Illustrative Audit Checklist for Capital Adequacy

Illustrative Audit Checklist for Capital Adequacy :

The checklist is only illustrative in nature. Members are expected to exercise their professional judgment while using the checklist depending upon facts and circumstances of each case.

Audit Procedures
CET 1, AT 1 and Tier II
1. Tally the balances in the various elements of Capital from the trial balance/ groupings/ draft financial statements
2. Check whether the various instruments comply with the guidelines as laid down in the Master Circular by referring to the Terms of Offer and whether the same are approved by the Board or other appropriate committee
3. Check whether the appropriate discounting has been applied in the case of instruments issued
4. In case of foreign banks, examine whether the undertaking has been obtained that the bank would not remit abroad the funds received and shown as Capital Reserve or Remittable Surplus
5. Examine whether the various limits upto which individual elements are to be included in CET1, AT1 and Tier II capital as laid down in the Master Circular are adhered to.
6. Verify the various deductions with the balances in the audited accounts and check the same for limits and eligibility (e.g. securitisation exposure) as laid down in the Master Circular.
6. Verify the various deductions with the balances in the audited accounts and check the same for limits and eligibility (e.g. securitisation exposure) as laid down in the Master Circular.
7. Verify the correctness of progressive discount based on the remaining maturity of instruments eligible for AT1 and Tier II
Capital Charge on Credit Risk
The capital charge for credit risk is the sum total of the capital charge to be maintained in respect of the following: · On balance sheet items · Off balance sheet items · Failed transactions · NPAs · Securitisation transactions duly adjusted for haircuts based on the nature of the collateral.
Risk Weights – On Balance Sheet Items
The risk weights for all on balance sheet items need to be determined based on the credit ratings assigned by the rating agencies chosen by the RBI.
1. Reconcile the balances of various advances and other operating receivables where there is a credit risk and which are considered for calculation with the following schedules in the financial statements to ensure completeness: · Schedule 6 – Cash and balances with Reserve Bank of India · Schedule 7- Balances with Banks and Money at Call and Short Notice · Schedule 9- Advances · Schedule 11(vi) – Other Assets – Others
2. Review and document the process of compilation and mapping of the various on balance sheet item based on the categories and their risk weights together with the appropriate ratings and / or other conditions, as applicable.

3. For a sample of transactions verify the ratings with the letters issued by the rating agencies and accordingly check the correctness of the risk weights assigned.
4. In cases where the risk weights are dependent on the fulfilment of certain conditions (other than ratings) verify the compliance therewith based on the appropriate documentary evidence. (e.g. claims on banks, regulatory retail portfolio, claims against residential property etc.)
5. Verify the validity of guarantees issued by Central or State Government. Verify whether the bank has properly classified claims on State Government and claims guaranteed by State Government due to difference risk weight.
6. Verify the correctness of claims on CGTSI and ECGC
7. Verify the classification of loans – restructured loans/ NPAs/ NBFC/ CRE/ CRERH etc.
8. Verify LTV ratio on a test check basis in respect of housing loans
Risk Weights – Off Balance Sheet Items
The risk weight for all off balance sheet credit exposures is generally calculated as a two step process as under, separately for market and non market related exposures: · The notional amount is converted into a credit equivalent amount by multiplying the amount by the specified credit conversion factor (for non market transactions) or by applying the current exposure method (for market related transactions). · The resulting credit equivalent amount is multiplied by the risk weight applicable to the counterparty or the purpose for which finance is extended or the type of asset, whichever is higher. Where the exposure is secured by eligible collateral or guarantee, the credit risk mitigation guidelines may be applied.
1. Reconcile the balances of the various off balance sheet exposures which are considered for calculation with the financial statements, especially the schedule of contingent liabilities.
2. Review and document the process of compilation and mapping of the various off balance sheet item based on the nature of the instruments.
3. For a sample of non-market transactions, check the calculations of the credit equivalent amount with specified credit conversion factor based on the nature of the instrument. Check the necessary documentation to confirm the nature of the instrument.
4. For a sample of market related transactions, check the necessary documentation to confirm the nature of the contract and accordingly check the calculations for the current credit exposure and the potential future exposure.
5. Verify the classification of Financial and Performance Guarantee by perusing the sample guarantee issued by the branches
6. Verify whether bills accepted under Letter of bCredit is assigned 100% risk weight as CCF
7. Verify whether the bank has proper control for accounting Buyer’s credit/ Letter of Comfort
8. Verify the correctness of undrawn exposures
Capital Charge – Failed Transactions
1. Review and document the procedures for tracking and monitoring the credit risk exposure arising from unsettled transactions, both on DVP and non DVP basis.
2. For a sample of DVP transactions, examine whether the settlement has taken place on a timely basis. In case of delays, check the calculation of the capital charge by multiplying the positive current exposure by the prescribed factor depending upon the number of days delayed.
3. For a sample of non-DVP transactions, examine whether the settlement has taken place as per the contracted maturity. In case of delays, ascertain whether any payment made is considered as a loan and the appropriate risk weight is considered. In case of settlement beyond five days ascertain whether the full amount is deducted from the capital.
Risk weights – NPAs
1. Review and document the procedures for identifying the unsecured portion of NPAs separately for qualifying residential mortgages and others.
2. For a sample of residential mortgages which are NPAs, examine whether they meet with the qualifying criteria with regard to the LTV ratio and other factors and accordingly check the assignment of the risk weight for the unsecured portion depending upon the level of provisioning.
3. For a sample of NPAs other than residential mortgages check the assignment of the risk weight based on the level of provisioning.
4. In respect of 3 above for identifying the secured portion examine whether only eligible collateral are considered and the same are properly documented and the bank has a clear and marketable title to realise the same.
5. Verify whether bucketing in difference risk weight in respect of NPAs based on NPA provision is carried out by the system and verify the correctness of classification on a test check basis
Capital Charge – Securitisation transactions
Banks are required to hold regulatory capital after adjusting the prescribed deductions eligible against all securitisation exposures including those arising from provision of credit mitigants, investment in asset backed securities, retention of subordinated tranche and extension of liquidity facility or credit enhancement.
Examine whether the securitisation transactions fulfil the requirements as prescribed in Master Circular on “Prudential Guidelines on Capital Adequacy and Market Discipline – New Capital Adequacy Framework” (extract of the ‘Revision to the Guidelines on Securitisation Transactions’, issued vide circular DBOD.No.BP.BC.103/ 21.04.177/ 2011-12 dated May 07, 2012 on ‘Revision to the Guidelines on Securitisation Transactions’) to be eligible for deduction from capital.
1. Based on the above, for a sample of transactions / deals examine whether the prescribed deduction from both CET 1, AT I and Tier II capital has been correctly done based on the rating and the level of provisions. Review the necessary documentation in support of the same.
2. Based on the above ascertain whether the appropriate risk weights have been assigned.
Collateral Risk Management and Credit Risk Mitigation
The objective of collateral risk management is to ensure that only the eligible collateral are considered for netting off which are adjusted for volatility depending upon the nature of the capital and further subjected to various types of hair cuts for different categories of mismatches like currency and tenor mismatches.
1. Review and document the process for collateral risk management as appropriate and relevant including but not limited to: · Ageing reports · Confirmation procedures. · Control of documents · Compliance with covenants · Audit of collateral by independent agencies
2. Examine whether the bank has complete legal rights to enforce the security including specific lien and is subject to hair cuts for residual tenor mismatch and currency mismatch. Check the necessary documentation in respect thereof.
Capital Charge for Market Risk
Capital charge for market risk involves computation of the capital charge on interest rate related instruments and equities in the trading book and foreign exchange risk, including gold and other precious metals. Accordingly, the following would be covered: · Securities under the HFT and AFS category · Open gold and FX position limits · Trading position in derivatives · Derivatives entered into for hedging trading book exposures
Interest Rate – General Market Risk
The capital requirement for general market risk is sum of the following four components: (i) Net short (only derivatives) or long position inthe trading book (ii) Small proportion of matched position for each time band (vertical disallowance) (iii) A larger proportion of the matched positions across different time bands (horizontal ) (iv) Net change for positions in options where applicable
1. Reconcile the balances considered for calculation of the general interest rate risks trading book positions with the figures reported in the financial statements.
2. Review and document the process for computation of the price sensitivity (modified duration) for each instrument and test check the calculations for a sample of instruments.
3. Review the process of capturing the above data into different time bands based on the maturity and accordingly apply the prescribed change in yield and check the calculations for the resulting capital charge and the consequential vertical and horizontal disallowances
Interest Rate – Specific Risk
The specific interest rate capital charge for different types of debt securities / issuers is prescribed separately for the following categories: · Central, State and Foreign government bonds under HFT and AFS category · Banks bonds under HFT and AFS category· Corporate bonds and securitised debt under HFT and AFS category
1. Reconcile the balances of government securities under AFS and HFT considered for computation of specific interest rate capital charge with the financial statements.
2. Review and document the process of compilation of data in respect of various types of government securities under AFS and HFT based on the type of investment and the residual maturity.
3. For a sample of transactions in respect of the above, verify the allocation percentage of the specific risk capital based on the type of investment and residual maturity based on the verification of the relevant documentation.
4. Reconcile the balances of bonds issued by banks under AFS and HFT considered for computation of specific interest rate capital with the financial statements.
5. Review and document the process of compilation of data in respect of various types of bonds issued by banks held as investments under AFS and HFT based on the following parameters: · Level of capital adequacy · Nature of the bank (scheduled or non scheduled) · Residual maturity
6. For a sample of transactions in respect of the above, verify the allocation percentage of the specific risk capital based on the various parameters based on the verification of the relevant documentation.
7. Reconcile the balances of corporate bonds and securitised debt under AFS and HFT considered for computation of specific interest rate capital charge with the financial statements.
8. Review and document the process of compilation of data in respect of corporate bonds and securitised debt instruments held as investments under AFS and HFT based on the following parameters: · Rating assigned · Nature of the investment · Residual maturity
9. For a sample of transactions in respect of the above, verify the allocation percentage of the specific risk capital based on the various parameters based on the verification of the relevant documentation.
Equity – General and Specific Market Risk
A uniform percentage of 9% is currently attracted for the gross equity position for both specific and A uniform percentage of 9% is currently attracted for the gross equity position for both specific and
Foreign Exchange and Gold
These currently attract a risk weight of 100% which is in addition to the capital charge for credit risk for on and off balance sheet items
1. Check the computation of the net open position in each currency as a summation of the following: · Net spot position · Net forward position · Guarantees and similar instruments · Net future expenses / incomes not yet accrued but fully hedged
2. Based on the calculations of the market risk for each of the above check the computation of the aggregate capital charge of market risks Interest rate risk a) General market risk · Net position · Horizontal disallowance · Vertical disallowance b) Specific market risk Specific and general market equity risk Exchange and gold
Capital Charge for Operational Risk
Currently banks are required to maintain capital charge for operational risk at 15% of the average gross income for the last three financial years
1. Obtain the computation of the gross total income and verify the same from the respective years audited financial statements. 2. Examine whether the various deductions from the net profit are appropriately considered.

 For computing the gross income for determining the capital to be held against operational risk, there is a clarification that the same should be considered based on the average of the last three financial years. However, there is no clarity as to whether this includes the current financial year though the better practice would be to consider the average of the preceding three years.

Audit Procedures

CET 1, AT 1 and Tier II

1. Tally the balances in the various elements of Capital from the trial balance/ groupings/ draft financial statements

2. Check whether the various instruments comply with the guidelines as laid down in the Master Circular by referring to the Terms of Offer and whether the same are approved by the Board or other appropriate committee

3. Check whether the appropriate discounting has been applied in the case of instruments issued

4. In case of foreign banks, examine whether the undertaking has been obtained that the bank would not remit abroad the funds received and shown as Capital Reserve or Remittable Surplus

5. Examine whether the various limits upto which individual elements are to be included in CET1, AT1 and Tier II capital as laid down in the Master Circular are adhered to.

6. Verify the various deductions with the balances in the audited accounts and check the same for limits and eligibility (e.g. securitisation exposure) as laid down in the Master Circular.

6. Verify the various deductions with the balances in the audited accounts and check the same for limits and eligibility (e.g. securitisation exposure) as laid down in the Master Circular.

7. Verify the correctness of progressive discount based on the remaining maturity of instruments eligible for AT1 and Tier II

Capital Charge on Credit Risk

The capital charge for credit risk is the sum total of the capital charge to be maintained in respect of the following:

· On balance sheet items

· Off balance sheet items

· Failed transactions

· NPAs

· Securitisation transactions

duly adjusted for haircuts based on the nature of the collateral.

Risk Weights – On Balance Sheet Items

The risk weights for all on balance sheet items need to be determined based on the credit ratings assigned by the rating agencies chosen by the RBI.

1. Reconcile the balances of various advances and other operating receivables where there is a credit risk and which are considered for calculation with the following schedules in the financial statements to ensure completeness:

· Schedule 6 – Cash and balances with Reserve Bank of India

· Schedule 7- Balances with Banks and Money at Call and Short Notice

· Schedule 9- Advances

· Schedule 11(vi) – Other Assets – Others

2. Review and document the process of compilation and mapping of the various on balance sheet item based on the categories and their risk weights together with the

appropriate ratings and / or other conditions, as applicable.

3. For a sample of transactions verify the ratings with the letters issued by the rating agencies and accordingly check the correctness of the risk weights assigned.

4. In cases where the risk weights are dependent on the fulfilment of certain conditions (other than ratings) verify the compliance therewith based on the appropriate documentary evidence. (e.g. claims on banks, regulatory retail portfolio, claims against residential property etc.)

5. Verify the validity of guarantees issued by Central or State Government. Verify whether the bank has properly classified claims on State Government and claims guaranteed by State Government due to difference risk weight.

6. Verify the correctness of claims on CGTSI and ECGC

7. Verify the classification of loans – restructured loans/ NPAs/ NBFC/ CRE/ CRERH etc.

8. Verify LTV ratio on a test check basis in respect of housing loans

Risk Weights – Off Balance Sheet Items

The risk weight for all off balance sheet credit exposures is generally calculated as a two step process as under, separately for market and non market related exposures:

· The notional amount is converted into a credit equivalent amount by multiplying the amount by the specified credit conversion factor (for non market transactions) or by applying the current exposure method (for market related transactions).

1. Reconcile the balances of the various off balance sheet exposures which are considered for calculation with the financial statements, especially the schedule of contingent liabilities.

2. Review and document the process of compilation and mapping of the various off balance sheet item based on the nature of the instruments.

3. For a sample of non-market transactions, check the calculations of the credit equivalent amount with specified credit conversion factor based on the nature of the instrument. Check the necessary documentation to confirm the nature of the instrument.

4. For a sample of market related transactions, check the necessary documentation to confirm the nature of the contract and accordingly check the calculations for the current credit exposure and the potential future exposure.

5. Verify the classification of Financial and Performance Guarantee by perusing the sample guarantee issued by the branches

6. Verify whether bills accepted under Letter of bCredit is assigned 100% risk weight as CCF

7. Verify whether the bank has proper control for accounting Buyer’s credit/ Letter of Comfort

8. Verify the correctness of undrawn exposures

Capital Charge – Failed Transactions

1. Review and document the procedures for tracking and monitoring the credit risk exposure arising from unsettled transactions, both on DVP and non DVP basis.

2. For a sample of DVP transactions, examine whether the settlement has taken place on a timely basis. In case of delays, check the calculation of the capital charge by multiplying the positive current exposure by the prescribed factor depending upon the number of days delayed.

Risk weights – NPAs

1. Review and document the procedures for identifying the unsecured portion of NPAs separately for qualifying residential mortgages and others.

2. For a sample of residential mortgages which are NPAs, examine whether they meet with the qualifying criteria with regard to the LTV ratio and other factors and accordingly check the assignment of the risk weight for the unsecured portion depending upon the level of provisioning.

3. For a sample of NPAs other than residential

mortgages check the assignment of the risk

weight based on the level of provisioning.

4. In respect of 3 above for identifying the

secured portion examine whether only eligible

collateral are considered and the same are

properly documented and the bank has a

clear and marketable title to realise the same.

5. Verify whether bucketing in difference risk

weight in respect of NPAs based on NPA

provision is carried out by the system and

verify the correctness of classification on a

test check basis

Capital Charge – Securitisation transactions

1. Based on the above, for a sample of transactions / deals examine whether the prescribed deduction from both CET 1, AT I and Tier II capital has been correctly done based on the rating and the level of provisions. Review the necessary documentation in support of the same.

2. Based on the above ascertain whether the appropriate risk weights have been assigned.

Collateral Risk Management and Credit Risk Mitigation

1. Review and document the process for collateral risk management as appropriate and relevant including but not limited to:

· Ageing reports

· Confirmation procedures.

· Control of documents

· Compliance with covenants

· Audit of collateral by independent agencies

2. Examine whether the bank has complete legal rights to enforce the security including specific lien and is subject to hair cuts for residual tenor mismatch and currency mismatch. Check the necessary documentation in respect thereof.

Capital Charge for Market Risk

Capital charge for market risk involves computation of the capital charge on interest rate related instruments and equities in the trading book and foreign exchange risk, including gold and other precious metals. Accordingly, the following would be covered:

· Securities under the HFT and AFS category

· Open gold and FX position limits

· Trading position in derivatives

· Derivatives entered into for hedging trading book exposures