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BFM MODULE - D
Chapter 26: COMPONENTS OF ASSETSAND
LIABILITIES IN BANK'S BALANCE (PART-I)
What we will study?
What is asset liability management (ALM)?
What is the significance of ALM?
What are the reasons of growing significance of
ALM?

WHAT IS ASSET LIABILITY MANAGEMENT:

Because the business of banking in volves the
identifying, measuring, accepting and managing the
risk, the heart of bank financial management is risk
management.

One of the most important risk-management

Functions in banking is Asset Liability Management
(ALM).

Traditionally, administered interest rates were used

To price the assets and liabilities of banks.
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However,
int
hederegul
atedenvir
onment,
competi
ti
onhasnarr
owedt hespreadsofbanks.
Thisnotonlyhasl edtotheintr
oduct
ionof
discr
iminatorypri
cingpoli
cies,
buthasalso
hi
ghlightedtheneedt omatchthemat ur
it
iesoft
he
assetsandl i
abil
it
ies.
Thedevel
opmentst
hathavetakenpl
acesi
nce
l
iber
ali
sat
ionhavel
edtoaremarkabl
etr
ansi
ti
oni
n
ther
iskpr
ofil
eofal
lbanks.
AssetLiabi
li
tyManagementisconcernedwi th
str
ategicbal
ancesheetmanagementi nvolv
ing
ri
skscausedbychangesininter
estrates,exchange
rat
e,credi
tri
skandtheli
qui
dityposi
tionofabank.
Withprofitbecomi ngakey -
fact
or,ithasnow
becomei mper ati
vef orabanktomov eawayfr
om
parti
alassetmanagement( CreditandNon
PerformingAsset )andparti
alli
abili
tymanagement,
towardsani ntegratedbal
ancesheetmanagement
wher eal
lthecomponent sofbalancesheetandit
s
dif
ferentmat uri
tymi xwil
lbelookedatf r
om t
he
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pr
ofi
tangl
eoft
hebank.
AssetLi abi
li
tyManagement(ALM)i
stheactof
planning,acqui
ri
ng,anddi
recti
ngt
hefl
owoff unds
throughanor gani
sati
on.
Theulti
mateobject i
veofthi
sprocessisto
generat
eadequat e/stabl
eearni
ngsandt ost
eadi
ly
buil
danorganisation'
sequit
yov ert
ime,whil
e
taki
ngreasonableandmeasur edbusinessri
sks,
ALM isther
efor
e,t
hemanagementoftheNet
I
nterestMargi
n(NIM)toensur
ethati
tslev
eland
ri
skinessar
ecompatibl
ewithri
sk/
ret
urnobject
ives
ofthebank.
SoALM i
smor ethanjustmanagingthei
ndi
vi
dual
asset
sandl
iabil
it
iescategor
ieswell
.
NetInter
estI
ncome(
NII
)=I
nter
estI
ncome-I
nter
est
Expenses.
NetInter
estMar
gin(
NIM)=NI
I/Av
eraget
otal
Assets.
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SI
GNI
FICANCEOFASSETLI
ABI
LITY
MANAGEMENT:

Whydoweneedassetl
iabi
li
tymanagement
?
Insi
mpleterms,af
inanciali
nst
it
uti
onmayhav
e
enoughassetst
opayof fit
sli
abi
li
ti
es.
Butwhatif50%oftheli
abi
li
ti
esaremat
uringwit
hin
1yearbutonly10%oftheasset
sarematuri
ng
wit
hinthesameperiod.
Thoughthefi
nanciali
nst
itut
ionhasenoughasset
s,
i
tmaybecomet empor ar
il
yinsol
ventduetoa
sever
eli
quidi
tycr
isis.
Thus,ALM i
srequi
redtomatchtheasset
sand
l
iabi
li
ti
esandmi ni
misethel
iqui
dit
yaswellas
marketri
sk.
Asset-
li
abil
it
ymanagementcanbeperfor
medona
per-
li
abil
it
ybasisbymatchi
ngaspeci
fi
cassett
o
supporteachli
abi
li
ty.
Hereyouensur
ethatf
orever
yli
abil
it
y,t
her
eisan
equi
val
entt
enureandamountmatchi
ngasset
.
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Againeveniftheassetsandliabi
li
ti
esmat ur
ityi
s
matchedt oalargeextent
,theint
erestratescan
changedur i
ngtheperiodther
ebyaf fecti
ngthe
i
nteresti
ncomef r
om assetsandinterestexpenses
onli
abili
ti
es.
Dependingupont hemovementofi nt
erestrat
est
he
netinter
estmarginmayincreaseordecrease
result
ingincor
respondi
ngincreaseordecreasei
n
profi
tduringacertai
nperi
od.

Someofthereasonsforgr
owi
ngsi
gni
fi
canceof
AssetLi
abi
li
tyManagementar
e:
1‐
Vol
ati
li
ty:
Theef fectoff r
eeeconomi cenvi
ronment(
dueto
globalizati
onandl iberal
isat
ion)arer
efl
ectedi
n
i
nt er
estr atestructur
es,moneysuppl yandthe
overallcreditpositi
onoft hemarket,
theexchange
ratesandpr i
cel ev
els.
Forabusiness,
whichinvol
vestr
adingi
nmoney ,
rat
efl
uctuati
onsinvar
iabl
yaff
ectthemarketv
alue,
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yields/costsofassetsandl
iabi
li
ti
es,
whi
chfur
ther
affectthemar ketval
ueofthebankandi
tsNet
InterestIncome(NII)
.

2‐
ProductI
nnov
ati
on:
Thesecondr easonforgr
owingi
mpor
tanceofALM
i
st herapi
dinnovati
onstaki
ngpl
acei
nthefi
nanci
al
productsofthebank.
Whi l
ethereweresomeinnovat
ionsthatcameas
passingfads,
othershav
erecei
v edt
remendous
response.
Whatevermaybefeat
uresoftheproduct
s,mostof
t
hem haveanimpactontheriskpr
ofil
eofthebank
t
herebyenhanci
ngtheneedforALM.
Forexampl
e,Fl
exi
-deposi
tfaci
li
ty.

3‐
Regul
ator
yEnv
ironment
:Att
hei
nter
nat
ionall
evel
,
Bankf
orI
nter
nat
ionalSet
tl
ement
s(BI
S)pr
ovi
desa
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fr
amewor kforbankst
otackl
ethemarketri
sksthat
mayar i
seduetoratef
luct
uat
ionsandexcessi
ve
credi
tri
sk.
Centr
alBanksinvari
ouscountr
ies(
incl
uding
Reser
veBankofI ndi
a)havei
ssuedframewor ksand
gui
deli
nesforbankstodevel
opAssetLiabil
it
y
Managementpolici
es.

4‐
ManagementRecogni
ti
on:
Al
ltheabov
e-menti
onedaspectsforcedbank
managementst
ogiveaseri
oust houghttoef
fect
ive
managementofasset
sandliabi
li
ti
es.
Themanagement shavereal
isedthatitisj
ustnot
suffi
cienttohaveaverygoodf r
anchiseforcr
edit
disbursement,nori
sitenoughtohavej ustaver
y
goodr etai
ldeposi
tbase.
Inaddit
iont
ot hese,abankshouldbeinapositi
on
torel
ateandli
nkt heassetsidewit
htheli
abil
it
y
sideandthi
scallsforeff
ici
entasset-
li
abi
li
ty
management .
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BFM MODULE - D
Chapter 26: COMPONENTS OF ASSETSAND
LIABILITIES IN BANK'S BALANCE (PART-II)
What we will study?
*What is Objective of ALM?
*What is NII?
*What is NIM?

PURPOSE AND OBJECTIVES OF ASSET LIABILITY

MANAGEMENT:
An effective Asset Liability Management technique
Aims to manage the volume, mix, maturity, rate
sensitivity, quality and liquidity of assets and
liabilities as a whole so as to attain a
predetermined acceptable risk/reward ratio.

Thus, the purpose of Asset Liability Management is

To enhance the asset quality; quantify the risks
Associated with the assets and liabilities and
Further manage them.
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Suchapr
ocesswi
lli
nvol
vet
hef
oll
owi
ngst
eps:
*Revi
ewingtheint
erestr
at est
ructur
eand
compari
ngt hesamet otheint
erest/
productpr
ici
ng
ofbothassetsandli
abil
iti
es.
*
Examini
ngt hel
oanandinvestmentpor
tfoli
osin
t
heli
ghtofthefor
eignexchangeri
skandliquidi
ty
r
iskt
hatmightari
se.

*Examini
ngthecredi
tri
skandcont i
ngencyri
skthat
mayor i
ginat
eei
therduetorat
ef l
uctuat
ionsor
other
wiseandassessthequal
ityofassets.
*Rev i
ewingtheactualper
formanceagai
nstthe
projecti
onsmadeandanal ysingt
hereasonsforany
effectonthespreads.

TheAssetLi abil
it
yManagementt echniquesso
designedt omanagev ar
iousrisks,primari
lyaimto
stabili
setheshort-
term profi
ts,long-
t er
m earni
ngs
andl ong-
term substance/qualit
yoft hebank.
Thepar
ametersthatar
esel
ectedfort
hepurposeof
st
abi
li
singAssetLi
abil
it
yManagementofbanksare:
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NetI
nter
estI
ncome(
NII
)
NetI
nter
estMar
gin(
NIM)
Economi
cEqui
tyRat
io

HereAbr
iefdescr
ipt
ionoft
hesepar
amet
ersi
s
gi
venbel
ow:

NetI
nter
estI
ncome(
NII
):
Thei
mpactofv
olati
li
tyontheshor
t-
ter
m pr
ofi
tis
measur
edbyNetInt
erestI
ncome.

NetInter
estI
ncome=I
nter
estI
ncome-I
nter
est
Expenses.

I
nor
dertost
abil
iseshort
-ter
m pr
ofi
ts,
bankshav
e
t
omini
misefl
uct
uationsintheNI
I.

NetI
nter
estMar
gin(
NIM)
:
 Joi
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NetI
nter
estMar
gini
sdefi
nedasnetinter
est
i
ncomedivi
dedbyav
eragetot
alasset
s.

NetI
nter
estMar
gin(
NIM)=
NetI
nter
estI
ncome/
Aver
aget
otalAsset
s.
NetI
nterestMar
gincanbev
iewedast
he"
Spr
ead'
onear
ningassets.
Thenetincomeofbankscomesmost l
yfrom t
he
spr
eadsmai ntai
nedbetweent
otali
nteresti
ncome
andtot
alinter
estexpense.
Thehi
ghert
hespr
ead,
themor
ewi
llbet
heNI
M.
Thereexi
stsadi
rectcor
rel
ati
onbet
weenr
isksand
ret
urn.
Asaresult
,great
erspr
eadsonl
yimpl
yenhanced
ri
skexposure.
Butsinceanybusinessi
sconduct edwit
hthe
objecti
veofmakingprofi
tsandachievi
nghigher
profi
tabil
it
yist
hetarget
,itist
hemanagementof
ri
sksandnotr i
skelimi
nation,
thathol
dsthekeyto
success.
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Economi
cEqui
tyRat
io:
Therati
ooftheshar
ehol
ders'
fundstot
hetotal
assetsmeasur
estheshi
ft
sintherat
ioofowned
fundstot
alf
unds.
EER=Shar
ehol
der
sfund/
Tot
alAsset
s
Thisf
actassessest
hesust
enancecapaci
tyoft
he
bank.

Obj
ect
ivesofALM:
Atmacr o-l
evel,
AssetLiabil
it
yManagementl eadst
o
theformulati
onofcrit
icalbusinesspolici
es,
effi
ciental
locati
onofcapitalanddesigningof
productswithappropr
iateprici
ngstrategies.
Andatmicr
o-l
eveltheobject
ivesofAssetLi
abi
li
ty
Managementaretwofolds.
Itai
msatprofi
tabil
i
tyt
hroughpr
icematchi
ngwhil
e
ensuri
ngl
iqui
ditybymeansofmatur
it
ymat chi
ng.
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Pr
iceMat
chi
ng:
Itbasical
lyai
mst omaintai
nspreadsbyensuri
ng
thatthedeploymentofli
abil
it
ieswil
lbeatarat
e
higherthanthecosts.
Thisexerci
sewouldindi
cat ewhethert hei nst
ituti
on
i
sinaposi ti
ont
obenef i
tf r
om ri
singi nterestrates
byhav i
ngaposit
ivegap( asset
s>l iabili
ti
es)or
whetheriti
sinapositi
ont obenefitfrom declining
i
nterestrat
esbyanegat i
vegap( l
iabilit
ies>asset s).

Li
qui
dit
y:
Iti
sensur edbygr oupingtheassets/li
abi
li
ti
es
basedont heirmatur
ingprofi
[Link] hen
assessedt oidenti
fyfutur
ef i
nancing
requi
rement [Link] t
enmat urit
y
mismat chwhi chmayt oacer t
ainextentaffectthe
expectedr esult
s.
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BFM MODULE - D
Chapter 26: COMPONENTS OF ASSETSAND
LIABILITIES IN BANK'S BALANCE (PART-III)
What we will study?
*What is balance sheet?
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BALANCESHEET:
Itisast at
ementofasset
s(whatisowned,
and
l
iabil
it
ies(whati
sowedt oot
hers)ofanent
it
yata
parti
cularmoment.
Asset
s:Whatf
ir
m owns
Li
abi
li
ty:
Whatf
ir
m owes
Iti
sli
keasnapshotofassetsandliabi
li
ti
esandjust
asonepict
uremaybedi ffer
entfr
om anothert
aken
anyti
meearli
er,t
hebalancesheetmayalsobe
dif
fer
entatdif
ferentmomentsofthesameday .
Theref
ore,ever
ybal
ancesheetmustindi
cat
ethe
dateattheendofwhichi
tisprepar
ed.
Nor
mal l
y,thebalancesheeti
sprepar
edatt
heend
oft
heaccount i
ngperiodforwhi
chtheP&Laccount
i
sprepared.
P&Laccounti
spr
epar
edf
oraper
iod.
Bal
anceSheeti
spr
epar
edf
orapar
ti
cul
ardat
ei.
e
asonadate.
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LI
ABI
LITI
ES(
Sour
ceoff
und)ASSETS(
Useoff
und)
Longt
erml
iabi
li
ti
es Cur
rentAsset
s
Cur
rentl
iabi
li
ti
es Fi
xedAsset
s
Networ
th I
ntangi
bleAsset
s
NonCur
rentAsset
s
Tot
al== ==Tot
al

Footnot
e Cont
ingentLi
abi
l
ity
BankGuar
ant
ee Let
terofcr
edi
t
Asset
s:
1-Cur
rentAsset
s
2-
NonCur
rentAsset
s
3-
FixedAsset
s
4-I
ntangi
bleAsset
s
1-
Cur
rentAsset
s:Thoseasset
swhi
char
eli
kel
yto
 Joi
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beeitherconsumedorconv er
tedi
ntocashwit
hin1
yearfrom t
hedat eofbal
ancesheetar
ecall
ed
CurrentAssets.
Exampl
e:
1-
BankBal
ance 5-
Debt
ors
2-
Inv
ent
ory
/st
ock 6-
Accr
uedI
ncome
3-
Cash 7-
PrepaidExpenses(I
nsur
ance,
AdvanceTax,AdvanceRent)
4-
Bil
lRecei
vabl
e
2-
Int
angi
bleAsset
sorFi
cti
ti
ousAsset
s:
Theassetswhichdonothavephy
sicalexi
stence
arecal
ledInt
angibl
eAsset
s.
Ex-
(
a)Goodwi
ll
,
(
b)Br
ands/
trademar
ks,
(
c)Comput
ersof
twar
e,
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(
d)Mi
ningr
ight
s,
(e)Copyr
ight
s,andpat
ent
sandot
heri
ntel
lect
ual
proper
tyri
ghts,
3-
FixedAsset
s:(
netbl
ock)
(t
angi
bleasset
s:whi
chcanbet
ouched)
Thoseasset
swhi
chwi
llbeusedf
orl
ongoft
ime.
OrThoseasset
swhi
char
enotmeantt
obesol
d.
(
a)Land, (
b)Bui
ldi
ngs,
(
c)Pl
antandEqui
pment
,(d)Fur
nit
ureandFi
xtur
es,
(
e)Vehi
cles,

4-
NonCur
rentAsset
s:
Thoseasset
swhi
chcannotbecl
assi
fi
edas
Ei
therf
ixedasset
s
Orcur
rentasset
s
OrI
ntangi
bleasset
s
Ar
ecal
ledNoncur
rentAsset
s.
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Li
abi
li
ty:
1-
Longt
erml
iabi
li
ty
2-
Cur
rentl
iabi
li
ty
3-
Networ
th

1-
Cur
rentLi
abi
li
ty:
Amountpayabl
etooutsiderWITHI
N1y earfrom t
he
dat
eofbalancesheeti
scalledCur
rentl
iabi
li
ty.
Exampl
e:
1-
Inst
all
ment
soft
erml
oanpay
abl
ewi
thi
noney
ear
.
2-
Bil
lspay
abl
e
3-
Sundr
yCr
edi
tor
s
4-
Prov
isi
onf
ort
ax
5-
Out
standi
ngexpenses
6-
BankBor
rowi
ngi
nfor
m ofCCandOD
2-
Longt
erml
iabi
li
ty:
Amountpay
abl
etoout
siderAFTER1y
earf
rom t
he
 Joi
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dat
eofbal
ancesheeti
scal
ledCur
rentl
iabi
li
ty.

Exampl
e:
1-
Unsecur
edLoan
2-
Debent
ures(
whi
char
emat
uri
ngaf
ter12mont
hs)
3-
Ter
mloan
(
inst
all
mentwhi
char
epay
abl
eaf
ter1y
ear
)
3-
Networ
thorOwner
'sEqui
ty:
Amountcontr
ibut
edbyOwner+Profi
tret
ainedi
n
thebusi
nessi
scalledt
henetwor
th.
Exampl
e:
1-
Capi
talorshar
ecapi
tal
2-
Reser
vesandsur
plus
3-
Shar
epr
emi
um
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BFM MODULE – D
Chapter 27: CAPITAL ADEQUACY
THE BASEL-II OVERVIEW (PART-I)
What will we study?
*What is BASEL-II?
*What is CAPITAL ADEQUACY?

INTRODUCTION:
Whey we call it BASEL?
Central Bank Governors of the Group of 10
Countries formed a committee of banking
Supervisory authorities in 1975.
This Committee usually meets at the Bank of
International Settlement (BIS) in Basel, Switzerland.
Hence it has come to be known as the Basel
Committee.
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TheBaselCommi t
teepr
ovidedtheframewor
kfor
capi
taladequacyi
n1988,whichisknownasthe
Basel
-Iaccord.
The1988BaselAccor
dledt
osigni
fi
canti
ncr
eases
i
nthecapi
talhel
dbybanksovert
henext10year
s.
Itdeser
vesagr
eatdealofcr
edi
tfori
mpr
ovi
ngt
he
stabi
li
tyoft
hegl
obalbanki
ngsyst
em.
Howev
er,
ithadcer
tai
nsi
gni
fi
cantweaknesses.
TheBasel
-Inormsforr
iskwei
ght
swer
emor
eofa
st
rai
ghtj
acketnat
ure.
Forexampl
e,al
lexposur
est
osov
erei
gnswer
e
gi
ven0%r i
skweight
.
Al
lbankexposur
eshadar
iskwei
ghtof20%.
Cor
por
ateadv
anceshadar
iskwei
ghtof100%.
Suchr i
gidappr
oachwithoutanyconsi der
ati
onf or
thestrengt
hsorweaknessesofi ndiv
idualenti
ties
wast hemainshort
comi ngoftheBasel -
Iaccord,
e.g.
,alll
oansbyabankt oacor porat
ionhavear i
sk
weightof100%andr equir
ethesameamountof
capit
al.
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Example:Aloantoacor
porati
onwit
haAAAcr
edi
t
rat
ingistr
eatedint
hesamewayasonetoa
corpor
ati
onwi t
haBcreditr
ati
ng.
Smal
lti
cketl
oans(
ret
aill
endi
ng)al
socar
ri
edar
isk
wei
ghtof100%.
Toovercomet heshortcomingsofBaselI ,t
heBasel
Commi tt
eeofBanki ngSupervisi
on( BCBS)rel
eased
the“I
nternati
onalConvergenceofCapi t
al
MeasurementandCapi talStandards:ARevised
Framewor k”onJune26, 2004.
Acompr ehensi
vev er
sionoftheRev
ised
Framewor kwasissuedinJune2006,whichi
sa
compil
ationoftheJune2004BaselIIFr
amework.
TheRev i
sedFrameworkseekstoarr
iveat
si
gnifi
cantl
ymoreri
sk-
sensiti
veapproachest
o
capi
talrequi
rement
s.
Itprovidesarangeofoptionsf ordeter
miningthe
capitalrequi
rementsforcreditri
skandoper at
ional
risktoallowbanksandsuper v i
sorstoselect
approachest hataremostappr opri
ateforthei
r
operationsandf i
nanci
almar kets.
 Joi
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TheRev i
sedFramewor kconsistsoft
hree-mut
ual
ly
rei
nforci
ngpil
lars,
v i
z.,
mi ni
mum capi
tal
requi
rements,supervi
soryrevi
ewofcapital
adequacy,andmar ketdisci
pli
ne.

BASEL-
II–REVI
SEDFRAMEWORK:
TheRevisedFrameworkconsi
stsoft
hree-
mut
ual
ly
rei
nfor
cingPil
lar
s,v
iz.
,
1-
Mini
mum capi
talr
equi
rement
s,
2-
Super
visor
yrev
iewofcapi
taladequacy
3-Mar
ketdi
sci
pli
ne.
UnderPi l
lar1,t
heFramewor koffer
st hr
eedi
sti
nct
optionsforcomput i
ngcapit
alrequi
r ementfor
creditri
skandt hr
eeotheropti
onsf orcomputing
capitalr
equirementforoper
ati
onalr isk.
Theseopti
onsforcreditandoper ati
onalri
sksare
basedonincr
easingrisk-sensi
ti
vi
t yandall
owbanks
tosel
ectanapproacht hatismostappr opri
ateto
thest
ageofdevelopmentofbank' soperat
ions.
 Joi
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Theopt
ionsav
ail
abl
eforcomput
ingcapi
talf
or
cr
edi
tri
skare:
1-
Standar
disedAppr
oach(
opt
edbyI
ndi
anbank)
2-Foundat
ionI
nter
nalRat
ingBasedAppr
oach
3-Adv
ancedI
nter
nalRat
ingBasedAppr
oach.

Theopt
ionsav
ail
abl
eforcomput
ingMar
ketr
iskar
e
1-
Standar
dizeddur
ati
onappr
oach
(
opt
edbyI
ndi
anbank)
2-
Standar
disedmat
uri
tyappr
oach
3-
Int
ernalmodel
sappr
oach(
suchasVAR)

Theopti
onsavai
labl
eforcomput
ingcapi
talf
or
oper
ati
onalr
iskare
1-
Basi
cIndi
cat
orAppr
oach(
opt
edbyI
ndi
anbank)
2-
Standar
disedAppr
oachand
3-
Adv
ancedMeasur
ementAppr
oach.
 Joi
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SCOPEOFAPPLI
CATI
ON:

Therevisedcapit
aladequacynor msar eappli
cabl
e
uni
formlytoallCommer cialBanks(except
Cooperativ
eBanks,LocalAr eaBanksandRegi onal
RuralBanks),
bothatthesol olevel(
globalposi
ti
on)
aswellasattheconsolidatedlevel.
AConsoli
dat
edbankisdef
inedasagroupof
ent
it
ieswher
eali
censedbankisthecont
rol
li
ng
ent
it
y.
Aconsoli
datedbankwil
lincl
udeal
lgroupenti
ti
es
underi
tscontr
ol,
excepttheexempt
edentit
ies.
Aconsol i
datedbankmayexcl udegr
oupcompani es,
whichar eengagedi
ni nsur
ancebusinessand
businessesnotpert
ainingtofi
nanci
alservi
ces.
Aconsolidatedbankshoul
dmai nt
ainami ni
mum
Capi
taltoRisk-wei
ghtedAsset
sRat i
o(CRAR)as
appl
icabl
et oabankonanongoi ngbasis.
 Joi
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KeepinginviewtheReserveBank'sgoalt ohave
consist
encyandhar monywithinternat
ional
standar
ds,itwasdecidedthatallcommer cial
banksinIndia(excl
udi
ngCo- operat
iveBanks,Local
AreaBanksandRegi onalRuralBanks)shalladopt
St
andar
disedAppr
oach(
SA)f
orcr
edi
tri
sk
Basi
cIndi
cat
orAppr
oach(
BIA)f
oroper
ati
onalr
isk
Standar
disedDur
ati
onAppr
oach(
SDA)f
ormar
ket
ri
sks.
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BFM MODULE – D
Chapter 27: CAPITAL ADEQUACY
THE BASEL-II OVERVIEW (PART-II)
What will we study?
*What is PILLAR-I (Minimum Capital Requirement)?

THREE PILLAR OF BASEL-II

Pillar-I: Minimum Capital Requirement

Pillar-II: Supervisory Review
Pillar-III: Market Discipline

PILLAR-I– MINIMUM CAPITAL REQUIREMENTS

The capital ratio continues to be calculated using
The definition of regulatory capital and risk-
Weighted assets.
 Joi
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Thedef i
nit
ionofel
igi
bleregul
ator
ycapitall
argel
y
continuest obeasdefinedint
heearli
eraccordof
1988andamendedt oincl
udeTier
-II
Icapit
alas
prescribedinJanuary96andSeptember97.
Thust
het
erm capi
talwoul
dincl
ude
Ti
er-
Iorcor
ecapi
tal
,
Ti
er-
IIorsuppl
ement
alcapi
tal
,and
Ti
er-
II
Icapi
tal
.
TierII
Icapi
tal,whi
chtookcareofmarketri
skoft
he
bankshassi ncebeenphasedoutwiththe
i
nt r
oducti
onofBaselIIIgui
del
ines.
Thet
otalcapi
talr
ati
oshoul
dbemi
mimum 8%.
(
9%i
nIndi
a).
Corecapit
alconsi
stsofpai
dupcapital,
free
reser
vesandunall
ocatedsur
pluses,
lessspeci
fi
ed
deducti
ons.
 Joi
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Supplementarycapit
alcompr i
sessubor dinated
debtofmor ethanfiv
ey ears’matur
it
y,loanl oss
reserves,
reval
uati
onr eser
ves(whichisnowpar tof
Tier-
Icapit
alinI
ndia),i
nvestmentfl
uctuat i
on
reserves,
andlimit
edlifepref
erenceshar es.
Ti
er-
IIcapi
tali
srest
ri
ctedt
o100%ofTi
er-
Icapi
tal
asbefore.
Tier-
II
I(Present
lynotall
owedbyRBI)capi
tal
consistsofshort-
ter
m subordi
nat
eddebtforthe
solepurposeofmeet ingapropor
ti
onofthecapit
al
requir
ementf ormarketri
sk.
Ti
er-
II
Icapi
talwillbeli
mitedt
o250%ofabank’s
Ti
er-
Icapi
talthatisrequi
redt
osuppor
tmarketr
isk.

Tier-
II
Icapitalwasprovi
dedundert heBaselII
guideli
nes,butRBIhasnotpermittedthiscapi
talfor
Banksi [Link]
ththeint
roduct
ionofBaselI I
I,
thiscapit
alwasphasedoutbyBCBSal so.
 Joi
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Anycapit
alrequi
rementar
isi
ngi
nrespectofcr
edit
andcounter-
part
yri
skneedstobemetbyTier-
Iand
Tier
-I
Icapi
tal.
Thescopeofri
skweightedassetsi
sexpandedto
i
ncludecer
tai
naddit
ionalaspect
sofmarketri
sk
andalsooper
ati
onalri
sk.
Theareaofoper
ati
onalr
iski
sbroughtundert
he
ambitofr
isk-
wei
ghtedasset
sforthefi
rstt
ime.
Capi
taladequacyrat
io=Regul
ator
yCapi
tal
/Tot
al
ri
skweightasset
s
Totalri
skweight
edasset sincludethecapi t
al
requi
rementformarketriskandoper ationalri
sk
multi
pli
edby12.5,i
.[Link]
ocaloft hemi ni
mum
capit
alrequi
rementof8%( I
nI ndi
a,t
her iskweight
hasbeencappedat11. 11si ncethemi nimum
capit
alrequi
rementis9%)
al
ongwi
thr
iskwei
ght
edasset
sforcr
edi
tri
sk.
 Joi
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ThusTot
alRi
skwei
ght
edasset
s=
Riskweight
edassetsforcr editr
isk+12.5*
Capi
tal
requi
rementformarketrisk+12.5*Capi
tal
requi
rementforoper
ationalrisk.
ThusTot
alRi
skwei
ght
edasset
s(I
NINDI
A)=
Riskweight
edassetsforcr editr
isk+11.
11*Capi
tal
requi
rementformarketrisk+11.11*Capi
tal
requi
rementforoper
ationalrisk.

Pi
ll
ar2:Super
visor
yRev
iew:
[Link]
aluat
eri
skassessment
[Link]
ntegr
it
yofbank’
sinter
nal
processestoassesst
headequacyofcapi
tal
[Link]
emaintenanceofmini
mum capitalwi
th
promptcor
rect
iveacti
on(PCA)forshor
tfal
l
[Link]
escr
ibedi
ff
erent
ialcapi
tal
,wher
enecessar
yi.
e.
 Joi
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wher
ethei
nter
nalpr
ocessesar
esl
ack.
Pi
ll
ar3:Mar
ketDi
sci
pli
ne:
1-Enhancedi
scl
osur
es
2-Cor
edi
scl
osur
esandsuppl
ement
arydi
scl
osur
es
3-Di
scl
osur
esshoul
dbemadeonhal
fyear
lybasi
s.

Thust heBasel
-I
Iaccorddoesnotmer el
yprescr
ibe
minimum capit
alrequi
rement,butenv
isages
processesofsupervi
soryr
eviewandmar ket
di
scipline.
Therevi
sedfr
amewor
kismor
eri
sksensi
ti
vet
han
the1988ccor
d.
Therear
eincent
ivesf
ort
hosebanks,whi
chhav
e
bett
erri
skmanagementcapabi
li
ti
es.
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BFM MODULE – D
Chapter 28: ASSET CLASSIFICATION AND
PROVISIONING NORMS (PART-I)
What will we study?
*What is Asset Classification?
*What is NPA?

ASSET CLASSIFICATION (History):

In August 1991, a high-level committee, headed by
M. Narasimhan was appointed to examine various
Aspects of financial system.
One of the important recommendations of the
Narasimham Committee was that balance sheets
Of the banks should be transparent and comply with
International accounting standards.
The Committee recommended that banks should
Adopt uniform accounting practices in regard to
Income recognition and bad debts provisioning.
 Joi
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Inparti
cul
ar,
incomer
ecogni
ti
onofnon-
perf
orming
assetsshoul
dnotbeonaccr
ualbasi
sbutonrecor
d
ofrecover
y.
TheCommitteeal
sosuggest
edthatpr
ovisi
oning
shoul
ddependuponapropercl
assi
fi
cati
onof
asset
s,whi
chintur
nshouldbebasedonobjecti
ve
cri
ter
ia.
I
nl i
newi ththeinternat
ionalpracti
cesandasper
therecommendat ionsmadebyt heCommi tteeon
theFinancialSystem (Chair
[Link] asi
mham) ,
theReser veBankofI ndiahasintroduced,ina
phasedmanner ,prudenti
alnormsf orincome
recognit
ion,assetclassif
icat
ionandpr ov i
sioning
fortheadv ancespor t
foli
oofthebanks.
 Joi
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Def
ini
ti
ons:Non-
per
for
mingAsset
s:
Anasset,i
ncl
udi
ngal easedasset
,becomesnon-
perf
ormingwhenitceasestogenerat
eincomefor
thebank.
Anon-
per
formingasset(
NPA)i
sal
oanoran
adv
ancewhere:
1-
IfTer
m Loan:
I
nt er
estand/ori
nstal
lmentofpri
nci
palr
emain
overdueforaperi
odofmor ethan90daysi
n
respectofatermloan.
2-
IfCC/
ODAccount
:
A)Theaccountr
emai
ns'
outofor
der'
inr
espectof
anOver
draft
/CashCr
edi
t(OD/
CC).
Or
B)IfCCandODli
mitisnotrenewed/rev
iewed
wit
hin180day
sfrom duedateofrenewal,
theni
tis
cal
ledNPA.
Or
 Joi
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C)Ifstockst
atementwhi
chi
ssubmi
tt
edi
nbankby
customeris
3mont
hsol
d:i
rr
egul
araccount
6mothsol
dornofr
eshst
ockst
atementi
srecei
ved
i
nlast6mont
hs:NPA

'
OutofOr
der
’St
atus:
Anaccountshouldbetr
eatedas“outoforder
'ift
he
out
standingbal
anceismorethansancti
onedli
mit
orDrawingpowerformorethan90days.
or
Eithert
herei
snocredi
torcr
edi
tsar
enotenought
o
recoverthei
nter
est
.
Thentheseaccount
sshoul
dbet
reat
edas“
outof
order
'.
 Joi
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3-
IfBi
llPur
chasedorBi
llHandl
ed:
Thebil
lremainsov
erdueforaperi
odofmoret
han
90daysinthecaseofbi
ll
spurchasedand
di
scounted.
'
Over
due'
:
Anyamountduet othebankunderanycr
edi
t
faci
li
tyi
s‘ov
erdue’i
fiti
snotpaidontheduedat
e
fi
xedbythebank.

4-
IfAgr
icul
tur
eLoan:
t
hei
nstal
lmentofpr
inci
palori
nter
estt
her
eon
r
emai
nsov er
duefor
*
Twocr
opseasonsf
orshor
tdur
ati
oncr
ops.
*
Onecr
opseasonf
orl
ongdur
ati
oncr
ops.
 Joi
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Banksshouldcl
assi
fyanaccountasNPAonlyi ft
he
i
nterestchar
geddur
inganyquart
erisnotser
viced
ful
lywithi
n90daysfr
om theendofthequart
er.
Theclassi
fi
cat
ionofanassetasNPAshoul
dbe
basedontherecor
dofrecover
y.
Bankshoul dnotcl assi
fyanadv anceaccountas
NPAmer elyduet otheexistenceofsome
defi
ciencieswhi charetempor aryi
nnaturesuchas
*non-
av ai
labil
it
yofadequat edr awi
ngpowerbased
onthel at
estav ail
ablestockstatement,
*
bal
anceoutst
andi
ngexceedi
ngt
hel
imi
t
t
emporar
il
y,
*nonsubmi
ssi
onofst
ockst
atement
sonduedat
e
and
*
non-
renewaloft
hel
imi
tsont
heduedat
e,et
c.
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AssetCl
assi
fi
cat
ion:
1-
Standar
dAsset
2-Subst
andar
dAsset
3-
Doubt
fulAsset
4-
LossAsset
Not
e:2,
3,
4ar
ecal
ledNPA.
1-
Standar
dAsset
:
Ifpaymenti
sregul
ator
ycomi
ngt
heni
tisa
standar
dasset.
Speci
alMensi
onAccount
:(
SMA)
*
Irr
egul
arst
andar
daccount
sar
ecal
ledSMA
Now,
SMA0:I
fir
regul
arf
or1-
30day
s
SMA1:
Ifi
rr
egul
arf
or31-
60day
s
SMA2:I
fir
regul
arf
or61-
90day
s
*Af
ter90day
saccountbecomeNPA.
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(
a)Subst
andar
dAsset
s:
OnbecomingNPAt heaccounti
scl
assi
fi
edas
Subst
andardaccount
.(
upto12months)
Witheff
ectfrom 31March2005,asubstandar
d
assetwouldbeone,whichhasremainedNPAf ora
peri
odlessthanorequalto12months.
(
b)Doubt
fulAsset
s:
I
fNPAorSubst
andar
dformor
ethan12mont
hs.

Witheffectfr
om March31,2005,anassetwouldbe
cl
assif
iedasdoubtfuli
fithasremainedi
nthe
subst
andar dcat
egoryforaperi
odof12mont hs.
Doubt
fulAsset
sar
efur
thercl
assi
fi
edas:

Doubt
ful1(
D1)
:Ifdoubt
fulupt
o1y
ear
Doubt
ful2(
D2):I
fdoubt
fulf
ormor
ethan1y
ear
andupto3years
Doubt
ful3(
D3)
:Ifdoubt
fulf
ormor
ethan3y
ear
s.
 Joi
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(
c)LossAsset
s:
Thataccounti
nwhi
chmoneycan'
tber
ecov
ered.
Alossassetisonewherelosshasbeenident
if
ied
bythebankorinter
nalorext
ernalaudi
tor
sorthe
RBIinspect
ionbuttheamounthasnotbeenwritt
en
offwholl
y.

I
ncomeRecogni
ti
on:
Thepol
icyofi
ncomerecognit
ionhastobe
obj
ect
iveandbasedontherecordofr
ecover
y.
I
nternat
ionall
y ,i
ncomefrom non-perf
ormingassets
(NPA)isnotr ecogni
sedonaccr ualbasi
s,butis
bookedasi ncomeonl ywhenitisactual
lyrecei
ved.
Ther
efor
e,t
hebanksshoul
dnotchar
geandt
aket
o
i
ncomeaccounti
nter
estonanyNPA.
Howev er,inter
estonadvancesagai
nstterm
deposi
t s,NSCs, KVPsandli
fepoli
ciesmaybe
takentoi ncomeaccountont heduedate,
provided
adequat emar gi
nisavai
labl
eintheaccounts.
 Joi
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Incaseofgovernmentguar ant
eedadvances
becomingNPA, thei
nterestonsuchadvances
shouldnotbetakentoincomeaccountunlessthe
i
nteresthasbeenreal
ised.
Summar
y:
*
SMA0:I
fir
regul
arf
or1-
30day
s
SMA1:
Ifi
rr
egul
arf
or31-
60day
s
SMA2:I
fir
regul
arf
or61-
90day
s
Thesear
est
andar
daccountbuti
rr
egul
ar
*Subst
andar
d:f
rom dat
eofNPA(
91t
hday
)andupt
o
1year
Thi
sisNPAaccount
.
*
Doubl
efulAsset
:IfNPAorSubst
andar
dformor
e
t
han1year.
D1:Doubt
fulf
or1y
ear
s
D2:Doubt
fulf
ormor
ethan1y
earupt
o3y
ear
s
D3:Doubt
fulf
ormor
ethan3y
ear
s
 Joi
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Exampl
e:
31-
03-
2020:I
nst
all
mentwasdue.
01-
04-
2020:SMA0
30-
04-
2020:SMA0
01-
05-
2020:SMA1
30-
05-
2020:SMA1
31-
05-
2020:SMA2
29-
06-
2020:SMA2
30-
06-
2020:NPAorSubst
andar
d
30-
06-
2021:
NPAorSubst
andar
d
01-
07-
2021:
Doubt
fulAsset(
D1)
01-
07-
2022:
Doubt
fulAsset(
D1)
02-
07-
2022:
Doubt
fulAsset(
D2)
02-
07-
2024:
Doubt
fulAsset(
D2)
03-
07-
2024:Doubt
fulAsset(
D3)
Thenl
ossasset
.
 Join CAIIB WITH ASHOK on YouTube & App

BFM MODULE – D
Chapter 28: ASSET CLASSIFICATION AND
PROVISIONING NORMS (PART-II)
What will we study?
*What is Provisioning Norm?

PROVISIONING NORMS:
A non-performing asset (NPA) causes two-fold
Impact on the profitability of a bank.

On one hand, the bank ceases to earn interest on

This asset and thus is deprived of its legitimate
Income from the asset.

On the other hand, the bank is required to make

Provisions for this asset, depending on the
classification/ category of the asset and value of
security, if any.
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Thismakesaf
urt
herdenti
nthepr
ofi
tabi
li
tyoft
he
bank.
TheReserveBankofI ndiaint
r oducedt hesy
stem of
assetcl
assifi
cati
onandpr ovisioninginli
newith
i
nternat
ionalpract
icesforthef i
rstti
mei n1993.
Thenormshaveunder
gonesev
eralchangesdur
ing
thel
ast27year
s.
Inconformi
tywit
htheprudenti
alnor
ms, pr
ovi
sions
shouldbemadeont henon-per
formi
ngassetson
thebasisofcl
assi
fi
cati
onofassetsint
oprescr
ibed
categori
es.
Takingintoaccountt hetimelagbet weenan
accountbecomi ngdoubtfulofrecovery,
its
recognit
ionassuch, t
hereali
sationofthesecurit
y
andt heerosionov erti
mei nthev al
ueofsecurit
y
chargedt othebank, t
hebanksshoul dmake
provisi
onagai nstsubstandardassets,doubtf
ul
assetsandl ossasset sasment ionedbelow:
 Joi
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St
andar
dAsset
s:
(i
)Banksarerequi
redtomakegeneralpr
ovi
sionf
or
standar
dassetsatthefol
lowi
ngr
ates:
LOAN(
Standar
dAsset
) Pr
ovi
sioni
ng
Nor
malRat
e 0.
4%
MSE 0.
25%
Medi
um Ent
erpr
ise 0.
40%
Advt
oAgr
icul
tur
e 0.
25%
Commer ci
alr
ealest
ate 1%
(shop,
offi
ce,
par
ketc.)
Commer
cialr
ealest
ate(
Housi
ng) 0.
75%
I
ndi
vi
dualHousi
ngl
oan 0.
25%
Housi
ngl
oanatt
easerr
ate 2%
Housi
ngl
oanatt
easerr
ate 0.
40%
aft
er1yearf
rom thedat
eonwhi ch
t
herat
esareresetathi
gherr
ates
 Joi
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(a)
(i
)Farm Cr
editt
oagr
icul
tur
alacti
vi
ti
esandSmall
andMi cr
oEnter
pri
ses(
SMEs)sectorsat0.
25per
cent.
(a)(
ii
)TheMedium Enterpri
seswi
llat
tract0.
40%
standar
dassetpr
ov i
sioning.
(b)
(i
)Advancest
oCommerci
alRealEst
ate(
CRE)
Sectorat1.
00percent
.
(b)
(i
i)AdvancestoCommercialRealEst
ate-
Resident
ialHousi
ngSect
or(CRE-RH)at0. 75per
cent.
(c)Housi
ngl
oansextendedatt
easerrat
esat2per
centi
nv i
ewoft
hehigherri
skassoci
atedwi
ththem.
Thepr ovi
sioningrateshallbereducedto0.40per
centafter1y earfrom thedateonwhichtherates
areresetathi gherrat
esiftheaccountsremain
'
standard'.
(d)Al
lotherl
oansandadvancesnoti
ncl
udedi
n(a)
and(b)aboveat0.
40percent.
 Joi
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(
ii
)Theprovi
sionsonstandar
dasset
sar
enott
obe
r
eckonedforarr
ivi
ngatnetNPAs.
(i
ii
)Theprovisi
onst owardsStandar
dAsset sneed
notbenettedfrom grossadvancesbutaretobe
shownseparatelyas'Conti
ngentProvisi
onsagainst
StandardAssets'under‘
OtherLiabi
li
ti
esand
Provi
sionsOthers'i
nSchedule5oft hebalance
sheet.
TeaserRat
e:
Wheninst
resestr
atesarelowint
hebegi
nni
ngand
af
tersometimeiti
ncreases.

Subst
andar
dAsset
s:
AssetTy
pe Pr
ovi
sioni
ng
Nor
malSubst
andar
dor 15%
Secur
edSubst
andar
d 15%
Usecur
edSubst
andar
d 25%
 Joi
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Ageneralprovi
sionof15%ont ot
aloutst
anding
shoul
dbemadewi thoutmakinganyall
owancefor
ECGCguar ant
eecov erandsecur
it
iesavai
labl
e.
The‘unsecuredexposures'
whicharei
dentif
iedas
substandar
dwoul dattr
actaddi
ti
onalpr
ovisi
onof
10%,i.e.
,atotalof25%ontheoutst
andingbalance.
Unsecur
edl
oan:
Aloanisconsider
edasunsecuredfrom begi
nning
i
freal
isabl
ev al
ueofsecur
it
iesattheti
meof
sanct
ionofloanwas10%orl essthan10%oft he
l
oanamountsanct i
oned.

Doubt
fulAsset
s:
Per
iodf
orwhi chAssetwas Secur
ed Unsecured
doubtful Porti
on Porti
on
Upt
o1y
ear
(D1) 25% 100%
1y
ear
+&upt
o3y
ear
s(D2) 40% 100%
3y
ear
s+(
D3) 100% 100%
 Joi
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(i
)100%oft heextenttowhichtheadv anceisnot
coveredbythereali
sablevalueofthesecurit
yto
whichthebankhasav al
idrecourseandt he
real
isabl
evalueisesti
mat edonar eal
isti
cbasis.
(i
i)I
nregardtothesecuredporti
on,provi
sionmay
bemadeont hef ol
lowingbasi
s,attherat
esr angi
ng
fr
om 25%t o100%oft hesecuredporti
ondepending
upontheperi
odf orwhichtheassethasremai ned
doubtf
ul.
LossAsset
s:
AssetTy
pe Pr
ovi
sioni
ngr
equi
rement
LossAsset 100%

*
Lossasset
sshoul
dbewr
it
tenof
f.
*Ifl
ossasset
sar epermit
tedtoremaininthebooks
foranyr
eason, 100%oftheoutstandi
ngshouldbe
provi
dedforprovisi
oni
ng.
 Joi
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Summar
y:
St
andar
dAsset
s:
LOAN(
Standar
dAsset
) Pr
ovi
sioni
ng
Nor
malRat
e 0.
4%
Advt
oSME 0.
25%
Advt
oMedi
um Ent
erpr
ise 0.
40%
Advt
oAgr
icul
tur
e 0.
25%
Commer ci
alr
ealest
ate 1%
(shop,
offi
ce,
par
ketc.)
Commerci
alr
ealest
ate 0.
75%
(Housi
ng)
I
ndi
vi
dualHousi
ngl
oan 0.
25%
Housi
ngl
oanatt
easerr
ate 2%
Housi
ngl
oanatt
easerr
ate 0.
40%
aft
er1y
earfrom t
hedateon
whi
cht
heratesarer
esetat
hi
gherrat
es
 Joi
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Subst
andar
dAsset
s:
AssetTy
pe Pr
ovi
sioni
ng
Nor
malSubst
andar
dor 15%
Secur
edSubst
andar
d 15%
Usecur
edSubst
andar
d 25%

Doubt
fulAsset
s:

Per
iodforwhi
ch Provi
sioni
ng Provi
sioning
Assetwas Requir
ement Requir
ement
doubt
ful Secured Unsecured
Porti
on Porti
on
Upt
o1y
ear 25% 100%
1y
ear
+&upto3 40% 100%
year
s
3y
ear
s+ 100% 100%
 Joi
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LossAsset
s:

AssetTy
pe Pr
ovi
sioni
ngr
equi
rement
LossAsset 100%
 Join CAIIB WITH ASHOK On YouTube & APP
BFM MODULE – D
CHPATER 28:- ASSET CLASSIFICATION AND
PROVISIONING NORMS
(CASE STUDY ) PART :- III

What we will study ?

*Case Study based on Provisioning Norms ?
 Join CAIIB WITH ASHOK On YouTube & APP
BFM MODULE – D
CHPATER 28:- ASSET CLASSIFICATION AND
PROVISIONING NORMS
(CASE STUDY-2 ) PART :- IV

What we will study ?

*Case Study based on Provisioning Norms ?
 Join CAIIB WITH ASHOK On YouTube & APP
BFM MODULE – D
CHPATER 28:- ASSET CLASSIFICATION AND
PROVISIONING NORMS
(CASE STUDY-3 ) PART :- V

What we will study ?

*Case Study based on GROOSS NPA,NET,NPA and
PROVISIONING ?
 Join CAIIB WITH ASHOK on YouTube & App

BFM MODULE - D
Chapter 29: LIQUIDITY MANAGEMENT (PART-I)
What we will study?

*What is Liquidity?
*What is Liquidity Management?

Funding liquidity risk vs market liquidity risk:

Funding liquidity risk is different from market

Liquidity risk.
Funding liquidity risk is the risk that a bank will be
Unable to pay its debts when they fall due.
In simple terms, it is the risk that the bank cannot
Meet the demand of customers wishing to
Withdraw their deposits.
Market liquidity risk, on the other hand, is the risk of
Not being able to sell assets in a timely fashion
Without having to offer a heavy discount.
Research has shown that funding liquidity issues
Can often lead to market liquidity risk and vice vers
 Joi
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I
NTRODUCTI
ON:
Theobj
ecti
vesofassetl
iabi
li
tymanagement
(ALM)
aret
wo-f
old:
Ensur
ingpr
ofi
tabi
li
ty and
Ensur
ingl
iqui
dit
y.
Li
quidi
ty,whichi
sr epr
esentedbythequal
it
yand
marketabi
li
tyofassetsandliabi
li
ti
es,
exposest
he
or
ganisati
ont ol
iquidi
tyr
isk.
Unli
keot herri
sksli
keinterestr at
er i
sk,mar ketri
sk,
operati
onalandtechnologyr isksandf orei
gn
exchanger i
sksthatcant hreatenthev er
ysol vency
ofthebank, l
iqui
dit
yriskisanor malaspectof
everydaymanagementofaf inanciali
nstit
ution.
Onl
yinext
remecases,l
iqui
dit
yri
skpr
obl
ems
t
ransl
atei
ntosol
vencyr
iskprobl
ems.
Thenumerousbankfai
lur
esandacoupleof
l
iqui
dit
ycr
isesatmajorbanksduri
ng1980sand
90shavemadebankersintheUSmor eandmore
awareoft
heneedforbankliqui
dit
y.
 Joi
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Oflate,t
hemar kett
urmoilt
hatbeganinmid-
2007
hashighli
ghtedthecruci
ali
mportanceofmarket
l
iquidi
tytothebankingsect
or.
Thecont r
actionofl iquidi
tyincert
ainproductsand
i
nterbankmar kets,aswel lasanincreased
probabil
it
yofof f
-balancesheetcommi tments
comingont obanks' balancesheets,l
edt osever
e
fundi
ngl i
quiditystrainsforsomebanksandcent ral
bankinterventionneededi nsomecases.
Theseev entsemphasisedthelinksbetween
fundi
ngandmar ketl
iqui
dityri
sk,the
i
nterrel
ati
onshipoffundingli
quidit
yriskandcredi
t
ri
sk,andt hefactt
hatli
quidit
yisakeydet er
minant
ofthesoundnessoft hebankingsector.

Toaddr esstheli
quidi
tyri
skoft
hebanksonly,Basel
II
Iguideli
neshav ecomeouttwoli
qui
dit
yrati
os,
Liqui
dityCoverageRati
o(LCR)andNetStabl
e
FundingRatio(NSFR).
 Joi
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DEFI
NITI
ON:
Banksneedl
iqui
dit
ytomeetdeposi
twi
thdr
awal
s
andtofundl
oandemands.
Thevari
abi
li
tyofloandemandandthevari
abil
it
yof
deposi
tsdet
ermineabank'
sliqui
dit
yneeds.
Li
quidityr
epresentstheabi
li
tyt
oaccommodatethe
decreasesinli
abil
it
yandtofundthei
ncr
easesin
assets.
Abankhasadequat eli
qui
dit
ywhenitcanobtai
n
suff
ici
entfundsei
therbyi
ncreasi
ngl
iabi
li
ti
esorby
convert
ingasset
s,prompt
lyandatareasonabl
e
cost.
Liabi
li
tyisessent
ialinal
lbankstocompensat efor
theexpectedandt heunexpectedbalancesheet
fl
uctuati
onsandtopr ovi
def undsforgrowth.
Thepr i
ceofli
qui
dit
yisafunct i
onofmar ket
conditi
onsandmarketpercepti
onsoft her i
sks,
bothinter
estr
ateri
skandcr editr
isks,refl
ectedi
n
thebank'sbal
ancesheetandof fbalancesheet
acti
vi
ties.
 Joi
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Ifl
iqui
dityneedsarenotmett hr
oughliqui
dassets
holdi
ngs, abankmaybef or
cedtorest
ructur
eor
acquir
eaddi t
ionall
iabi
li
ti
esunderadversemarket
condit
ions.

DI
MENSIONSANDROLEOFLI
QUI
DITYRI
SK
MANAGEMENT:
ABank'sli
quidi
tymanagementistheprocessof
generat
ingfundstomeetit
scontr
actualor
rel
ati
onshipobli
gati
onsatr
easonablepri
cesatal
l
ti
mes.
Newloandemand, existi
ngloancommitment
s,and
depositwi
thdr
awalsar ethebasi
ccont
ract
ualor
rel
ati
onshi
pobligat
ionsthatabankmustmeet.

Effect
ivel
iqui
dit
ymanagementbyabankser
ves
thefoll
owi
ngimport
antpurposes:
(a)I
tdemonstr
atesthemarketpl
acet
hatt
hebank
i
ssafeandtheref
orecapabl
eofrepay
ingi
ts
borr
owings.
 Joi
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(b)I
tenabl
esbankt
omeetit
spriorl
oan
commitments,
whet
herf
ormalorinf
ormal
.
(c)I
tenabl
est
hebankt
oav
oidunpr
ofi
tabl
esal
eof
assets.
Thisf
unct
ionper
mit
st hebankt
oavoidsaleof
asset
satfi
resal
epr
ices,t
ogenerat
efunds.
(d)I
tlower
sthesizeofthedef
aul
tri
skpr
emi
um t
he
bankmustpayforfunds.
Thisfunct
ionfocusesonthereasonabl
eprice
aspectsofthedefi
nit
ionofl
iqui
ditymanagement
.

Bank’
swit
hst r
ongbal
ancesheet
swillbeper
cei
ved
bythemarketpl
aceasbei
ngli
quidandsafe.
Suchbankswi l
lbeabl
etobuyf
undsatlowri
sk
premium ascomparedtot
hemarket
'sper
cei
ved
credi
tworthi
ness.

Adequacyofabank'
sli
qui
dit
yposi
tiondepends
uponananaly
sisoft
hefol
lowingf
actor
s:
 Joi
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[Link]
stor
icalf
undi
ngr
equi
rement
s
[Link]
rentl
iqui
dit
yposi
ti
on
[Link]
ici
pat
edf
utur
efundi
ngneeds
[Link]
cesoff
unds
[Link]
ionsf
orr
educi
ngf
undi
ngneeds
[Link]
esentandant
ici
pat
edassetqual
it
y
[Link]
esentandf
utur
eear
ningscapaci
ty
[Link]
esentandpl
annedcapi
talposi
ti
on

Asallbanksareaff
ectedbychangesinthe
economiccli
mate,themonit
ori
ngofeconomi cand
moneymar kettr
endsisthekeytoli
qui
ditypl
anni
ng.
Asoundf i
nancialmanagementcanminimizethe
negati
veeffect
softhesetrendswhi
leaccentuat
ing
theposit
iveones.

Thefact
orst
hatmayaf
fectabank'
sli
qui
dit
y
i
nclude:
 Joi
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[Link]
inei
near
nings
[Link]
ncr
easei
nnon-
per
for
mingasset
s(NPA)
[Link]
tconcent
rat
ions
[Link]
adi
ngbyr
ati
ngagenci
es
[Link]
nessoppor
tuni
ti
es
[Link]
sit
ions
[Link]
axi
nit
iat
ives
Toprovi
defundstosati
sfyi
tsf
undingneeds,a
bankmustperfor
m oneoracombinati
onofthe
fol
lowi
ng:
[Link]
sposeofl
iqui
dasset
s
2.I
ncr
easeshor
t-
ter
m bor
rowi
ngs
[Link]
easehol
dingsofl
essl
iqui
dasset
s
4.I
ncr
easel
iabi
li
ti
esofat
erm nat
ure
5.I
ncr
easecapi
talf
unds
Assuch, l
iqui
dit
ymanagementanditsassociat
ed
ri
sksassumepar amounti
mportanceunderthe
over
alll
iabil
it
ymanagementstr
ategi
es.
 Join CAIIB WITH ASHOK on YouTube & App

BFM MODULE - D
Chapter 29: LIQUIDITY MANAGEMENT (PART-II)
What we will study?

*What are the different types of liquidity risk?

Types of Liquidity Risks:

Liquidity exposure can stem from both internally
(Institution specific) and externally generated
factors.
External liquidity risks can be geographic, systemic
Or instrument-specific.
Internal liquidity risk relates largely to perceptions
Of an institution in its various markets: local,
regional, national or international.

Other categories of liquidity risk are:

1-FundingRisk
2-TimeRisk
3-CallRisk
 Joi
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Fundi
ngRi
sk:
Needt orepl
acenetout f
lowsduetounanti
cipated
withdrawal(
pre-
mat ureclosur
eofdeposi
ts)/non-
renewalofdeposit
s( wholesal
eandret
ail
),ar
ises
duet o:
1-
Fraudcausi
ngsubst
ant
iall
oss
2-
Syst
emi
cri
sk
3-
Lossofconf
idence
4-
Liabi
li
ti
esi
nfor
eigncur
renci
es

Ti
meRi
sk:
Needt
ocompensatefornon-
recei
ptofexpect
ed
i
nfl
owsoff
unds,ar
isesdueto:
1-
Sev
eredet
eri
orat
ioni
ntheassetqual
it
y
2-St
andardassetstur
ningint
onon-perf
orming
assetsand/
orbor r
owers'def
aul
ti
ngt orepayasper
thetermsofrepayment
3-
Tempor
arypr
obl
emsi
nrecov
ery
 Joi
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Cal
lRi
sk:
Cryst
all
isationofconti
ngentl
iabi
li
ti
esandi
nabil
i
ty
toundertakeprofi
tabl
ebusinessoppor
tuni
ti
es
whendesi rabl
e,ari
sesdueto:
1-Conv
ersi
onofnon-
fundbasedl
imi
tint
ofund-
based
2-
Swapsandopt
ions

Manyt
imesmorethanonefact
ormani
festand
maket
heli
qui
dit
ysituat
ionwor
se.
Forexample,abigfr
audcanti
ghtentheposi
ti
onof
abankalongwi t
hlossofconf
idenceoft
hepubli
c,
resul
ti
ngar unonthebank.
Inadditi
ontorun,
theremaybeint
er-
bankdeal
ings
andinturn,
otherbanksmayalsobeaff
ect
edinthe
process.
I
fabankf ai
lstohonourit
scommi t
ment stothe
marketpart
ici
pants,i
tcancauset
heot her
par
tici
pantnothonouri
ngitscommitmentsbased
ontheexpectedinfl
owoffundsfr
om thefail
ed
 Joi
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i
nst
it
uti
on.
Sometimesf
orei
gncurr
enciescr eatecomplexi
tyt
o
l
iqui
dit
ymanagementbecauset herealstr
engthof
thebankmaynotbeknownt othef orei
gncredi
tor
s.
Theymaynotbeinaposi
ti
ontodist
ingui
sh
betweent
herumourandt
hereal
it
yofcr i
sis.
I
ncertai
ncir
cumstances,
abankmaynotbeableto
mobil
isedomest
icfundstomeetf
orei
gncur
rency
l
iabi
li
ti
es.

MEASURI
NGANDMANAGI
NGLI
QUI
DITYRI
SK:
Measur
ingandmanagingli
qui
dit
yareamongt
he
mostvi
talact
ivi
ti
esofcommerci
albanks.
Byassuringabank'
sabil
itytomeetit
sli
abil
it
iesas
theybecomedue, l
i
quidi
tymanagementcanr educe
theprobabil
it
yofanadversesi
tuat
iondevel
oping.
Evenincaseswherecri
sisdevelopsbecauseofa
probl
em el
sewhereatabank, suchasasev er
e
deter
ior
ati
oninassetquali
tyortheuncoveri
ngof
fr
aud,orwhereacri
sisrefl
ectsagenerali
sedloss
 Joi
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ofconfi
dencei
nfi
nanci
alinst
it
utions,
thetime
avail
abl
etoabanktoaddresstheproblem wi
llbe
determi
nedbyi
tsli
qui
dit
y.
Indeed, t
heimportanceofliqui
dit
ytranscendsthe
i
ndi v
idualinsti
tut
ion,si
nceal i
quidi
tyshort
fal
lata
singleinsti
tut
ioncanhav esystem-wide
repercussions.
Forthi
sreason,t
heanalysisofli
quidi
tyrequi
res
bankmanagement stomeasur enotonlythe
l
iquidi
typosi
ti
onsofbanksonanongoi ngbasisbut
alsotoexaminehowfundingrequir
ement sare
l
ikelyt
oev ol
veundercr
isisscenari
os.
Inpar t
icular
,goodmanagementi nformat i
on
systems, centrall
iqui
ditycont
rol
, analysi
sofnet
fundingr equi
rement sunderal
ternat i
vescenarios,
diversi
ficati
onoff undingsour
ces, andcont i
ngency
planningar ecruci
alelementsofst rongli
quidit
y
managementatabankofanysi zeorscopeof
operations.
 Joi
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Thefol
lowingst
epsarenecessar
yformanagi
ng
l
iqui
dit
yriski
nbanks:
[Link]
elopi
ngast
ruct
uref
ormanagi
ngl
iqui
dit
yri
sk
[Link]
ti
ngt
oler
ancel
evelandl
imi
tforl
iqui
dit
yri
sk
[Link]
ingandmanagi
ngl
iqui
dit
yri
sk

Dev
elopi
ngaSt
ruct
uref
orManagi
ngLi
qui
dit
yRi
sk:
Soundliquidi
tyr
iskmanagementi nvolvessett
inga
str
ategyforthebankensur i
ngeff
ectiveboardand
seniormanagementov ersi
ghtaswel lasoperati
ng
underasoundpr ocessformeasuring,monitori
ng
andcont r
olli
ngl
iqui
dit
yrisk.
Vir
tual
lyever
yfi
nancialt
ransacti
onorcommi
tment
hasimpli
cati
onsforabank'sli
quidi
ty.
Mor
eover
,thetr
ansf
ormati
onofill
iqui
dasset
sint
o
mor
eli
quidonesisakeyact
ivi
tyofbanks.
Thus,
abank'
sliquidi
typol
ici
esandliqui
dit
y
managementapproachshouldfor
mt hekey
el
ementsofabank'sgeneralbusi
nessstr
ategy
.
 Joi
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Understandi
ngthecont extofl
iquidi
tymanagement
i
nv ol
vesexaminingabank' smanager i
alappr
oach
tofundi
ngandl i
quidityoperat
ionsandi t
sli
quidi
ty
planni
ngunderalternati
vescenari
os.

Theli
quidit
ystrat
egyshouldsetoutthegeneral
appr
oacht hebankwillhavetoadopttoimprovethe
l
iqui
dit
yincludi
ngv ar
iousquanti
tat
iveand
qual
it
ati
v etar
gets.
Thest rategyshouldalsoaddressthebank'sgoalof
protectingfi
nancialst
rategyandtheabili
tyto
withstandst r
essfulev
ent si
nthemar ketplace.
Itshoul
denunci atespecif
icpolici
esonparti
cular
aspectsofliquiditymanagementl ikecomposit
ion
ofassetsandl iabili
ti
es,maintenanceofcumulati
ve
gapsov ercertainper i
odsandt heapproachto
managingl i
quidi t
yindiff
erentcurrenci
esandfrom
onecount r
yt oanot her.
Thest
rat
egyofmanagingli
quidi
tyri
skshoul
dbe
communicat
edt
hroughouttheorgani
sat
ion.
 Joi
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Allbusinessunit
swithinthebankt hatconduct
activ
iti
eshavinganimpactonl iquidi
tyshouldbe
full
yawar eoftheli
quidit
ystrat
egyandshoul d
operateundertheappr ovedpoli
ciesand
procedures.
TheBoar dshoul
dmoni t
ortheperf
ormanceand
l
iquidityri
skprof
ileofthebankandper i
odically
revi
ewi nf
ormati
ont hatist
imelyandsuff
icientl
y
detailedtoall
owt hem tounderst
andandassess
theliquidi
tyri
skfacingthebank'skeyport
foliosand
thebankasawhol e.
ABankshouldhav eali
quidi
tymanagement
st
ructur
einplacetoexecuteef
fect
ivel
ythel
iqui
dit
y
st
rategy
,pol
iciesandprocedur
es.
Theresponsibi
li
tyofmanagi
ngtheov
eral
lli
qui
dit
y
oft
hebankshoul dbeplacedwit
haspeci
fi
c
i
denti
fiedgroupwithi
nthebank.
Thismi
ghtbei nthef or
m ofanAssetLi
abi
li
ty
Committeecompr i
singofseni
ormanagement,the
tr
easur
yf unct
ionorar i
skmanagementdepart
ment .
 Join CAIIB WITH ASHOK on YouTube & App

BFM MODULE - D
Chapter 29: LIQUIDITY MANAGEMENT (PART-III)
What we will study?

*How tolerance level of liquidity risk is set by bank?

The following steps are necessary for managing

Liquidity risk in banks:
[Link] a structure for managing liquidity risk
[Link] tolerance level and limit for liquidity risk
[Link] and managing liquidity risk

Developing a Structure for Managing Liquidity Risk:

(Some part already covered in PART-II)
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.
 Joi
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Fi
rst
,banksareoftenl
esswel
l-
knowntol
iabi
li
ty
hol
dersi
nforeigncurr
encymar
kets.
Intheev entofmar ketconcer
ns,especi
all
yifthey
rel
atet oabank'sdomest icoper
atingenvi
ronment,
theseliabil
it
yholdersmaynotbeabl etodisti
ngui
sh
rumour sfrom f
actaswel lorasquickl
yasdomest ic
currencycustomer s.
Second,intheeventofadistur
bance,abankmay
notalwaysbeabletomobi l
izedomesticl
iqui
dit
yto
meetf or
eigncur
rencyfundingrequi
rements.
Hence,
whenabankconductsit
sbusi
nessi
n
mult
ipl
ecur
renci
es,i
tsmanagementmustmake
t
wokeydecisi
ons.
Thefi
rstdeci
sionconcer
nst
hemanagement
st
ruct
ure.
ABankwi t
hfundingrequi
rement
sinfor
eign
curr
enci
eswillgener
all
yuseoneofthefoll
owi
ng
thr
eeapproaches.
1-
Itmaycompl
etel
ycentr
ali
zel
iqui
dit
y
management(
theheadoff
icemanagi
ngl
iqui
dit
y
 Joi
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f
ort
hewhol
ebanki
nev
erycur
rency
).
2-Al
ternati
vely,
itmaydecent r
ali
zebyassigni
ng
operat
ingdivisi
onsr esponsi
bil
it
yforthei
rown
l
iquidi
ty,butsubjecttoli
mitsi
mposedbyt hehead
offi
ceorf r
equent,routi
nereport
ingtothehead
offi
ce.
Forexampl
e,anon-Eur
opeanbankmi ghtassi
gnit
s
Londonoff
icet
heresponsibi
li
tyf
ortheli
quidi
ty
managementfori
tsEuropeanoperat
ionsinal
l
curr
enci
es.
3-Asat hirdapproach, abankmayassi gnt he
responsibil
ityf
orliquidit
yinthehomecur rencyand
forov er
allcoordi
nationt othehomeof f i
ce, and
responsibil
ityf
orthebank' sgloball
iquidityineach
maj orforei
gncur r
encyt othemanagementoft he
foreignofficei
nthecount r
yissui
ngt hatcur rency.
Forexampl e,t
hetreasur
eri
ntheTokyooff
iceofa
non-Japanesebankcouldberesponsi
blef
orthe
bank'sgloball
iqui
dit
yneedsinyen.
Al
loft
heseappr
oaches,however
,prov
idehead
of
fi
cemanagementwiththeoppor
tuni
tytomonit
or
 Joi
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andcont
rolwor
ldwi
del
iqui
dit
y.
Theseconddecisionconcernsthel
iquidi
tystrategy
i
neachcurrency
.I ntheordi
narycourseofbusi ness,
abankmustdeci dehowf or
eigncurr
encyf unding
needswil
lbemet .
Towhatextent,f
orexample,wil
labankf und
for
eigncurr
encyneedsindomest i
ccur r
encyand
conver
ttheproceedstofor
eigncurrencythr
ough
thefor
eignexchangemarketorcurrencyswaps?
Howwi llabankmanagetheassoci
atedri
ski
f
exchangemar ket
sceasetobeavai
labl
e?
Abank' sassessmentwi lldependonthesizeofi
ts
fundingneeds, i
tsaccesst oforei
gncurr
ency
fundingmar ket
,andi t
scapaci t
ytorel
yonof f
-
balance-sheeti
nstrument s(e.
g.,st
andbyli
nesof
credit,
swapf acil
it
ies,et
c.).
Abankmustal sodevel
opaback-upli
quidi
ty
str
ategyforci
rcumst
ancesinwhichit
snormal
approachtofundi
ngfor
eigncur
rencyoperat
ionsi
s
di
srupted.
 Joi
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Suchast r
ategywil
lcal
lfordrawingeit
heronhome
curr
encysourcesandconv er
tingthem t
ofor
eign
curr
encythroughtheexchangemar ket
sordrawi
ng
onback-upsourcesinpart
icul
arforei
gncurr
enci
es.
[Link]
ingTol
eranceLev
elandLi
mitf
orLi
qui
dit
y
Risk:
Bank'smanagementshoul dsetl
imit
stoensur
e
l
iqui
dityandtheseli
mitsshouldberevi
ewedby
supervi
[Link]
ter
nati
vely
,supervi
sorsmaysetthe
l
imits.
Li
mit
scoul
dbesetont
hef
oll
owi
ng:
[Link] ativ
ecashf lowmi smatches(i.
e.,t
he
cumul ati
venetfundingrequirementasa
percentageoftotall
iabi
lit
ies)overpart
icul
ar
peri
ods–nextday ,nextweek, nextf
ortni
ght,next
mont h,nextyear.
Thesemi smatchesshouldbecalcul
atedbytakinga
conserv
at i
vevi
ewofmar ketabi
li
tyofliqui
dassets,
wit
hadi scounttocoverpri
cevolati
li
tyandanydrop
i
npr i
ceintheev entofafor
cedsale,andshould
i
ncludeli
kelyoutfl
owsasar esul
tofdr aw-
downof
 Joi
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commi
tment
s,et
c.
[Link]
quidasset
sasaper
cent
ageofshor
t-
ter
m
l
iabi
li
ti
es.
Theassetsincludedinthi
scategoryshouldbe
thosewhicharehi ghl
yli
qui
d,i.
e.,
onlythoseassets
whicharejudgedt obehavingareadymar ketev
en
i
nper i
odsofstr ess.
[Link]
imi
tonl
oant
odeposi
trat
io.
[Link]
imi
tonl
oant
ocapi
talr
ati
o.
[Link] all
imitontherel
ati
onshi
pbetween
ant
ici
patedf undingneedsandavai
labl
esour
cesf
or
meeti
ngt hoseneeds.
[Link]
exiblelimit
sont hepercentagereli
anceona
part
icularli
abi
li
tycategory
, (
e.g.,cer
ti
fi
catesof
depositsorhighcostdepositsshouldnotaccount
formor ethanacertainpercentageoftotal
l
iabi
lit
ies).
[Link]
mitsont
hedependenceonindi
vidual
cust
omersormarketsegmentsf
orfundsin
l
iqui
dit
yposi
ti
oncalcul
ati
ons.
 Joi
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[Link]
exibl
eli
mitsont
hemi ni
mum/ maxi
mum
aver
agemat ur
it
yofdi
ff
erentcat
egori
esof
l
iabi
li
ti
es.

Anexampl
eofset
ti
ngt
oler
ancel
evelf
orabank:
[Link] hemi smatchlevelssoastoavert
wideliqui
dit
ygaps-Ther esidualmat ur
it
ypr
of i
leof
assetsandliabil
it
ieswil
lbesucht hatmismatch
l
evelforti
mebucketof1- 14day sand15–28day s
remainsaround80%cashout fl
owsi neachti
me
bucket.
[Link] i
quidi
tyandremainsolventby
maint
aini
ngshort-t
erm cumulat
ivegapupt oone
year(
short-
ter
ml i
abil
it
ies–short-
ter
m assets)at
15%oftotaloutfl
owoff unds.
Banksshoul danal
ysethelikel
yimpactofdi
ff
erent
stressscenari
osontheirl
iquidi
typosi
ti
onandset
theirl
imit
saccordi
ngly
.
 Join CAIIB WITH ASHOK on YouTube & App

BFM MODULE - D
Chapter 30: INTEREST RATE RISK MANAGEMENT
(PART-I)
What we will study?
*What is Interest rate risk?
*What are the sources of interest rate risk?

INTRODUCTION:

Till 1970, the regulatory restrictions on banks greatly

Reduced many of the risks in the financial system.
The deposits were taken in at mandatory rates and
Loaned out at legally established rates.
Interest rates therefore remained unaffected by
market pressures.
The phrase “3-6-3' i.e., bankers bring in short-term
Deposit sat 3%, lend long at 6% and be home for the
day
By 3 p.m. became a common reference about the
bankers.
In the 50s and 60s, banks considered only the credit
and
Liquidity risks as major constraints on profitability.
 Joi
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Deregul
ati
onofthebankingsystem i
nthe70s,however
,
gotmanybankersunpreparedtomanageinter
estrat
e
ri
sktowhichthei
rinst
it
utionsweresuddenl
yexposed.
Manybankfai
lur
esintheworl
ddur
ingthe70s,
80sand
90sweret
ri
ggeredoutofpoor
lymanagedi
nter
estr
ate
ri
sk.
Manyfinanci
ali
nsti
tut
ionsfundedt
heirl
ong-
ter
mfi
xed
asset
swi t
hshort
-t
ermv ol
atil
eli
abi
li
ti
es.
Soaslongasdeposi
tsandlendingr
atesremai
ned
regul
ated,
suchf
undi
ngmi smatcheswerenotatal
la
probl
em.
Thederegul
ati
onofthefi
nanci
alsy
stem i
nIndiahasput
i
nplacealotofoper
ati
onalfr
eedom t
othefinanci
al
i
nsti
tut
ions.
Thepr
ici
ngofv
ari
ousasset
sandl
iabi
li
ti
eshasbeenl
eft
tot
hei
rcommerci
alj
udgment.
Theearni
ngofassetsandthecostofl
iabi
li
ti
esare
ther
efor
eclosel
yrel
atedt
ot hei
nter
estrat
ev ol
ati
li
ty.
Thus,i
nter
estr
ateri
sk,
ater
mt ot
all
yunknownt
ot he
banki
ngindust
ryi
nIndi
ahassuddenl
ybecomesrelev
ant
.
 Joi
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ESSENTI
ALSOFI
NTERESTRATERI
SK:
Int
erestrat
eri
skistheexposur
eofabank'sf
inanci
al
condit
iontoadver
semov ementsi
nint
erestr
ates.
Butexcessi
vei
nter
estr
ateri
skcanposeasigni
fi
cant
thr
eattoabank'
searni
ngsandcapi
talbase.
Changesinint
erestratesaffectabank'
searni
ngsby
changi
ngitsnetint
erestincome( NI
I)andthel
evelof
otheri
nter
estsensit
iveincomeandoper at
ingexpenses.
Changesi ninter
estrat
esalsoaffecttheunder l
yi
ngvalue
ofthebank' sasset
s,li
abi
li
ti
es,andof f-
balance-
sheet
(OBS)instrumentsbecausethepr esentvalueoffut
ure
cashfl
ows( andinsomecases, t
hecashf l
ows
themselves)changewheni nt
erestr at
eschange.
Themar ketval
ueofanassetorliabi
li
tyi
sconcept
ual
ly
equalt
ot hepresentval
ueofcurr
entandfut
urecash
fl
owsfrom thatassetandl
iabi
li
ty.
Therefor
e,theri
singint
erestr
atesincr
easethediscount
rat
eont hosecashf l
owsanddecr easethemarketval
ue
ofthatassetorl
iabil
it
y.
Example:Iwil
lRs100inaf
teroneyearsowhati
sit
's
presentval
ueofthi
scashfl
ow(fut
ure)
?
I
fR=10%or20%or5%(
compoundi
ngy
ear
ly)
 Joi
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Sol
uti
on:
PV=FV/
(1+r
)^n
FV=100Rs.
n=1
A)
NowR=10% orr
=0.
1
(
1+r
)=1.
1
PV=FV/
1.1=100/
1.1=90Rs.
B)R=20%orr
=0.
2
(
1+r
)=1.
2
PV=100/
1.2=83Rs
C)R=5%orr
=0.
05
(
1+r
)=1.
05
PV=FV/
1.05=95Rs
Conver
sel
yfal
li
ngi
nter
estrat
esi
ncr
easet
hemar
ket
val
ueofasset
sorl
iabi
li
ti
es.
Moreover,
mi smatchingmat
urit
iesbyholdinglongert
erm
asset
sthanliabil
it
iesmeansthatwheninterestrat
esri
se,
themarketvalueofassetsf
all
sbyagr eateramountthan
l
iabi
li
ti
es.
 Joi
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Thi
sexposesthebankt
otheriskofeconomi
clossand
pot
ent
ial
lytheri
skofi
nsol
vency.
Int
erestr
ateriskr ef
erstovolat
il
it
yinNetI
nter
estI
ncome
(NII
)orvolat
il
ityinNetInter
estMar gi
n(NI
M),duet
o
changesininterestrat
es.
NI
I=I
NTERESTEARNED-
INTRESTPAI
D
NI
M=NI
I/Ear
ningAsset
s
Inotherwor
ds,i
nterestrat
eri
skar i
sesfrom hol
ding
assetsandl
iabi
li
ti
eswi t
hdiff
erentpri
ncipalamounts,
maturit
ydat
esorr epr
ici
ngdates,i
.e.,
“rol
loverr
ates'
.

Accordi
ngly,
anef f
ecti
veri
skmanagementprocesst
hat
maintai
nsinter
estrat
eriskwi
thi
nprudentl
evelsi
s
essenti
alt
ot hesafet
yandsoundnessofbanks.
Mostofthebankshav eal
readyident
ifi
edint
erestrat
e
ri
skasadragont hei
rprof
itabi
li
tyandhavestarted
assessi
ngthemagnitudeofint
erestrater
iskembedded
i
nt hei
rbal
ancesheets.
I
nterestrater
iskisbroadl
yclassi
fi
edint
omi smatchor
gaprisk,basi
srisk,
netinter
estposi
ti
onrisk,embedded
opti
onr i
sk,yi
eldcurveri
sk,pri
ceri
skandr ei
nvest
ment
ri
sk.
 Joi
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Theser
isksar
ebr
ief
lydi
scussedbel
ow:

SOURCESOFI
NTERESTRATERI
SK:
[Link]
smat
chRi
sk:
Agapormi smatchr i
skar i
sesfr
om holdi
ngasset
sand
l
iabil
it
ieswithdif
ferentpr i
nci
palamounts,mat
uri
tydates
orreprici
ngdates,therebycreat
ingexposur
etochanges
i
nt helevelofi
nterestrate.
I
notherwor
ds,whenassetsandli
abi
li
ti
esfal
ldueto
r
epr
ici
ngindif
fer
entper
iods,t
heycancreat
eami smat
ch.
Suchami smatchorgapmayleadtogai
norl
oss
dependinguponhowinter
estr
atesi
nthemar
kettendt
o
mov e.
Exampl
e1:
AbankholdsRs.100cror
eliabi
li
ti
esat9%ofoney
ear
maturi
tytofundasset
sofRs.100cror
eat10%wit
htwo
yearmaturi
ty.
ASSET(
2y) % LI
ABI
LITY(
1y) % Di
ff
100Cr 10% 100Cr 9% +1%
100Cr 10% 100Cr 11% -
1%
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Overt
hefir
sty
ear,bankisget
ti
ngapr
ofi
tspr
eadof1%
amounti
ngtoRs.1crore.
Howev
er,
itspr
ofi
tsf
orsecondy
earar
enotcer
tai
n.
Ifi
nter
estrat
eremainsunchanged,
thepr
ofi
tswi
ll
conti
nuetobethesame.
However,si
ncet hel
iabil
it
ies(
FD)aref
oroneyearand
needtober ol
ledoverforsecondyear
,banki
sexposedt
o
i
nter
estrateri
sk.
Ift
heint
erestrat
eonl
iabi
li
ties(FD)i
ncr
easeto11%in
secondyear,
bankwouldbei ncur
ri
ngalossof1%,i
.e.
,Rs.
1crorei
nthesecondyear.
Converselybankisagainexposedtointerestrateri
skifi
t
holdsshorterter
m assetsr
elati
vetoliabi
li
ties,i
.e.
,
l
iabil
it
iesmat uri
ngi
nt woyearsagainstasset smaturi
ng
i
noney ear.
Itt
henfacestheuncert
aint
yofint
erestr
ateatwhichi
t
canrei
nvestfundsaft
erthefi
rsty
earforfur
theroney
ear
matchi
ngt heli
abi
li
ti
esmaturi
ty.
Exampl
e2:
Consi
derthatabankhasinv
estedtheproceedsofa91
days8%depositin91day
sT-Bi
llear
ning10%and
maturi
ngont hesamedayasthedeposit
.
 Joi
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THASHOKonYouTube
I
nt hi
scase,thebankwi
llhav
enoasset–li
abi
li
ty
mismat chorgap,
andhencether
ewouldbenoi
nter
est
r
aterisk.
I
ft heinterestrateri
sesby100basispoi
ntsduringthe91
-dayst erm ofthedeposit
,thedeposi
twi
llberenewedat
9%andT- Billwil
lal
somat ureandthepr
oceedscanbe
reinvestedatt henewy i
eldof11%.
Thus,
the200basi
spoi
ntsNI
Iwi
llbepr
eser
ved.
Ifthepr oceedsofthe91day sdepositarereinvest
edina
floati
ngr ateloan(r
epr
icedatmont hlyint
ervals)wit
han
i
ni t
ialrateof10%, t
hei
nterestrat
eear nedont heloanwi
ll
changet wiceduri
ng91day s,whi
lethedeposi trat
e
remai nsunchanged.
Sincetheassetisrepr
icedmuchmorerapi
dlythanthe
l
iabil
it
yduri
ngt hi
speriod,t
hebanki
sassetsensit
ive.
Theassetsensit
ivebankcanproducealargeNIIi
fthe
i
nter
estrateri
sesinthemarketbecauseinter
estrat
eon
fl
oati
ngratel
oanmov eshi
gherduri
ngthe91day speri
od,
whil
eint
erestbeingpaidonthedeposi
tremainsat8%.
Conver
selyassetsensit
ivegappositi
onwouldcause
compressi
onintheNI Ii
ftheint
erestrat
esdecl
ine.
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Ift
hebankusesa91day s8%ter
m deposi
ttofunda5
yearfi
xedrat
emor t
gagel
oanat10%,t
heloanwill
conti
nuetoearn10%,whi
let
hedeposi
tgetsrepr
icedat
every91daysint
erv
al.
Thebankisnowli
abil
i
t ysensi
ti
vebecausetheint
erest
pai
donitsdeposi
tisr
esetmor erapi
dlythant
herate
bei
ngchargedontheloan.
Ariseorf
alli
nint
erestrat
einali
abil
it
ysensi
ti
vesi
tuat
ion
hastheopposi
teeffectontheNI
Ithanonanasset
sensi
ti
vebank.
Anyincr
easeinint
erestr
atewi
llcauseaner
osi
oni
nthe
l
iabi
li
tysensi
ti
vebank'sNII
.
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BFM MODULE - D
Chapter 30: INTEREST RATE RISK MANAGEMENT
(PART-II)
What we will study?
*What are the different types of interest rate risk?

Gap or Mismatch Risk. (Lecture1)

Price Risk:
Price risk occurs when assets are sold before them
Maturity dates.
In the financial market, bond prices and bond yields
Are inversely related.

For example, the price of 10-year 14% Government

Of India stock will receive only lower price than
Originally paid for, when coupon or stocks of similar
maturityhasgoneupto15%inthemarket.

The price risk is closely associated with the trading

Book which is created for making profit out of short
-term movements in interest rates.
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NetI
nter
estPosi
ti
onRi
sk:

Thebank'
sneti
nter
estposit
ional
soexposest
he
bankt
oanaddit
ionali
nter
estrat
erisk.
Ifabankhasmor eassetsonwhi chitearnsinterest
thanit
sli
abil
iti
esonwhichi tpaysint
erest,i
nterest
rater
iskari
seswheni nt
erestrateearnedonasset s
changeswhilethecostoffundingoftheliabi
li
ties
remainsthesame.
Thus,thebankwi
thaposit
iveneti
nter
estposit
ion
wil
lexperi
encear
educti
oninNIIasint
erestr
ate
decl
inesandanexpansi
oninNIIasint
erestr
ate
ri
ses.
Alar
gepositi
venetint
erestposi
ti
onaccount
sfor
mostoftheprof
itgenerat
edbymanyf i
nanci
al
i
nsti
tut
ions.
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EmbeddedOpt
ionRi
sk:
Largechangesi nmar ketint
erestrat
escreat
e
anot hersourceofr i
sktobankspr ofitby
prepay mentofl oansandbonds( wit
hputorcall
options)and/ orpremat ur
ewi t
hdrawalofdeposi
ts
befor ethei
rstatedmat uri
tydates.
I
ncaseswher etherei
snopenalt
yforprepayment
ofloans,t
heborr ower
shav
eanat uralt
endencyto
payoffthei
rloanswhenadeclineinint
erestr
ate
occurs.
I
nsuchcases,
thebankwi
llr
ecei
veonl
yal
owerNI
I.
Exampl
e:
Takethecaseofabankwhi
chhasdisburseda90
daysl
oanattherat
eof10%whichisfunded
thr
ougha90-dayCDatther
ateof8%.
I
ncasether at
eofinter
estdeclinet o9%after30
day
sandt heborrowerprepayshi sloan
i
mmediatelyandthebankr eceivesonly200basis
poi
ntsNI
If or30daysratherthant heanti
cipat
ed90
day
s.
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I
nt her emaini
ng60daysofthe90dayst
erm,
the
NIIwillbeonly100basi
spoint
s,ast
heBankwoul
d
ber ei
nv est
ingthef
undsat9%.
Theembeddedopti
onri
skisbecomingar eal
it
yin
I
ndiaandi
sexperi
encedi
nv ol
ati
lesi
tuat
ions.
Thefast
erandhighert
hemagni t
udeofchangesi
n
thei
nter
estrat
e,thegr
eaterwil
lbetheembedded
opti
onsri
sktothebank'
sNI I
.
Basi
sRi
sk:
I
naper f
ectl
ymat chedgappositi
on,ther
eisno
ti
mingdif
ferencebetweentherepri
cingdates;
i.
e.,
themagnit
udeofchangei nthedepositr
ateswould
beexact
lymat chedbythemagnitudeofchangein
thel
oanrate.
However,
int
erestrat
eoftwodi
ff
erentinst
ruments
wil
lsel
dom changebythesamedegreeduringt
he
sameperi
odoft i
me.
Ther
iskt
hattheint
erestr
ateofdi
ff
erentasset
s
andl
i
abil
it
iesmaychangeindif
fer
entmagnitudes
i
scal
ledbasisr
isk.
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Theundernot
edt
abl
eshowshowt
hebasi
sri
sk
occur
s.
GapSt
atementofXYZBank(
Amt
.inCr
oreofRs.
)
Repri
cing Repr
ici
ngLi
abi
li
ty
Assets
Cal
lMoney 50 Sav
ingDeposi
t 50
CashCr
edi
t 40 Fi
xedDeposi
t 50
90 100
Gap=90-
100=-10
10% 9 10% 10 1
9% 8.
1 9% 9 .
9
.
1
Thebankasofnowhasanegat
ivegapofRs.10
cr
ore.
Incasetheinterestrat
efall
sby1%, t
henaspert he
tradi
ti
onalgapmanagement( assumingratesonall
assetsandliabi
lit
ieschangeby1%-par all
elshi
ft
),
thebank'sNIIshouldimprove.
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I
nst eadoffall
ingi
nthesamemagni tude, assume
thattherateoncallmoneylendi
ngf allsby1%, the
rateoncashcr edi
tfal
lsby0.7%,ther ateonsav i
ngs
depositfall
sby0.5%andther at
eonf ixeddeposit
s
fal
lsby0. 4%.
Theundernotedcal
cul
ati
onsindi
cat
ethatt
he
bank'
sNIIwoulddeter
ior
ater
athert
hanimprov
ing
i
nt er
msoft heassumpti
onofgapmanagement.

Cal
lmoney 50*
1% Rs.0.
50
Cashcr
edi
t 40*
0.7% Rs.0.
28
Tot
al(
A)= Rs.0.
78
Sav
ingdeposi
t 50*
0.5% Rs.0.
25
Fi
xedDeposi
t 50*
0.4% Rs.0.
20
Tot
al(
B)= Rs.0.
45
NI
I=A-
B 0.
78-
0.45 Rs.0.
33
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Thedegreeofbasi sr
iski
sfai
rl
yhighi
nrespectof
bankst
hatcr eat
ecompositeasset
soutof
composi
t el
iabil
it
ies.

Yi
eldCur
veRi
sk:
Anyi
eldcur
veisali
neonagraphplot
ti
ngthey
iel
d
ofal
lmatur
it
iesofapar
ti
cul
ari
nstr
ument.
Yiel
dcurvechangesi
tssl
opeandshapefr
om ti
me
toti
medependinguponrepr
ici
ngandvar
iousother
fact
ors.
Astheeconomymov est
hroughthebusi
nesscy
cle,
theyi
eldcur
vechangesr
atherf
requent
ly.
Attheinter
vent
ionofReserveBankofIndia,t
he
yi
eldcurvecanbet wi
stedt
ot hedesi
reddirect
ion
byalt
eringtheyi
eldsongovernmentstocksor
di
ffer
entmat ur
it
iesbyRBI.
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Exampl
e:
Toil
lust
ratehowachangeintheshapeofy
iel
d
cur
veaffectsthebank'
sNI
I,
l
etusassumet hatXYZBank,used3yearsfloati
ng
rat
efixeddeposi
tsforf
unding3yearfl
oati
ngr at
e
l
oans( t
hedeposit
sandloansarerepr
icedat
quart
erlyi
nter
val
s).

I
fthebankpay s100basispointabovethe12.
50%
(91daysTreasur
yBil
lsrate)
,i.
e.13.5%tofi
xed
deposi
tsandcharges300basi spoint
,abovet
he
364daysTreasuryBi
ll
srateof13%, i.
e.,
16%onit
s
l
oans,
aNI
Iof250basi
spoi
ntsi
spr
oduced.
I
ft heyieldcurveturnsinvert
eddur i
ngthenext
repri
cingdat ewiththe91day sTBsr atei
ncreasi
ng
to14%and364day sTBsr at
eremai ni
ngat13%and
thespr eadrelat
ionshipordeposi
t sandloansto
TBsr emai nsconstant,t
heNI Iwi
llbereducedto
100basi spoints,i
.e.,
(16%-14%+1%=1%) .
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Rei
nvest
mentRi
sk:
Uncert
aint
ywithregar
dtointerestrat
eatwhicht
he
fut
urecashfl
owscanber einvestediscal
led
rei
nvest
mentrisk.

Exampl
e:
Suppose,
XYZBankhasazer ocoupondepositof
Rs.10,
000anditpr
omisestodoubletheamount
wit
hin7year
sandusest hefundsf
orinvest
ingi
na
7-
yearbondatanannualcouponof12%.
Incase,
theinter
estrat
ef al
lst
o10%af teroneyear
,
thebankcouldrei
nvestthecouponcashf l
owsonly
at10%againsttheanti
cipat
ionofrei
nvesti
ngthe
couponataf i
xedrat
eof12%.
Duetothi
srei
nvest
mentrisk,
thebankwil
lfi
ndit
di
ff
icul
ttopaythei
nter
estondepositonmatur
it
y.
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Thebondpr i
cingformulaassumesthatallcoupon
paymentsarer ei
nvest
edatthebond’sYieldto
Matur
it
y( YTM) .
Ift
heint
erestr
ateincreasesovert
heli
feofabond,
couponswil
lberei
nv estedathi
ghery
iel
dsther
eby
i
ncreasi
ngtherei
nvestmentincome.
Theincr
easei
nr ei
nvest
mentincomewi
lli
ncr
ease
ther
eali
sedyi
eldofthebond.
Whent heinter
estrat
egoesup, thebondspri
ce
decr
easesbutt hebond'sreal
isedcompoundy i
eld
wil
lincreaseduetohighercouponrei
nvest
ment
i
ncome.
Ontheot herhand,
whentheint
erestrat
edecl i
nes,
thebondpr i
ceincr
easesr
esult
inginacapitalgai
n,
butthereali
sedcompoundyiel
ddecreases
becauseoflowercouponrei
nvestmentincome.
Theshort
-t
erm bondshavemorerei
nvestmentri
sk
si
nceproceedsofthebondsmustbereinvest
ed
moreandmor eti
mes.
Al
ter
nat
ivel
y,l
ong-
ter
m bondshav
emor
epr
icer
isk.
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BFM MODULE - D
Chapter 31: RAROC AND PROFIT PLANNING
(PART-I)

What we will study ?

*What is Profit Planning?

PROFIT PLANNING:
Profit planning in a bank essentially involves
Maximisation of earnings and minimisation of
expenditure.
Bank's Income:

Banks' income arises from three sources, viz.

1-Interest income,
2-Feebased income and
3-Treasury income.
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1- Interest Income (First Source of Income):

Interest income is derived from lending as well as
investments in securities, bonds etc.
In most of the countries, there are norms that a
certain percentage of deposits is mandatorily required
to be kept in government securities.
In our country, statutory liquidity ratio (SLR) takescare of
this aspect.
Though, the investments in government securities are
practically risk-free, the yield on such investments is
lower when compared to the depositrates.
Similarly, the interest income on highly rated
corporate debt is much lower as compared to the
income on lower rated corporate debt.
Banks are required to have a proper blending of
investment in government securities and credit
portfolios to maximise the profits for a given levelof
risk appetite.
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Let us take one example of various combinations.

Suppose a bank has Rs. 1,000 to invest or lend. We
look at four different scenarios as follows:
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Thus, you would observe that risk would increase for

lending to lower rated customers resulting in an
increased need for capital and also improved yield on
the assets.
Effect of NPA on Interest based income:
Banks have to take into account the effect of NPAon
the interest income and thereby on the profitability.
NPAs do not generate income and therefore bringdown
the yield on advances.
Also, under Basel-II/III regime, the risk weightage ofsuch
assets is higher, thereby forcing a bank to maintain
higher capital.
Thus, NPAs have a two-fold effect,

1- reduction in income and

2- need for additional capital.

Hence, return on capital or profitability gets further
deteriorated.
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2- Fee based Income (Second Source of Income):

The second major source of income is derived from
fee-based activities.
The traditional activities such as
demand drafts,
remittances,
safe custody,
guarantees,
letters of credits,
bills, etc.,

continue to be prevalent.
However, with technological changes, some of the
services such as demand drafts, remittances, bills
handling may reduce drastically.
Some new services like
depository services,
internet banking,
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e-commerce
have appeared on the scene.
These services have given a boost to the fee
income.
Banks have also ventured into cross selling of other
financial products such as insurance policies, mutual
funds, etc., and with their established network and
position of trusted entity for their customers, banks can
make logical and natural entry in the selling of such
third party products.
Banks thus tend to become financial super markets
and such measures help increase the fee-based income.
Banks are required to keep in mind the operationalrisks
associated with these new services.
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3- Treasury Income (Third Source of Income):

The last and most important component of incomeis
treasury income, which is derived by trading in
securities, foreign exchange, equities, bullion,
commodities (not permitted in our country) and
derivatives.
This is largely a speculative activity, which banks
undertake with stringent internal controls and checks
in place.
Trading activities may provide large incomes to banks.
These activities may result in large amountsof losses
as well.
If a bank is not adequately capitalised, such lossescan
cause serious problems for it.
In the 90s, Barings Bank, a very old British Bank,
collapsed due to very large losses due to speculative
trading of Nikkei Futures on Tokyo Exchange.
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Bank's Expenditure:
On the expenses side, there are two major
expenses, viz.,
1- interest expenses and

2- operating expenses.
2- Interest expenses:(First factor of expenditure)
There are three major parts of the deposit portfolio.
Current Deposits which are interest free, and Savings
Deposits and Term (short & long) Deposits
– for which interest rates are deregulated in India.
The Savings Deposits interest rates were deregulated
with effect from 25th October, 2011 and interest is
paid on these deposits on daily product basis, but the
comfort for the banks is thatthese rates continue to
be low.
Thus, a bank has to find ways and means to improve
the share of low cost deposits such as Current and
Savings Bank. This helps them to lowerinterest costs.
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Interest rates of term deposits are largely decidedby

market forces.
A bank keeps such interest rates at a level, at whichit
can garner requisite deposits in competition with other
banks.
These interest rates are also influenced by other
instruments such as debentures, postal deposits,
Government securities, provident fund, etc.
2-operating expenses:(second factor of expenditure)
The second factor of expenditure is operating costs,
which consists of staff costs and other costs.
Banks try to improve productivity and also link up some
of the staff costs to productivity by providingincentive
based packages.
Thus, every effort is made to maintain and reducethe
percentage of staff costs to the income level.
Other cost comprises depreciation, rent, utilities,legal
expenses, travelling expenses, postage,
telecommunication charges, stationery, etc.
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Banks like any other commercial organisationswould

ensure that wasteful expenditures are avoided.
Cost benefit aspects are looked into and alternatives
are explored. Thus, every effort to rationalise this
segment of expenditure is made.
In nutshell, profitability is a function of six variables:

1. Interest income
2. Fee-based income
3. Trading income
4. Interest expenses
5. Staff expenses
6. Other operating expenses
Maximisation of the first three variables and minimisation
of the last three variables are therequisites to maximise
profitability.
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BFM MODULE - D
Chapter 31: RAROC AND PROFIT PLANNING
(PART-II)

What we will study ?

*What is RAROC?
RISK AGGREGATION AND CAPITAL ALLOCATION:
Banks, across the world, use different ways toestimate
the aggregate risk exposures.
Mostly 2 ways , one is RAROC and another one isbased
on cash flow and variability in earning.
RAROC:
The most commonly used approach is the RiskAdjusted
Return on Capital (RAROC).
Each type of risk is measured to determine both the
expected and unexpected losses using VaR or worst-
case type analytical model.
The key to RAROC is the matching of revenues, costs
and risks on transaction or portfolio basis
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over a defined time period.

This begins with a clear differentiation between

expected and unexpected losses.
Expected losses are covered by specific reservesand
provisions.
and
unexpected losses require capital allocation, which is
determined on the principles of confidence levels,time
horizon, diversification and correlation.
In this approach, risk is measured in terms ofvariability
of income.
Under this framework, the frequency distribution of
return, wherever possible, is estimated and the Standard
Deviation (SD) of this distribution is also estimated.
Capital is thereafter allocated to activities as afunction
of this risk or volatility measure.
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The second approach is similar to the RAROC, but

depends less on capital allocation and more on cash
flows or variability in earnings.
This is referred to as EaR (Earnings at Risk), when
employed to analyse interest rate risk.
Under this analytical framework also, frequency
distribution of returns for any one type of risk canbe
estimated from historical data.
Extreme outcome can be estimated from the tail ofthe
distribution. Either a worst-case scenario couldbe used
or Standard Deviation could also be considered.
Accordingly, each bank can restrict the maximum
potential loss to certain percentage of past/ current
income or market value.
Thereafter, rather than moving from volatility of value
through capital, this approach goes directly tocurrent
earnings implications from a risky position.
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This approach, however, is based on cash flows

and ignores the value changes in assets and liabilities
due to changes in market interest rates.
ECONOMIC CAPITAL AND RAROC:
The expected loss is a measure of the reserves
necessary to guard against future losses.
The pricing of products should provide a buffer
against expected losses.
The unexpected loss is a measure of the amount of
economic capital required to support the banks
financial risk. This capital is also called risk capital.
Some activities may require large amounts of risk
capital, which in turn requires higher returns.
This is the essence of risk adjusted return on
capital (RAROC) measures.
The central objective is to establish benchmarks to
evaluate the economic return of business activities.
This includes transactions, products, customertrades,
and business lines, as well as the entire
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business.
RAROC is also related to concepts such as shareholder
value analysis and economic valueadded.
In the past, performance was measured by
return on assets (ROA), which adjusts profits forthe
associated book value of assets, or
return on equity (ROE), which adjusts profits for the
associated book value of equity.
None of these measures - ROA and ROE - is satisfactory
for evaluating the performance ofbusiness lines as they
ignore risks.
Risk Capital:
RAROC is a part of the family of the risk-adjusted
performance measures (RAPM).
Consider, for instance, two traders such that each
returned a profit of $10 million over the last year.
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The first is a foreign currency trader,and

second a bond trader.

The question is, how do we compare their
performance?
This is important in providing appropriate compensation
as well as deciding which line ofactivity to expand.
Assume the FX and bond traders have notionalamount
and volatility as described below.
The bond trader deals in larger amounts, $200 million,
but in a market with lower volatility, at 4%per
[Link] FX dealer deals in amount of
$ 100 million and 12% of volatility per annum.
The risk capital can be computed as a VAR (Value at
Risk) measure, say at the 99% confidence level over
a year.
Assuming normal distributions, this translates into a
risk capital of
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For Forex dealer:

RC = VAR = $100,000,000 X .12 x 2.33 = $28 million

For Bond dealer:

RC= VAR= $100,000,000 X .04 x 2.33 = $9 million

The risk adjusted performance is then measured asthe

profit divided by the risk capital,
RAPM = Profit/RC RAPM(FX)=
10 million/28 million=0.36
RAPM(BOND)=10 million/9 million=1.11

Thus the bond trader is actually performing betteras

the FX trader, as the activity requires less risk capital.
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RAROC Methodology:

Risk Management:
Includes the measurement of portfolio exposure, the
volatility and correlations of the risks factors.
Capital Allocation:
This requires the choice of a confidence level and
horizon for the VAR measure, which translates intoan
economic capital.
Performance Measurement:
This requires the adjustment of performance forthe
risk capital.
Performance measurement can be based on RAPM
method.

For instance, Economic Value Added (EVA) focuses on

the creation of value during a particular period in excess
of the required return on capital.
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EVA measures the residual economic profit as

EVA = Profit – (Capital * k)

Where profits are adjusted for the cost of economic
capital, with k defined as the discount rate.
Assuming the whole worth is captured by the EVA, the
higher the EVA, the better the product or project.

Banking Industry in India:

The past few decades have been historically

momentous for the banking industry in India.
Starting with the Narasimhan committee report of
1991, the Indian banking has seen a total change inthe
scenario during the last 3 decades.
The process of deregulation which was set in motion
has brought in a sea change in the Indianbanking.
Regulated interest rates and directed investment/
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credit have become things of the past.

The Reserve Bank of India is now more concerned
about prudential norms and disclosure requirements
of the banks.
During the last few decades, several new privatesector
banks have come into existence. They havediverse
ownership patterns.
Similarly, foreign banks have also been givenclearances
for expansion.
Recently, the associate banks of State Bank of Indiaand
Bharatiya Mahila Bank have merged with State Bank of
India.
More mergers may also take place in the near
future.
RBI has also permitted opening of Small FinanceBanks
and Payment Banks which are called as'Differentiated
Banks'.
So in our country the Banking Industry consist of:Public
Sector Banks.
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New Generation Private Sector Banks.

Old Generation Private Sector [Link]-
operatiive Banks.
Regional Rural Banks.
Small Finance Banks.
Payment Banks.
Hence, there is a keen competition among thebanks
in the banking sector.
All banks have either upgraded their technology orare
in the process of upgrading it.
New products are being introduced and aggressive
marketing is the order of the day.
Profitability has now become one of the most
important parameters in the banks' functioning.
Indian banks have shown that they are alive to the
changing environment and are geared up to face the
new challenges.