INDIAN INSTITUTE OF
BANKING & FINANCE
RISK MANAGEMENT
MODULE C & D
By
M.Ravindran
ravindran@iibf.org.in
Syllabus
Module C: Treasury Management:
Treasury management; concepts and functions; instruments in the
treasury market; development of new financial products; control
and supervision of Treasury management; linkage of domestic
operations with foreign operations.
Asset-liability management; Interest rate risk; interest rate futures;
stock options; debt instruments; bond portfolio strategy; risk
control and hedging instruments.
Investments – Treasury bills – Money markets instruments such
as CDs, CPs, IBPs; Securitisation and Forfaiting; Refinance and
rediscounting facilities.
Syllabus
Module D
Capital Management and Profit Planning
 Prudential Norms- Capital Adequacy-Basel IIAsset Classification-provisioning
 Profit and Profitability-Historical Perspective of
the Approach of Banks to profitability-Effects of
NPA on profitability-A profitability Model-Share
holders value Maximization & EVA-Profit
Planning-Measures to improve profitability
Integrated Treasury
Integrated Treasury refers to integration of money
market, securities market and foreign exchange
operations.
Functions:
-Meeting reserve requirements
-Efficient merchant services
-Global cash management
-Optimizing profit by exploiting market
opportunities in forex market, money market and
securities market
-Risk management
-Assisting bank management in ALM
FRONT OFFICE
Dealing
MID OFFICE
BACK OFFICE
settlement
MIS
Treasury
Money Market
Certificate of Deposit (CD)
 Commercial Paper (C.P)
 Inter Bank Participation Certificates
 Inter Bank term Money
 Treasury Bills
 Call Money

Certificate of Deposit
CDs are short-term borrowings in the form of
Usance Promissory Notes having a maturity of
not less than 7 days up to a maximum of one
year.
 CD is subject to payment of Stamp Duty under
Indian Stamp Act, 1899 (Central Act)
 They are like bank term deposits accounts.
Unlike traditional time deposits these are freely
negotiable instruments and are often referred to
as Negotiable Certificate of Deposits

Features of CD







Issued by all scheduled commercial banks
except RRBs
Minimum period 7 days
Maximum period 1 year
Minimum Amount Rs 1 lac and in multiples of
Rs. 1 lac
CDs are transferable by endorsement
CRR & SLR are to be maintained
CDs are to be stamped
Commercial Paper
Commercial Paper (CP) is an unsecured
money market instrument issued in the
form of a promissory note.
 Who can issue Commercial Paper (CP)
Highly rated corporate borrowers, primary
dealers (PDs) and all-India financial
institutions (FIs)

Eligibility for issue of CP
the tangible net worth of the company, as per the
latest audited balance sheet, is not less than Rs. 4
crore;
b) the working capital (fund-based) limit of the
company has been sanctioned by banks
c) borrowal account of the company is classified as a
Standard Asset by the financing bank/s.
a)
Rating Requirement







All eligible participants should obtain the credit
rating for issuance of Commercial Paper
Credit Rating Information Services of India Ltd.
(CRISIL)
Investment Information and Credit Rating
Agency of India Ltd. (ICRA)
Credit Analysis and Research Ltd. (CARE)
Fitch Ratings
Duff & Phelps Credit Rating India Pvt. Ltd. (DCR
India)
The minimum credit rating shall be P-2 of
CRISIL or such equivalent rating by other
agencies
Features
CP can be issued for maturities between a
minimum of 7 days and a maximum upto
one year from the date of issue.
 Minimum issue price Rs. 5 lakhs and in
multiples of Rs. 5 lakhs
 Issued in demat form only

To whom issued
CP is issued to
 individuals,
 banking companies,
 other corporate bodies registered or
incorporated in India and unincorporated
bodies,
 Non-Resident Indians (NRIs)
 Foreign Institutional Investors (FIIs).
CP-Yield calculation

Yield =
(Face value-Price)*365*100
-------------------------------Price *No of days to maturity
Face value 5 lakhs price 4,92,711 for 90 days
Find out yield
500000-492711*365*100
---------------------------------= 6%
492711*90
Calculation of price-CP
PRICE=
Face Value
------------( 1+Yield *No of days
----------------------365*100)
Face Value Rs.500000 for 90 days at 6%
500000
-----------1(6*90/365*100) = Rs 492711
Meaning of Repo
It is a transaction in which two parties agree to
sell and repurchase the same securitya t a
mutually decided future date and a price
 The Repo/Reverse Repo transaction can only be
done at Mumbai between parties approved by
RBI and in securities as approved by RBI
(Treasury Bills, Central/State Govt securities).

Repo
Uses of Repo
It helps banks to invest surplus cash
It helps banks to raise funds at better rates
An SLR surplus and CRR deficit bank can use the
Repo deals as a convenient way of adjusting
SLR/CRR positions simultaneously.
RBI uses Repo and Reverse repo as instruments
for liquidity adjustment in the system
Coupon rate and Yield
The difference between coupon rate and
yield arises because the market price of a
security might be different from the face
value of the security.
Since coupon payments are calculated on
the face value, the coupon rate is different
from the yield.
Example
10% Aug 2015 10 year Govt Bond
 Face Value RS.1000
 Market Value Rs.1200
 In this case Coupon rate is 10%
 Yield is 8.33% =
1200*10
--------------1000

Call Money
The money that is lent for one day is
known as "Call Money",
If it exceeds one day (but less than 15 days)
it is referred to as "Notice Money".
Call Money Market
Banks borrow in this market for the
following purpose
 To fill the gaps or temporary mismatches
in funds
 To meet the CRR & SLR mandatory
requirements as stipulated by the Central
bank
 To meet sudden demand for funds arising
out of large outflows.
Factors influencing interest rates
The factors which govern the interest rates are
mostly economy related and are commonly
referred to as macroeconomic factors. Some of
these factors are:
1) Demand for money
2) Government borrowings
3) Supply of money
4) Inflation rate
5) The Reserve Bank of India and the Government
policies which determine some of the variables
mentioned above.
Gilt edged securities
The term government securities encompass all
Bonds & T-bills issued by the Central
Government, and state governments. These
securities are normally referred to, as "giltedged" as repayments of principal as well as
interest are totally secured by sovereign
guarantee.
Treasury Bills
Treasury bills, commonly referred to as T-Bills
are issued by Government of India against their
short term borrowing requirements with
maturities ranging between 14 to 364 days.
All these are issued at a discount-to-face value.
For example a Treasury bill of Rs. 100.00 face
value issued for Rs. 91.50 gets redeemed at the
end of it's tenure at Rs. 100.00.
Who can invest in T-Bill
Banks, Primary Dealers, State
Governments, Provident Funds, Financial
Institutions, Insurance Companies, NBFCs,
FIIs (as per prescribed norms), NRIs &
OCBs can invest in T-Bills.
What is auction of Securities
Auction is a process of calling of bids with
an objective of arriving at the market price.
It is basically a price discovery mechanism
Debenture
A Debenture is a debt security issued by a
company (called the Issuer), which offers
to pay interest in lieu of the money
borrowed for a certain period.
 These are long-term debt instruments
issued by private sector companies. These
are issued in denominations as low as Rs
1000 and have maturities ranging
between one and ten years.

Difference between debenture and
bond
Long-term debt securities issued by the
Government of India or any of the State
Government’s or undertakings owned by
them or by development financial
institutions are called as bonds.
Instruments issued by other entities are
called debentures.
Current yield
It is calculated by dividing the coupon rate
by the purchase price of the bond .
For e. g: If an investor buys a 10% Rs 100
debenture of ABC company at Rs 90, his
current Yield on the instrument would be
computed as:
Current Yield = (10%*100)/90 X 100 ,
That is 11.11% p.a.
Primary Dealers

Primary Dealers can be referred to as Merchant
Bankers to Government of India, comprising the
first tier of the government securities market.
These were formed during the year 1994-96 to
strengthen the market infrastructure
What role do Primary Dealers
play?
The role of Primary Dealers is to;
(i) commit participation as Principals in
Government of India issues through
bidding in auctions
(ii) provide underwriting services
(iii) offer firm buy - sell / bid ask quotes
for T-Bills & dated securities
(v) Development of Secondary Debt
Market
OMO
OMO or Open Market Operations is a
market regulating mechanism often
resorted to by Reserve Bank of India.
Under OMO Operations Reserve Bank of
India as a market regulator keeps buying
or/and selling securities through it's open
market window. It's decision to sell or/and
buy securities is influenced by factors such
as overall liquidity in the system etc
YIELD CURVE
The relationship between time and yield
on a homogenous risk class of securities is
called the Yield Curve. The relationship
represents the time value of money showing that people would demand a
positive rate of return on the money they
are willing to part today for a payback into
the future
SHAPE OF YIELD CURVE
A yield curve can be positive, neutral or flat.
A positive yield curve, which is most natural, is when the
slope of the curve is positive, i.e. the yield at the longer end is
higher than that at the shorter end of the time axis. This results,
as people demand higher compensation for parting their
money for a longer time into the future.
A neutral yield curve is that which has a zero slope, i.e. is flat
across time. T his occurs when people are willing to accept
more or less the same returns across maturities.
The negative yield curve (also called an inverted yield curve)
is one of which the slope is negative, i.e. the long term yield is
lower than the short term yield
Shape of Yield curve
LIBOR
LIBOR stands for the London Interbank Offered
Rate and is the rate of interest at which banks
borrow funds from other banks, in marketable
size, in the London interbank market.
 LIBOR is the most widely used "benchmark" or
reference rate for short term interest rates. It is
compiled by the British Bankers Association as a
free service and released to the market at about
11.00[London time] each day.

Calculation of Duration
Face Value Rs.100
 Tenor 7 years
 Coupon 7%
 Market Interest rate 8%
 Answer:543.0642/94.7941= 5.72888 yrs

Calculation of Duration
Answer:543.0642/94.7941= 5.72888
Sl No
Coupo Dis.Fa PV OF
n
ctor
cOUPON
At 8%
Wei PV*Wt
ght
in
yrs
1
7
.9259
6.4813
1
6.4813
2
7
.8573
6.0011
2
12.0022
3
7
.7938
5.5566
3
16.6698
4
7
.7350
5.1450
4
20.5800
5
7
.6806
4.7642
5
23.8210
6
7
.6302
4.4114
6
26.4684
7
7
.5835
62.4345
7
437.0415
CRR & SLR
The minimum and maximum levels of CRR are
prescribed at 3% and 20% of demand and term
liabilities (DTL) of the bank, respectively, under
Reserve Bank of India Act of 1934.
The minimum and maximum SLR are prescribed
at 25% and 40% of DTL respectively, under
Banking Regulation Act of 1949.
The CRR and SLR are to be maintained on
fortnightly basis.
Demand and Time Liabilities





Main components of DTL are:
Demand deposits (held in current and savings
accounts, margin money for LCs, overdue fixed
deposits etc.)
Time deposits (in fixed deposits, recurring deposits,
reinvestment deposits etc.)
Overseas borrowings
Foreign outward remittances in transit (FC liabilities
net of FC assets)
Other demand and time liabilities (accrued interest,
credit balances in suspense account etc. )
SLR
SLR is to be maintained in the form of the
following assets:
 Cash balances (excluding balances
maintained for CRR)
 Gold (valued at price not exceeding
current market price)
 Approved securities valued as per norms
prescribed by RBI.
VaR
Value at Risk (VaR) is the most probable loss
that we may incur in normal market conditions
over a given period due to the volatility of a
factor, exchange rates, interest rates or
commodity prices. The probability of loss is
expressed as a percentage – VaR at 95%
confidence level, implies a 5% probability of
incurring the loss; at 99% confidence level the
VaR implies 1% probability of the stated loss.
The loss is generally stated in absolute amounts
for a given transaction value (or value of a
investment portfolio).
VaR
The VaR is an estimate of potential loss, always for a given
period, at a given confidence level.. A VaR of 5p in USD /
INR rate for a 30- day period at 95% confidence level
means that Rupee is likely to lose 5p in exchange value
with 5% probability, or in other words, Rupee is likely to
depreciate by maximum 5p on 1.5 days of the period
(30*5% ) . A VaR of Rs. 100,000 at 99% confidence level
for one week for a investment portfolio of Rs. 10,000,000
similarly means that the market value of the portfolio is
most likely to drop by maximum Rs. 100,000 with 1%
probability over one week, or , 99% of the time the
portfolio will stand at or above its current value.
Exchange Rate Quotation
Exchange Quotations :
There are two methods
 Exchange rate is expressed as the price per unit of
foreign currency in terms of the home currency is known
as the “Home currency quotation” or “Direct Quotation”
 Exchange rate is expressed as the price per unit of home
currency in terms of the foreign currency is known as
the “Foreign Currency Quotation” or “Indirect Quotation”
 Direct Quotation is used in New York and other foreign
exchange markets and Indirect Quotation is used in
London foreign exchange market.

Principles

Direct Quotation: Buy Low, Sell High:
1USD= Rs.42.60 42.65

Indirect Quotation: Buy High, Sell
Low:
Rs.100 = USD 2.5600 – 2.5650
Spot and Forward Transactions
‘A’ Bank agrees to buy from ‘B’ Bank USD
100000. The actual exchange of
currencies i.e. payment of rupees and
receipt of US Dollars, under the contract
may take place :
 on the same day or
 two days later or
 some day later, say after a month.

Interpretation of Quotation
The market quotation for a currency consists of
the spot rate and the forward margin. The
outright forward rate has to be calculated by
loading the forward margin into the spot rate.
For example US Dollar is quoted as under in the
inter-bank market on a given day as under :
 Spot
1 USD = Rs.44.1000/1300
 Spot/November
0200/0500
 Spot/December
1500/1800

TT Buying Rate


TT Buying Rate (TT stands for Telegraphic
Transfer)
This is the rate applied when the transaction
does not involve any delay in realization of the
foreign exchange by the bank. In other
words, the nostro account of the bank would
already have been credited. The rate is
calculated by deducting from the inter-bank
buying rate the exchange margin as
determined by the Bank.
Bills Buying Rate

This is the rate to be applied when a
foreign bill is purchased. When a bill is
purchased, the proceeds will be realized
by the Bank after the bill is presented to
the drawee at the overseas center. In the
case of a usance bill the proceeds will be
realized on the due date of the bill which
includes the transit period and the usance
period of the bill.
Problem
You would like to import machinery from USA
worth USD 100000
to be payable to the overseas supplier on 31st Oct
[a] Spot Rate
USD = Rs.45.8500/8600
Forward Premium
September 0.2950/3000
October 0.5400/5450
November 0.7600/7650
[b] exchange margin 0.125%
[c] Last two digits in multiples of nearest 25 paise
 Calculate the rate to be quoted by the bank ?
Solution
This is an example Forward Sale Contract .
Inter Bank Spot Selling Rate Rs. 45.8600
Add Forward Margin
.5450
-------------46.4050
Add Exchange Margin
.0580
--------------Forward Rate
46.4630
Rounded Off to multiple of 25 paise
Rs.46.4625
Amount Payable to the bank
Rs.46,46,250
Swap
A swap agreement between two parties
commits each counterparty to exchange
an amount of funds, determined by a
formula, at regular intervals, until the
swap expires.
 In the case of a currency swap, there is an
initial exchange of currency and a reverse
exchange at maturity.

Mechanics
Firm A needs fixed rate loan –AAA rated
 Firm B needs floating rate
-A rated
 Firm A enjoys an absolute advantage in
both credit markets.

Fixedrate
finance
Firm A
Firm B
9%
11%
Floating- LIBOR LIBOR
rate
finance +0.0% +1%
Mechanics
STEP !
Firm A will borrow at Fixed rate 9%
Firm B will borrow at floating rate (LIBOR +1)%
STEP 2
Firm A will pay Floating rate [LIBOR] to Firm B
Firm B will Pay Fixed rate [9.5%] only
Gain
Net interest cost LIBOR- .5%
Net Interest cost 9+[ 1%+0.5%]=10.5%
Mechanics
Interest payments to each
other in years t 1 to t 7.
Gain
A
B
9.5%
Borrows at
9.0%
fixed
for 7 years
LIBOR
Borrows at
LIBOR + 1%
floating
for 7 years
Basel I to Basel II
Minimum capital requirements
→ 3 Pillars
 New credit risk approaches
 Market risk - unchanged
 Add operational risk portion

The Basel II Framework
Pillar 1:
Minimum capital
requirements
• A guiding
principle
for banking
supervision
Pillar 2:
Supervisory
review
• Credit Risk
• Market Risk
• Operational Risk
Pillar 3:
Market
discipline
• Disclosure
requirements
Pillar 1: Minimum Capital
Requirements

The calculation of regulatory minimum
capital requirements:
the amount of capital
 8%
Total risk - weighted assets
The Capital and Assets
Definition of capital:
 Tier 1 capital + Tier 2 capital +
adjustments
Total risk-weighted assets are determined by:
 multiplying the capital requirements for
market risk and operational risk by 12.5
 and adding the resulting figures to the
sum of risk-weighted assets for credit risk.
Credit Risk
Standardised Approach
 Foundation IRB Approach
 Advanced IRB Approach

Credit Risk Standardised Approach

In determining the risk weights in the
standardised approach, banks may use
assessments by external credit
assessment institutions.
 Risk Weigh t for Assets  Book Valus of Assets 
Risk Weight for Assets
Claims on sovereigns
Credit
Assessment
ECA risk
scores
Risk
Weight
Claims on banks and securities firms
Credit assessment of Banks
Credit
assessment of
Sovereign
Risk weight
Claims on
corporates
Risk weight
for shortterm
AAA to AA-
1
0%
20%
20%
20%
20%
A+ to A-
2
20%
50%
50%
20%
50%
BBB+ to BBB-
3
50%
100%
50%
20%
100%
BB+ to BB-
4~6
100%
100%
100%
50%
100%
B+ to B-
4~6
100%
100%
100%
50%
150%
Below B-
7
150%
150%
150%
150%
150%
Unrated
-
100%
100%
50%
20%
100%
Credit Risk - IRB Approach
In the internal ratings-based(IRB)
approach, it’s based on banks’ internal
assessment.
 The approach combines the quantitative
inputs provides by banks and formula
specified by the Committee.

Credit Risk - IRB Approach
Four quantitative inputs (risk components):
 Probability of default (PD)
 Loss given default (LGD)
 Exposure at default (EAD)
 Maturity (M)
Use formula of the Committee to calculate
the minimum requirements.
Credit Risk - IRB Approach
Data Input
Foundation IRB
Advanced IRB
Probability of default
(PD)
From banks
From banks
Loss given default
(LGD)
Set by the Committee
Exposure at default
(EAD)
Set by the Committee
Maturity (M)
Set by the Committee or
from banks
From banks
From banks
From banks
Market Risk
Standardised method
- the standards of the Committee
 Internal models
- use banks’ internal assessments
- Value at Risk (VaR)

Operational Risk

The risk of losses results from inadequate
or failed internal processes, people and
system, or external events.
Basic Indicator Approach
 Standardised Approach
 Advanced Measurement Approaches(AMA)

Operational Risk Basic Indicator Approach
K GI 
BIA
GI = average annual gross income(three
years, excepted the negative amounts)
 α = 15%

Operational Risk Standardised Approach
K   GI 
TSA
1 8
 

GI 1-8 = average annual gross income from
business line from one to eight (three
years, excepted the negative amounts)
 β = A fixed percentage set by the
Committee

Beta of Business Lines
Business Lines
Beta Factors
Corporate finance (β1)
18%
Trading and sales (β2)
18%
Retail banking (β3)
12%
Commercial banking (β4)
15%
Payment and settlement (β5)
18%
Agency services (β6)
15%
Asset management (β7)
12%
Retail brokerage (β8)
12%
Operational Risk - Advanced
Measurement Approaches
Under the AMA, the regulatory capital
requirement will equal the risk measure
generated by the bank’s internal
operational risk measurement system
using the quantitative and qualitative
criteria for the AMA.
 Use of the AMA is subject to supervisory
approval.

Pillar 2: Supervisory Review
Principle 1: Banks should have a process
for assessing and maintaining their overall
capital adequacy.
 Principle 2: Supervisors should review and
evaluate banks’ internal capital adequacy
assessments and strategies.

Supervisory Review
Principle 3: Supervisors should expect
banks to operate above the minimum
regulatory capital ratios.
 Principle 4: Supervisors should intervene
at an early stage to prevent capital from
falling below the minimum levels.

Pillar 3: Market Discipline
The purpose of pillar three is to
complement the pillar one and pillar two.
 Develop a set of disclosure requirements
to allow market participants to assess
information about a bank’s risk profile and
level of capitalization.

Minimum Capital Adequacy Ratios
Tier one capital to total risk weighted
credit exposures to be not less than 4 %;
 Total capital (i.e. tier one plus tier two less
certain deductions) to total risk weighted
credit exposures to be not less than 8%

Calculation of Capital
Tier One Capital
the ordinary share capital (or equity) of
the bank; and
 audited revenue reserves e.g.. retained
earnings; less
 current year's losses;
 future tax benefits; and
 intangible assets, e.g. goodwill.

Calculation of Capital
Upper Tier Two Capital





Un-audited retained earnings;
revaluation reserves;
general provisions for bad debts;
perpetual cumulative preference shares (i.e.
preference shares with no maturity date whose
dividends accrue for future payment even if the
bank's financial condition does not support
immediate payment);
perpetual subordinated debt (i.e. debt with no
maturity date which ranks in priority behind all
creditors except shareholders).
Calculation of Capital
Lower Tier Two Capital
Subordinated debt with a term of at least
5 years;
 Sedeemable preference shares which may
not be redeemed for at least 5 years.

Restrictions
Tier two capital may not exceed 100% of
tier one capital;
 Lower tier two capital may not exceed
50% of tier one capital;
 Lower tier two capital is amortized on a
straight line basis over the last five years
of its life.

Total Capital
This is the sum of tier 1 and tier 2 capital
less the following deductions:
 equity investments in subsidiaries;
 shareholdings in other banks that exceed
10 percent of that bank's capital;
 unrealized revaluation losses on securities
holdings.
Module D
Capital Management
Capital Management
&
Profit Planning
Basel II
Tier I-Core Capital
Paid up capital ,Free Reserves and unallocated surpluses
Tier II-Supplementary Capital
Subordinated debt of more than 5 years maturity ,loan
loss reserve, revaluation reserve,investment
fluctuation reserve,limited life preference sharerestricted to 100% of tier I capital
Tier III Capital
subordinated debt with shot term maturity [min 2 years]
for market risk
Total Risk weighted Assets
Risk weighted assets of credit risk
plus
 12.5* Capital requirement for market risk
plus
 12.5* capital requirement for for
operational risk

Three pillars
First Pillar-minimum capital requirements
 Second pillar-supervisory process
 Third pillar-market discipline

Capital Charge for Credit Risk
Standardized Approach
Internal rating based
approach
[1]Foundation Approach
[2]Advanced IRB
Approach
Credit rating of
sovereign
Risk weight for
sovereign
AAA TO AA
0%
Risk weight for
banks in that
country
20%
A+ TO A
20%
50%
BBB+ TO BBB-
50%
100%
BB+ TO BB-
100%
100%
BELOW B-
150%
150%
Risk Weight
Retail & SME
EXPOSURE
75%
Mortgage on
Residential
Property
35%
Past Due Loans
150%
-do-
100%
When specific
provisions are
less than 20%
of the loan
amount
If provision is
higher than
20%
Capital Charge for Operational
Risk
The Basic Indicator Approach
 The Standardized Approach
 Advanced Management Approach

Standardized Approach
for
Operational Risk
Beta factor- a fixed percentage set by Basel
committee
 Maximum 18%
 Minimum 12%
 Banks activities are divided into 8 business linescorporate finance,trading,retail banking,
commercial banking, payment &settlement,
agency services, asset management, retail
brokering

Asset Classification
Standard Assets
 Sub Standard Assets
 Doubtful Assts
 Loss Assets

Provisioning
Standard Assts 0.40%
 Substandard Secured -provision 10%
 Unsecured[realisable value is not more
than 10% of o/s] –provision 20%

Provision
Doubtful I- first 12 months
Provision 20% realizable value of security plus
100% shortfall of security
Doubtful II-further 24 months
Provision 30% realizable value of security plus
100% shortfall of security
Doubtful III-for over 36 months
100% provision
Loss Assets 100%
Thank you
With Best Wishes
ravindran@iibf.org.in