MODULE D CAPITAL ADEQUACY AND PROFIT PLANNING.

A PRESENTATION BY

K.ESWAR MBA (XLRI) CAIIB ASST. GENERAL MANAGER.

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

From Basel I to Basel II

Basel I :1988 Capital Accord established minimum capital requirements for banks Capital Minimum ratio: 8% Risk weighted assets 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.

BASEL II In 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 management Numerator (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 management To maintain a reasonable level playing field Basel II is not intended to be neutral between different banks/different exposures However, there is a desire not to change the overall amount of capital in the system

Three pillars of the Basel II framework

Minimum Capital Requirements

Credit risk
Operational risk Market risk

Supervisory Review Process

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

Market Discipline
Enhanced disclosure
Core disclosures and supplementary disclosures.

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.

BANKS TYPICALLY FACE THREE KINDS OF RISK

Type of Risk

Example
Risk of loss due to unexpected repricing of assets owned by the bank, caused by either Exchange rate fluctuation Interest rate fluctuations Market price of investment fluctuations
Daily price change (%)

Stocks

Market

Unexpected price volatility

Time

Risk of loss due to unexpected borrower default

Default rate (%)

Loans with credit rating 3

Unexpected default Avg. default

Credit

Time

Operational

Risk of loss due to a sudden reduction in operational margins, caused by either internal or external factors

Monthly change of revenue to cost (%)

Business unit A

Unexpected low cost utilization

Time

Pillar I Credit Risk

Pillar 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
Advanced Internal Ratings Based Approach Foundation Internal Ratings Based Approach
Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes

Standardized Approach

Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.

Risk weights are based on assessment by external credit assessment institutions

Reduce Capital requirements

Pillar I Operational Risk

Advanced Measurement Approach. Standardized approach

Basic Indicator Approach

Reduce Capital requirements

Pillar I Market Risk

Internal Models Method (VaR based approaches)

Standardized Duration Method.

Reduce Capital requirements

Advantages of capital

Provides safety and soundness Depositor protection Limits leveraging Cushion against unexpected losses Brings in discipline in risk taking

Framework

Claims on corporates
Credit assessment by domestic rating agencies Risk weight AAA AA A BBB and below Unrate d

20%

50%

100%

150%

100%

Mapping process draft guidelines

Short term ratings CARE
PR1+ PR1

Risk weights
A1+ A1 20% 30%

CRISIL FITCH ICRA

P1+ P1 F1+ F1

PR2
PR3 PR4/PR5
UNRATED

P2
P3 P4/P5

F2
F3 B/C/D

A2
A3 AR/A5
UNRATE D

50%
100% 150%
100%

UNRATED UNRATE D

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

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 loans

The unsecured portion of any loan that is past due for more than 90 days, net of specific provisions, to be given higher risk weight 150% if specific provision <20% o/s 100% if provision >or= 20% if provision = or > 50% with supervisory discretion for 50% weight 100% if provision > or = 15% if fully secured

Credit Risk Mitigation

Simple & comprehensive approaches Legal certainty, robust recovery procedures Effects of CRM not to be double counted Should not result in increasing other risks Haircuts to be used in the comprehensive approach

Eligible financial collateral

Cash EQUIVALENT, CDs, Counter party deposit with lending Bank. Gold bullion & jewellery (99.99 purity) Central & State Govt. securities IVP, KVP, NSC, LIC policy Debt securities rated by recognised credit rating agency
PSEs at least BB Other entities at least A ST debt instruments at least P2+/A3/PL3/F3

Equities Mutual Fund units daily NAV to be available on public domain

Internal Ratings Based Approach Internal ratings based (IRB) approach

Foundation Advanced Goal: Should contain incentives for migration from standardized to IRB approach

IRB approach

Risk 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 charge

Captures 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: 1. VaR to be calculated daily 2. Confidence level of 99% 3. Holding period 10 days 4. Historical data for at least one year to be taken and updated at least once in a quarter .

Operational Risk

Explicit charge on capital Basic 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 INCOME

GROSS 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 Risk
Standardised ApproachCapital charge is calculated as a simple summation of capital charges across 8 business lines
Business lines % of gross income

Corporate finance
Trading & sales Retail Banking Commercial Banking Payment & Settlement Agency Services Asset Management Retail Brokerage

18
18 12 15 18 15 12 12

General Standards to qualify for sophisticated approaches

Active 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 Review

Principle 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 DISCIPLINE
a. Third Pillar to supplement first two pillars namely minimum capital requirement and supervisory review. b. 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 application
Capital Risk Exposures Risk assessment processes Ultimately Capital Adequacy

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

e. Interaction with accounting disclosures :

Disclosure framework not to conflict with requirements under accounting standards. All 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

f. Scope and frequency of disclosures

- Total required capital

- Total Capital adequacy ratios

QUESTIONS ON NPA NORMS AND PROVISIONS

Under Income recognition guidelines income from non performing assets is recognized on: Accrual basis. When debited to account When 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 income All 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.

QUESTIONS ON NPA NORMS AND PROVISIONS

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. Interest realized in NPA may be taken to income provided the credits towards the interest are realized not from fresh or addl facilities. True False.

Recovery in NPA account should be first appropriated towards Interest Principal In equal proportion. None of above. Recovery in Suit filed/decreed/compromised cases,recovery should first be appropriated towards a. Interest, b. Principal c. Principal or as per terms of decree or settlement. d. None of above.

QUESTIONS ON NPA NORMS AND PROVISIONS

Availability of security/net worth of borrowers or guarantor Should be taken into consideration for treating account as NPA Should not be taken into consideration do None of above. Both are true.

A non performing loan shall be a loan or advance: Interest or instalment overdue for more than 90 days. Account remains out of order for 90 days in CC OD Bill 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.

In 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.

QUESTIONS ON NPA NORMS AND PROVISIONS

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. An asset to be classified as Doubtful asset if it remained : Remained as sub standard asset for 12 moths. Remained as over for 3 years. Remained over due for 4 years. None of above. Loss asset is an asset which Considered 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 NPA Both CC and TL is NPA None of accounts are NPA Depends on security and NW of borrower.s

A OD account of borrower is NPA. Investment made in debenture of same company and interest is serviced regular.: Debenture of company: Need not be classified as NPA Need 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 NPA This account will not be NPA Depends on out of order position. Depend on security.

QUESTIONS ON NPA NORMS AND PROVISIONS

TL account of ABC Co. is NPA . It is partnership concern. One of partners A is having a CC account which is in order: This account will also be NPA This account will not be NPA. Depends on account status. Depends on security and NW TL account granted to X partner is NPA. CC account of partnership where X is partner even if it is not out order Will be NPA Will not be NPA Depends on account status. Depends on NW. In account XYZ Ltd borrower committed fraud. But interest and installment 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 i.e realizable value of security is less than 50% and it was sanctioned just 3 months back: Classify account as SA Classify account as SSA Classify account as DA Classify account as LA

QUESTIONS ON NPA NORMS AND PROVISIONS

Realizable value of security less than 10% Classify account as SA Classify account as SSA Classify account as DA Classify account as LA

In 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 not reviewed by branch on 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 PROVISIONS

X 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 books 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 honored. Both are true. None are true.

Interest on above loan to FCI can be taken to income No as such exemption is not for recognition of income. Yes can be taken to income. None

State 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

QUESTIONS ON NPA NORMS AND PROVISIONS

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. Advance granted against security of gold : a. Need not be classified as NPA if value of security covers the interest even if interest not service. b. Income recognition guidelines are normally applicable. c. Both are true. d. None of true. Advance granted against security of government security :

a. Need not be classified as NPA if value of security covers the interest even if interest not serviced. b. Income recognition guidelines are normally applicable. c. Both are true. d. None of true Provision on standard assets: .25% .25% for SME and agricultural advances and .40% for others. .40 for all None of above.

QUESTIONS ON NPA NORMS AND PROVISIONS

Provision on commercial real estate will attract a provision of a. 1% b.0.25% c.0.40% d.None.

Provisions on fully secured SSA 10% 20% 30% 40% Provision on SSA where abninitio bank has sanctioned with security less than 10%

20% 30% 40% 15% The above provision on SSA is made on outstanding in any SSA accounts is net of unrealized interest and held in CD nominal account and realized securities held in CD nominal account should be made without making any allowance for ECGC/CGTMSE guarantee cover and securities available: True. False. Not sure. None.

QUESTIONS ON NPA NORMS AND PROVISIONS

Provisions on DA secured upto one year of remaining in DA category: 20% 30% 50% 100% Provision on DA secured upto 3 years of remaining in DA category: 30% 20% 50% 100% Provisions on DA secured. Remaining in DA for more than 3 years. 100% 50% 150% 10%

QUESTIONS ON NPA NORMS AND PROVISIONS

Provision on DA unsecured irrespective of age. 100% 10% 50% 70%

In case loss assets 100% of the outstanding after adjusting realized value of security held, claim received , unrealized interest held in nominal account, interest suspense account and margin held account: True. False. Not sure. None.

Profit Planning.

Profitability for Banks depends on six factors: Interest Income Fee 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.

Out of four scenarios Which scenario require highest capital Which scenario gives highest returns
I Inv in G.ec yield 6% 1000 AAA corp 8% interest A corp. interest 10% Lending to BBB+ Corp. Interest 12% Total 0 0 0 1000 II 400 600 0 0 1000 III 300 300 400 0 1000 IV 300 300 200 200 1000

Thank You!