Question Paper Management of Financial Institutions – II (322) : July 2005 Section D : Case Study (50 Marks) This section consists of questions with serial number 1 - 5. Answer all questions. Marks are indicated against each question. Do not spend more than 80 - 90 minutes on Section D.
Case Study Read the case carefully and answer the following questions: 1.
Compute the relevant ratios for assessing the performance of the bank in the following areas: a. b. c. d.
Liquidity Deployment Profitability Liability mix. (10 marks) < Answer >
2.
Comment on the performance of the bank based on the above ratios. (8 marks) < Answer >
3.
Comment on the risk profile of the bank based on (i) CAR (ii) Average Risk Weight (iii) Gross NPAs to Gross Advances (iv) Net NPAs to Net Advances and (v) ENPA.
4.
a.
How should a bank of this size manage its market risk? Discuss.
b.
What is CDR? How assets are classified under CDR?
(10 marks) < Answer >
(4 + 6 = 10 marks) < Answer > 5.
Discuss the guidelines of RBI on classification and valuation of investment portfolio of banks. (12 marks) < Answer > Indian Bank Balance Sheet as on 31st March 2005 (Rs. in Crore)
1
Schedule CAPITAL & LIABILITIES Capital Reserves and Surplus Deposits Borrowings Other Liabilities and Provisions TOTAL ASSETS Cash and Balances with RBI Balances with Banks and Money at Call and Short Notice Investments Advances Fixed Assets Other Assets TOTAL Contingent Liabilities Bills for Collection Notes to Accounts Principal Accounting Policies
As on 31.03.2005
As on 31.03.2004
1 2 3 4 5
4573.96 1362.41 34808.44 724.59 2391.31 43860.71
4573.96 963.87 30444.40 298.92 2872.92 39154.07
6
1962.04
2843.75
7 8 9 10 11
610.30 17920.99 18380.10 449.39 4537.89 43860.71 5862.03 1735.04
300.85 16696.21 14126.08 434.34 4752.84 39154.07 5237.21 1281.88
12 17 18
Profit and Loss Account for the year ended 31st March 2005 (Rs. in Crore)
2
Schedule I.
Year ended 31.03.2004
INCOME Interest earned
13
2870.65
2666.92
Other Income
14
568.82
747.33
3439.47
3414.25
TOTAL II.
Year ended 31.03.2005
EXPENDITURE Interest Expended
15
1567.00
1549.86
Operating expenses
16
914.40
1061.93
549.58
396.71
3030.98
3008.50
408.49
405.75
289.09
110.00
Transferred to Capital Reserve-Others
0.30
0.00
Transferred to Investment Fluctuation Reserve
114.10
280.00
Transferred to Staff Welfare Fund
5.00
3.00
Balance of Profit
0.00
12.75
Profit/(Loss) carried from last account
(3830.14)
(3842.89)
TOTAL
(3830.14)
(3830.14)
Balance carried over to Balance Sheet
(3830.14)
(3830.14)
TOTAL
(3830.14)
(3830.14)
Provisions and Contingencies TOTAL III. PROFIT/ LOSS Net Profit/(Loss) for the year IV.
APPROPRIATIONS Transfer to Statutory Reserve
SCHEDULES FORMING PART OF THE ACCOUNTS SCHEDULE 1: CAPITAL (Rs. in Crore) As at 31.03.2005
As at 31.03.2004
As per last Balance Sheet
4573.96
4573.96
Additions during the year
0.00
0.00
4573.96
4573.96
Capital (Fully owned by Central Government)
TOTAL
SCHEDULE 2 : RESERVES AND SURPLUS
3
I.
II.
B.
III.
IV.
STATUTORY RESERVES a) Opening Balance b) Additions during the year TOTAL I CAPITAL RESERVES A. Revaluation Reserve a) Opening Balance b) Deductions during the year TOTAL (A) Others a) Opening Balance b) Addition during the year TOTAL (B) TOTAL II (A + B) REVENUE AND OTHER RESERVES Opening Balance TOTAL III INVESTMENT FLUCTUATION RESERVE a)
Opening Balance
b)
Additions during the year TOTAL IV TOTAL (I + II + III + IV)
217.41 289.08 506.49
107.40 110.00 217.40
232.79 (4.94) 227.85
238.00 (5.20) 232.80
0.00 0.30 0.30 228.15
0.00 0.00 0.00 232.80
70.78 70.78
70.78 70.78
442.89
140.00
114.10 556.99 1362.41
302.89 442.89 963.87
SCHEDULE 3: DEPOSITS (Rs. in Crore) A.
B.
As at 31.03.2005 DEMAND DEPOSITS i) From Banks 35.45 ii) From Others 2822.85 TOTAL 2858.30 II. SAVINGS BANK DEPOSITS 9275.66 III. TERM DEPOSITS i) From Banks 420.63 ii) From Others 22253.85 TOTAL 22674.48 TOTAL (I + II + III) 34808.44 i) Deposits of Branches in India 34081.03 ii) Deposits of Branches outside India 727.41 TOTAL 34808.44 SCHEDULE 4: BORROWINGS
As at 31.03.2004
I.
4
67.92 2273.03 2340.95 7868.38 497.19 19737.88 20235.07 30444.40 29633.18 811.22 30444.40
I.
II.
BORROWINGS IN INDIA i)
Reserve Bank of India
0.00
0.00
ii)
Other Banks
241.43
58.71
iii)
Other Institutions & Agencies
212.81
114.33
TOTAL
454.24
173.04
BORROWINGS OUTSIDE INDIA
270.35
125.88
TOTAL (I + II)
724.59
298.92
Nil
Nil
Secured borrowings included above
SCHEDULE 5: OTHER LIABILITIES AND PROVISIONS I. II. III. IV.
Bills Payable 344.00 298.97 Inter Office Adjustments (Net) 465.26 552.98 Interest Accrued 164.44 140.93 Others (including provisions) 1417.61 1880.04 TOTAL 2391.31 2872.92 SCHEDULE 6: CASH AND BALANCES WITH RESERVE BANK OF INDIA (Rs. in Crore) As at 31.03.2005
As at 31.03.2004
I.
Cash in hand (including foreign currency notes)
87.70
79.29
II.
Balances with Reserve Bank of India in Current Account
1874.34
2764.46
TOTAL
1962.04
2843.75
SCHEDULE 7: BALANCES WITH BANKS & MONEY AT CALL AND SHORT NOTICE I.
IN INDIA i)
Balances with Banks a)
In Current Accounts
b)
In Other Deposit Accounts TOTAL (i)
ii)
30.95
34.68
250.29
94.44
281.24
129.12
0.00
0.00
0.00
0.00
281.24
129.12
320.13
166.63
Money at Call and Short Notice (with Banks) TOTAL (ii) TOTAL (i) + (ii)
II.
OUTSIDE INDIA (i)
In Current Accounts
(ii)
In Other Deposit Accounts
0.00
3.04
(iii)
Money at Call & Short Notice
8.93
2.06
329.06
171.73
610.30
300.85
TOTAL (i) + (ii) + (iii) GRAND TOTAL (I + II)
SCHEDULE 8: INVESTMENTS (Rs. in Crore)
5
I.
II.
III.
As at 31.03.2005 INVESTMENTS IN INDIA IN: i) Government Securities 15191.37 ii) Other approved Securities 562.84 iii) Shares 83.13 iv) Debentures and Bonds 1836.79 v) Subsidiaries and /or joint ventures 3.78 vi) Others (Mutual Fund Units) 80.19 TOTAL 17758.10 INVESTMENTS OUTSIDE INDIA IN: i) Government Securities (including local authorities) 140.78 ii) Other investments a) Shares 0.09 b) Debt Securities 22.02 TOTAL 162.89 GRAND TOTAL (I + II) 17920.99 GROSS & NET INVESTMENT A. IN INDIA Gross 17891.96 LESS: Provision for Depreciation 133.87 Net (A) 17758.09 B. OUTSIDE INDIA Gross 164.76 Less : Provision for Depreciation 1.86 Net (B) 162.90 NET GRAND TOTAL (A + B) 17920.99 SCHEDULE 9: ADVANCES
As at 31.03.2004 13826.20 584.13 53.83 1635.83 3.78 444.83 16548.60 112.57 0.09 34.95 147.61 16696.21 16677.25 128.65 16548.60 148.13 0.52 147.61 16696.21 (Rs. in Crore)
A.
i) ii) iii)
B.
i) ii) iii)
C.
I.
II.
As at 31.03.2005 Bills Purchased and Discounted 653.65 Cash Credits, Overdrafts & Loans repayable on demand 8474.19 Term Loans 9252.26 TOTAL 18380.10 Secured by Tangible Assets (including advances against Book Debts) 13358.49 Covered by Bank/ Government Guarantees 2742.49 Unsecured 2279.12 TOTAL 18380.10 ADVANCES IN INDIA i) Priority Sectors 7891.04 ii) Public Sector 3191.84 iii) Banks 4.53 iv) Others 6285.07 TOTAL (C – I) 17372.48 ADVANCES OUTSIDE INDIA i) Dues from Banks 439.03 ii) Dues from others a) Bills purchased and discounted 101.46 b) Syndicated loans 117.42 c) Others 349.71 TOTAL ( C – II) 1007.62 GRAND TOTAL (C-I + C+II) 18380.10 SCHEDULE 10: FIXED ASSETS
As at 31.03.2004 473.01 7723.49 5929.58 14126.08 10533.96 1792.21 1799.91 14126.08 5396.55 2774.42 6.03 4864.84 13041.84 548.58 62.49 127.25 345.92 1084.24 14126.08 (Rs. in Crore)
6
As at 31.03.2005 I.
PREMISES (At cost / Revaluation as per last Balance sheet Additions/Adjustments during the year
407.59 1.05 408.64 0.65 407.99 98.42 309.57 9.31
409.57 (0.53) 409.04 1.45 407.59 92.34 315.25 8.81
314.44 50.59 365.03 10.71 354.32 Depreciation to date 223.81 TOTAL 130.51 TOTAL (I + II + III) 449.39 SCHEDULE 11: OTHER ASSETS
286.53 44.84 331.37 16.93 314.44 204.16 110.28 434.34
Deducting during the year
II. III.
As at 31.03.2004
Depreciation to date TOTAL BUILDING UNDER CONSTRUCTION OTHER FIXED ASSETS (Including furniture and fixtures) At cost as per last Balance Sheet Additions/Adjustments during the year TOTAL Deductions during the year
(Rs. in Crore) As at 31.03.2005
As at 31.03.2004
I.
Interest accrued
343.37
406.36
II.
Tax paid in advance/tax deducted at source
134.00
141.82
III.
Stationery and Stamps
11.43
8.30
IV.
Non-banking Assets acquired in satisfaction of claims
2.41
2.43
V.
Others
216.54
363.79
VI.
Profit & Loss Account Balance (Loss)
3830.14
3830.14
4537.89
4752.84
TOTAL
SCHEDULE 12: CONTINGENT LIABILITIES (Rs. in Crore)
7
As at 31.03.2005 I.
Claims against the Bank not acknowledged as Debts
II.
Liability for partly paid Investments
III.
Liability on account of outstanding forward exchange contracts
IV.
As at 31.03.2004
277.62
206.95
0.08
0.08
2624.90
2890.92
1265.86
777.75
7.58
9.08
Guarantees given [including secured guarantees of Rs.813.88 Crores (previous year Rs.404.06 Crores)] on behalf of constituents a)
In India
b)
Outside India
V.
Acceptances, Endorsements and Other Obligations
1426.89
1161.22
VI.
Other item for which the bank is contingently liable
259.10
191.21
5862.03
5237.21
TOTAL
SCHEDULES TO PROFIT AND LOSS ACCOUNT SCHEDULE 13: INTEREST EARNED (Rs. in Crore) Year ended 31.03.2005
Year ended 31.03.2004
I.
Interest/Discount on Advances / Bills
1381.88
1171.95
II.
Income on Investments
1441.32
1454.64
III.
Interest on balances with RBI and other Inter-bank funds
46.02
40.20
IV.
Others
1.43
0.13
2870.65
2666.92
Year ended 31.03.2005 115.69 209.77 (3.62) (0.74) 68.66
Year ended 31.03.2004 107.87 465.47 0.00 0.12 58.32
4.64 174.42 568.82
5.84 109.71 747.33
1507.65 33.92 25.43 1567.00
1506.77 28.32 14.77 1549.86
TOTAL SCHEDULE 14: OTHER INCOME
I. II. III. IV. V. VI. VII.
I. II. III.
Commission, Exchange and Brokerage Profit on sale of Investments (Net) Profit on Revaluation of Investments Profit on sale of land, buildings and other assets (Net) Profit on exchange transactions (Net) Income earned by way of dividends etc. from subsidiaries/companies and/ or joint ventures abroad/in India Miscellaneous Income TOTAL SCHEDULE 15: INTEREST EXPENDED Interest on Deposits Interest on Reserve Bank of India / Inter-Bank borrowings Others TOTAL SCHEDULE 16: OPERATING EXPENSES
8
I. II. III. IV. V.
Payments to and Provisions for employees Rent, Taxes and Lighting Printing and Stationery Advertisement and Publicity Depreciation on Bank's property 35.76 35.95 Less : Transferred from 4.94 5.20 Revaluation Reserve VI. Directors' Fees, Allowances and Expenses VII. Auditors' Fees and Expenses(including Branch Auditors) VIII. Law Charges IX. Postages, Telegrams, Telephones etc. X. Repairs and Maintenance XI. Insurance XII. Other Expenditure TOTAL
637.51 64.81 12.28 11.02
862.70 57.25 10.79 3.97
30.82
30.75
0.19 8.67 1.73 0.96 19.50 26.38 100.53 914.40
0.36 8.21 1.54 0.92 16.27 15.82 53.35 1061.93
SCHEDULE 17: NOTES ON ACCOUNTS 1.
2.
RECONCILIATION AND ADJUSTMENTS 1.1
Reconciliation of inter-branch items is completed upto 31/03/2005. The Bank through various effective steps has achieved substantial reduction in the clearance of outstanding entries. Reconciliation and consequent adjustment of the remaining outstanding entries is in progress.
1.2
In view of net credit position in respect of unreconciled entries in the Inter Branch accounts outstanding for more than 6 months as on 31.03.05, no provision is required.
1.3
Old outstanding entries in drafts payable, clearing adjustments, sundries receivable, sundry deposit accounts, etc. and in bank reconciliation relating to Reserve Bank of India and other banks are being regularly reviewed for appropriate adjustments.
1.4
In certain branches, balances in some of the accounts including advances have to be reconciled with subsidiary ledgers/registers.
PROVISION FOR ADVANCES In respect of non-performing assets, the benefit of ECGC cover to the tune of Rs.3.51 Crores (Previous Year Rs.6.84 Crores) has been considered on the assumption that the claims lodged will be recovered in full.
3.
4.
FIXED ASSETS 3.1
Premises include properties costing Rs.11.18 crore, the book value of which is Rs.9.03 crore (previous year Rs.11.54 crore and Rs.9.51 crore respectively), for which registration formalities are in progress.
3.2
Certain premises of the Bank in India were revalued in the years 1992-93 and 94-95 and the resultant appreciation of Rs.286.03 crore was credited to “Revaluation Reserve Account”. Additional depreciation on the revalued portion amounting to Rs.4.94 crore (previous year Rs.5.20 crore) has been charged and an equivalent withdrawal is made from the “Revaluation Reserve Account.”
DISCLOSURES IN TERMS OF ACCOUNTING STANDARDS (AS) : 4.1
CASH FLOW STATEMENT (AS 3) The Cash Flow Statement for the year 2004-2005 is annexed separately.
4.2
NET PROFIT OF LOSS FOR THE PERIOD, PRIOR PERIOD ITEMS AND CHANGES IN ACCOUNTING POLICES (AS 5) AND REVENUE RECOGNITION (AS 9) Except the items referred to in para 5.3 below, all other items constitute less than 1% of the total income/total expenditure of the bank. Hence, no separate disclosure is required in accordance with the guidelines of RBI.
4.3
ACCOUNTING FOR RETIREMENT BENEFITS IN THE FINANCIAL STATEMENTS OF EMPLOYERS (AS 15) 9
In respect of leave encashment, on the basis of actuarial valuation, an amount of Rs.6.05 crore has been charged to profit and loss account of the current year. 4.4
LEASES (AS 19) The properties taken on lease/rental basis are renewable/cancelable at the option of the Bank. The Banks’s liabilities in respect of disputes pertaining to additional rent/lease rent are recognized on settlement or on renewal. The amount of rent/lease rent recognized in the Profit & Loss account for the year is Rs.35.71 crore.
5.
COUNTRY RISK MANAGEMENT The Bank has analysed its net funded exposure to various as on 31.03.05 and such exposure to countries other than Singapore was well within stipulation of 1 percent of the total assets of the Bank. In respect of Singapore, which is classified under ‘Insignificant’ risk category by ECGC Ltd., no provision is required to be provided (previous year Rs.1.02 crore) as per the guidelines of RBI on country risk management.
6.
VOLUNTARY RETIREMENT SCHEME (VRS) The expenditure relating to Voluntary Retirement Scheme aggregating to Rs.448.92 crore is amortised over a period of five years. Accordingly, a sum of Rs.355.37 crore has already been written off and the terminal balance of Rs.93.55 crore is charged to the current year’s Profit and Loss Account.
7.
OTHERS 7.1
7.2
Other liabilities include the following: a)
Recapitalisation loan received from Government of India as Tier II Capital – Subordinated debt Rs.180.94 crore (Previous year – Rs.180.94 crore)
b)
Tier II Bonds Rs.300.00 crore. (Previous year – NIL)
c)
Contingent provisions against standard assets Rs.45.56 crore (Previous year – Rs.34.42 crore).
d)
Contingent provisions against restructured Accounts Rs.166.09 crore (Previous year – 151.42 crore).
e)
Nostro Blocked Account Rs.18.72 crore (Previous year – 18.08 crore).
f)
IBGA Blocked Account of Rs.3.87 crore (Previous year – Rs.1.92 crore).
g)
10% VRS Bonds Rs.40.38 crore (Previous year – Rs.43.60 crore).
Provision for Income Tax :
The following provisions are made towards Income Tax Liability:
a)
Under Sec. 115JB of the Income Tax Act 1961, a provision of Rs.22 crore has been made. (Previous year Rs.21 crore)
b)
The disputed demand outstanding as at 31.03.05 amounts to Rs.156.19 crore out of which Rs.137.82 crore has been paid/adjusted by the Department against refund orders. Considering the decisions of various appellate authorities on similar issues and based on the fact that approval has been granted by the COD to contest the matters, in our opinion no further provision is required.
7.3
Bank has provide an amount of Rs.137.40 crore during the financial year 2004-05 towards Impending wage settlement.
7.4
During the year Bank has raised Rs.300 crore as Tier II bonds issuance of unsecured redeemable NonConvertible Subordinate Bonds at coupon rates of 6.15% and 6.25%.
7.5
No penalty has been imposed by RBI on the Bank and this disclosure is pursuant to RBI guidelines.
7.6
The exposure taken by the Bank in all the accounts as on 31.03.2005 are within the prudential exposure ceilings fixed by the Board in line with RBI guidelines except on Power Finance Corporation Ltd. The exposure taken with the approval of Board on Power Finance Corporation Ltd is 17.78% of capital funds as at 30.09.2004. This exposure is above the Normal Exposure In the case of exposures taken by the Bank in excess of the Normal exposure ceiling during the 9 months period upto 31.12.2004, the excess portions in all accounts (other than Power Finance Corporation Ltd) have been phased out in February 2005 on account of the increase in capital funds as on 30.09.2004 and the revised exposure ceiling fixed by the Board.
7.7
Out of the current year’s profit: a.
A sum of Rs.289.09 crore has been transferred to Statutory Reserve as per Section 17 of the Banking Regulation Act 1949. 10
b. c. d. 8.
A sum of Rs.30 crore has been transferred to Capital Reserve – Others as per RBI guidelines, being the Profit on Sale of Securities under HTM category. A sum of Rs.114.10 crore has been transferred to Investment Fluctuation Reserve (IFR) as per RBI guidelines. A sum of Rs.5.00 crore has been transferred to Staff Welfare Fund.
ADDITIONAL DISCLOSURE IN TERMS OF RBI GUIDELINES 2004-2005
2003-2004
(Percentage) 14.14 300.00
a) Capital Adequacy Ratio b) Amount of subordinated debt raised as Tier II Capital (Rs. cr.)
12.82 Nil
(Percentage)
c) Business Ratios : i) Capital Adequacy Ratio Tier I Capital ii) Capital Adequacy Ratio tier II Capital iii) Interest Income as a % to Average Working Funds iv) Non-Interest Income as a % to Average Working Funds v) Operating Profit as a % to Average working Funds
7.60 6.54 7.34 1.45 2.45
7.66 5.16 7.93 2.22 2.39
Maturity Pattern of Assets/Liabilities (As compiled by the Bank) Maturity Profile – GLOBAL – 31.03.2005 (Rs. in Crore) Over 3 month s and upto 6 month s
Over 6 month s and upto 1 year
Over 1 year and upto 3 years
Over 3 years and upto 5 years
Over 5 years
TOTAL
1-14 Days
15-28 Days
29 Days and upto 3 month s
Advances
1301. 10
1331. 34
614.7 4
2553. 84
2697. 93
5667.2 0
2253. 87
1960.0 8
18380.1 0
Investments
13.10
106.7 7
787.7 7
398.1 2
767.0 5
1707.5 8
2189. 44
11951.1 6
17920.9 9
Deposits
3548. 43
1089. 01
3055. 67
3382. 68
4100. 71
16921. 68
1395. 13
1315.1 2
34808.4 3
Borrowings
464.1 5
11.91
12.24
37.30
29.42
142.57
23.48
3.52
724.59
Of which Foreign Currency
184.5 3
391.3 8
113.21
41.46
84.32
143.57
79.55
132.50
1170.52
Assets Foreign Currency Liabilities
130.7 1
93.29
191.1 4
76.06
110.06
126.15
0.00
0.00
727.41
Restructuring undertaken during the year excluding CDR: (As compiled by the Bank) Particulars
2004-2005
2003-2004
Total amount of the loan assets subjected to Restructuring
199.05
185.20
Of which, Standard assets
182.17
162.00
Sub –Standard assets
16.88
23.20
11
Corporation Debt Restructuring (CDR) during the year Total amount of loan assets subjected to restructuring under CDR Of which, Standards assets Sub-Standard assets
105.19
191.78
99.84
182.16
5.35
9.62
10.24
4.55
235.17
187.46
533.247
410.31
Advances to Sensitive Sectors (As compiled by the Bank) a) Advances to Capital Market Sector b) Advances to Real Estate Sector c) Advances to Commodities Sector Movement in Non Performing Advances (NPAs) (Rs. in Crore) Particulars
2004-2005
2003-2004
Gross NPAs Opening balance
1191.78
1629.82
227.54
221.71
1419.32
1851.53
Less: Deductions during the year
670.97
659.75
Closing balance
748.35
1191.78
82.89
85.79
247.42
383.21
Opening balance
722.78
785.37
Add: Provision made during the year
198.92
341.55
Less: Write off/Write back of excess provisions
503.66
404.14
Closing Balance
418.04
722.78
Opening Balance
12.64
95.41
Add: Additions made the year
32.18
1.99
Sub-Total
44.82
97.40
0.00
84.76
44.82
12.64
Opening balance
8.54
58.69
Add: Provisions made during the year
0.10
2.39
Less: Write off/Write back of excess provisions
0.00
52.54
Closing Balance
8.64
8.54
Add: Additions during the year Sub-total
DICGC/ECGC Claims settled, Sundry Deposits and interest suspense Net NPAs Movement in Provision for non-Performing Advances
Movement in Non-Performing Investments (Gross NPAs)
Less: Deductions during the year Closing Balance Movement in Provision for Depreciation on Non-Performing Investments
12
Provision for Depreciation on Investments (Rs. in Crore) Particulars
2004-2005
2003-2004
Opening balance
128.65
150.76
Add: Provisions made during the year
136.48
0.79
Less: Write off? Write back of excess provisions
129.40
22.90
Closing Balance
135.73
128.65
Investments made in Equity Shares/Convertible debentures
84.98
55.68
Investments made in Units of equity Oriented Mutual Funds
61.93
82.92
Advances against shares (As compiled by bank)
26.27
9.60
Nil
Nil
Financing of equities and investment in shares
Total finance extended for margin trading Schedule 18: Removed intentionally.
END OF SECTION D
Section E : Caselets (50 Marks) This section consists of questions with serial number 6 - 12. Answer all questions. Marks are indicated against each question. Do not spend more than 80 - 90 minutes on Section E.
Caselet 1 Read the caselet carefully and answer the following questions: 6.
What are the various types of insurance products that can be offered through bancassurance? (6 marks) < Answer >
7.
Explain the various benefits and challenges bancassurance offer to Indian banks. (6 marks) < Answer >
8.
Discuss the various factors that may be responsible for the success of bancassurance in India.
(8 marks) < Answer > Liberalization and deregulation of the financial sector, the greater use of financial engineering techniques and models, significant advances in information technology and consumer demands have all resulted in greater competition and better pricing. As a result, banks started identifying new channels to improve their non-interest income by exploiting convergence in the financial industry and financial liberalization. Bancassurance as an alternative distribution channel was identified as a source of improving the non-interest income of banks. Bancassurance refers to a conglomerate offering both banking and insurance products, usually in the form of a holding structure of separate but interacting entities, an integrated alliance exchanging services or an integrated operational mode. It signifies a long-term relationship to provide a wide range of financial products to a common customer base, by exploiting synergies inherent in collaborating institutions. Bancassurance in its purest form refers to a bank issuing insurance policies under its own name and retaining the risk on its books. However, in its broad sense, it can also mean a bank selling insurance products through its own insurance subsidiary/allied company/any other insurer. The latter form is more prevalent in developed countries. The concept is not just a distribution alliance, but signifies a long-term relationship to provide a wider range of financial products to a common customer base, exploiting synergies inherent in the partnering institutions. The motives behind banks selling bancassurance are product diversification and a source of additional fee-based income. In turn, Return on Assets (ROA) can be increased with more fee-based income. In addition, they can leverage their name, 13
recognition and reputation at both local and regional levels. Insurance companies see bancassurance as a tool for increasing their market penetration and premium turnover. The customers see bancassurance as a bonanza in terms of reduced price, high quality product and delivery at doorsteps. Bancassurance has grown at different pace and taken different shapes and forms in different countries depending on the demography, economic and legislation prescription in that country. During the last two decades, bancassurance has taken deep roots in various countries, especially in Europe. In UK about a third of policies are sold through banks. In Spain 72% of premium income comes through bancassurance, whereas in France it is 55%. France, Italy and Spain recorded a penetration of more than 60% due to large middle class population and favorable tax treatment. It had little success in Germany, even after the purchase of Dresdner Bank in 2001 by Allianz, the country's largest insurer. Bancassurance recorded a huge growth in Europe, but not in the USA and Canada. In the US, there were regulatory hurdles as till recently banks were not allowed to do insurance business and vice versa. Even after Gramm-Leach Bliley Act of 1999, target customers have not responded well. In China, banks are limited to playing the role of tied agents to insurance companies, which can still provide a good platform for bancassurance to develop. It is a relatively new concept in Australia and Asia. In the Asian markets, bancassurance has become a favorite choice of bankers and insurers and as a result governments have been offering legislative support. Banks and insurance companies see bancassurance as the answer to the Indian retail financial industry's future income. Public sector banks, newly established private banks and foreign banks, among others, are seeking opportunities in this market. The banks plan to go in for cross selling exercises for their existing customers through direct mailers of regular insurance products. Off-the-shelf products would be sold through customer service executives in the branch lobby; bundled offerings along with auto loans and cards would be sold through the sales force; while complex life products would be sold to high net worth customers through relationship managers and investment advisors. Bancassurance has started picking up after the Insurance Regulatory and Development Authority (IRDA) notified Corporate Agency Regulations in October 2002. Since then, a large number of private and public sector insurance companies tied up with both public and private sector banks for selling insurance products.
Caselet 2 Read the caselet carefully and answer the following questions: 9.
Central banks all over the world are vested with the responsibility of managing foreign exchange reserves. Explain the various needs for holding reserves. (7 marks) < Answer >
10. What level of reserves should be adequate for a country? Discuss. (7 marks) < Answer > With the growth of external trade and cross-border capital flows, foreign currency funds flow from one country to another. Such flows are predominantly in US dollar and, thus, foreign exchange reserves of countries have a greater composition of the US dollar. With the liberalization of capital accounts in many emerging market economies, these economies are emerging as attractive investment destinations for investors from developed countries. Generally, the foreign exchange reserves of countries consist of currencies that are freely convertible in international markets. However, the US dollar has been chosen as the reporting currency of the reserves. Since depreciation of non-dollar currencies in the reserves would affect the total value of reserves in dollar terms, central banks constantly keep shifting the composition of reserve currencies, which depreciate in value in the international markets. Central banks keep a watch over the developments taking place in the foreign exchange markets, which have a direct impact on the value of the reserves. As stated by IMF in its guidelines on reserve management, reserve management is a process that ensures that official public sector foreign assets are readily available to and controlled by authorities for meeting a defined range of national objectives. Typically, countries hold official foreign exchange reserves in support of a range of objectives including to: •
Support and maintain confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency;
•
Limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed and in doing so;
•
Provide a level of confidence to markets that a country can meet its external obligations
•
Demonstrate the backing of domestic currency by external assets;
•
Assist the government in meeting its foreign exchange needs and external debt obligations;
•
Maintain a reserve for national disasters or emergencies; 14
The above guidelines on reserves management are common to any country irrespective of the exchange rate system followed and the type of foreign exchange flows received by the country. The foreign exchange reserves maintained by a central bank consist predominantly of foreign currency assets, the management of which is based on carefully devised policies. Many central banks accumulated gold stock when US dollar and gold were mutually convertible during the period of the Fixed Exchange Rate System of the IMF. Gold stock is considered to be an asset equivalent to foreign currency and has become an important component of the foreign exchange reserves. As regards deployment of foreign currency funds into assets, basically there are three important considerations, viz., safety, liquidity and return and, therefore, central banks do not venture to deploy them in high-risk assets. Some of the central banks that maintain very small levels of foreign exchange reserves place the funds entirely with the external fund managers for an agreed benchmark return.
Caselet 3 Read the caselet carefully and answer the following questions: 11. Elaborate how interest rate risk can be measured as per Basel II. (8 marks) < Answer > 12. Explain the three approaches for measuring operational risk under Basel II. (8 marks) < Answer > The Basel Committee on Banking Supervision (BCBS) has issued comprehensive guidelines to provide explicit capital for Credit and Market Risks. In order to strengthen the soundness and stability of the banking system, the committee imposed a capital charge on Market Risk, which covers a. the risks in trading book of debt and equity instruments and related off-balance sheet contracts and b. foreign exchange and commodities risk. Further, the banks have been given flexibility to use in-house models for measuring market risk. However, these internal models should comply with the criteria prescribed by the committee. The committee believes that operational risk is an important risk faced by the banks and expects Banks to hold capital to protect against losses from it also. The committee has thus developed a new regulatory capital approach taking into account the 3 broad categories of risks viz. Credit, Market and Operational Risks. The two important categories under Market Risk are 1. Interest Rate Risk 2. liquidity Risk. Interest Rate Risk Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured from the earnings and economic value perspective. Earnings perspective involves analyzing the impact of changes in interest rates or accrual or reported earnings in the near term. Economic value perspective involves analyzing the changes of impact of interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. Liquidity Risk Liquidity risk is the potential inability to meet the bank's liabilities as they become due. It originates due to mismatches in the maturity pattern of assets and liabilities. Measuring and managing liquidity needs are important for effective operation of commercial banks. Analysis of liquidity risk involves the measurement of not only the liquidity position of the bank on an ongoing basis but also to examine how funding requirements are required under crisis scenarios. Factors to be taken into consideration while determining liquidity of the bank's future stock of assets and liabilities include their potential market, extent to which maturing assets/liability will be renewed, acquisition of new assets/1iability and the normal growth in assets/liability accounts. Factors affecting the liquidity of assets and liabilities of the bank cannot always be foreseen. They need to be reviewed frequently due to the rapid change in financial markets. Operational Risk Besides the credit and market risk, operational risk is emerging as a fresh challenge to the banks. Operational risk is defined as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events". In simpler terms Operational risk is a risk other than Credit and Market risk. Measurement for this risk is not as easy as for Credit and 15
Market risk. Hence, the committee has developed a new regulatory capital approach. The committee provides banks the flexibility to calculate operational risk measurement within their framework and introduced the following approaches: i.
Basic Indicator Approach
ii.
Standardized Approach
iii.
Advanced Measurement Approach. END OF SECTION E END OF QUESTION PAPER
16
Suggested Answers Management of Financial Institutions (322) : July 2005 Section D : Case Study 1.
i.
Liquidity (Rs. in crore)
Particulars
2005 281.24 0 368.94
2004 79.29 129.12 0 208.41
2858.30 34808.44 43860.71
2340.95 30444.40 39154.07
12.91%
8.90%
1.06%
0.68%
0.84%
0.53%
87.70
Cash in hand
Balance with banks Money at call and short notice
Cash & Balance with banks including call money Demand Deposits Total Deposits Total assets Ratios
Cash and balance with banks including call money/Demand Deposits Cash and balance with banks including call money/Total Deposits
Cash and balance with banks including call money/Total Assets Deployment
ii. (Rs. in crore)
Particulars
2005 17920.99 34808.44 43860.71
2004 14126.08 16696.21 30444.40 39154.07
52.80% 51.48% 104.29% 82.76%
46.40% 54.84% 101.24% 78.72% iii.
18380.10
Credit Investment Total Deposits Total assets Ratios Credit/Deposits Investment/Deposits Credit + Investment / Deposits
Credit + Investment / Total assets Profitability
(Rs. in crore)
17
Particulars
2005
Interest earned
2870.65
Less: interest expended Net interest income (NII) Net Profit for the year Add: provisions and contingencies Operating profit Total assets Net worth (Capital + Reserves – Accumulated loss)
1567.00 1303.65 408.49 549.58 958.07 43860.71 2106.23
2004 2666.92 1549.86 1117.06 405.75 396.71 802.46 39154.07 1707.69
Ratios Net interest margin (NIM) = NII / Total assets
ROI = Net Profit / Total assets ROE = Net Profit / Net worth Operating profit / Total assets Liability Mix
2.97% 0.93% 19.39% 2.18%
2.85% 1.04% 23.76% 2.05% iv. (Rs. in crore)
Particulars Demand deposits Savings bank deposits Total deposits Total liabilities Equity Float funds Ratios Demand deposits / Total deposits
Demand deposits + Savings Bank deposits / Total deposits Total deposits / Total liabilities
Equity / Float funds
2005 2858.30 9275.66 34808.44 43860.71 2106.23 1869.99
2004 2340.95 7868.38 30444.40 39154.07 1707.69 2648.38
8.21% 34.86%
7.69% 33.53%
79.36% 1.1263
77.76% 0.6448 Calculation
of float funds for year 2005 = 2391.31 – 180.94 – 300.00 – 40.38 = Rs.1869.99 crore For year 2004 = 2872.92 – 180.94 – 43.60 = Rs.2648.38 crore.
2.
< TOP > Liquidity: All the liquidity ratios have been improved during the year 2005. Cash and bank balances as a percentage of total deposits increased significantly from 0.68% to 1.06%. The bank has able to improve its liquidity position in the current year. The overall liquidity position of the bank is satisfactory. Deployment: Credit Deposit ratio has been increased significantly from 46.40% to 52.80% and investment deposit ratio has gone down from 54.84% to 51.48%. This indicates bank has shifted its focus from investment to advances. The credit plus investment as a percentage of total deposit and total assets also have increased indicating the bank is able to deploy funds more efficiently. Also these ratios are more than 1 indicates the bank is able to generate more funds through other sources for the deployment. Profitability: The net interest margin has been improved marginally from 2.85% to 2.97% showing probable decrease in spread for the bank. Also ROI and ROE have also been decreased during the year indicating the bank’s profitability has been reduced. However, the operating profit margin has improved marginally from 2.05% to 2.18%, 18
3.
indicating the bank is able to improve its operational efficiency. The banks performance in the area of profitability is not satisfactory. Liability Mix: Demand deposits as a percentage of total deposits increased from 7.69% in the last year to 8.21% in the year 2005. Low cost deposits increased marginally from 33.53% to 34.86%. There is a significant increase in the equity/float funds indicate the bank’s non-interest paying funds have been decreased in the year 2005, which may create pressure on the profitability. Float funds helps the bank to have interest free funds and this helps to improve the profitability of the bank. The overall performance of the bank is not encouraging. < TOP > Capital provides a cushion to absorb possible losses so that entities or individuals dealing with banks are protected all the time. To assess the adequacy of capital based on the quality of assets, the capital to Risk Weighted Assets Ratio (CAR) is computed. The change in the average risk weighted assets (ARWAs) should be ascertained, to comment on the risk profile of the bank ARWAs =
RWAs Total Assets
Tier I Capital
Tier II Capital
Tier-I capital
RWAs =
Capital (Tier I + Tier II) CAR
= Paid up capital + disclosed free reserves + capital reserves – equity investments in subsidiaries – Intangible assets – Losses in current period and those brought forward from previous periods. = Undisclosed reserves + Investment Fluctuation reserve + 45% of revaluation of reserves + General provisions and loss reserves or 1.25% of risk weighted assets which ever is less + Subordinated debt + Contingency reserve.
31. 3. 2005 4573.96 + 506.49 + 0.3 + 70.78 – 3.78 – 3830.14 = 1317.61
Tier-II capital
31. 3. 2004 4573.96 + 217.40 + 0 + 70.78 –3.78 – 3830.14 = 1028.22 0 + 442.89 + 0.45 x 232.80 + 0 + 180.94 = 728.59 Rs.1756.81 crore 12.82% Rs.13,703.67 crore 0.3500
0 + 556.99 + 0.45 x 227.85 + 1.0 x 300 + 180.94 = 1140.46 Total capital (Tier I+II) Rs.2458.07 crore CAR 14.14% RWAs Rs.17,383.80crore ARW = (RWAs /TA) 0.3963 Incremental RWAs / Incremental TA = Average risk weight, which was 35% in 2004, has increased to 39.63% in 2005 indicating new deployment of funds in high-risk assets. Also Incremental RWAs / Incremental TA ratio shows that the new assets are deployed at a average risk weight of 78.19%. (Rs. in crore)
19
31. 3. 2005 Gross NPAs Net NPAs Gross advances Less provision for NPAs Net advances Gross NPAs as % of Gross advances Net NPAs as % of Net advances PBT for the year PBT / TA Net NPAs / TA ENPA
31. 3. 2004
1191.78
1629.82
247.42
383.21
18798.14 418.04 18380.10
14848.86 722.78 14126.08
6.34%
10.98%
1.35%
2.71%
430.49
426.75
173.99%
111.36%
Gross NPAs as percentage of gross advances decreased significantly from 10.98% to 6.34%. Net NPAs as percentage of net advances decreased significantly from 2.71% to 1.35% probably due to the written off loss assets. The higher the ENPA level the better it would be for the bank as it indicates lower credit risk. To achieve a higher level of ENPA, bank has to increase its profitability and reduce its NPA level. The ENPA level has been increased drastically due to the lowering of NPAs. The new credit portfolio of the bank seems to be satisfactory.
4.
a.
< TOP > The bank of such a huge size can form an Asset Liability Management Committee (ALCO) at the Corporate Office to engage it in evolving appropriate systems and procedures for identification, measurement and management of market risks. The mechanisms provide for detailed operative policy decisions within the broad parameters laid down by the Board-approved ALM policy, reviewing policy implementation, and facilitating joint decision making in critical areas.
The ALCO should actively manage and control the structure of assets and liabilities and interest rate sensitivity with a view to optimize profits. It should also ensure capital adequacy and sufficient liquidity. The exposure to market risk is measured through use of techniques, such as maturity gaps, duration analysis, simulation and analytic models for behavioral patterns of assets and liabilities under varying interest rates and other market dynamics. Through fine-tuning of MIS, the time lag in data collection for risk analysis should be reduced. The Treasury Mid-Office should be engaged in the management and control of operational risk inherent in treasury operations. b. The Corporate Debt Restructuring (CDR) mechanism has been formed to bail out outstanding debts of medium and large-size companies. However, such companies are supposed to satisfy all the viability criteria - technical factors, economical factors, commercial factors, technological factors and financial factors. The CDR system is a voluntary and non-statutory mechanism of restructuring corporate debts. Its objective is to develop a timely and transparent mechanism of restructuring corporate debts of viable entities. Under this mechanism, once a restructuring package has been accepted by 75% of the lenders (super-majority) based on their outstanding debt amount, the remaining lenders who are also participants to the CDR system have to fall in line with regard to the decisions taken. Under the CDR mechanism, assets are classified as category 1 assets and category 2 assets: •
•
Category 1 comprises those assets that lenders to the company have termed as a standard or a substandard asset; with only 10% lenders (based on the value of outstanding debt) calling it doubtful. Category 2 comprises those assets that have been considered doubtful by more than 10% of the lenders (based on their value of outstanding debts).
The reasoning behind such classification of assets under the two categories is that, while preparing the restructuring package under the CDR mechanism, if assets are classified under Category 1 then the lenders shall have to provide additional need-based funds as envisaged in the restructuring package, whereas in 20
case of Category 2, it will not be compulsive to the lenders to provide the additional funds, even if the restructuring package demands it.
< TOP > 5.
CLASSIFICATION AND VALUATION OF THE BANK’S INVESTMENTS Reserve Bank of India, in their Midterm Review of Monetary and Credit Policy for the year 2000-2001, had announced revised guidelines for Classification and Valuation of the investments by the Banks. A. CATEGORIZATION : The entire investment portfolio of the Bank, including the SLR and Non-SLR securities, shall be classified under 3 categories viz.,
B.
•
Held to maturity
•
Available for sale
•
Held for trading
Banks shall decide the category of the investments at the time of acquisition. Held to maturity: i. Securities acquired by the Bank with the intention to hold them upto maturity will be classified under this category. ii. Investments under this category shall not exceed 25% of the Bank’s total investments, excluding: a. Recapitalisation bonds received from Government of India towards the Bank’s recapitalisation, b. Investments in subsidiaries and joint ventures and c. Investments in debentures/bonds which are deemed to be in the nature of “advances”. iii. The profit on sale/maturity of investments, in this category, shall be first taken to P & L Account and thereafter be appropriated to the Capital Reserve Account. Loss, if any, on sale/maturity will be recognised in the P & L Account. Held for trading: Securities acquired by the Bank with the intention to trade by taking advantage of the short-term price/interest rate movements will be classified under Held for Trading. Banks shall evolve a separate policy on Trading Book and get it approved from the Board duly setting out the policies with regard to i. Composition & Volume ii. Maximum maturity / duration of the port-folio. iii. The holding period (defeasance period) iv. Cut loss limits. The maximum holding period of the securities in this category shall be 90 days. If the bank is not able to sell the securities within 90 days due to exceptional circumstances, such as tight liquidity conditions, extreme volatility, market becoming uni-directional, security shall be shifted to "Available for Sale" category with the approval of the Investment Committee and after providing for depreciation applicable on the date of transfer. Such transfer to "Available for Sale" category shall be done at the acquisition cost / book value / market value on the date of transfer whichever is the least. Profit or loss on sale of securities in this category will be taken to P & L A/c. Available for Sale: Securities not classified under the above 2 categories viz. Held to Maturity and Held for Trading shall be classified under this category. Bank shall hold minimum of 75% of the total securities (excluding recapitalisation bonds received from Govt. of India, investments in subsidiaries and joint ventures, investments in debentures, bonds which are deemed to be in the nature of advances) in both available for sale and held to maturity categories put together. Profit or loss on sale of investments in this category shall be taken to the Profit & Loss Account. VALUATION: i. Securities classified under "Held to Maturity" category will not be marked to market and will be carried at acquisition cost unless it is more than face value, in which case the premium shall be amortized over the period remaining to maturity. Such amortization shall be done once in a year as on the balance sheet date. Bank shall also provide for any diminution, other than 21
temporary in the value of investments in subsidiaries / joint ventures (individually) once in a year as on the balance sheet date. ii. Individual scrips in the "Available for Sale" category will be marked to market at the year-end once in a year. While net depreciation under each of the six classifications shall be recognised and fully provided for, net appreciation under each classification shall be ignored. iii. Individual scrips in the " Held for Trading " category shall be valued at monthly intervals and net appreciation / depreciation under each of the six classifications shall be recognised in the income account. After each valuation, the individual scrips in the " Held for Trading " category will be changed with re-valuation and will be carried at market value until next re-valuation. Market Value: Market value for the purpose of periodical valuation of investments / securities in the "Available for Sale" and " Held for Trading " categories shall be the market price of the scrip as available from the trades / quotes on the stock exchanges, SGL account transactions, price list of RBI. In the absence of these sources, prices / YTM declared by Primary Dealers' Association of India (PDAI) jointly with Fixed Income Money Market & Derivatives Association of India (FIMMDA) periodically shall be applied. < TOP >
Section E: Caselets Caselet 1 6.
The various types of insurance products that can be offered through bancassurance: Finance and Repayment Products To provide cover for default risk of the borrower, this will satisfy the concerns of both the lending institutions and borrowers arising from the possibility of early death or permanent disability of the borrowers. - Credit Insurance - Overdraft Insurance - Capital Repayment Insurance Depositors' Product To protect depositors' money against uncertain developments in the savings institutions or otherwise. - Depositors' Insurance - Objective achievement Insurance - Pure Investment Products Simple Standardized Package Products To combine covers and offer at a cost, which is less than if they are bought individually. - Group Policies Other Products To offer the widest possible range of products so as to enable the sales people to select the most suitable plan for each customer's specific needs. - Whole life - Accident and sickness - Hospitalization - Pension - Endowment - Unit-linked - Term Insurance - Family income benefit - Waiver-of-premium benefit - Permanent total disability benefit 22
- Income replacement benefit. Health Insurance Financing the healthcare needs of the aged especially is of great opportunity, as it remains a challenge to the governments around the world. It is no different in India, where the population is aging rapidly. Credit insurance and political risk insurance globalization and lower barriers to cross-border trade will spur continued internationalization of trade and support strong demand for credit and political risk insurance.
< TOP > 7.
There are significant advantages to banks particularly in the light of the changing interest scenario of banking in India. •
In a country of one billion people, there is unlimited scope for insurance products. After discounting the population below the poverty line, the middle class is highest next to China. Banks in India have a client base of 100 million and, therefore, are an ideal case for carrying bancassurance forward. Predominance of rural bank branches in sales processes and the closeness of the bank staff with the customers, in general, in the rural area has given an opportunity for the banks to capitalize on the situation by establishing joint-venture insurance companies with leading insurance majors of the world.
•
Banks have an established distribution network of more than 65000 branches spread throughout the country. Insurance companies are eager to enhance their geographical reach without any additional cost by utilizing this existing network.
•
Bancassurance offers a good opportunity to increase a bank's share of the customer's requirements through cross selling of insurance products. All financial products are available under one roof, there by facilitating convergence. Banks and insurance companies are very different in both value and culture. In India, the selling of insurance through banks is yet to emerge as regular activity and, therefore, using traditional products and systems may not be appropriate. For bancassurance to be successful, products and processes will need to be tailored to bank markets, rather than adjusted to the insurer's specifications. Challenges are legal, regulatory, cultural, strategic (marketing and distribution) as well as competitive.
< TOP > 8.
The various factors that may be responsible for the success of bancassurance in India: Lower cost of Distribution due to higher sales productivity The potential to be tapped is ample and increasing the clientele base for the insurance products will reduce the cost of distribution. Banks can leverage their existing strengths to develop additional mass. Mining Database Banks have huge database of clients. Banks should ensure relevant and flexible database systems. Bank Customer Relationship Dealing with high net-worth customers may require insurance specialists to address complex sales issues. Bank officials need to be very clear about service standards, policy issues, processing issues and sales and marketing support. The trust and esteem in which customers hold banks Banks enjoy pride of place in the hearts of people because of their experience. The existing bank branch network/infrastructure Branch network should be utilized in with much more ambiance for selling insurance products. The costs of infrastructure can be defrayed over a larger products and services. Life Insurance Products based on the insurer's desires (Sales driven) Rather than the consumer's needs (market oriented), in rural and semi-urban areas also, similar policies can be canvassed for sale. However, in these branches, the bank should be proactive and innovative to suggest a proper planning for payment of premiums. Information Technology The banks are technology-savvy now and competing with each other on the service front. Technology upgradation can ensure more effective utilization of the synergies the banks posses in bancassurance. Banks should train and equip their staff with the backing of technology, to deliver the requirements. Utilization of ATMs and debit cards as payment mechanism. 23
The bank's culture Bank culture must be transformed to sell insurance and it must be ensured that shelf space is adequately provided in a bank's retail delivery system. It is important to note though, that if the bank's sales culture is not compatible with selling insurance, then specialist insurance salesmen may be needed. The decision on what types of insurance products to be sold and methods of distribution of these products are symbiotically related. The effort and expertise required to sell a product must be in consonance with skills available and cost base of the chosen distribution method.
< TOP > Caselet 2 9.
The various needs for holding reserves: Support to Balance of Payment When the balance of payment is in deficit, countries take safety measures by maintaining adequate reserves to adjust the ultimate deficit. Alternatively, the member countries of IMF may borrow from it to bridge the deficit, but there are limitations for such borrowings. Therefore, it is a prudent measure for any country to build up its own reserves to tide over any temporary imbalance in the balance of payment. Exchange Rate Stability Secondly, countries follow different exchange rate systems and each of them has its own advantages and disadvantages. Irrespective of the exchange rate system followed, the central banks try to keep stability in the exchange rate of domestic currency vis-à-vis the pegged currency under fixed exchange rate system or to a freely convertible currency say, the US dollar, in case of a floating exchange rate system. This requires intervention by the central bank in the market to provide a supply of foreign currency or absorb the supply. In the case of independently floating currencies, it may not be always necessary for the central banks to support the currency levels which are determined by the market forces. However, when the foreign exchange market faces undue volatility in the exchange rates due to various reasons including speculation, the central banks intervene in the market directly when oral interventions prove to be ineffective. Therefore, the foreign exchange reserves are used to maintain stability in exchange rates. Confidence of Foreign Investors Recently, the emerging economies, particularly the Asian economies, have started attracting increased levels of foreign investment in the form of Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII). China tops the list of highest FDI flow of around $60 bn a year. Economies, which hitherto had scanty flows on these accounts due to internal policies relating to such investment, have now opened up their capital sector for investment by foreign investors. Foreign investors have also started showing interest in investing in these economies due to conducive conditions for such investment. For foreign institutions also, these economies proved to be a good ground for portfolio investments as the capital markets in these economies are showing signs of increased integration with global markets. The central banks' reserves act as a safety cushion in the eyes of foreign investors.
< TOP > 10. The question of adequacy of the reserves is being posed these days after the crises in some parts of the world, when the central banks were unable to meet the sudden liquidity demand in the market. It is difficult to measure the adequacy of the reserves with the scale of liquidity demand. However, a reasonable estimate can be made by the central banks depending on the status of the currency convertibility, composition of foreign capital investments and the exchange rate policy prevalent in the country. A high level of reserves also pose challenges to the central banks in deployment of funds, erosion in value due exchange rate fluctuations and also decline in return with a declining interest rate scenario in the international market. There are various assumptions about the adequacy of reserves held with the central banks. The adequacy denotes the ability of the central banks to meet the short-term market demand. The central banks generally come to the rescue of the market when there is a liquidity crunch in the market due to current payments overshooting the current receipts to a large extent. The measure of import cover is one of the indicators of reserves. Secondly, on the capital account side, the proportion of the short-term external debt to the total external debt is another factor for measuring the adequacy of the reserves. The reserves level and the proportion of short-term external debt are directly proportional. Thirdly, after the crises in South-East Asian economies, there is a general consensus that the countries should build funds equal to the total investments made by foreign institutional investors into their reserves. The adequacy of reserves is country-specific, which includes a degree of openness in current and capital accounts, type of exchange rate system in place, 24
composition of external debt, risk management systems in banks, etc.
< TOP > Caselet 3 11. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Banking books. Trading Book should ideally be marked to market on a daily basis. The potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR). The VaR is employed to assess potential loss on trading position portfolio due to variations in market interest rates and prices, using a confidence level of 95% to 99%, within a defined period of time. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-statistical concepts such as stop loss and gross/net positions can be used. Banking Book focuses on the earnings and economic value impacts generated by the changes in market interest rates. Hence, banks should have Interest Rate Risk measurement systems that assess the effects of the rate changes on both earnings and economic value under the present complexity and range of balance sheet products. The variety of techniques ranges from simple maturity gaps (Fixed Rate), repricing (Floating Rate) and duration gaps to static simulation based on current on and off-balance sheet positions to highly sophisticated techniques that incorporate assumptions on behavioral pattern of assets, liabilities and off-balance sheet items.
< TOP > 12. Basic Indicator Approach (BIA) Under this approach, the bank is to measure the average annual gross income over the previous three years. This average, multiplied by a factor of 0.15 set by the committee, gives the capital requirement. As a point of entry for capital allocation, there are no specific criteria for use of this approach. Standardized Approach In this approach, the bank's activities are divided into a number of business lines. To calculate the capital under this approach, gross income again serves as a proxy for the scale of bank's business operations and thus the likely scale of the related operational risk exposure for a given business line. The capital is arrived at by multiplying gross income by a factor determined by the supervisor for that particular business line. The total operational risk capital requirement will be the sum of all of its business lines capital requirement. To use this approach, it is important for banks to have adequate operational risk systems that comply with the minimum criteria outlined in the consultative paper submitted recently. Advanced Measurement Approach (AMA) In order to use this approach, a bank must satisfy its supervisor on the following criteria: •
Its board of directors and senior management are actively involved in the oversight of the operational risk management framework.
•
It has a conceptually sound risk management system and is implemented with integrity, and
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It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas. In addition to the above criteria, banks using the Standardized or AMA for capital purposes will be subject to certain qualitative and quantitative standards also.
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