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TABLE OF CONTENTS

Sr.no.

Particulars

Page No.

I 1 2

Executive Summary Introduction to Treasury Management The Federal Bank - An Overview 2.1 The Federal Bank - Treasury Department 3 4 Cash Credit Ratio & Statutory Liquidity Ratio Asset Liability Management 4.1 Models of ALM 5 Capital Adequacy

2 3 5 6 8 12 16 23 27

5.1 Calculation of Capital Charge (Market Risk) 5.2 Pillar II : SREP 5.3 Pillar III : Market Discipline 6 7 Internal Model Approach (IMA) Value at Risk (VaR) 7.1 VaR Parameters 7.2 VaR Models 52 7.3 Interpretation of VaR 7.4 Backtesting of VaR 7.5 Expected Shortfalls 8 9 Learnings and Shortfalls References 59 61 56 58 47 49 42 45 39 41

I. EXECUTIVE SUMMARY
Treasury management in an organization helps maintain adequate liquidity to ensure that the right amount of cash resources are available in the right place in the right currency and at the right time in such a way as to maximize the return on surplus funds, minimize the financing cost of the business, and control interest rate risk and currency exposure to an acceptable level. This project covers functions of treasury management operations in banks, organizational structure, objectives and functions of treasury which plays an important role in banks and a genuine attempt to study, understand the basics of Risk management in Banks with a special focus on Market Risk- valuation and computation of capital charge, Asset-Liability Management and also a brief overview of the risk management guidelines laid down by RBI. The project also involves the study of the responsibilities of the Banks treasury in managing cash reserve ratio (CRR), statutory liquidity ratio (SLR), government securities, etc. We have also tried to cover future scope / challenges in treasury management, role of information technology in treasury management and a study of Federal Banks treasury. Treasury Management is fast emerging as a specialization in many companies and its accounting function is being de-linked from the finance managing the treasury profit center successfully.

1. Introduction to Treasury Management


In general terms and from the perspective of commercial banking, treasury refers to the fund and revenue in the banks possession and day-to-day management of the same. Idle funds are usually source of loss, real or opportune, and, thereby need to be managed, invested, and deployed with intent to improve profitability. Thus, treasury operations seek to maximize profit and earning by investing available funds at an acceptable level of risks. Returns and risks both need to be managed. Moreover there is a trend among banks that they are under pressure to get best returns even from the surplus/idle funds In this context, treasury operations are becoming more and more important to the banks and a need for integration, both horizontal and vertical, has come to the attention of the corporate. The basic purpose of integration is to improve portfolio profitability, risk-insulation and also to synergize banking assets with trading assets. In horizontal integration, dealing/trading rooms engaged in the same trading activity are brought under same policy, technological and accounting platform, while in vertical integration, all existing and diverse trading and arbitrage activities are brought under one control with one common pool of funding and contributions. Treasury management in an organization helps maintain adequate liquidity to ensure that the right amount of cash resources are available in the right place in the right currency and at the right time in such a way as to maximize the return on surplus funds, minimize the financing cost of the business, and control interest rate risk and currency exposure to an acceptable level. In other words, Treasury management (or treasury operations) includes the management of an enterprise's holdings in and trading in government and corporate bonds, currencies, financial futures, options and derivatives, payment systems and the associated financial risk management. It binds together liquidity management, asset/liability management (ALM), capital requirements and risk management. At one end of the spectrum it manages balance sheets and liquidity, and does good things to enhance the yield on assets and minimize the cost of liabilities, mostly through the clever and intelligent use of derivatives. At the other end of the spectrum, treasury can help restructure the balance sheet and provide new products.

Integrated Treasury: We see integration of segmented financial markets- money market, debt and capital market and Forex market, etc., at the macro level and integration of treasury operations at the operational level of banks. The term integration means merger or centralization or consolidation. The reforms that were initiated in 90s made domestic markets closely linked to global markets. The domestic market is in integration with global market at the micro level, which has raised the need for integration of micro level units. Relaxation of regulations has almost integrated different segments of financial markets- debt market, money market, capital market, Forex market, etc., which enabled free flow of money from one market to another.

2. The Federal Bank Ltd An Overview


Federal Bank is one of the leading private sector banks in India with a banking history of around 70 years and its head office is located at Aluva near Kochi, Kerala. Federal bank has a wide network of more than 950 branches covering almost all major cities in the country with a major share in the state of Kerala .Federal Bank has played a pioneer role in developing and deploying technology assisted customer friendly products and services. The Bank has also the distinction of being one of the first banks in the country to deploy technology enabled services at the smaller branches including rural and semi-urban areas.

The Bank has the full range of delivery channels including, Internet Banking, Mobile Banking and Alerts, Any Where (Branch) Banking, Interconnected Visa enabled ATM network, Email Alerts, Telephone Banking and a Centralized customer Call Centre with toll free number. The Bank has now emerged into a financial supermarket giving the customers a range of products and services. Apart from the entire slew of banking products and delivery channels the bank also provides a variety of fee based services such as merchant banking services, depository services etc to name a few.

The Federal Bank Ltd has a three tier organizational structure; consisting of branches which are intended to be the profit centre for the Bank, the regional offices which are responsible for the administration, growth and development of the branches, and the central office which provides strategies, as well as well-defined systems and procedures for the operation of the regional office and branches. The bank is currently headed by its MD& CEO, Mr. Shyam Srinivasan

2.1

The Federal Bank Ltd-Treasury Department

Federal Bank Ltd has an Integrated Treasury, managed by the Front Office, Mid Office that is mainly concerned with Risk Management, the Back Office where the settlements take place and the Audit group.

Front office:
The dealing room comprises the front office that handles transactions for mainly Banks (proprietary deals) and also for its the clients. They are the first point of interface with other participants in the market (dealers of other banks, brokers and customers). The dealers have access to information on prices and volumes of trade in securities worldwide through News Screen/platforms like Reuters and Bloomberg and strike the best possible deals for the

purpose of complying with statutory requirements and optimizing profits. In the Federal Bank Ltd there are four sections in the front office: The G-Sec Desk The Money Market and Derivative Desk The Equity Desk The FOREX desk

Mid- office:

Mid-office is responsible for onsite risk measurement, monitoring and management, reporting and analysis, reports directly to the top management for control. This unit is responsible for daily tracking of risk exposures, individually as well as collectively. They report directly to the Integrated Risk Management Department (IRMD).

Back - office functions:

The back office undertakes accounting, settlement and reconciliation operation. The key functions of back-office are-: Deal slips verification and Monitoring approved exposure and position limits. Generation and dispatch of interbank confirmations and confirmations on forward contracts. Effecting/receiving payments and Monitoring receipt of FOREX funds in interbank contracts Settlement through CCIL or direct through NOSTRO as applicable Statutory reports to RBI

The audit group independently inspects/audits daily operations in the treasury department to ensure adherence to internal/regulatory systems and procedures.

3. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)


With a view to monitoring compliance of maintenance of statutory reserve requirements viz. CRR and SLR by the SCBs, the Reserve Bank of India has prescribed statutory returns CRR: At present, the CRR is prescribed at 4.75 per cent of a bank's total of DTL (Demand & Term Liabilities) Computation of DTL for the purpose of CRR compliances: Liabilities of a bank may be in the form of demand or time deposits or borrowings or other miscellaneous items of liabilities Demand Liabilities- E.g. (current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. Money at Call and Short Notice from outside the Banking System should be shown against liability to others). Time LiabilitiesEg.(fixed deposits, cash certificates, cumulative and recurring

deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit, if not payable on demand, deposits held as securities for advances which are not payable on demand and Gold deposits). Other Demand and Time Liabilities (ODTL)- Eg.( interest accrued on deposits, bills payable, unpaid dividends, suspense account balances representing amounts due to other banks or public, net credit balances in branch adjustment account, any amounts due to the banking system which are not in the nature of deposits or borrowing). Assets with the Banking System-Eg. ( balances with banks in current account, balances with banks and notified financial institutions, loans or deposits repayable at call or short notice of a fortnight or less and loans other than money at call and short notice made available to the banking system) Borrowings from abroad by banks in India Arrangements with Correspondent Banks for Remittance Facilities

Liabilities not to be included for DTL/NDTL computation Paid up capital, reserves, any credit balance in the Profit & Loss Account of the bank, amount of any loan taken from the RBI and the amount of refinance taken from EXIM Bank, NHB, NABARD, SIDBI Net income tax provision Amount received from DICGC towards claims and held by banks pending adjustments thereof; ECGC by invoking guarantee. The liabilities arising on account of utilization of limits under Bankers Acceptance Facility (BAF) District Rural Development Agency (DRDA) subsidy of Rs.10, 000/- kept in Subsidy Reserve Fund account in the name of Self Help Groups; Subsidy released by NABARD under Investment Subsidy Scheme for

Construction/Renovation/Expansion of Rural Godowns; Net unrealized gain/loss arising from derivatives transaction under trading portfolio; Income flows received in advance such as annual fees and other charges which are not refundable. Bill rediscounted by a bank with eligible financial institutions as approved by RBI Provision not being a specific liability arising from contracting additional liability and created from profit and loss account. Exempted Categories SCBs are not required to include inter-bank term deposits/term borrowing liabilities of original maturities of 15 days and above and up to one year in "Liabilities to the Banking System". Similarly banks should exclude their inter-bank assets of term deposits and term lending of original maturity of 15 days and above and up to one year in "Assets with the Banking System" (item III of Form A return) for the purpose of maintenance of CRR. The interest accrued on these deposits is also exempted from reserve requirements.

Maintenance of CRR on Daily Basis With a view to providing flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra fortnight cash flows, all SCBs are required to maintain minimum CRR balances up to 70 per cent of the average daily required reserves for a reporting fortnight on all days of the fortnight with effect from the fortnight beginning December 28, 2002. The Reserve Bank does not pay any interest on the CRR balances maintained by SCBs with effect from the fortnight beginning March 31, 2007. Penalties Default in maintenance of CRR requirement on a daily basis (70% of total CRR requirement): penal interest will be recovered for that day at the rate of three per cent per annum above the Bank Rate & if the shortfall continues on the next succeeding day/s, penal interest will be recovered at the rate of five per cent per annum above the Bank Rate. Default in maintenance of CRR on average basis during a fortnight, penal interest will be recovered as envisaged in sub-section (3) of Section 42 of Reserve Bank of India Act, 1934. SCBs are required to furnish the particulars such as date, amount, percentage, reason for default in maintenance of requisite CRR and also action taken to avoid recurrence of such default. Fortnightly Return Form: SCBs are required to submit to Reserve Bank a provisional Return in Form 'A' within 7 days from the expiry of the relevant fortnight. For reporting in Form 'A' return, banks should convert their overseas foreign currency assets and bank credit in India in foreign currency in four major currencies viz., US dollar, GBP, Japanese Yen and Euro into rupees at the Foreign Exchange Dealers Association of India's (FEDAI) noon mean rate on reporting Friday.

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Maintenance of SLR The value of such assets of a SCB shall not be less than such percentage not exceeding 40 per cent of its total DTL in India as on the last Friday of the second preceding fortnight as the Reserve Bank may, by notification in the Official Gazette, specify from time to time. SCBs can participate in the Marginal Standing Facility (MSF) scheme introduced by Reserve Bank of India. Under this facility, the eligible entities may borrow overnight, up to one per cent of their respective NDTL outstanding at the end of the second preceding fortnight. Every SCB has to maintain in India assets as detailed below:Cash Gold valued at a price not exceeding the current market price Investment in the following instruments which will be referred to as "Statutory Liquidity Ratio (SLR) securities" T-Bills, SDLs, dated securities, etc. Encumbered SLR securities shall not be included for the purpose of computing the percentage specified. Procedure for Computation of SLR SCBs are required to include inter-bank term deposits / term borrowing liabilities of all maturities in Liabilities to the Banking System. Similarly, banks should include their inter bank assets of term deposits and term lending of all maturities in Assets with the Banking System for computation of NDTL for SLR purpose. Penalties: Same as in case of non maintenance of CRR, however in case of SLR the bank needs to maintain 100% SLR requirement as prescribed by RBI. Return in Form VIII (SLR) Banks should submit to the Reserve Bank before 20th day of every month, a return in Form VIII showing the amounts of SLR held on alternate Fridays during immediate preceding month with particulars of their DTL in India held on such Fridays

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4. Asset-Liability Management

Asset Liability Management is the heart of every system particularly of Banks and Financial Institutions. We define Asset Liability Management is the process of decisi on making to control risks of existence, stability and growth of a system through the dynamic balancing of its assets and liabilities.

Importance of Asset Liability Management: In a deregulated environment since 1999, Indian banks are free to determine their own interest rates on deposits and advances in both domestic and foreign currencies on a dynamic basis. To decide a priori the impact of positive or negative changes on existing interest rate along with the target value of change there is a need to do sensitivity analysis of interest rate with respect to profitability, interest spread, and long-term viability. This scenario gives rise to the basic risks outlined as follows: 1. Interest rate risk: It is the risk of having a negative impact on banks futu re earnings and on the market value of its equity due to changes in interest rate. 2. Liquidity risk: It is the risk of having insufficient liquid assets to meet the liabilities at a given time. 3. Forex risk: It is the risk of having losses in foreign exchange assets and liabilities due to changes in exchange rates among multi-currencies under consideration. In order to address various financial risks and take proactive steps banks are required to introduce effective risk management systems in place. Asset Liability Management is concerned with risk management and it provides a comprehensive and dynamic framework for measuring, monitoring and managing associated risks. Asset Liability Management enforces the best practices of risk management to fulfill business and strategic objectives of the organization. ALM provides best strategies for managing funds of public for best returns and targets towards increasing the market value of equity

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Classification of Assets and Liabilities: For Asset Liability Management purpose the assets and liabilities are classified into different time periods popularly called as time or maturity buckets, depending on maturity profile and interest rate sensitivity. As per RBI guidelines issued for ALM implementation for Banks in 1999, there are 8 time buckets T-1 to T-8 classified respectively as follows:

i) 1 to 14 days ii) 15 to 28 days iii) 29 days and upto 3 months iv) Over 3 months and upto 6 months v) Over 6 months and upto 1 year vi) Over 1 year and upto 3 years vii) Over 3 years and upto 5 years viii) Over 5 years

Having regard to the international best practices, the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management, RBI has amended the bucketing structure as follows I. II. III. IV. V. VI. 1 day 2 to 7 days 8 to 14 days 15 to 28 days 29 days and up to 3 months Over 3 months and up to 6 months

VII. Over 6 months and up to 1 year VIII. Over 1 year and up to 3 years IX. X. Over 3 years and up to 5 years Over 5 years

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Asset Liability Management Committee (ALCO): ALM is an integrated activity requiring consolidated information from various sources and departments of an organization. The first step of the ALM process is to constitute a committee known as Asset Liability Committee (ALCO). The ALCO should generally have at least 4 members and a maximum of 8 members consisting of the bank's senior management from various departments including Chairman & Managing Director (CMD). It should be responsible for setting business policies, periodic review and ensuring adherence to the limits set by the Board as well as for deciding the next business strategy of the bank. The diagram below indicates the structure of ALCO and flow of reporting to the Board of Directors. ALM involves viewing the balance sheet as a complex interest rate arbitrage where funds are obtained from several sources with varying interest rates and employed in a wide variety of assets at rates high enough to cover interest paid on the liabilities and the operating expenses to produce profits. The structure of ALCO with selected executive members from various departments is shown in the figure below:

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The important functions of ALCO are: Define business policies and strategies Review economic scenario Articulate the interest rate view Price assets and Liabilities Establish investment policy guidelines Examine loan portfolio Measure liquidity risk, interest rate risk and FOREX risk particularly Review performance of the bank Involve in budgeting/planning Report, reviews, and developments at regular intervals to CMD, Management Committee (Supervisory Authority of ALCO) and to the Board Since ALCO is the driving force of the Bank, the co-ordination and dedication of its members, factual criticisms, use of analytical models and corrective risk measures, periodic reviews, support of real time triggers etc. help in the healthy growth of the organization.

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4.1

Asset Liability Management Models:

Analytical models are very important for ALM analysis and scientific decision making. The basic models (i) (ii) (iii) (iv) (v) GAP Analysis Model Duration GAP Analysis (DGAP) Model Scenario Analysis Model Value at Risk (VaR) Model Stochastic Programming (SP) Model

Gap Analysis (GAP) Model:


GAP model for asset liability management is concerned with measuring interest rate risk by finding the pattern of the net interest income over a given period of time. In this model the assets and liabilities are classified into different time periods (buckets) based on maturity pattern. Gap is defined as the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL). GAP = RSA RSL Gap may be (i) Positive Gap where GAP > 0 and (ii) Negative Gap where GAP < 0 with following general characteristics, (iii) Gap being zero is the equilibrium state.

Advantages of GAP Model: Simple to analyze Easy to implement. Helps in Future analysis on Interest rate risk. Helps in Projecting NII for further analysis. 16

Disadvantages of GAP Model: Ignores the time value of assets and liabilities. Does not consider the embedded options like premature withdrawal of deposits and prepayment of loans.

Example: Let us consider an XYZ Bank for which the maturity pattern of Assets and Liabilities as on a particular date, say 31.03.2004 is given in the table No.1 below

Here Rs.705.55 crores in the deposit liability of column-2 means that as on March 31, 2004 the bank is liable to repay this amount including the interest during the next 14 days on account of deposit received by the bank till date. Similarly Rs.376.05 crores in the loans and advances asset of column-5 indicates that as on March 31, 2004 the bank is expected to get back this amount during the next 14 days of the loans and advance that it has given till date.

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The results obtained using the formulas stated above are shown in Table No.2:

Observations: From the above results in Table No.2, GAP amount in col 4 is negative till 3-5 years period and positive for the last period, which means XYZ Bank can be grouped as Liability Sensitive. Long-term assets are funded with Short-term liabilities, and bank will benefit as Net interest income increases with decrease in interest rates as shown in col 7 for an example of decrease in rate of interest of 0.25%. Cumulative GAP amount in col 5 is also negative for all time periods. Gap Ratio in col 6 is between 0.30 and 0.92 up to 3 -5 years period indicating inflows are always less than outflows and for the last time period inflows are double than the outflows.

Duration Gap Analysis (DGAP) Model:

Duration is defined as the weighted average maturity of a resource (asset or liability) where the net present values (NPV) of cash flows are used as weights. We use the notation DA to mean Duration of Assets and DL to mean Duration of liabilities.

Example-1: Duration of a 3-year loan with 12% as rate of simple interest and having market value is Rs.700 is calculated as follows:

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Duration=Total Cumulative Returns/Market Value (MV) of loan=1883.04/700 = 2.69 yrs Duration Gap (DG): A method to quantify interest rate risk involving a comparison of the potential changes in value of assets and liabilities that are affected by interest rate fluctuations over all relevant intervals. The duration of each asset or liability defines an interval that is assessed first. DG = DA (u*DL) --- (1) Where u = TL / TA; TL = Total Liabilities excluding Equity, TA = Total Assets

Example: Find the Duration Gap (DG) for the following assets and liabilities of an organization, if the value unit is Rupees (INR) and duration is in years.

* computed as in example-1. Here Total Assets (TA) = 100 + 700 + 200 = 1000 and Total Liabilities (TL) = 620 + 300 = 920 (Without Equity) DA = Weighted average of Duration of all Assets = [ MV(Ai) x DAi ] / TA for i = 1 to m; where Ai is the i th asset out of m assets = [700*2.69+200*4.99] /1000 = 2.88 yrs DL = Weighted average of Duration of Liabilities = [ MV(Lj) x DLj ] / TL for j = 1 to n; where Lj is the j th liability out of n liabilities = [620*1+300*2.81] /920 = 1.59 yrs 19

Duration GAP (DG) = DA- [TL/TA] DL = 2.88 - 1.59 [920/1000] = 1.42 years Duration gap (DGAP) models focus on the market value of equity. Duration gap analysis compares the duration of assets with duration of liabilities and calculates the market value of equity when interest rate fluctuates. First an interest rate forecast is prepared and it estimates the market value of assets, liabilities and equity. Then the weighted average duration of assets and weighted average duration of liabilities is estimated. From this duration gap is calculated. Now with fluctuations in forecasted interest rates the changes in market value of equity is calculated. Based on Duration Gap value i.e. positive, negative or zero with changes in interest rates net interest income is also effectively calculated. Duration analysis is useful in assessing the impact of interest-rate changes on market value of equity i.e. asset liability structure.

Advantages: Duration Gap analysis serves as a strategic planning tool for evaluating and controlling the interest rate risk. Duration Gap analysis improves on the maturity gap and cumulative gap models by taking into account the timing and market value of cash flows rather than horizon maturity. Offers flexibility in spread management. Instead of changing the maturity structure of assets and liabilities duration gap analysis puts emphasis on change of mix of assets or liabilities whichever is feasible.

Disadvantages: Requires extensive data on specific characteristics and current market pricing schedules of the financial instruments. Requires a high degree of analytical expertise regarding issues such as the term structure of interest rates and yield curve dynamics. 20

Value at Risk (VaR) Model: VaR is a method to quantify the risk associated with each asset and liability which in turn can be aggregated to arrive at a value for all the assets and liabilities of an organization. It involves computation of the mean (), standard deviation (), specification of confidence level (), and the range based on the specific probability distribution function. The volatility of the return for an asset or liability is computed as follows: Volatility = Standard Deviation (SD) / Mean x100 V = / x 100 --- (1) VaR helps to estimate the possible loss for each asset and liability. Example: (1) For single asset or liability:

Suppose a bank deploys Rs.200 Crore in securities and the volatility is 10%. Then we have to find out the daily volatility (VD) to know the Value at Risk on a given day. For this we use the formula as given below: Volatility A = Volatility Dt Or VA = VD x t --- (2) So, 10 = VD x 250, Assuming 250 working days are there in a year VD = 10 / 250 = 0.63% Value at Risk (VaR) for a given confidence level , say, 68% and Standard deviation of 1 is calculated as below: VaR = Value of Asset x Daily Volatility --- (3) VaR = 200 x 1 x 0.63% = 1.26 Crores assuming normal distribution. And Value at Risk with 95% confidence that has Standard Deviation of 2 is: VaR = 200 x 2 x 0.63% = 2.72 Crores.

(2) For Multiple assets or liabilities: Here we consider two cases as below: (a) Two assets or liabilities:

Value at Risk is a function of volatility, which depends on the volatilities of individual assets. Let A1 and A2 be the two assets and (A1, A2) be the correlation between them. If variance is given for individual assets, we have to calculate Standard Deviation from that and to derive Correlation between them use the following formula given below: (A1,A2) = Covariance (A1,A2) / [ var(A1) x var(A2) ] ---(4) variance of (A1, A2) = var (A1) + var (A2) + 2 x Covariance(A1,A2) ---(5) 21

Example: If we invest Rs.200 Crores each in two assets A1 and A2 with given below details: Variance of A1 = 81, Variance of A2 = 36 and correlation (A1,A2) = 0.25 then calculate Value at Risk for each asset. Solution: Standard Deviation of A1 = 81 = 9 Standard Deviation of A2 = 36 = 6 Covariance of (A1,A2) = (A1,A2) x [var(A1) x var(A2)] = 0.25 x 81 x 36 = 0.25 x 9 x 6 = 13.5 variance of (A1,A2) = var(A1) + var(A2) + 2 x Covariance(A1,A2) = 81 + 36 + 2 x 13.5 = 144 Standard Deviation of (A1, A2) = 144 = 12 If these assets are invested for two years Daily volatility will be 0.45%, if the rate of return which is 10% decreases to 8% then computation of minimum and maximum loss on both assets with a confidence level of 95% will be as given below: Range of return: when confidence level is 95% and SD is 2 then maximum rate of return will be 10.90 and minimum return will be 9.10. Then the minimum loss will be Rs.2.2 Crores and maximum loss will be Rs.5.8 Crores.

(b) When more than two assets or liabilities are considered: Let A1, A2 an be the n assets. There are nc2 = n (n-1)/2 number of correlations between them which can be represented by a matrix [(Ai,Aj)] where i, j ranges between 1 to n. It is a square matrix of order n. From which one can derive covariance and standard deviation for calculating Value at Risk.

Uses of VaR: Translates portfolio exposures into potential profit and loss Aggregates and reports multi-product, multi-market exposures into one number Uses risk factors and correlations to create a risk weighted index Monitors VaR limits Meets external risk management disclosure and expectations.

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5. Capital Adequacy
Capital Adequacy is a measure to check the stability of an institution to withstand financial shocks due to exposures into various risks. Banks maintain a prescribed minimum capital in the form of Capital to Risk Adequacy Ratio (CRAR) in order to cover the aforesaid risks. Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure. The Basle Committee on Banking Supervision (BCBS)s New Framework on Capital Adequacy (NCAF) takes into account the elements of credit, market & operational risk in various types of assets in the balance sheet as well as off-balance sheet business and also to strengthen the capital base of banks. The Revised Framework consists of three-mutually reinforcing Pillars, viz. minimum capital requirements, supervisory review of capital adequacy, and market discipline. The BCBS recommends 3 distinct Pillars viz, Pillar 1,2 & 3 for computing the minimum Capital Charge, Supervisory Review and Market Discipline respectively.

BASEL REQUIREMENT

MINIMUM CAPITAL REQUIREMENT Pillar 1

SUPERVISORY REVIEW Pillar 2

MARKET DISCIPLINE Pillar 3

CREDIT RISK

OPERATIONAL RISK

MARKET RISK

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The Standardized Approach is the most widely used approach to compute the capital charge requirement for Credit, Operational and Market Risks. Having regard to the necessary upgradation of risk management framework as also capital efficiency likely to accrue to the banks by adoption of the advanced approaches envisaged under the Basel II Framework and the emerging international trend in this regard, it was considered, in July 2009, desirable to lay down a timeframe for implementation of the advanced approaches in India. This would enable banks to plan and prepare for their migration to the advanced approaches for computing capital charge. Keeping in view the likely lead time that may be needed by banks for creating the requisite technological and the risk management infrastructure, including the required databases, the MIS and the skill up-gradation, etc., the following time schedule has been laid down for implementation of the advanced approaches for the regulatory capital measurement.

Accordingly, the banks were advised to undertake an internal assessment of their preparedness for migration to advanced approaches, in the light of the criteria envisaged in the Basel II document, as per the aforesaid time schedule, and take a decision, with the approval of their Boards, whether they would like to migrate to any of the advanced approaches. 24

Capital Funds

The RBI prescribes Capital funds are broadly classified as Tier I and Tier II capital. Tier I capital is basically the quality capital whereas Tier II Capital is just a supplementary capital. Elements of Tier II capital will be reckoned as capital funds up to a maximum of 100 per cent of Tier I capital.

Elements of Tier I capital

For Indian banks 1. Paid-up equity capital, statutory reserves, and other disclosed free reserves 2. Reserves representing surplus arising out of sale proceeds of assets 3. Innovative perpetual debt instruments (IPDI) & Perpetual Non-Cumulative Preference Shares (PNCPS)

For foreign banks in India

1. Interest-free funds from Head Office kept in a separate account 2. Statutory reserves kept in Indian books 3. Interest-free funds remitted from abroad for the purpose of acquisition of property and held in a separate account 4. Capital reserve representing surplus arising out of sale of assets in India held in a separate account and which is not eligible for repatriation so long as the bank functions in India.

Limits on eligible Tier I Capital 1. IPDIs eligible to be reckoned as Tier I capital, will be limited to 15 percent of total Tier I capital 2. PNCPSs along with Innovative Tier I instruments shall not exceed 40 per cent of total Tier I capital at any point of time 3. Innovative instruments / PNCPS, in excess of the limit shall be eligible for inclusion under Tier II

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Elements of Tier II Capital

1. Revaluation Reserves 2. General Provisions and Loss Reserves 3. Hybrid Debt Capital Instruments 4. Subordinated Debt 5. Excess of IPDIs &PNCPSs

Limits on Tier II Capital

1. Upper Tier II instruments along with other components of Tier II capital shall not exceed 100 per cent of Tier I capital 2. Subordinated debt instruments eligible for inclusion in Lower Tier II capital will be limited to 50 percent of Tier I capital after all deductions

Capital to Risk Weighted Assets Ratio CRAR are a measure of the amount of a bank's core capital expressed as a percentage of its risk-weighted asset. Capital adequacy ratio is defined as

Tier I CRAR =

Eligible Tier I capital funds Credit Risk RWA* + Market Risk RWA + Operational Risk RWA

Total CRAR =

Eligible total capital funds Credit Risk RWA + Market Risk RWA + Operational Risk RWA

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5.1

Calculation Of Capital Charge (Market Risks) For The Investments Treasury

The focus area of this project work would be primarily about the computation of capital charge for market risk.

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are: The risks pertaining to interest rate related instruments and equities in the trading book; and

Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

The capital charge for interest rate related instruments and equities would apply to current market value of these items in banks trading book. Since banks are required to maintain capital for market risks on an ongoing basis, they are required to mark to market their trading positions on a daily basis. The current market value will be determined as per extant RBI guidelines.

The minimum capital requirement is expressed in terms of two separately calculated charges: Specific Risk charge for each security, which is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer, both for short (short position is not allowed in India except in derivatives) and long positions, and General Market Risk charge towards interest rate risk in the portfolio, where long and short positions (which is not allowed in India except in derivatives) in different securities or instruments can be offset.

For the debt securities held under AFS category, in view of the possible longer holding period and attendant higher specific risk, the banks shall hold total capital charge for market risk equal to or greater of:

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a) Specific risk capital charge, computed notionally for AFS securities treating them as held under HFT category plus the General Market Risk Capital Charge (as per Table 3 - Part A/C/E as applicable) b) Alternative total Capital Charge for the AFS category computed notionally by treating them as held in the banking book ( as computed in accordance with Table 3- Part B/D/F as applicable)

Trading book for the purpose of capital adequacy will include: (i) Securities included under the Held for Trading category (ii) Securities included under the Available for Sale category (iii) Open gold position limits (iv) Open foreign exchange position limits (v) Trading positions in derivatives, and (vi) Derivatives entered into for hedging trading book exposures.

Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day. Banks are also required to maintain strict risk management systems to monitor and control intra-day exposures to market risks.

Interest Rate Risk Specific Risk General Market Risk

Foreign Exchange Risk

Equity Risk Specific Risk General Market Risk

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Specific Market Risk:

The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. The risk weights to be used in this calculation must be consistent with those used for calculating the capital requirements in the banking book. Thus, banks using the standardized approach for credit risk in the banking book will use the standardized approach risk weights for counterparty risks in the trading book in a consistent manner. The specific risk charge where Government or Banks are counterparties will be as in Table 3 - Part A/B/C/D as applicable. The Specific Charge for all the other securities will be determined by the applicable risk weights assigned to them by the chosen external rating agencies as per Table 3- Part E/ F. The debt instruments which are eligible for inclusion as regulatory capital for capital adequacy purposes issued by banks which are meeting the minimum regulatory CRAR requirement (Tier 2 Bonds) have 9% Specific Risk Capital Charge. Specific risk charges for various kinds of exposures viz; 1) Central, State and Foreign Central Governments bonds (T-Bills) 2) Banks Bonds (CODs) 3) Corporate Bonds and Securitised debt (Debentures)

29

Table 3 Part A: Specific Risk Capital Charge for Sovereign securities issued by Indian and Foreign Sovereigns Held by banks under HFT Category Specific risk capital Sr.No. Nature of investment Maturity (as a % of exposure) A 1 Indian Central Government and State Governments Investment in Central Government and State Government Securities Investments in other approved securities guaranteed by Central Government All 0.0

All 6 months or

0.0

Investments in other approved securities guaranteed by State Government

less 6-24 months < 24 months

0.28 1.13 1.8

Investment in other securities where payment of 4 interest and repayment of principal are guaranteed by Central Government 6 months or Investments in other securities where payment of 5 less 0.28 1.13 1.8 All 0.0

interest and repayment of principal are guaranteed 6-24 months by State Government More than 24 months

B 1

Foreign Central Governments AAA to AA All 6 months or less 0.00 0.28 1.13 1.8 9.00 13.50

A to BBB

6-24 months More than 24 months

3 4

BB to B Below B

All All

30

Table 3 - Part B: Capital Charge for securities issued by Indian and Foreign Sovereigns Held by Banks under AFS Category

Total Sr.No. Nature of investment Maturity

Capital

Charge (as a % of exposure)

A 1 2

Indian Central Government and State Governments Investment in Government Securities Investments in other approved securities guaranteed by Central Government Investments in other approved securities guaranteed by State Government Investment in other securities where payment of All All 0.0 0.0

All

1.8

interest and repayment of principal are guaranteed by Central Government Investments in other securities where payment of

All

0.0

interest and repayment of principal are guaranteed by State Government

All

1.8

B 1 2 3 4 5

Foreign Central Governments AAA to AA A BBB BB to B Below B Unrated All All All All All All 0.00 1.80 4.50 9.00 13.50 13.50

31

Table 3 - Part C: Specific Risk Capital Charge issued by Scheduled Banks meeting minimum CRAR requirements Held by Banks under HFT Category Specific risk Sr.No. Nature of investment Residual Maturity capital (as a % exposure) 6 months or Claims on banks, including investment in securities which are guaranteed by banks as to payment of interest 1 and repayment of principal provided the counterparty bank is meeting the minimum regulatory CRAR requirement. less 6 to 24 0.28 of

months exceeding 24 months

1.13

1.8

Table 3- Part D: Alternative Capital Charge for Bonds issued by Scheduled Banks meeting minimum CRAR requirements- Held By Banks under AFS Category

Total Residual Maturity Capital Charge (as a % of

Sr.No. Nature of investment

exposure) Claims on banks, including investment in securities which are guaranteed by banks as to payment of interest 1 and repayment of principal provided the counterparty bank is meeting the minimum regulatory CRAR requirement. All 1.8

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Table 3: Part E: Specific Risk Capital charge for Corporate Bonds (other than Bank Bonds) Held By Banks under HFT Category.

Long term ratings of chosen credit Residual agencies Maturity

Specific Risk Capital Charge < 6 months 1.8 2.7 4.5 9 13.5

rating

operating in India

AAA to BBB

6-24 months >24 months

BBB BB & Below

All All

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Table 3 - Part F: Capital charge for Corporate Bonds (other than Bank Bonds) Held By Banks under AFS Category.

Long term ratings of chosen credit rating agencies operating in India AAA AA A BBB BB & Below Unrated

Total Capital Charge 1.8 2.7 4.5 9 13.5 13.5

The above table illustrates the amount of Specific Risk Capital Charge for Sovereign securities issued by Indian and foreign sovereigns Held by banks under several categories. Depending on the banks nature of investment into specific instruments, the total capital charge would be a weighted sum of individual instruments multiplied by specific risk capital charge. Similarly, RBI prescribes specific risk capital charge in the AFS category as well.

General Market Risk


The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market interest rates.

Maturity Method
Standard Method Methodologies Internal Methods Modified Duration

34

The standardized methods there are two principal methods of measuring market risk, a maturity method and a duration method. As duration method is a more accurate method of measuring interest rate risk, it has been decided to adopt standardised duration method to arrive at the capital charge. Accordingly, banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately.

Under this method, the mechanics are as follows:

Calculate the price sensitivity (modified duration) of each instrument

Duration (Macaulay duration) measures the price volatility of fixed income securities. It is often used in the comparison of the interest rate risk between securities with different coupons and different maturities. It is the weighted average of the present value of all the cash flows associated with a fixed income security. It is expressed in years. The duration of a fixed income security is always shorter than its term to maturity, except in the case of zero coupon securities where they are the same.

Macaulay duration = PVCF x t PVCF

The modified duration or volatility of an interest bearing security is its Macaulay duration divided by one plus the coupon rate of the security. It represents the percentage change in a securities' price for a 100 basis points change in yield. It is generally accurate for only small changes in the yield.

MD = - dP x 1 dY P

The weighted duration is computed by multiplying the modified duration of the security with the market exposure. The capital charge for general market risk would be the product of the weighted duration and the assumed change in yield as explained below. 35

The assumed change in yield to the modified duration of each instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument

Slot the resulting capital charge measures into a maturity ladder with the fifteen time bands as set out. Subject long and short positions (short position is not allowed in India except in derivatives) in each time band to a 5% vertical disallowance designed to capture basis risk

Carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out.

36

Computation of Capital Charge

37

Proforma of consolidated calculation of Capital Charge for Market Risk

The following table shows the CRAR of Federal bank for 2012-13 which is maintained at 16.64% . Capital Equity Capital Net Worth Capital Adequacy Ratio Tier 1 Tier 2 2011-12 171.05 5706.33 16.64 15.86 0.78 2010-11 171.05 5108.66 16.79 15.63 1.16 11.70% Growth

This means that 16.64% of the Banks total Capital is maintained for the purpose of Capital Adequacy. We can look at the glass half empty or half full. One that the bank is very conservative in their approach and they are not capitalizing on their opportunity i.e. misallocating the capital as a result. Second, the bank is well prepared to withstand huge financial shocks due to the high CRAR maintained.

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5.2

Pillar II- Supervisory Review and Evaluation Process (SREP)

The objective of the SRP is to ensure that banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks. This in turn would require a well-defined internal assessment process within banks through which they assure the RBI that adequate capital is indeed held towards the various risks to which they are exposed. The process of assurance could also involve an active dialogue between the bank and the RBI so that, when warranted, appropriate intervention could be made to either reduce the risk exposure of the bank or augment / restore its capital. Thus, ICAAP (Internal Capital Adequacy Assessment Process) is an important component of the SRP. The main aspects to be addressed under the SRP, and therefore, under the ICAAP, would include: (a) the risks that are not fully captured by the minimum capital ratio prescribed under Pillar 1 (b) the risks that are not at all taken into account by the Pillar 1 (c) the factors external to the bank.

Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is only the regulatory minimum level, addressing only the three specified risks (viz., credit, market and operational risks), holding additional capital might be necessary for banks, on account of both the possibility of some under-estimation of risks under the Pillar 1 and the actual risk exposure of a bank vis--vis the quality of its risk management architecture. Illustratively, some of the risks that the banks are generally exposed to but which are not captured or not fully captured in the regulatory CRAR would include:

(a) Interest rate risk in the banking book; (b) Credit concentration risk; (c) Liquidity risk; (d) Settlement risk; (e) Reputational risk; (f) Strategic risk; (g) Risk of under-estimation of credit risk under the Standardised approach; (h) Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches; (i) Risk of weakness in the credit-risk mitigants; (j) Residual risk of securitisation, etc. 39

It is, therefore, only appropriate that the banks make their own assessment of their various risk exposures, through a well-defined internal process, and maintain an adequate capital cushion for such risks. Banks were advised to develop and put in place, with the approval of their Boards, an ICAAP commensurate with their size, level of complexity, risk profile and scope of operations. The ICAAP, which would be in addition to a banks calculation of regulatory capital requirements under Pillar 1, has been operationalised with effect from March 31, 2008 by the foreign banks and the Indian banks with operational presence outside India, and from March 31, 2009 by all other commercial banks, excluding the Local Area Banks and Regional Rural banks. The ICAAP Document would be a comprehensive Paper furnishing detailed information on the ongoing assessment of the banks entire spectrum of risks, how the bank intends to mitigate those risks and how much current and future capital is necessary for the bank, reckoning other mitigating factors. The purpose of the ICAAP document is to apprise the Board of the bank on these aspects as also to explain to the RBI the banks internal capital adequacy assessment process and the banks approach to capital management. The ICAAP could also be based on the existing internal documentation of the bank. The ICAAP document should, inter alia, include the capital adequacy assessment and projections of capital requirement for the ensuing year, along with the plans and strategies for meeting the capital requirement. The ICAAP Document should contain the following sections:

I. Executive Summary II. Background III. Summary of current and projected financial and capital positions IV. Capital Adequacy V. Key sensitivities and future scenarios VI. Aggregation and diversification VII. Testing and adoption of the ICAAP VIII. Use of the ICAAP within the bank

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5.3

Pillar III- Market Discipline

The purpose of Market discipline in the Revised Framework is to complement the minimum capital requirements ( Pillar I and the supervisory review process detailed under Pillar 2). The aim is to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.

It facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. Operates by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution Qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually

The following sections are the disclosure requirements under Pillar 3.

Scope of Application Capital Structure Capital Adequacy Credit Risk: General Disclosures for All Banks Credit Risk: Disclosures for Portfolios Subject to the Standardised Approach Credit Risk Mitigation: Disclosures for Standardised Approaches Securitization Exposures: Disclosure for Standardised Approach Market Risk in Trading Book Operational Risk Interest Rate Risk in the Banking Book (IRRBB)

41

6. Internal Models Approach (IMA)


Basel II Framework offers a choice between two broad methodologies in measuring market risks for the purpose of capital adequacy. One methodology is to measure market risks in a standardised manner as per the Standardised Measurement Method (SMM) which is being used by banks in India since March 31, 2005. The alternative methodology known as Internal Models Approach (IMA) is also available which allows banks to use risk measures derived from their own internal market risk management models. The permissible models under IMA are the ones which calculate a value-at-risk (VaR)-based measure of exposure to market risk. VaR-based models could be used to calculate measures of both general market risk and specific risk. As compared to the SMM, IMA is considered to be more risk sensitive and aligns the capital charge for market risk more closely to the actual losses likely to be faced by banks due to movements in the market risk factors. The alternative method, viz., the IMA envisages use of banks own internal market risk management models for deriving risk measures for determining regulatory capital requirements for market risk, after the internal models have been approved by the supervisor. Compared to the SMM, the IMA is considered to be more risk sensitive and aligns the capital charge for market risk more closely to the actual losses likely to be incurred by banks due to movements in the market risk factors. With a view, therefore, to provide a wider choice to banks in selecting a method for determining the regulatory capital requirement for their market risk exposure, it was decided to introduce the IMA in India.

Under the IMA, the capital requirement for market risk will consist of the following two components, based on VaR measure:

a) General Market Risk Charge; b) Specific Risk Charge [including Incremental Risks Charge (IRC) for interest rate instruments] The guidelines for the IMA will be applicable to:

a) The risks pertaining to interest rate-related instruments and equities in the trading book; b) Exchange rate risk (including open position in gold) throughout the bank, that is, both in the banking book and trading book;

42

[In the case of foreign currency instruments, including derivatives, in addition to the exchange rate risk, the interest rate risk and equity price risk, as applicable, will also have to be captured]; and c) The risks relating to investments in mutual funds kept in trading book.

At present, the SMM is applicable to both Held-For-Trading (HFT) and Available for Sale (AFS) portfolios. Generally, the positions held in the AFS are more illiquid and the market prices for them may not be available or may be available with a very low frequency due to low trading volumes. Therefore, it would not be feasible to compute meaningful VaR measures for AFS portfolios. Accordingly, the trading book for the purpose of these guidelines will consist of only Held-For-Trading (HFT) portfolio, which will also include trading positions in derivatives and the derivatives transactions entered into for hedging trading book exposures. The AFS portfolio should continue to be under SMM for computation of capital charge for market risk.

Combination of SMM and IMA

The internal models approach will in principle require banks to have an integrated risk measurement system that captures the broad risk factor categories (i.e. interest rates, exchange rates (which may include gold), equity prices, with related options volatilities being included in each risk factor category. However, if a banks exposure to a particular risk factor is insignificant, it may request, in its letter of intent, exemption from application of standards of these guidelines for that risk factor. For such factors RBI, may allow banks to use the SMM for calculation of capital. However, banks which start to use models for one or more risk factor categories will, over time, be expected to extend the models to all their market risks. A bank which has developed one or more models will no longer be able to revert to measuring the risk measured by those models according to the SMM (unless, of course, RBI withdraws approval for that model). However, pending further experience regarding the process of changing to a models-based approach, no specific time limit will be set for banks now which use a combination of internal models and the SMM to move completely to IMA. The conditions mentioned below will apply to banks using such combinations. Banks can adopt the IMA for one or more of the broad risk factors and remain on SMM for other risk factors. However, each broad risk factor category must be assessed using a single approach (either internal models or the standardised approach), i.e. no combination of the two methods will in principle be permitted within a risk category or across banks different 43

entities for the same type of risk. This flexibility will be subject to explicit approval of RBI and will be reviewed regularly to ensure that there is no cherry-picking between SMM and IMA within a risk factor category. Banks should progressively adopt IMA for all broad risk factors so as to achieve integrated risk measurement system. In this regard, banks have to produce before RBI a credible plan for extending IMA to entire spectrum of market risk exposure. No element of market risk may escape measurement, i.e. the exposure for all the various risk factors, whether calculated according to the standardised approach or internal models would have to be captured; The capital charges assessed under the standardised approach and under the internal models approach are to be aggregated according to simple summation.

44

7. Value at Risk (VaR)


VaR (Value-at-Risk) was introduced precisely with the purpose of providing a one dimensional approximation of the infinitely dimensional risk. It provides an integrated way to deal with different markets and different risks and to combine all of the factors into a single number which is a good indicator of the overall risk level. The common measure used to express market risk is value-at-risk (VaR). The Table below shows the evolution of various risk measurement tools that has been put forth to the financial world over the years. The greatest benefit of VAR lies in the imposition of a structured methodology for critically thinking about risk. Institutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and to set up a proper risk management function. Thus the process of getting to VAR may be as important as the number itself. -Philippe Jorion

Value-at-Risk (VaR) has been widely promoted by regulatory authorities as a way of monitoring and managing market risk and as a basis for setting regulatory minimum capital standards. The VAR revolution started in 1993 when it was endorsed by the Group of Thirty (G-30) as part of best practices for dealing with derivatives. The methodology behind VaR, however, is not new. It results from a merging of finance theory, which focuses on the pricing and sensitivity of financial instruments, and statistics, which studies the behavior of the risk factors. It is an attempt to provide a single number summarizing the total risk in a portfolio of financial assets. It has become widely used by corporate treasurers and fund managers as well as by financial institutions. Bank regulators also use VaR in determining the capital a bank is required to keep for the risks it is bearing.

In its most general form, the Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. It is a measure of the loss (expressed in say rupees crores) on the portfolio that will not be exceeded by the end of the time period with the specified confidence level. If is the confidence level and T days is the time period, the calculation of VaR is based on the probability distribution of changes in the portfolio value over T days. Specifically, VaR is set equal to the loss in the portfolio at the (1-)*100 percentile point of the distribution. Thus, if the VaR on an asset is Rs 100 Crores at a one-week, 95% confidence level, there is a only a 5% chance that the value of the asset will drop more than Rs 100 Crores over any given week. Thus when applied in case of normal market risk, VaR indicates the possible maximum loss which will be suffered in a specified 45

period and at a specified confidence level from a fall in the price of security or exchange rate, given historic data on the price behaviour of the security or assessment of likely future market movements. It is a probability that specifies that the loss wont exceed a particular amount. The relationship between probability level p and confidence level is described as =100*(1p).VaR is an estimate of the potential loss, always for a given period at a given confidence level. This concept is applied to calculate risk content of an individual security, foreign exchange position, equity share or a portfolio of these instruments.

Table 3: Defining Value at risk

The inputs used to calculate VaR for a certain asset are the volatility, time horizon and a choice of confidence level () and the current MTM position (W). The volatility is estimated implicitly from option pricing or through statistical models (). In practice, past observations are often used to estimate the future volatility. The time period (T) chosen affects both the measured volatility and therefore also the VaR, where a longer time period gives a higher volatility measure and hence, a higher VaR. The chosen confidence interval states how often the loss on the specific asset will be greater than the VaR. The most commonly used confidence intervals are 95% and 99%. The formula to calculate VaR for one asset is: VaR = WT To calculate the portfolio VaR the formula below is used:

This methodology uses the above formulae in calculating VaR It is also called delta normal or VAR COVAR or variance method. 46

7.1

VaR PARAMETERS

1.

CONFIDENCE LEVEL To measure VAR, we first need to define two quantitative parameters, the confidence level and the horizon. It can be seen that higher the confidence level, the greater the VAR measure. Varying the confidence level provides useful information about the return distribution and potential extreme losses. It is not clear, however, whether one should stop at 99%, 99.9%, 99.99% and so on. Each of these values will create an increasingly larger loss, but less likely. Another problem is that, as increases, the number of occurrences below VAR shrinks, leading to poor measures of large but unlikely losses. The choice of the confidence level depends on the use of VAR. For most applications, VAR is simply a benchmark measure of downside risk. If so, what really matters is of the VAR confidence level across trading desks or time. The usual recommendation is to pick a confidence level that is not too high, such as 95 to 99 percent.

2. HORIZON It is seen that longer the horizon (T), greater the VaR measure. This extrapolation depends on two factors, the behaviour of the risk factors, and the portfolio positions. To extrapolate from a one-day horizon to a longer horizon, we need to assume that returns are independently and identically distributed. This allows us to transform a daily volatility to multiple-day volatility by multiplication by the square root of time. We also need to assume that the distribution of daily returns is unchanged for longer horizons, which restricts the class of distribution to the so-called stable family, of which the normal is a member. VaR has two parameters: the time horizon N, measured in days, and the confidence level X. In practice, analysts almost invariably set N = 1 in the first instance. This is because there is not enough data to estimate directly the behavior of market variables over periods of time longer than I day. The usual assumption is N-day VaR = 1-day VaR x N

This formula is exactly true when the changes in the value of the portfolio on successive days have independent identical normal distributions with mean zero. In other cases its is an approximation.

47

The Basel committee for Banking Supervision recommends calculation of capital for trading book using VaR measure with N=10 & X=99%. This means that it focuses on revaluation losses over a 10 day period which is expected to exceed only 1% of the times. The capital it requires the bank to hold is k times this VaR measure. The multiplier k varies from bank-tobank basis and RBI recommends that it must be atleast 3. Federal Bank uses this VaR multiplier and subsequently increases the value for higher level of exceptions as explained under Back Testing. Given the way a 10-day VaR is calculated, this minimum capital level is 3 x 10 = 9.49 times the 1-day 99% VaR.

If so, we have VaR (T days) = VaR (1 day) * T

This requires (1) The distribution to be invariant to the horizon (i.e., the same, as for the normal), (2) The distribution to be the same for various horizons (i.e., no time decay in variances), and (3) VaR can be extended from a 1 day horizon to days by multiplication by the square root of time. This adjustment is valid with i.e. returns that have a normal distribution. The choice of the horizon also depends on the characteristics of the portfolio. If the positions change quickly, or if exposures (e.g., option deltas) change as underlying prices change, increasing the horizon will create slippage in the VaR measure. Again, the choice of the horizon depends on the use of VaR. If the purpose is to provide an accurate benchmark measure of downside risk, the horizon should be relatively short, ideally less than the average period for major portfolio rebalancing. In contrast, if the VaR number is being used to decide how much capital to set aside to avoid bankruptcy, then a long horizon is advisable. Typically, banks measure P&L on a daily basis, and corporate on a longer interval (ranging from daily to monthly). This interval is the minimum horizon for VaR.

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7.2

VaR Models

Essentially there are three VaR models ,i.e. Parametric ,Non Parametric and Semi Parametric Models .While Historic Simulation method comes under Non Parametric method ,the Variance Co variance method , Risk Metrics( Delta Normal Method) ,GARCH etc models comes in Parametric models . Extreme Value Theory, Quasi Maximum GARCH comes under the Semi Parametric model types. Although there are numerous methods of calculating VaR, the 3 main methods are Historic Simulation Method, Variance co variance method and Monte Carlo simulation method are the most popular.

(A) Variance Co Variance Method The simplest possible VaR method is the normal (covariance) method. This is a parametric method, based on the assumption that the returns are normally distributed. Historical data is used to measure the major parameters: means, standard deviations, correlations. The overall distribution of the market parameters is constructed from this data. Using the risk mapping technique, the distribution of the profits and losses over the time horizon (typically one day) can be found. When the market value of the portfolio is a linear function of the underlying parameters, the distribution of the profits is normal as well. Therefore, the 5% quantile corresponding to VaR can be calculated at 1.65 below the mean (2.33 will give the 1% level). For example, consider the returns of Nifty Index Fund, which is Normally distributed over the Horizon. The average return of the fund is 8% with a standard deviation of 4%. The 99% VaR for the portfolio can be computed as 99%VaR= -Z * i.e -2.33 * 4= -9.32%. This means that, 99% of the times, the portfolio would give a returns of more than -9.32%. However, 1% of the times, the losses would exceed 9.32%. In case of two assets, the standard deviation is calculated as follows,

Where,

is the correlation co-efficient between the 2 assets.

49

Advantages: The Variance Covariance Method is easy to implement because it involves a simple matrix multiplication. It is also computationally fast, even with a large number of assets, because it replaces each position by its linear exposure. Portfolios that are linear combinations of normally distributed risk factors are themselves normally distributed. It only requires the market values and exposures of current positions, combined with risk data. Also, in many situations, the delta-normal method provides adequate measurement of market risks. As a parametric approach, VaR is easily amenable to analysis, since measures of marginal and incremental risk are a by-product of the VaR computation. Disadvantages: A first problem is the existence of fat tails in the distribution of returns on most financial assets. These fat tails are particularly worrisome precisely because VaR attempts to capture the behaviour of the portfolio return in the left tail. In this situation, a model based on a normal distribution would underestimate the proportion of outliers and hence the true Valueat-Risk. Another problem is that the method inadequately measures the risk of nonlinear instruments, such as options or mortgages. Asymmetry in the distribution of options is not captured by the Variance-Covariance Method.

(B)Historical Simulation Method The historic simulation method for calculating VaR is the simplest and avoids some of the pitfalls of the correlation method. Specifically the three main assumptions behind correlation (normally distributed returns, constant correlations, and constant deltas) are not needed in this case. It involves using past data in a very direct way as a guide to what might happen in the future. We apply the current weights to the historical asset returns by going back in time such as over the last 100 days. A distribution of portfolio returns is obtained. These portfolio returns are then sorted and depending on the target probability the corresponding quantile of the distribution is taken. This gives us the 1-day VaR using Historical Simulation method. Historical simulation calculates potential losses using actual historical returns in the risk factors and so captures the non-normal distribution of risk factor returns. This means rare events and crashes can be included in the results. As the risk factor returns used for revaluing the portfolio are actual past movements, the correlations in the calculation are also actual 50

past correlations. They capture the dynamic nature of correlation as well as scenarios when the usual correlation relationships break down. Historical VaR For eg, the Nifty returns of 500 historical days is plotted. The distribution would be most likely normal. In order to compute, 95%, the least 5% returns of the portfolio is taken. Which is the 25th value of the return from the left end- 5th percentile of the distribution return. Advantages: Historical simulation method is relatively simple to implement if the past data is readily available for estimating Value-at-Risk. It is not necessary that the distribution is linear and normal as it relies on the actual prices. It does not rely on underlying stochastic structure of the market or any specific assumptions about valuation models. Historical simulation method does not rely on valuation models and is not subjected to the risk that the models are wrong. Disadvantages: The Historical Simulation method assumes the availability of sufficient historical price data. This is a drawback because some of the assets may have a short history or in some cases no history at all. It is also probable that the institution may not store data that much farther into the past. There is also an assumption that the past represents the immediate future which is not always true. In case of unanticipated events the VaR calculated may not hold true. The Historical Simulation method quickly becomes cumbersome for large portfolios with complicated structures.

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7.3

Interpretation of VaR

Std Dev Nifty Sensex USD Nif+USD Sen+USD Total PF 12.01359 11.86539 5.273917 13.66105 13.44398 18.11964

MODEL BUILDING -19.82241727 -19.57789744 -8.701963601 -22.54073349 -22.1826 -31.103

HISTORICAL -20.1606 -20.1052 -7.69935

-32.010199

Historical Simulation: The Historical returns of 744 days for a Rs1000 Crore investment in the index funds of SENSEX and NIFTY were computed. For computing 95% VaR (5% level of significance), the 5th worst percentile return i.e (5% of 744= 37th worst) value is taken. Assuming, an average 1 day VaR for SENSEX &NIFTY are -20.1052 and -20.1606 respectively means that, 95% of the times, the losses from the portfolio would be less than Rs 20.1052 crores for SENSEX and Rs 20.1606 crores for NIFTY. There is 5% of a chance that the loss might exceed this value. This means that the risk involved in having a portfolio with an average return of 0.10% as computed would be Rs 20.16 crores. To compute the 10 day VaR from the 1 day VaR, we simply use the square root rule and multiply the computed 1 Day VaR by sqrt of 10 i.e 10 day, 95% VaR for SENSEX = 1 day , 95% VaR * sqrt(10) = Rs 63.578 crores

Similarly, the VaR can be computed for US Dollar returns as obtained is Rs -7.699 crores for a Rs1000 crore investment in the Dollar market. A combined portfolio VaR is also computed by firstly calculating the total Return on the portfolio containing Index funds(Nifty+SENSEX) and USD, and then the 95% VaR, the 5th worst percentile return i.e (5% of 744= 37th worst) value is taken. The average 1 day VaR for the Portfolio is Rs -32.010199 crores. This means that, 95% of the times, the losses from the portfolio would be less than Rs 32.010199 crores. There is 5% of a chance that the loss might exceed this value.

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80 70 60 50 40 30 20 10 0

5% Probablity of Loss more than Rs. 32.01

Histogram

Frequency

Frequency

Returns

1. Model Building Approach (MBA): The MBA uses Variance of the returns for the purpose of computing the VaR. As we know that the returns are normally distributed, the probability of a loss being more than the VaR value can be easily computed by multiplying the standard deviation of the return with the value for Z= 95 % i.e -1.65 (The negative sign indicates the loss in the Left tail of the distribution). The Standard deviations of the returns of SENSEX, NIFTY, USD and total Portfolio, is calculated. The individual VaRs is calculated as,

95% VaR = z * std dev (z= -1.65 for 95% left tail distribution)

Index Funds Index Funds USD 1 0.01249 USD 1

For calculating the Portfolio VaR, of a portfolio containing two kinds of security (Index funds & USD), the combined standard deviation for a two-asset portfolio is calculated as

where = correlation coefficient between the 2 securities.

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The 95 % VaR for a combined NIFTY +USD and SENSEX +USD is computed by the above mentioned method as Rs -22.54073349 crores and Rs -22.1826 crores respectively. Similarly the combined Portfolio VaR of Index funds + USD is computed as Rs -31.103 crores. The results obtained by the 2 methods are as tabled and we see that there is a slight variation in the values.

Computation of VaR for equity portfolios:


Geetanjali Vs Dollar

Geetanjali Vs Dollar
140 120 100 80 60 40 20 0 -82.02733756 -71.75347004 -61.47960253 -51.20573501 -40.93186749 -30.65799997 -20.38413246 -10.11026494 0.16360258 10.4374701 20.71133762 30.98520513 41.25907265 51.53294017 61.80680769 72.0806752 82.35454272 92.62841024 102.9022778 113.1761453 123.4500128 More Frequency

Frequency

Returns

Correlation Geetanjali Geetanjali Dollar 1 0.007396725 Dollar --1

MODEL Std Dev Geetanjali 18.62620694 Dollar PF 5.564639167 19.47906844 BUILDING -30.73324145 -9.181654626 -32.14046293 HISTORICAL -26.56546009 -6.958062428 -27.63959236

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Coal India Vs NTPC

CIL Vs NTPC
80 70 60 50 40 30 20 10 0 -68.69357885 -58.98104187 -49.26850489 -39.55596792 -29.84343094 -20.13089397 -10.41835699 -0.705820013 9.006716963 18.71925394 28.43179092 38.14432789 47.85686487 57.56940184 67.28193882 76.9944758 86.70701277 96.41954975 106.1320867 More Frequency

Frequency

Returns

Correlation CIL CIL NTPC 1 0.04262 NTPC 1

MODEL Std Dev CIL NTPC PF 19.98245163 15.11237807 24.53452041 BUILDING -32.97104518 -24.93542381 -40.48195867 HISTORICAL -28.9162 -24.1886 -39.4078

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7.4

Back Testing of VaR:

Back testing is an important part of VaR model validation which involves comparing the number of instances when the actual Profit/Loss exceeds the VaR level (called exceptions) with the number predicted by the model at the chosen level of confidence. For Eg. If a VaR of 10million is calculated at 95% confidence Level, we expect to have exceptions (losses) exceeding 10 million i.e 5% of the time. If exceptions are occurring with greater frequency, we are underestimating the actual Risk, and if exceptions are occurring within the acceptable level, then we are overestimating the actual Risk and misallocating capital as a result.

Basel Committee rules for Back Testing :

The Basel committee for Banking supervision (BCBS) rules attempts to strike a balance between Type I error (reject the return which is in the acceptable range) and a Type II error (accepting the unacceptable/exceptions). The committee recommends the market VaR to be calculated at 99% confidence level and back tested over the past years. Say at 99% confidence level we would normally expect to have (over 250 days period 2.5 exceptions) i.e. 1% of 250. In order to compensate for using inaccurate models (skewed data) the committee has established a scale of the number of exceptions and corresponding increases in the capital multiplier k.

The bank classifies its back-testing outcomes into the following three zones depending on the number of exceptions arising from back-testing:

Zone 1 Green: If the back-testing results produce four or fewer exceptions, it falls within the Green Zone and there may not be any increase in the multiplication factor beyond minimum three for both VaR and stressed VaR as mentioned in the guidelines.

Zone 2 Yellow: If the back-testing results produce five to nine exceptions, it falls within the Yellow Zone and there would be an increase in the multiplication factors for both VaR and stressed VaR as mentioned in the Table below.

Zone 3 Red: If the back-testing results produce ten or more exceptions, it falls within the Red Zone and the multiplication factors for both VaR and stressed VaR will be increased from 56

three to four. RBI will allow 10 or more exceptions under the most extraordinary circumstances. RBI may require banks whose model for market risk fall in Red Zone to either discontinue the model or begin work on improving the model immediately. RBI may also consider further increase in the capital requirements if the bank is not able to demonstrate that its models are capturing all market (general market risk and specific risk, if any) risks it is exposed to.

Zone
Green Yellow

Number of exceptions
0-4 5 6 7 8 9

Multiplier (k)
3.00 3.40 3.50 3.65 3.75 3.85 4.00

Red

10 or more

The bank normally recommends a multiplier of k which subsequently increases to 4 based on the accuracy of the banks VaR model. Increase in k significantly increases the amount of capital the bank must hold and lowers the banks performance measures like ROE. The penalty (raising the multiplier from 3 to 4) is automatically required for banks with 10 or more exceptions. The committee suggests 4 categories of causes for the exceptions as 1. The basic integrity of the model is lacking, exceptions occur because of incorrect data or errors in the model programming. 2. Model accuracy needs improvement, exceptions occur because the model does not accurately describe risks. 3. Intraday trading activity, the exceptions occur due to trading activity i.e. the VaR is based on static portfolios. 4. Bad luck, the exceptions occur market conditions (volatility and correlations among financial instruments) significantly varied from the accepted norms.

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7.5

Expected shortfall

A major limitation of the VaR measure is that it does tell the investor the amount or magnitude of the actual loss. VaR only provides the maximum value we can loose for a given confidence level. The expected shortfall (ES) provide the estimate of the tail loss by

averaging the VaRs for increasing the confidence levels in the tail. Specifically, the tail mask is divided into n equal slices and the corresponding (n-1) VaRs are computed. For example if n=5 we construct a table as below based on the normal distributions.

Confidence Level 96% 97% 98% 99% Average Theoretical true value

VaR 1.7507 1.8808 2.0537 2.3263

Difference 0.1301 0.1729 0.2726 2.003 2.063

We observe that VaR increases (from difference column) in order to maintain the same interval mass of 1% because the tail becomes thinner and thinner. The average of the 4 computed VaRs is 2.003 and represents the probability weighted expected loss (ES). Note that as n increases, the ES will increase and approach the theoretical true loss (2.063 in this case, the average of the high numbers of VaRs).

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8. Learning and Limitations


Due to the increasing importance of market risk management, commercial banks have integrated market risk identification, measurement, monitoring and control with business management activities such as strategic planning, business decision-making and financial budgeting. For this purpose it is imperative that certain measures be taken.

The banks maintain an independent risk monitoring wing (Mid Office) in the Treasury department which reports directly to the top management through Integrated Risk Management Department (IRMD) department. This specialized risk department constantly monitors the trades and deals and verifies and monitors each deal through an online monitoring system. The online monitoring system at Federal Bank follows a two-step process, as detailed below:

1. Monitor simultaneously and concurrently all the deals that are undertaken 2. Integrate and process data collected from the various sources and generate daily VaR so as to effectively manage the risk exposure.

Thus the Mid Officer is a part of the IRMD and performs a role of an independent risk oversight function. The relevant roles and responsibilities of this Mid Office would be clearly established and demarcated.

Federal Bank constantly upgrades its Risk identifications and assessment methodologies. They are on the path of setting up the state of the art, Risk Management Unit. However, presently they are computing market risk capital through SMM. While Valuation is done through their software they maintain the Valuation computations in Microsoft Excel for various scenarios analysis. This indeed calls for high end statistical tools which they are in process of acquiring for all the analysis. Implementing a specialized software which

streamlines the operations would increase overall efficiency and plug the loopholes, so that the manual functions will be minimized

The RBI (based on the BASEL framework) has suggested banks to migrate from the foundation approaches to the advanced methods of risk mitigation such as the Internal Models approach (IMA) for Market Risk, Internal Rating Based (IRB) approach for Credit 59

Risk and Advanced Management Approach (AMA) for Operational Risk. The migration to these methods is a slow and a gradual procedure which is the need of the hour for the Bank. Federal Bank is working towards compliance of Basel III norms as prescribed by RBI, which is a relatively an efficient practice for overall banking regulation and transparency.

Shortfalls/ Limitations to the Study:

1. Limited disclosure due to the confidential nature of the Treasury department and its functioning. 2. Short duration of 2 months resulted in limited scope of the study 3. Due to the live nature of the dealing room and the level of secrecy maintained, the study was limited to more theoretical information. 4. The RBI circulars which was used as a reference contained several sub-reference circulars which were not easily available

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9. References
1. RBI Master circulars Implementation of Internal Models Approach for Market Risk Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) Asset Liability Management New Capital Adequacy Framework

2. www.fimmda.org.in 3. www.investopedia.in 4. www.nse.in 5. NCFM reference module on Fixed Income Securities. 6. IDRBT Training Documents of Federal Banks 7. Options, Futures and other income Derivatives John C Hull 8. Handbook of Treasury Operations-Federal Bank

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