caiib risk manage mod cd

7/28/2019 Caiib Risk Manage Mod CD

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INDIAN INSTITUTE OFBANKING & FINANCE

RISK MANAGEMENT

MODULE C & D

ByM.Ravindran

[email protected]


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Syllabus

Module C: Treasury Management:Treasury management; concepts and functions; instruments in the

treasury market; development of new financial products; control

and supervision of Treasury management; linkage of domestic

operations with foreign operations.

Asset-liability management; Interest rate risk; interest rate futures;

stock options; debt instruments; bond portfolio strategy; risk

control and hedging instruments.

InvestmentsTreasury bills Money markets instruments such

as CDs, CPs, IBPs; Securitisation and Forfaiting; Refinance andrediscounting facilities.


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Syllabus

Module D

Capital Management and Profit Planning

Prudential Norms- Capital Adequacy-Basel II-

Asset Classification-provisioning

Profit and Profitability-Historical Perspective ofthe Approach of Banks to profitability-Effects of

NPA on profitability-A profitability Model-Shareholders value Maximization & EVA-ProfitPlanning-Measures to improve profitability


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FRONT OFFICE

BACK OFFICEMID OFFICE

Dealing

MIS

settlement


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Treasury


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Money Market

Certificate of Deposit (CD)

Commercial Paper (C.P)

Inter Bank Participation Certificates Inter Bank term Money

Treasury Bills

Call Money


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Certificate of Deposit

CDs are short-term borrowings in the form ofUsance Promissory Notes having a maturity ofnot less than 7 days up to a maximum of one

year. CD is subject to payment of Stamp Duty under

Indian Stamp Act, 1899 (Central Act)

They are like bank term deposits accounts.Unlike traditional time deposits these are freelynegotiable instruments and are often referred toas Negotiable Certificate of Deposits


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Features of CD

Issued by all scheduled commercial banksexcept RRBs

Minimum period 7 days

Maximum period 1 year

Minimum Amount Rs 1 lac and in multiples ofRs. 1 lac

CDs are transferable by endorsement CRR & SLR are to be maintained

CDs are to be stamped


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Commercial Paper

Commercial Paper (CP) is an unsecuredmoney market instrument issued in theform of a promissory note.

Who can issue Commercial Paper (CP)Highly rated corporate borrowers, primarydealers (PDs) and all-India financial

institutions (FIs)


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Eligibility for issue of CP

a) the tangible net worth of the company, as per thelatest audited balance sheet, is not less than Rs. 4

crore;b) the working capital (fund-based) limit of the

company has been sanctioned by banks

c) borrowal account of the company is classified as a

Standard Asset by the financing bank/s.


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Rating Requirement

All eligible participants should obtain the creditrating for issuance of Commercial Paper

Credit Rating Information Services of India Ltd.(CRISIL)

Investment Information and Credit RatingAgency of India Ltd. (ICRA)

Credit Analysis and Research Ltd. (CARE) Fitch Ratings Duff & Phelps Credit Rating India Pvt. Ltd. (DCR

India) The minimum credit rating shall be P-2 of

CRISIL or such equivalent rating by other

agencies


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Features

CP can be issued for maturities between aminimum of 7 days and a maximum uptoone year from the date of issue.

Minimum issue price Rs. 5 lakhs and inmultiples of Rs. 5 lakhs

Issued in demat form only


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To whom issued

CP is issued to

individuals,

banking companies, other corporate bodies registered or

incorporated in India and unincorporated

bodies, Non-Resident Indians (NRIs)

Foreign Institutional Investors (FIIs).


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CP-Yield calculation

Yield = (Face value-Price)*365*100

--------------------------------

Price *No of days to maturity

Face value 5 lakhs price 4,92,711 for 90 days

Find out yield

500000-492711*365*100---------------------------------= 6%

492711*90


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Calculation of price-CP

PRICE= Face Value

-------------

( 1+Yield *No of days

-----------------------365*100)

Face Value Rs.500000 for 90 days at 6%

500000------------

1(6*90/365*100) = Rs 492711


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Meaning of Repo

It is a transaction in which two parties agree tosell and repurchase the same securitya t amutually decided future date and a price

The Repo/Reverse Repo transaction can only bedone at Mumbai between parties approved byRBI and in securities as approved by RBI(Treasury Bills, Central/State Govt securities).


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Repo

Uses of RepoIt helps banks to invest surplus cashIt helps banks to raise funds at better rates

An SLR surplus and CRR deficit bank can use theRepo deals as a convenient way of adjustingSLR/CRR positions simultaneously.RBI uses Repo and Reverse repo as instruments

for liquidity adjustment in the system


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Coupon rate and Yield

The difference between coupon rate andyield arises because the market price of asecurity might be different from the face

value of the security.

Since coupon payments are calculated onthe face value, the coupon rate is different

from the yield.


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Example

10% Aug 2015 10 year Govt Bond

Face Value RS.1000

Market Value Rs.1200 In this case Coupon rate is 10%

Yield is 8.33% = 1200*10

---------------1000


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Call Money

The money that is lent for one day isknown as "Call Money",

If it exceeds one day (but less than 15 days)it is referred to as "Notice Money".


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Call Money Market

Banks borrow in this market for thefollowing purpose

To fill the gaps or temporary mismatches

in funds To meet the CRR & SLR mandatory

requirements as stipulated by the Central

bank To meet sudden demand for funds arising

out of large outflows.


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Factors influencing interest rates

The factors which govern the interest rates aremostly economy related and are commonlyreferred to as macroeconomic factors. Some ofthese factors are:

1) Demand for money2) Government borrowings3) Supply of money4) Inflation rate

5) The Reserve Bank of India and the Governmentpolicies which determine some of the variablesmentioned above.


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Gilt edged securities

The term government securities encompass allBonds & T-bills issued by the Central

Government, and state governments. Thesesecurities are normally referred to, as "gilt-edged" as repayments of principal as well asinterest are totally secured by sovereign

guarantee.


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Treasury Bills

Treasury bills, commonly referred to as T-Billsare issued by Government of India against theirshort term borrowing requirements with

maturities ranging between 14 to 364 days.All these are issued at a discount-to-face value.For example a Treasury bill of Rs. 100.00 facevalue issued for Rs. 91.50 gets redeemed at the

end of it's tenure at Rs. 100.00.


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Who can invest in T-Bill

Banks, Primary Dealers, StateGovernments, Provident Funds, FinancialInstitutions, Insurance Companies, NBFCs,FIIs (as per prescribed norms), NRIs &OCBs can invest in T-Bills.


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What is auction of Securities

Auction is a process of calling of bids withan objective of arriving at the market price.It is basically a price discovery mechanism


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Debenture

A Debenture is a debt security issued by acompany (called the Issuer), which offersto pay interest in lieu of the money

borrowed for a certain period. These are long-term debt instruments

issued by private sector companies. Theseare issued in denominations as low as Rs1000 and have maturities rangingbetween one and ten years.


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Difference between debenture andbond

Long-term debt securities issued by theGovernment of India or any of the StateGovernments or undertakings owned by

them or by development financialinstitutions are called as bonds.Instruments issued by other entities are

called debentures.


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Current yield

It is calculated by dividing the coupon rateby the purchase price of the bond .

For e. g: If an investor buys a 10% Rs 100debenture of ABC company at Rs 90, hiscurrent Yield on the instrument would becomputed as:Current Yield = (10%*100)/90 X 100 ,That is 11.11% p.a.


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Primary Dealers

Primary Dealers can be referred to as MerchantBankers to Government of India, comprising the

first tier of the government securities market.These were formed during the year 1994-96 tostrengthen the market infrastructure

What role do Primary Dealers


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What role do Primary Dealersplay?

The role of Primary Dealers is to;(i) commit participation as Principals inGovernment of India issues through

bidding in auctions(ii) provide underwriting services(iii) offer firm buy - sell / bid ask quotes

for T-Bills & dated securities(v) Development of Secondary DebtMarket


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OMO

OMO or Open Market Operations is amarket regulating mechanism oftenresorted to by Reserve Bank of India.

Under OMO Operations Reserve Bank ofIndia as a market regulator keeps buyingor/and selling securities through it's openmarket window. It's decision to sell or/and

buy securities is influenced by factors suchas overall liquidity in the system etc


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YIELD CURVE

The relationship between time and yieldon a homogenous risk class of securities is

called the Yield Curve. The relationshiprepresents the time value of money -showing that people would demand apositive rate of return on the money theyare willing to part today for a payback intothe future


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SHAPE OF YIELD CURVEA yield curve can be positive, neutral or flat.

A positive yield curve, which is most natural, is when theslope of the curve is positive, i.e. the yield at the longer end ishigher than that at the shorter end of the time axis. This results,as people demand higher compensation for parting their

money for a longer time into the future.A neutral yield curve is that which has a zero slope, i.e. is flatacross time. T his occurs when people are willing to acceptmore or less the same returns across maturities.

The negative yield curve (also called an inverted yield curve)is one of which the slope is negative, i.e. the long term yield islower than the short term yield


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Shape of Yield curve


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LIBOR

LIBOR stands for the London Interbank OfferedRate and is the rate of interest at which banksborrow funds from other banks, in marketablesize, in the London interbank market.

LIBOR is the most widely used "benchmark" orreference rate for short term interest rates. It is

compiled by the British Bankers Association as afree service and released to the market at about11.00[London time] each day.


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Calculation of Duration

Face Value Rs.100

Tenor 7 years Coupon 7%

Market Interest rate 8%

Answer:543.0642/94.7941= 5.72888 yrs

Calculation of Duration


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Calculation of DurationAnswer:543.0642/94.7941= 5.72888

Sl No Coupon Dis.Factor

At 8%

PV OFcOUPON Weightinyrs

PV*Wt

1 7 .9259 6.4813 1 6.4813

2 7 .8573 6.0011 2 12.0022

3 7 .7938 5.5566 3 16.6698

4 7 .7350 5.1450 4 20.5800

5 7 .6806 4.7642 5 23.8210

6 7 .6302 4.4114 6 26.4684

7 7 .5835 62.4345 7 437.0415


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CRR & SLR

The minimum and maximum levels of CRR areprescribed at 3% and 20% of demand and termliabilities (DTL) of the bank, respectively, under

Reserve Bank of India Act of 1934.The minimum and maximum SLR are prescribedat 25% and 40% of DTL respectively, underBanking Regulation Act of 1949.

The CRR and SLR are to be maintained onfortnightly basis.


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Demand and Time Liabilities

Main components of DTL are:

Demand deposits (held in current and savingsaccounts, margin money for LCs, overdue fixeddeposits etc.)

Time deposits (in fixed deposits, recurring deposits,reinvestment deposits etc.)

Overseas borrowings

Foreign outward remittances in transit (FC liabilitiesnet of FC assets)

Other demand and time liabilities (accrued interest,credit balances in suspense account etc. )


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SLR

SLR is to be maintained in the form of thefollowing assets:

Cash balances (excluding balancesmaintained for CRR)

Gold (valued at price not exceedingcurrent market price)

Approved securities valued as per normsprescribed by RBI.


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VaR

Value at Risk (VaR) is the most probable lossthat we may incur in normal market conditionsover a given period due to the volatility of afactor, exchange rates, interest rates or

commodity prices. The probability of loss isexpressed as a percentage VaR at 95%confidence level, implies a 5% probability ofincurring the loss; at 99% confidence level the

VaR implies 1% probability of the stated loss.The loss is generally stated in absolute amountsfor a given transaction value (or value of ainvestment portfolio).


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VaR

The VaR is an estimate of potential loss, always for a givenperiod, at a given confidence level.. A VaR of 5p in USD /INR rate for a 30- day period at 95% confidence levelmeans that Rupee is likely to lose 5p in exchange valuewith 5% probability, or in other words, Rupee is likely todepreciate by maximum 5p on 1.5 days of the period(30*5% ) . A VaR of Rs. 100,000 at 99% confidence levelfor one week for a investment portfolio of Rs. 10,000,000similarly means that the market value of the portfolio is

most likely to drop by maximum Rs. 100,000 with 1%probability over one week, or , 99% of the time theportfolio will stand at or above its current value.


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Exchange Rate Quotation

Exchange Quotations :

There are two methods

Exchange rate is expressed as the price per unit offoreign currency in terms of the home currency is known

as theHome currency quotation or Direct Quotation Exchange rate is expressed as the price per unit of home

currency in terms of the foreign currency is known astheForeign Currency Quotation or Indirect Quotation

Direct Quotation is used in New York and other foreignexchange markets and Indirect Quotation is used inLondon foreign exchange market.


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Principles

Direct Quotation: Buy Low, Sell High:

1USD= Rs.42.60 42.65

Indirect Quotation: Buy High, SellLow:

Rs.100 = USD 2.5600 2.5650


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Spot and Forward Transactions

A Bank agrees to buy from B Bank USD100000. The actual exchange ofcurrencies i.e. payment of rupees andreceipt of US Dollars, under the contractmay take place :

on the same day or

two days later or

some day later, say after a month.


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TT Buying Rate

TT Buying Rate (TT stands for TelegraphicTransfer)

This is the rate applied when the transaction

does not involve any delay in realization of theforeign exchange by the bank. In otherwords, the nostro account of the bank wouldalready have been credited. The rate is

calculated by deducting from the inter-bankbuying rate the exchange margin asdetermined by the Bank.

Bill B i R


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Bills Buying Rate

This is the rate to be applied when aforeign bill is purchased. When a bill ispurchased, the proceeds will be realized

by the Bank after the bill is presented tothe drawee at the overseas center. In thecase of a usance bill the proceeds will be

realized on the due date of the bill whichincludes the transit period and the usanceperiod of the bill.


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Problem

You would like to import machinery from USAworth USD 100000

to be payable to the overseas supplier on 31st Oct

[a] Spot Rate USD = Rs.45.8500/8600

Forward PremiumSeptember 0.2950/3000

October 0.5400/5450

November 0.7600/7650

[b] exchange margin 0.125%[c] Last two digits in multiples of nearest 25 paise

Calculate the rate to be quoted by the bank ?


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Solution

This is an example Forward Sale Contract .Inter Bank Spot Selling Rate Rs. 45.8600

Add Forward Margin .5450

--------------

46.4050

Add Exchange Margin .0580

---------------

Forward Rate 46.4630Rounded Off to multiple of 25 paise Rs.46.4625

Amount Payable to the bank Rs.46,46,250


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Swap

A swap agreement between two partiescommits each counterparty to exchangean amount of funds, determined by a

formula, at regular intervals, until theswap expires.

In the case of a currency swap, there is an

initial exchange of currency and a reverseexchange at maturity.


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Mechanics

Firm A needs fixed rate loan AAA rated

Firm B needs floating rate -A rated

Firm A enjoys an absolute advantageinboth credit markets.

11%9%

LIBOR+0.0%

LIBOR

+1%

Firm A Firm B

Fixed-rate

finance

Floating-rate

finance


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Mechanics

STEP !

Firm A will borrow at Fixed rate 9%

Firm B will borrow at floating rate (LIBOR +1)%

STEP 2Firm A will pay Floating rate [LIBOR] to Firm B

Firm B will Pay Fixed rate [9.5%] only

GainNet interest cost LIBOR- .5%

Net Interest cost 9+[ 1%+0.5%]=10.5%


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Mechanics

Gain

A B

Borrows at9.0%fixed

for 7 years

Borrows atLIBOR + 1%

floatingfor 7 years

9.5%

LIBOR

Interest payments to eachother in years t1 to t7.


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Basel I to Basel II

Minimum capital requirements

3 Pillars

New credit risk approaches

Market risk - unchanged

Add operational risk portion


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The Basel II Framework

Pillar 1:

Minimum capital

requirements

Pillar 2:Supervisory

review

Pillar 3:Market

discipline

A guiding

principle

for bankingsupervision

Credit Risk

Market Risk

Operational Risk

Disclosure

requirements

Pillar 1: Minimum Capital


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Pillar 1: Minimum CapitalRequirements

The calculation of regulatory minimumcapital requirements:

%8assetsweighted-riskTotal

capitalofamountthe


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The Capital and Assets

Definition of capital:

Tier 1 capital + Tier 2 capital +adjustments

Total risk-weighted assets are determinedby:

multiplying the capital requirements formarket risk and operational risk by 12.5

and adding the resulting figures to thesum of risk-weighted assets for credit risk.


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Credit Risk

Standardised Approach

Foundation IRB Approach

Advanced IRB Approach

Credit Risk


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Credit Risk -Standardised Approach

In determining the risk weights in thestandardised approach, banks may useassessments by external credit

assessment institutions.

AssetsofValusBookAssetsfortRisk Weigh


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Risk Weight for Assets

Credit

Assessment

Claims on sovereigns Claims on banks and securities firms

Claims on

corporatesECA risk

scores

Risk

Weight

Credit

assessment of

Sovereign

Credit assessment of Banks

Risk weight

Risk weight

for short-

term

AAA to AA- 1 0% 20% 20% 20% 20%

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

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

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

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

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

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


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Credit Risk - IRB Approach

In the internal ratings-based(IRB)approach, its based on banks internalassessment.

The approach combines the quantitativeinputs provides by banks and formulaspecified by the Committee.


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Four quantitative inputs (risk components):

Probability of default (PD)

Loss given default (LGD)

Exposure at default (EAD)

Maturity (M)

Use formula of the Committee to calculatethe minimum requirements.


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Data Input Foundation IRB Advanced IRB

Probability of default

(PD)

From banks From banks

Loss given default

(LGD)Set by the Committee

From banks

Exposure at default

(EAD)Set by the Committee

From banks

Maturity (M) Set by the Committee or

from banks

From banks


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Market Risk

Standardised method

- the standards of the Committee

Internal models

- use banks internal assessments

- Value at Risk (VaR)


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Operational Risk

The risk of losses results from inadequateor failed internal processes, people andsystem, or external events.

Basic Indicator Approach

Standardised Approach

Advanced Measurement Approaches(AMA)

Operational Risk -


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Operational Risk -Basic Indicator Approach

GI = average annual gross income(threeyears, excepted the negative amounts)

= 15%

GIKBIA

Operational Risk -


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Operational Risk -Standardised Approach

GI 1-8 = average annual gross incomefrom business line from one to eight(three years, excepted the negative

amounts) = A fixed percentage set by the

Committee

81GIKTSA


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Beta of Business Lines

Business Lines Beta Factors

Corporate finance (1) 18%

Trading and sales (2) 18%

Retail banking (3) 12%

Commercial banking (4) 15%

Payment and settlement (5) 18%

Agency services (6) 15%

Asset management (7) 12%

Retail brokerage (8) 12%

Operational Risk - Advanced


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Operational Risk AdvancedMeasurement Approaches

Under the AMA, the regulatory capitalrequirement will equal the risk measuregenerated by the banks internal

operational risk measurement systemusing the quantitative and qualitativecriteria for the AMA.

Use of the AMA is subject to supervisoryapproval.


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Pillar 2: Supervisory Review

Principle 1: Banks should have a processfor assessing and maintaining their overallcapital adequacy.

Principle 2: Supervisors should review andevaluate banks internal capital adequacy

assessments and strategies.


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Supervisory Review

Principle 3: Supervisors should expectbanks to operate above the minimumregulatory capital ratios.

Principle 4: Supervisors should interveneat an early stage to prevent capital fromfalling below the minimum levels.


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Pillar 3: Market Discipline

The purpose of pillar three is tocomplement the pillar one and pillar two.

Develop a set of disclosure requirements

to allow market participants to assessinformation about a banks risk profile and

level of capitalization.


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Minimum Capital Adequacy Ratios

Tier one capital to total risk weightedcredit exposures to be not less than 4 %;

Total capital (i.e. tier one plus tier two less

certain deductions) to total risk weightedcredit exposures to be not less than 8%


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Calculation of Capital

Tier One Capital

the ordinary share capital (or equity) ofthe bank; and

audited revenue reserves e.g.. retainedearnings; less

current year's losses;

future tax benefits; and

intangible assets, e.g. goodwill.

f


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Upper Tier Two Capital Un-audited retained earnings;

revaluation reserves;

general provisions for bad debts; perpetual cumulative preference shares (i.e.

preference shares with no maturity date whosedividends accrue for future payment even if the

bank's financial condition does not supportimmediate payment);

perpetual subordinated debt (i.e. debt with nomaturity date which ranks in priority behind all

creditors except shareholders).

l l f l


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Lower Tier Two Capital

Subordinated debt with a term of at least5 years;

Sedeemable preference shares which maynot be redeemed for at least 5 years.

i i


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Restrictions

Tier two capital may not exceed 100% oftier one capital;

Lower tier two capital may not exceed

50% of tier one capital;

Lower tier two capital is amortized on astraight line basis over the last five years

of its life.

T l C i l


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Total Capital

This is the sum of tier 1 and tier 2 capitalless the following deductions:

equity investments in subsidiaries;

shareholdings in other banks that exceed10 percent of that bank's capital;

unrealized revaluation losses on securities

holdings.


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Module D

Capital Management


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Capital Management&

Profit Planning

B l II


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Basel II

Tier I-Core CapitalPaid up capital ,Free Reserves and unallocated surpluses

Tier II-Supplementary Capital

Subordinated debt of more than 5 years maturity ,loanloss reserve, revaluation reserve,investmentfluctuation reserve,limited life preference share-restricted to 100% of tier I capital

Tier III Capitalsubordinated debt with shot term maturity [min 2 years]

for market risk

T t l Ri k i ht d A t


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Total Risk weighted Assets

Risk weighted assets of credit risk

plus

12.5* Capital requirement for market risk

plus

12.5* capital requirement for foroperational risk

Th ill


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Three pillars

First Pillar-minimum capital requirements

Second pillar-supervisory process

Third pillar-market discipline

C it l Ch f C dit Ri k


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Capital Charge for Credit Risk

Standardized Approach Internal rating basedapproach

[1]Foundation Approach

[2]Advanced IRBApproach

Credit rating of Risk weight for Risk weight for


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g

sovereign

g

sovereign

gbanks in thatcountry

AAA TO AA 0% 20%

A+ TO A 20% 50%

BBB+ TO BBB- 50% 100%

BB+ TO BB- 100% 100%

BELOW B- 150% 150%

Risk Weight


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Retail & SME

EXPOSURE75%

Mortgage onResidential

Property

35%

Past Due Loans 150% When specific

provisions areless than 20%of the loanamount

-do- 100% If provision ishigher than20%

Capital Charge for Operational


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p g pRisk

The Basic Indicator Approach

The Standardized Approach

Advanced Management Approach

Standardized Approachf


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forOperational Risk

Beta factor- a fixed percentage set by Baselcommittee

Maximum 18%

Minimum 12%

Banks activities are divided into 8 business lines-corporate finance,trading,retail banking,commercial banking, payment &settlement,agency services, asset management, retailbrokering

Asset Classification


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Asset Classification

Standard Assets

Sub Standard Assets

Doubtful Assts

Loss Assets

Provisioning


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Provisioning

Standard Assts 0.40%

Substandard-

Secured -provision 10%

Unsecured[realisable value is not morethan 10% of o/s]provision 20%

Provision


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Provision

Doubtful I- first 12 monthsProvision 20% realizable value of security plus

100% shortfall of security

Doubtful II-further 24 months

Provision 30% realizable value of security plus100% shortfall of security

Doubtful III-for over 36 months

100% provisionLoss Assets 100%

Thank you


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Thank you

With Best Wishes

[email protected]

caiib risk manage mod cd

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