|




O
  

  
 

!

   

A market where financial assets are

exchanged
Financial Assets are created and traded
in financial markets
Financial assets are intangible
 Represent a claim to future cash flow
Issuer
 The entity that has agreed to make future
cash payment
Investor
 The holder of a financial asset
! !
 
 

Financial Claims
(Equity and debt
instruments)

 
^
 


  


 
Cash

Example: A firm sells shares directly to investors without going

through a financial institution
! !

 
 

^
  
 





  
 
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and Insurance policies)
½ !

 
 

jaturity Intermediation
 Investors/lender are willing to invest/lend for
short term
 Issuers/borrowers want funds for long term
 FI are able to offer more choices to both
Denomination Intermediation
 Allow small investors to overcome constraints
imposed to buying assets imposed by large
minimum denomination size
Diversification
 Transforming more risky asset into less risky
asset through diversification
½ !

 
 


Reduced Cost
 Information processing and contracting
cost
Payment jechanism
 Cheque/ Debit Card/ Credit Card

|

 
Commercial Banking
 Intermediation and liquidity via deposits and loans
 Payment system
Investment Banking
 Trading ± equity and fixed income securities
 Underwriting
 Stockbroking
 Corporate advisory
 jerger & Acquisition
 Fund janagement
 Insurance
Universal Banking
 Combination of Commercial Banking and Investment
Banking under one legal entity

 |


jonetary Control
 Open jarket Operations
Buying and Selling of securities in market
Repo and Reverse Repo
 Reserve Ratios
Cash Reserve Ratio
Statutory Liquidity Ratio
 Bank Rate
Prudential Control
 Supervision
 Lender of Last Resort
Government Debt Placement
 Raising debt for the Government at reasonable cost
£
  

Interest Income
 Banks are deposit accepting institutions
Accept Deposit (Interest Paid)
Lend joney (Interest Income)
Spread (Interest Income ± Interest Paid)
Non interest income
 Fee based income
Loan Syndication Fee
Letter of Credit Fee
Credit Cards
Income from Investment
Interest/ Dividend
Trading Income
£ |

 




jultiple interface with the customer

 Branches
 ATj
 Corporate electronic banking
 Internet
 Phone
 jail
 Tied sales force
  ½ 


 


Customer Static
 jaster information about the customer
 Single location vs. multiple location
Contact janagement
 To bring together the entire customer
³contacts´ and ³events´ at one place
Customer Risk
 Group wide view of customer risk
Ñ


Back office staff and complex computer
systems to set up and maintain the
particular product or service for a customer
 Core Banking
 Assets Finance
 Wealth janagement
 Insurance
 Cards
 jortgages
 Capital jarket
 |


Activities of a typical commercial
bank that has both personal and
business customers;
 deposits and savings accounts
 personal and commercial lending
 payment services including direct debits,
cheques, cash, High Value payments and
currency payments
 Trade products such as Letters of Credit
and international Bonds and Guarantees
 |


Corporate/ Wholesale Banking
 Services corporations and governments
Current Account
Payment mechanism
Cash janagement Services
Commercial loans
Loan Syndication
Guarantees
Retail Banking
 Individuals and small businesses
Saving accounts
Loans ± personal, mortgages

 

Areas of personal and commercial
insurance broking and underwriting
 Life Assurance
 House Insurance
 jotor Insurance
 Health Insurance
 Commercial Insurance
 Loan Protector Insurance
 Specialised Insurance (jarine, Aviation, etc)
 !



Services such as leasing, vehicle finance,
debt factoring etc.
Quite distinct back office processes and
supporting IT.
Lease
 Assets are bought by the bank
 Possession is given to the user
 Ownership is retained by the Bank
 The borrower pays in installments
 Each installment is broken into principle and
interest
 !



Hire Purchase
 Assets are bought by the bank
 Possession is given to the user
 Ownership is retained by the Bank
 The borrower pays in installments
 Each installment is broken into principle
and interest
 The ownership is transferred to the
borrower upon payment of all the
installments
! 

Transfer of collection of receivables and related book-
keeping functions to a financial intermediary.
Factor usually extends an advance and may assume
the risk of non-recovery


 




 
 


! 
! 

ù : Credit sale
2 : Client sells the customer¶s account to
factor and notifies the customer
3 : Factor makes a part payment to client
after adjusting commission and interest
4 : Factor maintains customer¶s account and
follows up for payment
5 : Customer remits the amount due to the
factor
6 : Factor makes the final payment to the
client
!! 

Recourse Factoring
loss of bad debts to be borne by the client
Non-recourse Factoring
risk is borne by the factor
Factor participate in the credit granting process
jaturity Factoring/Collection Factoring
Payment to the client on the date of collection of
guaranteed payment day
Advance Factoring
Advance upto 75-85% of receivable
Balance on collection/guaranteed payment day
! ! 

Administrative Services ± Commission

Financing
Discount (if deducted upfront)
Interest (if charged subsequently)
For the Period between the date of advance
payment and the date of collection/guaranteed
payment date
Risk of bad debts ± del credere
commission
|
 

 ! 


To finance deferred credit transactions


Ñ
 


  #
 
"
!!   


$
|
 

 ! 

ù : Export transaction
2 : Promissory Note sent for co-acceptance (avalization)
3 :Avalled notes returned to importer
4: Avalled notes sent to exporter
5 :Avalled notes sold at a discount to farfaiter on a non-
recourse basis
6: Exporter obtains finance
7 : Forfaiter presents the notes to the avalling bank on
maturity
8: Avalling bank makes payment to the forfaiter
9: Avalling bank gets payment from the Importer
ü 
 


janaging funds on customers¶ behalf,

- retail or institutional
Active or passive funds management
managed
Other services like custody
 

ƒey credit and debit card processes:

 Card issuing, to both individuals and
companies
 jerchant acquisition
 Credit and Debit Card payment
processing

   

Wholesale market in money,

currency, bonds, securities and the
derivatives
Distinct back office requirements
    
Interaction with counter parties for the provision of a
service to a customer
Often highly automated and use industry standard
Gateways.
 SWIFT
 CHAPS
 SWITCH
 SOLO
 Bankers Automated Clearing Service (BACS)
 VISA /jASTERCARD
 CHEQUE CLEARING
 CURRENCY CHEQUE CLEARING
 Continuous Linked Settlement (CLS)
 LINƒ

 

 

Deriving information from the activities in the other
parts
External
 Government Tax Authorities - Information on
customer tax withheld and country of residence of
customers
 Government Security Services - Information on
Suspected Terrorists, joney Laundering and Fraud
 Central Bank and Financial Services Regulators -
Information on credit exposures, capital adequacy
and liquidity
Internal
 Analyzing assets, liabilities, costs and income as well
as non-financial data for a variety of marketing and
other management needs.



|

A number of stakeholders
Accounting statements meet their information
requirements
  

!
 
Accounting is not an exact science
To bring about uniformity in
accounting practices `good
accounting practices¶ called GAAP
evolved over a period of time
GAAP are formalized in the form of
Accounting Standards
jove towards harmonization of
accounting standards
 

joney jeasurement Concept

 Only those transaction that can be expressed
in terms of money is the subject matter of
accounting
 joney is the common unit of measurement
The Entity Concept
 Business is a separate accounting entity for
which accounts are kept
 Business and the businessman are separate
entities
 
The Going Concern Concept
 The business will continue to operate indefinitely
 Unless there are reasons to believe otherwise
 The business neither has the intention nor the
necessity to discontinue operations
The Cost Concept
 Assets are recorded in the accounts at its cost
 Subsequent changes in the value are normally
not recorded in the accounts
 Cost is however systematically reduced over the
useful life of the asset
 
The Dual Aspect Concept
 Each accounting transaction effects at-least two
accounts in such a way that
 Assets = Liabilities + Owner¶s Equity
 This system of accounting is called double-entry
system
Accounting Period Concept
 Income is measured for a specified interval of
time ± accounting period
A period of ù2 months
 jakes comparison easier
 

Accrual Concept
 Timing when income or expenses should be
recorded
 Income and expenses are recorded when
`accrued¶ and not when received or paid
Income recorded when earned
Expenses recorded when incurred
The jatching Concept
 Expenses should be matched against the
revenue generated to ascertain profit
 
The Conservatism Concept
 Anticipate no profit but anticipate all losses
Recognise gains only when they are reasonable
certain
Recognise losses even if they are reasonably
probable
The Consistency Concept
 Accounting methods once chosen must be
applied consistently period after period unless
there is strong reasons to change
 jakes inter-period comparison possible
 

The jateriality Concept

 Insignificant details should be avoided but all
important information must be disclosed
 Any information that may influence the
decision of the user of the financial statement
 The level of details to be maintained
| !

 !  


To answer the two basic questions

 How much profit was generated by the
business over a particular period?
 What is the accumulated wealth of the
business at the end of a particular
period?
Financial Statements
 Profit & Loss Account
 Balance Sheet
!

 !  

!  !

Shareholders¶ Funds
 Share Capital Interest Income
 Reserve and Surplus
Less: Interest Expenditure
Securities Premium Account
Reserves
Net Interest Income
P&L Account (Credit Balance) Other Income
Borrowed Funds Less: Other Expenses
 Deposits Less: Depreciation and
 Borrowing from other banks Amortization
 Other Liabilities Profit Before Tax


 
!
 Less: Taxes

Cash in hand Profit After Tax
Cash with other banks Less : Appropriations
joney at call and short notice Dividend
Investments
Reserves
Loans and Advances to customers
Other Assets
Retained Earnings
‰   
Shareholders¶ Funds
 Share Capital
 Reserve and Surplus
Securities Premium Account
Reserves
P&L Account (Credit Balance)
Borrowed Funds
 Deposits
 Borrowing from other banks
 Other Liabilities
 

Cash in hand
Cash with other banks
joney at call and short notice
Investments
Loans and Advances to customers
Other Assets
‰   
Deposits
 Current accounts: Cheque operated accounts
maintained for mainly business purposes. No
limits are fixed by banks on the number of
transactions permitted in the Account.
Banks generally insist on a higher minimum
balance
banks generally levy certain service charges for
operating a Current account.
Banks do not pay any interest on the balances
maintained in current accounts.
‰   
 Savings deposits
A Savings bank account is the most common
operating account for individuals and others for
non-commercial transactions.
 Banks generally put some ceilings on the total
number of withdrawals permitted during
specific time periods.
 Banks also stipulate certain minimum balance
to be maintained in savings accounts.
 Banks pay nominal interest on saving accounts
‰   

Time deposits/Fixed deposits

 Time deposits are deposits accepted by
banks for a specified period of time.
Interest rates are to be determined by respective
banks.
‰   
Borrowing from other banks
 Inter bank borrowings in case of liquidity
crunch.
‰   

Other liabilities
 Bills payable
 Accrued interest
 Dividends declared but yet to be paid
 Provisions for loan loss
Provisions made against doubtful asset
A bank specific parameter
·  

 ‰   
"·‰

Demand liabilities
 Payable on demand
 Current deposits, savings deposits, Demand
drafts etc.
 Does not include money at call and short notice.
Time liabilities
 Payable otherwise than on demand
 Fixed deposits, Gold deposits etc.
A sum of DLs and TLs is termed as NDTL
Banks are required to maintain CRR and
SLR with reference to the NDTL as of the
reporting day.
 
Cash in hand
 Actual cash held by the bank in its vault
for daily use
 Acts as the first line of defense in case of
insolvency.
Cash with other bank
 Banks (usually small banks) open
current account with other banks.
 Banks also keep cash with central bank¶s
current account.
 

joney at call and short notice

 Short term investments by banks which
can be called back immediately
 Call money transactions
Investments
 Held Till jaturity
 Held for Trading
 Available for Sale
 
Loans and Advances to customers
 Commercial & Industrial
Term Loan
Working Capital Loan
Cash Credit/ Overdraft
Bill Discounted
 Retail
Personal Loan
jortgage
Educational Loan
  #
  ‰

Term Loan
 Long term loan to finance capital expenditure
 Interest is charged on Loan
 Generally secured against the fixed assets of the
company
Working Capital Loan
 To finance the day to day operating
requirements
 Interest is charged on the amount sanctioned
 Generally secured by the hypothecation of
inventories and receivables
  #
  ‰

Cash Credit/ Overdraft

 To finance the day to day operating
requirements
 Interest is charged on the amount
actually utilized
 Generally secured by the hypothecation
of inventories and receivables
 Commitment fees on the amount
sanctioned and/or amount unutilized
  #
  ‰

Bills Discounting
 Discounting of trade bills by the bank
 A bill arises as a consequence of a trade
transaction
 The seller of goods on credit discounts
the bill from the bank
 The bank deducts the discount upfront
 !  
Hypothecation
 Security of moveable property
 Assets pledged continue to be in possession of the
borrower
 Lender has a right to attach the property in case of
default
Pledge
 Physical possession is given to the lender
 Lender must take reasonable care of the property
pledged
jortgage
 Transfer of legal/equitable interest in specific
immovable property to the lender
 jortgage Deed
 

Property and Other Assets

 Land & Buildings
 Furniture and Fixtures
 Computer Systems
 Vehicles

 !  

Interest Income
Less: Interest Expenditure
Net Interest Income
Other Income
Less: Other Expenses
Less: Depreciation and Amortisation
Profit Before Tax
Less: Taxes
Profit After Tax
Less : Appropriations
Dividend
Reserves
Retained Earnings

 !  

Interest income
 Loans
Interest
Interest expenses
 Interest paid on time deposits
 Interest on other deposits
 Interest expenses due to repo transaction
 Interest on bonds and debentures issued by the
bank
Investment income
 Securities, bonds, debentures etc.

 !  


Non-interest income
 Advisory activity
 Service charges on deposits
 Commissions and fees
 Foreign exchange trading gains and losses
Other expenses
 Overhead expenses ± salaries, employee
benefits etc
 Expense of premise and fixed assets
 Provision for loan loss
 Depreciation

 !  


Provision for Tax

Profit After Tax
Appropriations
 Reserves
 Dividend
Retained Earnings (Reserve and
Surplus)
$|
 !  

jost off-balance sheet activities are

commitments based on a contingent
claim. A contingent claim is an
obligation by a bank to provide funds
if a contingency is realized.
$|
 !  

Letters of credit
 letter from a bank guaranteeing that a
buyer's payment to a seller will be
received on time and for the correct
amount. In the event that the buyer is
unable to make payment on the
purchase, the bank will be required to
cover the full or remaining amount of the
purchase.
 $|
 !  

Commercial LCs

ù
Orders $ù million of machinery
3 German exporter
Indian importer
Goods shipped

2
$ù million LC issued

Bank XYZ in India

$|
 !  

Standby LCs
 SLCs perform an insurance function
similar to that of commercial letters of
credit. However, the structure and the
type of risk covered are different
(potentially more severe)
Default guarantees to back an issue of commercial
papers
Completion guarantee of a project
others
$|
 !  
Loan Commitments
 A loan commitment agreement is a contractual
commitment by a bank to a firm certain
maximum amount of loan at a given interest
rate.
 The agreement also defines the length of time
over which the borrower has the option to take
down the loan.
 The bank may charge an up-front fee which is
termed as loan commitment fee.
 Bank may also charge a back-end fee on the
unused component of a loan commitment.
!

  
 
 

Return on Equity
=

·
Income
Return on Assets ·
Income
Total quity ›apital Total 3ssets
=

·
Income
Profit jargin = Total Operating Income
!

  
 

 

Net Interest jargin =

Spread =


Income 

xpense
·


Income
º


Income - Interest xpenses
arning 3ssets
arning 3ssets 

Bearing Liabilities
 

 


 6 ·
‰   ‰  
Interest Income Ratio =


Income
T
 Assets
Non-Interest Income Ratio =
·  

Income
T
 Assets
!

  
 

 

Interest Expense Ratio =



xpense
T
 Operating Income
Non-Interest Income Ratio =
·  

xpense
T
 Operating Income

Provision for Loan Loss Ratio =

Pr 

 or oan osses
T
 Operating Income
½  

Credit Risk
 An asset or loan become irrecoverable or
experiences a delay in servicing
Counterparty Risk
 On traded financial instruments
Liquidity Risk
 Bank¶s inability to fund its day to day
operations
 `Funding short lending long¶
½
jarket Risk / Price Risk
 Due to fluctuations in the market price of
instruments held by bank
 Systematic Risk vs Unsystematic Risk
Operational Risk
 Due to failed internal processes, people and
systems or external events
Interest Rate Risk
 Due to movement in risk rate
Gearing Risk
 Due to high financial leverage
   
   %    
Assets whose value is determined by
some other underlying securities ±
hence termed as derivatives.
The underlying
 Stock
 Interest rate (bonds)
 Currency
 Bank loan
 Whether etc.
! 
Negotiated privately between two
parties to buy and sell a specific
quantity of a commodity, foreign
currency or financial instrument at a
specified price, with delivery and/or
settlement at a specified future date.
A forward contract is not formally
regulated by an organized exchange,
each party to the contract is subject to
the default of the other party.
!   

Futures and forwards are almost

similar in all respects except the
following
 Futures are exchange traded
standardized products and hence default
risk is essentially eliminated.
 Futures, being standardized products are
not as flexible as forwards are.




Options are the financial derivatives

that provides the right but not the
obligation to buy or sell the
underlying asset on a specified date
and a specified price.
Broadly, exchange traded products
with few exceptions.
!

A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules

  ½  !

Converting a liability from

 fixed rate to floatingConverting
rate an
 floating rate to fixedinvestment
rate from
 fixed rate to
floating rate
 floating rate to
fixed rate
!
$ Ñ


Company A has borrowed $ù m @

9%, wants to covert the borrowing
at floating rate
Company B has borrowed $ù m @
Floating Rate, wants to covert the
borrowing at fixed rate
Can they swap?
!

! 

& 

›
 ›
 ! 
& 

#%
 
#%
!

!& !&

›
 O  ›
 ! 
& 



 
#%

$#% #'%
 
! 
Process of settlement of cheques
lodged with a bank
Out-clearing: Processing of cheques
for a bank where it has been lodged
In-Clearing : Processing of cheques
for a bank on which the cheque has
been drawn
Adjusted by a system of debits and
credit
 
Cheque lodged with bank A
Cheque are sorted bank-wise
Send cheques to the clearing house
Cheques for out-clearing and in-clearing
are exchanged
Net position of the bank is determined by
the clearing house
Debit / Credit is given to the respective
customer with the net credit to the account
being maintained with the Central Bank
· & !  


Clearing
 Based upon the principle of netting
Real Time Gross Settlement (RTGS)
 Transactions are settled on Gross Basis
· 
$Ñ


Same Bank/ Same Branch

 A draws a cheque in favour of B. B
lodges the cheque in his account with the
same branch.
Same Bank / Different Branch
 A draws a cheque in favour of B. B
lodges the cheque in his account with the
same bank in another branch.
· 
$Ñ


Bank ù
 Cheques lodged by Customers Out In Net
 A : Rs.5 , (P2)
 B : Rs..3 , (Q2) 9 , 73, ù7,
 C : Rs..ù , (R3)
Bank 2
 Cheques lodged by Customers
 D : Rs.ù5, (Sù)
 E : Rs..45, (T3) ù45, 9 ,5 54,5
 F : Rs..85, (U3)
Bank 3
 Cheques lodged by Customers
 G : Rs.ù7,5 (Vù)
 H : Rs..4 ,5 (Uù) 68,5 ù4 , (7ù,5 )
 I : Rs..ù ,5 (W2)
· 
$Ñ


Bank ù
 S ù5 (Dr.) Bank 2
 V ù75 (Dr.)  P 5 (Dr.)
 U 4 5 (Dr.)  Q 3 (Dr.)
 CH ù7 (Dr.)  W ù 5 (Dr.)
 A 5 (Cr.)  CH 545 (Dr.)
 B 3 (Cr.)  D ù5 (Cr.)
 C ù (Cr.)  E 45 (Cr.)
 F 85 (Cr.)
· 
$Ñ


Bank 3
 R ù (Dr.) Central Bank
 T 45 (Dr.)
Bank 3 7ù5 (Dr.)
 U 85 (Dr.)
Bank ù ù7 (Cr.)
 CH 7ù5 (Cr.)
Bank 2 545 (Cr.)
 G ù75 (Cr.)
 H 4 5 (Cr.)
 I ù 5 (Cr.)
!   

Float ± time gap between the
initiation of payment and the
recipient getting the funds
 Often a period of 3 days
Faster payment ± new same day
payment capability
 Real Time based approach
 Inter-bank transactions several times
day
 
! 
APACS ± Association for Payment Clearing
Services
BACS Limited ± Bankers Automated
Clearing System - Automated clearing
house for non-paper based bulk clearing
e.g. standing orders, direct debits and
direct credits
CCCL ± Cheques and Credit Clearing
Company Limited ± paper based clearing
CHAPS ± Clearing House Automated
Payment System - RTGS for high value
payments
Banking Regulations

½  

Diversify Assets
 Avoid concentration to one company/ sector
joney Laundering
 Customer Acceptance Policy
 Customer Identification Procedure
 jonitoring of transactions
Capital Adequacy
 To protect against the risk of insolvency
Liquidity Requirements
 Cash Reserve Ratio
 Statutory Liquidity Ratio
Guarantee Funds
jonitoring and Surveillance
^ ½  !  
Type of Institution Regulator Legislation
Banks Bank of England Banking Act¶87
joney jkt Bank of England Financial Services
Institution Act¶ 86
Securities Firm Securities & Financial Services
Investments Act¶ 86
Board
Fund janagers Securities & Financial Services
Investments Act¶ 86
Board
Building Societies Building Societies Building Societies
Commission Act¶95
Insurance Department Of Insurance
Companies Trade & Industry Companies Act¶82
^ ½  !  
Type of Institution Regulator Legislation
Banks Financial Services Financial Services &
Authority jarkets Act¶ 2
joney jkt FSA FSjA¶2
Institution
Securities Firm FSA FSjA¶2

Fund janagers FSA FSjA¶2

Building Societies FSA FSjA¶2

Insurance FSA FSjA¶2
Companies
^ ½  

Risk Based Approach to Regulation
 Risk to Our Objectives (RTO)
Computing an Impact Score for each firm
 Impact of the problem x Probability of problem
arising
 A highest score; D lowest
 85% of the firm ± D
 High Impact firms ± large bank, insurance firms,
broker dealers, stock exchanges
^ ½  

Criteria for licensing of banks
EU¶s Large Exposure Directive
FSA must be satisfied with the banks¶ procedure for
taking, monitoring and controlling risk
Banks may be asked to supply regular information on
asset quality
Each bank must be externally audited and have a
system of internal audits.
 The FSA or external auditors can examine the
internal audits
 External Auditors must inform FSA any concern they
might have
^ ½  

Onsite examinations
 For high impact firms
 FSA supervisors may be supported by risk
management specialists
 Low impact firm will be supervised off-site
through key ratios
Appoint a money laundering reporting
officer approved by FSA
In addition to Basel, FSA sets an individual
capital ratio for each bank based upon risk
profile.
joney Laundering

‰
 


The process by which the proceeds

of crime are converted into assets

which appear to have a legitimate

origin.

 
 '  &&&

Drugs money

Terrorist financing

Tax evasion

All crimes
  
  

Dirty to clean
placement
layering
integration
  

Getting dirty money into the system
 often in emerging markets overseas
 or use a ³useful´ business
Bureaux de Change
car, boat, art, antique dealers
precious metal dealers
estate agents
travel agents
cash intensive businesses
friends / relatives
‰  

joving money around to confuse its
origins
 offshore banks, weak controls
 company formation agents
 Trusts / professionals
 trade related activities
Characterised by
 complexity
 lack of commercial rationale
 nominee accounts

  

Into legitimate economy

 purchase of an income generating asset

Dirty to clean
 may be most difficult to spot
j




Areas affected in a bank
 Retail banking
 Investment banking
 Private banking (asset management)
 Investment in real property
 Insurance sectors
! Ñ!·½! !

The involvement of a bank in a money

laundering exposes it to a number of
different kinds of risks:
Reputational risk: bank may find its
image damaged significantly and it may
sustain significant and lasting negative
business impacts
Legal risk: the discovery of money
laundering operations may lead to
disciplinary sanctions
Criminal liability risk: for senior
management personnel and staff
  


Select customers to deny access to the services
of the bank to individuals and legal entities
associated with money laundering
jonitor operations to prevent the use of bank
for illegal operations
In the event of suspicious activities:
 Report suspicions to the responsible authorities
 Freeze assets
 Terminate business relations
 
   

› 
 
 



  j

 
 


  
 

 


 


Capital Adequacy ± Basel II
½|  
 !
 
Why do banks need to hold capital in order
to do business?
 Provides a cushion against unexpected loss that
may arise due to credit/market/operational risk.
 Capital that needs to be maintained as a
proportion of risk based assets is termed as risk
based capital ± otherwise termed as capital
adequacy ratio (CAR).
e.g., bank does not maintain any capital
towards credit risk component of Government
bonds as it is non-existent.
|

½
  

Credit risk
 Risk arising due to default or deterioration
of the credit quality of the obligor/ borrower
jarket risk
 Risk arising due to market movement of
different benchmark rates.
Operational risk
 Loss resulting due to errors instructing
payments or setting transactions.

 
½



Operational risk is the risk of loss resulting
from inadequate or failed internal processes,
people and systems or from external events.
 Internal fraud
 External fraud
 Employment practices & workplace safety
 Clients, products & business practices
 Damage to physical assets
 Business disruption & system failures
 Execution, delivery & process management

 
½




Internal process
 Losses from failed transactions,
settlements, e.g., data entry
error/Unapproved access/Vendor
disputes etc.
People
 Losses caused by an employee, e.g.,
unauthorized trading, internal fraud,
harassment etc.

 
½




Systems
 Losses arising from disruption of
business or system failure, e.g.,
hardware or software breakdown,
telecommunication failure, programming
error, computer virus etc.
External events
 Losses from the actions of third parties,
e.g., natural disaster, terrorism, credit
card fraud, etc.
Ñ 

 !
 
Originated in July ù988 under the auspices
of Bank for International Settlement (BIS)
in Basle, Switzerland ± popularly termed as
Basle Committee.
 Basel I defines a common measure of solvency,
called the Cooke ratio which covers only credit
risk ± one size fits all policy.
 Specifies 8% capital charge on all exposures.
 Exposures being defined by respective risk
weights
 ù988 accord is termed as Basel ± I.
  ‰
|  
Capital in regulatory context
 Tier ù Capital
Shareholders¶ equity and disclosed reserves
 Tier 2 Capital (Supplementary)
Perpetual securities, unrealized gains on
investment securities, hybrid capital
instruments, long term subordinated debt and
hidden reserves.
 Total of tier 2 capital is limited to a maximum of
ù % of the total tier ù capital.
 Basel I requires tier ù and tie 2 capital to be at
least 8% of the total risk weighted assets.
Ñ

% |  
Liabilities Amount ($ Assets Amount ($ bn)
bn)
Equity ù5 Cash 2( )
Reserves 2 Govt. Bonds 3 ( )
Subordinated 5 Inter-bank Loan 2 (.2 )
Debt
Deposits ù8 jortgages 5 (.5)

Loan Loss 3 Loans ù 3(ù)

Reserve
Total 2 5 2 5

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 |  

Does not distinguish among different

credit exposures
 Both AAA and BBB assets attract the
same capital charge.
Does not allow any capital charge for
operational risk.
 · |  
 
‰‰½ ‰‰½ ‰‰½
jinimum capital Oupervisory jarket
requirements Review Discipline
Credit risk Review of the
jarket risk institution¶s Enhancing
Operational risk capital adequacy transparency
Review of the through
rigorous
internal risk disclosure
assessment norms.
processes
!  

  
Credit Risk Operational jarket Risk
Risk
Standardized Basic Indicator Standardized
Approach Approach Approach

Foundation Standardized Internal jodel

IRB Approach Approach

Advanced IRB Advanced

Approach jeasurement
Approaches



  
 
 


Advanced approaches are based upon

more sophisticated risk management
processes and require more
information
 Requirement of capital to be maintained
also goes down
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Comprehensive disclosure is essential for
market participants to understand the
relationship between risk profile and capital
of an institution.
Includes the disclosure of
 Capital structure
 Capital adequacy
 jethod for computing capital requirements
 Risk exposure such as market, credit and
operational
 Risk jitigation
O ,
 56  ''
    

 
 


&COj jeltdown

Enron/ Anderson

WorldCom

Stock jarket jeltdown

Loss of Investor Confidence in Financial

Statements of Public Companies and their
³Independent´ Auditors
   
  
  
 ()
  
*)))
  
    
   
+  

It is created by US Senator Paul Sarbanes and US

Congressman jichael Oxley.
It is passed by the Senate On July 25 2 2.
President Bush signed it into Law on July 3 2 2 and
we get Sarbanes-
Sarbanes-Oxley Act, 2 2.

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Yes 522
No 3
Not voting 9
! 
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The Sarbanes- xley Act seeks to:

 Restore the public confidence in both public
accounting and publicly traded securities

 Assure ethical business practices through

heightened levels of executive awareness and
accountability

 Increase the confidence of the investors in the

financial statements of a company
   ! 
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The Act aims to:

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All those companies which are

registered with Securities Exchange

Commission (SEC), US; except those

which are non-profit companies; and

it is a part of listing agreement.

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I. Public Company Accounting Oversight Board

II. Auditor Independence
III. Corporate Responsibility
IV. Enhanced Financial Disclosures
V. Analyst Conflicts of Interest
VI. Commission Resources and Authority
VII. Studies and Reports
VIII. Corporate and Criminal Fraud Accountability
IX. White Collar Crime Penalty
X. Corporate Tax Returns
XI. Corporate Fraud and Accountability
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 SEC report being filed has been reviewed
 Report does not contain any untrue statements or omit
any material facts necessary to make the statements
made not misleading
 Financial statements fairly present, in all material respects,
the financial position, results of operations and cash flows
 He/she is responsible for and has designed,
established, and maintained Disclosure Controls &
Procedures (³DC&P´), as well as evaluated and
reported on the effectiveness of those controls and
procedures within 9 days of the report filing date
½

½ +  

Deficiencies and material weaknesses in
internal control have been disclosed to Audit
Committee and auditors, as well as any fraud
(material or not) involving anyone with a
significant role in internal control
Significant changes in internal control affecting
controls for periods beyond review have been
reported in the certification, including any
corrective actions with regard to significant
deficiencies and material weaknesses

 

 
! 
4)4% 
 
  
 


 


 Internal control report states management¶s responsibility for
establishing and maintaining adequate internal control structure
and procedures for financial reporting
 janagement must assess effectiveness of internal control
structure and procedures for financial reporting as of the end of
the most recent fiscal year
 Attestation by external auditor (Section 4 4 and ù 3)
 ! 
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% Ñ!   
!

 ½

 Fully comply with various Acts and information fairly presents
financial condition and results of operations


One Time; there is an initial one off
description of lots of processes so that they
are understandable by the auditors.
Examples might be human related such as
›hange control processes and their key
measures/control points
systems related
 ënterest calculation and posting algorithms.
Ongoing; every year there will be an
exercise driven by both internal and
external auditors of sampling key controls
from key processes and analyzing whether
these controls are effective
 6 

ü  6 
0
Relationship between Re.ù today and
Re.ù in the future.
Two methods for accounting for time
value of money
 Compounding
Finding the future value of a present sum of
money
 Discounting
Finding the present value of a future sum of
money
ü  6 
0

Future Value (FV)

 Value of a sum
after investing over C = Sum invested today
one or more r = Interest rate
periods.  
(1 6 ) 

Present Value (PV)

 Value of a sum
today which is  
received after one (1 6 )
year or more C= Sum received n year hence
periods. r = Interest rate
!   6 





The general formula for the future value of an
investment over many periods can be written as:
! = › ó(ù + r)n
where
 › is cash flow at date ,
 r is the appropriate interest rate, and
 n is the number of periods over which the cash
is invested.
 (ù + r)n = !
 


!

!! 
  
6 




Present value of a future sum can be written as

 1

   !
 of the future sum Cn
(
where, PV = Present value1 6 )
n = number of years until the payment will
be received
r = annual discount (or interest) rate
ù/(ù+r)n is termed as  
6 
  
! " 6!7



 ‰  ! 

An annuity is defined as a level

stream of regular payments that lasts
for a fixed number of periods.
 Regular Annuity ± cash flow at the end of
each period
 Annuity Due ± cash flow at the beginning
of each period
!   6 



Future value of an annuity can be written as

where
 Â1 6   1

FVn = Future value
 ofthe annuity ! at the end of the
period 
r = The annual rate of interest
n = number of years for which annuity lasts
{(ù+r)n-ù
/r = !   6 
  ! 



"!6!7

  
6 




The formula for the present value of an annuity is:

 Â1 6  º 1


   !
 (1 6 )

where
PV = Present value of a regular annuity
C = Annual Contribution at the end of each period
r = The annual rate of discount
n = number of years for which annuity lasts

 ½  ! 

Capital Recovery Factor helps in computing:

 Loan installment to liquidate a loan
 Amount that can be withdrawn periodically when
a particular amount is invested now.
The Capital Recovery Factor is the inverse of
PVIFA
 CRF = ù/ PVIFA
Happy Learning«««««