1. Different banks in different countries have failed during different times. This shows bank failure is not an isolated episode. Why do you think bank failures happen? How would you like to explain the nature of the problems which banks encounter leading towards bank failures?
Causes of banking crises (is banking crisis and bank failures same? Confusing!!! Ans relates to banking crisis)
• (a) Macroeconomic circumstances
• (b) Microeconomic policies
• (c) Banking strategies and operations
• (d) Fraud, corruption
(a) Macroeconomic circumstances
• It is not uncommon for banking crises to be blamed on adverse macroeconomic developments.
• Indeed, macroeconomic instability is sometimes cited as the principal source of banking instability
• The trigger may be some combination of
• a collapse of asset prices, especially in real estate (perhaps following an earlier unsustainable increase, which may in turn have been fuelled by inappropriate macro-policy or reckless banking decisions);
• a sharp increase in interest rates or fall in the exchange rate;
• The onset of recession.
• All of these factors are, of course, interrelated.
• Another source of difficulties the removal of subsidies, creating pressure on particular businesses or sectors to which banks are exposed.
b) Microeconomic policies
• This heading covers all those structural and supervisory parameters which are under the government’s (or central bank’s) direct control or influence.
(i) Supervision
• There is a common perception that every bank failure represent a supervisory failure
(ii) Inadequate infrastructure in matters of accounting, law, etc
• Shortcomings in accounting or auditing may disguise, or delay realization of, problems of illiquidity or insolvency.
• Shortcomings in the legal infrastructure may, for example, inhibit the exercise of property rights or the pledging and realization of collateral in support of bank loans.
(iii) Liberalization / deregulation
• Deregulation in the financial sector has occasionally encouraged rash behavior, leading to subsequent problems.
• Deregulation – of activities - may require more attentive supervision in order to ensure that those activities are carried out and managed prudently.
• Some banking problems have arisen or been exacerbated because supervision has not kept pace.
(iv) Government interference
• There have been instances where government interference in a bank’s business - such as:
– directives or pressure to lend to particular customers,
– possibly at preferential interest rates, or
– to maintain or extend uneconomic branch networks
• has precipitated or hastened the onset of a liquidity or solvency crisis.
(v) Moral hazard
• If there is a general expectation that no bank will be allowed to fail, or if financial support in troubled times is too readily available to either banks or their depositors, moral hazard arises.
• Banks may be tempted into behavior which exacerbates rather than ameliorates their position
• And depositors may not bother to discriminate between “good” and “bad” banks,
• Thereby possibly prolonging survival, but magnifying a crisis when it eventually breaks.
(vi) Lack of transparency
• If, as a result of:
– an inadequate legal or regulatory framework, or
– perhaps simply as a matter of culture,
• the circumstances of a bank lack transparency to:
– depositors
– other counterparties, or
– shareholders,
• the role of market forces in determining the bank’s fate will be impeded and problems may be allowed to develop and multiply to an extent which might not otherwise have been possible.
(c) Banking strategies and operations
• In many instances the problems of a bank have been brought about by the shortcomings of its own strategy or by operational failure.
• Some of the more common operational failures are as follows:
(i) Poor credit assessment
Failure to make an accurate assessment of credit risk and to price accordingly is perhaps still the single most common cause of banks’ problems.
(ii) Interest rate or exchange rate exposures
• Sharp shifts in macroeconomic policies or circumstances may provoke losses on this account beyond the usual tolerance of regulatory limits.
(iii) Concentration of lending, and connected lending
• In some countries individual banks either have long-standing links to particular customers or economic sectors, or have been established in the more recent past specifically with such close links in mind.
• Such concentrations have been shown historically to be a source of problems, and steps should be taken where possible to reduce any such dependence.
• In the developed countries ceilings on loan concentration are clearly specified and enforced.
(iv) New areas of activity
• New activities, such as the trading of derivatives, may be imperfectly understood by senior management especially in countries where expertise is thinly spread.
• This indicates a need to proceed only step by step into new areas, but does not necessarily constitute a case for indefinite prohibitions.
(v) Unauthorized trading or position-taking, associated with a failure of internal controls
• This appears to have become an increasingly worrying source of bank losses or ultimate failure.
• In each of the cases of Barings, Jardine Fleming, Morgan Grenfell and Daiwa, a single maverick individual seemed to be responsible for losses.
• The losses in the region of $3 billion in the copper market, revealed in 1996 by the Sumitomo Corporation and apparently incurred by one trader, are another illustration of this danger; although Sumitomo Corporation is not a bank, there could have been knock-on effects to financial institutions.
• (vi) Other operational failures
• poor quality of staff,
• deficient management structure
• inability or reluctance to control costs;
• reward structure for staff that encourages excessive risk-taking;
• inadequate documentation, recording and audit trails;
• over-reliance on IT systems, without adequate back-up,
• absence of contingency plans
(d) Fraud, corruption
• Employees, management or outsiders may all be susceptible to corruption or capable of fraud on a bank; and there are many possible channels for fraud.
Transition economies
• hyper-inflation
• severe recession for a few years
• bankruptcy of traditional customers
• lax licensing
• lax supervision
• too close an involvement with particular industries
• loans to major shareholders
• government interference
• Source: FIM – 12
2. Give your opinion regarding the methodology or framework for having a stable and strong banking sector.
The steps for Banking Soundness
a. Improve Internal Governance
• It is not illegal to manage a bank poorly or even to let it fail, but it is illegal to operate a bank in disregard of laws and prudential regulations, and to conceal the true state of its financial position from supervisors.
• When their capital diminished or has been lost-- either through operational losses or lending to themselves- the owners must lose their money and control of their banks.
• Owners should never be allowed to operate an insolvent bank
b. Maintain Strict Licensing Rules
• Deregulation often opens the banking market to competition from new banks and other financial intermediaries, both domestic and foreign.
• Licensing practices should be designed to ensure that banks entering the system are operated in a safe and prudent manner and do not compete destructively.
• For example, the entry of high-quality foreign banks can make an important contribution to the long-term soundness of a banking system.
c. Beware of the Strains of Deregulation
• Deregulation enables banks to enter into new and unfamiliar areas of business, where they may incur increased exposure to credit and various market risks.
• Prior to deregulation tightly, regulated banks typically lack the necessary credit evaluation and risk- pricing skills to deploy available resources effectively.
• There have been numerous cases where banks after deregulation have entered into an almost mindless competition for market shares without regard for risks- and disregarded in the rush for profits.
d. Ensure Quality of Data
• The quality of data is a very special problem for banks, because most of their assets are loans, which are not traded and have no objectively determined market value.
• The value of collateral may also be highly uncertain, especially if asset values are unusually high.
• If managers have incentives to conceal the real value of a problem loan, for example, in order not to lose their jobs or their control of their bank, they are likely to do so-- especially if they can do so without impunity.
• It must be recognized that loan valuation rules are prone to manipulation by banks, which - especially when they have problems- typically overstate asset values, showing them at historical book value, and report paper earnings even when they are incurring economic losses.
• Misleading accounting, loan valuation and outright fraud can be difficult to detect in time and will require effective on-site inspection, external audits, and other types of monitoring.
e. Strengthen Incentives and Market Discipline
• The market is expected to reinforce banks' incentives to operate safely by driving out poorly managed and unsound banks, thus preventing problems in individual banks from growing, and in the process contaminating other banks and the system as a whole.
• Private market imposes discipline through creditors, who require higher interest rates or withdraw resources from weak banks.
• Such withdrawals involve the gradual transfer of funds from weaker into stronger banks, and ultimately the exclusion of weak banks from the interbank market.
• Market discipline requires that creditors have funds at risk in the market and have information about the banks in which they have placed their funds.
• Large and well - informed creditors, including other banks, typically are most effective in exercising market discipline because they have more resources with which to monitor and influence banks.
• Public sector creditors should act as any other large, well-informed creditor.
• For market discipline to work, three ingredients are needed;
• disclosure,
• limited official financial safety nets, and
• a strict exit policy.
f. Improve Disclosure
• Markets require prompt and reliable information in order to work, and disclosure of such information should be the responsibility of the banks.
• Banks, especially when in trouble, has incentives to withhold or distort information.
• When banks form part of larger financial groups, they may deliberately hide losses in other corporate units and not report a true consolidated position so that when information is ultimately disclosed, the opacity of banks' actual financial condition limits the ability or markets to rationally assess the information disclosed.
• This is the case even in the most advanced markets with the best external auditors, rating agencies, and other market analyst.
• In addition, disclosure of grossly misleading financial statements tends to implicate supervisors, who are expected to be informed and prevent the public from being misled.
g. Limit Scope of Safety Nets
• If it is known or expected that creditors ( and owners) of banks that run into trouble will be "bailed out" by the government or central bank, market discipline will not work.
• Overall generous official safety nets in the form of deposit guarantees and lender-of last-resort facilities lead to moral hazard and adverse selection, and provide incentives for poor internal government and excessive risk taking.
• Therefore, such safety nets should be strictly limited.
• Deposit guarantees, where appropriate, should be limited to basic consumer protection and not cover larger depositors and creditors. including other banks.
h. Uphold a Strict Exit Policy
• The exit of weak individual banks is critical for the maintenance of a sound and competitive banking system.
• The prolonged operation of unsound banks not only permits them to spiral into deeper insolvency (and higher resolution costs) but also causes damages to competitors though destructive market practices, which might enable short-term survival but are not sustainable.
• Experience has shown that unsound banks are always in worse condition than their financial statements indicate, and that the least intrusive, least expensive, and most efficient way of maintaining a sound banking system is to force the early exit of nonviable banks.
• A strong exit policy for banks (closure and liquidation) is at least as important for an efficient and competitive market system as entry policy, if not more important- although more attention is normally paid to the latter.
i. Strengthen Official Oversight
• Official oversight in the form of prudential regulation and supervision seeks to compensate for failures in internal governance and market discipline.
• But the objective of oversight is not to guarantee the survival of every bank but rather to ensure that the banking system as a whole remains sound.
• Laws and regulations provide the rules of the business and also seek to prevent destructive and fraudulent practices.
• Supervision ensures that rules are enforced, that banks are operated prudently, and that corrective measures are taken when needed.
j. Adopt Effective Regulatory Framework
• Most countries have adopted an extensive and regulatory framework for the prudent entry, operation, and exit of banks.
• To be effective, such frameworks should as far as possible rely on and reinforce banks' internal governance structures and market discipline.
• The most important prudential requirements in support of internal governance are those requiring that owners to be fit and proper and those they put their own money at risk.
• Capital adequacy is increasingly defined in relation to risk-weighted assets and off-balance-sheet items, with more capital required against higher risk (following the Basle Capital Accord).
• Effective measurement of capital requires proper evaluation of banks' asset quality and meaningful risk weights.
• Until this has been done properly, analysis of capital adequacy ratios should be made with extreme caution.
k. Improve Supervisory Autonomy and Authority
• Regulations are relatively simple to adopt, but difficult to implement.
• To effectively oversee compliance with regulations, the supervisory authority must have sufficient independence, authority, and competence.
• The supervisory authority must also have sufficient powers, established by law, to carry out its functions, including to regulate, request data, conduct on-site examinations in order to verify banks data, report and assume appropriate loan provisions, restrain unsound practices suggest corrective measures, revoke licenses, and - where needed- remove managers and force the exit of banks.
• Supervisory actions are often politically unpopular.
• But supervisors must be able to act against banks without the delays and pressures that often result from a need for political approval; they must also have legal protection for discharging their duties.
• The independence from political influences is a particularly thorny one as it requires an institutional structure that will combine independence with accountability.
l. Coordinate National and International Supervision
• In most countries, different parts of financial conglomerates (banks, securities, insurance, and pension funds) are regulated and supervised by different national authorities.
• It is important that such regulation and supervision be properly harmonized and coordinated in order to reduce the scope for regulatory arbitrage and inefficiencies.
• The need for consolidated supervision of conglomerates is a strong argument for an umbrella-type supervisory organization incorporating all financial supervision “under one roof."
m. Strengthen Macroeconomic Management
• The soundness of a banking system largely reflects the health of the economy in which it is operating.
• A stable macroeconomic environment, conducive of efficient savings and investment decisions and healthy economic growth, is a prerequisite for sound banking.
• If an economy is experiencing a slowdown or decline in growth or other adverse macroeconomic shocks, its banking system will also be affected.
Source: FIM – 13
3. What led to the move towards Basel (II) from Basel (I)?
Limitations of Basel I
• Banks have become more innovative
– Change in risk appetite and risk profiles
• Risk management practices of institutions have improved considerably
– Increased use of internal risk models
• Risk mitigants in market more prevalent (e.g. derivatives, securitization)
• Several major shortcomings of Basel I have become apparent
– Too simplistic; one size fits all approach
– Broad-brush risk weighting structure (e.g. sovereigns based on OECD and Non-OECD classification,100% risk weight for all corporates)
– Confined to credit
– Market risk and Operational risk ignored.
– Provides opportunities for regulatory arbitrage
– Seen as compliance requirement only and does not encourage good risk management practices
– Banks may have taken measures to mitigate risks, which Basel I simply do not recognize.
– Sometime, some amount from the capital amount may be required to be deducted.
– Sometime, regulator may note some risks for the bank, which that may not have given importance.
Basel II addresses the shortcomings of Basel I
• More comprehensive coverage
– Introduction of explicit capital charge for operational risk
– Able to capture other risks
• Basel II provides banks with a menu of options for capital measurement approaches
– Risk sensitive approach with wider range of risk weights to reflect the true underlying risks more accurately
– Availability of internal ratings based approaches
• Greater recognition of credit risk mitigants (Collateral, Guarantees)
• Provides more pro-active role for supervisors under Pillar 2 and encourages greater market discipline under Pillar 3
Source: FIM 05
4. What are the important features of Basel (II)?
1. Pillar One—Capital Requirements
1.1 Credit Risk
1.2 Market Risk
1.3 Operational Risk
2. Pillar Two
2.1 Supervisory Review
3. Pillar Three
3.1 Market Discipline
Source: FIM – 05 BASEL II overview
5. What prompted the authorities to move to Basel (III)?
Bank failures
With time more safety needed due to more transaction and more uncertainty
6. What are the important changes proposed to be made under Basel (III)?
Higher capital ratios
» Tier 1 Capital Ratio: increases from 4% to 6%
» The ratio will be set at 4.5% from 1 January 2013, 5.5% from 1 January 2014 and 6% from 1 January 2015
» Predominance of common equity will now reach 82.3% of Tier 1 capital, inclusive of capital conservation buffer
New Capital Conservation Buffer
» Used to absorb losses during periods of financial and economic stress
» Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirement to 7% (4.5% common equity requirement and the 2.5% capital conservation buffer)
» The capital conservation buffer must be met exclusively with common equity
» Banks that do not maintain the capital conservation buffer will face restrictions on payouts of dividends, share buybacks and bonuses
Countercyclical Capital Buffer
» A countercyclical buffer within a range of 0% - 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances
» When in effect, this is an extension to the conservation buffer
Higher Minimum Tier 1 Common Equity Requirement
» Tier 1 Common Equity Requirement: increase from 2% to 4.5%
» The ratio will be set at 3.5% from 1 January 2013, 4% from 1 January 2014 and 4.5% from 1 January 2015
Liquidity Standard
» Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid resources are available for one month survival in case of a stress scenario. Introduced 1 January 2015
» Net Stable Funding Ratio (NSFR): to promote resiliency over longer-term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis
» Additional liquidity monitoring metrics focused on maturity mismatch, concentration of funding and available unencumbered assets
Leverage Ratio
» A supplemental 3% non-risk based leverage ratio which serves as a backstop to the measures outlined above
» Parallel run between 2013-2017; migration to Pillar 1 from 2018
Minimum Total Capital Ratio
» Remains at 8%
» The addition of the capital conservation buffer increases the total amount of capital a bank must hold to 10.5% of risk-weighted assets, of which 8.5% must be tier 1 capital
» Tier 2 capital instruments will be harmonized; tier 3 capital will be phased out
Source: FIM BASEL III FAQ Moodys
7. What is stress testing?
• Stress testing refers to techniques used by financial institutions to analyze the effects of exceptional but plausible events in the market on a portfolio's values.
• A stress test is a rough estimate of how the value of a portfolio changes when there are large changes to some of its risk factors (such as asset prices).
• The term rough estimate is used to avoid the perception that stress testing is a precise tool that can be used with scientific accuracy.
Source: FIM 10 stress testing – A
8. Why are stress testing conducted?
Stress tests can also help policymakers in gauging the potential implications of different risks for the financial system as a whole, and hence in identifying those which may pose the greatest threat to systemic stability.
Stress tests help financial institutions to:
a. communicate extreme scenarios throughout the institution, thereby enabling management to take the necessary precautions (limit systems, additional capital, and so on)
b. manage risk better in more volatile and less liquid markets
c. bear in mind, during less volatile periods, that the probability of disastrous events occurring should not be neglected
Source: FIM 10 stress testing – A
9. What can happen in stress testing’s absence?
???
10. How stress testing is conducted?
System-focused stress testing is best seen as a process:
i. part investigative
– the identification of specific vulnerabilities or areas of concern
– followed by the construction of a scenario in the context of a consistent macroeconomic framework.
ii. part diagnostic
– map the outputs of the scenario into a form that is usable for an analysis of financial institutions’ balance sheets and income statements
iii. part numerical
– the numerical analysis, considering any second-round effects
iv. part interpretive
– summarizing and interpreting the results
Source: FIM 10 stress testing – A
11. What value addition banks get through stress testing?
???
12. Why do you think prudential regulations are issued and also why are they called prudential regulations, rather than simply regulations?
Issuance of prudential regulations for the banks and financial institutions are required because:
• Banks play an important role in the economy
• Their safety and soundness is very much required for a sound financial system and
• They play with other people’s money and such money must be made safe and secure.
Prudential Regulation
• Regulation means a rule or restriction made by an authority.
• Prudential means acting with or showing care and thought for the future.
• So Prudential Regulations here means those regulations issued by a regulator, (who has got the authority to issue it) with a view to have a safe and sound financial system in the country.
Source: FIM 14
13. Explain some of the important prudential regulations which banks and financial institutions in Nepal are required to follow.
a. How much capital they must have.
Capital Required for New Banks & Financial Institutions
b. What should be included in such Capital
A. Core Capital
1) Paid-up Capital
2) Share Premium
3) Non Redeemable Preference Share
4) General Reserve Fund
5) Cumulative Profit/ (Loss) (Up to Last Year)
6) Current Year Profit/ (Loss)
7) Capital Redemption Reserve
8) Capital Adjustment Fund
9) Other Free Reserves
10) Dividend Equalization Fund
B. Supplementary Capital
1) General Loan Loss Provision
2) Asset Revaluation Reserve
3) Hybrid Capital Instruments
4) Unsecured Subordinated Term Debt
5) Exchange Equalization Fund
6) Additional Loan Loss Provision
7) Investment Adjustment Reserve
8) Interest Spread Reserve
9) Contingent Reserves
10) Provision for Loss on Investment
c. How should their assets be classified
NPA
Good – up to 90 days
Sub standard – up to 180 days
Doubtful – Up to 365 days
Bad – More than 365 days
d. Under what circumstances banks must be required to make loan loss provision
e. How much such loan loss provision they must make
i. Good – 1%
ii. Sub standard – 25%
iii. Doubtful – 50%
iv. Bad – 100%
f. What should be the parameter for banks to book interest income
g. What type of risk management system banks must have
h. Should banks be allowed or debarred from making connected lending
i. How to make sure that bank exposure is not concentrated in one borrower.
j. How to comply banks with regard to corporate social responsibility.
Source: FIM 14
14. What are the risks which banks are required to encounter? Explain the nature and features of these risks.
a. Liquidity risk
b. Interest risk
c. Market risk
d. Credit risk
e. Off-balance sheet risk
f. Foreign exchange risk
g. Operating risk
Liquidity Risk
Definition: risk of not be able to honor bank’s financial commitments promptly
It arises from an uncertainty of the timing of cash flows
• Liability-side risk results from unexpectedly high rates of deposit redemption
• Asset-side risk results from borrowers unexpectedly drawing down loan commitment
Interest Risk
Definition: is the impact on banks’ earnings and market value of equity of changes in interest rates.
• Refinancing risk
• Reinvestment risk
• Matching average life of assets and liabilities reduces interest rate risk, but it is not perfect hedge
• Immunization requires dynamic rebalancing of the portfolio, which may be costly
Market Risk
Definition: the risk of bank losses from movement of market prices on its trading inventory
Credit Risk
Definition: the risk of loss due to the failure of a borrower, endorser, guarantor or counterparty to repay a loan or honor another predetermined financial obligation
• Off-balance Sheet Risk
Definition: activities that do not appear on the current balance sheet because it does not concern holding a currency primary claim (asset) or issuing a current secondary (liability)
Two categories: 1) Credit substitutes
2) Derivatives
• Foreign Exchange Risk
Definition: The potential adverse impact on a bank’s earning and value of its equity from foreign exchange rate movement
Source: FIM 10
Operating Risk
Definition: It is business risk which includes organizational behavior, technological systems and legal aspects of managing a bank
Operational Risk arises as a result of failure of operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc.
Operational Risks Include
– Internal Fraud.
– External Fraud.
– Employment Practices and Workplace Safety.
– Clients, Products and Business Practices.
– Damage to Physical Assets.
– Business Disruption and System Failures.
– Execution, Delivery and Process Management.
Source: FIM 10
15. Out of the various risks which banks have to face which one do you think banks in Nepal are very much required to face and why do you think so? How can banks manage this risk by following the standard asset liability management framework?
Liquidity Risk. (do not know the second part of the question)
16. Why is it important for Banks to maintain Liquidity?
Liquidity, the ability to convert assets into cash easily, is important if a person or company needs access to cash in a short time frame or need the money to pay for expenses
Liquidity is important for banks because it helps it to access its resources quickly in order to meet its financial obligations. Without cash, banks can quickly get into trouble with their creditors. Banks with a higher debt/equity ratio will be less liquid, as more of their available cash must be used to service and reduce the debt.
• The level of liquidity influences the ability of a banking system to withstand shocks.
• Common measures of liquidity include
• liquid assets to total assets (liquid asset ratio),
• liquid assets to short-term liabilities, or
• loans to assets
17. What is the difference between Return On Assets (ROA) and Return On Equity (ROE)?
ROA is an indicator of managerial efficiency. It indicates how capable the management of the bank has been converting the institution’s assets into net earnings
ROE is a measure of the rate of return flowing to the bank’s shareholders. It approximates the net benefit that the shareholders have received from investing their capital in the bank i.e. placing their funds at risk in the hope of earning a suitable profit.
Source: FIM 08
18. Banks have been found to be making good profit. What are the major sources of Bank Profit?
a. Interest Income
b. Commission and Discount
c. Exchange Gain
d. Non Operating Income
e. Other Income.
19. Do you think shareholders of a bank manage to get all the net profit of a bank? Yes or No, Explain
No. 20% goes to general reserve until double + LLP
Source: class hearing
20. Two Banks making an identical Net Profit may not be able to give identical dividends to the shareholder. Why do you think such thing happens?
20% goes to general reserve until double + LLP
Source: class hearing
21. What is the meaning and importance of Maturity Bucket analysis in terms of asset liability management framework?
a. Since assets and liabilities may be repriced at different time within the gapping period of, say, twelve months, balance sheet items can be grouped into a number of time intervals ('buckets') according to maturity/ repricing periods.
b. Typically the buckets will have intervals of 0-30 days, 30-60 days, 60-90 days and so on.
c. The gap for each bucket is calculated, conventionally, as the amount of rate sensitive assets less rate sensitive liabilities.
d. However, early repayment of loans can create a gap which is difficult to quantify, and the same is true of the uncertain drawdown of loans
e. Also, even if RSA and RSL are equal, the interest rate changes for assets and liabilities may not be of the same magnitude.
f. Such different repricing behavior is the basis of the standardized gap which adjusts gap measures for the relative measures for the relative volatilities of various financial instruments.
Source: FIM 11
22. Is there any difference between any other crisis and banking crisis? If so, why? Why we need to worry more about the banking crisis?
???
The causes of banking crises can be categorised under several headings: macroeconomic instability; deficient supervision; poor strategies; weak management; inadequate control systems; operational failures; fraud. The experience of a number of countries is reviewed. Whatever the causes, the authorities need a coherent strategy for addressing such crises.
23. What type of financial system we have in Nepal?
• Regulated by regulators: NRB, Securities Exchange Board,, Insurance Board
• Regulated by itself: Employee Provident Fund and Citizen Investment Trust
Source: FIM 1
24. What are the similarities and differences between Commercial Banks, Development Banks, Finance Companies and Micro Credit Units?
???Commercial Bank: minimum paid up capital required 200 crore, A class, basically for providing short term loans.. the only one to issue LC
Development bank: 64 crore. B class, provides long term loans for development projects.
Finance Companies: 20 crore paid up capital..C class, provides consumer loans
Micro credit units: 10 crore , needy people lai loan dincha... gives loan up to 90000 per person for carrying out small economic activities for ascertaining proper lives. No collateral needed.
25. What is a Bank Balance Sheet? What are its important components?
It is a statement of a bank’s financial position (as of a specific date) listing:
a. assets owned,
b. liabilities owed, and
c. owner’s equity
1.Share Capital 1.Cash Balance
2.Bills Payables 2.Balance With NRB
3.Income Tax Liabilities 3.Balance With Other FI
XXXXXXXXXXXXXX 4.Money At Call
4.Deposits 5.Investments
5.Borrowings 6.Fixed Assets
6.Debentures & Bonds XXXXXXXXXXXXXX
7.Reserve & Surplus 7.Loans & Advances +(BP)
8.Undistributed Dividends 8.Non-Banking Assets
9.Other Liabilities 9.Other Assets
TOTAL Liabilities TOTAL Assets
Source: FIM 02
26. What is the reason that in some of the bank balance sheets, we tend to see a negative figure under Retained Earning item?
.....if LLP is greater than the accumulated retained earnings of all the years.
27. All companies will have source and utilization of resources. For banks, what are the important sources and utilization of resources?
Deposit and Loans
Sources
Share capital
Reserves
Debentures and bonds
Bills payable
Deposits
Borrowings
Undistributed dividend
Income tax liabilities
Other liabilities
Utilization
Cash balance
Balance with NRB
Balance with other financial institutions
Money at call
Investments
Loans and advances
Fixed assets
Non banking assets
Other assets
28. Why do you think capital is given such an important role in the bank management?
In the first place, capital provides a cushion against the risk of failure by absorbing financial and operating losses until management can address the bank's problems and restore the institution's profitability.
Second, capital provides the funds needed to bet the bank chartered, organized and operating before deposits come flowing in.
A new bank needs starting up funding to acquire land, build a new structure or lease space, equip its facilities, and hire offers and staff even before opening day.
Third, capital promotes public confidence in a bank and reassures its creditors (including the depositors) of the bank's financial strength.
Capital also must be strong enough to reassure borrowers that the bank will be able to meet their credit needs even if the economy turns down.
Fourth, capital provides funds for the organization's growth and the development of new services, programs, and facilities.
When a bank grows, it needs additional capital to support that growth and to accept the risks that come with offering new services and building new facilities.
Most banks eventually outgrow the facilities they start with.
An infusion of additional capital will permit a bank to expand into larger quarters or building additional branch offices in order to keep pace with its expanding market area and follow its customers with convenient service offerings.
Finally, capital serves as a regulator of bank growth, helping to ensure that the individual bank's growth is held to a pace that is sustainable in the long run.
Both the regulatory authorities and the financial markets require that bank capital increase roughly in line with the growth of loans and other risky bank assets.
Thus, the cushion to absorb losses is supposed to increase along with a banking institution's growing risk exposure.
A bank that expands its loans and deposits too fast will start receiving signals from a market and the regulatory community that its growth must be slowed or additional capital must be acquired.
Capital regulation by regulatory agencies has become an increasingly important policy tool to limit how much risk exposure banks can accept, thereby promoting public confidence and protecting the government's deposit insurance system from massive losses.
Source: FIM 04
29. What is the meaning of Risk Weighted Assets? Explain.
RWA is a bank’s assets or off balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or CAR for a financial institution. In the Basel I accord published by the Basel committee on Banking supervision, the committee explains why using a risk weight approach is the preferred methodology which banks should adopt for capital calculation.
• It provides an easier approach to compare banks across different geographies
• Off balance sheet exposure can be easily included in capital adequacy calculations
• Banks are not deterred from carrying low risk liquid assets in their books
Usually, different classes of assets have different risk weights associated with them. The calculation of risk weights is dependent on whether the bank has adopted the standardised or IRB approach under the Basel II framework.
Some assets, such as debentures, are assigned a higher risk than others, such as cash or government securities/bonds. Since different types of assets have different risk profiles, weighing assets based on the level of risk associated with them primarily adjusts for assets that are less risky by allowing banks to discount lower risk assets. In most basic application, government debt is allowed a 0% risk weighting that is they are subtracted from total assets for purposes of calculating the CAR.
30. Is it logical to take Off Balance Sheet activities of a bank into consideration for the purpose of calculating Risk Weighted Assets of a bank? Give reasons
???
Yes, it is logical.
31. What are the components of Capital Fund? Explain
CORE
01.Capital Adjustment Reserve
02.Capital Redemption Reserve
03.Dividend Equalization Reserves
04.Irredeemable Non-cumulative preference shares
05.Other Free Reserve
06.Paid up Equity Share Capital
07.Proposed Bonus Equity Shares
08.Retained Earnings
09.Share Premium
10.Statutory General Reserves
11.Un-audited current year cumulative profit
SUPPLEMENTARY
01.Assets Revaluation Reserve
02.Cumulative and/or Redeemable Preference Share
03.Exchange Equalization Reserve
04.General loan loss provision
05.Hybrid Capital Instruments
06.Investment Adjustment Reserve
07.Other Reserves
08.Subordinated Term Debt
32. What are the differences between Core Capital and Supplementary Capital?
33. What is the meaning of Capital Adequacy Ratio?
is the ratio of bank’s capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory.
34. How is Capital Adequacy Ratio calculated?
Basel I= core +supp/ risk weight * ( assets +off balance sheet exposure)
Basel II = (core capital-specific deduction-adjustments under pillar II ) +supplement/Risk Weight *(CR+MR+OR)
+adjustment under pillar II
Source: FIM CAR Calculation
35. Why is Capital Adequacy Ratio such an important parameter in bank management?
???
36. What are Basel I and Basel II?
Basel 1 refers to the guidelines with regard to the required capital banks must possess.
They have been called Basel guidelines because they are issued by BIS (Bank for International Settlements) located at a Switzerland city by the name of Basel.
As per German language, this city is called Basle. So, sometime this guideline is also called Basle guidelines.
37. What are the important differences between Basel (I) and Basel (II)?
The main difference is that Basel I accord mainly focused on capital requirement for banks. The Basel II adds supervision and market discipline to these capital requirements through the “Three Pillars” concept. The first pillar is about capital requirement. The second pillar is about regulation and supervision and the Third pillar describes market discipline.
38. What are the important differences between Basel (I I) and Basel (III)?
Basel III is an enhancement over Basel II brought out with the experience of global financial turmoil the enhancement are primarily under two heads primarily one is capital and the other is liquidity.
Capital there is a minimum prescription off capital by the way of common equity under base III. That is to say all the capital that is reckoned under Basel II will not be eligible for such reckoning. Ex capital debt instrument will step up option after certain period are not eligible. Deduction from the capital was earlier considered from tier I and tier II equally. Under Basel III deductions is made from tier I capital only.
39. What is the meaning of Loan Classification? Why do you think they are undertaken in bank?
Loan classification refers to the process banks use to:
a. review their loan portfolios and
b. assign loans to categories or grades based on:
i. the perceived risk and
ii. other relevant characteristics of the loans.
The process of continual review and classification of loans enables banks to:
• monitor the quality of their loan portfolios and,
• when necessary to take remedial action:
• to counter deterioration in the credit quality of their portfolios.
Source: FIM 06
40. How is job of Loan Classification undertaken by banks in Nepal?
Good loan up to 90 days
Substandard 120 days
Doubtful 180 days
Bad 1 yr
41. Banks are said to be required to face deleterious effects due to the accumulation of NPAs. Why do you think NPAs happens?
Internal:
• diversion of funds for
• expansion / diversification / modernization
• taking up new projects
• helping/promoting associate concerns
• time/cost overrun during the project implementation stage
• business (product, marketing, etc.) failure,
• inefficient management,
• strained Labour relations,
• inappropriate technology/technical problems,
• product obsolescence, etc.
External:
• recession,
• non-payment in other countries
• inputs/power shortage,
• price escalation,
• accidents, and natural calamities, etc.
• changes in government policies in excise/import duties, pollution control orders, etc.,
42. Why are AMC related with bank’s NPA problem?
• The arguments for “carving out” the bad loans is that the originating bank may be less objective and may even continue lending to delinquent debtors. Furthermore, a bank preoccupied with managing bad debts may become very risk-averse, with little time or inclination for new lending. It is easier to give separate transparent goals if different people are charged with the ongoing banking operations and the resolution of bad loans. Moving bad assets off the balance sheet would also facilitate finding another bank to buy the troubled bank without complicated guarantee arrangements covering the NPLs. However, there is also a case for not moving all NPLs away from the bank. It is desirable for the bank to maintain some experience with work-out procedures. It is also unfair to the better managed banks if the distressed banks end up with no NPLs. It is important when such an approach is followed that the “bad bank” does not end up with all the “bad staff” as well as the “bad assets”. The alternative approach is to establish a single asset management corporation to purchase NPLs from a number of banks: in effect, there will be one large “bad bank” for the whole banking industry. This seems to be becoming the predominant approach.
43. Banks have been found to be making good profit. What are the major sources of Bank Profit?
i. Interest income
ii. Commission n discount
iii. Exchange gain and loss
iv. Non operating income and loss
v. Other income
44. Why do you think one should not focus exclusively on Net Profit only?
Next question answers
45. Why do you think, one should not hastily make conclusions based purely on Net Profit of a bank?
Income must be sustainable.
Net profit does not reflect the overall performance
Look at growth of key items of financial statements
Trend analysis
Differentiate organic and acquired growth
Sustainable growth =
ROE x (1 – Dividend payout ratio)
Dividend payout = Dividend / Earnings attributable to shareholders
= indicator of internally generated growth potential if the company’s profitability, dividend payout and level of debt financing are kept constant
Banks performance not measure by the profit only.
Profit varies according to the size of the banks, larger the bank larger might be the profits
Different ratios must be taken into consideration.
• ROA is an indicator of managerial efficiency. It indicates how capable the management of the bank has been converting the institution’s assets into net earnings
Net Income after taxes/Total Equity capital
• ROE is a measure of the rate of return flowing to the bank’s shareholders. It approximates the net benefit that the shareholders have received from investing their capital in the bank i.e. placing their funds at risk in the hope of earning a suitable profit.
Net Income after taxes/Total Equity capital
• The Net Interest Margin measures how large a spread between interest revenues and interest costs management has been able to achieve by close control over the bank’s earning assets and the pursuit of the cheapest sources of funding
Interest Income – Interest Expense/Total Asset
• The Non Interest Margin measures the amount of non-interest revenues stemming from various service charges and other service fees the bank has been able to collect (known as fee income) relative to the amount of non interest cost incurred.
Non Interest Income – Non Interest Expense/Total Asset
• Net Operating Margin
Total Operating Income – Total Operating Expense/Total Asset
46. What were the shortcomings in the Capital Adequacy Ratio regime before 1988? How these shortcomings were taken care in Basel I?
– Aimed at
• Strengthening stability and soundness of international banking system
• Creating greater consistency in the assessment of internationally active banks
– Minimum capital requirement = 8%
– Adopted in over 100 countries worldwide
– Refinement in 1996 to incorporate market risk
47. Why do you think global regulators were forced to formulate Basel III?
Basel III is a set of proposed changes to international capital and liquidity requirements and some other related areas of banking supervision. It is the second major revision to an original set of rules, now known as Basel I, which was promulgated by the Basel Committee in 1988.
THE MAJOR FEATURES OF BASEL 3 ARE:
• Better capital quality
• CAPITAL CONVERSATION Buffer
• COUNTERCYCLICAL BUFFER
• Minimum common equity and tier 1 capital requirement
• Leverage ratio
• Liquidity ratio
• Systematically important financial institutions
48. Why do you think banks are always vulnerable towards interest risk? What are the standard tools deployed by banks for managing interest risk?
IR: is the impact on banks’ earnings and market value of equity of changes in interest rates.
Interest Risk (measurements)
• Gap analysis
• Duration analysis
• Simulation model
49. In which way, do you think, banks will be helped in managing liquidity risk because of regulators imposing SLR (Statutory Liquidity Ratio) & CD (Credit Deposit) Ratio? What are these ratios in Nepal at the moment?
The latest monetary policy introduced by Nepal Rastra Bank (NRB) had slashed CRR to five per cent for commercial banks, 4.5 per cent for development banks and four per cent for finance companies to promote lending. Likewise, SLR has been reduced to 12 per cent for commercial banks, nine per cent for development banks and eight per cent for finance companies. Class ‘B’ and ‘C’ financial institutions that do not collect call deposits have to maintain SLR of six per cent.
CRR refers to the portion of total deposits that financial institutions have to keep at central bank as deposit. SLR is the portion of total deposits that financial institutions have to maintain as liquid assets such as cash, government securities and precious metals. Reduction in SLR and CRR has freed some funds of banks and financial institutions for lending and investment. Nepal Rastra Bank (NRB) has said that all loans refinanced by the central bank do not require to be included as part of the total credit while calculating the CD Ratio. The central bank requires financial institutions to maintain a CD Ratio of 80 per cent, which means that banks can only lend 80 per cent of the total deposit collection.
50. What are the prudential regulations covering Capital, Asset, Management, Earnings, Liquidity and Sensitivity? Explain
Prudential regulation
those regulations issued by a regulator, (who has got the authority to issue it) with a view to have a safe and sound financial system in the country. Issuance of such regulations for the banks and financial institutions are required because:
• Banks play an important role in the economy
• Their safety and soundness is very much required for a sound financial system and
• They play with other people’s money and such money must be made safe and secure.
51. What are the consequences of accumulation of non-performing assets by a bank?
• NPAs have a deleterious effect on the return on assets in several ways –
– They erode current profits through provisioning requirements
– They result in reduced interest income
– increased pressure on net interest margin (NIM) thereby reducing competitiveness,
– steady erosion of capital resources
– increased difficulty in augmenting capital resources.
– reputational risks arising out of greater disclosures on quantum and movement of NPAs, provisions
52. What the meanings are of write off and write back in terms of banking terminology? Is it same or different? What are their implications from bank balance sheet perspectives as well as bank profit perspectives?
• Accounting process whereby a loan determined to be a worthless asset is removed from the books as an earning asset and charged to the LOAN LOSS RESERVES account.
Process of removing a BAD DEBT or uncollectible loan from the balance sheet.
• In case of default by the borrower of the loan, banks will have to make provisions of loan loss.
• However, in the case of subsequent recovery of such loans and advances, then the banks will reverse such loan loss provisions.
• This is known as write back in the banking terminology.
Because, the initial fund for loan loss provisions will go from the bank profit, the subsequent such write back also naturally will go into the profit of the bank.
Causes of banking crises (is banking crisis and bank failures same? Confusing!!! Ans relates to banking crisis)
• (a) Macroeconomic circumstances
• (b) Microeconomic policies
• (c) Banking strategies and operations
• (d) Fraud, corruption
(a) Macroeconomic circumstances
• It is not uncommon for banking crises to be blamed on adverse macroeconomic developments.
• Indeed, macroeconomic instability is sometimes cited as the principal source of banking instability
• The trigger may be some combination of
• a collapse of asset prices, especially in real estate (perhaps following an earlier unsustainable increase, which may in turn have been fuelled by inappropriate macro-policy or reckless banking decisions);
• a sharp increase in interest rates or fall in the exchange rate;
• The onset of recession.
• All of these factors are, of course, interrelated.
• Another source of difficulties the removal of subsidies, creating pressure on particular businesses or sectors to which banks are exposed.
b) Microeconomic policies
• This heading covers all those structural and supervisory parameters which are under the government’s (or central bank’s) direct control or influence.
(i) Supervision
• There is a common perception that every bank failure represent a supervisory failure
(ii) Inadequate infrastructure in matters of accounting, law, etc
• Shortcomings in accounting or auditing may disguise, or delay realization of, problems of illiquidity or insolvency.
• Shortcomings in the legal infrastructure may, for example, inhibit the exercise of property rights or the pledging and realization of collateral in support of bank loans.
(iii) Liberalization / deregulation
• Deregulation in the financial sector has occasionally encouraged rash behavior, leading to subsequent problems.
• Deregulation – of activities - may require more attentive supervision in order to ensure that those activities are carried out and managed prudently.
• Some banking problems have arisen or been exacerbated because supervision has not kept pace.
(iv) Government interference
• There have been instances where government interference in a bank’s business - such as:
– directives or pressure to lend to particular customers,
– possibly at preferential interest rates, or
– to maintain or extend uneconomic branch networks
• has precipitated or hastened the onset of a liquidity or solvency crisis.
(v) Moral hazard
• If there is a general expectation that no bank will be allowed to fail, or if financial support in troubled times is too readily available to either banks or their depositors, moral hazard arises.
• Banks may be tempted into behavior which exacerbates rather than ameliorates their position
• And depositors may not bother to discriminate between “good” and “bad” banks,
• Thereby possibly prolonging survival, but magnifying a crisis when it eventually breaks.
(vi) Lack of transparency
• If, as a result of:
– an inadequate legal or regulatory framework, or
– perhaps simply as a matter of culture,
• the circumstances of a bank lack transparency to:
– depositors
– other counterparties, or
– shareholders,
• the role of market forces in determining the bank’s fate will be impeded and problems may be allowed to develop and multiply to an extent which might not otherwise have been possible.
(c) Banking strategies and operations
• In many instances the problems of a bank have been brought about by the shortcomings of its own strategy or by operational failure.
• Some of the more common operational failures are as follows:
(i) Poor credit assessment
Failure to make an accurate assessment of credit risk and to price accordingly is perhaps still the single most common cause of banks’ problems.
(ii) Interest rate or exchange rate exposures
• Sharp shifts in macroeconomic policies or circumstances may provoke losses on this account beyond the usual tolerance of regulatory limits.
(iii) Concentration of lending, and connected lending
• In some countries individual banks either have long-standing links to particular customers or economic sectors, or have been established in the more recent past specifically with such close links in mind.
• Such concentrations have been shown historically to be a source of problems, and steps should be taken where possible to reduce any such dependence.
• In the developed countries ceilings on loan concentration are clearly specified and enforced.
(iv) New areas of activity
• New activities, such as the trading of derivatives, may be imperfectly understood by senior management especially in countries where expertise is thinly spread.
• This indicates a need to proceed only step by step into new areas, but does not necessarily constitute a case for indefinite prohibitions.
(v) Unauthorized trading or position-taking, associated with a failure of internal controls
• This appears to have become an increasingly worrying source of bank losses or ultimate failure.
• In each of the cases of Barings, Jardine Fleming, Morgan Grenfell and Daiwa, a single maverick individual seemed to be responsible for losses.
• The losses in the region of $3 billion in the copper market, revealed in 1996 by the Sumitomo Corporation and apparently incurred by one trader, are another illustration of this danger; although Sumitomo Corporation is not a bank, there could have been knock-on effects to financial institutions.
• (vi) Other operational failures
• poor quality of staff,
• deficient management structure
• inability or reluctance to control costs;
• reward structure for staff that encourages excessive risk-taking;
• inadequate documentation, recording and audit trails;
• over-reliance on IT systems, without adequate back-up,
• absence of contingency plans
(d) Fraud, corruption
• Employees, management or outsiders may all be susceptible to corruption or capable of fraud on a bank; and there are many possible channels for fraud.
Transition economies
• hyper-inflation
• severe recession for a few years
• bankruptcy of traditional customers
• lax licensing
• lax supervision
• too close an involvement with particular industries
• loans to major shareholders
• government interference
• Source: FIM – 12
2. Give your opinion regarding the methodology or framework for having a stable and strong banking sector.
The steps for Banking Soundness
a. Improve Internal Governance
• It is not illegal to manage a bank poorly or even to let it fail, but it is illegal to operate a bank in disregard of laws and prudential regulations, and to conceal the true state of its financial position from supervisors.
• When their capital diminished or has been lost-- either through operational losses or lending to themselves- the owners must lose their money and control of their banks.
• Owners should never be allowed to operate an insolvent bank
b. Maintain Strict Licensing Rules
• Deregulation often opens the banking market to competition from new banks and other financial intermediaries, both domestic and foreign.
• Licensing practices should be designed to ensure that banks entering the system are operated in a safe and prudent manner and do not compete destructively.
• For example, the entry of high-quality foreign banks can make an important contribution to the long-term soundness of a banking system.
c. Beware of the Strains of Deregulation
• Deregulation enables banks to enter into new and unfamiliar areas of business, where they may incur increased exposure to credit and various market risks.
• Prior to deregulation tightly, regulated banks typically lack the necessary credit evaluation and risk- pricing skills to deploy available resources effectively.
• There have been numerous cases where banks after deregulation have entered into an almost mindless competition for market shares without regard for risks- and disregarded in the rush for profits.
d. Ensure Quality of Data
• The quality of data is a very special problem for banks, because most of their assets are loans, which are not traded and have no objectively determined market value.
• The value of collateral may also be highly uncertain, especially if asset values are unusually high.
• If managers have incentives to conceal the real value of a problem loan, for example, in order not to lose their jobs or their control of their bank, they are likely to do so-- especially if they can do so without impunity.
• It must be recognized that loan valuation rules are prone to manipulation by banks, which - especially when they have problems- typically overstate asset values, showing them at historical book value, and report paper earnings even when they are incurring economic losses.
• Misleading accounting, loan valuation and outright fraud can be difficult to detect in time and will require effective on-site inspection, external audits, and other types of monitoring.
e. Strengthen Incentives and Market Discipline
• The market is expected to reinforce banks' incentives to operate safely by driving out poorly managed and unsound banks, thus preventing problems in individual banks from growing, and in the process contaminating other banks and the system as a whole.
• Private market imposes discipline through creditors, who require higher interest rates or withdraw resources from weak banks.
• Such withdrawals involve the gradual transfer of funds from weaker into stronger banks, and ultimately the exclusion of weak banks from the interbank market.
• Market discipline requires that creditors have funds at risk in the market and have information about the banks in which they have placed their funds.
• Large and well - informed creditors, including other banks, typically are most effective in exercising market discipline because they have more resources with which to monitor and influence banks.
• Public sector creditors should act as any other large, well-informed creditor.
• For market discipline to work, three ingredients are needed;
• disclosure,
• limited official financial safety nets, and
• a strict exit policy.
f. Improve Disclosure
• Markets require prompt and reliable information in order to work, and disclosure of such information should be the responsibility of the banks.
• Banks, especially when in trouble, has incentives to withhold or distort information.
• When banks form part of larger financial groups, they may deliberately hide losses in other corporate units and not report a true consolidated position so that when information is ultimately disclosed, the opacity of banks' actual financial condition limits the ability or markets to rationally assess the information disclosed.
• This is the case even in the most advanced markets with the best external auditors, rating agencies, and other market analyst.
• In addition, disclosure of grossly misleading financial statements tends to implicate supervisors, who are expected to be informed and prevent the public from being misled.
g. Limit Scope of Safety Nets
• If it is known or expected that creditors ( and owners) of banks that run into trouble will be "bailed out" by the government or central bank, market discipline will not work.
• Overall generous official safety nets in the form of deposit guarantees and lender-of last-resort facilities lead to moral hazard and adverse selection, and provide incentives for poor internal government and excessive risk taking.
• Therefore, such safety nets should be strictly limited.
• Deposit guarantees, where appropriate, should be limited to basic consumer protection and not cover larger depositors and creditors. including other banks.
h. Uphold a Strict Exit Policy
• The exit of weak individual banks is critical for the maintenance of a sound and competitive banking system.
• The prolonged operation of unsound banks not only permits them to spiral into deeper insolvency (and higher resolution costs) but also causes damages to competitors though destructive market practices, which might enable short-term survival but are not sustainable.
• Experience has shown that unsound banks are always in worse condition than their financial statements indicate, and that the least intrusive, least expensive, and most efficient way of maintaining a sound banking system is to force the early exit of nonviable banks.
• A strong exit policy for banks (closure and liquidation) is at least as important for an efficient and competitive market system as entry policy, if not more important- although more attention is normally paid to the latter.
i. Strengthen Official Oversight
• Official oversight in the form of prudential regulation and supervision seeks to compensate for failures in internal governance and market discipline.
• But the objective of oversight is not to guarantee the survival of every bank but rather to ensure that the banking system as a whole remains sound.
• Laws and regulations provide the rules of the business and also seek to prevent destructive and fraudulent practices.
• Supervision ensures that rules are enforced, that banks are operated prudently, and that corrective measures are taken when needed.
j. Adopt Effective Regulatory Framework
• Most countries have adopted an extensive and regulatory framework for the prudent entry, operation, and exit of banks.
• To be effective, such frameworks should as far as possible rely on and reinforce banks' internal governance structures and market discipline.
• The most important prudential requirements in support of internal governance are those requiring that owners to be fit and proper and those they put their own money at risk.
• Capital adequacy is increasingly defined in relation to risk-weighted assets and off-balance-sheet items, with more capital required against higher risk (following the Basle Capital Accord).
• Effective measurement of capital requires proper evaluation of banks' asset quality and meaningful risk weights.
• Until this has been done properly, analysis of capital adequacy ratios should be made with extreme caution.
k. Improve Supervisory Autonomy and Authority
• Regulations are relatively simple to adopt, but difficult to implement.
• To effectively oversee compliance with regulations, the supervisory authority must have sufficient independence, authority, and competence.
• The supervisory authority must also have sufficient powers, established by law, to carry out its functions, including to regulate, request data, conduct on-site examinations in order to verify banks data, report and assume appropriate loan provisions, restrain unsound practices suggest corrective measures, revoke licenses, and - where needed- remove managers and force the exit of banks.
• Supervisory actions are often politically unpopular.
• But supervisors must be able to act against banks without the delays and pressures that often result from a need for political approval; they must also have legal protection for discharging their duties.
• The independence from political influences is a particularly thorny one as it requires an institutional structure that will combine independence with accountability.
l. Coordinate National and International Supervision
• In most countries, different parts of financial conglomerates (banks, securities, insurance, and pension funds) are regulated and supervised by different national authorities.
• It is important that such regulation and supervision be properly harmonized and coordinated in order to reduce the scope for regulatory arbitrage and inefficiencies.
• The need for consolidated supervision of conglomerates is a strong argument for an umbrella-type supervisory organization incorporating all financial supervision “under one roof."
m. Strengthen Macroeconomic Management
• The soundness of a banking system largely reflects the health of the economy in which it is operating.
• A stable macroeconomic environment, conducive of efficient savings and investment decisions and healthy economic growth, is a prerequisite for sound banking.
• If an economy is experiencing a slowdown or decline in growth or other adverse macroeconomic shocks, its banking system will also be affected.
Source: FIM – 13
3. What led to the move towards Basel (II) from Basel (I)?
Limitations of Basel I
• Banks have become more innovative
– Change in risk appetite and risk profiles
• Risk management practices of institutions have improved considerably
– Increased use of internal risk models
• Risk mitigants in market more prevalent (e.g. derivatives, securitization)
• Several major shortcomings of Basel I have become apparent
– Too simplistic; one size fits all approach
– Broad-brush risk weighting structure (e.g. sovereigns based on OECD and Non-OECD classification,100% risk weight for all corporates)
– Confined to credit
– Market risk and Operational risk ignored.
– Provides opportunities for regulatory arbitrage
– Seen as compliance requirement only and does not encourage good risk management practices
– Banks may have taken measures to mitigate risks, which Basel I simply do not recognize.
– Sometime, some amount from the capital amount may be required to be deducted.
– Sometime, regulator may note some risks for the bank, which that may not have given importance.
Basel II addresses the shortcomings of Basel I
• More comprehensive coverage
– Introduction of explicit capital charge for operational risk
– Able to capture other risks
• Basel II provides banks with a menu of options for capital measurement approaches
– Risk sensitive approach with wider range of risk weights to reflect the true underlying risks more accurately
– Availability of internal ratings based approaches
• Greater recognition of credit risk mitigants (Collateral, Guarantees)
• Provides more pro-active role for supervisors under Pillar 2 and encourages greater market discipline under Pillar 3
Source: FIM 05
4. What are the important features of Basel (II)?
1. Pillar One—Capital Requirements
1.1 Credit Risk
1.2 Market Risk
1.3 Operational Risk
2. Pillar Two
2.1 Supervisory Review
3. Pillar Three
3.1 Market Discipline
Source: FIM – 05 BASEL II overview
5. What prompted the authorities to move to Basel (III)?
Bank failures
With time more safety needed due to more transaction and more uncertainty
6. What are the important changes proposed to be made under Basel (III)?
Higher capital ratios
» Tier 1 Capital Ratio: increases from 4% to 6%
» The ratio will be set at 4.5% from 1 January 2013, 5.5% from 1 January 2014 and 6% from 1 January 2015
» Predominance of common equity will now reach 82.3% of Tier 1 capital, inclusive of capital conservation buffer
New Capital Conservation Buffer
» Used to absorb losses during periods of financial and economic stress
» Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirement to 7% (4.5% common equity requirement and the 2.5% capital conservation buffer)
» The capital conservation buffer must be met exclusively with common equity
» Banks that do not maintain the capital conservation buffer will face restrictions on payouts of dividends, share buybacks and bonuses
Countercyclical Capital Buffer
» A countercyclical buffer within a range of 0% - 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances
» When in effect, this is an extension to the conservation buffer
Higher Minimum Tier 1 Common Equity Requirement
» Tier 1 Common Equity Requirement: increase from 2% to 4.5%
» The ratio will be set at 3.5% from 1 January 2013, 4% from 1 January 2014 and 4.5% from 1 January 2015
Liquidity Standard
» Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid resources are available for one month survival in case of a stress scenario. Introduced 1 January 2015
» Net Stable Funding Ratio (NSFR): to promote resiliency over longer-term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis
» Additional liquidity monitoring metrics focused on maturity mismatch, concentration of funding and available unencumbered assets
Leverage Ratio
» A supplemental 3% non-risk based leverage ratio which serves as a backstop to the measures outlined above
» Parallel run between 2013-2017; migration to Pillar 1 from 2018
Minimum Total Capital Ratio
» Remains at 8%
» The addition of the capital conservation buffer increases the total amount of capital a bank must hold to 10.5% of risk-weighted assets, of which 8.5% must be tier 1 capital
» Tier 2 capital instruments will be harmonized; tier 3 capital will be phased out
Source: FIM BASEL III FAQ Moodys
7. What is stress testing?
• Stress testing refers to techniques used by financial institutions to analyze the effects of exceptional but plausible events in the market on a portfolio's values.
• A stress test is a rough estimate of how the value of a portfolio changes when there are large changes to some of its risk factors (such as asset prices).
• The term rough estimate is used to avoid the perception that stress testing is a precise tool that can be used with scientific accuracy.
Source: FIM 10 stress testing – A
8. Why are stress testing conducted?
Stress tests can also help policymakers in gauging the potential implications of different risks for the financial system as a whole, and hence in identifying those which may pose the greatest threat to systemic stability.
Stress tests help financial institutions to:
a. communicate extreme scenarios throughout the institution, thereby enabling management to take the necessary precautions (limit systems, additional capital, and so on)
b. manage risk better in more volatile and less liquid markets
c. bear in mind, during less volatile periods, that the probability of disastrous events occurring should not be neglected
Source: FIM 10 stress testing – A
9. What can happen in stress testing’s absence?
???
10. How stress testing is conducted?
System-focused stress testing is best seen as a process:
i. part investigative
– the identification of specific vulnerabilities or areas of concern
– followed by the construction of a scenario in the context of a consistent macroeconomic framework.
ii. part diagnostic
– map the outputs of the scenario into a form that is usable for an analysis of financial institutions’ balance sheets and income statements
iii. part numerical
– the numerical analysis, considering any second-round effects
iv. part interpretive
– summarizing and interpreting the results
Source: FIM 10 stress testing – A
11. What value addition banks get through stress testing?
???
12. Why do you think prudential regulations are issued and also why are they called prudential regulations, rather than simply regulations?
Issuance of prudential regulations for the banks and financial institutions are required because:
• Banks play an important role in the economy
• Their safety and soundness is very much required for a sound financial system and
• They play with other people’s money and such money must be made safe and secure.
Prudential Regulation
• Regulation means a rule or restriction made by an authority.
• Prudential means acting with or showing care and thought for the future.
• So Prudential Regulations here means those regulations issued by a regulator, (who has got the authority to issue it) with a view to have a safe and sound financial system in the country.
Source: FIM 14
13. Explain some of the important prudential regulations which banks and financial institutions in Nepal are required to follow.
a. How much capital they must have.
Capital Required for New Banks & Financial Institutions
b. What should be included in such Capital
A. Core Capital
1) Paid-up Capital
2) Share Premium
3) Non Redeemable Preference Share
4) General Reserve Fund
5) Cumulative Profit/ (Loss) (Up to Last Year)
6) Current Year Profit/ (Loss)
7) Capital Redemption Reserve
8) Capital Adjustment Fund
9) Other Free Reserves
10) Dividend Equalization Fund
B. Supplementary Capital
1) General Loan Loss Provision
2) Asset Revaluation Reserve
3) Hybrid Capital Instruments
4) Unsecured Subordinated Term Debt
5) Exchange Equalization Fund
6) Additional Loan Loss Provision
7) Investment Adjustment Reserve
8) Interest Spread Reserve
9) Contingent Reserves
10) Provision for Loss on Investment
c. How should their assets be classified
NPA
Good – up to 90 days
Sub standard – up to 180 days
Doubtful – Up to 365 days
Bad – More than 365 days
d. Under what circumstances banks must be required to make loan loss provision
e. How much such loan loss provision they must make
i. Good – 1%
ii. Sub standard – 25%
iii. Doubtful – 50%
iv. Bad – 100%
f. What should be the parameter for banks to book interest income
g. What type of risk management system banks must have
h. Should banks be allowed or debarred from making connected lending
i. How to make sure that bank exposure is not concentrated in one borrower.
j. How to comply banks with regard to corporate social responsibility.
Source: FIM 14
14. What are the risks which banks are required to encounter? Explain the nature and features of these risks.
a. Liquidity risk
b. Interest risk
c. Market risk
d. Credit risk
e. Off-balance sheet risk
f. Foreign exchange risk
g. Operating risk
Liquidity Risk
Definition: risk of not be able to honor bank’s financial commitments promptly
It arises from an uncertainty of the timing of cash flows
• Liability-side risk results from unexpectedly high rates of deposit redemption
• Asset-side risk results from borrowers unexpectedly drawing down loan commitment
Interest Risk
Definition: is the impact on banks’ earnings and market value of equity of changes in interest rates.
• Refinancing risk
• Reinvestment risk
• Matching average life of assets and liabilities reduces interest rate risk, but it is not perfect hedge
• Immunization requires dynamic rebalancing of the portfolio, which may be costly
Market Risk
Definition: the risk of bank losses from movement of market prices on its trading inventory
Credit Risk
Definition: the risk of loss due to the failure of a borrower, endorser, guarantor or counterparty to repay a loan or honor another predetermined financial obligation
• Off-balance Sheet Risk
Definition: activities that do not appear on the current balance sheet because it does not concern holding a currency primary claim (asset) or issuing a current secondary (liability)
Two categories: 1) Credit substitutes
2) Derivatives
• Foreign Exchange Risk
Definition: The potential adverse impact on a bank’s earning and value of its equity from foreign exchange rate movement
Source: FIM 10
Operating Risk
Definition: It is business risk which includes organizational behavior, technological systems and legal aspects of managing a bank
Operational Risk arises as a result of failure of operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc.
Operational Risks Include
– Internal Fraud.
– External Fraud.
– Employment Practices and Workplace Safety.
– Clients, Products and Business Practices.
– Damage to Physical Assets.
– Business Disruption and System Failures.
– Execution, Delivery and Process Management.
Source: FIM 10
15. Out of the various risks which banks have to face which one do you think banks in Nepal are very much required to face and why do you think so? How can banks manage this risk by following the standard asset liability management framework?
Liquidity Risk. (do not know the second part of the question)
16. Why is it important for Banks to maintain Liquidity?
Liquidity, the ability to convert assets into cash easily, is important if a person or company needs access to cash in a short time frame or need the money to pay for expenses
Liquidity is important for banks because it helps it to access its resources quickly in order to meet its financial obligations. Without cash, banks can quickly get into trouble with their creditors. Banks with a higher debt/equity ratio will be less liquid, as more of their available cash must be used to service and reduce the debt.
• The level of liquidity influences the ability of a banking system to withstand shocks.
• Common measures of liquidity include
• liquid assets to total assets (liquid asset ratio),
• liquid assets to short-term liabilities, or
• loans to assets
17. What is the difference between Return On Assets (ROA) and Return On Equity (ROE)?
ROA is an indicator of managerial efficiency. It indicates how capable the management of the bank has been converting the institution’s assets into net earnings
ROE is a measure of the rate of return flowing to the bank’s shareholders. It approximates the net benefit that the shareholders have received from investing their capital in the bank i.e. placing their funds at risk in the hope of earning a suitable profit.
Source: FIM 08
18. Banks have been found to be making good profit. What are the major sources of Bank Profit?
a. Interest Income
b. Commission and Discount
c. Exchange Gain
d. Non Operating Income
e. Other Income.
19. Do you think shareholders of a bank manage to get all the net profit of a bank? Yes or No, Explain
No. 20% goes to general reserve until double + LLP
Source: class hearing
20. Two Banks making an identical Net Profit may not be able to give identical dividends to the shareholder. Why do you think such thing happens?
20% goes to general reserve until double + LLP
Source: class hearing
21. What is the meaning and importance of Maturity Bucket analysis in terms of asset liability management framework?
a. Since assets and liabilities may be repriced at different time within the gapping period of, say, twelve months, balance sheet items can be grouped into a number of time intervals ('buckets') according to maturity/ repricing periods.
b. Typically the buckets will have intervals of 0-30 days, 30-60 days, 60-90 days and so on.
c. The gap for each bucket is calculated, conventionally, as the amount of rate sensitive assets less rate sensitive liabilities.
d. However, early repayment of loans can create a gap which is difficult to quantify, and the same is true of the uncertain drawdown of loans
e. Also, even if RSA and RSL are equal, the interest rate changes for assets and liabilities may not be of the same magnitude.
f. Such different repricing behavior is the basis of the standardized gap which adjusts gap measures for the relative measures for the relative volatilities of various financial instruments.
Source: FIM 11
22. Is there any difference between any other crisis and banking crisis? If so, why? Why we need to worry more about the banking crisis?
???
The causes of banking crises can be categorised under several headings: macroeconomic instability; deficient supervision; poor strategies; weak management; inadequate control systems; operational failures; fraud. The experience of a number of countries is reviewed. Whatever the causes, the authorities need a coherent strategy for addressing such crises.
23. What type of financial system we have in Nepal?
• Regulated by regulators: NRB, Securities Exchange Board,, Insurance Board
• Regulated by itself: Employee Provident Fund and Citizen Investment Trust
Source: FIM 1
24. What are the similarities and differences between Commercial Banks, Development Banks, Finance Companies and Micro Credit Units?
???Commercial Bank: minimum paid up capital required 200 crore, A class, basically for providing short term loans.. the only one to issue LC
Development bank: 64 crore. B class, provides long term loans for development projects.
Finance Companies: 20 crore paid up capital..C class, provides consumer loans
Micro credit units: 10 crore , needy people lai loan dincha... gives loan up to 90000 per person for carrying out small economic activities for ascertaining proper lives. No collateral needed.
25. What is a Bank Balance Sheet? What are its important components?
It is a statement of a bank’s financial position (as of a specific date) listing:
a. assets owned,
b. liabilities owed, and
c. owner’s equity
1.Share Capital 1.Cash Balance
2.Bills Payables 2.Balance With NRB
3.Income Tax Liabilities 3.Balance With Other FI
XXXXXXXXXXXXXX 4.Money At Call
4.Deposits 5.Investments
5.Borrowings 6.Fixed Assets
6.Debentures & Bonds XXXXXXXXXXXXXX
7.Reserve & Surplus 7.Loans & Advances +(BP)
8.Undistributed Dividends 8.Non-Banking Assets
9.Other Liabilities 9.Other Assets
TOTAL Liabilities TOTAL Assets
Source: FIM 02
26. What is the reason that in some of the bank balance sheets, we tend to see a negative figure under Retained Earning item?
.....if LLP is greater than the accumulated retained earnings of all the years.
27. All companies will have source and utilization of resources. For banks, what are the important sources and utilization of resources?
Deposit and Loans
Sources
Share capital
Reserves
Debentures and bonds
Bills payable
Deposits
Borrowings
Undistributed dividend
Income tax liabilities
Other liabilities
Utilization
Cash balance
Balance with NRB
Balance with other financial institutions
Money at call
Investments
Loans and advances
Fixed assets
Non banking assets
Other assets
28. Why do you think capital is given such an important role in the bank management?
In the first place, capital provides a cushion against the risk of failure by absorbing financial and operating losses until management can address the bank's problems and restore the institution's profitability.
Second, capital provides the funds needed to bet the bank chartered, organized and operating before deposits come flowing in.
A new bank needs starting up funding to acquire land, build a new structure or lease space, equip its facilities, and hire offers and staff even before opening day.
Third, capital promotes public confidence in a bank and reassures its creditors (including the depositors) of the bank's financial strength.
Capital also must be strong enough to reassure borrowers that the bank will be able to meet their credit needs even if the economy turns down.
Fourth, capital provides funds for the organization's growth and the development of new services, programs, and facilities.
When a bank grows, it needs additional capital to support that growth and to accept the risks that come with offering new services and building new facilities.
Most banks eventually outgrow the facilities they start with.
An infusion of additional capital will permit a bank to expand into larger quarters or building additional branch offices in order to keep pace with its expanding market area and follow its customers with convenient service offerings.
Finally, capital serves as a regulator of bank growth, helping to ensure that the individual bank's growth is held to a pace that is sustainable in the long run.
Both the regulatory authorities and the financial markets require that bank capital increase roughly in line with the growth of loans and other risky bank assets.
Thus, the cushion to absorb losses is supposed to increase along with a banking institution's growing risk exposure.
A bank that expands its loans and deposits too fast will start receiving signals from a market and the regulatory community that its growth must be slowed or additional capital must be acquired.
Capital regulation by regulatory agencies has become an increasingly important policy tool to limit how much risk exposure banks can accept, thereby promoting public confidence and protecting the government's deposit insurance system from massive losses.
Source: FIM 04
29. What is the meaning of Risk Weighted Assets? Explain.
RWA is a bank’s assets or off balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or CAR for a financial institution. In the Basel I accord published by the Basel committee on Banking supervision, the committee explains why using a risk weight approach is the preferred methodology which banks should adopt for capital calculation.
• It provides an easier approach to compare banks across different geographies
• Off balance sheet exposure can be easily included in capital adequacy calculations
• Banks are not deterred from carrying low risk liquid assets in their books
Usually, different classes of assets have different risk weights associated with them. The calculation of risk weights is dependent on whether the bank has adopted the standardised or IRB approach under the Basel II framework.
Some assets, such as debentures, are assigned a higher risk than others, such as cash or government securities/bonds. Since different types of assets have different risk profiles, weighing assets based on the level of risk associated with them primarily adjusts for assets that are less risky by allowing banks to discount lower risk assets. In most basic application, government debt is allowed a 0% risk weighting that is they are subtracted from total assets for purposes of calculating the CAR.
30. Is it logical to take Off Balance Sheet activities of a bank into consideration for the purpose of calculating Risk Weighted Assets of a bank? Give reasons
???
Yes, it is logical.
31. What are the components of Capital Fund? Explain
CORE
01.Capital Adjustment Reserve
02.Capital Redemption Reserve
03.Dividend Equalization Reserves
04.Irredeemable Non-cumulative preference shares
05.Other Free Reserve
06.Paid up Equity Share Capital
07.Proposed Bonus Equity Shares
08.Retained Earnings
09.Share Premium
10.Statutory General Reserves
11.Un-audited current year cumulative profit
SUPPLEMENTARY
01.Assets Revaluation Reserve
02.Cumulative and/or Redeemable Preference Share
03.Exchange Equalization Reserve
04.General loan loss provision
05.Hybrid Capital Instruments
06.Investment Adjustment Reserve
07.Other Reserves
08.Subordinated Term Debt
32. What are the differences between Core Capital and Supplementary Capital?
33. What is the meaning of Capital Adequacy Ratio?
is the ratio of bank’s capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory.
34. How is Capital Adequacy Ratio calculated?
Basel I= core +supp/ risk weight * ( assets +off balance sheet exposure)
Basel II = (core capital-specific deduction-adjustments under pillar II ) +supplement/Risk Weight *(CR+MR+OR)
+adjustment under pillar II
Source: FIM CAR Calculation
35. Why is Capital Adequacy Ratio such an important parameter in bank management?
???
36. What are Basel I and Basel II?
Basel 1 refers to the guidelines with regard to the required capital banks must possess.
They have been called Basel guidelines because they are issued by BIS (Bank for International Settlements) located at a Switzerland city by the name of Basel.
As per German language, this city is called Basle. So, sometime this guideline is also called Basle guidelines.
37. What are the important differences between Basel (I) and Basel (II)?
The main difference is that Basel I accord mainly focused on capital requirement for banks. The Basel II adds supervision and market discipline to these capital requirements through the “Three Pillars” concept. The first pillar is about capital requirement. The second pillar is about regulation and supervision and the Third pillar describes market discipline.
38. What are the important differences between Basel (I I) and Basel (III)?
Basel III is an enhancement over Basel II brought out with the experience of global financial turmoil the enhancement are primarily under two heads primarily one is capital and the other is liquidity.
Capital there is a minimum prescription off capital by the way of common equity under base III. That is to say all the capital that is reckoned under Basel II will not be eligible for such reckoning. Ex capital debt instrument will step up option after certain period are not eligible. Deduction from the capital was earlier considered from tier I and tier II equally. Under Basel III deductions is made from tier I capital only.
39. What is the meaning of Loan Classification? Why do you think they are undertaken in bank?
Loan classification refers to the process banks use to:
a. review their loan portfolios and
b. assign loans to categories or grades based on:
i. the perceived risk and
ii. other relevant characteristics of the loans.
The process of continual review and classification of loans enables banks to:
• monitor the quality of their loan portfolios and,
• when necessary to take remedial action:
• to counter deterioration in the credit quality of their portfolios.
Source: FIM 06
40. How is job of Loan Classification undertaken by banks in Nepal?
Good loan up to 90 days
Substandard 120 days
Doubtful 180 days
Bad 1 yr
41. Banks are said to be required to face deleterious effects due to the accumulation of NPAs. Why do you think NPAs happens?
Internal:
• diversion of funds for
• expansion / diversification / modernization
• taking up new projects
• helping/promoting associate concerns
• time/cost overrun during the project implementation stage
• business (product, marketing, etc.) failure,
• inefficient management,
• strained Labour relations,
• inappropriate technology/technical problems,
• product obsolescence, etc.
External:
• recession,
• non-payment in other countries
• inputs/power shortage,
• price escalation,
• accidents, and natural calamities, etc.
• changes in government policies in excise/import duties, pollution control orders, etc.,
42. Why are AMC related with bank’s NPA problem?
• The arguments for “carving out” the bad loans is that the originating bank may be less objective and may even continue lending to delinquent debtors. Furthermore, a bank preoccupied with managing bad debts may become very risk-averse, with little time or inclination for new lending. It is easier to give separate transparent goals if different people are charged with the ongoing banking operations and the resolution of bad loans. Moving bad assets off the balance sheet would also facilitate finding another bank to buy the troubled bank without complicated guarantee arrangements covering the NPLs. However, there is also a case for not moving all NPLs away from the bank. It is desirable for the bank to maintain some experience with work-out procedures. It is also unfair to the better managed banks if the distressed banks end up with no NPLs. It is important when such an approach is followed that the “bad bank” does not end up with all the “bad staff” as well as the “bad assets”. The alternative approach is to establish a single asset management corporation to purchase NPLs from a number of banks: in effect, there will be one large “bad bank” for the whole banking industry. This seems to be becoming the predominant approach.
43. Banks have been found to be making good profit. What are the major sources of Bank Profit?
i. Interest income
ii. Commission n discount
iii. Exchange gain and loss
iv. Non operating income and loss
v. Other income
44. Why do you think one should not focus exclusively on Net Profit only?
Next question answers
45. Why do you think, one should not hastily make conclusions based purely on Net Profit of a bank?
Income must be sustainable.
Net profit does not reflect the overall performance
Look at growth of key items of financial statements
Trend analysis
Differentiate organic and acquired growth
Sustainable growth =
ROE x (1 – Dividend payout ratio)
Dividend payout = Dividend / Earnings attributable to shareholders
= indicator of internally generated growth potential if the company’s profitability, dividend payout and level of debt financing are kept constant
Banks performance not measure by the profit only.
Profit varies according to the size of the banks, larger the bank larger might be the profits
Different ratios must be taken into consideration.
• ROA is an indicator of managerial efficiency. It indicates how capable the management of the bank has been converting the institution’s assets into net earnings
Net Income after taxes/Total Equity capital
• ROE is a measure of the rate of return flowing to the bank’s shareholders. It approximates the net benefit that the shareholders have received from investing their capital in the bank i.e. placing their funds at risk in the hope of earning a suitable profit.
Net Income after taxes/Total Equity capital
• The Net Interest Margin measures how large a spread between interest revenues and interest costs management has been able to achieve by close control over the bank’s earning assets and the pursuit of the cheapest sources of funding
Interest Income – Interest Expense/Total Asset
• The Non Interest Margin measures the amount of non-interest revenues stemming from various service charges and other service fees the bank has been able to collect (known as fee income) relative to the amount of non interest cost incurred.
Non Interest Income – Non Interest Expense/Total Asset
• Net Operating Margin
Total Operating Income – Total Operating Expense/Total Asset
46. What were the shortcomings in the Capital Adequacy Ratio regime before 1988? How these shortcomings were taken care in Basel I?
– Aimed at
• Strengthening stability and soundness of international banking system
• Creating greater consistency in the assessment of internationally active banks
– Minimum capital requirement = 8%
– Adopted in over 100 countries worldwide
– Refinement in 1996 to incorporate market risk
47. Why do you think global regulators were forced to formulate Basel III?
Basel III is a set of proposed changes to international capital and liquidity requirements and some other related areas of banking supervision. It is the second major revision to an original set of rules, now known as Basel I, which was promulgated by the Basel Committee in 1988.
THE MAJOR FEATURES OF BASEL 3 ARE:
• Better capital quality
• CAPITAL CONVERSATION Buffer
• COUNTERCYCLICAL BUFFER
• Minimum common equity and tier 1 capital requirement
• Leverage ratio
• Liquidity ratio
• Systematically important financial institutions
48. Why do you think banks are always vulnerable towards interest risk? What are the standard tools deployed by banks for managing interest risk?
IR: is the impact on banks’ earnings and market value of equity of changes in interest rates.
Interest Risk (measurements)
• Gap analysis
• Duration analysis
• Simulation model
49. In which way, do you think, banks will be helped in managing liquidity risk because of regulators imposing SLR (Statutory Liquidity Ratio) & CD (Credit Deposit) Ratio? What are these ratios in Nepal at the moment?
The latest monetary policy introduced by Nepal Rastra Bank (NRB) had slashed CRR to five per cent for commercial banks, 4.5 per cent for development banks and four per cent for finance companies to promote lending. Likewise, SLR has been reduced to 12 per cent for commercial banks, nine per cent for development banks and eight per cent for finance companies. Class ‘B’ and ‘C’ financial institutions that do not collect call deposits have to maintain SLR of six per cent.
CRR refers to the portion of total deposits that financial institutions have to keep at central bank as deposit. SLR is the portion of total deposits that financial institutions have to maintain as liquid assets such as cash, government securities and precious metals. Reduction in SLR and CRR has freed some funds of banks and financial institutions for lending and investment. Nepal Rastra Bank (NRB) has said that all loans refinanced by the central bank do not require to be included as part of the total credit while calculating the CD Ratio. The central bank requires financial institutions to maintain a CD Ratio of 80 per cent, which means that banks can only lend 80 per cent of the total deposit collection.
50. What are the prudential regulations covering Capital, Asset, Management, Earnings, Liquidity and Sensitivity? Explain
Prudential regulation
those regulations issued by a regulator, (who has got the authority to issue it) with a view to have a safe and sound financial system in the country. Issuance of such regulations for the banks and financial institutions are required because:
• Banks play an important role in the economy
• Their safety and soundness is very much required for a sound financial system and
• They play with other people’s money and such money must be made safe and secure.
51. What are the consequences of accumulation of non-performing assets by a bank?
• NPAs have a deleterious effect on the return on assets in several ways –
– They erode current profits through provisioning requirements
– They result in reduced interest income
– increased pressure on net interest margin (NIM) thereby reducing competitiveness,
– steady erosion of capital resources
– increased difficulty in augmenting capital resources.
– reputational risks arising out of greater disclosures on quantum and movement of NPAs, provisions
52. What the meanings are of write off and write back in terms of banking terminology? Is it same or different? What are their implications from bank balance sheet perspectives as well as bank profit perspectives?
• Accounting process whereby a loan determined to be a worthless asset is removed from the books as an earning asset and charged to the LOAN LOSS RESERVES account.
Process of removing a BAD DEBT or uncollectible loan from the balance sheet.
• In case of default by the borrower of the loan, banks will have to make provisions of loan loss.
• However, in the case of subsequent recovery of such loans and advances, then the banks will reverse such loan loss provisions.
• This is known as write back in the banking terminology.
Because, the initial fund for loan loss provisions will go from the bank profit, the subsequent such write back also naturally will go into the profit of the bank.
