session 6 hdfc-ibs mumbai -regulatory enviroment of indian banking system
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Dr. P.R Kulkarni
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Introduction There is need to regulate and supervise the financial intermediaries and
worlds over the central bank s of respective countries ensure the regulatory
compliance.
The banking sector is most closely regulated sector than any other sectors. The two critical issues that need to be considered in this process are
ability of the bank to control and manage the risk and allocation of
resources.
Both mismanagement of risk and misallocation of resources will lead to
failure of banking system.
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Need for regulatory Compliance Bank holds a major portion of the saving belonging to general
publics.
Banks act as intermediate between saving and investment and
funds economically viable projects.
Banks hold a large portion of funds and in position to influence
the monetary position.
Banks administer the national payment and settlement system.
In the recent past expansion in the net work branches-
particularly after nationalization.
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Need for Regulation in Banking
Banking companies in India are governed by two mainlegislations namely Banking Regulation Act, 1949 and theReserve Bank of India Act, 1934.
The Banking Regulation Act has undergone several changes to
suit the needs that emerged in post-independence period. Nationalization of Banks has transformed the functioning of
major banks necessitating new environment.
Banking Regulation Act demarcates the business to be carried
out by banking companies having regard to the interests ofeconomy and safety of the public deposits.
The main thrust of the act is to ensure sound banking throughregulation covering the opening of branches and maintenance ofliquid assets.
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Banking Regulation Act 1949
The B.R.Act 1949 was enacted to consolidate and amendthe law relating to banking and to provide for suitable
framework for regulating the banking companies.
The Act was amended to cover co-operative banks as well
with certain modifications. The Act regulate the entry in to banking business by
licensing as provided in section 22 thereof.
The restriction on the shareholding, directorship, voting
right and other accepts of banking companies.
There are several provisions in the Act regulating the
business of banking such as restriction on loans and
advances ,rate of interest to be charge.
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Requirement of Cash reserve and maintenance of % of
assets. There are provision regarding audit and inspections and
submission of balance and account.
In short the Act deals
(a) Regulation business of banking companies.
(b) control over the management of the banking
companies.
( C) suspension and winding of up of banking business
and
Penalties fr violation of the provisions of the Act
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Banking regulation Act 1949 defines banking as the acceptanceof money from public for the purpose of lending.
The Act is divided into five parts and consist of 56 sections.
It contains various guidelines for the banks.
The Act also empowered RBI to control and supervise thecommercial banks.
No commercial bank can commence business without
obtaining the license from RBI.
This applies for opening new branches for existing banks
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Discretion is given to RBI to withdraw a license granted.
Act also empowers the RBI to have an over all control over the
management of the banks
RBIs approval is required for appointment of chairman and
directors.
RBI has also power to appoint additional directors on Board of
Directors.
The advances made by the banks subject to the control of
exercised by the RBI.
The credit policy of bank in general is determined by RBI
through Selective credit control.
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Controls over the banks
The Banking regulation Act provide for regulation of the
organization of the banking companies.
There are restrictions at entry point , by way of licensing
and opening branches, capital, appointment of directors
and chairman, and formation subsidiaries.
Licensing of Banking companies :
The license requirement from RBI to commence or carry
on banking business in India, a company requires alicense from RBI under section 22 of BR Act 1949.
Discretion of RBI :Granting of licence by RBI may be
subject to such conditions as RBI may think fit in each
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Conditions to be satisfied : Before granting a license
under section 22 RBI may have to be satisfied by aninspection of the books of the banking company.
Foreign banks : following conditions have been stipulated
1. Whether carrying on of banking business by the
company in India will be in public interest.2. Whether the GOv, or thee law of the country in which
the company is incorporated discriminate any way
against banking company registered in India.
3. Whether the company complies with the provision of
BR Act, as applicable to foreign companies
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Local Banks : The RBI has recognized the concept of Local
area bank and licensed a few (4) such banks. They operate in limited areas.
Cancellation of License :Sub section 4 of section 22 of BR
Act authorizes RBI to cancel the license granted to any
banking company. Branch License : Bank have to obtain prior permission of
RBI for opening of new place of business or changing
location of existing place of business.
Within same location, for shifting branch the permission
from RBI is not required
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Paid up capital and reserves : Section 11 of BR Act
provides for certain minimum requirement as to paid upcapital and reserves of banking companies.
During 2005, RBI stipulated minimum capital requirement
for new private bank at Rs 300 crore.
Voting right of the share holders : there is no specifiedceiling on a person's holding of shares in the banking
company under BR Act.
However, the no shareholder can exercised voting right in
excess of 10% of the total voting right of all shareholders
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Board of Directors :
Qualifications : Section 10 of BR Act stipulate, 50 % 0f thedirectors should have special knowledge in respect of
accountancy, agriculture, rural economy, banking.
The director should not any interest with any employees
or a managing agent in any company. The director of a banking company should not hold the
office for more than 8 years,
Chairman :Every bank should have (sec 10B) full time or
part time chairman appointed from among its directors
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RBI Act 1934
The RBI Act 1934 was enacted to constitute the RBI.
1. to regulate the issue of bank notes
2. For keeping reserves for securing monetary stability in
India, and.
3. To operate currency and credit system of the country to
its advantage.
The Act deals with the constitutions, powers and
functions of RBI.
It does not directly deals with regulation of bankingsystems except section 42 which provides foe cash
reserves for schedules bank to be kept with RBI with the
view to regulating credit system and ensuring monetry
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The Act in short deals with:
1. Incorporation, capital, management and business of thebank.
2. The central banking function likes issue of bank notes,
monetary control, acting as banker to government and
banks, lender of last resort.3. Collection and furnishing of credit information.
4. Acceptance of deposits by non banking financial
institutions.
5. Generl provision regarding reserves funds, credit funds,
publication of bank, audit and accounts
6. Penalties for violation of provisions of the ACT
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RBI Act 1934
Credit market is the place where Fis and NBFCs provide shortmedium and long term loans to corporate, and individuals.
The RBI regulates the credit portfolio of the banks.
The following sections of the RBI Act empowered it regulate and
develop the credit market. The significant aspects which cover the regulatory authority of the
RBI by virtue of the power that are conferred on it by RBI Act 1934
are:
Maintenance of cash reserves by the scheduled commercial bankswith the RBI under section 42.
Issues related to the collection and furnishing of credit information
from the commercial banks under sections 45A and 45F.
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45B : Collection credit information
45c : call for information containing credit
information. 25(45JA) : Determine policy and issue direction
45K: collect information from NBFCs as to deposits
and give directions
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Regulations-RBI
Section 20 of the Act imposed some restrictions on loans and advances bybanking companies. Notwithstanding anything to the contrary to Section 77of the Companies Act, 1956, no banking company shall-
Grant any loans or advances on the security of its own shares, or --
Enter into any commitment for granting any loan or advance to or on behalfof --
any of its directors, any firm in which any of its directors is interested as partner, manager,
employee or guarantor, or
any company [not being a subsidiary of the banking company or a companyregistered under Section 25 of the Companies Act, 1956 (1 of 1956), or aGovernment company] of which 3[or the subsidiary or the holding company
of which] any of the directors of the banking company is a director,managing agent, manager, employee or guarantor or in which he holdssubstantial interest, or
any individual in respect of whom any of its directors is a partner orguarantor.
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Regulations-RBI
Section 21 of the Act gives the RBI enough power to issue directives to thebanking companies to regulate advances made by them. The RBI maydetermine the policy to check speculation and rising prices which thebanking companies shall bound to follow to disburse loans. In thatdirectives the RBI may indicate the following-
The purposes for which advances may or may not be made,
The margins to be maintained in respect of secured advances,
The maximum amount of advances or other financial accommodationwhich, having regard to the paid-up capital, reserves and deposits of abanking company and other relevant considerations, may be made by thatbanking company to any one company, firm, association of persons orindividual,
The maximum amount up to which, having regard to the considerationsreferred to in clause (c), guarantees may be given by a banking company onbehalf of any one company, firm, association of persons or individual, and
The rate of interest and other terms and conditions on which advances orother financial accommodation may be made or guarantees may be given.
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Regulations-RBI Section 23 of the Banking Regulation Act, 1949, requires that
every banking company (foreign or Indian), should obtainpermission from the RBI to open a new place of business orchange of location. It is necessary for Indian banks to get priorpermission for opening of a new business outside India.Following are exceptions where a bank need not require any
permission from the RBI- A change of location within the same city, town or village does
not require any permission from RBI.
A temporary business service offered by a banking companyfor not more than a month in a mela, conference or exhibition
in a place where the bank already is having its presence doesnot require any RBI permission.
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Policy Framework, Organizational Framework & Operational
Framework of Reserve Bank of India:
1. Department of Banking Operations & development (DBOD)
Responsible for:
Regulating commercial Banks
Fulfilling objectives of promotion & development of a sound andcompetitive banking system by laying down various prudentialregulations
Branch Licensing, Licensing of new banks, Approval for setting ofSubsidiaries
New activities of Commercial banks
Follow-up for rehabilitation of weak banks
2. Department of Government and Bank Accounts Banker to theGovernment and other commercial Banks, Reserve Banks InternalAccount
3. Department of Banking Supervision Inspects & supervises Commercial
Banks
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Banking Regulations & Supervision
Separation of the Regulatory and the supervisory roles of the RBI
Setting-up of Department of Supervision (DOS) in December 1993.
Establishment of Board for supervision in November 1994 for dedicated
and integrated supervision of overall credit institutions.
Supervisory Functions
Verification Capital Adequacy and Liquidity,
Management Practices
Adequacy of systems and controls
Compliance with laws and regulations
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Banking Regulations & Supervision: (Contd)
Supervisory Functions (Contd)
Three-pronged Supervisory Strategy
o On-site verification CAMELS Methodology
o Off-site monitoring and surveillance Prudential Quarterly Reporting
System.
Risk- Based Supervision (RBS)
Objectives:
i. Supervisory attention in accordance with the risk profile of the
concerned institution
ii. Strengthening the risk modeling capabilities based on off-site data and
associated research fro predictive supervision
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Regulatory Framework for Compliance (contd)
4. Department of Currency Management 18 issue offices
4195 Currency Chests
488 Repositories
3562 small coin depots
5. Urban Banks department Regulating & Supervising UCBs
Regulatory, Supervisory & Developmental Functions
6. Rural Planning & Credit Department
Policy Formulation
Monitoring timely & adequate flow of credit for agriculture
and rural employment programs
Formulates policies concerning priority sector
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Business Facilitator-Model
Under the Business Facilitator model, banks may use intermediaries, such as ,NGOs/Farmers' Clubs,cooperatives, community based organizations, IT enabled rural outlets of corporate entities, Post Offices,insurance agents, well functioning Panchayats, Village Knowledge Centers, Agri Clinics/ Agri BusinessCenters, Krishi Vigyan Kendras and KVIC/ KVIB units, depending on the comfort level of the bank, forproviding facilitation services. Such services may Include
identification of borrowers and fitment of activities;
collection and preliminary processing of loan applications including verification of primaryinformation/data
Creating awareness about savings and other products and education and advice on managing money anddebt counseling
processing and submission of applications to banks
promotion and nurturing Self Help Groups/ Joint Liability Groups
post-sanction monitoring
Monitoring and handholding of Self Help Groups/ Joint Liability Groups/ Credit Groups/ others
follow-up for recovery
disbursal of small value credit
recovery of principal / collection of interest
collection of small value deposits
sale of micro insurance/ mutual fund products/ pension products/ other third party products and valueremittances/ other payment instruments.
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Know Your Customer (KYC)
In November 2004, RBI issued comprehensive guidelines. The objective ofthe guidelines is to prevent banks from being used, intentionally orunintentionally, by criminal elements for money laundering activities or forfinancing of terrorism.
KYC procedures enables banks to know / understand their customers andtheir financial dealings better which in turn help them manage their risks
prudently. Banks have been asked to frame their KYC policies incorporating the
following for key elements:
Customer Acceptance Policy
Customer Identification Procedures
Monitoring of Transactions
Risk Management
Recent relaxation in KYC Norms
For opening small accounts, banks need to seek only a photograph of theaccount holder and self-certification of address.
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Government of India Department of Banking Division
The department of banking supervision exercise thesupervisory role relating to commercial bank in the following
form:
Perform independent inspection of CB.
Undertakes scheduled and special on-site inspection, offsitesurveillance, ensuring follow-up and compliance.
Determine the criteria for the appointment of statutory
auditors and special auditors and assessing audit
performance and discloser standards
Deals with the financial sector frauds
Exercises supervisory intermissions in the implimentation of
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The New Basel Accord Implication for Banks
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The New Basel Accord Implication for Banks
The Basel Comity on Banking supervision published the Capital Adequacy
Accord, also known as Basel Accord, in 1988.
It defines the parameters of Risk Management and Capital Adequacy for
Financial Service Providers (FSP).
The Basel Accord was adopted by the central banks of over 100 countries as a
basis of Risk Management within their banking system.
However the regulatory capital requirement set by the Accord proved to be
incompatible with the new sophisticated internal measures of economic
capital. The Accord was also unable to recognize credit risk techniques such as
collateral and guarantees. This result in an in flexible system an ultimately
increase the risk for financial institutions.
The Basel II was devised to plug these gaps. It also provides benefits of
enhanced risk management, efficient operations, and higher revenues to the
banking community.
Basel II has also laid down some controls on the International banking system
in the form of a higher capital requirement to underwrite mismanagement of
risks and lack of infrastructural controls in many economics.
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Basel II Accord (Cont..)
After a series of revisions Basel II has been finalized andmajor part of it will be applicable by the end of 2006.
Existing Accord New Accord
1. Focus on single risk. 1. More emphasis on banks measures
own internal methodology, supervisory
review and market discipline.
2. One size fits all. 2. Flexibility, menu of approaches,
incentive for better risk management.
3. Broad brush structure. 3. More risk sensitivity.
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Basel Norms
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The Three Pillar Architecture as defined by Basel II
The first pillar of Basel II is designed to help cover risks within the financial institutions.The second pillar intends to ensure the presence of sound processes at each bank.The third pillar attempts to boost market discipline through enhanced disclosure by banks
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Basel II Accord (Cont..) The Basel II Framework
Basel II intends to provide more risk sensitive approaches while maintaining the
overall level of regulatory capital within the financial system. This can be achieved
through meticulously designed framework that consists of three mutually reinforcing
pillars as shown below. The Three Pillar Architecture as defined by Basel II
Pillar 1
Minimum Capital Requirements
The first pillar is designed to help cover risks within a financial institution. It
aims to set minimum capital requirements and defines the current amount ofcapital. This pillar also stresses on defining the capital amount by quantifying
risks such as Credit Risk, Operational Risk and Market Risk.
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Basel II Accord (Cont..)
Pillar 2 Supervisory and Review Process
The second pillar of Basel II intends to ensure the presence of sound processes at eachbank. This pillar would also provide the framework to assess the adequacy of the bankscapital, based on a thorough evaluation of its risks. The Basel II framework emphasizesthe development of an internal capital assessment process by the bank management.Additionally, management should set targets for capital corresponding with the banks riskprofile and control environment.
Pillar 3
Market Discipline
The third pillar of the new framework attempts to boost marketdiscipline through enhanced disclosure by banks. Basel II identifies thedisclosure requirements and provides recommendations both on thedefining methods for calculating capital adequacy, and risk management
strategies. Effective disclosures by banks help market participantsunderstand the banks risk profile and adequacy of its capital positions,thereby facilitating market discipline. This strategy plays an importantrole in maintaining the confidence in a financial institution.
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Basel II Accord Pillar 1 (Cont..)
MEASURING CREDIT RISK
Credit Risk defines the minimum capital required to cover
exposure to customers and counter parties. The Basel II
framework provides a menu of approaches in respect of creditrisk. They are:
i. Standardized Approach,
ii. Internal Rating Based (IRB) Approach
a. Foundation
b. Advanced.
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Pillar 1 (Cont..)
Standardized Approach
In this approach a riskweight to each of its assets an off
balance sheet position is allocated. It then calculates a sum
of risk-weighted asset values.
The countrys central bank indicated the risk-weight which
should be allocated to the different types of assets.
The capital charge is equal to 8% of the asset value.
In Basel I individual risk- weights are dependent on the
category of borrowers. In Basel II these weights are defined
by referring to a rating provided by an external credit rating
agency.
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Pillar 1 (Cont..) Internal Ratings Based Approach (IRB): In this approach,
banks use their internal evaluation systems to assess aborrowers credit risk. The results, attained by this process, aretranslated into estimates of a potential future loss, thereby
defining the basis of minimum capital requirements. The IRB Approach supports the following methodologies for
corporate, sovereign and bank exposures:
FoundationUsing this methodology, banks canestimate the risk of default or the Probability of Default (PD)
associated with each borrower. Additional risk factors such asLoss Given Default (LGD) and Exposure at Default (EAD) arestandardized by supervisory rules that are laid down andmonitored by regulating authorities
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Pillar 1 (Cont..)
Internal Ratings Based Approach (IRB ) (Cont..)
Advanced This methodology allows banks with sufficientinternal capital to assess additional risk factors. These factorsinclude Exposure at Default (EAD), Loss Given Default (LGD)
and Maturity (M). It also allows banks to provide guaranteesand credit derivatives on the risk of exposure. The ranges ofrisks in both these methodologies are more diverse than in thestandardized approach, resulting in greater risk sensitivity.
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Pillar 1 (Cont..) Credit Risk Mitigation
The Consultative Document contains proposals for therecognition of certain credit risk mitigation techniquesin the calculation of regulatory capital. These includecollateral, guarantees and credit derivatives and on-balance sheet netting. Certain minimum conditions
must be met in each case to qualify for relief ofcapital.
In the case of collateral, these include legal certainty,low correlation with exposure and the operation ofrobust risk management practices.
Similar requirements apply to on-balance sheetnetting. For guarantees and credit derivatives a rangeof operational requirements are specified.
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Pillar 1 (Cont..) Asset Securitization The Committee has put forward proposals that are designed to
look through traditional asset securitization structures to ensurethat a capital charge is levied in respect of risks retained by thebank. Proposals are aimed at the level of originating, investingand sponsoring banks. Originating banks qualify for a relieffrom the capital charge only where it is established that thesecuritized assets have been effectively removed from the
balance sheet. Investing banks carry a capital charge based on the credit rating
of the assets they hold, where they are using the standardizedapproach for credit risk.
Sponsoring banks must also deduct credit enhancementsprovided to securitization structures from regulatory capital.
The Committee has proposed detailed operational rules toensure that implicit credit protection is not being provided byoriginating or sponsoring banks through these liquidityfacilities.
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Basel II Accord (Contd)
Pillar II : Supervisory and Review Process:
Intends to ensure presence of sound processes
Provide the framework to access the adequacy of the banks capital, based on a
thorough evaluation of its risks
Emphasizes development of Internal Capital Assessment Process
Management should set targets for capital corresponding with banks risk profileand controlled environment.
Role of Regulatory and Supervisory Bodies (i.e. the Central Banks):
Review the internal process
Assessment of banks capital adequacy in relation to its risks
Compliance with internal measurement methodologies, mitigation policies of
credit risk, and securitization policies are subject to supervisory control.
Responsible for reviewing operations and processes in trading, internet banking
and security processing.
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Basel II Accord (Contd)
Benefits of Pillar II:
Increased interaction between bank managers and supervisory bodies
Enhances level of transparency within the organization
Helps achieve a higher level of security within the organization
A level of standardization and conformity is established across the enterprise which
helps achieve higher returns with lower riskPillar III: Market Discipline:
Attempts to boost market discipline through enhanced disclosures
Helps market participants understand the banks risk profile and adequacy of its
capital position
Helps maintaining the confidence in a financial institution
Based on the recommendations in January 2000 relating to capital, risk exposure and
capital adequacy more specific quantitative and qualitative disclosures in key areas
on risk and capital adequacy have been laid down.
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Sarbanes Oxley
Sarbanes-Oxley Act of 2002 is named after its authors SenatorPaul S Sarbanes andCongressman Michael G Oxley and hasbeen enacted to improve the corporate responsibility amongAmerican firms. Major concerns that were addressed:
To oversee the audit of public companies which are subject tothe securities laws;
To establish audit report standards and rules;
To inspect, investigate, and enforce compliance on the part ofregistered public accounting firms, certified public accountants,
and their associated persons.
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Sarbanes Oxley
The major provisions of the Act
Independence of auditors
Corporate Responsibility Enhanced Financial Disclosures
Corporate and Criminal Fraud Accountability
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Business Continuity Management
Business Continuity Planning (BCP) is a planning process to ensurecontinuity of a business through challenging scenario. The BCP is alsoconventionally known as Business Recovery Planning, Disaster RecoveryPlanning. BCP has become more important due to ever increasingdependence of organisations on information technology andtelecommunication networks. Information Technology (IT) is inherentlyvulnerable to the operational risks and at the same time mission critical. In a
highly computerised environment if a system is down, the businesstransactions cannot be carried out. Any undesirable event or incident, whichmay result into disruption of business process and may lead to loss to theorganisation, is called a disaster. That is, any event, which causesunacceptable interruption of business operations for an unacceptable periodof time, is a disaster.
The purpose of BCP is to ensure availability of resources all the time at anycost to ensure continuity of business without any disruption as a disastermay put the organisation out of business.
18 April 2012 Dr. P.R Kulkarni
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Business Continuity Management
BCP is a business plan, rather than a technical plan.BCP considers what needs to be done in case adisaster impacts an organisations normal businessenvironment. BCP prepares the organisation by:
Identifying critical functions and enablers (resources)required to maintain an acceptable level of business,
Protecting those enablers; and
Preparing procedures to ensure survival of theorganisation in times of business disruption.
18 April 2012 Dr. P.R Kulkarni
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8/4/2019 Session 6 HDFC-IBS MUMBAI -REGULATORY ENVIROMENT OF INDIAN BANKING SYSTEM
45/45