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Risk Management - Assignment #2


Toms TC No. 36

Reserve Bank of India has circulated a master circular detailing broad as well as specific guidelines for banks and financial institutions on their credit exposure limits for single/group borrower and capital markets. For this purpose credit exposure (both funded and non-funded) and investment exposure are within the scope. The banks should use current exposure method to compute their credit exposures arising out of interest rate and FX transaction and gold. Bilateral netting of Mark-To-Market (MTM) values arising on account of such derivative contracts cannot be permitted. Accordingly, banks should count their gross positive MTM value of such contracts for the purposes of capital adequacy as well as for exposure norms.

Credit Exposures to Individual/Group Borrowers

15% and 40% of capital funds (Tier 1 and Tier 2) are set as exposure ceiling limits for single borrower and borrower group respectively. It can exceed to 20% and 50% respectively on account that the extension of credit is for infrastructure projects. In exceptional cases it can be further increased by 5% if the borrower/borrower group consents to making appropriate disclosures in their annual reports. The banks need to make appropriate disclosures in their financial statements under Notes on Account in respect of these exposures. In case of oil companies a further increase of 5% (i.e., 25% for single borrower) of capital funds is allowed. Banks may consider fixing internal limits for their aggregate exposure to all NBFCs put together. The exposure (both lending and investment) should not exceed 10%/15% for NBFC/NBFC-AFC. Additionally 5% increment is allowed on account of funds on-lent to the infrastructure sector. For IFCs the limit is 15% and additional 5% on account of lending for infrastructure projects. The same norms are applicable to lending under consortium arrangements. Bills purchased/discounted/negotiated under LC (where the payment to the beneficiary is not made 'under reserve') will be treated as an exposure on the LC issuing bank and not on the borrower. In the case of negotiations 'under reserve' the exposure should be treated as on the borrower. The ceiling are exempted for the banks in case of lending to y Weak/sick industrial units under rehabilitation packages y Borrowers allocated food credit by RBI y Single/borrower group where principal and interest are fully guaranteed by GoI y Loans and advances (both funded and non-funded facilities) granted against the security of a banks own term deposits provided banks have a specific lien on such deposits. y To NABARD. Banks can decide on the size of exposure to NABARD

Credit Exposure to Industry and Certain Sectors

To evenly spread exposures to different sectors like textiles, banks may consider additionally fixing internal limits apart from those specified by RBI. A detailed board policy is required to set limits in unhedged portions of foreign currency loans (incl. ECBs) above $10mn with regard to all their clients including SMEs. Banks having large exposure should review this on a monthly basis using a suitable reporting system. The Board should frame comprehensive prudential norms relating to the ceiling on total amount of real estate loans. The appraisal process should take into account statutory/government permission, aspects relating to National Building Code, guidelines of National Disaster Management

Risk Management - Assignment #2

Toms TC No. 36

Authority. SEZs are considered as commercial real estate sector so that they are given appropriate risk weights. Banks must ensure that credit so extended must not be used for speculation in real estate. Where banks undertake leasing, hire-purchasing, factoring services departmentally, they should maintain a balanced portfolio vis--vis the aggregate credit. Their exposure to each of these activities should not exceed 10% of total advances. Exposure to Indian JVs and wholly owned subsidiaries (WOS) overseas is limited to 20% of banks unimpaired capital funds, but subjected to conditions, such as 51% holding, compliance with Sec 25 of BR act. The resource base for such lending should be funds held in foreign currency accounts. Maturity mismatches arising out of such transactions should be within the overall gap limits approved by RBI. Commercial viability and not the reputation of promoters must be given weightage; similar is the case with non-fund based funding. The government of WOS should have no restrictions related to obtaining foreign currency loans or for repatriation and should permit non-resident banks to have legal charge on securities/assets abroad and the right of disposal in case of need. Under the refinance scheme of EXIM Bank, the banks may sanction term loans on merits to eligible Indian promoters for acquisition of equity in overseas JVs/WOS, provided that the term loans have been approved by the EXIM Bank for refinance. Banks exposure to capital markets must include both direct and indirect exposures. Direct exposures would include investment in shares, convertible bonds and debentures, units of equity oriented MFs, secured and unsecured advances/guarantees to stockbrokers, financing stockbrokers for margin trading, exposures to VC funds. Indirect exposures would include advances against shares and other such securities which are taken as primary security, loans sanctioned to corporates on clean basis for meeting promoters contribution to the equity of new companies in anticipation of raising resources, bridge loans to companies against expected equity flows/issues, underwriting commitments taken up by the banks for IPOs. Banks issue Irrevocable Payment Commitments (IPCs) in favor of stock exchanges on behalf of domestic MFs/FIIs to facilitate the transactions done by these clients. Only those custodian banks would be permitted to issue IPCs who have a clause in the agreement with their clients which gives them an inalienable right over the securities to be received as payout in any settlement, except for cases where transactions are pre-funded and in case of FX deals the nostro account has been credited before the issuance of IPC by custodian banks. The maximum risk is decided upon as a percentage based on the no. of days after trade. The IPC will be treated as a financial guarantee with a Credit Conversion Factor (CCF) of 100. BR Act specifies 30% of paid up capital as upper limit of shareholding by banks in corporates as pledgee, mortgagee or absolute owner. This also includes shared held in demat form. The aggregate exposure of a bank (both solo and consolidated basis) to the capital markets in all forms (both fund based and nonfund based) should not exceed 40% of its net worth, and within this <=20% for investment in shares, convertible bonds / debentures, units of equity-oriented mutual funds and all exposures to Venture Capital Funds (VCFs) (both registered and unregistered). Certain items are excluded from capital market exposure such as banks investment in RRBs, own subsidiaries, CDSL etc., CDs of other banks, shares acquired by CDR mechanism. Banks direct investment should be calculated at their cost price. For computing the exposure to the capital markets, loans/advances sanctioned and guarantees issued for capital market operations would be reckoned with reference to sanctioned limits or outstanding, whichever is higher. Banks are free to decide on their intra-day exposures to capital markets.

Risk Management - Assignment #2

Toms TC No. 36

Financing of equities and investments in shares

Loans against securities are limited to 10 lakh per individual if held in physical form and 20 lakh for demat shares. Banks may grant advances to individuals for subscribing to IPOs/FPOs but they should not support collusive action by a large group of individuals belonging to the same corporate or their interconnected entities to take multiple loans in order to support particular scrips or stock-broking activities of the concerned firms. Banks may extend finance to employees for purchasing shares of their own companies under ESOPs/reserved by way of employees' quota under IPO to the extent of 90% of the purchase price of the shares or 20 lakh whichever is lower. Within the overall ceiling of 40% sub ceilings are decided for stockbrokers and market makers and to any single stock broking entity, including its associates/ inter-connected companies. Advances against units of MFs are also subjected to certain conditions, for e.g., amount linked to NAVs, completion of minimum lock in period. For bridge loans banks can lend for a <1 year period against expected equity flows/issues within the ceiling of 40% also banks exposures to VCFs will be deemed to be on par with equity. For disinvestment program by GoI, successful bidders will be extended finance. Banks should not undertake arbitrage operations themselves or extend credit facilities directly or indirectly to stockbrokers for arbitrage operations in Stock Exchanges. Lending for margin trading is subjected to stipulations such as minimum margin of 50% by the borrower.

Risk Management and Internal Control System

The banks should build up adequate expertise in equity research by establishing a dedicated equity research department and formulate transparent policy and procedure for investment in shares. The Investment Committee should be held accountable for all investments made by the bank. The exposure to stockbrokers should be diversified and their track record and credit worthiness must be checked. The audit committee does the surveillance and monitoring of investment of shares/advances against shares and informs the board on the overall exposure to capital market.

Valuation and Disclosure

Equity shares in a banks portfolio - as primary security or as collateral for advances or for issue of guarantees and as an investment - should be marked-to-market at least on weekly basis. Banks should disclose the total investments made in equity shares, convertible bonds and debentures and units of equity oriented MFs as also aggregate advances against shares in the Notes on Account to their balance sheets.

Cross holding of capital among banks/financial institutions

Banks/FIs holding in other banks and FIs via equity shares, preference shares, subordinated debt instruments, hybrid debt capital instruments, should not exceed 10% of the investing banks capital funds. Banks/FIs investments in the equity capital of subsidiaries are at present deducted from their Tier I capital and those not deducted attract 100% risk weight.

Banks exposure to commodity markets - Margin Requirements

A uniform margin of 50 per cent shall be applied on all advances/financing of IPOs/issue of guarantees on behalf of stockbrokers and market makers with a minimum cash margin of 25%. However this is not applicable to currency derivatives segment.

Limits on exposure to unsecured guarantees and unsecured advances

Risk Management - Assignment #2

Toms TC No. 36

Unsecured exposure is defined as an exposure where the realizable value of the security, as assessed by the bank/approved valuers/Reserve Banks inspecting officers, is not more than 10%, ab-initio, of the outstanding exposure. Exposure shall include all funded and non-funded exposures (including underwriting and similar commitments. Banks have to limit their commitment by way of unsecured guarantees in such a manner that 20% of the banks outstanding unsecured guarantees plus the total of outstanding unsecured advances do not exceed 15% of total outstanding advances. 'Safety Net' Schemes for Public Issues of Shares, Debentures, etc.
Banks and their subsidiaries were found to provide buy-back facilities suo motto, and apparently there was no undertaking in such cases from the issuers to buy the securities. They were advised not to take such exposures. If, at the request of the issuers, the banks or their subsidiaries find it necessary to provide additional facilities to small investors subscribing to new issues, such buy-back arrangements should not entail commitments to buy the securities at pre-determined prices. Prices should be determined from time to time, keeping in view the prevailing stock market prices for the securities. Commitments should also be limited to a moderate proportion of the total issue in terms of the amount and should not exceed 20% of the owned funds of the banks/their subsidiaries