Question Paper

Management of Financial Institutions – I (321) : October 2003

Section A : Basic Concepts (30 Points)
• • This section consists of questions with serial number 1 - 30.
• • Answer all questions.
• • Each question carries one point.
< Answer
1. In the duration gap method, if the gap is negative and if the interest rates are expected to increase, then >
the market value of equity will
a. Increase
b. Decrease
c. Remain unchanged
d. Increase first and then decrease
e. Decrease first and then increase.
< Answer
2. Which of the following is true? >

a. When maturity gap is positive, decrease in interest rate increases the Net Interest Income (NII)
b. When maturity gap is Zero, increase in interest rate increases the Net Interest Income (NII)
c. When maturity gap is positive, increase in interest rate decreases the NII
d. When maturity gap is negative, decrease in interest rate increases the NII
e. When maturity gap is negative, increase in interest rate increases the NII.
< Answer
3. The idea that trade is beneficial to both parties rests on the assumption that buyers and sellers know >
what they are doing. The failure of this assumption is described as
a. Regulatory trade
b. Monopolistic market
c. Asymmetric information
d. Trade failure
e. None of the above.
< Answer
4. Bank rate is the >

a. Rate at which nationalized banks lend to borrowers

b. Rate at which private sector banks lend to borrowers
c. Rate at which Reserve Bank of India lends to banks
d. Rate at which Cooperative Banks lend to borrowers for agriculture
e. Rate at which Regional Rural Banks lend to borrowers for agriculture.
< Answer
5. Which of the following is false regarding Ways and Means Advances (WMA)? >

a. It is a permanent source of financing for the Government

b. Rate of Interest on WMA will be on mutually agreed rate between the RBI and Government of
India from time to time
c. When 75% of the WMA is utilized, RBI will go for a flesh floatation of Government securities
d. Any excess drawl over the WMA limit would be permitted only for 10 Consecutive working days
e. Any excess amount over the WMA limit carries additional interest on such excess amounts.
< Answer
6. The minimum paid up capital required to set up a Local Area Bank (LAB) is >

a. Rs. 25 lacs
b. Rs. 50 lacs
c. Rs. 100 lacs
d. Rs. 500 lacs
e. Rs.1,000 lacs.
< Answer
7. Replacement of the credit of one party to a transaction with the credit of a financial institution is called >

a. Bonding
b. Delegation
c. Credit substitution
d. Credit netting
 e. None of the above.
< Answer
8. Disintermediation means >

a. Increase in deposits experienced by banks due to increased network of branches

b. Increase in deposits experienced by banks due to the introduction of new schemes
c. Loss of deposits by financial intermediaries because direct lending becomes more attractive
d. Loss of deposits by financial intermediaries because alternative types of indirect lending becomes
more attractive
e. Loss of income by a bank due to loss assets.
< Answer
9. The commercial paper issued by a borrower is >

a. A secured money market instrument

b. An unsecured money market instrument
c. A money market instrument partly secured by the issuer’s assets
d. A money market instrument guaranteed by the RBI for repayment
e. A money market instrument guaranteed by the Government of India for repayment.
< Answer
10. In which of the following cases, an advance given to a company against collateral securities the charge >
need not be registered with the Registrar of Companies?
a. Hypothecation of stocks
b. Pledge of stocks
c. Book debts
d. Mortgage
e. Both (a) and (b) above.
< Answer
11. Given the ROA is 6%, non-performing assets is 15% of its book-size and total assets is Rs.500 crores, >
tax rate is 35%. The ENPA level of the bank is
a. 61.54%
b. 62.39%
c. 59.48%
d. 58.32%
e. 58.06%.
< Answer
12. The subordinated debt instruments issued by a bank should have a minimum maturity of >

a. 3 years
b. 5 years
c. 7 years
d. 9 years
e. 10 years.
< Answer
13. Given the ROA is 6%, non-performing assets is 15% of its book-size and total assets is Rs.500 crores, >
tax rate is 35%. The ENPA level of the bank is
a. 61.54%
b. 62.39%
c. 59.48%
d. 58.32%
e. 58.06%.
< Answer
14. The subordinated debt instruments issued by a bank should have a minimum maturity of >

a. 3 years
b. 5 years
c. 7 years
d. 9 years
e. 10 years.
< Answer
15. Which of the following risks is eliminated between the contracting parties in a REPO transaction? >

a. Liquidity risk
b. Interest rate risk
c. Rate level risk
d. Counter party risk
e. Call risk.
 < Answer
16. Fiduciary risk refers to the risk of losses that may arise by undertaking >

a. Project financing
b. Working capital finance
c. Off-balance sheet transactions
d. Financing of book debts
e. Pledge loans.
< Answer
17. If a 91-day T-bill of face value Rs.100 is acquired in the auction at a yield of 5%, then the purchase >
price is
a. Rs.97.77
b. Rs.98.27
c. Rs.98.77
d. Rs.98.88
e. Rs.99.89.
< Answer
18. Which of the following mortgages involves transfer of an interest in specific immovable property by >
deposit of title deeds?
a. Mortgage by conditional sale
b. Usufructory mortgage
c. English mortgage
d. Equitable mortgage
e. Anomalous mortgage.
< Answer
19. Which of the following risks arises if assets and liabilities are subjected to floating rates that are pegged >
to different benchmarks?
a. Basis risk
b. Put risk
c. Prepayment risk
d. Real interest rate risk
e. Call risk.
< Answer
20. Which of the following alternatives relating to the ENPA is true? >

a. As NPAs increase the ENPA will also increase

b. Higher ENPA implies greater credit risk
c. ENPA increases as the ROA increases
d. Margin of safety decreases as the ENPA increases
e. The graph that establishes the relation between ROA and ENPA shows a curve that is downward
sloping.
< Answer
21. Which of the following liabilities are classified under demand liabilities for the computation of NDTL? >

a. Unclaimed deposits
b. Cumulative deposits
c. Staff security deposits
d. India development bonds
e. Deposits held as securities for advances.
< Answer
22. Mismatch between maturity patterns of assets and liabilities for a bank exposes to >

a. Interest rate risk

b. Liquidity risk
c. Operational risk
d. Transactional risk
e. Market risk .
< Answer
23. The right of the insurer to stand in the place of the insured, after settlement of a claim, in so far as the >
insured’s right of recovery from an alternative source is involved is called
a. Subrogation
b. Nomination
c. Assignment
d. Indemnity
e. Warranty.
 < Answer
24. Smart Bank Ltd does not pay any interest on current account balance of customers. It also does not >
charge for issuing chequebooks to the customers. What pricing strategy is adopted in this transaction?
a. Rebate strategy
b. Implicit pricing
c. Explicit pricing
d. Relationship pricing
e. Symmetric account.
< Answer
25. M/s PGR Electronic has taken fire insurance policy for goods of value Rs.6 lakhs. The company has >
suffered a loss of 4 lakhs out of Rs.10 lakhs worth of stocks stored in the godown. How much amount is
payable by insurance company
a. Rs. 4 lakhs
b. Rs. 2.40 lakhs
c. Rs. 6 lakhs
d. Rs. 6.60 lakhs
e. Rs. 10 lakhs.
< Answer
26. Ratio of Total Asset to Total Equity is known as >

a. Return on Assets
b. Return on equity
c. Equity multiplier
d. Return on asset utilization
e. DSCR.
< Answer
27. Which of the following deposits of banks does RBI regulate for payment of interest? >

a. Term Deposit
b. Certificate of deposit
c. Capital gains deposit
d. Savings Bank
e. Gold deposit.
< Answer
28. Which of the following statements is/are true in respect of Capital Adequacy Ratio? >

a. Revaluation reserves should be valued at 55% of the outstanding balance

b. Provisions and contingencies shall not be accounted for if they are more than 1.25% of the risk-
weighted assets
c. Tier II capital shall not exceed 50% of Tier I capital
d. Subordinated debt shall not exceed 50% of Tier II capital
e. None of the above.
< Answer
29. Which of the following statements is true for a pledge advance? >

a. Pledgee can sell the security under notice without filing a suit
b. Pledgee can sell the security only by filing a suit
c. Pledgee becomes owner under pledge agreement
d. Pledgee cannot have possession of security
e. Pledgor has possession of security.
< Answer
30. What is the risk weight assigned to guarantees issued by banks against counter guarantees of other >
banks?
a. Zero
b. 2.5%
c. 20%
d. 50%
e. 100% .

END OF PART A
 Part B : Problems (50 Points)
• This part consists of questions with serial number 1 – 5.
• Answer all questions.
• Points are indicated against each question.
• Detailed workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Part B.
1. Consider the following details of Fortune Bank as on September 30, 2003:
(Rs. in crores)
Average Average
Liabilities Amount interest Assets Amount interest
(%) (%)
Capital and Reserves 800 0 Cash and bank balance 500 0
Deposits 9,700 6 Advances 7,200 10
Borrowing 300 7 Investments 2,700 6
Other Liabilities 400 0 Fixed and other assets 800 0
11,200 11,200
You are required to
Compute the Rate Sensitive Gap
b. Compute the Rate Adjusted Gap for the bank, assuming the interest rate on various assets and liabilities is
likely to be as given below.
Deposits 6.75%
Borrowings 8.00%
Advances 11.00%
Investments 6.80%
c. With the following additional information, assess the change in the market value of the equity due to increase
in interest rate by 1%
Duration of Assets 4 years
Duration of Liabilities 3 years
Current Interest rate 10%
d. How Fortune Bank can protect the market value of the equity? Explain.
(2 + 3 + 3 + 4 =12 points) < Answer >
2. The details given below represent the assets and liabilities of Dwarka Bank Ltd as on 31-03-2003:
 S.No Details Rs. in crores
1. Furniture & fixtures 25
2. Buildings 10
3. Investment in Government Securities 120
4. Investment in shares/debentures 45
5. Revaluation reserve 70
6. Cumulative perpetual preference shares 15
7. Statutory reserve 25
8. Equity 30
9. Undisclosed reserves 5
10. Balance with RBI 24
11. Cash on hand 73
12. General provision and loss reserves 9
13. Capital reserve (gain on sale of assets) 22
14. Equity investments in subsidiaries 15
15. Subordinated debt (maturity wise)
Maturity 2-3 yrs 5
4-5 yrs 10
Less than one year 10
16. Advances
Unsecured 335
Secured by tangible assets 245
Loans granted to Undertakings of Government of India 16
17. Guarantees given with 50% cash margin 65
18. Deposits from Banks 10
19. Deposits from others 550
20. Gold 20
21. Tax paid in advance 45
22. Letters of credit issued with 20% cash margin 40
23. Balances in accounts with other banks 15
24. Claims on Commercial Banks (CD’s) 20
You are required to calculate the following
i. Tier I Capital
ii. Tier II Capital
iii. Capital Adequacy Ratio.
(12 points) < Answer >
3. The following information is provided by the General Manager of a bank:
Particulars %
Capital Adequacy Ratio 10
CRR 4.5
SLR 25
Cost of capital 12
Cost of deposits
*Demand deposits 3
Term deposits 6
*50% of demand deposits are
interest free deposits
Ratio of demand to term deposit is 1:2
The lending rates offered to borrowers as per credit rating are as follows:
 Category Rate Proportion
A PLR 0.40
B PLR + 1 0.40
C PLR + 2 0.20

Interest earned on SLR investments 6%

Interest on CRR NIL
The bank’s total working funds consists of only
capital and deposits. The management requires a spread of 3%.
You are required to compute the PLR for the bank.
(8 points) < Answer >
4. On October 07, 2003 Janata Bank sold 11.43% GOI 2015 of Rs.100 crore to Fortune Bank on Repo basis for a
period of three days. The Repo rate was 6% p.a. The date of last coupon payment was August 07, 2003. The sale
price of the security was Rs.113 for the face value of Rs.100. You are required to compute the cash flows
involved in the transaction.
(6 points) < Answer >
5. Consider the following data relating to a prime borrower:
Contracted rate : 12% p.a.
Probability of default : 0.10
Recovery rate of principal : 80%
Loan term : 2 years
If the current prime rate is 10.5 % p.a. what is the
expected one-year prime rate after one year? In case of default, it is assumed that the entire interest is foregone.
(5points) < Answer >
6. The General manager of a bank has given the following forecast for interest rates

Change in interest rates Probability

– 0.5% 0.10
+0.5% 0.20
–1.0% 0.30
+1.0% 0.40

The earnings assets of the bank are at Rs.4,400 crore. The Net Interest Income (NII) figure is Rs.154 crore. The
bank is expecting a variation of 10% in the net interest income.
You are required to compute
a. The target gap for each of the four possible changes in the interest rates
b. The expected change in NII for different levels of gap.
(3 + 4 = 7 points) < Answer >

END OF PART B

Part C : Applied Theory (20 Points)

• This part consists of questions with serial number 7 - 8.
• Answer all questions.
• Points are indicated against each question.
• Do not spend more than 25 -30 minutes on Part C.
7. “ Liquidity management can be practiced on either side of balance sheet”. How are asset and liability management
similar and how do they differ? Why do smaller banks have a limited access to liability management?
(10 points) < Answer >
8. Insurance is an uberrimae fides contract. What is uberrimae fides? Explain its significance to an insurance
contract. Briefly explain the elements on which the insurance contract is built upon.
(10 points) < Answer >

END OF PART C

END OF QUESTION PAPER

 Suggested Answers
Management of Financial Institutions – I (321) : October 2003
1. Answer : (a) < TOP >

Reason : In the duration gap method, if the gap is negative and if the interest rates are expected to
increase, then decrease in market value of assets will be less than the decrease in market
value of liabilities. As the risk sensitive assets are less than the risk sensitive liabilities, it
will increase the value of equity.
2. Answer : (d) < TOP >

Reason : It is true, when maturity gap is negative decrease in interest rate increases the Net Interest
Income (NII). Options in (a), (b), (c) and (e) are false.
3. Answer : (c) < TOP >

Reason : The idea that trade is beneficial to both the parties rests on the assumption that buyers and
sellers know what they are doing. The failure of this assumption is described as
“asymmetric information”.
4. Answer : (c) < TOP >

Reason : Bank rate is the rate at which RBI lends to banks. Options in (a), (b), (d) and (e) are not
correct.
5. Answer : (a) < TOP >

Reason : Ways and Means Advances is not a source of financing for the Government but only
accommodates temporary mismatches in Government receipts and payments. Option in (a)
is false. Options in (b), (c), (d) and (e) are true.
6. Answer : (d) < TOP >

Reason : The minimum paid up capital required to set up a Local Area Bank (LAB) is Rs.500 lakhs.
7. Answer : (c) < TOP >

Reason : Replacement of the credit of one party to a transaction with the credit of a financial
institution is called ‘Credit substitution’. Putting of assets to guarantee performance is
called bonding.
Appointment of someone to act for others in a transaction is called delegation. There is no credit
netting. Correct answer is c.
8. Answer : (c) < TOP >

Reason : Disintermediation means loss of deposits by financial intermediaries because direct lending
becomes more attractive.
Loss of deposits by financial intermediaries because alternative types of indirect lending
becomes more attractive, is called reintermediation. Options in (a), (b), (d) and (e) are not
correct.
9. Answer : (b) < TOP >

Reason : The commercial paper issued by a borrower is an unsecured money market instrument.
Options in (a), (c), (d) and (e) are not correct.
10. Answer : (b) < TOP >

Reason : Registration of charge with the Registrar of Companies is not required in the case of pledge
loans given to the companies. In all other cases mentioned in (a), (c) and (d) charge is to be
registered with the Registrar of Companies.
11. Answer : (a) < TOP >

PAT /(1 − t) / TA 30 / 0.65

NPA / TA 0.15x 500
Reason : ENPA = = = 61.54%
12. Answer : (b) < TOP >

Reason : The subordinated debt instrument issued by a bank should have a minimum maturity of 5
years.
13. Answer : (d) < TOP >

Reason : Malhotra Committee setup by the Government of India recommended changes in the
insurance sector. Goiporia Committee made recommendations on customer service. Chore
committee made recommendations on maximum permissible bank finance in connection
with the working capital finance.
Narasimham Committee recommended on banking reforms.
Verma Committee recommended on restructuring of weak public sector banks. Correct answer is
(d).
14. Answer : (d) < TOP >

Reason : Every NBFC has to create reserve fund and transfer every year an amount not less than
20% of net profit.
15. Answer : (d) < TOP >

Reason : In a REPO transaction, there is no counter party risk as the lending is secured by
government/approved securities. Options in (a), (b) and (c) do not arise in a REPO
transaction.
16. Answer : (c) < TOP >

Reason : Fiduciary risk refers to the risk of losses that may arise by undertaking off-balance sheet
transactions.
17. Answer : (c) < TOP >

100 − x 365
×
x 91
Reason : = 0.05
X = 98.77
Purchase price of T-bill is Rs.98.77.
18. Answer : (d) < TOP >

Reason : Equitable mortgage is created by deposit of title deeds. Deposit of title deeds is an essential
feature of equitable mortgage. Options in (a), (b), (c) and (e) are not correct.

19. Answer : (a) < TOP >

Reason : Basis risk is the risk arising out of two different benchmark rates not moving in tandem.
When the costs of liabilities and the yields on assets are linked to different benchmarks in a
float rate situation, it gives rise to basis risk.
A put option is exercised by the investor in an increasing interest rate scenario. This is called put
risk. A call option is exercised by the issuer to redeem the bonds/securities before maturity
in a declining interest rate scenario. This is called call risk. Cash inflows in an declining
interest rate scenario due to prepayment of loans gives rise to prepayment risk since these
cash flows are to be redeployed at a lower rate. Real interest rate risk occurs because the
changes in the nominal interest rates may not match with the changes in inflation.
20. Answer : (c) < TOP >

Reason : Return on assets is the ratio of net profit to total assets while ENPA (Earnings before taxes
as a proportion to NPAS, is the ratio of profit before taxes to NPA.
The credit risk is quantified in terms of ENPA. As ROA increases ENPA will also increase.
Alternatives:
(b) Higher ENPA level indicates lower credit risk
(c) NPAs increase as ENPA level falls is not true
(d) Margin of safety increases with ENPA rise.
(e) The curve will be upward sloping not downward sloping since ENPA increases with
ROA.
21. Answer : (a) < TOP >

Reason : Unclaimed deposits is a demand liability and all the other liabilities under (b), (c), (d) and
 (e) are examples of time liabilities.

< TOP >

22. Answer : (b)
Reason : Mismatch between maturity patterns of assets and liabilities for a bank exposes to liquidity
risk.
Alternatives:
(a), (c), (d) and (e) are not related to maturity patterns.
< TOP >
23. Answer : (a)
Reason : (a) The right of the insurer to stand in the place of the insured after settlement of a claim
is so far as the insured’s right of recovery from an alternative since is involved, is
called subrogation.
(b) Nomination refers to the procedure which enables the nominee to get the policy
proceeds/ or deposits without the necessity of producing any legal representation
to the estate of the deceased.
(c) The situation in which one party transfers its rights and duties under a contact to
a third party with or without the concurrence of the other party to the contract is
called assignment.
(d) Indemnity refers to the assurance given by one to put the person who obtained
assurance in the event of loss, in the same position that he/she occupied
immediately before the happening of the event for which indemnity is sought for
(e) A warranty is a stipulation which is collateral to the main purpose of the
contract.
24. Answer : (b) < TOP >

Reason : By not paying interest on current a/c bank is saving its expenditure on cost of funds. By
offering free cheques, bank is not put to any leakage of income as the same is compensated
in saving the interest payment on current account balances. Such a pricing strategy is
referred as implicit pricing.
The other strategies in options (a), (c), (d) and (e) are as follows:
Rebate strategy: The bank makes charges but rebates on basis of balance
Explicit pricing: Charge as the costs go and competition permits.
Relationship pricing: If the customer has more than one account, he gets a better price.
Symmetric account: Paying interest as function of minimal or average balance.
25. Answer : (b) < TOP >

Reason : Value of insured property at the time of loss = Rs.10 lakhs

Sum insured = 6 lakhs
Amount of loss due to fire accident = 4 lakhs
Sum insured × Amount of loss
Value at the time of loss
Amount payable =
Rs.6 lakhs × Rs.4 lakhs
Rs.10 lakhs
=
= Rs.2.40 lakhs.
26. Answer : (c) < TOP >

Reason : Equity multiplier is a measure of asset creation. It is calculated on

Total Assets
Total Equity

Other alternatives are not correct as they are all measured against net profit.
27. Answer : (d) < TOP >

Reason : The interest rate on savings bank is regulated by Reserve Bank of India. The interest rates
on other deposits are deregulated.
28. Answer : (b) < TOP >

Reason : Revaluation reserves should be valued at 45%, Tier II capital should not exceed Tier I
capital and subordinate debt should not exceed 50% of Tier I capital. So only alternative (b)
is correct
29. Answer : (a) < TOP >

Reason : Pledgee can sell the security under notice without filing a suit.
Under pledge possession is with the pledgee and ownership remains with the pledgor. A
pledgee can auction the goods / security to recover the dues. Any surplus realized after
adjusting the dues is to be returned to the pledgor.

30. Answer : (c) < TOP >

Reason : Guarantees issued by banks against coenter guarantees of other banks carries risk weight of
20%.
 Part B : Problems
1. a. Rate Sensitive Gap = Rate Sensitive Assets – Rate Sensitive Liabilities
Rate Sensitive Assets = 7,200 + 2,700
= Rs.9,900 cr
Rate Sensitive Liabilities = 9,700 + 300
= Rs.10,000 cr
Rate Sensitive Gap = 9,900 – 10,000
= – 100cr
b. Rate Adjusted Gap = Rate Adjusted Assets – Rate Adjusted Liabilities
Rate Adjusted Assets:
Advances = 7,200 × 1 = 7,200
Investments = 2,700 × 0.80 = 2,160
Total Rs. 9,360 cr.
Rate Adjusted Liabilities:
Deposits = 9,700 × 0.75 = 7,275
Borrowings = 300 × 1.00 = 300
Total Rs.7,575 cr.
Rate Adjusted Gap = 9,360 – 7,575
= Rs.1,785 crore

-Duration of assets ×change in interest ×Total assets

1 +Current int erest rate
c. c. Change in the market value of assets =
−4 ×1×11, 200
1.10
=
= – 407.27 crore
New market value of assets = 11,200 – 407.27
= Rs.10,792.73 crores
Similarly the change in market value of liabilities can be computed with the above formula
−3 ×1×10, 400
1.10
Change in the market value of liabilities =
= – 283.64 core
New market value of the liabilities = 10,400 – 283.64
= Rs.10,116.36
New market value of the equity with the current rate = 10,792.73 – 10,116.36
= Rs.676.37 crore.
Change in market value of equity = 800 – 676.37
(Decrease by) = Rs.–123.63 crore
d. d. In order to protect the market value of the equity, the bank has to adjust the duration of either the assets
or liabilities.
The market value of the equity is protected by adjusting the duration of assets
 Liabilities
Assets
Duration of assets = Duration of liabilities ×
10, 400
11, 200
=3 ×
= 2.786 years
2, 786 ×1% ×11, 200
1.10
Change in the market value of assets =
= Rs.-283.66 crore
New market value of the assets = 11,200 – 283.66
= Rs.10,916.34 crores
3 ×1×10, 400
1.10
Change in the market value of the liabilities =
= – 283.64 crore
New market value of the liabilities = 10,400 – 283.64
= Rs.10,116.36 crore
New market value of equity at current rate = 10,916.34 – 10,116.36
= 799.98 crore
Hence by adjusting the duration of assets from 4 years to 2.786 years, the market value of the equity can be
protected.
< TOP >
2. Computation of Tier I Capital
Crores
Equity 30
Statutory Reserve 25
Capital Reserve 22
Total 77
Less Equity investments in subsidiaries 15
Total (Tier I Capital) 62 Computation of Tier II capital
Amount
Undisclosed reserves 5 5
Cumulative shares 15 15
Revaluation reserves 70 Discounted by 55% 31.50
General Provisions 9 Amount of GPLR or 1.25% of 9
RWA which ever is less
Subordinated debt
2-3 Yrs 5 40% 0.40 2
4-5 Yrs 10 80% 80% 8
Less then 1 Yr 10 0% – –
Total (Tier II Capital) 70.50
The total of Tier II capital is limited to a maximum of 100% of Tier I capital. Therefore, Tier II capital is taken as
Rs.62 crores.
Total Capital (Tier I + Tier II) = 62 + 62
= Rs.124 crores
Computation of Risk weighted Assets
Of Balance Sheet Assets
 Assets Value Risk Weight assigned Risk weight assets
(%)
Cash on Hand 73 0 –
Balance with RBI 24 0 –
Gold 20 0 0
Investment in Government securities 120 2.5 3
Claims on Commercial Banks 20 20 4
Balance in accounts with other banks 15 20 3
Investment in shares & Debentures 45 100 45
Loans granted to Undertakings
of Government of India 16 100 16
Others 580 100 580
Furniture & fixtures 25 100 25
Building 10 100 10
Tax paid in advance 45 0 0
Total 686
Off- Balance sheet items
Risk Weight Assets
Particulars Amount (Rs. in crores) Conversion factor Risk weight (%) (RWA) (Rs. in
crores)
Guarantees given 65 × 0.50 1.00 100 32.50
Letters of credit 40 × 0.80 1.00 100 32.00
Total 64.50
Total risk weighted assets = 686 + 64.50
= 750.50
Capital
Risk weighted Assets
Capital Adequary Ratio =
124
= 16.52%
750.50
=
< TOP >
3. The banks total working funds consists of only capital and deposits.

Amount Rate Cost (Rs.)

(Rs.)
Capital 10 12 1.20
Demand Deposits 15
Demand Deposits 15 3 0.45
Term Deposits 60 6 3.60
100 5.25
Lendable funds (working)
CRR 4.5% of 90 (60 + 15 + 15) 4.05
SLR 25% of 90 22.50
26.05
Funds after
Interest spread = 100 – 3 = 97
Lendable funds = 97 – 26.05 = 70.45
A = 70.45 × 0.40 = 28.18
B = 70.45 × 0.40 = 28.18
C = 70.45 × 0.20 = 14.09

Let the PLR be X%

The income of the bank is as follows
 Particulars Amount (Rs.) Rate (%) Income
CRR 4.05 – –
SLR 22.50 6 1.35
Loans
A 28.18 X 28.18X
B 28.18 X + 0.01 28.18X + 0.2818
C 14.09 X + 0.02 14.09 X + 0.2818
70.45X + 1.9136
Required spread = 3%
PLR for the bank
3 = (70.45X + 1.9136) – 5.25
X = 8.99%
Say 9%
< TOP >
st
4. 1 Leg: (Rs.
in crores)
The amount received by Janata Bank on sale at Rs.113 (100/100) 113.000
Interest for the broken period of 60 days

(From August 07,2003 to October 06,2003 at 11.43% on Rs.100 crore)

100 ×11.43 × 60 1.905

=
*36000

Total amount received in the first leg 114.905

2nd Leg
(Rs. in crores)
Amount repayable by Janata Bank 114.9050
Repo interest for 3 days

3 ×114.905 × 6 0.0567
=
**36500

Total amount paid in the 2nd leg of the Repo 114.9617

*
Compulation of days based on 30/360 day count convention
** Compulation of days based on actual /365 days count convention applicable to money market instruments
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5.
 Contracted rate : 12%
Probability of default : 0.10
Recovery rate : 80%
Term : 2 years
Expected return : P1(r) + P2 (R – 1)
Where P2 = Probability of default
P = Principal component
R = Recovery rate
Expected Return = 0.12 × 0.90 + 0.10 (0.80 – 1)
= 0.108 – 0.02
= 8.8%
8.8% is 2 year prime rate
10.5% is 1 year prime rate
If ‘X’ be 1 year prime rate after one year
(1.088)2 = (1.105) (1+r)
1+r = 1.0713
r = 7.13%
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6.
Earnings assets : Rs.4,400 cr
Net Interest Income : Rs.125 cr
Variation in NII : 10%
NIM (NII/Earning assets) : 3.5%
Target Gap =
Earnings Assets × NIM ×Variation in NIM
Change in interest rates

4, 400 ×0.035 ×0.10

= Rs.3, 080
0.005
= for a change of 0.5% in interest rate
4, 400 ×0.035 ×0.10
= Rs.1, 540
0.01
Target Gap = for a 1% change
Change in interest rate Probability Gap Rs. in crores
– 3,080 + 3,080 – 1,540 + 1,540
– 0.5% 0.10 +15.40 – 15.40 + 7.70 – 7.70

+ 0.5% 0.20 – 15.40 +15.40 – 7.70 + 7.70

– 1.0% 0.30 + 30.80 – 30.80 + 15.40 – 15.40

+ 1.0% 0.40 – 30.80 + 30.80 – 15.40 + 15.40

Expected change in NII – 4.62 + 4.62 – 2.31 + 2.31

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Part C: Applied Theory

7. It is rightly said that bank can manage the liability either through asset or through the liability management or a
mix of both.
A commercial bank requires liquidity to accommodate deposit withdrawals or to pay other liabilities as they
mature. Payments of withdrawals can be made only from assets. All cash accounts are available to the bank for
payments of immediate withdrawals at no cost to the bank. All other assets must be converted into cash assets. The
conversion process involves the time and the expenses to sell assets as well as the risk that they may be sold below
their purchase price (a capital loss). Asset management classified bank assets into four basic groups: 1) Primary
Reserves, 2) Secondary Reserves, 3) Bank Loans 4) Investments for income and tax shields.
Summary of Asset Management Strategy:
Category & Type of Asset Purpose Liquidity Yield
1. Primary reserves Immediate available funds Highest None
– Cash
– Interbank Deposits
2. Secondary Reserves Easily marketable funds High Low
– T-Bills
– Short term securities
3. Bank loans Income Lowest Highest
– Business loans
– Consumer loans
– Real estate loans
4. Investments Income when safe loans are Medium Medium
– Treasury securities Unavailable & Tax advantages
Liability Management: This is based on assumption that certain types of bank liabilities are very sensitive to
interest rate changes. Thus, by raising the interest rates paid on these liabilities above the market rate, a bank can
immediately attract additional funds. On the other hand, by lowering the rate paid on these liabilities, a bank may
allow funds to run off as the liability matures.
The liquidity gained by liability management is useful to bank in several ways. First, it could be used to counteract
deposit inflows and outflows and reduce their variability. Sudden or unexpected outflow can be offset immediately
by the purchase of new funds. Secondly funds attracted by liability management may be used to meet increase in
loan demand by bank’s customer. As long as the expected marginal return of the new loans exceeds the expected
marginal costs of funds, the bank can increase this income by acquiring the additional funds through liability
management.
Thus, liability management supplements asset management but does not replace it as a source of bank liquidity.
Asset management still remains the primary source of liquidity for banks particularly small banks. If used
properly, liability management allows bank to reduce their secondary reserves holding and invest these funds in
high yield assets.
Liability management is not well suited to smaller banks, because they do not have direct access to the whole sale
money markets where liability management is practiced.

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8. Legally, insurance is a uberrimae fides contract where one party agrees to compensate the other in consideration of
a certain smaller sum. Such compensation is contingent upon happening or non-happening of a certain event.
Uberrimae fides relates to one of the 8 elements of insurance – Utmost Good Faith. Uberrimae fides contracts
require utmost good faith on both the parties of an insurance contract that ask for voluntary disclosure of all
material facts relevant to the subject matter of the contract. Thus, in an insurance contract, both the person who is
buying insurance and the insurance company should disclose all material facts at the time of entering into the
contract. Any material facts that are not disclosed to the other party having a direct or indirect relationship to the
contract will make it null and void.
The assured must disclose material facts which he knows or ought to know, at the time when he is making or is
under the duty to make disclosure. The assured is under such duty until there is a binding contract of insurance
made. The question as to whether certain facts are material or not will not be decided by the assured but is to be
determined by the views of reasonable and prudent insurer. Thus materiality is a question of fact, to be decided in
the circumstances of each case and may be generally taken to embrace every circumstances which would influence
the judgment of a prudent insurer in fixing the premium or determining whether he will take the risk and if so, at
what premium and on what conditions.
It also means that the person who is buying insurance should disclose all material facts to the insurance company,
and it is for the insurance company to determine relevance of each material facts. But in practice, the prospective
assured is given a proposal form upon which certain questions relating the risk to be insured are asked. This has
considerable bearing upon the question of materiality involved in the non-disclosure and misrepresentation. The
express terms that are contained in the proposal form as a rule are called warranties, by which the truth of the
answers to proposal form is made the basis to the liability of insurers under contract. Apart from this, the insurance
company is obligated to explain the implication of the clauses in the agreement and further to explain each of the
questions of which the answers are sought in the personal statement.
Apart from Utmost Good Faith, there are seven other elements of insurance contract which are listed below:
• Insurable Interest
• Indemnity
• Subrogation
• Warranties
• Proximate Cause
• Assignment
• Nomination
Insurable Interest
A valid contract of insurance should have an insurable interest’ by the person who is buying insurance (the
policyholder) in the existence of the subject matter that is being insured. That is, the policyholder should be able to
establish a monetary relationship between her and the subject matter of the insurance. Any loss of subject matter
should directly lead to monetary loss to the policyholder. All insurance contracts should compulsorily have an
insurable interest by the policyholder.
Indemnity
Indemnity refers to the assurance given by one to put the person who obtained assurance, in the event of loss, in
the same position that he/she occupied immediately before the happening of the event for which indemnity is
sought for.
Therefore, all insurance contracts except for life insurance, are considered as contracts of indemnity.
The principles of indemnity and the principle of insurable interest are considered complementary to each other as
the insured has to prove that he/she is the person who will suffer a loss (approximately) to the extent of sum
assured.
Subrogation
Doctrine of Subrogation refers to “the right of the insurer to stand in the place of the insured, after settlement of a
claim, in so far as the insured’s right of recovery from an alternative source is involved”.
When the value of compensation that is recovered from the third party is more than the indemnified value, then the
insurer may charge the appropriate share of any expense incurred in recovering or collecting the money.
Warranties are conditions that are written by the insured in the insurance contracts that state the truth by affirming
or denying the existence of particular state of facts. Warranties that are mentioned in the policy are called express
warranties and those which are not written in the policy are implied warranties. Also, there are warranties which
are answers to the questions (called affirmative warranties) and some warranties fulfilling certain conditions or
promises.
Proximate Cause
Proximate cause refers to the immediate cause that resulted in the loss. For example, when there is loss of property
due to fire caused by a short circuit, the proximate cause will be short circuit (even if the short circuit occurs due to
some other cause, say, the malfunctioning of an electric equipment). It is the cause without which the loss would
not have occurred. An insurer is liable for any loss proximately caused by a peril insured against.
Assignment
Assignment refers to the situation in which one party transfers its rights and duties under a contract to another
party. Both life insurance policies as well as general insurance policies can be assigned. Many of the loan
companies and housing finance companies grant loan to the individuals on assignment of life insurance policies.
Nomination
Nomination refers to the procedure which enables the nominee (in whose favor nomination is given) to get the
policy proceeds without the necessity of producing any legal representation to the estate of the deceased life
assured There need not be any reason for nomination of a policy, a policy may be assigned for a legal
consideration or love and affection. The nomination may be changed during the course of the life of the assured.
However, once the assignment is made, it cannot be revoked by the assignor because he ceases to be the owner of
the policy unless re-assignment is made by the assignee in favor of the assignor.
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