Clarify your understanding on non-banking financial institutions (NBFI) with

their major sources of capital in the perspective of Bangladesh

Here's a comprehensive overview of Non-Banking Financial Institutions (NBFIs) in

Bangladesh, along with their major sources of capital:

What Are NBFIs?

Non-Banking Financial Institutions (NBFIs) in Bangladesh are financial entities that:

• Do not hold a full banking license

• Cannot accept demand deposits (like savings or current accounts)
• Provide specialized financial services such as leasing, term loans, housing finance,
merchant banking, and venture capital

They are regulated under the Financial Institutions Act, 1993 and supervised by Bangladesh
Bank.

Role and Importance in Bangladesh

• As of December 2023, there are 35 licensed NBFIs in Bangladesh:

o 3 government-owned
o 32 privately owned
• They operate 308 branches, with a concentration in Dhaka (173) and Chattogram (47)
• NBFIs fill critical gaps in long-term financing, especially for sectors underserved by
traditional banks
• They are key players in housing finance, SME lending, infrastructure development,
and green finance

Major Sources of Capital for NBFIs

NBFIs in Bangladesh mobilize funds from a variety of sources, including:

Source of Capital Description

Term Deposits Fixed-term investments from individuals and institutions
Bank Borrowings Loans and credit lines from commercial banks
Inter-NBFI Borrowings Short-term funds borrowed from other NBFIs
 Source of Capital Description
Very short-term borrowing (usually overnight) from other
Call Money Market
financial institutions
Bond Issuance Long-term debt instruments issued to institutional investors
Pooling of assets (like loans) to issue securities backed by those
Securitization
assets
Initial Public Offerings Equity raised by listing on the stock exchange (21 NBFIs have
(IPOs) done this)
Retained Earnings Profits reinvested into the business

Note: The minimum paid-up capital requirement for NBFIs is BDT 1.0 billion, as
per Bangladesh Bank regulations.

Strategic Focus Areas

• Leasing and Term Lending: Historically dominant, though now diversifying

• Housing Finance: A major portfolio segment for many NBFIs
• SME and Green Finance: Increasingly prioritized for inclusive and sustainable growth
• Merchant Banking & Venture Capital: Emerging areas of interest

b) Why Non-banking financial institutions (NBFI) are different from Banking

financial institutions?

Here's a clear breakdown of how Non-Banking Financial Institutions (NBFIs) differ from
Banking Financial Institutions (BFIs) in the context of Bangladesh:

Key Differences Between NBFIs and Banks

NBFIs (Non-Banking Financial

Feature Banks (BFIs)
Institutions)
Cannot accept demand deposits;
Can accept demand deposits (e.g.,
Deposit Acceptance only term deposits (usually ≥ 3
savings, current accounts)
months)
Cannot create money; only
Can create money through lending
Money Creation redistribute funds from other
and deposit multiplication
sources
 NBFIs (Non-Banking Financial
Feature Banks (BFIs)
Institutions)
Must maintain Cash Reserve Ratio
Regulatory Not required to maintain CRR or
(CRR) and Statutory Liquidity
Requirements SLR
Ratio (SLR)
Often have more flexible lending
Operate under stricter lending
Risk Appetite criteria, allowing higher risk
regulations and risk assessments
exposure
Specialize in leasing, housing
Offer full banking services: deposits,
Primary Activities finance, SME loans, merchant
loans, remittances, trade finance
banking
Access to Central Can borrow directly from Cannot borrow directly from the
Bank Funds Bangladesh Bank central bank
Participation in Not part of the national payment
Part of the national payment system
Payment System system
Sonali Bank, BRAC Bank, Islami IDLC Finance, LankaBangla
Examples
Bank Finance, IPDC Finance

Why These Differences Matter

• Banks are the backbone of the monetary system, ensuring liquidity and payment
facilitation.
• NBFIs complement banks by focusing on long-term financing, niche markets, and
innovative financial products.
• In Bangladesh, NBFIs play a vital role in housing finance, infrastructure development,
and SME support, where banks may be more risk-averse.

Describe the major banking systems around the globe

Here's a structured overview of the major banking systems around the globe, highlighting
their unique characteristics and regional distinctions:

Major Global Banking Systems

1. Anglo-American Banking System

• Countries: USA, UK, Canada, Australia

• Key Features:
o Clear separation between commercial banking and investment banking
 o Commercial banks focus on deposits and loans
o Investment banks handle securities, underwriting, and asset management
o Strong regulatory frameworks (e.g., Dodd-Frank Act in the US)

2. German Universal Banking System

• Country: Germany
• Key Features:
o No separation between commercial and investment banking
o Banks can own equity in corporations (up to 40%)
o Banks act as both creditors and shareholders
o Strong emphasis on relationship banking and long-term partnerships

3. Japanese Main Banking System

• Country: Japan
• Key Features:
o Hybrid of Anglo-American and German systems
o Banks can own up to 5% of a company’s shares
o A “main bank” provides the largest loan and acts as a key stakeholder
o Banks often step in to manage distressed firms temporarily

4. Indian Lead Banking System

• Country: India
• Key Features:
o Public sector banks dominate the system
o Lead bank scheme assigns one bank to coordinate development in each district
o Emphasis on financial inclusion and rural banking
o Regulated by the Reserve Bank of India (RBI)

Countries with Advanced Banking Systems

According to BankDeets, the most advanced banking systems are found in:

Country Notable Strengths

Luxembourg Transparent regulation, global banking hub, 93% foreign-owned banks
Jordan High liquidity, resilient to economic shocks
New Zealand Efficient, secure, and autonomous banking operations
Morocco Africa’s most competitive banking sector, closely regulated by the central bank

Summary of Key Differences

 Investment Ownership in Relationship
System Type Regulatory Focus
Banking Firms Banking
Anglo-American Separate Not allowed Market-based Low
Bank-firm
German Universal Integrated Up to 40% High
collaboration
Japanese Main Long-term firm
Partially separate Up to 5% Very High
Banking support
Indian Lead Development-
Separate Limited Moderate
Banking focused

a) In a commercial bank, loans create deposits and deposits create

loans. Explain the stated process with all the plausible criticism of the
process
Here's a detailed explanation of the statement "In a commercial bank, loans create deposits
and deposits create loans", along with plausible criticisms of each view:

Dual Perspectives in Banking

1. Loans Create Deposits (Modern View)

How It Works:

• When a bank approves a loan, it credits the borrower’s account with the loan amount.
• This creates a new deposit in the banking system.
• The bank does not need prior deposits to lend; it creates money through accounting
entries.

Example:

• Bank A grants a loan of BDT 10,000 to Mr. Rahim.

• Instead of giving cash, the bank credits Mr. Rahim’s account with BDT 10,000.
• This new deposit increases the money supply.

Strengths:

• Reflects endogenous money theory: money supply is driven by demand for credit.
• Supported by central banks like the Bank of England and Bundesbank.
• Explains how banks expand credit even in the absence of prior savings.
 Criticisms:

• Overlooks reserve constraints: Banks still need to meet capital adequacy and liquidity
ratios.
• May encourage excessive lending, leading to asset bubbles or inflation.
• Assumes borrowers will spend the loan, which may not always happen.
• Critics argue it ignores the role of central bank reserves and interbank settlement.

2. Deposits Create Loans (Traditional View)

How It Works:

• Banks mobilize deposits from savers.

• A portion is kept as reserves (e.g., 10% CRR), and the rest is lent out.
• This is the basis of the money multiplier model.

Example:

• A customer deposits BDT 10,000.

• The bank keeps BDT 1,000 as reserve and lends BDT 9,000.
• That BDT 9,000 is deposited again, and the cycle continues.

Strengths:

• Emphasizes prudence and liquidity management.

• Aligns with fractional reserve banking logic.
• Useful for teaching basic monetary theory.

Criticisms:

• Oversimplified: Assumes banks wait for deposits before lending.

• Empirically outdated: Modern banks lend based on creditworthiness, not deposit
levels.
• Ignores endogenous money creation: Lending decisions drive deposit creation, not vice
versa.

Reconciling the Two Views

 Viewpoint Core Idea Criticism
Loans create Lending precedes deposit
May ignore reserve and regulatory limits
deposits creation
Deposits create Lending is constrained by Ignores modern credit-driven money
loans deposits creation

Reality: Both processes occur. In practice, loans create deposits, but deposits also
fund further lending through the interbank market and capital management.

Should commercial bank trade-off profitability for liquidity or

trade-off liquidity for profitability? Discuss your argumentative
analysis on the stated issue and show how liquidity is different from
profitability
Here's a comprehensive argumentative analysis of whether commercial banks should trade off
profitability for liquidity or liquidity for profitability, along with a clear distinction between
the two concepts:

Liquidity vs. Profitability: Key Differences

Aspect Liquidity Profitability
Ability to meet short-term
Definition Ability to generate income over expenses
obligations and withdrawals
Measured Cash Ratio, Loan-to-Deposit Ratio, Return on Assets (ROA), Return on Equity
by CRR, SLR (ROE), Net Interest Margin
Focus Safety and solvency Earnings and growth
Risk Profile Low risk, low return Higher risk, higher return potential
Ensures trust and operational Ensures shareholder value and long-term
Implication
continuity sustainability

The Trade-Off: A Strategic Dilemma

Argument for Prioritizing Liquidity (Trading off Profitability)

• Survival First: Without liquidity, a bank cannot meet withdrawal demands, risking
insolvency.
 • Regulatory Compliance: Central banks (e.g., Bangladesh Bank) impose CRR and SLR
requirements.
• Crisis Resilience: During financial shocks (e.g., COVID-19), liquidity cushions prevent
collapse.
• Reputation Risk: Illiquidity can trigger panic and bank runs, damaging trust.

Example: Foreign Commercial Banks (FCBs) in Bangladesh maintain higher

liquidity and are still profitable due to efficient asset allocation.

Argument for Prioritizing Profitability (Trading off Liquidity)

• Shareholder Value: Profitability drives dividends, stock price, and retained earnings.
• Growth Capital: Profits fund expansion, innovation, and competitive positioning.
• Efficiency Signal: High profitability reflects effective asset utilization and cost control.
• Low-Yield Trap: Excess liquidity often earns minimal returns, dragging down
ROA/ROE.

Example: A study on Tanzanian banks found no statistically significant

relationship between liquidity and profitability, suggesting banks can pursue profits
without harming liquidity.

Empirical Insights from Bangladesh

• A study of Bangladeshi banks (2011–2020) found that higher liquidity ratios (e.g.,
cash-deposit) can increase profitability, indicating that a balanced approach is
optimal.
• However, excess liquidity—especially in state-owned banks—has been shown to
hamper profitability due to underutilized funds.

Strategic Conclusion: Balance is Key

Rather than choosing one over the other, commercial banks should aim to optimize the trade-
off:

• Maintain minimum regulatory liquidity to ensure solvency and compliance.

• Deploy excess funds into profitable, low-risk assets (e.g., government securities, high-
quality loans).
• Use liquidity forecasting tools and stress testing to dynamically adjust the balance.
 Optimal strategy: Neither extreme liquidity hoarding nor aggressive profit-chasing.
Instead, a risk-adjusted balance that aligns with the bank’s size, market, and regulatory
environment.

Though central bank of a country solely reserves the authority to issue

currency in the economy, it cannot issue currency as much as it is capable to
printe Explain the principles that stop a central bank to issue currency on its
wish

The central bank of a country—such as Bangladesh Bank—has the exclusive authority to issue
currency, but it cannot issue unlimited currency at will, even if it has the technical capacity to
print more. This restraint is grounded in several economic, legal, and institutional principles
that ensure monetary and financial stability.

Principles That Restrain Currency Issuance

1. Monetary Stability Principle

• Uncontrolled currency issuance leads to inflation or even hyperinflation.

• More money chasing the same amount of goods and services causes prices to rise.
• Central banks must maintain price stability, often targeting inflation rates (e.g., 5–6% in
Bangladesh).

Example: Zimbabwe and Venezuela experienced hyperinflation due to excessive

money printing.

2. Backing by Real Economic Output

• Currency must be backed by real economic activity—GDP, production, and services.

• Issuing money without corresponding growth in output devalues the currency.
• Central banks use tools like monetary aggregates and output gap analysis to guide
issuance.

3. Legal and Institutional Mandates

 • Central banks operate under legal frameworks (e.g., Bangladesh Bank Order, 1972).
• Their mandate includes price stability, financial system soundness, and supporting
economic growth—not printing money for fiscal needs.
• Many central banks are independent to prevent political misuse of currency issuance.

4. Foreign Exchange and External Balance

• Excessive currency issuance can weaken the exchange rate, leading to currency
depreciation.
• In countries like Bangladesh with import dependency, this raises the cost of essentials
(fuel, food).
• It also erodes foreign reserves and investor confidence.

5. Confidence and Trust in Money

• Currency is a social contract—its value depends on public trust.

• If people believe the central bank is printing irresponsibly, they may shift to foreign
currencies, gold, or crypto assets.
• This can trigger capital flight and bank runs.

6. Monetary Policy Frameworks

• Central banks use interest rates, open market operations, and reserve requirements to
manage liquidity.
• Currency issuance is part of a broader monetary policy strategy, not a standalone tool.

Summary Table
Principle Why It Matters
Price Stability Prevents inflation and protects purchasing power
Economic Backing Ensures money reflects real value in the economy
Legal Mandate Limits arbitrary issuance through institutional checks
Exchange Rate
Protects foreign reserves and trade competitiveness
Stability
Maintains trust in the currency as a store of value and medium of
Public Confidence
exchange
 Principle Why It Matters
Policy Coherence Aligns issuance with interest rates and liquidity management

narrate the available methods of note issuance by a central bank

Here's a detailed explanation of the available methods of note issuance by a central bank, based
on established monetary principles and global practices:

What Is Note Issuance?

Note issuance refers to the process by which a central bank creates and circulates currency
(banknotes) in the economy. While the central bank has the sole authority to issue legal tender, it
must follow specific methods to ensure monetary stability, trust, and economic alignment.

Major Methods of Note Issuance

1. Fixed Fiduciary System

• A fixed amount of currency is issued without full backing by gold or reserves.

• Any issuance beyond this limit must be backed 100% by metallic reserves (e.g., gold).
• Advantage: Provides monetary flexibility up to a limit.
• Limitation: Inflexible during economic expansion or crisis.

Example: Early Bank of England practices used this method.

2. Proportional Reserve System

• A fixed percentage of the total currency issued must be backed by metallic reserves
(e.g., 25% gold).
• The remaining portion can be backed by government securities or other assets.
• Advantage: Balances flexibility with reserve discipline.
• Limitation: Vulnerable to reserve depletion during crises.

3. Minimum Reserve System

 • The central bank maintains a minimum reserve (e.g., gold + foreign currency),
regardless of the amount of currency issued.
• Most modern central banks, including Bangladesh Bank, follow this method.
• Advantage: Offers maximum elasticity in currency issuance.
• Limitation: Requires strong monetary policy to prevent inflation.

Bangladesh Example: Bangladesh Bank maintains a minimum reserve of gold and

foreign exchange to back its currency issuance.

4. Maximum Fiduciary System

• The central bank is allowed to issue currency up to a maximum fiduciary limit, beyond
which full backing is required.
• Similar to the fixed fiduciary system but with a higher ceiling.
• Advantage: Offers more room for monetary expansion.
• Limitation: Still constrained by the fiduciary ceiling.

5. Simple Deposit System

• Currency is issued only against deposits of gold, silver, or foreign exchange.

• Advantage: Ensures full backing and trust.
• Limitation: Highly restrictive and obsolete in modern economies.

Summary Table
Method Backing Requirement Flexibility Common Today?
Fixed amount unbacked; rest 100%
Fixed Fiduciary System Low Rare
backed
Proportional Reserve
% of currency backed by reserves Moderate Occasionally
System
Minimum Reserve Yes (e.g.,
Fixed minimum reserve only High
System Bangladesh)
Maximum Fiduciary
Up to a ceiling unbacked Moderate Rare
System
Simple Deposit System Fully backed by deposits Very Low Obsolete
As a guardian of money market, Bangladesh Bank has the prime authority to
control the supply of money in the money market Bangladesh. Elaborately
discuss various tools that Bangladesh Bank usually applies to successfully
perform such crucial function.

As the guardian of the money market, Bangladesh Bank plays a pivotal role in controlling the
money supply to ensure price stability, economic growth, and financial system soundness. To
perform this crucial function, it employs a range of monetary policy tools, both quantitative
and qualitative.

Tools Used by Bangladesh Bank to Control Money

Supply
1. Open Market Operations (OMO)

• Definition: Buying and selling of government securities in the open market.

• Purpose: To regulate liquidity in the banking system.
• Mechanism:
o Purchase of securities → Injects money into the system → Increases money
supply.
o Sale of securities → Absorbs money from the system → Decreases money
supply.
• Instruments Used: Treasury bills, Bangladesh Bank bills, repo and reverse repo
operations.

2. Cash Reserve Ratio (CRR)

• Definition: The percentage of total deposits that commercial banks must hold as reserves
with Bangladesh Bank.
• Impact:
o Higher CRR → Less money available for lending → Reduces money supply.
o Lower CRR → More money available for lending → Increases money supply.

3. Statutory Liquidity Ratio (SLR)

• Definition: The minimum percentage of net demand and time liabilities (NDTL) that
banks must maintain in the form of liquid assets (e.g., gold, government securities).
• Impact:
 o Higher SLR → Reduces lending capacity → Contracts money supply.
o Lower SLR → Expands lending capacity → Expands money supply.

4. Policy Interest Rate (Repo and Reverse Repo Rates)

• Repo Rate: The rate at which Bangladesh Bank lends to commercial banks.
• Reverse Repo Rate: The rate at which it borrows from commercial banks.
• Impact:
o Higher repo rate → Costlier borrowing → Reduces money supply.
o Lower repo rate → Cheaper borrowing → Increases money supply.

5. Discount Rate

• Definition: The interest rate charged by Bangladesh Bank on loans to commercial banks.
• Impact:
o Higher discount rate → Discourages borrowing → Contracts money supply.
o Lower discount rate → Encourages borrowing → Expands money supply.

6. Moral Suasion

• Definition: Persuasive tactics used by Bangladesh Bank to influence and guide the
behavior of commercial banks.
• Examples:
o Advising banks to restrict credit in inflationary periods.
o Encouraging lending to priority sectors like agriculture or SMEs.

7. Selective Credit Controls

• Definition: Directives to control credit flow to specific sectors.

• Purpose: To prevent speculative lending (e.g., in real estate or stock markets) and
promote productive sectors.

Summary Table
 Tool Type Effect on Money Supply
Open Market Operations Quantitative Buy = ↑ Supply, Sell = ↓ Supply
CRR Quantitative ↑ CRR = ↓ Supply, ↓ CRR = ↑ Supply
SLR Quantitative ↑ SLR = ↓ Supply, ↓ SLR = ↑ Supply
Repo/Reverse Repo Rates Quantitative ↑ Rate = ↓ Supply, ↓ Rate = ↑ Supply
Discount Rate Quantitative ↑ Rate = ↓ Supply, ↓ Rate = ↑ Supply
Moral Suasion Qualitative Indirect influence on credit behavior
Selective Credit Control Qualitative Directs credit to or away from sectors

Financial institutions are suggested to develop risk culture inside the organization to face and
fight against the risk elements Discuss meaning of risk culture in a financial institution.

Risk culture in a financial institution refers to the shared values, beliefs, attitudes, and
behaviors that shape how employees at all levels perceive, understand, and manage risk. It is a
foundational element of effective risk management and plays a critical role in ensuring the
institution’s long-term stability and resilience.

What Is Risk Culture?

According to TimesPro and PwC, risk culture is:

“The set of norms, attitudes, and behaviors related to risk awareness, risk-taking, and risk
management that are shared across an institution.”

It reflects how well employees:

• Understand the risks associated with their roles

• Report and respond to risks
• Make decisions that align with the institution’s risk appetite
• Take accountability for risk-related outcomes

Key Elements of a Strong Risk Culture

Element Description
Leadership
Senior management sets the tone by modeling risk-aware behavior
Commitment
Clear Risk Appetite Defined limits on how much risk the institution is willing to take
 Element Description
Open Communication Employees feel safe to report risks and near-misses
Accountability Individuals are responsible for managing risks in their areas
Training & Awareness Ongoing education on risk policies, tools, and emerging threats
Integration with Risk considerations are embedded in decision-making and business
Strategy planning

Why Risk Culture Matters in Financial Institutions

1. Prevents Risk Blindness: Encourages proactive identification and mitigation of risks.
2. Reduces Operational Failures: Minimizes losses from fraud, compliance breaches, or
system failures.
3. Builds Resilience: Helps institutions adapt to market shocks and regulatory changes.
4. Enhances Reputation: Demonstrates integrity and responsibility to regulators, investors,
and customers.
5. Supports Regulatory Compliance: Aligns with global standards like Basel III and local
central bank expectations.

Consequences of a Weak Risk Culture

• Unchecked risk-taking (e.g., excessive lending or speculative investments)
• Delayed response to emerging threats
• Siloed risk management with poor coordination
• Regulatory penalties and reputational damage

Building a Positive Risk Culture: Best Practices

• Tone from the Top: Leadership must visibly support and prioritize risk management.
• Three Lines of Defense: Clear roles for business units, risk managers, and internal audit.
• Risk Champions: Appoint individuals in each department to promote risk awareness.
• Feedback Loops: Use incident reports and audits to refine risk practices.
• Cultural Assessments: Regular surveys and interviews to gauge risk attitudes and
behaviors.
Describe the effects of both sound risk culture and weak risk culture
on a financial institution.
Here's a comprehensive analysis of the effects of both sound and weak risk culture on a
financial institution, drawing from global research and supervisory insights:

Effects of a Sound Risk Culture

A sound risk culture fosters responsible behavior, informed decision-making, and long-term
stability. Its benefits include:

1. Enhanced Financial Stability

• Institutions with strong risk cultures are better at identifying, assessing, and mitigating
risks.
• They are more resilient during financial shocks or crises.

2. Improved Decision-Making

• Employees at all levels are empowered to challenge risky decisions.

• Risk is considered in strategic planning, lending, and investment decisions.

3. Regulatory Confidence

• Regulators view institutions with strong risk cultures as lower-risk.

• This can lead to fewer penalties, lower capital surcharges, and greater operational
freedom.

4. Reputation and Trust

• A culture of transparency and accountability builds stakeholder trust.

• Clients, investors, and partners are more likely to engage with institutions that
demonstrate ethical risk behavior.

5. Operational Efficiency

• Fewer compliance breaches, frauds, or operational failures.

• Risk-aware employees reduce the cost of risk management and internal controls.

Example: European banks with strong risk cultures showed higher loan quality and
lower legal expenses, according to a study using sentiment analysis of annual reports.
 Effects of a Weak Risk Culture
A weak risk culture can silently erode an institution’s foundation, often with devastating
consequences:

1. Increased Risk-Taking and Losses

• Employees may prioritize short-term profits over long-term sustainability.

• Leads to excessive lending, speculative investments, or poor credit decisions.

2. Regulatory Sanctions

• Weak internal controls and governance attract scrutiny from regulators.

• Can result in fines, license restrictions, or capital penalties.

3. Reputational Damage

• Scandals, fraud, or misconduct can destroy public trust.

• Recovery from reputational loss is slow and costly.

4. Internal Dysfunction

• Poor communication, lack of accountability, and fear of speaking up.

• Control functions (risk, compliance, audit) may be ignored or under-resourced.

5. Crisis Amplification

• During financial stress, weak cultures fail to respond quickly or cohesively.

• This can lead to bank runs, liquidity crises, or insolvency.

Case in Point: The 2008 global financial crisis exposed how weak risk cultures—
especially in investment banks—led to reckless behavior, over-leveraging, and systemic
collapse.

Summary Table
 Risk Culture
Positive Outcomes Negative Outcomes
Type
Stability, trust, compliance, better
Sound —
decisions, resilience
Misconduct, losses, regulatory action,
Weak —
reputational harm

Illustrate a proper risk governance for a financial institution to

mitigate major risk related dangers.

To effectively mitigate major risk-related dangers, a financial institution must establish a robust
risk governance framework. This framework ensures that risk management is not just a
function, but a culture and structure embedded throughout the organization. Based on global
best practices and Bangladesh Bank’s Integrated Risk Management Guidelines, here’s how a
proper risk governance model should be illustrated:

Components of a Proper Risk Governance Framework

1. Board and Senior Management Oversight

• The Board of Directors sets the risk appetite, approves the risk management strategy,
and ensures accountability.
• Senior Management implements the strategy, allocates resources, and monitors risk
exposure.
• A Board Risk Committee should be established to oversee enterprise-wide risks.

2. Three Lines of Defense Model

This model ensures clear roles and responsibilities across the organization:

Line of Defense Role

1st Line: Business Units Own and manage risks in day-to-day operations
2nd Line: Risk & Develop risk policies, monitor risk exposure, and ensure
Compliance compliance
Independently assess the effectiveness of risk controls and
3rd Line: Internal Audit
governance

3. Chief Risk Officer (CRO)

 • A CRO should be appointed with independent authority and direct access to the board.
• The CRO leads the enterprise risk management (ERM) function and ensures risk
integration across departments.

4. Risk Committees

• Management Risk Committee: Oversees operational, credit, market, and liquidity risks.
• Asset-Liability Committee (ALCO): Manages interest rate risk, liquidity, and balance
sheet structure.
• IT Risk Committee: Addresses cybersecurity and technology-related risks.

5. Risk Policies and Limits

• Clearly defined risk appetite statements, tolerance thresholds, and exposure limits.
• Policies should cover all major risk types: credit, market, operational, liquidity,
compliance, and reputational.

6. Risk Identification, Measurement, and Reporting

• Use of risk registers, stress testing, and scenario analysis.

• Regular risk dashboards and MIS reports to the board and regulators.

7. Internal Controls and Compliance

• Strong internal control systems to detect and prevent fraud, errors, and policy breaches.
• A compliance function ensures adherence to laws, regulations, and internal policies.

8. Risk Culture and Training

• Promote a risk-aware culture through training, incentives, and leadership example.

• Encourage whistleblowing, open communication, and ethical behavior.

Visual Summary: Risk Governance Structure

Board of Directors
│
├── Board Risk Committee
│ └── Approves risk strategy and monitors risk profile
│
├── Chief Risk Officer (CRO)
│ └── Independent oversight of all risk functions
│
├── Management Risk Committee
│ └── Operationalizes risk strategy across departments
│
├── Business Units (1st Line)
│ └── Own and manage risks
│
├── Risk & Compliance (2nd Line)
│ └── Monitor and report risks
│
└── Internal Audit (3rd Line)
└── Independent assurance

Briefly discuss the three-lines-of-defense-model

The Three Lines of Defense (3LoD) model is a widely adopted framework in financial
institutions for organizing and strengthening risk management and internal control systems. It
clearly defines roles and responsibilities across the organization to ensure that risks are
effectively identified, managed, and monitored.

The Three Lines of Defense Model: Overview

First Line of Defense: Operational Management

• Who: Business units, front-line staff, and operational managers

• Role:
o Own and manage risks directly
o Implement internal controls in day-to-day operations
o Identify, assess, and mitigate risks as part of their core responsibilities
• Examples:
o Loan officers ensuring creditworthiness
o Branch managers monitoring cash handling procedures

Goal: Embed risk awareness into business processes

Second Line of Defense: Risk Management and Compliance

• Who: Risk management, compliance, legal, and control functions

• Role:
o Develop risk policies, frameworks, and tools
o Monitor and support the first line
o Ensure compliance with laws, regulations, and internal standards
• Examples:
 o Compliance officers monitoring AML/CFT adherence
o Risk teams setting credit exposure limits

Goal: Provide oversight and guidance to ensure risks are managed within the
institution’s risk appetite

Third Line of Defense: Internal Audit

• Who: Independent internal audit function

• Role:
o Provide independent assurance to the board and senior management
o Evaluate the effectiveness of governance, risk management, and internal controls
o Identify gaps and recommend improvements
• Examples:
o Auditing loan approval processes
o Reviewing cybersecurity controls

Goal: Offer objective evaluation and strengthen accountability

Why the 3LoD Model Matters

• Clarifies responsibilities across the organization
• Reduces duplication and gaps in risk coverage
• Strengthens governance and regulatory compliance
• Improves risk transparency and decision-making

According to the Institute of Internal Auditors (IIA), the model enhances coordination
and ensures that all parts of the organization contribute to effective risk management.

How can we assess risk associated with financial sector?

Assessing risk in the financial sector is a structured process that helps institutions identify,
measure, and manage potential threats to their stability and performance. Here's a concise yet
comprehensive overview of how this is done:

Key Steps to Assess Risk in the Financial Sector

1. Define Scope and Objectives

• Determine what areas (e.g., credit, market, operational, compliance) and entities
(branches, subsidiaries) are being assessed.
• Set clear goals: regulatory compliance, capital adequacy, fraud prevention, etc.

2. Identify Potential Risks

• Common categories include:

o Credit Risk: Borrower default or counterparty failure
o Market Risk: Losses due to interest rate, currency, or equity fluctuations
o Operational Risk: Failures in internal processes, systems, or human error
o Liquidity Risk: Inability to meet short-term obligations
o Compliance Risk: Breach of laws, regulations, or internal policies
o Cybersecurity Risk: Threats to digital infrastructure and data

3. Assess and Quantify Risks

• Use both qualitative and quantitative methods:

o Value at Risk (VaR): Estimates potential losses under normal market conditions
o Stress Testing: Simulates extreme but plausible adverse scenarios
o Risk Scoring: Assigns risk levels based on likelihood and impact
o Scenario Analysis: Evaluates outcomes under different economic conditions

4. Evaluate Controls and Mitigation Measures

• Assess the effectiveness of existing controls (e.g., credit checks, firewalls, compliance
audits).
• Identify gaps and recommend improvements.

5. Determine Residual Risk

• Residual risk = Inherent risk – Control effectiveness

• Helps prioritize which risks need further mitigation or monitoring.

6. Document and Report

• Create a risk register or risk heat map to visualize risk exposure.

• Report findings to senior management and the board.

7. Monitor and Review

• Risk assessment is not a one-time task—regular updates are essential.

• Use Key Risk Indicators (KRIs) and early warning systems to track changes.
 Tools and Techniques Commonly Used
Technique Purpose
Value at Risk (VaR) Quantify market risk in monetary terms
Stress Testing Assess resilience under extreme conditions
Risk Heat Maps Visualize risk severity and likelihood
Risk Registers Catalog and track identified risks
Scenario Analysis Explore outcomes under different assumptions
Internal Ratings Evaluate creditworthiness of borrowers

Best Practices
• Align risk assessment with Basel III and local regulatory frameworks (e.g., Bangladesh
Bank guidelines).
• Integrate risk assessment into strategic planning and capital allocation.
• Use technology and data analytics to enhance accuracy and speed.

Source: SECTARA Guide to Risk Assessment in Finance, Finance on Point – Risk

Techniques

Briefly discuss the actions that can be taken to miligate risks.

To effectively mitigate risks in the financial sector, institutions must adopt a multi-layered
strategy that combines proactive planning, regulatory compliance, and operational resilience.
Here’s a concise overview of the key actions that can be taken to mitigate major financial risks:

Key Actions to Mitigate Risks in Financial Institutions

1. Diversification

• Spread exposure across different asset classes, sectors, and geographies.

• Reduces concentration risk and cushions against sector-specific shocks.

2. Robust Risk Assessment and Planning

 • Conduct regular risk assessments, scenario analysis, and stress testing.
• Identify vulnerabilities and prepare contingency plans for adverse events.

3. Capital and Liquidity Buffers

• Maintain adequate capital reserves and liquidity coverage ratios as per Basel III.
• Ensures solvency and operational continuity during financial stress.

4. Compliance and Regulatory Alignment

• Adhere to local and international regulations (e.g., AML/CFT, Basel III, FATF).
• Avoids legal penalties and enhances institutional credibility.

5. Hedging and Insurance

• Use financial instruments (e.g., derivatives) to hedge against market risks.

• Obtain insurance coverage for operational risks like cyberattacks or fraud.

6. Cybersecurity and IT Resilience

• Implement strong cybersecurity protocols and data protection measures.

• Regularly test systems for vulnerabilities and maintain disaster recovery plans.

7. Internal Controls and Governance

• Strengthen internal audit, compliance, and control functions.

• Promote accountability through the Three Lines of Defense model.

8. Risk Culture and Training

• Foster a culture of risk awareness and ethical behavior.

• Provide ongoing training to staff on risk identification and mitigation.

9. Debt and Credit Risk Management

• Set prudent lending standards and monitor borrower creditworthiness.

• Use credit scoring models and early warning systems to detect defaults.

10. Strategic Partnerships and Outsourcing Controls

• Vet third-party vendors and partners for risk exposure.

• Include risk clauses in contracts and monitor service-level agreements.
 Summary Table
Action Risk Type Addressed
Diversification Market, credit, investment risk
Capital & Liquidity Buffers Liquidity, solvency risk
Regulatory Compliance Legal, reputational risk
Cybersecurity Measures Operational, IT risk
Hedging & Insurance Market, operational, catastrophic risk
Internal Controls & Governance Fraud, compliance, reputational risk
Risk Culture & Training Behavioral, strategic risk

Source: Citrin Cooperman – 15 Strategies to Minimize Risk

What do you understand by excess reserve in a bank? How do the

banks handle their excess reserve?
Here's a clear and concise explanation of excess reserves in a bank and how banks typically
handle them:

What Are Excess Reserves?

Excess reserves are the funds that a commercial bank holds above the minimum reserve
requirement set by the central bank (e.g., Bangladesh Bank).

Formula:

[ \text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves} ]

• Total Reserves include cash in the vault and deposits with the central bank.
• Required Reserves are the minimum percentage of deposits that banks must hold to
ensure liquidity and stability.

These reserves act as a liquidity buffer to protect against unexpected withdrawals,

loan defaults, or economic shocks.
 How Do Banks Handle Excess Reserves?
Banks manage excess reserves based on economic conditions, regulatory incentives, and
profitability goals:

1. Deposit with the Central Bank

• Banks often park excess reserves with the central bank to earn interest on reserve
balances (IORB).
• This is a risk-free return, though typically lower than lending or investment returns.

2. Lend in the Interbank Market

• Banks with excess reserves may lend to other banks facing short-term liquidity
shortages.
• This helps maintain liquidity in the money market and earns interest.

3. Invest in Low-Risk Securities

• Banks may use excess reserves to buy government bonds or treasury bills, which are
safe and liquid.
• This generates modest returns while preserving capital.

4. Hold as a Safety Cushion

• Especially during uncertain times (e.g., financial crises), banks may intentionally hold
excess reserves to:
o Avoid liquidity crunches
o Maintain depositor confidence
o Strengthen their credit rating

5. Reduce Lending (Opportunity Cost)

• Holding excess reserves means not using funds for loans, which could yield higher
returns.
• This trade-off is carefully managed based on risk appetite and macroeconomic signals.

Strategic Considerations
Action Benefit Trade-Off
Deposit with central bank Safe, earns interest Low return
 Action Benefit Trade-Off
Interbank lending Supports liquidity, earns interest Counterparty risk
Invest in securities Generates income Market risk
Hold as buffer Enhances stability Opportunity cost
Reduce lending Avoids risk in volatile markets Slower credit growth

State the main sources of foreign exchange reserve for a country's

financial system.
The main sources of foreign exchange reserves for a country's financial system are the various
inflows of foreign currency and foreign-denominated assets that accumulate in the central bank's
holdings. These reserves are essential for maintaining currency stability, meeting international
obligations, and supporting monetary policy.

Main Sources of Foreign Exchange Reserves

1. Trade Surplus

• When a country exports more than it imports, it earns foreign currency.

• The central bank may purchase this surplus foreign currency to build reserves.

Example: Export earnings from garments, jute, and remittances contribute to

Bangladesh’s reserves.

2. Remittances from Abroad

• Migrant workers sending money home is a major source of foreign exchange.

• In countries like Bangladesh, remittances are a top contributor to reserves.

3. Foreign Direct Investment (FDI)

• Inflows from multinational companies investing in local businesses or infrastructure.

• These investments bring in foreign currency, which can be absorbed into reserves.
4. Portfolio Investment

• Foreign investors buying stocks, bonds, or treasury bills in the domestic market.
• These inflows are often short-term and sensitive to interest rate changes.

5. External Borrowing

• Loans or aid from international institutions (e.g., IMF, World Bank) or foreign
governments.
• These funds are often disbursed in foreign currency and added to reserves.

6. Earnings from Reserve Assets

• Interest income from foreign government securities, such as U.S. Treasury bonds.
• Central banks invest part of their reserves to earn returns and maintain liquidity.

7. Special Drawing Rights (SDRs)

• Allocations from the International Monetary Fund (IMF).

• SDRs are international reserve assets that can be exchanged for freely usable currencies.

8. Gold Reserves

• Central banks may hold gold as part of their reserve portfolio.

• Gold can be sold or pledged to raise foreign currency during crises.

Summary Table
Source Description
Trade Surplus Export earnings exceeding import payments
Remittances Inflows from citizens working abroad
FDI Long-term foreign investment in domestic sectors
Portfolio Investment Foreign purchases of stocks and bonds
External Borrowing Loans from international lenders
 Source Description
Reserve Asset Earnings Interest from foreign securities
SDRs IMF allocations convertible to usable currencies
Gold Reserves Held as a hedge and reserve asset

Source: Investopedia, 5paisa FinSchool

Foreign reserve management plays vital role in financial system of a country

and foreign reserve management exposed to many risks time to time. Discuss
various risks in foreign reserve management with plausible measures to
mitigate those risks

Foreign exchange reserve management is a critical function of a central bank, aimed at ensuring
liquidity, currency stability, and confidence in the financial system. However, managing
these reserves involves exposure to several financial, operational, and strategic risks. Below is
a structured discussion of the key risks and plausible mitigation measures based on IMF
guidelines and central bank practices.

Key Risks in Foreign Reserve Management

1. Market Risk

• Definition: Risk of loss due to fluctuations in interest rates, exchange rates, or asset
prices.
• Example: A fall in the value of U.S. Treasury bonds held in reserves due to rising
interest rates.

2. Credit Risk

• Definition: Risk that a counterparty (e.g., a foreign bank or government) will default on
its obligations.
• Example: Holding reserves in a foreign bank that later becomes insolvent.

3. Liquidity Risk

• Definition: Risk of not being able to convert assets into cash quickly without significant
loss.
• Example: Holding long-term securities that cannot be sold quickly during a currency
crisis.
4. Operational Risk

• Definition: Risk of loss due to internal failures—human error, system breakdowns, or

fraud.
• Example: Misreporting of reserve data or unauthorized transactions.

5. Legal and Settlement Risk

• Definition: Risk arising from legal uncertainties or failure of counterparties to settle

transactions.
• Example: Cross-border legal disputes over asset ownership or delayed settlement in FX
trades.

6. Political and Sovereign Risk

• Definition: Risk of losses due to political instability or policy changes in countries where
reserves are held.
• Example: Sanctions or capital controls imposed by a foreign government.

Measures to Mitigate These Risks

Risk Type Mitigation Measures
Diversify across currencies and asset classes; use duration limits and
Market Risk
benchmarks
Set exposure limits by counterparty; invest in high-rated sovereign and
Credit Risk
institutional assets
Maintain a portion of reserves in highly liquid instruments (e.g., short-term
Liquidity Risk
U.S. Treasuries)
Operational
Implement strong internal controls, audit trails, and staff training programs
Risk
Legal Risk Use standardized contracts; ensure legal review of cross-border agreements
Limit exposure to politically unstable regions; monitor geopolitical
Sovereign Risk
developments

Best Practices from IMF Guidelines

• Clear Objectives: Define reserve management goals—liquidity, safety, and return—in
that order.
• Governance Framework: Establish legal authority, accountability, and transparency in
reserve operations.
• Risk Management Framework: Use tools like Value-at-Risk (VaR), stress testing, and
scenario analysis.
• Performance Monitoring: Regularly evaluate reserve performance against benchmarks
and risk limits.
• Transparency: Publicly disclose reserve levels and management policies to build market
confidence.