Bankers ZONE ARENA

(An initiative by Ratinder Chopra, ex-Faculty PSB)

CAIIB SPECIAL NOTES

PAPER 2 BANK FINANCIAL MANAGEMT

ALL MODULES MERGED PDF

1.INTERNATIONAL BANKING

2. RISK MANAGEMENT

3. TREASURY MANAGEMENT

4.BALANCE SHEET MANAGEMENT

Compiled by-

Ratinder Chopra

[email protected] 9888812880
 Banker ZONE ARENA
(An initiative by Ratinder Chopra ex Faculty PSB)

CAIIB SPECIAL

PAPER 2 ACCOUNTING FINANCE FOR BANKERS

MODULE A
INTERNATIONAL BANKING

To the point and easy to understand

Ratinder Chopra
Contact at [email protected]
Phone: 9888812880
 FOREIGN EXCHANGE MANAGEMENT ACT, 1999
What is Foreign Exchange Management Act (FEMA)
FEMA Act 1999 was enacted on December 02, 1999 to replace FERA 1973. The
Act come into on June 01, 2000 and extends to entire Country.

FERA FEMA

Stringent Regulations Liberalized Regulations

Criminal Offense Civil Offense

Penalty plus Imprisonment Only Penalty

No evidence required Evidence required

Objectives of FEMA
1. Facilitating external trade and payments.
2. Promoting the orderly development and maintenance of foreign
exchange market in India. All transactions can be carried by
residents and Non-Residents through Authorized dealer.

BRANCH CATEGORIZATION

“A” Category Branches:

1. It maintains independent NOSTRO account and can deal with foreign

correspondents / its own foreign bank to settle FOREX transactions
through NOSTRO A/c.
2. Banks normally have very few branches in this category
“B” Category Branch:
It does not have any NOSTRO account but authorised to carry
transactions through the NOSTRO Account of “A” Branch and all Forex
debits / credits shall be carried out by such branch on behalf of category
“A” branch.
“C” Category Branch:
This branch cannot independently handle Forex transaction, but will
have to route transactions through either “A” or “B” Category Branch.
This is because infrastructure, including expertise staff is required - which
is a costly affair and run with a risk also.

AUTHORIZED PERSON
1. Means an AD (Authorized Dealer), Money Changer, Off-shore banking
unit or any person appointed under the Act FEMA by RBI which issues the
license to such authorized persons.
2. This Authorization can be revoked if found not complying with the
guidelines

Classification of Persons Authorized to deal in foreign exchange.

a. AD Category- I: Commercial, state & Urban Coo Banks. All Banks

currently authorized to deal in Foreign Exchange.
b. AD Category – II: (Upgraded FFMCs, Coop Banks, RRBs, and others)
Upgraded FFMCs, Select RRBs & UCBs, and other similar entities
permitted to undertake non- trade related Current Account
transactions
c. AD Category – III (Select Financial and other Institutions) Select FIs
& other institutions permitted to do foreign exchange transactions
related to their business.
d. Full-fledged Money Changers (FFMCS) Comprising Dept of Posts,
Urban Co-op Banks and other FFMCs.
FOREIGN EXCHANGE DEFINITION
The Foreign Exchange Management Act, 1999 defines:
All deposits, credits and balances payable in foreign currency including drafts,
travelers’ cheques, Letter of Credits & Bill of Exchange expressed or drawn in
Indian currency & Payable in any Foreign Currency.
A Foreign Exchange Transaction is a contract to exchange foreign funds of
one currency for funds in another currency at an agreed rate.

EXCHANGE RATE:
Exchange Rate is the rate at which one currency is converted into
another currency. It’s a dynamic rate which arrives from day to day,
minute to minute depending upon market factors.
AUTHORISED DEALER
An Authorized person who can be Category I, II or money changer is
called Authorized Dealer. An AD makes purchases or sell foreign
currency. Bankers are Authorized Dealers. When a bank sells foreign
currency, it acquires Home currency and vice versa.
SELLING RATE & BUYING RATE & EXCHANGE RATE QUOTATIONS
To keep spread or margin between the rate for sale and purchase the
banks quote two different rates i.e. Selling rate (at which the bank
sell foreign currency) and Buying rate (at which the bank buys foreign
currency).
DIRECT QUOTATION
When there is variable unit of home currency & Fixed unit of foreign
currency, it is called Direct Quotation.
For example, 1 US$ = 74 Rupees

INDIRECT QUOTATION
When there is Fix unit of home currency & variable unit of foreign
currency, it is called Indirect Quotation.
For example, Rs.100 = US$ 1.25

SPOT TRANSACTIONS & FORWARD TRANSACTIONS

When actual Payment in Home currency, say Indian rupee and Receipt
in foreign currency, say US$ on the same day it is called Spot
Transaction. And if its later date e.g. 1 month or 2 months etc. it is
called Forward Transaction.

TT Selling rate: is the rate at which banks sell Demand drafts, foreign
bills collected, Travellers cheques and receives INR.TT (Telegraphic
Transfer) buying rate indicates the rate at which bank convert foreign
inward remittances to INR. TT Selling rate indicates the rate at which
the bank sends an outward remittance through telegraphic transfer.
FOREIGN TYPE OF ACCOUNTS
EXCHANGE
NOSTRO Our Bank a/c with a bank in another country in
the currency of that country.
VOSTRO Other country account in our country in local
currency.
LORO It’s for a third bank which may use the account
with consent of Indian bank having Nostro
account in other country or vice versa.
MIRROR The a/c of a foreign bank maintained in the
books of bank in India. It is the copy of NOSTRO
account.

FOREIGN EXCHANGE TERMS

LIBOR London Interbank Offer Rate.
MIBOR Mumbai Interbank Offered Rate.
UCPDC Uniform Customs and Practice for Documentary
IEC Import Export code
DGFT Director General of Foreign Trade
PIP A pip in forex is simply .0001% or 1% of 1%.
INCOTERMS International Commercial terms
FAS Free alongside ship
CIF Cost, Insurance, Freight
FATCA Foreign Exchange Tax Compliance Act
FEDAI Foreign exchange dealers association of india
ECGC Export credit guarantee corporation of india ltd.
Factors Determining Exchange Rates
Foreign exchange rates are an important way of measuring a country’s economic
health, and a great way to assess the suitability of an economy for business
expansion. This is why the exchange rate markets are so closely watched.

Exchange rate volatility refers to the tendency for foreign currency to appreciate or
depreciate in value and ultimately affects the profitability of a trade (or transfer)
overseas.

1. Inflation rates
Inflation rates impact a country’s currency value. A low inflation rate typically
exhibits a rising currency value, as its purchasing power increases relative to other
currencies. Conversely, those with higher inflation typically see depreciation in their
currencies compared to that of their trading partners, and it’s also typically
accompanied by higher interest rates.

Government debt also plays a part in inflation rates. A country with government
debt (public or national debt owned by the central government) is less likely to
acquire foreign capital, leading to inflation.

2. Interest rates
Exchange rates, interest rates and inflation rates are all interconnected. An
increase in interest rates cause a country’s currency to appreciate, as lenders are
provided with higher rates and thereby attracting more foreign capital. This can
cause a rise in the value of a currency and therefore the exchange rate. Cutting
interest rates, on the other hand, can lead to a depreciation of the currency.

3. Monetary policy and economic performance

If a country has a history of strong economic performance and sound monetary
policy, investors are more inclined to seek out those countries. This inevitably
increases the demand and value of the country’s currency.

With the state of the global economy at present, it’s evident that we’re in a global
slowdown and fears of recession are looming. A recession may also cause a
depreciation in the exchange rate because interest rates usually fall.

Other recession factors that can influence currency value include the determent of
foreign investment, which would decrease the value. However, if a recession
causes inflation to fall, this helps a country become more globally competitive and
demand for the currency becomes greater.

4. Tourism
Let's use the US as an example here. If someone travels outside the US to another
country, they will get more from a money transfer to that country when the USD
appreciates against the foreign currency. Similarly, depreciation of a currency
means that foreigners will be more inclined to visit that country and spend more
while there.

Another factor here are 'visitor-weighted exchange rates', which measure a

destination's currency market with those of its primary visitor market. In essence,
countries that have a diversified range of visitor markets tend to be more resilient
against specific exchange rate margins, compared to those who rely on specific
visitor markets.

5. Geopolitical stability
The political state of a country, coupled with economic performance, can also affect
the strength of the currency. A country with less risk for political turmoil will be more
attractive to foreign investors, leading to an appreciation of the value of its domestic
currency from foreign capital.

‘Geopolitical risk’ is the risk posed to foreign investors by unexpected political

developments. If a country’s economy and political landscape remains predictable,
investors are more likely to buy the currency. The opposite effect is also true,
unexpected events lead investors to pull their money back, sending the currency
down in value.

6. Import and export value

A country’s balance of payments (BOP) summarises all international trade and
financial transactions made by individuals, companies and government bodies
complete with those bodies of that country. These transactions can consist of
imports and exports of goods, services and capital.

The BOP influences the ratio comparing export prices to import prices. If the price
of a country’s exports is greater than their imports, its ‘terms of trade’ have
improved. This creates a greater demand for that country’s exports, and in-turn,
greater demand for the currency.
Like many of the other factors influencing exchange rates, the converse reaction
can also occur. If the exports rise by a smaller rate than the imports, the value of
that country’s exports and currency decrease in value.

FOREX DERIVATIVES:
A derivative is a contract between two or more parties whose value is based on an
agreed-upon underlying financial asset (like a security) or set of assets (like an
index). Common underlying instruments include bonds, commodities, currencies,
interest rates, market indexes, and stocks.

Types of Forex Derivatives

Some of the financial instruments which have their values derived from forex
rates include the following derivatives:
1. Currency Futures
2. Currency Options, both Vanilla and Exotics
3. Currency Exchange Traded Funds or ETFs
4. Forex Contracts for Difference or CFDs
5. Forwards
6. Currency Interest Rate Swaps
7. Spot trades
These derivative instruments can be used to take forex related positions on
their own or in combinations.
Two of the forex derivatives that are often traded on exchanges, and hence are
also available to many individual forex traders, include currency futures and
options. They will be covered in greater detail in the sections below.

Currency Futures Trading

Currency futures are an exchange-traded futures contract that specify the price
in one currency at which another currency can be bought or sold at a future
date. Currency futures can be used to hedge other trades or currency risks, or
to speculate on price movements in currencies.
Currency futures used to be the main way that individual currency traders took
positions before retail forex brokers became widely available.
Each currency futures contract trades for a standardized forward delivery date,
often maturing on a quarterly basis, and so have similar pricing to a forward
outright contract delivering on those same value dates.
Currency futures can be actively traded by being either bought or sold via the
exchange they trade on. Their values are directly related to the corresponding
prices prevailing in the larger OTC spot and forward forex market.

Currency Options
Currency Options are Derivative contracts that enable market participants
which includes both Buyers and sellers of these Options to buy and sell the
currency pair at a pre-specified price (also known as Strike Price) on or before

Types of Currency Options

1 – Currency Call
Such options are entered into with the intent to benefit from the increase in
the price of the currency pair. It enables the buyer of the option to exercise his
right to buy the currency pair at the pre-specified strike price on or before the
expiry date of the contract. If on expiry, the currency pair is below the Strike
Price, the option ends worthless, and the Option seller pockets the premium
received.
2 – Currency Put
Such options are entered into with the intent to benefit from the decrease in
the price of the currency pair. It enables the buyer of the option to exercise his
right to sell the currency pair at the pre-specified strike price on or before the
expiry date of the contract. If on expiry, the currency pair is above the Strike
Price, the option ends worthless, and the Option seller pockets the premium
received.
Example of Currency Options
Surya International is undertaking a project in the United States of America and
will receive revenue in Foreign Currency, which in this case, will be in US
Dollars. The company wishes to protect itself against any adverse movement
in the currency rate.
To protect itself from any adverse moment which can arise on account of
appreciation of local currency INR against the US Dollar, the company decided
to purchase Currency Options. Surya expects to receive the payment in the
next three months, and the current USD/INR spot rate is 73, which means one
dollar is equivalent to 73 rupees.
By entering into an option with strike price 73 and expiry of three months,
Surya has covered its risk of fall in the price of foreign currency against the local
currency Indian Rupee.
Now, if the overseas currency US Dollar strengthens in the interim period, the
company will benefit from stronger currency when translating its profits in
Indian Rupee and will suffer the loss of the premium paid to purchase the
option.
However, on the contrary, if the foreign currency got weaker compared to the
local currency INR (which means INR getting stronger against US Dollar), the
currency option purchased by Surya will ensure that it can translate its profit
in India Rupee at the pre-specified rate, i.e., Strike Price.

Vanilla Currency Option Variations

The OTC vanilla currency option market has provided some creative solutions
for the needs of speculators and hedgers. Some of the more common choices
are described further below.
Currency Warrant – a currency option contract traded in the OTC market and
often for longer maturity dates of more than one year.
Currency Collar – A popular option combination involving the simultaneous
purchase of a call and the sale of a put, or vice versa. The strike prices are
usually set out of the money and at a similar distance from the forward rate in
order for the strategy to have no net cost. Also sometimes called a risk reversal.
Average Rate Options – Have their underlying rate determined by a process
that involves averaging some observed exchange rate sampled at periodic
intervals.
Average Strike Option – Have their strike prices determined by a process
that involves averaging some observed exchange rate sampled at periodic
intervals.
Binary Options – Also sometimes called digital options, they provide a holder
with a fixed payoff if their strike price is better than the prevailing market at
expiration, for European style binaries, or at any point during their lifetime, for
American style binaries.
Knockout Options– Ceases to exist when a pre-determined trigger level
trades during their lifetime.
Knock in Options – Starts to exist when a pre-determined trigger level trades
during their lifetime.
Basket Options – Are similar to vanilla European style options, except that
their strike price and their underlying rate are determined by reference to a
basket of currencies for which the weighted value of the option’s several
component counter currencies will be computed in its base currency.
Currency Interest rate swap: Agreement to exchange periodic payments
related to interest rates between currencies. Can be fixed for floating, or
floating for floating based on different indices. This group includes those swaps
whose notional principal is amortized according to a fixed schedule
independent of interest rates.
Currency Swaption – an OTC option granting the buyer the right but not the
obligation to enter into a currency interest rate swap. Such a swap involves a
commitment between counter parties to exchange interest payment streams
in different currencies for a set time frame and also to exchange the principal
amounts in different currencies at a set exchange rate on the maturity date.

Forex Contracts for Difference or CFDs

CFDs are foreign exchange agreements that are cash settled on their maturity
date. This means that just the net value of the contract, and not the principal
currency amounts, will be delivered to the counterparty showing the profit at
maturity.
CFDs can be traded for value spot or for value on some other selected business
day in the future.

Currency Interest Rate Swaps

These products generally involve taking on some form of interest rate
exposure, in addition to currency risk.

VERY IMPORTANT
Exchange Rates: Exchange Rates are applied when there is a sale or
purchase of foreign exchange.
Direct Rates and Indirect Rates:
Direct Rate: When foreign currency is fixed and value of home currency is
variable, it is Direct rate e.g., USD$1= Rs 74.12;
Indirect Rate: When home currency is fixed and value of foreign currency is
variable, it is Indirect rate e.g., Rs 100= US $ 1.23.
In India, direct rates are applied. When direct rates are applied, the
principle is "Buy Low and Sell High".
In India, rates are determined by market forces of demand and supply and
not by RBI or any other agency.
Buying or Selling Rate:
Buying Rate: When there is inflow of forex, it is purchased and buying rate is
applied. For example, in the case of purchase of export bills buying rate will
be applicable. Buying rate are of two types. TT Buying rate is applied when
Nostro account of the bank is credited before the payment to the tenderer
e.g., payment of FDD (Foreign Demand Draft) drawn on us or collection of
export bills. Bills Buying Rate is applied when Nostro account is credited later
and payment made earlier as in the case of negotiation of export bills or
purchase of foreign demand draft or cheque drawn abroad.
Selling Rate: When there is outflow of forex, it is sold and selling rate is
applied. For example, in the case of retirement of import bills, selling rate will
be applicable. Selling rates are of two types. Bills Selling rate is applied when
handling of import bill is involved. TT Selling Rate is applied when there is sale
of foreign exchange but import bill is not handled like issue of Foreign
Demand draft, crystalisation of overdue export bills.
TT selling rate is the rate at which banks sell Demand drafts, foreign bills
collected, Travellers cheques and receives INR. TT (Telegraphic Transfer)
buying rate indicates the rate at which bank convert foreign inward
remittances to INR. TT Selling rate indicates the rate at which the bank sends
an outward remittance through telegraphic transfer.

TT selling or buying rate is more favourable than Bills selling or

buying rate.
 SUMMARY OF EXCHANGE RATE APPLICATION
Rate Transaction
tt-Selling Outward remittance such as DD, TC etc.
Cancellation of purchase such as:
bills purchased returned unpaid,
bills transferred to collection account
forward purchase contract cancelled

Transfer of proceeds of import bills even if these are by

Bill-selling way DD or TT.

TCs/ currency note —

selling At the discretion of the AD
TT-Buying cancellation of outward TT, MT etc.
clean inward remittances (TT,DD, MT) where cover
already received
abroad
Conversion of proceeds of instruments that are sent for
collection
Cancellation of forward sale contract

Bills-Buying Purchase of bills and other instruments

TCs/currency note —
Buying At the discretion of the AD
NON-RESIDENT INDIAN UNDER FEMA, 1999

NRI is an Indian citizen or Foreign National of Indian Origin resident

outside India for purposes of employment, carrying on business or
vocation in circumstances as would indicate an intention to stay outside
India for an indefinite period.
An individual will also be considered NRI if his stay in India is less than
182 days during the preceding financial year. Student gone abroad for
studies are also considered NRI
NON- RESIDENT INDIANS UNDER INCOME TAX ACT

INCOME TAX ACT 1961 does not define who is non-resident. Rather it
defines who is resident and who are not ordinarily resident. Therefore, if
a person does not fall in the category of resident or not ordinarily resident,
he / she will be non-resident.

RESIDENT INDIAN
An individual is resident if any of the following conditions are satisfied:
(i) he stayed in India for 120 days (PREVIOUSLY 182 DAYS) or more
during the previous year, or
(ii) he stayed in India for 365 days or more during the four preceding
years and stays in India for at least 60 days. Stay in India for the above
criteria may be continuous or intermittent.

POI (PERSON OF INDIAN ORIGIN)

A person who is not a citizen of India is deemed to be of Indian origin
if he is not a citizen of Pakistan or Bangladesh and if:
1. he at any time held an Indian passport; or
2. he or either of his parents or any of his grandparents was a citizen
of India by virtue of the Constitution of India or Citizenship Act,
1955.
A spouse (not being a citizen of Pakistan or Bangladesh) of an Indian
citizen or of a Person of Indian Origin is also treated as a Person of
Indian Origin for the purpose of NRI deposits if the accounts are held
jointly with the NRI/PIO spouse. PIOs are extended the same facilities
for bank account maintenance in India as NRIs and are also, for such
purposes, called by the generic name as NRI.
NON- ORDINARILY RESIDENT
The budget proposed to amend the definition of “not ordinarily
resident". Till FY20, an individual was classified as a “not ordinarily
resident" if he was a non-resident in India for nine out of 10
preceding years. The budget proposal has reduced the numbers of
years to SEVEN (7) out of the 10.
FOREX TRADE INIDCATORS
1. Balance of Trade: (Export of goods less import of goods)
2. Balance of Payment: (Total receipts of foreign currency through trade,
services less total payment of foreign currency through the same way)
3. Forex Reserves: It consists of foreign currency, gold & SDRs etc.

FOREX TRANSANCTION IN INDIA

Transaction can be classified in to two categories:
1. Current Account
2. Capital Account
Current Account Transactions:
is a transaction other than a capital account transaction and includes: Payment
due in connection with foreign trade, other current business, services and
short-term banking and credit facilities in the ordinary course of business.
Payment due as interest on loans and as net income from investments.
Remittance for living expenses of parents, spouse and children residing
abroad.
Expenses in connection with foreign travel, education and medical care of
parents, spouse and children.

There are four categories of these transactions:

Prohibitory Category – Which include transactions with Nepal and Bhutan or
with their citizens and Schedule- I transactions i.e., remittance of earnings
from lottery/ racing etc.
Schedule –II transactions, requiring government approvals.
Schedule –III transactions where Ads (Authorised Dealers) can allow
remittance up to the prescribed limits and RBI permission requirement will be
for remittance exceeding the limit.
All other current account transaction for which the Ads can allow remittance
without monetary limit.

Capital Account Transaction

Capital account transaction is a transaction which alters the assets or liabilities
(including contingent liabilities) outside India of persons resident in India or
assets or liabilities in India of persons resident outside India.
1. Investment in foreign securities.
2. Raising foreign currency loans in India and abroad.
3. Transfer of immovable property outside India.
4. Issuing guarantees in favour of a resident outside India.
5. Sale purchase of forex derivatives in India and abroad and commodity
derivatives abroad by an India.
6. Maintenance of foreign currency accounts in India and abroad by an
Indian resident.
7. Export Import and holding of currency/currency notes, loan & overdrafts
borrowing from a person residing outside India.
8. Acquisition and transfer of immovable property in India.
9. Issuing guarantee in favour of or on behalf of and Indian resident.
10.Deposits between and Indian resident and a person residing outside
India.
11.Maintenance of foreign currency a/c in India and remittance outside
Indian of capital assets in India of a person residing outside India.
CONVERTIBILITY
1. Current account convertibility
2. Capital account convertibility

Current account convertibility: refers to the freedom to convert your

rupees into other internationally accepted currencies and vice versa without
any restrictions whenever you make payments. Similarly, capital account
convertibility means the freedom to conduct investment transactions without
any constraints.
Full convertibility on current accounts was introduced by RBI on 19.08.94 by
accepting the IMF article VIII which make it mandatory on a member to have
no inward or outward restrictions on current account and trade related
transactions.

Capital account convertibility: means that the currency of a country can

be converted into foreign exchange without any controls or restrictions. In
other words, Indians can convert their Rupees into Dollars or Euros and Vice
Versa without any restrictions placed on them. India is marching towards full
Capital Account convertibility.

ROLE – DGFT & RBI

DGFT: DGFT India - Director General of Foreign Trade provides a set of

guidelines and framework for importers and exporters wanting to trade in
India. DGFT IEC stands for Importer Exporter Code issued by DGFT. Any
bonafide person/ company starting a venture for International trade requires
DGFT IEC. The guidelines are set by DGFT India -Director General of Foreign
Trade.
FOREIGN TRADE POLICY:
1. Physical Import & Export of Goods - Issued by DGFT under Ministry of
Commerce
2. The National Foreign Trade Policy (2015-2020) notified by the Ministry of
Commerce, Govt. of India. It lays down the guidelines / procedures of
Trade Control, for the physical movement of goods into / out of India.
3. The policy states that Exports and Imports shall be free except those
regulated by the provisions of this policy or any other law for the time
being in force.

RBI NORMS & GUIDELINES

1. RBI periodically circulates to Authorized Persons, FEMA amendments &

general procedure, as may be applicable.
2. RBI advises the policy guidelines / norms on fixation of rate of interest
on export / import finance, NRI deposits etc. as also extension of forex
related finance by Bank.
ROLE – FEDAI (FOREIGN EXCHANGE DEALERS‘ ASSOCIATION OF
INDIA (FEDAI)
1. The FEDAI rules / guidelines ensure uniformity in terms and conditions
followed by Authorized Persons in India IN FOREIGN TRADE.
2. FEDAI also by way of AD circulars provide information / clarifications
pertaining to Forex handled by the banks.
FEDAI RULES:
1- Hours of Business
2- Export Transactions
3- Import Transactions
4- Merchanting Trade
5- Clean instruments
6- Guarantees
7- Exchange Contracts
8- Early delivery/ Ext. & cancellation of Forward Contracts
 9- Schedule of Charges
10- Business through Exchange Brokers
11- Inter-Bank TT Settlement & Dispatch
12- Inter-Bank TT Settlement of IB TTs & Dispatch FEDAI
13- Abolition of Sterling Rates Schedule
14- Clarification/Explanatory Notes & Certain Other Imp. Information.

LRS (Liberalised Remittance Scheme)

Total Remittance Allowed under the Scheme: USD 250000
Purpose of remittance:

1. For travel, studies, medical treatment etc.

2. To acquire shares or debt instruments in listed or unlisted companies or any
other assets including acquisition of immovable property directly or
indirectly outside India

3. To invest in Mutual funds, Venture funds, unrated debt securities, promissory

notes, etc
4. To gift or to give donations.
5. To acquire ESOPs in overseas companies (in addition to acquisition of ESOPs
linked to ADR/GDR)
6. Repayment of loan taken while an individual was a Non-Resident Indian
7. To open, maintain and hold foreign currency accounts with banks outside India
for carrying out any permitted transactions
UCP 600: The Uniform Customs and Practice for Documentary Credits
UCP is the rule governing the Documentary credits. It was established by
the international chamber of commerce (ICC) to mitigate the doubts caused
by individual countries promoting their own national rules on
documentary credit practice. The objective, was to create a set of
contractual rules that would establish uniformity in that practice, obtain
global understanding, a common interpretation and application of
documentary credit, so that practitioners would not have to cope with
plenty of conflicting national regulations. UCP is the most successful set of
private rules for trade ever developed.
UCP 600 (2007 Revision) regulates common market practice within the letter
of credit market. It defines a number of terms related to letters of credit which
categorise the various factors within any given transaction.
It comprises 39 Articles, which establish the requirements necessary to
regulate documentary credit operations.

Letter of credit (LC) in Foreign Trade

An LC is a commitment by a bank on behalf of the buyer that payment
will be made to the exporter, provided that the terms and conditions
stated in the LC have been met, as confirmed through the presentation
of all required documents.
In simple words, a Letter of Credit is an undertaking issued by a Bank, at
the request of a importer, affirming the payment to the exporter on
presentation of complying documents as stated in the LC.
Letter of credit is a type of payment term opted by importers and
exporters. Letters of credit (LCs) are one of the most secure instruments
accessible to international traders.
Letter of credit is also called Documentary Credits or Simple
Credits
TYPES OF LETTER OF CREDIT
1. Documentary letter of credit
A documentary letter of credit specifies the various documents which are
required to be produced by the exporter to the importer. Normally, the
documents specified in the documentary letter of credit are commercial
invoice, bill of lading, insurance policy, consular invoice, certificate of origin,
certificate of quality analysis, packing list, document of title to goods, bill of
exchange, etc.
The payment is made by the negotiating bank to exporter against this letter of
credit when a full set of documents specified in the letter of credit is handed over
by the exporter.

2. Revocable and irrevocable letter of credit

The revocable letter of credit can be withdrawn by the opener (importer) or
opening bank (importer’s bank) at any time. Withdrawal can be effected without
notice to the exporter. Revocable letter of credit, therefore, does not sufficiently
protect the interest of the exporter in getting his payment.

The irrevocable letter of credit is just the opposite of revocable letter of credit.
The irrevocable letter of credit cannot be withdrawn without prior permission
and intimation of the exporter. Through irrevocable letter of credit, the opening
bank gives definite guarantee to exporter ensuring payment of exports.
However, conditions specified in the letter of credit should be satisfied by the
exporter. Generally, exporter prefers irrevocable letter of credit as it protects the
exporter.

3. Clean letter of credit

A clean letter of credit does not lay down any condition as regards making the
payment. Further, it does not contain any condition for acceptance of bill of
exchange drawn by exporter upon the importer. Ii is clean in the sense that there
is no condition for payment to be made.
4. Assignable and non-assignable letter of credit
An assignable letter of credit is transferable while a non-assignable letter of
credit is not transferable. Assignable letter of credit means a letter of credit
which can be easily transferred by the exporter with its rights in favour of any
person. Therefore, exporter can assign this letter of credit to any person.

A non-assignable letter of credit cannot be transferred in favor of any person.

Only the beneficiary who is named in the letter alone can get the payment.

5. Revolving letter of credit

Revolving letter of credit is used when the export transaction between the same
parties is regular and continuous. Credit can be availed against one and the same
letter of credit for all subsequent export transactions. There is no need to open a
separate letter of credit for every export transaction again and again.

6. Confirmed letter of credit

The opening bank appoints a banker in the exporter’s country which is known
to the exporter. Through such bank, the confirmation of credit is made by the
opening bank. Exporter can draw the bill of exchange on such confirming bank.
So, any letter of credit which confirms credit is known as confirmed letter of
credit.

7. Back to back letter of credit

Merchant exporter purchases goods from the manufacturer for the purpose of
export. Such exporter requests opening bank to open the letter of credit in favor
of such manufacturer or supplier. The manufacturer or supplier gets the money
directly from the importer. This letter of credit helps the exporter to get goods
for export on credit basis.

8. With or Without recourse letter of credit

In with recourse letter of credit, the paying bank can hold the exporter
responsible for recovery of payment if the importer fails to reimburse it to the
paying bank. Exporter, then will have to refund all the money he has received
along with interest to paying bank in such an eventuality.

In case of without recourse letter of credit, the exporter cannot be held

responsible if the importer does not reimburse the paying bank. In such an
eventuality, the paying bank has the recourse to the importer only.
9. Red clause and green clause letter of credit
Under the red clause letter of credit, the exporter can get advance money from
the negotiating bank. This gives an authority to the negotiating bank to extend
credit and lend advance money to exporter. A red clause letter of credit is printed
in red.

Green clause letter of credit provides an arrangement for the storage of goods at
the port. Pre-shipment finance and storage facility are available to the exporter.

10. Restricted letter of credit

The importer may insist that shipping documents be negotiated (transferred)
through a specified bank only. Any letter of credit with such a restriction is
known as restricted letter of credit.

11. Traveling letter of credit

A traveling letter of credit enables the exporter to travel abroad and draw the
money specified from the bank. All banks honor all the cheques or bill drawn
upon.

12. Omnibus letter of credit

Reputed exporters can get omnibus letter of credit. This letter of credit allows
the exporter to draw the money from bank in lump sum against the security of
general lien on goods.

13. Stand by letter of credit

A Stand by Letter of Credit (SBLC) is a legal document that guarantees
a bank's commitment of payment to a seller in the event that the buyer–
or the bank's client–defaults on the agreement. Although the buyer is
certain to receive the goods and the seller certain to receive payment, a
SLOC doesn't guarantee the buyer will be happy with the goods. A
standby letter of credit can also be abbreviated SBLC.
It is just like simple LC, only point is seller is doubly sure of payment
even if the buyer is not satisfied by the goods received.
BUYER`S CREDIT & SELLER`S CREDIT
Buyer`s credit means finance for payment of imports in India
arranged by the importer (buyer) from a bank or financial
institution outside India.
And Supplier`s credit means credit extended for imports directly by
the overseas supplier instead of bank or financial Institution.
In India maximum period of Buyer seller credit is 3 years for
capital goods.

TYPES OF FACILITIES PROVIDED TO EXPORTERS

PRE-SHIPMENT OR PACKING CREDIT ADVANCE
Pre-Shipment Finance is issued by a Bank/ financial institution when the
seller wants the payment of the goods before shipment. The main
objectives behind pre-shipment finance or packing credit finance is to
enable exporter to:

• Procure raw materials.

• Carry out manufacturing process.
• Provide a secure warehouse for goods and raw materials.
• Process and pack the goods.
• Ship the goods to the buyers.
• Meet other financial cost of the business.
Types of Pre- Shipment Finance

• Packing Credit/ Pre-shipment

• Advance against Cheques/Draft etc. representing Advance Payments.

Pre-shipment/ Packing Credit finance is extended in the following form

• Packing Credit in Indian Rupee

• Packing Credit in Foreign Currency (PCFC)

Requirements for Getting Packing Credit

• A ten-digit Importer-Exporter code number allotted by DGFT.

• Exporter should not be in the caution list of RBI.
• If the goods to be exported are not under OGL (Open General
Licence), the exporter should have the required license /quota permit
to export the goods.

Packing credit facility can be provided to an exporter on production of the

following evidences to the bank:

1. Formal application for release the packing credit with undertaking to

the effect that the exporter would be ship the goods within stipulated
due date and submit the relevant shipping documents to the banks
within prescribed time limit.
2. Firm order or irrevocable L/C or original cable / fax / telex message
exchange between the exporter and the buyer.
3. Licence issued by DGFT if the goods to be exported fall under the
restricted or canalized category. If the item falls under quota system,
proper quota allotment proof needs to be submitted.
POST SHIPMENT CREDIT
Post shipment credit means any loan or advance granted or any
other credit provided by a bank to an exporter after shipment of goods
or (and) rendering of services to the date of realization of export
proceeds as per the period of realization.
The post-shipment stage consists of the following steps:
(a) Submission of Documents by the C&F Agent to the Exporter:
(b) On the completion of the shipping procedure, the C&F agent
submits the following documents to the exporter:
A copy of invoice duly attested by the customs. Drawback copy of
the shipping bill.
Shipping documents
are forms that accompany a shipment listing the date shipped, the
customer, the method of shipment, and the quantities and specifications
of goods shipped. Shipping documents usually include
A. bills of lading,
B. packing lists, invoices,
C. insurance documents,
D. and air waybills etc.

Crystallisation of Exports Bills

Crystallisation of export/import bills is done if they are not paid within a
stipulated period. To avoid loss on account of exchange risk, & rate fluctuations
in the market, the Liability is converted into Indian Rupee.
 Remittance under LRS (Liberalised Remittance Scheme ) USD
250000
Purpose of remittance:

1. For travel, studies, medical treatment etc.

2. To acquire shares or debt instruments in listed or unlisted companies or any
other assets including acquisition of immovable property directly or
indirectly outside
3. India

4. To invest in Mutual funds, Venture funds, unrated debt securities,

promissory notes, etc
5. To gift or to give donations
6. To acquire ESOPs in overseas companies (in addition to acquisition of
ESOPs linked to ADR/GDR)
7. Repayment of loan taken while an individual was a Non-Resident Indian
8. To open, maintain and hold foreign currency accounts with banks outside
India for carrying out any permitted transactions
Export Credit Guarantee Corporation (ECGC)
Export Credit Guarantee Corporation of India is fundamentally an export
promotion organization, which seeks to enhance the competitiveness of
Indian exports by offering them credit insurance covers. This corporation
was set up for ensuring smooth functioning of Indian exporters by
minimizing the risks associated with the payments emanating from other
nations. This insurance cover which is provided by ECGC also assists the
Indian exporters with better access to the credit facilities from banks and
other financial institutions. Export Credit Guarantee Corporation of India
offers protection against the non-payment by an importer. Due to this
insurance cover, the financial institutions are better placed for lending
and providing larger credit to exporters. ECGC also offers credit ratings
as well as shares the information on various countries and risks
associated with doing business with/in those countries.
ROLE OF ECGC
1. It offers an array of credit risk insurance covers to the Indian exporters
against the loss with respect to the export of their goods and services
2. It provides Export Credit Insurance covers to the banks and other
financial institutions for enabling exporters to find better services from
them
3. It offers Overseas Investment Insurance to the Indian companies
investing in Joint Ventures (JVs) abroad in the form of loan or equity
How does ECGC help the exporters?
1. Guiding export-related activities2. Making information available with
respect to various countries with its credit ratings
3. Making it easy to get export finance from the banks and other financial
institutions
4. Helping Indian exporters recover bad debts
5. Providing information on the credit-worthiness of foreign buyers ECGC
further insures exporter’s credit risks against both political as well as
commercial conditions and guarantees the payment to exporters.
ECGC offers several types of insurance covers and these could be
classified into the following groups:
a. Standard policies that protect Indian exporters against overseas credit
risks b. Construction works and services policies
c. Financial Guarantees
d. Special policies ECGC offers following types of guarantees to the
exporters:
i. Export finance guarantee
ii. Packing credit guarantee
 iii. post-shipment export credit guarantee
iv. Export production finance guarantee
v. Transfer guarantee
vi. Export performance guarantee
It pays 80 to 90 per cent of loss incurred by Indian exporters. The
remaining 10 to 20 per cent of the loss alone has to be borne by the
exporters. However, it doesn’t cover the risks mentioned below:
i. Exchange loss due to fluctuations in exchange rates
ii. Failure on the part of the buyer abroad to obtain the import
authorization or exchange
iii. A default of the exporter or his agent
iv. Any loss which arises due to dispute in quality
v. Risk which is inherent in the nature of goods

Export and Import Bank of India (EXIM)

The Export and Import Bank of India, popularly known as the EXIM Bank
was set up in 1982. It is the principal financial institution in India for
foreign and international trade. It was previously a branch of the IDBI, but
as the foreign trade sector grew, it was made into an independent body.
The main function of the Export and Import Bank of India is to provide
financial and other assistance to importers and exporters of the country.
And it oversees and coordinates the working of other institutions that
work in the import-export sector. The ultimate aim is to promote foreign
trade activities in the country.
The management of the EXIM bank is done by a board, headed by the
Managing Director. There are 17 other Directors on the board. The
whole paid-up capital of the bank (100 crores currently) is subscribed
by the Central Government exclusively.

Functions of the EXIM Bank

1. Finances import and export of goods and services from India
2. It also finances the import and export of goods and services from
countries other than India.
3. It finances the import or export of machines and machinery on
lease or hires purchase basis as well.
4. Provides refinancing services to banks and other financial institutes
for their financing of foreign trade
5. EXIM bank will also provide financial assistance to businesses
joining a joint venture in a foreign country.
6. The bank also provides technical and other assistance to importers
and exporters. Depending n the country of origin there are a lot of
processes and procedures involved in the import-export of goods.
The EXIM bank will provide guidance and assistance in
administrative matters as well.
7. Undertakes functions of a merchant bank for the importer or
exporter in transactions of foreign trade.
8. Will also underwrite shares/debentures/stocks/bonds of
companies engaged in foreign trade.
9. Will offer short-term loans or lines of credit to foreign banks and
governments.
10. EXIM bank can also provide business advisory services and expert
knowledge to Indian exporters in respect of multi-funded projects in
foreign countries
IMPORTANT FOREIGN TRADE TERMS
Based on current rates in inter bank market/international
Card Rate mkt at
beginning of each day, card rates are offered to
customers.
When foreign currency unit is fixed & local currency is
Direct rate variable i.e.,
1$ = Rs.72
When foreign currency is variable & Local currency is
Indirect rate fixed i.e., Rs100 = USD 1.26

Buying Rate When bank gives Rupees and get foreign currency
Selling Rate When bank gives foreign currency and gets rupees
Spot Rate Rate for next 2 working days
TT Rates Settlement within next 2 days
Deal today Delivery after settled period 3 m , 6 m or
Forward Rates more afterword’s.

Follow this
Rule Direct Rate =Buy Low Sell High

Indirect Rate = Buy High Sell Low

What is Swift: Society for Worldwide inter-bank Financial

Telecommunications
SWIFT is the fastest and most secure mode of transmission of financial
messages between Banks and Institutions. CSB provides the service to its
customers for transmission of foreign currency funds to anywhere in the
world for all eligible outward remittances in shortest possible time.
 Types of International Banking
1) Correspondent banks
Correspondent banks involve the relationship between different banks which are in
different countries. This type of bank is generally used by the multinational companies
for their international banking. This type of banks is in small size and provides service to
those clients who are out of their country.

2) Edge act banks

Edge act banks are based on the constitutional amendment of 1919. They will operate
business internationally under the amendment.

3) Off-shore banking centre

It is a type of banking sector which allows foreign accounts. Offshore banking is free from
the banking regulation of that particular country. It provides all types of products and
services.

4) Subsidiaries
Subsidiaries are the banks which incorporate in one country which is either partially or
completely owned by a parent bank in another country. The affiliates are somewhat
different from the subsidiaries like it is not owned by a parent bank and it works
independently.

5) Foreign branch bank

Foreign banks are the banks which are legally tied up with the parent bank but operate
in a foreign nation. A foreign bank follows the rules and regulations of both the countries
i.e. home country and a host country.
 Types of Risk in International Trade

1) Currency risk
An international bank has to be familiar with the currency exchange rate while doing
business internationally. The companies which choose to operate in a foreign country
and at that time it has to deal with currency risk.

2) Political/ country risk

Political risk also affects the business because business has to follow the rules and
regulation of host country and each country has their political effect on the business. If
the political decisions are unfavourable it affects the business.

3) Reputation risk
A reputation risk means the potential loss in reputational capital based on either real or
observed loss in reputational capital. A bank faces reputation risks like rumours about
the bank, data manipulation, bad customer service, and experience. A bank's reputation
is judged by the clients, investors, leaders, and critics.

4) Systematic risk
The systematic risk is not related to particular one bank but it affects the whole
economy. A systematic risk is associated with failures of the big entity and it affects the
whole economy.

5.Replacement Risk
Replacement risk occurs when counter-parties of a failed bank or Forex broker find they
are at risk of not receiving their funds from the failed bank.

6. Settlement Risk
Settlement risk occurs because of the difference of time zones on different continents.
Consequently, currencies may be traded at different prices at different times during the
trading day. Australian and New Zealand Dollars are credited first, then the Japanese
Yen, followed by the European currencies and ending with the US Dollar. Therefore,
payment may be made to a party that will declare insolvency or be declared insolvent,
prior to that party executing its own payments.
7. Counter-party Default Risk
Over-the-counter ("OTC") spot and forward contracts in currencies are not traded on
exchanges; rather, banks and FCM's typically act as principals in this market. Because
performance of spot and forward contracts on currencies is not guaranteed by any
exchange or clearing house, the client is subject to counter-party risk -- the risk that the
principals with a trader, the trader's bank or FCM, or the counter-parties with which the
bank or FCM trades, will be unable or will refuse to perform with respect to such
contracts. Furthermore, principals in the spot and forward markets have no obligation to
continue to make markets in the spot and forward contracts traded.

8. Leverage Risk
Low margin deposits or trade collateral are normally required in Foreign Exchange, (just
as with regulated commodity futures). These margin policies permit a high degree of
leverage. Accordingly, a relatively small price movement in a contract may result in
immediate and substantial losses in excess of the amount invested.

9. Transactional Risk
Errors in the communication, handling and confirmation of a trader's orders (sometimes
referred to as "out trades") may result in unforeseen losses. Often, even where an out
trade is substantially the fault of the dealing counter-party institution, the
trader/customer's recourse may be limited in seeking compensation for resulting losses
in the account.

10. Risk of Ruin

Even where a trader/customer's medium to longer term view of the market may be
ultimately correct, the trader may not be able to financially bear short-term unrealized
losses, and may close out a position at a loss simply because he or she is unable to meet
a margin call or otherwise sustain such positions. Thus, even where a trader's view of the
market is correct, and a currency position may ultimately turn around and become
profitable had it been held, traders with insufficient capital may experience losses.
NON-RESIDENT INDIAN UNDER FEMA 1999
NRI is an Indian citizen or Foreign National of Indian Origin resident outside
India for purposes of employment, carrying on business or vocation in
circumstances as would indicate an intention to stay outside India for an
indefinite period.
An individual will also be considered NRI if his stay in India is less than 182
days during the preceding financial year. Student gone abroad for studies are
also considered NRI

NON-RESIDENT INDIANS UNDER INCOME TAX ACT

INCOME TAX ACT 1961 does not define who is non resident. Rather it
define who is resident and who are not ordinarily resident. Therefore, if a
person does not fall in the category of resident or not ordinarily resident, he /
she will be non-resident.

RESIDENT- INDIAN:
An individual is resident if any of the following conditions are satisfied:
(i) he stayed in India for 120 days (PREVIOUSLY 182 DAYS) or more during the
previous year, or
(ii) he stayed in India for 365 days or more during the four preceding years
and stays in India for atleast 60 days
Stay in India for the above criteria may be continuous or intermittent.
POI (PERSON OF INDIAN ORIGIN)
A person who is not a citizen of India is deemed to be of Indian origin if he is
not a citizen of Pakistan or Bangladesh and if
1. he at any time held an Indian passport; or
2. he or either of his parents or any of his grandparents was a citizen of
India by virtue of the Constitution of India or Citizenship Act, 1955.
A spouse (not being a citizen of Pakistan or Bangladesh) of an Indian citizen or
of a Person of Indian Origin is also treated as a Person of Indian Origin for the
purpose of NRI deposits if the accounts are held jointly with the NRI/PIO
spouse. PIOs are extended the same facilities for bank account maintenance
in India as NRIs and are also, for such purposes, called by the generic name as
NRI.

NON- ORDINARILY RESIDENT

The budget proposed to amend the definition of “not ordinarily resident". Till
FY20, an individual was classified as a “not ordinarily resident" if he was a
non-resident in India for nine out of 10 preceding years. The budget proposal
has reduced the numbers of years to SEVEN (7) out of the 10.
NRO = NON-RESIDENT ORDINARY ACCOUNT

Any NRI can open NRO account Singly or Jointly

with Residents.
However, individuals / entities of Bangladesh
and Pakistan nationals require prior approval of
Who Can Open RBI.

Nomination Nominee can be a Resident or a Non Resident.

Claim Settlement – Resident Nominees – In INR,
NRI Nominee – Repatriable to that Country as
per RBI Norms.
Remittances of Balances held in NRO accounts
Repatriation can be allowed
up to USD one million per financial year, for all
bona fide
purposes to the satisfaction of Authorized
Dealer (AD)
Foreign Tourists visiting India – the balance
amount in the
account (other than local credits) can be
repatriated at the time
 of departure from India provided the account
has been
maintained for a period not exceeding six
months.
Type of account Current, Savings, Recurring, Term Deposits.
Period of Deposits As applicable to Domestic Deposits
Rate of Interest As applicable to Domestic Deposits
Deposit Loans As applicable to Domestic Deposits
Applicability of Local
Taxes
As applicable to Domestic Deposits

Permitted to NRE account within the overall

Transfer of funds ceiling of USD one
million per financial year
Premature Cancellation
of Deposits As applicable to Domestic Deposits

NRE: NON-RESIDENT EXTERNAL RUPEE ACCOUNT

Who Can Open the NRI can open NRE account Singly or Jointly with
account their resident, close relative
With regard to joint account with resident, the
operation of the account should invariably be:
“Former or Survivor” and former should be NRI
*The recent RBI guidelines allowed Non-
Resident Indians (NRIs) to operate resident
bank accounts on “either or survivor” basis.*
 However, Individuals/ entities of Bangladesh&
Pakistan require prior approval of RBI

Nomination Nominee can be a Resident or a Non Resident

Claim Settlement – Resident Nominees – In
Indian Rupee
Non Resident Nominee – Repatriable as per RBI
Norms
Repatriation Balances in the account are Fully Repatriable

Type of account Current, Savings, Recurring, Term Deposits.

Period of Term Deposits Minimum one year and Maximum 3 years
Applicability of Local
Taxes No Wealth Tax. Free from all Taxes
Transfer of amount to
other types Permitted to NRO / FCNR

RBI RECENT
GIDELINES

The recent RBI guidelines allowed Non-Resident Indians (NRIs) to

operate resident bank accounts on “either or survivor” basis.
Banks may include an NRI close relative in existing/new resident
bank accounts as joint holder with the resident account holder on
“either or survivor” basis, subject to fulfilment of a few
conditions. An NRI can be a joint holder in more than one account.
Cheques, instruments, remittances, cash, card or any other
proceeds belonging to the NRI relative shall not be eligible for
credit to this account.
Besides, the NRI relative shall operate such account only for and
on behalf of the resident for domestic payment and not for
creating any beneficial interest for himself. Due to any
eventuality, if the NRI becomes the survivor of such an account, it
shall be categorized as Non-Resident Ordinary Rupee (NRO)
account.

FCNR(B) - Foreign Currency Non-Resident

account
Any Non-Resident Indian (Individuals of Bangladesh /
Pakistan Nationality require approval from RBI) Singly
Who Can Open or jointly with another Non Resident only

Nominee can be a resident or a Non-Resident. Claim

Nomination Settlement
– Resident Nominees – In Indian rupees Non-Resident
Nominee
– Repatriable as per RBI Norms.
Type of
account Term Deposits only (FDR / Reinvestment)
Repatriation Fully Repatriable without any limits.
Period of
Deposits Minimum one year and Maximum 5 years
Foreign Currency loans to be allowed to depositor /
Deposit Loans third party
A/c can be opened at Designated branches. (C Category Branches)
Amount Transfer Permitted to NRO and NRE accounts
No Exchange Risk to the customer, in case of
Foreign Currency repatriation, as account is maintained in
Exchange Risk Foreign Currency.
No TDS on Interest earned and No Wealth
Applicability of Taxes Tax.
Account can be opened in any freely
Designated Currency convertible currency.
No interest payable and no SWAP cost to be
recovered for the deposits up to USD 10000
or equivalent, where the deposit is cancelled
before the expiry of one year. However,
SWAP cost to be recovered in case of
deposits above USD 10000 or its equivalent.
Cancellation of the deposit for the purpose of
renewal in the same currency, same type of
deposit/RFC, no SWAP cost is to be
recovered. If the deposit is cancelled after
one-year, applicable rate is to be paid
without Penalty. If the withdrawal for any
other reason applicable interest with 1%
Premature Cancellation penalty is to be levied.
 RFC – Resident Foreign Currency Accounts
Non-Resident Indians (NRI) returning to for
Who Can Open Permanent stay India who have been
NRIs for a continuous period of not less than one
year.

Nomination Nominee can be a resident or a Non-Resident

Claim Settlement – Resident Nominees – In Indian
rupees
Non-Resident Nominee – Repatriable as per RBI
Norms
Foreign Exchange received as pension /
Sources of funds superannuation / other
benefits from employers abroad. Realization of
assets held
abroad. Foreign Exchange acquired as gift or
inheritance from
person who was an NRI. Foreign Exchange
acquired or received
or any income arising or accruing there on which is
held outside
India by any person in terms of general or specific
permission
granted by RBI.

Types of accounts Savings, Current, Term Deposits

 Allowed with another eligible person/s or with
Joint Accounts resident close
relative (Former or Survivor)
As applicable to FCNR B Accounts. Min 1 year Max
Period of Term Dep 5 years

RFC – Resident Foreign Currency Domestic Account

Who Can
Open Any person resident in India
Joint
Accounts Not permitted
➢
Sources of Foreign Exchange acquired in the form of
funds currency notes,
bank notes, cheques, drafts, and traveller
cheques.
➢
Payment / honorarium / gift for services
rendered in India /
abroad.
➢
Unspent amount of foreign exchange
acquired by him from
an authorized person for travel abroad.
➢
Gift from close relatives as defined in sec.
6 of the company
act 1956.
➢
Proceeds of Insurance policy claims /
maturity / surrender
values settled in foreign currencies.
Types of
accounts Current Account / Savings Bank
No Interest on Current Account. Banks have
Interest discretion to fix
their own interest rates on Savings Deposits
 Pound Sterling, US Dollar, Euro, Australian
Currency Dollar, Canadian Dollar.

EEFC - Exchange Earner’s Foreign Currency Accounts

All Categories of Foreign Exchange Earners
such as Individuals, Companies etc., who are
Who Can resident in India, may open EEFC account
Open with 100% of their Forex earnings.
Resident Individuals are permitted to
include his close relative as a joint holder;
however, the joint holder is not allowed to
operate the account during the life time of
account holder

Authorized Dealers (AD) are allowed to

open, hold and maintain foreign currency
denominated accounts for the purpose of
transacting foreign exchange business and
other matters of the account holder.
The account can be maintained with one or
Purpose more Authorised Dealers
 The Account may be maintained in the
currency of the remittance or any other
permitted currency at the option of the
Currency depositor.

No credit facility, either fund or non-fund

based should be permitted against the
Credit facility security of balances held in EEFC accounts

EEFC accounts should be in the form of non-

Type of interest-bearing current accounts only.
account Cheque book facility is permitted.

Interest No Interest is payable

Nomination facility is permitted like any
Nomination domestic account.
Nominee can be Resident Indian only

---------------xxxxxxxxxxxxxxxxxxxx-------------
 Bankers ZONE ARENA
CAIIB PAPER 2 BFM RISK MANAGEMENT
WHAT IS RISK:
Risk is in financial terms Is the chance that an outcome or
investment's actual gains will differ from an expected
outcome or return. In the Capital Asset Pricing Model (CAPM),
risk is defined as the volatility of returns. The concept of “risk
and return” is that riskier assets should have higher expected
returns to compensate investors for the higher volatility and
increased risk.

Types of Risks Faced by Banks

Credit Risks.

Market Risks.

Operational Risks.

Moral Hazard.

Liquidity Risk.

Business Risk.

Reputational Risk.

Systemic Risk.
CREDIT RISK:
Credit risk in bank arises when a corporate or individual
borrower fails to meet their debt obligations. It is the
probability that the lender will not receive the principal and
interest payments of a debt required to service the debt
extended to a borrower.

On the side of the lender, credit risk will disrupt its cash flows
and also increase collection costs, since the lender may be
forced to hire a debt collection agency to enforce the
collection. The loss may be partial or complete, where the
lender incurs a loss of part of the loan or the entire loan
extended to the borrower.

In an efficient market system, banks charge a high interest

rate for high-risk loans as a way of compensating for the high
risk of default.

Conversely, when transacting with a corporate borrower with

a poor credit history, the lender can decide to charge a high
interest rate for the loan or reject the loan application
altogether. Lenders can use different methods to assess the
level of credit risk of a potential borrower in order to mitigate
losses and avoid delayed payments.

TYPES OF CREDIT RISK

1. Credit default risk

Credit default risk occurs when the borrower is unable to pay

the loan obligation in full or when the borrower is already 90
days past the due date of the loan repayment. The credit
default risk may affect all credit-sensitive financial
transactions such as loans, bonds, securities, and derivatives.

The level of default risk can change due to a broader

economic change. It can also be due because of a change in
a borrower’s economic situation, such as increased
competition or recession, which can affect the company’s
ability to set aside principal and interest payments on the
loan.

2. Concentration risk

Concentration risk is the level of risk that arises from

exposure to a single counterparty or sector, and it offers the
potential to produce large amounts of losses that may
threaten the lender’s core operations.

For example, a corporate borrower who relies on one major

buyer for its main products has a high level of concentration
risk and has the potential to incur a large amount of losses if
the main buyer stops buying their products.

3. Country risk

Country risk is the risk that occurs when a country freezes

foreign currency payments obligations, resulting in a default
on its obligations. The risk is associated with the country’s
political instability and macroeconomic performance, which
may adversely affect the value of its assets or operating
profits. The changes in the business environment will affect
all companies operating within a particular country.
4. Investment Risk

Investment risk is the probability or likelihood of occurrence

of losses relative to the expected return on any particular
investment. It is a measure of the level of uncertainty of
achieving the returns as per the expectations of the investor

5. Transaction Risk

Transaction Risk is the exposure to uncertainty factors that

may impact the expected return from a deal or transaction.
It can include but is not limited to foreign exchange risk,
commodity, and time risk. It essentially includes all negative
events that can prevent a deal from happening.

6. Portfolio Risk

Portfolio risk is a chance that the combination of assets or

units, within the investments that you own, fail to meet
financial objectives. Each investment within a portfolio carries
its own risk, with higher potential return typically meaning
higher risk.

A portfolio is a collection of financial investments like stocks,

bonds, commodities, cash, and cash equivalents, including
closed-end funds and exchange traded funds (ETFs). People
generally believe that stocks, bonds, and cash comprise the
core of a portfolio.
7. Counter party risk

Counterparty risk is the probability that the other party in an

investment, credit, or trading transaction may not fulfil its
part of the deal and may default on the contractual
obligations.

WHAT IS CREDIT RISK MODELLING:

Credit risk modelling is a technique used by lenders to

determine the level of credit risk associated with extending
credit to a borrower. Credit risk analysis models can be based
on either financial statement analysis, default probability, or
machine learning.

Factors Affecting Credit Risk Modelling

In order to minimize the level of credit risk, lenders should

forecast credit risk with greater accuracy. Some of the factors
that lenders should consider when assessing the level of
credit risk are:

1. Probability of Default (POD)

The probability of default, or POD, is the likelihood that a

borrower will default on their loan obligations. For individual
borrowers, POD is based on a combination of two factors, i.e.,
credit score and debt-to-income ratio.

The POD for corporate borrowers is obtained from credit

rating agencies. If the lender determines that a potential
borrower demonstrates a lower probability of default, the
loan will come with a low interest rate and low or no down
payment on the loan. The risk is partly managed by pledging
collateral against the loan.

2. Loss Given Default (LGD)

Loss given default (LGD) refers to the amount of loss that a

lender will suffer in case a borrower defaults on the loan.

For example, A and B, with the same debt-to-income ratio

and an identical credit score. Borrower A takes a loan of
Rs.10,000 while B takes a loan of Rs.200,000.

The two borrowers present with different credit profiles, and

the lender stands to suffer a greater loss when Borrower B
defaults since the latter owes a larger amount. Although
there is no standard practice of calculating LGD, lenders
consider an entire portfolio of loans to determine the total
exposure to loss.

3. Exposure at Default (EAD)

Exposure at Default (EAD) evaluates the amount of loss

exposure that a lender is exposed to at any particular time,
and it is an indicator of the risk appetite of the lender. EAD is
an important concept that references both individual and
corporate borrowers. It is calculated by multiplying each
loan obligation by a specific percentage that is adjusted
based on the particulars of the loan.

Although credit risk is largely defined as risk of not receiving

payments, banks also include the risk of delayed payments
within this category.
MARKET RISK
“Market risk” is the risk that a financial institution will incur
losses because of a change in the price of assets held
(including off-balance-sheet assets) resulting from changes in
interest rates, securities etc. prices, foreign exchange rates,
and other market risk factors.

Apart from making loans, banks also hold a significant

portion of securities. Some of these securities are held
because of the treasury operations of the bank i.e., as a
means to park money for the short term. However, many
securities are also held as collateral based on which banks
have given loans to their customers.

Banks face market risks in various forms. For instance, if they

are holding a large amount of equity then they are exposed
to equity risk. Also, banks by definition have to hold foreign
exchange exposing them to Forex risks. , banks lend against
commodities like gold, silver and real estate which exposes
them to commodity risks as well.

Some of Market risk include recessions, political turmoil,

changes in interest rates, natural disasters and terrorist
attacks. Systematic, or market risk, tends to influence the
entire market at the same time. This can be contrasted with
unsystematic risk, which is unique to a specific company or
industry.

In order to be able to mitigate such risks banks simply use

hedging contracts. They use financial derivatives which are
freely available for sale in any financial market. Using
contracts like forwards, options and swaps, banks are able to
almost eliminate market risks from their balance sheet.

OPERATIONAL RISK
Operational risk in banking is the risk of loss that stems from
inadequate or failed internal systems, internal controls,
procedures, or policies due to employee errors, breaches,
fraud, or any external event that disrupts a financial
institution's processes.

Operational risk can occur at every level in an organisation.

The type of risks associated with business and operation risk
relate to:

1. Business interruption
2. errors or omissions by employees
3. product failure
4. health and safety
5. failure of IT systems
6. fraud
7. loss of key people
8. litigation
9. loss of suppliers.

Examples of operational risk would also include payments

credited to the wrong account or executing an incorrect order
while dealing in the markets. None of the departments in a
bank are immune from operational risks.

Operational risks arise mainly because of hiring the wrong

people or alternatively they could also occur if there is a
breakdown of the information technology systems. A lapse in
the internal processes being followed could also lead to
catastrophic errors. For instance, Barings Bank ended up
bankrupt because of its failure to implement appropriate
internal controls. One trader was able to bet so much in the
derivatives market that the equity of Barings Bank was wiped
out and the bank simply ceased to exist.

MORAL HAZARD RISK

The recent bailout of banks by many countries has created
another kind of risk called the moral hazard. This risk is not
faced by the bank or its shareholders. Instead, this risk is
faced by the taxpayers of the country in which banks operate.
Banks have become accustomed to taking excessive risk. If
their risk pays off, they get to keep the returns. However, if
their risk backfires, then the losses are borne by taxpayers in
the form of bailouts. This too big to fail model has caused
banks to become reckless in their pursuit of profit. Although
central banks are using audits to ensure that safe business
practices are followed, banks nowadays indulge in risky
business the moment they are not under regulatory
oversight.

LIQUIDITY RISK

Liquidity risk is another kind of risk that is inherent in the

banking business. Liquidity risk is the risk that the bank will
not be able to meet its obligations if the depositors come in
to withdraw their money. This risk is inherent in the fractional
reserve banking system. Therefore, in this system, only a
percentage of the deposits received are held back as
reserves, the rest are used to create loans. Therefore, if all
the depositors of the institution came in to withdraw their
money all at once, the bank would not have enough money.
This situation is called a bank run.

These days banks are not very concerned about liquidity risk.
This is because they have the backing of the central / Reserve
bank. In case there is a run on a particular bank, the central
bank diverts all its resources to the affected bank. Therefore,
the depositors can be paid back when they demand their
deposits. This restores depositor’s confidence in the bank’s
finances and the run on the bank is averted.

BUSINESS RISK
Unlike operational risk, business risk is the risk arising from a
bank's long-term business strategy. It deals with a bank not
being able to keep up with changing competition dynamics,
losing market share over time, and being closed or acquired.

The banking industry today is considerably advanced and

diversified. Banks today have a wide variety of strategies from
which they have to choose. Once such strategy is chosen,
banks need to focus their resources on obtaining their
strategic goals in the long run.

Hence, there is always a risk that a given bank may choose

the wrong strategy. As a result of this wrong choice, the bank
may suffer losses and end up being acquired or may simply
collapse. Consider the case of banks such as Washington
Mutual and Lehman Brothers. These banks chose the
subprime route to growth. Their strategy was to be the
preferred lender to people who have less than perfect credit
scores. However, the whole area of subprime lending went
bust and since these banks had heavy exposures to such
loans, they suffered dire consequences too.

Banks have no possible way to mitigate the risks that are

created by following inappropriate business objectives.
Which objectives were right and which were wrong? This
question can only be answered in hindsight. More thoughts
need to make out the strategies which have massive
consequences if gone wrong.

REPUTATIONAL RISK
Reputational risk is a threat or danger to the Reputation or
good name or standing of a bank, business or entity.
Reputational risk can occur in the following ways:

1. Directly, as the result of the actions of the company

2. Indirectly, due to the actions of an employee or employees

3. Through other connected parties, such as joint venture

partners or suppliers. Reputation is an extremely important
intangible asset in the banking business. These reputations
enable them to generate more business more profitably.

Customers like their money to be deposited at places which

they believe follow safe and sound business practices. Hence,
if there is any news in the media which projects a given bank
in a negative light, such news negatively impacts the banks
business
Banks can save their reputation by ensuring that they never
participate in any unfair or manipulative business practices.
Also, banks need to continuously ensure that their public
relations efforts project them as a friendly and honest bank.

SYSTEMATIC RISK (VERY IMPORTANT)

Systemic risk refers to the risk of a breakdown of an entire
system rather than simply the failure of individual Bank. In a
financial context, if denotes the risk of a Toalfailure in the
financial sector, caused by linkages within the financial
system, resulting in a severe economic downturn. Systemic
risk arises because of the fact that the financial system is one
intricate and connected network. Hence, the failure of one
bank has the possibility to cause the failure of many other
banks as well. This is because banks are counterparties to
each other in a lot of transactions. Hence, if one bank fails,
the credit risk event for the other banks becomes a reality.

They have to write off certain assets as a result of the failure

of their counterparty. This writing off often leads to the
bankruptcy of other banks and an unstoppable domino
seems to take over. Systemic risk is an extremely bad
scenario to be in. For instance, when the subprime crisis
happened in 2008, it seemed like the entire global financial
system would collapse.

The very nature of banking system therefore makes them

prone to systemic risks. Systemic risks do not affect an
individual bank rather they affect the entire system. Hence,
there is very little that an individual bank can do to protect
itself in the event that such a risk materializes.
Thus, the management of banks requires a lot of skill since
multiple types of risks need to be mitigated. Some of these
risks can be avoided whereas for the others the best that
banks can do is to minimize their damage.

RISK MANAGEMENT
Risk management refers to the process designed to reduce
or eliminate the risk of certain kinds of events happening or
having an impact on the business - process for identifying,
assessing and prioritizing risks.

Also Risk management is the process of making and carrying

out decisions that will minimize the adverse effects of risk on
an organization. The adverse effects of risk can be objective
or quantifiable like insurance premiums and claims costs, or
subjective and difficult to quantify such as damage to
reputation or decreased productivity. By focusing attention
on risk and committing the necessary resources to control
and mitigate risk, a business will protect itself from
uncertainty, reduce costs, and increase the likelihood of
business continuity and success.

A risk exists where there is an opportunity for a profit or a

loss. In terms of losses, we commonly refer to the risks as
exposures to loss, or simply exposures. A fire is an exposure.
Defective products or defamation are liability exposures. The
loss of business that results from a damaged building or
tarnished reputation is also an exposure.

The extent of a risk can be expressed as follows:

Risk = Probability x Severity

PROBABILITY is the likelihood of an event occurring, and
SEVERITY is the extent and cost of the resulting loss.

PURE RISK - Risks where the possible outcomes are either a

loss or no loss. It includes things like fire loss, a building being
burglarized, having an employee involved in a motor vehicle
accident, etc.

SPECULATIVE RISK - Risks where the possible outcomes are

either a loss, profit, or status quo. It includes things like stock
market investments and business decisions such as new
product lines, new locations, etc.

RISK ANALYSIS PROCESS

Risk analysis is a qualitative problem-solving approach that
uses various tools of assessment to work out and rank risks
for the purpose of assessing and resolving them.The risk
analysis process is :

1. IDENTIFY EXISTING RISKS

Risk identification mainly involves brainstorming. A business

gathers its employees together so that they can review all the
various sources of risk. The next step is to arrange all the
identified risks in order of priority. Because it is not possible
to mitigate all existing risks, prioritization ensures that those
risks that can affect a business significantly are dealt with
more urgently.

2. ASSESS THE RISKS

In many cases, problem resolution involves identifying the

problem and then finding an appropriate solution. However,
prior to figuring out how best to handle risks, a business
should locate the cause of the risks by asking the question,
“What caused such a risk and how could it influence the
business?”

3. DEVELOP AN APPROPRIATE RESPONSE

Once a business entity is set on assessing likely remedies to

mitigate identified risks and prevent their recurrence, it
needs to ask the following questions: What measures can be
taken to prevent the identified risk from recurring? In
addition, what is the best thing to do if it does recur?

4. DEVELOP PREVENTIVE MECHANISMS FOR

IDENTIFIED RISKS

Here, the ideas that were found to be useful in mitigating

risks are developed into a number of tasks and then into
contingency plans that can be deployed in the future. If risks
occur, the plans can be put to action.

MITIGATION OF RISKS
Banks business may encounter many risks that can affect
their survival and growth. As a result, it is important to
understand the basic principles of risk management and how
they can be used to help mitigate the effects of risks on
business entities.

1. Diversification

Diversification is a method of reducing unsystematic (specific)

risk by investing in a number of different assets. The concept
is that if one investment goes through a specific incident that
causes it to underperform, the other investments will balance
it out.

2. Hedging

Hedging is the process of eliminating uncertainty by entering

into an agreement with a counterparty. Examples include
forwards, options, futures, swaps, and other derivatives that
provide a degree of certainty about what an investment can
be bought or sold for in the future. Hedging is commonly
used by investors to reduce market risk, and by business
managers to manage costs or lock-in revenues.

3. Insurance

There is a wide range of insurance products that can be used

to protect investors and operators from catastrophic events.
Examples include key person insurance, general liability
insurance, property insurance, etc. While there is an ongoing
cost to maintaining insurance, it pays off by providing
certainty against certain negative outcomes.

4. Operating Practices

There are countless operating practices that managers can

use to reduce the riskiness of their business. Examples
include reviewing, analyzing, and improving their safety
practices; using outside consultants to audit operational
efficiencies; using robust financial planning methods; and
diversifying the operations of the business.

5. Deleveraging
Companies can lower the uncertainty of expected future
financial performance by reducing the amount of debt they
have. Companies with lower leverage have more flexibility
and a lower risk of bankruptcy or ceasing to operate.

It’s important to point out that since risk is two-sided

(meaning that unexpected outcome can be both better or
worse than expected), the above strategies may result in
lower expected returns (i.e., upside becomes limited).

WHY MANAGE RISK?

There are many reasons to manage risk. Some of them
include:

1. Saving resources: people, income, property, assets, time

2. Protecting public image
3. Protecting people from harm
4. Preventing/reducing legal liability
5. Protecting the environment

MONITOR RESULTS
Many institutions/businesses including banks do things to
prevent losses or mitigate risks every day but don’t think of it
as risk management. Most prudent business people and
managers take great care to do things like prevent accidents,
protect property, and keep customers and employees from
harm.

Any effort to manage risks is positive. It is important,

however, to follow a formal process to ensure consistency
and thoroughness. The following are the essential elements
of the risk management process.
RISK ADJUSTMENT
Since different investments have different degrees of
uncertainty or volatility, financial analysts will “adjust” for the
level of uncertainty involved. Generally speaking, there are
two common ways of adjusting: the discount rate method
and the direct cash flow method.

1 DISCOUNT RATE METHOD

The discount rate method of risk-adjusting an investment is

the most common approach, as it’s fairly simple to use and is
widely accepted by academics. The concept is that the
expected future cash flows from an investment will need to
be discounted for the time value of money and the additional
risk premium of the investment.
2 DIRECT CASH FLOW METHOD

The direct cash flow method is more challenging to perform

but offers a more detailed and more insightful analysis. In
this method, an analyst will directly adjust future cash flows
by applying a certainty factor to them. The certainty factor is
an estimate of how likely it is that the cash flows will actually
be received. From there, the analyst simply has to discount
the cash flows at the time value of money in order to get
the net present value (NPV) of the investment.

It’s important to point out that since risk is two-sided

(meaning that unexpected outcome can be both better or
worse than expected), the above strategies may result in
lower expected returns (i.e., upside becomes limited).

SPREADS AND RISK-FREE INVESTMENTS

The concept of uncertainty in financial investments is based

on the relative risk of an investment compared to a risk-free
rate, which is a government-issued bond.

The yield spread is the difference in yield between a bond

yield and the risk-free rate (a notional rate offered by an
investment with the lowest level of risk), or between two
comparable assets. The spread is equivalent to the risk
differential between each investment.

A RISK-FREE ASSET is one that has a certain future return—

and virtually no possibility of loss. Debt obligations issued by
the Government like the Treasury (bonds, notes, and
especially Treasury bills) are considered to be risk-free
because the "full faith and credit" of the Government backs
them.

SPREAD

Spread hedging refers to a limited-risk strategy used by

options traders. All spread hedges involve more than one
strike price. These strike prices offset each other’s' risk to a
certain degree but also introduce a new type of risk: the risk
of incorrectly pricing and timing the strikes in relation to one
another.

1. RISK MEASUREMENT IN BANKS

Risks are desired to be measured to obtain control over the
risks. It assesses the risk management, risk exposure in the
financial sector like banking. Risk measurement maximizes
the extent of risk profile of the Bank. The best way to predict,
measure and forecast of the risk by the previous data of the
Bank.

Risk management relies on the quantitative measures of risk.

The risk measures seek to capture variations in earnings,
market value, losses due to default, etc., (referred to as target
variables), arising out of uncertainties associated with various
risk elements.

MARKET RISK MEASURES ARE BASED ON -

1. Sensitivity
2. Downside Potential
3. Value-at-Risk (VaR)
SENSITIVITY

Risk Sensitivity, also referred to as Greek, is the measure of a

financial instrument's value reaction to changes in underlying
factors. The value of a financial instrument is impacted by
many factors, such as interest rate, stock price, implied
volatility, time, etc.

Greeks are vital for risk management. Sensitivity, may be due

deviation of market price due to unit movement of a single
market parameter. Supply-demand position, interest rate,
market liquidity, inflation, exchange rate, stock prices, etc.,
are the market parameters, which drive market values. For
example, change in interest rate would drive the market
value of bonds and forward foreign exchange held in a
portfolio. If liquidity in the market increases, it may result in
increased demand which in turn may increase the market
price.

BASIS POINT VALUE (BPV)

A basis point is a unit of measure used in finance to describe

the percentage change in the value or rate of a financial
instrument. One basis point is equivalent to 0.01% (1/100 of
a percent) or 0.0001 in decimal form. If interest rates rose
from 2.00% to 2.50%, it would be said that rates rose 50 basis
points. This is the change in value due to 1 basis point (0.01%)
change in the market yield. This is used as a measure of risk.
The higher the BPV of a bond, higher is the risk associated
with the bond.

One basis point is equivalent to 0.0001, so multiply the

number of basis points by 0.0001. You can compute the basis
points as a percentage by multiplying the basis points (let's
use 250) by 0.0001 (250 × 0.0001 = 0.025).

The relationship between percentage changes and basis

points can be as follows:

1% change = 100 basis points and 0.01% = 1 basis point. Basis

points are typically expressed in the abbreviations "bp,"
"bps," or "bips."

WHAT IS A BASIS POINT

“Basis point” is simply a term used in finance to refer to an

increment of 0.01%. Put differently, the expressions “basis
point”, “1/100th of 1%”, “0.01%”, and “0.0001” all have the
same meaning. For example, 5 basis points would mean
0.05%. Likewise, if an interest rate increased from 5.00% to
5.25%, that would represent an upward move of 25 basis
points.

Basis Points Percentage Terms

100 1%

1000 10%

10000 100%

Example of Computation of BPV

For example, if a financial instrument is priced at a 10% rate

of interest and the rate experiences a 10% increase, it could
conceivably mean that it is now 0.10 x (1 + 0.10) = 11% or it
could also mean 10% + 10% = 20%.
For example, a 5year 6% semi-annual bond @ market yield of
8%, has a price of Rs. 92, which rises to Rs. 92.10 at a yield of
7.95%. So, for one BP fall in yield, market price changes by Rs.
0.02 or gains by Rs. 2,000 per Rs. crore face value. BPV of the
bond is, therefore, Rs. 2,000. per crore face value.

This also helps us to quickly calculate profit or loss for a given

change of yield. If the yield on a bond with BPV of 2,000
declines by 8 BPs, then that would result in a profit of 8 X 2000
= Rs. 16,000 per crore of face value. If one is holding Rs.
10,00,000 face value of this bond, he makes a profit of Rs.
1,600.

BPV changes with the remaining maturity. Suppose the bond

described above has 5 years to mature and the present BPV
is 2000, the BPV will decline with time and on the day of
maturity it will be zero.

Duration or Modified duration is Macaulay's duration

discounted by 1 period yield to maturity,

The longer the duration of a security, the greater will be the

price sensitivity to yield changes and the higher would be the
risk associated with the bond. Bond price changes can be
estimated with the help of modified duration by using the
following relationship.

Approx. % change in price = — modified duration X yield

change

DOWNSIDE POTENTIAL

Risk materializes only when earnings deviate adversely.

Downside potential captures the possible losses only and
ignores the profit potential. Downside risk is the most
comprehensive measure of risk as it integrates sensitivity and
volatility with the adverse effect of uncertainty. This is the
measure that is most relied upon by banking and financial
service industry as also the regulator.

Yield Vs Price Volatility

YIELD VOLATILITY is the degree of variance in yield. This is

largely unaffected by time and duration. The volatility rises as
yields fall.

PRICE VOLATILITY is degree of variance in price. This is

largely unaffected by yield and substantially affected by time
and duration.

Price Volatility = (Yield volatility BPV x Yield)/Price

Value-at-Risk (VaR)
Value at Risk (VaR) a statistical tool to measure and quantify
financial risk within a firm or portfolio over a specific time
frame. This metric is often used by Banks to determine the
extent and probability of occurrence of a potential loss on the
advances. It is quite commonly used as a tool for Risk
Management.

Value-at-risk is defined as the maximum amount expected to

be lost over a given time horizon, at a pre-defined confidence
level.

Value at Risk (VAR) calculates the maximum loss expected (or

worst-case scenario) on an investment, over a given time
period and given a specified degree of confidence.
For a given time period (normally ranging from 1 to 10 days),
and with a given probability confidence (generally equal to
95% or 99%); this measure represents the maximum loss the
investor can suffer when holding financial assets.

Banks Risk managers use VaR to measure and control the

level of financial risk exposure, which can be within the firm,
a portfolio consisting of any type of asset or a specific position
and thus be used to gauge the asset value needed to cover
possible losses.

WHAT IS CONFIDENCE LEVEL

The confidence Level tells more than just the possible range
around the estimate. It also tells you about how stable the
estimate is. A stable estimate is one that would be close to
the same value if the survey were repeated. 95% or 99% best
level. The Higher the level the better. the confidence interval
is quite narrow when computed from a large sample.

What does 95% VaR means:

It is defined as the maximum amount expected to be lost over

a given time horizon, at a pre-defined confidence level. For
example, if the 95% one-month VAR is Rs.1 million, there is
95% confidence that over the next month the portfolio will
not lose more than Rs.1 million.

There are three main approaches to calculating value-at-risk:

1. The correlation method, also known as the

variance/covariance matrix method
2. Historical simulation
3. Monte Carlo simulation
BACK TESTING
It is a process where model based VaR is compared with
Actual performance. It tells us whether results fall within pre-
specified confidence bonds as predicted by VaR models.

STRESS TESTING
It seeks to determine possible change in Market Value of
portfolio that could arise due to non-normal movement in
one or more market parameters (such as interest rate,
liquidity, inflation, Exchange rate and Stock price etc.).

Four tests are applied:

1. Simple sensitivity test;

If Risk factor is exchange rate, shocks may be exchange rate

+2%, 4%,6% etc.

2. Scenario test

It is leading stress testing technique. The scenario analysis

specifies the shocks, if possible, events occur. It assesses
potential consequences for a firm of an extreme. It is based
on historical event or hypothetical event.

3. Maximum loss

The approach assesses the risks of portfolio by identifying

most potential combination of moves of market risks
4. Extreme value theory

The theory is based on behaviour of tails (i.e. very high and

very low potential values) of probable distributions.

BASEL 1, BASEL, & BASEL 3

The key difference between Basel 1 2 and 3 is that Basel 1 is
established to specify a minimum ratio of capital to risk-
weighted assets for the banks whereas Basel 2 is established
to introduce supervisory responsibilities and to further
strengthen the minimum capital requirement and Basel 3 to
promote the need for liquidity buffers (an additional layer of
equity).

WHAT IS BASEL 1

Basel 1 was released in July 1988 to provide a framework to

address risk management from a bank’s capital adequacy
perspective. The principal concern here was the capital
adequacy of banks.

A minimum ratio of capital to risk-weighted assets of 8% was

stated to be implemented effective from 1992.

Basel 1 also specified the general provisions that can be

included in the calculation of the minimum required capital.

WHAT IS BASEL 2

The main objective of Basel 2 was to replace the minimum

capital requirement with a need to conduct a supervisory
review of the bank’s capital adequacy. Basel 2 consists of 3
pillars. They are,

1. Minimum capital requirements, which sought to develop

and expand the standardised rules set out in the Basel 1
2. Supervisory review of an institution’s capital adequacy
and internal assessment process
3. Effective use of disclosure as a lever to strengthen
market discipline and encourage sound banking
practices

WHAT IS BASEL 3

ALL ABOUT BASEL III

Basel III is only a continuation of effort initiated by the Basel

Committee on Banking Supervision to improve the banking
regulatory framework under Basel I and Basel II. This latest
Accord now seeks to improve the banking sector's ability to
deal with:

1. Financial and economic stress,

2. Improve risk management,

3.Strengthen the banks' transparency

WHAT IS CAPITAL ADEQUACY RATIO – CAR

The capital adequacy ratio (CAR) is a measurement of a

bank's available capital expressed as a percentage of a bank's
risk- weighted credit exposures.

The capital adequacy ratio, also known as capital-to-risk

weighted assets ratio (CRAR)
CALCULATING CAR

The capital adequacy ratio is calculated by dividing a bank's

capital by its risk- weighted assets.

The capital used to calculate the capital adequacy ratio is

divided into two tiers.

Capital (Tier-1 capital + Tier-2 Capital)/ Risk weighted Assets

Tier-1 capital, or core capital, consists of equity capital,

ordinary share capital, intangible assets and audited revenue
reserves.

Tier-2 capital comprises unaudited retained earnings,

unaudited reserves and general loss reserves.

RBI GUIDELINES FOR CAPITAL ADEQUACY RATIO

Total regulatory capital should be at least 9% of risk weighted

assets and within this, Tier 1 capital should be at least 6% of
risk weighted assets. Within Tier 1 capital, innovative Tier 1
instruments are limited to 15% of Tier 1 capital.

INNOVATIVE TIER 1 INSTRUMENTS

To enable banks to raise additional capital, RBI allows banks

to raise capital by issue of innovative perpetual debt
instruments (IPDI) and debt capital.

The banks may issue these instruments in Indian Rupees and

should obtain RBI’s permission for issue in foreign currency.

Banks now have been given time up to Ist January 2023 TO

COMPLY all BASEL III norms
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 Bankers ZONE ARENA
CAIIB PAPER 2 BFM TREASURY MANAGEMENT

TREASURY MANAGEMENT
Treasury Management refers as the planning, organizing and
controlling holding, funds and working capital of the financial
institutions/enterprises in order to make the best possible use of the
funds, maintain firm’s liquidity, reduce the overall cost of funds, and
mitigate operational and financial risk.
It covers working capital management, currency management,
corporate finance and financial risk management.
Simply put, treasury management is the management of all financial
affairs of the business such as raising funds for the business from
various sources, currency management, cash flows and various
strategies and procedures of corporate finance.
FUNCTIONS OF TREASURY MANAGEMENT

THE FUNCTIONS OF TREASURY MANAGEMENT

1. Cash Management: Treasury Management includes cash
management, and so it ensures that there are an effective collection
and payment system in the organization.
2. Liquidity Management: An optimum level of liquidity should be
maintained in the business, for the better and smooth functioning of
the business, i.e. the company must be able to fulfil its financial
obligation when they become due for payment, such as payment to
suppliers, employees, creditors, etc. And to do so, cash flow analysis
and working capital management act as the most important tool for
treasury management, to achieve its strategic goals.
3. Availability of funds in adequate quantity and at the right time:
The treasury manager has to ensure that the funds are available with
the organization in sufficient quantity, i.e. neither be more nor less,
to fulfil the day to day cash requirement for the smooth functioning
of the enterprise. Further timely availability of funds also smoothens
the firm’s operations, resulting in the certainty as to the amount of
inflows available with the company at a particular point in time.
4. Deployment of funds in adequate quantity and at the right time:
The deployment of funds has to be done in right quantity such as the
acquisition of fixed assets, purchase of raw material, payment of
expenses like rent, salary, bills, interest and so forth. For this
purpose, the treasury manager has to keep an eye on all receipts of
funds and the application thereof. Further the funds must be
available at the time of need, which may be different for different
firms and also for the purpose for which they are used.
5. Optimum utilization of resources: Treasury Management also aims
at ensuring the effective utilization of the firm’s resources, to reduce
the operating costs and also prevent liquidity shortage in the coming
time.
6. Risk Management: One of the primary objectives of the treasury
management is to manage financial risk to allow the enterprise to
meet its financial obligations, as they fall due and also ensure
predictable performance of the business. It tends to identify,
measure, analyse and manage risk in order to mitigate losses, that
has the potential to affect the company’s profitability and growth in
any way. Hence, treasury management is accountable for all types of
risk that can influence the business entity.
Further, the treasury management intends to maximise return on
the funds available with the company, by making such investments
which have higher return and low risk.
TREASURY BILLS
Treasury Bills, also known as T-bills are the short-term money market
instrument, issued by the RBI on behalf of the government to curb
temporary liquidity shortfalls.
These do not yield any interest, but issued at a discount, at its
redemption price, and repaid at par when it gets matured, with
guaranteed repayment at a later date. Funds collected through such
tools are typically used to meet short term requirements of the
government, hence, to reduce the overall fiscal deficit of a country.
TYPES OF MARKETABLE TREASURY SECURITIES
There are four types of marketable treasury securities:
1. Treasury bills,
2. Treasury notes,
3. Treasury bonds,
4. and Treasury Inflation Protected Securities (TIPS).
The government sells these securities in auctions conducted by RBI on
behalf of the Government,after which they can be traded in secondary
markets.
The difference between the issue price and the redemption value
indicates the interest on treasury bills, called as a discount.
These are the safest investment instrument of its category, as the risk
of default is negligible. Further, the date of issue is predetermined, as
well as the amount is also fixed.
SALIENT FEATURES OF TREASURY BILLS
Form: T-bills are issued either in physical form as a promissory note or
dematerialised form by crediting to Subsidiary General Ledger (SGL)
Account.
Eligibility: Individuals, firms, companies, trust, banks, insurance
companies, provident funds, state government and financial
institutions are eligible to invest in treasury bills.
Issue price: T-bills are issued at a discount, but redeemed at par.
Repayment: The repayment of the bill is made at par on the maturity
of the term.
Availability: Treasury bills are highly liquid negotiable instruments,
that are available in both financial markets, i.e. primary and
secondary.
Method of the auction: Uniform price auction method for 91 days T-
bills, whereas multiple price auction method for 364 days T-bill.
Day count: The day count is 364 days, in a year, for treasury bills.
Besides this, other characteristics of treasury bills include market-
driven discount rate, selling through auction, issued to meet short-
term mismatches in cash flows, assured yield, low transaction cost,
etc.
Minimum Amount: T-bills are available for a minimum amount of Rs.
25,000 and in multiples of Rs. 25,000. T-bills are issued at a discount
and are redeemed at par.
TYPES OF TREASURY BILLS
At present there are three types of auctioned T-bills, which are:
1. 14 days T-Bills: The Reserve Bank of India (RBI) has announced the
introduction of 14-day intermediate treasury bills.
The discount rate for the 14-day bills will be set every three months
and the effective yield on this instrument will be equivalent to the
interest rate on ways and means advances (WMA).
2. 91 days T-bills: The tenor of these bills completes on 91 days. These
are auctioned on Wednesday, and the settlement date is on following
day.
3. 182 days T-bills: These treasury bills get matured after 182 days,
from the day of issue, and the auction is on Wednesday of non-
reporting week. Moreover, these are repaid on following Friday, when
the term expires.
3. 364 days T-bills: The maturity period of these bills is 364 days. The
auction is on every Wednesday of reporting week and repaid on the
following Friday after the term gets over.
Treasury bills are backed by some advantages like no tax deducted at
source, high liquidity and trade-ability, zero risks of default,
transparency, good return on investment and so on.

MONEY MARKET

It is a market for short term debt securities such as commercial paper, repos,
negotiable certificates of deposit and treasury bills with a maturity of one year
or less.

CAPITAL MARKET
This market is different from the capital market, which deals with long term
instruments like bonds, debentures.

Difference between money market and capital market.

Basis for
Money Market Capital Market
Comparison
A segment of the financial A section of financial
market where lending and market where long-term
borrowing of short-term securities is issued and
Meaning securities are done. traded.
Nature of
Market Informal Formal
 Shares, Debentures,
Treasury Bills, Commercial Bonds, Retained
Financial Papers, Certificate of Earnings, Asset
instruments Deposit, Trade Credit etc. Securitization etc.
Central bank, Commercial Commercial banks, Stock
bank, non-financial exchange, non-banking
institutions, bill brokers, institutions like insurance
acceptance houses, and so companies etc.
Institutions on. (Regulated by RBI (Regulated by SEBI) .
Risk Factor Low Comparatively High
Liquidity High Low
To fulfill short term credit To fulfill long term credit
Purpose needs of the business. needs of the business.
Time Horizon Within a year More than a year
Increases liquidity of funds Mobilization of Savings in
Merit in the economy. the economy.
Return on
Investment Less Comparatively High

MONEY MARKET INSTRUMENTS

1. Promissory Note
2. Bills of exchange or commercial bills.
3. Treasury Bills (T-Bills)
4. Call and Notice Money.
5. Inter-bank Term Market.
6. Commercial Papers (CPs)
7. Certificate of Deposits (CD's)
8. Banker's Acceptance (BA)
COMMERCIAL PAPERS
A commercial paper in India is the monetary instrument issued in the
form of promissory note. It acts as the debt instrument to be used by
large corporate companies for borrowing short-term monetary funds
in the money market.
ELIGIBILITY FOR ISSUING COMMERCIAL PAPER
Companies, Primary Dealers (PDs) and Finance Institution (FIs) are
eligible to issue commercial paper. Commercial Paper (CPs) can be
issued based on the guidelines set by RBI. The following conditions
have to be fulfilled by corporates to receive privileges for issuing
commercial paper:
1. The tangible net worth of the company should not be less than
4 Crores, as per the latest audited Balance-Sheet.
2. The companies should have the ‘sanctioned working capital
limit’ by the banks or any Financial Institutions (FIs).
3. The Financial Institutions or Banks should classify the ‘Borrowal
Account’ as a Standard asset.
4. The Minimum credit rating to obtain the CP is A3, as per the
rating symbol and definition prescribed by SEBI.
TENOR
1. The maturity is a minimum of 7 Days and a maximum of one
year from the date of Issue.
2. Commercial paper should not be provided if the credit rating
is beyond the date of its validity.
3. The denomination for issuing commercial paper must be Rs.5
lakhs and its multiples.
4. CP will be issued at a discount to face value as may be
determined by the issuer.
CERTIFICATE OF DEPOSIT
Certificate of Deposit (CD) is a negotiable money market instrument
and issued in dematerialised form or as a Usance Promissory Note
against funds deposited at a bank or other eligible financial institution
for a specified time period.
ELIGIBILITY FOR CERTIFICATE OF DEPOSIT:
1. Certificates of Deposit are issued by scheduled commercial
banks and select financial institutions in India as allowed by RBI
within a limit. Certificates of Deposits are issued to individuals,
companies, corporations and funds among others.
2. Certificates of Deposits can also be issued to Non-Resident
Indians but on a non-repatriable basis only.
3. The banks and financial institutions cannot provide loans against
Certificates of Deposits. Also, banks cannot buy their own
Certificates of Deposits prior to the CD`s maturity.
MINIMUM SIZE AND MATURITY OF A CERTIFICATE OF DEPOSIT
1. A certificate of deposit can only be issued for a minimum of Rs.1
lakh by a single issuer and in multiples of Rs.1 lakh. The maturity
of a certificate of deposit depends on the investor.
2. A certificate of deposit issued by banks, the maturity period is
not less than 7 days and not above one year while for financial
institutions, a certificate of deposit should not be issued for less
than 1 year and not above three years.
CALL, NOTICE MONEY & TERM MONEY
Call Money' is the borrowing or lending of funds for 1day. Where
money borrowed or lend for period between 2 days and 14 days it is
known as 'Notice Money'. And 'Term Money' refers to
borrowing/lending of funds for period exceeding 14 days.
INTERBANK CALL MONEY MARKET
The interbank call money market is a short-term money market which
allows for large financial institutions, such as banks, mutual funds, and
corporations, to borrow and lend money at interbank rates, the rate
of interest that banks charge when they borrow funds from each
other. The loans in the call money market are very short, usually
lasting no longer than a week, and are often used to help banks meet
reserve requirements.
BANKER` ACCEPTANCE
A banker's acceptance is an instrument representing a promised
future payment by a bank. The payment is accepted and guaranteed
by the bank as a time draft to be drawn on a deposit. The draft
specifies the amount of funds, the date of the payment (or maturity),
and the entity to which the payment is owed.
1. A banker's acceptance is a short-term issuance by a bank that
guarantees payment at a later time.
2. A banker's acceptance is often used in importing and exporting,
with the importer's bank guaranteeing payment to the exporter.
3. A banker's acceptance differs from a post-dated check in that it
is seen as an investment and can be traded on a secondary
market.
4. Similar to buying a Treasury bill, an investor on the secondary
market might buy the acceptance at a discounted price, but still
get the full value at the time of maturity.
 CAPITAL MARKET INSTRUMENTS
1. Securities: 'Securities' is a general term for a stock exchange
investment.
2. Equity Shares: Equity Shares are the ordinary shares of a limited
company.
3. Preference Shares:
4. Debentures:
5. Bonds:
6. Government Securities:
PREFERENCE SHARES
Preference shares, more commonly referred to as preferred stock, are
shares of a company's stock with dividends that are paid out to
shareholders before common stock dividends are issued. ... Most
preference shares have a fixed dividend, while common stocks
generally do not.
DEBENTURES
1. A debenture is a type of debt instrument that is not backed by
any collateral and usually has a term greater than 10 years.
2. Debentures are backed only by the creditworthiness and
reputation of the issuer.
3. Both corporations and governments frequently issue
debentures to raise capital or funds.
4. Some debentures can convert to equity shares while others
cannot.
 CONVERTIBLE VS. NONCONVERTIBLE
Convertible debentures are bonds that can convert into equity
shares of the issuing corporation after a specific period. Companies
use debentures as fixed-rate loans and pay fixed interest payments.
However, the holders of the debenture have the option of holding
the loan until maturity and receive the interest payments or
convert the loan into equity shares.
Non-convertible debentures are traditional debentures that cannot
be converted into equity of the issuing corporation. To compensate
for the lack of convertibility investors are rewarded with a higher
interest rate when compared to convertible debentures.
WHAT ARE CORPORATE BONDS
1. Bonds are units of corporate debt issued by companies and
securitized as tradeable assets.
2. A bond is referred to as a fixed-income instrument since
bonds traditionally paid a fixed interest rate (coupon) to
debtholders. Variable or floating interest rates are also now
quite common.
3. Bond prices are inversely correlated with interest rates: when
rates go up, bond prices fall and vice-versa.
4. Bonds have maturity dates at which point the principal
amount must be paid back in full or risk default.
WHAT IS AN IOU IN CORPORATE BONDS
An IOU, a term used in corporate bond of the words "I owe you," is a
document that acknowledges the existence of a debt. An IOU is often
viewed as an informal written agreement rather than a legally binding
commitment.
GOVERNMENT SECURITIES, OR G-SECS
These are debt instruments issued by the government to borrow
money. The two key categories are treasury bills – short-term
instruments which mature in 91 days, 182 days, or 364 days, and
dated securities – long-term instruments, which mature anywhere
between 5 years and 40 years
TREASURY INFLATION PROTECTED SECURITIES (TIPS).
Treasury inflation-protected securities (TIPS) are popular with
bondholders, particularly when the economy isn't performing well.
For many investors, TIPS seem like an obvious choice when there is
above-average uncertainty about inflation and market returns.
1. TIPS frequently underperform traditional Treasuries, particularly
when deflation becomes an issue.
2. TIPS rely on the CPI, which may understate inflation for potential
TIPS investors because these investors tend to be older and less
likely to switch to new goods.
3. TIPS are considerably more volatile than cash, especially during
stock market crashes.
INTEREST RATE FUTURES
An Interest Rate Futures contract is "an agreement to buy or sell a
debt instrument at a specified future date at a price that is fixed
today." The underlying security for Interest Rate Futures is either
Government Bond or T-Bill. All futures contracts available for trading
on NSE are cash settled.
An interest rate future is a financial derivative (a futures contract) with
an interest-bearing instrument as the underlying asset. It is a
particular type of interest rate derivative. Examples include Treasury-
bill futures, Treasury-bond futures and Eurodollar futures.
HEDGING INSTRUMENTS
Hedging instrument is a general term that refers to all the financial
instruments used by investors aiming to offset the potential changes
in the fair value or cash flows of their hedged items. To minimise that
risk, these companies can purchase financial products to secure a
specific exchange rate on a future date.
1. Options
2. Futures
Options and futures are both financial products investors can use to
make money or to hedge current investments. Both an option and a
future allow an investor to buy an investment at a specific price by a
specific date.
1. Options and futures are similar trading products that provide
investors with the chance to make money and hedge current
investments.
2. An OPTION gives the buyer the right, but not the obligation, to
buy (or sell) an asset at a specific price at any time during the life
of the contract.
3. A FUTURES contract gives the buyer the obligation to purchase a
specific asset, and the seller to sell and deliver that asset at a
specific future date unless the holder's position is closed prior to
expiration.
INTEGRATED BUSINESS PLANNING (IBP)
Integrated business planning (IBP) is a strategy for connecting the
planning functions of each department in an organization to align
operations and strategy with the organization's financial
performance.
SAP Integrated Business Planning (IBP), which is powered by SAP
HANA, is a cloud-based next-generation planning solution that can
help overcome these key challenges and enable organizations ensure
smooth and efficient supply chain and planning processes. SAP IBP
provides a paradigm of efficiency.
FACTORING & FORFAITING
FACTORING
Factoring is a financial service in which the business entity sells its bill
receivables to a third party at a discount in order to raise funds. ...
Factoring involves the selling of all the accounts receivable to an
outside agency. Such an agency is called a factor.
Factoring: Deals with short-term accounts receivables, which typically
falls due within 90 days or less.
FORFAITING
Forfaiting is a method of trade finance that allows Exporters/ or Seller
to obtain cash by selling their medium and long-term foreign/or Other
bills accounts receivable at a discount on a “without recourse” basis.
“Without recourse” or “non-recourse” means that the forfaiter
assumes and accepts the risk of non-payment.
Forfaiting: Deals with medium- to long-term account receivables.
Forfaiting simply means relinquishing the right. In this, the exporter
renounces his/her right due at a future date, in exchange for instant
cash payment, at an agreed discount, to the forfaiter.erm accounts
receivables.
CREDIT SWAPS
CDS is a credit derivative contract in which one counterparty
(protection seller) commits to compensate the other counterparty
(protection buyer) for the loss in the value of an underlying debt
instrument resulting from a credit event with respect to a reference
entity.
The Reserve Bank of India (RBI) plans to allow retail users undertake
transactions in permitted credit derivatives for hedging their
underlying credit risk, according to its Draft guidelines on Credit
Default Swaps
The protection buyer makes periodic payments (premium) to the
protection seller until the maturity of the contract or the credit event,
whichever is earlier.
CDS is a tool to transfer and manage credit risk in an effective manner
through redistribution of risk. The RBI will allow only single-name CDS
contracts. Retail users shall undertake transactions in exchange-
traded CDS only for hedging their underlying credit risk.
Non-retail users will include insurance companies, pension funds,
mutual funds, alternate investment funds, foreign portfolio investors.
These entities will also be eligible to act as protection seller in CDS.
Standalone primary dealers (SPDs) and non-banking finance
companies (NBFCs), including housing finance companies (with
minimum net owned funds of ₹500 crore) and resident companies
(with minimum net-worth of ₹500 crore), too, will be classified as non-
retail users.
ELIGIBLE DEBT INSTRUMENTS
Debt instruments which will be eligible to be a reference / deliverable
obligation in a CDS contract include Commercial Papers, Certificates
of Deposit and Non-Convertible Debentures of original maturity up to
one year; Rated Indian Rupee (INR) denominated corporate bonds
(listed and unlisted); and Unrated INR bonds issued by the Special
Purpose Vehicles set up by infrastructure companies.
The RBI said the reference/deliverable obligations shall be in
dematerialised form only.
SECURITIES NOT PERMITTED
Asset-backed securities/mortgage-backed securities and structured
obligations such as credit enhanced/guaranteed bonds, convertible
bonds, bonds with call/put options etc. shall not be permitted as
reference and deliverable obligations.
Market-makers – entities which can buy and sell protection from/to
users and other market-makers in order to provide liquidity to the
market – will include Scheduled Commercial Banks (except Small
Finance Banks, Payment Banks, Local Area Banks and Regional Rural
Banks) and NBFCs, including HFCs, and SPDs with minimum net owned
funds of ₹500 crore.
They will also include Export-Import Bank of India, National Bank of
Agriculture and Rural Development, National Housing Bank and Small
Industries Development Bank of India.

The Reserve Bank of India (RBI) plans to allow retail users undertake
transactions in permitted credit derivatives for hedging their
underlying credit risk, according to its Draft guidelines on Credit
Default Swaps

ASSET LIABILITY MANAGEMENT

The primary function of the treasury department of any banks is to
ensure that its assets match its liabilities in every possible way. It is the
job of the treasury department to prepare various financial models
which help on forecasting the amount of net interest income that the
bank stands to make if different economic scenarios play out. It is also
the job of the treasury department to predict exactly how sensitive
this non-interest income is to external shocks like changes in the
interest rate.
The treasury department collates this critical information and then
passes the same on to decision makers who then decide the kind of
assets that they want on the banks’ balance sheet. These decisions are
then further translated into loan targets which bank officials have to
meet. Also, based on the information received from the treasury, the
bank refrains from using certain kinds of deposit liabilities. Hence,
treasury department profoundly influences both deposit taking and
loan sanctioning functions of the bank.

CAPITAL AND RESERVE REQUIREMENTS

Since the treasury department is basically in charge of the bank’s
balance sheet, it is also responsible for setting aside reserves to meet
the reserve requirements prescribed by the RBI. Also, the capital
requirements prescribed by the Basel norms have to be met. At the
same time, holding an excess amount in reserves provides no benefit
since such amount does not earn interest at the market rate and
therefore represents opportunity loss for the bank.
LIASIONING WITH REGULATORY BODIES
The treasury department of banks is highly regulated. Since they are
the ones that are supposed to maintain the capital adequacy ratios
and reserve ratios, they are also the ones that are supposed to have
liaison with regulatory agencies on such issues.
LIQUID INVESTMENTS IN GOVERNMENT SECURITIES
Treasury departments at banks are also in charge of maintaining a
certain portion of their portfolio in highly liquid government
securities. This is done because the banks act as broker-dealers to the
governments and are expected to hold these securities before they
can be further sold. In India, banks are required by law to maintain a
certain percentage of their portfolio in liquid government securities.
This lends safety to the bank’s portfolio while simultaneously creating
a highly liquid market for government securities.
DISASTER MANAGEMENT
The treasury operations of any bank are responsible for managing its
operations in the event of a disaster. Thus, to be prepared for the
same, the treasury department has to anticipate the risks that can
materialize over time. The treasury department is responsible for
using tools such as derivatives to hedge the bank’s exposure to
different kinds of risks. Apart from that, treasury departments are also
important for insuring all the physical assets, the destruction of which
can have a material impact on the bank’s business.
BACK-OFFICE FUNCTIONS
Treasury departments also have to perform a lot of normal back-office
activities. They are supposed to regularly communicate with their
branches regarding the extent of deposits that have been taken and
the extent of loans that can be made. They also have to liaise with
Forex department and proprietary trading department to monitor the
amount of risk that the bank can take in real time. At the same time,
the treasury department is responsible for ensuring that all branches,
as well as ATM’s, are well stocked with cash to meet the service levels.
When banks run out of cash, it severely affects their reputation. The
treasury department conducts complex calculations to ensure that
adequate amount of cash is available wherever required to avoid such
situations.

CONTROL OF TREASURY RISKS

Treasury risks are primarily managed by conventional control and
supervisory measures, mostly in the nature of preventive steps, which
may be divided into three parts:
1. ORGANISATIONAL CONTROLS:
The organisational controls refer to the checks and balances within
the system. Treasury is basically divided into three parts: the front
office, back office and the mid office.
The front office generates deals with counter-party banks (purchase
and sale of foreign exchange, securities etc. & lending and borrowing
operations). Treasury may enter in to currency dealings either on its
own (Trading Book), or on behalf of clients (Merchant Book) or for
bank’s internal requirement.

Security deals are either for Bank’s SLR requirement, or for Treasury’s
own trading book. Though Treasury may also buy and sell securities
on behalf of its retail clients, the activity as on date is not very
significant – many banks have associate companies specializing in fund
management. Treasury’s money market activity is exclusively to meet
bank’s own requirements.
The back office is responsible for confirmation, accounting and
settlement of the deals. The back office obtains independent
confirmation of each and every deal from the counterparty and settles
the deal only if it is within the exposure limits allowed for the
counterparty. Back office also verifies that the rates/prices mentioned
in the deal slips are conforming to the market at the time the deal is
entered into.
Banks also have a Middle Office (mid-office) which is responsible for
risk management and management information system (MIS). Mid-
office would ensure treasury’s compliance with Board approved
policies bearing upon FX risk management, investment management
and liquidity management.
Some of the key responsibilities of Mid-office are: monitoring
compliance with risk limits set in the respective policies, ensuring
compliance with regulatory requirement, daily mark-to-market
(MTM) valuation of Treasury positions, verification of pricing of
treasury products, including derivatives, and periodic reports to top
management.
Mid-office maintains the overall risk profile of Treasury and monitors
the liquidity and interest rate risks closely, in line with Asset Liability
Management (ALM) guidelines. In quite a few banks, the ALM support
group is a part of Mid-office, or works closely with the Mid-office.
2. INTERNAL CONTROLS:
The most important of the internal controls are position limits and
stop loss limits. The limits are imposed on the dealers who trade in
foreign exchange and securities. Trading is a high risk area, vulnerable
to sudden market fluctuations and the limits imposed by management
are preventive measures to avoid or contain losses in adverse market
conditions.
The trading limits in the context of foreign exchange are of three kinds:
1. Limits on deal size
2. Limits on open positions and
3. Stop-loss limits.
All limits are expressed in absolute amounts.
Limits on deal size prescribe the maximum value for a buy/sell
transaction. The limit is a protection against potential losses on the
deal. The limit generally corresponds to the marketable size of the
transaction, and applies only to trade deals.
Open positions refer to the trading positions, where the buy/sell
positions are not matched. The Treasury may buy USD 1 million, and
hold on to the position with an intention to sell when the USD
appreciates against the Rupee. Not only there is a potential loss if the
US dollar does not appreciate, but there is also a ‘carry’ cost, as the
Treasury loses interest on the USD funds during the holding period.
Treasury may also take forward positions expecting a rise or fall in the
exchange rate.

The management, therefore, limits the size of open or unmatched

positions. The limits in foreign exchange trade are defined as day light
and over-night – the day light limits pertain to the intra-day positions,
say if the dealer purchases currency in the morning and sell it in the
afternoon. As the forex market is very active, the currency prices may
move from moment to moment, the currency may lose value in the
mean-time. The overnight limits are smaller as the dealers may
continue to hold the position for next day.

Position limits are prescribed currency-wise as also for aggregate

position expressed in Rupees. For the purpose of aggregation,
currency-wise net position is first translated into USD at the day-end
rate and then converted into Rupees. The overnight limits are to be
pre-approved by RBI, who also prescribes the method of arriving at
the aggregate position.
Even when there are matching positions, there is scope for loss if the
delivery is at different points of time. In a swap deal, the dealer may
purchase USD at spot and sell it forward, say, after three months.
It is a matched deal as the purchase and sale prices are prefixed and
hence there is no exchange risk. However, the forward prices are
derived out of interest rate differentials and there is an opportunity
cost if interest rates move adversely during the transaction period.
The risk in forward positions is measured by ‘gaps’ (residual time for
completion of the transaction) which are then capped with a gap limit
– akin to position limits on spot trading positions. All the forwards are
re-valued periodically (generally monthly, but in most computer
systems, daily valuations will be available) and the outstanding
positions in each time bucket are subjected to gap limits. The gap
limits are internally approved by the management.
Position limits and gap limits attract capital requirement, as
prescribed by RBI.
Similar controls exist for securities trading, where the size of the deal,
maximum value of securities held for trading and holding period are
defined by the Management. For non-SLR securities, minimum credit
rating requirement is also prescribed by the Management.
STOP-LOSS:
Stop-loss limits represent the final stage of controlling trading
operations. When the market moves adversely, the open positions will
result in loss. A dealer typically would like to wait till the market turns
around, so that he can close the position with a profit. There is an
added risk in that the market correction may not take place as
anticipated, and the losses may continue to accumulate in the mean-
time.
The stop-loss limits prevent the dealer from waiting indefinitely and
limit the losses to a level which is acceptable to the management
(which the bank is in a position to absorb). If the stop loss limit is USD
5000, the dealer must close his position (i.e. sell or buy at a loss). Any
violation of stop-loss limit is viewed seriously by the management.
Stop-loss limits are applied on securities trading in a different manner,
as price movements in securities market are larger and more irregular
and as the market is less liquid as compared to forex market. The
market risk is controlled in terms of mark-to-market value of the
trading portfolio, applying risk measures such as VaR and duration.
3. EXPOSURE CEILING LIMITS:
Exposure limits are kept in place to protect the bank from credit risk.
Credit risk in Treasury may be split into default risk and settlement
risk. Default risk is typically when the bank lends in the money market
(mainly to other banks), the borrowing bank may fail to repay the
amount on due date. Similar risk is there in repo transactions also.
Even though inter-bank market is considered to be relatively risk free,
it is not uncommon that a weak bank may suddenly become bankrupt,
or, there is a run on the bank squeezing its liquidity. Even assuming
that there is no credit risk in short-term lending, it is not prudent that
Treasury lends its entire surpluses to a single bank or to a handful of
banks.
THE SETTLEMENT RISK refers to the possible failure of the
counterparty to the transaction (which is generally a bank or a
financial institution) to deliver/settle their part of the transaction.
While ideally all deals should take place in DvP (Delivery vs. Payment)
mode, it is not always possible to achieve the standard, either for want
of institutional mechanism, or due to physical barriers (such as
different time zones).
The exposure limits are fixed on the basis of the counterparty’s net
worth, market reputation, track record and/or credit rating.
The exposure limits are also fixed for foreign exchange and money
market brokers, in order to avoid business concentration, even though
they are only intermediaries and are not counterparties. While the
limits are generally left to the banks’ discretion, Reserve Bank of India
has imposed a ceiling of 5% of total business in a year for individual
brokers, subject to exceptions being reported to the bank’s
management for ratification. All the limits are to be reviewed at least
once in a year.
2. MARKET RISK AND CREDIT RISK:
We have frequently referred to default by a counterparty and market
movements. In that we are indirectly referring to two types of risks
faced by the bank in all spheres of its activity. One is credit risk, or the
risk of losing funds invested together with interest, fully or partly, on
account of failure of the counterparty to honour its obligations. Then
there is market risk, where the price of a security, interest rates or
exchange rates move in such a way that the value of an asset
diminishes or the liability under an existing obligation increases.
Thus market risk is a confluence of liquidity risk, interest rate risk,
exchange rate risk, equity risk and commodity risk. Considering all
these factors, the Bank for International Settlements (BIS) defines
market risk as “the risk that the value of on-or off-balance sheet
positions will be adversely affected by movements in equity and
interest rate markets, currency exchange rates and commodity
prices”. The market risk is also known as price risk.
The three main components of market risk are liquidity risk, interest
rate risk and currency risk.

1. LIQUIDITY RISK:
Liquidity risk refers to cash flow gaps which could not be bridged. Let
us assume that the Treasurer has borrowed in call market and
purchased a 5-year government security, assuming the bond prices
would go up next day and he can sell the security with profit. Let us
further assume that the bond market collapses next day and the
Treasurer could not dispose of the security. Though the bank is
solvent, the treasury has faced liquidity risk, as he needs to borrow
funds in the market at whatever cost, if he has to avoid default or
delay in repayment of the call borrowings. Liquidity risk thus translates
in to interest rate risk.
Treasury is generally prepared to meet the known events, such as due
date for a money market loan, or for a deposit. However there are
unforeseen events such as invocation of a guarantee or premature
payment of a large deposit which would strain the bank’s liquidity. The
Treasury needs to have a contingency plan to meet any liquidity crisis.
2. INTEREST RATE RISK:
Interest rate risk refers to rise in interest costs (of a liability) or fall in
interest earnings (from assets) eroding the business profits.
Treasury deals in financial assets, value of which is highly sensitive to
interest rate movements. A steep rise in interest rates may cause a
crash of bond market, eroding the value of securities held by Treasury.
If liquidity is not planned ahead, Treasury may need to borrow at
higher cost to meet its obligations.
The interest rate risk is present wherever there is a mismatch between
assets (cash inflows) and liabilities (cash outflows). The incremental
deposit funds of the bank, say with an average maturity of 1 year, to
the extent they are not lent, are invested by Treasury, say, in 3-month
T-bills. If the yield on T-bills, which changes every three months, does
not match with the cost of the deposit, the net earnings of the bank
will be negative.
3. Currency Risk:
Currency risk or exchange rate risk is also a manifestation of interest
rate risk, although for the sake of clarity, it is identified as a
component of market risk. Interest rates are influenced by factors like
domestic money supply, rate of inflation, activity in debt and equity
markets etc. which also influence exchange rates.
However, exchange rates are influenced more by external trade,
global interest rates and capital flows. As globalization progresses,
exchange rates and interest rates are increasingly influenced by
similar factors, most prominent being GDP growth rate, global interest
rates and capital flows.

Although bank treasuries have limited exposure to equity markets,

movement of stock prices is an important factor influencing financial
markets. Stock market also reflects the overall liquidity in the system,
interest rates and the exchange rate movements. If the currency is
convertible, the exchange rate and interest rate changes play even
greater role in attracting foreign investment inflows into the
secondary market.
All the free markets are highly susceptible to speculation, which in fact
is the essence of Treasury’s trading positions. It is therefore
perception of future changes in interest rates and exchange rates,
rather than the actual changes that direct the market movements.

The market risks directly affect the transaction values and thereby
profits of the treasury. Additionally, Treasury also plays an important
part in the risk management of the bank as a whole. Market risk
translates into balance sheet risk of the bank, and treasury is closely
connected with the asset – liability management. (ALM).Treasury
provides inputs to ALM and is also instrumental in implementing the
risk management solutions.
3. MEASURES OF RISK:
The movement in currency prices or security prices cannot be
accurately predicted and the uncertainty associated with their price
movements gives rise to price risk. At the same time the treasurer
should have some idea of the inherent risks and the way they would
affect his positions. This quest for risk solutions, led to two important
measures of risk, known as value at risk and duration.
1. Value at Risk (VaR):
VaR is a statistical measure indicating worst possible movement of a
market rate, over given period of time, under normal market
conditions, at a defined confidence level. For instance, a overnight VaR
of 45 bp for USD/INR rate at 95% confidence level implies that there
is only 5% chance of the rate worsening beyond 45 bp next day. If
today’s spot rate is 46.00, tomorrow the worst possible rate for
exports can be assumed to be 45.55, with reasonable safety – there is
only 5% chance of the rate being worse than 45.55.
Similarly, if overnight VaR of 1-year G-Sec yield is 0.35%, current yield
of 7.75% is expected to fall/rise by not more than 0.35% by tomorrow.
In the worst-case scenario, a prospective buyer of security may
therefore expect the yields to fall to 7.75% – 0. 35% = 7.40% by next
day, while a seller of security may expect rise in the yield to 7.75% +
0.35% = 8.10% by next day. At 95% confidence level, there is only 5%
possibility of adverse change being higher than 0.35% (at 99%
confidence level, there is only 1% possibility of loss being higher than
VaR).
VaR is derived from a statistical formula based on volatility of the
market. Volatility is the standard deviation from the mean of, say,
USD/INR exchange rates (or any other asset prices) observed over a
period. Volatility assumes a normal distribution curve and the no. of
standard deviations from the mean denote the probability of reaching
a target level. The volatility multiplied by the no of standard deviations
required for a given confidence level results in the VaR.
MONTE CARLO SIMULATION
The second approach is based on Monte Carlo simulation, where a
number of scenarios are generated at random and their impact on the
subject (stock price/exchange rate etc.) is studied.
HISTORICAL DATA
The third approach is to use historical data to arrive at the probable
loss.
The historical data may simply be time series of data prevailing over a
period (e g daily USD/INR exchange rate for last 90 days), or an index
of changes (e g change in price over previous day). Progressive weights
may also be assigned to the data, as more recent information has
greater impact on future price movements.
While the methodology to arrive at VaR may appear to be complex,
the utility lies in that the concept is easy to understand. The
Management would like to know VaR of all risk positions, as it offers a
single figure – an absolute amount – a potential loss which may affect
bank’s earnings, or, net worth.
In Treasury, VaR is used to measure potential loss, or the worst case
scenario, while holding a trading position either in foreign currency or
in securities, i.e. VaR measure can be used to assess the currency risk
as well as the interest rate and price risks. The VaR is used to measure
the risk of a single investment, or more generally, a portfolio of
investments.
VaR is most commonly used to measure overnight risk, or risk over
short periods, say, over 1 month. VaR for longer periods is calculated
as overnight VaR multiplied by √n (square root of n, where n is the
period for which VaR is required). However, for longer periods, VaR is
not a valid measure.
2. DURATION:
Duration is a measure widely used in investment business, though the
concept of duration is applicable to all assets and liabilities, where
interest rate risk is present. To understand Duration, we need to be
familiar with the concept of YTM or Yield to Maturity of a bond.
The effective return on a bond (based on the coupon rate, market
price and residual maturity) is known as yield. The yield is different
from interest rate in that the yield takes into account the cash flows
during the life of a bond, including interest payments (which are
normally semi-annual or annual) and the payment of principal upon
redemption.
All the cash flows are discounted to arrive at a present value (PV) and
the rate of discount at which the present value equals the market price
of a bond is known as the yield to maturity (YTM) or, simply, as yield
on the bond. Conversely, it is the discount rate at which NPV (net
present value = PV – market price of the bond) of the bond is zero.
Yield is effective rate of return on amount invested in the bond. (The
YTM is calculated on the bond calculator/built in formula in Excel/or
from bond tables).
For instance, a bond carrying a coupon rate of 5% with a balance
maturity of 2 years is traded at a discount of 2%, i.e. at a price of 98.
This indicates that market rate of interest is higher than 5% and hence
the market price is less than the par value. Interest at 5% on a unit
price of 98 will work out to 5.10% which is known as current yield of
the bond. The YTM of the bond works out to 6.08%.
The yield is internal rate of return reflecting the ruling interest rates.
Yield and price of a bond move in inverse proportion. If the yield rises,
price of a bond falls. If the yield falls the bond price rises. It is the same
relationship between interest rates and bond prices.
Bond yields tell us the rate of return at which the present value of cash
flows equals the market price. However the YTM does not reveal how
volatile are the bond prices and how they respond to changes in
interest rates. The YTM of two bonds may be same, but the price risk
associated with them may be different on account of maturity or
frequency of coupon payments. The YTM of two bonds hence is not
comparable.
Duration is a measure which helps us understand the impact of
interest rate on the price, by taking into account periodicity of coupon
flows.
Duration is weighted average measure of life of a bond, where the
time of receipt of a cash flow is weighted by the present value of the
cash flow. If the first cash flow (payment of interest) is occurring after
6 months from the date of investment, the period of 6 months is
multiplied by present value of the cash flow (0.5*PV).
If the second cash flow is occurring after 12 months, the period (1
year) is multiplied by present value of the cash flow. The present value
of final payment of interest and redemption of principal, occurring,
say, after 5 years from the date of investment is similarly used to
weigh the maturity period (5*PV).

The aggregate of results so obtained is divided by the total of weights

(total of PV of each cash flow, which is also market price of the bond)
to yield ‘Duration’. It is also known as Mecaulay Duration, following
the originator of the concept, Frederick Mecaulay.
Duration is expressed in terms of years. The longer the duration,
greater is the sensitivity of bond price to changes in interest rates. The
duration thus helps compare bonds with different structures to find
out which bond entails greater interest rate risk.
The duration of a zero coupon bond is equal to its time to maturity, as
there are no interim cash flows, and redemption value of the bond
includes interest on the initial investment.
To the Treasurer, duration of a bond portfolio is more important than
the duration of a single bond. The weighted average duration of a
number of bonds in the portfolio can be arrived at by adding weights
to the duration of individual bonds, the weight being the market price
of the bond (expressed as a % to the face value of the bond).
If the Treasurer has a target period of holding, say of 2 years, he can
immunize his portfolio from interest rate risk by ensuring that at any
point of time the average duration of his portfolio is equal to 2. This
of course necessitates constant reshuffling of the bonds in the
portfolio, as the duration changes with lapse of time (as a bond nears
its maturity).

-----------------------------XXXXXXXXXXXXXXXXXXXX---------------------------
 Banker ZONE ARENA
(An initiative by Ratinder Chopra ex Faculty PSB)

CAIIB SPECIAL

PAPER 2 ACCOUNTING FINANCE FOR BANKERS

MODULE 4

To the point and easy to understand

Ratinder Chopra
Contact at [email protected]
Phone: 9888812880
 CAIIB PAPER 2: BANK FINANCIAL MANAGEMENT
NON-PERFORMING ASSETS (NPA)
As per IRAC (“Issue, Rule, Application, Conclusion”) norms, an Asset
becomes non-performing when it ceases to generate income for the
Bank.
A non-performing asset (NPA) is a loan or an advance where;

a. Interest and/ or installment of principal remain overdue for a period

of more than 90 days in respect of a term loan,

b. The account remains ‘out of order’ for a period more than 90 days in respect
of an OD/CC,
c. The bill remains overdue for a period of more than 90 days in the case
of bills purchased and discounted,
d. if the installment of principal or interest thereon remains overdue (in case of
Agriculture Loan)
1) for two crop seasons, for loan granted for short duration crops
2) for one crop season, for a loan granted for long duration crops.

The crop season for each crop, which means the period up to harvesting of the
crops raised, would be as determined by the State Level Bankers’ Committee in
each State.
e. The amount of liquidity facility remains outstanding for more than 90
days, in respect of a Securitisation transaction undertaken in terms of
guidelines on securitization.
f. In respect of derivative transactions, the overdue receivables
representing positive mark-to- market value of a derivative contract, if the
same remain unpaid for a period of 90 days from the specified due date
for payment.
'Out of Order' status: An account should be treated as 'out of order' if
• the o/s balance remains continuously in excess of the sanctioned
limit/drawing power.
• In cases where the o/s balance in the principal operating account is
less than the sanctioned limit/drawing power, but there are no
credits continuously for 90 days as on the date of Balance Sheet or
credits are not enough to cover the interest debited during the
same period.
Overdue: Any amount due to the bank under any credit facility is ‘overdue’ if it
is not paid on the due date fixed by the bank.
CLASSIFICATION OF NPA ON A/C OF CHARGING OF INTEREST AT MONTHLY RESTS-

Date of classification of an advance as NPA should not be changed on

account of charging of interest at monthly rests. An account will be
classified as NPA if the interest charged during quarter is not serviced
fully within 90 days from the end of the quarter.
Other reasons for account turning NPA :-

Non –availability of DP in Working Capital account/ Non submission of stock

statement.
i. The o/s in the account based on DP calculated from stock
statements older than three months, would be deemed as
irregular.
ii. A working capital borrowal account will become NPA if such
irregular drawings are permitted in the account for a continuous
period of 90 days even though the unit may be working or the
borrower’s financial position is satisfactory.
iii. Non- Renewal of credit facilities /Non-Adjustment of Ad-hoc facility.
iv. Regular and Ad-hoc credit limits need to be
reviewed/regularized not later than three months from the due
date/ date of ad hoc sanction.
 v. An account where the regular /adhoc credit limits have not been
reviewed/renewed within 180 days from the due date/date of
ad hoc sanction will be treated as NPA.
Gross NPA: This is the sum total of all loan assets that are classified as
NPA as per RBI guidelines as on Balance Sheet date.
NET NPA: Gross NPA – (Balance in Interest Suspense Account + Total
Provision Held + DICGC/ECGC claims received and held pending
adjustment)

INCOME RECOGNITION
Income from NPA is not recognized on Accrual basis, but is booked as
income only when it is actually received. This will apply to Government
guaranteed accounts also.
1. As in case of interest and penal interest, No charges which are credited
to income head e.g., commission, incidental charges / service charges
etc., be debited to a NPA account. Such charges are to be calculated and
record to be kept.
2. However, interest on advances against term deposits, NSCs, IVPs, KVPs
and Life policies may be taken to income account on the due date,
provided adequate margin is available in the accounts.
3. Fees and commissions earned by the banks as a result of re-negotiations
or rescheduling of outstanding debts should be recognised on an accrual
basis over the period of time covered by the re-negotiated or
rescheduled extension of credit.
4. If Government guaranteed advances become NPA, the interest on such
advances should not be taken to income account unless the interest has
been realised.
5. The under noted types of charges to be debited to NPA accounts
because these are not taken to income of the bank, but are incurred on
behalf of the borrowers and paid to outside parties/ agencies:
 a. Insurance premium, ECGC. Guarantee Fee.
b. Charges of opinion/ issuance of notice, obtaining of non- encumbrance
certificate etc.
c. Other expenses actually incurred by the bank such as Postage, printing etc.

Reversal of income
If any advance, including bills purchased and discounted, becomes NPA ,
the entire interest accrued and credited to income account in the past
periods and also fees, commission and similar income that have accrued
should be reversed or provided for if the same is not realized/collected.
MEMORANDA INTEREST ACCOUNT: The Interest accrued but un-
realized on NPA accounts is to be reflected in the MEMORANDA INTEREST
ACCOUNT (Claw Back).
The recovery in all NPA accounts (including Non-suit filed, suit-filed/
decreed/ compromised accounts) shall be first appropriated towards
Principal amount outstanding in the account and the balance, if any,
towards Memorandum Interest for all NPAs. However, the account
which is marked for up-gradation or in the process of up-gradation, the
recovery affected should be appropriated towards adjustment of the
irregularity in the account till it is fully recovered and account is finally
upgraded.

ASSETS CLASSIFICATION
A) All advances irrespective of balance outstanding are to be classified in
the following four categories.
1. Standard Asset
2. Sub-Standard Assets
3. Doubtful Assets
4. Loss Assets
STANDARD ASSETS: A Standard Asset is one, which has no problem and
does not carry more than normal risk. Such an asset is not an NPA.
There are two Sub categories of Standard Accounts:
a) Standard Regular Accounts,
b) Special Mentioned Accounts.
Standard Regular Accounts: All those loans/Advances (Assets) of the
bank which are regular in payment of interest/installment /charges etc.
on or before due date are Standard Regular Accounts.
Special Mentioned Accounts: As per guidelines by RBI whereby banks
are required to identify potential stress in the account by creating a sub-
category under Standard advance. Accounts SMA classification is as
under:

Loan - Principal or interest Revolving credit facilities like

payment or any other cash credit- O/S balance
amount wholly or partly remains continuously in excess
overdue between of the sanctioned limit or DP,
whichever is lower for a period
of,
SM 0 30 days -
A
SM 1 31-60 days 31-60 days
A
SM 2 61-90 days 61-90 days
A

SUB-STANDARD ASSETS(SS): A Sub-Standard asset is one, which has

remained NPA for a period less than or equal to 12 months. Such an asset
will have well defined credit weakness that jeopardize the liquidation of
the debt. The bank may sustain some loss if deficiencies are not corrected.
DOUBTFUL ASSETS: An asset would be classified as doubtful if it has
remained in the Sub-Standard category for a period of more than 12
months.

Doubtful I Doubtful for upto one year i.e., if it has remained in the SS
category for a period of 12 months up to 2 years (12months
-24months) from NPA
Doubtful II Doubtful one year to upto 3 years i.e. If it has remained in
the Doubtful –I category for a period of 24 months i.e., 2 year
up to 4 Years
Doubtful III Doubtful more than 3 years i.e. More than 4 years

LOSS ASSETS: A Loss asset is one where loss has been identified by the
bank or internal or external auditors, or the RBI inspection but the amount
has not been written off wholly. Such an asset is considered uncollectible
and of such little value that its continuance as a bankable asset is not
warranted although there may be some salvage or recovery value.

Advances against Term Deposits, NSCs, KVP/IVP,LIC etc.

Irrespective of balance outstanding the advances against the above
security be classified as Performing Assets as on date of closing, provided
adequate margin is available i.e., balance outstanding is within face value
of security plus interest accrued thereon as on date of closing.
Advances against gold ornaments, government securities and all other
securities are not covered by this exemption.

Post-shipment Suppliers Credit:

In respect of post-shipment credit extended by the banks covering
export of goods to countries for which the ECGC’s cover is available, EXIM
Bank has introduced a guarantee-cum-refinance programme whereby, in
the event of default, EXIM Bank will pay the guaranteed amount to the
bank within a period of 30 days from the day the bank invokes the
guarantee after the exporter has filed claim with ECGC.
Accordingly, to the extent payment has been received from EXIM Bank,
the advance may not be treated as a NPA for asset classification and
provisioning purposes.

Export Project Finance: In respect of export project finance, there

could be instances where the actual importer has paid the dues to the
bank abroad but the bank in turn is unable to remit the amount due to
political developments such as war, strife, UN embargo, etc.
In such cases, where the lending bank is able to establish through
documentary evidence that the importer has cleared the dues in full by
depositing the amount in the bank abroad before it turned into NPA in
the books of the bank, but the importer's country is not allowing the
funds to be remitted due to political or other reasons, the asset
classification may be made after a period of one year from the date the
amount was deposited by the importer in the bank abroad.

Take-out Finance: Under this arrangement, the institution/the bank

financing infrastructure projects will have an arrangement with any
financial institution for transferring to the latter the outstanding in
respect of such financing in their books on a pre-determined basis. In
view of the time lag involved in taking-over, there may be a possibility of
a default.
The norms of asset classification will have to be followed by the
concerned bank/FI in whose books the account stands as a balance sheet
item as on relevant date.
The lending institution should also make provisions against any asset
turning into NPA pending its takeover by taking over institution. As and
when the asset is taken over by the taking over institution, the
corresponding provisions could be reversed.
However, the taking over institution, on taking over such asset, should
make provisions treating the account as NPA from the actual date of it
becoming NPA even though the account was not in its books on that
date.
 Government guaranteed advances: The credit facilities backed
by guarantee of the Central Government though overdue may be treated
as NPA only when the Government repudiates its guarantee when
invoked. This exemption from classification of Government guaranteed
advances as NPA is not for the purpose of recognition of income.
State Government guaranteed advances and investments in State
Government guaranteed securities would attract asset classification and
provisioning norms if interest and/or principal or any other amount due
to the bank remains overdue for more than 90 days.
Credit Card Accounts: A credit card account will be treated as NPA if
the minimum amount due, is not paid fully within 90 days from the
payment due date as mentioned in the statement .
Advances under rehabilitation approved: Banks are not permitted to
upgrade the classification of any advances in respect of which the terms
have been renegotiated unless the package of renegotiated terms has
worked satisfactorily for a period of one year.
Availability of security/ net worth of borrower/ guarantor: The
availability of security or net worth of borrower/ guarantor should not be
taken into account for the purpose of treating an advance as NPA or
otherwise,
Upgradation of Accounts classified as NPAs: If arrears of interest and
principal are paid by the borrower in the case of loan accounts classified
as NPAs, the account may be classified as ‘Standard’ accounts.
GENERAL GUIDELINES AND CLARIFICATIONS

Moratorium period/ Gestation period: In case of advances where

moratorium is given for payment of installments and/or interest, the
payment of installments and/or interest becomes "due" only after the
moratorium or gestation period is over.
Staff Loans: In case of housing loans or similar advances granted to Staff
members where interest is paid after recovery of principal, interest should
be considered as "due" only after 30 days after recovery of principal. Such
loans/advances should be classified as NPA only when there is default in
repayment of instalment of principal or payment of interest on the
respective due date
Treatment of NPA - Borrower wise: In case of a borrower enjoying
multiple facilities, any facility/Investment or part thereof becoming non-
performing will result in entire account becoming non-performing (NPA)
even if other facilities/Investment in that account are in order.
Stock statement should not be older than 3 months: Stock statement
are relied upon by the banks for determining drawing power. The
outstanding in the account based on drawing power calculated from stock
statements older than three months, would be deemed as irregular. A
working capital borrowal account will become NPA if such irregular
drawings are permitted in the account for a continuous period of 90 days
even though the unit may be working or the borrower's financial position is
satisfactory.
Regular and ad-hoc credit limits need to be reviewed/regularized not
later than three months from the due date/date of adhoc sanction. In case
of constraints such as non-availability of financial statements and other data
from the borrowers, the branch should furnish evidence to show that
renewal/review of credit limits is already on and would be completed soon.
In any case, delay beyond six months is not considered desirable as a
general discipline. Hence, an account where the regular/ad-hoc credit
limit has not been reviewed/renewed within 180 days from the due
date/date of ad-hoc sanction will be treated as NPA.
Accounts where there is Erosion in the value of Security/Frauds Committed
by Borrowers:
Irrespective of the age of the NPA, on account of erosion in value of the
security, Account can be classified as doubtful or loss as under:
1. When RVS (Both Primary & Collateral) falls below 10% of outstanding
balance the account, is straightway classified as LOSS and when RVS
is above 10% but less than 50% of the outstanding balance, it is
straightway classified as DOUBTFUL.
RVS: Value of Security (Realizable Value of Security) for the purpose of
reckoning NPA is the sum total of the amounts of security available in
each account of the borrower.
Consortium Accounts:
Asset classification of accounts under consortium should be based on the record
of recovery of the Individual member banks and other aspects having a bearing
on the recoverability of the advances.
Purchase/ Sale of Non-Performing Financial Assets

(NPFA) to Other Banks:

A NPA in the books of a bank shall be eligible for sale to other banks only
if it has remained a NPA for at least two years in the books of the selling
bank.
Banks shall sell NPFA to other banks only on cash basis, which should be
received upfront and the asset can be taken out of the books of the
selling bank only on receipt of the entire sale consideration.
A NPFA should be held by the purchasing bank in its books at least for a
period of 12 months before it is sold to other banks. Banks should not
sell such assets back to the bank, which had sold the NPFA.
ASSET CLASSIFICATIONS
STANDARD ASSETS: Provisioning percentage on Standard Assets are as under:

Sl.No. Category of Standard Assets Provision %age

1 Direct Agriculture 0.25%
2 Micro and Small Enterprises (MSE) 0.25%
3 Commercial Real Estate 1.00%
4 Advances to Commercial Real Estate – 0.75%
Residential Housing Sector(CRE-RH)*

5 Housing Loan Sanctioned on or after 0.25%

07/06/2017
6 Restructured accounts classified as Standard 5.00%
Assets
7 Other (excluding accounts at S.No.1 to 6) 0.40%

The provision on standard assets should not be reckoned for arriving at

net NPAs. It is not to be netted from Gross Advances but shown
separately as ` Contingent Provisions against Standard Assets under
`Other liabilities and Provisions in schedule 5 of the balance sheet
SUB-STANDARD ASSETS (SS)

Sub-Standard Provision requirement (%)

As per RBI Norms
Secured exposure 15
Unsecured exposure* 25
Unsecured exposure in respect of 20
infrastructure loan account where
escrow accounts are available.
 * Unsecured exposure is defined as an exposure where the realizable
value of the security, as assessed by the bank/ approved valuers / reserve
Banks’ inspecting officers is not more than 10% ab-initio( from the
beginning) of the outstanding exposure (funded +non funded). Security
means tangible security properly discharged to the bank and will not
include intangible securities like guarantees (including state Government
guarantees), comfort letters etc.
DOUBTFUL ASSETS:

Unsecured Portion: 100% to the extent to which the advance is not

covered by the realizable value of the security.
Secured portion: provision may be made @ ranging from 25% to 100 %
of the secured portion depending upon the period for which the asset has
remained doubtful:

Period for which the advance has Provision requirement (%)

remained in
‘doubtful’ category
As per RBI Norms
Up to one year 25
One to three years 40
More than three years 100

LOSS ASSETS:

A loss asset is one where loss has been identified by the bank or internal
or external auditors or the RBI inspection but the amount has not been
written off wholly. Loss assets should be written off. If Loss assets are
permitted to remain in the books for any reason, 100% of the balance
outstanding should be provided for.
Accelerated Provisioning Norms

In cases, where banks fail to report SMA status or the accounts to CRILC
or resort to methods with the intent to conceal the actual status of the
accounts or evergreen the account, banks will be subjected to
accelerated provisioning for these accounts and/or other supervisory
actions as deemed appropriate by RBI. The current provisioning
requirement and the revised accelerated provisioning in respect of such
non-performing accounts are as under:

Assets Period as NPA Current Prov.%age Proposed

Classification accelerated Prov.
%age.
Sub- Upto 6 months 15 No Change
Standard 6 months to 1 15 25
(Secured) Year
Sub-Standard Upto 6 months 25 No Change 25
(Unsecured 20 (infrastructure)
ab-intio) 6 months to 1 25 40
Year
Doubtful-I 2nd Year 25 (Secured 40 (Secured Portion)
Portion)
Doubtful-II 3rd & 4th Year 40 (Secured 100 (Secured
Portion) Portion)
Doubtful-III 5th year 100 No Change
onward
 Provisioning norms in respect of all cases of fraud

The entire amount due to the bank (irrespective of the

quantum of security held against such assets), or for
which the bank is liable (including in case of deposit
accounts), is to be provided for over a period not
exceeding four quarters commencing with the quarter
in which the fraud has been detected;
However, where there has been delay, beyond the
prescribed period, in reporting the fraud to the Reserve
Bank, the entire provisioning is required to be made at
once.
Provisioning for country risk.

Risk category ECGC Provisioning requirement (pe

classification cent)
Insignificant A1 0.25
Low A2 0.25
Moderate B1 5
High B2 20
Very high C1 25
Restricted C2 100
Off-credit D 100

The provisions on country risk are in respect of a

country where its net funded exposure is one percent
or more of its total assets.
BASEL 1, BASEL, & BASEL 3
The key difference between Basel 1 2 and 3 is that Basel 1 is
established to
whereas Basel 2 is established to introduce supervisory
responsibilities and to further strengthen the minimum capital
requirement and Basel 3 to promote the need for liquidity buffers (an
additional layer of equity).
What is Basel 1
Basel 1 was released in July 1988 to provide a framework to address
risk management from a bank’s capital adequacy perspective. The
principal concern here was the capital adequacy of banks.
A minimum ratio of capital to risk-weighted assets of 8% was stated to
be implemented effective from 1992. Basel 1 also specified the
general provisions that can be included in the calculation of the
minimum required capital.
What is Basel 2
The main objective of Basel 2 was to replace the minimum capital
requirement with a need to conduct a supervisory review of the bank’s
capital adequacy. Basel 2 consists of 3 pillars. They are:

1. Minimum capital requirements, which sought to develop and

expand the standardised rules set out in the Basel 1
2. Supervisory review of an institution’s capital adequacy and
internal assessment process
3. Effective use of disclosure as a lever to strengthen market
discipline and encourage sound banking practices
What is Basel 3
Basel III is only a continuation of effort initiated by the Basel
Committee on Banking Supervision to improve the banking regulatory
framework under Basel I and Basel II. This latest Accord now seeks to
improve the banking sector's ability to deal with:

1. Financial and economic stress,

2. Improve risk management,
3. Strengthen the banks' transparency
What is Capital Adequacy Ratio – CAR
The capital adequacy ratio (CAR) is a measurement of a bank's
available capital expressed as a percentage of a bank's risk- weighted
credit exposures.
The capital adequacy ratio, also known as capital-to-risk weighted
assets ratio (CRAR)

Calculating CAR
The capital adequacy ratio is calculated by dividing a bank's capital by
its risk- weighted assets.
The capital used to calculate the capital adequacy ratio is divided into
two tiers.

Capital (Tier-1 capital + Tier-2 Capital)/ Risk weighted Assets

Tier-1 capital, or core capital, consists of equity capital, ordinary share

capital, intangible assets and audited revenue reserves.
Tier-2 capital comprises unaudited retained earnings, unaudited
reserves and general loss reserves.

RBI guidelines for capital adequacy ratio

Total regulatory capital should be at least 9% of risk weighted Assets

and within this, Tier 1 capital should be at least 6% of risk weighted
assets. Within Tier 1 capital, innovative Tier 1 instruments are limited
to 15% of Tier 1 capital.

INNOVATIVE TIER 1 INSTRUMENTS

To enable banks to raise additional capital, RBI allows banks to raise
capital by issue of innovative perpetual debt instruments (IPDI) and
debt capital.
The banks may issue these instruments in Indian Rupees and should
obtain RBI’s permission for issue in foreign currency.
Banks now have been given time up to Ist January 2023 TO COMPLY
all BASEL III norms.
BALANCE SHEET OF MAR 21 MAR 20 MAR 19 MAR 18 MAR 17
ABC (in Rs. Cr.)

12 mths 12 mths 12 mths 12 mths 12 mths

EQUITIES AND
LIABILITIES

SHAREHOLDER'S
FUNDS

Equity Share Capital 4,052.67 701.05 564.91 564.91 400.41

TOTAL SHARE 4,052.67 701.05 564.91 564.91 400.41

CAPITAL

Revaluation Reserve 0.00 0.00 0.00 0.00 0.00

Reserves and Surplus 4,310.35 4,895.34 5,136.49 5,617.77 5,742.06

Total Reserves and 4,310.35 4,895.34 5,136.49 5,617.77 5,742.06

Surplus

TOTAL 8,363.02 5,596.40 5,701.40 6,182.69 6,142.47

SHAREHOLDERS
FUNDS

Deposits 96,108.18 89,667.55 98,557.60 101,726.17 85,540.16

Borrowings 2,643.55 3,213.05 2,714.00 3,682.98 2,958.44

Other Liabilities and 3,367.14 2,026.81 2,009.04 2,167.41 2,002.37

Provisions

TOTAL CAPITAL AND 110,481.89 100,503.81 108,982.05 113,759.24 96,643.44

LIABILITIES

ASSETS

Cash and Balances with 7,208.52 9,488.40 4,941.08 6,256.38 4,364.68

Reserve Bank of India

Balances with Banks 1,130.93 89.85 1,677.14 876.31 225.10

Money at Call and Short
Notice

Investments 32,022.78 24,552.10 26,172.93 32,981.76 27,948.50

Advances 60,941.70 58,411.91 69,175.53 66,569.45 58,334.53

Fixed Assets 1,584.91 1,240.83 1,230.38 1,082.60 1,095.43

Other Assets 7,593.05 6,720.72 5,784.98 5,992.75 4,675.20

TOTAL ASSETS 110,481.89 100,503.81 108,982.05 113,759.24 96,643.44

OTHER ADDITIONAL
INFORMATION

Number of Branches 0.00 1,526.00 1,048.00 1,514.00 1,500.00

Number of Employees 0.00 8,862.00 8,948.00 9,320.00 9,400.00

Capital Adequacy Ratios 0.12 12.09 10.71 11.00 11.00

(%)

KEY PERFORMANCE
INDICATORS

Tier 1 (%) 0.00 7.91 8.27 0.00 9.00

Tier 2 (%) 0.00 4.18 2.44 0.00 2.00

ASSETS QUALITY

Gross NPA 9,334.00 8,874.57 8,605.87 7,801.65 6,297.59

Gross NPA (%) 0.00 14.00 12.00 11.00 10.00

Net NPA 2,461.95 4,684.15 4,994.23 4,607.87 4,375.08

Net NPA (%) 0.04 8.03 7.22 7.00 8.00

Net NPA To Advances 0.00 8.00 7.00 7.00 8.00

(%)

CONTINGENT
LIABILITIES,
COMMITMENTS

Bills for Collection 0.00 899.09 764.70 763.73 597.07

Contingent Liabilities 0.00 6,720.72 7,262.52 6,010.28 9,729.68

COMPONENTS OF BANK BALANCE SHEET

1. ASSETS: assets represent uses of funds to generate

revenue for the bank.
2. LIABILTIES: Liabilities and Reserves form the
Sources of the bank's funds,

COMPONENETS OF LIABILITIES
Capital or Share Capital
Capital represents the owners' stake in a bank and it serves as a
cushion for depositors and creditors to fall back in case of losses. It is
considered to be a long-term source of funds. Minimum capital
requirement for the domestic and foreign banks is prescribed by
Reserve Bank of India.

Reserve and Surplus

The components under this item include statutory reserves, capital
reserves, share premium, Revaluation Reserves, revenue and other
reserves and Balance in profit and loss account.

Deposits: The main source of funds for the banks is deposits. The
deposits are broadly classified as deposits payable on demand which
include current deposits, overdue deposits, call deposits, etc. Second
category is savings bank deposits and lastly the term deposits which
are repayable after a specified period, known as fixed deposits, short
deposits and recurring deposits.

Borrowings: Borrowings in India consist of borrowings/refinance

obtained from the RBI, other commercial banks and other institutions
and agencies like IDBI, EXIM Bank of India, NABARD, etc.
Other Liabilities and Provisions:

1. Bills Payable: This includes drafts, telegraphic transfers,

travellers cheques, mail transfers payable, pay slips, bankers'
cheques and other miscellaneous items.
2. Inter-Office Adjustments: The credit balance of the net inter-
office adjustments.
3. Interest Accrued: The interest accrued but not due on deposits
and borrowings.
4. Others: All other liability items like provision for income tax, tax
deducted at source, interest tax, provisions, etc.

COMPONENTS OF ASSETS

Cash and Balances with RBI

All cash assets of banks are listed under this account and it forms the
most liquid account held by any bank. The cash assets consist of the
following:
1. Cash in Hand: This asset item includes cash in hand, including
foreign currency notes and cash balances in the overseas
branches of the bank.

2. Balances With RBI: Cash account also includes the balances held
by each hank with RBI in order to meet statutory cash reserve
requirements (CRR) and also surplus cash parked with RBI over
and above CRR requirement to meet emergency funding
requirements.

3. Balances with Banks and Money at Call and Short Notice: The
bank balances include the amount held by the bank in the
current accounts and term deposit accounts with other banks.
Under Call money market, funds are transacted on an overnight
basis and under Notice money market, funds are transacted for
a period between 2 days and 14 days.
Investments
A major asset item in the balance sheet of a bank is investments in
various kinds of securities. These include investments in government
securities, approved securities, shares, debentures and bonds, and/or
joint subsidiaries ventures and other investments.

Loans/Advances
The most important asset item on a bank's balance sheet is advances.
These advances which represent the Credit extended by a bank to its
customers, forms a major part of the assets for all the banks. The
Advances can be payable on demand & Term Loans

a) Cash credits/ Overdrafts and Loans Repayable on Demand. Items

under this category represent advances - which are repayable on
demand though they may have a specific due date.

b) Term Loans. All term loans extended by a bank are included here.
These advances also have a specific due date, but they will not become
payable on demand. In short, most of the term loans are repaid in the
form of EMIs (Equated Monthly Instalments).

c) Bills Purchased and Discounted. This item includes the bills

discounted purchased by banks from the client irrespective of
whether they are clean/documentary or domestic/foreign.

d) Secured/unsecured Advances. Based on the underlying security,

advances are classified into the following categories:
Secured by Tangible Assets: All advances or part of advances,
within/outside India, which are secured by tangible assets will be
considered as secured assets.

Covered by Bank/Government Guarantees: Advances in India and

outside India to the extent they are covered by guarantees of Indian
and foreign governments/banks and DICGC and ECGC will be included
here.
Unsecured Advances: All advances that do not have any security and
which do not appear in the above two categories will come under this
category.

Fixed Assets: All fixed assets of a bank, e.g., immovable properties,

premises, furniture and fixtures, hardware, motor vehicles are
classified into fixed assets.

Other Assets: The remainder of the items on the asset side of a bank's
balance sheet are categorised as other assets. The miscellaneous
assets that appear are:

1. Inter-office Adjustments: Debit balance of the net position or the

interoffice accounts, domestic as well as overseas.
2. Interest Accrued: This will be the interest accrued, but not due
on investments and advances and interest due, but not collected
on investments.
3. Tax Paid in Advance/tax Deducted at Source: This includes
amount of tax deducted at source on securities and the advance
tax paid to the extent that they are not set-off against relative
tax provisions.
4. Stationery and Stamps: Stock of stationery on hand is considered
under this head of account.
5. Non-Banking Assets Acquired in Satisfaction of Claims. Items
under this account include immovable properties/ tangible
assets which are acquired by a bank in satisfaction of the bank's
claims on others.
6. Others: Other items primarily include claims that are in the form
of clearing items, unadjusted debit balances representing
additions to assets and deductions from liabilities and advances
provided to the employees of a bank.
CONTINGENT LIABILITIES

A bank's obligations under issuance of letter of credit, guarantees and

acceptances on behalf of constituents and bills accepted by the bank
on behalf of its customers are reflected under contingent liabilities.

Other contingent liabilities include claims against the bank not

acknowledged as debts, liability for partly paid-up investments,
liability on account of outstanding forward exchange contracts and
other items like arrears of cumulative dividends, bills rediscounted,
underwriting, commitments, estimated amount of contracts
remaining to be executed on capital account and not provided for, etc.

BANK`S PROFIT & LOSS ACCOUNT

A bank's profit and loss account has following components:

Income: which includes Interest income and other income.

Expenses: which includes Interest expended, Operating expenses

and Provisions and Contingencies:

INCOME ITEMS:
Interest income
1. Interest/ Discount on Advances/ Bills
2. Income on investments
3. Interest on Balances with RBI and Other Interbank Funds
Other income
1. Commission, Exchange and Brokerage
2. Profit on sale or investment
3. Profit on Revaluation of investment
4. Profit on sale of land, Building and other Assets
5. Profit on Exchange Transactions
6. Misc. income
EXPENSES

1. Interest on Deposits
2. Interest on RBI/Interbank Borrowings
3. Operating Expenses

a. Payments to and Provisions for Employees

b. Rent, Taxes and Lighting

c. Printing and Stationery

d. Advertisement and Publicity

e. Depreciation on Bank’s Property

f. Director’s fees, Allowances and Expenses

g. Law-charges

h. Repairs and Maintenance

i. Insurance

ASSET & LIABILITY MANAGEMENT (ALM)

In banking institutions, asset and liability management is the practice
of managing various risks that arise due to mismatches between the
assets and liabilities (loans and advances) of the bank.

Banks face several risks such as the risks associated with assets,
interest, currency exchange risks. Asset Liability management (ALM) is
at tool to manage MAINLY Interest Rate Risk and Liquidity Risk faced
by various banks, other financial services companies.

In general, ALM refers to efforts by a bank’s board and senior

management team to carefully balance the bank’s current and long-
term potential earnings with the need to maintain adequate liquidity
and appropriate interest rate risk (IRR) exposures. Each bank has a
distinct strategy, customer base, product selection, funding
distribution, asset mix, and risk profile. These differences require that
assessments of risk exposures and risk management practices be
customized to each bank’s specific risks and activities and not take a
one-size-fits-all approach.

Mismatch of assets and liabilities:

Banks manage the risks of ALM mismatch by matching various assets

and liabilities according to the MATURITY PATTERN or the matching
the duration, by hedging and by securities.

Increasing integrated risks is done on a full mark to market basis rather

than the accounting basis that was at the heart of the first interest
rate sensitivity gap and duration calculations.

It is an attempt to match: Assets and Liabilities In terms of: Maturities

and Interest Rates Sensitivities To minimize: Interest Rate Risk and
Liquidity Risk.

ALM is an integral part of the financial management process of any

bank. It is concerned with strategic balance sheet management
involving risks caused by changes in the interest rates, exchange rates
and the liquidity position of the bank. While managing these three
risks forms the crux of ALM, credit risk and contingency risk also form
a part of the ALM

ALM can be termed as a risk management technique designed to earn

an adequate return while maintaining a comfortable surplus of assets
beyond liabilities. It takes into consideration interest rates, earning
power, and degree of willingness to take on debt and hence is also
known as Surplus Management
The ALM process rests on three pillars:

1 ALM information systems

2 Management Information System

3 Information availability, accuracy, adequacy and expediency

ALM involves identification of Risk parameters, Risk identification, Risk

measurement and Risk management and framing of Risk policies and
tolerance levels.

IMPORTANT TERMS IN ALM

Asset-liability Management (ALM): A function of planning, acquiring

and directing the flow of funds in a bank with a view to stablise /
improve the spread (NIM).

Components of balance sheet: There are two components i.e. (a)

Assets (b) Liabilities

Components of profit & loss account: There are-two components i.e.

(a) income (b) expenditure

Operating expenses: Expenses relating to cost of running the banking

activity such as employees' payment, rents, taxes, printing &
stationery etc.

Income: Comprises interest income and non-interest income

Expenses: Comprise interest expenses, operating expenses, provisions

and taxes.

Net interest income: Surplus of interest income over interest

expenditure

Net interest margin: Net interest income / total assets.

Economic equity ratio: Ratio of shareholders' funds to total assets

which measures the change in the ratio of owned funds to total funds.

Sources & use of funds: Sources are represented by liabilities and uses
are represented by assets.

Various types of risks with Assets:

Currency Risk;

Floating exchange rate arrangement has brought in its wake

pronounced volatility adding a new dimension to the risk profile of
banks’ balance sheets. The increased capital flows across free
economies following deregulation have contributed to increase in the
volume of transactions.
Large cross border flows together with the volatility has rendered the
banks’ balance sheets vulnerable to exchange rate movements.

Dealing in different currencies;

Banks undertake operations in foreign exchange like accepting

deposits, making loans and advances and quoting prices for foreign
exchange transactions. Irrespective of the strategies adopted, it may
not be possible to eliminate currency mismatches altogether. Besides,
some of the institutions may take proprietary trading positions as a
conscious business strategy. Managing Currency Risk is one more
dimension of Asset- Liability Management.

Mismatched currency position besides exposing the balance sheet to

movements in exchange rate also exposes it to country risk and
settlement risk. Ever since the RBI (Exchange Control Department)
introduced the concept of end of the day near square position in 1978,
banks have been setting up overnight limits and selectively
undertaking active day time trading.

Interest Rate Risk (IRR);

The phased deregulation of interest rates and the operational

flexibility given to banks in pricing most of the assets and liabilities
have exposed the banking system to Interest Rate Risk.

Interest rate risk is the risk where changes in market interest rates
might adversely affect a bank’s financial condition. Changes in interest
rates affect both the current earnings (earnings perspective) as also
the net worth of the bank (economic value perspective). The risk from
the earnings’ perspective can be measured as changes in the Net
Interest Income (Nil) or Net Interest

GAP ANALYSIS
Problem with poor Management Information systems;

In the context of poor MIS, slow pace of computerization in bank and

the absence of total deregulation, the traditional Gap analysis is
considered as a suitable method to measure the Interest Rate Risk. It
is the intention of RBI to move over to modern techniques of Interest
Rate Risk measurement like Duration Gap Analysis, Simulation and
Value at Risk at a later date when banks acquire sufficient expertise
and sophistication in MIS.

What Is a Gap Analysis?

A gap analysis process allows organizations to determine how to best
achieve their business goals. It compares the current state with an
ideal state or goals, which highlights shortcomings and opportunities
for improvement.
How do you know what to trim, fix, expand, or change to get your
business to the next level? You do a gap analysis.
You might have lots of guesses about what’s going on, and your team
might have different opinions on how to meet your objectives. Rather
than groping around in the dark, a gap analysis leads you through a
detailed examination of where your organization is currently and
where you want to be so you can act on facts, not assumptions, to
reach your potential.

Why Do Businesses Perform a Gap Analysis?

Some reasons that a company might kick off a gap analysis include the
following:
1. Benchmarking: Comparing results against external criteria. An IT
company may want to see where they stand against industry
performance criteria, or a Cement company may want to
compare their reputation with their competitors.
2. Portfolio Analysis: Examining their product portfolio to look for
new sales opportunities, a company can use a gap analysis to
identify new products to sell. In the opposite direction, they can
also look for existing products that are not selling well, use a gap
analysis to find out why, then promote them (e.g., feature them
more prominently in marketing or put them on sale), change
them to better to meet customer needs, or remove them from
their portfolio.
3. Profits: If a forecast profit percentage isn’t reached, a company
can use a gap analysis to determine what went wrong, and
whether it was in planning or execution. Was the organization
paying higher-than-expected expenses for materials, or having
to lower prices due to unexpected competition?
4. Processes: A gap analysis can help reveal the shortcomings of
processes, so that the real outcomes match the expected
outcomes. A shipping firm could examine their accounting
process to see why so many of their vendors are not getting paid
on time, or examine their billing processes to see why many of
their suppliers don’t get their invoices until after the due date.
5. Performance Indicators: A gap analysis can also be applied to key
performance indicators like new customer acquisition, average
 order amount, or return on investment (ROI). A mobile carrier
could look for the reasons that caused them to miss their
customer acquisition goal
6. Usage Gaps: A usage gap is the difference between current
market size for a product or service, and the potential market
size. A gap analysis in this area can help an organization see why
they are not reaching the full potential. Is a company's
reputation pushing down sales? Or did management misread the
demand for a product?

Gap Analysis Examples

While there are a countless departments of business areas (e.g.
accounting, sales, customer service, HR) and situations that can use
the gap analysis process, here are a few examples that illustrate the
broad range of ways a company can use a gap analysis:
1. New Product Launch: After a company launches a new product,
they might do a gap analysis to determine why sales didn’t meet
forecasts.
2. Productivity: When a factory’s productivity is not meeting
expectations, targeted customer needs, or the set of business
requirements that were laid out a gap analysis can help
determine what process to fix.
3. Supply Management: If a hospital finds itself running short of
supplies on a regular basis, they could perform a gap analysis to
identify the reason why.
4. Sales Performance: A manufacturer can look at the sales
performance of their catalog of products to make sure they are
producing the right mix, and use the result to maximize their
production–possibility frontier.
5. Individual Assessment: A team leader at an accounting firm can
have each member perform a gap analysis on themselves, and
use those results not only to find targets to improve each
person’s performance, but also to draw out the best practices
that everyone can adopt.
6. Product Evaluation: A software company might perform a gap
 analysis of their product to ensure that all features and functions
outlined in the business requirements are present and working
as expected.
Four (4) Simple Steps for Gap Analysis
follow these four simple steps. Regardless of any industry, it will be
able to apply these tips across any discipline and meet your business
goals.

1. Analyze your current state

First, you’ll need to choose which area of your business you want to
focus on and start with your current state. You need to discover where
your organization currently is before you can make a plan for reaching
your goals.
For example, your company wants to become the most loved in your
industry, but your customer support team reports that many calls and
customer interactions end in frustration on the customers’ part.
Is your product the problem or does your support team need more
training on handling difficult calls? You won’t know until you dig in,
which will mean talking to the people involved, gathering data, and
scrutinizing your KPIs (Key Performance Indicator). To make sense of
this information and visualize your current state, use a gap analysis
tool––a customer journey map, empathy map, service blueprint, or
process flow.
If you wanted to find out what causes customer frustration, you might
gather quantitative information, like the number of negative calls
handled each week. You might also look at qualitative information,
like customer comments or feedback from your support reps on the
current call process.
What’s most important at this stage is understanding the root of the
problem, which is much easier to see once you’ve laid out all the
contributing factors. In fact, your gap analysis process should evaluate
everything you currently do so you get the “big picture.”

2. Identify the ideal future state

Once you have the big picture figured out and understand how your
team or organization currently functions, you need to become
idealistic. Where would you like to be? What’s not happening that
should be? Don’t worry yet about how you’ll get there. That’s the next
step. Right now, the sky’s the limit, and you should dream big.
Maybe you have an exceptional marketing team that outsources all its
content, but after performing a content audit, you realize that your
brand is no longer cohesive because it’s handled by a different in type
of group of non-committed persons. Your dream could be to regain
control of the content creation process in order to reclaim your brand
identity.
Current performance clearly falls short or needs to be changed. But
instead of charging blindly ahead or slapping a Band-Aid on the
situation, picturing the ideal helps you reach a higher potential. A
good gap analysis tool here would be a brainstorming board or a mind
map to really capitalize on your team’s creativity.
3. Find the gap and evaluate solutions
Completing the first two steps in isolation won’t get you great results–
–the status quo can seem inescapable, and goals can feel lofty and
unattainable. Putting them together, however, exposes what’s
missing between your performance and your potential. You also need
to decide which solutions will most effectively bridge the gap.
A gap analysis would bring up the following question: How do we go
from a muddled brand voice to one that’s unified and under our
control?
Several solutions for bridging this gap present themselves, though not
all are created equal:
1. You could bring content creation (process of generating topic
ideas that appeal to your buyer) back in house by hiring more
full-time professionals, which would be more expensive than
using non committed persons.
2. You could reevaluate of all your existing staff to determine which
ones are worth keeping and which are falling short of your
standards.
3. You could tighten your brand creation guidelines and retrain
 your old staff. This option would also require time and doesn’t
necessarily guarantee an improvement in the content created by
your existing staff.
In the end, how you bridge the gap will depend on your organizational
and team priorities.
4. Create and implement a plan to bridge the gap
After you’ve charted out the possible ways to bridge the gap and
decided which would be best, you likely still need to convince others
in your organization of that as well. The changes that you’ll implement
may also affect other teams and department, so it’s important to
come up with a plan.
Establish a clear strategy and actionable objectives to help you
actualize your transition and get everyone on board.

The Gap or mismatch risk can be measured by calculating Gaps over

different time intervals as at a given date. Gap analysis measures
mismatches between rate sensitive liabilities and rate sensitive assets
(including off-balance sheet positions). An asset or liability is normally
classified as rate sensitive

Gap analysis tools

1. McKinsey 7Ss Framework

The McKinsey framework has seven categories: Strategy, Structure,
Systems, Shared values, Skills, Style, and Staff. The first three are
considered “hard” and the rest are considered “soft.”
An example of a misalignment (Uneven) might be if a production line
requires 20 people to operate at full capacity, but the graveyard shift
only has 15 people available. In this case, there's a misalignment
between systems and staff.
McKinsey 7Ss Framework
2.Nadler-Tushman Congruence Framework
This model breaks a company's’ performance into four areas: work,
people, structure, and culture. First find each area’s strengths and
weaknesses, and then compare them to the other areas. The goal is to
find out if the work being done in each area supports the others.
For example, if a compliance group is performing their tasks at a high
level and finds areas where the company is not following certain laws
and regulations, but the company’s organization doesn't have any way
to implement these changes, the people and structure are not
congruent.

SWOT analysis
SWOT analysis is perhaps one of the oldest textbook-marketing assets.
SWOT stands for strengths, weaknesses, opportunities, and threats.
You can perform a SWOT analysis both quantitatively and
qualitatively. This process will help you determine internal and
external threats to your organization and see where and how you
stand out against the competition.
SWOT Analysis Example
Fishbone diagram
Named for their distinctive shape, fishbone diagrams (also known as
Ishikawa, cause-and-effect, or herringbone diagrams) explore the
possible causes of a Root problem. This type of diagram would be
especially valuable when examining your current situation.
The most commonly used categories for investigation are:
• Measurements
• Materials
• People
• Machines
• Methods
• Environment
You can choose any categories that make sense for the central
problem or effect you’re examining, as shown in the example below.
Fishbone Diagram for Service Industry Example
PESTEL ANALYSIS
Similar to SWOT, PEST analysis helps you identify threats and
opportunities by examining the four primary external factors of your
business environment:
• Political
• Economic
• Sociological
• Technological
This approach eliminates gaps by pinpointing current issues,
highlighting opportunities for change, and minimizing risks in the
market.
PESTEL Analysis
IMPORTANT TERMS

Gap: It is the difference between the amount of assets and liabilities

on which the interest rates are reset during a given period.

Gap analysis: Technique for interest rate risk measurement in which

the earnings exposure is on the basis of subtracting the interest rate
liabilities in each time band from the corresponding interest rate
sensitive assets to produce a repricing gap for that time band.

Interest rate risk: It is the volatility in net interest income (NII) or

variation in net interest margin

Basis risk: The interest rate of assets and liabilities can change in
different magnitudes. Such risk is basis risk.

Mismatch risk or Gap risk: Risk arising from holding assets and
liabilities with different principal amounts, maturity dates or re-pricing
dates, that leads to exposure to changes in the level of interest' rates.

Net interest position risk: Risk on account of change in interest rate in

assets without any change in the interest rate of liabilities, when
interest earning assets are more than the interest payment liabilities.

Embedded option risk: Risk arising on account of use of put or call

option by the customers such as pre-payment of loan or withdrawal
of deposit before maturity.

Yield curve risk: Risk reflected by thee changes in curve (called yield
curve) due to changes in economic business cycles.

Price risk: Risk that arises on account of sale of assets (say investment)
before maturity that may result into loss.
Reinvestment risk: Risk on uncertainty about rate of interest at which
the future cash flows can be reinvested.

Earning perspective: The approach in which the effect of interest rate

changes is evaluated on earning of the bank (change in net interest
income or net interest margin).

Economic value perspective: The approach in which the effect of

interest rate changes is evaluated on the economic value of the assets,
liabilities or off-balance sheet items (if there is change in current
interest rates, the value of investments already made by the bank, will
change).

Embedded losses: The loss that may arise on account of previous

contracts at a different rate of interest than the prevailing rates. (a
fixed rate of interest loan allowed at a lower rate and funded by recent
high-cost liabilities).

Repricing schedules: The risk measurement technique in which

schedules are prepared that distribute the interest-sensitive assets or
liabilities into a certain no. of predetermined time banks according to
their maturity or time remaining for next re-pricing.

Duration: An interest rate risk measurement technique which is a

measure of %age change in the economic value of a position that will
occur given a small change in the level of interest rates.

Simulation: A technique to estimate the interest rate risk, by use of a

no. of changes and assumption about interest scenario. A simulation
may be static simulation or a dynamic simulation.

Limitations of Gap Analysis

Gap analysis is a useful way to determine the untapped potential of a
business’s performance. Gap analysis focuses on what the current
performance of a business is as opposed to what the market wants
from the business. Some limitations of this type of analysis are the lack
of actionable steps it provides, the competitor’s gap, the technology
needed, governmental influence and seasonal fluctuations.

Steps
The gap analysis helps define potential for business growth but does
not provide actionable steps for how to grow. In this way the gap
analysis is merely the first step in defining a business problem. Further
investigation is then necessary to define how the business can reach
the new market. What kind of financial investment will it take to reach
the growth potential? Will a new research and development
department need to be set up? How can we continue to evaluate our
products to stay at the top of this continually growing market

Competition
Every business should work to carve out a niche market for its
products. Businesses are independent and require business-specific
gap analysis. Still, competitors will always loom on the horizon and
may have already tapped some new growth potential. Gap analysis
does not always account for the actions of competitors. Managers
should continually analyze what markets competitors are moving into
as well as perform gap analyses on their own company’s performance.

Technology
Technological advances may be known within an organization already
and performing a gap analysis may serve to only highlight obvious
needs. The gap analysis merely points out what technological
advances might be desired by customers but it does not define how
these advances may take place. A hotel chain may realize there is
potential for space tourism and lodging, but the technology to take
civilians into space as tourists is not yet developed. Some company
growth relies on the technological advances of external organizations.
Government
Government entities often control what businesses can and cannot
explore. Gap analysis may serve to point out the desire for market
expansion, but without legal rights to expand the market, a business’s
hands are tied. Gap analysis does not provide methods for working
around this.

Seasonality
Using specific numbers, or benchmarking, performance of products
using quantifiable data is an excellent way to perform a gap analysis,
but numbers can sometimes be deceiving. Businesses often go
through cyclical changes due to external factors like the time of year,
disposable income of consumers around the holidays, or ever-
changing fashion trends. It is important to use a series of numbers or
average numbers when performing a gap analysis. The gap may be
unusually large if the growth potential of a business is judged against
a predictable slow season.

RELATIONS BETWEEN GAP & FINANCIAL STATEMENTS

Balance Sheet
Balance Sheet, or Statement of Financial Position, is directly related to
the income statement, cash flow statement and statement of changes
in equity.
Assets, liabilities and equity balances reported in the Balance Sheet at
the period end consist of:

1. Balances at the start of the period;

2. The increase (or decrease) in net assets as a result of the net
profit (or loss) reported in the income statement.
3. The increase (or decrease) in net assets as a result of the net
gains (or losses) recognized outside the income statement and
directly in the statement of changes in equity (e.g., revaluation
surplus).
 4. The increase in net assets and equity arising from the issue of
share capital as reported in the statement of changes in equity.
5. The decrease in net assets and equity arising from the payment
of dividends as presented in the statement of changes in equity.
6. The change in composition of balances arising from inter balance
sheet transactions not included above (e.g. purchase of fixed
assets, receipt of bank loan, etc).
7. Accruals and Prepayments.
8. Receivables and Payables.

Income Statement
Income Statement, or Profit and Loss Statement, is directly linked to
balance sheet, cash flow statement and statement of changes in
equity.

The increase or decrease in net assets of an entity arising from the

profit or loss reported in the income statement is incorporated in the
balances reported in the balance sheet at the period end.

The profit and loss recognized in income statement is included in the

cash flow statement under the segment of cash flows from operation
after adjustment of non-cash transactions. Net profit or loss during
the year is also presented in the statement of changes in equity.

Statement of Changes in Equity

Statement of Changes in Equity is directly related to balance sheet and
income statement.

Statement of changes in equity shows the movement in equity

reserves as reported in the entity’s balance sheet at the start of the
period and the end of the period. The statement therefore includes
the change in equity reserves arising from share capital issues and
redemption, the payments of dividends, net profit or loss reported in
the income statement along with any gains or losses recognized
directly in equity (e.g. revaluation surplus).
Cash Flow Statement
Statement of Cash Flows is primarily linked to balance sheet as it
explains the effects of change in cash and cash equivalents balance at
the beginning and end of the reporting period in terms of the cash
flow impact of changes in the components of balance sheet including
assets, liabilities and equity reserves.

Cash flow statement therefore reflects the increase or

decrease in cash flow arising from:

1. Change in share capital reserves arising from share capital issues

and redemption.
2. Change in retained earnings as a result of net profit or loss
recognized in the income statement (after adjusting non-cash
items) and dividend payments.
3. Change in long term loans due to receipt or repayment of loans.
4. Working capital changes as reflected in the increase or decrease
in net current assets recognized in the balance sheet.
5. Change in non-current assets due to receipts and payments
upon the acquisitions and disposals of assets (i.e., investing
activities).

What is Liquidity & Its Management

Liquidity refers to the efficiency or ease with which an asset or security
can be converted into ready cash without affecting its market price.
The most liquid asset of all is cash itself.
For example, if a person wants to buy a refrigerator for Rs. 10000, cash
is the asset that can most easily be used to obtain it. If that person has
no cash but a rare coin that has value of Rs.10000 he/ she is unlikely
to find someone willing to trade them the refrigerator for the coin.
Instead, he/she will have to sell the coin and use the cash to purchase
the refrigerator. That may be fine if the person can wait but it could
present a problem if the person only had a few days. He/ she may have
to sell the coin at a discount, instead of waiting for a buyer who was
willing to pay the full value.

Main Measures of Liquidity:

1. Market liquidity
2. Accounting liquidity.

Market Liquidity
Market liquidity refers to the extent to which a market, such as a
country's stock market or a city's real estate market, allows assets to
be bought and sold at stable, transparent prices. In the example
above, the market for refrigerators in exchange for rare coin is so
illiquid that, for all intents and purposes, it does not exist.

The stock market, on the other hand, is characterized by higher

market liquidity. If an exchange has a high volume of trade that is not
dominated by selling, the price a buyer offers per share (the bid price)
and the price the seller is willing to accept (the ask price) will be fairly
close to each other.

Investors, then, will not have to give up unrealized gains for a quick
sale. When the spread between the bid and ask prices grows, the
market becomes more illiquid. Markets for real estate are usually far
less liquid than stock markets. The liquidity of markets for other
assets, such as derivatives, contracts, currencies, or commodities,
often depends on their size, and how many open exchanges exist for
them to be traded on.

Accounting Liquidity
Accounting liquidity measures the ease with which an individual or
company can meet their financial obligations with the liquid assets
available to them—the ability to pay off debts as they come due.

In the example above, the rare coin collector's assets are relatively
illiquid and would probably not be worth their full value of Rs.1,0000
in a pinch. In investment terms, assessing accounting liquidity means
comparing liquid assets to current liabilities, or financial obligations
that come due within one year.

Measuring Liquidity
Financial analysts look at firm's ability to use liquid assets to cover
their short-term obligations. Generally, when using these formulas, a
ratio greater than one is desirable.

Current Ratio
The current ratio is the simplest and least strict. It measures current
assets (those that can reasonably be converted to cash in one year)
against current liabilities. Its formula would be:

Current Ratio = Current Assets / Current Liabilities

Quick Ratio (Acid-test ratio)
The quick ratio, or acid-test ratio, is slightly more strict. It excludes
inventories and other current assets, which are not as liquid as cash
and cash equivalents, accounts receivable, and short-term
investments. The formula is:

Quick Ratio = (Current Assets- Inventories) / Current Liabilities

CONTIGENCY FUNDING
A contingency fund is money reserved to address unforeseen financial
circumstances in a business. ... The role of the contingency fund is to
improve a company's financial stability by developing a safety net that
the firm can use to fill emergency needs.
Every prudent company keeps some part of profits in some type of
Reserves like general. Specific reserves to meet out any future
emergencies, deferred payments, of for buying new fixed assets in
future.
BUSINESS STRATEGIES
A business strategy is the combination of all the decisions taken and
actions performed by the business to accomplish business goals and
to secure a competitive position in the market.

It is the backbone of the business as it is the roadmap which leads to

the desired goals. Any fault in this roadmap can result in the business
getting lost in the crowd of overwhelming competitors.

Techniques of a Business Strategy:

1. Cross-sell more products.

2. Most innovative product or service.
3. Grow sales from new products.
4. Improve customer service.
5. Cornering a young market.
6. Product differentiation.
7. Pricing strategies.
8. Technological advantage.

Why Business Strategy

A business objective without a strategy is just a dream. It is no less
than a gamble if you enter into the market without a well-planned
strategy.

With the increase in the competition, the importance of business

strategy is becoming apparent and there’s a huge increase in the types
of business strategies used by the businesses.
Here are five reasons why a strategy is necessary for your business.

Planning
Business strategy is a part of a business plan. While the business plan
sets the goals and objectives, the strategy gives you a way to fulfil
those goals. It is a plan to reach where you intend to.
Strengths & Weaknesses
Most of the times, you get to know about your real strengths and
weaknesses while formulating a strategy. Moreover, it also helps you
capitalise on what you’re good at and use that to overshadow your
weaknesses (or eliminate them).

Efficiency & Effectiveness

When every step is planned, every resource is allocated, and everyone
knows what is to be done, business activities become more efficient
and effective automatically.

Competitive Advantage
A business strategy focuses on capitalising on the strengths of the
business and using it as a competitive advantage to position the brand
in a unique way. This gives an identity to business and makes it unique
in the eyes of the customer.

Control
It also decides the path to be followed and interim goals to be
achieved. This makes it easy to control the activities and see if they
are going as planned.

Levels Of Business Strategy

The business goal is achieved by the effective execution of different
business strategies. While every employee, partner, and stakeholder
of the company focus on fulfilling a single business objective, their
activities are defined by various business strategies according to their
level in the organisation.
Business strategies can be classified into three levels –

Level 1: The Corporate Level

The corporate level is the highest and most broad level of the business
strategy. It is the business plan which sets the guidelines of what is to
be achieved and how the business is expected to achieve it. It sets the
mission, vision, and corporate objectives for everyone.

Level 2: The Business Unit Level

The business unit level is a unit specific strategy which differs for
different units of the business. A unit can be different products or
channels which have totally different operations. These units form
strategies to differentiate themselves from the competitors using
competitive strategies and to align their objectives with the overall
business objective defined in the corporate level strategy.

Level 3: The Functional Level

The functional level strategies are set by different departments of the
units. The departments include but are not limited to marketing, sales,
operations, finance, CRM etc. These functional level strategies are
limited to day to day actions and decisions needed to deliver unit level
and corporate level strategies, maintaining relationships between
different departments, and fulfilling functional goals.

Key Components Of A Business Strategy

While an objective is defined clearly in the business plan, the strategy
answers all the what’s, why`s, who’s, where’s, when’s, & how’s of the
fulfilling that objective.
The key components of a business strategy.

Mission, Vision, & Business Objectives

The main focus of a business strategy is to fulfil the business objective.
It gives the vision and direction to the business with clear instructions
of what needs to be done, how it needs to be done, and who all are
responsible for it.

Core Values
It also states the ‘musts’ and ‘must nots’ of the business which clarify
most of the doubts and give a clear direction to the top level, units, as
well as the departments.

SWOT
A SWOT (strengths, weaknesses, opportunities, and threats) analysis
is a rundown of the company’s current situation. It is a necessary
component of a business strategy as it represents the current
strengths and opportunities which the company can make use of and
the weaknesses and threats which the company should be wary of.

Operational Tactics
Unit and functional business strategies get deep into the operational
details of how the work needs to be done in order to be most effective
and efficient. This saves a lot of time and effort as everyone knows
what needs to be done.

Resource Procurement & Allocation Plan

The strategy also answers where and how will you procure the
required resources, how will it be allocated, and who will be
responsible for handling it.

Measurement
Unless there are no control measures, the viability of a business
strategy can’t be assessed properly. A good business strategy always
includes ways to track the company’s output and performance against
the set targets.

Business Strategy Examples

Creating A New Market
Hubspot developed an executed a perfect strategy where it created a
market that didn’t even existed – inbound marketing.

It created an online resource guide explaining the limitations of the

interruption marketing and informing about the benefits of the
inbound marketing. The company even provided free courses to help
the target audience understand its offering better.

Buying The Competition

Facebook’s buy the competition strategy has been successful ever
since the company was launched. It focuses on buying the pioneer or
the competition instead of creating the technology of its own to
compete with it. So far there have been many notable acquisitions by
Facebook like Instagram, WhatsApp, etc. to increase its reach and user
base.

Product Differentiation
Apple differentiated its smartphone operating system iOS by making
it really simple as compared to Android. This differentiated it and built
its own followership. The company has been following a similar
strategy for its other products as well.

Cost Leadership
OnePlus launched its flagship product OnePlus 6T with similar features
to iPhone X but at a price which is less than half a price of iPhone X.
This strategy worked for OnePlus making it the top premium phone
brand in India and other countries.

EFFECT OF NPAs ON PROFITABILITY

LIQUIDITY POSITION
If the bank evaluates less capital the future business concern, which
affects the position of banks and creating a mismatch between the
assets and liability and they force the bank to raise the resources at a
high rate. So, there will be an impact on the profitability of banks,
were they not able to recover the amount from the borrower the level
of profits will come down.

UNDERMINE BANK’S IMAGE

Increase in non-performing assets which shadows the domestic
markets and global level markets, on that situation the bank
profitability decreases which lead to the bad image to banks.

EFFECT ON FUNDING
Increase in non-performing assets leads to scarcity in funding to other
borrowers. As well as the Indian capital market also get affected. And
then there will be only a few banking institutions lend money.

HIGHER COST OF CAPITAL

It shall result in increasing the cost of capital as banks will now have
to keep aside more funds for smooth operations.

HIGH RISK
High on non-performing assets, low profitability, high risk in business
and work against the bank and may take the two circumstances
survival of the bank. And it affects the risk-bearing capacity of the
bank.

BANK PROFITABILITY
The which makes low profits have lower capital adequacy ratio and
the low capital ratio which limits the further creation of assets. Such
kind of banks face difficulties in their growth, expansion, and plans and
there they need not wherewithal to march boldly on these fronts. In
these growth failures in the expansion, the only consequences and
stagnation and negative growth.
They reduce net interest income as they do not charge the interest to
these accounts.
Profit vs. profitability
Both profit and profitability give insight into different aspects of
business. To avoid confusing the two, one need to understand the
difference between profit and profitability.

PROFIT is the amount your business gains. It is a number that remains

when you subtract expenses from your revenue. You can find profit by
looking at your business’s income statement.

PROFITABILITY measures your business’s profits and helps you

determine your success or failure. It is not an absolute number.
Instead, it looks at what your business’s profits mean in the form of
percentages or decimals. There are different profitability ratios you
can use.

What is profitability analysis?

When a company is incepted, one of the sole purposes of it is to make
profits. Basically, to earn more than you spend is what every business
owner wants for his company. Thus, to assess the growth of your
business, careful study on profit is important. However, the meaning
that secretly lie under various financial statements, will give the real
picture of your company’s profits.

Analysing of the profits which is basically the money remaining from

the capital after subtracting all the overhead costs, will help one keep
a track of one`s business’ performance. Profitability analysis allows
companies to maximise their profit. Thus, resulting in maximising the
opportunities that business can take advantage of, in order to
continue growing in an extremely dynamic, competitive, and vibrant
market. Profitability analysis helps businesses identify growth
opportunities, fast/slow-moving stock items, market trends, etc,
ultimately helping decision-makers see a more concrete picture of the
company as a whole.
Importance of profitability analysis
While profitability analysis gives business owners a 360° view of the
company’s profits, different ratios that derive profitability ratios have
different roles to play.

Gross profit margin

1. Gross profit margin is an analytical metric expressed as a

company's net sales minus the cost of goods sold (COGS).
2. Gross profit margin is often shown as the gross profit as a
percentage of net sales.
3. The gross profit margin shows the amount of profit made before
deducting selling, general, and administrative costs, which is the
firm's net profit margin.

The Formula for Gross Profit Margin

Gross Profit Margin= Net sales -COGS/ Net sales

where
COGS= Cost of Goods Sold:
COGS = Beginning Inventory/stock + Purchases During the Period –
Ending Inventory/stock.
Net sales (gross revenues minus returns, allowances, and
discounts).

What Does the Gross Profit Margin Tells?

If a company's gross profit margin wildly fluctuates, this may signal
poor management practices and/or inferior products. On the other
hand, such fluctuations may be justified in cases where a company
makes sweeping operational changes to its business model, in which
case temporary volatility should be no cause for alarm.
Product pricing adjustments may also influence gross margins. If a
company sells its products at a premium, with all other things equal,
it has a higher gross margin. But this can be a delicate balancing act
because if a company sets its prices overly high, fewer customers may
buy the product, and the company may consequently hemorrhage
market share.

NET PROFIT MARGIN

1. Net profit margin measures how much net income is generated

as a percentage of revenues received.
2. Net profit margin helps investors assess if a company's
management is generating enough profit from its sales and
whether operating costs and overhead costs are being
contained.
3. Net profit margin is one of the most important indicators of a
company's overall financial health.

Net Profit Margin Formula

Net Profit margin = Net Profit ⁄ Net Sales x 100

Net profit is calculated by deducting all company expenses from its total
Sales/revenue. The result of the profit margin calculation is a percentage
– for example, a 10% profit margin means for each Rs.100 of revenue the
company earns Rs.10 in net profit. Revenue represents the total sales of
the company in a period.

Returns on equity
Returns on equity is the percentage of the earnings, which
shareholders get in return for the investments made towards the
company. Higher the ROE, higher will be the dividends shareholders
will receive. This triggers more investors for your company ultimately
aiding in keeping your company afloat in the market.
How to Calculate Return on Equity capital OR Capital
Return on Capital Formula

The return on capital formula is:

a) ROC = (net income - dividends) / (debt + equity)

or

ROC = (NOPAT) / (invested capital)

What is NOPAT?

NOPAT (or net operating profit after tax) looks at a company’s core
operations, net of taxes, and how well it’s faring in terms of income. Since
both debt and equity count as capital invested towards the business, the
formula above uses the term “invested capital.”

Returns on capital employed (ROCE) and return on assets (ROA)

These returns measure the efficiency of a company in utilising of its
assets. By evaluating ROCE, the management can take decisions that’ll
help them minimise the inefficiencies. Higher the ROCE, higher will be
the efficiency in the production process of the company.

ROA is a measure of every penny of income earned on every penny of

the asset owned by the company. Similar to ROCE, ROA also helps the
management manage the utilisation of assets, diligently.

Profitability ratio analysis:

Discussed above

Margin Ratios
To understand your company’s financial status during a specific
period, it is imperative to understand your company’s ability to
convert sales into profits. That is what margin ratio represents at
various degrees of measurement. Some of the examples are gross
profit margin, operating profit margin, net profit margin, cash flow
margin, EBIT, EBITDA (Earnings Before Interest, Taxes, Depreciation,
and Amortization), NOPAT (Net Operating Profit After Tax), operating
expense ratio, and overhead ratio.

What Is Economic Value Added (EVA)

EVA is a performance metric that calculates the creation of
shareholder value; however, it distinguishes itself from traditional
financial performance metrics, such as net profit and earnings per
share (EPS). EVA is the calculation of what profits remain after the
costs of a company's capital—debt and equity—are deducted from
operating profit. The idea is simple but rigorous: true profit should
account for the cost of capital.

To understand the difference between EVA and its infamous cousin,

net income, let's use an example based on fictitious company Ray's
House of Crockery. Ray's earned Rs.100,000 on a capital base of
Rs.1000000/- due to his new product for which there is less
competition. Traditional accounting metrics suggest that Ray is doing
a good job. His company offers a return on capital of 10%. However,
Ray's has only been operating for a year, and the market for his new
product still carries significant uncertainty and risk. Debt obligations
plus the required return that investors demand add up to an
investment cost of capital of 13%. That means that, although Ray's is
enjoying accounting profits, the company was unable to grant 3% to
its shareholders.

Conversely, if Ray's capital is Rs. 10 crores—including debt and

shareholder equity—and the cost of using that capital (interest on
debt and the cost of underwriting the equity) is Rs.1300000/- i.e, one
crore thirty lac, Ray will add economic value for his shareholders only
when profits are more than Rs.13000000/- (One crore thirty lac) per
year. If Ray's earns Rs. 2 crores, the company's EVA will be Rs.70 Lacs.
EVA charges the company for tying up investors' cash to support
operations. There is a hidden opportunity cost that goes to investors
to compensate them for forfeiting the use of their own cash. EVA
captures this hidden cost of capital that conventional measures
ignore.

Developed by the management consulting firm Stern Stewart, EVA

became wildly popular in the 1990s. Big companies employ EVA
internally to measure wealth creation performance. In turn, investors
and analysts are now scrutinizing companies' EVA just as they
previously observed EPS and P/E ratios.

The formula for calculating EVA is:

EVA = NOPAT - (Invested Capital * WACC)

Where:
NOPAT = Net operating profit after taxes
Invested capital = Debt + capital leases + shareholder’s' equity
WACC = Weighted average cost of capital

Special Considerations
The equation for EVA shows that there are three key components to
a company's EVA—NOPAT, the amount of capital invested, and the
WACC. NOPAT can be calculated manually but is normally listed in a
public company's financials.

Capital invested is the amount of money used to fund a company or a

specific project. WACC is the average rate of return a company expects
to pay its investors; the weights are derived as a fraction of each
financial source in a company's capital structure. WACC can also be
calculated but is normally provided.
KEY TAKEAWAYS
Economic value added (EVA), also known as economic profit, aims to
calculate the true economic profit of a company.EVA is used to
measure the value a company generates from funds invested in it.
However, EVA relies heavily on invested capital and is best used for
Asset-rich companies.

Understanding Economic Value Added (EVA)

EVA is the incremental difference in the rate of return (RoR) over a
company's cost of capital. Essentially, it is used to measure the value
a company generates from funds invested in it. If a company's EVA is
negative, it means the company is not generating value from the funds
invested into the business. Conversely, a positive EVA shows a
company is producing value from the funds invested in it.

What are Disclosures Guidelines

1. Disclosure, in financial terms, basically refers to the action of

making all relevant information about a business available to the
public in a timely fashion.
2. Relevant information about a business refers to any and every
piece of information, including facts, figures, dates, procedures,
innovations, and so on, that can potentially influence an
investor’s decision.
3. The disclosure requirements are strictly regulated by the
Securities and Exchange regulation bodies of each country for all
businesses listed on the respective national stock exchanges.

In India SEBI regulations require the disclosure of all relevant financial

information by publicly-listed companies. In addition to financial data,
companies are required to reveal their analysis of their strengths,
weaknesses, opportunities, and threats.

What Does “Relevant Information” Mean?

Relevant information about a business refers to any and every piece
of information, including facts, figures, dates, procedures,
innovations, and so on, that can potentially influence an investor’s
decision.
Any and every piece of information includes all relevant data, whether
advantageous or disadvantageous, positive or negative, fortunate or
unfortunate, that could affect the business and, in turn, its investors’
decisions.

How Disclosures Work

In the finance and investment world, disclosures are required to be
issued by businesses and corporations, disclosing all relevant
information that can potentially influence an investor’s decision. It
helps investors make informed decisions and choose stocks or bonds
that may suit their investment needs and investment portfolio.

Such information disclosures are issued via a disclosure statement,

containing all relevant information about the corporation, positive or
negative. The disclosures are footnotes at the end of a research
report, which provides vital information that one may want to
consider while making investment decisions.

Investment research analysts and strategists also issue disclosure

statements in research reports they publish.

Importance of Disclosures
The importance of full disclosure in the corporate and financial world
is essential. It is because:

1. Ensures transparency
Increased transparency in the corporations’ operations and
management makes it easier for investors to make informed
decisions. It also cuts down on the possibility of manipulation or
misuse of investors’ funds.
2. Avoids financial and economic crises
Severe financial and economic crises can be avoided with increased
transparency. The 2008 Global Financial Crisis is an excellent example
of a financial/economic crisis that was largely, if not entirely, the
product of the lack of transparency and accountability in the market.
It led to the mishandling of investors’ funds by corporations and
financial organizations.

3. Eliminates insider trading and window dressing

Full disclosure prevents agents with “inside information” in the
market from misusing it for personal gain and profit. It also prevents
the chance of window dressing and manipulation of accounts, thereby
further increasing transparency in the market.

What Is Insider Trading?

Under Section 2e of Companies Act: An insider is a person who
possesses either access to valuable non-public information about a
corporation or ownership of stock equalling more than 10% of a firm's
equity. This makes a company's directors and high-level executives’
insiders.

4. Allows investors to make informed decisions

Full disclosure of relevant information by businesses helps investors
make informed decisions. It decreases the sentiment of mistrust and
speculation and increases investor confidence as they feel fully
prepared to make investment decisions with transparency in
information at hand.

5. Reduces uncertainty in the market

Full disclosure also reduces uncertainty to a great extent in the
market. Uncertainty is one of the most prominent reasons for market
volatility. When there is full disclosure by businesses in the market,
there is an increased level of overall certainty in the market, thereby
decreasing volatility levels and bringing in stability, to some extent, in
the market.

Limitations with Disclosures

There are some limitations associated with company disclosures. One
of the limitations relates to financial Language or jargon.
Disclosures generally contain verbose information full of financial and
legal jargon, which investors usually find not easy to read. The
language used is complicated and difficult to decipher, making it
extremely complicated for investors not belonging to the field to make
sound investment decisions. Also, it’s very lengthy.

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