CAIIB Paper 2 BFM Module D Unit 6 : RAROC and Profit Planning (New Syllabus)
IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 2 (Bank Financial Management) includes an important topic called "RAROC and Profit Planning". Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.
In this article, we are going to cover all the necessary details of CAIIB Paper 2 (BFM) Module D (BALANCE SHEET MANAGEMENT) Unit 6 : RAROC and Profit Planning, Aspirants must go through this article to better understand the topic, RAROC and Profit Planning and practice using our Online Mock Test Series to strengthen their knowledge of RAROC and Profit Planning. Unit 6 : RAROC and Profit Planning
Profit Planning
Profit planning in a bank essentially involves balance sheet management; covering credit, investment and non-fund based income. Banks' income arises from three sources, viz. interest income, feebased income and treasury income. Interest income is derived from lending as well as investments in securities, bonds etc.
| TABLE |
| | I | II | III | IV |
| Investment in Govt. Securities with yield 6% and risk weight of 0%. | 1000 | 400 | 300 | 300 |
| Lending to AAA rated customers with yield 8% p.a & risk weigh of 20% | 0 | 600 | 300 | 300 |
| Lending to AA rated customers with Yield of 10% p.a. & risk weight of 50%. | 0 | 0 | 400 | 200 |
| Lending to A rated customers with yield of 12% p.a. and risk weight of 100% | 0 | 0 | 0 | 200 |
| Total Investment | 1000 | 1000 | 1000 | 1000 |
| YIELD |
| TOTAL (Amount X Yield) | 60 | 72 | 82 | 86 |
| Yield % | 6% | 7.20% | 8.20% | 8.60% |
| Risk Weight Assets# | 0 | 120 | 260 | 360 |
| Capital Required (@8%) | 0 | 9.60 | 20.8 | 28.8 |
Thus, you would observe that risk would increase for lending to lower rated customers resulting in an increased need for capital and also improved yield on the assets. Banks need to optimise the investment and lending portfolio to earn the best possible returns for a given capital level.
Banks have to take into account the effect of NPA on the interest income and thereby on the profitability. NPAs do not generate income and therefore bring down the yield on advances. Also, under Basel-II/III regime, the risk weightage of such assets is higher, thereby forcing a bank to maintain higher capital Thus, NPAs have a two-fold effect, reduction in income and need for additional capital. Hence, return on capital or profitability gets further deteriorated.
Thus, every effort to rationalise this segment of expenditure is made. In nutshell, profitability is a function of six variables:
- Interest income
- Fee-based income
- Trading income
- Interest expenses
- Staff expenses
- Other operating expenses
Maximisation of the first three variables and minimisation of the last three variables are the requisites to maximise profitability. All the six factors are dependent on each other and achieving the optimum level is the requirement here.
Economic Capital
- The expected loss is a measure of the reserves necessary to guard against future losses. The pricing of products should provide a buffer against expected losses and the unexpected loss is a measure of the amount of economic capital required to support the banks financial risk. This capital is also called risk capital.
- Some activities may require large amounts of risk capital, which in turn requires higher returns. This is the essence of risk adjusted return on capital (RAROC) measures. The central objective is to establish benchmarks to evaluate the economic return of business activities. This includes transactions, products, customer trades, and business lines, as well as the entire business.
Risk Capital
RAROC is a part of the family of the risk-adjusted performance measures (RAPM). Consider, for instance, two traders such that each returned a profit of $10 million over the last year. The first is a foreign currency trader, and second a bond trader. The question is, how do we compare their performance? This is important in providing appropriate compensation as well as deciding which line of activity to expand.
Assume the FX and bond traders have notional amount and volatility as described below. The bond trader deals in larger amounts, $200 million, but in a market with lower volatility, at 4% per annum, against $100 million and 12% for the FX trader. The risk capital can be computed as a VAR measure, say at the 99% level over a year, as Bankers Trust did. Assuming normal distributions, this translates into a risk capital of
RC = VAR = $100,000,000 X .12 x 2.33 = $28 million
The risk adjusted performance is then measured as the profit divided by the risk capital,
RAPM = Profit/RC
Thus the bond trader is actually performing better as the FX trader, as the activity requires less risk capital. More generally, risk capital should account for credit risk, operational risk, and any interaction.
RAROC Methodology
Risk Management: Includes the measurement of portfolio exposure, the volatility and correlations of the risks factors.
Capital Allocation: This requires the choice of a confidence level and horizon for the VAR measure, which translates into an economic capital.
Performance Measurement: This requires the adjustment of performance for the risk capital.
Performance measurement can be based on RAPM method. For instance, Economic Value Added (EVA) focuses on the creation of value during a particular period in excess of the required return on capital. EVA measures the residual economic profit as
EVA = Profit - (Capital X k)
Where profits are adjusted for the cost of economic capital, with k defined as the discount rate. Assuming the whole worth is captured by the EVA, the higher the EVA, the better the product or project.
NaBFID
- NaBFID has been set up as a Development Financial Institution (DFI) to support the development of long-term infrastructure financing in India. With this, India has seen the birth of a new entity in the financial market.
- The National Bank for Financing Infrastructure and Development (NaBFID) Act, 2021 received the assent of the President on 28 March, 2021 and was enforced on 19 April, 2021.
- Unlike banks, DFIs do not accept deposits from people. They source funds from the market, government, as well as multi-lateral institutions, and are often supported through government guarantees.
Case Study (BFM)
1)On 1 June 2016, a customer requests to book forward contract, for retirement of import bill for USD 100,000.00, due for payment on 15 September 2016. Given rates: Spot USD/INR 68.27/29, forward premium - Spot June: 10/12, Spot July 21/23, Spot August 32/34, Spot Sept. 43/45 and August to 15th Sept. 6/7 Charge Margin of 0.20% on the spot rate.
Answer
Being a merchant sale forward booking transaction, rate would be calculated as under:
USD/INR spot to be taken as 68.29
Premium payable:
Spot August 34 paise
August - 15th Sept. 07 paise
Add: Total premium 41 paise 0.41
Thus IB forward rate would be: 68.70
Add: Margin 0.20% 0.14
Rate for customer 68.84
2)Your foreign correspondent maintaining a NOSTRO Rupee account with your bank, wants to fund his account by purchase of Rs. 30.00 million, against US dollars. Assuming that the USD/INR interbank market is at 68.2550/2650, what rate would be quoted to the correspondent, ignoring exchange margin. Calculate amount of USD you would receive in your USD NOSTRO account, if the deal is struck.
Answer
The transaction is to sell Rs. 30.00 million, against US dollars, and the transaction is equivalent to an Inward Remittance for the bank/country. Hence, we would quote the lower of the two rates, i.e. 68.2550 (Sell low maxim).
If the deal is struck, the foreign bank would pay USD 439528.24 to our USD NOSTRO account.
3)M/s BCD wants to remit JPY 100.00 million by TT value spot, as payment of an import invoice. Given that USD/INR is at 68.2500/2600 and USD/JPY is 116.50/60, and a margin of 0.15% is to be loaded to the exchange rate, calculate rate to be quoted and the Rupee amount to be debited to the account of M/s BCD.
Answer
Since JPY is to be sold against Rupee, and the rate is not directly given, we would use cross rate mechanism to calculate the same.
We need to buy JPY against USD and USD against INR for the deal.
Thus, USD/INR rate would be 68.2600 (market USD selling rate - high) and USD/JPY at 116.50 (market JPY selling rate - low). The JPY/INR rate would be 68.2600/116.50 = .58592 per JPY
i.e. per 100 JPY Rs. 58.5923
Add: Margin of 0.15 0.0879
58.6802
Rounded off to 58.68
Total Rupee amount to be debited to the account of M/s BCD would thus be Rs. 586,80,000.00
[Note: JPY is quoted as per 100 Yen, as per FEDAI guidelines]
4) You are required to book forward sale contract for USD 1.00 million delivery 3rd month and another forward purchase contract for USD 2.00 Million for delivery 2nd month. Given that USD/INR spot is 68.9100/9200, premium quoted as under, calculate rates for merchant transactions, if the exchange margin of 0.15% is to be loaded for the purchase transaction and 0.20% for the sale transaction. Rate to be quoted to nearest 0.25 paise.
Premium (in paise): 1 m 0750/0850
2 m 1800/1900
3 m 2750/2850
Answer
(a) Calculation of rate for forward sale of USD 1.00 million:
Spot rate to be taken (higher rate of the market) 68.9200
3 m premium to be charged 0.2850
69.2050
Add: Margin 0.20% (on spot rate) 0.1378
Rounded off to 69.3428 or 69.33425
(b) Calculation of rate for forward purchase of USD 2.00 million:
Spot rate to be taken (lower rate of the market) 68.9100
1 m premium to be paid/passed on 0.0750
68.9850
Margin 0.15% (Less) 0.1035
Rounded off to 68.8815 or 68.8825
Note: For a sale contract premium for the full period, up to end date of the contract shall be charged, i.e. full 3 months, whereas, for purchase contract, premium would be passed on only up to the beginning of the contract period, i.e. only up to the start date, or for 1 month only.
5)A forward purchase contract for USD 500,000.00 booked 2 months back at 69.2500 is due for delivery 2 days later (spot date). The customer is informed by the drawee of the bill that the payment will be delayed by one month.
Given that the interbank spot is 67.5675/5775 and one month forward premium is 09/10 paise, and margin on TT buying and TT selling would be 0.15%, calculate rate for cancellation of the existing contract and also give indicative rate for re-booking of one month fixed date or option contract beginning one month from spot date.
Also, calculate the amount to be debited/credited to the customer's account on spot date, upon cancellation of the contract. Rate to be quoted to nearest 0.25 paise.
Answer
(a) The existing forward contract would have been booked at TT buying rate, and hence it has to be cancelled at opposite TT selling rate, computed as under:
Interbank USD/INR spot (higher of the two) 67.5775
Add: Margin 0.15% 0.1014
67.6789
The contract would be cancelled at 67.6800
Rupee amount at contracted rate USD 500,000 @ 69.2500 = Rs. 34625000
Less amount at cancellation rate USD 500,000 @ 67.6800 = Rs. 33840000
Amount due to the customer Rs. 7,85,000
(to be paid to his account on spot date)
(b) Indicative rate for contract proposed to be re-booked:
If the contract is booked with option of one month beginning spot date:
Interbank rate Less: 67.5675
Margin 0.15% 0.1014
67.4661
or say 67.4650
This is the rate (Rs. 67.4650) that would be given by the Bank in case the contract is booked option contract beginning one month from spot date.
If the contract is booked for delivery fixed date one month forward, premium for 1 month would be passed to the customer as under:
Interbank rate 67.5675
Less Margin (0.15%) 0.1014
67.4661
Add: Premium for one month 0.0900
67.5561 or 67.5550
CASE 6. Insurance
An LC calls for insurance from warehouse, and insurance to cover 110% of the invoice value.
Bank A negotiates and forwards documents, covering invoice for USD 17920.00 under a Multi model transport document (Combined Bill of Lading) dated 15.03.2017. to the opening bank, under the said LC. The insurance enclosed to the documents is for USD 20,000.00 and is dated 17.03.2017.
As per the Article 28 of UCP, the insurance must indicate the amount of insurance. It should be at least 110%, of the invoice value if the LC is silent on this requirement and the policy cover must not be dated prior to the date of transport document.
In the given scenario, the insurance is dated after the date of multimodal transport document, which should be covering the voyage of goods from the godown of the seller, and is more than the given percentage for insurance coverage, i.e. more than 110%.
Banks would normally accept some difference in insurance coverage which could be due to rounding off of the values/cover amount, but can still point out as a discrepancy and refuse the documents, in case the insurance cover falls below 110% of the invoice value. However, a document dated after the date of shipping document, is clearly a discrepancy, and requires specific approval from the applicant.
Case 7. Partial Shipments
An LC, covering shipment of 1000 cartons consisting of 15000 pieces of shirts, (readymade garments), from Chennai port to Dubai port, provides that partial shipment is not allowed.
The beneficiary hands over 500 cartons of Shirts, to the shipping company on 15.05.2017 and another 500 cartoons on 18.05.2017.
The Shipping Company issues BL for the first 500 cartons on 17.05.2017 and another BL covering 500 cartoons on 19.05.2017. Both the consignments are to be shipped by a vessel that is due to leave Chennai port on 21.05.2017. Thus the total goods under the LC, i.e. 1000 cartons, are shipped on a single vessel, but with two BLs.
The LC issuing bank, on receipt of documents drawn under the LC rejects the documents, stating the shipment is not made under one BL and as such constitutes partial shipment, which is not permitted under the LC. The issuing bank, informs the negotiating bank that goods are held at their disposal and further instructions are awaited.
As per article 31 of UCP, a presentation of documents consisting of more than one set of transport documents, covering shipment of goods on the same means of transport and has same journey, will not be considered as partial shipment, even if they indicate different dates of shipment.
As such, in the given scenario, the rejection of documents by the LC opening bank is not correct as per the Article 31 of UCP, and the bank must pay/honour the documents.
Illustration on credit risk mitigation:
Case 8
An exposure of Rs. 100 lakhs is backed by financial collateral of A+ debt security of Rs. 30 lakhs issued by others. The tenor of the exposure is 3 years. The residual maturity of the financial collateral is 2 years.
In this case, the financial collateral is an eligible credit risk mitigant.
As the residual maturity of the collateral is less than the residual maturity of the exposure, maturity mismatch is also there. However, there is no currency mismatch.
Let us first determine the hair cut of the collateral.
C*=C x (1 - HC-Hc - Hfx) = 30 x (1 - 6% -0%) = 30 x 94% = 28.20
Where C* = Haircut adjusted collateral value
C = Original collateral value
Hc = Hair cut applicable to the collateral
Hfx = Hair cut on account of currency mismatch between
collateral and exposure.
Hfx = 0.08 in all cases where this is applicable.
Let us now determine what would be the value of the haircut-adjusted collateral after adjustment on account of maturity mismatch.
P=C* x (t - 0.25)/(T-0.25) = 28.2 x (2 - 0.25)/(3 - 0.25) = 28.2 x 1.75/2.75 = 17.95
Where P = Value of credit risk mitigant adjusted for maturity mismatch.
C* = value of the collateral adjusted for any haircut.
t = minimum of T and residual maturity of the credit protection expressed in years.
T = minimum of 5 years and residual maturity of the exposure expressed in years.
The adjusted collateral value is Rs. 17.95 lacs. The value of the exposure after risk mitigation would be E = Max {0, (current value of exposure - value of the adjusted collateral for any haircut and maturity mismatch)} = Max {0, (100 - 17.95)} = 82.05
Net Exposure qualifying for Capital Adequacy is Rs. 82.05 lacs.
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CAIIB BFM Module D Unit 6 RAROC and Profit Planning ( Ambitious_Baba )
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