INTRODUCTION TO THE BANK

DEFINATION

A bank is an institution, usually incorporated with power to issue its promissory notes
intended to circulate as money (known as bank notes); or to receive the money of
others on general deposit, to form a joint fund that shall be used by the institution, for
its own benefit, for one or more of the purposes of making temporary loans and
discounts; of dealing in notes, foreign and domestic bills of exchange, coin, bullion,
credits, and the remission of money; or with both these powers, and with the
privileges, in addition to these basic powers, of receiving special deposits and making
collections for the holders of negotiable paper, if the institution sees fit to engage in
such business."

Types of banks in India

1. Public Banks
2. Private Banks
3. Cooperative Banks

The History of banking in India dates back to the early half of the 18th century. 3
Presidency Banks that were established in the country namely the Bank of Hindustan,
Bank of Madras and Bank of Bombay can also be referred to as some of the oldest
banking institutions in the country. The State Bank of India that was earlier known as
the Bank of Bengal is also one of the oldest in the genre. To know about the types of
banks in India, it is necessary that we first comprehend the banking system so as to be
able to distinguish about its various types.
 All types of Banks in India are regulated and the activities monitored by a standard
bank called the Reserve Bank of India that stands at the apex of the banking
structure. It is also called the Central Bank, as major banking decisions are taken at
this level. The other types of banks in India are placed below this bank in the
hierarchy.

The major types of banks in India are as follows:

Public sector banks in India - All government owned banks fall in this variety.
Besides the Reserve Bank of India, the State Bank of India and its associate banks and
about 20 nationalized banks, all comprises of the public sector banks. Many of the
regional rural banks that are funded by the government banks can also be clubbed in
this genre.

Private sector banks in India - A new wave in the banking industry came about with
the private sector banks in India. With policies on liberalization being generously
taken up, these private banks were established in the country that also contributed
heavily towards the growth of the economy and also offering numerous services to its
customers. Some of the most popular banks in this genre are: Axis Bank, Bank of
Rajasthan, Catholic Syrian Bank, Federal Bank, HDFC Bank, ICICI Bank, ING
Vysya Bank, Kotak Mahindra Bank and SBI Commercial and International Bank. The
Foreign Banks in India like HSBC, Citibank, and Standard Chartered bank etc can
also be clubbed here.

Cooperative banks in India - With the aim to specifically cater to the rural
population, the cooperative banks in India were set up through the country. Issues like
agricultural credit and the likes are taken care of by these banks.
Public Sector Banks in India

• Allahabad Bank
• Andhra Bank
• Bank of Baroda
• Bank of India
• Bank of Maharastra
• Canara Bank
• Central Bank of India
• Corporation Bank
• Dena Bank
• IDBI Bank
• Indian Bank
• Indian Overseas Bank
• Oriental Bank of Commerce
• Punjab & Sind Bank
• Punjab National Bank
• Syndicate Bank
• UCO Bank
• Union Bank of India
• United Bank of India
• Vijaya Bank
Private Sector Banks in India :

• Bank of Punjab
• Bank of Rajasthan
• Catholic Syrian Bank
• Centurion Bank
• City Union Bank
• Dhanalakshmi Bank
• Development Credit Bank
• Federal Bank
• HDFC Bank
• ICICI Bank
• IndusInd Bank
• ING Vysya Bank
• Jammu & Kashmir Bank
• Karnataka Bank
• Karur Vysya Bank
• Laxmi Vilas Bank
• South Indian Bank
• United Western Bank
• UTI Bank
MONITORING AUTHORITY OF INDIA
 Department of Banking Supervision
The Banking Regulation Act, 1949 empowers the Reserve Bank of India to inspect
and supervise commercial banks. These powers are exercised through on-site
inspection and off site surveillance.
Till 1993, regulatory as well as supervisory functions over commercial banks were
performed by the Department of Banking Operations and Development (DBOD).
Subsequently, a new Department of Banking Supervision (DBS) was set up to take
over the supervisory functions relating to the commercial banks from DBOD. For
dedicated and integrated supervision over all credit institutions, i.e., banks,
development financial institutions and non-banking financial companies, the Board
for Financial Supervision (BFS) was set up in November 1994 under the aegis of the
Reserve Bank of India. For focussed attention in the area of supervision over non-
banking finance companies, Department of Supervision was further bifurcated in
August 1997 into Department of Banking Supervision (DBS) and Department of
Non-Banking Supervision (DNBS). These Departments now look after supervision
over commercial banks & development financial institutions and non-banking
financial companies, respectively. Both these departments now function under the
direction of the Board for Financial Supervision (BFS).
The Board for Financial Supervision constituted an audit sub-committee in January
1995 with the Vice-Chairman of the Board as its Chairman and two non-official
members of BFS as members. The sub-committees main focus is upgradation of the
quality of the statutory audit and concurrent / internal audit functions in banks and
development financial institutions.
On site Inspection

On site inspection of banks is carried out on an annual basis. Besides the head office
and controlling offices, certain specified branches are covered under inspection so as
to ensure a minimum coverage of advances.
The Annual Financial Inspection (AFI) focusses on statutorily mandated areas of
solvency, liquidity and operational health of the bank. It is based on internationally
adopted CAMEL model modified as CAMELS, i.e., capital adequacy, asset quality,
management, earning, liquidity and system and control. While the compliance to the
inspection findings is followed up in the usual course, the top management of the
Reserve Bank addresses supervisory letters to the top management of the banks
highlighting the major areas of supervisory concern that need immediate
rectification, holds supervisory discussions and draws up an action plan, that can be
monitored. All these are followed up vigorously. Indian commercial banks are rated
as per supervisory rating model approved by the BFS which is based on CAMELS
concept.
Off-site Monitoring
As part of the new supervisory strategy, a focussed off-site surveillance function
was initiated in 1995 for domestic operations of banks. The primary objective of the
off site surveillance is to monitor the financial health of banks between two on-site
inspections, identifying banks which show financial deterioration and would be a
source for supervisory concerns. This acts as a trigger for timely remedial action.
During December 1995 first tranche of off-site returns was introduced with five
quarterly returns for all commercial banks operating in India and two half yearly
returns one each on connected and related lending and profile of ownership, control
and management for domestic banks. The second tranche of four quarterly returns
for monitoring asset-liability management covering liquidity and interest rate risk
for domestic currency and foreign currencies were introduced since June, 1999. The
Reserve Bank intends to reduce this periodicity with effect from April 1,2000.
Corporate Governance
With a view to strengthening the corporate governance and internal control function
in the banks, several steps have been initiated. Introduction of concurrent audit
system, constitution of independent audit committee of board, appointment of RBI
nominees on boards of banks, creation of a post of compliance officer, such are
some steps. Besides, the Reserve Bank monitors the implementation of
recommendations of Jilani Committee relating to internal control systems in banks
on an on-going basis during the annual financial inspection of banks.
Initiatives and Directions
The Reserve Bank has taken several other supervisory policy initiatives. These
include quarterly monitoring visits to banks displaying financial and systemic
weaknesses, appointment of monitoring officers and direct monitoring of certain
problem areas in house-keeping, etc. In addition the department provides secretarial
support to the Board for Financial Supervision and acts as its executive arm. It is the
BFS which evolves policies relating to supervision. It also attends to appointment of
statutory central auditors / branch auditors for all banks and selected all India
financial institutions and to complaints against banks. The department monitors
cases of frauds perpetrated in banks and reported to it. The department as a one time
measure, issued several guidelines to banks and all india financial institutions to
enable them to become Y2K compliant.
Core Principles
Against the backdrop of banking sector reforms in India and the global focus on
internal control and supervisory mechanism, the need for building a strong and
efficient banking system comparable to the international standards cannot be
gainsaid. A detailed study was carried out so as to ascertain gaps, if any, in
implementing the 25 core principles of effective banking supervision enunciated by
the Bank for International Settlements (BIS). Necessary steps have already been
initiated to fill in the gaps, so as to make the regulatory as well supervisory system
more sound and comparable to international standards.
Supervision over FIs
On the basis of the recommendations made by an in-house group, the monitoring of
the financial institutions first started after 1990. This was done through prescribed
quarterly returns on liabilities / assets, source and deployment of funds, etc. The
objective of this monitoring was to obtain a macro level perspective for evolving
monetary and credit policy, to assess the quality of assets of the financial system and
to improve co-ordination between banks and FIs. In 1994, these institutions were
brought under the prudential regulation of the Reserve Bank.
The Reserve Bank has adopted more or less, the CAMELS approach for regulation
of Fis. Since FIs are vested with developmental role as welland with responsibility
of supervision of other institutions, evaluation of their developmental, co-ordinating
and supervisory role is also undertaken.
The newly created division in the department at present supervises and regulates ten
select all-India financial institutions viz., IDBI, ICICI, IFCI, IIBI, Exim Bank,
NABARD, NHB, SIDBI, IDFC and TFCI. With a view to having a continuous
monitoring and supervision of these FIs, an off-site surveillance system has also
been put in place.
Further, the division collects from LIC, GIC and UTI information relating to assets
and liabilities and flow of funds for the purpose of overall assessment of the impact
of the operations of FIs on the total flow of resources in the economy and for
compiling new liquidity and monetary aggregates.
 INTRODUCTION TO THE BANKING
REFORMS
In 1991, the Indian economy went through a process of economic liberalization,
which was followed up by the initiation of fundamental reforms in the banking sector
in 1992. The banking reform package was based on the recommendations proposed
by the Narsimhan Committee Report (1991) that advocated a move to a more market
oriented banking system, which would operate in an environment of prudential
regulation and transparent accounting. One of the primary motives behind this drive
was to introduce an element of market discipline into the regulatory process that
would reinforce the supervisory effort of the Reserve Bank of India (RBI). Market
discipline, especially in the financial liberalization phase, reinforces regulatory and
supervisory efforts and provides a strong incentive to banks to conduct their business
in a prudent and efficient manner and to maintain adequate capital as a cushion
against risk exposures. Recognizing that the success of economic reforms was
contingent on the success of financial sector reform as well, the government initiated
a fundamental banking sector reform package in 1992.

Banking sector, the world over, is known for the adoption of multidimensional
strategies from time to time with varying degrees of success. Banks are very
important for the smooth functioning of financial markets as they serve as repositories
of vital financial information and can potentially alleviate the problems created by
information asymmetries. From a central bank’s perspective, such high-quality
disclosures help the early detection of problems faced by banks in the market and
reduce the severity of market disruptions. Consequently, the RBI as part and parcel of
the financial sector deregulation, attempted to enhance the transparency of the annual
reports of Indian banks by, among other things, introducing stricter income
recognition and asset classification rules, enhancing the capital adequacy norms, and
by requiring a number of additional disclosures sought by investors to make better
cash flow and risk assessments.

During the pre economic reforms period, commercial banks & development financial
institutions were functioning distinctly, the former specializing in short & medium
term financing, while the latter on long term lending & project financing.

Commercial banks were accessing short term low cost funds thru savings investments
like current accounts, savings bank accounts & short duration fixed deposits, besides
collection float. Development Financial Institutions (DFIs) on the other hand, were
essentially depending on budget allocations for long term lending at a concessionary
rate of interest.

The scenario has changed radically during the post reforms period, with the resolve of
the government not to fund the DFIs through budget allocations. DFIs like IDBI, IFCI
& ICICI had posted dismal financial results. Infact, their very viability has become a
question mark. Now they have taken the route of reverse merger with IDBI bank &
ICICI bank thus converting them into the universal banking system.

Major Recommendations by the Narasimham Committee on

Banking Sector Reforms

Strengthening Banking System

 Capital adequacy requirements should take into account market risks in

addition to the credit risks.
 In the next three years the entire portfolio of government securities should be
marked to market and the schedule for the same announced at the earliest
(since announced in the monetary and credit policy for the first half of 1998-
99); government and other approved securities which are now subject to a zero
risk weight, should have a 5 per cent weight for market risk.
  Risk weight on a government guaranteed advance should be the same as for
other advances. This should be made prospective from the time the new
prescription is put in place.
 Foreign exchange open credit limit risks should be integrated into the
calculation of risk weighted assets and should carry a 100 per cent risk weight.
 Minimum capital to risk assets ratio (CRAR) be increased from the existing 8
per cent to 10 per cent; an intermediate minimum target of 9 per cent be
achieved by 2000 and the ratio of 10 per cent by 2002; RBI to be empowered
to raise this further for individual banks if the risk profile warrants such an
increase. Individual banks' shortfalls in the CRAR are treated on the same line
as adopted for reserve requirements, viz. uniformity across weak and strong
banks. There should be penal provisions for banks that do not maintain
CRAR.
 Public Sector Banks in a position to access the capital market at home or
abroad be encouraged, as subscription to bank capital funds cannot be
regarded as a priority claim on budgetary resources.

Asset Quality

 An asset is classified as doubtful if it is in the substandard category for 18

months in the first instance and eventually for 12 months and loss if it has
been identified but not written off. These norms should be regarded as the
minimum and brought into force in a phased manner.
 For evaluating the quality of assets portfolio, advances covered by
Government guarantees, which have turned sticky, be treated as NPAs.
Exclusion of such advances should be separately shown to facilitate fuller
disclosure and greater transparency of operations.
 For banks with a high NPA portfolio, two alternative approaches could be
adopted. One approach can be that, all loan assets in the doubtful and loss
categories should be identified and their realisable value determined. These
assets could be transferred to an Assets Reconstruction Company (ARC)
which would issue NPA Swap Bonds.
  An alternative approach could be to enable the banks in difficulty to issue
bonds which could from part of Tier II capital, backed by government
guarantee to make these instruments eligible for SLR investment by banks and
approved instruments by LIC, GIC and Provident Funds.
 The interest subsidy element in credit for the priority sector should be totally
eliminated and interest rate on loans under Rs. 2 lakhs should be deregulated
for scheduled commercial banks as has been done in the case of Regional
Rural Banks and cooperative credit institutions.

Prudential Norms and Disclosure Requirements

 In India, income stops accruing when interest or installment of principal is not

paid within 180 days, which should be reduced to 90 days in a phased manner
by 2002.
 Introduction of a general provision of 1 per cent on standard assets in a phased
manner be considered by RBI.
 As an incentive to make specific provisions, they may be made tax deductible.

Systems and Methods in Banks

 There should be an independent loan review mechanism especially for large

borrowal accounts and systems to identify potential NPAs. Banks may evolve
a filtering mechanism by stipulating in-house prudential limits beyond which
exposures on single/group borrowers are taken keeping in view their risk
profile as revealed through credit rating and other relevant factors.
 Banks and FIs should have a system of recruiting skilled manpower from the
open market.
 Public sector banks should be given flexibility to determined managerial
remuneration levels taking into account market trends.
 There may be need to redefine the scope of external vigilance and
investigation agencies with regard to banking business.
 There is need to develop information and control system in several areas like
better tracking of spreads, costs and NPSs for higher profitability, , accurate
 and timely information for strategic decision to Identify and promote
profitable products and customers, risk and asset-liability management; and
efficient treasury management.

Structural Issues

 With the conversion of activities between banks and DFIs, the DFIs should,
over a period of time convert them to bank. A DFI which converts to bank be
given time to face in reserve equipment in respect of its liability to bring it on
par with requirement relating to commercial bank.
 Mergers of Public Sector Banks should emanate from the management of the
banks with the Government as the common shareholder playing a supportive
role. Merger should not be seen as a means of bailing out weak banks.
Mergers between strong banks/FIs would make for greater economic and
commercial sense.
 ‘Weak Banks' may be nurtured into healthy units by slowing down on
expansion, eschewing high cost funds/borrowings etc.
 The minimum share of holding by Government/Reserve Bank in the equity of
the nationalised banks and the State Bank should be brought down to 33%.
The RBI regulator of the monetary system should not be also the owner of a
bank in view of the potential for possible conflict of interest.
 There is a need for a reform of the deposit insurance scheme based on
CAMELs ratings awarded by RBI to banks.
 Inter-bank call and notice money market and inter-bank term money market
should be strictly restricted to banks; only exception to be made is primary
dealers.
 Non-bank parties are provided free access to bill rediscounts, CPs, CDs,
Treasury Bills, and MMMF.
 RBI should totally withdraw from the primary market in 91 days Treasury
Bills.
CAMELS FRAMEWORK
CAMELS FRAMEWORK

During an on-site bank exam, supervisors gather private information, such as details
on problem loans, with which to evaluate a bank's financial condition and to monitor
its compliance with laws and regulatory policies. A key product of such an exam is a
supervisory rating of the bank's overall condition, commonly referred to as a
CAMELS rating. This rating system is used by the three federal banking supervisors
(the Federal Reserve, the FDIC, and the OCC) and other financial supervisory
agencies to provide a convenient summary of bank conditions at the time of an exam.

The acronym "CAMEL" refers to the five components of a bank's condition that are
assessed: Capital adequacy, Asset quality, Management, Earnings, and Liquidity. A
sixth component, a bank's Sensitivity to market risk , was added in 1997; hence the
acronym was changed to CAMELS. (Note that the bulk of the academic literature is
based on pre-1997 data and is thus based on CAMEL ratings.) Ratings are assigned
for each component in addition to the overall rating of a bank's financial condition.
The ratings are assigned on a scale from 1 to 5. Banks with ratings of 1 or 2 are
considered to present few, if any, supervisory concerns, while banks with ratings of 3,
4, or 5 present moderate to extreme degrees of supervisory concern.

In 1994, the RBI established the Board of Financial Supervision (BFS), which
operates as a unit of the RBI. The entire supervisory mechanism was realigned to suit
the changing needs of a strong and stable financial system. The supervisory
jurisdiction of the BFS was slowly extended to the entire financial system barring the
capital market institutions and the insurance sector. Its mandate is to strengthen
supervision of the financial system by integrating oversight of the activities of
financial services firms. The BFS has also established a sub-committee to routinely
examine auditing practices, quality, and coverage.

In addition to the normal on-site inspections, Reserve Bank of India also conducts off-
site surveillance which particularly focuses on the risk profile of the supervised entity.
The Off-site Monitoring and Surveillance System (OSMOS) was introduced in 1995
as an additional tool for supervision of commercial banks. It was introduced with the
aim to supplement the on-site inspections. Under off-site system, 12 returns (called
DSB returns) are called from the financial institutions, wich focus on supervisory
concerns such as capital adequacy, asset quality, large credits and concentrations,
connected lending, earnings and risk exposures (viz. currency, liquidity and interest
rate risks).

In 1995, RBI had set up a working group under the chairmanship of Shri S.
Padmanabhan to review the banking supervision system. The Committee certain
recommendations and based on such suggetions a rating system for domestic and
foreign banks based on the international CAMELS model combining financial
management and systems and control elements was introduced for the inspection
cycle commencing from July 1998. It recommended that the banks should be rated on
a five point scale (A to E) based on the lines of international CAMELS rating model.

All exam materials are highly confidential, including the CAMELS. A bank's
CAMELS rating is directly known only by the bank's senior management and the
appropriate supervisory staff. CAMELS ratings are never released by supervisory
agencies, even on a lagged basis. While exam results are confidential, the public may
infer such supervisory information on bank conditions based on subsequent bank
actions or specific disclosures. Overall, the private supervisory information gathered
during a bank exam is not disclosed to the public by supervisors, although studies
show that it does filter into the financial markets.

CAMELS ratings in the supervisory monitoring of banks

Several academic studies have examined whether and to what extent private
supervisory information is useful in the supervisory monitoring of banks. With
respect to predicting bank failure, Barker and Holdsworth (1993) find evidence that
CAMEL ratings are useful, even after controlling for a wide range of publicly
available information about the condition and performance of banks. Cole and
Gunther (1998) examine a similar question and find that although CAMEL ratings
contain useful information, it decays quickly. For the period between 1988 and 1992,
they find that a statistical model using publicly available financial data is a better
indicator of bank failure than CAMEL ratings that are more than two quarters old.

Hirtle and Lopez (1999) examine the usefulness of past CAMEL ratings in assessing
banks' current conditions. They find that, conditional on current public information,
the private supervisory information contained in past CAMEL ratings provides further
insight into bank current conditions, as summarized by current CAMEL ratings. The
authors find that, over the period from 1989 to 1995, the private supervisory
information gathered during the last on-site exam remains useful with respect to the
current condition of a bank for up to 6 to 12 quarters (or 1.5 to 3 years). The overall
conclusion drawn from academic studies is that private supervisory information, as
summarized by CAMELS ratings, is clearly useful in the supervisory monitoring of
bank conditions.

CAMELS ratings in the public monitoring of banks

Another approach to examining the value of private supervisory information is to

examine its impact on the market prices of bank securities. Market prices are
generally assumed to incorporate all available public information. Thus, if private
supervisory information were found to affect market prices, it must also be of value to
the public monitoring of banks.

Such private information could be especially useful to financial market participants,

given the informational asymmetries in the commercial banking industry. Since banks
fund projects not readily financed in public capital markets, outside monitors should
find it difficult to completely assess banks' financial conditions. In fact, Morgan
(1998) finds that rating agencies disagree more about banks than about other types of
firms. As a result, supervisors with direct access to private bank information could
generate additional information useful to the financial markets, at least by certifying
that a bank's financial condition is accurately reported.

The direct public beneficiaries of private supervisory information, such as that

contained in CAMELS ratings, would be depositors and holders of banks' securities.
Small depositors are protected from possible bank default by FDIC insurance, which
probably explains the finding by Gilbert and Vaughn (1998) that the public
announcement of supervisory enforcement actions, such as prohibitions on paying
dividends, did not cause deposit runoffs or dramatic increases in the rates paid on
deposits at the affected banks. However, uninsured depositors could be expected to
respond more strongly to such information. Jordan, et al., (1999) find that uninsured
deposits at banks that are subjects of publicly-announced enforcement actions, such as
cease-and-desist orders, decline during the quarter after the announcement.

The holders of commercial bank debt, especially subordinated debt, should have the
most in common with supervisors, since both are more concerned with banks' default
probabilities (i.e., downside risk). As of year-end 1998, bank holding companies
(BHCs) had roughly $120 billion in outstanding subordinated debt. DeYoung, et al.,
(1998) examine whether private supervisory information would be useful in pricing
the subordinated debt of large BHCs. The authors use an econometric technique that
estimates the private information component of the CAMEL ratings for the BHCs'
lead banks and regresses it onto subordinated bond prices. They conclude that this
aspect of CAMEL ratings adds significant explanatory power to the regression after
controlling for publicly available financial information and that it appears to be
incorporated into bond prices about six months after an exam. Furthermore, they find
that supervisors are more likely to uncover unfavorable private information, which is
consistent with managers' incentives to publicize positive information while de-
emphasizing negative information. These results indicate that supervisors can
generate useful information about banks, even if those banks already are monitored by
private investors and rating agencies.

The market for bank equity, which is about eight times larger than that for bank
subordinated debt, was valued at more than $910 billion at year-end 1998. Thus, the
academic literature on the extent to which private supervisory information affects
stock prices is more extensive. For example, Jordan, et al., (1999) find that the stock
 market views the announcement of formal enforcement actions as informative. That
is, such announcements are associated with large negative stock returns for the
affected banks. This result holds especially for banks that had not previously
manifested serious problems.

Focusing specifically on CAMEL ratings, Berger and Davies (1998) use event study
methodology to examine the behavior of BHC stock prices in the eight-week period
following an exam of its lead bank. They conclude that CAMEL downgrades reveal
unfavorable private information about bank conditions to the stock market. This
information may reach the public in several ways, such as through bank financial
statements made after a downgrade. These results suggest that bank management may
reveal favorable private information in advance, while supervisors in effect force the
release of unfavorable information.

Berger, Davies, and Flannery (1998) extend this analysis by examining whether the
information about BHC conditions gathered by supervisors is different from that used
by the financial markets. They find that assessments by supervisors and rating
agencies are complementary but different from those by the stock market. The authors
attribute this difference to the fact that supervisors and rating agencies, as
representatives of debtholders, are more interested in default probabilities than the
stock market, which focuses on future revenues and profitability. This rationale also
could explain the authors' finding that supervisory assessments are much less accurate
than market assessments of banks' future performances.

In summary, on-site bank exams seem to generate additional useful information

beyond what is publicly available. However, according to Flannery (1998), the limited
available evidence does not support the view that supervisory assessments of bank
conditions are uniformly better and more timely than market assessments.

(A) Capital Adequacy

Capital base of financial institutions facilitates depositors in forming their risk

perception about the institutions. Also, it is the key parameter for financial managers
to maintain adequate levels of capitalization. Moreover, besides absorbing
unanticipated shocks, it signals that the institution will continue to honor its
obligations. The most widely used indicator of capital adequacy is capital to risk-
weighted assets ratio (CRWA). According to Bank Supervision Regulation
Committee (The Basle Committee) of Bank for International Settlements, a minimum
8 percent CRWA is required.

Capital adequacy ultimately determines how well financial institutions can cope with
shocks to their balance sheets. Thus, it is useful to track capital-adequacy ratios that
take into account the most important financial risks—foreign exchange, credit, and
interest rate risks—by assigning risk weightings to the institution’s assets.

A Capital Adquecy Ratio is a measure of a bank's capital. It is expressed as a

percentage of a bank's risk weighted credit exposures.

Also known as ""Capital to Risk Weighted Assets Ratio (CRAR).

Capital adequacy is measured by the ratio of capital to risk-weighted assets (CRAR).

A sound capital base strengthens confidence of depositors.

This ratio is used to protect depositors and promote the stability and efficiency of
financial systems around the world.

(B) Asset Quality:

Asset quality determines the robustness of financial institutions against loss of value in
the assets. The deteriorating value of assets, being prime source of banking problems,
directly pour into other areas, as losses are eventually written-off against capital, which
ultimately jeopardizes the earning capacity of the institution. With this backdrop, the
asset quality is gauged in relation to the level and severity of non-performing assets,
adequacy of provisions, recoveries, distribution of assets etc. Popular indicators
include non-performing loans to advances, loan default to total advances, and
recoveries to loan default ratios.

The solvency of financial institutions typically is at risk when their assets become
impaired, so it is important to monitor indicators of the quality of their assets in terms
of overexposure to specific risks, trends in nonperforming loans, and the health and
profitability of bank borrowers— especially the corporate sector. Share of bank assets
in the aggregate financial sector assets: In most emerging markets, banking sector
assets comprise well over 80 per cent of total financial sector assets, whereas these
figures are much lower in the developed economies. Furthermore, deposits as a share
of total bank liabilities have declined since 1990 in many developed countries, while
in developing countries public deposits continue to be dominant in banks. In India,
the share of banking assets in total financial sector assets is around 75 per cent, as of
end-March 2008. There is, no doubt, merit in recognising the importance of
diversification in the institutional and instrument-specific aspects of financial
intermediation in the interests of wider choice, competition and stability. However,
the dominant role of banks in financial intermediation in emerging economies and
particularly in India will continue in the medium-term; and the banks will continue to
be “special” for a long time. In this regard, it is useful to emphasise the dominance of
banks in the developing countries in promoting non-bank financial intermediaries and
services including in development of debt-markets. Even where role of banks is
apparently diminishing in emerging markets, substantively, they continue to play a
leading role in non-banking financing activities, including the development of
financial markets.

One of the indicators for asset quality is the ratio of non-performing loans to total
loans (GNPA). The gross non-performing loans to gross advances ratio is more
indicative of the quality of credit decisions made by bankers. Higher GNPA is
indicative of poor credit decision-making.

NPA: Non-Performing Assets

Advances are classified into performing and non-performing advances (NPAs) as per
RBI guidelines. NPAs are further classified into sub-standard, doubtful and loss assets
based on the criteria stipulated by RBI. An asset, including a leased asset, becomes
non-performing when it ceases to generate income for the Bank.

An NPA is a loan or an advance where:

1. Interest and/or instalment of principal remains overdue for a period of more

than 90
days in respect of a term loan;
2. The account remains "out-of-order'' in respect of an Overdraft or Cash Credit
(OD/CC);
3. The bill remains overdue for a period of more than 90 days in case of bills
purchased
and discounted;
4. A loan granted for short duration crops will be treated as an NPA if the
installments of
principal or interest thereon remain overdue for two crop seasons; and
5. A loan granted for long duration crops will be treated as an NPA if the
installments of
principal or interest thereon remain overdue for one crop season.

The Bank classifies an account as an NPA only if the interest imposed during any
quarter is not fully repaid within 90 days from the end of the relevant quarter.

This is a key to the stability of the banking sector. There should be no hesitation in
stating that Indian banks have done a remarkable job in containment of non-
performing loans (NPL) considering the overhang issues and overall difficult
environment. For 2008, the net NPL ratio for the Indian scheduled commercial banks
at 2.9 per cent is ample testimony to the impressive efforts being made by our banking
system. In fact, recovery management is also linked to the banks’ interest margins.
The cost and recovery management supported by enabling legal framework hold the
key to future health and competitiveness of the Indian banks. No doubt, improving
recovery-management in India is an area requiring expeditious and effective actions
in legal, institutional and judicial processes.

(C) Management Soundness

Management of financial institution is generally evaluated in terms of capital

adequacy, asset quality, earnings and profitability, liquidity and risk sensitivity
ratings. In addition, performance evaluation includes compliance with set norms,
ability to plan and react to changing circumstances, technical competence, leadership
 and administrative ability. In effect, management rating is just an amalgam of
performance in the above-mentioned areas.

Sound management is one of the most important factors behind financial institutions’
performance. Indicators of quality of management, however, are primarily applicable
to individual institutions, and cannot be easily aggregated across the sector.
Furthermore, given the qualitative nature of management, it is difficult to judge its
soundness just by looking at financial accounts of the banks.

Nevertheless, total expenditure to total income and operating expense to total expense
helps in gauging the management quality of the banking institutions. Sound
management is key to bank performance but is difficult to measure. It is primarily a
qualitative factor applicable to individual institutions. Several indicators, however,
can jointly serve—as, for instance, efficiency measures do—as an indicator of
management soundness.

The ratio of non-interest expenditures to total assets (MGNT) can be one of the
measures to assess the working of the management. . This variable, which includes a
variety of expenses, such as payroll, workers compensation and training investment,
reflects the management policy stance.

Efficiency Ratios demonstrate how efficiently the company uses its assets and how
efficiently the company manages its operations.

Revenue
=
Asset Turnover Ratio Total Assets

Indicates the relationship between assets and revenue.

Things to remember
  Companies with low profit margins tend to have high asset turnover,
those with high profit margins have low asset turnover - it indicates
pricing strategy.

 This ratio is more useful for growth companies to check if in fact they
are growing revenue in proportion to sales.

Asset Turnover Analysis:

This ratio is useful to determine the amount of sales that are generated from each
dollar of assets. As noted above, companies with low profit margins tend to have
high asset turnover, those with high profit margins have low asset turnover.

(D) Earnings & Profitability

Earnings and profitability, the prime source of increase in capital base, is examined
with regards to interest rate policies and adequacy of provisioning. In addition, it also
helps to support present and future operations of the institutions. The single best
indicator used to gauge earning is the Return on Assets (ROA), which is net income
after taxes to total asset ratio.

Strong earnings and profitability profile of banks reflects the ability to support present
and future operations. More specifically, this determines the capacity to absorb losses,
finance its expansion, pay dividends to its shareholders, and build up an adequate
level of capital. Being front line of defense against erosion of capital base from losses,
the need for high earnings and profitability can hardly be overemphasized. Although
different indicators are used to serve the purpose, the best and most widely used
indicator is Return on Assets (ROA). However, for in-depth analysis, another
indicator Net Interest Margins (NIM) is also used. Chronically unprofitable financial
institutions risk insolvency. Compared with most other indicators, trends in
profitability can be more difficult to interpret—for instance, unusually high
profitability can reflect excessive risk taking.

ROA-Return On Assets

An indicator of how profitable a company is relative to its total assets. ROA gives an
idea as to how efficient management is at using its assets to generate
earnings. Calculated by dividing a company's annual earnings by its total assets, ROA
is displayed as a percentage. Sometimes this is referred to as "return on investment".

The formula for return on assets is:

ROA tells what earnings were generated from invested capital (assets). ROA for
public companies can vary substantially and will be highly dependent on the industry.
This is why when using ROA as a comparative measure, it is best to compare it
against a company's previous ROA numbers or the ROA of a similar company.

The assets of the company are comprised of both debt and equity. Both of these types
of financing are used to fund the operations of the company. The ROA figure gives
investors an idea of how effectively the company is converting the money it has to
invest into net income. The higher the ROA number, the better, because the company
is earning more money on less investment. For example, if one company has a net
income of $1 million and total assets of $5 million, its ROA is 20%; however, if
another company earns the same amount but has total assets of $10 million, it has an
ROA of 10%. Based on this example, the first company is better at converting its
investment into profit. When you really think about it, management's most important
job is to make wise choices in allocating its resources. Anybody can make a profit by
throwing a ton of money at a problem, but very few managers excel at making large
profits with little investment

(E) Liquidity

An adequate liquidity position refers to a situation, where institution can obtain

sufficient funds, either by increasing liabilities or by converting its assets quickly at a
reasonable cost. It is, therefore, generally assessed in terms of overall assets and
liability management, as mismatching gives rise to liquidity risk. Efficient fund
management refers to a situation where a spread between rate sensitive assets (RSA)
and rate sensitive liabilities (RSL) is maintained. The most commonly used tool to
evaluate interest rate exposure is the Gap between RSA and RSL, while liquidity is
gauged by liquid to total asset ratio.
Initially solvent financial institutions may be driven toward closure by poor
management of short-term liquidity. Indicators should cover funding sources and
capture large maturity mismatches.

The term liquidity is used in various ways, all relating to availability of, access to, or
convertibility into cash.
 An institution is said to have liquidity if it can easily meet its needs for cash
either because it has cash on hand or can otherwise raise or borrow cash.
 A market is said to be liquid if the instruments it trades can easily be bought or
sold in quantity with little impact on market prices.
 An asset is said to be liquid if the market for that asset is liquid.

The common theme in all three contexts is cash. A corporation is liquid if it has ready
access to cash. A market is liquid if participants can easily convert positions into cash
—or conversely. An asset is liquid if it can easily be converted to cash.
The liquidity of an institution depends on:
 the institution's short-term need for cash;
 cash on hand;
 available lines of credit;
 the liquidity of the institution's assets;
 The institution's reputation in the marketplace—how willing will counterparty
is to transact trades with or lend to the institution?

The liquidity of a market is often measured as the size of its bid-ask spread, but this is
an imperfect metric at best. More generally, Kyle (1985) identifies three components
of market liquidity:
 Tightness is the bid-ask spread;
 Depth is the volume of transactions necessary to move prices;
 Resiliency is the speed with which prices return to equilibrium following a
large trade.
Examples of assets that tend to be liquid include foreign exchange; stocks traded in
the Stock Exchange or recently issued Treasury bonds. Assets that are often illiquid
include limited partnerships, thinly traded bonds or real estate.
Cash maintained by the banks and balances with central bank, to total asset ratio
(LQD) is an indicator of bank's liquidity. In general, banks with a larger volume of
liquid assets are perceived safe, since these assets would allow banks to meet
unexpected withdrawals.

Credit deposit ratio is a tool used to study the liquidity position of the bank. It is
calculated by dividing the cash held in different forms by total deposit. A high ratio
shows that there is more amounts of liquid cash with the bank to met its clients cash
withdrawals.

(F) Sensitivity To Market Risk

It refers to the risk that changes in market conditions could adversely impact earnings
and/or capital.

Market Risk encompasses exposures associated with changes in interest rates, foreign
exchange rates, commodity prices, equity prices, etc. While all of these items are
important, the primary risk in most banks is interest rate risk (IRR), which will be the
focus of this module.The diversified nature of bank operations makes them vulnerable
to various kinds of financial risks. Sensitivity analysis reflects institution’s exposure
to interest rate risk, foreign exchange volatility and equity price risks (these risks are
summed in market risk). Risk sensitivity is mostly evaluated in terms of
management’s ability to monitor and control market risk.
Banks are increasingly involved in diversified operations, all of which are subject to
market risk, particularly in the setting of interest rates and the carrying out of foreign
exchange transactions. In countries that allow banks to make trades in stock markets
or commodity exchanges, there is also a need to monitor indicators of equity and
commodity price risk.

Interest Rate Risk Basics

In the most simplistic terms, interest rate risk is a balancing act. Banks are trying to
balance the quantity of repricing assets with the quantity of repricing liabilities. For
example, when a bank has more liabilities repricing in a rising rate environment than
assets repricing, the net interest margin (NIM) shrinks. Conversely, if your bank is
asset
sensitive in a rising interest rate environment, your NIM will improve because you
have
more assets repricing at higher rates.

An extreme example of a repricing imbalance would be funding 30-year fixed-rate

mortgages with 6-month CDs. You can see that in a rising rate environment the
impact
on the NIM could be devastating as the liabilities reprice at higher rates but the assets
do
not. Because of this exposure, banks are required to monitor and control IRR and to
maintain a reasonably well-balanced position.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose
liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or
some other event causes counterparties to avoid trading with or lending to the
institution. A firm is also exposed to liquidity risk if markets on which it depends are
subject to loss of
liquidity.

Liquidity risk tends to compound other risks. If a trading organization has a position
in an illiquid asset, its limited ability to liquidate that position at short notice will
compound its market risk. Suppose a firm has offsetting cash flows with two different
counterparties on a given day. If the counterparty that owes it a payment defaults, the
firm will have to raise cash from other sources to make its payment. Should it be
unable to do so, it too we default. Here, liquidity risk is compounding credit risk.

Accordingly, liquidity risk has to be managed in addition to market, credit and other
risks. Because of its tendency to compound other risks, it is difficult or impossible to
isolate liquidity risk. In all but the most simple of circumstances, comprehensive
metrics of liquidity risk don't exist. Certain techniques of asset-liability management
can be applied to assessing liquidity risk. If an organization's cash flows are largely
contingent, liquidity risk may be assessed using some form of scenario analysis.
Construct multiple scenarios for market movements and defaults over a given period
of time. Assess day-to-day cash flows under each scenario. Because balance sheets
differed so significantly from one organization to the next, there is little
standardization in how such analyses are implemented.
Regulators are primarily concerned about systemic implications of liquidity risk.

Business activities entail a variety of risks. For convenience, we distinguish between

different categories of risk: market risk, credit risk, liquidity risk, etc. Although such
categorization is convenient, it is only informal. Usage and definitions vary.
Boundaries between categories are blurred. A loss due to widening credit spreads may
reasonably be called a market loss or a credit loss, so market risk and credit risk
overlap. Liquidity risk compounds other risks, such as market risk and credit risk. It
cannot be divorced from the risks it compounds.

An important but somewhat ambiguous distinguish is that between market risk and
business risk. Market risk is exposure to the uncertain market value of a portfolio.
Business risk is exposure to uncertainty in economic value that cannot be marked-to-
market. The distinction between market risk and business risk parallels the distinction
between market-value accounting and book-value accounting.

The distinction between market risk and business risk is ambiguous because there is a
vast "gray zone" between the two. There are many instruments for which markets
exist, but the markets are illiquid. Mark-to-market values are not usually available,
but mark-to-model values provide a more-or-less accurate reflection of fair value. Do
these instruments pose business risk or market risk? The decision is important because
firms employ fundamentally different techniques for managing the two risks.

Business risk is managed with a long-term focus. Techniques include the careful
development of business plans and appropriate management oversight. book-value
accounting is generally used, so the issue of day-to-day performance is not material.
The focus is on achieving a good return on investment over an extended horizon.

Market risk is managed with a short-term focus. Long-term losses are avoided by
avoiding losses from one day to the next. On a tactical level, traders and portfolio
managers employ a variety of risk metrics —duration and convexity, the Greeks, beta,
etc.—to assess their exposures. These allow them to identify and reduce any
exposures they might consider excessive. On a more strategic level, organizations
manage market risk by applying risk limits to traders' or portfolio managers' activities.
Increasingly, value-at-risk is being used to define and monitor these limits. Some
organizations also apply stress testing to their portfolios.

Each of the above six parameters are weighted on a scale of 1 to 100 and contains 
number of sub­parameters with individual weightages.
Rating 
Rating symbol indicates 
Symbol
A Bank is sound in every respect
B Bank is fundamentally sound but with moderate weaknesses
financial, operational or compliance weaknesses that give cause for supervisory 
C
concern.
serious or immoderate finance, operational and managerial weaknesses that could 
D
impair future viability
critical financial weaknesses and there is high possibililty of failure in the near 
E
future.