COMMERCIAL BANKS

COMMERCIAL BANKS
DEPOSITS THE MAIN SOURCE OF FUNDING. OTHER SOURCES INCLUDE SUBORDINATED NOTES & DEBENTURES. ON THE ASSET SIDE LOANS INCLUDE REAL ESTATE, COMMERCIAL, CONSUMER LOAN LETS LOOK AT THE TABLE BELOW FOR US COMMECIAL BANKS

ASSETS US GOVT. SEC 15.2% REAL ESTATE LOANS 25.5% C&I LOANS 18.0% INDVDL. LOANS 9.4% OTHER SECURITIES 7.4% CASH ASSETS 4.8% OTHER ASSETS 5.5% OTHER LOANS 10.0% INTER-BANK LOANS 4.2%

LIABILITIES LARGE TIME DEPOSITS 13.6% EQUITY 8.5% OTHER LIAB 8.8% BORROWINGS 19.1% TRANSACTION AC 12.7% OTHER TRANS AC. 37.3%

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COMMERCIAL BANKS ARE HIGHLY LEVERAGED. MAJOR RISK IS THE CREDIT RISK. EVEN A SMALL AMOUNT OF DEFAULT CAN WIPE OUT THE EQUITY OF A BANK. A MAJOR CHANGE IN THE TREND IS INCREASE IN THE MORTGAGE AND CONSUMER LOANS AGAINST BUSINESS LOAN. TRANSACTION ACCUNT ARE CHECKABLE DEPOSITS AND NOW THEY ALSO CARRY SOME INTEREST. IMPORTANT COMPONENT IS SMALL NON TRANSACTION ACCOUNTS WHICH INCLUDES PASSNOOK SAVINGS AC. AND RETAIL TIME DEPOSITS.THIS COMPONENTS IS FALLING OWING TO COMPETETION FROM MONEY MARKET MFS. LARGE TIME DEPOSITS PREDOMINANTLY INCLUDE CERTIFICATE OF DEPOSIT WITH FV OF 100000 OR MORE.

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BORROWINGS AND OTHER NON DEPOSIT LIABILITIES INCLUDE FED FUNDS( CALL BORROWING) REPO AND ALSO ISSUANCE OF NOTES AND BONDS. OFF-BALANCE SHEET ACTIVITIES:
GUARANTEES OR LETTER OF CREDIT. DERIVATIVE TRANSACTIONS BANKS FOCUS ON THESE ACTIVITIES IS INCREASING TO COMPLEMENT THE DECLING SPREADS ON THEIR TARDITIONAL LENDING BUSINESS. ALSO THERE ARE NO RESERVE RQMTS. OR DEPOSIT INSURANCE PREMIUMS REQUIREMENTS ON THIS LEG. HOWVER THEY DO CARRY LOT OF RISK. THE FAILURE OF BARINGS AND ORANGE COUNTY ARE CLASSICAL EXAMPLE OF FAILURES DUE TO OFF-BALANCE SHEET ACTIVITY IN THE AREA OF DERIVATIVES.

HOWEVR OFF-BALANCE SHEET ACTIVITIES CAN BOTH REDUCE RISK AND INCREASE INCREASE A MAJOR REASON FOR INCREASE IN THE OFF-BS ACTIVITY IS ON ACCOUNT OF EXTENSIVE USE OF DERIVATIVES TO MANAGE INT. RATE, CREDIT AND FOREX RISK.

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THE RISK FACED BY THE BANKS IN THESE OFF-BALANCE SHEET ACTIVITIES IS THE MARKET RISK IN THE CHANGE IN THE VALUE OF THE CONTRACT WHICH IS LESS TNA THE FACE VALUE. BECAUSE OF A LARGE INCREASE IN THESE ACTIVITIES REGULATORS HAVE IMPOSED CAPITAL REQUIREMENTS ON THESE ACTIVITIES. FEE GENERATING ACTIVITIES:

INVESTMENT BANKING FPENSION FUDNS MANAGEMENT CORRESPONDENT BANKING PROVISION OF BANKING SERVICES TO OTHER BANKS THAT DONT HAVE THE STAFF RESOURCES TO PERFORM THE SERVICES THEMSELVES.THESE SERVICES INCLUDE CHECK CLEARING , FOREX TRADING ETC.

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RECENT TRENDS IN THE US IN THE BANKING INDUSTRY:

MERGERS OF VARIOUS BANKS BANKS PERMITTED TO UNDERWRITE CORPROATE SECURITIES. INVESTMENT BAKING SEVICES ALLOWED SINCE 1999. ONE OF MAJOR FORCE DRIVING CONSOLIDATION IN THE BANKING INDUSTRY IS THE ECONOMIES OF SCALE AND SCOPE. NEED TO SPEND EXTENSILVELY IN TECHNOLOGY IS ANOTHER DRIVING FORCE. SOME EXAMPLES OF MERGERS- CHASE MANHATTAN AND CHEMICAL BANK-ANNUAL SAVINGS FROM MERGERS WAS ESTIMATED AT RS 1,5 BN $ PER ANNUM. GEOGRAPHIC DIVERSIFICATION ANOTHER REASON FOR MERGERS HAPPENING IN THE BANKS.

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BANK SIZE AND ACTIVITIES:

LARGE BANKS BECAUSE OF EASY ACCESS TO CAPITAL MARKETS USUALLY OPERATE WITH LESS CAPITAL AS COMPARED TO SMALLER BANKS. NARROW SPREADS AS THEY LEND TO LARGER CORPORATES. MORE FOCUS ON FEE BASED ACTIVITY TO ENHANCE ROE.ROC RECENT PERFORMANCE ROA=1.28% AND ROE = 14.97% THE PERFORMANCE WAS QUITE AN IMPROVEMNET OVER 1980S HIGH INTEREETS RATE ENVIRONMENT

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RETURN ON EQUITY AND ITS COMPONENTS:

INT. EXP/ TOT. OP. INC

PROV. FOR LOAN LOSSES/ TOT. OP. INC

ROA FUNCTION ROE

NET INCOME/ TOT. OP. INC

NON INT. INC/ TOT. OP. INC INCOME TAX/ TOT. OP. INC

TOT OP. INC TOT. ASSETS INT INC/TOT ASSETS NON INT INC/ TOT ASSETS

FUNCTION
TOTAL ASSETS/ TOTAL EQUITY

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ROE AND ITS COMPONENTS:

ROE= NET INCOME/ TOTAL ASSETS X TOTAL ASSETS/ TOTAL EQUITY CAP ROE= ROA X EQUITY MULTIPLIER ( A MEASURE OF LEVERAGE) AN INCREASE IN ROE DUE AN INCREASE IN THE BANKS LEVERAGE IMPLIES THAT BANKS SOLVENCY RISK HAS INCREASED. RETURN ON ASSETS= PROFIT MARGIN X ASSET UTILISATION ROFIT MARGIN MEASURES THE BANKS ABILITY TO CONTROL EXPENSES. ASSET UTILISATION MEASURES THE BANKS ABILITY TO GENERATE INCOME FROM ITS ASSETS. PROFIT MARGIN= 1- {INT EXP/TOT OP INC+ PROVISIONS /TOT OP INC +NON INT EXPENSE/ TOT OP INCOME + INCOME TAXES / TOT OP. INC} OTHER RATIOS NET INTEREST MARGIN: = INT INCOME INT EXPPENSE/{INVESTMENTS ECURITIES + NET LOANS AND LEASES}

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THE SPREAD: MEASURES THE DIFFERENCE BETWEEN THE AVERAGE YIELD OF EARNING ASSETS AND AVERAGE COST OF INTEREST BEARING LIAB AND IS THEREFORE A MEASURE OF BANKS RETURN ON ASSETS. SPREAD= INTERETS INCOME/ EARNING ASSETS INTEREST INCOME/INT BEARING LIABILITIES THE HIGHER THE SPREAD, THE MORE PROFITABLE IS THE BANK. BUT THE SOURCE OF HIGH APREAD AND THE POTENTIAL RISK ASSOCIATED WITH IT SHOULD BE CONSIDRED BEFORE REACHING ANY JUDGEMENT. OVERHEAD EFFICIENCY: NON INTEREST INCOME/ NON INTEREST EXPENSE THE RATIO IS SELDOM > 1. FOR A TYPICAL US BANK LETS TRY TO ANALYSE THIS RATIOS

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ROE AND ITS COMPONENTS:

ROE = 115.04/550.46= 20.9% ROE = ROA X EM = 115.04/6704.37[1.725] X6704.37/550.46[12.18] ROA= PROFIT MARGIN X ASSET UTILISATION PROFIT MARGIN = NET INCOME /TOTAL OP INCOME X TOTAL OP INCOME/ TOTAL ASSETS = 115.04/ [490.37 +30.01]= 22.11% AU = 490.37 +30.01/6704.37 = 7.76%= 1.72% PROFIT MARGIN = 1-{40.88%+1.20%+22.55%+13.26%}= 22.22% NET INTEREST MARGIN = 277.65/[6334.58]= 4.38% SPREAD= 490.37/6334.58 212.72/5803.26= 4.08% OVERHEAD EFFICIENCY= 30.01/117.37= 25.27%

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

CREDIT RISK LIQUIDITY RISK INTEREST RATE RISK MARKET RISK OFF-BALANCE-SHEET RISK FOREX RISK COUNTRY OR SOVEREIGN RISK TECHNOLOGY RISK OPERATIONAL RISK INSOLVENCY RISK.

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

CREDIT RISK: PROMISED C FLOWS ON CLAIMS WILL NOT BE PAID IN FULL. THE INTEREST CHARGED IS A FUNCTION OF PERCEIVED DEFAULT/CREDIT RISK. FIS NEED TO COLLECT INFO ABOUT BORROWERS AND TO NMONITOR THEIR PEREFORMANCE OVER TIME. FIS HAVE THE ADVANTAGE OF DIVERSIFYING THEIR RISK.DIVERSIFICATION LEADS TO REDUCTION OF UNSYSTEMATIC RISK BUT THE SYSTEMATIC RISK STILL REMAINS.

LIQUIDITY RISK: SUDDEN WITHDRAWLS FROM DEPOSITORS. SOMETIMES LESS ILLIQUID ASSETS HAVE TO BE SOLD AT A LOSS.

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

INTEREST RATE RISK: HAS INCREASED SINCE INCREASED GLOBALISATION OF FINANCIAL MARKETS FED WATCHING ALAN GREENSPAN IS A COMMON ACTIVITY. INTREST RATE CHANGES CAN AFFECT THE ASSETS AND LKIABILITIES TO A DIFFERENT EXTENT DEPENDING UPON THE MATURITY AND DURATION. USUALLY FOR THE BANKS THE LIABILITIES HAVE LOWER MATURITIES THAN ASSETS AND REFINANCING COST COULD BE HIGHER IF THE INT. RATE INCREASES. INTEREST RATE RISK NOT ONLY POSES REFINANCING OR REINVESTMENT RISK BUT IT AFFECTS THE PV OF OR ECONOMIC VALUE OF THE ASSETS AND LIAB. DURATION MATCHING OF ASSETS AND LIABILITIES IS ONE WAY OF PROTECTING AGAINST INTEREST RATE RISK.

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

MARKET RISK: ARISES BECAUSE OF TRADING ACTIVITIES. MARKET RISK IS CLOSELY RELATED TO INTEREST RATE RISK AND FOREX RISK. TRADING OF SECURITIES AND DERIVATIVES AS AN ACTIVITY IS BECOMING MORE PROMINENT AMONGST BANKS AND INVESTMENT BANKS SINCE INTEREST SPREAD IS COMING DOWN. AS THE VOLATILITY OF ASSET PRICES INCREASES, THE MARKET RISK FACED BY FIS THAT ADOPT OPEN TRADING POSITION INCREASES. THE CONCEPT OF VAR VALUE AT RISK IS BASED ON MARKET RISK. IT REQUIRES INSTITUTIONS AND THE REGULATORS TO ESTABLISH CONTROL OR LIMITS ON POSITIONS TAKEN BY TRADERS AS WELL AS DEVELOP MODELS TO MEASURE THE MARKET RISK EXPOSURE OF FOS ON A DAY TO DAY BASIS.

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

OFF-BALANCE SHEET RISK: LETTER OF CREDIT DERIVATIVES LIKE SWAPS MANY MUNCAPALITY AND STATE GOVTS ISSUE BONDS COUPLED WITH CREDIT ENHANCEMENT STRUCTURES I.E CREDIT GUARANTEE GIVEN BY BANKS. SOME OF THE POSITIONS IN THE DERIVATIVES IS TO REDUCE THE CREDIT, INT RATE AND NMARKET RISKS. BUT MISMANAGEMENT OR SPECULATIVE USE OF THESE INBSTRUMENTS CAN RSULT INMAJOR LOSSES FOR THE FI. FOREIGN EXCHANGE RISK: THE RISK THAT EXCHANGE RATE CHANGES CAN AFFECT THE VALUE OF AN FIS ASSETS AND LIABILITIES DENOMINATED IN FOREIGN CURRENCIES. A GOOD EXAMPLE PERHAPS WOULD BE THE CURRENCY CRISIS IN ASIA.THAI BAHT FELL 50% RELATIVE TO THE US $. THIS HAD A CONTAGION EFFECT.THIS AFFECTED ADVERSLY THE EARNINGS OF THE US BANKS.

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

FOREIGN EXCHANGE RISK: FOR EXAMPLE IN 1997 CHASE MANHATTAN BANK ANNOUNCED A 160 MN$ LOSS ON ACCOUNT OF FOREIGN CURRENCY TRADING AND HOLDING OF FOREIGN CURRENCY BONDS. EVEN THE STABILITY OF JAPANESE BANKS IS UNDER QUESTION AS THESE BANKS HAD HUGE EXPOSURE TO THESE ASIAN NATIONS. COUNTRY OR SOVEREIGN RISK: THE GOVT. OF THE COUNTRY MAY PROHIBIT OR LIMIT DEBT REPAYMENTS DUE TO FOREIGN CURRENCY SHORTAGES AND ADVERSE POLITICAL EVENTS. FOR EXAMPLE IN 1982 THE BRZIALIAN AND MEXICAN GOVT. ANNOUNCED A DEBT MORATORIUM TO THEIR WESTERN CREDITORS. SIMILARLY WHEN THE RUSSIAN GOVT. DEFAULTED ON ITS SHORT-TERM DEBT OBLIGATIONS, SOME BANKS AGREED TO TAKE 5 CENTS FOR EVERY $ THEY HAD LENT.

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RISKS INCURRED BY FINANCIAL INSTITUTIONS:

TECHNOLOGY RISK: WHEN INVESTMENTS IN THE TECHNOLOGY DONT PRODUCE THE DESIRED LEVEL OF SAVINGS. TECHNOLOGY RISK CAN ALSO RESULT IN MAJOR LOSSES IN AN FIS COMPETETIVE EFFICIENCY.

OPERATOINAL RISK MALFUCTIONING OF EXISTING TECHNOLOGY. BACK OFFICE SUPPORT SYSTEM BREAKS DOWN.

INSOLVENCY RISK: WHEN LOSSES DUE TO OTHE RISKS WIPE OUT THE ENTIRE EQUITY BASE OR NW. THE INSOLVENCY RISK IS A FUNCTION OF CAR AND QUALITY OF ASSETS THAT A FI OR A BANK HOLD.

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MANAGING THE CREDIT RISK

LOOK AT THE BALANCE SHEET BELOW FOR A BANK: DEPOSITS: 90 MN CASH: 20 MN EQUITY : 10 MN LOANS: 80MN NOW SUPPOSE THAT 10 MN$ WORTH OF LOANS GO BAD. FI NOW MUST WRITE-OFF THE 10 MN $ OF LOAN. THIS MEANS THAT VALUE OF LOAN FALLS TO 70 MN $ AND THE ENTIRE EQUITY GETS WIPED OFF. THE CREDIT RISK NOT ONLY APPLIES TO TRADITIONAL AREAS OF LENDING AND INVESTING BUT ALSO TO OFF-BALANCE SHEET ACTIVITIES SUCH AS OPTIONS; SWAPS AND FOREIGN EXCHANGE.

CREDIT ANALYSIS: MORTGAGE LOAN: BORROWERS ABILITY TO PAY & VALUE OF COLLATERAL

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CREDIT ANALYSIS: MORTGAGE LOAN: BORROWERS ABILITY TO PAY & VALUE OF COLLATERAL GROSS DEBT SERVICE RATIO: ANNUAL MORTGAGE PAYMENTS+PROP TAX/ANN. GROSS INCOME TOTAL DEBT SERVICE PAYMENTS: ANNUAL TOTAL DEBT PAYMENTS/ANNUAL GROSS INCOME THE THRESHHOLD IS NORMALLY 25% TO 30% FOR GDS AND 35% TO 40% FOR TDS.

CREDIT SCORING SYSTEM: A COMPREHENSIVE MODEL WHICH REPRESENTS THE APPLICANT PROBABILITY OF DEFAULT. THE LOAN OFFICER COLLECTS INFORMATION ON CUSTOMERS ASSETS, INCOME, MONTHLY EXPENSES, DEPENDANTS, CREDIT HISTORY ETC AS INPUT INTO A MODEL. ONCE A CLIENT CLEARS THIS CRITERION THE FI MUST ENSURE THAT COLLATERAL IS FREE AND CLEAR AND IN CASE OF FORECLOSURE IT CAN POSSESS THE ASSET AND AND HAS THE POWER OF SALE.

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CREDIT ANALYSIS: CORPORATECREDIT ANALYSIS: FIVE CS: CASH FLOW ANALYSIS: DETERMINE THE CASH FLOW FROM OPERATIONS C FLOW FROM OPERATION ARE USED IN REPAYING LOANS TO FI AND PLAY A KEY ROLE IN DECISION PROCESS.

RATIO ANALYSIS: BASED ON HISTORICAL FS AND PROJECTED FS. COMPARIOSON OVER TIME AND INDUSTRY IS A MUST. CURRENT RATIO, QUICK RATIO, SALES/FA; SALES/WC; ACC REC/365, INVENTORYX 365/COG; DEBT ASSET RATIO; CASH FLOW TO DEBT; FIXED CHARGE COVERAGE RATIO EQUITY CUSHION IS A MUST TO ABSORB THE FLUCTUATIONS OR VARIABILITY OF CFLOWS. {EBIT+LEASE PAYMENTS}/{INT +LEASE PAYMENTS +SINKING FUNDS/[1-T]} NOTE HERE THAT SINKING FUNDS ARE DIVIDECD BY 1-T TO MAKE THEM EQUIVALENT TO PRE TAX CASH FLOWS..

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RATIO ANALYSIS: PROFITABILITY RATIOS

ALTAMANS Z-SCORE THE VARIABLE Z IS AN OVERALL MEASURE OF BORROWERS DEFAULT RISK CLASSIFICATION THE Z SCORE DEPENDS UPON THE VALUES OF VARIOUS FINANCIAL RATIOS AND THE WEIGHTED IMPORTANCE OF THESE RATIOS BASED ON THE OBSERVED EXPERIENCE OF DEFAULTING VERSUS NON-DEFAULTING BORROWERS DERIVED FROM A DISCRIMINANT ANALYSIS MODEL. ACCORDING TO THIS SCORE ANY COMPANY WITH A SCORE OF LESS THAN 1.81 SHOULD BE CONSIDERED TO BE A HIGH DEFAULT RISK.

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KMV MODEL: USES THE VALUE OF EQUITY IN A FIRM AS EQUIVALENT TO HOLDING A CALL OPTION ON THE ASSETS OF FIRMS WITH THE AMOUNT OF DEBT BORROWED ACTING SIMILAR TO THE EXERCISE PRICE OF THE CALL OPTION. THE EXPECTED PROBABILITY OF DEFAULT (EDF) REFLECTS THE PROBABILITY THAT THE MV OF FIRMS ASSETS WILL FALL BELOW THE PROMISED REPAYMENTS ON DEBT LIABILITIES IN ONE YEAR. CALCULATING THE RETURN ON A LOAN: PLR= 12% RISK PREMIUM= 2% PLR IS BASED ON BANKS COST OF FUNDS(MARGINAL)AND IS THE RATE CHARGED TO BANKS PRIME CUSTOMERS. 1+K= [1+PROCESING FEE+ PLR + RP]/[1- B{1-R}] IF PROCESSING FEE IS 0.125% AND B IS DEPOSIT HELD BY THE BANK LENDS ONLY 90% OF THE LOAN AND R IS THE RESERVE RQMT ON THE LOAN

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CALCULATING THE RETURN ON A LOAN: 1+K= [.00125+.12+..02]/[1-((.10) X(.9)]= 15,52% RAROC MODELS: ONE YR INCOME ON A LOAN/CAPITAL AT RISK ALSO KNOWN AS RISK ADJUSTED RETURN ON CAPITAL RAROC= [ONE YR INCOME PER $]/[UNEXPECTED DEFAULT XLOSSGIVEN DEFAULT] THE NUMERATOR IS ROA COST OF FUNDS. THE DENOMINATOR IS PRODUCT OF UNEXPECTED DEFAULT RATE AND LOSS GIVEN THE DEFAULT RATE. THE EXTREME LOSS RATE IS CALCULATED BY TAKING THE AVERAGE ANNUAL LOSS RATE OVER SOME HISTORICAL PERIOD AND ESTIMATING THE STD DEV. IF THE STD. DEV IS MULTIPLIED BY 2.33 IT REFLECTS THE 99TH PERCENTILE WORST CASE SCENARIO. THE NUMERATOR ALSO ADJUSTS FOR THE EPECTED LOSSES. SUPPOSE THE COST OF FUNDS IS 15.2% AND ITS LOAN RATE IS 16%. EXPECTED LOSSES IS 0.5 %., WHICH MEANS THAT NUMEATOR IS.3%. THE 99% UNEXPECTED DEFAULT RATE IS 4% AND LOSS THEREON IS 80%. ,WHICH MEANS THE DENOMINATOR IS 3.2%. RAROC= .003..0032= 9.375%. THIS NO. NEEDS TO BE COMPARED WITH THE FIS ROE.

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MANAGING THE LIQUIDITY RISK CAUSES OF LIQUIDITY RISK 1. WITHDRAWL OF DEPOSITS 2. OFF-BALANCE SHEET COMMITT MATL. THE BANK CAN MEET THIS LIQUIDITY CRISIS BY PRUCHASING LIQUIDITY OR LIQUIDATING ASSETS. THE BANK CAN PURCHASE LIQUIDITY IN THE FED FUND MARKET AND ALSO BANK MAINTAIN SOME LIQUID ASSETS. BANKS CANMAINTAIN HIGHER LIQUIDITY ( MORE TREASURY SECURITIES0 BUT IT COMES AT A COST. SECURITISATION OF AUTOMOBILE AND MORTGAGE LOANS CAN ENHANCE A BANKS LIQUIDITY POSITION. THE PROCESS OF SECURITISATION COMMONLY INVOLVES THE SALE OF ASSETS BY THE BANK TO A TRUSTEE, WHO ISSUES SECURITIES THAT ARE COLLATERISED BY THE ASSETS.

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MANAGING THE INTEREST RATE RISK REPRICING MODEL: CONCENTERATES ON THE IMPACT OF INTEREST RATE CHANGES ON THE NET INTEREST INCOME. THIS MODEL PUTS ASSETS AND LIAB INTO VARIOUS TIME BUCKETS,TIME BEING THE FACTOR WHEN A PARTICULAR ASSET OR LIAB WILL BE REPRICED. THE GAP IN EACH MATURITY BUCKET IS CALCULATED BY ESTIMATING THE DIFFERENCE BETWEEN THE RATE SENSITIVE ASSETS AND RATE SENSITIVE LIABILITIES. RATE SENSITIVITY OR REPRICING HERE MEANS THAT THE ASSET AND THE LIABILITY IS REPRICED ON MATIRITY OR ROLLOVER OR IT COULD BE A FLOATING ASSET OR LIAB. LETS LOOK AT THE TABLE ON THE NEXT SLIDE.

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MANAGING THE INTEREST RATE RISK TIME BUCKET 1 DAY 1DAY-3M 3M-6M 6M-12M 1YR-5YRS > 5YRS ASSETS 20 30 70 90 40 10 LIABILITIES 30 40 85 70 30 5 GAPS -10 -10 -15 +20 +10 +5

A NEGATIVE GAP MEANS THAT A RISE IN INTEREST RATE WOULD LOWER THE INTEREST RATE INCOME. NII= (RSAi- RSLi) x Ri THIS METHOD OFCOURSE HAS A LIMITATION. THIS MODEL ONLY MEASURES THE CHANGES IN THE CURRENT INCOME. SOMETIMES THE GAP IN A PARTICULAR TIME BUCKET CAN BE EXPRESSED AS A PERCENTAGE OF TOTAL ASSETS.

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MANAGING THE INTEREST RATE RISK WE CAN ALSO MEASURE CUMULATIVE GAP UPTO A PARTICULAR MATURITY. WHEN CGAP IS +IVE, THE CHANGE IN NII IS POSITIVELY CORRELATED TO THE INTEREST RATES. NEGATIVES OF THIS MODEL: IT IGNORES THE CHANGES IN THE MV OF ASSETS AND LIAB.(DURATION) IT IGNORES THE C FLOWS PATTERN WITHIN A MATURITY IT ASSUMES NO PREPAYMENT RISK. IT IGNORES THE C FLOWS FROM OFF-BALANCE SHEET ACTIVITIES.

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MANAGING THE INTEREST RATE RISK DURATION ANALYSIS. A 10 YR ZERO COUPON BOND IS MORE SENSITIVE THAN A 10 YR COUPON BOND THE DURATION OF A PORTFOLIO IS THE WEIGHRTED AVERAGE DOF DURATION OF INDIVIDUAL SECURITIES. DURATION GAP= DURATION (ASSETS)- DURATION(LIAB) FOR MOST OF THE BANKS THE AVERAGE DURATION OF ASSETS EXCEED THE AVERAGE DURATION OF LIABILITIES. THIS MEANS THAT THE MV OF A BANKS ASSETS IS MORE SENSITIVE TO INTEREST RATES THAN THE THE VALUE OF OTS LIABILITIES. IF INTEREST RATE INCREASES THEN BANKS WITH POSITIVE DURATION GAPS WILL BE ADVERSLY AFFECTED. HOWEVER EVEN THE DURATION ANALYSIS IGNORES THE PREPAYMENT RISK.

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MANAGING THE INTEREST RATE RISK DURATION ANALYSIS. THE DURATION MEASURES AND IMMUNISATION STRATEGIES HAVE BEEN PROPOSED BY THE FED RESERVE AND THE BANK OF INTERNATIONAL SETTLEMENTS. TO IMMUNISE AGIANST THE INT. RATE RISK, THE DURATION OF ASSETS AND LIABILITIES SHOULD BE MATCHED. SOME ARGUE THAT IT INVOLVES MAJOR BALANCE SHEET RESTRUCTURING. THE ASSET SECURITISATION AND LOAN RESALE MARKETS HAVE MADE THIS JOB COMPARATIVELY EASIER. MANAGERS CAN ALTER THE DURATION OF ASSETS USING THE DERIVATIVES MARKETS. IMMUNISATION PROCESS HAS TO BE DYNAMIC. THE MANAGER ALSO MUST LOOK INTO THE CONVEXITY ISSUES.

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HOW REGULATORS MONITOR BANKS: CAR : CAPITAL DIVIDED BY RISK WEIGHTED ASSETS(TIER I AND TIER II) IF BANKS HOLD MORE CAPITAL THEY CAN SURVUVE EVEN WHILE ABSORBONG HIGHER POTENTIAL LOSSES. NORMALLY THE CAR OF 10% OR 12% IS TO PROTECT AGAINST THE CREDIT OR DEFAULT RISK. SIMILARILY REGULATOR ENSURES PROPER DIVERSIFICATION OF THE LOAN PORTFOLIO. ANOTHER LAYER OF PROTECTION IS THE INSURANCE OF DEPOSITS (DICGC). IN INDIA UPTO 1 LAC PER DEPOSIT HOLDER. ANOTHER LAYER IS MONITORING AND SURVELLIENCE BY THE REGULATOR. REGULATOR ALSO CONTROL CREDIT ALLOCATION . 40% TO PRIORITY SECTOR ..

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HOW REGULATORS MONITOR BANKS: ECONOMIC VALUE OF CAPITAL VS MV OF CAPITAL ECONOMIC VALUE MAKES ADJUSTMENT FOR THE CHANGES IN THE VALUE OF ASSETS AND LIAB DUE TO CHANGES IN THE INTEREST RATES. TO THIS EXTENT THE BV OF CAPITAL MAY BE AN ADEQUATE MEASURE OF INSOLVENCY RISK.

MANAGING MARKET RISKS: DUE TO CHANGES IN THE VALUE OF SECURITIES DUE TO CHANGES IN THE INTERST REATE; FOREX AND EQUITY PRICES AND ALL THE ABOVE THREE AFFECTING THE PRICES OF DERIVATIVES BOOK OF BANKS. MARKET RISK IS MEASURED BY VAR MODEL. 95% CONFIDENCE LEVEL TO MEASURE MAXIMUM EXPECTED ONE DAY LOSS. FOR EXAMPLE THIS MAY BE US$ 35 MN. AS PER BASLE COMMITTEE BANKS ARE SUPPOSE TO PROVIDE CAPITAL AGAINST THE VAR.

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BANKS MANAGEMENT OF CAPITAL: ROE= PAT/ASSETS XASSETS/EQUITY FOR EXAMPLE IF PAT/ASSETS = 1% AND ASSETS/EQUITY=15 THEN ROE= 15% THUS BANKS SHOULD NOT HOLD UNNECESSARILY HIGHER CAPITALAS IT EVENTUALLY EFFECTS THE ROE.