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JNANA VARDHINI
SIBSTC MONTHLY NEWSLETTER -COVERING
CONTEMPORARY BANKING RELATED TOPICS
30TH ISSUE
JANUARY - 2013
SOUTHERN INDIA BANKS’ STAFF
TRAINING COLLEGE
No.531, Faiz Avenue, 11th Main, 32nd Cross
IV Block, Jayanagar, BANGALORE-560 011
Website: www.sibstc.edu.in
Email:
[email protected]
[email protected]
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Third Quarter Review of Monetary Policy 2012-13 Announced
by RBI on 29th Jan 2013
Monetary Policy Stance
The policy document spells out the three broad contours of our monetary policy stance.
These are:
1.
To provide an appropriate interest rate environment to support growth as inflation
risks moderate;
2.
To contain inflation and anchor inflation expectations; and
3.
To continue to manage liquidity to ensure adequate flow of credit to the
productive sectors of the economy.
Guidance
With headline inflation likely to have peaked and non-food manufactured products
inflation declining steadily over the last few months, there is an increasing likelihood that
going into 2013-14, inflation will remain range-bound around the current levels.
Expected Outcomes of policy initiatives:
1.
Investment will be encouraged, thereby supporting growth;
2.
Medium-term inflation expectations will remain anchored on the basis of a
credible commitment to low and stable inflation;
3.
There will be an improvement in liquidity conditions to support credit flow.
Global Economy
In the US, activity gathered momentum in the third quarter of 2012 but this is unlikely to
have been sustained in the fourth quarter. While a political consensus to avert the ‘fiscal
cliff’ has calmed financial markets, how the debt ceiling is managed will be crucial in
shaping the market sentiment on the way forward. The euro area economy is threatened
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by continuing contraction, notwithstanding the liquidity firewall of the European Central
Bank (ECB) and the EU’s commitment to act collectively to backstop the union. Overall,
however, apprehensions that the sovereign debt crisis will disrupt the global financial
system have ebbed.
A pick-up in the pace of growth of China is likely. But growth in other emerging and
developing economies has slowed owing to a combination of a slump in external demand
and domestic structural bottlenecks. Furthermore, inflationary pressures persist in some
of them. Overall, global economic prospects have improved modestly since the RBI’s last
review in October 2012 even as significant risks remain.
Indian Economy
GDP growth has slowed significantly this year, dropping to 5.5 per cent in the first
quarter, and dropping even further to 5.3 per cent in the second quarter. The decline in
the GDP growth rate became more broad based, with consumption demand also slowing
alongside stalling investment and declining exports. While the series of recent policy
initiatives by the Government has boosted market sentiment, it will take some time to
reverse the investment slowdown and reinvigorate growth.
Accordingly, RBI has revised downwards the baseline projection of GDP growth for the
current year from 5.8 per cent to 5.5 per cent.
Inflation
Headline WPI inflation eased significantly from 8.1 per cent in September 2012 to 7.2
per cent by December. Notably, inflation on account of non-food manufactured products,
which have a weight of 55 per cent in the WPI, fell sharply in November-December as
input price pressures eased. The momentum indicators too suggest a moderation in
headline as well as non-food manufactured products inflation. Fuel group inflation
moderated in December, mainly reflecting the tempering of inflation of non-administered
petroleum products as well as the range-bound exchange rate of the rupee.
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Food inflation, on the other hand, showed a contrarian behavior, moving into double
digits in December, reflecting both cyclical and structural factors.
In contrast to WPI inflation, CPI inflation as measured by the new consumer price index,
rose to 10.6 per cent in December, largely reflecting the surge in food inflation.
Excluding food and fuel groups, CPI inflation remained unchanged at 8.4 per cent during
the third quarter.
Keeping in view the expected moderation in non-food manufactured products inflation,
domestic supply-demand balances and global trends in commodity prices, RBI has
revised downwards the baseline WPI inflation projection for March 2013 from 7.5 per
cent to 6.8 per cent.
Monetary Policies:
Based on an assessment of the current macroeconomic situation, RBI has decided to
reduce the repo rate under the liquidity adjustment facility (LAF) by 25 basis points from
8.0 per cent to 7.75 per cent. Consequent to this, the reverse repo rate determined with a
spread of 100 basis points below the repo rate, gets calibrated to 6.75 %. Similarly, the
marginal standing facility (MSF) rate, determined with a spread of 100 basis points above
the repo rate, and also the Bank Rate stand adjusted to 8.75 per cent.
CRR: CRR of scheduled banks is reduced by 25 basis points from 4.25% to 4.0 per cent
of their net demand and time liabilities (NDTL) effective the fortnight beginning
February 9, 2013
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ASSET LIABILITY MANAGEMENT (cont…d from previous issue)
Why Asset-Liability Management is important?
With the deregulation of interest rates, crystallization of exchange rate system,
development of secondary markets for bonds and deepening and widening of financial
system, banks are exposed to interest rates risk, liquidity risk, exchange rate risk etc.
Asset Liability management deals with these risk management measures which are very
much essential for mitigating these risks. Asset Liability Management outlays a
comprehensive and dynamic framework for measuring, monitoring and managing various
risks.
What is the scope of ALM Function?
The scope of ALM function is the following:

Liquidity risk management

Management of market risk

Trading risk management

Funding and capital planning

Profit planning and growth projection.
What are Rate Sensitive Assets and Liabilities?
An Asset or Liability is said to be rate sensitive if:
 Within the time interval under consideration, there is a cash flow;
 The interest rate resets contractually during the interval
 RBI changes the interest rate( interest rate on SB, CRR balance etc. in cases
where the interest rate are administered)
 It is contractually pre payable or withdrawable before the stated maturities.
What is Liquidity Risk?
Liquidity risk is the risk of not meeting the maturing liabilities due to insufficient liquid
assets. Liquidity Risk in turns consists of Funding Risk, Time Risk and call risk.
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 Funding Risk: It is the need to replace the net outflows due to unanticipated
incidents like premature closure or non-renewal of deposits.
 Time Risk: It is the need to compensate for the non-receipt of expected inflows.
For example performing assets turning to Non –performing assets, or delay in the
payment of anticipated inflows.
 Call Risk: Call risk occurs due to the crystallization of the contingent liabilities
and the inability to take up the profitable ventures when desired.
How is Liquidity Measured?
Liquidity is measured through structural liquidity statement. Liquidity is tracked by
classifying outflows and inflows into various time buckets mentioned above based on the
residual maturity. The total of assets as well as that of liabilities maturing in each time
bucket is calculated. The mismatch between the maturing assets and liabilities in each
time bucket is calculated. Cumulative mismatch is also calculated for the maturing assets
and liabilities.
Mismatches as a percentage to total outflows is calculated. Outflows are given more
importance as to know how much surplus is there than the required outflows. Tolerance
level is fixed for the mismatches as a percentage to total outflows. The mismatch is
continuously monitored for any instance of breach. The mismatches in the first two time
buckets are more important as it gives warning signal about forthcoming liquidity
problem. RBI is very specific in its policy that the mismatch in the first two time buckets
shall not exceed -20 %.
Tolerance level is set for the cumulative mismatches as a percentage to total outflows.
Cumulative mismatch is more important as it denotes the actual surplus or deficit
position.
Liquidity is also monitored through the calculation of Liquidity ratios. The Liquidity
ratios used for the liquidity management are:
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Core Deposits vis-a-vis core assets
The core deposits to core assets ratio indicates the long term asset liability position. The
core deposits are those deposits that are with the bank for long time and act as long term
source of funds. Core assets mean the assets that are receivable in long term.
Liquid assets vis-à-vis short term liabilities.
Liquid assets are those assets that can be quickly converted to cash. Short term liabilities
are those liabilities that are going to mature in short term. This ratio is important because
we require liquid assets to fund the short term liabilities.
Purchased funds vis-a–vis liquid assets.
Purchased funds include the bulk deposits of above Rs.10 crore that is contracted for a
higher interest rate. Liquid asset consists of assets that can be converted into cash very
quickly.
Commitment ratio
The commitment ratio is the ratio of total of Line of credit committed and LCs and
Guarantees to the total advances.
What is interest rate risk?
Interest Rate Risk is the risk of change in the earnings and economic value of equity of
bank to the interest rate fluctuations. Like liquidity risk, there are different types of
interest rate risk:
 Gap/Mismatch Risk: It is the risk arising due to the difference in the maturity or
amount or re-pricing date of assets and liabilities, thereby creating exposure to
unexpected interest rate fluctuations.
 Basis Risk: Basis risk is the risk due to the increase in the interest rates of assets
and liabilities in different magnitude.
 Embedded options risk: Embedded options risk consists of premature closure of
deposits before their maturity and prepayment of loans and advances. Premature
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closure of term deposits necessitate the immediate requirement of funds whereas
the prepayment may leads to deployment of funds at a lower rate.
 Reinvestment Risk: The reinvestment risk is the risk of deploying the
intermediate cash flows from an asset at a lower rate resulting in lesser income.
Liquidity Management
The Structural Liquidity Statement is prepared on a daily basis, to estimate the maturity
profiles of various assets and liabilities and its consequential impact on liquidity.
Liquidity risk is the potential inability of a bank to generate enough cash to cope with the
decline in deposits or increase in assets. This reveals the inflows and outflows under
various time frames. The gap between the two reveals the mismatch in each bucket and
helps the bank to estimate and manage its liquidity position on the residual maturity
basis.
The mismatch is continuously monitored for it involves the reputation of the Bank if a
liquidity crisis arises. The mismatches in the first four time buckets are more important as
it gives early warning signal about forthcoming liquidity condition. Liquidity is also
monitored through various liquidity ratios which indicate the liquidity position in the near
term as also examines asset –liability composition from the perspective of liquidity.
The implications of liquidity:
While introducing the concept of Asset – Liability management (ALM), it has been
mentioned that the objective of any ALM policy is two-fold : ensuring
1) Profitability and
2) Liquidity.
Liquidity risk management being one of the core objectives of Asset – Liability
Management, its efficient management has direct impact on not only profitability but the
very image of the Bank which would have been carefully nurtured over the years. Since
Banks basically deal with finance, the confidence of the public and its customers is
fundamental to its functioning.
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Liquidity risk management primarily involves managing cash flows - inflows and
outflows, and the ability of the bank to meet maturing liabilities and customer demands
for cash as also to meet the demand of the borrowers.
Liquidity is the ability to efficiently accommodate deposit and other liability decreases,
as well as, deployment of funds in assets portfolio as well as possible funding of offbalance sheet claims. A bank has adequate liquidity when sufficient funds can be raised,
either by increasing liabilities or converting assets, quickly and at reasonable cost. It
encompasses the potential sale of liquid assets and borrowings from money, capital and
forex markets. Thus, liquidity shall be a defense mechanism from losses on fire sale of
assets.
What are two different approaches to Interest Rate Risk Management?
Two different approaches for the interest rate risk management are from earnings
perspective and Economic value of Equity perspective (EVE).
Earning at Risk
The management of interest rate risk by estimating the change in NII (Net Interest
Income) is known as earnings perspective. The immediate impact of change in interest
rate is on the Net Interest Income and it is the management of interest rate risk in short
term.
Economic Value Perspective
Fluctuation in interest rates changes the values of assets and liabilities and thus the
economic value of future cash flows. Any decrease in the values of assets affect the
networth of the bank and in the long-run it further affects the value of networth by
limiting the leverage capacity of the bank. Economic value perspective of interest rate
risk is estimated through the duration of equity.
How interest rate risk is measured?
The mismatch risk is measured by calculating the gap over the time interval as at given
date. The gap is the difference between Rate sensitive assets and Rate sensitive liabilities.
Gap report is generated by grouping the total assets and liabilities into rate sensitive and
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bucketing them according to residual maturity or next re-pricing date whichever is
earlier. The non-sensitive portion is bucketed in the last time bucket. The mismatch in
each time bucket as a percentage to assets in each time bucket is calculated and shown in
the report. For monitoring the interest rate risk, prudential limits are set for the mismatch
% and watched for any changes.
What is traditional Gap Method?
Gap analysis measures the interest rate risk from the earnings perspective. It measures the
variation in the Net Interest Income using the rate sensitive gap. The positive gap
indicates that the Rate Sensitive Assets are more than the Rate sensitive Liabilities. This
also means that the short term assets are used to fund the long term liabilities. The
negative gap indicates that the Rate sensitive Liabilities are more than the rate sensitive
assets. That means that long term assets are used to fund the short term liabilities.
If there is a positive gap, the bank is in a position to benefit from the rising interest rates
as the Net Interest Income increases. The Net Interest Income increases as there are more
re-priceable assets than re-priceable liabilities. If the interest rates fall, bank will not
benefit as there are less liabilities than assets. If there is a negative gap bank is in a
position to benefit from the falling interest rates as the re-priceable liabilities are more
than the re-priceable assets.
What is Duration?
Duration is the weighted average time to maturity using the relative present values of
asset or liability cash flows as weights. It is the average life of asset or liability. It is the
weighted average of time to recover principal and interest. Duration varies from the
maturity on the view that the intermediate cash flows are reinvested. It is also direct
measure of sensitivity of prices to interest rate fluctuations.
Generally, the longer the maturity and smaller the cash flows, the higher will be the
duration. Higher duration implies that for a given change in the interest rates, the higher
will be the change in the economic value.
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What is Modified Duration?
Modified Duration is duration divided by change in yield. Modified duration is also
defined as approximate change in price for 100 bps change in interest rate. It indicates
how the price (or value) will change when the interest rates changes.
What is Modified Duration Gap?
Modified Duration Gap (DGAP) = Modified Duration of Assets – W* Modified
duration of Liabilities
W = Rate sensitive liabilities
Rate sensitive Assets
Modified Duration of Equity = DGAP * Leverage
Leverage =
Rate sensitive assets
Networth
Modified duration of equity is used to measure the percentage variation in the equity
value for the changes in the interest rates.
For example if the modified duration of equity is estimated as 9, percentage drop in the
value of equity for 200 bps variation in the interest rate is 9*2 = 18%.
Duration gap (DGAP) models focus on the market value of equity. Duration gap analysis
compares the duration of assets with duration of liabilities and calculates the market
value of equity when interest rate fluctuates. The Duration analysis tries to immunize the
effect of rate fluctuation on the equity by adjusting the duration gap to zero. This can be
attained by either adjusting the duration of assets or liabilities or both. Adjusting the
duration of assets is much easier than that of liabilities.
Change in Market Value of Equity (MVE) = Change in Market Value of Assets (MVA)
–
Change in Market value of Liabilities
(MVL)
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DGAP
Change in ROI
Change in Market value of
Equity
Positive
Increase
Decrease
Positive
Decrease
Increase
Negative
Increase
Increase
Negative
Decrease
Decrease
Zero
Increase
None
Zero
Decrease
None
What is Stress Testing?
Stress testing evaluates the potential vulnerability of the Bank to certain unlikely but
plausible events or movements in the financial variables. The vulnerability is measured
in relation to bank’s profitability, resources outflows, crystallization of commitment
credit, rating migration, possible increase in NPAs, etc.
There are two types of stress tests- sensitivity tests and scenario tests. Sensitivity test
deals with the effect of change in one variable on bank’s financial position. Scenario test
deals with the effect of change in simultaneous movement of several variables based on
one past event and its effect on the bank’s financial position.
The stress testing procedure makes the risk management system more strong and keeps
them equipped for any crisis situations as and when they arise. Stress testing framework
is also an important component of Bank’s Internal Capital Adequacy Process (ICAAP)
under Basel II requirements.
The stress testing is to be carried out for various risks like liquidity risk, interest rate risk,
credit risk and foreign exchange risk. Stress testing is based on a number of assumptions
that is based on Bank’s actual historical data or industry data or best guess estimates. The
stress testing frame work should also suggest the remedial actions to be followed, when
the stress tolerance level are breached.
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The role of ALCO
The business issues that an ALCO would consider include the product pricing for
deposits and advances, desired maturity profile and mix of incremental assets and
liabilities etc. ALCO take stock of the liquidity position of the Bank and also reviews the
results and progress in implementation of the decisions made in the previous meeting.
The ALCO also articulates the current interest rate view of the Bank and base its decision
for future business strategy on this view. Towards this end, it will have to develop a view
on the future directions of the interest rate movements and decide on funding mixes
between fixed versus floating rate funds, wholesale versus retail deposits, money market
versus capital market funding, domestic versus foreign currency funding.
RBI POLICY RATES
SLR
CRR
23.00%
4.25%.
4% w.e.f 09.02.2013
8.75%
7.75%
6.75%
8.75%
Bank Rate
Repo
Reverse Repo
Marginal Standing
Facility Rate
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