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On
Bank Financial
Management
For CAIIB
2015
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INDEX
Page No
Module – A International Banking
Foreign Exchange 2
Forex Risks and Derivatives 10
Correspondent Banking 12
Letter of Credit 16
Exports 19
Imports 24
Foreign Trade Risks and ECGC 27
Exim Bank 30
Reserve Bank of India , FEMA and FEDAI 31
International Banking
Forex, Exports, Imports, DGFT, RBI, LC, FEDAI etc.
2015
International Banking
Foreign Exchange
Foreign It includes all Currency, deposits, Credits and Balances payable in Foreign
Exchange currency. It also includes Drafts/TCs, LCs and Bills of Exchange payable in
Foreign currency. In nut shell, all claims payable abroad is Foreign
Exchange.
On the other hand, Foreign Currency is narrow term which includes hard
currency say Pounds, Dollars etc.
Forex Market It comprises of individuals and entities including banks across the globe
without geographical boundaries. Forex market is dynamic and it operates
round the clock. Exchange rate of major currencies change after about
every 4 seconds. It opens from Monday to Friday except in Middle east
countries where it is closed on Friday and opens on Saturday and Sunday.
Exchange Rate When settlement of funds and exchange
mechanism of currency takes place_________
TOD rate or Cash Rate Same day (it is also called ready rate)
TOM Rate Next working day
Spot Rate 2nd working day (48 hours)
Forward Rate After few days/months
If Next day or 2 day is holiday in either of the two countries, the
nd
settlement will take place on next day. For example Spot deal is
stuck on 23rd Dec. 25th is Christmas Day and 26th is Sunday. Under
such circumstances, value date will be 27th i.e. Monday.
There are two types of rates- Fixed and Floating. Floating rates are
determined by market forces of Demand and Supply. India
switched to Floating exchange rates regime in 1993.
2
Examples of Euro 1 = USD$1.3180/3190
Forward rates Forward differentials:
1M = 15/18, 2M= 30/37, 3M=41/49
Exchange
Margin Exchange margin is deducted while buying and added while selling.
Cross Rates
Cross rate is price of currency pair which is not directly quoted. It is arrived
at from price of two other currency equations.
1. Suppose bank hasto Quote GBP against INR, but in India, GBP is
not quoted directly. In India,
1USD =48.10 and GBP/USD is quoted as 1GBP= USD1.6000.
Therefore 1 GBP = 48.10X1.6 = 76.96
While buying GBP, bank would like to quote higher rate as Buy high Sell
Low maxim will apply. 1GBP = 1.5985
While selling USD, bank will opt to quote higher rate as Buy Low Sell High
maxim will apply.
3
Per Unit and 100 All currencies are quoted as per unit of currency whereas the following
Unit Quotes currencies are quoted as 100 units of Foreign currency:
1. Japanese Yen
2. Indonesian Rupiahs
3. Kenyan Schilling.
4. Belgian Francs
5. Spanish Peseta
Solution:
We will buy Japanese Yen and sell USD and the rate to be applied is:
48.2600/90.50 = .533260 per JPY
Rate per 100 JPY = 53.3260 + Margin @.15%(.0799) = 53.4059 (say
53.4050)
For customers the exchange rate is quoted in two decimal places i.e. Rupees and paisa. e.g. 1
USD =Rs. 55.54.
4
Foreign bills. This rate is used for cancellation of Forward Sales Contract.
Calculation
Spot Rate – Exchange Margin
Bill Buying Rate Bill Buying rate is applied when bank gives INR to the customer before
receipt of Foreign Exchange in the Nostro account i.e. Nostro account is
credited after the purchase transaction. In such cases.
Examples are:
Export Bills Purchased/Discounted/Negotiated.
Cheques/DDs purchased by the bank.
Calculation
Spot Rate + Forward Premium (or deduct forward discount) – Exchange
margin.
TT Selling Rate Any sale transaction where no delay is involved is quoted at TT selling rate.
It is desired in issue of TT, MT or Draft. It is also desired in crystallization of
Export bills and Cancellation of Forward purchase contract.
Calculation
Spot Rate + Exchange Margin
Bill Selling Rate It is applied where handling of documents is involved e.g. Payment against
Import transactions:
Calculation
Spot Rate + Exchange Margin for TT selling + Exchange margin for Bill
Selling
Examples
Q. 1
Bank received MT of USD 5000 on 15th Sep. The Nostro account was already credited. What
amount will be paid to the customer: Spot Rate 34.25/30. Oct Forward Differential is 22/24.
Exchange margin is .80%
Solution
TT buying Rate will be applied
34.25 - .274 = 33.976 Ans.
Q. 2
On 15th July, Customer presented a sight bill for USD 100000 for Purchase under LC. How
much amount will be credited to the account of the Exporter. Transit period is 20 days and
Exchange margin is 0.15%. The spot rate is 34.75/85. Forward differentials:
Aug: .60/.57 Sep:1.00/.97 Oct: 1.40/1.37
Solution
Bill Buying rate of August will be applied.
Spot Rate----34.75 Less discount .60 = 34.15
Less Exchange Margin O.15% i.e. .0512 =34.0988 Ans.
( Transit period is rounded to next month since currency will be cheaper as it is buy transaction)
Q. 3
Issue of DD on New York for USD 25000. The spot Rate is IUSD = 34.3575/3825 IM forward
rate is 34.7825/8250
Exchange margin: 0.15%
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Solution:
TT Selling Rate will Apply
Spot Rate = 34.3825 Add Exchange margin (.15%) i.e. 0.0516
TT Selling Rate = Spot Rate + Exchange Margin = 34.4341 Ans.
Q. 4
On 12th Feb, received Import Bill of USD-10000. The bill has to retired to debit the account of
the customer. Inter-bank spot rate =34.6500/7200. The spot rate for March is 5000/4500. The
exchange margin for TT selling is .15% and Exchange margin for Bill selling is .20%. Quote rate
to be applied.
Solution
Bill Selling Rate will be applied.
Spot Rate + Exchange margin for TT Selling + Exchange margin for Bill selling =
34.7200+.0520+.0695 = 34.8415 Ans.
Buy Transactions
Quote rates applicable to lower month (if currency is at premium) and same month (if currency
is at discount) due to the reason that currency becomes cheaper and Buy low and Sell High
Sale Transactions
Quote rates applicable to Same month (if currency is at premium) and lower month (if currency
is at discount) due to the reason that currency becomes dearer and Buy low and Sell High
Forward contracts can be booked by Resident Individuals up to USD1lac.
Buy On 22.7.2013,
Transactions- Spot Rate is 35.6000/6500 Forward 1M=3500/3000 2M=5500/5000
Currency at 3M=8500/8000
Discount Transit Period ----20 days Exchange Margin = 0.15%.
Find Bill Buying Rate & 2 M Forward Buying Rate
Transit Period is
rounded off to Solution
same month in Bill Buying Rate (Ready) : Bill Date +20 days = 11.8.2013
which due date Spot Rate = 35.6000 Less Forward Discount 1M (0.3500) Less Exchange
falls Margin 0.15% (0.529)
i.e. 35.6000-.3500-.0529(0.15% of 35.2500) = 35.1971
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2 M Forward Buying Rate: = Transaction date +2M +20 days =11.10.13
3 Month Forward Buying Rate will be applied.
Spot Rate = 35.6000 Less Forward Discount of 3M (.8500) Less Exchange
Margin (.0521)
i.e. 35.6000-.8500-.0521(0.15% of 34.7500) = 34.6979 Ans.
Cancellation of
Deal Cancellation of Buy contract is done at TT selling rate and cancellation of
Sale contract is done at TT buying rate.
Example
A bank purchased export bill of USD 50000 at Rs. 42.66, which was dishonored for non-
payment. How much amount will be recovered from exporter, if Spot rate is 42.2000/3000.
Exchange margin is 0.15%.
Solution
TT selling rate will be applied to recover the amount
TT Selling rate= Spot rate +Exchange margin
=42.3000+0.06345 = 42.36345= 42.3625 (Rounding off to nearest .0025)
Amount to be debited to customers‟ account =50000*42.3625=2118125 --------------Ans.
Per Cent and Per 1% is on part of 100 whereas per mille is 1 part of thousand
Mille
Authorized
Dealers Authorized dealers are called Authorized Persons. The categories are as
under:
AP category 1 -----AD banks, FIs dealing in Forex transactions.
AP category 2-----Money changers authorized to sell and purchase
Foreign currency notes, TCs and Handle remittances.
AP category 3----Only purchase of Foreign currency and Travelers
Cheques. These were earlier called “Restricted Money Changers.”
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USA, rate of interest is 6% whereas in Germany, rate of interest is 3% for
EURO. We will borrow from Germany and lend in USA where
1EURO =1.5 USD
= 1.5 x 3 x 90
100*360
=0.01125
Ex.2
A foreign correspondent intends to fund his Vostro Account maintained with Mumbai branch of
SBI. What rate will be quoted if 1 USD = 44.23/27 and margin is 0.08%
Solution : TT buying rate will quoted
44.23-.035 = 44.195 ---------------------------------------Ans.
Ex.3
If Swiss Franc is quoted as USD = CHF 1.2550/54 and in India, USD =INR43.50/52, how much
INR will exporter get for his export bill of CHF 50000.
Solution :
Swiss Franc will be sold for USD in overseas market and USD will be bought in local market i.e.
Sell Rate of CHF and Buy rate of USD.(Buy Low Sell High in both quotations)
1 USD = 1.2554 CHF and 1USD=INR 43.50
1CHF=43.50/1.2554 = 34.6503
Amount as paid to exporter = 34.6503*50000=17,32,515/- ----------------Ans.
(Both are direct quotations and Maxim Buy Low Sell High will apply in both)
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Ex.4
If Swiss Franc is quoted as USD = CHF 1.2550/54 and USD =INR43.50/52, how much INR will
Importer pay for his import bill of CHF 50000.
Solution :
Swiss Franc will be bought against USD in overseas market and USD will be sold in local
market i.e. Buy rate of CHF and Sell rate of USD.
1 USD = 1.2550 CHF and 1USD=INR 43.52
1CHF=43.52/1.2550 = 34.6773
Amount to be received from Importer = 34.6773*50000
=17,33,865/- ----Ans.
(Both are direct quotations and Maxim Buy Low Sell High will apply in both)
Q. 5
Exporter received Advance remittance by way of TT French Franc 100000.
The spot rates are in India IUSD = 35.85/35.92 1M forward =.50/.60
The spot rates in Singapore are 1USD = 6.0220/6.0340 1M forward =.0040/.0045
Exchange margin = 0.8%
Solution
Cross Rate will apply
USD will be bought in the local market at TT Buying rate and sold at Spot Selling Rates in
Singapore for French Francs:
TT Buying Rates USD/INR = Spot rate – Exchange margin = 35.8500-.0287 = 35.8213
Spot Selling Rate for USD/Francs = 6.0340
Inference:
6.0340 Franc = 1USD
= INR 35.8213
1 franc = 35.8213/6.0340 = INR 5.9366 Ans.
(Both are direct quotations and Maxim Buy Low Sell High will apply in both)
Q.6 What rate will be quoted for repatriation of FCNR deposit (spot rate or TT rate)
Ans. No rate as the amount is to be paid in Foreign currency itself.
Forex Dealing It is a service branch which deals Buying and Selling Operations of the
Room bank. It manages Foreign currency Assets and Liabilities and also
operations manages Nostro accounts.
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FOREX RISKS AND DERIVATIVES
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Difference between Futures and Forward Contracts
Forward Contract Futures
It is OTC (Over the Counter) Product It is Exchange traded product
It can be for any odd amount It is always for Standard amount
It can be for any Odd period It is always for Standard period
Delivery is essential Delivery is not must
Margin is not essential It is based on Margin requirement and
Marked to market
Options Option is Right to buy or sell an agreed quantity of currency or commodity
without obligation to do so. The buyer will exercise the option if market
price is in favor or otherwise option may be allowed to lapse.
Call Option
Right to buy at fixed price on or before fixed date.
Put Option
Right to sell at fixed price on or before fixed date.
Final day on which it expires is called maturity.
CALL OPTION;
If Strike price is below the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is above the spot price, the option is Out of money.
PUT OPTION
If Strike price is more the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
Swap Foreign Exchange transactions where one currency is sold and purchased
Transactions - for another simultaneously.
Swap Deal may involve:
1. Simultaneous purchase of spot and sale of forward or vice versa.
2. Simultaneous sale and purchase, both forward but for different
maturities. It is called “Forward to Forward Swap”.
Conditions of Swap Deal:
There should be simultaneous buying and selling of same foreign
currency of same value for different maturities.
The deal should be concluded with the understanding between the
banks that it is Swap Deal.
Buying and Selling is done at same rate. Only Forward margin
enters into the deal as a Swap difference.
Example:
PNB approaches UCO bank to quote its Swap rate for spot to 3months.
UCO bank has to sell spot and buy forward. Swap deal is at forward
differential of Rs. 1.40/1.35. UCO bank will sell spot and buy forward at a
discount of Rs.1.40 (Higher discount at purchase). Swap Difference will be
at Discount of Rs.1.40.
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CORRESPONDENT BANKING
Correspondent It is a relationship between two banks which have mutual accounts with
Banking each other:
Nostro accounts “ Our account with you “
E.g. SBI Mumbai maintaining USD account with City Bank, New York
Vostro accounts “Your account with us”
E.g.. City Bank New York maintains Rupee account with SBI Ludhiana.
Loro account“His account with them”
E.g. City bank referring to Rupee account of Bank of America with SBI
Mumbai.
Mirror account---- It is replica ofNostro account to reconcile.
What is Swift?
Society for Worldwide Interbank Financial Telecommunications. There are
8300 members of the society. Financial messages are sent through Swift.
The messages are automatically authenticated through BKE (Bilateral Key
Exchange). It is operational 24 hours and 365 days. Swift has now
introduced new system of authentication system wherein banks are
required to have authentication key exchanged between them through a set
format by use of RMA (Relationship Management Application). This is
called BIC or Bank Identifier Code).
CHIPS – New York
Clearing House Inter Bank Payment System.
CHIPS is major payment system in USA with 48 members. The participants
use the system throughout the day for sending and receiving electronic
payment instructions. These are netted at end of the day and net position is
debited or credited to Nostro account of Federal Reserve.
It is used for Foreign Exchange Inter bank settlements and Euro Dollar
Settlements.
FEDWIRE -USA
It is US payment system being operated by Federal Reserve Bank. It
handles majority of domestic payments. All US banks maintain account with
Federal Reserve Bank and are allotted ABA numbers to identify senders
and receivers of payments.
CHAPS – London
Clearing House Automated Payment System
It is UK based Settlement System. It handles receipts and Payments in UK.
It has 16 member banks and 400 Indirect members.
TARGET
The full form of TARGET is Trans-European Automated Real-Time Gross
Settlement Express Transfer System. It is Euro Payment System which
comprises of 15 national RTGS systems working in EUROPE. It process
high value payments from 30000 participating institutions across Europe.
RTGS-plus
RTGS plus has over 60 participants. It is a German Hybrid clearing system
and operating as a European oriented RTGS and Payment system.
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with minimum Rs. 2.00 lac. This system is managed by IDRBT, Hyderabad,
which connects all banks to Central server maintained by RBI. The network
is INFINET (Indian Financial Network)
Timings are:
8:00AM to 8:00PM (Saturday: 8:00 to 3:30 PM)
NEFT (National Electronic Fund Transfer) is mainly used for low amount
transactions. However, there is no minimum and maximum limit. The
timings are: 8:00AM to 7:00PM (Saturday 8:00 to 1:00 PM). There are 12
batches daily except Saturday with 6 batches. The time period is B+2.
Who is Resident A person who resides in India for more than 182 days during preceding
Indian? Who is financial year is Resident Indian. A person who is not resident is Non-
Non- Resident Resident.
Who is NRI? A person who is citizen of India but resides outside India owing to:
Employment, Business, vocation-------indicating indefinite period of
stay outside.
Work abroad on assignment with Foreign Govt., UNO, and IMF etc.
Deputation officially.
Study abroad.
PIO - Persons of PIO is a person who is citizen of any other country, but he at any time:
Indian Origin Held Indian Passport
He or his grand-parents or grand grand parents were Indian citizens
by virtue of constitution of India or under Indian Citizenship Act.
The person is spouse of Indian Citizen.
OCB – Overseas OCBs are firms, Cos, Society owned directly or indirectly to the extent of at-
Corporate least 60% by NRIs.
Bodies It also includes overseas trusts where at-least 60% irrevocable beneficial
interest is held by non-residents directly or indirectly.
NRE Deposit Only non-resident Indians can open following NRE accounts with banks:
Accounts Fixed Deposits & Recurring Deposits
SB and CA Deposits
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FCNR- B FCNRB accounts can also be opened by NRIs. The conditions of NRE
accounts deposits as explained above are also applicable on FCNR-B deposits with
the following additional features:
Only FD 1-5 years tenure can be opened.
The amount is kept in Foreign Currency and repaid in the Foreign
Currency.
6 currencies i.e. GBP, USD, Euro, JPY, CAD. AUD are eligible
currencies for opening the account.
No exchange risk for the customer. The bank bears the risk.
Interest on the basis of 360 days in a year
Half yearly intervals of 180 days
Interest exemptions from I.T.
Operating by P/A not permitted.
The amount of Principle and Interest is freely repatriable
Interest Rate on 1-3 years FD is LIBOR + 200 bps and that of 3-5
years FD is LIBOR + 400 bps.(Previously, it was LIBOR + 300 bps)
Rupee Loans Demand Loan or Overdraft is allowed against FDR. There is no maximum
against limitof loan against pledge of FDR (Which was100 lac earlier). The loan
NRE/FCNRB can be availed for :
FDRs Personal purpose.
Investment.
Purchase of property.
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Such account will be treated as resident bank account
Cheques, instruments, remittances, cash, card belonging to the NRI
close relative shall not be eligible for credit to this account
The NRI close relative shall operate such account only for and on
behalf of the resident for domestic payment
Where due to any eventuality, the non-resident account holder becomes
the survivor, it shall be categorized as NRO account
Investments by NRIs are allowed to invest in India on Repatriation basis as well as on Non-
NRIs in India Repatriation basis. NRI can purchase Equity Shares, Preference shares
and Convertible Debentures in Indian companies subject to conditions
under following categories:
1. Foreign Direct Investments.
2. Portfolio Investment
3. Purchase and Sale of Shares on Non-Repatriation basis.
4. Purchase of other securities of Indian Companies.
5. Exchange Traded Derivatives.
Besides above, NRIs are permitted to invest in:
Units of UTI and Mutual Funds
Company Deposits – Minimum 3 years‟ period.
Share in Proprietorship firm/partnership firm provided the firm is not
engaged in Agriculture and Plantation activity or Property business.
Acquiring of Immovable property not being Agriculture, Plantation or
Farm House.
NRI can acquire IP by way of :
Purchase out of funds received in India
By way of gift from resident in India or outside India.
By way of Inheritance from a person resident outside India.
The Income from the property or sale proceeds of the property can be
repatriated outside India up to monetary limit of USD1 Million per financial
year provided all the applicable taxes are paid.
NRIs can invest in Govt. securities, treasury bills on non- repatriation
basis. However, NRI cannot invest in Small saving Schemes including
PPF.
Loans to NRIs NRI can avail the following loans:
1. Rupee Loans in India
- Up to up to any limit subject to prescribed margin.
- For personal purpose, contribution to Capital in Indian
Companies or for acquisition of property.
- Repayment of loan will be either from inward remittances or
from local resources through NRO accounts.
2. Foreign Currency Loans in India
- Against security of funds in FCNR-B deposits.
- Maturity of loan should not exceed due date of deposits.
- Repayment from Fresh remittances or from maturity proceeds of
deposits.
3. Loans to 3rd Parties provided
- There is no direct or indirect consideration for NRE depositor
agreeing to pledge his FD.
- Margin, rate of Interest and Purpose of loan shall be as per RBI
guidelines.
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- The loan will be utilized for personal purpose or business
purpose and not for re-lending or carrying out
Agriculture/Plantation/Real estate activities.
- Loan documents will be executed personally by the depositor
and Power of attorney is not allowed.
4. Housing Loans to NRIs : HL can be sanctioned to NRIs subject to
following conditions:
- Quantum of loan, Margin and period of Repayment shall be
same as applicable to Indian resident.
- The loan shall not be credited to NRE/FCNR account of the
customer.
- EM of IP is must and lien on assets.
- Repayment from remittance abroad or by debit to NRE/FCNR
account or from rental income derived from property.
Portfolio RBI has permitted NRIs to invest in PIS subject to following conditions:
Investment Investment on repatriation as well as non-repatriation basis.
Scheme for NRIs Purchase/Sale of shares and debentures
Through Regd. Brokers
Amount is routed through designated branch.
Only delivery based transactions
Investment on Repatriation basis can be made out of inward
remittances or out of NRE/FCNR deposits.
Investment on Non-Repatriation basis can be made out of NRO
deposits besides NRE/FCNR deposits.
LETTER OF CREDIT
Documentary LC is a document:
Letters of Credit Issued by Buyer‟s bank at his request.
(LC) Carrying undertaking to pay to the seller
Upon presentation of documents evidencing shipping of goods.
In compliance with terms and conditions.
ILC is Inland Letter of Credit and FLC is Foreign Letter of Credit. The
parties to LC are as under:
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Negotiating Bank Bank in Exporter Country which makes payment
or Nominated Bank to exporter or accepts Bill of Exchange.
Confirming Bank In Exporter‟s country. It may be advising bank
also if it adds confirmation. This bank will be
responsible for default, if any.
Reimbursing Bank The bank which reimburses the negotiating
bank. (Usually, it is the bank having Nostro
account of Opening Bank.
UCP– 600 It is a publication of ICC (international Chamber of Commerce). It does not
Uniform Custom apply by default. There must be special mention in LC about applicability of
and Practice of UCPDC – 600. It has 39 articles. Some of the important are here under:
Documentary Issuing Bank gets Reasonable time for acceptance/refusal of
Credit Documents which is 5 Banking days after presentation.
Bank to deal with documents and not with goods. Bank not to check
quality of the goods. However shipping documents must contain the
particulars of commodity shipped which should match with LC.
Bank is not concerned with underlying contract of buyer and seller.
Courts refrain from passing injunction on complaint of importer
regarding any discrepancy of goods.
Amount of Bill may differ from LC amount ±10% (Tolerance limit)
Quantity of Bill may differ from LC specification ±5% (Tolerance
limit).
Documents are original if it carries original signatures, stamp mark
and label of issuer.
Documents must be presented for negotiation within 21
Calendardays from date of Shipment. It becomes stale thereafter.
If expiry of LC falls on Public holiday, under such situations
documents can be submitted on Preceding banking day.
Types of LC LC Type Features
Revocable It is an LC which can be amended or cancelled
without consent of all parties. UCPDC 600 does not
allow issue of such LC.
Irrevocable It is LC which cannot be cancelled or amended
without consent of all parties.
Confirmed LC If confirmed by some bank in exporter country.
Transferable LC It can be transferred in Full or part by advising bank at
the request of issuing bank. ONLY ONCE
Red Clause LC It enables the beneficiary to avail pre-shipment credit
.
Green Clause Besides pre-shipment, advising bank can allow
Letter of Credit advance for storage and shipment.
Revolving LC Where bills are negotiated and LC is automatically
renewed.
Back to Back LC Beneficiary Uses LC to open another LC in favor of
local suppliers.
Standby LC It is issued in lieu of Guarantee. It is substitute of
guarantee and is used in countries like US where
guarantees are not used.
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If nothing is mentioned, LC will be Irrevocable, non-transferable.
Documents under LC
1. Bill of exchange.
2. Invoice
3. Transport Documents: Bill of Lading & Airway Bill
4. Insurance Documents (Insurance is done at 110% of CIF value)
5. Certificate of Origin
Short Bill of Lading: Which does not carry detailed terms and conditions
Thorough Bill of Lading covers entire voyage with several modes of
transport
Straight Bill of Lading is issued directly in the name of consignee.
Clause Bill of Lading: It bears super imposed clause that declared
defective condition of Goods.
Clean Bill of Lading: It has no such super imposed clause declaring
goods or packaging as defective.
Crystallization of It is incumbent upon the issuing bank to make payment immediately.
Foreign In case of sight documents, the issuing bank can hold documents for
currency maximum period of 10 days. In case the bill is not retired or paid within this
Liability period, the issuing bank will crystallize the liability on 10th day at Bill
Selling rate or the rate at which the contract was booked (whichever is
higher)
In case of Usance bill, Forex liability will be crystallized on due date into
Indian Rupees at Bill Selling rate or Contracted Rate (which is higher)
Inco Terms Ex-Works
Exporter says that goods can be picked up from Factory. Exporter will not
pay the freight. The transport cost and risk will be borne by the Importer.
FCA (Main Freight Paid by Buyer)
Free Carrier means seller hands over the goods to first Carrier.
FAS (Main Freight Paid by Buyer)
Free alongside ship i.e. Goods will be delivered by exporter to shipping co.
FOB (Main Freight Paid by Buyer)
Free on Board (Say FOB Mangalore) means Goods will be loaded on
ship/Aero plane (main carriage still unpaid by the exporter)
CFR (Cost and Freight Paid by Seller)
Seller will pay cost and freight till destination
CIF (Cost, Insurance and Freight paid by Seller)
The cost, Insurance and Freight will be borne by seller.
Other related
guidelines UCPDC does not apply by default. It is required to be mentioned on
LC
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EXPORTS
RBI and DGFT RBI controls Foreign Exchange and DGFT (Directorate General of Foreign
Trade) controls Foreign Trade. Exim Policy as framed in accordance with
FEMA is implemented by DGFT. DGFT functions under direct control of
Ministry of Commerce and Industry. It regulates Imports and Exports
through EXIM Policy.
On the other hand, RBI keeps Forex Reserves, Finances Export trade and
Regulates exchange control. Receipts and Payments of Forex are also
handled by RBI.
IEC - Importer One has to apply for IEC to become eligible for Imports and Exports. DGFT
Exporter Code allots IEC to Exporters and Importers in accordance with RBI guidelines
and FEMA regulations. EXIM Policy is also considered before allotting IEC.
Export All exports (physically or otherwise) shall be declared in the following Form.
Declaration 1. GR form--- meant for exports made otherwise than by post.
Form 2. PP Form---meant for exports by post parcel.
3. Softex form---meant for export of software.
4. SDF (Statutory Declaration Form)----replaced GR form in order to
submit declaration electronically.
SDF is submitted in duplicate with Custom Commissioned who puts its
stamp and hands over the same to exporter marked “Exchange Control
Copy” for submission thereof to AD.
Exemptions
Up to USD 25000 (value) – Goods or services as declared by the
exporter.
Trade Samples, Personal effects and Central Govt. goods.
Gift items having value up to Rs. 5.00 lac.
Goods with value not exceeding USD 1000 value to Myanmar.
Goods imported free of cost for re-export.
Goods sent for testing.
ADs may consider waiver for export of goods free of cost for export
promotion up to 2% of average annual exports of previous 3 years subject
to ceiling of Rs. 5.00 lac. The limit is Rs. 10.00 lac for Status Holder
Exporters.
Prescribed Time The time norms for export trade are as under:
limits Submission of documents with “Exchange Control Copy” to AD
within 21 days from date of shipment.
Time period for realization of Export proceeds is has been reduced
to 9M for all types of exports including exports to SEZ (Special
economic zones), SHE(Status Holder Exporters) and 100%EOUs.
Previously, the time period was 12Months for SEZs and SHEs.
For, Exports to Warehouse established outside India, as soon as it
is realized and in any case within fifteen months from the date of
shipment of goods
After expiry of time limit, extension is sought by Exporter on ETX
Form. The AD can extend the period by 6M.
However, reporting will be made to RBI on XOS Form on half yearly basis
19
in respect of all overdue bills which remained outstanding for more than
prescribed period or the bills which are overdue
Direct Dispatch AD banks may handle direct dispatch of shipping documents provided
of Shipping export proceeds are up to USD 1 Million and the exporter is regular
Documents customer of at least 6 months.
Advance Exporters may receive advance payments from their overseas importers
Payments provided:
Shipment is made within 1 year from receipt of advance.
Rate of interest payable should not exceed LIBOR+100 bps.
Documents are routed through AD from which advance was routed.
Prescribed Exporter will receive payment though any of the following mode:
Method of Bank Drafts, TC, Currency, FCNR/NRE deposits, International
payment and Credit Card. But the proceeds can be in Indian Rupees from Nepal
Reduction in and Bhutan.
export proceeds Export proceeds from ACU countries can be settled in ACU/EURO
or ACU/Dollar. A separate Dollar/Euro account is maintained which
is denominated as ACU Dollar or ACU EURO.
ACU – Asian Clearing Union was formed in Tehran, Iran in 1974 and it
comprises of following 9 countries as members.
20
Pre-shipment Packing credit has the following features:
Finance or
Packing Credit 1. Calculation of FOB value of order/LC amount or Domestic cost of
production (whichever is lower).
2. IEC allotted by DGFT.
3. Exporter should not be on the “Caution List” of RBI.
4. He should not be under “Specific Approval list” of ECGC.
5. There must be valid Export order or LC.
6. Account should be KYC compliant.
Post Shipment Post shipment finance is made available to exporters on the following
Finance conditions:
IEC accompanied by prescribed declaration on GR/PP/Softex/SDF
form must be submitted.
Documents must be submitted by exporter within 21 days of
shipment.
Payment must be made in approved manner within 6 months.
Normal Transit Period is 25 days.
The margin is NIL normally. But in any case, it should not exceed
10% if LC is there otherwise it can be up to 25%.
Types of Post Shipment Finance:
Export Bills Purchased for sights bills and Discounting for Usance
bills.
Export bills negotiation.
Discrepancies of Documents
Late Shipment, LC expired, Late presentation of shipping documents, Bill
of Lading not signed properly, Incomplete Bill of Lading, Clause Bill of
Lading , Short Bill of Lading or Inadequate Insurance.
Advance against Un-drawn Balance
Undrawn balance is the amount less received from Importers. Bank can
finance up to 10% undrawn amount up to maximum period of 90 days.
Advance against Duty Drawback
Duty drawback is the support by Government by way of refund of
Excise/Custom duty in case the domestic cost of the product is higher than
the Price charged from the importer. This is done to boost exports despite
international competition. Bank can make loan to exporter against Duty
Drawback up to maximum period of 90 days.
GATS Credit can be afforded to exporters of all the 161 services covered under
GATS “General Agreement on Trade in Services”. The provisions
applicable to export of goods apply mutatis mutandis to export of services.
21
Crystallization of Consequent upon non-realization, Conversion of Foreign Exchange liability
Overdue Bills into Rupees is called crystallization. It is done on 30th day from notional
due date at prevailing TT selling rate or Original Bill Buying Rate
(Whichever is higher).
DA Bills
Notional due date is calculated in DA Bill by adding normal period of transit
i.e. 25 days in the Usance period. 30th day is taken from notional due date.
DP Bills
30th day after Normal Transit Period
Export of Credit can be provided to exporters of all 161 tradable services covered
services under GATS (General Agreement on Trade in services) where payment for
such services is received in Forex. The provisions applicable to export of
goods apply to export of services.
Gold Card All exporters in Small and Medium Sector with good track record are
Scheme eligible to avail Gold Card Scheme. The conditions are :
1. Account should be classified as Standard assets for the last 3
years.
2. Limit is sanctioned for 3 years and thereafter automatic renewal.
3. There is provision of 20% Standby limit.
4. Packing Credit is allowed in Foreign currency.
5. Concessional rate is allowed for 90 days initially which can be
extended for 360 days.
6. Bank may waive collateral and provide exemption from ECGC
Guarantee schemes.
7.
Factoring and Factoring is financing and collection of Receivables. The client sells
Forfaiting Receivables at discount to Factor in order to raise finance for Working
Capital. It may be with or without recourse. Factor finances about 80%
and balance of 20% is paid after collection from the borrower. Bill should
carry LR/RR. Maximum Debt period permitted is 150 days inclusive of
grace period of 60 days. Debts are assigned in favour of Factor. There are
2 factors in International Factoring. One is Export Factor and the other is
Import Factor. Importer pays to Import factor who remits the same to Export
Factor.
22
Pre-shipment & Post-shipment Finance
Q. 1
Received order of USD 50000(CIF) to Australia on 1.1.11 when USD/INR Bill Buying Rate is
43.50. How much pre-shipment finance will be released considering profit margin of 10% and
Insurance and freight cost@ 12%. Contribution from borrower is 25%.
Solution
FOB Value = CIF – Insurance and Freight – Profit (Calculation at Bill Buying Rate on 1.1.11)
= 50000X43.5 = 2175000 – 261000(12%) – 191400(10% of 1914000) = 1722600
Pre-shipment Finance = FOB value - 25% (Margin) = 1722600-430650=1291950.Ans.
Q. 2
What will be amount of Post-shipment Finance under Foreign Bill Purchased for USD 45000
when Bill Buying rate on 31.3.11 (date of submission of Export documents) is 43.85
Solution
45000X43.85 = 1973250 Ans.
Q. 3
Period for which concessional Rate of Interest is charged on DP bills from date of purchase.
Solution
25 days.Ans.
Q. 4 If the above said bill remains overdue for 2 months, what will be date of crystallization?
Due Date of Bill will be 31.3.11 + 25 days = 25.4.2011
The bill will be crystallized on 24.5.2011 i.e. on 30th day from due date. Ans.
Q. 5
On 8th Sep, an exporter tenders a demand bill for USD 100000 drawn on New York. The
USD/INR quote is as under:
Spot---------USD 1 =34.3000/3500
Spot Sep-------------------6000/7000
Spot Oct--------------------8000/9000
Spot Nov------------------10000/11000
Transit Period is 20 days and Exchange margin 0.15%
Calculate Rupee payable to the customer. Customer wants to retain 15% in Dollars
Interest @13% has to be charged on INR liability of the customer.
Solution
Since, the currency is at premium, the transit period will be rounded off to the lower month
(i.e. NIL). And the rate to the customer will be based on Spot Rate. If interest rate is 13%, how
much interest will be recovered from the Exporter
23
Q. 6
On 26th Aug, an exporter tenders for purchase a bill payable 60 days from sight and drawn on
New York for USD 25650. The dollar rupee rate is as under:
Spot----------------------1USD = 34.6525/6850
Spot Sep--------------------------------1500/1400
Spot Oct---------------------------------2800/2700
Spot Nov--------------------------------4200/4100
Spot Dec--------------------------------5600/5500
Exchange Margin is 0.15%, Transit Period is 20 days. Rate of Interest is 13%. An amount of Rs.
500/- on account of Out of Pocket expenses has to be charged.
What will be the exchange rate payable to the customer and Rupee amount payable?
Solution
Notional due Date = 20+60 days from 26th Aug i.e. 14th Nov. Since, the currency is at discount,
the period will be rounded off to the same month). Obviously, the discount of Nov will be more
and it will make the Buy Rate Lower.
IMPORTS
Imports – Pre- AD1 banks are to ensure that Imports are in accordance with:
requisites Exim Policy
RBI Guidelines
FEMA Rules
Goods are as per OGL (Open General list).
Importer is having IEC (Import Export Code) issued by DGFT.
Imports The following are essential elements of Imports:
Formalities & 1. An importer before remitting proceeds exceeding USD 5000 must
Time limit for submit application on Form A-1 to the Authorized Dealer.
import payment 2. AD banks can issue LC on the basis of License and Exchange
Control Copy.
24
Advance AD Banks may remit advance payment of Imports subject to following
Remittances conditions:
Up to USD 200000 or equivalent after satisfying about nature of
transaction, trade and standing of Supplier.
In excess of 2,00,000 USD, an irrevocable Standby LC or
Guarantee from a bank of international repute or a guarantee from
bank in India, if such guarantee is issued against Counter guarantee
of International bank outside India.
The requirement of guarantee may not be insisted upon in case of
remittances above USD200000 up to USD 50, 00,000 (5 million)
subject to suitable policy framed by BOD of bank. The AD should be
satisfied with track record of the exporter.
Approval of RBI is required only if Advance remittance exceeds
USD 50,00000 or equivalent.
Advance remittance will be made direct to overseas supplier or his
bank.
Physical imports must be made within 6 months from date of
Remittance. For Capital goods, the period is 3 years.
Evidence of Importer must submit Evidence of Imports i.e. Exchange control copy of
Imports “Bill Of Entry”. The AD will ensure receipt of Bill Of Entry in all cases
where Value of Forex exceeds USD 100000, within 3 months from date of
remittance.
Import Finance Importer can avail finance from banks/FIs in the shape of :
1. Letter of Credit
2. Import Loans against Pledge/Hypothecation of stocks.
3. Trade Credit – Supplier Credit or Buyer Credit.
Trade Credit If the Import proceeds are not remitted, within 6 months, it is treated as
Trade Credit up to the period less than 3 years. For period 3 years and
above, the credit is called ECB (External Commercial Borrowings).
Types of Trade Credit: There are two types of Trade Credit:
1. Suppliers Credit
2. Buyers Credit
Suppliers’ Credit
It is credit extended by Overseas suppliers to Importer normally beyond 6
months up to period of 3 years.
Up to 1 year for Current Account Transactions
Up to Less than 3 years for Capital Account Transactions
Monetary Limit is USD 20 million per transaction.
Buyers’ Credit
It is credit arranged by Importer from Banks/FIs outside countries. Banks
can approve proposals of Buyers‟ Credit with period of Maturity:
Up to 1 year for Current Account Transactions
Up to Less than 3 years for Capital Account Transactions
Monetary Limit is USD 20 million per transaction.
25
Crystallization of In case the importer fails to make payment,
Foreign Crystallization of Foreign Exchange liability into Indian Rupees is done on
Currency 10th day at Bill selling Rate or Original Bill Selling rate (whichever is
Liability into INR higher)
All-in Cost The present Ceilings for all-in-cost, including interest for buyers‟/suppliers‟
Ceiling credit, as fixed by RBI is as under:
1. Up to 365 days –--------------------- 6M LIBOR + 350 bps
2. Above 1 year up to 3 years ---------6M LIBOR + 350 bps
These ceilings include management fees, arrangement fees etc.
Example On 12th Feb, a customer has received an Import bill for USD 10000/-. He
asks you to retire the bill to the debit of the account. Considering Exchange
margin 0.15% for TT sales and 0.20% on Bill Selling Rate. What amount
will be debited to the account? Spot rate is 34.6500/34.7200
Spot march = 5000/4500
26
Whichever is higher
th
Crystallization of LC liability on 10 day Bill Selling rate or
Contracted rate
Whichever is higher
Retirement of Import Bill Bill Selling rate
Crystallization of Import bill on 10th day If Bill Selling rate or
there is default by the buyer Contracted rate
Whichever is higher
Cancellation of Forward Purchase TT selling rate
Contract on 7th working day after due date
Cancellation of Forward Sales Contract TT buying rate
on 7th Working Day after due date
Risks in Foreign trade risk may be defined as Uncertainty or Unplanned events with
International financial consequences resulting into loss. Types of Risks are as under:
Trade 1. Buyers‟ Risk: Non-Acceptance or non-payment
2. Sellers‟ Risk: Non- shipping or Shipping of poor quality goods or
delay.
3. Shipping Risk: Mishandling, Goods siphoned off, Strike by potters or
wrong delivery.
4. Other Risks:
- Credit Risk
- Legal Risk
- Country Risk
- Operational Risk
- Exchange Risk
5. Country Risk
Provision of risk is made if Exposure to one country is 1% or more of total
assets. ECGC has the list of Country Risk Ratings which can be referred to
by the Banks and the banks can make their own country risk policy.
Risk Export Credit and Guarantee Corporation provides guarantee cover for risks
Classification which can be availed by the banks after making payment of Premium.
of Countries ECGC adopts 7 fold classification covering 204 countries. The list is updated
and published on quarterly basis. The latest classification is as under:
1. Insignificant Risks A1
2. Low Risk A2
3. Moderately Low Risk B1
4. Moderate Risk B2
5. Moderately High Risk C1
6. High Risk C2
7. Very High Risk D
Besides above, 20 countries have been placed in “Restricted Cover
Group-1” where revolving limits are approved by ECGC and these are valid
for 1 year.
The other 13 countries are placed in “Restricted Cover Group-2” where
specific approval is given on case to case basis by ECGC.
27
ECGC _ Export ECGC was established in 1964. Export Credit and Guarantee Corporation
Credit and provides guarantee cover for risks which can be availed by the banks after
Guarantee making payment of Premium. Its activities are governed by IRDA.
Corporation The functions of ECGC are 3 fold:
1. It rates the different countries.
2. It issues Insurance Policies.
3. It guarantees proceeds of Exports.
Types of Policies:
1. Standard Policies
It provides cover for exporters for short term exports. These cover
Commercial and Political Risks. The different types of Policies are:
- Shipment (Comprehensive Risk) Policy – to cover
commercial and political risks from date of shipment. Default
of 4 months.
- Shipment (Political Risks) Policy.
- Contracts (Comprehensive Risk) Policy for both commercial
and Political risks.
- Contracts (Political Risks) Policy
2. Small Exporters’ policy
A small exporter is defined whose anticipated total export turnover
for the period of 12 M is not more than 50 lac. The policy is issued
to cover shipments 24 M ahead.
28
ECIB – PC – for individual exporters. The advance should be categorized as
Standard Asset. The period of coverage is 12M and %age of cover is 66-
2/3 %. The premium is 12 paisa% per month on highest outstanding.
- Monthly declaration by banks before 10th.
- Approval of Corporation beyond 360 days PC.
- Report of default within 4M from due date.
- Filing of claim within 6M of the report.
ECIB –(WT- PS) – Whole Turnover Post Shipment Credit Policy
- It is a common policy for all exporters.
- Advances against export bills are covered.
- Premium is 5-9 paisa % per month.
- Cover is usually 60-75%.
- If the cover is taken by exporter individually, the cover increases to
75-90%.
Export Finance When banks make advance to exporters against export incentives
Guarantee receivables like Duty Drawback etc. The cover available is 75% and the
premium ranges from 7 paisa onwards.
Exchange The cover is available for payment schedule over 12 months up to maximum
Fluctuation period of 15 years. Cover is available for payments specified in USD, GBP,
Risk Cover EURO, JPY, SWF, AUD and it can be extended for other convertible
Scheme currencies.
The contract cover provided a franchise of 2% Loss or gain within range of
2% of reference rate will go to the account of the exporter. If the loss
exceeds 2% , the ECGC will make good the portion of loss in excess of 2%
but not exceeding 35%.
The other guarantees are:
- Export Performance Guarantee
- Export Finance (Overseas Lending) Guarantee.
Transfer guarantee – cover to the confirming bank in India.
29
EXIM BANK
Exim Bank – its Exim Bank (Export/Import Bank) was established in 1981 with the objective
functions of financing Import Export Trade especially on Long term basis. The
functions of Exim bank are as under:
Offering Finance for Exports at competitive rates.
Developing alternate financial solution
Data and Information about new export opportunities.
Respond to export problems and pursue Policy solutions.
30
RESERVE BANK OF INDIA
FEMA The important FEMA guidelines with regard to Foreign exchange are as
provisions under:
1. No drawl of exchange for Nepal and Bhutan
2. If Rupee equivalent exceeds Rs. 50000/-, payment by way of
crossed Cheque.
3. During visit abroad, one can carry foreign currency notes up to USD
3000 or equivalent. For Libya and Iraq, the limit is USD5000 and the
entire amount for Iran and Russian states.
4. Indian citizens can retain and possess foreign currency up to USD
2000 or its equivalent.
5. Unspent currency must be surrendered within a period of 180 days
after arrival in India.
Basic Travel Quota (BTQ)
LRS (Liberalized The scheme is meant for Resident Indians individuals. They can freely
Remittance remit up USD 125000 per financial year in respect of any current or capital
Scheme) account transaction without prior approval of RBI. The precondition is that
the remitter should have been a customer of the bank for the last 1 year.
PAN is mandatory.
Not Applicable
The scheme is not applicable for remittance to Nepal, Bhutan, Pak,
Mauritius or other counties identified by FATF.
The scheme is not meant for remittance by Corporate.
Latest Guidelines
The scheme should not be used for making remittances for any
prohibited or illegal activities such as margin trading, lottery etc., as
hitherto.
Resident individuals have now been allowed to set up Joint
Ventures (JV) / Wholly Owned Subsidiaries (WOS) outside India for
31
bonafide business activities outside India within the limit of USD
125000
The limit for gift in Rupees by Resident Individuals to NRI close
relatives and loans in Rupees by resident individuals to NRI close
relatives shall accordingly stand modified to USD 1,25,000 per
financial year.
RBI has clarified that Scheme can now be used for acquisition of IP
outside India.
Any amount can be taken out while going to Nepal and Bhutan in any
denomination. (Prev. Notes up to 100 denomination were allowed)
Restrictions Customer is required to furnish PAN No. for cash remittance beyond
25000/-.
If rupee equivalent is 50000/- and above, the entire payment has to
be made by way of crossed cheque or DD.
RETURNS TO Following important returns are submitted to RBI
BE SUBMITTED R- Returns Forex Operations (Fortnightly)
TO RBI BAL statement Balance in Nostro/Vostro account
STAT 5 Transactions in FCNR B accounts
(Fortnightly)
STAT 8 Transactions in NRE/NRO accounts
(Fortnightly
LRS Statement UP to USD 200000 (monthly)
Trade Credit Statement Buyers‟ and Suppliers‟ Credit
XOS O/S Overdue Export bills (6M overdue)
BEF Import Remittance effected but Bill of Entry
not submitted for >3M.
ETX Form Seeking relaxation from RBI after expiry of
12M when export proceeds are not received.
„
RFC accounts Resident Foreign Currency account is opened by Indian residents who
were earlier NRIs and Forex is received by them from their overseas dues:
The accounts can be opened as SB/CA/FD type.
Proceeds are received from overseas.
Out of Monetary benefits accruing abroad
The funds are freely repatriable.
Minimum amount is USD 5000.
32
RFC- D accounts Resident Foreign Currency (Domestic) accounts are opened:
By Indian residents who visit abroad: and
Bring with them Foreign Exchange;
As honorarium, gift etc.
Unspent money can also be deposited.
These are CA nature accounts and no interest is paid.
33
In case of extension of contract, previous contract will be cancelled
at TT Buying rate or TT selling rate as the case may be.
Overdue contracts are liable to be cancelled on 7th working day
after maturity date if no instructions are received. The contracts
must state first and last date of the contract.
Banks are now free to fix their own rates of commission and margin
etc.
AP may be imposed penalty up to 3 times of contravention amount. If
amount is not quantifiable, up to 2.00 lac and up to 5000/- per day is
imposed, if the contravention continues.
ECBs – External External Commercial Borrowings are medium and long term loans as
Commercial permitted by RBI for the purpose of :
Borrowings Fresh investments
Expansion of existing facilities
Trade Credit (Buyers‟ Credit and Sellers‟ Credit) for 3 years or
more.
Automatic Rout
ECB for investment in Real Estate sector , Industrial sector and
Infrastructure do not require RBI approval
It can be availed by Companies registered under Indian Company
Act.
Funds to be raised from Internationally recognized sources such as
banks, Capital markets etc.
Maximum amount per transaction is USD 20 million with minimum
average maturity of 3 years
Maximum amount per transaction is USD 750 million with
minimum average maturity of 5 years
.
All in cost ceiling is :
ECB up to 5 years : 6M LIBOR+350 bps.
ECBs above 5 years: 6M LIBOR+500 bps.
Approval Route
Under this route, funds are borrowed after seeking approval from RBI.
The ECBs not falling under Automatic route are covered under
Approval Route.
Under this route, Issuance of guarantees and Standby LC are not
allowed.
Funds are to be raised from recognized lenders with similar caps of
all-in-cost ceiling.
ADRs – American Depository Receipts are Receipts or Certificates issued by US
American Bank representing specified number of shares of non-US Companies.
Depository Defined as under:
Receipts These are issued in capital market of USA alone.
These represent securities of companies of other countries.
These securities are traded in US market.
The US Bank is depository in this case.
ADR is the evidence of ownership of the underlying shares.
34
Unsponsored ADRs
It is the arrangement initiated by US brokers. US Depository banks create
such ADRs. The depository has to Register ADRs with SEC (Security
Exchange Commission).
Sponsored ADRs
Issuing Company initiates the process. It promotes the company‟s ADRs in
the USA. It chooses single Depository bank. Registration with SEC is not
compulsory. However, unregistered ADRs are not listed in US exchanges.
GDRs – Global Global Depository Receipt is a Dollar denominated instrument with
Depository following features:
Receipts 1. Traded in Stock exchanges of Europe.
2. Represents shares of other countries.
3. Depository bank in Europe acquires these shares and issues
“Receipts” to investors.
4. GDRs do-not carry voting rights.
5. Dividend is paid in local currency and there is no exchange risk for
the issuing company.
6. Issuing Co. collects proceeds in foreign currency which can be used
locally for meeting Foreign exchange requirements of Import.
7. GDRS are normally listed on “Luxembourg Exchange “ and traded
in OTC market London and private placement in USA.
8. It can be converted in underlying shares.
IDRs – Indian Indian Depository Receipts are traded in local exchanges and represent
Deposits security of Overseas Companies.
Receipts
CDF (Currency CDF is required to be submitted by the person on his arrival to India at the
Declaration Airport to the custom Authorities in the following cases:
Form) 1. If aggregate of Foreign Exchange including foreign currency/TCs
exceeds USD 10000 or its equivalent.
2. If aggregate value of currency notes (cash portion) exceeds USD
5000 or its equivalent.
Form A1 and Form A1 is meant for remittance abroad to settle imports obligations. It is
Form A2 not required if value of imports is up to USD 5000.
35
of 7%. It should be ensured that the benefit of 3% interest subvention is
passed on completely to the eligible exporters.
Foreign It has been decided to liberalize this facility further. Accordingly, AD Category
Currency - I banks may henceforth borrow funds from their Head Office, overseas
Borrowings branches and correspondents and overdrafts in Nostro accounts up to a limit
by ADs from of 100 per cent of their unimpaired Tier I capital as at the close of the
Overseas previous quarter or USD 10 million (or its equivalent), whichever is higher,
as against the existing limit of 50 per cent (excluding borrowings for financing
of export credit in foreign currency and capital instruments).
Trade Credit – Banks may approve availing of trade credit not exceeding USD 20 million up
Revised RBI to a maximum period of five years (from the date of shipment) for companies
guidelines in the infrastructure sector, subject to certain terms and conditions stipulated
therein.
Crystallization RBI has advised that AD will crystallize i.e. convert foreign currency deposit
of Inoperative (with fixed maturity date) into INR, if remains in-operative for 3 years from
Foreign date of maturity.
Currency
Deposits If a deposit account has not been operated for 10 years, the amount will be
transferred to DEAF.
36
Module - B
RISK MANAGEMENT
RISKS and CAPITAL
36
Risk Management
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).
Types of Risks Risk is anticipated at Transaction level as well as at Portfolio level.
Transaction Level
Credit Risk, Market Risk and Operational Risk are transaction level risk
and are managed at Unit level.
Portfolio Level
Liquidity Risk and Interest Rate Risk are also transaction level risks but
are managed at Portfolio level.
Risk Measurement
Based on Sensitivity
It is change in Market Value due to 1% change in interest rates. The interest rate gap is
sensitivity of the interest rate margin of Banking book. Duration is sensitivity of Investment
portfolio or Trading book.
Based on Volatility:
It is common statistical measure of dispersion around the average of any random variable
such as earnings, Mark to market values, losses due to default etc.
Downside Potential
It captures only possible losses ignoring profits and risk calculation is done keeping in view
two components:
1. Potential losses 2. Probability of Occurrence.
The measure is more relied upon by banks/FIs/RBI. VaR (Value at Risk is a downside Risk
Measure.)
37
Risk Pricing Risk Premium is added in the interest rate because of the following:
Necessary Capital is to be maintained as per regulatory
requirements.
Capital is raised with cost.
For example there are 100 loan accounts with Level 2 Risk. It means
there can be average loss of 2% on such type of loan accounts: Risk
Premium of 2% will be added in Rate of Interest.
Diversification of Advances
Business Year1 2 3 4 5 Total Mean sd
A
(Cash 10 3 4 8 11 36 7.20 3.56
flow)
38
Guarantees, LC and other obligations. It includes Derivatives also.
These may form part of Trading Book or Banking Book after they
become Fund based exposure.
Types of Risks
1. Liquidity Risk
It is inability to obtain funds at reasonable rates for meeting Cash flow obligations.
Liquidity Risk is of following types:
Funding Risk: It is risk of unanticipated withdrawals and non-renewal of FDs which
are raw material for Fund based facilities.
Time Risk: It is risk of non-receipt of expected inflows from loans in time due to
high rate NPAs which will create liquidity crisis.
Call Risk: It is risk of crystallization of contingent liabilities.
39
people and the system. The external factors like dacoity, floods, fire etc. may also
cause operational loss. It includes Frauds Risk, Communication Risk,
Documentation Risk, Regulatory Risk, Compliance Risk and legal risks but
excludes strategic /reputation risks.
Two of these risks are frequently occurred.
Transaction Risk: Risk arising from fraud, failed business processes and inability
to maintain Business Continuity.
Compliance Risk: Failure to comply with applicable laws, regulations, Code of
Conduct may attract penalties and compensation.
40
Tier I & Tier II Tier –I Capital
Capital Tier –I Capital includes
Equity capital & Statutory reserves,
Other disclosed free reserves,
Capital Reserve representing surplus out of sale proceeds of
assets,
Investment fluctuation reserve without ceiling,
Innovative perpetual Debt instruments (Max. 15% of Tier I
capital)
Perpetual non-cumulative Preference shares
( Less Intangible assets & Losses)
(Sum total of Innovative Debt Instruments and Preference shares as
stated above should not exceed 40% of Tier I capital. Rest amount will
be treated as Tier II capital.)
41
Other banks having CRR from 6% to <9% 50%
Secured loan to staff 20%
Other Staff loans -not covered by retirement dues 75%
Loans upto 1.00 lac against Gold/Silver 50%
Mortgage based securitization of assets 77.5%
Consumer Credit / Credit Cards/Shares loan 125%
Claims secured by NBFC-non-deposit taking 100%
(other than AFCs)
Venture Capital 150%
Commercial Real Estates 100%
Education Loans 75%
Other loans (Agriculture, Exports) 100%
42
Credit Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms
and conditions. In terms of extant guidelines contained in BASEL-II, there are three
approaches to measure Credit Risk given as under:
1. Standardized approach
2. IRB (Internal Rating Based) Foundation approach
3. IRB (Internal Rating Based) Advanced approach
1. Standardized Approach
RBI has directed all banks to adopt Standardized approach in respect of Credit Risks.
Under standardized approach, risk rating will be done by credit agencies. Following
Agencies are approved for external rating:
1. CARE 2. FITCH India (New name – India Rating.) 3.CRISIL 4. ICRA 5.Brickwork
6. SMERA (For SME units) and 7. Onicara (also for SME units)
Risk weights prescribed by RBI are as under:
Rated Corporate
Rating Risk Percentage
AAA 20%
AA 30%
A 50%
BBB 100%
BB & below 150%
Education Loans 75%
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Bank has developed its own rating module system to rate the undertaking internally. The
internal rating is being used for the following purposes:
1. Credit decisions
2. Determination of Powers
3. Price fixing
Credit Risk Management Department (CRMD) is responsible for implementing the Risk
Identification and Risk mitigate strategies.
Risk Identification
Credit risk has two components:
1. Default risk
2. Credit Spread Risk or Downgrade risk
Credit Risk at portfolio level is of following two types:
1. Systemic risk
2. Concentration risk – due to non- diversification
Rating Migration
Rating migration is change in the rating of a borrower over a period of time when rated on
the same standard or model.
Rating Migration of loan accounts based on internal rating of HSBC between 31.3.11 &
31.3.12 is as under:
44
BBB 200 10 120 30 40
45
Example -1
Bank has given loan of Rs. 400 lac to A rated Company for 5 years, out of which 2
year period has already lapsed and there has been no default. Present outstanding is
300 lac.
EAD (Exposure at Default) = 100% and
LGD (Loss Given Default + 50%
Find the expected loss on this account?
Solution:
It will be solved as under:
EAD X Probability of default X LGD =
Example -2
Solution:
Expected Loss = EAD*PD*LGD
= 400*100%*.4%*50%
=80000 ---------Ans
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How to Calculate RWAs and Capital Charge in respect of Credit risk
Ist Step : Calculate Fund Based and Non Fund Based Adjusted Exposure
2nd Step: Deduct Allowable Reduction after applying haircuts
3rd Step : Apply Risk Weights as per Ratings
4th Step: Calculate Risk Weighted Assets
5th Step : Calculate Capital Charge
Ist Step: Calculate Fund Based and Non Fund Based Exposure:
Example:
Fund Based Exposure (Amount in ‗000)
Nature of loan Limit Outstanding Undrawn portion
CC 200 100 100
Bills Purchased 60 30 30
Packing Credit 40 30 10
Term Loan 200 40 160
Total 200
Out of Undrawn portion of TL, 60 is to drawn in a year and balance
beyond 1 year.
Adjusted Exposure:
100% Outstanding(Unrated) = 200
20% of Undrawn CC, BP & PC (140*20/100) = 28
20% of Undrawn TL (1 yr) (60*20/100) = 12
50% of Undrawn TL (>1Yr) (100*50/100) = 50
Total Adjusted Exposure FB limits 290
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2nd Step: Allowable Reduction after adjusting CRMs (Credit Risk Mitigates)
Reduction from adjusted exposure is made on account of following eligible financial
collaterals:
Eligible Financial Collaterals.
Deposits being maintained by a borrower under lien.
Cash (including CDs or FDs), Gold, Govt Securities, KVP, NSC, LIC Policy, Debt
Securities, Mutual Funds‘
Equity and convertible bonds are no more eligible CRMs.
(C=Amount of Deposit; Hfx =0 (if same currency), Hfx = 0.08 (if diff currency) Mf =
Maturity factor).
There is a demand loan of Rs 100 secured by bank‘s own deposit of Rs 125. The haircuts
for exposure and collateral would be zero. There is no maturity mismatch. Adjusted
exposure and collateral after application of haircuts would be Rs 100 and Rs 125
respectively. Net exposure for the purpose of RWA would be zero
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Other Examples
No. 1:
1. Exposure----------------------------------------- 100 lac with tenure 3 years
2. Eligible Collateral in A+ Debt Security -----30 lac with Residual maturity 2 years
3. Hair cut on Collateral is 6%
4. Table of Maturity factor shows hair cut as 0.25 for remaining maturity of 2 years/3
years
Calculate Value of Exposure after Risk Mitigation?
Solution:
Value of Exposure after Risk Mitigation =
Current Value of Exposure – Value of adjusted collateral for Hair cut and maturity mismatch
Value of Adjusted Collateral for Hair cut = C*(1-Hc) = 30(1-6%) = 30*94% = 28.20
Value of Adjusted Collateral for Hair cut and Maturity Mismatch = C* (t-0.25)
(T-0.25)
= 28.20*(2-.25)/(3-.25) = 17.95
( Where t = Remaining maturity of Collateral T= Tenure of loan )
No. 2
An exposure of Rs. 100 lac is backed by lien on FD of 30 lac. There is no mismatch of
maturity.
Solution:
Hair Cut for CRM i.e. FDR is zero.
Hence Value of Exposure after Risk Mitigation is 100 lac – 30 lac = 70 lac.
Computation of CRAR
In a bank ; Tier 1 Capital = 1000 crore
Tier II Capital = 1200 crore
RWAs for Credit Risk = 10000 crore
Capital Charge for Market Risk = 500 crore
Capital Charge for Op Risk = 300 crore
Find Tier I CRAR and Total CRAR.
Solution:
RWAs for Credit Risk = 10000 crore
RWAs for Market Risk = 500/.09 = 5556 crore
RWAs for Op Risk = 300/.09 = 3333 crore
Total RWS = 10000+5556+3333 = 18889 crore
Tier I Capital = 1000 crore
Tier II Capital can be up to maximum 1000 crore
Total Capital = 2000 crore
Tier I CRAR = Eligible Tier I Capital /Total RWAs = 1000/18889=5.29%
Total CRAR = Eligible Total Capital /Total RWAs = 2000/18889 = 10.59%
We may conclude that Tier I Capital is less than the required level.
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Credit Risk Mitigates
It is a process through which credit Risk is reduced or transferred to counter party. CRM
techniques are adopted at Transaction level as well as at Portfolio level as under:
At Transaction level:
Obtaining Cash Collaterals
Obtaining guarantees
At portfolio level
Securitization
Collateral Loan Obligations and Credit Linked Notes
Credit Derivatives
What is LRM?
It is Loan Review Mechanism used to evaluate quality of loans and bring improvement in
credit administration.
1. Securitization
It is process/transactions in which financial securities are issued against cash flow
generated from pool of assets. Cash flow arising from receipt of Interest and Principal of
loans are used to pay interest and repayment of securities. SPV (Special Purpose
Vehicle) is created for the said purpose. Originating bank transfers assets to SPV and it
issues financial securities which are called PTC (Pass Through Certificates).
3. Credit Derivatives
It is managing risks without affecting portfolio size. Risk is transferred without transfer of
assets from the Balance Sheet though OTC bilateral contract. These are Off Balance Sheet
Financial Instruments. Credit Insurance and LC are similar to Credit derivatives. Under a
Credit Derivative PB (Protection buyer) enters into an agreement with PS (Protection
seller) for transfer of risks at notional value by making of Premium payments. In case of
delinquencies, default, Foreclosure, prepayments, PS compensates PB for the losses.
Settlement can be Physical or Cash. Under physical settlement, asset is transferred
whereas under Cash settlement, only loss is compensated.
Credit Derivatives are generally OTC instruments. ISDA (International Swaps and
Derivatives Association) has come out with documentation evidencing such transaction.
Credit Derivatives are:
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1. Credit Default Swaps
In Total Return Swap, PB swaps with PS, total return on an asset by making
payment of premium. It covers both credit risk and market risk.
CLO differs from CLN (Credit link notes in the following manner.
CLO provide credit Exposure to diverse pool of credit where CLN relates to single
credit.
CLO result in transfer of ownership whereas CLN do not provide such transfer.
CLO may enjoy higher credit rating than that of originating bank.
51
Operational Risk
Operational Risk is the risk of loss resulting from
Inadequate or failed internal processes, people and system.
External events such as dacoity, burglary, fire etc.
52
Operational
Risk Events Cause based
People oriented – losses due to negligence, incompetence, lack
of awareness etc.
Process oriented – losses due to business volume, less staff,
organization complexity, lack of supervision etc.
Technology oriented – failure of system etc.
External causes: Floods, natural disters etc.
Effect Based
Claim cases in court settled against the bank.
Penalties due to non-compliance
Tax penalties
Write off
Delayed interest
Event Based
Internal and External Frauds
Dacoity, Burg alary etc.
Damage to assets
Business disruption.
Employment practices and workplace safety.
Operational Insurance cover, if available can reduce the operational risk only when
Risk Mitigation AMA is adopted for estimating capital requirements. The recognition of
insurance mitigation is limited to 20% of total Operational Risk
Capital Charge calculated under AMA.
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Low risk-------------2
Medium Risk------3
High Risk--- -----4
Very High Risk----5
Example:
Probability of occurrence = 2
Probability of Financial impact = 4
Impact of Financial control = 50%
Solution
[ 2x4x(1-0.5)] ^0.5 = ∫4 = 2 (Low) Ans.
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Market Risk
It is simply risk of losses on Balance sheet and Off Balance sheet items basically in
investments due to movement in market prices.
It is risk of adverse deviation of mark to Market value of trading portfolio during the period.
Any decline in the market value will result into loss.
ALCO: Assets Liability Management Committee meets at frequent intervals and takes
decisions in respect of Product pricing, Maturity profiles and mix of incremental assets and
profiles, Interest rate, Funding policy, Transfer pricing and Balance Sheet Management.
Sensitivity Measurement
Change in market rate of interest has inverse relation with Value of Bonds. Higher interest
rates lower the value of bond whereas decline in interest rate would result into higher bond
value. Also More liquidity in the market results into enhanced demand of securities and it
will lead to higher price of market instrument. There are two methods of assessment of
Market risk: 1. Basis Point Value 2. Duration method
Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10
BPV = 0.10/0.05 = 2 paisa per Rs. 100 i.e. 2 basis points per Rs. 100/-
If Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/-
Now, if the yield on Bond declines by 8 bps, then it will result into profit of Rs. 16000/-
(8x2000). BPV declines as maturity reaches. It will become zero on the date of maturity.
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2. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration)to receive
Present Value of the bond.
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.
Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is
5 years. What will be the McCauley Duration.
3. Downside Potential
It captures only possible losses ignoring profit potentials. It integrates sensitivity and
volatility with adverse affect of Uncertainty.
This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method
to calculate downside potential.
Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is
only one chance in 100 that daily loss will be more than 10 crore under normal conditions.
VaR in days in 1 year based on 250 working days = 1 x 250 == 2.5 days per year.
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Back Testing
It is a process where model based VaR is compared with Actual performance. It tells us
whether results fall within pre-specified confidence bonds as predicted by VaR models.
Stress Testing
It seeks to determine possible change in Market Value of portfolio that could arise due to
non-normal movement in one or more market parameters (such as interest rate, liquidity,
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inflation, Exchange rate and Stock price etc.). Four test are applied:
1. Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate ±2%, 4%,6% etc.
2. Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if
possible events occur. It assesses potential consequences for a firm of an extreme.
It is based on historical event or hypothetical event.
3. Maximum loss
The approach assesses the risks of portfolio by identifying most potential
combination of moves of market risks
4. Extreme value theory
The theory is based on behavior of tails (i.e. very high and very low potential
values) of probable distributions.
Risk Management and Control
Market risk is controlled by implementing the business policies and setting of market risk
limits or controlling through economic measures with the objective of attaining higher
RAROC. Risk is managed by the following:
1. Limits and Triggers
2. Risk Monitoring
3. Models of Analyses.
The Basel Committee has two approaches for calculation of Capital Charge on Market
Risk as under:
1. Standardized approach
2. Internal Risk Management approach
Under Standardized approach, there are two methods: Maturity method and duration
method. RBI has decided to adopt Standardization duration method to arrive at capital
charge on the basis of investment rating as under:
Other Risks and Other Risks like Liquidity Risks, Interest Rate Risk, Strategic Risk,
Capital Reputational Risks and Systemic Risks are not taken care of while
Requirement calculating Capital Adequacy in banks.
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Pillar – II SRP has two issues:
Supervisory 1. To ensure that bank is having adequate capital.
Review Process 2. To encourage banks to use better techniques to mitigate risks.
(SRP) SRP concentrates on 3 main areas:
Risks not fully captured under Pillar -1 i.e. Interest Rate Risks,
Credit concentration Risks, Liquidity Risk, Settlement Risks,
Reputational Risks and Strategic Risks.
Risks not at all taken care of in Pillar -1.
External Factors.
This pillar ensures that the banks have adequate capital. This process
also ensures that the bank managements develop Internal risk capital
assessment process and set capital targets commensurate with bank‘s
risk profile and capital environment. Central Bank also ensures through
supervisory measures that each bank maintains required CRAR and
components of capital i.e. Tier –I & Tier –II are in accordance with
BASEL-II norms. RBIA and other internal inspection processes are the
important tools of bank‘s supervisory techniques.
Capital structure.
Components of Tier –I and Tier –II Capital
Bank‘s approach to assess capital adequacy
Assessment of Credit Risks, Market Risk and Operational Risk.
Credit Aspects like Asset Classification, Net NPA ratios,
Movement of NPAs and Provisioning.
Frequency of Disclosure
Banks with Capital funds of Rs. 100 crore or more will make
interim Disclosures on Quantitative aspects on standalone basis
on their respective websites.
Larger banks with Capital Funds of Rs. 500 crore or more will
disclose Tier-I capital , Total Capital, CAR on Quarterly basis on
website.
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Risk Weight on NPAs
Off balance sheet items like direct credit substitutes, trade and performance related
contingent items and commitments with certain draw downs are classified under Non-
market related off-balance sheet items. The credit equivalent amount is determined by
multiplying the contracted amount of that particular transaction by the relevant CCF.
Non-market related off-balance sheet items also include undrawn or partially
undrawn fund based and non-fund based facilities, which are not unconditionally
cancellable. The amount of undrawn commitment is to be included in calculating the off-
59
balance sheet items. Non-market related exposure is the maximum unused portion of the
commitment that could be drawn during the remaining period of maturity. In case of term
loan with respect to large project to be drawn in stages, undrawn portion shall be calculated
with respect of the running stage only.
Example
In the case of a cash credit facility for Rs.100 lakh (which is not
unconditionally cancelable) where the availed portion is Rs. 60 lakh, the un-availed
portion of Rs.40 lakh will attract a Credit Conversion Factor (CCF) of 20% (since the
cash credit facility is subject to review / renewal normally once a year). The credit
equivalent amount of Rs.8 lakh (20% of Rs.40 lakh) will be assigned the appropriate
risk weight as applicable to the counterparty / rating to arrive at the risk weighted
asset for the unavailed portion. The availed portion (Rs.60 lakh) will attract a risk
weight as applicable to the counterparty / rating.
In compliance of the new guidelines banks have advised all the branches for:
i) Insertion of Limit Cancellation Clause in loan documents
ii) Levying of Commitment Charges
Time frame for Application to RBI by Approval by RBI by
application of IRB approach for 01.04.2012 31.3.2014
different Credit Risk
approaches AMA approach for 01.04.2012 31.3.2014
Operational Risk
Internal Model 01.04.2010 31.3.2011
approach for
Market Risk
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VaR (Value at Value at Risk is how much can we expect to lose? What is potential
Risk) loss?
We can lose maximum up to VaR (value at Risk) over a given time at a
given confidence level.
Calculation of VaR
Market Factor Sensitivity X Daily Volatility X Probability at given
confidence level
∑ ( PV*T) / ∑PV
For example:
5 years bond of Rs. 100 @ 6% gives Duration of 3.7 years. It means
Total Cash flow of Rs. 130/- would be equivalent to receiving Rs. 130/-
at the end of 3.7 years.
Modified Duration = Duration / 1 + Yield
CREDIT RISK Fixed Assets : 500 Crore Govt. Securities : 5000 crore
How to find Standard Assets
Risk Weighted Retail ---3000 crore HL -------2000 crore Other loans—10000 cr
Assets? Sub-Standard Assets
Secured ----500 crore Unsecured -----150 crore
Doubtful (DAI) --------------------------------800 crore
Solution:
Retail----------------3000*75/100 = 2250 crore
HL---------------------2000*50/100=1000 crore
Other loans---------10000*100/100 = 10000 crore
Gsec------------------5000*0/100=0
SS Secured----------500*150/100=750 crore
SS Unsecured ------150*100/100=150 crore
Doubtful D1 --------800*100/100=800 crore
Total RWAs = 2250+1000+10000+750+150+800 = 14950 crore
OPERATIONAL
RISK Ist year 2nd year
How to find Net Profit 120 crore 150 crore
Risk Weighted Provisions 240 crore 290 crore
Assets? Staff Expenses 280 crore 320 crore
Other Oper. 160 crore 240 crore
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expenses
Gross Income 800 crore 1000 crore
Average Income 1800/2=900 crore
Capital Charge 900*15/100=135 crore
RWAs (assuming Capital Charge/8% = 135*100/8 =
BASEL rate of 8%) 1687.50 crore
Capital Charge LC within Retail portfolio -------------------1000 crore (AAA rated
on Off Balance securities)
Sheet Items Standby LC (As Financial Guarantee)-----500 crore (A rated Co.)
How to find Standby LC –particular transaction-------200 crore (AA rated Co)
Risk Weighted Performance Bonds & Bid bonds---------1000 crore (Unrated Co.)
Assets? Financial Guarantees------------------------400 crore (AA rated Co.)
Confirmed LC for Imports------------------100 crore (AAA rated Co.)
Off Balance Sheet CCF Adjusted RWAs
Exposure Exposure
LC Retail Portfolio 20% 1000*20% = 200 200 *20%
(AAA rated) crore =40 crore
Tier-II Capital
Provisions for contingencies ---------------------------200 crore
Revaluation Reserve--------------------------------------300 crore
Subordinate Debts----------------------------------------300 crore
Solution
Tier –I Capital = 100+300+400 = 800 crore
Tier-II Capital = ( 300*45/100) + 300 + 1.25 % of RWAs (or Rs. 200
crore) =135 + 300 + 175 = 610 crore
Total Capital = 800 + 610 = 1410 crore
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Minimum In the above example:
Capital CAR = 1410/14000*100 = 10.07%
Required and Minimum Capital Required to support Credit and Operational Risks =
Capital to 10000*9/100 = 900 crore
Support Market Minimum Tier –I Capital Required to support Credit and Operational
Risks Risks =
900*50=450 crore
Minimum Tier –I I Capital Required to support Credit and Operational
Risks =900-450=450 crore
Amount of Tier –I Capital to support Market Risks = 800-450 = 350
crore
Amount of Tier –II Capital to support Market Risks = 610-450 = 160
crore
Ans. 90% confidence level means on 10 days out of 100, the loss will be more than Rs.
50000/-.
Out of 250 days, loss will be more than 50000/- on 25 days Ans. It means, out of 250
days, loss will not exceed on 225 days.
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BASEL –III
RBI has rescheduled implementation of BASEL-III from 1.1.2013 to 1.4.2013. The ratios of
BASEL-III will be disclosed in the Balance Sheet as at 30.6.2013.
Under Basel-III, Capital will include the following:
64
Investment in Capital of Banking, Financial and Insurance entities.
%age of RWAs
Minimum CET-I (Common Equity) 5.5%
Max. AT-I (Additional Tier-I) 1.5%
Minimum Tier - I Capital 7.00 %
Maximum Tier-II Capital 2.00 %
Minimum CRAR 9%
CCB – Capital Conservative Buffer in the 2.5%
form of Common Equity(Tier –I )
Countercyclical Capital Buffer within range of 0-2.5%of RWAs
Leverage Ratio (Minimum Standard) 4.5%
65
LCR under Basel-III
Liquidity Coverage Ratio is a new concept adopted under BASEL-III. It aims at
ensuring that banks have sufficient High Quality Liquid Assets to survive an acute stress
scenario lasting for 30 days. LCR will be implemented in a phased manner from
1.1.2015 and its 100% implementation will be up to 1.1.2019.
It will be applicable on Indian banks on standalone basis including foreign branches. In
foreign banks, framework to be applicable for Indian operations only.
1. Level-1 Assets:
These are included in HQLA without any limit or haircut. Following are Level-1
assets:
Cash including Cash reserves in excess of CRR.
Govt. securities in excess of minimum SLR requirement.
Marketable securities issued/guaranteed by foreign sovereigns with zero
risk weight.
2. Level 2 Assets:
These are included in HQLA subject to maximum 40% of overall stock of HQLA
after applying haircut. Level-2 assets are further divided in 2 parts:
Level-2A assets are included after applying 15% hair cut. The examples
of these assets are:
I. Marketable securities guaranteed by sovereigns/PSEs with 20%
Risk Weight.
II. Corporate bonds whose valuation is readily available with AA
rating or above
III. Commercial Papers not issued by banks/PDs/FIs with minimum
AA rating
66
HQLA= Level 1 Assets + Level-2A Assets + Level 2B Assets – Adjustment of 15% Cap –
Adjustment of 40% Cap
Total NET Cash flow = Expected Cash Outflow - Expected Cash Inflow for subsequent
30 calendar days.
> 100%
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MODULE - C
Treasury Management
2015
67
Treasury
Concept of Treasury
It deals with short term fund flow (i.e. Securities with Less than 1 year maturity) except part of
SLR requirement. Previously, Liquidity Management was main function of Treasury. But now, it
includes all Trading and Investment activities in financial markets.
1. Money Market
2. Security Market
3. Forex Market
Role of Treasury
Liquidity Management : Managing short term funds besides maintaining CRR and SLR
Proprietary Positions: Trading in Currencies, Securities and other financial instruments
including Derivatives.
Risk Management: Bridging Asset Liability mismatches and managing Risks through
Derivative tools.
1. ALM Book
2. Merchant Book
3. Trading Book
ALM book deals with Internal Risk Management. Merchant Book deals with Client related
Derivatives. Trading Book deals sales and purchase of financial instruments for bank itself.
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Globalization and Growth :Rapid Economic growth is not possible without free capital flows
i.e. Overseas Companies invest in India and Domestic Companies invest outside India.
Exchange of technology and human resources has been made possible only after liberalization
after 1990.
Direct Investment,
ECB
Issue of Equity and Debt Capital in Global market
Mergers and Acquisitions
Payment of technology, and
Receipt of Interest, fees and dividend etc.
Automatic route
Approval Route
Impact of Globalization
Banks can Borrow and Invest Outside India through Overseas Correspondents in Foreign
Currency up to 100% of Tier–1 Capital or USD 10 Million (whichever is higher)
1. Inter- bank market is free from Credit risk and requires little capital allocation.
2. Treasury activity is highly leveraged. The risk ranges from 2% to 5%.
3. Operational costs are low.
1. Forex Business
Buy Low and Sell High
Position is generally squared on daily basis.
Stock of currency is not generally kept.
Overbought and Oversold is called ―Open Position‖
2. Money Market
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Banks lend surplus funds in Money Market and borrow the same when required. Interest
is earned.
3. Investment in Govt. Securities and Other Securities
Treasury profit is earned by investment in G-sec and other securities in Debt and Equity
Market.
4. Interest Arbitrage
If interest rates are in favour, banks borrow from centers having low rate of interest and
lend at other centers where rate of interest is high. This is called Arbitrage.
5. Trading in market
It is speculative activity. Banks trade in securities and currencies. Swap transactions are
also done to increase profits of the bank.
Organization Structure
In every bank, General Manager is CTO (Chief Transaction Officer) who reports direct to CEO.
There are four sections at HO:
1. Dealing Room : Chief Dealer is Head. There are separate dealers for Forex Operations,
Money market operations and Security Operations. For corporate, separate dealer is
appointed who deals with securities in Secondary as well as Primary market.
2. Mid-Office: It provides MIS, implements Risk Management system and monitors
exposure limits and Stop Loss Limit.
3. Back Office: This office is responsible for verification and settlement of deals,
confirmation of deals with counterparts, book-keeping of all deals and Maintaining
Nostro accounts.
4. Investment Office: This office deals with Primary Issues of Shares
70
Treasury Products
Forex Market Products: It is virtual market without boundaries, highly volatile and liquid and
most transparent. It includes the following products.
1. Spot Trades: Currencies are generally bought and sold at spot rates when payment and
settlement takes place on 2nd working day. Cash and Tom rates are quoted at discount
from Spot rate.
2. Forward Trades : Purchase or sale of currency at future rates. Exchange takes place
after few days/months. Importers and Exporters cover risks by Forward trades. Forward
rates are arrived at on the basis of interest rate differentials of two currencies.
3. Swaps: Foreign Exchange transactions where one currency is sold and purchased for
another simultaneously is called Swap. Swap Deal may involve:Simultaneous purchase
of spot and sale of forward or vice versa. It may also involve Simultaneous sale and
purchase, both forward but for different maturities. It is called ―Forward to Forward
Swap‖.
4. Investment in Foreign Currencies: If forex is surplus with bank, it makes investment.
Surplus arises from profits of treasury business, overseas operations, forex borrowings,
NRE, FCNR and EEFC deposits. Investment can be of following 3 types:
Interbank loans- normally not more than 1 year
Short term investments in T-bills and CPs issued by multinational agencies
Some Correspondent banks offer automatic investment facility in Nostro
Accounts subject to minimum balance.
5. Foreign Currency Loans: Banks extend WC loans in foreign currency and for this
purpose, clearance of Treasury is required.
6. Rediscounting of Foreign Bills :Treasury refinances the Foreign currency bills
purchased/negotiated by another bank. The advance covers Usance period 15-360
days.
Money Market Products: Money market products relate to raising and deploying short
term resources with maturity Maximum 1 year. The money market products are:
71
2. Notice Money: It is placement of funds beyond overnight up to maximum period of
14 days.
3. Term Money: It deals with placement of funds in excess of 14 days up to 1 year.
1 to 6 month products are very common.
1. Treasury Bills:
These are issued by Govt. of India through RBI.
Tenure is 91Days, 182 Days and 364 Days.
These are issued at Discount in auction.
Banks and PDs participate in the auction.
The auction is also available to all financial players (FIs/MFs/Corporate).
Auction takes place on Wednesday every week in case of 91 days bills.
It takes place on Wednesday every Fortnight in case of 182 D and 364 D bills.
.
3. LAF – Repo and Reverse Repo
It is Lending and Borrowing money for short term period (1 day to 1 year)
Under Repo, RBI purchases securities with commitment to sell at a later date in order to
Inject Liquidity. Presently, Govt. securities are dealt with. All Repo transactions are
routed through CCIL. RBI has permitted Repo in Corporate securities for only ―AA‖ rated
companies. But the market is yet to be activated.
Under Reverse Repo, RBI sells securities with a commitment to buy at a later date in
order to Contain Liquidity.
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Repo and Reverse Repo transactions are generally conducted for Overnight period
through Auction Twice Daily. The minimum Bid is Rs. 5.00 crore and its multiples.
Margin is normally 5%.
(Total available funds to a bank under LAF will be capped at 0.5% of NDTL w.e.f.
24.7.2013)
Bills Rediscounting:
Treasury re-discounts bills which are already discounted by other banks. The tenure is
3-6 months.
Security Market Products: Securities constitute Shares, Debentures, Bonds, and Govt
Securities etc. The various types of securities are:
1. Govt. Securities
These are issued by PDO (Public Debt Office) of RBI.
Price is determined in auction
There is active trading in Secondary market.
If Yield rate is more than coupon rate, these are issued at a discount.
Open Market Operations are conducted by GOI to maintain liquidity position.
SLR requirements are met by banks by investing in HTM securities.
2. Corporate Debt Papers
These are medium and long term Bonds and Debentures issued by Corporate
and FIs.
These are non-SLR securities.
These form part of Tier –II Capital.
Yield is more than that of Govt. Securities.
3. Debentures and Bonds: Both are Debt instruments and form part of Tier-II Capital.
SEBI has control over issuance and redemption.
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Debenture Bond
Issued by Corporate in Private sector Issued by institutions in Public sector
It is Secured by Floating charge It is not secured
Provisions of Company Law applies It is governed by Indian Contract Act
It can be transferred through registration It is negotiable instrument
It can be convertible or non-convertible Bond, if given option can be
convertible into equity shares.
It can be
Zero Coupon Bond
Perpetual Bond
Floating Bond
Deep Discount
4. Equities: It is Share Capital issued by both Private sector and Public sector Companies
to raise funds from public. The people who invest are called Shareholders:
Bank can invest subject to limit exposure set by RBI for Capital Market
SEBI has full control and these are traded in Stock Exchanges.
Derivative products are also available.
If offered by Company, it is called Primary Market. If purchased through Stock
Exchanges, it is called Secondary market.
Rupee is fully convertible on account of Current Account transactions and partially on account of
Capital Account transactions.Interaction between Domestic and Global markets takes place in
respect of following:
1. FII Investments: These are made by way of FDI (Foreign Direct Investments) and
Portfolio Investments. FDI is for Long term Project related investment whereas Portfolio
Investment related to Investment in Equity and Debt Market. In some areas, FDI is 100%
whereas it is up to 74% in other areas.
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2. ADR/GDR
American Depository Receipts are Receipts or Certificates issued by US Banks
representing specified number of shares of non-US Companies.
Any financial committee exceeding 1 billion USD in a financial year would require prior
permission of RBI even within overall limit of 400% of Net Worth.
It has been decided that Proprietorship concerns and Unregistered Partnership firms can
also participate in ODI up to 10% of average export realization of previous 3 years or
200% of Net Owned funds of the firm provided:
1. It is Status Holder Exporter and KYC compliant
2. It has proven track record i.e. exports outstanding does not exceed 10% of average
export realization of previous 3 years.
3. There is no adverse notice of any govt. agency.
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LRS (Liberalized Remittance Scheme)
The scheme is meant for Resident Indians individuals. They can freely remit up to USD
125000 per financial year in respect of any current or capital account transaction without
prior approval of RBI. The precondition is that the remitter should have been a customer
of the bank for the last 1 year. PAN is mandatory.
Not Applicable
The scheme is not applicable for remittance to Nepal, Bhutan, Pak, Mauritius or
other counties identified by FATF.
The scheme is not meant for remittance by Corporate.
Latest Guidelines
The scheme should not be used for making remittances for any prohibited or
illegal activities such as margin trading, lottery etc., as hitherto.
Resident individuals have now been allowed to set up Joint Ventures (JV) /
Wholly Owned Subsidiaries (WOS) outside India for bonafide business activities
outside India within the limit of USD 125000.
The limit for gift in Rupees by Resident Individuals to NRI close relatives and
loans in Rupees by resident individuals to NRI close relatives shall accordingly
stand modified to USD 125000 per financial year.
RBI has clarified that Scheme can now be used for acquisition of IP outside India.
The banks will use Marginal Standing Facility to borrow overnight money from RBI only
when they have exhausted all other existing channels like Collateralized Borrowing and
Lending Obligations (CBLO) and Liquidity Adjustment Facility (LAF). The features of the
scheme are as under:
The eligible entities can avail overnight, up to 2% of their respective
nd
NDTL outstanding at the end of the 2 preceding fortnight.
For the intervening holidays, the MSF facility will be for one day except on
Fridays when the facility will be for 3 days or more, maturing on the
following working day.
The facility is available on all working days in Mumbai, excluding
Saturdays between 3.30 P.M. and 4.30 P.M.
Interest on amount availed will be 100 bps above Repo i.e. 9.00%.
Requests will be received for a minimum amount of Rs.One Crore and in
multiple of Rs. One Crore thereafter.
MSF will be undertaken in all SLR-eligible transferable Government of
India dated Securities/Treasury Bills and State Development Loans
(SDL).
A margin of 5% will be applied in respect of GOI dated securities and Treasury Bills. In
respect of SDLs, a margin of 10 per cent will be applied
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FDI (Foreign Direct Investment)
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PRESENT RATES AT A GLANCE
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Funding and Regulatory Aspects
Broad Money (M3) includes currency in circulation, Demand and Time Liabilities of Banks and
Post Office SB accounts. Narrow money (M1) includes Currency in circulation, Demand
Liabilities of Banks and other deposits with RBI. M3 is 3-4 times than M1.
Money is impounded by RBI to reduce multiplier effect by means of CRR and SLR.
1. RTGS (Real Time Gross Settlement) is a payment system for Interbank transfer
with minimum Rs. 2.00 lac. This system is managed by IDBRT, Hyderabad, which
connects all banks to Central server maintained by RBI. The network is INFINET (Indian
Financial Network)
Timings are:
R-41 transactions 8:00AM to 8:00PM (Saturday: 8:00 to 3:30 PM)
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2. NEFT (National Electronic Fund Transfer) is mainly used for low amount
transactions. However, there is no minimum and maximum limit. The timings are:
8:00AM to 7:00PM (Saturday 8:00 to 1:00 PM). There are 12 batches daily except
Saturday with 6 batches. The time period is B+2.
5. NSDL and CDSL: National Securities Depository Ltd. (NSDL) and Central Depository
Services India Ltd.(CDSL) provide a settlement platform for shares and other securities
in the Secondary market. These institutions also maintain Demat accounts.
1. Hybrid System
Offsetting after every 5 minutes.
The transactions with normal priority would be settled in off-setting mechanism
within maximum 2 attempts.
Maximum time a transaction would be in normal queue is 10 minutes.
If transaction with normal priority is unable to be settled on offsetting mode within
10 minutes, it would be automatically converted to Urgent.
2. Future Value Transactions
Value Dated transactions would enable the customers/participants to initiate
RTGS transactions 3 working daysin advance for setting in RTGS on Value
Date.
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Treasury Risk Management
Why Treasury is risky?
1. High Leverage- Value of transaction is very high say 100 crore and 1% adverse
movement may result into loss of 1.00 crore.
2. There is sole discretion of Treasury Department to sell, buy or keep open position.
3. Transactions are confirmed and irrevocable.
Market Risk – It consists of Liquidity risk, Exchange rate risk, Interest rate risk, Equity
risk and Commodity risk
Take an example:
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.
Fluctuation of exchange rates due to many domestic and international factors can lead
to Currency Risk.
Risk of fluctuation in market price of Shares and Bonds is called Equity Risk whereas
Risk of Fluctuation in market price of Commodities such as Gold, Silver etc. lead to
Commodity Risk.
Credit Risk – It is risk of default by counter party due to various reasons such as Buyer
Risk, Seller Risk, Country Risk and Sovereign Risk.
1. Organizational Control
Segregation of Front, Back and Mid office for effective monitoring and control.
2. Internal Control
Setting up of limits like Deal Size limit, Open Position limit, Stop loss limit, Day light limit
and Overnight limit
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3. Exposure Ceiling Limit
Exposure limit of counterparty is fixed on the basis of Credit Rating. Ideally all deals
should take place DVP – Delivery Vs Payment and there is no risk. But ideal position is
not there always.
RBI has imposed a ceiling of 5% of Total Business in a year for Individual broker
Measurement of Risk
1.VaR (Value at Risk) It is statistical measure indicating worse movement of market rate
over given period of time under normal market conditions.
For example: Overnight VaR of 45 bps for USD/INR at 95% confidence level. If spot rate is
46.00, there are only 5% chances that the rate will be worse than 45.55 (46.00-0.45).
Another Example is: If Overnight VaR of 1 year G-Sec is 0.35%, the current yield of 7.75% is
expected to fall/rise not more than 0.35% by tomorrow.
Duration is the period during which Present Value of Outflows become equal to the Present
Value of Inflows.
Bonds carry coupon rate. If rate of return is higher than coupon rate, Value of Bond falls.
Effective rate of Bond is called Yield.
Duration is Weighted Average measure of life of Bond where time of receipt of cash is
weighted by Present Value of Cash Flow.
It is expressed in number of years during which PV of the bond equals the market price.
Formula is :
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Derivative Products
Derivatives don’t have independent value. Their value is derived from the underlying market.
The market may be financial market dealing in forex, bonds and equities as well as commodity
market dealing with underlying commodities like Gold, Silver etc.
Derivatives refer to Future Price based on Spot Market. Two types of Products are as under:
1. OTC Products
These are Over The Counter products which include Forward Contracts and Options.
These are offered by FIs. These derivatives offer contracts with date, amount of terms
fixed as per requirement of the client. Price is quoted by banks/FIs after adding margin.
Settlement is made by physical delivery. Counterparty Risk is always present.
2. Exchange Traded products
These include Futures traded on organized exchanges. Size of the contract is
standardized. Price is transparent. The exchanges collect margin based on Mark to
Market price. Physical delivery is not must. There is no counter party risk.
Types of Derivatives
1. Forward Contracts
2. Futures
3. Options
4. Interest Rate Swaps
5. Currency Swaps
Forward Contracts
It is a deal to buy or sell Shares, Commodity or Foreign Exchange at a contracted rate with
desired maturity. Forward rate is the interest rate differentiation of two currencies. If Interest
rate is high in a country, its currency will be cheaper.
Futures
It is Exchange traded product. The seller agrees to deliver a specified security, currency or
commodity on specified date at a fixed price. Currency Futures are traded in EURO, GBP, JPY,
CHF, AUD& CAD.
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OPTIONS
Option is a contract to buy or sell currency, bonds or Equity on future date. The party has right
to exercise option but there is no obligation.
Option is Right to buy or sell an agreed quantity of currency or commodity without obligation to
do so. The buyer will exercise the option if market price is in favor or otherwise option may be
allowed to lapse.
Call Option
Right to buy at fixed price on or before fixed date.
Put Option
Right to sell at fixed price on or before fixed date.
Final day on which it expires is called maturity. The pre-fixed rate is called Strike Rate.
CALL OPTION;
If Strike price is below the spot price, the option is In the money(ITM)
If Strike price is equal to the spot price, the option is At the money.(ATM)
If Strike price is above the spot price, the option is Out of money.(OTM)
PUT OPTION
If Strike price is more the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
Plain Vanilla Option
It is an option without any conditions. It is ideal for Hedging.
Zero Cost Option
It does not attract any premium. There is risk of holder i.e. importer to pay higher rate if market
rises beyond certain level.
Embedded Option
The bond holder is given option to convert its debt into equity.
It is OTC product. It deals with exchange of Interest flows on an underlying assets and liability.
For Example: A company is paying interest on 5 years Debentures @7%. In market, rate of
interest is declining; the company will be benefitted if Interest rate is linked to market rate of
interest. The Company enters into Interest rate swap with bank with the terms that Fixed rate of
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interest on Debentures will Swap 3M T-bills @5%. The fixed rate of 7 % on Debentures will be
swapped with T+2%. After every 3 months, bank will pay the company @ T-bills+2%.
Assuming that in the next quarter, 90 days T-bill rate is 4%, the Company will pay to
bank@6%(4+2%) and will receive from bank 7% thereby saving of 1%. This will neutralize the
loss of interest @1% (notional) on account of fall in the market interest rate.
On the other hand, if T-bill rate is increased to 5%, the company will lose by 1% which will
neutralize the gain of interest @1% (notional) on account of increase in the market interest rate.
It is Forward Interest rate which is an over-the-counter contract between parties that determines
the rate of interest to be paid or received on an obligation beginning at a future start date. The
contract will determine the rates to be used along with the termination date and notional value.
On this type of agreement, it is only the differential that is paid on the notional amount of the
contract.
For a basic example, assume Company A enters into an FRA with Company B in which
Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three years.
In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on
the principal amount. The agreement will be settled in cash in three years.
If, after three years' time, the LIBOR is at 5.5%, the settlement to the agreement will require that
Company A pay Company B. This is because the LIBOR is higher than the fixed rate.
Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million
at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net
difference between the two amounts is $5,000, which is paid to Company B.
Currency Swaps
It is exchange of cash flow in one currency with that of another currency. Two types of currency
swaps are there: Currency Only Swap & Principal Only Swap. Currency Swaps are used to
mitigate exchange risks for meeting Principal or Interest obligations.
Example: An investor in Germany needs INR to Invest in India. On the other hand, Reliance in
India needs Euro to acquire a Co. in France. German Investor will raise Euro funds at low rates
and Reliance India will raise Rupee loans at low rates from India. Two parties will Swap Loans
with Bank as financial intermediary.
Principal Only Swap allows the borrower to pay interest in USD. But payment of
Principal is made in home currency. As such risk fluctuations in respect of Principal are
eliminated.
Coupon Only Swap allows the borrower to pay interest in INR. Whereas Principal
amount is hedged by using some other derivative.
P+I Swap is there when borrower eliminates Currency risks as well as Interest Risk. The
risk is zero. Borrower will pay Principal + Interest in Domestic currency to settle Foreign
Currency borrowings. The swap cost is included in rupee interest rates.
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RBI Guidelines on Risk Exposure
1. Banks and Counter parties will sign agreement known as ISDA (International Swap
Derivative Association) – Master Agreement which is standardized by SDA (Swap
Derivative Association). The agreement is cleared by FIMMDA(Fixed Income Money
Market and Derivatives Association) and FEDAI.
2. RBI allowed MIFOR (combination of LIBOR and Forward Premium) for Inter-bank
dealings only.
3. RBI permitted banks under ISDA agreement to opt for dual jurisdiction.
4. Ceiling for Forward Contract for Designated Importers and Exporters is 100% of
previous year’s exports or average of 3 years exports (whichever is higher). The ceiling
is 50% for other Importers and Exporters.
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Treasury and ALM
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 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.
1-14 days.
14-29 days
1M – 3M
ALM measures the gap between Uses and Sources between above said Time bands.
RBI has also prescribed limits of maximum negative mismatch as under:
Interest rate Gap leads to erosion of NII (Net Interest Income) due to difference between
earnings and payments.
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Bank may arbitrage Forex. It can buy USD funds at cheaper rate (say 3%) and invest in
rupee loan at 6.5%. The spread can be 3.5%
Risks of Derivatives: Derivatives are not free from risks. Tworisks involved in Derivatives are:
1. Residual risk i.e. basis risk.
2. Embedded Option Risk :There are embedded options in certain bank products. E.g. FD
is paid premature or TL is pre-paid. It affects the ALM policy if pre-mature payments are
large.
Credit Derivatives
1. Credit Default Swaps
2. Total Returns Swap
3. Credit Linked Notes
Transfer Pricing
It is important function of ALM. It relates to:
Fixing cost of recourses and return on Assets.
ALM notionally buys and sells deposits and loans of the bank.
Price is paid for buying deposits and price is received for selling loans. This is called
Transfer Pricing.
The prices vary according to the tenure or maturity of deposits and loans.
Deposits are bought by Treasury at a rate arrived at by adjusting hedging cost from rate
of deposit. If bank accepts deposits%7% and cost of hedging is 1%, the deposits will be
bought by Treasury @6%.
Loans are sold to Treasury at transfer cost. For example, 10% loan may be notionally
sold to Treasury @7%. The balance is denoted as Risk premium.
Treasury Division, after implementing the Transfer Pricing takes care of Liquidity Risk
and Interest rate risk.
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MODULE – D
2015
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Bank’s 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.
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Contingent Liabilities: Schedule 12These 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:
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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 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 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
ALM techniques are so designed to manage various risks and the parameters are:
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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
Find NII (Net Interest Income), NIM and Economic Equity Ratio
= 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.
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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.
Asset Classification
Loan Account remains in Sub-standard category for 1 year
Loan becomes Doubtful afterremaining 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.
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3. Provision is made for NPAs (Bad and Doubtful debts) from the current year’s 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.
PROVISIONINGNORMS
In terms of Monetary policy 2011-12, the revised norms of provisioning are as under:
Standard Assets
Sub-standard Advances:
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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.
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.
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
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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
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.
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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.
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:
100
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.
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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
2. Gap Analysis
Gap is Difference between RSA (Risk Sensitive Assets) and RSL (Risk Sensitive
Liabilities)
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.
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Practical Example:
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. Bank’s NII will be reduced by 1.20 Crore.
Important Points
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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).
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:
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8% Capital 9.60 20.80 28.80
Requirement
Bank’s policy must be to invest in such a manner that optimum yield can be obtained at
a given level of Capital.
Bank’s non-interest income can be increased by popularizing 3rd party products and
widening scope of Treasury.
Bank’s profit can be enhanced through effective management of risks.
Low Cost Deposits must be increased to enhance Profits.
Through RAROC approach, each Risk is measured to determine both expected and
Unexpected losses using VaR (Value at Risk).
How to Calculate RC (Risk Capital) & RAMP (Risk Adjusted Performance Measures?
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:
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
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Bond Trader has less Risk Capital and Higher Risk Adjusted Performance. Therefore Bond
Trader is performing better.
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