other countries, the concepts of
American and European quotes are more popular in comparison to direct and indirect quotes.
Example (A) Example Convert the following direct quotes (in India) into indirect quotes:
1$ = Rs.40 1£ = Rs.82
Answer: Indirect quotes (in India) Re. 1 = $ 1/40 i.e. $ 0.0250
Re. 1 = £ 1/82 i.e. £ 0.0122
Example (B) Convert the following indirect quotes (in India) into direct quotes:
Re. 1 = $ 0.0222 Re. 1 = £ 0.0122
Answer : Direct quotes (In India) 1$ = Rs.1 / 0.0222 i.e. Rs.45 1£ = Rs.1/ 0.0122 i.e.
Rs.82
Bid and Ask Rate
The buying rate is also known as the ‘Bid rate’ and selling rate as the ‘offer/Ask‘ rate. The
difference between these rates is the gross profit for the bank and is known as the ‘Spread‘.
Principal types of Rates (bank to customer) :

In a purchase transaction the bank acquires foreign exchange from the customer and pays him in
home currency & vise versa for sale transaction.
Depending upon the time of realization of foreign exchange by the bank, two types of buying rates
are quoted in India. They are
(i) TT Buying Rate (ii) Bill Buying Rate (this is explained in chapter 6, pg.no.44)
(i) TT Buying Rate (TT stands for Telegraphic Transfer):

Some of the purchase transactions result in the bank acquiring foreign exchange immediately,
while some involve delay in the acquisition of foreign exchange. For instance, if the bank pays a

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demand drawn on it by its correspondent bank, there is no delay because the foreign corresponded
bank would already have credited the Nostro account of the paying bank while issuing the demand
draft.
This is the rate applied when the transaction does not involve any delay in realization of the foreign
exchange by the bank. In other words, the Nostro account (An account of Indian Bank with foreign
bank at overseas settlement center) of the bank would already have been credited. The rate is
calculated by deducting from the interbank buying rate the exchange margin as determined by the
bank. Though the name implies telegraphic transfer, it is not necessary that the proceeds of the
transaction are received by telegram. Any transaction where no delay is involved in the bank
acquiring the foreign exchange will be done at the TT rate.
Transaction where TT rate is applied is;
1. Payment of demand drafts, mail transfers, telegraphic transfers, etc drawn on the bank where
banks Nostro account is already credited.
2. Foreign bills collected. When a foreign bill is taken for collection, the bank pays the exporter only
when the his importer at foreign destination pays for the bill by SWIFT and the banks Nostro
account abroad is credited.
As relates to selling rates by bank, they are of two types:
(i) TT selling Rates (ii) Bills selling rate (this is explained in chapter 6, pg.no.45)
(i) TT Selling Rate

This is the rate to be used for all transactions that do not involve handling of documents by the
bank. Transactions for which this rate is quoted are:
1. Issue of demand drafts, mail transfers, telegraphic transfer, etc., other than for retirement of an
import bill.
2. Cancellation of foreign exchange purchased earlier.
Margin by bank :-
Exchange margin is the extra amount or percentage charged by the bank over and above the rate
quoted by bank.
When we are given the Spot rate / forward rate with margin for buying rate and margin for selling
rate then effective rate will be calculated as:
Deduct margin from buying rate to get desired exchange rate. Hence,
Now, buying rate will be = Bid rate – exchange margin
Example :- Given $ = Rs. 54.480/.900 and Margin is 0.08% then the Bid rate after margin will be:
$ = Rs.54.480 – 0.0435 ( 54.480 *0.08%) OR Rs. 54.480 ( 1-0.0008)
= Rs. 54.436
Add margin to selling rate to get the desired rate. Hence,

Now, selling rate = Ask rate + exchange margin
Example: Given $ = Rs. 54.480/.900 and Margin is 0.08% then the Ask rate after margin will be:
$ = Rs.54.900 + 0.0439 ( 54.900 *0.08%) OR Rs. 54.900 ( 1 + 0.0008)
= Rs. 54.9439
CROSS CURRENCY RATES

Before one currency gets converted into another, in most cases, it first gets c onverted into US
Dollars. However, all those currency conversions that happen in foreign exchange, wherein one
currency directly gets converted into the other currency (without converting it first to USD), are
called currency cross rates, i.e, EUR (euro) / GBP (Great British pound) or GBP / Yen (Japanese
yen) or GBP/Rs., Euro/Rs. etc. Sometimes we may not get a quote from market regarding our
currency with foreign currency and hence we need to get by cross currency only.
How to calculate Cross currency rates?

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Step 1: Review the five "major" crosses that are used to determine cross currencies. They are:
EUR/USD (euro/U.S. dollar)
GBP/USD (Great British Pound/U.S. dollar)
USD/CHF (U.S. dollar/Swiss franc)
USD/JPY (U.S dollar/Japanese Yen)
AUD/USD (Australian dollar/U.S. dollar)
Step 2 : Determine the rates for the two currencies you want to calculate a cross currency rate for.
Let's say you want to calculate a cross rate for the EUR/CHF and the current quote for EUR and
CHF is:
EUR/USD = 1.2060
USD/CHF = 1.5080
Step 3: Calculate the currency cross. Multiply the first currency in the pair by the second currency
in the pair. For instance, the EUR/CHF cross is calculated by multiplying the currency rate for EUR
by the currency rate for CHF. The calculation is: 1.2060 x 1.5080 = 1.8186
Example a. 1USD = Rs. 40.00 1USD = CHF 1.40 1 CHF = Rs. ?

Answer: 1$ = Rs.40.00 (It is Rs./$)
1$ = CHF 1.40 (It is CHF/$)
Re. 1 = $ 0.0250 (It is $/Re)
1CHF = $ 0.71429 (It is $/CHF)
We have to find (Rs./CHF)

Rs Rs. $
----- = ----- x ----- = 40 x 0.71429 = Rs.28.5714
CHF $ CHF
Example b: Given the following rates, find ‘bid’ and ‘ask’ rates for CY in terms of rupees.
1 USD = 5.7040 – 5.7090 CY
1 USD = 40.30 - 40.50 Rupees
Answer:
1$ = CY 5.7040/5.7090 (it is CY/$)
1$ = Rs.40.30/40.50 (it is Rs./$)
1CY = $(1/5.7090) / (1/5.7040 ) (it is $/CY)
1 Re. = $(1/40.50) / (1/40.30) (it is $/ Rs.)
We have to find Rs./CY.

Rs. $
Rs./CY = -------- x -------
$ CY
Rs. / CY (bid ) = (40.30) X (1 /5.7090) = 7.0590
Rs. / CY ( ask) = (40.50) X (1/5.7040) = 7.1003
Rs. / CY = 7.0590 / 7.1003
1 CY = Rs.7.0590 / Rs.7.1003
Cross Rates and Chain Rule (India):

In India, buying rates are calculated on the assumption that the foreign exchange ac quired is
disposed of abroad in the international market and the proceeds realized in US dollars. The US
dollars thus acquired would be sold in the local interbank market to realize the rupee. For example,
if the bank purchased a CHF 10,000 bill it is assumed that it will sell the Swiss francs at the
Singapore market and acquire US dollars there. The US dollars are then sold in the interbank
market against Indian rupee. The bank would get the rate for US dollars in terms of Indian rupees
in India. This would be the interbank rate for US dollars. It would also get the rate for US dollars in
terms of Swiss franc at the Singapore market. The bank has to quote the rate to the customer for
Swiss franc in terms of Indian rupees. The fixing of rate of exchange betw een the foreign currency

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and Indian rupee through the medium of some other currency is done by a method known as
‘Chain Rule‘. The rate thus obtained is the ‘Cross rate‘ between these currencies.
TRANSACTIONS IN INTERBANK MARKETS :

The exchange rates quoted by banks to their customer are based on the rates prevalent in the
interbank market. The big banks in the market are known as market makers, as they are willing to
buy or sell foreign currencies at the rates quoted by them up to any extent. Depending buy or sell
foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a
bank may be a market maker in one or few major currencies.
Spot and Forward transactions :

The transactions in the interbank market may place for settlement
(a) on the same day; or (b) two days later; or (c) some day late; say after a month i.e Forward
Where the agreement to buy and sell is agreed upon and executed on the same date, the
transaction is known as cash or ready transaction. It is also known as value today.
The transaction where the exchange of currencies takes place two days after the date of the
contact is known as the spot transaction. For instance, if the contract is made on Monday, the
delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on
the next day, i.e., Thursday. Rupee payment is also made on the same day the foreign currency is
received.
What is mean by ‘Forward transactions’?

The transaction in which the exchange of currencies takes places at a specified future date,
subsequent to the spot date, is known as a forward transaction. The forward transaction can be for
delivery one month or two months or three months etc. A forward contract for delivery one month
means the exchange of currencies will take place after one month from the date of contract. A
forward contract for delivery two months means the exchange of currencies will take place after two
months and so on. The rates quoted for such transactions are called as ‘Forward rates’.
A forward contract is normally entered into to hedge oneself against exchange risk (i.e., the
uncertainty regarding the future movements of the exchange rate). By entering into a forward
contract, the customer locks-in the exchange rate at which he will buy or sell the currency.
Forward rates can be derived from interest rates of the two currencies. It is basically a function of
the interest rate differential between the currencies. Let us take an example :
MARKET RATES :
3 Month GBP : 4.0 %
3 Month USD : 1.0 %
Spot GBP / USD : 1.7900
Interest Rate Differential --------------------------> Exchange Rate Differential
(Spot Rate X Int. Rate Differential)/100 X No. of Months Forward/12 Months
To make it more scientific you can take the actual number of days in the month.
12 months is taken as 365 for GBP and INR and 360 for other currencies as per market practice.
1.7900 * 3 X 3 = 0.0134
100 12
SPOT RATE USD 1.7900
SWAP RATE ( POINTS) 0.0134
Therefore, 3 month forward rate (outright rate): USD 1.7766
Discount and Premium :

A currency is said to be at premium against another currency if it is more expensive in the forward
market than in the spot market. In this case, its forward rate will be higher than its spot rate. This
happens when the future spot rate is expected to be higher than the current spot rate. Conversely,
a currency is said to be at a discount if it is cheaper in the forward market than in the spot market.

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In this case, its forward rate will be lower than its spot rate. This happens when the future spot rate
is expected to be lower than the current spot rate. Let us assume the Rs/$ quotes to be:
Rs/$ : 45.42/44
3-m Rs/$ : 46.62/70
Here, the bank is ready to give only Rs. 45.42 currently in exchange for a dollar, while it is ready to
give Rs. 46.62 after 3 months. Similarly, the bank is charging only Rs. 45.44 for selling a dollar
now, while it is charging Rs. 46.70 for a delivery 3 months hence. So the dollar is expected to be
more expensive in the future, and hence is at a premium against the rupee. On the other hand, the
rupee is expected to be cheaper in the future and hence is at a discount against the dollar.
Let us now assume the $/£ quotes to be:

$/£ : 1.6721/26
3-m $/£ : 1.6481/92
Here the dollar is at a premium against the pound, while the pound is at a discount against the
dollar. It is possible that a currency may be at a premium against one currency, while being at a
discount against another at the same time. It is also possible that a currency be at a premium
against another for a particular forward maturity, while being at a discount against the same
currency for another forward maturity. E.g., the $/£ quotes may be:
$/£ : 1.6721/26
2-m $/£ : 1.6726/34
3-m $/£ : 1.6481/92
Here, the pound is at a premium against the dollar for the 2-month maturity, but at a discount for
the 3-month maturity. It is also possible to have such a situation where a currency is at a premium
against another for a particular forward maturity, but a discount between two forward maturities.
E.g., the $/£ quotes may be:
$/£ : 1.6721/26
1-m $/£ : 1.6730/37
2-m $/£ : 1.6726/35
Here, the pound is at a premium against the dollar for both the forward maturities, but at a discount
between the one-month and the two-month maturities.
Forward premium/discount is generally calculated as percentage per annum.
= (Forward rate-Spot rate) 12/n. *100

Spot rate
Where ‘n’ indicates the number of months till maturity of the forward contract
Interpretation of Interbank quotations :

The market quotation for a currency consists of the spot rate and the forward margin. The outright
forward rate has to be calculated by loading the forward margin into the spot rate. For instance, US
dollar is quoted as under in the interbank market on 25th January under:
Spot USD 1 = Rs. 68.4000/4200

Spot/February 2000/2100
Spot / March 3500/3600
The following points should be noted interpreting the above quotations:

1. The first Statement is the spot rate for dollars. The quoting bank’s buying rate is 38.4000 and
selling rate is Rs 38.4200.

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2. The second and third statements are forward margins for forward delivery during the months of
February and March respectively. Spot/ February rate is valid for delivery end February. Spot/
March rate is valid for delivery end March.
3. The margin is expressed in points, i e 0.0001 of the currency. Therefore, the forward margin for
February is 20 paisa and 21 paise
4. We have seen that under direct quotation, the first rate in the spot quotation is for buying and
second for selling the foreign currency. Correspondingly, taking the forward margin, the first rate
relates to buying and the second to selling. Taking Spot/February as an example, the margin of 20
paise is for purchase and 21 paise is for sale of foreign currency.
5. Where the forward margin for a month’s is given in ascending order as in the quotation above, it
indicated that the forward currency is at premium. The outright forward rates they arrived at by
adding the forward margins to the spot rates.
The outright forward rates dollar can be derived from the above quotation as follows.
Buying rates selling rate
February March February March
Spot rate 68.4000 68.4000 68.4200 68.4200
Add: Premium 0.2000 0.3500 0.2100 0.3600
Forward Rates 68.6000 68.7500 68.6300 68.7800
From the above calculation we arrive at the following outright rates:

Buying rates Selling rate
Spot delivery USD 1 = Rs.38.4000 38.4200
Forward delivery February 38.6000 38.6300
Forward delivery March 38.7500 38.7800
If the forward currency is at discount, it would be indicated by quoting the forward margin in the
descending order.
Practice Problems:-
Q.1 An exporter customer requests a bank to sell 25,00,000 Singapore Dollar (SGD) . The inter -
bank market rates are as follows:
Mumbai US$ 1= Rs.45.85/45.90
London Pound 1= USD 1.7840/1.7850
Pound 1= SGD 3.1575/3.1590
The bank wishes to retain an exchange margin of 0.125%. (Calculate rate in multiples of .0001).
How many Rupees the exporter will receive?
Answer:-
1$ = Rs.45.85/45.90……....................... (It is Rs./$)
1Re = $(1/45.90) / ( 1/45.85) (It is $/Re)
1 £ = $1.7840/1.7850…… ………………… (It is $/£)
1 $ = £ ( 1/1.7850) / (1/1.7840)………… ( It is £/$)
1£ = SGD 3.1575/ 3.1590…………...........(It is SGD/£)
1SGD = £ (1/3.1590) / ( 1/3.1575)………… .(It is £/SGD)
Computation of SGD rate i.e. Rs/SGD.( The bank will be purchasing SGD, hence we have to
calculate ‘bid’ rate.)
RS = RS. X $ X £
SGD $ £ SGD
Rs. (bid) = 45.85 X 1.7840 X (1/3.1590) = Rs.25.8931307375
SDG
Taking bank margin into consideration bid rate per SGD: Rs.25.8931307375(1 -0.00125) i.e.
Rs.25.860764324. Total receipt = 6,46,51,911
Q.3. If the spot price for USD/EUR = 0.7395, then this means that 1 USD = .7395 EUR. The interest
rate in Europe is currently 3.75%, and the current interest rate in the United States is 5.25%.
Calculate the 1year forward rate.

11
Forward Exchange Rate = S(1+rq)n

───────
(1+rb)n
S = Spot Price rq = Interest Rate of Quote Currency rb = Interest Rate of Base Currency
n = Number of Compounding Periods
= 0.7395(1+0.0375)1
─────────────
(1+0.0525)1
= 0.7395 *1.0375
───────────
1.0525 = 0.7290
Thus, the forward exchange rate is 1 USD = 0.7290 (rounded) Euro, or simply, the forward rate.
Q 4. A person has to pay $ 13750 after three months today. Spot Rate: Re l = $ 0.0275. Rupee is
likely to depreciate by 5% over three months. What is likely forward rate?
Answer: Rupee is left had currency. It is at discount. Amount of discount should be deducted from
right hand currency for estimating the forward rate.
Hence forward rate is: Re. 1 = $ 0.0275 - $ 0.0275 (5/100) i.e. 0.026125.
Q.5: Six month T bill have a nominal rate of 7%, while default free Japanese bonds that mature in 6
months have a nominal rate of 5.5%. In spot market, 1$ = Yen 86. If interest rate parity holds, what
is the 6 month forward exchange rate?
Answer: (1.0275/1.035) x 86 = 85.3768
Q.7 : Dollar is quoted in the interbank market as follows.

Spot USD 1 = Rs. 65.3500/65.4000
1 months forward 2000/3000
Calculate 1 month, 2 months and 3 months forward rates for dollar.
Solution
Buying 1 months 2 months 3 months
Spot rate 65.3500 65.3500 65.3500
Add: Premium 0.2000 0.4000 0.6000
Forward Rates 65.5500 65.7500 65.9500
Selling 1 months 2 months 3 months

Spot rate 65.4000 65.4000 65.4000
Add: Premium 0.3000 0.5000 0.7000
Forward Rates 65.7000 65.9000 66.1000
*****

12
CHAPTER 2
FOREX DERIVATIVES
The financial environment today has more risks than earlier. Successful business firms are those
that are able to manage these risks effectively. Due to changes in the macroecon omic structures
and increasing internationalization of businesses, there has been a dramatic increase in the
volatility of economic variables such as interest rates, exchange rates, commodity prices etc. Firms
that monitor their risks carefully and manage their risks with judicious policies enjoy a more stable
business than those who are unable to identify and manage their risks.
There are many risks which are influenced by factors external to the business and therefore
suitable mechanisms to manage and reduce such risks need to be adopted. One of the modern
day solutions to manage financial risks is ‘hedging’. Before trying to understand hedging as a risk
management tool, we need to have a proper understanding of the term ‘risk’ and the various types
of risks faced by firms.
What is risk?
Risk, in simple terms, may be defined as the uncertainty of returns. Risks arise because of a
number of factors, but can be broadly classified into two categories: as business risks and financial
risks.
Business risks include strategic risk, macroeconomic risk, competition risk and technological
innovation risk. Managers should be capable of identifying such risks, adapting themselves to the
new environment and maintaining their competitive advantage.
Financial risk, on the other hand, is caused due to financial market activities and includes liquidity
risk and credit risk.
Risk Management
An effective manager should be aware of the various financial instruments available in the market
for managing financial risks. There are many tools for the same and a judicious mix of various tools
helps in efficient risk management.
Since the early 1970s, the world has witnessed dramatic increases in the volatility of interest rates,
exchange rates and commodity prices. This is fuelled by increasing internationalization of trade and
integration of the world economy, largely due to technological innovations. The risks arising out of
this internationalization are significant. They have the capacity to make or break not only
businesses but also the economies of nations. However, financial institutions are now equipped
with tools and techniques that can be used to measure and manage such financial risks. The most
powerful instruments among them are derivatives. Derivatives are financial instruments that are
used as risk management tools. They help in transferring risk from the risk averse to the risk taker.
Derivatives are financial contracts whose value is determined from one or more underlying
variables, which can be a stock, a bond, an index, an interest rate, an exchange rate etc. The most
commonly used derivative contracts are forwards and futures contracts and options. There are
other types of derivative contracts such as swaps, options, etc.
Currency derivatives can be described as contracts between the sellers and buyers whose values
are derived from the underlying which in this case is the Exchange Rate. Currency derivatives are
mostly designed for hedging purposes, although they are also used as instruments for speculation.
Currency markets provide various choices to market participants through the spot market or
derivatives market. Before explaining the meaning and various types of derivatives contracts, let us
present three different choices of a market participant.
The market participant may enter into a spot transaction and exchange the currency at current
time. The market participant wants to exchange the currency at a future date. Here the market
participant may either:
• Enter into a futures/forward contract, whereby he agrees to exchange the currency in the future at
a price decided now, or,

13
• Buy a currency option contract, wherein he commits for a future exchange of currency, with an
agreement that the contract will be valid only if the price is favorable to the participant.
Forward Contracts : Forward contracts are agreements to exchange currencies at an agreed rate
on a specified future date. The actual settlement date is more than two working days after the deal
date. The agreed rate is called forward rate and the difference between the spot rate and the
forward rate is called as forward margin. Forward contracts are bilateral contracts (privately
negotiated), traded outside a regulated stock exchange and suffer from counter -party risks and
liquidity risks. Counter Party risk means that one party in the contract may default on fulfilling its
obligations thereby causing loss to the other party.
In the previous chapter we have seen how to calculate the forward rates.
Example: Forward Discount/ Premium

If the ninety day ¥ / $ forward exchange rate is 109.50 and the spot rate is ¥ / $ = 109.38, then the
dollar is considered to be "strong" relative to the yen, as the dollar's forward value exceeds the spot
value. The dollar has a premium of 0.12 yen per dollar. The yen would trade at a discount because
its forward value in terms of dollars is less than its spot rate.
The annualized rate can be calculated by using the following formula:

Formula :-
Annualized = Forward Price – Spot Price x 12 x 100%
Forward Premium Spot Price # of months
forward
Answer:
So in the case listed above, the premium would be calculated as:
Annualized forward premium=
((109.50 – 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%
Similarly, to calculate the discount for the Japanese yen, we first want to calculate the forward and
spot rates for the Japanese yen in terms of dollars per yen. Those numbers would be (1/109.50 =
0.0091324) and (1/109.38 = 0.0091424), respectively.
So the annualized forward discount for the Japanese yen, in terms of U.S. dollars, would be:
((0.0091324 – 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%
See Chapter FEDAI rules for more calculations & situations of forward contract.
International Swaps and Derivatives Association - ISDA

An association created by the private negotiated derivatives market that represents participating
parties. This association helps to improve the private negotiated derivatives market by identifying
and reducing risks in the market.
Futures Contracts (Please also refer more on this in chapter Treasury Products in Module C
of this notes)
Futures contracts are also agreements to buy or sell an asset for a certain price at a future time.
Unlike forward contracts, which are traded in the over-the-counter market with no standard contract
size or standard delivery arrangements, futures contracts are exchange traded and are more
standardized. They are standardized in terms of contract sizes, trading parameters, settlement
procedures and are traded on a regulated exchange. The contract size is fixed and is referred to as
lot size.
Since futures contracts are traded through exchanges, the settlement of the contract is guaranteed
by the exchange or a clearing corporation and hence there is no counter party risk.
Exchanges guarantee the execution by holding an amount as security from both the parties. This
amount is called as Margin money. Futures contracts provide the flexibility of closing out the

14
contract prior to the maturity by squaring off the transaction in the market. Table will draws a
comparison between a forward contract and a futures contract.
Currency Futures
Exporters/Long on Foreign Importers/Short onForeign

Currency Currency
Short Currency future hedge Long Currency future hedge
I) Currency Futures in India:-

A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain
underlying asset or an instrument at a certain date in the future, at a specified price. When the
underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures
contract”. When the underlying is an exchange rate, the contract is termed a “currency futures
contract”. Both parties of the futures contract must fulfill their obligations on the settlement date.
Currency futures are a linear product, and calculating profits or losses on these instruments is
similar to calculating profits or losses on Index futures. In determining profits and losses in future s
trading, it is essential to know both the contract size (the number of currency units being traded)
and also the “tick” value.
A tick is the minimum size of price change. The market price will change only in multiples of the
tick. Tick values differ for different currency pairs and different underlyings. For e.g. in the case of
the USDINR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupee. To
demonstrate how a move of one tick affects the price, imagine a trader buys a contract (U SD 1000
being the value of each contract) at Rs. 44.7500. One tick move on this contract will translate to
Rs.44.7475 or Rs.44.7525 depending on the direction of market movement.
The contract amount (or “market lot”) is the minimum amount that can be trade d. Therefore, the
profit/loss associated with change of one tick is: tick x contract amount The value of one tick on
each USDINR contract is Rupees 2.50 (1000 X 0.0025). So if a trader buys 5 contracts and the
price moves up by 4 ticks, he makes Rupees 50.00 (= 5 X 4 X 2.5)
(Note: The above examples do not include transaction fees and any other fees, which are essential
for calculating final profit and loss).
Futures terminology:-
Some of the common terms used in the context of currency futures market are given below:
• Spot price: The price at which the underlying asset ($, £, €, ¥ etc.) trades in the spot market.
• Futures price: The current price of the specified futures contract.
• Contract cycle: The period over which a contract trades. The currency futures contracts on the
SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-month
expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in
time.
• Value Date/Final Settlement Date: The last business day of the month will be termed as the Value
date / Final Settlement date of each contract. The last business day would be taken to be the
same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including
those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by
Foreign Exchange Dealers’ Association of India (FEDAI).
• Expiry date: Also called Last Trading Day, it is the day on which trading ceases in the contract;
and is two working days prior to the final settlement date.
• Contract size: The amount of asset that has to be delivered under one contract. Also called as lot
size. In the case of USDINR it is USD 1000; EURINR it is EUR 1000; GBPINR it is GBP 1000 and
in case of JPYINR it is JPY 100,000.

15
• Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
• Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is
called marking-to-market.
CASE STUDIES:-
Example 1: An exporter of garments from India has contracted to export 10,000 pieces of shirt to a
large retailer in US. The agreed price was USD 100 per shirt and the payment would be made
three months after the shipment. The exporter would take one month to manufacture the shirt. The
exporter had used the prevailing spot price of 45 as the budgeted price while sig ning the export
contract. To avoid the FX risk, the exporter sells four month futures at the price of 46. The exporter
receives USD well on time and he converts USD to INR in the OTC market at the then prevailing
price of 47 and also cancels the futures contract at the same time at the price of 47.20. How much
was the effective currency price for the exporter.
The effective price would be summation of effect of change in USDINR price on the underlying
trade transaction and the effect of change in future price on the currency futures contract.
• Underlying trade transaction: Against the budget of 45, the exporter realizes the price of 47 and
therefore there is a net positive change of Rs 2
• Futures contract: Against the contracted price of 46, the exporter had to settle the contract at 47.2
and therefore resulting in a net negative change of Rs 1.2
• Combined effect: The combined effect of change in USDINR spot price and change in future price
i.e. (Rs 2) + (- Rs 1.2) = + Rs 0.8
• Effective price: Therefore the effective price was 45 (budgeted price) + 0.8 (effect of hedging and
underlying trade transaction) i.e. Rs 45.8.
In the same example, assume that INR appreciated against USD at time of converting USD to INR
the spot was 44 and futures contract’s cancellation rate was 44.2, the effective currency price for
the exporter would still be 45.8. This is because there would be a negative change of Rs 1 on
underlying trade transaction and a positive change of Rs 1.8 on futures contract. Therefore the net
effect will be summation of – 1 and + 1.8 i.e.Rs 0.8.
Please notice that because of the futures contract exporter always gets a price of 45.8 irrespective
of depreciation or appreciation of INR. However, not using currency futures would have resulted in
effective rate of 47 (in the first case when INR depreciated from 45 to 47) and effective rate of 44
(in the second case when INR appreciated from 45 to 44). Thus using currency futures, exporter is
able to mitigate the risk of currency movement.
2. Let us take an example where an importer hedges only partial amount of total exposure.
This example will also demonstrate the method of computing payoff when hedging is done for
partial exposure.
An importer of pulses buys 1000 tons of chickpea at the price of USD1600 per ton. O n the day of
finalizing the contract, USDINR spot price was 45. The importer was not sure about the INR
movement in future but he was more biased towards INR appreciation.
He decides to hedge half of the total exposure using currency futures and contracted a rate of 45.5
for two month contract. In the next two months, INR depreciated to 46.5 at the time of making
import payment. Let us assume that the day of making import payment coincides with expiry of
future contract and the settlement price of futures contract was declared as 46.7. What was the
effective USDINR for the importer and what would it have been had he hedged the full exposure.
The effective price would be summation of final price at which import remittance was made and
payoff from the futures contract.
• Futures contract: Against the contracted price of 45.5, the importer settled the contract at 46.7,
thereby resulting in a net positive change of Rs 1.2. Since importer hedged only half of the total
exposure, the net inflow from hedging would be available for half of total exposure.
• Effective price computation: Therefore the effective price would be 46.5 (final remittance price) for
the unhedged part and 45.3 for the balance half which was hedged. The figure of 45.3 is computed
by deducting 1.2 (inflow from hedging) from 46.5. Therefore final effective price would be:
(46.5 x 0.5) + (45.3 x 0.5) = 45.9

16
Please note that since it is import payment and a lower USDINR exchange rate would be positive
for the importer, therefore a positive inflow from future contract is reduced from the remittance price
to compute effective price for the hedged part.
As against the effective price of 45.9, the price would have been 45.3 had the importer decided to
hedge the total exposure. Also note that without hedging, the effective price would have been 46.5
i.e., the price at which importer made the import remittance.
Did you notice that in the second scenario of full hedging, the effective price (45.3) is different from
the contracted price of futures (45.5)? The difference is due to the difference in the final settlement
price of futures contract and the price at which remittance was done.
1. Mark to market Case study:

On Monday HLL enters into a future contract of purchasing $1,25,000/- at the rate of $ = Rs.44.50.
This contract is to mature on Thursday. At the close of trading on Monday, Tuesday & Wednesday,
the future prices are Rs.44.42, 44.65 & 44.22. At the close of trading on Thursday, the spot rate in
Rs.44.10. What amount the investor receives / pays on different days? Explain the outcome of the
contract explaining the theoretical concepts of the different steps. Initial margin is 1.25% of contract
amount. That means HLL has to deposit = $ 125000 X Rs.44.50 = Rs.55,62,500 X 1.25% =
Rs.69,531/- to exchange for this future contract.
The payoff table on mark to market daily basis will be as follows:
Day Market rate Strike Gain or Total Gain or Margin

Price loss loss on Account cash
contract flow
Monday 44.42 44.50 - 0.08 - Rs.10,000 Rs.59,531
Tuesday 44.50 44.50 0.00 0 Rs.59,531
Wednesday 44.65 44.50 0.15 + Rs.15,000 Rs.74,531
Thursday 44.90 44.50 0.40 + Rs.40,000 Rs.1,14,531
Here from the above we can conclude that HLL by entering in future contract gained by
Rs.15,000+Rs.40,000 – Rs.10,000 = Rs.45,000/-
This can be confirmed :- Margin account bal. Rs.1,14,531 – Initial Margin Rs.69,531
= Rs.45,000/-
If the rupee will trade at the premium then HLL will suffer a loss as given in following table
Day Market rate Strike Gain or Total Gain or Margin
Price loss loss on Account cash
contract flow
Monday 44.58 44.50 0.08 + Rs.10,000 Rs.79,531
Tuesday 44.50 44.50 0.00 0 Rs.79,531
Wednesday 44.35 44.50 - 0.15 - Rs.15,000 Rs.64,531
Thursday 44.10 44.50 - 0.40 - Rs.40,000 Rs.24,531
That means HLL lost Rs.45,000/- by entering future contract due to appreciation of rupee.
2) Currency Option:
As the word suggests, option means a choice or an alternative. To explain the concept though an
example, take a case where you want to a buy a house and you finalize the ho use to be bought.
On September 1st 2011, you pay a token amount or a security deposit of Rs 20,000 to the house
seller to book the house at a price of Rs 15,00,000 and agree to pay the full amount in three
months i.e., on November 30th 2011. After making full payment in three months, you get the
ownership right of the house. During these three months, if you decide not to buy the house,
because of any reasons, your initial token amount paid to the seller will be retained by him.
In the above example, at the expiry of three months you have the option of buying or not buying the
house and house seller is under obligation to sell it to you. In case during

17
these three months the house prices drop, you may decide not to buy the house and lose the initial
token amount. Similarly if the price of the house rises, you would certainly buy the house. Therefore
by paying the initial token amount, you are getting a choice/ option to buy or not to buy the house
after three months.
The above arrangement between house buyer and house seller is called as option contract. We
could define option contract as below:
Option: It is a contract between two parties to buy or sell a given amount of asset at a pre- specified
price on or before a given date.
We will now use the above example, to define certain important terms relating to options.
• The right to buy the asset is called call option and the right to sell the asset is called put option.
• The pre-specified price is called as strike price and the date at which strike price is applicable is
called expiration date.
• The difference between the date of entering into the contract and the expiration date is called time
to maturity.
• The party which buys the rights but not obligation and pays premium for buying the right is called
as option buyer and the party which sells the right and receives premium for assuming such
obligation is called option seller/writer.
• The price which option buyer pays to option seller to acquire the right is called as option price or
option premium
• The asset which is bought or sold is also called as an underlying or underlying asset.
Buying an option is also called as taking a long position in an option contract and selling is also
referred to as taking a short position in an option contract.
There are two types of Currency options i.e CALL & PUT as elucidated below.
Currency options
Call Options Put Option

(Right to buy but no obligation to buy) (Right to sale but no obligation to sale)
For example, a ABC Ltd having a liability in Euro with a view that the Euro/USD rate will be higher
on maturity date will buy an Euro call. On the maturity date, he has the option to buy the Euro at the
strike price or buy it from the market in case it is cheaper. If the ABC Ltd buys a Call Option with a
strike price at 0.9000 and on maturity date, the rate is 0.8700, the ABC Ltd has the right to exercise
the option. Since in the example cited, it would be cheaper for the ABC Ltd to by the Euro from the
market, the ABC Ltd -will not exercise the option
Style of options
Based on when the buyer is allowed to exercise the option, options ar e classified into two types:
A. European options: European options can be exercised by the buyer of the option only on the
expiration date. In India, all the currency options in OTC market are of European type.
B. American options: American options can be exercised by the buyer any time on or before the
expiration date. Currently American options are not allowed in currencies in India.
Illustration:-
Purchased Call option: Corporate buys a USD call option for covering its import transactions
from a ABN AMRO bank on 1 June 2011, at a strike rate of 45.50. The expiry date is 3 months i.e. 31st
August 2011. The premium is 30 paise on the call. Gain or loss at various levels of exchange rate
are demonstrated below vide pay off table
Market Exercise Rate call Premium paid Gain/Loss

18
Rate @ 45.50
43.00 0.00 0.30 -0.30
43.50 0.00 0.30 -0.30
44.00 0.00 0.30 -0.30
44.50 0.00 0.30 -0.30
46.00 0.50 0.30 0.20
46.50 1.00 0.30 0.70
47.00 1.50 0.30 1.20
When spot exchange rate rises above the strike price, there are gains, when it falls below the strike
price there are losses, which are maximum to the extent of premium paid.
That means it is always advisable to exercise Call Option when the spot rate is more and strike
price is lower.
Illustration:-
Buying Put Option : A leading garment exporter sold Put option in which USD shall be purchased
at 45.50, Premium paid for buying put option is 30 paise. Gain or loss at various levels of exchange
rate are shown above vide pay off table is given below.
Market Exercise Rate @ 45.50 Premium paid Gain/Loss

Rate
44.00 1.00 0.30 0.70
45.00 - 0.50 0.30 0.30
46.00 0.00 0.30 0.30
46.50 0.00 0.30 0.30
47.00 0.00 0.30 0.30
When spot exchange rate rises above the strike price, the put option will not give any profit but
when it falls below the strike price there are profits.
That means it is always advisable to exercise Put Option when the spot rate is less and strike price
is higher.
Selling Put Option : A leading garment exporter sold Put option in which USD shall be purchased
at 45.50, Premium paid for buying put option is 30 paise. Gain or loss at various levels of exchange
rate are shown above vide pay off table is given below.
Market Exercise Rate selling Premium Gain/Loss

Rate put @ 45.50 Received
45.00 - 0.50 0.30 - 0.20
46.00 0.00 0.30 0.30
46.50 0.00 0.30 0.30
47.00 0.00 0.30 0.30
47.50 0.00 0.30 0.30
When spot exchange rate rises above the strike price, there are gains, when it falls below the strike
price there are losses, which are maximum to the extent of premium received.
That means it is always advisable to exercise Put Option when the spot rate is more and strike
price is lower.
From above three illustrations one must conclude that the strategy will depend on the following
factors:
1. Who is a party to options i.e Importer or Exporter
2. Perception of exchange rate movement i.e At premium or at Discount
3. Premium to paid/received

19
What is meant by the terminology that an option is in the money, at the money, or out-of-the-
money?
Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money.
If St ≅ E the option is trading at-the-money.
If St < E (E < St) the call (put) option is trading out-of-the money.
St = Strike Price
E = Exercise Price
CASE STUDIES:-
1. An American manufacturer ABC plc. Ltd purchases Japanese goods worth 90 million Yens,
credit terms 1 month. i.e. the manufacturer has to pay ,after one month, the Japanese company 90
million Yen no matter what happens to the Yen-Dollar rate. That means the American co. is at risk
if the rate is not favorable. Here ABC plc. Ltd can hedge this risk by entering into option contract.
The co can buy a foreign currency option which gives him the right but not the obligation to buy 90
million yen at 110 Yens per Dollar. The option carries a premium or cost of US $ 0.02 million. Now
there can be Three Possibilities as regards this call option:-
a. If Yen Falls: Say 120 yens per US $ then ABC plc. Ltd will purchase Yens from the
market instead of going for option as he will need to pay only 0.75 million US $ to spot market. The
Co. will benefit even if they lost the premium on call option.
b. If Yen is Stable: ABC plc. Ltd purchases 90 million Yens either from the market or under his
option. He has to pay US $ 1.0909 million. Cost is $0.02 million, i.e. premium for purchasing
option.
c. If Yen Rises or will be at premium: Suppose after three months, yen rises to 100 Yen per US $. If
ABC plc. Ltd purchases Yens from the market, he has to pay 90 million / 100. i.e., 0.90 million US
$. That means co. can purchase yen by paying $ 9,00,000.
Whereas if Co. exercises the option, he can purchase 90 million Yens for at 110 yens per dollar or
90million/110 i.e 0.818 million US $. Or co. can purchase yen by paying $ 8,18,182. That means a
savings of $ 81818.00 over spot market.
And therefore Co. should exercise the option as the Net saving is $ 81,818 – Premium paid
$20,000 = $ 61,818
2. An American firm has just bought merchandise from a British firm for £50,000 on terms of net 90
days. The U.S. company has purchased a 3-month call option of 50,000 pounds at a strike of $1.7
per pound and premium cost of $0.02 per pound. On the day the option matures, the spot
exchange rate is $1.8 per pound. Should the U.S. company exercise the option at that time or buy
British pounds in the spot market?
A. exercise the option B. buys British pound spot
C. does not make any difference D. cannot tell
E. none of the above
Answer:- A… Explanation for answer:-

Here since American Firm is an importer and therefore need pounds to be delivered. Hence will go
for call option for to hedge position of purchase of £.
The contract in $ terms will be

Call option = £50,000 x $1.7 = $85,000, that means in this option the American firm can get
£50,000 by giving $85000.

20
Now since this contract is of 3 months, on the maturity the American firm has decide what to do
with this contract either to exercise or leave it. If the rate favours the American firm then they will
go with exercising the option under the contract. That means they will purchase the £ by giving $.
On maturity the spot rate is $1.8 which means if the American Firm not exercised the call option
they need to have spend in Spot transaction = £50,000 x $1.8 = $90,000.
Here, it is now very much clear that Spot transaction is not beneficial to firm and hence, the U.S.
company should exercise the call option which will save $5,000 over the spot transaction.
3. An American firm has just bought merchandise from a British firm for £50,000 on terms of net 90
days. The U.S. company has purchased a 3-month call option on 50,000 pounds at a strike price of
$1.7 per pound and a premium cost of $0.02 per pound. On the day the option matures, the spot
exchange rate is $1.8 per pound. What will be the approximate value of the pound pa yable in U.S.
dollars if the U.S. company exercises the option at that time?
A. $91,000 B. $90,000 C.$86,000 D. $85,000 E. $81,000
Answer :- D :- Call option = £50,000 x $1.7 = $85,000
4. Assume that on 1st December 2011, USD-INR spot was at 45, premium for January 2012
maturity put option at strike of 45.5 is INR 0.54/0.55 and premium for January 2011 maturity call
option at strike of 45 is INR 0.71/0.72. A client executes a trade wherein, client has entered sales
put (i.e he will be put writer) at a strike of 45.5 and a call at a strike of 45. On expiry the RBI
reference rate is 46.07. How much net profit/loss did the client make per USD?
(a) Loss of INR 0.2 (b) Profit of INR 0.15 (c) Profit of INR 0.91 (d) Loss of INR 0.96
Answer:- (c) …. Sale Put at strike price of Rs.45.5 and he must have received premium of Rs.0.55.
Call at Strike price of Rs.45.00 and he must have paid premium of Rs.0.71.
Now rate at the maturity is Rs.46.07, here the put buyer will not exercise the put option at s trike
price of Rs.45.50 (as the strike price is lower than RBI reference rate) and therefore the client as
put writer will retain the premium.
However since he has in the money for call option (strike price is less than reference rate) he will
benefit as 46.07 – 45 = 1.07
Now, Net payoff on this option strategy is = Rs.1.07 + 0.55- 0.71 = Profit of Rs.0.91
5. Assume today’s closing price on a NSE futures contract is $0.9716/EUR. You have a short
(future sale) position in one contract with strike price today’s closing. Your margin account
currently has a balance of $1,700. The next three days’ settlement prices are $0.9702, $0.9709,
and $0.9762. Calculate the changes in the margin account from daily marking-to-market and the
balance of the margin account after the third day. Contract of € 1,25,000.
Solution:
$1,700 + [($0.9716 – $0.9702) + ($0.9716 – $0.9709) + ($0.9716 – $0.9722)] x €125,000 =
Or $ 1,700 + [$0.0014 + $0.0007 - $0.0006 ] X € 125000
= $1,887.50.
6. Mr. Martin enters into one contract of purchasing futures of GBP on January 27, 2011 at a price
of £ = 1.50 USD. The standard size of one future contract is £1,00,000. Using rates of £ = $ on
different date: find gain /loss of Mr. Martin at this closing of each of above mentioned dates.
January 27 $ 1.38, January 28 $ 1.56, January 29 $ 1.63, January 30 $ 1.28, January 31
$ 1.81.

21
If the initial margin if $ 5,000 per contract and maintenance margin is $ 3,000 per contract, show
Mr. Martin’s margin account (also called as equity account) and the additional deposits to be made
(assume no withdrawals).
Date Market Difference = Adjustment in margin + / - Additional
rate strike & Deposit required
£=$ closing above $ 8000
27.01 1.38 - 0.12 100000 x -0.12 = $ -12,000 $ 4,000
28.01 1.56 + 0.06 100000 x 0.06 = $ 6,000 0
29.01 1.63 + 0.13 100000 x 0.13 = $ 13,000 0
30.01 1.28 - 0.22 100000 x -0.22 = $ - 22,000 $ 10,000
31.01 1.81 + 0.31 100000 x 0.31 = $ 33,000 0
7. A Singapore based firm exported goods to an Australian firm, invoice Australian dollars 4,00,000
on 2nd April, 2011, the payment is due on 25thJune 2011. On 18thApril, 2011, the finance manager
of the Singapore firm got an indication that the Singapore Dollar (SGD) will appreciate against
Australian Dollar (AUD).
The following foreign exchange rates are quoted on 18th April, 2011 : Spot SGD/AD = 1.4760 &
Dec. 2011 futures contract SGD/AUD = 1.4835. The standard size of the futures contract is AUD
1,00,000.
a. Suggest the hedging Strategy? Assuming that the finance manager follows your sugg estion,
find net cash inflow on 25th June, 2011 assuming that on that day the following rates were prevailed
in the market:
Spot SGD/AUD = 1.4275 Dec. 2007 futures contract SGD/AUD = 1.3998.
b. In Singapore, the forward price on SGD for delivery in 60 days is quoted at 1.60 per USD. The
futures market price for a similar contract is 0.65. Is there some arbitrage opportunity?
Answer:-
a. For hedging a firm need to buy future sale contract at a strike price of SGD = 1.4845.
The pay off at the date of cash flow i.e 25th June,2011, will be as follows:
4 contracts of AUD 1,00,000 will have to be entered.
Now on 25th June the strike 1.4845 and spot is 1.4275 and hence we will gain 1.4845 – 1.4275 =
AUD 0.057 x 4,00,000 = AUD 22,800.
So there is profit in going with futures.
b. Forward price: 1 $ = 1.60SGD.

Future prices are in indirect quotations. Hence direct quote for future price:
1SGD = 0.65$ means
1 / $0.65
= 1$ = 1.5385 SGD
Arbitrage opportunity is there. Buy $ in futures market @ 1.5385 SGD.
8. Mihan Ltd has purchased a 3-months call option of € with an exercise price of Rs.71. Determine
the value of Call option at expiration if the Euro price at expiration turns out to be either 67 or 74.
Answer:
Spot price on maturity Value call option
€ 67 0
€ 74 Rs.3
9. A US importer has decided to buy German goods worth € 105,000 and must settle the account in
a month’s time. At the moment, the spot exchange rate is US $0.7284/€. He runs the risk that the
euro will appreciate against the dollar, pushing up his dollar costs. One solution would be to buy a
euro contract on the CME (each contract is worth €125,000) at the futures rate of US $0.7458. In a
month’s time, the spot rate might move to US $0.7444 and the futures price to US $0.7430. If he
chose to go ahead with future what will be gain or loss:
Answer:

22
So the rise in the cost of the goods would be (US $0.7444 – US $0.7284) x €125,000 = US $2,000
if not going ahead with futures.
However, he can close out the futures position at a profit of US $ 350:
(US $0.7458 – US $0.7430) x €125,000.
Thus, despite the fact that the contract size exactly matched his exposure, the hedger still actually
lost out slightly. This is because the cash and futures markets did not move exactly in tandem. If
rates had not moved in his favour, the exporter would have lost money on the futures position but
gained on the post transaction.
The short hedge would work in the same way. An exporter contracted to sell US goods for a fixed
sum in deutschmarks runs the risk that the deutschmark will decline against the dollar. He would
sell the appropriate number of contracts to hedge this risk.
10. An IT professional buys a house for INR 500,000 for which payment has to be made after three
months. As he is expecting to receive USD 10,000 in three months, he executes 10 USDINR
futures contracts to hedge currency risk at a price of 50. When he received the payment, he
converted USD into INR with his bank at a price of 51 for making the payment for the house and
also settles the contract at a price of 49. Given this situation, would he have sold/ bought USDINR
futures and would the effective price for house be lower than or higher than USD 10,000?
(a) Bought, Higher (b) Sold, Higher (c) Bought, Lower (d) Sold, Lower
11. A trader executes following currency futures trade: buys one lot of USD/INR, sells one lot of
JPY/INR. What view has he executed?
(a) JPY strengthening against USD (b) JPY weakening against USD (c) INR strengthening against
USD (d) INR weakening against JPY
Unsloved:
Q:1 An oil-importing firm - ABC Co. is expected to make future payments of USD 100000 after 3
months (in USD) for payment against oil imports. Suppose the current 3-month futures rate is Rs.
60. ABC Co. can go in the futures contract to hedge itself.
(a) Short (b) Long
Q:2 A speculator buys 107 USD-INR contracts @ Rs. 49.00 per contract and sells them @ Rs.
50.00 per contract. Assuming 1 contract = 1000 USD, the total profit made by the speculator is Rs.
(a) 107000 (b) 109000 (c) 1070 (d) 10700
Q:3 A speculator buys 65 USD-INR contracts @ Rs. 41.00 per contract and sells them @ Rs.
42.00 per contract. Assuming 1 contract = 1000 USD, the speculator ends up with a .
(a) loss (b) profit (c) no profit no loss
Q:4 A speculator sells 65 USD-INR contracts @ Rs. 41.00 per contract and buys them @ Rs.
40.00 per contract. Assuming 1 contract = 1000 USD, the speculator ends up with a .
(a) loss (b) profit (c) no profit no loss
A person has invested USD 100,000 in US equities with a view of appreciation of US stock
market. In next one year, his investments in US equities appreciated in value to USD120,000. The
investor decided to sell off his portfolio and repatriate the capital and profits to India. At the time of
investing abroad the exchange rate was 44.5 and at the time of converting USD back into INR, he
received an exchange rate of 46. How much is the return on investment in USD and in INR
respectively?
(a) 20%, 16% (b) 20%, 24% (c) 20%, 20% (d) 20%, 18%
***END****

23
CHAPTER 3
LC & UPCDC 600
Introduction
Letter of Credit L/c also known as Documentary Credit is a widely used term to make payment
secure in domestic and international trade. The document is issued by a financial organization at
the buyer request. Buyer also provide the necessary instructions in preparing the document.
The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for
Documentary Credit (UCPDC) defines L/C as:
"An arrangement, however named or described, whereby a bank (the Issuing bank) acting at the
request and on the instructions of a customer (the Applicant) or on its own behalf :
1. Is to make a payment to or to the order third party (the beneficiary) or is to accept bills of
exchange (drafts) drawn by the beneficiary.
2. Authorised another bank to effect such payments or to accept and pay such bills of
exchange (draft).
3. Authorised another bank to negotiate against stipulated documents provided that the terms
are complied with.
A key principle underlying letter of credit (L/C) is that banks deal only in documents and not in
goods. The decision to pay under a letter of credit will be based entirely on whether the documents
presented to the bank appear on their face to be in accordance with the terms and conditions of the
letter of credit.
Parties to Letters of Credit

• Applicant (Opener): Applicant which is also referred to as account party is normally a buyer
or customer of the goods, who has to make payment to beneficiary. LC is initiated and
issued at his request and on the basis of his instructions.
• Issuing Bank (Opening Bank) : The issuing bank is the one which create a letter of credit
and takes the responsibility to make the payments on receipt of the documents from the
beneficiary or through their banker. The payments has to be made to the beneficiary within
seven working days from the date of receipt of documents at their end, provided the
documents are in accordance with the terms and conditions of the letter of credit. If the
documents are discrepant one, the rejection thereof to be communicated within seven
working days from the date of of receipt of documents at their end.
• Beneficiary : Beneficiary is normally stands for a seller of the goods, who has to receive
payment from the applicant. A credit is issued in his favour to enable him or his agent to
obtain payment on surrender of stipulated document and comply with the term and
conditions of the L/c.
• If L/c is a transferable one and he transfers the credit to another party, then he is referred to
as the first or original beneficiary.
• Advising Bank : An Advising Bank provides advice to the beneficiary and takes the
responsibility for sending the documents to the issuing bank and is normally located in the
country of the beneficiary.
• Confirming Bank : Confirming bank adds its guarantee to the credit opened by another
bank, thereby undertaking the responsibility of payment/negotiation acceptance under the
credit, in additional to that of the issuing bank. Confirming bank play an important role
where the exporter is not satisfied with the undertaking of only the issuing bank.
• Negotiating Bank: The Negotiating Bank is the bank who negotiates the documents
submitted to them by the beneficiary under the credit either advised through them or
restricted to them for negotiation. On negotiation of the documents they will claim the
reimbursement under the credit and makes the payment to the beneficiary provided the
documents submitted are in accordance with the terms and conditions of the letters of
credit.
• Reimbursing Bank : Reimbursing Bank is the bank authorized to honor the reimbursement
claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating
bank. It is normally the bank with which issuing bank has an account from which payment
has to be made.

24
• Second Beneficiary : Second Beneficiary is the person who represent the first or original
Beneficiary of credit in his absence. In this case, the credits belonging to the original
beneficiary is transferable. The rights of the transferee are subject to terms of transfer.
Process involved in Letter of Credits.
The following is a step-by-step description of a typical Letter of Credit transaction:
1. An Importer (Buyer) and Exporter (Seller) agree on a purchase and sale of goods where
payment is made by Letter of Credit.
2. The Importer completes an application requesting its bank (Issuing Bank) to issue a Letter of
Credit in favor of the Exporter. Note that the Importer must have a line of credit with the Issuing
Bank in order to request that a Letter of Credit be issued.
3. The Issuing Bank issues the Letter of Credit and sends it to the Advising Bank by
telecommunication or registered mail in accordance with the Importer’s instructions. A request may
be included for the Advising Bank to add its confirmation. The Advising Bank is typically located in
the country where the Exporter carries on business and may be the Exporter’s bank but it does not
have to be.
4. The Advising Bank will verify the Letter of Credit for authenticity and send a copy to the Exporter.
5. The Exporter examines the Letter of Credit to ensure:

a. It corresponds to the terms and conditions in the purchase and sale agreement;
b. Documents stipulated in the Letter of Credit can be produced; and
c. The terms and conditions of the Letter of Credit may be fulfilled.

6. If the Exporter is unable to comply with any term or condition of the Letter of Credit or if the
Letter of Credit differs from the purchase and sale agreement, the Exporter should immediately
notify the Importer and request an amendment to the Letter of Credit.

25
7. When all parties agree to the amendments, they are incorporated into the terms of the Letter of
Credit and advised to the Exporter through the Advising Bank. It is recommended that the Exporter
does not make any shipments against the Letter of Credit until the required amendments have
been received.
8. The Exporter arranges for shipment of the goods, prepares and/or obtains the documents
specified in the Letter of Credit and makes demand under the Letter of Credit by presenting the
documents within the stated period and before the expiry date to th e “available with” Bank. This
may be the Advising/Confirming Bank. That bank checks the documents against the Letter of Credit
and forwards them to the Issuing Bank. The drawing is negotiated, paid or accepted as the case
may be.
9. The Issuing Bank examines the documents to ensure they comply with the Letter of Credit terms
and conditions. The Issuing Bank obtains payment from the Importer for payment already made to
the “available with” or the Confirming Bank.
10. Documents are delivered to the Importer to allow them to take possession of the goods from
the transport company. The trade cycle is complete as the Importer has received its goods and the
Exporter has obtained payment.
Types of Letter of Credit :

1. Revocable Letter of CreditL/c
A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing
bank without notification. It is rarely used in international trade and not considered satisfactory for
the exporters but has an advantage over that of the importers and the issuing bank.
There is no provision for confirming revocable credits as per terms of UCPDC, Hence they cannot
be confirmed. It should be indicated in LC that the credit is revocable. if there is no such indication
the credit will be deemed as irrevocable.
2. Irrevocable Letter of CreditL/c
In this case it is not possible to revoked or amended a credit without the agreement of the issuing
bank, the confirming bank, and the beneficiary. Form an exporters point of view it is believed to be
more beneficial. An irrevocable letter of credit from the issuing bank insures the beneficiary that if
the required documents are presented and the terms and conditions are complied with, payment
will be made.
3. Confirmed Letter of Credit L/c
Confirmed Letter of Credit is a special type of L/c in which another bank apart from the issuing bank
has added its guarantee. Although, the cost of confirming by two banks makes it costlier, this type
of L/c is more beneficial for the beneficiary as it doubles the guarantee.
4. Sight Credit and Usance Credit L/c
Sight credit states that the payments would be made by the issuing bank at sight, on demand or on
presentation. In case of usance credit, draft are drawn on the issuing bank or the correspondent
bank at specified usance period. The credit will indicate whether the usance draft are to be drawn
on the issuing bank or in the case of confirmed credit on the confirming bank.
5. Back to Back Letter of Credit L/c
Back to Back Letter of Credit is also termed as Countervailing Credit. A credit is known as
backtoback credit when a L/c is opened with security of another L/c.
A backtoback credit which can also be referred as credit and countercredit is actually a method of
financing both sides of a transaction in which a middleman buys goods from one customer and
sells them to another.
The parties to a BacktoBack Letter of Credit are:
1. The buyer and his bank as the issuer of the original Letter of Credit.
2. The seller/manufacturer and his bank,
3. The manufacturer's subcontractor and his bank.
The practical use of this Credit is seen when L/c is opened by the ultimate buyer in favour of a
particular beneficiary, who may not be the actual supplier/ manufacturer offering the main credit

26
with near identical terms in favour as security and will be able to obtain reimbu rsement by
presenting the documents received under back to back credit under the main L/c.
6. Transferable Letter of Credit L/c

A transferable documentary credit is a type of credit under which the first beneficiary which is
usually a middleman may request the nominated bank to transfer credit in whole or in part to the
second beneficiary.
The L/c does state clearly mentions the margins of the first beneficiary and unless it is specified the
L/c cannot be treated as transferable. It can only be used when the company is selling the product
of a third party and the proper care has to be taken about the exit policy for the money transactions
that take place.
This type of L/c is used in the companies that act as a middle man during the transaction but don’t
have large limit. In the transferable L/c there is a right to substitute the invoice and the whole value
can be transferred to a second beneficiary.
7. Standby Letter of Credit L/c

Initially used by the banks in the United States, the standby letter of credit is v ery much similar in
nature to a bank guarantee. The main objective of issuing such a credit is to secure bank loans.
Standby credits are usually issued by the applicant’s bank in the applicant’s country and advised to
the beneficiary by a bank in the beneficiary’s country.
Unlike a traditional letter of credit where the beneficiary obtains payment against documents
evidencing performance, the standby letter of credit allow a beneficiary to obtains payment from a
bank even when the applicant for the credit has failed to perform as per bond.
A standby letter of credit is subject to "Uniform Customs and Practice for Documentary Credit"
(UCP), International Chamber of Commerce Publication No 500, 1993 Revision, or "International
Standby Practices" (ISP), International Chamber of Commerce Publication No 590, 1998.
"Red Clause" LC :-
In the case of a red clause letter of credit (documentary credit with advance payment) the seller can
request that the correspondent bank pay an agreed amount in advance (defined in t he terms and
conditions of the documentary credit). The advance is basically intended to finance the production
or purchase of the goods to be delivered under the documentary credit. The advance is normally
paid against receipt and commitment in writing from the beneficiary to subsequently deliver the
transportation documents by an agreed date.
IF in the LC this clause is permitted then it will be printed in RED INK.
"Green Clause"
In the case of a green clause letter of credit (documentary credit with advance payment) the
beneficiary can request that the correspondent bank pay an agreed amount in advance (defined in
the terms and conditions of the letter of credit). The advance is basically intended to finance the
production or purchase of the goods to be delivered under the documentary credit. Unlike the red
clause letter of credit, the advance is paid only against receipt of an additional document providing
proof that the goods to be shipped have been warehoused, as well as against receipt and written
commitment from the beneficiary to subsequently deliver the transportation documents by an
agreed date.
IF in the LC this clause is permitted then it will be printed in GREEN INK.
Amendments to a Letter of Credit:

After issuance of a Letter of Credit, changes can be done through amendments subject to acceptance
by the Exporter. Amendments to the Letter of Credit will be required when either the Importer or the
Exporter is unable to comply with the terms of the sale agreement or the agreement has been
changed. For example, an Exporter will ask for an amendment to extend the expiry date and the
latest shipping date if they are unable to manufacture the merchandise according to the agreed upon
time. An Importer may request an amendment to increase the value of th e Letter of Credit if they
subsequently decide to purchase a higher quantity of merchandise. The Importer must complete
an amendment application listing all required changes and forward the request to

27
the respective Global Trade Finance office via the same route the original application was sent.
Amendment requests will be processed subject to credit approval by the Issuing Bank where
necessary. Any amendments to the Letter of Credit must be accepted by the Exporter and where
more than one change is included in an amendment, they must be accepted as a whole as
opposed to accepting or rejecting individual items within the amendment.
Fees And Reimbursements:

The different charges/fees payable under import L/c is briefly as follows
The issuing bank charges the applicant fees for opening the letter of credit. The fee charged
depends on the credit of the applicant, and primarily comprises of :
(a) Opening Charges This would comprise commitment charges and usance charged to be
charged upfront for the period of the L/c.
The fee charged by the L/c opening bank during the commitment period is referred to as
commitment fees. Commitment period is the period from the opening of the letter of credit until the
last date of negotiation of documents under the L/c or the expiry of the L/c, whichever is later.
Usance is the credit period agreed between the buyer and the seller under the letter of credit. This
may vary from 7 days usance (sight) to 90/180 days. The fee charged by bank for the usance
period is referred to as usance charges.
(b) Retirement Charges

1. This would be payable at the time of retirement of LCs. LC opening bank scrutinizes the
bills under the LCs according to UCPDC guidelines , and levies charges based on value of
goods.
2. The advising bank charges an advising fee to the beneficiary unless stated otherwise The
fees could vary depending on the country of the beneficiary. The advising bank charges
may be eventually borne by the issuing bank or reimbursed from the applicant.
3. The applicant is bounded and liable to indemnify banks against all obligations and
responsibilities imposed by foreign laws and usage.
4. The confirming bank's fee depends on the credit of the issuing bank and would be borne by
the beneficiary or the issuing bank (applicant eventually) depending on t he terms of
contract.
5. The reimbursing bank charges are to the account of the issuing bank.
Export operations under L/c

Export Letter of Credit is issued in for a trader for his native country for the purchase of goods and
services. Such letters of credit may be received for following purpose:
1. For physical export of goods and services from India to a Foreign Country.
2. For execution of projects outside India by Indian exporters by supply of goods and services
from Indian or partly from India and partly from outside India.
3. Towards deemed exports where there is no physical movements of goods from outside
India. But the supplies are being made to a project financed in foreign exchange by
multilateral agencies, organization or project being executed in India with the aid of external
agencies.
4. For sale of goods by Indian exporters with total procurement and supply from outside India.
In all the above cases there would be earning of Foreign Exchange or conservation
of Foreign Exchange.
Banks in India associated themselves with the export letters of credit in various capacities such as
advising bank, confirming bank, transferring bank and reimbursing bank.
In every case the bank will be rendering services not only to the Issuing Bank as its agent
correspondent bank but also to the exporter in advising and financing his export activity.
1. Advising an Export L/c
The basic responsibility of an advising bank is to advise the credit received from its overseas
branch after checking the apparent genuineness of the credit recognized by the issuing bank.

28
It is also necessary for the advising bank to go through the letter of credit, try to understand the
underlying transaction, terms and conditions of the credit and advice the beneficiary in the
matter.
The main features of advising export LCs are:
1. There are no credit risks as the bank receives a onetime commission for the advising
service.
2. There are no capital adequacy needs for the advising function.
2. Advising of Amendments to L/Cs

Amendment of LCs is done for various reasons and it is necessary to fallow all the necessary
the procedures outlined for advising. In the process of advising the amendments the Issuing
bank serializes the amendment number and also ensures that no previous amendment is
missing from the list. Only on receipt of satisfactory information/ clarification the amendment
may be advised.
3. Confirmation of Export Letters of Credit

It constitutes a definite undertaking of the confirming bank, in addition to that of the issuing
bank, which undertakes the sight payment, deferred payment, acceptance or negotiation.
Banks in India have the facility of covering the credit confirmation risks with ECGC under their
“Transfer Guarantee” scheme and include both the commercial and political risk involved.
4. Discounting/Negotiation of Export LCs

When the exporter requires funds before due date then he can discount or negotiate the LCs
with the negotiating bank. Once the issuing bank nominates the negotiating bank, it can take
the credit risk on the issuing bank or confirming bank.
However, in such a situation, the negotiating bank bears the risk associated with the document
that sometimes arises when the issuing bank discover discrepancies in the documents and
refuses to honor its commitment on the due date.
5. Reimbursement of Export LCs

Sometimes reimbursing bank, on the recommendation of issuing bank allows the negotiating
bank to collect the money from the reimbursing bank once the goods have been shipped. It is
quite similar to a cheque facility provided by a bank.
In return, the reimbursement bank earns a commission per transaction and enjoys float income
without getting involve in the checking the transaction documents.
Reimbursement bank play an important role in payment on the due date ( for usance LCs) or
the days on which the negotiating bank demands the same (for sight LCs).
UCPDC Guidelines
Uniform Customs and Practice for Documentary Credit (UCPDC) is a set of predefined rules
established by the International Chamber of Commerce (ICC) on Letters of Credit. The UCPDC is
used by bankers and commercial parties in more than 200 countries including India to facilitate
trade and payment through LC.
UCPDC was first published in 1933 and subsequently updating it throughout the years. In 1994,
UCPDC 500 was released with only 7 chapters containing in all 49 articles. .
The latest revision was approved by the Banking Commission of the ICC at its meeting in Paris on
25 October 2006. This latest version, called the UCPDC600, formally commenced on 1 July 2007.
It contains a total of about 39 articles covering the following areas, which can be classified as 8
sections according to their functions and operational procedures.
Serial No. Article Area Consisting
Application, Definition and
1. 1 to 3 General
Interpretations
Credit vs. Contracts, Documents
2. 4 to 12 Obligations
vs. Goods
3. 13 to 16 Liabilities and Reimbursement, Examination of

29
responsibilities. Documents, Complying,

Presentation, Handling
Discrepant Documents
Bill of Lading, Chapter Party Bill of
Lading, Air Documents, Road Rail
4. 17 to 28 Documents etc. Documents, Courier , Postal etc.
Receipt. On board, Shippers' count,
Clean Documents, Insurance documents
Extension of dates, Tolerance in
5. Miscellaneous Credits, Partial Shipment and
29 to 33 Provisions
Drawings. House of Presentation
Effectiveness of Document
Transmission and Translation
6 34 to 37 Disclaimer
Force Majeure
Acts of an Instructed Party
7 Transferable Credits
38 & 39 Others Assignment of Proceeds
CASE STUDY:
I. A LC has mentioned that as per Article 20 (UPCDC 600) indication of port of loading, port of
discharge, and that the goods have been loaded on board ‘a named vessel’ is required while
negotiating the LC. When documents came for negotiation, the Bill of lading evidencing Bangkok as
the port of loading with addition of the words “via Singapore" to indicate that there will be a
transshipment in Singapore, Rotterdam as the port of discharge, "vessel Y" as the ocean vessel.
Negotiating bank refused to accept the documents and returned by mentioning reason a bill of
lading is required covering a port to port shipment from Bangkok to Rotterdam and thus violated
Article 20.
1. Whether the negotiating bank is right in action?

a. Yes b. No. c. Can’t say
2. Is the transshipment is also to be considered in the light of Article 23 even if not mentioned
in LC.
a. Yes b. No. c. Can’t say
II. Mr. Prakash Kumar –Branch Manager LPBC bank, Camp branch, Pune, was approached by
their client Mr.Suresh Chandra with a request to open an Import LC.
The LC was sanctioned by an appropriate authority and the importer Mr.Suresh Chandra required
some time to comply with the sanction conditions like depositing of margin money etc.
The importer Mr. Suresh Chandra requested Mr.Prakash Kumar –Branch Manager LPBC bank,
Pune Camp branch that though the bank can not open LC until sanction terms are compiled with ,
the bank should send a pre-advice of LC by SWIFT message as under:-
“Opened LC No.185/2008 on 24th April, 2008 for US$ 500000.00
Applicant: Sharmila Enterprises Pvt. Ltd.
Beneficiary: Clarisa INC, New York, USA
Covering: Titanium Plates
1. Whether the above Pre advice will act as LC and negotiation is possible
a. Yes b. No.
2. What should be further words in Pre advice to written as per UCP600 so that Pre advice
does not become LC under UCP 600
a. Pre advice b. Only consent of opening c. Details to follow d. No words are required.

30
III. A sight payment L/C is issued for the amount of (not exceeding) $50,000, allowing partial
shipment, the beneficiary presented his first shipping docs for the amount of $ 30,000 and was paid
due to complying presentation. 2 days before expiry date, the issuing bank received a second
shipping docs for an amount of $30,000 for payment (approval basis) due to overdrawing.
The applicant waived the discrepancy and instructed the issuing bank to notice the nominated bank
and the beneficiary with the following i.e agreed for amendment in LC:
- Documents of the second shipment are accepted.
- L/C amount to be increased to $75,000
- Latest shipment date and expiry date are extended (where a third shipment can be made).
After this amendment, the beneficiary presented his 3rd shipping docs for an amount of $25,000,
during the new L/C validity. As no discrepancies were found the nominated bank took them in
compliance and sent them to the issuing bank after debiting the account of the issuing bank for
payment.
The issuing bank rejected the claim saying that the LC is overdrawn. What is the amount of LC
overdrawn according to issuing bank:
a. $30000 b. $25000 c. $15000 d. $10000
IV. ABC Bank opens an L/C calls for shipment of :

1. 100mt ("About") of "X" product
2. 200mt ( "About") of "Y" product
Total LC value : not to exceed USD1,000,000. Partial shipments allowed.
Documents presented in one drawing for full LC value of USD1,000,000 but as separate sets of
documents relating to each item, represented by invoices as follows :
1. 120mt of "X" at unit price of USD5,000 per mt = USD600,000
2. 160mt of "Y" at unit price of USD2,500 per mt = USD400,000
A. Should the issuing bank reject the claim for the documents presented:
1. Yes 2. No.
B. Suppose the issuing bank rejected the claim by giving reason

1. Quantity of product "X" overshipped
2. Quantity of product "Y" undershipped
Then, do you agree with the issuing bank for
a. First reason is correct b. Second reason is wrong c. Both are wrong d. first is wrong
, second is correct
C. According to UCPDC 600 the tolerance is allowed to the extent of +/- 5% and since the LC
is not overdrawn then do you found that still issuing bank correct :
1. Yes 2. No
Ans: I.1 a, 2 a II. 1. B 2.c III. c Iv. A. Yes B. b C. 1
*****

31
CHAPTER 4
FACILITIES AVAILABLE TO EXPORTERS AND IMPORTERS
I) To Exporters:-
* Exporters are provided timely and adequate credit to meet the exports commitments.
* Exporters are allowed pre and post-shipment credit at competitive interest rates.
* Export Credit is made available both in Indian Rupee and Foreign Currency as well.
II) To Importers:-
* Bank provides import loan at attractive rates to importers of imported inputs and capital goods.
* Import loan is allowed in Indian Rupee and in Foreign Currency.
* To enable importers avail of credit for their purchases, we also issue Documentary Credits (Letter
of Credit and Standby Letter of Credit) favouring overseas supplier.
* Import LCs are issued and transmitted by fastest electronic means using ‘SWIFT’ systems.
* "Trade Credit" is arranged for importers in line with RBI guidelines. We arrange ‘Buyers’ Credit’
and ‘Suppliers’ Credit’. Issue of Letter of Credit, Letter of Comfort, Letter of Undertaking to facilitate
importer arrange for ‘Trade Credit’ at better rates.
I) Types of Facilities for Exports

a) Rupee Export Credit (pre-shipment and post-shipment):
The bank provides both pre and post shipment credit to the Indian exporters through Rupee
Denominated Loans as well as foreign currency loans in India. Credit facilities are sanctioned to
exporters who satisfy credit exposure norms of the bank. Exporters having firm export orders or
confirmed L/C from a bank are eligible to avail the export credit facilities.
Rupee Export Credit is available generally for a period of 180 days from the date of first
disbursement. In deserving cases extension may be permitted within the guidelines of RBI. The
corporate may also book forward contracts with the bank in respect of future export credit drawls, if
required, as per the guidelines/directives provided by RBI.
b) Pre-shipment Credit in Foreign Currency (PCFC):

The bank offers PCFC in the foreign currency to the exporters enabling them to fund their
procurement, manufacturing/processing and packing requirements. These loans are available at
very competitive international interest rates covering the cost of both domestic as well as import
content of the exports.
The corporate /exporters with a good track record can avail a running account facility with The bank
for PCFC. PCFC is generally available for a period of 180 days from date of first disbursement. In
deserving cases extension may be permitted within the guidelines of RBI.
c) Negotiation of Bills under L/C

The bank's Authorised Forex Branches are active in negotiation/discounting of sight/usance
international export bills under L/Cs opened by foreign banks as well as branches of Indian banks
abroad. The bank offers the most competitive rates. These transactions are undertaken by our
branches within The bank/Country Exposure ceilings prescribed by The bank.
d) Export Bill Rediscounting:

The bank provides financing of export by way of discounting of export bills, as a post shipment
finance to the exporters at competitive international rate of interest. This facility is available in four
currencies i.e. US$, Pound Sterling, Euro and JPY.
The export bills (both Sight and Usance) drawn in compliance of FEMA can be purchased/
discounted.
Exporters can avail this facility from The bank to cover the bills drawn under L/C as well as other
export bills.
e) Bank Guarantees:

32
The bank, on behalf of exporter constituents, issues guarantees in favour of beneficiaries abroad.
The guarantees may be Performance and Financial. For Indian exporters, guarantees are issued in
compliance to RBI guidelines.
II) Types of Facilities for Importers:-

a. Collection of Import Bills:The banks has correspondent relationship with reputed International
banks throughout the world and can thus provide valuable services to importers who may be
importing from any part of the Globe. The import bills are collected by Authorised Forex Branches
at very competitive rates. The import bills drawn on customers of other branches are also collected
through these branches.
b) Letter of Credit:
L/Cs of the banks is well accepted in the International market. For any special requirem ent the
banks can get the L/C confirmed by the top international banks.
Thus the bank's L/C facility for the purchase of goods/services etc. fulfills the requirements of all
importers to arrange a reliable supply. The bank offers this facility to importers in India within the
ambit of FEMA and Exim policy of Govt. of India. The bank uses state of the art SWIFT network to
transmit L/Cs and with a worldwide network of correspondents and our overseas branches
facilitates prompt & efficient services to the importers.
L/C facility is granted to the importers on satisfying credit exposure norms of the bank.
c) Financing of import
Usance L/C facility:- The bank's Usance L/C facility provides the importer an opportunity to avail
credit from their supplier/supplier's bank.
d) Deferred Payment Guarantee/Standby LC:- The bank's Deferred Payment Guarantee/Standby
LC facility also provides the importer an opportunity to avail credit from their supplier/supplier's
bank.
e) Rupee finance:- The bank also offers to Indian importers Rupee finance for payment of goods
and services imported from abroad under its various Rupee credit facilities on satisfying credit
exposure norms of The bank.
d) Foreign Currency Loans:-Short term External Commercial Borrowings or Trade Credits for less
than three years as permitted by RBI for imports into India is allowed by our overseas branches to
Indian importers at very competitive rates. These are generally backed by L/Cs opened by
importer's bank. Indian importers can also avail this facility from our overseas branches as roll-over
credit on their bank agreeing to extend the L/C in favour of our overseas branches.
e) Bank Guarantees:
The bank, on behalf of importer constituents or other customers, issues guarantees in favour of
beneficiaries abroad. The guarantees may be both Performance and Financial.
5. REMITTANCES
The banks, through its worldwide network of correspondents, Indian branches and overseas
branches, offers prompt inward and outward foreign remittance facilities at very compe titive rates.
The use of SWIFT network adds to reliability and efficient handling.
The remittances are handled by our Authorised Forex Branches. The outward remittances of
customers of other branches are also remitted through these branches. Through our we ll-spread
network of branches in India, inward remittances reach every nook & corner in India. The bank has tie-
up arrangements with Western Union Money Transfer.
Important RBI Guidelines on Rupee/Foreign Export Credit: Preshipment Rupee Export

Credit:-
1. Rupee Pre-shipment Credit/Packing Credit
• ‘Pre-shipment/Packing Credit is the working capital finance granted to an exporter for purchase,
processing, manufacturing or packing of goods prior to shipment/working capital expenses towards
rendering of services against LCs or confirmed/irrevocable order or any other evidence of an order
for export.
• The period of advance is to be decided by the Banks based on relevant factors. However, if the
finance is not adjusted by submission of export documents within 360 day s from the date of
advance, it ceases to qualify for concessional rate of interest ab initio. Refinance from RBI is

33
available for a period of 180 days.

• The facility may be released in one lump sum or in stages as per the requirement for executing the
orders / LC. Stage wise release accounts may be maintained depending upon the types of
goods/services to be exported. Banks should also keep a close watch on the end -use of the funds,
besides monitoring the progress of execution of the orders.
• Liquidation of the export credit facility may be out of the proceeds of the bills drawn thereby
converting the pre-shipment into post-shipment credit. It can also be liquidated out of the balances
in the Exchange Earners Foreign Currency A/c (EEFC A/c) as also from rupee resources of the
exporter to the extent exports have actually taken place. If not so liquidated/ repaid, banks are free
to decide the rate of interest from the date of advance.
• Banks would provide operational flexibility for repayment/liquidation of EPC with export documents
relating to other export order for the same or other commodity exported or the existing packing credit
may also be marked-off with proceeds of export documents against which no packing credit has
been drawn by the exporter to clients who have a good track record. These relaxations should not
be extended to transactions of sister / associate / group concerns.
‘Running Account’ Facility

• Pre-shipment export credit facility in respect of any commodity without insisting lodgement of
LC or export orders which should be produced within a reasonable period of time to be decided by
the banks. This facility is being extended only to those exporters whose track record has been good
as also to EOUs/ Units in Free Trade Zones / EPZs and SEZs. Running account facility should not
be granted to sub suppliers.
Rupee Pre-shipment Credit to Specific Sectors/Segments

• Banks are permitted to grant Rupee Export Packing Credit to Manufacturer Suppliers for Exports
Routed through STC/MMTC/Other Export Houses, Agencies etc. Such advances will be eligible
for refinance subject to some conditions including obtaining a letter from the export house setting the
details of the export order, etc.
Rupee Export Packing Credit to Sub-Suppliers

• Packing credit can be shared between an Export Order Holder (EOH) and sub-supplier of raw
materials, components etc. of the exported goods as in the case of EOH and manufacturer
suppliers, subject to the condition that it cannot be made available to Running Account facility.
• The scheme will cover the L/C or export order received in favour of Export Houses/Trading
Houses/Star Trading Houses etc. or manufacturer exporters only. The scheme should be made
available to the exporters with good track record. Banks may approach the ECG C for availing
suitable cover in respect of such advances.
Rupee Pre-shipment Credit to Construction Contractors

• The Packing Credit facility can be granted to the construction contractors to meet their initial
working capital requirements (preliminary expenses) for execution of contracts abroad on the basis of
a firm contract secured from abroad, in a separate account.
• The advances should be adjusted within 365 days of the date of advance by negotiation of bills
relating to the contract or by remittances received from abroad in respect of the contract executed
abroad. To the extent the outstanding in the account are not adjusted in the stipulated manner,
banks may charge normal rate of interest on such advance.
Export of Services
• Pre-shipment and post-shipment finance may be provided to exporters of all the 161 tradable
services covered under the General Agreement on Trade in Services (GATS). All provisions of the
circular shall apply mutatis mutandis to export of services as they apply to export of goods u nless
otherwise specified.
• Exporters of services qualify for working capital export credit (pre and post shipment) for
consumables, wages, supplies etc.
Export Credit to Processors/Exporters-Agri-Export Zones
• Export processing units set up in Agri- Export Zones may be provided packing credit for the

34
purpose of procuring and supplying inputs to the farmers so that quality inputs are available to them
which in turn will ensure that only good quality crops are raised, besides advantages of economics of
scale.
Export Credit Insurance Whole Turnover Packing Credit (ECIB-WTPC)

• Banks are eligible to obtain Whole-Turnover Packing Credit (ECIB-WTPC) for all its packing credit
accounts on payment nominal guarantee fee which is to be borne by the exporters. The pe riod of
cover is for 12 months. It gives protection to the banks against losses that may be incurred in
extending packing credit advances due to protracted default or insolvency of the exporter -client. The
coverage is available for banks taking the cover for the first time is 75% upto Grade Percentage limit
fixed and 65% beyond (For others varies from 55% to 75% depending on claim premium ratio of the
bank). For small exporters/SSIU, it is 90%. Banks are required to submit Monthly declaration along
with premium amount. Any extension of due date beyond 360 days should be approved by the
ECGC.
2. Post shipment Rupee Export Credit

• 'Post-shipment Credit' is the working capital facility granted or any other credit provided by a bank to
an exporter of goods / services from the date of extending credit after shipment of goods / rendering
of services to the date of realization of export proceeds. As per the extant instructions, the period
prescribed for realization of export proceeds is 12 months from the date of shipment.
• Post-shipment advance are made available in the form of - (i) Export bills
purchased/discounted/negotiated. (ii) Advances against bills for collection. (iii) Advances against duty
drawback receivable from Government.
• Post-shipment credit is to be liquidated by the proceeds of export bills received from
abroad in respect of goods exported / services rendered. It can also be repaid / prepaid out of
balances in Exchange Earners Foreign Currency Account (EEFC A/C) as also from proceeds of any
other unfinanced (collection) bills.
Rupee Post shipment Export Credit:

Nature of bill Period of Advance
Demand Bills Normal Transit Period (NTP)*
Usance Bills Max. 365 days from the date of
shipment (incl. of NTP)
Overdue bill – Demand bill Not paid within NTP plus grace period
Usance Bill Not paid on due date
* Average period involved from date of negotiation/purchase/discount till the receipt of proceeds in
the Nostro account of the Bank.
Advances against Undrawn Balances on Export Bills

• Banks are permitted to grant advances against the undrawn balances at concessional rate for a
maximum period of 90 days provided such remittances are received within 180 days after expiry of
NTP in case of demand bills and due date in case of usance bills. For the period beyond 90 days, the
rate of interest specified for the category 'ECNOS' (Export Credit Not Otherwise Specified) at post -
shipment stage may be charged.
Advances against Retention Money

• Banks may consider granting advance against retention money based on the natu re of the export
order like turnkey projects, etc. Such finance are subject to some guidelines as set out by RBI and
listed in the M. Circular dt. 01.07.2011. No advances to be granted against retention money relating
to services portion of the contract.
Export on Consignment Basis

• Export on consignment basis should be at par with exports on outright sale basis on cash terms in
matters regarding the rate of interest to be charged by banks on post-shipment credit.
• For pre-shipment finance against the exports of precious and semi-precious stones on consignment
exports, is adjusted as soon as export takes place, by transfer of the outstanding balance to a special

35
(post-shipment) account which in turn, should be adjusted as soon as the relative proceeds are
received from abroad but not later than 365 days from the date of export or such extended period as
may be permitted by Foreign Exchange Department, RBI. Balance in the special (post -shipment)
account will not be eligible for refinance from RBI.
• RBI (FED) permits on case to case basis longer period up to 12 months from the date of shipment
for realization of proceeds of exports in case of Consignments Exports to CIS and East European
Countries, Consignment exports to Russian Federation against repayment of S tate Credit in rupees,
Exporters who have been certified as 'Status Holder' in terms of Foreign Trade Policy, and Cent
percent EOU and units set up under Electronic Hardware Technology Park, Software Technology
Park and Bio-Technology Park Schemes. In case of Exports through the Warehouse–cum-Display
Centers abroad realization of export proceeds has been fixed upto 15 months from the date of
shipment.
Export of goods for Exhibition and Sale

• Export of goods for exhibition and sale are eligible for export finance both pre and post shipment
stages.
3. INTERST ON RUPEE EXPORT CREDIT : Interest Equalisation Scheme on Pre and Post
Shipment Rupee Export Credit :
The Government of India has announced the Interest Equalisation Scheme on Pre and Post
Shipment Rupee Export Credit to eligible exporters. The scheme is effective from April 1, 2015.
The rate of interest equalisation @ 3% per annum will be available on Pre Shipment Rupee Export
Credit and Post Shipment Rupee Export Credit. The scheme would be applicable w.e.f 01.04.2015
for 5 years.Government, however, Government reserves the right to modify/amend the Scheme at
any time. The scheme will be available to all exports under 416 tariff lines [at ITC (HS) code of 4
digit]as per Annexure A and exports made by Micro, Small & Medium Enterprises (MSMEs) across
all ITC(HS) codes. However, scheme would not be available to merchant exporters. Banks are
required to completely pass on the benefit of interest equalisation, as applicable, to the eligible
exporters upfront and submit the claims to RBI for reimbursement, duly certified by the external
auditor.
From the month of December 2015 onwards, banks shall reduce the interest rate charged to the
eligible exporters as per RBI extant guidelines on interest rates on advances by the rate of interest
equalisation provided by Government of India.
The interest equalisation benefit will be available from the date of disbursement up to the date of
repayment or up to the date beyond which the outstanding export credit becomes overdue.
However, the interest equalisation will be available to the eligible exporters only during the period
the scheme is in force.
3.1 ECNOS
• Banks are free to decide the rate of interest keeping in view of BPLR and spread guidelines in
respect of Export Credit Not Otherwise Specified (ECNOS). No penal interest to be charged on
ECNOS.
Period within which export value of goods/software to be realised :- Foreign Exchange

Management (Export of Goods & Services) (Amendment) Regulations, 2014:
The amount representing the full export value of goods or software exported shall be realised and
repatriated to India within Nine months from the date of export.
Provided that where the goods are exported to a warehouse established outside India with the
permission of the RBI, it will be as soon as it is realised and in any case within fifteen months from
the date of shipment of goods; Provided further that the RBI, or subject to the directions issued by
that Bank in this behalf, the authorised dealer may, for a sufficient and reasonable cause shown,
extend the said period of Nine months or fifteen months, as the case may be.
****

36
CHATPER 5
Risk in international trade
International trade is exchange of capital, goods, and services across international borders or
territories.. In most countries, it represents a significant share of gross domestic product (GDP).
While international trade has been present throughout much of history (see Silk Road, Amber
Road), its economic, social, and political importance has been on the rise in recent centuries.
Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing
are all having a major impact on the international trade system. Increasing international trade is
crucial to the continuance of globalization. Without international trade, nations would be limited to
the goods and services produced within their own borders.
Companies doing business across international borders face many of the same risks as would
normally be evident in strictly domestic transactions. For example,
• Buyer insolvency (purchaser cannot pay);
• Non-acceptance (buyer rejects goods as different from the agreed upon specifications);
• Credit risk (allowing the buyer to take possession of goods prior to payment);
• Regulatory risk (e.g., a change in rules that prevents the transaction);
• Intervention (governmental action to prevent a transaction being completed);
• Political risk (change in leadership interfering with transactions or prices); and
• War and other uncontrollable events.
In addition, international trade also faces the risk of unfavorable exchange rate movements (and,
the potential benefit of favorable movements)
ECGC
A. What is ECGC?
Export Credit Guarantee Corporation of India Limited, was established in the year 1957 by the
Government of India to strengthen the export promotion drive by covering the risk of exporting on
credit.
Being essentially an export promotion organization, it functions under the administrative control of
the Ministry of Commerce & Industry, Department of Commerce, Government of India. It is
managed by a Board of Directors comprising representatives of the Government, Reserve Bank of
India, banking, insurance and exporting community.
ECGC is the fifth largest credit insurer of the world in terms of coverage of national exports. The
present paid-up capital of the company is Rs.800 crores and authorized capital Rs.1000 crores.
B. What does ECGC does?

1.Offers insurance protection to exporters against payment risks
2.Provides guidance in export-related activities
3. Makes available information on different countries with its own credit ratings
4. Makes it easy to obtain export finance from banks/financial institutions
5.Assists exporters in recovering bad debts
6.Provides information on credit-worthiness of overseas buyers
C. What is the Need for export credit insurance?

Payments for exports are open to risks even at the best of times. The risks have assumed large
proportions today due to the far-reaching political and economic changes that are sweeping the
world. An outbreak of war or civil war may block or delay payment for goods exported. A coup or
an insurrection may also bring about the same result. Economic difficulties or balance of
payment problems may lead a country to impose restrictions on either import of certain goods or
on transfer of payments for goods imported. In addition, the exporters have to face commercial
risks of insolvency or protracted default of buyers. The commercial risks of a foreign buyer going
bankrupt or losing his capacity to pay are aggravated due to the political and economic
uncertainties. Export credit insurance is designed to protect exporters from the consequences of
the payment risks, both political and commercial, and to enable them to expand their overseas

37
business without fear of loss.

To protect such exporters, ECGC has the following types of covers.
Supply contracts and turnkey projects: For covering supply contracts and turnkey projects, specific
contract/shipments policy can be taken. This policy can be for covering only politi cal risks or for
covering comprehensive risks i.e. both commercial and political risks.
Construction contract: For covering construction contract, a Construction Works policy can be
obtained. This policy can be for either political risk alone or for comprehensive risk. The
Comprehensive Risks Policy provides protection against commercial risks such as insolvency of
buyer, protracted default, non-acceptance of goods shipped in addition to covering political risk of
war, civil war, exchange transfer delay etc. The political risk policy, on the other hand, provides
protection against the Political Risks Policy. Under the various export credit insurance policies,
ECGC generally covers loss up to 90 per cent.
Services Contract: For covering services contract, which involves only technical and/or professional
services, a Services Policy can be obtained. This also can be either for political or comprehensive
risks.
Overseas Investment Insurance:-OII provides cover for the investments made by Indian corporates
abroad in a joint venture or their wholly owned subsidiary (WOS) either in the form of equity or loan.
The Government of India or RBI should approve the JV. The basic principle is that the investment
should emanate from India and benefit of dividend/interest therefrom should accrue to India. The
investment should not in any way conflict with the policy of both our government and the overseas
government. Normally, there should be a bilateral agreement between India and the host country
for promotion and protection of Indian investment. In case there is no such agreement the
Corporation should be satisfied that the existing laws of the host country adequately safeguard
Indian investment.
In addition to the policy covers, which are issued to exporters, ECGC also extends its guarantee
support to banks in India against both funded and non-funded facilities extended to project
exporters. The types of guarantees issued by Indian banks are:
Funded:
* Packing Credit
* Post Shipment
* Overdraft
* Rupee Loan
Non-Funded
* Bid Bond
* Advance payment
* Performance guarantee
* Retention Money guarantee
* Overseas Lending Finance guarantee
Export Credit Insurance Covers to Banks from ECGC

• Covers for working capital granted by commercial banks to Exporters at Pre
shipment and Post shipment stages
• Covers available on exporter wise, bank branch wise and bank wise
• Losses due to protracted default / Insolvency of exporters covered
• Cover varies from 60% to 95% depending on the type of cover
****

38
CHAPTER 6
Role of RBI & Exchange Control
Custodian of Foreign Exchange Reserves:

It is the responsibility of the Reserve bank to stabilize the external value of the national currency.
The Reserve Bank keeps golds and foreign currencies as reserves against note issue and also
meets adverse balance of payments with other counties. It also manages foreign currency in
accordance with the controls imposed by the government.
As far as the external sector is concerned, the task of the RBI has the following dimensions:
• To administer the foreign Exchange Control;
• To choose, the exchange rate system and fix or manages the exchange rate between the
rupee and other currencies;
• To manage exchange reserves;
• To interact or negotiate with the monetary authorities of the Sterling Area, Asian Clearing
Union, and other countries, and with International financial institutions such as the IMF,
World Bank, and Asian Development Bank.
The RBI is the custodian of the country’s foreign exchange reserves, id it is vested with the
responsibility of managing the investment and utilization of the reserves in the most advantageous
manner. The RBI achieves this through buying and selling of foreign exchange market, from and to
schedule banks, which, are the authorized dealers in the Indian, foreign exchange market. The
Bank manages the investment of reserves in gold counts abroad’ and the shares and securities
issued by foreign governments and international banks or financial institutions.
Before going ahead with FEDAI Rules, let us see about Nostro, Vostro & Loro accounts
maintained by Authorised dealers:
The Foreign Exchange (FX) Market is one of the biggest and most liquid markets in which
currencies are traded over the counter (OTC) involving players like central banks, corporate
majors, hedge funds, investment banks, commercial banks etc. It aids activities such as cross-
border trade, mergers & acquisitions, tourism etc. In order to deal in the Foreign Exchange Market
and transact in foreign currencies, banks maintain accounts with other banks globally. This is
known as a Nostro Account. For instance, consider two banks: ABC Bank, New York and XYZ
Bank, Mumbai. For XYZ Bank, its account in ABC Bank is a ‘Nostro Account’ (My account with
you) and ABC Bank’s account with it is a ‘Vostro Account’ (your account with me). ‘Nostro’ and
‘Vostro’ are Italian words for “Our” and “Your” respectively. Reconciliation of these accounts is
called Nostro Account Reconciliation or simply Nostro Reconciliation. In India only Scheduled
Commercial Banks (SCB) can maintain a Nostro Account, and three types of branches are permitted
to deal in them. The A category branch owns, maintains and funds this account. After the Nostro
Reconciliation, they submit the statutory returns to the appropriate authorities. The B category
branch can operate the account maintained by A category branches and the C category branches are
the remaining Scheduled Commercial Bank branches dealing through B or A category branches for
their forex transactions.
Nostro debits may arise due to:

• Honoring the payment messages sent by the bank/payment of draft issued by the bank
• Charges debited in the Nostro accounts
• Reimbursement to negotiating bank, under Letters of Credit transactions
• Payments on account of interbank deals
Nostro credit may arise due to:

• Inward remittances received on behalf of customers
• Interest amount credited
• Receipts from interbank deals
• Realization of bills sent for collection
• Reimbursement of negotiated bills

39
Points to be remember:
a. The purchase/sale of currency may be spot or forward
b. Indian bank do not remit foreign currency in Nostro account from India. All receipt in FX and all
payment/remittances in FX will be made through Nostro account maintained with foreign bank.
c. Forward Purchase/Sale of FX do not affect Nostro A/C because there is no delivery of currency
as on date of entering such contract.
d. Spot purchase/Sales of CHF affects both exchange position as well as Nostro A/C (Cash
Position)
Loro account is an account wherein a bank remits funds in foreign currency to another bank for
credit to an account of a third bank. e.g . Canara Bank wants to utilize a NOSTRO account of, Say
PNB, at NY, with Bank of America. This arrangement is called as LORO account.
Example for Nostro transactions:

Example No. 1 - A bank in India want to send a payment in GBP let's say the bank name is ABC
Bank. This bank has a Nostro Acoount (in GBP) with a bank in UK e.g. XYZ Bank. However the
beneficiary has an account with some other bank e.g. QWE Bank. This is possible with the use of
Nostro account and swift messages. In the first swift message, ABC Bank will be the sender, XYZ
bank will be the receiver and QWE bank will be in loop (Account with institution). In the second
message XYZ bank will be the sender QWE bank will be the receiver and ABC bank will be in loop
(Ordering institution).
Example No. 2 - Cover method can be used when a bank (e.g. ABC Bank) has RMA (Relationship
Management Application) with another bank (e.g. XYZ Bank) but do no maintain a Nostro Account.
Here ABC can send message to XYZ Bank informing (Sender's Correspondent) that the funds will
come from another bank (e.g. QWE Bank). This Sender's Correspondent could be a common
correspondent of both the banks. ABC Bank will have to send one more message. ABC Bank will
have to send this message to QWE Bank.
FEDAI Rules
Role of FEDAI
Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks
that deals in foreign exchange in India as a self regulatory body under the Section 25 of the Indian
Company Act (1956).
The role and responsibilities of FEDAI are as follows:
• Formulations of FEDAI guidelines and FEDAI rules for Forex business.
• Training of bank personnel in the areas of Foreign Exchange Business.
• Accreditation of Forex Brokers.
• Advising/Assisting member banks in settling issues/matters in their dealings.
• Represent member banks on Government/Reserve Bank of India and other bodies.
• Rules of FEDAI also include announcement of daily and periodical rates to its member
banks.
FEDAI guidelines play an important role in the functioning of the markets and work in close
coordination with Reserve Bank of India (RBI), other organizations like Fixed Income Money Market
and Derivatives Association (FIMMDA), the Forex Association of India and various other market
participants.
• FEDAI Rules-1-Hours-Of-Business
• FEDAI Rules-2-Export-Transactions
• FEDAI Rules-3-Import-Transactions
• FEDAI Rules-4-Merchanting-Tradeing
• FEDAI Rules-5-Clean-Instruments
• FEDAI Rules-6-Guarantees
• FEDAI Rules-7-Exchange-Contracts
• FEDAI Rules-8-Early Delivery Extension-And-Cancellation-Of-Forward -Contracts
• FEDAI Rules-9-Schedule-Of-Charges
• FEDAI Rules-10-Business-Through-Exchange-Brokers

40
• FEDAI Rules-11-Inter-Bank-TT-Settlement-And-Dispatch
• FEDAI Rules-12-Inter-Bank-TT-Settlement-Of-Inter-Bank-TTs-And-Despatch Fedai
• FEDAI Rules-13-Abolition-Of-Sterling-Rates-Schedule
• FEDAI Rules-14-Clarification-Explanatory-Notes-Certain-Other-Important-Information
FEDAI Rules - General Guidelines/Instructions

1. The directives issued by the Reserve Bank of India in respect of Interest rates on Export &
Import Finance shall be adhered to by the Authorised Dealers.
2. The member banks are totally free to determine their own charges for various types of forex
transactions, keeping in view the advice of RBI that such charges are not out of line with the
average cost of providing services.
3. Authorised Dealers shall ordinarily not be parties to any guarantees for an unlimited amount
and/or an unlimited period. Authorised Dealers shall ensure to include a specific clause in all t he
guarantees stating the exact period within which claims must be made under the guarantee
besides the expiry date for the guarantee.
4. With a view to simplifying and liberalising import, authorised dealers are permitted to open
standby letters of credit on behalf of their importer constituents for importing goods into India
permissible under Foreign Trade Policy. RBI vide its AP (Dir Series) Circular No. 84 dated 3rd
March 2003 advised the authorised dealers to open standby letters of credit subject to adhe rence
to the guidelines issued by FEDAI. The detailed guidelines were issued by FEDAI vide Special
Circular No. SPL-16/Standby LC/2003 dated 1st April 2003.
5. Guidelines for calculation of Merchant Rate have been deleted from the Rule Book as the
procedure for calculating the rate for Merchant transactions have been left for our member banks to
decide.
Rule 1 Hours of Each Authorised Dealer will establish its business hours for various types
business of foreign exchange transactions at each centre where its branches
undertake forex business.
Authorised dealers are permitted to undertake forex business on behalf
of the bank during extended hours subject to the condition that the
Management in each bank lays down the working hours of the dealers.
RBI Foreign Department have advised that exchange trading hours for
inter-bank market would be from 9AM to 4PM.
Rule 2 Export Authorised Dealers will purchase only Approved Bills and the decision as
Transactions to what is an approved bill lies solely with Authorised Dealers. This
includes bills tendered under forward contracts, letters of credit, letters of
guarantee, letters of authority, orders to negotiate, orders for payment
and any other type of document of similar nature.
Export Bills purchased/discounted/negotiated:
Application of rate = Authorised Dealers’ current bill buying rate or at the
contracted rate. Interest for the normal transit period, and usance period
shall be recovered simultaneously.
Crystallisation and Recovery :-Exporters are liable for the repatriation of
proceeds of the export bills negotiated/purchased/discounted or sent for
collection by the AD's within time allowed for it. Considering risk in it AD's
should transfer the exchange risk to the exporter by crystallising the
foreign currency liability into rupee liability.
AD's to decide on the period for crystallisation which may be linked to
risk factors like credit perception of different types of exporter clients,
operational aspects etc.

41
Rate applicable for crystallisation: AD's TT selling rate on the date of

crystallisation. Exchange difference arising out of crystallisation to be
recovered from or passed on to the customer, as the case may be.
Interest shall be recovered on the date of crystallisation for the period
from the date of expiry of the normal transit period/notional due date to
the date of crystallisation at the appropriate rate of interest as per the
guidelines issued by RBI from time to time.
Realisation of Bills after crystallization :- AD's will adjust the Rupee
liability on the bill crystallised as above by applying the TT buying rate of
exchange or the contracted rate. Any difference shall be recovered
from/paid to the customer. Interest - From the date of crystallisation to
the date of realisation of the bill shall be recovered from the customer at
the appropriate rate of interest for overdue export bills as permitted by
Reserve Bank of India.
Dishonour of Bills:- The bank shall recover from the customer :
a. The Rupee equivalent at the current ready TT selling rate.
b. All foreign currency charges at the ruling ready TT selling rate.
c. Interest at appropriate rate as per the guidelines issued by RBI.
Interest At the applicable rate taking into consideration of Normal Transit period.
Normal Normal transit period comprises the average period normally involved
Transit from the date of negotiation/purchase/discount till the receipt of bill
Period proceeds in the Nostro account of the bank. Normal Transit Period is n ot
to be confused with the time taken for the arrival of the goods at the
destination.
Normal Transit Period for purposes of all bills in Foreign Currencies 25
days
Exports to Iraq :- 120 days from the date of shipment under UN
certificate
Normal Transit Period for purposes of bills drawn in Rupees: In the case
of bills drawn under letters of credit where reimbursement is provided at
the centre of negotiation: 3 days or else it will be 7 days.
In case of export usance bills (foreign currency and rupee bills): Since
due dates are reckoned from date of shipment or date of bill of exchange
etc. no Normal Transit Period shall be applicable, since the actual due
date is known.
TT Reimbursement under letter of credit : Reimbursement by
cable/SWIFT/Telex or other electronic means - 5 days
Overdue To be recovered from the customer in case payment is not received on
Interest or before the expiry date of Normal Transit Period in case of demand
bills, and on or before the notional due date/actual due date as the case
may be in case of usance bills as per RBI directives.
In Early Proportionate interest shall be refunded from the date of realisation i.e.,
realisation by credit to nostro account in case of a foreign currency bill, and by debit
to vostro account in case of a Rupee bill, upto the last date of normal
transit period in the case of demand bill and upto the notional due date in
case of usance bill.
Export bills Application of rates :- TT buying rate ruling on the date of payment of
sent for proceeds or the forward contract rate as the case may be.
collection
Bill Buying Bill buying Rate is the rate to be applied when a foreign bill is purchased.
Rate When a bill is purchased, the proceed will be realized by the bank after
the bill is presented to the drawee at the overseas centre. In the case of

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a usance bill the proceed will be realized on the due date of the bill which
includes the transit period and the usance period of the bill.
If the sight bill on London Is purchased, the realization will be after a

period about 20days (transfer period) the bank would be able to dispose
of the foreign exchange only after this period. Therefore, the rate quoted
to the customer would be based not on the spot rate in the interbank rate
for 20 days forward. Likewise if the bill purchased is 30 days usance bill.
Then the bill will realize after about 50 days (20 days transit plus 30 day’s
usance bill, period) Therefore bank would be able to dispose of foreign
exchange only after 50 days the rate to the customer would be based on
the interbank rate for 50 days forward.
Rule 3 Import “Bills” shall include all documentary/clean bills received under letter/s of
Transactions credit, standby letter's of credit, letter/s of guarantee, letter's of authority,
order's to negotiate, order/s for payment and other document's or
undertaking's of a similar nature or on collection basis covering imports
into India.
Application of rates for retirement of import bills : Bills selling rate ruling
on the date of retirement or the forward sale contract rate as the case
may be.
Application of interest :- Bills negotiated under import letters of credit

shall carry commercial rate of interest as applicable to banks’ domestic
advances.To be recovered from the date of debit to the AD’s Nostro
account to the date of crystallisation/retirement whichever is earlier.
Crystallisation of Import Bills under Letters of Credit: All foreign currency
import bills drawn under letters of credit, in the event of non-retirement
shall be crystallised into Rupee liability on the 10th day after the date of
receipt of documents at the letter of credit opening branch of the bank, in
case of demand bills and on due date in case of usance bills at Bills
Selling Rate/contracted rate as the case may be. In case the 10th day or
the due date falls on a holiday or Saturday, the importer’s liability shall be
crystallised into Rupee liability on the next working day.
Import bill under the Forward Exchange Contract results in early/late
delivery, the bank shall recover swap cost and interest, if any.
Bill selling This rate is to be used for all transactions which involve handling of
Rate documents by the bank, e.g. payment against import bill. The bill selling
rate is calculated by adding exchange margin to the TT selling rate.
Rule 5 Clean Encashment of Inward foreign currency travellers cheques and currency
Instruments notes will be at AD’s option at the rates ruling on the date of such
encashment. Outward remittances shall be effected at the TT selling rate
of the bank ruling on the date of such remittance or at the forward
contract rate.
All foreign currency inward remittances up to an equivalent of USD 5000
shall be immediately converted into Indian Rupees.
Beneficiary has the option of presenting the relative instrument for
payment within the maximum period prescribed under FEMA, 1999 for
remittances in excess of equivalent of USD 5000.
Saturday may continue to be treated as working day except for
transactions involving conversion at confirmed exchange rate (other than
travel related transactions like issue/encashment of foreign currency
travellers’ cheques, foreign currency notes etc.).

43
Rule 7 Foreign Exchange contracts shall be for definite amounts and periods.
Exchange
Contracts
Unless date of delivery is fixed, option period of not more than one month
be specified at the discretion of the customer. If the fixed date of delivery
or the last date of delivery option is a holiday/declared a holiday the
delivery shall be effected/delivery option exercised on the preceding
working day.
“Ready” or “Cash” merchant contract shall be deliverable on the same
day.
A spot contract shall be deliverable on second succeeding business day.
Merchant quotations:- The exchange rate shall be quoted in direct terms
i.e., so many Rupees and Paise for 1 unit of foreign currency or 100 units
of foreign currencies.
Rule 8 Early Allowed at the request of the customer. It is optional for a bank unless
Delivery, stated to the contrary in the provisions of FEMA, 1999, a. Accept or give
Extension early delivery. b. Extend the contract.
and
Cancellation
of Foreign
Exchange
Contracts
Early delivery:- If a bank accepts or gives early delivery, the bank shall
recover/pay swap difference, if any.In all cases of early delivery of
purchase or sale contracts, swap cost shall be recovered from customers
irrespective of whether an actual swap is made or not. In case of outlay
of fund (loss to bank) due to extension/cancellation, Interest at not below
the prime lending rate of the respective AD will be charged to customer
in addition to the swap cost .
Extension: If extension is sought by the customers the contract shall be
cancelled (at appropriate Selling or Buying Rate as on the date of
cancellation) and rebooked simultaneously only at current rate of
exchange. The difference between the contracted rate and the rate at
which the contract is cancelled shall be recovered from/paid to the
customer at the time of extension. Such request for extension shall be
made on or before the maturity date of the contract.
Cancellation:- Here, the AD shall recover/pay, as the case may be, the
difference between the contracted rate and the rate at which the
cancellation is effected.
Rate at for cancellation: a. Purchase contracts - Spot T.T. selling rate
b. Sale contracts- Spot T.T. buying rate c.Where the contract is
cancelled before maturity -appropriate forward T.T. rate
In the absence of any instructions from the customer contracts which
have matured shall be automatically cancelled on the 15th day after
maturity date. In case 15th day falls on a Saturday or holiday, the
contract shall be cancelled on the next succeeding working day. Here no
gain will be transferred to the customer but swap cost can be recovered.
Please refer to the illustration on the above points given after these
rules..

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Rule Business Authorised Dealers make contracts through brokers such contracts shall
10 through only be made through accredited exchange brokers.No brokerage or
Exchange other form of remuneration shall be paid by the Authorised Dealers to
Brokers other bank employees on contracts made in respect of any foreign
exchange business.
Any accredited broker who knowingly concludes any exchange business
contrary to the rules of this Association may have his recognition
withdrawn and no Authorised Dealer shall transact business with him
thereafter.
Rule Interbank It is absolutely necessary for AD's to reconcile all dealing items within a
11 TT- period of 24/48 hours by demanding cable/telex/SWIFT confirmation
Settlement regarding receipt of expected credits in “Nostro” accounts from the
and correspondents maintaining those accounts within a maximum period of
Despatch 15 days.
Notices of non-receipt of funds in the Nostro account must be followed
up by cable, telex, SWIFT etc. with defaulting counterparty banks who
should immediately take up the matter with their correspondents.
In case the seller-bank is unable to substantiate to the buyer-bank that it
had intended to effect proper delivery on the settlement day, thereby
amounting to ‘deliberate’ non-delivery of funds, the seller-bank shall pay
to the buyer-bank a penalty as decided by the Managing Committee of
the FEDAI or any other Sub-Committee specially appointed for the
purpose by the Managing Committee. The penalty as stated above shall
be in addition to the interest claim of the buyer-bank.
Timings:- Written instructions of buyer-banks to seller-banks regarding
their take-up of interbank TT transactions, not later than one hour before
the close of the general banking hours of the latter.
Settlement of interest claims on the delayed delivery of Foreign Currency
Funds: In the event of late delivery of foreign currency amount of an
interbank TT at the stated overseas centre, if it is London, interest for the
overdue period is to be paid by the seller-bank in India at 2% over the
“Barclays Bank’s Base Rate” ruling on the day the remittance should
have been received in London in the buyer-bank’s nostro account.
Further, the buyer-bank has to lodge the interest claim within 30 days
from the day on which the amount should have been received. In case
the buyer-bank lodges the claim after expiry of the said period of 30
days, interest at the applicable rate shall be paid for a maximum period
of 60 days only or for the actual overdue period whichever is less.
In the event of late delivery at centres other than London, interest for the
number of days of the delay shall be paid in India at two per cent over
the prime rate of the banks specified below at the respective centres,
ruling on the day the delivery should have been made provided the buyer-
bank lodges the claim for interest within 30 days from the day the delivery
should have been received abroad :
U.S.A. Citibank N.A.
Canada Bank of Nova Scotia
Japan Bank of Tokyo-Mitsubishi Ltd.
Switzerland Swiss Bank Corporation
EURO ABN Amro Bank
In case the buyer-bank lodges the claim for interest after expiry of the
aforesaid period of 30 days, interest at the applicable rate shall be paid
for a maximum period of 60 days only or the actual period, whichever is
less.

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No interest claims shall be entertained if claims are preferred after 90

days from the date on which the foreign currency funds should have
been received by the buyer bank.
Non-delivery of Foreign Currency Funds: The seller bank shall deliver
foreign currency funds within 48 hours of the receipt of the notification
from the buyer-bank. Such notification shall be sent by the buyer-bank
not later than 15 days from the contracted date of delivery.
Delay in payment of Rupee equivalent of interbank TTs in foreign
currencies :The buyer bank shall pay interest for each day of delay at 2%
over the NSE-MIBOR rate ruling on each such day of delay. In case the
seller-bank fails to lodge the claim within the said period of 15 days, the
seller-bank shall be entitled to receive interest for the maximum period of
30 days only. No interest claims shall be entertained if claims are
preferred after 90 days from the date on which the rupee funds should
have been received by the seller bank.
Period for settlement of interest claims in Rupees:- When a bank is
served with the notice of interest claim, it must settle the claim within 21
days of receipt thereof by making proper enquiry into its books and
investigating its records.
Payment of interest claim cannot be withheld for more than 21 days on
the plea that enquiries are being made in the matter of the interest claim.
Rule 2 : Some illustration for explanation:

Illustration:- A Ltd has exported certain material to US for $ 2,00,000 on 05.01.2012 and got it
discounted with X bank on 10.01.2012. The bill is usance bill for 60 days from the date of
presentation of bill. The rate as quoted in spot at the time of discounting is Rs.55.128/.340. The X
bank charges Rs.1000 per bill as presentation and also charges 0.150% as margin. On the basis of
the above information answer the following questions:
1. What is the due date for the bill
a. 04th March,2012 b. 5th March ,2012 c. 29th March,2012 d. 3rd April, 2012
2. What is the amount that is will be paid to customer, if RBI states the interest rate of 9%.
a.Rs.1,07,78,915 b.Rs.1,07,77,915 c.1,08,10,223 d.1,10,51,398
Ans:- b. $ = Rs.55.128 – 0.150% margin = Rs. 55.045 * $2,00,000 = 1,10,09,000 – Rs.1000 =
1,10,08,000 – 9% Intt for 85 days ( 60 days + 25 days normal transit period) Rs.2,30,085 =
Rs.1,07,77,915
3. If this bill got dishonoured then what will be the amount of crystallization of this bill, if the rate is $
55.320/.440
a. 1,10,64,000 b. 1,10,88,000 c.1,11,04,600 d.1,10,47,400
Ans: c : Refer Rule 2. And also consider the margin charged by bank.
SOME PROBLEMS ON FORWARD CONTRACT :-

The following situations are considered for explanation of Rule 8.
Cancellation of Forward Contract: In the absence of any instructions from the customer, contracts
which have matured are automatically cancelled on the fifteenth day from the date of maturity. In
case the fifteenth day falls on a Saturday or holiday, the contract is cancelled on the next working
day. Exchange loss, if any, is recovered from the customer under advice to him. The customer is
not paid any gains out of such cancellations.
Cancellation of forward contracts can be studied in two parts:-
I. Cancellation at the request of customers
II. Automatic cancellation by bank on the fifteenth day from date of maturity.

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I. Cancellation at the request of customers

Situation :- Cancellation before the date of maturity: - The bank enters into an opposite contract
with the customer, the new contract will have same maturity date as of old contract. That means
bank will cancelled the old contract and will enter in new with same maturity date.
For example, on 10 April, 2012, a bank entered into a forward purchase contract for 1,00,000 $ @
Rs.40 maturing on 10Th June 2012. On 10 th May, 200 the customer requests the bank to cancel
the contract. Suppose, on 10th May 2012, the following rates are there :
Spot : 1$ = Rs.40.00/40.10
1 month forward : 1$ =Rs.40.50/40.60
For this purpose, the bank will enter into a new forward sale contract, @ Rs.40.60, with the
customer maturing 10th June, 2012. The bank recovers the difference.
Illustration:- ABC Ltd., with whom the Bank had entered into 2 months’ forward purchase contract
for € 5,000 @ Rs.69.50 comes to bank after 1 months and requests for cancellation of the contract.
On this date, the prevailing rates are:
Spot € = Rs. 69.60 /.70
One month forward € = Rs. 69.90 / 70.04
What is the loss or gain to ABC Ltd on cancellation?

Answer:- On the day the ABC Ltd comes to the bank for cancellation, the bank will enter into a
forward contract ( same maturity date as that of the original ) under which bank will sell 5,000 € @
Rs.70.04. On maturity, bank will sell 5,000 € to ABC Ltd (@ Rs.70.04) for Rs.3,50,200 ( under the new
contract) and purchase 5,000 € from the ABC Ltd (@ Rs.69.50) for Rs.3,47,500 ( under the original
contract ). Loss to the ABC Ltd Rs.2,700. (This loss will be recovered from the ABC Ltd)
Illustration II:- As on November 15, an exporter has booked a sell contract of US$50,000 to be
delivered two months forward at a rate Rs. 48.25. The delivery date is January 15. As on
December 15, he wanted to cancel the contract. The Bank charges an exchange marg in of 0.15%
and flat cancellation charges of Rs.250. Estimate the cash flow, with the given information as at
December 15:
Interbank spot as at December 15: 47.40- 47.42
1-Month Forward: 15/30
Prime Lending Rate: 11.50% p.a
Answer:- One month before the due date the customer is cancelling the forward contract. Hence,
effectively the bank can cover its position by buying one month forward. Cancellation of forward sell
contract can be done by one month forward TT selling rate.
December Spot US$ Purchase rate: Rs.47.40
1-Month Forward Premium: 0.15 Rs. 47.62
Exchange Margin: 0.15%
Amount to be paid to the customer: {(Rs.48.25 – Rs.47.62)*US$ 50,000 } = Rs.39,000/

This payment is due on January 15. Since the settlement is made one month before, the PLR of
11.50% would be used for discounting the January 15 so as to pay it on December 15 and the
amount would be Rs. 38376/-
Situation:- Forward contract Cancellation on the date of maturity: The bank does opposite action
on spot basis i.e. if under original contract the bank was to sell a currency to ABC Ltd, the bank will
purchase that currency from the ABC Ltd on spot basis . The bank recovers/ pays the difference.
Illustration:- Wealthy Bank has booked a forward purchase contract for USD 1,00,000 due 14 th
August, 2012 @ Rs. 56.25. On maturity, the customer fails to deliver the Dollars and requests for
cancellation of the contract. Spot rate on 14th August, 2012:
USD = Rs. 56.652 /.732.

47
What amount of gain / loss will be payable to / receivable from customer?

Answer:- On 14th August, the Bank will sell $ 1,00,000 on spot ( @ Rs.56.732 per $ ) for Rs.
56,73,200, the bank will purchase $ 1,00,000 (@ Rs. 56.25 per $ ) for Rs. 56,25,000 under the
original ( forward) contract . Loss to the customer Rs.48,200. This loss will be recovered from the
customer.
Situation:- Forward contract Cancellation ‘after the date of maturity’ but ‘before fifteenth day after
the date of maturity’: The bank does opposite action on spot basis . Exchange loss , if any, is
recovered from the customer under advice to him. The customer is not paid any gains out of such
cancellations.
Illustration:- Bank of Hydrabad has booked a forward sale contract for USD 1,00,000 @ 54.45 due
10th June, 2012. The customer did not contact the bank on due date. However, on June 16, 2012,
the customer requests the bank to cancel the contract. On this date, spot rate is Rs. 54.20 /.29.
What amount of gain / loss will be payable to / receivable from customer?
Answer :- On 16th June, the Bank will sell 1,00,000 $ on under the original (forward) contract (@
Rs. 54.45 per $) for Rs. 54,45,000 the bank will purchase 1,00,000 $ (@ Rs. 54.20 per $ ) for Rs.
54,20,000 on spot. . Gain to the customer Rs.25,000. This gain won’t be given to the customer, it
will be retained by the bank.
Extension of Forward contract:-

Extension is permissible, at the customer’s request, only before maturity. The bank takes two
steps; (i) Cancels the original contract i.e. the bank will take all the steps required for cancellation
of the contract before the date of maturity. (ii) The bank will enter into a new forward contract
maturing on the date requested by the customer. The FEDAI guidelines summarize this situation
as: Cancel and Rebook. The amount of loss / gain is received from / paid to customer at the time of
the customer approaches the bank for extension.
Illustration:- On 15 June, X a customer of “Y” bank booked a forward sale contact (For bank it’s a
FX purchase contract) for USD 2,50,000 due July 30 @ Rs. 58.35. On 30th Jul y. the customer
requests the bank to extend the forward contact for 30th August. Foreign Exchange rates on 30th
July are:
Spot 58.458/.667
Forward 30th July 57.662/.717
Forward 30th August 57.442/.537
Bank PLR rate is 12.50% p.a.
What amount of loss / gain will be receivable from / payable to customer?

Answer:
On 15th June on entering into contract with customer “X”, the bank enters into simutanous contract
of Forward sale in the market at a higher price than the forward price of the customer. On maturit y
the banks will purchase it at Rs.58.35 and will sale at higher price in forward sale contract e.g say
at Rs.58.40 But, On 30th July, the customer has requested to extend the contract to 30th August.
So now on 30th July, the bank will have to the bank will cancel the contract with the following
calculations:
$ 2,50,000 X spot TT selling 58.667= Rs. 1,46,66,750 ( that is bank has to purchase from spot and
have to honour the commitment of its own other Forward sale contract)
$ 2,50,000 X 58.350 = Rs.1,45,87,500 ( this is the amt of bank commitment towards the customer)
And hence here the bank suffers a loss of Rs. 1,46,66,750 – 1,45,87,500 = Rs.79,250/-
Hence, this loss of Rs.79,250 is recoverable from the customer and also recover the interest at the
rate of 12.50% for 30 days = Rs.79,250*12.50% =9,906/365*30 = Rs.814/-
Early Delivery :-
The steps of early delivery can be divided into 3 parts: (I)

48
(a) Take delivery on spot basis and (b) make provisional payment on the original forward contract
rate basis. The net effect of these two steps is that there will be either debit or credit balance in
the customer’s account. This will be settled at the time of maturity of the original contract (i.e. at the
time of final settlement) along with interest. If there is credit balance in the customer’s account the
bank will pay interest at the rate of fixed deposit interest rate; if there is debit balance the bank will
charge the customer interest at the rate of its Prime Lending Rate (PLR).
(II) A fresh contract for the cancellation of the original contract: Generally bank enters into an
opposite forward contract with the market after the forward contract with the customer, and hence
in case of early delivery bank is required to reverse the contract as entered in original contract after
the early delivery. The new contract will have same maturity date as that of old contract (which is to
be cancelled).
(III) On maturity : The bank will execute both the forward contracts (original contract as well as the
contract entered on the date of early delivery). Under the original contract the bank will purchase
the foreign currency and under the new contract (entered on the date of early delivery) the bank will
sell the foreign currency.
Illustration:-
Suppose, a ABC Bank has originally entered a 3 month forward purchase of $ 1,00,000 currency at
a rate of Rs.54 maturing on 31st August. On 30th June customer received $ 100,000 from US
company and hence he approached bank with $ 1,00,000 to exchange in Rupee (when spot rate is
Rs. 54.28/.33 and forward rate is Rs.54.80/.89 for due date after 2 months) against forward
contract. How much amount will be payable to customer?
Answer:-
To settle this transaction, bank will do two things:
(i) the bank has to enter into another forward purchase contract maturing on 31 st August, i.e.due
date of original contract. Because bank at the time of entering contract of purchase of $ from
customer ,has entered reversed contract of Forward sale maturing on 31st August.
Now this new forward purchase bank needs to entered at Rs.54.89 maturing on 31st August. Here
bank will suffer a loss to the extent of Rs.54.89 – Spot sale of Rs.54.28 = Rs.0.61 * $1,00,000 =
Rs.61,000/- i.e outflow of fund i.e it will be treated as swap difference and hence bank will reco ver
this amount from customer.
II) Bank has to Purchase $ 1,00,000 at agreed rate Rs.54.35 and has to give Rs. 54,35,000 to
customer. However, here bank is not earning i.e its a outflow of fund for bank because bank is
selling in interbank market at 54.28 and paying to customer at Rs.54.35. And hence, the bank will
charge interest on Rs.7,000 (54,35,000 paid – 54,28,000 received) treating as outlay. Interest will
be either as mentioned in Forward contract or may be MCLR or may be as specified.
ROLL OVER FORWARD CONTRACT:

Another application of swaps is in the “roll-over forward contracts”. In some countries, forward
contracts do not exist beyond certain maturities. Like, in India, it is available for maximum
maturities of 6 months.
Exposures with longer terms are required to be hedged by roll-over forward contracts. Under these
contracts, the exchange rate protection is provided for the entire period of the contract and the
customer has to bear the roll over charges (swap charges), if any, at every roll over date.
Essentially, at every rollover date, the customer does a swap, sell spot and buy forward, or vice -
versa.
****

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CHAPTER 7
FOREIGN EXCHANGE MANAGEMENT ACT, 1999
BASICS
The Foreign Exchange Management Act, 1999 (FEMA) deals with cross border inv estments,
foreign exchange transactions and transactions between residents and non-residents. It has
replaced the erstwhile Foreign Exchange Regulation Act, 1973 (FERA) with effect from June 1,
2000.
The operation of FEMA is akin to any other commercial law. However as compared to most other
commercial laws FEMA is one of the smallest, having only 49 Sections. If guidelines, rules, etc. are
followed, the person can undertake the transaction without any approvals. If proposed transactions
fall outside the guidelines, one will have to take necessary approvals. The consequence of any
violation is a penalty. If penalty is not paid, then there can be prosecution.
FEMA extends to the whole of India. It also applies to all branches, offices and agencies outside
India, which are owned or controlled by a person resident in India.
IMPORTANT TERMS UNDER FEMA – Section 2

1. Capital Account Transaction means a transaction which: –
• Alters foreign assets and foreign liabilities (including contingent liabilities) of Indian residents.
• Alters Indian assets and Indian liabilities of Non-residents.
• Is a Specified transaction listed in section 6(3).
Essentially this is an economic definition and not an accounting or legal definition. It is intended to
cover cross border investments, cross border loans and transfer of wealth across borders. RBI has
been empowered to regulate capital account transactions. Unless the transaction is permitted as
per regulations, Foreign Exchange (FX) cannot be drawn for the same.
Capital account transactions though freed to a great extent, continue to be regulated by RBI.
Unless RBI permits by way of rules or specific approvals, transactions cannot be undertaken. But
there are two very important purposes for which RBI cannot impose any restrictions viz. drawing of
foreign exchange for the repayment of any loans and for replenishing depreciation of direct
investments in the ordinary course of business. (Section 6)
2. Current Account Transaction means all transactions, which are not capital account transactions.
Specifically it includes:–
• Business transactions between residents and non-residents.
• Short-term banking and credit facilities in the ordinary course of business.
• Payments towards interest on loans and by way of income from investments.
• Payment of expenses of parents, spouse or children living abroad or expenses on their foreign
travel, medical and education.
• Scholarships/Chairs.
Primarily there are no restrictions on current account transactions. A person may sell or draw
foreign exchange freely for his current account transactions, except in a few cases where limits
have been prescribed (Section 5). The Central Government has the power to regulate current
account transactions. Unless the transaction is restricted, FX can be drawn for the same.
3. Person includes:– (a) an individual (b) a Hindu Undivided Family (HUF) (c) a company
(d) a firm (e) an association of persons or body of individuals, whether incorporated or not
(f) every artificial judicial person not falling in any of the above sub-clauses
(g) any agency, office or branch owned or controlled by such person.
4. Resident/Non-Resident:– If an individual stays in India for more than 182 days during the course
of the preceding financial year, he will be treated as a person resident in India. Th ere are a few
exceptions as under:
• If a person goes/stays outside India for (a) taking up employment, or (b) carrying on
business or vocation, or (c) for any other purpose for an uncertain period; he will be treated
as a person resident outside India (non-resident). (It has been clarified that students going
abroad for further studies will be regarded as non-residents.)

50
• If a person who is residing abroad comes to/stays in India only for (a) taking up
employment, or (b) carrying on business or vocation, or (c) for any other purpose for an
uncertain period; he will be treated as a person resident in India.
The term financial year means a twelve-month period beginning from April 1 and ending on March
31 next. Following persons (other than individuals) will be treated as person resident in India:
• Person or body corporate which is registered or incorporated in India.
• An office, branch or agency in India, even if it is owned or controlled by a person resident
outside India.
• An office, branch or agency outside India, if it is owned or controlled by a person resident in
India.
The definition is however inadequate to define residential status of a firm, an HUF, a trust or any
entity which does not have to be registered. Conversely, a non-resident means a person who is
not a resident in India.
IMPORTANT FEATURES :
1. All dealings in foreign exchange or foreign security can be done only through an authorized
person if permitted by FEMA, rules & regulations framed there under, or by general or special
permission of the RBI. Further no payments can be made by a resident to a non-resident unless
permitted under FEMA (section 3).
2. Residents have been allowed to maintain foreign currency accounts in India as under:
A. EEFC ACCOUNT
A person is permitted to credit the under mentioned amounts out of his foreign exchange earnings to
his EEFC Account: -
Entity or person Limit in %
1 Status Holder Exporter (as defined in the EXIM Policy in force) 100
2 Individual professionals ** 100
3 100% EOU Unit in EPZ/STP/EHTP 100
4 Any other person 100
** Professionals mean Director on Board of overseas company; Scientist /Professor in Indian
University/Institution; Economist; Lawyer; Doctor; Architect; Engineer; Artist; Cost/Chartered
Account; Any other person rendering professional services in his individual capacity, as may be
specified by the Reserve Bank from time to time. Professional earnings including director's fees,
consultancy fees, lecture fees, honorarium and similar other earnings received by a professional by
rendering services in his individual capacity.
However, amounts received to meet specific obligations of the account holder cannot be credited
(e.g. equity investment from a non-resident investor). The balances do not earn any interest.
These funds can be used for several current account purposes. For many transactions, where
there are restrictions under the current account rules, funds in EEFC account can be used without
restrictions.
Units in SEZ are permitted to open, hold and maintain a Foreign Currency Account with an
authorized dealer in India.
B. By Other persons i.e NRI ( Non resident Indian’s)

Particulars Foreign Currency (Non- Non-Resident (External)Rupee Non-Resident
Resident) Account (Banks) Account Scheme (NRE Ordinary Rupee
Scheme (FCNR(B) Account Account) Account Scheme
(NRO Account
Who can NRIs (individuals / entities of NRIs Any person resident
open an Pakistan nationality/ownership (individuals / entities of outside India (other
account require prior approval of RBI) Pakistan nationality/ownership than a person
require prior approval of RBI) resident in Nepal and
Bhutan). (individuals
/ entities of
Bangladesh /
Pakistan nationality /

51
ownership as well as
erstwhile OCBs
require prior
approval of RBI)
Joint Non-Resident Indian (NRI), are Non-Resident Indians (NRIs), May be held jointly
account permitted to open FCNR(B) are permitted to open NRE / with residents
account jointly with their account jointly with their
resident close relative (relative resident close relative (relative
as defined in Section 2 of the as defined in Section 2 of the
Companies Act, 2013) with Companies Act, 2013) with
operational instructions ‘former operational instructions ‘former
or survivor’, where NRI is or survivor’, where NRI is
‘Former’. ‘Former’.
Nomination Permitted Permitted Permitted

Currency in Pound Sterling, US Dollar, Indian Rupees Indian Rupees
which Japanese Yen, Euro, Canadian
account is Dollar and Australian Dollar
denominated
Whether Repatriable Repatriable Not repatriable
Repatriable except for the
following in the
account - 1) current
income 2) up to USD
1 million per financial
year (April- March),
for any bonafide
purpose out of the
balances in the
account / sale
proceeds of assets in
India acquired by
way of inheritance /
legacy inclusive of
assets acquired out
of settlement subject
to certain conditions
Type of Term Deposit only Savings, Current, Recurring, Savings, Current,
Account Fixed Deposit Recurring, Fixed
Deposit
Period for For terms not less than 1 year At the discretion of the bank As applicable to
fixed and not more than 5 years. resident accounts
deposits
Rate of From 01.03.2014 Banks are free to determine Banks are free to
Interest Maturity Period: interest rates for term deposits determine interest
1 year to less than 3 years: w.e.f 14.08.13 rates for term
LIBOR/Swap plus 200 basis deposits w.e.f
points 14.08.13
3 - 5 years: LIBOR/ SWAP plus
300 basis points
Operations Operations on the account in Operations on the account in Operations on the
by Power of terms of Power of Attorney is terms of Power of Attorney is account in terms of
Attorney in restricted to withdrawals for restricted to withdrawals for Power of Attorney is
favour of a permissible local payments or permissible local payments or restricted to
resident by remittance to the account remittance to the account withdrawals for
the non- holder himself through normal holder himself through normal permissible local
resident banking channels. banking channels payments or

52
account remittance to the

holder account holder
himself through
normal banking
channels
a. When a person resident in India leaves India for Nepal and Bhutan for taking up employment or
for carrying on business or vocation or for any other purpose indicating his intention to stay in
Nepal and Bhutan for an uncertain period, his existing account will continue as a resident account.
Such account should not be designated as Non-resident (Ordinary) Rupee Account (NRO).
b. ADs may open and maintain NRE / FCNR (B) Accounts of persons resident in Nepal and Bhutan
who are citizens of India or of Indian origin, provided the funds for opening these accounts are
remitted in free foreign exchange, Interest earned in NRE / FCNR (B) accounts can be remitted
only in Indian rupees to NRIs and PIO resident in Nepal and Bhutan.
c. In terms of Regulation 4(4) of the Notification No.FEMA.5/2000-RB dated May 3, 2000, ADs may
open and maintain Rupee accounts for a person resident in Nepal / Bhutan.
Change of Status:
When a resident proceeds to foreign country for stay for uncertain period, the existing ordinary
rupee account will be converted as NRO account. Fresh NRE account should be opened with
remittance from abroad. On his return back to India for stay for uncertain period / permanent
settlement, all the Non Resident running accounts will be converted as resident acc ounts
immediately and Term Deposits will be allowed to continue till maturity.
Bank account outside India of employees of foreign companies on deputation in india

Employees of foreign companies (either foreign nationals or Indian nationals) who are on
deputation in India are permitted to open, hold and maintain a foreign currency account outside
India and receive salary due to them as under:–
(a) The amount of salary to be credited to such account should not exceed 75% of the salary
accrued or received by the employee from the foreign company.
(b) The remaining salary shall be paid in Rupees in India.
(c) The tax on the whole salary has been paid.
Note:
'Non-Resident Indian (NRI)' means a person resident outside India who is a citizen of India or is a
person of Indian origin;
‘Person of Indian Origin (PIO)’ means a person resident outside India who is a citizen of any
country other than Bangladesh or Pakistan or such other country as may be specified by the
Central Government, satisfying the following conditions:
a. Who was a citizen of India by virtue of the Constitution of India or the Citizenship Act, 1955 (57
of 1955); or
b. Who belonged to a territory that became part of India after the 15th day of August, 1947; or
c. Who is a child or a grandchild or a great grandchild of a citizen of India or of a person referred to
in clause (a) or (b); or
d. Who is a spouse of foreign origin of a citizen of India or spouse of foreign origin of a person
referred to in clause (a) or (b) or (c)
Explanation: for the purpose of this sub-regulation, the expression ‘Person of Indian Origin’
includes an ‘Overseas Citizen of India’ cardholder within the meaning of Section 7(A) of the
Citizenship Act, 1955.
Diamond Dollar Account (DDA) :

Under the scheme of Government of India, firms and companies dealing in purchase / sale of rough
or cut and polished diamonds / precious metal jewellery plain, minakari and / or studded with /
without diamond and / or other stones, with a track record of at least 3 years in import / export of

53
diamonds / coloured gemstones / diamond and coloured gemstones studded jewellery / plain gold
jewellery and having an average annual turnover of Rs. 5 crores or above during the preceding
three licensing years (licensing year is from April to March) are permitted to transact the ir business
through Diamond Dollar Accounts.
They may be allowed to open not more than five Diamond Dollar Accounts with their banks.
3. CONTRAVENTION, PENALTIES & APPEALS – Sections 13 To 35

1. Penalties for contraventions under FEMA are per se monetary in nature. If any person contravenes
any provisions, rules, regulations, etc. the penalty imposed may be 3 times the amount involved in
contravention; and if the amount of contravention is not ascertainable, penalty can be up to Rs.
200,000. If the contravention is a continuing one, a penalty up to Rs. 5,000 per day may be
imposed for every day after the 1st day during which the contravention continues.
2. The adjudicating officer may also confiscate any currency, security or property in addition to
imposing penalty.
3. If a person does not pay up the penalty within 90 days, he is liable for civil imprisonment.
4. There is a right to appeal given at every stage and an appeal against an order of the
Adjudicating Authority can be made to the Special Director (Appeal). An appeal against the order of
the Special Director (Appeals) can be made to the Appellate Tribunal. An appeal, on questions of
Law, against the order of the Appellate Tribunal can be made to the High Court.
5. A person preferring an appeal to the Special Director (Appeals) or the Appellate Tribunal can
take assistance of a Chartered Accountant or Legal Practitioner.
4. DIRECTORATE OF ENFORCEMENT – SECTIONS 36 TO 38

1. The officers of the Directorate have powers to investigate contraventions referred to in section
13.
2. The powers and limitations of these officers are the same as those conferred on Income -tax
Authorities under the Income-Tax Act, 1961.
5. COMPOUNDING OF CONTRAVENTIONS
Powers for compounding of offences – RBI has been given powers for compounding all cases of
contraventions other than cases under section 3(a) of FEMA. Cases of contravention under section
3(a) relate to dealing in or transfer of foreign exchange and foreign security to any person other
than an authorised dealer. For these, Enforcement Directorate will be responsible. Powers of
compounding with RBI should give confidence to public.
Depending on the amount involved, various officers have been designated to look into applications
for compounding. The compounding authority can call for any information, record or any other
documents relevant to the compounding proceedings. The compounding authority is required to
pass an order within 180 days from the date of application. The sum for which the contravention is
compounded has to be paid within 15 days from the date of order of compounding.
6. TRANSACTIONS BY RESIDENTS :
The details of restrictions on Current Account Transactions are as follows:
A. Payments or withdrawal of FX for following purposes are totally prohibited:-
1. Travel to Nepal and Bhutan. 2. Transaction with a person resident in Nepal and Bhutan.
3. Remittance out of lottery winnings. 4. Remittance of income from racing/riding, etc. or any other
hobby.
5. Remittance for purchase of lottery tickets, banned/ proscribed magazines, football pools,
sweepstakes, etc.
6. Payment of commission on exports made towards equity investment in Joint Ventures/Wholly
Owned Subsidiaries abroad of Indian companies.
7. Payment of commission on exports under Rupee State Credit Route, except commission up to
10% of invoice value of exports of tea and tobacco.
8. Payment related to “Call Back Services” of telephones.
9. Remittance of interest income on funds held in NRSR Scheme Account.
10. Remittance towards participation in lottery schemes involving money circulation or for securing
prize money / awards, etc.

54
Investments Abroad by Indian Residents :

Joint ventures & wholly owned subsidiaries.
Purpose Set up of Joint ventures wholly owned subsidiaries (WOS)
Automatic route (No Investment made upto 400% (w.e.f 14.08.2013 – 100%) of the
permission required) Net worth as per the last balance sheet. Investment over 100%
of net worth requires permission.
Who can set up JVs& WOS Indian Companies & Registered Partnership firms only.
Registered Trust/ Society operating hospitals in India, can invest
in same sector abroad.
Prohibited activity for Portfolio Investment & Investment in banking & real estate
Investment in JVs & WOS
Way of Investment Equity, loans or by way of guarantees.
Other Investments Options:-

Portfolio Investment (Automatic Route)
Who can invest & upto what amount a. Listed Indian company upto 50% of list net
worth as per last audited Balance sheets.
b. Indian MF registered with SEBI upto US$ 7
billion.
c. Indian VC registered with SEBI - Upto to US$
500 million in equity/ Equity linked investment of
off shore VC after SEBI approved.
Agriculture operations overseas Indian Company & registered partnership upto
Who can invest& upto what amount. 400% of its Net worth.
Investment by regional Star Exporters. Proprietory Concern/unregistered Partnership
firm, who exports for more than 15cr pa. KYC
compiled & exports outstanding not exceeding
10% of average export realization of last 3 yrs,
can invest max of avg. 3 yrs export realization of
200/- of their net owned Funds, whichever is
lower.
Remittance under the Us $ 2,50,000 Scheme (Monetary Policy Review’ in February, 2015,)
An individual resident in India is permitted to remit up to US $ 2,50,000 per calendar year for any legal
and lawful purpose without obtaining prior permission of RBI. The individual can use said facility for any
current account transaction, acquisition of any movable and/or immovable property, remittance towards
gift and donation, investment in overseas companies or opening of a bank account outside India.
However, remittances cannot be made to Bhutan, Nepal, Mauritius or Pakistan or countries identified as
“non co-operative countries and territories” by the Financial Action Task Force. Currently (i.e., as per list
updated as on February 17, 2006), the countries where investment cannot be made are Myanmar,
Nigeria. The updated list can be seen at the website of FATF - http://www.fatf-gafi.org. An application
cum declaration form is required to be filed with the A. D.
Borrowings from Non-residents: w.e.f 30/11.2015 & subsequent amendments in Jan’16 &
Mar’16.
External Commercial Borrowings(ECB)
Who can borrow?
Track I (Medium term - Companies in manufacturing, and software development sectors.
foreign currency - Shipping and airlines companies.
denominated ECB - Small Industries Development Bank of India (SIDBI).
with Minimum Average - Units in Special Economic Zones (SEZs).
Maturity (MAM) of 3/5 - Export Import Bank of India (Exim Bank) (only under the approval route)
years.) - Companies in infrastructure sector, Non-Banking Financial Companies
Infrastructure Finance Companies (NBFCIFCs), NBFCs-Asset Finance
Companies (NBFC-AFCs), Holding Companies and Core Investment
Companies (CICs).
Track II (Long term - All entities listed under Track I.

55
foreign currency - Companies in infrastructure sector.

denominated ECB - Holding companies.
with MAM of 10 - Core Investment Companies (CICs).
years.) - Real Estate Investment Trusts (REITs) and Infrastructure Investment
Trusts (INVITs) coming under the regulatory framework of the Securities
and Exchange Board of India (SEBI).
Track III (Indian - All entities listed under Track II.
Rupee denominated - All Non-Banking Financial Companies (NBFCs) coming under the
ECB with MAM of 3/5 regulatorypurview of the Reserve Bank.
years) - NBFCs-Micro Finance Institutions (NBFCs-MFIs), Not for Profit companies
registered under the Companies Act, 1956/2013, Societies, trusts and
cooperatives (registered under the Societies Registration Act, 1860, Indian
Trust Act, 1882 and State-level Cooperative Acts/Multi-level Cooperative
Act/State-level mutually aided Cooperative Acts respectively), Non-
Government Organisations (NGOs) which are engaged in micro finance
activities1.
- Companies engaged in miscellaneous services viz. research and
development (R&D), training (other than educational institutes), companies
supporting infrastructure, companies providing logistics services.
- Developers of Special Economic Zones (SEZs)/ National Manufacturing
and Investment Zones (NMIZs)
Purpose for which they can borrow?
Track I 1. Except for the prohibited activities, ECBs can be used for any bonafide
business requirement such as import of capital goods, new projects,
modernization / expansion of existing production units, etc. Overseas direct
investment in Joint ventures (JV)/ Wholly owned subsidiaries (WOS),
Refinancing of existing ECB provided the residual maturity is not reduced
2. SIDBI can raise ECB only for the purpose of on lending to the borrowers
in the Micro, Small and Medium Enterprises (MSME sector)
3. Units of SEZs can raise ECB only for their own requirements.
4. Shipping and airlines companies can raise ECB only for import of vessels
and aircrafts respectively.
5. ECB proceeds can be used for general corporate purpose (including
working capital) provided the ECB is raised from the direct / indirect equity
holder or from a group company for a minimum average maturity of 5 years.
6. ECBs for the following purposes will be considered under the approval
route:
a. Import of second hand goods as per the Director General of Foreign
Trade (DGFT) guidelines;
b. On-lending by Exim Bank.
Track II The ECB proceeds can be used for all purposes excluding the following:
Real estate activities, Investing in capital market, Using the proceeds for
equity investment domestically; On-lending to other entities with any of the
above objectives; Purchase of land.
2. Holding companies can also use ECB proceeds for providing loans to
their infrastructure SPVs.
Track III NBFCs can use ECB proceeds for: On-lending to the infrastructure sector;
providing hypothecated loans to domestic entities for acquisition of capital
goods/equipments; and providing capital goods/equipment to domestic
entities by way of lease and hire-purchases
2. Developers of SEZs/ NMIZs can raise ECB only for providing
infrastructure facilities within SEZ/ NMIZ.
3. NBFCs-MFI, other eligible MFIs, NGOs and not for profit companies
registered under the Companies Act, 1956/2013 can raise ECB only for on-
lending to self-help groups or for micro-credit or for bonafide micro finance
activity including capacity building.
4. For other eligible entities under this track, the ECB proceeds can be used
for all purposes excluding the following:

56
Real estate activities, Investing in capital market, Using the proceeds for
equity investment domestically; On-lending to other entities with any of the
above objectives; Purchase of land
Limit upto which ECB A. Automatic Route
can be raised? - Upto USD 750 million or equivalent for the companies in infrastructure and
manufacturing sectors, Non-Banking Financial Companies -Infrastructure
Finance Companies (NBFC-IFCs), NBFCs-Asset Finance Companies
(NBFCAFCs), Holding Companies and Core Investment Companies;
- Upto USD 200 million or equivalent for companies in software
development sector;
- Upto USD 100 million or equivalent for entities engaged in micro finance
activities; and
- Upto 500 million or equivalent for remaining entities.
B. Approval Route:
Limit above the automatic route will be considered on case by case basis.
Minimum Average Maturity Period
Track I & Track III i. 3 years for ECB upto USD 50 million or its equivalent.
ii. 5 years for ECB beyond USD 50 million or its equivalent.
iii. 5 years for eligible borrowers (Companies in infrastructure sector, Non-
Banking Financial Companies Infrastructure Finance Companies
(NBFCIFCs), NBFCs-Asset Finance Companies (NBFC-AFCs), Holding
Companies and Core Investment Companies (CICs)) irrespective of the
amount of borrowing, subject to 100 per cent hedging.
iv. 5 years for Foreign Currency Convertible Bonds (FCCBs)/ Foreign
Currency Exchangeable Bonds (FCEBs) irrespective of the amount of
borrowing. The call and put option, if any, for FCCBs shall not be
exercisable prior to 5 years.
Track II 10 years irrespective of the amount.
All-in-Cost (AIC)
Track I 3 years to 5 years : 300 basis points over 6 months LIBOR or applicable
Average Maturity in bench mark for the respective currency.
years More than 5 years: 500 basis points over 6 months LIBOR or applicable
bench mark for the respective currency.
Penal interest, if any, for default or breach of covenants should not be more
than 2 per cent over and above the contracted rate of interest.
Track II i. The maximum spread over the bench mark will be 500 basis points per
annum.
ii. Remaining conditions will be as given under Track I.
Track II The all-in-cost should be in line with the market conditions.
The term ‘All-in-Cost’ includes rate of interest, other fees, expenses,
charges, guarantee fees whether paid in foreign currency or Indian Rupees
(INR) but will not include commitment fees, pre-payment fees / charges,
withholding tax payable in INR. In the case of fixed rate loans, the swap
cost plus spread should be equivalent of the floating rate plus the applicable
spread.
7.3.1 Borrowings through Loans / Deposits

Indian Companies, other Body Corporates, Indian Proprietary Concerns and Firms can accept
fresh deposits from NRI only if the deposit is by way of debit to the NRO account o f the lender and
the amount deposited does not represent inward remittances or transfer from NRE/FCNR (B)
Accounts into the NRO Account of the lender. However, they are permitted to hold and renew on
maturity existing deposits received by them on repatriation as well as non-repatriation basis.
Resident Individuals are permitted to avail of interest free loans up to US $ 250,000 from their NRI /
PIO relatives subject to certain conditions.
Special permission of the RBI will be required in case where deposits / loans do not fulfil the
specified criteria or where the deposits/loans are on repatriation basis in the case of proprietary
concerns and firms.

57
8. PERMISSIBLE TRANSACTIONS BY NON-RESIDENTS:

Foreign Direct Investment (FDI) in India is : FDI( Foreign Direct Investment):
• Undertaken in accordance with the FDI Policy which is formulated and announced by the
Government of India. The Department of Industrial Policy and Promotion, Ministry of
Commerce and Industry, Government of India issues a “Consolidated FDI Policy Circular ”
on an yearly basis on March 31 of each year (since 2010) elaborating the policy and the
process in respect of FDI in India. The latest “Consolidated FDI Policy Circular” dated April
5, 2013 is available in public domain and can be downloaded from the website of Ministry of
Commerce and Industry, Department of Industrial Policy and Promotion –
• http://www.dipp.nic.in/English/Policies/FDI_Circular_01_2013.pdf governed by the
provisions of the Foreign Exchange Management Act (FEMA), 1999. FEMA Regulations
which prescribe amongst other things the mode of investments i.e. issue or acquisition of
shares / convertible debentures and preference shares, manner of receipt of funds, pricing
guidelines and reporting of the investments to the Reserve Bank. The Reserve Bank has
issued Notification No. FEMA 20 /2000-RB dated May 3, 2000 which contains the
Regulations in this regard. This Notification has been amended from time to time.
Foreign Direct Investment
Entry routes for investments can be made in shares, mandatorily and fully convertible debentures
investments in and mandatorily and fully convertible preference shares of an Indian company by
India non-residents through two routes:
a. Automatic Route: Under the Automatic Route, the foreign investor or the Indian
company does not require any approval from the Reserve Bank or Government of
India for the investment.
b. Government Route: Under the Government Route, the foreign investor or the
Indian company should obtain prior approval of the Government of India(Foreign
Investment Promotion Board (FIPB), Department of Economic Affairs (DEA),
Ministry of Finance or Department of Industrial Policy & Promotion, as the case
may be) for the investment.
List of activities (i) Foreign investment in any form is prohibited in a company or a partnership firm
or items in which or a proprietary concern or any entity, whether incorporated or not (such as,
FDI is prohibited Trusts) which is engaged or proposes to engage in the following activities:
a. Business of chit fund, or
b. Nidhi company, or
c. Agricultural or plantation activities, or
d. Real estate business, or construction of farm houses, or
e. Trading in Transferable Development Rights (TDRs).
(ii) It is clarified that “real estate business” means dealing in land and immovable
property with a view to earning profit or earning income there from and does not
include development of townships, construction of residential / commercial
premises, roads or bridges, educational institutions, recreational facilities, city and
regional level infrastructure, townships.
It is further clarified that partnership firms /proprietorship concerns having
investments as per FEMA regulations are not allowed to engage in print media
sector.
(iii) In addition to the above, Foreign investment in the form of FDI is also
prohibited in certain sectors such as
(a) Lottery Business including Government /private lottery, online lotteries, etc.
(b) Gambling and Betting including casinos etc.
(c) Business of Chit funds
(d) Nidhi company
(e) Trading in Transferable Development Rights (TDRs)
(f) Real Estate Business or Construction of Farm Houses
(g) Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of tobacco or of
tobacco substitutes
(h) Activities / sectors not open to private sector investment e.g. Atomic Energy
and Railway Transport (other than Mass Rapid Transport Systems).

58
Note: Foreign technology collaboration in any form including licensing for

franchise, trademark, brand name, management contract is also prohibited for
Lottery Business and Gambling and Betting activities.
Eligibility for (i) A person resident outside India or an entity incorporated outside India, can
Investment in invest in India, subject to the FDI Policy of the Government of India. A person who
India is a citizen of Bangladesh or an entity incorporated in Bangladesh can invest in
India under the FDI Scheme, with the prior approval of the FIPB. Further, a
person who is a citizen of Pakistan or an entity incorporated in Pakistan, may,
with the prior approval of the FIPB, can invest in an Indian company under FDI
Scheme, subject to the prohibitions applicable to all foreign investors and the
Indian company, receiving such foreign direct investment, should not be engaged
in sectors / activities pertaining to defence, space and atomic energy.
(ii) NRIs, resident in Nepal and Bhutan as well as citizens of Nepal and Bhutan
are permitted to invest in shares and convertible debentures of Indian companies
under FDI Scheme on repatriation basis, subject to the condition that the amount
of consideration for such investment shall be paid only by way of inward
remittance in free foreign exchange through normal banking channels.
Investment a) Foreign Investment Limits
Limits The details of the entry route applicable and the maximum permissible foreign
investment / sectoral cap in an Indian Company are determined by the sector in
which it is operating. The details of the entry route applicable along with the
sectoral cap for foreign investment in various sectors are given in sectoral
investment guidelines.
b) Investments in Micro and Small Enterprise (MSE)
A company which is reckoned as Micro and Small Enterprise (MSE) (earlier Small
Scale Industrial Unit) in terms of the Micro, Small and Medium Enterprises
Development (MSMED) Act, 2006, including an Export Oriented Unit or a Unit in
Free Trade Zone or in Export Processing Zone or in a Software Technology Park
or in an Electronic Hardware Technology Park, may issue shares or convertible
debentures to a person resident outside India (other than a resident of Pakistan
and to a resident of Bangladesh under approval route), subject to the prescribed
limits as per FDI Policy, in accordance with the Entry Routes and the provision of
Foreign Direct Investment Policy, as notified by the Ministry of Commerce &
Industry, Government of India, from time to time.
Any Industrial undertaking, with or without FDI, which is not an MSE, having an
industrial license under the provisions of the Industries (Development &
Regulation) Act, 1951 for manufacturing items reserved for the MSE sector may
issue shares to persons resident outside India (other than a resident/entity of
Pakistan and to a resident/entity of Bangladesh with prior approval FIPB), to the
extent of 24 per cent of its paid-up capital or sectoral cap whichever is lower.
Foreign investments under Portfolio Investment Scheme (PIS)
Investment Purchase of shares and convertible debentures issued by Indian companies
instruments under the Portfolio Investment Scheme (PIS).
Who can invest Foreign Institutional Investors (FIIs) registered with SEBI, NRIs, SEBI approved
sub accounts of FIIs (sub accounts),
Limits of A. FIIs
Investment (a) An Individual FII/ SEBI approved sub accounts of FIIs can invest up to a
maximum of 10 per cent of the total paid-up capital or 10 per cent of the paid-up
value of each series of convertible debentures issued by the Indian company. The
10 per cent limit would include shares held by SEBI registered FII/ SEBI approved
sub accounts of FII under the PIS (by way of purchases made through a
registered broker on a recognized stock exchange in India or by way of
offer/private placement) as well as shares acquired by SEBI registered FII under
the FDI scheme.
(b) Total holdings of all FIIs / SEBI approved sub accounts of FIIs put together
shall not exceed 24 per cent of the paid-up capital or paid-up value of each series
of convertible debentures. This limit of 24 per cent can be increased to the
sectoral cap / statutory limit, as applicable to the Indian company concerned, by

59
passing of a resolution by its Board of Directors, followed by a special resolution

to that effect by its General Body which should necessarily be intimated to the
Reserve Bank of India immediately as hitherto, along with certificate from the
Company Secretary stating that all the relevant provisions of the extant Foreign
Exchange Management Act, 1999 regulations and the Foreign Direct Investment
Policy, as amended from time to to time have been complied with.
B. NRIs
(a) NRIs are allowed to invest in shares of listed Indian companies in recognised
Stock Exchanges under the PIS.
(b) NRIs can invest through designated ADs, on repatriation and non-repatriation
basis under PIS route up to 5 per cent of the paid- up capital / paid-up value of
each series of debentures of listed Indian companies.
(c) The aggregate paid-up value of shares / convertible debentures purchased by
all NRIs cannot exceed 10 per cent of the paid-up capital of the company / paid-
up value of each series of debentures of the company. The aggregate ceiling of
10 per cent can be raised to 24 per cent by passing of a resolution by its Board of
Directors followed by a special resolution to that effect by its General Body which
should necessarily be intimated to the Reserve Bank of India immediately as
hitherto, along with Certificate from the Company Secretary stating that all the
relevant provisions of the extant Foreign Exchange Management Act, 1999
regulations and the Foreign Direct Investment Policy, as amended from time to
time have been complied with.
Prohibition for • FIIs are not permitted to invest in the capital of an Asset Reconstruction
investments by Company.
FIIs and NRIs • Both FIIs and NRIs are not allowed to invest in any company which is engaged
or proposes to engage in the following activities:
i. Business of chit fund, or
ii. Nidhi company, or
iii. Agricultural or plantation activities, or
iv. Real estate business* or construction of farm houses, or
v. Trading in Transferable Development Rights (TDRs).
* Real estate business" does not include construction of housing / commercial
premises, educational institutions, recreational facilities, city and regional level
infrastructure, townships.
Investment in Partnership Firm / Proprietary Concern
Who can invest A Non-Resident Indian (NRI) or a Person of Indian Origin (PIO) resident outside
India can invest by way of contribution to the capital of a firm or a proprietary
concern in India on non-repatriation basis provided:
i. Amount is invested by inward remittance or out of NRE / FCNR(B) / NRO
account maintained with Authorised Dealers / Authorised banks.
ii. The firm or proprietary concern is not engaged in any agricultural /
plantation or real estate business (i.e. dealing in land and immovable
property with a view to earning profit or earning income there from) or
print media sector.
iii. Amount invested shall not be eligible for repatriation outside India.
Investments with repatriation benefits
NRIs / PIO may seek prior permission of Reserve Bank for investment in sole
proprietorship concerns / partnership firms with repatriation benefits. The
application will be decided in consultation with the Government of India.
Investment by A person resident outside India other than NRIs / PIO may make an application
non-residents and seek prior approval of Reserve Bank, for making investment by way of
other than NRIs contribution to the capital of a firm or a proprietorship concern or any association
/ PIO of persons in India. The application will be decided in consultation with the
Government of India.
****
HERE IN AFTER MODULE B RISK MANAGEMENT

60
CHAPTER 1 RISK MANAGEMENT: AN OVERVIEW
Structure
1.1 Introduction
Risk Management
Categories of Risk
Steps in Risk Management
Integration of Risks leading to Enterprise-wise Risk Management System
INTRODUCTION
The business of banking today is synonymous with active risk management than it was ever
before. The success and failure of a banking institution heavily depends on the strength of the risk
management system in the current environment.
To diversify other than just lending, banks entered into a host of fee based services such as cash
management, funds transfer etc., capital market activities such as merchant banking, public issue
management, private placement of issues and advisory services to diversity from fund- based to fee-
based activities. It results in rapid growth in the size of investment portfolio of banks over a period of
time at the cost of advances portfolio. Over the period of time, the income from the businesses of
lending, investments and fee based services have come down due to competition both from within
and outside the industry. To counter this, the latest in the array of new products is the provision of
specialized services by structuring products to meet the unique requirements of corporate customers
and also to high networth individual clients for improving fee income. The scope of the business of
structuring products has widened to a significant level with the introduction of derivative products in
the markets. The net result of all the above developments is a metamorphic change in the risk and
return profile compared to the past. This will continue in future with more and more of derivatives
entering into the various segments of the market. While the complexities have increased tremendously,
tools to manage the complexities have to be in place to manage the complexities.
RISK MANAGEMENT
Meaning and Scope
Though the term risk has got different connotations from different angles, it can be defined as the
potential that events, expected or unexpected may have an adverse impact on a bank’s earnings or
capital or both. Both the risks having high probability low impact and low probability high impact are
covered under the definition. This working definition would be useful throughout the discussi on. It
is useful to recall at this stage that risk and expected return are positively related; higher the risk,
higher the expected return and vice versa. The scope of risk management function in any
organization is to ensure that systems and processes are set up in accordance with the risk
management policy of the institution.
Objectives
The very basic objective of risk management system is to put in place and operate a systematic
process to give a reasonable degree of assurance to the top management that the ultimate
corporate goals that are vigorously pursued by it would be achieved in the most efficient manner.
In this way, all the risks that come in the way of the institution achieving the goals it has set for itself
would be managed properly by the risk management system. In the absence of such a system, no
institution can exist in the long-run without fulfilling the objectives for which it was set up.
CATEGORIES OF RISK
Banking risks can be broadly categorized as under:
a) Credit Risk b) Interest Rate Risk c) Market Risk d) Liquidity Risk
e) Operational Risk
a) Credit Risk: Credit risk is the oldest risk among the various types of risks in the financial
system, especially in banks and financial institutions due to the process of intermediation.
Managing credit risk has formed the core of the expertise of these institutions. While the risk is

61
well known, growth in the markets, disintermediation, and introduction of a number of innovative
products and practices has changed the way. Credit risk is measured and managed in today’s
environment. Credit risk arises from all activities where success depends on counterparty, issuer
or borrower performance”. Credit risk enters the books of a bank the moment the funds are lent,
deployed, invested or committed in any form to counterparty whether the transaction is on or off
the balance sheet.
b) Interest Rate Risk: Interest Rate Risk (IRR) arises as a result of change in interest rates on
rate earning assets and rate paying liabilities of a bank. The scope of IRR management is to
cover the measurement, control and management of IRR in the banking book. With the
deregulation of interest rates, the volatility of the interest rates has risen considerably. This has
transformed the business of banking forever in our country from a mere volume driven business
to a business of carefully planning and choosing assets and liabilities to be entered into to
achieve targets of profitability.
There are two basic approaches to IRR. They are: a) Earnings Approach, and a) Economic Value
Approach.
c) Market Risk: Traditionally, credit risk management was the primary challenge for banks. With
progressive deregulation, market risk arising from adverse changes in market variables, such as
interest rate, foreign exchange rate, equity price and commodity price has become relatively
more important. Even a small change in market variables causes substantial changes in income
and economic value of banks.
Market risk takes the form of: a) Liquidity Risk, b) Interest Rate Risk, c) Foreign Exchange Rate
(Forex) Risk, d) Commodity Price Risk, and e) Equity Price Risk
d) Liquidity Risk: Liquidity risk is defined as the possibility that the bank would not be able to
meet the commitments in the form of cash outflows with the available cash inflows. This risk
arises as a result of inadequacy of cash available and near cash item including drawing rights to
meet current and potential liabilities. Liquidity risk is categorized into two types; a) Trading
Liquidity Risk; and b) Funding Liquidity Risk.
Trading liquidity risk arises as a result of illiquidity of securities in the trading portfolio of the bank.
Funding liquidity risk arises as a result of the cash flow mismatch and is an outcome of difference
in balance sheet strategies pursued by different institutions in the same industry. It is perfectly
possible for a few banks to have excess funding liquidity while other banks may suffer shortage of
liquidity.
e) Operational Risk: Operational risk is emerging as one of the important risks financial
institutions worldwide are concerned with. Unlike other categories of risks, such as credit and
market risks, the definition and scope of operational risk is not fully clear. A number of diverse
professions such as internal control and audit, statistical quality control and quality assurance,
facilities management and contingency planning, etc., have approached the subject of
operational risk thereby bringing in different perspectives to the concept. While studies carried out
on bank failures in the U.S. show that operational risk has accounted for an insignificant
proportion of large bank failures so far, it is widely acknowledged that most of the new, unknown
risks are under the category of operational risk. According to the Basel Committee, Operational
risk is defined as “the risk of loss resulting from inadequate or failed processes, people and
systems or external events. This definition includes legal risk, but excludes strategic and
reputation risk” (The New Basel Capital Accord, Consultative Document released in Apr il 2003).
There can be different classifications depending on the purpose.
STEPS IN RISK MANAGEMENT
1) Risk Identification: It is crucial that all the risks have to be identified first. The methodology
normally followed is the risk matrix approach which appears as under:
Risk Matrix ( Indicative)
Products Credit Risk Interest Rate Market Risk Liquidity Operational
Risk Risk Risk
Loans & Advances YES YES NO YES YES
Investments YES YES YES YES YES
Cash Management & NO NO NO NO YES
Payment services
Deposits NO YES NO YES YES

62
The matrix above has been prepared for main products. The matrix can be detailed to go down to
individual product level risks for better identification of risks present.
2) Risk Measurement: This step is the most crucial of all. Having identified the risks, tools for
measurement of each one of the risks need to be put in place to measure each one of the risks in a
numerical form. The most challenging task is the selection of an appropriate tool or methodology
for quantification of risks. The measures of quantification range from simple to highly complex.
What is important is to use an appropriate quantification method or tool suitable for the bank
3) Risk Control and Monitoring: Risk control and monitoring deal with setting up of limits to
each one of the risks and monitoring them to ensure that the actual exposure to each one of the
risks defined is within the limits prescribed in the risk management policy. Any violation of limits
needs to be thoroughly investigated to ascertain the reasons for violation and to avoid such
violations in future.
4) Capital Allocation: Under this step, activities of a bank would be broken down to various major
businesses, such as retail banking, corporate banking, government business, proprietary trading
etc. as each one of these businesses have become highly focused and require specialization to
manage them, unlike in the past when the entire banking business was viewed as a single
business requiring little or no specialization at all. Each one can be viewed as a Strategic Business
Unit (SBU) with targets of return performance. Each one of the SBUs is allocated a portion of the
bank’s equity capital. The allocation of capital is based on the contribution of each SBU to various
risks of the bank. Higher the contribution of an SBU to the risk of the bank, higher will be the
capital allocated
5) Risk-adjusted Performance Measurement: Having allocated capital to each SBU
commensurate with its contribution to the overall risk of the bank, a target return on the capital
allocated needs to be set. If the SBU is able to earn a return higher than the target, then it is adding
value to the bank, if the return earned is lower than the target set, then the value gets reduced. The
value is maintained if the actual return is equal to the target set.
REQUIREMENTS FOR AN EFFECTIVE RISK MANAGEMENT SYSTEM

The Basle committee has set out the requirements for an effective risk management system as
under:
• Well informed Board of Directors and Oversight of Board,
• Capable Management,
• Adequate Risk Management Policies and Processes,
• High quality MIS for Risk Management, and
• Appropriate Staffing of the Risk Management Function.
The job of the Board is to establish bank’s strategic direction and define risk tolerances for
various types of risk. The risk management policies and standards need to be approved by the
Board. The senior management of the bank is responsible for implementation, integrity and
maintenance of the risk management system.
****

63
CHAPTER 2 ASSET LIABILITY MANAGEMENT
Structure
Introduction
Nature of ALM Risks and its organisation
Balance Sheet Structure: Implications for ALM
Liquidity Risk- Measurement & Management
INTRODUCTION
As indicated in the previous chapter on risk management, risks can have an impact on either the
accounting earnings which are periodically reported and or Value of equity which is relatively a new
dimension. The Asset Liability Management (ALM) function involves planning, directing, and
controlling the flow, level, mix and rates on the bank assets and liabilities. The ALM responsibilities
are fully aligned to the overall objectives at the bank level. There was no need for an elaborate
ALM function till the interest rates were guided by the regulator and the business of banking was
purely volume driven. Deregulation of interest rates, interest rate volatility and increasing
competition in the financial market place has made the ALM function a significantly important
function in today’s environment.
Categorisation of Bank Balance Sheet

At this juncture, it is important to understand how the assets & liabilities in the balance sheet of a
bank are classified into Banking Book and Trading Book. The following are the points
distinguishing one from the other:
Held-till-maturity vs. Short-term holding period
The intention of the bank in case of banking books is to hold the assets and liabilities till maturity
whereas in case of trading book the holding period is extremely short and may vary between a few
hours (or minutes in some cases) to a maximum of 90 days (as per the RBI’s stipulation of holding
period).
Accrual Income vs. Price Change
The assets & liabilities in the banking book accrue income and expenses respectively over time.
The target variable in case of the banking book is the net accrual income. In case of the trading
book, price appreciation (or depreciation) due to fluctuation in market price is the main target
variable as the holding period is very short
Historical cost vs. Mark-to-market Value
The assets & liabilities in the banking book are valued at historical cost. Change in the values of
assets and liabilities are not recognized in the P&L account. The norm in case of trading book is
periodic valuation (mark-to-market) and reflection of the market value of the assets and liabilities in
the balance sheet. Any appreciation or depreciation with reference to the value prior to valuation
would pass through the P&L account as profit or loss.
Examples:
Banking Book includes; Deposits, Borrowings, Loans and Advances
Trading Book comprises of securities such as bonds and equity, various currency positions and
commodity positions specifically identified by the bank as part of the trading book. Derivative
contracts which are used as a hedge for the trading book or forming part of proprietary trading
position would also be part of trading book
Scope of ALM
ALM is a part of overall risk management of a bank which addresses the following risks:
• Liquidity Risk: Risk arising out of unexpected fluctuation in cash flows from the
assets and liabilities – both in banking and trading books.
• Interest Rate Risk: Risk arising out of fluctuations in the interest rates on assets and
liabilities in the banking book.
• Market Risk: Risk of price fluctuations due to market factors causing changes in the
value of the trading portfolio.

64
NATURE OF ALM RISKS AND ITS ORGANISATION

The nature of risks addressed by ALM is the ones which need to be and are centralized at the bank
treasury level for efficient management. In other words, interest rate and liquidity risks may be
created by branches of a bank in the process of their intermediation between depositors and
borrowers, but these risks need to be pooled at the highest level and managed. This is because
these risks arising at a branch is not relevant as they need to be offset by e xactly opposite
positions in some other branch of the same bank. Hence, what is significant to be managed is the
net position arising at the bank treasury level rather than individual positions arising at a number of
branches. In other words, branch heads do not have anything to with the management of interest
rate and liquidity risks at their own level. Their job at present is restricted to providing accurate and
timely data for the assessment of the risks which are centralized. By its very nature, as the trading
portfolio is managed at the treasury level, no further centralization is warranted.
Like in many countries, the RBI has entrusted the job of ALM in each bank to the Asset -Liability
Committee (ALCO) to be set up in each bank. ALCO, consisting of senior executives of a bank, is
the apex decision making unit responsible for managing all the three risks that come under the
purview of ALM in an integrated manner. As per RBI requirements, the ALCO is required to meet
periodically to assess the bank’s position in terms of the risks and provide strategic guidance to
achieve the overall targets and objectives set. With the above introduction, the concentration of the
following section is on the three risks that the ALCO is supposed to address. The typical
organizational structure for Risk Management with specific reference to
ALM defined by the RBI is as under:
BALANCE SHEET STRUCTURE: IMPLICATIONS FOR ALM

As the entire subject of ALM is about balance sheet and its management, it is useful at this stage to
understand the typical structure of an Indian commercial bank in terms of both rate earning assets
and rate paying liability products. Other assets and liabilities, which are not very significant, are

65
excluded.
Balance Sheet Structure: Assets
a. Advances
- A significant portion linked to Prime Lending Rate (PLR) in the form of CC/OD, Demand
loan & term loans
- PLR linked loans – Absence of reset dates (future dates on which the rates would be reset
is unknown)
- Pattern of repayment based on behavioural studies
- Unavailed portion of CC/OD – Uncertainty of utilisation
- Borrower Option to prepay in case of Fixed Rate Term loans
b. Investments
- Major portion Fixed Rate
- Medium to long duration portfolio
- Illiquidity of a significant portion of the portfolio – no or very low flexibility for reshuffling
(altering the structure)
Balance Sheet Structure: Liabilities

a. Deposits – Savings and Current
- Non-maturity – No date of maturity
- High volatility of balances in case of current account
- Customer Option to freely introduce or withdraw money at any time
- Administered interest rates unrelated to market interest rates
b. Term Deposits: Cumulative, Non-Cumulative and Recurring
- Overwhelming majority in Fixed Rates
- Customer Option (put option valuable when interest rates go above the contractual fixed
rate)
- The reinvestment risk in case of cumulative deposits
- Uncertain installment payments in case of recurring deposits
- Floating Rate (a recent development)
c. Borrowings
- Fixed or Floating Rate
- Various tenor
- Usually no options, hence no uncertainty about the term
It can be understood from the above structure that a significant portion of liabilities in the form of
term deposits have a fixed-rate meaning that the rates would remain unchanged till the maturity or
till the deposit remains with the bank. ‘Borrowings’ which is a smaller portfolio in the liabilities are
at market related rates.
A significant portion of loans and advances portfolio is linked to PLR, which is a floating rate. The
meaning of floating rate here is an asset or liability rate linked to a reference or index such as the
Treasury bill rate, Government of India security yield, bank rate, money market rate, etc., are the
rates reset at predetermined frequencies with reference to the reference rate. The problem that the
PLR of banks suffer from is the uncertainty caused by the absence of any predetermined reset
dates for the loans and advances linked to PLR. This implies that whenever PLR changes, the rate
on the loans & advances would change instantly without any time lag. Contrast this with a
hypothetical asset linked to a reference rate, say treasury bill rate with a 3-month reset, we know
very clearly that the rate once set for the asset can change only after 3 months and not before that.
An overwhelming majority of the investment portfolio is in the form of fixed-rate Government and
other securities.
Having discussed the balance sheet structure which determines the exposure of a bank to ALM
risks, the risks can be taken up for a detailed discussion.
****

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CHAPTER 3
LIQUIDITY RISK MANAGEMENT
Introduction:
Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the
ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan
portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity
when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly
and at a reasonable cost. It encompasses the potential sale of liquid assets and b orrowings from
money, capital and forex markets. Thus, liquidity should be considered as a defence mechanism
from losses on fire sale of assets.
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby
making the liabilities subject to rollover or refinancing risk.
I. TYPES:
The liquidity risk in banks manifest in different dimensions:
i) Funding Risk need to replace net outflows due to unanticipated withdrawal/non-renewal of
deposits (wholesale and retail);
ii) Time Risk need to compensate for non-receipt of expected inflows of funds, i.e. performing
assets turning into non-performing assets; and
iii) Call Risk due to crystallisation of contingent liabilities and unable to undertake profitable
business opportunities when desirable.
II. Liquidity Management

The first step towards liquidity management is to put in place an effective liquidity management
policy, which, inter alia, should spell out the funding strategies, liquidity planning under alternative
scenarios, prudential limits, liquidity reporting /reviewing, etc.
Following steps are necessary for managing liquidity risk in banks:
1. Developing a structure for managing liquidity risk.
2. Setting tolerance level and limit for liquidity risk.
3. Measuring and managing liquidity risk.
1. Developing a structure for managing liquidity risk:

Sound liquidity risk management involves setting a strategy for the bank ensuring effective board
and senior management oversight as well as operating under a sound process for measuring,
monitoring and controlling liquidity risk. Virtually every financial transaction or commitment has
implications for a bank’s liquidity. Moreover, the transformation of illiquid into more liquid ones is a
key activity of banks. Thus, a bank’s liquidity policies and liquidity management approach should
form key elements of bank’s general business strategy. Understanding the context of liquidity
management involves examining a banks managerial approach to funding and liquidity operations
and its liquidity planning under alternative scenarios.
Treatment of Foreign Currencies : For banks with an international presence, the treatment of
assets and liabilities in multiple currencies adds a layer of complexity to liquidity management for
two reasons. First, banks are often less well known to liability holders in foreign currency markets.
In the event of market concerns, these liability holders may not be able to distinguish rumours from
fact as well or as quickly as domestic currency customers.
Second, in the event of a disturbance, a bank may not always be able to mobilize domestic liquidity
to meet foreign currency funding requirements.
Hence, when a bank conducts its business in multiple currencies, its management must make two
key decisions.
The first decision concerns management structure. A bank with funding requirements in foreign
currencies will generally use one of three approaches.
• It may completely centralize liquidity management (the head office managing liquidity for the
whole bank in every currency )

67
• Alternatively, it may decentralize by assigning operating divisions responsibility for their own
liquidity, but subject to limits imposed by the head office or frequent, routine reporting to the
head office. For example, a non- European bank might assign its European operations in all
currencies,
As a third Approach, a bank may assign responsibility for liquidity in the home currency and for
overall coordination to the home office, and responsibility for the bank’s global liquidity in each
major foreign currency to the management of the foreign office in the country in the country issuing
that currency. For example, the treasurer in the Tokyo office of a non- Japanese bank could be
responsible for the bank’s global liquidity needs in yen. All of these approaches, however, p rovide
head office management with the opportunity to monitor and control worldwide liquidity
2. Setting tolerance level and limit for liquidity risk:

Bank’s management should set limit to ensure liquidity and these limits should be reviewed by
supervisors. Alternatively supervisors may set the limits. Limits could be set on the following:
1. The cumulative cash flow mismatches (i.e. the cumulative net funding requirement as a
percentage of total liabilities) over particular periods – Next day, next week, next fortnight,
next month, next year. These mismatches should be calculated by taking a conservative
view of marketability of liquid assets, with a discount to cover price volatility and any drop in
price in the event of a forced sale, and should include likely outflows as a result of draw-
down of commitments, etc.
2. Liquid assets as a percentage of short- term liabilities. The assets included in this category
should be those which are highly liquid, i.e. only those which are judged to be having a
ready market even in periods of stress.
3. A limit on loan to deposit ratio.
4. A limit loan to capital radio.
5. A general limit on the relationship between anticipated funding needs and available sources
for meeting those needs.
6. Primary sources for meeting those needs.
7. Flexible limits on the percentage reliance on a particular liability category.
(e.g. certificate of deposits should not account for more than certain per cent total Liabilities)
8. Limits on the dependence on individual customers or market segments for funds in
liquidity position calculation.
9. Flexible limits on the minimum/ maximum average maturity of different categories of
liabilities.
10. Minimum liquidity provision to be maintained to sustain operations.
An example of an setting tolerance level for a bank:

1. To manage the mismatch levels so as to avert wide liquidity gaps- The residual maturity profile of
assets and liabilities will be such that mismatch level for time bucket of 1-14 days and 15-28 days
remains around 20% of cash outflows in each time bucket.
2. To mange liquidity and remain solvent by maintaining short- term cumulative gap up to one year
(short-term liabilities-short –term )at 15% of total out flow of funds.
3. Measuring and Managing Liquidity Risk:-

Liquidity measurement is quite a difficult task and can be measured through
a. Stock approach
b. Flow (cash) approach.
a. Stock Approach:- Stock approach is based on the level of assets and liabilities as well as Off
balance sheet exposures on particular date. The key ratios, adopted across the banking system
are:
i) Ratio of Core deposit to total assets:- More the ratio better it is because core deposits are
treated to be the stable source of liquidity.
ii) Net loans to total deposit ratio:- It reflects the ratio of loans to public deposits or core deposits.
Loan is treated to be less liquid assets and therefore lower the ratio better is the case.

68
iii) Ratio of time deposit to total deposits:- Time deposit provide stable level of liquidity and
negligible volatility. Therefore, higher the ratio always better.
iv) Ratio of volatile liabilities to total assets:- Volatile liabilities like market borrowings are to be
assessed and compared with the total assets. Higher portion of volatile assets will cause higher
problems of liquidity. Therefore, lower ratio is desirable.
v) Ratio of Short term liabilities to liquid assets:- Short term liabilities are required to be redeemed
at the earliest. Therefore, they will require ready liquid assets to meet the liability. It is expected to
be lower in the interest of liquidity.
vi) Ratio of liquid assets to total assets:- Higher level of liquid assests in total assets will ensure
better liquidity. Therefore higher the ratio is better.
vii) Ratio of market liabilities to total assets:- Market liabilities may include money market
borrowings , inter bank liabilities repayable within a short period.
b. Flow Approach:- While the liquidity ratios are the ideal indicator of liquidity of banks operating in
developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks
which are operating generally in an illiquid market. Experiences show that assets commonly
considered as liquid like Government securities, other money market instruments, etc. have limited
liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of
cash flow mismatches.
For measuring and managing net funding requirements, the use of
a. maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates
is recommended as a standard tool.
The format prescribed by RBI in this regard under ALM System should be adopted for measuring
cash flow mismatches at different time bands. The cash flows should be placed in different time
bands based on future behaviour of assets, liabilities and off-balance sheet items. In other words,
banks should have to analyse the behavioural maturity profile of various components of on/ off -
balance sheet items on the basis of assumptions and trend analysis supported by time series
analysis. Banks should also undertake variance analysis, at least, once in six months to validate
the assumptions. The assumptions should be fine-tuned over a period which facilitate near reality
predictions about future behaviour of on/off-balance sheet items. Apart from the above cash flows,
banks should also track the impact of prepayments of loans, premature closure of deposits and
exercise of options built in certain instruments which offer put/call options after specified times.
Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a
liability holder could exercise an early repayment option or the earliest date contingencies could be
crystallised.
The difference between cash inflows and outflows in each time period, the excess or deficit of
funds, becomes a starting point for a measure of a bank’s future liquidity surplus or deficit, at a
series of points of time.
Liquidity Gap Analysis or Maturity Laddar

Liquidity gap report/maturity laddar which is useful for measuring short -term liquidity risk is
prepared by placing assets and liabilities into various time buckets on the basis of timing of cash
inflows from the assets and the timing of cash outflows from the liabilities. The cash flows from
assets and liabilities include both principal and interest cash flows. For the purpose of regulatory
reporting of liquidity mismatches, the RBI has prescribed a liquidity gap report. The following Table
is the summary of a real-life liquidity gap report of a commercial bank which would be used for our
discussion this point onwards.
Particulars 1-14D 2-28D 29-3M 3-6M 6-12M 1-3 Y 3-5 Y Over 5Y Total
Term deposits 851 613 1835 1858 2372 6601 3729 1172 19030
A. Total Outflows 3414 849 2806 3099 2799 18798 4092 4903 40758
B. Total Inflows 3440 752 2105 2636 2630 8036 4481 16501 40581
Net Gap (B-A) 26 -96 -702 -462 -170 -10761 389 11598 -177
Cumulative Gap 26 -70 -772 -1234 -1404 - 12165 -11776 -177

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As reflected in the gap summary, total outflows (A) denotes expected cash outflows from liabilities
including term deposits, and the total inflows (B) denotes expected cash inflows from assets as on
a particular reporting date. The net gap (C) is the difference between outflows and inflows, i.e., (B)-
(A). The net gap figure reflects the net liquidity mismatch, i.e., eithe r the excess of cash outflows
over inflows or the excess of cash inflows over outflows for each time bucket. It can be seen from
the summary report above that while the bank has a little surplus liquidity in the shortest bucket (1 -
14 days), the other buckets up to 1 -3 years show significant shortage of liquidity. The cumulative
gap which is a successive summation of net gaps in each bucket can be used to ascertain the
mismatch for a period longer than reflected in the short-term buckets. If the bank intends to
ascertain its liquidity position for the next three month period, then from the summary above, it can
be said that there would be shortage of liquidity to the extent of Rs. 772 crores which is the
cumulative gap upto he 3-month bucket.
Managing market access

The banks should also consider putting in place certain prudential limits to avoid liquidity crisis:
1) Cap on inter-bank borrowings, especially call borrowings;
2) Purchased funds vis-à-vis liquid assets;
3) Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and
Loans;
4) Duration of liabilities and investment portfolio;
5) Maximum Cumulative Outflows. Banks should fix cumulative mismatches across all time
bands;
6) Commitment Ratio – track the total commitments given to corporates/banks and other financial
institutions to limit the off-balance sheet exposure;
7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.
Banks should also evolve a system for monitoring high value deposits (other t han inter-bank
deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash flows arising out of
contingent liabilities in normal situation and the scope for an increase in cash flows during periods
of stress should also be estimated. It is quite possible that market crisis can trigger substantial
increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like
letters of credit, etc.
The liquidity profile of the banks could be analysed on a static basis, wherein the assets and
liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern
and the sensitivity of these items to changes in market interest rates and environment are duly
accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due
importance to:
1) Seasonal pattern of deposits/loans;
2) Potential liquidity needs for meeting new loan demands, unavailed credit limits, loan policy,
potential deposit losses, investment obligations, statutory obligations, etc.
Alternative Scenarios
The liquidity profile of banks depends on the market conditions, which influence the cash flow
behaviour. Thus, banks should evaluate liquidity profile under different conditions, viz. normal
situation, bank specific crisis and market crisis scenario. The banks should establish benchmark
for normal situation, cash flow profile of on / off balance sheet items and manages net funding
requirements.
Estimating liquidity under bank specific crisis should provide a worst-case benchmark. It should
be assumed that the purchased funds could not be easily rolled over; some of the core deposits
could be prematurely closed; a substantial share of assets have turned into non -performing and
thus become totally illiquid. These developments would lead to rating down grades and high cost of
liquidity. The banks should evolve contingency plans to overcome such situations.
The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out
of monetary policy stance of Reserve Bank, general perception about risk profile of the banking
system, severe market disruptions, failure of one or more of major players in the market, financial
crisis, contagion, etc. Under this scenario, the rollover of high value customer deposits and

70
purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. The banks
could also sell their investment with huge discounts, entailing severe capital loss.
III. Assumptions and issues in determine cash flows:

While the concept of liquidity gap is extremely simple to understand and use, there are a few issues
which need to be addressed to be able to use the gap approach.
The issues are:
1) Non-maturity Items in the Balance Sheet: A sizeable portion of deposits of the Indian banking
industry is in the form of current and savings deposits which do not have any specific maturity.
Similarly, advances in the form of cash credit & over draft do not have any specific maturity. These
items can result in a cash flow at any time. Absence of specific maturity dates in case of these
‘non- maturity’ items makes it difficult to place them in a definite bucket on the basis of cash flows.
As prescribed by the RBI, as these items do not have contractual maturity, their behavioural maturity
need to be ascertained on the basis of statistical analysis for placing them in appropriate buckets. In
the absence of such analysis, the approach suggested by the RBI for non -maturity deposits may be
used as an alternative
2) Renewal Assumptions in Case of Maturing Term Deposits: Though the term deposits are
expected to result in cash out flow on maturity, it has been observed that a sizeable chunk of the
maturing term deposits are actually renewed in the same branch. Such renewals prevent the
outflow of cash thereby reducing the net gap. While the renewal behaviour is positive, it is difficult
to predict perfectly the percentage of maturing deposits renewed period after period as the
depositor behaviour may vary from time to time depending on a number of factors. If a certain
percent of renewal of deposits, say 60% is assumed for the preparation of the gap reports and the
actual renewal is only say 40% for a period, this would create an unexpected deficit of liquidity
which is serious given the nature of banking business which is heavily dependent upon public
confidence. The public confidence in a bank is the function of its ability to meet all its commitments
to the depositors. Surplus of liquidity would be the result when the actual renewal is higher than
the expected renewal of deposits. While surplus is viewed favorably from the point of view of the
bank’s ability to meet the cash out flows, expected return may suffer as deploying unexpected
surplus may diminish expected return.
3) Assumptions Relating to Unavailed Portion of Cash Credit, Overdraft: A sizeable portion of the
advances portfolio of the Indian banking industry is in the form of cash credit, overdraft etc. In case
of CC/OD etc., a limit is sanctioned for each borrower and the right to borrow upto the limit is
vested with the borrower. While this has given a lot of flexibility to the borrowers to utilize the limit
sanctioned to the extent it is required for meeting business commitments, banks pay a price in the
form of uncertainty of timing of utilization by the borrowers of the unutilized limits as they may be
utilized at any time without prior notice. As a result of the uncertainty, banks can neither keep the
unutilized portion idle as returns may suffer, nor can deploy it in other assets as the requirement
may arise at any time unexpectedly. The assumptions relating to unavailed portion need to be
thoroughly validated on the basis of behavioral analysis and experience of the bank over a period
of time for proper handling of the same.
4) Assumptions Relating to off-balance Sheet Items: Guarantees provided in favour of customers
by banks in various forms, Letters of Credit etc. are off-balance sheet in nature as the nature of
liabilities are contingent upon events For example a financial or performance guarantee is a non-
funded commitment till the time it is invoked by the party in whose favour the guarantee was issued
by the bank. Analysis of the timing and magnitude of crystallization of a non-funded commitment
into a funded commitment is extremely important to assess the impact of such crystallization on the
liquidity position of the bank.
5) Embedded Options: As indicated earlier, a number of asset and liability products offered by
banks to customers have options embedded in them. The simplest example is the fixed rate term
deposit in the deposits portfolio. The term deposit holder has the right but not an obligation to
prematurely terminate the term deposit at any time during the currency of the deposit. This
behavior of the depositors increases whenever interest rate applicable for the deposit goes up in
the market and the new rate happens to be higher than original rate contacted at the time of
opening of the deposit. This leads to flight of deposits from a bank to its competitor causing an
impact on the liquidity position of the bank. Similarly, the term loan borrowers may exercise their

71
option to prepay the loan fully or partially when interest rates go down as they would be in a
position to get the advantage of lower rates elsewhere. It is important to understand here that the
customer exercising options either on the liability side or the asset side need not necessarily have
an impact on the existing liquidity position when the liability or asset is rebooked w ith the same
institution at new rates.
6) Static Nature of the Gap Report: The time taken to compile the report determines whether it
is useful for decision making or not. If time taken is fairly long, then the first few buckets of
information would be useless as the period for which the gaps are calculated would have simply
elapsed. Even if the time delay is considerably reduced, the dynamic nature of the business of
banking in which a lot of assets and liabilities are contracted on an ongoing basis would mak e the
figures less relevant in the light of new business, changing behaviour of customers, etc. These call
for the consideration of new business in the form of expected assets and liabilities in future and the
behavioural pattern of customers to take into account the dynamic nature of the balance sheet.
Unless the dynamic nature of positions and behavioural analysis as indicated in the previous points
are incorporated into the analysis of gaps, preparation of a meaningful liquidity report would not be
possible.
Contingency Plan
Banks should prepare Contingency Plans to measure their ability to withstand bank-specific or market
crisis scenario. The blue-print for asset sales, market access, capacity to restructure the maturity and
composition of assets and liabilities should be clearly documented and alternative options of funding
in the event of bank’s failure to raise liquidity from existing source/s could be clearly articulated.
Liquidity from the Reserve Bank, arising out of its refinance window and inter im liquidity adjustment
facility or as lender of last resort should not be reckoned for contingency plans. Availability of back-up
liquidity support in the form of committed lines of credit, reciprocal arrangements, liquidity support from
other external sources, liquidity of assets, etc. should also be clearly established.
RBI circular on Liquidity Mangement:

As stated above RBI vide its circular has given detail ALM process to be followed by bank and as
also gudience for Measuring and managing liquidity needs. Accordingly, Banks are required to
submit Statement of Structural Liquidity is given in Annexure I.
The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of
banks in different time buckets. The time buckets given the Statutory Reserve cycle of 14 days may
be distributed as under:
i) 1 to 14 days ii) 15 to 28 days iii) 29 days and upto 3 months
iv) Over 3 months and upto 6 months v) Over 6 months and upto 12 months
vi) Over 1 year and upto 2 years vii) Over 2 years and upto 5 years
viii) Over 5 years
Further circular also says that the banks may adopt a more granular approach to measurement of
liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural
Liquidity into three time buckets viz., next day , 2-7 days and 8-14 days.
In the annexure to this circular, RBI has also given the itemized time buckets related to Outflow &
Inflows. These are given below in brief:
A. Outflows
Capital, Reserves and Surplus : Over 5 years bucket.
Demand Deposits (Current and Savings Bank Deposits): Savings Bank and Current Deposits may
be classified into volatile and core portions. Savings Bank (10%) and Current (15%) Deposits are
generally withdrawable on demand. This portion may be treated as volatile. While volatile portion
can be placed in the Day 1 time bucket, the core portion may be placed in over 1 - 3 years bucket.
Term Deposits: Respective maturity buckets.
Other Liabilities: Respective maturity buckets.
B. Inflows

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Cash : Day 1 bucket.

Balances with RBI: While the excess balance over the required CRR/SLR may be shown under
Day 1 bucket, the Statutory Balances may be distributed amongst various time buckets
corresponding to the maturity profile of DTL with a time-lag of 14 days.
Balances with other banks- Current Account : Non-withdrawable portion on account of stipulations
of minimum balances may be shown under over 1-3 years bucket and the remaining balances may
be shown under Day 1 bucket.
Securities in the Trading Book: Day 1, 2-7 days, 8-14 days, 15-28 days and 29-90 days according
to defeasance periods(i.e. the time taken to liquidate the ‘position’ on the basis of liquidity in the
secondary market)
NPAs (Net of provisions, interest suspense and claims received from ECGC/DIC GC ): Sub-
standard: Over 3-5 years bucket. Doubtful and Loss: Over 5 years bucket.
Fixed Assets/ Assets on lease : Over 5 years bucket
Rest of the Assets including Advances : Respective maturity buckets.
Financing of Gap :
In case the net cumulative negative mismatches during the Day 1, 2-7 days, 8-14 days and 15-28
days buckets exceed the prudential limit of 5 % ,10%, 15 % and 20% of the cumulative cash
outflows in the respective time buckets the bank may show by way of a foot note as to how it
proposes to finance the gap to bring the mismatch within the prescribed limits. The gap can
be financed from market borrowings (call / term), Bills Rediscounting, Repos and deployment of
foreign currency resources after conversion into rupees ( unswapped foreign currency funds ),
etc.
Basel III Framework on Liquidity Standards, Liquidity Coverage Ratio (LCR), Liquidity Risk
Monitoring Tools and LCR Disclosure Standards
In ‘First Bi-monthly Monetary Policy Statement, 2014-15’ announced on April 1, 2014, RBI
proposed to issue guidelines relating to Basel III LCR and Liquidity Risk Monitoring tools by end -
May 2014, as the liquidity coverage ratio (LCR) stipulated by the Basel Committee becomes a
standard with effect from January 1, 2015. Accordingly, the final guidelines on the LCR, Liquidity
Risk Monitoring Tools and LCR Disclosure Standards are pronounced by RBI. The LCR will be
introduced in a phased manner starting with a minimum requirement of 60% from January 1, 2015
and reaching minimum 100% on January 1, 2019.
Two minimum standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
for funding liquidity were prescribed by the Basel Committee for achieving two separate but
complementary objectives.
The LCR promotes short-term resilience of banks to potential liquidity disruptions by ensuring that
they have sufficient high quality liquid assets (HQLAs) to survive an acute stress scenario lasting
for 30 days. The NSFR promotes resilience over longer-term time horizons by requiring banks to
fund their activities with more stable sources of funding on an ongoing basis. In addition, a set of
five monitoring tools to be used for monitoring the liquidity risk exposures of banks was also
prescribed in the said document.
Definition of LCR
Stock of high quality liquid assets (HQLAs) 100%
Total net cash outflows over the next 30 calendar days
The LCR requirement would be binding on banks from January 1, 2015; with a view to provide a
transition time for banks, the requirement would be minimum 60% for the calendar year 2015 i.e.
with effect from January 1, 2015, and rise in equal steps to reach the minimum required level of
100% on January 1, 2019, as per the time-line given below:
Jan’1 2015 Jan’1 2016 Jan’1 2017 Jan’1 2018 Jan’1 2019
Minimum LCR 60% 70% 80% 90% 100%
High Quality Liquid Assets:

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Liquid assets comprise of high quality assets that can be readily sold or used as collateral to obtain
funds in a range of stress scenarios. They should be unencumbered i.e. without legal, regulatory or
operational impediments. Assets are considered to be high quality liquid assets if they can be
easily and immediately converted into cash at little or no loss of value.
There are two categories of assets which can be included in the stock of HQLAs, viz. Level 1 and
Level 2 assets. Level 2 assets are sub-divided into Level 2A and Level 2B assets on the basis of
their price-volatility.
Level 1 assets of banks would comprise of the following and these assets can be included in the
stock of liquid assets without any limit as also without applying any haircut:
i. Cash including cash reserves in excess of required CRR.
ii. Government securities in excess of the minimum SLR requirement.
iii. Within the mandatory SLR requirement, Government securities to the extent allowed by RBI
under Marginal Standing Facility (MSF), [presently 2 per cent of the bank’s NDTL], and under
Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) [presently 8 per cent of the bank’s
NDTL+ 1% w.e.f 21.07.2016 =9%].
iv. Marketable securities issued or guaranteed by foreign sovereigns satisfying all the following
conditions:
(a) assigned a 0% risk weight under the Basel II standardized approach for credit risk;
(b) Traded in large, deep and active repo or cash markets characterised by a low level of
concentration; and proven record as a reliable source of liquidity in the markets (repo or sale) even
during stressed market conditions.
(c) not issued by a bank/financial institution/NBFC or any of its affiliated entities.
Level 2 assets (comprising Level 2A assets and Level 2B assets) can be included in the stock of
liquid assets, subject to the requirement that they comprise no more than 40% of the overall stock
of HQLAs after haircuts have been applied. The portfolio of Level 2 assets held by the bank should
be well diversified in terms of type of assets, type of issuers and specific counterparty or issuer.
Level 2A and Level 2B assets would comprise of the following:
(a) Level 2A Assets: A minimum 15% haircut should be applied to the current market value of
each Level 2A asset held in the stock. Level 2A assets are limited to the following:
i. Marketable securities representing claims on or claims guaranteed by sovereigns, Public Sector
Entities (PSEs) or multilateral development banks that are assigned a 20% risk weight under the
Basel II Standardised Approach for credit risk and provided that they are not issued by a
bank/financial institution/NBFC or any of its affiliated entities.
ii. Corporate bonds, not issued by a bank/financial institution/NBFC or an y of its affiliated entities,
which have been rated AA- or above by an Eligible Credit Rating Agency.
ii. Commercial Papers not issued by a bank/PD/financial institution or any of its affiliated entities,
which have a short-term rating equivalent to the long-term rating of AA- or above by an Eligible
Credit Rating Agency
(b) Level 2B Assets : A minimum 50% haircut should be applied to the current market value of
each Level 2B asset held in the stock. Further, Level 2B assets should comprise no more than 15%
of the total stock of HQLA. They must also be included within the overall Level 2 assets. Level 2B
assets are limited to the following:
i. Marketable securities representing claims on or claims guaranteed by sovereigns having risk
weights higher than 20% but not higher than 50%, i.e., they should have a credit rating not lower
than BBB- as per our Master Circular on ‘Basel III – Capital Regulations’.
ii. With effect from February 1, 2016, Corporate debt securities (including commercial paper),
meeting the following conditions:
• not issued by a bank, financial institution, PD, NBFC or any of its affiliated entities;
• have a long-term credit rating from an Eligible Credit Rating Agency between A+ and BBB - or in
the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating;

74
• traded in large, deep and active repo or cash markets characterised by a low level of
concentration; and
• have a proven record as a reliable source of liquidity in the markets (repo or sale) even during
stressed market conditions, i.e. a maximum decline of price not exceeding 20% or increase in
haircut over a 30-day period not exceeding 20 percentage points during a relevant period of
significant liquidity stress.
iii. Common Equity Shares which satisfy all of the following conditions:
a) not issued by a bank/financial institution/NBFC or any of its affiliated entities;
b) included in NSE CNX Nifty index and/or S&P BSE Sensex index.
Calculation of Total net cash outflows: The total net cash outflows is defined as the total
expected cash outflows minus total expected cash inflows for the subsequent 30 calendar days.
Total expected cash outflows are calculated by multiplying the outstanding balances of various
categories or types of liabilities and off-balance sheet commitments by the rates at which they are
expected to run off or be drawn down. Total expected cash inflows are calculated by multiplying the
outstanding balances of various categories of contractual receivables by the rates at which they are
expected to flow in up to an aggregate cap of 75% of total expected cash outflows. In other words,
Total net cash outflows over the next 30 days = Outflows - Min (inflows; 75% of outflows). The
various items of assets (inflow) and liabilities (outflow) along with their respective run-off rates and
the inflow rates are specified in the format of Basel III Liquidity Return-1 (BLR-1) of this Framework.
The formula for the calculation of the stock of HQLA is as follows:

Stock of HQLA = Level 1 + Level 2A + Level 2B – Adjustment for 15% cap – Adjustment for 40%
cap
Where:
Adjustment for 15% cap = Max [{Level 2B – 15/85*(Adjusted Level 1 + Adjusted Level 2A)}, {Level
2B - 15/60*Adjusted Level 1}, 0]
Adjustment for 40% cap = Max {(Adjusted Level 2A + Level 2B – Adjustment for 15% cap -
2/3*Adjusted Level 1 assets), 0}
Liquidity Risk Monitoring Tools

In addition to the two liquidity standards, the Basel III framework also prescribes five monitoring
tools / metrics for better monitoring a bank's liquidity position. While some of these m onitoring
tools/metrics have been in use by banks in the past in the form of various regulatory returns on
their liquidity position, certain additional returns under Basel III Liquidity Framework have been
prescribed. These metrics along with their objective and the prescribed returns are detailed below:
a. Contractual Maturity Mismatch
b. Concentration of Funding
c. Available Unencumbered Assets
d. LCR by Significant Currency
e. Market-related Monitoring Tools
Basel III Liquidity Returns:

The Bank is required to file the following returns to RBI as per the frequency mentioned:
Name of the Basel III Liquidity Return (BLR) Frequency Time period by
of which required to be
submission reported
Statement on Liquidity Coverage Ratio (LCR)- BLR-1 Monthly within 15 days
Statement of Funding Concentration - BLR Monthly within 15 days
Statement of Available Unencumbered Assets - BLR-3 Quarterly within a month
LCR by Significant Currency - BLR-4 Monthly within 15 days
Statement on Other Information on Liquidity - BLR-5 Monthly within 15 days

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LCR Disclosure Standards

Banks are required to disclose information on their LCR in their annual financial statements under
Notes to Accounts, starting with the financial year ending March 31, 2015.
Illustrations on Liquidity Risk:

1. Suppose PVB Bank's liquidity manager estimates that the bank will experience a Rs.375 million
liquidity deficit next month with a probability of 10 percent, Rs.200million liquidity deficit with a
probability of 40 percent, Rs.100 million liquidity surplus with a probability of 30 percent, and a
Rs.250 million liquidity surplus bearing a probability of 20 percent. What is this savings bank’s
expected liquidity requirement?
Solution:
Liquidity Deficits or Surpluses Associated Probabilities :
Deficit Rs.375 million 10%, Rs.200 million deficit 40%, Rs.100million surplus 30%, Rs.250 million
surplus 20% and hence the bank's expected liquidity requirement is:
Expected Liquidity Requirement =
0.10*(- Rs.375 million) + 0.40* (- Rs.200 million)+0.30* (+Rs.100 million) + 0.20 * (+Rs.250 million)
= - Rs.37.5 million - Rs.80 million + Rs.30 million + Rs.50 million
= - Rs.37.5 million
2. Madurai Bank estimates that over the next 24 hours the following cash inflow and outflows will
occur (all figures in millions of Rs.):
Deposit withdrawals 98, Scheduled loan repayments 89,
Sales of bank assets 40, Stockholder dividend payments150,
Deposit inflows 87, Revenues from sale of non deposit services 95,
Acceptable loan requests 56, Repayments of bank borrowings 60,
Borrowings from the money market 75, Operating expenses 45,
What is this bank’s projected net liquidity position in the next 24 hours? From what sources can the
bank cover its liquidity needs?
Solution: (all figures in millions of Rs.):

Deposit withdrawals Rs.98 -
Deposit inflows Rs.87 +
Scheduled loan repayments Rs.89 +
Acceptable loan requests Rs.56 -
Borrowings from the money market Rs.75 +
Sales of bank assets Rs.40 +
Stockholder dividend payments Rs.150 -
Revenues from sale of nondepositservices Rs.95 +
Repayment of bank borrowings Rs.60 -
Operating expenses Rs.45 -
= + [Rs.87+ Rs.89+ Rs.75+ Rs.40+ Rs.95] - [Rs.98+ Rs.56+ Rs.150+ Rs.60+ Rs.45]
= - Rs.23 million
Faced with an expected liquidity deficit Madurai Bank could arrange to increase its money market
borrowings from other institutions or sell some of its assets or do some of both.
****

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CHAPTER 4 MARKET RISK
1) Introduction
2) Market risk management
3) Tools for Measurement of Market risk
4) Stress Testing
1 Introduction:-
Market Risk arises as a result of volatility in price of assets (and liabilities) due to changes in:
• Interest Rates
• Currency Prices
• Commodity Prices, and
• Equity Prices
Price risk of the assets in the trading book is the prime decision point in market risk management.
Of the above, the most significant exposure is to the interest rates in the form of a sizeable portfolio
of Government and other securities. Hence the major concentration would be on interest rates.
2 MARKET RISKMANAGEMENT
Management of market risk should be the major concern of top management of banks. The Boards
should clearly articulate market risk management policies, procedures, prudential risk limits, review
mechanisms and reporting and auditing systems. The policies should address the bank’s exposure
on a consolidated basis and clearly articulate the risk measurement systems that capture all
material sources of market risk and assess the effects on the bank. The operating prudential limits
and the accountability of the line management should also be clearly defined. The Asset - Liability
Management Committee (ALCO) should function as the top operational unit for managing the
balance sheet within the performance/risk parameters laid down by the Board. The banks should
also set up an independent Middle Office to track the magnitude of market risk on a real time
basis. The Middle Office should comprise of experts in market risk management, economists,
statisticians and general bankers and may be functionally placed directly under the ALCO. The
Middle Office should also be separated from Treasury Department and should not be involved in
the day to day management of Treasury. The Middle Office should apprise the top management /
ALCO / Treasury about adherence to prudential / risk parameters and also aggregate the total
market risk exposures assumed by the bank at any point of time.
3 Tools for Measurement of Market Risk

Measures for market risk are broadly categorized as under:
a. Factor Sensitivity Measures
b. Volatility Based Measures
a. Factor Sensitivity Measures: Factor sensitivity measures assess the impact of change in the
major factors (which determine the market value of the positions) on the market value of the
portfolio. The most prominent factor sensitivity measure is the modified duration. Modified duration
is the direct measure of sensitivity in value of a security or a portfolio of bonds for a change in
interest rates. The modified duration concept rests on a number of assumptions which are
unrealistic in today’s environment. Though a number of refinements to the original concept have
been suggested to make it applicable in the current environment, a number of issues remain
unattended. Important among them are the relevance of the tool in an environment of non -parallel
shifts in the yield curve and adequacy of the concept for bonds embedded options in the form of
calls, puts, caps, floors etc. The most significant application of the factor sensitivity measures is to
use them for setting limits at portfolio level. For example, a bank may set the maximum modified
duration of its bond portfolio as (say) 7. This means that the price sensitivity that the bank is willing
to accept in case of the bond portfolio is maximum 7% of the value of the portfolio for 1% change in
the interest rates. Any loss higher than 7% would not be tolerated by the bank.
b. Volatility Based Measures: While factor sensitivity measures are still very popular in our

77
country and are practiced widely, in the recent past, volatility based measure popularly known as
Value-at-Risk (VAR). The greatest advantage of VAR is its uniformity in measuring trading risk
across various positions such as interest rates, currency, equity and commodity, which is the
weakest thing as far as factor sensitivity measures are concerned. As a result of this uniformity of
measurement, it is possible to aggregate risk across completely different positions, compare and
contrast among various positions to assess the relative riskiness and so on. Apart from this, VAR
has revolutionized the risk communication from trading desk to top management as the measure is
extremely simple to understand unlike the factor sensitivity measures which make sense only to the
respective trading and risk management community that uses them. It is important to recognize
here that unless the risk reports are understood and acted upon by the top management, there would
always be a possibility of a misalignment between what is perceived as acceptable risk by the top
management and others who are in operating lines. An example of VAR is as under:
Type of the portfolio: GOI Bond Trading Portfolio

Market Value: Rs. 200 crores
VAR = Rs. 5 crores
Confidence Level used for VAR computation: 99%
Holding Period used for VAR computation (days): 1
The above information can be interpreted easily with a little knowledge of probability.
The exact interpretation of VAR of Rs. 5 crores for a Rs.200 crore GOI Bond portfolio is: the
maximum loss that the bank will suffer on a single trading day (as holding period used is 1 day)
would not exceed Rs.5 crores on 99% of the trading days (as the confidence level used for VAR
computation is 99%). Only on 1% of the trading days, the loss would exceed the VAR of Rs. 5
crores. If we assume 100 trading days in a period, the above interpretation means that 99 trading
days out of 100 days would have losses less than Rs. 5 crores. Only on 1 day out of 100 days, the
losses would exceed the VAR number computed. Please note that the concept of VAR
concentrates on only the possible losses.
We can calculate estimated daily volatility of security as follows :

1. Calculation of VaR :
Suppose impact of 1% change of interest rate results change in Price of bond by Rs. 8000/ -, daily
Volatility = 3% : Confidence level is 99% (that means, probability of occurrence at 99% confidence
level is 2.326), Defeasance period = 1 day
Solution:
Market Factor Sensitivity X Daily Volatility X Probability at given confidence level
VaR = Rs. 8000 x 3 x 2.326 = 55824/-
2. If the volatility per annum is 25% and the number of trading days per annum is 252, find the
volatility per day.
a.1.58% b. 15.8% c. 158% d. 0.10
Solution:
Daily volatility of security = A
Total trading days is always to required to be taken at 252, and formula is
A = 25 x √1/252
A = 1.58%
3. Daily volatility of a security is 1%. What is its 16 days volatility approximately?

a. 3% b. 10% c. 1% d. 4%
Solution:
Wherein trading days has not been given then we have to assume it as 260 days in a year.
Accordingly, 16 days volatility = ‘X’
Daily volatility = 1% or 0.01
So formula will be : 0.01 = X √16/260
0.01 = X 0.2480

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0.01/0.2480 = X
OR X = 0.040
i.e X = 4%
There are at least three broad methods to computing VAR:
1. Historical Simulation: The approach relies heavily on past data of prices to estimate VAR. The
basic assumption of the method is that the past trends and volatilities in prices would repeat in
future also. This method does not require the use of any statistical distribution and tools, hence it is
non-parametric.
2. Analytical or Variance Covariance VAR: This is the most accepted and practiced method at
present popularized by the investment bank J.P.Morgan in the 90s. This approach is parametric as
it assumes the prices to follow normal distribution and uses statistical concepts such as standard
deviation, correlation, covariance etc. for the estimation of VAR.
3. Monte Carlo VAR: The term montecarlo denotes a popular approach to simulating random
numbers based on a specified statistical distribution. This approach does not make any
assumption of distributional properties of asset prices but involves empirical estimation of the
statistical distribution from the prices which is then used to simulate the prices leading to the
estimation of VAR.
Increasingly it has been found out that the VAR as a method for market risk measurement is
suitable for only normal market environment. Stress testing should be used to complement the
computed VAR to assess the performance of the portfolio in an environment of abnormal ma rket
movements which remain outside the standard VAR models as of date. This is attempted to be
accomplished by modeling extreme price movements using Extreme Value Theory and other
similar approaches.
4. Stress Testing :- "Stress testing" has been adopted as a generic term describing various
techniques used by banks to gauge their potential vulnerability to exceptional, but plausible, events.
Stress testing addresses the large moves in key market variables of that kind that lie beyond day to
day risk monitoring but that could potentially occur. The process of stress testing, therefore,
involves first identifying these potential movements, including which market variables to stress, how
much to stress them by, and what time frame to run the stress analysis over.
Once these market movements and underlying assumptions are decided upon, shocks are applied
to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market
movement has on the value of the portfolio and the overall Profit and Loss.
Stress test reports can be constructed that summarise the effects of different shocks of different
magnitudes. Normally, then there is some kind of reporting procedure and follow up with traders
and management to determine whether any action need to be taken in response.
Stress testing and value-at-risk*

Stress tests supplement value-at-risk (VaR). VaR is thought to be a critical tool for tracking the
riskiness of a firm’s portfolio on a day-to-day level, and for assessing the risk-adjusted
performance of individual business units. However, VaR has been found to be of limited use in
measuring firms’ exposures to extreme market events. This is because, by definition, such events
occur too rarely to be captured by empirically driven statistical models. Furthermore, observed
correlation patterns between various financial prices (and thus the correlat ions that would be
estimated using data from ordinary times) tend to change when the price movements themselves
are large. Stress tests offer a way of measuring and monitoring the portfolio consequences of
extreme price movements of this type.

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Stress Testing Techniques: Stress testing covers many different techniques. The four discussed
here are listed in the Table below along with the information typically referred to as the "result" of
that type of a stress test.
Stress Testing Techniques #
Technique What is the "stress test result"
Simple Sensitivity Test Change in portfolio value for one or more shocks
to a single risk factor
Scenario Analysis (hypothetical or historical) Change in portfolio value if the scenario were to
occur
Maximum loss Sum of individual trading units’ worst-case

scenarios
Extreme value theory Probability distribution of extreme losses
A simple sensitivity test isolates the short-term impact on a portfolio’s value of a series of
predefined moves in a particular market risk factor. For example, if the risk factor were an
exchange rate, the shocks might be exchange rate changes of +/_ 2 percent, 4 percent, 6 percent
and 10 percent.
A scenario analysis specifies the shocks that might plausibly affect a number of market risk factors
simultaneously if an extreme, but possible, event occurs. It seeks to assess the potential
consequences for a firm of an extreme, but possible, state of the world. A scenario analysis can be
based on an historical event or a hypothetical event. Historical scenarios employ shocks that
occurred in specific historical episodes. Hypothetical scenarios use a structure of shocks thought to
be plausible in some foreseeable, but unlikely circumstances for which there is no exact parallel in
recent history. Scenario analysis is currently the leading stress testing technique.
A maximum loss approach assesses the riskiness of a business unit’s portfolio by identifying the
most potentially damaging combination of moves of market risk factors. Interviewed risk managers
who use such "maximum loss" approaches find the output of such exercises to be instructive but
they tend not to rely on the results of such exercises in the setting of exposure limits in any
systematic manner, an implicit recognition of the arbitrary character of the combination of shocks
captured by such a measure.
Extreme value theory (EVT) is a means to better capture the risk of loss in extreme, but possible,
circumstances. EVT is the statistical theory on the behaviour of the "tails" (i.e., the very high and
low potential values) of probability distributions. Because it focuses only on the tail of a probability
distribution, the method can be more flexible. For example, it can accommodate skewed and fat -
tailed distributions. A problem with the extreme value approach is adapting it to a situation where
many risk factors drive the underlying return distribution. Moreover, the usually unstated
assumption that extreme events are not correlated through time is questionable. Despite these
drawbacks, EVT is notable for being the only stress test technique that attempts to attach a
probability to stress test results.
What Makes a good Stress Test:- A good stress test should

• be relevant to the current position
• consider changes in all relevant market rates
• examine potential regime shifts (whether the current risk parameters will hold or break
down)
• spur discussion
• consider market illiquidity, and

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• consider the interplay of market and credit risk
How should risk managers use stress tests:

Stress tests produce information summarising the firm’s exposure to extreme, but possible,
circumstances. The role of risk managers in the bank should be assembling and summarising
information to enable senior management to understand the strategic relationship between the
firm’s risk-taking (such as the extent and character of financial leverage employed) and risk
appetite. Typically, the results of a small number of stress scenarios should be computed on a
regular basis and monitored over time.
Some of the specific ways stress tests are used to influence decision-making are to:
• manage funding risk
• provide a check on modelling assumptions
• set limits for traders
• determine capital charges on trading desks’ positions
Manage funding risk: Senior managers use stress tests to help them make decisions regarding
funding risk. Managers have come to accept the need to manage risk exposures in anticipation of
unfavourable circumstances. The significance of such information will vary according to a bank’s
exposure to funding or liquidity risk.
Provide a check on modelling assumptions: Scenario analysis is also used to highlight the role of
particular correlation and volatility assumptions in the construction of banks’ portfolios of market
risk exposures. In this case, scenario analysis can be thought of as a means through which banks
check on the portfolio’s sensitivity to assumptions about the extent of effective portfolio
diversification.
Set limits for traders: Stress tests are also used to set limits. Simple sensitivity tests may be used
to put hard limits on bank’s market risk exposures.
Determine capital charges on trading desks’ positions: Banks may also initiate capital charges
based on hypothetical losses under certain stress scenarios. The capital charges are deducted
from each business unit’s bonus pool. This procedure may be designed to provide each business
unit with an economic incentive to reduce the risk of extreme losses.
Limitations of Stress Tests:- Stress testing can appear to be a straightforward technique. In

practice, however, stress tests are often neither transparent nor straightforward. They are based on
a large number of practitioner choices as to what risk factors to stress, how to combine factors
stressed, what range of values to consider, and what time frame to analyse. Even after such
choices are made, a risk manager is faced with the considerable tasks of sifting through results and
identifying what implications, if any, the stress test results might have for how the firm should
manage its risk-taking activities. A well-understood limitation of stress testing is that there are no
probabilities attached to the outcomes. Stress tests help answer the question "How much could be
lost?" The lack of probability measures exacerbates the issue of transparency and the seeming
arbitrariness of stress test design. Systems incompatibilities across business units make frequent
stress testing costly for some firms, reflecting the limited role that stress testing had played in
influencing the firm’s prior investments in information technology.
****

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CHAPTER 5
CREDIT RISK MANAGEMENT
Definition and Scope of Credit Risk

Organisational Structure
Significance Of Credit Risk:- Measurement And Management
Risk Identification
Approaches To Credit Risk Measurement: Intrinsic Risk
Approaches For Portfolio Concentration Risk
Tools of Credit Risk Management
Credit Risk Mitigation
DEFINITION AND SCOPE OF CREDIT RISK

Simon Hills (2004) of the British Bankers Association defines credit risk “is th e risk to a bank’s
earnings or capital base arising from a borrower’s failure to meet the terms of any contractual or
other agreement it has with the bank. Credit risk arises from all activities where success depends
on counterparty, issuer or borrower performance”. Credit risk enters the books of a bank the
moment the funds are lent, deployed, invested or committed in any form to counterparty whether
the transaction is on or off the balance sheet.
The nature, nomenclature and the quantum of credit risk may vary depending on a number of
factors. The internal organization of credit risk management should recognize this for effective
credit risk management.
Organisational Structure
Sound organizational structure is sine qua non for successful implementation of an effective credit
risk management system. The organizational structure for credit risk management should have the
following basic features:
The Board of Directors should have the overall responsibility for management of risks. The Board
should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign
exchange and equity price risks. The Risk Management Committee will be a Board level Sub
committee including CEO and heads of Credit, Market and Operational Risk Management
Committees. It will devise the policy and strategy for integrated risk management containing
various risk exposures of the bank including the credit risk. For this purpose, this Committee should
effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability
Management Committee and other risk committees of the bank, if any. It is imperative that the
independence of this Committee is preserved. The Board should, therefore, ensure that this is not
compromised at any cost. In the event of the Board not accepting any recommendation of this
Committee, systems should be put in place to spell out the rationale for such an action and should
be properly documented. This document should be made available to the internal and ext ernal
auditors for their scrutiny and comments. The credit risk strategy and policies adopted by the
committee should be effectively communicated throughout the organisation.
Each bank may, depending on the size of the organization or loan/investment book, constitute a
high level Credit Risk Management Committee (CRMC). The Committee should be headed by
the Chairman/CEO/ED, and should comprise of heads of Credit Department, Treasury, Credit Risk
Management Department (CRMD) and the Chief Economist. The functions of the Credit Risk
Management Committee should be as under:
a. Be responsible for the implementation of the credit risk policy/strategy approved by the Board.
b. Monitor credit risk on a bank wide basis and ensure compliance with limits approved by the
Board.
c. Recommend to the Board, for its approval, clear policies on standards for presentation of credit
proposals, financial covenants, rating standards and benchmarks,
d. Decide delegation of credit approving powers, prudential limits on large credit exposures ,
standards for loan collateral, portfolio management, loan review mechanism, risk concentrations,
risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc.

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Concurrently, each bank should also set up Credit Risk Management Department
(CRMD), independent of the Credit Administration Department. The CRMD should:
a. Measure, control and manage credit risk on a bank-wide basis within the limits set by the Board/
CRMC
b. Enforce compliance with the risk parameters and prudential limits set by the Board/ CRMC.
c. Lay down risk assessment systems, develop MIS, monitor quality of loan/investment portfolio,
identify problems, correct deficiencies and undertake loan review/audit. Large banks could consider
separate set up for loan review/audit.
d. Be accountable for protecting the quality of the entire loan/ investment portfolio.
The Department should undertake portfolio evaluations and conduct comprehensive studies on the
environment to test the resilience of the loan portfolio.
Credit Risk officer (CRO):- As per RBI circular, dated 20th April’2017, appointment of the CRO
shall be for a fixed tenure with the approval of the Board of Directors of the banks, that means BOD
will decide the tenure. The CRO may be transferred/removed from his post before completion of
the tenure only with the approval of the Board and such premature transfer/removal shall be
reported to the Department of Banking Supervision, Reserve Bank of India, Mumbai. CRO shall be
a senior official in the banks’ hierarchy and shall have the necessary and adequate professional
qualification/experience in the areas of risk management.
The CRO shall have direct reporting lines to the MD & CEO / Risk Management Committee (RMC)
of the Board. In case the CRO reports to the MD & CEO, the RMC shall meet the CRO on one-to-
one basis, without the presence of the MD & CEO, at least on a quarterly basis. There shall not be
any ‘dual hatting’ i.e. the CRO shall not be given the responsibility of Chief Executive Officer, Chief
Operating Officer, Chief Financial Officer, Chief of the internal audit function or any other function.
In case the CRO is associated with the credit sanction process, it shall be clearly enunciated
whether the CRO’s role would be that of an adviser or a decision maker. The policy shall include
the necessary safeguards to ensure the independence of the CRO.
In banks that follow committee approach in credit sanction process for high value proposals, if the
CRO is one of the decision makers in the credit sanction process, he shall have voting power and
all members who are part of the credit sanction process, shall individually and severally be liable for
all the aspects, including risk perspective related to the credit proposal. If the CRO is not a part of
the credit sanction process, his role will be limited to that of an adviser.
RISK IDENTIFICATION:-
Credit Risk and Default
Credit Risk is the risk of loss to the Bank in the event of Default.
Default arises due to counterparty's inability and/or unwillingness to meet commitments in relation
to lending.
Credit risk is the potential loss that a bank borrower or counter party will fail to meet its obligation in
accordance with the agreed terms.
TYPES OF THE CREDIT RISK

A) Transaction risk B) Portfolio risk
a) Grade risk a) concentration risk
b) default risk b) intrinsic risk
1) non payment
2) delayed payment
Credit risk may be in the following forms:

* In case of the direct lending
* In case of the guarantees and the letter of the credit
* In case of the treasury operations
* In case of the securities trading businesses
* In case of the cross border exposure

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Traditionally credit risk has 2 components

a) Solvency aspects of the credit risk-the risk borrower is unable to pay
b) Liquidity aspects of the risk-the risk that arise due to the delay in the repayment by the borrower
leading to the cash flow problems for the leader
Credit risk can be segmented into two major segments viz. Systematic or intrinsic and
portfolio (or concentration) credit risks. The focus of the intrinsic risk is measurement of risk at
individual loan level. This is carried out at lending unit level. Portfolio credit risk arises as a result
of concentration of the portfolio to a particular sector, geographic area, industry, type of facility, type
of borrowers, similar rating, etc. Concentration risk is managed at the bank level as it is more
relevant at that level.
APPROACHES TO CREDIT RISK MEASUREMENT: INTRINSIC RISK

There are three basic approaches to credit risk measurement at individual loan intrinsic level that
are used for various types of loans such as commercial loans, project and infrastructure finance,
consumer and retail loans. They are:
• Expert Systems,
• Credit Rating, and
• Credit Scoring.
Expert Systems: In an expert system, the decision to lend is taken by the lending officer who is
expected to possess expert knowledge of assessing the credit worthiness of the customer.
Accordingly the success or failure very much depends on the expertise, judgment and the ability to
consider relevant factors in the decision to lend. One of the most common expert systems is the
five “Cs” of credit. The five ‘C’ are as under :
a. Character: Measure of reputation of the firm, its willingness to repay and the repayment
history.
b. Capital: The adequacy of equity capital of the owners so that the owner’s interest remains in
the business. Higher the equity capital better the creditworthiness.
c. Capacity: The ability to repay is measured by the expected volatility in the sources of funds
intended to be used by the borrower for the repayment of loan along with interest. Higher the
volatility of this source, higher the risk and vice versa.
d. Collateral: Availability of collateral is important for mitigating credit risk. Higher the value of the
collateral, lower would be the risk and vice versa.
e. Cycle or (economic) Conditions: The state of the business cycle is an important element in
determining credit risk exposure. Some industries are highly dependent on the economic condition
while the others are less dependent or independent. Higher the dependence, higher the risk as during
recessionary period of the economy, the cyclic industries would suffer and vice versa. Industries such
as FMCG, pharmaceuticals, etc. are less dependent on economic cycles than industries such as
consumer durable, steel, etc. The expert view on the above would finally influence the decision to
lend or not.
Although many banks still use expert systems as part of their credit decision process, these
systems face two main problems :
a. Consistency: There may not be a consistent approach followed for different types of borrowers
and industries. Thereby the system would be person dependent
b. Subjectivity: As weights applied to different factors are subjective, comparability across time
may not be possible.
Credit Rating: Credit Rating is the most popular method at present among banks. Rating is the
process by which an alphabetic or numerical rating is assigned to a credit facility extended by a
bank to a borrower based on a detailed analysis of his character and matching it with the
characteristics of facility that is extended to him. The rating carried out by a bank is very much
similar to the credit rating carried out by external rating agencies such as CRISIL, ICRA, etc. The
only difference is that while the rating by the external agency is available in the public domain for
any one to use, the internal ratings carried out by a bank is confidential and is used for specific

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purpose only. Moreover, the internal ratings of banks are usually finer than the ratings of rating
agencies. This is to facilitate better distinction between credit qualities and pricing of loan in an
accurate manner.
Credit Scoring: A major disadvantage of a rating model is the subjectivity of weight to be applied
to different segments in the rating exercise. This drawback can be avoided in a scoring model
which is based on rigorous statistical techniques. This approach combines a number of ratios into a
single numerical score which is used to determine the credit quality or default. The basic
assumption of the method is that combination of a number of ratios explains the success (no
default) or failure (default) of a facility extended to a borrower. Starting with the historical data with
known outcome of success or failure, a set of ratios that differentiate the successful cases from the
failed ones along with the weights to be applied for each ratio is arrived at by multiple discriminant
analysis. The most popular among the models is the one by Altman’s (1968) Z-score model,
which is a classificatory model for corporate borrowers. Based on a matched sample (by year, size
and industry) of failed and solvent firms, and using linear discriminant analysis, the best fitting
scoring model for commercial loans took the following form:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5
Where
Z = Altman’s Z score of a commercial loan
X1 = working capital/total assets ratio
X2 = retained earnings/total assets ratio
X3 = earnings before interest and taxes/total assets ratio
X4 = market value of equity/book value of total liabilities
X5 = Sales/total assets ratio
As indicated, each one of the ratios in the equation is weighted by weight empirically arrived at on
the basis of past experience with similar type of loans.
Here are the rules for interpreting the Altman Z score.

When Z is >= 3.0, the firm is most likely safe based on the financial data.
When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area
and caution should be taken.
When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years.
When Z is <= 1.8, the company is highly likely to be bankrupt.
Illustration: Calculate the Altman’s Z score from the following information:

Current Assets: Rs. 10,00,000, Total Assets: Rs. 40,00,000, Current Liabilities: Rs. 9,00,000
Total Liabilities: Rs. 20,00,000, Retained Earnings: Rs. 1,500,000, Sales: Rs. 12,00,000
EBIT (Earnings Before Interest and Taxes): Rs.240,000, Share Price:Rs.6.36 Shares Outstanding:
500,000
Answer:
X1 = CA Rs.10,00,000 - CL Rs.9,00,000= Rs.1,00,000/Total Assets Rs.40,00,000 = 0.025
X2 = Retained Earnings: Rs. 15,00,000/Total Assets Rs.40,00,000 = 0.375
X3 = EBIT: Rs. 240,000/Total Assets Rs.40,00,000 = 0.060
X4 = Share Price:Rs.6.36 x Shares Outstanding: 500000 / Total Liabilities:Rs.20,00,000 = 1.59
X5 = Sales: Rs.12,00,000/ Total Assets: Rs. 40,00,000 = 0.30
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5

Z = 1.2 (0.025) + 1.4 (0.375) + 3.3 (0.060) + 0.6 (1.59) + 0.999 (0.30)
Z = 2.0067
Regulatory framework prescribed for measuring credit risk by the BASEL II & III:
The term standardized approach (or standardised approach) refers to a set of credit risk
measurement techniques proposed under Basel II capital adequacy rules for banking institutions.
Under this approach the banks are required to use ratings from External Credit Rating Agencies to
quantify required capital for credit risk. For a standardized approach bank, general risk weights are

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prescribed for every type of exposure under the Final Rule to determine the credit risk RWA
amount. Standardized approach banks are required to determine exposure amounts for each on-
balance sheet exposure.
The Basel Accord also permits the bank other alternative for measurement of credit risk based on
internal ratings. It will be called as “Internal Ratings Based Approach”.
For illustrations on calculations of credit risk by these method, please refer chapter BASEL III.
APPROACHES FOR PORTFOLIO CONCENTRATION RISK

The credit risk analysis described above is based on the notion that each loan should be made
against some norm. Concentration risk was generally addressed by limiting the size of exposures
to individual borrowers. Such an approach has proved inadequate to the task of limiting credit risk
as supposedly distinct borrowers in particular sectors have experienced similar problems at the
same time. For example: real estate, energy and shipping and loans to developing countries in the
80s and 90s of the U.S banks which led to huge losses despite religiously following a limit on
exposure to individual borrowers. On a loan by loan basis these areas offer better opportunities
than are available elsewhere.
Tools of Credit Risk Management.

The instruments and tools, through which credit risk management is carried out, are detailed below:
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds – say 15% for individual borrower
entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group,
Threshold limit is fixed at a level lower than Prudential Exposure; Substantial Exposur e, which is
the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the
Capital Funds of the bank (i.e. six to eight times).
b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers,
Higher delegated powers for better-rated customers; discriminatory time schedule for
review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal
based on risk rating, etc are formulated.
c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale.
Clearly define rating thresholds and review the ratings periodically preferably at half yearly
intervals. Rating migration is to be mapped to estimate the expected loss.
d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are
to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected
loss. Adopt the RAROC framework.
e) Portfolio Management The need for credit portfolio management emanates from the necessity to
optimize the benefits associated with diversification and to reduce the potential adverse impact of
concentration of exposures to a particular borrower, sector or
industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories,
distribution of borrowers in various industry, business group and conduct rapid portfolio reviews.
The existing framework of tracking the non-performing loans around the balance sheet date does
not signal the quality of the entire loan book. There should be a proper & regular on-going system
for identification of credit weaknesses well in advance. Initiate steps to preserve the desired
portfolio quality and integrate portfolio reviews with credit decision-making process.
f) Loan Review Mechanism This should be done independent of credit operations. It is also referred
as Credit Audit covering review of sanction process, compliance status, review of risk rating, pick
up of warning signals and recommendation of corrective action with the objective of improving
credit quality. It should target all loans above certain cut-off limit ensuring that at least 30% to 40%
of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in
the balance sheet have been tracked. This is done to bring about qualitative improvement in credit
administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions.
Ensure adherence to lending policies and procedures. The focus of the cre dit audit needs to be
broadened from account level to overall portfolio level. Regular, proper & prompt reporting to Top
Management should be ensured. Credit Audit is conducted on site, i.e. at the branch that has

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appraised the advance and where the main operative limits are made available. However, it is not
required to visit borrowers factory/office premises.
Credit Risk Mitigation

CRM is an essential part of credit risk management. This refers to the process through which
credit risk is reduced or it is transferred to a counter party. Stratergies for risk reduction at
transaction level differ from that at portfolio level.
At transaction level banks use a number of techniques to mitigate the credit risk to which they are
exposed. They are more traditional techniques e.g exposures collateralized by first priority claims,
either in whole or in part, with cash or securities, or an exposure guaranteed by a third party.
At portfolio level, asset securitisation, credit derivatives etc., are used to mitigate ri sks in the
portfolio.
A. Securitisation Transaction
Meaning :One of the most prominent developments in international finance in recent decades and
the one that is likely to assume even greater importance in future, is securitisation. Securitisation is
the process of pooling and repackaging of homogenous illiquid financial assets into marketable
securities that can be sold to investors. The process leads to the creation of financial instruments
that represent ownership interest in, or are secured by a segregated income producing asset or
pool of assets. The pool of assets collateralises securities. These assets are generally secured by
personal or real property (e.g. automobiles, real estate, or equipment loans), but in some cases are
unsecured (e.g. credit card debt, consumer loans).
There are four steps in a securitisation: (i) SPV is created to hold title to assets underlying
securities; (ii) the originator or holder of assets sells the assets (existing or future) to the SPV; (iii)
the SPV, with the help of an investment banker, issues securities which are distributed to investors;
and (iv) the SPV pays the originator for the assets with the proceeds from the sale of securities.
B Credit derivatives:
Credit derivatives are privately negotiated bilateral contracts that allow users to manage their
exposure to credit risk. For example, a bank concerned that one of its customers may not be able
to repay a loan can protect itself against loss by transferring the credit risk to another party while
keeping the loan on its books. This mechanism can be used for any debt instrument or a basket of
instruments for which an objective default price can be determined. In this process, buyers and
sellers of the credit risk can achieve various objectives, including reduction of risk concentrations in
their portfolios, and access to a portfolio without actually making the loans. Credit derivatives offer
a flexible way of managing credit risk and provide opportunities to enhance yields by purchasing
credit synthetically.
Example:- Consider Bank A that has lent to the steel industry. Suppose this bank wants to reduce
its credit risk. Bank B wants to lend to the steel industry but cannot do so because of locational
disadvantage. So, Bank A and Bank B enter into an agreement.
The agreement is that if, say, Steel Company X defaults on its loan payments, Bank B will pay
Bank A the defaulted amount. If not, Bank B will not pay any money. For providing this facility, Bank
B will receive a premium from Bank A. This simple agreement is one of the many credit derivatives
available in the international market.
Notice that the agreement works like a term assurance contract. You pay a yearly premium to the
life insurance company. If you die, the insurance company pays a death benefit. If not, your
premiums are not refundable. Credit derivatives are also useful in diversifying loan portfolio. In the
above example, by selling (writing) a credit protection, Bank B has taken exposure to the steel
sector. How? It will receive premiums just as it receives interest on loans. Bank B will also be
exposed to losses if the steel company defaults.
I. Credit default swap

The credit default swap or CDS has become the cornerstone product of the credit derivatives
market. This product represents over thirty percent of the credit derivatives market.

87
A credit default swap, in its simplest form (the unfunded single name credit default swap) is a
bilateral contract between a protection buyer and a protection seller. The credit default swap will
reference the creditworthiness of a third party called a reference entity (i.e borrower of any bank):
this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt
obligations of the reference entity: perhaps its bonds and loans, which fulfill certain pre-agreed
characteristics.
The protection buyer will pay a periodic fee to the protection seller in return for a contingent
payment by the seller upon a credit event affecting the obligations of the reference entity specified
in the transaction.
The relevant credit events specified in a transaction will usually be selected from amongst the
following:
a) the bankruptcy of the reference entity;
b) its failure to pay in relation to a covered obligation;
c) it defaulting on an obligation or that obligation being accelerated;
d) it agreeing to restructure a covered obligation or a repudiation or moratorium being declared
over any covered obligation.
If any of these events occur and the protection buyer serves a credit event notice on the protection
seller detailing the credit event as well as (usually) providing some publicly available information
validating this claim, then the transaction will settle.
The seller of the credit default swap is said to sell protection. The seller collects the periodic fee
and profits if the credit of the reference entity remains stable or improves while the swap is
outstanding. Selling protection has a similar credit risk position to owning a bond or loan, or “going
long risk.”
Example:-
As shown in Exhibit 2.1, Bank B (herein after Investor B), the buyer of protection, pays Bank S
(herein after Investor S), the seller of protection, a periodic fee (usually on the 20th of March, June,
September, and December) for a specified time frame. To calculate this fee on an annua lized
basis, the two parties multiply the notional amount of the swap, or the amount of risk being
exchanged, by the market price of the credit default swap (the market price of a CDS is also called
the spread or fixed rate). CDS market prices are quoted in basis points (bp) paid annually, and are
a measure of the reference entity’s credit risk (the higher the spread the greater the credit risk).
If credit event happened then:

Settlement following credit events :- Physical settlement:-
Following a credit event, the buyer of protection delivers to the seller of protection defaulted bonds
and/or loans with a face amount equal to the notional amount of the credit default swap contract.
The seller of protection (long risk) then delivers the notional amount on the CDS contract in cash to
the buyer of protection. Note that the buyer of protection pays the accrued spread from the last
coupon payment date up to the day of the credit event, then the coupon payments stop. The buyer

88
can deliver any bond issued by the reference entity meeting certain criteria that is pari passu, or of
the same level of seniority, as the specific bond referenced in the contract. Thus the protection
buyer has a “cheapest to deliver option,” as she can deliver the lowest price bond to settle the
contract. This type of settlement is known as “physical settlement”. See Exhibit 2.2
Generally, the legal framework of a CDS – that is, the documentation evidencing the transaction –
is based on a confirmation document and legal definitions set forth by the International Swaps and
Derivatives Association, Inc. (ISDA).
Exhibit 2.2: If the Reference Entity has a credit event, the CDS Buyer delivers a bond or loan
issued by the reference entity to the Seller. The Seller then delivers the Notional v alue of the CDS
contract to the Buyer.
Rs.100 face value of Bond or Loan
Notional ( Rs.100/- cash)

Cash settlement:
A CDS may specify that on occurrence of a credit event the protection seller shall pay difference
between the nominal value of the reference obligation and its market value at the time of credit
event. This type of settlement is known as “cash settlement”. This type of settlement is also known
as payment of par less recovery. A calculation agent plays an important role in the process of
settlement.
II Total return swap

A total return swap (also known as Total Rate of Return Swap) is a contract between two
counterparties whereby they swap periodic payments for the period of the contract. Typically, one
party receives the total return (interest payments plus any capital gains or losses for the payment
period) from a specified reference asset, while the other receives a specified fixed or floating cash
flow that is not related to the creditworthiness of the reference asset, as with a vanilla Int erest rate
swap. The payments are based upon the same notional amount. The reference asset may be any
asset, index or basket of assets.
III Credit linked notes

A credit linked note is a synthetic security, typically issued by a special purpose vehicle (SPV) t hat
trades like a bond issued by the reference entity but with the economics of the credit default swap.
For this security, the buyer of protection sells the note. The buyer of protection (note seller) will pay
periodic payments and profit if the reference entity defaults. Unlike the swap, the buyer of
protection in a credit linked note will receive money at the time of transaction from the sale of the
note, and will return this money at the contract’s maturity if no credit event occurs.
****

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CHAPTER 6
OPERATIONAL RISK
Introduction
Definition
Significance of operational risk
Objectives of operational risk
Developing appropriate environment
Methodologies for measurement of operational risk
INTRODUCTION
Operational risk is emerging as one of the important risks financial institutions worldwide are
concerned with. Unlike other categories of risks, such as credit and market risks, the definition and
scope of operational risk is not fully clear. A number of diverse professions such as internal control
and audit, statistical quality control and quality assurance, facilities management and contingency
planning, etc., have approached the subject of operational risk thereby bringing in different
perspectives to the concept. While studies carried out on bank failures in the U.S. show that
operational risk has accounted for an insignificant proportion of large bank failures so far, it is
widely acknowledged that most of the new, unknown risks are under the category of operational
risk. This necessitates the need for an understanding of the operational risks in financial services
in general and banking in particular.
DEFINITION OF OPERATIONAL RISK

According to the Basel Committee, Operational risk is defined as “the risk of loss resulting from
inadequate or failed processes, people and systems or external events. This definition includes
legal risk, but excludes strategic and reputational risk” (The New Basel Capital Accord,
Consultative Document released in April 2003. Bankers Trust (now a part of Deutsche Bank) asked
a very simple question way back in 1992 to understand the nature of operational risk: what risks
were not being addressed by market and credit risk models and functions? Answering the question
led the bank to identify risks associated with the bank’s exposures as under:
Primary operational risk/exposure classes are:
A. Cause based
Relationship Risks
Non-proprietary losses caused to a firm and generated through the relationship or contact that a
firm has with its clients, shareholders, third parties or regulators (e.g.
accommodations/reimbursements to clients, settlements or penalties paid, etc).
People/Human Capital Risks

The risk of loss caused intentionally or unintentionally by an employee (i.e. an employee error,
employee misdeed, etc.) or involving employees, such as in the area of employment disputes,
intellectual capital, etc.
Technology and Processing Risks

The risk of loss caused by a piracy, theft, failure, breakdown or other disruption in technology, data
or information; also includes technology that fails to meet the intended business needs.
Physical Risks
The risk of loss through damage of bank-owned properties or loss to physical property or assets for
which the firm is responsible.
B. Effect based
1. Legal Liabilility
2. Regulatory, compliance and taxation penalities
3. Loss or dame to assests
4. Restituion

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5. Write downs
C. Event Based
1. Internal Fraud
2. External Fraud
3. Employment practices and workplace safety
4. Clients, products and business practices.
5. Execution, delivery and process management.
SIGNIFICANCE OF OPERATIONAL RISK

There are number of reasons why operational risks need to be managed properly:
a. Increasing Complexity of Activities: The complexity of activities have grown over increasing the
probability of errors, intentional or otherwise. This is especially true as the activities of banks in the
financial markets have grown considerably, exposing them to operational risks apart from other
risks.
b. Adoption of Technology: While the adoption of technology helps in reducing ac number of errors
committed by human beings, technology absorption has created a number of new risks which need
to be managed. If not managed properly, the losses could be very large and may threaten the
existence of the institution.
c. Regulatory Requirement: As discussed elsewhere, the old capital accord concentrated only on
credit risk. The new capital accord, apart from fine-tuning capital requirements for credit risk,
proposed for the first time a minimum capital to be maintained for operational risks
d. New Products and Services: To effectively compete in the market place, many new products and
services are offered in the banking industry. The recent entry of a number of banks into the
business of insurance, either as agents or otherwise is a recent example. The introduction of new
products comes with its own risks which may or may not be detected. With a view to gain market
share, the time taken to introduce new products in the market is considerably shortened in some
cases leading to improper assessment of operational risks. Risks arising out of change in the
features of existing products to make it more attractive to
customers also fall in the same category.
e. Capital Allocation and Performance Management: As indicated in a previous unit, each one of
the risks needs allocation of capital commensurate with the quantum of risks. The return on
allocated capital is the performance to be evaluated against benchmarks to performance
measurement and management. Operational risks are very much a part of the various types of
risks included in arriving at performance at business unit level. With growing activism of the
shareholders to realize their expected return and the highly competitive market for capital, capital
allocation and performance management are important steps at various levels.
OBJECTIVES OF OPERATIONAL RISK MANAGEMENT

Operational Risk is managed with the following objectives:
i. To ensure that the Board of Directors and top management are suitably informed in the form of
reports to undertake appropriate monitoring of operational risks and set controls for them on an
ongoing basis.
ii. To ensure that there is a system of operational risk management to identify measure and control
operational risks as laid out in the operational risk policy.
iii. To make sure that operational risks, like other risks are considered at all stages in decision
making. This would enable proper pricing of products offered to customers.
iv. To generate a broader understanding of operational risk issues at all levels.
v. To put in place an effective system to demonstrate to the regulators the adequacy of the system
for the operational risks.
DEVELOPING AN APPROPRIATE RISK MANAGEMENT ENVIRONMENT

Failure to understand and manage operational risk, which is present in virtually all bank
transactions and activities, may greatly increase the likelihood that some risks will go unrecognised
and uncontrolled. Both the board and senior management are responsible for creating an
organisational culture that places high priority on effective operational risk management and

91
adherence to sound operating controls. Operational risk management is most effective where a
bank’s culture emphasises high standards of ethical behaviour at all levels of the bank. The board
and senior management should promote an organisational culture which establishes through both
actions and words the expectations of integrity for all employees in conducting the business of the
bank.
Principle 1: The board of directors4 should be aware of the major aspects of the bank’s operational
risks as a distinct risk category that should be managed, and it should approve and periodically
review the bank’s operational risk management framework.
The framework should provide a firm-wide definition of operational risk and lay down the principles
of how operational risk is to be identified, assessed, monitored, and controlled/mitigated.
Principle 2: The board of directors should ensure that the bank’s operational risk management
framework is subject to effective and comprehensive internal audit by operationally independent,
appropriately trained and competent staff. The internal audit function should not be directly
responsible for operational risk management.
Principle 3: Senior management should have responsibility for implementing the operational risk
management framework approved by the board of directors. The framework should be consistently
implemented throughout the whole banking organisation, and all levels of staff should understand
their responsibilities with respect to operational risk management. Senior management should also
have responsibility for developing policies, processes and procedures for managing operational risk
in all of the bank’s material products, activities, processes and systems.
Risk Management: Identification, Assessment, Monitoring, and Mitigation/Control

Principle 4: Banks should identify and assess the operational risk inherent in all material products,
activities, processes and systems. Banks should also ensure that before new products, activities,
processes and systems are introduced or undertaken, the operational risk inherent in them is
subject to adequate assessment procedures.
Principle 5: Banks should implement a process to regularly monitor operational risk profiles and
material exposures to losses. There should be regular reporting of pertinent information to senior
management and the board of directors that supports the proactive management of operational
risk.
Principle 6: Banks should have policies, processes and procedures to control and/or mitigate
material operational risks. Banks should periodically review their risk limitation and control
strategies and should adjust their operational risk profile accordingly using appropriate strategies,
in light of their overall risk appetite and profile.
Principle 7: Banks should have in place contingency and business continuity plans to ensure their
ability to operate on an ongoing basis and limit losses in the event of severe business disruption.
METHODOLOGIES FOR MEASUREMENT OF OPERATIONAL RISKS

The Basle committee has outlined three methodologies for measurement of operational risks. They
are:
a. The Basic Indicator Approach,
b. The Standardized Approach, and
c. The Advanced Measurement Approaches.
a. TheBasic Indicator Approach

A fixed percentage (denoted alpha) of average annual gross income over the previous three years
is the capital required to be maintained by banks under this approach. It is expressed as:
KBIA= GI × a
Where
KBIA = The Capital charge under the Basic Indicator Approach

92
GI = Average annual Gross Income over the previous three years*

a= 15% which is set by the Committee, relating the industry wide level of required capital to
the industry wide level of the indicator.
Gross income for the purpose of the above approach is defined as net interest income plus net
non-interest income. It is intended that this measure should:
Gross income = Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16)
{(OR) Net interest income plus net non-interest income)}
(-) profit on sale of HTM investments
(-) income from insurance
(-) extraordinary / irregular item of income
(+) loss on sale of HTM investments
*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.
Illustration:
From the following information calculate operational risk of Xis Bank Ltd for 31.03.2016.
Rs. in lakhs
31.03.14 31.03.15 31.03.16
Net Profit 2511.00 2860.00 3240.00
Reserves created for contingency 28.20 36.25 41.50
Provisions on NPA 85.00 112.00 78.00
Provisions on standard assets 12.00 16.00 28.00
Profit on sale of Trading 28.00 54.00 67.00
investments
Loss on sale of HTM investments -14.50 0 0
Profit on sale of HTM Investments 0 21.00 34.00
Operation Expenses 3455.00 3968.00 4294.00
Answer: Ascertain the Gross income on yearly basis for these 3 years:
Rs. in lakhs
31.03.14 31.03.15 31.03.16
Net Profit 2511.00 2860.00 3240.00
Add:
Reserves created for contingency 28.20 36.25 41.50
Provisions on NPA 85.00 112.00 78.00
Provisions on standard assets 12.00 16.00 28.00
Operation Expenses 3455.00 3968.00 4294.00
Loss on sale of HTM investments 14.50 0 0
Total 6105.70 6992.25 7681.50
Less:
Profit on sale of HTM Investments 0 21.00 34.00
Gross Income 6105.70 6971.25 7647.50
No adjustment required for Profit

on sale of Trading investments
Total Gross Income for 3 years = 6105.70 + 6971.25 + 7647.50 = 20,724.45

GI = Average annual Gross Income over the previous three years
= 20724.45 = 6908.15 lakhs
3
Operational Risk
KBIA= GI × a = 6908.15 x 15% = 1036.22 lakhs
b. The Standardized Approach

93
Under this approach, activities of the banks are divided into eight business lines:
1. Corporate Finance,
2 Trading and Sales,
3 Retail Banking,
4 Commercial Banking,
5 Payment and Settlement,
6 Agency Services,
7 Asset Management, and
8 Retail Brokerage.
Within each business line, gross income is a broad indicator that serves as a proxy for the scale of
business operations and thus the likely scale of operational risk exposure within each of these
business lines. The capital charge for each business line is calculated by multiplying gross income
by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry -
wide relationship between the operational risk loss experience for a given business line and the
aggregate level of gross income for that business line. It is to be appreciated that the gross income
is measured for each business line, not for the whole institution as in the case of basic indicator
approach.
The total capital required for operational risk then, is the simple summation of the capital required
across each of the eight business lines. This is expressed as under:
KTSA = S(GI1-8 × b1-8)
Where:
KTSA = the capital charge under the Standardised Approach
GI1-8 = the average annual level of Gross Income over the past three years, as defined above in the
Basic Indicator Approach, for each of the eight business lines
b1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level of
the gross income for each of the eight business lines.
The values of the betas are detailed below:
Business Lines Beta Factors

Corporate finance (b1) 18%
Trading & Sales (b2) 18%
Retail Banking (b3) 12%
Commercial Banking (b4) 15%
Payment & settlement (b5) 18%
Agency services (b6) 15%
Asset management (b7) 12%
Retail Brokerage (b8) 12%
Supplementary Business Line Mapping Guidelines

There are a variety of valid approaches that banks can use to map their activities to the eight
business lines, provided the approach used meets the business line mapping principles.
The following is an example of one possible approach that could be used by a bank to map its
gross income:
1. Gross income for retail banking consists of net interest income on loans an d advances to retail
customers and SMEs treated as retail, plus fees related to traditional retail activities, net income
from swaps and derivatives held to hedge the retail banking book, and income on purchased retail
receivables. To calculate net interest income for retail banking, a bank takes the interest earned on
its loans and advances to retail customers less the weighted average cost of funding of the loans
(from whatever source).
2. Similarly, gross income for commercial banking consists of the net interest income on loans and
advances to corporate (plus SMEs treated as corporate), interbank and sovereign customers and
income on purchased corporate receivables, plus fees related to traditional commercial banking

94
activities including commitments, guarantees, bills of exchange, net income (e.g. from coupons and
dividends) on securities held in the banking book, and profits/losses on swaps and derivatives held
to hedge the commercial banking book. Again, the calculation of net interest income is based o n
interest earned on loans and advances to corporate, interbank and sovereign customers less the
weighted average cost of funding for these loans (from whatever source).
3. For trading and sales, gross income consists of profits/losses on instruments held fo r trading
purposes (i.e. in the mark-to-market book), net of funding cost, plus fees from wholesale broking.
4. For the other five business lines, gross income consists primarily of the net fees/commissions
earned in each of these businesses. Payment and settlement consists of fees to cover provision of
payment/settlement facilities for wholesale counterparties. Asset management is management of
assets on behalf of others.
Illustration:
From the following information calculate operational risk of Xis Bank Lt d by standardized approach
for 31.03.2016.
Rs. in lakhs
31.03.14 31.03.15 31.03.16
Corporate finance (b1 ) – Beta Factor – 18%
Interest received 255.10 320.18 387.90
Weighted average cost of funding 192.14 268.70 310.22
Non interest income 22.00 18.00 27.00
Retail Banking (b3) – Beta Factor – 12%
Net income from derivatives 0 0 27.80
Fees & commission 32.20 44.78 69.34
Commercial Banking (b4) – Beta Factor -15%
Net interest income 78.24 126.10 156.08
BG/LC Fees & commission 56.78 92.24 103.12
Net income on securities held in the banking 109.12 98.70 124.56
book
Answer: Ascertain the Gross income on yearly basis for these 3 years for each line of business:
Rs. in lakhs
31.03.14 31.03.15 31.03.16
Corporate finance (b1 ) – Beta Factor – 18%
Add: Non interest income 22.00 18.00 27.00
Total 277.10 338.18 414.90
Less: Weighted average cost of funding 192.14 268.70 310.22
Gross income from corporate finance 84.96 69.48 104.68
Retail Banking (b3) – Beta Factor – 12%

Add: Net income from derivatives 0 0 27.80
Fees & commission 32.20 44.78 69.34
Total 491.10 564.89 768.04
Less: Weighted average cost of funding 356.00 427.45 578.16
Gross income from retail banking 135.10 137.44 189.88
Commercial Banking (b4) – Beta Factor -15%

95
Net interest income 78.24 126.10 156.08

Add: BG/LC Fees & commission 56.78 92.24 103.12
Net income on securities held in the banking 109.12 98.70 124.56
book
Gross income from commercial banking 244.14 317.04 383.76
Note: We will not deduct Weighted average cost
of funding as here Net Interest income is given
i.e the same is already deducted and hence no
need to deduct it again.
Total Gross Income for 3 years for each line of business will be :
31.03.14 31.03.15 31.03.16 Total Avg.
Income
Gross income from corporate finance 84.96 69.48 104.68 259.12 86.37
Gross income from retail banking 135.10 137.44 189.88 462.42 154.14
Gross income from commercial 244.14 317.04 383.76 944.94 314.98
banking
Operational Risk now will be: Taking it on the basis of average income of last 3 years :
KTSA = S(GI × b)
Amount Beta Operational

factor Risk
Gross income from corporate finance 86.37 18% 15.54
Gross income from retail banking 154.14 12% 18.49
Gross income from commercial banking 314.98 15% 47.25
Total 81.28
C. Advanced Measurement Approaches (AMA)

A number of approaches which are internally developed by banks using the quantitative and
qualitative criteria for the measurement of operational risks are categorized under AMA. While banks
are free to internally develop systems for the measurement of operational risks under AMA, only after
obtaining the approval of the local supervisor, the internal models can be put to use. Very few banks in
India would really be in a position to even think of AMA at present as it involves the creation of
database of losses and its drivers business line-wise. The internal model developed must be able to
measure variety of operational risks. It is important that the model develo ped must be able to reflect
both the dimensions of operational risks, i.e., the probability of loss and the severity of loss. While
high probability – low impact losses such as human errors, minor frauds, etc., are not very severe
and the institution must be in a position to absorb the losses in the normal course of business, the low
probability – high impact losses such as break-down of well laid out internal control systems owing to
connivance leading to unauthorized dealings in securities and consequent large losses can threaten
the very existence of the institution.
The approaches that banks are currently developing fall under three broad categories. These are
the Internal Measurement Approaches (IMA), Loss Distribution Approaches (LDA), and Scorecard
Approaches.
****
HERE IN AFTER
MODULE C
TREASURY

96
CHAPTER 1
TREASURY MANGEMENT
1 Treasury Management – An Overview

2 Functions of Treasury Department In Banks
3 Organisational Structure of Treasury
4 Objectives of The Treasury Management
5 Elements of Treasury Management
6 Functions of a Treasurer
7 Nature of Treasury Assets And Liabilities
8 List of Bank’s Treasury Products
1 TREASURY MANAGEMENT: AN OVERVIEW

Webster defines treasury as "a place where stores of treasures are kept; the place of deposit, care,
and disbursement of collected funds." Moreover, if one considers the treasury functions in ones
own organization; this definition would most likely broadly describe it. Treasury and its
responsibilities fall under the scope of the Chief Financial Officer. In man y organizations, the
Treasurer will be responsible for the treasury function and also holds the position of Chief Financial
Officer. The CFO's responsibilities usually include capital management, risk management, strategic
planning, investor relations and financial reporting. In larger organizations, these responsibilities
are usually separated between accounting and treasury, with the controller and the treasurer each
leading a functional area. Generally accepted accounting principles and generally accepte d
auditing standards recommend the division of responsibilities in areas of cash control and
processing.
The specific tasks of a typical treasury function include cash management, risk management,
hedging and insurance management, accounts receivable management, accounts payable
management, bank relations and investor relations.
A successful treasury function has the same attributes as any other function within the organization
that is considered successful. These qualities are:
* Teamwork * Respect for Organization * Forward Thinking
* Global Thinking * Technological Advancement * Customer Focused
* Finance/Accounting Knowledge * Legal Knowledge * Reliability
The treasury function must work with all operations within the organization. The operational
functions they are working with should consider treasury to be an internal consultant, with expertise
in risk and finance.
Treasury is an exciting and interesting function of the organization that gets involved in many
diverse areas of the business that most other positions in the company do not get the opportunity to
be involved in. It is a natural progression in the career of many who start out in credit management.
2 FUNCTIONS OF TREASURY DEPARTMENT IN BANKS

Since 1990s, the prime movers of financial intermediaries and services have been the policies of
globalization and reforms. All players and regulators had been actively participating, only with
variation of the degree of participation, to globalize the economy. With burgeoning forex reserves,
Indian banks and Financial Institutions have no alternative but to be directly affected by global
happenings and trades. This is where; integrated treasury operations have emerged as a basic tool
for key financial performance.
A treasury department of a bank is concerned with the following functions:
(a) Reserve Management & Investment: It involves (i) meeting CRR/SLR obligations, (ii) having an
appropriate mix of investment portfolio to optimise yield and duration. Duration is the weighted
average ‘life’ of a debt instrument over which investment in that instrument is recouped.
Duration Analysis is used as a tool to monitor the price sensitivity of an investment instrument
to interest rate charges.
(b) Liquidity & Funds Management: It involves (i) analysis of major cash flows arising out of asset-
liability transactions (ii) providing a balanced and well-diversified liability base to fund the
various assets in the balance sheet of the bank (iii) providing policy inputs to strategic planning

97
group of the bank on funding mix (currency, tenor & cost) and yield expected in credit and
investment.
(c) Asset Liability Management & Term Money: ALM calls for determining the optimal size and
growth rate of the balance sheet and also prices the Assets and liabilities in accordance with
prescribed guidelines. Successive reduction in CRR rates and ALM practices by banks
increase the demand for funds for tenor of above 15 days (Term Money) to match duration of
their assets.
(d) Risk Management: integrated treasury manages all market risks associated with a bank’s
liabilities and assets. The market risk of liabilities pertains to floating interest rate risk for assets
& liability mismatches. The market risk for assets can arise from (i) unfavorable change in
interest rates (ii) increasing levels of disintermediation (iii) securitization of assets (iv)
emergence of credit derivates etc. while the credit risk assessment continues to rest with Credit
Department, the Treasury would monitor the cash inflow impact from changes in assets prices
due to interest rate changes by adhering to prudential exposure limits.
(e) Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed optimally,
without sacrificing yield or liquidity. An integrated Treasury unit has as idea of the bank’s overall
funding needs as well as direct access to various market ( like money market, capital market,
forex market, credit market). Hence, ideally treasury should provide benchmark rates, after
assuming market risk, to various business groups and product categories abou t the correct
business strategy to adopt.
(f) Derivative Products: Treasury can develop Interest Rate Swap (IRS) and other Rupee based/
cross- currency derivative products for hedging Bank’s own exposures and also sell such
products to customers/other banks.
(g) Arbitrage: Treasury units of banks undertake this by simultaneous buying and selling of the
same type of assets in two different markets to make risk-less profits.
(h) Capital Adequacy: This function focuses on quality of assets, with Return on Assets (ROA)
being a key criterion for measuring the efficiency of deployed funds. An integrated treasury is a
major profit centre. It has its own P&L measurement. It undertakes exposures through
proprietary trading (deals done to make profits out of movements in market interest/ exchange
rates) that may not be required for general banking.
(i) Coordination: Banks do operate at more than one money market centers. All the centers
undertake similar transactions with differing volumes. There is a need to coordinate the
activities of these centers so that aberrations are avoided (situations where one center is
lending and the other one is borrowing at the same time). The task of coordination of foreign
exchanges positions is no different.
(j) Control and Development: Treasury operates as the focal point of dealing operations. Dealing
operations could include cash/spot, forward, futures, options, interest and currency liability
swaps, forward rate agreements and the like. Treasury is the sole owner and performer of
these transactions.
(k) Fraud Protection: The decade of nineties has witnessed more frauds in trading than banking
books. The amount and variety of such embezzlements have been directly relatable to the
operational level. The ground level task of this kind is to be undertaken at th e treasury. All the
aforesaid activities are funds management functions in a banking environment.
3 ORGANISATIONAL STRUCTURE OF TREASURY

There is no standard structure for treasury department of a bank. Depending on the responsibilities
assigned and power delegated, it can be aptly structured. Typically, banks maintain three
independent tiers at the functional/operational level-
Tier I – Dealing Desk (Front Office): The dealers and traders in different markets- money, stock,
debt, commodity, derivatives and forex- operate in their respective areas. They are the first point if
interface with other participants in the market. The number of dealers depends on the size and
frequency of the operations. In case of larger in each bank, operations would be carried ou t by
separate and independent set of dealers in each market. But, for a relatively smaller treasury,
operations would be done by one or more dealers jointly in all the markets.

98
Tier II – Settlement Desk (Back Office): Once the deals are concluded, it is for the back office to
process and settle the deals. Indeed, the back office undertakes settlement and reconciliation
operations.
Tier III – Accounting, Monitoring and Reporting Office (Audit group): This department looks
after the activities relating to accounting, auditing and reporting. Accountants’ record all deals in the
books of accounts, while auditors and inspectors closely monitor all deals and transactions done by
the front and the back office, and send regular reports to authorities concerned. This department
independently inspects daily operations in the treasury department to ensure internal/regulatory
system and procedures.
Head of Treasury
Chief Dealer Mkt. Intelligence Head of Head of Accounting

Research and analysis Settlements Monitoring and
Reporting
Manager- Manager- Manager Accounts/Moni Audit/Reportin

Funds/Reserve Settlements toring g
Settlements
Dealer- Rupee. Dealer- Forex. Dealer- Corpo.

M.Mkt. dept. Currency/Invest Merchant/Service
.
The three departments should be compartmentalized and they act independently. The heads of
each section reports directly to the Head of the Treasury. A treasury can have more functional desk
depending on the size and structure of the bank, and activities undertaken by the bank. For
example, the treasury may have separate individuals/managers for monitoring funds movement, for
monitoring of risks, developing and marketing innovative instruments/products.
4 OBJECTIVES OF THE TREASURY MANAGEMENT

Treasury of a commercial bank undertakes various operations in fulfillment of the following
objectives:
 To take advantage of the attractive trading and arbitrage opportunities in the bond and forex
markets.
 To deploy and invest the deposit liabilities, internal generation and cash flows from maturing
assets for maximum return on a current and forward basis consistent with the bank’s risk
policies/appetite.
 To fund the balance sheet on current and forward basis as cheaply as possible taking into
account the marginal impact of these actions.
 To effectively manage the forex assets and liabilities of the bank.
 To manage and contain the treasury risks of the bank within the approved and prudential
norms of the bank and regulatory authorities.

99
 To assess, advise and manage the financial risks associated with the non-treasury assets
and liabilities of the bank
 To adopt the best practices in dealing, clearing, settlement and risk management in treasury
operations.
 To maintain statutory reserves- CRR and SLR- as mandated by the RBI on current and
forward planning basis.
 To deploy profitably and without compromising liquidity the clearing surpluses of the bank
 To identify and borrow on the best terms from the market to meet the clearing deficits of the
bank
 To offer comprehensive value-added treasury and related services to the bank’s customers
 To act as profit center for the bank.
5. NATURE OF TREASURY ASSETS AND LIABILITIES

Bank’s balance sheet consists of treasury assets and liabilities on the one hand and non - treasury
assets and liabilities on the other. There is a clear distinction between the two groups. In general, if
a specific assets or liability is created through a transaction in the inter-bank market and/or can be
assigned or negotiated, it becomes a part of the treasury portfolio of the bank.
Treasury assets are marketable or tradable subject to meeting legal obligations such as payment of
applicable stamp duty, etc. another characteristic of treasury assets is that they can (and often are
required to be marked to market. An example of treasury asset/liability which is created by
corporate/treasury actions/decisions on funding/deployment but is not tradable, is the Inter-bank
Participation Certificate.
Loans and advances are specific contractual agreements between the bank and its borrowers, and
do not form a part of the treasury assets, although these are obligations to bank. (They can
however, be securitized and sold in the market. If a bank were to take a position in such securitized
debts, it would become part of treasury activity). On the other hand, an investment in G -Secs can
be traded in the market. It is, therefore, a treasury asset.
Treasury liabilities are distinguished from other liabilities by the fact that they are borrowings from
the money (or bond) market. Deposits (current and savings accounts and fixed deposits) are not
treasury liabilities, as they are not created by market borrowing.
6. ELEMENTS OF TREASURY MANAGEMENT

1. Cash Reserve Ratio/Statutory Liquidity Ratio Management: CRR, or cash reserve ratio,
refers to the portion of deposits that banks have to maintain with RBI. This serves two purposes.
First, it ensures that a portion of bank deposits is totally risk-free. Second, it enables RBI control
liquidity in the system, and thereby, inflation. Besides CRR, banks are required to invest a
portion (8.25 per cent now) of their deposits in government securities as a part of their statutory
liquidity ratio (SLR) requirements. The government securities (also known as gilt-edged
securities or gilts) are bonds issued by the Central government to meet its revenue
requirements. Although the bonds are long-term in nature, they are liquid as they have a ready
secondary market.
2. Dated Government Securities: The Government securities comprise dated securities issued
by the Government of India and state governments. The date of maturity is specified in the
securities therefore it is known as dated government securities.
a) The Government borrows funds through the issue of long term-dated securities, the lowest risk
category instruments in the economy. These securities are issued through auctions conducted by
RBI, where the central bank decides the coupon or discount rate based on the response received.
Most of these securities are issued as fixed interest bearing securities, though the government
sometimes issues zero coupon instruments and floating rate securities also. In one of its first
moves to deregulate interest rates in the economy, RBI adopted the market driven auction
method in FY 1991-92. Since then, the interest in government securities has gone up
tremendously and trading in these securities has been quite active. They are not generally in the
form of securities but in the form of entries in RBI's Subsidiary General Ledger (SGL).

100
b) The investors in government securities are mainly banks, FIs, insurance companies,
provident funds and trusts. These investors are required to hold a certain p art of their
investments or liabilities in government paper. Foreign institutional investors can also invest in
these securities up to 100% of funds-in case of dedicated debt funds and 49% in case of equity
funds.
c) Till recently, a few of the domestic players used to trade in these securities with a majority
investing in these instruments for the full term. This has been changing of late, with a good
number of banks setting up active treasuries to trade in these securities. Perhaps the most liquid
of the long term instruments, liquidity in gilts is also aided by the primary dealer network set up
by RBI and RBI's own open market operations.
1. Money Market Operations: The bank engages into a number of instruments that are available
in the Indian money market for the purpose of enhancing liquidity as well as profitability. Some of
these instruments are as follows:
A. Call Money Market

Call/Notice money is an amount borrowed or lent on demand for a very short period. If the period
is more than one day and up to 14 days it is called 'Notice money' otherwise the amount is known
as Call money'. Intervening holidays and/or Sundays are excluded for this purpose. No collateral
security is required to cover these transactions.
B. Treasury Bills Market

In the short term, the lowest risk category instruments are the treasury bills. RBI issues these at a
prefixed day and a fixed amount.
There are four types of treasury bills:-
 91-day T-bill - maturity is in 91 days. Its auction is on every Wednesday of every week.
The notified amount for this auction is Rs. 100 cr.
 182-day T-bill - maturity is in 182 days. Its auction is on every alternate Wednesday
(which is not a reporting week). The notified amount for this auction is Rs. 100 cr.
 364-Day T-bill - maturity is in 364 days. Its auction is on every alternate Wednesday
(which is a reporting week). The notified amount for this auction is Rs. 500 cr.
C. Inter-Bank Term Money

Inter bank market for deposits of maturity beyond 14 days and up to three months is referred to as
the term money market. The specified entities are not allowed to lend beyond 14 days. The market
in this segment is presently not very deep. The declining spread in lending operations, the volatility
in the call money market with accompanying risks in running asset/liability mismatches, the growing
desire for fixed interest rate borrowing by corporate, the move towards fuller integration between
forex and money markets, etc. are all the driving forces for the development of the term money
market. These, coupled with the proposals for Nationalization of reserve requirements and stringent
guidelines by regulators/managements of institutions, in the asset/liability and interest rate risk
management, should stimulate the evolution of term money market sooner than later. The DFHI, as
a major player in the market, is putting in all efforts to activate this market.
The development of the term money market is inevitable due to the following reasons
 Declining spread in lending operations
 Volatility in the call money market
 Growing desire for fixed interest rates borrowing by corporate
 Move towards fuller integration between forex and money market
 Stringent guidelines by regulators/management of the institutions
D. Certificates of Deposits
Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form
or as a Usance Promissory Note against funds deposited at a bank or other eligible financial institution
for a specified time period.

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Eligibility : CDs can be issued by (i) scheduled commercial banks {excluding Regional Rural Banks
and Local Area Banks}; and (ii) select All-India Financial Institutions (FIs) that have been permitted
by RBI to raise short-term resources within the umbrella limit fixed by RBI.
Aggregate Amount : Banks have the freedom to issue CDs depending on their funding
requirements.
Minimum Size of Issue and Denominations :Minimum amount of a CD should be Rs.1 lakh, i.e., the
minimum deposit that could be accepted from a single subscriber should not be less than Rs.1
lakh, and in multiples of Rs. 1 lakh thereafter.
Investors :CDs can be issued to individuals, corporations, companies (including banks and PDs),
trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only
on non-repatriable basis, which should be clearly stated on the Certificate. Such CDs cannot be
endorsed to another NRI in the secondary market.
Maturity : The maturity period of CDs issued by banks should not be less than 7 days and not more
than one year, from the date of issue.
Discount / Coupon Rate :CDs may be issued at a discount on face value.
E. Commercial Paper (CP)

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note. CP was introduced in India in 1990 with a view to enabling highly rated corporate
borrowers to diversify their sources of short-term borrowings and to provide an additional
instrument to investors.
Companies, PDs and FIs are permitted to raise short term resources through CP.
Individuals, banks, other corporate bodies (registered or incorporated in India) and unincorporated
bodies, Non-Resident Indians and Foreign Institutional Investors (FIIs) shall be eligible to invest in
CP.
A company shall be eligible to issue CP provided - (a) the tangible net worth of the company, as
per the latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund -
based) limit of the company from the banking system and (c) the borrower account of the company
is classified as a Standard Asset by the financing bank/s.
Some important points related to CP:
a. CP shall be issued in the form of a promissory note (as specified in Annex III to this Direction)
and held in physical form or in a dematerialized form through any of the depositories approved by
and registered with SEBI, provided that all RBI regulated entities can deal in and hold CP only in
dematerialised form through such depositories.
b. Fresh investments by all RBI-regulated entities shall be only in dematerialised form.
c. CP shall be issued in denominations of Rs. 5 lakh and multiples thereof. The amount invested by
a single investor should not be less than Rs. 5 lakh (face value).
d. CP shall be issued at a discount to face value as may be determined by the issuer.
e. CP shall be issued for maturities between a minimum of 7 days and a maximum of up to one
year from the date of issue.
f. Eligible participants/issuers shall obtain credit rating for issuance of CP from any one of the SEBI
registered CRAs. Theminimum credit ratingshall be ‘A3’ as per rating symbol and definitio n
prescribed by SEBI. The issuers shall ensure at the time of issuance of the CP that the rating so
obtained is current and has not fallen due for review.
F. Ready Forward Contracts

It is a transaction in which two parties agree to sell and repurchase the sa me security. Under such
an agreement the seller sells specified securities with an agreement to repurchase the same at a
mutually decided future date and a price. Similarly, the buyer purchases the securities with an
agreement to resell the same to the seller on an agreed date in future at a predetermined price.
Such a transaction is called a Repo when viewed from the prospective of the seller of securities
(the party acquiring fund) and Reverse Repo when described from the point of view of the supplier
of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on
which party initiated the transaction.
G. Commercial Bills

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Bills of exchange are negotiable instruments drawn by the seller (drawer) of the goods on the buyer
(drawee) of the goods for the value of the goods delivered. These bills are called trade bills. These
trade bills are called commercial bills when they are accepted by commercial banks. If the bill is
payable at a future date and the seller needs money during the currency of the bill then he may
approach his bank for discounting the bill. The maturity proceeds or face value of discounted bill,
from the drawee, will be received by the bank. If the bank needs fund during the currency of the bill
then it can rediscount the bill already discounted by it in the commercial bill rediscount market at
the market related discount rate.
8. TREASURY PRODUCTS & SERVICES
1. Forward Contract: It is a contract between the bank and its customers in which the
exchange/conversion of currencies would take place at future date at a rate of exchange in
advance under the contract. The essential idea of entering into a forward contract is to peg the
price and thereby avoid the pricerisk.
Forward Rates = Spot rate +/ Premium/Discount
2. Forward Rate Agreement (FRA): An FRA is an agreement between the Bank and a Customer
to pay or receive the difference (called settlement money) between an agreed fixed rate (FRA rate)
and the interest rate prevailing on stipulated future date (the fixing date) based on a notional
amount for an agreed period (the contract period). In short, this is a contract whereby interest rate
is fixed now for a future period. The basic purpose of the FRA is to hedge the interest rate risk.
For example, if a borrower is going to borrow FC loan for 6 months at LIBOR rate after 3 months,
he can buy an FRA whereby he can fix interest rate for the loan.
3. Interest Rate Swap(IRS) : What is an interest rate swap?

An interest rate swap is an over-the-counter (OTC) derivative instrument available in the currency
market where counter parties can exchange a floating payment for a fixed payment and vice-versa
related to an interest rate.
Interest rate swaps are also used speculatively by hedge funds or other investors who expect a
change in interest rates or the relationships between them. Traditionally, fixed income investors
who expected rates to fall would purchase cash bonds, whose value increased as rates fell.
Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall,
investors would pay a lower floating rate in exchange for the same fixed rate.
How does it work?

In an interest rate swap, each counter party agrees to pay either a fixed or floating rate
denominated in a particular currency to the other counter party. The fixed or floating rate is
multiplied by a notional principal amount (say, $1 million).
This notional amount is generally not exchanged between counter parties, but is used only for
calculating the size of cash flows to be exchanged.
The most common interest rate swap is one where one counter party A pays a fixed rate (the swap
rate) to counter party B while receiving a floating rate (usually pegged to a reference rate such as
LIBOR — London Inter Bank Offered Rate).
A pays fixed rate to B (A receives floating rate)
B pays floating rate to A (B receives fixed rate).
Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate
payments of 3.784%, in exchange for periodic floating interest rate payments of LIBOR + 70 bps
(0.70%). There is no exchange of the principal amount and that the interest rates are on a notional
principal amount.
The interest payments are settled in net. The fixed rate (3.784% in this example) is referred to as
the swap rate.

103
By convention, a fixed-rate payer is designated as the buyer of the swap, while the floating-rate
payer is the seller of the swap.
In most cases an interest rate swap is structured so that both the fixed and floating payments are
not actually paid. Rather, the difference between the two amounts is paid by the counterparty who
faces the net shortfall at each payment date.
Users and Uses of Interest Rate Swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial
operating companies, insurance companies, mortgage companies, investment vehicles and trusts,
government agencies and sovereign states for one or more of the following reasons:
1. To obtain lower cost funding
2. To hedge interest rate exposure
3. To obtain higher yielding investment assets
4. To create types of investment asset not otherwise obtainable
5. To implement overall asset or liability management strategies
6. To take speculative positions in relation to future movements in interest rates.
The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.
2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.
3. Swapping allows issuers to revise their debt profile to take advantage of current or expected
future market conditions.
4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt
service.
Swap Example:-
Consider XYZ corp a manufacturing firm which wants to raise 5 year fixed rate dollar funding for
this expansion programme. It finds that will have to pay 2% over 5 year TBill which are currently
yielding 9%. In floating rate market it can issue 5 year FRNs at a margin of 0.75% over the prime
rate. On the other hand, ABC Inc. a large bank looking for floating rate fundings finds that it will
have to pay prime rate while in the fixed rate market it can raise 5-year funs at 50bp(0.50%) above T-
bills due to its AAA ratings.
XYZ Corp ABC Inc

Requirement Fixed rate Floating rate
Cost (fixed) 11% 9.5%
Cost (floating) Prime +0.75% Prime
ABC has an absolute advantage over the XYZ in both the markets but XYZ has a comparative
advantage in the floating rate market. Both can achieve cost savings by each bo rrowing in the
market where it has a comparative advantage and then doing a fixed-to-floating interest rate swap.
9.75% fixed 9.50% fixed

SWAP BANK
Prime = 25bps Prime = 25bps

XYZ ABC
CO↓RP
Inco.
Prime + 75bp 9.50

To Floating rate Lenders To fixed rate lenders

104
ABC borrows at 9.5% fixed. XYZ borrows at Prime +0.75 floating rate. ABC pays the swap bank
(prime – 0.25T) and swap bank passes this on to ZYZ. XYZ pays the swap bank 9.75% and swap
bank pays ABC 9.5%. The key result is that both the parties have achieved their objectives with
some cost savings.
XYZ Corp: 9.75% + [prime +0.75 – (prime – 0.25)] % = 10.75% fixed 25bps below its own cost of
fixed rate funds.
ABC Inc: 9.5% – 9.5% + prime – 0.25% = prime – 0.25%, 25bps below its own cot of floating rate.
The swap bank earns a margin of 25bps.
ILLUSTRATION:-
Company A can borrow at 8% in USD markets and at 9% in AUD markets. Company B can borrow
at 9% in USD markets and at 9.5% in AUD markets. Company A wants to borrow in AUD and
company B wants to borrow in USD markets. If these companies enter a swap in which a dealer
gets 10 basis points, what is the net cost of borrowing to Company B?
a. 9% in USD.
b. 8.8% in AUD.
c. 8.75% in USD.
d. 8.8% in USD.
e. None of the above.
4. Currency Swap: It is an agreement between two parties to exchange obligations in different

currencies at the beginning, during the tenure and at the end of the transaction. At the start, initial
principal is exchanged, though not obligatory. Periodic interest payments (either fixed or floating)
are exchanged through out the life of the contract. The principal is exchanged invariably on
termination at the exchange rate decided at the start of the transaction. By means of currency
swap, the counterparties can reduce the cost of funding.
ILLUSTRATION:-
Current spot exchange rate is 1.6237 CAD/Euro. Assume that risk-free rates are 4% and 7% in
Canada and Europe, respectively. The Euro is selling for 1.6300 CAD/Euro forward in a three -
month contract.
a. Is there arbitrage?
b. If yes, briefly describe the strategy to exploit it.
Answer:
a. F0 = 1.6237e(.04 - .07).25 = 1.6116 CAD/Euro < 1.6300 => Arbitrage.
b. Today sell the forward, buy the Euros with borrowed CADs at 4% and invest the Euros at 7% in
Europe.
1.03
a. Forward rate for 1-year horizon is F1 = 1.7000 *  1.66762$ / £.
1.05
1.03 2
b.Forward rate for 2-year horizon is F2 = 1.7000 *
1.05   1.63585$ / £.
The swap for the institution is equivalent to two exchanges: paying $0.85mil and receiving £0.4 mil
in one year and paying $17.85mil and receiving £10.4 mil in two years. The swap value to the
financial institution is the sum of the values of the one- and two-year forward exchanges.
Value of swap = (0.4 *1.66762  0.85) (10.4 *1.63585  17.85)
  $0.96673 mil
1.03 1.032
CASE LET on Currency Swaps:

A UK firm is to advance a 3 years loan of £ 1,00,000 to its Japanese subsidiary. A Japanese firm is
to advance a 3 years loan of ¥ 2,00,00,000 to its UK subsidiary. Both the firms are brought to a

105
negotiation table by a finance corporation and a deal is negotiated. Under the deal, the UK firm will
advance £ 1,00,000 to UK Subsidiary of the Japanese firm at interest of 8 % p.a. compounded
annually payable on maturity, the Japanese firm will advance a loan of ¥ 2,00,00,000 to Japanese
subsidiary of UK firm at interest of 7 % p.a. compounded annually payable on maturity. The current
exchange rate is 1£ = 200 Yens. However, the £ is expected to decline by 4 Yens per £ over 3 next
years. Compare the £ value of receivables of each of the two firms at the end of 3 years.
Answer:
• UK firm will get £ 1,25,971 from UK subsidiary of the Japanese firm.
1st year: £ 1,00,000 x 8% p.a = £8,000
2nd year: £ 1,08,000 x 8% p.a = £8,640
3rd year: £ 1,16,640 x 8% p.a = £9,331
That means total will be £ 1,00,000 + Intt £ 25971
• The Japanese firm will get Yens 2,66,20,000 from the Japanese subsidiary of the UK firm:
the £ value of this receivable is expected to be 2,45,00,860 / 188 i.e. £ 1,30,323.
1st year: ¥ 2,00,00,000 x 7% p.a = ¥ 14,00,000
2nd year: ¥ 2,14,00,000 x 7% p.a = ¥ 14,98,000
3rd year: ¥ 2,28,98,000 x 7% p.a = ¥ 16,02,860
That means total will be ¥ 2,00,00,000 + Intt.¥ 45,00,860
5. Currency Derivatives:- Already seen in Chapter 1 of Module A

There are two types of currency derivatives to hedge the risk on currency rates fluctuations:
1. Forward
2. Futures & options
CASE LET on Interest Swaps:

Case 1: ABC Company just entered into an interest rate swap agreement with another company.
ABC has agreed to make semi-annual payments at a fixed rate of 7.6% per year. The counterparty,
on the other hand, has agreed to make variable payments at a rate of LIBOR + 1. With a notional
principal of $15 million, which of the following statements would hold true for the first payment in six
months if LIBOR were 6.1% today and 6.9% in six months?
A) ABC would receive a net payment of $37,500.
B) ABC would receive a net payment of $22,500.
C) ABC would have to make a net payment of $22,500.
D) ABC would have to make a net payment of $37,500
Explanation:
(7.6% / 2 ) of 15m = 5,70,000
Fixed payer: Float payer:

ABC Counterparty
( 6.1% + 1%) of 15m = 5,32,500
2 Net = 37,500
Note 1:- Since the fixed payer owes more than the float payer, only the fixed payer would make one
net payment of $37,500.
2:- We use semi annual rates by dividing the annual rate by 2.
3:- To determine the float payment we use the LIBOR rate at the beginning of the period,
even though the payment is made at the end of the period
Case 2: Two parties enter into a three-year interest rate swap, which involves the exchange of
LIBOR+1 for a fixed rate of 12% on a $100 million notional amount. The LIBOR rate today is 11%, but
is expected to increase to 15% in one year and fall back down to 8% in the following year.

106
Which of the following statements accurately depicts the flow of net cash flows between the two
counterparties?
(a) The fixed rate payer would receive a payment of $4 million at the end of year two, while the
variable rate payer would receive $3 million at the end of year three.
(b) The fixed rate payer will have to pay $4 million at the end of the second year and $3 million at
the end of the third year.
(c) The fixed rate payer will have to pay $1 million at the end of the first year.
(d) The variable rate payer would receive a payment of $4 million at the end of year two, while the
fixed rate payer would receive $3 million at the end of year three.
Explanation:-
End of Yr 1:- Fixed pays ( $ 100 million x 12% ) $ 12 million
Variable pays (100 million x 12%) $ 12 million
= Net cash flow received by fixed payer NIL

Variable pays (100 million x 16%) $ 16 million
= Net cash flow received by fixed payer $ 4 million

Variable pays (100 million x 9 %) $ 9 million
= Net cash flow paid by fixed payer $ 3 million
Problems on T- Bill:-
1. Assume an investor purchased a six-month T-bill with a Rs.10,000 par value for Rs.9,000 and
sold it ninety days later for Rs.9,700. What is the yield?
ANSWER:
Par  PP 365
YD 
PP n
365
 10, 000  9 7 00 
9, 700 90
 12. 54%
2. Newly issued three-month T-bills with a par value of Rs.10,000 sold for Rs.9,700. Compute the T-
bill discount.
ANSWER:
Par  PP 365
YD 
Par n
365
 10, 000  9 7 00 
10, 000 90
 12. 16%
3. Assume an investor purchased six-month commercial paper with a face value of Rs.1,000,000
for Rs.940,000. What is the yield?
ANSWER:
1,000,000 940,000 365
Ycp  
940,000 180
 12.94%

107
4. The Treasury is selling 91-day T-bills with a face value of Rs.10,000 for Rs.8,800. If the investor
holds them until maturity, calculate the yield.
ANSWER:
YT = (SP – PP/ PP) (365 / n)
YT = (10,000 – 8,800 / 8,800) (365 / 91) = 54.69%
Computation of DTL
Liabilities of a bank may be in the form of demand or time deposits or borrowin gs or other
miscellaneous items of liabilities. As defined under Section 42 of the RBI Act, 1934, liabilities of a
bank may be towards the banking system or towards others in the form of demand and time
deposits or borrowings or other miscellaneous items of liabilities.
I. Liabilities in India to the Banking System (excluding any loan taken by a Regional Rural Bank
from its sponsor Bank) : The following are to considered as part of it:
Demand Liabilities :
1. Current deposits
2. Demand liabilities portion of savings bank deposits,
3. Margins held against letters of credit/guarantees,
4. Balances in overdue fixed deposits,
5. Cash certificates and cumulative/recurring deposits,
6. Outstanding Telegraphic Transfers (TTs), Mail Transfers (MTs), Demand Drafts (DDs),
7. Unclaimed deposits,
8. Credit balances in the Cash Credit account and deposits held as security for advances which are
payable on demand.
9. Money at Call and Short Notice from outside the Banking System should be shown against
liability to others.
Time Liabilities
1. Fixed deposits,
2. Cash certificates, cumulative and recurring deposits,
3. Time liabilities portion of savings bank deposits,
4. Staff security deposits,
5. Margin held against letters of credit, if not payable on demand,
6. Deposits held as securities for advances which are not payable on demand
7. Gold deposits.
II. Liabilities in India to others (excluding borrowings from the Reserve Bank, Export-Import Bank of
India and National Bank for Agriculture and Rural Development)
Borrowings from abroad by banks in India: Loans/borrowings from abroad by banks in India will be
considered as 'liabilities to others' and will be subject to reserve requirements. Upper Tier II
instruments raised and maintained abroad shall be reckoned as liability for the computation of DTL
for the purpose of reserve requirements.
Other Demand and Time Liabilities (ODTL)

1. Interest accrued on deposits,
2. Bills payable & unpaid dividends,
3. Suspense account balances representing amounts due to other banks or public,
4. Net credit balances in branch adjustment account,
5. Any amounts due to the banking system which are not in the nature of deposits or borrowing.
Such liabilities may arise due to items like (i) collection of bills on behalf of other banks, (ii) interest
due to other banks and so on.
6. Participation Certificates issued to other banks,
7. The balances outstanding in the blocked account pertaining to segregated outstanding credit
entries for more than 5 years in inter-branch adjustment account,
8. The margin money on bills purchased / discounted and gold borrowed by banks from abroad,

108
9. Cash collaterals received under collateralized derivative transactions should be included in the
bank’s DTL/NDTL for the purpose of reserve requirements as these are in the nature of ‘outside
liabilities’.
10. Loans/borrowings from abroad by banks in India
11. Arrangements with Correspondent Banks for Remittance Facilities : When a bank accepts
funds from a client under its remittance facilities scheme, it becomes a liability (liability to others) in
its books. The liability of the bank accepting funds will extinguish only when the correspondent
bank honours the drafts issued by the accepting bank to its customers. As such, the balance
amount in respect of the drafts issued by the accepting bank on its correspondent bank under the
remittance facilities scheme and remaining unpaid should be reflected in the accepting bank's
books as liability under the head ' Liability to others in India' and the same should also be taken into
account for computation of DTL for CRR/SLR purpose.
III. Assets with the Banking System:

(a) Balances in current account with
(i) The State Bank of India, subsidiary banks and corresponding new banks.
(ii) Other banks and Notified financial Institutions
(b) Balances in other accounts with banks and notified financial institutions
(c) Money at call and short notice
(d) Advances to banks (i.e. dues from banks)
(e) Other assets
How to compute NDTL?

Net liabilities for the purpose of section 18 and 24 of the Banking Regulation Act, 1949
= Net liabilities to the Banking System+ Other demand and time liabilities
= (I-III)+II if (I-III) is a plus figure
OR
II only if (I-III) is a minus figure
Important Point:
SCBs are exempted from maintaining CRR on the following liabilities:
i. Liabilities to the banking system in India as computed under clause (d) of the explanation to
Section 42(1) of the RBI Act, 1934;
(As per this section, mostly liabilities towards SBI & subsidiaries, towards banks formed under 3 of
the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970); Section 3
of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980);],a
banking company as defined in clause (c) of section 5 of the Banking Regulation Act, 1949 (10 of
1949); a co-operative Bank; or any other financial institution notified by the Central Government in this
behalf)
ii. Credit balances in ACU (US$) Accounts; and
iii. Demand and Time Liabilities in respect of their Offshore Banking Units (OBU).
Maintenance of CRR on Daily Basis : With a view to providing flexibility to banks in choosing an
optimum strategy of holding reserves depending upon their intra fortnight cash flows, all SCBs are
required to maintain minimum CRR balances up to 90 per cent of the average daily required
reserves for a reporting fortnight on all days of the fortnight with effect f rom the fortnight beginning
April 16, 2016.
However, the actual CRR and SLR maintenance happens with a lag of one fortnight.
Liabilities not to be included in DTL / NDTL calculation

The following liabilities are not be included in the DTL calculation for purposes of maintaining CRR
and SLR

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- Paid up capital, reserves;

- Any credit balance in the Profit & Loss Account of the bank;
- Amount of any loan taken from the RBI;
- Amount of refinance taken from Exim Bank, NHB, NABARD, SIDBI;
- Net income tax provision;
- Amount received from Deposit Insurance and Credit Guarantee Corporation (DICGC) towards
claims and held by banks pending adjustments thereof;
- Amount received from ECGC by invoking the guarantee;
- Amount received from insurance company on ad-hoc settlement of claims pending judgment of
the Court;
- Amount received from the Court Receiver;
- The liabilities arising on account of utilization of limits under Bankers Acceptance Facility (BAF);
- District Rural Development Agency (DRDA) subsidy of Rs.10, 000/- kept in Subsidy Reserve
Fund account in the name of Self Help Groups;
- Subsidy released by NABARD under Investment Subsidy Scheme for
construction/renovation/expansion of Rural Godowns
- Net unrealized gain/loss arising from derivatives transaction under trading portfolio;
- Income flows received in advance such as annual fees and other charges which are not
refundable;
- Bill rediscounted by a bank with eligible financial institutions as approved by RBI;
- Provision not being a specific liability arising from contracting additional liability and created from
profit and loss account.
- The eligible amount of incremental FCNR (B) and NRE deposits of maturities of three years and
above from the base date of July 26, 2013, and outstanding as on March 7, 2014, till their
maturities/pre-mature withdrawals.
Illustration: CRR calculation:

From the following information calculate NDTL for CRR for the reporting Friday as mentioned:
04/09/2016
CAPITAL (Issued Paid up and subscribed) 58,96,149
RESERVES & SURPLUS 8,14,78,362
DEPOSITS:
A) Demand Deposits
i) Total Credit Balances in Current a/cs maintained with Co-operative bank by SBI, SUB, 0.00
banks a
ii) Total of Other Demand Liabilities to the Banking System 27,095.00
iii) Demand Liabilities in India to Others 1,37,701.30
B) Time Deposits
i) Time Liabilities in India to Others 31,443.63
Time Liabilities of the Banking System 3.057.00
BORROWINGS:
From Reserve Bank of India 6,39,600
From Public 70,202
OTHER LIABILITIES:
Bills payable 64,935
Interest accrued 23,809
CASH IN HAND 820

A. BALANCES IN CURRENT A/C WITH
a) Reserve Bank of India 710
b) State Co-op bank of the State 652

110
c) District Central Co-op Bank 4

Total of (a+b+c) 1,366
B. Balances of all other types with
a) State Co-op bank of the State 0.00
b) District Central Co-op bank 0.00
Total of (a+b) 0.00
C. Assets in India with the Banking system
a) Total of Credit Balances in current a/cs maintained with SBI & corresponding new 123
banks
b) Total of Other Assets with Banking system, viz. 7,391
i) Balance on all Accounts 368
i) Money at Call & Short Notice 0.00
ii) Advances 0.00
v) Any Other Assets 7,025
Total of (a + b (i+ii+iii+iv) ) 14,907
INVESTMENTS 45,35,662
ADVANCES 1,07,64,420
Answer:
04/09/2016
CAPITAL (Issued Paid up and subscribed) 0
RESERVES & SURPLUS 0
I. DEPOSITS:
A) Demand Deposits
i) Total Credit Balances in Current a/cs maintained with Co-operative bank by SBI, SUB, 0.00
banks a
ii) Total of Other Demand Liabilities to the Banking System 27,095
iii) Demand Liabilities in India to Others 1,37,701
Total A ( i + ii + iii ) 1,64,796
B) Time Deposits
Time Liabilities in India to Others 31,443
Time Liabilities of the Banking System 3,057
Total B ( i + ii ) 34,500
Total I ( A + B ) 1,99,296
II. Liabilities in India to others

BORROWINGS:
From Reserve Bank of India (Not to a TL) 00.00
From Public (To be considered as liabilities to others) 70,202
OTHER LIABILITIES:
Bills payable (To be considered as Other liabilities) 64,935
Interest accrued (To be considered as Other liabilities) 23,809
Total II 1,58,946
CASH IN HAND ( Not to be considered ) 0
III. Assets with the Banking System

A. BALANCES IN CURRENT A/C WITH
a) Reserve Bank of India ( Not to be considered ) 0
b) State Co-op bank of the State (To be considered ) 652
c) District Central Co-op Bank (To be considered ) 4

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Total of (a+b+c) 656
B. Balances of all other types with

a) State Co-op bank of the State 0.00
b) District Central Co-op bank 0.00
Total of (a+b) 0.00
C. Assets in India with the Banking system

a) Total of Credit Balances in current a/cs maintained with SBI & corresponding new 123
banks (To be considered )
b) Total of Other Assets with Banking system, viz. (To be considered ) 7,391
i) Balance on all Accounts (To be considered ) 368
i) Money at Call & Short Notice 0.00
iii) Advances 0.00
iv) Any Other Assets (To be considered ) 7,025
Total of (a + b (i+ii+iii+iv) ) 14,907
Total of III ( A + B + C) 15,563
INVESTMENTS ( Not a part of NDTL) 0
ADVANCES ( Not a part of NDTL) 0
Total (Net) Demand and Time Liabilities for the purpose of section 18 & 24
(I – III) + II (1,99,296 - 15,563 + 1,58,946 ) 3,42,679
CRR to calculated on this figure…
Procedure for Computation of SLR

The procedure to compute total NDTL for the purpose of SLR under Section 24 (2A) of Banking
Regulation Act, 1949 is broadly similar to the procedure followed for CRR. The liabilities mentioned
above for calculation of CRR, will not form part of liabilities for the purpose of SLR also. Scheduled
Commercial Banks (SCB) are required to include inter-bank term deposits / term borrowing
liabilities of all maturities in 'Liabilities to the Banking System'. Similarly, banks should include their
inter-bank assets of term deposits and term lending of all maturities in 'Assets with the Banking
System' for computation of NDTL for SLR purpose.
Maintenance of Statutory Liquidity Ratio (SLR) : Every SCB shall continue to maintain SLR in India
assets as detailed below:
(a) Cash or
(b) Gold valued at a price not exceeding the current market price, or
(c) Investment in the following instruments which will be referred to as "Statutory Liquidity Ratio
(SLR) securities":
(i) Treasury Bills of the Government of India;
(ii) Dated securities of the Government of India issued from time to time under the market
borrowing programme and the Market Stabilization Scheme;
(iii) State Development Loans (SDLs) of the State Governments issued from time to time under the
market borrowing programme; and
(iv) Any other instrument as may be notified by the Reserve Bank of India.
LAF (Liquidity Adjustment factor) : Liquidity adjustment facility (LAF) is a monetary policy tool
used by RBI to manage market liquidity and money supply targets. LAF was introduced in June
2000 and conducted daily on overnight basis. LAF consist of Repo and Reverse Repo transactions.
Corridor’ for LAF (Liquidity Adjustment factor) is the difference between repo and reverse repo
rates. It is so called as call rates should move between these two rates.
REPO & Reverse REPO Transactions:

112
Repo rate or repurchase rate is the rate at which banks borrow money from the central bank (read
RBI for India) for short period by selling excess Non SLR securities (mostly government bonds or
treasury bills) to the central bank with an agreement to repurchase it at a future date at
predetermined price. It is similar to borrowing money from anybody by selling him something with a
promise to buying it back later at a pre-fixed price ( fixed at the time of borrowing itself). E.g, A bank
is having Non SLR securities of Rs.300 cr. They don’t have much of the liquidity due to asset
mismatch and hence they will sell these securities to RBI with promise to purchase it within next 15
days. For 15 days they need pay interest prevailing at that time, currently rate is 7.25%. Hence the
calculations are Rs.300cr X 7.25% = Rs.21.75 cr p.a. and for 15 days it comes to 89 lakhs.
This amount will be adjusted in repurchase price, that mean while repurchasing the securities bank
will pay 300 cr + 89 lakhs = 389 cr.
Illustration:
Security offered under Repo 11.43% 2026
Coupon payment dates 7 August and 7 February
Market Price of the security offered under Rs.113.00 (1)
Repo
(i.e. price of the security in the first leg)
Date of the Repo 19 January, 2014
Repo interest rate 7.75%
Tenor of the repo 3 days
Broken period interest for the first leg* 11.43% x162/360 x100 = 5.1435 (2)
Cash consideration for the first leg (1) + (2) = 118.1435 (3)
Repo interest** 118.1435 x 7.75% x 3/365 =0.0753 (4)
Broken period interest for the second leg 11.43% x 165/360x100=5.2388 (5)
Price for the second leg (3)+(4)-(5) = 118.1435 + 0.0753-5.2388 = 112.98 (6)
Cash consideration for the second leg (5)+(6) = 112.98 + 5.2388 = 118.2188 (7)
* Computation of days based on 30/360 day count convention

** Computation of days based on Actual/365 day count convention applicable to money market
instruments
Reverse Repo Rate

Reverse repo transaction is exactly the opposite of Repo transaction. Here RBI is selling the
securities to Banks with a promise to purchase it back at predetermined rate. It the rate of interest
at which the RBI borrows funds from other banks for a short duration (by means of selling the
securities to banks). The banks deposit their short term excess funds with the central bank and
earn interest on it. Reverse Repo Rate is used by the central bank to absorb liquidity from the
economy. When it feels that there is too much money floating in the market, it increases the
reverse repo rate, meaning that the central bank will pay a higher rate of interest to the banks for
depositing money with it.
Both these rates are determined by the RBI based on the demand and supply of money in the
economy.
Marginal Standing Facility (MSF) :

MSF was introduced by RBI in2011, where banks can borrow from RBI when there is a
Considerable shortfall of liquidity. Under MSF, banks can borrow from RBI up to 1 % of NDTL and
can pledge securities within the SLR unlike under LAF where has to be above the SLR . RBI
recently restricted borrowing under LAF to 1 % of NDTL or approximately 75000cr.
NOTE: PLEASE REFER CHAPTER BOND VALUATION & RATIO ANALYSIS FROM ADVANCED
BANK MANAGEMENT, AS SOME QUESTIONS HAVE ASKED IN THE BFM PAPER FROM
THESE CHAPTERS ALSO.
****

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CHAPTER 2
INTEREST RATE RISK
Introduction
Types of Interest Rate Risk
Measuring Interest Rate Risk
Trading Book
Banking Book
Approaches to IRR
Interest rate risk measurement techniques
Introduction
Interest Rate Risk (IRR) arises as a result of change in interest rates on rate earning assets and
rate paying liabilities of a bank. The scope of IRR management is to cover the measurement,
control and management of IRR in the banking book. As indicated elsewhere, with the
deregulation of interest rates, the volatility of the interest rates have risen considerably. This has
transformed the business of banking forever in our country from a mere volume driven business (as
volume would take care of profitability in a regulated environment) to a business of careful planning
and to achieve targets of profitability by choosing the appropriate assets and liabilities to be
employed.
To take an example at this stage, a bank funding a three year fixed rate loan with a six month fixed
rate deposit is exposed to interest rate risk as the timing of repricing of assets and liabilities is
different. The asset has a repricing period of three years while the repricing period of the liability is
six months. The concept of repricing is extremely important in IRR management which re flects the
time remaining for interest rate to change on assets and liabilities. This concept would be
expanded further to cover finer aspects of repricing in a subsequent section. If the interest rates
go up in six months from now, the impact of the interest rate would hit the bank in the form of
reduction in the spread, where the spread is the difference between the yield on assets and the
cost of liabilities. This is because the asset rate would remain the same as it is a fixed rate and the
liability rate has gone up at a time when existing liability matured and a fresh liability is taken to
continue the funding of the assets in the balance sheet. Any fall in the interest rate would have led
to positive impact on the spread as liability rate falls while the asset rate remaining the same. This
is typically how the interest rate exposure of an institution is arrived at and analysed.
Types of Interest Rate Risk

Gap or Mismatch Risk:
A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with
different principal amounts, maturity dates or repricing dates, thereby creating exposure to
unexpected changes in the level of market interest rates.
Basis Risk
BPV is a method that is used to measure interest rate risk. It is som etimes referred to as a delta or
DV01. It is often used to measure the interest rate risk associated with swap trading books, bond
trading portfolios and money market books.
BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in
the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.
How does it work?
Let’s suppose you own a Rs. 10million bond that has a price of 100, a coupon of 5.00% and
matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal
repayment at maturity. You can value this bond by:
A. Using the current market price from a dealer quote, or
B. Discounting the individual bond cash flows in order to find the sum of the present va lues. (Refer
Bond Valuation chapter in Paper 1 of CAIIB (Revised)
Let’s assume you use the second method. You will use current market interest rates and a robust
method for calculating accurate discount factors. (Typically swap rates are used with zero c oupon

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methodology). For the sake of simplicity we will use just one interest rate to discount the bond
cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for
the 5 year bond of Rs.10,000,000. We will now repeat the exercise using an interest rate of
5.01%, (rates have increased by 0.01%). The bond now has a value of Rs.9,995,671.72. There is
a difference of Rs.4,328.28. It shows that the 0.01% increase in interest rates has caused a fall in
the value of the bond. If you held that bond you would have lost Rs.4,328.28 on a mark-to-market
basis. This is the BPV of the bond.
How do risk managers use this?

BPV is an estimate of the interest rate risk you have. You can therefore use it to manage interest
rate exposure. Some firms do this by giving traders a maximum BPV that they are permitted to
run. For example, a limit where the portfolio BPV must not exceed Rs.2,00,000. The more interest
rate risk you are prepared to let dealers take the higher the limit.
Embedded Option Risk

Significant changes in market interest rates create another source of risk to banks’ profitability by
encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put options
on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities.
The embedded option risk is becoming a reality in India and is experienced in volatile situations.
The faster and higher the magnitude of changes in interest rate, the greater will be the embedded
option risk to the banks’ NII. Thus, banks should evolve scientific techniques to estimate the
probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity)
to realistically estimate the risk profiles in their balance sheet. Banks should also endeavour for
stipulating appropriate penalties based on opportunity costs to stem the exercise of options, which
is always to the disadvantage of banks.
Yield Curve Risk

The yield curve describes the relationship between short- and long-term interest rates (i.e., the
"term structure"), and is often represented as a graph showing the duration of investment on the x-
axis and the annualized interest rate on the y-axis.
The yield curve is important because long-term interest rates are usually higher than short term
interest rates, reflecting the fact that long term loans tie up money and make it inaccessible for
longer periods of time. Many banks and financial institutions' profits are tied to the difference
between short-term and long-term interest rates, as they make money on a "borrow short, lend
long" strategy, rather than whether interest rates themselves are nominally low or high. In this
strategy, banks borrow money from their depositors and pay these depositors short -term interest
(such as in a savings account). Banks will then aggregate these deposits and lend them out in long-
term loans (such as mortgages) that will not be paid back for many years, but which pay higher
interest.
In a floating interest rate scenario, banks may price their assets and liabilities based on different
benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks
use two different instruments maturing at different time horizon for pricing their assets and
liabilities, any non-parallel movements in yield curves would affect the NII. The movements in yield
curve are rather frequent when the economy moves through business cycles. Thus, banks should
evaluate the movement in yield curves and the impact of that on the portfolio values and income.
Price Risk
Price risk occurs when assets are sold before their stated maturities. In the financial market, bond
prices and yields are inversely related. The price risk is closely associated with the trading book,
which is created for making profit out of short-term movements in interest rates. Banks which have
an active trading book should, therefore, formulate policies to limit the portfolio size, holding period,
duration, defeasance period, stop loss limits, marking to market, etc.
Reinvestment Risk
Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called
reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as

115
the market interest rates move in different directions.
Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors contributing towards profitability of
banks. When banks have more earning assets than paying liabilities, interest rate risk arises when
the market interest rates adjust downwards. Thus, banks with positive net interest positions will
experience a reduction in NII as the market interest rate declines and increases when interest rate
rises. Thus, large float is a natural hedge against the variations in interest rates.
Measuring Interest Rate Risk

Before interest rate risk could be managed, they should be identified and quantified. Unless the
quantum of IRR inherent in the balance sheet is identified, it is impossible to measure the degree
of risks to which banks are exposed. It is also equally impossible to develop effective risk
management strategies/hedging techniques without being able to understand the correct risk
position of banks. The IRR measurement system should address all material sour ces of interest
rate risk including gap or mismatch, basis, embedded option, yield curve, price, reinvestment and
net interest position risks exposures. The IRR measurement system should also take into account
the specific characteristics of each individual interest rate sensitive position and should capture in
detail the full range of potential movements in interest rates.
There are different techniques for measurement of interest rate risk, ranging from the traditional
Maturity Gap Analysis (to measure the interest rate sensitivity of earnings), Duration (to measure
interest rate sensitivity of capital), Simulation and Value at Risk. While these methods highlight
different facets of interest rate risk, many banks use them in combination, or use hybrid meth ods
that combine features of all the techniques.
Generally, the approach towards measurement and hedging of IRR varies with the
segmentation of the balance sheet. In a well functioning risk management system, banks broadly
position their balance sheet into Trading and Investment or Banking Books. While the assets in the
trading book are held primarily for generating profit on short-term differences in prices/yields, the
banking book comprises assets and liabilities, which are contracted basically on account of
relationship or for steady income and statutory obligations and are generally held till maturity.
Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic
value changes are the main focus of banking book.
Trading Book
The top management of banks should lay down policies with regard to volume, maximum maturity,
holding period, duration, stop loss, defeasance period, rating standards, etc. for classifying
securities in the trading book. While the securities held in the trading book should ideally be
marked to market on a daily basis, the potential price risk to changes in market risk factors should
be estimated through internally developed Value at Risk (VaR) models. The VaR method is
employed to assess potential loss that could crystalise on trading position or portfolio due to
variations in market interest rates and prices, using a given confidence level, usually 95% to 99%,
within a defined period of time. The VaR method should incorporate the market factors aga inst
which the market value of the trading position is exposed. The top management should put in
place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions,
derivative products, etc.) which is then disaggregated across different desks and departments. The
loss making tolerance level should also be stipulated to ensure that potential impact on earnings is
managed within acceptable limits. The potential loss in Present Value Basis Points should be
matched by the Middle Office on a daily basis vis-à-vis the prudential limits set by the Board. The
advantage of using VaR is that it is comparable across products, desks and Departments and it can
be validated through ‘back testing’. However, VaR models require the use of extens ive historical
data to estimate future volatility. VaR model also may not give good results in extreme volatile
conditions or outlier events and stress test has to be employed to complement VaR. The stress
tests provide management a view on the potential impact of large size market movements and also
attempt to estimate the size of potential losses due to stress events, which occur in the ’tails’ of the
loss distribution. Banks may also undertake scenario analysis with specific possible stress
situations (recently experienced in some countries) by linking hypothetical, simultaneous and

116
related changes in multiple risk factors present in the trading portfolio to determine the impact of
moves on the rest of the portfolio. VaR models could also be modified to reflect liquidity risk differences
observed across assets over time. International banks are now estimating Liquidity adjusted Value at
Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an
environment where VaR is difficult to estimate for lack of data, non- statistical concepts such as
stop loss and gross/net positions can be used.
2.6 Banking Book

The changes in market interest rates have earnings and economic value impacts on the banks’
banking book. Thus, given the complexity and range of balance sheet products, banks should
have IRR measurement systems that assess the effects of the rate changes on both earnings and
economic value. The variety of techniques ranges from simple maturity (fixed rat e) and repricing
(floating rate) to static simulation, based on current on-and-off-balance sheet positions, to highly
sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of
assets, liabilities and off-balance sheet items and can easily capture the full range of exposures
against basis risk, embedded option risk, yield curve risk, etc.
BCBS Paper on “Principles for the Management and Supervision of Interest Rate Risk" state
the following :
The main components of the approach prescribed in the above mentioned supporting document are
as under:
a) The assessment should take into account both the earnings perspective and economic value
perspective of interest rate risk.
b) The impact on income or the economic value of equity should be calculated by applying a
notional interest rate shock of 200 basis points.
c) The usual methods followed in measuring the interest rate risk are :
1. Earnings Approach: Gap Analysis, simulation techniques and Internal Models based on VaR
2. Economic Value Approach : Gap analysis combined with duration gap analysis, simulation
techniques and Internal Models based on VaR
Earnings Approach to IRR: Gap Analysis:-

The earnings approach is otherwise known as accounting approach. The main focus of the
approach is on the impact of interest rate changes on assets and liabilities on the Net Interest
Income (NII). NII is an important top-line performance indicator of a bank and is computed as
under:
NII = Interest Income – Interest Expenses ................................................. 1
The following example illustrated how term deposits similar in all respects but differing only in terms
of type of interest payment – fixed rate or floating rate has to be treated in the rate sensitive gap
report. Further discussion of the earnings approach would be enabled with the help of a real-life
interest rate sensitivity summary report as under:
Rate Sensitive Gap Summary
Particulars 0-1M 1-3M 3-6M 6-12M 1-3Y 3-5 Y over 5 Y Non Total
sensitive
Term deposits 1464 1835 1858 2372 6601 3729 1172 19030
A total liabilities 2099 2593 10930 2730 6601 3972 1172 10342 40258
Total Assets 2162 1480 10651 1425 2986 3893 12378 5605 40581
Net Group (B-A) 63 -1113 -280 -1305 -3614 102 11206 -4737 323
Cumulative Gap 63 -1049 -1329 -2634 -6248 - 6146 5060 323
As seen above, the gap is positive in the first repricing bucket and is negative in all other buckets
except the last two repricing buckets of 3-5 years and over 5 years.
What is the impact of the gaps on the NII of the bank? The formula for NII impact analysis is as
under:
Impact on NII = Gap × Interest Rate Change

117
The above formula assumes the impact is for a one year period and the interest rate change is per
annum. Computation of impact for shorter periods can be carried out by suitably adjusting both the
period of impact and the rate to reflect the period. To illustrate, what is the annual impact of the
positive gap in the first repricing bucket when interest rate is expected to go up by 1%? To answer
this, we need to make an assumption of timing of rate change within the first bucket as assets and
liabilities having different repricing periods upto 1 month are clubbed together for the sake of
convenience. The usual assumption is that the rate change takes place at the mid -point of the
bucket, i.e., 15 days from today, i.e., 0.5 month. Observe the following arising from the above:
Timing of change in rate = mid-point of the first bucket = (0+1)/2 = 0.5 month
Annual impact would be for a period of = 11.5 months (i.e., 12 – 0.5)
Rate change per annum = 1%
Gap in the first bucket = Rs. 63 crores
NII impact for the first bucket = Gap × Periodicity of annual impact × Rate Change
= 63 × 11.5 × (1%/12) = 0.60375
Hence, the annual impact of interest rate going up in case of the first repricing bucket is Rs.0.6037
crores. As the impact is positive, the NII would go up. What is the annual impact for the second
repricing bucket for the same interest rate change?
Timing of change in rate = (1+3)/2 = 2 months

Annual impact would be for a period of = 10 months (i.e. 12 – 2)
Rate change per annum = 1%
Gap in the second bucket = -1113 crores
NII impact for the second bucket = -1113 × 10 × (1%/12) = -9.275
While the NII impact of the gap in the first bucket was positive, the impact of the negative gap in the
second bucket is negative to the extent of 9.275 crores. This gives an indication that the NII would
suffer to an extent of 9.275 crores for the second bucket. The approach described above can be
used to arrive at the impact for each bucket and then aggregate bucket-wise impact to arrive at
quarterly, semi-annual and annual impact on NII. In the numerical analysis above, the reason for
difference in impact between the first and second buckets is simple. The gap in the first bucket is
an asset sensitive gap as more assets are repricing than the liabilities. An asset sensitive gap with
an increase in interest rates would produce positive impact on NII. That is what we observed in
case of the first bucket. The gap in the second bucket is liability sensitive as more liabilities are
repricing than assets in the bucket. A liability sensitive position with an increase in interest rates
would produce a negative impact that we observed in case of the second bucket. The following
table summarises the NII impact given the sign of the gaps and the sign of change in interest rates
Repricing Gap (assets and liab.) Interest Rate view impact on NII
Positive Up Positive
(RSA> RSL)
Positive down Negative
(RSA> RSL)
Negative Up Negative
(RSA<RSL)
Negative Down Positive
(RSA<RSL)
Zero Up or Down Zero
(RSA=RSL)
*RSA=Rate Sensitive Assets. RSL=Rate Sensitive Liabilities
Illustration 1:
A Bank has Rs.20 million in cash and Rs.180 million loan portfolio. The assets are funded with
demand deposits of Rs.18 million, Rs.162 million bonds, and Rs.20 million in equity. The loan

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portfolio has a maturity of 2 years, earns interest at the annual rate of 7 percent, and is amortized
monthly. The bank pays 7 percent annual interest on the bonds, but the principal will not be paid
until the bonds matures at the end of 2 years. What is the maturity gap for Bank?
Solution:
MA = [0*Rs.20 + 2*Rs.180]/Rs.200 = 1.80 years
ML = [0*Rs.18 + 2*Rs.162]/Rs.180 = 1.80 years
MGAP = 1.80 – 1.80 = 0 years.
Illustration 2:
The balance sheet for GBI bank, is presented below (Rs. millions):
Assets Liabilities and Equity
Cash 30 Core deposits 20
364 days T bill (5.60%) 20 Repo 50
Loans (floating) 105 Bonds (10 yrs) 130
Loans (fixed) 65 Equity 20
Total assets 220 Total liabilities & equity 220
Notes to the balance sheet: The Repo funds rate is 6.5%, the floating loan rate is LIBOR + 3 %,
and currently LIBOR is 8%. Fixed rate loans have five-year maturities, are priced at par, and pay
12% annual interest. The principal is repaid at maturity. Core deposits are fixed rate for a year at
8% paid annually. The principal is repaid at maturity. Bonds are at 8%.
a. What is the banks NII
b. What is the banks NII margin
c. If interest rates decline by 60 basis points, what will be effect on NII.
Solution: (a)
Interest Income = ( 20 x 5.60% + 105 x 11% + 65 x 12%) = 20.47
Interest Expense = ( 20 x 8% + 50 x 6.5% + 130 x 8%) = 15.25
So NII will be = 20.47 – 15.25 = 5.22 million
(b) NII margin = NII x 100

Earnings Assets
= 15.25 x 100 = 8.03%
190.00
(c) If interest rates decline by 60 basis points, then effect will be only on RSA and RSL and not on
other non sensitive assets or liabilities that are on fixed rates.
So now the gap of RSA & RSL is :
RSA = 364 days T bill (5.60%) 20 + Loans (floating) 105 = 125
RSL = Core deposits 20 + Repo 50 = 70
Gap = RSA – RSL = 125 – 70 = 55
Now refer to table on pg. no. and since the gap is positive and rates are declining by 60 bps
the NII will go down by 55 million x 0.60% = 0.33 million.
Economic Value Approach of IRR

Earnings approach of IRR has a short-term focus and covers only an initial part of the life of assets
& liabilities in the balance sheet. It does not cover the long-term impact of the exposure to the
changes in interest rates. The Economic Value Approach, which is known by many names such as
Market Value Approach, Net Portfolio Value Approach etc. considers the long -term impact of
interest rate changes by covering the entire life of all the assets and liabilities. Under the economic
value approach, the impact of interest rate changes are studied on an important variable called
Economic Value of Equity (EVE). It is known by many names such as Net Portfolio Value, Market
Value of Equity, Market Value of Portfolio Equity etc. The EVE is:
EVE = Economic Value of Assets – Economic Value of Outsider Liabilities ................ 5
The economic value of assets and economic value of outsider liabilities represent the fair value of
assets and the fair value of liabilities except equity respectively. The essence of the equation

119
reflects the residuary nature of the claims of the equity shareholders who are the owners. This
approach recognises the fact that changes in interest rates not only change the NII but also the
economic value of assets and liabilities, which in turn is reflected in the value of equity. The approach
to the valuation is the well known ‘present value of future cash flows’, which is a basic foundation for
the subject of finance.
The economic value approach has gained prominence as the NII impact and EVE impact for a
given change in interest rates on assets and liabilities need not have to be in the same direction. It
is perfectly possible for a bank to substantially gain in NII terms when interest rates go up, but end
up with a reduction in EVE and vice versa.
Sensitivity of Economic Value: Duration as a Measure of Elasticity of Value

Apart from the valuation of assets and liabilities using the principle of valuation, there is also a need
to use well known measures of interest rate sensitivity to understand the interest rate e lasticity of
each asset & liability in the balance sheet and for arriving at the net sensitivity, which would
ultimately impact the EVE as per equation 5. The well known measures of interest rate sensitivity
are the duration family measures which are used extensively in IRR in the current environment.
The following illustration would be used to explain the concept of valuation and measures of
interest rate sensitivity
Valuation and Computation of Duration Measures for a Term Deposit:
Principal and outstanding balance 10,000

Opening Date of Deposit 01/01/2013
Current Date 01/01/2014
Date of Maturity of Deposit 31/12/2018
Contractual Rate of Interest 9%
Freq. of Intt. Payment p.a. 1
Current Rate of Interest 8%
Residual Maturity (Years) 5
Time period (t) in yrs Cash Flow Present of Cash flow Duration Segment
1 900 833.3333 0.0801
2 900 771.6049 0.1484
3 900 714.4490 0.2061
4 900 661.5269 0.2545
5 10,900 7,418.357 3.5668
Value of Deposit 10,399.270 4.2559 3.9406 Modified Duration
The valuation carried out for the term deposit reveals that the economic value of the deposit is
Rs.10399.27 while the book value of the same is Rs.10000. As explained, a higher economic
value than book value for a liability is a negative impact on EVE. This can be interpreted as hinting
at deterioration in the future earning potential for the bank, which is reflected by a reduction in EVE.
This explanation would be crystal clear if the contractual interest rate and the current interest rate
are compared to draw conclusions on future earning potential. The comparison of interest rates
show that the bank has been incurring and will continue to incur till the deposit matures a cost of
9% while the current interest rate on similar deposit has fallen to 8%. The bank is not able to
reduce the interest rate on the deposit as the deposit carries a fixed rate. The EVE reduction to the
tune of Rs.399.27 (i.e., the current book value of Rs.10000 – the economic value of Rs. 13399.27)
is nothing but the present value of future losses that the bank is going to suffer in the next 5 years
of the life of deposit as it is compelled to pay a rate 1% higher than current interest rate on similar
deposits. This interpretation is as of the current date, which may change in future dep ending on
interest rate on the deposit.
Here, the modified duration number of 3.9406 can be interpreted as a measure of interest rate
sensitivity. This interpretation suggests that for 1% change in the interest rate on the deposit, the
value of the deposit would change in the opposite direction of the interest rate change by 3.9406%.
This is the direct measure of interest rate sensitivity of the deposit.

120
Subject to the limitations of the duration family measures, this measure of sensitivity can be used
both in case of assets and liabilities. The process explained above has to be followed for each
asset & liability in the balance sheet to arrive at aggregate duration at asset and liability level.
Consider the following example:
Duration of Assets = 5
Value of Asset = 100
Duration of Liabilities = 3.5
Value of Liabilities = 90
Economic Value of Equity = 10 (100 – 90)
A comparison of asset and liability durations reveals that the assets are more interest rate sensitive
than the liabilities of the bank. If interest rate goes up by 1% for both the asset and liability, there
would be a greater fall in the value of assets than the liabilities. As a result of higher fall in asset
value than liability value, the economic value of equity would fall from its present l evel of Rs.10.
The economic value of equity would increase to the same extent when the interest rate falls.
3 Simulation
Many of the international banks are now using balance sheet simulation models to gauge the effect
of market interest rate variations on reported earnings/economic values over different time zones.
Simulation technique attempts to overcome the limitations of Gap and Duration approaches by
computer modelling the bank’s interest rate sensitivity. Such modelling involves making
assumptions about future path of interest rates, shape of yield curve, changes in business activity,
pricing and hedging strategies, etc. The simulation involves detailed assessment of the potential
effects of changes in interest rate on earnings and economic value. The simulation techniques
involve detailed analysis of various components of on-and off-balance sheet positions.
Simulations can also incorporate more varied and refined changes in the interest rate environment,
ranging from changes in the slope and shape of the yield curve and interest rate scenario derived from
Monte Carlo simulations.
The usefulness of the simulation technique depends on the structure of the model, validity of
assumption, technology support and technical expertise of banks.
The application of various techniques depends to a large extent on the quality of data and the
degree of automated system of operations. Thus, banks may start with the gap or duration gap or
simulation techniques on the basis of availability of data, information technology and technical
expertise. In any case, as suggested by RBI in the guidelines on ALM System, banks should start
estimating the interest rate risk exposure with the help of Maturity Gap approach. Once banks are
comfortable with the Gap model, they can progressively graduate into the sophisticated
approaches.
INEREST RATE DERIVATIES:

Let us proceed to a discussion in some detail the first exchange traded derivatives on interest rates
in India, namely the ‘interest rate futures’ or IRF. Prior to December 5, 20 13, in Indian IRF was
required to be settled physically that means a compulsory delivery was required. The following are
the features for physically settled contract specificiation.
IRF: Contract Specifications

Symbol 10YGS7
Market Type Normal
Instrument type FUTIRD
Unit of trading 1 lot - 1 lot is equal to national bonds of FV Rs. 2 lacs.
Underlying 10 Year Notional Coupon bearing Government of India (GOI) security.
(Notional Coupon 7% with semiannual compounding.)
Tick size Rs. 0.0025 or 0.25 paise.
Trading hours Monday to Friday (On all business days) 9.00 a.m to 5.00 pm.
Contract trading cycle Four fixed quarterly contracts for entire year, expiring in March, June,
September and December.

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Last trading day Two business days preceding the last business day of the delivery
month.
Delivery day Last business day of delivery month.
Settlement Daily settlement – marked to market daily
Final settlement – physical settlement in the delivery month.
Introduction of cash settled IRF:

As per RBI circular No. :RBI/2013-14/402 IDMD.PCD. 08/14.03.01/2013-14,
The Interest Rate Futures deriving value from the following underlying are permitted on the
recognised stock exchanges:
(i) 91-Day Treasury Bills;
(ii) 2-year, 5-year and 10-year coupon bearing notional Government of India security, and
(iii) Coupon bearing Government of India security.
(i) The 91-Day Treasury Bill Futures shall satisfy the following requirements:
a. The contract shall be on 91-Day Treasury Bills issued by the Government of India.
b. The contract shall be cash settled in Indian Rupees. (Just like currency futures traded in India).
c. The final settlement price of the contract shall be based on the weighted average price/yield
obtained in the weekly auction of the 91-Day Treasury Bills on the date of expiry of the contract.
(ii) The 2-year and 5-year Interest Rate Futures contract shall satisfy the following requirements:
a. The 2-year and 5-year Interest Rate Futures contracts shall be on coupon bearing notional 2-
year and 5-year Government of India security respectively.
b. The coupon for the notional 2-year Government of India security shall be 7% per annum and that
of the notional 5-year Government of India security shall be 7% per annum with semi-annual
compounding.
c. The contracts shall be cash-settled in Indian Rupees.
d. The final settlement price of the 2-year and 5-year Interest Rate Futures contracts shall be based
on the yields on basket of securities for each Interest Rate Futures contract specified by the
respective stock exchange in accordance with guidelines issued by the Securities Exchange Board
of India from time to time.
e. The yields of the Government of India securities shall be polled and the same shall be as per the
guidelines issued by the Reserve Bank of India from time to time.
(iii) The 10-year Interest Rate Futures with coupon bearing Government of India security as
underlying shall satisfy the following requirements:
a. The underlying shall be a coupon bearing Government of India security of face value Rs. 100
and residual maturity between 9 and 10 years on the expiry of futures contract. The underlying
security within these parameters shall be, as decided by stock exchanges in consultation with the
Fixed Income Money Market and Derivatives Association (FIMMDA).
b. The contract shall be cash-settled in Indian rupees.
c. The final settlement price shall be arrived at by calculating the weighted average price of the
underlying security based on prices during the last two hours of the trading on Negotiated Dealing
System-Order Matching (NDS-OM) system. If less than 5 trades are executed in the underlying
security during the last two hours of trading, then FIMMDA price shall be used for final settlement.
****
HERE AFTER
MODULE D
BANK BALANCE SHEET

122
CHAPTER 1
BANKS BALANCESHEET
The Banking Regulation act, 1949 prescribes formats of preparing final accounts of the Banking
companies. The third schedule of section 29 gives forms ‘A’ for the balance sheet and Form ‘B’ for
Profit and loss account. The balance sheet consists of total 12 schedules. Schedule 1 to schedule
5 depicts capital and liabilities and schedule 6 to schedule 11 shows Assets of the bank and
schedule 12 shows contingent liabilities and there is no specific schedule prescribes for bills for
collection.
Form A
Balance Sheet As on 31st March
As on 31.3
As on 31.3 (previous
Capital and Liabilities Schedule (Current Year) Year)
Rs. Rs.
Capital 1
Reverse and Surplus 2
Deposits 3
Borrowing 4
Other liabilities & Provisions 5
Total
Assets
Cash & Balances with Reserve Bank of India, 6
Balances with banks and money At Call & Short Notice 7
Investments 8
Advances 9
Fixed Asset 10
Other Asset 11
Total
Contingent Liabilities and Bills for Collection 12
Schedule 1 : Capital As on 31.3

(Current Year) Year)
Rs. Rs.
I. For Nationalised Bank
(Fully owned by Central Government)
II. For Banks incorporated outside India
Capital
i. (The amount brought in by banks by way of start-up
Capital as prescribed by RBI should be shown under
this head)
ii. Amount of deposit kept with RBI u/s 11 (2) of
Banking Regulation Act,1949.
III. For other Banks
I Authorized Capital

123
Share of Rs. each

II. Issued Capital
shares of Rs each.
III. Subscribed Capital
shares of Rs each.
IV. Called up Capital:-
shares of Rs each.
Less : Calls Unpaid

Add : Forfeited Shares
Total
Schedule 2 : Reverse and Surplus As on 31.3

Rs. Rs.
I. Statutory Reserve
a. Opening Balance
b. additions during the year
c. Deductions during the year
II .Capital Reserve
a. Opening balance
b. Additions during the year
c. Deductions during this year
III Share Premium
a. Opening Balance
b. Additions during the year
c. Deductions during the year
IV Balance in Profit & Loss A/c

(Total (I, II, III and IV)
Schedule 3 : Deposits As on 31.3

Rs. Rs.
I. Demand Deposits:-
i. From Individuals
ii. From others
II. Savings Bank Deposit
III. Term Deposits
From Banks.
From others
Total (I, II and III)
B. i. Deposits of Branches in India
ii. Deposits of Branches outside India

124
Total ( I and II )
Schedule 4:- Borrowing As on 31.3

Rs. Rs.
I. Borrowings in India
i. From the Reserve Bank of India
ii. From other Banks
iii. Other Institutions & Agencies
II. Borrowings outside India
Total ( I and II )
Secured Borrowings are included in I & II
Schedule 5:- Other liabilities and provisions As on 31.3

Rs. Rs.
I. Bills payable
II. Inter- office adjustment (net)
III. Interest accrued
IV. Other (including provisions)
Total (I, II , III and IV)
Schedule 6 : Cash and Balances with Reverse Bank of As on 31.3

India As on 31.3 (previous
Rs. Rs.
I Cash in Hand
II Balances with Reserve Bank of India
a) In correct Account
b) In other accounts
Total (I and II)
Schedule 7 Balances with banks and money At Call & As on 31.3

Short Notice As on 31.3 (previous
Rs. Rs.
I. Balance with Banks & money at Call & Short Notice
i. Balance with Banks:-
a. Current deposits
b. other deposit Accounts
ii. Money at Call and Short Notice
a. With Banks
b. With other institutions

125
Total (i and ii)

II. Outside India
i. In Current Accounts
ii. In other deposits account
iii. Money at call & short notice
Total (i, ii and iii)
Total (I and II)
Schedule 8:- Investments As on 31.3
Rs. Rs.
I. Investments in India
a. In Central Government Securities
b. In other Approved Securities
c. Shares
d. In debentures and bonds
e. Subsidiaries and/or Joint ventures
f. Other (To be specified)
Total
II. Investments in outside India
a. Government Securities (including local authorities)
b. Subsidiaries and/or Joint ventures
c. Other (To be specified)
Total
Total (I and II)
Schedule 9 : Advances As on 31.3

Rs. Rs.
A.
i) Bills purchased & discounted
ii) Cash Credits, overdrafts& loans repayable on demand
iii) Term Loan
Total
B.
i) Secured by tangible assets
ii) Secured by bank/ government guarantees
iii) Unsecured
Total
C.
I. Advances in India
a. Priority sector
b. Public sector
c. Bank
d. Others
II. Advances outside India

126
a. Dues from Banks

b. Dues from others
i. Bills purchased & discounted
ii. Syndicated Loans
iii. Others
Total (C -I + II)
Schedule 10 : Fixed Assets As on 31.3

Rs. Rs.
I. Premises
a) At cost as on 31st March of the preceedings year
b) Additions
c) Deductions during the year
d) Total (Cost a and b minus c)
e) Less: Depreciation to date
f) Total (d minus e)
II. Other Fixed Assets (including furniture & fixture)
a) At cost as on 31st March of the preceedings year
b) Additions
c) Deductions during the year
d) Total (Cost a and b minus c)
e) Less: Depreciation to date
f) Total (d minus e)
Schedule 11 : Other assets As on 31.3

Rs. Rs.
I. Inter-office adjustment (net)
II. Interest accured
III. Tax Paid in Advance/Tax deducted at source
Iv. Stationary and stamps
V. Non-banking assets acquired in satisfaction of
claims
V. Others @
Total (I, II, III, IV, and V)
@ In case there is any unadjusted balance of loss, is the
same may be shown under this item with appropriate
footnote.
Schedule 12 : Contingent Liabilities and bliss for As on 31.3

collection:- As on 31.3 (previous
Rs. Rs.
I. Claims against the bank not acknowledgement as debts

127
II. Liability for partly paid investments

III. Liability on account of outstanding forward exchange
contracts
IV. Guarantees given on behalf of constituents
a. In India
b. Outside India
V. Acceptance, endorsements and other obligations
(including bills for collection)
VI. Other Items for which the bank is contingently liable
Total (I, II III, IV, V and VI)
Form B
Profit & Loss Account for the year ended on 31st
March
As on 31.3 As on 31.3
Schedule (Current Year) (previous Yr)
Rs. Rs.
I Income
Interest earned 13
Other income 14
Total
II. Expenditure
Interest expended 15
Operating expenses 16
Provisions& contingencies
Total
III. Profit/ Loss
Net Profit/ Loss (-) for the year
Profit/ Loss (-) brought forward
Total
IV. Appropriations
Transfer to statutory reserves
Transfer to other reserves(To be specified)
Tr. To Govt./Proposed Dividend
Balance carried to Balance Sheet
Total
Schedule 13 : Interest Earned

As on 31.3 As on 31.3
(Current Year) (previous Yr)
Rs. Rs.
I. Interest/ discount on advances/ bills
II. Income on investments
III. Interest on balances with reserve Bank of India and
other inter bank funds
IV. Others
Total

128
Schedule 14 : Other income

As on 31.3 As on 31.3
Rs. Rs.
I. Commission, exchange and brokerage
II. Profit on sale of investments
Less: loss on sale of investments
III. Profit on Revaluation of investments
Less:- Loss on revaluation of investments
IV. Profit on sale of land, buildings and other assets.
Less:- Loss on sale of land, buildings and other assets
V. Profit on exchange transactions.
Less:- Loss on exchange transactions
VI. Income earned by way dividends etc. from
subsidiaries/companies and/or joint ventures aboard/in
India
VII. Miscellaneous Income
Under I to V loss figures may be shown in bracket
Total
Schedule 15: Interest Expended As on 31.3 As on 31.3

Rs. Rs.
I. Interest on Deposit
II. Interest on RBI/Interbank borrowings
III. Others
Total
Schedule- 16: Operating Expenses As on 31.3 As on 31.3

Rs. Rs.
I. Payments to and provisions for employees
II. Rent, taxes, and lighting
III. Printing and stationery
IV. Advertisement and publicity
V. Depreciation on bank’s property
VI. Director’s fees, allowance and expenses
VII. Auditors’ fees and expenses (including branch
auditors)
VIII. Law charges
IX. Postage, Telegrams, Telephone, etc.
X. Repairs and maintenance
XI. Insurance
XII. Other expenditure
Total

129
IMPORTANT GUIDELINES ON DISCLOSURE IN FINANCIAL STATEMENTS *

1. PURPOSE
• The financial statements are required to provide the information about the financial position and
performance of the bank in making economic decisions by the users. They are interested in the
bank’s liquidity and solvency and the risks related to the assets and liabilities recognized on its
balance sheet and to it’s off balance sheet items. This useful information can be provided by way of
‘Notes’ to the financial statements, being supplementary information for market discipline. Market
discipline has been given due importance under Basel II framework on capital adequacy by
recognizing it as one of its three Pillars.
2. DISCLOSURE REQUIREMENT
• In this direction, RBI has, over the years, developed a set of disclosure requirements which allow
the market participants to assess key pieces of information on capital adequacy, risk exposures,
risk assessment processes and key business parameters which provide a consistent and
understandable disclosure framework that enhances comparability. Banks are also required to
comply with the Accounting Standard – 1 (AS -1) on disclosure issued by ICAI. This can be
achieved through revision of Balance Sheet and P & L Account of banks and enlarging the scope of
disclosures in “Notes to Accounts”.
3. ADDITIONAL/SUPPLEMENTARY INFORMATION
“Notes to Accounts” may contain the supplementary information such as:-
a) Capital (Current & Previous year) with breakup including CRAR – Tier I/II capital (%), % of share
holding of GOI, amount of subordinated debt raised as Tier II capital, etc.
b) Investments including details of Repo transactions, Non-SLR investment Portfolio, and Sales &
transfers to/from HTM category.
c) Derivatives with breakup of Forward Rate Agreement/Interest Rate Swap, Exchange Traded
Interest Rate Derivatives, and Disclosures on risk exposure in derivatives.
d) Asset Quality with details such as Non-Performing Assets, Particulars of Accounts Restructured,
Details of financial assets sold to Securitization / Reconstruction Company for Assets
Reconstruction, Details of Non-Performing financial assets purchased, Details of Non-Performing
Assets sold, and Provisions on Standard Assets.
e) Business Ratios giving Interest Income as a % to Working Funds, Non-interest income as a % to
working funds, Operating Profit as a % to working funds, etc.
f) Asset Liability Management giving the maturity pattern of certain items of assets and liabilities
such as deposits, advances, investments, borrowings, foreign current assets, and foreign currency
liabilities.
g) Exposures giving the segment wise breakup on Exposure to Real Estate Sector, Exposure to
Capital Market, Risk Category wise Country Exposure, Details of Single Borrower Limit
(SGL)/Group Borrower Limit (GBL) exceeded by the bank, and Unsecured Advances.
h) Miscellaneous relating to Amount of Provisions made for Income Tax during the year, and
Disclosure of Penalties imposed by RBI.
4. Disclosure Requirements as per Accounting Standards where RBI has issued guidelines
in respect of disclosure items for “Notes to Accounts”
a) AS-5 – relating to Net Profit or Loss for the period, prior period items and changes in
accounting policies.
b) AS -9 – Revenue Recognition giving the reasons for postponement of revenue recognition.
c) AS – 15 – Employee Benefits
d) AS – 17 – Segment Reporting such as Treasury, Corporate/wholesale Banking, Retails
Banking, ‘Other Banking Operations’ and Domestic and International segments, etc.
e) AS – 18 – Related Party Disclosures
f) AS – 21 – Consolidated Financial Statements (CFS)
g) AS – 22 – Accounting for Tax & Income – Adoption of AS – 22 entails creation of Deferred Tax
Assets (DTL) and Deferred Tax Liabilities (DTL) which have a bearing on the computation of capital
adequacy ratio and banks’ ability to declare dividends. DTA represents unabsorbed depreciation
and carry forward losses which can set-off against Assets future taxable income which is

130
considered as timing difference. DTL has an effect of decreasing future income tax payments which
indicates that they are prepaid income taxes and meet the definition of assets. It is created by
credit to opening balance of Revenue Reserves on the first day of application of AS – 22 or P & L
Account for the current year. DTA should be deducted from Tier I capital.
Deferred Tax Liability (DTL) is created by debit to opening balance of Revenue Reserves on the
first day of application of AS-22 or P & L Account for the current year and will not be eligible for
inclusion in Tier I and Tier II capital for capital adequacy purpose. DTL have an effect of increasing
the future year’s income tax payments which indicates that they are accrued taxes and meet the
definition of liabilities.
h) AS – 23 – Accounting for investments in Associates in Consolidated Financial Statements. It
relates to the effects of the investments in associates on the
financial position and operating results of a group
i) AS – 24 – Discontinuing Operations – resulted in shedding of liability and realization of the
assets by the bank, etc.
j ) AS – 25 – Interim Financial Reporting – Half yearly reporting.
k) Other Accounting Standards Banks are required to comply with the disclosure norms stipulated
under the various Accounting Standards issued by ICAI.
5. Additional Disclosures
a) Provisions and contingencies – Banks are required to disclose in the “Notes to Accounts” the
information on all Provisions and Contingencies giving Provision for depreciation on Investment,
Provision towards NPA, Provision towards Standard Assets, Provision made towards Income Tax,
and Other Provision and contingencies.
b) Floating Provisions - comprehensive disclosures on floating provisions.
c) Draw Down from Reserves - Details of draw down of reserves are to be disclosed.
d) Complaints - Brief details on ABC Ltd Complaints and Awards passed by the Banking
Ombudsman.
e) Letters of Comfort (LOC) issued by banks - Details of all the Letters of Comfort (LoCs) issued
during the year, including their assessed financial impact, etc.
f) Provision Coverage Ratio (PCR) - ratio of provisioning to gross non-performing assets
g) Bancassurance Business - Details of fees/remuneration received, etc.
6. Concentration of Deposits, Advances, Exposures, and NPAs

a) Concentration of deposits – Total deposits of 20 large depositors and percentage of the
deposits to total deposits of the bank.
b) Concentration of Advances - Total advances to 20 largest borrowers and percentage of the
advance to total advances of the bank.
c) Concentration of Exposures - Total Exposure to 20 largest borrowers/ABC Ltds and percentage
of the exposures to total exposure of the bank on borrowers/ABC Ltds.
d) Concentration of NPAs - Total exposure to top 4 NPA accounts
7. Sector-wise NPAs - Details of sector-wise NPAs such as Agriculture & Allied Activities,
Industry (Micro & Small, Medium and Large), Services, and Personal Loans.
8. Movement of NPAs - Additions, Recoveries, Upgradation, Write-offs, etc. from Gross NPAs
and the final position as on the date of the Financial Statement.
9. Overseas Assets, NPAs, and Revenue -Giving the Total assets, Total NPAs, and Total
Revenue.
10. Off-balance sheet SPVs sponsored - (consolidated) giving Domestic and Overseas SPVs
sponsored.
****

131
CHAPTER 2
Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining
to Advances
1. INTRODUCTION
In line with the international practices and as per the recommendations made by the Committee
on the Financial System (Chairman Shri M. Narasimham), the Reserve Bank of India
has introduced, in a phased manner, prudential norms for income recognition, asset classification
and provisioning for the advances portfolio of the banks so as to move towards greater
consistency and transparency in the published accounts.
The policy of income recognition should be objective and based on record of recovery rather
than on any subjective considerations. Likewise, the classification of assets of banks has to be
done on the basis of objective criteria which would ensure a uniform and consistent application of
the norms. Also, the provisioning should be made on the basis of the classification of assets based
on the period for which the asset has remained nonperforming and the availability of security and
the realisable value thereof.
2. NPA:- MEANING
Non performing Assets
An asset, including a leased asset, becomes non performing when it ceases to generate
income for the bank.
A non performing asset (NPA) is a loan or an advance where;
i.interest and/ or instalment of principal remain overdue for a period of more than 90 days in respect
of a term loan,
ii. the account remains ‘out of order’ as indicated at paragraph 2.2 below, in respect of an
Overdraft/Cash Credit (OD/CC),
iii. the bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted,
iv. the instalment of principal or interest thereon remains overdue for two crop seasons for short
duration crops,
v. the instalment of principal or interest thereon remains overdue for one crop season for long
duration crops,
vi. the amount of liquidity facility remains outstanding for more than 90 days, in respect of a
securitisation transaction undertaken in terms of guidelines on securitisation dated February 1,
2006.
vii. in respect of derivative transactions, the overdue receivables representing positive mark -to-
market value of a derivative contract, if these remain unpaid for a period of 90 days from the
specified due date for payment.
Banks should, classify an account as NPA only if the interest due and charged during any
quarter is not serviced fully within 90 days from the end of the quarter.
‘Out of Order’ status

An account should be treated as 'out of order' if the outstanding balance remains continuously in
excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the
principal operating account is less than the sanctioned limit/drawing power, but there are no
credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to cover
the interest debited during the same period, these accounts should be treated as 'out of order'.
‘Overdue’
Any amount due to the bank under any credit facility is ‘overdue’ if it is not paid on the due date fixed
by the bank.
3. INCOME RECOGNITION
Income Recognition Policy
The policy of income recognition has to be objective and based on the record of recovery.
Internationally income from nonperforming assets (NPA) is not recognised on accrual basis but

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is booked as income only when it is actually received. Therefore, the banks should not charge and
take to income account interest on any NPA.
However, interest on advances against term deposits, NSCs, IVPs, KVPs and Life policies
may be taken to income account on the due date, provided adequate margin is available in the
accounts.
Fees and commissions earned by the banks as a result of renegotiations or rescheduling of
outstanding debts should be recognised on an accrual basis over the period of time covered by the
renegotiated or rescheduled extension of credit.
If Government guaranteed advances become NPA, the interest on such advances should not
be taken to income account unless the interest has been realised.
Reversal of income
If any advance, including bills purchased and discounted, becomes NPA as at the close of any
year, the entire interest accrued and credited to income account in the past periods, should be
reversed or provided for if the same is not realised. This will apply to Government guaranteed
accounts also.
In respect of NPAs, fees, commission and similar income that have accrued should cease to
accrue in the current period and should be reversed or provided for with respect to p ast periods, if
uncollected.
Leased Assets
The finance charge component of finance income [as defined in ‘AS 19 Leases’ issued by the
Council of the Institute of Chartered Accountants of India (ICAI)] on the leased asset which
has accrued and was credited to income account before the asset became nonperforming, and
remaining unrealised, should be reversed or provided for in the current accounting period.
Appropriation of recovery in NPAs

Interest realised on NPAs may be taken to income account provided the credits in the accounts
towards interest are not out of fresh/ additional credit facilities sanctioned to the borrower
concerned.
In the absence of a clear agreement between the bank and the borrower for the purpose of
appropriation of recoveries in NPAs (i.e. towards principal or interest due), banks should adopt an
accounting principle and exercise the right of appropriation of recoveries in a uniform and
consistent manner.
Interest Application
There is no objection to the banks using their own discretion in debiting interest to an NPA account
taking the same to Interest Suspense Account or maintaining only a record of such interest in
proforma accounts.
Computation of NPA levels

Banks should deduct the following items from the Gross Advances and Gross NPAs to arrive at the
Net advances and Net NPAs respectively:
i) Balance in Interest Suspense Account
ii) DICGC/ECGC claims received and held, pending adjustment
iii) Part payment received and kept in suspense account
iv) Total provisions held (excluding amount of technical write off and provision on standard assets)
For the purpose, the amount of gross advances should exclude the amount of Technical Write off
but would include all outstanding loans and advances; including the advances for which refinance
has been availed but excluding the amount of rediscounted bills. The level of gross and net NPAs
will be arrived at in percentage terms by dividing the amount of gross and net NPAs by gross and
net advances, computed as above, respectively.
Projects under implementation (Classification of NPA)

• Project Loans are classified into 2 categories viz. Project Loans for infrastructure sector
and Project Loans for non-infrastructure sector.

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• An infrastructure project loan would be classified as NPA before the date of commen cement of
commercial operations (DCCO) as per record of recovery (90 days) unless it is restructured and
eligible for classification as standard asset.
• An infrastructure project would be classified as NPA if it fails to commence commercial operations
within 2 years from the original DCCO.
• If a project loan classified as standard asset is restructured any time during the period up to two
years from the original date of DCCO, it can be retained as a standard asset if the fresh DCCO is
fixed and the account continues to be serviced as per the restructured terms subject to the
application for restructuring should be received before the expiry of period of two years from the
original DCCO and when the account is still standard as per record of recovery.
• Delay in infrastructure projects involving court cases and projects in other than court cases,
extension of DCCO up to another 2 years (beyond the existing extended period of 2 years i.e. total
extension of 4 years) and up to another 1 year (beyond the existing extended period of 2 years i.e.
total extension of 3 years) respectively is considered for treating them as NPA.
• A loan for a non-infrastructure project will be classified as NPA during any time before
commencement of commercial operations as per record of recovery (90 days overdue).
• If the non-infrastructure project fails to commence commercial operations within 6 months from
the original DCCO, it is to be treated as NPA, etc.
Take out Finance

• Under Take out Finance, possibility of default, in view of the time-lag involved in taking-over,
cannot be ruled out. The norms of asset classification will have to be followed by the concerned
lending bank/financial institution and they should not recognize income on accrual basis, but only
on actual receipt. Bank/FI should also make suitable provision pending the takeover by other
institution. Upon takeover of the account, the provision could be reversed. But the taking over
institution is required to make provision in its books treating it as NPA from the actual date of
becoming NPA even though the account was not in its books as on that date.
Post-shipment Supplier's Credit

• Post shipment Supplier’s Credit under the EXIM Bank Guarantee-cum-refinance programme, the
extent payment has been received from the EXIM Bank, may not be treated as a non-performing
asset for asset classification and provisioning purposes.
Export Project Finance
• In the event of the export proceeds in respect of export project finance is held up due to political
developments in the importer’s country, the asset classification may be made after a period of one
year from the date the amount was deposited by the importer in the bank abroad.
Advances under rehabilitation approved by BIFR/ TLI

• In case of a unit under rehabilitation package approved by BIFR/Term Lending Institution, the
existing credit facilities continue to be classified as substandard or doubtful as the case may be.
Asset classification norms would be applicable in respect of additional facilities sanctioned under
the package after a period of one year from the date of disbursement.
4. ASSET CLASSIFICATION
4.1 Categories of NPAs
Banks are required to classify nonperforming assets further into the following three
categories based on the period for which the asset has remained nonperforming and the
realisability of the dues:
I. Substandard Assets
II. Doubtful Assets
iii. Loss Assets
4.1.1 Substandard Assets

With effect from 31 March 2005, a substandard asset would be one, which has remained NPA for a
period less than or equal to 12 months. In such cases, the current net worth of the borrower/ guarantor
or the current market value of the security charged is not enough to ensure recovery of

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the dues to the banks in full. In other words, such an asset will have well defined credit
weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct
possibility that the banks will sustain some loss, if deficiencies are not corrected.
4.1.2. Doubtful Assets

With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in the
substandard category for a period of 12 months. A loan classified as doubtful has all the
weaknesses inherent in assets that were classified as substandard, with the added
characteristic that the weaknesses make collection or liquidation in full, – on the basis of
currently known facts, conditions and values – highly questionable and improbable.
4.1.3 Loss Assets

A loss asset is one where loss has been identified by the bank or internal or external auditors or the
RBI inspection but the amount has not been written off wholly. In other words, such an asset
is considered uncollectible and of such little value that its continuance as a bankable asset is not
warranted although there may be some salvage or recovery value.
Guidelines for classification of assets

Broadly speaking, classification of assets into above categories should be done taking into
account the degree of well-defined credit weaknesses and the extent of dependence on collateral
security for realisation of dues.
Banks should establish appropriate internal systems to eliminate the tendency to delay or
postpone the identification of NPAs, especially in respect of high value accounts. The
banks may fix a minimum cut off point to decide what would constitute a high value account
depending upon their respective business levels. The cut off point should be valid for the entire
accounting year. Responsibility and validation levels for ensuring proper asset classification may be
fixed by the banks. The system should ensure that doubts in asset classification due to any reason
are settled through specified internal channels within one month from the date on which the
account would have been classified as NPA as per extant guidelines.
Availability of security / net worth of borrower/ guarantor
The availability of security or net worth of borrower/ guarantor should not be taken into account for
the purpose of treating an advance as NPA or otherwise, except to the extent provided in Para 4.
2.9, as income recognition is based on record of recovery.
Accounts with temporary deficiencies

The classification of an asset as NPA should be based on the record of recovery. Bank should not
classify an advance account as NPA merely due to the existence of some deficiencies which are
temporary in nature such as non-availability of adequate drawing power based on the latest
available stock statement, balance outstanding exceeding the limit temporarily, non -submission of
stock statements and non-renewal of the limits on the due date, etc. In the matter of classification
of accounts with such deficiencies banks may follow the following guidelines:
i) Banks should ensure that drawings in the working capital accounts are covered by the
adequacy of current assets, since current assets are first appropriated in times of distress. Drawing
power is required to be arrived at based on the stock statement which is current. However,
considering the difficulties of large borrowers, stock statements relied upon by the banks for
determining drawing power should not be older than three 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 even though the unit may be working or the
borrower's financial position is satisfactory.
ii) Regular and ad hoc credit limits need to be reviewed/ regularised not later than three
months from the due date/date of ad hoc sanction. In case of constraints such as non-availability of
financial statements and other data from the borrowers, the branch should furnish evidence to
show that renewal/ review of credit limits is already on and would be completed soon. In any case,

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delay beyond six months is not considered desirable as a general discipline. Hence, an account
where the regular/ ad hoc credit limits have not been reviewed/ renewed within 180 days from the
due date/ date of ad hoc sanction will be treated as NPA.
Upgradation of loan accounts classified as NPAs

If arrears of interest and principal are paid by the borrower in the case of loan accounts classified
as NPAs, the account should no longer be treated as nonperforming and may be classified
as ‘standard’ accounts.
Accounts regularised near about the balance sheet date

The asset classification of borrowal accounts where a solitary or a few credits are recorded before
the balance sheet date should be handled with care and without scope for subjectivity. Where the
account indicates inherent weakness on the basis of the data available, the account should be
deemed as a NPA. In other genuine cases, the banks must furnish satisfactory evidence to the
Statutory Auditors/Inspecting Officers about the manner of regularisation of the account to eliminate
doubts on their performing status.
Asset Classification to be borrower-wise and not facility-wise

i) It is difficult to envisage a situation when only one facility to a borrower/one investment in any of
the securities issued by the borrower becomes a problem credit/investment and not others.
Therefore, all the facilities granted by a bank to a borrower and investment in all the
securities issued by the borrower will have to be treated as NPA/NPI and not the particular
facility/investment or part thereof which has become irregular.
ii) If the debits arising out of devolvement of letters of credit or invoked guarantees are parked in a
separate account, the balance outstanding in that account also should be treated as a part of the
borrower’s principal operating account for the purpose of application of prudential norms on income
recognition, asset classification and provisioning.
iii) The bills discounted under LC favouring a borrower may not be classified as a Non-performing
advance (NPA), when any other facility granted to the borrower is classified as NPA. However, in
case documents under LC are not accepted on presentation or the payment under the LC is not
made on the due date by the LC issuing bank for any reason and the borrower does not
immediately make good the amount disbursed as a result of discounting of concerned bills, the
outstanding bills discounted will immediately be classified as NPA with effect fro m the date when
the other facilities had been classified as NPA.
iv) The overdue receivables representing positive mark-to-market value of a derivative contract will
be treated as a non-performing asset, if these remain unpaid for 90 days or more. In case the
overdues arising from forward contracts and plain vanilla swaps and options become NPAs, all
other funded facilities granted to the client shall also be classified as non-performing asset following
the principle of borrower-wise classification as per the existing asset classification norms.
Accordingly, any amount, representing positive mark-to-market value of the foreign exchange
derivative contracts (other than forward contract and plain vanilla swaps and options) that were
entered into during the period April 2007 to June 2008, which has already crystallised or might
crystallise in future and is / becomes receivable from the client, should be parked in a separate
account maintained in the name of the client / counterparty. This amount, even if overdue for a
period of 90 days or more, will not make other funded facilities provided to the client, NPA on
account of the principle of borrower-wise asset classification, though such receivable overdue for
90 days or more shall itself be classified as NPA, as per the extant IRAC norms. The classification
of all other assets of such clients will, however, continue to be governed by the extant IRAC norms.
v) If the client concerned is also a borrower of the bank enjoying a Cash Credit or Overdraft facility
from the bank, the receivables mentioned at item (iv) above may be debited to that account on due
date and the impact of its non-payment would be reflected in the cash credit / overdraft facility
account. The principle of borrower-wise asset classification would be applicable here also, as per
extant norms.
vi) In cases where the contract provides for settlement of the current mark-to-market value of a
derivative contract before its maturity, only the current credit exposure (not the potential future
exposure) will be classified as a non-performing asset after an overdue period of 90 days.

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vii) As the overdue receivables mentioned above would represent unrealised income already
booked by the bank on accrual basis, after 90 days of overdue period, the amount already taken to
'Profit and Loss a/c' should be reversed and held in a 'Suspense a/c' in the same manner as is
done in the case of overdue advances.
Advances under consortium arrangements

Asset classification of accounts under consortium should be based on the record of recovery of
the individual member banks and other aspects having a bearing on the recoverability of the
advances. Where the remittances by the borrower under consortium lending arrangements are
pooled with one bank and/or where the bank receiving remittances is not parting with the share of
other member banks, the account will be treated as not serviced in the books of the other member
banks and therefore, be treated as NPA. The banks participating in the consortium should,
therefore, arrange to get their share of recovery transferred from the lead bank or get an
express consent from the lead bank for the transfer of their share of recovery, to ensure proper
asset classification in their respective books.
Accounts where there is erosion in the value of security/frauds committed by borrowers

In respect of accounts where there are potential threats for recovery on account of erosion in the
value of security or non-availability of security and existence of other factors such
as frauds committed by borrowers it will not be prudent that such accounts should go through
various stages of asset classification. In cases of such serious credit impairment the asset should
be straightaway classified as doubtful or loss asset as appropriate:
i. Erosion in the value of security can be reckoned as significant when the realisable value of the
security is less than 50 per cent of the value assessed by the bank or accepted by RBI at the time
of last inspection, as the case may be. Such NPAs may be straighta way classified under doubtful
category and provisioning should be made as applicable to doubtful assets.
ii. If the realisable value of the security, as assessed by the bank/ approved valuers/ RBI
is less than 10 per cent of the outstanding in the borrowal accounts, the existence of
security should be ignored and the asset should be straightaway classified as loss asset. It may be
either written off or fully provided for by the bank.
Advances against Term Deposits, NSCs, KVP/IVP, etc

Advances against term deposits, NSCs eligible for surrender, IVPs, KVPs and life policies need not
be treated as NPAs, provided adequate margin is available in the accounts. Advances against gold
ornaments, government securities and all other securities are not covered by this exemption.
Loans with moratorium for payment of interest

i. In the case of bank finance given for industrial projects or for agricultural plantations etc. where
moratorium is available for payment of interest, payment of interest becomes 'd ue' only after the
moratorium or gestation period is over. Therefore, such amounts of interest do not become overdue
and hence do not become NPA, with reference to the date of debit of interest. They become
overdue after due date for payment of interest, if uncollected.
ii. In the case of housing loan or similar advances granted to staff members where interest
is payable after recovery of principal, interest need not be considered as overdue from the first
quarter onwards. Such loans/advances should be classified as NPA only when there is a default in
repayment of instalment of principal or payment of interest on the respective due dates.
5. PROVISIONING NORMS
General
The primary responsibility for making adequate provisions for any diminution in the val ue of
loan assets, investment or other assets is that of the bank managements and the statutory auditors.
The assessment made by the inspecting officer of the RBI is furnished to the bank to assist the
bank management and the statutory auditors in taking a decision in regard to making adequate and
necessary provisions in terms of prudential guidelines.
In conformity with the prudential norms, provisions should be made on the nonperforming
assets on the basis of classification of assets into prescribed categories as detailed in paragraphs 4

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supra. Taking into account the time lag between an account becoming doubtful of recovery,
its recognition as such, the realisation of the security and the erosion over time in the value of
security charged to the bank, the banks should make provision against substandard assets,
doubtful assets and loss assets as below:
Loss assets
Loss assets should be written off. If loss assets are permitted to remain in the books for
any reason, 100 percent of the outstanding should be provided for.
Doubtful assets
i. 100 percent of the extent to which the advance is not covered by the realisable value of the
security to which the bank has a valid recourse and the realisable value is estimated on a
realistic basis.
ii. In regard to the secured portion, provision may be made on the following basis, at the
rates ranging from 25 percent to 100 percent of the secured portion depending upon the period for
which the asset has remained doubtful:
Period for which the advance hasProvision requirement
remained in ‘doubtful’ category (%)
Up to one year 25
40
One to three years
100
More than three years
iii. Banks are permitted to phase the additional provisioning consequent upon the reduction in the
transition period from substandard to doubtful asset from 18 to 12 months over a four year period
commencing from the year ending March 31, 2005, with a minimum of 20 % each year.
Note: Valuation of Security for provisioning purposes
With a view to bringing down divergence arising out of difference in assessment of the value of
security, in cases of NPAs with balance of Rs. 5 crore and above stock audit at annual intervals by
external agencies appointed as per the guidelines approved by the Board would be mandatory in
order to enhance the reliability on stock valuation. Collaterals such as immovable
properties charged in favour of the bank should be got valued once in three
years by valuers appointed as per the guidelines approved by the Board of Directors.
Substandard assets
(i) A general provision of 15% on total outstanding should be made without making any allowance
for ECGC guarantee cover and securities available.
(ii) The ‘unsecured exposures’ which are identified as ‘substandard’ would attra ct additional
provision of 10 per cent, i.e., a total of 25 per cent on the outstanding balance. The provisioning
requirement for unsecured ‘doubtful’ assets is 100 per cent. Unsecured exposure is defined as an
exposure where the realisable value of the security, as assessed by the bank/approved
valuers/Reserve Bank’s inspecting officers, is not more than 10 percent, ab-initio, of the
outstanding exposure. ‘Exposure’ shall include all funded and non-funded exposures (including
underwriting and similar commitments). ‘Security’ will mean tangible security properly discharged to
the bank and will not include intangible securities like guarantees (including State government
guarantees), comfort letters etc.
Note:- However, “unsecured exposures” in respect of Infrastructure loan accounts classified as sub-
standard, in case of which certain safeguards such as escrow accounts are available as indicated in
RBI circular DBOD.No.BP.BC.96/08.12.014/2009-10 dated April 23, 2010, will attract an additional
provision of 5 per cent only i.e. a total of 20 per cent as against the existing 15 per cent
(iii) In order to enhance transparency and ensure correct reflection of the unsecured advances in
Schedule 9 of the banks' balance sheet, it is advised that the following would be applicable from
the financial year 2009-10 onwards :

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a) For determining the amount of unsecured advances for reflecting in schedule 9 of the published
balance sheet, the rights, licenses, authorisations, etc., charged to the banks as collateral in
respect of projects (including infrastructure projects) financed by them, should not be reckoned as
tangible security. Hence such advances shall be reckoned as unsecured.
b) Banks should also disclose the total amount of advances for which intangible securities such as
charge over the rights, licenses, authority, etc. has been taken as also the estimated value of such
intangible collateral. The disclosure may be made under a separate head in ';Notes to Accounts';.
This would differentiate such loans from other entirely unsecured loans.
Restructured Accounts:-
Category of Advances Rate (%)
Restructured accounts classified as standard advances

(In respect of new restructured standard accounts
(flow) with effect from June 1, 2013)
- with effect from March 31, 2014 (spread over the four 3.50
quarters of 2013-14)
- with effect from March 31, 2015 (spread over the 4.25
four quarters of 2014-15)
- with effect from March 31, 2016 (spread over the four 5.00
quarters of 2015-16)
Standard assets
(i) As a countercyclical measure, the provisioning requirements for all types of standard assets
stands amended as below. Banks should make general provision for standard assets at the
following rates for the funded outstanding on global loan portfolio basis:
(a) direct advances to agricultural and SME sectors at 0.25 per cent;
(b) advances to Commercial Real Estate (CRE) Sector at 1.00 per cent;
(c) advances to Commercial Real Estate Residential housing (CRE-RH) Sector at 0.75%
(d) Individual Housing loans 0.25% ( w.e.f all sanctions after 07.6.2017)
(e) all other loans and advances at 0.40 per cent
(ii) The revised norms would be effective prospectively but the provisions held at present should not
be reversed. However, in future, if by applying the revised provisioning norms, any provisions are
required over and above the level of provisions currently held for the standard category assets,
these should be duly provided for.
(iii) While the provisions on individual portfolios are required to be calculated at the rates applicable
to them, the excess or shortfall in the provisioning, vis-a-vis the position as on any previous date,
should be determined on an aggregate basis. If the provisions on an aggregate basis required to
be held are less than the provisions already held, the provisions rendered surplu s should not be
reversed to P&L and should continue to be maintained at the existing level. In case of shortfall
determined on aggregate basis, the balance should be provided for by debit to P&L.
(iv) The provisions on standard assets should not be reckoned for arriving at net NPAs.
(v) The provisions towards Standard Assets need not be netted from gross advances but shown
separately as 'Contingent Provisions against Standard Assets' under 'Other Liabilities and
Provisions Others' in Schedule 5 of the balance sheet.
NOTE:- Additional Provisions for NPAs at higher than prescribed rates

The regulatory norms for provisioning represent the minimum requirement. A
bank may voluntarily make specific provisions for advances at rates which are high er than the
rates prescribed under existing regulations, to provide for estimated actual loss in collectible
amount, provided such higher rates are approved by the Board of Directors and
consistently adopted from year to year. Such additional provisions are not to be considered

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as floating provisions. The additional provisions for NPAs, like the minimum regulatory provision on
NPAs, may be netted off from gross NPAs to arrive at the net NPAs.
SALE OF FINANCIAL ASSETS TO SC/RC

• Under the SARFAESI Act 2002, banks/FIs are permitted to sell financial assets to Securitization
Companies (SC) and Reconstruction Companies (RC). A financial asset which can be sold to the
SC/RC by any bank/ FI is:-
a) A NPA, including a non-performing bond/ debenture, and
b) A Standard Asset where: i) The asset is under consortium/multiple banking arrangements; ii) At
least 75% of value of the asset is classified as NPA in the books of other banks/FIs; and ii i) At
least 75% (by value) of the banks/FIs who are under the consortium/multiple banking arrangements
agree to the sale of the asset to SC/RC.
• The prudential guidelines have been grouped under various heads as under:-
a) Financial assets which can be sold.
b) Procedure for sale of banks’/ FIs’ financial assets to SC/ RC, including valuation and
pricing aspects.
c) Prudential norms, in the following areas, for banks/ FIs for sale of their financial assets
to SC/ RC and for investing in bonds/debentures/ security receipts and any other
securities offered by the SC/RC as compensation consequent upon sale of financial assets:
i) Provisioning / Valuation norms ii) Capital adequacy norms ii i) Exposure norms
d) Disclosure requirements
6. WRITE OFF OF NPAs

• In terms of Section 43(D) of the Income Tax Act 1961, interest income of NPAs shall be
chargeable to tax in the previous year in which it is credited to the bank’s profit and loss account or
received, whichever is earlier. Banks may either make full provision as per the guidelines or write
off such advances or claim such tax benefits as are applicable. Recoveries made in such accounts
should be offered for tax purposes as per the rules.
7. PRUDENTIAL GUIDELINES ON RESTRUCTURING OF ADVANCES :

• A restructured account is one where the bank grants concessions, which would not otherwise
consider, taking into account the borrower’s financial difficulty. Restructuring involves modification
of terms of advance/securities, which would generally include, among others, alteration of
repayment period / repayable amount/ the amount of instalments / rate of interest, etc.
• Specified Period means a period of one year from the date when the first payment of interest or
instalment of principal falls due under the terms of restructuring package.
The guidelines on restructuring issued by RBI are grouped in four categories as under:-
i) Restructuring of advances extended to industrial units.
ii) Restructuring of advances extended to industrial units under the Corporate Debt Restructuring
(CDR) Mechanism
iii) Restructuring of advances extended to Small and Medium Enterprises (SME)
iv) Restructuring of all other advances.
Eligibility
• Accounts classified under ‘Standard’, ‘Substandard’ and ‘doubtful’ categories. • Banks cannot
reschedule / restructure / renegotiate borrowal accounts with retrospective effect. While a
restructuring proposal is under consideration, the usual asset classification norms would continue
to apply.
• No account is taken up for restructuring by the banks unless the financial viability is established
and there is a reasonable certainty of repayment from the borrower, as per the terms of
restructuring package.
• Borrowers indulged in frauds and malfeasance is ineligible for restructuring. • BIFR cases are not
eligible for restructuring without their express approval.
CDR Core Group in the case of advances restructured under CDR Mechanism / the lead
bank in the case of SME Debt Restructuring Mechanism and the individual banks in other cases,

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may consider the proposals for restructuring in such cases, after ensuring that all the formalities in
seeking the approval from BIFR are completed before implementing the package.
Asset classification norms

Restructuring of advances could take place in the following stages:
(a)Before commencement of commercial production / operation;
(b) After commencement of commercial production / operation but before the asset has been
classified as 'sub-standard';
(c) After commencement of commercial production / operation and the asset has been classified as
'sub-standard' or 'doubtful'.
Upon restructuring:-
• 'Standard assets' should be reclassified as 'sub-standard assets'
• NPAs would continue asset classification as prior to restructuring and may slip into further lower
asset classification categories with reference to the prerestructuring repayment schedule.
• All NPA accounts would be eligible for being reclassified as ‘standard’ category after observation
of satisfactory performance during the ‘specified’ period. Thereafter, the account would be
governed as per the existing prudential norms with reference to repayment schedule.
• Additional finance considered may be treated as ‘standard asset’ during the ‘specified period.
’Any Interest income should be recognized only on cash basis in respect of accounts classified as
‘substandard’ or ‘doubtful’ at pre-restructuring stage.
• A restructured standard asset is subjected to restructuring on a subsequent occasion; it should be
classified as substandard. Similarly, a sub-standard or a doubtful restructured asset which is
subjected to restructuring on a subsequent occasion, its asset classification will be reckoned from
the date when it became NPA on the first occasion.
• Interest income in respect of restructured standard asset can be recognized on accrual basis
• In case part of the outstanding principal amount is converted into debt or equity instruments as
per the restructuring package, the asset so created will be classified in the same asset
classification category in which the restructured advance has been classified.
• The FITL / debt or equity instrument created by conversion of unpaid interest will be classified in
the same asset classification category in which the restructured advance has been classified.
Banks will hold provision in respect of restructured assets as per existing provisioning norms
Asset classification benefits are available to banks subject to:-
• The dues of the banks are fully secured except SSI borrowers where the outstanding is upto
Rs.25 Lakh
• Infrastructure projects provided the cash flows generated from these projects are adequate for
repayment of the advance, escrow mechanism for the cash flows available, and banks have a clear
and legal first claim on these cash flows.
• The unit becomes viable in 10 years, if it is engaged in infrastructure activities, and in 7 years in
the case of other units.
• The repayment period of the restructured advance including the moratorium, if any, does not
exceed 15 years in the case of infrastructure advances and 10 years in the case of other advances
other than restructured home loans.
• Promoters' sacrifice (contribution) and additional funds brought by them should be a minimum of
15% of banks' sacrifice upfront. However, if the banks are convinced that the promoters face
genuine difficulty in bringing the share of sacrifice immediately, the promoters could be all owed to
bring in 50% of their sacrifice i.e. 50% of 15% upfront and the balance within a period of one year.
OBJECTIVE OF RESTRUCTURING
It may be observed that the basic objective of restructuring is to preserve economic value of units
and not ever greening of problem accounts. This can be achieved by banks and the borrowers only
by careful assessment of the viability, quick detection of weaknesses in accounts and a time-bound
implementation of restructuring packages.
Question:1
(a) From the following information, compute the amount of provisions to be made in the Profit

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and Loss Account of a Commercial bank:

Assets Rs. in lakhs
(i) Standard (Value of security Rs.6,000 lakhs) 7,000

(ii) Sub-standard 3,000
(iii) Doubtful
(a)Doubtful for less than one year 1,000
(Realisable value of security Rs.500 lakhs)
(b)Doubtful for more than one year, but less than 3 500
years
(Realisable value of security Rs.300 lakhs)
(c)Doubtful for more than 3 years (No security) 300
Answer
(a) Asset Amount % of provision
Provision
Rs. in lakhs Rs.
in lakhs
Standard 7,000 0.40 28

Sub-standard 3,000 15 450
Doubtful (less than one year)
On secured portion 500 25 125
On unsecured portion 500 100 500
Doubtful (more than one year but less than
three years)
On secured portion 300 40 120
On unsecured portion 200 100 200
Doubtful Unsecured 300 100 300
(more than three years)
Total provision 1,723
Example 2:
Outstanding Balance Rs. 4 lakhs
ECGC Cover 50 percent
Period for which the advance has More than 2 years remained doubtful
remained doubtful (say as on March 31, 2014)
Value of security held Rs. 1.50 lakhs
Provision required to be made
Outstanding balance Rs. 4.00 lakhs
Less: Value of security held Rs. 1.50 lakhs
Unrealised balance Rs. 2.50 lakhs
Less: ECGC Cover Rs. 1.25 lakhs
(50% of unrealisable balance)
Net unsecured balance Rs. 1.25 lakhs
Provision for unsecured portion of Rs. 1.25 lakhs
advance (@ 100 percent of unsecured portion)
Provision for secured portion of advance Rs.0.60 lakhs
(as on March 31, 2014) (@ 40 per cent of the secured portion)
Total provision to be made Rs.1.85 lakhs (as on March 31, 2014)
****

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CHAPTER 3
BASEL ACCORD & PROVISIONS
Brief History:
The Basel Committee on Banking Supervision has its origins in the financial market turmoil that
followed the breakdown of the Bretton Woods system of managed exchange rates in 1973. After
the collapse of Bretton Woods, many banks incurred large foreign currency losses. On 26 June
1974, West Germany’s Federal Banking Supervisory Office withdrew Bankhaus Herstatt’s banking
licence after finding that the bank’s foreign exchange exposures amounted to three times its
capital. Banks outside Germany took heavy losses on their unsettled trades with Herstatt, add ing
an international dimension to the turmoil. In October the same year, the Franklin National Bank of
New York also closed its doors after incurring large foreign exchange losses.
In response to these and other disruptions in the international financial m arkets, the central bank
governors of the G10 countries established a Committee on Banking Regulations and Supervisory
Practices at the end of 1974. Later renamed the Basel Committee on Banking Supervision, the
Committee was designed as a forum for regular cooperation between its member countries on
banking supervisory matters. Its aim was and is to enhance financial stability by improving
supervisory knowhow and the quality of banking supervision worldwide.
The Committee seeks to achieve its aims by setting minimum standards for the regulation and
supervision of banks; by sharing supervisory issues, approaches and techniques to promote
common understanding and to improve cross-border cooperation; and by exchanging information
on developments in the banking sector and financial markets to help identify current or emerging
risks for the global financial system. Also, to engage with the challenges presented by diversified
financial conglomerates, the Committee also works with other standard-setting bodies.
In October 1996, the Committee released a report on The supervision of cross-border banking,
drawn up by a joint working group that included supervisors from non-G10 jurisdictions and offshore
centres. The document presented proposals for overcoming the impedi ments to effective consolidated
supervision of the cross-border operations of international banks. Subsequently endorsed by
supervisors from 140 countries, the report helped to forge relationships between supervisors in home
and host countries.
The involvement of non-G10 supervisors also played a vital part in the formulation of the
Committee’s Core principles for effective banking supervision in the following year. The impetus for
this document came from a 1996 report by the G7 finance ministers that calle d for effective
supervision in all important financial marketplaces, including those of emerging economies. When
first published in September 1997, the paper set out 25 basic principles that the Basel Committee
believed should be in place for a supervisory system to be effective. After several revisions, most
recently in September 2012, the document now embraces 29 principles, covering supervisory
powers, the need for early intervention and timely supervisory actions, supervisory expectations of
banks, and compliance with supervisory standards.
Basel I: the Basel Capital Accord

With the foundations for supervision of internationally active banks laid, capital adequacy soon
became the main focus of the Committee’s activities. In the early 1980s, the onset of the Latin
American debt crisis heightened the Committee’s concerns that the capital ratios of the main
international banks were deteriorating at a time of growing international risks. Backed by the G10
Governors, Committee members resolved to halt the erosion of capital standards in their banking
systems and to work towards greater convergence in the measurement of capital adequacy. This
resulted in a broad consensus on a weighted approach to the measurement of risk, both on and off
banks’ balance sheets.
There was strong recognition within the Committee of the overriding need for a multinational accord
to strengthen the stability of the international banking system and to remove a source of
competitive inequality arising from differences in national capital requirements. Following
comments on a consultative paper published in December 1987, a capital measurement system
commonly referred to as the Basel Capital Accord (1988 Accord) was approved by the G10
Governors and released to banks in July 1988.

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The 1988 Accord called for a minimum capital ratio of capital to risk-weighted assets of 8% to be
implemented by the end of 1992. Ultimately, this framework was introduced not only in member
countries but also in virtually all other countries with active international banks. In September 1993,
the Committee issued a statement confirming that G10 countries’ banks with material international
banking business were meeting the minimum requirements set out in the Accord.
The Accord was always intended to evolve over time. It was amended first in November 1991. The
1991 amendment gave greater precision to the definition of general provisions or general loan-loss
reserves that could be included in the capital adequacy calculation. In April 1995, the Committee
issued an amendment, to take effect at end-1995, to recognise the effects of bilateral netting of
banks’ credit exposures in derivative products and to expand the matrix of add -on factors. In April
1996, another document was issued explaining how Committee members intended to recognise
the effects of multilateral netting.
The Committee also refined the framework to address risks other than credit risk, which was the
focus of the 1988 Accord. In January 1996, following two consultative processes, the Committee
issued the so-called Market Risk Amendment to the Capital Accord (or Market Risk Amendment),
to take effect at the end of 1997. This was designed to incorporate within the Accord a capital
requirement for the market risks arising from banks’ exposures to foreign exchange, traded debt
securities, equities, commodities and options. An important aspect of the Market Risk Amendment
was that banks were, for the first time, allowed to use internal models (value-at-risk models) as a basis
for measuring their market risk capital requirements, subject to strict quantitative and qualitative
standards. Much of the preparatory work for the market risk package was undertaken jointly with
securities regulators.
Basel II: the new capital framework

In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace
the 1988 Accord. This led to the release of the Revised Capital Framework in June 2004. Generally
known as ‟Basel II”, the revised framework comprised three pillars, namely:
I. Minimum capital requirements, which sought to develop and expand the standardized rules set
out in the 1988 Accord;
II. Supervisory review of an institution’s capital adequacy and internal assessment process; and
III. effective use of disclosure as a lever to strengthen market discipline and encourage sound
banking practices.
The new framework was designed to improve the way regulatory capital requirements reflect
underlying risks and to better address the financial innovation that had occurred in recent years.
The changes aimed at rewarding and encouraging continued improvements in risk measurement
and control.
Basel II Provisions:
In India, various groups of banks are at present subject to differe nt minimum capital requirements
as prescribed in the statutes under which they have been set-up and operate. The foreign banks
operating in India should have foreign funds deployed in Indian business equivalent to 3.5% of their
deposits as at the end of each year. Further there are prescriptions regarding maintenance of
statutory reserves.
As per the new formula, every bank should maintain a minimum capital adequacy ratio based on
capital funds and risk assets. As per the prudential norms, all Indian scheduled commercial banks
(excluding regional rural banks) as well as foreign banks operating in India are required to maintain
capital adequacy ratio (or capital to Risk Weighted Assets Ratio) which is specified by RBI from
time to time.
At present capital adequacy ratio is 9%.*The capital adequacy ratio is worked out as below :
DEFINITION OF CAPITAL FUNDS

144
The Basle Committee has defined capital in two tiers - Tier-I and Tier-II. While Tier- I capital,
otherwise known as core capital, provides the most permanent and readily available support to a
bank against unexpected losses, Tier-II capital contains elements that are less permanent in nature
or less readily available. Norms have been established by the RBI identifying Tier -I and Tier-II
capital for Indian banks and foreign banks.
TIER-I AND TIER-II CAPITAL FOR INDIAN BANKS

Tier I capital (also known are core capital) provides the most permanent and readily available
support to a bank against unexpected losses.
Tier I capital comprises: The aggregate of paid-up capital, statutory reserves; and other disclosed
free reserves including share premium and capital reserves arising out of surplus on sale of assets
As reduced by :
a. intangible assets
b. current and broughtforward losses.
c. The DTA (Deferred tax asset) computed as under should be deducted from Tier I capital:
i) DTA associated with accumulated losses; and
ii) The DTA (excluding DTA associated with accumulated losses), net of DTL. Where the DTL is in
excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be
adjusted against item (i) nor added to Tier I capital.
Tier II capital comprises elements that are less permanent in nature or are less readily available
than those comprising Tier I capital. The elements comprising Tier II capital are as follows :
(a) Undisclosed reserves and cumulative perpetual preference assets
(b) Revaluation reserves - These reserves are taken at a discount of 55% (effective from 1st April,
1994) while determining their value for inclusion in Tier-II capital.
(c) General provisions and loss reserves - General provisions and loss reserves (including general
provision on standard assets) may be taken only up to a maximum of 1.25 per cent of weighted risk
assets.
(d) Hybrid Debt Capital instruments
(e) Subordinated Debt - These often carry a fixed maturity and as they approach maturity, they
should be subjected to progressive discount for inclusion in Tier-II capital. Instrument with an initial
maturity of less than five years or with a remaining maturity of one year sho uld not be included as
part of Tier-II capital. Subordinated debt instrument will be limited to 50% of Tier-I capital.
Ratio of Tier II capital to Tier I capital

The quantum of Tier II capital is limited to a maximum of 100% of Tier I Capital. This seeks to
ensure that the capital funds of a bank predominantly comprise of core capital rather than items of
a less permanent nature. It may be clarified that the Tier II capital of a bank can exceed its Tier I
capital; however, in such a case, the excess will be ignored for the purpose of computing the
capital adequacy ratio.
BASEL III Provisions:

The provisions of Basel III include:
a) The Basel III capital regulation has been implemented from April 1, 2013 in India in phases.
b) To ensure smooth transition to Basel III, appropriate transitional arrangements have been
provided for meeting the minimum Basel III capital ratios, full regulatory adjustments to the
components of capital etc. Consequently, Basel III capital regulations would be fully implemented
as on March 31, 2019.
c) Banks are required to maintain a minimum Pillar 1 Capital to Risk-weighted Assets Ratio (CRAR)
of 9% on an on-going basis (other than capital conservation buffer and Countercyclical capital
buffer etc.).

145
d) Capital requirements for the implementation of Basel III guidelines are lower in the initial periods
and higher in later years.
e) Banks are required to disclose the capital ratios computed under Basel III capital adequacy
framework from the quarter ending 30.06.2013.
f) The RBI may consider prescribing a higher level of minimum capital ratio for each bank under
Pillar 2 framework on the basis of their respective risk profiles and their risk management systems.
g) Banks are required to comply with the capital adequacy ratio at two levels viz. consolidat ed
(Group) and standalone (Solo) level. At consolidated level, the capital adequacy ratio requirements
of a bank measure the capital adequacy of a bank based on its capital strength and risk profile after
consolidating the assets and liabilities of its subsidiaries/joint ventures/associates, etc. except those
engaged in insurance and any non-financial activities. The standalone level capital adequacy ratio
requirements measure the capital adequacy of a bank based on its standalone capital strength and
risk profile. The overseas operations of a bank through its branches will be covered in both the
above scenarios. For the purpose of these guidelines, the subsidiary is an enterprise that is
controlled by another enterprise (known as the parent), etc.
Under the Basel II framework, the total regulatory capital comprises of Tier I (core capital) and Tier
2 capital (supplementary capital). In order to improve the quality and quality of regulatory capital,
capital will predominantly consist of Common Equity under Basel III. Non-equity Tier 1 and Tier 2
capital would continue to form part of regulatory capital subject to eligibility criteria as laid down in
Basel III. Banks have to comply with the regulatory limits and minima as prescribed under Basel III
capital regulations, on an ongoing basis. To ensure smooth transition to Basel III, appropriate
transitional arrangements have been provided for meeting the minimum Basel III capital ratios, full
regulatory adjustments to the components of capital etc. Consequently, Basel III capital regulations
would be fully implemented as on March 31, 2018. In view of the gradual phase -in of regulatory
adjustments to the Common Equity component of Tier 1 capital under Basel III, certain specific
prescriptions of Basel II capital adequacy framework (e.g. rules relating to deductions from
regulatory capital, risk weighting of investments in other financial entities etc.) will also continue to
apply till March 31, 2017.
Minimum Capital Requirements

As in the current accord, the new accord will have the same provisions relating to the regulatory
capital requirement: 9%. However, the difference is in the method of calculating bank risk, which
would, in turn, affect capital requirement.
Regulatory Capital / Risk weighted assets > 9%
Risk weighted assets = {Capital requirements for Market Risk + (Capital requirements for
Operational Risk} + (Risk weighted assets for credit risk )
The accord covers three risks:

1. Credit Risk: The potential that a bank borrower or counter party fails to meet the financial
obligations on the agreed terms.
External Rating Based Internal Ratings Based
Foundation IRB Advanced IRB
Calibrated on the basis of External Ratings Functions provided by Functions provided by
BASEL Committee BASEL Committee
2. Operational Risk: The risk loss arising from the various types of human or technical error,failed
internal process, fraud or the legal hurdles.
Basic Indicator Standardized Advance Measurement
Capital Charge =15% of Capital Charge= 12%-18% of Capital Charge =
three years average gross the gross income per Internally generated data on
income. regularity business line internal& External loss data,
Scenario analysis business

146
environment & Internal Control.
3. Market Risk:-
The standardized approach which specifies the standards in five categories
1. Interest Rate risk
2. Equity Position Risk
3. Foreign Exchange risk
4. Commodities Risk
5. Options risk
The second approach to deal in the market risk is based on the internal assessments of the banks.
The bank needs to consider following five elements in calculating the internal model based risk
structure.
1. General criteria, where the approval from the supervisory authority of the bank
is mandatory.
2. Qualitative standards regarding the maintenance of the Risk management unit
3. Specification of Market Risk Factors
4. Quantitative standards
5. Stress testing to identify the events that could impact the banks.
6. External Validation by External auditors and Supervisory authorities
Supervisory Review Process

The supervisory review process of the framework is intended not only to ensure that banks have
adequate capital to support all the risks in their business but also to encourage the banks to
develop and use better risk management techniques.
The key principles of Supervisory review
1. Banks should have the process for assessing their overall capital adequacy in relation to their risk
profile and a strategy for maintaining their capital levels.
2. Intervention at the early stage to prevent capital from declining to below benchmark level.
3.Review of internal capital adequacy assessment and strategy.
4.Assessment of overall capital in relation with risk profile.
Market Discipline
With the adoption of the IRB approach of the New Accord, according to which banks have greater
discretion in determining their capital needs, market discipline through public disclosure is called
for. This pillar is complementary to the first two pillars of the Model. It seeks to encourage the
market discipline and the public disclosure, so as to allow shareholders, stakeholder s and market
players to know about key information about risk profile and available capital resources. The
disclosure of capital structure, risk measurement and management practices, disclosure of risk
profile of the bank are expected to improve the disclosures of the banks using the Internal Risk
based approaches.
Implementation of the BASEL
The framework is applicable to wide range of the banking system of G-10 countries. In respect of
other countries Basel committee provides that supervisors of the natio n should strengthen the
supervisory system and then develop the road map for due implementation, through proper
planning to switch over to BASEL. There are some benefits of proper compliance with the
provisions of Basel II. If banks and financial institutions develop sophisticated internal risk-
measurement processes and can show them to be sufficiently accurate, they will be allowed to use
these to calculate the capital they must hold against their exposures Improved credit rating systems
and improved management of operational risk will also be of benefit. Organisations that address
compliance effectively will see the up-side to Basel II to be significant improvements in ABC Ltd
service, risk management, decision-making, operational efficiency and cost reduction. All such
improvements build consumer confidence and enhance brand and reputation.
The liability cost of non-compliance will be high, but there is equally a potential cost of attaining
compliance in the wrong way, and there are no prizes for over compliance. Instead over

147
compliance can create barriers to your ABC Ltds and so the key will be to identify best business
practice and implement rigorously.
Composition of Regulatory Capital Under Basel III (Pillar I ):

Banks are required to maintain a minimum Pillar 1 Capital to Risk- weighted Assets Ratio (CRAR)
of 9% on an on-going basis (other than capital conservation buffer and countercyclical capital
buffer etc.). The RBI will take into account the relevant risk factors and the intern al capital
adequacy assessments of each bank to ensure that the capital held by a bank is commensurate
with the bank’s overall risk profile. This would include, among others, the effectiveness of the
bank’s risk management systems in identifying, assessing / measuring, monitoring and managing
various risks including interest rate risk in the banking book, liquidity risk, concentration risk and
residual risk. Accordingly, RBI will consider prescribing a higher level of minimum capital ratio for
each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk
management systems. Further, in terms of the Pillar 2 requirements, banks are expected to operate
at a level well above the minimum requirement.
The total regulatory capital fund will consist of the sum of the following categories:-
(i) Tier 1 Capital (going-concern capital*): comprises of:

(a) Common Equity Tier 1 capital (b) Additional Tier 1 capital
(ii) Tier 2 Capital (gone-concern capital*)

(*From regulatory capital perspective, going-concern capital is the capital which can absorb losses
without triggering bankruptcy of the bank. Gone-concern capital is the capital which will absorb losses
only in a situation of liquidation of the bank).
Banks are required to compute the Basel III capital ratios in the following manner:-
Common Equity Tier 1 Capital Ratio =
Common Equity Tier 1 Capital

Credit Risk RWA* + Market Risk RWA + Operational Risk RWA
Tier 1 Capital Ratio =

Eligible Tier 1 Capital
Total Capital (CRAR) ( 9%) =

Eligible Total Capital (CET 1+ Additional Tier I + Tier II)
DEFINITION OF CAPITAL FUNDS

Common Equity TIER-I, Additional Tier I AND TIER-II CAPITAL FOR INDIAN BANKS:
Common Equity TIER-I (also known are core capital) provides the most permanent and readily
available support to a bank against unexpected losses.
Common Equity TIER-I capital comprises:

i) Common shares (All common shares should ideally be the voting shares as detailed in RBI M. Cir.,
mostly equity share capital & Perpetual Non-Cumulative Preference Shares)
Note: While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit,
Perpetual Non-Cumulative Preference Shares (PNCPS) together with Perpetual Debt Instruments
(PDI) in Additional Tier 1 Capital, more than 1.5% of risk weighted assets. However, once this
minimum total Tier 1 capital has been complied with, any additional PNCPS and PDI issued by the
bank can be included in Total Tier 1 capital reported. Excess PNCPS and PDI can be reckoned to
comply with Tier 2 capital if the latter is less than 2% of RWAs. PNCPS shall not be issued with a
'put option'.

148
ii) Stock surplus (share premium) resulting from the issue of common shares;
iii) Statutory reserves
iv) Capital reserves representing surplus arising out of sale proceeds of assets
v) Other disclosed free reserves, if any
vi) Balance in Profit & Loss Account at the end of previous year
vii) Revaluation reserves at a discount of 55% (that means only 45% to be included) subject to
meeting the following conditions:
• bank is able to sell the property readily at its own will and there is no legal impediment in selling
the property;
• the revaluation reserves are shown under Schedule 2: Reserves & Surplus in the Balance Sheet
of the bank;
• revaluations are realistic, in accordance with Indian Accounting Standards.
• valuations are obtained, from two independent valuers, at least once in every 3 years; where the
value of the property has been substantially impaired by any event, these are to be immediately
revalued and appropriately factored into capital adequacy computations;
• the external auditors of the bank have not expressed a qualified opinion on the revaluation of the
property;
viii) Banks may, at their discretion, reckon foreign currency translation reserve arising due to
translation of financial statements of their foreign operations in terms of Accounting Standard (AS)
11 as CET1 capital at a discount of 25% subject to meeting the following conditions:
• the FCTR are shown under Schedule 2: Reserves & Surplus in the Balance Sheet of the bank;
• the external auditors of the bank have not expressed a qualified opinion on the FCTR.
ix) Profit for current year calculated on quarterly basis provided the incremental provisions made for
non-performing assets at the end of any of the four quarters of the previous financial year have not
deviated more than 25% from the average of the four quarters. The amount which can be reckoned
would be arrived at by using the following formula:
EPt = {NPt – 0.25*D*t} Where;
EPt = Eligible profit up to the quarter ‘t’ of the current financial year; t varies from 1 to 4
NPt = Net profit up to the quarter ‘t’,
D= average annual dividend paid during last three years
Elements of Additional Tier 1 Capital – Indian Schedule Banks:

Elements of Additional Tier 1 capital will remain the same. Additional Tier 1 capital consists of the
sum of the following elements:
(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory
requirements specified as under:
Note: While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit,
(PDI) in Additional Tier 1 Capital, more than 1.5% of risk weighted assets. However, once this
minimum total Tier 1 capital has been complied with, any additional PNCPS and PDI issued by the
bank can be included in Total Tier 1 capital reported. Excess PNCPS and PDI c an be reckoned to
comply with Tier 2 capital if the latter is less than 2% of RWAs.
(ii) Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier
1 capital;
(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with the
regulatory requirements specified as under:
A bank cannot admit Perpetual Debt Instruments (PDI) in Additional Tier 1 Capital, together with
Perpetual Non-Cumulative Preference Shares (PNCPS), more than 1.5% of risk weighted assets.
However, once this minimum total Tier 1 capital has been complied with, any additional PNCPS
and PDI issued by the bank can be included in Total Tier 1 capital reported. Excess PNCPS and
PDI can be reckoned to comply with Tier 2 capital if the latter is less than 2% of RWAs. PDI shall
not be issued with a 'put option'.

149
(iv) Any other type of instrument generally notified by the Reserve Bank from time to time for
inclusion in Additional Tier 1 capital;
(v) While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments
issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for
inclusion in Additional Tier 1 capital as specified; and
Tier 2 : Elements of Tier 2 Capital - Indian Schedule Banks

(i) General Provisions and Loss Reserves
a. Provisions or loan-loss reserves held against future, presently unidentified losses, which are
freely available to meet losses which subsequently materialize, will qualify for inclusion within Tier 2
capital. Accordingly, General Provisions on Standard Assets, Floating Provisions, Provisions held
for Country Exposures, Investment Reserve Account, excess provisions which arise on account of
sale of NPAs and ‘countercyclical provisioning buffer’ will qualify for inclusion in Tier 2 capital.
However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25% of the
total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based
(IRB) approach, where the total expected loss amount is less than total eligible provisions, banks
may recognise the difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted assets
calculated under the IRB approach.
b. Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether
individual or grouped should be excluded. Accordingly, for instance, specific provisions on NPAs,
both at individual account or at portfolio level, provisions in lieu of diminution in the fair value of
assets in the case of restructured advances, provisions against depreciation in the value of
investments will be excluded.
(ii) Debt Capital Instruments (as bonds / debentures) issued by the banks;
(These debt instruments should have a minimum maturity of 10 years and there are no step-ups or
other incentives to redeem.)
The debt instruments shall not have any ‘put option’. Further, the debt instruments shall be
subjected to a progressive discount for capital adequacy purposes. As they approach maturity
these instruments should be subjected to progressive discount as indicated in the table below for
being eligible for inclusion in Tier 2 capital.
Remaining Maturity of Instruments Rate of Discount

(%)
Less than one year 100
One year and more but less than two years 80
Two years and more but less than three years 60
Three years and more but less than four years 40
Four years and more but less than five years 20
(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) /
Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative Preference
Shares (RCPS)] issued by the banks;
(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital;
(v) While calculating capital adequacy at the consolidated level (i.e Banks along with subsidiaries),
Tier 2 capital instruments issued by consolidated subsidiaries of the bank and held by third parties
which meet the criteria for inclusion in Tier 2 capital;
(vi) Any other type of instrument generally notified by the Reserve Bank from time to time for
inclusion in Tier 2 capital; and

150
REGULATORY ADJUSTMENTS/ DEDUCTIONS

a. Goodwill & Intangible assets
In terms of Basel III, goodwill and other intangibles should be deducted from the Common Equity
component of Tier 1.
b. The DTA (Deferred tax asset) computed as under should be deducted from Common Equity
component of Tier 1:
i) DTA associated with accumulated losses; and
ii) The DTA (excluding DTA associated with accumulated losses), net of DTL. Where the DTL is in
excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither
be adjusted against item (i) nor added to Tier I capital.
iii) DTAs which relate to timing differences (other than those related to accumulated losses) may,
instead of full deduction from CET1 capital, be recognised in the CET1 capital up to 10% of a
bank’s CET1 capital, at the discretion of banks [after the application of all regulatory adjustments
c. Cash Flow Hedge Reserve

(i) The amount of the cash flow hedge reserve which relates to the hedging of items that are not fair
valued on the balance sheet (including projected cash flows) should be derecognised in the
calculation of Common Equity Tier 1. This means that positive amounts should be deducted and
negative amounts should be added back.
d. Shortfall of the Stock of Provisions to Expected Losses

The deduction from capital in respect of a shortfall of the stock of provisions to expected losses
under the Internal Ratings Based (IRB) approach should be made in the calculation of Co mmon
Equity Tier 1. The full amount is to be deducted and should not be reduced by any tax effects that
could be expected to occur if provisions were to rise to the level of expected losses.
e. Any gain-on-sale arising at the time of securitisation, if recognised, should be deducted entirely
from Common equity Tier I capital. In terms of guidelines on securitisation of standard assets,
banks are allowed to amortise the profit over the period of the securities issued by the SPV. The
amount of profits thus recognised in the profit and loss account through the amortisation process
need not be deducted.
f. Deduction for Defined Benefit Pension Fund Assets and Liabilities: Under Basel III, defined
benefit pension fund liabilities, as included on the balance sheet, must be fully recognised in the
calculation of Common Equity Tier 1 capital (i.e. Common Equity Tier 1 capital cannot be increased
through derecognising these liabilities or cannot be added to calculated CET 1). For each defined
benefit pension fund that is an asset on the balance sheet, the asset should be deducted in the
calculation of Common Equity Tier 1 net of any associated deferred tax liability which would be
extinguished if the asset should become impaired or derecognized under the relevant accountin g
standards.
g. Investment in a bank’s own shares, etc. is to be deducted appropriately from Common Equity
Tier 1 capital.
h. The investment of banks in the regulatory capital instruments of other financial entities
contributes to the inter-connectedness amongst the financial institutions and hence it should be
deducted from the respective tiers of regulatory capital so as to avoid double counting of capital in
the financial system.
i. Reciprocal cross holdings of capital might result in artificially inflating the capital position of banks
and hence such holdings of capital has to be fully deducted from component of capital (Common
Equity, Additional Tier 1 and Tier 2 capital) for which the capital would qualify if it was issued by the
bank itself,

151
j. Capital instruments which no longer qualify as non-common equity Tier 1 capital or Tier 2 capital
(e.g. IPDI and Tier 2 debt instruments with step-ups) are to be phased out beginning 01.01.2013.
Transitional Arrangements
As per Basel III terms, in order to ensure smooth migration without any near stress, appropriate
transitional arrangements for capital ratios have been made which commenced as on 01.04.2013.
Capital ratios and deductions from Common Equity will be fully phased-in and implemented as on
31.03.2019 and accordingly the phase-in arrangements for Schedule Commercial Bank operating
in India are drawn as under w.e.f March 27, 2014:-
Transitional Arrangements (Excl. Local area bank and RRBs)
Minimum Capital 01.4.13 31.3.14 31.3.15 31.3.16 31.3.17 31.3.18 31.03.2019
Ratio
Common Equity 4.50% 5.00% 5.50% 5.50% 5.50% 5.50% 5.50%
Tier I
Additional Tier I 1.50% 1.50% 1.50% 1.50% 1.50% 1.50% 1.50%

Minimum Tier I 6.00% 6.50% 7.00% 7.00% 7.00% 7.00% 7.00%
Tier II 3.00% 2.50% 2.00% 2.00% 2.00% 2.00% 2.00%
Minimum Total 9.00% 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%
Capital
Capital - - - 0.625% 1.25% 1.875% 2.50%
conservation
buffer*
Minimum Total 9.00% 9.00% 9.00% 9.625% 10.25% 10.875% 11.50%
Capital + CCB
Phase-in of all 20% 40% 60% 80% 100% 100% 100%
deductions from
CET 1
The regulatory adjustments (i.e. deductions and prudential filters) would be fully deducted from
Common Equity Tier 1 only by March 31, 2017. During this transition period, the remainder not
deducted from Common Equity Tier 1 / Additional Tier 1 /Tier 2 capital will continue to be subject to
treatments given under Basel II capital adequacy framework.
*The capital conservation buffer (CCB) is designed to ensure that banks build up capital buffers
during normal times (i.e. outside periods of stress) which can be drawn down as losses incurred
during a stressed period. The requirement is based on simple capital conservation rules designed
to avoid breaches of minimum capital requirements. Outside the period of stress, banks should
hold buffers of capital above the regulatory minimum.
Illustration 1:
From the following information of ALL Banks Ltd., calculate the minimum capital requirement of the
bank for year ending on 31.03.2016 as per Basel III norms.
RWA (in Rs. Cr) : 2,13,163.90
Solution: As per Transitional arrangement, Minimum capital as per Basel III for 31.03.2016 will be :
CET 1: 5.5%, Additional Tier 1 : 1.50%, Tier II : 2% and Capital conservation buffer 0.625%
Accordingly, the following capital is required:
CET 1 : 2,13,163.90 x 5.50% = 11,724.01
Additional Tier I : 2,13,163.90 x 1.50% = 3,197.45
Tier II : 2,13,163.90 x 2% = 4,263.27
CCB : 2,13,163.90 x 0.625% = 1,332.27
Total Minimum required = 11,724.01 + 3,197.45 + 4,263.27 + 1,332.27 = 20,517.00
Illustration 2:
From the following particulars calculate CET1, Additional Tier I and Tier II for SSB Bank Ltd.
Particulars Amt in Millions Amount in Millions

152
Paid up Capital 4,435.60

Reserves & Surplus:
Statutory reserve 91,876.28
Capital reserve 20,695.39
Share premium 90,187.42
Special Reserve u/s 36(I)(VIII) of 44,322.06
I.T. act
Revenue & other reserve 1,42,119.76 3,89,200.91
Borrowings:
From banks 24,328.53
Other institutions and agencies 2,142.75
Repo transaction- 4 days 19,117.00
Capital instrument issued as bonds 50,000.00
– Tier II – 2013 -15 yrs
Subordinated Bonds 51,900.00 1,47,488.28
Other liabilities & provisions:

Bills Payable 21,908.81
Inter Office Adjustment (Net) 7,527.12
Provision against Standard 29,818.04
Advances
Other (including provision) 1,49,079.27 2,08,333.24
Total 7,49,458.03
Note : Capital Reserves include Revaluation Reserves of Rs. 10,003.80
Solution: Please refer to definition of Capital Funds as given on page no. of notes to know what is
required to be included.
Particulars Amt in Millions Amt in Millions

Common Equity Tier I
Paid up Capital 4,435.60
Share premium 90,187.42
Reserves & Surplus:
Statutory reserve 91,876.28
Special Reserve u/s 36(I)(VIII) of I.T. 44,322.06
act E
Capital reserve (including Revaluation 15,193.30
Reserves- ( 55% discount)
Revenue & other reserve 1,42,119.76 3,88,134.42
Additional Tier I
Borrowings:
Subordinated Bonds issued for 51,900.00 51,900.00
Compliance of Add.Tier I
Tier II
Borrowings:
Capital instrument issued as bonds – 50,000.00
Tier II – 2013 -15 yrs
Provision against Standard Advances 29,818.04 79,818.04
Total 5,19,852.46
Illustration 3: The following figures has been drawn from BBR Bank Ltd. (Rs. in Million)
Credit Risk – RWA : 10,02,851.08
Minimum capital required for Market Risk : 7266.56

153
Minimum capital required for Operational Risk : 8283.81

If the total eligible capital is Rs. 1,53,063.15, how much is the CRAR/CAR for the ban k, including
Capital conservation buffer on 31.03.2016.
Solution: The formula for calculation of CAR is
Total eligible capital x 100 RWA for Credit Risk + RWA for Market Risk +
RWA for Operational Risk
Here, we have given figure of total eligible capital is Rs. 1,53,063.15 and also we have RWA for
Credit Risk, but not the RWA for Market & operational risk.
To calculate the RWA for Market & operational risk, we have to do the following calculation:
We know that total minimum capital requirement in % including CCB for 31.03.2016 is = 10.25%,
Minimum capital for Market risk is given as Rs. 7266.56,

Now if we divide Rs. 7266.56, by 10.25%, then
we will get the RWA for Market Risk = Rs. 70,893.26
Same way, Minimum capital for Operational risk is given as Rs. 8283.81,
Now if we divide Rs. 8283.81, by 10.25%, then
we will get the RWA for Market Risk = Rs. 80,817.65
Now, we can put these figures in the formula :

1,53,063.15 x 100 = _1,53,063.15_ x 100 = 13.25%
10,02,851.08 + 70,893.26 + 80,817.65 11,54,561.99
CRAR/CAR for the bank, including Capital conservation buffer on 31.03.2016 = 13.25%
Illustration 4:
ZT Bank has the following position as on 31.03.2016. You are required to calculate CAR, CET 1,
Additional Tier 1, Tier II capital. (Figures in ‘000)
Paid-up Capital 6459.60
Reserves & Surplus:
STATUTORY RESERVE 151816.28
CAPITAL RESERVE (Incl. Revaluation Reserves 9003.80) 20695.39
SHARE PREMIUM 80486.42
Special Reserve u/s 36(I)(VIII) of I.T. act 4812.06
Revenue & other reserve 123129.76
Investment reserve account 1304.63
Borrowings:
From banks 24328.53
Subordinated Bonds ( Directly issued for Add. Tier I) 23381.19
Subordinated Bonds (Remaining maturity 4 yrs. initial maturity was 10 yrs) 35,618.10
Bills Payable 21908.81
Interest Accrued 47810.64
Total credit risk weighted assets 3500359.71

Total market risk weighted assets 209246.58
Total operational risk weighted assets 251873.17
Solution:
Calculation of CET -1
Paid-up Capital 6459.60
SHARE PREMIUM 80486.42

154
Reserves & Surplus:

STATUTORY RESERVE 151816.28
Special Reserve u/s 36(I)(VIII) of I.T. act 4812.06
Revenue & other reserve 123129.76
CAPITAL RESERVE (including Revaluation Reserves- ( 55% discount) 15743.30
Total Common Equity Tier 1 capital (a) 382447.42
Additional Tier 1 capital

Subordinated Bonds ( Directly issued for Add. Tier I) 23381.19
Total Additional Tier 1 capital (b) 23381.19
Tier 2 Calculations
Subordinated Bonds ( Remaining maturity 4 yrs – 20% discount) 28,494.48
General Provisions & Loss Reserves: Investment reserve account 1,304.63
Total Tier 2 capital (c ) 29,799.11
Total Eligible capital for CAR is (a+b+c) 434323.09
Total credit risk weighted assets 3500359.71

Total market risk weighted assets 209246.58
Total operational risk weighted assets 251873.17
Total Risk weighted assets 3961479.46
Capital Adequacy Ratio = 4,34,323.09 x 100 10.96%

39,61,479.46
Common Equity Tier 1 Ratio = 3,82,447.42 x 100 9.65%

39,61,479.46
Additional Tier 1 Ratio = 23,381.19 x 100 0.59%

39,61,479.46
Tier 2 capital Ratio = 29,799.11 x 100 0.75%

39,61,479.46
Illustration 5:
From the following information relating to DSW Bank Ltd., calculate the Tier 1, Additional Tier 1
capital and Tier 2 capital as on 31st March, 2016.
Rs. in lakhs
Capital & Liabilities Amount Amount
Paid up capital A1 5,544.00
Reserves & Surplus 4,39,170.50
Statutory Reserve B1 11736.50
Special Reserve B2 48,848.70
( Out of which created out of last current profit) - 236.00 B3
Securities premium B4 114957.70
Unrealised Investment reserves B5
4.90
Capital reserve B6 2,417.90
Foreign currency translation reserve B7 34984.50
Reserve fund B8 50.90
Revenue and other reserves B10 59636.30
Balance in Profit & Loss account B12 166533.10
( Out of which created out of last current profit) - 53,312.90 B13
Employees stock option outstanding C1 55.30
Borrowings: 10,18,425.42
From RBI D1 61,048.50

155
From banks D2 583036.30

From other institutions & agencies D3 152041.20
Borrowings in the form of bonds & debentures D4 222299.42
Tier II Bonds 10yrs to maturity - 150000.00 D5
Bonds are having 4 years to maturity - 42949.32 D6
Debentures are of 2 years to maturity - 29350.10 D7
Capital instruments D8 2,28,655.20
Perpetual Non cumulative Preference shares D9 3870.00
Securities Premium D10 277.00
Perpetual debt instruments D11 224508.20
Total 16,91,850.42
Total Risk weighted assets 74,62,912.80

Note: Provisions made for non-performing assets at the end of
any of the four quarters of the previous financial year has not
deviated more than 25% from the average of the four quarters.
Average dividend paid for last 3 years is 1,316.00
Answer:
We will first calculate Common Equity Tier 1 from the above:
Paid up capital + B4 ( Securities Premium) 1,20,501.70
Reserves & Surplus
(B1+B2+B5+B6+B7+B8+B10+B12) 3,24,212.80
– ( B3+B9+B11+B13) 54,448.10 2,69,764.70
Profits of current year eligible for inclusion
EPt= {NPt – 0.25*D*t}
Profit for the year = ( B3+B9+B11+B13) 54,448.10
= ( 54,448.10 – 0.25 x 1,316.00 x 4) 53,132.10
Common Equity Tier 1 (Before regulatory deductions) 4,43,398.50
Less:- Regulatory deductions ( no such deduction given) -
Common Equity Tier 1 4,43,398.50
CET 1 Ratio = 443398.50 = 443398.50 x 100 5.94%
Risk weighted assets 7462912.80
Calculation of Additional Tier 1 capital:

For Additional Tier 1 = D9 + D10 + D11 2,28,655.20
(Subject to condition that a bank cannot admit Perpetual Debt 1,11,943.69
Instruments (PDI) in Additional Tier 1 Capital, together with
Perpetual Non-Cumulative Preference Shares (PNCPS), more
than 1.5% of risk weighted assets
- Risk weighted assets 7462912.80 x 1.5%
So Additional Tier I capital will be lower of two above 1,11,943.69
Add.Tier 1 Ratio = 111943.69 = 111943.69 x 100 1.50%
Total Tier I capital will be

Additional Tier I capital 1,11,943.69
Tier I capital (Before regulatory deductions) 5,55,342.19
Tier I capital 5,55,342.19
Tier I capital Ratio will be
Tier 1 Ratio = 555342.19 = 555342.19 x 100 7.44%
Tier 2 capital will be:

156
Borrowings in the form of bonds & debentures = D4

(Subject to maturity discount – refer page no.)
D5 = Tier II Bonds 10yrs to maturity - 150000.00 - discount @ 0% 1,50,000.00
D6 =Bonds are having 4 years to maturity - 42949.32 - discount @ 20% 34,359.46
D7 =Debentures are of 2 years to maturity - 29350.10 - discount @ 60% 11,740.04
So D4 eligible to be included in Tier 2 is 1,96,099.55
Capital instruments (D9+D10+D11) can be included in Tier 2 if Perpetual -
Debt Instruments (PDI) & Perpetual Non-Cumulative Preference Shares
(PNCPS) is less than 2% of RWAs. 2% of RWA (7462912.80) is
1,49,258.25 and hence (D9+D10+D11) is more than it. So no excess can
be included in Tire 2.
Tier 2 capital (Before regulatory deductions) 1,96,099.55

Tier 2 capital 1,96,099.55
Tier 2 capital Ratio will be
CET 1 Ratio = 196099.55 = 196099.55 x 100 2.62%
Total CRAR for bank as on 31st March 2016 is:

Additional Tier I capital 1,11,943.69
Tier 2 capital 1,96,099.55
Total eligible funds for capital adequacy 7,51,441.74
CRAR = 7,51,441.74 = 7,51,441,74 x 100 10.06%
Risk weighted assets 74,62,912.80
Illustration 6:
In Illustration 5 if regulatory deductions is adjusted then the calculations of CET1 will change. It will
be subject to transitional arrangements. The following regulatory deduction is given as on 31st
March,2016.
Rs. in lakhs
Prudential valuation adjustments 187.10
Goodwill (net of related tax liability) 62.70
Other intangibles 1.80
Cash-flow hedge reserve 22.60
Securitisation gain on sale (Recognised) 14.50
Deferred tax assets 222.30
Reciprocal cross-holdings 70.10
Solution: CET 1 & deduction:

Less: Deductions
Prudential valuation adjustments 187.10
Goodwill (net of related tax liability) 62.70
Other intangibles 1.80
Cash-flow hedge reserve 22.60
Securitisation gain on sale 14.50
Deferred tax assets 222.30
Reciprocal cross-holdings 70.10
Total of deduction 581.10
Deduction will be 581.10
Common Equity Tier 1 (After regulatory deductions) 4,42,817.40
DISCLOSURE REQUIREMENTS:

157
1. In order to ensure adequate disclosure of details of the components of capital which aims at
improving transparency of regulatory capital reporting as well as improving market discipline, banks
are required to disclose the following:
(i) a full reconciliation of all regulatory capital elements back to the balance sheet in the audited
financial statements;
(ii) separate disclosure of all regulatory adjustments and the items not deducted from Common
Equity Tier 1
(iii) a description of all limits and minima, identifying the positive and negative elements of capital to
which the limits and minima apply;
(iv) a description of the main features of capital instruments issued; and
(v) banks which disclose ratios involving components of regulatory capital (e.g. “Equity Tier 1”,
“Core Tier 1” or “Tangible Common Equity” ratios) must accompany such disclosures with a
comprehensive explanation of how these ratios are calculated.
2. Banks are also required to make available on their websites the full term s and conditions of all
instruments included in regulatory capital. The Basel Committee will issue more detailed Pillar 3
disclosure shortly, based on which appropriate disclosure norms under Pillar 3 will be issued by
RBI.
3. During the transition phase banks are required to disclose the specific components of capital,
including capital instruments and regulatory adjustments which are benefiting from the transitional
provisions.
→How to calculate Risk weightage assets (RWA):-

In order to calculate the Risk weigtage assets one has to go by taking elements into consideration
of 3 risks as identified by BASEL- II.
I) Credit Risk:-
Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may fail to
meet its obligations in accordance with agreed terms. It is the possibility of losses associated with
diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem
from outright default due to inability or unwillingness of a ABC Ltd or a counterparty to meet
commitments in relation to lending, trading, settlement and other financial transactions.
Alternatively, losses result from reduction in portfolio arising from actual or perceived deterioration
in credit quality.
For most banks, loans are the largest and the most obvious source of credit risk; however, other
sources of credit risk exist throughout the activities of a bank, including in the banking book and in
the trading book, and both on and off balance sheet. Banks increasingly face credit risk (or
counterparty risk) in various financial instruments other than loans, including acceptances, inter -
bank transactions, trade financing, foreign exchange transactions, fin ancial futures, swaps, bonds,
equities, options and in guarantees and settlement of transactions.
The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by
maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit
risk inherent in the entire portfolio, as well as, the risk in the individual credits or transactions.
Banks should have a keen awareness of the need to identify measure, monitor and control credit
risk, as well as, to determine that they hold adequate capital against these risks and they are
adequately compensated for risks incurred.
Credit Risk Measurement by Standardised Approach:

Under the Standardised Approach, the rating assigned by the eligible external credit rating
agencies will largely support the measure of credit risk. The Reserve Bank has identified the
external credit rating agencies that meet the eligibility criteria specified under the revised
Framework. Banks may rely upon the ratings assigned by the external credit rating agencies
chosen by the Reserve Bank for assigning risk weights for capital adequacy purposes as per the
mapping furnished in these guidelines.
1. Claims on Domestic Sovereigns

Both fund based and non fund based claims on the central government 0%

158
Central Government guaranteed claims 0%

Direct loan / credit / overdraft exposure, if any, of banks to the State Governments and 0%
the investment in State Government securities
State Government guaranteed claims 20%
claims on central government exposures will also apply to the claims on the Reserve 0%
Bank of India, DICGC, Credit Guarantee Fund Trust for Micro and Small Enterprises
(CGTMSE), and Credit Risk Guarantee Fund Trust for Low Income Housing (CRGFTLIH)
claims on ECGC 20%
*The above risk weights for both direct claims and guarantee claims will be
applicable as long as they are classified as ‘standard’/ performing assets
Non-performing assets (NPAs)

The unsecured portion of NPA, net of specific provisions (including partial write-offs), will
be risk-weighted as follows
a. when specific provisions are less than 20 per cent of the outstanding amount of the 150%
NPA
b. when specific provisions are at least 20 per cent of the outstanding amount of the NPA 100%
c. when specific provisions are at least 50 per cent of the outstanding amount of the NPA 50%
NPA is fully secured , then
By collateral not recognized for credit mitigation purposes (net of specific provisions), 100 %
when provision reach at 15% of outstanding amount
Claims secured by residential property, (net of specific provisions) 100%
- If the specific provisions on loans are between 20%-50% 75%
- If the specific provisions on loans is more than 50% then 50%
2. Claims on ForeignSovereigns
S&P*/Fetch AAA to AA A BBB BB to B Below B unrated
ratings.
Moody’s rating Aaa to AA A Baa Ba to B Below B unrated
Risk weight 0% 20% 50% 100% 150% 100%

*standard & Poor’s
3. Claims on public sector entities (PSEs)

Domestic PSE :- Will be risk weighted in a manner similar to claims on Corporate.
Foreign PSE :-
S&P/ Fetch AAA to AA A BBB to BB” Below B unrated
Ratings
Moody’s Aaa to Aa A Bbb to Bb Below Ba Unrated
Ratings
RW (%) 20 50 100 150 100
4. Claims on MDBs, BIS and IMF

Assigned a uniform 20% risk weight : for a) World Bank Group: IBRD and IFC, b) Asian
Development Bank, c) African Development Bank, d) European Bank for econstruction &
Development, e) Inter-American Development Bank, f) European Investment Bank, g) European
Investment Fund, h) Nordic Investment Bank, i) Caribbean Development Bank, j) Islamic
Development Bank and k) Council of Europe Development Bank.
Similarly, claims on the International Finance Facility for Immunization (IFFIm) will also a ttract a
20% risk weight.
5. Claims on corporates:- Claims on corporates will include all fund based and non fund based
exposures other than those which qualify for inclusion under ‘sovereign’, ‘bank’, ‘regulatory retail’,

159
‘residential mortgage’, ‘non performing assets’, specified category addressed separately in these
guidelines.
Claims on corporates, including the exposures on Asset Finance companies and Non-Banking
Finance Companies-Infrastructure Finance Companies (NBFC-IFC), shall be risk weighted as per
the ratings assigned by the rating agencies registered with the SEBI and chosen by the Reserve
Bank of India.
a. Long term claimson corporate
Domestic AAA AA A BBB BB & Below Unrated
ratings
agencies
Risk weight 20% 30% 50% 100% 150% 100
b. Short Term Claims on Corporate

India’s Ratings SME Ratings
CARE CRISIL Research and ICRA Brickwork agencies of (%)
private limited India LTD
(India Ratings SMERA(12)
CARE CRISIL A1+ IND A1+ ICRA A1+ Brickwork SMERA A1+ 20
A1+ A+1
CARE A1 CRISILA1 INDA1 ICRA A1 Brickwork SMERA A1 30
A1
CAREA2 CRISIL A2 IND A2 ICRA A2 Brickwork SMERA A2 50
A2
CARE A3 CRISIL A3 IND A3 ICRA A3 Brickwork SMERA A3 100
A3 SMERA
A4&D
CARE CRISIL A4 IND A4 ICRA Brickwork unrated 150
A4&D &D A4&D A4 &D
unrated unrated unrated unrated unrated 100
Note: According to RBI notification dated August 25, 2016, with effect from June 30, 2017, all
unrated claims on Corporates, AFCs, and NBFC-IFCs having aggregate exposure from banking
system of more than INR 200 crore will attract a risk weight of 150%.
However, claims on Corporates, AFCs, and NBFC-IFCs having aggregate exposure from banking
system of more than INR 100 crore which were rated earlier and subsequently have become
unrated will attract a risk weight of 150% with immediate effect.
6. Claims included in the regulatory retail portfolios:- Claims (include both fund-based and non-
fund based) that meet all the four criteria listed below may be considered as retail claims for
regulatory capital purposes and included in a regulatory retail portfolio. Claims included in this
portfolio shall be assigned a risk-weight of 75%.
The following claims, both fund based and non-fund based, shall be excluded from the regulatory
retail portfolio:
(a) Exposures by way of investments in securities (such as bonds and equities), whether listed or
not;
(b) Mortgage Loans to the extent that they qualify for treatment as claims secured by residential
property or claims secured by commercial real estate;
(c) Loans and Advances to bank’s own staff which are fully covered by superannuation benefits
and / or mortgage of flat/ house;
(d) Consumer Credit, including Personal Loans and credit card receivables;
(e) Capital Market Exposures;
(f) Venture Capital Funds.
Four criteria :

160
(i) Orientation criterion - The exposure (both fund-based and non fund-based) is to an individual
person or persons or to a small business; Person under this clause would mean any legal person
capable of entering into contracts and would include but not be restricted to individual, HUF,
partnership firm, trust, private limited companies, public limited companies, co-operative societies
etc. Small business is one where the total average annual turnover is less than Rs. 50 crore. The
turnover criterion will be linked to the average of the last three years in the case of existing entities;
projected turnover in the case of new entities; and both actual and projected turnover for entities
which are yet to complete three years.
(ii) Product criterion - The exposure (both fund-based and non fund-based) takes the form of any of
the following: revolving credits and lines of credit (including overdrafts), term loans and leases (e.g.
instalment loans and leases, student and educational loans) and small business facilities and
commitments.
(iii) Granularity criterion - Banks must ensure that the regulatory retail portfolio is sufficiently
diversified to a degree that reduces the risks in the portfolio, warranting the 75 per cent risk weight.
One way of achieving this is that no aggregate exposure to one counterpart should exceed 0.2 per
cent of the overall regulatory retail portfolio. ‘Aggregate exposure’ means gross amount (i.e. not
taking any benefit for credit risk mitigation into account) of all forms of debt exposures (e.g. loans or
commitments) that individually satisfy the three other criteria. In addition, ‘one counterpart’ means
one or several entities that may be considered as a single beneficiary (e.g. in the case of a small
business that is affiliated to another small business, the limit would apply to the bank's aggregated
exposure on both businesses). While banks may appropriately use the group exposure concept for
computing aggregate exposures, they should evolve adequate systems to ensure strict adherence
with this criterion. NPAs under retail loans are to be excluded from the overall regulatory retail
portfolio when assessing the granularity criterion for risk-weighting purposes.
(iv) Low value of individual exposures - The maximum aggregated retail exposure to one
counterpart should not exceed the absolute threshold limit of Rs. 5 crore.
7. Claims secured by residential property: w.e.f 07.06.2017

Lending to individuals meant for acquiring residential property which are fully secured by
mortgages on the residential property that is or will be occupied by the borrower, or that is rente d,
shall be risk weighted as indicated below, based on Board approved valuation policy. LTV ratio
should be computed as a percentage with total outstanding in the account (viz. “principal + accrued
interest + other charges pertaining to the loan” without any netting) in the numerator and the
realisable value of the residential property mortgaged to the bank in the denominator.
Category of Loan LTV Ratio Risk Weight %

(a) Individual Housing Loans
(i) Up to Rs. 30 lakh
a. Less than or equal to 80% 35
b. Above 80% to less than or equal 50
to 90%
(ii) Above Rs. 30 lakh and up to 75 lakh Less than or equal to 80% 35
(iii) Above Rs. 75 lakh Less than or equal to 75% 50
(b) Commercial Real Estate – Residential NA 75
Housing (CRE-RH)
(c) Commercial Real Estate (CRE) NA 100
Note:
1. Restructured housing loans should be risk weighted with an additional risk weight of 25 per cent
to the risk weights prescribed above.
2. The LTV ratio should not exceed the prescribed ceiling in all fresh cases of sanction. In case the
LTV ratio is currently above the ceiling prescribed for any reasons, efforts shall be made to bring it
within limits.

161
3. CRE-RH means integrated housing projects comprising of some commercial space (e.g.
shopping complex, school, etc.) can also be classified under CRE-RH, provided that the
commercial area in the residential housing project does not exceed 10% of the total Floor Space
Index (FSI) of the project. In case the FSI of the commercial area in the predominantly residential
housing complex exceeds the ceiling of 10%, the project loans should be classified as CRE and not
CRE-RH.
8. Other Assets :-
1. Consumer credit, including personal loans and credit card receivables but excluding educational
loans, will attract a higher risk weight of 125 per cent or higher, if warranted by the external rating
(or, the lack of it) of the counterparty.
2. Loans and advances to bank’s own staff which are fully covered by superannuation benefits
and/or mortgage of flat/ house will attract a 20 per cent risk weight. Since flat / house is not an
eligible collateral and since banks normally recover the dues by adjusting the superannuation
benefits only at the time of cessation from service, the concessional risk weight shall be applied
without any adjustment of the outstanding amount. In case a bank is holding eligible collateral in
respect of amounts due from a staff member, the outstanding amount in respect of that staff
member may be adjusted to the extent permissible.
3. Other loans and advances to bank’s own staff will be eligible for inclusion under regulatory retail
portfolio and will therefore attract a 75 per cent risk weight.
4. All other assets will attract a uniform risk weight of 100 per cent
Illustration:
ABC bank has the following assets. Calculate the risk weighted assets as per prescribed Basel II
norms:
Rs. in cr.
Educational Loan Rs.50
Retail loan portfolio(consumer finance) Rs.80
Credit card receivables Rs.35
Staff Advance ( secured by residential property) Rs.25
Housing loan
Upto 30 lakhs (LTV 90%) Rs.35
Above 75 lakhs (LTV 75%) Rs.10
CRE- H Rs.20
CRE Rs.25
Premises (Bank) Rs.10
Ans:
Particulars Exposure Classification Risk Capital
weight charge
Educational Loan Rs.50 Retail 75% 37.50
Retail loan portfolio(consumer finance) Rs.80 Retail 75% 60.00
Credit card receivables Rs.35 Other asset 125% 43.75
Staff Advance ( secured by residential Rs.25 Other asset 20% 5.00
property)
Housing loan Claim
secured by
Upto 30 lakhs (LTV 90%) Rs.35 Residential 50% 17.50
Property
Above 75 lakhs (LTV 75%) Rs.10 --“-- 50% 5.00
CRE- H Rs.20 --“-- 75% 15.00
CRE Rs.25 --“-- 100% 25.00
Premises (Bank) Rs.10 Other asset 0 0.00
Total 208.75
Off-balance sheet exposures:
The risk-weighted amount of an off-balance sheet item that gives rise to credit exposure is
generally calculated by means of a two-step process:

162
(a) the notional amount of the transaction is converted into a credit equivalent amount, by
multiplying the amount by the specified credit conversion factor or by applying the current exposure
method, and
(b) the resulting credit equivalent amount is multiplied by the risk weight applicable to the
counterparty or to the purpose for which the bank has extended finance or the type of asset,
whichever is higher.
The credit equivalent amount in relation to a non-market related off-balance sheet item like, direct
credit substitutes, trade and performance related contingent items and commitments with certain
drawdown, other commitments, etc. will be determined by multiplying the contracted amount of that
particular transaction by the relevant credit conversion factor (CCF).
Where the non-market related off-balance sheet item is an undrawn or partially undrawn fund-
based facility, the amount of undrawn commitment to be included in calculating the off-balance
sheet non-market related credit exposures is the maximum unused portion of the commitment that
could be drawn during the remaining period to maturity. Any drawn portion of a commitment forms
a part of bank's on-balance sheet credit exposure.
Credit conversion Factor (CCF):

Sr. No. Instruments Credit
Conversion
Factor (%)
1. Direct credit substitutes e.g. general guarantees of indebtedness (including 100
standby L/Cs serving as financial guarantees for loans and securities, credit
enhancements, liquidity facilities for securitisation transactions), and
acceptances (including endorsements with the character of acceptance).
(i.e., the risk of loss depends on the credit worthiness of the counterparty or
the party against whom a potential claim is acquired)
2. Certain transaction-related contingent items (e.g. performance bonds, bid 50
bonds, warranties, indemnities and standby letters of credit related to
particular transaction).
3. Short-term self-liquidating trade letters of credit arising from the movement 20
of goods (e.g. documentary credits collateralised by the underlying
shipment) for both issuing bank and confirming bank.
4. Sale and repurchase agreement and asset sales with recourse, where the 100
credit risk remains with the bank.
(These items are to be risk weighted according to the type of asset and not
according to the type of counterparty with whom the transaction has been
entered into.)
5. Forward asset purchases, forward deposits and partly paid shares and 100
securities, which represent commitments with certain drawdown.
(These items are to be risk weighted according to the type of asset and not
according to the type of counterparty with whom the transaction has been
entered into.)
6 Lending of banks’ securities or posting of securities as collateral by banks, 100
including instances where these arise out of repo style transactions (i.e.,
repurchase / reverse repurchase and securities lending / securities
borrowing transactions)
7. Note issuance facilities and revolving / non-revolving underwriting facilities. 50
8 Commitments with certain drawdown 100
9. Other commitments (e.g., formal standby facilities and credit lines) with an
original maturity of
a) up to one year 20
b) over one year 50
Similar commitments that are unconditionally cancellable at any time by the 0
bank without prior notice or that effectively provide for automatic cancellation
due to deterioration in a borrower’s credit worthiness
10. Take-out Finance in the books of taking-over institution

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(i) Unconditional take-out finance 100

(ii) Conditional take-out finance 50
For classification of banks guarantees viz. direct credit substitutes and transaction -related
contingent items etc. (Sr. No. 1 and 2 of Table above), the following principles should be kept in
view for the application of CCFs:
(a) Financial guarantees are direct credit substitutes wherein a bank irrevocably undertakes to
guarantee the repayment of a contractual financial obligation. Financial guarantees essentially
carry the same credit risk as a direct extension of credit i.e., the risk of loss is directly linked to the
creditworthiness of the counterparty against whom a potential claim is acquired. An indicative list of
financial guarantees, attracting a CCF of 100 per cent is as under: i. Guarantees for credit facilities;
ii. Guarantees in lieu of repayment of financial securities; iii. Guarantees in lieu of margin
requirements of exchanges; iv. Guarantees for mobilisation advance, advance money before the
commencement of a project and for money to be received in various stages of project
implementation; v. Guarantees towards revenue dues, taxes, duties, levies etc. in favour of Tax/
Customs / Port / Excise Authorities and for disputed liabilities for litigation pending at courts; vi.
Credit Enhancements; vii. Liquidity facilities for securitisation transactions; viii. Acceptances
(including endorsements with the character of acceptance); ix. Deferred payment guarantees.
(b) Performance guarantees are essentially transaction-related contingencies that involve an

irrevocable undertaking to pay a third party in the event the counterparty fails to fulfil or perform a
contractual non- financial obligation. In such transactions, the risk of loss depends on the event
which need not necessarily be related to the creditworthiness of the counterparty involved. An
indicative list of performance guarantees, attracting a CCF of 50 per cent is as under:
(i) Bid bonds; (ii) Performance bonds and export performance guarantees; (iii) Guarantees in lieu of
security deposits / earnest money deposits (EMD) for participating in tenders; (iv)Retention money
guarantees; (v) Warranties, indemnities and standby letters of credit related to particular
transaction.
Market related Off-Balance Sheet Items

Market related off-balance sheet items would include:
a) interest rate contracts – including single currency interest rate swaps, basis swaps, forward rate
agreements, and interest rate futures;
b) foreign exchange contracts, including contracts involving gold, – includes cross currency swaps
(including cross currency interest rate swaps), forward foreign exchange contracts, currency
futures, currency options;
c) any other market related contracts specifically allowed by the Reserve Bank which give rise to
credit risk.
Exemption from capital requirements is permitted for :
a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or
less; and
b) instruments traded on futures and options exchanges which are subject to daily mark-to-market
and margin payments.
The credit equivalent amount of a market related off-balance sheet item, whether held in the
banking book or trading book must be determined by the current exposure method.
Current Exposure Method

(i) The credit equivalent amount of a market related off-balance sheet transaction calculated using
the current exposure method is the sum of current credit exposure and potential future credit
exposure of these contracts. While computing the credit exposure banks may exclude ‘sold
options’, provided the entire premium / fee or any other form of income is received / realised.
(ii) Current credit exposure is defined as the sum of the positive mark-to-market value of these
contracts. The Current Exposure Method requires periodical calculation of the current credit
exposure by marking these contracts to market, thus capturing the current credit exposure.

164
(iii) Potential future credit exposure is determined by multiplying the notional principal amount of
each of these contracts irrespective of whether the contract has a zero, positive or negative mark - to-
market value by the relevant add-on factor indicated below according to the nature and residual
maturity of the instrument.
Credit Conversion Factors for Market-Related Off-Balance Sheet Items

Credit conversion Factor (%)
Interest rate Exchange rate
contracts contracts & Gold
One year or less 0.50 2.00
Over one year to five years 1.00 10.00
Over five years 3.00 15.00
Illustration:
Find out from the following information risk weighted asset for non market related off balance sheet
item:
In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally cancellable) where
the drawn portion is Rs. 60 lakh, the undrawn portion of Rs. 40 lakh, credit rating being A2+ for the
said customer. Another customer having credit rating of A+ has been sanctioned TL of Rs. 700 cr
is sanctioned for a large project which can be drawn down in stages over a three year period. The
terms of sanction allow draw down in three stages – Rs. 150 cr in Stage I, Rs. 200 cr in Stage II
and Rs. 350 cr in Stage III, where the borrower needs the bank’s explicit approval for draw down
under Stages II and III after completion of certain formalities. If the borrower has drawn already Rs.
50 cr under Stage I.
Answer:
Off balance sheet items Amt. . Credit conversion Credit after Risk weight Risk
factor conversion (refer weighted
claims on asset,
Amt. corporate) Amt.
a. Undrawn CC Rs.40 20% (CCF table Rs.8.00 lakhs 50% Rs.4.00 lakhs
lakhs item 3 pg.no 162)
b. Undrawn TL within 1 Rs.100 20% (CCF table Rs.20.00 Cr 50% Rs.10.00 cr
year* cr. item 9 pg.no
162))
Total Rs.10.04 cr
* If Stage I is scheduled to be completed within one year, the CCF will be 20% and if it is more than
one year then the applicable CCF will be 50 %.
II. Credit Risk Mitigation:

Banks use a number of techniques to mitigate the credit risks to which they are exposed. For
example, exposures may be collateralised in whole or in part by cash or securities, deposits from
the same counterparty, guarantee of a third party, etc. The revised approach to credit risk
mitigation allows a wider range of credit risk mitigants to be recognised for regulatory capital
purposes than is permitted under the 1988 Framework provided these techniques meet the
requirements for legal certainty.
Credit risk mitigation approach as detailed in this section is applicable to the banking book
exposures.
1. Credit risk mitigation techniques - Collateralised transactions

A collateralised transaction is one in which:
(i) banks have a credit exposure and that credit exposure is hedged in whole or in part by collateral
posted by a counterparty or by a third party on behalf of the counterparty. Here, “counterparty” is
used to denote a party to whom a bank has an on- or off-balance sheet credit exposure.
(ii) banks have a specific lien on the collateral and the requirements of legal certainty are met.

165
i) The comprehensive approach

In the comprehensive approach, when taking collateral, banks will need to calculate their adjusted
exposure to a counterparty for capital adequacy purposes in order to take account of the effects of
that collateral. Banks are required to adjust both the amount of the exposure to the counterparty
and the value of any collateral received in support of that counterparty to take account of possible
future fluctuations in the value of either, occasioned by market movements. These adjustments are
referred to as ‘haircuts’. The application of haircuts will produce volatility adjusted amounts for both
exposure and collateral. The volatility adjusted amount for the exposure will be higher than the
exposure and the volatility adjusted amount for the collateral will be lower than the collateral, unless
either side of the transaction is cash. In other words, the ‘haircut’ for the exposure will be a
premium factor and the ‘haircut’ for the collateral will be a discount factor. It may be noted that the
purpose underlying the application of haircut is to capture the market-related volatility inherent in
the value of exposures as well as of the eligible financial collaterals. Since the valu e of credit
exposures acquired by the banks in the course of their banking operations, would not be subject to
market volatility, (since the loan disbursal / investment would be a “cash” transaction) though the
value of eligible financial collateral would be, the haircut stipulated in Table-14 would apply in
respect of credit transactions only to the eligible collateral but not to the credit exposure of the
bank.
ii) Additionally where the exposure and collateral are held in different currencies an additional
downwards adjustment must be made to the volatility adjusted collateral amount to take account of
possible future fluctuations in exchange rates.
iii) Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral
amount
(including any further adjustment for foreign exchange risk), banks shall calculate their risk -
weighted assets as the difference between the two multiplied by the risk weight of the counterparty.
2. Eligible financial collateral The following collateral instruments are eligible for recognition in
the comprehensive approach:
(i) Cash (as well as certificates of deposit or comparable instruments, including fixed deposit
receipts, issued by the lending bank) on deposit with the bank which is incurring the counterparty
exposure.
(ii) Gold: Gold would include both bullion and jewellery. However, the value of the collateralised
jewellery should be arrived at after notionally converting these to 99.99 purity.
(iii) Securities issued by Central and State Governments
(iv) Kisan Vikas Patra and National Savings Certificates provided no lock-in period is operational
and if they can be encashed within the holding period.
(v) Life insurance policies with a declared surrender value of an insurance company which is
regulated by an insurance sector regulator.
(vi) Debt securities rated by a chosen Credit Rating Agency in respect of which the banks should
be sufficiently confident about the market liquidity where these are either:
a) Attracting 100 per cent or lesser risk weight i.e., rated at least BBB(-) when issued by public
sector entities and other entities (including banks and Primary Dealers); or
b) Attracting 100 per cent or lesser risk weight i.e., rated at least CARE A3/ CRISIL A3/IND
A3/ICRA A3/Brickwork A3/ SMERA A3for short-term debt instruments.
vii) Debt securities not rated by a chosen Credit Rating Agency in respect of which the banks
should be sufficiently confident about the market liquidity where these are:
a) issued by a bank; and
b) listed on a recognised exchange; and
c) classified as senior debt; and
d) all rated issues of the same seniority by the issuing bank are rated at least BBB(-) or CARE A3/
CRISIL A3/IND A3/ICRA A3/Brickwork A3/ SMERA A3by a chosen Credit Rating Agency; and
e) the bank holding the securities as collateral has no information to suggest that t he issue justifies
a rating below BBB(-) or BBB(-) or CARE A3/ CRISIL A3/IND A3/ICRA A3/Brickwork A3/ SMERA
A3 (as applicable) and;

166
f) Banks should be sufficiently confident about the market liquidity of the security.
viii) Units of Mutual Funds regulated by the securities regulator of the jurisdiction of the bank’s
operation mutual funds where:
a) a price for the units is publicly quoted daily i.e., where the daily NAV is available in public
domain; and
b) Mutual fund is limited to investing in the instruments listed in this paragraph.
ix) Re-securitisations, irrespective of any credit ratings, are not eligible financial collateral.
3. Calculation of capital requirement

For a collateralised transaction, the exposure amount after risk mitigation is calculated as follows:
E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx )]}

Where:
E* = the exposure value after risk mitigation
E = current value of the exposure for which the collateral qualifies as a risk Mitigant
He = haircut appropriate to the exposure
C = the current value of the collateral received
Hc = haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between the collateral and exposure
Standard Supervisory Haircuts for Sovereign and other securities which

constitute Exposure and Collateral
Sl. No. Issue Rating by accredited ECAIs (CARE/ Residual Haircut
CRISIL/ India Ratings/ ICRA/ Maturity (in percentage)
Brickwork/SMERA) for Debt securities (in years)
A Securities issued / guaranteed by the
Government of India and issued by the
State Governments (Sovereign securities)
< or = 1 year 0.5
i Rating not applicable – as Government > 1 year and 2
securities are not currently rated in India < or = 5 years
> 5 years 4
B Domestic debt securities other than
those indicated at Item No. A above
including the securities guaranteed
by Indian State Governments
ii. AAA to AA < or = 1 year 1
PR1/P1/F1/A1 > 1 year and < or = 5 4
years
> 5 years 8
iii. A to BBB < or = 1 year 2
PR2 / P2 / F2 /A2;
PR3 /P3 / F3 / A3 and unrated bank > 1 year and < or = 5 6
securities as specified in paragraph years
7.3.5 (vii) of the circular > 5 years 12
iv. Units of Mutual Funds Highest haircut
applicable to any of
the above securities,
in which the eligible
mutual fund can
invest
C Cash in the same currency 0
D Gold 15
E Securitisation Exposures
ii. AAA to AA < or = 1 year 2

167
> 1 year and < or = 5 8

years
> 5 years 16
iii. A to BBB < or = 1 year 4
and unrated bank securities as
specified in paragraph 7.3.5 (vii) of
the circular
> 1 year and < or = 5 12
years
> 5 years 24
Credit Risk Mitigation Techniques - Guarantees

Where guarantees are direct, explicit, irrevocable and unconditional banks may take account of
such credit protection in calculating capital requirements.
A range of guarantors are recognised. Only guarantees issued by entities with a lower risk weight
than the counterparty will lead to reduced capital charges since the protected portion of the
counterparty exposure is assigned the risk weight of the guarantor, whereas the uncovered portion
retains the risk weight of the underlying counterparty. For e.g. If Bank A has credit rating of AA and
the guarantee issued to PSU has rating of AAA, then only credit risk mitigation is possible here and
not otherwise.
Range of Eligible Guarantors (Counter-Guarantors) Credit protection given by the following entities
will be recognised:
(i) Sovereigns, sovereign entities (including BIS, IMF, European Central Bank and European
Community as well as MDBs, ECGC and CGTMSE), banks and primary dealers with a lower risk
weight than the counterparty;
(ii) Other entities that are externally rated except when credit protection is provided to a
securitisation exposure. This would include credit protection provided by parent, subsidiary and
affiliate companies when they have a lower risk weight than the obligor.
(iii) when credit protection is provided to a securitisation exposure, other entities that currently are
externally rated BBB- or better and that were externally rated A- or better at the time the credit
protection was provided. This would include credit protection provided by parent, subsidiary and
affiliate companies when they have a lower risk weight than the obligor.
Risk Weights: The protected portion is assigned the risk weight of the protection provider.
Exposures covered by State Government guarantees will attract a risk weight of 20 per cent. The
uncovered portion of the exposure is assigned the risk weight of the underlying counterparty.
Illustration:
ABC bank has the following exposure to Corporate sector secured by financial assets. Find out the
credit risk weighted asset for these assets:
INR in Cr.
Party Amount in INR Maturity of Collateral Value of Exposure
exposure & collateral Rating
also of
collateral
S Ltd 15.00 2 Mutual Fund( AA) 15.00 AA
Y Ltd 10.00 3 Sovereign Bond 10.00 BBB
Z Ltd 25.00 6 Gold 26.00 A
Answer:
Party S Ltd Y Ltd Z Ltd
Exposure 15.00 10.00 25.00
Rating of Exposure AA BBB A
Risk Weight ( see pg no.158) 30% 100% 50%
Hair cut for exposure 0 0 0
Collateral value 15.00 10.00 26.00
Collateral Mutual Sovereign Gold
Fund( AA) Bond

168
Maturity of collateral 2 3 6
Hair cut for collateral(see p.no.166) 4% 2% 15%
Applying the credit risk mitigation formula on the above:
E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx )]}

where:
E* = the exposure value after risk mitigation
E = current value of the exposure for which the collateral qualifies as a risk Mitigant
He = haircut appropriate to the exposure
C = the current value of the collateral received
Hc = haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between the collateral and exposure
For S Ltd:
E* = max {0, [15 x (1 + 0) - 15 x (1 – 0.04 - 0 )]}
= max of 0 or [0.60]
Means the collateral value after mitigation is 15-0.60 = 14.40
So the net exposure is 15 – 14.40 = 0.60
RWA = 0.60 x Risk weight of exposure which is 30%
= 0.18 Cr.
For Y Ltd:
E* = max {0, [10 x (1 + 0) - 10 x (1 – 0.02 - 0 )]}
= max of 0 or [0.20]
= 0.20 Cr.
For Z Ltd:
E* = max {0, [25 x (1 + 0) - 26 x (1 – 0.15 - 0 )]}
= max of 0 or [2.90]
= 0.95 Cr.
Credit Risk Measurement by Internal Ratings Based Approach:

In this approach, banks that meet certain criteria are permitted to use their own estimated risk
parameters to calculate regulatory capital required for credit risk. Here, the credit risk will be
calculated on the basis of probability of default (PD) for each asset, while the regulator will
determine Loss Given Default (LGD), and Exposure at Default (EAD) as also the Recovery Rate
(RR).
Probability of default (PD) means, the likelihood that the borrower will fail to make full and timely
repayment of its financial obligations; LGD means the amount of the loss if there is a default,
expressed as a percentage of the EAD, Exposure at Default (EAD), the expected value of the loan
at the time of default.
Credit Risk will be calculated with the following formula under IRB:
Expected Loss = (1-PD) x PD x LGD x EAD = PD x LGD x EAD
Illustration:
AU Bank Ltd has a exposure to one entity to the tune of Rs.78 cr @ 11.5% p.a. The loan tenure is
7 yrs. The exposure is currently valued at Rs.52cr. The bank is assessing its position on this
advance and wants to know the expected loss on this exposure if, probability of default is 40%. The
given loss if exposure is at default is 22% of exposure. What is the expected loss to the bank?

169
Solution:
Probability of default (PD) : 40%, Exposure at Default (EAD) 52cr & Loss Given Default (LGD) is
22%
Expected Loss = PD x LGD x EAD = 0.40 x 52cr x 0.22 = 4.58cr
(3) Capital charge for MarketRisk

Introduction: Market risk is defined as the risk of losses in on-balance sheet and off-balance
sheet positions arising from movements in market prices. The market risk positions subject to
capital charge requirement are:
(i) The risks pertaining to interest rate related instruments and equities in the trading book; and
(ii) Foreign exchange risk (including open position in precious metals) throughout the bank ( both
banking and trading books).
Scope and coverage of capital charge for Market Risks: These guidelines seek to address the
issues involved in computing capital charges for interest rate related instruments in the trading
book, equities in the trading book and foreign exchange risk (including gold and other precious
metals) in both trading and banking books. Trading book for the purpose of capital adequacy will
include:
(i) Securities included under the Held for Trading category
(ii) Securities included under the Available for Sale category
(iii) Open gold position limits
(iv) Open foreign exchange position limits
(v) Trading positions in derivatives, and
(vi) Derivatives entered into for hedging trading book exposures.
(i) Interest rate related Instruments (Trading book):

The minimum capital requirement is expressed in terms of two separately calculated charges,
(a) "specific risk" charge for each security, which is designed to protect against an adverse
movement in the price of an individual security owing to factors related to the individual issuer, both
for short (short position is not allowed in India except in derivatives and Central Government
Securities) and long positions, and
(b) "general market risk" charge towards interest rate risk in the portfolio, where long and short
positions (which is not allowed in India except in derivatives) in different securities or instruments
can be offset.
(a) Specific Risk: The capital charge for specific risk is designed to protect against an adverse
movement in the price of an individual security owing to factors related to the individual issuer. The
specific risk charges for various kinds of exposures would be applied as given in RBI circular.
(b) General market Risk: The Basle Committee has suggested two broad methodologies for
computation of capital charge for general market risks. One is the standardised method and the
other is the banks’ internal risk management models method. As banks in India are still in a
nascent stage of developing internal risk management models, it has been decided that, to star t
with, banks may adopt the standardised method. Under the standardised method there are two
principal methods of measuring market risk, a “maturity” method and a “duration” method. As
“duration” method is a more accurate method of measuring interest rate risk, it has been decided to
adopt standardised duration method to arrive at the capital charge. Accordingly, banks are required
to measure the general market risk charge by calculating the price sensitivity (modified duration) of
each position separately. Under this method, the mechanics are as follows:
(i) first calculate the price sensitivity (modified duration) of each instrument;
(ii) next apply the assumed change in yield to the modified duration of each instrument between 0.6
and 1.0 percentage points depending on the maturity of the instrument (see Table attached with
RBI circular);
(iii) slot the resulting capital charge measures into a maturity ladder with the fifteen time band s as
set out in Table attached with RBI circular;

170
(iv) subject long and short positions (short position is not allowed in India except in derivatives) in
each time band to a 5 per cent vertical disallowance designed to capture basis risk; and
(v) carry forward the net positions in each time-band for horizontal offsetting subject to the
disallowances set out in Table attached with RBI circular.
(ii)Equities in Trading books:

Specific and general market risk :Capital charge for specific risk (akin to credit risk) will be 11.25%
or capital charge in accordance with the risk warranted by external rating of the counterparty,
whichever is higher and specific risk is computed on banks' gross equity positions (i.e. the sum of
all long and all short equity positions - short equity position is, however, not allowed for banks in
India).
Specific Risk Capital Charge for banks’ investment in Security Receipts will be 13.5% (equivalent to
150 per cent risk weight). Since the Security Receipts are by and large illiquid and not traded in the
secondary market, there will be no General Market Risk Capital Charge on them.
The general market risk charge will also be 9 per cent on the gross equity positions. Capital
charges for specific risk and general market risk are to be computed separately before aggregation.
For computing the total capital charge for market risks, the calculations may be plotted in the
following table:
Proforma
Risk category Capital Charge

I. Interest Rate a + b
a. General market risk
i) Net position (parallel shift)
ii) Horizontal disallowance (curvature)
iii)Vertical disallowances basis
iv)Options
b) Specific Risk
II. Equity A+B
a. General market risk
b. Specific risk
III. Foreign Exchange and gold
IV. Total capital charge for market Risk (I+ II+ III)
3. Measurement of capital charge for foreign exchange risk

The bank’s net open position in each currency should be calculated by summing:
• The net spot position (i.e. all asset items less all liability items, including accrued interest,
denominated in the currency in question);
• The net forward position (i.e. all amounts to be received less all amounts to be paid under
forward foreign exchange transactions, including currency futures and the principal on
currency swaps not included in the spot position);
• Guarantees (and similar instruments) that are certain to be called and are likely to be
irrecoverable;
• Net future income/expenses not yet accrued but already fully hedged (at the discretion of
the reporting bank);
• Depending on particular accounting conventions in different countries, any other item
representing a profit or loss in foreign currencies;
• The net delta-based equivalent of the total book of foreign currency options
Foreign exchange open positions and gold open positions are at present risk-weighted at 100 per
cent. Thus, capital charge for market risks in foreign exchange and gold open position is 9 per cent.
These open positions, limits or actual whichever is higher, would continue to attract capital
charge at 9 per cent. This capital charge is in addition to the capital charge for credit risk on the on-
balance sheet and off-balance sheet items pertaining to foreign exchange and gold transactions.

171
III. Capital Charge for Operational risk:-

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events. This definition includes legal risk, but excludes
strategic and reputational risk. Legal risk includes, but is not limited to, exposure to fines, penalties,
or punitive damages resulting from supervisory actions, as well as private settlements.
The New Capital Adequacy Framework provides that internationally active banks and banks with
significant operational risk exposures are expected to use an approach that is more sophisticated
than the Basic Indicator Approach and that is appropriate for the risk profile of the institution.
However, to begin with, banks in India shall compute the capital requirements for operational risk
under the Basic Indicator Approach. Reserve Bank will review the capital requirement produced by
the Basic Indicator Approach for general credibility, especially in relation to a bank’s peers and in
the event that credibility is lacking, appropriate supervisory action under Pillar 2 will be considered.
For details refer chapter 5 Module B
►How to calculate the general market risk & credit risk: Illustration 1:
Market Risk:- General Risk
Suppose a bank has invested in AAA rated bond in trading book with HFT category for Rs.100cr.
The bond carries coupon rate of 8% and currently traded at Rs.104/- and having maturity period of
2 years. Interest payments are semiannual. To calculate the capital charge for market risk the
following steps has to be followed:
Step 1:- calculate the current yield of the bond :-

Rs. 8 cr = 7.70%
Rs. 104
That means 0.077
Step 2 :- Calculate the duration of the above bond
Time period ( Interest receipts) 0.5 1 1.5 2

( A)
Inflow ( Intt + Maturity- last yr) 4 cr 4 cr 4 cr 104 cr
(B)
PV at yield 7.70% 4/(1+0.077/2)1 + 4/(1+0.077/2)2 + 4/(1+0.077/2)3 + 104/(1+0.077/2)4
(C) = 4/1.038 + 4/1.078 + 4/1.120 + 104/1.163
= 3.85 cr + 3.71 + 3.57 + 89.42
PV* Time ( C*A) = 1.92 + 3.71 + 5.35 + 178.84
Total Time weighted PV = 189.82 Cr.
Macaulay Duration in Years = Total Time weighted PV / Current market price of bond
= 189.82/104
= 1.82 years
Step 3 :- Calculate modified duration : Modified duration measures the percent change in a bond’s
price for a 1% change in its yield to maturity;
Modified Duration = Duration / { 1 + (Yield /no. of interest period in a year)}

= 1.82 / { 1+ (0.077/2)}
= 1.82/1.038 = 1.75 years
Note :- If you want to know that how much bond price will change if there is a change in
yield by one basis point ( 1% means 100 Bps), then use the following formula
= Modified Duration* ( Market Price/Face value of Bond)
Here, 1.75/(104/100) =1.68 and in Rs. terms it will be 0.016 paisa.
Step 4:- Apply the assumed change in yield to the modified duration according to classification
given in Table 17 (master circular)
Here, the modified duration is 1.51 and table value is Zone 2 – 0.90

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That means the risk value will have to be applied to 90 basis points to the portfolio.
= 1.51 x 0.90% = 0.013
Step 5 :-Since security is in HFT we will multiply the factor 1.26 to market value of security which is
104 cr. = 104.00 cr * 0.013 = Rs.1.35 cr.
Therefore total capital charge for general market risk is = Rs. 1.35 cr
Illustration 2:
Reno Bank has a repo transaction. The details of it has been given under. Calculate total capital
charge for a repo transaction comprising the capital charge for CCR and Credit/Market risk for the
underlying security, under Basel-II.
Type of the Security GOI security
Residual Maturity 5 years
Coupon 6%
Current Market Value Rs.1050
Cash borrowed Rs.1000
Modified Duration of the security 4.5 years
Assumed frequency of margining Daily
Haircut for security (adjusted for minimum holding period) 1.4 %
Haircut on cash Zero
Minimum holding period 5 business-days
Change in yield for computing the capital charge for general market risk 0.7 % p.a.
Answer:
Sr. No. Items Particulars Amount
A. Capital Charge for CCR
1 Exposure MV of the security 1050.00
2 CCF for Exposure 100 %
3 On-Balance Sheet Credit Equivalent 1050 * 100 % 1050.00
4 Haircut 1.4 %
5 Exposure adjusted for haircut 1050 * 1.014 1064.70
6 Collateral for the security lent Cash 1000.00
7 Haircut for exposure 0%
8 Collateral adjusted for haircut 1000 * 1.00 1000.00
9 Net Exposure ( 5- 8) 1064.70 - 1000 64.70
10 Risk weight (for a Scheduled CRAR- 20 %
compliant bank)
11 Risk weighted assets for CCR (9 x 10) 64.70 * 20 % 12.94
12 Capital Charge for CCR (11 x 9%) 12.94 * 0.09 1.16
B. Capital for Credit/ market Risk of the
security
1 Capital for credit risk Credit risk Zero (Being
(if the security is held under HTM) Govt. security)
2 Capital for market risk Specific Risk Zero (Being
(if the security is held under AFS / HFT) Govt. security)
General Market Risk
(4.5 * 0.7 % * 1050) 33.07
{Modified duration *
assumed yield
change (%) * market
value of
security}
Total capital required (for CCR + credit 34.23
risk + specific risk + general market risk)
Credit Risk capital charge:-

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The ‘Rich Bank’ has the following exposure in the banking book and would like to know the capital
charge for credit risk according to Basel II norms . Refer RBI master circular for your calculations: -
Particulars Amount of Rating Security Provided

Exposure ( Rs. Cr) Collateral
(A) Corporate Loan(10
yrs)
TL to Cement giant Rs.60.00 AA Immovable property
TL to Textile firm Rs.20.00 BB - --“---
(Turnover of these firms is
above Rs.50 cr.)
(B) Retail Loan

Loan to small Rs. 10.00 -- Commercial real estate
business
Housing Loan to Rs. 10.00
Individual
( Out of Above )
- Loan upto 30 lakhs Rs. 6.00 Residential House
(LTV is 80% to 90%) Property
- Loan above 75 lakhs Rs. 4.00 --“ ---
(C) Credit card & Rs.5.00 --- No security
personal Loan
(D) Corporate Loan

Loan to I.T companies Rs.20.00 A FDR :- Rs. 8.00 cr
GOI Bonds- Rs.12 cr
( Maturity 3 years)
(E) NPA – corporate Rs.3.00 -- Unsecured Portion 50%
Loan (Provision made for
18%)
Rs 5.00 -- ---“----
(Provision made for
50%)
Solution :-
According to Master circular, we need to know the risk weightage according to class of loans and
security. We have to go through this circular in entirety to know the different assets & exposure of
any bank.
Particulars Exposure Risk RWA
weight
(A) Corporate Loan
Loan to Cement giant Rs.60.00 30% Rs.18.00
Loan to Textile firm Rs.20.00 150% Rs.30.00
(Turnover of these firms is above Rs.50
cr.)
(B) Retail Loan

Loan to small business (20 accounts) Rs. 10.00 75% Rs.7.50
Housing Loan to Individual Rs. 10.00
( Out of Above )
- Loan upto 30 lakhs Rs. 6.00 50% Rs.3.00
- Loan above 75 lakhs Rs. 4.00 50% Rs.2.00
(C) Credit card & personal Loan Rs.5.00 125% Rs.6.25

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(D) Corporate Loan

Loan to I.T companies ( credit rating “A”) Rs.20.00 50%
Secured - FDR (I) Rs. 8.00
GOI Bonds (II) (Maturity 4 Rs.12.00
years)
Haircut as applicable to be deducted
from security amount
For ( I) Rs.0.00 0%
For (II) Rs.2.40 2%
Security after Haircut Rs.17.60
Now apply risk weight on above Rs.17.60 50% Rs.8.80
( E) NPA – corporate Loan - Rs.3.00 Rs.1.50 150% Rs.2.25

Unsecured 50% - 18% provisions ---
150% Rs.1.50 100% Rs.1.50
Secured 50% --- more than 15% ---100%
corporate Loan - Rs.5.00 Rs.2.50 50% Rs.1.25
Unsecured 50% - Atleast 50%
provisions --- 50% Rs. 2.50 100% Rs.1.25
Secured 50% --- more than 15% ---100%
RWA Rs.81.80
Question 2: From the following information calculate the CRAR of the National Bank Ltd on
31.03.2016 Rs. in Cr.
Liabilities Amount Amount
Shareholders Fund:
Ordinary equity capital 15.00
Redeemable Pref. share 10.00
Retained Earnings 6.00
Share Premium 5.00
Revaluation Reserves 3.00 39.00
Perpetual Non-Cumulative 5.00
Preference Shares
Share Premium on (PNCPS) 2.50
Borrowings:
Unsecured Tier II Bonds 4.00
Deposits 263.00 267.00
Other Liabilities & Provisions 52.50
Total 366.00
Assets Amount Amount

Cash 25.00
Money at call & notice 5.00 30.00
Investments:
Subsidiary capital 8.00
SLR 12.00
Non SLR 14.00 34.00
Advances:
Corporate loan 95.00
Housing Loan 95.00
Retail Loan 90.00 280.00
Fixed Assets 22.00
Total 366.00
Note: Off balance sheet exposure of the bank is as follows:
Contingent liability (BG & LC) Secured by immovable property : Rs.20.00 cr
(Corporate rating : Brickwork A2)

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Other Information:
1. Corporate loan portfolio will have the following constituents:
Long Term Loans (AA) :25.00
Long Term Loans (A) : 15.00
Short term loan (CARE A1): 35.00
Short term loan (ICRA A2): 20.00
2. Housing Loan details:

Above 75 lakhs : 25.00
Between 20 lakhs to 75 lakhs: 52.00
Below 50 lakhs : 18.00
3. Retail loans details:

Small business (Turnover below 50 cr) : 75.00
Credit card receivables: 10.00
Other consumer loans : 10.00
4. SLR investments:
Sovereign securities :
Maturity : 2 yrs : 1.00 (HFT) (Modified duration 1.5 yrs, change in assumed yield 0.90, MV: 1.20)
Maturity : 10 yrs : 4.00 (Modified duration 7.5 yrs, change in assumed yield 0.60, MV 4.00)
Maturity : 15 yrs: 7.00 (Modified duration 11.5 yrs, change in assumed yield 0.60, MV 7.05)
5. Non SLR investments:

Public sector enterprise bonds –(AAA)- HFT – Maturity 6 months & less: 5.00 (Table 16:Capital
charge 0.28%) (Modified duration 2 months, change in assumed yield 1.00, MV: 5 .18)
AFS – Corporate BBB bonds: 9.00 (Table 16:Capital charge 9%)
(Modified duration 6 months, change in assumed yield 1.00, MV: 9.20)
6. Gross income of the bank for last 3 years is as follows:

Year 1 : 80.00, Year 2: 45.00, Year 3 : 45.00
Answer:
To calculate CRAR the following formula is applicable
Total Eligible funds (Common Equity Tier 1 + Additional Tier 1 + Tier 2)
RWA for Credit risk + RWA for Market Risk+ RWA for operational Risk
Now we will first calculate Common Equity Tier 1 & Tier II capital from the information given:
Common Equity Tier 1 : Equity capital 15.00 + Retained Earnings 6.00 + Share Premium 5.00 +
Revaluation Reserves : Discount to 55%: 1.65 = 27.60
Additional Tier 1 capital:
Perpetual Non-Cumulative Preference Shares (PNCPS) = 5.00
Securities Premium on above = 2.50
7.50
Tier 2: Unsecured Tier II bonds: Subordinate debt : 4.00

(Assuming recently issued for 10yrs)
Total Eligible funds: CET 1, Additional Tier 1 & Tier 2 - 39.15 Cr
Calculation of RWA for credit Risk:

1. Corporate loan portfolio will have the following constituents:
Long Term Loans (AA) :25.00 @ 30% = 7.50
Long Term Loans (A) : 15.00 @ 50% = 7.50

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Short term loan (CARE A1) : 35.00 @ 30% = 10.50

Short term loan (ICRA A2) : 20.00 @ 50% = 10.00
35.50
2. Housing Loan details:
Above 75 lakhs : 25.00 @ 75% = 18.75
Between 20 lakhs to 75 lakhs: 52.00 @ 50% = 26.00
Below 50 lakhs : 18.00 @ 50% = 9.00
53.75
3. Retail loans details:
Small business
(Turnover below 50 cr) : 75.00 @ 75% = 56.25
Credit card receivables : 10.00 @125% = 12.50
Other consumer loans : 10.00 @ 75% = 7.50
76.25
4. SLR investments: This investments will call both Credit risk & Market risk, we will calculate Credit
Risk first & then market risk:
Sovereign securities :
Since Domestic Sovereign carries 0% risk weight only market risk is required to calculated..

Public sector enterprise bonds –HFT (AAA) – Maturity 6 months & less: 5.00 (Table 16:Capital
charge 0.28%) (Modified duration 2 months, change in assumed yield 1.00, MV: 5.18)
Public sector enterprise bonds –HFT (AAA) : 5.00 @ 20% = 1.00
AFS – Corporate BBB bonds: 9.00 (Table 16: Capital charge 9%) (Modified duration 6 months,
change in assumed yield 1.00, MV: 9.20)
Corporate BBB bonds: 9.00 @ 100% = 9.00
Therefore total credit risk = 1.00 + 9.00 = 10.00
6. Fixed assets : Credit risk 100% = 22.00
7. Credit risk for off balance sheet items:

Contingent liability (BG & LC): Secured by immovable property : Rs.20.00 cr
The above will fall in Short-term self-liquidating trade letters of credit arising from the movement of
goods (e.g. documentary credits collateralised by the underlying shipment) for both issuin g bank
and confirming bank and hence credit risk conversion factor will be 20%
So applying CCF = 20.00 x 20% = 4.00
Since rating for such exposure is Brickwork A2, the risk weight is 50%, therefore
Capital charge = 2.00
Total RWA for credit risk (Adding 1 to 7) = 199.50

Market Risk for Trading & Non trading interest bearing assets:
SLR investments: Sovereign securities :

Specific Risk: Zero for all being Sovereign Security.

General Market Risk:

177
=1.5 X0.90%x1.20 = 0.016

=7.5 x 0.60% x 4.00 = 0.18
= 11.5 x 0.60% x 7.05 = 0.49
Total General market risk charge = 0.69

Public sector enterprise bonds –HFT (AAA) – Maturity 6 months & less: 5.00 (Table 16:Capital
charge 0.28%) (Modified duration 2 months, change in assumed yield 1.00, MV: 5.18)
Specific Risk:0.02%
Public sector enterprise bonds –HFT (AAA) : 5.00 @ 0.28% = 0.014
General market risk: 0.20 x 1% x 5.18 = 0.010
Total market risk = 0.014 + 0.010 = 0.024
AFS – Corporate BBB bonds: 9.00 (Table 16: Capital charge 9%) (Modified duration 6 months,
change in assumed yield 1.00, MV: 9.20)
Specific Risk:1.4%
Corporate BBB bonds: 9.00 @ 1.4% = 0.12
General market risk: 0.6 x 1% x 5.18 = 0.031
Total market risk = 0.031+ 0.12= 0.15
Capital charge for Market risk =0.69+ 0.024 +0.015=0.73
Capital charge for operational risk:

Average of preceding 3 years income x alpha 15%
= 80.00 + 45.00 + 45.00
= 170/3 = 56.66
= 56.66 x 15% = 8.49
So total Capital charge =

RWA for credit risk 199.50
Capital charge for Market risk 0.73

Capital charge for operational Risk 8.49
9.22
RWA for all Market risk & operational risk
(Capital required for CAR to be 9%) = 9.22/0.09 = 102.44
So total RWA = 199.50 + 102.44 = 301.94
CRAR = Total Eligible Funds 39.15

RWA 301.94
CRAR = 12.96%
****END*****

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MULTIPLE OBJECTIVE QUESTIONS
Module A: International Banking
1. The current price of the specified future contract is

a. spot price b. market price c. option price d. future price
2. The last trading day in case of foreign exchange future contract is ----- is prior to the final
settlement date.
a. one day b. three days c. four days d. two days
3. In case of forward contract the difference between sport rate and forward rate is called as ---- a.
backward margin b. forward margin c. spot margin d. past margin
4. Rate applied for a foreign exchange transaction which involves immediate conversion of
currency is known as
(a) ready rate (b) forward rate (c) merchant rate (d) long rate
5. A quotation in which the home currency unit is the standard unit and the rate is expressed in
variable units of foreign currency is called
(a) direct rate (b) spot rate (c) indirect rate (d) forward rate
6. When conversion/exchange of currencies takes place at some future date at a rate of exchange
agreed upon now, such a transaction is known as
(a) spot transaction (b) cover transaction (c) cash transaction (d) forward transaction
7. The maxim applied in respect of Direct Quotation is

(a) buy low, sell low (b) buy low, sell high (c) buy high, sell low (d) buy high, sell high
8. A rate of exchange established between any two currencies on the basis of the respective
quotation of each currency in terms of a third currency is known as
(a) cross rate (b) merchant rate (c) wash rate (d) composite rate
9. Payments for retirement of bills against imports into India must be received by
(a) Directly by exporter (b) Directly by importer (c) Authorised Dealer (d) RBI
10. The rate quoted for issue of Drafts/TTs is

(a) Bill Selling rate (b) Inter-Office rate (c) Forward rate (d) TT Selling rate
11. The rate applicable for an export bill tendered for negotiation is
(a) bill buying rate (b) bill selling rate (c) composite rate (d) TT buying rate
12. The rate quoted for inward remittances by TT/DD, where the cover fund has already been
credited to our Nostro a/c is
(a) TT buying rate (b) DD buying rate (c) Inter-Office rate (d) Cross rate

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13. The transactions of the Bank undertaken to sell the surplus and buy the required foreign
currencies in order to keep its position ‘square’ are known as
(a) cover operations (b) merchant transactions (c) exchange transactions (d) forward
transactions
14. The rate quoted for clean instruments returned unpaid is

(a) TT selling rate (b) DD buying rate (c) Inter-Office rate (d) TT buying rate
15. In case of loans/overdrafts against FCNR deposit the margin requirement should be calculated
on the rupee equivalent at rate.
(a) TT selling rate (b) Bill selling rate (c) Others (d) Notional rate
16. Interest Rates on FCNR Deposit, withdrawn prematurely will be as follows :

(a) At the contracted rate, without levy of penalty
(b) Two percent below the rate applicable to the period the deposit remained with the Bank
(c) One percent below the rate applicable for the period the deposit remained with the Bank.
(d) At contracted rate, but subject to penalty, at the discretion of bank to recovery of swap cost.
17. The ceiling for repatriation of funds from NRE/FCNR accounts is :

(a) Rs.25 lacs (b) $ 1 million (c) Rs.100 lacs (d) No ceiling
18. Loans/OD granted against FCNR/NRE TDRs/STDRs may be liquidated

(a) by Indian rupee remittance (b) by Foreign inward remittance
(c) by adjustment against TDR/STDR proceeds (d) by any method mentioned above
19. Mr. Kumar, officer of State Bank of India is posted as IBO to one of our Foreign Offices. He
leaves India on 1st April 2010. What will be his residential status?
(a) Non-Resident (b) Resident (c) PIO (d) OCI
20. What would be the case, if Mr. Kumar proceeded abroad not because of a foreign posting but
for medical treatment extending for a period of one year?
21. Mr. Gerard, a German (of non-Indian Origin) sets up a proprietary concern in India during June
2012 for carrying on business. What will be his residential status for the financial Year 2012-2013?
22. A foreign citizen of Indian origin who is having NRE STDR for Rs.20.00 lacs with you asks for a
loan of Rs.12.00 lacs against STDR to buy a house
(a) the loan can be granted. (b) the loan cannot be granted as the loan amount exceeds the limit of
Rs.5.00 lacs (c) prior permission from controllers necessary (d) none of the above
23. Can NRE accounts be opened by power of attorney holders in India?

a) Yes b)No
24. Can an FCNR deposit in one currency be converted to a deposit in another currency?
a) Yes b)No
25. In which type of accounts of NRI, joint account can be opened with resident?:
a. FCNR b. NRE c. NRO
26. In FCNR (B) exchange risk is borne by:

a. Customer b. Banks
27. Number of days for Nostro and Vostro account credited (cooling period):
a.10 days b. 7 days c. 5 days d. 15 days

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28. Liberalised Remittance Scheme for Resident Individuals of USD 75,000 per financial year is
permissible for
a) Any permissible current or capital account transactions or a combination of both.
b) Acquire and hold immovable property or any other assets outside India.
c) Investment in Overseas Companies listed on a recognized stock exchange abroad.
d) Gift and Donation. e) All the above.
29. When the foreign nationals employed in India maintain resident accounts with an Authorised
Dealer Category - I (AD Category-I) bank in India, what should the bank do when such foreign
national leave the country?
a) The bank must close the resident accounts of such foreign national on their leaving the country
and transfer their assets to their accounts maintained abroad.
b) AD Category-I banks may, permit such foreign nationals to re-designate their resident account
maintained in India as NRO account on leaving the country after their employment to enable them
to receive their pending bonafide dues.
c) The bank may continue the account as it is to enable them to receive their pending bonafide
dues.
d) None of these
30. From the following information for WBC bank’s nostro account, calculate the balance as on
30.09.2013, maintained at Singapore Bank Ltd. Mirror account has been maintained at WBC’s
Singapore branch.
Balance as per mirror account (Dr), on 30.09.2013 $ 25,00,0000

Debit for charges in mirror account not accounted $ 2,500
Debit for Purchases unreconciled for nostro $ 12,50,000
Interest collected in mirror account not accounted $ 3,000
Export bill collected in nostro now reported by SBL $ 14,50,000
a. $25,00,500 b. $23,00,500 c. $ 23,03,500 d. $27,00,500
31. Permissible debits in EEFC account

a) Advance payments to overseas suppliers under the merchanting trade transactions subject to
compliance with the terms and conditions as applicable.
b) Payment of freight on imports into India/exports from India by the account holder to
shipping/airline companies or their agents operating in India.
c) Payment of Customs duty in accordance with provisions of Exim Policy of Government of India.
d) Payments to residents in India in consideration of supply of goods/services including payments
for air fare and hotel expenditure. (The resident beneficiaries of foreign exchange in such cases will
not be eligible for EEFC facility).
e) All the above.
32. Mr. Kiran has taken up employment with DS corporation Pts London On 16th of May 1982. He
got married with Kerry a UK resident in 1984. From them a son Joy took birth in 1986. Mr Kiran
took divorce from Kerry in year 1990. Mr Joy has done an MBA and wants to settle in India. He
wants to open up a bank account in joint with his mother. whether he can open an account? Which
account he can open?
a. No he cannot open any account b. He can open FCNR & NRE only
c. He can open NRO account only d. He can open NRE account only
33. In a LC transaction, which Bank is authorized to honour the payment claim in settlement of
negotiation/acceptance/payment lodged with it by the negotiating bank?
(a) Reimbursing Bank (b) Opening Bank (c) Advising Bank (d) Foreign Bank
34. In documentary credit transactions

181
(a) all parties deal with documents and not goods (b) all parties deal in documents and goods as
well (c) buyer and seller deal in goods and banks in documents (d) all parties deal in goods only
35. When the Advising Bank, at the request of the issuing Bank, adds its confirmation which would
constitute a definite undertaking by the former the L/C is known as a / an
(a) Irrevocable L/C (b) Transferable L/C (c) Confirmed L/C (d) Revolving L/C
36. An irrevocable LC which authorises the advising bank to extend preshipment /packing credit
upto a certain amount to the beneficiary to enable him to meet preshipment expenses is known as
a / an
(a) Irrevocable LC (b) Transferable LC (c) Revolving LC (d) Red Clause LC
37. All demand bills in foreign currency drawn under and import LC will be crystalised into Rupee
liability on th day from the date of receipt of document.
(a) 10 (b) 7 (c) 15 (d) 30
38. If on an LC alongwith date of shipment “on or about” is written, shipment can be made up to
what time?:
a. 5 days before or 5 days after the date mentioned in LC
b. 2 days before or 2 days after the date mentioned in LC
c. 15 days before or 15 days after the date mentioned in LC
d. At the time given on Bill of Lading
39. Post-shipment finance can be provided upto how much value of the goods covered?
(a) 75 % (b) 50 % (c) 100 % (d) 30 %
40. How many days are allowed to issuing bank and negotiating bank for checking that documents
as per
LC?
a. 5 banking days b. 4 working days c. 10 working days d. 15 banking days
41. Insurance document for Import letter of credits should be opened :

a. 0% of FOB b. 110 % of CIF value c. 100% of CIF d. Value given by customer
42. A bank financed an exporter by discounted foreign bills but, customers did not pay amount on
due date. Bank wanted reverse the transaction. What rate bank will apply?
a) TT selling b) TT buying c) Bill selling rate d) Bills buying rate e) Bank rate
43. A customer is a need of export finance for his export order worth $ 2 million CIF. The insurance
is of 2% of FOB and freight is $ 3,000. How much amount you will give to your customer as packing
credit, if the bank margin is 15%.
a. $16,64,116 b. $17,00,000 c. $16,63,450 d. None of these
44. A customer has approached you for finance against his retention in export contract. The export
order was of $ 1 million ( retention of 20%) and its trunckey project where in 25% amount is for
services. How much amount you will sanction to your customer.
a. Max of $ 1 million b. Max of 0.75 million c. Max of 0.20 million d. Max of 0.15 million
45. Post Shipment export credit can be liquidated

a) Out of balances held in EEFC account b) Proceeds of any other un-financed export bill
c) Proceeds of the export bill received d) Rupee resources, when the export bill is overdue for
payment e) All the above.
46. Delinking (Crystallisation) of Export bills should be done

a) Sight bills remaining unpaid beyond 15 days from the expiry of normal transit period and usance
bills remaining unpaid beyond a period of 15 days from the due date should be delinked.

182
b) Sight bills remaining unpaid beyond 30 days from the expiry of normal transit period and usance
c) Sight bills remaining unpaid beyond 21 days from the expiry of normal transit period and usance
d) AD is free to decide the period based on risk perception of the exporter.
47. A customer of your bank has approached you for export bill discounted on 16th July 2013
against a bill of £0.2 million. You have discounted it for £ 0.19 million with a maturity on 18 th sept
2013. On 18th sept the bill got dishonoured. The rate on that day was £= Rs 84.221/.228. How
much will be the amount to be recovered from customer for such dishonor, if charges for dishonor
is 0.025% and RBI interest rate is 8% p.a.
a.Rs.1,62,34,020 b.1,62,29,963 c. Rs.1,62,35,313 d. $ 1,62,31,369
48. You are a dealer and the following is your position in $ with NSB Bank of Newyork. Find out the
balance in Nostro account.
Opening balance 30,000
Opening position (short) 8,000
Purchased a TT 2,25,000
Issued a travelers cheque 15,000
Purchased and export bill payable at Washington 1,00,000
Forward sales 3,00,000
Export bill realized 2,50,000
closing position (overbought) 35,000
a. $ 3,25,000 b.$ 3,60,000 c. $ 3,33,000 d. $4,90,000
49. M/s. Gary International offers your Pune branch a sight bill for USD 258000 on 28.01.2012
drawn under a letter of credit established by Amas Bank, Geneva. Assuming the following, what
INR amount will you credit exporters account?
Interbank USD = Rs. 63.5850/60 Transit period 10 days. Interest Rate 11% Exchange Margin
0.15% Exporter being valuable client 0.50 Ps better rate.
a. Rs.1,63,40,309 b. Rs.1,64,28,063 c. 1,63,80,003 d. Rs. 1,63,17,550
50. Mr. Jayesh Arya bought a Life Insurance Policy GBP 20,000 for 12 years on January 2003,
while in service at London. On his return to Pune he requests your Pune branch to remit GBP 891
towards annual premium payment due value date 02.02.2013. Whether Mr. Jaya’s request can be
accepted under FEMA 1999?
a. Yes b. No.
51. LC says "Shipment must be made in two lots. 2nd shipment must be made within 30 days after
the first shipment." If the first shipment is made on 1st January, which of the following is correct?*
a. 2nd shipment must be made on 30th January b. 2nd shipment must be made on 31st January
c. Latest date for 2nd shipment is 30th January d. Latest date for 2nd shipment is 31st January
52. A Letter of Credit was issued in favor of SM International on 12th December 2007. The LC
shows the latest shipment date as "on or before 15th January". Which of the following is the
shipment date under this LC?
a. 10th to 20th January b. 11th to 19th January c. Anytime before 15th January* d.
None of these
53. The issuing bank wants to cancel a letter of credit before it has been advised to the beneficiary
by the advising bank. What is the option available to the issuing bank?
a. The issuing bank may cancel the LC anytime
b. The issuing bank must obtain the consent of the beneficiary*[ Correct Answer ]
c. The issuing bank must recall the LC from the advising bank
d. The issuing bank should seek permission from the advising bank

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54. If the CIF or CIP value cannot be determined from the documents, a nominated bank will
accept an insurance document, which covers:
1. 110% of the gross amount of the invoice. 2. 100% of the gross amount of the invoice.
3. 110% of the documentary credit amount.
4. 110% of the amount for which payment, acceptance or negotiation is requested under the credit.
a. 1 and 3 only b. 2 and 4 only c. 1, 2 and 4 only d. 1, 3 and 4 only
55. We issued the L/C as follows: L/C expired: Dec 27, 2012 at beneficiary’s country
Latest shipment date: Dec 06, 2012
Period of presentation: documents to be presented within 21 days after date of shipment but within
the validity of credit, state documents acceptable. Which of the following is acceptable?
a. B/L on board date: Dec 01, 2012, all documents presented on Dec 25, 2012
b. B/L on board date: Dec 01, 2012, all documents presented on Dec 31, 2012
c. B/L on board date: Dec 10, 2012, all documents presented on Dec 25, 2012
d. B/L on board date: Dec 01, 2012, all documents presented on Dec 15, 2012
Module B: Risk management

1. Which of the following statements are true?
a. A bank’s assets are its sources of funds. b. A bank’s liabilities are its uses of funds.
c. A bank’s balance sheet shows that total assets equal total liabilities plus equity capital.
d. Each of the above.
2. When Rs. 1 million is deposited at a bank, the required reserves ratio is 20 percent (SLR), and
the bank chooses not to hold any reserves but makes loans instead, then, in the bank’s final
balance sheet,
a. the assets at the bank increase by Rs.200,000
b. the liabilities of the bank increase by Rs.200,000
c. SLR reserves increase by Rs. 200,000.
d. each of the above occurs.
3. If a bank has Rs.1 million of deposits, a required reserve ratio of 20 percent, and Rs.300,000 in
reserves, it need not rearrange its balance sheet if there is a deposit outflow of
a. Rs.50,000 b. Rs.75,000 c. Rs.150,000 d. either (A) or (B) of the above.
4. If a bank has Rs.100,000 of deposits, a required reserve ratio of 25 percent, and Rs.50,000 in
reserves, then the maximum deposit outflow it can sustain without altering its balance she et is
a. Rs.30,000 b. Rs.25,000 c. Rs.20,000 d. Rs.10,000
5. In the process of A.L.M., price matching is used to assess whether an institution is in a position
to benefit by raising interest rates through "Positive Gap". Positive Gap means:
a. Assets more than liabilities. b. Liabilities more than assets. c. Either a or b
d. None of the above
6. Risk of having to compensate for non-receipt of expected cash flows by a Bank is called……..
a. Call risk b. Funding risk c. Time risk d .Credit risk
7. In the raising interest rate scenario, a prudent and aggressive banker would follow the following
strategy……
a. Reprice assets more frequently b. Reprice liabilities more frequently
c. Match assets and liabilities closely d. All of the above
8. Certain risks in banking business are managed at transaction level and aggregate level; whereas
few risks are managed at aggregate level only. Identify the risks managed at aggregate level only?
a. Credit risk b. Operational risk c. Market risk d. Liquidity risk

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9. As per principle of credit pricing based on credit rating, a borrower rated B shall be charged more
interest compared to another borrower rated A is due to:
a. Regulatory requirement. b. Industry practice. c. Higher probability of default.
d. All of the above.
10. The probability of a company entering bankruptcy within next 12 months period is measured by
the following technique……
a. Credit metrics b. Credit risks c. Credit maps d. All man's Z score
11. Risk arising out of mismatch in maturity payment in assets and liability is known as…….
a. Credit b. Operational transactions c. Liquidity d. None of the above.
12. The parameters that are important in ALM are:

a. NIM b. Net Interest Income c. Economic Equity Ratio d. All of the above
13. Liquidity is ensured by grouping assets and liabilities based on their…..

a. Pricing b. Maturity c. Risk Weight d. None of the above
14. The liquidity of the Bank is determined by:

a. Ability to accommodate decrease in liabilities b. Abilities to fund increase in assets
c. Converting assets to cash quickly and at good costs d. All of the above
15. Price of liquidity is determined by……

a. Market conditions b. Nature of convertible assets on hand
c. Market perception of risks d. All of the above
16. Ratio of liquid assets to total assets is one of the nine ratios used in……
a. Flow approach b. Stock approach c. Balance Sheet analysis d. All of the above
17. ‘HLM Bank’ is encouraging its home loan borrowers to shift to a floating rate option. We can
conclude that the bank is:
a. Trying to maximize interest income from home loans.
b. Expecting home loan rates to go down in near future.
c. Trying to imitate the international best practices in interest rates.
d. Reduce asset sensitivity to interest rates in home loan segment.
18. Which of the following is correct? Collateral is that element of a credit assessment which deals
with:
a. the security available when credit is extended.
b. the knock-on effects that credit problems have with the lender.
c. the increased rate applied to a loan to reflect credit quality.
d. none of the above.
19. What is meant by ‘concentration risk’ in the context of credit risk management?
a. The risk that a large number of counterparties default at the same time.
b. The risk that a large number of counterparties share common risk characteristics.
c. There is a strong positive correlation in the historical behaviour of credit-sensitive assets in a
portfolio.
d. All of a, b, and c.
20. A bank that specializes in granting loans to firms in a specific line of business:
a. May decrease its operating cost and decrease its credit risk.
b. May increase both its operating cost and its credit risk.
c. May increase its operating cost and decrease its credit risk.
d. May decrease its operating costs and increase its credit risk.

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21. The fact that a bank's assets tend to be long-term while its liabilities are short term creates:
a. Interest rate risk. b. Credit risk. c. Lower risk for the bank, this is why they follow this
strategy.
d. Trading risk.
22. The fact that a bank's assets tend to be long-term while its liabilities are short term creates the
following situation when interest rates rise?
a. The value of assets increases by more than the value of liabilities.
b. The value of assets will decrease by more than the value of liabilities.
c. The value of assets increases and the value of liabilities decreases.
d. The value of assets decreases and the value of liabilities increases.
23. What are the basic parameters required for stabilising ALM of Banks?
a. Net Interest Income b. Net Interest Margin c. Economic Equity Ratio d. All these
24. What are the features of Net Interest Income?

a. It is a tool for measuring the impact of volatility on the short term profit.
b. This indicates difference between interest income and interest
c. Short term profits can be stabilised by minimising fluctuations in Net Interest Income.
d. All the above.
25. The Net Interest Margin signifies:

a. It is the result of Net Interest Income divided by average total Assets.
b. It can be viewed as spread on earning Assets.
c. The higher the spread. more will be the Net Interest Margin.
d. All the above.
26. Which of the following combinations is important to meet funding needs of a Bank?
a. Increase short term Borrowings. b. Minimise holding of less liquid Assets.
c. Increase Capital Funds. d. All the above.
27. The extent of cumulative cash flow mismatches could be arrived as under
a. Taking a conservative view of marketability of liquid Assets.
b. Provision for discount to cover price volatility
c. Expected outflows as a result of draw down of commitments.
d. All the above.
28. A limit can be fixed for the following for managing liquidity Risk:
a. Extent of dependence on individual customer.
b. Flexible limits on average maturity of different liabilities.
c. Minimum liquidity provision.
d. Any or all of the above.
29. For every Rs.100 in assets, a bank has Rs.40 in interest rate sensitive assets, and the other
Rs.60 in non-interest rate sensitive assets. The same bank has Rs.50 for every Rs.100 in liabilities
in interest sensitive liabilities, the other Rs.50 are in liabilities that are not interest rate sensitive. If
the interest rate on assets increases from 5 to 6 percent, and the interest rate on liabiliti es
increases from 3 to 4, percent the impact on the bank's profits per Rs.100 of assets will be:
a. An increase of Rs.0.10 b. A decrease of Rs.0.10 c. A reduction of Rs.1.00
d. Constant since the interest rates on assets and liabilities increased by the sa me amount.
30. A bank that makes most of its long term loans at adjustable interest rates is:
a. Reducing both interest rate and credit risk.
b. Increasing credit risk and reducing interest rate risk.
c. Reducing credit risk and increasing interest rate risk.
d. Increasing both interest rate and credit risk.

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31. From the following information calculate the effect on NIM of the bank if the rate of interest has
changed in upward direction to the extent of 50 bps.
(Rs. in Cr)
Deposit – demand 30.00 Investment – Non SLR-HTM 10.00
Deposit – term 25.00 Advances – fixed 30.00
Borrowing from RBI- Repo 5.00 Advances – floating 20.00
Borrowing in call market 2.00 Cash in hand 5.00
a. Decrease by 0.05 cr b. Increase by 0.05cr c. Decrease by 0.27 cr d. Increase by 0.27cr
32. From the following one of the event is a credit event for credit default swap.
a. restructuring of advance b. payment of advance in full c. take over by other bank
d. none of these
33. The seller of protection incase of CDS is going risk.

a. short b. narrow c. long d. near
34. The settlement of CDS in which protection by a delivers wants of reference entity is called as
a. cash settlement b. credit settlement c. default settlement d. physical settlement
35. On occurrence of a credit event the protection seller shall pay difference between nominal
value of the reference obligation and its market value at the time of credit event is called as
a. cash settlement b. credit settlement c. default settlement d. physical settlement
36. From the following information calculate operational risk.

Profit for last two years Year 1 Rs 300 cr, Year 2 Rs 380 cr. the bank has provided provisions for
unpaid interest in the year 2 Rs 30 cr. In year 1 the bank has sold out certain securities in the
banking book and booked the profit of Rs 10 cr.
a. Rs.30cr b. Rs.49.50cr c. Rs.33.99cr d. Rs.52.50cr
37. In the following activities one activities is not to be considered under standardize approach for
measurement of operational risk.
a. corporate finance b. retail banking c. asset management d. non fund based finance.
38. In case of money market operation fourteen day treasury bill will be auction on every
week.
a. Thursday b. Friday c. Monday d. Tuesday
39. A late night news report says the President of a local bank is about to be arrested for
embezzling money from the bank he works at. This causes most of the depositors to line up in front
of the bank the next morning wanting to withdraw their deposits. This is an example of:
a. Liquidity risk b. Operational risk c. Interest rate risk d. Credit risk
40. If Bank A sells some its loans to Bank B for cash, everything else equal:
a. Bank A's assets decrease and Bank B's assets increase.
b. Bank A becomes less liquid while Bank B becomes more liquid.
c. Banks A' total assets do not change, but Bank A is more liquid.
d. Bank A's liabilities decrease by the amount of the loans that are sold.
41. Which of the following statement is incorrect regarding credit default swaps?
a. A CDS is in effect an insurance policy on the default risk of a corporate bond.
b. CDS were designed to allow lenders to buy protection against losses on sizable loans.
c. CDS are designed to transfer the credit exposure of variable income products between parties.
d. The swap buyer pays an annual premium to the swap seller in exchange, receives a payoff if a
credit instrument goes into default.

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42. Which of the following procedures is essential in validating the VaR estimates.
a. Back Testing
b. Scenario Analysis
c. Stress Testing
d. Once approved by regulators no further validation is required.
43. A Bank reports a one-week VaR of $1M at the 95% confidence level. Which of the following
statements is most likely to be true?
a. The daily return on the company portfolio follows a normal distribution so that a one-week VaR
could be computed.
b. The one week VaR at the 99% confidence level is $5M
c. With probability 95%, the company will not experience a loss greater than $95M in one week.
d. With probability 5%, the company will loose $1M or more in one week.
44. If the default probability for an “A”-rated company over a three year period is 0.30%, then the
most likely probability of default for the same company over a six year period is:
a. 0.30% b. Between 0.30% and 0.60% c. 0.60% d. Greater than 0.60%
45. Counter party risk is embedded mainly in………

a. Forex transactions b. Credit transactions c. Liquidity management systems
d. All of the above
46. A dealer has a $200 million open position. He finds that his VaR for a one day period with a
one percent probability is $1000,000. Which of the following is true?
a) This means that the dealer can expect to lose at least $1000,000 in any given day about one
percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days).
b) This means that the dealer can expect to lose at least $1000,000 in any given day about 99
c) This means that the dealer can expect to lose at least $2,000,000 in any given day about one
d) This means that the dealer can expect to lose at least $ 4000,000 in any given day about one
47. Under standardized approach for measurement of operational risk, beta factor for retail banking
is…..
a.12% b.15% c.18% d.20%
48. 3. Answer the following questions based on RBI circular on Liquidity management using the
following information:
Capital — Rs.1540cr, Reserves — Rs.9800cr, Current account — Rs.1870cr, Saving Bank—
Rs.5620cr, Term deposits1 month maturity bucket — Rs. 600cr, 1 to less than 3months maturity
bucket Rs. 900cr, 3 months to less than 6months maturity bucket — Rs. 1400cr, 6 months to less
than 12 maturity bucket Rs. 2400cr, 1year to less than 3 years maturity bucket—Rs.1800cr,3 years
to less than 5 years maturity bucket—Rs.700cr and above 5 years maturity bucket—Rs.950 cr.
Borrowing from RBI—Rs.600cr.
1. What is the amount of current account deposit that can be placed in 14 days bucket:
a) Rs. 187 cr b) Rs. 280 cr c) Rs. 374 cr d) None
2. What is the amount of saving bank deposit that can be placed in 14 days bucket:
a) Rs. 843 cr b) Rs. 1124 cr c) Rs. 562 cr d) Rs. 281 cr
3. What is the amount of current account deposit that can be placed in 1-3 years bucket:

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4. What is the total of amount of term deposit that will be placed in various maturity buckets up to less
than 12 months;
Module C: Treasury
1. A swap transaction involves
a) purchase of currency b) sale of currency
c) purchase of currency against sale or forward sale of the currency. d) simultaneous purchase
and sale of one currency against another for different settlement dates.
2. If you purchase a Rs.100,000 interest-rate futures contract for 105, and the price of the Treasury
securities on the expiration date is 108
a) your profit is Rs.3000. b) your loss is Rs.3000. c) your profit is Rs.8000. d) your loss is
Rs.8000. e) your profit is Rs.5000.
3. If you sell a Rs.100,000 interest-rate futures contract for 110, and the price of the Treasury
securities on the expiration date is 106
a) your profit is Rs.4000. b) your loss is Rs.4000. c) your profit is Rs.6000. d) your
loss is Rs.6000. e) your profit is Rs.10,000.
4. To hedge the interest rate risk on Rs. 4 million of Treasury bonds with Rs.100,000 futures
contracts, you would need to purchase
a) 4 contracts. b) 20 contracts. c) 25 contracts. d) 40 contracts. e) 400
contracts.
5. The number of futures contracts outstanding is called

a) liquidity. b) volume. c) float. d) open interest. e) turnover.
6. If a bank manager wants to protect the bank against losses that would be incurred on its portfolio
of treasury securities should interest rates rise, he could
a) buy put options on financial futures. b) buy call options on financial
futures. c) sell put options on financial futures. d) sell call options on
financial futures.
7. A swap that involves the exchange of a set of payments in one currency for a set of payments in
another currency is an
a) interest rate swap. b) currency swap. c) swap options. d) national swap.
8. If Second National Bank has more rate-sensitive assets than rate-sensitive liabilities, it can
reduce interest rate risk with a swap that requires Second National to
a) pay fixed rate while receiving floating rate.
b) receive fixed rate while paying floating rate.
c) both receive and pay fixed rate.
d) both receive and pay floating rate.
9. If the RBI announces that it has done repos of Rs. 3000 crore, what does this imply?
a. RBI has lent securities worth Rs. 3000 crore through the repo markets to the participants.
b. RBI has reversed the repo deals of participants who entered into a repo with RBI.
c. RBI has inducted funds amounting to Rs. 3000 crores into the market.
d. RBI has borrowed securities from the banking system, and lent them onward in the repo
markets.
10. A 3-day repo is entered into on July 10, 2013, on an 11.99% 2022 security, maturing on April 7,
2022. The face value of the transaction is Rs. 3,00,00,000. The price of the security is Rs. 116.42.
If the repo rate is 7%,

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I. What is the settlement amount on July 10, 2013 (transaction value for repo)? Consider Face
value of security Rs.100/- & number of days from last coupon is 93 days.
a. Rs. 3,58,55,225 b. Rs.3,00,17,500 c. Rs.3,00,03,331 d. Rs.3,49,29,331
II. What is the amount to be settled against borrowing in repo?

a. Rs.3,00,17,260 b. Rs. 3,58,75,854 c. Rs.3,00,59,128 d. None of these
11. A bank has having following figures in 1- 3 months bucket. You are required to calculate impact
on NII if interest rates goes up by 0.50%. Total liabilities Rs 3123 cr, Total assets Rs 2106cr.
a. + 5.08 cr b. - 4.16cr c. – 5.08cr d. + 4.16 cr
12. With regard to a swap bank acting as a dealer in swap transactions, interest rate risk refers to
a. The risk that arises from the situation in which the floating-rates of the two counterparties are not
pegged to the same index.
b. The risk that interest rates changing unfavorably before the swap bank can lay off to an opposing
counterparty on the other side of an interest rate swap entered into with the first counterparty.
c. The risk the swap bank faces from fluctuating exchange rates during the time it takes for the
bank to lay off a swap it undertakes with one counterparty with an opposing transaction.
d. The risk that a counterparty will default.
13. Use the following information to calculate the quality spread differential (QSD):
Fixed Rate Borrowing Floating rate borrowing
cost cost
Company X 10% LIBOR
Company Y 12% LIBOR + 1.5%
a. 0.50% b. 1.00% c. 1.50% d. 2.00%
14. The term interest rate swap

a. refers to a "single-currency interest rate swap" shortened to "interest rate swap"
b. involves "counterparties" who make a contractual agreement to exchange cash flows at periodic
intervals
c. can be "fixed-for-floating rate" or "fixed-for-fixed rate"
d. All of the above
15. Which of the following is an agreement to exchange two currencies on one date and to reverse
the transaction at a future date?
a. Interest rate swap b. Foreign currency swap c. Total return swap d. Credit default swap
16. What will be the impact on EVE if interest rates goes up by 1%

a. increase b. decrease c. no change d. decreases by 1%
17. In case of interest rate future contract the underlined bond is ------
a. notional 10 yr 7% bond b. 7% bond 5 yrs maturity c. 7.5% bond for more than 15 yr
maturity d. none of these
18. The minimum lots size for interest rate future is

a. 100 bonds b. 200 bonds c. 1,000 bonds d.2,000 bonds
19. The last trading day incase of IRF is ------ before the expiry date.
a. 2 business days b. 3 business days c.1 business days d. 4 business days.
20. The final settlement in case of IRF involves ----- of the bond.
a. cash settlement b. physical delivery c. non-delivery d. difference between sell and by
price

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21. Which of the following is not a characteristic of money market instruments?

a. short-term to maturity b. small denomination c. low default risk d. high marketability
22. Which of the following market securities is usually not found on a commercial bank’s balance
sheet?
a. commercial paper b. treasury bills c. certificate of deposit d. banker’s acceptance
23. Banks invest in government securities for a variety of reasons except:

a. income b. safety c. acceptable for collateral d. high relative yield
24. The bank discount rate (ask) on a 91-day T-bill is 5.35%. What is the price of the Rs.1000 T-
bill?
a. Rs.976.40 b. Rs.986.48 c. Rs.981.20 d. Rs.989.45
25. In a portfolio of a bank, Bond A has duration of 5.6 while bond B has duration of 6.0. Bond B:
a. will have greater price variability, given a change in interest rates, relative to bond A
b. will have a shorter maturity than bond A
c. will have a higher coupon rate than bond A
d. will have less price variability, given a change in interest rates, relative to bond A
26. Interest rate risk is

a. duration
b. the extent that coupon rates vary with time
c. the potential variability in the realized rate of return caused by a change in market interest rates
d. the potential variability in the realized rate of return caused by a changing discount rates.
27. Balance Sheet for Hamara Bank is as follows:

Assets Yield Liabilities Cost
Rate sensitive Rs. 500 8.0% Rs. 600 4.0%
Fixed rate Rs. 350 11.0% Rs. 220 6.0%
Non earning Rs. 150 Rs. 100
Rs. 920
Equity
Rs. 80
Total Rs. 1,000 Rs. 1,000
I. Calculate NII from it

a. -41.3 b. 41.3 c. 35.30 d. 68.80
II. How much is the NIM

a. 4.13% b. 4.48% c. 5.03% d. 4.86%
III. Calculate the GAP

a. -100 b. 100 c. 80 d. -20
IV. What is the effect on NIM if the spread is decrease by 1%

a. NIM increases b. NIM decreases c. NIM remains the same in % points
V. If the all assets and liabilities has been doubled what is effect on NIM
a. NIM will increase by 100% b. NIM decreases by 100% c. NIM remains the same in % points
d. NIM will increase/decrease according to gap
VI. RSAs increase to Rs.540, while fixed-rate assets decrease to Rs.310 and RSLs decrease to
Rs.560 while fixed-rate liabilities increase to Rs.260, what is the effect on gap & NII
a. Gap increase, NII lower b. Gap Decrease, NII higher c. Both decreases d. Both
increases

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28. To Reduce asset sensitivity, what the bank is required to do:

a. Shorten loan maturities b. Make more loans on a floating-rate basis
c. Move from floating-rate loans to term loans d. Increase the non fund based loans
29. To Increase liability sensitivity, what the bank is required to do:

a. Issue long-term subordinated debt b. Shorten loan maturities
c. Reduce the short term deposit rate d. Increase short-term deposit rates
30. Excel Bank enters into an Interest rate swap with ABC Ltd on the following terms:
Principal Amount Rs. 100crores
Corporate to Pay 6.50% Fixed
Corporate to Receive 3 month NSE MIBOR
Start date 25-4-12
Tenor 6 months
Termination date 25-10-12

Interest Payment Dates 25th July & 25th Oct
First Fixing 6.10%
In the above case, which of the following is correct in respect of net interest amount
payable/receivable on 25th July 2012?
a. ABC Ltd to pay Rs.986301 b. ABC Ltd to receive Rs.986301
c. ABC Ltd to pay Rs. 1972602 d. ABC Ltd to receive Rs.1972602
31. General Ledger Balance of Modern Bank as on 12-10-2012

Rs. In 000’s
Liabilities Rs Assets Rs
Paid up capital 10,000 Building 10,000
Current Account 180,000 Car 20,000
SB 450,000 Cash Credit 10,00,000
Fixed Deposit 600,000 Term Loan 8,00,000
Interest accrued 10,000
Margin on LCs 2,000 Suspense Account 10,000
TT Payable 1,000 Branch Adjustment Account 20,000
CBLO(Colaterised Borrowing & 600,000
Lending Obligations)
ECGC Claims 7,000
Total 18,60,000 Total 18,60,000
1. Demand Liabilities in the above case works out to ……………
a. 632000 b. 638000 c. 1238000 d. None of the above
2. Time Liabilities is equal to ………………………..

a. 120000 b. 600000 c. 127000 d. None of the above
3. Which of the following can be included for DTL/NDTL computation

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a. Amount received from DICGC Claims

b. Amount received from Insurance company on ad hoc settlement of claims
c. Amount received from the court receiver
d. Amount held as margin against LC
4. Other demand and time Liabilities amounts to ……………………

a. 10000 b.17000 c. 18000 d. None of the above
32. Which set of the following statements is true in respect of Commercial Paper (CP):
1, Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note
2. CP can be issued by Corporate, primary dealers (PDs) and the all-India financial institutions (FIs)
3. A corporate would be eligible to issue CP provided the tangible net worth of the company, as
per the latest audited balance sheet, is not less than Rs.4 crore;
4. The minimum credit rating shall be P-1 of CRISIL or such equivalent rating by other agencies.
5. CP can be issued for maturities between a minimum of 7 days and a maximum up to six months
from the date of issue.
6. Amount invested by a single investor should not be less than Rs.15 lakh .
a.1,2 & 4 b.1,2 & 3 c.1,4 & 5 d.1,4 & 6
33. The issuer of loans pooled and securitized is often:

a. A Liquidity enhancement b. A Credit Enhancement c. A Trustee
d. A credit rating agency
Module D: Bank Balancesheet & Basel

1. Examples of off-balance-sheet activities include
a. loan sales b. foreign exchange market transactions c. trading in financial futures
d. all of the above e. only A) and B) of the above.
2. If a bank sells off all of its assets and pays all of its liabilities, the amount remaining would be:
A) Net profit. B) Reserves. C) Net worth. D) Excess reserves.
3. A bank's loan loss reserves are:

a. The amount of loans that have defaulted in the past twelve months.
b. The same as equity capital.
c. An amount the bank sets aside to cover potential losses from defaulted loans.
d. A liability of the bank since it is a source of funds.
4. For a bank, off balance sheet activities usually:

a. Increase both assets and liabilities while reducing net income.
b. Increase net income but do not change assets or liabilities.
c. Increases a bank's liabilities but not their assets.
d. Income earned from activities not associated with banking.
5. Acceptances, endorsements and guarantees are shown as-----

a. other assets b. contingent liabilities c. advances d. other liabilities and provisions
6. Choose the wrong pair from the following. The information given in the pair is pertaining to
banking companies
a. Reserves & surplus - Share premium b. Time deposits - Matured time
deposits
c. Borrowings in India - Refinance from NABARD
d. Other Liabilities & Provisions - Inter office/branch adjustments(net)

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7. Choose the wrong pair from the following. The information given in the pair is pertaining to
banking companies
a. Demand Deposits - Compulsory deposits under excise rules
b. rebate on bills discounted - unexpired discount
c. Operating Expenses Schedule 14
d. Other Income - Profit on sale of investments less loss on sale of investments
8. Account when becomes NPA, if principal and interest not serviced beyond 90 days from which
date:
a. From end of month in which it become NPA
b. From the date of application during defaulting quarter
c. From 91st day of becoming NPA
d. None of these
9. If an account is doubtful for more than 3 years what is percentage of provision on secured
portion?
a. 40% on secured & 100% on unsecured b. 25% on secured & 100% on unsecured
c. 100% Provision both on secured and unsecured. d. 15% on secured & 100% on unsecured
10. “Prudential Write Off” means

a) An NPA account which is written off at H.O level even though the account is outstanding in the
book of the bank. However the required provision as per the classification should have been made.
b) A fully provided account written off at branch level but maintained at H.O.
c) An N.P.A. account transferred to A.R.M. Branch
d) None of the above.
11. The provision on Standard Asset is kept in the Balance Sheet as part of:
a. Schedule 11 advances b. Deduct from Sch. 13 other assets
c. Deduct from Sch. 4 Deposit d. Other liability and provision.
12. From the following information calculate Net NPA:

NPAs Gross : Opening balance 3,152.50
Additions during the year 3,443.31
Reductions during the year 2,131.06
Movement of provisions for NPAs excluding provisions on standard assets:
Opening balance 2,361.62
Provisions made during the year 1,836.42
Write-off/ write-back of excess provisions 1,276.93
a.3905.26 b. 1,543.64 c.6,266.88 d.2628.33
13. Upon restricting of any NPA account it will be classified as

a. Standard assets b. Doubtful asset c. Sub-standard asset d. loss assets
14. 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, who in turns not shared with member bank.
a. Account will be NPA treating as non served in the books of this Bank.
b. Account will be PA as money received by SBI leader of consortium.
c. None of above. d. Both of above.
15. Given loan by your Bank against Govt Guarantee to Govt company. Loan is over due for more
than 90 days.:
a. Will be treated as NPA.
b. Will be treated as NPA only if guaranteed is invoked and guarantee is not honoured.
c. Both are true. d. None are true.

194
16. Interest on above loan to Govt company can be taken to income

a. No, as such exemption is not for recognition of income. b. Yes can be taken to income
c. None
17. State Govt guaranteed loans and investment in State Govt guaranteed bonds will
a. Attract loan provisions and asset classification if over due for 90 days
b. Only loan provisioning required c. Only asset classification required
d. No need to classify as NPA
18. In a account 6 months moratorium is given.

a. Account will become NPA only if moratorium is over.
b. It will attract NPA provisions even before moratorium for interest servicing.
c. None of above.
19. Provision on standard assets:

a. 0.25% b. 0.25% for SME and agricultural advances and .40% for others.
c. 0.40 for all d. None of above.
20. Erosion in security value to 50% or more and it was sanctioned just 3 months back:
a. Classify account as SA b. Classify account as SSA
c. Classify account as DA d. Classify account as LA
21. Erosion in security value leaving value at 10% or less.

a. Classify account as SA b. Classify account as SSA
c. Classify account as DA d. Classify account as LA
22. In a CC account the stock statement is not submitted for last 3 months and DP is allowed
against old stock statement:
a. Account will be NPA now.
b. Account will be NPA if drawings are permitted in such account for 90 days based on such old
stock statement.
c. None of above. d. Both are true.
23. 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:
a. Need not be reversed b. To be reversed c. None of above d. Both of the
above
24. From the following information find out the amount of provisions required to be made in the
Profit & Loss Account of a commercial bank for the year ended 31st March, 2015:
Packing credit outstanding from Food Processors Rs 60 lakhs against which the bank holds
securities worth Rs 15 lakhs. 40% of the above advance is covered by ECGC. The above
advances has remained doubtful more than 3 years.
Other advances:
Asset classification Rs in lakhs
standard 3,000
Sub-standard (Secured 75%) 2,200
Doubtful (Full secured)
For one year 900
For two year 600
For three years 400
For more than 3 years 300
Loss assets than 600
a. 45 lakhs & 1997.50lakhs b. 51 lakhs & 1765lakhs c. 60 lakhs & 1997.50

195
d. 42 lakhs & 2162 lakhs
25. Bidisha Bank ltd. had extended the following credit lines to a Small & Micro Industry which had
not paid any interest since March, 2009. How much provision is required for 31.03.2015.
Term Loan Export Credit
Balance outstanding on Rs 70 lakhs Rs 60 lakhs
31.3.2015
CGTMS/ECGC cover 50% 40%
Securities held Rs 30 lakhs Rs 25 lakh
Realisable value of securities Rs 20 lakhs Rs 15 lakhs
a. TL 40 lakhs & EC 35 lakhs b. TL 35 lakhs & EC 36 lakhs c. TL 15 & EC 21 lakhs
d. TL 45 lakhs & EC 42 lakh
26. From the following information, compute the amount of provisions to be made in the Profit and
Loss Account of a Commercial bank:
Assets Rs in lakhs
Standard (Value of security Rs 6,000 lakhs) 7,000
Sub-standard 3,000
doubtful
a. Doubtful for less than one year (realizable value of security Rs 500 lakhs) 1,000
b. Doubtful for more than one year, but less than 3 years (Realisable value of 500
security Rs 300 lakhs)
c. Doubtful for more than 3 years (No security) 300
a. 1319 lakhs b. 898 lakhs c. 1478 lakhs d. 2023 lakhs
27 Find out the income to be recongnised at Good Bank Limited for the year ended 31.3.2013 in
respect of Interest on advances ( Rs in lakhs) as detailed below:-
Performing Assets NPA
Interest Interest Interest Interest
earned received earned received
Term loan 240 160 150 10
Cash credits and overdraft 1500 1240 300 24
Bills purchased and discounted 300 300 100 40
a. Intt on TL 240, Intt on CC & OD 1500, Intt on Bill Purch.& disc. 300
b. Intt on TL 160, Intt on CC & OD 1240, Intt on Bill Purch.& disc. 300
c. Intt on TL 250, Intt on CC & OD 1524, Intt on Bill Purch.& disc. 340
d. Intt on TL 310, Intt on CC & OD 1540, Intt on Bill Purch.& disc. 400
28. From the following details, what will be the closing balance for collection Account:
On 1.4.2012, Bills for collection were 51,00,000

During the year 2012-13 Bills received for collection amounted to 75,00,000
Bill collected during the year 2012-13 98, 47,000
Bills dishonoured and returned during the year 27,10,000
a. 47,37,000 b. 3,10,000 c. 43,000 d. 27,53,000
29. Investment Fluctuation Reserve is part of which type of capital:

a. Common Equity Tier 1 b. Additional Tier 1 c. Tier 2 d. None of these
30. Revaluation Reserves are taken as part of Tier I capital at a discount of :

a.50% b.45% c. 55 % d. No discount

196
31. Under BASEL-III, what is the Risk Weightage on the Loans and advances given to Staff of the
bank:
a. 75% b. 30% c. 45% d. 20%
32. Which of the following does not come under Tier 2 capital?
a) General Provisions & Loss reserves b) Debt capital instuments c) revaluation reserves
d) Non cumulative perpetual shares.
33. Sundry Assets attracts …………… % risk weight for Capital Adequacy Ratio
a) 25 b) 50 c) 75 d) 100
34. From the following information calculate CET 1 and Tier II capital according to basel III
requirements:
Paid up Share capital 12.54
Share Premium 43.37
Statutory Reserves 112.25
Capital Reserves 7.80
Special Reserve 36 (i) viii) 3.99
Revaluation Reserves 18.69
Investment Reserve 0.74
Special Reserve (Swap) 0.51
Other reserves (disclosed) 82.43
7 years non convertible bonds ( 4 years to maturity) 92.80
Provision for Standard Assets 19.21
Deferred Tax Assets and Other Intangible Assets 30.24
a. CET 1 Rs.232.14, Tier II Rs.123.54 b. CET 1 Rs.241.91, Tier II Rs.19.95

c. CET 1 Rs.229.40, Tier II Rs.122.29 d. CET 1 Rs.119.89, Tier II Rs.119.89
35. The credit portfolio of ABC Bank has undergone a uniform downgrade as on 31-3- 2014 after
an economic downturn. The position prior to the downgrade is given below: The minimum capital
required after downgrade is …………..
Rating Scale Risk Weight (%) Exposure Extent of
Rs. In crores downgrade
AAA 20 200 AA
AA 30 200 A
A 50 100 BBB
BBB 100 200 BB
BB& Below 150 100
800
Minimum capital under Basel III Rs.48.60 Cr

a. 63.9 crores b. 58.6 crores c. 60.6 crores d. 52.6 crores
36. A Capital debt instrument which is part of Tier II capital has a remaining maturity of more than
1 year but less than 2 years. At what rate of discount it will be taken for Tier II capital:
a. 50% discount b. 80% discount c. 75% discount d. 55% discount
37. Which of the following is a part of Additional Tier 1 capital?

a. Floating provisions b. Provision for Standard asset c. disclosed free reserves.
d. Perpetual Non-Cumulative Preference Shares (PNCPS)

197
38. You are working as a Middle Level Executive with ‘Strong Bank Ltd.,’ The MIS Department has
submitted the following Statistics from which you are required to estimate the likely Capital Funds
required by the Bank as of March,31st, 2014 taking into account the Basel III implementation
compliance.
i) Risk-Weighted Assets for Credit Risk likely to be Rs.53,889.50 crores
ii) Capital Allocation for Market Risk to be Rs.100/- crores
iii) For Operational Risk following Data available.
The bank is required to calculate Capital Charge for Operational Risk by Basic Indicator Approach.
(Amount in Crore)
Year 31-03-2011 31-03-2012 31-03-2013
Gross Income 2600.00 3000.00 3400.00
I. Based on the Gross Income given above, the likely Capital Charge for Strong Bank Ltd., as on
March 31, 2014 to cover Operational Risk under Basic Indicator Approach shall be
a. 375 crores b. 540 crores c. 450 crores d. 360 crores
II. The Strog Bank Ltd., will require total Capital Funds for covering Credit Risk. As on March
31,2014 to comply Basel III norms of Rs. crores.
a. 5400 crore b. 4850 crores c. 4800 crores d. 4311.16 crores
39. Using the following data, calculated capital charge for borrower A & B under Basel III after
credit risk mitigation
Borrower- A Ltd Borrower- B Ltd
Exposure Rs.100 crore Rs.100 crore
Maturity of exposure(years) 6 2
Nature of exposure Corporate Corporate
Currency USD INR
Rating of Exposure BBB UNRATED
Haircut for exposure 12% 25%
Value of collateral after haircut Rs.88crore Rs75 crore
Risk weight 100% 100%
a. Rs.24 crore and Rs 50 crore respectively b. Rs.172.50 crore and Rs.53 crore respectively
c. Rs.18 crore and Rs.12 crore respectively d. Rs.150 crore and Rs.75 crore respectively
40. The maximum amount of General provisions and loss reserves should be taken for Tier II
a. 1.50 % of RWA b. 2.75% of RWA c. 5% of RWA d. 1.25% of RWA
41. “Netting” is a method of aggregating two or more obligations to achieving a reduced net
obligation. The benefits accrues from “Netting” is:
a. Reduced Credit Risk b. Liquidity Risk c. Systemic Risk d. All of the above
42. The debt instruments (bonds/debenture) issued by bank for inclusion in Tier II should be issued
without
a. Call option b. Put option c. Setup option d. None of these
43. Under transitional arrangements for Basel III implementation, the regulatory deductions to the
extent of % is required to be taken for CRAR calculation on 31st March,2014
a. 100 b. 60 c. 20 d. 40

198
44. Specific Risk Capital Charge for banks’ investment in Security Receipts will be
a. 100% b. 75% c. 150% d. 0%
45. A Collateralised Transaction is one in which

a. A bank is having general lien and right for set off
b. bank has hedge the position in the market
c. banks have a specific lien on the collateral and the requirements of legal certainty are met.
d. All of the above
46. Gone concern capital means

a. Capital to protect bank without triggering bankruptcy of the bank
b. Special capital build up for absorbing abnormal losses to bank
c. Capital which RBI has to build by issuing bonds
d. Capital to absorb losses only in a situation of liquidation of the bank
47. Going concern capital means

a. Capital to protect bank without triggering bankruptcy of the bank
b. Special capital build up for absorbing abnormal losses to bank
c. Capital which RBI has to build by issuing bonds
d. Capital to absorb losses only in a situation of liquidation of the bank
48. While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit,
(PDI) in Additional Tier 1 Capital more than % of RWA
a. 2% b. 3% c. 4.5% d. 1.5%
49. Under transitional arrangements Additional tier 1 ratio on 31 st March, 2014 should be
a. 2% b. 1.5% c. 7% d. 2.50%
50. Capital conservation buffer means capital buffers build up in

a. Stress period b. Normal times c. Contagion times d. Catasphoric times
*****************************************************************************************************************
Keys:
Module A: International Banking

1 d 2 d 3 b 4 a 5 c
6 d 7 b 8 b 9 c 10 d
11 a 12 a 13 a 14 a 15 d
16 d 17 d 18 d 19 a 20 b
21 b 22 a 23 b 24 a 25 c
26 b 27 d 28 e 29 b 30 d
31 e 32 b 33 a 34 a 35 c
36 d 37 c 38 a 39 a 40 a
41 b 42 a 43 a 44 d 45 e
46 d 47 c 48 d 49** d 50 a
51 d 52 c 53 b 54 d 55 d
49.** Ans. Spot Rate USD 1 = 63.5850

(-) Margin 0.15% 00.0953
——————
= 63.4897 Rounded off to 63.4875 (In multiples to 0.0025)
Better rate 0.50 Ps. = 63.4875 – 0.050 = 63.4375
USD 258000 = 258000 x 63.4375 = Rs.1,63,66,875.00

199
Recover Interest @ 11% for 10days on Rs.1,63,66,875.00 = Rs.49,324.82

Net payable = Rs. 1,63,66,875.00 - Rs.49,324.82 = 1,63,17,550.18 or Say 1,63,17,550
Module B: Risk management

1 c 2 c 3 d 4 b 5 a
6 c 7 a 8 d 9 c 10 d
11 c 12 d 13 b 14 d 15 d
16 b 17 d 18 a 19 a 20 d
21 a 22 b 23 c 24 d 25 d
26 d 27 d 28 d 29 b 30 b
31 a 32 a 33 c 34 d 35 a
36 d 37 d 38 b 39 a 40 c
41 c 42 a 43 d 44 d 45 b
46 a 47 a 48 (1) b 48 (2) c 48 (3) a
48 (4) d
Module C: Treasury
1 d 2 a 3 a 4 d 5 d
6 a 7 b 8 b 9 c 10 (I)** a
10 (II)* b 11 b 12 b 13** a 14 d
15 b 16 a 17 a 18 d 19 a
20 b 21 b 22 d 23 d 24 b
25 a 26 c 27 - I b 27 - II d 27 - III a
27 -IV b 27 -V c 27 VI c 28 c 29 d
30** a 31 – 1** a 31- 2 b 31 - 3 d 31 - 4 a
32 b 33 1
10.** Answer: I.
Settlement amount on July 10, 2013 is the transaction value for the securities plus accrued interest.
Transaction Value: 3,00,00,000*116.42/100= Rs.3,49,26,000 Accrued Interest: The security’s
maturity date is April 7, 2022. The number of days is 93 from the last coupon date.
Accrued interest=3,00,00,000 * 11.99%* 93/360 = Rs. 9,29,225.00
Therefore, the settlement amount is: Rs. 3,49,26,000 + Rs. 9,29,225.00= Rs. 3,58,55,225.00
II.
Interest on the Amount borrowed: = 35855225 * .07 * 3/365 = Rs. 20629.03
Amount to be settled: 35855225 + 20629.03 = Rs. 35875854.03
14.** The QSD = (12% - 10%) - (LIBOR + 1.5% - LIBOR) = 0.50%
30.** 1000000000*90*.4
-------------------------
36500
31.** Explanation:
Demand and Time Liabilities: Main components of DTL are:
Demand deposits (held in current and savings accounts, margin money for LCs, overdue fixed
deposits etc.)
Time deposits (in fixed deposits, recurring deposits, reinvestment deposits etc.)
Overseas borrowings
Foreign outward remittances in transit (FC liabilities net of FC assets)
Other demand and time liabilities (accrued interest, credit balances in suspense account etc.)
Module D: Bank Balancesheet & Basel

1 d 2 c 3 c 4 b 5 b
6 b 7 c 8 b 9 c 10 a
11 d 12 b 13 c 14 a 15 b
16 a 17 a 18 a 19 b 20 c

200
21 d 22 b 23 b 24** d 25 d
26 d 27 c 28 c 29 a 30 c
31 d 32 d 33 d 34** b 35** a
36 b 37 d 38 - I c 38 - II b 39 a
40 d 41 a 42 b 43 d 44 c
45 c 46 d 47 a 48 d 49 b
50 b
24.** Note: In the case of advances classified as doubtful and guaranteed by ECGC, provision
should be made after deducting realizable of value of security and the amount guaranteed by the
Corporation. Further, while arriving at the provision required to be made for doubtful assets,
realisable value of the securities should first be deducted from the outstanding balance in respect
of the amount guaranteed by the Corporation and then provision will be made.
34.** CET 1 calculation

Paid up Share capital 12.54
Share Premium 43.37
Statutory Reserves 112.25
Capital Reserves 7.80
Special Reserve 36 (i) viii) 3.99
Other reserves (disclosed) 82.43
Revaluation Reserves (Discount of 55%) 10.28
Total 272.66
Less: Deferred Tax Assets and Other Intangible Assets 30.24
Less: Special Reserve (Swap) – Cash flow hedge reserves 0.51
Total CET1 241.91
Tier 2
Investment Reserve 0.74
7 years non convertible bonds – Not to be included as initial 0
minimum maturity is less than 10 years
Provision for Standard Assets 19.21
Total Tier 2 19.95
35.**
Rating Scale Risk Exposure Risk weight RWA
Weight after AFTER
downgrade DOWNGRADE
AAA 20% 200 30% 60
AA 30% 200 50% 100

A 50% 100 100% 100
BBB 100% 200 150% 300
BB & below 150% 100 - 150
710

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BANK FINANCIAL MANAGEMENT

CAIIB (REVISED) –PAPER2

1. GlobalForeign Exchange Markets

2. Introduction to Foreign Exchange

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

4. Broad factors that affect Foreign Exchange Markets :

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

2. Balance of Payments: This has three components:-

3. Industrial production / Capacity Utilisation/Unemployment: This indicates the health of the

2. Foreign Exchange Rates & Arithmetic

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

American vs. European Quote

Direct vs. Indirect Quote

Principal types of Rates (bank to customer) :

(i) TT Buying Rate (TT stands for Telegraphic Transfer):

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

As relates to selling rates by bank, they are of two types:

(i) TT Selling Rate

Add margin to selling rate to get the desired rate. Hence,

CROSS CURRENCY RATES

How to calculate Cross currency rates?

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Example a. 1USD = Rs. 40.00 1USD = CHF 1.40 1 CHF = Rs. ?

We have to find (Rs./CHF)

We have to find Rs./CY.

Cross Rates and Chain Rule (India):

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

TRANSACTIONS IN INTERBANK MARKETS :

Spot and Forward transactions :

What is mean by ‘Forward transactions’?

Discount and Premium :

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Let us now assume the $/£ quotes to be:

Forward premium/discount is generally calculated as percentage per annum.

= (Forward rate-Spot rate) 12/n. *100

Interpretation of Interbank quotations :

Spot USD 1 = Rs. 68.4000/4200

The following points should be noted interpreting the above quotations:

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

From the above calculation we arrive at the following outright rates:

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Forward Exchange Rate = S(1+rq)n

Q.7 : Dollar is quoted in the interbank market as follows.

Selling 1 months 2 months 3 months

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Example: Forward Discount/ Premium

The annualized rate can be calculated by using the following formula:

((109.50 – 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%

International Swaps and Derivatives Association - ISDA

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Exporters/Long on Foreign Importers/Short onForeign

Short Currency future hedge Long Currency future hedge

I) Currency Futures in India:-

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

1. Mark to market Case study:

The payoff table on mark to market daily basis will be as follows:

Day Market rate Strike Gain or Total Gain or Margin

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Call Options Put Option

CAIIB (REVISED) –PAPER2 BANK FIANACIAL MANAGEMENT

Market Exercise Rate @ 45.50 Premium paid Gain/Loss