RISK AND ASSETS & LIABILITIES MANAGEMENT OF URBAN CO- OP BANKABHYUDAYA CO-OP BANK LTD.

Subject: Submitted to:

Enterprise Risk Management. 404 (Visiting faculty) NALSAR University of Law Institute of Insurance & Risk Management Swapnil Singh Roll No. FS11-017 IInd Year , IVth Semester Masters in Law Of Financial Services And Capital Markets

Submitted By:

NALSAR University of law

Institute of Insurance and Risk Management

Table of Contents Chapter No. 1 2 3 4 5 6 7 8 9 10 11 Topic Evolution of Urban Co-op Bank What is Assets Liabilities management Page No 1 6

(ALM)? Risks Management in Banks 9 Guidelines of RBI for ALM 14 Non-Performing Assets(NPAs) and Income Recognition 41 Norms Management of Off- Balance Sheet Activities 44 Capital Adequacy For Urban Co-op Banks 48 Overview of Financial Structure of ABHYUDAYA CO- 57 OP BANK UCBs Present Status And their Challenges Recommendation and Conclusion Bibliography 58 62 63

CHAPTER 1 INTRODUCTION

Abhyudaya Co-op. Bank Ltd., one of the leading co-operative banks in India, in its outlook and approach, has the objective of progress and prosperity of all. From a humble beginning in January 1964 as a Co-operative Credit society with a share capital of a merely Rs.5,000/- held by 83 members, today Abhyudaya Co-op bank has become one of the largest urban co-operative banks with a "Scheduled Bank" status in Maharashtra. Currently, the capital base of the bank stands at Rs. 20.21 crores and Reserves and surpluses at Rs. 437.28 crores. The bank has 1,06,195 members and more than 11 lakh depositors. The Bank has seen a tremendous growth in deposits. The deposits of the bank are over Rs. 1623 crores as on 31.03.2004, which were Rs. 1518 crores as at the end of the financial year 2002-2003. The loans and advances stood at Rs. 770 crores as on 31.03.2004. The bank had posted a net income of Rs. 15.61 crores as on 31.03.2004. The growth rate of the bank compares well with that of others in the sector. The Bank has maintained a steady growth. The bank has been paying dividend @ 12% to its members which is maximum permissible as per the MCS Act. The Bank has launched different loan schemes tailor-made to suit the needs of various customers. The schemes aim at providing loans for purchase or construction of residential premises, repair/renovation of house property, purchase of car, seeking higher education and for purchase of household consumer durable. One of the loan schemes, viz. "Udyog Vikas Yojana" is specially designed for the benefit of small entrepreneurs and businessmen. The procedure for sanctioning of loans under the schemes has been simplified and relaxed with a view to attract new customers and facilitating speedy sanction of loans. The Bank has total 40 Branches including 1 Extension Counter and a Mobile Bank in Navi Mumbai. The area of operation of the Bank has been extended to the territorial jurisdiction of entire State of Maharashtra. Bank is committed to spread network of branches throughout the State and provide much needed banking services to the population, which has been deprived of the banking facilities.

Innovative Banking is another area of operation that Abhyudaya is currently focusing on for a sustainable long term growth. The Bank has always endeavored for providing satisfactory customer service with the help of the latest technology. The Bank has provided fully computerized services to its valued clients. Bank is offering 11 Hours fully computerized services at 16 branches and 24 hours ATM service at 31 branches. With a view to meet the challenges of technologically advanced banking system and to upgrade its existing technology, the bank has decided to introduce "Total Bank Automation" to provide the facility of inter-branch connectivity for any time and any branch banking transactions. FEATURES:01. 02. 03. 04. 05. 06. 07. 08. Attractive Interest Rates on Deposits. 0.50% additional interest on Deposits for Co-op. Societies. 1.00% additional interest on Deposits for Senior Citizens. Various Loan Facilities to fulfill your needs. We have cheque drawing & cheque collection facility on major cities all over India. Electricity Bills of B.E.S.T., M.S.E.B. etc accepted. NO TDS to our Shareholders. Lockers available at lowest rate.

CHAPTER 2 EVOLUTION OF URBAN CO-OPERATIVE BANK.

Co-operative as a distinct economic system arose out of reaction to the abuses of Capitalist System based on free market economy. Co-operation as a form of business organization, therefore owes its origin to poverty and economic distress. There were two evils, which were constantly affecting the poor section of the society. One was Usury and the other Profiteering i.e. the needy people had to pay an exorbitant rate of interest on money they borrowed, and the greedy shop keepers always charged an unreasonably high price for the necessaries of life sold by them, as the market was under the control of capitalists. Therefore, as an alternative to Usury and competition from the organized sector co-operative banks and other co-operative institutions emerged. Early history of co-operative movement throughout the world shows that the Cooperative organizations began with the consumers Co-operatives. The first Co-operative society known as Rochdale Pioneers was formed by 28 flannel weavers in England in 1843 to protect themselves against the organized sector. The movement later on spread to other fields of economic activities. But, the ultimate aim of Co-operative was the protection of poor section of society by pooling the available resources with them to help their members by providing financial assistance to face the competition from the organized sector. Various sectors of economic life where Co-operative organizations developed were agriculture credit, supply of agriculture requisites, farming, agriculture marketing, dairying, industrial production, distribution, consumer Co-operatives, housing and urban credit, etc. The Urban Co-operative Banks were first started in Germany by D.Schultze in 1888 and by F.L Luzzetti in Italy in February 1898. Thus Urban Co-operative Banks are more than 100 years old. In India, first Urban Co-operative bank was started by Mr. Vithal Laxman Kavthekar in 1889. The guiding principles of urban Co-operative bank have been the lofty ideas of voluntary an open membership, equal economic participations and concern for community.

Co-operation Defined The word Co-operation has been defined in different ways by economists, lawmakers and others. The International Labour Office in its publications. Co-operative Management and Administration has defined Co-operation as an association of persons, usually of limited means who have voluntarily joined together to achieve a common economic end and through the formation of a democratically-controlled business organization, making equitable contribution to the capital required and accepting a fair share of risks and benefits of the undertaking. Accordingly to Co-operative Planning Committee appointed by the government of India in 1945, known as Saraiya Committee, Co-operation is a form of organization in which persons voluntarily associate together on a basis of equality for the promotion of the economic interest. Those who come together have a common aim, which they cannot achieve by individual, isolated action because of the weakness of economic position of a large majority of them. This element of individual weakness is overcome by pooling their resources by making self-help effective through mutual aid; and by strengthening the bonds of moral solidarity between them. Main features of Co-operative Organization The main features of Co-operative organization are: Voluntary Association Democratic Administration Self-help and Mutual Aid Common Welfare through Common Action Participation Of Members on the basis of Equality

Urban Co-operative Banks- Structure and Functions The primary objective of a Co-operative bank is to encourage Thrift and self help and to raise resources by way of deposits. Hence the basis tenet of a Co-operative bank is to encourage the savings habits of its members. Co-operation is definitely a school of thrift, and Co-operative savings create first the basis of funds, which are then employed for granting credits and for securing the confidence of depositors and clients. Another objective of Co-operative banks is to lend money to those who may not have acceptable assets to secure funds, but who are in need of it, especially to the weaker section of the community. The resources of banks should not be given to a few chosen members. All members are entitled to get loans and an individual maximum if fixed to avoid the monopolizing of resources by a few. While lending money, the Co-operative banks see that they are properly used for productive purpose. Then only it would be possible for the borrower to repay the loans in time. The Co-operative system possesses certain qualities, which eliminate the difficulty encountered by commercial banks when lending to small borrowers. Co-operative banks are generally local in character and they have local feel. Therefore, lending by them is more to the needy people of the community and hence recovery becomes easier. The aim of Co-operative lending is not to weaken a member by making debt on unbearable burden but to help him to get rid of financial difficulties by creating assets and to start a new economic life. The purpose of a Co-operative bank is also to offer service to the customer at a reasonable cost. As profit motive is eliminated, a Co-operative banker can afford to render services at a reasonable cost. Co-operative banks been enjoying legislative support from the government. In India, they have been working under the Co-operative Societies Acts of the respective states and have been provided certain concessions In order to help them to face challenges from commercial banks. They do not have to pay income tax on their income they are allowed to pay slightly higher interest on their deposits and have been provided separate machinery in the form of Co-operative Courts for the purpose of

recovery of their dues. At present, Co-operative Banks have been providing all modern banking services comparable to that offered by any Commercial Bank. The functions of Co-operative Banks in India are governed by the Banking Regulation Act, 1949. the Banking Regulation Act was not applicable to Urban Co-operative Banks till March 1966. It was made applicable to them with the ultimate objective of protecting customers interest as large amounts of deposits were at stake. According to Section 6 of banking Regulation Act, Urban Co-operative Banks can immediate following functions. In addition to normal business of banking, Co-operative banks may engage in any one or more of the following activities namely: The borrowing, raising or taking up of money, the lending or advancing of money either upon or without security, the drawing making accepting discounting, buying, selling, collecting and dealing of bills of exchange, hundies, promissory notes, coupons, drafts, bills of landing, railway receipts, warrants, debentures, certificates, scrips and other instruments and securities whether transferable or negotiable or not; the granting and issuing of letters of credit, travelers cheques an circular notes : the buying and selling of foreign exchange, securities and investments of all kinds, the purchasing and selling of bonds, scrips or valuables on deposits or for safe custody or otherwise, the providing of safe deposits vaults: the collecting and transmitting and securities. Acting as a agent for any government or local authority or any other persons or persons: the carrying on of agency business of any descriptions including the clearing and forwarding of goods, giving of receipts an discharges and otherwise acting as an attorney on behalf of customers.

Contracting for public and private loans and negotiating and issuing the same

 Carrying on and transacting every kind of guarantee and indemnity business

Managing, selling and realizing any property which may come into the possession of the Co-operative bank in satisfaction or part satisfaction of its claims. Undertaking and executing trusts.

Undertaking the administration of estates as executor, trustee or otherwise. The acquisition, construction, maintenance, and alteration of any building or works necessary or convenient for the purpose of the Co-operative bank.

Acquiring and undertaking the whole or any part of the business of any persons or company or Co-operative society- when such business is of nature enumerated or described in the sub-section Doing all such other things as are identical or conducive to the promotion or advancement of the business of the Co-operative bank. Any other form of business which the central government may by notification in the official gazette, specify as a form of business in which it is lawful for a Co-operative bank to engage. RELEVANCE AND IMPORTANCE OF ASSET-LIABILITY MANAGEMENT Asset Liability Management (ALM) as a concept is gradually gaining currency in Indian conditions in the wake of the on-going financial sector reforms, particularly reforms

relating to interest rate deregulation. The technique of managing both Assets and liabilities together has come into being as a strategic response of banks to inflationary pressure, volatility in interest rates and severe recessionary trends which marked the global economy in the 70s and 80s . There are three distinct phases of the volution of the concept. While the First phase witnessed the advent of highly volatile global financial environment in the 70s the second phase was marked by the explosive growth of new financial products leading the banks in developed economies to focus on liability management and spread management .In the decade to follow , due to new regulatory standards, better internal policy development and rapid advancement in information technology , the Experimentations of last 2/3 decades have converged into comprehensive technique of managing entire bank balance sheet in a cohesive manner , which later came to be known as Asset-Liability management . Although the process is too complex to practice, it is perhaps the only solution for banks to survive in dynamic environment which requires to stress on total balance sheet management.

CHAPTER 3 WHAT IS ASSET LIABILITY MANAGEMENT (ALM)?

To put it simply, ALM is the management of total balance sheet dynamics with regard to its size and quality . It involves(a) (b) Quantification of risk and Conscious decision making with regard to asset liability structure in order to maximize interest earning with framework perceived risk. In other words ALM can be defined as the process of managing the net interest margin (NIM) within the overall risk bearing capacity of a bank. Thus it calls for an integrated approach towards financial management conditioned to simultaneous decision making with regard to types and size of financial assets and liabilities, their mix and volumes so as to insulate the spread from moving in adverse direction. Thus , the secret of successful banking under deregulated and competitive environment hinges on matching of assets and liabilities in terms of rate and maturity with a view to obtaining optimum yield.

SCOPE AND OBJECTIVES OF ALM: A sound ALM system should focus on: 1. review of interest rate outlook 2. fixation of interest/ product pricing on both asset and liabilities 3. examining loan portfolio 4. examining investment portfolio 5. measuring foreign exchange risk and 6. managing liquidity risk 7. Review of actual performance vis--vis projections in respect of net profit, interest spread and other balance sheet ratio. 8. budgeting and strategic planning 9. Examining the profitability of new products.

Since management of risk is fundamental to sound banking practice, no bank can afford to err on this count. If poorly managed, a bank can experience earning, liquidity and ultimately capital adequacy problem. Hence the primary objective of the asset liability management is not to eliminate risk; but to manage it in such a way that the volatility of net interest income is minimized in the short term horizon and net economic value of the organization is protected in long term horizon. Broadly the objectives would include controlling the volatility of net income, net interest margin, capital adequacy, liquidity risk and finally ensuring an acceptable balance between profitability growth and risk.

Branches

Branch Information

Weekly Return Cell

Treasury Investment Forex Call money

Residual Maturities Maturity Details

Norms

ALM System

Norms

ALCO

Resources Analysis & Norm Setting Management

NEED FOR ALM: AN ANTIDOTE FOR VOLATILITY With the onset of financial sector reforms and the liberalization process growing from strength to strength, Indian banks are now being more and more exposed to uncertainty. Under the protective wings of administered framework of yesteryears , hardly, was it necessary to monitor spread as interest on both assets and liabilities side were as per the guidelines of RBI . So also the sourcing and funding pattern which was equally subjected to control leaving insignificantly narrow space for the management to use its discretion. However, things have changed too rapidly since 1991. As the veil of regulations gradually giving into the more autonomous system, post reform banking scenario is marked by 1. Partial deregulation of deposit rates in a phased manner and with rapid frequency 2. Freeing interest rate on lending over Rs.2 lacs 3. Allowing new players in the market 4. Introduction of new products in the market 5. Greater use of information technology with increasing MIS capability. All these developments have increased the volatility of the market in so far as the movement of funds from one segment of the market to another is concerned. Besides the trend towards greater integration of money market, foreign exchange market and capital market is more visible. With the emergence of an active debt market, the volatility in the market condition is expected to be further accentuated. In this changing scenario where risks and opportunities are plenty, banks can no longer ignore to examine their competitive ability to emerge as active players in market. Besides, Indian banks are under compulsion to take active interest in the market development as a matter of survival. Public sector banks, more conspicuous by their inherent organizational and systematic deficiencies are more under pressure to adopt the new technique of better asset liability management as a strategic response to the increasing trends towards globalised competition.

CHAPTER 4 RISK MANAGEMENT IN BANKS

RISKS

FINANCIAL

NON- FINANCIAL

CREDIT RISK

CONTIGENCY RISK

OPERATIONAL RISK

SYSTEMIC RISK

MARKET RISK

INTEREST RATE RISK

LIQUIDITY

FOREX - RISK

Risks are inherent in banking business. Risk may be simply defined as the probability of loss or damage. Given the complexities of bank balance sheets and rapidity of changes, chances of loss or risks are not only complex in nature but also varied in dimension. Interplay of simultaneous risks makes the ALM both interesting and dangerous and requires the exercise to move beyond a work out for insulating profitability risk. Broadly speaking banks are exposed to the following five types of financial risks. These are (A) Credit Risk (B) Interest Rate Risk (C) Liquidity Risk (D) Capital Risk (E) Market Risk.

(A) CREDIT RISK The risk of the counter failure in performing the repayment obligation on due date is known as credit risk. Traditionally credit risk management is the primary challenge for financial institution and such risk are regulated by laid down credit/loan policy of the institution. Misjudgment of credit risk may lead to eventual fall of banks. The problems of many of the Japanese banks, failure of savings and loan association in USA in the 80s are cases in example. Even though the credit risk is managed by credit policy, there is a strong inter-relationship between market risk and credit risk. To the extent credit risk is caused by market risk variables, management of such risks becomes part of ALM. In a highly volatile interest rate environment, loan defaults may increase thereby deteriorating the credit quality. (B) INTEREST RATE RISK By traditional definition interest rate risk means changes in the interest income due to changes in the rate of interest. While this focus is not misplaced, it is definitely incomplete in as much as it overlooks an important aspects changes in the interest rate resulting in the value of Assets/Liabilities. Thus interest rate risk may be viewed from two different but complementary perspectives earning sensitivity to rate fluctuations and price sensitivity of instruments/products to changes in interest rate. Absence of appropriate management of interest rates, among other factors, is one of the reasons which had accentuated the spell of liquidity problems experienced in the recent past. Changes in the interest rates can affect banks with regards to changes in: a) Market value of Assets/liabilities and off balance sheet items, ultimately impacting the value of net worth. b) Net interest income due to mismatching in the repricing terms of the assets and liabilities. c) Net income as a result in changes in income. d) Net interest margin due to changes in interest income.

e) Net income margin owing to changes in interest income and sensitivity of non interest income to rate changes. f) Net margin for the changes mentioned above (b) to (e) g) Capital asset ratio due to changes in net margin.

Fluctuations in interest rates, being a very common phenomenon, thus lead to a host of risks of different dimensions to which assets and liabilities of banks are perennially exposed. These risks are as under: i. RATE LEVEL RISK: Refers to the possibility of rates going up or down during a given period. The general changes in interest rates is a key factor in deciding the mix of asset/liabilities in terms of maturity, type etc. ii. VOLATILITY RISK: Frequency in the changes in interest rate will affect the business volume, product mix and pricing of both assets and liabilities. In a dynamic environment such volatility in rates will have substantial impact on the cash flow and net present value.

iii.

PREPAYMENT RISK: Risks of prepayment of assets resulting in fall of margin.

iv.

BASIS RISK: Where two rates do not move simultaneously thereby impacting the cash flow in a given time frame.

v.

REAL INTEREST RATE RISK: In a inflationary economy the challenge is to manage the real interest cost adjusted to inflation levels.

vi.

EVENT RISK: Basically refers to risk associated with unforeseen events and is organization specific in nature.

(C) LIQUIDITY RISK: Liquidity risk is the potential inability to generate cash to cope with the decline in deposits or increase in assets. Liquidity risk originates from the mismatches in the maturity patterns of asset and liability. There are obvious relationship between liquidity risk and interest rate risk. Banks protect their liquidity position generally by controlling mismatch between maturities of asset and liabilities, focusing on core deposits- the most permanent source of liquidity, and other liquid assets. Since banks deal with assets and liabilities with varied maturity pattern and risk profile, what they need is to strike a reasonable trade-off between being overly liquid and relatively illiquid. One of the basic indicators of liquidity measurement is the ratio of volatile liability to loans. (D) CAPITAL RISK: Maintaining adequate capital on a continuous basis is the sine qua non for sound banking practices. Each bank has to assess how much capital they would require to fulfill the regulatory norms. More than that, in a business situation banks require capital to insulate themselves from the risks of business they undertake and, hence, risks relating to credit, liquidity, interest rates and movement of market prices. Since it is imperative for every bank to understand the importance of capital adequacy as also the economic level of capital, management of capital risk is also one of the important plank of the overall balance-sheet management. (E) MARKET RISK: Market risk is the risk to a banks financial condition that would result from adverse movement in market prices. Primarily the impact of market risks is observed in the

movement of portfolio value. There is a strong inter-relationship between interest rate risk and market risks variables. Inadvertently taken market risk could prove to be dangerous for banks. The fall of Barings and the trouble faced by Daiwa are the cases in point.

APPROACHES TO QUANTIFICATION OF RISK: Even though a considerable degree of interest rate deregulation has taken place and the proverbial interest rate volatility hitherto unfamiliar to the Indian banks are slowly being visible, quantification of risk relating to interest rate has not received the kind of attention it deserves. Failure to mange interest rate risk optimally may wreak havoc on banks in as much as they can lose more through interest rate movement than through bad credit decisions. Especially it is more crucial to banks in India in view of the large proportion of their assets are in the form of fixed interest government securities. Hence, management of interest rate risk is s important and so the quantification of risk without which risk management its impracticable. Universally, there are four principal approaches used to quantify the risk . These are under: a) GAP METHOD: The Gap Approach addresses to the rate sensitivity of assets and liabilities. The gap is the differences between the existing Rate Sensitivity Assets (RSA) and Rate Sensitive Liabilities (RSL) in a particular time period. It ignores the time , in the chosen period , the assets and liabilities would need to be repriced and , hence, shorter the period more sensitive is the model. Interest rate risk is minimized if the gap is managed to near zero for each period. b) SIMULATION: Simulation involves a series of what if analyses of the impact of interest rate changes on the net income. It therefore requires forecasting the asset liability picture under different scenarios, ascribing

probabilities to them and choosing the most optimum model. The method being more dynamics, its utility depends upon the accuracy of forecasts.

c) DURATION METHOD: Duration method evaluates the impact of interest rate changes on the market value of assets and liabilities. The duration of an asset or liability is calculated as the weighted average maturity of the resultant cash flows, the weights being the present value of the cash flow. Duration, expressed in the time periods, is less than the maturity for coupon bonds and is equal to maturity for a zero coupon bond. Greater the value of duration gap, higher is the interest rate risk exposure of the assets/liabilities. The method, being too complex, is however, far more flexible. How much interest rate risk a bank should assume, however, depends upon how risk savvy or risk averse the bank is. d) VALUE AT RISK METHOD: The method enables to work out depreciation/appreciation in the value of assets/liabilities due to change in interest rate so as to indicate the trend in economic value of portfolio. Impact of interest rate changes on the value of off market items of balance sheets such as loan, deposits etc. need to be calculated under different rate scenarios for evaluating the opportunity cost/benefits of carrying such assets/liabilities in a longer time frame. Although this is a new approach for quantification of risks, this is emerging as a very useful tool for calculating the net worth of the organization at a particular time so as to focus on the longer term risk implications of the decisions that have already been taken/or to be taken.

CHAPTER 5 GUIDELINES of RBIASSET - LIABILITY MANAGEMENT (ALM) SYSTEM IN BANKS

ALM has to be supported by a management philosophy which clearly specifies the risk policies and tolerance limits. This framework needs to be built on sound methodology with necessary information system as back up. Thus, information is the key to the ALM process. It is, however, recognized that varied business profiles of banks in the public and private sector as well as those of foreign banks do not make the adoption of a uniform ALM System for all banks feasible. There are various methods prevalent world-wide for measuring risks. These range from the simple Gap Statement to extremely sophisticated and data intensive Risk Adjusted Profitability Measurement methods. However, the central element for the entire ALM exercise is the availability of adequate and accurate information with expedience and the existing systems in many Indian banks do not generate information in the manner required for ALM. Collecting accurate data in a timely manner will be the biggest challenge before the banks, particularly those having wide network of branches but lacking full scale computerization. However, the introduction of base information system for risk measurement and monitoring has to be addressed urgently. As banks are aware, internationally, regulators have prescribed or are in the process of prescribing capital adequacy for market risks. A pre-requisite for this is that banks must have in place an efficient information system. Considering the large network of branches and the lack of (an adequate) support system to collect information required for ALM which analyses information on the basis of residual maturity and behavioral pattern, it will take time for banks in the present state to get the requisite information. The problem of ALM needs to be addressed by following an ABC approach i.e. analyzing the behavior of asset and liability products in the sample branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches. In respect of foreign exchange, investment portfolio and money market operations, in view of the centralized nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. The spread of computerization will also help banks in accessing data. ALM Organization

a. Successful implementation of the risk management process would require strong commitment on the part of the senior management in the bank, to integrate basic operations and strategic decision making with risk management. The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.

b. The Asset - Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives.

c. The ALM Support Groups consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits. The ALCO is a decision making unit responsible for balance sheet planning from risk -return perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for deposits and advances, desired maturity profile and mix of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should

review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on funding mixes between fixed vs. floating rate funds, wholesale vs. retail deposits, money market vs. capital market funding, domestic vs. foreign currency funding, etc. Individual banks will have to decide the frequency for holding their ALCO meetings. Composition of ALCO The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity. To ensure commitment of the Top Management and timely response to market dynamics, the CEO/CMD or the ED should head the Committee. The Chiefs of Investment, Credit, Resources Management or Planning, Funds Management / Treasury (forex and domestic), International Banking and Economic Research can be members of the Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerization. Some banks may even have Sub-committees and Support Groups.

Committee of Directors The Management Committee of the Board or any other Specific Committee constituted by the Board should oversee the implementation of the system and review its functioning periodically. ALM Process: The scope of ALM function can be described as follows: i. Liquidity risk management

ii. iii. iv. v. vi.

Management of market risks Trading risk management Funding and capital planning Profit planning and growth projection The guidelines given in this note mainly address Liquidity and Interest Rate risks.

Liquidity Risk Management Measuring and managing liquidity needs are vital for effective operation of commercial banks. By assuring a bank's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. Banks management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions. Experience shows that assets commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The time buckets, given the Statutory Reserve cycle of 14 days may be distributed as under: i. ii. iii. 1 to 14 days 15 to 28 days 29 days and up to 3 months

iv. v. vi. vii. viii.

Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years

The investments in SLR securities and other investments are assumed as illiquid due to lack of depth in the secondary market and are therefore required to be shown under respective maturity buckets, corresponding to the residual maturity. However, some of the banks may be maintaining securities in the 'Trading Book', which are kept distinct from other investments made for complying with the Statutory Reserve requirements and for retaining relationship with customers. Securities held in the 'Trading Book' are subject to certain preconditions like:

The composition and volume are clearly defined; Maximum maturity/duration of the portfolio is restricted; The holding period not to exceed 90 days; Cut-loss limit prescribed; Defeasance periods (product-wise) i.e. time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed;

Marking to market on a daily/weekly basis and the revaluation gain/loss charged to the profit and loss account; etc.

Banks which maintain such 'Trading Books' and complying with the above standards are permitted to show the trading securities under 1-14 days, 15-28 days and 29-90 days buckets on the basis of the defeasance periods. The Board/ALCO of the banks should approve the volume, composition, holding/defeasance period, cut loss, etc. of the

'Trading Book' and copy of the policy note thereon should be forwarded to the Department of Banking Supervision, RBI. Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches up to one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-14 days and 15-28 days. Banks, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Management Committee. The mismatches (negative gap) during 1-14 days and 15-28 days in normal course may not exceed 20% of the cash outflows in each time bucket. If a bank in view of its current asset -liability profile and the consequential structural mismatches needs higher tolerance level, it could operate with higher limit sanctioned by its Board / Management Committee giving specific reasons on the need for such higher limit. The discretion to allow a higher tolerance level is intended for a temporary period, i.e. till March 31, 2000. The Statement of Structural Liquidity may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would also be necessary to take into account the rupee inflows and outflows on account of forex operations. While determining the likely cash inflows / outflows, banks have to make a number of assumptions according to their asset - liability profiles. For instance, Indian banks with large branch network can (on the stability of their deposit base as most deposits are rolled-over) afford to have larger tolerance levels in mismatches in the longterm if their term deposit base is quite high. While determining the tolerance levels the banks may take into account all relevant factors based on their asset-liability base, nature of business, future strategy, etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management.

In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days, banks may estimate their short-term liquidity profiles on the basis of business projections and other commitments for planning purposes Currency Risk Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks' balance sheets. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. Large cross border flows together with the volatility has rendered the banks' balance sheets vulnerable to exchange rate movements. Dealing in different currencies brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. Banks undertake operations in foreign exchange like accepting deposits, making loans and advances and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. Besides, some of the institutions may take proprietary trading positions as a conscious business strategy. Managing Currency Risk is one more dimension of Asset- Liability Management. Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978, banks have been setting up overnight limits and selectively undertaking active day time trading. Following the introduction of "Guidelines for Internal Control over Foreign Exchange Business" in 1981, maturity mismatches (gaps) are also subject to control. Following the recommendations of Expert Group on Foreign Exchange Markets in India (Sodhani Committee) the calculation of exchange position has been redefined

and banks have been given the discretion to set up overnight limits linked to maintenance of capital to Risk-Weighted Assets Ratio of 8% of open position limit. Presently, the banks are also free to set gap limits with RBI's approval but are required to adopt Value at Risk (VAR) approach to measure the risk associated with forward exposures. Thus the open position limits together with the gap limits form the risk management approach to forex operations. For monitoring such risks banks should follow the instructions contained in Circular A.D (M. A. Series) No.52 dated December 27, 1997 issued by the Exchange Control Department. Interest Rate Risk (IRR) The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities imply the need for the banking system to hedge the Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The changes in interest rates affect banks in a larger way. The immediate impact of changes in interest rates is on bank's earnings (i.e. reported profits) by changing its Net Interest Income (NII). A long-term impact of changing interest rates is on bank's Market Value of Equity (MVE) or Net Worth as the economic value of bank's assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as 'earnings perspective' and 'economic value' perspective, respectively. The risk from the earnings perspective can be measured as changes in the Net Interest Income (NII) or Net Interest Margin (NIM). There are many analytical techniques for measurement and management of Interest Rate Risk. In the context of poor MIS, slow pace of computerization in banks and the absence of total deregulation, the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk in the first place. It is the intention of RBI to move over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk over time when banks acquire sufficient expertise and sophistication in acquiring and handling MIS.

The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). An asset or liability is normally classified as rate sensitive if:

within the time interval under consideration, there is a cash flow; the interest rate resets/reprices contractually during the interval; RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered ; and

it is contractually pre-payable or withdrawal before the stated maturities.

The Gap Report should be generated by grouping rate sensitive liabilities, assets and offbalance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds, etc. that mature/reprice within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. This includes final principal payment and interim installments. Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating. The interest rates on advances could be repriced any number of occasions, corresponding to the changes in PLR. The Gaps may be identified in the following time buckets: 1. 1-28 days 2. 29 days and up to 3 months

3. Over 3 months and up to 6 months 4. Over 6 months and up to 1 year 5. Over 1 year and up to 3 years 6. Over 3 years and up to 5 years 7. Over 5 years 8. Non-sensitive The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity. Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should have a bearing on the Total Assets, Earning Assets or Equity. The banks may work out Earnings at Risk (EAR) or Net Interest Margin (NIM) based on their views on interest rate movements and fix a prudent level with the approval of the Board/Management Committee. RBI will also introduce capital adequacy for market risks in due course. General The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. Banks which are better equipped to reasonably estimate the behavioral pattern, embedded options, rolls-in and rolls-out, etc

of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision. The present framework does not capture the impact of embedded options, i.e. the customers exercising their options (premature closure of deposits and prepayment of loans and advances) on the liquidity and interest rate risks profile of banks. The magnitude of embedded option risk at times of volatility in market interest rates is quite substantial. Banks should therefore evolve suitable mechanism, supported by empirical studies and behavioral analysis to estimate the future behaviour of assets, liabilities and off-balance sheet items to changes in market variables and estimate the embedded options. A scientifically evolved internal transfer pricing model by assigning values on the basis of current market rates to funds provided and funds used is an important component for effective implementation of ALM System. The transfer price mechanism can enhance the management of margin i.e. lending or credit spread, the funding or liability spread and mismatch spread. It also helps centralizing interest rate risk at one place which facilitates effective control and management of interest rate risk. A well defined transfer pricing system also provides a rational framework for pricing of assets and liabilities.

CHAPTERV 6 NONPERFORMING ASSETS AND INCOME RECOGNITION NORMS (NPAs)

Since 1992, the attempt by the Reserve bank has been on reducing the Banks nonperforming assets and on enforcing a rigid adherence to certain norms for income recognition. A banks balance sheet will look different if the assets are not classified properly. The Reserve Bank asked the banks to classify the accounts in terms of the guidelines issued by it. A term loan facility is to be treated as non-performing if interest or installment of principal amounts remains past-due for a period of two quarters out of four. Past-due is an amount due under any facility but not paid within 30 days after it becomes due. Cash credit or overdraft accounts may be treated as non-performing if the account remains out of order for a period of any two quarters during the year ending, say March1999. An account is to be treated as out of order if the outstanding balance remains

continuously in excess of sanctioned limit/drawing power or there are no credits continuously for six months as on the balance sheet date or are insufficient to cover interest debited during the period. The RBI further told the banks to classify the accounts into four categories: Standard assets are those that do not disclose any problem nor carry more than normal risk. Substandard assets are those that have been classified as non-performing for a period not exceeding two years. In such cases, the current net worth of the borrower/guarantor or the current market value of the security charged is not enough to ensure recover fully. It has fully developed weakness that jeopardizes the liquidation of a debt. Doubtful assets are those that have remained non-performing for a period exceeding two years and where some security is available. Loss assets are those ones where loss has been identified but the amount has not been written off wholly or partly. Such an asset is uncollectible and of such little value that is continuance as a bankable asset is not warranted although there may be some salvage value. The provisions to be made are impacted directly by the classification. There is an important distinction between writing off or writing down and providing against them. When writing off a loan, the creditor institution reduces the book value of the assets on its balance sheet to a level that more accurately reflects its net present value. Banks are generally reluctant to write down loans. In many cases, recovery through compromises or other demands has been made, The RBI has laid down the norms for provisions that need to be made against the four categories of the assets above: Standard assets Obviously no provisions are required

Substandard assets Such assets have a well defined credit weakness that jeopardize the liquidation of a debt and is characterized by a distinct possibility that the bank will sustain some loss if deficiencies are not corrected. It will not be prudent for banks to classify them first as substandard and then as doubtful after two years. Such accounts should straightway be classified as doubtful assets and treated as such. Doubtful assets 100percent of the extent to which advances are not covered by the realizable value of the security to which a bank has resources. Over and above this, depending on the period for which the advances has remained, 20 to 50 % of the secured portion. Table gives a sample of provision required Doubtful Assets First year of doubtful status Second year of doubtful status Third year of doubtful status Loss Assets Deficit = Advance Security Loss asset Provision Deficit + 20% of security Deficit + 30% of security Deficit + 50% of security 100%

In this case, has been identified by the bank or the external auditors or the

RBI inspectors, but the amount has not been written off. Such assets are uncollectible and merely because there is some salvage value, writing them off would be a desirable course. Banks, however, experienced difficulties in making provision on the scale required in case of accounts of Rs.25000 and less. There were some concessions for such advances. They could make either a general provision of 15 % of the aggregate amount or as per norms for other advances. We have so far dealt with the advances sanctioned by banks. Banks also make investments and these could lose in value like any other asset. A major part of the banks investment comprises Government Securities. Banks were advised to divide approved securities into permanent and current. Permanent investment are those that bank intend to hold till maturity, while current investment are those which banks deal in i.e. buy and

sell, on a daily basis. No provisions were required on permanent securities while current investment were to be provided for fully.

CHAPTER 7 MANAGEMENT OF OFF BALANCE SHEET ACTIVITIES.

In simplistic terms, banks are in a business of buying (borrowing) and selling (lending) money. Interest is the rent earned or paid for the use of money for the term of the related loans, investment or deposits. The margin of interest earned and interest paid is the primary source of earning for most banks. Moving from the conceptual framework, we now break down the earnings so that mangers will be in a position to see how with a given asset base the income earned is determined and then take remedial measures: THREE-STAGE APPROACH FOR ASSET/LIABILITY MANAGEMENT Step 1 General Asset management Liability management

 Capital management Loan position management Long-term debt management Liquidity management

Step 2. Specific Investment management Loan management Fixed asset management

Step 3. Income and Expenditure Revenues management Interest cost Overhead cost Taxes 1. It would be obvious to anyone that higher the percentage of earning assets in the total assets, other things being equal, the higher would be the level of interest income. We have seen from the table above that buildings/equipment/cash earn little interest but need to be supported. 2. As regards composition of earning assets, higher interest flows from loan/cash credit advances than from investment. 3. From the above analysis, it is clear that achieving higher interest through managing interest is the crux of the problem. Higher level of interest rate risk and cost of funds over a period of time. 4. Coming to the cost of funds, the higher the ratio of interest- bearing funds to average assets, the higher would be the level of expenses and the lower would be the level of net income. Obviously, banks that have substantial current accounts or heavily capitalized would have above average level of income.

5. In a break-up of interest-bearing funds, current and savings accounts are generally the lowest cost funds. Obviously, any bank with an easy access to these funds will have lower cost and higher earnings. Those banks that are forced to have high cost deposits will obviously have higher costs and less income. 6. All these days bankers in India never showed any particular concern about asset/liability mismatches or about GAP management. A bank asset/liability GAP is the difference in repricing between its earning assets and its costing liabilities. Interest rate fluctuations impact both the level of interest income and interest expenses. They also effect the level of net interest income. Maximizing net interest income overtime requires co-ordination of funding and investment decision. A banks policies regarding the setting of rates and maturities on loans and deposits may be influenced by overriding marketing considerations, which in turn may be independent of conscious spread management decision. Customer preferences, local competition, national economic condition, etc, may limit a banks option in managing its spread. Trade-offs in terms of interest rate yield versus maturity yield versus credit quality, and pricing versus balance sheet growth may limit flexibility. Maintaining or improving the net interest margin requires management to focus continuously on identifying, quantifying and controlling the interest rate risk related to the structure of its earning asset and interest bearing liability bases. Good spread management does not happen by chance- managements must work on these problems all the time to build and maintain quality earnings stream. It may be useful to look at the characteristics of successful banks published by the American Bankers Association and the Bank Administration Institute: High performance banks have higher returns on their assets. Interest payments, personnel cost and occupancy expenses were all lower for high performance banks. Loan losses were generally less than one-half of other banks.

The extraordinary profitability was due to better ROA rather than higher equity multiplier (EM).

While the balance sheets of Indian banks present an extremely dismal picture, there is no need for despondency. The banks have strengths that are not reflected in the balance sheets. They can boast of staff that is highly qualified, trained and experienced. They have adapted themselves to varied situations in the past equally important is the information base. Indian banks, through their branch networks, have during the last two decades collected a most valuable database. However, the change in the entire approach introduced rather suddenly has created a sense of despondency. There was no need to force all banks to conform to all these norms. Subsequently, relaxations were made and banks allowed deferring implementation. The champions of the reform process painted a picture of such a gloom that the only course left would have been the liquidation of these banks. The fact that these banks were owned by the government, invested them with the strengths in the minds of the people and this confidence, more than anything else, is important for systemic stability. The so called adequacy norms reflect only a given historical trend. Newer products and concomitant risks can create unprecedented situation and make the adequacy norms redundant. It is of paramount important for bankers to learn to look at various tools for analyzing balance sheets critically and use them as audits of their management capabilities. These progress cards of managements highlight strength and weakness, and point to the tasks ahead. Managers and others who look on these documents as of no particular consequence will do so as their own peril.

CHAPTER 8 CAPITAL ADEQUACY FOR URBAN COOPERATIVE BANKS

The High Power Committee appointed by the Reserve Bank of India has suggested that the continued financial stability of urban co-operative banks cannot be ensured unless they are subject to the discipline of maintenance of prescribed minimum capital-to-riskasset ratio (CRAR) as in case of commercial banks. Urban banks will therefore have to critically have their present capital base vis--vis their overall risk exposure and devise suitable strategy for mobilizing required capital in a short time frame. While this is both desirable and inevitable in the long run qualitative aspects such as business franchise and management quality are more important determinants of financial strength. The road ahead is no longer easy. Outflow of credit for the sake of the members welfare without adequate coverage of risk with capital and responsible management for protecting depositors interest can prove to be too simplistic a strategy which could erode a banks credibility and financial stability beyond repair.

One of the critical problems faced by the banks relates to raising and maintaining adequate capital comprising of members stock free reserve and retained earnings. Capital performs several functions-supplying resources to get a new bank started providing a base for growth defending against various risks and maintaining public confidence in banks management, In a competitive environment capital also regulates how much risk exposure a bank can accept. It also serves to protect the Deposit insurance Corporation from serious losses in the event of banks failure. BASLE AGREEMENT There has been much debate about who should set capital standards for banks-the banks themselves or the regulatory agencies. It has been argued that banks themselves are best judges of their capital requirement in the long run, The counter agreement is that while a bank may make efficient use of all the information it may have some of the more pertinent information needed to asses a banks true level of risk exposure may be deliberately hidden and it becomes the regulators job to bring this out for proper assessment of its capital requirement to cover possible losses. The incidence of bank failures at international level in the early 1980s seems to have clinched the argument in favour of regulatory agencies determining the minimum capital requirement of all banks, irrespective of their own internal or market situation. These minimum requirements were initially mandated in the U.S.A by congressional passage of the International Lending and Supervision Act of 1983. In 1987, the Federal Reserve Board, representing United States and representatives from eleven other leading industrialized countries announced preliminary agreement on new capital standard often referred to as the Basle Agreement that would be uniformly applied to all banks in their respective jurisdictions. Formally approved in July 1988, those new requirements are designed to encourage banks to strengthen their capital position, reduce inequality in the regulatory rules of different nations and consider the risk to the banks on their off-balance commitments they have made in recent years. The new capital requirements were phased in gradually overtime and became fully enforceable in January 1993, through adjustments and modification continue to be made.

Sources of Capital Under the terms of Basle Agreement the sources of banks capital are divided into two tiers a Tier I capital (core capital) includes paid up capital, statutory reserve and other disclosed free reserve , Tier II capital (supplementary capital) comprises of undisclosed reserve and cumulative preference shares, revaluation reserves, general provision and loss reserve, hybrid and subordinate debts etc. Indian Standards set by Narasimham Committee In the Indian context, the committee on Banking Sector Reforms (Narasimham Committee II) observed that the capital ratios of Indian banks were generally low and some banks were seriously undercapitalized. The committee pointed out that adequacy of capital has been traditionally regarded as a sign of banking strength irrespective of whether the institution is owned by government or otherwise. It recommended that banks in India should also conform to the standards laid down by the Basle committee. Accordingly Reserve Bank of India has laid down that all commercial banks should attain the minimum CRAR of 8 %, which has to be increased from 8% to 10 % in a phased manner with an intermediate target of 9 % by March 2000. Application of CRAR to Urban Co-op Banks The High Power Committee appointed by the Reserve Bank of India has suggested that the continued financial stability of urban co-operative banks cannot be ensured unless they are subject to the discipline of maintenance of prescribed minimum capital-to-risk-asset ratio (CRAR) for the following reasons: i. ii. CRAR serves as a buffer which can absorb the unforeseen losses a UCB may occur in the future. UCB sector is an important segment of the financial system and the exclusion of this segment from the CRAR discipline would undermine the stability of the whole system

iii. iv.

UCBs perform the same banking function as commercial banks and are subject to similar risks. To exempt UCBs from CRAR discipline therefore be untenable. Entities similar to UCBs in other countries where the cooperative segment has taken strong roots (for Credit Union of USA , and cooperative banks in Germany) are all subject to CRAR discipline and exclusion of UCBs from this would undermine the efficacy of regulation.

Accordingly, the High Power Committee recommended that the UCBs would also be subject to CRAR discipline in a phased manner with initially a lower CRAR norms being prescribed for non-scheduled UCBs as compared to UCBs as shown below; Date 31st March 2001 31st March 2002 31st March 2003 Scheduled UCBs 8% 9% As applicable commercial banks The committee has further recommended that until an UCB attains the specified CRAR norms, it should be required to transfer not less than 50% of its net profits to the Reserve Fund and there should be a ceiling of 205 on the % of dividend it can distribute to its members. Non-Scheduled UCBs 6% 7% to 9%

CALCULATING RISK-WEIGHTED ASSETS Before comparing capital and risk-weighted assets in the context of UCBs (a) Capital comprises of fully paid up capital, statutory reserve fund, disclosed free reserves and capital reserves representing surplus arising out of sale proceeds of assets. Reserves, if any, created by way of revaluation of fixed assets or those created to meet outside liabilities should not be included for this purpose. In other words, while building fund, development fund, bad and doubtful debts reserves and investment depreciation reserves would be included, staff provident fund, gratuity fund etc. which are provisions against outside liabilities would be excluded for computing capital.

(b) Risk-Weighted Assets: The value of each asset item on a banks balance sheet and any offbalance sheet commitment it has made is allotted a risk-weighting factor or weight designed to reflect its credit risk exposure. The weight allotted to each of the items, as fixed by Reserve Bank of India for commercial banks is briefly given below. Funded Risk Assets Cash and balance with Reserve Bank Investment in Government securities Investment in other approved Percentage Weight 0 2.5 securities 2.5

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

guaranteed by Central/State government Investment in other approved securities not 20 guaranteed by Central/State government Balance in other accounts with other banks 20 Investment in bonds issued by other banks/public 20 financial institutions All other investments 100 Loans guaranteed by state/central government 0 Loans granted to public sector undertaking of 100 state/central government Loan against NSC/VP/KVP Loans to bank staff Premises furniture and fixtures Income tax deducted at source Advance tax paid Interest due on Government securities Accrued interest on CRR Balances Other assets Guarantee/letters of credit etc 0 0 100 0 0 0 0 100 100

Capital-to-risk-weighted asset Ratio Once we know a banks total risk-weighted assets and the total amount of its capital, we can determine its capital adequacy ratio as required under the Basle Agreement. The key formula is Capital Adequacy Ratio= Total capital / Total Risk-weighted Bank Assets

This can be illustrated by the following case study wherein the investment pattern of two hypothetical banks-Banks A and Bank B is compared. Both the banks are supposed to have same capital and working funds at Rs 50 lakhs and Rs 100 lakhs respectively. However they are found to have varying risk and capital requirement depending upon their investment pattern. (c) Comparative Analysis If the proposed CRAR norms are 9%, bank A will require additional capital of just Rs. 0.31 lakhs, which can be easily managed. On the other hand bank B will require additional capital of Rs 16.69 lakhs due to higher investment in other loans/limits (s .no. 8) carrying comparatively higher risk. In other words if bank decides to go in for higher risk business (read higher profit) ot will have to mobilize matching additional capital. Conversely, if a bank does not go in for risky business, its capital requirement will be comparatively lower. In this manner, CRAR norms will help in covering the risk exposure of a bank and thereby improve its financial strength and public confidence. BANK A Funded Risk 1 2 3 4 5 6 7 8 9 10 11 12 Asset Cash Current A/c With banks SLR Funds with Apex Bank FD with other banks FD Loans NCS/KVP Loans Staff Loans Other Loans/Limits Total CRAR @ 9% Actual capital Required Capital Value of Asset Weight Risk Weighted % 1000000 2000000 25000000 27500000 2000000 2000000 500000 45000000 105000000 0 20 20 20 0 0 0 100 Asset 0 400000 5000100 5500000 0 0 0 45000000 55900000 5031000 5000000 31000

BANK B

Funded Risk 1 2 3 4 5 6 7 8 9 10 11 12 Asset Cash Current A/c With banks SLR Funds with Apex Bank FD with other banks FD Loans NCS/KVP Loans Staff Loans Other Loans/Limits Total CRAR @ 9% Actual capital Required Capital

Value of Asset Weight Risk Weighted % 1000000 2000000 25000000 6000000 2000000 1000000 500000 67500000 105000000 0 20 20 20 0 0 0 100 Asset 0 400000 5000000 1200000 0 0 0 67500000 74100000 6669000 5000000 1669000

It may be noted here that the existing prescription of share linking to borrowing for UCBs is not adequate in as much as it is based upon fixed capital concept, irrespective of risk addition. Against this, CRAR norms prescribe additional capital in proportion to enhancement of risk. Thus, any restructuring of the asset portfolio of a bank has to be based on effective management of risk. If the incidence of risk is controlled, a bank can win public confidence for raising required capital. If not, its growth will be hampered resulting in stagnation and weakness CRITICAL APPROACH While the imposition of uniform minimum capital standard on all banks is easier for RBI, there are may be some potential problems in this simple approach to capital adequacy. If a bank, which is otherwise sound and showing profits, reports dropping of capital adequacy ratio below the minimum requirement, there could be a run on the banks deposits even though it still has adequate capitalization from the market perspective. Another problem is that uniform capital adequacy ratio for all banks could sometime lead to erroneous conclusions. For example, if all banks hold at least the minimum required capital, does it mean that all banks are safe? Obviously, this cannot be so

The size of a bank is also an important factor. As a banks capital to total asset ratio depends heavily on the size of the bank, a smaller bank will report a higher capital to asset ratio, as compared to a larger bank. Does it mean that larger bank are undercapitalized or smaller banks are overcapitalized? This cannot be decided without considering other factors relevant to the specific conditions inside each bank and the environment in which it functions. Because the imposition of minimum capital ratios on all banks can sometimes be misleading, the international regulatory agencies have also applied the yardstick of regulatory judgment in assessing the adequacy of a banks capital position. This requires viewing each bank within the context of its own market environment and looking at several different dimensions of surrounding the bank. These relate to management quality, asset liquidity, earning history, quality of ownership, occupancy costs, and quality of operating procedures, deposit volatility and local market conditions. It therefore follows that while adequate capital is both desirable and necessary, capital alone cannot guarantee the financial stability of a bank. In the long run, qualitative aspects such as business franchise and management quality are considered to be important determining of financial strength of bank. For the above reasons RBI has now evolved a new model for rating of banks based on CAMELS (capital adequacy, asset quality, management, earnings, liquidity, and system control ) For the present, the new model is applied to commercial banks only In the context of UCBs the specific local environment and the market condition in which UCBs operate different from state to state. In fact, some of the condition could be peculiar to individuals banks as well. In such scenario, the qualitative aspects will play a major role in deciding the financial health of a bank. It may therefore be relevant for the management of UCBs have a look at the new model and consider its adoption with suitable modification keeping in view their working environment SN 1 COMPONENTS Capital Adequacy SEGMENTS A Capital-to-Asset-Ratio (CRAR) B Quality of Capital C Ability to access capital market WEIGHTS 70 10 10

Asset Quality

Management

D Asset growth & its risk profile Total A RatioNet NPAs to Net Advance B Debt recovery C Adequacy of lending policy D Management of investment portfolio E Adequacy of provision Total A Working of the board B Technical competence C Management effectiveness in laying down policies D Adequacy of control E Achievement of corporate mission F Effectiveness of various committees Total A Return on assets B Return on Equity C Net interest margin D Ratio-non-interest income to netinterest expenses E Ratio-retained earnings to net profit F Operating profit as % to total assets Total A Liquidity of appraisal-stock approach B Liquidity of appraisal-flow approach C Effectiveness of asset liability

10 100 40 10 20 20 10 100 20 20 20 20 10 10 100 40 20 10 10 10 10 100 30 30 20

Earnings Appraisal

Liquidity

management D Access to markets 10 E Compliance with cash reserve ratio 10 (CRR) 6 System & Control A B C D E F Total Adequacy of internal inspection Adequacy of controls System and procedures Regulatory compliance Prevention of frauds Adherence to rules and regulations Total 100 30 14 14 14 14 14 100

Camels Rating

The salient features if the new models evolved by the RBI for rating of commercial banks are as under. 1. The CAMELS stand for six basic components Capital adequacy, Asset quality, Management, Earnings, Liquidity, and System control . 2. Each of these six components is weighted on a scale of 1 to 100 and contains several parameters with individual weight age. 3. On the basis of weight ages attached to each of the components the banks would be provided with a composite ranking under four categories from A to D 4. While category A denotes a sound institution category D implies serious financial, operational and marginal weakness. 5. The basic components of CAMELS model and the weights assigned by the RBI to the various parameters within each component are summarized in the table above. On the basis of this, UCBs can evolve their own CAMELS model. The NAFCUB can consider adopting the new model with necessary modifications for rating of its member UCBs.

CHAPTER 9 URBAN CO-OPERATIVE BANKS: PRESENT STATUS AND THEIR CHALLANGES

PRESENT STATUS The urban cooperative banking system has witnessed phenomenal growth during the last one and a half decades. From 1307 urban cooperative banks (UCBs) in 1991, the number of UCBs has risen to 2105 in the year 2004. Deposits have increased by over 1100 percent from Rs. 8600 crore to over Rs.100, 000 crore, while advances have risen from Rs. 7800 crore to over Rs.65,000 i.e. by 733 percent during the above 15-year period. This growth path has been possible mainly on account of the

enabling policy environment in the Post 1991 period, which encouraged setting up of new urban cooperative banks. Further, the deregulation of interest rates, as available to commercial banks, enabled the UCBs to mobilize vast deposits, which, together with the liberal licensing policy propelled the growth of UCBs in terms of numbers as also in size. This significant growth in business, which has come about in a competitive environment was largely due to the efforts and the ability of the sector to harness resources from the small depositors. Thus, while the sector has shown spectacular growth during the last decade exhibiting substantial potential for sustained growth, there are certain infirmities in the sector that have manifested in the form of weakness of some of the entities resulting in erosion of public confidence and causing concern to the regulators as also to the sector at large. There is, thus, a need to harness the benefit of rapid growth and mitigate the risk to which individual banks and the system are exposed by providing a regulatory and supervisory framework that will address the problems of the sector as also the shortcomings of dual control Structures and Spread of UCBs 4.1. In terms of geographical spread, UCBs are unevenly distributed across the states. Five states viz., Maharashtra, Gujarat, Karnataka, Andhra Pradesh and Tamil Nadu account for 1523 out of 1924 banks that presently comprise the sector. Further, the UCBs in these states account for approximately 82% of the deposits and advances of the sector as may be seen from the table below: Name of the State No of banks in operation Maharashtra Gujarat Karnataka Tamil Nadu 639 321 300 132 % to of banks 26.68 15.24 14.25 6.27 Deposits lakhs) 60,72,498 16,27,946 8,35,274 3,10,521 % of deposits to total deposits 55.08 14.77 7.58 2.82 Advances (Rupees in lakhs) 37,42,401.2 9,70,287.03 5,37,186.7 2,12,113.28 % of advances to total advances 55.09 14.28 7.91 3.12

total no. (Rupees in

Andhra Pradesh Total

131 1,523

6.22 2,106

2,11,324 90,57,563

1.92 82.15

1,37,888.23 55,99,876.5

2.03 82.44

For all UCBs in the country, the total Deposits are Rs. 1,10,25,642 lakhs and total Advances are Rs. 67,93,017 lakhs. CHALLENGES So far the UCBs have been able to manage their affairs under the first phase of economic reforms as is evident from their operations. However, the second phase of financial sector reforms have brought about vast changes in the working of Indian banking and financial sectors and these changes have not shown their impact on urban banks. A number of reforms implemented by commercial banks have not bees introduced in urban co-operative banks. The urban co-operative have to prepare themselves to introduce those reforms with necessary modification to suit their operations. The points which are important and deserve immediate attention by UCBs to face the challenges include Strengthening of the regulatory and supervisory framework. Enhancing capital adequacy Stringent licensing norms new banks Corporate governance measurers The Narasimham Committee had made a suggestion that RBI should review the entry point norms regarding UCBs and prescribe minimum capital adequacy norms for them. The committee had also suggested that UCBs should be brought within the ambit of the Board of Finance Supervision. In response to Narasimham Committee recommendation RBI appointed a high power committee under the chairmanship of Mr. K. Madhava Rao, former Chief Secretary of Government of Andhra Pradesh to study the performance of UCBs and suggest measures to strengthen them. Some of the recommendation of Madhava Rao committee are of a great significance and would put challenge before UCBs in the years to come. The

recommendation which are relating to entry point of new urban co-operative banks, dual control on UCBs and capital adequacy norms will change the shape of UCBs in the country. The recommendations of Narasimham Committee have already brought a number of changes for UCBs. The introduction of Prudential Accounting Norms i.e. income recognitions, classifications of assets and provisioning has already created a new awareness in the banks and the banking industry is finding it difficult to maintain their position including co-operative banks. The norms are going to be further tightened relating to provisioning. Even a provision of 0.25 has introduced in case of Standard Assets, the time period for classification of Substandard Assets is being reduced from 24 months to 18 months. Moreover the grace period of 30 days for classifying an asset as NPA is going to be withdrawn from March 2001 and there are further recommendations to tighten the norms as per Bank for International (BIS) standards. In the light of all these developments and ever increasing competition, the UCBs would have to make use of modern technology particularly, internet banking and develop their staff on professional lines to retain their hold on traditional customers. If things do not improve according to the expectations of urban masses the UCBs would lose their hold on their base of clientele to private sector banks with sophisticated techniques and innovative schemes at their command. UCBs still have a edge on public sector banks in terms of their services because of their staff to cater to the needs of their members. But under the changed situation, their clientele cannot be taken for granted. They have to repackage their schemes of advances and deposits if they want to maintain and retain their share of business. The further tightening of prudential accounting norms, introduction of capital adequacy norms and developments in information technology are certain very pertinent factors which have to be taken seriously by the UCBs to maintain their position in the era of liberalized economy. In the light of above discussion, the challenges faced by the urban banks can be summarized as under: They are required to improve their capital base and maintain their NPAs at minimum possible levels.

 They have to make full use of modern techniques of information technology in order to provide competitive and fast service to retain their own customer base. Formulate special schemes for artisans, cottage and small scale units their traditional areas. The credit schemes should be linked with some support marketing. Developing human resources in the new areas of banking including agriculture by providing them training. In order to maintain their clientele base, the UCBs should take advantage of their strength and eliminate their weaknesses. They have to be financially strong with adequate system of control and supervision.

CHAPTER 10 RECOMMENDATIONS & CONCLUSION Recommendation The central element for the entire ALM exercise is the availability of adequate and accurate information with expedience and the existing systems in many Indian banks do not generate information in the manner required for ALM. Collecting accurate data in a timely manner will be the biggest challenge before the banks, particularly those having wide network of branches but lacking full scale computerization. However, the introduction of base information system for risk measurement and monitoring has to be addressed urgently. The problem of ALM needs to be addressed by following an ABC approach i.e. analyzing the behavior of asset and liability products in the sample branches accounting

for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches The ALCO Committee should meet weekly instead of monthly. Conclusion The rapid changes in banking and financial services market are creating opportunities and challenges. Increased competition in the financial services industry and increased synergies provided by banks result into important benefit to customers. But the increased size, breath, complexity and geographic scope of banking have increased the challenges of managing and of regulating and supervising banks. The central banks worlds wide are also reviewing their positions with regard to electronic, commerce, internal banking and electronic money applications. While freedom is essential to foster efficiency, it also raises an equally important question of appropriate regulatory framework, given the wide divergence between private and social interest in ensuring stability of the financial system. As banks internal risk management and management technologies improve and as depth and sophistication of financial markets increases, bank supervisors should continually find ways to incorporate market advances into their prudential policies, when appropriate. Bank should have their obligation to their shareholders, creditors and customer to measure and manage risk appropriately.

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