Risk in Financial Services

IIBF Adda
Certificate Examination in
Risk in financial services

( IIBF & Other Exams)
(2022)
Compiled by
Srinivas Kante B.Tech, CAIIB
Page 1
Compiled by Srinivas Kante srinivaskante4u@gmail.com
AboutCertificate Examination in Risk in Financial Services
Rules & Syllabus 2020
Introduction :
The Certificate examination in Risk in Financial Services is offered in collaboration with Chartered
Institute for Securities & Investment (CISI), London.
Objective :
The objective of the course is to enable bankers to gain expertise in the area of Risk Management in
Financial Services.
Structure :
‘Risk in Financial Services’ is open to Members and Non-members. The examination has two parts-one
covering Indian scenario and the other dealing with the international scenario. This certificate examination
is offered in collaboration with Chartered Institute for Securities & Investment (CISI), London. First part of
examination is conducted by IIBF and the second part is conducted by CISI. Candidates who complete
both the parts are awarded a joint certificate.
Course has two levels :
Level - I :
a) Two hour examination with 40 to 60 hours of study, covering Indian scenario on
Risk Management (Indian Perspective)

b) On completion of the above examination, candidates have to undergo Training for 3 days at pre-
announced centres.
Level - II :
Candidates who have passed the Level-I can apply for Level-II examination of CISI. i.e. Risk in Financial
Services Two hour examination for 100 study hours. Dealing with the International scenario.
Institute will issue a certificate after completing Level-I of the course, which would include the
online examination and training. In addition to this, candidates who complete Level-II will be
awarded a joint certificate by the Institute and CISI.
Examinations :
Level - I examination will be held in online mode at half yearly intervals on the pre-announced dates. List
of examination centres will be available on the website. (Institute will conduct examination in those
centres where there are 20 or more candidates)
Level - II examinations will be held in online mode only at 8 centres throughout the year (excluding
Saturdays / Sundays). Candidates will have to make it convenient to appear the Level - II examination at
any one of the 8 centres.
Target group :
Employees of banks and financial institutions.
Eligibility :
1. Members and Non-Members of the Institute
2. Candidates must have passed the 12th standard examination in any discipline or its equivalent.
Exemption from Level-I Examination :

Members of IIBF who have passed 1) DTIRM examination or 2) CAIIB with elective subject 'Risk
Management' or 3) CAIIB holders who have passed Certificate in Risk Management as separate Elective
are eligible to take Level-II examination directly without passing Level-I examination. However they are
required to register for the Level-I examination by paying the requisite fees plus applicable taxes to be
eligible to apply for exemption.
Candidates who are eligible for exemption as per the above criteria are required to 1) Apply for the
examination by paying the requisite fee plus applicable taxes and 2) Send immediately a separate written
request for granting exemption along with a) Copy of the acknowledgement received while applying for
examination and b) copy of the Result Advice / Final certificate of the above examination/s passed to
Examination Corporate Office of the Institute so as to reach the same before the last date for applying for
examination. Requests received for exemption after the last date for applying for the examination will not
be considered for granting exemption.
Offices after the last date for applying for the examination will not be considered for granting exemption.
Subject of Examination (Level - I) :
Risk Management
Page 2
PASSING CRITERIA:
Minimum marks for pass in the subject is 50 out of 100.
Examinat Particular Examinat Training Total
ion / s ion
Training
Fees : Sr.
No. Fee Fee** Examination
+ Training Fee
1. Virtual Rs.6,000/- Nil Rs.6,000/-
training
mode
plus GST plus GST
2. Physical Rs.6,000/- Rs.5,000/- Rs.11,000
classroom /-
training
mode
at Mumbai, plus GST plus GST plus GST
Delhi,
Chennai and
Kolkata centres
3. Physical Rs.6,000/- Rs.9,000/- Rs.15,000
classroom /-
training
mode
at other plus GST plus GST plus GST
centres
Medium of Examination :
Examination will be conducted in English only
Pattern of Examination :
(i) Question Paper will contain approximately 100 objective type multiple choice questions for a total of
100 marks including questions based on case studies / case-lets. The Institute may however verified
number of questions to be asked for a subject.
(ii) The examination will be held in Online Mode only
(iii) There will NOT be negative marking for wrong answers.
DURATION OF EXAMINATION:
The duration of the examination will be of 2 hours.
Syllabus
Paper - 1 : Risk Management
Module - A : An overview
a) Risk - definition, policies
Page 3
- Risk Process-Risk Organization
- Key risks-Credit risk, market risk, operational risk, liquidity risk, legal risk, interest rate risk and currency risk
b) Asset Liability Management
- ALM Concept
- ALM Concept
- ALM Organization
- ALCO techniques / tools
- Simulation, Gap, Duration analysis, Linear and other statistical methods of control
c) Risk Measurement & Control
- Calculation
- Risk exposure analysis
- Risk management / mitigation policy
- Risk immunization policy / strategy for fixing exposure limits
- Risk management policy and procedure
- Risk adjusted return on capital
d) Risk management
- Capital adequacy norms
- Prudential norms
- Exposure norms
- Concept of Mid office
- Forwards
- Futures
- Options
- Strategies and Arbitrage opportunities
- Regulatory prescriptions of risk management
Module - B : Credit Risk Management

- Introduction
- BASEL Norms
- Three pillars of BASEL Norms and Capital for Operational risk
- Frame work for risk management
- RBI guidelines on risk management
- Risk rating and risk pricing
- Methods for estimating capital requirements
- Credit risk - standardized approach
- Credit risk - advanced approach
- Credit rating / credit scoring and rating system design
- Credit Bureaus
- Stress test and sensitivity analysis
- Internal Capital Adequacy Assessment Process (ICAAP)
Page 4
- Introduction to structured products
Module - C : Operational Risk

- Introduction, BASEL Norms
- RBI guidelines
- Likely forms of operational risk and causes for significant increase in operational risk
- Sound Principles of Operational Risk Management (SPOR)
- SPOR - organizational set up and key responsibilities of ORM
- SPOR - policy requirements and strategic approach for ORM
- SPOR identification, measurement, control / mitigation of operational risks
- Capital allocation for operational risk, methodology, qualifying criteria for banks for the adoption of the methods
- Computation of capital charge for operational risk
Module - D : Market Risk
- Introduction and definition
- Prescriptions of BASEL Norms
- Liquidity risk
- Interest rate risk
- Foreign exchange risk
- Price risk (Equity)
- Commodity risk
- Treatment of market risk under Basel
a) Standardized duration method
b) Internal measurement approach - VaR
Basel-III guidelines
- Risk Management Policy - ALCO structure and functions.
Rules / Syllabus for Level - II Examination (CISI, London)

As regards Paper 2 (Level - II) Examination the rules / syllabus, courseware, venue and other details will be provided directly by
CISI, London to all the enrolled candidates for the Paper 2 examination, after passing the Level - I as stipulated earlier. The general
information regarding rules / syllabus as provided by CISI is reproduced here which is subject to changes as per their rules /
syllabus of CISI.
Subject of Examination (Level - II) :
Paper - 2 : Risk in Financial Services
Registration / Examination Fees :
(For Members of IIBF £110 (Including
under the collaboration Registration fee)
arrangement) 1st attempt
2nd attempt £60 (During the
continuation of the
syllabus)
Duration of Examination :
Paper 2 - Examination will be of 2 hour duration.
Periodicity of Examination:
The Examination is conducted throughout the year except Saturday and Sunday.
Passing criteria :
Passing marks for paper- 2 subject is 70%
Delivery :
The program is delivered through soft copy of study material in PDF format.
Syllabus for examination – Level - II Paper - 2 : Risk in Financial Services
1. Principles of Risk Management
2. International Risk Regulation
3. Operational Risk
4. Credit Risk
5. Market Risk
Page 5
6. Investment Risk
7. Liquidity Risk
8. Corporate Governance and Risk Oversight
9. Model Risk
10. Enterprise Risk Management (ERM) -
(Supported by specially designed courseware which is supplied by e-copy to all enrolled candidates as part of the fee by CISI
directly)
PROCEDURE FOR APPLYING FOR EXAMINATION (Level - II) :
IIBF will provide a list of candidates, who have passed the Level - I examination / granted exemption based on prior qualification and
eligible to apply for Level - II examination to CISI periodically. CISI will inform those candidates directly the procedure / guidance for
the registration for Level - II examination. Candidates can also contact CISI for guidance on the contact no. and e-mail provided on
the trailing pages under course structure and delivery, if needed.
For further information / Registration (CISI)
RISK MANAGEMENT: AN OVERVIEW

Structure
1.1 Introduction
1.2 Risk Management
1.3 Categories of Risk
1.4 Steps in Risk Management
1.5 Integration of Risks leading to Enterprise-wise Risk Management System
1.1 INTRODUCTION
Page 6
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. This is true as the business of banking is risk taking in
its traditional role of an intermediary, i.e. interposing between savers (depositor) on one hand and the
borrower on the other hand, thereby accepting the risks of intermediation. With the rapid development
of public capital markets worldwide, there has been a steady reduction in the dependence of borrowers
on the banking system for funding their activities. This ‘disintermediation’ not only by the borrowers but
also by the bank depositors directly investing their funds in capital market instruments, has caused a
significant change in the business of banking. To arrest the fall in customer business and base owing
to disintermediation, 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.
Another outcome of the disintermediation is the rapid growth in the size of investment portfolio of banks
over a period of time at the cost of advances portfolio which can be attributed to various other reasons
apart from disintermediation, thereby changing the complexion of banking risks. 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.
What is Risk ?
Risk is the probability that the realized return would be different from the anticipated/expected return on
investment.
Risk is a measure of likelihood of a bad financial outcome.
All other things being equal risk will be avoided.
All other things are however not equal and that a reduction in risk is accompanied by a reduction in
expected return.
The uncertainties associated with risk elements impact the net cash flow of any business or investment.
Under the impact of uncertainties, variations in net cash flow take place. This could be favourable or
un-favourable. The un-favaourable impact is ‘RISK’ of the business.
Page 7
1.2 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 discussion. 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.
Page 8
Risk management is the identification, evaluation, and prioritization of risks (defined in ISO 31000 as
the effect of uncertainty on objectives) followed by coordinated and economical application of
resources to minimize, monitor, and control the probability or impact of unfortunate events[1] or to
maximize the realization of opportunities.
Risks can come from various sources including uncertainty in financial markets, threats from project
failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities,
credit risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of
uncertain or unpredictable root-cause. There are two types of events i.e. negative events can be
classified as risks while positive events are classified as opportunities. Several risk management
standards have been developed including the Project Management Institute, the National Institute of
Standards and Technology, actuarial societies, and ISO standards.[2][3] Methods, definitions and
goals vary widely according to whether the risk management method is in the context of project
management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or
public health and safety.
Strategies to manage threats (uncertainties with negative consequences) typically include avoiding the
threat, reducing the negative effect or probability of the threat, transferring all or part of the threat to
another party, and even retaining some or all of the potential or actual consequences of a particular
threat, and the opposites for opportunities (uncertain future states with benefits).
Certain aspects of many of the risk management standards have come under criticism for having no
measurable improvement on risk; whereas the confidence in estimates and decisions seem to increase.
For example, one study found that one in six IT projects were "black swans" with gigantic overruns
(cost overruns averaged 200%, and schedule overruns 70%)
A widely used vocabulary for risk management is defined by ISO Guide 73:2009, "Risk management.
Vocabulary."
In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss
(or impact) and the greatest probability of occurring are handled first, and risks with lower probability of
occurrence and lower loss are handled in descending order. In practice the process of assessing
overall risk can be difficult, and balancing resources used to mitigate between risks with a high
probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence
can often be mishandled.
Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but
is ignored by the organization due to a lack of identification ability. For example, when deficient
knowledge is applied to a situation, a knowledge risk materializes. Relationship risk appears when
ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective
operational procedures are applied. These risks directly reduce the productivity of knowledge workers,
decrease cost-effectiveness, profitability, service, quality, reputation, brand value, and earnings quality.
Intangible risk management allows risk management to create immediate value from the identification
and reduction of risks that reduce productivity.
Page 9
Risk management also faces difficulties in allocating resources. This is the idea of opportunity cost.
Resources spent on risk management could have been spent on more profitable activities. Again, ideal
risk management minimizes spending (or manpower or other resources) and also minimizes the
negative effects of risks.
According to the definition to the risk, the risk is the possibility that an event will occur and adversely
affect the achievement of an objective. Therefore, risk itself has the uncertainty. Risk management
such as COSO ERM, can help managers have a good control for their risk. Each company may have
different internal control components, which leads to different outcomes. For example, the framework
for ERM components includes Internal Environment, Objective Setting, Event Identification, Risk
Assessment, Risk Response, Control Activities, Information and Communication, and Monitoring
Method
For the most part, these methods consist of the following elements, performed, more or less, in the
following order.
identify, characterize threats

assess the vulnerability of critical assets to specific threats
determine the risk (i.e. the expected likelihood and consequences of specific types of attacks on
specific assets)
identify ways to reduce those risks
prioritize risk reduction measures
Principles
The International Organization for Standardization (ISO) identifies the following principles of risk
management
Risk management should:
create value – resources expended to mitigate risk should be less than the consequence of inaction
be an integral part of organizational processes
be part of decision making process
explicitly address uncertainty and assumptions
be a systematic and structured process
be based on the best available information
be tailorable
take human factors into account
be transparent and inclusive
be dynamic, iterative and responsive to change
be capable of continual improvement and enhancement
be continually or periodically re-assessed
Process
According to the standard ISO 31000 "Risk management – Principles and guidelines on
implementation,"the process of risk management consists of several steps as follows:
Page 10
Establishing the context
This involves:
identification of risk in a selected domain of interest

planning the remainder of the process
mapping out the following:
the social scope of risk management
the identity and objectives of stakeholders
the basis upon which risks will be evaluated, constraints.
defining a framework for the activity and an agenda for identification
developing an analysis of risks involved in the process
mitigation or solution of risks using available technological, human and organizational resources
Identification
After establishing the context, the next step in the process of managing risk is to identify potential risks.
Risks are about events that, when triggered, cause problems or benefits. Hence, risk identification can
start with the source of our problems and those of our competitors (benefit), or with the problem itself.
Source analysis – Risk sources may be internal or external to the system that is the target of risk
management (use mitigation instead of management since by its own definition risk deals with factors
of decision-making that cannot be managed).
Examples of risk sources are: stakeholders of a project, employees of a company or the weather over
an airport.
Problem analysis[citation needed] – Risks are related to identified threats. For example: the threat of
losing money, the threat of abuse of confidential information or the threat of human errors, accidents
and casualties. The threats may exist with various entities, most important with shareholders,
customers and legislative bodies such as the government.
When either source or problem is known, the events that a source may trigger or the events that can
lead to a problem can be investigated. For example: stakeholders withdrawing during a project may
endanger funding of the project; confidential information may be stolen by employees even within a
closed network; lightning striking an aircraft during takeoff may make all people on board immediate
casualties.
The chosen method of identifying risks may depend on culture, industry practice and compliance. The
identification methods are formed by templates or the development of templates for identifying source,
problem or event. Common risk identification methods are:
Objectives-based risk identification[citation needed] – Organizations and project teams have objectives.
Any event that may endanger achieving an objective partly or completely is identified as risk.
Scenario-based risk identification – In scenario analysis different scenarios are created. The scenarios
may be the alternative ways to achieve an objective, or an analysis of the interaction of forces in, for
example, a market or battle. Any event that triggers an undesired scenario alternative is identified as
risk – see Futures Studies for methodology used by Futurists.
Taxonomy-based risk identification – The taxonomy in taxonomy-based risk identification is a
breakdown of possible risk sources. Based on the taxonomy and knowledge of best practices, a
questionnaire is compiled. The answers to the questions reveal risks.[7]
Page 11
Common-risk checking [8] – In several industries, lists with known risks are available. Each risk in the
list can be checked for application to a particular situation.[9]
Risk charting[10] – This method combines the above approaches by listing resources at risk, threats to
those resources, modifying factors which may increase or decrease the risk and consequences it is
wished to avoid. Creating a matrix under these headings enables a variety of approaches. One can
begin with resources and consider the threats they are exposed to and the consequences of each.
Alternatively one can start with the threats and examine which resources they would affect, or one can
begin with the consequences and determine which combination of threats and resources would be
involved to bring them about.
Assessment
Main article: Risk assessment
Once risks have been identified, they must then be assessed as to their potential severity of impact
(generally a negative impact, such as damage or loss) and to the probability of occurrence. These
quantities can be either simple to measure, in the case of the value of a lost building, or impossible to
know for sure in the case of an unlikely event, the probability of occurrence of which is unknown.
Therefore, in the assessment process it is critical to make the best educated decisions in order to
properly prioritize the implementation of the risk management plan.
Even a short-term positive improvement can have long-term negative impacts. Take the "turnpike"
example. A highway is widened to allow more traffic. More traffic capacity leads to greater
development in the areas surrounding the improved traffic capacity. Over time, traffic thereby increases
to fill available capacity. Turnpikes thereby need to be expanded in a seemingly endless cycles. There
are many other engineering examples where expanded capacity (to do any function) is soon filled by
increased demand. Since expansion comes at a cost, the resulting growth could become
unsustainable without forecasting and management.
The fundamental difficulty in risk assessment is determining the rate of occurrence since statistical
information is not available on all kinds of past incidents and is particularly scanty in the case of
catastrophic events, simply because of their infrequency. Furthermore, evaluating the severity of the
consequences (impact) is often quite difficult for intangible assets. Asset valuation is another question
that needs to be addressed. Thus, best educated opinions and available statistics are the primary
sources of information. Nevertheless, risk assessment should produce such information for senior
executives of the organization that the primary risks are easy to understand and that the risk
management decisions may be prioritized within overall company goals. Thus, there have been several
theories and attempts to quantify risks. Numerous different risk formulae exist, but perhaps the most
widely accepted formula for risk quantification is: "Rate (or probability) of occurrence multiplied by the
impact of the event equals risk magnitude."[vague]
Risk options
Risk mitigation measures are usually formulated according to one or more of the following major risk
options, which are:
Design a new business process with adequate built-in risk control and containment measures from the
start.
Periodically re-assess risks that are accepted in ongoing processes as a normal feature of business
operations and modify mitigation measures.
Page 12
Transfer risks to an external agency (e.g. an insurance company)
Avoid risks altogether (e.g. by closing down a particular high-risk business area)
Later research[11] has shown that the financial benefits of risk management are less dependent on the
formula used but are more dependent on the frequency and how risk assessment is performed.
In business it is imperative to be able to present the findings of risk assessments in financial, market,
or schedule terms. Robert Courtney Jr. (IBM, 1970) proposed a formula for presenting risks in financial
terms. The Courtney formula was accepted as the official risk analysis method for the US
governmental agencies. The formula proposes calculation of ALE (annualized loss expectancy) and
compares the expected loss value to the security control implementation costs (cost-benefit analysis).
Potential risk treatments

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more
of these four major categories:[12]
Avoidance (eliminate, withdraw from or not become involved)

Reduction (optimize – mitigate)
Sharing (transfer – outsource or insure)
Retention (accept and budget)
Ideal use of these risk control strategies may not be possible. Some of them may involve trade-offs that
are not acceptable to the organization or person making the risk management decisions. Another
source, from the US Department of Defense (see link), Defense Acquisition University, calls these
categories ACAT, for Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is reminiscent
of another ACAT (for Acquisition Category) used in US Defense industry procurements, in which Risk
Management figures prominently in decision making and planning.
Risk avoidance
This includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the legal liability that comes with it. Another would be not
flying in order not to take the risk that the airplane were to be hijacked. Avoidance may seem the
answer to all risks, but avoiding risks also means losing out on the potential gain that accepting
(retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the
possibility of earning profits. Increasing risk regulation in hospitals has led to avoidance of treating
higher risk conditions, in favor of patients presenting with lower risk.
Risk reduction
Risk reduction or "optimization" involves reducing the severity of the loss or the likelihood of the loss
from occurring. For example, sprinklers are designed to put out a fire to reduce the risk of loss by fire.
This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire
suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.
Acknowledging that risks can be positive or negative, optimizing risks means finding a balance
between negative risk and the benefit of the operation or activity; and between risk reduction and effort
applied. By an offshore drilling contractor effectively applying Health, Safety and Environment (HSE)
management in its organization, it can optimize risk to achieve levels of residual risk that are tolerable.
Page 13
Modern software development methodologies reduce risk by developing and delivering software
incrementally. Early methodologies suffered from the fact that they only delivered software in the final
phase of development; any problems encountered in earlier phases meant costly rework and often
jeopardized the whole project. By developing in iterations, software projects can limit effort wasted to a
single iteration.
Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher capability
at managing or reducing risks. For example, a company may outsource only its software development,
the manufacturing of hard goods, or customer support needs to another company, while handling the
business management itself. This way, the company can concentrate more on business development
without having to worry as much about the manufacturing process, managing the development team,
or finding a physical location for a call center.
Risk sharing
Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a risk, and
the measures to reduce a risk."
The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can
transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or
contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As
such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is
often described as a "transfer of risk." However, technically speaking, the buyer of the contract
generally retains legal responsibility for the losses "transferred", meaning that insurance may be
described more accurately as a post-event compensatory mechanism. For example, a personal injuries
insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lies
with the policy holder namely the person who has been in the accident. The insurance policy simply
provides that if an accident (the event) occurs involving the policy holder then some compensation may
be payable to the policy holder that is commensurate with the suffering/damage.
Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining
the risk for the group, but spreading it over the whole group involves transfer among individual
members of the group. This is different from traditional insurance, in that no premium is exchanged
between members of the group up front, but instead losses are assessed to all members of the group.
Risk retention
Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self-insurance falls in
this category. Risk retention is a viable strategy for small risks where the cost of insuring against the
risk would be greater over time than the total losses sustained. All risks that are not avoided or
transferred are retained by default. This includes risks that are so large or catastrophic that either they
cannot be insured against or the premiums would be infeasible. War is an example since most property
and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any
amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if
the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great
that it would hinder the goals of the organization too much.
Risk management plan

Page 14
Main article: Risk management plan
Select appropriate controls or countermeasures to mitigate each risk. Risk mitigation needs to be
approved by the appropriate level of management. For instance, a risk concerning the image of the
organization should have top management decision behind it whereas IT management would have the
authority to decide on computer virus risks.
The risk management plan should propose applicable and effective security controls for managing the
risks. For example, an observed high risk of computer viruses could be mitigated by acquiring and
implementing antivirus software. A good risk management plan should contain a schedule for control
implementation and responsible persons for those actions.
According to ISO/IEC 27001, the stage immediately after completion of the risk assessment phase
consists of preparing a Risk Treatment Plan, which should document the decisions about how each of
the identified risks should be handled. Mitigation of risks often means selection of security controls,
which should be documented in a Statement of Applicability, which identifies which particular control
objectives and controls from the standard have been selected, and why.
Implementation
Implementation follows all of the planned methods for mitigating the effect of the risks. Purchase
insurance policies for the risks that it has been decided to transferred to an insurer, avoid all risks that
can be avoided without sacrificing the entity's goals, reduce others, and retain the rest.
Review and evaluation of the plan

Initial risk management plans will never be perfect. Practice, experience, and actual loss results will
necessitate changes in the plan and contribute information to allow possible different decisions to be
made in dealing with the risks being faced.
Risk analysis results and management plans should be updated periodically. There are two primary
reasons for this:
to evaluate whether the previously selected security controls are still applicable and effective
to evaluate the possible risk level changes in the business environment. For example, information risks
are a good example of rapidly changing business environment.
Limitations
Prioritizing the risk management processes too highly could keep an organization from ever completing
a project or even getting started. This is especially true if other work is suspended until the risk
management process is considered complete.
It is also important to keep in mind the distinction between risk and uncertainty. Risk can be measured
by impacts × probability.
If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that
are not likely to occur. Spending too much time assessing and managing unlikely risks can divert
resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough
to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur.
Page 15
Qualitative risk assessment is subjective and lacks consistency. The primary justification for a formal
risk assessment process is legal and bureaucratic.
Areas
As applied to corporate finance, risk management is the technique for measuring, monitoring and
controlling the financial or operational risk on a firm's balance sheet, a traditional measure is the value
at risk (VaR), but there also other measures like profit at risk (PaR) or margin at risk. The Basel II
framework breaks risks into market risk (price risk), credit risk and operational risk and also specifies
methods for calculating capital requirements for each of these components.
In Information Technology, Risk management includes "Incident Handling", an action plan for dealing
with intrusions, cyber-theft, denial of service, fire, floods, and other security-related events. According
to the SANS Institute, it is a six step process: Preparation, Identification, Containment, Eradication,
Recovery, and Lessons Learned.
Enterprise
In enterprise risk management, a risk is defined as a possible event or circumstance that can have
negative influences on the enterprise in question. Its impact can be on the very existence, the
resources (human and capital), the products and services, or the customers of the enterprise, as well
as external impacts on society, markets, or the environment. In a financial institution, enterprise risk
management is normally thought of as the combination of credit risk, interest rate risk or asset liability
management, liquidity risk, market risk, and operational risk.
In the more general case, every probable risk can have a pre-formulated plan to deal with its possible
consequences (to ensure contingency if the risk becomes a liability).
From the information above and the average cost per employee over time, or cost accrual ratio, a
project manager can estimate:
the cost associated with the risk if it arises, estimated by multiplying employee costs per unit time by
the estimated time lost (cost impact, C where C = cost accrual ratio * S)
.
the probable increase in time associated with a risk (schedule variance due to risk, Rs where Rs = P *
S):
Sorting on this value puts the highest risks to the schedule first. This is intended to cause the greatest
risks to the project to be attempted first so that risk is minimized as quickly as possible.
This is slightly misleading as schedule variances with a large P and small S and vice versa are not
equivalent. (The risk of the RMS Titanic sinking vs. the passengers' meals being served at slightly the
wrong time).
the probable increase in cost associated with a risk (cost variance due to risk, Rc where Rc = P*C =
P*CAR*S = P*S*CAR)
sorting on this value puts the highest risks to the budget first.
see concerns about schedule variance as this is a function of it, as illustrated in the equation above.
Page 16
Risk in a project or process can be due either to Special Cause Variation or Common Cause Variation
and requires appropriate treatment. That is to re-iterate the concern about extremal cases not being
equivalent in the list immediately above.
Enterprise Security
ESRM is a security program management approach that links security activities to an enterprise's
mission and business goals through risk management methods. The security leader's role in ESRM is
to manage risks of harm to enterprise assets in partnership with the business leaders whose assets
are exposed to those risks. ESRM involves educating business leaders on the realistic impacts of
identified risks, presenting potential strategies to mitigate those impacts, then enacting the option
chosen by the business in line with accepted levels of business risk tolerance[17]
Medical device
For medical devices, risk management is a process for identifying, evaluating and mitigating risks
associated with harm to people and damage to property or the environment. Risk management is an
integral part of medical device design and development, production processes and evaluation of field
experience, and is applicable to all types of medical devices. The evidence of its application is required
by most regulatory bodies such as the US FDA. The management of risks for medical devices is
described by the International Organization for Standardization (ISO) in ISO 14971:2007, Medical
Devices—The application of risk management to medical devices, a product safety standard. The
standard provides a process framework and associated requirements for management responsibilities,
risk analysis and evaluation, risk controls and lifecycle risk management.
The European version of the risk management standard was updated in 2009 and again in 2012 to
refer to the Medical Devices Directive (MDD) and Active Implantable Medical Device Directive (AIMDD)
revision in 2007, as well as the In Vitro Medical Device Directive (IVDD). The requirements of EN
14971:2012 are nearly identical to ISO 14971:2007. The differences include three "(informative)" Z
Annexes that refer to the new MDD, AIMDD, and IVDD. These annexes indicate content deviations
that include the requirement for risks to be reduced as far as possible, and the requirement that risks
be mitigated by design and not by labeling on the medical device (i.e., labeling can no longer be used
to mitigate risk).
Typical risk analysis and evaluation techniques adopted by the medical device industry include hazard
analysis, fault tree analysis (FTA), failure mode and effects analysis (FMEA), hazard and operability
study (HAZOP), and risk traceability analysis for ensuring risk controls are implemented and effective
(i.e. tracking risks identified to product requirements, design specifications, verification and validation
results etc.). FTA analysis requires diagramming software. FMEA analysis can be done using a
spreadsheet program. There are also integrated medical device risk management solutions.
Through a draft guidance, the FDA has introduced another method named "Safety Assurance Case"
for medical device safety assurance analysis. The safety assurance case is structured argument
reasoning about systems appropriate for scientists and engineers, supported by a body of evidence,
that provides a compelling, comprehensible and valid case that a system is safe for a given application
in a given environment. With the guidance, a safety assurance case is expected for safety critical
devices (e.g. infusion devices) as part of the pre-market clearance submission, e.g. 510(k). In 2013,
Page 17
the FDA introduced another draft guidance expecting medical device manufacturers to submit
cybersecurity risk analysis information.
Project management
Main article: project risk management
Project risk management must be considered at the different phases of acquisition. In the beginning of
a project, the advancement of technical developments, or threats presented by a competitor's projects,
may cause a risk or threat assessment and subsequent evaluation of alternatives (see Analysis of
Alternatives). Once a decision is made, and the project begun, more familiar project management
applications can be used:
An example of the Risk Register for a project that includes 4 steps: Identify, Analyze, Plan Response,
Monitor and Control.
Planning how risk will be managed in the particular project. Plans should include risk management
tasks, responsibilities, activities and budget.
Assigning a risk officer – a team member other than a project manager who is responsible for
foreseeing potential project problems. Typical characteristic of risk officer is a healthy skepticism.
Maintaining live project risk database. Each risk should have the following attributes: opening date, title,
short description, probability and importance. Optionally a risk may have an assigned person
responsible for its resolution and a date by which the risk must be resolved.
Creating anonymous risk reporting channel. Each team member should have the possibility to report
risks that he/she foresees in the project.
Preparing mitigation plans for risks that are chosen to be mitigated. The purpose of the mitigation plan
is to describe how this particular risk will be handled – what, when, by whom and how will it be done to
avoid it or minimize consequences if it becomes a liability.
Summarizing planned and faced risks, effectiveness of mitigation activities, and effort spent for the risk
management.
Anatomy of Bank Risk
Financial Risk
Non-Financial Risk
Page 18
Balance Sheet Risk
Balance Sheet Risk
Credit Risk
Market Risk
Concentration Risk Intrinsic Risk
Page 19
Commodity Risk
Interest Rate Risk
Price Risk Reinvestment Risk Yield Curve Risk Basis Risk
Gap Risk
Page 20
Risk in Traditional Sense
Systematic Risks::
Affects all Industry/ All securities
Non-controllable
Non-diversifiable
Unsystematic Risks:::
Affects specific Industry/ Specific Securities
Controllable
Diversifiable
Enterprise Wide Risk Management
Introduction:
Achievement of business and financial objectives is of paramount importance for a Bank or a Financial
Services Organisation. The Top Managements of Banks and Financial Services Organisations are always
under pressure to perform and to achieve their business targets. When periodical reviews are undertaken,
related questions surface. Some such questions could be “What sort of roadblocks they can face on their
way to achievement of their business goals? What are the risk-factors faced by the organisation? To
what extent, can these risk-factors impact the achievement of the business objectives? How can these
risk factors be mitigated? How to regularly control and monitor the risk-factors? ” etc.
Enterprise-Wide Risk Management (EWRM) provides an answer to such questions. We can define
EWRM as a continuous and structured process of identifying all external and internal risk-factors;
assessing their impact on the achievement of the organisation’s business and financial targets; prioritising
the risk-factors; exploring alternatives for mitigating the risks; and controlling and monitoring such risks.
Thus, we may say that EWRM encompasses the entire gamut of the organisation’s operations and is not
limited to a single event or circumstance impacting the organisation’s functioning. It is a dynamic process
Page 21
involving people at all levels, covers every aspect of the organisation’s resources and operations and
takes a holistic picture of the entire organisation for the purpose of risk management.
Implementation of Enterprise Wide Risk Management:
EWRM involves listing the objectives of the organisation; identifying the risk-factors that could adversely
impact the achievement of each of the objectives; assessing the impact of the risk-factors on the
achievement of each of the objectives; finding alternatives for mitigating the risk-factors and take steps to
control and monitor the risk-factors on a regular basis..
Let us illustrate the enterprise wide risk management by taking the example of a Bank which has an
objective to achieve an increase of 25% in its market share of deposits in 2017-18. The Bank has
identified one of the risk-factors that could have an adverse impact on its projected growth is shortage of
a well-trained marketing team at its branches. The Top Management of the Bank realises that if it does
not have a well-trained team in place, it would at best achieve a deposit growth of 10%, which is almost
the same as the previous year’s deposit growth. This shows that “untrained marketing team” is a major
risk-factor. There could be other risk-factors too, like competition from other Banks, competition from
mutual funds, reduction in interest rates and lack of brand awareness.
Now let us explore a few risk-mitigating options for “untrained marketing team”.
The options could be:
 Train the existing marketing team
 Hire well-trained personnel from the market
 Use a mix of the two
For each of the above available choices, the Bank shall have to carry out a cost-benefit analysis before
deciding on a particular course of action.
The implementation of EWRM therefore, involves the following steps:

1. Evaluation of the existing risk management systems involving
a) Review of the internal environment with a view to assess the risk philosophy and risk culture
b) Review of the process of setting objectives
c) Assessment of the existing mechanism of identifying risk-factors that can affect achievement of
the desired objectives
d) Evaluation of the existing process of assessing risks
e) Assessment of the process of responding to identified risks
f) Evaluation of the adequacy of existing control processes
g) Assessment of the adequacy of existing management information system (MIS)
h) Review of the process of monitoring risks
2. Formulation of a road map for the implementation plan that seeks to bridge the gaps in risk
management practices vis-à-vis EWRM.
Enterprise Risk Management for Banks:
Risk management in the banking sector has been in the limelight especially after the recent turbulences
that have impacted the effective functioning of the banking sector. The repercussions/impact of not
managing the risks effectively in banks has also been recognised by the Governments all over the world
and several regulations to control risks that arise in the banking business and operations were enacted as
a result.
The risk function in the banks evolved over a period of time and reached a stage where the need was felt
to have a common criterion to measure and quantify the risks faced by the banks so as have a
comparative analysis of the banks. BASEL Norms have been introduced to align the risk management
practices of various banks with the BASEL Norms over a period of time. The Basel norms are focused on
the risks in Operational, Credit and Market areas which in turn have helped the banks to quantify the risks
and standardize their risk management practices in the said areas. Of late, liquidity risk has also emerged
as an important element in the whole risk management process.
However, for effective and comprehensive risk management, it is desirable to have a comprehensive risk
management system which shall help the banks to identify, mitigate risks across enterprise in all the
areas and at the same time rationalize and mature their risk management practices across the enterprise.
Page 22
The above factors should lead to a scenario where the banks start looking beyond Regulatory compliance
and Basel norms for an Enterprise‐wide approach to cater to all risk requirements in more cost effective
and efficient manner. It is most probably with this purpose in mind that the Reserve Bank of India has
issued instructions to the banks to implement the recommendations of the Committee on Capacity
Building constituted in July 2014 under the Chairmanship of former Executive Director, Shri G
Gopalakrishna, with the objective of implementing non-legislative recommendations of the Financial
Sector Legislative Reforms Commission. The Banks are required to identify specialised areas for
certification of the staff manning key responsibilities which includes enterprise-wide risk.
Banks have identified and started adapting the Enterprise Risk Management Framework released by
COSO (Committee of Sponsoring Organizations of the Treadway Commission) as a framework to drive
their initiatives in risk management beyond Basel norms and regulatory compliances. The COSO ERM
framework has all the components that could help the banks to stand a chance to derive business value
while meeting compliance requirements. The ERM Framework is structured around eight key components
and four key objectives of business viz. strategic, operations, reporting and compliance. The components
of the ERM Framework are given below:
COSO’s Enterprise Risk Management – Integrated Framework
Enterprise Risk Management enables the organizations to pragmatically deal with uncertainty and
associated risk and opportunity thus enhancing the brand value and profitability. Enterprise risk
management helps in identifying and selecting among alternative risk responses – risk avoidance,
reduction, transfer, and acceptance. It helps to ensure effective reporting and compliance with laws and
regulations, and avoid damage to the entity’s reputation and associated consequences.
To summarize, Enterprise Risk Management helps an entity get to where it wants to go and avoid pitfalls
and surprises along the way. An organization has to understand the challenges, various risk domains and
risk areas relevant to the business and the different kinds of ERM activities which need to be carried out
to successfully implement the ERM framework.
Page 23
Risk and Risk is possible unfavorable impact on net cash flow in future due to
Capital uncertainty of happening or non-happening of events. Capital is a
cushion or shock observer required to absorb potential losses in future.
Higher the Risks, high will be the requirement of Capital and there will
be rise in RAROC (Risk Adjusted Return on Capital).
Types of Risks Risk is anticipated at Transaction level as well as at Portfolio level.
Transaction Level
Credit Risk, Market Risk and Operational Risk are transaction level risk
and are managed at Unit level.
Portfolio Level
Liquidity Risk and Interest Rate Risk are also transaction level risks but
are managed at Portfolio level.
Risk Measurement
Based on Sensitivity
It is change in Market Value due to 1% change in interest rates. The interest rate gap is
sensitivity of the interest rate margin of Banking book. Duration is sensitivity of Investment
portfolio or Trading book.
Based on Volatility:
It is common statistical measure of dispersion around the average of any random variable
such as earnings, Mark to market values, losses due to default etc.
Statistically Volatility is Standard deviation of Value of Variables

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

Example 2
Daily Volatility =1.5%
Monthly Volatility = 1.5 X ∫30 = 1.5 X 5.48 = 8.22
Volatility will be more if Time horizon is more.
Downside Potential
Page 24
It captures only possible losses ignoring profits and risk calculation is done keeping in view
two components:
1. Potential losses 2. Probability of Occurrence.
The measure is more relied upon by banks/FIs/RBI. VaR (Value at Risk is a downside Risk
Measure.)
Page 25
Risk Pricing Risk Premium is added in the interest rate because of the following:
 Necessary Capital is to be maintained as per regulatory
requirements.
 Capital is raised with cost.
For example there are 100 loan accounts with Level 2 Risk. It means
there can be average loss of 2% on such type of loan accounts: Risk
Premium of 2% will be added in Rate of Interest.
Pricing includes the following:

1. Cost of Deploying funds
2. Operating Expenses
3. Loss Probabilities
4. Capital Charge
Risk Mitigation Credit Risk can be mitigated by accepting Collaterals, 3rdparty
guarantees, Diversification of Advances and Credit Derivatives.
Interest rate Risk can be reduced by Derivatives of Interest Rate
Swaps.
Forex Risk can be reduced by entering into Forward Contracts and
Futures etc.
Diversification of Advances
Business Year1 2 3 4 5 Total Mean sd
A
(Cash 10 3 4 8 11 36 7.20 3.56
flow)
Risk = sd/mean = 3.56/7.20 = .49 i.e. 49%
If we make advances to different types of business with different Risk

percentage, the overall risk will be reduced through diversification of
Portfolio.
Banking Book, Banking Book
Trading Book It includes all advances, depositsand borrowings which arise from
and Off Balance Commercial and Retail Banking. These are Held till maturity and
Sheet Items Accrual system of accounting is applied. The Risks involved are:
Liquidity Risk, Interest Rate Risk, Credit Default Risk, and Operational
Risk.
Trading Book
It includes Assets which are traded in market.
 These are not held till maturity.
 The positions are liquidated from time to time.
 These are Mark- to–market i.e. Difference between market
price and book value is taken as profit.
 Trading Book comprises of Equities, Foreign Exchange
Holdings and Commodities etc.
 These also include Derivatives
The Risks involved are Market Risks. However Credit Risks and
Liquidity Risks can also be there.
Off Balance Sheet Exposures
The Off Balance sheet exposures are Contingent Liabilities,
Page 26
Guarantees, LC and other obligations. It includes Derivatives also.
These may form part of Trading Book or Banking Book after they
become Fund based exposure.
Types of Risks
BI. Liquidity Risk

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

Risk of loss due to adverse movement of interest rates. Interest rate risk is of
following types:
Gap or Mismatch Risk: The risk of Gap between maturities of Assets andLiabilities.
Sometimes, Long term loans are funded by short term deposits. After maturity of
deposits, these liabilities are get repriced and Gap of Interest rates between Assets
and Liabilities may become narrowed thereby reduction of profits.
Basis Risks: Change of Interest rates on Assets and Liabilities may change
indifferent magnitudes thus creating variation in Net Interest Income.
Yield Curve Risk: Yield is Internal Rate of Return on Securities. Higher
InterestRate scenario will reduce Yield and thereby reduction in the value of assets.
Adverse movement of yield will certainly affect NII (Net Interest Income).
Embedded Option Risk : Adverse movement of Interest Rate may result into pre-
payment of CC/DL and TL. It may also result into pre-mature withdrawal of
TDs/RDs. This will also result into reduced NII. This is called Embedded Risk.
Re-investment Risk: It is uncertainty with regard to interest rate at which
futurecash flows could be re-invested.
BK. Market Risk
Market Risk is Risk of Reduction in Mark-to-Market value of Trading portfolio i.e.
equities, commodities and currencies etc. due to adverse market sensex. Market
Risk comprises of:
Price Risk occurs when assets are sold before maturity. Bond prices and Yield
are inversely related.
IRR affects the price of the instruments.
Price of Other commodities like Gold etc,. is also affected by the market trends.
Forex Risks are also Market Risks.
Liquidity Risk or Settlement Risk is also present in the market.
BL.Credit Risk or Default Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed
terms and conditions. There are two types of credit Risks:
Counter party Risk: This includes non-performance by the borrower due to
hisrefusal or inability.
Country Risk : When non-performance of the borrower arises due to constrains
orrestrictions imposed by a country.
BM. Operational Risk
Operation Risk is the risk of loss due to inadequate or Failed Internal procedures,
Page 27
people and the system. The external factors like dacoity, floods, fire etc. may also
cause operational loss. It includes Frauds Risk, Communication Risk,
Documentation Risk, Regulatory Risk, Compliance Risk and legal risks but
excludes strategic /reputation risks.
Two of these risks are frequently occurred.
Transaction Risk: Risk arising from fraud, failed business processes and inabilityto
maintain Business Continuity.
Compliance Risk: Failure to comply with applicable laws, regulations, Code
ofConduct may attract penalties and compensation.
Other Risks are:

4. Strategic Risk: Adverse Business Decisions, Lack of Responsiveness to business
changes and no strategy to achieve business goals.
5. Reputation Risk ; Negative public opinions, Decline in Customer base and litigations
etc.
6. Systemic Risks ; Single bank failure may cause collapse of whole Banking System
and result into large scale failure of banks.
In 1974, closure of HERSTATT Bank in Germany posed a threat for the entire Banking
system
BASEL–I Bank for International Settlements (BIS) is situated at Basel (name of
(back-ground) the city in Switzerland). Moved by collapse of HERSTATT bank, BCBS
– Basel Committee on Banking Supervision consisting of 13 members
of G10 met at Basel and released guidelines on Capital Adequacy in
July 1988. These guidelines were implemented in India by RBI w.e.f.
1.4.1992 on the recommendations of Narsimham Committee. The basic
objective was to strengthen soundness and stability of Banking system
in India in order to win confidence of investors, to create healthy
environment and meet international standards.
BCBS meets 4 times in a year. Presently, there are 27 members.
BCBS does not possess any formal supervisory authority.
1996  Allowed banks to use Internal Risk Rating Model.
Amendment  Computation of VaR daily using 99th percentile.
 Use of back-testing
 Allowing banks to issue short term subordinate debts with lock-
in clause.
Calculation of Basel – I requires measurement of Capital Adequacy in respect of
CRAR (Capital Credit risks and Market Risks only as per the following method:
to Risk
Weighted Asset Capital funds ( Tier I & Tier II)
Ratio) --------------------------------------------------------------------------------- X 100
Credit Risk Weighted Assets + Market RWAs + Operational RWAs
Minimum requirement of CRAR is as under:

As per BASEL-II recommendations 8%
As per RBI guidelines 9%
Banks undertaking Insurance business 10%
New Private Sector Banks 10%
Local Area banks 15%
For dividend declaration by the banks (during 9%
previous 2 years and current year)
Tier I & Tier II Tier –I Capital
Page 28
Capital Tier –I Capital includes
 Equity capital & Statutory reserves,
 Other disclosed free reserves,
 Capital Reserve representing surplus out of sale proceeds of
assets,
 Investment fluctuation reserve without ceiling,
 Innovative perpetual Debt instruments (Max. 15% of Tier I
capital)
 Perpetual non-cumulative Preference shares
( Less Intangible assets & Losses)
(Sum total of Innovative Debt Instruments and Preference shares as
stated above should not exceed 40% of Tier I capital. Rest amount will
be treated as Tier II capital.)
Tier –II Capital

It includes:
 Redeemable Cumulative Preference shares,
 Redeemable non-cumulative Preference shares
 Revaluation reserves at a discount of 55%,
 General Provisions & Loss reserves up to 1.25 % of RWAs,
 Hybrid debts (say bonds) & Subordinate debts
(Long term Unsecured loans) limited to 50% of Tier –I Capital.
Tier – II capital should not be more than 50% of Total Capital.
Tier – III Capital

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

adequacy in introducing CRAR in RRBs also in a phased manner.
RRBs
Two ways to 1. By raising more capital. Raising Tier I capital will dilute the equity
improve CRAR stake of existing investors including Govt. Raising Tier II Capital is
definitely a costly affair and it will affect our profits.
2. Reduction of risk weighted assets by implementing Risk mitigation
Policy.
Risk Weights Cash and Bank Balance 0%
on different Advances against NSC/KVC/FDs/LIC 0%
Assets Govt. guaranteed Advances 0%
Central Govt. Guarantees 0%
State Govt. Guarantees 20%
Govt. approved securities 2.5%
Balance with other scheduled banks having CRR 20%
at least 9%
Page 29
Other banks having CRR from 6% to <9% 50%
Secured loan to staff 20%
Other Staff loans -not covered by retirement dues 75%
Loans upto 1.00 lac against Gold/Silver 50%
Mortgage based securitization of assets 77.5%
Consumer Credit / Credit Cards/Shares loan 125%
Claims secured by NBFC-non-deposit taking 100%
(other than AFCs)
Venture Capital 150%
Commercial Real Estates 100%
Education Loans 75%
Other loans (Agriculture, Exports) 100%
H Revised
L Revised LTV Risk
Weight
up to 20 lac Allowed up to 90% 50%
20-75 lac Allowed up to 80% 50%
Above 75 lac Allowed up to 75% 75%
CRE-RH NA 75%
CRE NA 100%
Restructured Risk weight as
Housing Loans prescribed above
+ 25%
BASEL II The Committee on Banking Regulations and Supervisory Practices
released revised version in the year 2004. These guidelines have been
got implemented by RBI in all the banks of India. Parallel run was
started from 1.4.2006. In banks having overseas presence and foreign
banks (except RRBs and local area banks. Complete switchover has
taken place w.e.f. 31.3.2008. In banks with no foreign branch,
switchover took place w.e.f. 31.3.2009.
Distinction
between Basel I Basel – I measures credit risks and market risks only whereas Basel II
and Basel II measures 3 types of risks i.e. Credit Risk, Operational Risk and
Market Risk. Risk weights are allocated on the basis of rating of the
borrower i.e. AAA, AA, A, BBB, BB and B etc. Basel –II also recognized
CRM such as Derivatives, Collaterals etc.
Three Pillars of Pillar –I Minimum Capital Requirement

BASEL-II Pillar – II Supervisory Review Process
Pillar –III Market Discipline
Pillar –I CRAR will be calculated by adopting same method as discussed above

Minimum under Basel – I with the only difference that Denominator will be arrived
Capital at by adding 3 types of risks i.e. Credit Risks, Market Risks and
Requirement Operational Risks.
Page 30
Minimum Capital Requirement
Pillar One Standardized
Internal Ratings
Credit Risk Models
Credit Risk
Credit Mitigation
Trading Book
Banking Book
Risks Market Risk
Operational
Other
Other Risks
Page 31
1.3 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 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. Studies carried
out on bank failures in the U.S. show that credit risk alone has accounted for 71% of large bank
failures in the period from 1980 to 2004 as well as recent in 2008. Simon Hills of the British Bankers
Association defines credit risk “is the 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.
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
Page 32
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 April 2003). There can be different
classifications depending on the purpose.
1.4 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
Loans & Advances YES Risk YES NO RiskYES RiskYES

Investments YES YES YES YES YES
Cash Management & NO NO NO NO YES
Payment services
Deposits NO YES NO YES YES
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.
The traditional control based risk management ends with step 3 above. The modern risk management
which strives to align risk management with overall corporate objectives and strategies to achieve the
objectives takes two more additional steps in the form of capital allocation and risk adjusted
performance measurement as explained in the following section.
From Risk Management to Value Management
The subject of finance suggests that the ultimate objective of any commercially oriented enterprise is
‘shareholder wealth maximisation’. This means that all the decisions should be towards maximizing the
market value of equity shares traded in the market in the long-term. This approach of targeting and
attaining performance has been widely accepted as the measure of performance at corporate level in
India.
Accounting measures of performance evaluation such as Net Profit margin, Return on Assets, Return
on Equity, Earnings per Share etc. are at best useless as they are only return measures. They do not
consider the actual risk taken to earn the return earned. Hence, the accounting measures fail to qualify
as true measures of performance. The measures of shareholder wealth maximization, broadly called
as SWM measures consider both the return and risk in its framework and are superior to the
accounting measures.
The following description explains the relationship between the expected return, actual return and
addition to shareholder wealth:
AR > ER: Addition to existing wealth of shareholders
AR < ER: Decrease of existing wealth of shareholders
AR = ER: Maintenance of existing wealth of shareholders
Where
AR = Actual Rate of Return on Shareholders’ Capital ER
= Expected Rate of Return on Shareholders’ Capital
Page 33
As it can be seen, wealth maximization takes place only when the actual return is higher than the
expected return. Actual return for this purpose is not an accounting measure. It is arrived at from the
accounting returns after making a number of adjustments to the accounting number. The term
‘expected return’ denotes the rate of return expected by the shareholders for the level of risk that they
are exposed to by investing in the shares of a corporate. There are a number of approaches to
estimating the expected return such as Capital Asset Pricing Model (CAPM), Arbitrage Pricing etc .
There has been a gradual shift from accounting based measures to SWM measures in many industries.
Banking industry too is not an exception to this. The most popular SWM measure in the banking
industry is Risk Adjusted Return on Capital (RAROC) and its variants. RAROC has in numerator the
return earned and capital allocated in its denominator. Given the importance of SWM measures, the
traditional control oriented risk management system (as described above in steps 1 to 3) should pave
the way to value based risk management system, which have SWM based performance measures at
their core. In order to achieve this, the following two more steps need to be added to the existing steps
in risk management:
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. In this process of capital allocation and setting a target return to be
achieved, the true performance of each one of the SBUs can be brought out. The most important data
required for the top management of a bank is the disaggregated data at SBU level for initiatives such
as restructuring etc. What is arrived at by most of the banks religiously is the bank level accounting
performance measures. Even if SWM measures are brought out at bank level, they are not useful at all
unless individual performances of SBUs are known, as cross -subsidization of one or more businesses
by the others are quite possible without revealing the real performance at SBU level. The SBU level
performance can be further drilled down to products, customers, accounts and transactions to enable
customer profitability analysis.
The above approach, apart from clarifying the true measure of performance both at bank level and at
individual SBU level, enables perfect alignment of objectives between the SBUs on one hand and the
bank on the other as similar measures of performance are used throughout the bank.
1.5 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. ****
Credit Risk
Page 34
Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms
and conditions. In terms of extant guidelines contained in BASEL-II, there are three
approaches to measure Credit Risk given as under:
55. Standardized approach

56. IRB (Internal Rating Based) Foundation approach
57. IRB (Internal Rating Based) Advanced approach
1. Standardized Approach
RBI has directed all banks to adopt Standardized approach in respect of Credit Risks.
Under standardized approach, risk rating will be done by credit agencies. Following
Agencies are approved for external rating:
(AI) CARE 2. FITCH India (New name – India Rating.) 3.CRISIL 4. ICRA
5.Brickwork
(BI) SMERA (For SME units) and 7. Onicara (also for
SME units) Risk weights prescribed by RBI are as under:
Rated Corporate
Rating Risk Percentage
AAA 20%
AA 30%
A 50%
BBB 100%
BB & below 150%
Education Loans 75%
Retail portfolio and SME portfolio 75%

Housing loans secured by mortgage 50 to 75%
Unrated Exposure 100%
2. IRBA – Internal rating Based Approach

At present all advances of Rs. 5.00 crore and above are being rated from external agencies
in our bank.
IRBA
IRBA is based on bank‘s internal assessment. It has two variants (Foundation and
advanced). Bank will do its own assessment of risk rating and requirement of Capital will be
calculated on
 Probability of default (PD)- It measures the likelihood that borrower will default.
 Loss given default (LD) – It measures proportion of exposure that will be lost in
case of default
 Exposure of default (ED) – It measures the facility that is likely to be drawn in
the event of default.
 Effective maturity. (M) – It measures the remaining economic maturity of
Exposure.
Bank has developed its own rating module system to rate the undertaking internally. The
internal rating is being used for the following purposes:
4. Credit decisions
Page 35
5. Determination of Powers
6. Price fixing
Credit Risk Management Department (CRMD) is responsible for implementing the

RiskIdentification and Risk mitigate strategies.
Risk Identification
Credit risk has two components:
31 Default risk
32 Credit Spread Risk or Downgrade risk
3. Systemic risk
4. Concentration risk – due to non- diversification
Rating Migration
Rating migration is change in the rating of a borrower over a period of time when rated on
the same standard or model.
Rating Migration of loan accounts based on internal rating of HSBC between 31.3.11 &
31.3.12 is as under:
Last Nos. of Present Rating

Rating Accoun
ts
AAA AA+ AA A+ A BBB C
AAA 50 35 8 2 2 1 1 1

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

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

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

Rating Accoun
ts
Page 36
BBB C Default
C 30 5 20 5
 %age of AAA rated borrowers remained in the same rating:35/50 = 70%

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

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

X2=Retained earnings / Total Assets Ratio
X3=Earnings before Interest and Tax / Total Assets Ratio (ROCE)
X4 = Market Value of Equity / Long Term Liabilities Ratio (Debt Equity)
X5=Sales/Total Assets ratio
Higher the value of Z, lower will be default risk.
JP Morgan’s Model of Scoring

JP Morgan developed a portfolio model ―Credit Metrics‖ for evaluating Credit Risks. The
volatility is computing by tracking probability that borrower may migrate from one rating to
another
Example -1
XYZ bank has provided the following figures in respect of advances:

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

Page 37
Base Rate of the bank = 11% for AAA category
Load factor = 1% for AA , 2% for A, 3% for BBB and 4% for BB accounts.
Load factor for additional maturity over 3 years = 0.5%
Bank has given loan of Rs. 400 lac to A rated Company for 5 years, out of which 2
year period has already lapsed and there has been no default. Present outstanding is
300 lac.
EAD (Exposure at Default) = 100% and
LGD (Loss Given Default + 50%
Find the expected loss on this account?
Solution:
It will be solved as under:
EAD X Probability of default X LGD =
300,00,000 X .30% X 50% = Rs. 45000 Ans.
Example -2
PLR bank has provided the following figures in respect of advances:

Rating AAA AA A BBB BB B CCC
3 year .05% .20% .40% 1% 5% 20% 50%
5 year .8% .30% .70% 1.8% 8% 40% 60%
Bank has given loan to A category borrower with repayment schedule of 4 years out of
which 1 year has lapsed and there has been no default. O/s 400 lac, EAD 100% and LGD
is 50%. Find Expected loss on this account.
Solution:
Expected Loss = EAD*PD*LGD
2 400*100%*.4%*50%
=80000 ---------Ans
How to Calculate RWAs and Capital Charge in respect of Credit risk
Ist Step : Calculate Fund Based and Non Fund Based Adjusted Exposure
2ndStep: Deduct Allowable Reduction after applying haircuts
3rdStep : Apply Risk Weights as per Ratings
4thStep: Calculate Risk Weighted Assets
5thStep : Calculate Capital Charge
Ist Step: Calculate Fund Based and Non Fund Based Exposure:
Example:
Fund Based Exposure (Amount in ‗000)
Nature of loan Limit Outstanding Undrawn portion
CC 200 100 100
Page 38
Bills Purchased 60 30 30
Packing Credit 40 30 10
Term Loan 200 40 160
Total 200
Out of Undrawn portion of TL, 60 is to drawn in a year and balance
beyond 1 year.
Adjusted Exposure:
100% Outstanding(Unrated) = 200
20% of Undrawn CC, BP & PC (140*20/100) = 28
20% of Undrawn TL (1 yr) (60*20/100) = 12
50% of Undrawn TL (>1Yr) (100*50/100) = 50
Total Adjusted Exposure FB limits 290
Non Fund Based Exposure (Amount in ‗000)

Type of NBF Exposure CCF Adjusted
Exposure
Financial Guarantees 90 100% 90
Acceptances 80 100% 80
Standby LC 50 100% 50
Clean LC 50 100% 50
Unconditional Take out finance 100 100% 100
Performance Guarantee 80 50% 40
Bid Bonds 20 50% 10
Conditional Take out finance 50 50% 25
Documentary LC 40 20% 8
Total Adjusted Exposure FB limits = 453
Total Adjusted Exposure = 290000+453000 = 7,43,000
2ndStep: Allowable Reduction after adjusting CRMs (Credit Risk Mitigates)

Reduction from adjusted exposure is made on account of following eligible financial
collaterals:
Eligible Financial Collaterals.
 Deposits being maintained by a borrower under lien.
 Cash (including CDs or FDs), Gold, Govt Securities, KVP, NSC, LIC Policy, Debt
Securities, Mutual Funds‘
 Equity and convertible bonds are no more eligible CRMs.
Formula for Deposits under lien: C*(1-Hfx) X Mf
(C=Amount of Deposit; Hfx =0 (if same currency), Hfx = 0.08 (if diff currency) Mf =
Maturity factor).
Formula for Approved Financial collaterals: C*(1-Hc-Hfx) *Mf ) - E*He
Haircuts(He–Haircut for Exposure & Hc-Haircut for Collateral)
Page 39
Haircut refers to the adjustments made to the amount of exposures to the counter party
and also the value of collateral received to take account of possible future fluctuations in
the value of either, on account of market movements. Standardized Supervisory Haircuts
for collateral /Exposure have been prescribed by RBI and given in the said circular.
Capital Requirement for collateralized transaction

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

In the case of exposure of Rs 100 (denominated in USD) having a maturity of 6 years to a
(b) rated (rating by external credit rating agency) corporate borrower secured by collateral
of Rs 100 by way of A+ rated corporate bond with a maturity of 6 years, the exposure
amount after the applicable haircut @ 12%, will be Rs 112 and the volatility adjusted
collateral value would be Rs 80, (after applying haircut @ 12% as per issue rating and 8%
for currency mismatch) for the purpose of arriving at the value of risk weighted asset &
calculating charge on capital.
There is an exposure of Rs 100 to an unrated Corporate (having no rating from any

external agency) having a maturity of 3 years, which is secured by Govt. Securities outside
the main index having a market value of Rs 100. The haircut for exposure as well as
collateral will be 25%. There is no currency mismatch in this case. The volatility adjusted
exposure and collateral after application of haircuts works out to Rs 125 and Rs 75
respectively. Therefore, the net exposure for calculating RWA works out to Rs 50.
There is a demand loan of Rs 100 secured by bank‘s own deposit of Rs 125. The haircuts
for exposure and collateral would be zero. There is no maturity mismatch. Adjusted
exposure and collateral after application of haircuts would be Rs 100 and Rs 125
respectively. Net exposure for the purpose of RWA would be zero
Other Examples
No. 1:
(a) Exposure----------------------------------------- 100 lac with tenure 3 years
(b) Eligible Collateral in A+ Debt Security -----30 lac with Residual maturity 2 years
(c) Hair cut on Collateral is 6%
(d) Table of Maturity factor shows hair cut as 0.25 for remaining maturity of 2 years/3
years
Calculate Value of Exposure after Risk Mitigation?
Solution:
Value of Exposure after Risk Mitigation =
Current Value of Exposure – Value of adjusted collateral for Hair cut and maturity mismatch
Value of Adjusted Collateral for Hair cut = C*(1-Hc) = 30(1-6%) = 30*94% = 28.20
Value of Adjusted Collateral for Hair cut and Maturity Mismatch = C* (t-0.25)
(T-0.25)
= 28.20*(2-.25)/(3-.25) = 17.95
( Where t = Remaining maturity of Collateral T= Tenure of loan )
Page 40
Value of Exposure after Risk Mitigation = 100-17.95= 82.05 lac.
No. 2
An exposure of Rs. 100 lac is backed by lien on FD of 30 lac. There is no mismatch of
maturity.
Solution:
Hair Cut for CRM i.e. FDR is zero.
Hence Value of Exposure after Risk Mitigation is 100 lac – 30 lac = 70 lac.
Computation of CRAR
In a bank ; Tier 1 Capital = 1000 crore
Tier II Capital = 1200 crore
RWAs for Credit Risk = 10000 crore
Capital Charge for Market Risk = 500 crore
Capital Charge for Op Risk = 300 crore
Find Tier I CRAR and Total CRAR.
Solution:
RWAs for Market Risk = 500/.09 = 5556 crore
RWAs for Op Risk = 300/.09 = 3333 crore
Total RWS = 10000+5556+3333 = 18889 crore
Tier I Capital = 1000 crore
Tier II Capital can be up to maximum 1000
crore Total Capital = 2000 crore
Tier I CRAR = Eligible Tier I Capital /Total RWAs = 1000/18889=5.29%
Total CRAR = Eligible Total Capital /Total RWAs = 2000/18889 = 10.59%
We may conclude that Tier I Capital is less than the required level.
Credit Risk Mitigates

It is a process through which credit Risk is reduced or transferred to counter party.
CRM techniques are adopted at Transaction level as well as at Portfolio level as under:
At Transaction level:
 Obtaining Cash Collaterals
 Obtaining guarantees
 Securitization
 Collateral Loan Obligations and Credit Linked Notes
 Credit Derivatives
What is LRM?
It is Loan Review Mechanism used to evaluate quality of loans and bring improvement in
credit administration.
1. Securitization
It is process/transactions in which financial securities are issued against cash flow
generated from pool of assets. Cash flow arising from receipt of Interest and Principal of
loans are used to pay interest and repayment of securities. SPV (Special PurposeVehicle)
is created for the said purpose. Originating bank transfers assets to SPV and itissues
financial securities which are called PTC (Pass Through Certificates).
Page 41
4. Collateral Loan Obligations (CLO) / Collateralized Debt Obligation (CDO)
It is also a form of securitization. Through CLO, bank removes assets from Balance Sheet
and issues tradable securities. They become free from Regulatory Capital.
Collateralized loan obligations (CLOs) are a form ofsecuritizationwherepayments
frommultiple middle sized and large business loansare pooled together and passed on to
different classes of owners in various classes.. A CLO is a type of collateralized debt obligation.
It allow banks more often to immediately sell loans to external investor/lenders so as to

facilitate the lending of money to business clients and earn fees with little to no risk to
themselves.
3. Credit Derivatives
It is managing risks without affecting portfolio size. Risk is transferred without transfer of
assets from the Balance Sheet though OTC bilateral contract. These are Off Balance Sheet
Financial Instruments. Credit Insurance and LC are similar to Credit derivatives. Under a
Credit Derivative PB (Protection buyer) enters into an agreement with PS
(Protectionseller) for transfer of risks at notional value by making of Premium payments.
In case ofdelinquencies, default, Foreclosure, prepayments, PS compensates PB for the
losses. Settlement can be Physical or Cash. Under physical settlement, asset is transferred
whereas under Cash settlement, only loss is compensated.
Credit Derivatives are generally OTC instruments. ISDA (International Swaps and
Derivatives Association) has come out with documentation evidencing such transaction.
Credit Derivatives are:
1.Credit Default Swaps

2.Total Return Swaps
3.Credit Link Notes
a) Credit Default Swaps
It is a transaction in which PB pays a premium to PS in return of protection against

credit event experienced on reference obligation. i.e. insolvency, default etc.
b) Total Return Swaps
In Total Return Swap, PB swaps with PS, total return on an asset by making
payment of premium. It covers both credit risk and market risk.
c) Credit Linked Notes
A credit linked note (CLN) is a form of funded credit derivative. It is structured as a

securitywith an embedded credit default swapallowing the issuer to transfer a
specific credit risk to credit investors. The issuer is not obligated to repay the debt if a
specified event occurs. This eliminates a third-party insurance provider.
1. It is issued by a special purpose company or trust, designed to offer investors
parvalueatmaturity unless the referenced entitydefaults. In the case of default,
theinvestors receive a recovery rate.
Page 42
 The trust will also have entered into a default swap with a dealer. In case of default, the
trust will pay the dealer par minus the recovery rate, in exchange for an annual fee
which is passed on to the investors in the form of a higher yield on their note.
3. The purpose of the arrangement is to pass the risk of specific default onto
investors willing to bear that risk in return for the higher yield it makes available.
The CLNs themselves are typically backed by very highly-rated collateral, such as
U.S.Treasury securities.
CLO differs from CLN (Credit link notes in the following manner.
 CLO provide credit Exposure to diverse pool of credit where CLN relates to single
credit.
 CLO result in transfer of ownership whereas CLN do not provide such transfer.
 CLO may enjoy higher credit rating than that of originating bank.
SPV – Special Purpose Vehicle

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

raise resources from QIBs (Qualified Institutional Buyers). Security Receipt is issued to
QIBs by SCRC in lieu of amount contributed by them.
Page 43
CHAPTER 2 ASSET LIABILITY MANAGEMENT
Structure
2.1 Introduction
2.2 Nature of ALM Risks and its organisation
2.3 Balance Sheet Structure: Implications for ALM
2.4 Liquidity Risk- Measurement & Management
2.1 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.
Page 44
2.2 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 exactly 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:
2.3 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
Page 45
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.
****
Page 46
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 borrowings 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.
Liquidity is a bank’s capacity to fund increase in assets and meet both expected and unexpected cash
and collateral obligations at reasonable cost and without incurring unacceptable losses. Liquidity risk is
the inability of a bank to meet such obligations as they become due, without adversely affecting the
bank’s financial condition. Effective liquidity risk management helps ensure a bank’s ability to meet its
obligations as they fall due and reduces the probability of an adverse situation developing. This assumes
significance on account of the fact that liquidity crisis, even at a single institution, can have systemic
implications..
To put it in plain vanilla terms, liquidity is having enough cash to meet the current needs and liquidity risk
is the current and prospective risk to a bank's earnings and equity arising out its inability to meet the
obligations when they become due. Thus, effective liquidity risk management is the management of
liquidity by raising sufficient funds either by increasing liabilities or by converting assets promptly and at a
reasonable cost. It has now become imperative for banks to have an adequate liquidity risk management
process commensurate with it's size, complexity and liquidity risk profile as one size does not fit all.
Liquidity problems arise on account of the mismatches in the timing of inflows and outflows. Per se, the
liabilities being the sources of funds are inflows while the assets being application of funds are outflows.
However, in the context of Liquidity Risk Management, we need to look at this issue from the point of
maturing liabilities and maturing assets; a maturing liability is an outflow while a maturing asset is an
inflow. The need for Liquidity Risk Management arises on account of the mismatches in maturing assets
and maturing liabilities.
Mismatching, as we all know, is an inherent feature of banking. It’s said and said very well too, that the
crux of banking is managing mismatches. If banks were to have perfectly matched portfolios they would
neither make money nor need treasury managers to run their business. Anyone can manage banks.
1. Liquidity Risk Management - Need & Importance:
A bank is said to be solvent if it's net worth is not negative. To put it differently, a bank is solvent if the
total realizable value of its assets is more than its outside liabilities (i.e. other than it's equity/owned funds).
As such, at any point in time, a bank could be (i) both solvent and liquid or (ii) liquid but not solvent or (iii)
solvent but not liquid or (iv) neither solvent nor liquid. The need to stay both solvent and liquid therefore,
makes effective liquidity management crucial for increasing the profitability as also the long-term
viability/solvency of a bank. This also highlights the importance of the need of having the best Liquid Risk
Management practices in place in Banks.
We can very well imagine what could happen to a bank if a depositor wanting to withdraw his deposit is
told to do so later or the next day in view of non-availability of cash. The consequences could be severe
and may even sound the death knell of the bank. Any bank, however, strong it may be, would not be able
to survive if all the depositors queue up demanding their money back.
A Liquidity problem in a bank could be the first symptom of financial trouble brewing and shall need to be
assessed and addressed on an enterprise-wide basis quickly and effectively, as such problems can not
only cause significant disruptions on either side of a bank's balance sheet but can also transcend
individual banks to cause systemic disruptions. Banks play a significant role as liquidity providers in the
financial system and to play it effectively they need to have sound liquidity risk management systems in
place. With greater opening up of the world economies and easier cross border flows of funds, the
repercussions of liquidity disturbances in one financial system could cause ripples in others. The recent
Page 47
sub-prime crisis in the US and its impact on others, stands ample testimony to this reality. Liquidity Risk
Management, thus, is of critical importance not only to bankers but to the regulators as well.
Some Key Considerations in LRM include
(i) Availability of liquid assets,

(ii) Extent of volatility of the deposits,
(iii) Degree of reliance on volatile sources of funding,
(iv) Level of diversification of funding sources,
(v) Historical trend of stability of deposits,
(vi) Quality of maturing assets,
(vii) Market reputation,
(viii) Availability of undrawn standbys,
(ix) Impact of off balance sheet exposures on the balance sheet, and
(x) Contingency plans.
Some of the issues that need to be kept in view while managing liquidity include
(i) The extent of operational liquidity, reserve liquidity and contingency liquidity that are required
(ii) The impact of changes in the market or economic condition on the liquidity needs
(iii) The availability, accessibility and cost of liquidity
(iv) The existence of early warning systems to facilitate prompt action prior to surfacing of the
problem and
(v) The efficacy of the processes in place to ensure successful execution of the solutions in times of
need.
2. Potential Liquidity Risk Drivers:
The internal and external factors in banks that may potentially lead to liquidity risk problems in Banks are
as under:
Internal Banking Factors External Banking Factors
High off-balance sheet exposures. Very sensitive financial markets depositors.
The banks rely heavily on the short-term corporate External and internal economic shocks.
deposits.
A gap in the maturity dates of assets and liabilities. Low/slow economic performances.
The banks’ rapid asset expansions exceed the Decreasing depositors’ trust on the banking
available funds on the liability side sector.
Concentration of deposits in the short term Tenor Non-economic factors
Less allocation in the liquid government Sudden and massive liquidity withdrawals from
instruments. depositors.
Fewer placements of funds in long-term deposits. Unplanned termination of government
deposits.
3. Types of Liquidity Risk:
Banks face the following types of liquidity risk:

(i) Funding Liquidity Risk– the risk that a bank will not be able to meet efficiently the expected and
unexpected current and future cash flows and collateral needs without affecting either its daily
operations or its financial condition.
(ii) Market Liquidity Risk – the risk that a bank cannot easily offset or eliminate a position at the
prevailing market price because of inadequate market depth or market disruption.
4. Principles for Sound Liquidity Risk Management:
After the global financial crisis, in recognition of the need for banks to improve their liquidity risk
management, the Basel Committee on Banking Supervision (BCBS) published “Principles for Sound
Liquidity Risk Management and Supervision” in September 2008. The broad principles for sound liquidity
risk management by banks as envisaged by BCBS are as under:
Page 48
Fundamental principle for the management and supervision of liquidity risk
Principle 1 A bank is responsible for the sound management of liquidity risk. A bank should
establish a robust liquidity risk management framework that ensures it maintains
sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to
withstand a range of stress events, including those involving the loss or impairment of
both unsecured and secured funding sources. Supervisors should assess the
adequacy of both a bank’s liquidity risk management framework and its liquidity
position and should take prompt action if a bank is deficient in either area in order to
protect depositors and to limit potential damage to the financial system.
Governance of liquidity risk management
Principle 2 A bank should clearly articulate a liquidity risk tolerance that is appropriate for its
business strategy and its role in the financial system.
Principle 3 Senior management should develop a strategy, policies and practices to manage
liquidity risk in accordance with the risk tolerance and to ensure that the bank
maintains sufficient liquidity. Senior management should continuously review
information on the bank’s liquidity developments and report to the board of directors
on a regular basis. A bank’s board of directors should review and approve the
strategy, policies and practices related to the management of liquidity at least annually
and ensure that senior management manages liquidity risk effectively.
Principle 4 A bank should incorporate liquidity costs, benefits and risks in the internal pricing,
performance measurement and new product approval process for all significant
business activities (both on- and off-balance sheet), thereby aligning the risk-taking
incentives of individual business lines with the liquidity risk exposures their activities
create for the bank as a whole.
Measurement and management of liquidity risk
Principle 5 A bank should have a sound process for identifying, measuring, monitoring and
controlling liquidity risk. This process should include a robust framework for
comprehensively projecting cash flows arising from assets, liabilities and off-balance
sheet items over an appropriate set of time horizons.
Principle 6 A bank should actively monitor and control liquidity risk exposures and funding needs
within and across legal entities, business lines and currencies, taking into account
legal, regulatory and operational limitations to the transferability of liquidity.
Principle 7 A bank should establish a funding strategy that provides effective diversification in the
sources and tenor of funding. It should maintain an ongoing presence in its chosen
funding markets and strong relationships with funds providers to promote effective
diversification of funding sources. A bank should regularly gauge its capacity to raise
funds quickly from each source. It should identify the main factors that affect its ability
to raise funds and monitor those factors closely to ensure that estimates of fund
raising capacity remain valid.
Principle 8 A bank should actively manage its intraday liquidity positions and risks to meet
payment and settlement obligations on a timely basis under both normal and stressed
conditions and thus contribute to the smooth functioning of payment and settlement
systems.
Principle 9 A bank should actively manage its collateral positions, differentiating between
encumbered and unencumbered assets. A bank should monitor the legal entity and
physical location where collateral is held and how it may be mobilised in a timely
manner.
Principle 10 A bank should conduct stress tests on a regular basis for a variety of short-term and
protracted institution-specific and market-wide stress scenarios (individually and in
combination) to identify sources of potential liquidity strain and to ensure that current
exposures remain in accordance with a bank’s established liquidity risk tolerance. A
bank should use stress test outcomes to adjust its liquidity risk management
strategies, policies, and positions and to develop effective contingency plans.
Principle 11 A bank should have a formal contingency funding plan (CFP) that clearly sets out the
strategies for addressing liquidity shortfalls in emergency situations. A CFP should
outline policies to manage a range of stress environments, establish clear lines of
responsibility, include clear invocation and escalation procedures and be regularly
tested and updated to ensure that it is operationally robust.
Principle 12 A bank should maintain a cushion of unencumbered, high quality liquid assets to be
Page 49
held as insurance against a range of liquidity stress scenarios, including those that
involve the loss or impairment of unsecured and typically available secured funding
sources. There should be no legal, regulatory or operational impediment to using
these assets to obtain funding.
Public disclosure
Principle 13 A bank should publicly disclose information on a regular basis that enables market
participants to make an informed judgment about the soundness of its liquidity risk
management framework and liquidity position.
Thus, a sound liquidity risk management system would envisage that:

i) A bank should establish a robust liquidity risk management framework.
ii) The Board of Directors (BoD) of a bank should be responsible for sound management of liquidity risk
and should clearly articulate a liquidity risk tolerance appropriate for its business strategy and its role in
the financial system.
iii) The BoD should develop strategy, policies and practices to manage liquidity risk in accordance with
the risk tolerance and ensure that the bank maintains sufficient liquidity. The BoD should review the
strategy, policies and practices at least annually.
iv) Top management/ALCO should continuously review information on bank’s liquidity developments and
report to the BoD on a regular basis.
v) A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk,
including a robust framework for comprehensively projecting cash flows arising from assets, liabilities and
off-balance sheet items over an appropriate time horizon.
vi) A bank’s liquidity management process should be sufficient to meet its funding needs and cover both
expected and unexpected deviations from normal operations.
vii) A bank should incorporate liquidity costs, benefits and risks in internal pricing, performance
measurement and new product approval process for all significant business activities.
viii) A bank should actively monitor and manage liquidity risk exposure and funding needs within and
across legal entities, business lines and currencies, taking into account legal, regulatory and operational
limitations to transferability of liquidity.
ix) A bank should establish a funding strategy that provides effective diversification in the source and
tenor of funding, and maintain ongoing presence in its chosen funding markets and counterparties, and
address inhibiting factors in this regard.
x) Senior management should ensure that market access is being actively managed, monitored, and
tested by the appropriate staff.
xi) A bank should identify alternate sources of funding that strengthen its capacity to withstand a variety of
severe bank specific and market-wide liquidity shocks.
xii) A bank should actively manage its intra-day liquidity positions and risks.
xiii) A bank should actively manage its collateral positions.
xiv) A bank should conduct stress tests on a regular basis for short-term and protracted institution-specific
and market-wide stress scenarios and use stress test outcomes to adjust its liquidity risk management
strategies, policies and position and develop effective contingency plans.
xv) Senior management of banks should monitor for potential liquidity stress events by using early
warning indicators and event triggers. Early warning signals may include, but are not limited to, negative
publicity concerning an asset class owned by the bank, increased potential for deterioration in the bank’s
financial condition, widening debt or credit default swap spreads, and increased concerns over the
funding of off- balance sheet items.
xvi) To mitigate the potential for reputation contagion, a bank should have a system of effective
communication with counterparties, credit rating agencies, and other stakeholders when liquidity
problems arise.
xvii) A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for
addressing liquidity shortfalls in emergency situations. A CFP should delineate policies to manage a
range of stress environments, establish clear lines of responsibility, and articulate clear implementation
and escalation procedures.
xviii) A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as
insurance against a range of liquidity stress scenarios.
xix) A bank should publicly disclose its liquidity information on a regular basis that enables market
participants to make an informed judgment about the soundness of its liquidity risk management
framework and liquidity position.
5. Governance of Liquidity Risk Management:
Page 50
The Reserve Bank had issued guidelines on Asset Liability Management (ALM) system, covering inter
alia liquidity risk management system, in February 1999 and October 2007. Successful implementation of
any risk management process has to emanate from the top management in the bank with the
demonstration of its strong commitment to integrate basic operations and strategic decision making with
risk management. Ideally, the organisational set up for liquidity risk management should be as under:
A. The Board of Directors (BoD):
The BoD should have the overall responsibility for management of liquidity risk. The Board should decide
the strategy, policies and procedures of the bank to manage liquidity risk in accordance with the liquidity
risk tolerance/limits as detailed in paragraph 14. The risk tolerance should be clearly understood at all
levels of management. The Board should also ensure that it understands the nature of the liquidity risk of
the bank including liquidity risk profile of all branches, subsidiaries and associates (both domestic and
overseas), periodically reviews information necessary to maintain this understanding, establishes
executive-level lines of authority and responsibility for managing the bank’s liquidity risk, enforces
management’s duties to identify, measure, monitor, and manage liquidity risk and formulates/reviews the
contingent funding plan.
B. The Risk Management Committee:
The Risk Management Committee, which reports to the Board, consisting of Chief Executive Officer
(CEO)/Chairman and Managing Director (CMD) and heads of credit, market and operational risk
management committee should be responsible for evaluating the overall risks faced by the bank including
liquidity risk. The potential interaction of liquidity risk with other risks should also be included in the risks
addressed by the risk management committee.
C. The Asset-Liability Management Committee (ALCO):
The Asset-Liability Management Committee (ALCO) consisting of the bank’s top management should be
responsible for ensuring adherence to the risk tolerance/limits set by the Board as well as implementing
the liquidity risk management strategy of the bank in line with bank’s decided risk management objectives
and risk tolerance.
D. The Asset Liability Management (ALM) Support Group:
The ALM Support Group consisting of operating staff should be responsible for analysing, monitoring and
reporting the liquidity risk profile to the ALCO. The group should also prepare forecasts (simulations)
showing the effect of various possible changes in market conditions on the bank’s liquidity position and
recommend action needed to be taken to maintain the liquidity position/adhere to bank’s internal limits.
6. Liquidity Risk Management Policy, Strategies and Practices:
The first step towards liquidity management is to put in place an effective liquidity risk management policy,
which inter alia, should spell out the liquidity risk tolerance, funding strategies, prudential limits, system for
measuring, assessing and reporting / reviewing liquidity, framework for stress testing, liquidity planning
under alternative scenarios/formal contingent funding plan, nature and frequency of management
reporting, periodical review of assumptions used in liquidity projection, etc. The policy should also
address liquidity separately for individual currencies, legal entities like subsidiaries, joint ventures and
associates, and business lines, when appropriate and material, and should place limits on transfer of
liquidity keeping in view the regulatory, legal and operational constraints.
The BoD or its delegated committee of board members should oversee the establishment and approval of
policies, strategies and procedures to manage liquidity risk, and review them at least annually.
6.1 Liquidity Risk Tolerance:
Banks should have an explicit liquidity risk tolerance set by the Board of Directors. The risk tolerance
should define the level of liquidity risk that the bank is willing to assume, and should reflect the bank’s
financial condition and funding capacity. The tolerance should ensure that the bank manages its liquidity
in normal times in such a way that it is able to withstand a prolonged period of, both institution specific
and market wide stress events. The risk tolerance articulation by a bank should be explicit,
comprehensive and appropriate as per its complexity, business mix, liquidity risk profile and systemic
significance. They may also be subject to sensitivity analysis. The risk tolerance could be specified by
way of fixing the tolerance levels for various maturities under flow approach depending upon the bank’s
liquidity risk profile as also for various ratios under stock approach. Risk tolerance may also be expressed
in terms of minimum survival horizons (without Central Bank or Government intervention) under a range
Page 51
of severe but plausible stress scenarios, chosen to reflect the particular vulnerabilities of the bank. The
key assumptions may be subject to a periodic review by the Board.
6.2 Strategy for Managing Liquidity Risk:
The strategy for managing liquidity risk should be appropriate for the nature, scale and complexity of a
bank’s activities. In formulating the strategy, banks/banking groups should take into consideration its legal
structures, key business lines, the breadth and diversity of markets, products, jurisdictions in which they
operate and home and host country regulatory requirements, etc. Strategies should identify primary
sources of funding for meeting daily operating cash outflows, as well as expected and unexpected cash
flow fluctuations.
7. Management of Liquidity Risk:
A bank should have a sound process for identifying, measuring, monitoring and mitigating liquidity risk as
enumerated below:
8.1 Identification:
A bank should define and identify the liquidity risk to which it is exposed for each major on and off-
balance sheet position, including the effect of embedded options and other contingent exposures that
may affect the bank’s sources and uses of funds and for all currencies in which a bank is active.
8.2 Measurement of Liquidity Risk:

There are two simple ways of measuring liquidity; one is the stock approach and the other, flow approach.
The stock approach is the first step in evaluating liquidity. Under this method, certain ratios, like liquid
assets to short term total liabilities, purchased funds to total assets, core deposits to total assets, loan to
deposit ratio, etc. are calculated and compared to the benchmarks that a bank has set for itself. While the
stock approach helps up in looking at liquidity from one angle, it does not reveal the intrinsic liquidity
profile of a bank.
The flow approach, on the other hand, forecasts liquidity at different points of time. It looks at the liquidity
requirements of today, tomorrow, the day thereafter, in the next seven to 14 days and so on. The maturity
ladder, thus, constructed helps in tracking the cash flow mismatches over a series of specified time
periods. The liquidity controls, apart from being fixed maturity-bucket wise, should also encompass
maximum cumulative mismatches across the various time bands.
8. Ratios in respect of Liquidity Risk Management:
Certain critical ratios in respect of liquidity risk management and their significance for banks are given
below. Banks may monitor these ratios by putting in place an internally defined limit approved by the
Board for these ratios. The industry averages for these ratios are given for information of banks. They
may fix their own limits, based on their liquidity risk management capabilities, experience and profile. The
stock ratios are meant for monitoring the liquidity risk at the solo bank level. Banks may also apply these
ratios for monitoring liquidity risk in major currencies, viz. US Dollar, Pound Sterling, Euro and Japanese
Yen at the solo bank level.
Sl. Ratio Significance Industry

No. Average
(in %)
1. (Volatile liabilities –
Measures the extent to which volatile money supports 40
Temporary Assets) bank’s basic earning assets. Since the numerator
/(Earning Assets –
represents short-term, interest sensitive funds, a high
Temporary Assets) and positive number implies some risk of illiquidity.
2. Core deposits/Total Assets
Measures the extent to which assets are funded 50
through stable deposit base.
3. (Loans + mandatory SLR + Loans including mandatory cash reserves and 80
mandatory CRR + Fixed statutory liquidity investments are least liquid and
Assets)/Total Assets hence a high ratio signifies the degree of ‘illiquidity’
embedded in the balance sheet.
Page 52
4. (Loans + mandatory SLR + Measure the extent to which illiquid assets are 150
mandatory CRR + Fixed financed out of core deposits.
Assets) / Core Deposits
5. Temporary Assets/Total Measures the extent of available liquid assets. A 40
Assets higher ratio could impinge on the asset utilisation of
banking system in terms of opportunity cost of holding
liquidity.
6. Temporary Assets/ Volatile Measures the cover of liquid investments relative to 60
Liabilities volatile liabilities. A ratio of less than 1 indicates the
possibility of a liquidity problem.
7. Volatile Liabilities/Total Measures the extent to which volatile liabilities fund the 60
Assets balance sheet.
Volatile Liabilities: (Deposits + borrowings and bills payable up to 1 year). Letters of credit – full
outstanding. Component-wise CCF of other contingent credit and commitments. Swap funds (buy/ sell)
up to one year. Current deposits (CA) and Savings deposits (SA) i.e. (CASA) deposits reported by the
banks as payable within one year (as reported in structural liquidity statement) are included under volatile
liabilities. Borrowings include from RBI, call, other institutions and refinance.
Temporary assets =Cash + Excess CRR balances with RBI + Balances with banks + Bills
purchased/discounted up to 1 year + Investments up to one year + Swap funds (sell/ buy) up to one year.
Earning Assets = Total assets – (Fixed assets + Balances in current accounts with other banks + Other
assets excluding leasing + Intangible assets)
Core deposits = All deposits (including CASA) above 1 year (as reported in structural liquidity
statement)+ net worth
The above stock ratios are only illustrative and banks could also use other measures / ratios. For
example to identify unstable liabilities and liquid asset coverage ratios banks may include ratios of
wholesale funding to total liabilities, potentially volatile retail (e.g. high cost or out of market) deposits to
total deposits, and other liability dependency measures, such as short term borrowings
9. Stress Testing:
Stress testing should form an integral part of the overall governance and liquidity risk management
culture in banks. A bank should conduct stress tests on a regular basis for a variety of short term and
protracted bank specific and market wide stress scenarios (individually and in combination). In designing
liquidity stress scenarios, the nature of the bank’s business, activities and vulnerabilities should be taken
into consideration so that the scenarios incorporate the major funding and market liquidity risks to which
the bank is exposed. These include risks associated with its business activities, products (including
complex financial instruments and off-balance sheet items) and funding sources. The defined scenarios
should allow the bank to evaluate the potential adverse impact these factors can have on its liquidity
position. While historical events may serve as a guide, a bank’s judgment also plays an important role in
the design of stress tests.
Stress tests outcomes should be used to identify and quantify sources of potential liquidity strain and to
analyse possible impacts on the bank’s cash flows, liquidity position, profitability and solvency. The
results of stress tests should be discussed thoroughly by ALCO. Remedial or mitigating actions should be
identified and taken to limit the bank’s exposures, to build up a liquidity cushion and to adjust the liquidity
profile to fit the risk tolerance. The results should also play a key role in shaping the bank’s contingent
funding planning and in determining the strategy and tactics to deal with events of liquidity stress.
The stress test results and the action taken should be documented by banks and made available to the
Reserve Bank / Inspecting Officers as and when required. If the stress test results indicate any
vulnerability, these should be reported to the Board and a plan of action charted out immediately. The
Department of Banking Supervision, Central Office, Reserve Bank of India should also be kept informed
immediately in such cases.
10. Contingency Funding Plan:
Page 53
A bank should formulate a contingency funding plan (CFP) for responding to severe disruptions which
might affect the bank’s ability to fund some or all of its activities in a timely manner and at a reasonable
cost. CFPs should prepare the bank to manage a range of scenarios of severe liquidity stress that include
both bank specific and market-wide stress and should be commensurate with a bank’s complexity, risk
profile, scope of operations. Contingency plans should contain details of available / potential contingency
funding sources and the amount / estimated amount which can be drawn from these sources, clear
escalation / prioritisation procedures detailing when and how each of the actions can and should be
activated and the lead time needed to tap additional funds from each of the contingency sources.
Contingency plans must be tested regularly to ensure their effectiveness and operational feasibility and
should be reviewed by the Board at least on an annual basis.
11. Overseas Operations of the Indian Banks’ Branches and Subsidiariesand Branches of Foreign
banks in India:
A bank’s liquidity policy and procedures should also provide detailed procedures and guidelines for their
overseas branches/subsidiaries to manage their operational liquidity on an ongoing basis. Similarly,
foreign banks operating in India should also be self reliant with respect to liquidity maintenance and
management.
12. BROAD NORMS IN RESPECT OF LIQUIDITY MANAGEMENT:
Some of the broad norms in respect of liquidity management are as follows:
i. Banks should not normally assume voluntary risk exposures extending beyond a period
of ten years.
ii. Banks should endeavour to broaden their base of long- term resources and funding
capabilities consistent with their long term assets and commitments.
iii. The limits on maturity mismatches shall be established within the following tolerance
levels: (a) long term resources should not fall below 70% of long term assets; and (b) long and
medium term resources together should not fall below 80% of the long and medium term assets.
These controls should be undertaken currency-wise, and in respect of all such currencies which
individually constitute 10% or more of a bank’s consolidated overseas balance sheet. Netting of
inter-currency positions and maturity gaps is not allowed. For the purpose of these limits, short
term, medium term and long term are defined as under:
Short-term: those maturing within 6 months

Medium-term: those maturing in 6 months and longer but within 3 years
Long-term: those maturing in 3 years and longer
1. The monitoring system should be centralised in the International Division (ID) of the bank
for controlling the mismatch in asset-liability structure of the overseas sector on a consolidated
basis, currency-wise. The ID of each bank may review the structural maturity mismatch position
at quarterly intervals and submit the review/s to the top management of the bank.
13. Liquidity Across Currencies
Banks should have a measurement, monitoring and control system for liquidity positions in the major
currencies in which they are active. For assessing the liquidity mismatch in foreign currencies, as far as
domestic operations are concerned, banks are required to prepare Maturity and Position (MAP)
statements according to the extant instructions. A bank should also undertake separate analysis of its
strategy for each major currency individually by taking into account the outcome of stress testing.
14. Management Information System (MIS)
A bank should have a reliable MIS designed to provide timely and forward-looking information on the
liquidity position of the bank and the Group to the Board and ALCO, both under normal and stress
Page 54
situations. The MIS should cover liquidity positions in all currencies in which the bank conducts its
business – both on a subsidiary / branch basis (in all countries in which the bank is active) and on an
aggregate group basis. It should capture all sources of liquidity risk, including contingent risks and those
arising from new activities, and have the ability to furnish more granular and time sensitive information
during stress events.
Liquidity risk reports should provide sufficient detail to enable management to assess the sensitivity of the
bank to changes in market conditions, its own financial performance, and other important risk factors. It
may include cash flow projections, cash flow gaps, asset and funding concentrations, critical assumptions
used in cash flow projections, funding availability, compliance to various regulatory and internal limits on
liquidity risk management, results of stress tests, key early warning or risk indicators, status of contingent
funding sources, or collateral usage, etc.
15. Reporting to the Reserve Bank of India
Banks are required to submit the liquidity return, as per the prescribed format to the Chief General
Manager-in-Charge, Department of Banking Supervision, Reserve Bank of India, Central Office, World
Trade Centre, Mumbai.
16. Internal Controls
A bank should have appropriate internal controls, systems and procedures to ensure adherence to
liquidity risk management policies and procedure as also adequacy of liquidity risk management
functioning.
Management should ensure that an independent party regularly reviews and evaluates the various
components of the bank’s liquidity risk management process. These reviews should assess the extent to
which the bank’s liquidity risk management complies with the regulatory/supervisory instructions as well
as its own policy. The independent review process should report key issues requiring immediate attention,
including instances of non compliance to various guidance/limits for prompt corrective action consistent
with the Board approved policy.
Basel III Framework on Liquidity Standards – Liquidity Coverage Ratio (LCR), Liquidity Risk
Monitoring Tools and LCR Disclosure Standards
Liquidity Coverage Ratio

1. Introduction:
With the objective of promoting a more resilient banking sector, the ‘Basel III International framework for
liquidity risk measurement, standards and monitoring’was issued in December 2010. The Basel
Committee prescribed two minimum standards viz. Liquidity Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR) for funding liquidity to achieve two separate but complementary objectives.
While 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.
2. Objective:
The LCR standard aims to ensure that a bank maintains an adequate level of unencumbered HQLAs that
can be converted into cash to meet its liquidity needs for a 30 calendar day time horizon under a
significantly severe liquidity stress scenario specified by supervisors. At a minimum, the stock of liquid
Page 55
assets should enable the bank to survive until day 30 of the stress scenario, by which time it is assumed
that appropriate corrective actions can be taken.
3.Scope:
To start with, the LCR and monitoring tools would be applicable for Indian banks at whole bank level only
i.e. on a stand-alone basis including overseas operations through branches. However, banks should
endeavour to move over to meeting the standard at consolidated level also. For foreign banks operating
as branches in India, the framework would be applicable on standalone basis (i.e. for Indian operations
only).
4. Definition of LCR:
Stock of high quality liquid assets (HQLAs) ≥ 100%
Total net cash outflows over the next 30 calendar days
The LCR requirement is binding on banks from January 1, 2015. However, to provide a transition time for
banks, Reserve Bank of India has permitted a gradual increase in the ratio starting with a minimum 60%
for the calendar year 2015 as per the time-line given below:
January 1 2015 January 1 January 1 January 1 January 1
2016 2017 2018 2019
Minimum LCR 60% 70% 80% 90% 100%
Banks should, however, strive to achieve a higher ratio than the minimum prescribed above as an effort
towards better liquidity risk management.
With effect from January 1, 2019, i.e. after the phase-in arrangements are complete, the LCR should be
minimum 100% (i.e. the stock of HQLA should at least equal total net cash outflows) on an ongoing basis
because the stock of unencumbered HQLA is intended to serve as a defence against the potential onset
of liquidity stress. During a period of financial stress, however, banks may use their stock of HQLA, and
thereby falling below 100%. Banks shall be required to immediately report to RBI (Department of Banking
Operations and Development as also Department of Banking Supervision) such use of stock of HQLA
along with reasons for such usage and corrective steps initiated to rectify the situation.
The stress scenario specified by the BCBS entails a combined idiosyncratic and market-wide shock that
would result in:
a) the run-off of a proportion of retail deposits;
b) a partial loss of unsecured wholesale funding capacity;
c) a partial loss of secured, short-term financing with certain collateral and counterparties;
d) additional contractual outflows that would arise from a downgrade in the bank’s public credit rating by
up to three notches, including collateral posting requirements;
e) increases in market volatilities that impact the quality of collateral or potential future exposure of
derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other
liquidity needs;
f) unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to
its clients; and
g) the potential need for the bank to buy back debt or honour non-contractual obligations in the interest of
mitigating reputational risk.
5 High Quality Liquid Assets:
5.1 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. The liquidity of an asset depends on the
underlying stress scenario, the volume to be monetized and the timeframe considered. Nevertheless,
there are certain assets that are more likely to generate funds without incurring large discounts due to
fire-sales even in times of stress.
5.2 While the fundamental characteristics of these assets include low credit and market risk; ease and
certainty of valuation; low correlation with risky assets and listing on a developed and recognized
exchange market, the market related characteristics include active and sizeable market; presence of
committed market makers; low market concentration and flight to quality (tendencies to move into these
types of assets in a systemic crisis).
5.3 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
Page 56
price-volatility. Assets to be included in each category are those that the bank is holding on the first day of
the stress period.
6. Calculation of LCR:
As stated in the definition of LCR, it is a ratio of two factors, viz, the Stock of HQLA and the Net Cash
Outflows over the next 30 calendar days. Therefore, computation of LCR of a bank will require
calculations of the numerator and denominator of the ratio, as detailed in the RBI Circular.
7. Liquidity Risk Monitoring Tools:

7.1 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. These metrics along with their objective and the
prescribed returns are as under:
(a) Contractual Maturity Mismatch
The contractual maturity mismatch profile identifies the gaps between the contractual inflows and outflows
of liquidity for defined time bands. These maturity gaps indicate how much liquidity a bank would
potentially need to raise in each of these time bands if all outflows occurred at the earliest possible date.
This metric provides insight into the extent to which the bank relies on maturity transformation under its
current contracts.
(b) Concentration of Funding

This metric is meant to identify those sources of funding that are of such significance, the withdrawal of
which could trigger liquidity problems. The metric thus encourages the diversification of funding sources
recommended in the Basel Committee's Sound Principles. This metrics aims to address the funding
concentration of banks by monitoring their funding from each significant counterparty, each significant
product / instrument and each significant currency.
(c) Available Unencumbered Assets
This metric provides supervisors with data on the quantity and key characteristics of banks' available
unencumbered assets. These assets have the potential to be used as collateral to raise additional
secured funding in secondary markets and / or are eligible at central banks.
(d) LCR by Significant Currency
While the LCR standard is required to be met in one single currency, in order to better capture potential
currency mismatches, the LCR in each significant currency needs to be monitored.
(e) Market-related Monitoring Tools
This includes high frequency market data that can serve as early warning indicators in monitoring
potential liquidity difficulties at banks.
8. Basel III Liquidity Returns:
S. No. Name of the Basel III Liquidity Frequency of Time period by which
Return (BLR) submission required to be reported
1. Statement on Liquidity Coverage Monthly within 15 days
Ratio (LCR)-BLR-1
2. Statement of Funding Concentration Monthly within 15 days
- BLR-
3. Statement of Available Quarterly within a month
Unencumbered Assets - BLR-3
4. LCR by Significant Currency - BLR-4 Monthly within a month
5. Statement on Other Information on Monthly within 15 days
Liquidity - BLR-5
9. LCR Disclosure Standards:
9.1 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, for which the LCR related
information needs to be furnished only for the quarter ending March 31, 2015. However, in subsequent
annual financial statements, the disclosure should cover all the four quarters of the relevant financial year.
10. Net Stable Funding Ratio (NSFR):
Page 57
10.1 This ratio aims at promoting medium to long term structure funding of assets and activities of the
Banks. BCBS aims to trial this ratio from 2012 and makes it mandatory in January 2018.
RBI released its Draft guidelines on NSFR on May 28, 2015. The objective of NSFR is to ensure that
banks maintain a stable funding profile in relation to the composition of their assets and off-balance sheet
activities. A sustainable funding structure is intended to reduce the probability of erosion of a bank’s
liquidity position due to disruptions in its regular sources of funding that would increase the risk of its
failure and potentially lead to broader systemic stress. The NFSR limits overreliance on short-term
wholesale funding, encourages better assessment of funding risk across all on- and off-balance sheet
items, and promotes funding stability. The Reserve Bank proposes to make NFSR applicable to banks in
India from January 1, 2018. (Source RBI).
10.2 Definition of the Standard Net Stable Funding Ratio:
(Available Stable Funding (ASF))/Required Stable Funding (RSF)) x 100 = Should be 100% or above.
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.
The liquidity strategy should set out the general approach the bank will have to liquidity including
various quantitative and qualitative targets. The strategy should also address the bank’s goal of
protecting financial strategy and the ability to withstand stressful events in the market place. It should
enunciate specific policies on particular aspects of liquidity management like composition of assets and
liabilities, maintenance of cumulative gaps over certain period and approach to managing liquidity in
different currencies and from one country to another. Further, the strategy of managing liquidity risk
should be communicated through out the organization. All business units within the bank that conduct
activities having an impact on liquidity should be fully aware of the liquidity strategy and operate under
the approved policies and procedures. The Board should monitor the performance and liquidity risk
profile of the bank and periodically review information that is timely and sufficiently detailed to allow
them to understand and asses the liquidity risk facing the bank’s key portfolios and the bank as a
whole. Bank should have a liquidity management structure in place to execute effectively the liquidity
Page 58
strategy, policies and procedures. The responsibility of managing the overall liquidity of the bank
should be placed with a specific identified
Page 59
group within the bank. This might be in the form of an Asset Liability Committee comprised of senior
management, the treasury function or a risk management department.
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 )
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, provide 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.
Page 60
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.
Banks should analyse the likely impact of different stress scenarios on their liquidity Position and set
their limits accordingly. Limits should be appropriate to the size complexity and financial condition of
the bank. Management should define the specific procedures and approval necessary for exceptions to
policies and limits.
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.
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
Page 61
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.
b.1 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
Net Gap (B -A) 26 -96 -702 -462 -170 -10761 389 11598 -177
Cumulative Gap 26 -70 -772 -1234 -1404 - 12165 -11776 -177
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., either 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.
b.2 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 than 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
Page 62
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.
b.3 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 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
Page 63
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.
This problem of banks has been exacerbated by the behavior of a few large corporate who maintain an
unutilized limit and borrow from the money or capital market as the rate would be cheaper than the
lending rate of banks. These corporate return to the unutilized portion when the market turns tight or
the market as a source of borrowing by corporate dry up. 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.
This option of the term deposit holder is the put option. Similarly, the term loan borrowers may exercise
their call 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 with the same institution
at new rates. To continue with our term deposit holder example, if the deposit is prematurely withdrawn
and taken out, then it would have an impact on liquidity. But if the deposit is withdrawn prematurely but
rebooked in the same bank at a higher rate, then there is impact on liquidity. A careful analysis of the
embedded options and their impact on the liquidity position need to be analyzed as they display
appreciable variations in terms of geographic region, the socio-economic profile of the customer,
remaining life of the asset or liability, size of the asset or liability, the extent of change in the market
interest rates, etc.
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 make 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.
b.4 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
Page 64
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 interim 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.
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:
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).
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;
Page 65
(c) 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.
(d) 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:
(e) 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 any 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
(f) 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. 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
Page 66
tools / metrics for better monitoring a bank's liquidity position. While some of these monitoring
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
BLR
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
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, for which the LCR related
information needs to be furnished only for the quarter ending March 31, 2015.
Operational Risk
Operational Risk is the risk of loss resulting from
 Inadequate or failed internal processes, people and system.
 External events such as dacoity, burglary, fire etc.
It includes legal risks but excludes strategic /reputation risks.

Identification
 Actual Loss Data Base
 RBIA reports
 Risk Control & Self Assessment Survey
 Key Risk indicators
 Scenario analysis
 Prevent
 Reduce
 Transfer
 Carry/Accept
Page 67
Operation Three approaches have been defined to measure Operational Risk at the
al Risk – branches/offices of the bank:
Measurem 1. Basic Indicator approach
ent 2. Standardized approach
3. AMA i.e. Advanced measurement approach
Basic 15% of Average positive gross annual income of previous 3 years will be
Indicator requirement of capital. To start with banks will have to adopt this
Approach approach and huge capital is required to be maintained.
The All banking activities are to be divided in 8 business lines. 1) Corporate

Standardi finance 2) Trading & Sales 3) Retail Banking 4) Commercial Banking 5)
zed Asset Management 6) Retail brokerage 7) Agency service 8) Payment
approach settlement
– β factor Within each business line, Capital requirement will be calculated as
under:
By multiplying the average gross income generated by a business over
previous 3 years by a factor β ranging from 12 % to 18 % depending
upon industry-wise relationships as under:
Retail Banking, Retail Brokerage and Asset Management -----------12%

Commercial Banking and Agency Services----------------------------- 15%
Corporate, Trading and Payment Settlement---------------------------- 18%
Advanced Capital requirement is calculated by the actual risk measurement system
Measurem devised by bank‘s own internal Operational Risk Measurement methods
ent using quantitative and qualitative criteria. Our bank has started measuring
approach actual losses and estimating future losses by introducing statement of
Operational Risk Loss data w.e.f. 1.4.2005. Minimum 5 year data is
required for a bank to switch over to AMA.
How to calculate RWAs for Operational Risk?
RWAs for Operational Risk = Capital Charge (If required CAR is 9%)
.09%
52
Page 68
Operational
Risk Events Cause based
 People oriented – losses due to negligence, incompetence, lack
of awareness etc.
 Process oriented – losses due to business volume, less staff,
organization complexity, lack of supervision etc.
 Technology oriented – failure of system etc.
 External causes: Floods, natural disters etc.
Effect Based
 Claim cases in court settled against the bank.
 Penalties due to non-compliance
 Tax penalties
 Write off
 Delayed interest
Event Based
 Internal and External Frauds
 Dacoity, Burg alary etc.
 Damage to assets
 Business disruption.
 Employment practices and workplace safety.
Operational It is a term used in measurement of Operational Risk on the basis of

Risk - scenario estimates.
Scenario Banks use scenario analysis based on expert opinion in conjunction
Analysis with external data to evaluate its exposure to high severity events.
In addition, scenario analysis is used to assess impact of deviations

from correlation assumptions in the bank‘s Operational Risk
measurement framework to evaluate potential losses arising from
operational risk loss events.
Operational Insurance cover, if available can reduce the operational risk only when
Risk Mitigation AMA is adopted for estimating capital requirements. The recognition of
insurance mitigation is limited to 20% of total Operational Risk
Capital Charge calculated under AMA.
ORMC (Operational Risk Management Committee) under ORMD

(Operational Risk Management Division) is formed at bank level to
record, report and prevent Operational Risks at Branch level.
Practical Under AMA approach, Estimated level of Operational Risk is calculated

Example –AMA on the basis of:
approach 1. Estimated probability of occurrence
2. Estimated potential financial impact
3. Estimated impact of internal control.
Estimated Probability of Occurrence : This is based on historical

frequency of occurrence and estimated likelihood of future occurrence.
Probability is mapped on scale of 5 as under:
Negligible risk -----1
53
Page 69
Low risk-------------2
Medium Risk------3
High Risk--- -----4
Very High Risk----5
For Calculation, following formula is used:
Estimated level of Operational Risk = {Estimated probability of

occurrence x Estimated potential financial impact x Estimated impact of
internal control} ^0.5
^0.5 implies Under root of whole
Example:
Probability of occurrence = 2
Probability of Financial impact = 4
Impact of Financial control = 50%
Solution
[ 2x4x(1-0.5)] ^0.5 = ∫4 = 2 (Low) Ans.
In case financial impact is 20%

Solution would be:
[ 2x4x(1-0.2)] ^0.5 = ∫6.40 = 1.6 (Low) Ans.
Example for Balance sheet figures of ABC bank are as under:
calculation of
Capital Charge Ist year (Rs. in crores) 2nd Year (Rs. I
for operational Net Profits 120 150
Risk Provisions 240 290
Staff expenses 280 320
Other operating expenses 160 240
Other Income 320 460

Calculate Capital Charge for Operational Risk and RWAs
Capital Charge for Operational Risk is calculated as under:

Gross Income *15/100
Gross Income = Net Profit + Provisions + Staff expenses + Other
operating expenses
Ist year = 120+240+280+160= 800 crore
2nd Year = 150+290+320+240=1000 crore
Average Gross Income = (800+1000)/2 = 900 crore
Capital for operational Risk = 900*15/100 = 135 crore
Risk Weighted Assets for Operational Risk =

135/.08 = 1687.50 Crore (as per BASEL norms)
Or 135/.09 = 1500 crore (as per RBI norms)
Page 70
CHAPTER 4 MARKET RISK
3) Introduction
4) Market risk management
5) Tools for Measurement of Market risk
6) 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.
Market Risk
It is simply risk of losses on Balance sheet and Off Balance sheet items basically in
investments due to movement in market prices.
It is risk of adverse deviation of mark to Market value of trading portfolio during the period.
Any decline in the market value will result into loss.
Market Risk involves the following:

1 Risk Identification
2 Risk Measurement
3 Risk monitoring and control
4 Risk mitigation.
ALCO: Assets Liability Management Committee meets at frequent intervals and

takesdecisions in respect of Product pricing, Maturity profiles and mix of incremental assets
and profiles, Interest rate, Funding policy, Transfer pricing and Balance Sheet Management.
Market Risk measurement

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

This is change in value of security due to 1 basis point change in Market Yield. Higher the
BPV higher will be the risk.
Page 71
Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10
Difference in Market price = 0.10

Difference Yield = 0.05%
BPV = Diff in Market price/Difference in Yield
BPV = 0.10/0.05 = 2 paisa per Rs. 100 i.e. 2 basis points per Rs. 100/-
If Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/-
Now, if the yield on Bond declines by 8 bps, then it will result into profit of Rs. 16000/-
(8x2000). BPV declines as maturity reaches. It will become zero on the date of maturity.
55
Page 72
$ Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration)to receive
Present Value of the bond.
e.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7 years. It
means Total Cash Flow of Rs. 130 to be received in 5 years would be discounted with
Present Value which will be equivalent as amount received in 3.7 years. The Duration of
the Bond is 3.7 Years.
Formula of Calculation of McCauley Duration = ∑PV*T

∑PV
Modified Duration = Duration
1+Yield
Approximate % change in price = Modified Duration X Change in Yield
Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is
5 years. What will be the McCauley Duration.
Modified Duration = Duration/ 1+YTM

Duration = Modified Duration x (1+YTM)
5 x 1.06 = 5.30 Ans.
$ Downside Potential
It captures only possible losses ignoring profit potentials. It integrates sensitivity and
volatility with adverse affect of Uncertainty.
This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method
to calculate downside potential.
Value at Risk (VaR)

It means how much can we expect to lose? What is the potential loss?
Let VaR =x. It means we can lose up to maximum of x value over the next period say week
(time horizon). Confidence level of 99% is taken into consideration.
Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is
only one chance in 100 that daily loss will be more than 10 crore under normal conditions.
VaR in days in 1 year based on 250 working days = 1 x 250 == 2.5 days per year.
100
Back Testing
It is a process where model based VaR is compared with Actual performance. It tells us
whether results fall within pre-specified confidence bonds as predicted by VaR models.
Stress Testing
It seeks to determine possible change in Market Value of portfolio that could arise due to
non-normal movement in one or more market parameters (such as interest rate, liquidity,
56
Page 73
inflation, Exchange rate and Stock price etc.). Four test are applied:
$ Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate ±2%, 4%,6% etc.
$ Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if
possible events occur. It assesses potential consequences for a firm of an extreme.
It is based on historical event or hypothetical event.
$ Maximum loss
The approach assesses the risks of portfolio by identifying most potential
combination of moves of market risks
$ Extreme value theory
The theory is based on behavior of tails (i.e. very high and very low potential
values) of probable distributions.
Risk Management and Control
Market risk is controlled by implementing the business policies and setting of market risk
limits or controlling through economic measures with the objective of attaining higher
RAROC. Risk is managed by the following:
3. Limits and Triggers
4. Risk Monitoring
5. Models of Analyses.
Calculation of Capital Charge of Market Risk
The Basel Committee has two approaches for calculation of Capital Charge on Market
Risk as under:
4. Standardized approach
5. Internal Risk Management approach
Under Standardized approach, there are two methods: Maturity method and duration
method. RBI has decided to adopt Standardization duration method to arrive at capital
charge on the basis of investment rating as under:
Investment rating Capital Required

AAA to AA 0%
A+ to BBB
Residual term to maturity
Up to 6M .28%
Up to 24M 1.14%
More than 24 M 1.80%
Unrated 9.00%
Rated BB and Below 13.5%
How to Calculate RWAs, if Capital Charge is given:

RWAs for Market Risk = Capital Charge (If required CAR is 9%)
.09%
Other Risks and Other Risks like Liquidity Risks, Interest Rate Risk, Strategic Risk,
Capital Reputational Risks and Systemic Risks are not taken care of while
Requirement calculating Capital Adequacy in banks.
57
Page 74
Pillar – II SRP has two issues:
Supervisory 1. To ensure that bank is having adequate capital.
Review Process 2. To encourage banks to use better techniques to mitigate risks.
(SRP) SRP concentrates on 3 main areas:
 Risks not fully captured under Pillar -1 i.e. Interest Rate Risks,
Credit concentration Risks, Liquidity Risk, Settlement Risks,
Reputational Risks and Strategic Risks.
 Risks not at all taken care of in Pillar -1.
 External Factors.
This pillar ensures that the banks have adequate capital. This process
also ensures that the bank managements develop Internal risk capital
assessment process and set capital targets commensurate with bank‘s
risk profile and capital environment. Central Bank also ensures through
supervisory measures that each bank maintains required CRAR and
components of capital i.e. Tier –I & Tier –II are in accordance with
BASEL-II norms. RBIA and other internal inspection processes are the
important tools of bank‘s supervisory techniques.
Every Bank will prepare ICAAP (Internal Capital Adequacy Assessment

Plan) on solo basis which will comprise of functions of measuring and
identifying Risks, Maintaining appropriate level of Capital and
Developing suitable Risk mitigation techniques.
Pillar – III Market discipline is complete disclosure and transparency in the

Market balance sheet and all the financial statements of the bank. The
Discipline disclosure is required in respect of the following:
 Capital structure.
 Components of Tier –I and Tier –II Capital
 Bank‘s approach to assess capital adequacy
 Assessment of Credit Risks, Market Risk and Operational Risk.
 Credit Aspects like Asset Classification, Net NPA ratios,
Movement of NPAs and Provisioning.
Frequency of Disclosure
 Banks with Capital funds of Rs. 100 crore or more will make
interim Disclosures on Quantitative aspects on standalone basis
on their respective websites.
 Larger banks with Capital Funds of Rs. 500 crore or more will
disclose Tier-I capital , Total Capital, CAR on Quarterly basis on
website.
58
Page 75
Risk Weight on NPAs
a) Risk weight on NPAs net of specific provision will be calculated as under:
When provision is less than 20% of NPA o/s ---- 150%

When provision is at least 20% of NPA o/s ---- 100%
Category Provision Rate Criteria Risk Weight

Substandard 15% Provision is less 150%
(Secured) than 20%
Substandard 25% Provision is at-least 100%
(Unsecured) 20%
Doubtful (DI) 25% Provision is at-least 100%
(Secured) 20%
Doubtful (DI) 100% Provision is at-least 50%
(Un-Secured) 50%
Doubtful (D2) 40% Provision is at-least 100%
(Secured) 20%
(Secured) 50%
(Un-Secured) 50%
Off-balance sheet items
Off-balance sheet items have been bifurcated as follows:

(iii) Non-market related off-balance sheet items
(iv) Market related off-balance sheet items
There is two-step process for the purpose of calculating risk weighted assets in respect of
off-balance sheet items:
BI. The notional amount of the transaction is converted into a credit equivalent factor by
multiplying the amount by the specified Credit Conversion Factor (CCF)
The resulting credit equivalent amount is then multiplied by the risk weight
applicable to the counter party or to the purpose for which the bank has extended
finance or the type of asset whichever is higher.
Where the off-balance sheet item is secured by eligible collateral or guarantee, the credit
risk mitigation guidelines will be applied.
Non-market related off-balance sheet items:
Off balance sheet items like direct credit substitutes, trade and performance related
contingent items and commitments with certain draw downs are classified under Non-
market related off-balance sheet items. The credit equivalent amount is determined by
multiplying the contracted amount of that particular transaction by the relevant CCF.
Non-market related off-balance sheet items also include undrawn or partially
undrawn fund based and non-fund based facilities, which are not unconditionally
cancellable. The amount of undrawn commitment is to be included in calculating the off-
59
Page 76
balance sheet items. Non-market related exposure is the maximum unused portion of the
commitment that could be drawn during the remaining period of maturity. In case of term
loan with respect to large project to be drawn in stages, undrawn portion shall be calculated
with respect of the running stage only.
RBI guidelines on CCF (Credit Conversion Factor)
Direct Credit Substitutes CCF

General Guarantees (including Standby LCs), 100%
Acceptances
Transaction related contingent items (Performance 50%
bonds, Bid bonds, Warranties, Indemnities, Standby
LC relating to particular transaction
Short Term LC (Documentary) for Issuing bank as well 20%
as confirming bank
Capital Charge on Un-availed limit
Capital Charge on Undrawn limits is calculated as under:
 20% on Undrawn CC limit

 20% on Undrawn TL limit (which is to be drawn in a year)
 50% on Undrawn TL limit (which is to be drawn beyond a year)
Example
In the case of a cash credit facility for Rs.100 lakh (which is not
unconditionally cancelable) where the availed portion is Rs. 60 lakh, the un-availed
portion of Rs.40 lakh will attract a Credit Conversion Factor (CCF) of 20% (since the
cash credit facility is subject to review / renewal normally once a year). The credit
equivalent amount of Rs.8 lakh (20% of Rs.40 lakh) will be assigned the appropriate
risk weight as applicable to the counterparty / rating to arrive at the risk weighted
asset for the unavailed portion. The availed portion (Rs.60 lakh) will attract a risk
weight as applicable to the counterparty / rating.
In compliance of the new guidelines banks have advised all the branches for:
k) Insertion of Limit Cancellation Clause in loan documents
l) Levying of Commitment Charges
Time frame for Application to RBI by Approval by RBI by
application of IRB approach for 01.04.2012 31.3.2014
different Credit Risk
approaches AMA approach for 01.04.2012 31.3.2014
Operational Risk
Internal Model 01.04.2010 31.3.2011
approach for
Market Risk
60
Page 77
VaR (Value at Value at Risk is how much can we expect to lose? What is potential
Risk) loss?
We can lose maximum up to VaR (value at Risk) over a given time at a
given confidence level.
Calculation of VaR
Market Factor Sensitivity X Daily Volatility X Probability at given
confidence level
Suppose impact of 1% change of interest rate (Price) = 6000/-

Daily Volatility = 3% : Confidence level is 99%
Probability of occurrence at 99% confidence level is 2.326
Defeasance period = 1 day
VaR = 6000x3x2.326 = 41874/-
Duration and Duration is the time that Bondholder must wait for a number of years
Modified (duration) to receive Present Value of Cash Inflows i.e. period in which
Duration PV of Cash Inflows equals Actual Cash outflows..
Formula of calculating Duration (Macaulay‘s Duration)
∑ ( PV*T) / ∑PV
For example:
5 years bond of Rs. 100 @ 6% gives Duration of 3.7 years. It means
Total Cash flow of Rs. 130/- would be equivalent to receiving Rs. 130/-
at the end of 3.7 years.
Modified Duration = Duration / 1 + Yield
CREDIT RISK Fixed Assets : 500 Crore Govt. Securities : 5000 crore
How to find Standard Assets
Risk Weighted Retail ---3000 crore HL -------2000 crore Other loans—10000 cr
Assets? Sub-Standard Assets
Secured ----500 crore Unsecured -----150 crore
Doubtful (DAI) --------------------------------800 crore
Solution:
Retail----------------3000*75/100 = 2250 crore
HL---------------------2000*50/100=1000 crore
Other loans---------10000*100/100 = 10000 crore
Gsec------------------5000*0/100=0
SS Secured----------500*150/100=750 crore
SS Unsecured ------150*100/100=150 crore
Doubtful D1 --------800*100/100=800 crore
Total RWAs = 2250+1000+10000+750+150+800 = 14950 crore
OPERATIONAL
RISK Ist year 2nd year
How to find Net Profit 120 crore 150 crore
Risk Weighted Provisions 240 crore 290 crore
Assets? Staff Expenses 280 crore 320 crore
Other Oper. 160 crore 240 crore
61
Page 78
expenses
Gross Income 800 crore 1000 crore
Average Income 1800/2=900 crore
Capital Charge 900*15/100=135 crore
RWAs (assuming Capital Charge/8% = 135*100/8 =
BASEL rate of 8%) 1687.50 crore
Capital Charge LC within Retail portfolio ------------------- 1000 crore (AAA rated
on Off Balance securities)
Sheet Items Standby LC (As Financial Guarantee)-----500 crore (A rated Co.)
How to find Standby LC –particular transaction-------200 crore (AA rated Co)
Risk Weighted Performance Bonds & Bid bonds--------- 1000 crore (Unrated Co.)
Assets? Financial Guarantees------------------------ 400 crore (AA rated Co.)
Confirmed LC for Imports------------------ 100 crore (AAA rated Co.)
Off Balance Sheet CCF Adjusted RWAs
Exposure Exposure
LC Retail Portfolio 20% 1000*20% = 200 200 *20%
(AAA rated) crore =40 crore
Standby LC (As 100% 500*100% = 500 500*50%

Financial Guarantee) crore =250 crore
(A rated)
Standby LC – 50% 200*50%=100 100*30%
particular transaction crore =30 crore
(AA rated)
Performance Bonds 50% 1000*50%=500 500*100%
& Bid bonds crore =500 crore
(Unrated)
Financial Guarantees 400*100%=400 400*30% 100%
(AA rated) crore =120 crore
Confirmed LC for 20% 100*20%=100 20*20%
Imports crore 4 crore
Total RWAs 40+250+30+500+120+4=944 crore
Capital Required = 944 *9%= 84.96 crore
Tier-I and Tier II RWAs --- Credit and Operational Risks = 10000 crore
Capital RWAs ---- Market Risk =4000 crore
CRAR
Tier –I Capital
Paid up Capital---------------------------------------------100 crore
Free Reserves --------------------------------------------- 300 crore
Perpetual non-Cumulative Preference Shares -----400 crore
Tier-II Capital
Provisions for contingencies --------------------------- 200 crore
Revaluation Reserve-------------------------------------- 300 crore
Subordinate Debts---------------------------------------- 300 crore
Solution
Tier –I Capital = 100+300+400 = 800 crore
Tier-II Capital = ( 300*45/100) + 300 + 1.25 % of RWAs (or Rs. 200
crore) =135 + 300 + 175 = 610 crore
Total Capital = 800 + 610 = 1410 crore
62
Page 79
Minimum In the above example:
Capital CAR = 1410/14000*100 = 10.07%
Required and Minimum Capital Required to support Credit and Operational Risks =
Capital to 10000*9/100 = 900 crore
Support Market Minimum Tier –I Capital Required to support Credit and Operational
Risks Risks =
900*50=450 crore
Minimum Tier –I I Capital Required to support Credit and Operational
Risks =900-450=450 crore
Amount of Tier –I Capital to support Market Risks = 800-450 = 350
crore
Amount of Tier –II Capital to support Market Risks = 610-450 = 160
crore
Volatility with time horizon & Bond Value

Ex.1
If daily volatility of a Security is 2%, how much will be monthly volatility?
Solution
Monthly volatility = Daily Volatility * ∫30 = 2*∫30 = 2*5.477 = 10.95%
AnsEx.2
If per annum volatility is 30% and nos. of trading days per annum be 250, how much will be
daily volatility?
Solution
Annual Volatility = Daily Volatility * ∫250 = Daily Volatility * 15.81
30 = Daily Volatility *15.81
Daily volatility = 30/15.81 = 1.90% Ans.
Ex.3
If 1 day VaR of a portfolio is Rs. 50000/- with 97% confidence level. In a period of 1 year of
300 trading days, how many times the loss on the portfolio may exceed Rs. 50000/-.
Solution
97% confidence level means loss may exceed the given level (50000)on 3 days out of
100.
If out of 100 days loss exceeds the given level on days =3
Then out of 300 days, loss exceeds the given level = 3/100*300 =9 days. Ans.
Ex.4
A 5 year 5% Bond has a BPV of Rs. 50/-, how much the bond will gain or lose due to
increase in the yield of bond by 2 bps
Solution
Increase in yield will affect the bond adversely and the bond will lose.
Since BPV of the bond is Rs. 50/-. Increase in yield by 2 bps will result into loss of value
of Bond by 50*2=100.
Ex.5
1 day VaR of a portfolio is Rs. 50000/- with 90% confidence level. In a period of 1 year (250
days) how many times the loss on the portfolio may exceed Rs.50000/-
Ans. 90% confidence level means on 10 days out of 100, the loss will be more than Rs.
50000/-.
Out of 250 days, loss will be more than 50000/- on 25 days Ans. It means, out of 250
days, loss will not exceed on 225 days.
2 MARKET RISK MANAGEMENT

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
Page 80
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
Page 81
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. 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
A = 25 x 52
A = 1.58%
2. Daily volatility of a security is 1%. What is its 16 days volatility approximately?

a. 3% b. 10% c. 1% d. 4%
Solutions:
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
0.01 = X 0.2480
0.01/0.2480 = X
OR X = 0.040
i.e X = 4%
There are at least three broad methods to computing VAR:
Page 82
4. 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.
5. 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.
6. 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 market 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.
5. 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 correlations 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.
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"
Page 83
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
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
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
Page 84
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.
****
Page 85
CHAPTER 5
CREDIT RISK MANAGEMENT
4.1 Definition and Scope of Credit Risk

4.2 Organisational Structure
4.3 Significance Of Credit Risk:- Measurement And Management
4.4 Risk Identification
4.5 Approaches To Credit Risk Measurement: Intrinsic Risk
4.6 Approaches For Portfolio Concentration Risk
4.7 Tools of Credit Risk Management
4.8 Credit Risk Mitigation
4.1 DEFINITION AND SCOPE OF CREDIT RISK

Simon Hills (2004) of the British Bankers Association defines credit risk “is the 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.
It can be understood from the above that credit risk arises from a whole lot of banking activities apart
from traditional lending activity such as trading in different markets, investment of funds, provision of
portfolio management services, providing different type of guarantees and opening of letters of credit in
favour of customers etc. For example, even though guarantee is viewed as a non -fund based product,
the moment a guarantee is given, the bank is exposed to the possibility of the non- funded commitment
turning into a funded position when the guarantee is invoked by the entity in whose favour the
guarantee was issued by the bank. This means that credit risk runs across different functions
performed by a bank and has to be viewed as such.
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.
4.2 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 external auditors for their scrutiny and comments. The
credit risk strategy and policies adopted by the committee should be effectively communicated
throughout the organisation.
4.2.1 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.
Page 86
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.
4.2.2 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.
4.3 SIGNIFICANCE OF CREDIT RISK:- MEASUREMENT AND MANAGEMENT
The surge in interest in credit risk is due to the following :
Increase in Bankruptcies: Compared to the past, bankruptcies have increased. As a result of this, the
permanent, accurate credit risk analysis practices have become more important than in the past.
Deregulation: Innovation stimulated by deregulation has led to new entrants into the markets to provide
services. The credit risk assessment of the new entrants is very much essential for the well functioning
of the market.
Disintermediation: As large institutions with strong credit quality are less dependent on bank funds,
banks are left to serve institutions with weaker credit quality. The disintermediation has led to fall in the
overall credit quality of the lending book, increasing the importance of credit risk measurement and
management.
Shrinking Margins on Loans: Trends in international markets reveal that the interest margins or
spreads, i.e. the difference between interest income and interest expenses has been falling. Apart from
other factors, the increasing competition in the market is cited as the major reason for this.
Growth of off-Balance Sheet Risks: The phenomenal expansion of the Over-the-Counter (OTC)
derivative products which carry counterparty risk unlike the exchange traded derivatives has increased
the exposure of a number of banks to such products.
Volatility in the Value of Collateral: It has been observed that predicting the market value of collateral
held against loan is very difficult. This may lead to a situation where the value of collateral may fall
below the value of loan granted against it. Falling value of the collateral had been the cause for
banking crises in well developed countries such as US, Europe and Japan.
Advances in Finance Theory and Computer Technology: These advances have paved the way for
banks to test very sophisticated credit risk models that would not have been possible in the absence of
finance theory and computer technology.
Risk-based Capital Regulations: Apart from the above, the development of risk-based capital
requirements pronounced by the Basle Committee has been one of the important drivers of credit risk
initiatives. This is more so with the Basle Accord –II which recognizes the differences in credit quality in
the form of ratings and availability of collateral unlike the previous accord which is in force till date
4.4 RISK IDENTIFICATION:-
Credit Risk and Default
Credit Risk is the risk of loss to the Bank in the event of Default.
Page 87
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
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.
4.5 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
Page 88
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 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 + 0.6X4 + 0.999X5
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.
4.6 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.
Page 89
4.7 Tools of Credit Risk Management.
The instruments and tools, through which credit risk management is carried out, are detailed below:
d) 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 Exposure, 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).
e) 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.
f) 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.
g) 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.
h) 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.
i) 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 credit 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 appraised the advance and where the
main operative limits are made available. However, it is not required to visit borrowers factory/office
premises.
4.8 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 risks 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
Page 90
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.
A securitisation transaction generally involves some or all of the following parties: (i) the initial owner of
the asset (the originator or sponsor) who has a loan agreement with the borrowers (obligors); (ii) the
issuer of debt instruments who also is the SPV. The structure keeps the SPV away from bankruptcy of
the originator, technically called ‘bankruptcy remote’; (iii) the investment bankers who assist in
structuring the transaction and who underwrite or place the securities for a fee; (iv) the rating agencies,
who assess credit quality of certain types of instruments and assign a credit rating; (v) the credit
enhancer, possibly a bank, surety company, or insurer, who provides credit support through a letter of
credit, guarantee, or other assurance; (vi) the servicer, usually the originator, who collects payments
due on the underlying assets and, after retaining a servicing fee, pays them over to the security holders;
(vii) the trustee, who deals with issuer, credit enhancer and servicer on behalf of the security holders;
(viii) the legal counsel, who participates in the structuring of the transaction1; and (ix) the swap
counterparty who provides interest rate / currency swap, if needed.
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
Page 91
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.
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 annualized 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:
Page 92
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 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 value 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 Interest rate
Page 93
asset, index or basket of assets.
The TRS is simply a
III Credit linked notes
buying and selling credit-
inception.
Credit-Linked Notes at glance:-
****
Page 94
CHAPTER 5
OPERATIONAL RISK
5.1 Introduction
5.2 Definition
5.3 Significance of operational risk
5.4 Objectives of operational risk
5.5 Developing appropriate environment
5.6 Methodologies for measurement of operational risk
5.1 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.
5.2 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
Page 95
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.
5.3 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.
5.4 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.
5.5 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
Page 96
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.
5.6 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. The Basic 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
Page 97
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 31.03.2014.
1 2 Rs. in lakhs 3
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
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
31.03.11 31.03.12 31.03.13
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
Page 98
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:
K = S(GI × b )
Where:TSA1-8 1-8
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:
Corporate finance (b 18%

Trading & Sales (b ) 1 18%
Retail Banking (b )2 12%
Commercial Banking3 (b ) 15%
Payment & settlement (b4 ) 18%
Agency services (b ) 5 15%
Asset management6 (b ) 12%
Retail Brokerage (b8) 7 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:
4. Gross income for retail banking consists of net interest income on loans and 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).
5. 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
Page 99
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 on 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).
6. For trading and sales, gross income consists of profits/losses on instruments held for trading
purposes (i.e. in the mark-to-market book), net of funding cost, plus fees from wholesale broking.
7. 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 Ltd by standardized approach
for 31.03.2014. Rs. in lakhs

1 2 3
Interest received 1 255.10 320.18 387.90
Weighted average cost of funding 192.14 268.70 310.22

Non interest income 22.00 18.00 27.00

Net income from derivatives 0 0 27.80
Fees & commission 32.20 44.78 69.34
Net interest income 4 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
31.03.12 31.03.12 31.03.13
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

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
Page 100
Net interest income 78.24 126.10 156.08
Add: BG/LC Fees & commission 56.78 92.24 103.12
bookNet income on securities held in the banking 109.12 98.70 124.56
Gross income from commercial banking 244.14 317.04 383.76
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 :
31.03.11 31.03.12 31.03.13 Total Avg.
Income
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
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 developed 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.
Page 101
Assets & Liability management
Asset Liability Management (ALM) can be defined as a mechanism to address the

risk faced by a bank due to a mismatch between assets and liabilities either due to
liquidity or changes in interest rates. Liquidity is an institution’s ability to meet
its liabilities either by borrowing or converting assets. Apart from liquidity, a bank
may also have a mismatch due to changes in interest rates as banks typically tend to
borrow short term (fixed or floating) and lend long term (fixed or floating).
A comprehensive ALM policy framework focuses on bank profitability and long-
term viability by targeting the net interest margin (NIM) ratio and Net Economic
Value (NEV), subject to balance sheet constraints. Significant among these
constraints are maintaining credit quality, meeting liquidity needs and obtaining
sufficient capital.
An insightful view of ALM is that it simply combines portfolio management
techniques (that is, asset, liability and spread management) into a coordinated
process. Thus, the central theme of ALM is the coordinated – and not piecemeal –
management of a bank’s entire balance sheet.
Although ALM is not a relatively new planning tool, it has evolved from the simple
idea of maturity-matching of assets and liabilities across various time horizons into a
framework that includes sophisticated concepts such as duration matching, variable-
rate pricing, and the use of static and dynamic simulation.
Measuring Risk
The function of ALM is not just protection from risk. The safety achieved through
ALM also opens up opportunities for enhancing net worth. Interest rate risk (IRR)
largely poses a problem to a bank’s net interest income and hence profitability.
Changes in interest rates can significantly alter a bank’s net interest income (NII),
depending on the extent of mismatch between the asset and liability interest rate
reset times. Changes in interest rates also affect the market value of a bank’s equity.
Methods of managing IRR first require a bank to specify goals for either the book
value or the market value of NII. In the former case, the focus will be on the current
value of NII and in the latter, the focus will be on the market value of equity.
In either case, though, the bank has to measure the risk exposure and formulate
strategies to minimise or mitigate risk.
The immediate focus of ALM is interest-rate risk and return as measured by a bank’s
net interest margin.
NIM = (Interest income – Interest expense) / Earning assets

A bank’s NIM, in turn, is a function of the interest-rate sensitivity, volume, and mix
of its earning assets and liabilities. That is, NIM = f (Rate, Volume, Mix)
Sources of interest rate risk
The primary forms of interest rate risk include repricing risk, yield curve risk, basis
risk and optionality.
Effects of interest rate risk
Changes in interest rates can have adverse effects both on a bank’s earnings and its
economic value.
The earnings perspective:
From the earnings perspective, the focus of analyses is the impact of changes in
interest rates on accrual or reported earnings. Variation in earnings (NII)
is an important focal point for IRR analysis because reduced interest earnings will
threaten the financial performance of an institution.
Economic value perspective:
Variation in market interest rates can also affect the economic value of a bank’s
assets, liabilities, and Off Balance Sheet (OBS) positions. Since the economic value
perspective considers the potential impact of interest rate changes on the present
Page 102
value of all future cash flows, it provides a more comprehensive view of the potential
long-term effects of changes in interest rates than is offered by the earnings
perspective.
Interest rate sensitivity and GAP management
This model measures the direction and extent of asset-liability mismatch through
a funding or maturity GAP (or, simply, GAP). Assets and liabilities are grouped
in this method into time buckets according to maturity or the time until the
An insightful view of ALM is that it simply
combines portfolio management techniques
into a coordinated process.
Sl.
No.
Type of GAP Change in Interest Rates
(∆r)
Change in Net Interest
Income (∆NII)
1 RSA = RSLs Increase No change
2 RSA = RSLs Decrease No change
3 RSAs ≥ RSLs Increase NII increases
4 RSAs ≥ RSLs Decrease NII decreases
5 RSAs ≤ RSLs Increase NII decreases
6 RSAs ≤ RSLs Decrease NII increases
first possible resetting of interest rates. For each time bucket the GAP equals the
difference between the interest rate sensitive assets (RSAs) and the interest rate
sensitive liabilities (RSLs). In symbols:
GAP = RSAs – RSLs
When interest rates change, the bank’s NII changes based on the following
interrelationships:
∆NII = (RSAs - RSLs) x ∆r
∆NII = GAP x ∆r
A zero GAP will be the best choice either if the bank is unable to speculate interest
rates accurately or if its capacity to absorb risk is close to zero. With a zero GAP, the
bank is fully protected against both increases and decreases in interest rates as its
NII will not change in both cases.
As a tool for managing IRR,
GAP management suffers from
three limitations:
• Financial institutions in the normal course are incapable of out-predicting the
markets, hence maintain the zero GAP.
• It assumes that banks can flexibly adjust assets and liabilities to attain the
desired GAP.
• It focuses only on the current interest sensitivity of the assets and liabilities,
and ignores the effect of interest rate movements on the value of bank assets
and liabilities.
Cumulative GAP model
In this model, the sum of the periodic GAPs is equal to the cumulative GAP
measured by the maturity GAP model. While the periodic GAP model corrects
many of the deficiencies of the GAP model, it does not explicitly account for the
influence of multiple market rates on the interest income.
Duration GAP model (DAGAP)
Duration is defined as the average life of a financial instrument. It also provides an
approximate measure of market value interest elasticity. Duration analysis begins
by computing the individual duration of each asset and liability and weighting the
individual durations by the percentage of the asset or liability in the balance sheet to
obtain the combined asset and liability duration.
DURgap = DURassets – Kliabilities DURliabilities
Where, Kliabilities = Percentage of assets funded by liabilities
Page 103
DGAP directly indicates the effect of interest rate changes on the net worth of the
institution. The funding GAP technique matches cash flows by structuring the
short-term maturity buckets. On the other hand, the DGAP hedges against IRR
by structuring the portfolios of assets and liabilities to change equally in value

whenever the interest rate changes. If DGAP is close to zero, the market value of the
bank’s equity will not change and, accordingly, become immunised to any changes
in interest rates.
DGAP analysis improves upon the maturity and cumulative GAP models by taking
into account the timing and market value of cash flows rather than the horizon
maturity. It gives a single index measure of interest rate risk exposure.
The application of duration analysis requires extensive data on the specific
characteristics and current market pricing schedules of financial instruments.
However, for institutions which have a high proportion of assets and liabilities
with embedded options, sensitivity analysis conducted using duration as the sole
measure of price elasticity is likely to lead to erroneous results due to the existence
of convexity in such instruments. Apart from this, duration analysis makes an
assumption of parallel shifts in the yield curve, which is not always true. To take
care of this, a high degree of analytical approach to yield curve dynamics is required.
However, immunisation through duration eliminates the possibility of unexpected
gains or losses when there is a parallel shift in the yield curve. In other words, it is a
hedging or risk-minimisation strategy; not a profit-maximisation strategy.
Simulation analysis
Simulations serve to construct the risk-return profile of the banking portfolio.
Scenario analysis addresses the issue of uncertainty associated with the future
direction of interest rates by allowing the analysis of isolated attributes with the
use of ‘what if’ simulations. However, it is debatable if simulation analysis, with its
attendant controls and ratification methods, can effectively capture the dynamics of
yield curve evolution and interest rate sensitivity of key financial variables.
Managing Interest Rate Risk
Depending upon the risk propensity of an institution, risk can be controlled using
a variety of techniques that can be classified into direct and synthetic methods. The
direct method of restructuring the balance sheet relies on changing the contractual
characteristics of assets and liabilities to achieve a particular duration or maturity
GAP. On the other hand, the synthetic method relies on the use of instruments
such as interest rate swaps, futures, options and customised agreements to alter the
balance sheet risk exposure. Since direct restructuring may not always be possible,
the availability of synthetic methods adds a certain degree of flexibility to the asset-
liability GAP management process. In addition, the process of securitisation and
financial engineering can also be used to create assets with wide investor appeal in
order to adjust asset-liability GAPs.
Using interest rate swaps to hedge interest rate risk
Interest rate swaps (IRS) represent a contractual agreement between a financial
institution and a counterparty to exchange cash flows at periodic intervals, based
on a notional amount. The purpose of an interest rate swap is to hedge interest rate
risk. By arranging for another party to assume its interest payments, a bank can
put in place such a hedge. Financial institutions can use such swaps to synthetically
convert floating rate liabilities to fixed rate liabilities. The arbitrage potential
associated with different comparative financing advantages (spreads) enables both
parties to benefit through lower borrowing costs.
In case of a falling interest rate scenario, prepayment will increase with an attendant
shortening of the asset’s average life. The financial institution may have to continue
exchanging swap cash flows for a period longer than the average life of the asset. In
order to protect such situations, options on swaps or ‘swaptions’ may be used. Call
options on swaps allow the financial institution to call the swap, while put options
on swaps allow the institution to activate or put the swap after a specific period.
Page 104
Using financial futures to hedge interest rate risk
A futures contract is an agreement between a buyer and seller to exchange a fixed
quantity of a financial asset at an agreed price on a specified date. Interest rate
futures (IRF) can be used to control the risk associated with the asset/liability GAP
either at the macro-level or at the micro-level. A macro-hedge is used to protect
the entire balance sheet, whereas a micro-hedge is applied to individual assets or
transactions. A buyer, holding a long position, would purchase a futures contract
when interest rates are expected to fall. The seller of a futures contract, on the other
hand, would take a short position in anticipation of rising rates. The protection
provided by financial futures is symmetric in that losses (or gains) in the value of
the cash position are offset by gains (or losses) in the value of the futures position.
Forward contracts are also available to hedge against exchange rate risk.
Futures contracts are not without their own risks. Among the most important is
basis risk, especially prevalent in cross hedging. Financial institutions must also pay
close attention to the hedging ratio, and managements must be careful to follow
regulatory and accounting rules governing the use of futures contracts.
Using options to hedge interest rate risk
Options can be used to create a myriad risk-return profiles using two essential
ingredients: calls and puts. Call option strategies are profitable in bullish interest
rate scenarios. With respect to the ALM process, options can be used for reducing
risk and enhancing yield. Put options can be used to provide insurance against price
declines, with limited risk if the opposite occurs. Similarly, call options can be used
to enhance profits if the market rallies, with the maximum loss restricted to the
upfront premium.
Customised interest rate agreements
‘Customised interest rate agreements’ is the general term used to classify
instruments such as interest rate caps and floors. In return for the protection against
rising liability costs, the cap buyer pays a premium to the cap seller. The pay-off
profile of the cap buyer is asymmetric in nature, in that if interest rates do not
rise, the maximum loss is restricted to the cap premium. Since the cap buyer gains
when interest rates rise, the purchase of a cap is comparable to buying a strip of
put options. Similarly, in return for the protection against falling asset returns, the
floor buyer pays a premium to the seller of the floor. The pay-off profile of the floor
buyer is also asymmetric in nature since the maximum loss is restricted to the floor
premium. As interest rates fall, the pay-off to the buyer of the floor increases in
proportion to the fall in rates. In this respect, the purchase of a floor is comparable
to the purchase of a strip of call options.
By buying an interest rate cap and selling an interest rate floor to offset the cap
premium, financial institutions can also limit the cost of liabilities to a band of
interest rate constraints. This strategy, known as an interest rate ‘collar,’ has the
effect of capping liability costs in rising rate scenarios.
The role of securitisation in ALM
By using securitisation, financial institutions can create securities suitable for resale
in capital markets from assets which otherwise would have been held to maturity.
In addition to providing an alternative route for asset/liability restructuring,
securitisation may also be viewed as a form of direct financing in which savers are
directly lending to borrowers. Securitisation also provides the additional advantage
of cleansing the balance sheet of complex and highly illiquid assets as long as the
transformations required to enhance marketability are available on a cost-effective
basis. Securitisation transfers risks such as interest rate risk, credit risk (unless the
loans are securitised with full or partial recourse to the originator) and pre-payment
risk to the ultimate investors of the securitised assets.
Besides increasing the liquidity and diversification of the loans portfolio,
securitisation allows a financial institution to recapture some part of the profits of
lending and permits reduction in the cost of intermediation.
Conclusion
As the landscape of the financial services industry becomes increasingly competitive,
Page 105
with rising costs of intermediation due to higher capital requirements and deposit
insurance, financial institutions face a loss of spread income. In order to enhance the
loss in profitability due to such developments, financial institutions may be forced
to deliberately mismatch asset/liability maturities in order to generate
higher spreads.
ALM is a systematic approach that attempts to provide a degree of protection to
the risk arising out of the asset/liability mismatch. ALM consists of a framework
to define, measure, monitor, modify and manage liquidity and interest rate risk. It
is not always possible for financial institutions to restructure the asset and liability
mix directly to manage asset/liability GAPs. Hence, off-balance sheet strategies
such as interest rate swaps, options, futures, caps, floors, forward rate agreements,
swaptions, and so on, can be used to create synthetic hedges to manage asset/
liability GAPs.
Basel III & its implications
Introduction:
John Kenneth Galbraith, famous Harvard economist and the US ambassador to India
during J.F. Kennedy’s administration wrote:
‘All financial crises are the result of debt that, in one fashion or another, has
become dangerously out of scale’.
This was clearly demonstrated in the financial crisis which took place in the US in 2008.
Aggressive lending characterized by sub-prime housing loans and excessive leverage in
major banks and financial institutions led to the most serious financial challenge since
the Great Depression of 1930s. The Sub Prime Crisis had reportedly led to a total write
off of 1.18 trillion dollars. One has to understand the causes of the financial crisis and
take appropriate measures to avoid its recurrence. In order to withstand such a shock in
future, the Basel Committee on Banking Supervision (BCBS) has announced on
September 13, 2010, new capital rules as agreed by the global regulators. The new
requirement, known as Basel III, demands a substantial strengthening of existing capital
requirements. This involves higher global minimum capital standards for banks.
As cited above, Basel III reforms are the response of BCBS to improve the banking
sector’s ability to absorb shocks arising from financial and economic stress, whatever
the source, thus reducing the risk of spill over from the financial sector to the real
economy. During the Pittsburgh Summit in September 2009, the G20 leaders committed
to strengthen the regulatory system for banks and other financial firms and also act
together to raise capital standards, to implement strong international compensation
standards aimed at ending practices that lead to excessive risk-taking, to improve the
over-the-counter derivatives market and to create more powerful tools to hold large
global firms to account for the risks they take. For all these reforms, the leaders set for
themselves strict and precise timetables. Consequently, the BCBS released
comprehensive reform package entitled “Basel III: A global regulatory framework
Page 106
formore resilient banks and banking systems” (known as Basel III capital regulations)
inDecember 2010. (Source: RBI)
Basel III reforms strengthen the bank-level i.e. micro prudential regulation, with the
intention to raise the resilience of individual banking institutions in periods of stress.
Besides, the reforms have a macro prudential focus also, addressing system wide risks,
which can build up across the banking sector, as well as the pro-cyclical amplification of
these risks over time. These new global regulatory and supervisory standards mainly
Page 107
seek to raise the quality and level of capital to ensure banks are better able to absorb
losses on both a going concern and a gone concern basis, increase the risk coverage of
the capital framework, introduce leverage ratio to serve as a backstop to the risk-based
capital measure, raise the standards for the supervisory review process (Pillar 2) and
public disclosures (Pillar 3) etc. The macro prudential aspects of Basel III are largely
enshrined in the capital buffers. Both the buffers i.e. the capital conservation buffer and
the countercyclical buffer are intended to protect the banking sector from periods of
excess credit growth. (Source: RBI)
Reserve Bank issued Guidelines based on the Basel III reforms on capital regulation on
May 2, 2012, to the extent applicable to banks operating in India. Banks have started
implementing the guidelines from April 1, 2013 in India in a phased manner. Banks are
advised by RBI to report the CRAR as per Basel II and Basel III simultaneously in all their
disclosures to the stakeholders. The Basel III guidelines are expected to be fully
implemented by March 31, 2019.
 Comparison between the Basel Guidelines:
Basel I Basel II Basel III

• Basel Committee on  BCBS came out with  BCBS came out with
Banking Supervision these guidelines in the this Consultative
(BCBS) had come out year June 2004 to Paper on 13th
with these guidelines overcome the September 2010 as a
in the year July, 1988 inadequate risk fall out of Sub-Prime
as a solution to measurement Crisis of US, which
mitigate the Herstatt approach of Basel I later on became a
Risk that took place in arising out of the contagion effect and
the year 1974 due to changed banking resulted into a
collapse of the German scenario more due to global crisis.
Bank. technology adoption.  As stated above,
 By definition,  Besides, credit & Basel III calls only for
recognized only the market risks, additional capital for
Credit risk as the recognized the the Banks to
potential risk for the following additional withstand the global
failure of the Banks. risk: shocks such as Sub-
 Subsequently, BCBS o Operational Risk. prime crisis in the
came out with Market  The Credit risk of Basel future.
Risk paper in the year I was completely
1996 a set of rules to revamped and Basel II
strengthen the adopted a risk-based
treasury operations of approach. Also
the banks. This was introduced risk
necessitated out of mitigation techniques
Page 108
Page 109
Basel I Basel II Basel III
Nick Leeson Fraud, due as Basel I did not
to which the world saw recognize the role of
the collapse of Barings credit risk mitigants,
Bank Ltd. such as credit
derivatives,
securitizations,
collaterals and
guarantees in reducing
the credit risk.
• Why Basel III?

o According to BCBS, the Basel III guidelines aim to improve the banking
sectors’ability to absorb shocks arising from financial and economic stress.
o In short the objectives of Basel III are:
Strengthening of resilience of the banking sector against future shocks.
Supplementing the current recovery process.
Reducing the risk spillover effect of a financial crisis to the real economy. o The new
Basel III requirement demands bank’sto hold top quality capital
totaling 7% of the risk weighted assets.
o The sigh of relief for the Banks is that the guidelines have given long lead-time
and graded approach for the banks to bring/raise the capital.
o The tier 1 capital ratio would require banks to hold 7% common equity
including2.50% of Capital Conservation Buffer.
• Capital Conservation Buffer (CCB):

3. The 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 are
incurred during a stressed period. The requirement is based on simple capital
conservation rules designed to avoid breaches of minimum capital requirements.
F Banks have been given time until 2019 and in case banks do not comply with the
guidelines, and then they may not be allowed to declare/pay dividends to the
shareholders. The drawdown table of CCB as given by RBI is given below:
Minimum capital conservation standards for individual bank

Common Equity Tier 1 Ratio after including Minimum Capital Conservation
the current periods retained earnings Ratios
(expressed as a percentage of
earnings)
5.5% - 6.125% 100%
>6.125% - 6.75% 80%
Page 110
Page 111
>6.75% - 7.375% 60%
>7.375% - 8.0% 40%
>8.0% 0%
3. For example, a bank with a Common Equity Tier 1 capital ratio in the range of
6.125% to 6.75% is required to conserve 80% of its earnings in the subsequent
financial year (i.e. payout no more than 20% in terms of dividends, share
buybacks and discretionary bonus payments is allowed) – Source RBI.
 The Tier 1 Capital should be in the nature of Going-Concern Capital, i.e., Capital
which can absorb losses without triggering bankruptcy of the Bank. The
components of Tier 1 Capital is:
o Common Equity Tier 1, which would broadly consist of
Common shares (paid-up equity capital)
Share Premium.
Statutory Reserves.
Capital Reserves representing surplus arising out of sale process of assets.
Other disclosed reserves if any.
Balance in Profit & Loss account at the end of previous financial year.
Banks can also reckon the profits in current financial year for CRAR
calculation on a quarterly basis provided the incremental provisions
made for NPAs at the end of the four quarters of the previous financial
year have not deviated more than 25% from average of the four
quarters.
Revaluation reserves at a discount of 55% (This item was originally part of
Tier II capital. RBI has brought the same under Tier I vide Circular of March
1, 2016).
Foreign currency translation reserve arising due to translation of financial

statements of their foreign operations in terms of Accounting Standard (AS)
11 at a discount of 25%.
Deferred Tax Assets (DTAs) which related to timing differences (other

than related to accumulated losses) can be recognized upto 10% of CET1.
The DTA recognized portion + significant investments in the common
shares of unconsolidated financial entities (i.e, banking, financial and
insurance) taken together should not exceed 15% of the CET1.
Banks instead of recognizing as part of CET1 upto 10% can net the
same with associated Deferred Tax Liabilities (DTLs) subject to
approval of tax authorities. In case, a Bank has either not recognized
part of DTA as CET1 or netted the same with associated DTL, then
that portion of DTA would be risk weighted at 250%.
Accumulated losses and any other intangible assets if any such as
goodwill have to be deducted.
Page 112
Additional Tier 1 Capital, which would broadly consist of
Perpetual Non-Cumulative Preference Shares (PNCPS).
Stock Surplus arising out of issue of instruments included in AT1.
Debt instruments such as Innovative Perpetual Debt Instruments (IPDI) and any
other instruments as permitted by the Supervisor.
 The Tier 2 Capital should be in the nature of Gone-Concern Capital, i.e., capital
which would absorb losses only in a situation of liquidation of the Bank. The
components of Tier 2 capital are:
General Provisions and Loss Reserves such as Provision on Standard Assets,
Floating Provisions, Incremental Provisions in respect of Unhedged foreign
currency exposures, provision held for Country exposures, Investment
Reserve Account, excess provision which arise on account of sale of NPAs.
However, these provisions put together should not exceed 1.25% of total
credit risk-weighted assets under Standardized Approach.
6. Debt Instruments issued by the Banks.
o Preference Share Capital instruments such as Perpetual Cumulative
Preference Shares (PCPS), Redeemable Non-Cumulative Preference Shares
(RNCPS), Redeemable Cumulative Preference shares (RCPS) issued by the
Banks.
7. Premium receipt on account of issued above debt instruments.
8. By virtue of the above, Banks have to raise equity capital to replace hybrids and
other instruments such as Perpetual Bonds that will not qualify as Core Capital or
Common Equity Capital under the new rules.
10. RBI has given the full picture of the Basel III in a tabulated form as given
below, once the full implementation of Basel III takes place.
Regulatory Capital As % to RWAs

(i) Minimum Common Equity Tier 1 Ratio 5.5
(ii) Capital Conservation Buffer (comprised of Common 2.5
Equity)
(iii) Minimum Common Equity Tier 1 Ratio plus Capital 8.0
Conservation Buffer [(i)+(ii)]
(iv) Additional Tier 1 Capital 1.5
(v) Minimum Tier 1 Capital Ratio [(i) +(iv)] 7.0
(vi) Tier 2 Capital 2.0
(vii) Minimum Total Capital Ratio (MTC) [(v)+(vi)] 9.0
(viii) Minimum Total Capital Ratio plus Capital 11.5
Conservation Buffer [(vii)+(ii)]
(Source: RBI)
Page 113
Page 114
 Counter-cyclical buffer/provision:
o The above provision guidelines are based on the model followed by
Spanishbanks that fared better during the recent financial crisis by adhering to
this
provision approach.
o For example, in the second half of 2008, in India, the Banks shied away
fromlending (credit crunch) triggered by the psychological effect of global
financial crisis, which led to negative effect of our economy and caused major
downturn in the Sensex (From 20,900 as of February, 2008, the Sensex came
down to 8,300 in March 2009). The sectors most affected were Realty,
Automotive, Textile and
IT.
o Further a downturn in the economy generally leads to deterioration of
assetquality of the Banks, which causes increase in the NPA levels of the Banks.
To overcome this only, RBI had come out with special dispensation of
restructuring of the loans for the sectors, which suffered due to macroeconomic
fundamental,
which is outside the control of the borrowers.
o Higher NPA leads to creation of increased provision by banks. To avoid
this,Banks would slow down their lending. In fact, the higher provisioning for
NPA has led to several PSBs showing loss in their financials for the Quarter ended
December, 2015. Such a situation would further tighten the credit, which would
lead to deteriorating borrowers’ financial position, thus making the general
economy still worse.
o At the peak of the businesscycle (boom), the borrowers’ performances would
begood and the Banks’ NPA would also be low. Most of the corporates make profit
in their business.
o In the boom time, the Banks tend to reduce the provisions because of
lowerNPAs, ease credit terms and expand their loan book. The economy is
pushed
into the fast economic growth (leads to high GDP growth).
o The easy credit approach during the boom period results in poor loan
selection(example of Sub-Prime crisis), leading to higher NPAs when the cycle
turns into
recession.
o The result is that the Banks actions tend to further amplify the cycle (boom
leading to more boom and recession leading to further recession).
o The alternative for this is recommended in the form of
countercyclicalprovisioning approach under which, banks build their reserves
during good times when their earnings are high and the accumulated reserves
can be used during
the economic slow down.
o One more argument in favor of this provision is that:
During the boom, the loans made are generally poorer in quality requiring more
provision.
Page 115
The loans made during recession are of superior quality as banks are very careful and
hence need lesser provision.
7. The creation of Capital Conservation Reserve provision is more forward looking
based on expected loss method (EL) rather than the current incurred loss
Page 116
provisioning model. These concepts would come very handy, when banks adopt
IndAS by March, 2018 as proposed by the Ministry of Corporate Affairs,
Government of India.
 Leverage Ratio:
 Besides the above, BCBS has also introduced one more ratio called ‘Leverage Ratio’.
An underlying cause of the global financial crisis was the build-up of excessive on-
and off-balance sheet leverage in the banking system. In many cases, banks built up
excessive leverage while apparently maintaining strong risk-based capital ratios.
During most severe part of the crisis, the banking sector was forced by the market to
reduce its leverage in a manner that amplified downward pressure on asset prices.
This deleveraging process exacerbated the feedback loop between losses, falling
bank capital and contraction in credit availability. Therefore, under Basel III, a simple,
transparent, non-risk based leverage ratio has been introduced. The leverage ratio is
calibrated to act as a credible supplementary measure to the risk based capital
requirements and is intended to achieve the following objectives:
Act as a Check on the build-up of leverage in the banking sector to avoid
destabilising and deleveraging processes which can damage the broader financial
system and the economy;
Reinforce the risk-based requirements with a simple, non-risk based “backstop”
measure.
 The Basel III leverage ratio is defined as the capital measure (the numerator) divided
by the exposure measure (the denominator), with this ratio expressed as a
percentage.
Capital Measure
Leverage Ratio =--------------------------
Exposure Measure
 The BCBS will use the revised framework for testing a minimum Tier 1 leverage ratio
of 3% during the parallel run period up to January 1, 2017. The BCBS will continue to
track the impact of using either Common Equity Tier 1 (CET1) or total regulatory
capital as the capital measure for the leverage ratio. The final calibration, and any
further adjustments to the definition, will be completed by 2017, with a view to
migrating to a Pillar 1 treatment on January 1, 2018. Currently, Indian banking
system is operating at a leverage ratio of more than 4.5%. The final minimum
leverage ratio will be stipulated by RBI taking into consideration the final rules
prescribed by the BCBS by end-2017. In the meantime, these guidelines will serve as
the basis for parallel run by banks and also for the purpose of disclosures as outlined
by RBI. During this period, Reserve Bank will monitor individual banks against an
indicative leverage ratio of 4.5% to curb the build-up of excessive on and off-balance
sheet leverage in the banking system. (Source: RBI).
Page 117
 Liquidity Risk: BCBS had observed that one of the factors for the recent
financialcrises were due to inaccurate and ineffective management of liquidity risk.
To overcome this, BCBS had come out with two ratios – Liquidity Coverage Ratio and
Net Stable Funding Ratio (NSFR).
o The Liquidity Coverage Ratio (LCR):This ratio ensures enough liquid assets to
survive an acute stress scenario lasting for 30 days.
o The objective of the LCR is to promote the short-term resilience of the
liquidityrisk profile of the banks. This is done by ensuring that banks have an
adequate stock of unencumbered high-quality assets (HQLA) that can be
converted easily and immediately in private markets into cash to meet their
liquidity needs for a
30 calendar day liquidity stress scenario. (Source BIS).
o This ratio is introduced from 1stJanuary 2015, after an observation
periodbeginning in 2011.
o The LCR would be binding on banks from January 1, 2015; with a view to providea
transition time for banks, the LCR 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 100% on January 1, 2019, as per the time-line given below by RBI.
January 1 January 1 January 1 January 1 January 1

2015 2016 2017 2018 2019
Minimum
60% 70% 80% 90% 100%
LCR
2. The formula for arriving at LCR is given below:


LCR = (Stock of HQLA / Total Net Cash Outflows over the next 30 calendar days)
x 100.

It should be minimum 100% or above 100% subject to timelines given by RBI as
above.
AI. RBI vide its circular of February, 2016 also relaxed the maintenance of HQLA
by the Banks. Presently, the assets allowed as the Level 1 High Quality Liquid
Assets (HQLAs) for the purpose of computing the LCR of banks, inter alia, include
Government securities in excess of the minimum SLR requirement, and 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 5 per cent of the bank’s NDTL]. RBI has, in addition to the above-
mentioned assets, permitted banks to reckon government securities held by
them up to another 3 per cent of their NDTL under FALLCR within the mandatory
SLR requirement as level 1 HQLA for the purpose of computing their LCR. Hence
the total carve-out from SLR available to banks would be 10 per cent of their
NDTL. (Source: RBI)
Page 118
Page 119
2. The Net Stable Funding Ratio (NSFR): This ratio aims at promoting medium
tolong term structure funding of assets and activities of the Banks. BCBS aims to
trial this ratio from 2012 and makes it mandatory in January 2018.
BN. RBI released its Draft guidelines on NSFR on May 28, 2015. The objective of
NSFR is to ensure that banks maintain a stable funding profile in relation to the
composition of their assets and off-balance sheet activities. A sustainable
funding structure is intended to reduce the probability of erosion of a bank’s
liquidity position due to disruptions in its regular sources of funding that would
increase the risk of its failure and potentially lead to broader systemic stress. The
NFSR limits overreliance on short-term wholesale funding, encourages better
assessment of funding risk across all on- and off-balance sheet items, and
promotes funding stability. The Reserve Bank proposes to make NFSR applicable
to banks in India from January 1, 2018. (Source RBI).
7. Definition of the Standard Net Stable Funding Ratio =

(Available Stable Funding (ASF))/Required Stable Funding (RSF)) x 100 = Should be
100% or above.
Page 120
RBI’s Strategic Debt Restructuring (SDR)
RBI has given powers and a tool to the Banks vide its Circular of June 2015 to try and
clean up their balance sheets through SDR. SDR allows banks to convert their debt or
loans into equity holding in a defaulting company, change management if needed and
also find a suitable buyer for the company or its assets so that the Bank can recover its
dues. As per the reports published in newspapers, Banks have already used the SDR
effectively and converted debt into equity in several cases.
To go back to history, Corporate Debt Restructuring (CDR) was introduced in our

country in 2001 based on the systems that was prevalent in countries such as UK,
Thailand, South Korea etc. CDR allows a distressed company to restructure with debt of
more than Rs. 10 crores with two or more lenders. To carry out CDR, consent of lenders
representing 75% or more in value and 60% or more by number is required.
When compared to CDR, SDR is a more powerful tool as the lenders can effect change in
the management. Hence, the borrowers also have taken the SDR exercise more carefully
than the routine CDR exercise. RBI also gives lot of importance to SDR exercise and the
RBI, Governor has observed in a meeting held in November, 2014, ‘The sanctity of the
debt contract has been continuously eroded in India in recent years, not by small
borrower but by the large borrower. And this has to change if we are to get banks to
finance the enormous infrastructure needs and industrial growth that this country aims
to attain’.
The only problem that the Banks may face is the challenge in finding a new buyer or
strategic investor who can buy the majority of equity from the Banks and take over the
company within the 18 months, a time period allowed to the Banks by RBI. The idea
behind RBI encouraging the change of management is that the new management may
bring better technology, governance on the table so that the unit can overcome its
problem.
With a view to ensuring more stake of promoters in reviving stressed accounts and
provide banks with enhanced capabilities to initiate change of ownership in accounts
which fail to achieve the projected viability milestones, banks may, at their discretion,
undertake a ‘Strategic Debt Restructuring (SDR)’ by converting loan dues to equity
shares, which will have the following features:
i. At the time of initial restructuring, the Joint Lending Forum (JLF), created by the
lenders must incorporate, in the terms and conditions attached to the restructured
loan/s agreed with the borrower, an option to convert the entire loan (including unpaid
interest), or part thereof, into shares in the company in the event the borrower is not
able to achieve the viability milestones and/or adhere to ‘critical conditions’ as
stipulated in the restructuring package. This should be supported by necessary
Page 121
approvals/authorisations (including special resolution by the shareholders) from the
borrower company, as required under extant laws/regulations, to enable the lenders to
exercise the said option effectively.
2. Provisions of the SDR would also be applicable to the accounts which have been
restructured before the date of RBI circular provided that the necessary enabling clauses,
are included in the agreement between the banks and borrower;
3. The decision on invoking the SDR by converting the whole or part of the loan into
equity shares should be taken by the JLF as early as possible but within 30 days from the
review of the account. Such decision should be well documented and approved by the
majority of the JLF members (minimum of 75% of creditors by value and 60% of
creditors by number);
4. In order to achieve the change in ownership, the lenders under the JLF should
collectively become the majority shareholder by conversion of their dues from the
borrower into equity. However, the conversion by JLF lenders of their outstanding debt
(principal as well as unpaid interest) into equity instruments shall be subject to the
member banks’ respective total holdings in shares of the company conforming to the
statutory limit in terms of Section 19(2) of Banking Regulation Act, 1949;
5. Post the conversion, all lenders under the JLF must collectively hold 51% or more of
the equity shares issued by the company;
6. The share price for such conversion of debt into equity will be determined as per the
method given prescribed by RBI;
7. Henceforth, banks should include necessary covenants in all loan agreements,

including restructuring, supported by necessary approvals/authorisations (including
special resolution by the shareholders) from the borrower company, as required under
extant laws/regulations, to enable invocation of SDR in applicable cases;
8. The JLF must approve the SDR conversion package within 90 days from the date of
deciding to undertake SDR;
9. The conversion of debt into equity as approved under the SDR should be completed
within a period of 90 days from the date of approval of the SDR package by the JLF;
10. The invocation of SDR will not be treated as restructuring for the purpose of asset
classification and provisioning norms;
11. On completion of conversion of debt to equity as approved under SDR, the existing
asset classification of the account, as on the reference date will continue for a period of
18 months from the reference date. Thereafter, the asset classification will be as per the
extant IRAC norms;
Page 122
58. JLF should closely monitor the performance of the company and consider appointing
suitable professional management to run the affairs of the company;
59. JLF and lenders should divest their holdings in the equity of the company as soon as
possible. On divestment of banks’ holding in favour of a ‘new promoter’, the asset
classification of the account may be upgraded to ‘Standard’. However, the quantum of
provision held by the bank against the said account as on the date of divestment, which
shall not be less than what was held as at the ‘reference date’, shall not be reversed. At
the time of divestment of their holdings to a ‘new promoter’, banks may refinance the
existing debt of the company considering the changed risk profile of the company
without treating the exercise as ‘restructuring’ subject to banks making provision for
any diminution in fair value of the existing debt on account of the refinance. Banks may
reverse the provision held against the said account only when all the outstanding
loan/facilities in the account perform satisfactorily during the ‘specified period’ (as
defined in the extant norms on restructuring of advances), i.e. principal and interest on
all facilities in the account are serviced as per terms of payment during that period. In
case, however, satisfactory performance during the specified period is not evidenced,
the asset classification of the restructured account would be governed by the extant
IRAC norms as per the repayment schedule that existed as on the reference date.
However, in cases where the bank exits the account completely, i.e. no longer has any
exposure to the borrower, the provision may be reversed/absorbed as on the date of
exit;
60. The asset classification benefit provided at the above paragraph is subject to the
following conditions:
a. The ‘new promoter’ should not be a person/entity/subsidiary/associate etc. (domestic
as well as overseas), from the existing promoter/promoter group.
b. The new promoters should have acquired at least 51 per cent of the paid up equity
capital of the borrower company. If the new promoter is a non-resident, and in sectors
where the ceiling on foreign investment is less than 51 per cent, the new promoter
should own at least 26 per cent of the paid up equity capital.
(AJ) The conversion price of the equity shall be determined as per the guidelines
given below:
(i) Conversion of outstanding debt (principal as well as unpaid interest) into equity
instruments should be at a ‘Fair Value’ which will not exceed the lowest of the following,
subject to the floor of ‘Face Value’ (restriction under section 53 of the Companies Act,
2013):
a) Market value (for listed companies): Average of the closing prices of the instrument
on a recognized stock exchange during the ten trading days preceding the ‘reference
date’.
b) Break-up value: Book value per share to be calculated from the company's latest
audited balance sheet (without considering 'revaluation reserves', if any) adjusted for
cash flows and financials post the earlier restructuring; the balance sheet should not be
Page 123
Page 124
more than a year old. In case the latest balance sheet is not available this break-up value
shall be Re.1.
(BJ)The above pricing formula under Strategic Debt Restructuring Scheme has been
exempted from the Securities and Exchange Board of India (SEBI) (Issue of Capital and
Disclosure Requirements) Regulations, 2009. Banks should adhere to all the prescribed
conditions by SEBI in this regard.
(BK) In addition to conversion of debt into equity under SDR, banks may also
convert their debt into equity at the time of restructuring of credit facilities under the
extant restructuring guidelines.
(BL) Acquisition of shares due to such conversion will be exempted from
regulatory ceilings/restrictions on Capital Market Exposures, investment in Para-Banking
activities and intra-group exposure subject to reporting to RBI.
-----
Central Repository of Information on Large Credits (CRILC)
RBI has set up a Central Repository of Information on Large Credits (CRILC) to collect,
store, and disseminate credit data to lenders. Accordingly, Department of Banking
Supervision (DBS) has advised vide circular of February 13, 2014 on ‘Central Repository
of Information on Large Credits (CRILC) – Revision in Reporting’ that banks will be
required to report credit information, including classification of an account as SMA to
CRILC on all their borrowers having aggregate fund-based and non-fund based exposure
of Rs.50 million and above with them (Rs. 5 crores). However, Crop loans are exempted
from such reporting, but, banks should continue to report their other agriculture loans
in terms of the above instruction. Banks need not report their interbank exposures to
CRILC including exposures to NABARD, SIDBI, EXIM Bank and NHB.
As per RBI norms, before a loan account turns into a NPA, banks are required to identify
incipient stress in the account by creating stress sub-categories under the Special
Mention Account category as given below:
SMA Sub- Basis for classification

Categories
SMA-0 Principal or interest payment not overdue for more than 30 days but
account showing signs of incipient stress)
SMA-1 Principal or interest payment overdue between 31 – 60 days
SMA-2 Principal or interest payment overdue between 61 – 90 days
In cases where banks fail to report SMA (Special Mention Accounts) status of the
accounts to CRILC or resort to methods with the intent to conceal the actual status of
the accounts or evergreen the account, banks will be subjected to accelerated
provisioning for these accounts and/or other supervisory actions as deemed appropriate
Page 125
Page 126
by RBI. The current provisioning requirement and the revised accelerated provisioning in
respect of such non performing accounts are as under:
Asset Classification Period as NPA Current Revised accelerated

Provisioning (%) Provisioning (%)
Sub-standard Upto 6 months 15 No change
(secured) 6 months to 1 year 15 25
Sub-standard Upto 6 months 25 (other than 25
(unsecured infrastructure loans)
abiinitio) 20 (Infrastructure
loans)
6 months to One 25 (other than 40
year infrastructure loans)
20 (Infrastructure
loans)
nd
Doubtful I 2 year 25 (secured portion) 40 (secured portion)
100 (unsecured 100 (unsecured
portion) portion)
rd th
Doubtful II 3 & 4 year 40 (secured portion) 100 (for both
100 (unsecured secured and
portion) unsecured portion)
Doubtful III 5th year onwards 100 100
------
Page 127
Base Rate System
Till the late 1980s, the interest rate structure in India was largely administered in nature
by RBI and was characterized by numerous rate prescriptions for different activities. On
account of the complexities under the administered rate structure, efforts were made
since 1990 by RBI to rationalize the interest rate structure so as to ensure price
discovery and transparency in the loan pricing system. The freeing up of lending rates of
scheduled commercial banks for credit limits of over Rs.2 lacs along with the
introduction of Prime Lending Rate (PLR) system in October1994 was a major step in this
direction aimed at ensuring competitive loan pricing. Initially, PLR acted as a floor rate
for credit above Rs. 2 lacs.
To bring in transparency, RBI directed banks to declare maximum spread over PLR for all
advances other than consumer credit. Banks were allowed prescribing separate PLRs
and spreads over PLRs, both for loan and cash credit component. With regard to term
loans of 3 years and above, the banks were given the freedom to announce separate
Prime Term Lending Rates (PTLRs) in 1997.
In 2001, RBI relaxed the requirement of PLR being the floor rate for loans above Rs.2
lakhs and allowed Banks to offer loans at below PLR to exporters and other creditworthy
borrowers with objective policy approved by the Banks’ Boards in a transparent manner.
Banks were allowed to charge fixed/floating rate on their lending for credit limit of over
Rs.2 lakh. However, there was large divergence among banks in their PLRs and spread
over PLRs. It failed to reflect the credit market conditions in the country. Therefore,
Benchmark PLR system (BPLR) came into being and tenor-linked PLRs got discontinued
The system of BPLR introduced in 2003 was expected to serve as a benchmark rate for
banks’ pricing of their loan products so as to ensure that it truly reflected the actual cost.
In course of time, competition forced the Banks to price a significant portion of their loans
out of alignment with BPLRs and thereby undermining the role of BPLR as a reference rate.
The worrying factor was that most of the banks started lending at Sub-BPLR rates ignoring
the risk sensitivity of the borrowers and also quoted ‘competition’ as the main reason for
going below the BPLR. Hence, RBI opined that the BPLR system had fallen short of its
original objective of bringing transparency to lending rates.
In April 2004, the then RBI Governor, Sri Y.V. Reddy had asked industry body IBA to come
up with a transparent calculation of the BPLR. In October 2005, RBI again stated that the
BPLR system might be reviewed as there is public perception that there is
Page 128
Page 129
under-pricing of credit for corporates, while there could be over-pricing of lending
to agriculture and SME (cross subsidization).
Over time, sub-BPLR lending had become a rule rather than an exception as about two-
thirds of bank lending took place at rates below the BPLR. Further Banks have been
reluctant to adjust their BPLRs in response to policy changes. Mainly, it lacked the
downward stickiness. To explain further, there was a general complaint from the
borrowers that lenders are quick to raise their BPLR when the regulator raises the
signaling rates (repo, reverse repo, CRR & SLR), but lag behind considerably when the
regulator drop these rates. The BPLR system has, therefore, become an inadequate tool
to evaluate monetary transmissions.
To overcome the above hiccups, RBI set up a Working Group headed by its Executive
Director Shri Deepak Mohanty in the month of June 2009 to review the current system
of loan pricing by the Banks popularly known as BPLR and also to improve the
transmission of monetary signals to interest rates in the economy. The Group came out
with its report on 20th October 2009. In April 2010, after a series of circulars,
discussions and consultative process, the RBI announced its decision to implement the
base rate from 1 July 2010. Banks were not allowed to lend below this rate. Under this
new rule, banks were free to use any method to calculate their base rates (the RBI did
provide an 'illustrative' formula), provided the RBI found it consistent. Banks were also
directed to announce their base rates on their websites, in keeping with the objective
of making lending rates more transparent.
Banking major, State Bank of India first announced its Base Rate on 29th June, 2010 by
fixing the same at 7.50% per annum. Soon, all other banks announced their base rates.
Most public sector banks kept their rates at 8%. As per RBI norms, the following inputs
have to be factored while arriving at the Base Rate:

Cost of deposits/borrowings.

Negative Carry on CRR & SLR –This arises as RBI is not paying any
interest onthe portion of CRR kept with it. Also, the investments that Banks
make in Government Bonds having SLR status carries less rate of interest when
compared to the deposit rate at which Banks accept deposits from the public.

Unallocable overhead cost such as maintaining administrative
office, Boardexpenses, and common advertisements about the Bank etc.

Average Return on Networth (Profit element) as decidedby the Bank’s Board.
Page 130
Page 131
The cost of deposits has the highest weight in calculating the Base Rate. For arriving at
the Cost of deposits/funds in Base Rate working, Banks can choose any benchmark for a
specific tenor that may be disclosed transparently. For example, SBI took cost of its 6
month deposit into account while initially calculating its Base Rate. To the Base Rate,
borrower-specific charges, product specific operating costs and premium on account of
credit risks and tenure would be added for arriving at the borrower specific lending rate.
The Base Rate would set the floor for interest rates on all types of loans. There would be
exceptions as permitted by RBI (given below):
 Loans covered by schemes specially formulated by Government of India
wherein banks have to charge interest rate as per the scheme.
 Working Capital Term Loan, Funded Interest Term Loan etc granted as part
of the rectification / restructuring package.
 Loans granted under various refinance schemes formulated by
Government of India or any Government Undertakings wherein banks
charge interest at the rates prescribed under the schemes.
 Advances to banks’ depositors against their own deposits.
 Advances to banks’ own employees including retired employees.
 Advances granted to the Chief Executive Officer / Whole Time Directors.
 Loans linked to a market determined external benchmarks such as LIBOR,
MIBOR etc.
RBI had stipulated that the banks should declare their Base Rate and made it effective
from July, 1, 2010. However, all the existing loans, including home loans and other retail
loans, would continue to be at the current rate. Only the new loans taken on or after
July 1, 2010 would be linked to Base Rate. All the existing loans when they come for
renewal, borrowers are given a choice either to go with Base Rate or with BPLR.
In the first year of operation of Base Rate, RBI had permitted banks a window of six
months till December 2010 during which they can revisit the methodology. This
flexibility was subsequently extended by RBI upto June 2011. Banks were allowed to use
whatever benchmark they felt was best suited to arrive at the rate, provided, the Bank
used the same consistently. However, RBI had asserted that:
 The methodology needed to be transparent.
 Banks are required to review the Base Rate at least once in a quarter with
the approval of the Board or the Asset Liability Management Committees
(ALCOs) as per the bank’s practice.
Page 132
Once the methodology for arriving at the Base Rate has been finalized by the Banks,
they cannot change the same for first five years. In case a Bank desires to review its
Base Rate methodology after five years from the date of its finalization, the Bank has to
approach RBI for permission in this regard. However, RBI has recently (January 19, 2016)
changed this norm. With a view to providing banks greater operational flexibility, RBI
has permitted bank to review the Base Rate methodology after three years from the
date of its finalization, instead the earlier periodicity of five years. Accordingly, Banks
can change their Base Rate methodology after completion of prescribed period with the
approval of their Board / ALCO.
Again in the methodology, Banks were following different methods. RBI wanted to
streamline this procedure also. Hence, RBI took feedback from the Banks and other
stakeholders. Thereafter, it has come out with its fresh guidelines in this regard
(December 17, 2015). RBI has instructed all the Banks that for all the rupee loans
sanctioned and credit limits renewed w.e.f. April 1, 2016 would be priced with
reference to the Marginal Cost of Funds based Lending Rate (MCLR). Hence, from April,
2016, MCLR would act as Internal Benchmark for the lending rates. The component of
MCLR is almost same when compared to the previous instructions and the same is given
below:
 Marginal Cost of Funds.
 Negative carry on account of CRR.
 Operating Costs.
 Tenor premium.
Marginal Cost of funds = 92% x Marginal cost of borrowings + 8% x Return on networth
Negative Carry on CRR arises due to return on CRR balances being nil. This will be
calculated as Required CRR x (marginal cost) / (1- CRR). The marginal cost of funds, as
calculated above, will be used for arriving at negative carry on CRR.
Operating Costs associated with providing the loan product including cost of raising
funds will be included under this head. It should be ensured that the costs of providing
those services which are separately recovered by way of service charges do not form
part of this component.
Tenor premium arise from loan commitments with longer tenor. The change in tenor
premium should not be borrower specific or loan class specific. In other words, the
tenor premium will be uniform for all types of loans for a given residual tenor.
Page 133
Page 134
Since MCLR will be a tenor linked benchmark, banks shall arrive at the MCLR of a
particular maturity by adding the corresponding tenor premium to the sum of
Marginal cost of funds, Negative carry on account of CRR and Operating costs.
Accordingly, RBI has permitted banks to publish the internal benchmark for the
following maturities:
1 Overnight MCLR.
1 One-month MCLR.
1 3 month MCLR.
1 6 month MCLR.
1 One year MCLR.
1 In addition to the above, Banks are given the option of publishing
MCLR of any other longer maturity.
Further, RBI has advised the Banks that they should have Board approved policy
delineating the components of spread charged to a customer. Existing customers
are given the option to move to the MCLR linked loan at mutually acceptable terms.
-----------
Loan to Value Ratio
The loan-to-value ratio (LTV Ratio) is a lending risk assessmentratio that Banks and
Financial institutionsarrive at before sanctioning Housing or Home Loans. Typically,
assessments with high LTV ratios are generally seen as higher risk and, therefore, if the
mortgageis accepted, the loan would generally be charged with high interest when
compared to another loan proposal with lesser LTV ratio.
The formula for calculating LTV ratio is:
Loan to Value Ratio = (Loan amount sanctioned/Apprised value of the property) x 100.
For example, Mr. X needs to borrow Rs. 60 lakhs to purchase a flat worth Rs. 80 lakhs.
The LTV ratio would work out to 75% (60/80 x 100). In fact, the Sub-Prime crisis that
took place in 2007-08 and the Japanese Housing Bubble that occurred from 1986 to
Page 135
1991 have emanated out of Lenders not giving the due importance that was
required for maintaining this ratio.
Realizing the value of LTV ratio, RBI has also come out with its norms on this ratio. As
per RBI guidelines, lending to individuals meant for acquiring residential property
which are fully secured by mortgages on the residential property that is or would be
occupied by the borrower, or that is rented, would be risk weighted as per norms
stipulated by RBI. Based on RBI guidelines, every bank should have a Board mandated
Valuation Policy. RBI has also given its formula for arriving at this ratio.
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.
RBI has, in the month of October, 2015 rationalized this ratio for individual
housing loans as given below, for loans sanctioned upto June 6, 2017.
Category of Loan LTV ratio (%) Risk Weight (%)

Upto Rs. 30 lakhs Equal to and less than 80% 35
More than 80% and equal 50

to and less than 90%
Above Rs. 30 lakhs and Equal to and less than 75% 35
upto Rs. 75 lakhs More than 75% and equal 50
to and less than 80%
Above Rs. 75 lakhs Equal to and less than 75% 75
RBI, in its second bi-monthly monetary policy statement 2017-18, revised the LTV ratio,
Risk Weight and Standard Asset Provisioning rates, as under, for loans sanctioned on
orafter June 7, 2017:
Category of Loan LTV ratio (%) Risk Weight (%) Standard Asset
Provision (%)
Upto Rs. 30 lakhs Equal to and less
35
than 80% 0.25
More than 80% and 50
Page 136
equal to and less
than 90%
Above Rs. 30 lakhs Equal to and less
and upto Rs. 75 than 80% 35
lakhs
Above Rs. 75 lakhs Equal to and less
50
than 75%
Page 137
RISK MANAGEMENT-INFORMATION SECURITY
1. INTRODUCTION:
Banks deal with public money and therefore, trust is the most important pillar of the banking business.
While trust may be considered synonymous with banking, security is also considered equally important.
The concept and perception of security in banking has, over a period of time, changed drastically, in
tandem with changes in the way banking business is conducted. Now a days, banks maintain their assets
more in digitized rather than physical form, carry out their transactions over technology enabled
platforms/applications and communicate through electronic modes. The banking business does not face
any growth impediments because of physical, geographical or product/knowledge-related boundaries as
technology has come to their aid. There are newer products and channels of delivery. Networked
environment has enabled delivery of banking services at the doorstep of the customer. Anywhere,
anytime banking with core banking and newer delivery channels viz., ATM, online banking, mobile
banking etc. have provided convenience of banking to the customer and more and more people are now
relying upon the convenience and ease of use of Internet banking services in their business as well as
daily life. But, this has also resulted in enhanced customer expectations about efficient delivery of
services with the highest level of security. Growth of business, customer satisfaction and retention of
customers’ loyalty, therefore, depend on the highest quality of service coupled with the state of the art
security features.
Information and the knowledge based on it have increasingly become recognized as ‘information assets’,
which are vital enablers of business operations. It is therefore, absolutely crucial for any organisation to
provide adequate levels of protection to these assets. Reliable information is even more critical for banks,
as banks are purveyors of money in physical and digital form and hence information security is a vital
area of concern.
Robust information is at the heart of risk management processes in a bank. Inadequate data quality is
likely to induce errors in decision making. Data quality requires building processes, procedures and
disciplines for managing information and ensuring its integrity, accuracy, completeness and timeliness.
The fundamental attributes supporting data quality include accuracy, integrity, consistency, completeness,
validity, timeliness, accessibility, usability and auditability. The data quality provided by various
applications depends on the quality and integrity of the data upon which that information is built. Entities
that treat information as a critical organizational asset are in a better position to manage it proactively.
Information security not only deals with information in various channels like spoken, written, printed,
electronic or any other medium but also information handling in terms of creation, viewing, transportation,
storage or destruction .This is in contrast to IT security which is mainly concerned with security of
information within the boundaries of the network infrastructure technology domain. From an information
security perspective, the nature and type of compromise is not as material as the fact that security has
been breached. It is therefore, imperative for Bank Managements to establish an effective information
security risk governance framework as a part of the overall Corporate Governance Framework so that
the Banks develop and maintain a comprehensive information security programme.
2. BASIC PRINCIPLES OF INFORMATION SECURITY:
The basic principles of information security are as under:
a) Confidentiality: Confidentiality is the term used to prevent the disclosure of information to

unauthorized individuals or systems. For example, a credit card transaction on the Internet requires
the credit card number to be transmitted from the buyer to the merchant and from the merchant to a
transaction processing network.The system attempts to enforce confidentiality by encrypting the card
number during transmission, by limiting the places where it might appear (in databases, log files,
backups, printed receipts, and so on), and by restricting access to the places where it is stored. If an
unauthorized party obtains the card number in any way, a breach of confidentiality has occurred.
Page 138
Breaches of confidentiality take many forms like Hacking, Phishing, Vishing, Email-spoofing, SMS
spoofing, and sending malicious code through email or Bot Networks, as discussed earlier.
b) Integrity: In information security, integrity means that data cannot be modified without authorization.
This is not the same thing as referential integrity in databases. Integrity is violated when an employee
accidentally or with malicious intent deletes important data files, when he/she is able to modify his
own salary in a payroll database, when an employee uses programmes and deducts small amounts
of money from all customer accounts and adds it to his/her own account (also called salami
technique), when an unauthorized user vandalizes a web site, and so on. On a larger scale, if an
automated process is not written and tested correctly, bulk updates to a database could alter data in
an incorrect way, leaving the integrity of the data compromised. Information security professionals are
tasked with finding ways to implement controls that prevent errors of integrity.
c) Availability: For any information system to serve its purpose, the information must be Available when
it is needed. This means that the computing systems used to store and process the information, the
security controls used to protect it, and the communication channels used to access it must be
functioning correctly. High availability systems aim to remain available at all times, preventing service
disruptions due to power outages, hardware failures, and system upgrades. Ensuring availability also
involves preventing denial-of-service (DoS) and distributed denial-of service (DDoS) attacks.
d) Authenticity: In computing, e-business and information security it is necessary to ensure that the
data, transactions, communications or documents (electronic or physical) are genuine. It is also
important for authenticity to validate that both parties involved are who they claim they are.
e) Non-repudiation: In law, non-repudiation implies one's intention to fulfill one’s obligations under a
contract / transaction. It also implies that a party to a transaction cannot deny having received or
having sent an electronic record. Electronic commerce uses technology such as digital signatures
and encryption to establish authenticity and non-repudiation. In addition to the above, there are other
security-related concepts and principles when designing a security policy and deploying a security
solution. They include identification, authorization, accountability, and auditing.
f) Identification: Identification is the process by which a subject professes an identity and
accountability is initiated. A subject must provide an identity to a system to start the process of
authentication, authorization and accountability. Providing an identity can be typing in a username,
swiping a smart card, waving a proximity device, speaking a phrase, or positioning face, hand, or
finger for a camera or scanning device. Proving a process ID number also represents the
identification process. Without an identity, a system has no way to correlate an authentication factor
with the subject.
g) Authorization: Once a subject is authenticated, access must be authorized. The process of
authorization ensures that the requested activity or access to an object is possible given the rights
and privileges assigned to the authenticated identity. In most cases, the system evaluates an access
control matrix that compares the subject, the object, and the intended activity. If the specific action is
allowed, the subject is authorized. Else, the subject is not authorized.
h) Accountability and auditability: An organization’s security policy can be properly enforced only if
accountability is maintained, i.e., security can be maintained only if subjects are held accountable for
their actions. Effective accountability relies upon the capability to prove a subject’s identity and track
their activities. Accountability is established by linking a human to the activities of an online identity
through the identification. Thus, human accountability is ultimately dependent on the strength of the
authentication process. Without a reasonably strong authentication process, there is doubt that the
correct human associated with a specific user account was the actual entity controlling that user
account when an undesired action took place.
3. INFORMATION SECURITY GOVERNANCE:

Information security governance consists of the leadership, organizational structures and processes that
protect information and mitigation of growing information security threats like the ones detailed above.
Critical outcomes of information security governance include:
 Alignment of information security with business strategy to support organizational objectives
 Management and mitigation of risks and reduction of potential impacts on information resources
to an acceptable level
 Management of performance of information security by measuring, monitoring and reporting
information security governance metrics to ensure that organizational objectives are achieved
Page 139
 Optimisation of information security investments in support of organizational objectives
It is important to consider the organisational necessity and benefits of information security governance.
They include increased predictability and the reduction of uncertainty in business operations, a level of
assurance that critical decisions are not based on faulty information, enabling efficient and effective risk
management, protection from the increasing potential for legal liability, process improvement, reduced
losses from security-related events and prevention of catastrophic consequences and improved
reputation in the market and among customers.
A comprehensive security programme needs to include the following main activities:
 Development and ongoing maintenance of security policies
 Assignment of roles, responsibilities and accountability for information security
 Development/maintenance of a security and control framework that consists of standards,
measures, practices and procedures
 Classification and assignment of ownership of information assets
 Periodic risk assessments and ensuring adequate, effective and tested controls for people,
processes and technology to enhance information security
 Ensuring security is integral to all organizational processes
 Processes to monitor security incidents
 Effective identity and access management processes
 Generation of meaningful metrics of security performance
 Information security related awareness sessions to users/officials including senior officials and
board members
4. ORGANIZATIONAL STRUCTURE, ROLES AND RESPONSIBILITIES:
(A) BOARDS OF DIRECTORS/SENIOR MANAGEMENT:

The Board of Directors is ultimately responsible for information security. Senior Management is
responsible for understanding risks to the bank to ensure that they are adequately addressed from a
governance perspective. To do so effectively requires managing risks, including information security risks,
by integrating information security governance in the effectiveness of information security governance is
dependent on the involvement of the Board/senior management in approving policy and appropriate
monitoring of the information security function.
The major role of top management involves implementing the Board approved information security policy,
establishing necessary organizational processes for information security and providing necessary
resources for successful information security. It is essential that senior management establish an
expectation for strong cyber security and communicate this to their officials down the line. It is also
essential that the senior organizational leadership establish a structure for implementation of an
information security programme to enable a consistent and effective information security programme
implementation apart from ensuring the accountability of individuals for their performance as it relates to
cyber security.
Given that today’s banking is largely dependent on IT systems and since most of the internal processing
requirements of banks are electronic, it is essential that adequate security systems are fully integrated
into the IT systems of banks. It would be optimal to classify these based on the risk analysis of the
various systems in each bank and specific risk mitigation strategies need to be in place.
(B) INFORMATION SECURITY TEAM/FUNCTION:

Banks should form a separate information security function/group to focus exclusively on information
security management. There should be segregation of the duties of the Security Officer/Group dealing
exclusively with information systems security and the Information Technology Division which actually
implements the computer systems. The organization of the information security function should be
commensurate with the nature and size of activities of a bank including a variety of e-banking systems
and delivery channels of a bank. The information security function should be adequately resourced in
terms of the number of staff, level of skills and tools or techniques like risk assessment, security
architecture, vulnerability assessment, forensic assessment, etc. While the information security
group/function itself and information security governance related structures should not be outsourced,
specific operational components relating to information security can be outsourced, if required resources
are not available within a bank. However, the ultimate control and responsibility rests with the bank.
Page 140
(C) INFORMATION SECURITY COMMITTEE:
Since information security affects all aspects of an organization, in order to consider information security
from a bank-wide perspective a steering committee of executives should be formed with formal terms of
reference. The Chief Information Security Officer would be the member secretary of the Committee. The
committee may include, among others, the Chief Executive Officer (CEO) or designee, chief financial
officer (CFO), business unit executives, Chief Information Officer (CIO)/ IT Head, Heads of human
resources, legal, risk management, audit, operations and public relations.
A steering committee serves as an effective communication channel for management’s aims and
directions and provides an ongoing basis for ensuring alignment of the security programme with
organizational objectives. It is also instrumental in achieving behaviour change toward a culture that
promotes good security practices and compliance with policies.
Major responsibilities of the Information Security Committee, inter-alia, include:
 Developing and facilitating the implementation of information security policies, standards and
procedures to ensure that all identified risks are managed within a bank’s risk appetite
 Approving and monitoring major information security projects and the status of information
security plans and budgets, establishing priorities, approving standards and procedures
 Supporting the development and implementation of a bank-wide information security
management programme
 Reviewing the position of security incidents and various information security assessments and
monitoring activities across the bank
 Reviewing the status of security awareness programmes
 Assessing new developments or issues relating to information security
 Reporting to the Board of Directors on information security activities
Minutes of the Steering Committee meetings should be maintained to document the committee’s activities
and decisions and a review on information security needs to be escalated to the Board on a quarterly
basis.
(D) CHIEF INFORMATION SECURITY OFFICER (CISO):
A sufficiently senior level official, of the rank of GM/DGM/AGM, should be designated as Chief Information
Security Officer, responsible for articulating and enforcing the policies that banks use to protect their
information assets apart from coordinating the security related issues / implementation within the
organization as well as relevant external agencies. The CISO needs to report directly to the Head of Risk
Management and should not have a direct reporting relationship with the CIO. However, the CISO may
have a working relationship with the CIO to develop the required rapport to understand the IT
infrastructure and operations, to build effective security in IT across the bank, in tune with business
requirements and objectives.
5. CRITICAL COMPONENTS OF INFORMATION SECURITY:
1) Policies and procedures:

Banks need to frame Board approved information security policy supported with relevant standards,
guidelines and procedures need to be framed and appropriate measures/practices need to be identified
and implemented keeping in view the business needs.
2) Risk Assessment:
Risk assessment is the core competence of information security management and must include, for each
asset within its scope, identification of the threat/vulnerability combinations that have a likelihood of
impacting the confidentiality, availability or integrity of that asset - from a business, compliance or
contractual perspective.
3) Inventory and information/data classification:
Effective control requires a detailed inventory of information assets. Such a list is the first step in
classifying the assets and determining the level of protection to be provided to each asset.
By assigning classes or levels of sensitivity and criticality to information resources and establishing
specific security rules/requirements for each class, it is possible to define the level of access controls that
should be applied to each information asset.
4) Defining roles and responsibilities:
All defined and documented responsibilities and accountabilities must be established and communicated
to all relevant personnel and management. Some of the major ones include:
Page 141
a) Information owner
b) Application owner
c) User manager
d) Security Administrator
e) End user
5) Access Control:
An effective process for access to information assets is one of the critical requirements of information
security. Internal sabotage, clandestine espionage or furtive attacks by trusted employees, contractors
and vendors are among the most serious potential risks that a bank faces. Current and past employees,
contractors, vendors and those who have an intimate knowledge of the inner workings of the bank’s
systems, operations and internal controls have a significant advantage over external attackers. A
successful attack could jeopardise customer confidence in a bank’s internal control systems and
processes. Hence, access to information assets needs to be authorised by a bank only where a valid
business need exists and only for the specific time period that the access is required.
6) Information security and information asset life-cycle:
Information security needs to be considered at all stages of an information asset’s life-cycle like planning,
design, acquisition and implementation, maintenance and disposal. Banks need to apply systematic
project management oriented techniques to manage material changes during these stages and to ensure
that information security requirements have been adequately addressed.
7) Personnel security:
Application owners grant legitimate users access to systems that are necessary to perform their duties
and security personnel enforce the access rights in accordance with institution standards. Because of
their internal access levels and intimate knowledge of financial institution processes, authorized users
pose a potential threat to systems and data. Employees, contractors, or third-party employees can also
exploit their legitimate computer access for malicious or fraudulent reasons. Further, the degree of
internal access granted to some users can increase the risk of accidental damage or loss of information
and systems. Risk exposures from internal users include altering data, deleting production and back-up
data, disrupting/destroying systems, misusing systems for personal gain or to damage the institution,
holding data hostage and stealing strategic or customer data for espionage or fraud schemes. It is,
therefore, important to have a process to verify job application information for all new employees and
additional background and credit checks based on the sensitivity of a particular job or access level.
8) Physical security:
The confidentiality, integrity, and availability of information can be impaired through physical access and
damage or destruction to physical components. As such, it is important to mitigate the physical security
risks through zone-oriented implementations and by having proper risk assessment and environmental
controls.
9) User Training and Awareness:
It is acknowledged that the human link is the weakest link in the information security chain. Hence, there
is a vital need for an initial and ongoing training and information security awareness programme. The
programme may be periodically updated keeping in view changes in information security,
threats/vulnerabilities and/or the bank’s information security framework. There needs to be a mechanism
to track the effectiveness of training programmes through an assessment/testing process designed on
testing the understanding of the relevant information security policies, not only initially but also on a
periodic basis. At any point of time, a bank needs to maintain an updated status on user training and
awareness relating to information security and the matter needs to be an important agenda item during
Information Security Committee meetings.
10) Incident management:
Incident management is defined as the process of developing and maintaining the capability to manage
incidents within a bank so that exposure is contained and recovery achieved within a specified time
objective. Incidents can include the misuse of computing assets, information disclosure or events that
threaten the continuance of business processes. An effective incident management framework for
preventing, detecting, analyzing and responding to information security incidents is therefore, required to
be implemented.
11) Application Control and Security:
Financial institutions have different types of applications like the core banking system, delivery channels
like ATMs, internet banking, mobile banking, phone banking, network operating systems, databases,
Page 142
enterprise resource management (ERP) systems, customer relationship management (CRM) systems,
etc., all used for different business purposes. Then these institutions have partners, contractors,
consultants, employees and temporary employees. Users usually access several different types of
systems throughout their daily tasks, which makes controlling access and providing the necessary level of
protection on different data types difficult and full of obstacles. This complexity may result in unforeseen
and unidentified holes in the protection of the entire infrastructure including overlapping and contradictory
controls, and policy and regulatory noncompliance. Banks, therefore, need to implement proper
application control and risk mitigation measures.
12) Migration controls:
A documented Migration Policy indicating the requirement of roadmap/ migration plan / methodology for
data migration (which includes verification of completeness, consistency and integrity of the migration
activity and pre and post migration activities along with responsibilities and timelines for completion of
same) is required to be put in place to take care of data integrity, completeness, confidentiality,
consistency and continuity.
13) Implementation of new technologies:
Banks need to carry out due diligence with regard to new technologies since they can potentially
introduce additional risk exposures. A bank needs to authorise the large scale use and deployment in
production environment of technologies that have matured to a state where there is a generally agreed
set of industry-accepted controls and robust diligence and testing has been carried out to ascertain the
security issues of the technology or where compensating controls are sufficient to prevent significant
impact and to comply with the institution’s risk appetite and regulatory expectations. A formal product
approval process incorporating, inter-alia, security related aspects and fulfilment of relevant legal and
regulatory prescriptions should also be in place for all new business products introduced by the bank.
14) Encryption:
There are two types of encryption – Symmetric and Asymmetric.
Symmetric encryption is the use of the same key and algorithm by the creator and reader of a file or
message.
Asymmetric encryption lessens the risk of key exposure by using two mathematically related keys, the
private key and the public key. When one key is used to encrypt, only the other key can decrypt.
Therefore, only one key (the private key) is required to be kept secret.
Typical areas or situations requiring deployment of cryptographic techniques, given the risks involved,
include transmission and storage of critical and/or sensitive data/information in an ‘un-trusted’
environment or where a higher degree of security is required, generation of customer PINs which are
typically used for card transactions and online services, detection of any unauthorised alteration of
data/information and verification of the authenticity of transactions or data/information. Since security is
primarily based on the encryption keys, effective key management is crucial.
15) Data security:
Banks need to define and implement procedures to ensure the integrity and consistency of all data stored
in electronic form, such as databases, data warehouses and data archives.
16) Vulnerability Assessment:
Banks need to scan for vulnerabilities and address discovered flaws proactively to avoid a significant
likelihood of having their computer systems compromised because any significant delays in finding or
fixing software with critical vulnerabilities provides ample opportunity for persistent attackers to break
through, gaining control over the vulnerable machines and getting access to the sensitive data they
contain.
17) Establishing on-going security monitoring processes:

A bank needs to have robust monitoring processes in place to identify events and unusual activity
patterns that could impact on the security of IT assets. The strength of the monitoring controls needs to
be proportionate to the criticality of an IT asset. Alerts would need to be investigated in a timely manner,
with an appropriate response determined.
18) Security measures against Malware:
Malicious software is an integral and a dangerous aspect of internet based threats which target end-users
and organizations through modes like web browsing, email attachments, mobile devices, and other
vectors. Malicious code may tamper with a system's contents, and capture sensitive data. It can also
Page 143
spread to other systems. Modern malware aims to avoid signature-based and behavioral detection, and
may disable anti-virus tools running on the targeted system. Anti-virus and anti-spyware software,
collectively referred to as anti-malware tools, help defend against these threats by attempting to detect
malware and block their execution. Banks should, therefore, have proper preventive and
detective/corrective controls at the host, network, and user levels to protect against malicious codes by
using layered combinations of technology, policies and procedures and training.
19) Patch Management:
A documented standards / procedures for patch management needs to be in place to address technical
system and software vulnerabilities quickly and effectively in order to reduce the likelihood of a serious
business impact arising.
20) Change Management:
Banks need to establish a change management process covering all types of change. For example,
upgrades and modifications to application and software, modifications to business information,
emergency ‘fixes’, and changes to the computers/networks that support the application.
21) Audit trails:
Banks needs to ensure that audit trails exist for IT assets satisfying the banks business requirements
including regulatory and legal requirements, facilitating audit, serving as forensic evidence when required
and assisting in dispute resolution.
22) Information security reporting and metrics:
Banks need to have security monitoring arrangements to provide key decision-makers and Senior
Management/Board of Directors with an informed view of aspects like the effectiveness and efficiency of
information security arrangements, areas where improvement is required, information and systems that
are subject to an unacceptable level of risk, performance against quantitative, objective targets, actions
required to help minimize risk (e.g., reviewing the organization’s risk appetite, understanding the
information security threat environment and encouraging business and system owners to remedy
unacceptable risks).
23) Information security and Critical service providers/vendors:
Banks use third-party service providers in a variety of different capacities like an Internet service provider
(ISP), application or managed service provider (ASP/MSP) or business service provider (BSP).
Management should evaluate the role that the third party performs in relation to the IT environment,
related controls and control objectives and institute effective third-party controls to enhance the ability of
the bank to achieve its control objectives.
24) Network Security:
Protection against growing cyber threats requires multiple layers of defenses, known as defense in depth.
As every organization is different, this strategy should therefore be based on a balance between
protection, capability, cost, performance, and operational considerations. Some of the important network
protection devices are
a) Firewalls,
b) Intrusion Detection Systems
c) Network Intrusion Prevention Systems
d) Quarantine
e) DNS Placement
25) Remote Access:

Banks may sometimes provide employees, vendors, and others with access to the institution’s network
and computing resources through external connections. Those connections are typically established
through modems, the internet, or private communications lines. Remote access to a bank’s provides an
attacker with the opportunity to manipulate and subvert the bank’s systems from outside the physical
security perimeter. The management should establish policies restricting remote access and be aware of
all remote-access devices attached to their systems. These devices should be strictly controlled.
26) Distributed Denial of service attacks(DDoS/DoS):
Banks providing internet banking should be responsive to unusual network traffic conditions/system
performance and sudden surge in system resource utilization which could be an indication of a DDoS
attack. Consequently, the success of any pre-emptive and reactive actions depends on the deployment of
appropriate tools to effectively detect, monitor and analyze anomalies in networks and systems. Banks
Page 144
should, therefore, install and configure network security devices appropriately for reasonable
preventive/detective capability.
27) Implementation of ISO 27001 Information Security Management System:
Commercial banks should implement Information Security Management System (ISMS) best practices for
their critical functions/processes with the best known ISMS as described in ISO/IEC 27001 and ISO/IEC
27002 and related standards published jointly by ISO and IEC.
28) Wireless Security:
Wireless network includes all wireless data communication devices like personal computers, cellular
phones, PDAs, etc. connected to a bank’s internal networks. Wireless networks security is a challenge
since the wireless data communication devices do not have well-defined perimeters or well-defined
access points and unauthorized monitoring and denial of service attacks can be performed without a
physical wire connection. Further, unauthorized devices can potentially connect to the network, perform
man-in-the- middle attacks, or connect to other wireless devices. To mitigate those risks, wireless
networks rely on extensive use of encryption to authenticate users and devices and to shield
communications. The banks using a wireless network should, therefore, carefully evaluate the risks
involved and implement appropriate additional controls.
29) Business Continuity Considerations:
Events that trigger the implementation of a business continuity plan may have significant security
implications. Depending on the event, some or all of the elements of the security environment may
change. Different tradeoffs may exist between availability, integrity, confidentiality, and accountability,
with a different appetite for risk on the part of management. It is, therefore, imperative that the business
continuity plans are reviewed as an integral part of the security process.
30) Information security assurance:
a) Penetration Testing:
Penetration testing is defined as a formalized set of procedures designed to bypass the security controls
of a system or organization for the purpose of testing that system’s or organization’s resistance to such
an attack. Penetration testing is performed to uncover the security weaknesses of a system and to
determine the ways in which the system can be compromised by a potential attacker.
b) Audits
Auditing compares current practices against a set of policies/standards/guidelines formulated by the
institution, regulator including any legal requirements. Bank management is responsible for demonstrating
that the standards it adopts are appropriate for the institution. Audits should not only look into technical
aspects but also the information security governance process.
c) Assessment
An assessment is a study to locate security vulnerabilities and identify corrective actions. An assessment
differs from an audit by not having a set of standards to test against. It differs from a penetration test by
providing the tester with full access to the systems being tested. Assessments may be focused on the
security process or the information system. They may also focus on different aspects of the information
system, such as one or more hosts or networks.
A bank should manage the information security risk management framework on an ongoing basis as a
security programme following project management approach, addressing the control gaps in a systematic
way.
31) General information regarding delivery channels:
Provision of various electronic banking channels like ATM/debit cards/internet banking/phone banking
should be issued only at the option of the customers based on specific written or authenticated electronic
requisition along with a positive acknowledgement of the terms and conditions from the customer. A
customer should not be forced to opt for services in this regard. Banks should provide clear information to
their customers about the risks and benefits of using e-banking delivery services to enable customers to
decide on choosing such services. When new operating features or functions, particularly those relating
to security, integrity and authentication, are being introduced, the bank should ensure that customers
have sufficient instruction and information to be able to properly utilize them. Banks should sensitize
customers on the need to protect their PINs, security tokens, personal details and other confidential data
to raise security awareness levels. Banks need to ensure suitable security measures for their web
applications and take reasonable mitigating measures against various web security risks.
6. EMERGING TECHNOLOGIES AND INFORMATION SECURITY:
Page 145
The security concerns in respect of the technologies like virtualisation and cloud computing which have
been emerging increasingly of late also need to be considered by Banks.
(a) Virtualization
Of late, the trend in the data center has been towards decentralization, also known as horizontal scaling
because centralized servers were seen as too expensive to purchase and maintain. However,
decentralization’s application sandboxes have a high annual maintenance cost and lower efficiency.
Virtualization is a modified solution between centralized and decentralized deployments. Instead of
purchasing and maintaining an entire computer for one application, each application is given its own
operating system, and all those operating systems reside on a single piece of hardware. This provides the
benefits of decentralization, like security and stability, while making the most of a machine’s resources.
Challenges of Virtualization
a. Compatibility and support
b. Licensing
c. Staff training
d. Reliability
(b) Cloud Computing
Cloud computing refers to computing environment owned by a company which is shared with client
companies through web-based service over Internet which hosts all the programs to run everything from
e-mail to word processing to complex data analysis programs. Service may include software, platform or
infrastructure. At the backend, cloud computing can make use of virtualization and grid computing. In grid
computing, networked computers are able to access and use the resources of every other computer on
the network.
Cloud Computing Concerns
The biggest concerns about cloud computing are security and privacy.
7. IMPLEMENTATION OF RECOMMENDATIONS OF THE WORKING GROUP ON INFORMATION

SECURITY, ELECTRONIC BANKING, TECHNOLOGY RISK MANAGEMENT AND CYBER
FRAUDS:
The Banking Industry has been conscious of the challenges to Security and appreciable efforts are being
made by all the stakeholders in the context, viz. Governments, Regulators, banks and technology
providers. In this regard, the Reserve Bank of India issued Guidelines on Information security, Electronic
Banking, Technology risk management and cyber frauds in 2011, which were based on the report
submitted by the working group constituted by RBI under the Chairmanship of Shri. G. Gopalakrishna,
Executive Directror, RBI.
The guidelines are not “one-size-fits-all” and the implementation of these recommendations need to be
risk based and commensurate with the nature and scope of activities engaged by banks, the technology
environment prevalent in the bank and the support rendered by technology to the business processes.
Banks with extensive leverage of technology to support business processes were required to implement
all the stipulations outlined in the circular. Banks were also required to conduct a formal gap analysis
between their current status and stipulations as laid out in the guidelines and put in place a time-bound
action plan to address the gap and comply with the guidelines.
The guidelines are fundamentally expected to enhance safety, security, efficiency in banking processes
leading to benefits for banks and their customers. The measures suggested for implementation are not
static. Banks need to pro-actively create/fine-tune/modify their policies, procedures and technologies
based on new developments and emerging concerns.
8. CONCLUSION:
In the IT enabled banking environment, information security is of paramount importance because it

involves tremendous risk that can result in huge business and financial losses which can also assume
international dimensions. As it is often said, in a chain, it is the weakest link that is the most vulnerable.
Therefore, it is not only important to ab initio take care of the information security risks but we also need
to make sure that the information security risk management process adopted by us is continuously
benchmarked against the international standards. There has to be a paradigm shift in the perception
about security in banking and the top management’s response to the same. It is important for banks to
Page 146
realize that they have a vital role and responsibility to ensure that appropriate risk management measures
are in place to avoid frauds, losses and business disruption.
It may be noted that the real challenge in this environment goes beyond merely providing additional
technology solutions and increasingly complex security layers, and translates into providing secured
banking while balancing the same against customer convenience requirements, which puts the regulators
and security implementers on the horns of a dilemma. For a Bank, while the challenges to information
security are stiff and are increasing by the day, being alive to threats is of the highest importance. This
also involves resources - human and monetary, attitude and aptitude and a continuous monitoring and
review of the information security management processes.
Important points
Risk Management
Risk and Capital

Risk is possible unfavorable impact on net cash flow in future due to uncertainty of happening or non-
happening of events. Capital is a cushion or shock observer required to absorb potential losses in future.
Higher the Risks, high will be the requirement of Capital and there will be rise in RAROC (Risk Adjusted
Return on Capital).
Types of Risks
Risk is anticipated at Transaction level as well as at Portfolio level.
Transaction Level
Credit Risk, Market Risk and Operational Risk are transaction level risk and are managed at Unit level.
Portfolio Level
Liquidity Risk and Interest Rate Risk are also transaction level risks but are managed at Portfolio level.
Risk Measurement
Based on Sensitivity
It is change in Market Value due to 1% change in interest rates. The interest rate gap is sensitivity
of the interest rate margin of Banking book. Duration is sensitivity of Investment portfolio or Trading
book.
Page 147
Based on Volatility:
It is common statistical measure of dispersion around the average of any random variable such as
earnings, Markto market values, losses due to default etc.
Statistically Volatility is Standard deviation of Value of Variables

Calculation
Example 1 : We have to find volatility of Given Stock price over a given period. Volatility may
be weekly or monthly. Suppose we want to calculate weekly volatility. We will note down Stock
price of nos. of weeks.
Mean Price = 123.62 and
Variance (sum of Squared deviation from mean) is 82.70
(extracted from weekly Stock prices) Volatility i.e. sd =
∫Variance = ∫82.70 = 9.09
Volatility over Time Horizon T = Daily Volatility X ∫T
Example 2
Daily Volatility =1.5%
Monthly Volatility = 1.5 X ∫30 = 1.5 X 5.48 = 8.22
Volatility will be more if Time horizon is more.
Downside Potential
It captures only possible losses ignoring profits and risk calculation is done keeping in view two
components:
7. Potential losses
8. Probability of Occurrence.
The measure is more relied upon by banks/FIs/RBI. VaR (Value at Risk is a downside Risk
Measure.)
Risk Pricing Risk Premium is added in the interest rate because of the following:
6. Necessary Capital is to be maintained as per regulatory requirements.
7. Capital is raised with cost.
For example there are 100 loan accounts with Level 2 Risk. It means there can be average loss of 2% on
such type of loan accounts: Risk Premium of 2% will be added in Rate of Interest.
Pricing includes the following:

j) Cost of Deploying funds
k) Operating Expenses
l) Loss Probabilities
m) Capital Charge
Risk Mitigation
Credit Risk can be mitigated by accepting Collaterals, 3rd party guarantees, Diversification
ofAdvances and Credit Derivatives.
Page 148
Interest rate Risk can be reduced by Derivatives of Interest Rate Swaps.
Forex Risk can be reduced by entering into Forward Contracts and Futures etc.
If we make advances to different types of business with different Risk percentage, the overall risk will
be reduced through diversification of Portfolio.
Banking Book, Trading Book and Off Balance Sheet Items
Banking Book
It includes all advances, deposits and borrowings which arise from Commercial and Retail Banking.
These are Held till maturity and Accrual system of accounting is applied. The Risks involved are:
Liquidity Risk, Interest Rate Risk, Credit Default Risk, Market Risk and Operational Risk.
Trading Book
It includes Assets which are traded in market.
6. These are not held till maturity.
7. The positions are liquidated from time to time.
8. These are Mark- to–market i.e. Difference between market price and book value is taken as
profit.
9. Trading Book comprises of Equities, Foreign Exchange Holdings and Commodities etc.
10. These also include Derivatives
The Risks involved are Market Risks. However Credit Risks and Liquidity Risks can also be there.
Off Balance Sheet Exposures

The Off Balance sheet exposures are Contingent Liabilities, Guarantees, LC and other obligations. It
includes Derivatives also. These may form part of Trading Book or Banking Book after they become
Fund based exposure.
Types of Risks
1. Liquidity Risk
It is inability to obtain funds at reasonable rates for meeting Cash flow obligations. Liquidity Risk is of
following types:
Funding Risk: It is risk of unanticipated withdrawals and non-renewal of FDs which are rawmaterial
for Fund based facilities.
Time Risk: It is risk of non-receipt of expected inflows from loans in time due to high rateNPAs
which will create liquidity crisis.
Call Risk: It is risk of crystallization of contingent liabilities.
Page 149
2. Interest Rate Risk
Risk of loss due to adverse movement of interest rates. Interest rate risk is of following types:
Gap or Mismatch Risk: The risk of Gap between maturities of Assets and Liabilities.Sometimes, Long
term loans are funded by short term deposits. After maturity of deposits, these liabilities are get repriced
and Gap of Interest rates between Assets and Liabilities may become narrowed thereby reduction of
profits.
Basis Risks: Change of Interest rates on Assets and Liabilities may change in
differentmagnitudes thus creating variation in Net Interest Income.
Yield Curve Risk: Yield is Internal Rate of Return on Securities. Higher Interest Rate scenariowill
reduce Yield and thereby reduction in the value of assets. Adverse movement of yield will certainly
affect NII (Net Interest Income).
Embedded Option Risk : Adverse movement of Interest Rate may result into pre-payment ofCC/DL
and TL. It may also result into pre-mature withdrawal of TDs/RDs. This will also result into reduced NII.
This is called Embedded Risk.
Re-investment Risk: It is uncertainty with regard to interest rate at which future cash flowscould be
reinvested.
3. Market Risk
Market Risk is Risk of Reduction in Mark-to-Market value of Trading portfolio i.e. equities,
commodities and currencies etc. due to adverse market sensex. Market Risk comprises of:
8. Price Risk occurs when assets are sold before maturity. Bond prices and Yield are inversely
related.
9. IRR affects the price of the instruments.
10. Price of Other commodities like Gold etc,. is also affected by the market trends.
11. Forex Risks are also Market Risks.
12. Liquidity Risk or Settlement Risk is also present in the market.
4. Credit Risk or Default Risk

Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms and
conditions. There are two types of credit Risks:
Counter party Risk: This includes non-performance by the borrower due to his refusal orinability.
Country Risk : When non-performance of the borrower arises due to constrains or

restrictionsimposed by a country.
5. Operational Risk
Operation Risk is the risk of loss due to inadequate or Failed Internal procedures, people and the
system. The external factors like dacoity, floods, fire etc. may also cause operational loss. It
Page 150
includes Frauds Risk, Communication Risk, Documentation Risk, Regulatory Risk, Compliance Risk and
legal risks but excludes strategic /reputation risks.
Two of these risks are frequently occurred.
Transaction Risk: Risk arising from fraud, failed business processes and inability to
maintainBusiness Continuity.
Compliance Risk: Failure to comply with applicable laws, regulations, Code of Conduct mayattract
penalties and compensation.
Other Risks are:

3. Strategic Risk: Adverse Business Decisions, Lack of Responsiveness to business changes and no
strategy to achieve business goals.
4. Reputation Risk ; Negative public opinions, Decline in Customer base and litigations etc.
5. Systemic Risks ; Single bank failure may cause collapse of whole Banking System and result into
large scale failure of banks.
In 1974, closure of HERSTATT Bank in Germany posed a threat for the entire Banking system
BASEL–I
Bank for International Settlements (BIS) is situated at Basel (name of the city in Switzerland). Moved by
collapse of HERSTATT bank, BCBS – Basel Committee on Banking Supervision consisting of 13
members of G10 met at Basel and released guidelines on Capital Adequacy in July 1988. These
guidelines were implemented in India by RBI w.e.f. 1.4.1992 on the recommendations of Narsimham
Committee. The basic objective was to strengthen soundness and stability of Banking system in India in
order to win confidence of investors, to create healthy environment and meet international standards.
BCBS meets 4 times in a year. Presently, there are 27 members.

BCBS does not possess any formal supervisory authority.
1996 Amendment
7. Allowed banks to use Internal Risk Rating Model.
8. Computation of VaR daily using 99th percentile.
9. Use of back-testing
10. Allowing banks to issue short term subordinate debts with lock-in clause.
Calculation of CRAR (Capital to Risk Weighted Asset Ratio)
Basel – I requires measurement of Capital Adequacy in respect of Credit risks and MarketRisks
only as per the following method:
Capital funds(Tier I & Tier II)/(Credit Risk Weighted Assets + Market RWAs + Operational RWAs) X
100
Minimum requirement of CRAR is as under:

As per BASEL-II recommendations 8%
Page 151
As per RBI guidelines 9%
Banks undertaking Insurance business 10%
New Private Sector Banks 10%
Local Area banks 15%
For dividend declaration by the banks (during previous 2 years and current year) 9%
Tier I & Tier II Capital
Tier –I Capital
Tier –I Capital includes:
8. Paid up capital, Statutory reserves, Other disclosed free reserves, Capital Reserve representing
surplus out of sale proceeds of assets.
9. Investment fluctuation reserve without ceiling.
10. Innovative perpetual Debt instruments (Max. 15% of Tier I capital)
11. Perpetual non-cumulative Preference shares
Less Intangible assets & Losses.
5 Sum total of Innovative Perpetual Instruments and Preference shares as stated above should not
exceed 40% of Tier I capital. Rest amount will be treated as Tier II capital.
Tier –II Capital

It includes:
6. Redeemable Cumulative Preference shares, Redeemable non-cumulative Preference shares
& Perpetual cumulative Preference shares,
7. Revaluation reserves at a discount of 55%,
8. General Provisions & Loss reserves up to 1.25 % of RWAs
9. Hybrid debts (say bonds) & Subordinate debts (Long term Unsecured loans) limited to 50% of
Tier –I Capital.
Tier – III Capital

Banks may at the discretion of the National Authority, employ 3rd tier of Capital consisting of short term
subordinate debts for the sole purpose of meeting a proportion of capital requirements for market risks.
Tier III capital will be limited to 250% of bank’s Tier –I Capital (Minimum of 28.5%) that is required to
support market risks.
Tier – II capital should not be more than 50% of Total Capital.
Capital adequacy in RRBs

The committee on financial sector assessment has suggested introducing CRAR in RRBs also in a
phased manner.
Two ways to improve CRAR

$ By raising more capital. Raising Tier I capital will dilute the equity stake of existing investors including
Govt. Raising Tier II Capital is definitely a costly affair and it will affect our profits.
$ Reduction of risk weighted assets by implementing Risk mitigation Policy.
Page 152
Risk Weights on different Assets
Cash and Bank Balance 0%
Advances against NSC/KVC/FDs/LIC 0%
Govt. guaranteed Advances 0%
Central Govt. Guarantees 0%
State Govt. Guarantees 20%
Govt. approved securities 2.5%
Balance with other scheduled banks having CRR at least 9% 20%
Other banks having CRR at least 9% 100%
Secured loan to staff 20%
Other Staff loans -not covered by retirement dues 75%
Loans upto 1.00 lac against Gold/Silver 50%
Residential Housing Loans O/S above 30 lac 75%
Residential Housing loans O/S upto 30 lac 50%
Residential property if LTV ratio is above 75% 100%
Residential Housing Loans O/S above 75 lac 125%
Mortgage based securitization of assets 77.5%
Consumer Credit / Credit Cards/Shares loan 125%
Claims secured by NBFC-non-deposit taking (other than AFCs) 100%
Venture Capital 150%
Education Loans (Basel –II -75%) 100%
Other loans (Agriculture, Exports) 100%
Indian Banks having overseas presence and Foreign banks will be on parallel run (Basel -I) and Basel-II
for 3 years commencing from 31.3.2010 up to 31.3.2013. These banks will ensure that : Basel-II
minimum capital requirement continues to be higher than 80% of Basel-I minimumcapital requirement
for credit Risk and Market Risk.”
Further, Tier –I CRAR should be at-least 6% up to 31.3.2010 and 8% up to 31.3.2011
BASEL II
The Committee on Banking Regulations and Supervisory Practices released revised version in the year
2004. These guidelines have been got implemented by RBI in all the banks of India. Parallel run was
started from 1.4.2006. In banks having overseas presence and foreign banks (except RRBs and local
area banks. Complete switchover has taken place w.e.f. 31.3.2008. In banks with no foreign branch,
switchover will took place w.e.f. 31.3.2009.
Distinction between Basel I and Basel II

Basel – I measures credit risks and market risks only whereas Basel II measures 3 types of risks i.e.
Credit Risk, Operational Risk and Market Risk. Risk weights are allocated on the basis of rating of the
borrower i.e. AAA, AA, A, BBB, BB and B etc. Basel –II also recognized CRM such as Derivatives,
Collaterals etc.
Page 153
Three Pillars of BASEL-II
Pillar –I Minimum Capital Requirement

Pillar – II Supervisory Review Process
Pillar –III Market Discipline
Pillar - I – Minimum Capital Requirement

CRAR will be calculated by adopting same method as discussed above under Basel – I with the only
difference that Denominator will be arrived at by adding 3 types of risks i.e. Credit Risks, Market Risks
and Operational Risks.
Credit Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms and
conditions. In terms of extant guidelines contained in BASEL-II, there are three approaches to
measure Credit Risk given as under:
$ Standardized approach
$ IRB (Internal Rating Based) Foundation approach
$ IRB (Internal Rating Based) Advanced approach
1. Standardized Approach
RBI has directed all banks to adopt Standardized approach in respect of Credit Risks. Under
standardized approach, risk rating will be done by credit agencies. Four Agencies are approved for
external rating:
1. CARE 2. FITCH India 3.CRISIL 4. ICRA
Risk weights prescribed by RBI are as under:

Rated Corporate
Rating & Risk Percentage

$ 20%
6. 30%
6. 50%
(v) 100%
BJ. & below 150%
Education Loans 75%
Retail portfolio and SME portfolio 75% Housing
loans secured by mortgage 50 to 75%
Unrated Exposure 100%
2. IRBA – Internal rating Based Approach

At present all advances of Rs. 5.00 crore and above are being rated from external agencies in our bank.
IRBA is based on bank’s internal assessment. It has two variants (Foundation and advanced). Bank will
do its own assessment of risk rating and requirement of Capital will be
Page 154
calculated on
i) Probability of default (PD)
j) Loss given default (LD)
k) Exposure of default (ED)
l) Effective maturity. (M)
Bank has developed its own rating module system to rate the undertaking internally. The internal rating is
being used for the following purposes:
m)Credit decisions
n) Determination of Powers
o) Price fixing
Rating by Outside Agencies

The risk weights corresponding to the newly assigned rating symbols are as under:
Table : PART A – Long term Claims on Corporate – Risk Weights Long

Term Ratings
CARE CRISIL Fitch ICRA Risk Weights (%) CARE AAA
CRISIL AAA Fitch AAA ICRA AAA 20 CARE AA CRISIL
AA Fitch AA ICRA AA 30 CARE A CRISIL A Fitch A ICRA
A 50
CARE BBB CRISIL BBB Fitch BBB ICRA BBB 100
CARE BB & below CRISIL BB & below Fitch BB & below ICRA BB & below 150 Unrated
Unrated Unrated Unrated 100
How to Calculate RWAs and Capital Charge in respect of Credit risk
Ist Step : Calculate Fund Based and Non Fund Based Exposure
2nd Step: Allowable Reduction
3rd Step : Apply Risk Weights as per Ratings
4th Step: Calculate Risk Weighted Assets
5th Step : Calculate Capital Charge
Ist Step: Calculate Fund Based and Non Fund Based Exposure:
Example:
Fund Based Exposure (Amount in ‘000)
Nature of loan Limit Outstanding Undrawn portion
CC 200 100 100
Bills Purchased 60 30 30
Packing Credit 40 30 10
Term Loan 200 40 160
Total Outstanding 200
Out of Undrawn portion of TL, 60 is to drawn in a year and balance beyond 1 year.
Page 155
Adjusted Exposure:
100% Outstanding(Unrated) = 200
20% of Undrawn CC, BP & PC (140*20/100) = 28
20% of Undrawn TL (1 yr) (60*20/100) = 12
50% of Undrawn TL (>1Yr) (100*50/100) = 50
Total Adjusted Exposure FB limits 290
Non Fund Based Exposure (Amount in ‘000)

Type of NBF Exposure CCF Adjusted Exposure
Financial Guarantees 90 100% 90
Acceptances 80 100% 80
Standby LC 50 100% 50
Clean LC 50 100% 50
Unconditional Take out finance 100 100% 100
Performance Guarantee 80 50% 40
Bid Bonds 20 50% 10
Conditional Take out finance 50 50% 25
Documentary LC 40 20% 8
Total Adjusted Exposure FB limits = 453
Total Adjusted Exposure = 290000+453000 = 7,43,000
2nd Step: Allowable Reduction after adjusting CRMs (Credit Risk Mitigates)
Reduction from adjusted exposure is made on account of following eligible financial collaterals:
Eligible Financial Collaterals .

7. Deposits being maintained by a borrower under lien.
8. Cash (including CDs or FDs), Gold, Govt Securities, KVP, NSC, LIC Policy, Debt Securities,
Mutual Funds’
9. Equity and convertible bonds are no more eligible CRMs.
Formula for Deposits under lien: C*(1-Hfx) X Mf

(C=Amount of Deposit; Hfx =0 (if same currency), Hfx = 0.08 (if diff currency) Mf = Maturity factor).
Formula for Approved Financial collaterals: C*(1-Hc-Hfx) *Mf ) - E*He
Haircuts(He–Haircut for Exposure & Hc-Haircut for Collateral)

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

E* = max { 0, [E X (1+He) – C X (1-Hc- Hfx) } ]
E* - exposure value alter risk mitigation
E – Current value of exposure for which coll. Qualifies
C = current value of collateral received
Page 156
Hfx = Haircut appropriate for currency mismatch between collateral and exposure.
E* will be multiplied by the risk weight of the counter party to obtain RWA amount.
Illustrations clarifying CRM

In the case of exposure of Rs 100 (denominated in USD) having a maturity of 6 years to a BBB rated
(rating by external credit rating agency) corporate borrower secured by collateral of Rs 100 by way of A+
rated corporate bond with a maturity of 6 years, the exposure amount after the applicable haircut @ 12%,
will be Rs 112 and the volatility adjusted collateral value would be Rs 80, (after applying haircut @ 12%
as per issue rating and 8% for currency mismatch) for the purpose of arriving at the value of risk weighted
asset & calculating charge on capital.
There is an exposure of Rs 100 to an unrated Corporate (having no rating from any external agency)
having a maturity of 3 years, which is secured by Equity shares outside the main index having a market
value of Rs 100.
The haircut for exposure as well as collateral will be 25%. There is no currency mismatch in this case.
The volatility adjusted exposure and collateral after application of haircuts works out to Rs 125 and Rs
75 respectively. Therefore, the net exposure for calculating RWA works out to Rs 50.
There is a demand loan of Rs 100 secured by bank’s own deposit of Rs 125. The haircuts for
exposure and collateral would be zero. There is no maturity mismatch. Adjusted exposure and
collateral after application of haircuts would be Rs 100 and Rs 125 respectively. Net exposure for the
purpose of RWA would be zero
Other Examples
No. 1:
• Exposure----------------------------------------- 100 lac with tenure 3 years
• Eligible Collateral in A+ Debt Security -----30 lac with Residual maturity 2 years
• Hair cut on Collateral is 6%
• Table of Maturity factor shows hair cut as 25% for remaining maturity of 2 years/
Calculate Value of Exposure after Risk Mitigation:
Solution:
Value of Exposure after Risk Mitigation =
Current Value of Exposure – Value of adjusted collateral for Hair cut and maturity mismatch
Value of Adjusted Collateral for Hair cut = C*(1-Hc) = 30(1-6%) = 30*94% = 28.20
Value of Adjusted Collateral for Hair cut and Maturity Mismatch = C*(t-0.25) / (T-0.25)
= 28.20*(2-.25)/(3-.25) = 17.95
(Where t = Remaining maturity of Collateral T= Tenure of loan )
Value of Exposure after Risk Mitigation = 100-17.95= 82.05 lac.
No. 2
An exposure of Rs. 100 lac is backed by lien on FD of 30 lac. There is no mismatch of maturity.
Page 157
Solution:
Hair Cut for CRM i.e. FDR is zero.
Hence Value of Exposure after Risk Mitigation is 100 lac – 30 lac = 70 lac
Computation of CRAR
In a bank ; Tier 1 Capital = 1000 crore
Tier II Capital = 1200 crore
Capital Charge for Market Risk = 500 crore
Capital Charge for Op Risk = 300 crore
Find Tier I CRAR and Total CRAR.
Solution:
RWAs for Market Risk = 500/.09 = 5556 crore
RWAs for Op Risk = 300/.09 = 3333 crore
Total RWS = 10000+5556+3333 = 18889 crore
Tier I Capital = 1000 crore
Tier II Capital can be up to maximum 1000 crore
Total Capital = 2000 crore
Tier I CRAR = Eligible Tier I Capital /Total RWAs = 1000/18889=5.29% Total
CRAR = Eligible Total Capital /Total RWAs = 2000/18889 = 10.59% We may
conclude that Tier I Capital is less than the required level.
Credit Risk Mitigates
It is a process through which credit Risk is reduced or transferred to counter party. CRM
techniques are adopted at Transaction level as well as at Portfolio level as under:
At Transaction level:
4. Obtaining Cash Collaterals
5. Obtaining guarantees
At portfolio level
4. Securitization
5. Collateral Loan Obligations and Collateral Loan Notes
1. Securitization
It is process/transactions in which financial securities are issued against cash flow generated from
pool of assets.
Cash flow arising from receipt of Interest and Principal of loans are used to pay interest and
repayment of securities. SPV (Special Purpose Vehicle) is created for the said purpose.
Originating bank transfers assets to SPV and it issues financial securities.
Page 158
2. Collateral Loan Obligations (CLO) and Credit Linked Notes (CLN)
It is also a form of securitization. Through CLO, bank removes assets from Balance Sheet and issues
tradable securities. They become free from Regulatory Capital.
CLO differs from CLN (Credit link notes in the following manner.
i) CLO provide credit Exposure to diverse pool of credit where CLN relates to single credit.
ii) CLO result in transfer of ownership whereas CLN do not provide such transfer.
iii) CLO may enjoy higher credit rating than that of originating bank.
It is managing risks without affecting portfolio size. Risk is transferred without transfer of assets from the
Balance Sheet though OTC bilateral contract. These are Off Balance Sheet Financial Instruments. Credit
Insurance and LC are similar to Credit derivatives. Under a Credit Derivative PB (Prospective buyer)
enter into an agreement with PS (Prospective seller) for transfer of risks at notional value by making of
Premium payments. In case of delinquencies, default, Foreclosure, prepayments, PS compensates PB
for the losses. Settlement can be Physical or Cash. Under physical settlement, asset is transferred
whereas under Cash settlement, only loss is compensated.
Credit Derivatives are generally OTC instruments. ISDA (International Swaps and Derivatives
Association) has come out with documentation evidencing such transaction. Credit Derivatives are:
vii) Credit Default Swaps
viii) Total Return Swaps
ix) Credit Linked Notes
x) Credit Spread Options
Operational Risk
Operational Risk is the risk of loss resulting from

iii. Inadequate or failed internal processes, people and system.
iv. External events such as dacoity, burglary, fire etc.
It includes legal risks but excludes strategic /reputation risks.
Identification
(iii) Actual Loss Data Base
(iv) RBIA reports
(v) Risk Control & Self Assessment Survey
(vi) Key Risk indicators
(vii) Scenario analysis
Four ways to manage Risk

8. Prevent
9. Reduce
10. Transfer
11. Carry/Accept
Page 159
Operational Risk – Measurement
Three approaches have been defined to measure Operational Risk at the bank:
• Basic Indicator approach

• Standardized approach
• AMA i.e. Advanced measurement approach
Basic Indicator Approach

15% of Average positive gross annual income of previous 3 years will be requirement of capital. To start
with banks will have to adopt this approach and huge capital is required to be maintained. In our bank,
estimated requirement of capital will be about Rs. 1000 crore.
The Standardized Approach

All banking activities are to be divided in 8 business lines. 1) Corporate finance 2) Trading &
Sales 3) Retail Banking 4) Commercial Banking 5) Asset Management 6) Retail brokerage 7)
Agency service 8) Payment settlement
Within each business line, Capital requirement will be calculated as under:
By multiplying the average gross income generated by a business over previous 3 years by a factor
β ranging from 12 % to 18 % depending upon industry-wise relationships as under:
Retail Banking, Retail Brokerage and Asset Management -----------12%
Commercial Banking and Agency Services--------------------------- 15%
Corporate, Trading and Payment Settlement------------------------ 18%
Advanced Measurement Approach

Capital requirement is calculated by the actual risk measurement system devised by bank’s own internal
Operational Risk Measurement methods using quantitative and qualitative criteria. Our bank has started
measuring actual losses and estimating future losses by introducing statement of Operational Risk Loss
data w.e.f. 1.4.2005. Minimum 5 year data is required for a bank to switch over to AMA.
How to calculate RWAs for Operational Risk?
RWAs for Operational Risk = Capital Charge / 0.09% (If required CAR is 9%)
Operational Risk – Scenario Analysis

It is a term used in measurement of Operational Risk on the basis of scenario estimates.
Banks use scenario analysis based on expert opinion in conjunction with external data to evaluate its
exposure to high severity events.
In addition, scenario analysis is used to assess impact of deviations from correlation assumptions in the
bank’s Operational Risk measurement framework to evaluate potential losses arising from operational
risk loss events.
Operational Risk Mitigation

Insurance cover, if available can reduce the operational risk only when AMA is adopted for
Page 160
estimating capital requirements. The recognition of insurance mitigation is limited to 20% oftotal
Operational Risk Capital Charge calculated under AMA.
Practical Example - AMA approach

Under AMA approach, Estimated level of Operational Risk is calculated on the basis of:
• Estimated probability of occurrence
• Estimated potential financial impact
• Estimated impact of internal control.
Estimated Probability of Occurrence: This is based on historical frequency of occurrence &

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

Low risk-------------2
Medium Risk--------3
High Risk------------4
Very High Risk------5
For Calculation, following formula is used:
Estimated level of Operational Risk = {Estimated probability of occurrence x Estimated potential

financial impact x Estimated impact of internal control} ^0.5
^0.5 implies Under root of whole
Example:
Probability of occurrence = 2 (medium)
Probability of Financial impact = 4 (very high)
Impact of Financial control = 50%
Solution
[ 2x4x(1-0.5)] ^0.5 = ∫4 = 2 (Low)
Market Risk
It is simply risk of losses on Balance sheet and Off Balance sheet items basically in investments due to
movement in market prices. It is risk of adverse deviation of mark to Market value of trading portfolio
during the period. Any decline in the market value will result into loss.
Market Risk involves the following:

d) Risk Identification
e) Risk Measurement
f) Risk monitoring and control
g) Risk mitigation.
Page 161
ALCO: Assets Liability Committee meets at frequent intervals and takes decisions in respect ofProduct
pricing, Maturity profiles and mix of incremental assets and profiles, Interest rate, Funding policy,
Transfer pricing and Balance Sheet Management.
Market Risk measurement

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

This is change in value of security due to 1 basis point change in Market Yield. Higher the BPV higher
will be the risk.
Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10
Difference Yield = 0.5%
Difference in Market price = 0.10
BPV = 0.10/0.05 = 2 i.e. 2 basis points.
Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/- (1,00,00,000*.02/100) Now, if the
yield on Bond with BPV 2000 declines by 8 bps, then it will result into profit of Rs. 16000/- (8x2000).
BPV declines as maturity reaches. It will become zero on the date of maturity.
2. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration) to receive Present Value of
the bond. e.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7 years. It
means Total Cash Flow of Rs. 130 to be received in 5 years would be discounted with Present Value
which will be equivalent as amount received in 3.7 years. The Duration of the Bond is 3.7 Years.
Formula of Calculation of McCauley Duration = ΣPV*T / ΣPV

Modified Duration = Duration / 1+Yield
Approximate % change in price = Modified Duration X Change in Yield
Page 162
Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is 5
years. What will be the McCauley Duration.
Modified Duration = Duration/ 1+YTM
Duration = Modified Duration x (1+YTM)
= 5 x 1.06 = 5.30
3. Downside Potential
It captures only possible losses ignoring profit potentials. It integrates sensitivity and volatility with
adverse affect of Uncertainty.
This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method to
calculate downside potential.
Value at Risk (VaR)

It means how much can we expect to lose? What is the potential loss?
Let VaR =x. It means we can lose up to maximum of x value over the next period say week (time horizon).
Confidence level of 99% is taken into consideration.
Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is only one
chance in 100 that daily loss will be more than 10 crore under normal conditions. VaR in days in 1 year
based on 250 working days = 1 x 250 / 100 == 2.5 days per year.
Back Testing
It is a process where model based VaR is compared with Actual performance. It tells us whether results
fall within pre-specified confidence bonds as predicted by VaR models.
Stress Testing
It seeks to determine possible change in Market Value of portfolio that could arise due to non-normal
movement in one or more market parameters (such as interest rate, liquidity, inflation, Exchange rate
and Stock price etc.).
Four test are applied:

1. Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate +2%, 4%,6% etc.
2. Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if possible events occur.
It assesses potential consequences for a firm of an extreme. It is based on historical event or
hypothetical event.
Page 163
3. Maximum loss
The approach assesses the risks of portfolio by identifying most potential combination of moves of
market risks
4. Extreme value theory

The theory is based on behavior of tails (i.e. very high and very low potential values) of probable
distributions.
RBI guidelines on CCF (Credit Conversion Factor)
Direct Credit Substitutes CCF

General Guarantees (including Standby LCs), Acceptances - 100%
Transaction related contingent items (Performance bonds, Bid bonds, - 50%
Warranties, Indemnities, Standby LC relating to particular transaction
Short Term LC (Documentary) for Issuing bank as well as confirming bank - 20%
Capital Charge on Un-availed limit
Capital Charge on Undrawn limits is calculated as under:

(iii) 20% on Undrawn CC limit
(iv) 20% on Undrawn TL limit (which is to be drawn in a year)
(v) 50% on Undrawn TL limit (which is to be drawn beyond a year)
Example
In the case of a cash credit facility for Rs.100 lakh (which is not unconditionally cancelable) where
the
availed portion is Rs. 60 lakh, the un-availed portion of Rs.40 lakh will attract a Credit Conversion Factor
(CCF) of 20% (since the cash credit facility is subject to review / renewal normally once a year). The
credit equivalent amount of Rs.8 lakh (20% of Rs.40 lakh) will be assigned the appropriate risk weight as
applicable to the counterparty / rating to arrive at the risk weighted asset for the unavailed portion. The
availed portion (Rs.60 lakh) will attract a risk weight as applicable to the counterparty / rating.
In compliance of the new guidelines banks have advised all the branches for:
2. Insertion of Limit Cancellation Clause in loan documents
3. Levying of Commitment Charges
Time frame for application of different approaches

Application to RBI by Approval by RBI by
IRB approach for Credit Risk 01.04.2012 31.3.2014
AMA approach for Operational Risk 01.04.2012 31.3.2014
Internal Model approach for
Market Risk 01.04.2010 31.3.2011
BASEL -III Basel III covers Liquidity Risk in addition to Basel II.
Page 164
It is planned to implement BASEL-III w.e.f. 1.1.2013. The propose reforms are as under:
Capital Common Equity Tier –I Total Capital

Minimum 4.5% 6% 8%
+ Conservative Buffer 2.5% 2.5% 2.5%
Transition Arrangement
As on 1.1.2013, the banks will meet new minimum requirement in relation to Risk Weighted Assets
as under:
3.5% of Common Equity + 4.5% of Tier –I Capital = .8% of Total Capital /Risk Weighted Assets.
VaR (Value at Risk)

Value at Risk is how much can we expect to lose? What is potential loss?
We can lose maximum up to VaR (value at Risk) over a given time at a given confidence level.
Calculation of VaR
Market Factor Sensitivity X Daily Volatility X Probability at given confidence level
Suppose impact of 1% change of interest rate (Price) = 6000/-
Daily Volatility = 3% : Confidence level is 99%
Probability of occurrence at 99% confidence level is 2.326
Defeasance period = 1 day
VaR = 6000x3x2.326 = 41874/-
Duration and Modified Duration

Duration is the time that Bondholder must wait for a number of years (duration) to receive Present
Value of Cash Inflows i.e. PV of Cash Inflows equals Actual Cash Inflows.
Formula of calculating Duration (Macaulay’s Duration)

Σ ( PV*T) / ΣPV
For example:
5 years bond of Rs. 100 @ 6% gives Duration of 3.7 years. It means Total Cash flow of Rs. 130/-would
be equivalent to receiving Rs. 130/- at the end of 3.7 years.
Modified Duration = Duration / 1 + Yield
Risk Management and Control
Market risk is controlled by implementing the business policies and setting of market risk limits or
controlling through economic measures with the objective of attaining higher RAROC. Risk is managed
by the following:
ii) Limits and Triggers

iii) Risk Monitoring
iv) Models of Analyses.
Page 165
Calculation of Capital Charge of Market Risk
The Basel Committee has two approaches for calculation of Capital Charge on Market Risk as under:
vii) Standardized approach

viii) Internal Risk Management approach
Under Standardized approach, there are two methods: Maturity method and duration method. RBI
has decided to adopt Standardization duration method to arrive at capital charge on the basis of
investment rating as under:
Investment rating Capital Required

AAA to AA 0%
A+ to BBB (Residual term to maturity)

Less than 6 M 0.25%
Less than 24M 1.00%
More than 24 M 1.60%
Other Investments 8.00%
How to Calculate RWAs, if Capital Charge is given:

RWAs for Market Risk = Capital Charge / 0.09 (If required CAR is 9%)
Other Risks and Capital Requirement
Other Risks like Liquidity Risks, Interest Rate Risk, Strategic Risk, Reputational Risks and
Systemic Risks are not taken care of while calculating Capital Adequacy in banks.
Pillar – II – Supervisory Review Process (SRP)

SRP has two issues:
(a) To ensure that bank is having adequate capital.
(b) To encourage banks to use better techniques to mitigate risks.
SRP concentrates on 3 main areas:

(i) Risks not fully captured under Pillar -1 i.e. Interest Rate Risks, Credit concentration Risks,
Liquidity Risk, Settlement Risks, Reputational Risks and Strategic Risks.
(j) Risks not at all taken care of in Pillar -1.
(k) External Factors.
This pillar ensures that the banks have adequate capital. This process also ensures that the bank
managements develop Internal risk capital assessment process and set capital targets commensurate
with bank’s risk profile and capital environment. Central Bank also ensures through supervisory
measures that each bank maintains required CRAR and components of capital i.e. Tier –I & Tier –II are
in accordance with BASEL-II norms. RBIA and other internal inspection processes are the important
tools of bank’s supervisory techniques.
Page 166
Every Bank will prepare ICAAP (Internal Credit Adequacy Assessment Plan) on solo basis which will
comprise of functions of measuring and identifying Risks, Maintaining appropriate level of Capital and
Developing suitable Risk mitigation techniques.
Pillar – III – Market Discipline
Market discipline is complete disclosure and transparency in the balance sheet and all the
financial statements of the bank. The disclosure is required in respect of the following:
(ai) Capital structure.

(aj) Components of Tier –I and Tier –II Capital
(ak) Bank’s approach to assess capital adequacy
(al) Assessment of Credit Risks, Market Risk and Operational Risk.
(am) Credit Aspects like Asset Classification, Net NPA ratios, Movement of NPAs and
Provisioning.
Frequency of Disclosure
(bi) Banks with Capital funds of Rs. 100 crore or more will make interim Disclosures on
Quantitative aspects on standalone basis on their respective websites.
(bj) Larger banks with Capital Funds of Rs. 500 crore or more will disclose Tier-I capital, Total
Capital, CAR on Quarterly basis on website.
Risk Weight on NPAs

(iv) Risk weight on NPAs net of specific provision will be calculated as under:
When provision is less than 20% of NPA o/s ---- 150%
Category Provision Rate Risk Weight

Substandard (Secured) 15% 150%
Substandard (Unsecured) 25% 100%
Doubtful (DI) (Secured) 25% 100%
Doubtful (DI) (Un-Secured) 100% 50%
Doubtful (D2) (Secured) 40% 100%
Doubtful (D3) (Secured) 100% 50%
Doubtful (D2)(Un-Secured) 100% 50%
Off-balance sheet items

Off-balance sheet items have been bifurcated as follows:
6. Non-market related off-balance sheet items
7. Market related off-balance sheet items
There is two-step process for the purpose of calculating risk weighted assets in respect of off-
balance sheet items:
4. The notional amount of the transaction is converted into a credit equivalent factor by
multiplying the amount by the specified Credit Conversion Factor (CCF)
Page 167
2. The resulting credit equivalent amount is then multiplied by the risk weight applicable to the counter
party or to the purpose for which the bank has extended finance or the type of asset whichever is
higher.
Where the off-balance sheet item is secured by eligible collateral or guarantee, the credit risk
mitigation guidelines will be applied.
Non-market related off-balance sheet items:

Off balance sheet items like direct credit substitutes, trade and performance related contingent items
and commitments with certain draw downs are classified under Non-market related off-balance sheet
items. The credit equivalent amount is determined by multiplying the contracted amount of that
particular transaction by the relevant CCF.
Non-market related off-balance sheet items also include undrawn or partially undrawn fund based and
non-fund based facilities, which are not unconditionally cancellable. The amount of undrawn commitment
is to be included in calculating the off-balance sheet items. Non-market related exposure is the maximum
unused portion of the commitment that could be drawn during the remaining period of maturity. In case of
term loan with respect to large project to be drawn in stages, undrawn portion shall be calculated with
respect of the running stage only.
CREDIT RISK
How to find Risk Weighted Assets?
Fixed Assets : 500 Crore

Govt. Securities : 5000 crore
Standard Assets
Retail ---3000 crore
HL -------2000 crore
Other loans—10000 cr
Sub-Standard Assets
Secured ----500 crore
Unsecured -----150 crore
Doubtful (DAI) -----800 crore
Solution:
Retail----------------3000*75/100 = 2250 crore
HL---------------------2000*50/100=1000 crore
Other loans---------10000*100/100 = 10000 crore
Gsec------------------5000*0/100=0
12. Secured----------500*150/100=750 crore SS
Unsecured ------150*100/100=150 crore
Page 168
Doubtful D1 --------800*100/100=800 crore
Total RWAs = 2250+1000+750+150+800 = 4950 crore
OPERATIONAL RISK
How to find Risk Weighted Assets?
Ist year 2nd year

Net Profit 120 crore 150 crore
Provisions 240 crore 290 crore
Staff Expenses 280 crore 320 crore
Other Oper.
Expenses 160 crore 240 crore
Gross Income 800 crore 1000 crore
Average Income 1800/2=900 crore

Capital Charge 900*15/100=135 crore
RWAs (assuming BASEL rate of 8%)

Capital Charge/8% = 135*100/8 = 1687.50 crore
Tier-I and Tier II Capital

CRAR
RWAs --- Credit and Operational Risks = 10000 crore
RWAs ---- Market Risk =4000 crore
Tier –I Capital
Paid up Capital--------------------------------------------- 100 crore
Free Reserves --------------------------------------------- 300 crore
Perpetual non-Cumulative Preference Shares ----- 400 crore
Tier-II Capital
Provisions for contingencies --------------------------- 200 crore
Revaluation Reserve-------------------------------------- 300 crore
Subordinate Debts---------------------------------------- 300 crore
Solution
Tier –I Capital = 100+300+400 = 800 crore
Tier-II Capital = ( 300*45/100) + 300 + 1.25 % of RWAs (or Rs. 200 crore)
=135 + 300 + 175 = 610 crore
Total Capital = 800 + 610 = 1410 crore
Page 169
Minimum Capital Required and Capital to Support Market Risks In the
above example:
CAR = 1410/14000*100 = 10.07%
Minimum Capital Required to support Credit and Operational Risks = 10000*9/100 = 900 crore Minimum
Tier –I Capital Required to support Credit and Operational Risks = 900*50=450 crore Minimum Tier –I I
Capital Required to support Credit and Operational Risks =900-450=450 crore
Amount of Tier –I Capital to support Market Risks = 800-450 = 350 crore Amount
of Tier –II Capital to support Market Risks = 610-450 = 160 crore
Volatility with time horizon & Bond Value
Ex.1
If daily volatility of a Security is 2%, how much will be monthly volatility?
Solution
Monthly volatility = Daily Volatility * ∫30 = 2*∫30 = 2*5.477 = 10.95%
Ex.2
If per annum volatility is 30% and nos. of trading days per annum be 250, how much will be daily
volatility?
Solution
Annual Volatility = Daily Volatility * ∫250 = Daily Volatility * 15.81 30 = Daily
Volatility *15.81
Daily volatility = 30/15.81 = 1.90%
Ex.3
If 1 day VaR of a portfolio is Rs. 50000/- with 97% confidence level. In a period of 1 year of 300 trading
days, how many times the loss on the portfolio may exceed Rs. 50000/-.
Solution
97% confidence level means loss may exceed the given level (50000)on 3 days out of 100. If out
of 100 days loss exceeds the given level on days =3
Then out of 300 days, loss exceeds the given level = 3/100*300 =9 days.
Ex.4
A 5 year 5% Bond has a BPV of Rs. 50/-, how much the bond will gain or lose due to increase in the yield
of bond by 2 bps
Solution
Increase in yield will affect the bond adversely and the bond will lose.
Since BPV of the bond is Rs. 50/-. Increase in yield by 2 bps will result into loss of value of Bond by
50*2=100.
Page 170
Ex.5
1 day VaR of a portfolio is Rs. 50000/- with 90% confidence level. In a period of 1 year (250 days)
how many times the loss on the portfolio may not exceed Rs.50000/-
Ans. 90% confidence level means on 10 days out of 100, the loss will be more than Rs. 50000/-.
Out of 250 days, loss will be more than 50000/- on 25 days Ans.
Bond Value, Current Yield
Bond-1 Bond-2
Face Value 100 100
Annual Coupon 8% 10%
Term to Maturity 3 yrs 4 yrs
Market Price 80 90
Ex. 1 Find Current Yield of Bond 2

Solution
Coupon amount X100 = 10/90*100 = 11.11%
Market Value
Ex. 2 Find YTM of Bond 1 & 2

YTM of Bond 1 = 17.07%
YTM of Bond 2 = 13.41%
Ex. 3 Find McCauley Duration of Bond 1

2.76 years
Ex. 4
Find Modified Duration of Bond 2
Solution
McCauley duration/1+yield
=3.46/(1+13.41%) = 3.46/1.1341 = 3.05 yrs.
Ex. 5 What is %age change in price of Bond 2 if YTM increases by

1%Expected %age change in price
=Modified Duration x %age change in yield
=3.5 x 1 = -3.05% (Decrease in price of bond)
Ex. 5 What is %age change in price of Bond 2 if YTM decreases by 1%=3.5

x 1 = 3.05% (Increase in price of bond)
Ex.6 As an investor, in which bond would you like to invest.

Bond 1 (YTM is more)
AMA – Estimated level of Operational Risk and Impact of Internal Control
Guidelines on Partial Credit Enhancement to corporate

bonds by banks
I. Purpose
1. The credit needs of the infrastructure sector in India are huge. Resources are generally raised
through the bond market by corporates for project development. However, the Indian corporate bond
market, being at a nascent stage of development, there is excessive pressure on the banking system
to fund the credit needs of such projects thereby leading to greater asset-liability mismatch and
exposing banks to liquidity risk. The insurance and provident/pension funds, whose liabilities are long
term, may be better suited to finance such projects.
Page 171
2. The regulatory requirement for insurance and provident/pension funds is to invest in bonds of high
or relatively high credit rating.
3. With a view to enabling long term providers of funds such as insurance and provident/pension
funds, as also other investors, to invest in the bonds issued for funding projects by corporates/SPVs,
RBI, in its Second Quarter Review of Monetary Policy 2013-14, proposed to allow banks to offer
Partial Credit Enhancement (PCE) to corporate bonds.
4. The objective behind allowing banks to extend PCE is to enhance the credit rating of the bonds
issued so as to enable corporates to access the funds from the bond market on better terms.
5. It has been decided that, to begin with, banks can provide PCE to a project as a non-funded
subordinated facility in the form of an irrevocable contingent line of credit which will be drawn in case
of shortfall in cash flows for servicing the bonds and thereby improve the credit rating of the bond
issue.
II. Salient features of the PCE facility
6. The aggregate PCE provided by all banks for a given bond issue shall be 50 per cent of the bond
issue size, with a limit up to 20 per cent of the bond issue size for an individual bank.
7. The PCE facility shall be provided at the time of the bond issue and will be irrevocable.
8. Banks are not expected to invest in corporate bonds which are credit enhanced by other banks.
9. Banks may offer PCE only in respect of bonds whose pre-enhanced rating is BBB minus or
better.
10. Banks cannot provide PCE by way of guarantee.
11. Banks should have a board approved policy on PCE.
III. Balance sheet treatment, capital requirements, exposure and asset classification norms for
exposures arising on account of providing PCE
12. PCE facilities to the extent drawn should be treated as an advance in the balance sheet. Undrawn
facilities would be an off-balance sheet item and reported under ‘Contingent Liability – Others’.
13. The aggregate capital required to be maintained by the banks providing contingent PCE for a
given bond issue for their exposure on account of PCE provided will be computed, as if the entire
bond issue was held by banks, as the difference between (a) the capital required on the entire bond
amount, corresponding to its pre-credit enhanced rating and (b) the capital required on the bond
amount corresponding to its post-credit enhanced rating, as per the risk weights applicable to claims
on corporates in the Master Circular – Basel III Capital Regulations (as updated from time to time).
To illustrate, assume that the total bond size is Rs.100 for which PCE to the extent of Rs.20 is
provided by a bank. The pre-enhanced rating of the bond is BBB which gets enhanced to AA with
the PCE. In this scenario –
a. At the pre-enhanced rating of BBB (100% risk weight), the capital requirement on the total
bond size (Rs.100) is Rs.9.00.
b. The capital requirement for the bond (Rs.100) at the enhanced rating (AA, i.e., 30% risk
weight)) would be Rs.2.70.
c. As such, the PCE provider will be required to hold the difference in capital i.e., Rs.6.30
(Rs.9.00 – Rs.2.70).
14. On a review of the capital requirement for PCE, it has been decided that:
a) To be eligible for PCE from banks, corporate bonds shall be rated by a minimum of two
external credit rating agencies at all times;
b) The rating reports, both initial and subsequent, shall disclose both standalone credit rating
(i.e., rating without taking into account the effect of PCE) as well as the enhanced credit rating
(taking into account the effect of PCE).
c) For the purpose of capital computation in the books of PCE provider, lower of the two
standalone credit ratings and the corresponding enhanced credit rating of the same rating
agency shall be reckoned.
d) Where the reassessed standalone credit rating at any time during the life of the bond
shows improvement over the corresponding rating at the time of bond issuance, the capital
requirement may be recalculated on the basis of the reassessed standalone credit rating and
the reassessed enhanced credit rating, without reference to the constraints of capital floor and
difference in notches.
15. In situations where the notional pre-enhanced rating of the bond slips below investment grade
(BBB minus), capital must be maintained as per risk weight of 1250% on the amount of PCE
provided.
16. The PCE providing bank will observe the following exposure limits:
(a) PCE exposure to a single counterparty or group of counterparties shall not exceed 5 per
cent of the bank’s Single Borrower / Group Borrower limit to the counterparty to whom the
PCE is provided,
(b) The aggregate PCE exposure of a bank shall not exceed 20 per cent of its Tier 1 capital.
Page 172
LARGE EXPOSURES FRAMEWORK (LEF)
The following write up on Large Exposures Framework (LEF) is based on RBI Notification No.
RBI/2016-17/167 DBR.No.BP.BC.43/21.01.003/2016-17 dated December 1, 2016. Candidates are
advised to refer to the Notification for additional details.
In order to align the exposure norms for Indian banks with the BCBS standards, RBI has laid down the
guidelines on Large Exposures Framework on December 1, 2016. The guidelines are aimed at
significant tightening of norms pertaining to concentration risks of banks, especially in relation to large
borrowers. The guidelines come into effect from April 1, 2019.
A large exposure is defined as any exposure to a counter-party or group of counter-parties which is
equal to 10 per cent of the bank’s eligible capital base (defined as tier-I capital).
LARGE EXPOSURE LIMITS
Single Counterparty: The sum of all the exposure values of a bank to a single counterparty must not
be higher than 20 percent of the bank’s available eligible capital base at all times. In exceptional cases,
Board of banks may allow an additional 5 percent exposure of the bank’s available eligible capital base.
Banks shall lay down a Board approved policy in this regard.
Groups of Connected Counterparties: The sum of all the exposure values of a bank to a group of
connected counterparties, as defined below, must not be higher than 25 percent of the bank’s available
eligible capital base at all times.
Any breach of the above LE limits shall be under exceptional conditions only and shall be reported to
RBI immediately and rectified at the earliest but not later than a period of 30 days from the date of the
breach.
Definition of connected counterparties
Bank may have exposures to a group of counterparties with specific relationships or dependencies
such that, where one of the counterparties fail, all of the counterparties are likely to fail. A group of this
sort is referred to, in this framework, as a group of connected counterparties and must be treated as a
single counterparty. In this case, the sum of the bank’s exposures to all the individual entities included
within a group of connected counterparties is subject to the large exposure limit and to the regulatory
reporting requirements.
Counterparties exempted from LEF
The exposures that will be exempted from the LEF are listed below:
a. Exposures to the Government of India and State Governments which are eligible for zero percent
Risk Weight under the Basel III – Capital Regulation framework of the Reserve Bank of India;
b. Exposures to Reserve Bank of India;
c. Exposures where the principal and interest are fully guaranteed by the Government of India; d.
Exposures secured by financial instruments issued by the Government of India,
e. Intra-day interbank exposures;
f. Intra-group exposures;
g. Borrowers, to whom limits are authorised by the Reserve Bank for food credit;
h. Banks’ clearing activities related exposures to Qualifying Central Counterparties (QCCPs)
i. Rural Infrastructure Development Fund (RIDF) deposits placed with NABARD.
However, a bank’s exposure to an exempted entity which is hedged by a credit derivative shall be
treated as an exposure to the counterparty providing the credit protection notwithstanding the fact that
the original exposure is exempted.
.
RISK MANAGEMENT
SECTION I
Facilities for Persons Resident in India other than Authorised Dealers Category-I
The facilities for persons resident in India (other than AD Category I banks) are elaborated under
paragraphs A and B. Paragraph A describes the products and operational guidelines for the
respective product. In addition to the operational guidelines under A, the general instructions that
are applicable across all products for residents (other than AD Category I banks) are detailed under
Paragraph B.
A. Products and Operational Guidelines
Page 173
The product/purpose-wise facilities for persons resident in India (other than AD Category I banks)
are detailed under the following subheads:
Contracted Exposure
Probable Exposure
Special Dispensation
4. Contracted Exposures
AD Category I banks have to evidence the underlying documents so that the existence of
underlying foreign currency exposure can be clearly established. AD Category I banks, through
verification of documentary evidence, should be satisfied about the genuineness of the
underlying exposure, irrespective of the transaction being a current or a capital account. Full
particulars of the contracts should be marked on the original documents under proper
authentication and retained for verification. However, in cases where the submission of original
documents is not possible, a copy of the original documents, duly certified by an authorized
official of the user, may be obtained. In either of the cases, before offering the contract, the AD
Category I banks should obtain an undertaking from the customer and also certificates from the
statutory auditor (for details refer para B (b) for General Instructions). While details of the
underlying have to be recorded at the time of booking the contract, in the view of logistic issues,
a maximum period of 15 days may be allowed for production of the documents. If the documents
are not submitted by the customer within 15 days, the contract
Page 174
may be cancelled, and the exchange gain, if any, should not be passed on to the customer. In
the event of non-submission of the documents by the customer within 15 days on more than
three occasions in a financial year, booking of permissible derivative contracts in future may be
allowed only against production of the underlying documents, at the time of booking the contract.
The products available under this facility are as follows:
F Forward Foreign Exchange Contracts

Participants
Market-makers - AD Category I banks Users
- Persons resident in India
Purpose
To hedge exchange rate risk in respect of transactions for which sale and /or purchase of
foreign exchange is permitted under the FEMA 1999, or in terms of the rules/
regulations/directions/orders made or issued there under.
To hedge exchange rate risk in respect of the market value of overseas direct investments
(in equity and loan).
Contracts covering overseas direct investment (ODI) can be cancelled or rolled
over on due dates. If a hedge becomes naked in part or full owing to contraction
(due to price movement/impairment) of the market value of the ODI, the hedge may
be allowed to continue until maturity, if the customer so desires. Rollovers on due
date shall be permitted up to the extent of the market value as on that date.
To hedge exchange rate risk of transactions denominated in foreign currency but settled in
INR, including hedging the economic (currency indexed) exposure of importers in respect
of customs duty payable on imports.
Forward foreign exchange contracts covering such transactions will be settled in
cash on maturity.
These contracts once cancelled, are not eligible to be rebooked.
In the event of any change in the rate(s) of customs duties, due to Government
notifications subsequent to the date of the forward contracts, importers may be
allowed to cancel and/or rebook the contracts before maturity.
Page 175
Operational Guidelines, Terms and Conditions
General principles to be observed for forward foreign exchange contracts.
4. The maturity of the hedge should not exceed the maturity of the underlying transaction. The
currency of hedge and tenor, subject to the above restrictions, are left to the customer.
Where the currency of hedge is different from the currency of the underlying exposure, the
risk management policy of the corporate, approved by the Board of the Directors, should
permit such type of hedging.
5. Where the exact amount of the underlying transaction is not ascertainable, the contract
may be booked on the basis of reasonable estimates. However, there should be periodical
review of the estimates.
6. Foreign currency loans/bonds will be eligible for hedge only after final approval is accorded
by the Reserve Bank, where such approval is necessary or Loan Registration Number is
allotted by the Reserve Bank.
7. Global Depository Receipts (GDRs)/American Depository Receipts (ADRs) will be eligible
for hedge only after the issue price has been finalized.
8. Balances in the Exchange Earner's Foreign Currency (EEFC) accounts sold forward by the
account holders shall remain earmarked for delivery and such contracts shall not be
cancelled. They are, however, eligible for rollover, on maturity.
9. In case of contracted exposures, forward contracts, involving Rupee as one of the
currencies, in respect of all current account transactions as well as capital account
transactions with a residual maturity of one year or less may be freely cancelled and
rebooked.
10. In case of forward contracts involving Rupee as one of the currencies, booked by residents
in respect of all hedge transactions, if cancelled with one AD Category I bank can be
rebooked with another AD Category I bank subject to the following conditions:
A. the switch is warranted by competitive rates on offer, termination of banking
relationship with the AD Category I bank with whom the contract was originally
booked;
B. the cancellation and rebooking are done simultaneously on the maturity date of the
contract; and
C. the responsibility of ensuring that the original contract has been cancelled rests
with the AD Category I bank who undertakes rebooking of the contract.
Page 176
5. Forward contracts can be rebooked on cancellation subject to condition (i) below.
6. The facility of rebooking should not be permitted unless the corporate has submitted the
exposure information as prescribed in Annex V.
7. Substitution of contracts for hedging trade transactions may be permitted by an AD
Category I bank on being satisfied with the circumstances under which such substitution
has become necessary. The AD Category I bank may also verify the amount and tenor of
the underlying substituted.
7. Cross Currency Options (not involving Rupee)

Participants
Market-makers - AD Category I banks as approved for this purpose by theReserve Bank
Users – Persons resident in India
Purpose
To hedge exchange rate risk arising out of trade transactions.
To hedge the contingent foreign exchange exposure arising out of
submission of a tender bid in foreign exchange.
7. AD Category I banks can only offer plain vanilla European options1.
8. Customers can buy call or put options.
9. These transactions may be freely booked and/ or cancelled subject to verification of the
underlying.
10. All guidelines applicable for cross currency forward contracts are applicable to cross
currency option contracts also.
11. Cross currency options should be written by AD Category I banks on a fully covered back-
to-back basis. The cover transaction may be undertaken with a bank outside India, an Off-
shore Banking Unit situated in a Special Economic Zone or an internationally recognized
option exchange or another AD Category I bank in India. AD Category I banks desirous of
writing options, should obtain a one-time approval from the Chief General Manager,
Financial Markets Regulation Department, Reserve Bank of India, Central Office, 1st Floor,
Main Building, Shahid Bhagat Singh Road, Fort, Mumbai – 400 001, before undertaking the
business.
A European option may be exercised only at the expiry date of the option, i.e. at a single pre-
8.
defined point in time.

7
Page 177
9. Foreign Currency - INR Options
Participants
Market-makers - AD Category I banks, as approved for this purpose by theReserve Bank.
Users – Persons resident in India
Purpose
€ To hedge foreign currency exposures in accordance with Schedule I of Notification No.
FEMA 25/2000-RB dated May 3, 2000, as amended fromtime to time.
€ To hedge the contingent foreign exchange exposure arising out of submission of a tender
bid in foreign exchange.

11. AD Category I banks having a minimum CRAR of 9 per cent, can offer foreign currency–
INR options on a back-to-back basis.
12. For the present, AD category I banks can offer only plain vanilla European options.
13. Customers can buy call or put options.
14. All guidelines applicable for foreign currency-INR foreign exchange forward contracts are
applicable to foreign currency-INR option contracts also.
15. AD Category I banks having adequate internal control, risk monitoring/ management
systems, mark to market mechanism, etc. are permitted to run a foreign currency– INR
options book on prior approval from the Reserve Bank, subject to conditions. AD Category I
banks desirous of running a foreign currency-INR options book and fulfilling minimum
eligibility criteria listed below, may apply to the Reserve Bank with copies of approval from
the competent authority (Board/ Risk Committee/ ALCO), detailed memorandum in this
regard, specific approval of the Board for the type of option writing and permissible limits.
The memorandum put up to the Board should clearly mention the downside risks, among
other matters.
Minimum Eligibility Criteria:
Net worth not less than Rs 300 crore
CRAR of 10 per cent
Net NPAs not exceeding 3 per cent of the net advances
Continuous profitability for at least three years
Page 178
The Reserve Bank will consider the application and accord a one-time approval at its
discretion. AD Category I banks are expected to manage the option portfolio within the
Reserve Bank approved risk management limits.
12. AD banks may quote the option premium in Rupees or as a percentage of the
Rupee/foreign currency notional.
13. Option contracts may be settled on maturity either by delivery on spot basis or by net cash
settlement in Rupees on spot basis as specified in the contract. In case of unwinding of a
transaction prior to the maturity, the contract may be cash settled based on market value of
an identical off-setting option.
14. Market makers are allowed to hedge the ‘Delta’ of their option portfolio by accessing the
spot and forward markets. Other ‘Greeks’ may be hedged by entering into option
transactions in the inter-bank market.
15. The ‘Delta’ of the option contract would form part of the overnight open position.
16. The ‘Delta’ equivalent as at the end of each maturity shall be taken into account for the
purpose of AGL. The residual maturity (life) of each outstanding option contract can be
taken as the basis for the purpose of grouping under various maturity buckets.
17. AD banks running an option book are permitted to initiate plain vanilla cross currency
option positions to cover risks arising out of market making in foreign currency-INR options.
18. Banks should put in place necessary systems for marking to market the portfolio on a daily
basis. FEDAI will publish daily a matrix of polled implied volatility estimates, which market
participants can use for marking to market their portfolio.
19. The accounting framework for option contracts will be as per FEDAI circular No.SPL-
24/FC-Rupee Options/2003 dated May 29, 2003.
8. Foreign Currency-INR Swaps

Participants
Market-makers – AD Category I banks in India. For2enteringinto swapswith Multilateral
(MFI) or International Financial Institutions (IFIs) in which
7. A. P. (DIR Series) Circular No. 28 dated November 5, 2015

9
Page 179
Government of India is a shareholder, refer to para. (g) under operational guidelines, terms
and conditions.
Users –
3. Residents having a foreign currency liability and undertaking a foreign currency-INR
swap to move from a foreign currency liability to a Rupee liability.
4. Incorporated resident entities having a rupee liability and undertaking an INR – foreign
currency swap (INR-FCY) to move from rupee liability to a foreign currency liability,
subject to certain minimum prudential requirements, such as risk management systems
and natural hedges or economic exposures. In the absence of natural hedges or
economic exposures, the INR-foreign currency swap (to move from rupee liability to a
foreign currency liability) may be restricted to listed companies or unlisted companies
with a minimum net worth of Rs 200 crore. Further, the AD Category I bank is required
to examine the suitability and appropriateness of the swap and be satisfied about the
financial soundness of the corporate.
Purpose
To hedge exchange rate and/or interest rate risk exposure for those having long-term foreign
currency borrowing or to transform long-term INR borrowing into foreign currency liability.
2 No swap transactions involving upfront payment of Rupees or its equivalent in any form shall be
undertaken.
3 The term “long-term exposure” means exposures with residual maturity of one year or more.
4 The swap transactions, once cancelled, shall not be rebooked or re-entered, by
whichever mechanism or by whatever name called. In3case of FCY-INR swaps however, where the
underlying is still surviving, the client, on cancellation of the swap contract, may be permitted to
re‐enter into a fresh swap, to hedge the underlying but only after the expiry of the tenor of the
original swap contract that had been cancelled. This flexibility is not permitted for INR-FCY swaps.
5 AD Category I banks should not offer leveraged swap structures. Typically, in leveraged swap
structures, a multiplicative factor other than unity is attached to the
3. A.P. (DIR Series) Circular No. 78 dated February 13, 2015

10
Page 180
benchmark rate(s), which alters the payables or receivables vis-à-vis the situation in the absence of
such a factor.
AJ. The notional principal amount of the swap should not exceed the outstanding amount of the
underlying loan.
AK. The maturity of the swap should not exceed the remaining maturity of the underlying loan.
AL. For hedging their long term foreign currency borrowings residents may enter in to FCY-INR
swaps with Multilateral or International Financial Institutions (MFI/IFI) in which Government of India
is a shareholding member subject to the following terms and conditions in addition to (a) to (f)
above:
Such swap transactions shall be undertaken by the MFI / IFI concerned on a back -to-back
basis with an AD Category-I bank in India.
2. AD Category - I banks shall face, for the purpose of the swap, only those Multilateral
Financial Institutions (MFIs) and International Financial Institutions (IFIs) in which
Government of India is a shareholding member.
The FCY-INR swaps shall have a minimum tenor of three years.
In the event of a default by the resident borrower on its swap obligations, the MFI / IFI
concerned shall bring in foreign currency funds to meet its corresponding liabilities to the
counterparty AD Cat-I bank in India.
BO.Cost Reduction Structures i.e. cross currency option cost reduction structuresand foreign
currency –INR option cost reduction structures.
Participants
Market-makers - AD Category I banks
Users – Listed companies and their subsidiaries/joint ventures/associateshaving common
treasury and consolidated balance sheet or unlisted companies with a minimum net worth
of Rs. 200 crore
provided
8. All such products are fair valued on each reporting date;
9. The companies follow the Accounting Standards notified under section 211 of the
Companies Act, 1956 and other applicable Guidance of the Institute of Chartered
Accountants of India (ICAI) for such products/ contracts as also the principle of
prudence which
11
Page 181
requires recognition of expected losses and non-recognition of unrealized gains;
12. Disclosures are made in the financial statements as prescribed in ICAI press
release dated 2nd December 2005; and
13. The companies have a risk management policy with a specific clause in the policy
that allows using the type/s of cost reduction structures.
(Note: The above accounting treatment is a transitional arrangement till AS 30 / 32 or equivalent

standards are notified.)”
Purpose
To hedge exchange rate risk arising out of trade transactions, External Commercial Borrowings
(ECBs) and foreign currency loans availed of domestically against FCNR (B) deposits.

61. Writing of options by the users, on a standalone basis, is not permitted.
62. Users can enter into option strategies of simultaneous buy and sell of plain vanilla
European options, provided there is no net receipt of premium.
63. Leveraged structures, digital options, barrier options, range accruals and any other exotic
products are not permitted.
64. The portion of the structure with the largest notional, computed over the tenor of the
structure, should be reckoned for the purpose of underlying.
65. The delta of the options should be explicitly indicated in the term sheet.
66. AD Category I banks may, stipulate additional safeguards, such as, continuous profitability,
higher net worth, turnover, etc depending on the scale of forex operations and risk profile of
the users.
67. The maturity of the hedge should not exceed the maturity of the underlying transaction and
subject to the same the users may choose the tenor of the hedge. In case of trade
transactions being the underlying, the tenor of the structure shall not exceed two years.
68. The MTM position should be intimated to the users on a periodical basis.
12
Page 182
(AK) Hedging of Borrowings in foreign exchange, which are in accordance withthe
provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange)
Regulations, 2000.
Products – Interest rate swap, Cross currency swap, Coupon swap, Crosscurrency option, Interest
rate cap or collar (purchases), Forward rate agreement (FRA)
Participants
Market-makers –
AD Category I banks in India
Branch outside India of an Indian bank authorized to deal in foreign exchange in India
(ix) Offshore banking unit in a SEZ in India.
Users –
Persons resident in India who have borrowed foreign exchange in accordance with the
provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange)
Regulations, 2000.
Purpose
For hedging interest rate risk and currency risk on loan exposure and unwinding from such hedges.

14. The products, as detailed above should not involve the rupee under any circumstances.
15. Final approval has been accorded or Loan Registration Number allotted by the Reserve
Bank for borrowing in foreign currency.
16. The notional principal amount of the product should not exceed the outstanding amount of
the foreign currency loan.
17. The maturity of the product should not exceed the unexpired maturity of the underlying loan.
18. The contracts may be cancelled and rebooked freely.
13
Page 183
35 Probable exposures based on past performance
Participants
Market-makers – AD Category I banks in India. Users –
Importers and exporters of goods and services
Purpose
To hedge currency risk on the basis of a declaration of an exposure and based on past
performance up to the average of the previous three financial years’ (April to March) actual
import/export turnover or the previous year’s actual import/export turnover, whichever is higher.
Probable exposure based on past performance can be hedged only in respect of trades in
merchandise goods as well as services.
Products
Forward foreign exchange contracts, cross currency options (not involving the rupee), foreign
currency-INR options and cost reduction structures [as mentioned in section B para I 1(v)].
Corporates having a minimum net worth of Rs 200 crores and an annual export and import
turnover exceeding Rs 1000 crores and satisfying all other conditions as stipulated in section B
para I 1(v) may be allowed to use cost reduction structures.
The contracts booked during the current financial year (April-March) and the outstanding
contracts at any point of time should not exceed
The eligible limit i.e. the average of the previous three financial years’ actual export
turnover or the previous year’s actual export turnover, whichever is higher for
exports.
Hundred percent of the eligible limit i.e. the average of the previous three financial
years’ actual import turnover or the previous year’s actual import turnover,
whichever is higher for imports. Importers, who have already booked contracts up
to previous limit of fifty per cent in the current financial year, shall be eligible for
difference arising out of the enhanced limit.
Contracts booked up to 75 percent of the eligible limit mentioned at paragraph (b) (i) and
(b) (ii) above may be cancelled with the exporter/importer bearing/being entitled to the loss or
gain as the case may be. Contracts booked in excess of 75 percent of the eligible limit
mentioned at paragraph (b) (i) and
(b) (ii) above shall be on a deliverable basis and cannot be cancelled, implying
14
Page 184
that in the event of cancellation, the exporter/importer shall have to bear the loss but will not be
entitled to receive the gain.
9. These limits shall be computed separately for import/export transactions.
10.Higher limits will be permitted on a case-by-case basis on application to the Chief General
Manager, Financial Markets Regulation Department, Reserve Bank of India, Central Office, 1st
Floor, Main Building, Shahid Bhagat Singh Road, Fort, Mumbai – 400 001. The additional limits,
if sanctioned, shall be on a deliverable basis.
11. Any contract booked without producing documentary evidence will be marked off
against this limit. These contracts once cancelled, are not eligible to be rebooked. Rollovers are
also not permitted.
12.AD banks should permit their clients to use the past performance facility only after satisfying
themselves that the following conditions are complied with:
An undertaking may be taken from the customer that supporting documentary evidence
will be produced before the maturity of all the contracts booked.
Importers and exporters should furnish a quarterly declaration to the AD Category I
banks, signed by the Chief Financial Officer (CFO) and the Company Secretary (CS),
regarding amounts booked with other AD Category I banks under this facility, as per
Annex VI. In the absence of a CS, the Chief Executive Officer (CEO) or the Chief
Operating Officer (COO) shall co-sign the undertaking along with the CFO.
For an exporter customer to be eligible for this facility, the aggregate of overdue bills
shall not exceed 10 per cent of the turnover.
Aggregate outstanding contracts in excess of 50 per cent of the eligible limit may be
permitted by the AD Category I bank on being satisfied about the genuine requirements
of their customers after examination of
document as per the format in Annex VII, signed by the CFO and CS, containing the
following:
A declaration that all guidelines have been adhered to while utilizing this facility;
and.
A certificate of import/export turnover of the customer during the past three years.
In the absence of a CS, the CEO or the CFO shall co-sign the undertaking along with the CFO.
15
Page 185
2 The past performance limits once utilised are not to be reinstated either on cancellation or
on maturity of the contracts.
2 AD Category I banks must arrive at the past performance limits at the beginning of every
financial year. The drawing up of the audited figures (previous year) may require some time at
the commencement of the financial year. However, if the statements are not submitted within
three months from the last date of the financial year, the facility should not be provided until
submission of the audited figures.
2 As part of the annual audit exercise, the Statutory Auditor shall certify the following:
The amounts booked with AD Category-I banks under this facility; and
All guidelines have been adhered to while utilizing this facility over the past financial
year.
2 AD Category I banks must institute appropriate systems for validating the past performance
limits at pre-deal stage. In addition to the customer declarations, AD Category I banks should
also assess the past transactions with the customers, turnover, etc.
2 AD Category I banks are required to submit a monthly report (as on the last Friday of every
month) on the limits granted and utilised by their constituents under this facility as prescribed in
Annex X.
3) Special Dispensation
7) Small and Medium Enterprises (SMEs)
Participants
Market-makers – AD Category I.
Users – Small and Medium Enterprises (SMEs)4
Purpose
To hedge direct and / or indirect exposures of SMEs to foreign exchange risk
Product
Forward foreign exchange contracts
Operational Guidelines: Small and Medium Enterprises (SMEs) having directand / or indirect
exposures to foreign exchange risk are permitted to book / cancel /
4 SME as defined by the Rural Planning and Credit Department, Reserve Bank of India vide
circularRPCD.PLNS. BC.No.63/06.02.31/2006-07 dated April 4, 2007.
16
Page 186
(e) roll over forward contracts without production of underlying documents to manage their
exposures effectively, subject to the following conditions:
Such contracts may be booked through AD Category I banks with whom the SMEs have
credit facilities and the total forward contracts booked should be in alignment with the credit
facilities availed by them for their foreign exchange requirements or their working capital
requirements or capital expenditure.
AD Category I bank should carry out due diligence regarding “userappropriateness” and
“suitability” of the forward contracts to the SMEcustomers as per Para 8.3 of
'Comprehensive Guidelines on Derivatives' issued vide DBOD.No.BP.BC.
44/21.04.157/2011-12 dated November 2,2011.
The SMEs availing this facility should furnish a declaration to the AD Category I bank
regarding the amounts of forward contracts already booked, if any, with other AD Category
I banks under this facility.
(g) Resident Individuals, Firms and Companies

Participants
Market-makers – AD Category I banks
Users: Resident Individuals, Firms and Companies
Purpose
To hedge their foreign exchange exposures arising out of actual or anticipated remittances, both
inward and outward, can book forward contracts, without production of underlying documents, up to
a limit of USD 1,000,000 (USD one million), based on self-declaration.
Product
Forward foreign exchange contracts and FCY-INR options

7) While the contracts booked under this facility would normally be on a deliverable basis,
cancellation and rebooking of contracts are permitted. Based on the track record of the
entity, the concerned AD Cat-I bank may, however, call for underlying documents, if
considered necessary, at the time of rebooking of cancelled contracts. The notional value
of the outstanding contracts should not exceed USD 1,000,000 at any time.
8) The contracts may be permitted to be booked up to tenors of one year only.
17
Page 187
Such contracts may be booked through AD Category I banks with whom the resident
individual / firm / company has banking relationship, on the basis of an application-cum-
declaration in the format given in Annex XV. The AD Category I banks should satisfy
themselves that the hedging entities understand the nature of risk inherent in booking of
forward contracts or FCY-INR options and should carry out due diligence regarding
“userappropriateness” and “suitability” of the forward contracts / FCY-INR optionsto such
customer.
8. Simplified Hedging Facility

Users: Resident and non-resident entities, other than individuals.
Purpose: To hedge exchange rate risk on transactions, contracted or anticipated,permissible under
Foreign Exchange Management Act (FEMA), 19995.
Products: Any Over the Counter (OTC) derivative or Exchange Traded CurrencyDerivative (ETCD)
permitted under FEMA, 1999.
Cap on Outstanding Contracts: USD 30 million, or its equivalent, on a grossbasis.
Designated Bank: Any Authorised Dealer Category-I (AD Cat-I) bank designatedas such by the
user.
n) The user shall appoint an AD Cat-I bank as its “Designated Bank”. The designated bank will
assess the hedging requirement of the user and set a limit up to the stipulated cap on the
outstanding contracts.
o) If hedging requirement of the user exceeds the limit in course of time, the designated bank
may re-assess and, at its discretion, extend the limit up to 150% of the stipulated cap.
p) Hedge contracts in OTC market can be booked with any AD Cat-I bank, provided the
underlying cash flow takes place with the same bank.
q) Cost reduction structures can be booked by users provided that resident unlisted
companies can use such structures only if they have a minimum net worth of Rs.200 crores
r) Users are not required to furnish any documentary evidence for establishing underlying
exposure under this facility. Users may, however, provide basic
11.
Rupee denominated bonds issued overseas may be hedged provided it is permitted under
contracted exposure hedging.
18
Page 188
details of the underlying transaction in a standardised format6, only in the case of OTC
hedge contracts.
13. Cancelled contracts may be freely rebooked with the same bank.
14. In case of hedge contracts booked in OTC market, while losses will be recovered from the
user, net gains i.e. gains in excess of cumulative losses, if any, will be transferred at the
time of delivery of the underlying cash flow. In case of part delivery, net gains will be
transferred on a pro-rata basis.
15. For hedge contracts on underlying capital account transactions, gains/losses may be
transferred to the user as and when they accrue if the underlying asset/liability is already in
existence.
16. On full utilisation of the limit or in case of breach of limit, user shall not book new contracts
under this facility. In such a case, contracts booked earlier under this facility will be allowed
to continue till they expire or are closed. Any further hedging requirements thereafter may
be booked under other available hedging facilities.
17. Users booking contracts under this facility shall not book contracts under any other facility
in OTC or ETCD market except as provided in para (ix).
18. At the end of each financial year, the user will provide the designated bank with a statement
signed by the head of finance or the head of the entity, to the effect that,
Hedge contracts booked in both OTC and ETCD market, under this facility, are
backed by underlying exchange rate exposures, either contracted or anticipated.
The exposures underlying the hedge contracts booked under this facility are not
hedged under any other facility.
19. On being appointed, the designated bank shall report the details of the users and limits
granted to the Trade Repository (TR). On a request by the TR, the exchanges shall report
all contracts booked by such users to the TR on a daily basis.
20. The TR will compute user wise outstanding position (across OTC and ETCD market) and
provide this information to the designated bank for monitoring. If the outstanding contracts
of a user exceeds the limit (or the extended
6.
Standardized format will be devised by Foreign Exchange Dealers Association of India (FEDAI)
and will include details like transaction type, i.e. current account (import, export) or capital account
(ECB, FPI, FDI etc.), amount, currency and tenor.
19
Page 189
limit, if applicable) the designated bank shall advise the user to stop booking new contracts
under this facility.
When user migrates to other available facilities, the designated bank shall report this
information to the TR. The TR shall update this information in its records and notify the
recognized stock exchanges to stop reporting data for the user concerned.
Banks shall have an internal policy regarding the time limit up to which a hedge contract for
a given underlying can be rolled-over or rebooked by the user.
12. General Instructions for OTC forex derivative contracts entered by Residents in India
While the guidelines indicated above govern specific foreign exchange derivatives, certain general
principles and safeguards for prudential considerations that are applicable across the OTC foreign
exchange derivatives, are detailed below. In addition to the guidelines under the specific foreign
exchange derivative product, the general instructions should be followed scrupulously by the users
(residents in India other than AD Category I banks) and the market makers (AD Category I banks).
For Simplified Hedging Facility, para (a) and (b) below will not be applicable.
6 In case of all forex derivative transactions [except INR- foreign currency swaps i.e. moving
from INR liability to foreign currency liability as in section B para I(1)(iv)] is undertaken, AD
Category I banks must take a declaration from the clients that the exposure is unhedged
and has not been hedged with another AD Category I bank. The corporates should provide
an annual certificate to the AD Category I bank certifying that the derivative transactions
are authorized and that the Board (or the equivalent forum in case of partnership or
proprietary firms) is aware of the same.
7 In the case of contracted exposure, AD Category I banks must obtain:
d. An undertaking from the customer that the same underlying exposure has not been
covered with any other AD Category I bank/s. Where hedging of the same
exposure is undertaken in parts, with more than one AD Category I bank, the
details of amounts already booked with other AD Category I bank/s should be
clearly indicated in the declaration. This undertaking can also be obtained as a part
of the deal confirmation.
20
Page 190
a An annual certificate from the statutory auditors to the effect that the contracts
outstanding with all AD category I banks at any time during the year did not exceed
the value of the underlying exposures at that time. It is reiterated, however, that
that the AD bank, while entering into any derivative transaction with a client, shall
have to obtain an undertaking from the client to the effect that the contracted
exposure against which the derivative transaction is being booked has not been
used for any derivative transaction with any other AD bank.
$ Derived foreign exchange exposures are not permitted to be hedged. However, in case of
INR- foreign currency swaps, at the inception, the user can enter into one time plain vanilla
cross currency option (not involving Rupee) to cap the currency risk.
$ In any derivative contract, the notional amount should not exceed the actual underlying
exposure at any point in time. Similarly, the tenor of the derivative contracts should not
exceed the tenor of the underlying exposure. The notional amount for the entire transaction
over its complete tenor must be calculated and the underlying exposure being hedged must
be commensurate with the notional amount of the derivative contract.
$ Only one hedge transaction can be booked against a particular exposure/ part thereof for a
given time period.
$ The term sheet for the derivative transactions (except forward contracts) should also
necessarily and clearly mention the following:
the purpose for the transaction detailing how the product and each of its
components help the client in hedging;
the spot rate prevailing at the time of executing the transaction; and
quantified maximum loss/ worst downside in various scenarios.
$ AD Category I banks can offer only those products that they can price independently. This
is also applicable to the products offered even on back to back basis. The pricing of all
forex derivative products should be locally demonstrable at all times.
$ The market-makers should carry out proper due diligence regarding ‘user appropriateness’
and ‘suitability’ of products before offering derivative products (except forward contracts) to
users as detailed in. No.BP.BC. 44/21.04.157/2011-12 dated November 2, 2011.
$ AD Category I may share with the user the various scenario analysis
21
Page 191
encompassing both the possible upside as well as the downsides and sensitivity analysis
identifying the various market parameters that affect the product.
$ The provisions of comprehensive guidelines on Derivatives issued vide DBOD.No.BP.BC.
86/21.04.157/2006-07 dated April 20, 2007andasamended from time to time are also
applicable to forex derivatives.
$ Sharing of information on derivatives between banks is mandatory and as detailed vide
circular DBOD.No.BP.BC.46/08.12.001/2008-09 datedSeptember 19, 2008andDBOD.No.
BP. BC. 94/08.12.001/2008-09 datedDecember 8, 2008.
4. Currency Futures on recognised Stock /New Exchanges
As part of further developing the derivatives market in India and adding to the existing menu of
foreign exchange hedging tools available to the residents and non-residents, currency futures
contracts have been permitted to be traded in recognized stock exchanges or new exchanges,
recognized by the Securities and Exchange Board of India (SEBI) in the country. The currency
futures market would function subject to the directions, guidelines, instructions issued by the
Reserve Bank and the SEBI, from time to time.
Participation in the currency futures market in India is subject to directions contained in the
Currency Futures (Reserve Bank) Directions, 2008 [NotificationNo.FED.1/DG(SG)-2008 dated
August 6, 2008] (Directions) andNotificationNo.FED. 2/ED (HRK)-2009 dated January 19, 2010, as
amended7fromtime totime, issued by the Reserve Bank of India under Section 45W of the Reserve
Bank of India Act, 1934.
Currency futures are subject to following conditions:

Permission
$ Currency futures are permitted in US Dollar (USD) - Indian Rupee (INR), Euro (EUR)-INR,
Japanese Yen (JPY)-INR, Pound Sterling (GBP)-INR, EUR-USD, GBP-USD and USD-JPY.
$ ‘Persons resident in India’ may purchase or sell currency futures contracts subject to the terms
and conditions laid down in paragraph 6 below.
7. A.P. (DIR Series) No. 35 dated December 10, 2015containingAmendment Directions

issuedunder RBI Act, 1934 for introduction of cross-currency futures and options and exchange
traded options in EUR-INR, GBP-INR and JPY-INR currency pairs.
22
Page 192
7. Foreign Portfolio Investors (FPIs) are permitted to enter into currency futures contracts subject
to the terms and conditions laid down in Part A, Section II, paragraph no. 2.
Features of currency futures

Standardized currency futures shall have the following features:
(vi) Foreign Currency-Indian Rupee contracts, viz. USD-INR, EUR-INR, GBP-INR and JPY-INR and
Cross Currency contracts (not involving the Indian Rupee), viz. EUR-USD, GBP-USD and USD-
JPY are allowed to be traded.
(vii) The size of the USD-INR and USD-JPY contracts shall be USD 1000, of EUR-INR and EUR-
USD contracts shall be EUR 1000, of GBP-INR and GBP-USD contracts shall be GBP 1000 and
JPY-INR contract shall be JPY 100,000.
(viii) All Foreign Currency-INR contracts shall be quoted and settled in Indian Rupees. EUR-
USD and GBP-USD cross currency contracts shall be quoted in USD and USD-JPY contract shall
be quoted in JPY. All cross currency contracts shall be settled in Indian Rupees as per the method
approved by Reserve Bank.
(ix) The maturity of the contracts shall not exceed 12 months.
(x) The settlement price for USD-INR shall be the Reserve Bank’s Reference Rate and for Euro-
INR, GBP-INR and JPY-INR contracts shall be the exchange rates published by the Reserve Bank
in its press release on the last trading day. The settlement price in Indian Rupees of the cross-
currency contracts shall be computed using the Reserve Bank’s USD-INR Reference Rate and the
corresponding exchange rate published by Reserve Bank for EUR-INR, GBPINR and JPY-INR on
the last trading day.
Membership
BK. The membership of the currency futures market of a recognised stock exchange shall be
separate from the membership of the equity derivative segment or the cash segment. Membership
for both trading and clearing, in the currency futures market shall be subject to the guidelines
issued by the SEBI.
BL. Banks authorized by the Reserve Bank under section 10 of the Foreign Exchange
Management Act, 1999 as ‘AD Category - I bank’ are permitted to become trading and clearing
members of the currency futures market of the recognized stock exchanges, on their own account
and on behalf of their clients, subject to fulfilling the minimum prudential requirements.
23
Page 193
m) AD Category - I banks which do not meet the above minimum prudential requirements and AD
Category - I banks which are Urban Co-operative banks or State Co-operative banks can
participate in the currency futures market only as clients, subject to approval therefore from the
respective regulatory Departments of the Reserve Bank.
Position limits
i. The position limits for various classes of participants in the currency futures market shall be
subject to the guidelines issued by the SEBI.
p) The AD Category - I banks, shall operate within prudential limits, such as Net Open Position
(NOP) and Aggregate Gap (AG) limits.
Risk Management measures

The trading of currency futures shall be subject to maintaining initial, extreme loss and calendar
spread margins and the Clearing Corporations / Clearing Houses of the exchanges should ensure
maintenance of such margins by the participants on the basis of the guidelines issued by the SEBI
from time to time.
Surveillance and disclosures

The surveillance and disclosures of transactions in the currency futures market shall be carried out
in accordance with the guidelines issued by the SEBI.
Authorisation to Currency Futures Exchanges / Clearing Corporations

Recognized stock exchanges and their respective Clearing Corporations / Clearing Houses shall
not deal in or otherwise undertake the business relating to currency futures unless they hold an
authorization issued by the Reserve Bank under section 10(1) of the Foreign Exchange
Management Act, 1999.
5. Currency Options on recognised Stock /New Exchanges
In order to expand the existing menu of exchange traded hedging tools available to the residents
and non-residents, plain vanilla currency options contracts have been permitted to be traded in
recognized stock exchanges or new exchanges, recognized by the Securities and Exchange Board
of India (SEBI) in the country. Exchange traded Currency options are subject to following conditions:
24
Page 194
Permission
10. Currency option contracts8are permitted in USD-INR spot rate, EUR-INR spot rate GBP-INR
spot rate and JPY-INR spot rate. Cross currency option contracts (not involving the Indian Rupee)
are permitted in EUR-USD spot rate, GBP-USD spot rate and the USD-JPY spot rate.
11. ‘Persons resident in India’ may purchase or sell exchange traded currency options contracts
subject to the terms and conditions laid down in paragraph 6 below.
12. Foreign Portfolio Investors (FPIs) are permitted to enter into exchange traded currency options
contracts subject to the terms and conditions laid down in Part A, Section II, paragraph no. 2.
Features of exchange traded currency options

Standardized exchange traded currency options shall have the following features:
• The underlying for the currency option shall be the spot rate of the corresponding
permitted currency pair.
• The options shall be premium styled European call and put options.
• The size of the USD-INR and USD-JPY contracts shall be USD 1000, of EUR-INR and
EUR-USD contracts shall be EUR 1000, of GBP-INR and GBPUSD contracts shall be
GBP 1000 and JPY-INR contract shall be JPY 100,000.
• The premium for all contracts involving the Indian Rupee shall be quoted in Indian
Rupees. The premium for EUR-USD and GBP-USD contracts shall be quoted in USD
and for USD-JPY contract shall be quoted in JPY. For cross currency contracts the
premium shall be payable in Indian Rupees based on the USD-INR Reference Rate or
the corresponding exchange rates published by Reserve Bank. The outstanding position
shall be in USD for USD-INR and USD-JPY contracts, in Euro for EUR-INR and EUR-
USD contracts and in GBP for GBP-INR and GBP-USD contracts.
• The maturity of the contracts shall not exceed twelve months.
• The contracts shall be settled in cash in Indian Rupees.
• The settlement price for USD-INR option contract shall be the Reserve
Bank’s Reference Rate and for Euro-INR, GBP-INR and JPY-INR
6. A.P. (DIR Series) No. 35 dated December 10, 2015containingAmendment Directions

issuedunder RBI Act, 1934 for introduction of cross-currency futures and options and exchange
traded options in EUR-INR, GBP-INR and JPY-INR currency pairs.
25
Page 195
contracts shall be the exchange rates published by the Reserve Bank in its press release
on the expiry date of the contract. The settlement price in Indian Rupees of the cross-
currency contracts shall be computed using the Reserve Bank’s USD-INR Reference
Rate and the corresponding exchange rate published by Reserve Bank for EUR-INR,
GBP-INR and JPYINR on the expiry date of the contract.
Membership
7. Members registered with the SEBI for trading in currency futures market shall be eligible to trade
in the exchange traded currency options market of a recognised stock exchange. Membership for
both trading and clearing, in the exchange traded currency options market shall be subject to the
guidelines issued by the SEBI.
8. Banks authorized by the Reserve Bank under section 10 of the Foreign Exchange Management
Act, 1999 as ‘AD Category - I bank’ are permitted to become trading and clearing members of the
exchange traded currency options market of the recognized stock exchanges, on their own account
and on behalf of their clients, subject to fulfilling the following minimum prudential requirements:
Minimum net worth of Rs. 500 crores.
Minimum CRAR of 10 per cent.
Net NPA should not exceed 3 per cent.
Made net profit for last 3 years.
The AD Category - I banks, which fulfil the prudential requirements, should lay down detailed
guidelines with the approval of their Boards for trading and clearing of the exchange traded
currency options contracts and management of risks.
iv) AD Category - I banks, which do not meet the above minimum prudential requirements and AD
Category - I banks, which are Urban Co-operative banks or State Co-operative banks, can
participate in the exchange traded currency options market only as clients, subject to approval
therefor from the respective regulatory Departments of the Reserve Bank.
Position limits
xi) The position limits for various classes of participants for the currency options shall be subject to
the guidelines issued by the SEBI.
xii) The AD Category - I banks shall operate within prudential limits, such as Net Open Position
(NOP) and Aggregate Gap (AG) limits.
26
Page 196
Risk Management measures
The trading of exchange traded currency options shall be subject to maintaining initial, extreme loss
and calendar spread margins and the Clearing Corporations / Clearing Houses of the exchanges
should ensure maintenance of such margins by the participants on the basis of the guidelines
issued by the SEBI from time to time.
Surveillance and disclosures

The surveillance and disclosures of transactions, in the exchange traded currency options market,
shall be carried out in accordance with the guidelines issued by the SEBI.
Authorisation to the Exchanges / the Clearing Corporations for dealing in Currency Options
Recognized stock exchanges and their respective Clearing Corporations / Clearing Houses shall
not deal in or otherwise undertake the business relating to the exchange traded currency options
unless they hold an authorisation issued by the Reserve Bank under section 10 (1) of the Foreign
Exchange Management Act, 1999.
v. Terms and conditions for residents participating in the Exchange Traded Currency
Derivatives (ETCD)
Persons resident in India may take positions (long or short), without having to establish
existence of underlying exposure, upto a single limit of USD 100 million equivalent
across all currency pairs involving INR, put together, and combined across all
exchanges.
Residents shall be allowed to take positions in the cross-currency futures and
exchange traded cross-currency option contracts without having to establish underlying
exposure subject to the position limits as prescribed by the exchanges.
Domestic participants who want to take a position in excess of limits mentioned at
paragraph (a) above in the ETCD market will have to establish the existence of an
underlying exposure. The procedure for the same shall be as under:
27
Page 197
(viii) For participants who are exporters or importers of goods and services, the
eligible limit up to which they can take appropriate hedging positions in
ETCDs will be determined as higher of the (I) average of the last three
years’ export or import turnover, or (II) previous year’s export or import
turnover.
(ix) The participants shall furnish, to the trading member of the exchange, a
certificate(s) from their statutory auditors regarding the limit(s) mentioned
above along with an undertaking signed by the Chief Financial Officer
(CFO) to the effect that at all time, the sum total of the outstanding OTC
derivative contracts and the outstanding ETCD contracts shall be
corresponding to the actual exports or imports contracted, as the case may
be.
(x) Based on the above certificate, a trading member can book ETCD
contracts upto fifty per cent of the eligible limit [as at paragraph (i) above]
on behalf of the concerned customer. If a participant wishes to take
position beyond the fifty per cent of the eligible limit in the ETCD, it has to
produce a signed undertaking from the Chief Financial Officer (CFO) or the
senior most functionary responsible for company's finance and accounts
and the Company Secretary (CS) to the effect that the sum total of the
outstanding OTC derivative contracts and outstanding ETCD contracts has
been in correspondence with the eligible limits. In the absence of a CS, the
Chief Executive Officer (CEO) or the Chief Operating Officer (COO) shall
co-sign the undertaking along with the CFO or the senior most functionary
responsible for company's finance and accounts. Based on such an
undertaking, the trading member can book ETCD contracts beyond fifty per
cent of the limit and up to limit mentioned in paragraph (i) above.
(xi) For all other participants having an underlying foreign currency exposure in
respect of both current and capital account transactions as also exporters
and importers who wish to access the ETCD market on the basis of
contracted exposure, they will have to undertake the transaction through
AD
28
Page 198
Category-I bank/s who are operating as trading members. In such cases,
the responsibility for verification of the underlying exposures and ensuring
that the ETCD bought/sold is in conformity with the underlying exposure
and that no OTC contract has been booked against the same underlying
exposure shall rest with the concerned (AD Category I bank) trading
member.
All participants in the ETCD market, except those covered by paragraph (iv)
above, will be required to submit to the concerned trading member of the
exchange a half-yearly signed undertaking from the Chief Financial Officer
(CFO) or the senior most functionary responsible for company's finance
and accounts and the Company Secretary (CS) to the effect that the sum
total of the outstanding OTC derivative contracts and outstanding ETCD
contracts has been in correspondence with the eligible limits. In the
absence of a CS, the Chief Executive Officer (CEO) or the Chief Operating
Officer (COO) shall co-sign the undertaking along with the CFO or the
senior most functionary responsible for company's finance and accounts.
• The onus of complying with the provisions of this circular rests with the participant in
the ETCD market and in case of any contravention the participant shall be liable to any
action that may be warranted as per the provisions of Foreign Exchange Management
Act, 1999 and the regulations, directions, etc. issued thereunder. The position limits
shall also be monitored by the exchanges, and breaches, if any, may be reported to the
Financial Markets Regulation Department, Reserve Bank of India.
29
Page 199
7. Commodity Hedging
Refer Hedging of Commodity Price Risk and Freight Risk in Overseas Markets (Reserve Bank)
Directions (RBI/2017-18/138 A.P. (DIR Series) Circular No. 19dated March 12, 2018).
8. Freight hedging
Refer Hedging of Commodity Price Risk and Freight Risk in Overseas Markets (Reserve Bank)
Directions (RBI/2017-18/138 A.P. (DIR Series) Circular No. 19dated March 12, 2018).
SECTION II
Facilities for Persons Resident outside India
Participants
Market-makers – AD Category I banks.
Users – Foreign Portfolio Investors(FPIs), Investors having Foreign Direct
Investments (FDI), Non Resident Indians (NRIs), Non Resident exporters and importers,
Non Residents lenders having ECBs designated in INR.
The purpose, products and operational guidelines of each of the users is detailed below:
• Facilities for Foreign Portfolio Investors (FPIs) Purpose

To hedge currency risk on the market value of entire investment in equity and/or debt in
India as on a particular date.
To hedge the coupon receipts arising out of investments in debt securities falling due
during the following twelve months.
To hedge Initial Public Offers (IPO) related transient capital flows under the Application
Supported by Blocked Amount (ASBA) mechanism.
Products
Forward foreign exchange contracts with rupee as one of the currencies and foreign currency-INR
options. Foreign Currency – INR swaps for IPO related flows.

h) FPIs may approach any AD Category I bank for hedging their currency risk on the
market value of entire investment in equity and/or debt in India as on a particular date
subject to the following conditions:
30
Page 200
i. The eligibility for cover may be determined on the basis of a valuation certificate
provided by the designated AD category bank along with a declaration by the FPI
to the effect that its global outstanding hedges plus the derivatives contracts
cancelled across all AD category banks is within the market value of its
investments.
The FPI should also provide a quarterly declaration to the custodian bank that
the total amount of derivatives contract booked across AD Category banks are
within the market value of its investments.
The hedges taken with AD banks other than designated AD banks have to be
settled through the Special Non-Resident Rupee A/c maintained with the
designated bank through RTGS/NEFT.
If an FPI wishes to enter into a hedge contract for the exposure relating to that
part of the securities held by it against which it has issued any PN/ODI, it must
have a mandate from the PN/ODI holder for the purpose. Further, while AD
Category bank is expected to verify such mandates, in cases where this is
rendered difficult, they may obtain a declaration from the FPI regarding the
nature/structure of the PN/ODI establishing the need for a hedge operation and
that such operations are being undertaken against specific mandates obtained
from their clients.
iv) AD Category I banks may undertake periodic reviews, at least at quarterly intervals, on the
basis of market price movements, fresh inflows, amounts repatriated and other relevant
parameters to ensure that the forward cover outstanding is supported by underlying
exposures. In this context, it is clarified that in case an FPI intends to hedge the exposure
of one of its sub-account holders, (cf paragraph 4 of schedule 2 to Notification No. FEMA
20/2000-RB dated 3rd May 2000)it will be required to produce a clearmandate from the
sub-account holder in respect of the latter’s intention to enter into the derivative transaction.
Further, the AD Category I banks shall have to verify the mandate as well as the eligibility
of the contract vis-a-vis the market value of the securities held in the concerned sub-
account.
v) If a hedge becomes naked in part or in full owing to contraction of the market value of the
portfolio, for reasons other than sale of securities, the hedge may be allowed to continue till
the original maturity, if so desired.
vi) Forward contracts booked by FPIs, once cancelled, can be rebooked up to
31
Page 201
the extent of 10 per cent of the value of the contracts cancelled. The forward contracts
booked may, however, be rolled over on or before maturity.
Forward contracts booked for hedging coupon receipts as indicated in para.

(1)(ii) above shall not be eligible for rebooking on cancellation. They may however be rolled
over on maturity provided the relative coupon amount is yet to be received.
The cost of hedge should be met out of repatriable funds and /or inward remittance through
normal banking channel.
All outward remittances incidental to the hedge are net of applicable taxes.
For IPO related transient capital flows
FPIs can undertake foreign currency- rupee swaps only for hedging the flows
relating to the IPO under the ASBA mechanism.
The amount of the swap should not exceed the amount proposed to be invested in
the IPO.
The tenor of the swap should not exceed 30 days.
The contracts, once cancelled, cannot be rebooked. Rollovers under this scheme
will also not be permitted.
FPIs and other foreign investor are free to remit funds through any bank of its choice for
any transaction permitted under FEMA, 1999 or the Regulations / Directions framed
thereunder. The funds thus remitted can be transferred to the designated AD Category -I
custodian bank through the banking channel. Note should, however, be taken that KYC in
respect of the remitter, wherever required, is a joint responsibility of the bank that has
received the remittance as well as the bank that ultimately receives the proceeds of the
remittance. While the first bank will be privy to the details of the remitter and the purpose of
the remittance, the second bank, will have access to complete information from the
recipient's perspective. Besides, the remittance receiving bank is required to issue FIRC to
the bank receiving the proceeds to establish the fact the funds had been remitted in foreign
currency.
4. Terms and conditions for Foreign Portfolio Investors participating in the Exchange
Traded Currency Derivatives (ETCD) [Refer Part A, sub-paragraphs
(4) & (5)]
Foreign portfolio investors (FPIs) eligible to invest in securities as laid down in
32
Page 202
Schedules 2, 5, 7 and 8 of the Foreign Exchange Management (Transfer or Issue of Security by a
person resident outside India) Regulations, 2000 (FEMA 20/2000-RB dated May 3, 2000(GSR406
(E) dated May 3, 2000)) as amended from timeto time may enter into currency futures or exchange
traded currency options contracts subject to the following terms and conditions:
a. FPIs will be allowed access to the currency futures or exchange traded currency options
for the purpose of hedging the currency risk arising out of the market value of their
exposure to Indian debt and equity securities.
b. Such investors can participate in the currency futures / exchange traded options market
through any registered / recognised trading member of the exchange concerned.
c. FPIs may take positions (long or short), without having to establish existence of
underlying exposure, upto a single limit of USD 100 million equivalent across all currency
pairs involving INR, put together, and combined across all exchanges.
d. FPIs, are allowed to take positions in the cross-currency futures and exchange traded
cross-currency option contracts without having to establish underlying exposure subject to
the position limits as prescribed by the exchanges.
e. An FPI cannot take a short position beyond USD 100 million equivalent across all
currency pairs involving INR, put together, and combined across all exchanges. In order to
take a long position in excess of these limits, it will be required to have an underlying
exposure. The onus of ensuring the existence of an underlying exposure shall rest with the
FPI concerned.
f. The exchange will, however, be free to impose additional restrictions as prescribed by the
Securities and Exchange Board of India (SEBI) for the purpose of risk management and
fair trading.
g. The exchange/ clearing corporation will provide FPI wise information on day-end open
position as well as intra-day highest position to the respective custodian banks. The
custodian banks will aggregate the position of each FPI on the exchanges as well as the
OTC contracts booked with them (i.e. the custodian banks) and other AD banks. If the total
value of the contracts exceeds the market value of the holdings on any day, the concerned
FPI shall be liable to such penal action as may be laid down by the SEBI in this regard and
action as may be taken by Reserve Bank of India under the Foreign Exchange
Management Act (FEMA), 1999. The designated
33
Page 203
custodian bank will be required to monitor this and bring transgressions, if any, to the
notice of RBI / SEBI.
h. The onus of complying with the provisions of this circular rests with the participant in the
ETCD market and in case of any contravention the participant shall be liable to any action
that may be warranted as per the provisions of Foreign Exchange Management Act, 1999
and the regulations, directions, etc. issued thereunder. The position limits shall also be
monitored by the exchanges, and breaches, if any, may be reported to the Financial
Markets Regulation Department, Reserve Bank of India.
3. Facilities for Non-resident Indians (NRIs)
Purpose
v) To hedge the exchange rate risk on the market value of investment made under the
portfolio scheme in accordance with provisions of FERA, 1973 or under notifications issued
there under or in accordance with provisions of FEMA, 1999. For access to ETCD market,
see para. 4 below.
vi) To hedge the exchange rate risk on the amount of dividend due on shares held in Indian
companies.
vii) To hedge the exchange rate risk on the amounts held in FCNR (B) deposits.
viii) To hedge the exchange rate risk on balances held in NRE account.
Products
ix) Forward foreign exchange contracts with rupee as one of the currencies, and foreign currency-
INR options.
x) Additionally, for balances in FCNR (B) accounts – Cross currency (not involving the rupee)
forward contracts to convert the balances in one foreign currency to other foreign currencies in
which FCNR (B) deposits are permitted to be maintained.
(c) Terms9and conditions for Non-Resident Indians (NRIs) participating in the Exchange
Traded Currency Derivatives (ETCD)
i. NRIs shall designate an AD Cat-I bank for the purpose of monitoring and reporting their combined
positions in the OTC and ETCD segments.
(l) A.P. (DIR Series) Circular No. 30 dated February 2, 2017

34
Page 204
(an)NRIs may take positions in the currency futures / exchange traded options market to hedge the
currency risk on the market value of their permissible (under FEMA, 1999) Rupee investments in
debt and equity and dividend due and balances held in NRE accounts.
(ao)The exchange/ clearing corporation will provide details of all transactions of the NRI to the
designated bank.
(ap)The designated bank will consolidate the positions of the NRI on the exchanges as well as the
OTC derivative contracts booked with them and with other AD banks. The designated bank shall
monitor the aggregate positions and ensure the existence of underlying Rupee currency risk and
bring transgressions, if any, to the notice of RBI / SEBI.
(aq)The onus of ensuring the existence of the underlying exposure shall rest with the NRI
concerned. If the magnitude of exposure through the hedge transactions exceeds the magnitude of
underlying exposure, the concerned NRI shall be liable to such penal action as may be taken by
Reserve Bank of India under the Foreign Exchange Management Act (FEMA), 1999.
5. Facilities for Hedging Foreign Direct Investment in India Purpose
(bk)To hedge exchange rate risk on the market value of investments made in India since
January 1, 1993, subject to verification of the exposure in India
(bl) To hedge exchange rate risk on dividend receivable on the investments in Indian
companies
(bm) To hedge exchange rate risk on proposed investment in India
Products
Forward foreign exchange contracts with rupee as one of the currencies and foreign currency-INR
options.

(v) In respect of contracts to hedge exchange rate risk on the market value of investments
made in India, contracts once cancelled are not eligible to be rebooked. The contracts may,
however, be rolled over.
(vi) In respect of proposed foreign direct investments, following conditions would apply:
Contracts to hedge exchange rate risk arising out of proposed
35
Page 205
investment in Indian companies may be allowed to be booked only after ensuring that
the overseas entities have completed all the necessary formalities and obtained
necessary approvals (wherever applicable) for the investment.
8. The tenor of the contracts should not exceed six months at a time beyond which
permission of the Reserve Bank would be required to continue with the contract.
9. These contracts, if cancelled, shall not be eligible to be rebooked for the same inflows.
10. Exchange gains, if any, on cancellation shall not be passed on to the overseas investor.
6. Facilities for Hedging Trade Exposures, invoiced in Indian Rupees in India Purpose
To hedge the currency risk arising out of genuine trade transactions involving exports from and
imports to India, invoiced in Indian Rupees, with AD Category I banks in India.
Products
Forward foreign exchange contracts with rupee as one of the currencies, foreign currency-INR
options.

The AD Category I banks can opt for either Model I or Model II as given below:
Model I
Non-resident exporter / importer or its central treasury (of the group and being a group
entity)10dealing through their overseas bank (including overseas branches of AD banks in India)
5. Non-resident exporter / importer, or its central treasury approaches his banker overseas
with appropriate documents with a request for hedging their Rupee exposure arising out of
a confirmed import or export order invoiced in Rupees.
6. The overseas bank in turn approaches its correspondent in India (i.e. the AD bank in India)
for a price to hedge the exposure of its customer along
3.A. P. (DIR Series) Circular No. 8 dated October 12, 2017.

36
Page 206
with documentation furnished by the customer that will enable the AD bank in India to
satisfy itself that there is an underlying trade transaction (scanned copies would be
acceptable). The following undertakings also need to be taken from the customer:
That the same underlying exposure has not been hedged with any other AD
Category I bank/s in India
If the underlying exposure is cancelled, the customer will cancel the hedge contract
immediately
In case of a central treasury, an authorization from the entity having INR exposure
to hedge on its behalf
iii. A certification on the end client KYC may also be taken as a one-time document from the
overseas bank by the AD bank in India.
iv. The AD bank in India based on documents received from the overseas correspondent
should satisfy itself about the existence of the underlying trade transaction and offer a
forward price (no two-way quotes should be given) to the overseas bank who, in turn, will
offer the same to its customer. The AD bank, therefore, will ‘not be’ dealing directly with the
overseas importer / exporter.
v. The amount and tenor of the hedge should not exceed that of the underlying transaction
and should be in consonance with the extant regulations regarding tenor of payment /
realization of the proceeds.
vi. On due date, settlement is to be done through the correspondent bank’s Vostro or the AD
bank’s Nostro accounts.
vii. The contracts, once cancelled, cannot be rebooked.
viii. The contracts may, however, be rolled over on or before maturity subject to maturity of the
underlying exposure.
ix. On cancellation of the contracts, gains may be passed on to the customer subject to the
customer providing a declaration that he is not going to rebook the contract or that the
contract has been cancelled on account of cancellation of the underlying exposure.
x. In case the underlying trade transaction is extended, rollover can be permitted once based
on the extension of the underlying trade transaction for which suitable documentation is to
be provided by the overseas bank and the same procedure followed as in case of the
original contract.
Model II
37
Page 207
Non-resident exporter / importer or its central treasury (of the group and being a group
entity)11dealing directly with the AD bank in India
i. The overseas exporter / importer or its central treasury approaches the AD bank in India
with a request for forward cover in respect of underlying transaction for which he furnishes
appropriate documentation (scanned copies would be acceptable), on a pre-deal basis to
enable the AD bank in India to satisfy itself that there is an underlying trade transaction,
and details of his overseas banker, address etc. The following undertakings also need to
be taken from the customer
a. That the same underlying exposure has not been hedged with any other AD
Category I bank/s in India.
b. If the underlying exposure is cancelled, the customer will cancel the hedge contract
immediately.
c. In case of a central treasury, an authorization from the entity having INR exposure
to hedge on its behalf
ii. The AD bank may obtain certification of KYC/AML in the format in Annex XVIII. The format
can be obtained through the overseas correspondent / bank through SWIFT authenticated
message. In case the AD bank has a presence outside India, the AD may take care of the
KYC/AML through its bank’s offshore branch.
iii. AD banks should evolve appropriate arrangements to mitigate credit risk. Credit limits can
be granted based on the credit analysis done by self / the overseas branch.
iv. The amount and tenor of the hedge should not exceed that of the underlying transaction
v. On due date, settlement is to be done through the correspondent bank’s Vostro or the AD
bank’s Nostro accounts. AD banks in India may release funds to the beneficiaries only after
sighting funds in Nostro / Vostro accounts.
vi. The contracts, once cancelled, cannot be rebooked.
vii. The contracts may, however, be rolled over on or before maturity subject to maturity of the
11 A. P. (DIR Series) Circular No. 8 dated October 12, 2017.

38
Page 208
viii. On cancellation of the contracts, gains may be passed on to the customer subject to the
ix. In case the underlying trade transaction is extended, rollover can be permitted once based
on the extension of the underlying trade transaction for which suitable documentation is to
be provided by the overseas bank and the same procedure followed as in case of the
original contract.
x. AD banks shall report hedge contracts booked under this facility to CCIL’s trade repository
with a special identification tag12.
7. Facilities for Hedging of ECBs, designated in Indian Rupees, in India
I) Purpose: To hedge the currency risk arising out of ECBs designated in INReither directly with
AD Category- I banks in India or through their overseas banks on a back to back basis as per
operational guidelines, terms and conditions given under (II) below
Products
Forward foreign exchange contracts with rupee as one of the currencies, foreign currency-INR
options and foreign currency-INR swaps.

i. The foreign equity holder / overseas organisation or individual approaches the AD bank in
India with a request for forward cover in respect of underlying transaction for which he
needs to furnish appropriate documentation (scanned copies would be acceptable), on a
pre-deal basis to enable the AD bank in India to satisfy itself that there is an underlying
ECB transaction, and details of his overseas banker, address, etc. The following
undertakings also need to be taken from the customer –
a. That the same underlying exposure has not been hedged with any other AD
Category- I bank/s in India.
b. If the underlying exposure is cancelled, the customer will cancel the hedge contract
immediately.
12 A. P. (DIR Series) Circular No. 8 dated October 12, 2017.

39
Page 209
ii. The amount and tenor of the hedge should not exceed that of the underlying transaction
iii. On due date, settlement is to be done through the correspondent bank’s Vostro or the AD
bank’s Nostro accounts. AD banks in India may release funds to the beneficiaries only after
sighting funds in Nostro / Vostro accounts.
iv. The contracts, once cancelled, cannot be rebooked.
v. The contracts may, however, be rolled over on or before maturity subject to maturity of the
vi. On cancellation of the contracts, gains may be passed on to the customer subject to the
AI) Purpose: To hedge the currency risk arising out of ECBs designated in INR
extended by recognised non-resident lenders13with AD Category- I banks in India through their
overseas banks on a back to back basis.
Products: Foreign currency-INR swaps

(i) The recognised non-resident lender approaches his overseas bank with appropriate
documentation as evidence of an underlying ECB denominated in INR with a request for
a swap rate for mobilising INR for onward lending to the Indian borrower.
(ii) The overseas bank, in turn, approaches an AD Cat-I bank for a swap rate along with
documentation furnished by the customer that will enable the AD bank in India to satisfy
itself that there is an underlying ECB in INR (scanned copies would be acceptable). The
following undertakings also need to be taken from the customer –
a) That the same underlying exposure has not been hedged with any other AD
Category- I bank/s in India.
13In terms of A.P. (DIR Series) Circular No. 25 dated September 3, 2014and A.P. (DIR
Series)Circular No. 103 dated May 21, 2015
40
Page 210
b) If the underlying exposure is cancelled, the customer will cancel the hedge contract
immediately.
(iii) A KYC certification on the end client shall also be taken by the AD bank in India as a one-time
document from the overseas bank.
(iv) Based on the documents received from the overseas bank, the AD bank in India should satisfy
itself about the existence of the underlying ECB in INR and offer an indicative swap rate to the
overseas bank which, in turn, will offer the same to the non-resident lender on a back-to-back basis.
(v) The continuation of the swap shall be subject to the existence of the underlying ECB at all
times.
(vi) On the due date, settlement may be done through the Vostro account of the overseas bank
maintained with its correspondent bank in India.
(vii) The concerned AD Cat-I bank shall keep on record all related documentation for verification
by Reserve Bank.
8. Facility for hedging exposures of Indian subsidiaries 14

Users
Non-resident parent of an Indian subsidiary or its centralised treasury or its regional treasury
outside India.
Products
All FCY-INR derivatives, OTC as well exchange traded that the Indian subsidiary is eligible to
undertake as per FEMA, 1999 and Regulations and Directions issued thereunder.

(i) The transactions under this facility will be covered under a tri-partite agreement involving
the Indian subsidiary, its non-resident parent / treasury and the AD bank. This agreement
will include the exact relationship of the Indian subsidiary or entity with its overseas related
entity, relative roles and responsibilities of the parties and the procedure for the
transactions, including settlement. The ISDA agreement between the AD bank and the
non-resident entity will be distinct from this agreement.
14 Refer A.P. (DIR Series) Circular No. 41 dated March 21, 2017
41
Page 211
(ii) The non-resident entity should be incorporated in a country that is member of the Financial
Action Task Force (FATF) or member of a FATF-Style Regional body.
(iii) The AD Bank may obtain KYC/ AML certification on the lines of the format in Annex XVIII of
the Master Direction on Risk Management and Inter Bank Dealings, as amended from time
to time.
(iv) The non-resident entity may approach an AD Cat-I bank directly which handles the foreign
exchange transactions of its subsidiary for booking derivative contracts to hedge the
currency risk of and on the latter’s behalf.
(v) The non-resident entity may contract any product either under the contracted route or on
past performance basis, which the Indian subsidiary is eligible to use.
(vi) The Indian subsidiary shall be responsible for compliance with the rules, regulations and
directions issued under FEMA 1999 and any other laws/rules/regulations applicable to
these transactions in India.
(vii) The profit/ loss of the hedge transactions shall be settled in the bank account and books of
accounts of the Indian subsidiary. The AD bank shall obtain from the Indian subsidiary an
annual certificate by its Statutory Auditors to this effect.
(viii) The concerned AD Bank shall be responsible for monitoring all hedge transactions (OTC
as well as exchange traded) booked by the non-resident entity and ensuring that the Indian
subsidiary has the necessary underlying exposure for the hedge transactions.
(ix) AD banks shall report hedge contracts booked under this facility by the non-resident related
entity to CCIL’s trade repository with a special identification tag.
9. Simplified Hedging Facility
Users: Resident and non-resident entities, other than individuals.
Purpose: To hedge exchange rate risk on transactions, contracted or anticipated,permissible under

Foreign Exchange Management Act (FEMA), 199915.
15
Rupee denominated bonds issued overseas may be hedged provided it is permitted under
contracted exposure hedging.
42
Page 212
Products: Any Over the Counter (OTC) derivative or Exchange Traded CurrencyDerivative (ETCD)
permitted under FEMA, 1999.
Cap on Outstanding Contracts: USD 30 million, or its equivalent, on a grossbasis.
Designated Bank: Any Authorised Dealer Category-I (AD Cat-I) bank designatedas such by the
user.

i. The user shall appoint an AD Cat-I bank as its “Designated Bank”. The designated bank
will assess the hedging requirement of the user and set a limit up to the stipulated cap on
the outstanding contracts.
ii. If hedging requirement of the user exceeds the limit in course of time, the designated bank
may re-assess and, at its discretion, extend the limit up to 150% of the stipulated cap.
iii. Hedge contracts in OTC market can be booked with any AD Cat-I bank, provided the
underlying cash flow takes place with the same bank.
iv. Cost reduction structures can be booked by users provided that resident unlisted
companies can use such structures only if they have a minimum net worth of Rs.200 crores
v. Users are not required to furnish any documentary evidence for establishing underlying
exposure under this facility. Users may, however, provide basic
details of the underlying transaction in a standardised format16, only in the case of OTC
hedge contracts.
vi. Cancelled contracts may be freely rebooked with the same bank.
vii. In case of hedge contracts booked in OTC market, while losses will be recovered from the
user, net gains i.e. gains in excess of cumulative losses, if any, will be transferred at the
time of delivery of the underlying cash flow. In case of part delivery, net gains will be
transferred on a pro-rata basis.
16
Standardized format will be devised by Foreign Exchange Dealers Association of India (FEDAI)
and will include details like transaction type, i.e. current account (import, export) or capital account
(ECB, FPI, FDI etc.), amount, currency and tenor.
43
Page 213
viii. For hedge contracts on underlying capital account transactions, gains/losses may be
transferred to the user as and when they accrue if the underlying asset/liability is already in
existence.
ix. On full utilisation of the limit or in case of breach of limit, user shall not book new contracts
under this facility. In such a case, contracts booked earlier under this facility will be allowed
to continue till they expire or are closed. Any further hedging requirements thereafter may
be booked under other available hedging facilities.
x. Users booking contracts under this facility shall not book contracts under any other facility
in OTC or ETCD market except as provided in para (ix).
xi. At the end of each financial year, the user will provide the designated bank with a
statement signed by the head of finance or the head of the entity, to the effect that,
a. Hedge contracts booked in both OTC and ETCD market, under this facility, are
backed by underlying exchange rate exposures, either contracted or anticipated.
b. The exposures underlying the hedge contracts booked under this facility are not
hedged under any other facility.
xii. On being appointed, the designated bank shall report the details of the users and limits
granted to the Trade Repository (TR). On a request by the TR, the exchanges shall report
all contracts booked by such users to the TR on a daily basis.
xiii. The TR will compute user wise outstanding position (across OTC and ETCD market) and
provide this information to the designated bank for monitoring. If the outstanding contracts
of a user exceeds the limit (or the extended limit, if applicable) the designated bank shall
advise the user to stop booking new contracts under this facility.
xiv. When user migrates to other available facilities, the designated bank shall report this
information to the TR. The TR shall update this information in its records and notify the
recognized stock exchanges to stop reporting data for the user concerned.
xv. Banks shall have an internal policy regarding the time limit up to which a hedge contract for
a given underlying can be rolled-over or rebooked by the user.
44
Page 214
10. Operational Guidelines, Terms and Conditions applicable to all non-residents (except
non-residents hedging exposures of Indian subsidiaries at para. 8 above and those hedging
under Simplified Hedging Facility)
The operational guidelines as outlined for FPIs would be applicable, with the exception of the
provision relating to rebooking of cancelled contracts. All foreign exchange derivative contracts
permissible for a resident outside India other than a FPI, once cancelled, are not eligible to be
rebooked.
45
Page 215
SECTION III
Facilities for Authorised Dealers Category-I
1. Management of Banks’ Assets-Liabilities Users
– AD Category I banks
Purpose - Hedging of interest rate and currency risks of foreign exchange asset-liability portfolio
Products - Interest Rate Swap, Interest Rate Cap/Collar, Currency Swap, ForwardRate Agreement.
AD banks may also purchase call or put options to hedge their cross currency proprietary trading
positions.

The use of these instruments is subject to the following conditions:
a) An appropriate policy in this regard is approved by the Top Management.
b) The value and maturity of the hedge should not exceed those of the underlying.
c) No ‘stand alone’ transactions can be initiated. If a hedge becomes naked, in part or full,
owing to the contraction of the value of portfolio, it may be allowed to continue till the
original maturity and should be marked to market at regular intervals.
d) The net cash flows arising out of these transactions are booked as income/ expenditure
and reckoned toward foreign exchange position, wherever applicable.
2. Hedging of Gold Prices
Users –
i. Banks authorised by the Reserve Bank to operate the Gold Deposit Scheme
ii. Banks, which are allowed to enter into forward gold contracts in India in terms of the
guidelines issued by the Department of Banking Regulation (including the positions arising
out of inter-bank gold deals)
Purpose – To hedge price risk of gold
46
Page 216
Products - Exchange-traded and over-the-counter hedging products availableoverseas.

a) While using products involving options, it may be ensured that there is no net receipt of
premium, either direct or implied.
b) Authorised banks are permitted to enter into forward contracts with their constituents
(exporters of gold products, jewellery manufacturers, trading houses, etc.) in respect of the
underlying sale, purchase and loan transactions in gold with them, subject to the conditions
specified by the Reserve Bank in this regard. The tenor of such contracts should not exceed
six months.
3. Hedging of Capital
Users – Foreign banks operating in India
Product – Forward foreign exchange contracts

a) Tier I capital -
i) The capital funds should be available in India to meet local regulatory and CRAR
requirements and, hence, these should not be parked in nostro accounts. Foreign currency
funds accruing out of hedging should not be parked in Nostro accounts but should remain
swapped with banks in India at all times.
ii) The forward contracts should be for tenors of one or more years and may be rolled over on
maturity. Rebooking of cancelled hedges will require prior approval of the Reserve Bank.
b) Tier II capital -
i) Foreign banks are permitted to hedge their Tier II capital in the form of Head Office
borrowing as subordinated debt, by keeping it swapped into rupees at all times in terms of
DBOD circular No.IBS.BC.65/23.10.015/2001-02 dated February 14, 2002.
ii) Banks are not permitted to enter into foreign currency-INR swap transactions involving
conversion of fixed rate rupee liabilities in respect of
47
Page 217
Innovative Tier I/Tier II bonds into floating rate foreign currency liabilities.
4. Participation in the currency futures market in India
Please refer to Part-A Section I, paragraph 4. In continuation of the same:
a) AD Category I Banks may be guided by the DBOD instructions vide DBOD.No.FSD.BC.

29/24.01.001/2008-09 dated August 6, 2008.
b) AD Category I Banks are permitted to become trading and clearing members of the
currency futures market of recognised stock exchanges, on their own account and on
behalf of their clients, subject to fulfilling the following minimum prudential requirements:
i) Minimum net worth of Rs. 500 crores.
ii) Minimum CRAR of 10 per cent.
iii) Net NPA should not exceed 3 per cent.
iv) Net profit for last 3 years.
The AD Category - I banks which fulfill the prudential requirements should lay down detailed
guidelines with the approval of their Boards for trading and clearing of currency futures contracts
and management of risks.
(c). AD Category - I banks which do not meet the above minimum prudential requirements and AD
Category - I banks which are Urban Co-operative banks or State Co-operative banks can
participate in the currency futures market only as clients, subject to approval and directions from
the respective regulatory Departments of the Reserve Bank.
(d) The AD Category - I banks, shall operate within prudential limits, such as Net Open Position
(NOP) and Aggregate Gap (AG) limits. The exposure of the banks, on their own account, in the
currency futures market shall form part of their NOP and AG limits.
5. Participation in the exchange traded currency options market in India
Please refer to Part-A Section I, paragraph 5. In continuation of the same:
48
Page 218
a) AD Category - I banks are permitted to become trading and clearing members of the exchange
traded currency options market of the recognized stock exchanges, on their own account and on
behalf of their clients, subject to fulfilling the following minimum prudential requirements:
i. Minimum net worth of Rs. 500 crores.
ii. Minimum CRAR of 10 per cent.
iii. Net NPA should not exceed 3 per cent.
iv. Made net profit for last 3 years.
The AD Category - I banks, which fulfil the prudential requirements, should lay down detailed
guidelines with the approval of their Boards for trading and clearing of the exchange traded
currency options contracts and management of risks.
b) AD Category - I banks, which do not meet the above minimum prudential requirements and AD
Category - I banks, which are Urban Co-operative banks or State Co-operative banks, can
participate in the exchange traded currency options market only as clients, subject to approval
therefor from the respective regulatory Departments of the Reserve Bank.
c) The AD Category - I banks shall operate within prudential limits, such as Net Open Position
(NOP) and Aggregate Gap (AG) limits. The option position of the banks, on their own account, in
the exchange traded currency options shall form part of their NOP and AG limits.
6. Operational Guidelines, terms and conditions for AD Category-I banks participation in

the ETCD market
(a) AD Category-I banks may undertake trading in all permitted exchange traded currency
derivatives within their Net Open Position Limit (NOPL) subject to limits stipulated by the
exchanges (for the purpose of risk management and preserving market integrity) provided that any
synthetic USD-INR position created using a combination of exchange traded FCY- INR and cross-
currency contracts shall have to be within the position limit prescribed by the exchange for the
USD-INR contract.
49
Page 219
(b) AD Category-I banks may net / offset their positions in the ETCD market against the positions
in the OTC derivatives markets. Keeping in view the volatility in the foreign exchange market,
Reserve Bank may however stipulate a separate sub-limit of the NOPL (as a percentage thereof)
exclusively for the OTC market as and when required.
50
Page 220
PART B
ACCOUNTS OF NON-RESIDENT BANKS
1. General
(i) Credit to the account of a non-resident bank is a permitted method of payment to non-residents
and is, therefore, subject to the regulations applicable to transfers in foreign currency.
(ii) Debit to the account of a non-resident bank is in effect an inward remittance in foreign currency.
2. Rupee Accounts of Non-Resident Banks
AD Category I banks may open/close Rupee accounts (non-interest bearing) in the names of their
overseas branches or correspondents without prior reference to the Reserve Bank. Opening of
Rupee accounts in the names of branches of Pakistani banks operating outside Pakistan requires
specific approval of the Reserve Bank.
3. Funding of Accounts of Non-resident Banks
(i) AD Category I banks may freely purchase foreign currency from their overseas
correspondents/branches at on-going market rates to lay down funds in their accounts for meeting
their bonafide needs in India.
(ii) Transactions in the accounts should be closely monitored to ensure that overseas banks do
not take a speculative view on the Rupee. Any such instances should be notified to the Reserve
Bank.
NOTE: Forward purchase or sale of foreign currencies against Rupees for funding is
prohibited. Offer of two-way quotes in Rupees to non-resident banks is also prohibited.
4. Transfers from other Accounts
Transfer of funds between the accounts of the same bank or different banks is freely permitted.
51
Page 221
5. Conversion of Rupees into Foreign Currencies
Balances held in Rupee accounts of non-resident banks may be freely converted into foreign
currency. All such transactions should be recorded in Form A2 and the corresponding debit to the
account should be in form A3 under the relevant Returns.
6. Responsibilities of Paying and Receiving Banks
In the case of credit to accounts the paying banker should ensure that all regulatory requirements
are met and are correctly furnished in form A1/A2 as the case may be.
7. Refund of Rupee Remittances
Requests for cancellation or refund of inward remittances may be complied with without reference
to Reserve Bank after satisfying themselves that the refunds are not being made in cover of
transactions of compensatory nature.
8. Overdrafts / Loans to Overseas Branches/ Correspondents
(i) AD Category I banks may permit their overseas branches/ correspondents temporary
overdrawals not exceeding Rs.500 lakhs in aggregate, for meeting normal business requirements.
This limit applies to the amount outstanding against all overseas branches and correspondents in
the books of all the branches of the authorised AD Category I bank in India. This facility should not
be used to postpone funding of accounts. If overdrafts in excess of the above limit are not adjusted
within five days a report should be submitted to the Chief General Manager, Financial Markets
Regulation Department, Reserve Bank of India, Central Office, 1st Floor, Main Building, Shahid
Bhagat Singh Road, Fort, Mumbai
– 400 001 within 15 days from the close of the month, stating the reasons thereof. Such a report is
not necessary if arrangements exist for value dating.
(ii) AD Category I bank wishing to extend any other credit facility in excess of (i) above to overseas
banks should seek prior approval from the Chief General Manager, Financial Markets Regulation
Department, Reserve Bank of India, Central Office.
52
Page 222
9. Rupee Accounts of Exchange Houses
Opening of Rupee accounts in the names of Exchange Houses for facilitating private remittances
into India requires approval of the Reserve Bank. Remittances through Exchange Houses for
financing trade transactions are permitted upto Rs.15,00,000 per transaction17.
17 A. P. (DIR Series) Circular No. 102 May 21, 2015

53
Page 223
PART C
INTER-BANK FOREIGN EXCHANGE DEALINGS
1. General
The Board of Directors of AD Category I banks should frame an appropriate policy and fix suitable
limits for various Treasury functions.
2. Position and Gaps
The net overnight open exchange position (Annex-I) and the aggregate gap limits should be
communicated to the Reserve Bank soon after the approval of the Board / Management Committee.
3. Inter-bank Transactions
Subject to compliance with the provisions of paragraphs 1 and 2, AD Category I banks may freely
undertake foreign exchange transactions as under:
a) With AD Category I banks in India:
(i) Buying/Selling/Swapping foreign currency against Rupees or another foreign currency.
(ii) Placing/Accepting deposits and Borrowing/Lending in foreign currency.
b). With banks overseas and Off-shore Banking Units in Special Economic Zones
(i) Buying/Selling/Swapping foreign currency against another foreign currency to cover client
transactions or for adjustment of own position,
(ii) Initiating trading positions in the overseas markets.
NOTE :
A. Funding of accounts of Non-resident banks - please refer to paragraph 3 of Part B.
B. Form A2 need not be completed for sales in the inter-bank market, but all such transactions shall
be reported to Reserve Bank in R Returns.
54
Page 224
4. Foreign Currency Accounts/ Investments in Overseas Markets
(i) Inflows into foreign currency accounts arise primarily from client-related transactions, swap
deals, deposits, borrowings, etc. AD Category I banks may maintain balances in foreign currencies
up to the levels approved by the Board. They are free to manage the surplus in these accounts
through overnight placement and investments with their overseas branches/correspondents subject
to adherence to the gap limits approved by the Reserve Bank.
(ii) AD Category I banks are free to undertake investments in overseas markets up to the limits
approved by their Board. Such investments may be made in overseas money market instruments
and/or debt instruments issued by a foreign state with a residual maturity of less than one year and
rated at least as AA (-) by Standard & Poor / FITCH IBCA or Aa3 by Moody's. For the purpose of
investments in debt instruments other than the money market instruments of any foreign state,
bank's Board may lay down country ratings and country - wise limits separately wherever
necessary.
NOTE: For the purpose of this clause, 'money market instrument' would includeany debt instrument
whose life to maturity does not exceed one year as on the date of purchase.
(iii) AD Category I banks may also invest the un-deployed FCNR (B) funds in overseas markets in
long-term fixed income securities subject to the condition that the maturity of the securities invested
in do not exceed the maturity of the underlying FCNR (B) deposits.
(iv) Foreign currency funds representing surpluses in the nostro accounts may be utilised for:
a) making loans to resident constituents for meeting their foreign exchange requirements or for
the Rupee working capital/capital expenditure needs of exporters/ corporates who have a natural
hedge or a risk management policy for managing the exchange risk subject to the
prudential/interest-rate norms, credit discipline and credit monitoring guidelines in force.
55
Page 225
b) extending credit facilities to Indian wholly owned subsidiaries/ joint ventures abroad in which at
least 51 per cent equity is held by a resident company, subject to the guidelines issued by Reserve
Bank (Department of Banking Regulation).
(v) AD Category I banks may write-off/transfer to unclaimed balances account, un-reconciled

debit/credit entries as per instructions issued by Department of Banking Regulation, from time to
time.
5. Loans/Overdrafts
a) All categories of overseas foreign currency borrowings of AD Category I banks, (except for
borrowings at (c) below), including existing External Commercial Borrowings and loans/overdrafts
from their Head Office, overseas branches and correspondents outside India, International /
Multilateral Financial Institutions [see
(e) below] or any other entity as permitted by Reserve Bank of India and overdrafts in nostro
accounts (not adjusted within five days), shall not exceed 100 per cent of their unimpaired Tier I
capital or USD 10 million (or its equivalent), whichever is higher subject to conditions laid down in (f)
below. The aforesaid limit applies to the aggregate amount availed of by all the offices and
branches in India from all their branches/correspondents abroad and also includes overseas
borrowings in gold for funding domestic gold loans (cf. DBOD circular
No.IBD.BC.33/23.67.001/2005-06 dated September 5, 2005). If drawals in excess of theabove limit
are not adjusted within five days, a report, as per the format in Annex-VIII, should be submitted to
the Chief General Manager, Financial Markets Regulation Department, Reserve Bank of India
Central Office, 1st Floor, Main
Building, Shahid Bhagat Singh Road, Fort, Mumbai – 400 001, within 15 days from the close of the
month in which the limit was exceeded. Such a report is not necessary if arrangements exist for
value dating.
b) The funds so raised may be used for purposes other than lending in foreign currency to
constituents in India and repaid without reference to the Reserve Bank. As an exception to this rule,
AD Category I banks are permitted to use borrowed funds as also foreign currency funds received
through swaps for granting foreign currency loans for export credit in terms of IECD Circular No
12/04.02.02/2002-03dated January 31, 2003. Any fresh borrowing above this limit shall be made
onlywith the prior approval of the Reserve Bank. Applications for fresh ECBs should be made as
per the current ECB Policy.
56
Page 226
c) The following borrowings would continue to be outside the limit of 100 per cent of unimpaired
Tier I capital or USD 10 million (or its equivalent), whichever is higher:
i).Overseas borrowings by AD Category I banks for the purpose of financing export credit
subject to the conditions prescribed in DBOD Master Circular dated July 2, 2015 on Rupee
/ Foreign Currency Export Credit & Customer Service To Exporters.
ii).Subordinated debt placed by head offices of foreign banks with their branches in India as
Tier II capital.
iii) Capital funds raised/augmented by the issue of Innovative Perpetual Debt Instruments
and Debt Capital Instruments, in foreign currency, in terms of Circulars DBOD. No.
BP.BC.57/21.01.002/2005-06 dated January25, 2006,DBOD. No.
BP.BC.23/21.01.002/2006-07 dated July 21, 2006and Perpetual Debt Instruments and
Debt Capital Instruments in foreign currency issued in terms of circular
DBOD.No.BP.BC.98/21.06.201/2011-12dated May 2, 2012.
iv) Any other overseas borrowing with the specific approval of the Reserve Bank.
d) Interest on loans/overdrafts may be remitted (net of taxes) without the prior approval of Reserve
Bank.
e) 18AD category-I banks may borrow only from International / Multilateral Financial Institutions in
which Government of India is a shareholding member or which have been established by more
than one government or have shareholding by more than one government and other international
organizations.
f) The borrowings beyond 50 per cent of unimpaired Tier I capital of AD Category – I banks will be
subject to the following conditions:
(i) The bank should have a Board approved policy on overseas borrowings which shall
contain the risk management practices that the bank would adhere to while borrowing
abroad in foreign currency.
18 A.P. (DIR Series) Circular No. 112 dated June 25, 2015
57
Page 227
(ii) The bank should maintain a CRAR of 12.0 per cent.
(iii) The borrowings beyond the existing ceiling shall be with a minimum maturity of three
years.
All other existing norms (FEMA regulations, NOPL norms, etc) shall continue to be applicable.
RBI Guidelines on exposure norms
CONTENTS
Para No. Particulars Page
No.
A Purpose 1
B Classification 1
C Previous instructions 1
D Application 1
1 Introduction 2
2 Guidelines 2
2.1 Credit Exposures to Single/Group Borrowers 2
2.1.1 Ceilings 2
2.1.2 Exemptions 4
2.1.3 Definitions 4
2.1.4 Review 7
2.2 Credit Exposure to Industry and Certain Sectors 8
2.2.1 Internal Exposure Limits 8
2.2.2 Exposure to leasing to higher purchase and factoring services 9
2.2.3 Exposure to Indian JVs / Wholly Owned Subsidiaries Abroad and 9
Overseas Step-Down Subsidiaries of Indian Corporates
2.3 Banks' Exposure to Capital Markets- Rationalisation of Norms 10
2.3.1 Components of Capital Market Exposure (CME) 10
2.3.2 Limits on Banks’ Exposure to Capital Markets 11
2.3.3 Definition of Net Worth 12
2.3.4 Items excluded from Capital Market Exposure 12
2.3.5 Computation of Exposure 13
2.3.6 Intra-day Exposure 14
2.3.7 Enhancement Limits 14
3 Prudential limits on intra-group exposures 14
4 Financing of equities and investments in shares 15
5 'Safety Net' Schemes for Public Issues of Shares, Debentures, etc. 19
Annex 1 List of All-India Financial Institutions guaranteeing bonds of 20
corporate
Annex 2 List of All-India Financial Institutions whose instruments are 21
exempted from Capital Market Exposure ceiling
Appendix List of circulars consolidated 22
Page 228
ii
DBR– MC on Exposure Norms - 2015
Page 229
MASTER CIRCULAR ON EXPOSURE NORMS
4. Purpose
This Master Circular provides a framework of the rules/regulations/instructions issued by the

Reserve Bank of India to Scheduled Commercial Banks relating to credit exposure limits for
single/ group borrowers and credit exposure to specific industry or sectors and the capital
market exposure of banks.
• Classification
A statutory guideline issued by the Reserve Bank in exercise of the powers conferred by the
Banking Regulation Act, 1949.
• Previous instructions
This Master Circular consolidates and updates the instructions on the above subject
contained in the circulars listed in Appendix.
5. Application
To all scheduled commercial banks, excluding Regional Rural Banks.
1
DRB– MC on Exposure Norms - 2015
Page 230
F INTRODUCTION
As a prudential measure aimed at better risk management and avoidance of

concentration of credit risks, the Reserve Bank of India has advised the banks to fix
limits on their exposure to specific industry or sectors and has prescribed regulatory
limits on banks’ exposure to single and group borrowers in India. In addition, banks
are also required to observe certain statutory and regulatory exposure limits in
respect of advances against / investments in shares, convertible debentures /bonds,
units of equity-oriented mutual funds and all exposures to Venture Capital Funds
(VCFs). Banks should comply with the following guidelines relating to exposure
norms.
F GUIDELINES
2.1 Credit Exposures to Single/Group Borrowers
2.1.1 Ceilings
2.1.1.1 The exposure ceiling limits would be 15 percent of capital funds in case of a
singleborrower and 40 percent of capital funds in the case of a borrower group. The
capital funds for the purpose will comprise of Tier I and Tier II capital as defined
under capital adequacy standards (please also refer to paragraph 2.1.3.5 of this
Master Circular).
2.1.1.2 Bank’s clearing exposure to a Qualifying CCP (QCCP) will be kept outside of
theexposure ceiling of 15 per cent of its capital funds applicable to a single
counterparty. Clearing exposure would include trade exposure and default fund
exposure as defined in the guidelines on capital requirements for banks’ exposure to
central counterparties issued vide Circular DBOD.No.BC.28/21.06.201/ 2013-14
dated July2, 2013. Other exposures to QCCPs such as loans, credit lines,
investments in thecapital of CCP, liquidity facilities, etc. will continue to be within the
existing exposure ceiling of 15 per cent of capital funds to a single counterparty.
However, all exposures of a bank to a non-QCCP should be within this exposure
ceiling of 15 per cent. (please also refer to circular
DBOD.No.BP.BC.82/21.06.217/2013-14 datedJanuary 7, 2014)
2.1.1.3 Credit exposure to a single borrower may exceed the exposure norm of 15 percent
ofthe bank's capital funds by an additional 5 percent (i.e. up to 20 percent) provided
the additional credit exposure is on account of extension of credit to infrastructure
projects. Credit exposure to borrowers belonging to a group may exceed the
exposure norm of 40 percent of the bank's capital funds by an additional 10 percent
(i.e., up to 50 percent), provided the additional credit exposure is on account of
extension of credit to infrastructure projects. The definition of infrastructure lending
and the list of sub-sectors under infrastructure is included in the Master Circular on
‘Loans and Advances – Statutory and other Restrictions’ dated July 1, 2015.
2.1.1.4 In addition to the exposure permitted under paragraphs 2.1.1.1 and 2.1.1.2
above,banks may, in exceptional circumstances, with the approval of their Boards,
consider enhancement of the exposure to a borrower (single as well as group) up to
a further 5 percent of capital funds subject to the borrower consenting to the banks
making
2
Page 231
appropriate disclosures in their Annual Reports.
2.1.1.5 With effect from May 29, 2008, the exposure limit in respect of single borrower
hasbeen raised to twenty five percent of the capital funds, only in respect of Oil
Companies who have been issued Oil Bonds (which do not have SLR status) by
Government of India. In addition to this, banks may in exceptional circumstances, as
hitherto, in terms of paragraph 2.1.1.3 of the Master Circular, consider enhancement
of the exposure to the Oil Companies up to a further 5 percent of capital funds.
2.1.1.6 The bank should make appropriate disclosures in the ‘Notes on account’ to
theannual financial statements in respect of the exposures where the bank had
exceeded the prudential exposure limits during the year.
2.1.1.7 Exposures to NBFCs

The exposure (both lending and investment, including off balance sheet exposures)
of a bank to a single NBFC / NBFC-AFC (Asset Financing Companies) should not
exceed 10% / 15% respectively, of the bank's capital funds as per its last audited
balance sheet. Banks may, however, assume exposures on a single NBFC / NBFC-
AFC up to 15%/20% respectively, of their capital funds provided the exposure in
excess of 10%/15% respectively, is on account of funds on-lent by the NBFC /
NBFC-AFC to the infrastructure sector. Exposure of a bank to Infrastructure Finance
Companies (IFCs) should not exceed 15% of its capital funds as per its last audited
balance sheet, with a provision to increase it to 20% if the same is on account of
funds on-lent by the IFCs to the infrastructure sector. Further, banks may also
consider fixing internal limits for their aggregate exposure to all NBFCs put together.
Infusion of capital funds after the published balance sheet date may also be taken
into account for the purpose of reckoning capital funds. Banks should obtain an
external auditor’s certificate on completion of the augmentation of capital and submit
the same to the Reserve Bank of India (Department of Banking Supervision) before
reckoning the additions to capital funds.
2.1.1.8 Lending under Consortium Arrangements

The exposure limits will also be applicable to lending under consortium
arrangements.
2.1.1.9 Bills discounted under Letter of Credit (LC)
In cases where the bills discounting/purchasing/negotiating bank and LC issuing

bank are different entities, bills purchased/discounted/negotiated under LC (where
the payment to the beneficiary is not made ‘under reserve’), will be treated as an
exposure on the LC issuing bank and not on the third party / borrower. However, in
cases where the bills discounting/purchasing/negotiating bank and LC issuing bank
are part of the same bank, i.e. where LC is issued by the Head Office or branch of
the same bank, then the exposure should be taken on the third party/borrower and
not on the LC issuing bank. In the case of negotiations ‘under reserve’, the exposure
should be treated as on the borrower.
Page 232
2.1.1.10 Disinvestment Programme of the Government of India
On account of banks’ financing of acquisition of PSU shares under the Government

of India disinvestment programmes, if any bank, is likely to exceed the regulatory
ceiling of single / group borrower limit, RBI will consider relaxation on specific
requests from banks in the singlel/group credit exposure norms on a case by case
basis, provided that the bank’s total exposure to the borrower, net of its exposure
due to acquisition of PSU shares under the Government of India disinvestment
programme, should be within the prudential singlel/group borrower exposure ceiling
prescribed by RBI.
2.1.2 Exemptions
2.1.2.1 Rehabilitation of Sick/Weak Industrial Units
The ceilings on single/group exposure limits are not applicable to existing/additional
credit facilities (including funding of interest and irregularities) granted to weak/sick
industrial units under rehabilitation packages.
2.1.2.2 Food credit
Borrowers, to whom limits are allocated directly by the Reserve Bank for food credit,
will be exempt from the ceiling.
2.1.2.3 Guarantee by the Government of India
The ceilings on single /group exposure limit would not be applicable where principal
and interest are fully guaranteed by the Government of India.
2.1.2.4 Loans against Own Term Deposits
Loans and advances (both funded and non-funded facilities) granted against the
security of a bank’s own term deposits should not be reckoned for computing the
exposure to the extent that the bank has a specific lien on such deposits.
2.1.2.5 Exposure on NABARD
The ceiling on single/group borrower exposure limit will not be applicable to
exposure assumed by banks on NABARD. The individual banks are free to
determine the size of the exposure to NABARD as per the policy framed by their
respective Board of Directors. However, banks may note that there is no exemption
from the prohibitions relating to investments in unrated non-SLR securities
prescribed in terms of the Master Circular on Prudential Norms for Classification,
Valuation and Operations of Investment Portfolio by Banks, as amended from time
to time.
2.1.3 Definitions
2.1.3.1 Exposure
Exposure shall include credit exposure (funded and non-funded credit limits) and
investment exposure (including underwriting and similar commitments). The
sanctioned limits or outstandings, whichever are higher, shall be reckoned for
arriving at the exposure limit. However, in the case of fully drawn term loans, where
there is no scope for re-drawal of any portion of the sanctioned limit, banks may
reckon the outstanding as the exposure.
4
Page 233
2.1.3.2 Measurement of Credit Exposure of Derivative Products
For the purpose of exposure norms, banks shall compute their credit exposures,
arising on account of the interest rate & foreign exchange derivative transactions and
gold, using the 'Current Exposure Method', as detailed below. While computing the
credit exposure banks may exclude 'sold options', provided the entire premium / fee
or any other form of income is received / realised.
Bilateral netting of Mark-To-Market (MTM) values arising on account of such
derivative contracts cannot be permitted. Accordingly, banks should count their gross
positive MTM value of such contracts for the purposes of capital adequacy as well as
for exposure norms.
Current Exposure Method
11.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 / realized.
12.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.
A. 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.
CCF for market related off-balance sheet items

Credit conversion factors
Residual Maturity 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%
8. For contracts with multiple exchanges of principal, the add-on factors are to be
multiplied by the number of remaining payments in the contract.
9. For contracts that are structured to settle outstanding exposure following specified
payment dates and where the terms are reset such that the market value of the
contract is zero on these specified dates, the residual maturity would be set equal to
the time until the next reset date. However, in the case of interest rate contracts
5
Page 234
which have residual maturities of more than one year and meet the foregoing
criteria, the CCF or "add-on factor" applicable shall be subject to a floor of 1.00 per
cent.
8. No potential future credit exposure would be calculated for single currency floating
/floating interest rate swaps; the credit exposure on these contracts would be
evaluated solely on the basis of their mark-to-market value.
9. Potential future exposures should be based on effective rather than apparent

notional amounts. In the event that the stated notional amount is leveraged or
enhanced by the structure of the transaction, banks must use the effective
notional amount when determining potential future exposure. For example, a
stated notional amount of USD 1 million with payments based on an internal rate
of two times the Base Rate would have an effective notional amount of USD 2
million.
2.1.3.3. Credit Exposure

Credit exposure comprises the following elements:
12. all types of funded and non-funded credit limits.
facilities extended by way of equipment leasing, hire purchase finance and
factoring services.
2.1.3.4 Investment Exposure

9. Investment exposure comprises the following elements:
investments in shares and debentures of companies.
investment in PSU bonds
investments in Commercial Papers (CPs).
10. Banks’ / FIs’ investments in debentures/ bonds / security receipts / pass-
through certificates (PTCs) issued by an SC / RC as compensation consequent upon
sale of financial assets will constitute exposure on the SC / RC. In view of the
extraordinary nature of the event, banks / FIs will be allowed, in the initial years, to
exceed the prudential exposure ceiling on a case-to-case basis.
11. The investment made by the banks in bonds and debentures of corporates
which are guaranteed by a PFI1(as per list given in Annex 1) will be treated as an
exposure by the bank on the PFI and not on the corporate.
1
With the merger of ICICI Ltd. with ICICI Bank Ltd. effective from 30.03.2002, the entire liabilities of ICICI Ltd.
have been taken over by ICICI Bank Ltd. As per the scheme of merger all loans and guarantee facilities to ICICI
Ltd. provided by Government would be transferred to the merged entity. Similarly, the investments made in
erstwhile ICICI Ltd. by banks would be treated outside the ceiling of 40% till redemption.
With the merger of IDBI Bank Ltd. with IDBI Ltd., effective April 2, 2005, the entire liabilities of the erstwhile IDBI
Bank Ltd. have been taken over by the new, combined entity Industrial Development Bank of India Ltd., since
renamed as IDBI Bank Ltd. Therefore, for the purpose of exposure norms, investments made by the banks in the
bonds and debentures of corporates guaranteed by the erstwhile IDBI Ltd. would continue to be treated as an
exposure of the banks on IDBI Ltd. and not on the corporates, till redemption. Similarly, investments made in the
erstwhile IDBI Ltd. by banks would be treated as outside the capital market exposure ceiling of 40%, till
redemption.
Page 235
10. Guarantees issued by the PFI to the bonds of corporates will be treated as
an exposure by the PFI to the corporates to the extent of 50 per cent, being a non-
fund facility, whereas the exposure of the bank on the PFI guaranteeing the
corporate bond will be 100 per cent. The PFI before guaranteeing the
bonds/debentures should, however, take into account the overall exposure of the
guaranteed unit to the financial system.
2.1.3.5 Capital Funds

Capital funds for the purpose will comprise Tier I and Tier II capital as defined under
capital adequacy standards and as per the published accounts as on March 31 of the
previous year. However, the infusion of capital under Tier I and Tier II, either through
domestic or overseas issue (in the case of branches of foreign banks operating in
India, capital funds received by them from their Head Office in accordance with the
provisions of Master Circular on New Capital Adequacy Framework as amended
from time to time), after the published balance sheet date will also be taken into
account for determining the exposure ceiling. Other accretions to capital funds by
way of quarterly profits etc. would not be eligible to be reckoned for determining the
exposure ceiling. Banks are also prohibited from taking exposure in excess of the
ceiling in anticipation of infusion of capital at a future date.
2.1.3.6 Group
16. The concept of 'Group' and the task of identification of the borrowers
belonging to specific industrial groups is left to the perception of the banks/financial
institutions. Banks/financial institutions are generally aware of the basic constitution
of their clientele for the purpose of regulating their exposure to risk assets. The group
to which a particular borrowing unit belongs, may, therefore, be decided by them on
the basis of the relevant information available with them, the guiding principle being
commonality of management and effective control. In so far as public sector
undertakings are concerned, only single borrower exposure limit would be applicable.
17. In the case of a split in the group, if the split is formalised the splinter groups will
be regarded as separate groups. If banks and financial institutions have doubts
about the bona fides of the split, a reference may be made to RBI for its final view in
the matter to preclude the possibility of a split being engineered in order to prevent
coverage under the Group Approach.
2.1.4 Review
An annual review of the implementation of exposure management measures may be
placed before the Board of Directors before the end of June.
Page 236
2.2. Credit Exposure to Industry and certain Sectors
2.2.1 Internal Exposure Limits

2.2.1.1 Fixing of Sectoral Limits
Apart from limiting the exposures to a single or a Group of borrowers, as indicated
above, banks may also consider fixing internal limits for aggregate commitments to
specific sectors, e.g. textiles, jute, tea, etc., so that the exposures are evenly spread
over various sectors. These limits could be fixed by the banks having regard to the
performance of different sectors and the risks perceived. The limits so fixed may be
reviewed periodically and revised, as necessary.
2.2.1.2 Unhedged Foreign Currency Exposure of Corporates
To ensure that each bank has a policy that explicitly recognises and takes account of
risks arising out of foreign exchange exposure of their clients, foreign currency loans
above US $10 million, or such lower limits as may be deemed appropriate vis-à -vis
the banks’ portfolios of such exposures, should be extended by banks only on the
basis of a well laid out policy of their Boards with regard to hedging of such foreign
currency loans. Further, the policy for hedging, to be framed by their boards, may
consider, as appropriate for convenience, excluding the following:
20. Where forex loans are extended to finance exports, banks may not insist on
hedging but assure themselves that such customers have uncovered receivables
to cover the loan amount.
21. Where the forex loans are extended for meeting forex expenditure.
Banks are also advised that the Board policy should cover unhedged foreign
exchange exposure of all their clients including Small and Medium Enterprises
(SMEs). Further, for arriving at the aggregate unhedged foreign exchange exposure
of clients, their exposure from all sources including foreign currency borrowings and
External Commercial Borrowings should be taken into account.
Banks which have large exposures to clients should monitor and review on a monthly
basis, through a suitable reporting system, the unhedged portion of the foreign
currency exposures of those clients, whose total foreign currency exposure is
relatively large (say, about US $ 25 million or its equivalent). The review of unhedged
exposure for SMEs should also be done on a monthly basis. In all other cases,
banks are required to put in place a system to monitor and review such position on a
quarterly basis.
In the case of consortium/multiple banking arrangements, the lead role in monitoring

unhedged foreign exchange exposure of clients, as indicated above, would have to
be assumed by the consortium leader/bank having the largest exposure.
Banks are also advised to adhere to the instructions relating to information sharing
among themselves as indicated in our circular DBOD.No.BP.BC.94/08.12.001/2008-
09 dated December 8, 2008on'Lending under Consortium Arrangement /
MultipleBanking Arrangements'. In this connection, banks may also refer to the
circularDBOD.BP.BC.No.62/21.04.103/2012-13 dated November 21, 2012.
Page 237
Events relating to derivative trades have shown that excessive risk taking by
corporates could lead to severe distress to them and large potential credit loss to
their bankers in the event of sharp adverse movements in currencies. It is observed
that unhedged forex exposure risks are not being evaluated rigorously and built into
pricing of credit by banks. It is emphasized that unhedged forex exposure of
corporates is a source of risk to the corporates as well as to the financing bank and
the financial system. Further, large unhedged forex exposures of corporates have
resulted in some accounts turning non-performing. In view of the importance of
prudent management of foreign exchange risk, banks are advised that in accordance
with the guidelines, they should put in place a proper mechanism to rigorously
evaluate the risks arising out of unhedged foreign currency exposure of corporates
and price them in the credit risk premium while extending fund based and non-fund
based credit facilities to corporates. Banks may also consider stipulating a limit on
unhedged position of corporates on the basis of bank's Board approved policy.
2.2.1.3 Exposure to Real Estate
9. Banks should frame comprehensive prudential norms relating to the ceiling on the
total amount of real estate loans, single/group exposure limits for such loans,
margins, security, repayment schedule and availability of supplementary finance and
the policy should be approved by the banks' Boards.
10. The exposure of banks to entities for setting up Special Economic Zones (SEZs)
or for acquisition of units in SEZs which includes real estate would be treated as
exposure to commercial real estate sector for the purpose of risk weight and capital
adequacy from a prudential perspective. Banks would, therefore, have to make
provisions, as also assign appropriate risk weights for such exposures, as per the
existing guidelines. The above exposure may be treated as exposure to
Infrastructure sector only for the purpose of Exposure norms which provide some
relaxations for the Infrastructure sector. In this connection, attention is invited to
paragraph 3 of our circular DBOD.BP.BC.No.42/08.12.015/2009-10 dated
September9, 2009.
2.2.2 Exposure to Leasing, Hire Purchase and Factoring Services

Banks have been permitted to undertake leasing, hire purchase and factoring
activities departmentally. Where banks undertake these activities departmentally,
they should maintain a balanced portfolio of equipment leasing, hire purchase and
factoring services vis-à-vis the aggregate credit. Their exposure to each of these
activities should not exceed 10 per cent of total advances.
2.2.3 Exposure to Indian Joint Ventures/Wholly-owned Subsidiaries Abroad
andOverseas Step-down Subsidiaries of Indian Corporates
2.2.3.1 Banks are allowed to extend credit/non-credit facilities (viz. letters of credit
andguarantees) to Indian Joint Ventures/Wholly-owned Subsidiaries abroad and
step-down subsidiaries which are wholly owned by the overseas subsidiaries of
Indian Corporates. Banks are also permitted to provide at their discretion, buyer's
credit/acceptance finance to overseas parties for facilitating export of goods &
services from India. The above exposure will, however, be subject to a limit of 20
percent of banks’ unimpaired capital funds (Tier I and Tier II capital).and would be
9
Page 238
subject to the conditions laid down in this regard in the Master Circular on ‘Loans and
Advances – Statutory and Restrictions’ dated July 1, 2015.
2.3 Banks’ Exposure to Capital Markets – Rationalisation of Norms
As announced in the Mid-Term Review of Annual Policy Statement for the year 2005-
2006, the prudential capital market exposure norms prescribed for banks have
beenrationalized in terms of base and coverage. Accordingly, the existing guidelines
on banks’ exposure to capital markets were modified and the revised guidelines,
which came into effect from April 1, 2007, are as under.
2.3.1 Components of Capital Market Exposure (CME)
Banks' capital market exposures would include both their direct exposures and
indirect exposures. The aggregate exposure (both fund and non-fund based) of
banks to capital markets in all forms would include the following:
direct investment in equity shares, convertible bonds, convertible debentures and
units of equity-oriented mutual funds the corpus of which is not exclusively
invested in corporate debt;
advances against shares/bonds/debentures or other securities or on clean basis
to individuals for investment in shares (including IPOs/ESOPs), convertible bonds,
convertible debentures, and units of equity-oriented mutual funds;
advances for any other purposes where shares or convertible bonds or
convertible debentures or units of equity oriented mutual funds are taken as
primary security;
advances for any other purposes to the extent secured by the collateral security
of shares or convertible bonds or convertible debentures or units of equity
oriented mutual funds i.e. where the primary security other than
shares/convertible bonds/convertible debentures/units of equity oriented mutual
funds does not fully cover the advances;
secured and unsecured advances to stockbrokers and guarantees issued on
behalf of stockbrokers and market makers;
loans sanctioned to corporates against the security of shares / bonds/ debentures
or other securities or on clean basis for meeting promoter’s contribution to the
equity of new companies in anticipation of raising resources;
bridge loans to companies against expected equity flows/issues;
underwriting commitments taken up by the banks in respect of primary issue of
shares or convertible bonds or convertible debentures or units of equity oriented
mutual funds.
financing to stockbrokers for margin trading;
all exposures to Venture Capital Funds (both registered and unregistered).
5. Irrevocable Payment Commitments issued by custodian banks in favour of stock
exchanges.
10
Page 239
2.3.2 Limits on Banks’ Exposure to Capital Markets
2.3.2.1 Statutory limit on shareholding in companies
In terms of Section 19(2) of the Banking Regulation Act, 1949, no banking company
shall hold shares in any company, whether as pledgee, mortgagee or absolute owner,
of an amount exceeding 30 percent of the paid-up share capital of that company or
30 percent of its own paid-up share capital and reserves, whichever is less, except
as provided in sub-section (1) of Section 19 of the Act. Shares held in demat form
should also be included for the purpose of determining the exposure limit. This is an
aggregate holding limit for each company. While granting any advance against
shares, underwriting any issue of shares, or acquiring any shares on investment
account or even in lieu of debt of any company, these statutory provisions should be
strictly observed.
2.3.2.2 Regulatory Limit
6 Solo Basis
The aggregate exposure of a bank to the capital markets in all forms (both fund
based and non-fund based) should not exceed 40 per cent of its net worth (as
defined in paragraph 2.3.4), as on March 31 of the previous year. Within this overall
ceiling, the bank’s direct investment in shares, convertible bonds / debentures, units
of equity-oriented mutual funds and all exposures to Venture Capital Funds (VCFs)
[both registered and unregistered] should not exceed 20 per cent of its net worth.
7 Consolidated Basis
The aggregate exposure of a consolidated bank to capital markets (both fund based
and non-fund based) should not exceed 40 per cent of its consolidated net worth as
on March 31 of the previous year. Within this overall ceiling, the aggregate direct
exposure by way of the consolidated bank’s investment in shares, convertible bonds
/ debentures, units of equity-oriented mutual funds and all exposures to Venture
Capital Funds (VCFs) [both registered and unregistered] should not exceed 20 per
cent of its consolidated net worth.
Note For the purpose of application of prudential norms on a group-wise basis, a

‘consolidated bank' is defined as a group of entities, which include a licensed bank, which
may or may not have subsidiaries.
2.3.2.3 The above-mentioned ceilings (sub-paragraphs A and B) are the

maximumpermissible and a bank’s Board of Directors is free to adopt a lower ceiling
for the bank, keeping in view its overall risk profile and corporate strategy. Banks are
required to adhere the ceilings on an ongoing basis.
2.3.2.4 If acquisition of equity shares, as indicated in paragraph 5.5

ofcircularDBOD.BP.BC.No.97/21.04.132/2013-14 dated February 26, 2014, results
inexceeding the extant regulatory Capital Market Exposure (CME) limit, the same will
not be considered as a breach of regulatory limit. However, this will require reporting
11
Page 240
to RBI and disclosure by banks in the Notes to Accounts in Annual Financial
Statements.
On account of banks financing acquisition of PSU shares under the Government of

India disinvestment programmes, if any bank is likely to exceed the regulatory ceiling
the capital market exposure, RBI will consider requests from these banks for
relaxation of the ceiling on a case by case basis, subject to adequate safeguards
regarding margin, bank’s exposure to capital market, internal control and risk
management systems, etc. The relaxation of ceiling will be considered in such a
manner that the bank’s exposure to capital market in all forms, net of its advances for
financing of acquisition of PSU shares shall be within the regulatory ceiling limit.
2.3.3 Definition of Net Worth
Net worth would comprise Paid-up capital plus Free Reserves including Share
Premium but excluding Revaluation Reserves, plus Investment Fluctuation Reserve
and credit balance in Profit & Loss account, less debit balance in Profit and Loss
account, Accumulated Losses and Intangible Assets. No general or specific
provisions should be included in computation of net worth. Infusion of capital through
equity shares, either through domestic issues or overseas floats after the published
balance sheet date, may also be taken into account for determining the ceiling on
exposure to capital market. Banks should obtain an external auditor’s certificate on
completion of the augmentation of capital and submit the same to the Reserve Bank
of India (Department of Banking Supervision) before reckoning the additions, as
stated above.
2.3.4 Items excluded from Capital Market Exposure
The following items would be excluded from the aggregate exposure ceiling of 40 per
cent of net worth and direct investment exposure ceiling of 20 per cent of net worth
(wherever applicable):
4. Banks’ investments in own subsidiaries, joint ventures, sponsored Regional Rural

Banks (RRBs) and investments in shares and convertible debentures, convertible
bonds issued by institutions forming crucial financial infrastructure such as
National Securities Depository Ltd. (NSDL), Central Depository Services (India)
Ltd. (CDSL), National Securities Clearing Corporation Ltd. (NSCCL), National
Stock Exchange (NSE), Clearing Corporation of India Ltd., (CCIL), a credit
information company which has obtained Certificate of Registration from RBI and
of which the bank is a member, Multi Commodity Exchange Ltd. (MCX), National
Commodity and Derivatives Exchange Ltd. (NCDEX), National Multi-Commodity
Exchange of India Ltd. (NMCEIL), National Collateral Management Services Ltd.
(NCMSL), National Payments Corporation of India (NPCI) and United Stock
Exchange of India Ltd. (USEIL) and other All India Financial Institutions as given
in Annex 2. After listing, the exposures in excess of the original investment (i.e.
prior to listing) would form part of the Capital Market Exposure.
5. Tier I and Tier II debt instruments issued by other banks;
6. Investment in Certificate of Deposits (CDs) of other banks;
12
Page 241
AM. Preference Shares;
AN. Non-convertible debentures and non-convertible bonds;
AO. Units of Mutual Funds under schemes where the corpus is invested
exclusively in debt instruments;
AP.Shares acquired by banks as a result of conversion of debt/overdue interest into
equity under Corporate Debt Restructuring (CDR) mechanism;
3. Term loans sanctioned to Indian promoters for acquisition of equity in overseas
joint ventures / wholly owned subsidiaries under the refinance scheme of Export
Import Bank of India (EXIM Bank).
BP.With effect from April 16, 2008, banks may exclude their own underwriting
commitments, as also the underwriting commitments of their subsidiaries,
through the book running process, for the purpose of arriving at the capital
market exposure of the solo bank as well as the consolidated bank. (However,
the position in this regard would be reviewed at a future date).
Promoters shares in the SPV of an infrastructure project pledged to the lending
bank for infrastructure project lending.
xi banks exposure to brokers under the currency derivates segment
2.3.5 Computation of exposure
For computing the exposure to the capital markets, loans/advances sanctioned and
guarantees issued for capital market operations would be reckoned with reference to
sanctioned limits or outstanding, whichever is higher. However, in the case of fully
drawn term loans, where there is no scope for re-drawal of any portion of the
sanctioned limit, banks may reckon the outstanding as the exposure. Further, banks’
direct investment in shares, convertible bonds, convertible debentures and units of
equity-oriented mutual funds would be calculated at their cost price.
As regards Irrevocable Payment Commitments (IPC) issued by custodian banks in
favour of Stock Exchange, the computation of Capital Market Exposure would be as
follows:
i. The maximum risk to the custodian banks issuing IPCs would be reckoned at 50%,
on the assumption of downward price movement of the equities bought by FIIs/
Mutual Funds on the two successive days from the trade date (T) i.e., on T+1 and
T+2, of 20% each with an additional margin of 10% for further downward movement.
10. Accordingly the potential risk on T+1 would be reckoned at 50% of the
settlement amount and this amount would be reckoned as CME at the end of T+1 if
margin payment / early pay in does not come in.
11. In case there is early pay in on T+1, there will be no Capital Market
exposure. By T+1, we mean ‘end of day’ (EOD) as per Indian Time. Thus, funds
received after EOD as per Indian Time, will not be reckoned as early pay-in on T+1.
CME will have to be computed accordingly.
12.In case margin is paid in cash on T+1, the CME would be reckoned at 50% of
settlement price minus the margin paid. In case margin is paid on T+1 by way of
13
Page 242
permitted securities to FIIs / Mutual Funds, the CME would be reckoned at 50% of
settlement price minus the margin paid plus haircut prescribed by the Exchange on
the securities tendered towards margin payment.
v. The IPC will be treated as a financial guarantee with a Credit Conversion Factor
(CCF) of 100. However, capital will have to be maintained only on exposure which is
reckoned as CME because the rest of the exposure is deemed to have been covered
by cash/securities which are admissible risk mitigants as per Basel II. Thus capital is
to be maintained on the amount taken for CME and the risk weight would be 125%
thereon. As the nature of IPC remains the same irrespective of the client for whom it
is issued, the measures prescribed for IPCs will be applicable to all IPCs issued by
custodian banks.
2.3.6 Intra-day Exposures
At present, there are no explicit guidelines for monitoring banks’ intra-day exposure
to the capital markets, which are inherently risky. It has been decided that the Board
of each bank should evolve a policy for fixing intra-day limits and put in place an
appropriate system to monitor such limits, on an ongoing basis. The position will be
reviewed at a future date.
2.3.7 Enhancement in limits
Banks having sound internal controls and robust risk management systems can
approach the Reserve Bank for higher limits together with details thereof.
14. Prudential Limits on Intra-Group Exposure
To contain concentration and contagion risks arising out of ITEs, certain quantitative
limits on financial ITEs and prudential measures for the non-financial ITEs have been
imposed as under:
69. Exposure should include credit exposure (funded and non-funded credit limits)
and investment exposure (including underwriting and similar commitments). However,
exposure on account of equity and other regulatory capital instruments should be
excluded while computing exposure to group entities.
70. Banks should adhere to the following intra-group exposure limits :
(AL) Single Group Entity Exposure
5% of Paid-up Capital and Reserves in case of non-financial companies8 and

unregulated financial services companies
10% of Paid-up Capital and Reserves in case of regulated financial services

companies
14
Page 243
b. Aggregate Group Exposure
i. 10% of Paid-up Capital and Reserves in case of all non-financial companies and
unregulated financial services companies taken together
(BM) 20% of Paid-up Capital and Reserves in case of the group i.e. all group
entities (financial and non-financial) taken together.
(BN) Intra-group Exposures Exempted from the Prudential Limits

The following intra-group exposures would be excluded from the stipulated limits :
(x) Banks' investments in the equity of group entities and other capital
instruments are presently governed by the RBI
CircularsDBOD.FSD.BC.62/24.01.001/2011-12 dated December 12,
2011on'Investments in
Subsidiaries and Other companies - Guidelines' and
DBOD.No.BP.BC.2/21.06.201/2013-14 dated July 1, 2013on'Basel III
CapitalRegulations'. Accordingly, banks' exposures to other banks / financial
institutions in the group in form of equity and other capital instruments are exempted
from the limits stipulated in above guidelines, and the extant instructions as cited
above will continue to apply, subject to the prohibitions stipulated at iv below.
(xi) Inter-bank exposures among banks in the group operating in India. However,
prudential limits in respect of both outstanding borrowing and lending transactions in
call / notice money market for scheduled commercial banks would continue to be
governed by extant instructions on Call / Notice Money Market Operations.
(xii) Letters of Comfort issued by parent bank in favour of overseas group entities
to meet regulatory requirements.
iv. Prohibited Exposures
Wherever a bank has been set-up under a NOFHC structure,
19. Bank cannot take any credit or investments (including investments in the
equity / debt capital instruments) exposure on NOFHC, its Promoters / Promoter
Group entities or individuals associated with the Promoter Group.
20. Bank cannot invest in the equity / debt capital instruments of any financial
entities under the NOFHC. (for detailed instructions please refer to
circularDBOD.No.BP.BC.96/21.06.102/2013-14 dated February 11, 2014)
36 Financing of equities and investments in shares

13. 1 Advances against shares to individuals
15
Page 244
Loans against security of shares, convertible bonds, convertible debentures and
units of equity oriented mutual funds to individuals from the banking system should
not exceed the limit of Rs.10 lakh per individual if the securities are held in physical
form and Rs. 20 lakhs per individual if the securities are held in demat form. Such
loans are meant for genuine individual investors and banks should not support
collusive action by a large group of individuals belonging to the same corporate or
their inter-connected entities to take multiple loans in order to support particular
scrips or stock-broking activities of the concerned firms. Such finance should be
reckoned as an exposure to capital market. Banks should formulate, with the
approval of their Board of Directors, a Loan Policy for granting advances to
individuals against shares, debentures, and bonds keeping in view the RBI
guidelines. As a prudential measure, banks may also consider laying down
appropriate aggregate sub-limits of such advances.
4.2 Financing of Initial Public Offerings (IPOs)
Banks may grant advances to individuals for subscribing to IPOs. Loans/advances to

any individual from the banking system against security of shares, convertible bonds,
convertible debentures, units of equity oriented mutual funds and PSU bonds should
not exceed the limit of Rs.10 lakh for subscribing to IPOs. The corporates should not
be extended credit by banks for investment in other companies’ IPOs. Similarly,
banks should not provide finance to NBFCs for further lending to individuals for IPOs.
Finance extended by a bank for IPOs should be reckoned as an exposure to capital
market.
4.3 Bank finance to assist employees to buy shares of their own companies
4.3.1 Banks may extend finance to employees for purchasing shares of their own
companiesunder Employees Stock Option Plan(ESOP)/ reserved by way of
employees' quota under IPO to the extent of 90% of the purchase price of the shares
or Rs.20 lakh, whichever is lower. Finance extended by banks for ESOPs/
employees' quota under IPO would be treated as an exposure to capital market
within the overall ceiling of 40 per cent of their net worth. These instructions will not
be applicable for extending financial assistance by banks to their own employees for
acquisition of shares under ESOPs/ IPOs, as banks are not allowed to extend
advances including advances to their employees / Employees' Trusts set up by them
for the purpose of purchasing their own banks' shares under ESOPs / IPOs or from
the secondary market. This prohibition will apply irrespective of whether the
advances are secured or unsecured.
4.3.2 Banks should obtain a declaration from the borrower indicating the details of the loans
1 advances availed against shares and other securities specified above, from any
other bank/s in order to ensure compliance with the ceilings prescribed for the
purpose.
4.3.3 Follow-on Public Offers (FPOs) will also be included under IPO.
4.4 Advances against shares to Stock Brokers & Market Makers
4.4.1 Banks are free to provide credit facilities to stockbrokers and market makers on the
16
Page 245
basis of their commercial judgment, within the policy framework approved by their
Boards. However, in order to avoid any nexus emerging between inter-connected
stock broking entities and banks, the Board of each bank should fix, within the overall
ceiling of 40 per cent of their net worth as on March 31 of the previous year, a sub-
ceiling for total advances to –
2 all the stockbrokers and market makers (both fund based and non-
fund based, i.e. guarantees); and
2 to any single stock broking entity, including its associates/ inter-connected
companies.
4.4.2 Further, banks should not extend credit facilities directly or indirectly to stockbrokers
for arbitrage operations in Stock Exchanges.
4.5 Bank financing to individuals against shares

to joint holders or third party beneficiaries
While granting advances against shares held in joint names to joint holders or third
party beneficiaries, banks should be circumspect and ensure that the objective of the
regulation is not defeated by granting advances to other joint holders or third party
beneficiaries to circumvent the above limits placed on loans/advances against
shares and other securities specified above.
4.6 Advances against units of mutual funds
While granting advances against units of mutual funds, the banks should adhere to
the following guidelines:
8) The units should be listed in the stock exchanges or repurchase facility for
the units should be available at the time of lending.
9) The units should have completed the minimum lock-in-period stipulated in
the relevant scheme.
10) The amount of advances should be linked to the Net Asset Value (NAV) /
repurchase priceor the market value, whichever is less and not to the face value
of the units.
11) Advances against units of mutual funds (except units of exclusively debt
oriented mutual funds) would attract the quantum and margin requirements as
are applicable to advances against shares and debentures. However, the
quantum and margin requirement for loans/ advances to individuals against units
of exclusively debt-oriented mutual funds may be decided by individual banks
themselves in accordance with their loan policy.
12) The advances should be purpose oriented taking into account the credit
requirement of the investor. Advances should not be granted for subscribing to or
boosting up the sales of another scheme of a mutual fund or for the purchase of
shares/ debentures/ bonds etc.
17
Page 246
4.7 Bank Loans for Financing Promoters' Contributions
These loans will also be subject to single/group of borrowers exposure norms as well
as the statutory limit on shareholding in companies, as detailed above.
4.8 Margin Trading
4.8.1 Banks may extend finance to stockbrokers for margin trading. The Board of each
bank should formulate detailed guidelines for lending for margin trading, subject to
the following parameters:
(f) The finance extended for margin trading should be within the overall ceiling of 40% of
net worth prescribed for exposure to capital market.
(g) A minimum margin of 50 per cent should be maintained on the funds lent for margin
trading.
(h) The shares purchased with margin trading should be in dematerialised mode under
pledge to the lending bank. The bank should put in place an appropriate system for
monitoring and maintaining the margin of 50% on an ongoing basis.
(i) The bank’s Board should prescribe necessary safeguards to ensure that no "nexus"
develops between inter-connected stock broking entities/ stockbrokers and the bank
in respect of margin trading. Margin trading should be spread out by the bank among
a reasonable number of stockbrokers and stock broking entities.
4.8.2 The Audit Committee of the Board should monitor periodically the bank’s exposure
byway of financing for margin trading and ensure that the guidelines formulated by
the bank’s Board, subject to the above parameters, are complied with. Banks should
disclose the total finance extended for margin trading in the "Notes on Account" to
their Balance Sheet.
4.9 Cross holding of capital among banks / financial institutions
4.9.1 (i) Banks' / FIs' investment in the following instruments, which are issued by other
banks / FIs and are eligible for capital status for the investee bank / FI, should not
exceed 10 percent of the investing bank's capital funds (Tier I plus Tier II):
Equity shares;
Preference shares eligible for capital status;
Subordinated debt instruments;
Hybrid debt capital instruments; and
Any other instrument approved as in the nature of capital.
9) Banks / FIs should not acquire any fresh stake in a bank's equity shares, if by
such acquisition, the investing bank's / FI's holding exceeds 5 percent of the investee
bank's equity capital.
10) It is clarified that a bank’s/FI’s equity holdings in another bank held under
provisions of a Statute will be outside the purview of the ceiling prescribed above.
18
Page 247
4.9.2 Banks’ / FIs’ investments in the equity capital of subsidiaries are at present deducted
from their Tier I capital for capital adequacy purposes. Investments in the instruments
issued by banks / FIs which are listed at paragraph 2.7.1(i) above, which are not
deducted from Tier I capital of the investing bank/ FI, will attract 100 percent risk
weight for credit risk for capital adequacy purposes.
9. 'Safety Net' Schemes for Public Issues of Shares, Debentures, etc.
5.1 ‘Safety Net' Schemes

Reserve Bank had observed that some banks/their subsidiaries were providing buy-back
facilities under the name of ‘Safety Net’ Schemes in respect of certain public issues as part
of their merchant banking activities. Under such schemes, large exposures are assumed by
way of commitments to buy the relative securities from the original investors at any time
during a stipulated period at a price determined at the time of issue, irrespective of the
prevailing market price. In some cases, such schemes were offered suo motto without any
request from the company whose issues are supported under the schemes. Apparently,
there was no undertaking in such cases from the issuers to buy the securities. There is also
no income commensurate with the risk of loss built into these schemes, as the investor will
take recourse to the facilities offered under the schemes only when the market value of the
securities falls below the pre-determined price. Banks/their subsidiaries have therefore been
advised that they should refrain from offering such ‘Safety Net’ facilities by whatever name
called.
5.2 Provision of buy back facilities

In some cases, the issuers provide buy-back facilities to original investors up to Rs. 40,000/-
in respect of non-convertible debentures after a lock-in-period of one year, to provide
liquidity to debentures issued by them. If, at the request of the issuers, the banks or their
subsidiaries find it necessary to provide additional facilities to small investors subscribing to
new issues, such buy-back arrangements should not entail commitments to buy the
securities at pre-determined prices. Prices should be determined from time to time, keeping
in view the prevailing stock market prices for the securities. Commitments should also be
limited to a moderate proportion of the total issue in terms of the amount and should not
exceed 25 percent of the owned funds of the banks/their subsidiaries. These commitments
will also be subject to the overall exposure limits which have been or may be prescribed
from time to time.
19
Page 248
ANNEX
1
List of All-India Financial Institutions

(Counter party exposure - List of institutions guaranteeing bonds of corporates)
[paragraphs 2.1.3.4(c)]
9. Industrial Finance Corporation of India Ltd.
10. Industrial Investment Bank of India Ltd.
11. Tourism Finance Corporation of India Ltd.
12. Risk Capital and Technology Finance Corporation Ltd.
13. Technology Development and Information Company of India Ltd.
14. Power Finance Corporation Ltd.
15. National Housing Bank
16. Small Industries Development Bank of India
17. Rural Electrification Corporation Ltd.
18. Indian Railways Finance Corporation Ltd.
19. National Bank for Agriculture and Rural Development
20. Export Import Bank of India
21. Infrastructure Development Finance Company Ltd.
22. Housing and Urban Development Corporation Ltd.
23. Indian Renewable Energy Development Agency Ltd.
20
Page 249
ANNEX 2
List of All-India Financial Institutions
[Investment in equity/convertible bonds/ convertible debentures by banks -

List of FIs whose instruments are exempted from Capital Market Exposure ceiling] [paragraph
2.3.4(i)]
s) Industrial Finance Corporation of India Ltd. (IFCI)
t) Tourism Finance Corporation of India Ltd. (TFCI)
u) Risk Capital and Technology Finance Corporation Ltd. (RCTC)
v) Technology Development and Information Company of India Ltd. (TDICI)
w) National Housing Bank (NHB)
x) Small Industries Development Bank of India (SIDBI)
y) National Bank for Agriculture and Rural Development (NABARD)
z) Export Import Bank of India (EXIM Bank)
aa) Industrial Investment Bank of India (IIBI)
12. Life Insurance Corporation of India (LIC)
General Insurance Corporation of India (GIC)
MEMORY BASED MCQs ON RISK MANAGEMENT
01 RBI implemented the Basel-III recommendations in India, w.e.f:

a) 01.01.2013, b. 31.03.2013, c. 01.04.2013, d. 30.09.2013
02 Basel III recommendations shall be completely implemented in India by:
31.03.2020, b. 31.03.2019 c. 31.03.2618 d. 31.03.2017
Page 250
03 Basel III capital regulations were released by Basel Committee on Banking Supervision (BCBS)
during as a
Global Regulatory Framework for more resilient banks and banking systems:
December 2010, b. March 2011, c. December 2011, d. December 2012
04 Basel III capital regulations are based on 3 mutually reinforcing pillar. These pillars are (1) Pillar-1
minimum capital standards (2)
supervisory review of capital adequacy (3) risk management.
all the 3 are correct, b. only 1 and 2 are correct, c. only 1 and 3 are correct, d. only 2 and 3 are correct
Under Basel II,
05.Under Basel II the option available to compute capital for credit risk are:-
standardized approach, b. risk management approach, c. advance measurement approach, d.
standardized approach,
06. Under Basel III, the options available to compute capital for operational risk are :
standardized approach, b) risk management approach, c) advance measurement, approach, d) basic
indicator
approach,
07.Under Basel III, the options available to compute capital for market risk are :
standardized approach, b) risk management approach, c) advance, measurement approach, d) basic
indicator approach
08.Certain specific prescription of Basel II capital adequacy framework will continue to apply along
with Basel III (parallel run), till:
31.03.2019, b) 31.03.2018, c) 31.03.2017, d) 31.03.2016
09. A bank in India is to comply with capital adequacy ratio requirements at :(1) consolidated (group)
level after consolidating the
assets liabilities of its subsidiaries / joint ventures (2) solo level (3) overseas operations of the bank
under (I) and (2).
a)1 and 2 only correct, b) 1 and 3 only correct, c) 2 and 3 only correct, d) 1 to 3 all correct.
10. In India, the banks are required to maintain a minimum Pillar 1 capital to risk weighted assets ratio
(or minimum total
capital to risk weighted assets ratio) of a s o n
a) 8%, 31' Mar each year, b) 9%, 31" Mar each year, c) 8%, ongoing basis, d) 9%, ongoing basis.
11. The banks in India are required to compute Basel III capital ratios in the following manner (1)
Common equity Tier I capital ratio (2)
Tier I capital ratio (3) Tier 2 capital ratio (4) Total capital to risk weighted asset ratio a) I to 4 all, b) 1,2
and 4 only, c) 1, 3
and 4 only, d) 1 and 4 only
12. To calculate capital adequacy ratio, the banks are to take into account, which of the following risk:
credit risk and operational risk only, b) credit risk and market risk only, c) market risk and operational
risk only, d)
credit risk, market risk and operational risk.
13.Which of the following statement regarding the Total regulatory capital under Basel III is correct:
total regulatory capital is sum total of Tier I capital and Tier 2 capital, b) Tier I capital is called `aning-
concern' capital and Tier 2
capital is called 'gone-concern' capital, c) Tier I capital comprises common equity Tier I and additional
Tier I, d) all the above.
14 As per Basel III implementation in India, Common Equity Tier 1 capital must be % of
risk weighted assets on ongoing basis: a: 5.5% b: 7%, c: 9% d: 11%
15. As per Basel III implementation in India, minimum Tier 1 capital must be % of risk weighted assets
on ongoing basis:
a: 5.5% . b: 7%, c: 9% d: 11%
16. As per Basel III implementation in India, within the minimum Tier 1 capital, the additional Tier
capital can be:
Page 251
a: min 5.5% of risk weighted assets (RWA), b: max 5.5% of RWA, c: min 1.5% of RWA, d: max 1.5%
of RWA
17. As per BaselIII implementation in India, within total capital of 9% of risk weighted assets, the Tier 2
capital can be:
a: max equal to Tier I capital, b) min equal to Tier I capital c) max equal to 2% of risk weighted assets,
d) min equal to 2%
of risk weighted assets
18. Which of the following statements is not correct regarding Basel III implementation in India:
a) minimum common equity Tier I ratio should be 5.5% of RWAs, b) capital conservation buffer, c)
(CCB) consisting of
common equity, should be 2.5% of RWAs, d) maximum additional tier 1 capital should be 1.5% of
RWAs, e) minimum common
equity Tier I ratio plus capital conservation buffer should be 7%
19. Which of the following statements is not correct regarding Basel III implementation in India:
a) minimum Tier I capital ratio should be 8%, b) Tier 2 capital should be max 2%, c) minimum total
capital ratio should be 9%, d)
minimum total capital ratio plus capital conservation buffer should be 11.5%
20. As per Basel III, which of the following is an element of Common Equity component of Tier I (1)
common shares i.e. paid
up equity capital (2) stock surplus i.e. share premium (3) statutory reserves (4) capital reserves
representing surplus arising
out of sale proceeds of assets (5) balance in profit and loss account at the end of the previous year.
a) 1 to 5 all, b) I to 4 only, c) 1,4 and 5 only, d) 1, 2 and 3 only
21. As per Basel III, which of the following can be included in Additional Tier I capital (1) Perpetual
Noncumulative Preference
shares — PNCPS (2) stock surplus or share premium resulting from issue of Additional Tier I
instruments (3) Debit capital
instruments eligible to be included in additional Tier I.: a) 1 to 3 all, b) 1 and 2 only, c) 1 and 3 only, d)
2 and 3 only
22. As per Basel III, Tier 2 capital comprises which. of the following (1) general provisions and loss
reserves (2) debt capital
instruments issued by bank (3) preference share capital instruments with redeemable or cumulative
feature (4) revaluation reserve
(5) stock surplus i.e. share premium resulting from issue of Tier 2 eligible instruments.
a) 1 to 5 all, b) 1 to 4 only, c) 1, 4 and 5 only, d) 1, 2 and 3 only.
23. As per Basel III, general provisions and loss reserves are included in Tier-2 capital maximum to
the extent of: 1.25% of total risk
weighted assets under standardized approach and 0.6% of total risk weighted assets under IRB
approach
a) 0.6% of total risk weighted assets under standardized approach and 0.6% of total risk weighted
assets under IRB approach
b) 0.6% of total risk weighted assets under standardized approach and 1.25% of total risk weighted
assets under IRB approach
c) 1.25% of total risk weighted assets under standardized approach and 1.25% of total risk weighted
assets under IRB approach.
24 As per Basel III, the value of revaluation reserve is to be taken at % discount to include in Tier 2
capital:-
a: 60% b: 55%, c: 50% d: 45%
25 As per Basel III, adjustments / deductions are required to be made from Tier I and Tier 2 capital,
relating to which of the following
(1) goodwill and other intangible assets (2) deferred tax assets (3) Investment in own shares (treasury
stock) (4) investment
Page 252
in capital of banking, financial or insurance entities :
1 to 4 all, b) 1 and 2 only, c) 1 and 3 only, d) 1 only
26 As per Basel III, the investment of a bank in the capital of a banking or financial or insurance entity
is restricted to which of the
following: a) 10% of capital funds (after deductions) of the investing bank, b) 5% of the investee bank's
equity capital, c
30% of paid up capital and reserves of the bank or 30%, of paid up capital of the company, whichever
is lower. d all the above
27 The net stable funding ratio (NSFR) under Basel-III will be implemented in India from:
a 01.01.2017, b 01.04.2017, c 01.01.2018, d 01.04.2018
28. Under Basel III, the risk weight for capital charge for credit risk on the basis of standardized
approach, does not match in respect
of which of the following:
a. Fund & non-fund based claims on Central Govt. 0%, b Fund and non-fund based Central Govt.
guaranteed claims —0%, c
Fund and non-fund based State Govt. guaranteed claims— 0%
D Fund and non-fund based claims on State Govt. —0%.
29 Under Basel III, the risk weight for capital charge for credit risk on the basis of standardized
approach, does not match in respect
of which of the following:
a) Claims on RBI or DICGC 0%, b) Claims on Credit Guarantee Fund Trust for MSE —0%, c) Claims
on Credit Risk
Guarantee Fund Trust for Low Income Housing—0%, d) Claims on ECGC—0%.
approach, does not match for claims
on foreign governments (based on rating of international rating agencies such as S & P, Fitch,
Moody's Rating), in respect of which of
the following:
AAA to AA rating—0%, b: BBB rating—20%, c: Below B rating—150%, d: unrated— 100%
on foreign public sector enterprises (based on rating of S & P, Fitch, Moody's Rating), in respect of
which of the following:
a: AAA to AA rating—20%, b: A rating—20%, c: BBB to BB rating—100%, d: unrated—100%.
32. Under Basel III, what is the risk weight for capital charge for credit risk on the basis of
standardized approach, for claims on
Bank for International Settlements, International Monetary Fund, Multi lateral Development Banks:
a: 0% b: 10%, c: 20%d: 50%.
33. Under Basel III, the risk weight is % for capital charge for credit risk on the basis of standardized
approach, for claims
on banks incorporated in India and foreign bank branches in India, where they meet the level of
common equity Tier I capital
and applicable CCB: a: 0% b: 10%, c: 20% d: 50%

34.Under Basel III, the risk weight for capital charge for credit risk on the basis of standardized
on foreign banks (based on rating of international rating agencies such as S & P, Fitch, Moody's
Rating), in respect of which of the
following: a) AAA to AA rating—20% b) BBB rating—50%, c) Below B rating —150% d) unrated —
150%,
approach for long term loans, does
Page 253
not match for claims on domestic corporates, AFC and NBFC-IFC (based on rating of internal rating
agencies such as CRISIL, CARE,
ICRA etc.), in respect of which of the following:
a) AAA rating—20%, b) A rating—50%, c) BBB—100%, d) unrated—150%
approach for short term loans, does
not match for claims on domestic corporates, AFC and NBFC-IFC (based on rating of internal rating
agencies such as CRISIL, CARE,
ICRA etc.), in respect of which of the following: a) Al+ - 20%, b) A2 — 50%, c) A3 — 75%, d) A4 —
150%
37. Under Basel III, the risk weight is % for capital charge for credit risk on the basis of standardized
approach, for
claims included in regulatory retail portfolio: a 20% b: 50%, c 75%d: 100%
38. Under Basel III, which of the following is part of the regulatory retail portfolio (1) mortgage loans
which qualify as claim
secured by residential property or commercial real estate (2) consumer credit or personal loans or
credit card receivables
(3) capital market exposure (4) venture capital exposure.
a) I and 3 only, b) 2 and 4 only, c) 1 to 4 all, d) none of the above
39. Under Basel III, to consider a claim as part of regulatory retail portfolio, which of the following
condition is stated correctly:
(1) orientation criteria i.e. the exposure to individual person or to small business, where total average
annual turnover in small
business is less than Rs.50 or (2) granularity criteria i.e. no aggregate exposure to one counterpart is
more than 02% of overall
regulatory retail portfolio (3) maximum retail exposure to one counterpart does not exceed the
threshold limit of Rs. I cr.
a) 1 to 3 all, b) 1 and 2 only c) I and 3 only, d) 2 and 3 only
approach for home loan up to Rs.20
lac where loan to value (LTV) ratio is 90% is : a) 20% b) 50%, c) 75% d) 100%.
approach for home loan of above
Rs.20 lac up to Rs.75 lac, where loan to value (LTV) ratio is 80% is : a) 20% b: 50%, c 75% d: 100%
42. Under Basel III, the risk weight for capital charge for credit risk as per standardized approach for
home loan
of above Rs.75 lac, where loan to value (LTV) ratio is 75% is :- a) 20% b: 50%, c 75% d: 100%
43. Under Basel III, the risk weight is for capital charge for credit risk on the basis of standardized
approach
for commercial real estate— residential housing: a) 20% b: 50%, c) 75% d: 100%.
44. Under Basel III, the risk weight is for capital charge for credit risk on the basis of standardized
approach for exposure to
commercial real estate:- 20% b: 50%, c: 75% d: 100%.
45. Under Basel III, for home loan purpose, the loan to value ratio (LTV) ratio is calculated as :
a) (principal + other charges) / (realizable value of mortgage property), b) (principal + accrued interest
+ other charges) /
(realizable value of mortgage property) c) (principal + accrued interest) / (realizable value of mortgage
property), d) (principal +
accrued interest + other charges) / (cost of mortgage property)
46. Bank's exposure for dwelling unit to an individual shall be treated as exposure to commercial real
estate, as per Basel III:- a:
2nd b: 3rd, c 4th d: 5th
Page 254
47. As per BaselIII implementation, the risk weight for unsecured portion of NPA for credit risk as per
standardized approach is
% if the specific provision is less than 20% of the outstanding in NPA account:- a. 150%, b: 100%, c:
75% d: 50%
% if the specific provision is at least 20% of the outstanding in NPA account:- a 150% b: 100%, c: 75%
d: 50%
% if the specific provision is at least 50% of the outstanding in NPA account:- a 150% b: 100%, c: 75%
d: 50%
approach for which of the following
exposure, does not match: a) venture capital — 150% b) consumer credit or personal loans— 125%, c)
credit card -
125%, d) capital market exposure 100%
approach is % for staff loans
secured by superannuation benefits or mortgage of flat / house: 20% b: 50%, c 75% d: 100%
approach is % for staff loans
other than secured by superannuation benefits or mortgage of flat / house, being eligible under
regulatory retail portfolio:
a: 20% b: 50%, c 75% d: 100%
53. Under Basel III,under standardized approach, the total risk weighted off-balance sheet credit
exposure is calculated by taking into
account, thecredit conversion factor (CCF). In which of the following, the CCF is not correctly stated: -
a) direct credit substitutes
such as financial guarantee or standby LC — 100%, b) performance guarantees 50%, c) self
liquidating short term LC
covering trading in goods— 50%, d) note issuance facilities and revolving underwriting facilities -50%
54. Credit enhancements under Securitization exposure, that are first loss positions, is to be risk
weighted at _% under Basel III
requirements:- A: 125% b: 375%, c: 625%, d: 1111%
55. Out of the following, which are domestic credit rating agencies, approved by RBI for the purpose of
credit rating to determine
risk weight for rated exposures (1) Brickwork (2) CARE (3) Fitch (4) CRISIL (5) Moody's (6) SMERA (7)
Standard & Poor:
a 1, 2, 4, 7, b: 1, 2, 4, 6, c: 1,2 3,4, d: 1, 2, 4, 5
56 To be eligible for risk weighting purposes under Basel Ill, the rating from a credit rating agency
approved by RBI, should be in force and confirmed from the monthly bulletin of the concerned rating
agency. The rating agency
should have reviewed the rating at least once during the previous months.
A 6 months, b: 9 months, c: 12 months, d: 15 months
57. Under Basel III, which of the following are eligible as collateral for credit risk mitigation purpose: (1)
cash (2) gold (3) Central or
State Govt. securities (4) Kissan Vikas Tatra or National Saving Certificates (5) Life insurance policies
and units of mutual funds (6)
debt securities rated or unrated.
a: 1 to 6 all, _ b:A 2 to 6 only, cz to 5 only,
Page 255
dt 3 to 5 only
58. As per Basel HI requirements, modified by RBI, call option on Additional Tier 1 instrument
(PNCPS and PDI) will be
permissible at the initiative of the issuer after the instrument has run for at least years. a) two years b)
three years c)
five years d) ten years
5 9 . A s p e r B a s e l I I I , t h e r i s k o f l o s s e s i n o n - b a l a n c e s h e e and off-balance sheet
positions arising from movements in market prices is called :- a) credit risk, b) market risk, c) pricing
risk, d) liquidity risk
60. The market risk positions, that are subject to capital charge requirement, includes which of the
following positions, under Basel
III: a) risk pertaining to interest rate related instruments in the trading book, b) risk pertaining to
equities in the trading book, c)
forex risk including open positions in precious metal d) all the above.
61. The trading book of a bank is subject to market risk. As per Basel III, which of the following is not
included in the trading book for
capital adequacy purpose:- securities under HFT and AFS, b) open gold positions and forex positions,
c) trading
positions in derivatives, d) securities under HTM
62. If a security has matured and remains unpaid, it attract capital for risk on completion of 90 days
delinquency period:- credit
risk, b: market risk, c: operational risk, d: at discretion of the bank
63. F o r ma r k e t r i s k , t h e minimum capital requirement is expressed in terms of two separately
calculated charges which
are:- a) specific risk and general market risk, b: special risk and general risk, c: liquidity risk and
liquidation risk, d)
counterparty credit risk and trading partner's risk.
64. The capital requirement for general market risk is designed under Basel III to capture the risk of
loss arising from change in :-
a prices of securities, b: market value securities, c: interest rate on securities, d: all the above
65. The capital charge for specific risk under market risk will be % or capital charge in accordance with
the risk warranted by
external rating of the counterparty, whichever is higher, under Basel HI. A: 9.00%, b: 9.75%, c:
10.50%,
d: 11.25%
66 The capital charge for general market risk under the market risk will be % on gross equity position,
under Basel HI.
a: 9.00%, b: 9.75%, c: 10.50%, d: 11.25%
67. Under Basel III, the risk weight for open foreign currency and open gold position is:-
a: 50% b:75%, c: 100% d: 125%
68. The capital charge (CAR) for open foreign exchange positions and open gold positions, under
Basel HI, for market risk is:- a 6%
b: 7%, c: 8% d: 9%
69. The aggregate capital charge for market risk is the sum total of capital charge for (1) interest rate
(2) equity investment (3) forex
and gold open positions:- a) 1 to 3 all, b) 1 and 3 only, c) 1 and 2 only, d) 2 and 3 only
70. Under Basel Ill, the risk of loss resultingfrom inadequate or failed internal processes, people and
systems or from
external events is called :- a) credit risk, b) operational risk, c) market risk, d) reputation risk
71. As per Basel III, which of the following is part of operational risk :- a) legal risk, b) reputational risk,
c) strategic risk,
d) all the above.
Page 256
72. Under Basel HI, by using the Basic Indicator Approach, banks must hold capital for operational
risk equal to the average over the
previous years of a fixed percentage (denoted as alpha) of positive annual gross income. a) 2 years, b)
3 years, c) 5 years,
d) at bank discretion
73. Under Basel III, by using the Basic Indicator Approach, banks must hold capital for operational risk
equal to the average over the
prescribed no. of previous years, at % (denoted as alpha) of positive annual gross income. a: 8% b:
9%,
c: 12% d: 15%
74. For the purposeof calculation of capital charge for • operational risk under basic indicator
approach, the gross
income means:- a net interest income, b: net non-interest income, c: net interest income + net non-
interest
income, d: net interest income minus net non-interest income.

75. For the purposeof calculation of capital charge for operational risk under basic indicator approach,
the gross income
means:- a net profit + provisions and contingencies, b: net profit + provisions and contingencies +
operating expenses,
c net profit + operating-expenses, d: provisions and contingencies + operating expenses.
76 The risks that the banks are generally exposed to and are not captured or not fully captured in
regulatory CRAR include which of
the following:- a settlement risk, liquidity risk, b: reputational risk, strategic risk, c: risk of under-
estimation of credit
risk under standardized approach, d: all the above.
77. Under Pillar-2 of Basel III, the banks are required to have a Board approved ICAAP and assess
capital accordingly. ICAAP
stands for: a) Internal Capital Adequacy Assessment Procedure, b) Internal Capital Approval
Assessment Process
c) Internal Capital Adequacy Assessment Process, d) Internal Capital Assessment Approved Process
78. As per Basel III requirements, modified by RBI during Sept 2014, banks can issue Tier 2 capital
instruments with a
minimum original maturity of at least years : a two years, b three years, c five years, d ten years
79 Which of the 'following better explains the meaning of risk :- a loss arising on happening of some
event, b loss arising
on non-happening of some event, c probability of loss that could arise due to uncertainty, d probability
of risk
that could arise due to uncertainty, e risk due to loss as a result of uncertainty
80 Market risk is the risk of loss in (a) on-balance sheet positions (b) off balance sheet positions (c)
arising from movement in
market prices:- a a to c all are correct, b only a and c correct, c only b and c correct, d only a and b
correct
81 Risk that is associated with inability/failure of banks in payment of amount representing clearing
cheques
presented by different banks:- a liquidity risk, b settlement risk, c credit risk, d legal risk e clearing
process risk.
82. Risk that could arise due to legal actions or uncertainty of interpretations of contracts and
agreements is called:- a) legal risk,
b) contract risk, c) country risk, d) uncertainty risk, e) counter-party risk
83. A bank finds it difficult to repay the short term deposits on maturity to its deposits because the
funds of the bank are locked in
Page 257
long term loans or investments. The risk arising from this situation is called:
a Interest rate risk, b Liquidity risk, c Operational risk, d Market risk, e Credit risk.
84. When failure of the financial system affects other systems such as insurance market or forex
market, such risk is:- a liquidity
risk, b settlement risk systemic risk, d systematic risk, e clearing process risk
85 Market risk takes the form of (which one is not correct):-
a commodity price risk, b interest rate risk c loan default risk d liquidity risk.
86 The risk that loss may arise on account of trading in SLR and other securities by a bank is
classified as:
a credit risk, b investment fluctuation risk c trading risk, d operational risk, e market risk
87. The risk that the interest rate of different assets and liabilities may change in dif ferent magnitude i
scalled?
A) Embedded Risk, b) Maturity Risk, c) Basis Risk, d) Price Risk
88. Exposure to uncertainty in economi c value of an investment that could not be marked to market is
called:- a) trading
risk, b) business risk, c) market risk, d) liquidity risk, e) investment risk,
89. A foreign exchange dealer forgets to square the over bought position in a foreign currency. It is a..
a) foreign exchange risk, b) settlement risk, c) liquidity risk, d) operational risk
90. Risk that is associated with failure of internal processes of a bank or bus i nes s organization:
a) settlement risk, b) procedural risk, c) operational risk, d) credit risk
91. A bank has failed to meet its obligation on account of a payment on due date due to its incapacity
to pay. What kind of risk it is:
a) credit risk, b) liquidity risk, c) settlement risk, d) payment risk, e) all the above
92. Risk associated with changes in the credit profile of the borrowers and counter parties, is called:
a) credit risk, b) market risk, c) counter-party risk, d) liquidity risk, e) a and b –above
93. The customer service in a bank branch, has been disrupted for 2 hours, due to failure of the
central server. What type of risk it
is: a reputation risk, b systemic risk, c operational risk, d settlement risk
94. When the bank is selling 3rd party products, which type of risk is involved:-
a reputation risk, b operational risk, c credit risk, d liquidity risk e Financial Sector Terms
95 When the objective is to follow the best practices to conduct the affairs of a company or bank in a
transparent manner for
giving fair deal to all the stake holders, this is called: a implementation of prudential guidelines, b
organisational
restructuring, c corporate governance, d corporate restructuring, e autonomy
96 Replacement of relatively high -cost debt with that of lower cost borrowing to take advantage of
falling interest rates is called:
a debt replacement, b derivative, c credit enhancement, d credit risk management, e debt swap
97 In capital market, the term 'Market cap' is the product of a market price x authorised capital, b
market price x paid
up capital, c market price x outstanding no. of shares, d ma r k e t p r i c e x s h a r e s e b a n d d
9 8 . A banking system under which the banks are to raise low cost funds and invest such funds in low
risk assets such as govt.
securities, is known as:
a) narrow banking, b) universal banking, c) rural banking, d) risk management banking asset liability
management banking
99. An entity established or incorporated outside India which proposes to make investment in India
and which is registered as such,
in accordance with the SEBI Regulations is called: a) Indian Depository Receipt b) Foreign
Institutional Investor c) Foreign
Direct Investment, d) Foreign Currency Convertible Bond
100. market provides a platform for trading of existing securities and price discovery thereof:
Page 258
a) primary market, b) secondary market, c) money market, d) insurance market
ANSWER
1 C 2 B 3 A 4 B 5 C 6 B 7 C 8 C 9 D 10 D
11 B 12 D 13 D 14 A 15 B 16 D 17 C 18 D 19 A 20 A
21 A 22 A 23 A 24 B 25 A 26 D 27 C 28 C 29 D 30 B
31 B 32 C 33 C 34 D 35 D 36 C 37 C 38 D 39 B 40 B
41 B 42 C 43 C 44 D 45 B 46 B 47 A 48 B 49 D 50 D
51 A 52 C 53 C 54 D 55 B 56 D 57 A 58 C 59 B 60 D
61 D 62 A 63 A 64 C 65 D 66 A 67 C 68 D 69 A 70 B
71 A 72 B 73 D 74 C 75 B 76 D 77 C 78 C 79 C 80 A
81 B 82 A 83 B 84 C 85 C 86 E 87 C 88 B 89 D 90 C
91 C 92 A 93 C 94 B 95 C 96 E 97 C 98 A 99 B 100 B
Page 259
CASE STUDIES / CASE LETS / PROBLEMS ON RISK MANAGEMENT
Case Study on regulatory adjustments under Basel III
Bank-B has to make regulatory adjustment of Rs.300 cr. This amount relates to deferred tax assets.
RBI rules relating to regulatory adjustment under Basel III provide that adjustments are to be phased- in to the extent of 20% as on
1.4.2013 from Common Equity Tier 1 only. The complete phase-in is to be done 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.
Based on above information, answer the following questions:
01 If the deduction amount is taken off from Common Equity Tier I
under Basel III, what amount will be deducted from CET1?
5. Rs.300 cr
6. Rs.240 cr
7. Rs.60 cr
8. Rs.20 cr
02 What amount will be deducted from Tier 1 capital as per these rules ?
9. Rs.300 cr
10. Rs.240 cr
11. Rs.60 cr
12. Rs.20 cr
Answers : 1-c 2-b
Explanation:
Que-1 As per RBI guidelines, only 20% amount is to be reduced from CETI.. Hence amount to be deducted = 300 x 20% = 60 cr.
Que-2 As per RBI guidelines, 20% i.e. Rs.60 cr, is to be reduced from CE 1. (300 x 20% = 60 cr). The remaining amount is to be deduced
as per theexisting treatment rules i.e. rules under Basel IL Under Basel II, the amount of DTA is to be reduced from Tier I capital. Hence
the remaining amount (300 - 60 = 240) is to be reduced from Tier I capital).
Case study on Capital Conservation Buffer in Basel - III
Bank-A earned a net profit after tax and provisions of Rs.3000 and Bank-B of Rs.1200 cr. Common Equity Tier I capital ratio of
Bank-A is 6.75% after including the current period retained profits. This ratio for Bank-B is 7%. Both the banks propose to
mobilize fresh capital through public issue and to make the issue attractive, want to pay highest dividend.
RBI rules reaardin4 CCR provide as under:
Ratio after including the current periods retained Minimum Capital ConservationRatios
earnings (expressed as a percentage of earnings)
5.5% - 6.125% 100%
Page 260
>6.125% - 6.75% 80%
>6.75% - 7.375% 60%
>7.375% - 8.0% 40%
>8.0% 0%
Based on the given information, answer the following questions:
13. What is the amount of net profit which the Bank-A is required not
to distribute to ensure compliance of Basel III prescription.
a: Rs.3000 cr b: Rs.2400 cr c: Rs.1600 cr d: Rs.600 cr
02 What is the maximum -amount which the Bank-A can distribute as dividend to ensure compliance of Basel III prescription.
03 What is the amount of net profit which the Bank-B is required not to distribute to ensure compliance of Basel III prescription.
a: Rs.1200 cr b: Rs.720 cr c: Rs.480 crd: Rs.240 cr
04 What is the maximum amount which the Bank-A can distribute as dividend to ensure compliance of Basel III
prescription.
a: Rs.1200 cr b: Rs.720 cr c: Rs.480 crd: Rs.240 cr
Answers : 1-b 2-d 3-b 4-c
Explanation: Que-1. Ratio of Bank-A is 6.75% due to which it is required to conserve 80% of its earning. Hence amount to be conserved
= 3000 x 80% = 2400 cr. The max amount that can be distributed = 3000 — 2400 =, Rs.600 cr.
Que-2. Ratio of Bank- A is 6.75% due to which it is required to conserve 80% of its earning. Hence amount to be conserved = 3000 x
80% = 2400 cr. The max amount that can be distributed = 3000 — 2400 = Rs.600 cr. Que-3. Ratio of Bank-B is 7% due to which it is
required to conserve 60% of its earning. Hence amount to be conserved = 1200 x 60%
14. 720 cr. The max amount that can be distributed = 1200 — 720 = Rs.480 cr. Que-4. Ratio of Bank-B is 7% due to which it is required
to conserve 60% of its earning. Hence amount to be conserved = 1200 x 60% = 720 cr. The max amount that can be distributed = 1200
— 720 = Rs.480 cr.
Case Study on Credit Risk Mitigation as per Basel HI Popular Bar k granted a corporate loan of Rs.10 cr to XYZ Limitedrepayable over 3
years. The credit rating of the company is A. The value of collateral in the account is Rs.10 cr in the form of unrated Bonds issued by
another bank with a residual maturity of 3 years.
As per RBI guidelines, risk weight of loan to A rated borrower is 50%. The haircut on such bonds is 6% and the haircut for such
exposure is zero. Based on this information, answer the following questions.
15. What is the value of collateral security after prescribed haircut.
a: Rs.10 cr b: Rs.9.40 cr c: Rs.0.60 cr d: Rs.0.30 cr
02 What is the value of net exposure after credit risk mitigation taking
into account the collateral security with prescribed haircut.
03 What is the value of risk weight assets after credit risk mitigation
based on the collateral security.
Answers : 1-b 2-c 3-d
Explanation :
The following formula is used for calculation of Exposure amount for
collateralised transactions:
E = Max{ 0, [ Ex (1 + He )—Cx( 1 — Hc— HFX ) ] I
Where,
E = Exposure value after risk mitigation
E = Current value of the exposure
He = Haircut appropriate to the exposure
C = Current value of the collateral received
He = Haircut appropriate to the collateral
HFX = Haircut appropriate for currency mismatch between the collateral and exposure
Que-1. As per RBI guidelines, the risk weight for such loans is 50%. The heir cut for such exposure is zero. The hair cut of collateralbeing
6%, the value of collateral = 9.40 cr (10 cr — 0.60 cr). Hence, the net exposure = Rs.0.60 cr. With 50% risk weight the value of RWA =
0.60 cr x 50% = Rs.0.30 cr.
0.60 cr x 50% = Rs.0.30 cr.
0.60 cr x 50% = Rs.0.30 cr.
Calculation of Admissible AdditionalTier 1and Tier 2capital as per Basel III Universal bank calculated the ca ital ad uacy ratios as under:
Common Equity Tier 1. Ratio 8.5% of risk weighted assets
Capital conservation buffer 2.5% of risk weighted assets
PNCPS / PDI 3.5% of risk weighted assets
Tier 2 capital issued by bank 2.5% of risk weighted assets
Page 261
Total capital available 17% of risk weighted assets
As per Basel III rules of RBI, for the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 (AT1) capital and Tier 2
(12) capital will be recognised in the same proportion as that applicable towards minimum capital requirements. At min 9% total
capital, the max AT1 can be 1.5% and 12 can be max 2%. On the basis of given information, answer the following questions:
16. What is the amount of total CE I. capital:
a:9% b : 1 0 % c: 11% d: 12%
17. What is the amount of PNCPS / PDI eligible for Tier1?
a:3% b : 2 . 5 % c: 2.125% d: 1.375%
18. What is the amount of PNCPS / PDI not eligible for Tier I?
a:3% b : 2 . 5 % c: 2.125% d: 1.375%
19. What is the amount of Tier 2 eligible for CRAR?
a:2% b : 2 . 5 % c: 2.833% d: 0.333%
20. What is the amount of PNCPS / PDI eligible for Tier2?
a:2% b : 2 . 5 % c: 2.833% d: 0.333%
21. What is the amount of PNCPS / PDI not eligible for Tier 2 capital?
a: 1.375% b: 1.042% c: 2.125% d: 0.333%
22. What is the total amount of eligible capital?
a: 17% b: 16.43% c: 15.96% d: 14.13%
Answers : 1-c 2-c 3-c 4-c 5-d 6-b 7-c
Explanation
Que-1 : Total CET1 = CETI. + CCB = 8.5% + 2.5% = 11% Que-2 : PNCPS / PDI eligible for Tier 1 = 1.5 / 6 x 8.5 = 2.125% Que-3 : PNCPS /
PDI not eligible for Tier 1 = 3.5 - 2.125 = 1.375% Que-4 : Tier 2 eligible for CRAR = 2 / 6 x 8.5 = 2.833% Que-5 : PNCPS / PDI eligible for
Tier 2 = 2.833 - 2.5 = 0.333% Que-6: PNCPS / PDI not eligible for Tier 2 = 1.375 - 0.333 = 1.042%
Que-7 : Total CE I. = CET1 + CCB = 8.5% + 2.5% = 11%
PNCPS / PDI eligible for Tier 1 = 1.5 / 6 x 8.5 = 2.125%
PNCPS / PDI not eligible for Tier 1 = 3.5 - 2.125 = 1.375%
Tier 2 eligible for CRAR = 2 / 6 x 8.5 = 2.833%
PNCPS / PDI eligible for Tier 2 = 2.833 - 2.5 = 0.333%
PNCPS / PDI not eligible for Tier 2 = 1.375 - 0.333 = 1.042%
Total capital available :
= CETI. + AT1 + T2 = 11% + 2.125 + 2.833 = 15.958 or 15.96%
Case study on calculation of eligible amount of profits earned after previous financial year, for inclusion in Capital Fund under
Basel III.
Bank-A had capital adequacy ratio of 11.33% as on March 31, 2016 and risk weighted assets of Rs.50000 cr. Bank paid annual average
dividend of Rs.200 crore during the previous 3 years. In the current year, bank earned a net profit of Rs.100 cr in the first quarter (Jun
2016) and Rs.130 cr in the 2nd quarter (Sep 2016).
On the basis of given information, answer the following questions:
23. What is the amount of profit eligible for inclusion in capital fund at the
end of 2nd quarter.
a Rs.230 cr b Rs.200 cr c Rs.130 cr d Rs.100 cr
02 Out of th e following, the capital fund increase will be represented by increase in ...
a Common Equity Tier-1 capital b Additional Tier-1 capital c Tier-2 capital d Capital conservation buffer
24. If the level of risk weighted assets remains at Rs.54000 cr as on
Sept 30, 2016, what is the capital adequacy ratio of the bank as on :30.09.16?
a 11.33% b 11.57% C 11.:77% d 11.98%
Answers : 2-A, 3-B
Solution:
25. Profit eligible for inclusion in capital fund at end of Sep 2016
Eligible profits EPt= {NPt - 0.25 D (EPt stands for eligible profit up to
the quarter. t varies from 1 to 4. NPt stands for net profit up to quarter t and D is average annual dividend paid during last 3 years)
EPt= - 0.25 D = 230 — 0.25 200 x 2 = 230 — 100 = 130 cr
26. The current year profit, if taken to be included in capital fund
shall become part of Common Equity Tier-1 capital, as per RBI guidelines.
27. If the level of risk weighted assets is Rs.54000 cr as on Sept 30,
2016, the capital adequacy ratio of the bank as on 30.09.16: Existing capital = Rs.6118 cr
(54000/11.33) New capital = 6118 + 130 = 6248.
CAR = 6248 / 54000 x 100 = 11.57%
Case study on calculation of amount investment by banks in instruments issued by other banks as per Basel III guidelines of RBI
Bank-Z has surplus funds and plans to:
28. invest Rs.500 cr in the equity issued by bank X
29. invest Rs.200 cr in the capital of a subsidiary company, being promoted by the bank.
Page 262
30. Lend Rs.400 cr against fully paid up equity shares of Bank Y with a paid up equity capital of Rs.1000 cr.
The paid-up capital and reserves of Bank Z are Rs.400 cr and its capital funds as calculated as per Basel III are Rs.600 cr.
RBI guidelines : When banks invest in equity of other banks and
financial institutions, they have to comply with the following:
31. Max investment in equity can be up to 10% of their capital funds.
32. Investment should not be more than 5% of investee bank's equity capital.
33. Investment in subsidiary company can be up to 10% of paid-up capital and reserves
34. The bank can hold as owner, mortgagee or pledgee, the shares of another company max 30% of its own paid up capital and
reserves or 30% of paid up capital of the company, whichever is lower.

35. What is the maximum amount that Bank-Z can invest in equity issued
by Bank-X?
36. What is the maximum amount that Bank-Z can invest in equity of its
subsidiary company?
03 What is the maximum amount that Bank-Z can lend against equity shares issued by Bank-Y?
Answers : 1-C, 2-D, 3-B Solution:
01 - Maximum amount Bank-Z can invest in equity issued by Bank-X: Capital funds of Bank Z = 600 cr. Max investment = 10% of
600 = 60 cr
37. Maximum amount Bank-Z can invest in equity of subsidiary company Paid up capital + reserves of Bank Z = 400 cr. Max
investment = 10% of Rs.400 cr = Rs.40 cr.
3.Max amount Bank-Z can lend against equity shares issued by Bank-X: Paid up capital + reserves of Bank Z = 400. 30% of 400 = 120 cr
Paid up capital of Bank X = 1000. 30 of 1000 = 300 cr. Hence maximum investment can be Rs.120 cr.
CasestudyonRoleofSupervisor underPillar-2of BaselIII

Under Pillar-2ofBagel III, thereare4principlesof SupervisoryReview.Basedon theseprinciples,answerthefollowingquestions:
38. Supervisorshouldhavetheabilitytorequirethebankstohold capitalinexcessofminimumrequiredcapitalasper:
a Principle-1 b Principle-2 c Principle-3 d Principle-4
39. Supervisorshould reviewand evaluateabank'scompliancewiththe regulatory capital, as per:
a Principle-1 b Principle-2 c Principle-3 d Principle-4
40. Supervisorshouldseektointerveneatan earlystagetoprevent capitalfromfallingbelowtheminimumregulatorylevelasper:
a Principle-1, b Principle-2 c Principle-3 d Principle-4 Answers:1-C,2-B,3-
D
Solutions:
UnderPillar-2ofBaselIII,thereare4principlesofSupervisoryReviewasunder:
Principle-1:Banksshouldhaveaprocesstomakeinternalassessmentofits capital requirements
Principle-2:Supervisorshould reviewand evaluateabank'scompliancewith the regulatory capital
Principle-3 : Supervisor should have the ability to require the banks to holdcapitalinexcess of minimumrequired capital
Principle-4 : Supervisor should seek to intervene at an early stage to prevent capital from falling below the minimum regulatory level:
Case study on Calculation of Capital Ratios as per Basel III

Popular Bank Ltd has provided following information as on 31.03.16 (amount in crores of rupees)
Open position in foreign currency 200

Term loan to an Indian corporate with A rating 300
Staff loans fully secured as per bank policy 1500
Loans guaranteed by CGTMSE 1600
Housing loans guaranteed by CRGFLIG 100
Individual house loans amount < 30 lac, LW 75% 2000
Retail loans 1000
Other loans 600
Cash with other banks with CAR of 9% 300
Credit cards issued by the bank 200
7800
Amount of Additional Tier-1 @1.5% 45.15

Based on this information, answer the following questions:
Page 263
41. What is the amount of risk weight of assets in respect of
incividual home loans:
a 2030 b 1000 c 703 d zero
42. What is the amount of risk weight of assets in respect of
loans to Indian corporates:
a 30) b 375 c 60 d 150
03 What is the capital ratio requirement for credit cards?
a 9% b 11.25% c 6.75% d 4.50%
04 What is the amount of total risk weight of all assets?
a 7800 b 3010 c 5030 d 6040
05 Wiat is the amount of total capital requirement?
a 270.90 b 165.55 c 45 . 1 5 d . 6 0. 20
06 What is the required amount of Common Equity Tier-1 capital?
a 270.90 b 165.55 c 45.15 d 60.20
Answers : l-c, 2-d, 3-b, 4-b, 5-a, 6-b
Open position in foreign currency NO 100% 200

Term loan to an Indian corporate with A rating 300 50% 150
Staff loans fully secured as per bank policy 1500 20% 300
Loans guaranteed by CGTMSE 1600 0% 0
Housing loans guaranteed by CRGFLIG 100 0% 0
Individual house loans amount < 30 lac, LTV 75% 2000 35% 700
Retail loans 1000 75% 750
Other loans 600 100% 600
Cash with other banks with CAR of 9% 300 20% 60
Credit cards issued by the bank 200 125% 250
7800 3010
Amount of capital funds @ 9% 270.9

Amount of Common Equity Tier-1 @5.5% 165.55
Amount of Tier-2 capita @2% 60.2
Amount of capital for credit cards : 9% X 125% = 11.25%

Case study on Capital Conservation Buffer in Basel III
The following information relating to 5 different banks is avaiiable:
Bank Common Equity Tier-1 Net profit after tax and

Ratio provisions (Rs.cr)
Bank-A 5.75% 800
Bank-B 6.5% 1200
Bank-C 6.8% 600
Bank-D 7.75% 1700
Bank-E 8.1% 1100
RBI rules regarding CCR provide as under:
Ratio after Minimum Capital
including the Conservation Ratios
current periods (expressed as a percentage of
5.5% - 6.125% 100%
>6.125% - 6.75% 80%
>6.75% - 7.375% 60%
>7.375% - 8.0% 40%
>8.0% 0%
Based on the given information, answer the following questions:
43. What is the amount of net profit which the Bank-A is required not to
distribute to ensure compliance of Basel III prescription.
02 What is the maximum amount which the Bank-B can distribute as dividend to ensure compliance of Basel III prescription.
44. What is the amount of net profit which the Bank-C is required not to
distribute to ensure compliance of Basel III prescription.
Page 264
a: Rs.600 cr b: Rs.360 cr Rs.240 cr d: Rs.120 cr
04 What is the maximum amount which the Bank-D can distribute as dividend to ensure compliance of Basel III prescription.
05 What is the maximum amount which the Bank-E can distribute as dividend to ensure compliance of Basel III prescription.
a: Rs.1:.00 cr b: Rs.880 cr c: Rs.660 crd: Rs.440 cr
06 What is the maximum amount which these Banks can distribute as dividend to ensure compliance of Basel III prescription.
a: Rs.3200 cr b: Rs.2980 cr Rs.2600 cr d: Rs.2440 cr
Answers : 1-a 2-b 3-c 4-d 5-a 6-c
Explanation:
Que-1. Ratio of Bank-A is 5.75% due to which it is required to conserve 100% of its earning. Hence amount to be conserved = 800 x 100% = 800 cr.
The max amount that can be distributed = Nil.
Que-2. Ratio of Bank-B is 6.5% due to which it is required to conserve 80% of its earning. Hence amount to be conserved = 1200 x 80% = 960 cr.
Themax amount that can be distributed = 1200 — 960 = Rs.240 cr. Que-3. Ratio of Bank-C is 6.8% due to which it is required to conserve 60% of
its earning. Hence amount to be conserved = 600 x 60% = 360 cr. The max amount that can be distributed = 600 — 360 = Rs.240 cr. Que-4.
Ratio of Bank-D is 7.75% due to which it is required to conserve 40% of its earning. Hence amount to be conserved = 1700 x 40% = 680 cr. The
max amount that can be distributed = 1700 — 680 = Rs.1020 cr. Que-5. Ratio of Bank-E is 8.1% due to which it is required to conserve 0% of its
earning. Hence amount to be conserved = 1100 x 0% = 0 cr. The max amount that can be distributed = 1100 cr.
Que-6. 240 + 240 + 1020 + 1100 = 2600
SOME MORE CASE STUDIES

Case Studies on Risk Identification
Case No: 1
A Gujarat based cooperative bank permitted loans amounting to Rs.1500 cr to the group companies of M/s Patel and Shah Limited,
against overpriced shares of group companies. The following modus operandi was followed by the bank in disbursing these loans:
The bank will issue pay orders to the borrower without having any real cash balance in their account or without ensuring funding requirements as
necessary in case of pre-paid instruments. M/s Patel and Shah Limited was having an account with bank B at a branch in Ahmedabad. Bank B
discounted the pay order issued by the cooperative bank amounting to Rs.112 cr and presented these through clearing house. But the cooperative
Bank failed to honour the pay order due to lack of fund. Resultantly, the pay orders were dishonoured. The clearing house regulator put embargo on
the cooperative Bank. Bank B is still to recover Rs.90 cr form M/s Patel and Shah Limited out of total of Rs.112 cr.
Later on the investigations revealed that on the day of failure to make payment by the cooperative Bank, 65% of the pay orders
discounted by Bank B belonged to the cooperative Bank.
Bank B now hold its manager responsible for inadequate management control.
It is also found that around 65% of total loans given by the said cooperative Bank were restricted to 12 entities.
The collapse of the said cooperative Bank had a chain reaction in other cooperative banks.
Based on the above facts, answer the following questions:
01 Bank B's loss of Rs.90orin discounting the pay orders is falls under: a) credit risk'b)
operational risk
45. marketrisk
46. combination of credit risk and operational risk
02 Cooperative Bank's outstanding loans to M/s Patel and-Shah Limited group was more than 38% of their capital funds.
Suchhigh exposure to a single group by a bank is against the regulatory guidelines to avoid: a) concentration risk b) systematic
risk
c) funding risk d) reputation risk
03 RBI is hesitant, for the time being to put embargo or ordered liquidation of the said cooperative Bank, as it could lead to
possible:
a) legal risk b) systemic risk
c) counterparty risk d) liquidity risk
04 As per existing guidelines of RBI, the cooperative Bank was required to disclose their exposure to capital market under
theheading of:
47. segmentreporting
48. transaction with related parties
49. exposure to sensitive sectors
50. maturity pattern of assets and liabilities
Ans-1-d2-a3-b4-c
Explanations:
Qua-1: Credit risk because it involves borrowing. Operational risk because of staff negligence.
Que-2: Major portion of the advances relate to one group.
Que-3: Systemic risk means the risk of failure of a banking system due to failure of a major bank.
Que-4: Banks are submitting information to RBI on sensitive sector advances such as capital market
exposure,commodity exposureetc.
CASE STUDIES ON ASSET LIABILITY MANAGEMENT
Page 265
Case-1
As per RBI guidelineson ALM, capital and reserves are tobe placedin over 5years bucket, Savings Bank and Current Deposits maybe
classified intovolatile andcoreportions. Savings Bank (10%) and Current(15%) Deposits aregenerally withdrawableon demand. This
portion may be treated as volatile. While volatile portion canbeplaced inthetimebucket14days,thecoreportionmaybeplacedinover1-
3yearsbucket. Thetermdepositsaretobeplacedrespective maturitybuckets.
Capital—Rs.1180cr,Reserves—Rs.12000cr,Currentaccount—Rs.1000cr,SavingBank—Rs.4000cr,Termdeposits1monthmaturitybucket—
Rs.400cr, 1tolessthan3monthsmaturitybucketRs.800cr,3 monthstolessthan6monthsmaturitybucket—Rs.
1200cr,6monthstolessthan12maturitybucketRs. 2000cr,1yeartolessthan3yearsmaturitybucket—
Rs.1200cr,3yearstolessthan5yearsmaturitybucket—Rs.600crandabove5yearsmaturitybucket— Rs.800cr.BorrowingfromRBI—Rs.400cr.
Based on the giveninformation, answer thefollowing questions:
01 What is the amount of current account deposit that can be placed in 14 days bucket:
a) Rs. 100 cr b) Rs. 150 cr c) Rs. 200 cr d) Nil
02 What is the amount of saving bank deposit that can be placed in 14 days bucket:
a) Rs. 100 cr b) Rs. 200 cr c) Rs. 300 cr d) Rs. 400 cr
03 What is the amount of current account deposit that can be placed in 1-3 years bucket:
04 What is the amount of saving bank deposit that can be placed in 1-3 years bucket:
05 What is the total of amount of term deposit that will be placed in various maturity buckets up
to less than 12 months;
Answers: 1-b 2-d 3-d 4-b 5-d
Explanations:
Que-1:Volatile portion of 15% tobe placed in thisbucket. Hence = 1000x 15% = 150 cr Que-2: Volatile portion of 10% to be placed
in this bucket. Hence = 4000 x 10% = 400 cr Que-3: Non-volatile portion of 90% to be placed in this bucket. Hence = 1000 x 90% =
900 cr Que-4: Non-volatileportion of 90% to be placed in this bucket. Hence = 4000 x 90% = 3600 cr Que-5:400+800+1200+2000 =
4400 cr
Case-2
International Bankhasfollowing assets and liabilities in its balance-sheet as on Mar 31, 2010:
Capital — Rs. 4000 cr, Reserves — Rs. 24000 cr, Current accounts — Rs. 120000 cr, Saving Bank accounts — Rs. 120000 cr, Term deposits — Rs.
120000 cr, Borrowing from RBI — Rs. 12000 cr, cash balances — Rs. 27600 cr, balances withother banks — Rs. 60000cr, investment in securities —
Rs. 60000 cr, bills payable — Rs. 80000 cr, cash credit — Rs. 80000 cr, term loans — Rs. 80000 cr and fixed assets — Rs. 12400 cr. Total assets and
total liabilities = Rs. 400000 cr. Thetermloanshavefixedrateofinterest.Basedonthisinformation,answerthefollowingquestions.
01 What is the amount of interest rate sensitive assets:
a) Rs. 252000 b) Rs. 320000 c) Rs. 360000 d) Rs. 400000
02 What is the amount of interest rate sensitive liabilities:
a) Rs. 252000 b) Rs. 320000 c) Rs. 360000 d) Rs. 400000
03 In this case, how much and what type of gap in rate sensitive assets and liabilities, the bank
is having: —-
51. Rs. 108000 cr, Negative gap 53. Rs. 108000 cr, Positive gap
52. Rs. 120000 cr, negative gap 54. Information is inadequate
04 What is the amount of Tier-1 capital of the bank:
a) Rs. 4000 cr b) Rs. 24000 cr c) Rs. 28000 cr d) Inadequate information
Answers:1-c2-a3-b4-c
Explanations:
Que-1:Assetsotherthan cashand otherassetsareratesensitive.Hence400000—27600 Q
que-2:Liabilitiesotherthan capital,reservesand currentaccountsareratesensitive400000 4000 —24000--120000 =Rs. 252000cr
Que-3: Interest sensitive assets are more than interest sensitive liabilities i.e. 360000 Hence, there is positive gap.
Que-4:Tier-1 capital comprises reserves and capital. Hence 4000 +24000 = 28000cr
Case-3
The bank-wisematurityprofileof select deposit categoryof banksin%age terms of select maturity buckets,as on Mar 31, 2010is as
under:(figuresin %age)
Liability/Asset ( PSU Old New [Foreign
Banks Private Pvt Banks
Banks Banks
Deposits 100 100 100 100
Upto 1 year 33 54 52 44
Over 1 yr to 37 33 44 44
3 years
Over 3 year to 13 6 3 4
5 years
Page 266
Over5years 17 7 1 8
Onthe basis of given information, answer thefollowing questions:

01 There is decline in rate of interest of 2% for a period up to 1. year. The bank group which will gain most is:
a) PSU Banks b) Old Private Banks
c) New Private Banks d) Foreign Banks
02 There is decline in rate of interest of 2% for a period up to 1 year. The bank group which will gain least is:
03 There is increase in rate of interest of 1% for deposit with a period above 1 year to 5 years. The bank group which will be
most affected adiersely is:
04 There is increase in rate of interest of 1% for deposit with a period above 1 year to 5 years. The bank group which will be
list affected adversely is:
05 The bank group which is more relying on long term deposits above 3 years:
Answers: 1-b2-a3-a4-b_5-a
Explanations:
Que-1:Oldprivatebanks are dependentup to54% depositsin up to 1year category. Hence they gainmost. Que-2:Publicsector banks
havethelowestamount of depositin this category33%. Hence they gainleast.Que-3:PSUbanks have 50% of their depositin
thiscategory,whichis highest in all the 4 bank groups. Hence
they are affected most.
Que-4:Old privatebanks have 39% of their deposits in thiscategory whichlowest. Hence they are least affect. Que-5:PSU banks
are having 30% oftheir deposits in this category, which is highest.
Case- 4
The bank-wise maturity profile of borrowing of banks in %age terms of select maturity buckets as on Mar 31, 2010 is as under
Figures in %age )
Liability/Asset PSU Old New Foreign
Banks Banks
Deposits 100 100 100 100
Up to 1 year 81 84 51 84
Over 1 yr to 15 3 45 11
3 years
5 years
Over 5 years 2 7 2 2
on thebasisofgiveninformation,answerthefollowingquestions
01 There is increase in rate of interest of 2% for a period over 5 years. The bank group which Will lose most is:a) PSU Banksb)
OldPrivate Banks c) New Private Banks d) Foreign Banks
02 There is increase in rate of interest of 2% for a period over 1 year up to 3 years. The bank group which will lose most is:
03 There is decrease in rate of interest of 0.5% for a period of over 3 years to 5 years. The bank group which will gain most is:
_
04 There is decrease in rate of interest of 0.5% for a period of up to 1 year. The bank group which will gain least is:
05 The bank group which is depending most on over 3 years' borrowing is:
Answers: 1-b 2-c 3-b 4-c 5-b
Page 267
Explanations:
Que-1:Oldprivatebanks carrythelargest%ageborrowingof7%inthisbucket. Hencehighest costincrease. Que-2:Newprivatebankscarrythelargest
%ageborrowingof45% inthisbucket. Hencehighestcostincrease.
Que-3:Oldprivate banks carry thelargest%ageborrowing of 6%in thisbucket. Hence highest cost decrease. Que-4:New private-banks carrythe
smallest %age borrowing—of 51%in thisbucket. Hence lowest cost decline.
Que-5:Oldprivatebankscarry the largest %age borrowingof 13% in this bucket.
Case- 5
Thebank-wisematurityprofileofselectloansandadvancesbanksin%agetermsofselectmaturitybucketsason Mar 31,
2010isasunder:(figuresin %age)
Liability/Asset PSU Old New Foreign
Banks Banks
Deposits 100 100 100 100
Up to 1 year 39 — 42 42 54
Over 1 yr to 37 32 31 18
3years
5 years
Over5years 13 20 15 24
01 There is increase in rate of interest of 0.5% for a period up to 1 year. The bank group which will gain most is:
a)PSUBanks b)OldPrivate Banks
c) New PrivateBanksV Foreign Banks
02 There is increase in rate of interest of 0.5% for a period up to 1 year. The bank group which will gain least is:
c) New PrivateBanksd)Foreign Banks
03 There is decrease in rate of interest of 1.5% for a period of above 1 year to 3 years. The bank group which will lose least is:
04 There is decrease in rate of interest of 1.5% for a period of above 1 year to 3 years. The bank group which will lose most is:
05 If there is upward movement in interest rare scenario for loans, the bank group having
highest %age of loans due for repricing for up to one year term is:
Answers: 1-d 2-a 3-d 4-a 5-d
Explanations:
Que-1: Foreign banks carry the largest %age loans and advances of 54% in this bucket. Hence
highest interestincreaseon loans.
Que-2: PSU banks carry the smallest %age loans and advances of 39% in this bucket. Hence
lowest interestincreaseon loans.
Que-3: Foreign banks carry the smallest %age loans and advances of 18% in this bucket. Hence
lowestinterest decreaseon loans.
Que-4: PSU banks carry the highest %age loans and advances of 37% in this bucket. Hence
highest loss ofinterest.
Que-5: Foreign banks having the largest %age of 54% in this category.
Case- 6
The bank-wise maturity profile of select investments of banks in %age terms of select maturity
buckets as on Mar 31, 2010is asunder:(Figuresin %age)
Liability/Asset PSU OldPvt New Foreign

Banks Banks Pvt Banks
Banks
Investments 100 100 100 100
Up to 1 year 13 14 53 45
Over 1 yr to 3 16 13 42 34
year
Page 268
5 year
Over 5 year 49 64 3 16
01 There is decrease in average yield of 0.75% for up to 1 year maturity. The bank group which will lose most is:
02 There is decrease in average yield of 0.75% for over 5 years maturity. The bank group which will lose least is :
03 --There is increase in average yield of 1.05% for over 5 years maturity. —The bank group which will gain-most is:
04 There is increase in average yield of 1.05% for over 5 years maturity. The bank group which will gain least is:
05 Assume that most of the investment comprise investment in govt. bonds and have negligible investments in shares and
debentures. There is increase in market rate of interest of 1%. The
highest diminution in the value of investment will be faced by in the over 5 year category:
a) • PSU Banks b) Old Private Banks
55. New Private Banks d) Foreign Banks-7
Ans. 1-c 2-c 3-b • 4-c 5-b
Explanations:
Que-1: New private banks have the highest i.e. 53%age of their investment in_ Phis category.
Hence they willloose the most
Que-2:New private banks have the lowest %age of 3% in this category. Hence, their losswill be lowest.
Que-3: Oldprivate banks have the highest %age of 64% inthis category. Hence, they gainmost.
Que-4: New private banks have the lowest %age of 3% in this group. So they gain least.
Que-5: Oldprivatebanks have largest i.e. 64% of their investment inthis category.
Thediminution (decline) in value will behighest in their case.
CASE STUDIES: INTEREST RATE RISK MANAGEMENT
Case- I
International Bank has come out with a policy for its branches for acceptance of deposits and granting
of advances. its branches have taken deposits and allowed loans as under:
01 One of its branches accepted a deposit of Rs.10 lac which is to double in 10 years. These funds have been invested by the
bank in a 3 year bond carrying interest rate of 13%. Which of the following kind of risk the bank is facing:
a) yield curve risk b) embedded option risk
c) basis risk d) reinvestment risk
02 The deposits as well as advance are linked by the bank to floating rate. The bank has been facing: a) real interest
rate risk b) basis risk
0) reinvestment risk d) volatility risk
03 A branch has given a loan out of deposits at floating rate. The rate of interest on deposit has been linked by the bank with 91
days treasury bill rate and for the loan it is linked to 364 days treasury bill rate. The risk from such situation is called"
a) gap or mismatch risk b) interest risk
c) yield curve risk d) basis risk
04 The bank has advised its branches that while sanctioning a term loans, they must put a condition that premature paymentwill
not be accepted in any circumstances. By putting this condition, the bank has avoided which type of interest rate risk?
a) yield curve risk b) Embedded option risk
c) Mismatch risk d) Basis risk
05 The depositors at times, have the tendency to withdraw the deposits before maturity, which leads to
a) yield curve risk b) embedded option risk
c) basis risk d) reinvestment risk
Ans. 1-d 2-b 3-c 4-b 5-b
Explanations:
Que-1: The bank has accepted a deposit with a maturity of 10 years, but the investment has to be rolled over after 3 year and will
pose the reinvestment risk.
Que-2: Where the interest rate of different assets and liabilities may change in different magnitudes such interest rate risk, is
called basis risk.
Que-3: Where the interest rates on deposit and advance can vary and not necessarily identically, the yield curve risk arises.
Que-4: Embedded option risk is the risk associated with the right given to the borrower to pre-pay their loans or right given to
their depositors, to withdraw the deposit before maturity.
Que-5: Embedded option risk is the risk associated with the right given to the borrower to pre-pay their loans or right given to
their depositors, to withdraw the deposit before maturity.
Case 2
Page 269
Mumbai branch of Popular Bank granted term loan of Rs. 2 cr to a reputed corporate client for 6 years at 2% + Base rate. Presently,
the base rate of the bank is 10%. The loan will be repaid by the company in 20 equal quarterly installments with a moratorium
period of 6 months. The loan has been funded by the bank out of fixed deposit @ 7% fixed rate of interest, of equal amount, with a
maturity period of 4 years. The CRR and SLR are to be ignored fbr the purpose of any calculations.
01 In this case, the loan is carrying floating rate and deposit is carrying fixed rate. If rate of interest is reduced during the first 4
years i.e. during the period of FDR, what type of risk, the bank is exposed to:
a) Funding risk b) Embedded option risk c) Basis risk • d) Gap or mismatch
02 The rate of interest at the and of 4 years on loan and on the fresh deposit to be raised for funding this loan can be different.
This is called:
a) Reinvestment risk b) Embedded option risk c) Basis risk d) Gap or mismatch
03 With quarterly repayment of the loan, the repayment amount have to be deployed by the bank elsewhere and the rate of
interest may not be at par with the interest being charged on the loan. Due to this, the bank is exposed to:
04 There is a possibility that the company may pre-pay the loan or the depositor may withdraw the deposit pre-maturely. Due
to this, the bank is exposed to:.
05 Which of the following other risk is not associated with this transaction:
a) Liquidity risk b) Market risk Credit risk d) Operational risk
Answers: 1-c 2-d 3-a 4-b 5-b
56. Explanations:If change in interest rate is of different magnitude, for an asset and its funding liability, such risk is called
basis risk.
57. The gap or mismatch risk arises when cost of funding does not match the return on funds and bank finds
it difficult to fund the investment gainfully.
58. Reinvestment risk is the risk on account of lack of opportunities to invest the funds at the acceptable rate
of return.
59. Embedded risk represents a situation where the counter party is given the option to terminate the
transaction before the fixed price of the contract.
60. Market risk is associated with the trading book items. Hence market risk is not associated with this
transaction. Other risks are possible.
Case -3
Basic Principles
If Rate sensitive assets are more than Rate sensitive liabilities, there is a positive gap and if Rate Senstivie liabilities are more
than Rate sensitive assets, there is negative gap.
If there is negative gap Nll increases if there is decline in interest rate and if there is positive gap, Nil increases if there is increase in
interest rates. $t
The international Bank, provides following data regarding rate sensitive assets and liabilities of the bank as on 31 Mar 2010.
Time of buckets Assets Liability Gap Cumulative
gap
1-28 days 800 1000 -200 -200
29 days to 3 months 650 550 100 -100
3-6months 2700 3150 -450 -550
6-12 months 450 600 -150 -700
1-3 years 150 300 -150 -850
3-5 years 450 200 250 -600
Over 5 years— 1000 200 800 200
Non-sensitive 300 500 -200 0
Total 6500 6500 0
Using the details given above, answer the following questions.
01 if interest rate falls by 25 bps, in the first time bucket, the likely impact on the NII for the bank shall be :
a) +15.50 cr b) +0.50 cr
61. Overall impact will be nil
62. +0.05 or
02 In terms of extant RBI guidelines on ALM, the maximum non-sensitive assets, a bank can have in percentage to total assets
is.
a) 25% b) 10%
63. no such restriction by RBI
64. 20%—03ThetotalratesensitiveassetsforthebanksisRs.
a) 6500 b) 6200
c) 6300 d) 6000
04 In rising interest scenario, the bank will have a impact of interest rate changes on NU:
a) favourable b) adverse
c) insufficient input d) neutral
Ans. 1-b 2-c 3-b 4-a
Page 270
Explanation:
Que-1: 200 x 0.25% = 0.50 cr i.e. gain of 0.5 crore. When gap is negative bank gains when interest rate
goes down
Que-2: There is no such ceiling prescription of RBI.
Que-3: 6500--300 = 6200
Que-4: Rate sensitive 6200 and liabilities 6000. Bank is asset sensitive. Hence in a rising scenario, the bank
gains and in declining, the bank loses.
Case-4
The International Bank, provides following data regarding rate sensitive assets and liabilities of the bank as on 31st Mar 2010.
The Nil spread in percentage terms for the bank is 2.00%
Time of buckets Assets Liability Gap Cumulative
gap
1-28 days 2100 2400 -300 - -300
29 days to 3 months 2400 2200 200 -100
3-6 months 3100 3700 -600 -700
6-12 months 1200 1400 , -200 -900
1-3 years 300 500 -200 -1100
, 800 300 500 -600
Over 5 years 900 100 800 200
Non-sensitive 800 1000 -200 0
Total 11600 11600 0
01 If interest rate falls by 30 bps, in the time bucket (3-6 months), the likely impact on the Nil for the bank
shallbe :
a) +18.00 cr b) +9.00 cr
c) -18.00 cr d) +1.80 cr
02 In terms of extant RBI guidelines on ALM, the maximum non-sensitive assets, a bank can have in percentage to total assets is.
a) 15% b) 5%
c) 1% d) no such restriction by RBI
03 The total rate sensitive assets for the banks is Rs.
a) 11600 b) 11300
c) 11100 d) 10800
04 The declining interest scenario, the bank will have a impact of interest rate changes on Nil:
a) favourable b) adverse
c) insufficient input d) neutral
Ans. 1-d 2-d 3-d 4-b
Explanation:
Que-1:600x0.30%=1.80cr
Que-2: Thereis no such restriction imposed by RBI.
Que-3:11600-800=10800
Que-4: Rate sensitive 10800 and liabilities 10600. Bank is-asset sensitive. Hence in a rising scenario, the bank
gains andin declining, thebankloses.
Case-5
International Bank has thefollowing re-pricing assets andliabilities:
Call money - Rs. 300 cr
Cash credit loans — Rs. 240 a
Cash in hand — Rs. 200 cr
Saving Bank — Rs. 300 cr
Fixed Deposits — Rs. 300 cr
Current deposits — Rs. 250 a
On the basis of aboveinformation, answer the following questions:
01 What is the adjusted gap in re-pricing assets and liabilities:
a) Rs. 540 cr b) Rs. 600 cr
c) Rs. 60 cr negative d) Rs. 60 cr positive
02 What is the change in net interest income, if interest falls by 2% points across the board i.e. for all assets and liabilities:
65. Improves byRs. 1.20 cr
66. DeclinesbyRs.1.20cr
67. Changes by Rs. 1 cr
68. Thereisnochange
03 if the interest rates on assets and liabilities increase by 2%, what is the change in net interest income:
Improves by Rs. 120 cr
69. Declines by Rs. 1.20 cr
70. Change by Rs. 1 cr
Page 271
71. There is no change
04Ifinterestratefallsoncallmoneyby1%,oncashcreditby0.6%,onsavingbankby0.2%andonFDby1%,whatIschangeinnetinterestincome:
Improvesby Rs. 0/2 cr
Declines by Rs. 0.82 cr
Declines by Rs. 0.84 cr
DeclinesbyRs.0.96 cr
05Ifinterestrateincreasesoncallmoneyby0.5%,oncashcreditby1%,onsavingbankby0.1%andonFDby0.8%,whatischangeinnetinterestincome:
Improvesby Rs. t05 cr
Answers:1-c2-a3-b4-c5d
Explanations:
Que-1: (SB+FD) - (Call money +CC) = (300+300) — (300+240) = Rs. 60 cr (assets are less than liabilities Hence negative gap). The cash in hand
and current account deposits are not subject to re-pricing as these are not interest bearing, hence these have been ignored.
Que-2: There is negative gap (interest bearing liabilities more) of Rs. 60 cr [(300+300) — (300+240)1, which means the interest
cost declines @2% on this negative gap, which leads to increase in Nil. Hence it is Rs. 60 cr x 2% = Rs. 1.20 cr.
Que-3: There is negative gap of Rs. 60 cr [(300+300) — (300+240)1, which means that the interest cost increases @2% on this
negative gap which leads to decline in Nil. Hence it is Rs. 60 cr x 2% = Rs. 1.20
Cr.
Que-4: Fall in interest income in case of assets = (Call -300 x 1% = 3 cr) + (Cash credit -240 x 0.6% = 1.44) = Rs. 4.44cr.
Fall in interest expenses in case of liabilities(SB -300 x0.2 = 0.60 cr) + (300 xl% = 3.00 cr) = 3.60cr Net fall in interest
income = 4.44 er — 3.60 cr = 0.84 cr
Que-5: Increase in interest amount in case of assets = (Call -300 x 0.5% = 1.50 cr) + (Cash credit -240 x 1% =2.40) = Rs. 3.90 cr.
Increase in interest amount in case of liabilities (SB -300 x 0.1 = 0.30 cr) + (300 x 0.8% = 2.40 cr) = 2.70 cr
Net improvement = 3.90 cr — 2.70 cr = 1.20 cr.
Case- 6
International Bank has the following re-pricing assets and liabilities:
Call money - Rs. 500 cr
Cash credit loans — Rs. 400 cr
Cash inhand — Rs. 100 cr
Saving Bank — Rs:500 a
Fixed Deposits — Rs. 500 a
Current deposits — Rs. 200 cr
Thereisreductioninrateofinterestby0.5%incallrates,1%forcashcredit,0.1%forsavingbankand0.8%forFD.
Onthebasisofaboveinformation,answerthefollowingquestions:
01 What is the adjusted gap in re-pricing assets and liabilities: a) Rs. 200 cr positive b)
Rs. 200 a negative c) Rs. 100 cr positive d) Rs. 100 cr negative
02Takingintoaccount,thechangeininterestrate,calculatetheamountofre-pricingassetsasperthestandardgapmethodinre-pricingassetsandliabilities:
a) Rs. 700 a b) Rs. -650 cr —
c) Rs. 600 cr d) Inadequate information
03Takingintoaccount,thechangeininterestrate,calculatetheamountofrepricingliabilitiesasperthestandardgapmethodinrepricingassetsandliabilities:
a) Rs. 450 cr b) Rs. 400 cr
c) Rs. 300 cr d) Insufficient information
04Whatisthestandardgapofthebankinrepricingassetsandliabilities:
a)Rs.150 crnegativeb)Rs. 175crpositive
72. Rs. 200 cr positived) Rs. 250
cr negative 01:d 02:b 03:a 04:c
Explanations:
Que-1:Adjustedgap=(Callmoney+CC)--(SB-r-FD)=(500+400)—(500+500)=(-)Rs.100cr(assetsare
less than liabilities — Hence negative gap). The cash inhand and current account
deposits are not subjecttore-pricing,hencethesehavebeenignored.
Que-2:Callmoney500x0.5=Its.250cr+Cashcredit400x1=400cr;Total=650cr
Que-3:SB500x0.1=50cr+FD500x0.8=400cr;Total=450cr
Que-4:Assets—Callmoney500x0.5=250cr+Cashcredit400x1=400crTotal=650Cr
Liabilities—SB500x0.1=50cr+FD500x0.8=400crTotal=450cr Netchange=650-
450=Rs.200crpositive
Case-7
InternationalBankraisedfundsbywayof91daystermdepositat6%rateofinterest.Ithasfollowingoptionstoinvestthesefunds:
73. 91daystreasurybills@8%
Page 272
74. 91daysfloatingrateloan@8%withmonthlyre-pricing
(c) 3 years term loan @ 8%
If bank makes investment in 91 days treasury bills @ 8% and during the 91 days period, there is 1% increase in interest rate,
what will be change in the net interest income, on reinvestment after 91 days?
a) 1% b) 0.5%
75. Nochange
76. Inadequateinformation to take decision
02 If bank invests the funds in 91 days floating rate loan @ 8% with monthly repricing and there is interest rate rise, what will be
impact on net interest income of the bank:
a) NIT will increase b) NII will decrease
c) No change in NII d) Information is inadequate
03 If bank invests the funds in 91 days floating rate loan @ 8% with monthly repricing and there is interest rate fall, what will be
impact on net interest income of the bank:
04 If bank invests these funds in a 3 years term loan @ 8%, what will be impact on net interest income of the bank, if there is
increase in interest rates:
a) NII will increase b) NII will decrease
05 If bank invests these funds in a 3 years term loan @ 8%, what will be impact on net interest income of the bank, if there is fall
in interest rates:
c) No change in NH d) Information is inadequate
Answers: 1-c 2-a 3-b 4-b . 5-a
Que-1: Existing cost of deposit = 6% Existing interest on loans = 8%. NII = 8-6 = 2%
New cost of deposit= 6+1= 7%. New return ontreasurybills = 8+1 =9%. NII
=9-7= 2% Hence no change in NII. It will continue to be 2%.
Que-2: Bank is asset sensitive because change in rate of interest on loan will take place twice in 91 days period due to monthly
repricing of the loanwhile the deposit rate will not change during this period. Hence if interest rate increases, the interest
income will increase and the NII will increase.
Que-3: Bank is asset sensitive because change in rate of interest on loan will take place twice in 91 days period due to monthly repricing of the loanwhile
the deposit ratewillnot changeduringthis period. Hence ifinterest ratefalls, theinterestincomewilldecline and the NIIwilldecline.
Que-4: Bank is liability sensitive because change in rate of interest on deposit will take place after each period of 91 days, as deposits have
to be rolledover. On the other hand, the interest on loan will not change during this period. Hence if interest rate increases, the
cost of deposits to the bankwillincreaseand therewill beno changeininterestincome. Hence NIT willdecrease.
Que-5: Bank is liability sensitive because change in rate of interest on deposit will take place after each period of 91 days, as deposits have
to be rolledover. On the other hand, the interest on loan will norchange during this period. Hence if interest rate falls, the cost of
deposits to the bank will decrease and there will be no change in interest income. Hence NII will increase.
Case —8
InternationalBankraisedfundsbywayof182daystermdepositat7% rateofinterest.Ithasfollowingoptionstoinvestthesefunds:
(a) 182 days treasurybills @ 9%
(b)182dayscommercialpaperatfloatingrateof @9% withmonthlyre-pricing7(C)3yearstermloan.@9%
01 If bank makes investment in 182 days treasury bills @ 9% and during the 182 days period, there is 1% increase in interest rate,
what will be change in the net interest income, on reinvestment after 182 days?
a) 2% b) 1% c) 0,5% d) No change
02 If bank invests the funds in 182 days floating rate commercial paper @ 9% with monthly repricing and there is interest rate rise,
what will be impact on net interest income of the bank:
a) NIT will increase b) NH will decrease
03 If bank invests the funds in 182 days. floating rate commercial paper @ 9% with monthly repricing and there is interest rate fall,
what will be impact on net interest income of the bank:
a) Nil will increase b) NII will decrease
c) No change in NH d) Information is inadequate
04 If bank invests these funds in a 3 years term loan @ 90/0, what will be impact on net interest . income of the bank, if there is
increase in interest rates:
05 If bank invests these funds in a 3 years term loan @ 9%, what will be impact on net interest income of the bank, if there is fall in
interest rates:
Page 273
Answers: 1-d 2-a 3-b 4-b 5-a
Explanations:
Que-1: Existing cost of deposit = 7% Existing interest on loans = 9%. NII = 9-7 = 2%
Newcostofdeposit=7+1=8%. Newreturn ontreasurybills=9+1= 10%. NII=10-8 =2% Hencenochangein
NII.Itwillcontinuetobe 2%.
Que-2:Bank is asset sensitive because change in rate of interest on loan will takeplace five times during 182 days period due to
monthlyrepricingofthe commercial paper while the deposit rate will not change duringthis period. Hence if interest rate
increases, the interest incomewill increase and the NIX will increase.
Que-3: Bank is asset sensitive because change in rate of interest on loan will take place 5 times during the 91 days period due to
monthly repricing ofthe commercial paper while the deposit rate will not change during this period. Hence if interest rate
falls, the interest income will decline andthe NIT will decline.
Que-4: Bank is liability sensitive because change in rate of interest on deposit will take place after each period of 182 days, as
deposits have to berolled over during this period to fund the loan. On the other hand, the interest on loan will-not
change during this period. Hence if interest rate increases, the cost of deposits to the bank will increase and there will
be no change in interest income. Hence NIT will decrease.
Que-5: Bank is liability sensitive because change in rate of interest on deposit will take place after each period of 182 days, as deposits
have to be rolledover. On the other hand, the interest on loan will not change during this period. Henceif interest rate fall, the
cost of deposits to the bank will decreaseand there will beno change in interestincome. Hence NII willincrease.
Case 9
77.X purchased 20000shares at Rs. 50per share (total amount Rs 10 lac) with his own capital plus borrowingfrom market (his
borrowing limit being 9 times ofhis capital. Hence ratio =1:9).in afew days,thereis 2% declineinthevalueof shares, which reduced
thevalueof his portfolio to Rs. 980000and alsotheamount of hiscapitalby Rs.20000 (leaving capital of Rs. 80000).
78. In the light of reduction in capital of Rs. 80000, he is required to liquidate the holding by Rs. 2 lac (10 times of reduced capital) to pay
the excessive borrowing (due to reduced capital). But the market expects further fail in the value of this stock due to which the
investment has become illiquid. In such circumstances, he can liquidate the holding at a loss only, which will further deplete his capital,
which would force him for further liquidation of his holding for keeping the borrowingin permissiblelimit of 9times of capital.
79.In case the liquidity position of the market suffers, it will further drivethe share price down, which would result in losses.
On the basis of this information, answer the following questions?
80. The risk of adverse movement In the price of shares has reduced the capital. This is called:
a) Price risk b)_Asset liquidity risk
c) Market liquidity risk d) Liquidation risk
02 For a specific security, as in the above case, when the liquidity in the market is reduced, it is called:
a) Price risk . b) Asset liquidity risk
03 In case the liquidity position of the market suffers, it will further drive the share price down, which would result in losses.
This is called:
a) Price risk b) Asset liquidity risk
Answers: 2-b 3-c
Explanations:
81.The riskof adyerse movement in the price is calledprice risk
82.The risk of reduced liquidity in the market for a specific security is called asset liquidity risk
83.In case the liquidity position of the market suffers, it will further drive the share price down, which would result in losses. This
is called market liquidityrisk.
CASE STUDIES ON VOLATILITY, BPV, DURATION, VaR
Basic Principles
Steps for calculating Mean, Variance, Volatility
84. Divide total of observations with number of observations. This will give mean.
85. For calculating variance, for each observation deviation is calculated from mean. Then square of each deviation is
calculated. The sum of squared deviation is divided by number of observations. This will give variance.
86. The volatility is square root of variance. It is also called Standard Deviation
87. Lower the Standard Deviation to Mean ratio lower the risk_
88. The risk associated with a portfolio is lesser than risk associated with individual components of portfolio.
Case—1
You have the following information available regarding closing stock price movement of share price of ABC Limited for 12
months period ended December 2009:
On the basis of above information answer the following questions:
Month Closing Month Closing Month Closing
Price Price Price
Page 274
Jan 20 May 24 Sept. 76
Feb 22 Jun 34 Oct. 90
Mar 38 July 46 Nov. 42
April 20 Aug 82 Dec 102
01 What is the mean price (average price) of this stock for the observation period?
a) Rs.51'.37 b) Rs.53.17
c) Rs.55.79 d) Rs.56.22
02 Thevarianceof the selected data (for 12 months) will be approximately....
a) 974.15 b) 986.12
c) 997.16
89. inadequate information tocalculate
03 The volatility (i.e. standard deviation) of this stock for these 12 months period is:
a) 34.67 b) 33.41
c) 32.39 d) 31.21
Ans. 1-b 2-a 3-d
Explanations: -
Que-1: The average comes to Rs.53.17 (total of all values/12) = 638/12= 53.17
Que-2: For calculating variance, for each observation deviation is calculated from mean. Then square of
each deviation is calculated. The sum of squared deviation is divided by number of observations.
This will give variance.
Que-3: The volatility is square root of variance.
Case 2
The stock price of lnfosys Limited has shown the following closing prices at the end of each
month for the year ended December 2009:
Month Closing Month Closing Month Closing
price - price .price
January 265 May 345 Sept 512
February 276 June 267 October 324
March 390 July 415 Nov 285
April 312 August 421 December 302
Onthebas's of aboveinformation answer thefollowing questions.
01 What is the mean price (average price) of this stock for the observation period?
a) Rs.342.83 b) Rs.351.22 .
c) Rs.355.84 d) Rs.356.29
02 The variance of the selected data (for 12 months) will be approximately ......................
a) 5431.09 b) 5587.78
c) 5743.56 d) 5887.06
03 The volatility (i.e. standard deviation) of this stock for these 12 months period is :
a) 74.54 b) 76.73
c) 82.93 d) 91.52
Ans.1-a2-d3-b
xplanations:
Que-1:TheaveragecomestoRs.342.83(totalofallvalues/12)=4114/12= 342.83
Que-2: For calculating variance, for each observation deviation is calculated from mean. Then
square of each deviation is calculated. The sum of squared deviation is divided by number of
observations. This will give variance..
Que-3: The volatilityis squareroot ofvariance.
Case-3
International Bank analyzed the Operating Profits of 5 regions for last 5 years. The Standard Deviation and Standard Deviation to
Mean for the 5 Years are gwen in the following table.
Name of Year Year Year Year Year Total Mean Standard S.D.
Zones 1 2 3 4 5 (average) Deviation To
(S.D) Mean
Jaipur 10 3 4 8 11 36 7.20 3.56 0.46
Chandigarh 3 8 1 6 4 22 4.40 2.70 0.61
Bangalore 12 8 9 2 4 35 7.00 4.00 0.57
Lucknow 6 9 2 3 5 25 5.00 2.74 0.55
Patna 7 12 5 8 6 38 7.60 2.70 0.36
Total of 38 40 21 27 30 156 31.20 7.85

Zones
From the above data, answer the following questions assuming that the bank's credit exposure is at equal levels for each zone:
01 From business risk point of view, the performance of the zone which is subjected to maximum risk exposure appears to be
a) Jaipur b) Patna
c) Chandigarh d) Lucknow
Page 275
02 From business risk point of view, the performance of the zone which is subjected least risk exposure appears to be
a) Bangalore b) Patna
c) -Chandigarh d) Lucknow
03 The ratio of Standard Deviation to Mean for all zones put together for ABC Bank Limited is
a) 7.85 b) 31.20
c) 0.516 d) 0.25
04 The Zones having wide variance of results from year to year is .
a) Jaipur b) Lucknow
c) Chandigarh d) Bangalore
Ans. 1-c 2-b 3-d 4-d
Explanations:
Que-1: The zone having highest standard deviation to mean ratio, is exposed to more risk, compared to
otherzones.
Que-2: The zone having lowest standard deviation to mean ratio, is exposed to least risk, compared to
other zones.
Que-3: SD/Mean = 7.85131.20 = 0.25
Que-4: The variation range for this zone is highest. The lowest was 2 in 4th year and highest was 12 in
the lst year.
Case - 4
Mumbai branch of Popular Bank has following cash flow from its loan portfolio from different segments:
Year1 Year2 Year3 Total Mean Standard SD/ deviation Mean
Corporate 40 31 36 107 35.66667 4.50925 0.1264

MSE 20 28 19 67 22.33333 4.932883 0.2209
.
Retail 15 17 17 49 16.33333 1.154701 0.0707
Personal 5 8 6 19 6.333333 1.527525 0.2415
Total 80 84 78 242 80.66667 3.05505 0.0379
01 The risk associated-with cash flow in case of corporate business segment (measured by way of ratio of standard deviation
tomean) is:
a) 35.66% b) 4.50%
c) 12.64% d) 3.79%
02 The highest risk in all the 4 segments of business, in the above case in terms of cash flows, is in case of: a)
Corporatebusiness b) MSE business
c) Retail business d) Personal business
03 The lowest risk in all the 4 segments of business, in the above case in terms of cash flows is in case of a)
Corporatebusiness b) MSE business
c) Retail business d) Personal business
04 The variation in net cash flows arising out of all the business line is:
a) Unidirectional b) Not unidirectional
90. Veryvolatile
91. Adequate information is not available
05 The overall risk, to the portfolio at the branch is and the variation in different segments ranges
between :
92. 3.79%, 3.79%to24.12%
93. 3.79%, 7.07%to24.12%
94. 7.07%, 7.07%to24.12%
95. 7.07%, 3.79%to24.12%
A nswer s: 1- c 2- d 3- c 4- b 5- b E x pl ana tio ns:
96. The ratio of standard deviation to mean is 0.1264 or 12.64% in case of corporate business in the above case.
97. The highest variation of 0.2412 or 24.12% is in respect of personal business and the lowest in case of retail segment
where it is 7.07% only. For the overall portfolio this is 3.79% only.
98. The highest variation of 0.2412 or 24.12% is in respect of personal business and the lowest in case of retail segment
where it is 7.07% only. For the overall portfolio this is 3.79% only.
99. The net cash flows are not unidirectional because in case of retail., these are regularly increasing. In case of MSE segment,
the variation is quite wide. So is the position with corporate segment.
100. From the given information, it is observed that for the overall portfolio the risk is 3.79% and the range is 7.07% to 24.12%
Case - 5
International Bank analyzed and Operating Prof ts of 5 regions for last 5 years. The Standard Deviation and Standard Deviation to
Mean for the 5 years are green in the following table.
Page 276
Name of ' Year Year Year Year Year Total Mean Standard S.D.
Zones 1 2 3 4 5 (average) Deviation To
(S.D) Mean_,
Jaipur 16 21 18 20 24 99 19.8 3.03 0.15
Chandigarh 9 19 5 12 5 50 10.0 5.83 0.58
Bangalore 13 15 17 18 19 82 16.4 2.41 0.15
Lucknow 16 14• 13 16 14 73 14.6 1.34 0.09
Patna 12 21 19 12 17 81 16.2 4.09 0.25
Total of 66 90 72 78 69 385 77.0 8.94

Zones
From the above data, answer the following questions assuming that the bank's cred t exposure is -at equal levels for each zone:
a) Jaipur b) Patna
02 From business risk point of view, the performance of the zone which is subjected least risk exposure appears to be
a) Bangalore b) Patna
03 The ratio of Standard Deviation to Mean for all zones put together for ABC Bank Limited is
a) 8.94 b) 77.0
c) 0.32 d) 0.12
04 The Zones having wide variance of results from year to year is
a) Jaipur b) Lucknow
c) Chandigarh d) Bangalore
Ans. 1-c 2-d 3-d 4-d
Explanations:
Que-1: The zone having highest standard deviation to mean ratio, is exposed to more risk, compared to
other zones.
Que-2: The zone having lowest standard deviation to mean ratio, is exposed to least risk, compared to
other zones.
Que-3: SD/Mean = 8.94/77.00 = 0.12
Que-4: The variation range for this zone is highest. The lowest was 5 in 3n1 year and highest was 19 in
the 2nd year.
Case- 6
International Bank an investment in bonds as under, on Sept 30, 2009:
Face Yield % Price Cost
value (Rs.) (Rs.)
Rs.
7% Gol 100000 7.12 108.40 108400
Bond 2016
9% Gol 100000 7.34 124.00 124000
Loan 2018
Due to change in yield of these securities, the yield and price changed as under as on Mar 31, 2010:
7% Gol 100000 7.32 105.80 105800
Bond 2016
9% Gal 100000 7.65 120.50 120500
Loan 2018
On the basis of above information, answer the following questions:
01 What is change in basis point value for each basis point increase in yield for 7% Gol bonds during this period?
a) 14.5 paise b) 13.1 paise c) 12.5 paise d) 12.34 paise
02 What is the change in basis point value for each basis point increase in yield for 9% Gal bonds during this period?
a) 10.02 paise b) 11 paise c) 11.29 paise d) 11.90 paise
03 If there is increase in yield by 100 basis points during this period, what will be the price of 7% Gal bonds.
a) Rs.95.20 b) Rs.93.90 c) Rs.92.10 d) no change will take place
04 If there is increase in yield by 100 basis points during this period, what will be the price of 9% Gal bonds.
----
a) Rs.112.71 b) Rs.111.96 c) Rs.111.12 d) Rs.110.87
05 The bank decides to sell the 7% Gol bonds on Mar 31, 2010 itself, to stop the loss. How much it will lose on this sale
transaction?
a) Rs.1210 b) Rs.1670 c) Rs.2400 d) Rs.2600
06 The bank decides to sell the 9% Gol bonds on Mar 31, 2010 itself, to stop the loss. How much it will lose on this sale
transaction?
a) Rs.3500 b) Rs.3100 c) Rs.2800 d) Rs.2600
Ans. 1-a 2-c 3-b 4-a 5-d 6-a
Page 277
Explanations:
Que-1: (108.40-105.80)/ (7.32-7.12) = Rs.2.90/20 = 14.5 paise
Que-2: (124-120.50)/(7.65-7.34)= Rs.3.50/31 = 11.29 paise
Que-3: Change for one basis points = (108.40-105.80)1(7.32-7.12) = Rs.2.90/20 = 14.5 paise. Change for
100 basis points = 14.5p x 100 = Rs.14.50. Hence value after change = 108.40 -14.50 = Rs.93.90
Que-4: Change for one basis points = (124-120.50) /(7.65-7.34)= Rs.3.50/31= 11.29 paise. Change
for 100 basis points = 11.29 x100 = Rs.11.29. Hence changed value = 12.40-11.29 = Rs.112.71
Que-5: 108400 -105800 = 2600
Que-6: 124000-120500 = 3500
Case - 7
International bank an investment in bonds as under, on Seat 30.2009:
Face . Yield % Price Cost
value (Rs.) (Rs.)
Rs.
9% Gol 200000- -8.40 107.60 215200
Bond 2016
11%' Go! 200000 8:80 110.50 221000
Loan 2018
Due to change in yield of these securities, the yield and price changed as under as on Mar 31, 2010:
9% Gol 200000 8.20 109.80 219600
Bond 2016
11% Gol 200000 8.60 113.30 226600
Loan 2018
01 What is change in basis paint value for each basis point increase in yield for 9% Gal bonds during this period?
a) 12 paise b) 11 paise
c) 10 paise d) no change
02 What is the change in basis point value for each basis point increase in yield for 11% Gal bonds during this period?
a) 12 paise b) 13 paise
e) 14 paise d) no change
03 If there is increase in yield by 100 basis points during this period, what will be the price of 9% Gol bonds.
a) Rs.118.60 b) Rs.116.90
c) Rs.114.80 d) no change
04 If there is decrease in yield by 100 basis points during this period, what will be the price of 11% Gol bonds.
a) Rs.105.20 b) Rs.109.90
c) Rs.119.10 d) Rs.124.50
05 Due to expected adverse change, the bank decides to sell the 9% Gol bonds on Mar 31, 2010 itself, to make the profit.
How much profit it will be able to make on this sale?
a) Rs.4200 b) Rs.4000
c) Rs.3800 d) Rs.3750
06 Due to expected adverse change, the bank decides to sell the 11% Gol bonds on Mar 31, 2010 itself, to make the profit How
much profit it will be able to make on this sale?
a) Rs.4210 b) Rs.4670 c) Rs.5400 d) Rs.5600
Ans. 1-b 2-c 3-a 4-d 5-a 6-d
Explanations:
Que-1: (109.80-107.60)/ (8.40-8_20) = Rs.2.20/20 = 11 paise
Que-2: (113.30-110.50)/(8.80-8.60)= Rs.2.80/20 = 14 paise
Que-3: Change for one basis points = (109.80-107.60)1(8.40-8.20) = Rs.2.20/20 = 11 paise. Change for
100 basis points = 11 x 100 = Rs.11.00. Hence value after change = 107.60+ 11.00 = Rs.118.60
Que-4: Change for one basis points = (113.30-110.50) /(8.80-8.60)= Rs.2.80/20=14 paise. Change for
100 basis points = 14 x100 = Rs.14.00. Hence changed value = 110.50-14.00 = Rs.124.50
Que-5: 219600—215200 = 4200
Que-6: 226600-221000 = 5600
C ase 8
Popular Bank made an investment in govt. bonds worth Rs. 5 cr. The maturity period of the bonds is 5 years, the face value is Rs.
100 and the coupon rate is 8%. The bond has a market yield of 10% and the price is Rs. 92.00. Due to change in interest rates, the
market yield changes to 9.90% and the market value to Rs. 92,50.
01 Based on the above information, please calculate the basis point value of the bond:
a) 0.02 b) 0.05 c) 0.10 d) 0.20
02 What will be the change in value of investment, for the total investment of Rs. 5 cr for per basis point in the yield:
a) Rs. 25000 b) Rs. 20000 c) Rs. 15000 d) Rs. 10000
03 If there is 0.10% change in the yield, what will be change in the value of the bond on an investment of Rs. 5 cr:
a) 100000 6) 200000 c) 250000 d) 500000
Answers: 1-b 2-a 3-c Explanations:
Page 278
101. Change in price of bond = 0.50. Change in yield 10 basis points. Per basis
point change = 0.50/.10 = Rs. 0,05
102. Change in price of bond = 0.50. Change in yield 10 basis points. Per basis point
change = 0.50/.10 = Rs. 0.05 OR Per Rs. 1 Cr = Rs. 5000
103. Change in price of bond = 0.50. Change in yield 10 basis points.
Per basis point change = 0.50/.10 = Rs. 0.05 OR Per Rs. 1 cr = Rs. 5000
For total investment the change per basis point is = 50000000 x 0.05 = 25000
If per basis point change, the value change is Rs. 25000, for 10 points it will be 25000 x 10 = 250000
Case 9
Popular Bank want to invest Rs. 1 lac. It has option to make investment in the following two securities. The cted return is also
iven:
Cashflow Year1 Year2 Year 3 Year4 Year5 Total
Investment1 8000 8000 8000 8000 8000 40000
Investment2 5000 7000 14000 6000 12000 44000
01 If time value of money is not taken into account, the rate of return on these investments is:
a) 8% and 8% b) 8% and 8.5%
c) 8% and 8.8% d) 8.5% and 8.8%
02Out of these 2investment, which one would be more preferablefor the bank:
104. Investment1becauseitprovidesstablereturn
105. Investment 2becauseitprovideshigherreturn
106. Investment1or2atjudgementofthebankbasedonrisk
107. Inadequateinformationisgiven. Decisionnotpossible
03Ifreturnfromboth theinvestmentsistaken asequaltakingintoaccounttheriskassociatedwithvolatility,whatistheriskadjusted rate
ofreturnandwhatistheriskpremium:
a) 8.8%,8% b) 8%, 8.8% e) 8.8%, 0.8% d) 8, 0.8%
Answers: 1-c 2-a 3-d Explanations:
108. Investment1=Averagereturn=40000/5=8000.Rateofreturn8000/1lac=8%
Investment2=Averagereturn=44000/5=8800.Rateofreturn8000/1lac=8.8%
109. Investment 1 providesstable return which is riskfree, while Investment2provides
volatilereturn, whichis risk prone. Hence, overallinvestment 1 is better.
110. Thegapofreturnwillbetheriskpremiumi.e.8.8%-8%=0.8%.Theriskadjustedrateofreturnwill
be8%.
Case -10
The dealer at Popular Bankpurchased 5000shares of a public sector undertaking at Rs. 200per shares totaling Rs. 10,00,000. Ifthe
price change is 1%, therewill beimpact of Rs. 10000. Theprice change can goupto4%. That may resultinto aloss of Rs. 93040.
03. In this transaction, the stock price is known as:
a) Market factor b) Market factor sensitivity c) Volatility d) Defeasance period
02 What is the market factor sensitivity:
a) 5000 shares b) Rs. 200 per shares c) Rs. 10 lac d) Rs. 10000
03 The price change can go up to 4%. This means the daily _______________ is 4%:
a) Defeasance factor b) Market factor c) Volatility d) Value at risk
04 The defeasance period in this transaction is:
a) One day b) 2 days c) 4 days d) 7 days
05 What is the value at risk (VaR) in this transaction:
a) Rs. 93040 b) Rs. 100000 c) Rs. 105900 d) Rs. 120000
Answers: 1-a 2-d 3-c 4-a 5-a Explanations:
111. Thestockpriceisknownasmarketfactor.
112. Rs. 10000is themarketfactor sensitivity as with1% change, the effectwouldbe Rs. 10000.
113. This is called volatilityi.e.dailyfluctuation.
114. Thedefeasanceperiodrepresentsthedailyfluctuationperiod.
Case - 11
The VaR of a Govt. of Indiabond securityis 0.70%. The current yield is 8.10%.
01 In the worst case scenario, the prospective:
115. buyerofthesecuritycan expect,theyieldtofallto7.40% bynextday
116. buyerofthesecuritycan expect,theyieldtoriseto8.80%bynextday
117. sellerofthesecuritycan expect,theyieldtofallto7.40%bynextday
118. Noneoftheabove
02 In the worst case scenario, the prospective:
119. seller of the securitycan expect, theyield tofall to 7.40% by next day
120. buyer of the security can expect, the yield to rise to 8.80% by next day
Page 279
121. seller of the securitycan expect, theyield torise to 8.80% by next day
122. None of the above
03 In the above case, the VaR at 95% confidence means:
123. There is 5% possibility for theyield tobe higher than 0.70%
124. There is 1% possibility for theyield tobe lower than0.70%
125. Thereis 5% possibility of adverse change beinghigher than 0.70%
126. Inadequate information to draw any conclusion Answers: 1-a
2-c 3-c Explanations:
127. VaRof0.70% meansthatthemaximumchangeintheyieldcanbe0.70%.Henceinaworstcase
scenario, thebuyerofthesecuritycan expect,theyieldtofallto7.40%(8.10 —0.70%)bynextdayand the sellercan
expecttheyieldtoriseto8.80% (8.10 +0.70%).
128. VaRof0.70% meansthatthemaximumchangeintheyieldcanbe0.70%.Henceinaworstcase
scenario, thebuyerofthesecuritycan expect,theyieldtofallto7.40%(8.10 —0.70%)bynextdayand the sellercan
expecttheyieldtoriseto8.80% (8.10 +0.70%).
129. At 95% confidencelevel, the possibility for an adverse changeinyieldbeing higher than0.70%is only
totheextent of 5%.(i.e. lossbeinghigher than 0.70%). At 99% confidence, this possibilityis totheextent of 1% only.
Page 280
Asst. Liability Management – Terminology
Asset
An asset is anything of value that is owned by a person or business
Available for Sale
The securities available for sale are those securities where the intention of the
bank is neither to trade nor to hold till maturity. These securities are valued at
the fair value which is determined by reference to the best available source of
current market quotations or other data relative to current value.
Balance Sheet
A balance sheet is a financial statement of the assets and liabilities of a trading
concern, recorded at a particular point in time.
Banking Book
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.
Basel Capital Accord

The Basel Capital Accord is an Agreement concluded among country
representatives in 1988 to develop standardised risk-based capital
requirements for banks across countries. The Accord was replaced with a new
capital adequacy framework (Basel II), published in June 2004. Basel II is
based on three mutually reinforcing pillars that allow banks and supervisors to
evaluate properly the various risks that banks face.
These three pillars are: minimum capital requirements, which seek to refine the
present measurement; supervisory review of an institution's capital adequacy
and internal assessment process; and market discipline through effective
disclosure to encourage safe and sound banking practices
Page 281
Basel Committee on Banking Supervision
The Basel Committee is a committee of bank supervisors consisting of
members from each of the G10 countries. The Committee is a forum for
discussion on the handling of specific supervisory problems. It coordinates the
sharing of supervisory responsibilities among national authorities in respect of
banks' foreign establishments with the aim of ensuring effective supervision of
banks' activities worldwide.
Basic Indicator Approach
An operational risk measurement technique permitted under Basel II. The
approach sets a charge for operational risk as a fixed percentage ("alpha factor")
of a single indicator. The indicator serves as a proxy for the bank's risk
exposure.
Basis Risk
The risk that the interest rate of different assets, liabilities and off-balance sheet
items may change in different magnitude is termed as basis risk.
Capital
Capital refers to the funds (e.g., money, loans, equity) which are available to
carry on a business, make an investment, and generate future revenue. Capital
also refers to physical assets which can be used to generate future returns.
Capital adequacy
A measure of the adequacy of an entity's capital resources in relation to its
current liabilities and also in relation to the risks associated with its assets. An
appropriate level of capital adequacy ensures that the entity has sufficient
capital to support its activities and that its net worth is sufficient to absorb
adverse changes in the value of its assets without becoming insolvent. For
example, under BIS (Bank for International Settlements) rules, banks are
required to maintain a certain level of capital against their risk-adjusted assets.
Capital reserves
That portion of a company's profits not paid out as dividends to shareholders.
They are also known as un-distributable reserves.
Convertible Bond
A bond giving the investor the option to convert the bond into equity at a fixed
conversion price or as per a pre-determined pricing formula.
Core Capital
Tier 1 capital is generally referred to as Core Capital
Page 282
Credit risk
Risk that a party to a contractual agreement or transaction will be unable to
meet their obligations or will default on commitments. Credit risk can be
associated with almost any transaction or instrument such as swaps, repos,
CDs, foreign exchange transactions, etc. Specific types of credit risk include
sovereign risk, country risk, legal or force majeure risk, marginal risk and
settlement risk.
Debentures
Bonds issued by a company bearing a fixed rate of interest usually payable half
yearly on specific dates and principal amount repayable on a particular date on
redemption of the debentures.
Deferred Tax Assets

Unabsorbed depreciation and carry forward of losses which can be set-off
against future taxable income which is considered as timing differences result in
deferred tax assets. The deferred Tax Assets are accounted as per the
Accounting Standard 22. Deferred Tax Assets have an effect of decreasing
future income tax payments, which indicates that they are prepaid income taxes
and meet definition of assets; whereas deferred tax liabilities have an effect of
increasing future year's income tax payments, which indicates that they are
accrued income taxes and meet definition of liabilities.
Derivative
A derivative instrument derives much of its value from an underlying product.
Examples of derivatives include futures, options, forwards and swaps. For
example, a forward contract can be derived from the spot currency market and
the spot markets for borrowing and lending. In the past, derivative instruments
tended to be restricted only to those products which could be derived from spot
markets. However, today the term seems to be used for any product that can be
derived from any other.
Duration
Duration (Macaulay duration) measures the price volatility of fixed income
securities. It is often used in the comparison of the interest rate risk between
securities with different coupons and different maturities. It is the weighted
average of the present value of all the cash flows associated with a fixed
income security. It is expressed in years. The duration of a fixed income
security is always shorter than its term to maturity, except in the case of zero
coupon securities where they are the same.
Foreign Institutional Investor
An institution established or incorporated outside India which proposes to make
investment in India in securities; provided that a domestic asset management
Page 283
company or domestic portfolio manager who manages funds raised or collected
or brought from outside India for
Page 284
Module-III : Theory and Practice of Forex and Treasury Management
investment in India on behalf of a sub-account shall be deemed to be a Foreign

Institutional Investor.
Forward Contract
A forward contract is an agreement between two parties to buy or sell an
agreed amount of a commodity or financial instrument at an agreed price for
delivery on an agreed future date. In contrast to a futures contract, a forward
contract is not transferable or exchange tradable, its terms are not standardized
and no margin is exchanged. The buyer of the forward contract is said to be
long the contract and the seller is said to be short the contract.
General provisions and loss reserves
Such reserves, if they are not attributable to the actual diminution in value or
identifiable potential loss in any specific asset and are available to meet
unexpected losses, can be included in Tier II capital
General risk
Risk that relates to overall market conditions while specific risk is risk that
relates to the issuer of a particular security
Hedging
Taking action to eliminate or reduce exposure to risk
Held for Trading
Securities where the intention is to trade by taking advantage of short-term price
/ interest rate movements.
Horizontal Disallowance
A disallowance of offsets to required capital used the BIS Method for assessing
market risk for regulatory capital. In order to calculate the capital required for
interest rate risk of a trading portfolio, the BIS Method allows offsets of long and
short positions. Yet interest rate risks of instruments at different horizontal
points of the yield curve are not perfectly correlated. Hence, the BIS Method
requires that a portion of these offsets be disallowed.
Hybrid debt capital instruments
In this category fall a number of capital instruments which combine certain
characteristics of equity and certain characteristics of debt. Each has a
particular feature which can be considered to affect its quality as capital. Where
these instruments have close similarities to equity, in particular when they are
able to support losses on an ongoing basis without triggering liquidation, they
may be included in Tier II capital.
Page 285
Interest rate risk

Risk that the financial value of assets or liabilities (or inflows/outflows) will be
altered because of fluctuations in interest rates. For example, the risk that future
investment may have to be made at lower rates and future borrowings at higher
rates.
Long Position
A long position refers to a position where gains arise from a rise in the value of the
underlying.
Market risk
Risk of loss arising from movements in market prices or rates away from the
rates or prices set out in a transaction or agreement.
Modified Duration
The modified duration or volatility of an interest bearing security is its Macaulay
Duration divided by one plus the coupon rate of the security. It represents the
percentage change in the securities’ price for a 100-basis point change in yield.
It is generally accurate for only small changes in the yield.
MD = - dP /dY x 1/P
Where, MD= Modified Duration
P= Gross price (i.e. clean price plus accrued interest)
dP= Corresponding small change in price
dY = Small change in yield compounded with the frequency of the coupon payment.
Mortgage-backed security
A bond-type security in which the collateral is provided by a pool of mortgages.
Income from the underlying mortgages is used to meet interest and principal
repayments.
Mutual Fund
Mutual Fund is a mechanism for pooling the resources by issuing units to the
investors and investing funds in securities in accordance with objectives as
disclosed in offer document. A fund established in the form of a trust to raise
monies through the sale of units to the public or a section of the public under
one or more schemes for investing in securities, including money market
instruments.
Net Interest Margin
Net interest margin is the net interest income divided by average interest earning assets
Net NPA
Net NPA = Gross NPA – (Balance in Interest Suspense account + DICGC/ECGC claims
Page 286
113
Page 287
received and held pending adjustment + Part payment received and kept in suspense
account
(x) Total provisions held)‘
Nostro accounts
Foreign currency settlement accounts that a bank maintains with its overseas
correspondent banks. These accounts are assets of the domestic bank.
Off-Balance Sheet exposures
Off-Balance Sheet exposures refer to the business activities of a bank that
generally do not involve booking assets (loans) and taking deposits. Off-balance
sheet activities normally generate fees, but produce liabilities or assets that are
deferred or contingent and thus, do not appear on the institution's balance sheet
until or unless they become actual assets or liabilities.
Open position
It is the net difference between the amounts payable and amounts receivable in
a particular instrument or commodity. It results from the existence of a net long
or net short position in the particular instrument or commodity.
Option
An option is a contract which grants the buyer the right, but not the obligation, to
buy (call option) or sell (put option) an asset, commodity, currency or financial
instrument at an agreed rate (exercise price) on or before an agreed date
(expiry or settlement date). The buyer pays the seller an amount called the
premium in exchange for this right. This premium is the price of the option.
Risk
The possibility of an outcome not occurring as expected. It can be measured
and is not the same as uncertainty, which is not measurable. In financial terms,
risk refers to the possibility of financial loss. It can be classified as credit risk,
market risk and operational risk.
Risk Asset Ratio
A bank's risk asset ratio is the ratio of a bank's risk assets to its capital funds.
Risk assets include assets other than highly rated government and government
agency obligations and cash, for example, corporate bonds and loans. The
capital funds include capital and undistributed reserves. The lower the risk asset
ratio the better the bank's 'capital cushion'.
Risk Weights
Basel II sets out a risk-weighting schedule for measuring the credit risk of
obligors. The risk weights are linked to ratings given to sovereigns, financial
institutions and corporations by external credit rating agencies.
Page 288
Securitization
The process whereby similar debt instruments/assets are pooled together and
repackaged into marketable securities which can be sold to investors. The
process of loan securitisation is used by banks to move their assets off the
balance sheet in order to improve their capital asset ratios.
Short position
A short position refers to a position where gains arise from a decline in the
value of the underlying. It also refers to the sale of a security in which the seller
does not have a long position.
Specific risk
Within the framework of the BIS proposals on market risk, specific risk refers to
the risk associated with a specific security, issuer or company, as opposed to
the risk associated with a market or market sector (general risk).
Subordinated debt
Refers to the status of the debt. In the event of the bankruptcy or liquidation of
the debtor, subordinated debt only has a secondary claim on repayments, after
other debt has been repaid.
Tier one (or Tier I) capital

A term used to refer to one of the components of regulatory capital. It consists
mainly of share capital and disclosed reserves (minus goodwill, if any). Tier I
items are deemed to be of the highest quality because they are fully available to
cover losses. The other categories of capital defined in Basel II are Tier II (or
supplementary) capital and Tier III (or additional supplementary) capital.
Tier two (or Tier II) capital
Refers to one of components of regulatory capital. Also known as
supplementary capital, it consists of certain reserves and certain types of
subordinated debt. Tier II items qualify as regulatory capital to the extent that
they can be used to absorb losses arising from a bank's activities. Tier II's
capital loss absorption capacity is lower than that of Tier I capital.
Trading Book
A trading book or portfolio refers to the book of financial instruments held for the
purpose of short-term trading, as opposed to securities that would be held as a
long- term investment. The trading book refers to the assets that are held
primarily for generating profit on short - term differences in prices/yields. The
price risk is the prime concern of banks in trading book.
Page 289
Page 290
Module-III : Theory and Practice of Forex and Treasury Management
Underwrite
Generally, to underwrite means to assume a risk for a fee. Its two most common
contexts are:
16 Securities: a dealer or investment bank agrees to purchase a new issue of
securities from the issuer and distribute these securities to investors. The
underwriter may be one person or part of an underwriting syndicate. Thus
the issuer faces no risk of being left with unsold securities.
17 Insurance: a person or company agrees to provide financial compensation
against the risk of fire, theft, death, disability, etc., for a fee called a
premium.
Undisclosed Reserves
These reserves often serve as a cushion against unexpected losses, but they
are less permanent in nature and cannot be considered as ‘Core Capital’.
Revaluation reserves arise from revaluation of assets that are undervalued on
the bank’s books, typically bank premises and marketable securities. The extent
to which the revaluation reserves can be relied upon as a cushion for
unexpected losses depends mainly upon the level of certainty that can be
placed on estimates of the market values of the relevant assets, the subsequent
deterioration in values under difficult market conditions or in a forced sale,
potential for actual liquidation at those values, tax consequences of revaluation,
etc.
Value at risk (VAR)
It is a method for calculating and controlling exposure to market risk. VAR is a
single number (currency amount) which estimates the maximum expected loss
of a portfolio over a given time horizon (the holding period) and at a given
confidence level.
Venture capital Fund
A fund with the purpose of investing in start- up business that is perceived to
have excellent growth prospects but does not have access to capital markets.
Vertical Disallowance
In the BIS Method for determining regulatory capital necessary to cushion market risk, a
reversal of the offsets of a general risk charge of a long position by a short position in
two or more securities in the same time band in the yield curve where the securities
have differing credit risks
ACH - Automated Clearing Houses

ACU - Asian Clearing Union
AD - Authorised Dealer
Page 291
ADB - Asian Development Bank
ADR - American Depository Receipt
AFS - Available for Sale
AIFI - All India Financial Institutions
ALD - Aggregate Liabilities to the Depositors
ALM - Asset Liability Management
AMFI - Association of Mutual Funds in India
AML - Anti Money Laundering
AMS - Aggregate Measures of Support
ARCIL - Asset Reconstruction Company of India Ltd.
ARDC - Agriculture Refinance and Development Corporation
ASEAN - Association of South East Asian Nations
BCBS - Basel Committee on Banking Supervision
BCP - Business Continuity Plan
BFS - Board for Financial Supervision
BFSI - Banking, Financial Services and Insurance
BIFR - Board for Industrial and Financial Reconstruction
BIS - Bank for International Settlements
BoP - Balance of Payments
BPLR - Benchmark Prime Lending Rate
Page 292
BPSS - Board for Payment and Settlement Systems
Collateralized Borrowing and Lending
CBLO - Obligation
CBoT - Chicago Board of Trade
CCIL - Clearing Corporation of India Limited
CD - Certificate of Deposit
CDR - Corporate Debt Restructuring
CEPT - Common External Preferential Tariff
CFMS - Centralized Funds Management System
CFS - Consolidated Financial Statement
CFTS - Centralized Funds Transfer System
CGRA - Currency and Gold Revaluation Account
Credit Guarantee Fund Trust for Small
CGTSI - Industries
CIB - Capital Indexed Bond
CIBIL - Credit Information Bureau of India Limited
CLF - Collateralized Lending Facility
CPI - Consumer Price Index
CPI-IW - Consumer Price Index for Industrial Workers
CPR - Consolidated Prudential Report
CP - Commercial Paper
Committee on Payment and Settlement
CPSS - Systems
CRAR - Capital to Risk-Weighted Assets Ratio
CRM - Country Risk Management
CRR - Cash Reserve Ratio
Constituents' Subsidiary General Ledger
CSGL - Account
Currency Verification and Processing
CVPS - System
Department of Banking Operations and
DBOD - Development
DBS - Department of Banking Supervision
DCA - Debtor-Creditor Agreement
Page 293
DFHI - Discount and Finance House of India
DFI - Development Finance Institution
DFRC - Duty Free Replenishment Certificate
DICGC - Deposit Insurance and Credit Guarantee Corporation
DNSS - Deferred Net Settlement System
DP - Depository Participant
DRI - Differential Rate of Interest
DRS - Disaster Recovery System
DSS - Debt Swap Scheme
DRT - Debt Recovery Tribunal
DTA - Domestic Tariff Area
DTL - Demand and Time Liabilities
DvP - Delivery versus Payment
EC - Exchange Control
ECB - External Commercial Borrowing
ECD - Exchange Control Department
ECGC - Export Credit Guarantee Corporation
ECR - Export Credit Refinance
ECS - Electronic Clearing Services
EDI - Electronic Data Interchange
EEA - Exchange Equalization Account
EEFC - Exchange Earners' Foreign Currency Account
EFT - Electronic Funds Transfer
EKMS - Enterprise Knowledge Management System
EME - Emerging Market Economy
EMU - European Monetary Union
EOU - Export Oriented Unit
EPCG - Export Promotion Capital Goods
Page 294
EU - European Union
EXIM - Export Import
FCA - Foreign Currency Assets
FCNRA - Foreign Currency Non-Resident Account
FCNR (B)
- Foreign Currency Non-Resident (Banks)
FCRA - Forward Contract Regulation Act
FCCB - Foreign Currency Convertible Bond
FDI - Foreign Direct investment
FEDAI - Foreign Exchange Dealers’ Association of India
FED - Foreign Exchange Department
FEMA - Foreign Exchange Management Act
FER - Foreign Exchange Reserves
FET-ERS Foreign Exchange Transactions Electronic Reporting
- System
FII - Foreign Institutional Investor
Fixed Income Money Market and Derivatives
FIMMDA - Association of India
FRA - Forward Rate Agreement
FRB - Floating Rate Bond
FRBM - Fiscal Responsibility and Budget Management
FSSA - Financial System Stability Assessments
FTT - Foreign Travel Tax
G-20 - Group of Twenty
GAAP - Generally Accepted Accounting Principles
GATS - General Agreement on Trade in Services
GATT - General Agreement on Tariffs and Trade
GDCF - Gross Domestic Capital Formation
GDP - Gross Domestic Product
GDS - Gross Domestic Saving
GDR - Global Depository Receipt
Page 295
GFCF - Gross Fixed Capital Formation
GFD - Gross Fiscal Deficit
GRF - Guarantee Redemption Fund
GSO - Green Shoe Option
HFT - Held for Trading
HTM - Held to Maturity
IAS - Integrated Accounting System
ICA - Inter-creditor Agreement
ICDs - Inter-Corporate Deposits
ICOR - Incremental Capital Output Ratio
IDL - Intra-day Liquidity
IDMD - Internal Debt Management Department
IDR - Indian Depository Receipt
IFC - International Finance Corporation
IFCI - Industrial Finance Corporation of India
IFI - International Financial Institution
IFR - Investment Fluctuation Reserve
IIBI - Industrial Investment Bank of India
IIP - Index of Industrial Production
IIP - International Investment Position
IMF - International Monetary Fund
IMFC - International Monetary and Financial Committee
INFINET - Indian Financial Network
IRB - Internal Rating Based
IRDA - Insurance Regulatory and Development Authority
IRF - Interest Rate Future
IRS - Interest Rate Swap
ISA - Information System Audits
Page 296
ISP - Information Security Policy
LAF - Liquidity Adjustment Facility
LaR - Liquidity at Risk
LC - Letter of Credit
LIBOR - London Inter-Bank Offered Rate
London Inter-Bank Financial Futures
LIFFE - Exchange
M3 - Broad Money
MBS - Mortgage-Backed Securities
MFA - Multi Fiber Agreement
MICR - Magnetic Ink Character Recognition
Mumbai Inter-Bank Forward Offered
MIFOR - Rate
MNBC - Miscellaneous Non-Banking Company
MoU - Memorandum of Understanding
MPBF - Maximum Permissible Bank Finance
MPI - Macro-Prudential Indicator
MSS - Market Stabilization Scheme
Medium-Term Fiscal Reforms
MTFRP - Programme
NAV - Net Asset Value
NFA - Net Foreign Assets
NBFC - Non-Banking Financial Company
National Council of Applied Economic
NCAER - Research
NCD - Non-Convertible Debenture
NDA - Net Domestic Assets
NDS - Negotiated Dealing System
NDTL - Net Demand and Time Liabilities
NEER - Nominal Effective Exchange Rate
NEFT - National Electronic Funds Transfer
NHAI - National Highway Authority of India
Page 297
NIC - National Industrial Credit
NMS - Network Management System
NOF - Net-Owned Fund
NPA - Non-Performing Asset
NPC - National Payments Council
NRE - Non-Resident External
NRI - Non-Resident Indian
NR(NR)R
D - Non-Resident (Non-Repatriable) Rupee Deposits
NRO - Non-Resident Ordinary Accounts
NRSR - Non-Resident Special Rupee Deposits
NSSF - National Small Saving Fund
NSDL - National Securities Depository Ltd.
NSS - National Settlement System
NIC - National Industrial Credit
OBU - Offshore Banking Unit
OCB - Overseas Corporate Body
OLTAS - Online Tax Accounting Systems
OMO - Open Market Operation
ONGC - Oil and Natural Gas Commission
OPAC - Online Public Access Catalogue
OPEC - Organisation of Petroleum Exporting Countries
OSMOS - Off-site Monitoring and Surveillance
OTCEI - Over-the-Counter Exchange of India
OTS - One-Time Settlement
PCA - Prompt Corrective Action
PCD - Partially Convertible Debenture
PD - Primary Dealer
PDO - Public Debt Office
Page 298
PFI - Public Financial Institution
PIO - Person of Indian Origin
PKI - Public Key Infrastructure
PLR - Prime Lending Rate
PMO - Primary Market Operations
PMS - Portfolio Management Services
PSRS - Prudential Supervisory Reporting System
Payment and Settlement Systems
PSSC - Committee
PTA - Preferential Trading Agreement
QIS - Quantitative Impact Study
RBS - Risk-Based Supervision
RC - Reconstruction Companies
RDBMS - Relational Data Base Management System
REER - Real Effective Exchange Rate
RFC (D) - Resident Foreign Currency (Domestic)
Repo - Ready Forward/Repurchase Agreement
RIB - Resurgent India Bond
RIDF - Rural Infrastructure Development Fund
RIN - Risk Intelligence Network
RNBC - Residuary Non-Banking Company
ROA - Return on Total Assets
ROE - Return on Equity
RPT - Risk Profile Template
Recommendations for Securities Settlement
RSSS - System
RTGS - Real Time Gross Settlement
RTIA - Regional Trade and Investment Area
South Asian Federation of Stock
SAFE - Exchanges
SAFTA - South Asian Free Trade Agreement
Page 299
SASF - Stressed Assets Stabilization Fund
SCRA - Securities Contracts (Regulation) Act, 1956
SDF - Submission of Declaration Form
SDRM - Sovereign Debt Restructuring Mechanism
SDR - Special Drawing Right
SEFER - Securities held as Foreign Exchange Reserves
SEFT - Special Electronic Funds Transfer
SFMS - Structured Financial Messaging Solution
SGL - Subsidiary General Ledger
SIPS - Systemically Important Payment System
SITP - Strategic Information Technology Plan
SLR - Statutory Liquidity Ratio
SME - Small and Medium Enterprise
SPV - Special Purpose Vehicle
BS -Securities Settlement System
STP - Straight Through Processing
SIFI - Systemically Important Financial Intermediaries
Society for Worldwide Inter-bank Financial
SWIFT - Telecommunications
TAC - Technical Advisory Committee
TBT - Technical Barriers to Trade
TFPG - Total Factor Productivity Growth
TIN - Tax Information Network
UIP - Uncovered Interest Parity
UNCTA United Nations Conference for Trade and
D - Development
VaR - Value at Risk
WADR - Weighted Average Discount Rate
WAN - Wide Area Network
WCDL - Working Capital Demand Loan
Page 300
Wholesale Debt
WDM - Market
Ways and Means
WMA - Advance
Wholesale Price
WPI - Index
Y-on-Y - Year-on-Year
YTM - Yield-to-Maturity
Page 301
RISK MANAGEMENT recollected questions:-
Maturity bucket case study
Modified Duration (YTM) Semiannual, Convexity case study
Basel 3 T1 and T2 case study
LTV ratio case study
Foreign exchange case study
Rating Migration case study
MCLR Case Study
Basis risk
Trading book
EAD, PD, LGD
BPV
Various Approaches for Market Risk, Credit Risk , Operational Risk
Various 1 marks numericals on foreign exchange
Various RWA were asked
Etc.
Risk management
Case study: 1 case study on forex option

1 case study spot forward rate
Case study of YTM
Case study maculary duration modified duration
Case study on stress testing
Case study on exposure norms using tier 1 tier 2 capital reference
Basic indicator approach, standardised approach case study
Var calculation
Daily volatility 2 qstn
Caiib Risk management recollected
Chief risk officer duty,reporting,appointmemt

Leverage ratio numerical
Operational risk
Pcr
Firb credit risk
Rsca operstional risk
Page 302
Pilar 3 disclosure norms period
Rwas calculation
Numerical from BVP was also there,

Ques Obejective from PD ,EAD ,LGD
Market credit and operational risk theory based,
Which method we use for calculation of capital for credit operational and market risk
Case beta factor for agency services,
Icaap come under which piller,
CRO function
Reputation risk systematic risk come under
Recollected Question on Risk Management Date 23.08.2020
01 Case study on Duration, Modified duration,& convexity
02 Case Study on Haircut, hair cut formulas based question on collateral asset ,haircut in risk
mitigation
03 Case study on Interest rate
04 Numerical on Value at Risk, Calculate Geometric mean, NIIcalculation ,RWA Numerical on

Tier 1 and tier 2 Case Study on Risk Weight ration ( unrated corporate Company , RWA on
venture capital, exposure to foreign banks,RWA value on commercial infrastructure company)
Numerical on BPV
05 Mark to model definitions
06 Beta value on risk free asset
07 Credit risk mitigation purpose not included choose from options
08 LTV is part of which type of risk Management
9 translational level risk not included
10 Loan review mechanism is used for
11 Definition of YTM
12 staff irritation and loss of appeal of employer is failed in which conditions
Page 303
13 Rate of inertest swap for PEF
14 PD,EAD,LGD
15 Call Options Definitions
16 Monte carlo simulation method definitions
17 Embedded option risk
18 counterparty risk,SPV,
Most of the question of one-liner type, ratio of numerical & theory is 40 and 60
Theory was easy. All the question from book. read the book carefully 2 time.
Good luck.
mitigation

Numerical on BPV
Page 304
14 PD,EAD,LGD
Good luck.
mitigation

Numerical on BPV
Page 305
14 PD,EAD,LGD
Good luck.
**BEST OF LUCK **
Disclaimer
While every effort has been made by me to avoid errors or omissions in this publication, any error or
discrepancy noted may be brought to my notice through e-mail to
Srinivaskante4u@gmail.comwhich shall be taken care of in the subsequent editions. It is also suggested
that to
clarify any doubt colleagues should cross-check the facts, laws and contents of this publication with
original Govt. / RBI / Manuals/Circulars/Notifications/Memo/Spl Comm. of our bank.
Page 306
Page 307
Page 308
Compiled by Srinivas Kante Email: srinivaskante4u@gmail.com

Risk in Financial Services

Uploaded by

Copyright:

Available Formats

Risk in Financial Services

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Risk in Financial Services

Uploaded by

Copyright:

Available Formats

IIBF Adda

Risk in financial services

Srinivas Kante B.Tech, CAIIB

Risk Management (Indian Perspective)

Exemption from Level-I Examination :

(ii) The examination will be held in Online Mode only

(iii) There will NOT be negative marking for wrong answers.

- ALCO techniques / tools

- Risk exposure analysis

- Risk management / mitigation policy

- Risk immunization policy / strategy for fixing exposure limits

- Risk management policy and procedure

- Risk adjusted return on capital

- Capital adequacy norms

- Concept of Mid office

- Strategies and Arbitrage opportunities

- Regulatory prescriptions of risk management

Module - B : Credit Risk Management

- Three pillars of BASEL Norms and Capital for Operational risk

- Frame work for risk management

- RBI guidelines on risk management

- Risk rating and risk pricing

- Methods for estimating capital requirements

- Credit risk - standardized approach

- Credit risk - advanced approach

- Credit rating / credit scoring and rating system design

- Stress test and sensitivity analysis

- Internal Capital Adequacy Assessment Process (ICAAP)

Module - C : Operational Risk

- SPOR - organizational set up and key responsibilities of ORM

- SPOR - policy requirements and strategic approach for ORM

- SPOR identification, measurement, control / mitigation of operational risks

- Prescriptions of BASEL Norms

- Interest rate risk

- Foreign exchange risk

- Price risk (Equity)

- Treatment of market risk under Basel

a) Standardized duration method

b) Internal measurement approach - VaR

Rules / Syllabus for Level - II Examination (CISI, London)

2. International Risk Regulation

8. Corporate Governance and Risk Oversight

10. Enterprise Risk Management (ERM) -

RISK MANAGEMENT: AN OVERVIEW

Meaning and Scope

identify, characterize threats

Risk management should:

identification of risk in a selected domain of interest

Potential risk treatments

Avoidance (eliminate, withdraw from or not become involved)

Risk management plan

Review and evaluation of the plan

Anatomy of Bank Risk

Balance Sheet Risk

Concentration Risk Intrinsic Risk

Interest Rate Risk

Price Risk Reinvestment Risk Yield Curve Risk Basis Risk

Enterprise Wide Risk Management

Implementation of Enterprise Wide Risk Management:

The implementation of EWRM therefore, involves the following steps:

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