Risk Management in Banks

Part A: Basic Concepts

Q. Which of the following situations can earn profit to a bank? a. Go long on Euro and Euro depreciates against rupee b. Go short on Euro and Euro appreciates against rupee c. Go short on euro and rupee depreciates against euro

d. Go short on euro and euro depreciates against rupee e. Go long on euro and rupee appreciates against euro

Q. The Altmans Z score model adopted in credit rating uses a. Profit after tax to total assets ratio b. Earnings before tax to total assets c. Sales to total assets ratio

d. Working capital to total assets ratio e. Both ( c ) and (d)

Q. Risk arising on account of changes in exchange rates at the time of finalizing the assets/liabilities by converting foreign currency denominated assets into domestic currency is known as a. Transaction exposure b. Translation exposure c. Operating exposure

d. Currency exchange exposure e. Currency swapping exposure

Q. Which of the following statements is false? a. The cause and effect of liquidity risk are primarily linked to the nature of assets and liabilities of a bank. b. The Basel II norms are meant to be followed by all banks across the globe irrespective of being internationally active. c. Country risk arises due to cross-border transactions that are growing dramatically owing to economic liberalization and globalization.

d. Interest rate risk is a part of the market risk. e. Call risk arises on account of crystallization of liabilities under off balance sheet items.

Q. In respect of Cash Credit Accounts, early signals of sickness can be identified a. By observing the returned cheques in the account b. Frequent exceeding of the limit granted c. By offering a lower level of collateral security

d. Improper submission of stock statements e. (a) + (b) + (d)

Q. The risk arising from the possibility of not being able to repay its liabilities due to huge amount of outstanding receivables is called a. Credit risk b. Financial risk c. Liquidity risk d. Default risk e. Contingent risk

Q. The lowest bucket of classification of assets and liabilities for the purpose of liquidity management is a. 2-7 days b. 1-14 days c. 1 day d. 8-9 days e. 1-28 days

Q. Which of the following is not a precondition for a subordinate debt instrument to be included as Tier III capital a. Fully unsecured b. Fully paid up instrument c. Original maturity of not less than two years

d. Must be guaranteed by central or state government e. Must not be repayable before due date.

Q. Which one of the following aptly explains nationalization of banks in India in 1969? a. Country Risk b. Sovereign Risk c. Currency risk

d. Operating risk e. Political risk

Q. The rating model developed by Credit Suisse uses a. Langrangian multiplier model b. Binomial principles c. Probability distribution

d. Differential calculus e. Actuarial calculations

Q. Income recognition norms of Narasimham Committee recommendations deal with a. Asset classification and provisioning b. Prompt and systematic tracking of assets c. Repayment of recovery of loans on the due dates

d. Assets acquisition and monitoring of credit e. Review of loan sanctioning procedures.

The prime objective of ALM implementation is a. To acquire liabilities as per the needs of the assets b. To improve profitability c. To maintain good liquidity

d. To ensure profitability and liquidity e. To acquire capital that satisfies shareholders

Q. Duration of an interest related instrument is a. Equal to its left over maturity period b. Equal to the period up to which the ytm is calculated c. Equal to the time period up to which the instrument is to be held in order to nullify the interest rate risk

d. Equal to the maturity period in case of zero-coupon bond. e. Both (d) and (e)

Q. If the CRR amount maintained by a bank as on the last reporting Friday i.e.19th Sep 2008 is Rs 3645 crore, calculate the SLR amount of to be maintained by the bank. a. 10000 b. 36450 c. 10125 d. 45364 e. 25000

Q. When the primary movable security is in the possession and use of the borrower, the charge created against such security in the working capital finance is a. Pledge b. Hypothecation c. Lien

d. Mortgage e. None of the above

Q. In the case of currency futures, the settlement price on the last trading day will be a. Reserve Banks reference rate on that date b. RBI prime lending rate c. Bank Rate

d. Spot rate on the date of entering into the futures transaction e. Mutually acceptable rate

Q. According to the latest amendment by Reserve Bank of India, all commercial banks (excluding RRBs) are required to adopt granular approach to measurement of liquidity by splitting the first time-bucket in the Statement of Structural Liquidity into a. 1day, 2-10days, 11-14 days b. 1 day, 2-7 days, and 8-14 days c. 1 day, 2-8 days, and 9-14 days

d. 1 day, 2-9 days, and 10-14 days e. 1 day, 2-6 days, and 7-14 days

Q. An Indian exporter who invoices in US $ is benefited most a. By realizing the export proceeds immediately if the US$ is at a discount b. By delaying the realization of export proceeds if the US $ is at a premium c. By delaying the realization of export proceeds if the US $ is at a discount

d. By entering into a forward contract covering the receivables\ e. Both (a) and (b) given above.

Q. Which of the following factors influence(s) the decision relating to the deployment of excess funds? a. Deposit withdrawals b. Profit fluctuations c. Credit accommodation

d. Maintaining Cash Reserve Ratio and Statutory liquidity Ratio e. Options (a) + (b) + (c)

Q. Capital adequacy ratio measures the relationship between its a. Capital to its total assets b. Capital to its off balance sheet assets c. Short term capital to the total risk weighted assets d. Capital to Risk weighted Assets e. Total assets to its total liabilities Q. A Counter guarantee refers to a. A guarantee issued by a bank countering the guarantee of a customer b. A bank obtaining a guarantee from a borrower constituent on whose behalf the bank has issued a guarantee c. A guarantee issued by another bank in favor of the issuing bank d. When a guarantee is invoked, the constituent agrees to be sued e. None of the above. Q. The granular approach of the first time-bucket suggests categorization into three sub-buckets. The net cumulative negative gap under the second sub-bucket should not exceed of the cumulative cash outflows in the respective time buckets in order to recognize the cumulative impact on liquidity. a. 20% b. 15% c. 10% d. 5% e. None of the above. Q. At the macro level, which of the following methods will enable a bank to manage its credit risk? a. By verifying all the borrowal accounts of the bank through a well developed IT system. b. As the risk weighted assets increase, there should be a proportionate or more than proportionate rise in capital c. Introducing credit risk management department d. RBI conducting regular inspections of the Head Office of the bank e. Consolidating the MSOD and QIS Statements regularly. Q. When a term loan account is identified as a Non-performing account as on 30-6-2008, a. The bank will have to reverse the interest debited as on 31-3-2008 b. The other income like commission and exchange received from the borrowal account during 1-4-2008 to 30-6-2008 will be reversed from the P and L account. c. The account will be reported as substandard asset. d. The bank will have to make a provision of 50% e. Both (a) and (b)

Q. Economic Equity Ratio (EER) measures a. Profitability of the bank b. Sustenance capacity of the bank c. Debt equity ratio of the bank

d. Equity cost of the bank e. Macro economic factors of the bank

Q. The tier 3 capital consists of a. Medium and short term dated securities b. Short term bonds with an original maturity of at least two years c. Long and medium term bonds with moderate durations

d. Short term bonds with an original maturity of at least two years and the total of such capital should not exceed 250% of Tier 1 capital e. Both (b) and (d)

Q. The Second consultative paper of Basel II suggested classification of the following type of risk based on causes and effects a. Interest rate risk b. Market risk c. Operational risk d. Credit Risk e. Strategic Risk

Q. A study of risk migration is used in a. Strengthening operational risk b. Reviewing and redesigning the existing credit rating models c. Studying lendable funds

d. Improving the NIM of the bank e. Developing risk mitigation techniques

Q. Herstatt Risk refers to a. The risk of settlement that arises due to the difference in time-zones of different countries across the world b. The risk element due to difference between the inflows of assets and outflows of liabilities c. The risk due to fall in price due to rise in the interest rate structure

d. The risk due to change in the duration of interest bearing instruments e. The risk due to holding excess of cash over the approved limits by the Head office of a bank.

Q. Which one of the following does not relate to liquidity risk a. Loss arising due to adverse changes in the cash flows of transactions. b. Short term assets values are not sufficient to match short term liabilities. c. Difficulties in raising short term money at a reasonable cost. d. Inability to sell a security in the market to raise funds due to unfavorable market conditions e. Devolving of liability on account of bank guarantees and letters of credit.

Part-B & C
1. The following table indicates the VaR (value at risk) values of 8 different investments. Investment name A B C D E F G H Parameters 10-days, 99% 10-days, 95% 1-day, 95% 1-day, 99% 5-days, 95% 5-days, 99% 20-days, 99% 20-days, 95% VaR Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs. 5 crore Rs. 5 crore

You are required to compare these investments using both the levels of confidence and place in the order of preference considering the riskiness in them duly showing detailed workings. (Hint: consider that the stock exchange works for 5 days a week) (10 marks) Suggested Answer: Annual 1% Loss (99% confidenc e) 35.70 25.50 112.84 80.60 24.22 17.30 50.47 36.05 Annual 5% Loss (95% confidence) 25.50 18.21 80.60 57.57 17.30 12.36 36.05 25.75 Comparative Riskiness at 99% confidence level 2.06 1.47 6.52 4.66 1.40 1.00 2.92 2.08 Comparat ive Riskiness at 95% confidenc e level 1.47 1.05 4.66 3.33 1.00 0.71 2.08 1.49 Rank

Parameters

VAR

10-days, 95% 10-days, 99% 1-day, 95% 1-day, 99% 20-days, 95% 20-days, 99% 5-days, 95% 5-days, 99%

Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore Rs.5 crore

4 3 8 7 2 1 6 5

2. A company rated B++ estimated a need of Rs. 1575 crore by 1-11-2008 for meeting their projected growth in business and the board of directors decided to go for a debenture. The company decided to offer 12.5% interest payable annually and redeemable at 5% premium after five years. Keeping in view the current market trends, the YTM is expected to be 15% (compounded annually). A scheduled commercial bank decided to invest Rs. 150 crore in this bond, with a view to increasing their NIM. To avoid interest-rate risk, how many years should the bank hold the investment? (5 marks) Suggested Answer: Assume face value = Rs 1000

Years Coupon Interest Redemption amount Total Discounted at 15% PV of cash inflow PV * year

1 125

2 125

3 125

4 125

5 125 1050

125 0.87 108.7 108.7

125 0.756 94.52 189

125 0.658 82.19 246.6

125 0.572 71.47 285.9

1175 0.497 62.15 310.7

Duration

2.723

years

3. The risk weighted assets for credit risk of a public sector bank were estimated at Rs. 69364 crore. The amounts of capital estimated for covering the market risk and operational risk are respectively Rs 1057 crore and Rs 598 crore. Calculate the total risk weighted assets of the bank for the purpose of maintaining minimum capital adequacy ratio as per the extant guidelines. (5 marks) Suggested Answer: Rs in crore TRWA RWA for Credit Risk 69364 87751.05 69364 11.11 (Cap for MR) 11.11 * 1057 11743.27 11.11(Cap for OR) 11.11 * 6643.78 598

4. Differentiate the following: (5 * 2 =10 marks) a. Mortgage Vs Pledge b. Solvency Risk Vs Liquidity Risk c. VaR Vs Variance d. Refinance Vs Rediscounting of Bills e. Guarantor Vs Co-borrower

Answer: a. Mortgage Vs Pledge: Mortgage is creation of charge on the immovable property to secure a loan, it could be a primary security or collateral security.. Pledge is creation of charge on the movable property in favor of a bank, whereby the bank will be in the possession of the goods. b. Solvency Risk Vs Liquidity Risk : Solvency Risk is a long term incapability of a bank in meeting the payment obligations, while liquidity risk refers to a short term incapability c. VaR Vs Variance: It is defined as the predicted worst-case loss at a specific confidence level over a certain period of time assuming Normal Trading conditions while Variance is simply the mean of sum of the square of the deviations from a mean.

d. Refinance Vs Rediscounting of Bills : Refinance refers to the amount lent to banks at reasonably low rate of interest by refinance corporations like NABARD for promoting priority sector lending, Rediscounting of bills is done by RBI to help banks suffering from liquidity problems in short term. e. Guarantor Vs Co-borrower: Guarantor is a person who will be required to repay the debt, after the borrower has failed to repay and such a notice is served on the borrower whereas a coborrower has a concurrent responsibility to repay the loan along with the original borrower.

5. Explain the factors necessitating the implementation of Asset Liability Management (ALM) in banks. Also briefly explain the parameters selected for stabilizing the ALM. (10 marks) Suggested Answer: 1. Volatility: Shift from Closely regulated to deregulated or market driven economies has augmented volatility - in terms of Interest rate structures Money supply Overall credit position of market Exchange rates Price levels

2. Product innovation: rapid innovations in the products and delivery of products. Flexi deposits (premature withdrawal of deposits or raise loan ag deposit) Auto-loans coordinating with auto dealers 3. Regulatory environment: addition to the credit risk BASEL frame-work to tackle market risks and operational risk in

4. Management recognition: Support from the top management Managements have realized that it is not good enough to have a sound credit base; it also needs matching of the retail deposit base with that of the credit base Parameters: (explain each in one sentence)

Net Interest Income (NII) Net Interest Margin (NIM) Economic Equity Ratio (EER)

6. Banking is a business full of risks. Lot of attention is given to credit and market risks ignoring operational risks. Operational risk is because of failure of man, machine or systems to operate as expected. With more and more implementation of Information Technology based systems, the chances of IT related operational risks may increase day by day unless some measures are not implemented. Banks have to identify the risks from the increased use of computerization and automation in their processes as the types of controls required to manage the risks are different from the manual systems. Discuss (10 marks) Suggested Answer: Student should elaborate on these risks There are three types of risks:

a. IT Environment Risks Regulatory risks Strategic risks Organization Risk Outsourcing Risk

b. IT Operations Risks Error risk Computer fraud risk Disclosure risk Interruption risk

c.

Product/Service Risk

Part C: Case Analysis

CAPITAL MANAGEMENT AT HSBC INTRODUCTION
HSBC, which began as part of efforts to promote British imperial trade in opium, silk, and tea in East Asia, was the UK's largest banking company. It owned The Hongkong and Shanghai Banking Corporation, France's CCF, and 62% of Hong Kong's Hang Seng Bank. HSBC had more than 8,000 offices in about 80 countries, providing consumer and business banking, asset management, investment banking, securities trading, insurance, and leasing services. US operations, which included HSBC USA and joint venture Wells Fargo HSBC Trade Bank, had been significantly expanded with the $15 billion stock purchase of consumer lender Household International.

Exhibit 1 HSBC: Business Segment Information Half-year to 30 June 2003 US$m Profit (loss) before tax-cash basis* Personal Financial Services Consumer Finance** Total Personal Financial Services Commercial Banking Corporate, Investment Banking and Markets Private Banking Other Profit before tax-cash basis Goodwill amortisation Profit before tax * 2082 649 2731 1647 2237 268 -4 6879 -767 6112 100 30.3 9.4 39.7 23.9 32.5 3.9 1757 1484 2069 249 -101 5458 -401 5057 1757 32.2 27.2 37.9 4.6 -1.9 100 1634 1530 1827 164 -100 5055 -462 4593 32.3 30.3 36.1 3.3 -2 100 % 30 June 2002 US$m % 31 December 2002 US$m %

Line of business figures for 2002 have been restated to reflects changes in management responsibility arising from an alignment of domestic private banking in the United States with international private banking and consequent reclassification of the US business's results from Personal Financial Services to Private Banking. In 2003, North America implemented a revised funds transfer pricing system to transfer interest rate from the business units to Corporate, Investment Banking and Markets. The figures for 2002 have been restated to reflect the impact of transfer pricing had it been in place on a similar basis. Comprises Household since the date of acquisition.

**

Source: HSBC Holdings PLC Interim Report, June 2003.

REGULATORY FRAMEWORK
The Financial Services Authority (FSA) supervised HSBC on a consolidated basis, received information on the capital adequacy, and set capital requirements for HSBC as a whole. Individual banking subsidiaries were directly regulated by their local banking supervisors, which set and monitored their capital adequacy requirements. In some regions, certain non-banking subsidiaries were also subject to the supervision and capital requirements of local regulatory authorities. The FSA required each bank and banking group to maintain the appropriate ratio of total capital to risk-weighted assets taking into account both balance sheet assets and off-balance-sheet transactions. Under EU Directive, the FSA allowed banks to calculate capital requirements for market risk in the trading book using VAR techniques. The Household segment was not directly supervised by banking regulatory bodies but was subject to the supervision of the Federal Reserve. As part of HSBC, it was also subject to consolidated

supervision by the FSA. Individual Household subsidiaries were subject to banking and insurance regulatory oversight in the relevant jurisdictions.

TIER 1 & TIER 2 CAPITAL

HSBCs capital was divided into two tiers. Tier 1, comprised shareholders funds, innovative tier 1 securities and minority interests in Tier 1 capital, but excluded revaluation reserves. Tier 2 comprised general loan loss provisions, revaluation reserves, qualifying subordinated loan capital and minority and other interests in Tier 2 capital. The amount of qualifying Tier 2 capital could not exceed that of Tier 1 capital, and term subordinated loan capital might not exceed 50 percent of Tier 1 capital. There were also limitations on the amount of general provisions, which might be included in Tier 2 capital. The book values of goodwill, own shares held and intangible assets were deducted in arriving at Tier 1 capital. Total capital was calculated by deducting the book values of unconsolidated investments, investments in the capital of banks, and certain regulatory items from the total of Tier 1 and Tier 2 capital. In 2003, Tier 1 capital increased by US $9.3 billion. Retained profits on a cash basis (excluding goodwill amortization) contributed US $2.3 billion. Shares issued to fund the acquisition of Household, net of the increased goodwill, added US $4.4 billion to Tier 1 capital. The issue of Tier 1 securities contributed US $1.2 billion and exchange movements on reserves and other movements also added US $1.4 billion to Tier 1 capital. The increase of US $2.0 billion in Tier 2 capital mainly reflected the proceeds of capital issues, net of redemption and regulatory amortization. Tier 2 capital also benefited from debt in issue in Household and higher levels of general provisions, mainly reflecting the acquisition of Household.

RISK-WEIGHTED ASSETS
Banking operations were categorized as either trading book (broadly, marked-to-market activities) or banking book (all other activities). Risk-weighted assets were determined accordingly. Banking book risk-weighted assets were measured by means of a hierarchy of risk weightings classified according to the nature of each asset and counterparty, taking into account any eligible collateral or guarantees. Banking book off-balance-sheet items leading to credit, foreign exchange or interest rate risk were assigned weights appropriate to the category of the counterparty, taking into account any eligible collateral or guarantees. Trading book risk-weighted assets were determined by taking into account market-related risks such as foreign exchange, interest rate and equity and counterparty risks. Total risk-weighted assets increased by US $139 billion during 2003. The acquisition of Household contributed US $109 billion to this increase. The remaining increase was largely due to currency translation differences and growth in the loan book.

POLICY GUIDELINES
HSBCs policy was to maintain a strong capital base to support the needs of its business. HSBC attempted to maintain a prudent balance between the different components of its capital and between the composition of its capital and that of its investment in subsidiaries. Each subsidiary managed its own capital in line with an approved annual plan, which determined the optimal amount and mix of capital required to support growth and meet local regulatory capital requirements. Capital generated in excess of planned requirements was paid up to HSBC Holdings normally by way of dividends.

Exhibit 2 HSBC: Source and Application of Tier 1 capital Half-yearly 30 June 2003 US $m Movement in Tier 1 capital Opening tier 1 capital Attributable profits Add back: goodwill amortization Dividends Add back: shares issued in lieu of dividends Increase in goodwill deducted Merger reserve Shares issued Innovative tier 1 capital issued Redemption of preference shares Other (including exchange movements) Closing tier 1 capital Movement in risk-weighted assets Opening risk-weighted assets Movements Closing risk-weighted assets 430,551 139,062 569,613 391,478 19,508 410,986 410,986 19,565 430,551 38,949 4,106 767 (2,589) 444 (10,919) 12,768 1,069 1,237 2,428 48,260 35,073 3,280 401 (1,929) 856 (999) 182 (50) 2,913 39,727 39,727 2,959 462 (3,072) 167 (2,730) 156 1,280 38,949 30 June 2002 US $m 31December 2002 US $m

Source: HSBC Holdings PLC Interim Report, June 2003. HSBC Holdings was primarily a provider of equity capital to its subsidiaries. These investments were substantially funded by HSBC Holdings own equity issuance and profit retentions. Major subsidiaries usually raised their own non-equity tier 1 and subordinated debt in accordance with HSBC guidelines regarding market and investor concentration, cost, market conditions, timing and the effect on the composition and maturity profile of HSBCs capital. The subordinated debt requirements of other HSBC companies were met internally. HSBC sought to strike a balance between the advantages and flexibility afforded by a strong capital position and the higher returns made possible by greater leverage. HSBC used a benchmark Tier 1 capital ratio of 8.25 percent in considering its long-term capital planning.

Exhibit 3 HSBC: Capital Structure (Amounts in US $m) 30 June 2003 30 June 2002 31 December 2002 Composition of Capital TIER 1 Shareholder's funds Minority interests Innovative tier 1 securities Less: Property revaluation reserves Goodwill capitalized and intangible assets Own shares held 1 Total qualifying tier 1 capital 1707 28007 801 48260 2292 15587 576 39727 1954 17855 -601 38949 70290 3521 4564 51178 3434 3570 52406 3306 3647

TIER 2 Property revaluation reserves General provisions Perpetual subordinated debt Term subordinated debt Minority and other interests in tier 2 capital Total qualifying tier 2 capital 1707 2816 3543 14885 556 23507 2292 2085 3514 9882 793 18566 1954 2348 3542 12875 775 21494

Unconsolidated investments Investments in other banks Other deductions Total capital Total risk-weighted assets Capital ratios (percent) TOTAL CAPITAL Tier 1 capital
1

3703 662 521 66881 569613

2031 696 126 55440 410986

2231 638 144 57430 430551

11.7 8.5

13.5 9.7

13.3 9

This principally reflects shares held in trust available to fulfill HSBC's obligations under employee share option plans. Note: The exhibit above sets out the analysis of regulatory capital. The above figures were computed in accordance with the EU Banking Consolidation Directive.

Exhibit 4 HSBC: Risk Weighted Assets (Amounts in US $ millions) 30th June 2003 30th June 2002 31st December 2002 Risk-weighted assets Hang Seng Bank Limited The Hongkong and Shanghai Banking Corporation Limited and Other subsidiaries The Hongkong and Shanghai Banking Corporation Limited HSBC Private Banking Holdings (Suisse) S.A. CCF HSBC Bank plc and other subsidiaries HSBC Bank plc HSBC Bank USA Household HSBC Bank Canada GF Bital HSBC Bank Middle East Limited HSBC Bank Malaysia Berbad HSBC South American Operations HSBC Holdings sub group Other HSBC risk-weighted assets Source: HSBC Annual Report, 2002. 21189 43723 150004 214916 57177 108650 18968 7717 6558 5025 5692 890 17688 569613 6074 4334 5621 1031 29166 410986 16213 15499 7853 6573 4713 4865 554 16657 430551 17521 38743 120755 177019 54100 20374 40399 138206 198979 54576 33348 92984 126332 32358 85070 117428 32350 87932 120282

Note: The exhibit above analyses the disposition of risk-weighted assets by principal subsidiary. The risk-weighted assets are calculated using FSA rules and exclude intra-HSBC items.

LIQUIDITY AND FUNDING MANAGEMENT

HSBCs liquidity policy aimed at ensuring that all obligations and commitments, which needed to be funded, could be met out of readily available and secure sources of funding. Liquid assets were supplemented by secured funding facilities, to take care of stress conditions. Funding policy attempted to ensure that the necessary sources of funds were available at an optimized cost. The management of liquidity and funding was carried out locally in the operating companies of HSBC and was not centralized. HSBC expected each legal entity to be self sufficient with regard to funding its own operations, except for certain short-term treasury requirements and small start-up operations which were funded under strict guidelines from HSBCs largest banking operations. There were also

regulatory restrictions and limitations on the transfer of resources between HSBC entities to meet liquidity and funding needs across the range of currencies, markets, regulatory jurisdictions and time zones within which HSBC operated. Local management was responsible for ensuring compliance with local regulatory and Group Executive Committee requirements. These varied by entity and took account of the depth and liquidity of the market in which the local financial unit operated. HSBC required operating entities to manage the liquidity profile of their assets, liabilities and commitments so that all funding obligations could be met when due. Liquidity was managed on a daily basis by local treasury functions, with the larger regional treasury sites providing support to smaller entities as required. HSBC accessed professional markets in order to provide funding for operating subsidiaries that did not accept deposits, to maintain a presence in local money markets and to optimize asset and liability maturities. Compliance with liquidity and funding requirements was monitored by the local Asset and Liability Management Committees, which reported to Group Head Office on a regular basis. This process included: Projecting cashflows by major currency and considering the level of liquid assets necessary in relation thereto; Monitoring balance sheet liquidity ratios against internal and regulatory requirements; Maintaining a diverse range of funding sources with adequate back-up facilities; Managing the concentration and profile of debt maturities; Maintaining debt financing plans; Monitoring depositor concentration in order to avoid undue reliance on large individual depositors and to ensure a satisfactory overall funding mix; and Maintaining liquidity and funding contingency plans, which identified early indicators of stress conditions and suggested actions to be taken during systemic or other crises.

HSBC
Current accounts and savings deposits payable on demand or at short notice formed a significant part of HSBCs funding for mainly of the operating companies. HSBC attached considerable importance to the stability of these deposits. In this context, HSBC believed it was important to enhance HSBCs brand value in terms of trust and stability across the Groups geographically diverse retail banking network and by maintaining depositor confidence in HSBCs capital strength. With the exception of Household, limited use was made of wholesale market funding. In aggregate, HSBC was a liquidity provider to financial markets placing significantly more funds with other banks than it borrowed. Household funded itself mainly through term funding in the professional markets and through securitisation of assets. As on 30 June 2003, US $100.7 billion of Households liabilities were drawn from professional markets, utilizing a range of products, maturities and currencies to avoid undue reliance on any particular funding source. Since Household became a member of the HSBC Group, its access to funding had improved in terms of both the breadth of available sources and the pricing. In aggregate, 51 percent (31 December 2002 - 46 percent) of HSBCs balance sheet was lent to customers and some 31 percent (31 December 2002 - 36 percent) was held in liquid assets, namely interbank lending and debt securities. Of total liabilities of US $983 billion as on 30 June 2003, funding from customers amounted to US $548 billion, of which US $535 billion was contractually repayable within one year. Although the contractual repayments of many customer accounts were on demand or at short notice, HSBC

believed deposit balances remained stable with deposits and withdrawals offsetting each other as customers remained confident that their funds would be available when required. Other liabilities included US $76 billion of deposits by banks (US $70 billion repayable within one year), US $26 billion of short positions in securities and US $145 billion of securities in issue. Assets available to meet these liabilities, and to cover outstanding commitments to lend (US $56 billion), included cash, central bank balances, items in the course of collection and treasury and other bills (US $40 billion); loans to banks (US $116 billion, including US $105 billion repayable within one year); and loans to customers (US $504 billion, including US $227 billion repayable within one year). In the normal course of business, a proportion of customer loans contractually repayable within one year would be extended. In addition, HSBC held debt securities marketable at a value of US $190 billion. Of these assets, some US $45 billion of debt securities and treasury and other bills had been pledged to secure liabilities. HSBC believed it could meet unexpected outflows in excess of available liquid assets by selling securities and accessing additional funding sources such as interbank markets or by securitization. Exhibit 5 HSBC: Customer Accounts and Deposits by Banks 30 June 2003 30 June 2002 US $m 61,455 190,638 280,140 532,233 % 11.6 35.8 52.6 100.0 31 December 2002 US $m 52,933 213,071 282,367 548,371 % 9.7 38.8 51.5 100.0

US $m
Deposits by banks Current Savings and other deposits 75,771 230,625 316,922 623,318 % Deposits by banks Current Savings and other deposits 12.2 37.0 50.8 100.0

TOTAL

TOTAL
Source: HSBC Annual Report, 2002.

HSBC HOLDINGS
HSBC Holdings primary source of cash was dividends from its directly and indirectly held subsidiaries. The ability of these subsidiaries to pay dividends or advance capital to HSBC Holdings depended on their respective regulatory capital requirements, statutory reserves, and financial and operating performance. HSBC actively managed the cashflows from its subsidiaries to maximize the amount of cash held at the holding company level, and expected to continue doing so in the future. Because of the wide range of HSBCs activities, HSBC Holdings believed it was not dependent on a single source of profits to fund its dividends. HSBC Bank plc, HSBC Bank USA Inc, Household International, Inc. and The Hongkong and Shanghai Banking Corporation Limited, which planned to make the largest contributions to HSBC Holdings cashflows, were themselves diversified banking businesses. With its accumulated liquid assets, HSBC Holdings believed that dividends from subsidiaries, coupled with debt and equity financing, would enable it to meet anticipated cash obligations.

As on 30 June 2003, the short-term liabilities of HSBC Holdings totalled US $4.4 billion, including US $2.6 billion in respect of the proposed first interim dividend for 2003. In practice, the full amount of the proposed dividend might not be paid out as shareholders could elect to receive their dividend entitlement in scrip rather than in cash. Short-term assets of US $9.0 billion, consisting mainly of cash at bank and money market deposits of US $5.8 billion and other amounts (including dividends) due from HSBC undertakings of US $2.1 billion, exceeded short-term liabilities.

6. Question for Analysis a. What are the current guidelines on Tier-I and Tier-II Capital as pronounced by RBI? Compare them with the data given in the case? (3 + 3 = 6 marks)

b. What are the key issues considered for allotting the Risk Weights? With reference to the Exhibit 4 in the case what types of risks do you consider to be factored into and why? What is the impact of increase in the risk weighted assets on the functioning of the bank? (4 + 3 + 2 = 9 marks) c. What is liquidity management and explain with reference to the HSBC. (5 marks)

END OF THE QUESTION PAPER