Set- 1 Q.1. (a) What are core deposits and why are they so important today?

(b)How has the composition of deposits changed in recent years? Ans. A If you want to understand the value to banks of having a strong core deposit base compared to reliance on wholesale funding, take a look at what Washington Mutual (WM) is lately having to pay on a one-year CD:a whopping 5% . Thats fully 135 basis points more than what the typical one-year CD pays, according to Bankrate.com. To me, its the latest piece of evidence that the conventional wisdom on how to run a bank is completely upside down. Kerry Killinger built his empire by aggressively generating assetsin this case, by selling mortgages of just about every shape and size, to basically anyone who wanted one. Unfortunately how those mortgages were funded was an afterthought. So as WaMus asset quality has deteriorated, the company has had to rely for funding on sources such as FHLB advances and highpriced deposits. Worse, should credit at WaMu continue to deteriorate, its funding squeeze figures to only get worse. To me, the key to building a banking franchise is building a strong core deposit base. There is never a time that banks dont depend on funding by outsiders. When times are good, bankers can be tempted to follow the path of least resistance and rely on brokered CDs and other forms of wholesale funding. But that can come back to haunt them when the cycle turns down. Now, when times are not so good, that wholesale money either flies out the door or becomes exorbitant to retain. Banks end up having to pay up for capital at the time they need it the most. People used to chuckle when Id remind them that core deposits dont charge off. Now, with so many banks facing a rising tide of bad loans and fleeing deposits, I suspect a lot of bankers are seeing the wisdom of building a solid, loyal base of depositors. B Among other major research projects that have engaged its attention, the Committee wishes to endorse especially a detailed analysis of the composition, flow and behaviour of deposits in our banks. This study is essential to an understanding of financial developments in recent years and as background material for some of the most important work now going forward in monetary theory. The influence of excessive or deficient reserves on the willingness of banks to expand their loans and investments has been analyzed extensively and ample data are available to measure fluctuations in the total volume of deposits in response to the availability of reserves. During the recent financial cataclysm, however, changes in the total volume of deposits did not always correspond to the availability of reserves. Moreover, the most important factors in the general credit situation were not always those which had to do with the availability of reserves; they were rather those that made for changes in the composition and activity of deposits as between different classes of depositors. The monetary effects of the stock market collapse in 1929, for example, are not reflected in changes in reserves or in changes in total deposits, but rather are disclosed in the extent to which the repayment of brokers' loans resulted in a transfer of deposits from the balances of potential consumers, who were holding securities on margin, to those of business corporations, which had loaned surplus

funds on the call market. To the extent to which this happened, the absence of change in the total volume of bank deposits during the autumn of 1929 concealed one of the important factors in the banking collapse, namely, that the purchasing power of consumers was being seriously depleted. During 1937 an Q.2 How have banking and the financial-service market changed in recent years? What powerful forces are shaping financial markets and institutions today? Ans. What items would I highlight here? First on my list is the emphasis on strong capital positions that began about 1986 and that resulted in the Basel I international capital accord of 1988. The accord helped to focus supervisors and the industry on the importance of adequate capital for bank safety and soundness. Indeed, it was a de facto increase in capital standards for a number of depository institutions, particularly large banks. Second, the accord also emphasized the importance of making supervisory standards sensitive to an individual institutions risk and thus ushered in what we now call risk-focused supervision. Last, the international nature of the accord meant that it explicitly recognized the increasing globalization of banking and financial markets. December 1991 saw enactment of the Federal Deposit Insurance Corporation Improvement Act (FDICIA). This massive act contained critical reforms, many of which had been recommended in Perspectives on Safe and Sound Banking. FDICIA required that bank supervisors take prompt corrective action, or PCA, against troubled depositories. PCAs incentives for deterring moral hazard and limiting taxpayer losses were reinforced by the leastcost-resolution requirements of FDICIA. Although the act provided for certain exceptions to this charge to the FDIC, the general thrust of least-cost resolution was to encourage market discipline by putting uninsured epositors and other uninsured creditors at greater risk. Indeed, according to the FDIC,uninsured depositors have suffered losses in more than 70 percent of bank failures since 1993, and all resolutions were consistent with least cost. Not surprisingly, research suggests that market discipline has increased in the postFDICIA period. Bob mentions this result, but I think it deserves more highlighting. Market discipline is a powerful tool for deterring excessive risk taking. Indeed, one of FDICIAs most important reforms, PCA, was designed to make supervisors mimic what the market would do as a banks financial condition deteriorated. The fact that market discipline appears to have increased in the postFDICIA period is, I would say, a very positive development. The so-called systemic risk exception in FDICIA has been one of the acts most controversial provisions. However, in my view the strict conditions under which this provision can be exercised have exerted a restraining influence on supervisors, although I confess the exception has yet to be put to a true test. Still, I would argue that, to date, this provision has also supported improved market discipline. FDICIA required the FDIC to implement a system of risk-based deposit insurance premiums, something that many economists had long advocated. This requirement also reinforced the notion that bank supervision should be risk focused. Unfortunately, the Deposit Insurance Funds Act of 1996 essentially removed this authority, and the vast majority of insured depositories have paid zero premiums since that time. However, the Federal Deposit Insurance Reform Act of 2005 breathed new life into risk-based premiums, and the FDIC currently has a proposal out for public comment. While I am personally quite disappointed with what the FDIC

is proposing, it certainly is superior to a system of zero pricing. Another significant change in the banking and financial landscape, and another reason I would highlight for the banking system being so resilient and healthy, is the impressive improvements in risk measurement and management and the growing adoption of these technologies by mostly large banks and other large financial intermediaries over the last ten years. Truly, risk measurement and management today are a far cry from that practiced in 1986. Careful judgment by human beings is still, and I believe will always be, required. But I think there is no doubt that a much deeper analytical and quantitative understanding of risk is possible today than ever before. Indeed, the attempt to devise a new Basel Capital Accord is, despite all its KWAST commentary 4/12/07 4:10 PM Page 77F E D E R A L R E S E R V E B A N K O F A T L A N T A controversy, an attempt to recognize and encourage these developments in both the private and public sectors. Improved risk measurement and management have been supported and encouraged by the growth of syndicated loans and securitized assets and the invention of entirely new financial instruments, such as credit derivatives, that greatly aid the dispersion of risk to those most willing and able to bear it. Such developments no doubt bring their own problems and concerns, but it seems clear to me that net benefits have been provided. The importance of syndicated loans, securitized assets, and over-thecounter derivatives brings me to my next major difference between 1986 and today: the expanded importance of financial markets, financial market prices, and nonbank financial intermediaries. One significant implication of this development is theincreased importance of the liquidity of the markets for a wider range of financial assets for thinking about such subjects as the nature of systemic risk. Along with the increased importance of financial markets has come an impressive array of nonbank providers of financial services. Some of these, such as investment banks and insurance companies, have long been with us. But others, such as hedge funds and huge government-sponsored enterprises, are relatively new. The evolution of such institutions has had far-reaching effects for banks, people who study banks, and for those of us who worry about such matters as financial stability and competition. Now let me turn my attention to deregulation. As Bob has indicated, the twenty years since the publication of Perspectives have seen some pretty impressive deregulation in the U.S. financial sector. In the post-1986 period, I would highlight the same two acts that Bob emphasized: the relaxation of most restrictions on interstate banking in the Riegle-Neal Act of 1994 and the repeal of the Glass-Steagall Acts restrictions on most combinations of commercial and investment banking in the Gramm-LeachBliley Act of 1999. Both of these acts were the culmination of a long process, and both have profoundly changed the banking and financial landscape. The Riegle-Neal Act ended the balkanization of the U.S. banking system dating back to the founding of our republic, sparked the consolidation and restructuring of the U.S. banking system, facilitated risk-reducing geographic diversification and other efficiencies, and sharply raised the level of competition in many banking markets. Gramm-LeachBliley officially recognized the increasing blurring of distinctions between commercial and investment banking, sparked its own wave of financial consolidation, facilitated risk-reducing product diversification and other efficiencies, and sharply raised the level of competition in a variety of financial markets. Bob has appropriately emphasized the next item on my list: the major consolidation of the banking industry that has occurred since 1986. Ill quickly review some well-known facts. First, the number of banking organizations has declined quite significantly. Since 1986 the number of banking organizations has declined by 40 percent. Second, as Bob points

out, the national share of banking assets (or deposits) held by the largest organizations has risen steeply. It really doesnt make much difference how you look at it. Next on my list is globalization, a hot topic these days. I will resist the temptation to say anything more about globalization, since I know that one of our newest Federal Reserve governors, Randy Kroszner, will be speaking to us about cross-border banking before dinner tonight. However, I would like to spend a couple of minutes talking about the next item on my list, which is also on Bobs: the greatly intensified level of competition that we 78 E C O N O M I C R E V I E W First and Second Quarters 2007 KWAST commentary 4/12/07 4:10 PM Page 78F E D E R A L RESERVE BANK OF ATLANTA ECONOMIC REVIEW First and Second Quarters 2007 79 observe in banking today relative to 1986. Virtually all of the factors that I have discussed thus far, including much of the consolidation that has occurred, have led to this intensification of competition from, maybe, category 1 in 1986 to category 4 in 2006. Bob covers a lot of this topic, but I would like to point out some more facts that I think are interesting and that provide a little different perspective on some of the factors behind competition in todays banking markets. One of the most interesting facts, I think, is one that Bob pointed out: average local market concentration has stayed largely unchanged despite all the other changes over the past twenty years. Bob showed you one figure that combined urban and rural markets, but you get the same picture if you separate the two types of markets. Moreover, you get the same picture if you look at more intuitive measures of oncentration, such as the average three-firm concentration ratio or the average number of banking organizations in a market. But now I want to drill down a little deeper and ask, Are local markets really all that important still? And I want to argue that the answer is yesand no. Indeed, I think the situation is more complex than at least some of us may have thought, and thus I believe that this area deserves further research. I want to look briefly at two sets of bank customers that I think sometimes get short-changed by finance researchers, but who are clearly very important to the economy: small businesses and households. Starting with small businesses, consider some data from the Federal Reserves 1993, 1998 and 2003 Surveys of Small Business Finances (SSBF). Table 1 shows the percentage of small businesses that use depository and nondepository providers of financial services as well as the percentage that use a depository institution within ten miles of their business and a nondepository institution within ten miles of their business. What are my takeaways? First, depository institutions (line 1) and local depositories (line 2) have been and remain really important. Second, nondepository institutions (line 3) are growing in importance (a fairly recent phenomenon), but they still are not as important as depositories. Third, local nondepositories (line 4), have never been all that important, and their importance seems to be declining. Another interesting question is, What does all this mean for the future of local community banks and the importance of relationship finance? Bob highlighted this as well and suggested that our traditional notions of relationship finance should be changing as the conventional division of labor between large and small banks begins to blur. I very much agree with that view, but I think we need to be careful about just how fast we think things are changing. So, consider this set of facts. The figure (on the next page) again uses the Feds 1993, 1998, and 2003 SSBFs. It shows the percentage of small businesses that use community banks (less than $1 billion in real total assets) and that use noncommunity banks. (Please note that the observations in the figure represent

small businessbank pairs; thus, because small businesses sometimes have relationships with more than one bank, the percentages can total more than 100 percent.) Q.3 What does securitization of assets mean? What kinds of assets are most amenable to the securitization process? What advantages does securitization offer lending institutions? Ans. Securitization Securitization of debt, or asset securitization as is more often referred to, is a process by which identified pools of receivables, which are usually illiquid on their own, are transformed into marketable securities through suitable repackaging of cash flows that they generate. Securitization, in effect, is a credit arbitrage transaction that permits for more efficient management of risks by isolating a specific pool of assets from the originator's balance sheet. Further, unlike the case of conventional debt financing, where the interest and principal obligations of a borrowing entity are serviced out of its own general cash flows, debt servicing with Asset-backed Securities (ABS) is from the cash flows originating from its underlying assets. Importance of Securitization Securitization effort will call for considerable investments in time and resources. Hence, on a comparative cost scale it can even be somewhat more expensive than other types of debt financing that may be available to a borrower, at least in the initial stages. However, it has been demonstrated that a continuing securitization program rather than a single deal often goes to reduce the costs, as economies of scale and expertise pick up over a period of time. Bearing this in mind, many securitization programs are run with a long-term strategic perspective. From the viewpoint of an originator of such paper, the following are typically the main persuasions to securitize. Funding Alternative Being distinct and different from the originator's own obligations, a well structured ABS stands on its own credit rating and thus generates genuine incremental funding. This is so as the originator's existing creditors may invest in the ABS in addition to providing lines of credit to the originator. Further, there may also be other investors in the ABS who do not have a lending relationship with the originator. It is also possible to achieve a superior credit rating for the ABS than the originator's own through appropriate structuring and credit enhancement. This could mean accessing an investor base focusing on high grades, which otherwise may not be possible for an originator. Balance Sheet Management Fundamental benefit of a true sale, i.e., freeing up the capital of the originator would apply in the case of all securitization transactions. In response, the balance sheet gets compressed and becomes more robust. Its ratios improve. Alternately, reduction in leverage post-securitized sale can be restored by adding on new assets to the balance sheet. Thus the asset through-put of the originator's balance sheet increases. Securitization can also generate matched funding for balance sheet assets.

Further, it may also enable the disposal of non-core assets through suitable structuring. Re-allocation of Risks Securitization transfers much of the credit risk in the portfolio to the ABS investors and helps to quantify the residual credit risk that the originator is exposed to this is very useful, as the originator can then take larger exposure to individual obligors as well as provide a higher degree of comfort to his creditors. Securitization also transfers the originator's market risks, i.e., liquidity, interest rate and prepayment risks, to ABS investors and reduces risk capital requirement. This can lead to more competitive pricing of the underlying asset products. Operating Process Efficiency The extent of portfolio analysis and information demanded by securitization programs often lead to serious re-examination and consequent re-engineering of operating processes within the originator organisation. Further, specialist handling of various functional components, such as origination, funding, risk management and administration, often achieved through outsourcing, promotes efficiency across operating processes. Securitization improves Operating Leverage The originator usually assumes the function of the servicer, the issuing and paying agent, and sometimes that of the credit enhancer. Fees accrue on account of all of these. Excess servicing, i.e., the difference between the assets yield and the cost of funds, is also normally extracted by the originator. These income streams can push up the operating leverage of the originator generating income from a larger asset base than what may be otherwise possible for a given capital structure. Securitization Process Essential features of a securitization transaction comprise the following: 1. Creation of asset pool and its sale: The originator/seller (of assets) creates a pool of assets and executes a legal true sale of the same to a Special Purpose Vehicle (SPV). An SPV in such cases is either a trust or a company, as may be appropriate under applicable law, setup to carry out a restricted set of activities, management of which would usually rest with an independent board of directors. 2. Issuance of the securitized paper: This activity is usually performed by the SPV. Design of the instrument however would be based on the nature of interest that investors would have on the asset pool. In the case of pass-through issuances, the investors will have a direct ownership interest in the underlying assets, while paythrough are debt issued by the SPV secured by the assets and their cash flows. 3. Credit risk: It must be made abundantly clear at the very outset that the accretions on the asset-backed security, i.e., interest, amortization and redemption payments, are entirely dependent on the performance of the pooled assets, and will have nothing to do with the credit of the originator. By the same argument, such cash flows would also be not influenced by events affecting the condition of the originator, including insolvency. 4. Pool selection: The process of selecting assets to build a securitization pool would take into careful consideration, loan characteristics that are important from a

cash flow, legal, and credit points of view, such as type of asset, minimum and maximum loan size, vintage, rate, maturity and concentration limits (geographic, single-borrower, etc.). 'Cherry-picking' to include only the highest quality assets in the pool should be consciously avoided. Ideal selection would be a random choice among assets conforming only to cash flow or legal criteria. Often, substitution of eligible assets in the place of original assets that mature/prepay in order to maintain the level of asset cover would also be required.

Q.4 Download a latest quarterly commercial / private bank balance sheet and prepare the following ratios: a. Profitability ratios b. Assets ratios c. Asset quality d. Staff productivity e. sustenance

Ans. A Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company's bottom line. Profitability measures are important to company managers and owners alike. If a small business has outside investors who have put their own money into the company, the primary owner certainly has to show profitability to those equity investors.Profitability ratios show a company's overall efficiency and performance. We can divide profitability ratios into two types: margins and returns. Ratios that show margins represent the firm's ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm's ability to measure the overall efficiency of the firm in generating returns for its shareholders. B The asset ratio is the percentage of total debt financing the firm uses as compared to the percentage of the firm's total assets. It helps you see how much of

your assets are financed using debt financingStep 1: To calculate the debt to asset ratio, you look at the firm's balance sheet; specifically, the liability side of the balance sheet. Add together the current liabilities and the long-term debt.Step 2: Look at the asset side of the balance sheet. Add together the current assets and the net fixed assets.Step 3: Divide the result from Step 1 (total liabilities or debt) by the result from Step 2 (total assets). You will get a percentage. For example, if your total debt is $100 and your total assets are $200, then your debt to assets ratio is 50%. This means that 50% of your firm is financed by debt financing and 50% of your firm's assets is financed by your investors or by equity financing In order for this to mean anything to you, you need to compare this result with other years of data for your firm (trend analysis) and with the debt to assets ratio for other firms in your industry. If your debt ratio is too high, then you need to take a serious look at why. C Most bankers and examiners will agree that the single greatest risk in banking is the risk of loan losses. This is because loans typically comprise a majority of the assets in most banks. Its not hard to imagine an entire years worth of earnings being completely eliminated because of one or two large loans being charged off. Because the exposure is so vast, examiners spend a significant amount of time assessing asset quality, primarily loan quality, at almost every examination. Of course, given the size of the exposure, we think the directorate should spend a significant amount of time assessing this risk as well, in formulating loan policies, attending loan committee meetings, reading credit reviews, and reviewing various management reports on the condition of the loan portfolio. This lesson will explain how examiners assess loan quality and how directors can keep a more watchful eye on their banks loan portfolio. We will review the examiners comments about asset quality for our sample bank and let you recommend some corrective measures and assign a rating to the component. Go to the "Next" button below to begin the instructional content for asset quality. D The purpose of this paper is to compare the productivity and profitability of Public Sector Banks with that of Private Sector Banks. There is a general notion that staffs of rivate sector banks perform better than the staff of public sector banks and this study has been conducted to compare the business per employee and profit per employee to the two groups. The study has been done through the comparison of 5 years profit and loss and balance sheet of two banks and A Profile of Banks 200910' released by the RBI, Analysis of profit per employee and business per employee showed that Bank of Baroda is doing better than ING Vysya bank and this is mainly because of two reasons; first being the computerisation and the second being the entry of Bank of Baroda in retail loans and SME loans. The retail and SME loans on the one side increase the margins and on the other side are helpful in controlling the NPAs. The public sector banks understand the Indian market better than the private banks. They have a nationwide presence and can follow local sentiments, the general public has greater confidence in the public sector banks. Lastly and more significantly the public sector banks have been able to adapt well post liberalization. They have reduced their work force, outsourced where ever economical and computerize all the banking functions, now even the smallest public sector bank offers ATM/debit cards, RTGS fund transfer, internet banking, telephone banking etc. The staff in public sector banks is now

motivated and they realise the importance of a good performance whereas the private bank staff is generally offered contractual employment and therefore, they lack the sense of belongingness with their organization, which is generally seen in public sector banks. The DSA (Direct Sales Agent) culture in private sector banks is also tarnishing their image Bank of Baroda is doing quite well and it seems that in coming years also it will be proving itself as the strong pillars of Indian economy. To compare the productivity and profitability of ING Vysya Bank Ltd with Bank of Baroda, their Balance Sheets and Profit Loss Accounts for the last five years have been compared. The study has been done on basis of Ratio Analysis. In financial analysis, ratios are generally used as benchmarks for evaluating a firms position or performance. The absolute values may not provide us meaningful values until and unless they are related to some other relevant information. Ratios represent the relationship between two or more variables. Ratios help to summarize large data to draw qualitative judgments about the firms performance. The common denominator used for developing the various profitability ratios is business volume (deposits + investments + advances). The banks generally calculate spread ratio as % of total assets. The total assets are accounting (Balance sheet) figures, which are based on historical costs and hence are not very suitable to evaluate the current performance of the banks. In order to have a suitable indicator for evaluating current bank performance we are using the volume of business (Advances + Investments + Deposits) in the denominator. It is like using Gross profit ratio (Gross profit / sales) as a substitute for Return on Total Asset (Profit / Total asset) as an indicator of the profitability of a business organisation. E Over the last few years Indian Banking, in its attempt to integrate itself with the global banking has been facing lots of hurdles in its way due to its inherent weaknesses, despite its high sounding claims and lofty achievements. In a developing country like ours, banking is seen as an important instrument of development, while with the strenuous NPAs, banks have become helpless burden on the economy. Looking to thechanging scenario at the world level, the problem becomes more ironical because Indian banking, cannot afford to remain unresponsive to the global requirements. The banks are, however, aware of the grim situation and are trying their level best to reduce the NPAs ever since the regulatory authorities i.e., Reserve Bank of India and the Government of India are seriously chasing up the issue. Banks are exposed to credit risk, liquidity risk, interest risk, market risk, operational risk and management/ownership risk. It is the credit risk which stands out as the most dreaded one. Though often associated with lending, credit risk arises whenever a party enters into an obligation to make payment or deliver value to the bank. The nature and extent of credit risk, therefore, depend on the quality of loan assets and soundness of investments. Based on the income, expenditure, net interest income, NPAs and capital adequacy one can comment on the profitability and the long run sustenance of the bank. Further, a comparative study on the performance of various banks can be done using a ratio analysis of these parameters. There are a number of ratios that can be used to comment on the different aspects. Q.5 Describe the precautions used by banks while issuing guarantee and letter of credit Ans. Guarantee

Guarantee is a contract to perform the promise, or discharge the liability of a third person in case of his default. In the ordinary course of business, the bank often issues guarantees on behalf of its customers in favour of third parties. When the bank issues such a guarantee, it assumes a responsibility to pay the beneficiary, in the event of a default made by the customer. Therefore, it is important to understand the nature and type of guarantees issued by the bank. Guarantees are generally issued to: Government Departments for fulfillment of contracts for supply of goods or for rendering services or in lieu of security deposit or tender money. Railways and Airlines for payment of freight. Shipping companies for delivery of goods without production of Bills of Lading (it should be given only in those cases where the relative shipping documents negotiated under Letter of Credit opened by the bank, have not been received and the relative bill has been retired). Collector of Excise/Customs for payment of Excise/Customs duty. No guarantee, which gives the beneficiary the right of transfer or assignment, is issued by the bank. 1 Types of Guarantee The guarantees can broadly be classified under two main heads, namely, Performance and Financial Guarantees. The criteria for classification of Performance and Financial Guarantees and an illustrative list of such guarantees are as under: Performance Guarantee Performance guarantees are those which secure performance of contract not involving loan transactions or financial obligations. Performance with regard to construction of building, installation of plant and machinery within a given time frame and with agreed specification. Performance of plant/machinery up to the agreed level of capacities. Performance relating to supply of material as per agreed specification/ quantity within the stipulated time schedule. Guarantees given to secure advance payment, in place of security deposit/earnest money deposit/tender deposit, to secure adjustment of mobilization advance, to fulfil the requirements under the bid bonds.Performance of any other works contract. Financial Guarantee The guarantees which are given to secure loan transactions or financial obligations whereby the guarantor (the bank) undertakes to make payment to the beneficiary within the limits of a stated sum of money in the event of default by the principal debtor to pay/repay in accordance with the terms and conditions of a contract between the principal debtor and the beneficiary. Guarantees for payment of determined liabilities towards tax, excise duties, custom duties, octroi etc. Guarantees issued towards Disputed Liabilities. In addition to applying the above criteria for classifying the guarantees, the contents of the guarantee to be issued are required to be gone through carefully and also the contract entered into between the principal debtor and the beneficiary to decide as to whether a particular guarantee is a Performance Guarantee or Financial Guarantee.

In simple terms, a letter of credit is an undertaking by a bank to make a payment to a named beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the letter of credit. A letter of credit is opened by an importer (applicant), to ensure that the documentation requested reflects and proves that the seller has performed under the requirements of the underlying sales contract, by the exporter by making them conditions of the letter of credit (N.B. The sales contract is not an inherent part of the Letter of Credit, although the Letter of Credit may contain a reference to such contract). For the exporter, a letter of credit, apart from cash in advance, is the most secure method of payment in international trade as long as the terms of the credit are met. The following diagram shows those involved in a Letter of Credit transaction:

Its main advantage is providing security to both the exporter and the importer. The security offered, however, comes at a price and must be weighed against the additional costs resulting from bank charges. The exporter must understand the conditional nature of the letter of credit and the fact that payment will not be made unless the terms of the credit are met precisely. When an exporter asks for payment by letter of credit, he is transferring the risk of non-payment by the buyer to the issuing bank (and the confirming bank if the letter of credit is confirmed), providing the exporter presents the required documents in strict compliance with the credit.

Exporters will need to be certain that it is necessary to use a letter of credit. Typical considerations include: Is it a legal requirement in the importing country? What is the value of the order-will the bank charges be out of proportion to the value? 'Always Traded This Way' always using letters of credit for a particular customer or region without periodically re-assessing the reasons for requesting this method of payment What is the credit rating of the importer and are they a new customer or has a trading relationship already been established? What is the country risk of the importing country (would a confirmed letter of credit be more suitable)? What is the standing of the issuing bank (would a confirmed letter of credit be more suitable)? What is the usual practice in trading with that country and in that particular commodity? Are there any other measures that could be taken to protect the exporter (e.g. credit insurance)? Insistence by a Credit Insurer to trade on letter of credit terms with buyers in certain markets. Recommendation by banks who may advise that the best method of payment is a 'confirmed irrevocable letter of credit' irrespective of the country, strength of issuing bank and without much regard to the value of the consignment. Strategic decision made by the exporter, however, this strategy should be flexible to adapt to the changing risk profile of both the country and the buyer. It is important to remember that all parties in the letter of credit transaction deal with documents, not goods.

Q.6 Mr. Chellaram has availed Rs.1crore loan for his rice mill. During one of your factory inspection you find not much activity is taking place in his mill even during post-harvest season. Your market enquiry reveals that Mr. Chellaram is not taking personal interest in his mill and he is dependent on his manager to run his business. Unfortunately his manager has no formal

technical background. Assess the attendant risk associated with continuation of facility to Mr. Chellaram. What risk mitigation measures you would initiate to protect the interest of the bank? Ans. Human Resource Risk: Risks relating to lack of adequate skills, knowledge and experience, high attrition/turnover rate, continuous competence assessment, personal account dealing rules and its monitoring, absence of recruitment/training policies (if policies put in place, its non-adherence) etc. Resource Allocation Risk: Risks relating to poor allocation of resources at the point of need. Wrongful Act Risk: Risks arising out of wrongful acts committed by employees that may result into loss to the bank. Record-keeping/Reporting System related risk: Risks arising out of poor recordkeeping and reporting system leading to falsifying/tampering of records, concealment of information, non-disclosure of sensitive issues etc. Employee Error Risk: Risks arising out of employees' mis-performance due to lack of skills leading to incorrect transactions or error in transactions. Working Environment and Workplace Safety Risk: Risk arising out of poor working environment or work place safety leading to employees' personal injury such as physical injury (bodily injury, health and safety, sanitation, ambience, security etc.) or non-physical injury (libel, defamation, slander, discrimination, harassment) that may bring about fall in efficiency, motivation and productivity of personnel.

Set- 2 Q.1 What are the principal accounts that appear on a banks balance sheet? What are off-balance sheet items? Ans. Off balance sheet financing: This is a form of borrowing in which the obligation is not recorded on the borrowers financial statements. Off balance sheet

financing can employ several different techniques, which include development arrangements, leasing, product financing arrangements or recourse sales of receivables. Off balance sheet financing does raise concerns regarding the lenders overall risk, but it improves their debt to equity ratio, which enhances their borrowing capacity. As a result, loans are often easy to arrange and are given lower interest rates because of the improved debt structure on the balance sheet. Off balance sheet financing is a technique often used by multinational businesses in order to secure additional loans on the worldwide loan market. Example: Securitization is a type of off balance sheet term because banks do not record any transaction involved in securitization once they sell and remove loans from their balance sheets. Banks only disclose the detail of securitization in notes to financial statements. Example: A bank may have substantial sums in off-balance sheet accounts, and the distinction between these accounts may not seem obvious. For example, when a bank has a customer who deposits Rs.1 million in a regular bank deposit account, the bank has Rs.1 million liabilities. If the customer chooses to transfer the deposit to a money market mutual fund account sponsored by the same bank, the Rs.1 million would not be a liability of the bank, but an amount held in trust for the client (formally as shares or units in a form of collective fund). If the funds are used to purchase stock, the stock is similarly not owned by the bank, and do not appear as an asset or liability of the bank. If the client subsequently sells the stock and deposits the proceeds in a regular bank account, these would now again appear as a liability of the bank (although the same funds held in a brokerage account may or may not be off-balance sheet). However, it's been argued that the contrary is also feasible. The on and off balance sheet items can be better understood from the balance sheet of ICICI bank given below: Net current assets of ICICI bank from March 2005-09 are given in the balance sheet are as follows Balance Sheet Mar ' 09 Mar ' 08 Mar ' 07 Mar ' 06 Mar ' 05

The off balance sheet items are given as a note below the balance sheet are as follows:

1 Factors Affecting the Growth of Off Balance Sheet Financing The following are the key factors affecting the growth of off balance sheet financing: Increased volatility, giving rise to demand for risk management by companies Banks scope for tailoring financial instruments Banks interest in saving capital and avoiding reserve requirements Reduced competitiveness in traditional activities Some government assistance, such as the US government sponsorship of the securitized mortgage market (to allow risks to be diversified where banks were confined to one area) 2 Importance of Off Balance Sheet Financing The following are the key importance of off balance sheet financing and use of SPV: Off-balance sheet financing is attractive from a risk management standpoint. When assets and liabilities are moved from one balance sheet to another, the risks associated with those assets and liabilities go with them. For example, if a firm transfers credit risky assets to an SPV, the credit risk goes with those assets. Off-balance sheet financing also affords considerable flexibility in financing. An SPV doesn't utilize the sponsoring firm's credit lines or other financing channels. It is presented to financiers as a stand-alone entity with its own risk-reward characteristics. It can issue its own debt or establish its own lines of credit. Often, a sponsoring firm overcapitalizes an SPV or supplies it with credit enhancement. In this circumstance, the SPV may have a higher credit rating than the sponsoring firm, and it will achieve a lower cost of funding. A BBB-rated firm can achieve AAA-rated financing costs if it arranges that financing through a sufficiently capitalized SPV. Off-balance sheet financing is often employed as a means of asset-liability management. Obviously, if assets and liabilities are never placed on the balance sheet, they don't have to be matched! They do need to be matched on the SPV's balance sheet, but the SPV can be structured in a way that facilitates this. A pass-

through is a security issued by a special purpose vehicle. The SPV holds assets and pays the pass-through's investors whatever net cash flows those assets generate. In this way, the SPV's assets and liabilities are automatically cash matched, so there is no asset-liability risk. Many securitizations are structured as pass-through. See, for example, the discussion of mortgage pass-throughs. Off-balance sheet financing has other applications. SPVs can be used in tax avoidance. Banks use off-balance sheet financing to achieve reductions in their regulatory capital requirements. This is a compelling reason for many securitizations. It is also the purpose of trust preferred securities. While SPVs and off-balance sheet financing have many legitimate purposes, they can also be used to misrepresent a firm's financial condition. Prior to its bankruptcy, Enron created numerous SPVs and used them to hide billions of dollars in debt.

Q.2 What different regions around the globe today appear to offer the greatest opportunities for expansion for international banks? Why do you think this is so? Ans. International Banking International Banking is a process that involves banks dealing with money and credit between different countries across the political boundaries. It is also known as Foreign/Offshore Banking. In another words, International Banking involves banking activities that cross national frontiers. It concerns the international movement of money and offering of financial services through off shore branching, correspondents banking, representative offices, branches and agencies, limited branches, subsidiary banking, acquisitions and mergers with other foreign banks. All the basic tools and concepts of domestic bank management are relevant to international banking. However, special problems or constraints arise in international banking not normally experience when operating at home. In particular: Business activities have to be transacted in foreign languages and under foreign laws and regulations. Information on foreign countries needed by a particular bank wishing to operate internally may be difficult to obtain. Control and communication systems are normally more complex for foreign than for domestic operations. Risk level may be higher in foreign markets. Foreign currency transaction is necessary. International bank managers require a broader range of management skills than managers who are concerned only with domestic problems. It is more difficult to observe and monitor trends and activities in foreign countries. Larger amounts of important work might have to be left to intermediaries, consultants and advisers.

International banking deals with all banking transactions private and governmental of two or more countries. Private Banks undertake such transactions for profit; governments may be for provision of various services. 1 Reasons for Engaging in International Banking Banks undertake international operations in order to expand their revenue/profit base, acquire resources from foreign countries, or diversify their activities. Specific reasons expanding operations abroad include the saturation of domestic market; discovery of lucrative opportunities in other countries; desire to expand volume of operations in order to obtain economy of scale. Further motives for operating internationally are as follows: Commercial risk can be spread across several countries Facilitation of international businesses and trade Involvement in international banking can facilitate experience curve effect Economies of scope might become available Reduce cost of service delivery Recognition and reputation 2 Modes of International Banking There are a lot of available methods for entry into international banking operations. This include; Correspondent Banks, Representative Offices, Branches and Agencies, Limited Branches, Subsidiary Banks, Bank Acquisitions and Bank Mergers. Correspondent Banks In order to adequately provide needed international banking services, commercial banks establish a network of foreign correspondent banks to supplement their own facilities worldwide. Frequently, the expense of establishing a related banking entity, such as overseas branch, is not warranted due to the low volume of transactions concluded for the banks international clients. Therefore, to provide services while keeping costs minimal, account relationships are developed with foreign banks to facilitate international payment mechanisms between the institutions. Deposit accounts are opened at the correspondent banks, which enable them to make direct payments overseas by means of debiting and crediting the respective accounts with settlement to be made at a later date. Such accounts are termed due to (or Nostro) accounts and due from (or Vostro) accounts on the banks books. In addition to payment accounts, correspondent bank relationship facilitates transactions such as letters of credit, documentary collection, foreign exchange services, and loan services for a banks international clients. Thus, the correspondent bank relationship gives the domestic bank a presence in overseas markets, which permits international transactions to be concluded. Representative Offices A representatives office is both the most commonly used and the most limited in function of all foreign banking operating internationally. The international representative office functions mainly as liaison between correspondent banks and

the parent bank. Representative offices are usually prohibited from engaging in general banking activities, although they may receive checks for forwarding to the home office, solicit loans for the home office, and develop customer relations. However, they may not receive deposits or make loans. Generally, representative offices serve as the preliminary step to other forms of banking activity since they are a relatively inexpensive means of establishing a presence in a new location. Branches and Agencies Depending upon the extent of services that the institution wishes to offer, either a branch or an agency may be established. The basic definition of branch and agency may be found in the U.S. International Banking Act of 1978. A branch is any office of a foreign bank at which deposits are received. On the other hand, an agency is any office at which deposits may not be accepted from citizens or residents of the U.S. if they are not engaged in international activities, but at which credit balance may be maintained. Thus, the principal difference between branches and agencies is that agencies cannot accept deposits for U.S citizens or residents and can only maintain credit balances related to their international activities. In addition, agencies cannot engage in either fiduciary or investment advisory activities with the exception of acting as custodians for individual customers. Agencies do engage in a variety of activities to finance international trade, such as the handling of letters of credit. Both agencies and branches are principally active in international market. As extensions of the foreign parent bank, branches are generally subject to more stringent state regulation than agencies due to the more extensive nature of their operations. The powers of a federal branch are similar in scope of those of a national bank; these branches possess full deposit-taking, loan, and commercial banking powers in addition to other trust powers. They are also subject to duties, restrictions, and limitations similar to those of a national bank organized in the same area. Limited Branches In pursuant to the International Banking Activities, an additional means by which a foreign bank may participate in foreign banking market is through a so-called limited federal branch. Basically, this is an office chartered by the Comptroller of the Currency subject to the condition that the foreign bank enter into an agreement with the countrys apex bank or regulatory authorities restricting the branchs deposittaking activities to those permitted by law. Since this office may be established outside the foreign banks home state, they are restricted to deposit taking activities of an international nature. Subsidiary Banks Foreign banks gain control of subsidiary banks by establishing new institutions or by acquiring existing domestic banking institutions and these subsidiaries generally may engage in a full line of banking activities. With respect to the designation of a foreign bank subsidiary, the term bank and subsidiary has the same meaning as those provides by section 2 of the Bank Holding Company Act (BHCA). A subsidiary bank of a foreign bank may be either a national or a state bank. State banks are governed by the laws of the state in which they are located, while national banks are chartered by the Comptroller of the Currency under the National Bank Act. In United States for example, although foreign ownership is not restricted, non-U.S. citizens may not form a majority of a national banks Board of Directors.

Bank Acquisitions Firms willing to gained access to international banking operations may also adopt the acquisition approach by acquiring indigenous or domestic banks. However, the acquisition process is guided by stringent conditions. For instance, Under the United States Bank Holding Company Act, the Federal Reserve Board must approve the acquisition of direct or indirect control of a U.S. bank by a domestic or foreign bank holding company. Various factors are considered in the approval or denial of a BHC application. These include analysis of the competitive effect of the acquisition, the acquirers financial and managerial resources, and future prospects of the bank being acquired, community needs, and the applicants organizational structure. Bank Mergers Bank mergers is another option that is opened to those who whishes to provide international banking services in foreign countries. There are several reasons for a foreign bank merging with a domestic bank. For example, this provides an expedient and economical means of expanding into new markets; it becomes easier to establish an identity on a state-wide basis; and the bank is able to continue smooth operations with experienced management and personnel. Q.3 What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change? Ans. Interest Rate Risk (IRR) Management The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). The risk from the earnings' perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM). People Risk Human Resource Risk: Risks relating to lack of adequate skills, knowledge and experience, high attrition/turnover rate, continuous competence assessment, personal account dealing rules and its monitoring, absence of recruitment/training policies (if policies put in place, its non-adherence) etc. Resource Allocation Risk: Risks relating to poor allocation of resources at the point of need. Wrongful Act Risk: Risks arising out of wrongful acts committed by employees that may result into loss to the bank. Record-keeping/Reporting System related risk: Risks arising out of poor recordkeeping and reporting system leading to falsifying/tampering of records, concealment of information, non-disclosure of sensitive issues etc. Employee Error Risk: Risks arising out of employees' mis-performance due to lack of skills leading to incorrect transactions or error in transactions.

Working Environment and Workplace Safety Risk: Risk arising out of poor working environment or work place safety leading to employees' personal injury such as physical injury (bodily injury, health and safety, sanitation, ambience, security etc.) or non-physical injury (libel, defamation, slander, discrimination, harassment) that may bring about fall in efficiency, motivation and productivity of personnel. 2 Process Risk Business Process Risk: Risk arising out of inability to perform at required levels due to either lacuna in the processes/technology itself or due to the practices followed therein. New Product Risk: Risk arising out of introduction of new products/processes/services/delivery channels/technology without proper market research about its acceptability, cost-benefit analysis, inherent risk assessment, laying down control measures, defining audit tools and skill upgradation of staff through proper training/ seminar/ workshop etc. Product Quality Risk: Risk arising out of non-assessment of existing product/processes/services/ delivery channels/technology regarding their quality, relevance and cost-benefit in the light of fast changing scenario. Product Development Risk: Risk arising out of inability to keep pace with the changes in the market and development of new products/ processes/services/delivery channels/technology without proper market research regarding customer's requirement and his acceptability to the product. Business Interruption Risk: Risk arising out of interruption in the business due to disasters (natural as well as non-natural), IT failures, strike, shortage of resources etc. Systems and Control Risk: Risk arising out of inadequate systems and control, documentation of procedures/job specifications/operational limits/manuals etc. Compliance Risk: Risk arising out of non-compliance of organisational policies, Govt./RBI regulations, directions from the Board or its sub-committees, laws etc. leading to fine/penalties/regulatory criticism/ adverse media reactions etc. Merger Risk: Risk arising out of merger without proper due-diligence and poor implementation of merger processes. 3 Management Risk Leadership Risk: Risk arising out of management lacking in direction, customer focus, motivation to perform, trust within the unit and alignment of self-objectives with corporate goal. Communication Risk: Risk that the communication from the top management is different from what they wanted to convey or the line managers understand the communication differently than what is conveyed. Disaster Prevention and Recovery Risk: Risk arising out of lack of an adequate disaster prevention & recovery plan leading to an adhoc response to any unforeseen event or disaster.

Budget Planning Risk: Risk arising on account of fixing unrealistic budget and using unreliable planning information leading to wrong financial conclusion and decisions. Internal Control Risk: Risk arising on account of lack of control or inadequate control exercised by the management leading to irrepressible violation of established systems & procedures by the down the line officials. 4 Business Risk Customer Satisfaction Risk: Risk arising out of possibility that the bank may not be able to meet or exceed the customer satisfaction. Customer Relation Risk: The risk of customer responding negatively to a particular event/campaign or policy of the bank. Outsourcing Risk: Risk arising out of availing outsourced services without defining area/activities of outsourcing, proper due-diligence of vendor/third party, lack of effective control over vendor/third party and security against breach of confidentiality. Product Obsolescence Risk: Risk arising out of possible situation wherein the product may not be what the customer actually wants or the product/services is not able to adequately satisfy his needs. Marketing Risk: Risk arising out of inadequate/poor marketing of bank's products/services resulting in inadequate off-take of product/service. Competition Risk: Risk arising out of very active competition, which leads to extra resources being consumed to respond to different challenges posed by it. Rigidity Risk: Risk arising out of management's inability to keep itself abreast of changes in the competitive scenario and lack of flexibility to change the business model/processes etc. Business Concentration Risk: Risk arising out of concentration of business to a particular sector/area/particular set of products that does not optimise overall performance. MIS Risk: Risk arising out of irrelevant or unreliable information concerning current commitment that may result in new commitment, which are not in the best interest of the bank. Relationship Risk: Risk resulting from relationship issues with customers, vendor/third party etc. in absence of proper documentation/ contract. 5 Environment Risk Regulatory Risk: Risk arising on account of changing regulations/bank's guidelines impacting operations of 'Business Units'. Event Risk: Risk of business adversely affected by catastrophe, disasters, riots, terrorism, war, etc. Media Risk: Risk arising out of coverage of particular event or of the BO/ RO/ZO/bank as a whole that would tarnish the image of the bank in the eyes of customers, employees, general public etc. The risk could stem from positive coverage of a competitor by the media thus swinging customers' sentiment in the

favour of the competitor or from mis-representation of the bank's stand/philosophies etc., thus swinging customers' sentiment against the bank. Economic Risk: Risk arising on account of happenings in other sectors of economy indirectly affecting branch/bank business or the risk of impact of the status of economy as a whole on the business of the bank. IT Risk IT Opportunity Risk: Risk arising out of inability to take advantage of advances in technology that could have either thwarted the threat posed by the existing technology or could have kept the bank at par or ahead of a competitor who has taken advantage of advanced technology. Access Risk: Risk associated with accessibility to the confidential data without proper authorization due to loopholes in the security system. Data Validity Risk: Risk associated with the data given to the user, which is not verified and validated appropriately, thus preventing him to take effective/meaningful decision. Data Integrity Risk: Risk associated with incomplete or inaccurate information about transactions at the entry stage and inaccurate reporting by IT systems thereafter. Data Availability and Connectivity Risk: The risk that the data may not be available at the time it is needed. This may be due to lack of proper management of data, loss of connectivity or slow connectivity etc. Data Transmission Risk: The risk that the data could be lost/hacked/intercepted during transmission from one system to another. IT Infrastructure Risk: The risk relating to inadequate or inappropriate IT infrastructure consisting of networks, software, hardware, server, security system, processes, IT Professionals etc. to effectively manage and use the information system. IT Application Risk: The risk relating to deficiencies or errors in processes, controls, or projects related to the development or purchase of IT applications (software including interfaces), their maintenance and continuous development. Building and Equipment Risk: The risk relating to deficiencies or errors in processes, controls, or projects related to the sourcing, construction, and maintenance of buildings and equipments i.e. workstation set up, telecommunication facilities, other building and IT equipments etc.

Q.4 What is consortium lending? State the latest RBI guidelines on Consortium advances. Ans. RBI Guidelines for the Foreign Banks in India The guidelines for setting up of WOS by foreign banks and conversion of existing branches of foreign banks into WOS are given hereunder: 1 Eligibility of the Parent Bank

1. Foreign banks applying to the RBI for setting up a WOS in India must satisfy RBI that they are subject to adequate prudential supervision in their home country. In considering the standard of supervision exercised by the home country regulator, the RBI will have regard to the Basel standards. 2. The setting up of a wholly-owned banking subsidiary in India should have the approval of the home country regulator. 3. Other factors (but not limited to) that will be taken into account while considering the application are given below: i) Economic and political relations between India and the country of incorporation of the foreign bank ii) Financial soundness of the foreign bank iii) Ownership pattern of the foreign bank iv) International and home country ranking of the foreign bank v) Rating of the foreign bank by international rating agencies vi) International presence of the foreign bank 2 Capital 1. The minimum start-up capital requirement for a WOS would be Rs. 3 billion and the WOS shall be required to maintain a capital adequacy ratio of 10 per cent or as may be prescribed from time to time on a continuous basis, from the commencement of its operations. 2. The parent foreign bank will continue to hold 100 per cent equity in the Indian subsidiary for a minimum prescribed period of operation. 3 Corporate Governance The composition of the Board of directors should meet the following requirements: Not less than 50 per cent of the directors should be Indian nationals resident in India. Not less than 50 per cent of the Directors should be non-executive directors. A minimum of one-third of the directors should be totally independent of the management of the subsidiary in India, its parent or associates. The directors shall conform to the Fit and Proper criteria as laid down in RBIs extant guidelines dated June 25, 2004. RBIs approval for the directors may be obtained as per the procedure adopted in the case of the erstwhile Local Advisory Boards of foreign bank branches. 4 Accounting, Prudential Norms and Other Requirements The WOS will be subject to the licensing requirements and conditions, broadly consistent with those for new private sector banks. The WOS will be treated on par with the existing branches of foreign banks for branch expansion. The Reserve Bank may also Prescribe market access and national treatment limitation consistent with WTO as also other appropriate

limitations to the operations of WOS, consistent with international practices and the countrys requirements. The banking subsidiary will be governed by the provisions of the Companies Act, 1956, Banking Regulation Act, 1949, Reserve Bank of India Act, 1934, other relevant statutes and the directives, prudential regulations and other guidelines/instructions issued by RBI and other regulators from time to time. 5 Capital Fund Norms for Foreign Banks For foreign banks, 'capital funds' would include the following elements: Elements of Tier I Capital 1. Interest-free funds from Head Office kept in a separate account in Indian books specifically for the purpose of meeting the capital adequacy norms. 2. Statutory reserves kept in Indian books. 3. Remittable surplus retained in Indian books which is not repatriable so long as the bank functions in India. Notes: (a) The foreign banks are required to furnish to Reserve Bank, (if not already done), an undertaking to the effect that the banks will not remit abroad the remittable surplus retained in India and included in Tier I capital as long as the banks function in India. (b) These funds may be retained in a separate account titled as 'Amount Retained in India for Meeting Capital to Risk-weighted Asset Ratio (CRAR) Requirements' under 'Capital Funds'. (c) An auditor's certificate to the effect that these funds represent surplus remittable to Head Office once tax assessments are completed or tax appeals are decided and do not include funds in the nature of provisions towards tax or for any other contingency may also be furnished to Reserve Bank. (d) Foreign banks operating in India are permitted to hedge their Tier I capital held in Indian books. These banks are free to make their own decision as regards the timing of the hedge transactions subject to compliance with all other terms and conditions contained in Exchange Control Departments circular No.EC.CO.FMD.6/02.03.75/2002-2003 dated November 20, 2002. 4. Capital reserve representing surplus arising out of sale of assets in India held in a separate account and which is not eligible for repatriation so long as the bank functions in India. 5. Interest-free funds remitted from abroad for the purpose of acquisition of property and held in a separate account in Indian books. 6. The net credit balance, if any, in the inter-office account with Head Office/overseas branches will not be reckoned as capital funds. However, any debit balance in Head Office account will have to be set-off against the capital. Elements of Tier II Capital

To the extent relevant, elements of Tier II capital in respect of Indian banks will be eligible. 1. Undisclosed reserves and cumulative perpetual preference shares: These often have characteristics similar to equity and disclosed reserves. These elements have the capacity to absorb unexpected losses and can be included in capital, if they represent accumulations of post-tax profits and not encumbered by any known liability and should not be routinely used for absorbing normal loss or operating losses. Cumulative perpetual preference shares should be fully paid-up and should not contain clauses which permit redemption by the holder. 2. Revaluation reserves: These reserves often serve as a cushion against unexpected losses, but they are less permanent in nature and cannot be considered as Core Capital. Revaluation reserves arise from revaluation of assets that are undervalued on the banks books, typically bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets, the subsequent deterioration in values under difficult market conditions or in a forced sale, potential for actual liquidation at those values, tax consequences of revaluation, etc. Therefore, it would be prudent to consider revaluation reserves at a discount of 55 percent while determining their value for inclusion in Tier II capital. Such reserves will have to be reflected on the face of the Balance Sheet as revaluation reserves. 3. General provisions and loss reserves: Such reserves, if they are not attributable to the actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, can be included in Tier II capital. Adequate care must be taken to see that sufficient provisions have been made to meet all known losses and foreseeable potential losses before considering general provisions and loss reserves to be part of Tier II capital. General provisions/loss reserves will be admitted up to a maximum of 1.25 percent of total risk weighted assets. 4. Hybrid debt capital instruments: In this category, fall a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital. 5. Subordinated debt: (a) To be eligible for inclusion in Tier II capital, the instrument should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India. They often carry a fixed maturity, and as they approach maturity, they should be subjected to progressive discount, for inclusion in Tier II capital. Instruments with an initial maturity of less than 5 years or with a remaining maturity of one year should not be included as part of Tier II capital. Subordinated debt instruments eligible to be reckoned as Tier II capital will be limited to 50 percent of Tier I capital.

(b) In the case of public sector banks, the bonds issued to the VRS employees as a part of the compensation package, net of the unamortised VRS Deferred Revenue Expenditure, could be treated as Tier II capital, subject to compliance with the terms and conditions. (c) The subordinated debt instruments included in Tier II capital may be subjected to discount at the rates shown below: Remaining Maturity of Instruments Less than one year One year and more but less than two years Two years and more but less than three years Three years and more but less than four years Four years and more but less than five years Rate of Discount (%) 100 80 60 40 20

(d) Banks should indicate the amount of subordinated debt raised as Tier II capital by way of explanatory notes/ remarks in the Balance Sheet as well as in Schedule 5 under 'Other Liabilities & Provisions'. 6. The Investment Fluctuation Reserve (IFR) would continue to be treated as Tier II capital but it would not be subject to the ceiling of 1.25 per cent of the total risk weighted assets. The above treatment would be effective from March 31, 2003 onwards. 7. Banks are allowed to include the General Provisions on Standard Assets and provisions held for country exposures in Tier II capital. However, the provisions on standard assets together with other general provisions/loss reserves and provisions held for country exposures will be admitted as Tier II capital up to a maximum of 1.25 per cent of the total risk-weighted assets. The elements of Tier I & Tier II capital do not include foreign currency loans granted to Indian parties. For more details about the TIER I and TIER II capital you can visit www.rbi.org.in . 6 Conversion of Existing Branches into a WOS All the above requirements prescribed for setting up a WOS will be applicable to existing foreign bank branches converting into a WOS. In addition they would have to satisfy the following requirements. 7 Supervisory Comfort Permission for conversion of existing branches of a foreign bank into a WOS will inter alia be guided by the manner in which the affairs of the branches of the bank are conducted, compliance with the statutory and other prudential requirements and the over all supervisory comfort of the Reserve Bank.

Capital Requirements The minimum net worth of the WOS on conversion would not be less than Rs. 3 billion and the WOS will be required to maintain a minimum capital adequacy ratio of 10 per cent of the risk weighted assets or as may be prescribed from time to time on a continuous basis. While reckoning the minimum net worth, the local available capital including remittable surplus, retained in India, as assessed by the RBI, will qualify. Reserve Bank will cause an inspection/audit to assess the financial position of the branches operating in India and arrive at the aggregate net worth of the branches. RBIs assessment of the net worth will be final. 8 Acquisition of Holding in Select Private Sector Banks Foreign banks may apply to the Reserve Bank for making investment in private sector banks that are identified by RBI for restructuring. Reserve Bank will examine the application with regard to the eligibility criteria prescribed for foreign banks to set up a WOS according to norms as well as their track record in restructuring banks. While permitting foreign banks to acquire stake in the identified private sector banks, RBI may undertake enhanced due diligence on the major shareholders to determine their Fit and Proper status. Reserve Bank may also prescribe additional conditions in this regard as may be considered appropriate. 9 Application Procedure Applications for setting up of wholly-owned banking subsidiaries by foreign banks including conversion of existing branches should be made to the Chief General Manager-in-Charge, Department of Banking Operations and Development, Reserve Bank of India, World Trade Centre, Cuffe Parade, Colaba, Mumbai 400 005. The prescribed application form will be placed on the RBI's web site.

Q.5 Detail Nayak Committees recommendations on SME financing Ans. Credit Assessment of SMEs Assessment of Working Capital requirement in SMEs: 1. Simplified method in case of borrower seeking fund based working capital limits of upto Rs.25 lakhs (raised from the earlier limit of Rs. 20 lakhs) adopting a holistic approach, taking into account the borrowers business potential, business plans, past dealings, credit- worthiness, market standing, collateral security available and ability to repay etc. Wherever the activity of the borrower is such that stocks/current assets are not available or creation of charge on stocks/current assets is not possible the same need not be insisted upon. The limits assessed through this simplified method are to be secured by current assets primarily wherever the credit facilities are extended for procuring/against the current assets. The collateral security required to be obtained from the borrowers assessed through the simplified procedure is now relaxed to not less than 125% of the value of the advance from the earlier requirement of at least 150% of the value of the advance. 2. Liberalised Trade Finance Scheme to the small traders and small businessman on the basis of total turnover declared in the sales tax returns upto a limit of Rs. 25 lakhs.

3. Turnover method in the case of borrower (non-SSI/SSSBE) seeking fund based working capital credit limits upto Rs. 2 crores and SSI & SSSBE borrowers upto Rs. 5 crores. If the borrower is eligible for higher credit limit as per EWCL method, the same can be adopted instead of turnover method. 4. Eligible working capital limit (EWCL) method in case of non-SSI borrowers seeking working capital limits of above Rs. 2 crores from the banking system but upto and inclusive of Rs. 20 crores from the Bank. (For SSI/SSSBE borrowers seeking fund based limits of over Rs. 5 crores and upto and inclusive of Rs. 20 crores). 5. Cash budget or EWCL method for working capital needs of borrowers seeking fund based limit of above Rs. 20 crores. 6. Assessment of working capital on cash budget method for seasonal and construction industry wherever adequate MIS support is available with the borrower. 7. For assessment of working capital requirements of export customers, any of the above methods, viz., projected turnover method or EWCL method or cash budget method, whichever is most suitable and appropriate to their business operations may be adopted. 8. In the case of credit limits of above Rs.2.00 crore for IT & software industry, cash budget method shall be adopted for assessment (for details, please refer Circular No 218/98/BC/CR/64/CRPPD dtd.26.10.1998) Overall Compliance to Basic Financial Parameters 1. While it may be ideal to look for sound financial parameters say, current ratio at 1.33, low TOL/ TNW ratio, strong security position etc. in practice it may not always be possible to get borrowers all of whose financial parameters strong. In view of this, one of the parameters may be relaxed by the sanctioning authority, if other financial parameters have stronger values within the prescribed bands. In other words, all the basic financial parameters accepted for sanctioning the credit facilities should collectively satisfy proper risk management standards. 2. However, in case of existing borrowers, whose dealings are satisfactory and limits are fully secured by way of mortgage of fixed assets/ deposits/KVP/NSC/surrender value of Life Insurance Policies, sanctioning authorities may renew the limits even if more than one of the basic parameters are not complied with and in case any enhancement is involved clearance from the next higher authority shall be obtained. 3. The deviations in other cases may be permitted by the next Higher Authority, if required on merits of each case and having due regard to the business expediency. 4. In the case of ED/CMD/MC sanctions, the respective sanctioning authorities may permit deviations. Turnover Method The Working Capital requirements of the borrowers, both in the SSI as well as NonSSI Sector, shall be assessed under Turnover Method (except in the cases where the simplified procedure as above is adopted) as follows: a) Projected Annual Gross Sales (Turnover)

b) Working Capital Finance requirement at 25% of (a) c) Minimum Margin to be brought in by the borrower at 5% for SSI & 6.25% for non SSI of (a) or actual NWC, whichever is higher d) Working Capital Finance Permissible (b - c) Eligible Working Capital Limit (EWCL) Method The EWCL Method shall be applied in the case of borrowers seeking fund-based Working Capital limits of Rs. 2 Crores and above (Non SSI) and Rs. 5 Crores and above (SSI) from the Banking System but upto and inclusive of Rs. 20.00 Crores from the Banking System and the assessment shall be carried out as under: Projections for the ensuing year a) Total Current Assets b) Current Liabilities other than Bank borrowings c) Working Capital Gap (I-II) d) Bench-Mark Net-Working Capital (NWC) at 25% of (I) or projected NWC, whichever is higher e) Eligible Working Capital Limit (III-IV) Cash Budget Method The working capital requirements of the borrowers seeking fund based limits of above Rs. 20.00 crores shall be assessed either under CASH BUDGET Method or the EWCL Method discussed earlier, as may be decided by the Bank. The corporate borrowers whose management of finance is cash budget driven and the existing clients of the bank who have a consistency good track record of fulfilling the specified norms/covenants financial & performance related can opt for the assessment under Cash Budget Method. 1 P. R. Nayak Committees Report on SME/SSI Financing RBI constituted a committee under the chairmanship of P. R. Nayak to examine the adequacy of institutional credit to SSI sector and related aspects. The main recommendations of the report as accepted by Reserve Bank for implementation are given below: 1. Credit requirement of village industries, tiny industries and other SSI units having aggregate fund?based working capital credit limits upto Rs. 500.00 lakh from the banking system, the norms of inventory and receivables as also 1st method of lending will not apply. Such units may be provided working capital limits computed on the basis of a minimum of 20 per cent of their projected annual turnover. This basis will be adopted for all new as well existing units. The SSI units will he required to bring in 5 per cent of annual turnover as margin money. In cases where output exceeds the projections or where initial assessment of working capital is found inadequate, suitable enhancement in working capital limits will be granted as per the above formula. Other SSI units having aggregate fund?based working capital limits?of above Rs. 200.00 lakh would, however, continue to be governed by the existing guidelines.

2. Each branch of the bank will prepare an annual budget in respect of working capital requirement of all SSI units before commencement of year which will form the basis of credit budget of the bank for SSI. 3. The guidelines relating to definition of sick SSI unit and interest applicable on Working Capital Term Loan (WCTL) have been amended as under: (a) Definition of a sick SSI Unit: A SSI unit may be classified as sick unit (i) when any of its borrowal accounts has become 'doubtful' advance i.e. principal or interest in respect of any of its borrowal accounts has remained overdue for a period exceeding 2?11, years and (ii) there is erosion in the net worth due to accumulated cash losses to the extent of 50% or more of its peak net worth during preceding two accounting years. (b) Interest on WCTL: In respect of WCTL the rate of interest applicable may be 1.5 to 3 percentage points below the prevailing fixed rate/minimum lending rate, wherever applicable, but not more than the lowest lending rate for tiny/decentralised sector units and not more than 5 percentage points below the minimum lending rate in the case of advances of over Rs.2.00 lakh for the other SSI units. 4. SSI units having a project outlay of Rs. 200 lakh (both term loan and working capital needs) may be covered under Single Window Scheme of SIDBI under which the term loan and working capital requirements must be met by a single financing agency i.e. either by the bank or State Financial Institution. For more details you can visit www.rushabinfosoft.com .

Q.6 Explain operational risk management process with suitable examples. Ans. Operational Risk Management Processes Management of Operational Risk mean: Identification Assessment Monitoring and control/mitigation of this risk 1 Risk Identification As a principle of sound practice, banks should identify and assess the operational risk inherent in all material products, activities, processes and system. As such, banks are expected to continuously identify operational risks inherent in all its products/processes/activities/systems (existing as well as new) by adopting Risk & Control Self Assessment (RCSA) approach for each business line as well as analyzing its historical loss data. The first step towards identifying risk events is to list out all the activities that are susceptible to operational risk. Usually this is carried out at several "levels". Level 1 lists the main business groups, corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management, and retail brokerage.

Level 2 lists out the product teams in these business groups, e.g. transaction banking, trade finance, general banking, cash management and securities markets. Level 3 lists out the product offered in these business e.g. import bills, letter of credit, and bank guarantee under trade finance. If required, a fourth level can be added. 2 Risk Assessment Risk & Control Self-Assessment (RCSA) Concept The approach is forward looking, less rigorous, as the people drawn from fields that know the processes best, are involved in the survey. The measurement framework is designed to focus on the principal drivers and controls of operational risk and is measured through a series of organisation specific risk-based weighted questions. The responses are then calibrated by adopting structured approach to enable the Operational Risk experts to identify and assess risks in order to plan appropriate actions. Objective of Self-Assessment Banks are expected to achieve following objectives through Risk Self Assessment process: Identification: The process would identify key operational risk areas, which is vital for development of a viable operational risk monitoring & control system. Assessment: The process would result in better understanding of risk profile and assessment of vulnerability to these identified risks. Monitoring: The process would enable Banks to deploy/re-direct their risk management resources for monitoring of identified risks. Mitigation/Control: Self-assessment process would enable Banks to chalk-out necessary action plan to reduce operational risk exposure to an accepted level. Self-assessment Process The steps involved in the Self Assessment Process by the banks include: Preparation of a Generic Process that will suit all the activities/products undertaken by the bank Mapping of key business processes, which would be generic in nature and preparation of generic steps Conduct of workshop of risk experts to sensitize them Identification of key risk areas in the processes and the operational risk loss events through surveys with business line experts Identification of Operational Risks risk category wise along with their brief description and conveying them to the concerned divisions Assessment of potential events/impacts with causative factors and related key controls in place. groups,

Documentation of entire exercise encompassing different steps of the process, key findings, and action taken on gaps observed. Repetition of the exercise for all business lines Process Mapping Concept Process map is representation of steps involved in any process from its start to its end. It is a technique, which will enable the banks to identify, describe, understand and ultimately improve the processes, which take place within an organisation or any of its divisions. Process mapping is: A technique to identify and understand how processes operate. A tool to manage, monitor, and improve processes. An effective means of training employees, especially those new to the organisation. Bank's Generic Product Process Mapping An illustrated framework for Generic Product Process involved in a product dealt by the Bank starting from origination of a new product to ending with closure of the account is as below:

3 Risk Monitoring Monitoring of Operational Risk at the corporate level of banks by and large focuses on three areas: Correctly interpreting and observing all the standards and guidelines set out in the operational risk policy and other related documents Monitoring operational risks in a timely manner and in the framework of the defined methods, structure, and processes Pursuing the measures initiated by the concerned corporate division for addressing the weaknesses in processes, structures and control, and for limiting the losses Operational Risk areas identified through Self-Assessment Survey and historical loss data would be monitored by the Risk Management Division of the banks and user divisions at the process level, activity level, and bank level. Operational Risks in banks are generally monitored by the banks through following measures:

Loss Event Database By analysis of historical loss data, banks will identify actual loss events. The bank is in the process of finalizing the structure of loss database for capturing actual loss events. Operational Risk Loss Events Tracking of individual internal event data is an essential prerequisite for development, functioning, and monitoring of operational risk management system. As such, the concerned Risk Management Division of the banks track individual internal loss event data for analyzing the bank's risk estimates to actual loss experience. Collected loss data are analysed loss event category and business line wise to look into the processes and plug any deficiencies, and take remedial steps to reduce such incidents. Self-assessment Survey On the basis of findings in the Self-Assessment Survey, very high and high-risk potential events are identified and are placed to the senior management of the bank. Key Risk Indicator (KRI) Limits On the basis of self-assessment survey and historical loss data (internal as well as external), the Banks are to develop their own Key Risk Indicators (KRI) or Early Warning Indicators (EWI) for monitoring of Operational Risk. Once the processes of self-assessment for all business lines risk category wise and establishing the loss database are completed, bank-specific KRIs are identified on the basis of potential as well as actual loss events. Prudential limit in respect of each KRI is set to monitor operational risk after building up loss data for minimum of 3 years. Management Information System (MIS) After completion of the process of conducting self-assessment and collection of loss data, Risk Management Division of the banks in consultation with other concerned divisions design a structured MIS for reporting of pertinent information to senior management and Board of Directors for proactive monitoring of operational risk. Audit Reports Risk Management Division of banks at corporate level are to maintain close liaison with their internal audit divisions and external auditors report to understand and capture very high and high operational risk areas. Internal and External Audit reports throw light on the need for developing new risk management policies, procedures, and practices/revising the existing practices vis a vis the trend in the industry. Risk Control/Mitigation Risk Control/Mitigation Process enables the bank to take risk prudently, keeping in mind risk/earnings aspects and Bank's capital resources. Risk Prevention Banks are to take all measures appropriate for stopping operational risks, which includes written Policies & Procedures, strong Internal Control System, and Business Contingency & Continuity Plan.

Policies & Procedures Banks are to put in place a well-defined and laid-down policies and procedures for accomplishing various tasks in various banking activities. These policies and procedures are to be periodically reviewed to incorporate the changes and align the policies to best risk management practices. Internal Control System The framework of formal written policies & procedures is reinforced through strong internal control system of the individual banks. Regular banking activities are closely monitored through internal control mechanism. Duties of officials at all level are well defined in banks by and large to avoid conflicting responsibilities. They are also reviewed periodically to identify the areas of potential conflicts of interest to minimise it. Once the Self Assessment Surveys are conducted, on the basis of findings in the Self-Assessment Survey and Causal - Factor Analysis of historical losses, banks undertake conducting of Gap-Analysis to revisit the existing internal control system. Further, to align the existing information system to risk sensitivity, major banks are in the process of establishing data warehouse. Business Contingency & Continuity Planning (BCCP) Some of the Major Banks have put in place Business Continuity & Contingency Planning to anticipate stress situation and plans to deal with them timely and effectively. Stress situations cover: Disaster recovery planning, Public relation damage control, Litigation strategy, Responding to regulatory criticism, System failures or unauthorised intrusions etc The objective of BCCP is to cover stress situations emanating from all the four operational risk types viz. People, Process, Systems, External Events and will address issues relating to data recovery, alternate data processing capabilities, emergency staffing and customer service support to resume operations without much loss of time.