MODULE D

CAPITAL ADEQUACY AND PROFIT PLANNING.

A PRESENTATION BY

K.ESWAR MBA (XLRI) CAIIBASST. GENERAL MANAGER.31.10.09

The BIS Mission Statement: The BIS

Aims at promoting monetary and financial stabilityActs as a forum for discussion and cooperation among central banks and the financial communityActs as a bank to central banks and international organisations

Corporate User - Use the exact formulation on the BIS webside

What is the Basel Committee?Established at the end of 1974 by Central Bank Governors of G10 to address cross-border banking issuesReports to G10 Governors/Heads of SupervisionMembers are senior bank supervisors from G10, Luxembourg and SpainWork undertaken through several working groups

Belgium, Canada, France, Germany, Italy, Japan, Luxemburg, Netherlands, Spain, Sweden, Switzerland, UK and USA

From Basel I to Basel II

Basel I :1988 Capital Accord established minimum capital requirements for banks

Risk Weights were straight jacket nature or One size fits approach Eg Sovereigns were given 0% Risk weight, Banks 20% and corporate 100%.Lacked in its objectives to strengthen the soundness and stability of Banks.

CapitalRisk weighted assets

8 %Minimum ratio:

BASEL IIIn 1998, Committee started revising the 1988 Accord: International Convergence of capital measurement and capital standards:More risk sensitive More consistent with current best practice in banks risk managementNumerator (definition of capital) remains unchanged.Basel II provides Banks incentives to Banks invest and increase sophistication of their internal risk management capabilities to gain reduction in capital.Greater Disclosure by Banks.Follow certain standards of market discipline.

What are the basic aims of Basel II?To deliver a prudent amount of capital in relation to risk To provide the right incentives for sound risk managementTo maintain a reasonable level playing field

Basel II is not intended to be neutral between different banks/different exposuresHowever, there is a desire not to change the overall amount of capital in the system

Three pillars of the Basel II framework Credit risk Operational risk Market risk Evaluate Risk Assessment.Banks own capital strategy. Supervisors review.Ensure soundness and integrity of banks internal processes to assess the adequacy of capital.Ensure maintenance of minimum capital Prescribe differential capital where internal controls are slack.

Enhanced disclosureCore disclosures and supplementary disclosures. Minimum Capital RequirementsSupervisory Review ProcessMarket Discipline

The three pillars

All three pillars together are intended to achieve a level of capital commensurate with a banks overall risk profile.

Tier I capital and Tier II capital.Core and supplementary capital. Limits on components of capital.

MarketCredit

Operational

BANKS TYPICALLY FACE THREE KINDS OF RISKRisk of loss due to unexpected re-pricing of assets owned by the bank, caused by eitherExchange rate fluctuationInterest rate fluctuationsMarket price of investment fluctuations

Risk of loss due to unexpected borrower default

Risk of loss due to a sudden reduction in operational margins, caused by either internal or external factorsDaily price change (%)Unexpected price volatilityTimeTimeDefault rate (%)Unexpected defaultAvg. defaultTimeMonthly change of revenue to cost (%)Unexpected low cost utilizationExampleStocksLoans with credit rating 3Business unit AType of Risk

Pillar I Credit RiskStandardized ApproachFoundation Internal Ratings Based ApproachAdvanced Internal Ratings BasedApproach Risk weights are based on assessment by external credit assessment institutionsBanks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classesPillar 1 Credit Risk stipulates three levels of increasing sophistication. The more sophisticated approaches allow a bank to use its internal models to calculate its regulatory capital. Banks who move up the ladder are rewarded by a reduced capital charge Increase SophisticationReduce Capital requirements

Pillar I Operational RiskBasic Indicator ApproachStandardized approachAdvanced Measurement Approach..Increase SophisticationReduce Capital requirements

Pillar I Market RiskStandardized Duration Method.Internal Models Method(VaR based approaches)Increase SophisticationReduce Capital requirements

Advantages of capitalProvides safety and soundness Depositor protectionLimits leveragingCushion against unexpected lossesBrings in discipline in risk taking

Framework

Claims on corporates

Credit assessment by domestic rating agenciesAAAAAABBB and belowUnratedRisk weight20%50%100%150%100%

Claims on Banks is 20% but for following.

CRAR of respective Bank if less than 9%6 % to

Mapping process draft guidelines

Short term ratingsRisk weightsCARECRISILFITCHICRAPR1+P1+F1+A1+20%PR1P1F1A130%PR2P2F2A250%PR3P3F3A3100%PR4/PR5P4/P5B/C/DAR/A5150%UNRATEDUNRATEDUNRATEDUNRATED100%

Mapping Long term ratings.AAA 20%AA 30%A 50%BBB 100%BB AND BELOW: 150%UNRATED 100%+- SIGN CORROSPONDING MAIN RATING WILL BE USED.

Retail Portfolio - Criteria Orientation criterion - exposure to individual person or persons or to a small business.

Product criterion - revolving credit, line of credit, personal term loan and lease small business facilities and commitments. Granularity criterion- regulatory retail portfolio is sufficiently diversified to a degree that reduces the risk in the portfolio no aggregate exposure to one counterpart can exceed 0.2% of the overall regulatory retail portfolio Low value of individual exposures- the maximum aggregate retail exposure to one counterpart cannot exceed an absolute threshold of euro 1 million.( Rs. 5 Crores for our Bank)Turnover Rs.50 Crores.(AVERAGE FOR LAST 3 YEARS)

Exclusion in Regulatory Retail.

Mortgage loans to the extent they qualify for treatment as claims secured by residential property: Margin 25% : RW upto Rs.30 lakhs :50% and Rs.30 lakh and above 75% Margin less than 25% RW 100%Consumer credit, credit card exposure etc. RW125%Capital market exposure and NBFCs RW125%Commercial Real Estate : RW 150%Staff loans: 20% if covered by superannuation funds or mortgage.Other staff loans : 75% RW

Past Dues ( NPAs)Past due loansThe unsecured portion of any loan that is past due for more than 90 days, net of specific provisions, to be given higher risk weight150% if specific provision or= 20%if provision = or > 50% with supervisory discretion for 50% weight100% if provision > or = 15% if fully secured

Credit Risk MitigationSimple & comprehensive approachesLegal certainty, robust recovery proceduresEffects of CRM not to be double countedShould not result in increasing other risksHaircuts to be used in the comprehensive approach

Eligible financial collateralCash EQUIVALENT, CDs, Counter party deposit with lending Bank.Gold bullion & jewellery (99.99 purity)Central & State Govt. securitiesIVP, KVP, NSC, LIC policyDebt securities rated by recognised credit rating agencyPSEs at least BBOther entities at least AST debt instruments at least P2+/A3/PL3/F3EquitiesMutual Fund units daily NAV to be available on public domain

Internal Ratings Based ApproachInternal ratings based (IRB) approachFoundationAdvanced Goal: Should contain incentives for migration from standardized to IRB approach

.

IRB approachRisk components PD, LGD, EAD,

Retail PD, LGD & EAD given by banks

Differentiation between IRB Advanced & Foundation.Only PD from Bank in IRB foundation.In advanced approach Banks provide their own PD, LGD, EAD.

General Market Capital chargeCaptures risk of loss arising from general changes in market interest rates / other market variables

Two Approaches

Standardized Duration approach.Internal risk management models

RBI adopted Standardized approach.Specific charge is similar to credit risk.

Market Risk Internal Models

BIS requirement:VaR to be calculated dailyConfidence level of 99%Holding period 10 daysHistorical data for at least one year to be taken and updated at least once in a quarter .

Operational RiskExplicit charge on capitalBasic Indicator approach 15% of gross income Gross income = net interest income plus net non interest income.Gross of any provisions.Gross of operating expenses.Exclude realized profits/losses from sales investments from Banking book.

GROSS INCOMEGROSS INCOME = NET PFORIT+ PROVISIONS+OPERATING EXPENSES-PROFIT ON SALE OF INVSTEMENT-INCOME FROM INSURANCE-EXTRA ORDINARY ITEM OF INCOME+ LOSS ON SALE OF INVESTMENT

Operational RiskStandardised Approach-Capital charge is calculated as a simple summation of capital charges across 8 business lines

Business lines% of gross incomeCorporate finance18Trading & sales18Retail Banking12Commercial Banking15Payment & Settlement18Agency Services15Asset Management12Retail Brokerage12

General Standards to qualify for sophisticated approachesActive involvement of Board and senior management in oversight of ORM framework.Sound RM system implemented with integrity.Sufficient resources and skill level for use of the approach. Subject to initial monitoring by supervisor.

Supervisory review.Supervisors need to concentrate on riskNot addressed under pillar I Viz Concentration risk.Factors not addressed in pillar 1 such strategic risk or interest rate risk in Banking book.Factors external to Bank viz Business cycles.

Supervisory ReviewPrinciple I : Board and senior management overview on assessing their capital in relation to risk profile and strategy.Principle II: Supervisory review of Banks internal capital adequacy systems. On site /off site/discussions etc.Principal III: Operate above minimum regulatory capital ratios.Principal IV: Supervisors to intervene at early stage.

MARKET DISCIPLINEThird Pillar to supplement first two pillars namely minimum capital requirement and supervisory review.The aim of this pillar is o encourage market discipline by developing a set of disclosure requirements which allows market participants to assess :Scope of applicationCapitalRisk ExposuresRisk assessment processesUltimately Capital Adequacy

Such disclosures with common framework provides enhanced comparability.Achieving Appropriate DisclosureMarket Discipline contributes to safe and sound banking.Non-disclosure attracts penalty including a financial penalty.No direct penalty of additional capital for non-disclosure but indirectly by way of lower risk weight under pillar-1 provided certain disclosures are made etc.

Interaction with accounting disclosures :Disclosure framework not to conflict with requirements under accounting standards.Scope and frequency of disclosuresAll banks should provide Pillar-III disclosures both qualitative and quantitative as on March end each year along with annual financial statements.Banks with capital funds of more than Rs.500 crores and their significant subsidiaries must disclosure on quarterly basis.- Tier 1 Capital- Total Capital- Total required capital- Total Capital adequacy ratios

QUESTIONS ON NPA NORMS AND PROVISIONSIncome from non performing assets is recognized on:Accrual basis.When debited to accountWhen actually received.All of above.Income from advance against Term Deposit, NSC, IVP, KVP and LIC Pol may be taken to income provided:Adequate margin is available.Cannot be taken to income if not received actually.In all cases it can be taken to incomeAll of above.If Govt guaranteed advance becomes NPA then the interest on such advances Can be taken to income.Can be taken only when interest has been realized.All of above.None of above.If any advance including bill purchased and discounted becomes NPA as at the end of any quarter/half year/year, interest accrued and credited to income account in the previous periods if not realized:Need not be reversed.To be reversed.None of above.Both of the above.

QUESTIONS ON NPA NORMS AND PROVISIONSInterest realized in NPA may be taken to income provided the credits towards the interest are realized not from fresh or addl facilities.TrueFalse.Recovery in NPA account should be first appropriated towardsInterestPrincipalIn equal proportion.None of above.Availability of security/networth of borrowers or guarantorShould be taken into consideration for treating account as NPAShould not be taken into consideration doNone of above.Both are true.A non performing loan shall be a loan or advance:Interest or instalment overdue for more than 90 days.Accont remains out of order for 90 days in CC ODBill remain over due for more than 90 days for bill purchased or discounted.All of above are true.In case of agricultural loan it will be treated as NPA if a. Installments of principal or interest over due for two crop season if loan is granted for short duration crops.b. Installment or interest over for one crop season if loan is for long duration crop.c. Both are true.d. Both are wrong.

QUESTIONS ON NPA NORMS AND PROVISIONSIn case when bank charges interest monthly, the date of classification of NPA in case of non service of interest will be a. 90 days after date of charging monthly interest.b. 90 days after the end of quarter in which interest was charged.c. none of above.d. both are correct.In CC account when outstanding balance remains within limit/DP:Account can become NPA if no credit for 90 days.If credits are not enough to cover the interest debited during the same period.Only b is correct.Both are correct.Sub standard asset is asset which Remained as NPA for period less than or equal to 12 months.Remained overdue for more than 12 months.None of above.Doubtful asset is asset which :Remained as sub standard asset for more than 12 moths.Remained as over for 3 years.Remained over due for 4 years.None of above.Loss asset is an asset whichConsidered un collectable and its continuance as bankable asset is not warranted even if some salvage value or recovery value.Over due for 5 years.Over due for 10 years.None of above.

QUESTIONS ON NPA NORMS AND PROVISIONS

A CC account of borrower is out of order for 90 days. IN his Term Loan installment and interest regularly served:Only CC account is is NPABoth CC and TL is NPANone of accounts are NPADepends on security and NW of borrower'sA OD account of borrower is NPA. Investment made in debenture of same company and interest is serviced regulr.:Need not be classified as NPANeed to be classified as NPA.Depends on servicing of interest on debenture.None of above.OD account XYZ Ltd a partnership is NPA . One of partner is having a sole proprietorship account with same bank and availing CC account and this account is in order:This account will also be NPAThis account will not be NPADepends on out of order position.Depdend on security.TL account of ABC Ltd is NPA . It is partnership concern. One of partners A is having a CC account which is in order:This account will also be NPAThis account will not be NPA.Depends on account status.Depends on security and NWTL account granted to X partner is NPA. CC account of partnership where X is partner even if it is not out order Will be NPAWill not be NPADepends on account status.Depends on NW.

QUESTIONS ON NPA NORMS AND PROVISIONS

In account XYZ Ltd borrower committed fraud. But interest and instalment recovered regularly:Account should be classified as DA or Loss account.Account can continue as Standard.Account will be SSA.None of above.Erosion in security value to 50% or more and it was sanctioned just 3 months back:Classify account as SAClassify account as SSAClassify account as DAClassify account as LAErosion in security value leaving value at 10% or less.Classify account as SAClassify account as SSAClassify account as DAClassify account as LAIn a CC account the stock statement is not submitted for last 3 months and DP is allowed against old stock statement:Account will be NPA now.Account will be NPA if drawings are permitted in such account for 90 days based on such old stock statement.None of above.Both are true.A CC account no reviewed by branch due date:It will be NPA on due date.It will be NPA if not renewed in 180 days from due date.If will be NPA if not renewed in 90 days from due date.None .

QUESTIONS ON NPA NORMS AND PROVISIONSX Co. is consortium account. No credits came to account for last 90 days. But party remitted the money to consortium leader SBI in time.Account will be NPA treating as non served in the b ooks of this Bank.Account will be PA as money received by SBI leader of consortium.None of above.Both of above.FCI given loan by your Bank against Govt Guarantee. Loan is over due for more than 90 days.:Will be treated as NPA.Will be treated as NPA only if guaranteed is invoked and guarantee is not honoured.Both are true.None are true.Interest on above loan to FCI can be taken to incomeNo as such exemption is not for recognition of income.Yes can be taken to income.NoneState Govt guaranteed loans and investment in State Govt guaranteed bonds will Attract loan provisions and asset classification if over due for 90 days.Only loan provisioning required.Only asset classification required.No need to classify as NPA.In a account 6 months moratorium is given.Account will become NPA only if moratorium is over.It will attract NPA provisions even before moratorium for interest servicing.None of above.Provision on standard assets:.25%.25% for SME and agricultural advances and .40% for others..40 for allNone of above.

QUESTIONS ON NPA NORMS AND PROVISIONSProvisions on fully secured SSA10%20%30%40%Provision on SSA where abninitio bank has sanctioned with security less than 10%20%30%40%15%Provisions on DA secured upto one year 20%30%50%100%Provision on DA secured upto 3 years30%20%50%100%Provisions on DA secured. more than 3 years.100%50%150%10%Provision on DA unsecured irrespective of age.100%10%50%70%

Profit Planning.Profitability for Banks depends on six factors:Interest IncomeFee Based Income.Trading Income.Interest expenses.Staff expense.Other operating expense.

Profit Planning.Basel committee norms have brought in standardization in the norms for capital adequacy and provided benchmarks.Hence Banks have to optimum mix of assets and liabilities , keep balance of capital requirement and optimize profits.

Thank You!

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