Question Paper

Management of Financial Institutions – I (321): April 2005

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.
< Answer
1. Economies of scope means >
(a) Increase in profits that are available due to increased level of operations
(b) Increase in profits due to decrease in the level of operations
(c) Savings in costs due to changes in the composition of liabilities
(d) Savings in costs that result from engaging in complementary activities
(e) Increase in spread consequent to interest rate risk management.
< Answer
2. Reintermediation means >
(a) Increase in deposits experienced by banks due to merchant banking activities
(b) Increase in deposits experienced by banks due to increased net work of branches
(c) Loss of deposits by financial intermediaries because alternative types of indirect lending
become more attractive
(d) Loss of deposits by financial intermediaries because direct lending become more attractive
(e) Mobilization of deposits by introducing new schemes.
< Answer
3. The pricing strategy in which banks pay good interest but charge a low fee per transaction is referred >
to as
(a) Relationship pricing
(b) Implicit pricing
(c) Symmetric account
(d) Universal account
(e) Rebate strategy.
< Answer
4. DGap = Duration of assets – U× duration of liabilities where U is >
(a) Ratio of total assets to total liabilities
(b) Ratio of total liabilities to total assets
(c) Ratio of rate sensitive assets to rate sensitive liabilities
(d) Ratio of rate sensitive liabilities to rate sensitive assets
(e) Ratio of capital to risk weighted assets.
< Answer
5. Which of the following statements is / are true >
I. Tier II capital shall not exceed 50% of Tier I capital
II. Tier II capital shall not exceed 50% of total capital
III. Subordinated debt shall not exceed 50% of Tier I capital
(a) Both (I) and (II) above
(b) Both (II) and (III) above
(c) Both (I) and (III) above
(d) Only (I) above
(e) (I), (II) and (III) above.
 < Answer
6. Fiduciary risk refers to the risk of losses arising by undertaking >
(a) Trustee activities
(b) Merchant banking activities
(c) Project functioning
(d) Off balance sheet finances
(e) Agricultural financing.
< Answer
7. Which of the following are the approaches adopted to quantify interest rate risk >
I. Maturity gap method.
II. Rate adjusted gap.
III. Duration Analysis.
(a) Both (I) and (II) above
(b) Both (II) and (III) above
(c) Both (I) and (III) above
(d) Only (I) above
(e) (I), (II) and (III) above.
< Answer
8. A certificate of deposit with a face value of Rs.10,00,000 is issued at a discount price of Rs.9,70,874 >
with a term of 6 months. If the CRR is 4.5% and stamp duty is 0.125% per quarter. The cost to the
bank and yield to the investor respectively are (assume no interest is earned on CRR deposits)
(a) 6.5%; 3% (b) 6.5%; 6% (c) 6.78%; 6%
(d) 6.98%; 6% (e) 6.88%; 6%.
< Answer
9. Sovereign yield curve is drawn based on the >
(a) Current yield of the government securities
(b) Realized yield of the government securities
(c) Realized yield of all the securities available in the market
(d) Yield to maturities of the government securities
(e) Yield to maturities of all the securities.
< Answer
10. Which of the following is not included in the Tier-II capital of a NBFC? >
(a) Undisclosed reserve
(b) Revaluation reserve
(c) Capital reserve arising out of sale proceeds of assets
(d) General provision and loss reserve up to a maximum of 1.25% of the risk weighted assets
(e) Hybrid debt capital instruments.
< Answer
11. ABC Bank Ltd. has posted an operating profit of Rs.460 crore. The bank has made provision for >
taxes and other contingencies to the extent of Rs.120 crore. The minimum amount to be transferred
to statutory reserve as per section 17 of the Banking Regulation Act, 1949 is
(a) Rs.115 crore (b) Rs.145 crore (c) Rs.85 crore
(d) Rs.92 crore (e) Rs.116 crore.
< Answer
12. On 01.04.2004, ABC Bank bought 7.25% Central Government security maturing on 31.3.2005 at a >
price of Rs.98.50. The face value of the security is Rs.100. If the bank holds the security till
maturity, the realized yield from security is
(a) 7.25% (b) 8.75% (c) 8.77% (d) 8.88% (e)
8.99%.
< Answer
13. If a 91-day T-bill with a face value of Rs.100 is acquired in the auction at a yield of 9.50%, then the >
purchase price is
(a) Rs.91.30 (b) Rs.91.65 (c) Rs.97.58 (d) Rs.97.68 (e)
Rs.98.68.
 < Answer
14. Given the ROA (return on assets) is 4% non-performing assets is 8% of its book size and total assets >
is Rs.800 crore, tax rate is 30%. The ENPA level of the bank is
(a) 0.50% (b) 56.66% (c) 66.67% (d) 71.43% (e) 200%.
< Answer
15. If the market value of assets and liabilities are Rs.5,500 crore and Rs.4,400 crore respectively, >
duration of assets and liabilities are 2.4 and 1.8 respectively, then the immunizing asset duration is
(a) 1.44 (b) 1.92 (c) 2.25 (d) 3.00 (e) 3.44.
< Answer
16. Tendency of an insured person to take more risk, because they have insurance is known as >
(a) Composition problem (b) Externality
(c) Moral suasion (d) Moral hazard
(e) Morale hazard.
< Answer
17. In marine insurance, loss due to ‘jettison peril’ arises when >
(a) The goods are stolen
(b) The goods are lost in fire
(c) The goods are seized by pirates
(d) The goods are thrown off the ship by the captain in order to save the vessel and the crew
(e) The goods are fraudulent disposed by the captain of the ship.
< Answer
18. Which of the following is true regarding Ways and Means Advances (WMA)? >
(a) It is a permanent source of finance for the Government
(b) The limit for WMA is fixed by the Government
(c) The rate of interest for WMA is decided by the RBI
(d) If 50% of WMA is utilized, RBI will go for a fresh floatation of Government securities
(e) Any excess drawal over WMA limits would be permitted only for 10 consecutive working
days.
< Answer
19. An arrangement among the bankers to finance a borrower using common loan documentation is >
called
(a) Narrow banking (b) Forfaiting (c) Syndicated
credit
(d) Securitization (e) Takeout financing.
< Answer
20. The following data is extracted from the books of Janata Bank >
Head of account Rs. in crore
Interest income 400
Non-interest income 300
Interest expense 200
Non-interest expense 100
The overhead efficiency ratio of the bank is
(a) 1.00 (b) 1.33 (c) 2.00 (d) 3.00 (e) 3.50.
< Answer
21. Consider the following data >
Total loans given Rs.1600 crore
Average rate of loan 10%
Debt funds Rs.800 crore
Average cost of debt 8%
Servicing cost 1% total business
If the equity of the bank is Rs.400 crore, then return on the equity is
(a) 16% (b) 18% (c) 20% (d) 22% (e) 24%.
 < Answer
22. Deposits which are likely to be withdrawn during the planning tenure are categorized as >
(a) Float funds (b) Volatile funds (c) Vulnerable funds
(d) Stable funds (e) Owned funds.
< Answer
23. DICGC covers insurance of deposits accepted by >
I. Public and private sector banks
II. Foreign banks
III. Cooperative banks
IV. NBFCs
V. Companies
(a) Only (I) above (b) Both (I) and (II) above
(c) (I), (II) and (III) above (d) (I), (II), (III) and (IV) above
(e) (I), (II), (III), (IV) and (V) above.
< Answer
24. Which of the following is an approved security for SLR purpose >
(a) Municipal corporation bonds
(b) Bonds issued by National Thermal Power Corporation
(c) Kisan Vikas Patra
(d) Indira Vikas Patra
(e) Units of UTI.
< Answer
25. Which of the following is true with respect to valuation of permanent investments by banks? >
I. Permanent investments should be valued at cost
II. In case cost price is higher than the face value the premium should be accounted to income
account.
III. In case cost price is less than the face value the difference should be ignored and it should not
be taken to income account.
IV. Any gain on sale of securities in permanent category should be considered as profit in profit &
loss account.
(a) Both (I) and (II) above (b) Both (I) and (III) above
(c) Both (II) and (III) above (d) Both (II) and (IV) above
(e) Both (I) and (IV) above.
< Answer
26. Which of the following assets of a bank carry zero risk weight? >
(a) Investments in government securities
(b) Investments in bonds issued by other banks
(c) Balances held in current accounts of other banks
(d) Loans given to staff of the bank
(e) Investments in subordinated debt in the form of Tier-II capital bonds of other banks.
< Answer
27. The core functions of Credit Information Bureau are to >
I. Furnish credit information.
II. Provide short term credit to banks
III. Provide refinance to banks
IV. Maintain a data bank on borrowers from lending institutions
(a) Both (I) and (II) above (b) Both (I) and (III) above
(c) Both (I) and (IV) above (d) (I), (II) and (III) above
(e) (I), (II), (III) and (IV) above.
 < Answer
28. Which of the following mortgages involves transfer of an interest in specific immovable property by >
deposit of title deeds?
(a) Mortgage by conditional sale (b) Usufructory mortgage
(c) English mortgage (d) Equitable mortgage
(e) Anomalous mortgage.
< Answer
29. Which of the following alternatives relating to the ENPA is true? >
(a) As NPAs increase the ENPA will also increase
(b) Higher ENPA implies greater credit risk
(c) ENPA increases as the ROA increases
(d) Margin of safety decreases as the ENPA increases
(e) The graph that establishes the relation between ROA and ENPA shows a curve that is
downward sloping.
< Answer
30. M/s PGR Electronic has taken fire insurance policy for goods of value Rs.6 lakhs. The company has >
suffered a loss of 4 lakhs out of Rs.10 lakhs worth of stocks stored in the godown. How much
amount is payable by insurance company
(a) Rs.3.60 lakhs (b) Rs.2.40 lakhs (c) Rs.4 lakhs
(d) Rs.6 lakhs (e) Rs.10 lakhs.

END OF SECTION A
 Section B : Problems (50 Marks)
• This section consists of questions with serial number 1 – 5.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.

1. Consider the following details of Swastik Bank as on September 30, 2004:

(Rs. in crore)
Average Average
Liabilities Amount Interest Assets Amount Interest
(%) (%)
Capital and Reserves 1200 0 Cash in hand 200 0
Deposits 16600 5 Balance with RBI 800 0
Borrowing from RBI 900 7 Advances 12300 12
Other liabilities 800 0 Investments 5100 6.5
Fixed and 1100 0
other assets
19500 19500
You are required to
a. Compute the Rate Sensitive Gap
b. Compute the Rate Adjusted Gap for the bank, assuming the interest rates on various assets and liabilities
are likely to be as given below.

Deposits 5.50%

Borrowings 8.00%

Advances 13.00%

Investments 7.00%
c. With the following additional information assess the change
in the market value of the equity due to increase in interest rate by 1%

Duration of Assets 3 years

Duration of liabilities 2 years

Current interest rate 10%

d. How Swastik Bank can protect the market value of
the equity? Explain.
(2 + 3 + 3 + 4 = 12 marks) < Answer >
2. The following data pertains to Janata Bank as at March 31, 2005
 Amount (Rs. in Cr.)
Total Assets 7,500
Risk weighted assets 6,000
Capital 750
The return on assets as at the end of March 31, 2006 is expected to be 1.50%.
If the addition to assets during the year is expected to be at Rs.1500 cr.
a. What is the maximum addition to the risk weighted assets if the existing CAR is to be maintained.
b. If the incremental funds are subjected to CRR and SLR at 4.5% and 25% respectively, what is the minimum
addition to Risk weighted assets on account of off-balance sheet items, if the targeted CAR for the year
March 31, 2006 is 12%? Assume that incremental funds deployed carry 100% risk weight.
(4 + 6 = 10 marks) < Answer >
3. The following information relates to the assets of Ideal Bank Ltd. as at the end of March 31, 2004

Particulars Amount in Estimates

Rs. in Cr. Up grade Down grade
Standard assets 6,200 – 2%
Sub standard assets 600 5% 6%
Doubtful assets
- Up to 1 year 500 10% 5%
- 1-3 years 400 5 10%
- More than 3 years 300 10% 5%
Loss assets 50 20% – Note that all the assets
excluding loss assets are secured to the extend of 100%. The additional credit extended during the year is
estimated at Rs.1,100 cr. out of which 95% will remain as standard asset and rest will be sub-standard. You are
required to:
a. Compute the incremental provisioning required for the year ending March 31, 2005.
b. Compute the Gross NPA/Gross Advances and Net NPA / Net advances for both the years and comment.
c. Compute the ENPA for the year ending March 31, 2005, if the ENPA for the year ending March 31, 2004 was
80% and the profit before tax is expected to grow by 30%.
(6 + 3 + 3 = 12 marks) < Answer >
4. The treasurer of Best Bank proposes to manage the liquidity position of the bank during the second quarter of
2004-05 by choosing a proper investment policy to earn more income without sacrificing the liquidity. He has
finalized the following forecast for the six fortnights during the quarter.
Fortnight Inflow Outflow
Rs. in Cr. Rs. in Cr.
1 840 720
2 960 770
3 710 810
4 660 650
5 700 730
6 890 980 The treasurer has collected the following information on the yields
that can be expected on investments for different periods.
 Period (Days) Yield (%)
15 4.50
30 4.60
45 4.75
60 4.80
75 4.90
90 5.00 You are required to
a. Comment on the liquidity position of the bank based on the above forecast.
b. Calculate the interest earned if the bank follows:
i. Short-term investment policy assuming investment horizon of maximum 2 fortnights.
ii. Long-term investment policy.
(3 + 7 = 10 marks) < Answer >
5. The following data pertains to a prime borrower who is sanctioned a loan of Rs.200 lacs.
Contracted rate : 12%
Probability of default : 0.10
Recovery rate of principal : 95%
Loan term : 3 years
If the current prime rate is 10.5%, what is the expected two year prime rate after 1 year.
In case of default, it is assumed that the entire interest is foregone.
(6 marks) < Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 6 - 7.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on section C.

6. Liquidity risk can be managed by using both fundamental and technical approaches. Explain both the approaches
and state how they can supplement each other.
(10 marks) < Answer >
7. The primary activity of banks is lending and loan pricing has an implication on the profitability and the sustenance
of the bank. Explain the various methods of loan pricing.
(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER

 Suggested Answers
Management of Financial Institutions – I (321): April
2005
Section A : Basic Concepts
1. Answer : (d) < TOP >

Reason : Economies of scope means savings in costs that result from engaging in complementary
activities.
2. Answer : (c) < TOP >

Reason : Reintermediation means loss of deposits by financial intermediaries because alternative types of
indirect lending become more attractive.
3. Answer : (d) < TOP >

Reason : The pricing strategy in which banks pay good interest but charges a low fee per transaction is
referred to as universal account
4. Answer : (b) < TOP >

Reason : DGap = Duration of assets – Ux duration of liabilities where U is Ratio of total liabilities to total
assets.
5. Answer : (b) < TOP >

Reason : Tier II capital shall not exceed 50% of total capital and Subordinated debt shall not exceed 50%
of Tier I capital.
6. Answer : (d) < TOP >

Reason : Fiduciary risk refers to the risk of losses arising by undertaking off balance sheet finances.

7. Answer : (e) < TOP >

Reason : Maturity gap method, Rate adjusted gap and Duration Analysis are the approaches adopted to
quantify interest rate risk
8. Answer : (c) < TOP >

10, 00, 000 − 9, 70, 874 12

× ×100
9, 70, 874 6
Reason : Yield to investor =
= 6%
10, 00, 000 − 9, 70, 874 12
× ×100 + 0.125 × 4
9, 70, 874 (0.955) 6
Cost to bank =
= 6.78%.
9. Answer : (d) < TOP >

Reason : Sovereign yield curve is drawn based on the yield to maturities of the government securities.

10. Answer : (c) < TOP >

Reason : Capital reserve arising out of sale proceeds of assets is not included in the Tier-II capital of a
NBFC
11. Answer : (c) < TOP >

Reason : The minimum amount to be transferred to statutory reserve as per section 17 of the Banking
Regulation Act, 1949 is Rs.85 crore. (25% of the net profit of Rs. 340 cr.)
12. Answer : (d) < TOP >

100 −98.50 + 7.25

= 8.88%
98.50
Reason : Realised yield =
13. Answer : (d) < TOP >

Reason : Let X = Purchase price

100 − x 365
× = 0.0950
x 91

or x = Rs.97.68.
14. Answer : (d) < TOP >

PAT /(1 − t)
NPA
Reason : ENPA =
32 / 0.70
0.08 × 800
=
= 71.43%
15. Answer : (a) < TOP >

L
A
Reason : Immunizing asset duration (DAZ) = DL x
 4400 
 
 5500 
1.8 x
= 1.44.
16. Answer : (e) < TOP >

Reason : Tendency of an insured person to take more risk, because they have insurance is known as Morale
hazard.
17. Answer : (d) < TOP >

Reason : In marine insurance, loss due to ‘jettison peril’ arises when the goods are thrown off the ship by
the captain in order to save the vessel and the crew.
18. Answer : (e) < TOP >

Reason : Any excess drawal over WMA limits would be permitted only for 10 consecutive working days is
true regarding Ways and Means Advances (WMA)
19. Answer : (c) < TOP >

Reason : It is called syndicated credit.

(a) Narrow banking means a bank with interests in government securities only.
(b) Forfaiting means financing of export receivables, which are maturing in the medium and
long term.
(d) The process of pooling and repackaging of homogeneous illiquid loans into marketable
securities and issuing to the investors through the capital markets is called securitization.
(e) Takeout financing is an arrangement where the institution / bank financing the infrastructure
projects will have an arrangement with any financial institution for transferring their
outstanding in respect of such financing, to latter books on a predetermined basis.
 Hence, the correct answer is (c).
20. Answer : (d) < TOP >

Non − int erest income

Non − int erest exp ense
Reason : The overhead efficiency ratio of the bank is =
= 300/100
= 3.
< TOP >
21. Answer : (b)
Reason : If the equity of the bank is Rs.400 crore, then return on the equity =

1600  0.10  (800  0.08  2400  0.01)

400
= 18%
< TOP >
22. Answer : (c)
Reason : Deposits which are likely to be with drawn during the planning tenure are categorized as
Vulnerable funds.
23. Answer : (c) < TOP >

Reason : DICGC covers insurance of deposits accepted by Public and private sector banks, Foreign banks
and Cooperative banks.
24. Answer : (a) < TOP >

Reason : Municipal Corporation Bonds is not an approved security for SLR purpose.
25. Answer : (b) < TOP >

Reason : Permanent investments should be valued at cost, In case cost price is less than the face value the
difference between should be ignored and it should not be taken to income account is true
26. Answer : (d) < TOP >

Reason : Loans given to staff of the bank carry zero risk weight
27. Answer : (c) < TOP >

Reason : The core functions of Credit Information Bureau are Furnish credit information and Provide
reference to banks
28. Answer : (d) < TOP >

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

29. Answer : (c) < TOP >

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

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

Sum insured = 6 lakhs
Amount of loss due to fire accident = 4 lakhs
Sum insured × Amount of loss
Value at the time of loss
Amount payable =
Rs.6 lakhs × Rs.4 lakhs
Rs.10 lakhs
=
= Rs.2.40 lakhs.
 Section B : Problems
1. a. Rate Sensitive Gap = Rate Sensitive Assets – Rate Sensitive Liabilities
Rate Sensitive Assets = 12300 + 5100
= Rs. 17400 cr
Rate Sensitive Liabilities = 16600 + 900
= Rs. 17500 cr
Rate Sensitive Gap = 17400 – 17500
= – 100 cr
b. Rate Adjusted Gap = Rate Adjusted Assets – Rate Adjusted Liabilities
Rate Adjusted Assets:
Advances = 12300 x 1 = 12300
Investments = 5100 x 0.5 = 2550
Total Rs. 14850 cr.
Rate Adjusted Liabilities:
Deposits = 16600 x 0.5 = 8300
Borrowings = 900 x 1.0 900
Total Rs. 9200 cr.
Rate Adjusted Gap = 14850 – 9250
= Rs. 5600 crore

c. Change in the market value of assets =

=
= – 531.82 crore
New market value of assets = 19500 – 531.82
= Rs. 18968.18 crores
Similarly the change in market value of liabilities can be computed with the above formula

Change in the market value of liabilities =

= – 332.73 core
New market value of the liabilities = 18300 – 332.73
= Rs.17967.27 cr
New market value of the equity with the current rate = 18968.18 – 17967.27
= Rs. 1000.91 crore.
Change in market value of equity = 1200 – 1000.91
 (Decrease by) = Rs. 199.09 crore
d. In order to protect the market value of the equity, the bank has to adjust the duration of either the
assets or liabilities.
The market value of the equity is protected by adjusting the duration of assets

Duration of assets = Duration of liabilities ×

=2 ×
= 1.877 years

Change in the market value of assets =

= – 332.74 crore
New market value of the assets = 19500 – 332.74
= Rs. 19167.26 crores

Change in the market value of the liabilities =

= Rs. 332.73 crore
New market value of the liabilities = 18300 – 332.73
= Rs. 17967.27 crore
New market value of equity at current rate = 19167.26 – 17967.27
= Rs.1199.99 crore
Hence by adjusting the duration of assets from 3 years to 1.88 years, the market value of the
equity can be protected.
< TOP >

2. a. Existing CAR = = 12.50%

Return on assets = 0.015 × (7,500 + 1,500) = Rs.135 cr.
Capital at the end of March 31, 2006 = 750 + 135 = Rs.885 cr.

Risk weighted assets at 12.50% CAR = = Rs.7,080 cr.

Addition to Risk Weighted Assets = Rs.7,080 – 6,000 = Rs.1,080 cr.
b. Incremental funds = 1,500
CRR at 4.5% = 67.50
SLR at 25% = 375.00
Balance that can be deployed = 1,057.50
If the targeted CAR is 12% then the risk weighted assets at the end of March 31, 2006

= = Rs.7,375 cr.
Additional Risk Weighted Assets = Rs.7,375 – (Rs.6,000 + Rs.375 × 0.025) = Rs.1,365.63 cr.
(Note CRR carries zero risk weight and SLR investment carries 2.5% risk weight)
 Additions on account of off Balance sheet items to Risk Weighted Assets
= 1,365.63 – 1,057.50 = Rs.308.13 cr.
< TOP >
3. a. Provisioning done for the year ended March 31, 2004
Amount provided
Nature of asset Provisioning
Rs. in Cr.
Standard Assets 6,200 × 15.50
0.0025
Sub standard Assets 600 × 0.10 60.00
Doubtful Assets
- up to 1 year 500 × 0.20 100.00
- 1 to 3 years 400 × 0.30 120.00
- Above 3 years 300 × 0.50 150.00
Loss assets 50 × 1.00 50.00
Total 495.50
Provisioning for the year ended March 31, 2005 would be
Amount provided
Nature of asset Provisioning
Rs.in Cr.
Standard assets 6,200 + 1,100 × 0.95 – 124 + 30 = 7,151 × 0.0025 17.88
Sub standard assets 600 + 1,100 × 0.05 + 124 + 50 – 30 – 36 = 763 × 76.30
0.10
Doubtful assets
- up to 1 year 500 + 36 + 20 – 50 – 25 = 481 × 0.20 96.20
- 1 to 3 years 400 + 25 + 30 – 20 – 40 = 395 × 0.30 118.50
- Above 3 years 300 + 10 + 40 – 30 – 15 = 305 × 0.50 152.50
Loss assets 50 + 15 – 10 = 55 × 1.00 55.00
Total 516.38
Incremental provisioning required for the year ended March 31, 2005 = 516.38 – 495.50 =
Rs.20.88 crore.
b.
Particulars March 31, March 31, 05
04
Gross NPA (i) 1,850 1999
Less provisions (ii) 495.50 516.38
Net NPAs (i – ii) = A 1,354.50 1,482.62
Gross Advances (iii) 8,050 9,150
Net Advances (iii – ii) = B 7,554.50 8,633.62
Net NPAs/Net Advances 17.93% 17.17%
Gross NPAs/Gross Advances 22.98% 21.85%
 Comments: Both the ratios namely gross NPAs to gross advances and Net NPAs to Net advances
have declined. This is due to increase in advance by Rs.1,100 crore during the year. There is an
absolute increase in gross NPAs and net NPAs in the current year.

ENPA =
For March 31, 2004 ENPA = 80%

0.80 =
PBT = Rs.1,083.60 as on 31.03.2004
For March 31, 2005 PBT = 1,083.60 × 1.30 = Rs.1,408.68

ENPA for March 31, 2005 = = 95.01%

< TOP >

4. a.
Fortnight Inflow Outflow Net flow Cumulative cash flow
1 840 720 120 120
2 960 770 190 310
3 710 810 -100 210
4 660 650 10 220
5 700 730 -30 190
6 890 980 -90 100
The liquidity position of the bank is comfortable as the cumulative position is in surplus for all
the periods.

b. i. We require Rs.100 crore in the third fortnight which can be met from the second fortnights
surplus. So Rs. 120 crore surplus of first fortnight can be invested two fortnights and Rs.
90 crore after adjusting for the requirement of third fortnight can be invested for two
fortnights.
In the fifth fortnight we require Rs.30 crore which can be met from the Rs.10 crore surplus
in the fourth fortnight plus Rs.120 crore investment matured during the month. Balance of
Rs.100 crore can be invested for the remaining two fortnights.
In the sixth fortnight we require Rs.90 crore which will be met from the investment of
Rs.90 crore matured during the fortnight. So the investment schedule is as follows:
Rs. 120 cr. for 2 fortnights
Rs. 90 cr. for 2 fortnights
Rs. 100 cr. for 2 fortnights
The rupee yield for short term investment plant is

(120 + 90 + 100) x 0.0460 x = Rs.1.1883 cr.

ii. We require Rs.100 cr. in the third fortnight which can be met from the surplus of Rs.190 cr.
in the second fortnight.
We require Rs. 30 cr. in the fifth quarter which can also be met from the surplus of the
second fortnight. We need to arrange Rs. 90 cr. for the sixth fortnight. Rs. 60 cr. surplus is
available from second fortnight, Rs. 10 cr. surplus we can provide from fourth fortnight.
 The rest of Rs. 20 cr. we will meet from the surplus of the first fornight. So the investment
schedule is as follows:
Rs. 100 cr. (120-20) for 5 fortnights
Rs. 20 cr. for 4 fortnights
Rs. 30 cr. for 2 fortnights
Rs. 60 cr. for 3 fortnights
Rs. 10 cr. for 1 fortnight.

100 x 0.049 x + 20 x 0.048 x 30 x 0.046 x 60 x 0.0475 x 10 x 0.045 x

= Rs. 1.6708 Cr.

It is better to follow long-term investment policy to earn more income.
< TOP >
5. Expected return = P1 (r) + P2 (R – 1)
Where P2 = Probability of defau

R = Recovery rate
E(r) = 0.12 x 0.90 + 0.10 (0.95 – 1.00)
= 10.3%
year prime rate
‘x’ be the two years prime rate after 1 year
103)3 = (1.105) (1 + x)2
Section C: Applied Theory
6. Fundamental Approach
Thestenance is the driving factor in this approach, the financial institution tries to tackle/eliminate the
liquidity risk in the long run by basically controlling its asset/liability position. A prudent way of tackling
this situation can be by adjusting the maturity of assets and liabilities or by diversifying and broadening the
sources of funds.
The two alternatives available to control the liquidity exposure under this approach are Asset Management
and Liability Management.
Asset Management: Asset Management aims to eliminate liquidity risk by holding near cash assets i.e.
those assets which can be turned into cash whenever required. For instance, sale of securities from the
investment portfolio can raise liquidity.
When asset management is resorted to, the liquidity requirements are generally met from primary and
secondary reserves. Primary reserves refer to cash assets held to meet the statutory cash reserve
requirements and other operating purposes. Though primary reserves do not serve the purpose of liquidity
management for long period, they can be held as second line of defense against daily demands for cash.
This is possible mainly due to the flexibility in the cash reserve balances (statutory cash reserves/liquidity
reserves are required to be satisfied only on a daily average basis for a reserve maintenance period).
Liability Management: Converse to the asset management strategy is liability management which focuses
on the sources of funds. Here the financial institution does not maintain any surplus funds, but tries to
achieve the required liquidity by borrowing funds when the need arises. The underlying implications of this
process will be that the financial institution mostly will be investing in long-term securities/loans (since the
surplus balance will be kept nil) and further, it will not depend on its liquidity position/surplus balance for
credit accomodation/business proposals. Thus in liability management, a proposal may be passed even
when there is no surplus balance since the financial institution intends to raise the required funds from
external sources.
two strategies available in fundamental approach, it is understood that while asset management tries to
answer the basic question of how to deploy the surplus funds to eliminate liquidity risk, liability
management tries to achieve the same by mobilizing additional funds.
Technical Approach
Technical approach focuses on the liquidity position of the financial institution in the short run. Liquidity in
the short run is primarily linked to the cash flows arising due to the operational transactions. Thus, when
technical approach is adopted to eliminate liquidity risk, it is the cash flows position that needs to be
tackled. The financial institution should know its cash requirements and the cash inflows and adjust these
two to ensure a safe level for its liquidity position. Working funds approach and the cash flows approach
are two methods to assess the liquidity position in the short run.
rking Funds Approach: Under this approach, liquiditiy position is assessed based on the quantum of
working funds available to the financial institution. Since working funds reflect the total resources available
with the financial institution to execute its business operations, the amount of liquidity is given as a
percentage to the total working funds. The financial institution can arrive at this percentage based on its
historical performance. This approach of forecasting liquidity requirement takes a broad overview of the
liquidity position since the working funds are taken as a consolidated figure.
Instead of a consolidated approach, the financial institution can have a segment-wise break-up of the
working funds to arrive at the percentage for maintaining liquidity. The working funds comprises of owned
funds, deposits and float funds. Based on the position of these funds, the financial institution will have to
invest/borrow the surplus/deficit balances to adjust the liquidity position. In this approach, the financial
institution will have to assess the liquidity requirements for each of the components of working funds.
Cash Flows Approach: This method of forecasting liquidity tries to eliminate the drawback faced in the
Working Funds approach by forecasting the potential increase/decrease in deposits/credit accommodation.
To tackle such a situation, trend can be established based on historical data about the change in the deposits
and loans.planninf a financial institution may be a financial year or a part of it i.e. a few months to a
quarter/half-year period. The financial institution should ensure that the planning horizon for estimating the
liquidity position should neither be too long nor too short if the benefits of forecasting have to be
reaped.The fundamental approach is useful as a long-term measure whereas technical approach is useful as
a short-term measure. Thus both the approaches need to be used together to obtain optimal results.
< TOP >
7. The various methods of loan pricing are:
Prime rate based loan pricing
Customer profitablity analysis based pricing
Loan pricing incorporating deposit balances.
i. Cost plus method of loan pricing: In this method of pricing, the required margin is added to the sum
of costs of various sources of funds and operating expenses, to arrive at the interest to be changed on the loan.
Interest rate on loan = Cost of funds + Non-fund bank operating costs + Risk margins
+ Profit margin of the bank.
In the above equation, the term `cost of funds’ may be separated as `return on equity’ and `cost of debt
funds’ to enable the bank to check whether the loan in question meets the target ROE or not.
ii. Prime rate based loan pricing: The prime lending rate is the rate charged to the best
borrower, who is supposed to be risk free, for a short term loan, say of ninety days. In this
method of pricing, the rate of interest to be charged to a customer is decided based on the
prime rate, by adding suitable premium to the prime rate. The premium is decided depending
on the term for which funds are required by the borrower and his risk level.
iii. Interest rate on the loan= Prime rate + default risk premium + Term risk premium
iii. Customer profitability analysis based pricing: In this method of pricing, income and expenses
of each o the services rendered to each individual customer is broken up and analysed, to indicate the
incremental profit from each individual service. The price of the loan to be given to that customer is then
based on the total customer profitability, taking into account the return requirements of the bank.
Hence, net rate of return from the customer is obtained by using the formula:

iv. Loan pricing incorporating deposit balances: In this method, deposit balances kept by the
customer with the bank are also taken into account while calculating the net loaned funds. The return
required by the bank is calculated only on the net loaned funds. Through it appears logical, the pitfall in this
methods is that the deposit balances may not be kept by the customer at the expected level through out, and
the relationship may turn out to be unprofitable.

Recovery rate

E(r)

0.12 x 0.90 + 0.10

10.3%
10.3% is 3 year prime r
10.5% is 1 year prime r
If ‘x’ be the two years p
(1.103)3 = (1.105) (1 +
X = 10.20 %

6.

Fundamental Approa
The long run sustenan
tries to tackle/eliminat
asset/liability position.
maturity of assets and l
The two alternatives av
Asset Management and
Asset Management: A
cash assets i.e. those
instance, sale of securit
When asset manageme
primary and secondary
statutory cash reserve
reserves do not serve t
held as second line of
due to the flexibility
reserves are required
maintenance period).
Liability Managemen
management which foc
not maintain any surpl
funds when the need a
financial institution m
surplus balance will
position/surplus balanc
management, a propos
financial institution inte
Of the two strategies av
management tries to a
eliminate liquidity risk
additional funds.
Technical Approach
Technical approach fo
short run. Liquidity in
the operational transac
liquidity risk, it is th
institution should know
to ensure a safe level
flows approach are two
Working Funds Appr
on the quantum of wo
funds reflect the total
business operations, th
funds. The financial i
performance. This appr
of the liquidity position
Instead of a consolida
break-up of the workin
working funds compr
position of these fun
surplus/deficit balance
institution will have to
working funds.
Cash Flows Approac
drawback faced in
increase/decrease in de
be established based on
The planning horizon o
a few months to a qua
the planning horizon fo
too short if the benefit
useful as a long-term
measure. Thus both the

7.
The various methods o
• Prime rate based l
• Customer profitab
• Loan pricing inco

i.

Cost plus m
margin is ad
operating exp

Interest rate on loan =

margins

+ Profit margin of the b

In the abov
`return on e
whether the

ii.

Prime rate
charged to th
term loan, s
interest to b
by adding su
 depending o
his risk level

Interest

= Prime rate + default r

iii.

Customer p
pricing, inco
individual c
incremental
be given t
profitability,

Hence, net rate of retur

iv.

Loan pricin
balances kep
while calcul
is calculated
the pitfall in
the customer
turn out to b