MODERN BANK MANAGEMENT

MBA II YEAR STUDENTS

C. Krishnan
IFMR GSB, Krea University

July - September, 2020

1
 TOPICS PROPOSED TO BE COVERED
• Pre-course Quiz
• Banks and their functions
• Structure, classification of banks
• Role of different departments in a bank
• Role of Central Bank (RBI)
• Banking products and services
• Principles of Lending
• Capital & Risk Management
• Basel Accords
• Asset Liability Management
• Trade Finance
• Payment Systems
• Global Financial Crisis & Case Studies
2
 BANKS & THEIR FUNCTIONS

3
 EVOLUTION OF BANKING

4
 WHAT IS A BANK?
“A Banker is one who lends his umbrella during fair
weather and takes it back when it rains” - Mark Twain

“A bank is a financial institution and a financial

intermediary that accepts deposits and channels those
deposits into lending activities, either directly or through
the capital market. A bank connects customers with funds
deficit to customers with funds surplus”
5
 BASIC BANKING ACTIVITY
 Money is the raw material for banks - re-packagers of
money
 A bank’s balance sheet lists sources of bank funds
(liabilities) and uses to which they are put (assets)
 Banks invest these liabilities (sources) into assets (uses)
in order to create value for their capital providers
 Solvency and Liquidity are very important for banks

 Liabilities Sources of Funds

 Assets Uses of Funds

6
 BASIC BANKING ACTIVITY…

8 CRR = 4% & SLR =

19.5% in 2019
 TYPICAL DEPARTMENTS IN A BANK

 Wholesale Banking - for Corporate & Institutional

clients, Trade Finance, Cash Management
 Retail Banking - for small / individual borrowers
 Operations
 Payments / Remittances
 Treasury / Investment Banking
 Finance
 Risk Management
 Information Technology
 Human Resources

8
 BANK’S CAPITAL

 It is the source of funds supplied by the bank owners,

either directly through purchase of ownership shares
or indirectly through retention of earnings (retained
earnings being the portion of funds which are earned
as profits but not paid out as ownership dividends)
 This is generally at least about 9% of risk-weighted assets
(Capital Adequacy Ratio)

9
 BANK’S CAPITAL…
Tier 1 Capital:
• Permanent shareholders’ equity
• Disclosed reserves (including retained earnings)

Less: Goodwill

Tier 2 Capital:
• General provisions/general loan-loss reserves
• Revaluation reserves
• Hybrid (debt/equity) capital instruments
• Subordinated term debt
• Undisclosed reserves (not allowed for U.S. banks)
Less: Investments in unconsolidated financial subsidiaries
Less: Investments in the capital of other financial institutions
10
 BANKING STRUCTURE IN INDIA

• A well-regulated banking system is a key comfort for local and foreign

stake-holders in any country. Prudent banking regulation is recognized
as one of the reasons why India was less affected by the global
financial crisis
• Banks can be broadly categorized as Commercial Banks or Co-
operative Banks
• Banks which meet specific criteria are included in the second schedule
of the RBI Act, 1934. These are called scheduled banks. They may be
commercial banks or co-operative bank
• Scheduled banks are considered to be safer, and are entitled to special
facilities like re-finance from RBI. Inclusion in the schedule also comes
with its responsibilities of reporting to RBI and maintaining a
percentage of its demand and time liabilities as Cash Reserve Ratio
(CRR) with RBI
 STRUCTURE & CLASSIFICATION OF BANKS

13
BANKING STRUCTURE IN INDIA…
BROAD CLASSIFICATION OF BANKS IN INDIA

Reserve Bank of India:

The RBI is the supreme monetary and banking authority in the

country and has the responsibility to control the banking system in
the country. It keeps the reserves of all scheduled banks and hence
is known as the ‘Reserve Bank’

• Public Sector Banks:

 State Bank of India plus Associates (now merged with SBI)
 Nationalized Banks
 Regional Rural Banks Sponsored by Public Sector Banks
 BROAD CLASSIFICATION OF BANKS IN INDIA…

• Old Generation Private Sector Banks

• New Generation Private Banks
• Foreign Banks
• Development Banks

• Universal Banks
• Payment Banks
• Small Finance Banks
 COMMERCIAL BANKS

• Commercial banks comprising public sector banks, foreign

banks, and private sector banks represent the most important
financial intermediary in the Indian financial system
• The changes in banking structure and control have occurred
due to wider geographical spread and deeper penetration of
rural areas, higher mobilization of deposits, reallocation of
bank credit to priority activities, and lower operational
autonomy for a bank management
• Public sector commercial banks dominate the commercial
banking scene in the country

17
 MAIN FUNCTION OF COMMERCIAL BANKS

A) Acceptance of deposits
• Fixed deposit account
• Saving bank account
• Current account

B) Advancing of loan
• Cash Credit / Overdraft
• Loans
• Bills discounting
MAIN FUNCTION OF COMMERCIAL BANKS…

C) Agency function
• Collecting receipts
• Making payments
• Buy and sell securities
• Trustee and executor

D) General utility function

• Issuing Letters of Credit, Guarantees
• Underwriting share and debentures
• Safe custody of valuables
• Providing ATM and credit card facilities
• Providing credit information
 COOPERATIVE BANK

• These banks play a vital role in mobilizing savings and

stimulating agricultural investment. Co-operative credit
institutions account for the second largest proportion of 44.6%
of total institutional credit. The co-operative sector is very much
useful for rural people. The co-operative banking sector is
divided into the following categories.
• State Co-operative Banks
• Central Co-operative banks
• Primary Agriculture Credit Societies

20
 DEVELOPMENT BANKS

• A development bank may be defined as a financial institution

concerned with providing all types of financial assistance to
business units in the form of loans, underwriting, investment
and guarantee operations and promotional activities-economic
development in general and industrial development in particular
• A development bank is basically a term lending institution. It is a
multipurpose financial institution with a broad development
outlook
• The Industrial Finance Corporation of India, the first
development bank was established in 1948
• Subsequently many other institutions were set-up. Ex. IDBI,
IFCI, SIDBI, etc.

21
 FUNCTION OF DEVELOPMENT BANKS

• Fostering industrial growth

• Providing Long term assistance
• Balanced development
• Providing Promotional services
• Infrastructure building
• Entrepreneur Development
• Fulfilling socio economic objectives

22
 INVESTMENT BANKS
• Financial intermediaries that acquire the savings of people and
direct these funds into the business enterprises seeking capital for
the acquisition of plant and equipment and for holding inventories
are called ‘Investment Banks’
• Features: Long term financing, Security, merchandiser, Security
middlemen, Insurer, Underwriter
• Functions: Capital formation, Underwriting, Purchase of securities,
Selling of securities, Advisory services, Acting as dealer

23
 UNIVERSAL BANKS
Eligibility

• Companies in the private and public sectors and non-banking financial

companies (NBFCs) will be eligible to set up a bank through a wholly-
owned non-operative financial holding company (NOFHC). These
applicants need to meet the criteria set by RBI
• The players will also need to have a sound and successful track record of
10 years

Capital requirement

• The initial minimum paid-up voting equity capital for a bank needs to be
at least Rs.500 crore
• The bank will need to be listed within three years of starting business

24
 UNIVERSAL BANKS…

Scope of activity

• The bank can accept deposits and carry out lending activities without
limitations in the area of operations. Also, the banks will have to work
towards achieving financial inclusion and 40 per cent of their lending
should be towards the priority sector
• IDFC (Mumbai) and Bandhan Bank (Kolkata) are two such banks

25
 SMALL FINANCE BANKS
Eligibility

• Resident individuals/professionals with 10 years of experience in banking

and finance, companies and societies owned and controlled by residents,
existing NBFCs, microfinance institutions, and local area banks can apply
for small finance bank licences. All entities should be owned and
controlled by Indian residents and should be able to meet the 'fit and
proper' criteria stated by RBI

Capital requirements

The minimum paid-up equity capital required is Rs.100 crore

26
 SMALL FINANCE BANKS…

Scope of activity

• They will primarily undertake basic banking activities of accepting

deposits and lending to unserved and underserved sections,
including small business units, small and marginal farmers, micro
and small industries and unorganised sector entities
• There will not be any restriction in the area of operations of small
finance banks

27
 PAYMENT BANKS
Eligibility

• Prepaid payment Instrument issuers, individuals/professionals, NBFCs,

corporate business correspondents, mobile telephone companies, super-
market chains, real sector cooperatives that are owned and controlled by
residents, and public sector entities are eligible to apply for payments bank
licences
• The promoter should be able to meet the 'fit and proper' criteria with a
sound track record of five years

Capital requirements

The minimum paid-up equity capital for payments banks shall be Rs.100
crores

28
 PAYMENT BANKS…

Scope of activity

• Can accept deposits of up to Rs.1 lakh a customer and issue debit cards
• It can also carry out payments and remittance services and is allowed to
distribute insurance and mutual fund products
• Payments banks can also serve as a business correspondent of another
bank

29
 NON BANK FINANCIAL COMPANIES (NBFCs)

• Nonbank financial companies (NBFCs), also known as nonbank

financial institutions (NBFIs), are financial institutions that offer
various banking services but do not have a banking license
• Generally, these institutions are not allowed to take traditional
demand deposits - readily available funds, such as those in checking
or savings accounts - from the public

30
 NON BANK FINANCIAL COMPANIES (NBFCs)

Salient Features of NBFC companies

• Non-banking financial companies are also known as non-banking

financial institutions (NBFIs)
• These are entities which provide bank-like financial services but do
not hold a banking license.

• Therefore, the NBFCs are not bound by the banking regulations

and oversight to which the traditional banks have to adhere
• NBFCs are regulated by the Ministry of Corporate Affairs and the
Reserve Bank of India

31
 NON BANK FINANCIAL COMPANIES
(NBFCs)…

Differences from Banks:

• A government authorized financial intermediary that aims at providing

banking services to the general public is called the bank. An NBFC is a
company that provides banking services to people without holding a bank
license
• An NBFC is incorporated under the Indian Companies Act, 1956 whereas
a bank is registered under Banking Regulation Act, 1949
• NBFC is not allowed to accept such deposits which are repayable on
demand. Unlike banks, which accepts demand deposits
• Foreign Investments up to 100% is allowed in NBFC
• Only banks of the private sector are eligible for foreign investment, and
that would be not more than 74%

32
 NON BANK FINANCIAL COMPANIES
(NBFCs)…
Differences from Banks:

• Banks are an integral part of payment and settlement cycle while NBFC, is
not a part of the system
• It is mandatory for banks to maintain reserve ratios like CRR or SLR. As
opposed to NBFC, which does not require to maintain reserve ratios
• The deposit insurance facility is allowed to the depositors of banks by
Deposit Insurance and Credit Guarantee Corporation (DICGC). Such
facility is unavailable in the case of NBFC
• Banks create credit, whereas NBFC is not involved in the creation of
credit
• Banks provide transaction services to the customers, such as providing
overdraft facility, the issue of traveller’s cheque, transfer of funds, etc.
Such services are not provided by NBFC

33
 ROLE OF RESERVE BANK OF INDIA

34
 ROLE OF CENTRAL BANK

 Issuer of currency
 Banker to Government
 Banker’s Bank
 Custodian of Foreign Exchange Reserves
 Controller of Credit
 Netting and Settlement of payments

35
 ROLE OF RESERVE BANK OF INDIA

• The Reserve Bank of India (RBI) is the Central Bank of India,

and was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934
• Though originally privately owned, RBI has been fully owned by
the Government of India since nationalization in 1949
• RBI is governed by a central board (headed by a Governor)
appointed by the Central Government
• RBI has 4 zonal offices, 19 regional offices and 11 sub-offices in
India
 FUNCTIONS OF RBI

Monetary Authority

• Formulates, implements and monitors the monetary policy.

• Objective: maintaining price stability and ensuring adequate
flow of credit to productive sectors
• Regulator and supervisor of the financial system
• Prescribes broad parameters of banking operations within which
the country’s banking and financial system functions
• Objective: Maintain public confidence in the system, protect
depositors’ interest and provide cost-effective banking services
to the public. The Banking Ombudsman Scheme has been
formulated by the Reserve Bank of India (RBI) for effective
redressal of complaints by bank customers
 FUNCTIONS OF RBI…

Manager of Foreign Exchange and Control:

• Manages the foreign exchange through Foreign Exchange
Management Act, 1999
• Objective: to facilitate external trade and payment and promote
orderly development and maintenance of foreign exchange
market in India
• Issuer of currency
• Issues and exchanges or destroys currency and coins not fit for
circulation
• Objective: to give the public adequate supplies of currency
notes and coins and in good quality
 FUNCTIONS OF RBI…
Developmental role:
• Performs a wide range of promotional functions to support
national objectives

Related functions
• Banker to the Government: Performs merchant banking
function for the central and the state governments; also acts as
their banker
• Banker to banks: maintains banking accounts of all scheduled
banks
• Owner and operator of the depository (SGL) and exchange
(NDS) for government bonds
 FUNCTIONS OF RBI…

Supervisory Functions:
• In addition to its traditional central functions, the Reserve bank has
certain non-monetary functions of the nature of supervision of banks
and promotion of sound banking in India
• The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949
have given the RBI wide powers of supervision and control over
commercial and cooperative banks, relating to licensing and
establishments, branch expansion, liquidity of their assets,
management and methods of working, amalgamation, reconstruction
and liquidation
• The RBI is authorized to carry out periodical inspections of the banks
and to call for returns and necessary information from them.. The
supervisory functions of the RBI have helped a great deal in
improving the standard of banking in India to develop on sound lines
and to improve the methods of their operation
 FUNCTIONS OF RBI…
Promotional Functions:
• The Reserve Bank promotes banking habit, extend banking facilities to rural
and semi-urban areas, and establish and promote new specialized financing
agencies
• The Reserve bank has helped in the setting up of the IFCI and the SFC: it set
up the Deposit Insurance Corporation of India in 1963 and the Industrial
Reconstruction Corporation of India in 1972. These institutions were set up
directly or indirectly by the Reserve Bank to promote saving habit and to
mobilize savings, and to provide industrial finance as well as agricultural
finance
• The RBI set up the Agricultural Credit Department in 1935 to provide
agricultural credit. The Bank has developed the co-operative credit movement
to encourage saving, to eliminate money-lenders from the villages and to
route its short term credit to agriculture. The RBI has set up the Agricultural
Refinance and Development Corporation to provide long-term finance to
farmers
 MARGINAL COST OF FUNDS BASED
LENDING RATE (MCLR)

• The MCLR methodology for fixing interest rates for advances

was introduced by the Reserve Bank of India with effect from
April 1, 2016
• This new methodology replaces the base rate system introduced
in July 2010
• In other words, all rupee loans sanctioned and credit limits
renewed w.e.f. April 1, 2016 are priced with reference to the
Marginal Cost of Funds based Lending Rate (MCLR) which will
be the internal benchmark (means a reference rate determined
internally by the bank) for such purposes
 METHOD OF COMPUTING MCLR

• MCLR is a tenor-linked internal benchmark of an individual bank

• It varies for different maturities of loans and advances
• Important components taken into account for calculating MCLR are:

- Marginal Cost of Funds

- Operating Expenses
- Negative carry on CRR and SLR
- Average Return on Net Worth (hurdle rate of return on equity
determined by the Board of the Bank)
 METHOD OF COMPUTING MCLR…

• The actual lending rates are determined by adding the components of

spread to the MCLR. Banks will review and publish their MCLR of
different maturities every month, on a pre-announced date

• The MCLR comprises the following:

a) Marginal cost of funds, which is a novel concept under the MCLR
methodology; it comprises marginal cost of borrowings and return on
net worth, appropriately weighted
i.e.,
Marginal cost of funds = (92% x marginal cost of borrowings) + (8% x Return
on net worth)
 METHOD OF COMPUTING MCLR…

• Thus, marginal cost of borrowings has a weightage of 92% while return on

net worth has 8% weightage in the marginal cost of funds
• Here, the weight given to return on net worth is set equivalent to the 8% of
risk weighted assets prescribed as Tier I Capital for the bank
• The marginal cost of borrowing refers to the average rates at which
deposits of a similar maturity were raised in the specified period preceding
the date of review, weighed by their outstanding balance in the bank’s
books
i.e,
• Rates offered on deposits of a similar maturity on the date of review/ rates
at which funds raised x Balance outstanding as a percentage of total funds
(other than equity) as on any day, but not more than seven calendar days
prior to the date from which the MCLR becomes effective
 METHOD OF COMPUTING MCLR…

b) Negative carry on account of' Cash reserve ratio (CRR)- Negative carry
on the mandatory CRR arises because the return on CRR balances is nil.
Negative carry on mandatory Statutory Liquidity Ratio (SLR) balances may
arise if the actual return thereon is less than the cost of funds

c) Operating Cost associated with providing the loan product, including cost
of raising funds, but excluding those costs which are separately recovered by
way of service charges

d) Tenor Premium - The change in tenor premium cannot be borrower

specific or loan class specific. In other words, the tenor premium will be
uniform for all types of loans for a given residual tenor
 Marginal Cost of Funds Based Lending Rate
Formula
Formula:

Marginal Cost of Funds = MCB x 0.92 + RN x 0.08

Marginal Cost of Funds Based Lending Rate = MCF + CRR + OC + TP

Where,
MCB = Marginal Cost of Borrowing
RN = Return on Net Worth
CRR = Negative Carry on CRR
OC = Operating Costs
TP = Tenor Premium
Related Calculator:
 REASONS FOR INTRODUCING MCLR

• RBI decided to shift from base rate to MCLR because the rates based on
marginal cost of funds are more sensitive to changes in the policy rates
• Prior to MCLR system, different banks were following different
methodologies for calculation of base rate /minimum rate – that is either on
the basis of average cost of funds or marginal cost of funds or blended cost
of funds
• Thus, MCLR aims
- to improve the transmission of policy rates into the lending rates of banks
- to bring transparency in the methodology followed by banks for
determining interest rates on advances
- to ensure availability of bank credit at interest rates which are fair to
borrowers as well as banks
- to enable banks to become more competitive and enhance their long run
value and contribution to economic growth
 METHOD OF COMPUTING MCLR…

• RBI mandates at least 5 MCLR, viz.,

- Overnight, 1month, 3 months, 6months and 1 year
• Banks can have MCLR of longer tenures if they so desire
• Banks have to declare MCLR for various tenors every month
• All new loans in that month will be offered at a spread over the
MCLR
• Spread will depend on credit worthiness of the borrower

https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=101
79&Mode=0
https://www.youtube.com/watch?v=4mbF2DMFZSw
 MCLR vs. BASE RATE
• Base rate calculation is based on cost of funds, minimum rate of
return, i.e., margin or profit, operating expenses and cost of
maintaining cash reserve ratio while the MCLR is based on
marginal cost of funds, tenor premium, operating expenses and
cost of maintaining cash reserve ratio
• The main factor of difference is the calculation of marginal cost
under MCLR
• Marginal cost is charged on the basis of following factors -
interest rate for various types of deposits, borrowings and return
on net worth
• Therefore MCLR is largely determined by marginal cost of
funds and especially by deposit rates and repo rates
GLOBAL FINANCIAL MARKET
 The Money Merry-go-round

• Financial markets are all about raising capital and matching those who
want capital (borrowers) with those who have it (lenders)
• How do borrowers find lenders? With difficulty, clearly, but for the
presence of intermediaries such as banks
• Banks take deposits from those who have money to save and bundle
the money up in various ways so that it can be lent to those who wish
to borrow
• More complex transactions than a simple bank deposit require markets
in which borrowers and their agents can meet lenders and their agents,
and existing commitments to borrow or lend can be resold to other
people
• Stock exchanges are a good example - Companies raise money by
selling shares to investors, and existing shares are freely bought and
sold.
• The money goes round and round, just like a carousel on a fairground
The Money Merry-go-round…
 MONEY MARKETS & CAPITAL MARKETS

Money Markets:

• The money market is the global financial market for short-term

borrowing and lending and provides short term liquid funding
for the global financial system
• The average amount of time that companies borrow money in a
money market is about thirteen months or lower
• Basically, what the money market consists of is banks that
borrow and lend to each other
MONEY MARKETS & CAPITAL MARKETS…
Major Players in the Money Market in India:

• RBI
• Central Government
• State Governments
• Banks
• Financial Institutions
• Micro Finance Institutions
• Foreign Institutional Investors (FII)
• Mutual Funds

Money Market Instruments

• Treasury Bills
• Commercial Papers
• Certificate of Deposit
• Bankers Acceptance
 MONEY MARKETS & CAPITAL MARKETS…

Capital Market:

Capital market can be primary market and secondary market . In

primary market new securities are issued where as in secondary
market already issue securities are traded

Capital Market Instruments:

1. Shares
2. Debentures
3. Bonds
 RAISING CAPITAL
Suppose a commercial company needs $200m to finance building a
new factory. What are the choices to do so?

A. Bank loans:
• One obvious source of money when we need it is the bank
• When large sums of money are required, it may be a syndicate
of banks in order to spread the risk
• The banks take deposits lent to them and relend the money to
the commercial company - it’s their classic role as an
intermediary
• In the international syndicated bank lending market, based in
London, the money will not be lent at a fixed rate, but at a
variable rate, which changes from time to time according to
market rate in Europe, plus a given margin, such as 0.75%. The
bank will readjust the rate, say, every 3 months. The rate is fixed
for 3 months but then changes for the next 3 months rates
• The banks may lend at a basic rate, such as the prime rate in the
US or the interbank
 RAISING CAPITAL…
B. Bonds:
• Another choice would be to issue a bond
• A bond is just a piece of paper stating the terms on which the money
will be paid back
• For example, it may be a 10-year bond, paying interest at 7% in two
instalments per year
• The word ‘bond’ implies that the rate of interest is fixed
• If it’s floating, then we have to find another name, such as floating rate
note
• The bond may be bought by a bank as another use for depositors’
money, or it might be bought directly by an investor who sees the bond
notice in the paper and instructs his agent to buy
 RAISING CAPITAL…
C. Equity:
• A final choice would be to raise the money by selling shares in the
company
• Shares are called equity
• If it’s the first time the company has done this, we call it a ‘new issue’
• If the company already has shareholders, it may approach them with
the opportunity to buy more shares in the company, called a rights
issue
• The reward for the shareholders by way of income is the dividend
• However, the income is usually poorer than that paid on a bond, and
the shareholders look to capital gains as well, believing that the share
price will go up as time goes by

file:///F:/Introduction%20to%20Global%20Financial%20Markets.
pdf
 FACTORING / FORFAITING

• Factoring is a financial transaction and a type of debtor finance

in which a business sells its accounts receivable (i.e., invoices) to
a third party (called a factor) at a discount
• A business will sometimes factor its receivable assets to meet its
present and immediate cash needs
• Factoring is not the same as invoice discounting
• Factoring is the sale of receivables, whereas invoice discounting
is a borrowing that involves the use of the accounts receivable
assets as collateral for the loan
 FACTORING / FORFAITING…

• “Forfait” is derived from French word ‘A Forfait’ which means

surrender of rights
• Forfaiting is a mechanism by which the right for export
receivables of an exporter (Client) is purchased by a Financial
Intermediary (Forfaiter) without recourse to him
• It is different from International Factoring in as much as it deals
with receivables relating to deferred payment exports, while
Factoring deals with short term receivables
 FACTORING
vs
BILLS DISCOUNTING

BILL DISCOUNTING FACTORING

1. Bill is separately examined and 1. Pre-payment made against all
discounted unpaid and not due invoices
purchased by Factor
2. Financial Institution does not
2. Factor has responsibility of Sales
have responsibility of Sales Ledger Administration and
Ledger Administration and collection of Debts
collection of Debts 3. Notice of assignment is provided
3. No notice of assignment to customers of the Client.
provided to customers of the
Client
 FACTORING
vs
BILLS DISCOUNTING…

BILLS DISCOUNTING FACTORING

4. Bill discounting is usually done 4. Factoring can be done with or
with recourse without recourse to client. In
India, it is done with recourse
5. Financial Institution can get
the bills re-discounted before 5. Factor cannot re-discount the
they mature for payment receivable purchased under
advanced factoring
arrangement
 SECURITIZATION

• Securitization is the financial practice of pooling various types of

contractual debt such as residential mortgages, commercial
mortgages, auto loans or credit card debt obligations (or other
non-debt assets which generate receivables) and selling their
related cash flows to third party investors as securities, which
may be described as bonds, pass-through securities, or
collateralized debt obligations (CDOs)
• Investors are repaid from the principal and interest cash flows
collected from the underlying debt and redistributed through the
capital structure of the new financing. Securities backed by
mortgage receivables are called mortgage-backed securities
(MBS), while those backed by other types of receivables are
asset-backed securities (ABS)
PRODUCTS & SERVICES OFFERED BY BANKS
 PRODUCTS/SERVICES OFFERED BY BANKS

The different products in a bank can be broadly classified into:

• Corporate or Wholesale Banking

• Retail Banking
• Trade Finance
• Treasury/Investment Banking
• Retail Banking and Trade Finance operations are conducted at
the branch level while the wholesale banking operations, which
cover treasury operations, are at the Head Office or a designated
main branch
Retail Banking:

• Deposits
• Loans, Cash Credit and Overdraft
• Remittances
• Receiving all kinds of bonds for safe keeping

Trade Finance:

• Issuing and confirming letter of credit

• Issuing Bank Guarantees
• Drawing, accepting, discounting, buying, selling, collecting of bills of
exchange, promissory notes, drafts, bill of lading and other securities
Treasury Operations:

• Buying and selling foreign exchange

• Acquiring, holding, underwriting and dealing in shares, debentures, etc.
• Purchasing and selling of bonds and securities on behalf of
constituents
• The bank can also act as an agent of the Government or local
authority. They insure, guarantee, underwrite, participate in managing
and carrying out issue of shares, debentures, etc.
• Apart from the above-mentioned activities, the bank provides other
services like investment counseling for individuals, short-term funds
management and portfolio management for individuals and companies
 COMMON BANKING PRODUCTS

• Credit Card: Credit Card is ‘post paid’ or ‘pay later’ card that
draws from a credit line-money made available by the card issuer
(bank) and gives one a grace period to pay. If the amount is not
paid fully by the end of the period, the customer is charged
interest

• Debit Cards: Debit Card is a ‘prepaid’ or ‘pay now’ card with

some stored value. Debit Cards quickly debit or subtract money
from one’s savings account, or if one were taking out cash.
Every time a person uses the card, the merchant can get the
money transferred to his account from the bank of the buyers,
by debiting an exact amount of purchase from the card
Electronic Funds Transfer:
The system called electronic fund transfer (EFT) automatically
transfers money from one account to another. This system
facilitates speedier transfer of funds electronically from any branch
to any other branch. In this system the sender and the receiver of
funds may be located in different cities and may even bank with
different banks. Funds transfer within the same city is also
permitted

Telebanking:
Telebanking refers to banking on phone services. A customer can
access information about his/her account through a telephone call
and by giving the coded Personal Identification Number (PIN) to
the bank. Telebanking is extensively user friendly and effective in
nature
Mobile Banking:

• A new revolution in the realm of e-banking is the emergence of

mobile banking
• On-line banking is now moving to the mobile world, giving everybody
with a mobile phone access to real-time banking services, regardless of
their location
• It provides a new way to pick up information and interact with banks
to carry out the relevant banking business
• The potential of mobile banking is limitless and is expected to be a big
success
• Booking and paying for travel and even tickets is a growth area
GLOBAL FINANCIAL MARKET
 The Money Merry-go-round

• Financial markets are all about raising capital and matching those who
want capital (borrowers) with those who have it (lenders)
• How do borrowers find lenders? With difficulty, clearly, but for the
presence of intermediaries such as banks
• Banks take deposits from those who have money to save and bundle
the money up in various ways so that it can be lent to those who wish
to borrow
• More complex transactions than a simple bank deposit require markets
in which borrowers and their agents can meet lenders and their agents,
and existing commitments to borrow or lend can be resold to other
people
• Stock exchanges are a good example - Companies raise money by
selling shares to investors, and existing shares are freely bought and
sold.
• The money goes round and round, just like a carousel on a fairground
The Money Merry-go-round…
 MONEY MARKETS & CAPITAL MARKETS

Money Markets:

• The money market is the global financial market for short-term

borrowing and lending and provides short term liquid funding
for the global financial system
• The average amount of time that companies borrow money in a
money market is about thirteen months or lower
• Basically, what the money market consists of is banks that
borrow and lend to each other
MONEY MARKETS & CAPITAL MARKETS…
Major Players in the Money Market in India:

• RBI
• Central Government
• State Governments
• Banks
• Financial Institutions
• Micro Finance Institutions
• Foreign Institutional Investors (FII)
• Mutual Funds

Money Market Instruments

• Treasury Bills
• Commercial Papers
• Certificate of Deposit
• Bankers Acceptance
 MONEY MARKETS & CAPITAL MARKETS…

Capital Market:

Capital market can be primary market and secondary market . In

primary market new securities are issued where as in secondary
market already issue securities are traded

Capital Market Instruments:

1. Shares
2. Debentures
3. Bonds
 RAISING CAPITAL
Suppose a commercial company needs $200m to finance building a
new factory. What are the choices to do so?

A. Bank loans:
• One obvious source of money when we need it is the bank
• When large sums of money are required, it may be a syndicate
of banks in order to spread the risk
• The banks take deposits lent to them and relend the money to
the commercial company - it’s their classic role as an
intermediary
• In the international syndicated bank lending market, based in
London, the money will not be lent at a fixed rate, but at a
variable rate, which changes from time to time according to
market rate in Europe, plus a given margin, such as 0.75%. The
bank will readjust the rate, say, every 3 months. The rate is fixed
for 3 months but then changes for the next 3 months rates
• The banks may lend at a basic rate, such as the prime rate in the
US or the interbank
 RAISING CAPITAL…
B. Bonds:
• Another choice would be to issue a bond
• A bond is just a piece of paper stating the terms on which the money
will be paid back
• For example, it may be a 10-year bond, paying interest at 7% in two
instalments per year
• The word ‘bond’ implies that the rate of interest is fixed
• If it’s floating, then we have to find another name, such as floating rate
note
• The bond may be bought by a bank as another use for depositors’
money, or it might be bought directly by an investor who sees the bond
notice in the paper and instructs his agent to buy
 RAISING CAPITAL…
C. Equity:
• A final choice would be to raise the money by selling shares in the
company
• Shares are called equity
• If it’s the first time the company has done this, we call it a ‘new issue’
• If the company already has shareholders, it may approach them with
the opportunity to buy more shares in the company, called a rights
issue
• The reward for the shareholders by way of income is the dividend
• However, the income is usually poorer than that paid on a bond, and
the shareholders look to capital gains as well, believing that the share
price will go up as time goes by

file:///F:/Introduction%20to%20Global%20Financial%20Markets.
pdf
 FACTORING / FORFAITING

• Factoring is a financial transaction and a type of debtor finance

in which a business sells its accounts receivable (i.e., invoices) to
a third party (called a factor) at a discount
• A business will sometimes factor its receivable assets to meet its
present and immediate cash needs
• Factoring is not the same as invoice discounting
• Factoring is the sale of receivables, whereas invoice discounting
is a borrowing that involves the use of the accounts receivable
assets as collateral for the loan
 FACTORING / FORFAITING…

• “Forfait” is derived from French word ‘A Forfait’ which means

surrender of rights
• Forfaiting is a mechanism by which the right for export
receivables of an exporter (Client) is purchased by a Financial
Intermediary (Forfaiter) without recourse to him
• It is different from International Factoring in as much as it deals
with receivables relating to deferred payment exports, while
Factoring deals with short term receivables
 FACTORING
vs
BILLS DISCOUNTING

BILL DISCOUNTING FACTORING

1. Bill is separately examined and 1. Pre-payment made against all
discounted unpaid and not due invoices
purchased by Factor
2. Financial Institution does not
2. Factor has responsibility of Sales
have responsibility of Sales Ledger Administration and
Ledger Administration and collection of Debts
collection of Debts 3. Notice of assignment is provided
3. No notice of assignment to customers of the Client.
provided to customers of the
Client
 FACTORING
vs
BILLS DISCOUNTING…

BILLS DISCOUNTING FACTORING

4. Bill discounting is usually done 4. Factoring can be done with or
with recourse without recourse to client. In
India, it is done with recourse
5. Financial Institution can get
the bills re-discounted before 5. Factor cannot re-discount the
they mature for payment receivable purchased under
advanced factoring
arrangement
 SECURITIZATION

• Securitization is the financial practice of pooling various types of

contractual debt such as residential mortgages, commercial
mortgages, auto loans or credit card debt obligations (or other
non-debt assets which generate receivables) and selling their
related cash flows to third party investors as securities, which
may be described as bonds, pass-through securities, or
collateralized debt obligations (CDOs)
• Investors are repaid from the principal and interest cash flows
collected from the underlying debt and redistributed through the
capital structure of the new financing. Securities backed by
mortgage receivables are called mortgage-backed securities
(MBS), while those backed by other types of receivables are
asset-backed securities (ABS)
PRODUCTS & SERVICES OFFERED BY BANKS
 PRODUCTS/SERVICES OFFERED BY BANKS

The different products in a bank can be broadly classified into:

• Corporate or Wholesale Banking

• Retail Banking
• Trade Finance
• Treasury/Investment Banking
• Retail Banking and Trade Finance operations are conducted at
the branch level while the wholesale banking operations, which
cover treasury operations, are at the Head Office or a designated
main branch
Retail Banking:

• Deposits
• Loans, Cash Credit and Overdraft
• Remittances
• Receiving all kinds of bonds for safe keeping

Trade Finance:

• Issuing and confirming letter of credit

• Issuing Bank Guarantees
• Drawing, accepting, discounting, buying, selling, collecting of bills of
exchange, promissory notes, drafts, bill of lading and other securities
Treasury Operations:

• Buying and selling foreign exchange

• Acquiring, holding, underwriting and dealing in shares, debentures, etc.
• Purchasing and selling of bonds and securities on behalf of
constituents
• The bank can also act as an agent of the Government or local
authority. They insure, guarantee, underwrite, participate in managing
and carrying out issue of shares, debentures, etc.
• Apart from the above-mentioned activities, the bank provides other
services like investment counseling for individuals, short-term funds
management and portfolio management for individuals and companies
 COMMON BANKING PRODUCTS

• Credit Card: Credit Card is ‘post paid’ or ‘pay later’ card that
draws from a credit line-money made available by the card issuer
(bank) and gives one a grace period to pay. If the amount is not
paid fully by the end of the period, the customer is charged
interest

• Debit Cards: Debit Card is a ‘prepaid’ or ‘pay now’ card with

some stored value. Debit Cards quickly debit or subtract money
from one’s savings account, or if one were taking out cash.
Every time a person uses the card, the merchant can get the
money transferred to his account from the bank of the buyers,
by debiting an exact amount of purchase from the card
Electronic Funds Transfer:
The system called electronic fund transfer (EFT) automatically
transfers money from one account to another. This system
facilitates speedier transfer of funds electronically from any branch
to any other branch. In this system the sender and the receiver of
funds may be located in different cities and may even bank with
different banks. Funds transfer within the same city is also
permitted

Telebanking:
Telebanking refers to banking on phone services. A customer can
access information about his/her account through a telephone call
and by giving the coded Personal Identification Number (PIN) to
the bank. Telebanking is extensively user friendly and effective in
nature
Mobile Banking:

• A new revolution in the realm of e-banking is the emergence of

mobile banking
• On-line banking is now moving to the mobile world, giving everybody
with a mobile phone access to real-time banking services, regardless of
their location
• It provides a new way to pick up information and interact with banks
to carry out the relevant banking business
• The potential of mobile banking is limitless and is expected to be a big
success
• Booking and paying for travel and even tickets is a growth area
GLOBAL FINANCIAL MARKET
 The Money Merry-go-round

• Financial markets are all about raising capital and matching those who
want capital (borrowers) with those who have it (lenders)
• How do borrowers find lenders? With difficulty, clearly, but for the
presence of intermediaries such as banks
• Banks take deposits from those who have money to save and bundle
the money up in various ways so that it can be lent to those who wish
to borrow
• More complex transactions than a simple bank deposit require markets
in which borrowers and their agents can meet lenders and their agents,
and existing commitments to borrow or lend can be resold to other
people
• Stock exchanges are a good example - Companies raise money by
selling shares to investors, and existing shares are freely bought and
sold.
• The money goes round and round, just like a carousel on a fairground
The Money Merry-go-round…
 MONEY MARKETS & CAPITAL MARKETS

Money Markets:

• The money market is the global financial market for short-term

borrowing and lending and provides short term liquid funding
for the global financial system
• The average amount of time that companies borrow money in a
money market is about thirteen months or lower
• Basically, what the money market consists of is banks that
borrow and lend to each other
MONEY MARKETS & CAPITAL MARKETS…
Major Players in the Money Market in India:

• RBI
• Central Government
• State Governments
• Banks
• Financial Institutions
• Micro Finance Institutions
• Foreign Institutional Investors (FII)
• Mutual Funds

Money Market Instruments

• Treasury Bills
• Commercial Papers
• Certificate of Deposit
• Bankers Acceptance
 MONEY MARKETS & CAPITAL MARKETS…

Capital Market:

Capital market can be primary market and secondary market . In

primary market new securities are issued where as in secondary
market already issue securities are traded

Capital Market Instruments:

1. Shares
2. Debentures
3. Bonds
 RAISING CAPITAL
Suppose a commercial company needs $200m to finance building a
new factory. What are the choices to do so?

A. Bank loans:
• One obvious source of money when we need it is the bank
• When large sums of money are required, it may be a syndicate
of banks in order to spread the risk
• The banks take deposits lent to them and relend the money to
the commercial company - it’s their classic role as an
intermediary
• In the international syndicated bank lending market, based in
London, the money will not be lent at a fixed rate, but at a
variable rate, which changes from time to time according to
market rate in Europe, plus a given margin, such as 0.75%. The
bank will readjust the rate, say, every 3 months. The rate is fixed
for 3 months but then changes for the next 3 months rates
• The banks may lend at a basic rate, such as the prime rate in the
US or the interbank
 RAISING CAPITAL…
B. Bonds:
• Another choice would be to issue a bond
• A bond is just a piece of paper stating the terms on which the money
will be paid back
• For example, it may be a 10-year bond, paying interest at 7% in two
instalments per year
• The word ‘bond’ implies that the rate of interest is fixed
• If it’s floating, then we have to find another name, such as floating rate
note
• The bond may be bought by a bank as another use for depositors’
money, or it might be bought directly by an investor who sees the bond
notice in the paper and instructs his agent to buy
 RAISING CAPITAL…
C. Equity:
• A final choice would be to raise the money by selling shares in the
company
• Shares are called equity
• If it’s the first time the company has done this, we call it a ‘new issue’
• If the company already has shareholders, it may approach them with
the opportunity to buy more shares in the company, called a rights
issue
• The reward for the shareholders by way of income is the dividend
• However, the income is usually poorer than that paid on a bond, and
the shareholders look to capital gains as well, believing that the share
price will go up as time goes by

file:///F:/Introduction%20to%20Global%20Financial%20Markets.
pdf
 FACTORING / FORFAITING

• Factoring is a financial transaction and a type of debtor finance

in which a business sells its accounts receivable (i.e., invoices) to
a third party (called a factor) at a discount
• A business will sometimes factor its receivable assets to meet its
present and immediate cash needs
• Factoring is not the same as invoice discounting
• Factoring is the sale of receivables, whereas invoice discounting
is a borrowing that involves the use of the accounts receivable
assets as collateral for the loan
 FACTORING / FORFAITING…

• “Forfait” is derived from French word ‘A Forfait’ which means

surrender of rights
• Forfaiting is a mechanism by which the right for export
receivables of an exporter (Client) is purchased by a Financial
Intermediary (Forfaiter) without recourse to him
• It is different from International Factoring in as much as it deals
with receivables relating to deferred payment exports, while
Factoring deals with short term receivables
 FACTORING
vs
BILLS DISCOUNTING

BILL DISCOUNTING FACTORING

1. Bill is separately examined and 1. Pre-payment made against all
discounted unpaid and not due invoices
purchased by Factor
2. Financial Institution does not
2. Factor has responsibility of Sales
have responsibility of Sales Ledger Administration and
Ledger Administration and collection of Debts
collection of Debts 3. Notice of assignment is provided
3. No notice of assignment to customers of the Client.
provided to customers of the
Client
 FACTORING
vs
BILLS DISCOUNTING…

BILLS DISCOUNTING FACTORING

4. Bill discounting is usually done 4. Factoring can be done with or
with recourse without recourse to client. In
India, it is done with recourse
5. Financial Institution can get
the bills re-discounted before 5. Factor cannot re-discount the
they mature for payment receivable purchased under
advanced factoring
arrangement
 SECURITIZATION

• Securitization is the financial practice of pooling various types of

contractual debt such as residential mortgages, commercial
mortgages, auto loans or credit card debt obligations (or other
non-debt assets which generate receivables) and selling their
related cash flows to third party investors as securities, which
may be described as bonds, pass-through securities, or
collateralized debt obligations (CDOs)
• Investors are repaid from the principal and interest cash flows
collected from the underlying debt and redistributed through the
capital structure of the new financing. Securities backed by
mortgage receivables are called mortgage-backed securities
(MBS), while those backed by other types of receivables are
asset-backed securities (ABS)
PRODUCTS & SERVICES OFFERED BY BANKS
 PRODUCTS/SERVICES OFFERED BY BANKS

The different products in a bank can be broadly classified into:

• Corporate or Wholesale Banking

• Retail Banking
• Trade Finance
• Treasury/Investment Banking
• Retail Banking and Trade Finance operations are conducted at
the branch level while the wholesale banking operations, which
cover treasury operations, are at the Head Office or a designated
main branch
Retail Banking:

• Deposits
• Loans, Cash Credit and Overdraft
• Remittances
• Receiving all kinds of bonds for safe keeping

Trade Finance:

• Issuing and confirming letter of credit

• Issuing Bank Guarantees
• Drawing, accepting, discounting, buying, selling, collecting of bills of
exchange, promissory notes, drafts, bill of lading and other securities
Treasury Operations:

• Buying and selling foreign exchange

• Acquiring, holding, underwriting and dealing in shares, debentures, etc.
• Purchasing and selling of bonds and securities on behalf of
constituents
• The bank can also act as an agent of the Government or local
authority. They insure, guarantee, underwrite, participate in managing
and carrying out issue of shares, debentures, etc.
• Apart from the above-mentioned activities, the bank provides other
services like investment counseling for individuals, short-term funds
management and portfolio management for individuals and companies
 COMMON BANKING PRODUCTS

• Credit Card: Credit Card is ‘post paid’ or ‘pay later’ card that
draws from a credit line-money made available by the card issuer
(bank) and gives one a grace period to pay. If the amount is not
paid fully by the end of the period, the customer is charged
interest

• Debit Cards: Debit Card is a ‘prepaid’ or ‘pay now’ card with

some stored value. Debit Cards quickly debit or subtract money
from one’s savings account, or if one were taking out cash.
Every time a person uses the card, the merchant can get the
money transferred to his account from the bank of the buyers,
by debiting an exact amount of purchase from the card
Electronic Funds Transfer:
The system called electronic fund transfer (EFT) automatically
transfers money from one account to another. This system
facilitates speedier transfer of funds electronically from any branch
to any other branch. In this system the sender and the receiver of
funds may be located in different cities and may even bank with
different banks. Funds transfer within the same city is also
permitted

Telebanking:
Telebanking refers to banking on phone services. A customer can
access information about his/her account through a telephone call
and by giving the coded Personal Identification Number (PIN) to
the bank. Telebanking is extensively user friendly and effective in
nature
Mobile Banking:

• A new revolution in the realm of e-banking is the emergence of

mobile banking
• On-line banking is now moving to the mobile world, giving everybody
with a mobile phone access to real-time banking services, regardless of
their location
• It provides a new way to pick up information and interact with banks
to carry out the relevant banking business
• The potential of mobile banking is limitless and is expected to be a big
success
• Booking and paying for travel and even tickets is a growth area
INSOLVENCY AND BANKRUPTCY CODE 2016
Definition of Insolvency & Bankruptcy

• Insolvency is a situation where an entity cannot raise enough

cash to meet its obligations or to pay debts as they become due
to payment
• Bankruptcy is when a person voluntarily declares him as an
insolvent and goes to the Court
• On declaring the person as “Bankrupt”, the Court is responsible
to liquidate the personal property of the insolvent and distribute
it among the creditors of the insolvent
Background - IB Code 2016

• Insolvency and Bankruptcy Process done through Judicial Courts

– Civil Courts, High Courts, Supreme Court
– Lack of timely information of debtors
– Time delay
• Prolonged Process
• Courts are already loaded with multiple cases
• Need for a special authority to deal with these cases
Applicable Laws

• For individual cases:

- Presidency Towns Insolvency Act 1909
- Provincial Insolvency Act 1920
• For Corporates:
- Sick Industrial Companies (Special Provisions) Act 1985
- Recovery of Debt Due to Banks and Financial Institutions
Act, 1993
- Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest Act 2002 (SARFAESI)
- BIFR and Debt Recovery Tribunals
Scenario as at 2016-17

CASES PENDING FOR NO. OF CASES (INR lakhs)

Over 10 years 6.81

Between 5 to 10 years 11.89

Between 2 to 5 years 22.42

Less than 2 years 34.37

TOTAL PENDING CASES 75.50

Time taken for Settlement of Cases globally

COUNTRY TIME TAKEN FOR

DECIDING INSOLVENCY
PETITION

SINGAPORE 8 MONTHS

MALAYSIA / U.K. 1 YEAR

UNITED STATES 1.5 YEARS

INDIA 4.3 TO 6 YEARS

India ranks 130th in WORLD BANK’S Ease of doing

Business out of 189 countries
Objectives of new code

• To facilitate time bound Insolvency Resolution Process and Liquidation

• To improve ease of doing business in and also set up a better and faster debt recovery
mechanism in India
Coverage
• Individuals
• Partnership Firms
• Corporates
• Limited Liability Partnerships

Not applicable to:

- NBFCs
- Investment Companies
 WHO CAN INVOKE
Financial Creditor (Sec.7)
- Any person to whom a financial debt is owed &
- Includes a person to whom such debt legally assigned or transferred

Operational Creditor (Sec.9)

- A person to whom an operational debt is owed &
- Includes any person to whom such debt legally assigned or transferred

Corporate Debtor (Sec.10)

- A corporate person who owes a debt to any person

• NCLT
- Deal with insolvency matters of Co. & LLP
- Appeal to NCLAT
• Debt Recovery Tribunal
- Deal with insolvency matters of individual & Partnership firm
- Appeal as to DRAT

Adjudicating Authority within 14 days of receipt of application, by an order -

Admit the application Reject the application

If it is
If it is complete incomplete Default Default not
occurred occurred

Adjudicating Authority shall before rejecting application, give notice to

applicant to rectify defects in application within 7 days from the date of
receipt of such notice
 DEFAULT

In case of Co. & LLP In case of Partnership & Individual

Minimum amount of ` 1 lakh Minimum amount of ` 1 thousand

Minimum amount of ` 1 lakh & ` 1 thousand can be increased upto ` 1 Cr & ` 1

lakh respectively by CG

Where any Company or LLP commits-

A default in paying its

Financial debt Operational debt

Then a financial creditor/ operational creditor/ Company & LLP itself

May file an application, for initiating corporate insolvency resolution process with
the Adjudicating Authority.
 180 days 90 days 270 days
(Maximum)

FAST TRACK :

45 days 135 days

90 days (One time)

Adjudicating Authority after admission of application shall, by an order

Declare a Cause a Public Appoint Interim

Moratorium Announcement Resolution Professional
 No. of cases resolved so far @ May 2020
• A total of 3,774 cases or corporate insolvency resolution
processes (CIRPs) have been filed since the Insolvency and
Bankruptcy Code (IBC) came into force on December 1, 2016
• Of these, about 43 percent have closed, by way of resolution,
liquidation or other means, total lying 1,604 cases. The
remaining 57 percent or 2,170 cases are still ongoing, many of
which have exceeded the 330-day maximum time limit set
under the bankruptcy laws
• Of the 1,604 closed cases, only 14 percent have found a
resolution, whereas 57 percent have ended in the liquidation of
the companies
• In total, 312 cases have been closed on appeal or review or
settled; 157 have been withdrawn; 914 have ended in orders for
liquidation and most importantly- 221 have ended in approval
of resolution plans

https://www.cnbctv18.com/legal/6-of-total-and-14-of-closed-cases-find-
resolution-under-ibc-so-far-5964301.htm
Cases under IBC
 Challenges
• The NCLT infrastructure is proving inadequate for the
quantum of cases flooding the system
• The lack of established legal precedents, which will only build
up over time, also makes litigation under the IBC framework
elaborate and time-consuming
• The net result is that resolution, especially in marquee cases
involving large amounts of bad debt, is often taking far longer
than the envisaged timeline of 180-270 days
• “The NCLT courts are starting to resemble metropolitan
magistrate’s courts with little infrastructure and makes us
wonder if the government is serious about recovery of debt,”
says Supreme Court senior advocate MV Kini

https://ibbi.gov.in/webadmin/pdf/whatsnew/2019/Jun/190609_Under
standingtheIBC_Final_2019-06-09%2018:20:22.pdf
BANKING
RISKS

1
2
WHAT IS RISK?...

1
3
CAMELS RATING SYSTEM

1
3
PURPOSE
Background:

• CAMELS is a rating system developed in the US that is used by supervisory authorities to

rate banks and other financial institutions
• It applies to every bank in the U.S and is also used by various financial institutions outside
the U.S. This rating system was adopted by National Credit Union Administration in 1987
• In 1988, the Basel Committee on Banking Supervision of the Bank of International
Settlements (BIS) proposed the CAMELS framework for assessing financial institutions

Purpose:

To determine a bank’s overall condition and to identify its strengths and weaknesses:
• Financial
• Operational
• Managerial

1
3
RATING PROVISIONS

Each element is assigned a numerical rating based on five key

components:
• Strong performance, sound management, no cause for supervisory
concern
• Fundamentally sound, compliance with regulations, stable, limited
supervisory needs
• Weaknesses in one or more components, unsatisfactory practices,
weak performance but limited concern for failure
• Serious financial and managerial deficiencies and unsound practices.
Need close supervision and remedial action
• Extremely unsafe practices and conditions, deficiencies beyond
management control. Failure is highly probable and outside financial
assistance needed

1
3
SCORING
• Bank supervisory authorities assign each bank a score on a scale of 1
(best) to 5 (worst) for each factor
• If a bank has an average score less than 2, it is considered to be a
high-quality institution while banks with scores greater than 3 are
considered to be less than satisfactory establishments
• The system helps the supervisory authority identify banks that are in
need of attention

1
3
CONSIDERATIONS FOR
CAPITAL RATING
• Nature and volume of assets in relation to total capital and adequacy
of other reserves
• Balance sheet structure including off balance sheet items, market and
concentration risk
• Nature of business activities and risks to the bank
• Asset and capital growth experience and prospects
• Earnings performance and distribution of dividends
• Capital requirements and compliance with regulatory requirements
• Access to capital markets and sources of capital

1
3
 ASSET
QUALITY

• One of the indicators for asset quality is the ratio of non- performing loans to
total loans (GNPA)
• The gross non-performing loans to gross advances ratio is more indicative of the quality
of credit decisions made by bankers. Higher GNPA is indicative of poor credit decision-
making
• Asset represents all the assets of the bank, current and fixed, loan portfolio, investments
and real estate owned as well as off balance sheet transactions

1
3
RATING
FACTORS
Asset Quality is based on the following considerations:

• Volume of problem of allassets

• Volume of overdue or rescheduled loans
• Ability of management to administer all the assets of the bank
and to collect problem loans
• Large concentrations of loans and insiders loans, diversification of
investments
• Loan portfolio management, written policies, procedures,
internal control, Management Information System
• Loan Loss Reserves in relation to problem credits and other assets
• Growth of loans volume in relation to the bank’s capacity

1
3
TYPES OF
CAPITAL

13
 TYPES OF CAPITAL
• Economic Capital (EC) or Risk Capital
An estimate of the level of capital that a firm requires to
operate its business

• Regulatory Capital (RC)

The capital that a bank is required to hold by regulators in
order to operate

• Bank Capital (BC)

The actual physical capital held
13
 ECONOMIC CAPITAL
• Economic capital is the amount of capital that a firm, usually in
financial services, needs to ensure that the company stays solvent
• Economic capital is calculated internally and is the amount of
capital the firm should have to support any risks it takes on
• Financial strength is represented by the probability of the firm
not becoming insolvent over the measurement period and is the
confidence level in the statistical calculation
• Most banks will use a confidence measurement of between
99.96% and 99.98%, which is the insolvency rate expected for an
institution with a AA or Aa credit rating

14
 ECONOMIC CAPITAL…
• The firm's expected loss is the anticipated average loss over the
measurement period
• Expected losses represent the cost of doing business and are
usually absorbed by operating profits
• The relationship between frequency of loss, amount of loss,
expected loss, financial strength and economic capital can be seen
in the graph on the next slide

14
ECONOMIC CAPITAL…

14
CAPITAL ADEQUACY MANAGEMENT

15
 CAPITAL ADEQUACY
MANAGEMENT
1. Bank capital is a cushion that prevents bank failure. For example, consider these
two banks:
 CAPITAL ADEQUACY
MANAGEMENT…
What happens if these banks make loans or invest in securities (say, subprime mortgage
loans, for example) that end up losing money?
Let’s assume both banks lose $5 million from bad loans
 CAPITAL ADEQUACY MANAGEMENT…

• Impact of $5 million loan loss

Conclusion: A bank maintains reserves to lessen the

chance that it will become insolvent
 RISK-WEIGHTED
ASSETS
• Risk Weighted Assets (RWA) refer to the fund based assets such as Cash,
Loans, Investments and other assets
• They are the total assets owned by the Banks
• However, the value of each asset is assigned a risk weight (for example 100%
for corporate loans and 50% for mortgage loans) and the credit equivalent
amount of all off-balance sheet activities
• Each credit equivalent amount is also assigned a risk weight
 RISK-WEIGHTED
ASSETS…
Degree of risk expressed %weights assigned by the Reserve Bank
of India in an increasing order
Asset Weighted Risk
Cash 0%
Balancewith ReserveBankofIndia 0%

Central/ state GovernmentGuaranteed advances 0%

SSIadvancesup to CGFguarantee 0%

Loansagainst FD(Fixed Deposits),LIC Policy 0%

GovernmentapprovedSecurities 2.50%

Balancewith Banksotherthan RBIwhichmaintainthe9%CRAR 20%

Secured Loan to the Staff Members 20%

Housing Loans<="" td=""> 50%

Housing Loans>Rs. 30Lakhs 75%

Loansagainst Gold and Jewellery<=""td=""> 50%

Retail Lendingup to Rs.5crore 75%

LoansGuaranteedby DGCGC / ECGC 50%

Loansto PublicSectorUndertakings 100%

ForeignExchangeand Gold in Open Position 100%

Claims on unratedcorporates 100%

Commercial Realestate 100%

ConsumerCredit 125%
Credit Cards 125%
Exposure to CapitalMarkets 125%

VentureCapitalInvestmentasapart of CapitalMarketexposure 150%

 RISK-WEIGHTED
ASSETS…
How does this work?
Let’s take the example of a AAA client, the risk weight is 20%, which means
banks have to set aside its own capital of 1.80 for every Rs.100 loan (this
means 20% of 9% of 100)
Similarly, in case of 100% risk weight (such as capital markets exposures),
banks have to keep aside its own capital of Rs.9 on the loan

Calculation of the Ratio

Under Basel-III, banks are to compute ratio as follows:
Common Equity Tier-I Capital Ratio = Common Equity Tier-I Capital /
RWAfor (Credit risk + Market risk + Operationalrisk)
 RISK ADJUSTED RETURN ON CAPITAL

The formula for RAROC is:

 RISK ADJUSTED RETURN ON CAPITAL
Detailed formula:
 RISK ADJUSTED RETURN ON
CAPITAL…
• Risk adjusted return on capital is based on the idea of balancing fee income
and expected interest minus cost of capital and divide by the loan's
expected risk
• Banks, like any other business, seek to generate a superior risk adjusted
return to their WACC (weighted average cost of capital)
• Generally, the cost of capital is around 10% and profit targets between 10%
and 15%
INTERNAL CAPITAL ADEQUACY ASSESSMENT
PROCESS (ICAAP)

&

STRESS TESTING

25
 WHAT IS
ICAAP?
ICAAP is a bank’s internal process for assessing its overall capital
adequacy in relation to its risk profile and strategy for
maintaining their capital levels

• ICAAP should be proportional to the size and complexity of the

bank – risk and capital management must match risk taking
• ICAAP must be bank-specific and bank-driven – not something
that can be bought off-the-shelf, not something that should be
designed for compliance purposes
• Large capital buffers is not an excuse for not having a good
ICAAP
 OBJECTIVES OF ICAAP &
STRESS TEST
Ensure banks have adequate capital to support all risks

• Risks covered under Pillar 1 – Banks should not rely on Pillar 1

numbers without determining whether the numbers are
appropriate
• Risks not covered under Pillar 1 – e.g., interest rate risk in the
banking book (IRRBB), credit concentration risk, business and
strategic risk, reputational risk, liquidity risk, residual risk
• Factors external to the bank – e.g. economic cycle effects
 OBJECTIVES OF ICAAP &
STRESS TEST…
Ensure banks have adequate capital to withstand stress
• Stress over a range of scenarios, under capital planning

Encourage banks to develop and use better risk management

techniques
• Use of economic capital (EC)* approaches has been spurred
on, in part, by Pillar 2
• EC is one way of assessing/ measuring capitalneeds

• Economic capital can be determined as the cushion required to keep

the bank solvent over a specified time horizon with the defined
confidence level (CL)
 WHY PILLAR 2?

1. Measurement and Management of Bank specific risks other than

regulatory defined

2. Pillar 2 establishes a process of prudential supervision that

complements and strengthens Pillar 1

3. Pillar II includes quantifiable (interest rate risk in the non-trading

book, concentration risk and the residual risk that remains when
collateral is lower than expected), but also risks that require a more
qualitative approach (such as reputational and strategic risk). (ICAAP)

4. ICAAP links together the Bank’s strategy, future business

development, the risks related to these and the capital adequacy

29-Aug-20
OVERVIEW OF PILLAR II
ICAAP & SREP
 ICAAP
PROCESS
ICAAP PROCESS – RISK
ASSESSMENT
ICAAP PROCESS – PROJECTIONS INCLUDING
STRESS TEST
SUPERVISORY REVIEW OF ICAAP & CAPITAL
ADEQUACY
Review and evaluate a bank’s internal capital adequacy assessment and strategies
• Critically evaluate and challenge the bank’s approaches to ensure that a sound bank-
wide risk management framework is in place to define its risk appetite and recognise
all material risks
• Evaluate the sufficiency of bank’s internal assessment of capital adequacy and to
intervene, where appropriate
• Review methodologies and critical assumptions – small errors in
methodology or assumptions can lead to significant reductions
in capital requirements
 SUPERVISORY REVIEW OF ICAAP & CAPITAL
ADEQUACY…
• Some risk areas will involve quantitative techniques. Results from the models can
provide an indication of what a reasonable amount of capital should be
• Other areas may be more qualitative in approach, with a more
subjective link between risk and capital
• Comprehensively assess that rigorous and forward-looking stress tests are conducted
and are part of ICAAP
The Process of ICAAP of a bank can be
illustrated through the following diagram
STRESS TESTING

40
 STRESS
TESTING
What is Stress Testing?

• “What if ” scenarios that assist an institution in understanding the

potential impact from unplanned events
• Can include threats such as increased credit losses, declines in collateral
values, illiquid markets and strains on liquidity
• The goal of stress testing is to identify a bank’s potential exposure from
possible events that affect capital, earnings or liquidity and estimate the
likely impact of risk scenarios on:
- Capital
- Concentrated loan portfolios
- Liquidity
- Earnings
 STRESS
•
TESTING…
By requiring banks to run simulations of various
macroeconomic scenarios, regulators gain transparency into
how banks determine their capital levels and if they are
sufficiently capitalized to survive widespread, severely adverse
economic scenarios
• Regulators have shifted their focus from simply understanding
the effects of stress scenarios on credit performance and revenue
to making stress testing an integral part of a bank’s capital plan
• Post 2007-08 financial crisis, regulators have also made it
mandatory for banks to carry out forward-looking stress tests
 WHY STRESS
TEST?
• Regulatory Requirements:

• Basel II mandates stress-testing around low-probability events

to validate capital estimates
• Regulators want similar assurances that portfolios can
withstand
• extended economic downturns
• It became more important after the financial crisis of 2008

• Better Portfolio Management:

• Stresses will occur. Planning for them is profitable

 WHY STRESS
TEST?
• Regulatory Requirements:

• Basel II mandates stress-testing around low-probability events

to validate capital estimates
• Regulators want similar assurances that portfolios can
withstand
• extended economic downturns
• It became more important after the financial crisis of 2008

• Better Portfolio Management:

• Stresses will occur. Planning for them is profitable.

 STRESS TEST IS NOT A NEW
CONCEPT
• Stress Testing is not unique to financial industry
• Auto industry and its regulatory agency crash automobiles to test safety
measures as part of standard operation process (SOP)
 KEY TO STRESS
TESTING
• The key to Stress Testing is designing stress scenarios which are extreme
yet plausible
• Stress-testing should be about identifying risks that have yet to occur as
opposed to using historical models and assuming that history repeats
itself
• And those scenarios usually required approval from senior management
• Sometimes it requires the approval of regulators as well
• If it is too lenient, regulators may not like it
• If it is too tough, senior management or the board of directorsmay not
like it because that may require holding additional capital
 EXAM
PLE
1960’s anti-nuclear activists in Japan hypothesized a scenario:
• A huge earthquake hit Japan, causes
• Huge tsunami, which hit the nuclear plant by the shore and causes
• Nuclear catastrophe!
 EXAMPLE
(contd)
• They recommended that the government built robots which can be used
during nuclear catastrophe
• But the Japanese government turned down the idea arguing that the
action would dim the public confidence in nuclear power
• Then we all know what happened in 2011
• And the highly impossible yet plausible hypothetical scenario became
historical scenario
 Stress Testing
Parameters
• The basic step in stress testing is in identifying the main risk factors to be
tested
• The bank must list these factors in the light of the risks of each portfolio
and analyse these factors and specify the correlation with them
• The common risk factors related to the banking business include the
following:
- Country Risk
- Risk concentration, namely, concentration in the form of exposures
towards individuals, or particular industry, concentration in particular
sectors of the market, or concentration in countries or regions
- Interest Rate risks
- Market Risks
- Operational Risks
- Risks of extraordinary market movements
- Overall economic factors
 Stress Testing
Parameters…
• Stress testing scenarios must cover various levels of the adverse effects, namely,

- mild level
- medium level
- severe level

• Examples of Stress Testing Scenarios Related to other risks

- Decrease in the Net Income from Interests and profit margins

- Increase in NPAs
- Adverse changes in the major exchange rates
- Incremental MTM losses
- Decrease in the market value of the financial instruments, collateral
- Business Breakdown or system failure
 Scena
rios
• Assume existing CAR is 14.5%

Mild Medium Severe

Decline in 5% 10% 15%

earnings

Decline in 5% 9% 20%
Collateral
Value
Increase in
NPAs/Prov 5% 8% 12%
isions
Decline in
value of 5% 10% 15%
Investmen
 Impact on Capital
Adequacy Ratio
• Assume existing CAR is 14.5%

Mild Medium Severe

CAR 13% 11.5% 8.5%

Expected action by bank:
- Reduce exposure to more risky assets
- Seek additional collateral
- Review Investment portfolio
- Increase capital (last option)
 VIDEOS / LINKS
https://www.wsj.com/video/stress-test-what-is-bank-capital/2982540B-
906F-4603-9E0F-E3DA963B4915.html

https://analystprep.com/study-notes/frm/part-1/stress-testing-
and- other-risk-management-tools/

RBI guidelines:
https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=3605&Mod
e=0

Basel Guidelines on Stress Testing Principles:

https://www.bis.org/bcbs/publ/d450.pdf

Dodd-Frank Act Stress Test 2019: Supervisory Stress Test Results

file:///E:/Dodd%20Frank%20Stress%20Test%20results%202019.p
df
BASEL ACCORDS
– I, II & III

18
2
 The Basel
Committee
• Committee of Banking Supervisory authorities established by
Central Bank governors in 1975 *
• Consists of senior representatives of bank supervisory authorities
and central banks from various countries*
• Meets at the Bank for International Settlements in Basel
• Evolved the Capital Accord (Basel I) in 1988
• Revised the earlier accord and released the New Capital Accord
(Basel II) in 2004

* Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,

Netherlands, Spain, Sweden, Switzerland, UK and the US

18
3
 BASE
L I by BCBS in 1988 , known as the
• First set of capital requirements
1988 Basel Accord or Basel I, focused on credit risk and risk-
weighting of assets
• Assets of Banks , including off-balance sheet items, grouped in
five categories as per credit risk, carrying risk weights of 0% (
cash, home country debt etc. ), 20% securitisations such
as mortgage-backed securities with the highest AAA rating , 50%
(municipal revenue bonds, residential mortgages), 100% (
corporate and retail debt) and some with no rating
• Banks to hold capital equal to 8% of risk-weighted assets (RWA)
• India began implementing Basel Accord from April 1994
Genesis of
Basel I
Accord

18
5
Basel I Capital
calculations
Basel I Principles
• Strengthen the stability of the international banking system
• Create minimum risk-based capital adequacy requirements

Basel I Benefits:
• Relatively simple framework
• Widely adopted
• Increased banks’ capital

18
6
Capital Calculation

18
7
RIWAC Calculation

18
8
RIWAC Weightings

18
9
 Basel I Regulatory Capital
Rules
Types of capital Basel I capital calculation

• Stock issues
• Disclosed reserves
Core
Capit – Loan loss reserves to cushion future
al losses or for smoothing out income Capital (Tiers 1, 2, 3)
(Tier volatility
Risk-Weighted Assets and
≥ 8%
1)
• 50% of total capital Contingents
• Perpetual securities
• Unrealised gains on investment
Supplementa securities
ry
Capital • Hybrid capital instruments
(Tier 2) • Long-term subordinated debt with
maturity > 5 years

• Short-term subordinated debt

Market
risk
Capital
(Tier 3)

19
0
 BASEL I- RIWAC
Examples
Corporate
XYZ Bank Lends USD 100 M to UAE Corporate for 1 year
Capital = USD 100 M X 100% (Risk Weight) X 8% (Capital Adequacy) = USD
8M

Banks
XYZ Bank Lends USD 100 M to Barclays Bank for 2 years
Capital = USD 100 M X 20% (Risk Weight) X 8% (Capital Adequacy) = USD
1.6 M

Contingents
XYZ confirms Sight L/C of USD 100 M issued by ABN AMRO
Capital = USD 100 M X 20% (Risk Weight) X 20% (CCF) X 8%(Capital
Adequacy) = USD 0.32 M

19
1
Basel I Regulatory Capital rules – Credit Risk
On-Balance Sheet risk weights and Basel I capital calculation
Risk weight (%) On-balance sheet asset category
C a s h & gold
0
Obl igat ions on OECD and PAK treasuries Step 1: RWA = On BS exposure X Risk Weight
C l a i m s on OECD banks
20  Govt. agency securities Step 2: Capital = 8% X RWA
C l a i m s on municipalities
50 Resi dential mortgages
Corporat e bonds, equity, real-estate
100 Less-developed countries’ debt
C l a i m s on non-OECD banks

Off-balance sheet risk weights and Basel I capital calculation for non-trading assets
Credit
Conversion Off-balance sheet non-trading assets
Risk weight (%) Off-balance sheet asset category Factor (%)
U n d r a w n commitments – Maturity ≤
0 O E C D governments 0
1 year
O E C D banks and public sector Documentary credits related to
20 20
entities shipment of goods
Corporates and other Transaction-related contingencies –
50 counterparties
warranties, performance bonds
50 U n d r a w n commitments – Maturity >
1 year
G e n e r a l guarantees, standby letters
100
of
credit, banker’s acceptance, etc
Step 1: Credit Equivalent Amount (CEA) = Notional amount X Credit Conversion Factor
Step 2: RWA = CEA X Risk Weight
Step 3: Capital = 8% X RWA 64
 BASEL I- Drawbacks
• Criticisms of Basel IAccord • Consequences in the
industry
• Lack of risk sensitivity of capital
requirements
• Sub-optimal lending behavior

• One-size-fits-all’ approach to risk

• management • Increased divergence between
regulatory capital and
• Limited attention to credit risk
economic capital
• mitigation

• Over emphasis on minimum capital

• Regulatory capital arbitrage
• requirements
• through product
innovation
• Exclusive focus on financial risk

65
Basel II
of
Base
l II

19
5
Basel I vs.
Basel II

19
6
 Basel II approaches to Credit
Risk
Evolutionary approaches to measuring Credit Risk under Basel II

Internal Ratings Based (IRB) Approaches

Standardised Approach Foundation Advanced
• RWA based on externally • RWA based on internal models • RWA based on internal models
provided: for: for
– Probability of Default (PD) – Probability of Default (PD) – Probability of Default (PD)
– Exposure At Default (EAD) • RWA based on externally – Exposure At Default (EAD)
– Loss Given Default (LGD) provided: – Loss Given Default (LGD)
– Exposure At Default (EAD)
– Loss Given Default (LGD)
• Limited recognition of credit • Limited recognition of credit • Internal estimation of
risk mitigation & supervisory risk mitigation & supervisory parameters for credit risk
treatment of collateral and treatment of collateral and mitigation – guarantees,
guarantees guarantees collateral, credit derivatives

Increasing complexity and data requirement

Decreasing regulatory capital requirement

Basel II provides a ‘tailored’ or ‘evolutionary’ approach to banks that are sensitive to their credit
risk profiles
19
7
 Credit Risk - IRB Approach

Data Input Foundation IRB Advanced IRB

Probability of default From banks From banks

(PD)

Loss given default From banks

Set by the Committee
(LGD)

Exposure at default From banks

Set by the Committee
(EAD)

Maturity (M) Set by the Committee or From banks

from banks
Risk components in
Credit Risk

71
 Risk Weight for Assets
Claims on sovereigns Claims on banks and securities firms

Credit Credit assessment of Banks Claims on

Assessment Credit corporates
ECArisk Risk
assessment of
scores Weight Risk weight
Sovereign
Risk weight
for short-
term

AAA toAA- 1 0% 20% 20% 20% 20%

A+ to A- 2 20% 50% 50% 20% 50%

BBB+ to BBB- 3 50% 100% 50% 20% 100%

BB+ to BB- 4~6 100% 100% 100% 50% 100%

B+ to B- 4~6 100% 100% 100% 50% 150%

Below B- 7 150% 150% 150% 150% 150%

Unrated - 100% 100% 50% 20% 100%

2
0
1 Extent of saving on Capital that a bank would get if its assets
were rated

If a bank has high-quality assets (for example, if the majority of its assets
is in the 'AAA' and 'AA' categories) it will save capital because of low
credit risk; the difference is apparent in the illustration below:
 Types of
financial
risk
Equity Risk Trading Risk
Market Risk
Interest Rate Risk
Gap Risk
Currency Risk

Commodity Risk

Transaction Risk Counterparty Risk

Credit Risk
Financial Portfolio Issuer Risk
Concentration Risk
Risks Liquidity Risk

Operational Risk

Regulatory Risk

Human Factor
Risk
20
2
Market Risk
under Basel II
• Market risk is defined as the risk of losses arising from movements in
market prices
• The risks subject to market risk capital charges include but are not
limited to:
• (a) Default risk, interest rate risk, credit spread risk, equity risk, foreign
exchange risk and commodities risk for trading book instruments; and
• (b) Foreign exchange risk and commodities risk for banking book
instruments
• In determining its market risk for regulatory capital requirements, a
bank may choose between two broad methodologies: the standardized
approach and internal models approach for market risk

20
3
Revised minimum capital
requirements for market risk
• The revised framework for market risk capital requirements is known as
the Fundamental Review of the Trading Book (FRTB)
• The new market risk framework set out in the final rules maintains the
relationship between the regulatory trading books and instruments
“held for trading” by the bank
• However, the rules have been formulated to address the gap in the
trading book and banking book boundary which was not addressed in
the previous framework
• This gap was used to exploit the regulatory arbitrage opportunities
between these two regulatory books of the bank

20
4
Revised minimum capital
requirements for market risk…
Key points covered in the regulation are:

Covered Instruments:
• The rules clearly specify the instruments included as part of the trading
book within the new framework
• Any instrument held for short-term resales, profiting from price
movements, arbitrage opportunity or that hedges the risks from these
strategies, is considered to be a part of the trading book

Trading Desk:
Trading desks have been defined as a group of traders or accounts which
implement a trading/business strategy for that particular group and that
have a dedicated risk management function for monitoring risk within the
desk

20
5
Revised minimum capital
requirements for market risk…
Moving Instruments between Regulatory Books:
• Switching instruments for regulatory arbitrage is now strictly prohibited
• Banks are now required to calculate the capital charge before and after
the switch and if it is reduced because of the movement, then the
difference is imposed on the bank as a Pillar 1 capital surcharge

Internal Risk Transfers:

• There is no recognition of regulatory capital for internal risk transfer
from trading book to banking book
• For risk transfer from the banking book to trading book, regulatory
capital recognition will be provided only if the trading book executes a
hedge with external counterparty and the value of the hedge completely
matches that of the internal risk transfer

20
6
Value at Risk
(VaR) Curve

20
7
 Value at Risk
(VaR) Curve…
The diagram shows that:
• 95% of the time, the portfolio’s value remains above $80
million
• 5% of the time, the portfolio’s value falls to $80 million or
less
• The VaR of this portfolio is, therefore, $100 million - $80
million = $20 million
• VaR has the advantage that the risks of different assets can
be combined to produce a single number that reflects the
risk of a portfolio

20
8
 Expected
Shortfall
• Expected shortfall (ES) is a risk measure—a concept used in the field
of financial risk measurement to evaluate the market risk or credit risk
of a portfolio. The "expected shortfall at q% level" is the expected
return on the portfolio in the worst. of case
• This is also sometimes referred to as conditional VAR, or tail loss.
Where VAR asks the question 'how bad can things get?', expected
shortfall asks 'if things do get bad, what is our expected loss?’
• Expected shortfall, like VAR, is a function of two parameters: N (the
time horizon in days) and X% (the confidence level)
• It is the expected loss during an N-day period, conditional that the loss
is greater than the Xth percentile of the loss distribution
• For example, with X = 99 and N = 10, the expected shortfall is the
average amount that is lost over a 10-day period, assuming that the loss
is greater than the 99th percentile of the loss distribution

20
9
Three approaches to
Operational Risk

21
0
 Operational Risk –
Business Line Mapping

21
1
Operational Risk –
Advanced Approach
• According to the BCBS Supervisory Guidelines, an AMA framework
must include the use of four data elements:
(i) Internal loss data (ILD)
(ii) External data (ED)
(iii) Scenario analysis (SBA)
(iv) Business environment and internal control factors (BEICFs)
• One of the most common approaches taken in the banking industry is
the loss distribution approach (LDA)
• With LDA, a bank first segments operational losses into homogeneous
segments, called units of measure
• For each unit of measure, the bank then constructs a loss distribution
that represents its expectation of total losses that can materialize in a
one-year horizon

21
2
Operational Risk –
Advanced Approach…
• Given that data sufficiency is a major challenge for the industry,
annual loss distribution cannot be built directly using annual loss
figures
• Instead, a bank will develop a frequency distribution that
describes the number of loss events in a given year, and a severity
distribution that describes the loss amount of a single loss event
• The frequency and severity distributions are assumed to be
independent
• The convolution (blending of one function with the other) of
these two distributions then give rise to the annual loss
distribution

21
3
Operational Risk –
Safety Risk Matrix

21
4
BASEL III
Basel II to Basel III
Why
Basel
III?
Mainly due to failure of Basel II:

• Inability to strengthen financial stability

• Insufficient capital reserve

• Inadequate comprehensive risk management

approach

• Lack of uniformed definition of capital 91

 Objectives of
Basel
III
The main objective of the Basel framework is to promote
a safer and more resilient financial system through the
definition and application of enhanced solvency
requirements

Specifically,

• To minimize the probability of recurrence of crises to

greater extent
• To improve the banking sector's ability to absorb
shocks arising from financial and economic stress
• To improve risk management and governance
92

• To strengthen banks' transparency and disclosures

 of
refo
rm
• Increasing the quality and quantity capital
• Enhancing risk coverage of capital
• Introducing Leverage ratio
• Improving liquidity rules
• Establishing additional buffers
• Managing counter party risks

93
 Basel
III
• The macro prudential aspects of Basel III are in the
capital buffers
• Both buffers (Capital Conservation Buffer and
Countercyclical Capital Buffer ) are for protecting
Banks from periods of excess credit growth
• Reserve Bank issued Guidelines on Basel III reforms
on capital regulation on May 2, 2012 for banks in
India
• Basel III capital regulation has been implemented
from April 1, 2013
• It is expected to be fully implemented by March 31,
2020
95
96
Capital Standards

97
Capital requirements under Basel II & Basel III

98
 Minimum Capital Requirements
• Banks' regulatory capital is divided into Tier 1 and Tier 2, while
Tier 1 is subdivided into Common Equity Tier 1 and additional
Tier 1 capital
• The distinction is important because security instruments
included in Tier 1 capital have the highest level of subordination
• Under Basel III, the minimum tier 1 capital ratio is 10.5%, which
is calculated by dividing the bank's tier 1 capital by its total risk-
weighted assets (RWA)
• For example, assume there a financial institution has US$200
billion in total tier 1 assets. They have a risk-weighted asset value
of 1.2 trillion. To calculate the capital ratio, they divide $200
billion by $1.2 trillion in risk for a capital ratio of 16.66%, well
above the Basel III requirements.

99
 Minimum Capital Requirements…

• Common Equity Tier 1 capital includes equity instruments that have

discretionary dividends and no maturity, while additional Tier 1 capital
comprises securities that are subordinated to most subordinated debt,
have no maturity, and their dividends can be cancelled at any time
• Tier 2 capital consists of unsecured subordinated debt with an original
maturity of at least five years
• Undisclosed reserves are not common but are accepted by some
regulators where a bank has made a profit, but the profit has not
appeared in normal retained profits or in general reserves of the bank
• It is fairly standard for undisclosed reserves first to be accepted by a
bank's supervisory authorities but many countries do not accept
undisclosed reserves as an accounting concept or as a legitimate form
of capital

100
Capital Charge for
Market Risk…
 Capital Charge for Market Risk…

Capital Charge for Market Risks will include:

(i) Securities included under the Held for Trading category

(ii) Securities included under the Available for Sale category
(iii)Open gold position limits
(iv)Open foreign exchange position limits
(v) Trading positions in derivatives, and
(vi) Derivatives entered into for hedging trading book exposures

• Capital for market risk would not apply to securities already matured
and remaining unpaid
• These will attract capital only for credit risk. On completion of 90
days delinquency, these will be treated as NPAs for deciding
appropriate risk weights for credit risk
 Capital Charge for Interest Rate Risk

• Interest Rate risk is risk of holding or taking positions in debt securities and other interest rate related
instruments in the trading book. Banks should mark to market their trading positions on a daily basis
• The capital charge here includes two charges:
(i) ‘Specific risk’ charge for each security, which is designed to
protect against adverse movement in price of an individual
security owing to factors related to the individual issuer
(ii) ‘General market risk’ charge towards interest rate risk in the
portfolio in different securities or instruments
 Capital Charge for Foreign Exchange Risk
Bank’s net open position in each currency is the total of:

1. Net spot position (all assets less all liabilities + accrued interest )
2. Net forward position ( amounts to be received less amounts to be
paid under forward forex transactions +currency futures +principal
on currency swaps not included in spot position)
3. Guarantees (and similar instruments) certain to be called and likely to
be irrecoverable
4. Net future income/expenses not yet accrued but already fully hedged
(at discretion of reporting Bank)
5. Depending on particular accounting conventions in different countries,
any other item representing a profit or loss in foreign currencies
6. The net delta-based equivalent of the total book of foreign currency
options
 Capital Charge for Foreign Exchange Risk…

• Forex open positions and gold open positions are at present risk-weighted at 100 per cent
• Thus, capital charge for market risks in forex and gold open position is 9 per cent
• These open positions, limits or actual whichever is higher, would continue to attract capital charge at 9 per
cent
• This capital charge is in addition to the capital charge for credit risk on the on-balance sheet and off-balance sheet
items pertaining to forex and gold transactions
 Fundamental Review of
the
•Trading Book
In January 2016, the Basel Committee on Banking Supervision (BCBS)
published its last update on the revised minimum capital requirements
for market risk, which represents a key outstanding element of the post-
crisis reforms
• All banks are required to finalize the implementation of the revised
market risk standards by January 2019 and to start reporting under the
new standards by the end of 2019
• As per the BCBS rules, the revised boundary has been strengthened to
discourage regulatory arbitrage

106
 Fundamental Review of
the Trading
Book…
Boundary of Trading & Banking Book

• Positions marked as being held to maturity are defined for regulatory

purposes to be in the banking book, while positions that are tradable
are defined for regulatory purposes to be in the trading book. It stands
to reason then that trading book positions are subject to mark to
market and so attract higher market risk capital charges
• To reduce incentives for arbitrage between banking and trading book
treatment, the definition of the trading book is supplemented with a
list of instruments presumed to be in the trading book unless explicit
supervisory approval is received for any deviations
• In addition, strict limits on the movement of instruments between
banking and trading books is introduced

107
 Fundamental Review
of the
Trading
Book…
Impact 1:

• The intention of the Committee was to make it less likely that illiquid
instruments would find their way to the trading book which was one
of the reasons that led to the financial crisis
• These revisions would make it more difficult for banks and they will
face higher capital charges when transferring instruments from one
book to another
• Also daily attribution of profit and losses could be difficult if the
instruments are illiquid

108
 Fundamental Review of
the Trading
Book…
Impact 2:

Move from VaR to Expected Shortfall:

• The current framework relies on VaR to calculate what would be the loss
based on a confidence interval
• But VaR has various drawbacks, one of which is it completely ignores the
‘tail risk’. For example, in a portfolio of USD 100,000 if the VaR is 5% at
99% confidence interval, then we can say that we are 99% sure that loss in
the portfolio would not be more than USD 5000 but VaR ignores that 1%
case and doesn’t clarify what would be the loss in that case
• Hence Expected Shortfall is replacing VaR as it accounts for tail risk in a
more comprehensive manner considering both the size and losses above a
threshold

109
Fundamental Review of
the Trading
Book…
Impact 2 (contd)…

Move from VaR to Expected Shortfall:

• The Committee has proposed reducing the confidence interval

from 99th to 97.5th percentile. This will capture broadly the same
amount of risk as VaR but provides additional benefits of more
stable model output and less sensitivity to outlier observations
• Also, Expected Shortfall is a more conservative measure than VaR
and it would help ensure that regulatory capital is sufficient in
times of significant market stress

110
Fundamental Review of
the Trading
Book…
• Expected Shortfall is defined as the average of all losses which
are greater or equal than VaR, i.e., the average loss in the worst
(1-p)% cases, where p is the confidence level
• Said differently, it gives the expected value of an investment in
the worst q% of the cases. It is important to clarify that CVaR
(Conditional VaR) is NOT the worst case scenario – the worst
case scenario is always a 100% loss, and in case of many
leveraged instruments, a loss exceeding 100% of the initial
investment
• CVaR is simply an average of losses past arbitrarily selected risk
threshold – so for 95% VaR, CVaR will represent the average of
outcomes in the worst 5% of the cases
• Expected Shortfall is the opposite of Expected Upside

111
COLLATERAL
HAIRCUT
 Collateral Haircuts under
the Basel Accord
• A haircut refers to the lower-than-market value placed on an asset being used as
collateral for a loan
• The haircut is expressed as a percentage of the markdown between the two
values
• When they are used as collateral, securities are generally devalued, since a
cushion is required by the lending parties in case the market value falls
• When collateral is being pledged, the degree of the haircut is determined by the
amount of associated risk to the lender
• These risks include any variables that may affect the value of the collateral in
the event that the lender has to sell the security due to a loan default by the
borrower
• Variables that may influence that amount of a haircut include price, volatility
and liquidity risks of the collateral
 What determines the
haircut amount?
• Generally speaking, price predictability and lower associated risks result in
compressed haircuts, as the lender has a high degree of certainty that the
full amount of the loan can be covered if the collateral must be liquidated
• For example, Treasury bills are often used as collateral for overnight
borrowing arrangements between government securities dealers, which are
referred to as repurchase agreements (repos)
• In these arrangements, haircuts are negligible due to the high degree of
certainty on the value, credit quality, and liquidity of the security
• Securities that are characterized by volatility and price uncertainty have
larger haircuts when used as collateral
• For example, an investor seeking to borrow funds from a brokerage by
posting equity positions to a margin account as collateral can only borrow
50% of the value of the account due to the lack of price predictability,
which is a haircut of 50%
 Credit Risk
Mitigation
• Where banks take eligible financial collateral (e.g., cash or securities), they
are allowed to reduce their credit exposure to a counterparty when
calculating their capital requirements to take account of the risk mitigating
effect of the collateral
• Banks may opt for either the simple approach, which substitutes the risk
weighting of the collateral for the risk weighting of the counterparty for
the collateralized portion of the exposure (generally subject to a 20%
floor), or for the comprehensive approach, which allows a more precise
offset of collateral against exposures, by effectively reducing the exposure
amount by the value ascribed to the collateral
• Banks may operate under either, but not both, approaches in the banking
book, but only under the comprehensive approach in the trading book
• Partial collateralization is recognized in both approaches

https://www.bis.org/basel_framework/chapter/CRE/22.htm
REGULATORY
ARBITRAGE
 Regulatory
Arbitrage
• Situation where companies take advantage of loopholes in order to avoid
unprofitable regulations. For example, a company may relocate its
headquarters to a country with lower tax rules and favorable regulatory
policies to save cost and increase profit
• The result, of course, is that the risk becomes insufficiently regulated
• In very general terms, regulatory arbitrage takes three forms - the first can
be described as cross-jurisdiction arbitrage
• This exploits the fact that rules for banks differ from one country to
another. Some rules, for example, might be less strict in country A, while
others might be less strict in country B
• The effect of one bank doing this might not be that big, but if, over time,
more and more business shifts to countries where the rules are less strict,
this could easily become a threat to stability – not just in one country, but
everywhere
 Regulatory
Arbitrage…
• While the banking sector is highly regulated, other parts of the financial
system are much less so - the shadow banking sector, for example
• This opens the door to what could be referred to as cross-framework
arbitrage
• Banks can pass through that door by moving business to the shadow
banking sector
• They can shift exposures to entities that are not consolidated for prudential
purposes
• Looking back at the run-up to the financial crisis, one of the more popular
ways to do this was through special-purpose vehicles, or SPVs
• The danger, of course, is that these risks could eventually spill back into the
banking sector
• Out of the shadows, banks could suddenly be hit by a flood of risks that
have not been accounted for
 Capital Charge for Operational Risk

• Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events
• This includes legal risk, but excludes strategic and reputational risk
• Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from
supervisory actions, as well as private settlements
 Capital Charge for
Operational
The Measurement Methodologies:
Risk
• Three methods for calculating operational risk capital charges:
(i) the Basic Indicator Approach (BIA)
(ii)the Standardised Approach (TSA)
(iii) Advanced Measurement Approaches (AMA) *

* https://www.bis.org/ifc/publ/ifcb33p.pdf

https://www.bis.org/publ/bcbs195.pdf (Principles for the

Sound Management of Operational Risk)

• To begin with, banks in India must compute the capital requirements

for Operational Risk under the Basic Indicator Approach
 Capital Charge for
Operational Risk…
Basic Indicator Approach:
• Banks to hold capital for operational risk equal to average over previous
three years of a fixed percentage (denoted as alpha) of positive annual
gross income
• Figures for year in which annual gross income is negative or zero
excluded from both numerator and denominator

• KBIA = [ Σ (GI1…nx α )]/n : Where:

KBIA = capital charge under Basic Indicator Approach
GI = annual gross income, where positive, over previous three years
n = number of the previous three years for which gross income is
positive
α = 15 per cent, which is set by the BCBS
 Capital
Buffers
• The macro prudential aspects of Basel III are largely enshrined in the capital buffers
• Both the buffers, i.e., the Capital Conservation Buffer and the Countercyclical Capital Buffer
are intended to protect the banking sector from periods of excess credit growth
• In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are also
required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of
Common Equity Tier 1 Capital
 Capital
Conservation
Buffer
• Capital Conservation Buffer (CCB) is one of the main new
features of Basel III
• Designed to ensure that banks build up capital buffers during
normal times (outside periods of stress) which can be drawn
down when losses are incurred during a stressed period
• Outside the period of stress, banks should hold buffers of
capital above regulatory minimum. When buffers have been
drawn down, Banks will have to bring the buffer back to the
desired level within a time limit prescribed by RBI
• Banks which have depleted capital buffers will have to restrict
dividend payments, share buybacks and staff Bonus payments,
till the buffers are built back
• Alternatively, fresh capital may be raised
 Capital
Conservation
• The capital Buffer…
conservation buffer can be drawn down only when
a bank faces a systemic or idiosyncratic stress. A bank should
not choose in normal times to operate in the buffer range
simply to compete with other banks.
• 'Idiosyncratic Risk’: Risk that is specific to an asset or a
small group of assets. Idiosyncratic risk has little or no
correlation with market risk , and can therefore be substantially
mitigated or eliminated from a portfolio by using adequate
diversification.
• Banks which draw down their capital conservation buffer
during a stressed period should also have a definite plan to
replenish the buffer as part of Internal Capital Adequacy
Assessment Process (ICAAP)
 Leverage Ratio
Framework
• A major cause of the 2008 financial crisis was the build-up of excessive on
and off-balance sheet leverage in the banking system
• In many cases, banks built up excessive leverage while apparently
maintaining strong risk-based capital ratios
• Lehman Brothers was leveraged at 30.7 to 1 at that point of time. Merrill
Lynch was at 26.9 to 1. While leverage spruces up returns when times are
good, it also causes problems when times are bad. In fact, hedge fund
manager David Einhorn believed that if calculated properly, Lehman
Brothers had a leverage of 44:1. At a conference, Einhorn explained that
even a 1% fall in the value of the investments of Lehman, would wipe out
half of its equity and push the leverage to almost 80 times
• Therefore, under Basel III, a simple, transparent, non-risk based leverage
ratio has been introduced
• Definition: The Basel III leverage ratio is defined as the capital measure
(the numerator) divided by the exposure measure (the denominator), with
this ratio expressed as a percentage
 Leverage Ratio
Framework…
• The higher the tier 1 leverage ratio, the higher the likelihood of the bank
withstanding negative shocks to its balance sheet
• The leverage ratio is used as a tool by central monetary authorities to ensure
the capital adequacy of banks and place constraints on the degree to which
a financial company can leverage its capital base
What is the difference between leverage ratio and tier 1capital
adequacy ratio?
• The tier 1 capital adequacy ratio (CAR) is the ratio of a bank’s core tier 1
capital—that is, its equity capital and disclosed reserves—to its total risk-
weighted assets. It is a key measure of a bank's financial strength that has
been adopted as part of the Basel III Accord on bank regulation. It
measures a bank’s core equity capital as against its total risk-weighted assets
• The leverage ratio is a measure of the bank's core capital to its total assets.
The ratio uses tier 1 capital to judge how leveraged a bank is in relation to
its consolidated assets whereas the tier 1 capital adequacy ratio measures
the bank's core capital against its risk-weighted assets
 Leverage Ratio
Framework…
• The Basel Committee proposed to use the revised framework for
testing a minimum Tier 1 leverage ratio of 3% during the parallel run
period up to January 1, 2017
• RBI revised regulation on the implementation of leverage ratio for
banks in India, under the Basel III capital regulations. RBI has decided
that the minimum leverage ratio shall be 4% for domestic systemically
important banks (D-SIBs) and 3.5% for other banks

Capital Measure:
• In other words, the capital measure used for the leverage ratio at any
particular point in time is the Tier 1 capital measure applying at that
time under the risk-based framework
 Leverage Ratio
framework…
Capital measure
• The capital measure is Tier 1 capital as defined for the purposes of the
Basel III risk-based capital framework but after taking account of the
corresponding transitional arrangements
• In other words, the capital measure for the leverage ratio at a particular
point in time is the applicable Tier 1 capital measure at that time under
the risk-based framework
 Leverage Ratio
framework…
Exposure measure for leverage ratio:

A bank’s total exposure measure is the sum of the following

exposures:

(a) on-balance sheet exposures

(b) derivative exposures
(c) securities financing transaction (SFT) exposures, and
(d) off- balance sheet (OBS) items
 Leverage Ratio Formula

The Formula for the Tier 1 Leverage Ratio is:

 Leverage Ratio Calculation

• Tier 1 capital for the bank is placed in the numerator of the leverage
ratio
• Tier 1 capital represents a bank's common equity, retained earnings,
reserves, and certain instruments with discretionary dividends and no
maturity
• The bank's total consolidated assets for the period is placed in the
denominator of the formula, which is typically reported on a bank's
quarterly or annual earnings report
• Divide the bank's tier 1 capital by total consolidated assets to arrive at
the tier 1 leverage ratio
• Multiply the result by 100 to convert the number to a percentage

The ratio uses Tier 1 capital to evaluate how leveraged a bank is in relation
to its overall assets. The higher the Tier 1 leverage ratio is, the higher the
likelihood that the bank could withstand a negative shock to its balance
sheet
Leverage Ratio of banks
in India @ 2019
 Countercyclical Capital
Buffer Framework
Two Objectives:

1. It requires banks to build up a buffer of capital in good times

which may be used to maintain flow of credit to the real sector
in difficult times
2. It achieves the broader macro-prudential goal of restricting the
banking sector from indiscriminate lending in the periods of
excess credit growth that have often been associated with the
building up of system-wide risk
• CCCB is to be maintained in the form of Common Equity Tier 1 (CET
1) capital
• The amount of the CCCB may vary from 0 to 2.5% of total risk
weighted assets (RWA) of the banks
 Countercyclical Capital
Buffer Framework
• All banks operating in India (both foreign and domestic banks)
should maintain capital for Indian operations under CCCB
framework based on their exposures in India
• Banks will be subject to restrictions on discretionary distributions
(may include dividend payments, share buybacks and staff bonus
payments) if they do not meet the requirement on countercyclical
capital buffer (CCCB) which is an extension of the requirement for
capital conservation buffer (CCB)
 Countercyclical Capital
Buffer Framework…
• Banks must ensure that their CCCB requirements are calculated and
publicly disclosed with at least the same frequency as their minimum
capital requirements as applicable in various jurisdictions
• The buffer should be based on the latest relevant jurisdictional
CCCB requirements that are applicable on the date that they
calculate their minimum capital requirement
• When disclosing their buffer requirement, banks must also disclose
the geographic breakdown of their private sector credit exposures
used in the calculation of the buffer requirement
Economic foundations of
the risk
weight
formulas… • While it is never possible to know in advance the
losses a bank will suffer in a particular year, a bank
can forecast the average level of credit losses it can
reasonably expect to experience. These losses are
referred to as Expected Losses (EL)
• One of the functions of bank capital is to provide
a buffer to protect a bank’s debt holders against
peak losses that exceed expected levels
• Such peaks are illustrated by the spikes above the
dashed line in the graph on the previous slide
• Losses above expected levels are usually referred to
as Unexpected Losses (UL)
• There are a number of approaches to determining
how much capital a bank should hold
• The IRB approach adopted for Basel II focuses on
the frequency of bank insolvencies arising from
credit losses that supervisors are willing to accept
• By means of a stochastic credit portfolio model, it
is possible to estimate the amount of loss which
will be exceeded with a small, pre-defined
probability
• This probability can be considered the probability
of bankinsolvency

13
7
 The ASRF
framework
• ASFR Model (asymptotic single factor risk model) is a simplified Credit
Portfolio risk model that underpins the Basel II capital requirements
• Portfolio invariance of the capital requirements is a property with a strong
influence on the structure of the portfoliomodel
• It can be shown that essentially only so-called Asymptotic Single Risk Factor
(ASRF) models are portfolio invariant
• ASRF models are derived from ‘ordinary’ credit portfolio models by the law of
large numbers
• When a portfolio consists of a large number of relatively small exposures,
idiosyncratic risks* associated with individual exposures tend to cancel out
one-another and only systematic risks that affect many exposures have a
material effect on portfolio losses
• In the ASRF model, all systematic (or system-wide) risks, that affect all
borrowers to a certain degree, like industry or regional risks, are modelled with
only one systematic risk factor
* Idiosyncratic risk is also referred to as a specificrisk orunsystematic risk; the oppositeof
idiosyncraticrisk is a systematic risk, whichis the overall risk that affects all assets, such as
fluctuations in the stock market, interest rates, orthe entire financialsystem
139
The ASRF
framework…
• Given the ASRF framework, it is possible to estimate the sum of
the expected and unexpected losses associated with each credit
exposure
• This is accomplished by calculating the conditional expected loss
for an exposure given an appropriately conservative value of the
single systematic risk factor
• The implementation of the ASRF model developed for Basel II
makes use of average PDs that reflect expected default rates
under normal business conditions
• These average PDs are estimated by banks
• To calculate the conditional expected loss, bank-reported average
PDs are transformed into conditional PDs using a supervisory
mapping function

140
Calculating Regulatory
Capital with the ASRF
Model
The following is an indicative list of assumptions / design choices
in constructing the ASFR model:

• One year risk horizon

• Single factor model
• Normal distributions
• Homogeneous and large pool of exposures

Refer: https://www.openriskmanual.org/wiki/ASRF_model
https://in.mathworks.com/help/risk/asrf-model-capital.html

141
GUARAN
TEES

26
Guarantee
s
• It is a form of indirect finance
• A guarantee is issued by a bank on behalf of its customer in favor
of a beneficiary guaranteeing that the customer’s contractual
obligations will be fulfilled
• If obligations are not fulfilled, the guarantor undertakes to pay a
sum of money to the importer in compensation
• It may seem to be similar to LC but has a clear distinction
• While in LC, the issuing Bank promises to pay if the LC terms are
met, in a Guarantee, the Bank agrees to pay the beneficiary if
something does not happen or if the applicant doesn’t fulfill the
promise

26
Types of Bonds & Guarantees:

• Bid / Tender
• Performance
• Advance payment
• Retention
• Maintenance / Warranty
• Customs
• Shipping

26
26
27
27
27
27
27
Differences between LCs and
Guarantees

27
CORRESPONDEN
T BANKING

27
 WHAT IS CORRESPONDENT BANKING?

• Correspondent banking can be defined, in general terms, as

“an arrangement under which one bank
(correspondent) holds deposits owned by other
banks (respondents) and provides payment and other
services to those respondent banks”
• The most common services provided by a correspondent bank are currency
exchange, handling business transactions and trade documentation and money
transfers
• Correspondent Banking works through an agreement between a foreign and
domestic bank where a correspondent account, usually referred to as a Vostro
or Nostro account, is established at one bank for the other
• At the most basic level, correspondent banking requires the opening of
accounts by respondent banks in the correspondent banks’ books and the
exchange of messages to settle transactions by crediting and debiting those
accounts

27
 CORRESPONDENT BANKING

• Correspondent banking works through an agreement between a foreign

and domestic bank where a correspondent account, usually referred to
as a vostro or nostro account, is established at one bank for the other
• Correspondent banking typically involves the two banks establishing
reciprocal accounts with each other. These accounts are established to
enable the domestic bank to make payments or money transfers on
behalf of the foreign bank
• Such correspondent accounts enable banks to handle international
financial transactions for their customers that ordinarily require foreign
currency exchange, such as those that commonly occur between an
exporting business in one country to an importer in another country

27
 CORRESPONDENT BANKING…

Example:

• A customer of a bank in one country needs to pay for products

purchased from a supplier in another country
• The customer's domestic bank determines the necessary foreign
currency exchange transaction to facilitate appropriate payment in the
currency of the seller
• It deducts the appropriate amount from the customer's account, then
instructs its correspondent bank in the supplier's country to pay out the
corresponding amount to the supplier in the supplier's currency from
the domestic bank's correspondent account with the foreign bank

27
 CORRESPONDENT BANKING

Nostro Account:

Due from account - the foreign currency account of a major bank with
the foreign banks abroad to facilitate international payments and
settlements

Vostro Account:

Due to account - the account held by a bank on behalf of a

correspondent bank

28
NOSTRO ACCOUNT

28
VOSTRO ACCOUNT

28
LORO ACCOUNT

28
FOREIGN EXCHANGE MARKET

28
 HOW ARE EXCHANGE RATES
DETERMINED?
• Exchange rates are determined by the demand and supply for
different currencies
• Three factors impact future exchange rate movements

a) A country’s price inflation

b) A country’s interest rate
c) Market psychology

28
2
4

TYPES OF FOREIGN EXCHANGE TRANSACTIONS

• Spot market Transactions involving sale and

purchase of currencies for
immediate delivery

• Forward Markets Transactions meant to be settled

on a future date as specified in the
contract
• Futures Markets is a localized exchange where
derivative instruments called
‘futures’ are traded
 TYPES OF FOREIGN EXCHANGE
TRANSACTIONS…
• Options
•are derivative instruments that give a
• choice to a foreign exchange market operator
to buy or sell a foreign currency
• on or up to a date (maturity date) at a
• specified rate (strike price)
• Swaps are instruments that permit exchange
of two streams of cash flows in
two different currencies

28
 SPOT MARKET

• It is the market where transactions are conducted for spot

delivery of currencies
• Spot transaction deals generate foreign exchange risk since the
relative value of the two currencies in the spot transaction may
change
• Normally, exchange rates are quoted on a spot basis; wherever
foreign exchange rate is delivered after the spot rate, it is known
as forward transaction
• Quotes are usually made in the form of buy & sell or bid & ask
rates
• The ask and bid differential is called the spread

28
 FORWARD MARKET
• The market segment in which currencies are exchanged for a
settlement to be done in the future is known as forward market
• This is usually done to secure against adverse movements in
currencies (a hedging transaction) or as a product of a particular
view on a currency (a speculative transaction)
• The exchange rate for delivery and payment of foreign exchange
at a specified future date is called forward exchange rate
• A forward exchange rate can be lower or higher than the spot rate
prevailing at that time
• Forward rates, globally, are a function of the spot rate prevailing
between the given pair of currencies and the interest rate
differentials that prevail in the respective countries

28
 FORWARD MARKET…

Example:
• Suppose an importer’s shipment is expected to reach India
only after 3 months
• He feels that the FX rate in the 3rd month at the time of
retirement of the import bill may not be favorable to him
• He can choose to fix an assured rate for this transaction
• This fixing of the exchange rate for a future transaction at a
time earlier than the date of actual transaction is known as
forward contract

29
 CURRENCY FUTURES CONTRACTS
• It is a contract for future delivery of a specified currency against
another
• A futures contract is similar to the forward contract but is more
liquid because it is traded in an organized exchange i.e., the
futures market
• Because currency futures contracts are marked-to-market daily,
investors can exit their obligation to buy or sell the currency prior
to the contract's delivery date
• Depreciation of a currency can be hedged by selling futures and
appreciation can be hedged by buying futures

29
 CURRENCY OPTIONS

• A Currency Option is a contract giving the right, not the

obligation, to buy or sell a specific quantity of one foreign
currency in exchange for another at a fixed price called the
Exercise Price or Strike Price
• The fixed nature of the exercise price reduces the uncertainty of
exchange rate changes and limits the losses of open currency
positions
• Call Options are used if the risk is an upward trend in price (of
the currency), while Put Options are used if the risk is a
downward trend

29
 CURRENCY OPTION EXAMPLE

• Assume that an investor is bullish on the euro and believes it will

increase against the U.S. dollar
• The investor purchases a currency call option on the euro with a strike
price of $115
• When the investor purchases the contract, the spot rate of the euro is
equivalent to $110. Assume the euro's spot price at the expiration date
is $118
• Consequently, the currency option is said to have expired in the money.
Therefore, the investor's profit is $300, or (100 * ($118 - $115)), less the
premium paid for the currency call option

29
 DERIVATIVE
S BARINGS BANK
CASE STUDY
 Barings Bank Case Study

Background:

• Founded in 1762, Barings Bank was Britain’s oldest merchant bank and Queen
Elizabeth’s personal bank
• Once a behemoth in the banking industry, Barings was brought to its knees by
a rogue trader in a Singapore office
• The trader, Nick Leeson, was employed by Barings to profit from low risk
arbitrage opportunities between derivatives contracts on the Singapore
Mercantile Exchange and Japan’s Osaka Exchange
• A scandal ensued when Leeson left a $1.4 billion hole in Barings’ balance sheet
due to his unauthorized derivatives speculation, causing the 233-year-old bank’s
demise
 Barings Bank Case Study
About Nick Leeson:

• Barings recruited Nick Leeson in July, 1989, to work in futures and options
settlement in its London office
• In March, 1992, Nick Leeson was transferred to Singapore to run the back
office of Barings Future Singapore (BFS), a Barings subsidiary involved in
futures dealing on the Singapore Monetary Exchange, SIMEX
• He was promoted rapidly and, by late 1992, he was BFS’s general manager and
head trader
 Barings Bank Case Study

• Much of BFS’s business consisted of own-account trading aimed at

exploiting small pricing differences between similar contracts on the
Singapore and Japanese exchanges
• It also acted as broker for clients wishing to trade on SIMEX
• Leeson and his traders had authority to perform two types of trading:
- Transacting futures and options orders for clients or for other firms
within the Barings organization, and
- Arbitraging price differences between Nikkei futures traded on the
SIMEX and Japan’s Osaka exchange
• Arbitrage is an inherently low risk strategy and was intended for Leeson
and his team to garner a series of small profits, rather than spectacular
gains
 Barings Bank Case Study

• From late 1992 until early 1995, Leeson reported increasingly large
profits on apparently risk free arbitrage trading in which positions on
SIMEX were supposedly hedged by equal, offsetting positions on
Japanese exchanges
• He made unauthorized speculative trades that at first made huge
contributions for Barings - up to 10% of the bank’s profits at the end
of 1993. He became a star within the organisation, earning unlimited
trust from his London bosses who considered him nearly infallible
• However, he soon lost money in his operations and hid the losses in an
error account, 88888
• He claimed that the account had been opened in order to correct an
error made by an inexperienced member of the team
 Barings Bank Case Study

• At the same time, Leeson hid documents from statutory auditors of the
bank, making the internal control of Barings seem completely
inefficient
• At the end of 1994, his total losses amounted to more than 208 million
pounds, almost half of the capital of Barings
• He persuaded a back office programmer to alter Barings accounting
systems so that the information about 88888 would not be reported
back to London
• The fact that Leeson was in charge of both dealing and back office
operations in BFS was crucial in facilitating the deception
 Barings Bank Case Study

The Collapse of Barings

• On January 16th, 1995, with the aim of ‘recovering’ his losses, Leeson
placed a short straddle* on Singapore Stock Exchange and on Nikkei
Stock Exchange, betting that Nikkei would drop below 19,000 points
• But the next day, the unexpected Kobe earthquake shattered his
strategy. Nikkei lost 7 % in the week when the Japanese economy
seemed on the verge of recovery after 30 weeks of recession
• Nick Leeson took a 7 billion dollar value futures position in Japanese
equities and interest rates, linked to the variation of Nikkei
• He was ‘long’ on Nikkei
 Barings Bank Case Study
The Collapse of Barings…

• Straddle:

• A straddle strategy is a strategy that involves simultaneously taking a

long position and a short position on a security
• Consider the following example: A trader buys and sells a call option
and put option at the same time for the same underlying asset at a
certain point of time. Both options have the exact same expiry date and
strike price
• The straddle strategy is usually used by a trader when they are not sure
which way the price will move. The trades in different directions can
compensate for each other’s losses
 Barings Bank Case Study

The Collapse of Barings…

• In the three days following the earthquake of Kobé, Leeson bought

more than 20,000 futures, each worth 180,000 dollars
• He tried to recoup his losses by taking even more risky positions,
betting that the Nikkei Stock Exchange would make a rapid recovery; he
believed he could move the market but he lost his bet, worsening his
losses
• They attained an abysmal low ($ 1.4 billion), more than double the
bank’s capital which is now bankrupt because its own capital would be
insufficient to absorb the losses generated by Leeson
 Barings Bank Case Study

Factors that played to Leeson’s advantage:

• In Singapore, Leeson enjoyed great freedom within the local office -

even an internal memo from 1993 proved to have no consequence
• Leeson operated in both the dealing desk (front office) and the back
office. So he confirmed and settled trades transacted by the front office
- which he himself passed
• He was therefore able to hide what he wanted
• The profits brought in by Leeson instilled confidence in management
who lacked knowledge in subtle trading techniques and financial
markets, and therefore did not pose any questions at Leeson
• They did not seem to be aware of the risks incurred by the bank
 Barings Bank Case Study

Factors that played to Leeson’s advantage…

• Leeson made false declarations to regulation authorities which allowed
him to accumulate his losses and to avoid a margin call which should
have audited losses from day to day
• It is true that these false declarations did not attract the attention of
control authorities in Singapore
• Barings benefited from special privileges from the Bank of England (an
exception to the rule that a bank could not lend more that 25% of its
capital to any one entity)
• Nothing was detected by statutory auditors and control interns, despite
the fact that Leeson had hidden certain losses and had forged
documents - both of which should have drawn attention to him. This
proves that the account regulation procedures within the institution
were completely inefficient
 Barings Bank Case Study

Aftermath:

• Feeling that his losses had become to great and seeing that the bank was on the
verge of a crisis, Leeson decided to flee, leaving a note which read “I’m sorry”
• He went to Malaysia, Thailand and finally Germany
• There he was arrested upon landing and extradited back to Singapore on 2nd
March 1995
• He was condemned to six and a half years in prison but was released in 1999
after a diagnosis of colon cancer
• In 1996 he published an autobiography ‘Rogue Trader’ in which he detailed his
acts leading to the collapse of Barings. The book was later made into a film*
starring Ewan McGregor as Leeson

* https://www.youtube.com/watch?v=cxSZzTYpZAg
CORRESPONDENT
BANKING

3
 WHAT IS CORRESPONDENT BANKING?

• Correspondent banking can be defined, in general terms, as

“an arrangement under which one bank
(correspondent) holds deposits owned by other
banks (respondents) and provides payment and other
services to those respondent banks”
• The most common services provided by a correspondent bank are currency
exchange, handling business transactions and trade documentation and money
transfers
• Correspondent Banking works through an agreement between a foreign and
domestic bank where a correspondent account, usually referred to as a Vostro
or Nostro account, is established at one bank for the other
• At the most basic level, correspondent banking requires the opening of
accounts by respondent banks in the correspondent banks’ books and the
exchange of messages to settle transactions by crediting and debiting those
accounts

3
 CORRESPONDENT BANKING…

Example:

• A customer of a bank in one country needs to pay for products

purchased from a supplier in another country
• The customer's domestic bank determines the necessary foreign
currency exchange transaction to facilitate appropriate payment in the
currency of the seller
• It deducts the appropriate amount from the customer's account, then
instructs its correspondent bank in the supplier's country to pay out the
corresponding amount to the supplier in the supplier's currency from
the domestic bank's correspondent account with the foreign bank

3
 CORRESPONDENT BANKING

Nostro Account:

Due from account - the foreign currency account of a major bank with
the foreign banks abroad to facilitate international payments and
settlements

Vostro Account:

Due to account - the account held by a bank on behalf of a

correspondent bank

3
NOSTRO ACCOUNT

3
VOSTRO ACCOUNT

3
LORO ACCOUNT

3
 DERIVATIVES
BARINGS BANK CASE
STUDY
 Barings Bank Case Study
Background:

• Founded in 1762, Barings Bank was Britain’s oldest merchant bank and Queen
Elizabeth’s personal bank
• Once a behemoth in the banking industry, Barings was brought to its knees by
a rogue trader in a Singapore office
• The trader, Nick Leeson, was employed by Barings to profit from low risk
arbitrage opportunities between derivatives contracts on the Singapore
Mercantile Exchange and Japan’s Osaka Exchange
• A scandal ensued when Leeson left a $1.4 billion hole in Barings’ balance sheet
due to his unauthorized derivatives speculation, causing the 233-year-old bank’s
demise
 Barings Bank Case Study
About Nick Leeson:

• Barings recruited Nick Leeson in July, 1989, to work in futures and options
settlement in its London office
• In March, 1992, Nick Leeson was transferred to Singapore to run the back
office of Barings Future Singapore (BFS), a Barings subsidiary involved in
futures dealing on the Singapore Monetary Exchange, SIMEX
• He was promoted rapidly and, by late 1992, he was BFS’s general manager and
head trader
 Barings Bank Case Study
• Much of BFS’s business consisted of own-account trading aimed at
exploiting small pricing differences between similar contracts on the
Singapore and Japanese exchanges
• It also acted as broker for clients wishing to trade on SIMEX
• Leeson and his traders had authority to perform two types of trading:
- Transacting futures and options orders for clients or for other firms
within the Barings organization, and
- Arbitraging price differences between Nikkei futures traded on the
SIMEX and Japan’s Osaka exchange
• Arbitrage is an inherently low risk strategy and was intended for Leeson
and his team to garner a series of small profits, rather than spectacular
gains
 Barings Bank Case Study
• From late 1992 until early 1995, Leeson reported increasingly large
profits on apparently risk free arbitrage trading in which positions on
SIMEX were supposedly hedged by equal, offsetting positions on
Japanese exchanges
• He made unauthorized speculative trades that at first made huge
contributions for Barings - up to 10% of the bank’s profits at the end
of 1993. He became a star within the organisation, earning unlimited
trust from his London bosses who considered him nearly infallible
• However, he soon lost money in his operations and hid the losses in an
error account, 88888
• He claimed that the account had been opened in order to correct an
error made by an inexperienced member of the team
 Barings Bank Case Study

• At the same time, Leeson hid documents from statutory auditors of the
bank, making the internal control of Barings seem completely
inefficient
• At the end of 1994, his total losses amounted to more than 208 million
pounds, almost half of the capital of Barings
• He persuaded a back office programmer to alter Barings accounting
systems so that the information about 88888 would not be reported
back to London
• The fact that Leeson was in charge of both dealing and back office
operations in BFS was crucial in facilitating the deception
 Barings Bank Case Study
The Collapse of Barings

• On January 16th, 1995, with the aim of ‘recovering’ his losses, Leeson
placed a short straddle* on Singapore Stock Exchange and on Nikkei
Stock Exchange, betting that Nikkei would drop below 19,000 points
• But the next day, the unexpected Kobe earthquake shattered his
strategy. Nikkei lost 7 % in the week when the Japanese economy
seemed on the verge of recovery after 30 weeks of recession
• Nick Leeson took a 7 billion dollar value futures position in Japanese
equities and interest rates, linked to the variation of Nikkei
• He was ‘long’ on Nikkei
 Barings Bank Case Study
The Collapse of Barings…

• Straddle:

• A straddle strategy is a strategy that involves simultaneously taking a

long position and a short position on a security
• Consider the following example: A trader buys and sells a call option
and put option at the same time for the same underlying asset at a
certain point of time. Both options have the exact same expiry date and
strike price
• The straddle strategy is usually used by a trader when they are not sure
which way the price will move. The trades in different directions can
compensate for each other’s losses
 Barings Bank Case Study
The Collapse of Barings…

• In the three days following the earthquake of Kobé, Leeson bought

more than 20,000 futures, each worth 180,000 dollars
• He tried to recoup his losses by taking even more risky positions,
betting that the Nikkei Stock Exchange would make a rapid recovery; he
believed he could move the market but he lost his bet, worsening his
losses
• They attained an abysmal low ($ 1.4 billion), more than double the
bank’s capital which is now bankrupt because its own capital would be
insufficient to absorb the losses generated by Leeson
 Barings Bank Case Study
Factors that played to Leeson’s advantage:

• In Singapore, Leeson enjoyed great freedom within the local office -

even an internal memo from 1993 proved to have no consequence
• Leeson operated in both the dealing desk (front office) and the back
office. So he confirmed and settled trades transacted by the front office
- which he himself passed
• He was therefore able to hide what he wanted
• The profits brought in by Leeson instilled confidence in management
who lacked knowledge in subtle trading techniques and financial
markets, and therefore did not pose any questions at Leeson
• They did not seem to be aware of the risks incurred by the bank
 Barings Bank Case Study
Factors that played to Leeson’s advantage…
• Leeson made false declarations to regulation authorities which allowed
him to accumulate his losses and to avoid a margin call which should
have audited losses from day to day
• It is true that these false declarations did not attract the attention of
control authorities in Singapore
• Barings benefited from special privileges from the Bank of England (an
exception to the rule that a bank could not lend more that 25% of its
capital to any one entity)
• Nothing was detected by statutory auditors and control interns, despite
the fact that Leeson had hidden certain losses and had forged
documents - both of which should have drawn attention to him. This
proves that the account regulation procedures within the institution
were completely inefficient
 Barings Bank Case Study

Aftermath:

• Feeling that his losses had become to great and seeing that the bank was on the
verge of a crisis, Leeson decided to flee, leaving a note which read “I’m sorry”
• He went to Malaysia, Thailand and finally Germany
• There he was arrested upon landing and extradited back to Singapore on 2nd
March 1995
• He was condemned to six and a half years in prison but was released in 1999
after a diagnosis of colon cancer
• In 1996 he published an autobiography ‘Rogue Trader’ in which he detailed his
acts leading to the collapse of Barings. The book was later made into a film*
starring Ewan McGregor as Leeson

* https://www.youtube.com/watch?v=cxSZzTYpZAg
 ANTI MONEY
LAUNDERING (AML)

20
 Background
• The September 11 attacks in 2001, which led to the Patriot Act in the
U.S. and similar legislation worldwide, led to a new emphasis on money
laundering laws to combat terrorism financing
• The Group of Seven (G7) nations used the Financial Action Task Force
on Money Laundering to put pressure on governments around the
world to increase surveillance and monitoring of financial transactions
and share this information between countries
• Starting in 2002, governments around the world upgraded money
laundering laws and surveillance and monitoring systems of financial
transaction
• Anti-money laundering regulations have become a much larger burden
for financial institutions and enforcement has stepped up significantly
 What is Money Laundering?

• Money laundering is the process by which the proceeds of the crime, and the true
ownership of those proceeds, are concealed or made opaque so that the proceeds
appear to come from a legitimate source
• Generally money laundering is the process by which one conceals the existence,
illegal source, or illegal application of income to make it appear legitimate
• In other words, it is the process used by criminals through which they make “dirty”
money appear “clean” or the profits of criminal activities are made to appear
legitimate
 Money Laundering
Money laundering generally refers to ‘washing’ of the proceedsor
profits generated from:

(i) Drug trafficking

(ii) People smuggling
(iii) Arms, antique, gold smuggling
(iv) Prostitution rings
(v) Financial frauds
(vi) Corruption, or
(vii) Illegal sale of wild life products and other specified predicate
offences
 Money Laundering…

• Money launderers are big time criminals who operate through international networks
without disclosing their identity.
• The money laundered every year could be in the range of $600 bio to $2 trio. This
gives money launderers enormous financial power to engage or coerce or bribe
people to work for them
• Generally, money launderers use professionals to create legal structure/ entities
which act as ‘front’ and use them for laundering of funds
 Money Laundering Process
• Money Laundering consists of three stages:

• The first stage involves the Placement of proceeds derived from

illegal activities – the movement of proceeds, frequently currency,
from the scene of the crime to a place, or into a form, less
suspicious and more convenient for the criminal
• The second stage is called Layering. It involves the separation of
proceeds from illegal source through the use of complex
transactions designed to obscure the audit trail and hide the
proceeds
• Criminals frequently use shell corporations, offshore banks or
countries with loose regulation and secrecy laws for this purpose
 Money Laundering Process…

3. The third stage is called Integration

It represents the conversion of illegal proceeds into apparently legitimate business

earnings through normal financial or commercial operations. Integration creates the
illusion of a legitimate source for criminally derived funds and involves techniques as
numerous and creative as those used by legitimate businesses. For e.g., false invoices
for goods exported, domestic loan against a foreign deposit, purchasing of property
and co-mingling of money in bank accounts.
 The Process

Investments
Purchases

Placement: Illegal funds or assets Layering: Use of multiple Integration: Laundered funds are
are first brought into the financial accounts, banks, intermediaries, made available as apparently
system corporations, trusts, countries to legitimate funds.
disguise the origin.

Important: All money laundering transactions need not go through this three-stage process.
 High Risk countries

Geography:

• Drug producing nations

• Drug transshipment countries
• Drug using countries
• Secrecy jurisdictions and tax havens, particularly those that grant offshore
banking licenses.
• Countries with high degree of public corruption
• Countries linked to terrorist financing
• Non Cooperative Countries and Territories
 Potential high risk customers

• Non-bank financial institutions (money transmitters, security

brokers & dealers etc.)
• Travel agencies / Property dealers/ builders
• Professional and consulting firms
• Exporters or importers of goods and services
• Cash intensive business e.g. retail stores, restaurants, gambling
casinos, second hand car dealerships etc.
• Off-shore corporations, banks in secrecy heavens
• Non-profit organizations, e.g., charities
 High risk products & services

• Wire transfers
• Electronic banking services which includes services offered through internet, credit
cards, stored value cards
• Private banking relationships
• Correspondent banking relationships
 Payment gateways/ wire transfers

• Both domestic and cross border wire transfers carry potential risk of money
laundering
• Payment gateways facilitate wire transfers for customers of banks located anywhere
in the world
• Whether AML/ KYC compliance in place
• Ascertain whether it is regulated at the place of incorporation
• Insist on complete originator information with wire
• Make payment to beneficiary through account or DD
• Keep record of transactions
 Reporting obligations
Reporting of Suspicious Transactions:

• All suspicious transactions whether or not made in cash

• STR should be filed with FIU within seven working days of
establishment of suspicion at the level of Principal Officer

Suspicious transaction means a transaction whether or not made in cash

which, to a person acting in good faith
• gives rise to a reasonable ground of suspicion that it may involve
the proceeds of crime; or
• appears to be made in circumstances of unusual or unjustified
complexity; or
• appears to have no economic rationale or bonafide purpose
 KYC – what does it mean?
Customer?
• One who maintains an account, establishes business relationship, on
who’s behalf account is maintained, beneficiary of accounts maintained
by intermediaries, and one who carries potential risk through one off
transaction

Your? Who should know?

• Branch manager, audit officer, monitoring officials, PO

• Know?
• What you should know?
• True identity and beneficial ownership of the accounts
• Permanent address, registered & administrative address
 KYC – what does it mean…

• Making reasonable efforts to determine the true identity and beneficial ownership of
accounts
• Sources of funds
• Nature of customers’ business
• What constitutes reasonable account activity?
• Who are your customer’s customer?

33
 Core elements of KYC

• Customer Acceptance Policy

• Customer Identification Procedure- Customer Profile
• Risk classification of accounts- risk based approach
• Risk Management
• Ongoing monitoring of account activity
• Reporting of cash and suspicious transactions

34
Know Your Customer (KYC) Guidelines

Customer Acceptance - Ensure that only

legitimate and bona fide customers are
accepted.

Customer Identification- Ensure that

customers are properly identified to
understand the risks they may pose.

Transactions Monitoring- Monitor

customers accounts and transactions to
prevent or detect illegal activities.

Risk Management- Implement processes

to effectively manage the risks posed by
customers trying to misuse facilities.
STRUCTURED
PRODUCTS

34
2
 WHAT ARE STRUCTURED PRODUCTS?
• Structured products are synthetic investment instruments specially
created to meet specific needs that cannot be met from the standardized
financial instruments available in the markets
• Synthetic is the term given to financial instruments that are engineered
to simulate other instruments while altering key characteristics. Often
synthetics will offer investors tailored cash flow patterns, maturities, risk
profiles and so on
• Structured products are designed to facilitate highly customized risk-
return objectives
• This is accomplished by taking a traditional security, such as a
conventional investment-grade bond and replacing the usual payment
features (e.g. periodic coupons and final principal) with non-traditional
payoffs derived not from the issuer's own cash flow, but from the
performance of one or more underlying asset

34
3
 TYPES OF STRUCTURED PRODUCTS
Two of the most well known structured products are:

• Credit Default Swaps (CDS)

• Credit Default Obligations (CDO)

- CDOs caused between $400 to $600 billion of the write-downs

of banks, while the market size of CDSs peaked at $60 trillion
- These two instruments have a well-deserved reputation for being
very technical, but at their core they are simple concepts
- A CDO is a fancy bond, while a CDS is mostly an insurance
policy

34
4
 CREDIT DEFAULT OBLIGATIONS
• A structured financial product that pools together cash flow-generating
assets and repackages this asset pool into discrete tranches that can be
sold to investors
• A collateralized debt obligation (CDO) is so-called because the pooled
assets – such as mortgages, bonds and loans – are essentially debt
obligations that serve as collateral for the CDO
• The tranches in a CDO vary substantially in their risk profile
• The senior tranches are relatively safer because they have first priority
on the collateral in the event of default
• As a result, the senior tranches of a CDO generally have a higher credit
rating and offer lower coupon rates than the junior tranches, which
offer higher coupon rates to compensate for their higher default risk

34
5
 CREDIT DEFAULT OBLIGATIONS…
As many as five parties are involved in constructing CDOs:

• Securities firms, who approve the selection of collateral, structure the

notes into tranches and sell them to investors
• CDO managers, who select the collateral and often manage the CDO
portfolios
• Rating agencies, who assess the CDOs and assign them credit ratings
• Financial guarantors, who promise to reimburse investors for any losses
on the CDO tranches in exchange for premium payments, and
• Investors such as pension funds and hedge funds

34
6
CREDIT DEFAULT SWAPS

34
7
34
8
 Origin of Credit Default Swap
• Exxon needed to open a line of credit to cover potential damages of
five billion dollars resulting from the 1989 Exxon Valdez oil spill
• J. P. Morgan was reluctant to turn down Exxon, which was an old client,
but the deal would tie up a lot of reserve cash to provide for the risk of
the loans going bad
• The new Basel norms limited the amount of lending bankers could do,
the amount of risk they could take on, and therefore the amount of
profit they could make
• But, if the risk of the loans could be sold, it logically followed that the
loans were now risk-free; and, if that were the case, what would have
been the reserve cash could now be freely loaned out
• No need to suck up useful capital

34
9
 Origin of Credit Default Swap…
• In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team,
pitched the idea of selling the credit risk to the European Bank of
Reconstruction and Development
• So, if Exxon defaulted, the E.B.R.D. would be on the hook for it and, in
return for taking on the risk, would receive a fee from J. P. Morgan
• Exxon would get its credit line, and J. P. Morgan would get to honour its
client relationship but also to keep its credit lines intact for other
activities
• The deal was so new that it didn’t even have a name: eventually, they
settled for ‘Credit Default Swap’

35
0
35
1
GOVERNANCE, RISK &
COMPLIANCE
(GRC)

35
2
 Sarbanes-Oxley Act of 2002

• The Sarbanes–Oxley Act of 2002, also known as the ‘Public Company

Accounting Reform and Investor Protection Act’ and ‘Corporate and
Auditing Accountability, Responsibility, and Transparency Act’ and
more commonly called Sarbanes–Oxley or SOX, is a United States
federal law that set new or expanded requirements for all U.S. public
company boards, management and public accounting firms
• The bill was enacted as a reaction to a number of major corporate and
accounting scandals, including Enron and WorldCom
• The sections of the bill cover responsibilities of a public corporation's
board of directors, add criminal penalties for certain misconduct, and
require the Securities and Exchange Commission to create regulations
to define how public corporations are to comply with the law
 Sarbanes-Oxley Act of 2002…

• Enacted by the US Congress on July 30, 2002

• Defined a new paradigm for corporate accountability
• Applies to all companies registered with the Securities and Exchange
Commission (SEC)
• Clearly defines corporate responsibilities
• Audit Committee
• Created a new standard for the design implementation and operation of
an internal control structure
• Sound internal controls are no longer just a best practice; they are
required by law
 Governance, Risk and
Compliance
• GRC is not new or unknown

•Has always been of fundamental concern to

businesses, the financial service industry and to regulators
and supervisors

• Such benefits would outweigh the cost of putting in place

•Enormous benefits
processes, of observing
procedures, GRC that enable effective
and controls
implementation of GRC

35
5
Governance, Risk and Compliance
Governance
• It is all about self discipline

• Process by which the Board of Directors sets the objectives for an

organization and oversees progress towards achieving these objectives

• Involves mainly Shareholders, Management & Board of Directors but

would also encompass employees, suppliers, customers, banks and other
lenders, regulators, etc.

• Accountability of certain individuals, especially in Senior / Top

Management

• The higher the sophistication of the financial system, the higher would be
the demand for governance as regulation and supervision cannot cover all
risk elements in their supervisory processes
35
6
Governance, Risk and Compliance
Common factors in Corporate Governance break-down:
• The Board of Directors fails to understand the risks that the firm was
taking and did not exercise appropriate oversight or questioning of senior
managers’ and employees’ actions

• Conflicts of interest and a lack of independent board members and senior

executives resulted in decisions that benefited a few at the expense of
many

• Internal controls were either weak or non-existent, or appeared to be

adequate on paper but were not implemented in practice

• Internal and external audit ‘fell asleep at the switch’ and failed to detect
fraudulent behaviour, and in some cases even aided and abetted such
behaviour
35
7
Governance, Risk and Compliance
Common factors in Corporate Governance break-down (cont’d):

• Transactions and organizational structures were designed to reduce

transparency and prevent market participants and regulators from
gaining a genuine picture of the firm’s condition

• The corporate culture fostered unethical behaviour and discouraged

questions from being raised

• Senior executives’ compensation pegged to company’s stock price

can tempt them to inflate earnings

35
8
 Governance, Risk and Compliance
• Example 1: Erosion of Ethics

• EBIDTA: Earnings before Earnings before I tricked the dumb

interest expenses, taxes, Auditor
depreciation amortization

• EBIT : Earnings before Earnings before irregularities and

interest tampering
• expenses and taxes
Chief Embezzlement Officer
• CEO: Chief Financial
Normal Andersen Valuation
Officer NAV: Net asset
Eventual Prison Sentence
value
35
9 • EPS: Earnings per share
Governance, Risk and Compliance
Risk Management:

• Identification, assessment, continuous monitoring of risks and risk mitigation

while maximizing returns

• Risks can emanate from areas other than credit, liquidity, market, and
operational – e.g., cross-border, product, legal, reputation

• If managed properly, risks can be confined to the institution concerned

• If not, any one of these risks or a combination can affect a group of financial
institutions or the entire financial services industry thereby creating a systemic
risk
“The financial services industry is famous for privatizing its gains and socializing its losses….”
36
- Martin Wolf, Financial Times journalist
0
Governance, Risk and Compliance
Which Risk Management practices have worked well?
• Role of senior management oversight in assessing and responding to the
changing risk landscape

• Adopting a comprehensive view of all exposures - generally shared

quantitative and qualitative information more effectively across the
organization

• Timing and quality of information flow up to senior management

• Develop in-house expertise to conduct independent assessments of the credit

quality of assets underlying the complex securities to help value their
exposures appropriately

36
• Good liquidity risk management is especially important during periods of
1 financial stress
Governance, Risk and Compliance
Compliance:

• Compliance literally means obedience or dutifulness

• The Compliance function should protect the institution against unlawful

behaviour and strengthen its ethical standards

• Compliance also has a connotation of regulatory and supervisory functions -

that there is an external regulatory or supervisory body to ensure adherence to
norms, guidelines, and rules set by it

36
2
Governance, Risk and Compliance
Underpinning principles of an integrated GRC:

• While ERM adopts a holistic view of different types of risk, GRC implies an
integrated view of governance, compliance and risk

Organizations should:
 broaden their vision of corporate
governance
Risk Compliance Governance
Management
 regard risk management as an integral
part of business decision making
 embrace a new vision of compliance –
regards compliance as an outcome, not a
function

• Objectives across the organization should be aligned to support the mission,

58 business objectives, strategy and values of the organization
Governance, Risk and Compliance
Underpinning principles of an integrated GRC (cont’d):

• Governance, Risk and Compliance objectives should be linked to performance

objectives

• It requires a change management programme with buy-in and contribution

from many departments

• Key GRC enablers are people, processes and technology

59
 GRC – Key
Drivers
Drivers necessitating a strategic GRC focus

• Need for business stability, sustainability

• Desire to keep organizational reputation high
• Compulsion to demonstrate consistent and ethical performance to
stakeholders, investors and customers
• Imperative to instill / enhance public confidence

Far from fulfilling a hazy ideal, a strategic focus on GRC integration can raise the
company’s status in the eyes of investors, improve internal operations and company
data and ultimately increase competitiveness in the market.

Instead of paying lip service, in response to external pressures, the internal organization
must adapt to apply best business principles to manage risk. When this is achieved,
expenditure falls too
– Terry Ernest Jones in The Economist

Industry groups have been started to focus on the GRC area,

e.g., OCEG (Open Compliance and Ethics Group)

60
 Assuring ‘PAT’ in
complex scenarios
Credit risk Operationalrisk Concentration risk
Marketrisk Liquidity risk Reputation risk

Risk Management

Profitability
Customer satisfaction Regulatory
Risk Adjusted Return reporting
on Capital (RAROC) Financial\legal
Economic ValueAdded compliance
(EVA) KYC
Revenue growth AML
Market share Environmental Sox
Market value/ Complexity Internal
Shareholder value compliance
Brand value
Accountability &
Performance
Transparency

Natural calamities, Globalization,

Multiple regulatory authorities, IT security, Consolidation

62
 The imbalance
during turmoil Credit risk
Marketrisk
Operationalrisk
Liquidity risk Regulatory
Concentration risk SEC reporting
Reputation risk SOX Financial\legal
Internal governance compliance
KYC
AML
Sox
Internal
Profitability compliance
Customer satisfaction Accountability &
Risk Adjusted Return Transparency
Environmental
on Capital (RAROC)
Complexity
Economic ValueAdded
(EVA)
Revenue growth
Market share GreedIndulgence
Market value/ Indiscipline
Shareholder value
Brand value
Performance

Natural calamities, Globalization,

Multiple regulatory authorities, IT security, Consolidation

63
 GRC Do’s and
Don’ts
Executives interviewed for this paper have been intimately involved with GRC implementation at their
own companies and as advisers to other companies. Their recommendations on what to do and what to
avoid in implementing a GRC programme are listed below:

DO’S DON’TS
 Bring together  Communicate risk policy  Expect fast results – the  Attempt to consolidate
stakeholders from down to the most junior process of fully integrating GRC “under one roof”:
different business units to members of the organization, GRC into the company allow responsibility to
provide a full picture of effective communication, culture is likely to take be shared across the
risk exposure across the intranets, special years relevant functions
enterprise, and to thrash committees, newsletters, e-
out co-ordinated GRC learning and workshops
plans

 Ensure there is good  Underpin GRC with sound  Overlook HR and  Wait for a damaging
communication between business continuity planning; employment risk: these incident before taking
different security it needs to be understood can pose more danger action (which could
functions (especially IT across the firm and than higher-profile areas have prevented it in
and physical) rehearsed regularly such as financial and the first place)
operational risk

 Focus on gearing IT  Try to guess future crises,

systems to provide while overlooking smaller
executives with GRC risks: the greatest damage
summaries across silos can come from a series of
small events happening
simultaneously

65
 Examples of lack of governance
• Enron*, Orange County,** – all went bust
• Nick Leeson – The Rogue Trader – Barings Bank
• Derivative trading without knowledge and risk management tools
or governance
• Citi Bank, Gurgaon affair ***

* https://www.youtube.com/watch?v=hwollZoVmUc
https://www.youtube.com/watch?v=e5qC1YGRMKI
https://www.youtube.com/watch?v=H2f7FunDuTU (The smartest guys in the
room)
* https://www.applied-corporate-governance.com/case-study/enron-case-
study/
** https://financetrain.com/orange-county-case/
*** https://www.livemint.com/Opinion/boyUkBCBuR0qJtc5pyTTMM/The-
curious-case-of-a-Citibank-fraudster.html
BUSINESS CONTINUITY PLANNING / DISASTER RECOVERY
MANAGEMENT

67
 BCP definition
• Business Continuity Management (BCM) is defined by the Business Continuity
Institute (BCI), UK as a

“holistic management process that identifies potential impacts that

threaten an organization and provides a framework for building
resilience and the capability for an effective response that safeguards
the interests of its key stakeholders, reputation, brand and value
creating activities”

• BCM is the preparedness of an organization to ensure continuity, resumption

and recovery of critical business processes at an agreed level and limit the
impact of the disaster on people, processes and infrastructure
• BCP, therefore, is not merely making arrangements for recovery of IT
infrastructure, but a comprehensive plan that includes people, processes and
non-IT infrastructure such as workspace as well
37
 Objective
of BCP
• The purpose of Business Continuity is to maintain a minimum
level of service while restoring the organization to business as
usual
• An organization which fails to provide a minimum level of
service to its clients following a disaster event may not have a
business to recover
• Customers may go to a competitor
• Funding may disappear

37
 Importance of
BCP in
on banks
Banks
• Much of the commercial activity that we see today is dependent

• Banks, in turn, have turned to increasingly complex technology

and business models to deliver the services expected in this age
of boundary-less commerce
• Sophisticated and interconnected Automated Teller Machine
(ATM), Networks, Tele-banking, Core Banking Solutions and
Internet Banking
• Solutions for seamless customer access are but some of
technologies currently deployed
• Given the above, it is indeed worrying to imagine a scenario
where a disaster may render a bank inoperative for an extended
period of time

37
 BCBS
guidelines
• In keeping with the theme of continuous availability of banking
operations, the Basel Committee on Banking Supervision (BCBS)
released a publication which provided that all banks should have in
place contingency and continuity plans to ensure that they could
continue to operate on an ongoing basis and limit losses in the event of
a severe business disruption
• Banks should identify critical business processes, including
dependencies on third parties or external vendors and identify
alternative mechanisms for resuming service in the event of an outage
• Attention should be paid to the restoration of physical or electronic
records; care should be taken so that back-up are at an adequate
distance from the impacted operations to minimize the risk that back-
up facilities are unavailable
• Banks should periodically review their disaster recovery and business
continuity plans so that they are consistent with current operations

37
 BCP
methodolo
gy

37
 BCP
methodolo
gyof:
This involves the key phases

• Analysis of the current state

• Development of a BCP
• Implementation of BCP

A key aspect, often overlooked in a BCM programme, involves

continuous testing and maintenance of BCP without which the plan
would become obsolete quite quickly

37
 What needs to
be ensured
• Business functions - functions which provide products or services
• Critical support functions - functions without which the business
functions cannot function (e.g. Facilities, IT)
• Corporate level support functions - functions required for
effective operation of Business Functions (e.g. HR, Finance)
• Business continuation processes are designed so the organization
maintains at least a minimum level of service to assure there will
be a business to recover
• Each Business and Support function must have a continuation
plan
• How quickly the process must be functioning depends on the
maximum allowable outage

37
 Rating of
Ris
• Not all risks present theks
same danger to an organization
• Risks are rated based on
- Probability of occurrence
- Impact on the organization

37
 Develop a Business Continuity /
Disaster Recovery Plan
• Establish a disaster-recovery team of employees who know your
business best, and assign responsibilities for specific tasks
• Identify your risks (kinds of disasters you are most likely to
experience)
• Prioritize critical business functions and how quickly these must
be recovered
• Establish a disaster recovery location where employees may work
• off-site and access critical back-up systems, records and supplies
• Obtain temporary housing for key employees, their families
• Update and test plan at least annually

37
 Alternate
Operational
Locations
Determine which alternatives are available

Example:

• A satellite or branch office of the business

• The office of a business partner
• Home or hotel
• Geographic considerations

38
 Back-up Site
requirements
Equip backup operations site with critical equipment, data
files and supplies:

- Power generators
- Computers and software
- Critical computer data files (payroll, accounts payable and
receivable, customer orders, inventory)
- Phones/radios/TVs
- Equipment and spare parts
- Vehicles and spare parts
- Common supplies
- Supplies unique to the business (order forms, contracts, etc.).
- Food

38
 Back-up Site
requirements…
Contact information:
Current and multiple contact information (e.g., home and cell phone
numbers, personal e-mail addresses) for:

- Key employees
- Key customers?
- Important vendors, suppliers, business partners
- Insurance companies
- Is contact information accessible electronically for fast access by all
employees?

38
 Back-up Site
requirements…
Communication:

• Emergency toll-free hotline

• Website
• Cell phones, Satellite phones
• Internet
• E-mail

38
 Train
ing
The training program has two primary goals:

• To assure personnel will be able to efficiently and effectively

respond following a disaster event
• To develop self-confidence in the personnel to perform their
assigned functions

38
 What is a Disaster?

Any natural or man-made event that disrupts the

operations of a business in such a significant way that a
considerable and coordinated effort is required to
achieve a recovery
 DISASTER
RECOVERY PLAN
• Disaster Recovery is an important part of a Bank’s Business
Continuity Plan
• It s a set of processes or procedures that helps prepare for
disruptive events
• The goal of the plan is to recover and protect a business IT
facilities – network, document management system, core banking
system during disruptive events
• They include both natural disaster like floods, earthquake, etc and
major power outages

38
 GOAL
OF DRP
The goal should address items such as:

• What functional areas need to be recovered?

• What length of time is acceptable for recovery?
• What amount of data loss is acceptable?
• This often involves prioritization and a cost-benefit analysis to
determine the worth of recovery
• What are the critical systems?
• What are the key processes and applications?
• What are the dependencies on other systems?

38
 SCO
PE
• The scope of this effort includes people, software, equipment,
and infrastructure
• It is important to look at the ‘big picture’, which includes:
- Impact of the failure
- Probability of failure
- Estimated incidents (failures)
- Annualized loss expectancy
- Cost of mitigation

38
 BCP &
DRP
Differences:

• Business Continuity is PROACTIVE; its focus is to avoid or

mitigate the impact of a risk
• Disaster Recovery is REACTIVE; its focus is to pick up the
pieces and to restore the organization to business as usual after a
risk occurs
• Disaster Recovery is an integral part of a Business Continuity
plan

38
 Industry Standards
Supporting
BCP and
DRP
• ISO 27001: Requirements for Information Security Management Systems. Section
14 addresses Business Continuity Management

• ISO 27002: Code of Practice for Business ContinuityManagement

 Reserve Bank of India
guidelines for Indian Banks
• Senior Management is responsible for prioritizing critical business functions,
allocating knowledgeable personnel and sufficient financial resources to
implement the BCP
• Senior official needs to be designated as the Head of BCP
• All departments to fulfil their respective roles in a co-ordinated manner
• Adequate teams for various aspects of the BCP at CentralOffice,
Zonal/Controlling Office and branch level
• BCP to include measures to identify & reduce probability of risk
• Vulnerabilities should be incorporated into the Business Impact Analysis
• People aspect should be an integral part of a BCP
• Pandemic planning needs to be incorporated as part of BCP framework

https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WREB210111_C
7.pdf
ASSET LIABILITY MANAGEMENT / FUNDS
TRANSFER PRICING
 Definition of ALM

The term ‘asset/liability management’ refers to the processes of

acquiring and deploying funds to maximize net interest income,
and thereby profitability and the value of the bank, while balancing
against related financial risks and constraints

ALM levers:

• Pricing
• Mix Optimization
• Interest Rate Risk
• Liquidity Risk
 Key components of a
Bank Balance Sheet
Liabilities Assets

1. Capital 1. Cash & Balances with

2. Reserve & Surplus Central Bank
3. Deposits 2. Balances with Banks &
Money at Call and Short
4. Borrowings
Notices
5. Other Liabilities
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets
Contingent Liabilities
 Purpose & Objective of ALM
• 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
• It is aimed to stabilize short-term profits, long-term earnings and long-term
sustenance of the bank. The parameters for an ALM system are:

1. Net Interest Income (NII)

2. Net Interest Margin (NIM)
3. Economic Equity Ratio *

* The ratio of the shareholders funds to the total assets measures the shift
in the ratio of owned funds to totals funds. This shows the sustenance capacity
of the bank
 ALM Strategy
• ALM Strategy is the responsibility of the treasurer of the
organization
• But the control of Risk in the Balance Sheet is typically the
mandate of the Risk Management function
• The Asset Liability Management Committee is the traditional
name in the banking industry for what is often known today as
the Senior Risk Committee
• Larger banks may have separate Asset Liability Management
Committee and Senior Risk Committee
 Drivers of Net Interest Income

• Rate (Pricing, credit risk, interest rate risk, liquidity risk)

• Volume of assets and liabilities
• Mix of assets and liabilities
 Net Interest Margin
Net Interest Margin = Interest Income – Interest Expenses

Total Earning assets

Example:
$100 million 5-year fixed-rate loans at 8% = $8 million interest
$90 million 30-day time deposits at 4% = $3.6 million interest
If $10 million is equity
Net interest income = $4.4 million
Net interest margin (NIM) = ($8 - $3.6)/$100 = 4.4%
If interest rates rise 2%, deposit costs will rise in next year but not loan interest
Now, NIM = ($8 - $5.4)/$100 = 2.6%
Basel III compliant Asset Liability Management
/ Funds Transfer Pricing Solution
• The core concepts of Asset Liability Management (ALM) have
remained fairly stable in the past, but with evolving regulations,
Basel III redefines the global standards for bank capital, liquidity
and leverage and has a profound impact on how banks manage
or optimize their balance sheets
• Banks across the world are shifting their focus to liquidity risk
and the ability to integrate data across banking and trading books
on a real-time basis
 Basel III compliant Asset
Liability Management / Funds
Transfer Pricing Solution…
• Basel III establishes new liquidity standards that drive new
balance sheet strategies to limit illiquid assets, restrict
wholesale/unstable sources of funding, and manage higher
funding costs
• The regulations include specific requirements on how the banks
should categorize their HQLA assets, net cash flows, etc.
• It specifies new capital target ratios and new standards for short-
term funding (Liquidity Coverage Ratio) and long-term funding
(Net Stable Funding Ratio)
• This calls for integration of Balance Sheet Management across
capital, liquidity stress testing and planning
BALANCE SHEET MANAGEMENT UNDER BASEL
ACCORDS II AND III
Adequacy of liquidity position for a bank

Analysis of following factors throw light on a bank’s

adequacy of liquidity position:

a. Historical Funding requirement

b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
h. Present and planned capital position
Statement of Structural Liquidity
All Assets & Liabilities to be reported as per their
maturity profile into 8 maturity Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
13
Maturity Pattern of Select Assets & Liabilities of a Bank
Liability/Assets In local In Percentage
currency

I. Deposits 15200 100

a. Up to 1 year 8000 52.63
b. Over 1 yr to 3 yrs 6700 44.08
c. Over 3 yrs to 5 yrs 230 1.51
d. Over 5 years 270 1.78
II. Borrowings 450 100
a. Up to 1 year 180 40.00
b. Over 1 yr to 3 yrs 00 0.00
c. Over 3 yrs to 5 yrs 150 33.33
d. Over 5 years 120 26.67
III. Loans & Advances 8800 100
a. Up to 1 year 3400 38.64
b. Over 1 yr to 3 yrs 3000 34.09
c. Over 3 yrs to 5 yrs 400 4.55
d. Over 5 years 2000 22.72
Iv. Investment 5800 100
a. Up to 1 year 1300 22.41
b. Over 1 yr to 3 yrs 300 5.17
15.52
c. Over 3 yrs to 5 yrs 900
d. Over 5 years 3300 56.90
ALM Organization

• The Board should have overall responsibilities and should set the limit for
liquidity, interest rate, foreign exchange and equity price risk

• The Asset - Liability Committee (ALCO)

• ALCO, consisting of the bank's senior management (including CEO)

should be responsible for ensuring adherence to the limits set by the
Board
• Is responsible for balance sheet planning from risk - return perspective,
including the strategic management of interest rate and liquidity risks
• The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and liabilities
• It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs. floating rate
funds, wholesale vs. retail deposits, money market vs. capital market
funding, domestic vs. foreign currency funding
• It should review the results of and progress in implementation of the
decisions made in the previous meetings
Risks managed under
Asset Liability
Management

16
Liquidity Risk
• Liquidity risk arises from funding of long term assets by short term liabilities,
thus making the liabilities subject to refinancing

Funding • Arises due to unanticipated withdrawals of the

Risk deposits from wholesale or retail clients

• It arises when an asset turns into a NPA. So,

Time Risk the expected cash flows are no longer available
to the bank

• Due to crystallisation of contingent liabilities

Call Risk and inability to undertake profitable business
opportunities when available
 Liquidity Risk
Management
 Bank’s liquidity management is the process of generating funds to meet
contractual or relationship obligations at reasonable prices at all times
 Liquidity Management is the ability of bank to ensure that its liabilities are met
as they become due
 Liquidity positions of bank should be measured on an ongoing basis
 A standard tool for measuring and managing net funding requirements, is the
use of maturity ladder and calculation of cumulative surplus or deficit of
funds as selected maturity dates are adopted

(LIQUIDITY RISK MANAGEMENT IN BANK: A

CONCEPTUAL FRAMEWORK:
https://apps.aima.in/ejournal_new/articlesPDF/Manish-
Kumar.pdf)

18
 Liquidity Risk
Management – Lessons
learnt
• More central coordination and management of business line funding and
liquidity risk profiles
• Better integration of liquidity management and liquidity risk management
into overall enterprise-wide risk management process
• Robust internal pricing of funding and liquidity risks, including the assignment
of liquidity risk premiums in product pricing and business line P&L attribution
• Enhanced internal MIS
• Enhanced contingency funding plans
• More robust liquidity risk stress testing

19
 Liquidity Risk
Management – Lessons
learnt…
• Clear articulation of supervisory expectations on liquidity risk
management
• Enhanced oversight and enforcement ensuring that supervisory
expectations are met
• Strengthening the consistency and robustness of liquidity risk
supervision globally through:
• Use of consistent supervisory metrics and benchmarks for monitoring
the liquidity risk profiles of institutions
• Enhanced communication mechanisms among home and host
supervisors on the liquidity risk profiles of cross-border institutions

20
 Liquidity Risk
Management Best
Practices
• The institution utilizes a proprietary or vendor liquidity simulation
model that evaluates cash flows across time buckets for both assets and
liabilities at a detailed level
• The institution uses a framework which consists of early warning
indicators, ratio analysis, a liquidity maturity ladder, liquidity gap
analysis, and stress testing to quantify liquidity risk exposure
• Stress testing should include both idiosyncratic and systemic scenarios
• The liquidity policy, liquidity contingency plan, and funding should be
consistent with liquidity stress test scenarios
• The assumptions for liquidity stress scenarios, funds transfer pricing
assumptions, NII simulation, and market value of portfolio equity
calculations are consistent

21
 Currency Risk

Management
The increased capital flows from different nations following deregulation have
contributed to increase in the volume of transactions

 Dealing in different currencies brings opportunities as well as risk

 To prevent this, banks have been setting up overnight limits and undertaking
active day time trading

 Value at Risk approach to be used to measure the risk associated with forward
exposures. Value at Risk estimates probability of portfolio losses based on the
statistical analysis of historical price trends and volatilities

22
 Interest
Rate Risk
 Interest Rate risk is the exposure of a bank’s financial conditions
to adverse movements of
• interest rates
 Though this is normal part of banking business, excessive
interest rate risk can pose a significant threat to a bank’s
earnings and capital base
 Changes in interest rates also affect the underlying value of the
bank’s assets, liabilities and
• off-balance-sheet item
 Interest rate risk refers to volatility in Net Interest Income (NII) or
variations in Net Interest Margin(NIM)
 NIM = (Interest income – Interest expense) / Earning assets 23
Risk Measurement
Techniques
Various techniques for measuring exposure of banks to interest rate
risks

• Maturity Gap Analysis

• Duration
• Simulation
• Value at Risk
 Maturity gap method (IRS)

THREE OPTIONS:

• Rate Sensitive Assets > Rate Sensitive Liabilities = Positive Gap

• Rate Sensitive Assets < Rate Sensitive Liabilities = Negative Gap
• Rate Sensitive Assets = Rate Sensitive Liabilities = Zero Gap
 Gap
Analysis
• Simple maturity/re-pricing schedules can be used to generate simple
indicators of interest rate risk sensitivity of both earnings and economic value
to changing interest rates

- If a negative gap occurs (RSA<RSL) in given time band, an increase in

market interest rates could cause a decline in NII

- Conversely, a positive gap (RSA>RSL) in a given time band, a

decrease in market interest rates could cause a decline in NII

• The basic weakness with this model is that this method takes into account
only the book value of assets and liabilities and hence ignores their market
value
 Duration
Analysis
• It basically refers to the average life of the asset or the liability

• It is the weighted average time to maturity of all the preset values of

cash flows

• The larger the value of the duration, the more sensitive is the price of
that asset or liability to changes in interest rates
• Generally, the longer the maturity of the asset, the more sensitive the
asset to changes in interest rates

• As per the above equation, the bank will be immunized from interest
rate risk if the duration gap between assets and the liabilities is zero
Simulatio
n
• Basically simulation models are used to provide what if scenarios - for
example, what if

• The absolute level of interest rates shift

• Marketing plans are under or over achieved
• Margins achieved in the past are not sustained/improved
• Bad debt and prepayment levels change in different interest rate
scenarios
• There are changes in the funding mix e.g., an increasing reliance on
short-term funds for balance sheet growth

• This dynamic capability adds value to this method and improves the
quality of information available to the management
 Basel
IV
• Basel IV refers to updates in the way banks calculate their
capital requirements with the aim of making outcomes
more comparable across banks globally
• It introduces changes that limit the reduction in capital
that can result from banks' use of internal models under
the Internal Ratings-Based approach. This includes:
- A standardised floor, so that the capital requirement will
always be at least 72.5% of the requirement under the
Standardized approach
- A simultaneous reduction in standardised risk weights
for low risk mortgage loans
• Requires banks to meet higher maximum leverage ratios
(an initial leverage ratio maximum is likely to be set as
part of the completion of the Basel III package)
2
 Basel
IV…
• A higher leverage ratio for Global Systemically
Important Banks (G-SIBs), with the increase equal to
50% of the risk adjusted capital ratio
• More detailed disclosure of reserves and other financial
statistics
• These reforms will take effect from January 2022 with
the exception of the output floor, which is phased in,
taking full effect only on 1 January 2027
• British banks alone may have to raise another £50 bn in
capital in order to meet Basel IV requirements

3
The consequences of
Basel IV – QIS
Study

4
 Basel IV

https://assets.kpmg/content/dam/kpmg/xx/pdf/201
8/12/basel-4-an-overview.pdf

5
 MODEL RISK
MANAGEMENT
Machine Learning Governance:

• The ability of machine learning models to read great quantities of

unstructured data, spot patterns and translate it into actionable information
is driving a significant uptake in the technology
• In contrast to traditional statistical models, which are limited in the
number of dimensions they can effectively access, machine learning
models overcome these limitations and can ingest vast amounts of
unstructured data, identify patterns and translate them into actionable
information
• A recent survey conducted by SAS and the Global Association
of Risk Professionals found that, over the next three to five
years,
businesses expect to significantly increase adoption of artificial intelligence
(AI) and machine learning models to support key risk business use cases
42
 MODEL RISK
MANAGEMENT

42
 MODEL RISK
MANAGEMENT
• Banks, for example, are using machine learning models in marketing,
fraud detection and anti-money laundering
• However, the fact that machine learning models need more
governance than other data models is often overlooked
• While machine learning models offer the promise of better
predictions, they may also introduce ethical biases and increased model
risk
• Machine learning models are designed to improve automatically
through experience. This ability to ‘learn’ is what enables greater
machine learning model accuracy and predictability
• At the same time, it can heighten the need to quickly identify when a
model begins to fail

42
 MODEL RISK
MANAGEMENT…
• Looking ahead, the need for effective governance for machine
learning models will only increase
• This is a result of:
- Growing complexities of the global, multidimensional
marketplace
- An increasing volume and complexity of data
- Rapidly increasing model usage by industries
- Growing complexity of machine learning models

42
DODD-FRANK WALL STREET REFORM AND
CONSUMER PROTECTION
ACT

11
 SUMMARY OF THE DODD-
FRANK ACT
• The Dodd-Frank was designed to ensure that a financial crisis like
that in 2008 won't happen again. As such, it sought to attack the
principal problem that policymakers believed had caused the crisis
in the first place -- the growth and proliferation of too-big-to-fail
banks
• It is an Act to promote the financial stability of the United States
by improving accountability and transparency in the financial
system, to protect the American taxpayer by ending bailouts, to
protect consumers from abusive financial services practices, and
for other purposes
• The act increases the amount of capital banks must hold in
reserve, giving the banks an added cushion to absorb loan losses
in future downturns
12
SUMMARY OF THE DODD-FRANK
ACT…
• It similarly requires banks to keep a larger portion of their assets
invested in things that can be easily liquidated in the event of a bank run
-- namely, cash and government securities as opposed to term loans
• Under Dodd-Frank, every bank with more than $50 billion worth
of assets on its balance sheet must submit to annual stress tests
administered by the Federal Reserve, which then determines if they
would survive a hypothetically severe crisis akin to the one in 2008
• Even among the biggest banks, the Dodd-Frank Act makes distinctions.
The biggest among them are classified as global systemically important
banks, or G-SIBs, which must hold an additional tranche of capital,
known as the G-SIB surcharge

https://corpgov.law.harvard.edu/2010/07/07/summary-of-dodd-
frank-financial-regulation-legislation/

13
ASSET LIABILITY MANAGEMENT
/ FUNDS TRANSFER
PRICING
 Definition of ALM

The term ‘asset/liability management’ refers to the processes of

acquiring and deploying funds to maximize net interest income,
and thereby profitability and the value of the bank, while balancing
against related financial risks and constraints

ALM levers:

• Pricing
• Mix Optimization
• Interest Rate Risk
• Liquidity Risk
 Key components of a
Bank Balance Sheet
Liabilities Assets

1. Capital 1. Cash & Balances with

2. Reserve & Surplus Central Bank
3. Deposits 2. Balances with Banks &
Money at Call and Short
4. Borrowings
Notices
5. Other Liabilities
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets
Contingent Liabilities
 Purpose & Objective of ALM
• 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
• It is aimed to stabilize short-term profits, long-term earnings and long-term
sustenance of the bank. The parameters for an ALM systemare:

1. Net Interest Income (NII)

2. Net Interest Margin (NIM)
3. Economic Equity Ratio *

* The ratio of the shareholders funds to the total assets measures the shift
in the ratio of owned funds to totals funds. This shows the sustenance capacity
of the bank
 ALM Strategy
• ALM Strategy is the responsibility the treasurer of the
of organization
• But the control of Risk in the Balance Sheet is typically the
mandate of the Risk Management function
• The Asset Liability Management Committee is the traditional
name in the banking industry for what is often known today as
the Senior Risk Committee
• Larger banks may have separate Asset Liability Management
Committee and Senior Risk Committee
 Drivers of Net Interest Income

• Rate (Pricing, credit risk, interest rate risk, liquidity risk)

• Volume of assets and liabilities
• Mix of assets and liabilities
 Net Interest Margin
Net Interest Margin = Interest Income – Interest Expenses

Total Earning assets

Example:
$100 million 5-year fixed-rate loans at 8% = $8 million interest
$90 million 30-day time deposits at 4% = $3.6 million interest
If $10 million is equity
Net interest income = $4.4 million
Net interest margin (NIM) = ($8 - $3.6)/$100 = 4.4%
If interest rates rise 2%, deposit costs will rise in next year but not loan
interest
Now, NIM = ($8 - $5.4)/$100 = 2.6%
 Basel III compliant Asset Liability
Management / Funds Transfer
Pricing Solution
• The core concepts of Asset Liability Management (ALM) have
remained fairly stable in the past, but with evolving regulations,
Basel III redefines the global standards for bank capital, liquidity
and leverage and has a profound impact on how banks manage
or optimize their balance sheets
• Banks across the world are shifting their focus to liquidity risk
and the ability to integrate data across banking and trading
books on a real-time basis
 Basel III compliant Asset Liability
Management /
Funds Transfer Pricing Solution…
• Basel III establishes new liquidity standards that drive new
balance sheet strategies to limit illiquid assets, restrict
wholesale/unstable sources of funding, and manage higher
funding costs
• The regulations include specific requirements on how the banks
should categorize their HQLA assets, net cash flows, etc.
• It specifies new capital target ratios and new standards for
short-term funding (Liquidity Coverage Ratio) and long-term
funding (Net Stable Funding Ratio)
• This calls for integration of Balance Sheet Management
across
capital, liquidity stress testing and planning
BALANCE SHEET MANAGEMENT UNDER
BASEL ACCORDS II AND III
Adequacy of liquidity position for a bank

Analysis of following factors throw light on a bank’s

adequacy of liquidity position:

a. Historical Funding requirement

b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
h. Present and planned capital position
 Statement of Structural Liquidity
All Assets & Liabilities to be reported as per their
maturity profile into 8 maturity Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
26
 Maturity Pattern of Select Assets & Liabilities of a Bank
Liability/Assets In local In Percentage
currency

I. Deposits 15200 100

a. Up to 1 year 8000 52.63
b. Over 1 yr to 3 yrs 6700 44.08
c. Over 3 yrs to 5 yrs 230 1.51
d. Over 5 years 270 1.78
II. Borrowings 450 100
a. Up to 1 year 180 40.00
b. Over 1 yr to 3 yrs 00 0.00
c. Over 3 yrs to 5 yrs 150 33.33
d. Over 5 years 120 26.67
III. Loans & Advances 8800 100
a. Up to 1 year 3400 38.64
b. Over 1 yr to 3 yrs 3000 34.09
c. Over 3 yrs to 5 yrs 400 4.55
d. Over 5 years 2000 22.72
Iv. Investment 5800 100
a. Up to 1 year 1300 22.41
b. Over 1 yr to 3 yrs 300 5.17
15.52
c. Over 3 yrs to 5 yrs 900
d. Over 5 years 3300 56.90
Organizatio
n
• The Board should have overall responsibilities and should set the limit for
liquidity, interest rate, foreign exchange and equity price risk

• The Asset - Liability Committee (ALCO)

– ALCO, consisting of the bank's senior management (including CEO)

should be responsible for ensuring adherence to the limits set by the
Board
– Is responsible for balance sheet planning from risk - return perspective,
including the strategic management of interest rate and liquidity risks
– The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and liabilities
– It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs. floating rate
funds, wholesale vs. retail deposits, money market vs. capital market
funding, domestic vs. foreign currency funding
– It should review the results of and progress in implementation of the
decisions made in the previous meetings
 Risks managed under
Asset Liability
Management

29
Liquidity Risk
• Liquidity risk arises from funding of long term assets by short term liabilities,
thus making the liabilities subject to refinancing

Funding • Arises due to unanticipated withdrawals of the

Risk deposits from wholesale or retail clients

• It arises when an asset turns into a NPA. So,

Time Risk the expected cash flows are no longer available
to the bank

• Due to crystallisation of contingent liabilities

Call Risk and inability to undertake profitable business
opportunities when available
 Liquidity Risk
Management
 Bank’s liquidity management is the process of generating funds to meet
contractual or relationship obligations at reasonable prices at all times
 Liquidity Management is the ability of bank to ensure that its liabilities
are met as they become due
 Liquidity positions of bank should be measured on an ongoing basis
 A standard tool for measuring and managing net funding requirements,
is the use of maturity ladder and calculation of cumulative surplus or
deficit of funds as selected maturity dates are adopted

(LIQUIDITY RISK MANAGEMENT IN BANK: A

CONCEPTUAL FRAMEWORK:
https://apps.aima.in/ejournal_new/articlesPDF/Manish-
Kumar.pdf)
44
 Liquidity Risk Management –
Lessons learnt
• More central coordination and management of business line funding
and liquidity risk profiles
• Better integration of liquidity management and liquidity risk
management into overall enterprise-wide risk management process
• Robust internal pricing of funding and liquidity risks, including the
assignment of liquidity risk premiums in product pricing and business
line P&L attribution
• Enhanced internal MIS
• Enhanced contingency funding plans
• More robust liquidity risk stress testing

44
 Liquidity Risk Management –
Lessons learnt…
• Clear articulation of supervisory expectations on liquidity risk
management
• Enhanced oversight and enforcement ensuring that supervisory
expectations are met
• Strengthening the consistency and robustness of liquidity risk
supervision globally through:
• Use of consistent supervisory metrics and benchmarks for monitoring
the liquidity risk profiles of institutions
• Enhanced communication mechanisms among home and host
supervisors on the liquidity risk profiles of cross-border institutions

45
 Liquidity Risk Management
Best Practices
• The institution utilizes a proprietary or vendor liquidity simulation
model that evaluates cash flows across time buckets for both assets
and liabilities at a detailed level
• The institution uses a framework which consists of early warning
indicators, ratio analysis, a liquidity maturity ladder, liquidity gap
analysis, and stress testing to quantify liquidity risk exposure
• Stress testing should include both idiosyncratic and systemic scenarios
• The liquidity policy, liquidity contingency plan, and funding should be
consistent with liquidity stress test scenarios
• The assumptions for liquidity stress scenarios, funds transfer pricing
assumptions, NII simulation, and market value of portfolio equity
calculations are consistent

45
 Currency Risk

Management
The increased capital flows from different nations following deregulation have
contributed to increase in the volume of transactions

 Dealing in different currencies brings opportunities as well as risk

 To prevent this, banks have been setting up overnight limits and undertaking
active day time trading

 Value at Risk approach to be used to measure the risk associated with forward
exposures. Value at Risk estimates probability of portfolio losses based on the
statistical analysis of historical price trends and volatilities

45
 Interest
Rate Risk
 Interest Rate risk is the exposure of a bank’s financial conditions to adverse
movements of interest rates

 Though this is normal part of banking business, excessive interest rate risk can
pose a significant threat to a bank’s earnings and capital base

 Changes in interest rates also affect the underlying value of the bank’s assets,
liabilities and off-balance-sheet item

 Interest rate risk refers to volatility in Net Interest Income (NII) or variations
in Net Interest Margin(NIM)

 NIM = (Interest income – Interest expense) / Earning assets

45
Risk Measurement Techniques

Various techniques for measuring exposure of banks to interest rate

risks

• Maturity Gap Analysis

• Duration
• Simulation
• Value at Risk
 Maturity gap method (IRS)

THREE OPTIONS:

• Rate Sensitive Assets > Rate Sensitive Liabilities = Positive Gap

• Rate Sensitive Assets < Rate Sensitive Liabilities = Negative Gap
• Rate Sensitive Assets = Rate Sensitive Liabilities = Zero Gap
 Gap Analysis

• Simple maturity/re-pricing schedules can be used to generate simple

indicators of interest rate risk sensitivity of both earnings and
economic value to changing interest rates

- If a negative gap occurs (RSA<RSL) in given time band, an increase

in market interest rates could cause a decline in NII

- Conversely, a positive gap (RSA>RSL) in a given time band, a

decrease in market interest rates could cause a decline in NII

• The basic weakness with this model is that this method takes into
account only the book value of assets and liabilities and hence ignores
their market value
 Duration Analysis
• It basically refers to the average life of the asset or the liability

• It is the weighted average time to maturity of all the preset values of

cash flows

• The larger the value of the duration, the more sensitive is the price
of that asset or liability to changes in interest rates
• Generally, the longer the maturity of the asset, the more sensitive the
asset to changes in interest rates

• As per the above equation, the bank will be immunized from interest
rate risk if the duration gap between assets and the liabilities is zero
Simulation
• Basically simulation models are used to provide what if scenarios - for
example, what if

– The absolute level of interest rates shift

– Marketing plans are under or over achieved
– Margins achieved in the past are not sustained/improved
– Bad debt and prepayment levels change in different interest rate
scenarios
– There are changes in the funding mix e.g., an increasing reliance on
short-term funds for balance sheet growth

• This dynamic capability adds value to this method and improves the
quality of information available to the management
FUNDS TRANSFER PRICING
 FUNDS TRANSFER
PRICING
• Funds Transfer Pricing (FTP) is a method used to individually
measure how much each source of funding is contributing to the
overall profitability of a firm
• The FTP process is most often used in the banking industry as a
means of outlining the areas of strength and weakness within
the funding of the institution. FTP can also be used to indicate
the profitability of the different product lines, branches, etc.
• The strategy behind FTP is to provide a representation of the
profitability of each funding source based on its operational
needs and the functions of the two primary divisions: lending
and deposits
 FUNDS TRANSFER
PRICING
• The 3 components of Funds Transfer Pricing are the asset
spread, liability spread, and residual spread
• The asset spread (credit spread) is the net interest margin earned
by funds users, generated by assets such as loans, investments,
and fixed assets that receive an FTP charge
• The liability spread (deposit spread) is the net interest margin
earned by funds providers on products that provide funding for
the institution such as savings, checking, CDs, and institution
borrowings that receive an FTP credit
• The residual spread is the margin that your Treasury/Funds
Management group earns by ensuring adequate liquidity and
managing interest rate risk exposure and other risks
FUNDS TRANSFER PRICING
OBJECTIVES
 FUNDS TRANSFER
PRICING
• A commercial bank typically has two major divisions: Lending and
Deposit
• The deposit division acquires funds from customers in the form
of deposits (CASA or TD), that are then passed on to the
Treasury division for proper deployment
• These funds are passed on to the Lending division for lending to
customers as loans. In case of shortage of funds from Deposits for
loans, Treasury procures additional funds from the wholesale market
• The interest earned on loans constitutes Interest Income; the interest
expensed on Deposits is called interest expense and the difference
between the two is called Net Interest Income (which is generally
reported on the income statement)
 FUNDS TRANSFER
PRICING…
• By merely ascertaining the Net Interest Income equation from
the income statement it would seem as though all loans are
profitable and all deposits cause loss
• But this is not the case - each deposit has its own value as a
source for loans and similarly each loan has its own cost of
funding
• The purpose of FTP is to measure individually how each source
of funding contributes to the overall profitability of the bank
 FUNDS TRANSFER
PRICING…
• Funds-transfer pricing can be viewed as the interest payments
charged when one unit lends funds to another
• It is the structure of funds-transfer pricing which moves
interest-rate and liquidity risks between units
• A typical situation in a universal bank is that the retail banking
group takes in deposits and lends them out to retail customers
• The amount of deposits generally exceeds retail loans, so the
excess is given to the bank's ALM desk
 FUNDS TRANSFER PRICING
EXAMPLE
• Take a 2-year loan financed by a 3-month deposit
• Let’s say the Deposit division acquires USD 1 million as funds from
the customer at the cost of 4%
• The funds are then passed on to Treasury at 6% (FTP rate) and earns a
deposit spread of 2% in the process
• Treasury then passes the funds on to the Loan division at 8% (FTP
rate) which gives it to the customer at 11% and earns a deposit spread
of 3%
• In the process, Treasury earns a spread of 2% for managing the
Interest Rate Risk caused due to the mismatch in the maturity of the
funds
• By assigning FTP rate, also called Transfer Price (TP), for both
divisions, we are able to de-compose the spread earned by each
division
TRADITIONAL TRANSFER PRICING
ISSUES…
• This traditional transfer-pricing framework has several negative
consequences
• First, within the retail banking group, there is no clear line
between the profitability of retail loans and deposits
• If the retail group as a whole is profitable, it is not clear whether
the profit is driven by raising cheap funds from deposits or
giving well-priced loans.
• Consequently, it is not clear whether to expand either the deposit
program, the loan program, or both
• Second, the interest rate given to the retail group for their excess
funds tends to be lower than the rate they would have received if
they had been able to lend the funds directly into the interbank
capital market
 MATCHED-FUNDS TRANSFER
PRICING
• To avoid these problems, a transfer-pricing framework is needed
that recognizes the-true value of the funds and concentrates the
interest-rate risk into one unit: the ALM desk
• This can be achieved by matched-funds-transfer pricing
• To introduce matched-funds-transfer pricing, consider an
example using traditional transfer pricing, and then see how
matched-funds-transfer pricing can be introduced to bring clarity
to the risk and profitability
 MATCHED-FUNDS TRANSFER
PRICING…
Consider a traditional bank raising funds in the form of 3-month
deposits (FD) and lending 5-year, fixed-rate loans

If the bank pays 4% for the FDs and receives 11% for the loans,
the nominal net interest margin (NIM) is 7%
This is illustrated in the Figure below:
 MATCHED-FUNDS TRANSFER
PRICING…
The 7% spread between the loans and deposits should cover
• the administrative costs
• the credit loss on the loan, and
• the interest-rate risks due to the mismatch

There are two problems with this situation:

• It is not possible to attribute profitability separately to the loans
and FDs
• There is interest-rate risk because if rates rise to 8% in 3 months,
the bank will find itself with a net interest margin reduced to
only 3%, which would not be enough to cover expenses
MATCHED-FUNDS TRANSFER
PRICING…
In the arrangement shown below, the bank has no interest-
rate risk because the 3-month liabilities are matched with a
3-month asset, and the 5-year loans are matched with a 5-
year liability
Furthermore, we can clearly see the profitability of each
product
 MATCHED MATURITY
MARGINAL FUNDS
• TRANSFER
Assume that a bank PRICING
has issued a short-term time deposit costing 7%
and funded a long term loan yielding 12%
• The deposit costs 100 basis points (bps) less than purchased funds
with a similar maturity, and the loan has a yield 200 bps higher than the
bank would pay for funds of the same maturity
GENERAL RULES FOR MATCHED-FUNDS
TRANSFER PRICING
1st Rule:

• The funding requirements for all transactions are considered to

go through the ALM desk

(This process is illustrated in the figure in the next slide)

• The business units do not just go to the ALM desk for their net
requirements
• Each business unit gives all of its deposits to the ALM desk to
be invested at market rates, and goes to the ALM desk for all its
funding requirements if it wishes to make loans
GENERAL RULES FOR MATCHED-FUNDS
TRANSFER
PRICING…
 GENERAL RULES FOR
MATCHED-FUNDS
2nd Rule: TRANSFER PRICING…
• For every transaction, there is an agreement between the
business unit and the ALM desk about the terms of the asset or
liability
• These terms are the same as would be agreed between the bank
and an external counterparty
• The terms specify the amount, the repricing frequency, the time
for final repayment of the principle, any amortization, any
prepayment options, and the rate, which is the current market
rate
• These terms should mirror the interest-rate characteristics of
the
business unit's transaction with the customer
 GENERAL RULES FOR
MATCHED-FUNDS
TRANSFER PRICING…
3rd rule:

• For each transaction, the business unit receives an asset

(liability) and the ALM desk receives the opposite liability (asset)
GENERAL RULES FOR MATCHED-FUNDS
TRANSFER PRICING…
4th rule:

• The trading unit is a special case

• Like the other units, any transaction between the trading unit
and the ALM desk has the price fixed according to the effective
maturity of the loan
• However, unlike the other business units, the trading unit has
access directly to the interbank market and is not required go to
the ALM desk to match every transaction
 POST 2008 FINANCIAL CRISIS
IMPLICATIONS
• Following the Global Financial crisis, it became apparent that the
increased funding costs for banks had not been priced into
products
• During the global financial crisis, many banks, particularly those
banks heavily funded by wholesale markets, suffered from a
jump in funding costs
 REGULATORY
• COSTS
Link product pricing to regulatory cost
• The most prevalent example of this phenomenon is including
the ‘costs’ of meeting the Liquidity Coverage Ratio (LCR) into
product pricing. The LCR forces banks to hold a portfolio of
high-quality liquid assets (HQLA) yield a comparatively poor
return
• This requirement, along with its status as a binding constraint for
many banks, has led to the LCR being a commonly referenced
regulatory cost in FTP frameworks
• More recently, some banks are looking at incorporating net
stable funding ratio (NSFR) costs into their FTP frameworks as
well
• The NSFR requires long term/ stable funding to be held against
a portion of the asset book and can contribute to a higher
overall funding cost
 REGULATORY
• COSTS…
It should be noted that, once again, incorporating such
regulatory cost into product pricing is not relevant to all banks
• In Asia, for example, an abundance of retail funding ensures that
ratios such as the LCR and NSFR are way over regulatory
minimums, making regulatory cost transfer irrelevant
 CASE STUDY

48
 NORTHERN ROCK

Background:

• Northern Rock was a building society (i.e. a mutually owned savings

and mortgage bank) until its decision to go public and float its shares
on the stock market in 1997
• In spite of its modest origins, Northern Rock had larger ambitions
• From June 1998 to June 2007 (on the eve of its crisis), Northern
Rock’s total assets grew from 17.4 billion pounds to 113.5 billion
pounds
• This growth in assets corresponds to a constant equivalent annual
growth rate of 23.2%, a very rapid rate of growth by any standards

48
 NORTHERN ROCK …

Funding policy:

• Retail deposits only grew from 10.4 billion pounds to 24 billion

pounds
• Retail funding fell to 23% of total liabilities on the eve of thecrisis
• Even in the case of retail deposits, only a small proportion consisted
of the traditional branch-based deposits
• The gap in funding was made up by securitized notes and other forms
of non-retail funding such as interbank deposits and covered bonds

48
 NORTHERN ROCK …

48
 NORTHERN ROCK …

48
 LESSONS LEARNED FROM NORTHERN ROCK
COLLAPSE
• Northern Rock deserves censure for its dangerous business model
• The mortgage lender had grown too fast by raising most of its funds
from the money markets rather than branch deposits
• The balance sheet maturity mismatch of Northern Rock’s balance
sheet proved to be its undoing
• Central bankers had for months been warning about the likelihood of
credit tightening
• The FSA should have paid attention and discouraged Northern Rock
from pursuing its risky strategy
(Refer http://www.imfmetac.org/Upload/Link4_734_106.pdf
for Northern Rock case study) and
https://www.economist.com/briefing/2007/10/18/lessons-of-the-fall

48
 TRADE
FINANCE

48
 AGENDA

1. International Chamber of Commerce/UCP 600

2. Challenges in International Trade
3. Business Cycles & Trade Products
4. Terms of Trade
5. Pre-shipment financing
6. Types of Letters of Credit
7. Types of Guarantees

48
 International Chamber of
Commerce
(ICC)
• ICC has been a driver of global fair trade for almost a century
• The role of the International Chamber of Commerce (ICC) has
become crucial in today’s world due to the ever increasing trade
disputes between countries, traders and banks, and with nations
competing in placing protectionist measures in contravention of
globally-set rules
• The most important ICC rules that help drive global trade are the
uniform customs and practice (UCP) for documentary credit
• This is the most widely used tool and have so far undergone six
revisions, and issuing rules on issuance and use of letters of credit
(LCs)
• Currently, UCP 600 is in vogue across countries and these rules are
implied unless the LC stipulates the contrary

48
 ky

49
 Challenges in
International Trade
• Foreign trade involves much greater risk than home trade. Goods have to be transported over
long distances and they are exposed to perils of the sea. Many of these risks can be covered
through marine insurance but increases the cost of goods
• Another major challenge that international trade faces regularly is on the payment front such as
banks rejecting an LC citing a slew of reasons, which includes inaccurate documentation
• According to the ICC, a whopping 70-75% LCs are rejected by banks globally. This happens due
to the subjectivity with which LC documents are examined, leading to disputes between banks
citing incomplete documentation

49
 Terms of Trade:

There are many modes of payment but the four most

common ones are:

• Advance Payment
• Letter of Credit
• Documentary Collection
• Open Account

49
49
49
49
49
 TYPES OF DOCUMENTARY
COLLECTI
ON against Payment (D/P)
Documents

• Release documents only after buyer’s payment

• Used in Sight Bills
• Also called Cash against Documents (CAD)

Documents against Acceptance (D/A)

• Release documents against buyer’s acceptance

• Usually Usance Bills
• Types of Documentary Collection
49
 Incoterms:

• FAS Free Alongside Ship

• FOB Free on Board
• CFR Cost & Freight
• CIF Cost, Insurance, Freight
• DES / Q Delivered ex ship / ex quay
• DDP / U Delivered, Duty Paid / Unpaid
• EXW Ex-Works / Ex-Factory
• FCA Free on Carrier
• CPT Cost & Freight Paid to a Point
• CIP Cost, Insurance, Freight Paid to a Point
• DAF Delivered at Frontier

49
90
 Pre-Shipment Credit
• Pre-shipment finance is an export finance which is also known as
Packing Credit
• Importers are always reluctant to make advance payments as
advance payments can be risky
• Pre-shipment finance is granted by banks and financial
institutions to the seller or exporter to facilitate manufacturing
of goods
• Pre-shipment finance assists the exporters to procure requisite
factors of production such as labour, raw materials, etc.

91
 Pre-shipment Credit…

92
 Post-shipment Credit…
• Post-shipment finance refers to an advance or a loan extended to
the exporter after the goods have been shipped to the importer
• Receivable finance is a mere discounting of a commercial invoice
and is popular in both domestic as well as cross border trade
whereas, under post-shipment finance transaction, the bank
providing the facility calls for a full of set documents including
the transport document (as a proof of shipment), commercial
invoice, Letter of Credit and draft (as applicable)
• Post shipment finance is more popular in cross border trade
transactions.

93
 Post-Shipment Credit…

94
95
 What is a Letter of Credit?

Definition:

A conditional undertaking given by a bank (issuing bank) at the

request of a customer (applicant) to pay a seller (beneficiary) against
stipulated documents provided all terms and conditions are
complied with

96
 Parties Involved:

Applicant - Buyer / Importer

Beneficiary - Seller / Export
Issuing Bank - Applicant‘s Bank that Issues the LC & undertakes to make the
payment
Advising Bank - A Bank in the Beneficiary‘s country that advises the LC to the
Beneficiary
Confirming Bank - A Bank in Beneficiary‘s country which assumes the risk of
Issuing Bank
Reimbursing Bank - A Bank authorized by the Issuing Bank to reimburse the
bank making payment
Negotiating Bank - A Bank nominated to negotiate documents under the LC

97
 Example

• Assume that there is a transaction between 2 parties A and B

• A is the buyer (importer) and B is the seller (exporter)
• A will open an LC in favour of B. A’s bank will issue the LC and send
it to B’s bank (let us call this Bank 1)
• At this point of time Bank 1 will advise B that they have received an
LC from A’s bank
• In this case, Bank 1 is acting as an advising bank
• Now, as per the terms of the LC, B will have to send the documents
required under the LC to A’s bank
• B can choose to do this through Bank 1 or any other bank of its
choice

98
 Example…

• The bank through which B will proceed to send the documents to A is

called the negotiating bank
• For most cases, the advising bank and the negotiating bank are the
same, since in that case B can just submit the documents to Bank 1
• If, however, the negotiating bank is different from the advising bank
then B would have to collect the LC from Bank 1 and submit the LC
along with the documents to the bank through which it would like to
negotiate the documents

99
100
 Common Documents in LC:

• Bill of Exchange (draft)

• Commercial Invoice
• Transport documents
• Insurance documents

101
 Other common documents:

- Certificate of weight (weight list)

- Packing list
- Inspection certificate (official & non-official)
- Certificate of origin (official & non-official)
- Consular invoice
- Special customs invoice
- Export license - certificate of analysis
- Other certificates or statements

102
 Banks deal in documents only:

• A key principle underlying Letters of Credit is that banks deal

only in documents and not in goods
• The decision to pay under a Letter of Credit is entirely on
whether the documents presented to the bank appear on their
face to be in accordance with the terms and conditions of the
Letter of Credit

103
104
LC Types…

Export and Import LCs:

• LCs are sometimes referred to as Export & Import LCs. But such a classification may
give a misleading impression that there are two types of LCs. An instrument that is
‘Export LC’ for the exporter would be labeled by the importer as ‘Import LC’

Revocable and Irrevocable LCs:

• In the case of Revocable LC, the issuing Bank can cancel or amend the LC without
any notice to the exporter (beneficiary) *
• An Irrevocable LC is one where the issuing Bank cannot go back on its undertaking or
amend or cancel the LC without the consent of thebeneficiary

* Current letter of credit rules, UCP 600, do not cover revocable letters of credit
Fixed and Revolving LCs:

• In the case of a Fixed LC, an exporter can only draw bills up to that amount.
Once the bill is drawn, the limit is reduced automatically by the amount of the
bill
• But under Revolving LC, as and when a bill gets paid, the limit gets reinstated
by the amount of the Bill

Confirmed and Unconfirmed LC:

• If an LC issued by the importer‘s bank carried the confirmation of another

bank in the exporter‘s country, then it is known as a ‘Confirmed LC’
• From the exporter’s point of view, a confirmed LC will give additional
comfort. A bank would just not confirm the LC without carrying out
proper risk assessment vis-à-vis the issuing bank
 LCs for Financing the Middlemen:

• Transferable Letter of Credit

• Back-to-back Letter of Credit

These LCs arise in the case of a transit business. Transit Business

refers to an exporter buying certain goods or commodities from a
number of players and then exporting them. Thus the exporter
happens to be an intermediary between the importer and the actual
manufacturers. For use in such trade, LCs need to have some special
features

107
Transferable LC:

• Transferable credit means a credit that specifically states it is

‘transferable’
• A transferable credit may be made available in whole or in part
to another beneficiary (second beneficiary) at the request of the
beneficiary (first beneficiary)
• An LC which allows the beneficiary to transfer his right to
receive payment to a third party
• Used by middleman, which may be working on narrow margins
or do not carry stock or have limited working capital

108
109
 Risks to applicant:
• As in the case of an ‘ordinary’ LC, possibly greater risk in that second
beneficiary is not known

Risks to second beneficiary:

• Letter of transfer is not an LC

Risks to first beneficiary:

• Second beneficiary does not present compliant documents

110
 Risks to Transferring Bank:

• Operational Risk
• Letter of transfer is not an undertaking to pay
• If first beneficiary fails to submit documents, documents of
second beneficiary can be forwarded to the LC issuing bank

111
 Back to Back LC:

• The issuance of an LC (slave/baby LC) based on the terms of another

LC (master LC) and covering the same goods

• Master LC remains with the middleman’s bank which issues the slave
LC to the second beneficiary

112
 Back-to-Back LC:

There are two separate LCs

• Master LC supports the issuance of the slave LC, but should not be
considered to be a tangible security
• Credit terms may be changed
- Smaller amount / unit price
- Earlier shipment / expiry date
- Shorter presentation period
- Increased insurance cover percentage
- Name of beneficiary

113
114
 Stand-by LC:

• A Stand-by Letter of Credit (SBLC) is a written obligation of an

issuing bank to pay a sum of money to a beneficiary on behalf of its
customer in the event that the customer does not pay the beneficiary

• The standby letter of credit comes from the banking legislation of the
United States, which forbids US credit institutions from assuming
guarantee obligations of third parties. (Most other countries outside of
the USA continue to allow bank guarantees.)

115
Stand-by LC…

Performance Standby:

This instrument supports an obligation to perform other than to pay

money including the purpose of covering losses arising from a default of
the applicant in completion of the underlying transaction

Commercial Standby:

This is the most used standby and it supports the obligations of an

applicant to pay for goods or services in the event of non-payment by a
business debtor
 Red clause Letter of Credit:

• An LC that carries a provision (traditionally written or typed in

red ink) which allows a seller to draw up to a fixed sum from the
advising or paying bank, in advance of the shipment or before
presenting the prescribed documents
• It is normally used only where the buyer and seller have close
working relationship because, in effect, the buyer is extending an
unsecured loan to the seller (and bears the financial risk and the
currency risk)
• Quite rare nowadays, but the red clause LCs were once popular
in fur trade with China and wool trade with Australia

117
 LC - DISCREPANCIES IN DOCUMENTS

Common Discrepancies:

1. Letter of credit has expired

2. Late presentation of documents
3. Late shipment of goods
4. Inconsistent spelling of parties’ names in documents
5. Terms of sale not complied with
6. Merchandise description not strictly as per L/C term
7. Partial shipment or trans shipment effected despite L/C terms
8. Foreign language documents must be exactly as per L/C

118
 LC - DISCREPANCIES IN DOCUMENTS…

Common Discrepancies:

9. Documents are not consistent with one another

10. Ocean Bill of Lading issued by forwarding agent unacceptable
11. Bills of Lading not clean
12. Insurance does not cover risks stipulated in L/C
13. Insurance issued after shipment date
14. Bills of Lading and Drafts not properly endorsed
15. Drafts not completed properly

119
 LC - DISCREPANCIES IN DOCUMENTS…

Major discrepancies:

1. Late shipment
2. Late presentation
3. L/C expired
4. Draft in excess of amount permitted in L/C
5. Bills of Lading incorrectly issued
6. Insurance policy bears a date later than the date of shipment shown on
Bill of Lading

120
 LCs and Blockchain

https://www.youtube.com/watch?v=5wkkIaemSw4&feature
=youtu.be

https://www.youtube.com/watch?v=Uclr6OhQN-M

121
BUSINESS CONTINUITY PLANNING / DISASTER RECOVERY
MANAGEMENT

1
 BCP definition
• Business Continuity Management (BCM) is defined by the Business Continuity Institute
(BCI), UK as a

“holistic management process that identifies potential impacts that

threaten an organization and provides a framework for building
resilience and the capability for an effective response that safeguards
the interests of its key stakeholders, reputation, brand and value
creating activities”

• BCM is the preparedness of an organization to ensure continuity, resumption and recovery

of critical business processes at an agreed level and limit the impact of the disaster on
people, processes and infrastructure
• BCP, therefore, is not merely making arrangements for recovery of IT infrastructure, but a
comprehensive plan that includes people, processes and non-IT infrastructure such as
workspace as well

2
 Objective of BCP

• The purpose of Business Continuity is to maintain a minimum

level of service while restoring the organization to business as
usual
• An organization which fails to provide a minimum level of
service to its clients following a disaster event may not have a
business to recover
• Customers may go to a competitor
• Funding may disappear

3
 Importance of BCP in Banks
• Much of the commercial activity that we see today is dependent
on banks
• Banks, in turn, have turned to increasingly complex technology
and business models to deliver the services expected in this age
of boundary-less commerce
• Sophisticated and interconnected Automated Teller Machine
(ATM), Networks, Tele-banking, Core Banking Solutions and
Internet Banking
• Solutions for seamless customer access are but some of
technologies currently deployed
• Given the above, it is indeed worrying to imagine a scenario
where a disaster may render a bank inoperative for an extended
period of time

4
 BCBS guidelines
• In keeping with the theme of continuous availability of banking
operations, the Basel Committee on Banking Supervision (BCBS)
released a publication which provided that all banks should have in
place contingency and continuity plans to ensure that they could
continue to operate on an ongoing basis and limit losses in the event of
a severe business disruption
• Banks should identify critical business processes, including
dependencies on third parties or external vendors and identify
alternative mechanisms for resuming service in the event of an outage
• Attention should be paid to the restoration of physical or electronic
records; care should be taken so that back-up are at an adequate
distance from the impacted operations to minimize the risk that back-
up facilities are unavailable
• Banks should periodically review their disaster recovery and business
continuity plans so that they are consistent with current operations

5
BCP methodology

6
 BCP methodology
This involves the key phases of:

• Analysis of the current state

• Development of a BCP
• Implementation of BCP

A key aspect, often overlooked in a BCM programme, involves

continuous testing and maintenance of BCP without which the plan
would become obsolete quite quickly

7
 What needs to be ensured

• Business functions - functions which provide products or services

• Critical support functions - functions without which the business
functions cannot function (e.g. Facilities, IT)
• Corporate level support functions - functions required for
effective operation of Business Functions (e.g. HR, Finance)
• Business continuation processes are designed so the organization
maintains at least a minimum level of service to assure there will
be a business to recover
• Each Business and Support function must have a continuation
plan
• How quickly the process must be functioning depends on the
maximum allowable outage

8
 Rating of Risks

• Not all risks present the same danger to an organization

• Risks are rated based on
- Probability of occurrence
- Impact on the organization

9
Operational Risk – Safety Risk Matrix

10
 Develop a Business Continuity / Disaster Recovery Plan

• Establish a disaster-recovery team of employees who know your

business best, and assign responsibilities for specific tasks
• Identify your risks (kinds of disasters you are most likely to
experience)
• Prioritize critical business functions and how quickly these must
be recovered
• Establish a disaster recovery location where employees may work
off-site and access critical back-up systems, records and supplies
• Obtain temporary housing for key employees, their families
• Update and test plan at least annually

11
 Alternate Operational Locations

Determine which alternatives are available

Example:

• A satellite or branch office of the business

• The office of a business partner
• Home or hotel
• Geographic considerations – time zone considerations, etc

12
 Back-up Site requirements

Equip backup operations site with critical equipment, data

files and supplies:

- Power generators
- Computers and software
- Critical computer data files (payroll, accounts payable and
receivable, customer orders, inventory)
- Phones/radios/TVs
- Equipment and spare parts
- Vehicles and spare parts
- Common supplies
- Supplies unique to the business (order forms, contracts, etc.).
- Food

13
 Back-up Site requirements…

Contact information:
Current and multiple contact information (e.g., home and cell phone
numbers, personal e-mail addresses) for:

- Key employees
- Key customers?
- Important vendors, suppliers, business partners
- Insurance companies
- Is contact information accessible electronically for fast access by all
employees?

14
 Back-up Site requirements…

Communication:

• Emergency toll-free hotline

• Website
• Cell phones, Satellite phones
• Internet
• E-mail

15
 Training

The training program has two primary goals:

• To assure personnel will be able to efficiently and effectively

respond following a disaster event
• To develop self-confidence in the personnel to perform their
assigned functions

16
 What is a Disaster?

Any natural or man-made event that disrupts the

operations of a business in such a significant way that a
considerable and coordinated effort is required to
achieve a recovery
 DISASTER RECOVERY PLAN

• Disaster Recovery is an important part of a Bank’s Business

Continuity Plan
• It s a set of processes or procedures that helps prepare for
disruptive events
• The goal of the plan is to recover and protect a business IT
facilities – network, document management system, core banking
system during disruptive events
• They include both natural disaster like floods, earthquake, etc.,
and major power outages

18
 GOAL OF DRP

The goal should address items such as:

• What functional areas need to be recovered?

• What length of time is acceptable for recovery?
• What amount of data loss is acceptable?
• This often involves prioritization and a cost-benefit analysis to
determine the worth of recovery
• What are the critical systems?
• What are the key processes and applications?
• What are the dependencies on other systems?

19
 SCOPE

• The scope of this effort includes people, software, equipment,

and infrastructure
• It is important to look at the ‘big picture’, which includes:
- Probability of failure
- Impact of the failure
- Estimated incidents (failures)
- Annualized loss expectancy
- Cost of mitigation

20
 BCP & DRP

Differences:

• Business Continuity is PROACTIVE; its focus is to avoid or

mitigate the impact of a risk
• Disaster Recovery is REACTIVE; its focus is to pick up the
pieces and to restore the organization to business as usual after a
risk occurs
• Disaster Recovery is an integral part of a Business Continuity
plan

21
 Industry Standards Supporting
BCP and DRP

• ISO 27001: Requirements for Information Security Management Systems. Section

14 addresses Business Continuity Management

• ISO 27002: Code of Practice for Business ContinuityManagement

 Reserve Bank of India guidelines for Indian Banks
• Senior Management is responsible for prioritizing critical business functions,
allocating knowledgeable personnel and sufficient financial resources to
implement the BCP
• Senior official needs to be designated as the Head of BCP
• All departments to fulfil their respective roles in a co-ordinated manner
• Adequate teams for various aspects of the BCP at CentralOffice,
Zonal/Controlling Office and branch level
• BCP to include measures to identify & reduce probability of risk
• Vulnerabilities should be incorporated into the Business Impact Analysis
• People aspect should be an integral part of a BCP
• Pandemic planning needs to be incorporated as part of BCP framework

https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WREB210111_C
7.pdf
 Bank
Frauds
 Fraud landscape in India: An overview

• Banks reported a total fraud of Rs 71,543 crore in 2018-19, a

74% increase as against Rs 41,167 crore in the previous financial
year, according to a report by the Reserve Bank of India
• The number of fraud cases reported by lenders also jumped to
6,801 in 2018-19, compared to 5,916 cases in 2017-18
• "Public sector banks accounted for a bulk of frauds reported in
2018-19 -- 55.4% of the number of cases reported and 90.2% of
the amount involved -- mainly reflecting the lack of adequate
internal processes, people and systems to tackle operational risks,"
the RBI's report on 'Trends and Progress of Banking 2018-19'
showed
 Fraud landscape in India: An overview

• Private sector lenders and foreign banks accounted for 30.7 per
cent and 11.2 per cent, respectively, of the total number of
reported fraud in 2018-19
• Their share in the amount involved in the frauds reported were
7.7 per cent and 1.3 per cent, respectively
• Pareto law applies: A granular analysis in this study reveals that
nearly 80% of all fraud cases involved amounts less than INR 1
lakh, while on an aggregated basis, the amount involved in such
cases was only around 2% of the total amount involved
 Fraud landscape in India: An overview…

• Tax evasion and money laundering

• Black money stashed abroad
• Cybercrime
• Debit/credit card fraud
• Identity theft
• Fake demat accounts
• Benami accounts
• Collusive frauds emanating kickbacks to employee of financial
institutions
• Use of forged instruments such as stamp papers and shares
• Violation of Know Your Customer (KYC) norms
 Key
Findings
Key measures &
trends
 What is contributing to the
rise in fraud?
• Lack of oversight by line managers/ senior manager on deviations from existing
process/controls
• Business pressures to meet unreasonable targets
• Collusion between employees and external parties
• Poor ethical practices
• Inadequate Board oversight
• Ignorance of customers
 Fraud Risks:
Banking
Some examples:
• An individual illegally obtains personal information/documents of another
person and takes a loan in the name of that person
• He/she provides false information about his/her financial status, such as salary
and other assets, and takes a loan for an amount that exceeds his eligible limits
with the motive of non-repayment
• A person takes a loan using a fictitious name and there is a lack of a strong
framework pertaining to spot verifications of address, due diligence of
directors/promoters, pre-sanction surveys and identification of
faulty/incomplete applications and negative/criminal records in client history
• Fake documentation is used to grant excess overdraft facility and withdraw
money
• A person may forge export documents such as airway bills, bills of lading,
Export Credit Guarantee Cover and customs purged numbers/orders issued
by the customs authority
 Fraud Risks:
Banking…
Identity theft - some examples:

• Unauthorized emails asking for account information for updating bank

records are sent by fraudsters
• The customer information is then misused for misappropriating funds
• Access rights for making entries are given to unauthorized people
• Bank employees keep original Fixed Deposit (FD) receipts with
themselves and hand over phony FD receipts to customers. They then
revoke FDs by forging signatures
• Lost/stolen card: It refers to the use of a card lost by a legitimate
account holder for unauthorized/illegal purposes
 Fraud Risks -
Banking…
Some examples:

• Triangulation/Site cloning: Customers enter their card details on

fraudulent shopping sites. These details are then misused
• Hacking: Hackers/fraudsters obtain unauthorized access to the card
management platform of banking system. Counterfeit cards are then
issued for the purpose of money laundering
• Online fraud: Card information is stolen at the time of an online
transaction
• Debit card skimming: A machine or camera is installed at an ATM in
order to pick up card information and PIN numbers when customers
use their cards
• ATM fraud: A fraudster acquires a customer’s card and/or PIN and
withdraws money from the machine
 Fraud Risks -
External
Merchant collusion:

Merchant owners and/or their employees conspiring to commit frauds

using their customers’ accounts and/or personal information

Vendor Risks:
- Outsourced marketing staff
- Overnight storage of cash (actual case)
- Lounge access at airports (actual case)
 Fraud Risks – External
(Vendor)
• A bank had engaged a 3rd party service provider for collecting surplus
cash from the bank’s branches and depositing the cash at Central Bank.
As per contract, the provider should verify the cash for genuineness
before depositing with the Central Bank
• One incidence of fake notes found and the bank was fined close to
USD 100,000
• Incident of engaging an agent to facilitate ‘lounge access at airports’.
Bank expected to pay approx. USD 9 per credit card to the agent.
Dispute arose on interpretation of contract terms resulting in a court
case between the two parties. The verdict went in favor of the agent
and the bank lost USD 1 MN
• Key controls for “detection of suspicious trading activity” failed at an
India outsourcing unit, contributing to USD 2.3-billion loss caused by a
rogue trader of a global banking giant in 2012
(https://www.thehindu.com/business/companies/India-
outsourcing-failure-blamed-for-2.3bn-loss-by-UBS-
trader/article15617120.ece)
 Fraud
Analytics
• Financial institutions need comprehensive analytics to build a strong
bank fraud detection strategy
• Advanced analytics software provides the tools necessary for banks to
recognize and act on suspicious patterns, quickly notify customers of
fraud incidents and position themselves for faster settlements
• Customers with deposit, checking, credit card and personal loan
accounts have usage patterns that deep analytics can combine and check
against its own fraud indicators
• For instance, a bank's fraud prevention system can be set up to trigger a
temporary hold on unusually high transactions until the charges are
confirmed with the account holder
 Fraud
Analytics…
• Information Age reports that pattern analysis of average balances,
number of bounced checks and other customer attributes can help
banks detect potential check fraud
• Bank fraud detection indicators for new accounts might include
application anomalies, unusually high purchases of popular items or
multiple accounts being opened in a short period with similar data,
according to Equifax
• Banks could benefit from a machine learning-based fraud detection
solution in that they would be able to instrument it across more than
one channel of data to be analyzed
Fraud Analytics…
• Teradata* is an AI firm selling fraud detection solutions to banks
• They claim their machine learning platform can enhance banking
fraud detection by helping their data analytics software recognize
potential fraud cases while avoiding acceptable deviations from the
norm
• In other cases, these deviations may be flagged and end up as false
positives that offer the system feedback to “learn” from its mistakes
• Teradata helped Danske Bank modernize their fraud detection
process and reduce their purported 1,200 false positives per day

* World's leading provider of pervasive data intelligence, data

and analytics solutions and hybrid cloud products
Fraud Analytics…
• They were able to:
- reduce their false positives by 60% and were expected to reach
80% as the machine learning model continued to learn
- increase detection of real fraud by 50%
• Anomaly detection-based fraud detection and prevention
solutions are more common than those of predictive and
prescriptive analytics
 Card
Frauds
 India Banking Fraud Survey – Deloitte

https://www2.deloitte.com/content/dam/Deloitte/in/Docu
ments/finance/in-finance-
DeloitteIndiaBankingFraudSurveyIII-noexp.pdf
Financial Regulation / Regtech
 Financial Regulation

• After the 2008 financial crisis, governments across the world were
empowered to push for financial reforms designed to provide greater
transparency of transactions and reduce risk in order to make financial
systems more stable and better regulated, and to make global markets
safer
• These reforms aim at reducing global markets systemic risk by making
them safer
• Regulations involving restructuring banks, increasing tax transparency
or strengthening capital requirements, are being drawn up and rolled out
• These are complex and in many cases overlap products and regional
jurisdiction
 Financial Regulation…

The objectives of financial regulators are usually:

• market confidence – to maintain confidence in the financial system

• financial stability – contributing to the protection and enhancement of
stability of the financial system
• consumer protection – securing the appropriate degree of protection
for consumers
 What is Regtech?

• Regtech is the management of regulatory processes within the financial

industry through technology
• The main functions of Regtech include regulatory monitoring,
reporting and compliance
• Regtech consists of a group of companies that use cloud computing
technology through software-as-a-service (SaaS) to help businesses
comply with regulations efficiently and less expensively
• Regtech is also known as regulatory technology
 What is Regtech?...

• A bank that receives huge amounts of data may find it too complex,
expensive, and time-consuming to comb through
• A regtech firm can combine complex information from a bank with
data from previous regulatory failures to predict potential risk areas that
the bank should focus on
• By creating the analytics tools needed for these banks to successfully
comply with the regulatory body, the regtech firm saves the bank time
and money
• The bank also has an effective tool to comply with rules set out by
financial authorities
• Regtech tools seek to monitor transactions that take place online in real
time to identify issues or irregularities in the digital payment sphere
 Global Banking
Regulatory Radar
 Regulatory Expenses
for Banks
• Globally, banks are spending more than $275 billion a year on
compliance and regulatory obligations, having on average 10–15% of
their staff dedicated to compliance
• By 2021, regulatory costs are expected to rise from 4% to 10% of
revenue, driven primarily by the sheer volume of regulations – each
week sees an average of 45 new regulatory-related documents issued
• The impact of this change on information governance in a financial
institution is profound across all stages – data collection, data
processing, data sharing, and data security
 Banking
Regulations
• Banking Regulation Amendment Bill, 2020: What it means for banks,
customers
https://www.livemint.com/industry/banking/banking-regulation-amendment-
bill-2020-passed-what-it-means-for-banks-customers-11600337144895.html
• Banking Regulation USA:
https://www.globallegalinsights.com/practice-areas/banking-and-finance-laws-
and-
regulations/usa#:~:text=As%20of%20January%202020%2C%20the%20rule%2
0has%20not%20yet%20been%20finalised.&text=Implementing%20a%20major
%20change%20in,IHC%20by%20July%201%2C%202016.
• 2020 Global Bank Regulatory Outlook
https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/banking-and-
capital-markets/ey-global-regulatory-outlook-four-major-themes-dominating-the-
regulatory-landscape-in-2020_v2.pdf
• Key regulatory challenges of 2020:
https://advisory.kpmg.us/content/dam/advisory/en/pdfs/2019/ten-key-
regulatory-challenges.pdf
 Sharpe
Ratio
• The Sharpe ratio was developed by American economist and
Noble laureate William F. Sharpe
• This ratio helps investors understand the risk-adjusted returns of
their investments; in other words, the return on their investments
compared to the risk taken to earn those returns
• The Sharpe ratio is often used to compare the risk-adjusted
returns of various investments such as stocks, mutual funds,
ETFs and investment portfolios
 Sharpe
Ratio…
• The Sharpe ratio tells investors how much, if any, excess return
they can expect to earn for the investment risk they are taking
• Investors should be compensated for taking extra risk beyond
holding risk-free assets
• The Sharpe ratio is often used to judge the performance of
investment managers on a risk-adjusted basis
• In other words, the manager may have delivered very solid,
perhaps even outstanding levels of return over a given time
period
• The question that the Sharpe ratio attempts to answer is how
much risk the manager has assumed to generate those returns.
This can be very important in a down-market environment
 Sharpe
Ratio…
Formula:

Sharpe Ratio Grading Thresholds:

Less than 1: Bad
1 – 1.99: Adequate/good
2 – 2.99: Very good
Greater than 3: Excellent