Banking

Management of NPAs
Non-Performing Assets (NPAs):
• An asset, including a leased asset, becomes non
performing when it ceases to generate income for
the bank.
• Banks should, classify an account as NPA only if
the interest due and charged during any quarter is
not serviced fully within 90 days from the end of
the quarter.

Contd.
Out of Order
An account should be treated as 'out of order'
if the outstanding balance remains continuously
in excess of the sanctioned limit/drawing power.
In cases where the outstanding balance in the
principal operating account is less than the
sanctioned limit/drawing power, but there are
no credits continuously for 90 days as on the
date of Balance Sheet or credits are not enough
to cover the interest debited during the same
period, these accounts should be treated as 'out
of order'.

Overdue
Any amount due to the bank under any credit
facility is ‘overdue’ if it is not paid on the due date
fixed by the bank.

Asset Classification Guidelines
Sub-standard Assets
• A sub-standard asset would be one, which has
remained NPA for a period less than or equal to 12
months.
• In such cases, the current net worth of the
borrower/ guarantor or the current market value of
the security charged is not enough to ensure
recovery of the dues to the banks in full.

Doubtful Assets
A doubtful asset would be one, which has remained
NPA for a period exceeding 12 months.
Loss Assets
A loss asset is one where loss has been identified by
the bank or internal or external auditors or the RBI
inspection but the amount has not been written off
wholly. In other words, such an asset is considered
uncollectible and of such little value that its
continuance as a bankable asset is not warranted
although there may be some salvage or recovery
value.

Guidelines for Provisioning
Loss Assets
In case of loss assets, 100% of the outstanding
should be provided for, regardless of the security.
Doubtful Assets
100 percent of the extent to which the advance is
not covered by the realizable value of the security
to which the bank has a valid recourse and the
realizable value is estimated on a realistic basis.

Period for which the advance has been Provision requirement
considered as doubtful (%)
Up to one year 20
One to three years 30
More than three years 50

Sub standard Assets
A general provision of 10 percent on total
outstanding should be made.
Standard Assets
The provision on standard assets is 0.40% of the
funded outstanding on a portfolio basis (for banks
direct advances to agriculture and SME segment it
continues to be 0.25%).

Income Recognition Guidelines
• The policy of income recognition has to be
objective and based on the record of recovery.
Internationally income from non-performing assets
(NPA) is not recognised on accrual basis but is
booked as income only when it is actually received.
Therefore, the banks should not charge and take to
income account interest on any NPA.
• However, interest on advances against term
deposits, NSCs, IVPs, KVPs and Life policies may
be taken to income account on the due date,
provided adequate margin is available in the
accounts.

• Fees and commissions earned by the banks as a
result of re-negotiations or rescheduling of
outstanding debts should be recognized on an
accrual basis over the period of time covered by the
re-negotiated or rescheduled extension of credit.
• If Government guaranteed advances become NPA,
the interest on such advances should not be taken
to income account unless the interest has been
realized.

NPA Management Policy
• Seeks to lay down bank’s policy on management
and recovery of NPAs.
• Stresses on proactive initiatives to prevent fresh
NPAs by prescribing time norms for detection of
EWS for taking corrective action
• Periodic scrutiny of financial statements and
evaluation of securities
• Periodic dialogue with the borrower
• Continuous watch over management of borrowing
company
• Unit inspection- pre and post sanction period

• Pledge
It refers to bailment of goods as security for payment of a debt or
performance of a promise. The person delivering the goods as security is
called pledger and the person to whom goods are delivered is called
pledgee.
Loan
The act of giving money, property or other material goods to another party
in exchange for future repayment of the principal amount along with
interest or other finance charges
• Mortgage
As per section 58 of Transfer of Property Act,
Mortgage refers to
• transfer of interest in a specific immoveable property
• for the purpose of securing the payment of money advanced by way of
loan,
• an existing or future debt or the performance of an engagement
• which may give rise to a pecuniary liability.
The mortgage secures your promise that you'll repay the money you've
borrowed to buy your home/property.

Regulatory Institutions
• RBI (Reserve Bank of India)
• SEBI (Securities and Exchange Board of India)
• IRDA (The Insurance Regulatory and Development
Authority)
• NABARD (National Bank for Agriculture and Rural
Development)
• NHB (National Housing Bank)

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Reserve Bank of India (RBI)
• Objectives
The objectives of establishment (Central Bank) of RBI are to:
– Maintain the internal value of the nation’s currency;
– Preserve the external value of the currency;
– Secure reasonable price stability; and
– Promote economic growth through increasing employment,
output and real income.
• Functions
The functions of RBI may be classified into two categories:
a) Traditional functions, and b) Developmental functions
a) Traditional Functions:
– RBI acts as a lender of last resort;
– It acts as a banker to banks;
– It issues currency and operates the clearing system for banks;
– It supervises the operations of credit institutions;
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RBI Contd…..
– It acts as the custodian of the foreign reserves;
– It formulates and implements monetary and credit policies;
– It moderates the fluctuations in the exchange value of the
rupee.
b) Developmental Functions:
– The prime developmental function is to integrate the
unorganized financial sector with the organized financial
sector;
– It encourages opening of semi-urban and rural branches;
– It provides education and training to banking personnel of
commercial and co-operative banks;
– It influences the allocation of credit;
– It promotes the collection pooling and dissemination of credit
information among banks;
– It promotes the establishment of new institutions.
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MONETARY POLICY

MONETARY POLICY IS CONCERNED WITH THE MANIPULATION OF
MONEY SUPPLY IN THE ECONOMY. MONETARY POLICY AFFECTS
THE ECONOMY MAINLY THROUGH ITS IMPACT ON INTEREST
RATES.

THE MAIN TOOLS OF MONETARY POLICY ARE:
• OPEN MARKET OPERATION
• BANK RATE
• RESERVE REQUIREMENTS
• DIRECT CREDIT CONTROLS

FISCAL POLICY IS CONCERNED WITH THE SPENDING
• AND TAX INITIATIVES OF THE GOVERNMENT. IT IS THE
• MOST DIRECT TOOL TO STIMULATE OR DAMPEN THE
• ECONOMY.
• AN INCREASE IN GOVERNMENT SPENDING STIMULATES
• THE DEMAND FOR GOODS AND SERVICES, WHEREAS A
• DECREASE DEFLATES THE DEMAND FOR GOODS AND
• SERVICES.
• BY THE SAME TOKEN, A DECREASE IN TAX RATES
• INCREASES THE CONSUMPTION OF GOODS AND
• SERVICES AND AN INCREASE IN TAX RATES DECREASES
• THE CONSUMPTION OF GOODS AND SERVICES.

Establishing a Loan Policy
Important elements of a good bank loan policy are as
follows:
1. A clear mission statement for the bank's loan
portfolio in terms of types, maturities, sizes, and quality
of loans.

2. Specification of the lending authority given to each
loan officer and loan committee (measuring the
maximum amount and types of loan that each person
and committee can approve and what signatures are
required).

Contd.
3. Lines of responsibility in making assignments and
reporting information within the loan department.

4. Operating procedures for soliciting, reviewing,
evaluating, and making decisions on customer loan
applications.

5. The required documentation that is to accompany
each loan application and what must be kept in the
bank's credit files (required financial statements,
security agreements, etc.).

Contd.
6. Lines of authority within the bank, detailing who is
responsible for maintaining and reviewing the bank's
credit files.
7. Guidelines for taking, evaluating, and perfecting
loan collateral.
8. A presentation of policies and procedures for
setting loan interest rates and fees and the terms for
repayment of loans.
9. A statement of quality standards applicable to all
loans.

Contd.
10. A statement of the preferred upper limit for total loans
outstanding (i.e., the maximum ratio of total loans to
total assets allowed).

11. A description of the bank's principal trade area, from
which most loans should come.

12. A discussion of the preferred procedures for detecting,
analyzing, and working out problem loan situations.

A loan policy is loan underwriting guidelines and the
written documentation setting forth the standards as
determined by the bank’s senior loan committee.

Principles of Lending
(read text book ask pratyu)
• Safety
• Security
• Suitability
• Profitability
• Liquidity
• Integrity
• Adequacy of Finance
• Timeliness

Steps in the Lending Process
1. Loan requests:
– often arise from contacts the bank's loan officers
and sales representatives make as they solicit new
accounts from individuals and firms operating in the
bank's market area.
2. Customers fill out a loan application.
3. An interview with a loan officer.
– Interview provides an opportunity for the bank's
loan officer to assess the customer's character and
sincerity of purpose.

Contd.
4. Site visits:
– If a business or mortgage loan is applied for, a site
visit is usually made by an officer of the bank.
5. Credit References:
– The loan officer may contact other creditors who
have previously loaned money to this customer for
credit references.
6. Financial Statements and Documentation needed for
Loan Evaluation, including:
– complete financial statements and,
– board of directors' resolutions authorizing the
negotiation of a loan with the bank.

Contd.
7. Credit Analysis:
– The credit analysis is aimed determining whether the
customer has sufficient cash flows and backup assets
to repay the loan.
8. Perfecting the Bank’s Claims to Collateral:
– To ensure that the bank has immediate access to the
collateral or can acquire title to the property involved
if the loan agreement is defaulted.
9. Preparing a Loan Agreement:
– Once the loan and the proposed collateral are
satisfied, the note and other documents that make
up a loan agreement are prepared and are signed by
all parties to the agreement.

Contd.
10. Loan Monitoring:
– The new agreement must be monitored continuously to
ensure that the terms of the loan are being followed and
that all required payments of principal and/or interest
are being made as promised.
– For larger commercial credits, the loan officer will visit
the customer's business periodically to check on the
firm's progress and to see what other services the
customer may need.
Usually a loan officer or other staff member places
information about a new loan customer in a computer file
known as a bank customer profile. This file shows what bank
services the customer is currently using and contains other
information required by bank management to monitor a
customer's progress and financial-service needs.

5C’s of Credit Analysis
• Capacity
• Character
• Collateral
• Conditions
• Capital

Loan Proposal
It is a detailed report (based on a potential borrower’s
loan application and credit worthiness) presented
usually by a bank’s officer (with his/her comments) to a
senior loan officer or the bank’s loan committee.

Loan Proposal Submission
• Information requirements from borrower
Documents of creation of the entity, names, address, bio-
data and details of assets/liabilities, particulars of
securities, details of borrowing arrangements, etc.
• Terms and Conditions for the credit facilities
This is an important aspect in pre-sanction appraisal and
post-sanction monitoring, as these need continuous
compliance for the safety of an advance by a bank.
There needs to be a complete agreement between the
banker and the borrower w.r.t. terms and conditions on
which the loan is being sanctioned so it helps the banks
to keep the health of borrowal accounts good and risk of
their lending to minimum.

Contd.
• A check list
Whether the appropriate loan application form is duly
filled and signed; whether the proposal prepared on the
appropriate proposal format and all the columns
properly filled in; the balance sheet analysis by doing
the ratio analysis is appropriate or not; if the proposed
terms and conditions, are discussed with the borrower
concerned; if the interest rate has been duly accounted
for; why this account will not become a NPA; and if
the relevant documents have been duly enclosed with
the proposal.

ASSET-LIABILITY
MANAGEMENT SYSTEM

WHY ALM?

Globalisation of financial markets.
Deregulation of Interest Rates.
Multi-currency Balance Sheet.
Prevalance of Basis Risk and Embedded
Option Risk.
Integration of Markets – Money Market,
Forex Market, Government Securities
Market.
Narrowing NII / NIM.

ALM
• ALM is the process involving decision making
about the composition of assets and liabilities
including off balance sheet items of the bank /
FI and conducting the risk assessment.

ASSET LIABILITY MANAGEMENT
• Various risks affecting banks / FIs
– Credit, Market, Operational
– Deregulation & competition
• Need to manage risk to protect NIM
• Need for proper risk mgt policy
• Liquidity planning, interest rate risk management
– ALM guidelines issued for banks in Feb 1999 and for FIs
in Dec 1999

Concept of ALM
ALM is concerned with strategic
management of Balance Sheet by giving due
weightage to market risks viz. Liquidity Risk,
Interest Rate Risk & Currency Risk.
ALM function involves planning, directing,
controlling the flow, level, mix, cost and yield
of funds of the bank
ALM builds up Assets and Liabilities of the
bank based on the concept of Net Interest
Income (NII) or Net Interest Margin (NIM).

WHAT IS ALM
• ALM is concerned with strategic Balance
Sheet management involving all market risks
• It involves in managing both sides of balance
sheet to minimise market risk

ALM Objectives
Liquidity Risk Management.
Interest Rate Risk Management.
Currency Risks Management.
Profit Planning and Growth Projection.

LIQUIDITY RISK
• What is liquidity risk?
– Liquidity risk refers to the risk that the institution might not be able
to generate sufficient cash flow to meet its financial obligations

EFFECTS OF LIQUIDITY CRUNCH
• Risk to bank’s earnings
• Reputational risk
• Contagion effect
• Liquidity crisis can lead to runs on institutions
– Bank / FI failures affect economy

LIQUIDITY RISK
• Factors affecting liquidity risk
– Over extension of credit
– High level of NPAs
– Poor asset quality
– Mismanagement
– Non recognition of embedded option risk
– Reliance on a few wholesale depositors
– Large undrawn loan commitments
– Lack of appropriate liquidity policy & contingent plan

LIQUIDITY RISK
• Tackling the liquidity problem
– A sound liquidity policy
– Funding strategies
– Contingency funding strategies
– Liquidity planning under alternate scenarios
– Measurement of mismatches through gap
statements

LIQUIDITY RISK
• METHODOLOGIES FOR MEASUREMENT
– Liquidity index
– Peer group comparison
– Gap between sources and uses
– Maturity ladder construction

LIQUIDITY RISK
• RBI GUIDELINES
– Structural liquidity statement
– Dynamic liquidity statement
– Board / ALCO
• ALM Information System
• ALM organisation
• ALM process (Risk Mgt process)
– Mismatch limits in the gap statement
– Assumptions / Behavioural study

ALM SYSTEM
• Liquidity Gap report – fortnightly
– 1-14 d & 15 – 28 d – tolerance limit
– Fix cumulative gap limits
• IRS statements – monthly
– Fix prudential limits
• To compile currency wise liquidity and IRS
reports

MATURITY PROFILE-LIQUIDITY
• Outflows
– Capital, Reserves & Surplus
– Deposits
– Borrowings and bonds
– Other liabilities

MATURITY PROFILE-LIQUIDITY
• Inflows
– Cash
– Balance with RBI
– Balance with other banks
– Investments
– Advances

IRR - Relevance in India

• Deregulation of interest rates brought:
– Volatility in rates - call, PLR, Govt. securities Yield
Curve

– Competition - free pricing of assets and liabilities

– Pressure on NII / NIM, MVE

RSA, RSL

• RSA (Rate Sensitive Assets) – Assets whose
value is dependent on current interest rate
• RSL (Rate Sensitive Liabilities) – Liabilities
whose value is dependent on current interest
rate

Gap/Mismatch Risk

• It arises on account of holding rate sensitive
assets and liabilities with different principal
amounts, maturity/repricing rates
• Even though maturity dates are same, if there
is a mismatch between amount of assets and
liabilities it causes interest rate risk and affects
NII

IMPACT ON NII

Gap Interest rate Impact on NII
Change
Positive Increases Positive

Positive Decreases Negative

Negative Increases Negative

Negative Decreases Positive

ALM
ORGANISATION
Three-tier organizational set-up for ALM
Implementation :
1. Management Committee of the Board
(MC)
 Oversees the ALM implementation by ALCO
 Reviews the ALM implementation
periodically
 Funding strategies for correcting the
mismatches in ALM Statements.

ASSET-LIABILITY
MANAGEMENT COMMITTEE
(ALCO) - ALCO headed by E.D.
- GM (T) – (Nodal
Officer).
- GMs : Central Accounts,
P&D, Credit, Risk
Management International
Division are the
members.
- GM (IT) & AGM (Economist)
are the invitees for
ALCO meetings.

FUNCTIONS OF
ALCO
Implementation of ALM System
- Monitor the risk levels of the Bank.
- Articulate the Interest Rate Position &
fix interest rate on Deposits &
Advances.
- Fix differential rate of interest rate
on Bulk Deposits.
- Facilitating and coordinating to put in
place the ALM System in the Bank.

ALM STATEMENTS TO
BE SUBMITTED TO RBI
1. Statement of Structural Liquidity
(Annexure - I) [DSB Statement No.8] - Rupee
2. Statement of Interest Rate Sensitivity
(Annexure - II) [DSB Statement No. 9] - Rupee
3. Statement of Dynamic Liquidity (Annexure -
III)
4. Statement of Maturity and Position (MAP)
(Annexure - IV) [DSB Statement No.10 ] -
Forex
5. Statement of Sensitivity to Interest Rate
(SIR)(Annexure - V)[DSB Statement No.11] -

Tools for ALM System

Gap Analysis
Modified Gap
Analysis
Duration Gap
Analysis
Value at Risk (VaR)
Simulation

LIQUIDITY RISKS
• Broadly of three types:
• Funding Risk: Due to withdrawal/non-renewal of
deposits
• Time Risk: Non-receipt of inflows on account of
assets(loan installments)
• Call Risk: contingent liabilities & new demand for
loans
• Dynamic liquidity is done to measure the liquidity
risks

STATEMENT OF STRUCTURAL
LIQUIDITY
• Placed all cash inflows and outflows in the maturity
ladder as per residual maturity
• Maturing Liability: cash outflow
• Maturing Assets : Cash Inflow
• Classified in to 8 time buckets
• Mismatches in the first two buckets not to exceed
20% of outflows
• Banks can fix higher tolerance level for other
maturity buckets.

ADDRESSING TO MISMATCHES
• Mismatches can be positive or negative
• Positive Mismatch: M.A.>M.L. and vice-versa for
Negative Mismatch
• In case of +ve mismatch, excess liquidity can be
deployed in money market instruments, creating
new assets & investment swaps etc.
• For –ve mismatch,it can be financed from market
borrowings(call/Term),Bills rediscounting,repos &
deployment of foreign currency converted into
rupee.

DYNAMIC LIQUIDITY
• Prepared every fortnight for ALCO
• Projection is given for the next three months
• Tools for assessing the day to day liquidity
needs of the bank

STATEMENT OF INTEREST RATE
SENSITIVITY
• Generated by grouping RSA,RSL & OFF-
Balance sheet items in to various (8)time
buckets.
• Positive gap : Beneficial in case of rising
interest rate
• Negative gap: Beneficial in case of declining
interest rate

CALCULATION OF NII/NIM
• NII: INT.EARNED-INT. EXPENDED
• INT. EARNED: ADV+INVEST+BALANCE WITH
RBI
• INT. EXPENDED:DEPOSITS+INT. ON RBI
BORROWINGS
• NIM= (NII/TOT.EARNING ASSET)X100

SUCCESS OF ALM IN
BANKS :
PRE - CONDITIONS
1. Awareness for ALM in the Bank staff at all levels–
supportive Management & dedicated Teams.
2. Method of reporting data from Branches/ other
Departments. (Strong MIS).
3. Computerization - Full computerization, networking.
4. Insight into the banking operations, economic
forecasting, computerization, investment, credit.
5. Linking up ALM to future Risk Management Strategies.

Value-at-Risk (VaR)

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What is VaR?
• VaR is a measure of the worst expected loss that a firm
may suffer over a period of time under normal market
conditions at a specified level of confidence/probability.
• VaR is the expected loss of a portfolio or a single asset
over a specified time period for a set level of
probability.
• VaR is a measure of market risk. It is the maximum loss
which can occur with X% confidence over a holding
period of ‘n’ days.
• The VaR captures only those risks that can be measured
in quantitative terms; it does not capture risk exposures
such as operational risk, liquidity risk, regulatory risk or
sovereign risk.
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• VaR answers the question: How much can I lose
with X percent probability over a preset horizon?
• For example, Suppose that a portfolio manager has
a daily VaR equal to $1 million at 1 percent. This
statement means that there is only one chance in
100 that a daily loss bigger than $1 million occurs
under normal market conditions.
• If a daily VaR is stated as £100,000 to a 95% level of
confidence, this means that during the day there is
only a 5% chance that a daily loss greater than
£100,000 occurs under normal conditions.
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The VaR for one month for a portfolio is
US$50,000 at the 95% level.
This means that the chances of the portfolio’s
losses in one month being less than
US$50,000 are 95%. To put it another way, the
chance of portfolio losses exceeding
US$50,000 is 5%.
• VaR measures the potential loss in market
value of a portfolio using estimated volatility
and correlation.

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• The “correlation” referred to is the correlation
that exists between the market prices of
different instruments in a bank’s portfolio.
• The most commonly used VaR models assume
that the prices of assets in the financial
markets follow a normal distribution.
• The overall risk has to be calculated by
aggregating the risks from individual
instruments across the entire portfolio.
• The potential move in each instrument has to
be inferred from past daily price movements
over a given observation period.

• For regulatory purposes, this period is at least one
year. Hence, the data on which VaR estimates are
based should capture all relevant daily market moves
over the previous year.
• There is no one VaR for a single portfolio, because
different methodologies used for calculating VaR
produce different results.
• The basic time period T and the confidence level (the
quantile) q are the two major parameters that should
be chosen in a way appropriate to the overall goal of
risk measurement.

• The time horizon can differ from a few hours
for an active trading desk to a year for a
pension fund.
• When the primary goal is to satisfy external
regulatory requirements, such as bank capital
requirements, the quantile is typically very
small (for example, 1 percent of worst
outcomes).
• However, for an internal risk management
model used by a company to control the risk
exposure, the typical number is around 5
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Risk Measurement: Market Risk
Calculation methods
There are three different methods for calculating
VaR.
■ The variance/covariance or Delta Normal (or
correlation or parametric method);
■ Historical simulation (non-parametric
method);
■ Monte Carlo simulation (non-parametric
method).

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Calculation methods
■ The variance/covariance (or correlation or
parametric method)
VaRt+1 = 1.65 δ Vt
Where,
Vt is the market value of the instrument at the
anchor date t.
δ is the estimated standard deviation of returns
for target date t+1 made at time t.
The value 1.65 is the standard normal variable
corresponding to the confidence level of 95%.
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Assumptions of The Variance/Covariance
• The returns on risk factors are normally
distributed.
• The correlations between risk factors are
constant.
• The delta (or price sensitivity to changes in a
risk factor) of each portfolio constituent is
constant.

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Calculation methods
■ Historical simulation (non-parametric
method)
1. This method uses the distribution of historical
prices to calculate VaR.
2. The daily prices for the last t day is used to
revalue the anchored portfolio with a
composition as on the anchor date.

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Risk Measurement: Credit Risk
1. Credit risk has been traditionally defined as
default risk, i.e. the risk of loss from a borrower
or counterparty’s failure to repay the amount
owed (principal or interest) to the bank on a
timely manner based on a previously agreed
payment schedule.

2. A more comprehensive definition includes
value risk, i.e. the risk of loss of value from a
borrower migrating to a lower credit rating
(opportunity cost of not pricing the loan correctly

Credit Risk Building Blocks
Therefore, in order to protect themselves
against volatility in the level of default/value
losses banks have adopted methodologies that
allow them to quantify such risks and thereby
derive the amount of capital required to
support their business – what is referred to as
Economic Capital.

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Expected Loss (EL) is based on three parameters:
(i) Probability of Default (PD): The likelihood that
default will take place over a specified time
horizon.
(ii) Exposure at Default (EAD) : The amount
owned by the counterparty at the moment of
default.
(iii) Loss Given Default (LGD): The fraction of the
exposure, net of any recoveries, which will be lost
following a default event.

Credit Risk Building Blocks
Expected Loss (EL)
Assume for example that, based on historical
performance, a bank has come to expect
around 1% of its loans to default every year for
a credit portfolio of $1 billion with an average
recovery rate of 50%
• In that case, the bank’s Expected Loss (EL) for a
credit portfolio of $1 billion is $5 million.
EL = PD x EAD x LGD
EL= 1% x $1 billion x 50%
= $5 million
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Traditional approaches to measure credit risk
1. Expert Judgment: This is the oldest approach to
credit risk assessment involves an expert judgment
by a loan officer based on the 5Cs of credit.
(i) Character: Refers to the integrity of the borrower.
(ii) Capital: Is the equity contribution in the project.
(iii) Capacity: Is reflected by the amount and stability of cash flows
of the firm.
(iv) Conditions: Refers to economic conditions in the economy and
their potential to impact the repayment of the loan.
(v) Collateral: It is the security available to the lender in case of
default by the borrower.

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2. Rating Systems: This system combines
accounting ratios and expert judgment to
categorize debt into rating categories.
---Banks have their own internal rating scales that
are used to categorize and price loans.
--- Rating agencies such as S&P, Fitch, Moody's
Investors Service, CRISIL, ICRA also assess the
creditworthiness of the issuer or the borrower.

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3. Credit Scoring Models: These models are
mathematical models which combine financial
information and non-financial information of
borrowers into a credit score. (e.g. management
quality, years in operation in case of companies and
for retail customers, this might include income,
work history and other demographic data)
This credit core is either a probability of default by
the borrower or can be used to assign borrowers
into rating categories that reflect varying
probabilities of default.

• In univariate accounting based credit-scoring
systems, the banker compares various key accounting
ratios of potential borrowers with industry or group
norms.
• In multivariate models, the key accounting variables
are combined and weighted to produce either a
credit risk score or a probability of default measure.
• Decision: If the credit risk score, or probability,
attains a value above a critical benchmark, a loan
applicant is either rejected or subjected to increased
scrutiny.

There are at least four methodological
approaches to develop multivariate credit-scoring
systems:
(i)The Linear Probability Model, (ii)The Logit
Model, (iii)The Probit Model, and (iv)The Linear
Discriminant Model.

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Stress Testing
1. Stress testing is used to analyze impact of movements
in basic risk factors that reflect stressful environments.
2. An analysis conducted under unfavorable economic
scenarios which is designed to determine whether a bank
has enough capital to withstand the impact of adverse
developments.
3. Stress tests can either be carried out internally by banks
as part of their own risk management, or by supervisory
authorities as part of their regulatory oversight of the
banking sector.
4. These tests are meant to detect weak spots in the
banking system at an early stage, so that preventive
action can be taken by the banks and regulators.

5. Based on RBI guidelines, a “Stress Test Policy of a
Bank” may be approved by the Board of Directors. This
involves the construction of plausible events/ scenarios
to stress the credit and the market portfolios of banks.
For example, the following events/ scenarios can be
identified to stress the credit and the market portfolios
of banks. :
• What happens if equity markets crash by more than Z% this year?
• What happens if GDP falls by Y% in a given year?
• What happens if interest rates go up by at least X%?
• What if half the borrowers in the portfolio of credit terminate
their loan contracts prematurely?
• What happens if oil prices rise by 150%?
86

Asset Liability Management (ALM)
1. ALM is defined as ‘a continuous process of
planning, organizing, controlling and adjusting
the bank liabilities to meet loan demands,
liquidity needs and safety requirements’.

87

Objectives of ALM
1. Planning to meet the liquidity needs/
requirements.
2. Arranging maturity pattern of asset and
liabilities.
3. Controlling the rates received from assets and
paid to liabilities so as to maximize the spread or
net interest income.
4. To protect and enhance the market value of the
net worth.

ALM is concerned with the following six types of
financial risks
1. Interest Rate Risk
2. Liquidity Risks
3. Credit risks
4. Currency risks
5. Capital risks
6. Contingent risks

BASEL NORMS AND RISK MANAGEMENT IN BANKS

90

Bank for International Settlements (BIS)
The mission of BIS is to serve central banks in their goal of
maintaining monetary and financial stability, to foster
international cooperation in those areas and to act as a bank for
central banks.
In broad, the BIS pursues its mission by:
1. Promoting discussion and facilitating collaboration among
central banks;
2. Supporting dialogue with other authorities that are responsible
for promoting financial stability;
3. Conducting research on policy issues confronting central banks
and financial supervisory authorities;
4. Acting as a prime counterparty for central banks in their
financial transactions;
5. Serving as an agent or trustee in connection with international
financial operations.
91

About the Basel Committee
1. The Basel Committee on Banking Supervision provides a forum
for regular cooperation on banking regulation and supervisory
matters.
2. Its objective is to enhance understanding of key supervisory
issues and improve the quality of banking supervision
worldwide.
3. It seeks to do so by exchanging information on national
supervisory issues, approaches and techniques, with a view to
promoting common understanding.
4. In this regard, the Committee is best known for its International
Standards on Capital Adequacy; the Core Principles for Effective
Banking Supervision; and the Agreement on Cross-Border
Banking Supervision.

92

About the Basel Committee
5. The Committee's members come from Argentina, Australia,
Belgium, Brazil, Canada, China, France, Germany, Hong Kong,
India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the
Netherlands, Russia, Saudi Arabia, Singapore, South Africa,
Spain, Sweden, Switzerland, Turkey, the United Kingdom and the
United States.
6. The present Chairman of the Committee is Mr Stefan Ingves,
Governor of Sveriges Riksbank and Mr Wayne Byres is the
Secretary General of the Basel Committee
7. The Committee encourages contacts and cooperation among its
members and other banking supervisory authorities.
8. It circulates to supervisors throughout the world both published
and unpublished papers providing guidance on banking
supervisory matters.
93

Basel Capital Accords
1. The first accord by the name Basel Accord I was established
in 1988 and was implemented by 1992. It was the very first
attempt to introduce the concept of minimum standards of
capital adequacy to develop standardized risk-based capital
requirements for banks across countries.
2. Next, the second accord by the name Basel Accord II was
established in 1999, published in 2004 for implementation
by 2006 as Basel II Norms.
3. Initially it was directed by RBI that all commercial banks in
India will start implementing Basel II with effect from March
31, 2007. Unfortunately, India could not fully implement this
but, is gearing up under the guidance from the Reserve
Bank of India to implement it from 1 April, 2009.

94

Different types of Risk faced by Banking Industry
1. Market/General risk (systematic risk): Risk of loss
arising from movements in market variables such as
market prices or rates away from the rates or prices
set out in a transaction or agreement.
BIS defines market risk as “ the risk that the value of
‘on’ or ‘off’ balance sheet positions will be adversely
affected by movements in equity and interest rate
markets, currency exchange rates and commodity
prices”.
2. Specific risk (unsystematic 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).
95

Off-Balance Sheet Exposures

Off-Balance Sheet exposures refer to the business
activities of a bank that generally do not involve loan
assets and taking deposits.
Off-balance sheet activities normally generate
fees/commissions but produce liabilities or assets that
are deferred or contingent and thus, do not appear on
the banks balance sheet until or unless they become
actual assets or liabilities.

96

3. 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.
In asset and liability management, risk that changes in
interest rates will re-price interest-incurring liabilities
differently from re-pricing the interest-earning assets,
thus causing an asset-liability mismatch.

Example: Risk presented when yields on assets and costs on
liabilities are based on different bases, such as the LIBOR,
SIBOR, MIBOR versus the U.S. prime rate, Indian PLR and so on.
In some circumstances different bases will move at different
rates or in different directions, which can cause erratic changes
in revenues and expenses. 97

3. Credit risk: Risk that a party to a contractual
agreement or transaction will be unable to meet their
obligations or will default on commitments.

4. 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.

98

6. Liquidity risk: Probability of loss arising from a situation
where (1) there will not be enough cash and/or cash
equivalents to meet the needs of depositors and
borrowers, (2) sale of illiquid assets will yield less than
their fair value, or (3) illiquid assets will not be sold at
the desired time due to lack of buyers.

99


Funding Risk – need to replace net outflows due to
unanticipated withdrawal/non-renewal of deposits
(wholesale and retail).
Time Risk – need to compensate for non-receipt of
expected inflows of funds, i.e. performing assets
turning into non-performing assets.
Call Risk – due to crystallization of contingent liabilities
because of which banks are unable to undertake
profitable business opportunities when desirable.

100

7. Operational risk: It has been defined by the Basel
Committee on Banking Supervision as, “the risk of loss
resulting from inadequate or failed internal processes,
people and systems or from external events”. This
definition includes legal risk, but excludes strategic and
reputational risk.
Operational Risk Events
Internal fraud, External fraud, Employment practices
and workplace safety. Clients, products and business
practices. Damage to physical assets. Business
disruption and system failures. Execution, delivery and
process management.
101

Green Banking
• It means promoting environmental-friendly practices and
reducing carbon footprint from banking activities.
• This comes in many forms. For example, using online banking
instead of branch banking. Paying bills online instead of mailing
them. Opening up CDs and money market accounts at online
banks, instead of large multi-branch banks. Or finding the local
bank in your area that is taking the biggest steps to support local
green initiatives.
• Any combination of the above personal banking practices can
help the environment. In general, online banks and smaller
community banks have better track record than larger banks.

103

Risk Management Process

Identify

Report Measure

Monitor Mitigate

105

Capital Adequacy
The basic approach of capital adequacy framework is
that a bank should have sufficient capital to provide a
stable resource to absorb any losses arising from the
risks in its business.

This requirement is popularly called as Capital Adequacy
Ratio (CAR) or Capital to Risk Weighted Assets Ratio
(CRAR).

108

Basel I Norms
1. Basel I, that is, the 1988 Basel Accord, primarily focused
on credit risk. Assets of banks were classified and
grouped in five categories according to credit risk.
2. Banks with international presence are required to hold
capital equal to 8 % of the risk-weighted assets.
I. 0% - Central Bank and Government Debt and any OECD
Government Debt.
II. 10%- Public Sector Debt.
III. 20% - Development bank debt, OECD Bank Debt, OECD
Securities Firm Debt, non-OECD bank debt (under one year
maturity) and Non-OECD Public Sector Debt.
IV. 50% - residential mortgages.
V. 100% - Private Sector debt, Non-OECD bank debt (maturity
over a year), real estate, plant and equipment, capital
instruments issued at other banks. 109

Why BASEL-II ?
Because Basel-I has the following shortcomings :

1. The Basel I has been criticized as being inflexible
due to focus only on credit risk.
2. Treating all types of borrowers under one risk category
irrespective of credit rating.
3. Less sensitive to risk because it is using similar approach
irrespective of quality of counterparty or credit.
4. Limited scope for credit risk mitigation.
5. Over the years, the business of banking, risk management
practices, supervisory approaches and financial markets have
undergone significant transformation.

Basel II Norms
The new proposal is based on three mutually reinforcing pillars that
allow banks and supervisors to evaluate properly the various risks
that banks face and realign regulatory capital more closely with
underlying risks.

1. The Basel II Norms primarily stress on 3 factors, viz.
Capital Adequacy, Supervisory Review and Market
discipline. The Basel Committee calls these factors as
the Three Pillars to manage risks.

2. Capital is divided into tiers according to the
characteristics/qualities of each. For supervisory
purposes capital is split into two categories: Tier I and
Tier II. These categories represent different
instruments’ quality as capital.
111

Basel II: Basic Structure

Three Pillars

Pillar 1 Pillar 2
Pillar 3
Minimum Capital Requirements Supervisory
Market Discipline
Review

Risk weighted Capital
assets

Credit Risk Operational Risk Market Risk Tier I Tier II
Capital Capital

Pillar I: Capital Adequacy Requirements
Capital Charge for Credit Risk:
1. Basel II takes a more sophisticated approach to credit risk,
in that it allows banks to make use of Internal Rating Based
Approach (IRB Approach) as they have become known to
calculate their capital requirement for credit risk.
2. The bank allocates a risk weight to each of its assets and
off-balance sheet positions and produces a sum of risk-
weighted asset value.
3. Individual risk weight currently depends on the broad
category of borrower (i.e. sovereign, banks or corporates).
4. Under the new accord, the risk weights are to be refined
by reference to a rating provided by an external credit
assessment institution (such as rating agency) that meets
strict standards.
114

5. Under Basel II Norms, banks should maintain a minimum
capital adequacy requirement of 8% of risk assets.
6. For India, the Reserve Bank of India has mandated
maintaining of 9% minimum capital adequacy
requirement.

115


Capital Charge for Market Risk:
(i) Assign an additional risk weight of 2.5 per cent on the
entire investment portfolio;
(ii) Assign a risk weight of 100 per cent on the open position
limits on foreign exchange and gold; and
(iii) Build up Investment Fluctuation Reserve up to a
minimum of 5% of the investments held in for Trading
and available for Sale categories in the investment
portfolio.

117


Capital Charge for Operational Risk:
Under the Basic Indicator Approach, Banks are required
to hold capital for operational risk equal to the average
over the previous three years of a fixed percentage
(15%) of annual gross income.

118

Pillar I- Minimum Capital

Total Capital (Tier I + Tier II)
CRAR= --------------------------------------------------- >= 9%
Risk Weighted Assets (Credit Risk+ Market Risk +Operational Risk)

Credit Risk Operational
----------------- Market Risk
Risk
----------------
--------------
Potential that a Failed or
borrower or Risk of losses on
inadequate
counterparty shall and off- Balance
internal
not be able to Sheet Positions
processes,
meet his arising out of
people and
obligations as per market
systems or
agreed terms movements
external events

Computation of Capital for Credit Risk

120

Components of Capital: Tier I and Tier II Capital
1. For supervisory purposes capital is split into two categories: Tier
I and Tier II. These categories represent different instrument’s
quality as capital.
2. Tier I capital consists mainly of share capital and disclosed
reserves and it is a bank’s highest quality capital because it is
fully available to cover losses.
3. Tier II capital on the other hand consists of certain reserves and
certain types of subordinated debt. The loss absorption
capacity of Tier II capital is lower than that of Tier I capital.

122

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.

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.

127

Pillar II: Supervisory Review
1. Supervisory review process has been introduced to ensure
not only that banks have adequate capital to support all
the risks, but also to encourage them to develop and use
better risk management techniques in monitoring and
managing their risks.
The process has four key principles:
a) Banks should have a process for assessing their overall
capital adequacy in relation to their risk profile and a
strategy for monitoring their capital levels.
b) Supervisors should review and evaluate bank’s internal
capital adequacy assessment and strategies, as well as
their ability to monitor and ensure their compliance with
regulatory capital ratios.

129

Pillar II: Supervisory Review
c) Supervisors should expect banks to operate above the
minimum regulatory capital ratios and should have the
ability to require banks to hold capital in excess of the
minimum.
d) Supervisors should seek to intervene at an early stage to
prevent capital from falling below minimum level and
should require rapid remedial action if capital is not
restored.

130

Pillar III: Market Discipline (Disclosure Norms)
1. Market discipline imposes banks to conduct their banking
business in a safe, sound and effective manner.
2. It is proposed to be effected through a series of disclosure
requirements on capital and different risk exposures.
3. Mandatory disclosure requirements on capital risk
exposure (semiannually or more frequently, if appropriate)
are required to be made public so that market participants
can assess a bank's capital adequacy. Qualitative
disclosures such as risk management objectives and
policies, definitions should also be published.

131

BASEL III
1. Basel III is a comprehensive set of reform measures,
developed by the Basel Committee on Banking
Supervision, to strengthen the regulation, supervision
and risk management of the banking sector.
These measures aim to:
a. Improve the banking sector's ability to absorb shocks
arising from financial and economic stress, whatever
the source.
b. Introduces new regulatory requirements on bank’s
liquidity
c. Improve risk management and governance.
d. Strengthen banks' transparency and disclosures.
132

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