MBA 520F FINANCE & MONEY MARKET

UNIT I : Structure of Financial System – role of Financial System in
Economic Development – Financial Markets and Financial Instruments –

Capital Markets – Money Markets – Primary Market Operations – Role of
SEBI – Secondary Market Operations – Regulation – Functions of Stock
Exchanges – Listing – Formalities – Financial Services Sector Problems and
Reforms.
Unit II: Introduction to Financial Institutions- SFC’s & DFI’s, their
importance & scope (IDBI, IFCI, SIDBI). Credit Rating Agencies –importance
and Issues.
Unit III: Asset Liability Management - Significance, ALM process.
Techniques - Gap, Duration. Simulation, Value at Risk, Book value of equity
and market value of equity perspective, Risk Management in Banks - Credit
risk management. Operational risk management, Market risk management.
Corporate treasury management. Liquidity risk management, Governance risk
and compliance.
Unit IV: Monetary Theory and Policy - Determination of Interest Rates,
Structure of Interest Rates, Bond Markets
Unit V: Basel l and 2
MBA520F FINANCE & MONEY MARKET Compiled By Prof. VILAS SIR

In any functional economy, economic resources are limited, with individuals having unlimited
wants and desires. This problem, referred to as scarcity, is one of the significant drivers of an
economy. However, it challenges an economy in determining when, where, to whom to
distribute its resources. Consequently, it resulted in a financial system structure capable of
efficiently allocating economic resources to stimulate growth. Also, it allows participants to
benefit by:
 Providing a way of making payments (banks)
 Giving participants a way of earning interest in the form of time value (investment
institutions)
 Protecting them against financial risks (insurance)
 Collecting and distributing financial information (credit agencies)
 Governing regulations to maintain stability (central banks and governments)
 Maintaining liquidity and converting investments into cash (banks and financial
institutions)
A financial system is the set of global, regional, or firm-specific institutions and practices used
to facilitate the exchange of funds. Financial systems can be organized using market principles,
central planning, or a hybrid of both.
A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges, that permit the exchange of funds. Financial systems exist on firm, regional, and
global levels. Borrowers, lenders, and investors exchange current funds to finance projects,
either for consumption or productive investments, and to pursue a return on their financial
assets. The financial system also includes sets of rules and practices that borrowers and lenders
use to decide which projects get financed, who finances projects, and terms of financial deals.
Financial institutions are at the core of the financial system, giving individuals the ability to
save and invest whenever and wherever they want. Investors put their money in these
institutions, which offer them a reward for saving and use it to lend to borrowers. The
borrowers can use these funds to build goods and services or fund other projects. All this
activity helps promote economic growth – either by creating additional jobs or generating a
profit and contributing back to the economy.
The money or funds flow from the lender to the borrower in one of two ways:
 Market-Based
 Centrally Planned
In a market-based economy, borrowers, lenders, and investors can obtain funds by trading
securities, such as stocks and bonds in the financial markets. The law of supply and demand
will determine the price of these securities. With a centrally planned economy, governing
authority or central planner makes the investment decisions. In most instances, there will be a
mix of both types of economies. For example, a business firm is a centrally planned financial
system with respect to its internal financial decisions; however, it typically operates within a
broader market interacting with external lenders and investors to carry out its long term plans.
At the same time, all modern financial markets operate within some kind of government
regulatory framework that sets limits on what types of transactions are allowed. Financial
systems are often strictly regulated because they directly influence decisions over real assets,
economic performance, and consumer protection.
The features of a financial system are as follows:

1) Financial system provides an ideal linkage between depositors and investors, thus
encouraging both savings and investments.
2) Financial system facilitates expansion of financial markets over space and time.
3) Financial system promotes efficient allocation of financial resources for socially desirable
and economically productive purposes.
4) Financial system influences both the quality and the pace of economic development.
Components of Financial Systems
There are several financial system components to ensure a smooth transition of funds between
lenders, borrowers, and investors.
 Financial Institutions: Financial institutions act as intermediaries between the lender
and the borrower when providing financial services. These include:
 Banks (Central, Retail, and Commercial)
 Insurance Companies
 Investment Companies
 Brokerage Firms
 Financial Markets: These are places where the exchange of assets occurs with
borrowers and lenders, such as stocks, bonds, derivatives, and commodities.
Financial markets help businesses to grow and expand by allowing investors to contribute
capital. Investors invest in company stock with the expectation of it producing a return in
the future. As the business makes a profit, it can then pass on the surplus to the investors.

 Tradable or Financial Instruments: Tradable or financial instruments enable
individuals to trade within the financial markets. These can include cash, shares of stock
(representing ownership), bonds, options, and futures.
 Financial Services: Financial services provide investors a way of managing assets and
offer protection against systemic risk. These also ensure individuals have the appropriate
amount of capital in the most efficient investments to promote growth. Banks, insurance
companies, and investment services would be considered financial services.
 Currency (Money): A currency is a form of payment to exchange products, services, and
investments and holds value to society.
A financial system allows its participants to prosper and reap the benefits. It also helps in
borrowing and lending when needed. In simpler words, it will circulate the funds to different
parts of an economy. Some of the functions of financial systems are:
 Payment System – An efficient payment system allows businesses and merchants to
collect money in exchange for their products or services. Payments can be made with
cash, checks, credit cards, and even cryptocurrency in certain instances.
 Savings – Public savings allow individuals and businesses to invest in a range of
investments and see them grow over time. Borrowers can use them to fund new projects
and increase future cash flow, and investors get a return on investment in return.
 Liquidity – The financial markets give investors the ability to reduce the systemic risk by
providing liquidity. It thus allows for easy buying and selling of assets when needed.
 Risk Management – It protects investors from various financial risks through insurances
and other types of contracts.
 Government Policy – Governments attempt to stabilize or regulate an economy by
implementing specific policies to deal with inflation, unemployment, and interest rates.
 Role of Financial System
Financial system plays role of economic development and promotional role.
Economic development or economic progress has been defined in two ways;

1) Economic Growth Means Growth of National Income of the Country: It implies an
increase in the net national product in a given periods, say, a year. Some economists
consider this definition as inadequate and unsatisfactory. They argue that even if the
national income goes up, the general standard of living may go down. This can happen if
population of the country is rising more rapidly than the growth of the national income. If
the national income is rising at the rate of 2 percent and population is increasing at the
rate of 3 percent, the level of living of the people is bound to go down. This is because on
account of population increasing at a higher rate than the growth of the national income,
per capita income falls and when per capita income goes down, we cannot call it
economic growth. The country will have registered economic growth only if per capita
income has gone up and this will happen only if the national income grows at a higher
rate than the growth rate of the population.
Economic Growth Means the Increase in Per Capita Income of the Country at
Constant Prices: A better definition of economic development will be to base it on per
capita income. Here economic growth means the increase in per capita income of the
country at constant prices. A higher per capita income would mean that people are
better off and enjoy a higher standard of living, and to raise the level of living of the
people is the main objective of economic development, but the increase in national
income or per capita income must be maintained for a long time. A temporary or
short-lived increase will not connote real economic growth.
The mutual interactions between the financial and real system may take promotional or
developmental forms. It is in this context that the development role of the financial system is to
be emphasized.
This role assumes two forms; innovation and promotion, which are inter-related.
1) Innovation: The innovatory role relates to the creative activity of these institutions. Thus,
dynamisms as well as creative imagination can be in both the assets and liabilities side of
the activities of financial institutions. This takes the form of improving the quality of
assets as well as showing new and more profitable activities or keeping pace with the
developmental priorities of the Government.
This creative element in the case of commercial banks can be seen in the Lead Bank Scheme,
financing of neglected sectors, opening of branches in the rural areas, etc. The creative role in
the case of development banker takes the form of a critical examination of the appraisal and
follow-up actions including the application of social cost benefit analysis. The development
banker follows sound appraisal techniques including the economic and financial tools both from
the point of view of the company as well as the economy. The industrialist finds a contractive
partner in the banker who will help him in improving his project plan and prospects of
investment.
2) Promotion: The financial institutions by virtue of long experience, expertise and
information, which they acquire during the course of their project appraisal, are in a
better position to play the promotional role in the economy.

Firstly, they can share their expertise with their clients and improve the project
preparation, plug up the loopholes in their schemes and advice them on improving project
prospects as well as on the new areas they can explore.
Secondly, these institutions have established their own training institutions or schools as in the
case of IFC (Management Development Institute) and ICICI (Institute of Financial
Management), etc.
Thirdly, they are instrumental in setting up consultancy companies, accounting firms, leasing
companies and industrial estates, etc. The I.D.B.I. with the help of other institutions has set up
at State levels various consultancy service centre. Iran and Greece have also set up similar
institutions.
Fourthly, development bankers can share their experience with the government in the
formulation of their financial policy as their experience with projects and project
implementation would help the government. Their day-to-day market knowledge about the
demand pattern, export market etc., would also enable the development bankers to advise the
government.
After the introduction of planning, rapid industrialization has taken place. It has in turn led to
the growth of the corporate sector and the government sector. In order to meet the growing
demand of the government and Industries, many innovative financial instruments have been
introduced. The Indian financial system is now more developed and integrated today than what
it was few years ago. Yet it suffers from some weaknesses.
 Lack of Coordination between different Financial Institutions: There are a large
number of FIs. Most of the vital FIs are owned by the government. At the same time,
the government is also the controlling authority of these institutions. In these
circumstances, the problem of coordination arises. As there is multiplicity of
institutions in the Indian financial system, there is lack of coordination in the working
of these institutions.
 Monopolistic Market Structures: In India, some FIs are so large that they have
created a monopolistic market structure of financial system. For instance, almost
entire life insurance business is in the hands of LIC of India. So, large structures could
delay development of financial system of the country itself.
 Dominance of Development Banks in Industrial Financing: The development
banks constitute the backbone of the Indian financial system occupying an important
place in the capital market. The industrial financing today in India is largely through
the FI created by the government, both at the national and regional levels. As such,
they fail to mobilize the savings of the public. However, in recent times attempts have
been made to raise funds from public through the issue of bonds, units, debentures and
so on.
 Inactive and Erratic Capital Market: The Indian capital market is not strong and
dependable. Because of regular scams and frauds, general public is not having faith in
the Capital Markets. The weakness of the capital market is a serious problem in Indian
financial system.
 Imprudent Financial Practices: The dominance of development banks has
developed imprudent financial practice among corporate customer. The development
banks provide most of the funds in the form of term loans. So the predominance of
debt capital has made the capital structure of the borrowing concerns uneven and
lopsided. However in recent times, all efforts have been made to activate the capital
market. Integration is also taking place between different FIs. Similarly, the refinance
and rediscounting facilities provided by the IDBI aim at integration.
Introduction
A business needs two types of funding to succeed. These are generally short-term working
capital requirements and long-term fixed capital requirements. To meet short-term or working
capital needs, companies take out loans and issue promissory notes and other securities on the
money market. On the other hand, companies raise long-term funds or fixed capital by issuing
shares, bonds, or debentures on the capital market.
Capital markets are marketplaces for buying and selling bonds, stocks, currencies and other
financial assets. They assist entrepreneurs and help small businesses grow into big ones.
Additionally, they provide opportunities for regular people to invest and save for their future.
Capital markets are key engines of economic growth and wealth creation in any economy.
Capital markets play a very important role in the financial industry. They connect capital
suppliers with those seeking it. The funding may come from the government, businesses, or
even individuals who want to buy a home. These markets help move money from people who
have it to people who need it.
What Are Capital Markets?
Capital markets are the exchange system platform that transfers capital from investors who want
to employ their excess capital to businesses that require the capital to finance various projects or
investments.
A capital market is a platform for channelling savings and investments among suppliers and
those in need for economic activities. An entity with a surplus fund can transfer it to another
that needs capital for its business purpose through this platform.

Typically, suppliers include banks and investors who offer capital for lending or investing.
Businesses, governments, and individuals seek capital in this market. A capital market aims to
improve transaction efficiency by bringing together suppliers and investors and facilitating their
share exchange.
A capital market is a broad term for the physical and online spaces where financial instruments
are traded. Stock markets, bond markets, and currency markets (forex) are all types of capital
markets. They facilitate the sale and purchase of equity shares, debentures, preference shares,
zero-coupon bonds, and debt instruments.
How Does a Capital Market Work?
Capital markets assist economies by providing a platform for raising funds to operate
businesses, develop projects, or enhance wealth. Capital markets function according to the
circular flow of money theory.
Typically, capital markets are used for selling financial products such as stocks and bonds.
Stocks, or ownership shares of a company, are equities. A bond is an interest-bearing IOU, as
are other debt securities.
A firm, for example, borrows money from households or individuals for business operations.
Individuals or households invest money in a company's shares or bonds in the capital markets.
In exchange for their investment, investors gain profits and goods.
The capital market consists of finance suppliers and buyers, as well as trading instruments and
mechanisms. Regulatory bodies are also present.
There are two main categories of capital markets: Primary markets and secondary markets.
Primary Markets
Primary capital markets are where companies first sell new stock or bonds publicly. Also
known as the 'New Issues Market', it is a place where businesses and governments seek out new
financing. The new money is converted into debt or shares of the company. Debt or stocks are
locked in until they are sold on a secondary market, repurchased by the company, or mature.
Primary capital markets trade two major financial instruments: equities (stocks) and debt.
An Initial Public Offering (IPO) is the process of introducing new equities to the market. It's
simply the process of selling part of a company to the public for capital.
Bonds, on the other hand, are a bit more complicated. Underwriters act as intermediaries in the
issuance of bonds. If Company A wants to issue INR 10 crore in bonds, it goes to the
underwriter. These bonds are then issued and sold by the underwriter to investors.
In this instance, the underwriter is responsible for ensuring that Company A gets the capital it
needs. A bond underwriter buys bonds from Company A and then sells them on the market -

typically at a higher price. The underwriter then takes on the risk, but Company A receives the
entire loan.
Secondary Market
Investors trade old debt or stocks on the secondary capital market. It differs from the primary
market because the debt has already been issued here.
Investors trade stock in the secondary capital markets through exchanges such as the Bombay
Stock Exchange, the Calcutta Stock Exchange, and the New York Stock Exchange. A stock
exchange also allows people to sell the old stock if they no longer want it, which results in the
'liquidation' of these stocks. Thus, the seller now has cash rather than an asset.
Unlike stocks, bonds are typically held for a longer period - usually until they expire. However,
those who hold bonds but need cash quickly can rely on the secondary market.
Investors use the secondary market to obtain cash, either to invest in another stock or for
personal consumption. It involves liquidating assets so that other things can be purchased.
Capital Market Transactions

As mentioned earlier, transactions can take place in two types of markets. Both the primary
market and the secondary market host such transactions.
As a company matures from a start-up to a larger company, it will usually require capital to
finance the expansion of its operations. They will raise the required capital either through equity
markets – on a stock exchange – or through debt markets.
The transactions are facilitated by investment bankers, lawyers, and accountants who ensure
that the ownership transfer is legally executed and that enough investors are willing to invest
their capital into the company.
After the money’s been invested, and securities are issued in exchange, investors can decide to
sell their securities on the secondary market to other investors.
The transactions are facilitated either through a centralized exchange – such as the Bombay
Stock Exchange (BSE) – or facilitated over-the-counter (OTC), which is a decentralized way of
trading securities without a central exchange or broker.
● Market sources of funds include individual investors, financial institutions, insurance

companies, commercial banks, businesses, and retirement funds.
● Investors invest money intending to make capital gains as their investments grow over time.
They also receive dividends, interest, and ownership rights.
● Fund-seekers include companies, entrepreneurs, governments, etc. For example, to fund the
economy and development projects, the government issues bonds and deposits.

● These markets usually trade long-term investments such as stocks, bonds, debentures, and
government securities. Moreover, hybrid securities like convertible debentures and preference
shares are available.
● The market is primarily operated by stock exchanges. Brokerage firms, investment banks,
and venture capitalists are other intermediaries.
● The regulatory bodies are responsible for monitoring and eliminating any illegal activities in
the capital market. Securities and Exchange Commission, for example, oversees stock exchange
operations.
Links Borrowers and Investors: Capital markets serve as an intermediary between people
with excess funds and those in need of funds.
Capital Formation: The capital market plays an important role in capital formation. By timely
providing sufficient funds, it meets the financial needs of different sectors of the economy.
Regulate Security Prices: It contributes to securities' stability and systematic pricing. The
system monitors whole processes and ensures that no unproductive or speculative activities
occur. A standard or minimum interest rate is charged to the borrower. As a result, the
economy's security prices stabilize.
Provides Opportunities to Investors: The capital markets have enough financial instruments
to meet any investor's needs, regardless of the risk level. Capital markets also provide investors
with the opportunity to increase their capital yields. The interest rate on most savings accounts
is extremely low compared to the rate on equities. Therefore, investors can earn a higher rate of
return on the capital market, though some risks are involved as well.
Minimises Transaction Cost And Time: Long-term securities are traded on the capital market.
The whole trading process is simplified and reduced in cost and time. A system and program
automate every aspect of the trading process, thus speeding up the entire process.
Capital Liquidity: The financial markets allow people to invest their money. In exchange, they
receive ownership of a stock or bond. Bond certificates cannot be used to purchase a car, food,
or other assets, so they may need to be liquidated. Investors can sell their assets for liquid funds
to a third party on the capital markets.
Capital Market Products
There are many different capital market products, some of which we referred to earlier:
Equity securities
Commodities
Debt securities
Foreign exchange
Derivatives
Each of the above is traded in different markets and exchanges. Some of these are centralized,
such as equity securities, foreign exchange, and some derivative securities.
Others are decentralized and traded between market participants without an exchange or a
broker, such as debt securities, commodities, and other derivatives.
Derivatives can get complicated, but they represent a huge market as well. They are versatile
and can be structured and created to tailor features such as risk and return for other securities.
Capital markets are a staple of the global economy. They provide an arena in which investors
looking to invest saved funds in return for compensation. They can funnel their capital towards
people and businesses who need the capital now in order to expand. This is the crux of how a
capitalist, market-based economy grows.
Listing of securities
Listing means the formal admission of securities of a company to the trading platform of the
Exchange. It is a significant occasion for a company in the journey of its growth and
development. It enables a company to raise capital while strengthening its structure and
reputation.
In corporate finance, a listing refers to the company's shares being on the list (or board) of stock
that are officially traded on a stock exchange.
Step 1: Hiring Of An Underwriter Or Investment Bank.

To start the initial public offering process, the company will take the help of financial experts,
like investment banks. The underwriters assure the company about the capital being raised and
act as intermediaries between the company and its investors. The experts will also study the
crucial financial parameters of the company and sign an underwriting agreement. The
underwriting agreement will usually have the following components:
Details of the deal
Amount to be raised
Details of securities being issued
Step 2: Registration for IPO.
This IPO step involves the preparation of a registration statement along with the draft
prospectus, also known as Red Herring Prospectus (RHP). Submission of RHP is mandatory, as
per the Companies Act. This document comprises all the compulsory disclosures as per the
SEBI and Companies Act. Here’s a look at the key components of RHP:
Definitions: It contains the definitions of the industry-specific terms.
Risk Factors: This section discloses the possibilities that could impact a company’s finances.
Use of Proceeds: This section discloses how the money raised from investors will be used.

Industry Description: This section details the working of the company in the overall industry
segment. For instance, if the company belongs to the IT segment, the section will provide
forecasts and predictions about the segment.
Business Description: This section will detail the core business activities of the company.
Management: This section provides information about key management personnel.
Financial Description: This section comprises financial statements along with the auditor's
report.
Legal and Other Information: This section details the litigation against the company along
with miscellaneous information.
This document has to be submitted to the registrar of companies, three days before the offer
opens to the public for bidding. Alongside, the submitted registration statement has to be
compliant with the SEC rules. Post-submission, the company can make an application for an
IPO to SEBI.
Step 3: Verification by SEBI:
Market regulator, SEBI then verifies the disclosure of facts by the company. If the application is
approved, the company can announce a date for its IPO.
Step 4: Making an Application to the Stock Exchange.
The company now has to make an application to the stock exchange for floating its initial issue.
Step 5: Creating a Buzz by Roadshows.
Before an IPO opens to the public, the company endeavors to create a buzz in the market by
roadshows. Over a period of two weeks, the executives and staff of the company will advertise
the impending IPO across the country. This is basically a marketing and advertising tactic to
attract potential investors. The key highlights of the company are shared with various people,
including business analysts and fund managers. The executives adopt various user-friendly
measures, like Question and Answer sessions, multimedia presentations, group meetings, online
virtual roadshows, and so on.
Step 6: Pricing of IPO.
The company can now initiate pricing of IPO either through Fixed Price IPO or by Book
Binding Offering. In the case of Fixed Price Offering, the price of the company’s stocks is
announced in advance. In the event of Book Binding Offering, a price range of 20% is
announced, following which investors can place their bids within the price bracket. For the
bidding process, the investors have to place their bids as per the company’s quoted Lot price,
which is the minimum number of shares to be purchased. Alongside, the company also provides
for IPO Floor Price, which is the minimum bid price and IPO Cap Price, which is the highest
bidding price. The booking is typically open from three to five working days and investors can
avail the opportunity of revising their bids within the stipulated time. After completion of the

bidding process, the company will determine the Cut-Off price, which is the final price at which
the issue will be sold.
Step 7: Allotment of Shares.
Once the IPO price is finalised, the company along with the underwriters will determine the
number of shares to be allotted to each investor. In the case of over-subscription, partial
allotments will be made. The IPO stocks are usually allotted to the bidders within 10 working
days of the last bidding date.
The State Finance Corporations (SFCs) are an integral part of institutional finance structure of a
country. SFC promotes small and medium industries of the states. Besides, SFC helps in
ensuring balanced regional development, higher investment, more employment generation and
broad ownership of various industries.
At present in India, there are 18 state finance corporations (out of which 17 SFCs were
established under the SFC Act 1951). Tamil Nadu Industrial Investment Corporation Ltd. which
is established under the Company Act, 1949, is also working as state finance corporation.
The Micro, Small, and Medium Enterprises are of increased importance in India. They form a
large part of Rural and Semi-Urban industries and provide employment opportunities to a large
number of people. The number of people employed in Small and Medium industries is more as
the technique of production is labour-intensive than capital intensive. Due to the high number of
employees needed, the SMEs have a huge need for working capital and also fixed capital for
installing machinery and such. The State Financial Corporations are set up to meet these
requirements of Small and Medium Industries and to provide thrust to the rural economy.
Organization and Management
A Board of ten directors manages the State Finance Corporations. The State Government
appoints the managing director generally in consultation with the RBI and nominates the name
of three other directors.
All insurance companies, scheduled banks, investment trusts, co-operative banks, and other
financial institutions elect three directors.
Thus, the state government and quasi-government institutions nominate the majority of the
directors.
Functions of State Finance Corporations
The various important functions of State Finance Corporations are:
(i) The SFCs provides loans mainly for the acquisition of fixed assets like land, building, plant,
and machinery.
(ii) The SFCs help financial assistance to industrial units whose paid-up capital and reserves do
not exceed Rs. 3 crore (or such higher limit up to Rs. 30 crores as may be notified by the central
government).
(iii) The SFCs underwrite new stocks, shares, debentures etc., of industrial units.
(iv) The SFCs offer guarantee loans raised in the capital market by scheduled banks, industrial
concerns, and state co-operative banks to be repayable within 20 years.
(V) The SFCs also refinance term loans of up to Rs. 20 lakh from other financial institutions.
(VI) The SFCs help small and medium enterprises by providing loans for the purchase of plant
and machinery, equipment, tools, etc.
(VII) The SFCs also offer venture capital funding to small and medium enterprises.
(VIII) The SFCs provide term loans to sick units for rehabilitation purposes.
(IX) The SFCs also undertake developmental activities such as establishing industrial estates,
providing infrastructure facilities, etc.
Working of SFCs
The Indian government passed the State Financial Corporation Act in 1951. It is applicable to
all the States.
The authorized Capital of a State Financial Corporation should be within the minimum and
maximum limits of Rs. 50 lakhs and Rs. 5 crores which are fixed by the State government.
It is divided into shares of equal value which were acquired by the respective State
Governments, the Reserve Bank of India, scheduled banks, co-operative banks, other financial
institutions such as insurance companies, investment trusts, and private parties.

The State Government guarantees the shares of SFCs. The SFCs can augment its fund through
issue and sale of bonds and debentures also, which should not exceed five times the capital and
reserves at Rs. 10 Lakh.
Problems of State Financial Corporations
No Independent Organization
All SFCs are dependent upon the rules and regulations made by the state government.
SFCs’ problem is that all decision of these institutions is dependent on the political environment
of the state.
Due to this, the loan is not available at the right time for the right person.
Corruption
Like other government offices of our country, we can also see the evil of corruption in state
financial corporation.
Hoarding of wealth and money, SFCs’ officer object has become to earn by a good or bad way.
That is the problem that these institutions have no proper transparency like banks.
Effect of the World Bank and WTO Policies
Almost all SFCs in India are tied up with World Bank and WTO agreement.
Due to this, these institutions’ decisions are influenced by the World Bank and WTO policies.
World Bank can easily pressurize for accepting its policies. It may also influence the Indian
small scale industry adversely.
As a result of this, most SFCs in India are connected to the World Bank and WTO rules. These
organisations’ choices are thus influenced by the World Bank and WTO policies as a result of
their agreements. The World Bank has a lot of power over India since it is the largest
development financier in the world. It can easily push for its ideas to be implemented. It may
also have a detrimental impact on India’s small-scale industry.
The SFCs have been plagued by several other problems in recent years, which have led to their
declining role in the Indian economy. Some major problems faced by SFCs are:
 The SFCs have a high proportion of non-performing assets (NPAs), which has eroded
their capital.
 The SFCs are highly dependent on the state government for capital infusion, which is
often not forthcoming promptly.
 The SFCs have been hit hard by the recent economic downturn, as many of their
borrowers are small businesses and farmers who have been adversely affected by the
slowdown.
 The SFCs are also facing competition from newer players such as NBFCs and
microfinance institutions, which are better equipped to serve the needs of small
businesses and farmers.
Prospects of State Financial Corporations
Special Help to Women Entrepreneurs: Various state financial corporations like Delhi SFC
have state new scheme for helping women entrepreneurs who want to establish their new
business in India. This is a very innovative prospect of State financial corporation for the
development of women.
Highest loan provider for small scale industry: It is also a good prospect of SFCs that these
institutions have provided more than Rs. 6300 crore loan to small scale industry in 2010.
Industrial research: Since establishing SFCI in 1951, SFCs are working for a long period of
59 years in India. So, these financial institutions have a wide range of industrial information. A
new entrepreneur can start their industrial research by contacting these institutions if he wants
to establish a new business.
The development finance institutions or development finance companies are organizations

owned by the government or charitable institution to provide funds for low-capital projects or
where their borrowers are unable to get it from commercial lenders. Development finance
institutions (DFIs) occupy an intermediary space between public aid and private investment,
facilitating international capital flows.
The Development Financial Institutions of India play the most important role in the growth of
the Indian Economy. These institutions support the financial pillar needed for the private or
public sectors of our country.
Features of Development Financial Institutions
Some of the significant features of Development Finance Institutions (DFIs) are as follows:
 Development Finance Institutions (DFIs) do not accept deposits from individuals.
Therefore, they raise capital by borrowing from states, sovereign reserves, and insurance
corporations.
 These institutions deliver technical aid like project information, viability analyses, and
consultancy assistance.
 DFIs deliver credit enhancement facilities for infrastructure and accommodation
undertakings. It also assists in enhancing debt streams towards infrastructure schemes.
 DFIs strike a proportion between public interest via profit maximization and
infrastructure and usually prioritize one over another.
The role of a Development Finance Institution (DFI) is to take cognizance of the gaps in
institutions and markets in the country's financial sector and to act as a gap fillers. They provide
two types of funds – Medium (1 to 5 years) and long (< 5 years)
India had its first DFI in 1948 and it is the IFCI. Thereafter, the ICICI bank was opened by an
initiative of the World Bank in 1955. These institutes provided needed financial support to the

economic agents who played an important role in the economic growth of India. The
development banks are needed to –
 Boost the economic growth of India,
 Enhancement in crediting money for house and infrastructure projects
 Attract the debt rate toward the infrastructure projects.
 Boost long-term finances.
There are different types of DFIs in India and those are –

 National Development Banks
 Investment Institutions
 State-level institutions
 Sector specific financial institutions
Some examples of national development banks are IDBI, SIDBI, IRBI, ICICI, IDFC, IFCI, etc.
Some important investment banks are LIC, GIC, UTI, etc. The main state-level institutions are
the SIDCs and the state finance corporations. The Sector-specific financial institutions are
TFCI, NABARD, NHB, HDFC, EXIM Bank, etc.
The DFIs are classified into two types based on their investment types –
Investment Institutions &
Sector-Specific Financial Institutions
Those institutions that focus on providing financial support for business operations are called
Investment institutions. They provide support mainly to equity offerings, financing for capital
expenditure, etc.
Objectives of Development Finance Institutions
 The prime objective of DFI is the economic development of the country
 These banks provide financial as well as the technical support to various sectors
 DFIs do not accept deposits from people
 They raise funds by borrowing funds from governments and by selling their bonds to the
general public
 It also provides a guarantee to banks on behalf of companies and subscriptions to shares,
debentures, etc.
 Underwriting enables firms to raise funds from the public. Underwriting a financial
institution guarantees to purchase a certain percentage of shares of a company that is
issuing IPO if it is not subscribed by the Public.
 They also provide technical assistance like Project Report, Viability study, and
consultancy services.

IFCI – 1st DFI in India. Industrial Finance Corporation of India was established in 1948.
ICICI – Industrial Credit and Investment Corporation of India Limited was established in 1955
by an initiative of the World Bank.
It established its subsidiary company ICICI Bank limited in 1994.
In 2002, ICICI limited was merged into ICICI Bank Limited making it the first universal bank
of the country.
Universal Bank – Any Financial institution performing the function of Commercial Bank +
DFI
It was established in the private sector and is still the Only DFI in the private sector.
IDBI – Industrial Development Bank of India was set up in 1964 under RBI and was granted
autonomy in 1976
It is responsible for ensuring adequate flow of credit to various sectors
It was converted into a Universal Bank in 2003 with the establishment of IDBI Bank.
IRCI – Industrial Reconstruction Corporation of India was set up in 1971.
It was set up to revive weak units and provide financial & technical assistance.
SIDBI – Small Industries development bank of India was established in 1989.
Was established as a subsidiary of IDBI
It was granted autonomy in 1998
Foreign Trade
EXIM Bank – Export-Import Bank was established in January 1982 and is the apex institution
in the area of foreign trade investment.
Provides technical assistance and loan to exporters
Agriculture Sector
NABARD – National Bank for agriculture and rural development was established in July 1982
It was established on the recommendation of the Shivraman Committee
It is the apex institution in the area of agriculture and rural sectors
It functions as a refinancing institution
Housing
NHB- National Housing Bank was established in 1988.
It is the apex institution in Housing Finance
Importance of Development Financial Institutions
1. They lay the foundation of sector-specific growth and development in the economy
2. They essentially meet the long-term capital needs
3. They also undertake promotional activities for the respective sectors
4. They help small and medium sectors
Focus of Development Financial Institutions
The main focus of Development Financial Institutions is to boost the economy of the country.
The DFIs provide funds for the low capital projects or where their borrowers are unable to get it
from commercial lenders.
DFIs deliver financial support to various sectors in the form of higher risk loans, equity
positions, and guarantees. The guarantees to banks are provided on behalf of companies and
subscriptions to shares, debentures, etc.
DFIs do not accept deposits from people instead they raise funds. The funds raised are
borrowed from governments, insurance companies, pension funds, and sovereign funds.
Through Underwriting funds can be raised from the public. Underwriting a financial institution
guarantees ensures that a certain percentage of shares of a company that is issuing IPO will be
purchased if it is not subscribed by the Public.
Technical assistance like Project Report, Viability study, and consultancy services are also
provided by the Development Financial Institute.
A credit rating agency (CRA, also called a ratings service) is a company that assigns credit
ratings, which rate a debtor's ability to pay back debt by making timely principal and interest
payments and the likelihood of default.
The debt instruments rated by CRAs include government bonds, corporate bonds, CDs,
municipal bonds, preferred stock, and collateralized securities, such as mortgage-backed
securities and collateralized debt obligations.
Credit rating agencies in India came into existence in the second half of the 1980s. In India,
CRAs are regulated by SEBI (Credit Rating Agencies) Regulations, 1999 of the Securities and
Exchange Board of India Act, 1992.
SEBI’s directions for CRAs
The Securities and Exchange Board of India tightened disclosure standards for credit rating
agencies while assigning ratings to companies and their debt instruments.
1. The regulator directed that rating agencies must now disclose the liquidity position of a
company being rated.
2. If the rating is assigned on the assumption of cash inflow, the agencies would need to
disclose the source of the funding.
3. Rating agencies must disclose their rating history and how the ratings have transitioned
across categories.
4. Credit rating firms will also have to analyze the deterioration of liquidity and also check
for asset liability mismatch.

Some of the key functions of credit rating agencies are discussed below:
Low-cost information:- The credit rating agency collects, analyses, interprets and makes a
proper conclusion of any complex data and transforms it into a very lucid and easily
understandable manner.
Provides a basis for suitable risk and return:- The instruments rated by rating agency gets
greater confidence amongst investor community. It also gives an idea regarding the risk
associated with the instrument.
Helps in the formulation of Public policy:- If debt instruments are professionally rated, it
becomes very easy to judge the eligibility of various securities for inclusion in the institutional
portfolio with greater confidence.
Provides superior information:- Credit rating agency being an independent rating agency, due
to highly trained and professional staffs and with the access to information which is not publicly
available information, these agencies are able to deliver superior information.
Enhances corporate image:- Better credit rating for any credit investment enhances visibility
and corporate image in the industry.
Rating agencies assess the credit risk of specific debt securities and the borrowing entities. In
the bond market, a rating agency provides an independent evaluation of the creditworthiness of
debt securities issued by governments and corporations. Large bond issuers receive ratings from
one or two of the big three rating agencies. In the United States, the agencies are held
responsible for losses resulting from inaccurate and false ratings.
The ratings are used in structured finance transactions such as asset-backed securities,
mortgage-backed securities, and collateralized debt obligations. Rating agencies focus on the
type of pool underlying the security and the proposed capital structure to rate structured
financial products. The issuers of the structured products pay rating agencies to not only rate
them, but also to advise them on how to structure the tranches.
Rating agencies also give ratings to sovereign borrowers, who are the largest borrowers in most
financial markets. Sovereign borrowers include national governments, state governments,
municipalities, and other sovereign-supported institutions. The sovereign ratings given by a
rating agency shows a sovereign’s ability to repay its debt.
The ratings help governments from emerging and developing countries to issue bonds to
domestic and international investors. Governments sell bonds to obtain financing from other
governments and Bretton Woods institutions such as the World Bank and the International
Monetary Fund.

At the consumer level, the agency’s ratings are used by banks to determine the risk premium to
be charged on loans and bonds. A poor credit rating shows that the loan has a higher risk
premium, and this prompts an increase in the interest charged to individuals and entities with a
low credit rating. A good credit rating allows borrowers to easily borrow money from the public
debt market or financial institutions at a lower interest rate.
At the corporate level, companies planning to issue a security must find a rating agency to rate
their debt. Rating agencies such as Moody’s, Standards and Poor’s, and Fitch perform the rating
service for a fee. Investors rely on the ratings to decide on whether to buy or not to buy a
company’s securities.
Although investors can also rely on the ratings given by financial intermediaries and
underwriters, ratings provided by international agencies are considered more reliable and
accurate since they can access lots of information that is not publicly available.
At the country level, investors rely on the ratings given by the credit rating agencies to make
investment decisions. Many countries sell their securities in the international market, and a
good credit rating can help them access high-value investors. A favorable rating may also attract
other forms of investments like foreign direct investments to a country.
In addition, a low credit rating or relegation of a country from a high rating to a low rating can
discourage investors from purchasing the country’s bonds or making direct investments in the
country. For example, the downgrading of Greece, Portugal, and Ireland by S&P in 2010
worsened the European sovereign debt crisis.
Credit ratings also help in the development of financial markets. Rating agencies provide risk
measures for various entities, and this allows investors to understand the credit risk of various
borrowers. Institutions and government entities can access credit facilities without having to go
through lengthy evaluations by each lender.
The ratings provided by rating agencies also serve as a benchmark for financial market
regulations. Some laws now require certain public institutions to hold investment-grade bonds,
which have a rating of BBB or higher.
There are six credit rating agencies registered under SEBI namely, CRISIL, ICRA, CARE,
SMERA, Fitch India and Brickwork Ratings.
CRISIL
1. This full-service rating agency is the major credit rating agency in India, with a market
share of more than 60%.
2. It is offering its services in financial, manufacturing, service, and SME sectors.
3. The headquarter of CRISIL is in Mumbai
4. The majority stake of CRISIL was held by the world’s largest rating agency Standard &
Poor’s.
Credit Analysis and Research Limited Ratings (CARE)
1. Credit Analysis and Research Limited Ratings was established in 1993.
2. It is supported by Canara Bank, Unit Trust of India (UTI), Industrial Development Bank
of India (IDBI), and other financial and lending institutions.
3. This is considered as the second-largest credit rating company in India.
4. The headquarter of Credit Analysis and Research Limited Ratings is in Mumbai
Small and Medium Enterprises Rating Agency (SMERA)
1. It is a rating agency entirely created for the rating of Small Medium Enterprises.
2. It is a joint enterprise by SIDBI, Dun & Bradstreet Information Services India Private
Limited (D&B), and some chief banks in India.
3. The headquarter of SMERA is in Mumbai
4. It has accomplished 7000 ratings.
ONICRA Credit Rating Agency
1. It was incorporated by Mr. Sonu Mirchandani in 1993
2. It investigates data and arranges for possible rating solutions for Small and Medium
Enterprises and Individuals.
3. The headquarter of ONICRA Credit Rating Agency is located in Gurgaon
4. It has a broad experience in performing a wide range of areas such as Accounting,
Finance, Back-end Management, Analytics, and Customer Relations. It has rated more
than 2500 SMEs.
Fitch (India Ratings & Research)
1. Fitch Ratings is a global rating agency dedicated to providing the world’s credit markets
with independent and prospective credit opinions, research, and data.
2. The headquarter of Fitch Ratings is in Mumbai.
ICRA
1. It was created in 1991 by prominent financial institutions and commercial banks in India
with a devoted crew of experts for the MSME sector
2. Moodys, which is considered as the International credit rating agency holds the major
share.
Issues or Problems related with Credit Rating Agencies
Conflict of interest: The CRA Regulations in India currently recognise only the issuer-pays
model, under which, the rating agencies charge issuers of bond and debt instruments a fee for
providing a ratings opinion. Thus, this model has an inbuilt conflict of interest.
Another example of conflict of interest is non-rating services such as risk consulting, funds
research and advisory services given to issuers for which ratings have been provided.

Rating shopping: It is the practice of an issuer choosing the rating agency that will either
assign the highest rating or that has the most lax criteria for achieving a desired rating. Hence,
the system does not permit publishing a rating without the issuer’s consent.
Less competition: Credit-rating market in India is oligopolistic, with high barriers to entry.
Lack of competition in the market enables CRAs to have longer, well- established relationships
with the issuers which can hamper their independence.
Poor Rating Quality: Often ratings are provided on limited information. For e.g. If the issuer
decides not to answer some determinant questions, the rating may be principally based on
public information. Many rating agencies don’t have enough manpower which often leads to
poor quality.
Independence of the ratings committee: Over the years, the membership of the ratings
committee has shifted from external experts to employees of the ratings agency which has
raised concerns about their independence.
Solutions for addressing these challenges
Removal of conflict of Interest: Moving back to the earlier “subscriber pays” model in which
investors pay for the ratings can be a possible approach.
More Players: Rules should be made easier for new players to enter the credit rating space and
compete against them.
Improve Quality of Ratings:
 SEBI must also assess the predictive ability of the current rating models followed by the
agencies. There is a need to invest in high-tech predictive modelling techniques.
 Increased remuneration for manpower to attract the best talent must be ensured.
Cursory disclosure of all ratings: CRAs can be asked to provide briefly in their press release
to the ratings given by other CRAs to the same borrower. This can help in discouraging “rating
shopping”.
Legal protection for CRAs: There are instances of Indian CRAs being sued by the company it
rates, in a bid to prevent the rating downgrade. The regulator should consider framing laws that
allow CARs to express their rating opinion without fear of being sued.
Awareness among Investors: Investors should be made aware about the rating process and be
asked to conduct a review by themselves too and stop relying solely on the ratings.
Rotation of rating agencies: SEBI can also explore the possibility of a mandatory rotation of
rating agencies by the debt issuers (like corporations are required to change their auditors
periodically under the Companies Act, 2013).

Asset/liability management is the process of managing the use of assets and cash flows to
reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and
liabilities increase business profits. The asset/liability management process is typically applied
to bank loan portfolios and pension plans. It also involves the economic value of equity.
The concept of asset/liability management focuses on the timing of cash flows because
company managers must plan for the payment of liabilities. The process must ensure that assets
are available to pay debts as they come due and that assets or earnings can be converted into
cash. The asset/liability management process applies to different categories of assets on the
balance sheet.
A company can face a mismatch between assets and liabilities because of illiquidity or changes
in interest rates; asset/liability management reduces the likelihood of a mismatch.
Asset and liability management (often abbreviated ALM) is the practice of managing financial
risks that arise due to mismatches between the assets and liabilities as part of an investment
strategy in financial accounting.
ALM sits between risk management and strategic planning. It is focused on a long-term
perspective rather than mitigating immediate risks and is a process of maximising assets to meet
complex liabilities that may increase profitability.
ALM includes the allocation and management of assets, equity, interest rate and credit risk
management including risk overlays, and the calibration of company-wide tools within these
risk frameworks for optimisation and management in the local regulatory and capital
environment.
 Asset/liability management reduces the risk that a company may not meet its obligations
in the future.
 The success of bank loan portfolios and pension plans depend on asset/liability
management processes.
 Banks track the difference between the interest paid on deposits and interest earned on
loans to ensure that they can pay interest on deposits and to determine what a rate of
interest to charge on loans.

The exact roles and perimeter around ALM can vary significantly from one bank (or other
financial institutions) to another depending on the business model adopted and can encompass a
broad area of risks. The traditional ALM programs focus on interest rate risk and liquidity risk
because they represent the most prominent risks affecting the organization balance-sheet (as
they require coordination between assets and liabilities).
But ALM also now seeks to broaden assignments such as foreign exchange risk and
capital management.
The scope of the ALM function to a larger extent covers the following processes:
1. Liquidity risk: the current and prospective risk arising when the bank is unable to meet
its obligations as they come due without adversely affecting the bank's financial
conditions. From an ALM perspective, the focus is on the funding liquidity risk of the
bank, meaning its ability to meet its current and future cash-flow obligations and
collateral needs, both expected and unexpected. This mission thus includes the bank
liquidity's benchmark price in the market.
2. Interest rate risk: The risk of losses resulting from movements in interest rates and their
impact on future cash-flows. Generally because a bank may have a disproportionate
amount of fixed or variable rates instruments on either side of the balance-sheet. One of
the primary causes are mismatches in terms of bank deposits and loans.
3. Capital markets risk: The risk from movements in equity and/or credit on the balance
sheet. An insurer may wish to harvest either risk or fee premia. Risk is then mitigated by
options, futures, derivative overlays which may incorporate tactical or strategic views.
4. Currency risk management: The risk of losses resulting from movements in exchanges
rates. To the extent that cash-flow assets and liabilities are denominated in different
currencies.
5. Funding and capital management: As all the mechanism to ensure the maintenance of
adequate capital on a continuous basis. It is a dynamic and ongoing process considering
both short- and longer-term capital needs and is coordinated with a bank's overall strategy
and planning cycles (usually a prospective time-horizon of 2 years).
6. Profit planning and growth.
7. In addition, ALM deals with aspects related to credit risk as this function is also to
manage the impact of the entire credit portfolio (including cash, investments, and
loans) on the balance sheet. The credit risk, specifically in the loan portfolio, is handled
by a separate risk management function and represents one of the main data contributors
to the ALM team.
The broad objectives of ALM are:

Meet financial goals: A primary function of ALM is generating earnings. Financial institutions
have very specific financial goals. Key profitability outputs ALM measures include net interest
income, return on assets, and return on equity. Within those outputs are metrics like yield on
earning assets, cost of funds, non-interest income, and non-interest expense that drive bottom-
line profitability figures.
An effective ALM process will consider different strategies and approaches and measure the
potential impact on profitability. For example, if an institution wants to venture into a different
type of lending to try to increase yield on earning assets, it will want to measure the potential
yield from those new products as well as the cost of funding those assets and all related costs of
obtaining that new business in the first place. It will look at the cash flows in and out of the
institution to determine whether certain approaches will help meet the desired margin, ROA,
and most importantly, ROE, which is a measure of shareholder return or, for credit unions, a
measure of the ability to provide continued or additional value to members.
Manage risks: The idea of going into the marketplace and figuring out how to make more
money is probably appealing to a lot of folks. Still, as we all know, where there’s potential
return, there is always potential risk, and banking is no different. Risk in the context of ALM is
the difference between expected cash flows versus and actual cash flows.
The logical example here is credit risk. When making an auto loan with an 8% interest rate, an
institution expects to collect all the cash flows from principal and interest, but that isn’t always
what happens. Sometimes the borrower defaults and the institution never collects all that it’s
owed and expected to collect. That loss of yield on earning assets has an impact on financial
goals like margin, ROA, and ROE.
While credit risk is probably the most intuitive example of risk that institutions face, there are
many types of risks that need to be considered. Three main risks institutions face:
 Credit risk
 Interest rate risk
 Liquidity risk
It’s this reality that forces institutions to make smart and measured decisions on how to generate
earnings. No institution is putting all its eggs in the highly volatile commercial real estate
(CRE) basket due to the potential volatility of the cash flows in those products. Institutions are
constantly walking a tightrope of generating enough return without exposing themselves to
excessive risk. An effective ALM model will help measure the level of potential risk in
different market conditions to help decision-makers discern which strategies show the
opportunity to create enough return to meet desired goals while also actively managing risks
that could jeopardize the safety and soundness of the institution.
Maintain safety and soundness: Bank and credit union leaders are also acutely aware of
regulatory expectations in terms of providing assurances of the long-term viability and solvency
of the institution. Usually expressed in the form of regulatory capital ratios, these ratios ensure
institutions have enough capital to withstand adverse financial or economic scenarios. After the
great recession in the late 2000s, regulatory expectations of capital levels are higher than ever,
which can lead institutions to be conservative in terms of risk-taking.
ALM combined with an effective capital planning process can help ensure that an institution’s
strategies don’t jeopardize capital levels and lead to regulatory pressure that can further
constrain the institution’s operations.
A financial institution could use its ALM model to avoid risk. However, as noted earlier, where
there’s potential return, there is also potential risk. With that in mind, you can reason that where
there is no potential risk, there is probably no potential return, and if a financial institution is not
earning, then it likely isn’t growing or surviving. It’s certainly not thriving in a way that
provides the most flexibility to meet the wants and needs of stakeholders like customers or
members, shareholders, and the community.
One of the goals of ALM is to manage risk, not actively avoid risk. It’s inevitable that an
institution must take some level of risk to survive. It is just a matter of what types of risk and
how much of those risks an institution is willing to take. Like personal investors, institutions all
have different risk appetites. The sooner an institution’s management can define how much risk
is tolerable to them, the sooner they’ll be able to make the decisions that make money.
Risk tolerances are reflected in a financial institution’s written policy limits. Once established,
these policy limits act as a roadmap for the level of risk that can be undertaken while
maximizing profitability. A function of ALM is to monitor these board-established policy limits
in terms of volatility to earnings/equity, profitability, credit quality, and liquidity in different
rate environments. A financial institution’s balance sheet and income statement can be “tested”
through different scenarios that measure the impact of different decisions to make sure the
exposures represent reasonable levels of risk that are in line with risk policy limits. If the board
finds the results indicate they’re a little too vulnerable to their liking, a tweak, change or
abandonment of the strategy may be required. It’s this process, performed repeatedly, that
allows institutions to manage their risk levels while still being able to produce the return needed
to meet their financial goals.
Approaches to ALM
As one could probably imagine, the complexity and sophistication of ALM models vary from
institution to institution. However, most banks and credit unions typically steer toward one of
two main approaches to the ALM function: a regulatory approach or a management
approach.
Regulatory approach – This approach to ALM aims to “check the (regulatory) box.” It is
called the regulatory approach because there is regulatory expectation for the measurement and
management of risk on an institution’s balance sheet and income statement. This approach is
geared toward meeting those expectations, at least minimally.
This approach usually includes conducting an analysis on a static (no growth) balance sheet,
which does not consider any future changes in the institution’s growth, strategy, pricing, or
business plan. As a result, this approach includes no future risk/return analysis because it only
considers what the institution is currently doing, not how it plans to make money down the
road. While it may pass a regulatory “smell test,” it is not giving institution leaders the full
picture of current and future balance sheet performance and risk levels, which could lead to
riskier or less profitable decisions or both. Furthermore, the minimalist analysis in a regulatory
approach often examines what might happen in the unlikely event of a sudden and indefinite
extreme spike in interest rates. That type of information is far less useful for managing an
institution's performance than weighing more realistic "what-if" scenarios a bank or credit union
might encounter.
Management approach – A management approach to ALM, on the other hand, makes it much
easier to assess the risk/return trade-off in proposed strategies and make decisions that benefit
the institution both in the short term and the long term. This approach leverages all the analyses
typically performed in the regulatory approach, and so meets examiner requirements. But it also
considers dynamic modeling of the balance sheet, which means that future growth plans and
strategies are analyzed as well, giving management a realistic look at the outlook of the
institution today and tomorrow. This more impactful approach informs decisions related to both
risk and strategy and enables boards and management to make good decisions in different rate
environments.
Advantages and Disadvantages of Asset and Liability Management
Understanding how assets and liabilities are flowing is important to know for business
operations. Implementing the asset and liability management frameworks helps to provide
several different benefits for businesses and organizations.
One of the biggest advantages is that the practice allows a business to effectively manage the
liabilities that they incur. This enables them to be able to strategically prepare for uncertainties
that could happen in the future.
As well, the asset and liability management frameworks help organizations recognize
present risks on their balance sheet. When they’re able to recognize these risks from a
mismatch of assets and liabilities, they can then reduce them. When a business is able to
strategically match its assets and liabilities, they can achieve higher efficiency. They can also
increase overall profitability all while reducing the overall risk.
However, there are a few disadvantages that come with asset and liability management that
are worth exploring. Since almost every organization is going to operate differently than others,

there isn’t a single framework that can get adopted. So not implementing the proper type of
framework and strategy can be detrimental.
To overcome this, you should try to design an asset and liability management framework that’s
unique to your business. It should cover the most specific objectives, any regulatory constraints,
and all of the risk levels.
Another challenge is that asset and liability management is a long-term strategy. This means it
requires some strategic thinking and forward-looking datasets and projections. So once
information becomes readily available to your business, you need to turn it into quantifiable
measures.
The final challenge to overcome is that it’s an incredibly coordinated process that oversees the
entire balance sheet of an organization. This means it’s going to involve lots of coordination
between different departments. Not doing this effectively can make the process time-consuming
and lead to additional, unexpected challenges.
Gap Analysis : Gap Analysis is a technique of Asset – Liability management . It is used to

assess interest rate risk or liquidity risk. It measures at a given point of time the gaps between
Rate Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off balance sheet
position) by grouping them into time buckets according to residual maturity or next re-pricing
period , whichever is earlier. An asset or liability is treated as rate sensitive if;
i)Within time bucket under consideration is a cash flow.
ii.) The interest rate resets/reprices contractually during time buckets
iii.) Administered rates are changed and
iv.) It is contractually pre-payable or withdrawal allowed before contracted maturities.
Thus ;
GAP=RSA-RSL
GAP Ratio=RSAs/RSL
• Mismatches can be positive or negative
• Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch
• In case of +ve mismatch, excess liquidity can be deployed in money market instruments,
creating new assets & investment swaps etc.
• For –ve mismatch, it can be financed from market borrowings(call/Term),Bills
rediscounting,repos & deployment of foreign currency converted into rupee.
Gap analysis was widely used by financial institutions during late 1990s and early years of
present century in India. The table below gives you idea who does a positive or negative gap
would impact on NII in case there is upward or downward movement of interest rates:
Duration Gap Analysis :

This is an alternative method for measuring interest-rate risk. This technique examines the
sensitivity of the market value of the financial institution’s net worth to changes in interest
rates. Duration analysis is based on Macaulay’s concept of duration, which measures the
average lifetime of a security’s stream of payments.
We know that Duration is an important measure of the interest rate sensitivity of assets and
liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and
liabilities. It is the weighted average time to maturity of all the preset values of cash flows.
Duration basically refers to the average life of the asset or the liability. DP /p =D ( dR /1+R)
The above equation describes the percentage fall in price of the bond for a given increase in the
required interest rates or yields.
The larger the value of the duration, the more sensitive is the price of that asset or liability to
changes in interest rates. Thus, as per this theory, the bank will be immunized from interest
rate risk if the duration gap between assets and the liabilities is zero. The duration model has
one important benefit. It uses the market value of assets and liabilities.
Duration analysis summarises with a single number exposure to parallel shifts in the term
structure of interest rates.
It can be noticed that both gap and duration approaches worked well if assets and liabilities
comprised fixed cash flows. However options such as those embedded in mortgages or callable
debt posed problems that gap analysis could not address. Duration analysis could address these
in theory, but implementing sufficiently sophisticated duration measures was problematic.
Scenario Analysis :
Under the scenario analysis of ALM several interest rate scenarios are created during next 5 to
10 years . Such scenarios might specify declining interest rates , rising interests rates, a gradual
decrease in rates followed by sudden rise etc. Different scenarios may specify the behavior of
the entire yield curve, so there could be scenarios with flattening yield curve, inverted yield
curves etc. Ten to twenty scenarios might be specified to have a holistic view of the scnario
analysis. Next assumptions would be made about the performances of assets and liabilities
under each scenario. Assumptions might include prepayment rates on mortgages and surrender
rates on insurance products. Assumptions may also be made about the firms performance .
Based upon these assumptions the performance of the firm’s balance sheet could be projected
under each scenario. If projected performance was poor under specific scenario the ALCO
might adjust assets or liabilities to address the indicated exposure . A short coming of scenario
analysis is the fact that it is highly dependent on the choice of scenario. It also requires that
many assumptions be made about how specific assets or liabilities will perform under specific
scenario.
Value at Risk

VaR or Value ar Risk refers to the maximum expected loss that a bank can suffer over a target
horizon, given a certain confidence interval. It enables the calculation of market risk of a
portfolio for which no historical data exists. It enables one to calculate the net worth of the
organization at any particular point of time so that it is possible to focus on long term risk
implications of decisions that have already been taken or that are going to be taken. It is used
extensively for measuring the market risk of a portfolio of assets and/or liabilities.
Risk refers to an undesirable or an unplanned event concerning finances that can result in loss
of investment or reduced earning. It includes the possibility of losing some or the entire amount
of investment. So why do banks take a risk? Well, it is because of the fundamental relationship
between risk and return, there is a direct relationship between risk and return. Hence, the greater
the risk, the higher the chances of profit. But it is not always the case, hence the risks that the
banks take need to be managed well.
Risk Management thus refers to managing the impact of the risks by analyzing, forecasting and
making predictions based on the historical trends. It also includes taking corrective measures to
reduce the impact of the risks. Financial risks can be in the form of high inflation, volatility in
capital markets, recession, volatility, bankruptcy, etc. The magnitude of these risks depends on
the type of financial instruments in which an organization or an individual invests.
Banks must prioritize risk management in order to stay on top (and ahead) of the various
critical risks they face every day. Risk management in banks also goes far beyond compliance,
as banks must be on the lookout for strategic, operational, price, liquidity, and reputational risk.
Types of Risks
The risk may more generally be defined as the possibility of loss either in financial terms or loss
of reputation. Considering the relationship between risk and return, banks are prudent enough to
identify, measure and price the risk that they take and also maintain appropriate capital to take
care of any unforeseen event. The different types of risk in the banking industry are:
Liquidity Risk: This type of risk arises when an institution is unable to meet its financial
commitments or is able to do so only by external borrowing. This may be due to the conversion
of assets into NPAs. In the modern banking model, this is the most vulnerable risk that banks
are subjected to.
So, how do banks manage liquidity risk? Well, it can be efficiently managed by creating a
difference in the timeframe between asset maturity and liability maturity. And then, by ensuring
that those differences keep enough funds flowing in the bank to both increase assets and meet
obligations when customers ask for their money.
Market Risk: It will not be an understatement to say that banks operate at the whims of the
market! Market risk is the risk that stems from the idea that the value of investment might
decrease due to changes in factors governing a market. It is also known as a systematic risk
because it is related to factors governing the market such as recession that impacts the entire
market and not just one industry.
Managing market risk is very crucial in times like today when the market is extremely volatile
and unpredictable. The most efficient way to do manage market risk is by diversification of
funds. Ensuring that the assets are held in a wide range of investment options can minimize the
market risk.
 Earlier, majorly for all the banks managing credit risk was the primary task or challenge.
 But due to the modernization and progress in banking sector, market risk started arising
such as fluctuation in interest rates, changes in market variables, fluctuation in
commodity prices or equity prices and even fluctuation in foreign exchange rates etc.
 So, it became essential to manage the market risk too. As even a minute change in market
variables results into substantial change of economic value of banks.
 Market risk comprises of liquidity risk, interest rate risk, foreign exchange rate risk and
hedging risk.
Managing market risk
 The major concern for the top management of banks is to manage the market risk.
 Top management of banks should clearly articulate the market risk policies, agreements,
review mechanisms, auditing & reporting systems etc. and these policies should clearly
mention the risk measurement systems which captures the sources of materials from
banks and thus has an effect on banks.
 Banks should form Asset-Liability Management Committee whose main task is to
maintain & manage the balance sheet within the risk or performance parameters.
 In order to track the market risk on a real time basis, banks should set up an independent
middle office.
 Middle office should consist of members who are market experts in analyzing the market
risk. The experts can be: economists, statisticians and general bankers.
 The members of Middle office should be separated from treasury departments or in daily
activities of treasury department.
Credit or Default Risk: Credit or Default Risk is simply the potential of the borrower to fail to
meet its obligations in accordance with the signed contract. Loans are the largest and most
obvious source of credit or default risk for most banks. Amongst all, this is the most significant
risk typically in the Indian banking sector where NPA size is significantly high.
Although this risk can’t be avoided, there are certain ways that can help in mitigating the risk.
The banks manage this risk mostly by assessing the worthiness of the borrower before
sanctioning the loan. A credit score is generated keeping various factors in mind, and on the
basis of the score, a loan is sanctioned or suspended.

 Credit risks involve borrower risk, industry risk and portfolio risk. As it checks the
creditworthiness of the industry, borrower etc.
 It is also known as default risk which checks the inability of an industry, counter-party or
a customer who are unable to meet the commitments of making settlement of financial
transactions.
 Internal and external factors both influences credit risk of bank portfolio.
 Internal factors consist of lack of appraisal of borrower’s financial status, inadequate risk
pricing, lending limits are not defined properly, absence of post sanctions surveillance,
proper loan agreements or policies are not defined etc.
 Whereas external factor comprises of trade restrictions, fluctuation in exchange rates and
interest rates, fluctuations in commodities or equity prices, tax structure, government
policies, political system etc.
Managing credit risk
 Top management consent or attention should be received in order to manage the credit
risk.
 Credit Risk Management Process include:
i) In a loan policy of banks, risk management process should be articulated.
ii) Through credit rating or scoring the degree of risk can be measured.
iii) It can be quantified through estimating expected and unexpected financial losses and
even risk pricing can be done on scientific basic.
 Credit Policy Committee should be formed in each bank that can look after the credit
policies, procedures and agreements and thus can analyze, evaluate and manage the credit
risk of a bank on a wide basis.
 Credit Risk Management consists of many management techniques which helps the bank
to curb the adverse effect of credit risk. Techniques includes: credit approving authority,
risk rating, prudential limits, loan review mechanism, risk pricing, portfolio management
etc.
Operational Risk: Operational Risk is the risk of loss that arises due to breakdown in the
internal procedures, people and systems or from external events. It is important to manage
operational risk for banks because banks are exposed to a higher volume of global financial
interlinkages and a high level of automation is being used in rendering banking and financial
services.
The operational risk is managed by adding more internal rules and accountability. Further,
adding monitoring programs to identify this risk can also be beneficial to mitigate the impact of
operational risk.
 For a better risk management practice, it has become essential to manage the operational
risk.
 Operational risk arise due to the modernization of banking sector and financial markets
which gave rise to structural changes, increase in volume of transactions and complex
support systems.
 Operational risk cannot be categorized as market risk or credit risk as this risk can be
described as risk related to settlement of payments, interruption in business activities,
legal and administrative risk.
 As operational risk involves risk related to business interruption or problem so this could
trigger the market or credit risks. Therefore, operational risk has some sort of linkages
with credit or market risks.
Managing operational risk
 There is no uniform approach in measuring the operational risk of banks. Till date simple
and experimental methods are used but foreign banks have introduced some advance
techniques to manage the operational risk.
 For measuring operational risk, it requires estimation of the probability of operational
loss and also potential size of the loss.
 Banks can make use of analytical and judgmental techniques to measure operational risk
level.
 Risk of operations can be: audit ratings, data on quality, historical loss experience, data
on turnover or volume etc. Some international banks has developed rating matrix which
is similar to bond credit rating.
 Operational risk should be assessed & reviewed at regular intervals.
 For quantifying operational risk, Indian banks have not evolved any scientific methods
and are using simple benchmark system which measures business activity.
Apart from the above, there are certain other risks also that banks face
Liquidity risk: When a bank can’t meet its obligations, it jeopardizes its financial standing or
existence. In such cases, the bank can’t convert assets to cash to meet funding obligations so
customers can withdraw their deposits. It’s mainly caused by over-reliance on short-term
funding sources, mismanaged asset-liability duration, or customers’ loss of confidence in the
bank.
Cyber security risk: Financial services providers grapple with cyber security risks, which
involve safekeeping private electronic information from theft, misuse, or damage. Factors
increasing this risk include poor password policies, lack of transaction business and logical
access controls, and personal vetting shortcomings.
Reputational risk: Refers to the potential damage to a bank’s reputation or brand, caused by
employee and organizational behavior or actions, resulting in a negative perception and
subsequent loss of confidence by the public in the bank. Potential causes include customer

records manipulation or mismanagement, poor customer support or after-sales services, the
inability of the bank to honor regulatory or government commitments.
Business risk: A bank’s strategy may also threaten its profitability, especially if it doesn’t align
with the digital era. The bank risks market share loss, acquisition by other financial institutions,
or closure.
Compliance risk: Failure to comply with industry or federal laws and regulations leads to
compliance risks and eventual reputational damage, legal penalties, legal or regulatory
sanctions, and financial loss. For instance, if a bank has a faulty anti-money laundering program
or violates the Bank Secrecy Act.
Having a clear, formalized risk management plan brings additional visibility into consideration.
Standardizing risk management makes identifying systemic issues that affect the entire bank
simple. The ideal risk management plan for a bank serves as a roadmap for improving
performance by revealing key dependencies and control effectiveness. With proper
implementation of a plan, banks ultimately should be able to better allocate time and resources
towards what matters most.
Size, brand, market share, and many more characteristics all will prescribe a bank’s risk
management program. That being said, all plans should be standardized, meaningful, and
actionable. The same process for defining the steps within your risk management plan can be
applied across the board:
Risk Identification
Banks must create a risk identification process across the organization in order to develop a
meaningful risk management program. Note that it’s not enough to simply identify what
happened; the most effective risk identification techniques focus on root cause. This allows for
identification of systemic issues so that controls can be designed to eliminate the cost and time
of duplicate effort.
Assessment & Analysis Methodology
Assessing risk in a uniform fashion is the hallmark of a healthy risk management system. It’s
important to be able to collect and analyze data to determine the likelihood of any given risk
and subsequently prioritize remediation efforts.
Mitigate
Risk mitigation is defined as the process of reducing risk exposure and minimizing the
likelihood of an incident. Top risks and concerns need to be continually addressed to ensure the
bank is fully protected.

Monitor
Monitoring risk should be an ongoing and proactive process. It involves testing, metric
collection, and incidents remediation to certify that the controls are effective. It also allows for
addressing emerging trends to determine whether or not progress is being made on various
initiatives.
Connect
Creating relationships between risks, business units, mitigation activities, and more paints a
cohesive picture of the bank. This allows for recognition of upstream and downstream
dependencies, identification of systemic risks, and design of centralized controls. Eliminating
silos eliminates the chances of missing critical pieces of information.
Report
Presenting information about how the risk management program is going – in a clear and
engaging way – demonstrates effectiveness and can rally the support of various stakeholders at
the bank. Develop a risk report that centralizes information and gives a dynamic view of the
bank’s risk profile.
Monetary theory is based on the idea that a change in money supply is a key driver of economic
activity. It argues that central banks, which control the levers of monetary policy, can exert
much power over economic growth rates by tinkering with the amount of currency and other
liquid instruments circulating in a country's economy.
According to monetary theory, if a nation's supply of money increases, economic activity will
rise, too, and vice versa. A simple formula governs monetary theory: MV = PQ. M represents
the money supply, V is the velocity (number of times per year the average dollar is spent), P is
the price of goods and services, and Q is the number of goods and services. Assuming constant
V, when M is increased, either P, Q, or both P and Q rise.

General price levels tend to rise more than the production of goods and services when the
economy is closer to full employment. When there is slack in the economy, Q will increase at a
faster rate than P under monetary theory.
Money creation has become a hot topic under the “Modern Monetary Theory (MMT)" banner.
The relation between money and what it will buy has always been a central issue of
monetary theory. Crucial to understanding this matter is the distinction economists make
between face (or nominal) values and real values—that is, between official values stated in
current rupees, dollars, pesos, pounds, yen, euros, and so on and the same quantities
adjusted by the price level. The latter is a “real” value, meaning the real quantity of
goods, services, and assets that money will buy. This can also be understood as the real
purchasing power of the money stock.
Monetary policy is enacted by a central bank to sustain a level economy and keep
unemployment low, protect the value of the currency, and maintain economic growth. By
manipulating interest rates or reserve requirements, or through open market operations, a central
bank affects borrowing, spending, and savings rates.
Monetary policy is a set of tools used by a nation's central bank to control the overall money
supply and promote economic growth and employ strategies such as revising interest rates and
changing bank reserve requirements.
Monetary policy is commonly classified as either expansionary or contractionary.
Monetary policy is the control of the quantity of money available in an economy and the
channels by which new money is supplied.
Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry
and sector-specific growth rates influence monetary policy strategy.
The monetary policy in India is carried out under the authority of the Reserve Bank of
India.
Monetary policies are seen as either expansionary or contractionary depending on the level of
growth or stagnation within the economy.
Expansionary
During times of slowdown or a recession, an expansionary policy grows economic activity. By
lowering interest rates, saving becomes less attractive, and consumer spending and borrowing
increase.
Contractionary

A contractionary policy increases interest rates and limits the outstanding money supply to slow
growth and decrease inflation, where the prices of goods and services in an economy rise and
reduce the purchasing power of money.
Simply put the main objective of monetary policy is to maintain price stability while keeping in
mind the objective of growth as price stability is a necessary precondition for sustainable
economic growth.
In India, the RBI plays an important role in controlling inflation through the consultation
process regarding inflation targeting. The current inflation-targeting framework in India is
flexible.
Monetary policy is concerned with making money available to the market at reasonable rates
and in sufficient quantities at the appropriate time in order to achieve:
Price stability: The primary goal of monetary policy is to maintain price stability while keeping
growth in mind. Price stability is a prerequisite for long-term growth. In order to maintain price
stability, inflation must be kept under control.
Accelerating growth of economy:
Exchange rate stabilization
Balancing savings and investment
Generating employment
Financial stability
Inflation
Contractionary monetary policy is used to temper inflation and reduce the level of money
circulating in the economy. Expansionary monetary policy fosters inflationary pressure and
increases the amount of money in circulation.
Every five years, the Indian government sets an inflation target. The Reserve Bank of India
(RBI) plays an important role in the consultation process for inflation targeting. The current
inflation-targeting framework in India is flexible.
Unemployment
An expansionary monetary policy decreases unemployment as a higher money supply and
attractive interest rates stimulate business activities and expansion of the job market.
Exchange Rates
The exchange rates between domestic and foreign currencies can be affected by monetary
policy. With an increase in the money supply, the domestic currency becomes cheaper than its
foreign exchange.
How does the RBI get its Mandate to conduct Monetary Policy?
The Reserve Bank of India (RBI) is charged with implementing monetary policy. The Reserve
Bank of India Act of 1934 expressly mandates this responsibility.
There have recently been many changes in the way India's monetary policy is formed, with the
introduction of the Monetary Policy Framework (MPF), Monetary Policy Committee (MPC),
and Monetary Policy Process (MPP).
Monetary Policy Framework (MPF)
 While the Government of India establishes the Flexible Inflation Targeting Framework in
India, the Reserve Bank of India (RBI) is in charge of the country's Monetary Policy
Framework.
 The amended RBI Act explicitly gives the Reserve Bank the legislative mandate to run
the country's monetary policy framework.
 The framework aims to set the policy (repo) rate based on an assessment of the current
and evolving macroeconomic situation, as well as to modulate liquidity conditions in
order to anchor money market rates at or near the repo rate.
 Changes in repo rates are transmitted through the money market to the entire financial
system, influencing aggregate demand – a key determinant of inflation and growth.
 Once the repo rate is announced, the Reserve Bank's operating framework envisions day-
to-day liquidity management through appropriate actions aimed at anchoring the
operating target - the weighted average call rate (WACR) – around the repo rate.
Monetary Policy Committee (MPC)
 The Monetary Policy Committee now determines the policy interest rate required to
achieve the inflation target in India.
 The MPC is a six-person committee appointed by the Central Government (Section 45ZB
of the amended RBI Act, 1934).
 The MPC must meet at least four times per year. The MPC meeting requires a quorum of
four members. Each MPC member has one vote, and in the event of a tie, the Governor
has a second or casting vote.
 Following the conclusion of each MPC meeting, the resolution adopted by the MPC is
published.
 The Reserve Bank is required to publish a document called the Monetary Policy Report
once every six months to explain:
o the sources of inflation; and
o the forecast of inflation for the next 6-18 months.
Monetary Policy Instruments
Monetary policy is implemented using a variety of direct and indirect instruments.
Repo Rate
The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks in
exchange for the government and other approved securities as collateral under the liquidity
adjustment facility (LAF).
Reverse Repo Rate
The (fixed) interest rate at which the Reserve Bank absorbs liquidity from banks on an
overnight basis in exchange for eligible government securities under the LAF.
Liquidity Adjustment Facility (LAF)
o The LAF is made up of both overnight and term repo auctions.
o The Reserve Bank has gradually increased the proportion of liquidity injected through
fine-tuning variable rate repo auctions of various tenors.
o The goal of the term repo is to help develop the inter-bank term money market, which in
turn can set market-based benchmarks for loan and deposit pricing and thus improve
monetary policy transmission.
o The Reserve Bank also conducts variable interest rate reverse repo auctions as market
conditions dictate.
Marginal Standing Facility (MSF)
o A facility through which scheduled commercial banks can borrow an additional amount
of overnight money from the Reserve Bank by dipping into their Statutory Liquidity
Ratio (SLR) portfolio up to a certain limit at a penal rate of interest.
o This acts as a safety valve for the banking system in the event of unexpected liquidity
shocks.
Corridor
The corridor for the daily movement in the weighted average call money rate is determined by
the MSF rate and the reverse repo rate.
o It is the rate at which the Reserve Bank is willing to purchase or rediscount bills of
exchange or other commercial papers.
o Section 49 of the Reserve Bank of India Act, 1934 mandates the publication of the Bank
Rate.
o This rate has been aligned with the MSF rate and, as a result, changes automatically when
the MSF rate and the policy repo rate change.
The average daily balance that a bank is required to maintain with the Reserve Bank as a share
of such percentage of its Net demand and time liabilities (NDTL) as specified by the Reserve
Bank in the Gazette of India from time to time.
o The percentage of NDTL that a bank must keep in safe and liquid assets such as
unencumbered government securities, cash, and gold.

o SLR changes frequently have an impact on the availability of resources in the banking
system for lending to the private sector.
These include the outright purchase and sale of government securities for the purpose of
injecting and absorbing long-term liquidity, respectively.
o This monetary management tool was introduced in 2004.

o Short-term government securities and treasury bills are sold to absorb longer-term surplus
liquidity resulting from large capital inflows.
o The money raised in this manner is kept in a separate government account of the Reserve
Bank.
The interest rates in an economy are determined by the forces of demand and supply of money.
Therefore, the determination of interest rates depends on factors that influence both demand for
and supply of money. The demand factors can be individuals and companies’ transactions,
precautionary and speculative demand for money. Usually, the supply of money is determined
by the central bank of an economy through monetary policy – using mainly three tools (open
market operations, discount rate, and required reserve ratio).
The transaction and precautionary demand for money are positively related to GDP
The speculative demand for money is negatively related to the expected return of other financial
assets
Open market operations are the most frequently used tool to change the money supply.
Demand for Money
Three factors typically impact the demand for money, which in turn influences interest rates.
Transaction demand for money (TDM): the TDM tends to rise, as the average value of
transactions in the economy increase. Therefore, generally speaking, as the economy (i.e. GDP)
grows over time, individuals will tend to hold more of their wealth in cash/money for
transactions.
Precautionary demand for money (PDM): the PDM arises out of individuals wanting to hold
money/currency to act as a buffer for contingencies or unforeseen events that may require
money to be spent. It is also positively related to GDP.
Speculative demand for money (SDM): the SDM or portfolio demand for money is related to
the demand to hold money based on potential investment opportunities/risks that are out there in
other financial instruments. On the aggregate, speculative demand for money is negatively

related to the expected return of other financial assets and positively related to the perceived
risk of the same.
Basel I refers to a set of international banking regulations created by the Basel Committee on
Bank Supervision (BCBS), which is based in Basel, Switzerland. The committee defines the
minimum capital requirements for financial institutions, with the primary goal of minimizing
credit risk. Basel I is the first set of regulations defined by the BCBS and is a part of what is
known as the Basel Accords, which now includes Basel II and Basel III. The accords’ essential
purpose is to standardize banking practices all over the world.
Under Basel I, banks that operate internationally were required to maintain at least a minimum
amount of capital (8%) based on their risk-weighted assets. Basel I is the first of three sets of
regulations known individually as Basel I, II, and III, and collectively as the Basel Accords.
The BCBS was founded in 1974 as an international forum where members could cooperate on
banking supervision matters. The BCBS says it aims to enhance "financial stability by
improving supervisory know-how and the quality of banking supervision worldwide."
The Basel Committee is made up of 45 members from 28 countries and other jurisdictions,
representing central banks and supervisory authorities.
Basel I, the committee's first accord, was issued in 1988 and focused mainly on credit risk by
creating a classification system for bank assets.
 It focused almost entirely on credit risk.
 Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or
meet contractual obligations. Traditionally, it refers to the risk that a lender may not
receive the owed principal and interest.
 It defined capital and structure of risk weights for banks.
 The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
 RWA means assets with different risk profiles.
 For example, an asset backed by collateral would carry lesser risks as compared to
personal loans, which have no collateral.
 India adopted Basel-I guidelines in 1999.
The BCBS regulations do not have legal force. Members are responsible for implementation in
their home countries. Basel I originally called for a minimum ratio of capital to risk-weighted
assets of 8%, which was to be implemented by the end of 1992. In September 1993, the BCBS
announced that G10 countries' banks with material international banking business were meeting
the minimum requirements set out in Basel I. According to the BCBS, the minimum capital
ratio framework was adopted not only in its member countries but in virtually every other
country with active international banks.
Requirements for Basel I
The Basel I classification system groups a bank's assets into five risk categories, labeled with
the percentages 0%, 10%, 20%, 50%, and 100%. A bank's assets are assigned to these
categories based on the nature of the debtor.
The 0% risk category consists of cash, central bank and government debt, and any Organisation
for Economic Co-operation and Development (OECD) government debt. Public sector debt can
be placed in the 0%, 10%, 20%, or 50% category, depending on the debtor.
It provided a simplified structure for overseeing credit risk by calculating the percentage of risk
weighing of different assets.
The bank must maintain capital (referred to as Tier 1 and Tier 2 capital) equal to at least 8% of
its risk-weighted assets. This is meant to ensure that banks hold an adequate amount of capital
to meet their obligations. For example, if a bank has risk-weighted assets of $100 million, it is
required to maintain capital of at least $8 million. Tier 1 capital is the most liquid type and
represents the core funding of the bank, while Tier 2 capital includes less liquid hybrid capital
instruments, loan-loss and revaluation reserves, as well as undisclosed reserves.
Tier 1 Capital vs. Tier 2 Capital
Banks have two main silos of capital that are qualitatively different from one another.
Tier 1: It refers to a bank's core capital, equity, and the disclosed reserves that appear on the
bank's financial statements.
 In the event that a bank experiences significant losses, Tier 1 capital provides a cushion
that allows it to weather stress and maintain a continuity of operations.
Tier 2: It refers to a bank's supplementary capital, such as undisclosed reserves and unsecured
subordinated debt instruments that must have an original maturity of at least five years.
Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to
accurately calculate and more difficult to liquidate.
Basel II was given in 2004.

Basel II is the second of three Basel Accords. It is based on three main "pillars": minimum
capital requirements, regulatory supervision, and market discipline. Minimum capital

requirements play the most important role in Basel II and obligate banks to maintain certain
ratios of capital to their risk-weighted assets.
Because banking regulations varied significantly among countries before the introduction of the
Basel Accords, the unified framework of Basel I (and subsequently, Basel II) helped countries
standardize their rules and alleviate market anxiety regarding risks in the banking system. The
Basel Framework currently consists of 14 standards.
First requirement (Minimum capital requirement)

Building on Basel I, Basel II provided guidelines for the calculation of minimum regulatory
capital ratios and confirmed the requirement that banks maintain a capital reserve equal to at
least 8% of their risk-weighted assets.
Minimum capital requirements play the most important role in Basel II and obligate banks to
maintain certain ratios of capital to their risk-weighted assets.
Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier the
more secure and liquid its assets.
Tier 1 capital represents the bank's core capital and is composed of common stock, as well as
disclosed reserves and certain other assets. At least 4% of the bank's capital reserve must be in
the form of Tier 1 assets.
Tier 2 is considered supplementary capital and consists of items such as revaluation reserves,
hybrid instruments, and medium- and long-term subordinated loans. Tier 3 consists of lower-
quality unsecured, subordinated debt.
Basel II also refined the definition of risk-weighted assets, used in calculating whether a bank
meets its capital reserve requirements. Risk weighting is intended to discourage banks from
taking on excessive amounts of risk in terms of the assets they hold. The main innovation of
Basel II in comparison to Basel I is that it takes into account the credit rating of assets in
determining their risk weights. Higher the credit ratings lower the risk weight.
The first requirement deals with ongoing maintenance of regulatory capital that is required to
safeguard against the three major components of risk that a bank faces. Credit Risk, Operational
Risk, and Market Risk.
Credit Risk component can be calculated in three different ways of varying degree of
sophistication, namely Standardized Approach, Foundation Internal Rating-Based (IRB)
Approach, and Advanced IRB Approach.
For Operational Risk, there are three different approaches:
 Basic Indicator Approach (BIA)
 Standardized Approach (STA)

 Internal Measurement Approach, an advanced form of which is the Advanced
Measurement Approach (AMA)
For Market Risk, Basel II allows for Standardized and Internal approaches. The preferred
approach is Value at Risk (VaR).
 As the Basel II recommendations are phased in by the banking industry, it moves from
standardized requirements to more refined and specific requirements that are tailored for
each risk category by each individual bank. The benefit for banks that do develop their
own bespoke risk measurement systems is that they are rewarded with potentially lower
risk capital requirements.
Second requirement (Regulatory Supervision)
Regulatory supervision is the second pillar of Basel II and provides a framework for national
regulatory bodies to deal with various types of risks, including systemic risk, liquidity risk, and
legal risks.
Third requirement (Market discipline)
The market discipline pillar introduces various disclosure requirements for banks' risk
exposures, risk assessment processes, and capital adequacy. It is intended to foster greater
transparency into the soundness of a bank's business practices and allow investors and others to
compare banks on equal footing.
 Least capital prerequisites: Banks should keep a base capital ampleness necessity of 8%
of hazard weighted resources. Additionally, Basel-II partitions the capital into 3 levels.
Level 3 capital incorporates transient subject credits. (subject credits imply lower in the
positioning. It is reimbursed after different obligations in the event of bank liquidation.)
In any case, the meaning of capital sufficiency proportion was refined.
 Administrative oversight: According to this, banks were needed to create and utilize
better danger executive procedures in checking and dealing with every one of the three
kinds of dangers that a bank faces, viz. credit, market, and operational dangers
 Market Discipline: It expanded divulgence necessities. Banks need to compulsorily
reveal their CAR, hazard openness, and so forth to the national bank.
Basel II expanded upon Basel I to help regulators handle the financial innovations and new
financial products that came about since the inception of Basel I in the 1980s. For example,
Basel II required that banks maintain a capital reserve equal to at least 8% of their risk weighted
assets.
Basel II attempted to discourage risky behavior, but it also resulted in several strategies banks
used to make risky investments. Among these strategies were ones that resulted in the
emergence of the subprime mortgage market and moving higher-risk assets to unregulated parts
of holding or parent companies. Another tactic was to transfer the risk directly to investors by
securitization, which is the process of taking a non-liquid asset or groups of assets and
transforming them into a security that can be traded on open markets.
Some experts contend that the risky behavior Basel II enabled was in part responsible for the
subprime mortgage meltdown and accompanying Great Recession of 2008.
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UNIT I : Structure of Financial System – role of Financial System in

Economic Development – Financial Markets and Financial Instruments –