Unit II

Banking industry in India

How did banks evolve?

The term “Bank” is derived from an Italian word called “Banco”.

Banco means a bench.

Italian merchants placed money for borrowing/lending on a bench

Barter system
No common measure of value

All goods cannot be divided

Perishable goods

No money

Goods exchanged for goods (Barter)

Limitations of barter system

Discovery of money
Commercial Banks
Accept deposits

Make loans to general public

Operate on a “for-profit” basis

Scheduled banks

Non-scheduled banks

Banks in Second schedule of RBI are scheduled banks. Must fulfill RBI criteria to
be recognised as scheduled bank.

Public Sector Banks

Commercial banks in which

majority shareholding is of the

Government (>50%)

Two types:

Nationalised banks
 SBI and its associates

Private Sector Banks

Banks with shareholding of private bodies, institutions and individuals

Managed privately; regulated by RBI

Local Banks

Foreign Banks

Public Sector Bank Private Sector Bank

Majority stake held by Majority stake held by

Government private shareholders

Charge relatively lower Offer higher interest rates

interest rate on loans on loans

Lower service charges Higher service charges

Large customer base Lower customer base

Higher NPAs Low NPAs

Regional Rural Banks (RRBs)

Serve rural regions

Finance and banking support to agriculture and farming

Aim to discourage unorganised and unregulated Institutions

Shareholding
 Central Government – 50%

State Government – 15%

Sponsor Bank – 35%

Co-operative Banks
Established under Co-operative Societies Act.

No profit no loss

Managing committee

manages functioning

Urban co-operative bank

Rural co-operative bank

Small Finance Banks

Finance to small business units, micro and small enterprises, small industries.

Minimum capital: Rs.100 cr

Accepts deposits, lends to unserved and underserved sectors

SLR, CRR requirements applicable

75% of Adjusted Net Bank Credit (ANBC) to priority sector

50% loan portfolio to constitute loans and advances of up to 25 lakh

Examples

Equitas Small Finance Bank, Janalakshmi

Small Finance Bank, AU Small Finance Bank

Payments Banks
 Financial inclusion is the key objective

Payment and remittance services

labour workforce

low income households

unorganised sector entities

Can hold deposits of 1 Lakh per customer

Cannot lend money or issue credit cards

Minimum paid up equity capital: 100 crore

Airtel Payment Bank, Paytm Payment Bank

Asset Liability Management

Asset Liability Management (ALM) can be defined as a mechanism to address the risk
faced by a bank due to a mismatch between assets and liabilities either due to liquidity or
changes in interest rates.

Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting

assets.

Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as
banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or
floating).

Measuring Risk
The function of ALM is not just protection from risk. The safety achieved through ALM
also opens up opportunities for enhancing net worth. Interest rate risk (IRR) largely poses
a problem to a bank’s net interest income and hence profitability. Changes in interest
rates can significantly alter a bank’s net interest income (NII), depending on the extent of
mismatch between the asset and liability interest rate reset times. Changes in interest rates
also affect the market value of a bank’s equity. Methods of managing IRR first require a
bank to specify goals for either the book value or the market value of NII. In the former
case, the focus will be on the current value of NII and in the latter, the focus will be on
 the market value of equity. In either case, though, the bank has to measure the risk
exposure and formulate strategies to minimise or mitigate risk.

The ALM process rests on three pillars:

ALM Information Systems

ALM Organisation

ALM Process

ALM Information Systems

Management Information Systems

Information availability, accuracy, adequacy and expediency

ALM Organisation

Structure and responsibilities

Level of top management involvement

ALM Process

Risk parameters

Risk identification

Risk measurement

Risk management

Risk policies and tolerance levels.

ALM Information Systems

information is the key to the ALM process
 Collecting accurate data in a timely manner will be the biggest challenge before the
banks, particularly those having wide network of branches but lacking full scale
computerisation.

the introduction of base information system for risk measurement and monitoring has to
be addressed urgently.

ALM Organisation
Successful implementation of the risk management process would require strong
commitment on the part of the senior management in the bank, to integrate basic
operations and strategic decision making with risk management.

The Board should have overall responsibility for management of risks and should decide
the risk management policy of the bank and set limits for liquidity, interest rate, foreign
exchange and equity price risks.

The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the limits set by the
Board as well as for deciding the business strategy of the bank (on the assets and
liabilities sides) in line with the bank’s budget and decided risk management objectives.

The ALM Support Groups consisting of operating staff should be responsible for
analysing, monitoring and reporting the risk profiles to the ALCO. The staff should also
prepare forecasts (simulations) showing the effects of various possible changes in market
conditions related to the balance sheet and recommend the action needed to adhere to
bank’s internal limits.

ALM Process
The scope of ALM function can be described as follows: ·

Liquidity risk management

Management of market risks

Trading risk management

Funding and capital planning

 Profit planning and growth projection

Liquidity Risk Management

Measuring and managing liquidity needs are vital for effective operation of commercial
banks.

By assuring a bank’s ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation developing.

GAP Analysis
Maturity Gap Analysis

Duration Gap Analysis

MATURITY GAP ANALYSIS

A maturity/repricing schedule –distribute all interest sensitive assets & liabilities into
time bands.

Time bands

Related to maturities-if fixed interest

Related to next repricing- if floating interest

Relative differences in each time band – represents the sensitivity in that band.
 IMPACT OF INCREASE / DECREASE IN RATE OF INTEREST ON NII
COL1 COL2 COL3 COL4 COL5

Maturity pattern RSL - OUTFLOWS RSA - INFLOWS GAP - RSA - RSL CHANGE IN NII FOR
0.25 % DECREASE

1- 14 DAYS 18785.27 15920.09 -2865.18 7.16

15 - 28 DAYS 31772.55 31161.34 -611.21 1.53
29 DAYS - 3 MTS 68403.39 77914.78 9511.39 (-23.78)
3-6 MONTHS 87629.72 90673.27 3043.55 (-7.61)
6-ONE YEAR 101260.22 98917.23 -2342.99 5.86
ONE - 3 YEARS 108310.71 106316.51 -1994.2 4.99
3-5 YEARS 114558.21 124538.91 9980.7 (-24.95)
ABOVE 5 YRS 134964.33 137905.36 2941.03 -7.35

DURATION GAP ANALYSIS

Duration of a bond effective maturity/weighted average life of a bond calculated based on

present value of the cash flows

Apply sensitivity weight to each time band

The same concept can be used for any kind of asset if the timing and volume of cash
flows and prevailing interest rate is known

Non- performing Asset

An Asset, including a leased asset, becomes an NPA when it ceases to generate income for the
bank. An NPA is a loan or an advance where :

(i) The interest and/ or instalment of principal remain overdue for a period of more than
ninety days in respect of a term loan.

(ii) An account remains ‘out of order’ in respect of an overdraft/ cash credit

(iii) A bill remains overdue for a period of more than ninety days, in the case of bills
purchased and discounted
(iv) An instalment of the principal or the interest thereon remains overdue for two crop
seasons for short duration crops :

(v) An instalment of the principal or the interest thereon remains overdue for one crop season
for long duration crops

‘Out of order’ status

An account is treated as ‘out of order’, if the outstanding balance remains continuously in
excess of the sanctioned limit/ drawing power.

In cases, where the outstanding balance in the operating account is less than the
sanctioned limit/ drawing power, but there are no credits continuously for ninety days as
on the date of balance sheet or credits are not enough to cover the interest debited during
the same period, these accounts should be treated as ‘out of order’.

Asset classification
Categories of NPAs

(a) Substandard Assets – With effect from 31 March 2005, a substandard asset would be one,
which has remained a NPA for a period less than or equal to twelve months.

(b) Doubtful Assets – With effect from 31 March 2005, an asset would be classified as
doubtful if it has remained in the substandard category for a period of twelve months.

(c) Loss Assets – Such an asset is considered as uncollectible.

Prudential norms for managing NPA

Asset classification

Income recognition - If an asset is performing, income can be recognized on accrual basis

but if the asset is non-performing, income should not be recognized on accrual basis but
should be booked only when it is actually received (cash basis).

Provisioning requirements

Impact of Non-Performing Assets on Banks:

 The Non-performing Assets represent idle physical assets in the economy. NPA affects
the profitability, liquidity and the competitive functioning of the banking industry. NPAs
impose a double burden – first while providing for them and the second by putting a
constraint on the bank’s ability to lend further.

The important causes behind the loan accounts turning non-performing are:

i. Political influences and compulsions while sanctioning, rescheduling, restructuring and

recollecting the loans.

ii. Legal environment causing not only delay in recovery of dues but also more geared to
protect borrowers, not lenders.

iii. Directed/Targeted lending towards priority sectors and neglected areas.

iv. Diversion of funds for the purpose other than for what the funds were borrowed.

v. Willful defaults and frauds.

vi. Business failures due to unsuccessful projects, inefficient management, wrong

technology, strained labour relations, product obsolescence etc.

vii. External causes like industrial recession/sickness, natural calamities, changes in

government policies etc.

viii. Inadequate risk management practices.

ix. Moral degradation of borrowers.

Measures to Manage the Non-Performing Advances:

The huge piles of NPAs had continued to be a major drag on the performance of banks.
The large volume of NPAs reflects both a legacy of past dues and an ongoing problem of
fresh accretion.

A number of corrective and preventive measures have been taken

In order to recover NPAs Lok Adalats, debt recovery tribunals, compromise/ settlement
scheme, corporate debt restructuring, asset reconstruction companies, national company
law tribunal, civil courts, credit information bureau have been established from time to
time. Earlier, it has been observed that banks were able to force recovery from smaller
 borrowers but seemed utterly helpless against large borrowers because of such large
willful defaulters taking refuge under the sluggish legal process.

Besides these legal measures, a number of non-legal and preventive measures have been
taken like recovery camps, rehabilitation of sick units, loan compromises, warning
system, circulation of list of defaulters, credit rating, proper follow-up etc.

Management of Non-Performing Assets – An Alternative Solution:

Banks are already taking a number of preventive and corrective measures to reduce the
level of NPAs in their portfolio. But to my mind, there cannot be a quick-fix solution to
solve this problem. What the banks need to do is to adopt a holistic approach and come
out with a detailed plan calling for the different strategies a credit facility passes through.

Banking Sector Reforms

Major Banking Sector Reforms – 1991-92 onwards

Policy Reforms

Prudential norms relating to income recognition, asset classification, provisioning and

capital adequacy were introduced in a phased manner in April 1992.

Guidelines on entry of private sector banks were put in place in January 1993.

The BFS instituted a computerised Off-site Monitoring and Surveillance (OSMOS)

system for banks in November 1995 as a part of crisis management framework for ‘early
warning system’ (EWS) and as a trigger for on-site inspections of vulnerable institutions.

A phased reduction in the SLR was undertaken beginning January 1993. The SLR was
progressively brought down from the peak rate of 38.5 per cent in February 1992 to the
then statutory minimum of 25.0 per cent by October 1997.

The CRR was progressively reduced effective April 1993 from the peak level of 15 per
cent to 4.5 per cent by June 2003. The CRR was subsequently raised in stages to 9.0 per
cent effective August 30, 2008.
The Board for Financial Supervision (BFS) was set up in July 1994 within the Reserve
Bank to attend exclusively to supervisory functions and provide effective supervision in
an integrated manner over the banking system, financial institutions, non-banking
financial companies and other para-banking financial institutions.

Rationalisation of lending interest rates was undertaken begining April 1993, initially by
simplifying the interest rate stipulations and the number of slabs and later by deregulation
of interest rates. Deposit interest rates, other than those on savings deposits and FCNR(B)
were fully deregulated

The Banking Ombudsman Scheme was introduced in June 1995 under the provisions of
the BR Act, 1949.

Rationalisation of lending interest rates was undertaken begining April 1993, initially by
simplifying the interest rate stipulations and the number of slabs and later by deregulation
of interest rates. Deposit interest rates, other than those on savings deposits and FCNR(B)
were fully deregulated

The Banking Ombudsman Scheme was introduced in June 1995 under the provisions of
the BR Act, 1949.

Rationalisation of lending interest rates was undertaken begining April 1993, initially by
simplifying the interest rate stipulations and the number of slabs and later by deregulation
of interest rates. Deposit interest rates, other than those on savings deposits and FCNR(B)
were fully deregulated

The Banking Ombudsman Scheme was introduced in June 1995 under the provisions of
the BR Act, 1949.

The maximum permissible bank finance (MPBF) was phased out from April 1997.

In order to strengthen the capital base of banks, the capital to risk-weighted assets ratio
for banks was raised to 9 per cent from 8 per cent, from year ended March 31, 2000.

With a view to liberalising foreign investment in the banking sector, the Government
announced an increase in the FDI limit in private sector banks under the automatic route
to 49 per cent in 2001 and further to 74 per cent in March 2004, including investment by
FIIs, subject to guidelines issued by the Reserve Bank.

The Banking Codes and Standards Board of India (BCSBI) was set up by the Reserve
Bank as an autonomous and independent body adopting the stance of a self-regulatory
organisation in order to provide for voluntary registration of banks committing to provide
customer services as per the agreed standards and codes.
 A comprehensive policy framework for governance in private sector banks was put in
place in February 2005 in order to ensure that

(i) ultimate ownership and control was well diversified;

(ii) important shareholders were ‘fit and proper’;

(iii) directors and CEO were ‘fit and proper’ and observed sound corporate governance
principles;

(iv) private sector banks maintained minimum capital for optimal operations and for systemic
stability; and

(v) policy and processes were transparent and fair.

The roadmap for the presence of foreign banks in India was drawn up in February 2005.

A mechanism of State level Task Force for Co-operative Urban Banks (TAFCUBs)
comprising representatives of the Reserve Bank, State Government and federation/
association of UCBs was instituted in March 2005 to overcome the problem of dual
control over UCBs.

A risk based supervision (RBS) approach that entails

monitoring according to the risk profile of each institution

was initiated on a pilot basis in April 2004.

Banks were advised to introduce a facility of ‘no frills’ account

with nil or low minimum balances in November 2005.

In January 2006, banks were permitted to utilise the services of non-governmental

organisations (NGOs/ SHGs), micro-finance institutions and other civil society
organisations as intermediaries in providing financial and banking services through the
use of business facilitator and business correspondent (BC) models.

Legal Reforms

The Recovery of Debts Due to Banks and Financial Institutions Act was enacted in 1993,
which provided for the establishment of tribunals for expeditious adjudication and
recovery of non-performing loans. Following the enactment of the Act, debt recovery
tribunals (DRTs) were established at a number of places.
 In order to allow public sector banks to approach the capital market directly to mobilise
funds from the public, an Ordinance was promulgated in October 1993 to amend the
State Bank of India Act, 1955 so as to enable the State Bank of India to enhance the
scope of the provision for partial private shareholding.

Amendments to the Banking Companies (Acquisition and Transfer of Undertakings) Act,

1970/80 were also carried out to allow nationalised banks to have access to the capital
market, subject to the condition that the Government ownership would remain at least at
51 per cent of equity of nationalised bank.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security

Interest (SARFAESI) Act, 2002 was enacted in March, 2002.

Section 42 of the RBI Act was amended in June 2006 to remove the ceiling (20 per cent)
and floor (3 per cent) on the CRR.

Section 24 of the BR Act was amended in January 2007 to remove the floor of 25 per
cent on the SLR to be statutorily held by banks.

Prudential Norms on Capital Adequacy - UCBs

1. Introduction
Capital acts as a buffer in times of crisis or poor performance by a bank. Sufficiency of capital
also instills depositors' confidence. As such, adequacy of capital is one of the pre-conditions for
licensing of a new bank as well as its continuance in business.

2. Statutory Requirements
In terms of the provisions contained in Section 11 of Banking Regulation Act (AACS), no co-
operative bank shall commence or carry on banking business unless the aggregate value of its
paid up capital and reserves is not less than one lakh of rupees. In addition, under Section
22(3)(d) of the above Act, the Reserve Bank prescribes the minimum entry point capital (entry
point norms) from time to time, for setting-up of a new Primary (Urban) Cooperative Bank.

3. Share linking to Borrowings

Traditionally, Primary (Urban) Co-operative Banks (UCBs) have been augmenting their share
capital by linking the same to the borrowings of the members. The Reserve Bank has prescribed
the following share linking norms:
(i) 5% of the borrowings, if the borrowings are on unsecured basis.
(ii) 2.5% of the borrowings, in case of secured borrowings.
(iii) In case of secured borrowings by SSIs, 2.5% of the borrowings, of which 1% is to be
collected initially and the balance of 1.5% is to be collected in the course of next 2 years.
The above share linking norm may be applicable for member's shareholdings up to the limit of
5% of the total paid up share capital of the bank. Where a member is already holding 5% of the
total paid up share capital of an UCB, it would not be necessary for him / her to subscribe to any
additional share capital on account of the application of extant share linking norms. In other
words, a borrowing member may be required to hold shares for an amount that may be computed
as per the extant share linking norms or for an amount that is 5% of the total paid up share capital
of the bank, whichever is lower. All the State Governments have been requested to carry out
necessary amendments to the respective State Co-operative Societies Acts for dispensing with,
wherever applicable, monetary ceilings on individual share holding and restricting the individual
shareholding of a member to 5% of the total paid up share capital of a UCB. Pending amendment
to the State Cooperative Societies Act, UCBs are required to adhere to the above mentioned
share linking to borrowing norms and ceiling on individual share holding
UCBs, which maintain capital to risk-weighted assets ratio (CRAR) of 12 per cent on a
continuous basis, are exempted from the extant mandatory share linking norm with effect from
November 15, 2010.

4. Capital Adequacy Norms

The traditional approach to sufficiency of capital does not capture the risk elements in various
types of assets in the balance sheet as well as in the off-balance sheet business and compare the
capital to the level of the assets.
The Basel Committee* on Banking Supervision had published the first Basel Capital Accord
(popularly called as Basel I framework) in July, 1988 prescribing minimum capital adequacy
requirements in banks for maintaining the soundness and stability of the International Banking
System and to diminish existing source of competitive inequality among international banks. The
basic features of the Capital Accord of 1988 are as under:
(i) Minimum Capital Requirement of 8% by end of 1992.
(ii) Tier approach to capital:
• Core Capital: Equity, Disclosed Reserves
• Supplementary Capital: General Loan Loss Reserves, Other Hidden Reserves,
Revaluation Reserves, Hybrid Capital Instruments and Subordinate Debts
• 50% of the capital to be reckoned as core capital.

(iii) Risk Weights for different categories of exposure of banks ranging from 0% to 127.5%
depending upon the riskiness of the assets as indicated in Annex 1. While commercial loan assets
had a risk weight of 100%, inter-bank assets were assigned 20% risk weight; sovereign paper
carried 0 % risk weight. In 2002, maintenance of capital funds as a percentage of risk weighted
assets was extended to all UCBs. Since 2005, the minimum Capital to Risk Assets Ratio that is
expected to be maintained is 9 percent. Further, vide 1996 amendment to the original Basel
Accord, capital charge was prescribed for market related exposures.
___________________
* The Basel Committee is a committee of bank supervisors drawn from 27 member countries
(Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR,
India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherland, Russia, Saudi Arabia,
Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, United Kingdom, United States of
America). It was sounded in 1974 to ensure international cooperation among a number of
supervisory authorities. It usually meets at the Bank for International Settlements in Basel,
Switzerland where its permanent Secretariat is located.

Capital Funds
'Capital Funds' for the purpose of capital adequacy standard consist of both Tier I and Tier II
Capital as defined in the following paragraphs.

Tier I Capital
Tier I would include the following items:
(i) Paid-up share capital collected from regular members having voting rights.
(ii) Contributions received from associate / nominal members where the bye-laws permit
allotment of shares to them and provided there are restrictions on withdrawal of such shares, as
applicable to regular members.
(iii) Contribution / non-refundable admission fees collected from the nominal and associate
members which is held separately as 'reserves' under an appropriate head since these are not
refundable.
(iv) Perpetual Non-Cumulative Preference Shares (PNCPS). (Please refer to Annex 3 for detailed
guidelines).
(v) Free Reserves as per the audited accounts. Reserves, if any, created out of revaluation of
fixed assets or those created to meet outside liabilities should not be included in the Tier I
Capital. Free reserves shall exclude all reserves / provisions which are created to meet
anticipated loan losses, losses on account of fraud etc., depreciation in investments and other
assets and other outside liabilities. For example, while the amounts held under the head
"Building Fund" will be eligible to be treated as part of free reserves, "Bad and Doubtful
Reserves" shall be excluded.
(vi) Capital Reserve representing surplus arising out of sale proceeds of assets.
(vii) Innovative Perpetual Debt Instruments*
(viii) Any surplus (net) in Profit and Loss Account i.e. balance after appropriation towards
dividend payable, education fund, other funds whose utilisation is defined, asset loss, if any, etc.
(ix) Outstanding amount in Special Reserve created under Section 36(1) (viii) of the Income Tax
Act, 1961 if the bank has created Deferred Tax Liability (DTL) on this reserve.

Tier II Capital
Tier II capital would include the following items:

Undisclosed Reserves
These often have characteristics similar to equity and disclosed reserves. They have the capacity
to absorb unexpected losses and can be included in capital, if they represent accumulation of
profits and not encumbered by any known liability and should not be routinely used for
absorbing normal loss or operating losses.

Revaluation Reserves
These reserves often serve as a cushion against unexpected losses, but they are less permanent in
nature and cannot be considered as 'Core Capital'. Revaluation reserves arise from revaluation of
assets that are undervalued in the bank's books. The typical example in this regard is bank
premises and marketable securities. The extent to which the revaluation reserves can be relied
upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be
placed on estimates of the market value of the relevant assets, the subsequent deterioration in
values under difficult market conditions or in a forced sale, potential for actual liquidation of
those values, tax consequences of revaluation, etc. Therefore, it would be prudent to consider 5
revaluation reserves at a discount of 55 % when determining their value for inclusion in Tier II
Capital i.e. only 45% of revaluation reserve should be taken for inclusion in Tier II Capital. Such
reserves will have to be reflected on the face of the balance sheet as revaluation reserves.

General Provisions and Loss Reserves

These would include such provisions of general nature appearing in the books of the bank which
are not attributed to any identified potential loss or a diminution in value of an asset or a known
liability. Adequate care must be taken to ensure that sufficient provisions have been made to
meet all known losses and foreseeable potential losses before considering any amount of general
provision as part of Tier II capital as indicated above. To illustrate : General provision for
Standard Assets, excess provision on sale of NPAs etc. could be considered for inclusion under
this category. Such provisions which are considered for inclusion in Tier II capital will be
admitted up to 1.25% of total weighted risk assets.
As per the extant instructions, provisions made for NPAs as per prudential norms are deducted
from the amount of Gross NPAs to arrive at the amount of Net NPAs. The prudential treatment
of different type of provisions and its treatment for capital adequacy purposes is given below:
(a) Additional General Provisions (Floating Provisions)
Additional general provisions (floating provisions) for bad debts i.e., provisions not earmarked
for any specific loan impairments (NPAs) may be used either for netting off of gross NPAs or for
inclusion in Tier II capital but cannot be used on both counts
(b) Additional Provisions for NPAs at higher than prescribed rates
In cases where banks make specific provision for NPAs in excess of what is prescribed under the
prudential norms, the total specific provision may be deducted from the amount of Gross NPAs
while reporting the amount of Net NPAs. The additional specific provision made by the bank
will not be reckoned as Tier II capital.
(c) Excess Provisions on Sale of NPAs
In case of sale of NPAs, if the sale proceeds exceed the book value of asset, net of provisions
held, the excess amount of provision should not be written back to Profit and Loss account. For
example, for an NPA of `1,00,000, the bank holds provision of `50,000 (i.e., 50%). If the asset is
sold for `70,000, there will be a loss of `30,000, which will be adjusted against the provision of
`50,000 leaving an excess provision of `20,000 on account of the sale of the NPA. Such excess
provisions should continue to be shown under 'provisions' and would be considered as Tier II
capital subject to the overall ceiling of 1.25% of risk weighed assets.
(d) Provisions for Diminution in Fair Value
In terms of paragraph 5.1 of circular UBD.PCB.BPD.No.53 dated March 6, 2009, banks were
advised that they should hold provisions for restructured advances as per the extant provisioning
norms. In addition to such provisions, banks were advised to make provisions to cover the
economic loss to the bank due to reduction in the rate of interest or reschedulement of repayment
of principal amount of loan restructured. Such additional provisions made for diminution in the
fair value of restructured advances, both in respect of standard assets and NPAs, are permitted to
be netted from the relative loan asset.

Investment Fluctuation Reserve

It includes balance, if any, in the Investment Fluctuation Reserve Fund of the bank.

Hybrid Debt Capital Instruments

Under this category, there are a number of capital instruments, which combine certain
characteristics of equity and certain characteristics of debt. Each has a particular feature which
can be considered to affect its qualification as capital. Where these instruments have close
similarities to equity, in particular, when they are able to support losses on an ongoing basis
without triggering liquidation, they may be included in Tier II capital. The instruments are as
follows:
(i) Tier II Preference Shares: Primary (Urban) Cooperative Banks are permitted to issue
Perpetual Cumulative Preference Shares (PCPS), Redeemable Non Cumulative Preference
Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS) subject to extant
instructions as per Annex 3.
(ii) Long Term (Subordinated) Deposits: UCBs are permitted to raise term deposits for a
minimum period of not less than 5 years, which will be eligible to be treated as lower Tier II
capital. The detailed guidelines are given in Annex 4.
UCBs may issue preference shares and Long Term (Subordinated) Deposits subject to
compliance with their bye-laws / provisions of the Co-operative Societies Act under which they
are registered and with the approval of the concerned Registrar of Co-operative Societies /
Central Registrar of Cooperative Societies concerned.

Subordinated Debt
To be eligible for inclusion in Tier II capital, the instrument should be fully paid-up, unsecured,
subordinated to the claims of other creditors, free of restrictive clauses and should not be
redeemable at the initiative of the holder or without the consent of the banks' supervisory
authorities. They often carry a fixed maturity and as they approach maturity, they should be
subjected to progressive discount for inclusion in Tier II capital. Instruments with an initial
maturity of less than 5 years or with a remaining maturity of one year should not be included as
part of Tier II capital. Subordinated debt instruments will be limited to 50 percent of Tier I
capital.

Other Conditions
It may be noted that the total of Tier II elements will be limited to a maximum of 100 percent of
total Tier I elements for the purpose of compliance with the norms.

Capital for Market Risk

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions
arising from movements in market prices. The market risk positions, which are subject to capital
charge are as under:
 The risks pertaining to interest rate related instruments and equities in the trading book; and
 Foreign exchange risk (including open position in precious metals) throughout the bank (both
banking and trading books).

As an initial step towards prescribing capital requirement for market risks, UCBs were advised to
assign an additional risk weight of 2.5 per cent on investments. These additional risk weights are
clubbed with the risk weights prescribed for credit risk in respect of investment portfolio of
UCBs and banks are not required to provide for the same separately. Further, UCBs were
advised to assign a risk weight of 100% on the open position limits on foreign exchange and gold
and to build up investment fluctuation reserve up to a minimum of 5% of the investments held in
HTM and AFS categories in the investment portfolio.

Returns
Banks should furnish to the respective Regional Offices annual return indicating (i) capital funds,
(ii) conversion of off-balance sheet / non-funded exposures, (iii) calculation of risk weighted
assets, and (iv) calculation of capital funds and risk assets ratio. The format of the return is given
in the Annex 2. The returns should be signed by two officials who are authorized to sign the
statutory returns submitted to Reserve Bank.

Fixed and Floating rates

Determinants of Fixed rate

• Banks generally offer either of the following loan options: Floating Rate Home Loans
and Fixed Rate Home Loans.

• For a Fixed Rate Loan, the rate of interest is fixed either for the entire tenure of the loan
or a certain part of the tenure of the loan.

• In case of a pure fixed loan, the EMI due to the bank remains constant.

• If a bank offers a Loan which is fixed only for a certain period of the tenure of the loan, it
is necessary to elicit information from the bank whether the rates may be raised after the
period (reset clause).

• The customer can try to negotiate a lock-in that should include the rate that you have
agreed upon initially and the period the lock-in lasts.

• Hence, the EMI of a fixed rate loan is known in advance.

• This is the cash outflow that can be planned for at the outset of the loan.

• If the inflation and the interest rate in the economy move up over the years, a fixed EMI
is attractively stagnant and is easier to plan for.

• However, if you have fixed EMI, any reduction in interest rates in the market, will not
benefit you.

Determinants of Floating rate

• The EMI of a floating rate loan changes with changes in market interest rates.
• If market rates increase, your repayment increases.

• When rates fall, your dues also fall. The floating interest rate is made up of two parts: the
index and the spread.

• The index is a measure of interest rates generally (based on say, government securities
prices), and the spread is an extra amount that the banker adds to cover credit risk, profit
mark-up etc.

• The amount of the spread may differ from one lender to another, but it is usually constant
over the life of the loan.

• If the index rate moves up, so does your interest rate in most circumstances and you will
have to pay a higher EMI. Conversely, if the interest rate moves down, your EMI amount
should be lower.

• Also, sometimes banks make some adjustments so that your EMI remains constant.

• In such cases, when a lender increases the floating interest rate, the tenure of the loan is
increased (and EMI kept constant).

• Some lenders also base their floating rates on their Benchmark Prime Lending Rates
(BPLR).

• A customer should ask what index will be used for setting the floating rate, how it has
generally fluctuated in the past, and where it is published/disclosed.

• However, the past fluctuation of any index is not a guarantee for its future behavior.