Risk Management

By Arindam Patra on Wednesday, 9 May 2012 at 10:09

CAPITAL MANAGEMENT AND PROFIT PLANNING

1) One of the important parameters of financial strength is Capital or Net worth.

2) The correlation between business level & capital position is called Capital Adequacy.

3) The incentive for doing business hails from profitability.

UNIT 17: CAPITAL ADEQUACY – THE BASEL – II OVERVIEW

1) The Central bank Governors of 10 countries formed a committee on Banking Supervisory

Authorities in 1975.

2) The Banking Supervisory Authority Committee usually meets at the Bank of International
Settlements (BIS) at Basel, in Switzerland.

3) The Basel Committee provided the framework for Capital Adequacy in 1988 is known as the
Basel – I accord.

4) The Basel norms for Risk weights were more of a straightjacket nature.

5) As per Basel – I all exposures to sovereign were given 0% risk weight and all bank exposures
were given 20% Risk weight.
6) Assigning Risk Weightage to assets without considering the strengths and weaknesses of
individual entities was the main shortcoming of Basel – I.

7) The Basel – I defined components of Capital and allotted the Risk weights to different
categories of assets.

8) Basel – I stipulated minimum ratio of Capital to Risk weighted Assets.

9) The first round of proposal for changes in the Basel – I accord came up for deliberations and
consultative process in June 1999.

10) The Report of Basel – II Committee is titled as International Convergence of Capital

Measurement and Capital Standards a Revised frame work.

11) The Committee intends that the revised framework would be implemented by the end of year
2006.

12) The fundamental of Basel – II was to revise 1988 accord and to strengthen the soundness and
stability of banking system.

13) Basel – II demands Capital allocation for operational risk for the first time.

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14) The Basel – II accord rests on Three Pillars.

15) First Pillar of Basel – II is Minimum Capital requirement.

16) The Second Pillar of Basel – II is Supervisory Review process.

17) The Third Pillar of Basel – II is Market Discipline.

18) As per Second Pillar Supervisors have to ensure adequate capital for Risk management
through robust internal processes .

19) The Third Pillar puts in place disclosure norms about Risk Management practices and
allocation of regulatory Capital.

20) As per First Pillar minimum capital is required for Credit Risk, Market Risks and
Operational Risk.

21) The Capital for credit risk can be calculated in two methodologies, they are

Standardized Approach and Internal Rating Based (IRB) Approach.

22) Under IRB Approach two options are available they are Foundation Approach and Advanced
Approach.

23) The Capital for Market Risk is calculated in two methods, they are Standardized Method and
Internal Model Method.

24) The Standardized Method for Market Risk is of two types i.e. Maturity & Duration methods.
25) Capital for Operational Risk is calculated in 3 methods. They are Basic Indicator Approach,
Standard Approach and Advanced Management Approach.

26) Pillar – II Supervisory Review consists of A) Evaluate Risk Assessment

B) Ensure Soundness and Integrity of Bank’s internal process to assess the Capital Adequacy C)
Ensure maintenance of minimum capital with PCA for shortfall D) Prescribe differential Capital,
where necessary i.e. where the internal process are slack.

27) Pillar – III Market Discipline – consists of A) Enhance disclosures B) Core disclosures and
Supplementary disclosures C) Timely at least semi annual disclosures.

28) The Basel – II accord is more risk sensitive.

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29) There are incentives for banks with better risk management capabilities.

30) Tier – I Capital is Core Capital & Tier – II Capital is Supplementary Capital

31) The Capital ratio is calculated by using the Regulatory Capital & RW Assets.

32) The term Capital includes Tier – I capital, Tier – II capital & Tier – III Capital.

33) The total Capital Adequacy Ratio must not be less than 8%.
34) Core Capital consists of Paid up capital, free reserves and unallocated surpluses less
specified deductions.

35) Subordinated debts of more than 5 years maturity, loan loss reserves, revaluation reserves,
investment fluctuation reserves and limited life preferential shares are Supplementary capital.

36) Tier – III Capital consists of short term subordinated debts for the sole purpose of meeting a
portion of the capital requirement for Market Risk.

37) Tier – II Capital is restricted to 100% of Core Capital and long term-subordinated debts may
not exceed 50% of Tier – I Capital.

38) Tier – III Capital will be limited to 250% of Tier – I Capital required to support Market Risk.

39) 28.5% of Market Risk needs to be supported by Tier – I Capital.

40) Revision exercise of Basel – I was began in June – 1999.

41) Basel – II accord rests on Three Pillars viz. A) Minimum Capital requirement B) Supervisory
review process C) Market discipline.

42) Basel – II provides various options to work out the minimum Capital requirement for Credit
Risk, Market Risk and Operational Risks.

43) Capital Adequacy Ratio = Regulatory Capital / Total Risk Weighted Assets.
44) Total Risk Weighted Assets = Risk Weighted Assets for Credit Risk + 12.5 * Capital for
Market Risk + 12.5 * Capital for Operational Risk.

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UNIT 18: PILLAR – I – CAPITAL CHARGE FOR CREDIT RISK

1. Higher the risk, higher would be the capital requirement.

2. The asset with high credit rating has lower risk and requires lower Capital.

3. The Basel – II accord suggests two options for rating. They are rating by external agency and
Rating based on internal assessment.

4. Credit Risk is defined as the possibility of loss associated with the reduction of credit quality
of borrowers or counter parties.

5. In Banks losses arise from outright default due to inability or unwillingness of customers to
pay.

6. Under Basel – I assets were assigned uniform Risk Weights based on their category.

7. Under Basel – I exposure to sovereign were assigned a Risk Weight of 0%, claims against
Banks 20% and advances to corporates, individuals and firms were assigned 100% risk weights.
8. Under revised accord along with category of a customer his credit rating is given the due
regard for assigning the Risk Weights.

9. Under Basel – II banks were given choice between two methodologies for calculating capital
requirement for credit risk.

10. Internal Rating Based (IRB) Approach has further two options Foundation Approach and
Advanced IRB Approach.

11. Standardized Approach allows banks to measure Credit Risk in a Standardized manner based
on External Credit Assessment.

12. The Risk Weights are inversely related to the rating of the counter party.

13. The criteria required for Credit Assessment by External Credit Assessment Institutions
(ECAI) are A) Objectivity B) Independence C) International Access D) Transparency E)
Disclosure F) Resources G) Credibility.

14) For the purpose of Credit Rating of Sovereigns, the Country scores of Export Credit Agency
(ECA) may be recognized.

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15) All Commercial Banks in a given country will be assigned a risk weightage either one touch
below the risk weight assigned to that sovereign or based on the external credit assessment of the
Bank itself.

16) Under Standard Approach retail and SME exposures attract a uniform Risk weightage of
75%.

17) Bonds and Securities are excluded from Retail Category.

18) No aggregate exposure to one counter party can exceed 0.2% of the overall retail portfolio.

19) Lending fully secured by mortgage on residential property will have a Risk Weightage of
35%.

20) The Loans secured by commercial property will have 100% Risk Weightage.

21) A Bank is allowed netting of the security from the outstanding provided it has the right to
liquidate the security promptly in the event of default.

22) Liquid Securities would be available for netting to the extent of realizable value provided the
securities can be promptly liquidated.

23) If the claim amount were guaranteed by another party or agency, which has a better rating,
risk weight would reduce accordingly.

24) In IRB Approach the bank’s internal assessment of key risk parameters serves as a primary
input to capital computation.
26) Capital charge computation under IRB Approach is dependent on four parameters. They are
PD – Probability of default B) LGD – Loss Given at Default

C) EAD – Exposure at Default D) M – Effective Maturity

27) IRB Approach computes the capital requirement of each exposure directly.

28) Under IRB Approach Banks need to categories as:

A) Corporates B) Sovereigns C) Banks D) Retail E) Equity.

29) Risk Weighted Assets are derived from capital charge computation.

30) Foundation Approach and Advanced Approach differ primarily in terms of inputs that are
provided by the Banks on its own estimates and those that are specified by the supervisor.

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31) Under Foundation Approach Banks provide their own estimates of PD and rely on
supervisory estimates for other risk components.

32) Under Advance Approach banks provide more of their own estimates of PD, LGD, EAD and
Effective Maturity.

33) Banks adopting IRB Approach are expected to continue to use the same.

34) The regulator has to select on external credit assessment institution based on seven Criteria.
35) IRB Approaches depend upon four parameters viz, PD, LGD, EAD and effective
management

UNIT19: PILLAR – I CAPITAL CHARGE FOR MARKET & OPERATIONAL

RISK

1. Value of financial instruments may fall due to changes in market parameters. This Risk is
called Market Risk.

2. Banks face the Operational Risk in addition to Credit Risk and Market Risks.

3. Market Risk is defined as Risk of losses in On-Balance Sheet and Off-Balance Sheet positions
arising from movements in Market Prices.

4. The Market Risk positions that require Capital Charge are A) Interest rate related Instruments
in Trading Book B) Equities in Trading Book C) Foreign Exchange open positions through out
the Bank.

5. A Trading Book consists of financial instruments and commodities held either with trading
intent or in order to hedge other elements in Trading Book.

6. In Indian scenario the Trading Book comprises A) Securities held for trading B) Securities
available for sale C) Open Forex positions D) Open Gold positions E) Trading positions in
Derivatives F) Derivatives for hedging Trading Positions.

7) Banks are required to calculate counter party credit risk charge for OTC Derivatives.
8) The minimum capital requirement for Market Risk comprises two components i.e. Specific
charge for each security & General Market Risk charge towards interest rate risk in the portfolio.

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9) The Capital charge for specific risk is designed to protect against the adverse movement in the
price of individual security owing to factors related to individual security

10) Capital requirements for general market risk are designed to capture the risk of loss arising
from changes in the market interest rates.

11) Basel Committee has suggested Two Methods for computation of Capital Charge for Market
Risk. One is Standardized Method and another is Bank’s Internal Risk Management Method.

12) Under Standardized method there are two options A) Maturity method and B) Duration
method.

13) RBI prescribed Duration method to arrive at capital charge for Market Risk.

14) In Basel – I, Capital for Operational Risk was not envisaged.

15) Operational Risk would vary with volume and nature of business.
16) Operational Risk is defined as the risk of loss resulting from inadequate or failed internal
process, people and system or from external events.

17) Basel – II provides three methods for calculating Operational Risk Capital Charge. They are
A) The Basic Indicator Approach (BIA) B) The Standardized Approach and C) Advanced
Management Approach (AMA).

18) The Banks are expected to move from BIA to AMA & not allowed to revert .

19) Under BIA a Bank must hold capital for OR equal to 15% of average positive annual gross
income of previous 3years. If annual income is negative or zero it should be excluded while
calculating the average.

20) Gross Income = Operating profit + Operating expenses – extraordinary items – Residual
profits from sale of investments in banking book.

21) Under Standardized Approach Bank’s activities are divided into eight business lines. They
are 1) Corporate Finance 2) Trading & Sales 3) Payments & settlements 4) Commercial
Banking 5) Agency services 6) Retail banking 7) Retail Brokerage and 8) Assessment
Management.

22) Under Standardized method within each business line gross income is broad indicator for
Operational Risk exposure.

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23) The capital charge for each business line is calculated by multiplying gross income by a
factor assigned to that business line.
24) Under Advance Management Approach bank’s internal operational risk measurement is
used, which is required to be vetted by the superior.

25) Basic Indicator Approach (BIA) provides thumb rule prescription for minimum capital
requirement as 15% of Operating Income.

26) The capital charge required in Market Risk in case of investment in mortgage based
securities of all maturities is 4.5%

27) First Pillar of Basel – II covers Capital Charge for CR, Mkt. risk & OR

28) Credit concentration risk was not fully captured under Pillar – I

29) Strategic Risk and Interest rate Risk are not addressed in Pillar – I

30) Business cycle effects are external factors to the bank.

UNIT20: PILLARS 2 & 3 SUPERVISORY REVIEW AND MARKET DISCIPLINE

1. The process of assessing capital adequacy needs to be reviewed and monitored by the super
visors.

2. Basel – II considers transparency and objectivity as important parameters in review exercise.

8. The emphasis of the supervisory review should be on the quality of the Bank’s Risk
management and Control.

9. The periodic review would involve A) On site examination or Inspections B) Off site review
C) Discussions with bank’s management D) Review of work done by auditors E) Periodic
reporting.
10. Supervisors will require banks to operate with a buffer over and above the Pillar – I
standard.

11. If a Bank is not meeting the requirements in four principles, the supervisor should consider a
range of options like extensive monitoring, restricting dividend payments, requiring banks to
raise capital etc.

12. The important issue that require focused attention of supervisory review and which are not
directly addressed under Pillar – I are A) Interest Rate Risk in Banking Book B) Operational risk
and C) Credit Risk.

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13. Credit Risk includes A) Stress tests under IRB Approach B) Definition of default C)
Residual Risk D) Credit concentration Risk.

14. Disclosures allow market participants to assess key information and thereby make informed
decision about a Bank.

15. The disclosures under Pillar – III should be made at least on semi – annual basis subject to
some exceptions.

16. Qualitative disclosures such as policies, systems definitions may be made on annual basis.

17. Critical information such as Tier – I capital, capital ratios and other components may be
published on a quarterly basis.
18. Banks should have a formal disclosure policy approved by Board of Directors.

19. Pillar – III prescribes qualitative and quantitative disclosure under 13 areas.

UNIT 21: ASSET CLASSIFICATION AND PROVISIONING NORMS

1. In August 1991 a high level committee headed by Mr. M.M. Narsimham was appointed to
execute various aspects of our financial system.

2. One of the important recommendations of Narsimham Committee was that Balance Sheet of
the Banks should be transparent and comply with international standards.

3. Following the Narsimham Committee recommendations the RBI issued guidelines /

instructions to banks in Apr 1992 for classification of assets.

4. From March 2004 an asset becomes NPA, if interest / installment remains unpaid for 90 days.

5. In case of agricultural advances, interest or installments remains unpaid for two crop seasons
incase of short term crops and one crop season incase of long duration crops then the account
becomes NPA.

6. Long duration crop is one incase of which crop season is more than one year

7. An NPA remains for a period of 12 months in the category of SS & D1and 24 months as D2
thereafter migrates to D3.
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8. The RBI introduced asset classification and provisioning in line with international practices
for the first time in 1993.

9. With passage of time, probability of recovery diminishes and hence requirement of provision
goes up.

10. Unsecured assets are those, where the realizable value of security is not more than 10% of
the outstanding dues.

11. The provision is made based on category, sub-category of the asset and value of realizable
security.

12. Once the account becomes NPA, it goes through a process of ageing where asset
classification shall progressively deteriorate.

UNIT 22: PROFIT PLANNING

1. Traditional Approach is reduce expenditure & increase fee based income.

2. Profit planning in a bank involves Balance Sheet Management.

3. Bank’s income arises from three sources viz Interest, fee based & treasury.
4. The interest income on highly rated corporates is much lower as compared to the income on
lower rated corporates.

5. The investment in Government securities practically risk free but the yield on such
investments is lower.

6. Banks are required to have proper blending of investment in Govt. securities and credit
profiles to maximize the profits for a given level of risk appetite.

7. Banks need to optimize the investment and lending portfolio to earn the best possible returns
for a given capital level.

8. The second major source of income is derived from fee based activities.

9. Banks have ventured into cross selling of other financial products such as insurance policies
& mutual funds etc.

10. The treasury income is derived by trading in Securities, Foreign Exchange, Equities,
Bullion, Commodities and Derivatives.

11. Treasury business is largely a speculative activity.

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12. Treasury business is to be undertaken by banks with stringent internal controls and checks.
13. Interest rates for Term Deposits in India are deregulated but Savings Bank Interest rates are
regulated by RBI.

15. Caps on open position, Mark to market variations capital provisioning based on value of
risks are risk management measure.

16. In 1990s Barings Bank, a very old British bank, collapsed due to very large losses on the
Exchange.

17.Income maximization & expenditure minimization are required to maximize profitability.

18. Due to modern technology, new products and aggressive marketing public sector banks and
old private sector banks had to change their ways.
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UNIT 17: CAPITAL ADEQUACY – THE BASEL – II OVERVIEW – NOTES

The Basel Committee defined components of Capital, allotted Risk Weights to different types or
categories of assets and pronounced as to what should be the minimum ratio of capital to sum of
total Risk Weighted Assets.

TERMINAL QUESTIONS

1. Process of revision of BASEL accord:

Central Bank Governors of a group of 10 countries formed a committee of Banking Supervisory
Authority in 1975. This Committee usually meets at Bank of International Settlement (BIS) at
Basel, in Switzerland. Hence it is known as Basel Committee. The Committee provided the
framework for Capital Adequacy in 1988, known as Basel – I accord. The limitations of the
accord were noticed over a period of time. A revision exercise was begun in June 1999. After
the exhaustive consultative process a revised framework was finalized in June 2004. The revised
framework promotes the adoption of stronger Risk Management practices by banks. It also
introduces capital allocation for Operational Risks.

II. List out the 3 pillars of Basel – II accord.

Three Pillars of Basel – II are A) Minimum Capital requirement B) Supervisory review process
and C) Market discipline.

III. Write a short notes on regulatory capital.

Regulatory capital consists of Tier –I capital, Tier – II Capital and Tier – III Capital

Tier – I Capital is called Core Capital and it consists of Paid-up Capital, free reserves and
unallocated surpluses less specified deductions.

Tier – II Capital is called Supplementary Capital and it consists of subordinated debts of more
than 5 years maturity, loan loss reserves, revaluation reserves, investment fluctuation reserves
and limited life preferential shares. It is restricted to 100% of Tier – I Capital and Long term
Subordinated debts may not exceed 50% of Tier – I Capital.

Tier – III Capital consists of short term subordinated debts for the sole purpose of meeting a
portion of capital requirement for Market risk. Short-term bond must have an original maturity
of at least 2 years. Tier – III Capital will be restricted to 250% of Tier – I Capital that is required
to support Market Risk.

IV. List out 3 parts of Total Risk Weighted Assets.

Total Risk Weighted Assets consists of 1) Risk Weighted Assets for Credit Risk, 2) Risk
Weighted Assets for Market Risk and 3) Risk Weighted Assets for Operational Risk.

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V. What are the objectives for revision of Basel – I accord.

The fundamental objective for revision of Basel – I accord was to strengthen the soundness and
stability of the banking system. The revised framework would promote the adoption of stronger
Risk Management practices by banks. It provides capital allocation for Operational Risk for the
first time. It emphasizes the need for consistency in approach.

UNIT 18: PILLAR – I – CAPITAL CHARGE FOR CREDIT RISK

TERMINAL QUESTIONS

I. Define the term Credit Risk.

A: Credit Risk is defined as the possibility of losses associated with reduction of credit quality of
borrowers or counter-parties. In Banks losses arise from outright default due to inability or
unwillingness of the customer to repay.

II. Features of Standard Approach for assigning Risk Weights – discuss.

A: Standard Approach allows Banks to measure Credit Risk in a standard manner based on
External Credit Assessment. The External Credit Assessment Institution (ECAI) should meet the
required criteria. The regulator has to select an external credit assessment institution based on 7
criteria viz 1) Objectivity

2) Independence 3) International Access 4) Transparency 5) Disclosure

6) Resources and 7) Credibility.

III. Criteria for selection of External Credit Assessment Institution.

A: There are 7 criteria for selection of ECAI. They are 1) Objectivity

2) Independence 3) International Access 4) Transparency 5) Disclosure

6) Resource ness and 7) Credibility.

IV. Criteria to be eligible under Retail portfolio:

A: 1) Exposure to an individual / Individuals or to small Business

2) Exposure is in the form of revolving credit, personal term loans, Small

Business facilities, securities, bonds and equities are specially excluded.

3) The portfolio must be sufficiently diversified. No aggregate exposure to

One borrower can exceed 0.2% of the overall retail portfolio.

4) Low value individual exposures. The maximum aggregate retail

Exposure to a single borrower should not exceed an absolute threshold of

Euro 1 Million. In our country Rs. 2 – 3 Crore or so.

V: Discuss the Simplified Standardized Approach (SSA).

A: SSA prescribes sovereign rating based on the Export Credit Agency (ECA). Risk Weight
for corporates is 100%, for retail portfolio 75% and for housing portfolio 35%. The treatment of
past due loans would be the same and off- Balance Sheet items will have credit conversion
factors as before.

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VI: Write a short note on Internal Rating Based (IRB) Approach.

A: IRB method involves assigning Risk Weights based on the internal rating of the borrowers.
The Rating exercise must fulfill certain criteria to the satisfaction

of the regulator. There are two options available, Foundation Method and Advanced Approach.
Under this method the capital charge computation is dependent on 1) PD – Probability of Default
2) LGD – Loss Given at Default

3) ED – Exposure at Default 4) M – Effective Maturity.

IRB – Approach computes the capital requirement of each exposure directly.

The salient points of Simplified Standard Approach (SSA) are:

A) For sovereign exposures rating is used by Export Credit Rating Agency.

B) For Corporates 100% Risk weight C)For Retail 75% and for housing portfolio 35% Risk. D)
Off Balance sheet items will have credit conversion factors.

UNIT19: PILLAR – I CAPITAL CHARGE FOR MARKET & OPERATIONAL RISK –

TERMINAL QUESTIONS

1. define the term Market Risk:

A: - Market Risk is defined as the risk of losses in on-Balance Sheet and off-Balance Sheet
positions arising from movements in market prices.

2. List out the Market Risk positions that require capital allocation:

A: - The Market Risk positions that require allocation of capital are 1) Interest rate related
instruments in trading book 2) Equities in trading book and 3) Foreign Exchange open positions
throughout the bank.

3) List out the components of trading book in Indian context:

A: - In Indian scenario, the trading book comprises 1) Securities held for trading 2) Securities
available for sale 3) Open Forex positions 4) Open gold positions 5) Trading positions in
derivatives 6) Derivatives for hedging trading positions.

4A. What is specific capital charge for investment in other non-approved securities guaranteed
by Government?

A: - The specific capital charge required for investment in other non-approved securities
guaranteed by Government, in case of all maturities, is 1.8% and investment in other approved
securities guaranteed by Government is also 1.8%.

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4B. What is specific capital charge required for Tier – II bonds?

A:- The specific capital charge required for Tier – II bonds for all maturities is 9% and all other
securities of all maturities is 9%.

4C. What is specific capital charge required for claims on banks for residual term other Tier – II
bonds?

A:- The specific capital charge required for claims on banks for residual term other Tier – II
bonds is 0.3% for maturities upto 6 months, 1.125% for maturities six months to 24 months and
1.8% for above 24 months.

5. Define the Term Operational Risk.

A:- Operational Risk is defined as the risk of loss resulting from inadequate or failed internal
process, people and systems or from external events.

6. What are the 3 methodologies to work out capital charge for Operational Risk?

A:- Basel – II provides three methods for calculating Operational Risk Capital Charge. They are
1) Basic Indicator Approach 2) Standardized Approach and 3) Advanced Management
Approach.

7. Write a short notes on Basic Indicator Approach.

A:- Under Basic Indicator Approach a bank must hold capital for Operational Risk equal to the
average over the 3 years of a fixed percentage of positive annual gross income. If annual gross
income is negative or zero, it should be excluded while calculating the average.

8. List out eight business lines suggested in Standardized Approach.

A:- Under Standardized Approach bank’s activities are divided into eight business lines. They
are 1) Corporate Finance 2) Trading and sales 3) Retail Banking 4) Commercial banking 5)
Payment & settlements 6) Agency services 7) Asset Management and 8) Retail brokerage. With
in each business line gross income is a broad indicator for operational risk exposure. The capital
charge for each business line is calculated by multiplying gross income by a factor assigned to
that business line.

I. Capital requirement for Commercial banking and agency services – 15%.

II. Capital requirement for Corporate finance, trading & sales and payments and settlements –
18%

III. Capital requirement for Retail banking, Retail brokerage & Asset Management – 12%
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TERMINAL QUESTIONS

1. what are the two issues dealt with by supervisory review process?

A:- The two issues that are dealt by Supervisory review Process are 1) Ensuring adequate capital
with banks to support all the issues in their business and 2) Encouraging banks to develop and
use better risk management techniques in monitoring and maintaining their risks.

2. Please state the four Principles of Supervisory review process:

A:- The four principles of Supervisory review process are 1) Banks should have a process for
assessing their capital adequacy in relation to their risk profile and a strategy for maintaining
their capital levels 2) Supervisors should review and evaluate banks internal capital adequacy
assessments and strategies as well as their liquidity to monitor and ensure their compliance with
regulatory capital ratios. 3) Supervisors should expect banks to operate above the minimum
regulatory capital ratios and should have the ability to require banks to hold capital in excess of
the minimum. 4) Supervisors should seek to intervene at an early stage to prevent capital from
falling below the minimum levels required to support the risk characteristics of a particular back
and should require rapid action if capital is not maintained or restored.

3. Write a short note on 3rd Pillar viz Market Discipline:

A:- Basel – II, 3rd Pillar viz Market discipline provides disclosure requirements for banks.
Disclosure will allow market participants to assess key information and thereby make informed
decision about a bank. Market discipline can contribute to a safe and sound banking
environment. The decisions under Pillar – III can be made on a semi-annual basis subject to
some exceptions.

4. Please state at least five areas of disclosure which are prescribed by Pillar – III of Basel – II
frame work.

A:- !) Scope of application 2) Capital structure 3) Capital adequacy 4) Operational risk 5) Credit
risk – General disclosure.
5. Basel – II committee has identified four key principles of Supervisory Review.

6. The four key principles of supervisory review are A) Banks should have a process for
assessing their capital adequacy in relation to their risk profile and a strategy for maintaining
their capital levels B) Supervisors should review and evaluate banks internal capital adequacy
assessment and strategies as well as their ability to monitor and ensure their compliance with
regulatory capital ratios.

C) Supervisors should expect banks to operate above the minimum regulatory capital ratios and
should have the ability to require banks to hold capital in excess of the minimum. D)
Supervisors should seek to intervene at an early

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stage to prevent capital from falling below the minimum levels required to support the risk
characteristics of a particular bank and should require rapid remedial action if capital is not
maintained or restored.

3. Supervisors has to ensure that A) Banks have adequate capital to support all risks in their
business and Supervisors has to encourage Banks to develop and use better risk management
techniques in monitoring and mitigating their risks.

4. The supervisors need to concentrate on three main areas 1) Risk considered under Pillar – I
but not fully captured 2) Factors that are not addressed in Pillar – I process 3) External factors to
the Bank .

7. The five main features of ensuring capital adequacy are 1) Bond and Senior management
review 2) Sound capital assessment 3) Comprehensive assessment of risk 4) Monitoring and
reporting 5) Internal control review.
UNIT 21: ASSET CLASSIFICATION AND PROVISIONING NORMS

TERMINAL QUESTIONS

1. Discuss the concepts of NPA s & Income recognition:

A:- Following the recommendations of Narsimham Committee, RBI issued instructions to banks
in Apr 1992, for Asset Classification and provisioning. Initially an advance was treated NPA, if
interest & / installment remained past due for four quarters. Now an account is considered as
NPA if interest & / installment remains unpaid for 90 days. NPA causes two fold impact on the
profitability of a bank. A NPA is one which ceases to generate any income for the bank. The
provision depends upon category & sub-category of the asset and reasonable value of the
security.

2. State four main categories of Asset classification and their definitions:

A:- The four categories of assets are 1) Standard Assets 2) Sub –Standard Assets 3) Doubtful
Assets and 4) Loss Assets. An asset becomes NPA if interest & / installment remains unpaid for
90 day. Incase of Agricultural advances, an asset becomes NPA if interest & / installments
remains unpaid for two crop seasons incase of loans given for short term crops and one crop
season incase of loans given for long duration crops.

3. State the provisioning norms for Sub Standard Assets:

A:- An NPA account remains SS for a period of 12 months. If account is secured one, it is
denoted by code No.21 and requires 10% provision of out standing dues. If realizable value of
security is not more than 10% of outstanding dues, it is treated as unsecured and denoted by
Code No.22 and requires a provision of 20% of the outstanding dues.

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4. Discuss the provisioning norms of Doubtful Assets:

A:- Doubtful Assets has three sub categories viz D1, D2 and D3, which are denoted by code 31,
32 and 33 respectively. Provisions required are for D1 – 20% of realizable value of secured
portion plus 100% of shortfall, incase of D2 – 30% of realizable value secured portion plus
100% of shortfall and incase of D3 – 100% of outstanding irrespective of realizable value of
security. An NPA remaining SS for 12 months D1and it remains12 months in D1 it becomes D2
and remains D2 for 24 months and then migrates to D3.

5. State the NPA norms for agricultural advances:

A:- In case of agricultural advances 1) a loan granted for short duration crops will be treated as
NPA if the interest & / installments remains overdue for two crop seasons and 2) A loan granted
for long duration crops will be treated as NPA if the interest & / installment remains unpaid for
one crop season. Long duration crop would be one for which the crop season is longer than one
year.

UNIT 22: PROFIT PLANNING – TERMINAL QUESTIONS

1. Write a short note on profitability in banks:

A:- Profitability has become the most important parameter in bank’s functioning. Profitability is
a function of six variables 1) Interest income 2) Fee based income 3) Trading income 4) Interest
expenses 4) Staff expenses and t6) other operating expenses. Maximization of first three and
minimization of last three variables are the requisites to maximize profitability.

2. Discuss the impact of allocation of funds, in different categories of assets, on the profitability
and capital requirement of a bank:

A:- Lending to lower rated customers results in increased profit but requires increased capital.
Therefore banks need to optimize the investment and lending portfolio to earn the best possible
returns for a given capital.
3. Discuss the factors responsible for profitability of banks:

A:- There are six factors for profitability of banks. They are 1) Interest income 2) Fee based
income 3) Trading income 4) Interest expenses 5) Staff expenses and 6) other operating
expenses. Maximization of first three variables and minimization of last three variables are
required to maximize the profitability of banks.

:RM-D19:

4. Discuss the effects of NPA s on the profitability of banks:

A:- The NPA s have two fold effect on the profitability of banks i.e. reduction in income and
requirement of provisioning and need for additional capital. Hence return on capital or
profitability gets further deteriorated.

5. Write short notes on the profitability of Indian banks:

A:- Starting from Narsimham Committee report of 1991, Indian banking has seen a total change
in the scenario during last 14 years. RBI has been more concerned about prudential norms and
disclosure requirements. The new entrants have brought modern technology, new products and
aggressive marketing. Profitability has become the most important parameter in bank’s
functioning