treasury manageement

www.icai.orgMay / 2010 (Reprint)

ISBN : 978-81-8441-296-3

The Institute of Chartered Accountants of India(Set up by an Act of Parliament)

New Delhi

Price : Rs. 150/-

Technical Guide

on Internal Audit of

Treasury Function in Banks

Te

ch

nic

al G

uid

e o

n In

tern

al A

ud

it of T

reasu

ry F

un

ctio

n in

Ban

ks 2

010

Technical Guide on Internal Audit of

Treasury Function in Banks

DISCLAIMER:

The views expressed in the Technical Guide are those of author(s). The Institute of Chartered Accountants of India may not necessary subscribe to the views of the author(s).

The Institute of Chartered Accountants of India

(Set up by an Act of Parliament) New Delhi

ii

© The Institute of Chartered Accountants of India

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission, in writing, from the publisher.

Edition : January, 2010

Committee / : Internal Audit Standards Board Department

Email : [email protected]

Website : www.icai.org

Price : Rs. 150/- (Including CD)

ISBN No. : 978-81-8441-296-3

Published by : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi-110 002.

Printed by : Sahitya Bhawan Publications, Hospital Road, Agra-3. May/2010/1,000 Copies (Reprint)

iii

FOREWORD

With the significant developments that have taken place in the capital, money and foreign exchange markets in the recent years affecting volatility in exchange rates and accentuating liquidity constraints, organisations have started paying closer attention to the treasury management function. The globalization of the economy with mobilization and deployment of funds from/in other countries is also necessitating increased attention in the area of treasury management. Banking industry has been all long focusing on successful treasury management, which is extremely necessary for their strong, viable and profitable existence.

In view of the complexity, volume and growth of treasury function in banks, internal auditors have a dynamic role to play to support the banks in helping to achieve the strategic goals. Internal auditors can strengthen the bank’s treasury functions by reviewing critical control systems and risk management processes and providing valuable suggestions.

I am happy to note that the Internal Audit Standards Board of the Institute is issuing this publication “Technical Guide on Internal Audit of Treasury Function in Banks” containing extensive knowledge on this complex subject.

I congratulate CA. Shanti Lal Daga, Chairman, Internal Audit Standards Board and the members of the Board on issuance of this publication. I am confident that this comprehensive publication would help the members as well as other readers in acquiring good knowledge of products, practices and regulations of treasury function in banks.

January 12, 2010 CA. Uttam Prakash Agarwal New Delhi President

v

PREFACE

In this financially globalized volatile world, bank’s treasury groups which are ultimately responsible for keeping their banks in business are witnessing tremendous changes. The change is being forced with rapid economic developments, globalizing industries and competition, new technologies and revolutionary changes in the regulatory environment. Apart from responding to these changes, treasury functions of banks are under pressure to add value to the banks through their operations and contribute to achieve strategic goals.

Internal audit helps the organisations to achieve their stated objectives. Carrying out an internal audit of treasury functions in banks requires an in-depth understanding of the applicable statutes, systems and processes since it operates under a very regulated and governed atmosphere. Specialist knowledge in certain areas of banking is also of equal importance.

In the wake of these developments in the field of treasury management in banks, the Internal Audit Standards Board of the Institute is issuing this publication “Technical Guide on Internal Audit of Treasury Function in Banks” for the members of the Institute as well as bankers. This publication is aimed to help the readers in understanding the roles and responsibilities of the treasury function in banks as well as in determining the nature of internal audit procedures to be undertaken. The Technical Guide has been divided into various chapters covering aspects such as treasury products and services, treasury dealing room, organisational structure of a bank’s treasury, investment portfolio, asset liability management, treasury risks. The guide also deals with the fundamental controls and the internal audit procedures with special reference to treasury/ market risk segments. It also contains detail checklist on internal audit of treasury operations, foreign exchange operations and domestic operations of treasury. It also includes a compilation of relevant circulars issued by the Reserve Bank of India applicable to treasury operations of a bank. For better understanding of the readers, the guide also contains an introduction section and also a glossary of some technical terms used in the Guide.

At this juncture, I am grateful to CA. Rajkumar S. Adukia, Central Council Member and convenor of the Group ably assisted by other members of the Group, viz., CA. Pankaj Adukia, CA. Abhay Arolkar and CA. Vijay Joshi for

vi

squeezing out time out of their professional and personal commitments and preparing the basic draft of this Technical Guide. I would also take the opportunity of placing on record my gratitude to CA. Akeel Master for reviewing the draft and giving his valuable comments and suggestions.

I also wish to thank CA. Uttam Prakash Agarwal, President and CA. Amarjit Chopra, Vice President for their continuous support and encouragement to the initiatives of the Board. I must also thank my colleagues from the Council at the Internal Audit Standards Board, viz., CA. Ved Jain, CA. Abhijit Bandyopadhyay, CA. Bhavna G. Doshi, CA. Pankaj I. Jain, CA. Sanjeev K. Maheshwari, CA. Mahesh P. Sarda, CA. S. Santhanakrishnan, CA. Vijay K. Garg, Shri Krishna Kant, Shri Manoj K. Sarkar and Shri K. P. Sasidharan for their vision and support. I also wish to place on record my gratitude for the coopted members on the Board, viz., CA. N. K. Aneja, CA. Verendra Kalra, CA. M. Guruprasad, CA. Dilip Kumar Vadilal Shah and CA. K. S. Sundara Raman as also special invitees on the Board, viz., CA. K. P. Khandelwal, CA. S. Sundarraman, CA. Ravi H. Iyer, CA. Rajiv Dave, CA. Pawan Chagti, CA. Ram Mohan Johri and CA. Arindam Guha for their devotion in terms of time as well as views and opinions to the cause of the professional development. I also wish to place on record the efforts put in by CA. Jyoti Singh, Secretary, Internal Audit Standards Board and CA. Arti Aggarwal, Senior Executive Officer, for their inputs in giving final shape to the publication.

I am sure that the members of the Institute would find the Technical Guide immensely useful in understanding the intricacies of the subject matter and in carrying out their professional duties diligently.

January 29, 2010 CA. Shantilal Daga Hyderabad Chairman Internal Audit Standards Board

vii

CONTENTS

Foreword................................................................................................... iii Preface.......................................................................................................v Glossary.................................................................................................... ix Introduction ............................................................................................ xvii CHAPTER : 1. Treasury- An Introduction .............................................................. 1 - 4 2. Treasury Products and Services ............................................. 1 - 7 3. The Treasury Dealing Room................................................... 1 - 3 4. Organisational Structure of A Bank’s Treasury ........................ 1 - 6 5. Investment Portfolio..................................................................... 1 - 13 6. Asset Liability Management...........................................................1 – 6 7. Treasury Risks....................................................................... 1 - 6 8. Treasury Unit – Fundamental Controls........................................ 1 - 13 9. Internal Audit of Treasury Operations............................................ 1 - 6 ANNEXURES : Annexure A- Specimen Checklist for Internal Audit of Treasury Operations...... Annexure B - Specimen Checklist for Internal Audit of Foreign Exchange Operations of Treasury......................................... Annexure C- Specimen Checklist for Internal Audit of Domestic Operations of Treasury........................................................ Annexure D- Guidance Note on Market Risk Management ................... Annexure E - Assets Liability Management (ALM) System.................... Annexure F- RBI Mc Guide primary dealers 2009................................. Annexure G RBI Mc Capadeqrm 2009 .................................................

viii

Annexure H- RBI Mc Callmoney 2009.................................................. Annexure I - RBI Mc Cd 2009 .............................................................. Annexure J - RBI Mc Comlpaper 2009 ................................................. Annexure K- RBI Mc Prunormsinvestt 2009 ........................................

GLOSSARY

Arbitrage The purchase or sale of an instrument and simultaneous taking of an equal and opposite position in a related market, in order to take advantage of small price differentials between markets.

Asset Class Securities with identical risk/reward composition, attributes and features.

At-the-money An option contract with identical risk/ reward composition and features.

Asset Allocation Investment practice that divides funds among different markets to achieve diversification for risk management purposes and/or expected returns consistent with an investor’s objectives.

Asset Liability Management (ALM)

A risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities.

Business Risk Risk associated with the unique circumstances of a particular entity, as they might affect the price of that entity’s securities.

Back-office The departments and processes related to the settlement of financial transactions.

Cash Money in the form of authorized currency (including coins) and bank balances.

Cash Management: The strategy by which a company administers and invests its cash.

Technical Guide on Internal Audit of Treasury Function in Banks

x

Cash Flow at Risk The Cash Flow at Risk approach answers the question of how large the deviation between actual cash flow and the planned value (or that used in the budget) is due to changes in the underlying risk factors.

Cash Position Cash Position in foreign exchange deals with all the transactions effecting Nostro account, funding of Nostro (in case of overdraft), utilization of surplus cash balance in Nostro and deployment of funds so as to ensure optimum utilization. Examples are delivery under forward contracts, inward /outward telex transfer, etc. It is also called fund position.

Centralised Funds Management System (CFMS)

The Centralised Funds Management System (CFMS) provides for a centralised viewing of balance positions of the account holders across different accounts maintained at various locations of the RBI.

Collar Option A protective options strategy that is implemented after a long position in a stock has experienced substantial gains. It is created by purchasing a “put option” while simultaneously writing a “call option.” (also known as “hedge wrapper”)

Cost of Carry Expenses incurred while a position is being held, for example, interest on securities bought on margin, dividends paid on short positions, and other expenses.

Cross Hedge Hedging a cash market position in a futures or option contract for a different but price-related commodity.

Credit Information Bureau of India Ltd. (CIBIL)

India’s first credit information bureau- is a repository of information, which contains the credit history of commercial and consumer

Glossary

xi

borrowers. CIBIL provides this information to its members in the form of credit information reports.

Currency Position It deals with daily sale/purchase of foreign currency/transaction. It could be excess, less or equal. In that case we call it overbought (more purchase) oversold (more sales) or square (purchase matches sales) respectively.

Currency Risk The probability of an adverse change in exchange rates.

Day Trading Refers to positions which are opened and closed on the same trading day.

Derivative A contract that changes in value in relation to the price movements of a related or underlying security, future or other physical instrument. An option is the most common derivative instrument.

Duration The weighted average term to maturity of a security's cash flows, where the weights are the present value of each cash flow as a percentage to the security's price.

Earnings at Risk Outcome of notional interest rate shock on interest income.

Electronic Clearing Services (ECS) ECS (Credit)

Credit clearing ensures multiple repetitive credits to the accounts of constituents of banks situated at various branches of banks on the basis of a single debit to the account of a corporate customer called the “user”.

ECS (Debit) Debit clearing ensures multiple repetitive debits to the accounts of constituents of banks situated at various branches of banks and a corresponding single debit to the account of a corporate customer called the “user”.


xii

Expected Loss High frequency but low severity from any activity or risk.

Financial Risk Uncertainty of results to the investor due to financial modality.

Forward The pre-specified exchange rate for a foreign exchange contract settling at some agreed future date, based upon the interest rate differential between the two currencies involved.

Fundamental Analysis Analysis of economic and political information with the objective of determining future movements in a financial market.

Futures Contract An obligation to exchange a good or instrument at a set price on a future date. (The primary difference between a future and a forward is that futures are typically traded over an exchange (Exchange Traded Contracts – ETC), versus forwards, which are considered Over the Counter (OTC) contracts. An OTC is any contract not traded on an exchange.)

Growth Stock Stock of a company which is growing earnings and/or revenue faster than its industry or the overall market, and as compared to stock with similar risk features.

Herstatt Risk or Systemic Risk This risk was in focus in 1974 when Herstattt Bank (a German bank) had to shutter down, as settlement of second leg of currency could not be completed due to time zonefactors.

Hedge A position or combination of positions that reduces the risk of your primary position.

Indian Financial Network (INFINET)

The Indian Financial Network (INFINET) is the communication backbone for the Indian

Glossary

xiii

Banking and Financial Sector. All banks, public sector undertakings, private sector organisations, co-operative, etc., and the premier financial institutions in the country are eligible to become members of the INFINET.

Inflation An economic condition whereby prices for consumer goods rise, eroding purchasing power.

Initial Margin The initial deposit of collateral required to enter into a position as a guarantee on future performance.

In the Money Situation in which an option's strike price is below the current market price of the underlier (for a call option) or above the current market price of the underlier (for a put option). Such an option has intrinsic value.

Leading Indicators Statistics that are considered to predict future economic activity.

Limit Order An order with restrictions on the maximum price to be paid or the minimum price to be received.

Liquidity The ability of a market to accept large transaction with minimal to no impact on price stability.

Liquidity Risk The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset.


xiv

Liquidation The closing of an existing position through the execution of an off-setting transaction.

Long Position A position that appreciates in value if market prices increase.

Market Risk Exposure to changes in market prices.

Mark-to-Market Process of re-evaluating all open positions with the current market prices. These new values then determine margin requirements.

Maturity The date for settlement or expiration of a financial instrument.

National Settlement System (NSS)

All clearings conducted in all clearing houses in all parts of the country will be settled in a single centralized location in central bank money.

Negotiated Dealing System (NDS)

Negotiated Dealing System (NDS) is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments.

Offer The rate at which a dealer is willing to sell a currency.

Open Position A deal not yet reversed or settled with a physical payment.

Operational Risk The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

Over the Counter (OTC) It is used to describe any transaction that is not conducted over an exchange.

Overnight A trade that remains open until the next business day.

Political Risk Exposure to changes in governmental policy which will have an adverse effect on an investor’s position.

Glossary

xv

Position The netted total holdings of a given currency.

Premium In the currency markets, it describes the amount by which the forward or futures price exceed the spot price.

Primary Dealers Primary dealers can be referred to as Merchant Bankers to the Government of India, comprising the first tier of the government securities market. Satellite dealers work in tandem with the Primary dealers forming the second tier of the market to cater to the retail requirements of the market.

Quote An indicative market price, normally used for information purposes only.

Rate The price of one currency in terms of another, typically used for dealing purposes.

Risk Exposure to uncertain change, most often used with a negative connotation of adverse change.

Risk Management The employment of financial analysis and trading techniques to reduce and/or control exposure to various types of risk.

Roll Over Process whereby the settlement of a deal is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies.

Settlement The process by which a trade is entered into the books and records of the counterparts to a transaction .The settlement of currency trades may or may not involve the actual physical exchange of one currency for another.

Settlement Risk The risk that one party will fail to deliver the terms of a contract with another party at the time of settlement.


xvi

Short Position Investments position that benefit from a decline in market price.

Spot Price The current market price. Settlement of spot transactions usually occurs within two business days.

Spread The difference between the bid and offer prices.

Structured Financial Messaging Solution (SFMS)

SFMS allows intra/inter bank message transfer. This also provides for transfer of file attached in a secured mode.

Swap A currency swap is the simultaneous sale and purchase of the same amount of a given currency at a forward exchange rate.

Tail Risk Probability of loss due to most unsecured market movements.

Technical Analysis An effort to forecast prices by analyzing market data, i.e., historical price trends and averages, volumes, open interest, etc.

Tick Size The smallest increment in which the price for a futures contract can move.

Transaction Cost The cost of buying or selling a financial instrument.

Transaction Date The date on which a trade occurs. Turnover The total money value of all executed

transactions in a given time period. Value at Risk (VAR) It is a measure of how the market value of

an asset or of a portfolio of assets is likely to decrease over a certain time period under usual conditions.

Yield to Maturity (YTM) The percentage rate of return paid on a bond, note, or other fixed income security if the investor buys and holds it to its maturity date.

INTRODUCTION

1. Preface to the Standards on Internal Audit issued by the Institute of Chartered Accountants of India defines Internal Audit as follows:

“Internal audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entity’s strategic risk management and internal control system. Internal audit, therefore, provides assurance that there is transparency in reporting, as a part of good governance.”

2. Internal audit objectives, with specific reference to treasury function in a bank, includes following important aspects:

(a) To ensure that policies and procedures relating to all treasury activities have been framed and are periodically reviewed for adequacy and coverage.

(b) To determine whether management has planned for liquidity needs for both normal operating conditions and emergency situations.

(c) To ensure adequate physical and access control procedures are in place in the department.

(d) To verify existence of satisfactory controls in the processing of deals.

(e) To ascertain that the bank receives favorable rates for all its deals.

(f) To check authenticity and appropriateness of the sources of inputs used for valuation of unquoted treasury instruments.

(g) To check that there is accurate recording and accounting of positions.

(h) To ensure that proper documentation procedures and filing systems are in place.

(i) To ensure that limits are set for different procedures and they are adhered to in a consistent manner.

xviii

(j) To verify that any violations are promptly reported and properly dealt with.

(k) To ensure that reconciliation is being made timely and accurately, including daily reconciliation of the dealer’s profit and loss to the general ledger.

(l) To evaluate the adequacy and effectiveness of the internal control system and to suggest measures for improvement, if any.

(m) To indicate probable risk-prone areas within treasury, based on the prevailing external economic environment, and to offer views for safeguarding the interest of the bank.

(n) To aid and facilitate risk based supervision function of the RBI (Pillar 2 of the Basel Accord) in regard to a bank’s treasury/market risk business areas.

(o) To ensure compliance with the guidelines issued by the RBI, SEBI, FEMA, FEDAI, etc., and other guidelines issued from time to time.

(p) To verify that interest and dividend income is accounted for fully and correctly.

(q) To verify that all counterparty confirmations are received.

3. The precise scope of risk-based internal audit of treasury transactions must be determined by each bank for low, medium, high, very high and extremely high risk areas. This Technical Guide contains matter relevant for domestic compliance only. In case of overseas treasury operations, the RBI guidelines on the subject and the domicile country requirements will also be required to be considered.

CHAPTER 1

TREASURY- AN INTRODUCTION

Meaning

1.1 A treasury is any place where currency or items of high monetary value are kept. The term “treasury” was first used in classical times to describe the votive buildings erected to house gifts to the gods, such as the Siphnian Treasury in Delphi or other similar buildings erected in Olympia, Greece by competing city-states, to impress others during the ancient Olympic Games.

1.2 A treasury can either be:

• The part of a government which manages all money and revenue;

• The funds of a government or institution or individual;

• The government department responsible for collecting, managing and spending public revenues;

• A depository ( room or building) where wealth and precious objects can be kept; or

• The center of financial operations within an organisation.

Treasury in Banks 1.3 Traditionally, the treasury function in banks was limited to Funds management, i.e., maintaining adequate cash balances to meet day-to-day requirements and deploying surplus funds from operations. The treasury in a bank is also responsible for maintenance of reserve requirements (Cash Reserve Ratio and Statutory Liquidity Ratio). Treasury was considered a service centre and liquidity management was its main function.

The scope of treasury has now expanded beyond liquidity management and treasury has now evolved as a profit centre with its own trading and investment activity.

1.4 Presently, as per RBI circular on “Guidelines – Accounting Standard 17 (Segment Reporting) – Enhancement of Disclosures dated April 18, 2007, banks


2

are required to report under the following business segments as primary reporting format and for the purpose of segment reporting under Accounting Standard (AS) 17, “Segment Reporting”:

(a) Treasury

(b) Corporate / Wholesale banking

(c) Retail banking and

(d) Other banking operations

“Domestic” and “International” segments will be the geographic segments for disclosure. Treasury activity in a bank depends on its size, complexity of operations, area of operations and risk profile.

Integrated Treasury

1.5 Traditionally, the domestic treasury operations were independent of forex dealings of a bank. The need for an integrated treasury rose in the backdrop of interest rate deregulations, liberalization of exchange control, development of forex market and advancement in the settlement systems and dealing environment. The integrated treasury besides performing the functions of the traditional roles also performs the following functions:

(a) Reserve management and Investment- This involves meeting Cash Reserve Ratio (CRR)/Statutory Liquidity Ratio (SLR) obligations and having an optimum mix of investment portfolio.

(b) Liquidity and Funds management- This involves analysis of major cash flows; providing inputs to planning group on funding mix( currency, tenor and cost) and yield expected in credit and investment.

(c) Asset liability management and term money- This involves determining the optimum size and growth rate of the balance sheet; and also price the assets and liabilities in accordance with the prescribed guidelines.

(d) Risk Management- This involves managing all market risks associated with the bank’s assets and liabilities. Risk management also includes management of credit risks on treasury products and operations risks on payments and settlements.

(e) Transfer pricing- Ideally , the integrated unit should provide benchmark rates after assuming market risks to various business groups and product

Treasury- An Introduction

3

categories about adopting the correct business strategy to ensure that the funds are deployed optimally.

(f) Derivative products- Treasury can develop Interest rate swaps, and other derivative products to hedge the bank’s exposure and also sell such products to customers or other banks.

(g) Arbitrage- This involves simultaneous buying and selling of the same type of assets in two different markets in order to make risk-less profits.

(h) Capital adequacy- This focuses on quality of assets and Return on investments is key criteria for evaluating the efficiency of deployed funds.

(i) Canalizing and managing other asset instruments into investment instruments e.g., instruments resulting out of Corporate Debt Restructuring, Asset Reconstruction, Pass Thru certificates, Asset Backed Securitization (ABS), Mortgage Backed Securitization(MBS), etc.

(j) To monitor the Rating Migrations on an on going basis and take timely corrective action.

(k) To minimize the level of provisional requirements due to non-performing investments.

1.6 Treasury operations play a pivotal role in not only improving the bottom line of banks but also in Balance Sheet management by reducing risks by hedging sensitive exposures. Treasury management would, normally, consist of management of its cash flows, banking, money market and capital market transactions; effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks keeping in mind the business objectives and in consonance with the regulatory framework.

Objectives of Treasury management 1.7 The objectives of treasury management can be stated as under:

(a) To plan, organize and manage funds profitably and to ensure compliance with respect to regulatory requirements (SLR/CRR).

(b) Treasury services are also being utilized for Balance Sheet management (CRAR-Capital Risk weighted Adequacy Ratio, Asset and Liability product hedging, etc).

(c) To optimize return on surplus funds invested and to keep cost of funds to the minimum.


4

(d) To keep investment portfolio healthy and liquid.

(e) To minimize non-performing investments.

(f) To take advantage of market volatility and trade/arbitrage in permitted products (including overseas) and avail arbitrage opportunities between rupee and forex treasury operations.

(g) To invest in tax free instruments as per the tax planning of the bank.

(h) To conduct derivative transactions to hedge bank’s own balance sheet gaps and exposure of the clients.

(i) To optimize returns from forex operations.

Areas in treasury management 1.8 From the viewpoint of a bank or a financial institution, treasury management

covers the following major areas:

(a) Liquidity risk management

(b) Interest risk management

(c) Currency risk management

(d) Equity risk management

(e) Commodity risk management

(f) Investment management.

CHAPTER 2

TREASURY PRODUCTS AND SERVICES

Money Market 2.1 Money market desk is involved in management of assets and liabilities of the bank. The main function involves the following:

(a) Management of statutory reserves viz., Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) of the bank.

(b) Daily Funds Management for the bank. (c) Balance Sheet Management. (d) Debt Securities Trading.

Range of Products 2.2 The Money Market Desk trades in the following Instruments:

(i) Treasury-Bills

• Treasury Bills (T-bills) are short-term debt instruments issued by the Central Government for maturities of 91, 182 and 364 days.

• Commercial banks, primary dealers, mutual funds, corporates, institutions, provident or pension funds and insurance companies can participate.

• RBI issues a calendar of T-bill auctions. Periodic auctions are held for their issue and these are tradable in the secondary market, which is quite active.

• T-bills are issued at a discount to face value and are redeemable at par on maturity.

(ii) Commercial Paper (CP)

• A Commercial Paper (CP) is an unsecured money market instrument through which corporate entities raise short-term money.


6

• It is issued as per RBI guidelines. (Refer “Master Circular on Guidelines for Issue of Commercial Paper” dated July 1, 2009.)

• It is issued at a discount to face value

• It can be issued either in the form of a promissory note or in a dematerialised form.

• It attracts issuance stamp duty in primary issue.

• It has to be mandatorily rated for issuance by one of the four credit rating agencies.

• It can be issued for maturities between a minimum of seven days and a maximum upto one year from the date of issue.

(iii) Call Linked Products

• Corporates can participate both as lenders and borrowers.

• It can be issued for a maximum period of 89 days.

• Pricing is linked to a benchmark like, MIBOR.

• Flexible call or put option could be exercised.

(iv) Certificates of Deposit (CD)

• Certificate of Deposits (CDs) are unsecured, negotiable money market instrument usually issued at a discount on face value. (Refer to RBI Master Circular on Guidelines for Issue of Certificates of Deposit dated July 1, 2009.)

• The maturity period is from 7 days to 12 months.

• It attracts issuance stamp duty and is issued in dematerialised form or as a Usance Promissory note. .

• They are negotiable, and transferred by endorsement and delivery, after 15 days of issue.

(v) Collateralised Borrowing and Lending Obligations (CBLO)

• CBLO is a money market instrument designed to meet the borrowing and lending needs of banks, financial institutions, mutual funds, NBFCs and corporates.

Treasury Products and Services

7

• Borrowing and lending is collateralised i.e., secured using G-Sec or T-Bills.

Trades are screen based and with Clearing Corporation of India Limited (CCIL) being central counter party.

(vi) Repo/ Reverse Repo

The Reserve Bank of India (Amendment) Act, 2006 provides a legal definition of “repo” and “reverse repo” as an instrument for borrowing (lending) funds by selling (purchasing) securities with an agreement to repurchase (resell) the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed (lent). Such a transaction is called a Repo when viewed from the perspective of the seller of the securities and Reverse Repo when viewed from the perspective of the buyer of the securities. Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which party initiated the transaction. Market participants may undertake repos from any of the three categories of investments, viz., Held for Trading, Available for Sale and Held to Maturity.

(vii) Liquidity Adjustment Facility (LAF) with RBI

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. All commercial banks (except RRBs) and Primary Dealers having current account and SGL account with RBI can use eligible securities as collateral through a repo agreement and will use funds to alleviate their short-term requirements, thus remaining stable.

RBI has issued Circular “Liquidity Adjustment Facility – Revised Scheme” on March 25, 2004 which lays down the revised scheme effective from March 29, 2009.

Operation of LAF through repo by means of daily auctions has provided the benchmark for collateralised lending and borrowing in the money market. This mechanism has helped in providing liquidity to the government securities market.


8

(viii) Inter-Bank Participation Certificate (IBPC)

The objective behind introduction of this instrument is to even out the short term liquidity within the banking system. This instrument was introduced in 1988 and Scheduled commercial banks were permitted to share a portion of their eligible loan assets with other banks through issue of IBPC. RBI has vide Circular “Inter-Bank Participations – Scheduled Commercial Banks” dated August 4, 2009 has allowed Regional Rural Banks (RRBs) to also issue IBPCs. The bank sharing its loan portfolio is known as issuing bank, and the bank which is buying the portion of loan portfolio through IBPC is known as participating bank. Both issuing and participating bank will have to execute participation contract. The loan asset which is to be shared with participating bank must be a standard loan asset and it cannot be more than 40 per cent of the outstanding advance at the time of issue of IBPC. As per the existing guidelines of the RBI, commercial banks have been permitted to issue two types of IBPCs which are as under:

(a) With Risk Sharing Basis

Under risk sharing participation certificate scheme, risk of default of the borrower is shared by the issuing bank and the participating bank. The participating bank has no recourse to the issuing bank if there is default by the borrower for that loan amount which is shared. The IBPC can be issued for a minimum period of 91 days and a maximum period of 180 days.

(b) Without Risk Sharing Basis

Under without risk sharing participation certificate scheme, the participating bank does not share any risk with the issuing bank and, therefore, participating bank has a right to receive the payment from the issuing bank even though the borrower has defaulted in its payment. Tenor of IBPC under this scheme cannot be more than 90 days.

Forex Market 2.3 Customers (exporters and importers) buy and sell their foreign exchange needs from the treasury in various currencies depending on their business exposure. Rates are quoted by the dealers depending on the amounts and delivery period. Dealers trade on these flows from the customers and try to maximize profits. Besides, customer flows, dealers take proprietary position in various currencies in Spot and Forward contracts for trading.


9

Range of Products

2.4 The following are products traded in Foreign Exchange Market:

(i) Spot Contract

It is the simplest and most common foreign exchange transaction widely used by corporates to cover their receivables and payables. The commitment by the client is to buy and sell one currency against another at a fixed rate for delivery two business days after the transaction. This eliminates the possible risk due to exchange rate fluctuation for the client. Corporate can buy or sell foreign currency for genuine transactional purposes only.

(ii) Forward Contract

It is a contract between the bank and its customers in which the exchange/conversion of currencies would take place at future date at a rate of exchange in advance under the contract. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. Forward Rates = spot rate +/- premium/discount

(iii) Currency Swaps

It is an agreement between two parties to exchange obligations in different currencies at the beginning, during the tenure and at the end of the transaction. At the start, initial principal is exchanged, though it is not obligatory. Periodic interest payments (either fixed or floating) are exchanged throughout the life of the contract. The principal is exchanged invariably on termination at the exchange rate decided at the start of the transaction. By means of currency swap, the associated currency and interest rate risks on the underlying asset can be hedged.

(iv) Interest Rates Swaps(IRS)

It is a financial transaction in which two counterparties agree to exchange streams of cash flows throughout the life of contract in which one party pays a fixed interest rate on a notional principal and the other pays a floating rate on the same sum. The basic purpose of IRS is to hedge the interest rate risk of constituents and enable them to structure the asset/liability profile best suited to their respective cash flows.


10

(v) Options

It is a contract between the bank and its customers in which the customer has the right to buy/sell a specified amount of underlying asset at fixed price within a specific period of time, but has no obligation to do so. In this contract, the customer has to pay specified amount upfront to the counterparty which is known as premium. This is in contrast to the forward contract in which both parties have a binding contract. This is a facility offered to customers to enable them to book forward contracts in cross currencies at a target rate or price. This facility helps the customers to encash the currency movements in late European market, New York market and early Asian market

(vi) Forward Rate Agreement (FRA)

A Forward Rate Agreement (FRA) is an agreement between the bank and a customer to pay or receive the difference (called settlement money) between an agreed fixed rate (FRA rate) and the interest rate prevailing on stipulated future date (the fixing date) based on a notional amount for an agreed period (the contract period). In short, this is a contract whereby interest rate is fixed now for a future period. The basic purpose of the FRA is to hedge the interest rate risk. For example, if a borrower is going to borrow FC loan for 6 months at LIBOR rate after 3 months, he can buy an FRA whereby he can fix interest rate for the loan.

Capital Market

2.4 Funds are also invested through:

a) Investment in units of Mutual fund- Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Each scheme of a mutual fund can have different character and objectives. Mutual funds issue units to the investors, which represent an equitable right in the assets of the mutual fund.

b) Investment in Equity IPO – These are securities which were not previously available and are offered to the investing public for the first time.

Regulatory Framework for Capital Markets in India 2.5 In India, the capital market is regulated by the Capital Markets Division of the Department of Economic Affairs, Ministry of Finance. The division is responsible for formulating the policies related to the orderly growth and development of the securities markets (i.e., share, debt and


11

derivatives) as well as for protecting the interest of the investors. In particular, it is responsible for following:

(i) institutional reforms in the securities markets;

(ii) building regulatory and market institutions;

(iii) strengthening investor protection mechanism; and

(iv) providing efficient legislative framework for securities markets, such as Securities and Exchange Board of India Act, 1992 (SEBI Act 1992), Securities Contracts (Regulation) Act, 1956, and the Depositories Act, 1996.

The Division administers these legislations and the rules framed thereunder.

2.6 The Securities and Exchange Board of India (SEBI) is the regulatory authority established under the SEBI Act 1992. The Preamble of the SEBI describes the basic functions of the SEBI, as to protect the interests of the investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto”. It involves regulating the business in stock exchanges; supervising the working of stock brokers, share transfer agents, merchant bankers, underwriters, etc; as well as prohibiting unfair trade practices in the securities market. The following departments of SEBI take care of the activities in the secondary market:-

• Market Intermediaries Registration and Supervision Department (MIRSD) – It is concerned with the registration, supervision, compliance monitoring and inspections of all market intermediaries in respect of all segments of the markets, such as equity, equity derivatives, debt and debt related derivatives.

• Market Regulation Department (MRD) – It is concerned with formulation of new policies as well as supervising the functioning and operations (except relating to derivatives) of securities exchanges, their subsidiaries, and market institutions such as clearing and settlement organizations and depositories.

• Derivatives and New Products Departments (DNPD) – It is concerned with supervising trading at derivatives segments of stock exchanges, introducing new products to be traded and consequent policy changes.

CHAPTER 3

THE TREASURY DEALING ROOM

3.1 The Treasury Dealing Room within a bank is, generally, the clearinghouse for matching, managing and controlling market risks. It may provide funding, liquidity and investment support for the assets and liabilities generated by regular business of the bank. The Dealing Room is responsible for the proper management and control of market risks in accordance with the authorities granted to it by the bank's Risk Management Committee. The Dealing Room is also responsible for meeting the needs of business units in pricing market risks for application to its products and services. The Dealing Room acts as the bank's interface to international and domestic financial markets and, generally, bears responsibility for managing market risks in accordance with the instructions received from the bank's Risk Management Committee.

3.2 The Dealing Room may also have allocated to it by the Risk Management Committee, a discretionary limit within which it may take market risk on a proprietary basis. For these reasons, effective control and supervision of bank's Dealing Room activities is critical to its effectiveness in managing and controlling market risks.

3.3 It is critical to effective functioning of the Dealing Room that the dealer has access to a comprehensive Dealing Room manual covering all aspects of their day-to-day activities. All dealers active in day-to-day trading activities must acknowledge familiarity with and provide an undertaking in writing to adhere to the bank's dealing guidelines and procedures. The Dealing Room procedures manual should be comprehensive in nature covering operating procedures for all the bank’s trading activities in which the Dealing Room is involved and, in particular, must cover the bank's requirements in respect of:

a) Code of Conduct - All dealers active in day-to-day trading activities in the lndian market must acknowledge familiarity with and provide an undertaking to adhere to Foreign Exchange Dealers’ Association of India (FEDAI) code of conduct (and Fixed Income Money Market and


14

Derivatives Association of India (FIMMDA) Code of Conduct where applicable).

b) Adherence to Internal Limits - All dealers must be aware of, acknowledge and provide an undertaking to adhere to the limits governing their authority to commit the bank to risk exposures, as they apply to their own particular risk responsibilities and level of seniority.

c) Adherence to RBI limits and guidelines - All dealers must acknowledge and provide an undertaking to adhere to their responsibility to remain within RBI limits and guidelines in their area of activity.

d) Dealing with Brokers - All dealers should be aware of, acknowledge and provide an undertaking to remain within the guidelines governing the bank's activities with brokers, including conducting business only with brokers authorised by bank's Risk Management Committee on the bank's Brokers Panel. The following are important aspects in this regard:

(i) Ensuring that their activities with brokers do not allow for the brokers to act as principals in transactions but remain strictly in their authorised role as market intermediaries.

(ii) Requiring brokers to provide all broker’s notes and confirmations of transactions before close of business each day (or exceptionally by the beginning of the next business day, in which case the note must be prominently marked by the broker as having been transacted the previous day, and the back office must recast the previous night's position against limits reports) to the bank's back office for reconciliation with transaction data.

(iii) Ensuring all brokerage payments and statements are received. reconciled and paid by the bank's back office department and under no circumstances authorised or any payment released by dealers.

(iv) Prohibiting acceptance by the dealers of gifts, gratifications or other favours from brokers, instances of which should be reported in detail to RBI’s Department of Banking Supervision indicating the nature of the case.

(v) Prohibiting dealers from nominating a broker in transactions not done through that broker.

The Treasury Dealing Room

15

(vi) Rules should be framed for prompt investigation of complaints against dealers and malpractices by brokers and reporting to FEDAI and RBI’s Department of Banking Supervision.

e) Dealing Hours - All dealers should be aware of the bank's normal trading hours, cut-off time for overnight positions and rules governing after hours and off-site trading (if allowed by the bank).

f) Security and Confidentiality - All dealers should be aware of the bank's requirements in respect of maintaining confidentiality over its own and its customers' trading activities as well as the responsibility for secure maintenance of access media, keys, passwords and PINS.

g) Staff Rotation and leave requirements - All dealers should be aware of the requirement to take at least one period of leave of not less than 14 days continuously per annum, and the bank's internal policy in regards to staff rotation.

h) Customer/User Appropriateness and Suitability Policy - Banks usually have a ‘Customer/User Appropriateness and Suitability Policy’ in place for transacting in complex treasury instruments such as, derivatives. The objective of such policy is to protect the bank against the credit, reputation and litigation risks which may arise on account of ‘misselling’ products to users who may not understand the nature of the risks inherent in these transactions or products. All front office sales team or dealers, must be aware of and be educated about such policy. Sales dealers should conduct proper due diligence regarding ‘user appropriateness and suitability’ of products before offering derivative products or other complex treasury instruments to users.

CHAPTER 4

ORGANISATIONAL STRUCTURE OF A BANK’S TREASURY

4.1 The various functions handled by a bank treasury can be divided as under:

(a) Front-office: Dealing – Risk taking

(b) Mid-office: Risk Management and Management Information

(c) Back-office: Confirmations, Settlements, Accounting and Reconciliation.

1. Front-office 4.2 The scope of functions of front-office, as the name itself states, is to buy, sell and trade in money market instruments, securities, forex, equity, derivatives and precious metal. The decisions in regard to any restructuring, reorganizing, pre payment, etc. are taken at front-office. The front-office dealers keep track of and develop their views on different asset class, securities, currencies, derivative products which are put up to Department Head/Investment Committee for arriving at trading/strategic investment entry/exit decisions.

4.3 Front-office functions can be summarized as under:

• Significant interaction with various trading and delivery teams; • Liquidity Management; • ALM implementation; • Striking of Deals (trading) and earning profits from trading; • Maintenance of CRR and SLR; • Follow ‘When Issued Securities’ place order and square up the order well in

time against future holding; • Manage short selling and square off the securities well in advance; and • Reporting to respective authorities.


18

Mid-office

4.4 The mid-office can be considered to be the conscience keeper of the treasury. It is responsible for the critical functions of independent market risk monitoring, measurement, analysis and reporting for the bank's Asset-Liability Management Committee (ALCO). Ideally, this is a full time function of reporting to, or encompassing the responsibility for, acting as Asset-Liability Management Committee (ALCO)'s secretariat. An effective mid-office provides independent risk assessment which is critical to Asset-Liability Management Committee (ALCO)'s key function of controlling and managing market risks in accordance with the mandate established by the Board/Risk Management Committee. It is a highly specialised function and must include trained and competent staff, and expert in market risk concepts.

4.5 The methodology of analysis and reporting will vary from bank to bank depending on their degree of sophistication and exposure to market risks. These same criteria will govern the reporting requirements demanded of the mid-office, which may vary from simple gap analysis to computerized VaR modeling. Mid-office staff may prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to risk exposures. Banks using VaR or modeling methodologies should ensure that its Asset-Liability Management Committee (ALCO) are aware of and understand the nature of the output, how it is derived, assumptions and variables used in generating the outcome and any shortcomings of the methodology employed. Segregation of duties principles must be evident in this function which must report to Asset-Liability Management Committee (ALCO) independently of the treasury function.

4.6 The main functions of mid-office can be summarized as under:

(i) Management of risks:

(a) Market risk which arises on account of:

- Interest rate movement

- Foreign exchange rate movement

- Commodity prices

- Equity prices

Organisational Structure of a Bank’s Treasury

19

(b) Liquidity risk

(c) Country risk

(i) Independent market risk monitoring, measurement, analysis and reporting for bank’s ALCO (Asset Liability Management Committee)

(ii) Formation of Investment policy for bank’s treasury

(iii) Formation of ALM policy for the bank.

Back-Office 4.7 The back-office is responsible for delivery and settlement of all transactions concluded by the front-office officials. It is also responsible for reconciliation of securities portfolio with respective holding entity. Payment of brokerage to brokers, empanelment of brokers, reviewing performance of brokers and monitoring the volume of business passed on to each broker is also under the purview of back-office.

4.8 The main functions of back-office can be summed up as under:

• Co-ordination with front-office to ensure optimum usage of all treasury dealing systems;

• Internal control and check over treasury dealings, confirmation and settlement activities, and accounting thereof;

• Ensuring compliance with stated treasury procedures and stipulations;

• Monitoring of SLR/CRR maintenance and submission of compliances, MIS to Board of Directors and RBI;

• Audit facilitation (concurrent, statutory and AFI / RBI).

4.9 The key controls over market risk activities, and particularly over dealing room activities, exist in the back-office. It is critical that clear segregation of duties and reporting lines is maintained between dealing room staff and back-office staff, as well as clearly defined physical and systems access is also maintained between the two areas. It is essential that critical back-office controls are executed diligently and completely at all times including:

a) The control over confirmations both inward and outward: All confirmations for transactions concluded by the dealing room must be


20

issued and received by the back-office only. Discrepancies in transaction details, non-receipts and receipts of confirmations without application must be resolved promptly to avoid instances of unrecorded risk exposure.

b) The control over dealing accounts (vostros and nostros) - Prompt reconciliation of all dealing accounts is an essential control to ensure accurate identification of risk exposures. Discrepancies, non-receipts and receipts of funds without application must be resolved promptly to avoid instances of unrecorded risk exposure. Unreconciled items and discrepancies in these accounts must be kept under heightened management supervision, and as such discrepancies may at times have significant liquidity impacts, represent unrecognised risk exposures, or at worst represent collusion or fraud.

c) Revaluations and marking-to-market of market risk exposures: All market rates used by the bank for marking risk exposures to market or used to revalue assets or for risk analysis models such as, Value at Risk analysis must be sourced independently of the dealing room in order to provide an independent risk and performance assessment.

One of the audit objectives with specific reference to treasury also includes verifying the authenticity and appropriateness of the sources of inputs used for valuation of unquoted treasury instruments and derivative products (such as swaps, options) which the bank has entered into. When quotations or rates are not directly available for treasury instruments, then usually such instruments are valued as at any reporting date using appropriate valuation techniques or models. Such valuation techniques involve an amount of subjectivity and also certain objective parameters such as, reference to any recent past market transaction in the underlying instrument or a like instrument. Such model based valuations require data feed or inputs (such as ‘volatility’ in case of valuing options using Black-Scholes Model).

The inherent risk here is the appropriateness of the input parameters fed into the valuation model/technique, stale quotes. For example, where the bank has positions in interest rate swaps then for the purpose of projecting the future floating interest rates (for projecting future cashflows) the appropriate interest rate curve should be used (this is usually the par curve). As per extant RBI guidelines, investments in unquoted equity shares should be valued at their break-up value, however, the latest financials of the respective

Organisational Structure of a Bank’s Treasury

21

companies may not be available to the banks for determining the break-up value.

The risk of using inappropriate or stale quotes for valuation has a direct bearing not only on financial reporting but also on computing exposure limits. Thus, the scope of the auditor should include an evaluation of the control environment surrounding the valuation and marking-to-market of treasury instruments. If the bank has an established and independent mid-office function, the responsibility or soliciting quotes, rates, curves resides with the mid-office. Another related risk to valuation and marking-to-market of treasury investments is the timely monitoring of non-performing investments (‘NPIs’). RBI has defined NPIs as investments where the interest/return or principal has been in arrears for a period exceeding 90 days. The important consideration for NPIs is that, banks should not reckon income on such investments and should provide for depreciation on them appropriately, such depreciation is further not allowed to be set-off against appreciation on other performing investments. The back-office of a bank should have appropriate procedures/controls instated for timely capturing of NPIs.

d) Monitoring and reporting of risk limits and usage: Reporting of usage of risk against limits established by the Risk Management Committee (as well as Credit Department for Counterparty risk limits) should be maintained by the back-office independently of the dealing room. Maintenance of all limit systems must also be undertaken by the back-office and access to limit systems (such as counterparty limits, overnight limits, etc.) must be secure from access and tampering by unauthorised personnel. If the bank has an established and independent mid-office function, this responsibility may properly pass on to the mid-office.

e) Control over payments systems: The procedures and systems for making payments must be under, at least, dual control in the back-office independent from the dealing function. Payment systems should be at all times secure from access or tampering by unauthorised personnel.

f) Reconciliation of dealers profit or loss account: All dealers at the end of day prepare their profit or loss account for the day and compute their net open position. The back-office personnel who are independent of the front-office dealer are responsible for recording and processing of the deals/transactions into the general ledger system or the core banking system. Banks should have in place a process of daily reconciliation of


22

the dealers profit or loss vis-à-vis the profit or loss as per the general ledger system to avoid instances of unrecorded transactions.

g) Controls in respect of financial reporting and MIS: A bank’s financial statements include many exhaustive disclosures with treasury related disclosures forming a significant portion thereof (such as, concentration risk for swaps, PV01 disclosures for derivatives, maturity pattern for investments, forex). The collation of information to be presented in these disclosures is tedious and requires liaisoning with several treasury sub-functions. Further, banks also have an exhaustive base of MIS (such as ALM, concentration exposures, VAR or other measures capturing market risk, net open positions) presented at the various senior management committees (such as ALCO, Risk, Board, Investment, Credit).

Contents of an MIS pack or in a bank’s financials have a direct bearing on the management decision making and users of financial statements. The internal auditor should include within his scope the controls around information flow and data integrity for collation and preparation of the disclosures and MIS reports.

CHAPTER 5

INVESTMENT PORTFOLIO

5.1 The primary function of banks is to accept deposits and to lend money. Earlier, the investments were made only to meet out the SLR requirements. By the span of time the face of banking has changed. Due to the recessionary conditions in the economy the credit demand decreased substantially. It forced the banks to invest the surplus medium to long term funds in SLR/NSLR securities and debts. The investments portfolio of a bank may have a number of varieties of instruments. Keeping in view the return from lending and surplus investments, dynamic decision making is required whereby return on deployment is optimized.

5.2 The banks investment book may comprise the following:

(a) Central Government dated securities

(b) State Government developmental loans

(c) Treasury Bills

(d) Trust Securities

(e) Equity / Preference Shares

(f) Units of Mutual Funds

(g) Pass through Certificate/CDR/ARCIL

(h) Commercial Papers

(i) Corporate Bonds and Debentures

(j) Bonds and debentures of PSUs, Government / Semi-Government autonomous bodies, etc.

(k) Venture capital investments

(l) Investment in subsidiaries and joint ventures(Indian/overseas)

(m) Other Asset backed/Mortgage backed securities.


24

Merchant and Trading in Precious Metal 5.3 The RBI launched the gold import scheme in September, 2000 and subsequently, included import of silver business in the same. Precious metal dealing desk functions is a part of inter-bank forex desk in the front office of the treasury. Presently, banks only deal in gold and silver in terms of approval obtained from the RBI. Gold and silver are imported on a consignment basis from the designated supplier on the terms and conditions agreed to with them by the bank. Precious metal consignment is kept in the vaults of designated branches or security agencies. As and when the parts of consignment are sold to the importers in India the remittances are being made to the suppliers for the gold quantity on spot payment basis. Similarly, trading in gold and silver is done with the agreement tied foreign banks.

Investment Policy

5.4 RBI has issued Master Circular on “Prudential Norms for classification,valuation and operation of investment portfolio by banks” (DBOD No. BP. BC.3 / 21.04.141 / 2009-10) on July 1, 2009.

The following is a gist of RBI guidelines issued to banks with respect to investment policy.

(a) Banks should frame Internal Investment Policy Guidelines and obtain the Board’s approval.

(b) The investment policy guidelines should be implemented to ensure that operations in securities are conducted in accordance with sound and acceptable business practices

(c) The size of the bank’s operations, composition of assets and liabilities, risk policy and risk appetite are to be considered while framing the policy.

(d) The broad structure of the Investment policy should be based on: (i) No sale transaction is to be completed without the bank actually holding

the relative security (ii) Banks may sell a government security already contracted for purchase

subject to certain conditions. (iii) Banks successful in the auction of primary issue of government

securities, may enter into contracts for sale of the allotted securities in accordance with the terms and conditions given in the Master Circular.

Investment Portfolio

25

(iv) All the transactions put through by a bank, either on outright basis or ready forward basis and whether through the mechanism of Subsidiary General Ledger (SGL) Account or Bank Receipt (BR), should be reflected on the same day in its investment account and, accordingly, for SLR purpose wherever applicable.

(v) All brokerage deals have to be specifically approved by the delegated authorities in the bank and a

(vi) separate account of brokerage paid, broker-wise, should be maintained.For issue of Bank Receipts ( BRs), the banks should adopt the format prescribed by the Indian Banks' Association (IBA) and strictly follow the guidelines prescribed by them in this regard. The banks, subject to the above, could issue BRs covering their own sale transactions only and should not issue BRs on behalf of their constituents, including brokers.

(vii) The banks should be circumspect while acting as agents of their broker clients for carrying out transactions in securities on behalf of brokers.

(viii) Investment in equity shares and debentures must be undertaken after considering the following: • Build up adequate expertise in equity research by establishing a

dedicated equity research department, as warranted by their scale of operations;

• Formulate a transparent policy and procedure for investment in shares, etc., with the approval of the Board; and

• The decision in regard to direct investment in shares, convertible bonds and debentures should be taken by the Investment Committee set up by the bank's Board. The Investment Committee should be held accountable for the investments made by the bank.

(ix) The bank’s Board of Directors should specify: • the level of authority to put through deals, • procedure to be followed for obtaining the sanction of the

appropriate authority, • procedure to be followed while putting through deals, • various prudential exposure limits, and • the reporting system.


26

Internal control System

5.5 The abovementioned Master Circular issued by the RBI requires the banks to adopt the following guidelines for internal control system while undertaking investment transactions:

(a) There should be a clear functional separation of trading, settlement, monitoring and control, and accounting.

(b) There should be a functional separation of trading and back office functions relating to banks' own Investment Accounts, Portfolio Management Scheme (PMS) Clients' Accounts and other Constituents (including brokers') accounts.

(c) PMS Clients Accounts should be subjected to a separate audit by external auditors.

(d) For every transaction entered into, the trading desk should prepare a deal slip containing data relating to following:

nature of the deal,

name of the counter-party,

whether it is a direct deal or through a broker, and if through a broker, name of the broker,

details of security,

amount,

price, and

contract date and time.

The deal slips should be serially numbered and controlled separately to ensure that each deal slip has been properly accounted for. Once the deal is concluded, the dealer should immediately pass on the deal slip to the back office for recording and processing. For each deal there must be a system of issue of confirmation to the counterparty.

(e) Once a deal has been concluded, there should not be any substitution of the counter party bank by another bank by the broker, through whom the deal has been entered into; likewise, the security sold/purchased in the deal should not be substituted by another security.


27

(f) The Accounts Section should independently write the books of account on the basis of vouchers passed by the back office.

(g) Records of SGL and BR transactions should be maintained.

(h) Balances as per bank's books should be reconciled at quarterly intervals with the balances in the books of the Public Debt office (PDOs).

(i) The investment transactions should be reported to the top management, on a weekly basis covering the following:

• details of transactions in securities,

• details of bouncing of SGL transfer forms issued by other banks,

• BRs outstanding for more than one month, and

• a review of investment transactions undertaken during the period.

(j) Bankers' cheques/ pay orders should be issued for third party transactions, including inter-bank transactions.

(k) In case of investment in shares, the surveillance and monitoring of investment should be done by the Audit Committee of the Board. In each of its meetings it shall review:

• the total exposure of the bank to capital market both fund based and non-fund based, in different forms,

• ensure that the guidelines issued by RBI are complied with, and

• adequate risk management and internal control systems are in place.

(l) In order to avoid any possible conflict of interest, it should be ensured that the stockbrokers as directors on the Boards of banks or in any other capacity, do not involve themselves in any manner with the Investment Committee or in the decisions in regard to making investments in shares, etc., or advances against shares.

(m) An on-going internal audit system should be in place to report the deficiencies directly to the management of the bank.

(n) The banks should get compliance in key areas certified by their statutory auditors and furnish such audit certificate to the Regional Office of Department of Banking Supervision of RBI under whose jurisdiction the HO of the bank falls.


28

Classification

5.6 The RBI’s Master Circular on “Prudential norms for clarification, valuation and operation of investment portfolio by banks” lays down that the entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories

(a) Held to Maturity

(b) Available for Sale and

(c) Held for Trading.

However, in the balance sheet, the investments will continue to be disclosed as per the following existing six classifications:

(a) Government securities,

(b) Other approved securities,

(c) Shares,

(d) Debentures and Bonds,

(e) Subsidiaries/ joint ventures, and

(f) Others (CP, Mutual Fund Units, etc.).

Held to Maturity 5.7 The securities acquired by the banks with the intention to hold them up to maturity will be classified under Held to Maturity (HTM).The investments included under “Held to Maturity” should not exceed 25 per cent of the bank’s total investments. The banks may include, at their discretion, under Held to Maturity category securities less than 25 per cent of total investment. The following investments will be classified under ‘Held to Maturity’ but will not be accounted for the purpose of ceiling of 25% specified for this category: a) Re-capitalisation bonds received from the Government of India towards

their re-capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of other banks acquired for investment purposes.


29

b) Investment in subsidiaries and joint ventures. [A joint venture would be one in which the bank, along with its subsidiaries, holds more than 25% of the equity.]

c) The investments in debentures/ bonds, which are deemed to be in the nature of an advance.

5.8 Banks are, however, allowed since September 2, 2004, to exceed the limit of 25 per cent of total investment under HTM category provided the excess comprises only of SLR securities; and the total SLR securities held in HTM is not more than 25 per cent of their DTL as on last Friday of the second preceding fortnight.

Profit on sale of investments in this category should be first taken to the Profit & Loss Account and thereafter be appropriated to the ‘Capital Reserve Account’. Loss on sale will be recognised in the Profit & Loss Account.

Available for Sale and Held for Trading 5.9 The securities acquired by the banks with the intention to trade by taking advantage of the short-term price/interest rate movements will be classified under Held for Trading (HFT). The securities which do not fall within the above two categories will be classified under Available for Sale. The banks will have the freedom to decide on the extent of holdings under Available for Sale and Held for Trading categories taking into account various aspects such as basis of intent, , trading strategies, risk management capabilities, tax planning, manpower skills, capital position. HFT securities are to be sold within 90 days from the date of acquisition. Profit or loss on sale of investments in both the categories will be taken to the Profit & Loss Account.

Shifting among Categories

5.10 As per the RBI Guidelines, banks may shift investments to/from Held to Maturity category with the approval of the Board of Directors once a year. Such shifting will normally be allowed at the beginning of the accounting year. No further shifting to/from this category will be allowed during the remaining part of that accounting year. Banks may shift investments from Available for Sale category to Held for Trading category with the approval of their Board of Directors/ ALCO/ Investment Committee. In case of exigencies, such shifting may be done with the approval of the Chief Executive of the bank/ Head of the ALCO, but should be ratified by the Board of Directors/ ALCO.


30

5.11 Shifting of investments from Held for Trading category to Available for Sale category is generally not allowed. However, it will be permitted only under exceptional circumstances with the approval of the Board of Directors/ ALCO/ Investment Committee. Transfer of scrips from one category to another, under all circumstances, should be done at the acquisition cost/ book value/ market value on the date of transfer, whichever is the least, and the depreciation, if any, on such transfer should be fully provided for.

Valuation

5.12 RBI Guidelines for valuation for the three categories is as follows:

(a) Held to maturity

(i) Investments classified under Held to Maturity category need not be marked to market and will be carried at acquisition cost, unless it is more than the face value, in which case the premium should be amortised over the period remaining to maturity.

(ii) Banks should recognise any diminution, other than temporary, in the value of their investments in subsidiaries/ joint ventures which are included under Held to Maturity category and provide therefore. Such diminution should be determined and provided for each investment individually.

(b) Available for sale

(i) The individual scrips in the Available for Sale category will be marked to market at quarterly or at more frequent intervals.

(ii) While the net depreciation under each classification should be recognised and fully provided for, the net appreciation under each classification should be ignored.

(iii) The book value of the individual securities would not undergo any change after the marking of market.

(iv) The provisions required to be created on account of depreciation in the Available for Sale category in any year should be debited to the Profit & Loss Account and an equivalent amount (net of tax benefit, if any, and net of consequent reduction in the transfer to Statutory Reserve) or the balance available in the Investment Fluctuation Reserve Account, whichever is less, shall be transferred from the Investment Fluctuation Reserve Account to the Profit & Loss


31

Account. In the event provisions created on account of depreciation in the Available for Sale category are found to be in excess of the required amount in any year, the excess should be credited to the Profit & Loss Account and an equivalent amount (net of taxes, if any, and net of transfer to Statutory Reserves as applicable to such excess provision) should be appropriated to the Investment Fluctuation Reserve Account to be utilised to meet future depreciation requirement for investments in this category. The amount debited to the Profit & Loss Account for provision and the amount credited to the Profit & Loss Account for reversal of excess provision should be debited and credited respectively under the head “Expenditure – Provisions & Contingencies”. The amounts appropriated from the Profit & Loss Account and the amount transferred from the Investment Fluctuation Reserve to the Profit & Loss Account should be shown as ‘below the line’ items after determining the profit for the year.

(c) Held for Trading category

The individual scrips in the Held for Trading category will be revalued at monthly or at more frequent intervals and provided for as in the case of those in the Available for Sale category. The book value of the individual scrip will change with the revaluation.

General 5.13 In respect of securities included in any of the three categories where interest/ principal is in arrears, the banks should not reckon income on the securities and should also make appropriate provisions for the depreciation in the value of the investment. The banks should not set-off the depreciation requirement in respect of these non-performing securities against the appreciation in respect of other performing securities.

Market value 5.14 The ‘market value’ for the purpose of periodical valuation of investments included in the Available for Sale and the Held for Trading categories would be the market price of the scrip as available from the trades/ quotes on the stock exchanges, SGL account transactions, price list of RBI, prices declared by Primary Dealers Association of India (PDAI) jointly with the Fixed Income Money Market and Derivatives Association of India (FIMMDA) periodically.


32

In respect of unquoted securities, the procedure as detailed below should be adopted.

Unquoted Non-SLR Securities-Debentures/ Bonds 5.15 All debentures/ bonds other than debentures/ bonds which are in the nature of advance, should be valued on the YTM basis. Such debentures/ bonds may be of different companies having different ratings. These will be valued with appropriate mark-up over the YTM rates for Central Government securities as put out by PDAI/ FIMMDA periodically. The mark-up will be graded according to the ratings assigned to the debentures/ bonds by the rating agencies subject to the following: -

(a) The rate used for the YTM for rated debentures/ bonds should be at least 50 basis points above the rate applicable to a Government of India loan of equivalent maturity. The special securities, which are directly issued by Government of India to the beneficiary entities, which do not carry SLR status, may be valued at a spread of 25 basis points above the corresponding yield on Government of India securities, with effect from the financial year 2008 - 09. At present, such special securities comprise: Oil Bonds, Fertiliser Bonds, bonds issued to the State Bank of India (during the recent rights issue), Unit Trust of India, Industrial Finance Corporation of India Ltd., Food Corporation of India, Industrial Investment Bank of India Ltd., the erstwhile Industrial Development Bank of India and the erstwhile Shipping Development Finance Corporation.

(b) The rate used for the YTM for unrated debentures/ bonds should not be less than the rate applicable to rated debentures/ bonds of equivalent maturity. The mark-up for the unrated debentures/ bonds should appropriately reflect the credit risk borne by the bank.

(c) Where the debenture/ bonds is quoted and there have been transactions within 15 days prior to the valuation date, the value adopted should not be higher than the rate at which the transaction is recorded on the stock exchange.

Investment Fluctuation Reserve 5.16 A reserve is to be maintained to guard against any possible reversal of interest rate environment on unexpected developments. It is prudent to transfer maximum amount of gains realised on sale of securities to the Investment Fluctuation Reserve (IFR). Banks are free to build IFR up to 10 per cent of the


33

investment portfolio under HFT and AFS with the approval of the Board of Directors. The amount held under IFR arising out of gains on sale of investments will be reckoned for the purpose of TIER –II capital.

Transactions through SGL Account 5.17 SGL or CSGL are a demat form of holding government securities with the RBI. SGL stands for 'Subsidiary General Ledger' account. It is a facility provided by RBI to large banks and financial institutions to hold their investments in Government securities and Treasury bills in the electronic book-entry form. Such institutions can settle their trades for securities held in SGL through a Delivery-versus-Payments (DVP) mechanism which ensures movement of funds and securities simultaneously.

5.18 As all investors in Government securities do not have an access to the SGL accounting system, the RBI has permitted such investors to hold their securities in physical stock certificate form. The RBI, being the R&T agent of all Government securities issued by Central and State Governments, keeps the records of holding of various investors in the securities issued. The SGL, in short keeps the names of all investor in a particular security at any point of time. The securities are held in electronic form in SGL accounts. They may also open a Constituent SGL account with any entity authorised by the RBI for this purpose and thus avail of the DVP settlement. Such client accounts are referred to as Constituent SGL accounts.

5.19 Securities kept on behalf of customers by banks or PDs in Constituent SGL account are kept in a segregated CSGL A/c with the RBI. Thus, if the bank or the PD buys security for his client, it gets credited to the CSGL account of bank or PD with the RBI. Successful bidders are allotted securities bid by them. The RBI can debit their current accounts for amount payable and credit their SGL account with the securities allotted to them. The amount debited to the current account is placed to the credit of Government Account. In the same manner secondary market operations are also handled by the RBI.

5.20 The following are to be noted with regard to transactions through SGL Account:

• It is necessary for both the selling bank and the buying bank to maintain current account with the RBI.

• All transactions in Govt. securities for which SGL facility is available should be put through SGL A/c only.


34

• A SGL transfer form issued by a bank in favour of another bank should not bounce for want of sufficient balance of securities in the SGL A/c of seller or for want of sufficient balance of funds in the current A/c of the buyer. If a SGL transfer form bounces for want of sufficient balance in the SGL A/c, the (selling) bank which has issued the form will be liable to the penal action against it.

• If the bouncing of the SGL form occurs thrice, the bank will be debarred from trading with the use of the SGL facility for a period of 6 months from the occurrence of the third bouncing.

• The SGL transfer form received by purchasing banks should be deposited in their SGL A/c Immediately, i.e., the date of lodgment of the SGL Form with the RBI shall be within one working day after the date of signing of the Transfer Form.

• No sale should be effected by way of return of SGL form held by the bank.

• Participants must indicate the deal/trade/contract date in Part C of the SGL Form under Sale date. Where this is not completed the SGL Form will not be accepted by the RBI.

• SGL transfer forms should be signed by two authorised officials of the bank whose signatures should be recorded with the respective PDOs of the Reserve Bank and other banks.

Non-performing Investments 5.21 In respect of securities included in any of the three categories where interest/ principal is in arrears, the banks should not reckon income on the securities and should also make appropriate provisions for the depreciation in the value of the investment. The banks should not set-off the depreciation requirement in respect of these non-performing securities against the appreciation in respect of other performing securities.

5.22 A non performing investment (NPI), similar to a non performing advance (NPA), is one where:

(a) Interest/ instalment (including maturity proceeds) is due and remains unpaid for more than 90 days.

(b) The above would apply mutatis-mutandis to preference shares where the fixed dividend is not paid.


35

(c) In the case of equity shares, in the event the investment in the shares of any company is valued at Re.1 per company on account of the non-availability of the latest balance sheet, those equity shares would also be reckoned as NPI.

(d) If any credit facility availed by the issuer is NPA in the books of the bank, investment in any of the securities issued by the same issuer would also be treated as NPI and vice versa.

(e) The investments in debentures / bonds, which are deemed to be in the nature of advance would also be subjected to NPI norms as applicable to investments.

(f) In case of conversion of principal and / or interest into equity, debentures, bonds, etc., such instruments should be treated as NPA abinitio in the same asset classification category as the loan if the loan's classification is substandard or doubtful on implementation of the restructuring package and provision should be made as per the norms.

Income Recognition 5.23 Banks may book income on accrual basis on securities of corporate bodies/ public sector undertakings in respect of which the payment of interest and repayment of principal have been guaranteed by the Central Government or a State Government, provided interest is serviced regularly and as such is not in arrears. Banks may book income from dividend on shares of corporate bodies on accrual basis provided dividend on the shares has been declared by the corporate body in its Annual General Meeting and the owner's right to receive payment is established. Banks may book income from Government securities and bonds and debentures of corporate bodies on accrual basis, where interest rates on these instruments are pre-determined and provided interest is serviced regularly and is not in arrears. Banks should book income from units of mutual funds on cash basis.

Broken Period Interest 5.24 Banks should not capitalise the Broken Period Interest paid to seller as

part of cost, but treat it as an item of expenditure under Profit and Loss Account in respect of investments in Government and other approved securities. However, the banks should comply with the requirements of Income Tax Authorities in the manner prescribed by them.

CHAPTER 6

ASSET LIABILITY MANAGEMENT

6.1 Asset Liability Management (ALM) defines management of all assets and liabilities (both off and on balance sheet items) of a bank. It requires assessment of various types of risks and altering the asset liability portfolio to manage risks. Asset Liability Management provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange, equity and commodity price risks of a bank that needs to be closely integrated with the banks' business strategy. It involves assessment of various types of risks and altering the asset-liability portfolio in a dynamic way in order to manage risks.

6.2 As per the RBI Guidelines on Asset Liability Management (ALM) System, the ALM process rests on following three pillars:

(i) ALM Information Systems

• Management Information Systems

• Information availability, accuracy, adequacy and expediency.

(ii) ALM Organisation

• Structure and responsibilities

• Level of top management involvement

(iii) ALM Process

• Risk parameters

• Risk identification

• Risk measurement

• Risk management

• Risk policies and tolerance levels.

6.3 ALM has to be supported by a management philosophy which clearly specifies the risk policies and tolerance limits. This framework needs to be built


38

on sound methodology with necessary information system as back up. Thus, information is the key to the ALM process. It is, however, recognised 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.

6.4 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.

6.5 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. The ALM Support Groups consisting of operating staff should be responsible for analysing, 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.

6.6 The scope of ALM function can be described as follows:

(a) Liquidity risk management

(b) Management of market risks

(c) Trading risk management

(d) Funding and capital planning

(e) Profit planning and growth projection

ALM Models 6.7 Analytical models are very important for ALM analysis and scientific decision making. The basic models are as follows:

(a) GAP Analysis Model

(b) Duration GAP Analysis Model

Asset Liability Management

39

(c) Scenario Analysis Model

(d) Value at Risk (VaR) model

Gap Analysis Model 6.8 Gap analysis model measures the direction and extent of asset-liability mismatch through either funding or maturity gap. It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. This model looks at the repricing gap that exists between the interest revenue earned on the bank's assets and the interest paid on its liabilities over a particular period of time*. It highlights the net interest income exposure of the bank to changes in interest rates in different maturity buckets.

6.9 Repricing gaps are calculated for assets and liabilities of differing maturities. A positive gap indicates that assets get repriced before liabilities, whereas a negative gap indicates that liabilities get repriced before assets. The bank looks at the rate sensitivity (the time the bank manager will have to wait in order to change the posted rates on any asset or liability) of each asset and liability on the balance sheet. The general formula that is used is as follows:

NIIi = R i (GAPi)

While NII is the net interest income, R refers to the interest rates impacting assets and liabilities in the relevant maturity bucket and GAP refers to the differences between the book value of the rate sensitive assets and the rate sensitive liabilities. Thus, when there is a change in the interest rate, one can easily identify the impact of the change on the net interest income of the bank. Interest rate changes have a market value effect. The basic weakness with this model is that this method takes into account only the book value of assets and liabilities and hence ignores their market value. This method, therefore, is only a partial measure of the true interest rate exposure of a bank.

Duration Model 6.10 Duration is an important measure of the interest rate sensitivity of assets and liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and liabilities. It is the weighted average time to maturity of all the preset values of cash flows. Duration basically refers to the average life of the asset or the liability.

* Saunders, 1997.


40

6.11 The following equation describes the percentage fall in price of the bond for a given increase in the required interest rates or yields:-

DP p = D ( dR /1+R)

The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates. As per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero. The one important benefit of duration model is that it uses the market value of assets and liabilities.

6.12 Under this technique assumptions were made on various conditions, for example: -

• Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all.

• Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayment rates on mortgages or surrender rates on insurance products.

• Assumptions were also made about the firm's performance like, the rates at which new business would be acquired for various products, demand for the product, etc.

• Market conditions and economic factors like, inflation rates and industrial cycles were also included.

6.13 Based upon these assumptions, the performance of the firm's balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee would adjust assets or liabilities to address the indicated exposure. Let us consider the procedure for sanctioning a commercial loan. The borrower, who approaches the bank, has to appraise the banks credit department on various parameters like, industry prospects, operational efficiency, financial efficiency, management qualities and other things, which would influence the working of the company. On the basis of this appraisal, the banks would then prepare a credit grading sheet after covering all the aspects of the company and the business in which the company is in. Then the borrower would then be charged a certain rate of interest which would cover the risk of lending. The main shortcoming of scenario analysis was that it was highly dependent on the choice of scenarios. It also required that many

Asset Liability Management

41

assumptions were to be made about how specific assets or liabilities will perform under specific scenarios. Gradually, the firms recognized a potential for different type of risks which was overlooked in ALM analysis.

Relationship between Treasury and ALM 6.14 The banking operations are confined to lending, accepting deposits and miscellaneous services. It is the treasury which operates in financial markets directly, establishing a link between core banking functions and market operations. Thus, the market risk is identified and monitored through treasury. Treasury uses derivatives and other means to bridge the liquidity and rate sensitivity gaps. Treasury products are marketable and liquidity can be infused at any point of time. Treasury monitors exchange rate and interest rate movements. Hence, risk management is an integral part of treasury. In many banks, either ALM desk is part of the dealing room or Asset Liability Management Committee (ALCO) support group is part of the treasury team. The head of the treasury is an important member of ALCO, thereby contributing not only to risk management but also to product pricing and other policy issues.

RBI Guidelines on Asset Liability Management 6.15 The RBI had issued guidelines on ALM system vide Circular No. DBOD. BP. BC. 8 / 21.04.098/ 99 dated February 10, 1999, which covered, among others, interest rate risk and liquidity risk measurement, reporting framework and prudential limits. The abovementioned guidelines are given in Annexure VII of the Guide.

6.16 RBI reviewed the above guideline and made the following changes vide Circular “Guidelines on Asset Liability Management (ALM) System – amendments” (DBOD. No. BP. BC. 38 / 21.04.098/ 2007-08) dated October 24, 2007:

• As per the revised guidelines, banks must adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket of 1-14 days in the Statement of Structural Liquidity into three time buckets – next day, 2-7 days and 8-14 days.

• The net cumulative negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 per cent, 10 per cent, 15 per cent and 20 per cent of the cumulative cash outflows in the respective buckets in order to recognise the cumulative impact on liquidity,


42

• Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity, may, however, be reported to RBI, once a month, as on the third Wednesday of every month. However, the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly, with effect from the fortnight beginning April 1, 2008.

CHAPTER 7

TREASURY RISKS

7.1 Banks are highly sensitive to treasury risks, as the risks arrive out of high leverage treasury business enjoys. The risks of losing capital are much more than the credit business. Treasury faces broadly three types of risk, viz., market risk, credit risk, and operational risk.

Market Risk 7.2 Market risk may be defined as the possibility of loss to a bank caused by changes in the market variables. The Bank for International Settlements (BIS) defines market risk as “the risk that the value of on or off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. Thus, market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those prices.

Market risk broadly covers liquidity risk, interest rate risk and foreign exchange risk.

Liquidity Risk 7.3 Liquidity risk is the potential inability to meet the bank's liabilities as they become due. It arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and liabilities. 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 liquidity risk in banks manifest in different dimensions:

(a) Funding Risk - need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);

(b) Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e., performing assets turning into non-performing assets; and


44

(c) Call Risk - due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

Interest Rate Risk (IRR) 7.4 Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank's net worth since the economic value of a 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 valueperspective’, respectively.

7.5 Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective.

(a) Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM), i.e., the difference between the total interest income and the total interest expense.

(b) Economic Value perspective involves analysing the changes of impact of interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long term interest rate gaps.

Foreign Exchange Risk 7.6 Foreign exchange risk may be defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result,

Treasury Risks

45

banks may suffer losses due to changes in premium/discounts of the currencies concerned.

7.7 In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallisation does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or “Herstatt risk” which arises out of time lags in settlement of one currency in one centre and the settlement of another currency in another time zone. The forex transactions with counterparties from another country also trigger sovereign or country risk. The three important issues that need to be addressed in this regard are:

(a) Nature and magnitude of exchange risk;

(b) Strategy to be adopted for hedging or managing exchange risk; and

(c) Tools of managing exchange risk;

Credit Risk

7.8 Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial institution or a sovereign.

7.9 Credit risk may take the following forms:

• in the case of direct lending - principal/and or interest amount may not be repaid;

• in the case of guarantees or letters of credit - funds may not be forthcoming from the constituents upon crystallization of the liability;

• in the case of treasury operations - the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases;


46

• in the case of securities trading businesses - funds/ securities settlement may not be effected;

• in the case of cross-border exposure - the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.

Operational Risk

7.10 Britain's oldest merchant bank, Barings Bank, collapsed in 1995 due to unauthorised trading by a single trader, Nick Leeson, General Manager, Barings Futures (Singapore). The collapse of the bank was mainly attributed to failure of systems and procedures of control. The most serious failure was that Leeson controlled both the front and back offices and there was no middle office. There was no single person within Barings responsible for supervising Leeson.

7.11 Basel I defined operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”. Basel II, however, defined operational risk as, “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. For emergence of such a risk four causes have been mentioned and they are people, process, systems and external factors.

(a) People risk - Lack of key personnel, lack of adequate training/experience of dealer (measured in terms of opportunity cost/employee turnover), unauthorised access to the dealing room, tampering voice recorders, nexus between the front and back offices, etc.

(b) Process risk - Wrong reporting of important market developments to the management resulting in faulty decision making, errors in entry of data in deal slips, non-monitoring of exposure in positions, loss of interest owing to the liquidity beyond prescribed limits, non-revision of card rates in cases of volatility, non-monitoring of closing and opening positions, wrong funding of accounts (wrong currency, wrong way swap), lack of policies, particularly in respect of new products.

(c) Systems: Losses due to systems failure such as NDS — not maintaining secrecy of system passwords.

(d) Legal and regulatory risk: Treasury activities should comply with the regulatory and statutory obligation.

Treasury Risks

47

7.12 It is necessary that formal policies are in place with respect to trigger limits; stop loss limits; prudential limits; well defined procedures and check lists; effective internal controls and audit; insurance, wherever possible; business process re-engineering to eliminate weak links in the process chain; prudential limits on investments in banks; cap on unrated issues and private placements; sub-limits for PSU bonds, corporate bonds and guaranteed bonds; same degree of credit risk analysis in the case of any loan proposal; and more stringent appraisal for non-borrower issuers.

Market Risk Limits 7.13 Market risk limits should be established at different levels of the entity, i.e., the entity as a whole, various risk-taking units, trading desk heads and individual traders. In determining how market risk limits are established and allocated, management should take into account following factors:

(a) Past performance of the trading unit;

(b) Experience and expertise of the traders;

(c) Level of sophistication of the pricing, valuation and measurement systems; quality of internal controls;

(d) Projected level of trading activity having regard to the liquidity of particular products and markets; and

(e) Ability of the operating systems to settle the resultant trades.

Commonly Used Market Risk Limits 7.14 The following are some of the commonly used market limits:

(a) Notional or Volume Limits

Limits based on notional amount of derivatives contracts are the most basic and simplest form of limits for controlling the risks of derivatives transactions. They are useful in limiting transaction volume, liquidity and settlement risks. However, these limits cannot take account of price sensitivity and volatility.

(b) Stop Loss Limits

These limits are established to avoid unrealized loss in a position from exceeding a specified level. When these limits are reached, the position will either be liquidated or hedged. Typical stop loss limits include those relating to


48

accumulated unrealized losses for a day, a week or a month. Some institutions also establish management action trigger (MAT) limits in addition to stop loss limits. These are for early warning purposes. For example, management may establish a MAT limit at 75 per cent of the stop loss limit. When the unrealized loss reaches 75 per cent of the stop loss limit, management will be alerted of the position and may trigger certain management actions, such as close monitoring of the position, reducing or early closing out the position before it reaches the stop loss limits. The above loss triggers complement other limits, but they are generally not sufficient by themselves. They are not anticipatory; they are based on unrealized losses to date and do not measure the potential earnings at risk based on market characteristics. They will not prevent losses larger than the stop loss limits if it becomes impossible to close out positions, e.g., because of market illiquidity.

(c) Gap or Maturity Band Limits

These limits are designed to control loss exposure by controlling the volume or amount of the derivatives that mature or are repriced in a given time period.

For example, management can establish gap limits for each maturity band of 3 months, 6 months, 9 months, one year, etc. to avoid maturities concentrating in certain maturity bands. Such limits can be used to reduce the volatility of derivatives revenue by staggering the maturity and/or repricing and thereby smoothening the effect of changes in market factors affecting price. Maturity limits can also be useful for liquidity risk control and the repricing limits can be used for interest rate management.Similar to notional and stop loss limits, gap limits can be useful to supplement other limits, but are not sufficient to be used in isolation as they do not provide a reasonable proxy for the market risk exposure which a particular derivatives position may present to the institution.

(d) Value-at-risk Limits

These limits are designed to restrict the amount of potential loss from certain types of derivatives products or the whole trading book to levels (or percentages of capital or earnings) approved by the board and senior management. To monitor compliance with the limits, management calculates the current market value of positions and then uses statistical modeling techniques to assess the probable loss (within a certain level of confidence) given historical changes in market factors.

There are three main approaches to calculating value-at-risk : the correlation method, also known as the variance/ co-variance matrix method; historical

Treasury Risks

49

simulation and Monte Carlo simulation. The advantage of value-at-risk (VAR) limits is that they are related directly to the amount of capital or earnings which are at risk. The level of VAR limits should reflect the maximum exposures authorized by the board and senior management, the quality and sophistication of the risk measurement systems and the performance of the models used in assessing potential loss by comparing projected and actual results. A drawback in the use of such models is that they are only as good as the assumptions on which they are based (and the quality of the data which has been used to calculate the various volatilities, correlations and sensitivities).

(e) Options Limits

These are specifically designed to control the risks of options. Options limits should include Delta, Gamma, Vega, Theta and Rho limits.

• Delta is a measure of the amount an options price would be expected to change for a unit change in the price of the underlying instrument.

• Gamma is a measure of the amount delta would be expected to change in response to a unit change in the price of the underlying instrument.

• Vega is a measure of the amount an option's price would be expected to change in response to a unit change in the price volatility of the underlying instrument.

• Theta is a measure of the amount an option's price would be expected to change in response to changes in the options time to expiration.

• Rho is a measure of the amount an option's price would be expected to change in response to changes in interest rates.

CHAPTER 8

TREASURY UNIT – FUNDAMENTAL CONTROLS

8.1 Every banking entity is different and the challenge lies in the integration of effective controls into the correct area of risk, i.e., how well controls are designed and executed. Thus, every entity has to identify its areas of risk and decide how much control is required. Unfortunately, there is no standard precedent for a treasury to simply follow. It is only with careful analysis and understanding of the business and its risks that controls can be implemented in a targeted and effective manner. In order to do this is real skill and expertise is required. Proper controls not only save a bank from financial loss, but also assist management in the running of the business more effectively.

Risk Appetite

8.2 It may be noted that before deciding on the control framework, it is necessary to determine ‘risk appetite’. This depends on the type of business and treasury operation. For instance, one would expect to see a tighter control framework around a business that runs a profit centre treasury and trades to make a return as opposed to a more simple transaction based (e.g., purely hedging) treasury. Similarly, a different framework is also required for a treasury that runs a more manual process as opposed to one that has a greater level of straight through processing.

Governance

8.3 The bank’s board has the ultimate responsibility for ensuring that an adequate system of internal controls is established and maintained. The importance of the board and senior management understanding the risks the business is facing, articulating its risk appetite and developing policies and procedures that reflect that position hardly needs to be stressed. Every bank should have a policy that covers the identification, measurement, management, monitoring and control of financial risk. The policy should be approved by the board. The board should also establish a Treasury Committee that meets every


52

month or so. Members of this committee normally consist of the treasurer, chief financial officer (CFO), representatives from areas such as, tax or corporate finance, and perhaps a person from the business operations side.

8.4 The Treasury Committee should receive a report, along with minutes of the previous meeting. The report should include a review of the past month's treasury performance and also look into the future, to see what actions treasury will need to take (e.g., replacing funding facilities). However, treasury reports are often not particularly clear or meaningful and procedures should be adopted to developing a clear, concise, timely and relevant reporting process. Treasury Committee should also carry out a half yearly review of investment portfolio of treasury to vouch safe adherence of investment policy laid down by the bank as well as the applicable RBI guidelines.

Operating Controls

8.5 The first 'line of defense' is a set of operating controls around the processes undertaken in the treasury function. Some of the operating controls crucial to the functioning of a treasury are discussed in the following paragraphs.

Segregation of Duties 8.6 No two treasuries are the same. However, one thing is for sure, it is vital that different individuals within the front, middle (if there is one) and back offices are responsible for the different activities during the deal life cycle (such as, dealing, recording, confirmation, settlement, reporting and monitoring).The front-office should be responsible for the operation of the strategy approved by the board or treasury committee, and designing and executing transactions to manage the financial risks of the business. The back-office provides the necessary checks to prevent unauthorised trading and minimise the potential for error or fraud. The role of the back-office is to check, confirm, settle and reconcile trades conducted by the front-office and possibly provide management information.

8.7 It is ideal that the people who perform the respective duties of front-office and back-office have different reporting lines.

If it is impossible to have total separation (as in the case of small treasuries) then at least the responsibilities should be segregated such that no two sequential steps are undertaken by the same person. These responsibilities include:

• identification of positions and dealing;

Treasury Unit – Fundamental Controls

53

• authorization of deals;

• confirmations;

• authorization of settlement;

• release of settlement; and

• accounting.

Dealing 8.8 It is market practice for dealers to select banks to be contacted on the basis of known competitiveness in the relevant instrument, creditworthiness and limit availability. Competitive quotes should always be sought, unless there is a specific reason not to do so. Records should be maintained of banks contacted and rates quoted, indicating those that have been accepted. This should ensure that no one bank or broker is favoured over another and the best returns are being achieved. Once the deal has been struck, the dealer should immediately input the details into the deal recording system, either a specialist treasury management system (TMS) or the bank's alternative to this. Normally, the system will automatically number the trades using a sequence of numbers. The TMS is the firm's official record of the trade, but the dealer may choose to have either paper deal tickets or a 'blotter'. These can be useful when confirming that all trades have been input into the system and that they are accurate. This would typically be conducted by the back-office. The phones of dealers should be taped to provide a record if there is a dispute with counterparty. These tapes should be checked regularly to ensure that the tapes are working and there is room to continue recording. Dealers should not have access to these tapes.

Access to the Front -office 8.9 There has been debate over the physical access to the dealing room within a treasury environment. It is common within a banking environment to have staff from the front and back offices physically separated. Otherwise, the entity will need to rely more heavily on IT controls, e.g., computers locked with password entry. House-keeping becomes extremely important with systems, ensuring old users are deleted and current users have the correct access profile.

System Security 8.10 Irrespective of the physical set-up of the treasury, it is important that systems have passwords that are regularly checked and that personal computers


54

are locked if unattended. Timeout locks should assist this if a machine is not touched for a period of time. Control procedures within treasury usually depend to a great extent upon the correct usage of computer software packages. All authorized users should be assigned a unique user identification (ID) and personal password. Users should log out of the system when it is not being used and, particularly, when leaving their desks. All computers should have screen saver passwords that prevent access, other than by password, if the computer is left unattended.

8.11 The following are some of the important system controls implemented by banks in the present day treasury environment: (a) In a treasury system with online deal entry (usually referred to as a

front-office dealing system), deals are entered directly in the system. The back-office support function has only view rights to the deals entered into such dealing system and every time they note a new deal they confirm the particulars of the deal with the back-office of the counterparty to the transaction. On confirmation, they approve the deal through their security ID in the system and only then the deal finally gets booked. In case of discrepancies, the back-office informs the front-office dealer and then the deal is not booked in the system.

(b) In case of foreign exchange transactions, the treasury system is configured to compare the rates at which the transactions are done by the bank with the market rate range and generate an exception report. This report is useful to note significant variations in rates which the dealers would have transacted at.

(c) Front-office systems in banks may be configured to compute limits on a real-time basis, such as, dealer limits, counterparty limits, broker limits, currency limits, exposure limits, etc. When a transaction is entered into the system these limits are automatically computed and flashed on the screen to prompt the dealer of a potential limit breach if the deal is executed.

(d) Systems may also be configured to perform automated nostro reconciliations whereby the system extracts the bank’s nostro account data from the general ledger and account statements of the counterparty bank and then matches the similar trades and generates an exception report for trade mismatches (or reconciling items). A designated back-office team tracks the ageing of such reconciling items


55

and follows up with the respective functions within the bank for resolving the same.

(e) As noted above, all authorized users are assigned a unique user identification (ID) and personal password. In any IT environment, usually, the user rights and entitlements to the various IT systems is clearly defined and documented and also subjected to a periodic review. In an instance when a user ID that does not have access to a particular set of information or command is trying to retrieve such information, then a modification log automatically gets saved in the system which gives details of the user ID trying to gain unauthorised access. Such controls are referred to as ‘fraud risk controls’.

(f) Some bank’s IT system are interfaced to the financial accounting or general ledger system. At the end of the day, usually, the balances and positions in all the systems is uploaded in the financial accounting system. At the time of such upload an exception report/log is automatically generated which gives the details of the balances which could not be uploaded correctly or completely. Banks have a dedicated team in their back-office who are only responsible for resolving the open items in such exception report on a timely basis.

8.12 IT creates opportunities but also calls for a new genre of risks, such as:

♦ Logical or processing errors caused by the underlying program code. Systematic errors may be more difficult to detect.

♦ Unauthorised access to systems due to compromised controls over access IDs and passwords or non-discontinuance of system access for exit/transfer cases of staff members.

♦ Non-updation of master data fields leading to errors (such as, mailing address, customer name, staff account status, dormant/unclaimed account status).

♦ Loss of laptops, remote access control devices, blackberry, palmtops or personal digital assistants (‘PDAs’) which may get misused for authorising certain transactions or initiating certain communication.

8.13 The banking industry is one of the most significant users of technology as compared to other industries. The bank’s management also enforces controls such as, periodic reviews of access to the financial system resources and other confidential/critical data, to confirm the appropriateness of these access rights


56

(access control matrix). An internal auditor should, therefore, have as a part of his scope the evaluation of the IT general control environment. IT general controls offers the backdrop on which various specific system controls operate, hence, the effectiveness of specific system controls depends on the effectiveness of IT general controls.

Confirmations 8.14 It is usually the responsibility of the back-office to confirm the details of all the treasury transactions before settlement is made so as to minimise the risk of error or fraud.

Settlement 8.15 Once transactions have been confirmed, the back-office is responsible for initiating any payment that may be required. Back-office will also usually be responsible for questioning 'failed' trades, i.e., if a trade is not settled correctly, the back office will try and resolve the query by contacting the counterparty or broker.

Disaster Recovery 8.16 Treasury should maintain and update a disaster recovery plan (DRP) operative in circumstances leading to partial breakdown of facilities or the inability to access the building. The DRP is to assist the treasury department to continue its daily responsibilities with immediate effect in such types of unforeseen conditions.

Personnel 8.17 The recruitment process that is followed by an organisation is important to ensure that people employed have the right skills and experience, as well as the outlook to match the organisation. Once a decision of hiring has been made, employees need ongoing training in accordance with their job requirements. This should be provided internally and externally to ensure people are kept up-to-date with market developments and leading practice.

In addition, a good way of making it easier for newcomers is to have an up-to-date and comprehensive procedures manual. By rotating the staff and forcing them to have one holiday of at least two weeks each year, a different person is allowed to carry out their duties on a day-to-day basis and this helps to prevent and detect fraud.


57

Document Security 8.18 All paper records should be filed in cabinets. Sensitive or valuable documents should be kept in locked and preferably fire proof storage.

Oversight Controls 8.19 The treasurer should receive the following reports on a daily basis.

• breached credit limits;

• list of deals done for the day;

• off-market trades, with an explanation; and

• changes to standing data.

8.20 Back-office management should also ensure that their controls are being conducted as they were designed. Some examples include a summary of unreconciled items, suspense account items and outstanding confirmations that have not been matched. It is very useful to see how numerous and large these amounts are, and also how long they have been outstanding. Needless to say, concurrent audit of treasury operations would ensure that these controls are in operation.

Monitoring Controls and Treasury Reporting

8.21 Regular reporting to management is the most common form of monitoring treasury activity. The purpose of treasury reporting is:

(a) To inform senior management of financial exposure;

(b ) To demonstrate to senior management that treasury activity is within parameters authorised by the board; and

(c) To promote the analysis of activities and performance measurement within treasury and so lead to improvements in efficiency and control.

8.22 The treasury report will include information on the major risks of the business and the performance of the treasury function over the past month. Examples of such information are:

• Economic update - based on market sources (e.g., relationship banks) giving details on the current economic environment and likely future scenarios and how these will impact the bank;


58

• Foreign exchange - open positions, average forex rates achieved as compared to forecast, gains and losses on forex trading, translation exposure and steps to control that exposure;

• Long term funding - graph of funding horizon and plans to implement new funding to replace existing lines, headroom over existing facilities, cost of funds, loan covenants and compliance;

• Interest rate exposure - sensitivity to interest rate movement, proportion of fixed and floating debt;

• Cash management and investments - returns on funds over the month as compared to a benchmark, cash forecasts over the short and long term;

• Bank relationships and credit exposure - how bank relationships are being managed, exposures as compared to limits, headroom; and

• A record of outstanding guarantees and the costs involved.

CHAPTER 9

INTERNAL AUDIT OF TREASURY OPERATIONS

Scope of Internal Audit with Special Reference to Treasury/Market Risk Segments 9.1 The precise scope of risk-based internal audit must be determined by each bank for low, medium, high, very high and extremely high risk areas. However, at the minimum, it must review/report on the following aspects:-

(a) Process by which risks are identified and managed in various areas;

(b) Control environment in various areas;

(c) Gaps, if any, in control mechanism which might lead to frauds, identification of fraud prone areas;

(d) Data integrity, reliability and integrity of Management Information system;

(e) Internal, regulatory and statutory compliance;

(f) Budgetary control and performance reviews;

(g) Transaction testing/verification of assets to the extent considered necessary;

(h) Monitoring compliance with the internal audit report; and

(i) Variation, if any, in the assessment of risks under the audit plan vis-à-vis the risk-based internal audit.

9.2 The scope of risk-based internal audit should also include review of the systems in place for ensuring compliance with money laundering controls; identifying potential inherent business risks and control risks, if any; suggesting various corrective measures and undertaking follow up reviews to monitor the action taken thereon.


60

Functional Independence 9.3 The internal auditor should be independent from the internal control process in order to avoid any conflict of interest. He should be given an appropriate standing within the bank to carry out the assignments. He should not be assigned the responsibility of performing other accounting or operational functions. The internal audit staff should perform their duties with objectivity and impartiality. The internal audit head should not report to any authority below the level of the Board of Directors/Audit Committee.

Code of Ethics and Internal Auditors 9.4 A code of ethics is necessary and appropriate for the profession of internal auditing, as it is founded on the trust placed in its objective assurance about risk management, control, and governance. A member of the Institute of Chartered Accountants of India, carrying out an internal audit activity, would apart from other requirements, additionally be governed by:-

(i) the requirements of the Chartered Accountants Act, 1949;

(ii) the Code of Ethics issued by the Institute of Chartered Accountants of India; and

(iii) other relevant pronouncements of the Institute of Chartered Accountants of India.

Internal auditor has to uphold the golden principles of integrity, objectivity, confidentiality and competence.

Stages of Internal Audit 9.5 The internal audit of treasury operations can be broadly divided into following five stages:

Internal Audit of Treasury Operations

61

Pre-commencement Work

Knowledge of the entity and its environment

Overall audit plan – Audit Programme

Audit Documentation

Audit Procedures

Internal Audit Report

Pre-commencement Work 9.6 The following points have to be considered before commencing the internal audit:

(a) Decision on whether the engagement should be accepted. This will be based on:

• Consider whether capability, time and resources are available; and

• Consider whether it satisfies ethical requirements.

(b) Internal auditor cannot be the statutory auditor for the same financial year or the same bank.


62

(c) The decision for acceptance or rejection of assignment has to be communicated to the concerned authority.

(d) The objective and scope of work has to be considered with specific considerations to time available for conducting internal audit.

(e) The internal auditor and the auditee should agree on the terms of the engagement before commencement. The agreed terms should be recorded in an engagement letter. Standard on Internal Audit (SIA) 8, “Terms of Internal Audit Engagement” establishes standards and provides guidance in respect of terms of engagement of the internal audit activity whether carried out in house or by an external agency.

Knowledge of the Entity and its Environment 9.7 The next step is that the internal auditor should obtain knowledge of the entity’s business and its operating environment, including its regulatory environment and the industry in which it operates, sufficient to enable him to review the key risks and entity-wide processes, systems, procedures and controls. Standard on Internal Audit (SIA) 15, “Knowledge of the Entity and its Environment” establishes standards and provides guidance on these aspects. It also sets out the guidelines regarding the application, usage and documentation of such knowledge by the internal auditor.

9.8 The internal auditor should specifically obtain knowledge on following aspects:-

(a) Relevant laws and regulations

(b) Circulars/Guidelines issued by the RBI

(c) Circulars/Guidelines issued by the head office of the bank

(d) Organisational structure

(e) Type/nature of transactions

(f) Accounting system

(g) Internal control framework

• Risk assessment

• Monitoring

(h) Risk Management


63

• Risk tolerance

• Back-up system

(i) Reporting requirements

9.9 Knowledge of the entity’s business is a frame of reference within which the internal auditor exercises professional judgment in reviewing the processes, controls and risk management procedures of the entity. Understanding the business and using this information appropriately assists the internal auditor in:

(a) Assessing the risks and identifying key focus area.

(b) Planning and performing the internal audit effectively and efficiently.

(c) Evaluating audit evidence.

(d) Providing better quality of services to the client.

Overall Internal Audit Plan 9.10 The success of any internal audit is dependent upon an appropriate audit plan and its timely execution. The internal audit plan should be comprehensive enough to ensure that it helps in achieving of the overall objectives of an internal audit. The following are some of the important aspects in this regard:

(a) The annual audit plan, approved by the Board, should include the schedule and the rationale for audit work planned.

(b) The plan should include all risk areas and their prioritization based on the level of risk.

9.11 Internal audit plan should cover areas such as:

• Obtaining the knowledge of the legal and regulatory framework within which the entity operates.

• Obtaining the knowledge of the entity’s accounting and internal control systems and policies.

• Determining the effectiveness of the internal control procedures adopted by the entity.

• Determining the nature, timing and extent of procedures to be performed.


64

• Identifying the activities warranting special focus based on the materiality and criticality of such activities, and their overall effect on operations of the entity.

• Identifying and allocating staff to the different activities to be undertaken.

• Setting the time budget for each of the activities.

• Identifying the reporting responsibilities.

The internal audit plan should also identify the benchmarks against which the actual results of the activities, the actual time spent, the cost incurred would be measured.

9.12 Adequate planning ensures that appropriate attention is devoted to significant areas of audit. Planning also ensures that the work is carried out in accordance with the applicable pronouncements of the Institute of Chartered Accountants of India. ICAI has till date issued 17 Standards on Internal Audit and the same are as follows.

(a) Standard on Internal Audit (SIA) 1, Planning an Internal Audit

(b) Standard on Internal Audit (SIA) 2, Basic Principles Governing Internal Audit

(c) Standard on Internal Audit (SIA) 3, Documentation

(d) Standard on Internal Audit (SIA) 4, Reporting

(e) Standard on Internal Audit (SIA) 5, Sampling

(f) Standard on Internal Audit (SIA) 6, Analytical Procedures

(g) Standard on Internal Audit (SIA) 7, Quality Assurance in Internal Audit

(h) Standard on Internal Audit (SIA) 8, Terms of Internal Audit Engagement

(i) Standard on Internal Audit (SIA) 9, Communication with Management

(j) Standard on Internal Audit (SIA) 10, Internal Audit Evidence

(k) Standard on Internal Audit (SIA) 11, Consideration of Fraud in an Internal Audit

(l) Standard on Internal Audit (SIA) 12, Internal Control Evaluation

(m) Standard on Internal Audit (SIA) 13, Enterprise Risk Management


65

(n) Standard on Internal Audit (SIA) 14, Internal Audit in an Information Technology Environment

(o) Standard on Internal Audit (SIA) 15, Knowledge of the Entity and its Environment

(p) Standard on Internal Audit (SIA) 16, Using the Work of an Expert

(q) Standard on Internal Audit (SIA) 17, Consideration of Laws and Regulations in an Internal Audit

Internal Audit Procedures 9.13 After completing the preliminary review, the internal auditor performs the procedures outlined in the audit program. These procedures usually test the internal controls and the accuracy and the propriety of the transactions. The audit procedures would include:

(a) Inspection

(b) Observation

(c) Inquiry and confirmation

(d) Computation

(e) Analytical Procedures

9.14 While selecting the internal audit tests and procedures that meet the internal audit objectives with regard to internal control and risk assessment, the internal auditor should consider the following items:

(a) The requirements to meet internal audit objectives.

(b) The relative materiality of matters to be investigated.

(c) The effectiveness of system of accounting and internal control.

(d) The estimates of costs of implementing internal audit test plans in relation to likely benefits to be derived.

Risk Assessment Process and Methodology 9.15 The risk assessment process should, inter alia, include the following:-

(a) Identification of inherent business risks in various activities undertaken by the bank.


66

(b) Evaluation of the effectiveness of the control systems for monitoring the inherent risks of the business activities.

(c) Drawing up a risk matrix for taking into account both the factors, viz., inherent business risks and control risks.

(d) The basis for determination of the level (high, medium, low) and trend (increasing, stable, decreasing) of inherent business risks and control risks should be clearly spelt out. The risk assessment may make use of both quantitative and qualitative approaches. While the quantum of credit, market, and operational risks could largely be determined by quantitative assessment, the qualitative approach may be adopted for assessing the quality of controls in various business activities. In order to focus attention on areas of greater risk to the bank, identification of activity-wise and location-wise risks should be undertaken.

(e) The risk assessment methodology should include, inter alia, the following parameters:

• Previous internal audit reports and compliance;

• Proposed changes in business lines or change in focus;

• Significant change in management/key personnel;

• Results of latest regulatory examination report;

• Reports of external auditor;

• Industry trends and other environmental factors;

• Time lapsed since last audit;

• Volume of business and complexity of activities; and

• Substantial performance variations from the budget.

9.16 For the risk assessment to be accurate, it will be necessary to have in place proper MIS and data integrity. The internal audit function should be kept informed of all developments such as introduction of new products, changes in reporting lines, changes in accounting practices/policies, etc. The risk assessment should invariably be undertaken on a yearly basis. The assessment should also be periodically updated to take into account changes in business environment, activities and work processes, etc.


67

Risk Perspectives 9.17 Inherent business risks indicate the intrinsic risk in a particular area/activity of the bank and could be grouped into low, medium and high categories depending on the severity of risk. Control risks arise out of inadequate control systems, deficiencies, gaps and/or likely failures in the existing control processes. The control risks could also be classified into low, medium and high categories.

Risk and Audit Matrix 9.18 In the overall risk assessment both the inherent business risks and control risks should be factored in. The overall risk assessment as reflected in each cell of the risk matrix is explained below:

RISK MATRIX

High A High Risk

B Very High

Risk

C Extremely High Risk

Medium D Medium

Risk

E High Risk

F Very High

Risk Low G

Low Risk H

Medium Risk

I High Risk

Low Medium High

Control Risks

Risk Assessment A. High Risk: Even though the control risk is low, this is a high risk area

due to high inherent business risks.

B. Very High Risk: The high inherent business risk coupled with medium control risk makes this a Very High Risk area

Inhe

rent

Bus

ines

s Risk

s


68

C. Extremely High Risk: Both the inherent business risk and control risk are high which makes this an Extremely High Risk area. This area would require immediate audit attention, maximum allocation of audit resources besides ongoing monitoring by the bank’s top management.

D. Medium Risk: Although the control risk is low this is a Medium Risk area due to medium inherent business risks.

E. High Risk: Although the inherent business risk is medium this is a High Risk area because of control risk also being medium.

F. Very High Risk: Although the inherent business risk is medium, this is a Very High Risk area due to high control risk.

G. Low Risk: Both the inherent business risk and control risk are low.

H. Medium Risk: The inherent business risk is low and the control risk is medium.

I. High Risk: Although the inherent business risk is low, due to high control risk this becomes a High Risk area.

9.19 The banks should also analyse the inherent business risks and control risks with a view to assess whether these are showing a stable, increasing or decreasing trend. Illustratively, if an area falls within cell ‘B’ or ‘F’ of the Risk Matrix and the risks are showing an increasing trend, these areas would also require immediate audit attention, maximum allocation of audit resources besides ongoing monitoring by the bank’s top management (as applicable for cell ‘C’). The Risk Matrix should be prepared for each business activity/location.

Internal Audit Documentation 9.20 Internal auditor should have proper working papers that will enable him to substantiate his results. The internal auditor’s work papers serve as the connecting link between the audit assignment, the auditor's fieldwork, and the final report. Work papers contain the records of planning and preliminary surveys, audit procedures, fieldwork, and other documents relating to the internal audit. Most importantly, the work papers document the internal auditor's conclusions and the reasons those conclusions were reached. As each audit step in the audit procedures is satisfied, the internal audit supervisor should request review of the related work papers.


69

9.21 Standard on Internal Audit (SIA) 3, “Documentation” establishes standards and provides guidance on the documentation requirements in an internal audit. Internal auditor’s working papers serve the following purposes:

• Aid in planning, performance, and review of internal audit.

• Document whether the internal audit objectives were achieved.

• A support for internal audit reports.

• Record information.

• Document internal audit findings and accumulate evidence

• Basis for supervisory review.

• Support and evidence for issues like fraud, lawsuits, etc.

• Basis /reference for subsequent internal audit.

• Document whether the internal audit objectives were achieved.

• Facilitate third party reviews.

• Aid to peer review.

• Provide a basis for evaluating the internal audit's quality assurance programme.

9.22 The internal audit documentation should cover all the important aspects of an engagement, viz., engagement acceptance, engagement planning, risk assessment and assessment of internal controls, evidence obtained and examination/evaluation carried out, review of the findings, communication and reporting and follow-up. The internal audit documentation would, therefore, generally, include:

• Planning documents and internal audit procedures.

• Controls questionnaires, flowcharts, checklists and narratives.

• Notes and minutes resulting from interviews.

• Organisational data such as charts and job descriptions.

• Copies of important documents.

• Information about operating and financial policies.

• Results of control evaluations.


70

• Letters of confirmation and representation.

• Analysis and test of transactions, processes, and account balances.

• Results of analytical review procedures.

• Audit reports and management responses.

• Audit correspondence that documents the audit conclusions reached.

9.23 Internal audit documentation should be sufficiently complete and detailed for an internal auditor to obtain an overall understanding of the audit.

Reporting 9.24 The internal auditor’s report should contain a clear written expression of significant observations, suggestions/recommendation based on the policies, processes, risks, controls and transaction processing taken as a whole and managements’ responses. Standard on Internal Audit (SIA) 4, “Reporting” establishes standards on the form and content of the internal auditor’s report. 9.25 The internal auditor’s report includes the following basic elements, ordinarily, in the following layout: (a) Title; (b) Addressee; (c) Report Distribution List; (d) Period of coverage of the Report; (e) Opening or introductory paragraph;

(i) identification of the processes/functions and items of financial statements audited; and

(ii) a statement of the responsibility of the entity’s management and the responsibility of the internal auditor;

(f) Objectives paragraph - statement of the objectives and scope of the internal audit engagement;

(g) Scope paragraph (describing the nature of an internal audit):


71

(i) a reference to the generally accepted audit procedures in India, as applicable;

(ii) a description of the engagement background and the methodology of the internal audit together with procedures performed by the internal auditor; and

(iii) a description of the population and the sampling technique used.

(h) Executive Summary, highlighting the key material issues, observations, control weaknesses and exceptions;

(i) Observations, findings and recommendations made by the internal auditor;

(j) Comments from the local management; (k) Action Taken Report – Action taken/ not taken pursuant to

the observations made in the previous internal audit reports; (l) Date of the report; (m) Place of signature; and (n) Internal auditor’s signature with Membership Number.

A measure of uniformity in the form and content of the internal auditor’s report is desirable because it helps to promote the reader’s understanding of the internal auditor’s report and to identify unusual circumstances when they occur.

Annexures

ANNEXURE – A

SPECIMEN CHECKLIST FOR INTERNAL AUDIT OF TREASURY OPERATIONS

The internal auditor’s procedures with respect to the following specific areas of treasury operations are as follows:

S. No. Description Remarks

I. General a Whether the bank has policies for all treasury activities

b Whether the policy commensurate with the nature of operations and adequately covers all the activities.

c Whether the policy include a list of responsible persons.

d Whether the policy specifies types and purposes of the financial Instruments.

e Whether the policy specifies frequency of reporting and reporting authority.

f Whether the Cash Reserve Ratio and Statutory Liquidity Ratios has been maintained.

II. Organisation Structure a Whether treasury activities are over sighted by an

officer independent of day-to-day activities.

b Whether there is an effective segregation of key duties including dealing, settlement and accounting/reconciliation.

c Whether the policy and procedures are properly documented and easily accessible to all staff.


76

d Whether there is a job descriptions or delegations for key treasury positions.

e Whether sufficient resources are available to operate the treasury effectively.

f Whether there is segregation between functions of authorization, execution and recording of transactions.

III. Personnel: Training, Compliance and Performance

a Whether all personnel are appropriately trained.

b Whether all employees’ references are properly checked.

c Whether all the employees signs an ethics policy at the time of joining.

IV. Deal Execution Process a Whether transactions concluded by the dealing room

are confirmed by the back office manager.

b Whether there is a systematic procedure of filing.

c Examine third party payment and verify that a letter of instruction to that effect is filed.

d Whether outward confirmations are recorded in a register.

V. Limits a Check counterparty exposure limit for all brokers,

lenders, etc.

b Check deal limits i.e., maximum amount, a person can transact without seeking higher level approval.

c Check product limits i.e., maximum exposure, the entity should have in a particular instrument or product.

Annexure – A

77

d Check sector limits i.e., maximum investment in a particular sector.

VI. Recording Control i) Control over Documents

a Whether all money market deals have been timely carried out and accurately recorded.

b Whether all the documents and statements have been received from concerned parties (brokers, bankers and lenders, etc.) and properly filed in a logical sequence.

c Whether filed copies are pre-numbered and continuous for ease of reference and filing.

ii) Control over Accounting Procedures

a Whether adequate systems are in place to track all matured investments.

b Whether there are accurate recording and accounting of positions..

c Whether an independent person checks the recording of postings.

d Whether all deals are recorded in the General Ledger.

e Whether account reconciliation has been done and time frame has been set for clearing all outstanding items.

f Inspect source documents and verify that they are initialed by the checkers.

VII. Reconciliation of Bank Accounts and Treasury Records with the General Ledger

a Verify the bank balance with bank statement.

b Whether the treasury srecords is reconciled to the general ledger.


78

VIII. Cash Management a Whether there is an effective procedure for monitoring

the daily cash position.

b Whether the management has planned the liquidity needs for normal operating conditions and emergency situations.

c Whether cash forecasting has been done after trend analysis.

d Obtain Bank statements.

e Review the liquidity position.

IX. Investment a Review the investment strategy and verify whether the

investment strategy is followed in letter and spirit.

b Whether authority level are set for investment in different instrument monetary limits.

c Obtain the list of investments.

d Analyse the investment portfolio statements.

e Whether all investments are in name of the bank.

f Whether the bank has all the documents with regard to ownership of investments.

g Whether the bank utilises third party investment managersand verify the reasons for such selection.

h How does the entity control the investment managers’ activities.

i Whether the investment managers are apprised of the investment policies of the entity. How does the entity ensure compliance with them.

j How is the performance of internal / external investment managers evaluated.

Annexure – A

79

X Documentation for Derivative transactions a Whether derivative contracts are properly

documented. Note: The following instructions in this regard may, therefore, be strictly adhered to: (i) For the sake of uniformity and standardisation in respect of all derivative products, participants may use ISDA documentation, with suitable modifications. Counterparties are free to modify the ISDA Master Agreement by inserting suitable clauses in the schedule to the ISDA Master to reflect the terms that the counterparties may agree to, including the manner of settlement of transactions and choice of governing law of the Agreement. (ii) besides the ISDA Master Agreement, participants should obtain specific confirmation for each transaction which should detail the terms of the contract such as gross amount, rate, value date, etc. duly signed by the authorised signatories. (iii) It is also preferable to make a mention of the Master Agreement in the individual transaction confirmation. (iv) Participants should further evaluate whether the counterparty has the legal capacity, power and authority to enter into derivative transactions. (v) Participants must ensure that ISDA Master Agreement is signed with the counterparty prior to undertaking any derivatives business with them. (vi) Participants shall obtain documentation regarding customer suitability, appropriateness, etc. as specified.

XI Investment in Debt Securities a Verify the frequency of interest payments.

b Whether the bank has obtained information about the issuer and the credit rating.


80

c Whether the bank has checked the terms of the issue like the use of the issue proceeds, the monitoring agency, the formation of trustees, the secured or unsecured nature of the bonds, the assets underlying the security and the credit-worthiness of the organisation.

d Check the Yield To Maturity (YTM) of the debt security with the YTMs of other comparable debt securities of the same class and features.

ANNEXURE – B

SPECIMEN CHECKLIST FOR INTERNAL AUDIT OF FOREIGN EXCHANGE

OPERATIONS OF TREASURY

The internal auditor’s procedures with respect to the following specific areas of foreign exchange operations are as follows:

Sr. No. Particulars Remarks

I Interbank Deal a Whether the bank has specified the dealing hours for the

dealers operating in foreign exchange market.

b Whether adequate care is exercised in selecting and grooming the dealers.

c1.3 Whether dealers operate in the interbank market according to the guidelines lay down by the management

d Whether there is a system of rotation of duties of dealers.

e1.5 Whether dealers have furnished an undertaking to conform to the code of conduct prescribed by Foreign Exchange Dealer’s Association of India (FEDAI).

f Whether the trading date, time and the transaction serial number are entered automatically in the system and the same can not be altered by the dealer after a contract is finalised.


82

g In case of deviations in the transaction data, whether approval of the competent official is taken.

h Whether late deals are marked and included in day’s position.

i Whether the access to the equipment and tapes are subject to strict control.

k Whether a dealer’s pad is maintained by the front office to record the inter bank and merchant deals.

l Whether any delay of more than half an hour was observed between striking the deal and entering the same in K+.

m Whether deal confirmations are stamped in case of “phone” deals which do not have a REUTER’s screen.

n Whether a default register as prescribed by RBI vide its letter no. ECS: 95/86(SPL)-82/83 dated January 30, 1982 is maintained.

o Whether deal slips are serially numbered.

p Whether all required particulars are furnished therein and slips are checked / signed / initialed by the dealer.

q Whether the deal slips are immediately prepared and passed on to back office immediate after conclusion of the deals.

r Whether accounting department keeps the receipt of confirmations/Reuter’s screen/telex message of the deals received from counterparty banks and checks the correctness thereof.

s Whether the deal slips, contract notes, etc. are maintained in proper sets and in sequential order to facilitate control and further reference.

t Whether back office prepares monthly bank wise lists of all, unconfirmed outstanding exchange contracts and the outstanding are followed-up with the counterparty banks expeditiously to finally settle the deals.

Annexure – B

83

u Whether any unusual features are noticed in inter bank / inter-office dealings, e.g., transactions concluded for window dressing in the books.

v Whether any swap deal has been undertaken at level rate and if so, the reasons thereof.

w Whether the base rates at which the deals were concluded and the swap differences were realistic and reflect the prevailing conditions in the interbank market.

x Whether there is any deal that not reflect in dealers pad but found subsequently.

y Whether specimen signature of counter party Banks is kept for verification of deals.

z Whether accounting entries are promptly booked, and payments committed under the deals are promptly advised and effected. Whether receipts are suitably recorded in the Nostro Account.

aa Whether exchange confirmatory message over telex are obtained where business with other authorised dealers is done, directly over telephone.

ab Whether dealers nominate brokers after the deals of the above nature have been struck.

II Merchant

a Whether the profit/ loss on cancellation of merchant deals has been correctly calculated and accounted for.

b Whether statement of overnight position including late deals is submitted.

c Whether reconciliation of the positions between the dealers’ records and the accounting system is done.

d Whether the osition and the Fund Registers are continuously updated on the basis of deal slips and the reports of business


84

flowing in from the Branches (CPC & NRI).

e Whether the rates for the foreign currencies are being taken thrice a day (viz. at opening hours, afternoon and closing hours).

f Whether crystallization of export bills are promptly resorted on respective due dates.

g Whether there is any overdue merchant contract outstanding without utilization / cancellation. (as per the latest FEDAI guidelines, contracts will automatically have to be cancelled, if not utilized by due date / within delivery period.)

h Whether forward purchase/sales (FP/FS) cancellation charges are collected on due date.

III Brokerage a Whether branch is maintaining panel of brokers

approved by the management .

b Whether substitution of one bank by another in inter-bank contract by brokers is noticed.

c Whether provisions of Income Tax Act regarding the tax deducted at source (TDS) on brokerage have been complied with.

d Whether all brokerage claims are being verified from the above broker-wise register.

e Whether the back office is preparing a monthly summary of brokerage paid to each broker in the abovementioned register and the contents thereof are being submitted to head office.

f Whether back office department ensures that all broker notes have been received expeditiously and particulars therein including the dates thereof agree with relative deal slips.

g In case of discrepancies in the brokers note, whether the

Annexure – B

85

same are brought to the dealer’s attention and clarification / rectification obtained promptly from the dealer and / or broker directly by the ccounting Department.

h Whether brokers, with whom no hotlines are established, are also encouraged over extra telephone lines.

i Whether brokerage bills received by the backup department from the brokers, are sent to the dealers for certification.

j Whether brokerage on outright and swap deals has been paid as per revised rates prescribed in terms of FEDAI Rules.

IV Limits

a Whether limit is fixed for the exposure to other banks in respect of interbank dealings. If so, whether the dealings are within the limits. If not, verify the procedure followed for regularisingit.

b Whether day light limits have been exceeded and if so, check the extent. Ascertain and indicate the reasons for same and verify whether higher authorities ratified the same.

c Whether the overnight open position limits in various currencies, as fixed by the management, have been exceeded at any time and if so,verify the time and extent. Indicate the action taken to regularize the position.

d Whether the gap limits are adhered to. If not, indicate the details and the steps taken to comply with the requirements in this regard.

e Whether statements of maturities are being submitted to higher authorities / RBI by accounting department and check the intervals of the submission also.

f Whether particulars reported in Gap statements are


86

correct as per the office records.

g Whether any dealing limits have been fixed for the dealer. Checkthe date when these limits were fixed. Whether they have been exceeded, and if so,chack the time and extent. Also indicate action taken by the division for obtaining ratification / confirmation.

h Whether there is any exceeding in respect of single country exposure.

i Whether off credit countries exposure are monitored on a daily basis.

V POS Register

a Whether daily currency position report (Form IC-5 of guidelines) is being submitted to higher authorities.

b Whether statement of currency positions in each currency as on the last Friday of each month computed after taking into account the effect of all pipeline transactions, is submitted to the management indicating the steps to be taken for reducing the distortions, if any.

c Whether the particulars reported in the last statement of true currency positions prepared and submitted to the management are correct as per records maintained.

d Whether there is any alteration / correction at the dates of the contracts in order to manipulate currency position.

e Whether dealers have maintained position pads, funds chart and maturity pattern of the contracts.

f Whether currency wise position and funds position is communicated and / or updated in the system frequently to enable the dealer to have updated position.

g Whether positions are taken purely for covering positions.

h Whether positions are also taken in advance.

Annexure – B

87

VI Nostro Reconciliation a Whether accounting entries are promptly booked and

payments committed under the deals are promptly advised and effected. Whether receipts are suitably recorded in the “Nostro” account.

b Whether a separate department / section, under the charge of a separate official, is there forreconciliation work.

c Whether the officials attached to the reconciliation department have been entrusted with the operation of Nostro Accounts or passing of entries in the Mirror Account.

d Whether statement of accounts are received at least once in month by the reconciliation department and the department is: (a) Watching the receipt of statement (b) Ensuring that there are no unauthenticated alterations, erasures, etc.

e Whether the reconciliation work is undertaken expeditiously and is upto date.

f Whether the credits are advised to the concerned branches immediately.

g Whether the follow up action on the entries, especially debit items appearing in the statements and/or mirror account is promptly initiated / taken.

h Whether the department is submitting a report once a month to the higher authorities indicating the progress of reconciliation work and the special features, such as large non reconciled items etc., and if so, what action has been taken on such reports by the branch?

i Whether large balance has been held in an inoperative account, for a long period and if so, the reasons thereof.


88

j Indicate the details of arrangement, if any made for automatic transfer of funds to secure benefit of interest for overnight idle funds.

k Whether overdrawn balance of US $ 5 lacs and above for continuous period of more than 5 days have been observed and if so, give details, also indicate whether the matter has been reported to RBI for post facto approval as required under Exchange Control Manual (ECM).

l Whether bank has been submitting the BAL Statements promptly and regularly to RBI and the particulars reported in the last BAL statements submitted to RBI are correct as per bank's records.

m Whether any new Nostro account opened during the month is under review. If so, whether the same has been reported to RBI?

n Whether any large overdrafts observed in Nostro accounts during the month and if so, whether conductive / monitoring method are initiated.

o Whether proper registers are maintained regarding the rupee postings in Nostro account.

VII R- Returns

a Whether timely, accurate and comprehensive management information system is in place,

b Whether monitoring and reporting is undertaken by officials who are not directly concerned with trading activities.

c Whether R-Returns are submitted to RBI within the stipulated due-date.

VIII Forex Profits/ Losses

a Whether dealer-wise profit targets are fixed.

b Whether the bank is reckoning only the Nostro balances for adjustment of the profits / losses revealed in the

Annexure – B

89

mirror accounts or whether it also consider the forward transactions as at the date of evaluation.

c Check rates used to liquidate the month-wise positions. Whether any departure is noticed in this regard. Whether this work is entrusted to a department / person independent of the dealing function.

IX Trading Operations Done by the Division

a Whether the position taken by the dealer is in tune with the prevailing rates in the market, the loss or profitability of the trading transactions. Whether the dealer has exceeded the cut-loss prescribed by the head office.

b Whether the profit arrived by the division on trading operations is correct.

c Whether the trading operations does not exceed and are within the IGL / AGL prescribed by the head office.

X Dealing Room: System/Ethics/ Profit Evaluation a Check brief description of organizational set-up and

whether the dealing function is separated from the accounting, funding and other back-up functions.

b Whether, before the dealer starts the work for the days, he confers on the trend in the overnight markets and markets still operating in the same time zone and keep the management informed of the conclusion.

c Whether dealer is allowed to sign contract notes, passing accounting entries and sending payment instructions/receipt intimations to correspondents / brokerage claims.

d Whether the deals are done from outside the dealing rooms / hours.

e Whether a “Rate Scan report is: - Prepared for each day showing the day’s market spread for each currency dealt by it during the day both spot and forward and submits it to an official independent of the dealing department.


90

- On a test verification of such reports with relative deal slips whether there was any aberration detected in the rates and if so what is explanation given by the dealer and where the aberrations few by exception or were they quite frequent.

f Check procedure / policy followed for posting / rotation of staff. Whether consideration of knowledge and experience of the foreign exchange department are taken into account while posting the staff.

XI Internal Control a Whether data processing system is adequate to the

nature / volume of activities and is designed to functional separation.

b Whether back up facilities are available for deployment in case of system failure and other emergencies.

c Whether job rotation is provided to the dealers as well as back office personnel.

d Whether clear functional separation of dealing, back office, settlement / accounting / reconciliation is being observed.

e Whether the bank has the system of internal audit of the Forex Department.

f Whether the bank has proper system of receiving, distributing and filing all relevant RBI circulars.

g Whether the bank has sufficient number of Exchange Control Manuals with all the amendments.

XII Overnight Placement of Orders in Trading a Whether there are any instances that the bank has

invested funds in overseas markets above $10 million (or 25% of Unimpaired Tier 1 capital) or borrowed above $ 10 million (or 25% of Unimpaired Tier 1 Capital) whichever is higher, from the correspondents.

Annexure – B

91

b Whether the limit for placement of overnight orders is exceeded during the month.

c Whether the dealers place overnight orders only with correspondent banks with which they maintain Nostro accounts and other approved counter party banks, for which exposure limits are fixed by the competent authority from time to time.

d Whether exit points for the position, i.e., stop loss are clearly mentioned.

e Whether the division is submitting the details of overnight orders placed to higher authorities in their daily report on trading.

f Whether the amount placed as overnight orders is within the IGL / AGL limits fixed by the head office.

g Whether the amount placed as overnight orders is shown as VaR as VaR Trading position.

h Whether the overall overnight position includes the amount of overnight orders.

ANNEXURE – C

SPECIMEN CHECKLIST FOR INTERNAL AUDIT OF DOMESTIC OPERATIONS OF

TREASURY

The internal auditor’s procedures with respect to the following specific areas of domestic operations of treasury would include:

Sr. No Particulars Remarks

I Investment Policy a Whether bank has framed an investment policy.

b Whether the policy is revised periodically and is in accordance with the RBI guidelines/

c Whether the policy after approval by Board is sent to RBI.

d Whether the investment activity of the bank is in consonance with the policy

II Internal Control System a. Whether there is functional separation of trading,

settlement, monitoring, control and accounting.

b Whether the deal slips contain the requisite particulars such as nature of the deal, name of the counterparty, category (HTM/AFS/HFT). Whether it is a direct deal or through a broker, and if through a broker, name of the broker, brokerage amount, details of security, amount, price, yield, contract date and time has been recorded.

Annexure – C

93

c Whether there is a functional separation of trading and back office functions relating to banks' own Investment Accounts, Portfolio Management Scheme (PMS), Clients' Accounts and other constituents (including brokers’) accounts.

d Whether there is a system to ensure that no sale transactions are put without actually holding the security in its investment account by the bank.

e Whether all the deals as per the Kondor (FO) tally with the deal details as per ITMS.

f Whether deal slips are serially numbered and controlled separately to ensure that each deal slip has been properly accounted for.

g Whether there is a system of issue of confirmation to counter party and whether timely receipt of requisite written confirmation from counter party is monitored.

h Whether any modifications were made in the deal tickets.

i Whether there has been any change in the security / counterparty after conclusion of the deal.

j Whether the back office monitors the essential details on the counterparty confirmation.

k Whether a dealer’s pad/deal blotter is maintained in respect of all transactions.

l Whether any discrepancies were observed in the dealer’s pad / deal blotter.

m Whether there is proper system for signature verification in respect of the confirmations received from the counterparty.

n Whether there was any instance of substitution of the counterparty bank by another bank by the broker.


94

o Whether there was any instance of security sold/purchased in the deal been substituted by another security.

p Whether the accounts section independently writes the books of account on the basis of the vouchers received from the back office.

q Whether profit or loss on sale is arrived at by applying weighted average cost as required by the investment policy of the bank.

r Whether a written contingency plan is in place to ensure that in the event of a breakdown of the equipment, back up facilities can be deployed at a short notice.

s In case of a sale transactions entered into on basis of the corresponding purchase contract, whether the purchase contract is confirmed prior to the sale contract and whether the same is guaranteed by CCIL or else the security is contracted for purchase from the RBI. Also whether the same transaction settles in the same settlement cycle as per the preceding purchase contract or in a subsequent settlement cycle.

t In case of securities purchased from RBI through OMO, whether the same transaction is entered into only on receiving the confirmation of buy deal or the allotment advises recieved from RBI.

III SGL Forms

a. Whether there is a system of control, accounting and verification of authenticity of SGL transfer forms issued / received.

b Whether SGL transfer forms are issued on semi/security paper in the prescribed format.

c Whether the same are serially numbered.

d Whether SGL forms are signed by two authorised signatories whose signatures are placed on record with the PDO.

Annexure – C

95

e Whether there is a system of verification of SGL forms received from other banks and confirmation of the authorised signatories.

f Whether proper records of SGL forms issued are maintained.

g Whether there were any instances of bouncing of SGL forms. If yes, whether these instances were reported to RBI immediately.

h Whether SGL forms received are deposited in the SGL account immediately (within 24 hours).

i Whether any sales are affected by return of SGL forms held.

j Whether it is ensured that there is sufficient balance in the SGL account before issuing SGL forms.

k Whether there were instances where Bank held an oversold position, i.e., selling the security without the adequate balance in investment account.

m Whether the SGL balances are reconciled at monthly intervals with balances in the books of PDO.

n Whether the settlement of transactions as per bank’s books is reflected correctly in the RBI statements.

o Whether the bank has drawn cheques on their account with the RBI for third party transactions, including inter-bank transactions.

p Whether any sale was made of security allotted to bank in the auction for primary issues. If yes, whether the contract of sale was entered once only and on the basis of an authenticated allotment advice by RBI.

q Whether there is a system of reporting exceptions in securities transactions like bouncing of SGL transfer forms to the top management.


96

r Whether the RBI guidelines on Delivery Versus Payment (DVP) III system are adhered to.

s Whether the RBI guidelines on Portfolio Management Scheme (PMS) operations are adhered to.

IV Negotiated Dealing Systems (NDS) a Whether the deals are put through by the dealers and

settled by the back office.

b Whether the settlement of transactions in Government securities and Repo transactions are settled in electronic form as per RBI guidelines.

c On completion and approval of the deal by the buyer and seller, whether the same is taken over by Clearing Corporation of India Ltd. (CCIL) for settlement via electronic mode.

d Whether the report on settlements received from Clearing Corporation of India Ltd. (CCIL) at the end of the day is reconciled with the books.

e. Whether all the call deals are reported on Negotiated Dealing Systems (NDS) as required.

V Ready Forward Deals

a Whether the bank has entered into any ready forward deal other than in the permitted securities (i.e., Treasury Bills and other approved securities).

b Whether all the ready forward contracts are settled through the SGL account maintained with RBI with CCIL acting as a central counterparty for all such transactions.

c Whether any ready forward deal was entered into without actually holding the security in the portfolio of the bank.

d In case of sale, whether the corresponding amount is deducted from the investment account of the bank and its SLR assets for the entire period of holding by purchasers/ counterparty.

Annexure – C

97

e Whether any forward or double ready forward deals were put through in any securities on behalf of PMS Clients and other constituents including brokers.

f Whether any ready forward transactions were undertaken by the bank with parties other than banks, financial institutions and mutual funds notified by RBI during the period under review.

g Whether the existing ready forward deals in dated securities have been completed on due dates without resorting to any roll over or extension.

h Whether the ready forward deals are correctly accounted for.

i Whether the bank has followed the guidelines issued by the RBI (RBI Master circular dated 2nd July 2007) in respect of ready forward transactions.

j Whether the securities contracted for repurchase are sold on the basis of the settlement cycle coinciding with the second leg of ready forward deal or a subsequent settlement cycle.

k Whether any double ready forward transactions have been put through.

VI Transactions with Constituents

b Whether the bank is providing a facility to its customers for opening of constituent account.

c Whether the bank maintains the separate account in respect of constituents.

d Whether requisite instructions in respect of settlements are received from the constituent account holders.

e Whether the deal details are correctly recorded in the ITMS system.

f Whether the Constituent Subsidiary General Ledger (CSGL) balances are reconciled at monthly intervals with balances in the books of Public Debt Office (PDO).


98

g Whether the signature in the requisition letter received from the constituent match with the list of authorised signatories.

h Whether the bank obtains independent confirmation from the constituents of the holdings held by the bank on their behalf.

VII Call Money Transactions

a Whether call borrowal/deposit receipts are acknowledged by the counterparty.

b Whether cheques received from counterparties were deposited on the same day.

c Whether cheques received from counter parties were routed through clearing channels.

d Whether there were any defaults on settlement.

e Whether interest paid on call borrowings and interest received on call lending were computed correctly.

f Whether the transactions of borrowing by the bank during the month are correctly accounted.

VIII Banker’s Reciepts

a Whether bank receipts have been issued or received.

b Whether the bank has any outstanding banker’s receipts.

IX Dealings Through Brokers

a Whether criteria have been laid down for empanelment and delisting of brokers andit is being reviewed annually.

b Whether the brokers are the members of specified stock exchanges.

c Whether services of broker(s), who are not empanelled with the bank, are taken.

Annexure – C

99

d Whether broker note is received for each deal entered through broker containing relevant details.

e Whether the details given in the broker's note agree with the details as per the deal ticket.

f Whether the brokers contract note clearly indicates the name of the counterparty.

g Whether broker-wise record is being maintained of deals put through brokers and brokerage is paid.

h Whether the bills received from brokers are checked and reviewed by the staff independent of trading prior to payment.

i Whether the broker’s role is restricted to bring the two parties to deal together (i.e. broker is not involved in funds settlement and delivery of securities).

j Whether the transactions entered into through individual brokers exceed 5% of the total transactions.

k If yes, whether such excesses have been reported to the Board through half yearly review.

l Whether accounting for brokerage is correct.

X Non-SLR Investments

A General a Whether bank’s aggregate capital market exposure is

within the limit of 40 per cent of its net worth on a solo and consolidated basis as per RBI circular ref no: DBOD. No. Dir. BC. 47/13.07.05/2006-2007 dated 15th December 2006.

b Whether the bank is monitoring the exposure limits in respect of the investment transactions in Non-SLR securities.

c Whether the bank has framed an investment policy in respect of investments in Non SLR investments


100

including prudential limits on investments in bonds and debentures, caps on unrated issues, private placements, sub-limits for PSU bonds, corporate bonds and guaranteed bonds, etc.

d Whether the bank has exceeded the limit of 25% of the total Investment portfolio for investments under Held to Maturity category.

e Whether the credit exposure in respect of investments in corporate is being monitored.

f Whether the physical verification of investments was conducted. In case where the stock is held in Demat form, whether the same have been checked with the holding statement received from the Depository Participants (DP).

g Whether the investment of the bank in unlisted securities is in consonance with RBI circular no. DBOD.BP.BC. 44/21.04.141/ 2003-04 dated November 12, 2003 and DBOD. NO. BP.BC. 53/ 21.04.141 /2003 dated December 10, 2003. • Whether original maturity period is not less than 1

year, except for those exempted category given in RBI Circular dated December 10, 2003.

• Whether prudential limits were complied with as on 31st March of previous year.

• Whether the security (except for those exempted category) has been rated. Whether rating is as per RBI guidelines prescribed vide circular dated December 10, 2003.

• Whether the investments are made in listed debt securities of companies, which have complied with SEBI guidelines.

h In case investment is in privately placed security, whether copy of offer document has been filed with Credit Information Bureau (India) Ltd. (CIBIL).

Annexure – C

101

i Whether total investments in unlisted non-SLR securities exceed 10% of total investment in non-SLR securities as on March 31 of the Previous Year.

j Whether excess over 10%, if any, is on account of investment in securitization papers issued for infrastructure projects, bonds/debentures/Pass through certificates issued by Securitization Companies and Reconstruction Companies.

k Whether excess over 10% as mentioned above, if any, is within 20% of total investment in non-SLR and is in prescribed instruments.

l Whether internal credit analysis and internal rating system is referred to the Credit Committee/ Independent authority for their assessment.

m Whether quarterly review of investments in non-SLR has been undertaken as per RBI guidelines and placed before the Board.

n Whether there is any default (of privately placed security) with regard to interest/ installment. If yes, whether matter reported to Credit Information Bureau (India) Ltd. (CIBIL) along with a copy of the offer document.

o Whether any investment is non-performing investment (NPI).

p Whether extent of non-performing investment in non-SLR category has been placed before Board for review at least at quarterly intervals.

q Whether all trades other than spot transactions in listed security are executed through stock exchange.

r Whether transition time frame, as detailed below, is being adhered to: • RBI guidelines with regard to investment in units of

mutual fund schemes where the entire corpus is


102

invested in debt securities will be applicable from 31-12-2004.

• With effect from January 1, 2005 only investment in units of such mutual fund schemes which have an exposure to unlisted securities of less than 10 per cent of the corpus of the fund will be treated on par with listed securities for the purpose of compliance with the prudential limits prescribed in the above guidelines.

A) Investments in the existing unlisted securities (those issued on or before November 30, 2003).

B) With effect from April, 2004, investments in above category of unlisted securities until 31-12-2004 provided the issuers have applied to the stock exchange(s) for listing and the security is rated minimum investment grade.

C) Investment in unlisted securities issued after November 30, 2003 provided it is up to 10% of incremental Non-SLR investments over the outstanding Non-SLR investments as on November 30, 2003 up to December 31, 2004.

B Bonds and Debentures

a Whether the bank has invested in any securities, which do not have the minimum rating as prescribed by the investment policy of the bank. If so and where the external rating is not available, Whether the bank has obtained the waiver from the appropriate authority for the same.

b Whether any delay was observed in receipt of stock or any instance of delivery of stock with late receipt of funds.

C Equity Shares

a Whether there were any investments in equity shares during the month under review.

Annexure – C

103

b Whether separate broker notes are received for each transaction.

c Whether the investments and dis-investments are done in respect of scripts approved by the Board.

d Whether all the scripts are listed on the stock exchange.

e Whether all purchases and sales result in actual receipt/ delivery and no arbitrage operation is undertaken.

f Whether the Investment Committee reviews the investments in equities.

g Whether the investments in shares in a company exceed 30% of the paid up capital of that company or 30% of its own share capital and reserves, whichever is less, as required by Section 19(2) of the Banking Regulation Act.

h Whether transaction in equities are reflected in the DEMAT statement within reasonable period and there are no instances of abnormal delays in the debit/credit of the instrument to the Bank’s demat account.

i Whether the Closing Stock Report tallies with the DP Holding Statement.

D Mutual Funds a Whether any transaction undertaken in mutual funds

during the month is under review. If yes, appropriate documents were kept on record.

b Whether there are any transaction put through by the branches. If yes, whether required documents such as the e-mail containing approval of the appropriate authority and the transaction statement are attached with the deal ticket.

c Whether in case of sale, the Net Asset Value (NAV) at which the sale is made matches with the statement of account received from the mutual fund.


104

d Whether accounting for purchases and sales including profit or loss on sale is correctly done.

e Whether dividend has been received on the mutual fund units.

f Whether any amount lying in the application money as on month ending is outstanding for more than 30 days. If yes, verify the details of the same.

E Commercial Paper a Whether the tenors of the Commercial Papers are not

less than 7 days and not exceeding one year from the date of issue?

b Whether the denominations of Commercial Papers are in multiples of Rs.5 lakhs.

c Whether bank is holding letter from issuing and Paying Agent (IPA) that they are holding in custody certified copies of: • Credit Rating Certificate • Letter of offer of CP • Board resolution authorising issue of the CP • Declaration from the issuer that the amount

proposed to be raised is within the ceiling mentioned by the credit rating agency or as approved by the Board whichever is lower, and also state the amount of CP issued and subscribed so far on the strength of the credit rating under reference.

d Whether maturity date of Commercial Paper is not beyond the date upto which the credit rating of the issuer is valid.

e Whether the transactions have been accounted for correctly.

f Whether the interest on Commercial paper is accrued in accordance with the RBI guidelines dated 13 July, 2006.

Annexure – C

105

F Certificate of Deposit (CD) a Whether the maturity period of the CDs is in accordance

with the RBI Circuilar.

b Whether the denomination of CDs is in multiples of Rs. 1 lakh.

XI Accounting and Valuation A Accounting

a Whether the bank has classified its investments into ‘Held to Maturity (HTM), Available for Sale (AFS) and Held for Trading (HFT)’ as per RBI guidelines.

b Whether the category of the investment is decided at the time of acquisition of the security and the same is mentioned on the deal ticket.

c Whether cost associated with acquisition of securities such as brokerage, commission and stamp charges, etc. are recognised as expenses and not as part of cost of investment.

d Whether the shifting of investment to/from Held to Maturity is done by the bank at the beginning of the year with the approval of the Board of Directors.

e Whether there was an instance of an investment in the Held for Trading category not sold off within the stipulated period of 90 days.

f Whether approval has been obtained from the appropriate authority for transfer of security from Available for Sale to Held for Trading or vice versa.

g Whether the shifting between categories has been done at the least of market value of security, acquisition cost or book value as on the day of transfer.

h Whether loss is recognised on transfer of security from one category to another.


106

i Whether all the transactions have been correctly accounted.

j Whether income on securities was accounted correctly.

k Whether the investment in the nature of advanceare in accordance with the guidelines issued by RBI.

l Whether the broken period interest paid at the time of acquisition of security is taken as part of cost of the investment.

m Whether broken period interest has been correctly calculated.

n Whether the bank has been accruing interest on securities at monthly intervals Or at more frequent intervals.

B Valuation

i. Held to Maturity Category

a Whether investments under the HTM category are carried at their acquisition cost and are not marked to market.

b Whether any premium on the acquisition of a security is amortised over the balance period.

ii. Available for Sale Category

a Whether the valuation of investments has been done at quarterly intervals or at more frequent intervals as required by RBI guidelines.

b Whether necessary accounting entries for valuation are passed in accordance with the RBI guidelines.

c Whether investments are revalued at cost or market price which ever is lower.

d Whether the net depreciation, if any, under each classification has been provided for.

Annexure – C

107

iii. Held for Trading Category

a Whether investments are marked to market at monthly intervals as required by RBI guidelines.

b Whether the net depreciation, if any, under each classification has been provided for.

c Whether equity investments under each of the above three categories are marked to market at monthly or more frequent intervals as required by the RBI Guidelines on.

d Whether treasury bills are valued at carrying cost by the bank.

XII Audit, Review and Reporting a Whether half-yearly review of investment portfolio

indicating and certifying an adherence to the laid down investments policy and procedures and RBI guidelines is undertaken and whether the same has been placed before the Board within a month and a copy of the same was forwarded to RBI.

b Whether periodical returns are submitted to RBI on due dates.

c Whether the returns submitted to RBI are accurate.

XIII Income a Whether due date diary for interest and redemption is

maintained by the back office.

b Whether redemption money due is received during the monthon due dates

c Whether there are cases of overdue redemptions in investments. If yes, verify the details.

d Whether interest due is received during the month for all investments as per coupon dates falling within that month.


108

e Whether there are any cases of overdue interest on investments. If yes, verify the details.

f Whether the interest on delayed payment is received.

g Whether interest accrued on investments is correctly computed.

h Whether TDS on interest is accounted for properly.

i In case the interest/principal on the debentures/ bonds is in arrears, whether the provisions for the same are made.

ANNEXURE – D

GUIDANCE NOTE ON MARKET RISK MANAGEMENT

INDEX

Chapter No. Subject Page No.

1. Policy Framework 2. Organizational set up 3. Liquidity Risk Management 4. Interest Rate Risk Management 5. Foreign Exchange Risk Management 6. The Treatment of Market Risk in the

Proposed Basel Capital Accord:

Annexures Annexure I BCBS Principles for the Assessment of

Liquidity Management in Banks

Annexure II BCBS Principles for Interest Rate Risk Management

Annexure III Sources, effects and measurement of interest rate risk

Annexure IV Value at Risk Annexure V Stress Testing


110

Chapter 1- Policy Framework 1.1 Market Risk may be defined as the possibility of loss to a bank caused by changes in the market variables. The Bank for International Settlements (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. Thus, Market Risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. Besides, it is equally concerned about the bank’s ability to meet its obligations as and when they fall due. In other words, it should be ensured that the bank is not exposed to Liquidity Risk. This Guidance Note would, thus, focus on the management of Liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity price risk and equity price risk. 1.2 An effective market risk management framework in a bank comprises risk identification, setting up of limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk reporting, etc. These aspects are elaborately discussed in the ensuing paragraphs. 1.2.1 Risk Identification • All Risk Taking Units must operate within an approved Market Risk

Product Programme; this should define procedures, limits and controls for all aspects of the product.

• New products may operate under a Product Transaction Memorandum on a temporary basis while a full Market Risk Product Programme is being prepared. At the minimum this should include procedures, limits and controls. The final product transaction program should include market risk measurement at an individual product and aggregate portfolio level.

1.2.2 Limits and Triggers • All trading transactions will be booked on systems capable of

accurately calculating relevant sensitivities on a daily basis; usage of

Annexure – D

111

Sensitivity and Value at Risk limits for trading portfolios and limits for accrual portfolios (as prescribed for ALM) must be measured daily. Where market risk is not measured daily, Risk Taking Units must have procedures that monitor activity to ensure that they remain within approved limits at all times.

• Mandatory market risk limits are required for Factor Sensitivities and Value at Risk for mark to market trading and appropriate limits for accrual positions including Available-for-Sale portfolios. Requests for limits should be submitted annually for approval by the Risk Policy Committee. The approval will take into consideration the Risk Taking Unit's capacity and capability to perform within those limits evidenced by the experience of the Traders, controls and risk management, audit ratings and trading revenues.

• Approved Management Action Triggers or Stop-loss are required for all mark to market risk taking activities.

• Risk Taking Units are expected to apply additional, appropriate market risk limits, including limits for basis risk, to the products involved; these should be detailed in the Market Risk Product Programme.

1.2.3 Risk Monitoring • A rate reasonability process is required to ensure that all transactions

are executed and revalued at prevailing market rates; rates used at inception or for periodic marking to market for risk management or accounting purposes must be independently verified.

• Financial Models used for revaluations for income recognition purposes or to measure or monitor Price Risk must be independently tested and certified.

• Stress tests must be performed preferably quarterly for both trading and accrual portfolios. This may be done when the underlying assumptions of the model/ market conditions significantly change as decided by the Asset Liability Committee.

1.2.4 Models of analysis • Line Management must ensure that the software used in Financial

Models that value positions or measure market risk is performing


112

appropriate calculations accurately. • The Risk Policy Committee is responsible for administering the model

control and certification policy, providing technical advice through qualified and competent personnel. It is left to the bank to seek any independent certification.

• Financial Models must be fully documented and minimum standards of documentation must be established.

• Someone other than the person who wrote the software code must perform certification of models; testers must be competent in designing and conducting tests; records of testing must be kept, including details of the type of tests and their results. Assumptions contained in the Financial Models must be documented as part of he initial certification and reviewed annually. Unusual parameter sourcing conventions require annual approval by the Risk Policy Committee.

• Any mathematical model that uses theory, formulae or numerical techniques involving more than simple arithmetic operations must be validated to ensure that the algorithm employed is appropriate and accurate.

• Persons who are acceptable to the Risk Policy Committee and independent of the area creating the model must validate models in writing. It is left to the bank to decide on who should validate, whether internal or external, at the discretion of the Risk Policy Committee.

• Models to calculate risk measures like Sensitivities to market factors either at transaction or portfolio level and Value-at-Risk should be validated independently.

• Unauthorised or unintended changes should not be made to the models. These standards should also apply to models that are run on spreadsheets until development of fully automated processors for generating valuations and risk measurements.

• The models should also be subject to model assumption review on a periodic basis. The purpose of this review is to ensure applicability of the model over time and that the model is valid for its original intended use. The review consists of evaluating the components of the financial model and the underlying assumptions, if any.

Annexure – D

113

1.2.5 Risk Reporting: Risk report should enhance risk communication across different levels of the bank, from the trading desk to the CEO. In order of importance, senior management reports should: • be timely • be reasonably accurate • highlight portfolio risk concentrations • include written commentary, and • be concise.


114

Chapter 2- Organisational Set Up

2.1 Management of market risk should be the major concern of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/ risk parameters laid down by the Board.

2.2 Successful implementation of any risk management process has to emanate from the top management in the bank with the demonstration of its strong commitment to integrate basic operations and strategic decision making with risk management. Ideally, the organization set up for Market Risk Management should be as under :-

• The Board of Directors

• The Risk Management Committee

• The Asset-Liability Management Committee (ALCO)

• The ALM support group/ Market Risk Group

i) The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.

ii) The Risk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will decide the policy and strategy for integrated risk management containing various risk exposures of the bank including the market risk. The responsibilities of Risk Management Committee with regard to market risk management aspects include:

• Setting policies and guidelines for market risk measurement,

Annexure – D

115

management and reporting

• Ensuring that market risk management processes (including people, systems, operations, limits and controls) satisfy bank’s policy

• Reviewing and approving market risk limits, including triggers or stop-losses for traded and accrual portfolios

• Ensuring robustness of financial models, and the effectiveness of all systems used to calculate market risk

• Appointment of qualified and competent staff; Ensuring posting of qualified and competent staff and of independent market risk manager/s, etc.

iii) The Asset-Liability Management Committee, popularly known as ALCO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank in line with bank’s budget and decided risk management objectives. The role of the ALCO should include, inter alia, the following:-

• Product pricing for deposits and advances

• Deciding on desired maturity profile and mix of incremental assets and liabilities

• Articulating interest rate view of the bank and deciding on the future business strategy

• Reviewing and articulating funding policy

• Decide the transfer pricing policy of the bank

• Reviewing economic and political impact on the balance sheet The size (number of members) of ALCO would depend on the size of each institution, business mix and organisational 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


116

Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerisation. Some banks may even have Sub-committees and Support Groups.

iv) The ALM Support Groups consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The Risk management group should 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, etc.

v) The Middle Office is responsible for the critical functions of independent market risk monitoring, measurement, analysis and reporting for the bank’s ALCO. Ideally this is a full time function reporting to, or encompassing the responsibility for, acting as ALCO's secretariat. An effective Middle Office provides the independent risk assessment which is critical to ALCO's key-function of controlling and managing market risks in accordance with the mandate established by the Board/Risk Management Committee. It is a highly specialised function and must include trained and competent staff, expert in market risk concepts. The methodology of analysis and reporting will vary from bank to bank depending on their degree of sophistication and exposure to market risks. These same criteria will govern the reporting requirements demanded of the Middle Office, which may vary from simple gap analysis to computerised VaR modelling. Middle Office staff may prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to risk exposures. Banks using VaR or modelling methodologies should ensure that its ALCO are aware of and understand the nature of the output, how it is derived, assumptions and variables used in generating the outcome and any shortcomings of the methodology employed. Segregation of duties should be evident in the middle office which must report to ALCO independently of the treasury function. In respect of banks without a formal Middle Office, it should be ensured that risk control and analysis should rest with a department with clear reporting independence from Treasury or risk taking units, until formal Middle Office frameworks are established.

Annexure – D

117

TYPICAL ORGANISATIONAL STRUCTURE FOR RISK MANAGEMENT


118

2.3 The Dealing Room

The Treasury Dealing Room within a bank is generally the clearing house for matching, managing and controlling market risks. It may provide funding, liquidity and investment support for the assets and liabilities generated by regular business of the bank. The Dealing Room is responsible for the proper management and control of market risks in accordance with the authorities granted to it by the bank's Risk Management Committee. The Dealing Room also is responsible for meeting the needs of business units in pricing market risks for application to its products and services. The Dealing Room acts as the bank's interface to international and domestic financial markets and generally bears responsibility for managing market risks in accordance with instructions received from the bank's Risk Management Committee.

The Dealing Room may also have allocated to it by Risk Management Committee, a discretionary limit within which it may take market risk on a proprietary basis. For these reasons effective control and supervision of bank's Dealing Room activities is critical to its effectiveness in managing and controlling market risks.

Critical to a Dealing Room's effective functioning is dealers’ access to a comprehensive Dealing Room manual covering all aspects of their day-today activities. All dealers active in day-to-day trading activities must acknowledge familiarity with and provide an undertaking in writing to adhere to the bank's dealing guidelines and procedures. A Dealing Room procedures manual should be comprehensive in nature covering operating procedures for all the bank’s trading activities in which the Dealing Room is involved and in particular must cover the bank's requirements in respect of:

• Code of Conduct - all dealers active in day-to-day trading activities in the lndian market must acknowledge familiarity with and provide an undertaking to adhere to FEDAI code of conduct (and FIMMDA when available).

• Adherence to Internal Limits - All dealers must be aware of, acknowledge and provide an undertaking to adhere to the limits governing their authority to commit the bank to risk exposures as they apply to their own particular risk responsibilities and level of seniority.

• Adherence to RBI limits and guidelines - All dealers must acknowledge and provide an undertaking to adhere to their responsibility to remain within RBI limits and guidelines in their area of

Annexure – D

119

activity.

• Dealing with Brokers - All dealers should be aware of, acknowledge and provide an undertaking to remain within the guidelines governing the bank's activities with brokers including conducting business only with brokers authorised by bank's Risk Management Committee on the bank's Brokers Panel.

• Ensuring their activities with brokers do not allow for the brokers to act as principals in transactions, but remain strictly in their authorised role as market intermediaries.

• Requiring brokers to provide all broker notes and confirmations of transactions before close of business each day (or exceptionally by the beginning of the next business day, in which case the note must be prominently marked by the broker as having been transacted the previous day, and the Back Office must recast the previous night's position against limits reports) to the bank's Back Office for reconciliation with transaction data.

• Ensuring all brokerage payments and statements are received, reconciled and paid by the bank's Back Office department and under no circumstances authorised or any payment released by dealers.

• Prohibiting the acceptance by dealers of gifts, gratifications or other favours from brokers, instances of which should be reported in detail to RBI’s Department of Banking Supervision indicating the nature of the case

• Prohibiting dealers from nominating a broker in transactions not done through that broker.

• Rules for the prompt investigation of complaints against dealers and malpractices by brokers and reporting to FEDAI and RBI’s Department of Banking Supervision.

• Dealing Hours - All Dealers should be aware of the bank's normal trading hours, cut off time for overnight positions and rules governing after hours and off-site trading (if allowed by the bank)

• Security and Confidentiality - All dealers should be aware of the bank's requirements in respect of maintaining confidentiality over its own and its customers' trading activities as well as the responsibility for


120

secure maintenance of access media, keys, passwords and PINS.

• Staff Rotation and leave requirements - All dealers should be aware of the requirement to take at least one period of leave of not less than 14 days continuously per annum, and the bank's internal policy in regards to staff rotation.

2.4 The Back Office

The key controls over market risk activities, and particularly over Dealing Room activities, exist in the Back Office. It is critical that both a clear segregation of duties and reporting lines is maintained between Dealing Room staff and Back Office staff, as well as clearly defined physical and systems access between the two areas. It is essential that critical Back Office controls are executed diligently and completely at all times including:

• The control over confirmations both inward and outward: All confirmations for transactions concluded by the Dealing Room must be issued and received by the Back Office only. Discrepancies in transaction details, non-receipts and receipts of confirmations without application must be resolved promptly to avoid instances of unrecorded risk exposure.

• The control over dealing accounts (vostros and nostros)- Prompt reconciliation of all dealing accounts is an essential control to ensure accurate identification of risk exposures. Discrepancies, non-receipts and receipts of funds without application must be resolved promptly to avoid instances of unrecorded risk exposure. Unreconciled items and discrepancies in these accounts must be kept under heightened management supervision as such discrepancies may at times have significant liquidity impacts, represent unrecognised risk exposures, or at worst represent collusion or fraud.

• Revaluations and marking-to-market of market risk exposures: All market rates used by the bank for marking risk exposures to market, used to revalue assets or for risk analysis models such as Value at Risk analysis, must be sourced independently of the Dealing Room to provide an independent risk and performance assessment. If the bank has an established and independent Middle Office function, this responsibility may properly pass to the Middle Office.

• Monitoring and reporting of risk limits and usage: Reporting of

Annexure – D

121

usage of risk against limits established by the Risk Management Committee (as well as Credit Department for Counterparty risk limits) should be maintained by the Back Office independently of the Dealing Room. The Back Office must also undertake maintenance of all limit systems and access to limit systems (such as counterparty limits, overnight limits etc.) must be secure to avoid unauthorised access and tampering. If the bank has an established and independent Middle Office function, this responsibility may properly pass to the Middle Office.

• Control over payments systems: The procedures and systems for making payments must be under at least dual control in the Back Office independent from the dealing function. Payments systems should be at all times secure from access or tampering by unauthorised personnel.


122

Chapter 3- Liquidity Risk Management 3.1 Liquidity risk is the potential inability to meet the bank’s liabilities as they become due. It arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and liabilities. 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. 3.2 Analysis of liquidity risk involves the measurement of not only the liquidity position of the bank on an ongoing basis but also examining how funding requirements are likely to be affected under crisis scenarios. Net funding requirements are determined by analysing the bank’s future cash flows based on assumptions of the future behaviour of assets and liabilities that are classified into specified time buckets and then calculating the cumulative net flows over the time frame for liquidity assessment. 3.3 Future cash flows are to be analysed under “what if” scenarios so as to assess any significant positive / negative liquidity swings that could occur on a day-to-day basis and under bank specific and general market crisis scenarios. Factors to be taken into consideration while determining liquidity of the bank’s future stock of assets and liabilities include their potential marketability, the extent to which maturing assets /liability will be renewed, the acquisition of new assets / liability and the normal growth in asset / liability accounts. 3.4 Factors affecting the liquidity of assets and liabilities of the bank cannot always be forecast with precision. Hence they need to be reviewed frequently to determine their continuing validity, especially given the rapidity of change in financial markets. 3.5 The liquidity risk in banks manifest in different dimensions: i) Funding Risk – need to replace net outflows due to

unanticipated withdrawal/non-renewal of deposits (wholesale and retail);

ii) Time Risk – need to compensate for non-receipt of expected

Annexure – D

123

inflows of funds, i.e. performing assets turning into non-performing assets; and

iii) Call Risk – due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

3.6 The first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia , should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting / reviewing, etc. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are Loans to Total Assets, Loans to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans, etc. 3.7 While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on projected future behaviour of assets, liabilities and off-balance sheet items. In other words, banks should have to analyse the behavioural maturity profile of various components of on / off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance analysis, at least, once in six months to validate the assumptions. The assumptions should be fine-tuned over a period which facilitate near reality predictions about future behaviour of on / off- balance sheet items. Apart from the above cash flows, banks should also track the


124

impact of prepayments of loans, premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallised. 3.8 The difference between cash inflows and outflows in each time period, the excess or deficit of funds, becomes a starting point for a measure of a bank’s future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits as detailed below to avoid liquidity crisis: i) Cap on inter-bank borrowings, especially call borrowings; ii) Purchased funds vis-à-vis liquid assets; iii) Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio,

Statutory Liquidity Ratio and Loans; iv) Duration of liabilities and investment portfolio; v) Maximum Cumulative Outflows across all time bands; vi) Commitment Ratio – track the total commitments given to

corporates/banks and other financial institutions to limit the off- balance sheet exposure;

vii) Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

3.9 Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further, the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc. 3.10 The liquidity profile of the banks could be analysed on a static basis, wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern and the sensitivity of these items to changes in market interest rates and

Annexure – D

125

environment are duly accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to: 1) Seasonal pattern of deposits/loans; 2) Potential liquidity needs for meeting new loan demands,

unavailed credit limits, potential deposit losses, investment obligations, statutory obligations, etc.

3.11 Contingency Funding Plan • All banks are required to produce a Contingency Funding Plan.

These plans are to be approved by ALCO, submitted annually as part of the Liquidity and Capital Plan, and reviewed quarterly. The preparation and the implementation of the plan may be entrusted to the treasury.

• Contingency Funding Plans are liquidity stress tests designed to quantify the likely impact of an event on the balance sheet and the net potential cumulative gap over a 3-month period. The plan also evaluates the ability of the bank to withstand a prolonged adverse liquidity environment. At least two scenarios require testing: Scenario A, a local liquidity crisis, and Scenario B, where there is a nationwide name problem or a downgrade in the credit rating if the bank is publicly rated.

• The bank’s contingency funding plans should reflect the funding needs of any bank managed mutual fund whose own Contingency Funding Plan indicates a need for funding from the bank.

• Reports of Contingency Funding plans should be performed at least quarterly and reported to ALCO.

• If a Contingency Funding plan results in a funding gap within a 3-month time frame, the ALCO must establish an action plan to address this situation. The Risk Management Committee should approve the action plan.

• At a minimum, Contingency Funding plans under each scenario must consider the impact of accelerated runoff of Large Funds Providers.

• The plans must consider the impact of a progressive, tiered deterioration, as well as sudden, drastic events.


126

• Balance sheet actions and incremental sources of funding should be dimensioned with sources, time frame and incremental marginal cost and included in the Contingency Funding plans for each scenario.

• Assumptions underlying the Contingency Funding plans, consistent with each scenario, must be reviewed and approved by ALCO.

• The Chief Executive / Chairman must be advised as soon as a decision has been made to activate or implement a Contingency Funding Plan. Either the Chief Executive or the Risk Management Committee may call for implementation of a Contingency Funding Plan.

• The ALCO will implement the Contingency Funding Plan, amending it with the approval of the Risk Management Committee, where necessary, to meet changing conditions; daily reports are to be submitted to the Treasury Head, comparing actual cashflows with the assumptions of the Contingency Funding Plan.

3.12 Foreign Currency Liquidity Management 3.12.1 For banks with an international presence, the treatment of assets and liabilities in multiple currencies adds a layer of complexity to liquidity management for two reasons. First, banks are often less well known to liability holders in foreign currency markets. Therefore, in the event of market concerns, especially if they relate to a bank’s domestic operating environment, these liability holders may not be able to distinguish rumour from fact as well or as quickly as domestic currency customers. Second, in the event of a disturbance, a bank may not always be able to mobilise domestic liquidity and the necessary foreign exchange transactions in sufficient time to meet foreign currency funding requirements. These issues are particularly important for banks with positions in currencies for which the foreign exchange market is not highly liquid in all conditions. 3.12.2 Banks should, therefore, have a measurement, monitoring and control system for liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake

Annexure – D

127

separate analysis of its strategy for each currency individually. 3.12.3 When dealing in foreign currencies, a bank is exposed to the risk that a sudden change in foreign exchange rates or market liquidity, or both, could sharply widen the liquidity mismatches being run. These shifts in market sentiment might result either from domestically generated factors or from contagion effects of developments in other countries. In either event, a bank may find that the size of its foreign currency funding gap has increased. Moreover, foreign currency assets may be impaired, especially where borrowers have not hedged foreign currency risk adequately. The Asian crisis of the late 1990s demonstrated the importance of banks closely managing their foreign currency liquidity on a day-to-day basis. 3.12.4 The particular issues to be addressed in managing foreign currency liquidity will depend on the nature of the bank’s business. For some banks, the use of foreign currency deposits and short-term credit lines to fund domestic currency assets will be the main area of vulnerability, while for others it may be the funding of foreign currency assets with domestic currency. As with overall liquidity risk management, foreign currency liquidity should be analysed under various scenarios, including stressful conditions.


128

Chapter 4- Interest Rate Risk (IRR) Management 4.1 Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank’s networth since the economic value of a 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.

4.2 Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective.

Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense.

Economic Value perspective involves analysing the changes of impact og interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off- balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long- term interest rate gaps.

4.3 The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose bank’s NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility.

Annexure – D

129

4.4 Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Banking Books. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic value changes are the main focus of banking book.

4.5 Trading Book

The top management of banks should lay down policies with regard to volume, maximum maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for classifying securities in the trading book. While the securities held in the trading book should ideally be marked to market on a daily basis, the potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models. The VaR method is employed to assess potential loss that could crystallise on trading position or portfolio due to variations in market interest rates and prices, using a given confidence level, usually 95% to 99%, within a defined period of time. The VaR method should incorporate the market factors against which the market value of the trading position is exposed. The top management should put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions, derivative products, etc.) which is then disaggregated across different desks and departments. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. The potential loss in Present Value Basis Points should be matched by the Middle Office on a daily basis vis-à-vis the prudential limits stipulated (see section 2.5 for mandatory risk limits). The advantage of using VaR is that it is comparable across products, desks and Departments and it can be validated through ‘back testing’. However, VaR models require the use of extensive historical data to estimate future volatility. VaR model also may not give good results in extreme volatile conditions or outlier events and stress test has to be employed to complement VaR. The stress tests provide management a view on the potential impact of large size market movements and also attempt to estimate the size of potential losses due to stress events, which occur in the


130

‘tails’ of the loss distribution. Banks may also undertake scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical, simultaneous and related changes in multiple risk factors present in the trading portfolio to determine the impact of moves on the rest of the portfolio. VaR models could also be modified to reflect liquidity risk differences observed across assets over time. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an environment where VaR is difficult to estimate for lack of data, non- statistical concepts such as stop loss and gross/net positions can be used.

4.6 Banking Book

The changes in market interest rates have earnings and economic value impacts on the bank’s banking book. Thus, given the complexity and range of balance sheet products, banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. The variety of techniques ranges from simple maturity (fixed rate) and repricing (floating rate) gaps and duration gaps to static simulation, based on current on-and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk, embedded option risk, yield curve risk, etc.

4.7 Rigidities and the remedial measures:

4.7.1 However, there are certain rigidities at micro level of banks and also at the systemic level, which the banks have to address. At the micro level, the banks have to strengthen their Management Information System (MIS) and computer processing capabilities for accurate measurement of interest rate risk in their banking books, which impact, in the short-term, their net interest income (NII) or net interest margin (NIM) or “spread” and in the long-term, the economic value of the bank.

4.7.2 At the systemic level, the rigidities are the following:

• Most of the liabilities of banks, like deposits and borrowings are on fixed interest rate basis while their assets like loans and advances are on floating rate basis.

Annexure – D

131

• There is still some regulation in place on interest rates in the system, such as savings bank deposit, export credit, refinances, etc.

• There is no definite interest rate repricing dates for floating Prime Lending Rate (PLR) based products like loans and advances, thereby placing them in accurate time buckets for measurement of interest rate risk difficult.

he RBI has taken a number of measures to correct the systemic rigidities, like introduction of:

• Floating rate deposits,

• Fixed rate lending,

• Tenor-linked PLR,

• Interest rate derivative products like Interest Rate Swaps (IRSs) and Forward Rate Agreements (FRAs), and

• For pricing of rupee interest rate derivatives, banks have been allowed to use interest rate implied in foreign exchange forward market, etc.

4.7.3 In order to align the Indian accounting standards with the international best practices and taking into consideration the evolving international developments, the norms for classification and valuation of investments have been modified with effect from September 30, 2000. Now, the entire investment portfolio is required to be classified under three categories, viz., Held to Maturity, Available for Sale and Held for Trading. While the securities ‘Held for Trading’ and ‘Available for Sale’ should be marked to market periodically, the securities ‘Held to Maturity’, which should not exceed 25% of the total investments need not be marked to market.

4.8 The Narasimham Committee II on Banking Sector Reforms had recommended that in order to capture market risk in the investment portfolio, a risk-weight of 5% should be applied for Government and other approved securities for the purpose of capital adequacy. The Reserve Bank of India has prescribed 2.5% risk-weight for capital adequacy for market risk on SLR and non-SLR securities, with effect from 31 March 2000 and 2001 respectively, in addition to appropriate risk-weights for credit risk. It may be mentioned here that the Basle Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS) has introduced capital charge for market risk, inter alia, for the interest rate related instruments and equity


132

positions in the trading book and gold and forex position in both trading and banking books. The banks in India are required to apply the 2.5% risk-weight for capital charge for market risk for the whole investment portfolio and 100% risk- weight on open gold and forex position limits. In the “New Capital Adequacy Framework” consultative paper, the BCBS recognises the significance of interest rate risk in some banking books and proposes to develop a capital charge for interest rate risk in the banking book for banks where interest rate risks are significantly above average (“outliers”). (The proposed Basel Capital Accord is separately covered in Chapter 7 and annexure)

4.9 Equity Position Risk Management

Internationally banks use VAR models for management of equity position risk. The banks should devise specific price risk structure (like sensitivity limits, VAR, stop-loss limits) and the methods to measure liquidity of shares to mitigate equity position risk.

Annexure – D

133

Chapter 5- Foreign Exchange Risk Management 5.1 The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks’ balance sheets. Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premia/discounts of the currencies concerned.

5.2 In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallisation does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one centre and the settlement of another currency in another time-zone. The forex transactions with counterparties from another country also trigger sovereign or country risk (dealt with in details in the guidance note on credit risk).

5.3 The three important issues that need to be addressed in this regard are:

• Nature and magnitude of exchange risk

• The strategy to be adopted for hedging or managing exchange risk.

• The tools of managing exchange risk.

5.4 Nature and Magnitude of Risk

5.4.1 The first aspect of management of foreign exchange risk is to acknowledge that such risk does exist and that it must be managed to avoid adverse financial consequences. Many banks refrain from active management of their foreign exchange exposure because they feel that


134

financial forecasting is outside their field of expertise or because they find

it difficult to measure currency exposure precisely. However not recognising a risk would not make it go away. Nor is the inability to measure risk any excuse for not managing it. Having recognized this fact the nature and magnitude of such risk must now be identified.

5.4.2 The basic difficulty in measuring exposure comes from the fact that available accounting information which provides the most reliable base to calculate exposure (accounting or translation exposure) does not capture the actual risk a bank faces, which depends on its future cash flows and their associated risk profiles (economic exposure). Also there is the distinction between the currency in which cash flows are denominated and the currency that determines the size of the cash flows. For instance a borrower selling jewellery in Europe may keep its records in Rupees, invoice in Euros, and collect Euro cash flow, only to find that its revenue stream behaves as if it were in U.S. dollars! This occurs because Euro- prices for the exports might adjust to reflect world market prices which could be determined in U.S. dollars.

5.4.3 Another dimension of exchange risk involves the element of time. In the very short run, virtually all local currency prices for goods and services (although not necessarily for financial assets) remain unchanged after an unexpected exchange rate change. However, over a longer period of time, prices and costs respond to price changes. It is therefore necessary to determine the time frame within which the bank can react to (unexpected) rate changes.

5.4.4 For a bank, being a financial entity, it is relatively easier to gauge the nature as well as the measure of forex risk simply because all financial assets/liabilities are denominated in a currency. A bank’s future cash streams are more predictable than those of a non-financial firm. Its net exposure, or position, completely encapsulates the measure of its exposure to forex risk.

5.4.5 In order to manage forex risk some forex market relationships need to be understood well. The first and most important of these is the covered interest parity relationship. If there is free and unrestricted mobility of capital, the interest differential between two currencies will equal the forward premium/discount for either of the currency. This relationship must hold under the assumptions; otherwise arbitrage opportunities will arise to restore the relationship. However, in the case of Rupee, since it is not totally

Annexure – D

135

convertible, this relationship does not hold exactly. Although interest rate differentials are the driving factor for the Dollar premium against the Rupee, it also is a factor of forward demand / supply factors. This brings in typical complications to forward hedging which must be taken into account.

5.4.6 From the above it can easily be determined that a currency with a lower interest rate will be at a premium to a currency with a higher interest rate. The other relationships in the forex market are not as deterministic as the covered interest parity, but needs to be recognised to manage forex exposure because they are the theoretical tools used for predicting exchange rate movements, essential to any hedging strategy particularly to economic risk as opposed to accounting risk. The most important of these is the Purchasing Power Parity relationship which says exchange rate changes are determined by inflation differentials. The Uncovered Interest Parity theory says that the forward exchange rate is the best and unbiased predictor of future spot rates under risk neutrality. These relationships have to be clearly understood for any meaningful forex risk management process.

5.5 Managing Foreign Exchange Risk

5.5.1 For a bank therefore the first major decision on forex risk management is for the management to fix its open foreign exchange position limits. Although typically this is a management decision, it could also be subject to regulatory capital and could also be required to be in tune with the regulatory environment that prevails. These open position limits have two aspects, the Daylight limit and the Overnight limit. The daylight limit could typically be substantially higher for two reasons, (a) It is easier to manage exchange risk when the market is open and the bank is actively present in the market and (b) the bank needs a higher limit to accommodate client flows during business hours. Overnight position, being subject to more uncertainty and therefore being more risky should be much lower.

5.5.2 Having decided on the overall open position limits, the next step is to allocate these limits among different operating centres of the bank (in the case of banks which hold positions at multiple centres). Within a centre there could be a further allocation among different dealers. It must however be ensured that the bank has a system to monitor the overall open position limit for the bank on a real time basis.

5.6 Tools and Techniques for managing forex risk

5.6.1 There are various tools, often substitutes, available for hedging of


136

foreign exchange risk like over the counter forwards, futures, money market instruments, options and the like. Most currency management instruments enable the bank to take a long or a short position to hedge an opposite short or long position. In equilibrium and in an efficient market the cost of all will be the same, according to the fundamental relationships. The tools differ to the extent that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows where risk is non-linear: options may be better suited to the latter.

5.6.2 Foreign exchange forward contracts are the most common means of hedging transactions in foreign currencies. However since they require future performance, and if one party is unable to perform on the contract, the hedge disappears, bringing in replacement risk which could be high. This default risk also means that many banks may not have access to the forward market to adequately hedge their exchange exposure. For such situations, futures may be more suitable, where available, since they are exchange traded and effectively minimise default risk. However, futures are standardised and therefore may not be as versatile in terms of quantity and tenor as over the counter forward contracts. This in turn gives rise to assumption of basis risk.

5.6.3 Money market borrowing to invest in interest-bearing assets to offset a foreign currency payment – also serves the same purpose as forward contracts. This follows from the covered interest parity principle. Since the carrying cost of a position is the same in both, the forex or the money market hedging can also be done in either market. For instance, let us say a bank has a short forward Dollar position. It can of course hedge the position by buying forward Dollars. Alternatively it can borrow Rupees now, buy Dollar with the proceeds, and place the Dollars in a forward deposit to meet the short Dollar position on maturity. The Rupees received on the sale on maturity are used to pay off the Rupee borrowing. The cost of this money market hedge is the difference between the Rupee interest rate paid and the US dollar interest rate earned. According to the interest rate parity theorem, the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge.

5.6.4 Currency options are another tool for managing forex risk. A foreign exchange option is a contract for future delivery of a currency in exchange for

Annexure – D

137

another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, the strike or exercise price, but is not required to do so. The right to buy is a call; the right to sell, a put. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the instrument being delivered is the currency itself; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date; European options, only on the expiration date.

5.6.5 Futures and forwards are contracts in which two parties oblige themselves to exchange something in the future. They are thus useful to hedge or convert known currency or interest rate exposures. An option, in contrast, gives one party the right but not the obligation to buy or sell an asset under specified conditions while the other party assumes an obligation to sell or buy that asset if that option is exercised. Options being non-linear instruments are more difficult to price and therefore their risk profiles need to be well understood before they can be used. For example it needs to be understood that the value of a currency changes not just when exchange rate changes (the event for which the bank usually hedges using forwards/futures) but also if the underlying volatility of the currency pair changes, a risk which banks are not directly concerned with while hedging.

5.7 Treasury operations.

5.7.1 The primary treasury operation of a bank is that of catering to customer needs, both in the spot as well as forward market. This lands the bank with net foreign exchange positions which it needs to manage on a real time basis. If the bank needs to sell Dollars forward to an importer, the bank has a short Dollar position. It can offset the position by buying matching forward Dollars in the market in which case all risks apart from the profit element are covered for the bank. However, it may be easier for the bank to immediately cover the forex risk with a purchase of Dollars in the spot market. Here again the exchange risk is fully covered except for the profit element. However the bank now has a swap position. This is called a gap. The bank has a gap risk which affects it if interest rates change affecting the forward premia for Dollar. In the case of our domestic markets, in addition, premia could also change due to forward demand/supply factors. However, gap risks are easier to manage than exchange risks. So the bank can build up gaps, subject to the management mandated gap limits, and do offsetting


138

swaps to reduce gap risks if it so desires periodically.

5.7.2 The bank’s treasury might also do transactions to take advantage of disequilibrium situations, subject to such transactions being permissible. For instance if the forward premium for 6 months is say 5% while the 6- month interest differential between Rupee and Dollar is say 4%, the bank can receive in the forex market (buy spot, sell 6-month swap to earn 5% annualised for 6 months) and finance the transaction by borrowing in the money market (money market cost being 4% annualised for 6 months).

5.7.3 The bank can also do transactions to take advantage of expected interest rate changes. It can then use either the money market route (mismatched cash-flow maturities) or the forex market route (by running a gap risk).

5.7.4 The bank of course also trades on currency movements with a view to make profits. Here the management must keep in place systems of stop loss discipline, proper monitoring and evaluation of open positions, etc.

5.8 Risk Control Systems:

The management of the bank need to lay out clear and unambiguous performance measurement criteria, accountability norms and financial limits in its treasury operations. Management must specify in operational terms the goals of exchange risk management. It must also clearly recognise the risks of trading arising from open positions, credit risks, and operations risks. The bank must also keep in place a system to independently evaluate through marking to market the net positions taken. Marking to market should ideally be based on objective market prices provided by an external agency. All position limits should be made explicit and expressed in simple terms for easy control.

Annexure – D

139

Chapter 6- Treatment of Market Risk in the Proposed Basel Capital Accord

6.1 The Basle Committee on Banking Supervision (BCBS) had issued comprehensive guidelines to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. The banks have been given flexibility to use in- house models based on VaR for measuring market risk as an alternative to a standardised measurement framework suggested by Basle Committee. The internal models should, however, comply with quantitative and qualitative criteria prescribed by Basle Committee. 6.2 Reserve Bank of India has accepted the general framework suggested by the Basle Committee. RBI has also initiated various steps in moving towards prescribing capital for market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments in Government and other approved securities, besides a risk weight each of 100% on the open position limits in forex and gold. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks. As the ability of banks to identify and measure market risk improves, it would be necessary to assign explicit capital charge for market risk. While the small banks operating predominantly in India could adopt the standardised methodology, large banks and those banks operating in international markets should develop expertise in evolving internal models for measurement of market risk. 6.3 The Basle Committee on Banking Supervision proposes to develop capital charge for interest rate risk in the banking book as well for banks where the interest rate risks are significantly above average (‘outliers’). The Committee is now exploring various methodologies for identifying ‘outliers’ and how best to apply and calibrate a capital charge for interest rate risk for banks. Once the Committee finalises the modalities, it may be necessary, at least for banks operating in the international markets to comply with the explicit capital charge requirements for interest rate risk in the banking book. As the valuation norms on banks’ investment portfolio have already been put in place


140

and aligned with the international best practices, it is appropriate to adopt the Basel norms on capital for market risk. In view of this, banks should study the Basel framework on capital for market risk as envisaged in Amendment to the Capital Accord to incorporate market risks published in January 1996 by BCBS and prepare themselves to follow the international practices in this regard at a suitable date to be announced by RBI. 6.4 The Proposed New Capital Adequacy Framework The Basel Committee on Banking Supervision has released a Second Consultative Document, which contains refined proposals for the three pillars of the New Accord – Minimum Capital Requirements, Supervisory Review and Market Discipline. It may be recalled that the Basel Committee had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework for comments. However, the proposal to provide explicit capital charge for market risk in the banking book which was included in the Pillar I of the June 1999 Document has been shifted to Pillar II in the second Consultative Paper issued in January 2001. The Committee has also provided a technical paper on evaluation of interest rate risk management techniques. The Document has defined the criteria for identifying outlier banks. According to the proposal, a bank may be defined as an outlier whose economic value declined by more than 20% of the sum of Tier 1 and Tier 2 capital as a result of a standardised interest rate shock (200 bps.) 6.5 The second Consultative Paper on the New Capital Adequacy framework issued in January, 2001 has laid down 13 principles intended to be of general application for the management of interest rate risk, independent of whether the positions are part of the trading book or reflect banks' non-trading activities. They refer to an interest rate risk management process, which includes the development of a business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. In particular, they address the need for effective interest rate risk measurement, monitoring and control functions within the interest rate risk management process. The principles are intended to be of general application, based as they are on practices currently used by many international banks, even though their specific application will depend

Annexure – D

141

to some extent on the complexity and range of activities undertaken by individual banks. Under the New Basel Capital Accord, they form minimum standards expected of internationally active banks. The principles are given in Annexure II.


142

Annexure-I BCBS Principles for the Assessment of Liquidity

Management in Banks*

* Sound Practices for managing liquidity in banking organizations, Basel Committee on Banking Supervision, February, 2000

Developing a Structure for Managing Liquidity Principle 1: Each bank should have an agreed strategy for the day-to-day management of liquidity. This strategy should be communicated throughout the organisation. Principle 2: A bank’s board of directors should approve the strategy and significant policies related to the management of liquidity. The board should also ensure that senior management takes the steps necessary to monitor and control liquidity risk. The board should be informed regularly of the liquidity situation of the bank and immediately if there are any material changes in the bank’s current or prospective liquidity position. Principle 3: Each bank should have a management structure in place to execute effectively the liquidity strategy. This structure should include the ongoing involvement of members of senior management. Senior management must ensure that liquidity is effectively managed, and that appropriate policies and procedures are established to control and limit liquidity risk. Banks should set and regularly review limits on the size of their liquidity positions over particular time horizons. Principle 4: A bank must have adequate information systems for measuring, monitoring, controlling and reporting liquidity risk. Reports should be provided on a timely basis to the bank’s board of directors, senior management and other appropriate personnel. Measuring and Monitoring Net Funding Requirements Principle 5: Each bank should establish a process for the ongoing measurement and monitoring of net funding requirements. Principle 6: A bank should analyse liquidity utilising a variety of “what if” scenarios. Principle 7: A bank should review frequently the assumptions utilised in managing liquidity to determine that they continue to be valid.

Annexure – D

143

Managing Market Access Principle 8: Each bank should periodically review its efforts to establish and maintain relationships with liability holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets. Contingency Planning Principle 9: A bank should have contingency plans in place that address the strategy for handling liquidity crises and include procedures for making up cash flow shortfalls in emergency situations. Foreign Currency Liquidity Management Principle 10: Each bank should have a measurement, monitoring and control system for its liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake separate analysis of its strategy for each currency individually. Principle 11: Subject to the analysis undertaken according to Principle 10, a bank should, where appropriate, set and regularly review limits on the size of its cash flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which the bank operates. Internal Controls for Liquidity Risk Management Principle 12: Each bank must have an adequate system of internal controls over its liquidity risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should be available to supervisory authorities. Role of Public Disclosure in Improving Liquidity Principle 13: Each bank should have in place a mechanism for ensuring that there is an adequate level of disclosure of information about the bank in order to manage public perception of the organisation and its soundness.


144

Annexure II

BCBS Principles for Interest Rate Risk Management*

* Principles for the Management and Supervision of Interest Rate Risk, Supporting Document to the New Basel Capital Accord, BCBS, January, 2001

Board and senior management oversight of interest rate risk Principle 1: In order to carry out its responsibilities, the board of directors in a bank should approve strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks. The board of directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk. Principle 2: Senior management must ensure that the structure of the bank's business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk. Principle 3: Banks should clearly define the individuals and/or committees responsible for managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the risk management process to avoid potential conflicts of interest. Banks should have risk measurement, monitoring and control functions with clearly defined duties that are sufficiently independent from position-taking functions of the bank and which report risk exposures directly to senior management and the board of directors. Larger or more complex banks should have a designated independent unit responsible for the design and administration of the bank's interest rate risk measurement, monitoring and control functions. Adequate risk management policies and procedures Principle 4: It is essential that banks' interest rate risk policies and procedures are clearly defined and consistent with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible obstacles to cash movements among affiliates.

Annexure – D

145

Principle 5: It is important that banks identify the risks inherent in new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the board or its appropriate delegated committee. Risk measurement, monitoring and control functions Principle 6: It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management. Principle 7: Banks must establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies. Principle 8: Banks should measure their vulnerability to loss under stressful market conditions - including the breakdown of key assumptions- and consider those results when establishing and reviewing their policies and limits for interest rate risk. Principle 9: Banks must have adequate information systems for measuring, monitoring, controlling and reporting interest rate exposures. Reports must be provided on a timely basis to the bank's board of directors, senior management and, where appropriate, individual business line managers. Internal controls Principle 10: Banks must have an adequate system of internal controls over their interest rate risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should be available to the relevant supervisory authorities.


146

Information for supervisory authorities Principle 11: Supervisory authorities should obtain from banks sufficient and timely information with which to evaluate their level of interest rate risk. This information should take appropriate account of the range of maturities and currencies in each bank's portfolio, including off-balance sheet items, as well as other relevant factors, such as the distinction between trading and non-trading activities. Capital adequacy Principle 12: Banks must hold capital commensurate with the level of interest rate risk they undertake. Disclosure of interest rate risk Principle 13: Banks should release to the public information on the level of interest rate risk and their policies for its management.

Annexure – D

147

Annexure-III Sources, effects and measurement of interest rate risk*

* Principles for the Management and Supervision of Interest Rate Risk, Supporting Document to the New Basel Capital Accord, BCBS, January, 2001

Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base. Changes in interest rates affect a bank's earnings by changing its net interest income and the level of other interest-sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the bank's assets, liabilities and off-balance sheet instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change. A. Sources of Interest Rate Risk Repricing risk: As financial intermediaries, banks encounter interest rate risk in several ways. The primary and most often discussed form of interest rate risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off- balance-sheet (OBS) positions. While such repricing mismatches are fundamental to the business of banking, they can expose a bank's income and underlying economic value to unanticipated fluctuations as interest rates vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase. These declines arise because the cash flows on the loan are fixed over its lifetime, while the interest paid on the funding is variable, and increases after the short-term deposit matures. Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank's income or underlying economic value. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the


148

yield curve steepens, even if the position is hedged against parallel movements in the yield curve. Basis risk: Another important source of interest rate risk (commonly referred to as basis risk) arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing frequencies. Optionality: An additional and increasingly important source of interest rate risk arises from the options embedded in many bank assets, liabilities and OBS portfolios. Formally, an option provides the holder the right, but not the obligation, to buy, sell, or in some manner alter the cash flow of an instrument or financial contract. Options may be stand alone instruments such as exchange-traded options and over-the-counter (OTC) contracts, or they may be embedded within otherwise standard instruments. While banks use exchange-traded and OTC-options in both trading and non-trading accounts, instruments with embedded options are generally most important in non-trading activities. They include various types of bonds and notes with call or put provisions, loans which give borrowers the right to prepay balances, and various types of non- maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not adequately managed, the asymmetrical payoff characteristics of instruments with optionality features can pose significant risk particularly to those who sell them, since the options held, both explicit and embedded, are generally exercised to the advantage of the holder and the disadvantage of the seller. Moreover, an increasing array of options can involve significant leverage which can magnify the influences (both negative and positive) of option positions on the financial condition of the firm. B. Effects of Interest Rate Risk As the discussion above suggests, changes in interest rates can have adverse effects both on a bank's earnings and its economic value. This has given rise to two separate, but complementary, perspectives for assessing a bank's interest rate risk exposure.

Annexure – D

149

Earnings perspective: In the earnings perspective, the focus of analysis is the impact of changes in interest rates on accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken by many banks. Variation in earnings is an important focal point for interest rate risk analysis because reduced earnings or outright losses can threaten the financial stability of an institution by undermining its capital adequacy and by reducing market confidence. In this regard, the component of earnings that has traditionally received the most attention is net interest income (i.e. the difference between total interest income and total interest expense). This focus reflects both the importance of net interest income in banks' overall earnings and its direct and easily understood link to changes in interest rates. However, as banks have expanded increasingly into activities that generate fee-based and other non-interest income, a broader focus on overall net income - incorporating both interest and non-interest income and expenses - has become more common. The non-interest income arising from many activities, such as loan servicing and various asset securitisation programs, can be highly sensitive to market interest rates. For example, some banks provide the servicing and loan administration function for mortgage loan pools in return for a fee based on the volume of assets it administers. When interest rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages prepay. In addition, even traditional sources of non-interest income such as transaction processing fees are becoming more interest rate sensitive. This increased sensitivity has led both bank management and supervisors to take a broader view of the potential effects of changes in market interest rates on bank earnings and to factor these broader effects into their estimated earnings under different interest rate environments. Economic value perspective: Variation in market interest rates can also affect the economic value of a bank's assets, liabilities and OBS positions. Thus, the sensitivity of a bank's economic value to fluctuations in interest rates is a particularly important consideration of shareholders, management and supervisors alike. The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted to reflect market rates. By extension, the economic value of a bank can be viewed as the present value of bank's expected net cash flows, defined as the expected cash flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on OBS


150

positions. In this sense, the economic value perspective reflects one view of the sensitivity of the net worth of the bank to fluctuations in interest rates. Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective. This comprehensive view is important since changes in near-term earnings – the typical focus of the earnings perspective - may not provide an accurate indication of the impact of interest rate movements on the bank's overall positions. Embedded losses: The earnings and economic value perspectives discussed thus far focus on how future changes in interest rates may affect a bank's financial performance. When evaluating the level of interest rate risk it is willing and able to assume, a bank should also consider the impact that past interest rates may have on future performance. In particular, instruments that are not marked to market may already contain embedded gains or losses due to past rate movements. These gains or losses may be reflected over time in the bank's earnings. For example, a long term fixed rate loan entered into when interest rates were low and refunded more recently with liabilities bearing a higher rate of interest will, over its remaining life, represent a drain on the bank's resources. C. Measuring Interest Rate Risk The techniques available for measuring interest rate risk range from calculations that rely on simple maturity and repricing tables, to static simulations based on current on- and off-balance sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions about the behaviour of the bank and its customers in response to changes in the interest rate environment. Some of these general approaches can be used to measure interest rate risk exposure from both an earnings and an economic value perspective, while others are more typically associated with only one of these two perspectives. In addition, the methods vary in their ability to capture the different forms of interest rate exposure: the simplest methods are intended primarily to capture the risks arising from maturity and repricing mismatches, while the more sophisticated methods can more easily capture the full range of risk exposures.

Annexure – D

151

Gap analysis: Simple maturity/repricing schedules can be used to generate simple indicators of the interest rate risk sensitivity of both earnings and economic value to changing interest rates. When this approach is used to assess the interest rate risk of current earnings, it is typically referred to as gap analysis. Gap analysis was one of the first methods developed to measure a bank's interest rate risk exposure, and continues to be widely used by banks. To evaluate earnings exposure, interest rate sensitive liabilities in each time band are subtracted from the corresponding interest rate sensitive assets to produce a repricing "gap" for that time band. This gap can be multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income that would result from such an interest rate movement. The size of the interest rate movement used in the analysis can be based on a variety of factors, including historical experience, simulation of potential future interest rate movements, and the judgement of bank management. A negative, or liability-sensitive, gap occurs when liabilities exceed assets (including off-balance sheet positions) in a given time band. This means that an increase in market interest rates could cause a decline in net interest income. Conversely, a positive, or asset-sensitive, gap implies that the bank's net interest income could decline as a result of a decrease in the level of interest rates. Limitations of Gap Analysis: Although gap analysis is a very commonly used approach to assessing interest rate risk exposure, it has a number of shortcomings. First, gap analysis does not take account of variation in the characteristics of different positions within a time band. In particular, all positions within a given time band are assumed to mature or reprice simultaneously, a simplification that is likely to have greater impact on the precision of the estimates as the degree of aggregation within a time band increases. Moreover, gap analysis ignores differences in spreads between interest rates that could arise as the level of market interest rates changes (basis risk). In addition, it does not take into account any changes in the timing of payments that might occur as a result of changes in the interest rate environment. Thus, it fails to account for differences in the sensitivity of income that may arise from option-related positions. For these reasons, gap analysis provides only a rough approximation to the actual change in net interest income which would result from the chosen change in the pattern of interest rates. Finally, most gap analyses fail to capture variability in non-interest revenue and expenses, a potentially important


152

source of risk to current income. Duration A maturity/repricing schedule can also be used to evaluate the effects of changing interest rates on a bank's economic value by applying sensitivity weights to each time band. Typically, such weights are based on estimates of the duration of the assets and liabilities that fall into each time band. Duration is a measure of the percent change in the economic value of a position that will occur given a small change in the level of interest rates. Duration may also be defined as the weighted average of the time until expected cash flows from a security will be received, relative to the current price of the security. The weights are the present values of each cash flow divided by the current price. In its simplest form, duration measures changes in economic value resulting from a percentage change of interest rates under the simplifying assumptions that changes in value are proportional to changes in the level of interest rates and that the timing of payments is fixed. Modified duration∗ is standard duration divided by 1 + r, where r is the level of market interest rates - is an elasticity. As such, it reflects the percentage change in the economic value of the instrument for a given percentage change in 1 + r. As with simple duration, it assumes a linear relationship between percentage changes in value and percentage changes in interest rates. In other words, Modified Duration = Macaulay’s Duration/(I+r), where Macaulay’s Duration= � CFt(t)/(I+r) / � CFt/(1+r) to the power t CFt=Rupee value of cash flow at time t T= Number of periods of time until the cash flow payment r=Periodic yield to maturity of the security generating cash flow and k=the number of cash flows Duration reflects the timing and size of cash flows that occur before the instrument's contractual maturity. Generally, the longer the maturity or next repricing date of the instrument and the smaller the payments that occur before maturity (e.g. coupon payments), the higher the duration (in ∗ Timothy Koch (1995): Bank Management (Dryden, New York)

Annexure – D

153

absolute value). Higher duration implies that a given change in the level of interest rates will have a larger impact on economic value. Duration-based weights can be used in combination with a maturity/ repricing schedule to provide a rough approximation of the change in a bank's economic value that would occur given a particular change in the level of market interest rates. Specifically, an "average" duration is assumed for the positions that fall into each time band. The average durations are then multiplied by an assumed change in interest rates to construct a weight for each time band. In some cases, different weights are used for different positions that fall within a time band, reflecting broad differences in the coupon rates and maturities (for instance, one weight for assets, and another for liabilities). In addition, different interest rate changes are sometimes used for different time bands, generally to reflect differences in the volatility of interest rates along the yield curve. The weighted gaps are aggregated across time bands to produce an estimate of the change in economic value of the bank that would result from the assumed changes in interest rates. Alternatively, a bank could estimate the effect of changing market rates by calculating the precise duration of each asset, liability and off-balance sheet position and then deriving the net position for the bank based on these more accurate measures, rather than by applying an estimated average duration weight to all positions in a given time band. This would eliminate potential errors occurring when aggregating positions/cash flows. As another variation, risk weights could also be designed for each time band on the basis of actual percent changes in market values of hypothetical instruments that would result from a specific scenario of changing market rates. That approach - which is sometimes referred to as effective duration - would better capture the non-linearity of price movements arising from significant changes in market interest rates and, thereby, would avoid an important limitation of duration. Estimates derived from a standard duration approach may provide an acceptable approximation of a bank's exposure to changes in economic value for relatively non-complex banks. Such estimates, however, generally focus on just one form of interest rate risk exposure - repricing risk. As a result, they may not reflect interest rate risk arising – for instance - from changes in the relationship among interest rates within a time band (basis risk). In addition, because such approaches typically use


154

an average duration for each time band, the estimates will not reflect differences in the actual sensitivity of positions that can arise from differences in coupon rates and the timing of payments. Finally, the simplifying assumptions that underlie the calculation of standard duration means that the risk of options may not be well-captured. The other methods of measurement of market risk, viz., Value at Risk (VaR) and Stress Testing Techniques are elaborately discussed in the subsequent chapters.

Annexure – D

155

Annexure-IV Value at Risk (VaR)

Definition: VaR is defined as an estimate of potential loss in a position or asset/liability or portfolio of assets/liabilities over a given holding period at a given level of certainty. VaR measures risk. Risk is defined as the probability of the unexpected happening - the probability of suffering a loss. VaR is an estimate of the loss likely to suffer, not the actual loss. The actual loss may be different from the estimate. It measures potential loss, not potential gain. Risk management tools measure potential loss as risk has been defined as the probability of suffering a loss. VaR measures the probability of loss for a given time period over which the position is held. The given time period could be one day or a few days or a few weeks or a year. VaR will change if the holding period of the position changes. The holding period for an instrument/position will depend on liquidity of the instrument/ market. With the help of VaR, we can say with varying degrees of certainty that the potential loss will not exceed a certain amount. This means that VaR will change with different levels of certainty. The Bank for International Settlements (BIS) has accepted VaR as a measurement of market risks and provision of capital adequacy for market risks, subject to approval by banks' supervisory authorities. VaR Methodologies VAR can be arrived as the expected loss on a position from an adverse movement in identified market risk parameter(s) with a specified probability over a nominated period of time. Volatility in financial markets is usually calculated as the standard deviation of the percentage changes in the relevant asset price over a specified asset period. The volatility for calculation of VaR is usually specified as the standard deviation of the percentage change in the risk factor over the relevant risk horizon. The following table describes the three main methodologies to calculate VaR∗

∗ Risk Management: A Practical Guide, RiskMetrics Group, J.P. Morgan, August, 1999


156

There are three main approaches to calculating value-at-risk: the correlation method, also known as the variance/covariance matrix method; historical simulation and Monte Carlo simulation. All three methods require a statement of three basic parameters: holding period, confidence interval and the historical time horizon over which the asset prices are observed.

Under the correlation method, the change in the value of the position is calculated by combining the sensitivity of each component to price changes in the underlying asset(s), with a variance/covariance matrix of the various components' volatilities and correlation. It is a deterministic approach.

The historical simulation approach calculates the change in the value of a position using the actual historical movements of the underlying asset(s), but starting from the current value of the asset. It does not need a variance/covariance matrix. The length of the historical period chosen does impact the results because if the period is too short, it may not capture the full variety of events and relationships between the various assets and within each asset class, and if it is too long, may be too stale to predict the future. The advantage of this method is that it does not require the user to make any explicit assumptions about correlations and the dynamics of the risk factors because the simulation follows every historical move.

The Monte Carlo simulation method calculates the change in the value of a portfolio using a sample of randomly generated price scenarios. Here the user has to make certain assumptions about market structures, correlations between risk factors and the volatility of these factors. He is essentially imposing his views and experience as opposed to the naive approach of the historical simulation method. At the heart of all three methods is the model. The closer the models fit economic reality, the more accurate the estimated VAR numbers and therefore the better they will be at predicting the true VAR of the firm. There is no guarantee that the numbers returned by each VAR method will be anywhere near each other.

Other uses of VaR

VaR is used as a MIS tool in the trading portfolio in the trading portfolio to “slice and dice” risk by levels/ products/geographic/level of organisation etc. It is also used to set risk limits. In its strategic perspective, VaR is used to decisions as to what business to do and what not to do. However VaR as a useful MIS tool has to be “back tested” by comparing each day’s VaR with actuals and necessary reexamination of assumptions needs to be made so

Annexure – D

157

as to be close to reality. VaR, therefore, cannot substitute sound management judgement, internal control and other complementary methods. It is used to measure and manage market risks in trading portfolio and investment portfolio.

Estimating Volatility

VaR uses past data to compute volatility. Different methods are employed to estimate volatility. One is arithmetic moving average from historical time series data. The other is the exponential moving average method. In the exponential moving average method, the volatility estimates rises faster to shocks and declines gradually. Further, different banks take different number of days of past data to estimate volatility. Volatility also does not capture unexpected events like EMU crisis of September 1992 (called “event risk”). All these complicate the estimation of volatility. VaR should be used in combination with "stress testing" to take care of event risks. Stress test takes into account the worst case scenario.

Why Backtest Backtests compare realized trading results with model generated risk measures, both to evaluate a new model and to reassess the accuracy of existing models. Although no single methodology for backtesting has been established, banks using internal VaR models for market risk capital requirements must backtest their models on a regular basis. Banks should generally backtest risk models on a monthly or quarterly basis to verify accuracy. In these tests, they should observe whether trading results fall within pre-specified confidence bands as predicted by the VaR models. If the models perform poorly, they should probe further to find the cause (e.g., check integrity of position and market data, model parameters, methodology). The BIS outlines backtesting best practices in its January 1996 publication “Supervisory framework for the use of ‘backtestin’ in conjunction with the internal models approach to market risk capital requirements


158

Annexure-V Stress Testing

“Stress testing” has been adopted as a generic term describing various techniques used by banks to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing addresses the large moves in key market variables of that kind that lie beyond day to day risk monitoring but that could potentially occur. The process of stress testing, therefore, involves first identifying these potential movements, including which market variables to stress, how much to stress them by, and what time frame to run the stress analysis over. Once these market movements and underlying assumptions are decided upon, shocks are applied to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market movement has on the value of the portfolio and the overall Profit and Loss. Stress test reports can be constructed that summarise the effects of different shocks of different magnitudes. Normally, then there is some kind of reporting procedure and follow up with traders and management to determine whether any action need to be taken in response.

Stress testing and value-at-risk∗ Stress tests supplement value-at-risk VaR). VaR is thought to be a critical tool for tracking the riskiness of a firm’s portfolio on a day-to-day level, and for assessing the risk-adjusted performance of individual business units. However, VaR has been found to be of limited use in measuring firms’ exposures to extreme market events. This is because, by definition, such events occur too rarely to be captured by empirically driven statistical models. Furthermore, observed correlation patterns between various financial prices (and thus the correlations that would be estimated using data from ordinary times) tend to change when the price movements themselves are large. Stress tests offer a way of measuring and monitoring the portfolio consequences of extreme price movements of this type.

∗ Philip Best: “Stress Testing”, Marc Lore & Lev Borodovsky (ed)-The Professional’s Handbook of Financial Risk Management, Global Association of Risk Professionals (GARP), 2001

Annexure – D

159

Stress Testing Techniques: Stress testing covers many different techniques. The four discussed here are listed in the Table below along with the information typically referred to as the “result” of that type of a stress test.

A simple sensitivity test isolates the short-term impact on a portfolio’s value of a series of predefined moves in a particular market risk factor. For example, if the risk factor were an exchange rate, the shocks might be exchange rate changes of +/- 2 percent, 4 percent, 6 percent and 10 percent.

A scenario analysis specifies the shocks that might plausibly affect a number of market risk factors simultaneously if an extreme, but possible, event occurs. It seeks to assess the potential consequences for a firm of an extreme, but possible, state of the world. A scenario analysis can be based on an historical event or a hypothetical event. Historical scenarios employ shocks that occurred in specific historical episodes. Hypothetical scenarios use a structure of shocks thought to be plausible in some foreseeable, but unlikely circumstances for which there is no exact parallel in recent history. Scenario analysis is currently the leading stress testing technique.

A maximum loss approach assesses the riskiness of a business unit’s portfolio by identifying the most potentially damaging combination of moves of market risk factors. Interviewed risk managers who use such “maximum loss” approaches find the output of such exercises to be instructive but they tend not to rely on the results of such exercises in the setting of exposure limits in any systematic manner, an implicit recognition of the arbitrary character of the combination of shocks captured by such a measure.

Extreme value theory (EVT) is a means to better capture the risk of loss in extreme, but possible, circumstances. EVT is the statistical theory on the behaviour of the “tails” (i.e., the very high and low potential values) of probability distributions. Because it focuses only on the tail of a probability distribution, the method can be more flexible. For example, it can accommodate skewed and fat-tailed distributions. A problem with the extreme value approach is adapting it to a situation where many risk factors drive the underlying return distribution. Moreover, the usually unstated assumption that extreme events are not correlated through time is questionable. Despite these drawbacks, EVT is notable for being the only stress test technique that attempts to attach a probability to stress test results.


160

What Makes a good Stress Test

A good stress test should

• be relevant to the current position

• consider changes in all relevant market rates

• examine potential regime shifts (whether the current risk parameters will hold or break down)

• spur discussion

• consider market illiquidity, and

• consider the interplay of market and credit risk

How should risk managers use stress tests:

Stress tests produce information summarising the bank’s exposure

to extreme, but possible, circumstances. The role of risk managers in the bank should be assembling and summarising information to enable senior management to understand the strategic relationship between the firm’s risk-taking (such as the extent and character of financial leverage employed) and risk appetite. Typically, the results of a small number of stress scenarios should be computed on a regular basis and monitored over time. Some of the specific ways stress tests are used to influence decision-making are to:

manage funding risk

provide a check on modelling assumptions

set limits for traders

determine capital charges on trading desks’ positions

Limitations of Stress Tests

Stress testing can appear to be a straightforward technique. In practice, however, stress tests are often neither transparent nor straightforward. They are based on a large number of practitioner choices as to what risk factors to stress, how to combine factors stressed, what range of values to consider, and what time frame to analyse. Even after such choices are made, a risk manager is faced with the considerable tasks of sifting through results and identifying what implications, if any, the stress test results might have for how the bank should manage its risk-taking activities.

Annexure – D

161

A well-understood limitation of stress testing is that there are no probabilities attached to the outcomes. Stress tests help answer the question “How much could be lost?” The lack of probability measures exacerbates the issue of transparency and the seeming arbitrariness of stress test design. Systems incompatibilities across business units make frequent stress testing costly for some banks, reflecting the limited role that stress testing had played in influencing the bank’s prior investments in information technology.

ANNEXURE – E

ASSET - LIABILITY MANAGEMENT (ALM) SYSTEM

BP.BC. 8/21.04.098/99 February 10, 1999

To

All Scheduled Commercial Banks

(excluding RRBs)

Dear Sir,

Asset - Liability Management ( ALM ) System

Please refer to our circular DBOD No. BP. BC. 94/21. 04. 098/ 98 dated September 10, 1998 forwarding therewith draft Guidelines for putting in place Asset-Liability Management (ALM) System in banks. The draft Guidelines have been reviewed by us in the light of the issues raised/suggestions made by banks in the seminars held at Bankers Training College and also at the Review Meeting of the Chairmen/Chief Executive Officers of banks. The final Guidelines revised on the basis of the feedback received from banks are enclosed, for implementation by banks, effective April 1, 1999. In this connection, we have to advise as under:

2. Banks should give adequate attention to putting in place an effective ALM System. Banks should set up an internal Asset-Liability Committee (ALCO), headed by the CEO/CMD or the ED. The Management Committee or any specific Committee of the Board should oversee the implementation of the system and review its functioning periodically.

3. Keeping in view the level of computerisation and the current MIS in banks, adoption of a uniform ALM System for all banks may not be feasible. The final guidelines have been formulated to serve as a benchmark for those banks which lack a formal ALM System. Banks which have already adopted

Annexure – E

163

more sophisticated systems may continue their existing systems but they should ensure to fine-tune their current information and reporting system so as to be in line with the ALM System suggested in the Guidelines. Other banks should examine their existing MIS and arrange to have an information system to meet the prescriptions of the new ALM System. To begin with, banks should ensure coverage of at least 60% of their liabilities and assets. As for the remaining 40% of their assets and liabilities, banks may include the position based on their estimates. It is necessary that banks set targets in the interim, for covering 100 per cent of their business by April 1, 2000. The MIS would need to ensure that such minimum information/data consistent in quality and coverage is captured and once the ALM System stabilises and banks gain experience, they must be in a position to switch over to more sophisticated techniques like Duration Gap Analysis, Simulation and Value at Risk for interest rate risk management.

4. In order to capture the maturity structure of the cash inflows and outflows, the Statement of Structural Liquidity (Annexure-I) should be prepared, to start with, as on the last reporting Friday of March/June/ September/December and put up to ALCO/Top Management within a month from the close of the last reporting Friday. It is the intention to make the reporting system on a fortnightly basis by April 1, 2000. The Statement of Structural Liquidity should be placed before the bank s Board in the next meeting. It would also be necessary to take into account the rupee inflows and outflows on account of previously contracted forex transactions (swaps, forwards, etc). Tolerance levels for various maturities may be fixed by the bank s Top Management depending on the bank s asset - liability profile, extent of stable deposit base, the nature of cash flows, etc. In respect of mismatches in cash flows for the 1-14 days bucket and 15-28 days bucket, it should be the endeavour of the bank s management to keep the cash flow mismatches at the minimum levels. To start with, the mismatches (negative gap) during 1-14 days and 15-28 days in normal course may not exceed 20% each of the cash outflows during these time buckets. If a bank in view of its structural mismatches needs higher limit, it could operate with higher limit with the approval of its Board/Management Committee, giving specific reasons on the need for such higher limit. The objective of RBI is to enforce the tolerance levels strictly by April 1, 2000.

5. In order to enable the banks to monitor their liquidity on a dynamic basis over a time horizon spanning from 1-90 days, an indicative format (Annexure


164

III) is enclosed. The statement of Short-term Dynamic Liquidity should be prepared as on each reporting Friday and put up to the ALCO/Top Management within 2/3 days from the close of the reporting Friday.

6. We advise that in the Statement of Interest Rate Sensitivity (Annexure - II) only rupee assets, liabilities and off-balance sheet positions should be reported. The statement should be prepared as on the last reporting Friday of March/June/September/December and submitted to the ALCO / Top Management within a month from the last reporting Friday. It should also be placed before the bank s Board in the next meeting. The banks are expected to move over to monthly reporting system by April 1, 2000. The information collected in the statement would provide useful feedback on the interest rate risk faced by the bank and the Top Management/Board would have to formulate corrective measures and devise suitable strategies wherever needed.

7. The guidelines for ALM cover the banks operations in domestic currency. In regard to foreign currency risk, banks should follow the instructions contained in Circular AD (MA Series) No.52 dated December 27, 1997 issued by the Exchange Control Department.

8. As regards furnishing of data to RBI, a separate communication will follow from the Department of Banking Supervision.

9. This circular may please be placed before the Board of Directors at its next meeting

10. Please acknowledge receipt.

Yours faithfully,

(A . Ghosh) Chief General Manager

Encl: As above

Annexure – E

165

Asset - Liability Management (ALM) System in banks - Guidelines

In the normal course, banks are exposed to credit and market risks in view of the asset-liability transformation. With liberalisation in Indian financial markets over the last few years and growing integration of domestic markets and with external markets, the risks associated with banks operations have become complex and large, requiring strategic management. Banks are now operating in a fairly deregulated environment and are required to determine on their own, interest rates on deposits and advance in both domestic and foreign currencies on a dynamic basis. The interest rates on banks investments in government and other securities are also now market related. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. Imprudent liquidity management can put banks earnings and reputation at great risk. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk , liquidity risk and operational risk. It is, therefore, important that banks introduce effective risk management systems that address the issues related to interest rate, currency and liquidity risks.

Banks need to address these risks in a structured manner by upgrading their risk management and adopting more comprehensive Asset-Liability Management (ALM) practices than has been done hitherto. ALM, among other functions, is also concerned with risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the banks business strategy. It involves assessment of various types of risks and


166

altering the asset-liability portfolio in a dynamic way in order to manage risks.

2. This note lays down broad guidelines in respect of interest rate and liquidity risks management systems in banks which form part of the Asset-Liability Management (ALM) function. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management systems should be that these systems will evolve into a strategic tool for bank management.

3. The ALM process rests on three pillars:

• ALM Information Systems

Management Information Systems

Information availability, accuracy, adequacy and expediency

• ALM Organisation

Structure and responsibilities

Level of top management involvement

• ALM Process

Risk parameters

Risk identification

Risk measurement

Risk management

Risk policies and tolerance levels.

4. ALM Information Systems

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, recognised 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

Annexure – E

167

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 computerisation. 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 behavioural 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. analysing the behaviour 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 centralised 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 computerisation will also help banks in accessing data.

5. ALM Organisation

5.1 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


168

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 analysing, 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.

5.2 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 both 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

Annexure – E

169

meetings.

5.3 Composition of ALCO

The size (number of members) of ALCO would depend on the size of each institution, business mix and organisational 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 computerisation. Some banks may even have Sub-committees and Support Groups.

5.4 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.

5.5 ALM Process:

The scope of ALM function can be described as follows:

• Liquidity risk management

• 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.

6. Liquidity Risk Management

6.1 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


170

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 format of the Statement of Structural Liquidity is given in Annexure I.

6.2 The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of banks in different time buckets. The time buckets, given the Statutory Reserve cycle of 14 days may be distributed as under:

i) 1 to 14 days

ii) 15 to 28 days

iii) 29 days and upto 3 months

iv) Over 3 months and upto 6 months

v) Over 6 months and upto 1 year

vi) Over 1 year and upto 3 years

vii) Over 3 years and upto 5 years

viii) Over 5 years

6.3 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

Annexure – E

171

relationship with customers. Securities held in the Trading Book are subject to certain preconditions like :

i) The composition and volume are clearly defined;

ii) Maximum maturity/duration of the portfolio is restricted;

iii) The holding period not to exceed 90 days;

iv) Cut-loss limit prescribed;

v) Defeasance periods (product-wise) i.e. times taken to liquidate the position on the basis of liquidity in the secondary market are prescribed;

vi) 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.

6.4 Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches upto 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.


172

6.5 The Statement of Structural Liquidity ( Annexure I ) 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 long-term 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.

6.6 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. An indicative format (Annexure III) for estimating Short-term Dynamic Liquidity is enclosed.

7. Currency Risk

7.1 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.

7.2 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

Annexure – E

173

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.

7.3 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.

7.4 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.

8. Interest Rate Risk (IRR)

8.1 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


174

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 computerisation 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:

i) within the time interval under consideration, there is a cash flow;

ii) the interest rate resets/reprices contractually during the interval;

iii) 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

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

8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance 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

Annexure – E

175

receive it within the time horizon. This includes final principal payment and interim instalments. 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:

i) 1-28 days

ii 29 days and upto 3 months

iii) Over 3 months and upto 6 months

iv) Over 6 months and upto 1 year

v) Over 1 year and upto 3 years

vi) Over 3 years and upto 5 years

vii) Over 5 years

viii) Non-sensitive

The various items of rate sensitive assets and liabilities and off-balance sheet items may be classified as explained in Appendix - II and the Reporting Format for interest rate sensitive assets and liabilities is given in Annexure II.

8.3 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.

8.4 Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should


176

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.

8.5 RBI will also introduce capital adequacy for market risks in due course.

9. General

9.1 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 behavioural 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.

9.2 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 behavioural analysis to estimate the future behaviour of assets, liabilities and off-balance sheet items to changes in market variables and estimate the embedded options.

9.3 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 centralising 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.

Annexure – E

177

APPENDIX I

Maturity Profile Liquidity Heads of Accounts Classification into time buckets

A. Outflows

1. Capital, Reserves and Surplus

Over 5 years bucket.

2. Demand Deposits (Current and Savings Bank and Current Deposits

Savings may be Bank Deposits) classified into volatile and core portions. Savings Bank (10%) and Current (15%) Deposits are generally withdrawable on demand. This portion may be treated as volatile. While volatile portion can be placed in the first time bucket i.e., 1-14 days, the core portion may be placed in over 1- 3 years bucket.

The above classification of Savings Bank and Current Deposits is only a benchmark. Banks which are better equipped to estimate the behavioural pattern, roll-in and roll-out, embedded options, etc. on the basis of past data/empirical studies could classify them in the appropriate buckets, i.e. behavioural maturity instead of contractual maturity, subject to the approval of the Board/ALCO.

3. Term Deposits Respective maturity buckets. Banks which are better equipped to estimate the behavioural pattern, roll-in and roll-out, embedded options, etc. on the basis of past data/empirical studies could classify the retail deposits in the appropriate buckets on the basis of


178

behavioural maturity rather than residual maturity. However, the wholesale deposits should be shown under respective maturity buckets.

4. Certificates of Deposit, Borrowings and Bonds (including Sub-ordinated Debt)

Respective maturity buckets. Where call/put options are built into the issue structure of any instrument/s, the call/put date/s should be reckoned as the maturity date/s and the amount should be shown in the respective time buckets.

5. Other Liabilities and Provisions

i) Bills Payable The core component which could reasonably be estimated on the basis of past data and behavioural pattern may be shown under over 1-3 years time bucket. The balance amount may be placed in 1-14 days bucket.

ii) Inter-office Adjustment The net credit balance may be shown in 1-14 days bucket.

iii) Provisions other than for loan loss and depreciation in investments

Respective buckets depending on the purpose.

iv) Other Liabilities Respective maturity buckets. Items not representing cash payables (i.e. income received in advance, etc.) may be placed in over 5 years bucket.

6. Export Refinance – Availed

Respective maturity buckets of underlying assets.

B. Inflows

1. Cash 1-14 days bucket.

2. Balances with RBI While the excess balance over the required CRR/SLR may be shown under 1-14 days bucket, the Statutory

Annexure – E

179

Balances may be distributed amongst various time buckets corresponding to the maturity profile of DTL with a time-lag of 14 days.

3. Balances with other Banks

(i) Current Account (i) Non-withdrawable portion on account of stipulations of minimum balances may be shown under over 1-3 years bucket and the remaining balances may be shown under 1-14 days bucket..

(ii) Money at Call and Short Notice, Term Deposits and other placements

(ii) Respective maturity buckets

4. Investments (Net of provisions)#

(i) Approved securities i) Respective maturity buckets excluding the amount required to be reinvested to maintain SLR corresponding to the DTL profile in various time buckets.

(ii) Corporate debentures and bonds, PSU bonds, CDs and CPs, Redeemable preference shares, Units of Mutual Fund (close ended), etc.

ii) Respective maturity buckets. Investments classified as NPAs should be shown under over 3-5 years bucket (sub-standard) or over 5 years bucket (doubtful).

(iii) Shares/Units of Mutual Funds (open ended)

(iii) Over 5 years bucket.

(iv) Investments in Subsidiaries/ Joint Ventures

(iv) Over 5 years bucket.

# Provisions may be netted from the gross investments provided provisions are held security-wise. Otherwise provisions should be shown in over 5 years bucket.


180

(v) Securities in the Trading Book

(v) 1-14 days, 15-28 days and 29-90 days according to defeasance periods.

5. Advances (Performing) (i) Bills Purchased and Discounted (including bills under DUPN)

(i) Respective maturity buckets.

(ii) Cash Credit / Overdraft (including TOD) and Demand Loan component of Working Capital.

(ii) Banks should undertake a study behavioural and seasonal pattern of availments based on outstandings and the core and volatile portion should be identified. While the volatile portion could be shown in the near-term maturity buckets, the core portion may be shown under over 1-3 years bucket.

(iii) Term Loans (iii) Interim cash flows may be shown under respective maturity buckets.

6. NPAs (Net of provisions, interest suspense and claims received from ECGC/DICGC ) (i) Sub-standard (i) Over 3-5 years bucket. (ii) Doubtful and Loss (ii) Over 5 years bucket. 7. Fixed Assets Over 5 years bucket 8. Other Assets (i) Inter-office Adjustment The net debit balance may be shown in

1-14 days bucket. Intangible assets and assets not representing cash receivables may be shown in over 5 years bucket.

(ii) Leased Assets Interim cash flows may be shown under respective maturity buckets.

C. Contingent Liabilities / Lines of Credit committed / available and other Inflows / Outflows

1. (i) Lines of Credit committed to/ from Institutions

(i) 1-14 days bucket.

Annexure – E

181

(ii) Unavailed portion of Cash Credit/Overdraft/ Demand loan component of Working Capital limits (outflow)

(ii) Banks should undertake a study of the behavioural and seasonal pattern of potential availments in the accounts and the amounts so arrived at may be shown under relevant maturity buckets upto 12 months.

(iii) Export Refinance – Unavailed (inflows)

(iii) 1-14 days bucket.

2. Letters of Credit / Guarantees (outflow)

Devolvement of Letters of Credit/ Guarantees, initially entails cash outflows. Thus, historical trend analysis ought to be conducted on the devolvements and the amounts so arrived at in respect of outstanding Letters of Credit / Guarantees (net of margins) should be distributed amongst various time buckets. The assets created out of devolvements may be shown under respective maturity buckets on the basis of probable recovery dates.

3. Repos / Bills Rediscounted (DUPN) / Swaps INR / USD, maturing forex forward contracts etc. (outflow / inflow)

Respective maturity buckets.

4. Interest payable / receivable (outflow/inflow) Accrued interest which are appearing in the books on the reporting day

Respective maturity buckets.

Note :

i. Liability on account of event cash flows i.e. short fall in CRR balance on reporting Fridays, wage settlement, capital expenditure, etc. which are known to the banks and any other contingency may be shown under respective maturity buckets.


182

ii. All overdue liabilities may be placed in the 1-14 days bucket.

iii. Interest and instalments from advances and investments, which are overdue for less than one month may be placed in over 3-6 months, bucket. Further, interest and instalments due (before classification as NPAs) may be placed in over 6-12 months bucket without the grace period of one month if the earlier receivables remain uncollected.

D. Financing of Gap :

In case the negative gap exceeds the prudential limit of 20% of outflows, (1-14 days and 15-28 days) the bank may show by way of a foot note as to how it proposes to finance the gap to bring the mismatch within the prescribed limits. The gap can be financed from market borrowings (call / term), Bills Rediscounting, Repos and deployment of foreign currency resources after conversion into rupees ( unswapped foreign currency funds ), etc.


APPENDIX - II

Interest Rate Sensitivity Heads of Accounts Rate sensitivity and time bucket

Liabilities


Non-sensitive.

2. Current Deposits Non-sensitive.

3. Savings Bank Deposits Sensitive to the extent of interest paying (core) portion. This may be included in over 3-6 months bucket. The non-interest paying portion may be shown in non-sensitive bucket.

Where banks can estimate the future behaviour/sensitivity of current/savings bank deposits to changes in market

Annexure – E

183

variables, the sensitivity so estimated could be shown under appropriate time buckets.

4. Term Deposits and Certificates of Deposit

Sensitive and reprices on maturity. The amounts should be distributed to different buckets on the basis of remaining term to maturity. However, in case of floating rate term deposits, the amounts may be shown under the time bucket when deposits contractually become due for repricing.

5. Borrowings – Fixed Sensitive and reprices on maturity. The amounts should be distributed to different buckets on the basis of remaining maturity.

6. Borrowings – Floating Sensitive and reprices when interest rate is reset. The amounts should be distributed to the appropriate bucket which refers to the repricing date.

7. Borrowings – Zero Coupon Sensitive and reprices on maturity. The amounts should be distributed to the respective maturity buckets.

8. Borrowings from RBI Upto 1 month bucket.

9. Refinances from other agencies.

(a) Fixed rate : As per respective maturity.

(b) Floating rate : Reprices when interest rate is reset.

10. Other Liabilities and Provisions

i) Bills Payable i) Non-sensitive.

ii) Inter-office Adjustment ii) Non-sensitive.

iii) Provisions iii) Non-sensitive.

iv) Others iv) Non-sensitive.


184

11. Repos / Bills Re-discounted (DUPN), Swaps (Buy / Sell) etc.

Reprices only on maturity and should be distributed to the respective maturity buckets.

Assets 1. Cash Non - sensitive. 2. Balances with RBI Interest earning portion may be shown

in over 3 – 6 months bucket. The balance amount is non-sensitive.

3. Balances with other Banks i) Current Account i) Non-sensitive. ii) Money at Call and Short Notice, Term Deposits and Notice, Term Deposits and

ii) Sensitive on maturity. The amounts should be distributed other placements to the respective maturity buckets.

4. Investments (Performing). i) Fixed Rate / Zero Coupon i) Sensitive on maturity. ii) Floating Rate ii) Sensitive at the next repricing date 5. Shares/Units of Mutual Funds

Non-sensitive.

6. Advances (Performing) (i) Bills Purchased and Discounted (including bills under DUPN)

(i) Sensitive on maturity.

(ii) Cash Credits / Overdrafts (including TODs) / Loans repayable on demand and Term Loans

(ii) Sensitive only when PLR/risk premium is changed. Of late, frequent changes in PLR have been noticed. Thus, each bank should foresee the direction of interest rate movements of funding options and capture the amounts in the respective maturity buckets which coincides with the time taken by banks to effect changes in PLR in response to changes in market interest rates.

Annexure – E

185

7. NPAs (Advances and Investments) *

(i) Sub-Standard (i) Over 3-5 years bucket.

(ii) Doubtful and Loss (ii) Over 5 years bucket.

8. Fixed Assets Non-sensitive.

9. Other Assets.

(i) Inter-office Adjustment (i) Non-sensitive.

(ii) Leased Assets (ii) Sensitive on cash flows. The amounts should be distributed to the respective maturity buckets corresponding to the cash flow dates.

(iii) Others (iii) Non-sensitive.

10. Reverse Repos, Swaps (Sell/Buy) and Bills Rediscounted (DUPN)

Sensitive on maturity.

11. Other products (Interest Rate)

(i) Swaps (i) Sensitive and should be distributed under different buckets with reference to maturity.

(ii) Other Derivatives (ii) Should be suitably classified as and when introduced.

• Amounts to be shown net of provisions, interest suspense and claims received from ECGC / DICGC.


186

ANNEXURE - I

Name of the bank :

Statement of Structural Liquidity as on :

(Amounts in Crores of Rupees)

RESIDUAL MATURITY

OUTFLOWS 1 to 14

days

15 to 28

days

29 days and

upto 3 months

Over 3 months

and upto 6 onths

Over 6 Months

and upto 1 year

Over 1 year and

upto 3 years

Over 3 years and

upto 5 years

Over 5

years Total

1.Capital

2.Reserves & Surplus

3.Deposits XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i) Current Deposits

(ii) Savings Bank Deposits

(iii) Term Deposits

(iv) Certificates of Deposit

4.Borrowings XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i) Call and Short Notice

(ii) Inter-Bank (Term)

(iii) Refinances

(iv) Others (specify)

5.Other Liabilities & Provisions

XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i) Bills Payable

(ii) Inter-office Adjustment

(iii) Provisions

Annexure – E

187

(iv) Others

6.Lines of Credit committed to


(i) Institutions

(ii) Customers

7. Unavailed portion of Cash Credit / Overdraft / Demand Loan component of Working Capital

8. Letters of Credit / Guarantees

9.Repos

10. Bills Rediscounted (DUPN)

11.Swaps (Buy/Sell) / maturing forwards

12. Interest payable

13.Others (specify)

A. TOTAL OUTFLOWS

INFLOWS

1.Cash

2.Balances with RBI

3.Balances with other Banks


(i) Current Account



188

4.Investments (including those under Repos but excluding Reverse Repos)

5.Advances (Performing)


(i) Bills Purchased and Discounted (including bills under DUPN)

(ii) Cash Credits, Overdrafts and Loans repayable on demand

(iii) Term Loans

6. NPAs (Advances and Investments)*

7. Fixed Assets

8. Other Assets XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i) Inter-office Adjustment

ii) Leased Assets

(iii) Others

9. Reverse Repos

10. Swaps (Sell / Buy)/ maturing forwards

11. Bills discounted (DUPN)

12. Interest receivable

13. Committed Lines of Credit

Annexure – E

189

14. Export Refinance from RBI.

15. Others (specify)

B. TOTAL INFLOWS

C. MISMATCH (B-A)

D. CUMULATIVE MISMATCH

E. C as % To A

* Net of provisions, interest suspense and claims received from ECGC/DICGC.


190

ANNEXURE - II

Name of the bank:

Statement of Interest Rate Sensitivity as on:

(Amounts in Crores of Rupees)

LIABILITIES 1-28 days

29 days and

upto 3 months

Over 3 months

and upto 6 months

Over 6 months

and upto 1 year

Over 1 year and

upto 3 years

Over 3 Years And

Upto 5 Years

Over 5

years

Non- sensitive

Total

1. Capital

2. Reserves & Surplus

3. Deposits XXX XXX XXX XXX XXX XXX XXX XXX XXX


(ii) Savings Bank Deposits

(iii) Term Deposits


4. Borrowings XXX XXX XXX XXX XXX XXX XXX XXX XXX


(ii) Inter-Bank(Term)

(iii) Refinances


5. Other Liabilities & Provisions


(i) Bills Payable

(ii) Inter-office

Annexure – E

191

Adjustment

(iii) Provisions *

(iv) Others

6. Repos

7. Bills Re discounted (DUPN)

8. Swaps (Buy/Sell)

9. Others (specify)

A. TOTAL LIABILITIES

* Excluding provisions for NPAs and investments.

ASSETS

1.Cash

2.Balances with RBI



(i) Current Account

(ii) Money at Call and Short Notice, Term Deposits and other placements.

4.Investments (including those under Repos but excluding Reverse Repos)

5.Advances (Performing)



(ii) Cash Credits, Overdrafts and Loans


192

repayable on demand

(iii) Term Loans

6. NPAs (Advances and Investments) *

7. Fixed Assets

8. Other Assets XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i)Inter-office Adjustment

(ii) Leased Assets

(iii) Others

9. Reverse Repos

10. Swaps (Sell/ Buy)

11.Bills Rediscounted (DUPN)


B. TOTAL ASSETS

C. GAP ( B-A )

OTHER PRODUCTS (INTEREST RATE)


(i) FRAs

(ii) Swaps

(iii) Futures

(iv) Options

(v) Others

D. TOTAL OTHER PRODUCTS

E.NET GAP (C-D)

F.CUMULATIVE GAP

G. E AS % TO B

* Amounts to be shown net of provisions, interest suspense and claims received from ECGC/DICGC.

Annexure – E

193

ANNEXURE - III

Name of the Bank :

Statement of Short-term Dynamic Liquidity as on ..

(Amounts in Crores of Rupees) A. Outflows 1- 14 days 15-28 days 29-90 days 1 Net increase in loans and advances 2 Net increase in investments:

i) Approved securities ii) Money market instruments (other than

Treasury bills) iii) Bonds/Debentures /shares iv) Others

3 Inter-bank obligations 4 Off-balance sheet items (Repos, swaps, bills

discounted, etc.)

5 Others TOTAL OUTFLOWS B. Inflows 1 Net cash position 2 Net increase in deposits (less CRR obligations) 3 Interest on investments 4 Inter-bank claims 5 Refinance eligibility (Export credit) 6 Off-balance sheet items (Reverse repos, swaps,

bills discounted, etc.)

7 Others TOTAL INFLOWS C. Mismatch (B - A) D. Cumulative mismatch E. C as a % to total outflows


194

RBI/2007-2008/165 DBOD. No. BP. BC. 38 / 21.04.098/ 2007-08 October 24, 2007

Chairmen / Chief Executive Officers All Commercial Banks (excluding RRBs)

Guidelines on Asset-Liability Management (ALM) System –amendments

Reserve Bank had issued guidelines on ALM system vide Circular No. DBOD. BP. BC. 8 / 21.04.098/ 99 dated February 10, 1999, which covered, among others, interest rate risk and liquidity risk measurement / reporting framework and prudential limits. As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee. As per the guidelines, the mismatches (negative gap) during the time buckets of 1-14 days and 15-28 days in the normal course, are not to exceed 20 per cent of the cash outflows in the respective time buckets.

2. Having regard to the international practices, the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management, these guidelines have been reviewed and it has been decided that:

(a) the banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz. Next day , 2-7 days and 8-14 days.

(b) the Statement of Structural Liquidity may be compiled on best available data coverage, in due consideration of non-availability of a fully networked environment. Banks may, however, make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner.

(c) the net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 % ,10%, 15 % and 20

Annexure – E

195

% of the cumulative cash outflows in the respective time buckets in order to recognise the cumulative impact on liquidity.

(d) banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity, may, however, be reported to RBI, once a month, as on the third Wednesday of every month.

3. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. The guidance for slotting the future cash flows of banks in the revised time buckets has also been suitably modified and is furnished at Annex II. The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines.

4. To enable the banks to fine tune their existing MIS as per the modified guidelines, the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1, 2008 and the reporting frequency would continue to be monthly for the present. However, the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly, with effect from the fortnight beginning April 1, 2008.

Yours faithfully,

(Prashant Saran) Chief General Manager-in-Charge


196

Annex - I

Name of the bank :

Statement of Structural Liquidity as on :

(Amounts in Crores of Rupees) Residual maturity

OUTFLOWS Day 1

2-7 day s

8-14 day s

15 -28 days

29 days

and

upto 3 months

Over 3 months

and

upto 6 months

Over 6 Month

and

upto 1 year

Over 1 year

and

upto 3 years

Over 3 years

and

upto 5 years

Over 5

years

Total

1. Capital

2. Reserves & Surplus

3. Deposits XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX


(ii) Savings Bank

Deposits

(iii) Term Deposits


4. Borrowings XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX


(ii) Inter-Bank (Term)

(iii) Refinances


5.Other Liabilities &

Provisions

XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i) Bills Payable

Annexure – E

197

(ii) Provisions

(iii) Others

6. Lines of Credit committed to


(i) Institutions

(ii) Customers

7. Unavailed portion of Cash Credit /

Overdraft / Demand Loan component of

Working Capital

8. Letters of Credit /

Guarantees

9. Repos

10. Bills Rediscounted (DUPN)

11.Swaps (Buy/Sell) / maturing forwards

12. Interest payable


A. TOTAL OUTFLOWS

B. CUMULATIVE OUTFLOWS


198

Residual Maturity

INFLOWS Day 1 2-7

days 8-14 days

15 -28 days

29 days and

upto 3

months

Over 3 months

and

upto 6 months

Over 6 months

and

upto 1year

Over 1 year

and

upto 3years

Over 3 years

and

upto 5 years

Over 5

years

Total

1. Cash

2. Balances with RBI



(i) Current Account

(ii) Money at Call and

Short Notice, Term Deposits and other

placements

4.Investments

(including those under Repos but

excluding Reverse

Repos)

5. Advances (Performing)


(i) Bills Purchased and Discounted

(including bills under DUPN)

(ii) Cash Credits, Overdrafts and Loans

repayable on demand

(iii) Term Loans

6. NPAs (Advances

Annexure – E

199

and Investments) *

7. Fixed Assets

8. Other Assets XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

(i) Leased Assets

(ii) Others

9. Reverse Repos

10. Swaps (Sell /

Buy)/ maturing forwards

11.Bills Rediscounted (DUPN)

12. Interest

receivable

13. Committed Lines of Credit

14. Export Refinance from RBI.


C. TOTAL INFLOWS

D. MISMATCH( C-A )

E. MISMATCH as % to OUTFLOWS (D as % to A)

F. CUMULATIVE MISMATCH

G. CUMULATIVE MISMATCH as a % to CUMULATIVE OUTFLOWS ( F as a % to B)


200

Annex - II

Guidance for slotting the future cash flows of banks in the revised time buckets

Heads of Accounts Classification into time buckets

A. Outflows


Over 5 years bucket.

2. Demand Deposits (Current and Savings Bank Deposits)

Savings Bank and Current Deposits may be classified into volatile and core portions. Savings Bank (10%) and Current (15%) Deposits are generally withdrawable on demand. This portion may be treated as volatile. While volatile portion can be placed in the Day 1, 2-7 days and 8-14 days time buckets, depending upon the experience and estimates of banks and the core portion may be placed in over 1- 3 years bucket.

The above classification of Savings Bank and Current Deposits is only a benchmark. Banks which are better equipped to estimate the behavioural pattern, roll-in and roll-out, embedded options, etc. on the basis of past data/empirical studies could classify them in the appropriate buckets, i.e. behavioural maturity instead of contractual maturity, subject to the approval of the Board/ALCO.

3. Term Deposits Respective maturity buckets. Banks which are better equipped to estimate the behavioural pattern, roll-in and roll-out, embedded options, etc. on the basis of past data/empirical studies could classify the retail deposits in the appropriate buckets on the basis of behavioural maturity rather than residual maturity. However, the wholesale deposits should be shown under respective maturity buckets.

(wholesale deposits for the purpose of this statement may be Rs 15 lakhs or any such higher threshold approved by the bank’s Board).

4. Certificates of Deposit, Borrowings and Bonds (including Sub-ordinated Debt)

Respective maturity buckets. Where call/put options are built into the issue structure of any instrument/s, the call/put date/s should be reckoned as the maturity date/s and the amount should be shown in the respective time buckets.

Annexure – E

201


5. Other Liabilities and

Provisions

(i) Bills Payable

(ii) Provisions other than for loan loss and depreciation in investments

(iii) Other Liabilities

(i) The core component which could reasonably be estimated on the basis of past data and behavioural pattern may be shown under ‘Over 1-3 years’ time bucket. The balance amount may be placed in Day 1, 2-7 days and 8-14 days buckets, as per behavioural pattern.

(ii) Respective buckets depending on the purpose.

(iii) Respective maturity buckets. Items not representing cash payables (i.e. income received in advance, etc.) may be placed in over 5 years bucket.

6. Export Refinance – Availed

Respective maturity buckets of underlying assets.

B. Inflows


1. Cash Day 1 bucket.

2. Balances with RBI While the excess balance over the required CRR/SLR may be shown under Day 1 bucket, the Statutory Balances may be distributed amongst various time buckets corresponding to the maturity profile of DTL with a time-lag of 14 days.

3. Balances with other banks

(i) Current Account


(i) Non-withdrawable portion on account of stipulations of minimum balances may be shown under ‘Over 1-3 years’ bucket and the remaining balances may be shown under Day 1 bucket.

(ii) Respective maturity buckets.

4. Investments (Net of provisions)#

(i) Approved securities (i) Respective maturity buckets, excluding the amount required to be reinvested to maintain SLR corresponding to the DTL profile in various time buckets.

(ii) Corporate debentures (ii) Respective maturity buckets. Investments classified as NPIs


202

Heads of Accounts Classification into time buckets and bonds, PSU bonds, CDs and CPs, Redeemable preference shares, Units of Mutual Funds (close ended), etc.

should be shown under over 3-5 years bucket (sub-standard) or over 5 years bucket (doubtful).

(iii) Shares

(iv) Units of Mutual Funds (open ended)

(iii) Listed shares (except strategic investments ) in 2-7days bucket, with a haircut of 50%. Other shares in ‘Over 5 years’ bucket.

(iv) Day 1 bucket

(v) Investments in Subsidiaries/ Joint Ventures

(v) ‘Over 5 years’ bucket.

(vi) Securities in the Trading Book

(vi) Day 1, 2-7 days, 8-14 days, 15-28 days and 29-90 days according to defeasance periods.

5. Advances (Performing)


Annexure – E

203




(ii) Cash Credit / Overdraft (including TOD) and Demand Loan component of Working Capital.

(ii) Banks should undertake a study of behavioural and seasonal pattern of availments based on outstandings and the core and volatile portion should be identified. While the volatile portion could be shown in the near-term maturity buckets, the core portion may be shown under ‘Over 1-3 years’ bucket.

(iii) Term Loans (iii) Interim cash flows may be shown under respective maturity buckets.

6. NPAs (Net of provisions, interest suspense and claims received from ECGC/DICGC )

(i) Sub-standard (i) ‘Over 3-5 years’ bucket.

(ii) Doubtful and Loss (ii) ‘Over 5 years’ bucket.

7. Fixed Assets/ Assets on lease

‘Over 5 years’ bucket / Interim cash flows may be shown under respective maturity buckets.

8. Other Assets

Intangible assets

Intangible assets and assets not representing cash receivables may be shown in ‘Over 5 years’ bucket.

C. Off balance sheet items

1. Lines of Credit committed / available

(i) Lines of Credit committed to/ from Institutions

(ii) Unavailed portion of Cash Credit/ Overdraft / Demand loan component of Working Capital limits (outflow)

(iii) Export Refinance – Unavailed (inflow)

(i) Day 1 bucket.

(ii) Banks should undertake a study of the behavioural and seasonal pattern of potential availments in the accounts and the amounts so arrived at may be shown under relevant maturity buckets upto 12 months.

(iii) Day 1 bucket.


204

2. Contingent Liabilities Letters of Credit / Guarantees (outflow)

Devolvement of Letters of Credit/ Guarantees, initially entails cash outflows. Thus, historical trend analysis ought to be conducted on the devolvements and the amounts so arrived at in respect of outstanding Letters of Credit / Guarantees (net of margins) should be distributed amongst various time buckets. The assets created out of devolvements may be shown under respective maturity buckets on the basis of probable recovery dates.

3. Other Inflows / outflows (i) Repos / Bills Rediscounted (DUPN)/ CBLO/ Swaps INR / USD, maturing forex forward contracts etc. (outflow / inflow)


(ii) Interest payable / receivable (outflow / inflow)

(ii) Respective maturity buckets.

Note:

(i) Liability on account of event cash flows i.e. short fall in CRR balance on reporting Fridays, wage settlement, capital expenditure, etc. which are known to the banks and any other contingency may be shown under respective maturity buckets. The event cash outflows, including incremental SLR requirement should be reported against “Outflows – Others”.

(ii) All overdue liabilities may be placed in the Day 1, 2-7 days and 8-14 days buckets, based on behavioural estimates.

(iii) Interest and instalments from advances and investments, which are overdue for less than one month may be placed in Day 1, 2-7 days and 8-14 days buckets, based on behavioural estimates. Further, interest and instalments due (before classification as NPAs) may be placed in ‘29 days to 3 months bucket’ if the earlier receivables remain uncollected.

Annexure – E

205

D. Financing of Gap:

In case the net cumulative negative mismatches during the Day 1, 2-7 days, 8-14 days and 15-28 days buckets exceed the prudential limit of 5 % ,10%, 15 % and 20% of the cumulative cash outflows in the respective time buckets, the bank may show by way of a foot note as to how it proposes to finance the gap to bring the mismatch within the prescribed limits. The gap can be financed from market borrowings (call / term), Bills Rediscounting, Repos, LAF and deployment of foreign currency resources after conversion into rupees (unswapped foreign currency funds ), etc.


206

RBI/2007-08/278 DBOD. No. BP. BC. 68 / 21.04.098/ 2007-08 April 9, 2008

Chairmen / Chief Executive Officers All Commercial Banks (excluding RRBs)

Guidelines on Asset-Liability Management (ALM) System

Please refer to DBOD Circular No.DBOD. BP. BC. 38 / 21.04.098/ 2007-08 dated October 24, 2007 advising banks to adopt a more granular approach to measurement of liquidity risk. Banks were also advised to undertake dynamic liquidity management and prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity was, however, to be reported to RBI, once a month, as on the third Wednesday of every month.

2. It was also indicated that to enable the banks to fine tune their existing MIS as per the modified guidelines, the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1, 2008 and the reporting frequency would continue to be monthly for the present. However, the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly, with effect from April 1, 2008.

3. Accordingly, banks are advised to submit the Statement of Structural Liquidity as on the first and third Wednesday of every month to Reserve Bank of India, Department of Banking Supervision, OSMOS Division. The due-date of the submission of the Statement would be the seventh day from the reporting date.

Yours faithfully,

(P. Vijaya Bhaskar) Chief General Manager

ANNEXURE – F

RBI MC GUIDE PRIMARY DEALERS 2009

TELEGRAMS: "RESERVBANK" POST BOX 10007

TELEPHONE 22661602/04 FAX NO. 022-22644158

RESERVE BANK OF INDIA CENTRAL OFFICE

INTERNAL DEBT MANAGEMENT DEPARTMENT

CENTRAL OFFICE BUILDING MUMBAI 400 001

RBI/2009-10/56 July 1, 2009

IDMD.PDRS. 01/03.64.00/2009-10

All Primary Dealers in the Government Securities Market

Dear Sir

Master Circular – Operational Guidelines to Primary Dealers

The Reserve Bank of India has, from time to time, issued a number of guidelines/instructions/circulars to the Primary Dealers (PDs) in regard to their operations in the Government Securities Market. To enable the PDs to have all the current instructions at one place, this Master Circular is being issued, incorporating the guidelines/instructions/directives on the subject issued upto June 30, 2009. The additional guidelines applicable to banks undertaking PD business departmentally are incorporated under Section II of this Master Circular. The list of circulars consolidated is given in Annex. The guidelines on Risk Management and Capital Adequacy for the stand alone PDs are being issued vide our Master Circular IDMD.PDRD.02/03.64.00/2009-10 dated July 1, 2009. The banks undertaking PD activities departmentally shall follow the extant


208

guidelines applicable to the banks regarding their capital adequacy requirement and risk management.

Yours faithfully

(K.V.Rajan) Chief General Manager Encl: As above

Annexure – F

209

Table of Contents

Section I: Regulations governing Primary Dealers 1. Primary Dealership System 2

2. Role of Primary Dealers in Primary Market 7

3. Primary Dealers operations - Sources and application of funds 10

4. Diversification of activities by stand-alone Primary Dealers 12

5. Investment Guidelines 15

6. Prudential systems/controls 18

7. Trading of Government Securities on Stock Exchanges 23

8. Business through brokers 25

9. Norms for Ready Forward transactions 26

10. Portfolio Management Services by PDs 27

11. Guidelines on interest rate derivatives 28

12. Guidelines on declaration of dividends 28

13. Guidelines on Corporate Governance 29

14. Prevention of Money Laundering Act, 2002 29

15. Violation/Circumvention of Instructions 29

Section II: Additional Guidelines applicable to banks undertaking PD business departmentally 1. Introduction 30

2. Procedure for Authorisation of Primary Dealers 30

3. Applicabilty of Guidelines issued for PDs 30

4. Maintenance of books and accounts 32

5. Capital Adequacy and Risk Management 32

6. Supervision by RBI 33


210

Annexes: I. Form of Undertaking 34

II. Statements/Returns required to be submitted by PDs 37

II A. Statements/Returns required to be submitted by banks on their PD business 39

III. Illustration showing the underwriting scheme 40

IV. Illustration showing PDs commitment to T-Bill auctions 43

V. Format PDR–I 44

VI. Format PDR-II 46

VII. Format PDR-IV 48

VIII. Publication of Financial Results 52

IX. Interest Rate Risk of Rupee Derivatives 53

X. List of circulars consolidated 54

Annexure – F

211

Section I: Regulations governing Primary Dealers 1. Primary Dealership System

1.1 Introduction

In 1995, the Reserve Bank of India (RBI) introduced the system of Primary Dealers (PDs) in the Government Securities Market, which comprised independent entities undertaking Primary Dealer activity. In order to broad base the Primary Dealership system, banks were permitted to undertake Primary Dealership business departmentally in 2006-07. Further, the standalone PDs were permitted to diversify into business activities, other than the core PD business, in 2006-07, subject to certain conditions. As on June 30, 2009, there are six standalone PDs and eleven banks authorized to undertake PD business departmentally.

1.2 The objectives of Primary Dealer System

The objectives of the PD system are:

i. To strengthen the infrastructure in the government securities market in order to make it vibrant, liquid and broad based.

ii. To ensure development of underwriting and market making capabilities for government securities outside the RBI so that the latter will gradually shed these functions.

iii. To improve secondary market trading system, which would contribute to price discovery, enhance liquidity and turnover and encourage voluntary holding of government securities amongst a wider investor base.

iv. To make PDs an effective conduit for conducting open market operations (OMO).

1.3 Eligibility conditions

1.3.1 The following institutions are eligible to apply for Primary Dealership:

i. Subsidiary of scheduled commercial bank/s and all India financial institution/s dedicated predominantly to the securities business and in particular to the government securities market.

ii. Company incorporated under the Companies Act, 1956 and engaged predominantly in the securities business and in particular the government securities market.


212

iii. Subsidiaries/ joint ventures set up by entities incorporated abroad under the approval of Foreign Investment Promotion Board (FIPB).

iv. Banks which do not have a partly or wholly owned subsidiary undertaking PD business and fulfill the following criteria :

a. Minimum net owned funds (NOF) of Rs.1,000 crore

b. Minimum CRAR of 9 per cent

c. Net NPAs of less than 3 per cent and a profit making record for the last three years.

1.3.2 Indian banks which are undertaking PD business through a partly or wholly owned subsidiary and wish to undertake PD business departmentally by merging / taking over PD business from their partly / wholly owned subsidiary may do so subject to fulfilling the criteria stipulated above.

1.3.3 Foreign banks operating in India who wish to undertake PD business departmentally by merging the PD business being undertaken by a group entity may do so subject to fulfillment of the criteria stipulated above.

1.3.4 A non-bank entity applying for permission to undertake PD business shall obtain Certificate of Registration as an NBFC under Section 45-IA of the RBI Act, 1934 from the Department of Non-Banking Supervision, Reserve Bank of India.

1.3.5 A non-bank applicant shall have net owned funds (NOF) of a minimum of Rs. 50 crore. In the case of a PD intending to diversify into permissible activities, the minimum NOF shall be Rs.100 crore. NOF will be computed in terms of the explanatory note to Section 45-IA of Chapter III-B of the Reserve Bank of India Act, 1934.

1.3.6 PDs are not permitted to set up step-down subsidiaries.

1.4 Procedure for Authorisation of Primary Dealers

1.4.1 For enlistment as a Primary Dealer, an eligible institution should submit its application to the Chief General Manager, Internal Debt Management Department (IDMD), Reserve Bank of India. The Reserve Bank will consider the application and, if satisfied, would grant approval `in principle’. The applicant will thereafter submit an undertaking in respect of the terms and conditions agreed to. Based on the application and undertaking, an authorization letter will be issued by RBI. Continuation as a Primary Dealer would depend on its compliance with the terms and conditions of authorisation.

Annexure – F

213

Note: The decision to enlist Primary Dealers will be taken by Reserve Bank of India based on its perception of market needs, suitability of the applicant and the likely value addition to the system.

1.5 PDs’ role and obligations

PDs are expected to play an active role in the government securities market, both in its primary and secondary market segments. A Primary Dealer will be required to have a standing arrangement with RBI based on the execution of an undertaking (Annex I) and the authorisation letter issued by RBI each year. The major roles and obligations of PDs are as below:

i. Support to Primary Market: PDs are required to support auctions for issue of Government dated securities and Treasury Bills as per the minimum norms for underwriting commitment, bidding commitment and success ratio as prescribed by RBI from time to time.

ii. Market making in Government securities: PDs should offer two-way prices in Government securities, through the Negotiated Dealing System-Order Matching (NDSOM), over-the-counter market and recognised Stock Exchanges in India and take principal positions in the secondary market for Government securities.

iii. PDs should maintain adequate physical infrastructure and skilled manpower for efficient participation in primary issues, trading in the secondary market, and to advise and educate investors.

iv. A Primary Dealer shall have an efficient internal control system for fair conduct of business, settlement of trades and maintenance of accounts.

v. A Primary Dealer will provide access to RBI to all records, books, information and documents as and when required.

vi. PDs’ investment in Government Securities and Treasury Bills on a daily basis should be at least equal to its net call/notice/repo (including CBLO) borrowing plus net RBI borrowing (through LAF/ Intra-Day Liquidity/ Liquidity Support) plus the minimum prescribed NOF.

vii. PDs should annually achieve a minimum turnover ratio of 5 times for Government dated securities and 10 times for Treasury Bills of the average month-end stocks. The turnover ratio in respect of outright transactions should not be less than 3 times in government dated securities and 6 times in Treasury Bills (Turnover ratio is computed as the


214

ratio of total purchase and sales during the year in the secondary market to average month-end stocks).

viii. A PD should submit periodic returns as prescribed by RBI from time to time.

ix. PDs’ operations are subject to prudential and regulatory guidelines issued by RBI from time to time.

1.6 Facilities from RBI to PDs

The Reserve Bank currently extends the following facilities to PDs to enable them to effectively fulfill their obligations:

i. Access to Current Account facility with RBI.

ii. Access to Subsidiary General Ledger (SGL) Account facility (for Government securities) with RBI.

iii. Permission to borrow and lend in the money market including call money market and to trade in all money market instruments.

iv. Memberships of electronic dealing, trading and settlement systems (NDS platforms/INFINET/RTGS/CCIL).

v. Access to the Liquidity Adjustment Facility (LAF) of RBI.

vi. Access to liquidity support from RBI under a scheme separately notified for standalone PDs.

vii. Favoured access to open market operations by Reserve Bank of India.

The facilities are, however, subject to review, depending upon the market conditions and requirement.

1.7 Regulation

i. PDs are required to meet registration and such other requirements as stipulated by the Securities and Exchange Board of India (SEBI) including operations on the Stock Exchanges, if they undertake any activity regulated by SEBI.

ii. PDs are expected to join Primary Dealers Association of India (PDAI) and Fixed Income Money Market and Derivatives Association (FIMMDA) and abide by the code of conduct framed by them and such other actions as initiated by them in the interest of the securities markets.

Annexure – F

215

iii. In respect of transactions in Government securities, a Primary Dealer should have a separate desk and maintain separate accounts in respect of its own position and customer transactions and subject them to external audit also.

iv. Any change in the shareholding pattern / capital structure of a PD needs prior approval of RBI. PDs should report any other material changes such as business profile, organization, etc. affecting the conditions of licensing as PD to RBI immediately.

v. Reserve Bank of India reserves the right to cancel the Primary Dealership if, in its view, the concerned institution has failed to adhere to the terms of authorisation or any other RBI guideline as applicable.

vi. A Primary Dealer should bring to the RBI’s attention any major complaint against it or action initiated/taken against it by authorities such as the Stock Exchanges, SEBI, CBI, Enforcement Directorate, Income Tax, etc.

1.8 Supervision by RBI

1.8.1 Off-site supervision: PDs are required to submit prescribed periodic returns to RBI promptly. The current list of such returns, their periodicity, etc. is furnished in Annex II.

1.8.2 On-site inspection: RBI will have the right to inspect the books, records, documents and accounts of the PD. PDs are required to make available all such documents, records, etc. to the RBI officers and render all necessary assistance as and when required.

2. Role of Primary Dealers in the Primary Market

Concomitant with the objectives of PD system, the PDs are expected to support the primary issues of dated securities of Central Government and State Government and Treasury Bills of Central Government, through underwriting/bidding commitments and success ratios. The related guidelines are as under:

2.1 Underwriting of Dated Government Securities

2.1.1 Dated securities of Central Government:

i. The underwriting commitment on dated securities of Central Government will be divided into two parts - i) Minimum Underwriting Commitment (MUC) and ii) Additional Competitive Underwriting (ACU).


216

ii. The MUC of each PD will be computed to ensure that at least 50 percent of the notified amount of each issue is mandatorily underwritten equally by all PDs. The share under MUC will be uniform for all PDs, irrespective of their capital or balance sheet size. The remaining portion of the notified amount will be underwritten through an Additional Competitive Underwriting (ACU) auction.

iii. RBI will announce the MUC of each PD and the balance amount which will be underwritten under the ACU auction. In the ACU auction, each PD would be required to bid for an amount at least equal to its share of MUC. A PD cannot bid for more than 30 per cent of the notified amount in the ACU auction.

iv. The auction could be either uniform price-based or multiple price-based depending upon the market conditions and other relevant factors, which will be announced before the underwriting auction for each issue.

v. Bids will be tendered by PDs within the stipulated time, indicating both the amount of the underwriting commitment and underwriting commission rates. A PD can submit multiple bids for underwriting. Depending upon the bids submitted for underwriting, RBI will decide the cut-off rate of commission and inform the PDs.

vi. Underwriting commission: All successful bidders in the ACU auction will be paid underwriting commission on the ACU segment as per the auction rules. Those PDs who succeed in the ACU for 4 per cent and above of the notified amount of the issue, will be paid commission on the MUC at the weighted average of all the accepted bids in the ACU. Others will get commission on the MUC at the weighted average rate of the three lowest bids in the ACU.

vii. In the GOI securities auction, a PD should bid for an amount not less than their total underwriting obligation. If two or more issues are floated on the same day, the minimum bid amount will be applied to each issue separately.

viii. Underwriting commission will be paid on the amount accepted for underwriting by the RBI, irrespective of the actual amount of devolvement, by credit to the current account of the respective PDs at the RBI, Fort, Mumbai, on the date of issue of security.

ix. In case of devolvement, PDs would be allowed to set-off the accepted

Annexure – F

217

bids in the auction against their underwriting commitment accepted by the Reserve Bank. Devolvement of securities, if any, on PDs will take place on pro-rata basis, depending upon the amount of underwriting obligation of each PD after setting off the successful bids in the auction.

x. RBI reserves the right to accept any amount of underwriting up to 100 per cent of the notified amount or even reject all the bids tendered by PDs for underwriting, without assigning any reason.

xi. An illustration pertaining to the underwriting procedure is given in Annex III.

2.1.2 Dated securities of State Governments

i. On announcement of an auction of dated securities of the State Governments for which auction is held, RBI may invite PDs to collectively bid to underwrite up to 100 per cent of the notified amount of State Development Loans (SDL).

ii. A PD can bid to underwrite up to 30 per cent of the notified amount of the issue. If two or more issues are floated on the same day, the limit of 30% is applied by taking the notified amounts separately.

iii. Bids will be tendered by PDs within the stipulated time, indicating both the amount of the underwriting commitments and underwriting commission rates. A PD can submit multiple bids for underwriting.

iv. Depending upon the bids submitted for underwriting, the RBI will decide the cut-off rate of commission and the underwriting amount up to which bids would be accepted and inform the PDs.

v. RBI reserves the right to accept any amount of underwriting up to 100 per cent of the notified amount or even reject all the bids tendered by PDs for underwriting, without assigning any reason.

vi. In case of devolvement, PDs would be allowed to set-off the accepted bids in the auction against their underwriting commitment accepted by the Reserve Bank. Devolvement of securities, if any, on PDs will take place on pro-rata basis, depending upon the amount of underwriting obligation of each PD after setting off the successful bids in the auction.

vii. Underwriting commission will be paid on the amount accepted for underwriting by the RBI, irrespective of the actual amount of devolvement, by credit to the current account of the respective PDs at the RBI, Fort,


218

Mumbai, on the date of issue of security.

2.2 Bidding in Primary auctions of Treasury Bills

i. Each PD will individually commit, at the beginning of the year, to submit bids for a fixed percentage of the notified amount of Treasury Bills in each auction.

ii. The minimum bidding commitment amount / percentage for each PD will be determined by the Reserve Bank, in consultation with the PD. While finalizing the bidding commitments, the RBI will take into account the net owned funds (NOF), the offer made by the PD, its track record and its past adherence to the prescribed success ratio. The amount/percentage of minimum bidding commitment so determined by the Reserve Bank will remain unchanged for the entire financial year or till the conclusion of agreement on bidding commitments for the next financial year, whichever is later.

iii. In any auction of Treasury Bills, if a PD fails to submit the required minimum bid or submits a bid lower than its commitment, the Reserve Bank may take appropriate action against the PD.

iv. A PD would be required to achieve a minimum success ratio of 40 percent of bidding commitment for Treasury Bills auctions which will be monitored on a half yearly basis. A PD is required to achieve the minimum level of success ratio in each half year (April to September and October to March) separately. (For illustrations please refer to Annex IV).

2.3 ‘When-Issued’ transactions in Central Government Securities

PDs shall adhere to the guidelines issued by the RBI vide circular IDMD.No. 2130 /11.01.01 (D) /2006-07 dated November 16, 2006, as amended from time to time, for undertaking “When Issued” transactions.

2.4 Submission of non-competitive bids

PDs shall adhere to the guidelines issued vide circular RBI / 2008-09 / 479 - IDMD.No.5877 / 08.02.33 / 2008-09 dated May 22, 2009, as amended from time to time, in respect of submission of non-competitive bids in the auctions of the Government of India securities.

2.5 Sale of securities allotted in primary issues on the same day

PDs shall adhere to the guidelines issued vide circulars IDMC.PDRS.No. PDS.1 /

Annexure – F

219

03.64.00 / 2000-01 dated October 6, 2000 and RBI / 2005 / 461 – IDMD.PDRS.4777 / 10.02.01 / 2004-05 dated May 11, 2005, for undertaking sale of securities allotted in primary issues on the same day.

2.6 Settlement of primary auctions

PDs shall adhere to the guidelines issued vide circular IDMD.PDRD.No. 1393 / 03.64.00 / 2008-09 dated September 19, 2008. The primary auction settlement is independent from the secondary market settlements and therefore has to be funded separately. Successful PDs shall provide sufficient funds in their current account with the RBI on the auction settlement days before 3:00 pm to meet their obligations against the subscriptions in the primary auctions failing which the shortage will be treated as an instance of ‘SGL bouncing’ and will be subjected to the applicable penal provisions.

2.7 Secondary Market Transactions - Short-selling

PDs shall adhere to the guidelines issued by the RBI vide circular RBI / 2006-07 / 243 IDMD.No./11.01.01 (B)/2006-07 dated January 31, 2007, on short sale in Central Government dated securities, as amended from time to time.

3. Primary Dealers operations - Sources and application of funds

3.1 PDs are permitted to borrow funds from call/notice/term money market and repo (including CBLO) market. They are also eligible for liquidity support from RBI.

3.2 PDs are allowed to borrow from call/notice market, on an average in a reporting fortnight, up to 200 percent of their net owned funds (NOF) as at the end March of the preceding financial year.

3.3 PDs may lend up to 25 percent of their NOF in call/notice market. The limit will be determined by PDs on an average basis during a ‘reporting fortnight’.

3.4 These limits on borrowing and lending are subject to periodic review by Reserve Bank of India.

3.5 Liquidity Support from RBI

In addition to access to the RBI's Liquidity Adjustment Facility, stand-alone PDs are also provided with liquidity support by the Reserve Bank of India against eligible Government securities including State Development Loans (SDLs). The parameters based on which liquidity support will be allocated are given below:

i. Of the total liquidity support, half of the amount will be divided equally


220

among all the stand-alone PDs. The remaining half (i.e. 50%) will be divided in the ratio of 1:1 based on market performance in primary market and secondary market. Performance in primary market will be computed on the basis of bids accepted in the T-Bill auction and G-sec auction in the proportionate weights of 1 and 3. Similarly, the secondary market performance will be judged on the basis of outright turnover in T-Bills and dated Government securities in the proportionate weights of 1 and 3.

ii. The PD-wise limit of liquidity support will be revised every half-year (April-September and October-March) based on the market performance of the PDs in the preceding six months.

iii. The liquidity support to PDs will be made available at the ‘Repo rate’ announced by the Reserve Bank.

iv. The liquidity support availed by a PD will be repayable within a period of 90 days. The penal rate of interest payable by PDs if liquidity support is repaid after 90 days is Bank rate plus 5 percentage points for the period beyond 90 days.

3.6 Inter-Corporate Deposits

3.6.1 Inter-Corporate Deposits (ICD) may be raised by Primary Dealers sparingly and should not be used as a continuous source of funds. After proper and due consideration of the risks involved, the Board of Directors of the PD should lay down the policy in this regard, which among others, should include the following general principles:

i. While the ceiling fixed on ICD borrowings should in no case exceed 50% of the NOF as at the end of March of the preceding financial year, it is expected that actual dependence on ICDs would be much below this ceiling.

ii. ICDs accepted by PDs should be for a minimum period of one week.

iii. ICDs accepted from parent/promoter/group companies or any other related party should be on "arms length basis" and disclosed in financial statements as "related party transactions".

iv. Funds raised through ICDs are subject to ALM discipline.

3.6.2 PDs are prohibited from placing funds in ICD market.

3.7 FCNR (B) loans / External Commercial Borrowings

Annexure – F

221

3.7.1 PDs may avail of FCNR(B) loans up to a maximum of 25% of the NOF as at the end of March of the preceding financial year and subject to the foreign exchange risk of such loans being hedged at all times at least to the extent of 50 per cent of the exposure.

3.7.2 PDs are not permitted to raise funds through External Commercial Borrowings.

3.8 Reporting Requirements

3.8.1 PDs are required to report the sources and application of funds maintained on daily basis and reported to RBI on fortnightly basis. The format of return (PDR-I) is enclosed in Annex V.

3.8.2 PDs are required to report the securities market turnover on monthly basis. The format of return (PDR-II) is enclosed in Annex VI.

3.8.3 PDs are required to submit a quarterly statement on capital adequacy in the prescribed format (PDR-III).

3.8.4 PDs are required to report select financial and Balance Sheet indicators on quarterly basis. The format of return (PDR-IV) is enclosed in Annex VII.

4. Diversification of activities by stand-alone Primary Dealers

4.1 Stand-alone Primary Dealers (PDs) are permitted to diversify their activities, as considered appropriate, in addition to their existing business of Government securities, subject to limits.

4.2 PDs may bifurcate their operations into core and non-core activities.

4.2.1 The following activities are permitted under core activities:

i. Dealing and underwriting in Government securities

ii. Dealing in Interest Rate Derivatives

iii. Providing broking services in Government securities

iv. Dealing and underwriting in Corporate / PSU / FI bonds/ debentures

v. Lending in Call/ Notice/ Term/ Repo/ CBLO market

vi. Investment in Commercial Papers

vii. Investment in Certificates of Deposit

viii. Investment in Security Receipts issued by Securitization Companies/


222

Reconstruction Companies, Asset Backed Securities (ABS), Mortgage Backed Securities (MBS)

ix. Investment in debt mutual funds where entire corpus is invested in debt securities

4.2.2 PDs are permitted to undertake the following activities under non-core activities:

4.2.2.1 Activities which are expected to consume capital such as:

i. Investment / trading in equity and equity derivatives market

ii. Investment in units of equity oriented mutual funds

iii. Underwriting public issues of equity

4.2.2.2 Services, which do not consume capital or require insignificant capital outlay such as:

i. Professional Clearing Services

ii. Portfolio Management Services

iii. Issue Management Services

iv. Merger & Acquisition Advisory Services

v. Private Equity Management Services

vi. Project Appraisal Services

vii. Loan Syndication Services

viii. Debt restructuring services

ix. Consultancy Services

x. Distribution of mutual fund units

xi. Distribution of insurance products

4.2.3 For distribution of insurance products, the PDs may comply with the guidelines contained in the circular DNBS(PD)CC.No.35/10.24/2003-04 dated February 10, 2004 issued by the Department of Non-Banking Supervision.

4.2.4 Specific approvals of other regulators, if needed, should be obtained for undertaking the activities detailed above.

4.2.5 PDs are not allowed to undertake broking in equity, trading / broking in

Annexure – F

223

commodities, gold and foreign exchange.

4.3 The investment in Government Securities should have predominance over the non-core activities in terms of investment pattern. Stand-alone PDs are required to ensure predominance by maintaining at least 50 per cent of their total financial investments (both long term and short term) in Government Securities at any point of time. Investment in Government securities will include the PD’s Own Stock, Stock with RBI under Liquidity Support / Intra-day Liquidity (IDL)/ Liquidity Adjustment Facility (LAF), Stock with market for repo borrowings and Government Securities pledged with the Clearing Corporation of India Ltd (CCIL).

4.4 The exposure to non-core activities shall be subject to the guidelines on regulatory and prudential norms for diversification of activities by stand-alone PDs, which are as under:

4.4.1 The minimum NOF requirement for a PD, proposing to undertake non-core activities, as detailed in para 4.2.2, should be Rs.100 crore as against Rs.50 crore for a PD, which does not diversify into these activities.

4.4.2 The exposure to non-core activities, as defined in paragraph 4.2.2 above , shall be subject to risk capital allocation as prescribed below.

4.4.2.1. PDs may calculate the capital charge for market risk on the stock positions / underlying stock positions/ units of equity oriented mutual funds using Internal Models (VaR based) based on the guidelines prescribed vide RBI Master circular No. IDMD.PDRD. 2/03.64.00/2009-10 dated July 1, 2009 on Capital Adequacy and Risk Management, as updated from time to time. PDs may continue to provide for credit risk arising out of equity, equity derivatives and equity oriented mutual funds as prescribed in the circular mentioned above.

4.4.2.2 The guidelines for both credit risk and market risk in respect of Commercial Paper, Corporate / PSU / FI bonds / Underwriting are contained in the RBI Master circular IDMD.PDRD./03.64.00/2009-10 dated July 1, 2009, as updated from time to time.

4.4.2.3 The capital charge for market risk (VaR calculated at 99 per cent confidence interval, 15-day holding period, with multiplier of 3.3) for the activities defined in para 4.2.2.1 above should not be more than 20 per cent of the NOF as per the last audited balance sheet.

4.4.2.4 PDs choosing to diversify into non-core business segments should define internally the scope of diversification, organization structure and reporting levels for those segments. PDs should clearly lay down exposure and risk limits for


224

those segments in the investment policy with the approval of their Board.

5. Investment Guidelines

5.1 Investment policy – PDs should frame and implement investment and operational policy guidelines on securities transactions which should be approved by their Boards. The guidelines should contain the broad objectives to be followed while undertaking transactions in securities on their own account and on behalf of clients, clearly define the authority to put through deals, and lay down procedure to be followed while putting through deals, various prudential exposure limits, policy regarding dealings through brokers, systems for management of various risks, guidelines for valuation of the portfolio and the reporting systems etc. Operational procedures and controls in relation to the day-to-day business operations should also be worked out and put in place to ensure that operations in securities are conducted in accordance with sound and acceptable business practices. While laying down these guidelines, the PDs should strictly adhere to Reserve Bank’s instructions, issued from time to time. The effectiveness of the policy and operational guidelines should be periodically evaluated.

5.2 PDs should necessarily hold their investments in Government securities portfolio in SGL with RBI. They may also have a dematerialised account with depositories (NSDL/CDSL). All purchase/sale transactions in Government securities by PDs should be compulsorily through SGL/CSGL/Demat accounts.

5.3 PDs should hold all other investments such as commercial papers, bonds and debentures, privately placed or otherwise, and equity instruments, only in dematerialized form.

5.4 All problem exposures, which are not backed by any security or backed by security of doubtful value, should be fully provided for. Where a PD has filed suit against another party for recovery, such exposures should be evaluated and provisions made to the satisfaction of auditors. Any claim against the PD should also be taken note of and provisions made to the satisfaction of auditors.

5.5 The profit and loss account should reflect the problem exposures if any, and also the effect of valuation of portfolio, as per the instructions issued by the Reserve Bank, from time to time. The report of the statutory auditors should contain a certification to this effect.

5.6 PDs should formulate, within the above parameters, their own internal guidelines on securities transactions in both primary and secondary markets, with

Annexure – F

225

the approval of their Board of Directors.

5.7 Guidelines on investments in non-Government securities

5.7.1 These guidelines cover PDs’ investments in non-Government securities (including capital gains bonds, bonds eligible for priority sector status, bonds issued by Central or State public sector undertakings with or without Government guarantees and bonds issued by banks and financial companies) generally issued by corporates, banks, FIs and State and Central Government sponsored institutions, SPVs etc. These guidelines will, however, not be applicable to (i) units of equity oriented mutual fund schemes where any part of the corpus can be invested in equity, (ii) venture capital funds, (iii) commercial paper, (iv) certificate of deposit, and (v) investments in equity shares. The guidelines will apply to investments both in the primary market and the secondary market.

5.7.2 PDs should not invest in non-Government securities of original maturity of less than one year, other than Commercial Paper and Certificates of Deposits, which are covered under RBI guidelines.

5.7.3 PDs should undertake usual due diligence in respect of investments in non-Government securities.

5.7.4 PDs must not invest in unrated non-Government securities.

5.7.5 PDs will abide by the requirements stipulated by the SEBI in respect of corporate debt securities. Accordingly, while making fresh investments in non-Government debt securities, PDs should ensure that such investments are made only in listed debt securities, except to the extent indicated in paragraph 5.7.6 below.

5.7.6 PDs' investment in unlisted non-Government securities should not exceed 10% of the size of their non-Government securities portfolio on an on-going basis. The ceiling of 10% will be inclusive of investment in Security Receipts issued by Securitization Companies/Reconstruction Companies and also the investment in Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS). The unlisted non-Government debt securities in which PDs may invest up to the limits specified above, should comply with the disclosure requirements as prescribed by the SEBI for listed companies.

5.7.7 PDs are required to report their secondary market transactions in corporate bonds done in the OTC market on FIMMDA's reporting platform as indicated vide circular IDMD.530/03.64.00/2007-08 dated July 31, 2007.


226

5.7.8 PDs should ensure that their investment policies duly approved by the Board of Directors are formulated after taking into account all the relevant issues specified in these guidelines on investment in non-Government securities. PDs should put in place proper risk management systems for capturing and analysing the risk in respect of non-Government securities before making investments and taking remedial measures in time. PDs should also put in place appropriate systems to ensure that investment in privately placed instruments is made in accordance with the systems and procedures prescribed under respective PDs’ investment policy.

5.7.9 Boards of PDs should review the following aspects of investment in non-Government Securities at least at quarterly intervals:

i. Total business (investment and divestment) during the reporting period.

ii. Compliance with the prudential limits prescribed by the Board for investment in non-Government securities.

iii. Compliance with the prudential guidelines on non-Government securities prescribed above.

iv. Rating migration of the issuers/ issues held in the PDs’ books.

5.7.10 In order to help the creation of a central database on private placement of debt, a copy of all offer documents should be filed with the Credit Information Bureau (India) Ltd. (CIBIL) by the PDs. Further, any default relating to interest/ installment in respect of any privately placed debt should also be reported to CIBIL by the investing PDs along with a copy of the offer document.

5.7.11 As per the SEBI guidelines, all trades with the exception of the spot transactions, in a listed debt security, shall be executed only on the trading platform of a stock exchange. In addition to complying with these SEBI guidelines, (as and when applicable) PDs should ensure that all spot transactions in listed and unlisted debt securities are reported on the NDS and settled through the CCIL.

6. Prudential systems/controls

6.1 Internal Control System in respect of securities transactions

i. PDs should have an Audit Committee of the Board (ACB) which should meet at least at quarterly intervals. The ACB should peruse the findings of the various audits. ACB should ensure efficacy and adequacy of the audit function.

Annexure – F

227

ii. All security transactions (including transactions on account of clients) should be subjected to concurrent audit by internal/external auditors to the extent of 100% and the results of the audit should be placed before the CEO/CMD of the PD once every month. The compliance should be monitored on ongoing basis and reported directly to the top management. The concurrent audit should also cover the business done through brokers and include the findings in their report.

iii. The scope of concurrent audit should include monitoring of broker wise limits, prudential limits laid down by RBI, accuracy and timely submission of all regulatory returns, reconciliation of SGL/ CSGL balances with PDO statements, reconciliation of current account balance with DAD statements, settlements through CCIL, stipulations with respect to short sale deals, when-issued transactions, constituent deals, money market deals, adherence to accounting standards, verification of deal slips, reasons for cancellation of deals, if any, transactions with related parties on "arms length basis" etc.

iv. PDs should have a system of internal audit focused on monitoring the efficacy and adequacy of internal control systems.

v. All the transactions put through by the PD either on outright basis or ready forward basis should be reflected on the same day in its books and records i.e. preparation of deal slip, contract note, confirmation of the counter party, recording of the transaction in the purchase/sale registers, etc.

vi. With the approval of their Board of Directors, PDs should place appropriate exposure limits / dealing limits, for each of their counterparties which cover all dealings with such counter parties including money market, repos and outright securities transactions. These limits should be reviewed periodically on the basis of financial statements, market reports, ratings, etc. and exposures taken only on a fully collateralized basis where there is slippage in the rating/assessment of any counterparty.

vii. With the approval of their Boards, PDs should put in place reasonable leverage ratio for their operations, which should take into account all outside borrowings as a multiplier of their net owned funds.

viii. There should be a clear functional separation of (i) trading (front office) (ii) risk management (mid office), and (iii) settlement, accounting and reconciliation (back office). Similarly, there should be a separation of


228

transactions relating to own account and constituents’ accounts.

ix. For every transaction entered into, the trading desk should generate a deal slip which should contain data relating to nature of the deal, name of the counter-party, whether it is a direct deal or through a broker, and if through a broker, name of the broker, details of security, amount, price, contract date and time and settlement date. The deal slips should be serially numbered and controlled separately to ensure that each deal slip has been properly accounted for. Once the deal is concluded, the deal slip should be immediately passed on to the back office for recording and processing. For each deal, there must be a system of issue of confirmation to the counter-party. The timely receipt of requisite written confirmation from the counter-party, which must include all essential details of the contract, should be monitored by the back office. With respect to transactions matched on the NDS-OM module, the need for counterparty confirmation of deals matched on NDS-OM does not arise.

x. Once a deal has been concluded, there should not be any substitution of the counterparty by the broker. Similarly, the security sold/purchased in a deal should not be substituted by another security under any circumstances.

xi. On the basis of vouchers passed by the back office (which should be done after verification of actual contract notes received from the broker/counter-party and confirmation of the deal by the counter party), the books of account should be independently prepared.

xii. PDs should periodically review securities transactions and report to the top management, the details of transactions in securities, details of funds/securities delivery failures, even in cases where shortages have been met by CCIL.

6.2 Purchase/Sale of securities through SGL transfer forms

All PDs should report / conclude their transactions on NDS / NDS(OM) and clear/settle them through CCIL as central counter-party. In such cases where exceptions have been permitted to tender physical SGL transfer forms, the following guidelines should be followed:

i. Records of all SGL transfer forms issued/received should be maintained and a system for verification of the authenticity of the SGL transfer forms received from the counter-party and confirmation of authorised signatories

Annexure – F

229

should be put in place.

ii. Under no circumstances, a SGL transfer form issued by a PD in favour of a counterparty should bounce for want of sufficient balance in the SGL/Current Account. Any instance of return of SGL form from the Public Debt Office of the Reserve Bank for want of sufficient balance in the account should be immediately brought to the notice of the PD’s top management and reported to RBI with the details of transactions.

iii. SGL Transfer forms received by purchasing PDs should be deposited in their SGL Accounts immediately. No sale should be effected by way of return of SGL form held by the PD.

iv. SGL transfer form should be in a standard format prescribed by the Reserve Bank and printed on semi-security paper of uniform size. They should be serially numbered and there should be a control system in place to account for each SGL form.

6.3 Bank Receipt or similar receipt should not be issued or accepted by the PDs under any circumstances in respect of transactions in Government securities.

6.4 Accounting Standards for securities transactions

i. PDs should adopt the practice of valuing all securities in their trading portfolio on mark to market basis, at appropriate intervals.

ii. Costs such as brokerage fees, commission or taxes incurred at the time of acquisition of securities, are of revenue/deferred nature. The broken period interest received/paid also get adjusted at the time of coupon payment. PDs can adopt either the IAS or GAAP accounting standards, but has to ensure that the method should be true and fair and should not result in overstating the profits or assets value and should be followed consistently and be generally acceptable especially to the tax authorities.

iii. Broken period interest paid to seller as part of cost on acquisition of Government and other securities should not be capitalised but treated as an item of expenditure under Profit and Loss Account. The PDs may maintain separate adjustment accounts for the broken period interest.

iv. The valuation of the securities portfolio should be independent of the dealing and operations functions and should be done by obtaining the prices declared by Fixed Income Money Market and Derivatives


230

Association of India (FIMMDA) periodically.

v. PDs should publish their audited annual results in leading financial dailies and on their website in the format prescribed (Annex VIII). The following minimum information should also be included by way of notes to the Balance Sheet: -

a. Net borrowings in call (average and peak during the period),

b. Basis of valuation,

c. Leverage Ratio (average and peak),

d. CRAR (quarterly figures), and

e. Details of the issuer composition of non-Government securities investments.

PDs may also furnish more information by way of additional disclosures.

6.5 Reconciliation of holdings of Government securities

Balances as per PDs books should be reconciled at least at monthly intervals with the balances in the books of PDOs. If the number of transactions so warrant, the reconciliation should be undertaken at more frequent intervals. This reconciliation should be periodically checked during audit.

6.6. Transactions on behalf of Constituents:

i. The PDs should be circumspect while acting as agent of their clients for carrying out transactions in securities.

ii. PDs should not use the constituents’ funds or assets for proprietary trading or for financing of another intermediary’s operations.

iii. All transaction records should give a clear indication that the transaction belongs to constituents and does not belong to PDs’ own account.

iv. The transactions on behalf of constituents and the operations in the Constituent SGL accounts should be conducted in accordance with the guidelines issued by RBI on the Constituent SGL accounts.

v. PDs who act as custodians (i.e. CSGL account holders) and offer the facility of maintaining gilt accounts to their constituents, should not permit settlement of any sale transaction by their constituents unless the security sold is actually held in the gilt account of the constituent.

Annexure – F

231

vi. Indirect access to NDS-OM has been permitted to certain segments of investors through banks and PDs vide circular IDMD.DOD.No.5893/ 10.25.66/2007-08 dated May 27, 2008. PDs should adhere to the guidelines on maintenance of gilt accounts and investments on behalf of gilt account holders while undertaking 'constituent deals' on NDS-OM.

6.7 Failure to complete delivery of security/funds in an SGL transaction

Any default in delivery of security/funds in an SGL sale /purchase transaction undertaken by a PD will be viewed seriously. A report on such transaction, even if completed through the securities/funds shortage handling procedure of CCIL, must be submitted to the Internal Debt Management Department, Reserve Bank of India immediately. The occurrence of third default in a period of 6 months (April -September and October-March) in funds and/or securities delivery will result in debarment of the PD from the use of SGL facility for a period of 6 months from the date of the third occurrence. If, after restoration of the facility, any default occurs again, the PD will be debarred permanently from the use of SGL facility.

7. Trading of Government Securities on Stock Exchanges

7.1 With a view to encouraging wider participation of all classes of investors, including retail, in Government securities, trading in Government securities through a nationwide, anonymous, order driven screen based trading system on stock exchanges, in the same manner in which trading takes place in equities, has been permitted. Accordingly, trading of dated Government of India securities in dematerialized form is allowed on automated order driven system of the National Stock Exchange (NSE) of India, the Stock Exchange Mumbai (BSE) and the Over the Counter Exchange of India (OTCEI). This trading facility is in addition to the reporting/trading facility in the Negotiated Dealing System. Being a parallel system, the trades concluded on the exchanges will be cleared by their respective clearing corporations/clearing houses.

7.2 PDs are expected to play an active role in providing liquidity to the Government securities market and promote retailing. They may, therefore, make full use of the facility to distribute Government securities to all categories of investors through the process of placing and picking-up orders on the exchanges. PDs may open demat accounts with a Depository Participant (DP) of NSDL/CDSL in addition to their accounts with RBI. Value free transfer of securities between SGL/CSGL and demat accounts is enabled by PDO-Mumbai subject to guidelines issued by RBI’s Department of Government and Bank


232

Accounts (DGBA).

7.3 Operational Guidelines

i. PDs should take specific approval from their Board to enable them to trade in the Stock Exchanges.

ii. PDs may undertake transactions only on the basis of giving and taking delivery of securities.

iii. Brokers/trading members shall not be involved in the settlement process; all trades have to be settled either directly with clearing corporation/clearing house (in case they are clearing members) or else through clearing member custodians.

iv. The trades done through any single broker will also be subject to the current regulations on transactions done through brokers.

v. A standardized settlement on T+1 basis of all outright secondary market transactions in Government Securities has been adopted to provide the participants more processing time for transactions and to help in better funds as well as risk management.

vi. In the case of repo transactions in Government Securities, however, market participants will have the choice of settling the first leg on either T+0 basis or T+1 basis, as per their requirements.

vii. Any settlement failure on account of non-delivery of securities/ non-availability of clear funds will be treated as SGL bouncing and the current penalties in respect of SGL transactions will be applicable. Stock Exchanges will report such failures to the respective Public Debt Offices.

viii. PDs who are trading members of the Stock Exchanges may have to put up margins on behalf of their non-institutional client trades. Such margins are required to be collected from the respective clients. PDs are not permitted to pay up margins on behalf of their client trades and incur overnight credit exposure to their clients. In so far as the intra day exposures on clients for margins are concerned, the PDs should be conscious of the underlying risks in such exposures.

ix. PDs who intend to offer clearing /custodial services should take specific approval from SEBI in this regard. Similarly, PDs who intend to take trading membership of the Stock Exchanges should satisfy the criteria laid down by SEBI and the Stock Exchanges.

Annexure – F

233

8. Business through brokers

8.1 Business through brokers and contract limits for approved brokers -

PDs may undertake securities or derivative transactions among themselves or with clients through the members of the BSE, NSE and OTCEI. A disproportionate part of the business should not be transacted through only one or a few brokers. PDs should fix aggregate contract limits for each of the approved brokers. A limit of 5%, of total transactions (both purchase and sales) entered into by a PD during a year should be treated as the aggregate upper contract limit for each of the approved brokers. However, if for any reason it becomes necessary to exceed the aggregate limit for any broker, the specific reasons there for should be recorded and the Board should be informed of this, post facto.

8.2 With the approval of their top management, PDs should prepare a panel of approved brokers, which should be reviewed annually or more often if so warranted. Clear-cut criteria should be laid down for empanelment of brokers, including verification of their creditworthiness, market reputation, etc. A record of broker-wise details of deals put through and brokerage paid, should be maintained.

8.3 The brokerage on the deal payable to the broker, if any (if the deal was put through with the help of a broker), should be clearly indicated on the notes/memorandum put up seeking approval for putting through the transaction, and a separate account of brokerage paid, broker-wise, should be maintained.

8.4 The role of the broker should be restricted to that of bringing the two parties to the deal together. Settlement of deals between PDs and counter-parties should be directly between the counter-parties and the broker will have no role in the settlement process.

8.5 While negotiating the deal, the broker is not obliged to disclose the identity of the counter-party to the deal. On conclusion of the deal, he should disclose the counter-party and his contract note should clearly indicate the name of the counter-party.

9. Norms for Ready Forward transactions

Primary Dealers are permitted to participate in Ready Forward (Repo) market both as lenders and borrowers. The terms and conditions subject to which ready forward contracts (including reverse ready forward contracts) may be entered into by PDs will be as under:


234

i. Repos may be undertaken only in a) dated securities and Treasury Bills issued by the Government of India and b) dated securities issued by the State Governments.

ii. Repos may be entered into only with scheduled commercial banks, Urban Cooperative banks, other PDs, NBFCs, mutual funds, housing finance companies, insurance companies and any listed company, provided they hold either an SGL account with RBI or a Gilt account with a custodian.

iii. Listed companies can enter into repo transactions subject to the following conditions:

(a) The minimum period for Reverse Repo (lending of funds) by listed companies is seven days. However, listed companies can borrow funds through repo for shorter periods including overnight;

(b) Where the listed company is a ‘buyer’ of securities in the first leg of the repo contract (i.e. lender of funds), the custodian through which the repo transaction is settled should block these securities in the gilt account and ensure that these securities are not further sold or re-repoed during the repo period but are held for delivery under the second leg; and

(c) The counterparty to the listed companies for repo/reverse repo transactions should be either a bank or a Primary Dealer maintaining SGL Account with the Reserve Bank.

iv. A PD may not enter into a repo with its own constituent or facilitate a repo between two of its constituents.

v. PDs should report all repos transacted by them (both on own account and on the constituent's account) on the Negotiated Dealing System (NDS). All repos shall be settled through the SGL Account/CSGL Account maintained with the RBI, Mumbai, with the Clearing Corporation of India Ltd (CCIL) acting as the central counter party.

vi. The purchase/sale price of the securities in the first leg of a repo should be in alignment with the market rates prevalent on the date of transaction.

vii. Repo transactions, which are settled under the guaranteed settlement mechanism of CCIL, may be rolled over, provided the security prices and repo interest rate are renegotiated on roll over.

viii. The Global Master Repos Agreement’ on repos, with suitable schedules,

Annexure – F

235

as proposed by FIMMDA may be entered into by PDs with their counter parties to repos transactions.

10. Portfolio Management Services by PDs

10.1 PDs may offer Portfolio Management Services (PMS) to their clients under the SEBI scheme of PMS, subject to the following conditions. Before undertaking PMS, the PD must have obtained the Certificate of Registration as Portfolio Manager from the SEBI and also a specific approval from the RBI.

i. PMS cannot be offered to any RBI regulated entity. However, advisory services can be provided to them with suitable disclaimers.

ii. Where applicable, the clients regulated by any other authority should obtain clearance from the regulatory or any other authority before entering into any PMS arrangement with the PD.

iii. PDs are required to comply with the SEBI (Portfolio Managers) Regulations, 1993 and any amendments issued thereto or instructions issued there under.

10.2 In addition, PDs should adhere to the under noted conditions:

i. A clear mandate from the PMS clients should be obtained and the same strictly followed. In particular, there should be full understanding on risk disclosures, loss potential and the costs (fees and commissions) involved.

ii. PMS should be entirely at the customer's risk without guaranteeing, either directly or indirectly, any return.

iii. Funds/securities, each time they are placed with the PD for portfolio management, should not be accepted for a period less than one year.

iv. Portfolio funds should not be deployed for lending in call/ notice/term money/Bills rediscounting markets, badla financing or lending to/ placement with corporate/noncorporate bodies.

v. Client-wise accounts/records of funds accepted for management and investments made there against should be maintained and the clients should be entitled to get statements of account at frequent intervals.

vi. Investments and funds belonging to PMS clients should be kept segregated and distinct from each other and from those of the PD. As far as possible, all client transactions should be executed in the market and not off-set internally, either with the PD or any other client. All transactions


236

between the PD and any PMS client or between two PMS clients should be strictly at market rates.

11. Guidelines on interest rate derivatives

11.1 PDs shall adhere to the guidelines laid down in circular DBOD.No.BP.BC.86 /21.04.157 /2006-07 dated April 20, 2007 as applicable to interest rate derivatives.

11.2 PDs are required to report all their IRS/FRA trades on the CCIL reporting platform within 30 minutes from the deal time in terms of circular IDMD/11.08.15/809/2007-08 dated August 23, 2007.

11.3 PDs are required to report to IDMD, as per the pro forma indicated in Annex IX, their FRAs/ IRS operations on a monthly basis.

12. Guidelines on declaration of dividends

PDs should follow the following guidelines while declaring dividend distribution:

i. The PD should have complied with the regulations on transfer of profits to statutory reserves and the regulatory guidelines relating to provisioning and valuation of securities, etc.

ii. PDs having Capital to Risk Weighted Assets Ratio (CRAR) below the regulatory minimum of 15 per cent in any of the previous four quarters cannot declare any dividend. For PDs having CRAR between the regulatory minimum of 15 per cent during all the four quarters of the previous year, but lower than 20 per cent in any of the four quarters, the dividend payout ratio should not exceed 33.3 per cent. For PDs having CRAR above 20 per cent during all the four quarters of the previous year, the dividend payout ratio should not exceed 50 per cent. Dividend payout ratio should be calculated as a percentage of dividend payable in a year (excluding dividend tax) to net profit during the year.

iii. The proposed dividend should be payable out of the current year’s profits. In case the profit for the relevant period includes any extraordinary profit income, the payout ratio should be computed after excluding such extraordinary items for reckoning compliance with the prudential payout ratio ceiling of 33.3 per cent or 50 per cent, as the case may be.

iv. The financial statements pertaining to the financial year for which the PD is declaring dividend should be free of any qualifications by the statutory auditors, which have an adverse bearing on the profit during that year. In

Annexure – F

237

case of any qualification to that effect, the net profit should be suitably adjusted downward while computing the dividend payout ratio.

v. In case there are special reasons or difficulties for any PD in strictly adhering to the guidelines, it may approach Reserve Bank in advance for an appropriate ad hoc dispensation in this regard.

vi. All the PDs declaring dividend should report details of dividend declared during the accounting year as per the prescribed pro forma. The report should be furnished within a fortnight of payment of dividend.

13. Guidelines on Corporate Governance

PDs may adhere to circular DNBS.PD/CC 94/03.10.042/2006-07 dated May 8, 2007 on guidelines on corporate governance.

14. Prevention of Money Laundering Act, 2002 - Obligations of NBFCs

PDs shall adhere to the guidelines contained in circular DNBS(PD).CC.68 /03.10.042/2005-06 dated April 5, 2006.

15. Violation/Circumvention of Instructions

Any violation/circumvention of the above guidelines or the terms and conditions of the undertaking executed by a Primary Dealer with the Reserve Bank of India (Annex I) would be viewed seriously and such violation would attract penal action including the withdrawal of liquidity support, denial of access to the money market, withdrawal of authorisation for carrying on the business as a Primary Dealer, and/or imposition of monetary penalty or liquidated damages, as the Reserve Bank may deem fit.

Section II: Additional Guidelines applicable to banks undertaking PD business departmentally

1. Introduction

Scheduled commercial banks (except Regional Rural Banks) have been permitted to undertake Primary Dealership business departmentally from 2006-07.

2. Procedure for Authorisation of bank-PDs

2.1 Banks eligible to apply for Primary Dealership, for undertaking PD business, (please see eligibility conditions at (iv) of paragraph 1.3.1 above) may approach the Chief General Manager, Department of Banking Operations & Development (DBOD), Reserve Bank of India, Central Office, Centre I, World


238

Trade Centre, Cuffe Parade, Mumbai-400 005. On obtaining an in-principle approval from DBOD, banks may then apply to the Chief General Manager, Internal Debt Management Department, Reserve Bank of India, 23rd Floor, Central Office Building, Fort, Mumbai- 400 001 for an authorization for undertaking PD business departmentally.

2.2 The banks, proposing to undertake the PD business by merging / taking over PD business from their partly / wholly owned subsidiary, or foreign banks, operating in India, proposing to undertake PD business departmentally by merging the PD business being undertaken by a group company, will be subject to the terms and conditions, as applicable, of the undertaking given by such subsidiary/ group company till such time a fresh undertaking is executed by the bank.

2.3 The banks authorized to undertake PD business will be required to have a standing arrangement with RBI based on the execution of an undertaking (Annex I) and the authorization letter issued by RBI each year (July-June).

3. Applicability of the guidelines issued for Primary Dealers

3.1 The bank-PDs would be governed by the operational guidelines as given in Section – I above, to the extent applicable, unless otherwise stated. Furthermore, the bank-PDs' role and obligations in terms of supporting the primary market auctions for issue of Government dated securities and Treasury Bills, underwriting of dated Government securities, market-making in Government securities and secondary market turnover of Government securities will also be on par with those applicable to stand-alone PDs as enumerated in Section - I of this Master Circular.

3.2 Bank-PDs are expected to join Primary Dealers Association of India (PDAI) and Fixed Income Money Market and Derivatives Association (FIMMDA) and abide by the code of conduct framed by them and such other actions initiated by them in the interests of the securities markets.

3.3 The requirement of ensuring minimum investment in Government Securities and Treasury Bills on a daily basis based on net call/ RBI borrowing and Net Owned Funds will not be applicable to bank-PDs who shall be guided by the extant guidelines applicable to banks.

3.4 As banks have access to the call money market, refinance facility and the Liquidity Adjustment Facility (LAF) of RBI, bank-PDs will not have separate access to these facilities and liquidity support as applicable to the standalone

Annexure – F

239

PDs.

3.5 It is clarified that for the purpose of "when-issued trades" issued vide circular IDMD.No/2130/11.01.01 (D)/2006-07 dated November 16, 2006, bank-PDs will be treated as Primary Dealers.

3.6 Bank-PDs shall be guided by the extant guidelines applicable to banks as regards borrowing in call/notice/term money market, Inter-Corporate Deposits, FCNR (B) loans /External Commercial Borrowings and other sources of funds.

3.7 The investment policy of the bank may be suitably amended to include PD activities also. Within the overall framework of the investment policy, the PD business undertaken by the bank will be limited to dealing, underwriting and market-making in Government Securities. Investments in Corporate/ PSU/ FIs bonds, Commercial Papers, Certificate of

deposits, debt mutual funds and other fixed income securities will not be deemed to be a part of PD business.

3.8 The classification, valuation and operation of investment portfolio guidelines as applicable to banks in regard to "Held for Trading" portfolio will also apply to the portfolio of Government Dated Securities and Treasury Bills earmarked for PD business.

3.9 The Government Dated Securities and Treasury Bills under PD business will count for SLR.

3.10 Bank-PDs shall be guided by the extant guidelines applicable to banks as regards business through brokers, ready forward transactions, interest rate derivatives (OTC & exchange traded derivatives), investment in non-Government Securities, Issue of Subordinated Debt Instruments and declaration of dividends.

4. Maintenance of books and accounts

4.1 The transactions related to Primary Dealership business, undertaken by a bank departmentally, should be executed through the existing Subsidiary General Ledger (SGL) account of the bank. However, such banks will have to maintain separate books of accounts for transactions relating to PD business (as distinct from normal banking business) with necessary audit trails. It should be ensured that, at any point of time, there is a minimum balance of Rs. 100 crore of Government Securities earmarked for PD business.

4.2 Bank-PDs should subject 100 per cent of the transactions and regulatory returns submitted by PD department to concurrent audit. An auditors' certificate


240

for having maintained the minimum stipulated balance of Rs. 100 crore of Government Securities in the PD-book on an ongoing basis and having adhered to the guidelines/ instructions issued by RBI, should be forwarded to IDMD, RBI on a quarterly basis.

5. Capital Adequacy and Risk Management

5.1 The capital adequacy and risk management guidelines applicable to a bank undertaking PD activity departmentally, will be as per the extant guidelines applicable to banks. In other words, for the purpose of assessing the bank's capital adequacy requirement and coverage under risk management framework, the PD activity should also be taken into account.

5.2 The bank undertaking PD activity may put in place adequate risk management systems to measure and provide for the risks emanating from the PD activity.

6. Supervision by RBI

6.1 The banks authorized to undertake PD business departmentally are required to submit prescribed periodic returns to RBI promptly. The current list of such returns and their periodicity, etc. is furnished in Annex II A.

6.2 Reserve Bank of India reserves its right to amend or modify the above guidelines from time to time, as may be considered necessary.

Annexure – F

241

Annex I

UNDERTAKING To

The Chief General Manager, Internal Debt Management Department, Reserve Bank of India, Central Office Building, Mumbai-400 001.

By ………………………………………………………………. Registered Office ………………………………………… ……………………………………………………………… ……………………………………………………………….

WHEREAS the Reserve Bank of India (RBI) has offered in principle to permit us to undertake Primary Dealer activity in Government securities in accordance with the Guidelines issued thereon from time to time.

AND WHEREAS as a precondition to our being authorised to undertake Primary Dealership activity we are required to furnish an undertaking covering the relative terms and conditions.

AND WHEREAS at the duly convened Board of Directors meeting of ________________ on __________, the Board has authorised Shri/Smt./Kum. _________________ and Shri/Smt./Kum. __________________ to execute and furnish an UNDERTAKING to the Reserve Bank of India jointly and severally as set out below:

NOW, THEREFORE, in consideration of the RBI agreeing to permit us to undertake Primary Dealer activity, we hereby undertake and agree:

1. To commit to aggregatively bid in the auction of Treasury Bills and Government of India Dated Securities, to the extent of …….per cent of each issue of auction Treasury Bills and for a minimum amount equal to the underwriting commitment (allotted under Minimum Underwriting Commitment and Additional Competitive Underwriting) for Government of India Dated Securities and to maintain the success ratio in aggregate winning bids at not less than 40 per cent for Treasury Bills.


242

2. To offer to underwrite primary issues of Government of India dated securities, Treasury Bills and State Government securities, for which auction is held, and accept devolvement, if any, of any amount as may be determined by RBI in terms of prevalent scheme for Bidding/Underwriting.

3. a) To determine prudential ceilings, with the prior approval of the Board of Directors of the company, for reliance on borrowings from the money market including repos, as a multiple of net owned funds, subject to the guidelines, if any, issued by the Reserve Bank in this regard. (applicable to standalone PDs only)

b) To adhere to prudential ceilings, with the prior approval of the Board of Directors of the bank, subject to the guidelines, if any, issued by the Reserve Bank in this regard. (applicable to bank-PDs only)

4. To offer firm two-way quotes through the Negotiated Dealing System (NDS) / NDS-OM, over the counter telephone market / recognised Stock Exchanges in India and deal in the secondary market in Government dated securities and Treasury Bills of varying maturity from time to time and take principal positions.

5. To achieve a sizeable portfolio in Government securities and to actively trade in the Government securities market.

6. To achieve an annual turnover of not less than 5 times in Government dated securities and not less than 10 times in Treasury Bills of the average of month-end stocks (in the book separately maintained for the Primary Dealership business) subject to the turnover in respect of outright transactions being not less than 3 times in government dated securities and 6 times in Treasury Bills.

7. To maintain the capital adequacy standards prescribed by the Reserve Bank of India, and to subject ourselves to all prudential and regulatory guidelines as may be issued by the Reserve Bank of India from time to time.

8. To maintain adequate infrastructure in terms of both physical apparatus and skilled manpower for efficient participation in primary issues, trading in the secondary market, and for providing advice and education to investors.

9. To adhere to “Guidelines on Securities Transaction to be followed by Primary Dealers” issued vide circular IDMC.No.PDRS/2049-A/03.64.00

Annexure – F

243

/99-2000 dated December 31, 1999 and Master Circulars issued from time to time and put in place necessary internal control systems for fair conduct of business and settlement of trades and maintenance of accounts.

10. To comply with all applicable Reserve Bank of India/Securities and Exchange Board of India (SEBI) requirements under the existing guidelines and which may be laid down from time to time in this behalf, failing which RBI would be at liberty to cancel the authorisation as a Primary Dealer.

11. To abide by the code of conduct as laid down by RBI/SEBI, the Primary Dealers’ Association of India (PDAI) and the Fixed Income, Money Markets and Derivatives Association of India (FIMMDA).

12. To maintain separate books of account for transactions relating to PD business (distinct from the normal banking business) with necessary audit trails and to ensure that, at any point of time, there is a minimum balance of Rs. 100 crore of Government securities earmarked for PD business. (applicable to bank-PDs only)

13. To maintain and preserve such information, records, books and documents pertaining to our working as a Primary Dealer as may be specified by the RBI from time to time.

14. To permit the RBI to inspect all records, books, information, documents and make available the records to the officers deputed by the RBI for inspection/scrutiny and render all necessary assistance.

15. To maintain at all times a minimum net owned funds of Rs. 50 crore / Rs.100 crore in Government securities and to deploy the liquidity support from the RBI, net borrowings from call money market and net repo borrowings exclusively in Government securities. (applicable to standalone PDs only)

16. To maintain an arms length relationship in transactions with group and related entities.

17. To obtain prior approval of Reserve Bank of India for any change in the shareholding pattern of the company. (applicable to standalone PDs only)

18. To submit in prescribed formats periodic reports including daily transactions and market information, monthly report of details of


244

transactions in securities and risk position and performance with regard to participation in auctions, annual audited accounts and an annual performance review and such statements, certificates and other documents and information as may be specified by RBI from time to time.

19. To report the matter immediately to Internal Debt Management Department of the RBI and abide by such orders, instructions, decisions or rulings given by the RBI if and when any kind of investigation/inquiry/ inspection is initiated against us by statutory/regulatory authorities, e.g. SEBI/RBI, Stock Exchanges, Enforcement Directorate, Income-tax authorities etc.

20. To pay an amount of Rupees Five Lakh, or as applicable, to the Reserve Bank, for violation of any of the instructions issued by the Reserve Bank in the matter or for non-compliance with any of the undertakings given hereinabove.

We do hereby confirm that the above undertakings will be binding on our successors and assigns.

Dated this day of Two Thousand …………..

Signed, sealed and delivered by the within named, ) being the authorized persons, in terms of the ) Resolution No._______ of the Board of Directors ) at the duly convened Meeting held on___________ ) in the in the presence of _______________ )

Signatory (i)

(ii)

Witness (i)

(ii)

Notes :

1. Para 3.a, 15 and 17 are applicable to standalone PDs only.

2. Paras 3.b, words in italics in para 6 and para 12 are applicable to bank-PDs only.

Annexure – F

245

Annex II A. Statements / Returns required to be submitted by Primary Dealers to

IDMD Sr. No. Return/Report Periodicity Last date for

submission Reference under which required

1. PDR-I* Fortnightly Next working day of the reporting fortnight

2. PDR-II* Monthly 10th of the following month

3. PDR-III* Quarterly 15 of the month following the reporting quarter

4. PDR IV* Quarterly 15th of the month of the month following the reporting quarter

5. Return on FRAs / IRS Monthly 10th of the following month

6. Annual Report & Annual Audited A/cs

Annual As soon as annual accounts audited and finalised

7. Auditor's Certificate on Net Owned Funds

Yearly 30th June

PD Guidelines

8. Reconciliation of holdings of Govt. Securities in own A/c and constituent A/c

Yearly

One month from the close of accounting year

IDMC.No.PDRS/2049A/03.64.00/99-2000 dated December 31,

1999

9. Investments in non-Government securities

Yearly Disclosures in the ‘Notes on Accounts’ of the balance sheet, with effect from the financial year ending 31 March 2004.

IDMD.PDRS.No.3/03.64.00/2003-04 March 08, 2004

10 Details of dividend declared during the accounting year

Yearly Within a fortnight from the payment of dividend

IDMD.PDRS.No 6/03.64.00/2003-04 June 03, 2004


246

* = Indicates that these returns should be submitted in electronic form as an excel file attachment through e-mail.

B. Statements / Returns required to be submitted by Primary Dealers to departments other than IDMD of Reserve Bank of India

Sr. No.

Return/Report Periodicity To be filed with Deptt.

Reference under which required

1. Return on FRAs/IRS Fortnightly MPD MPD.BC.187/07.01.2 79/1999-2000 dated July 7, 1999.

2. Statement showing balances of Govt. Securities held on behalf of each Gilt A/c holder

Half-Yearly PDO

3. Return on Call Money transactions with Commercial Banks

Fortnightly DEAP, DMB

4. Information for Issue of Commercial Paper

On each issue of CP

MPD IECD.2/08.15.01/200 1-02 dated July 23, 2001

Note: The last date prescribed for submission of these statements by the departments concerned and/or IDMD should be adhered to.

Annexure – F

247

Annex II A Statements / Returns required to be submitted by banks on their Primary Dealership business to IDMD*:

Sr. No.

Return/Report Periodicity Last date for submission

11. PDR-II** (format enclosed as Appendix III)

Monthly 10th of the following month

12. Concurrent auditor certificate for having maintained the minimum stipulatedbalance of Rs. 100crore of Government Securities in the PD book on an ongoing basis.

Quarterly 15th of the month following the reporting month

13. Annual Report on PD activity of the bank.

Annual Within 30 days of the finalization of audited accounts.

* In addition to reports on "when issued" transactions and short-sales.

**Return should be submitted in electronic form as an excel file attachment through email at [email protected]


248

Annex III Illustration showing the underwriting amount, cut off rate of underwriting fee accepted by Reserve Bank of India

Illustration showing the underwriting amount, cut-off of fee quoted, commission payable to PDs

Instrument Name XXXXXXXX

Auction Type Multiple

(amount in crore)

Notified amount (NA) 4000

Total No. of PDs (n) 19

Minimum Underwriting Commitment (MUC ) 2000

Per PD MUC (MUC/ n) 105.263 Rounded off to

106

Total PD commitment under MUC collectively (AdjustedMUC)

2014

Additional competitive underwriting ACU = (NA –Adjusted MUC)

1986

Minimum bidding by each PD in ACU (equal to per PDMUC)

106

Total underwriting commitment for each PD under MUCand ACU

212

Total Underwriting ( 212 *19) 4028

Minimum allotment to a PD to be eligible for higher commission on MUC i.e. min 4% of Notified Amount

160

Annexure – F

249

Bids submitted under Additional Competitive Underwriting Auction

S. No

PDs participated

in U/W auction

Amount of bid in

ACU (Rs.

Crore)

Cumulative Amount (Rs. Cr)

Underwriting fee (in paise /

Rs.100)

Amount of bid * U/w fee

Remarks

Weighted Average

underwriting fee (paise /

Rs.100)

1 A 150 150 1.52 228.00 1.52

2 B 155 305 2.56 396.80 2.05

3

A

60 365 3.50 210.00

Three lowest bids

2.29

4 C 95 460 3.70 351.50 2.58

5 B 200 660 3.94 788.00 2.99

6 B 25 685 4.00 100.00 3.03

7 D 120 805 4.00 480.00 3.17

8 E 95 900 4.49 426.55 3.31

9 F 70 970 4.50 315.00 3.40

10 G 50 1020 4.75 237.50 3.46

11 E 115 1135 4.90 563.50 3.61

12 C 90 1225 4.94 444.60 3.71

13 F 220 1445 4.95 1089.00 3.90

14 G 200 1645 5.00 1000.00 4.03

15 H 120 1765 5.00 600.00 4.10

16 I 120 1885 5.00 600.00 4.15

17 I 109 1994 5.00 545.00 CUT-OFF

4.20

18 I 25 2019 5.50 137.50 4.22

19 J 120 2139 5.94 712.80 4.31

20 K 120 2259 6.00 720.00 4.40

21 L 120 2379 6.00 720.00 4.48


250

22 M 55 2434 6.50 357.50 4.53

23 N 120 2554 6.94 832.80 4.64

24 O 120 2674 7.00 840.00 4.75

25 P 120 2794 7.00 840.00 4.84

26 Q 120 2914 7.00 840.00 4.93

27 R 106 3020 8.00 848.00 5.04

28 S 106 3126 8.50 901.00 5.16

29 M 80 3206 9.00 720.00 5.25

30 K 100 3306 9.25 925.00 5.38

Rate of commission payable to PDs on MUC for those who have been allotted an amount >= 4% of ACU amount

4.20 (weighted average of all allotted bids)

Rate of commission payable to other PDs on MUC 2.29 (weighted average of the three lowest bids)

Annexure – F

251

PD Wise eligible commission on ACU and ACU Allotment

[a] [b] [c] [d]={[b]*10000000*[c]/100}/100

Successful PDs Successful bids in ACU (Rs. Cr)

Underwriting fee bid (in paise / Rs.100)

Bid wise commission payable on ACU (In Rs.)

A 150 1.52 228,000.00

A 60 3.50 210,000.00

A Total 210 438,000.00

B 155 2.56 396,800.00

B 200 3.94 788,000.00

B 25 4.00 100,000.00

B Total 380 1,284,800.00

C 95 3.70 351,500.00

C 90 4.94 444,600.00

C Total 185 796,100.00

D 120 4.00 480,000.00

D Total 120 480,000.00

E 95 4.49 426,550.00

E 115 4.90 563,500.00

E Total 210 990,050.00

F 70 4.50 315,000.00

F 220 4.95 1,089,000.00

F Total 290 1,404,000.00

G 50 4.75 237,500.00

G 200 5.00 1,000,000.00

G Total 250 1,237,500.00

H 120 5.00 600,000.00

H Total 120 600,000.00

I 120 5.00 600,000.00

I 101 5.00 505,000.00

I Total 221 1,105,000.00


252

Underwriting Commission Details

PD

MUC

amou

nt ac

cept e

d

ACU

amou

nt ac

cept e

d

Total

amou

nt ac

cept e

d Whether ACU

accepted is >= 4%

NA

Wighted average fee

taken for MUC

commission calculation

Comm

n on M

UC

Comm

ission

on A

CU

Total

Com

miss

ion

(in crore)

(in crore)

(in crore)

(paise per Rs.100)

(Rs.)

A 106 210 316 YES 4.20 445,200 438,000 883,200

B 106 380 486 YES 4.20 445,200 1,284,800 1,730,000

C 106 185 291 YES 4.20 445,200 796,100 1,241,300

D 106 120 226 NO 2.29 242,740 480,000 722,740

E 106 210 316 YES 4.20 445,200 990,050 1,435,250

F 106 290 396 YES 4.20 445,200 1,404,000 1,849,200

G 106 250 356 YES 4.20 445,200 1,237,500 1,682,700

H 106 120 226 NO 2.29 242,740 600,000 842,740

I 106 221 327 YES 4.20 445,200 1,105,000 1,550,200

J 106 0 106 NO 2.29 242,740 0 242,740

K 106 0 106 NO 2.29 242,740 0 242,740

L 106 0 106 NO 2.29 242,740 0 242,740

M 106 0 106 NO 2.29 242,740 0 242,740

N 106 0 106 NO 2.29 242,740 0 242,740

O 106 0 106 NO 2.29 242,740 0 242,740

P 106 0 106 NO 2.29 242,740 0 242,740

Q 106 0 106 NO 2.29 242,740 0 242,740

R 106 0 106 NO 2.29 242,740 0 242,740

S 106 0 106 NO 2.29 242,740 0 242,740

TOTAL 2014 1986 4000 6,029,280 8,335,450 14,364,730

Annexure – F

253

Annex IV

Illustrations showing adherence by PDs to Commitments on aggregative bidding in auction of Treasury Bills and success ratio

1. A PD has committed to bid aggregatively Rs. 500 crore GOI Treasury Bills as shown below. The success ratio to be maintained by the PD is 40 per cent in respect of Treasury Bills. Various scenarios in respect of fulfillment of the bidding commitment and the success ratio assuming that the bids tendered and the bids accepted will be as under:

(1) Treasury Bills: (Rs. crore)

SCENARIOS (I) (II) (III)

Bidding Commitment (a) 500 500 500

Bids Tendered (b) 600 500 400

Bids Accepted (c) 300 200 100

Success Ratio Achieved (c)/(a) 60% 40% 20%

Fulfilment of Bidding Commitment Yes Yes No

Fulfilment of Success Ratio Yes Yes No

Success ratio in Treasury Bills is the ratio of bids accepted and bidding commitment.


254

Annex V PDR I Return Name of PD: Net Owned Funds(as per last b/s): Return for fortnight ending: date wise fortnightly statement

1

A Outright purchases (Face Value)

(i) Government Securities and Treasury bills

(ii) Other securities

B Outright sales (Face Value)

(i) Government Securities and Treasury bills

(ii) Other securities

C Repo transactions

(i) Borrowing (amount)

- from Reserve Bank of India

- from the market

(ii) Lending (amount)

- to Reserve Bank of India

- to the market

D Call Money transactions

- Borrowing

- Lending

2 Outstanding balances (Settled position figures)

A Sources of Funds

a) Net Owned funds (as per last audited balance sheet)

b) Current years accruals under profit /loss account

Annexure – F

255

c) Call Money Borrowings

d) Notice/Term Money borrowings

e) Borrowing from RBI under Assured Support/LAF

f) Repo borrowing from market

g) Borrowing under CBLO

h) Borrowing under credit lines of banks/FIs

i) Borrowings through Inter-Corporate Deposits

- maturing up to 14 days

- maturing beyond 14 days

j) FCNR(B) Loans

k) Commercial Paper/ Bond issuances

k) Others (Give details for items in excess of Rs 10 crore)

Total

B Application of Funds

a) Government Securities & Treasury bills (Book value) @

i) Own Stock

ii) Stock with RBI under Assured Support/LAF

iii) Stock with market for repo borrowing

b) Lending in Call money Market

c) Lending in Call/Notice/ Term money market

d) Repo Lending to market

e) Lending under CBLO

f) Repo lending to RBI

g) Corporate /PSU/FI Bonds

h) Investment in shares


256

i) Investment in Mutual funds schemes

- debt oriented

- equity oriented

j) Investment in Subsidiaries.

k) Other finacial assets if any

l) Fixed Assets

m) Others (Give details for items in excess of Rs10 crore)

Total

Own Stock position (SGL Balance) (Face value)

i) Treasury bills

ii) Dated Government Securities

3 Portfolio duration for Government Securities

VaR for the day (with prescribed holdingperiod) as % of portfolio

@ Exclude stock received as pledge for repo lending to RBI/market participants and also the stock reported under a (ii) and a (iii).

Annexure – F

257

PDR – II Format Annex VI


258

PRIMARY DEALER'S MONTHLY REPORT Form PDR 2 Name of the Primary Dealer Statement as at the end of:

(Rs. in crores) Cumulative figures SECTION A - SECURITES MARKETS TURNOVER

Dated GOI State Govt. T-bills Total Securities Securities

I. PRIMARY MARKET NEW SUBSCRIPTIONS i) Bidding commitment* N.A. ii) Bids Tendered** iii) Non-competive bids iv) Bids Accepted ( A ) v) Success Ratio N.A N.A REDEMPTIONS (B) II. TOTAL = I(A)+I(B) III. UNDERWRITING i) Amount offered for underwriting N.A. ii) Amount of underwriting accepted by RBI N.A. iii) Amount of devolvement N.A. iv) Underwriting fee received N.A. IV. SECONDARY MARKET TURNOVER – OTC OUTRIGHT (including OMO) i) Purchases ii) Sales TOTAL OUTRIGHT TURNOVER (A)

i) Purchases ii) Sales

Annexure – F

259

REPURCHASE AGREEMENTS i) Repo (both legs) ii) Reverse Repo (both legs)

TOTAL REPOS TURNOVER (B) V. Total Turnover - OTC (IV(A)+IV(B)) VI. SECONDARY MARKET TURNOVER – STOCK EXCHANGES

i) Purchases N.A. N.A. ii) Sales N.A. N.A.

SECTION - B: EXCHANGE TRADED INTEREST RATE DERIVATIVES NPA** of the NPA of the NPA of the NPA of the futures contract futures contract futures contract futures contract outstanding at the entered into reversed outstanding at beginning of the during the during the the end of the month month month month

I. Activity during the month

91-Day T-bill

month 1

month2

month3

10 year zero coupon bond

month 1

month2

month3

10 year notional bond

month 1

month2

month3

(NPA is to be furnished according to the underlying interest exposure wise break up)

II. Analysis of "highly effective" hedges

A certificate from Concurrent Auditors stating that the size of the hedge portfolio and that the hedge is highly effective as per the definition of RBI circular dated June 3, 2003


260

III. Analysis of trading positions

NPA of the Trading MTM value of the trading Futures Position futures position

91-Day T-bill

month2

month3

10 year zero coupon bond

month2

month3

10 year notional bond

month2

month3

** NPA = Notional Principal Amount

Signature

Annexure – F

261

Annex VII Name of the Primary Dealer : PDR – IV

Quarterly return on select Financial & Balance Sheet indicators for quarter ended

(Rs. in crore)

Quarter ended (cumulative)

Previous Quarter

I. BALANCE SHEET INDICATORS SOURCES OF FUNDS Share Capital Reserves & Surplus Deposits, if any Secured loans Unsecured loans TOTAL APPLICATION OF FUNDS Fixed Assets Gross Block less Depreciation Net block Add Capital work in progress Investments a. Govt. Securities 1. Dated GOI securities 2. State Govt. Securities 3. T-bills b. Others (Specify) Current Assets, Loans and Advances (A) Current Assets Accrued Interest

Stock – in – Trade Cash & Bank balance


262

(B) Loans & Advances Less: Current Liabilities and provisions

Liabilities Provisions Net Current Assets Deferred Tax Miscellaneous Expenses not written off Others (specify) TOTAL


Previous Quarter

II. P& L INDICATORS INCOME Discount Income 1. G-secs 2. Others Interest Income 1. G-secs 2. Call/Term 3. Repo 4. Others Trading Profits 1. G-secs 2. Others Other Income 1. G-secs 2. Others (specify) TOTAL INCOME EXPENDITURE

Annexure – F

263

Interest Expenses 1. Call/Term 2. Repo 3. Borrowing from RBI 4. Others Operating Expenses Establishment & Administrative Expenses Provisions against doubtful assets Depreciation on Fixed Assets Other expenses (specify) TOTAL EXPENDITURE PROFIT BEFORE TAX Less provision for taxation and deferred tax PROFIT AFTER TAX III. FINANCIAL INDICATORS Certain Key Figures Dividend paid/proposed Retained earnings Average Earning assets Average Non-earning assets

*** Average total assets 1. Average dated G-secs (Central and

State) 2. Average T-Bills 3. Other average assets **** Average Interest bearing liabilities 1. Call borrowing 2. Repo 3. Borrowing from RBI 4. Others


264

Average yield on assets (Total interest income/Average Earning

Assets) Average cost of funds (Total interest expended/Average

interest bearing liabilities) Net interest income Non-interest income Non-interest expenditure Net total income Measures of Return Return on Assets Before tax (PBT/Ave.Total Assets) After tax (PAT/Ave.Total Assets) Return on average Equity Before tax (PBT/Ave.Equity) After tax (PAT/Ave.Equity) Return on Capital Employed Before tax (PBT/(Owners' Equity+Total Debt)) After Tax (PAT/(Owners' Equity+Total Debt))Net Margin Analysis Net Margin (PAT/Total Income) Interest expenses/Total income IV. PERFORMANCE INDICATORS NOF (Rs. In crore) CRAR (as %)


Previous Quarter

Annexure – F

265

Average duration of the Portfolio (in years) Average leverage (as ratio) Effect of 1% shock in yields on portfolio value (Rs. in crore) ***** MTM value of all securities (Rs. In crore)

Notes:

1. The details of share capital, reserves,etc. may be enclosed as Annexes.

2. Where average figures are involved, it may be taken to mean as average of month end balances.

*** Average assets refers to the simple average of month end book balance.

**** Average liabilities refers to the simple average of month end book balance.

***** Before adjusting Repo transactions and MTM depreciation on IRS transactions.

Signature


266

Annex VIII Publication of Financial Results

Name of Primary Dealer

Audited Financial Results for the year ended 31st March ………

Sources of Funds

Capital

Reserves and Surplus

Loans

Secured

Unsecured

(of which call money borrowings)

Application of Funds

Fixed Assets

Investments

Government Securities (inclusive of T. Bills)

Commercial Papers

Corporate Bonds

Loans and Advances

(of which call money lendings)

Non Current Assets

Others

Profits and Loss account

Income (business segment wise)

Interest

Discount

Trading Profit

Annexure – F

267

Expenses

Interest

Administrative Costs

Profit before tax

Net Profit

Regulatory Capital required (as per Capital Adequacy Guidelines)

Actual Capital

Return on Net Worth


268

Annex IX Monthly Return on Interest Rate Risk of Rupee Derivatives

As at end-month

Name of the Bank/Institution:

1. Cash Bonds Market Value (Rs. in Crore)

PV01(Rs. In Crore)

(a) (b) (c)

(a) HFT (See Note 1)

(b) AFS (See Note 1)

(c) HTM (See Note 1)

Total [(a) to (c) above]

2. Rupee Interest Rate Derivatives Notional Amount (Rs. In Crore)

PV01(Rs. In Crore)

(a) Bond Futures (See Note 1)

(b) MIBOR (OIS) (See Note 2)

(c) MIFOR (See Note 2)

(d) G-Sec benchmarks (See Note2)

(e) Other benchmarks (Please report

separately)

(See Note

2&4)

(f) Forward Rate Agreements (See Note 3)

Total [(a) to (f) above]

3. Grand Total of (1) & (2)

4. Tier I Capital

Note 1. PV01 may be taken as POSITIVE for long positions and NEGATIVE for short positions. Note 2. PV01 may be taken as POSITIVE if receiving a swap and NEGATIVE if paying a swap. Note 3. For FRAs, use the PVO1 of the underlying deposit/instrument.

Note 4. In 2 (e) above, swaps on other benchmarks such as LIBOR may be reported separately for each benchmark

Annexure – F

269

Annex X List of circulars consolidated

No Circular no Date Subject

1 IDMC.PDRS.1532./03.64.00/1999-00

November 2, 1999 Primary Dealers – Leverage

2 IDMC.PDRS.2049A/03.64.00/1999-2000

December 31, 1999

Guidelines on Securities transactions to be followed by Primary Dealers

3 IDMC.PDRS.5122./03.64.00/1999-00

June 14,2000 Guidelines on Securities Transactions by Primary dealers

4 IDMC.PDRS.4135/03.64.00/2000-01

April 19,2001 Scheme for Bidding, Underwriting and Liquidity support to Primary Dealers

5 IDMC.PDRS.87/03.64.00/2001-02

July 5, 2001 Liquidity support to Primary Dealers

6 IDMC.PDRS.1382./03.64.00/2000-01

September 18, 2001

Dematerialised holding of bonds and debentures

7 IDMC.PDRS.3369./03.64.00/2001-02

January 17, 2002 Guidelines on Counter party limits and Inter-corporate deposits

8 IDMC.PDRS.4881/03.64.00/2001-02

May 8,2002 Guidelines to Primary Dealers

9 IDMC.PDRS.5018./03.64.00/2001-02

May 17, 2002 Scheme for Bidding, Underwriting and liquidity support to Primary dealers 2001-02

10 IDMC.PDRS.5039./03.64.00/2001-02

May 20,2002 Transactions in Government securities

11 IDMC.PDRS.5323./03.64.00/2001-02

June 10,2002 Transactions in Government securities

12 IDMC.PDRS.418./03.64.00/2002-03

July 26,2002 Publication of Financial results

13 IDMC.PDRS.1724./03.64.00/2002-03

October 23, 2002 Underwriting of Government dated securities by Primary Dealers


270


14 IDMC.PDRS.2269./03.64.00/2002-03

November

28,2002

Publication of Financial results

15 IDMC.PDRS.2896./03.64.00/2002-03

January 14, 2003 Trading in Government securities on Stock Exchanges

16 IDMC.PDRS.3432./03.64.00/2002-03

February 21, 2003 Ready Forward Contracts

17 IDMC.PDRS.3820./03.64.00/2002-03

March 24, 2003 Availment of FCNR(B) loans by Primary Dealers

18 IDMC.PDRS.1./03.64.00/2002-03

April 10, 2003 Portfolio Management Services by Primary Dealers – Guidelines

19 IDMC.PDRS.4802./03.64.00/2002-03

June 3, 2003 Guidelines on Exchange Traded Interest Rate Derivatives

20 IDMC.PDRS.122./03.64.00/2002-03

September 22, 2003

Rationalisation of returns submitted by Primary Dealers

21 IDMD. PDRS.No.3/ 03.64.00/2003-04

March 08, 2004 Prudential guidelines on investment in non-Government securities

22 IDMD.PDRS.05/10.02.01/2003-04

March 29, 2004 Transactions in Government Securities

23 IDMD.PDRS. No06/ 03.64.00/2003-04

June 03, 2004 Declaration of dividend by Primary Dealers

24 IDMD.PDRS. 01 10.02.01/2004-05

July 23, 2004 Transactions in Government securities

25 IDMD.PDRS. 02 /03.64.00/2004-05

July 23, 2004 Success Ratio in Treasury Bill auctions for Primary Dealers

26 RBI/2004-05/ 136 – IDMD.PDRS.No/ 03 /10.02.16/2004-05

August 24, 2004 Dematerialization of Primary Dealer’s investment in equity

27 RBI/2005/459/IDM D.PDRS/4783/10.02 .01/2004-05

May 11, 2005 Government Securities Transactions – T+1 settlement

Annexure – F

271


28 RBI/2005/460/IDM D.PDRS/4779/10.02 .01/2004-05

May 11, 2005 Ready Forward Contracts

29 RBI/ 2005 / 461 IDMD.PDRS.4777 / 10.02.01 / 2004-05

May 11, 2005 Sale of securities allotted in primary issues

30 RBI/2005/474/IDM D.PDRS/4907/03.64 .00/2004-05

May 19, 2005 Conduct of Dated Government Securities Auction under Primary Market Operations (PMO) module of PDO-NDS – Payment of Underwriting Commission

31 RBI/2005-06/ 73 IDMD.PDRS. 337 /10.02.01/2005-06

July 20, 2005 Transactions in Government Securities

32 RBI/2005-06/132 IDMD.No.766/10.26 .65A/2005-06

August 22, 2005 NDS-OM – Counterparty Confirmation

33 RBI/2005-06/308 DBOD.FSD.BC.No.6 4/24.92.01/2005-06

February 27, 2006 Guidelines for banks’ undertaking PD business

34 RBI/2006-07/49 IDMD.PDRS/26/03. 64.00/2006-07

July 4, 2006 Diversification of activities by stand-alone Primary Dealers- Operational Guidelines

35 RBI/2006-2007/298 FMD.MOAG No.13 /01.01.01/2006-07

March 30, 2007 Liquidity Adjustment Facility-Acceptance of State Development Loans under Repos

36 IDMD.530/03.64.00 /2007-08

July 31, 2007 FIMMDA Reporting Platform for Corporate Bond Transactions

37 DBOD.FSD.BC.No.2 5/24.92.001/2006-07

August 9, 2006 Guidelines for banks undertaking PD business

38 IDMD.PDRS.1431/03.64.00/2006-07

October 5, 2006 Operational guidelines for banks undertaking/proposing to undertake PD business


272


39 IDMD/11.08.15/809/2007-08

August 23, 2007 Reporting platform for OTC Interest Rate Derivatives

40 RBI/2007-2008/186 IDMD.PDRS.No.2382 /03.64.00/2007-08

November 14, 2007

Revised Scheme of Underwriting Commitment and Liquidity Support

41 IDMD.DOD.No.5893/ 10.25.66/2007-08

May 27, 2008 NDS-Order Matching (OM) Sytem – Access through the CSGL route

42 RBI/2008-09/187 IDMD.PDRD.No.1393 / 03.64.00 / 2008-09

September 19, 2008

Settlement of Primary Auctions – Shortage of Funds

43 RBI/2008-09/479 IDMD.No.5877/08.02. 33 / 2008-09

May 22, 2009 Auction process of Government of India Securities

ANNEXURE – G

RBI MC CAPADEQRM 2009

TELEGRAMS: "RESERVBANK" POST BOX 10007 TELEPHONE 22661602/04 FAX NO. 022-22644158

RESERVE BANK OF INDIA CENTRAL OFFICE INTERNAL DEBT MANAGEMENT DEPARTMENT


RBI/2009-10/55 July 1, 2009 IDMD.PDRD.02/03.64.00/2009-10

All Primary Dealers in the Government Securities Market

Dear Sir

Master Circular on Capital Adequacy Standards and Risk Management Guidelines for standalone Primary Dealers

The Reserve Bank of India has, from time to time, issued a number of guidelines on Capital Adequacy Standards and Risk Management for standalone Primary Dealers (PDs). To enable the PDs to have all the current instructions at one place, a Master Circular incorporating the guidelines on the subject is enclosed as an Appendix.

2. Banks undertaking PD activities departmentally may follow the extant guidelines applicable to banks in regards to their capital adequacy requirement and risk management.

Yours faithfully

(K.V.Rajan) Chief General Manager

Encl : As above


274

APPENDIX

RESERVE BANK OF INDIA INTERNAL DEBT MANAGEMENT DEPARTMENT


(Ref: RBI/2009-10/ IDMD.PDRD.02 /03.64.00/2009-10 dated July 1, 2009)

CAPITAL FUNDS & CAPITAL REQUIREMENTS

General Guidelines

1 General 1.1 Capital adequacy standards for Primary Dealers in Government Securities market have been in vogue since December 2000. The guidelines were revised keeping in view the developments in the market, experience gained over time and introduction of new products like exchange traded derivatives. The revised guidelines were issued vide circular IDMD.1/(PDRS)03.64.00/2003-04 dated January 07, 2004. The present circular has been updated with the guidelines on capital requirements issued subsequent to the aforesaid circular.

2 Capital Funds Capital Funds would include the following elements:

2.1 Tier-I Capital

Tier-I Capital would mean paid-up capital, statutory reserves and other disclosed free reserves. Investment in subsidiaries where applicable, intangible assets, losses in current accounting period, deferred tax asset (DTA) and losses brought forward from previous accounting periods will be deducted from the Tier I capital.

In case any PD is having substantial interest/ (as defined for NBFCs) exposure by way of loans and advances not related to business relationship in other Group companies, such amounts will be deducted from its Tier I capital.

2.2 Tier-II capital

Tier II capital includes the following:-

(i) Undisclosed reserves and cumulative preference shares other than those which are compulsorily convertible into equity. Cumulative Preferential shares should be fully paid-up and should not contain clauses which

Annexure – G

275

permit redemption by the holder.

(ii) Revaluation reserves discounted at a rate of fifty five percent;

(iii) General provisions and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, up to the maximum of 1.25 percent of total risk weighted assets;

(iv) Hybrid debt capital instruments, which combine certain characteristics of equity and certain characteristics of debt.

(v) Subordinated debt:

a) To be eligible for inclusion in Tier II capital, the instrument should be fully paid-up, unsecured, subordinated to the claims of other creditors, free of restrictive clauses, and should not be redeemable at the initiative of the holder or without the consent of the Reserve Bank of India. It often carries a fixed maturity, and as it approaches maturity, it should be subjected to progressive discount, for inclusion in Tier II capital. Instruments with an initial maturity of less than 5 years or with a remaining maturity of one year should not be included as part of Tier II capital. Subordinated debt instruments eligible to be reckoned as Tier II capital will be limited to 50 percent of Tier I capital.

b) The subordinated debt instruments included in Tier II capital may be subjected to discount at the rates shown below:

Remaining Maturity of Instruments

Rate of Discount (%)

Less than one year 100

One year and more but less than two years

80

Two years and more but less than three years

60

Three years and more but less than four years

40

Four years and more but less than five years

20


276

2.3 Tier – III Capital

Tier III capital is the capital issued to meet solely the market risk capital charge in accordance with the criteria as laid down below.

The principal form of eligible capital to cover market risk consists of shareholders' and retained earnings (Tier I Capital) and supplementary capital (Tier II Capital). But PDs may also employ a third tier of capital ("Tier III"), consisting of short-term subordinated debt, as defined below, for the sole purpose of meeting a portion of the capital requirements for market risks.

For short-term subordinated debt to be eligible as Tier III Capital, it needs, if circumstances demand, to be capable of becoming part of PD's permanent capital and available to absorb losses in the event of insolvency. It must, therefore, at a minimum;

(i) be unsecured, subordinated and fully paid up;

(ii) have an original maturity of at least two years;

(iii) not be repayable before the agreed repayment date unless the RBI agrees;

(iv) be subject to a lock-in clause that neither interest nor principal may be paid (even at maturity) if such payment means that the PD falls below or remains below its minimum capital requirement.

2.4 Guidelines on Subordinated Debt Instruments

Guidelines relating to the issue of Subordinated Debt Instruments under Tier II and Tier III Capital are furnished below:

i. The amount of Subordinated Debt to be raised may be decided by the Board of Directors of the PD.

ii. The primary dealers may issue subordinated Tier II and Tier III bonds at coupon rates as decided by their Boards of Directors.

iii. The instruments should be 'plain vanilla' with no special features like options, etc.

iv. The debt securities shall carry a credit rating from a Credit Rating Agency registered with the Securities and Exchange Board of India.

v. The issue of Subordinated Debt instruments should comply with the guidelines issued by SEBI vide their circular SEBI/MRD/SE/AT/36/2003/

Annexure – G

277

30/09 dated September 30, 2003 as amended from time to time, wherever applicable.

vi. In case of unlisted issues of Subordinated Debt, the disclosure requirements as prescribed by the SEBI for listed companies in terms of the above guidelines should be complied with.

vii. Necessary permission from the Foreign Exchange Department of the Reserve Bank of India should be obtained for issuing the instruments to NRIs/FIIs. PDs should comply with the terms and conditions, if any, prescribed by SEBI/other regulatory authorities in regard to issue of the instruments.

viii. Investments by PDs in Subordinated Debt of other PDs/banks will be assigned 100% risk weight for capital adequacy purpose. Further, the PD’s aggregate investments in Tiers II and III bonds issued by other PDs, banks and financial institutions shall be restricted up to 5 percent of the investing PD's total capital. The capital for this purpose will be the same as that reckoned for the purpose of capital adequacy.

ix. The PDs should submit a report to the Internal Debt Management Department, Reserve Bank of India giving details of the capital raised, such as, amount raised, maturity of the instrument, rate of interest together with a copy of the offer document, soon after the issue is completed.

2.5 Minimum Requirement of Capital Funds

PDs are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) norm of 15 percent on an ongoing basis.

In calculating eligible capital, it will be necessary first to calculate the PDs’ minimum capital requirement for credit risk, and thereafter its market risk requirement, to establish how much Tier I and Tier II capital is available to support market risk. Eligible capital will be the sum of the whole of the PDs’ Tier I capital, plus all of its Tier II capital under the limits imposed as summarized in Annex C. Tier III capital will be regarded as eligible only if it meets the criteria set out in para 2.3 above.

3 Measurement of Risk Weighted Assets:

The details of credit risk weights for the various on-balance sheet items and offbalance sheet items based on the degree of credit risk and methodology of


278

computing the risk weighted assets for the credit risk are listed in Annex A. The procedure for calculating capital charge for market risk is detailed in Annex B. In order to ensure consistency in the calculation of the capital requirements for credit and market risks, an explicit numerical link will be created by multiplying the measure of market risk by 6.67 (i.e., the reciprocal of the credit risk ratio of 15%) and adding the resulting figure to the sum of risk-weighted assets compiled for credit risk purposes. The ratio will then be calculated in relation to the sum of the two, using as the numerator only eligible capital as given in Annex C.

4 Regulatory reporting of Capital adequacy:

All PDs should report the position of their capital adequacy in PDR III return on a quarterly basis. The PDR III statement is given in Annex D. Apart from the Appendices I to V which are to be submitted alongwith PDR III, PDs should also take into consideration the criteria for use of internal model to measure market risk capital charge (as given in Annex E) alongwith the "Back Testing" mechanism (detailed in Annex F)

5 Diversification of PD Activities

5.1 The guidelines on diversification of activities by stand-alone Primary Dealers have been issued vide circular IDMD. PDRS.26/03.64.00/2006-07 dated July 4, 2006.

5.2 The capital charge for market risk (Value-at-Risk calculated at 99 per cent confidence interval, 15-day holding period, with multiplier of 3.3) for the activities defined below should not be more than 20 per cent of the NOF as per the last audited balance sheet:

1. Investment / trading in equity and equity derivatives

2. Investment in units of equity oriented mutual funds

3. Underwriting public issues of equity

5.3 PDs may calculate the capital charge for market risk on the stock positions / underlying stock positions/ units of equity oriented mutual funds using Internal Models (Value-at-Risk based) based on the guidelines prescribed in Appendix III of Annex D. PDs may continue to provide for credit risk arising out of equity, equity derivatives and equity oriented mutual funds as prescribed Annex A.

Annexure – G

279

6 Risk reporting of derivatives business

In order to capture interest rate risk arising out of interest rate derivative business, all PDs are advised to report the interest rate derivative transactions, as per the format enclosed in Annex G, to the Chief General Manager, Internal Debt Management Department, RBI, Central Office, Mumbai, as on last Friday of every month.


280

Annex A CAPITAL ADEQUACY FOR CREDIT RISK Risk weights for calculation of CRAR (a) On-Balance Sheet assets

All the on-balance sheet items are assigned percentage weights as per degree of credit risk. The value of each asset/item is to be multiplied by the relevant risk weight to arrive at risk adjusted value of the asset, as detailed below. The aggregate of the Risk Weighted Assets will be taken into account for reckoning the minimum capital ratio.

Nature of asset/item Percentage weight

(i) Cash balances and balances in Current 0 Account with RBI

(ii) Amounts lent in call/notice money market/ 20 Other money market instruments of banks/ FIs including CDs and balances in Current account with banks

(iii) Investments (a) `Government’securities/‘Approved’securities 0

guaranteed by Central/State Governments [other than at (e) below]

(b) Fixed Deposits, Bonds of banks and FIs 20 (as specified by DBOD)

(c) Bonds issued by banks/Financial Institutions 100 as Tier II capital

(d) Shares of all Companies and 100 debentures/bonds/Commercial Paper of Companies other than in (b) above/units of mutual funds

(e) Securities of Public Sector Undertakings 20 guaranteed by Government but issued outside the market borrowing programme

(f) Securities of and other claims on 100

Annexure – G

281

Primary Dealers including rediscounting of bills discounted by other PDs

(g) Bills discounted by banks/FIs that are 20 Rediscounted

(iv) Current assets

(a) Inter-corporate deposits 100

(b) Loans to staff 100

(c) Other secured loans and advances considered good 100

(d) Bills purchased/discounted 100

(e) Others (to be specified) 100

(v) Fixed Assets (net of depreciation)

(a) Assets leased out (net book value) 100

(b) Fixed Assets 100

(vi) Other assets

(a) Income tax deducted at source (net of provision) 0

(b) Advance tax paid (net of provision) 0

(c) Interest accrued on Government securities 0

(d) Others (to be specified and risk weight x indicated as per counter party)

Notes: (1) Netting may be done only in respect of assets where provisions for depreciation or for bad and doubtful debts have been made.

(2) Assets which have been deducted from capital fund as at `Capital Funds’ above, shall have a risk weight of `zero’.

(3) The PDs net off the Current Liabilities and Provisions from the Current Assets, Loans and Advances in their Balance Sheet, as the Balance Sheet is drawn up as per the format prescribed under the Companies Act. For capital adequacy purposes, no such netting off should be done except to the extent indicated above.


282

(b) Off-Balance Sheet items

The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face value of each of the off-Balance Sheet items by ‘credit conversion factor’ as indicated in the table below. This will then have to be again multiplied by the weights attributable to the relevant counter-party as specified above under balance sheet items.

Nature of item Credit Conversion Factor percentage

i) Financial guarantees considered 100 as credit substitutes ii) Other guarantees 50 iii) Share/debenture/stock 50 underwritten iv) Partly-paid shares/debentures/other securities 100 and actual devolvement v) Notional Equity /Index position underlying the equity Derivatives * 100 vi) Bills discounted/rediscounted 100 vii) Repurchase agreements (e.g. buy/sell) 100 where the credit risk remains with the PD viii) Other contingent liabilities/ 50 commitments like standby facility with original maturity of over one year ix) Similar contingent liabilities/ 0 commitments with original maturity of upto one year or which can be uncondi- tionally cancelled at any time *For guidelines on calculation of notional positions underlying the equity derivatives, please refer to section A.2, Annex B (Measurement of Market Risk) Note: Cash margins/deposits shall be deducted before applying the Conversion Factor.

Annexure – G

283

(c) Interest Rate Contracts

For the trading/hedging positions in Interest Rate related contracts, such as, interest rate swaps, forward rate agreements, basis swaps, interest rate futures, interest rate options, exchange traded interest rate derivatives and other contracts of similar nature, risk weighted asset and the minimum capital ratio will be calculated as per the two steps given below.

Step 1

The notional principal amount of each instrument is to be multiplied by the conversion factor given below:

Original Maturity Conversion Factor Less than one year 0.5 per cent One year and less than two years 1.0 per cent For each additional year 1.0 per cent

Step 2:

The adjusted value thus obtained shall be multiplied by the risk weightage allotted to the relevant counter-party as specified below: Government/any exposure guaranteed by Government 0% Banks/Financial Institutions (as specified by DBOD) 20% Primary Dealers in the Government Securities market 100% All others 100%

(d) Foreign Exchange Contracts (if permitted):

Like the interest rate contracts, the outstanding contracts should be first multiplied by a conversion factor as shown below:

Aggregate outstanding foreign exchange contracts of original maturity

• less than one year 2% • for each additional year or part thereof 3%

This will then have to be again multiplied by the weights attributable to the relevant counter-party as specified above.

Foreign exchange contracts with an original maturity of 14 calendar days or less, irrespective of the counterparty, may be assigned "zero" risk weight as per international practice.


284

Annex B MEASUREMENT OF MARKET RISK Market risk may be defined as the possibility of loss caused by change in market variables. The objective in introducing the capital adequacy for market risk is to provide an explicit capital cushion for the price risk to which the PDs are especially exposed in their portfolio.

The methods for working out the capital charge for market risks are the standardised model and the internal risk management framework based model. PDs would continue to calculate capital charges based on the standardised method as also under the internal risk management framework based (VaR) model and maintain the higher of the two requirements. However, where price data is not available for specific category of assets, then PDs may follow the standardized method for computation of market risk. In such a situation, PDs shall disclose to Reserve Bank of India, details of such assets and ensure that consistency of approach is followed. PDs should obtain Reserve Bank of India’s permission before excluding any category of asset for calculations of market risk. The Bank would normally consider the instruments of the nature of fixed deposits, commercial bills etc., for this purpose. Such items will be held in the books till maturity and any diminution in the value will have to be provided for in the books.

Note: In case of underwriting commitments, following points should be adhered to:

a) In case of devolvement of underwriting commitment for government securities, 100% of the devolved amount would qualify for the measurement of market risk.

b) In case of underwriting under merchant banking issues (other than Gsecs), where price has been committed/frozen at the time of underwriting, the commitment is to be treated as a contingent liability and 50% of the commitment should be included in the position for market risk. However, 100% of devolved position should be subjected to market risk measurement. The methodology for working out the capital charges for market risk on the portfolio is explained below:

A: Standardised Method: Capital charge under standardized method will be the measures of risk arrived at in terms of paragraphs A.1-3 below summed arithmetically.

Annexure – G

285

A1. For fixed income instruments

Under standardized method, duration method would continue to apply as hitherto. Under this, the price sensitivity of all interest rate positions viz., Dated securities, Treasury bills, Bills purchased/Discounted, Commercial papers, PSU/FI/Corporate Bonds, Special Bonds, Mutual fund units and derivative instruments like IRS, FRAs, Interest Rate Futures etc., including underwriting commitments/devolvement and other contingent liabilities having interest rate/equity risk will be captured.

In duration method, the capital charge is the sum of four components given below:

a) the net short or long position in the whole trading book;

b) a small proportion of the matched positions in each time-band (the “vertical disallowance’’);

c) a larger proportion of the matched positions across different time-bands (the “horizontal disallowance’’) ;

d) a net charge for positions in options, where appropriate

Note : Since blank short selling in the cash position is not allowed, netting as indicated at (a) and the system of `disallowances’ as at (b) and (c) above are applicable currently only to the PDs entering into FRAs/ IRSs/ exchange traded derivatives.

However, under the duration method, PDs with the necessary capability may, with Reserve Bank of India’s permission use a more accurate method of measuring all of their general market risks by calculating the price sensitivity of each position separately. PDs must select and use the method on a consistent basis and the system adopted will be subjected to monitoring by Reserve Bank of India. The mechanics of this method are as follows:

i. First calculate the price sensitivity of all instruments in terms of a change in interest rates of between 0.6 and 1.0 percentage points depending on the duration of the instrument (as per Table 1 given below );

ii. Slot the resulting sensitivity measures into a duration-based ladder with the thirteen time-bands set out in Table 1;


286

iii. Subject the lower of the long and short positions in each time-band to a 5% capital charge towards vertical disallowance designed to capture basis risk;

iv. Carry forward the net positions in each time-band for horizontal offsetting across the zones subject to the disallowances set out in Table 2.

Note : Points iii and iv above are applicable only where opposite positions exist as explained at Note above.

Table 1

Duration time-bands and assumed changes in yield

Assumed change in yield (%) Assumed change in yield (%)

Zone 1 Zone 3

0 to 1month 1.00 4 to 5 years 0.85

1 to 3 months 1.00 5 to 7 years 0.80



15 to 20 years 0.65

Over 20 years 0.60

Zone 2

1to2 years 0.95

2 to 3 years 0.90

3 to 4 years 0.85

Annexure – G

287

Table 2

Horizontal disallowances

Zones Time-band Within the zone

Between adjacent

zones

Between zones 1 and 3

0 – month 1 – 3 months 3 – 6 months

Zone 1

6 – 12 months

40%

1 – 2 years 2 – 3 years Zone 2 3 – 4 years

30%

4 – 5 years 5 – 7 years

7 – 10 years 10 – 15 years 15 – 20 years

Zone 3

Over 20 years

30%

40% 100%

The gross positions in each time-band will be subject to risk weighting as per the assumed change in yield set out in Table 1, with no further offsets.

A1.1. Capital charge for interest rate derivatives:

The measurement system should include all interest rate derivatives and off balance-sheet instruments in the trading book which react to changes in interest rates, (e.g. forward rate agreements (FRAs), other forward contracts, bond futures, interest rate positions).

A1.2. Calculation of positions

The derivatives should be converted into positions in the relevant underlying and become subject to market risk charges as described above. In order to calculate the market risk as per the standardized method described above, the amounts reported should be the market value of the principal amount of the underlying or of the notional underlying.


288

A1.3. Futures and forward contracts, including forward rate agreements

These instruments are treated as a combination of a long and a short position in a notional government security. The maturity of a future or a FRA will be the period until delivery or exercise of the contract, plus - where applicable - the life of the underlying instrument. For example, a long position in a June three-month interest rate future taken in April is to be reported as a long position in a government security with a maturity of five months and a short position in a government security with a maturity of two months. Where a range of deliverable instruments may be delivered to fulfill the contract, the PD has flexibility to elect which deliverable security goes into the maturity or duration ladder but should take account of any conversion factor defined by the exchange. In the case of a future on a corporate bond index, positions will be included at the market value of the notional underlying portfolio of securities.

A1.4. Swaps

Swaps will be treated as two notional positions in government securities with relevant maturities. For example, an interest rate swap under which a PD is receiving floating rate interest and paying fixed will be treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the residual life of the swap. For swaps that pay or receive a fixed or floating interest rate against some other reference price, e.g. a stock index, the interest rate component should be slotted into the appropriate repricing maturity category, with the equity component being included in the equity framework.

A1.5. Calculation of capital charges

(a) Allowable offsetting of matched positions

PDs may exclude from the interest rate maturity framework altogether (long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon and maturity. A matched position in a future or forward and its corresponding underlying may also be fully offset, and thus excluded from the calculation. When the future or the forward comprises a range of deliverable instruments, offsetting of positions in the future or forward contract and its underlying is only permissible in cases where there is a readily identifiable underlying security which is most profitable for the trader

Annexure – G

289

with a short position to deliver. The leg representing the time to expiry of the future should, however, be reported. Security, sometimes called the "cheapest-to-deliver", and the price of the future or forward contract should in such cases move in close alignment. In addition, opposite positions in the same category of instruments can in certain circumstances be regarded as matched and allowed to offset fully. To qualify for this treatment the positions must relate to the same underlying instruments can be of the same nominal value. In addition:

(i) for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates must be for identical products and mature within seven days of each other;

(ii) for swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (i.e. within 15 basis points); and

(iii) for swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond within the following limits:

• less than one month hence: same day;

• between one month and one year hence: within seven days;

• over one year hence: within thirty days.

PDs with large swap books may use alternative formulae for these swaps to calculate the positions to be included in the duration ladder. One method would be to first convert the payments required by the swap into their present values. For that purpose, each payment should be discounted using zero coupon yields, and a single net figure for the present value of the cash flows entered into the appropriate time-band using procedures that apply to zero (or low) coupon bonds; these figures should be slotted into the general market risk framework as set out earlier. An alternative method would be to calculate the sensitivity of the net present value implied by the change in yield used in the duration method and allocate these sensitivities into the time-bands set out in Table 1. Other methods which produce similar results could also be used. Such alternative treatments will, however, only be allowed if:

• the supervisory authority is fully satisfied with the accuracy of the systems being used;


290

• the positions calculated fully reflect the sensitivity of the cash flows to interest rate changes and are entered into the appropriate time-bands;

General market risk applies to positions in all derivative products in the same manner as for cash positions, subject only to an exemption for fully or very closely-matched positions in identical instruments as defined in above paragraphs. The various categories of instruments should be slotted into the maturity ladder and treated according to the rules identified earlier.

A 2. Capital charge for equity positions:

A2.1. Equity positions

This section sets out a minimum capital standard to cover the risk of holding or taking positions in equities by the PDs. It applies to long and short positions in all instruments that exhibit market behavior similar to equities, but not to nonconvertible preference shares (which will be covered by the interest rate risk requirements). Long and short positions in the same issue may be reported on a net basis. The instruments covered include equity shares, convertible securities that behave like equities, i.e., units of MF and commitments to buy or sell equity securities. The equity or equity like positions including those arrived out in relation to equity /index derivatives as described below may be included in the duration ladder below one month.

A2.2. Equity derivatives

Equity derivatives and off balance-sheet positions which are affected by changes in equity prices should be included in the measurement system. This includes futures and swaps on both individual equities and on stock indices. The derivatives are to be converted into positions in the relevant underlying.

A2.3. Calculation of positions

In order to calculate the market risk as per the standardized method for credit and market risk, positions in derivatives should be converted into notional equity positions:

• futures and forward contracts relating to individual equities should in principle be reported at current market prices;

• futures relating to stock indices should be reported as the marked-tomarket value of the notional underlying equity portfolio;

Annexure – G

291

• equity swaps are to be treated as two notional positions

Note: As per the circular IDMD. PDRS./26/03.64.00/2006-07 dated July 4, 2006 on "Diversification of PD Activities", PDs have been allowed to calculate the capital charge for market risk on equity and equity derivatives using the Internal Models approach only.

A.3 Capital Charge for Foreign Exchange Position (if permitted):

PDs normally would not be dealing in foreign exchange transactions. However, by virtue of they having been permitted to raise resources under FCNR(B) loans route, subject to prescribed guidelines, may end up holding open foreign exchange position. This open position in equivalent rupees arrived at by marking to market at FEDAI rates will be subject to a flat market risk charge of 15%.

B. Internal risk model (VaR) based method

The PDs should calculate the capital requirement based on their internal Value at Risk (VaR) model for market risk, as per the following minimum parameters:

(a) "Value-at-risk" must be computed on a daily basis.

(b) In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used.

(c) An instantaneous price shock equivalent to a 15-day movement in prices is to be used, i.e. the minimum "holding period" will be fifteen trading days.

(d) Interest rate sensitivity of the entire portfolio should be captured on an integrated basis by including all fixed income securities like Government securities, Corporate/PSU bonds, CPs and derivatives like IRS, FRAs, Interest rate futures etc., based on the mapping of the cash flows to work out the portfolio VaR. Wherever data for calculating volatilities is not available, PDs may calculate the volatilities of such instruments using the G-Securities curve with appropriate spread. However, the details of such instruments and the spreads applied have to be reported and consistency of methodology should be ensured.

(e) Instruments which are part of trading book, but found difficult to be subjected to measurement of market risk may be applied a flat market


292

risk measure of 15%. The instruments likely to be applied the flat market risk measure are units of MF, Unquoted Equity, etc., and added arithmetically to the measure obtained under VaR in respect of other instruments.

(f) Underwriting commitments as explained at the beginning of the Annex should also be mapped into the VaR framework for risk measurement purposes.

(g) The unhedged foreign exchange position arising out of the foreign currency borrowings under FCNR(B) loans scheme would carry a market risk of 15% as hitherto and the measure obtained will be added arithmetically to the VaR measure obtained for other instruments.

(h) The choice of historical observation period (sample period) for calculating value-at-risk will be constrained to a minimum length of one year and not less than 250 trading days. For PDs who use a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (that is, the weighted average time lag of the individual observations cannot be less than 6 months).

(i) The capital requirement will be the higher of :

i. the previous day's value-at-risk number measured according to the above parameters specified in this section and

ii. the average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a multiplication factor prescribed by Reserve Bank of India (3.3 presently).

(j) No particular type of model is prescribed. So long as the model used captures all the material risks run by the PDs, they will be free to use models, based for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations or EVT etc.

(k) The criteria for use of internal model to measure market risk capital charge are given in Annex E.

Annexure – G

293

Annex C SUMMATION OF CAPITAL ADEQUACY REQUIREMENTS

The capital adequacy requirements for the PDs will comprise

• the capital charge for credit risk requirements as indicated in Annex A, plus

• the capital charge for market risk requirements as indicated in Annex B

• In working out the eligible capital, the PDs are required to first calculate their minimum capital requirements for credit risk and only afterwards the capital charge towards market risk requirements. The total capital funds will represent the capital available to meet both the credit as also the market risks.

• Of the 15% capital charge for credit risk, at least 50% should be met by Tier I capital, that is the total of Tier II Capital, if any, shall not exceed one hundred per cent of Tier I Capital, at any point of time, for meeting the capital charge for credit risk.

• Subordinated debt as capital should not exceed 50% of tier II capital.

• The total of Tier III Capital, if any, shall not exceed two hundred and fifty per cent of the Tier I Capital that is available for meeting market risk capital charge i.e. excess over the credit risk capital requirements.

• The total of Tier II and Tier III capital eligible for working out the total capital funds should not exceed 100% of Tier I capital.

• The overall capital adequacy ratio will be calculated by establishing an explicit numerical link between the credit risk and the market risk factors, by multiplying the market risk capital charge with 6.67 i.e. the reciprocal of the minimum credit risk capital charge of 15 %. The resultant figure is added to the sum of risk weighted assets worked out for credit risk purpose. The numerator for calculating the overall ratio will be the PD’s Tier I, Tier II and the Tier III Capital after head room deductions, if any. The calculation of capital charge is illustrated in PDR III format, which is enclosed as Annex D.


294

Annex D PDR III Return

Statement of Capital Adequacy - Quarter ended -

Name of the Primary Dealer :

Statement - 1 ( Summary) Rupees

(i) Total of Risk Weighted Assets for Credit Risk (Annex I) Rs.

(ii) (a) Tier I Capital funds (after deductions) Rs. (b) Tier II Capital funds eligible Rs. (c) Total of available Tier I & II capital funds Rs.

(iii) Minimum credit risk capital required Rs. i.e. (i) x 15 per cent

(iv) Excess of Tier I & II capital funds available Rs. For market risk capital charge i.e. (ii) (c) – (iii)

(v) The Market Risk capital charge worked Rs. out as the higher of the amounts under the Standardised method and the one as per Internal Risk Management (VaR) Model (Appendices II and III)

(vi) Capital funds available to meet (v) Rs. i.e: excess of Tier I and Tier II as at (iv) above, Plus eligible Tier III capital funds [maximum up to 250 % of surplus Tier I capital]

(vii) Over all Capital Adequacy (a) Total RWA for credit risk i.e. (i) Rs. (b) Capital charge for market risk i.e. (v) Rs. (c) Numerical Link for (b) = 6.67 i.e.(reciprocal of credit risk capital ratio of 15%) (d) Risk Weighted Assets relating to Market Risk i.e. (b) x (c) Rs. (e) Total Risk Weighted Assets i.e. (a) + (d) Rs. (f) Minimum capital required i.e. (e) x 15% Rs. (g) Total Capital funds available i.e. (ii) + (vi) Rs.

Annexure – G

295

(h) less : Capital funds prescribed by other regulators/ Rs. licensors e.g. SEBI/ NSE/ BSE/OTCEI (i) Net capital funds available (g – h) Rs. for PD business (viii) Surplus Tier III Capital funds, if any Rs. (ix) Capital Adequacy Ratio (CRAR) % (i / e) * 100

Following Appendices are to be sent along with the return*:

Appendix I - Details of the various on-balance sheet and off-balance sheet items, the risk weights assigned and the risk adjusted value of assets have to be reported in this format. The format enclosed is purely illustrative. PDs are required to adhere to the guidelines on activities permitted to be undertaken by PDs while diversifying business activities.

Appendix II - Details of the market risk charge using the standardised model are required to be reported in the format enclosed.

Appendix III - Details of market risk using the internal model should be reported as per the format enclosed.

Appendix IV - Details of back-testing results for the previous quarter, giving the details of VaR predicted by the model, the actual change in the value of the portfolio and the face value of the portfolio should be reported.

Appendix V - Details of stress testing, giving details of the change in the value of the portfolio for a given change in the yield, should be reported in the format enclosed.

* The above Appendices (in printable form) may be sent by e-mail to [email protected]


296

Appendix I

CREDIT RISK A. ALANCE SHEET TEMS

FUNDED RISK ASSET BOOK VALUE Rupees

RISK WEIGHT

%

RISK ADJ

VALUE I. Cash balances and balances in current

account with RBI 0%

II. Amounts lent in call/ notice money market and balances in current account with banks 20%

III. Investments (a) Government and Approved

securities, guaranteed by Central/state governments other than at (e) below 0%

(b) Fixed deposits, Bonds and Certificates of Deposit of banks, PDs and public Financial Institutions as specified by DBOD 20%

(c) Bonds issued by banks/PDs/ public financial Institutions ( as specified by DBOD) as Tier II capital 100%

(d) Shares of all companies and debentures/ bonds/ commercial papers of companies other than in (b) above/ Units of mutual funds 100%

(e) Securities of Public sector Undertakings guaranteed by Central/state govts. but issued

Annexure – G

297

outside the market borrowing programme 20% Note : In case where the guarantee has been invoked and the concerned state government has remained in default, PDs should assign 100% risk weight.

(f) Securities of and other exposures on Primary Dealers in the Government 100% Securities market including bills rediscounted

(g) Bills discounted by banks / FIs that are 20% rediscounted

IV. Current Assets (a) Inter-corporate deposits 100% (b) Loans to staff 100% (c) Other secured loans and advances

considered good 100%

(d) Bills purchased/discounted 100% (e) Others (to be specified) 100%

V. Fixed Assets (net of depreciation) (a) Assets leased out 100% (b) Fixed Assets 100%

VI. Other assets (a) Income-tax deducted at source (net

of provision) 0%

(b) Advance tax paid (net of provision) 0%

(c) Interest due on Government securities 0%

(d) Others (to be specified and risk weight indicated as per the counter party) X%

AA. OTAL RISK-WEIGHTED BALANCE SHEET ASSETS


298

B. FF-BALANCE SHEET ITEMS


CREDIT CONV

FACTOR %

RISK WEIGHT

%

RISK ADJ

VALUE

I. Financial guarantees considered as credit substitutes

Government/ any exposure guaranteed by Government

100% 0%

Banks/ Financial Institutions (as specified by DBOD)

100% 20%

Primary Dealers in the Government securities market

100% 100%

All others 100% 100%

II. Other guarantees


50% 0%


50% 20%


50% 100%

All others 50% 100%

III. Share/ debenture/ auction stock underwritten


100% 0%


100% 20%


100% 100%


IV. Partly - paid shares/ debentures including actual devolvement and other securities


100% 0%

Annexure – G

299


CREDIT CONV

FACTOR %

RISK WEIGHT

%

RISK ADJ

VALUE


100% 20%


100% 100%


V. Notional Equity/Index Positions underlying the equity derivative

100% 100%

VI. Bills discounted/ rediscounted


100% 0%


100% 20%


100% 100%


VII. Repurchase agreements where the credit risk remains with the PD


100% 0%


100% 20%


100% 100%


VIII. Other contingent liabilities/ commitments like standby


50% 0%


50% 20%


50% 100%


300


CREDIT CONV

FACTOR %

RISK WEIGHT

%

RISK ADJ

VALUE

All others 50% 100%

IX. Interest Rate swaps

Original maturity of less than 1 year 0.5% 100%

Original maturity of 1 year and above but less than 2 years

1% 100%

Original maturity of 2 years and above but less than 3 years

2% 100%


3% 100%


4% 100%


5% 100%

Original maturity of 6 years and above but less than 7 years ( Every additional year - CCF increases by 1%)

6% 100%

X. Foreign Exchange Forward Contract

Original maturity of less than 1 year$ 2% 20 - 100%

Original maturity of more than 1 year and less than 2 years$ (Every additional year – CCF increases by 3%) $ Risk depends on the counter party

5% 20 - 100%

Note: Cash margins/ deposits should be deducted before applying the credit conversion factor

BB. TOTAL RISK-WEIGHTED OFF-BALANCE SHEET ASSETS

CC. TOTAL RISK-WEIGHTED BALANCE SHEET & OFF-BALANCE SHEET ASSETS

Appe

ndix

II

PD

R-III

St

atem

ent 3

Qu

arte

rly

Re

turn

M

ARKE

T RI

SK C

APIT

AL S

TATE

MENT

(Cor

relat

ions i

.e. a

ppre

ciatio

n no

t rec

ognis

ed)

(i)

Stan

dard

ised

Met

hod

A.

Inte

rest

rate

Instr

umen

ts &

Equit

y /Eq

uity l

ike in

strum

ents

INST

RUME

NT

Maturity Date

POSITION (FV)

BOOK PRICE

BOOK VALUE

MODIFIED DURATION

DURATION BUCKET

ZONE

YIELD

ASSU

MED

CH

ANGE

IN

YIE

LD

(bps

)

CHANGED YIELD

CHANGED PRICE

CHAN

GE

IN

PRIC

E

MAR

KET

RISK

CH

ARGE

(1)

(2)

(3)

(4)

(5)

(6

) (7

) (8

) (9

) (1

0)

(11)

(1

2)

(13)

(In

cludin

g eq

uity

posit

ions)

Tota

l of A

B.

Un

hedg

ed F

oreig

n Ex

chan

ge P

ositio

n

15

%

Tota

l (A+

B)

Posit

ion M

arke

t Risk

Mea

sure

(M

arke

d to

Mar

ket v

alue)

(15%

of t

he p

ositio

n)

Tech

nica

l Gui

de o

n In

tern

al Au

dit o

f Tre

asur

y Fun

ctio

n in

Ban

ks

302

B.

Unhe

dged

For

eign

Exch

ange

Pos

ition

C.

Asse

t ite

ms su

bjecte

d to

flat

char

ge o

f 15%

for m

arke

t risk

mea

sure

ment

M

emo

item

s: Ite

ms o

f ass

ets w

hich,

with

the

appr

oval

of R

BI, h

ave

been

clas

sified

as i

nves

tmen

t ite

ms a

nd n

ot su

bjecte

d to

mar

ket r

isk m

easu

re:

Asse

t

Book

Valu

e

MTM

/NAV

1.

2.

3.

Anne

xure

– G

303

Appe

ndix

III

Deta

ils o

f the

VaR

cal

cula

tion

- for

the

last

60

days

To

tal

Date

Po

rtfoli

o Va

lue (R

s.)

VaR

(Rs.)

one

day

Va

R wi

th h

olding

pe

riod

VaR

with

hold

ing p

eriod

as a

Pe

rcen

tage

of p

ortfo

lio

(a

) Ave

rage

of 6

0 da

y Va

r (wi

th h

oldi

ng p

erio

d)

(b

) 3.3

tim

es th

e 60

day

ave

rage

VaR

(with

hol

ding

per

iod)

(c) L

ast d

ay's

VaR

(d

) Mar

ket R

isk

Meas

ure

(hig

her o

f ( b

) an

d (c

) ab

ove)

Tech

nica

l Gui

de o

n In

tern

al Au

dit o

f Tre

asur

y Fun

ctio

n in

Ban

ks

304

Appe

ndix

IV

Back

Tes

ting

of V

aR M

odel

Fo

r the

last

250

trad

ing

days

Ba

ck te

stin

g Re

port

as p

art o

f PDR

III f

or Q

uarte

r end

ed _

____

____

____

____

_

Ac

tual

Hypo

thet

ical

No o

f obs

erva

tions

(exc

luding

holi

days

) 25

0 25

0 No

of f

ailur

es ie

no

of tim

es V

aR u

nder

pred

icted

the

actu

al tra

ding/

hyp

othe

tical

MTM

loss

e 0

0

Sr.

No.

Date

1 day

VaR

Enti

re

Portf

olio R

s. crs

Mk

t Valu

e Enti

re

Portf

olio

Mkt V

alue N

ext

Day S

ame

Portf

olio

Diffe

renc

e

Rs. c

rs Fa

ilure

(Y

/N)

Actua

l P/(L

) Rs

. crs

Failu

re (Y

/N)

1

2

3

4

.

.

.

.

.

25

0

The

daily

VaR

pre

cedin

g ho

liday

s sh

ould

be u

psca

led b

y th

e sq

uare

root

of n

umbe

r of i

nter

venin

g ho

liday

s. Fo

r exa

mple

if th

e Fr

iday i

s foll

owed

by 2

holi

days

, the

n th

e on

e Va

R fig

ure

for F

riday

shou

ld be

mult

iplied

by s

quar

e ro

ot o

f 2.

Appendix V Details of stress testing

STRESS TEST AS ON:

Name of the PD:

ASSETS (All tradable interest rate relatedassets)

MTM Value (Rs. Crore)

Weighted Average Mod. Duration

(years) 1 G-Secs and T-Bills 2 Corporate/PSU/FI Bonds

3 Receiving leg in respect of FRA/IRS 4 Other tradable interest rate instruments

Total MTM value of assets (Va)

Weighted Average Mod. Duration of the assets (Da)

LIABILITES (excluding NOF)

MTM Value (Rs. Crore)

Weighted Average Mod. Duration

(years) 1 Net borrowing Call, notice & term money

2 Net borrowing in Repo (including LAF of RBI) 3 Net Borrowing through CBLO

4 Borrowing through ICDs 5 Borrowing through CPs 6 Borrowing through Bond issuances

7 Credit lines from banks/FIs 8 Paying leg in respect of FRA/IRS

9 Other tradable interest rate liabilites

Total MTM value of liabilities (Vl) Weighted Average Mod. Duration of Liabilites (Dl)


306

Mod. Duration of NOF (Dn) = (Va*Da - Vl*Dl)/(Va-Vl)

Percentage change in NOF = (-) Dn*Change in interest rates (1%)

Change in NOF = (-) Dn* Change in Interest rates (1%)*NOF

Other details:

Net interest income in the current year so far

Trading profits/loss in the current year so far

Unrealised MTM (Net gain/loss on cash positions)

Unrealised MTM (Net gain/loss on derivative positions)

Other income, if any (Details to be specified) ***

NOF deployed in fixed income and related instruments

Total NOF (Break-up to be furnished)

Note: NOF should be determined as per the definition prescribed in this regard. The MTM gains or losses should be adjusted in the NOF.

***Details of Other Income

Annexure – G

307

Capital funds of the firm as on the date of stress test (Rs.in crore)

i. Tier I captial

ii. Tier II Capital

iii. Tier III Capital

iv. Details of Deductions

investment in subsidiaries

intangible assets

losses in current accounting period

deferred tax assets

losses brought forward from previous accounting periods

Capital funds prescribed by other regulator

v. Net total capital funds

Less

vi. change in NOF due to one percent increase in yields

vii. Net capital funds available after providing for change in NOF

viii. Risk-weighted assets for the credit risk of the firm

ix. Risk-weighted assets for the market risk of the firm

x. Total risk-weighted assets

xi. Capital adequacy ratio as on the date of stress test (vii/x)


308

Annex E Criteria for use of internal model to

measure market risk capital charge

A. General criteria

1. In order that the internal model is effective, it should be ensured that :

- the PD's risk management system is conceptually sound and its implementation is certified by external auditors;

- the PD has sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit, and back office areas;

- the PD has a proven track record of reasonable accuracy in measuring risk (back testing);

- the PD regularly conducted stress tests along the lines discussed in Para B.4 below

2. In addition to these general criteria, PDs using internal models for capital purposes will be subject to the requirements detailed in Sections B.1 to B.5 below.

B.1 Qualitative standards

The extent to which PDs meet the qualitative criteria contained herein will influence the level at which the RBI will ultimately set the multiplication factor referred to in Section B.3 (b) below, for the PD. Only those PDs, whose models are in full compliance with the qualitative criteria, will be eligible for use of the minimum multiplication factor. The qualitative criteria include:

a) The PD should have an independent risk control unit that is responsible for the design and implementation of the system. The unit should produce and analyse daily reports on the output of the PD's risk measurement model, including an evaluation of the relationship between measures of risk exposure and trading limits. This unit must be independent from trading desks and should report directly to senior management of the PD.

b) The unit should conduct a regular back testing programme, i.e. an ex-post comparison of the risk measure generated by the model against

Annexure – G

309

actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions.

c) Board of Directors and senior management should be actively involved in the risk control process and must regard risk control as an essential aspect of the business to which significant resources need to be devoted. In this regard, the daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions in positions taken by individual traders and reductions in the PD’s overall risk exposure.

d) The PD’s internal risk measurement model must be closely integrated into the day-to-day risk management process of the institution. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the PD’s market risk profile.

e) The risk measurement system should be used in conjunction with internal trading and exposure limits. In this regard, trading limits should be related to the PD’s risk measurement model in a manner that is consistent over time and that it is well-understood by both traders and senior management.

f) A routine and rigorous programme of stress testing should be in place as a supplement to the risk analysis based on the day-to-day output of the PD’s risk measurement model. The results of stress testing should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the Board of Directors. Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps should be taken to manage those risks appropriately.

g) PDs should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. The risk measurement system must be well documented, for example, through a manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measure market risk.

h) An independent review of the risk measurement system should be carried out regularly in the PD’s own internal auditing process. This


310

review should include both the activities of the trading desks and of the risk control unit. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:

• the adequacy of the documentation of the risk management system and process;

• the organisation of the risk control unit ;

• the integration of market risk measures into daily risk management;

• the approval process for risk pricing models and valuation systems used by front and back-office personnel;

• the validation of any significant change in the risk measurement process;

• the scope of market risks captured by the risk measurement model;

• the integrity of the management information system;

• the accuracy and completeness of position data;

• the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;

• the accuracy and appropriateness of volatility and other assumptions;

• the accuracy of valuation and risk transformation calculations;

• the verification of the model's accuracy through frequent back testing as described in (b) above and in the Annex G.

i) The integrity and implementation of the risk management system in accordance with the system policies/procedures laid down by the Board of Directors should be certified by the external auditors as outlined at Para B.5.

j) A copy of the back testing result should be furnished to Reserve Bank of India.

Annexure – G

311

B.2 Specification of market risk factors

An important part of a PD’s internal market risk measurement system is the specification of an appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the PD’s trading positions. The risk factors contained in a market risk measurement system should be sufficient to capture the risks inherent in all the PD’s portfolio of on-and-off-balance sheet positions. The following guidelines should be kept in view:

(a) For interest rates, there must be a set of risk factors corresponding to interest rates in each portfolio in which the PD has interest-rate-sensitive on-or-off-balance sheet positions.

The risk measurement system should model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. The yield curve should be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve. For material exposures to interest rate movements in the major instruments, PDs must model the yield curve using all material risk factors, driven by the nature of the PD’s trading strategies. For instance, a PD with a portfolio of various types of securities across many points of the yield curve and that engages in complex arbitrage strategies, would require a greater number of risk factors to capture interest rate risk accurately.

The risk measurement system must incorporate separate risk factors to capture spread risk (e.g. between bonds and swaps), i.e. risk arising from less than perfectly correlated movements between Government and other fixed-income instruments.

(b) For equity prices, at a minimum, there should be a risk factor that is designed to capture market-wide movements in equity prices (e.g. a market index). Position in individual securities or in sector indices could be expressed in "beta-equivalents" relative to this market-wide index. More detailed approach would be to have risk factors corresponding to various sectors of the equity market (for instance, industry sectors or cyclical, etc.), or the most extensive approach, wherein, risk factors corresponding to the volatility of individual equity issues are assessed. The method could be decided by the PDs corresponding to their exposure to the equity market and concentrations.


312

B.3. Quantitative standards

(a) PDs should update their data sets at least once every three months and should also reassess them whenever market prices are subject to material changes. Reserve Bank of India may also require a PD to calculate their value-at-risk using a shorter observation period if, in it’s judgement, this is justified by a significant upsurge in price volatility.

(b) The multiplication factor will be set by Reserve Bank of India on the basis of the assessment of the quality of the PD’s risk management system, as also the back testing framework and results, subject to an absolute minimum of 3. The document `Back testing’ mechanism to be used in conjunction with the internal risk based model for market risk capital charge’, enclosed as Annex-F, presents in detail the back testing mechanism.

PDs will have flexibility in devising the precise nature of their models, but the parameters indicated at Annex-E are the minimum which the PDs need to fulfill for acceptance of the model for the purpose of calculating their capital charge. Reserve Bank of India will have the discretion to apply stricter standards.

B.4 Stress testing

1. PDs that use the internal models approach for meeting market risk capital requirements must have in place a rigorous and comprehensive stress testing program to identify events or influences that could greatly impact them.

2. PD’s stress scenarios need to cover a range of factors than can create extraordinary losses or gain in trading portfolios, or make the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risks, including the various components of market, credit and operational risks.

3. PD’s stress test should be both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances. Quantitative criteria should identify plausible stress scenarios to which PDs could be exposed. Qualitative criteria should emphasize that two major goals of stress testing are to evaluate the capacity of the PD’s capital to absorb potential large losses and to identify steps the PD can take to reduce its risk and conserve capital.

Annexure – G

313

This assessment is integral to setting and evaluating the PD’s management strategy and the results of stress testing should be regularly communicated to senior management and, periodically, to the PD’s Board of Directors.

4. PDs should combine the standard stress scenarios with stress tests developed by PDs themselves to reflect their specific risk characteristics. Specifically, Reserve Bank of India may ask PDs to provide information on stress testing in three broad areas, which are discussed below.

(a) Scenarios requiring no simulations by the PD

PDs should have information on the largest losses experienced during the reporting period available for Reserve Bank of India’s review. This loss information could be compared to the level of capital that results from a PD’s internal measurement system. For example, it could provide Reserve Bank of India with a picture of how many days of peak day losses would have been covered by a given Value-at-Risk estimate.

(b) Scenarios requiring a simulation by the PD

PDs should subject their portfolios to a series of simulated stress scenarios and provide Reserve Bank of India with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance, incorporating both the large price movements and the sharp reduction in liquidity associated with these events. A second type of scenario would evaluate the sensitivity of the PD’s market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the PD’s current positions against the extreme values of the historical range. Due consideration should be given to the sharp variation that at times has occurred in a matter of days in periods of significant market disturbance.

(c) Scenarios developed by the PD itself to capture the specific characteristics of its portfolio

In addition to the scenarios prescribed by Reserve Bank of India under (a) and (b) above, a PD should also develop its own stress tests which it identified as most adverse based on the characteristics of its portfolio. PDs should provide Reserve Bank of India with a description of the methodology


314

used to identify and carry out stress testing under the scenarios, as well as with a description of the results derived from these scenarios.

The results should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the Board of Directors. Moreover, if the testing reveals particular vulnerability to a given set of circumstances, Reserve Bank of India would expect the PD to take prompt steps to manage those risks appropriately (e.g. by reducing the size of its exposures).

B.5 External Validation

PDs should get the internal model’s accuracy validated by external auditors, including at a minimum, the following:

(a) verifying that the internal validation processes described in B.1(h) are operating in a satisfactory manner;

(b) ensuring that the formulae used in the calculation process as well as for the pricing of complex instruments are validated by a qualified unit, which in all cases should be independent from the trading desks;

(c) Checking that the structure of internal models is adequate with respect to the PD’s activities and geographical coverage;

(d) Checking the results of the PD’s back testing of its internal measurement system (i.e. comparing Value-at-Risk estimates with actual profits and losses) to ensure that the model provides a reliable measure of potential losses over time. PDs should make the results as well as the underlying inputs to their value-at-risk calculations available to the external auditors;

(e) Making sure that data flows and processes associated with the risk measurement system are transparent and accessible. In particular, it is necessary that auditors are in a position to have easy access, wherever they judge it necessary and under appropriate procedures, to the models’ specifications and parameters.

Annexure – G

315

Annex F “BACK TESTING” mechanism to be used in conjunction with the internal risk based model for market risk capital charge

The following are the parameters of the back testing framework for incorporating into the internal models approach to market risk capital requirements.

Primary Dealers that have adopted an internal model-based approach to market risk measurement are required routinely to compare daily profits and losses with modelgenerated risk measures to gauge the quality and accuracy of their risk measurement systems. This process is known as "back testing".

The objective of the back testing efforts is the comparison of actual trading results with model-generated risk measures. If the comparison uncovers sufficient differences, problems almost certainly must exist, either with the model or with the assumptions of the back test.

Description of the back testing framework

The back testing program consists of a periodic comparison of the Primary Dealer’s daily Value-at-Risk measures with the subsequent daily profit or loss (“trading outcome”). The Value-at-Risk measures are intended to be larger than all but a certain fraction of the trading outcomes, where that fraction is determined by the confidence level of the Value-at-Risk measure. Comparing the risk measures with the trading outcomes simply means that the Primary Dealer counts the number of times that the risk measures were larger than the trading outcome. The fraction actually covered can then be compared with the intended level of coverage to gauge the performance of the Primary Dealer’s risk model.

Under the Value-at-Risk framework, the risk measure is an estimate of the amount that could be lost on a set of positions due to general market movements over a given holding period, measured using a specified confidence level.

The back tests to be applied compare whether the observed percentage of outcomes covered by the risk measure is consistent with a 99% level of confidence.

That is, they attempt to determine if a PD’s 99th percentile risk measures truly cover 99% of the firm’s trading outcomes.


316

i) Significant changes in portfolio composition relative to the initial positions are common at trading day end. For this reason, the back testing framework suggested involves the use of risk measures calibrated to a one-day holding period.

A more sophisticated approach would involve a detailed attribution of income by source, including fees, spreads, market movements, and intra-day trading results.

Primary Dealers should perform back tests based on the hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged.

ii) Back testing using actual daily profits and losses is also a useful exercise since it can uncover cases where the risk measures are not accurately capturing trading volatility in spite of being calculated with integrity.

Primary Dealers should perform back tests using both hypothetical and actual trading outcomes. The steps involve calculation of the number of times that the trading outcomes are not covered by the risk measures (“exceptions”). For example, over 200 trading days, a 99% daily risk measure should cover, on average, 198 of the 200 trading outcomes, leaving two exceptions.

The back testing framework to be applied entails a formal testing and accounting of exceptions on a quarterly basis using the most recent twelve months of date. Primary Dealers may however base the back test on as many observations as possible. Nevertheless, the most recent 250 trading days' observations should be used for the purposes of back testing. The usage of the number of exceptions as the primary reference point in the back testing process is the simplicity and straightforwardness of this approach.

Normally, in view of the 99% confidence level adopted, a level of 4 exceptions in the observation period of 250 days would be acceptable to consider the model as accurate. Exceptions above this, would invite supervisory actions. Depending on the number of exceptions generated by the Primary Dealer’s back testing model, both actual as well as hypothetical, Reserve Bank of India may initiate a dialogue regarding the Primary Dealer’s model, enhance the multiplication factor, may impose an increase in the capital requirement or disallow use of the model as indicated above depending on the number of exceptions.

Annexure – G

317

In case large number of exceptions are being noticed, it may be useful for the PDs to dis-aggregate their activities into sub sectors in order to identify the large exceptions on their own. The reasons could be of the following categories:

Basic integrity of the model

1) The PD’s systems simply are not capturing the risk of the positions themselves (e.g. the positions of an office are being reported incorrectly).

2) Model volatilities and/or correlations were calculated incorrectly (e.g. the computer is dividing by 250 when it should be dividing by 225).

Model’s accuracy could be improved

3) The risk measurement model is not assessing the risk of some instruments with sufficient precision (e.g. too few maturity buckets or an omitted spread).

Bad luck or markets moved in fashion unanticipated by the model

4) Random chance (a very low probability event).

5) Markets moved by more than the model predicted was likely (i.e. volatility was significantly higher than expected).

6) Markets did not move together as expected (i.e. correlations were significantly different than what was assumed by the model).

Intra-day trading

7) There was a large (and money-losing) change in the PD’s positions or some other income event between the end of the first day (when the risk estimate was calculated) and the end of the second day (when trading results were tabulated).


318

Annex G

Annex

Monthly Return on Interest Rate Risk of Rupee Derivatives

As at end-month

Name of the Bank/Institution:

1. Cash Bonds Market Value (Rs. In Crore)

PV01 (Rs. In Crore)

(a) (b) (c)

(a) HFT (See Note 1)

(b) AFS (See Note 1)

(c) HTM (See Note 1)

Total [(a) to (c) above]

2. Rupee Interest Rate Derivatives Notional Amount (Rs. in Crore)

PV01(Rs. in

Crore)

(a) Bond Futures (See Note 1)

(b) MIBOR (OIS) (See Note 2)

(c) MIFOR (See Note 2)

(d) G-Sec benchmarks (See Note2)

(e) Other benchmarks (Please report separately) (See Note 2&4)

(f) Forward Rate Agreements (See Note 3)

Total [(a) to (f) above]

3. Grand Total of (1) & (2)

4. Tier I Capital

Note 1. PV01 may be taken as POSITIVE for long positions and NEGATIVE for short positions.

Note 2. PV01 may be taken as POSITIVE if receiving a swap and NEGATIVE if paying a swap.

Note 3. For FRAs, use the PVO1 of the underlying deposit/instrument.

Note 4. In 2 (e) above, swaps on other benchmarks such as LIBOR may be reported separately for each benchmark

Annexure – G

319

Annex H List of circulars Consolidated

No Circular No Date Subject

1 IDMD.1 / (PDRS) 03.64.00 /

2003-04

January 07, 2004

Capital Adequacy Standards and Risk Management Guidelines for Primary Dealers

2 IDMD.PDRS.No.06 /03.64.00

/ 2004-05

October 15, 2004

Capital Adequacy Standards – Guidelines on Issue of Subordinated Debt Instruments – Tier II and Tier III Capital

3 IDMD. PDRS.26 /03.64.00

/2006-07

July 4, 2006 Diversification of activities by standalone Primary Dealers – Operational Guidelines

4 IDMD.PDRS.No.148 / 03.64.00 / 2006-07

July 10, 2006 Risk reporting of derivatives business

5 RBI / 2008-09 / 424

IDMD.PDRD.No. 4878 /

03.64.00 /2008-09

April 1, 2009 Issue of Tier II and Tier III Capital

ANNEXURE – H

RBI MC CALLMONEY 2009

RBI/2009-10/46 FMD. MSRG. No. 36/02.08.003/2009-10 July 1, 2009

Aashadha 9, 1931 (S) The Chairmen/Chief Executives of all Scheduled Commercial Banks (excluding RRBs) / Co-operative Banks / Primary Dealers Dear Sirs,

Master Circular on Call/Notice Money Market Operations

As you are aware, the Reserve Bank of India has, from time to time, issued a number of guidelines/instructions/directives to banks in regard to matters relating to call/notice money market. To enable eligible institutions to have current instructions at one place, a Master Circular incorporating all the existing guidelines/instructions/directives on the subject has been prepared. It may be noted that this Master Circular consolidates and updates all the instructions/guidelines contained in the circulars issued up to June 30, 2009, in so far as they relate to operations of eligible institutions in the call/notice money markets. This Master Circular has been placed on the RBI website at www.mastercirculars.rbi.org.in.

Yours faithfully,

(Chandan Sinha) Chief General Manager Encls.: As above

Annexure – H

321

Master Circular Call/Notice Money Market Operations

Table of Contents

1. Introduction

2. Participants

3. Prudential Limits

4. Interest Rate

5. Dealing Session

6. Documentation

7. Reporting requirement

8. Annexes

I. List of institutions permitted in Call/Notice Money Market

II. Reporting Format

III. Definitions

9. Appendix: List of Circulars


322

Master Circular on Call / Notice Money Market Operations 1. Introduction

1.1 The money market is a market for short-term financial assets that are close substitutes of money. The most important feature of a money market instrument is that it is liquid and can be turned over quickly at low cost and provides an avenue for equilibrating the short-term surplus funds of lenders and the requirements of borrowers. The call/notice money market forms an important segment of the Indian Money Market. Under call money market, funds are transacted on overnight basis and under notice money market, funds are transacted for the period between 2 days and 14 days.

2. Participants

2.1 Participants in call/notice money market currently include banks (excluding RRBs) and Primary Dealers (PDs), both as borrowers and lenders (Annex I).

3. Prudential Limits

3.1 The prudential limits in respect of both outstanding borrowing and lending transactions in call/notice money market for banks and PDs are as follows:-

Table 1: Prudential Limits for Transactions in Call/Notice Money Market

Sr. No. Participant Borrowing Lending

1 Scheduled Commercial Banks

On a fortnightly average basis, borrowing outstanding should not exceed 100 per cent of capital funds (i.e., sum of Tier I and Tier II capital) of latest audited balance sheet. However, banks are allowed to borrow a maximum of 125 per cent of their capital funds on any day, during a fortnight.

On a fortnightly average basis, lending outstanding should not exceed 25 per cent of their capital funds; however, banks are allowed to lend a maximum of 50 per cent of their capital funds on any day, during a fortnight.

2 Co-operative Banks Borrowings outstanding by State Co-operative Banks/District Central Co-operative Banks/Urban Co-op. Banks in call/notice money market on a daily basis should not exceed 2.0 per cent of their aggregate deposits as at end March of the previous financial year.

No Limit.

Annexure – H

323

3. Primary Dealers (PDs)

PDs are allowed to borrow, on average in a reporting fortnight, up to 200 per cent of their net owned funds (NOF) as at end- March of the previous financial year.

PDs are allowed to lend in call/notice money market, on average in a reporting fortnight, up to 25 per cent of their NOF.

3.2 Non-bank institutions are not permitted in the call/notice money market with effect from August 6, 2005.

4. Interest Rate

4.1 Eligible participants are free to decide on interest rates in call/notice money market.

4.2 Calculation of interest payable would be based on FIMMDA’s (Fixed Income Money Market and Derivatives Association of India) Handbook of Market Practices.

5. Dealing Session

5.1 Deals in the call/notice money market can be done upto 5.00 pm on weekdays and 2.30 pm on Saturdays or as specified by RBI from time to time.

6. Documentation

6.1 Eligible participants may adopt the documentation suggested by FIMMDA from time to time.

7. Reporting Requirement

7.1 All dealings in call/notice money on screen-based negotiated quote-driven system (NDS-CALL) launched since September 18, 2006 do not require separate reporting. It is mandatory for all Negotiated Dealing System (NDS) members to report their call/notice money market deals (other than those done on NDS-CALL) on NDS. Deals should be reported within 15 minutes on NDS, irrespective of the size of the deal or whether the counterparty is a member of the NDS or not. In case there is repeated nonreporting of deals by an NDS member, it will be considered whether non-reported deals by that member should be treated as invalid.

7.2 The reporting time on NDS is upto 5.00 pm on weekdays and 2.30 pm on Saturdays or as decided by RBI from time to time.


324

7.3 With the stabilisation of reporting of call/notice money transactions over NDS as also to reduce reporting burden, the practice of reporting of call/notice/term money transactions by fax to RBI has been discontinued with effect from December 11, 2004. However, deals between non-NDS members will continue to be reported to the Financial Markets Department (FMD) of RBI by fax as hitherto (Annex II).

7.4 In case the situation so warrants, Reserve Bank may call for information in respect of money market transactions of eligible participants by fax.

8. Annexes

Annex I

I. List of Institutions Permitted to Participate in the Call/Notice Money Market both as Lenders and Borrowers

a) All Scheduled Commercial Banks (excluding RRBs).

b) All Co-operative Banks other than Land Development Banks.

c) All Primary Dealers ( PDs ).

Annexure – H

325

Annex - II Daily Return on Call/Notice/Term Money Market Transactions

To The Chief General Manager, Financial Markets Department, 23rd Fl oor NCOB, RBI, Mumbai-400001 Fax-91-22-22630981

Name of the Bank/Institution : _____________________________________

Code No.(As specified by RBI) : _____________________________________

Date : _____________________________________

Borrowed Lent

Amount

(Rs. crore)

Range of

Interest Rates

(% p.a.)

Weighted Average Interest

Rates (% p.a.)

Amount (Rs.

crore)

Range of

Interest Rates

(% p.a.)

Weighted Average Interest

Rates (% p.a.)

1. Call Money (Overnight)

2.

Notice Money (2-14 Days)

(a) Transacted on the day

(b) Outstanding * (including day's transactions)

3. Term Money @

(a) Transacted on the day

(15 Days

(1 Month

(3 Months

(6 Months

(b) Outstanding *(Including day's transactions) Amount


326

Borrowed Amount Lent

(15 Days

(1 Month

(3 Months

(6 Months

*In case of outstandings, rates need not be given. @ Where applicable.

_____________________

Authorised Signatories

Phone No. :

Annexure – H

327

Annex III

Definitions

In these guidelines, unless the context otherwise requires:

1. "Call Money" means deals in overnight funds

2. "Notice Money" means deals in funds for 2 - 14 days

3. "Fortnight" shall be on a reporting Friday basis and mean the period from Saturday to the second following Friday, both days inclusive

4. "Bank” or “banking company" means a banking company as defined in clause (c) of Section 5 of the Banking Regulation Act, 1949 (10 of 1949) or a "corresponding new bank", "State Bank of India" or "subsidiary bank" as defined in clause (da), clause (nc) and clause (nd) respectively thereof and includes a "co-operative bank" as defined in clause (cci) of Section 5 read with Section 56 of that Act

5. “Scheduled bank” means a bank included in the Second Schedule of the Reserve Bank of India Act, 1934

6. "Primary Dealer" means a financial institution which holds a valid letter of authorisation as a Primary Dealer issued by the Reserve Bank, in terms of the "Guidelines for Primary Dealers in Government Securities Market" dated March 29, 1995, as amended from time to time

7. "Capital Funds" means the sum of the Tier I and Tier II capital as disclosed in the latest audited balance sheet of the entity.

9. Appendix

List of Circulars Sr. No. Circular Number Subject

1. CPC.BC.103/279A 90 dated.12 2. Ref.DBOD.No.Dir.BC.97/C.347 90 dated

April 18, 1990 Access to the Call Money Market

3. CPC.BC.111/279A-91 dated.12-4-1991 Call/Notice Money and Bills Rediscounting Market.

4. CPC.BC.144/07.01.279/94-95 dated.17-4-1995

Widening Access to Call/Notice Money Market


328

Sr. No. Circular Number Subject

5. Ref.DBOD.No.FSC.BC.68/24.91.001-95 dated June 27, 1995

6. CPC.BC.162/07.01.279/96-97 dated April 15, 1997

Money Market - Routing of Transactions through DFHI

7. CPC.BC.165/07.01.279/97-98 dated. April 21, 1997

Money Market - Routing of Transactions through Primary Dealers

8. CPC.BC.175/07.01.279/97-98 dated April 29, 1998 Money Market

9. CPC.BC.185/07.01.279/98-99 dated April 20, 1999

Measures for Developing the Money Market - Call/Notice Money Market

10. Ref.No.MPD.2785/279A(MM)/98-99 dated April 24, 1999

Call/Notice Money and Bills Rediscounting Markets - Routing of Transaction

11. CPC.BC.190/07.01.279/99-2000 dated October 29, 1999 Money Market

12. CPC.BC.196/07.01.279/99-2000 dated April 27, 2000 Money Market

13. Ref.No.MPD.3513/279A(MM)/1999- 2000 dated April 28, 2000

Call/Notice Money and Bills Rediscounting Markets - Routing of Transactions - Extract from the Statement on Monetary and Credit Policy for the Year 2000-01 dated April 27, 2000

14. MPD.BC.201/07.01.279/2000-01 dated October 10, 2000

Permission to non-banks to lend in the call money market

15. MPD.BC.206/07.01.279/2000-01 dated April 19, 2000

Moving towards Pure Inter-bank Call Money Market

16. DS.PCB.CIR.40/13.01.00/2000-01 dated April 19, 2001

Operations in call/notice money market

17. MPD.2991/03.09.01/2000-01 dated April 21, 2001

Participation in Call/Notice Money Market

18. MPD.3173/03.09.01/2000-01 dated May 8, 2001

Participation in Call/Notice Money Market

19. Ref.DBOD.No.FSC.BC.125/24.92.001 /2000-01 dated May 25, 2001

Permission to participate in Call/Notice/Term Money Market

Annexure – H

329


and Bills Rediscounting Scheme - Primary Dealers


Money Market - Moving towards Pure Interbank Call Money Market

21. DS.PCB.CIR.52/13.01.00/2001-02 dated June 24, 2002

Reporting of Call Money Transactions

22. MPD.217/07.01.279/2001-02 dated June 27, 2002

Reliance on Call/Notice Money Market: Prudential Norm

23. MPD.220/07.01.279/2002-03 dated July 31, 2002

Access to Call/Notice Money Market for Primary Dealers: Prudential Norms.

24. MPD.222/07.01.279/2002-03 dated October 29, 2002 Money Market

25. MPD.225/07.01.279/2002-03 dated November 14, 2002


26. MPD.226/07.01.279/2002-03 dated December 11, 2002


27. DBOD.FSC.BC.85/24.91.001/2002-03 dated March 26, 2003

Permission to participate in Call/Notice Money Market and Bills Rediscounting Scheme - Private Sector Mutual Funds

28. DBOD.FSC.BC.86/24.91.001/2002-03 dated March 26, 2003

Permission to participate in Call/Notice/Term Money Market and Bills Rediscounting Scheme - Primary Dealers


Money Market - Moving towards Pure Interbank Call Money Market


Participation of Non-bank Entities in Call/Notice Money Market


Reporting of Call/Notice Money Market Transactions on NDS Platform.

32. MPD.BC.241/07.01.279/2003-04 dated November 3, 2003

Money Market - Moving towards Pure Interbank Call/Notice Money Market


330



Primary Dealers' Access to Call/Notice Money Market


Moving towards Pure Inter-bank Call/Notice Money Market

35. MPD.BC.250/07.01.279/2003-04 dated May 25, 2004


36. MPD.BC.253/07.01.279/2004-05 dated July 3, 2005.

Master Circular on Call/Notice Money Market Operations

37. MPD.BC.259/07.01.279/2004-05 dated October 26, 2004.


38. MPD.BC.260/07.01.279/2004-05 dated December 10, 2004.

Reporting of Call/Notice Money Market Transactions.

39. MPD.BC.265/07.01.279/2004-05 dated April 29, 2005.

Call/Notice Money Market – Review of Benchmark.

40. MPD.BC.266/07.01.279/2004-05 dated April 29, 2005.

Participation in Call/Notice Money Market.

ANNEXURE – I

RBI MC CD 2009

RBI/2009-10/47 FMD.MSRG.No. 38/02.08.003/2009-10 July 1, 2009 The Chairmen / Chief Executives of All Scheduled Banks (excluding RRBs and LABs) and All-India Term Lending and Refinancing Institutions Dear Sirs,

Guidelines for Issue of Certificates of Deposit

As you are aware, with a view to further widening the range of money market instruments and giving investors greater flexibility in deployment of their short-term surplus funds, Certificates of Deposit (CDs) were introduced in India in 1989. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time.

A Master Circular incorporating all the existing guidelines / instructions / directives on the subject has been prepared. It may be noted that this Master Circular consolidates and updates all the instructions / guidelines contained in the circulars listed in the Appendix, in so far as they relate to 'guidelines for issue of CDs'. This master circular has been placed on RBI website at www.mastercircular.rbi.org.in

Yours faithfully,

(Chandan Sinha)

Chief General Manager


332

Master Circular on Guidelines for Issue of Certificates of Deposit (CDs)

(as Amended up to June 30, 2009)

Introduction

Eligibility

Aggregate Amount

Minimum Size of Issue and Denominations

Who can Subscribe

Maturity

Discount

Reserve Requirements

Transferability

Loans / Buy-backs

Format of CDs

Payment of Certificate

Issue of Duplicate Certificates

Accounting

Standardised Market Practice and Documentation

Reporting

Annex I

Annex II

Appendix

Annexure – I

333

Introduction Certificates of Deposit (CDs) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. The guidelines for issue of CDs incorporating all the amendments issued till date are given below for ready reference.

Eligibility 2. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.

Aggregate Amount 3. Banks have the freedom to issue CDs depending on their requirements.

4. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments, viz., term money, term deposits, commercial papers and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.

Minimum Size of Issue and Denominations 5. Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs. 1 lakh and in the multiples of Rs. 1 lakh thereafter.

Who can Subscribe 6. CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. Non- Resident Indians (NRIs) may also subscribe to CDs, but only on non-repatriable basis which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market.

Maturity 7. The maturity period of CDs issued by banks should be not less than 7 days and not more than one year.


334

8. The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue.

Discount / Coupon Rate 9. CDs may be issued at a discount on face value. Banks / FIs are also allowed to issue CDs on floating rate basis provided the methodology of compiling the floating rate is objective, transparent and market-based. The issuing bank / FI are free to determine the discount / coupon rate. The interest rate on floating rate CDs would have to be reset periodically in accordance with a pre-determined formula that indicates the spread over a transparent benchmark.

Reserve Requirements 10. Banks have to maintain the appropriate reserve requirements, i.e., cash reserve ratio (CRR) and statutory liquidity ratio (SLR), on the issue price of the CDs.

Transferability 11. Physical CDs are freely transferable by endorsement and delivery. Dematted CDs can be transferred as per the procedure applicable to other demat securities. There is no lock-in period for the CDs.

Loans / Buy-backs 12. Banks / FIs cannot grant loans against CDs. Furthermore, they cannot buyback their own CDs before maturity. However, the Reserve Bank may relax these restrictions for temporary periods through a separate notification.

Format of CDs 13. Banks / FIs should issue CDs only in the dematerialised form. However, according to the Depositories Act, 1996, investors have the option to seek certificate in physical form. Accordingly, if investor insists on physical certificate, the bank / FI may inform the Chief General Manager, Financial Markets Department, Reserve Bank of India, Central Office, Fort, Mumbai - 400 001 about such instances separately. Further, issuance of CDs will attract stamp duty. A format (Annex I) is enclosed for adoption by banks / FIs. There will be no grace period for repayment of CDs. If the maturity date happens to be holiday, the issuing bank should make payment on the immediate preceding working day. Banks / FIs may, therefore, so fix the period of deposit that the maturity date does not coincide with a holiday to avoid loss of discount / interest rate.

Annexure – I

335

Security Aspect 14. Since physical CDs are freely transferable by endorsement and delivery, it will be necessary for banks to see that the certificates are printed on good quality security paper and necessary precautions are taken to guard against tampering with the document. They should be signed by two or more authorised signatories.

Payment of Certificate 15. Since CDs are transferable, the physical certificate may be presented for payment by the last holder. The question of liability on account of any defect in the chain of endorsements may arise. It is, therefore, desirable that banks take necessary precautions and make payment only by a crossed cheque. Those who deal in these CDs may also be suitably cautioned.

16. The holders of dematted CDs will approach their respective depository participants (DPs) and have to give transfer / delivery instructions to transfer the demat security represented by the specific ISIN to the 'CD Redemption Account' maintained by the issuer. The holder should also communicate to the issuer by a letter / fax enclosing the copy of the delivery instruction it had given to its DP and intimate the place at which the payment is requested to facilitate prompt payment. Upon receipt of the Demat credit of CDs in the "CD Redemption Account", the issuer, on maturity date, would arrange to repay to holder / transferor by way of Banker's cheque / high value cheque, etc.

Issue of Duplicate Certificates 17. In case of the loss of physical certificates, duplicate certificates can be issued after compliance with the following:

(a) A notice is required to be given in at least one local newspaper

(b) Lapse of a reasonable period (say 15 days) from the date of the notice in the newspaper; and

(c) Execution of an indemnity bond by the investor to the satisfaction of the issuer of CDs.

18. The duplicate certificate should only be issued in physical form. No fresh stamping is required as a duplicate certificate is issued against the original lost CD. The duplicate CD should clearly state that the CD is a Duplicate one stating the


336

original value date, due date, and the date of issue (as "Duplicate issued on ________").

Accounting 19. Banks / FIs may account the issue price under the Head "CDs issued" and show it under deposits. Accounting entries towards discount will be made as in the case of "cash certificates". Banks / FIs should maintain a register of CDs issued with complete particulars.

Standardised Market Practices and Documentation 20. Fixed Income Money Market and Derivatives Association of India (FIMMDA) may prescribe, in consultation with the RBI, for operational flexibility and smooth functioning of the CD market, any standardised procedure and documentation that are to be followed by the participants, in consonance with the international best practices. Banks / FIs may refer to the detailed guidelines issued by FIMMDA in this regard on June 20, 2002.

Reporting 21. Banks should include the amount of CDs in the fortnightly return under Section 42 of the Reserve Bank of India Act, 1934 and also separately indicate the amount so included by way of a footnote in the return.

22. Further, banks / FIs should submit a fortnightly return, as per the format given in Annex II, to the Chief General Manager, Financial Markets Department, Reserve Bank of India, Central Office Building, Fort, Mumbai - 400 001, Fax: 91-22-22630981 / 22634824 within 10 days from the end of the fortnight date.

-------------------------------

Annexure – I

337

Annex - I Name of the Bank / Institution

No.

Rs. ___________

Dated ___________

NEGOTIABLE CERTIFICATE OF DEPOSIT

___________ months / days after the date hereof, ___________ <Name of the Bank / Institution> ___________, at ___________ <name of the place> ___________, hereby promise to pay to ___________ <name of the depositor> ___________ or order the sum of Rupees ___________ <in words> ___________ only, upon presentation and surrender of this instrument at the said place, for deposit received. For ___________ <Name of the institution> ___________ Date of maturity ___________ without days of grace.

Instructions Endorsements Date

1. 1.

2.

3.

4.

5.


338

Annex - II Fortnightly Return on Certificates of Deposit (CDs)

(SFR III – D)

Name of the Bank/Institution

For the Fortnight ended

Issue of Certificates of Deposit (CDs)

Total amount of CDs outstanding as at the end of the fortnight

(1) On Discount Value Basis (Rs. Crore)

Face Value

Discounted Value

(2) On Coupon Bearing Basis (Rs. Crore)

Face Value

Particulars of CDs issued during the fortnight

I CDs issued on Discount value basis

Sr. No.

Discounted value of CDs issued (Amount in

Rs.)

Maturity period (in

days)

Effective interest rate (per cent per

annum)

Demat or Physical CDs issued (D/P)

1.

2.

3.

4.

5.

6.

Annexure – I

339

II CDs issued on Floating Rate Basis

Sr. No.

Face value of CDs issued

(Amount in Rs.)

Maturity period

(in days) Benchmark Spread

Demat or Physical

CDs issued (D/P)

1.

2.

3.

4.

5.

6.


340

Appendix

List of Circulars

Sr. No Reference No. Date Subject

1. DBOD.No.BP.BC.134/65-89 June 6, 1989 Certificates of Deposit (CDs)

2. DBOD.No.BP.BC.112/65-90 May 23, 1990 Certificates of Deposit (CDs)

3. DBOD.No.BP.BC.60/65-90 December 20, 1990

Certificates of Deposit (CDs)

4. DBOD.No.BP.BC.113/65-91 April 15, 1991 Certificates of Deposit (CDs)

5. DBOD.No.BP.BC.83/65-92 February 12, 1992


6. DBOD.No.BC.119/12.021.001/92 April 21, 1992 Section 42(1) of the Reserve Bank of India Act 1934 - Cash Reserve Ratio on incremental Certificates of Deposit - Exemption

7. DBOD.No.BC.106/21.03.053/93 April 7, 1993 Certificates of Deposit (CDs) - Enhancement of Limit

8. DBOD.No.BC.171/21.03.053/93 October 11, 1993

Certificates of Deposit (CDs) Scheme

9. DBOD.No.BP.BC.109./21.03.053/96 August 9, 1996 Certificates of Deposit (CDs) Scheme

10. DBOD.No.BP.BC.49/21.03.053/97 April 22, 1997 Certificates of Deposit (CDs)

11. DBOD.No.BP.BC.128/21.03.053/97 October 21, 1997


12. DBOD.No.Dir.BC.96/13.03.00/2001-02 April 29, 2002 Issue of Certificates of Deposit (CDs) in dematerialised form

13. DBOD.No.BP.BC.115/21.03.053/2001-02 June 15, 2002 Certificates of Deposit (CDs)

Annexure – I

341

14. DBOD.No.BP.BC.43/21.03.053/2002-03 November 16, 2002

Mid-Term Review of Monetary and Credit Policy 2002-03: Certificates of Deposit

15. MPD.No.254/07.01.279/2004-05 July 12, 2004 Guidelines for Issue of Certificates of Deposit

16. MPD.No.263/07.01.279/2004-05 April 28, 2005 Certificates of Deposit

ANNEXURE – J

RBI MC COMLPAPER 2009

RESERVE BANK OF INDIA FINANCIAL MARKETS DEPARTMENT

Market Surveillance & Research Group

------------------------------------------------------------------------------------------------------------ Master Circular

on Guidelines for Issue of Commercial Paper

RBI/2009-10/ 45 Ref.No. FMD.MSRG.No.37/02.08.003/2009-10

July 1, 2009 Ashadha 09, 1931 (S)

The Chairmen/Chief Executives of All Scheduled Banks, Primary Dealers and All-India Financial Institutions Dear Sir,

Guidelines for Issue of Commercial Paper

As you are aware, Commercial Paper (CP), an unsecured money market instrument issued in the form of a promissory note, was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Guidelines for issue of CP are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time.

A Master Circular incorporating all the existing guidelines/instructions/ directives on the subject has been prepared. It may be noted that this Master Circular

Annexure – J

343

consolidates and updates all the instructions/guidelines contained in the circulars listed in the Appendix, in so far as they relate to ‘guidelines for issue of CP’. This master circular has been placed on RBI website at www.mastercirculars.rbi.org.in

Yours faithfully,

(Chandan Sinha) Chief General Manager


344

Master Circular on

Guidelines for Issue of Commercial Paper (CP) as amended up to June 30, 2009

Introduction

Who can issue CP

Rating Requirement

Maturity

Denominations

Limits & Amount of Issue of CP

Who can be IPA

Investments in CP

Mode of Issuance

Preference for Dematerialised form

Payment of CP

Stand-by Facility

Procedure for Issuance

Role and Responsibilities

Documentation Procedure

Defaults in CP market

Non-applicability of Certain Other Directions

Schedule I

Schedule II

Schedule III

Annex I

Annex II

Appendix

Annexure – J

345

Introduction

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP, as a privately placed instrument, was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers, satellite dealers*and all- India financial institutions were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations. Guidelines for issue of CP are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. The guidelines for issue of CP incorporating all the amendments issued till date is given below for ready reference.

Who can Issue Commercial Paper (CP) 2. Corporates, primary dealers (PDs) and the all-India financial institutions

(FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by the Reserve Bank of India are eligible to issue CP.

3. A corporate would be eligible to issue CP provided: (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs.4 crore; (b) company has been sanctioned working capital limit by bank/s or all- India financial institution/s; and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s/ institution/s.

Rating Requirement 4. All eligible participants shall obtain the credit rating for issuance of

Commercial Paper from either the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other credit rating agencies as may be specified by the Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. The issuers shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review.


346

Maturity 5. CP can be issued for maturities between a minimum of 7 days and a

maximum up to one year from the date of issue. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.

Denominations 6. CP can be issued in denominations of Rs.5 lakh or multiples thereof.

Amount invested by a single investor should not be less than Rs.5 lakh (face value).

Limits and the Amount of Issue of CP 7. CP can be issued as a "stand alone" product. The aggregate amount of

CP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. Banks and FIs will, however, have the flexibility to fix working capital limits duly taking into account the resource pattern of companies’ financing including CPs.

8. An FI can issue CP within the overall umbrella limit fixed by the RBI, i.e., issue of CP together with other instruments, viz., term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet.

9. The total amount of CP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. CP may be issued on a single date or in parts on different dates provided that in the latter case, each CP shall have the same maturity date.

10. Every issue of CP, including renewal, should be treated as a fresh issue.

Who can Act as Issuing and Paying Agent (IPA) 11. Only a scheduled bank can act as an IPA for issuance of CP.

Investment in CP 12. CP may be issued to and held by individuals, banking companies, other

corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors

Annexure – J

347

(FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI).

Mode of Issuance 13. CP can be issued either in the form of a promissory note (Schedule I) or

in a dematerialised form through any of the depositories approved by and registered with SEBI.

14. CP will be issued at a discount to face value as may be determined by the issuer.

15. No issuer shall have the issue of CP underwritten or co-accepted.

Preference for Dematerialisation 16. While option is available to both issuers and subscribers to issue/hold CP

in dematerialised or physical form, issuers and subscribers are encouraged to prefer exclusive reliance on dematerialised form of issue/holding. However, with effect from June 30, 2001, banks, FIs and PDs are required to make fresh investments and hold CP only in dematerialised form.

Payment of CP 17. The initial investor in CP shall pay the discounted value of the CP by

means of a crossed account payee cheque to the account of the issuer through IPA. On maturity of CP, when CP is held in physical form, the holder of CP shall present the instrument for payment to the issuer through the IPA. However, when CP is held in demat form, the holder of CP will have to get it redeemed through the depository and receive payment from the IPA.

Stand-by Facility 18. In view of CP being a 'stand alone' product, it would not be obligatory in

any manner on the part of the banks and FIs to provide stand-by facility to the issuers of CP. Banks and FIs have, however, the flexibility to provide for a CP issue, credit enhancement by way of stand-by assistance/credit, back-stop facility etc. based on their commercial judgement, subject to prudential norms as applicable and with specific approval of their Boards.

19. Non-bank entities including corporates may also provide unconditional and irrevocable guarantee for credit enhancement for CP issue provided:


348

(i) the issuer fulfils the eligibility criteria prescribed for issuance of CP;

(ii) the guarantor has a credit rating at least one notch higher than the issuer given by an approved credit rating agency; and

(iii) the offer document for CP properly discloses the net worth of the guarantor company, the names of the companies to which the guarantor has issued similar guarantees, the extent of the guarantees offered by the guarantor company, and the conditions under which the guarantee will be invoked.

Procedure for Issuance

20. Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for crediting the CP to the investor's account with a depository. Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement with the IPA and documents are in order (Schedule III).

Role and Responsibilities

21. The role and responsibilities of issuer, issuing and paying agent (IPA) and credit rating agency (CRA) are set out below:

(a) Issuer

With the simplification in the procedures for CP issuance, issuers would now have more flexibility. Issuers would, however, have to ensure that the guidelines and procedures laid down for CP issuance are strictly adhered to.

(b) Issuing and Paying Agent (IPA)

(i) IPA would ensure that issuer has the minimum credit rating as stipulated by RBI and amount mobilised through issuance of CP is within the quantum indicated by CRA for the specified rating or as approved by its Board of Directors, whichever is lower.

(ii) IPA has to verify all the documents submitted by the issuer, viz., copy of board resolution, signatures of authorised executants (when CP in physical form) and issue a certificate that documents

Annexure – J

349

are in order. It should also certify that it has a valid agreement with the issuer (Schedule III).

(iii) Certified copies of original documents verified by the IPA should be held in the custody of IPA.

(iv) Every CP issue should be reported to the Chief General Manager, Financial Markets Department, Reserve Bank of India, Central Office, Fort, Mumbai- 400001.

(v) IPAs, which are NDS member, should report the details of CP issue on NDS platform within two days from the date of completion of the issue.

(vi) Further, all scheduled banks, acting as an IPA, will continue to report CP issuance details as hitherto within three days from the date of completion of the issue, incorporating details as per Schedule II till NDS reporting stabilises to the satisfaction of RBI.

(c) Credit Rating Agency (CRA)

(i) Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of capital market instruments shall be applicable to them (CRAs) for rating CP.

(ii) Further, the credit rating agency would henceforth have the discretion to determine the validity period of the rating depending upon its perception about the strength of the issuer. Accordingly, CRA shall at the time of rating, clearly indicate the date when the rating is due for review.

(iii) While the CRAs can decide the validity period of credit rating, they would have to closely monitor the rating assigned to issuers vis-a-vis their track record at regular intervals and would be required to make their revision in the ratings public through their publications and website.

Documentation Procedure

22. Fixed Income Money Market and Derivatives Association of India (FIMMDA) may prescribe, in consultation with the RBI, for operational flexibility and smooth functioning of CP market, any standardised procedure and documentation that are to be followed by the participants, in consonance with the international best practices. Issuer / IPAs may


350

refer to the detailed guidelines issued by FIMMDA in this regard on July 5, 2001.

23. Violation of these guidelines will attract penalties and may also include debarring of the entity from the CP market.

Defaults in CP market

24. In order to monitor defaults in redemption of CP, scheduled banks which act as IPAs, are advised to immediately report, on occurrence, full particulars of defaults in repayment of CPs to the Financial Markets Department, Reserve Bank of India, Central Office, Fort, Mumbai-400001, Fax: 022- 22630981/ 22634824 in the format as given in Annex I.

Non-applicability of Certain Other Directions

25. Nothing contained in the Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 1998 shall apply to any non-banking financial company (NBFC) insofar as it relates to acceptance of deposit by issuance of CP, in accordance with these Guidelines.

26. Definitions of certain terms used in the Guidelines are provided in the Annex II.

Annexure – J

351

Schedule I Stamp to be

Affixed as in force in the State in which

it is to be issued

(NAME OF THE ISSUING COMPANY/INSTITUTION)

SERIAL NO.

Issued at :_______________________ Date of issue :_____________________

(PLACE)

Date of Maturity:___________________________without days of grace.

(If such date happens to fall on a holiday, payment shall be made on the immediate preceding working day)

For value received ___________________________________________hereby

(NAME OF THE ISSUING COMPANY/ INSTITUTION)

Promises to pay _______________________________________or order on the

(NAME OF THE INVESTOR)

maturity date as specified above the sum of Rs._________________________ (in words) upon presentation and surrender of this Commercial Paper to ________________________________________________________________

(NAME OF THE ISSUING AND PAYING AGENT)

For and on behalf of ________________________________________

(NAME OF THE ISSUING COMPANY/INSTITUTION)

AUTHORISED AUTHORISED

SIGNATORY SIGNATORY


352

ALL ENDORSEMENTS UPON THIS COMMERCIAL PAPER MUST BE CLEAN AND DISTINCT.

EACH ENDORSEMENT SHOULD BE WRITTEN WITHIN THE SPACE ALLOTTED.

Pay to ____________________________________________________ or order

(NAME OF TRANSFEREE)

the amount within named.

For and on behalf of

________________________________________________________________

(NAME OF THE TRANSFEROR)

________________________________________________________________1. "

2. "

3. "

4. "

5 . "

6. "

7. "

8. "

Annexure – J

353

Schedule II

Proforma of information to be submitted by the Issuer for issue of Commercial Paper (To be submitted to the Reserve Bank through the Issuing and Paying Agent (IPA) within 3 days of the completion of issue of CP to the GGM, FMD, RBI, Mumbai)

To:

The Chief General Manager Financial Markets Department Reserve Bank of India Central Office, Fort Mumbai - 400 001.

Through: (Name of IPA)

Dear Sir

Issue of Commercial Paper

In terms of the guidelines for issuance of commercial paper issued by the Reserve Bank dated August 19, 2003, we have issued Commercial Paper as per details furnished hereunder:

i) Name of the Issuer :

ii) Registered Office and Address :

iii) Business activity :

iv) Name/s of Stock Exchange/s with whom shares of the : issuer are listed (if applicable)

v) Tangible net worth as per latest audited balance sheet :

vi) Total Working Capital Limit :

vii) Outstanding Bank Borrowings :

viii) (a) Details of Commercial Paper


354

issued (Face Value) : Date of Date of Amount Rate Issue Maturity i) ii) (b) Amount of CP outstanding (Face Value) including the : present issue

ix) Rating(s) obtained from the i) Credit Rating Information Services of India Ltd.(CRISIL) ii) or any other agency as specified by the Reserve Bank iii)

x) Whether stand-by facility has been provided in respect of CP issue?

xi) If yes i) the amount of the : Rs. crore stand-by facility ii) provided by (Name of bank/FI)

xii) Whether unconditional and irrevocable guarantee has been provided in respect of CP issue?

xiii) If yes

i) the amount of the guarantee : Rs. Crore

ii) provided by (Name of guarantor)

iii) Credit rating of the guarantor

For and on behalf of

_________________

(Name of the issuer)

Annexure – J

355

Schedule III CERTIFICATE

We have a valid IPA agreement with the ________________________________

(Name of Issuing Company/Institution)

2. We have verified the documents viz., board resolution and certificate issued by Credit Rating Agency submitted by ____________________________________

(Name of the Issuing Company/Institution)

and certify that the documents are in order. Certified copies of original documents are held in our custody.

3.* We also hereby certify that the signatures of the executants of the attached Commercial Paper bearing Sr. No. ______________ dated _______________ for Rs._______________ (Rupees ____________________________________)

(in words)

tally with the specimen signatures filed by _______________________________

( Name of the issuing Company/Institution)

(Authorised Signatory/Signatories)

(Name and address of Issuing and Paying Agent)

Place :

Date :

* (Applicable to CP in physical form)


356

Annex I Details of Defaults on Repayment of CP

Name of the issuer

Date of

issue of CP

Amou

nt

Due d

ate of

repa

ymen

t

Initia

l Rati

ng

Lates

t Rati

ng

Whether the CP issue

enjoyed a standby

assistance/ credit back stop facility/ guarantee

If so, the name of the entity providing the facility indicated at Col. (7)

Whether the facility at Col (7) has been honoured

and payment made.

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Annexure – J

357

Annex II Definitions In these guidelines, unless the context otherwise requires:

(a) "bank” or “banking company" means a banking company as defined in clause (c) of Section 5 of the Banking Regulation Act, 1949 (10 of 1949) or a "corresponding new bank", "State Bank of India" or "subsidiary bank" as defined in clause (da), clause (nc) and clause (nd) respectively thereof and includes a "co-operative bank" as defined in clause (cci) of Section 5 read with Section 56 of that Act.

(b) “scheduled bank” means a bank included in the Second Schedule of the Reserve Bank of India Act, 1934.

(c) “All-India Financial Institutions (FIs)” mean those financial institutions which have been permitted specifically by the Reserve Bank of India to raise resources by way of Term Money, Term Deposits, Certificates of Deposit, Commercial Paper and Inter-Corporate Deposits, where applicable, within umbrella limit.

(d) "Primary Dealer" means a non-banking financial company which holds a valid letter of authorisation as a Primary Dealer issued by the Reserve Bank, in terms of the "Guidelines for Primary Dealers in Government Securities Market" dated March 29, 1995, as amended from time to time.

(e) "corporate” or “company" means a company as defined in Section 45 I (aa) of the Reserve Bank of India Act, 1934 but does not include a company which is being wound up under any law for the time being in force.

(f) "non-banking company" means a company other than banking company.

(g) “non-banking financial company” means a company as defined in Section 45 I

(f) of the Reserve Bank of India Act, 1934.

(h) “working capital limit” means the aggregate limits, including those by way of purchase/discount of bills sanctioned by one or more banks/FIs for meeting the working capital requirements.


358

(i) "Tangible net worth" means the paid-up capital plus free reserves (including balances in the share premium account, capital and debentures redemption reserves and any other reserve not being created for repayment of any future liability or for depreciation in assets or for bad debts or reserve created by revaluation of assets) as per the latest audited balance sheet of the company, as reduced by the amount of accumulated balance of loss, balance of deferred revenue expenditure, as also other intangible assets.

(j) words and expressions used but not defined herein and defined in the Reserve Bank of India Act, 1934 (2 of 1934) shall have the same meaning as assigned to them in that Act.

Annexure – J

359

Appendix

List of Circulars


IECD.No.PMD.15/87 (CP)- 89/90 January 3,1990

Issue of Commercial paper (CP)

IECD.No.PMD.19/87 (CP)-89/90 January 23,1990


IECD.No.PMD.28/87 (CP)- 89/90 April 24,1990 Commercial Paper (CP) - Amendment to Directions.

IECD.No.PMD.1/08.15.01/93-94 July 2,1990 Guidelines for provision of factoring services

IECD.No.PMD.2/87 (CP)-90/91 July 7,1990 Commercial Paper (CP) - Renewal of existing issue.

IECD.No.PMD.57/87 (CP)-90/91 May 30,1991 Commercial Paper (CP) - Amendment to Directions.

IECD.No.16/PMD/87 (CP)-91/92 August 20, 1991


IECD.No.39/PMD/87 (CP)-91/92 December 20, 1991

Commercial Paper (CP) - Amendment to Directions.

IECD.No.49/CC&MIS/87/91-92 February 7, 1992

Issue of Commercial paper (CP) - Submission of Returns etc.

IECD.No.63/08.15.01/91-92 May 13,1992 Commercial Paper (CP) - Amendment to Directions.

IECD.No.34/08.15.01/92-93 May 19,1993 Commercial Paper (CP) – Application of Stamp Duty

IECD.No.13/08.15.01/93-94 October 5, 1993

Commercial Paper (CP) - Amendment to Directions.

IECD.No.17/08.15.01/93-94 October 18, 1993

Commercial Paper (CP)-Amendment to Directions.

IECD.No.25/08.15.01/93-94 December 17, 1993

Issue of Commercial Paper (CP)

IECD.No.19/08.15.01/94-95 October 20, 1994

Commercial Paper - Stand by Arrangement

IECD.No.28/08.15.01/95-96 June 20, 1996

Commercial Paper (CP)-

IECD.No.3/08.15.01/96-97 July 25, 1996 Commercial Paper (CP) - Amendment to Directions.


360


IECD.No.14/08.15.01/96-97 November 5, 1996

Commercial Paper

IECD.No.25/08.15.01/96-97 April 15, 1997 Commercial Paper IECD.No.14/08.15.01/97-98 October 27,

1997 Commercial Paper

IECD.No.43/08.15.01/97-98 May 25, 1998 Commercial Paper MPD.48/07.01.279/2000-01 July 6, 2000 Guidelines for Issue of

Commercial Paper IECD. No. 15/08.15.01/2000-01 April 30, 2001 Guidelines for Issue of

Commercial Paper IECD.No.2/08.15.01/2001-02 July 23, 2001 Guidelines for Issue of

Commercial Paper IECD.No.11/08.15.01/2002-03 November 12,

2002 Guidelines for Issue of Commercial Paper

IECD. No. 19/08.15.01/2002-03 April 30, 2003 Guidelines for Issue of Commercial Paper

IECD. No. /08.15.01/2003-04 August 19, 2003

Guidelines for Issue of Commercial Paper – Defaults in Commercial Paper market

MPD. NO. 251/07.01.279/2004-05 July 1, 2004 Guidelines for Issue of Commercial Paper

MPD. NO. 258/07.01.279/2004-05 October 26, 2004

Guidelines for Issue of Commercial Paper

MPD. NO. 261/07.01.279/2004-05 April 13, 2005 Reporting of Commercial Paper (CP) issuance on NDS Platform

* The system of satellite dealers has since been discontinued with effect from June 1, 2002.

ANNEXURE – K

RBI MC PRUNORMSINVESTT 2009

RBI/ 2009-10/20 DBOD No. BP. BC.3 / 21.04.141 / 2009-10 July 1, 2009 All Commercial Banks (excluding Regional Rural Banks) Dear Sir, Master Circular – Prudential norms for classification, valuation and operation of investment portfolio by banks Please refer to the Master Circular No. DBOD. BP. BC.5 / 21.04.141/ 2007-08 dated July 1, 2008, containing consolidated instructions/guidelines issued to banks till June 30, 2008, on matters relating to prudential norms for classification, valuation and operation of investment portfolio by banks. The above Master Circular has since been suitably updated by incorporating instructions/guidelines issued between July 1, 2008 and June 30, 2009, and furnished in the Annex. This updated version has also been placed on the RBI web-site (http://www.rbi.org.in). 2. An appendix containing a list of circulars referred for the purpose of the current Master circular is furnished at the end of the Annex. Yours faithfully, (B.Mahapatra) Chief General Manager Encl: As above

Department of Banking Operations and Development, Central Office, 12th Floor, Central Office

Building, Shahid Bhagat Singh Marg,, Mumbai,400001 Tel No:22661602 Fax No:22705691 Email ID:[email protected]


362

MASTER CIRCULAR – PRUDENTIAL NORMS FOR

CLASSIFICATION, VALUATION AND OPERATION OF INVESTMENT PORTFOLIO BY BANKS

Table of Contents

Introduction 4 1.1 Investment Policy 4

1.1.1 Ready forward contracts in Government Securities

7

1.1.2 Transactions through SGL account 9 1.1.3 Use of Bank Receipts (BR) 11 1.1.4 Retailing of Government Securities 12 1.1.5 Internal Control System 13 1.1.6 Engagement of brokers 16

1.1.7 Audit, review and reporting of investment transactions

17

1.2 Non-SLR investment 18 1.3 General 25

1.3.1 Reconciliation of holdings of Govt. securities, etc

25

1.3.2 Transactions in securities - Custodial functions 25 1.3.3 Portfolio Management on behalf of clients 25

1.

1.3.4 Investment Portfolio of bank - Transactions in Government Securities

26

2. Classification 27 2.1 Held to Maturity 28 2.2 Available for Sale & Held for Trading 30

2.3 Shifting among categories 30 3. Valuation 31

Annexure – K

363

3.1 Held to Maturity 31 3.2 Available for Sale 31 3.3 Held for Trading 32 3.4 Investment Fluctuation Reserve 32 3.5 Market Value 34

3.6 Unquoted SLR securities 35 3.6.1 Central Government Security 35

3.6.2 State Government Security 35 3.6.3 Other Approved Security 35

3.7 Unquoted Non-SLR Securities 35 3.7.1 Debentures/Bonds 35 3.7.2 Zero Coupon Bonds 36 3.7.3 Preference Share 36 3.7.4 Equity Share 37 3.7.5 Mutual Fund Units 38 3.7.6 Commercial Paper 38 3.7.7 Investment in RRBs 38 3.8 Investment in securities Issued by SC/RC 38 3.9 Valuation & classification of bank’s investment in

VCF 39

3.10 Non Performing investments 41 4. Uniform Accounting for Repo/Non-Repo Transactions 42 5. General 47

5.1 Income Recognition 47 5.2 Broken period Interest 48

5.3 Dematerialized Holding 48 Annexures 49 Appendix 76


364

MASTER CIRCULAR – PRUDENTIAL NORMS FOR CLASSIFICATION, VALUATION AND OPERATION OF

INVESTMENT PORTFOLIO BY BANKS 1. Introduction

With the introduction of prudential norms on capital adequacy, income recognition, asset classification and provisioning requirements, the financial position of banks in India has improved in the last few years. Simultaneously, trading in securities market has improved in terms of turnover and the range of maturities dealt with. In view of these developments and taking into consideration the evolving international practices, Reserve Bank of India (RBI) has issued guidelines on classification, valuation and operation of investment portfolio by banks from time to time as detailed below:

1.1 Investment Policy

i) Banks should frame Internal Investment Policy Guidelines and obtain the Board’s approval. The investment policy may be suitably framed/ amended to include Primary Dealer (PD) activities also. Within the overall framework of the investment policy, the PD business undertaken by the bank will be limited to dealing, underwriting and market–making in Government Securities. Investments in Corporate/ PSUs/ FIs bonds, Commercial Papers, Certificate of Deposits, debt mutual funds and other fixed income securities will not be deemed to be part of PD business. The investment policy guidelines should be implemented to ensure that operations in securities are conducted in accordance with sound and acceptable business practices. While framing the investment policy, the following guidelines are to be kept in view by the banks:

(a) Banks may sell a government security already contracted for purchase, provided:

(i) The purchase contract is confirmed prior to the sale,

(ii) The purchase contract is guaranteed by CCIL or the security is contracted for purchase from the Reserve Bank and,

(iii) The sale transaction will settle either in the same settlement cycle as the preceding purchase contract, or in a subsequent settlement cycle so that the delivery obligation under the sale contract is met by the securities acquired under the purchase contract (e.g. when

Annexure – K

365

a security is purchased on T+0 basis, it can be sold on either T+0 or T+1 basis on the day of the purchase; if however it is purchased on T+1 basis, it can be sold on T+1 basis on the day of purchase or on T+0 or T+1 basis on the next day). For purchase of securities from RBI through Open Market Operations (OMO), no sale transactions should be contracted prior to receiving the confirmation of the deal/advice of allotment from the RBI.

• In addition to the above, the Scheduled Commercial Banks (other than RRBs and LABs) and Primary Dealers have been permitted to short sell Government securities in accordance with the requirements specified in Annexure I-A.

• Further, the NDS-OM members have been permitted to transact on ‘When Issued’ basis in Central Government dated securities, subject to the guidelines specified in Annexure I-B.

(b) Banks successful in the auction of primary issue of government may enter into contracts for sale of the allotted securities in accordance with the terms and conditions as per Annexure I-C.

(c) The settlement of all outright secondary market transactions in Government Securities will be done on a standardized T+1 basis effective May 24, 2005.

(d) All the transactions put through by a bank, either on outright basis or ready forward basis and whether through the mechanism of Subsidiary General Ledger (SGL) Account or Bank Receipt (BR), should be reflected on the same day in its investment account and, accordingly, for SLR purpose wherever applicable.

(e) The brokerage on the deal payable to the broker, if any, (if the deal was put through with the help of a broker) should be clearly indicated on the notes/ memoranda put up to the top management seeking approval for putting through the transaction and a separate account of brokerage paid, broker-wise, should be maintained.

(f) For issue of BRs, the banks should adopt the format prescribed by the Indian Banks' Association (IBA) and strictly follow the guidelines prescribed by them in this regard. The banks, subject to the above, could issue BRs covering their own sale transactions only and should not issue


366

BRs on behalf of their constituents, including brokers.

(g) The banks should be circumspect while acting as agents of their broker clients for carrying out transactions in securities on behalf of brokers.

(h) Any instance of return of SGL form from the Public Debt Office of the Reserve Bank for want of sufficient balance in the account should be immediately brought to Reserve Bank's notice with the details of the transactions.

(i) Banks desirous of making investment in equity shares/ debentures should observe the following guidelines:

(i) Build up adequate expertise in equity research by establishing a dedicated equity research department, as warranted by their scale of operations;

(ii) Formulate a transparent policy and procedure for investment in shares, etc., with the approval of the Board; and

(iii) The decision in regard to direct investment in shares, convertible bonds and debentures should be taken by the Investment Committee set up by the bank's Board. The Investment Committee should be held accountable for the investments made by the bank.

ii) With the approval of respective Boards, banks should clearly lay down the broad investment objectives to be followed while undertaking transactions in securities on their own investment account and on behalf of clients, clearly define the authority to put through deals, procedure to be followed for obtaining the sanction of the appropriate authority, procedure to be followed while putting through deals, various prudential exposure limits and the reporting system. While laying down such investment policy guidelines, banks should strictly observe Reserve Bank's detailed instructions on the following aspects:

(a) Ready Forward (buy back) deals (Paragraph 1.1.1)

(b) Transactions through Subsidiary General (Paragraph 1.1.2) Ledger A/c

(c) Use of Bank Receipts (Paragraph 1.1.3)

(d) Retailing of Government Securities (Paragraph 1.1.4)

(e) Internal Control System (Paragraph 1.1.5)

Annexure – K

367

(f) Dealings through Brokers (Paragraph 1.1.6)

(g) Audit, Review and Reporting (Paragraph 1.1.7)

(h) Non- SLR investments (Paragraph 1.1.8)

iii) The aforesaid instructions will be applicable mutatis mutandis, to the subsidiaries and mutual funds established by banks, except where they are contrary to or inconsistent with, specific regulations of Securities and Exchange Board of India (SEBI) and RBI governing their operations.

1.1.1 Ready Forward Contracts in Government Securities.

The terms and conditions subject to which ready forward contracts (including reverse ready forward contracts) may be entered into are as under:

(a) Ready forward contracts may be undertaken only in (i) Dated Securities and Treasury Bills issued by Government of India and (ii) Dated Securities issued by State Governments.

(b) Ready forward contracts in the above-mentioned securities may be entered into by:

i) persons or entities maintaining a Subsidiary General Ledger (SGL) account with RBI, Mumbai and

ii) the following categories of entities who do not maintain SGL accounts with the RBI but maintain gilt accounts (i.e gilt account holders) with a bank or any other entity (i.e. the custodian) permitted by the RBI to maintain Constituent Subsidiary General Ledger (CSGL) account with its Public Debt Office, Mumbai:

(a) Any scheduled bank,

(b) Any primary dealer authorised by the RBI,

(c) Any non-banking financial company registered with the RBI, other than Government companies as defined in Section 617 of the Companies Act, 1956,

(d) Any mutual fund registered with the SEBI,

(e) Any housing finance company registered with the National Housing Bank,

(f) Any insurance company registered with the Insurance Regulatory and Development Authority,


368

(g) Any non-scheduled Urban Co-operative bank,

(h) Any listed company, having a gilt account with a scheduled commercial bank, subject to the following conditions:

(1) The minimum period for Reverse Repo (lending of funds) by listed companies is seven days. However, listed companies can borrow funds through repo for shorter periods including overnight;

(2) Where the listed company is a 'buyer' of securities in the first leg of the repo contract (i.e. lender of funds), the custodian through which the repo transaction is settled should block these securities in the gilt account and ensure that these securities are not further sold or re-repoed during the repo period but are held for delivery under the second leg; and

(3) The counterparty to the listed companies for repo / reverse repo transactions should be either a bank or a Primary Dealer maintaining SGL Account with the RBI.

(c) All persons or entities specified at (ii) above can enter into ready forward transactions among themselves subject to the following restrictions:

i) An SGL account holder may not enter into a ready forward contract with its own constituent. That is, ready forward contracts should not be undertaken between a custodian and its gilt account holder,

ii) Any two gilt account holders maintaining their gilt accounts with the same custodian (i.e., the CSGL account holder) may not enter into ready forward contracts with each other, and

iii) Cooperative banks may not enter into ready forward contracts with the non-banking financial companies. This restriction would not apply to repo transactions between Urban Co-operative banks and authorised Primary Dealers in Government Securities.

(d) All ready forward contracts shall be reported on the Negotiated Dealing System (NDS). In respect of ready forward contracts involving gilt account holders, the custodian (i.e., the CSGL account holder) with whom the gilt accounts are maintained will be responsible for reporting the deals on the NDS on behalf of the constituents (i.e. the gilt account holders).

(e) All ready forward contracts shall be settled through the SGL Account /

Annexure – K

369

CSGL Account maintained with the RBI, Mumbai, with the Clearing Corporation of India Ltd. (CCIL) acting as the central counter party for all such ready forward transactions.

(f) The custodians should put in place an effective system of internal control and concurrent audit to ensure that:

i) ready forward transactions are undertaken only against the clear balance of securities in the gilt account,

ii) all such transactions are promptly reported on the NDS, and

iii) other terms and conditions referred to above have been complied with.

(g) The RBI regulated entities can undertake ready forward transactions only in securities held in excess of the prescribed Statutory Liquidity Ratio (SLR) requirements.

(h) No sale transaction shall be put through, in the first leg of a ready forward transaction by CSGL constituent entities, without actually holding the securities in the portfolio.

(i) Securities purchased under the ready forward contracts shall not be sold during the period of the contract except by entities permitted to undertake short selling.

(j) Double ready forward deals in any security are strictly prohibited.

(k) The guidelines for uniform accounting for Repo / Reverse Repo transactions are furnished in paragraph 4.

1.1.2 Transactions through SGL account

The following instructions should be followed by banks for purchase / sale of securities through SGL A/c, under the Delivery Versus Payment (DvP) System wherein the transfer of securities takes place simultaneously with the transfer of funds. It is, therefore, necessary for both the selling bank and the buying bank to maintain current account with the RBI. As no ‘Overdraft facility’ in the current account would be extended, adequate balance in current account should be maintained by banks for effecting any purchase transaction.

i) All transactions in Govt. securities for which SGL facility is available should be put through SGL A/cs only.

ii) Under no circumstances, a SGL transfer form issued by a bank in favour


370

of another bank should bounce for want of sufficient balance of securities in the SGL A/c of seller or for want of sufficient balance of funds in the current a/c of the buyer.

iii) The SGL transfer form received by purchasing banks should be deposited in their SGL A/cs. immediately i.e. the date of lodgement of the SGL Form with RBI shall be within one working day after the date of signing of the Transfer Form. While in cases of OTC trades, the settlement has to be only on 'spot' delivery basis as per Section 2(i) of the Securities Contracts (Regulations) Act, 1956, in cases of deals on the recognised Stock Exchanges; settlement should be within the delivery period as per their rules, bye laws and regulations. In all cases, participants must indicate the deal/trade/contract date in Part C of the SGL Form under 'Sale date'. Where this is not completed the SGL Form will not be accepted by the RBI.

iv) No sale should be effected by way of return of SGL form held by the bank.

v) SGL transfer forms should be signed by two authorised officials of the bank whose signatures should be recorded with the respective PDOs of the RBI and other banks.

vi) The SGL transfer forms should be in the standard format prescribed by the RBI and printed on semi-security paper of uniform size. They should be serially numbered and there should be a control system in place to account for each SGL form.

vii) If a SGL transfer form bounces for want of sufficient balance in the SGL A/c, the (selling) bank which has issued the form will be liable to the following penal action against it :

a) The amount of the SGL form (cost of purchase paid by the purchaser of the security) would be debited immediately to the current account of the selling bank with the RBI.

b) In the event of an overdraft arising in the current account following such a debit, penal interest would be charged by the RBI, on the amount of the overdraft, at a rate of 3 percentage points above the SBI Discount and Finance House of India's (SBIDFHI) call money lending rate on the day in question. However, if the SBIDFHI's closing call money rate is lower than the prime lending rate of banks, as stipulated in the RBI's interest rate directive in force, the

Annexure – K

371

applicable penal rate to be charged will be 3 percentage points, above the prime lending rate of the bank concerned, and

c) If the bouncing of the SGL form occurs thrice, the bank will be debarred from trading with the use of the SGL facility for a period of 6 months from the occurrence of the third bouncing. If, after restoration of the facility, any SGL form of the concerned bank bounces again, the bank will be permanently debarred from the use of the SGL facility in all the PDOs of the RBI.

d) The bouncing on account of insufficient balance in the current account of the buying bank would be reckoned (against the buying bank concerned) for the purpose of debarment from the use of SGL facility on par with the bouncing on account of insufficient balance in SGL a/c. of the selling bank (against selling bank). Instances of bouncing in both the accounts (i.e SGL a/c and current a/c) will be reckoned together against the SGL account holder concerned for the purpose of debarment (i.e three in a half-year for temporary suspension and any bouncing after restoration of SGL facility, for permanent debarment.)

1.1.3 Use of Bank Receipt (BR)

The banks should follow the following instructions for issue of BRs:

a) No BR should be issued under any circumstances in respect of transactions in Govt. securities for which SGL facility is available.

b) Even in the case of other securities, BR may be issued for ready transactions only, under the following circumstances:

(i) The scrips are yet to be issued by the issuer and the bank is holding the allotment advice.

(ii) The security is physically held at a different centre and the bank is in a position to physically transfer the security and give delivery thereof within a short period.

(iii The security has been lodged for transfer / interest payment and the bank is holding necessary records of such lodgements and will be in a position to give physical delivery of the security within a short period.


372

c) No BR should be issued on the basis of a BR (of another bank) held by the bank and no transaction should take place on the basis of a mere exchange of BRs held by the bank.

d) BRs could be issued covering transactions relating to banks' own Investments Accounts only, and no BR should be issued by banks covering transactions relating to either the Accounts of Portfolio Management Scheme (PMS) Clients or Other Constituents' Accounts, including brokers.

e) No BR should remain outstanding for more than 15 days.

f) A BR should be redeemed only by actual delivery of scrips and not by cancellation of the transaction/set off against another transaction. If a BR is not redeemed by delivery of scrips within the validity period of 15 days, the BR should be deemed as dishonoured and the bank which has issued the BR should refer the case to the RBI, explaining the reasons for which the scrips could not be delivered within the stipulated period and the proposed manner of settlement of the transaction.

g) BRs should be issued on semi-security paper, in the standard format (prescribed by IBA), serially numbered and signed by two authorised officials of the bank, whose signatures are recorded with other banks. As in the case of SGL forms, there should be a control system in place to account for each BR form.

h) Separate registers of BRs issued and BRs received should be maintained and arrangements should be put in place to ensure that these are systematically followed up and liquidated within the stipulated time limit.

i) The banks should also have a proper system for the custody of unused B.R. Forms and their utilisation. The existence and operations of these controls at the concerned offices/ departments of the bank should be reviewed, among others, by the statutory auditors and a certificate to this effect may be forwarded every year to the Regional Office of Department of Banking Supervision (DBS), RBI, under whose jurisdiction the Head Office of the bank is located.

j) Any violation of the instructions relating to BRs would invite penal action, which could include raising of reserve requirements, withdrawals of refinance facility from the RBI and denial of access to money markets. The RBI may also levy such other penalty as it may deem fit in

Annexure – K

373

accordance with the provisions of the Banking Regulation Act, 1949.

1.1.4 Retailing of Government Securities

The banks may undertake retailing of Government securities with non-bank clients subject to the following conditions:

i) Such retailing should be on outright basis and there is no restriction on the period between sale and purchase.

ii) The retailing of Government securities should be on the basis of ongoing market rates/ yield curve emerging out of secondary market transactions.

1.1.5 Internal Control System

The banks should observe the following guidelines for internal control system in respect of investment transactions:

(a) There should be a clear functional separation of (i) trading, (ii) settlement, monitoring and control and (iii) accounting. Similarly, there should be a functional separation of trading and back office functions relating to banks' own Investment Accounts, Portfolio Management Scheme (PMS) Clients' Accounts and other Constituents (including brokers') accounts. The Portfolio Management service may be provided to clients, subject to strictly following the guidelines in regard thereto (covered in paragraph 1.3.3). Further, PMS Clients Accounts should be subjected to a separate audit by external auditors.

(b) For every transaction entered into, the trading desk should prepare a deal slip which should contain data relating to nature of the deal, name of the counter-party, whether it is a direct deal or through a broker, and if through a broker, name of the broker, details of security, amount, price, contract date and time. The deal slips should be serially numbered and controlled separately to ensure that each deal slip has been properly accounted for. Once the deal is concluded, the dealer should immediately pass on the deal slip to the back office for recording and processing. For each deal there must be a system of issue of confirmation to the counterparty. The timely receipt of requisite written confirmation from the counterparty, which must include all essential details of the contract, should be monitored by the back office.

(c) With respect to transactions matched on the NDS-OM module, since CCIL is the central counterparty to all deals, exposure of any counterparty


374

for a trade is only to CCIL and not to the entity with whom a deal matches. Besides, details of all deals on NDS-OM are available to the counterparties as and when required by way of reports on NDS-OM itself. In view of the above, the need for counterparty confirmation of deals matched on NDS-OM does not arise. However, all government securities transactions, other than those matched on NDS-OM, will continue to be physically confirmed by the back offices of the counterparties, as hitherto.

(d) Once a deal has been concluded, there should not be any substitution of the counter party bank by another bank by the broker, through whom the deal has been entered into; likewise, the security sold/purchased in the deal should not be substituted by another security.

(e) On the basis of vouchers passed by the back office (which should be done after verification of actual contract notes received from the broker/ counterparty and confirmation of the deal by the counterparty), the Accounts Section should independently write the books of account.

(f) In the case of transaction relating to PMS Clients' Accounts (including brokers), all the relative records should give a clear indication that the transaction belongs to PMS Clients/ other constituents and does not belong to bank's own Investment Account and the bank is acting only in its fiduciary/ agency capacity.

(g) (i) Records of SGL transfer forms issued/ received, should be maintained.

(ii) Balances as per bank's books should be reconciled at quarterly intervals with the balances in the books of PDOs. If the number of transactions so warrant, the reconciliation should be undertaken more frequently, say on a monthly basis. This reconciliation should be periodically checked by the internal audit department.

(iii) Any bouncing of SGL transfer forms issued by selling banks in favour of the buying bank, should immediately be brought to the notice of the Regional Office of Department of Banking Supervision of RBI by the buying bank.

(iv) A record of BRs issued/ received should be maintained.

(v) A system for verification of the authenticity of the BRs and SGL transfer forms received from the other banks and confirmation of authorised signatories should be put in place.

Annexure – K

375

(h) Banks should put in place a reporting system to report to the top management, on a weekly basis, the details of transactions in securities, details of bouncing of SGL transfer forms issued by other banks and BRs outstanding for more than one month and a review of investment transactions undertaken during the period.

(i) Banks should not draw cheques on their account with the RBI for third party transactions, including inter-bank transactions. For such transactions, bankers' cheques/ pay orders should be issued.

(j) In case of investment in shares, the surveillance and monitoring of investment should be done by the Audit Committee of the Board, which shall review in each of its meetings, the total exposure of the bank to capital market both fund based and non- fund based, in different forms as stated above and ensure that the guidelines issued by RBI are complied with and adequate risk management and internal control systems are in place;

(k) The Audit Committee should keep the Board informed about the overall exposure to capital market, the compliance with the RBI and Board guidelines, adequacy of risk management and internal control systems;

(l) In order to avoid any possible conflict of interest, it should be ensured that the stockbrokers as directors on the Boards of banks or in any other capacity, do not involve themselves in any manner with the Investment Committee or in the decisions in regard to making investments in shares, etc., or advances against shares.

(m) The internal audit department should audit the transactions in securities on an on going basis, monitor the compliance with the laid down management policies and prescribed procedures and report the deficiencies directly to the management of the bank.

(n) The banks' managements should ensure that there are adequate internal control and audit procedures for ensuring proper compliance of the instructions in regard to the conduct of the investment portfolio. The banks should institute a regular system of monitoring compliance with the prudential and other guidelines issued by the RBI. The banks should get compliance in key areas certified by their statutory auditors and furnish such audit certificate to the Regional Office of DBS, RBI under whose jurisdiction the HO of the bank falls.


376

1.1.6 Engagement of brokers

i) For engagement of brokers to deal in investment transactions, the banks should observe the following guidelines:

(a) Transactions between one bank and another bank should not be put through the brokers' accounts. The brokerage on the deal payable to the broker, if any (if the deal was put through with the help of a broker), should be clearly indicated on the notes/memorandum put up to the top management seeking approval for putting through the transaction and separate account of brokerage paid, broker-wise, should be maintained.

(b) If a deal is put through with the help of a broker, the role of the broker should be restricted to that of bringing the two parties to the deal together.

(c) While negotiating the deal, the broker is not obliged to disclose the identity of the counterparty to the deal. On conclusion of the deal, he should disclose the counterparty and his contract note should clearly indicate the name of the counterparty. It should also be ensured by the bank that the broker note contains the exact time of the deal. Their back offices may ensure that the deal time on the broker note and the deal ticket is the same. The bank should also ensure that their concurrent auditors audit this aspect.

(d) On the basis of the contract note disclosing the name of the counterparty, settlement of deals between banks, viz. both fund settlement and delivery of security should be directly between the banks and the broker should have no role to play in the process.

(e) With the approval of their top managements, banks should prepare a panel of approved brokers which should be reviewed annually or more often if so warranted. Clear-cut criteria should be laid down for empanelment of brokers, including verification of their creditworthiness, market reputation, etc. A record of broker-wise details of deals put through and brokerage paid, should be maintained.

(f) A disproportionate part of the business should not be transacted through only one or a few brokers. Banks should fix aggregate contract limits for each of the approved brokers. A limit of 5% of

Annexure – K

377

total transactions (both purchase and sales) entered into by a bank during a year should be treated as the aggregate upper contract limit for each of the approved brokers. This limit should cover both the business initiated by a bank and the business offered/ brought to the bank by a broker. Banks should ensure that the transactions entered into through individual brokers during a year normally do not exceed this limit. However, if for any reason it becomes necessary to exceed the aggregate limit for any broker, the specific reasons therefor should be recorded, in writing, by the authority empowered to put through the deals. Further, the board should be informed of this, post facto. However, the norm of 5% would not be applicable to banks' dealings through Primary Dealers.

(g) The concurrent auditors who audit the treasury operations should scrutinise the business done through brokers also and include it in their monthly report to the Chief Executive Officer of the bank. Besides, the business put through any individual broker or brokers in excess of the limit, with the reasons therefor, should be covered in the half- yearly review to the Board of Directors/ Local Advisory Board. These instructions also apply to subsidiaries and mutual funds of the banks. [Certain clarifications on the instructions are furnished in the Annexure II.]

ii) Inter-bank securities transactions should be undertaken directly between banks and no bank should engage the services of any broker in such transactions.

Exceptions:

Note (i) Banks may undertake securities transactions among themselves or with non- bank clients through members of the National Stock Exchange (NSE), OTC Exchange of India (OTCEI) and the Stock Exchange, Mumbai (BSE). If such transactions are not undertaken on the NSE, OTCEI or BSE, the same should be undertaken by banks directly, without engaging brokers.

Note (ii) Although the Securities Contracts (Regulation) Act, 1956 defines the term `securities' to mean corporate shares, debentures, Govt. securities and rights or interest in securities, the term `securities' would exclude corporate shares. The Provident / Pension Funds and Trusts registered under the Indian Trusts Act, 1882, will be outside the purview of the expression `non-bank clients'


378

for the purpose of note (i) above.

1.1.7 Audit, review and reporting of investment transactions

The banks should follow the following instructions in regard to audit, review and reporting of investment transactions:

a) Banks should undertake a half-yearly review (as of 30 September and 31 March) of their investment portfolio, which should, apart from other operational aspects of investment portfolio, clearly indicate amendments made to the Investment Policy and certify adherence to laid down internal investment policy and procedures and RBI guidelines, and put up the same before their respective Boards within a month, i.e by end-April and end-October.

b) A copy of the review report put up to the Bank's Board, should be forwarded to the RBI (concerned Regional Office of DBS, RBI) by 15 May and 15 November respectively.

c) In view of the possibility of abuse, treasury transactions should be separately subjected to concurrent audit by internal auditors and the results of their audit should be placed before the CMD of the bank once every month. Banks need not forward copies of the above mentioned concurrent audit reports to RBI of India. However, the major irregularities observed in these reports and the position of compliance thereto may be incorporated in the half yearly review of the investment portfolio.

1.2 Non- SLR investments

1.2.1

(i) Appraisal

Banks have made significant investment in privately placed unrated bonds and, in certain cases, in bonds issued by corporates who are not their borrowers. While assessing such investment proposals on private placement basis, in the absence of standardised and mandated disclosures, including credit rating, banks may not be in a position to conduct proper due diligence to take an investment decision. Thus, there could be deficiencies in the appraisal of privately placed issues.

(ii) Disclosure requirements in offer documents

The risk arising from inadequate disclosure in offer documents should be

Annexure – K

379

recognised and banks should prescribe minimum disclosure standards as a policy with Board approval. In this connection, RBI had constituted a Technical Group comprising officials drawn from treasury departments of a few banks and experts on corporate finance to study, inter alia, the methods of acquiring, by banks, of non-SLR investments in general and private placement route, in particular, and to suggest measures for regulating these investments. The Group had designed a format containing the minimum disclosure requirements as well as certain conditionalities regarding documentation and creation of charge for private placement issues, which may serve as a 'best practice model' for the banks. The details of the Group’s recommendations are given in the Annexure III and banks should have a suitable format of disclosure requirements on the lines of the recommendations of the Technical Group with the approval of their Board.

(iii) Internal assessment With a view to ensuring that the investments by banks in issues through private placement, both of the borrower customers and non-borrower customers, do not give rise to systemic concerns, it is necessary that banks should ensure that their investment policies duly approved by the Board of Directors are formulated after taking into account the following aspects:

(a) The Boards of banks should lay down policy and prudential limits on investments in bonds and debentures including cap and on private placement basis, sub limits for PSU bonds, corporate bonds, guaranteed bonds, issuer ceiling, etc.

(b) Investment proposals should be subjected to the same degree of credit risk analysis as any loan proposal. Banks should make their own internal credit analysis and rating even in respect of rated issues and should not entirely rely on the ratings of external agencies. The appraisal should be more stringent in respect of investments in instruments issued by non-borrower customers.

(c) Strengthen their internal rating systems which should also include building up of a system of regular (quarterly or half-yearly) tracking of the financial position of the issuer with a view to ensuring continuous monitoring of the rating migration of the issuers/issues.

(d) As a matter of prudence, banks should stipulate entry-level minimum ratings/ quality standards and industry-wise, maturity-wise, duration-wise, issuer-wise etc. limits to mitigate the adverse impacts of concentration and the risk of illiquidity.


380

(e) The banks should put in place proper risk management systems for capturing and analysing the risk in respect of these investments and taking remedial measures in time.

(iv) Some banks / FIs have not exercised due precaution by reference to the list of defaulters circulated / published by RBI while investing in bonds, debentures, etc., of companies. Banks may, therefore, exercise due caution, while taking any investment decision to subscribe to bonds, debentures, shares etc., and refer to the ‘Defaulters List’ to ensure that investments are not made in companies / entities who are defaulters to banks / FIs. Some of the companies may be undergoing adverse financial position, turning their accounts to substandard category due to recession in their industry segment, like textiles. Despite restructuring facility provided under RBI guidelines, the banks have been reported to be reluctant to extend further finance, though considered warranted on merits of the case. Banks may not refuse proposals for such investments in companies whose director’s name(s) find place in the ‘Defaulter Companies List’ circulated by RBI, at periodical intervals and particularly in respect of those loan accounts, which have been restructured under extant RBI guidelines, provided the proposal is viable and satisfies all parameters for such credit extension.

Prudential guidelines on investment in Non-SLR securities

1.2.2 Coverage

These guidelines cover banks’ investments in non-SLR securities issued by corporates, banks, FIs and State and Central Government sponsored institutions, SPVs etc, including, capital gains bonds, bonds eligible for priority sector status. The guidelines will apply to investments both in the primary market as well as the secondary market.

1.2.3 The guidelines on listing and rating pertaining to non-SLR securities vide paragraphs 1.2.7 to 1.2.16 are not applicable to banks’ investments in:

(a) Securities directly issued by the Central and State Governments, which are not reckoned for SLR purposes.

(b) Equity shares

(c) Units of equity oriented mutual fund schemes, viz. those schemes where any part of the corpus can be invested in equity

Annexure – K

381

(d) Equity/debt instruments/Units issued by Venture capital funds

(e) Commercial Paper

(f) Certificates of Deposit

1.2.4 Definitions of a few terms used in these guidelines have been furnished in Annexure IV with a view to ensure uniformity in approach while implementing the guidelines.

Regulatory requirements

1.2.5 Banks should not invest in Non-SLR securities of original maturity of less than one-year, other than Commercial Paper and Certificates of Deposits, which are covered under RBI guidelines.

1.2.6 Banks should undertake usual due diligence in respect of investments in non- SLR securities. Present RBI regulations preclude banks from extending credit facilities for certain purposes. Banks should ensure that such activities are not financed by way of funds raised through the non- SLR securities.

Listing and rating requirements

1.2.7 Banks must not invest in unrated non-SLR securities. However, the banks may invest in unrated bonds of companies engaged in infrastructure activities, within the ceiling of 10 per cent for unlisted non-SLR securities as prescribed vide paragraph 1.2.10 below.

1.2.8 The Securities Exchange Board of India (SEBI) vide their circular dated September 30, 2003(amended vide circular dated May 11, 2009) have stipulated requirements that listed companies are required to comply with, for making issue of debt securities on a private placement basis and listed on a stock exchange. According to this circular, any listed company, making issue of debt securities on a private placement basis and listed on a stock exchange, has to make full disclosures (initial and continuing) in the manner prescribed in Schedule II of the Companies Act 1956, SEBI (Disclosure and Investor Protection) Guidelines, 2000 and the Listing Agreement with the exchanges. Furthermore, the debt securities shall carry a credit rating of not less than investment grade from a Credit Rating Agency registered with the SEBI.

1.2.9 Accordingly, while making fresh investments in non-SLR debt securities, banks should ensure that such investment are made only in listed debt


382

securities of companies which comply with the requirements of the SEBI circular dated September 30, 2003(amended vide circular dated May 11, 2009), except to the extent indicated in paragraph 1.2.10 and 1.2.11 below.

Fixing of prudential limits

1.2.10 Bank’s investment in unlisted non-SLR securities should not exceed 10 per cent of its total investment in non-SLR securities as on March 31, of the previous year, and such investment should comply with the disclosure requirements as prescribed by the SEBI for listed companies.

1.2.11 Bank’s investment in unlisted non-SLR securities may exceed the limit of 10 per cent, by an additional 10 per cent, provided the investment is on account of investment in securitisation papers issued for infrastructure projects, and bonds/debentures issued by Securitisation Companies (SCs) and Reconstruction Companies (RCs) set up under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFEASI Act) and registered with RBI. In other words, investments exclusively in securities specified in this paragraph could be up to the maximum permitted limit of 20 per cent of non-SLR investment.

1.2.12 Investment in the following will not be reckoned as ‘unlisted non-SLR securities’ for computing compliance with the prudential limits prescribed in the above guidelines:

(i) Security Receipts issued by SCs / RCs registered with RBI.

(ii) Investment in Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS), which are rated at or above the minimum investment grade. However, there will be close monitoring of exposures to ABS on a bank specific basis based on monthly reports to be submitted to RBI as per proforma being separately advised by the Department of Banking Supervision.

(iii) Investments in unlisted convertible debentures. However, investments in these instruments would be treated as “Capital Market Exposure”.

1.2.13 The investments in RIDF / SIDBI Deposits may not be reckoned as part of the numerator as well as denominator for computing compliance with the prudential limit of 10 per cent of its total non-SLR securities as on March 31, of the previous year.

Annexure – K

383

1.2.14 With effect from January 1, 2005, only investment in units of such mutual fund schemes, which have an exposure to unlisted securities of less than 10 per cent of the corpus of the fund, will be treated on par with listed securities for the purpose of compliance with the prudential limits prescribed in the above guidelines. While computing the exposure to the unlisted securities for compliance with the norm of less than 10 percent of the corpus of the mutual fund scheme, Treasury Bills, Collateralised Borrowing and Lending Obligations (CBLO), Repo/Reverse Repo and Bank Fixed Deposits may not be included in the numerator.

1.2.15 For the purpose of the prudential limits prescribed in the guidelines, the denominator viz., 'non-SLR investments', would include investment under the following four categories in Schedule 8 to the balance sheet viz., 'shares', 'bonds & debentures', 'subsidiaries/joint ventures' and 'others'.

1.2.16 Banks whose investment in unlisted non-SLR securities are within the prudential limit of 10 per cent of its total non-SLR securities as on March 31, of the previous year may make fresh investment in such securities and up to the prudential limits.

Role of Boards

1.2.17 Banks should ensure that their investment policies duly approved by the Board of Directors are formulated after taking into account all the relevant issues specified in these guidelines on investment in non-SLR securities. Banks should put in place proper risk management systems for capturing and analysing the risk in respect of non-SLR investment and taking remedial measures in time. Banks should also put in place appropriate systems to ensure that investment in privately placed instruments is made in accordance with the systems and procedures prescribed under respective bank’s investment policy.

1.2.18 Boards of banks should review the following aspects of non-SLR investment at least at quarterly intervals:

a) Total business (investment and divestment) during the reporting period.

b) Compliance with the prudential limits prescribed by the Board for non-SLR investment.

c) Compliance with the prudential guidelines issued by RBI on non-SLR securities.


384

d) Rating migration of the issuers/ issues held in the bank’s books and consequent diminution in the portfolio quality.

e) Extent of non-performing investments in the non-SLR category.

Disclosures

1.2.19 In order to help in the creation of a central database on private placement of debt, a copy of all offer documents should be filed with the Credit Information Bureau (India) Ltd. (CIBIL) by the investing banks. Further, any default relating to interest/ instalment in respect of any privately placed debt should also be reported to CIBIL by the investing banks along with a copy of the offer document.

1.2.20 Banks should disclose the details of the issuer composition of non-SLR investments and the non-performing non-SLR investments in the ‘Notes on Accounts’ of the balance sheet, as indicated in Annexure V.

Trading and settlement in debt securities

1.2.21 As per the SEBI guidelines, all trades with the exception of the spot transactions, in a listed debt security, shall be executed only on the trading platform of a stock exchange. In addition to complying with the SEBI guidelines, banks should ensure that all spot transactions in listed and unlisted debt securities are reported on the NDS and settled through the CCIL from a date to be notified by RBI.

1.2.22 Limits on Banks' Exposure to Capital Markets

A. Solo Basis

The aggregate exposure of a bank to the capital markets in all forms (both fund based and non- fund based) should not exceed 40 per cent of its net worth as on March 31 of the previous year. Within this overall ceiling, the bank’s direct investment in shares, convertible bonds / debentures, units of equity-oriented mutual funds and all exposures to Venture Capital Funds (VCFs) [both registered and unregistered] should not exceed 20 per cent of its net worth.

B. Consolidated Basis

The aggregate exposure of a consolidated bank to capital markets (both fund based and non- fund based) should not exceed 40 per cent of its consolidated net worth as on March 31 of the previous year. Within this overall ceiling, the aggregate direct exposure by way of the consolidated bank’s investment in

Annexure – K

385

shares, convertible bonds / debentures, units of equity- oriented mutual funds and all exposures to Venture Capital Funds (VCFs) [both registered and unregistered] should not exceed 20 per cent of its consolidated net worth.

The above-mentioned ceilings are the maximum permissible and a bank’s Board of Directors is free to adopt a lower ceiling for the bank, keeping in view its overall risk profile and corporate strategy. Banks are required to adhere to the ceilings on an ongoing basis.

1.3 General

1.3.1 Reconciliation of holdings of Govt. securities – Audit Certificate

Banks should furnish a ‘Statement of the Reconciliation of Bank's Investments (held in own Investment account, as also under PMS)’, as at the end of every accounting year duly certified by the bank's auditors. The statement should reach the Regional Office of the DBS, RBI, under whose jurisdiction the bank’s head office is located within one month from the close of the accounting year. Banks in the letters of appointment, issued to their external auditors, may suitably include the aforementioned requirement of reconciliation. The format for the statement and the instructions for compiling thereto are given in Annexure VI.

1.3.2 Transactions in securities - Custodial functions

While exercising the custodial functions on behalf of their merchant banking subsidiaries, these functions should be subject to the same procedures and safeguards as would be applicable to other constituents. Accordingly, full particulars should be available with the subsidiaries of banks of the manner in which the transactions have been executed. Banks should also issue suitable instructions in this regard to the department/office undertaking the custodial functions on behalf of their subsidiaries.

1.3.3 Portfolio Management on behalf of clients

i) The general powers vested in banks to operate PMS and similar schemes have been withdrawn. No bank should, therefore, restart or introduce any new PMS or similar scheme in future without obtaining specific prior approval of the RBI. However, bank-sponsored NBFCs are allowed to offer discretionary PMS to their clients, on a case-to-case basis. Applications in this regard should be submitted to the Department of Banking Operations and Development (DBOD), RBI, World Trade Centre, Mumbai – 400 005.


386

ii) The following conditions are to be strictly observed by the banks operating PMS or similar scheme with the specific prior approval of RBI:

(a) PMS should be entirely at the customer's risk, without guaranteeing, either directly or indirectly, a pre-determined return.

(b) Funds should not be accepted for portfolio management for a period less than one year.

(c) Portfolio funds should not be deployed for lending in call/notice money; interbank term deposits and bills rediscounting markets and lending to/placement with corporate bodies.

(d) Banks should maintain client wise account/record of funds accepted for management and investments made there against and the portfolio clients should be entitled to get a statement of account.

(e) Bank's own investments and investments belonging to PMS clients should be kept distinct from each other, and any transactions between the bank's investment account and client's portfolio account should be strictly at market rates.

(f) There should be a clear functional separation of trading and back office functions relating to banks’ own investment accounts and PMS clients' accounts.

iii) PMS clients' accounts should be subjected by banks to a separate audit by external auditors as covered in paragraph 1.1.5 (a).

iv) Banks should note that violation of RBI instructions will be viewed seriously and will invite deterrent action against the banks, which will include raising of reserve requirements, withdrawal of facility of refinance from the RBI and denial of access to money markets, apart from prohibition from undertaking PMS activity.

v) Further, the aforesaid instructions will apply, mutatis mutandis, to the subsidiaries of banks except where they are contrary to specific regulations of the RBI or SEBI, governing their operations.

vi) Banks / merchant banking subsidiaries of banks operating PMS or similar scheme with the specific prior approval of the RBI are also required to comply with the guidelines contained in the SEBI (Portfolio Managers) Rules and Regulations, 1993 and those issued from time to time.

Annexure – K

387

1.3.4 Investment Portfolio of bank - transactions in Government Securities

In the light of fraudulent transactions in the guise of Government securities, transactions in physical format by a few co-operative banks with the help of some broker entities, it has been decided to accelerate the measures for further reducing the scope of trading in physical forms. These measures are as under:

(i) For banks, which do not have SGL account with RBI, only one gilt account can be opened.

(ii) In case the gilt accounts are opened with a scheduled commercial bank, the account holder has to open a designated funds account (for all gilt account related transactions) with the same bank.

(iii) The entities maintaining the gilt / designated funds accounts will be required to ensure availability of clear funds in the designated funds accounts for purchases and of sufficient securities in the gilt account for sales before putting through the transactions.

(iv) No transactions by the bank should be undertaken in physical form with any broker.

(v) Banks should ensure that brokers approved for transacting in Government securities are registered with the debt market segment of NSE/BSE/OTCEI.

2. Classification

i) The entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories

viz. ‘Held to Maturity’,

‘Available for Sale’ and

‘Held for Trading’.

• However, in the balance sheet, the investments will continue to be disclosed as per the existing six classifications:

viz. a) Government securities,

b) Other approved securities, c) Shares,

d) Debentures & Bonds,

e) Subsidiaries/ joint ventures and


388

f) Others (CP, Mutual Fund Units, etc.).

ii) Banks should decide the category of the investment at the time of acquisition and the decision should be recorded on the investment proposals.

2.1 Held to Maturity

i) The securities acquired by the banks with the intention to hold them up to maturity will be classified under ‘Held to Maturity (HTM)’.

ii) Banks are allowed to include investments included under HTM category upto 25 per cent of their total investments.

The following investments are required to be classified under HTM but are not accounted for the purpose of ceiling of 25 per cent specified for this category:

(a) Re-capitalisation bonds received from the Government of India towards their re- capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of other banks acquired for investment purposes.

(b) Investment in subsidiaries and joint ventures (A Joint Venture would be one in which the bank, along with its subsidiaries, holds more than 25 percent of the equity).

(c) The investments in debentures/bonds, which are deemed to be in the nature of advance. [Refer sub-paragraph (vii) below]

iii) Banks are, however, allowed since September 2, 2004 to exceed the limit of 25 percent of total investment under HTM category provided:

(a) the excess comprises only of SLR securities, and

(b) the total SLR securities held in the HTM is not more than 25 percent of their DTL as on the last Friday of the second preceding fortnight.

iv) The non-SLR securities, held as part of HTM as on September 2, 2004 may remain in that category. No fresh non-SLR securities, are permitted to be included in HTM, except the following:

(a) Fresh re-capitalisation bonds, received from the Government of India, towards their re-capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of

Annexure – K

389

other banks acquired for investment purposes.

(b) Fresh investment in the equity of subsidiaries and joint ventures.

(c) RIDF / SIDBI deposits

v) To sum up, banks may hold the following securities under HTM:

(a) SLR Securities upto 25 percent of their DTL as on the last Friday of the second preceding fortnight.

(b) Non-SLR securities included under HTM as on September 2, 2004.

(c) Fresh re-capitalisation bonds received from the Government of India towards their re-capitalisation requirement and held in Investment portfolio.

(d) Fresh investment in the equity of subsidiaries and joint ventures

(e) IDF/SIDBI deposits.

(vi) Profit on sale of investments in this category should be first taken to the Profit & Loss Account, and thereafter be appropriated to the ‘Capital Reserve Account’. Loss on sale will be recognised in the Profit & Loss Account.

(vii) The debentures/ bonds must be treated in the nature of an advance when:

• The debenture/bond is issued as part of the proposal for project finance and the tenure of the debenture is for a period of three years and above

Or

The debenture/bond is issued as part of the proposal for working capital finance and the tenure of the debenture/ bond is less than a period of one year

And

• the bank has a significant stake i.e.10% or more in the issue

And

• the issue is part of a private placement, i.e. the borrower has approached the bank/FI and not part of a public issue where the bank/FI has subscribed in response to an invitation.


390

Since, no fresh non-SLR securities are permitted to be included in the HTM, these investments should not be held under HTM category and they should be subjected to mark- to-market discipline. They would be subjected to prudential norms for identification of non-performing investment and provisioning as applicable to investments.

2.2 Available for Sale & Held for Trading

i) The securities acquired by the banks with the intention to trade by taking advantage of the short-term price/interest rate movements will be classified under ‘Held for Trading (HFT)’.

ii) The securities which do not fall within the above two categories will be classified under ‘Available for Sale (AFS)’.

iii) The banks will have the freedom to decide on the extent of holdings under HFT and AFS. This will be decided by them after considering various aspects such as basis of intent, trading strategies, risk management capabilities, tax planning, manpower skills, capital position.

iv) The investments classified under HFT would be those from which the bank expects to make a gain by the movement in the interest rates/market rates. These securities are to be sold within 90 days.

v) Profit or loss on sale of investments in both the categories will be taken to the Profit & Loss Account.

2.3 Shifting among categories

i) Banks may shift investments to/from HTM with the approval of the Board of Directors once a year. Such shifting will normally be allowed at the beginning of the accounting year. No further shifting to/from HTM will be allowed during the remaining part of that accounting year.

ii) Banks may shift investments from AFS to HFT with the approval of their Board of Directors/ ALCO/ Investment Committee. In case of exigencies, such shifting may be done with the approval of the Chief Executive of the bank/Head of the ALCO, but should be ratified by the Board of Directors/ ALCO.

iii) Shifting of investments from HFT to AFS is generally not allowed.

Annexure – K

391

However, it will be permitted only under exceptional circumstances like not being able to sell the security within 90 days due to tight liquidity conditions, or extreme volatility, or market becoming unidirectional. Such transfer is permitted only with the approval of the Board of Directors/ ALCO/ Investment Committee.

iv) Transfer of scrips from one category to another, under all circumstances, should be done at the acquisition cost/ book value/ market value on the date of transfer, whichever is the least, and the depreciation, if any, on such transfer should be fully provided for. Banks may apply the values as on the date of transfer and in case, there are practical difficulties in applying the values as on the date of transfer, banks have the option of applying the values as on the previous working day, for arriving at the depreciation requirement on shifting of securities.

3. Valuation

3.1 Held to Maturity

i) Investments classified under HTM need not be marked to market and will be carried at acquisition cost, unless it is more than the face value, in which case the premium should be amortised over the period remaining to maturity. The banks should reflect the amortised amount in ‘Schedule 13 – Interest Earned : Item II – Income on Investments’, as a deduction. However, the deduction need not be disclosed separately. The book value of the security should continue to be reduced to the extent of the amount amortised during the relevant accounting period.

ii) Banks should recognise any diminution, other than temporary, in the value of their investments in subsidiaries/ joint ventures, which are included under HTM and provide therefore. Such diminution should be determined and provided for each investment individually.

3.2 Available for Sale

The individual scrips in the Available for Sale category will be marked to market at quarterly or at more frequent intervals. Domestic Securities under this category shall be valued scrip-wise and depreciation/ appreciation shall be aggregated for each classification referred to in item 2(i) above and foreign investments under this category shall be valued scrip-wise and depreciation/ appreciation shall be aggregated for five classifications (viz. Government securities (including local authorities), Shares, Debentures & Bonds, Subsidiaries and/or joint ventures abroad and Other investments (to be specified)). Further, the investment in a


392

particular classification, both in domestic and foreign securities, may be aggregated for the purpose of arriving at net depreciation/appreciation of investments under that category.Net depreciation, if any, shall be provided for. Net appreciation, if any, should be ignored. Net depreciation required to be provided for in any one classification should not be reduced on account of net appreciation in any other classification. The banks may continue to report the foreign securities under three categories (Government securities (including local authorities), Subsidiaries and/or joint ventures abroad and Other investments (to be specified)) in the balance sheet. The book value of the individual securities would not undergo any change after the marking of market.

3.3 Held for Trading

The individual scrips in the Held for Trading category will be marked to market at monthly or at more frequent intervals and provided for as in the case of those in the Available for Sale category. Consequently, the book value of the individual securities in this category would also not undergo any change after marking to market.

3.4 Investment Fluctuation Reserve

(i) With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments, banks were advised to build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment portfolio within a period of 5 years.

(ii) To ensure smooth transition to Basel II norms, banks were advised in June 24, 2004 to maintain capital charge for market risk in a phased manner over a two year period, as under:

(a) In respect of securities included in the HFT category, open gold position limit, open foreign exchange position limit, trading positions in derivatives and derivatives entered into for hedging trading book exposures by March 31, 2005, and

(b) In respect of securities included in the AFS category by March 31, 2006.

(iii) With a view to encourage banks for early compliance with the guidelines for maintenance of capital charge for market risks, it was advised in April 2005 that banks which have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT

Annexure – K

393

(items as indicated at (a) above) and AFS category may treat the balance in excess of 5 per cent of securities included under HFT and AFS categories, in the IFR, as Tier I capital. Banks satisfying the above were allowed to transfer the amount in excess of the said 5 per cent in the IFR to Statutory Reserve.

(iv) Banks were advised in October 2005 that, if they have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT (items as indicated at (a) above) and AFS category as on March 31, 2006, they would be permitted to treat the entire balance in the IFR as Tier I capital. For this purpose, banks may transfer the balance in the Investment Fluctuation Reserve ‘below the line’ in the Profit and Loss Appropriation Account to Statutory Reserve, General Reserve or balance of Profit & Loss Account.

Investment Reserve Account (IRA)

(v) In the event, provisions created on account of depreciation in the ‘AFS’ or ‘HFT’ categories are found to be in excess of the required amount in any year, the excess should be credited to the Profit & Loss account and an equivalent amount (net of taxes, if any and net of transfer to Statutory Reserves as applicable to such excess provision) should be appropriated to an IRA Account in Schedule 2 – “Reserves & Surplus” under the head “Revenue and other Reserves”, and would be eligible for inclusion under Tier-II within the overall ceiling of 1.25 per cent of total Risk Weighted Assets prescribed for General Provisions/ Loss Reserves.

(vi) Banks may utilise IRA as follows:

The provisions required to be created on account of depreciation in the AFS and HFT categories should be debited to the P&L Account and an equivalent amount (net of tax benefit, if any, and net of consequent reduction in the transfer to Statutory Reserve), may be transferred from the IRA to the P&L Account. Illustratively, banks may draw down from the IRA to the extent of provision made during the year towards depreciation in investment in AFS and HFT categories (net of taxes, if any, and net of transfer to Statutory Reserves as applicable to such excess provision). In other words, a bank which pays a tax of 30% and should appropriate 25% of the net profits to Statutory Reserves, can draw down Rs.52.50 from the IRA, if the provision made for depreciation in investments included in the AFS and HFT categories is Rs.100.


394

(vii) The amounts debited to the P&L Account for provision should be debited under the head ‘Expenditure - Provisions & Contingencies’. The amount transferred from the IRA to the P&L Account, should be shown as ‘below the line’ item in the Profit and Loss Appropriation Account, after determining the profit for the year. Provision towards any erosion in the value of an asset is an item of charge on the profit and loss account, and hence should appear in that account before arriving at the profit for the accounting period. Adoption of the following would not only be adoption of a wrong accounting principle but would, also result in a wrong statement of the profit for the accounting period:

(a) the provision is allowed to be adjusted directly against an item of Reserve without being shown in the profit and loss account, OR

(b) a bank is allowed to draw down from the IRA before arriving at the profit for the accounting period (i.e., above the line), OR

(c) a bank is allowed to make provisions for depreciation on investment as a below the line item, after arriving at the profit for the period,

Hence none of the above options are permissible.

(viii) In terms of our guidelines on payment of dividend by banks, dividends should be payable only out of current year's profit. The amount drawn down from the IRA will, therefore, not be available to a bank for payment of dividend among the shareholders. However, the balance in the IRA transferred ‘below the line’ in the Profit and Loss Appropriation Account to Statutory Reserve, General Reserve or balance of Profit & Loss Account would be eligible to be reckoned as Tier I capital.

3.5 Market value

The ‘market value’ for the purpose of periodical valuation of investments included in the AFS and HFT would be the market price of the scrip as available from the trades/ quotes on the stock exchanges, SGL account transactions, price list of RBI, prices declared by Primary Dealers Association of India (PDAI) jointly with the Fixed Income Money Market and Derivatives Association of India (FIMMDA) periodically. In respect of unquoted securities, the procedure as detailed below should be adopted.

Annexure – K

395

3.6 Unquoted SLR securities

3.6.1 Central Government Securities

i) Banks should value the unquoted Central Government securities on the basis of the prices/ YTM rates put out by the PDAI/ FIMMDA at periodical intervals.

ii) The 6.00 per cent Capital Indexed Bonds may be valued at “cost”, as defined in circular DBOD.No.BC.8/12.02.001/ 97-98 dated January 22, 1998 and BC.18/12.02.001/ 2000-2001 dated August 16, 2000.

iii) Treasury Bills should be valued at carrying cost.

3.6.2 State Government Securities

State Government securities will be valued applying the YTM method by marking it up by 25 basis points above the yields of the Central Government Securities of equivalent maturity put out by PDAI/ FIMMDA periodically.

3.6.3 Other ‘approved’ Securities

Other approved securities will be valued applying the YTM method by marking it up by 25 basis points above the yields of the Central Government Securities of equivalent maturity put out by PDAI/ FIMMDA periodically.

3.7 Unquoted Non-SLR securities

3.7.1 Debentures/ Bonds

All debentures/ bonds other than debentures/bonds, which are in the nature of advance, should be valued on the YTM basis. Such debentures/ bonds may be of different companies having different ratings. These will be valued with appropriate mark-up over the YTM rates for Central Government securities as put out by PDAI/ FIMMDA periodically. The mark-up will be graded according to the ratings assigned to the debentures/ bonds by the rating agencies subject to the following: -

(a) The rate used for the YTM for rated debentures/ bonds should be at least 50 basis points above the rate applicable to a Government of India loan of equivalent maturity.

NOTE:

The special securities, which are directly issued by Government of India to the beneficiary entities, which do not carry SLR status, may be valued


396

at a spread of 25 basis points above the corresponding yield on Government of India securities, with effect from the financial year 2008 - 09. At present, such special securities comprise: Oil Bonds, Fertiliser Bonds, bonds issued to the State Bank of India (during the recent rights issue), Unit Trust of India, Industrial Finance Corporation of India Ltd., Food Corporation of India, Industrial Investment Bank of India Ltd., the erstwhile Industrial Development Bank of India and the erstwhile Shipping Development Finance Corporation.

(b) The rate used for the YTM for unrated debentures/ bonds should not be less than the rate applicable to rated debentures/ bonds of equivalent maturity. The mark-up for the unrated debentures/ bonds should appropriately reflect the credit risk borne by the bank.

(c) Where the debenture/ bonds is quoted and there have been transactions within 15 days prior to the valuation date, the value adopted should not be higher than the rate at which the transaction is recorded on the stock exchange.

3.7.2 Zero coupon bonds (ZCBs)

ZCBs should be shown in the books at carrying cost, i.e., acquisition cost plus discount accrued at the rate prevailing at the time of acquisition, which may be marked to market with reference to the market value. In the absence of market value, the ZCBs may be marked to market with reference to the present value of the ZCB. The present value of the ZCBs may be calculated by discounting the face value using the ‘Zero Coupon Yield Curve’, with appropriate mark up as per the zero coupon spreads put out by FIMMDA periodically. In case the bank is still carrying the ZCBs at acquisition cost, the discount accrued on the instrument should be notionally added to the book value of the scrip, before marking it to market.

3.7.3 Preference Shares

The valuation of preference shares should be on YTM basis. The preference shares will be issued by companies with different ratings. These will be valued with appropriate mark-up over the YTM rates for Central Government securities put out by the PDAI/FIMMDA periodically. The mark-up will be graded according to the ratings assigned to the preference shares by the rating agencies subject to the following:

a) The YTM rate should not be lower than the coupon rate/ YTM for a GOI

Annexure – K

397

loan of equivalent maturity.

b) The rate used for the YTM for unrated preference shares should not be less than the rate applicable to rated preference shares of equivalent maturity. The mark-up for the unrated preference shares should appropriately reflect the credit risk borne by the bank.

c) Investments in preference shares as part of the project finance may be valued at par for a period of two years after commencement of production or five years after subscription whichever is earlier.

d) Where investment in preference shares is as part of rehabilitation, the YTM rate should not be lower than 1.5% above the coupon rate/ YTM for GOI loan of equivalent maturity.

e) Where preference dividends are in arrears, no credit should be taken for accrued dividends and the value determined on YTM should be discounted by at least 15% if arrears are for one year, and more if arrears are for more than one year. The depreciation/provision requirement arrived at in the above manner in respect of non- performing shares where dividends are in arrears shall not be allowed to be set-off against appreciation on other performing preference shares.

f) The preference share should not be valued above its redemption value.

g) When a preference share has been traded on stock exchange within 15 days prior to the valuation date, the value should not be higher than the price at which the share was traded.

3.7.4 Equity Shares

The equity shares in the bank's portfolio should be marked to market preferably on a daily basis, but at least on a weekly basis. Equity shares for which current quotations are not available or where the shares are not quoted on the stock exchanges, should be valued at break-up value (without considering ‘revaluation reserves’, if any) which is to be ascertained from the company’s latest balance sheet (which should not be more than one year prior to the date of valuation). In case the latest balance sheet is not available the shares are to be valued at Re.1 per company.

3.7.5 Mutual Funds Units (MF Units)

Investment in quoted MF Units should be valued as per Stock Exchange quotations. Investment in un-quoted MF Units is to be valued on the basis of the


398

latest re-purchase price declared by the MF in respect of each particular Scheme. In case of funds with a lock-in period, where repurchase price/ market quote is not available, Units could be valued at Net Asset Value (NAV). If NAV is not available, then these could be valued at cost, till the end of the lock- in period. Wherever the re-purchase price is not available, the Units could be valued at the NAV of the respective scheme.

3.7.6 Commercial Paper

Commercial paper should be valued at the carrying cost.

3.7.7 Investments in Regional Rural Banks (RRBs)

Investment in RRBs is to be valued at carrying cost (i.e. book value) on a consistent basis.

3.8 Investment in securities issued by SC/RC

When banks / FIs invest in the SRs / Pass-Through Certificates (PTCs) issued by SCs / RCs, in respect of the financial assets sold by them to the SCs / RCs, the sale shall be recognised in books of the banks / FIs at the lower of:

• the redemption value of the SRs /PTCs, and

• the net book value (NBV) (i.e. Book value less provisions held), of the financial asset.

The above investment should be carried in the books of the bank / FI at the price as determined above until its sale or realisation, and on such sale or realisation, the loss or gain must be dealt with as under:

(i) if the sale to SC /RC is at a price below the NBV, the shortfall should be debited to the profit and loss account of that year.

(ii) If the sale is for a value higher than the NBV, the excess provision will not be reversed but will be utilised to meet the shortfall / loss on account of sale of other financial assets to SC / RC. All instruments received by banks / FIs from SC / RC as sale consideration for financial assets sold to them and also other instruments issued by SC / RC in which banks / FIs invest will be in the nature of non-SLR securities. Accordingly, the valuation, classification and other norms applicable to investment in non-SLR instruments prescribed by RBI from time to time would be applicable to bank’s / FI’s investment in debentures / bonds / security receipts / PTCs issued by SC / RC. However, if any of the above instruments issued

Annexure – K

399

by SC / RC is limited to the actual realisation of the financial assets assigned to the instruments in the concerned scheme the bank / FI shall reckon the Net Asset Value (NAV), obtained from SC / RC from time to time, for valuation of such investments.

3.9. Valuation and classification of banks’ investment in VCFs

3.9.1 The quoted equity shares / bonds/ units of VCFs in the bank's portfolio should be held under AFS and marked to market preferably on a daily basis, but at least on a weekly basis, in line with valuation norms for other equity shares as per existing instructions.

3.9.2 Banks’ investments in unquoted shares/bonds/units of VCFs made after August 23, 2006 (i.e issuance of guidelines on valuation, classification of investments in VCFs) will be classified under HTM for initial period of three years and will be valued at cost during this period. For the investments made before issuance of these guidelines, the classification would be done as per the existing norms.

3.9.3 For this purpose, the period of three years will be reckoned separately for each disbursement made by the bank to VCF as and when the committed capital is called up. However, to ensure conformity with the existing norms for transferring securities from HTM, transfer of all securities which have completed three years as mentioned above will be effected at the beginning of the next accounting year in one lot to coincide with the annual transfer of investments from HTM category.

3.9.4 After three years, the unquoted units/shares/bonds should be transferred to AFS category and valued as under:

i) Units: In the case of investments in the form of units, the valuation will be done at the NAV shown by the VCF in its financial statements. Depreciation, if any, on the units based on NAV has to be provided at the time of shifting the investments to AFS category from HTM category as also on subsequent valuations which should be done at quarterly or more frequent intervals based on the financial statements received from the VCF. At least once in a year, the units should be valued based on the audited results. However, if the audited balance sheet/ financial statements showing NAV figures are not available continuously for more than 18 months as on the date of valuation, the investments are to be valued at Rupee 1.00 per VCF.


400

ii) Equity: In the case of investments in the form of shares, the valuation can be done at the required frequency based on the break-up value (without considering ‘revaluation reserves’, if any) which is to be ascertained from the company’s (VCF’s) latest balance sheet (which should not be more than 18 months prior to the date of valuation). Depreciation, if any on the shares has to be provided at the time of shifting the investments to AFS category as also on subsequent valuations which should be done at quarterly or more frequent intervals. If the latest balance sheet available is more than 18 months old, the shares are to be valued at Rupee.1.00 per company.

(iii) Bonds: The investment in the bonds of VCFs, if any, should be valued as per prudential norms for classification, valuation and operation of investment portfolio by banks issued by RBI from time to time.

3.9.5 Valuation norms on conversion of outstanding

(a) Equity, debentures and other financial instruments acquired by way of conversion of outstanding principal and / or interest should be classified in the AFS category, and valued in accordance with the extant instructions on valuation of banks' investment portfolio, except to the extent that (a) equity may be valued as per market value, if quoted, (b) in cases, where equity is not quoted, valuation may be at breakup value in respect of standard assets and in respect of substandard / doubtful assets, equity may be initially valued at Re1 and at breakup value after restoration / up gradation to standard category.

3.10 Non-Performing Investments (NPI)

3.10.1 In respect of securities included in any of the three categories where interest/ principal is in arrears, the banks should not reckon income on the securities and should also make appropriate provisions for the depreciation in the value of the investment. The banks should not set-off the depreciation requirement in respect of these non-performing securities against the appreciation in respect of other performing securities.

3.10.2 An NPI, similar to a non performing advance (NPA), is one where :

(i) Interest/ instalment (including maturity proceeds) is due and remains unpaid for more than 90 days.

Annexure – K

401

(ii) The above would apply mutatis-mutandis to preference shares where the fixed dividend is not paid.

(iii) In the case of equity shares, in the event the investment in the shares of any company is valued at Re.1 per company on account of the non availability of the latest balance sheet in accordance with the instructions contained in paragraph 28 of the Annex to the circular DBOD.BP.BC.32/ 21.04.048/ 2000-01 dated October 16, 2000, those equity shares would also be reckoned as NPI.

(iv) If any credit facility availed by the issuer is NPA in the books of the bank, investment in any of the securities, including preference shares issued by the same issuer would also be treated as NPI and vice versa. However, if only the preference shares are classified as NPI, the investment in any of the other performing securities issued by the same issuer may not be classified as NPI and any performing credit facilities granted to that borrower need not be treated as NPA.

(v) The investments in debentures / bonds, which are deemed to be in the nature of advance would also be subjected to NPI norms as applicable to investments.

(vi) In case of conversion of principal and / or interest into equity, debentures, bonds, etc., such instruments should be treated as NPA abinitio in the same asset classification category as the loan if the loan's classification is substandard or doubtful on implementation of the restructuring package and provision should be made as per the norms.

3.10.3 State Government guaranteed investments

For the year ending March 31, 2005, investment in State Government guaranteed securities would attract prudential norms for identification of NPI and provisioning, if interest and/or principal or any other amount due to the bank remains overdue for more than 180 days. With effect from the year ending March 31, 2006, investment in State Government guaranteed securities, including those in the nature of ‘deemed advance’, will attract prudential norms for identification of non- performing investments and provisioning, when interest/ instalment of principal (including maturity proceeds) or any other amount due to the bank remains unpaid for more than 90 days.

4. Uniform accounting for Repo / Reverse Repo transactions.

4.1 In order to ensure uniform accounting treatment for accounting repo


402

/reverse repo transactions and to impart an element of transparency, uniform accounting principles, have been laid down for repo / reverse repo transactions undertaken by all the regulated entities. However, for the present, these norms would not apply to repo / reverse repo transactions under the Liquidity Adjustment Facility (LAF) with RBI.

4.2 The uniform accounting principles were made applicable from the financial year 2003-04. The market participants may undertake repos from any of the three categories of investments, viz., Held for Trading, Available For Sale and Held to Maturity.

4.3 The securities sold under repo (the entity selling referred to as “seller”) are excluded from the Investment Account of the seller of securities and the securities bought under reverse repo (the entity buying referred to as “buyer”) are included in the Investment Account of the buyer of securities. Further, the buyer can reckon the approved securities acquired under reverse repo transaction for the purpose of Statutory Liquidity Ratio (SLR) during the period of the repo.

4. 4 At present repo transactions are permitted in Central Government securities including Treasury Bills and dated State Government securities. Since the buyer of the securities will not hold it till maturity, the securities purchased under reverse repo by banks should not be classified under Held to Maturity category. The first leg of the repo should be contracted at prevailing market rates. Further, the accrued interest received / paid in a repo / reverse repo transaction and the clean price (i.e. total cash consideration less accrued interest) should be accounted for separately and distinctly.

4.5 The other accounting principles to be followed while accounting for repos / reverse repos will be as under:

4.5.1 Coupon

In case the interest payment date of the security offered under repo falls within the repo period, the coupons received by the buyer of the security should be passed on to the seller on the date of receipt as the cash consideration payable by the seller in the second leg does not include any intervening cash flows. While the buyer will book the coupon during the period of the repo , the seller will not accrue the coupon during the period of the repo. In the case of discounted instruments like Treasury Bills, since there is no coupon, the seller will continue to accrue the discount at the original discount rate during the period of the repo. The buyer will not therefore accrue the discount during the period of the repo.

Annexure – K

403

4.5.2 Repo Interest Income / Expenditure

After the second leg of the repo / reverse repo transaction is over,

(a) the difference in the clean price of the security between the first leg and the second leg should be reckoned as Repo Interest Income / Expenditure in the books of the buyer / seller respectively;

(b) the difference between the accrued interest paid between the two legs of the transaction should be shown as Repo Interest Income/ Expenditure account, as the case may be; and

(c) the balance outstanding in the Repo interest Income / Expenditure account should be transferred to the Profit and Loss account as an income or an expenditure.

As regards repo / reverse repo transactions outstanding on the balance sheet date, only the accrued income / expenditure till the balance sheet date should be taken to the Profit and Loss account. Any repo income / expenditure for the subsequent period in respect of the outstanding transactions should be reckoned for the next accounting period.

4.5.3 Marking to Market

The buyer will mark to market the securities acquired under reverse repo transactions as per the investment classification of the security. To illustrate, for banks, in case the securities acquired under reverse repo transactions have been classified under Available for Sale category, then the mark to market valuation for such securities should be done at least once a quarter. For entities that do not follow any investment classification norms, the valuation for securities acquired under reverse repo transactions may be in accordance with the valuation norms followed by them in respect of securities of similar nature. In respect of the repo transactions outstanding as on the balance sheet date

(a) the buyer will mark to market the securities on the balance sheet date and will account for the same as laid down in the extant valuation guidelines issued by the respective regulatory departments of RBI.

(b) the seller will provide for the price difference in the Profit & Loss account and show this difference under “Other Assets” in the balance sheet if the sale price of the security offered under repo is lower than the book value.

(c) the seller will ignore the price difference for the purpose of Profit & Loss account but show the difference under “Other Liabilities” in the Balance


404

Sheet, if the sale price of the security offered under repo is higher than the book value; and

(d) similarly the accrued interest paid / received in the repo / reverse repo transactions outstanding on balance sheet dates should be shown as "Other Assets" or "Other Liabilities" in the balance sheet.

4.5.4 Book value on re-purchase

The seller shall debit the repo account with the original book value (as existing in the books on the date of the first leg) on buying back the securities in the second leg.

4.5.5 Disclosure

The disclosures to be made by banks in the “Notes on Accounts’ to the Balance Sheet is given in Annexure VII.

4.5.6 Accounting methodology

The accounting methodology to be followed is given below and illustrations are furnished in Annexure VIII. While market participants, having different accounting systems, may use accounting heads different from those used in the illustration, there should not be any deviation from the accounting principles enunciated above. Further, to obviate disputes arising out of repo transactions, the participants may consider entering into bilateral Master Repo Agreement as per the documentation finalized by FIMMDA.

4.5.7 Recommended Accounting Methodology for Uniform Accounting of Repo / Reverse Repo transactions

a) The following accounts may be opened, viz. (i) Repo Account, (ii) Repo Price Adjustment Account, (iii) Repo Interest Adjustment Account, (iv) Repo Interest Expenditure Account, (v) Repo Interest Income Account, (vi) Reverse Repo Account, (vii) Reverse Repo Price Adjustment Account, and (viii) Reverse Repo Interest Adjustment Account.

b) The securities sold/ purchased under repo should be accounted for as an outright sale / purchase.

c) The securities should enter and exit the books at the same book value. For operational ease, the weighted average cost method whereby the investment is carried in the books at their weighted average cost, may be adopted.

Annexure – K

405

d) In a repo transaction, the securities should be sold in the first leg at market related prices and re-purchased in the second leg at the derived price. The sale and repurchase should be accounted in the Repo Account.

e) The balances in the Repo Account should be netted from the bank's Investment Account for balance sheet purposes.

f) The difference between the market price and the book value in the first leg of the repo should be booked in Repo Price Adjustment Account. Similarly the difference between the derived price and the book value in the second leg of the repo should be booked in the Repo Price Adjustment Account.

Reverse repo

g) In a reverse repo transaction, the securities should be purchased in the first leg at prevailing market prices and sold in the second leg at the derived price. The purchase and sale should be accounted for in the Reverse Repo Account.

h) The balances in the Reverse Repo Account should be part of the Investment Account for balance sheet purposes and can be reckoned for SLR purposes if the securities acquired under reverse repo transactions are approved securities.

i) The security purchased in a reverse repo will enter the books at the market price (excluding broken period interest). The difference between the derived price and the book value in the second leg of the reverse repo should be booked in the Reverse Repo Price Adjustment Account.

Other aspects relating to Repo / Reverse Repo

j) In case the interest payment date of the security offered under repo falls within the repo period, the coupons received by the buyer of the security should be passed on to the seller on the date of receipt as the cash consideration payable by the seller in the second leg does not include any intervening cash flows.

k) The difference between the amounts booked in the first and second legs in the Repo / Reverse Repo Price Adjustment Account should be transferred to the Repo Interest Expenditure Account or Repo Interest Income Account, as the case may be.


406

l) The broken period interest accrued in the first and second legs will be booked in Repo Interest Adjustment Account or Reverse Repo Interest Adjustment Account, as the case may be. Consequently the difference between the amounts booked in this account in the first and second legs should be transferred to the Repo Interest Expenditure Account or Repo Interest Income Account, as the case may be.

m) At the end of the accounting period the, for outstanding repos, the balances in the Repo / Reverse Repo Price Adjustment Account and Repo / Reverse repo Interest Adjustment account should be reflected either under item VI - 'Others' under Schedule 11 - 'Other Assets' or under item IV 'Others (including Provisions)' under Schedule 5 - 'Other Liabilities and Provisions' in the Balance Sheet, as the case may be.

n) Since the debit balances in the Repo Price Adjustment Account at the end of the accounting period represent losses not provided for in respect of securities offered in outstanding repo transactions, it will be necessary to make a provision therefore in the Profit & Loss Account.

o) To reflect the accrual of interest in respect of the outstanding repo/ reverse repo transactions at the end of the accounting period, appropriate entries should be passed in the Profit and Loss account to reflect Repo Interest Income / Expenditure in the books of the buyer / seller respectively and the same should be debited / credited as an income / expenditure accrued but not due. Such entries passed should be reversed on the first working day of the next accounting period.

p) In respect of repos in interest bearing (coupon) instruments, the buyer would accrue interest during the period of repo. In respect of repos in discount instruments like Treasury Bills, the seller would accrue discount during the period of repo based on the original yield at the time of acquisition.

q) At the end of the accounting period the debit balances (excluding balances for repos which are still outstanding) in the Repo Interest Adjustment Account and Reverse Repo Interest Adjustment Account should be transferred to the Repo Interest Expenditure Account and the credit balances (excluding balances for repos which are still outstanding) in the Repo Interest Adjustment Account and Reverse Repo Interest Adjustment Account should be transferred to the Repo Interest Income Account.

Annexure – K

407

r) Similarly, at the end of accounting period, the debit balances (excluding balances for repos which are still outstanding) in the Repo / Reverse Repo Price Adjustment Account should be transferred to the Repo Interest Expenditure Account and the credit balances (excluding balances for repos which are still outstanding) in the Repo / Reverse Repo Price Adjustment Account should be transferred to the Repo Interest Income Account.

5. General

5.1 Income recognition

i) Banks may book income on accrual basis on securities of corporate bodies/ public sector undertakings in respect of which the payment of interest and repayment of principal have been guaranteed by the Central Government or a State Government, provided interest is serviced regularly and as such is not in arrears.

ii) Banks may book income from dividend on shares of corporate bodies on accrual basis provided dividend on the shares has been declared by the corporate body in its Annual General Meeting and the owner's right to receive payment is established.

iii) Banks may book income from Government securities and bonds and debentures of corporate bodies on accrual basis, where interest rates on these instruments are pre- determined and provided interest is serviced regularly and is not in arrears.

iv) Banks should book income from units of mutual funds on cash basis.

5.2 Broken Period Interest

Banks should not capitalise the Broken Period Interest paid to seller as part of cost, but treat it as an item of expenditure under Profit and Loss Account in respect of investments in Government and other approved securities. It is to be noted that the above accounting treatment does not take into account taxation implications and hence the banks should comply with the requirements of Income Tax Authorities in the manner prescribed by them.

5.3 Dematerialised Holding

Banks should settle the transactions in securities as notified by SEBI only through depositories. After the commencement of mandatory trading in demat form, banks would not be able to sell the shares of listed companies if they were


408

held in physical form. In order to extend the demat form of holding to other instruments like bonds, debentures and equities, it was decided that, with effect from October 31, 2001, banks, FIs, PDs and SDs would be permitted to make fresh investments and hold bonds and debentures, privately placed or otherwise, only in dematerialised form. Outstanding investments in scrip forms were required to be converted into dematerialised form by June 30, 2002. As regards equity instruments, banks were required to convert all their equity holding in scrip form into dematerialised form by December 31, 2004.

Annexure – K

409

Annexure I-A

Short sale in Government Securities Banks may undertake short sale of Central Government dated securities, subject to the short position being covered within a maximum period of five trading days, including the day of trade. In other words, the short sale position initiated today (trade date, T+0) will have to be covered on or before close of T+4 day. Such short positions shall be covered only by outright purchase of an equivalent amount of the same security. The short positions may be reflected in ‘Securities Short Sold (SSS) A/c’, specifically created for this purpose. For the purposes of this circular short sale and notional short sale are defined as under:

‘Short Sale’ is defined as sale of securities one does not own. A bank can also undertake 'notional' short sale where it can sell a security short from HFT even if the security is held under its AFS/HTM book. The resultant 'notional' short position would be subject to the same regulatory requirements as in the case of a short sale. For the purpose of these guidelines, short sale would include 'notional' short sale as well. The short sale by banks and the cover transaction shall not affect the holdings and valuation of the same security in AFS/HTM categories in any way.

Short sale transactions can be undertaken by banks, subject to the following conditions:

Minimum requirements:

In respect of short sales, banks shall ensure adherence to the following conditions:

a) The sale leg of the transaction should be executed only on the Negotiated Dealing System – Order Matching (NDS-OM) platform. The cover leg of the short sale transaction can, however, be executed either on or outside the NDS-OM platform.

b) The sale leg as well as the cover leg of the transaction should be accounted in the HFT category.

c) Under no circumstances, should participants fail to deliver, on settlement date, the securities sold short. Failures to deliver securities short sold shall be treated as an instance of ‘SGL bouncing’ and the concerned banks will be liable to disciplinary action prescribed in respect of SGL


410

bouncing, besides attracting such further regulatory action as may be considered necessary.

d) At no point of time should a bank accumulate a short position (face value) in any security in the HFT category in excess of the following limits:

i) 0.25% of the total outstanding stock issued of each security in case of securities other than liquid securities.

ii) 0.50% of the total outstanding stock issued of each security in case of liquid securities.

e) Banks shall be entirely responsible for ensuring strict compliance with the above prudential limits on real time basis for which they may put in place appropriate systems and internal controls. The controls provided in the trading platform (NDS-OM) are merely in the nature of additional tools and should not be cited as a reason for any breach of internal or regulatory limits. The information regarding the outstanding stock of each Government of India dated security is being made available on the RBI website (URL: http://rbi.org.in/Scripts/NDSUserXsl.aspx). The list of liquid securities for compliance with the limits shall be provided by FIMMDA from time to time.

f) Banks which undertake short sale transactions shall mark-to-market their entire HFT portfolio, including the short positions, on a daily basis and account for the resultant mark-to-market gains / losses as per the relevant guidelines for marking-to-market of the HFT portfolio.

g) Gilt Accounts Holders (GAHs), under CSGL facility, are not permitted to undertake short sales. Entities maintaining CSGL Accounts are required to ensure that no short sale is undertaken by the GAHs.

Borrowing security (through the repo market) to meet delivery obligations:

Since securities that are short sold are to be invariably delivered on the settlement date, participants are permitted to meet their delivery obligations by acquiring securities in the repo market. Accordingly, with a view to enable participants to run short positions across settlement cycles, banks have been permitted to use the securities acquired under a reverse repo to meet the delivery obligation of the short sale transaction. While the reverse repos can be rolled over, it is emphasised that the delivery obligations under the successive reverse repo contracts are also to be invariably met, failing which the concerned banks shall attract the regulatory action as specified above. It may, however, be

Annexure – K

411

noted that the permission to use securities acquired under reverse repo as above applies only to securities acquired under market repo and not to securities acquired under RBI’s Liquidity Adjustment Facility.

Policy and internal control mechanisms:

Before actually undertaking transactions in terms of this circular, banks shall put in place a written policy on short sale, which should be approved by their respective Boards of Directors. The policy should lay down the internal guidelines which should include, inter alia, risk limits on short position, an aggregate nominal short sale limit (in terms of Face Value) across all eligible securities, stop loss limits, the internal control systems to ensure adherence to regulatory and internal guidelines, reporting of short selling activity to the Board and the RBI, procedure to deal with violations, etc. Banks shall also put in place a system to detect violations if any, immediately, certainly within the same trading day.

In addition to the internal control mechanisms, the concurrent auditors should specifically verify compliance with these instructions, as well as with internal guidelines and report violations, if any, within a reasonably short time, to the appropriate internal authority. As part of their monthly reporting, concurrent auditors may verify whether the independent back/mid office has taken cognizance of lapses, if any, and whether they have reported the same within the required time frame to the appropriate internal authority. Any violation of regulatory guidelines noticed in this regard should immediately be reported to the respective Public Debt Office (PDO) where the SGL account is maintained and Internal Debt Management Department, Reserve Bank of India, Mumbai.


412

Annexure I-B When Issued Market - Guidelines

Definition ‘When, as and if issued’ (commonly known as ‘when-issued’ (WI)) security refers to a security that has been authorized for issuance but not yet actually issued. ‘WI’ trading takes place between the time a new issue is announced and the time it is actually issued. All 'when issued' transactions are on an 'if' basis, to be settled if and when the actual security is issued.

Mechanics of Operation

Transactions in a security on a ‘When Issued’ basis shall be undertaken in the following manner:

a) ‘WI’ transactions can be undertaken in the case of securities that are being reissued as well as newly issued, on a selective basis.

b) ‘WI’ transactions would commence on the issue notification date and it would cease on the working day immediately preceding the date of issue.

c) All ‘WI’ transactions for all trade dates will be contracted for settlement on the date of issue.

d) At the time of settlement on the date of issue, trades in the ‘WI’ security will be netted off with trades in the existing security, in the case of reissued securities.

e) The originating transactions (sale or purchase of 'WI' securities) shall be undertaken only on NDS-OM. Any reversal of a When Issued transaction can, however, be undertaken on or outside the NDS-OM platform.

f) Only PDs can take a short position in the ‘WI’ market. In other words, non-PD entities can sell the ‘WI’ security to any counterparty only if they have a preceding purchase contract for equivalent or higher amount.

g) Open Positions in the ‘WI’ market are subject to the following limits:

Annexure – K

413

Category Reissued security Newly issued security

Non-PDs Long Position, not exceeding 5 per cent of the notified amount.

Long Position, not exceeding 5 per cent of the notified amount.

PD Long or Short Position, not exceeding 10 per cent of the notified amount

Short Position, not exceeding 6 per cent and Long Position, not exceeding 10 per cent of the notified amount.

h) In the event of cancellation of the auction for whatever reason, all ‘WI’ trades will be deemed null and void ab initio on grounds of force majeure.

Internal Control

All banks participating in the ‘WI’ market are required to have in place a written policy on ‘WI’ trading which should be approved by the Board of Directors. The policy should lay down the internal guidelines which should include, inter alia, risk limits on ‘WI’ position (including, in the case of reissued securities, overall position in the security, i.e., ‘WI’ plus the existing security), an aggregate nominal limit (in terms of Face Value) for ‘WI’ and in the case of reissued securities, ‘WI’ plus the existing security, the internal control arrangements to ensure adherence to regulatory and internal guidelines, reporting of ‘WI’ activity to the top management, procedure to deal with violations, etc. A system should be in place to detect violations immediately, certainly within the trading day.

The concurrent auditors should specifically verify compliance with these instructions and report violations on the date of trade itself, within a reasonably short time, to the appropriate internal authority. As part of their monthly reporting, concurrent auditors may verify whether the independent back/mid office has taken cognizance of all such lapses and reported the same within the required time frame. Any violation of regulatory guidelines noticed in this regard should immediately be reported to the Public Debt Office (PDO), Mumbai and IDMD, Reserve Bank of India.


414

Annexure I-C

Para 1.1 (i) (b) Investment portfolio of banks – Transactions in securities – Conditions subject to which securities allotted in the auctions for primary issues can be sold (i) The contract for sale can be entered into only once by the allottee

bank on the basis of an authenticated allotment advice issued by Reserve Bank of India. The buyer from an allottee in a primary auction is also permitted to re-sell the security subject to compliance with the terms and conditions stipulated in our circular No.IDMD.PDRS.05/ 10.02.01/2003-04 dated March 29, 2004. Any sale of securities should be only on a T + 0 or T + 1 settlement basis.

(ii) The contract for sale of allotted securities can be entered into by banks with entities maintaining SGL Account with RBI as well as with and between CSGL account holders for delivery and settlement on the next working day through the Delivery versus Payment (DvP) system.

(iii) The face value of securities sold should not exceed the face value of securities indicated in the allotment advice.

(iv) The sale deal should be entered into directly without the involvement of broker/s.

(v) Separate record of such sale deals should be maintained containing details such as number and date of allotment advice, description and the face value of securities allotted, the purchase consideration, the number, date of delivery and face value of securities sold, sale consideration, the date and details of actual delivery i.e. SGL Form No., etc. This record should be made available to RBI for verification. Banks should immediately report any cases of failure to maintain such records.

(vi) Such type of sale transactions of Government securities allotted in the auctions for primary issues on the same day and based on authenticated allotment advice should be subjected to concurrent audit and the relative audit report should be placed before the Executive

Annexure – K

415

Director or the Chairman and Managing Director of the Bank once every month. A copy thereof should also be sent to the Department of Banking Supervision, RBI, Central Office, Mumbai.

(vii) Banks will be solely responsible for any failure of the contracts due to the securities not being credited to their SGL account on account of non-payment / bouncing of cheque etc.


416

Annexure – II Para 1.1.6 (i) (g)

Investment portfolio of banks - Transactions in securities - Aggregate contract limit for individual brokers

Sr. No. Issue Raised Response

1. The year should be calendaryear or financial year?

Since banks close their accounts at the end of March, it may be more convenient to follow the financial year. However, the banks may follow calendar year or any other period of 12 months provided, it is consistently, followed in future.

2. Whether the limit is to be observed with reference tototal transactions of theprevious year as the totaltransactions of the currentyear should be known only at the and of the year?

The limit has to be observed with reference to the year under review. While operating the limit, the bank should keep in view the expected turnover of the current year which may be based on turnover of the previous year and anticipated rise or fall in the volume of business in the current year.

3. Whether to arrive at the totaltransactions of the year,transactions entered intodirectly with counter-parties i.e. where no brokers are involved would also be taken into account

Not necessary. However, if there are any direct deals with the brokers as purchasers or sellers the same would have to be included in the total transactions to arrive at the limit of transactions to be done through an individual broker.

4. Whether in case of readyforward deals both the legs of the deals i.e. purchase as well as sale will be includedto arrive at the volume of total transactions?

Yes. This is however only theoretical as R/F transactions in Govt. security now prohibited except in Treasury Bills and the 3 year dated securities issued by conversion of Treasury Bills recently

Annexure – K

417


5. Whether central loan /state loan /treasury bills etc. purchased subscriptions/auction will be, included in the volume of total transactions?

No, as brokers are not involved as intermediaries.

6. It is possible that even though bank considers that a particular broker has touched the prescribed limit of 5% hemay come with an offerduring the remaining period of the year which the bank may find it to its advantage ascompared to offers

If the offer received is more advantageous the limit for the broker may be exceeded the reasons therefor recorded and approval of the competent authority / Board obtained post facto.

received from the other brokers who have not yet done business upto the prescribed limit.

7. Whether the transactionsconducted on behalf of theclients would also be includedin the total transactions of the year?

Yes. If they are conducted through the brokers.

8. For a bank which rarely deals through brokers and consequently the volume ofbusiness is small maintaining the broker-wise limit of 5% may mean splitting the ordersin small values amongst different brokers and theremay also arise price differential.

There may be no need to split an order. If any deal causes the particular broker's share to exceed 5% limit, our circular provides the necessary flexibility in as much as Board's post facto approval can be obtained.


418


9. During the course of the yearit may not be possible to reasonably predict what will be the total quantum oftransactions through brokersas a result of which therecould be deviation in complying with the norm of 5% .

The bank may get post facto approval from the Board after explaining to it the circumstances in which the limit was exceeded.

10. Some of the small privatesector banks have mentionedthat where the volume ofbusiness particularly thetransaction done through brokers is small the observance of 5% limit may be difficult. A suggestion hastherefore been made that the limit may be required to beobserved if the business done through a broker exceeds a cut-off point of say Rs.10 crores

As already observed the limit of 5% can be exceeded subject to reporting the transactions to the competent authority post facto. Hence, no change in our instructions is considered necessary.

Annexure – K

419

Annexure III Para 1.2(ii)

Recommendations of the Group on Non-SLR Investments of Banks

Pro-forma of minimum disclosure requirements in respect of private placement issues - Model Offer Document All issuers must issue an offer document with terms of issue, authorised by Board Resolution not older than 6 months from the date of issue. The offer document should specifically mention the Board Resolution authorising the issue and designations of the officials who are authorized to issue the offer document. The offer document may be printed or typed "For Private Circulation Only". The ‘Offer Document’ should be signed by the authorised signatory. The offer document should contain the following minimum information:

I. General Information

1. Name and address of registered office of the company

2. Full names (expanded initials), addresses of Directors and the names of companies where they are Directors.

3. Listing of the issue (If listed, name of the Exchange)

4. Date of opening of the issue

Date of closing of the issue

Date of earliest closing of the issue.

5. Name and addresses of auditors and Lead Managers / arrangers

6. Name address of the trustee - consent letter to be produced (in case of debenture issue)

7. Rating from any Rating Agency and / or copy of the rationale of latest rating.

II. Particulars of the issue

(a) Objects

(b) Project cost and means of financing (including contribution of promoters) in case of new projects.


420

III. The model offer document should also contain the following information:

(1) Interest rate payable on application money till the date of allotment.

(2) Security: If it is a secured issue, the issue is to be secured, the offer documents should mention description of security, type of security, type of charge, Trustees, private charge-holders, if any, and likely date of creation of security, minimum security cover, revaluation, if any.

(3) If the security is collateralised by a guarantee, a copy of the guarantee or principal terms of the guarantee are to be included in the offer document.

(4) Interim Accounts, if any. (5) Summary of last audited Balance Sheet and Profit & Loss

Account with qualifications by Auditors, if any. (6) Last two published Balance Sheet may be enclosed. (7) Any conditions relating to tax exemption, capital adequacy etc.

are to be brought out fully in the documents. (8) The following details in case of companies undertaking major

expansion or new projects :- (copy of project appraisal may be made available on request) (a) Cost of the project, with sources and uses of funds (b) Date of commencement with projected cash flows (c) Date of financial closure (details of commitments by

other institutions to be provided) (d) Profile of the project (technology, market etc) (e) Risk factors

(9) If the instrument is of tenor of 5 years or more, projected cash flows.

IV. Banks may agree to insist upon the following conditionalities for issues under private placements

All the issuers in particular private sector corporates, should be willing to execute a subscription agreement in case of all secured debt issues, pending

Annexure – K

421

the execution of Trust Deed and charge documents. A standardised subscription agreement may be used by the banks, inter-alia, with the following important provisions:

(a) Letter of Allotment should be made within 30 days of allotment. Execution of Trust Deed and charge documents will be completed and debentures certificates will be dispatched within the time limit laid down in the Companies Act but not exceeding in any case, 6 months from the date of the subscription agreement.

(b) In case of delay in complying with the above, the company will refund the amount of subscription with agreed rate of interest, or, will pay penal interest of 2% over the coupon rate till the above conditions are complied with, at the option of the bank.

(c) Pending creation of security, during the period of 6 months (or extended period), the principal Directors of the company should agree to indemnify the bank for any loss that may be suffered by the bank on account of the subscription to their debt issue. (This condition will not apply to PSUs).

(d) It will be the company's responsibility to obtain consent of the prior charge-holders for creation of security within the stipulated period. Individual banks may insist upon execution of subscription agreement or a suitable letter to comply with the terms of offer such as appointment of trustee, creation of security etc. on the above lines.

(e) Rating: The Group recommends that the extant regulations of SEBI in regard to rating of all debt instruments in public offers would be made applicable to private placement also. This stipulation will also apply to preference shares, which are redeemable after 18 months.

(f) Listing: Currently, there is a lot of flexibility regarding listing required by banks in private placement issues. However, the Group recommends that listing of companies should be insisted upon, (exceptions, if any, to this rule shall be provided in the Investment Policy of the banks) which would in due course help develop secondary market. The advantage of listing would be that the listed companies would be required to disclose information periodically to the Stock Exchanges which would also help develop the secondary markets by way of investor information. In fact, SEBI has advised all the Stock Exchanges that all listed companies should publish


422

unaudited financial results on a quarterly basis and that they should inform the Stock Exchanges immediately of all events which would have a bearing on the performance / operations of the company as well as price sensitive information.

(g) Security / documentation: To ensure that the documentation is completed and security is created in time, the Group has made recommendations, which is contained in this model offer document. It may be noted that in case of delay in execution of Trust Deed and Charge documents, the company will refund the subscription with agreed rate of interest or will pay penal interest of 2% over the coupon rate till these conditions are complied with at the option of the bank. Moreover, Principal Directors of the company will have to agree to indemnify the bank for any loss that may be suffered by the bank on account of the subscription to the debt issue during the period of 6 months (or extended period) pending creation of security.

----------------------------------------------

Annexure – K

423

Annexure - IV Para 1.2.4

Guidelines on Investments by Banks in Non-SLR Investment Portfolio by Banks - Definitions

1. With a view to imparting clarity and to ensure that there is no divergence in the implementation of the guidelines, some of the terms used in the guidelines on non-SLR investments are defined below.

2. A security will be treated as rated if it is subjected to a detailed rating exercise by an external rating agency in India, which is registered with SEBI and is carrying a current or valid rating. The rating relied upon will be deemed to be current or valid if

(i) The credit rating letter relied upon is not more than one month old on the date of opening of the issue, and

(ii) The rating rationale from the rating agency is not more than one year old on the date of opening of the issue, and

(iii) The rating letter and the rating rationale is a part of the offer document.

(iv) In the case of secondary market acquisition, the credit rating of the issue should be in force and confirmed from the monthly bulletin published by the respective rating agency. Securities, which do not have a current or valid rating by an external rating agency, would be deemed as unrated securities.

3. The investment grade ratings awarded by each of the external rating agencies operating in India would be identified by the IBA / FIMMDA. These would also be reviewed by IBA / FIMMDA at least once a year.

4. A 'listed' security is a security which is listed in a stock exchange. If not so, it is an 'unlisted' security.

----------------------------------------------


424

Annexure - V Para 1.2.20

Prudential Guidelines on Management of the Non-SLR Investment Portfolio by Banks - Disclosures Requirements

Banks should make the following disclosures in the 'Notes on Accounts' of the balance sheet in respect of their non-SLR investment portfolio, with effect from the financial year ending 31 March 2004.

(i) Issuer composition of Non SLR investments

(Rs. in crore)

Sl. No.

Issuer Amount Extent of private

placement

Extent of 'below

investment grade'

securities

Extent of 'unrated'

securities

Extent of 'unlisted' securities

1 2 3 4 5 6 7 1. PSUs 2. FIs 3. Banks 4. Private

Corporates

5. Subsidiaries/ Joint ventures

6. Others 7. Provision held

towards depreciation

XXX

XXX

XXX

XXX

Total *

Note: 1. * Total under column 3 should tally with the total of investments included under the following categories in Schedule 8 to the balance sheet:

(a) Shares

Annexure – K

425

(b) Debentures & Bonds

(c) Subsidiaries / joint ventures

(d) Others

2. Amounts reported under columns 4, 5, 6 and 7 above may not be mutually exclusive.

(ii) Non-performing Non-SLR investments

Particulars Amount (Rs. Crore)

Opening balance Additions during the year since 1st April Reductions during the above period Closing balance Total provisions held

----------------------------------------------


426

Annexure VI Para 1.3.1

RETURN / STATEMENT NO. 9 Proforma Statement showing the position of Reconciliation of Investment Account as on 31st March

Name of the bank/ Institution: ______________________________________

(Face value Rs. in crore)

SGL Balance

Particulars of securities

General Ledger Balance

As per PDO

Books

As per bank’s /

institution’s books

BRs

held

SGL

Form

s he

ld

Actu

al S

crip

s He

ld

Outs

tand

in g

de

liver

ies

1 2 3 4 5 6 7 8

Central Govt

State Government

Other approved securities

Public Sector Bonds

Units of UTI (1964)

Others (Shares & Debenture etc)

TOTAL

Signature of the Authorised Official with the Name and Designation

Note : Similar statements may be furnished in respect of PMS client’s Accounts and other constituents’ Accounts (including Brokers). In the case of PMS/other constituents’ accounts, the face value and book value of securities appearing in the relevant registers of the bank should be mentioned under Column 2.

Annexure – K

427

General instructions for compiling reconciliation statement a) Column - 2 (GL balances)

It is not necessary to give complete details of securities in the format. Only aggregate amount of face value against each category may be mentioned. The corresponding book value of securities may be indicated in bracket under the amount of face value of securities under each category.

b) Column - 3 and 4 (SGL balances)

In the normal course balances indicated against item three and four should agree with each other. In case of any difference on account of any transaction not being recorded either in PDO or in the books of the bank this should be explained giving full details of each transaction.

c) Column - 5 (BRs held)

If the bank is holding any BRs for purchases for more than 30 days from the date of its issue, particulars of such BRs should be given in a separate statement.

d) Column - 6 (SGL forms held)

Aggregate amount of SGL forms received for purchases, which have not been tendered with PDO, should be given here.

e) Column - 7

Aggregate amount of all scrips held in the form of bonds, letters of allotments, subscription receipts as also certificates of entries in the books of accounts of the issuer (for other than government securities), etc. including securities which have been sold but physical delivery has not been given should be mentioned.

f) Column - 8 (outstanding deliveries)

This relates to BRs issued by the bank, where the physicals/scrips have not been delivered but the balance in General Ledger has been reduced. If any BR issued is outstanding for more than thirty days the particulars of such BRs may be given in a separate list indicating reasons for not affecting the delivery of scrips.


428

g) General

Face value of securities indicated against each item in column two should be accounted for under any one of the columns from four to seven. Similarly, amount of outstanding deliveries (BRs issued) which has been indicated in column eight will have to be accounted for under one of the columns four to seven. Thus the total of columns two and eight should tally with total of columns four to seven.

Annexure – K

429

Annexure - VII Para 4.5.5

Disclosures The following disclosures should be made by banks in the ‘Notes on Accounts' to the Balance Sheet.

(Rs. in crore)

Minimum outstanding during the

year

Maximum outstanding during the

year

Daily Average outstanding during the

year

As on

March

31

Securities sold under repos

Securities purchased under reverse repos


430

Annexure - VIII Para 4.5.6

Illustrative examples for uniform accounting of Repo / Reverse repo transactions

A. Repo / Reverse Repo of Coupon bearing security

1. Details of Repo in a coupon bearing security:

Security offered under Repo 11.43% 2015

Coupon payment dates 7 August and 7 February

Market Price of the security offered under Repo (i.e. price of the security in the first leg)

Rs.113.00 (1)

Date of the Repo 19 January, 2003

Repo interest rate 7.75%

Tenor of the repo 3 days

Broken period interest for the first leg* 11.43%x162/360x100=5.1435 (2)

Cash consideration for the first leg (1) + (2) = 118.1435 (3)

Repo interest** 118.1435x3/365x7.75%=0.0753 (4)

Broken period interest for the second leg 11.43% x 165/360x100=5.2388 (5)

Price for the second leg (3)+(4)-(5) = 118.1435 + 0.0753 -5.2388

= 112.98

(6)

Cash consideration for the second leg (5)+(6) = 112.98 + 5.2388 = 118.2188

(7)

* Computation of days based on 30 / 360 day count convention

** Computation of days based on Actual / 365 day count convention applicable to money market instruments

2. Accounting for seller of the security

We assume that the security was held by the seller at the book value (BV) of Rs.120.0000

Annexure – K

431

First leg Accounting

Debit Credit

Cash Repo Account 118.1435 120.0000 (Book value)

Repo Price Adjustment account 7.0000 (Difference between BV & repo

price)

Repo Interest Adjustment account 5.1435

Second Leg Accounting

Debit Credit

Repo Account Repo Price Adjustment account

120.0000 7.02 (the difference between the BV and

2nd leg price)

Repo Interest Adjustment account Cash account

5.2388 118.2188

The balances in respect of the Repo Price Adjustment Account and Repo Interest Adjustment Account at the end of the second leg of repo transaction are transferred to Repo Interest Expenditure Account. In order to analyse the balances in these accounts, the ledger entries are shown below:

Repo Price Adjustment account

Debit Credit

Difference in price for the 1st leg

7.00 Difference in price for the 2nd leg

7.02

Balance carried forward to Repo Interest Expenditure account

0.02

Total 7.02 Total 7.02


432

Repo Interest Adjustment account

Debit Credit

Broken period interest for the 2nd leg

5.2388 Broken period interest for the 1st leg

5.1435


0.0953


Repo Interest Expenditure Account

Debit Credit

Balance from Repo Interest Adjustment account

0.0953 Balance from Repo Price Adjustment account

0.0200

Balance carried forward to P & L a/c.

0.0753


3. Accounting for buyer of the security

When the security is bought, it will bring its book value with it. Hence market value is the book value of the security.


Debit Credit

Reverse Repo Account 113.0000

Reverse Repo Interest Adjustment account 5.1435

Cash account 118.1435

Annexure – K

433


Debit Credit


Reverse Repo Price Adjustment account(Difference between the 1st and 2nd leg prices)

0.0200

Reverse Repo account 113.0000

Reverse Repo Interest Adjustment account 5.2388

The balances in respect of the Reverse Repo Interest Adjustment Account and Reverse Repo Price adjustment account at the end of the second leg of reverse repo in these accounts are transferred to Repo Interest Income Account. In order to analyse the balances in these two accounts, the ledger entries are shown below:

Reverse Repo Price Adjustment Account

Debit Credit

Difference in price of 1st & 2nd leg

0.0200 Balance to Repo Interest Income a/c.

0.0200


Reverse Repo Interest Adjustment Account

Debit Credit

Broken period interest for the 1st leg

5.1435 Broken period interest for the 2nd leg

5.2388

Balance carried forward to Repo Interest Income Account

0.0953



434

Reverse Repo Interest Income Account

Debit Credit Difference between the 1st & 2nd leg prices

0.0200 Balance from Reverse Repo Interest Adjustment account

0.0953

Balance carried forward to P & L account

0.0753


4. Additional accounting entries to be passed on a Repo / Reverse Repo transaction on a coupon bearing security, when the accounting period is ending on an intervening day

Transaction Leg --- > 1st leg End of accounting period

2nd leg

Dates --- > 19 Jan 03 21 Jan 03* 22 Jan 03

The difference in the clean price of the security between the first leg and the second leg should be apportioned upto the Balance Sheet date and should be shown as Repo Interest Income / Expenditure in the books of the seller / buyer respectively and should be debited / credited as an income / expenditure accrued but not due. The balances under Income / expenditure accrued but not due should be taken to the balance sheet

The coupon accrued by the buyer should also be credited to the Repo Interest Income account. No entries need to be passed on "Repo / Reverse Repo price adjustment account and Repo / Reverse repo interest adjustment account". The illustrative accounting entries are shown below:

a) Entries in Seller's books on January 21, 2003

Account Head Debit Credit Repo Interest Income account[Balances under the account to be transferred to P & L]

0.0133 (Notional credit balance 0.0133 in the Repo Price Adjustment Account by way of apportionment of price difference for two days i.e. upto the balance sheet day)

Repo interest Income accrued but not due

0.0133

* January 21, 2003 is assumed to be the balance sheet date

Annexure – K

435

b) Entries in Seller's books on January 21, 2003

Account Head Debit Credit

Repo interest income 0.0133

P & L a/c 0.0133

(c) Entries in Buyer's Books on January 21, 2003


Repo interest income accrued but not due

0.0502

Repo Interest Income account[Balances under the account to be transferred to P & L]

0.0502 (Interest accrued for 3 days of Rs. 0.0635* - Apportionment of the difference in the clean price of Rs. 0.0133)

* For the sake of simplicity the interest accrual has been considered for 2 days.

(d) Entries in Buyer's Books on January 21, 2003


Repo interest income account 0.0502

P& L a/c 0.0502

The difference between the repo interest accrued by the seller and the buyer is on account of the accrued interest forgone by the seller on the security offered for repo.


436

B. Repo / Reverse Repo of Treasury Bill

1. Details of Repo on a Treasury Bill

Security offered under Repo GOI 91 day Treasury Bill maturing on 28 February,

2003

Price of the security offered under Repo

Rs.96.0000 (1)

Date of the Repo 19 January, 2003 Repo interest rate 7.75% Tenor of the repo 3 days Total cash consideration for the first leg

96.0000 (2)

Repo interest 0.0612 (3) Price for the second leg (2)+(3) = 96.0000 +

0.0612 = 96.0612

Cash consideration for the 2nd leg 96.0612

2. Accounting for seller of the security

We assume that the security was held by the seller at the book value (BV) of Rs.95.0000


Debit Credit Cash Repo Account 96.0000 95.0000 (Book value) Repo Price adjustment account 1.0000 (Difference

between BV & repo price )

Annexure – K

437


Repo Account Repo Price adjustment account

95.0000 1.0612

(the difference between the BV

and 2nd leg price)


The balances in respect of the Repo Price Adjustment Account at the end of the second leg of repo transaction are transferred to Repo Interest Expenditure Account. In order to analyse the balances in this account, the ledger entries are shown:

Repo Price Adjustment account

Debit Credit Difference in price for the 2nd leg

1.0612 Difference in price for the 1st leg

1.0000


0.0612


Repo Interest Expenditure Account

Debit Credit Balance from Repo Price Adjustment account

0.0612 Balance carried forward to P & L a/c.

0.0612


The Seller will continue to accrue the discount at the original discount rate during the period of the repo.


438

3. Accounting for buyer of the security

When the security is bought, it will bring its book value with it. Hence market value is the book value of the security.

First leg Accounting:

Debit Credit Reverse Repo Account 96.0000 Cash account 96.0000


Debit Credit Cash account 96.0612 Repo Interest Income account(Difference between the 1st and 2nd leg prices)

0.0612

Reverse Repo account 96.0000

The Buyer will not accrue for the discount during the period of the repo.

4. Additional accounting entries to be passed on a Repo / Reverse Repo transaction on a Treasury Bill, when the accounting period is ending on an intervening day

Transaction Leg -� 1st leg B/S date 2nd leg Date -� 19 Jan.03 21 Jan.03* 22 Jan.03

* 21 January, 2003 is assumed to be the balance sheet date

(a) Entries in Seller's books on January 21, 2003

Account Head Debit Credit Repo Interest Expenditure account(after apportionment of repo interest for two days) [ Balances under the account to be transferred to P & L]

0.0408

Repo interest expenditure accrued but not due

0.0408

Annexure – K

439

(b) Entries in Seller's books on January 21, 2003


Repo interest expenditure account 0.0408

P & L a/c 0.0408

(c) Entries in Buyer's Books on January 21, 2003

Account Head Debit Credit Repo interest income accrued but not due

0.0408

Repo Interest Income account [Balances under the account to be transferred to P & L]

0.0408

(d) Entries in Buyer's Books on January 21, 2003

Account Head Debit Credit Repo interest income account 0.0408 P & L a/c 0.0408


440

Appendix

List of Circulars consolidated by the Master Circular

No. Circular No. Date Relevant

para no. of the circular

Subject Para no.

of the master circular

1. DBOD.No.FSC.BC.69/C.469- 90/91

Jan 18, 1991

1,2,4 Portfolio Management on behalf of clients

1.3. 3

2. DO.DBOD.No.FSC.46/C.469- 91/92

July 26, 1991

4(i), (ii), (iii), (iv), (v), (iv)

Investment portfolio of banks- Transaction in securities

1.2 (i)

3. DBOD.No.FSC.BC.143A/24.48. 001/ 91-92

June 20, 1992

3(I), 3(I)- (ii)- (iii)- (iv)- (v)- (xi)- (xii)-

(xvi)- (xvii), 3(II), 3(III),

3(V)- (i)- (ii)- (iii), (3) & (4)

Investment portfolio of banks- Transaction in securities

1.2 (ii), (iii)

& (iv), 1.2.2, 1.2.3, 1.2.5, 1.2.6, 1.2.7

4. DBOD.No.FSC.BC.11/24.01.009/ 92-93

July 30, 1992

3,4,5,6 Portfolio Management on behalf of clients

1.3.3

5. DBOD.No.FMC/BC/17/24.48.001. 92/93

Aug 19, 1992

2 Investment portfolio of banks- Transaction in securities

1.3.2

6. DBOD.FMC.BC.62/27.02.001/ 92-93

Dec 31, 1992

1 Investment portfolio of banks- Transaction in securities

1.2.6

7. DBOD.No.FMC.1095/27.01.002/93

April 15, 1993

1 & enclosed

format

Investment portfolio of banks- Reconciliation of holdings

1.3.1 & Anne-

xure VI 8. DBOD.No.FMC.BC.141/

27.02.006/ 93/94 July 19,

1993 Annex Investment portfolio of

banks- Transaction in securities- Aggregate

contract limit for individual brokers-

Clarifications

Anne- xure II

Annexure – K

441



Subject Para no.


9 DBOD.No.FMC.BC.1/27.02.001/ 93-94

Jan 10, 1994

1 Investment portfolio of banks- Transaction in securities- Bouncing

of SGL transfer forms-Penalties to be

imposed.

1.2.2

10 DBOD.No.FMC.73/27.07.001/ 94-95

June 7, 1994

1,2 Acceptance of deposits under

Portfolio Management Scheme

1.3.3

11. DBOD.No.FSC.BC.130/24.76.002/ 94-95

Nov 15, 1994

1 Investment portfolio of banks- Transaction in

securities-Bank Receipts (BRs)

1.2.3

12. DBOD.No.FSC.BC.129/24.76.002/ 94-95

Nov 16, 1994

2 & 3 Investment portfolio of banks- Transaction in

securities-Role of brokers

1.2.6

13. DBOD.No.FSC.BC.142/24.76.002/ 94-95

Dec 9, 1994

1& 2 Do 1.2.6

14. DBOD.No.FSC.BC.70/24.76.002/ 95-96

June 8, 1996

2 Retailing of Government Securities

1.2.4

15. DBOD.No.FSC.BC.71/24.76.001/ 96

June 11, 1996


securities

1.2.2

16. DBOD.No.BC.153/24.76.002/96

Nov 29, 1996

1 Do 1.2.6

17. DBOD.BP.BC.9/21.04.048/98

29 Jan 1997

3 Prudential norms - capital adequacy,

income recognition, asset classification and provisioning.

5.1 (iii) & (iv)

18. DBOD.BP.BC.32/21.04.048/97

April 12, 1997

1&2 Do 5.1 (i) &(ii)

19. DBOD.FSC.BC.129/24.76.002-97

Oct 22, 1997

1 Retailing of Government Securities

1.2.4

20. DBOD.No.BC.112/24.76.002/1997

Oct 14, 1997


securities-Role of

1.2.6


442



Subject Para no.


brokers 21. DBOD.BP.BC.75/21.04.

048/98 4 Aug 1998

All Acquisition of Government and other approved securities -

Broken Period Interest, - Accounting

Procedure

5.2

22. DBS.CO.FMC.BC.1/22.53.014/98-99

July 7, 1999

1 Investment portfolio of banks – Transactions

in securities

1.3.1(i)

23. DBS.CO.FMC.BC.18/22.53.014/ 99-2000

Oct 28, 1999

2, 3, 4 & 5

Do 1.2.2

24. DBOD.No.FSC.BC.26/24.76.002/ 2000

Oct 6, 2000

2 Sale of Government securities allotted in

the auctions for Primary issues

1.2(i)(b)

25. DBOD.BP.BC.32/21.04.048/ 2000-01

Oct 16, 2000

All Guidelines on classification and

valuation of investments.

2 & 3

26 DBOD.FSC.BC.No.39/24.76.002/ 2000

Oct 25, 2000


securities-Role of brokers

1.2.6

27. Dir.BC.107/13.03.00/2000-01

April 19, 2001

6 Monetary and Credit Policy for the year

2000- 2002 - Interest

Rate Policy

5.3

28. DBOD.BP.BC.119/21.04.137/ 2000-2001

May 11, 2001

Annex - 5 &12

Bank financing of equities and

investments in shares - Revised guidelines

1.2, 1.2.5

1.3, 1.3.1

29. DBOD.BP.BC.127/21.04.048/ 2000- 01

June 7, 2001

All Non- SLR Investments of Banks

1.2.8 Annexure

III 30. DBOD.BP.BC.61/21.04.

048/ 2001-02 Jan 25,

2002 All Guidelines for

investments by banks/Fis and Guidelines for

financing of

1.2.8 (iv)

Annexure – K

443



Subject Para no.


restructured accounts by banks/FIs

31. DBOD.No.FSC.BC.113/24.76.002/ 2001- 02

June 7 2002

All On Investment Portfolio of Banks

Transaction in Govt. Securities

1.3.4

32. DBS.CO.FMC.BC.7/22.53.014/ 2002-03

Nov 7, 2002

Para 2 Operation of investment

portfolio by banks- submission of

concurrent audit reports by banks

1.2.7(c)

33. DBOD.No.FSC.BC.90/24.76.002/ 2002-03

March 31 2003

All Ready Forward Contracts

1.2.1(i), (ii) and

(iii) 34. IDMC.3810/11.08.10/20

02-03 March 24

2003 All Guidelines for uniform

accounting for Repo / Reverse

Repo transactions

4, Anne- xure VII &

Anne- xure VIII

35. DBOD.BP.BC.44/21.04.141/03-04

Nov 12, 2003

All Prudential guidelines on banks' investment in non-SLR securities

1.2.8

Annexure IV, V

36. DBOD.BP.BC.53/21.04.141/03-04

Dec 10, 2003

All do 1.2.8

37. DBOD.FSC.BC.59/24.76.002 /03-04

Dec 26, 2003

All Sale of Government securities allotted in

the auctions for primary issues on the

same day

Anne- xure

I C

38 IDMD.PDRS.05/10.02.01/ 2003-04

Mar 29, 2004

3, 4, 6 & 7

Transactions in Government Securities

1.2(i) (a)

39. IDMD.PDRS/4777/10.02.01/ 2004-05

May 11, 2005

3 Sale of securities allotted in primary

issues

1.2(i) (b)

40. IDMD.PDRS/4779/10.02.01/ 2004-05

May 11, 2005

2,3,4,5 Ready forward contracts

1.2.1 (b),

1.2.1 (c)


444



Subject Para no.


41. IDMD.PDRS/4783/10.02.01/ 2004-05

May 11, 2005

3 Government securities transactions - T+1

settlement

1.2(i) (c)

42. DBOD.FSC.BC.28/24.76.002/ 2004-05

Aug 12, 2004

2 Transactions in Government securities

1.2(i)(a)

43. DBOD.BP.BC. 29/21.04.141/ 2004-05

Aug 13, 2004

2(b) of Annex

Prudential norms - State Government

guaranteed exposures

3.5.2

44. DBOD.Dir.BC.32/13.07.05/ 2004-05

Aug 17, 2004

2 Dematerialisation of banks' investment in

equity

5.3

45. DBOD.BP.BC.37/21.04.141/ 2004-05

Sep 2, 2004

1(i) & (ii) Prudential norms on classification of

investment portfolio of banks

2.1 (ii) & (iii)

46. DBOD.FSD.BC.No.31/24.76.002/ 2005-06

Sep 1, 2005

2, 3 NDS-OM - Counterparty Confirmation

1.2.5 (i) (c)

47. DBOD.BP.BC.38/21.04.141/ 2005-06

Oct 10, 2005

All Capital Adequacy - Investment

Fluctuation Reserve

3.4

48. IDMD.No.03/11.01.01(B)/2005-06

Feb 28, 2006

2,3,4,5 Secondary Market transactions in Government

Securities- Intra day short selling

1.2 (i) (a)

49. IDMD.No.3426 /11.01.01 (D)/ 2005-06

May 3, 2006

All 'When Issued' transactions in Central

Government Securities'

1.2 (i) (a)

50 DBOD.No.BP.BC.27/21.01.002/2006-07

Aug 23, 2006

2, 4 Prudential guidelines – Bank’s investments

in VCF

3.9

51 IDMD.No.2130/11.01.01(D)/2006-07

Nov 16, 2006

All When Issued transactions in Central

Government Securities

1.2(i)(a)

52 DBOD.No.FSD.BC.46/24.01.028/2006-07

Dec 12, 2006

16B(ii) Financial Regulation of Systemically

Important NBFCs and Bank’s Relationship

1.3.3(i)

Annexure – K

445



Subject Para no.


with them 53 IDMD.No.

/11.01.01(B)/2006-07 Jan 31,

2007 All Secondary Market

transactions in Government

Securities- Short selling

1.2.(i)a

54 Mailbox Clarification July 11, 2007

All HTM Securities 3.1.(i)

55 DBOD.No.BP.BC.56/21.04.141/2007-08

December6, 2007

All Limits on investment in unrated Non-SLR

securities- infrastructure

bonds

1.2.7

56. DBOD.No.BP.BC.86/21.04.141/2007-08

May 22, 2008

All Valuation of securities 3.7.1

57. Mailbox Clarification February 6,2009

All Non-SLR Securities 1.2.12


All Unlisted Non-SLR Securities

1.2.13

59. Mailbox Clarification March 16,2009

All Classification of Securities

3.2


All Investment Portfolio of Banks

Annexure 1(c )(i)

treasury manageement

Documents

banks treasury functions

treasury functions of

banks treasury groups

treasury products

treasury management

treasury risks

growth of treasury function

field of treasury management