Treasury - Regulatory Perspective & Risk Management in Banks. Yogesh Satpute, FCA. 15 th December 2018

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1 54 th BFSICM Roundtable WIRC, ICAI Towers, Mumbai. Treasury - Regulatory Perspective & Risk Management in Banks Satpute@icai.org 15 th December Presentation For ensuring the alignment of session

2 2 Overview of Session Treasury Business and; Regulatory Brief on Derivatives Fixed Income and Money Market Activities Foreign Exchange Business Nostro Accounts Presentation For ensuring the alignment of session

3 3 Regulatory Aspects Derivatives RBI Specified Comprehensive Guidelines on Derivatives (2007, 2011, and 2018) read with Direction on IRO , Permissible derivative instruments and their benchmarks Control Framework setup Risk management and corporate governance aspects Suitability and Appropriateness requirements All Documentation Requirements With examples including BR, ISDA & CSA Risk Management (Identify Measure Monitor Prudential Limits and examples thereto) Independent risk control Management Information Systems Audit Requirements Relaxation of S&A 2018 Amendment References to RMIBD Common as Forex Business

4 4 Regulatory Aspects Derivatives Reporting Accounting and Valuation Novation etc. of Contract Peculiar circumstances of deal exceptions

5 5 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank Board approved Investment Policy Reporting on NDS - OM Selling a government security already contracted for purchase (same or Subsequent settlement cycle) confirmation of the deal/advice of allotment from the Reserve Bank When one of the party is FPI T+2 Settlement Responsibilities of Custodian Bank

6 6 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank STRIP read with Guidelines on Stripping/ Reconstitution of Government Securities dated 3 rd May 2018 STRIPS - Separate Trading of Registered Interest and Principal Securities. Periodic coupon payments of an existing Government Security > tradable zero-coupon securities, > trade in the market at a discount > redeemed at face value. Stripping a five-year Government Security would yield 10 coupon securities (representing the coupons), maturing on the respective coupon dates and one principal security representing the principal amount, maturing on the redemption date of the five-year security. Securities that could be tendered for stripping/reconstitution - minimum of Rs.1 crore and in multiples thereof Reserve Bank will not charge any fees on stripping/reconstitution Stripping/reconstitution - any time from the date of issuance of a GS till maturity

7 7 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank STRIP read with Guidelines on Stripping/ Reconstitution of Government Securities dated 3 rd May 2018 Reconstitution - reverse process of stripping > the Coupon STRIPS and Principal STRIPS are reassembled into the original Government Security. Being G-Sec, STRIPS are eligible for SLR with separate ISINs (Coupon STRIPS with the same maturity date shall have the same ISIN) Detailed guidelines outlining the process and 2018 Requests directly in e-kuber for stripping/reconstitution Requests for stripping/reconstitution by Gilt Account Holders (GAH) shall be placed with the respective Custodian maintaining the CSGL account, who in turn, will place the requests on behalf of its constituents in e-kuber

8 8 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank Ready Forwards Dated Securities, T-Bills of Central/State Government RBI SGL Account or Gilt Account Holders with bank/pd through RBI CSGL No ready forward contracts between a custodian and its gilt account holder Listed Companies Minimum 7 Days lending and borrow for any short time The counterparty Bank or a PD maintaining SGL Account with the Reserve Bank When securities bought/money Lent 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 Unlisted company 2 additional conditions for specially issued securities

9 9 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank Ready Forwards 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 Cooperative banks may not enter into ready forward contracts with NBFCs. This restriction would not apply to repo transactions between Urban Co-operative banks and authorised PDs in Government Securities Reporting 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). 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

10 10 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank Ready Forwards Effective Internal Controls and Concurrent Audit Requirements Entities can undertake ready forward transactions only in securities held in excess of the prescribed Statutory Liquidity Ratio (SLR) requirements Permissibility of Re-Repo and certain RBI stipulated conditions Scheduled commercial banks, Primary Dealers along with Mutual Funds and Insurance Companies (subject to the approval of the regulators concerned) maintaining Subsidiary General Ledger account > Government securities, including SDLs and Treasury Bills, acquired under reverse repo, subject to various conditions and guidelines

11 11 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank INTERNAL CONROLS Clear functional separation FIMMDA code of conduct while executing trades on NDS-OM and in the OTC market Deal Slips, confirmations (Except for NDS-OM), and Operations activities OTC trades in Commercial Papers (CPs) and Certificate of Deposits (CDs) and OTC repo trades in corporate debt securities, CPs, CDs and non-convertible debentures (NCDs) of original maturity less than one year to be reported on F-TRAC - Clearcorp In F-TRAC, both the counterparties individually report their respective sides of the trades and the trades are validated for trade details before matching by F-TRAC This ensures implicit confirmation by both counterparties. Further, the details of the transactions are available on the F-TRAC system. The requirement of exchange of physical confirmation of trades matched on F- TRAC is waived subject to conditions (Bilateral, Stamp Duty, and Risk Management)

12 12 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank INTERNAL CONROLS Reconciliation of Balances as per bank's books with the balances in the books of PDOs and Its Audit Regular reporting to Top Management Audit Committee of the Board shall review in each of its meetings the total exposure of the bank to capital market Plus compliance with the Reserve Bank and Board guidelines and adequacy of risk management and internal control systems Managements should ensure - adequate internal control and audit procedures for ensuring proper compliance Half Yearly Review

13 13 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank BROKERS Empanelment Process and as per Policy Annual review of Brokers Clear-cut criteria, verification of their creditworthiness, market reputation, etc. A record of broker-wise details of deals put through and brokerage paid Broker is not obliged to disclose the identity of the counterparty to the deal On Conclusion Disclose name and mention on contact note (CN) Importance of Timestamp, Mandatory disclosure on CN and back-office to validate Aggregate contract limits for each of the approved brokers and, a limit of 5% of total transactions through brokers breach to be notified to board

14 14 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank NON SLR Investments Appraisal Process Investment proposals should be subjected to the same degree of credit risk analysis as any loan proposal (More stringent for non-borrower customer) Refer to the list of defaulters/wilful defaulters Prudential limits and sub limits on investments Strengthen their internal rating systems and regular (quarterly or half-yearly) tracking of the financial position of the issuer Continuous monitoring of the rating migration Prudential Limits for entry-level minimum ratings/ quality standards and industry-wise, maturitywise, duration-wise, issuer-wise etc. limits to mitigate the adverse impacts of concentration and the risk of illiquidity

15 15 Regulatory Aspects FIMM Master Circular on Investment Portfolio by Bank NON SLR Investments No Investment in: Non-SLR securities of original maturity of less than one-year (Except CD/CP/NCDs) No Investment in: unrated non-slr securities (unrated bonds of companies engaged in infrastructure activities with regulatory caps) Unlisted non-slr securities should not exceed 10 per cent of total investment in non-slr securities as on March 31, of the previous year Additional 10% with stipulations: Investments of Securitization papers (InfraProjects), bonds and debentures (SARFAESI) Liquid/Short Term Debt Weighted Average Maturity < 1Year 10% of Previous Year Networth Quarterly Review of Non-SLR Portfolio

16 16 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank SDL State Governments also raise loans from the market which are called SDLs SDLs are dated securities issued through normal auction similar to the auctions conducted for dated securities issued by the Central Government Interest at half-yearly intervals and the principal is repaid on the maturity date SDLs issued by the State Governments qualify for SLR They are also eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF) and special repo conducted under market repo by CCIL State Governments have also issued special securities under Ujjwal Discom Assurance Yojna (UDAY) Scheme for Operational and Financial Turnaround of Power Distribution Companies (DISCOMs) notified by Ministry of Power

17 17 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank WHEN ISSUED (WI) Approved an Investment Policy A Security that has been authorized for issuance but not yet actually issued Commence fro issue notification date and it would cease on the working day immediately preceding the date of issue Contracted for settlement on the date of issue The originating transactions (sale or purchase of 'WI' securities) shall be undertaken only on NDS-OM and any reversal of on or outside the NDS-OM platform Only PDs can take a short position in the WI market, non-pd entities can sell the WI security only if they have a preceding purchase contract for equivalent or higher amount Open Position LIMITS

18 18 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank SHORT SELLING Latest RBI Direction 2018 Approved an Investment Policy HFT Category, Other Stipulations and Daily Audit

19 19 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank GENERAL Banks should furnish RBI, 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 CLASSIFICATION: Classification for Balance Sheet Categories HTM AFS AFT Max 25% under HTM (Excess SLR) Shifting Among Categories Shifting Among Categories to/from HTM, AFS HFT, Valuation Aspects HTM, AFTM and AFS and Non Performing Investments (NPI)

20 20 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank GENERAL HTM HFT AFS Need not be marked to market Acquisition Cost Amortize Premium Impairment events Marked to market at monthly or at more frequent Marked to market at quarterly or at more frequent

21 21 Regulatory Aspects FIMM Investment Fluctuation Reserve Lower of the: (a) net profit on sale of investments during the year; (b) net profit for the year less mandatory appropriations; shall be transferred to the IFR, until the amount of IFR is at least 2 percent of the HFT and AFS portfolio, on a continuing basis. Where feasible, this should be achieved within a period of 3 years Discretion for draw down the balance available in IFR in excess of 2 percent of its HFT and AFS portfolio, for credit to the balance of profit/loss as disclosed in the profit and loss account at the end of any accounting year. Balance in the IFR is less than 2 percent of the HFT and AFS investment portfolio, a draw down subject to : (a) The drawn down amount is used only for meeting the minimum CET1/Tier 1 capital requirements by way of appropriation to free reserves or reducing the balance of loss, and (b) The amount drawn down is not more than the extent the MTM provisions made during the aforesaid year exceed the net profit on sale of investments during that year

22 22 Regulatory Aspects FIMM Master Circular - Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Bank EQUITY/DEBENTURES Broad investment objectives Expertise in equity research - dedicated equity research department Transparent policy and procedure Investment Committee Set up by Board The Investment Committee should be held accountable for the investments made by the bank

23 23 Regulatory Aspects Nostro Foreign currency balances management - Treasury Internal Control Guidelines Chapter 5 Process and Controls SWIFT, Accounting Systems and Reconciliation Outstanding/Unreconciled Entries Unclaimed balances, return of funds and DD Payables Management Reporting Audit

24 24 Regulatory Aspects Forex Business RBI Guidelines on Risk Management & Interbank Dealings Products and Operational Stipulations Contracted Exposure Probable Exposure Special Dispensation Permissible Facilities Forex Merchant and Interbank - Overview Documentation and Underlying

25 25 RISK MANAGEMENT SYSTEM IN BANKS 15 th December 2018

26 26 Coverage Executive Summary Introduction Risk Management Function in Banks Types of Risks Credit Risk Market Risk Operational Risk Conclusion

27 27 Executive Summary Executive Summary Introduction Risk Management Function in Banks Types of Risks Credit Risk Market Risk Operational Risk Conclusion

28 28 Introduction The risk is potential of occurrence of a loss i.e. potential negative effect on an asset that may be derived from given progress or some future event. Risk cannot be separated from growth opportunities. Banks are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks interdependent and events that affect one area of risk can have effects on other risk categories. Considerable importance should be given to improve the ability to identify, measure, monitor and control the overall level of risks.

29 29 Risk Management Function The primary responsibility of understanding the risks and ensuring that the risks are appropriately managed should clearly be vested with the Board of Directors. The Board should set risk limits by assessing the bank s risk and risk- bearing capacity. The risk management is a complex function and it requires core skills and expertise of the domain. It is difficult to adopt a single uniform framework for management of risks for all banks in India. Hence, risk management functions should be designed bank specific, depending on by the size, the level of technical expertise, complexity of functions, and the quality of MIS.

30 30 Types of Risk In order to understand the fundamentals, we will divide these into various types of risk as shown in diagram Types of Risks Credit Risk Market Risk Operational Risk Default Risk Liquidity Risk Portfolio Risk Interest Rate Risk Foreign Exchange Rate (Forex) Risk

31 31 Credit Risk Credit risk is also known as default risk. It results from inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. The Credit Risk is generally comprised of default risk and portfolio risk. Default risk is the risk arising as a result of default in repayment of credit facilities Portfolio risk is the risk of concentration of credit portfolio. The credit risk of a bank s portfolio depends on both external and internal factors

32 32 Credit Risk The Factors Affecting Credit Risk The external factors:- Existing state of the economy Fluctuations in commodity/equity prices Movement of foreign exchange rates Movement of interest rates Existing trade restrictions among various countries Various economic sanctions, Licenses, tariff policies. Various Government policies, amendments thereto etc.

33 33 Credit Risk The Factors Affecting Credit Risk The internal factors are:- Improper loan policies/loan administration Lac of prudential credit concentration limits Inadequate Monitoring of credit concentration limits Deficiencies in lending limits for Loan Officers/Credit Committees Incorrect / Deficient appraisal of borrower s financial position excessive reliance on collaterals instead of repayment capacity Lack of periodic loan review mechanism system Inefficient post disbursement monitoring, etc.

34 34 Credit Risk Coverage of Credit Risk Management Measurement of risk through comprehensive credit rating/scoring; Quantifying the risk through estimating expected loan losses Risk pricing on a scientific basis Controlling the risk through effective Loan Review Mechanism and portfolio management Carefully formulated scheme of delegation of powers Credit Approving Authority Enforcing Prudential Limits and its timely monitoring Risk-return pricing and Risk Adjusted Return on Capital (RAROC) framework for credit pricing Investment banking proposal subject to credit risk analysis.

35 35 Market Risk With progressive deregulation, market risk arising from adverse changes in market variables, such as interest rate, foreign exchange rate, equity price and commodity price Even a small change in market variables causes substantial changes in income and economic value of banks. Market risk takes the form of: Liquidity Risk: - The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk.

36 36 Market Risk Interest Rate Risk:- Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE), caused by unexpected changes in market interest rates. Foreign Exchange Rate (Forex) Risk:- Forex risk is 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

37 37 Operational Risk An operational risk is defined as a risk arising out of organisation's internal activities. It is the risk arising from the failure of people, systems and processes It can also include other classes of risk, such as fraud, legal risks, physical or environmental risks etc. According to Basel II regulations, operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational risk management differs from other types of risk, because it is not used to generate profit

38 38 Operational Risk As per RBI guidelines on Risk Management operational risk is defined as any risk, which is not categories as market or credit risk, or the risk of loss arising from various types of human or technical error. The most important type of operational risk involves failure in internal controls and corporate governance. Such failures can result in financial loss through error, fraud, or failure to perform in a timely manner or cause the interest of the bank to be compromised. Internal controls and the internal audit are the primary means to mitigate operational risk. Insurance is also an important mitigator of some forms of operational risk. Awareness of people for familiarising the complex operations at all levels of staff can also reduce operational risk.

39 39 Conclusion Risk management is basically the focused task of identification, assessment, and prioritization of risks. The risk cannot be avoided altogether, in order to tap growth opportunities banks have to accept risks with efficient management practices. Sometimes these risks can be transferred e.g. insurance and sometimes can be avoided to the limited extent. The risk management is science as well as art to the extent of management skills are involved. The effectiveness of risk measurement in banks depends on efficient Management Information System, sanitized database and optimum utilization of available IT resources.

40 40 Thank You 15 th December 2018

RBI/ /109 DBOD No BP.BC. 8 / / July 1, 2013

RBI/ /109 DBOD No BP.BC. 8 / / July 1, 2013 RBI/2012-13/109 DBOD No BP.BC. 8 /21.04.141/2013-14 July 1, 2013 All Commercial Banks (excluding Regional Rural Banks) Dear Sir, Master Circular Prudential norms for Classification, Valuation and Operation