Question Paper Management of Financial Institutions – I (321) : October 2003 Section A : Basic Concepts (30 Points) • • • • • • 1.
5.
c. d. e. 6.
7.
< Answer >
It is a permanent source of financing for the Government Rate of Interest on WMA will be on mutually agreed rate between the RBI and Government of India from time to time When 75% of the WMA is utilized, RBI will go for a flesh floatation of Government securities Any excess drawl over the WMA limit would be permitted only for 10 Consecutive working days Any excess amount over the WMA limit carries additional interest on such excess amounts. < Answer >
Rs. 25 lacs Rs. 50 lacs Rs. 100 lacs Rs. 500 lacs Rs.1,000 lacs.
Replacement of the credit of one party to a transaction with the credit of a financial institution is called a. b. c. d.
< Answer >
Rate at which nationalized banks lend to borrowers Rate at which private sector banks lend to borrowers Rate at which Reserve Bank of India lends to banks Rate at which Cooperative Banks lend to borrowers for agriculture Rate at which Regional Rural Banks lend to borrowers for agriculture.
The minimum paid up capital required to set up a Local Area Bank (LAB) is a. b. c. d. e.
< Answer >
Regulatory trade Monopolistic market Asymmetric information Trade failure None of the above.
Which of the following is false regarding Ways and Means Advances (WMA)? a. b.
< Answer >
When maturity gap is positive, decrease in interest rate increases the Net Interest Income (NII) When maturity gap is Zero, increase in interest rate increases the Net Interest Income (NII) When maturity gap is positive, increase in interest rate decreases the NII When maturity gap is negative, decrease in interest rate increases the NII When maturity gap is negative, increase in interest rate increases the NII.
Bank rate is the a. b. c. d. e.
< Answer >
Increase Decrease Remain unchanged Increase first and then decrease Decrease first and then increase.
The idea that trade is beneficial to both parties rests on the assumption that buyers and sellers know what they are doing. The failure of this assumption is described as a. b. c. d. e.
4.
Each question carries one point.
Which of the following is true? a. b. c. d. e.
3.
Answer all questions.
In the duration gap method, if the gap is negative and if the interest rates are expected to increase, then the market value of equity will a. b. c. d. e.
2.
This section consists of questions with serial number 1 - 30.
Bonding Delegation Credit substitution Credit netting
< Answer >
e. 8.
Disintermediation means a. b. c. d. e.
9.
None of the above. Increase in deposits experienced by banks due to increased network of branches Increase in deposits experienced by banks due to the introduction of new schemes Loss of deposits by financial intermediaries because direct lending becomes more attractive Loss of deposits by financial intermediaries because alternative types of indirect lending becomes more attractive Loss of income by a bank due to loss assets.
The commercial paper issued by a borrower is a. b. c. d. e.
11.
< Answer >
3 years 5 years 7 years 9 years 10 years.
15. Which of the following risks is eliminated between the contracting parties in a REPO transaction? a. b. c. d. e.
< Answer >
61.54% 62.39% 59.48% 58.32% 58.06%.
14. The subordinated debt instruments issued by a bank should have a minimum maturity of a. b. c. d. e.
< Answer >
3 years 5 years 7 years 9 years 10 years.
13. Given the ROA is 6%, non-performing assets is 15% of its book-size and total assets is Rs.500 crores, tax rate is 35%. The ENPA level of the bank is a. b. c. d. e.
< Answer >
61.54% 62.39% 59.48% 58.32% 58.06%.
12. The subordinated debt instruments issued by a bank should have a minimum maturity of a. b. c. d. e.
< Answer >
Hypothecation of stocks Pledge of stocks Book debts Mortgage Both (a) and (b) above.
Given the ROA is 6%, non-performing assets is 15% of its book-size and total assets is Rs.500 crores, tax rate is 35%. The ENPA level of the bank is a. b. c. d. e.
< Answer >
A secured money market instrument An unsecured money market instrument A money market instrument partly secured by the issuer’s assets A money market instrument guaranteed by the RBI for repayment A money market instrument guaranteed by the Government of India for repayment.
10. In which of the following cases, an advance given to a company against collateral securities the charge need not be registered with the Registrar of Companies? a. b. c. d. e.
< Answer >
Liquidity risk Interest rate risk Rate level risk Counter party risk Call risk.
< Answer >
16. Fiduciary risk refers to the risk of losses that may arise by undertaking a. b. c. d. e.
Project financing Working capital finance Off-balance sheet transactions Financing of book debts Pledge loans.
17. If a 91-day T-bill of face value Rs.100 is acquired in the auction at a yield of 5%, then the purchase price is a. b. c. d. e.
< Answer >
Interest rate risk Liquidity risk Operational risk Transactional risk Market risk .
23. The right of the insurer to stand in the place of the insured, after settlement of a claim, in so far as the insured’s right of recovery from an alternative source is involved is called a. b. c. d. e.
< Answer >
Unclaimed deposits Cumulative deposits Staff security deposits India development bonds Deposits held as securities for advances.
22. Mismatch between maturity patterns of assets and liabilities for a bank exposes to a. b. c. d. e.
< Answer >
As NPAs increase the ENPA will also increase Higher ENPA implies greater credit risk ENPA increases as the ROA increases Margin of safety decreases as the ENPA increases The graph that establishes the relation between ROA and ENPA shows a curve that is downward sloping.
21. Which of the following liabilities are classified under demand liabilities for the computation of NDTL? a. b. c. d. e.
< Answer >
Basis risk Put risk Prepayment risk Real interest rate risk Call risk.
20. Which of the following alternatives relating to the ENPA is true? a. b. c. d. e.
< Answer >
Mortgage by conditional sale Usufructory mortgage English mortgage Equitable mortgage Anomalous mortgage.
19. Which of the following risks arises if assets and liabilities are subjected to floating rates that are pegged to different benchmarks? a. b. c. d. e.
< Answer >
Rs.97.77 Rs.98.27 Rs.98.77 Rs.98.88 Rs.99.89.
18. Which of the following mortgages involves transfer of an interest in specific immovable property by deposit of title deeds? a. b. c. d. e.
< Answer >
Subrogation Nomination Assignment Indemnity Warranty.
< Answer >
24. Smart Bank Ltd does not pay any interest on current account balance of customers. It also does not charge for issuing chequebooks to the customers. What pricing strategy is adopted in this transaction? a. b. c. d. e.
Rebate strategy Implicit pricing Explicit pricing Relationship pricing Symmetric account.
25. M/s PGR Electronic has taken fire insurance policy for goods of value Rs.6 lakhs. The company has suffered a loss of 4 lakhs out of Rs.10 lakhs worth of stocks stored in the godown. How much amount is payable by insurance company a. b. c. d. e.
c. d. e.
< Answer >
Pledgee can sell the security under notice without filing a suit Pledgee can sell the security only by filing a suit Pledgee becomes owner under pledge agreement Pledgee cannot have possession of security Pledgor has possession of security.
30. What is the risk weight assigned to guarantees issued by banks against counter guarantees of other banks? a. b. c. d. e.
< Answer >
Revaluation reserves should be valued at 55% of the outstanding balance Provisions and contingencies shall not be accounted for if they are more than 1.25% of the riskweighted assets Tier II capital shall not exceed 50% of Tier I capital Subordinated debt shall not exceed 50% of Tier II capital None of the above.
29. Which of the following statements is true for a pledge advance? a. b. c. d. e.
< Answer >
Term Deposit Certificate of deposit Capital gains deposit Savings Bank Gold deposit.
28. Which of the following statements is/are true in respect of Capital Adequacy Ratio? a. b.
< Answer >
Return on Assets Return on equity Equity multiplier Return on asset utilization DSCR.
27. Which of the following deposits of banks does RBI regulate for payment of interest? a. b. c. d. e.
< Answer >
Rs. 4 lakhs Rs. 2.40 lakhs Rs. 6 lakhs Rs. 6.60 lakhs Rs. 10 lakhs.
26. Ratio of Total Asset to Total Equity is known as a. b. c. d. e.
< Answer >
Zero 2.5% 20% 50% 100%
. END OF PART A
< Answer >
Part B : Problems (50 Points)
1.
• •
This part consists of questions with serial number 1 – 5. Answer all questions.
• •
Points are indicated against each question. Detailed workings should form part of your answer.
•
Do not spend more than 110 - 120 minutes on Part B.
Consider the following details of Fortune Bank as on September 30, 2003: (Rs. in crores) Amount
Average interest (%)
800
0
Cash and bank balance
9,700
6
Borrowing
300
Other Liabilities
400
Liabilities Capital and Reserves Deposits
11,200
Amount
Average interest (%)
500
0
Advances
7,200
10
7
Investments
2,700
6
0
Fixed and other assets
800
0
Assets
11,200
You are required to Compute the Rate Sensitive Gap b. Compute the Rate Adjusted Gap for the bank, assuming the interest rate on various assets and liabilities is likely to be as given below. Deposits 6.75% Borrowings 8.00% Advances 11.00% Investments 6.80% c. With the following additional information, assess the change in the market value of the equity due to increase in interest rate by 1% Duration of Assets 4 years Duration of Liabilities 3 years Current Interest rate 10% d. How Fortune Bank can protect the market value of the equity? Explain. 2.
(2 + 3 + 3 + 4 =12 points) < Answer > The details given below represent the assets and liabilities of Dwarka Bank Ltd as on 31-03-2003:
S.No 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.
Details Furniture & fixtures Buildings Investment in Government Securities Investment in shares/debentures Revaluation reserve Cumulative perpetual preference shares Statutory reserve Equity Undisclosed reserves Balance with RBI Cash on hand General provision and loss reserves Capital reserve (gain on sale of assets) Equity investments in subsidiaries Subordinated debt (maturity wise) Maturity 2-3 yrs 4-5 yrs Less than one year 16. Advances Unsecured Secured by tangible assets Loans granted to Undertakings of Government of India 17. Guarantees given with 50% cash margin 18. Deposits from Banks 19. Deposits from others 20. Gold 21. Tax paid in advance 22. Letters of credit issued with 20% cash margin 23. Balances in accounts with other banks 24. Claims on Commercial Banks (CD’s) You are required to calculate the following i. Tier I Capital ii. Tier II Capital iii. Capital Adequacy Ratio.
Rs. in crores 25 10 120 45 70 15 25 30 5 24 73 9 22 15 5 10 10 335 245 16 65 10 550 20 45 40 15 20
(12 points) < Answer > 3.
The following information is provided by the General Manager of a bank: Particulars
%
Capital Adequacy Ratio
10
CRR
4.5
SLR
25
Cost of capital
12
Cost of deposits *Demand deposits
3
Term deposits
6
interest free deposits Ratio of demand to term deposit is 1:2 The lending rates offered to borrowers as per credit rating are as follows:
*50% of demand deposits are
Category
Rate
Proportion
A
PLR
0.40
B
PLR + 1
0.40
C
PLR + 2
0.20
Interest earned on SLR investments
6%
Interest on CRR
NIL
The bank’s total working funds consists of only
capital and deposits. The management requires a spread of 3%. You are required to compute the PLR for the bank. 4.
(8 points) < Answer > On October 07, 2003 Janata Bank sold 11.43% GOI 2015 of Rs.100 crore to Fortune Bank on Repo basis for a period of three days. The Repo rate was 6% p.a. The date of last coupon payment was August 07, 2003. The sale price of the security was Rs.113 for the face value of Rs.100. You are required to compute the cash flows involved in the transaction. (6 points) < Answer >
5.
Consider the following data relating to a prime borrower: Contracted rate
: 12% p.a.
Probability of default
: 0.10
Recovery rate of principal
: 80%
Loan term
: 2 years
If the current prime rate is 10.5 % p.a. what is the expected one-year prime rate after one year? In case of default, it is assumed that the entire interest is foregone. (5points) < Answer > 6.
The General manager of a bank has given the following forecast for interest rates Change in interest rates
Probability
– 0.5%
0.10
+0.5%
0.20
–1.0%
0.30
+1.0%
0.40
The earnings assets of the bank are at Rs.4,400 crore. The Net Interest Income (NII) figure is Rs.154 crore. The bank is expecting a variation of 10% in the net interest income. You are required to compute a. The target gap for each of the four possible changes in the interest rates b. The expected change in NII for different levels of gap. (3 + 4 = 7 points) < Answer >
END OF PART B
Part C : Applied Theory (20 Points) •
This part consists of questions with serial number 7 - 8.
• •
Answer all questions. Points are indicated against each question.
•
Do not spend more than 25 -30 minutes on Part C.
7.
8.
“ Liquidity management can be practiced on either side of balance sheet”. How are asset and liability management similar and how do they differ? Why do smaller banks have a limited access to liability management? (10 points) < Answer > Insurance is an uberrimae fides contract. What is uberrimae fides? Explain its significance to an insurance contract. Briefly explain the elements on which the insurance contract is built upon. (10 points) < Answer >
END OF PART C END OF QUESTION PAPER
Suggested Answers Management of Financial Institutions – I (321) : October 2003 1.
Answer : (a) Reason : In the duration gap method, if the gap is negative and if the interest rates are expected to increase, then decrease in market value of assets will be less than the decrease in market value of liabilities. As the risk sensitive assets are less than the risk sensitive liabilities, it will increase the value of equity.
< TOP >
2.
Answer : (d) Reason : It is true, when maturity gap is negative decrease in interest rate increases the Net Interest Income (NII). Options in (a), (b), (c) and (e) are false.
< TOP >
3.
Answer : (c) Reason : The idea that trade is beneficial to both the parties rests on the assumption that buyers and sellers know what they are doing. The failure of this assumption is described as “asymmetric information”.
< TOP >
4.
Answer : (c) Reason : Bank rate is the rate at which RBI lends to banks. Options in (a), (b), (d) and (e) are not correct.
< TOP >
5.
Answer : (a) Reason : Ways and Means Advances is not a source of financing for the Government but only accommodates temporary mismatches in Government receipts and payments. Option in (a) is false. Options in (b), (c), (d) and (e) are true.
< TOP >
6.
Answer : (d) Reason : The minimum paid up capital required to set up a Local Area Bank (LAB) is Rs.500 lakhs.
< TOP >
7.
Answer : (c) Reason : Replacement of the credit of one party to a transaction with the credit of a financial institution is called ‘Credit substitution’. Putting of assets to guarantee performance is called bonding. Appointment of someone to act for others in a transaction is called delegation. There is no credit netting. Correct answer is c.
< TOP >
8.
Answer : (c) Reason : Disintermediation means loss of deposits by financial intermediaries because direct lending becomes more attractive. Loss of deposits by financial intermediaries because alternative types of indirect lending becomes more attractive, is called reintermediation. Options in (a), (b), (d) and (e) are not correct.
< TOP >
9.
Answer : (b) Reason : The commercial paper issued by a borrower is an unsecured money market instrument. Options in (a), (c), (d) and (e) are not correct.
< TOP >
10.
Answer : (b) Reason : Registration of charge with the Registrar of Companies is not required in the case of pledge loans given to the companies. In all other cases mentioned in (a), (c) and (d) charge is to be registered with the Registrar of Companies.
< TOP >
11.
Answer : (a)
< TOP >
Reason : ENPA = 12.
PAT /(1 − t) / TA NPA / TA
=
30 / 0.65 0.15x 500
= 61.54%
Answer : (b) Reason : The subordinated debt instrument issued by a bank should have a minimum maturity of 5 years.
< TOP >
13.
Answer : (d) Reason : Malhotra Committee setup by the Government of India recommended changes in the insurance sector. Goiporia Committee made recommendations on customer service. Chore committee made recommendations on maximum permissible bank finance in connection with the working capital finance. Narasimham Committee recommended on banking reforms. Verma Committee recommended on restructuring of weak public sector banks. Correct answer is (d).
< TOP >
14.
Answer : (d) Reason : Every NBFC has to create reserve fund and transfer every year an amount not less than 20% of net profit.
< TOP >
15.
Answer : (d) Reason : In a REPO transaction, there is no counter party risk as the lending is secured by government/approved securities. Options in (a), (b) and (c) do not arise in a REPO transaction.
< TOP >
16.
Answer : (c) Reason : Fiduciary risk refers to the risk of losses that may arise by undertaking off-balance sheet transactions.
< TOP >
17.
Answer : (c)
< TOP >
Reason :
100 − x 365 × x 91
= 0.05 X = 98.77 Purchase price of T-bill is Rs.98.77.
18.
Answer : (d) Reason : Equitable mortgage is created by deposit of title deeds. Deposit of title deeds is an essential feature of equitable mortgage. Options in (a), (b), (c) and (e) are not correct.
< TOP >
19.
Answer : (a) Reason : Basis risk is the risk arising out of two different benchmark rates not moving in tandem. When the costs of liabilities and the yields on assets are linked to different benchmarks in a float rate situation, it gives rise to basis risk. A put option is exercised by the investor in an increasing interest rate scenario. This is called put risk. A call option is exercised by the issuer to redeem the bonds/securities before maturity in a declining interest rate scenario. This is called call risk. Cash inflows in an declining interest rate scenario due to prepayment of loans gives rise to prepayment risk since these cash flows are to be redeployed at a lower rate. Real interest rate risk occurs because the changes in the nominal interest rates may not match with the changes in inflation.
< TOP >
20.
Answer : (c) Reason : Return on assets is the ratio of net profit to total assets while ENPA (Earnings before taxes as a proportion to NPAS, is the ratio of profit before taxes to NPA. The credit risk is quantified in terms of ENPA. As ROA increases ENPA will also increase. Alternatives: (b) Higher ENPA level indicates lower credit risk (c) NPAs increase as ENPA level falls is not true (d) Margin of safety increases with ENPA rise. (e) The curve will be upward sloping not downward sloping since ENPA increases with ROA.
< TOP >
21.
Answer : (a) Reason : Unclaimed deposits is a demand liability and all the other liabilities under (b), (c), (d) and
< TOP >
(e) are examples of time liabilities. 22.
Answer : (b) Reason : Mismatch between maturity patterns of assets and liabilities for a bank exposes to liquidity risk. Alternatives: (a), (c), (d) and (e) are not related to maturity patterns.
< TOP >
23.
Answer : (a) Reason : (a)
< TOP >
The right of the insurer to stand in the place of the insured after settlement of a claim is so far as the insured’s right of recovery from an alternative since is involved, is called subrogation. (b) Nomination refers to the procedure which enables the nominee to get the policy proceeds/ or deposits without the necessity of producing any legal representation to the estate of the deceased. (c) The situation in which one party transfers its rights and duties under a contact to a third party with or without the concurrence of the other party to the contract is called assignment. (d) Indemnity refers to the assurance given by one to put the person who obtained assurance in the event of loss, in the same position that he/she occupied immediately before the happening of the event for which indemnity is sought for (e) A warranty is a stipulation which is collateral to the main purpose of the
contract. 24.
Answer : (b) Reason : By not paying interest on current a/c bank is saving its expenditure on cost of funds. By offering free cheques, bank is not put to any leakage of income as the same is compensated in saving the interest payment on current account balances. Such a pricing strategy is referred as implicit pricing. The other strategies in options (a), (c), (d) and (e) are as follows: Rebate strategy: The bank makes charges but rebates on basis of balance Explicit pricing: Charge as the costs go and competition permits. Relationship pricing: If the customer has more than one account, he gets a better price. Symmetric account: Paying interest as function of minimal or average balance.
< TOP >
25.
Answer : (b) Reason : Value of insured property at the time of loss = Rs.10 lakhs Sum insured = 6 lakhs Amount of loss due to fire accident = 4 lakhs
< TOP >
Amount payable =
Sum insured × Amount of loss Value at the time of loss
Rs.6 lakhs × Rs.4 lakhs Rs.10 lakhs
= = Rs.2.40 lakhs. 26.
Answer : (c) Reason : Equity multiplier is a measure of asset creation. It is calculated on
< TOP >
Total Assets Total Equity
Other alternatives are not correct as they are all measured against net profit. 27.
Answer : (d) Reason : The interest rate on savings bank is regulated by Reserve Bank of India. The interest rates on other deposits are deregulated.
< TOP >
28.
Answer : (b) Reason : Revaluation reserves should be valued at 45%, Tier II capital should not exceed Tier I capital and subordinate debt should not exceed 50% of Tier I capital. So only alternative (b) is correct
< TOP >
29.
Answer : (a) Reason : Pledgee can sell the security under notice without filing a suit. Under pledge possession is with the pledgee and ownership remains with the pledgor. A pledgee can auction the goods / security to recover the dues. Any surplus realized after adjusting the dues is to be returned to the pledgor.
< TOP >
30.
Answer : (c) Reason : Guarantees issued by banks against coenter guarantees of other banks carries risk weight of 20%.
< TOP >
Part B : Problems 1.
a.
Rate Sensitive Gap
= Rate Sensitive Assets – Rate Sensitive Liabilities
Rate Sensitive Assets
= 7,200 + 2,700 = Rs.9,900 cr
Rate Sensitive Liabilities = 9,700 + 300 = Rs.10,000 cr Rate Sensitive Gap
= 9,900 – 10,000 = – 100cr
b.
Rate Adjusted Gap
= Rate Adjusted Assets – Rate Adjusted Liabilities
Rate Adjusted Assets: Advances
= 7,200 × 1
= 7,200
Investments
= 2,700 × 0.80
= 2,160
Total
Rs. 9,360 cr.
Rate Adjusted Liabilities: Deposits
= 9,700 × 0.75
Borrowings
=
300 × 1.00
Total Rate Adjusted Gap
= 7,275 =
300
Rs.7,575 cr. = 9,360 – 7,575 = Rs.1,785 crore
c.
c.
Change in the market value of assets = =
-Duration of assets ×change in interest ×Total assets 1 +Current int erest rate
−4 ×1×11, 200 1.10
= – 407.27 crore New market value of assets
= 11,200 – 407.27 = Rs.10,792.73 crores
Similarly the change in market value of liabilities can be computed with the above formula Change in the market value of liabilities
=
−3 ×1×10, 400 1.10
= – 283.64 core New market value of the liabilities
= 10,400 – 283.64 = Rs.10,116.36
New market value of the equity with the current rate = 10,792.73 – 10,116.36 = Rs.676.37 crore.
d.
Change in market value of equity
= 800 – 676.37
(Decrease by)
= Rs.–123.63 crore
d. In order to protect the market value of the equity, the bank has to adjust the duration of either the assets or liabilities. The market value of the equity is protected by adjusting the duration of assets
Duration of assets
= Duration of liabilities × =3 ×
Liabilities Assets
10, 400 11, 200
= 2.786 years Change in the market value of assets =
2, 786 ×1% ×11, 200 1.10
= Rs.-283.66 crore New market value of the assets
= 11,200 – 283.66 = Rs.10,916.34 crores
Change in the market value of the liabilities =
3 ×1×10, 400 1.10
= – 283.64 crore New market value of the liabilities
= 10,400 – 283.64 = Rs.10,116.36 crore
New market value of equity at current rate
= 10,916.34 – 10,116.36 = 799.98 crore
Hence by adjusting the duration of assets from 4 years to 2.786 years, the market value of the equity can be protected. < TOP >
2.
Computation of Tier I Capital Crores 30 25 22 77 15 62
Equity Statutory Reserve Capital Reserve Total Less Equity investments in subsidiaries Total (Tier I Capital) Undisclosed reserves Cumulative shares Revaluation reserves General Provisions
5 15 70 9
Computation of Tier II capital Amount
Discounted by 55% Amount of GPLR or 1.25% of RWA which ever is less
5 15 31.50 9
Subordinated debt 2-3 Yrs 5 40% 0.40 2 4-5 Yrs 10 80% 80% 8 Less then 1 Yr 10 0% – – Total (Tier II Capital) 70.50 The total of Tier II capital is limited to a maximum of 100% of Tier I capital. Therefore, Tier II capital is taken as Rs.62 crores. Total Capital (Tier I + Tier II) = 62 + 62 = Rs.124 crores Computation of Risk weighted Assets Of Balance Sheet Assets
Assets
Value
Cash on Hand Balance with RBI Gold Investment in Government securities Claims on Commercial Banks Balance in accounts with other banks Investment in shares & Debentures Loans granted to Undertakings of Government of India Others Furniture & fixtures Building Tax paid in advance Total Off- Balance sheet items Particulars
Risk weight assets
73 24 20 120 20 15 45
Risk Weight assigned (%) 0 0 0 2.5 20 20 100
16 580 25 10 45
100 100 100 100 0
16 580 25 10 0 686
Amount (Rs. in crores)
Conversion factor
Risk weight (%)
65 × 0.50 40 × 0.80
1.00 1.00
100 100
Guarantees given Letters of credit Total
Total risk weighted assets
Capital Adequary Ratio
= = =
– – 0 3 4 3 45
Risk Weight Assets (RWA) (Rs. in crores) 32.50 32.00 64.50
686 + 64.50 750.50 Capital Risk weighted Assets 124 = 16.52% 750.50
=
< TOP >
3.
The banks total working funds consists of only capital and deposits.
Capital Demand Deposits Demand Deposits Term Deposits
Amount (Rs.) 10 15 15 60
100 Lendable funds (working) CRR 4.5% of 90 (60 + 15 + 15) SLR 25% of 90 Funds after Interest spread = 100 – 3 = 97 Lendable funds = 97 – 26.05 = A = 70.45 × 0.40 = B = 70.45 × 0.40 = C = 70.45 × 0.20 =
Rate
Cost (Rs.)
12
1.20
3 6
0.45 3.60 5.25
4.05 22.50 26.05 70.45 28.18 28.18 14.09
Let the PLR be X% The income of the bank is as follows
Particulars CRR SLR Loans A B C
Amount (Rs.) 4.05 22.50
Rate (%) – 6
28.18 28.18 14.09
X X + 0.01 X + 0.02
Income – 1.35 28.18X 28.18X + 0.2818 14.09 X + 0.2818 70.45X + 1.9136
Required spread = 3% PLR for the bank 3 = (70.45X + 1.9136) – 5.25 X = 8.99% Say 9% < TOP >
4.
st
1 Leg: in crores) The amount received by Janata Bank on sale at Rs.113 (100/100)
(Rs. 113.000
Interest for the broken period of 60 days (From August 07,2003 to October 06,2003 at 11.43% on Rs.100 crore) =
100 ×11.43 × 60 *36000
Total amount received in the first leg
1.905 114.905
2nd Leg
(Rs. in crores) Amount repayable by Janata Bank
114.9050
Repo interest for 3 days =
3 ×114.905 × 6 **36500
Total amount paid in the 2nd leg of the Repo
0.0567 114.9617
* Compulation of days based on 30/360 day count convention ** Compulation of days based on actual /365 days count convention applicable to money market instruments < TOP >
5.
Contracted rate
: 12%
Probability of default
: 0.10
Recovery rate
: 80%
Term
: 2 years
Expected return
: P1(r) + P2 (R – 1) Where
P2 = Probability of default P = Principal component R = Recovery rate
= 0.12 × 0.90 + 0.10 (0.80 – 1)
Expected Return
= 0.108 – 0.02 = 8.8% 8.8% is 2 year prime rate 10.5% is 1 year prime rate If ‘X’ be 1 year prime rate after one year (1.088)2
=
(1.105) (1+r)
1+r
=
1.0713
r
=
7.13%
< TOP >
6. Earnings assets
:
Rs.4,400 cr
Net Interest Income
:
Rs.125 cr
Variation in NII
:
10%
NIM (NII/Earning assets) :
3.5%
Target Gap
=
Earnings Assets × NIM ×Variation in NIM Change in interest rates
= Target Gap
=
4, 400 ×0.035 ×0.10 = Rs.3, 080 0.005 4, 400 ×0.035 ×0.10 = Rs.1, 540 0.01
Change in interest rate
for a change of 0.5% in interest rate for a 1% change
Probability
Gap
Rs. in crores
– 3,080
+ 3,080
– 1,540
+ 1,540
– 0.5%
0.10
+15.40
– 15.40
+ 7.70
– 7.70
+ 0.5%
0.20
– 15.40
+15.40
– 7.70
+ 7.70
– 1.0%
0.30
+ 30.80
– 30.80
+ 15.40
– 15.40
+ 1.0%
0.40
– 30.80
+ 30.80
– 15.40
+ 15.40
– 4.62
+ 4.62
– 2.31
+ 2.31
Expected change in NII
Part C: Applied Theory
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7.
It is rightly said that bank can manage the liability either through asset or through the liability management or a mix of both. A commercial bank requires liquidity to accommodate deposit withdrawals or to pay other liabilities as they mature. Payments of withdrawals can be made only from assets. All cash accounts are available to the bank for payments of immediate withdrawals at no cost to the bank. All other assets must be converted into cash assets. The conversion process involves the time and the expenses to sell assets as well as the risk that they may be sold below their purchase price (a capital loss). Asset management classified bank assets into four basic groups: 1) Primary Reserves, 2) Secondary Reserves, 3) Bank Loans 4) Investments for income and tax shields. Summary of Asset Management Strategy: Category & Type of Asset Purpose Liquidity Yield Primary reserves Immediate available funds Highest None – Cash – Interbank Deposits 2. Secondary Reserves Easily marketable funds High Low – T-Bills – Short term securities 3. Bank loans Income Lowest Highest – Business loans – Consumer loans – Real estate loans 4. Investments Income when safe loans are Medium Medium – Treasury securities Unavailable & Tax advantages Liability Management: This is based on assumption that certain types of bank liabilities are very sensitive to interest rate changes. Thus, by raising the interest rates paid on these liabilities above the market rate, a bank can immediately attract additional funds. On the other hand, by lowering the rate paid on these liabilities, a bank may allow funds to run off as the liability matures. The liquidity gained by liability management is useful to bank in several ways. First, it could be used to counteract deposit inflows and outflows and reduce their variability. Sudden or unexpected outflow can be offset immediately by the purchase of new funds. Secondly funds attracted by liability management may be used to meet increase in loan demand by bank’s customer. As long as the expected marginal return of the new loans exceeds the expected marginal costs of funds, the bank can increase this income by acquiring the additional funds through liability management. Thus, liability management supplements asset management but does not replace it as a source of bank liquidity. Asset management still remains the primary source of liquidity for banks particularly small banks. If used properly, liability management allows bank to reduce their secondary reserves holding and invest these funds in high yield assets. Liability management is not well suited to smaller banks, because they do not have direct access to the whole sale money markets where liability management is practiced. 1.
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8.
Legally, insurance is a uberrimae fides contract where one party agrees to compensate the other in consideration of a certain smaller sum. Such compensation is contingent upon happening or non-happening of a certain event. Uberrimae fides relates to one of the 8 elements of insurance – Utmost Good Faith. Uberrimae fides contracts require utmost good faith on both the parties of an insurance contract that ask for voluntary disclosure of all material facts relevant to the subject matter of the contract. Thus, in an insurance contract, both the person who is buying insurance and the insurance company should disclose all material facts at the time of entering into the contract. Any material facts that are not disclosed to the other party having a direct or indirect relationship to the contract will make it null and void. The assured must disclose material facts which he knows or ought to know, at the time when he is making or is under the duty to make disclosure. The assured is under such duty until there is a binding contract of insurance made. The question as to whether certain facts are material or not will not be decided by the assured but is to be determined by the views of reasonable and prudent insurer. Thus materiality is a question of fact, to be decided in the circumstances of each case and may be generally taken to embrace every circumstances which would influence the judgment of a prudent insurer in fixing the premium or determining whether he will take the risk and if so, at what premium and on what conditions.
It also means that the person who is buying insurance should disclose all material facts to the insurance company, and it is for the insurance company to determine relevance of each material facts. But in practice, the prospective assured is given a proposal form upon which certain questions relating the risk to be insured are asked. This has considerable bearing upon the question of materiality involved in the non-disclosure and misrepresentation. The express terms that are contained in the proposal form as a rule are called warranties, by which the truth of the answers to proposal form is made the basis to the liability of insurers under contract. Apart from this, the insurance company is obligated to explain the implication of the clauses in the agreement and further to explain each of the questions of which the answers are sought in the personal statement. Apart from Utmost Good Faith, there are seven other elements of insurance contract which are listed below: •
Insurable Interest
•
Indemnity
•
Subrogation
•
Warranties
•
Proximate Cause
•
Assignment
•
Nomination
Insurable Interest A valid contract of insurance should have an insurable interest’ by the person who is buying insurance (the policyholder) in the existence of the subject matter that is being insured. That is, the policyholder should be able to establish a monetary relationship between her and the subject matter of the insurance. Any loss of subject matter should directly lead to monetary loss to the policyholder. All insurance contracts should compulsorily have an insurable interest by the policyholder. Indemnity Indemnity refers to the assurance given by one to put the person who obtained assurance, in the event of loss, in the same position that he/she occupied immediately before the happening of the event for which indemnity is sought for. Therefore, all insurance contracts except for life insurance, are considered as contracts of indemnity. The principles of indemnity and the principle of insurable interest are considered complementary to each other as the insured has to prove that he/she is the person who will suffer a loss (approximately) to the extent of sum assured. Subrogation Doctrine of Subrogation refers to “the right of the insurer to stand in the place of the insured, after settlement of a claim, in so far as the insured’s right of recovery from an alternative source is involved”. When the value of compensation that is recovered from the third party is more than the indemnified value, then the insurer may charge the appropriate share of any expense incurred in recovering or collecting the money. Warranties are conditions that are written by the insured in the insurance contracts that state the truth by affirming or denying the existence of particular state of facts. Warranties that are mentioned in the policy are called express warranties and those which are not written in the policy are implied warranties. Also, there are warranties which are answers to the questions (called affirmative warranties) and some warranties fulfilling certain conditions or promises. Proximate Cause Proximate cause refers to the immediate cause that resulted in the loss. For example, when there is loss of property due to fire caused by a short circuit, the proximate cause will be short circuit (even if the short circuit occurs due to some other cause, say, the malfunctioning of an electric equipment). It is the cause without which the loss would not have occurred. An insurer is liable for any loss proximately caused by a peril insured against. Assignment Assignment refers to the situation in which one party transfers its rights and duties under a contract to another party. Both life insurance policies as well as general insurance policies can be assigned. Many of the loan companies and housing finance companies grant loan to the individuals on assignment of life insurance policies. Nomination
Nomination refers to the procedure which enables the nominee (in whose favor nomination is given) to get the policy proceeds without the necessity of producing any legal representation to the estate of the deceased life assured There need not be any reason for nomination of a policy, a policy may be assigned for a legal consideration or love and affection. The nomination may be changed during the course of the life of the assured. However, once the assignment is made, it cannot be revoked by the assignor because he ceases to be the owner of the policy unless re-assignment is made by the assignee in favor of the assignor. < TOP >
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