MODULE D

Balance Sheet
Management

2014
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 Banks Balance Sheet

All Banks are governed by Indian Companies Act, 1956 as well as Banking Companies Act,
1949. The Banks include Nationalized Banks, SBI and its subsidiaries, Foreign Banks,
Cooperative banks, RRBs and Private Sector Banks.

Section 5 of Banking Regulation Act stipulates that Banking is accepting of deposits of money
from public for the purpose of lending or investment. The deposits are repayable on demand or
otherwise by cheque, draft or otherwise.

Other Important provisions of Banking Regulation Act

Section 8 prohibits the banks to engage in trading activities.

Section 9 restricts the banks to hold Immovable property beyond a period of 7 years
except for own use.
Section 29 stipulates that Balance Sheet of a Banking Company will be prepared on
Form A of 3rd schedule. Further, Profit and Loss Account will be prepared on Form
B of 3rd Schedule.
Section 30 states that Balance sheet must be audited by qualified auditors.
Section 31 & 32 3 copies of Balance Sheet & PL account will be submitted to RBI
within 3 months from end of the period. This period can be extended by another 3
months by RBI.
Final accounts and Auditors report must be published in a newspaper within maximum
period of 6 months.
Sec 17 states that at-least 20% of profits will be transferred to Statutory Reserve by all
the banks. Presently this limit has been raised to 25% by RBI.

3rd Schedule : Form A

Balance Sheet of _____Bank as on _________

Capital and Liabilities Schedul Amount

e
Capital 1
Reserves and Surplus 2
Deposits 3
Borrowings 4
Other Liabilities and Provisions 5
Assets
Cash and Balance with RBI 6
Balances with Banks and Money at call 7
and shot Notices
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11

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 Total
Contingent Liabilities: Schedule 12 These are such type of liabilities which may or may not
arise in future. This figure does not form part of Total of Balance sheet but shown as footnote.
These are also called Off Balance Sheet Items. Such items are as under:

1. LC & LG as well as co-acceptance of bills.

2. Claims against banks not acknowledged as Debts.
3. Liability for partly paid up Investments.
4. Outstanding Forward exchange contracts.
5. Bills Rediscounted.

3rd Schedule : Form B

Profit and Loss Account of _____Bank for the year _________

Incomes Schedul Amount

e
Interest earned: It includes interest on Term 13
Loans, Cash Credit, Demand Loan, OD and
Rebate on Bills Purchased and Discounted
It also includes Income from Investments
Other Income : It includes Commission, 14
Brokerage, Profit on sale or revaluation of assets
and Misc. Income
Expenditure
Interest Expanded 15
Operating Expenses 16
Provisions and Contingencies --
Profit or Loss for the year
Appropriations
Transfer to Statutory Reserves (
Transfer to Other Reserves
Transfer to other Reserves
Proposed Dividend
Balance carried forward to Balance sheet
Total

Statutory Reserve requirement is minimum 20% of Profits. However RBI

has prescribed that banks will maintain 25% of Profits as Reserve.
(Sec 17 of Banking Regulation Act, 1949)

Schedule 17 Additional Disclosure

Following additional disclosures are required as foot-note in the Balance sheet:
1. Non-performing Assets
2. Movement of provisions held towards NPA
3. Movement of provisions held towards depreciation on Investments.
4. Asset Classification Standard Assets, Sub-standard Assets, Doubtful Assets & Loss
Assets.
5. Income Recognition and Provisioning

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 6. Investments SLR and Non- SLR. Further these are to be classified in 3 categories;
Held Till Maturity, Held for Trading and Available for Sale.
7. Provision for Depreciation
8. Repo and Reverse Repo transactions.
9. CDR Restructuring
10. Profit per Employee
11. Maturity pattern and ALM (Asset Liability Management)
12. AS-17 Segment Reporting
13. AS-18 Related Party Disclosure
14. AS-21 Consolidated Financial Statements

ALM (Asset Liability Management

ALM refers to risk management to avoid mismanagement between Assets and Liabilities. The
risk of Liquidity and Interest rates, if not controlled may result into negative spread and can
cause loss to bank. Therefore ALM manages two risks : 1. Liquidity Risk & 2. Interest Rate Risk.

Liquidity Risk and Interest Rate Risk

We borrow from Money market and invest in 5 year G-securities. If Bond prices come down, we
are not willing to sell the bond, but loan has to be repaid. This may lead to shortage of funds
which is called Liquidity Risk.

Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at higher
rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.

Significance of ALM

1. Market is Volatile. The rate fluctuations affect the NII and ultimate profits are affected.
2. Rapid innovations of products are taking place. Most products affect risk profile of the
bank.
3. Regulatory Environment also expects from banks compliance of Basel norms which
cannot be undertaken without ALM.
4. Management also recognises ALM mechanism as innovative job.

Objectives of ALM

Objectives of ALM are two fold

1. Profitability through Price matching

2. Ensuring Liquidity through maturity matching.

ALM techniques are so designed to manage various risks and the parameters are:

1. NII Net Interest Income

The impact of volatility on short term profit is measured by NII.

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 NII = Interest Income Interest Expenditure
2. NIM Net Interest Margin
It is comparison of NII with Average Total Assets
It is calculated as under:
NIM = NII (Net Interest Income)
Average Total Assets
3. Economic Equity Ratio
It is comparison of Shareholders Funds with Total Assets.
It is calculated as under:

Shareholders Funds
Total Assets

Practical Example

Expenses Incomes
Interest Paid 10 Interest Earned 170
Other expenses 35 Other Income 110
Provisions 75
Operating Expenses 120
Gross Profit 40

Total 280 Total 280

Total Liabilities are 2000 crore out of which Capital is 400 crore

Find NII (Net Interest Income), NIM and Economic Equity Ratio

NII= 170-10 = 160

NIM = NII/ Total Assets = 160/2000= 8%

Economic Equity Ratio = Share Holders funds / total assets

= 400/2000= 20%

Find out Capital Charge on Operational Risk and Risk Weighted Assets for Operational
Risk.

Capital Charge on Operational risk is 15% of average gross positive income of previous 3 years.
In the instant case, only 1 year study is given.

Therefore Capital charge for Op risk = 15% of 280 = 42 crores

RWAs for Operational Risk = 42*100/9 = 467 crores

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 Asset Classification
One of the important recommendations of Narsimham Committee was to adopt International
Accounting Practices and Accounting Standards with an objective of bringing transparency in
the Balance Sheet.

The major source of Income in the banks is in the from Interest on loans, which is booked
initially and recovered later on i.e. on Accrual basis. If the same is not recovered within
reasonable time, the Income should not be recognized as per International Standards.

Narsimham Committee suggested as under:

1. Classification of assets into 4 categories:

Standard Assets: The loan account which is not NPA.
Sub-standard Assets: The loan account which is classified as NPA.
Doubtful assets: The loan account which remains NPA for >1year
Loss Assets: The loan account in which security is not available.
How and when the account becomes NPA?

Type of Account Period

TL becomes NPA if Interest/Principal remains Overdue More than 90 days
CC/OD becomes NPA if it remains out of order More than 90 days
The account is treated as out of order: if
Outstanding balance is continuously above DP
There are no credits in the account for >90 days
Credit is not enough to cover interest during same period
Bill becomes NPA if it remains Overdue for More than 90 days
Agriculture Loan account becomes NPA if overdue After 2 crop seasons
In case of Long duration crops After 1 crop season

Asset Classification
Loan Account remains in Sub standard category for 1 year
Loan becomes Doubtful after remaining 1 year in D1 category for 1 year
Substandard category). D2 category from 1-3 years
(The account is transferred to Doubtful category directly if D3 category beyond 3 years
security loss is 50% or above)
Loan becomes Loss Asset If Loss of security is either 100%
or 90% or more.

Non- Financial reasons for account becoming NPA

1. Stock Statement not received for 3 Months.
2. Limit is overdue for renewal for 6 M.

Up-gradation of NPA into Standard Category

The account is upgraded on same day when the recovery is made.

Implications of Accounts after becoming NPA

1. Interest is not charged and not credited to Income head.

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 2. Interest accrued and credited to Income account but not recovered during corresponding
previous year will be reversed.
3. Provision is made for NPAs (Bad and Doubtful debts) from the current years profits.
Asset Classification Borrower wise and not Facility wise
It means if one account of the borrower is classified as NPA, other accounts will also be
treated as NPAs even if these are regular.
Advances under Consortium
Each bank will take view of transferring account to NPA category on the basis of its own
recovery.

PROVISIONING NORMS

In terms of Monetary policy 2011-12, the revised norms of provisioning are as under:
Standard Assets

Classification Rate of
provision
Direct SME and Direct 0.25%
Agriculture
Others 0.40%
CRE-RH (Residential Housing) 0.75%
CRE Commercial Real Estate 1%
Teaser Housing Loans 2%
Restructured accounts classified as 2.75%
standard advances:
In the first two years from the date of
restructuring.

Restructured accounts earlier 2.75%

classified as NPA and later upgraded
to standard category:
In the first year from the date of up-
gradation.

Sub-standard Advances:

Secured Exposures 15%

Unsecured Exposures (abnitio unsecured) 25%
Unsecured Exposures in respect of Infrastructure loan 20%
accounts where certain safeguards such as escrow
accounts are available.
Doubtful Advances Unsecured Portion 100%

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 Doubtful Advances- Secured Portion

For Doubtful up to 1 year 25%

For Doubtful>1 year and up to 3 years 40%
For Doubtful >3 years 100%

Some Important Equations:

1. Net NPAs = Gross NPAs (Provision +DICGC/ECGC cover).
2. Provisioning Coverage Ratio = NPA Provision X 100
Gross NPAs
3. Provisioning Coverage Ratio should not be less than 70% of Gross NPAs as per bank
guidelines.
4. Amount of ECGC/DICGC guarantee cover must be excluded while calculating provision
in respect of Doubtful assets. But in case of Sub-standard assets, this cover need not to
be deducted.
5. In case of Doubtful Assets, Secured portion and Un-secured portion (Security reduced
subsequently) will be segregated and provision will be calculated accordingly.
6. Advances against Gold/NSCs/KVPs/FDs/LIC Policies need not to be classified as NPAs.
7. Advances against Gold and Govt. Securities are not classified as NPAs.

GOVT. GUARANTED ACCOUNTS

STATE GOVT: It will be declared NPA as in other loan cases.
CENTRAL GOVT: Continued to be Standard Assets till repudiation of guarantee by the
Central Govt. However interest would not be taken into income unless actually received

Practical Examples

Ex. 1
Account with Outstanding of Rs. 10.00 lac became Out of order on 22.1.11 and it became NPA
on 22.4.2011. The Value of Security at later stage is Rs. 7.00 lac. Calculate Provision as on
31.3.12.
Solution
It is a Sub-Standard Asset as on 31.3.2012.
Provision is 1000000*15/100 = 150000/-

Ex. 2
A loan account with outstanding of Rs. 10.00 lac and Value of Security Rs. 6.00 lac was Sub-
standard as on 30.3.2008. What will be provision as on 31.3.2012?
Solution
The account will be Doubtful (DI) on 30.3.2009, D2 on 30.9.2010, D3 on 30.3.2012. Provision
will as under:
Secured portion = 6.00*100/100 = 6.00 lac
Un-secured portion = 4.00*100/100 = 4.00 lac
Total Provision = 6+4 = 10.00 lac.

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Ex. 3
A loan became Doubtful on 12.2.2009. The outstanding is 6.00 lac. What will be provision on
31.3.2012.
Solution
The Account will be categorized as Doubtful (D3) as on 12.2.2012. Provision is 100% of 6.00 lac
= 6.00 lac

Ex. 4
D2 category account has outstanding--10.00 lac, DI/SI ----2.00 lac, Value of security ---6.00 lac
Solution
Un- Secured portion = 10-2-6 = 2.00 lac Provision = 2.00 * 100/100 = 2.00 lac
Secured portion = 6.00 * 40/100 = 2.40 lac
Total provision = 2.00 + 2.40 = 4.40 lac

Ex. 5
D2 Category loan is having outstanding 4.00 lac, Value of Security 1.50 lac and ECGC cover
50%. Calculate provision as on 31.3.2012.
Solution
Unsecured portion = 50% of (O/s VS) = 50% (4.00 1.50) = 1.25 lac
Secured portion = 1.50 lac
Provision on Unsecured portion = 1.25*100/100 = 1.25 lac
Provision on Secured portion = 1.50*40/100 = 0.60 lac
Total provision = 1.25 +0.60 = 1.85 lac.

Ex. 6
A D2 category loan is having outstanding Rs. 6.00 lac. The Collateral Security is Rs. 3.00 lac
and Primary Security is Rs. 2.00 lac. There is also Guarantee of Rs. 10.00 lac. Calculate
provision.
Solution
Unsecured portion = O/s Primary Security Collateral = 6.00 2.00 -3.00 = 1.00 lac
Secured portion = 2.00 + 3.00 = 5.00 lac.
Provision on Unsecured portion = 1.00 *100/100 = 1.00 lac
Provision on Secured portion = 5.00*40/100 = 2.00 lac
Total provision = 1.00 + 2.00 = 3.00 lac.

Ex. 7
Advance portfolio of a bank is as under:
Total advances = 40000 crore, Gross NPAs = 9%, Net NPAs = 2%
Find out 1) Total Provision 2) Provisioning Coverage Ratio
Solution
NPAs = Total Advances *9/100 = 40000*9/100 = 3600 crore
Standard Assets = 40000-3600 = 36400 crore
Provision on Standard Assets = 36400*0.40% = 145.60 crore
Provision on NPAs = 9% - 2% = 7% = 40000*7/100 = 2800 crore
1) Total provision = 145.60 + 2800 = 2945.60 crore
Gross NPAs = 40000*9/100 = 3600 crore
Net NPAs = 40000*2/100 = 800 crore

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 2) Provision Coverage Ratio = Provision on NPAs / Gross NPAs = 2800/3600 = 77%.

Ex. 7 Account becomes doubtful on 12th Feb 2008. The Balance is Rs. 6 lac. Value of security is
3 lac. What will be the provision on 31.3.2011?
Solution
It is D3 Type of account.
Therefore, provision will be 100% i.e. 6 lac = 6.00 lac Ans.

Ex. 8 NPA o/s : Rs. 10 lac including suspended interest/Derecognized interest Rs. 2 lac.
Security value is Rs. 6 lac. It became NPA on 25th Feb 2008. What would be the provision on
31.3.2011.
It is D2 category account
4.40 LAC (10-2-6= 2x100%= 2 lac + 40% on 6 lac ie 2.40 lac = 4.40 lac) D2

Ex. 9 A/c became NPA on 2nd January 2008. Balance o/s is 10 lac including Derecognized
interest Rs. 2 lac and ECGC cover of 50%. Value of security is 4 lac. What will be provision on
31.3.2009.

It is D1 category account.
10 lac 2 lac, DI 4 lac Sec. = 4 lac
ECGC Cover: 4 lac x 50% = 2 lac
Provision on Unsecured portion
Unsecured: 4 lac 2 lac = 2 lac x100% = 2.00 lac
Provision on Secured portion
Secured: 4 lac x 25% = 1.00 lac
Total Provision: 2 + 1 = 3.00 lac

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 Liquidity Management
Banks are required to honour withdrawals from Deposits. Also the banks are supposed to
disburse loans in time. Liquidity is needed to meet both these requirements. In other words,
liquidity is the ability to accommodate decrease in liability as well as funding of increase in
assets.

Functions of Liquidity Management:

1. It defines market place of bank.
2. It enables banks to meet prior loan commitments.
3. It enables the banks to avoid unprofitable sale of assets.
4. It lowers size of default risk premium.

Liquidity Mismanage may lead to the following:

It declines earnings.
It increases NPAs.
It results in downgrading of rating.

Factors affecting Liquidity

Liquidity is affected by the following:
1. Less profits leads to less liquidity
2. Rise in NPAs means less liquidity
3. Deposit concentration in Term Deposits may lead to less liquidity
4. More taxes means less liquidity.

Types of Liquidity Risks

1. Funding Risk: Decrease in deposits due of bad reputation or loss of confidence.
2. Time Risk: Installments of loan are not forthcoming in time.
3. Call Risk: Non-fund based credit facilities converted into Fund based. Crystallization of
Contingent liabilities like LC/LG turning into Fund Based Loans.
4. Embedded Risk: Adverse movement of Interest Rate may result into pre-payment of
CC/DL and TL. It may also result into pre-mature withdrawal of TDs/RDs. This will also
result into reduced NII. This is called Embedded Risk.

How to manage Liquidity Risk?

1. Developing an organizational structure.
2. Setting of Tolerance level limits.
Limit of cash flow mismatches for tomorrow, next week, next month or next year.
Limit of Loan to Deposit Ratio
Limit of Loan to Capital ratio.
Mismatch level in 1-14 days bucket and 15-88 days bucket should remain about 80% of cash
flow in the particular period. To manage liquidity and remain solvent by maintaining short term
gap up to 1 year should be around 15% .

Measurement of Liquidity Risks: Liquidity Risk can be measured in any of the two ways:
1. Stock Approach
2. Flow Approach

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Stock Approach
Following ratios are calculated to measure Liquidity Gap:

Better it is from Liquidity Point of view

Ratio of Core Deposits to Total Assets More the ratio, better it is
Net Loans to Total Deposits Lower ratio is better
Time deposits to Total Deposits Higher ratio is better
Volatile Liabilities to Total Assets (Market Lower ratio is better
borrowings are volatile liabilities
Short Term Liabilities to Liquid Assets Lower ratio is better.
Liquid Assets to Total Assets Higher ratio is better.
Short Term Liabilities to Total assets Lower is desirable
Prime Assets to Total Assets (Prime assets are Higher is better
Cash, Balance with banks etc.
Market Liabilities to Total assets (Market Lower is better
liabilities are Money Market borrowings, Repo
and Inter-bank liabilities

Flow Approach: It has 3 major dimensions:

1. Measuring and managing net funding requirements through
Maturity ladder
General Market conditions
Bank specific crisis.
General Market crisis.
2. Measuring Liquidity over chosen time frames.
3. Contingency Planning

RBI guidelines for maturity Buckets:

All Assets and Liabilities are classified into 10 maturity buckets:
1. Tomorrow
2. 2-7 Days
3. 8-14 Days
4. 15-28 Days
5. 29 Days to 3M
6. 3M to 6M
7. 6m to 1 Year
8. 1-3 Years
9. 3-5 Years
10. Over 5 years
.

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 Interest Rate Risk Management

There is complete deregulation of Interest rates on Fixed Deposits, Recurring Deposits, and SB
Deposits above Rs. 1.00 lac. Banks are also free to determine Interest rates on NRE Deposit
accounts. This has led to interest rate Volatility resulting into greater Interest Rate Risk.

Adverse movement of Interest rates has direct impact on NII as well as NIM. Market Interest
rate also has impact on Present Value of Bonds and Securities. 1% rise in market rate of return
will cause lesser valuation of securities. Also 1% fall in interest rate will cause higher valuation
of securities resulting into increase in Mark to Market Price.

Types of Interest Rate Risk

Following are various types of Interest Rate Risk:

1. Mismatch or Gap Risk

This is risk of gap between maturities of Assets and Liabilities. Sometimes, Long term
loans are funded by short term deposits. After maturity of deposits, these liabilities are
get repriced and Gap of Interest rates between Assets and Liabilities may become
narrowed thereby leading to reduction of profits.
2. Basis Risk
Change of Interest rates on Assets and Liabilities may change in different magnitudes
thus creating variation in Net Interest Income. It tries to explain what will be the %age
effect on Earnings due to increase or decrease in interest rates by 1bps.
3. Net Interest Position Risk
If the bank has more assets than the liabilities, 1% decrease in interest rate will result
into less earnings and more expenditure on account of interest. This will directly affect
NII and NIM.
4. Embedded Option Risk
Adverse movement of Interest Rate may result into pre-payment of CC/DL and TL. It
may also result into pre-mature withdrawal of TDs/RDs. This will also result into reduced
NII. This is called Embedded Risk.
5. Yield Curve Risk
Yield is Internal Rate of Return on Securities. Higher Interest Rate scenario will reduce
Yield and thereby reduction in the value of assets. Adverse movement of yield will
certainly affect NII (Net Interest Income).
6. Price Risk
In financial market, when assets are sold before maturity in order to meet liquidity
requirements, loss may occur due to lower selling price.
7. Re-investment Risk
It is uncertainty with regard to interest rate at which future cash flows could be re-
invested.

Effects of Interest Rate Risk

Effect on Earnings.
Effect on Economic value of share
Embedded Losses

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Measurement of Interest Rate Risk
1. Re-pricing Schedules
All Assets and Liabilities are assigned to Re-pricing time bands according to past
judgment and experience of the banks. The schedule distributes Interest Sensitive
Assets, Liabilities and Off Balance Sheet Items into certain number of pre-defined time
bands.
Under this method, steps are as under:
Ist step---------Adjusted Gap is calculated by netting Interest bearing assets and interest
bearing liabilities.
2nd step---------Re pricing of assets is done as per the following example
3rd step---------Standard Gap is calculated after deducting Re pricing liabilities from Re
pricing Assets.

How it is calculated?
A bank has following Assets and Liabilities:
Call Money -------500 crore
Cash Credit----400 crore
Cash in hand ---100 crore
SB Deposits-------500 crore
Fixed Deposits----500 crore
Current Deposits--200 crore

There is reduction in interest rates by 0.5% in call money, 1% in CC, 0.1% for SB and
0.8% for FD

Calculate Adjusted Gap

Adjusted Gap = (Call Money +CC) (SB+FD) = 900 - 1000 = 100 crore Negative
Calculate Re pricing Assets
Re pricing Assets = (500*.5) + (400*1) = 250+400=650 crore
Calculate Re pricing Liabilities
Re pricing Liabilities = (500*.1) + (500*.8) = 50+400 = 450 crore
Calculate Standard Gap
Standard Gap = Re Pricing Assets Re Pricing Liabilities
= 650 450 = 200 crore positive

2. Gap Analysis
Gap is Difference between RSA (Risk Sensitive Assets) and RSL (Risk Sensitive
Liabilities)

If RSA > RSL , it is called Positive Gap or Asset Sensitive Gap.

If RSA < RSL, it is called Negative Gap or Liability Sensitive Gap.

3. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration) to receive
Present Value of the bond.

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 E.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7
years. It means Total Cash Flow of Rs. 130 to be received in 5 years would be
discounted with Present Value which will be equivalent as amount received in 3.7 years.
The Duration of the Bond is 3.7 Years.

Formula of Calculation of McCauley Duration = PV*T

PV
Modified Duration = Duration
1+Yield
Approximate % change in price = Modified Duration X Change in Yield

4. Simulation Approach: It involves detailed assessment of potential effects of changes in

interest rates on earnings and economic value by simulating the future path of interest
rates and their impact on cash flows.

Simulation techniques could be

Static simulation on the basis of existing Assets and Liabilities
Dynamic simulation Detailed assumption about future structure of interest
rate regime.

Measures to Control Interest Rate Risk

1. Reduce Asset Sensitivity

Extend Investment portfolio maturity, Increase of Floating rate Deposits, Increase of
Fixed Rate lending, and Increase of short term borrowings and Long term Lending.

2. Reduce Liability Sensitivity

Reduction of Investment portfolio maturity, Increase of Floating rate lending, Increase of
Long term Deposits and Short term Lending.

3. Control and Supervision

Board and Senior Management of Oversight Interest Rate Risk.
Board of Directors must have proper control over Interest rate regime.
Senior Management should be responsible for implementing policy.
Lines of Authority and Responsibility must be clearly defined.

Practical Example:

ABC Bank has following Assets and Liabilities:

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 SB Deposits 300 crore Cash in Hand------------ 200 crore

FD Deposits 300 crore Call Money -------------- 300 crore

CA Deposits 250 crore CC & TL------------------ 240 crore

RSA (Rate Sensitive Assets) = 300+240 = 540 crore

RSL (Rate Sensitive Liabilities = 300+300 = 600 crore

Adjusted Gap = RSA-RSL = 540-600 = (60) --------Negative

Suppose Interest rate falls 2% on all assets and liabilities. Liabilities are in excess. Bank
will have to pay less thereby improvement in NII by (60*2/100) i.e. 1.20 Crore
Now, if Interest Rate rises by 2%, bank will have to pay more. Since Negative gap is 60
crore. Banks NII will be reduced by 1.20 Crore.

Important Points

Interest rate Risk is a type of Market Risk

A bank holds a security that is rated A+. The rating of the security migrates to A. What is
the risk that bank will face: Credit Risk
Lower is the rating of the company, higher will be the interest rate on its Bonds. Bond
with BBB rating will carry higher interest rate than one with AA rating.

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 RAROC (Risk Adjusted Return on Capital)
Profit Planning involves Balance Sheet Management. Higher risk will fetch more profits whereas
lower risk is the cause of lesser profits.

Risk and Risk is possible unfavorable impact on net cash flow in future due to
Capital uncertainty of happening or non-happening of events. Capital is a
cushion or shock observer required to absorb potential losses in future.
Higher the Risks, high will be the requirement of Capital and there will
be rise in RAROC (Risk Adjusted Return on Capital).

Banks Income comprises of the following 3 components:

1. Interest from Loans as well as from Investments

2. Fee Based Income
3. Treasury Income

Banks Expenditure consists of the following:

1. Interest on Demand and Time Deposits

2. Staff Expenses
3. Other Operating Expenses

Motive of the bank is to Expand Income and Reduce Expenditure so that Profit can be
maximized. But, in order to Expand Income, more risks have be incurred which requires higher
Capital.

Example:

Bank has Rs. 1000 crore for Investment in Securities which can be invested under any of the
following alternative:

Yield Risk Situation 1 Situation 2 Situation 3 Situation 4

Weight
G-sec 6% 0% 1000 400 300 300
AAA Rated 8% 20% 0 600 300 300
AA Rated 10% 50% 0 0 400 200
A Rated 12% 100% 0 0 0 200
Total 1000 1000 1000 1000
Yield 60 24+48 18+24+40 18+24+20+2
=72 82 4
=86
%age Yield 6% 7.2% 8.2% 8.6%
RWAs 0 120 60+200 60+100+200
=120 =260 =360
8% Capital 9.60 20.80 28.80
Requiremen

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t

Banks policy must be to invest in such a manner that optimum yield can be obtained at
a given level of Capital.
Banks non-interest income can be increased by popularizing 3rd party products and
widening scope of Treasury.
Banks profit can be enhanced through effective management of risks.
Low Cost Deposits must be increased to enhance Profits.

Risk Aggregation and Capital Allocation

Through RAROC approach, each Risk is measured to determine both expected and
Unexpected losses using VaR (Value at Risk).

Expected Losses are covered by Reserves and provisions.

Unexpected losses require capital allocation determined on the Principal of Confidence
level, Time horizon, Diversification and Correlation

How to Calculate RC (Risk Capital) & RAMP (Risk Adjusted Performance Measures?

RC (Risk Capital) = VaR

RAPM = Profit
RC

Example:
There are two traders One is Forex Trader and the other is Bond Trader. Each is having profit
of 10 Million USD last year. The performance of each can be compared as under:

Deals in amount Volatility Probability Table RC (Risk Capital)

at 99% volatility
Forex Trader $100 Million 12% p.a. 2.33 28 Million
Bond Trader $200 Million 4% p.a. 2.33 18.6 Million

Forex Trader
RC (Risk Capital) = VAR = 100,000,000 x 0.12 x2.33 = 28 Million USD
RAPM = 10/28 = 0.35

Bond Trader
RC (Risk Capital) = VAR = 200,000,000 x 0.04 x2.33 = 18.6 Million USD
RAPM = 10/18.6 = 0.53

Bond Trader has less Risk Capital and Higher Risk Adjusted Performance. Therefore Bond
Trader is performing better.

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