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BFM MODULE - D  Reserve and Surplus:

The components under this item include
Chapter:26 COMPONENTS OF ASSETS AND statutory reserves, capital reserves, share
LIABILITIES IN BANK’S BALANCE SHEET AND premium, revenue and other reserves and
THEIR MANAGEMENT balance in profit and loss account.
 Deposits: The main source of funds for the
BULLET POINTS banks is deposits.

The deposits are broadly classified as deposits

payable on demand which include current
 COMPONENTS OF A BANK'S BALANCE SHEET:
deposits, overdue deposits, call deposits, etc.
The summarized form and its components are:
Second category is savings bank deposits and
Table 26.1 lastly the term deposits which are repayable
after a specified period, known as fixed
Sources of Funds Application of Funds
deposits, short deposits and recurring deposits.
Capital Cash In Hand and
 Borrowings: Borrowings in India consist of
Balance with RBI
borrowings/refinance obtained from the RBI,
Reserves Balances with Banks other commercial banks and other institutions
and Money at Call and and agencies like IDBI, EXIM Bank of India,
Short Notice NABARD, etc.

Deposits Investments
 Other Liabilities and Provisions: The other
Borrowings Advances liabilities of the bank are grouped into the
following categories:
Other Liabilities and Fixed Assets
 Bills Payable: This includes drafts, telegraphic
provisions
transfers, travelerscheque, mail transfers
Other Assets payable, pay slips, bankers' cheque and other
miscellaneous items.
TOTAL TOTAL
 Inter-Office Adjustments: The credit balance of
the net inter-office adjustments.
 Interest Accrued: The interest accrued but not
 Components of Liabilities
due on deposits and borrowings.
 Capital
 Others: All other liability items like provision
Capital represents the owners' stake in a bank and for income tax, tax deducted at source, interest
it serves as a cushion for depositors and creditors tax, provisions, etc.
to fall back in case of losses. It is considered to be
a long-term source of funds.
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 Components of Assets  Fixed Assets: All fixed assets of a bank, e.g.,
 Cash and Balances with RBI immovable properties, premises, furniture and
fixtures, hardware, motor vehicles are
All cash assets of banks are listed under this
classified into fixed assets.
account and it forms the most liquid account
held by any bank.
 Other Assets: The remainder of the items on
The cash assets consist of the following: the asset side of a bank's balance sheet are
categorized as other assets.
 Cash in Hand: This asset item includes cash in
 Bank's Profit and Loss Account
hand, including foreign currency notes and cash
balances in the overseas branches of the bank. A bank's profit and loss account has following
 Balances with RBI: Cash account also includes the components:
balances held by each hank with RBI in order to
Income: which includes Interest income and
meet statutory cash reserve requirements (CRR)
other income.
and also surplus cash parked with RBI over and
above CRR requirement to meet emergency Expenses: which includes Interest expended,
funding requirements. Operating expenses and Provisions and
 Balances with Banks and Money at Call and Short Contingencies.
Notice: The bank balances include the amount
 WHAT IS ASSET LIABILITY MANAGEMENT?
held by the bank in the current accounts and
Asset Liability Management (ALM) is the act of
term deposit accounts with other banks. Under
planning, acquiring, and directing the flow of
call money market, funds are transacted on an
funds through an organization.
overnight basis and under notice money market,
funds are transacted for a period between 2 days The ultimate objective of this process is to
and 14 days. generate adequate/stable earnings and to
 Investments steadily build an organization’s equity over
time, while taking reasonable and measured
These include investments in government business risks.
securities, approved securities, shares,
debentures and bonds, subsidiaries and/or joint  SIGNIFICANCE OF ASSET LIABILITY
ventures and other investments. MANAGEMENT:
ALM is required to match the assets and
 Advances liabilities and minimize the liquidity as well as
The advances represent the credit extended by a market risk. Asset-liability management can be
bank to its customers, form a major part of the performed on a per-liability basis by matching a
assets for all the banks thereby becoming the specific asset to support each liability.
major source of income for banks.
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 Some of the reasons for growing significance of  Objectives of ALM
Asset Liability Management are:  Price Matching basically aims to maintain
a. Volatility spreads by ensuring that the deployment of
b. Product Innovation liabilities will be at a rate higher than the costs.
c. Regulatory Environment  Liquidity is ensured by grouping the
d. Embedded Options in Assets and Liabilities assets/liabilities based on their maturing
e. Management Recognition profiles.
The gap is then assessed to identify future
 The parameters that are selected for the financing requirements.
purpose of stabilizing Asset Liability
Management of banks are:  ALM AS CO-ORDINATED BALANCE SHEET
 Net Interest Income (NII) MANAGEMENT:
 Net Interest Margin (NIM) The asset liability management function can be
 Economic Equity Ratio viewed in terms of two-stage approach to
balance sheet financial management as follows:
 Net Interest Income (NII)  Stage 1
The impact of volatility on the short-term profit Specific Balance Sheet Management Functions
is measured by Net Interest Income.
 Asset side Management will include:
Net Interest Income = Interest Income -  Reserve position management
Interest Expenses.
 Liquidity management
In order to stabilize short-term profits; banks  Investment/Security Management
have to minimize fluctuations in the NII.  Loan Management
 Fixed-Assets Management
 Net Interest Margin (NIM)
 Liability side Management will include:
Net Interest Margin is defined as net interest  Liability Management
income divided by average total assets.  Reserve Position Management
Net Interest Margin (NIM) = Net Interest  Long-Term Management (Notes and
Income/Average total Assets. Debentures)
 Capital Management
 Economic Equity Ratio

The ratio of the shareholders' funds to the total  Stage 2

assets measures the shifts in the ratio of owned  Income-Expense Functions
funds to total funds. Profit =Interest Income Interest expense -
This ratio assesses the sustenance capacity of the provision for loan loss + non-interest revenue -
bank. non-interest expense - taxes
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 Banks are required to formulate policies to
achieve following objectives of Asset Liability
Management:
 Spread Management
 Loan Quality
 Generating fee income and service charges
 Control of non-interest operating expenses
 Tax Management
 Capital Adequacy

BFM MODULE - D

Chapter 27: CAPITAL ADEQUACY-BASEL NORMS BULLET POINT

BULLET POINT

 INTRODUCTION: Three Pillars of Basel-III

The Revised Basel Framework consists of three-  The Three Pillars of Basel III is given in the form
mutually reinforcing Pillars, viz., minimum capital of a diagram below:
requirements, supervisory review of capital
adequacy, and market discipline.

 SCOPE OF APPLICATION:
The revised capital adequacy norms are applicable
uniformly to all Commercial Banks (except Co-
operative Banks, Local Area Banks and Regional
Rural Banks), both at the solo level (global
position) as well as at the consolidated level.
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 The Basel Capital Adequacy Framework rests  Pillar 3: Market Discipline - which seeks to
on the following three mutually-reinforcing achieve increased transparency through
pillars: expanded disclosure requirements for banks.
 Pillar 1: Minimum Capital Requirements -  Guiding Principles for Banks' Pillar 3 Disclosures
which prescribes a risk-sensitive calculation of
The Basel Committee on Banking Supervision
capital requirements that, for the first time,
(BCBS) has agreed upon the following five
explicitly includes operational risk in addition
guiding principles on Pillar 3 disclosures:
to market and credit risk.
 Pillar 2: Supervisory Review Process (SRP) - Principle 1: Disclosures should be clear.
which envisages the establishment of suitable
Principle 2: Disclosures should be
risk management systems in banks and their
comprehensive.
review by the supervisory authority.
 The Basel Committee has also laid down the Principle 3: Disclosures should be meaningful to
following four key principles in regard to the users.
SRP envisaged under Pillar 2:
Principle 4: Disclosures should be consistent over
Principle 1: Banks should have a process for time.
assessing their overall capital adequacy in
Principle 5: Disclosures should be comparable
relation to their risk profile and a strategy for
across banks.
maintaining their capital levels.
 The Structural Aspects of the ICAAP
Principle 2: Supervisors should review and
evaluate the banks' internal capital adequacy The broad parameters of the ICAAP that the
assessments and strategies, as well as their banks are required to comply with in designing
ability to monitor and ensure their compliance and implementing their ICAAP are:
with the regulatory capital ratios. (a) Every bank to have an ICAAP
Principle 3: Supervisors should expect banks to (b) ICAAP to encompass Firm-wide risk profile
operate above the minimum regulatory capital
ratios and should have the ability to require the  Review of the ICAAP Outcomes: The board of
banks to hold capital in excess of the minimum. directors shall, at least once a year, assess and
document whether the processes relating the
Principle 4: Supervisors should seek to ICAAP implemented by the bank successfully
intervene at an early stage to prevent capital achieve the objectives envisaged by the board.
from falling below the minimum levels required  ICAAP to be an Integral part of the management
to support the risk characteristics of a particular and decision-making culture. This integration
bank and should require rapid remedial action could range from using the ICAAP to internally
if capital is not maintained or restored. allocate capital to various business units, to
having it play a role in the individual credit
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decision process and pricing of products or more  An Illustrative Outline of the ICAAP Document
general business decisions such as expansion
1. What is an ICAAP document?
plans and budgets.
 The Principle of Proportionality: The The ICAAP Document would be a comprehensive
implementation of ICAAP should be guided by paper furnishing detailed information on the
the principle of proportionality. ongoing assessment of the bank's entire spectrum
 ICAAP to be a Forward-looking Process: of risks, how the bank intends to mitigate those
risks and how much current and future capital is
The ICAAP should be forward looking in nature,
necessary for the bank, reckoning other mitigating
and thus, should take into account the expected/
factors.
estimated future developments such as strategic
plans, macro-economic factors, etc., including  The purpose of the ICAAP document is to apprise
the likely future constraints in the availability the Board of the bank on these aspects as also to
and use of capital. explain to the RBI the bank's internal capital
adequacy assessment process and the banks'
 The plan shall outline:
approach to capital management.
a) The bank's capital needs;
b) The bank's anticipated capital utilization; 2. Contents
c) The bank's desired level of capital;
The ICAAP Document should contain the following
d) Limits related to capital;
sections:
e) A general contingency plan for dealing with
divergences and unexpected events.  Executive Summary
 Background
 ICAAP to be a Risk-based Process  Summary of Current and Projected Financial
and Capital Positions
The adequacy of a bank's capital is a function of
 Capital Adequacy
its risk profile. Banks shall, therefore, set their
 Firm-wide Rick Oversight and Specific Aspects
capital targets, which are consistent with their
of Risk Management
risk profile and operating environment.
 Key Sensitivities and Future Scenarios
 ICAAP to include Stress Tests and Scenario  Aggregation and Diversification
Analyses  Testing and Adoption of the ICAAP
As part of the ICAAP, the management of a bank  Use of the ICAAP within the Bank
shall, as a minimum, conduct relevant stress tests  Executive Summary
periodically, particularly in respect of the bank's The purpose of the Executive Summary is to
material risk exposures, in order to evaluate the present an overview of the ICAAP methodology
potential bank to some unlikely but plausible events and results.
or movements in the market conditions that could
have an adverse impact on the bank.
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 Capital Adequacy  Management Actions

This section might start with a description of the This section would elaborate on the
bank's risk appetite, in quantitative terms, as management actions assumed in deriving the
approved by the bank's Board and used in the ICAAP, in particular:
ICAAP.
 The quantitative impact of management actions -
The information provided would include the sensitivity testing of key management actions
following elements: and revised ICAAP figures with management
actions excluded.
a. Timing
 Evidence of management actions implemented in
b. Risks Analysed
the past during similar periods of economic
c. Methodology and Assumptions
stress.
 Firm-wide Risk Oversight and Specific Aspects
 Aggregation and Diversification
of Risk Management
a. Risk Management System in the bank This section would describe how the results of the
b. Off-balance Sheet Exposures with a focus on various separate risk assessments are brought
Securitization together and an overall view taken on capital
c. Assessment of Reputational Risk and Implicit adequacy.
Support
 Testing and Adoption of the ICAAP
d. Assessment of valuation and Liquidity Risk
e. Stress Testing Practices This section would describe the extent of
f. Sound Compensation Practices challenging and testing that the ICAAP has been
 Key Sensitivities and Future Scenarios subjected to.

This section would explain how a bank would be It would thus include the testing and control
affected by an economic recession or downswings processes applied to the ICAAP models and
in the business cycle or markets relevant to its calculations.
activities.
 Use of the ICAAP within the Bank
 Typical scenarios would include:
This section would contain information to
 How an economic downturn would affect:
demonstrate the extent to which the concept of
(a) The bank's capital funds and future earnings; capital management is embedded within the
and bank, including the extent and use of capital
modelling or scenario analyses and stress testing
(b) The bank's CRAR taking into account future
within the bank's capital management policy.
changes in its projected balance sheet.
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 Presentation of the Disclosure Requirements e. Securitization Exposures: Disclosure for
Standardized Approach
The Master Circular on Basel III Regulations issued
f. Market risk in trading Book
by Reserve Bank of India has prescribed the
g. Operational risk
following disclosure :
h. Interest Rate Risk in the Banking Book (IRRBB)
a. Scope of Application i. General Disclosure for exposures related to
b. Capital Adequacy counter party credit risk
c. Credit Risk: Disclosures for Portfolios - Subject
to the Standardized Approach
d. Credit Risk Mitigation: Disclosures for
Standardized approaches

BFM MODULE - D

Chapter: 28 ASSET CLASSIFICATION AND PROVISIONAL NORMS

BULLET POINT

 ASSET CLASSIFICATION: (a) Substandard Assets

Asset classification is a systematic approach to (b) Doubtful Assets
categorizing and managing an organization's
assets. This process involves identifying, (c) Loss Assets
organizing, and managing assets based on their a. Substandard Assets
type, function, and other relevant
characteristics. With effect from 31 March 2005, a substandard
asset would be one, which has remained NPA for
 Definitions: Non-performing Assets a period less than or equal to 12 months.

An asset, including a leased asset, becomes b. Doubtful Assets

non-performing when it ceases to generate
With effect from March 31, 2005, an asset would
income for the bank.
be classified as doubtful if it has remained in the
 Categories of NPAs substandard category for a period of 12 months.

Banks are required to classify non-performing c. Loss Assets

assets into the following three categories, based
A loss asset is one where the bank or internal or
on the period for which the asset has remained
external auditors or the RBI inspection has
non-performing and the realis ability of the dues:
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identified loss but the amount has not been operations (DCCO) etc., the instructions as
written off wholly. specified for such cases shall be applicable
 Conditions for Upgrade
 Accounts with Temporary Deficiencies
 For MSME accounts where aggregate exposure of
In the matter of classification of accounts with the lenders is less than 25 crores:
temporary deficiencies such as non-availability
An account may be considered for upgradation
of adequate drawing power, based on the
to 'standard' only if it demonstrates satisfactory
latest available stock statement, balance
performance during the specified period.
outstanding exceeding the limit temporarily,
non-submission of stock statements and non- 'Specified Period' means a period of one year
renewal of the limits on the due date, etc., from the commencement of the first payment of
banks may be guided by the following interest or principal, whichever is later, on the
guidelines: credit facility with longest period of moratorium
under the terms of restructuring package.
a. Banks should ensure that drawings in the
working capital accounts are covered by the  For all other accounts
adequacy of current assets, since current assets  Standard accounts classified as NPA and NPA
are first appropriated in times of distress. accounts retained in the same category on
b. A working capital borrowable account will restructuring by the lenders may be upgraded
become NPA if such irregular drawings are only when all the outstanding loan / facilities in
permitted in the account for a continuous the account demonstrate 'satisfactory
period of 90 days even though the unit may be performance' 16 during the period from the date
working or the borrower's financial position is of implementation of RP up to the date by which
satisfactory. at least 10 per cent of the sum of outstanding
c. Regular and adhoc credit limits need to be principal debt 17 as per the RP and interest
reviewed/ regularized not later than three capitalization sanctioned as part of the
months from the due date/date of ad hoc restructuring, if any, is repaid ('monitoring
sanction. period').
 Provided that the account cannot be upgraded
Upgradation of Loan Accounts Classified as NPAS
before one year from the commencement of the
 If the borrower in the case of loan accounts first payment of interest or principal (whichever
classified as NPAs pays arrears of interest and is later) on the credit facility with longest period
principal, the account should no longer be of moratorium under the terms of RP.
treated as non-performing and may be classified  PROVISIONING NORMS:
as 'standard' accounts. A non-performing asset (NPA) causes two-fold
 With regard to upgradation of accounts classified impact on the profitability of a bank:-
as NPA due to restructuring, non-achievement of
date of commencement of commercial
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 On one hand, the bank ceases to earn interest on Period for which the Provision
this asset and thus is deprived of its legitimate advance has remained in Requirement
income from the asset. ‘doubtful' category
 On the other hand, the bank is required to make
provisions for this asset, depending on the
classification/ category of the asset and value of Up to one year 25%
security, if any.
One to three years 40%
 Taking into account the time lag between an
accounts becoming doubtful of recovery, the More than three years 100%
banks should make provision against
substandard assets, doubtful assets and loss
assets as mentioned below:

a. Loss Assets c. Substandard Assets

Loss assets should be written off. If loss assets In view of certain safeguards such as escrow
are permitted to remain in the books for any accounts available in respect of infrastructure
reason, 100% of the outstanding should be lending, infrastructure loan accounts, which are
provided for. classified as sub-standard, will attract a
provisioning of 20 per cent instead of the
b. Doubtful Assets
aforesaid prescription of 25 per cent.
(i) 100% of the extent to which the advance is not
 Standard Assets
covered by the realizable value of the security to
which the bank has a valid recourse and the Banks are required to make general provision for
realizable value is estimated on a realistic basis. standard assets at the following rates for the
funded outstanding on global loan portfolio
(ii) In regard to the secured portion, provision may
basis:
be made on the following basis, at the rates
ranging from 25% to 100% of the secured portion a. Farm Credit to agricultural activities and Small
Depending upon the period for which the asset and Micro Enterprises (SMEs) sectors at 0.25 per
has remained doubtful: cent;
b. advances to Commercial Real Estate (CRE)1
Sector at 1.00 per cent;
c. advances to Commercial Real Estate - Residential
Housing Sector (CRE - RH)2 at 0.75 per cent
d. Housing loans extended at teaser rates at 2.00
per cent the provisioning on these assets would
revert to 0.40 per cent after 1 year from the date
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on which the rates are reset at higher rates if the  Some of the Key highlights of the Code are given
accounts remain 'standard'. below:
e. Restructured advances as stipulated in the  The Code proposes to cover Insolvency of
prudential norms for restructuring of individuals, unlimited liability partnerships,
advances. Limited Liability partnerships (LLPs) and
 Provisioning Coverage Ratio companies.
 Bankrupt individuals would be barred from
Provisioning Coverage Ratio (PCR) is essentially
contesting elections.
the ratio of provisioning to gross non-
 Under the new law, a debtor could be jailed for
performing assets and indicates the extent of
up to five years for concealing property or
funds a bank has kept aside to cover loan
defrauding creditors.
losses.
 It will strengthen hands of lenders to recover
 Central Repository of Information on Large outstanding debts by setting a deadline of 180
Credits (CRILC) days for companies to pay or face liquidation.
RBI has set up a Central Repository of  To create Insolvency Professionals who will
Information on Large Credits (CRILC) to collect, specialize in such cases, assist creditors, manage
store, and disseminate credit data to lenders. liquidation process.
 It will also create good data base and from this
 Insolvency and Bankruptcy Code, 2016 (IBC) dissemination of information is possible related
The Insolvency and Bankruptcy Code, 2016 (IBC) to the debtors.
enacted on May 28, 2016, against the backdrop  Concept of Bad Bank
of mounting non-performing loans, with a view  A bad bank is a financial entity set up to buy
to establishing a consolidated framework for Non-Performing Assets (NPAs), or Bad Loans,
insolvency resolution of corporations, from banks.
partnership firms and individuals in a time-  The aim of setting up a bad bank is to help ease
bound manner, seeks to tackle the non- the burden on banks by taking bad loans off their
performing assets (NPAs). balance sheets and get them to lend again to
customers without constraints.
The code includes the best practices following
 A bad bank makes a profit in its operations if it
from around the world including USA and UK
manages to sell the loan at a price higher than
with regard to insolvency and bankruptcy.
what it paid to acquire the loan from a
 The three class targets commercial bank.
 Generating profits is usually not the primary
The IBC sets out three classes of persons who can
purpose of a bad bank - the objective is to ease
trigger the corporate insolvency resolution
the burden on banks, of holding a large pile of
process (CIRP) financial creditors, operational
stressed assets, and to get them to lend more
creditors and corporate debtors.
actively.
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 NATIONAL ASSET RECONSTRUCTION COMPANY  If the bad bank is unable to sell the bad loan, or
LIMITED” (NARCL). has to sell it at a loss, then the government
 The name given for the bad bank "National Asset guarantee will be invoked and the difference
Reconstruction Company Limited” (NARCL). between what the commercial bank was
 NARCL has already been incorporated under the supposed to get and what the bad bank was able
Companies Act. It will acquire stressed assets to raise will be paid from the Rs 30,600 crore that
worth about Rs 2 lakh crore from various has been provided by the government.
commercial banks in different phases.
 The NARCL will first purchase bad loans from
banks. It will pay 15% of the agreed price in cash
and the remaining 85% will be in the form of
"Security Receipts". When the assets are sold,
with the help of IDRCL, the commercial banks will
be paid back the rest.

Current Provisioning:

Asset Classification Provisioning (%)

Sub-standard (secured) 15%

Sub-standard (unsecured) 25%

Sub-standard (unsecured) 20%

Infrastructure loans

Doubtful I Secured portion 25%

(Up to 1 year)
Unsecured portion 100%

Doubtful II Secured portion 40%

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(1 year + & Up to 3 years) Unsecured portion 100%

Doubtful III Secured portion 100%

(3 year +)
Unsecured portion 100%

Loss 100%

Accelerated Provisioning:

NOTE:

A high level of unhedged foreign currency exposures of the entities can increase the probability of
default in times of high currency volatility. Hence, banks are required to estimate the riskiness of
unhedged position of their borrowers as per the instruction contained in RBI circular DBOD.
No.BP.BC.85/21.06.200/2013-14 dated January 15, 2014 as well as circular
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DBOD.NO.BP.BC.116/21.06.200/20113-14 dated June 3, 2014 and make incremental provisions on their
exposures to such entities.

 Other Disclosure Requirements

In addition to the above disclosure requirements,

banks are required to make the following
disclosure in respect of the composition of capital:

 Full Terms and Conditions: banks are required

to make available on their websites the full
terms and conditions of all instruments
included in regulatory capital.
 Banks are required to keep the terms and
conditions of all capital instruments up-to-date
in the prescribed form.
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BFM MODULE - D of deposits)/non-renewal of deposits (wholesale
and retail), arises due to:
Chapter 29: INTEREST RATE RISK
 Fraud causing substantial loss
MANAGMENT
 Systemic risk
BULLET POINT  Loss of confidence
 Liabilities in foreign currencies
 DIMENSIONS AND ROLE OF LIQUIDITY RISK
MANAGEMENT: b. Time Risk: Need to compensate for non-receipt
A Bank's liquidity management is the process of of expected inflows of funds, arises due to:
generating funds to meet its contractual or  Severe deterioration in the asset quality
relationship obligations at reasonable prices at  Standard assets turning into non-performing
all times. assets and/or borrowers' defaulting to repay as
Effective liquidity management by a bank serves per the terms of repayment
the following important purposes:  Temporary problems in recovery
 Time involved in managing liquidity
a. It demonstrates the market place that the bank is
safe and therefore capable of repaying its c. Call Risk: Crystallization of contingent liabilities
borrowings. and inability to undertake profitable business
b. It enables bank to meet its prior loan initiatives when desirable, arises due to:
commitments, whether formal or informal.  Conversion of non-fund based limit into fund-
c. It enables the bank to avoid unprofitable sale of based
assets. This function permits the bank to avoid
 Swaps and options
sale funds.  MEASURING AND MANAGING LIQUIDITY RISK:
d. It lowers the size of the default risk premium the
bank must pay for funds. The following steps are necessary for managing
 Types of Liquidity risks liquidity risk in banks:
 External liquidity risks can be geographic, 1. Developing a structure for managing liquidity
systemic or instrument-specific. risk
 Internal liquidity risk relates largely to
perceptions of an institution in its various 2. Setting tolerance level and limit for liquidity
markets: local, regional, national or risk
international. 3. Measuring and managing liquidity risk
 Other categories of liquidity risk are:
 Measuring and Managing Liquidity Risk
a. Funding Risk: Need to replace net outflows due
to unanticipated withdrawal (pre-mature closure Measuring and managing funding requirement can
be done through two approaches.
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(i) Stock approach B. Managing market access
C. Contingency planning
(ii) Flow approach

 Stock Approach (to Measuring and Managing  A. Measuring and Managing Net Funding
Liquidity) Requirements
 In this method, net funding requirement is
Stock approach is based on the level of assets
calculated on the basis of residual maturities of
and liabilities as well as off-balance sheet
assets and liabilities.
exposures on a particular date.
 These residual maturities will represent the net
 The following ratios are calculated to assess the cash flow, i.e., difference of outflow and inflow
liquidity position of a bank :- of cash in the future time buckets.
a. Ratio of Core Deposit to Total Assets Core  These aspects will be elaborated under the
Deposit/Total Assets following heads:-
b. Net Loans to Totals Deposits Ratio - Net i. The Maturity Ladder
Loans/Total Deposits: ii. Alternative Scenarios
c. Ratio of Time Deposits to Total Deposits Time iii. Measuring Liquidity over the Chosen Time-
Deposits/Total Deposits frame
d. Ratio of Volatile Liabilities to Total Assets - iv. Assumptions used in Determining Cash Flows
Volatile Liabilities/Total Assets
(i) The Maturity Ladder: A maturity ladder should
e. Ratio of Short-Term Liabilities to Liquid Assets -
be used to compare a bank's future cash inflows
Short-term Liabilities/Liquid Assets
to its future cash outflows over a series of
f. Ratio of Liquid Assets to Total Assets Liquid
specified time periods.
Assets/Total Assets
g. Ratio of Short-Term Liabilities to Total Assets As a preliminary step to constructing the
Short-term Liabilities/Total Assets maturity ladder, cash inflows can be ranked by
h. Ratio of Prime Asset to Total Asset-Prime the date on which assets mature or a
Asset/Total Assets conservative estimate of when credit lines can be
i. Ratio of Market Liabilities to Total Assets drawn down.
Market Liabilities/Total Assets
Similarly, cash outflows can be ranked by the
 Flow Approach (to Measuring and Managing
date on which liabilities fall due, the earliest date
Liquidity)
a liability holder could exercise an early
The framework for assessing and managing repayment option, or the earliest date
bank liquidity through flow approach has three contingencies can be called.
major dimensions:
(ii) Alternative Scenarios: This involves evaluating
A. Measuring and managing net funding whether a bank has sufficient liquidity and
requirements
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depends in a large measure on the behavior of renewed, and new assets acquired, thus reducing
cash flows under different conditions. contractual cash inflows.

There may be three scenarios for a bank in  Determining the level of a bank's potential assets
connection with management of liquidity, which involves answering three questions:
provide useful benchmarks: -  What proportion of maturing assets will a bank
be able and willing to roll over or renew?
(a) General Market Conditions
 What is the expected level of new loan
(b) Bank-specific Crisis requests that will be accepted?
(c) General Market Crisis  What is the expected level of drawdowns of
commitments to lend that a bank will need to
(iii) Measuring Liquidity over the Chosen fund?
Timeframe: The evolution of a bank's liquidity  In determining the marketability of assets, the
profile under one or more scenarios can be approach segregates the assets into three
tabulated or portrayed graphically, by cumulating categories by their degree of relative liquidity:-
the balance of expected cash inflows and cash  The most liquid category includes components
outflows at several time points. such as cash, securities, and interbank loans.
For example, a high-quality institution may look  A less liquid category comprises a bank's
very liquid in a going-concern scenario, marginally saleable loan portfolio.
liquid in a bank-specific crisis and quite liquid in a  The least liquid category includes essentially
general market crisis. unmarketable assets such as loans not capable
of being readily sold, bank premises and
(iv) Assumptions used in Determining Cash Flows:
investments in subsidiaries, as well as,
The total number of major liquidity assumptions possibly, severely trouble credits.
to be made is fairly limited and fall under the  Assets pledged to third parties are deducted
categories of :- from each category.

(a) Assets, (b) Assumptions Regarding Liabilities: To

evaluate the cash flows arising from a bank's
(b) Liabilities,
liabilities, a bank would first examine the
(c) off-balance-sheet activities, and behavior of its liabilities under the normal
business conditions.
(d) Others.
 In examining the cash flows arising from a
(a) Assumptions regarding assets: Assumptions
bank's liabilities in the two crisis scenarios, a
about a bank's future stock of assets include their
bank would examine the following basic
potential marketability and use as collateral of
questions:
existing assets which could increase cash inflows,
and the extent to which maturing assets will be
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 Which sources of funding are likely to stay with (d) Other assumptions: Besides the liquidity needs
a bank under any circumstances, and can these arising from business activities, banks also require
be increased? excess funds to support other operations.
 Which sources of funding can be expected to
For example, many large banks provide clearing
run off gradually if problems arise and at what
services to correspondent banks and financial
rate? Is deposit pricing a means of controlling
institutions that generate significant and not
the rate of run off?
always easily predictable cash inflows and
 Which maturing liabilities or liabilities with
outflows, the amounts of which depend on the
non-contractual maturities can be expected to
clearing column of the correspondent banks.
run off immediately at the first sign of trouble?
Are these liabilities with early withdrawal Unforeseen fluctuations in these volumes can
options that are likely to be exercised? result in depletion of a bank's funds.
 Does the bank have back-up facilities that it can  B. Managing Market Access
drawdown?
 The first two categories represent cash-flows As a check for adequate diversification of
developments that tend to reduce the cash liabilities, a bank needs to examine the level of
outflows and project directly from contractual reliance on individual funding sources, by
maturities. instrument type, nature of the provider of funds,
 The second category liabilities that are likely to and geographic market.
stay with a bank during periods of mild In addition, a bank should strive to understand
difficulties and to run off relatively slowly in a and evaluate the use of inter-company financing
crisis, include core deposits that are not for its individual business officers.
already included in the first category.
 The third category comprises the remainder of  C. Contingency Planning
the maturing liabilities, including some without Effective contingency plans should address two
contractual maturities, such as wholesale major questions:-
deposits.
 Does management have a strategy for handling
(c) Off-balance sheet activities: A bank should also a crisis?
examine the potential for substantial cash flows  Does management have procedures in place for
from its off-balance sheet activities, even if such accessing cash in emergency?
cash flows are not always a part of bank's current
liquidity analysis.  Strategy for Handling a Crisis:
Contingent liabilities, such as letters of credit and  A game plan for dealing with a crisis should
financial guarantees, represent potentially involve managerial coordination.
significant cash drains for a bank, but are usually
not dependent on a bank's condition.
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 A contingency plan needs to spell out  Depending on the severity of a crisis, a bank
procedures to ensure that information flows may choose - or be forced to use previously
remain timely and uninterrupted. unused credit facilities and credit lines from
 A clear division of responsibility must be set the domestic central bank or one or more of
out. these sources.
 Another major element in the plan should be a  The plan should spell out as clearly as possible
strategy for taking certain actions to alter asset the amount of funds available to the bank from
and liability behaviours. these sources, and under what scenarios a
 Other components of the game plan involve bank could use them.
maintaining customer relationships with
borrowers, trading and off-balance-sheet
counter parties, and liability holders.
 Back up Liquidity for Emergency Situations:

BFM MODULE - D

Chapter: 30 INTEREST RATE RISK MANAGEMENT

BULLET POINT
the amount of assets and liabilities on which the
interest rates are reset during a given period.
 Interest rate risk is the exposure of a bank's
financial condition to adverse movements in  Basis Risk
interest rates.  The risk that the interest rate of different assets
 An effective risk management process that and liabilities may change in different
maintains interest rate risk within prudent and magnitudes is called basis risk.
acceptable levels is essential to the safety and  The basis risk is quite visible in volatile interest
soundness of banks. rate scenarios. When the variation in market
interest rate causes the NII to expand, the banks
 SOURCES OF INTEREST RATE RISK: experience a favourable basis shift and if the
 Gap or Mismatch Risk interest rate movement causes the NII to
contract, the basis moves against the bank.
A gap or mismatch risk arises from holding assets
and liabilities with different principal amounts,
maturity dates or repricing dates, thereby
creating exposure to changes in the level of
interest rate. The gap is the difference between
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 Net Interest Position Risk  Non-interest income arising from many
 Interest rate risk arises when interest rate activities, such as loan servicing and various
earned on assets changes while the cost of asset securitization programmers, can be
funding of the liabilities remains the same. highly sensitive to, and may have complex
 Thus, the bank with a positive net interest relationships with market interest rates.
position will experience a reduction in NII as  In addition, even traditional sources of non-
interest rate declines and an expansion in NII interest income such as transaction processing
as interest rate rises. fees are becoming more interest rate-sensitive.
 Embedded Option Risk
 Economic Value Perspective
Large changes in the level of market interest
rates create another source of risk to banks The economic value of an instrument represents
profit by prepayment of loans and bonds (with an assessment of the present value of its
put or call options) and/or premature expected net cash flows, discounted to reflect
withdrawal of deposits before their stated market rates.
maturity dates.
 Advantages of Economic Value Added
 Yield Curve Risk  EVA complements financial data from various
other methods of business valuation and
A yield curve is a line on a graph plotting the
assessment.
yield of all maturities of a particular
 It shows the cost management of businesses and
instrument.
illustrates working capital availability after the
 Price Risk deduction of its actual opportunity cost.
Price risk occurs when assets are sold before  Another advantage of EVA is that it is also used
their maturity dates. In the financial market, as a management incentive that ensures a
bond prices and bond yields are inversely company's continuity of operations.
related.  Disadvantages of Economic Value Added
 Economic value added cannot determine how
 Reinvestment Risk effectively capital asset holders utilize the
Uncertainty with regard to interest rate at retained profits through project management
which the future cash flows can be reinvested is and other company ventures.
called reinvestment risk.  Economic Value-Added also cannot calculate the
return on expenses like research and
 EFFECTS OF INTEREST RATE RISK: development
 Earnings Perspective
 In the earnings perspective, the focus of
analysis is the impact of changes in interest
rates on accrual or reported earnings.
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 MEASUREMENT OF INTEREST RATE RISK: Limitations of duration approach are:
Measurement systems should:
 Simulation Approaches
 Assess all material interest rate risks associated
The simulation techniques typically involve
with a bank's assets, liabilities, and OBS
detailed assessments of the potential effects of
positions
changes in interest rates on earnings and
 Utilize generally accepted financial concepts
economic value by simulating the future path of
and risk measurement techniques
interest rates and their impact on cash flows.
 Have well-documented assumptions and
parameters Simulations techniques could be:-
 INTEREST RATE RISK MEASUREMENT
 Static Simulation
TECHNIQUES:
 Dynamic Simulation
 Repricing Schedules

The simplest techniques for measuring a bank's  STRATEGIES FOR CONTROLLING INTEREST RATE
interest rate risk exposure begin with a RISK:
maturity/repricing schedule that distributes The strategies for reducing the assets and
interest-sensitive assets, liabilities, and OBS liabilities sensitivity are:
positions into a certain number of predefined
 Reduce Asset Sensitivity
time bands/buckets according to their maturity
 Extend investment portfolio maturities
(if fixed-rate) or time remaining till their next
 Increase floating rate deposits
repricing (if floating-rate).
 Increase fixed rate lending
 Gap Analysis  Sell floating rate loans
 Increase short-term borrowings
This approach is used to assess the interest rate
 Increase long-term lending
risk of current earnings; it is typically referred to
 Reduce Liability Sensitivity
as gap analysis.
 Reducing investment portfolio maturities
 A negative or liability-sensitive gap occurs when  Increase floating rate lending
liabilities exceed assets (including OBS positions)  Increase long-term deposits
in a given time band.  Increase short-term lending
 Conversely, a positive or asset-sensitive gap  CONTROLS AND SUPERVISION OF INTEREST RATE
occurs when assets exceed liabilities. RISK MANAGEMENT:
 Duration An effective system of internal control for
Duration (more particularly Modified Duration) is interest rate risk includes:
a measure of the percentage change in the  A strong control environment and compliance
economic value of a position that will occur, given culture
a small change in the level of interest rates.
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 An adequate process for identifying and capital and earnings arising from adverse
evaluating risk movements in interest rates that affect banking
 The establishment of control activities such as book positions.
policies, procedures, and methodologies
 Enhanced Guidelines on IRRBB
 Adequate information systems
 Continual review of adherence to established (A) Governance
policies and procedures Governance of IRRBB involves:
 SOUND INTEREST RATE RISK MANAGEMENT
PRACTICES: (i) Clearly defined risk appetite statement for
Sound interest rate risk management involves IRRBB approved by their Board.
the application of four basic elements in the (ii) Regular monitoring of the nature and the level
management of assets, liabilities and OBS of the bank's IRRBB exposure.
instruments:
(iii) Clearly defined procedures to approve major
 Appropriate board and senior management hedging or risk-taking initiatives.
oversight
(iv) Systems for prompt management attention
 Adequate risk management policies and
and escalations in case of violations in Board
procedures
approved limits.
 Appropriate risk measurement, monitoring, and
control functions (B) Measurement
 Comprehensive internal controls and
For the purpose of computing, reporting, and
independent audits.
disclosing risks separately for IRRBB from both
 RBI'S GUIDELINES ON INTEREST RATE RISK IN
earnings as well as economic value perspective,
BANKING BOOK:
banks should compute the IRRBB and its impact on
 For certain types of deposits, like current
economic value and earnings of the Bank, based
deposits or savings bank deposits which are
on:
essentially Non Maturity Deposits (NMDs),
banks are required to estimate behavioural i. Internally selected interest rate shock scenarios
patterns and place them into appropriate addressing the bank's risk profile, according to
buckets. its Policy on Internal Capital Adequacy
 Banks, which are not able to estimate these Assessment Process (ICAAP);
behavioural patterns, are required to follow ii. Historical and hypothetical interest rate stress
the standardized approach. scenarios, which tend to be more severe than
ordinary/ normal shock scenarios; and
 Interest rate risk in banking book iii. The six prescribed interest rate shock scenarios.

Interest Rate Risk in Banking Book (IRRBB) refers

to the current or prospective risk to a bank's
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 Need for specific requirements on IRRBB for comments from Scheduled Commercial Banks
 In order to promote global consistency, on 2nd February, 2017.
transparency and comparability of IRRBB with
that of global banks, it is considered appropriate
to require banks to compute IRRBB separately
and disclose it based on BCBS prescribed
standards.
 RBI has, therefore, considered it appropriate to
enhance guidelines on IRRBB governance and
measurement and has circulated draft guidelines

BFM MODULE - D
Chapter: 31 RAROC AND PROFIT PLANNING
BULLET POINTS

 PROFIT PLANNING: take into account the effect of NPA on the

interest income.
Profit planning in a bank essentially involves
balance sheet management; covering credit,  The second major source of income is derived
investment and non-fund-based income. from fee-based activities.

 Banks' income arises from three sources, viz. With technological changes some new services
interest income, fee-based income and like depository services, internet banking, e-
treasury income. commerce has appeared on the scene. These
 The first source of income is derived from services have given a boost to the fee income or
interest-based activities. else have resulted in higher minimum balance
Banks are required to have a proper blending of requirements.
investment in government securities and credit  The last and most important component of
portfolios to maximize the profits for a given income is treasury income, which is derived by
level of risk appetite. trading in securities, foreign exchange, equities,
Banks need to optimize the investment and bullion, commodities (not permitted in our
country) and derivatives.
lending portfolio to earn the best possible
returns for a given capital level. Banks have to
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Trading activities may provide large incomes to  RISK AGGREGATION AND CAPITAL
banks but may also result in large amounts of ALLOCATION:
losses as well.
The most commonly used approach to estimate
In the 90s, Barings Bank, a very old British Bank, the aggregate risk exposures by banks is the
collapsed due to very large losses due to Risk Adjusted Return on Capital (RAROC).
speculative trading of Nikkei Futures on Tokyo
 The RAROC is designed to allow all the
Exchange.
business
 On the expenses side, there are two major streams of a financial institution to be
expenses, viz., interest expenses and operating evaluated on an equal footing.
expenses.  The key to RAROC is the matching of revenues,
 There are three major parts of the deposit costs and risks on transaction or portfolio
portfolio. basis over a defined time period. This begins
i. Current Deposits which are interest free, with a clear differentiation between expected
ii. Savings Deposits and unexpected losses.
iii. Term (short & long) Deposits - for which interest  Expected losses are covered by specific reserves
rates are deregulated in India. and provisions and unexpected losses require
 In nutshell, profitability is a function of six capital allocation, which is determined on the
variables: principles of confidence levels, time horizon,
diversification and correlation.
1. Interest income
 In this approach, risk is measured in terms of
2. Fee-based income variability of income. Under this framework,
the frequency distribution of return, wherever
3. Trading income
possible, is estimated and the Standard
4. Interest expenses Deviation (SD) of this distribution is also
estimated.
5. Staff expenses
 Capital is thereafter allocated to activities as a
6. Other operating expenses function of this risk or volatility measure.
Maximization of the first three variables and
 The second approach is similar to the RAROC,
minimization of the last three variables are the
but depends less on capital allocation and
requisites to maximize profitability.
more on cash flows or variability in earnings.
This is referred to as EaR (Earnings at Risk),
when employed to analyses interest rate risk.
 Under this analytical framework also,
frequency distribution of returns for any one
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type of risk can be estimated from historical second a bond trader. The question is, how do
data. we compare their performance?
 Extreme outcome can be estimated from the
This is important in providing appropriate
tail of the distribution.
compensation as well as deciding which line of
activity to expand.
 ECONOMIC CAPITAL AND RAROC:
 The expected loss is a measure of the reserves Assume the FX and bond traders have notional
necessary to guard against future losses. amount and volatility as described below.

The pricing of products should provide a buffer The bond trader deals in larger amounts, $200
against expected losses and the unexpected million, but in a market with lower volatility, at
loss is a measure of the amount of economic 4% per annum, against $100 million and 12% for
capital required to support the banks financial the FX trader.
risk. This capital is also called risk capital.
The risk capital can be computed as a VAR
Some activities may require large amounts of measure, say at the 99% level over a year, as
risk capital, which in turn requires higher Bankers Trust did.
returns. This is the essence of risk adjusted
Assuming normal distributions, this translates
return on capital (RAROC) measures.
into a risk capital of
 The central objective benchmarks to evaluate
RC VAR $100,000,000 X .12 × 2.33 = $28 million
the economic return of business activities. This
includes transactions, products, customer The risk adjusted performance is then measured
trades, and business lines, as well as the entire as the profit divided by the risk capital,
business. RAPM= Profit/RC
 In the past, performance was measured by
yardsticks such as return on assets (ROA), Thus, the bond trader is actually performing
which adjusts profits for the associated book better than the FX trader, as the activity requires
value of assets, or return on equity (ROE), less risk capital.
which adjusts profits for the associated book More generally, risk capital should account for
value of equity. credit risk, operational risk, and any interaction.
 Risk Capital
 RAROC Methodology
RAROC is a part of the family of the risk-adjusted  Risk Management: Includes the measurement
performance measures (RAPM). of portfolio exposure, the volatility and
Consider, for instance, two traders such that correlations of the risks factors.
each returned a profit of $10 million over the last  Capital Allocation: This requires the choice of a
year. The first is a foreign currency trader, and confidence level and horizon for the VAR
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measure, which translates into an economic  RBI has also permitted opening of Small
capital. Finance Banks and Payment Banks which are
 Performance Measurement: This requires the called as 'Differentiated Banks'.
adjustment of performance for the risk capital.  So in our country the Banking Industry consist
of:
For instance, Economic Value Added (EVA)
 Public Sector Banks.
focuses on the creation of value during a
 New Generation Private Sector Banks.
particular period in excess of the required return
on capital.  Old Generation Private Sector Banks.
 Co-operative Banks.
EVA measures the residual economic profit as:  Regional Rural Banks.
EVA = Profit (Capital × k)  Small Finance Banks.
 Payment Banks.
Where profits are adjusted for the cost of
 NaBFID
economic capital, with k defined as the discount
rate. NaBFID has been set up as a Development
Financial Institution (DFI) to support the
Assuming the whole worth is captured by the
development of long-term infrastructure
EVA, the higher the EVA, the better the product
financing in India.
or project.
The National Bank for Financing Infrastructure
 Banking Industry in India
and Development (NaBFID) Act, 2021 received
 Starting with the Narasimha committee report the assent of the President on 28 March, 2021
of 1991, the Indian banking has seen a total
and was enforced on 19 April, 2021.
change in the scenario during the last 26 years.
 The process of deregulation which was set in Unlike banks, DFIs do not accept deposits from
motion has brought in a sea change in the people. They source funds from the market,
Indian banking. government, as well as multi-lateral institutions,
 The Reserve Bank of India is now more and are often supported through government
concerned about prudential norms and guarantees.
disclosure requirements of the banks.
 Several new private sector banks have come
into existence. They have diverse ownership
patterns. Similarly, foreign banks have also
been given clearances for expansion.
 Recently, the associate banks of State Bank of
India and Bhartiya Mahila Bank have merged
with State Bank of India.
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BFM MODULE - D  The last and most important component of
income is treasury income, which is derived by
Chapter: 31 RAROC AND PROFIT trading in securities, foreign exchange,
equities, bullion, commodities (not permitted
PLANNING
in our country) and derivatives.
BULLET POINTS Trading activities may provide large incomes to
banks but may also result in large amounts of
losses as well.
 PROFIT PLANNING:
In the 90s, Barings Bank, a very old British Bank,
Profit planning in a bank essentially involves collapsed due to very large losses due to
balance sheet management; covering credit, speculative trading of Nikkei Futures on Tokyo
investment and non-fund-based income. Exchange.
 Banks' income arises from three sources, viz.  On the expenses side, there are two major
interest income, fee-based income and expenses, viz., interest expenses and operating
treasury income. expenses.
 The first source of income is derived from
 There are three major parts of the deposit
interest-based activities.
portfolio.
Banks are required to have a proper blending of iv. Current Deposits which are interest free,
investment in government securities and credit v. Savings Deposits
portfolios to maximize the profits for a given vi. Term (short & long) Deposits - for which interest
level of risk appetite. rates are deregulated in India.
 In nutshell, profitability is a function of six
Banks need to optimize the investment and
variables:
lending portfolio to earn the best possible
returns for a given capital level. Banks have to 1. Interest income
take into account the effect of NPA on the
2. Fee-based income
interest income.
3. Trading income
 The second major source of income is derived
from fee-based activities. 4. Interest expenses

With technological changes some new services 5. Staff expenses

like depository services, internet banking, e- 6. Other operating expenses
commerce has appeared on the scene. These
services have given a boost to the fee income or Maximization of the first three variables and
else have resulted in higher minimum balance minimization of the last three variables are the
requirements. requisites to maximize profitability.
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 RISK AGGREGATION AND CAPITAL  Extreme outcome can be estimated from the
ALLOCATION: tail of the distribution.

The most commonly used approach to estimate

 ECONOMIC CAPITAL AND RAROC:
the aggregate risk exposures by banks is the
 The expected loss is a measure of the reserves
Risk Adjusted Return on Capital (RAROC).
necessary to guard against future losses.
 The RAROC is designed to allow all the
The pricing of products should provide a buffer
business
against expected losses and the unexpected
streams of a financial institution to be
loss is a measure of the amount of economic
evaluated on an equal footing.
capital required to support the banks financial
 The key to RAROC is the matching of revenues,
costs and risks on transaction or portfolio risk. This capital is also called risk capital.
basis over a defined time period. This begins Some activities may require large amounts of
with a clear differentiation between expected risk capital, which in turn requires higher
and unexpected losses. returns. This is the essence of risk adjusted
 Expected losses are covered by specific reserves return on capital (RAROC) measures.
and provisions and unexpected losses require
 The central objective benchmarks to evaluate
capital allocation, which is determined on the
the economic return of business activities. This
principles of confidence levels, time horizon,
includes transactions, products, customer
diversification and correlation.
trades, and business lines, as well as the entire
 In this approach, risk is measured in terms of
business.
variability of income. Under this framework,
 In the past, performance was measured by
the frequency distribution of return, wherever
yardsticks such as return on assets (ROA),
possible, is estimated and the Standard
which adjusts profits for the associated book
Deviation (SD) of this distribution is also
value of assets, or return on equity (ROE),
estimated.
which adjusts profits for the associated book
 Capital is thereafter allocated to activities as a
value of equity.
function of this risk or volatility measure.
 Risk Capital
 The second approach is similar to the RAROC,
but depends less on capital allocation and RAROC is a part of the family of the risk-
more on cash flows or variability in earnings. adjusted performance measures (RAPM).
This is referred to as EaR (Earnings at Risk),
Consider, for instance, two traders such that
when employed to analyses interest rate risk.
each returned a profit of $10 million over the
 Under this analytical framework also,
last year. The first is a foreign currency trader,
frequency distribution of returns for any one
and second a bond trader. The question is, how
type of risk can be estimated from historical
do we compare their performance?
data.
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This is important in providing appropriate For instance, Economic Value Added (EVA)
compensation as well as deciding which line of focuses on the creation of value during a
activity to expand. particular period in excess of the required return
on capital.
Assume the FX and bond traders have notional
amount and volatility as described below. EVA measures the residual economic profit as:

The bond trader deals in larger amounts, $200 EVA = Profit (Capital × k)
million, but in a market with lower volatility, at
Where profits are adjusted for the cost of
4% per annum, against $100 million and 12% for
economic capital, with k defined as the discount
the FX trader.
rate.
The risk capital can be computed as a VAR
Assuming the whole worth is captured by the
measure, say at the 99% level over a year, as
EVA, the higher the EVA, the better the product
Bankers Trust did.
or project.
Assuming normal distributions, this translates
 Banking Industry in India
into a risk capital of
 Starting with the Narasimha committee report
RC VAR $100,000,000 X .12 × 2.33 = $28 million of 1991, the Indian banking has seen a total
change in the scenario during the last 26 years.
The risk adjusted performance is then measured
 The process of deregulation which was set in
as the profit divided by the risk capital,
motion has brought in a sea change in the
RAPM= Profit/RC Indian banking.
Thus, the bond trader is actually performing  The Reserve Bank of India is now more
better than the FX trader, as the activity requires concerned about prudential norms and
less risk capital. disclosure requirements of the banks.
 Several new private sector banks have come
More generally, risk capital should account for into existence. They have diverse ownership
credit risk, operational risk, and any interaction. patterns. Similarly, foreign banks have also
 RAROC Methodology been given clearances for expansion.
 Risk Management: Includes the measurement  Recently, the associate banks of State Bank of
of portfolio exposure, the volatility and India and Bhartiya Mahila Bank have merged
correlations of the risks factors. with State Bank of India.
 Capital Allocation: This requires the choice of a  RBI has also permitted opening of Small
confidence level and horizon for the VAR Finance Banks and Payment Banks which are
measure, which translates into an economic called as 'Differentiated Banks'.
capital.  So in our country the Banking Industry consist
 Performance Measurement: This requires the of:
adjustment of performance for the risk capital.  Public Sector Banks.
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 New Generation Private Sector Banks.  Reserve Bank of India Guidelines for Maturity
 Old Generation Private Sector Banks. Buckets: All the assets and liabilities are
 Co-operative Banks. classified into the following time buckets as
 Regional Rural Banks. given below:-
 Small Finance Banks.  Tomorrow
 Payment Banks.  2-7 days
 NaBFID  8-14 days.
 15-30 days
NaBFID has been set up as a Development
 31 days and up to 2 months
Financial Institution (DFI) to support the
 Over 2 months and up to 3 months
development of long-term infrastructure
 Over 3 months and up to 6 months
financing in India.
 Over 6 months and up to 1 year
The National Bank for Financing Infrastructure  Over 1 year and up to 3 years
and Development (NaBFID) Act, 2021 received  Over 3 years and up to 5 years
the assent of the President on 28 March, 2021  Over 5 years
and was enforced on 19 April, 2021.

Unlike banks, DFIs do not accept deposits from

people. They source funds from the market,
government, as well as multi-lateral institutions,
and are often supported through government
guarantees.