Commercial Banking System and Role of RBI

April 2022 Examination

Q1. One of the important mandate of RBI is prudent management of monetary policy,
curbing inflation and checking unemployment in economy. Explain how RBI achieves these
diverse parameters by use of different tools available with it. (10 Marks)

Answer 1.

Introduction
The Reserve bank of India uses monetary policy to maintain inflation in looking at even as
selling economic growth. A 125-basis factor repo rate drop by way of the Reserve bank of India
in 2015 will probably result in reduced lending and deposit prices from banks. During a repo, the
RBI sells securities, repurchasing them at a predetermined fee. To get cash from the RBI, the
central bank repurchases the guards from the banks. To position it truly, better repo rates imply
higher interest charges charged with the aid of banks to their clients. High-interest rates imply
that banks should pay an excessive rate for borrowing money, which means that much less credit
may be to be had to the economy, which helps reduce liquidity. RBI uses the reverse repo rate to
shop the excess bank price range. That's the other of the standard repo rate. Instead of the bank
charge, the repo has served as a reference for banks in setting interest prices in current years.

Concept and analysis

The central bank can alter the ratio to a most. Liquidity is limited by an excessive percent, even
as a low CRR has the reverse impact. The RBI can tighten or loosen liquidity depending on
market situations via adjusting the CRR. As of right now, CRR is at 4%. This refers to the
Reserve bank of India's (RBI) buy and sells brief-time period authorities' assets. The Reserve
bank of India can boom the amount of cash within the system using shopping government assets
and injecting budget. It may lower the quantity of money in circulation using selling those
securities to banks. The RBI often manages liquidity with this tool, even if not conducting a
financial policy evaluation. The share of a bank's overall deposits that the government requires
them to invest in government securities. The less SLR a bank has, the more money it can lend to
the majority. This method has reduced the SLR from 22% to 21.5 %, and the intention is to
lessen it with the aid of 0.25 % in step with sector till March 31, 2017. Bills of change,
commercial papers, and other identified property are eligible for this re-discounting rate from the
Reserve bank of India (RBI). In place of the bank charge, the repo has served as a reference for
banks in putting interest charges in current years. However, its miles are currently sitting at
8.25%.

Traditionally, bank quotes have tracked repo prices. The imperative bank boosts the bank rate if
it discovers that inflation has constantly been rising, making borrowing from the primary bank
extra pricey for commercial banks. Corporations and people borrowing much less from business
banks will see growth inside the interest prices charged by banks that lend to such institutions. A
reduction in credit availability limits price increases. But, the significant bank decreases the bank
price when expenses are depressed. Investment is recommended, central to a rise in output,
employment, earnings, and demand, and restraining the value of products and services. When an
imperative financial institution conducts open marketplace activities, it sells and shops for
securities within the money market. At the same time, the safety rate starts to rise and wishes to
be controlled and the vital bank will sell it. Because of the depletion of their reserves,
commercial banks can not extend new loans to organizations or the general public. The price
increase is confined, and new funding is discouraged. Alternatively, the crucial bank purchases
securities while the economic system is in the midst of a recession.

Commercial banks have their reserves reinforced to lend more money to businesses and the
overall populace. It creates even more critical questions. CRR and SLR are the two primary
deposit ratios used on this method to lessen or improve commercial banks' idle coins balances.
Maintaining a reserve fund in-house and a part of your deposits at the critical bank is needed by
law for each economic institution. They have got diminished their coins reserves. For that
reason, they lend much less. Funding, output, and employment are all harmed because of this
situation. While the reserve ratio is decreased, industrial banks' reserves increase. They grow
their lending, which has a fantastic effect on the financial system.
Conclusion

Speculative sports inside the economy are generally managed using adjusting the margin
necessities for trading to save them from excessive. The imperative bank boosts the margin
requirement on certain commodities while speculative interest choices up, and expenses rise in
some issues or industries. While a specific industry reviews a recession, the central bank lowers
the loan margin necessities. It follows that borrowers will acquire much less cash while taking
out loans secured by specific securities. When the margin requirement is accelerated to 70%, the
ledger of Rs 10,000 well worth of assets will gain a loan of Rs 3,000 or 30% in their cost.

Q2. Credit appraisal is a critical analytical tool of bank. Largely the profitability of bank
hinges on this tool. Any weakness on this front is reflected on the profitability of banks and
it also results in accumulation of stressed assets. BASEL-II has given strong
recommendations to check this menace. Elaborate in details the important
recommendations of this committee. (10 Marks)

Answer 2.

Introduction
The Basel Committee on Bank Supervision proposed global banking regulations known as Basel
II to harmonize international banking laws. Additional standards for minimal capital necessities
have been introduced through Basel II and described transparency necessities for banks' capital
adequacy exams below Basel II. The number one distinction between Basel II and Basel I is that
Basel II includes the credit risk of property held by financial institutions in calculating regulatory
capital ratios. Worldwide banking policies primarily based on the three primary pillars of modest
capital necessities, regulatory tracking, and marketplace subject were implemented in the second
global banking accord. Supervisors have a wide range of equipment at their disposal. However,
they ought to make use of them in a manner appropriate to the trouble to hand and within a
selected time restrict. Regulators need to locate the proper balance between strict regimes that
require rapid corrective motion and more lenient techniques.

Concept and analysis

According to Basel II, regulatory capital has been described, and no less than 8% of regulatory
capital over chance-weighted property was set up for Basel II. through Basel II, a bank's
permissible regulatory capital is separated into three kinds. The decrease the tier, the more
outstanding subordinated securities are allowed in a bank's portfolio. The regulatory capital
ratios are calculated using every tier's numerator as a percentage of the overall regulatory capital.
A massive variety of Tier 1 securities, bank reserves, hybrid contraptions, and lengthy-term
subordinated loans are protected at this tier. Tier 3 has subordinated loans with quick-term terms.
Danger-weighted assets are used as a denominator to calculate regulatory capital ratios, and
danger weights for each asset type are increased together. Basel II is operating to improve the
definition of risk-weighted assets. The greater a load of an asset, the more extraordinary
dangerous it's far. Basel II adds asset credit scores into threat weights, drastically departing from
Basel I. The lower the credit score's chance weight, the better. Regulation is the second pillar of
Basel II, supplying national regulators with the framework to cope with various risks, inclusive
of systemic and liquidity and legal worries. The market field pillar specifies many disclosure
requirements for banks' exposures, risk evaluation methods, and capital sufficiency. For the
primary time considering Basel I, hazard-weighted assets are considered in Pillar 1, similarly to
credit score threat. 8% of RWA is the naked minimal that banks must keep as capital adequacy.
Based totally on diverse asset instructions' particular dangers and characteristics, Basel II
provides banks with progressed techniques for computing capital requirements primarily based
on credit score risk. The standardized technique can help banks with fewer transactions and an
extra straightforward management structure. External credit assessment institutes are used to
determine the creditworthiness of a bank's consumer.

An internal ratings-based method is first-rate proper for banks with complicated enterprise
operations and danger management systems. To specify parameters like the chance of Default
and Loss Given Default, banks inside the economic establishments Regulatory Authority depend
upon their evaluations. Nevertheless, the supervisor sets the requirements for different chance
components, including exposure at Default and Loss Given Default. Internal superior rankings-
based techniques: underneath the AIRB approach, banks look at all danger additives and other
characteristics using their opinions. As a result, the need for effective monitoring and its absence
in Basel I necessitated the addition of Pillar 2. A bank's internal capital adequacy needs to be
assessed by using Pillar 2 to ensure that it may cowl all dangers that it can come upon in the
course of its operations. All risks connected with an organization have to be evaluated and
protected using the bank's manager. The danger profile must be considered while assessing the
bank's inner capital adequacy and devising a plan to preserve the critical capital level. To ensure
that banks adhere to regulatory capital necessities, regulators have to scrutinize and assess their
internal capital adequacy tests and rules. Additional components of Basel II include the
requirement that regulators ensure that banks keep their capital structure beyond the required
stage, which means supervisors ought to intervene daily to preserve capital over the primary
want actively.

Conclusion

Marketplace field is the cause of Pillar 3, which mandates that relevant marketplace facts be
made public. Economic statistics are assured to recognize to make educated trading decisions
and maintain the market field. Basel II's minimal capital requirements need to be met, as they
pressure banks to keep the ratio of regulatory capital to threat-weighted property at a specific
stage. To fix a bank's shortcomings and issues, its board of administrators and management has
to take the lead. Any other alternative could be guidelines for pre-agreed supervisory sports that
protect the supervisor from interfering unnecessarily with the decision-making system.
Q3. Risk mitigation is one of the main function/concern of bank in volatile economy. In
course of business banks face different types of risks which may vary from one bank to
another.
a. Which are the major risks banks are exposed to and how they mitigate it? (5 Marks)
b. Suppose the regulator asks one of the losses making Bank XYZ to close a few branches
to reduce cost thereby make the bank more sustainable/profitable. But XYZ Bank refuses
to close its few branches, citing some risk/s involved in the process. What are the risks XYZ
Bank perceives if it closes a few branches? (5 Marks)

Answer 3a.

Introduction
The capability of a bank to manage risk has a sizeable effect on the choices made by traders.
With the enormous size of some banks, overexposure to chance can result in bank collapses that
damage tens of millions of people. Governments should better understand the risks of banks if
they're to inspire conservative management and decision-making.

Concept and analysis

Banks are more involved approximately credit chance. A contract breach occurs when one party
fails to satisfy its contractual duties. Derivatives and guarantees can also be locations in which
responsibilities aren't met. The nature of banks' business model method is that they cannot be
entirely shielded from credit score risk. But, banks can lessen their publicity in numerous
approaches. Banks lessen their threat through diversifying their portfolios, as deterioration in a
sector or provider is probably unanticipated. A credit downturn is less likely to occur if banks are
not overexposed to an unstable industry. People with correct credit facts may be loaned money,
high-quality counterparties may be used, or they could possess property to secure the loans.
While people, structures, or methods reason errors, interruptions, or damages, we are speakme
about operational risk. Selling and trading carry a more stage of operational risk than retail
banking or asset management, which have low ranges of operational chance. Human blunders
can bring about financial losses in the diffusion of methods.
An instance of that is while a teller offers a client an additional $50 bill through a twist of fate.
Big-scale fraud may be perpetrated via a bank's cyber protection being violated. It gives hackers
admission to the bank's consumer information and funds, allowing them to blackmail the
institutions into paying them more money. As a result, banks are left with much less capital and
less self-belief from their customers. Reputational harm to a bank may make attracting deposits
and destiny business harder. Adjustments inside the supply and demand for commodities may be
hard to expect. Investing in the diffusion of different varieties of securities can help lessen your
publicity to marketplace chance. Banks can also lower their investment using investing in
inversely associated assets as an opportunity to hedge.

Conclusion

Maximum of a bank's marketplace danger comes from its capital market sports. A bank's
vulnerability will increase if it has a significant presence within the capital markets or sales and
buying and selling. Investing in businesses that produce commodities is another factor. Changes
in commodity costs without delay affect the price of each employer and the funding.

Answer 3b.

Introduction

Risky decisions like cutting back at the range of branch locations XYZ bank takes must now not
cross ignored. The bank has no longer yet decided to close down all of its locations across the
USA for that reason. Making ready for a discussion of the issue requires knowledge of its
principles.

Concept and analysis

Credit risks
Credit risk is the opportunity that borrowers will default on their debts. While assessing credit
danger, banks do not simply examine nonpayment as an alternative; additionally, they consider
fee delays. When most straightforward humans and companies who aren't going to run out of
cash in the course of the loan are thoroughly vetted and sanctioned for lending, this threat can be
prevented.

Market Risks

Further to lending cash, banks have a good-sized stockpile of securities. Bank treasury holds
some guards, i.e., to park cash inside the short period. As a result, banks have lent cash to their
customers primarily based on many securities as collateral. In this way, banking and the
inventory marketplace are inextricably related. Banks can mitigate such dangers thru hedging
contracts. Those traders use financial derivatives that can be traded in any monetary market.
Ahead, choice and swap contracts permit financial institutions to do away with marketplace risk
honestly.

Business risk

We stay in an incredibly superior and diverse time for the economic enterprise. In the intervening
time, banks can pick out from an extensive desire of techniques to healthy their needs. Once an
extended-time period approach has been established, banks should put all their efforts into
achieving it. Due to this, any financial institution's plan can cross wrong at any time. The bank
can be obtained or moved beneath due to this negative choice. The banks' bankers and other
advisory crew contributors have to be proactive in their danger management activities. They can
dive into and ask questions that might unearth hazards that you have not even observed and then
devise robust hazard mitigation solutions—promoting and buying and selling carry a more stage
of an operational chance than retail banking or asset control, which both have low degrees of an
active threat. Within destiny, you could help other corporations avoid the errors you made.
Human mistakes can bring about financial losses in an expansion of approaches.

Conclusion

To mitigate the threat, the board has to approve the coverage of departure plans. Portfolio
exposure in one nation may also have passed an acceptable degree and must be reduced or
removed using a predetermined action plan. The substance of a go-out approach must be
proportionate to the extent of exposure of the organization.