Principles & Practices of Banking

Financial System

• An institutional framework existing in a country to enable financial transactions

• Three main parts• Financial instruments/assets (bonds, equities, commercial papers,

T-bills, etc.)• Financial institutions (banks, mutual funds, insurance companies,

etc.)• Financial markets (money market, capital market, forex market,

etc.)

• Regulation is another aspect of the financial system (RBI, SEBI, IRDA, FMC)

Financial assets/instruments• Enable channelising funds from surplus units to deficit units• There are instruments for savers such as deposits, equities,

mutual fund units, etc.• There are instruments for borrowers such as loans,

overdrafts, etc.• Like businesses, governments too raise funds through issue of

bonds, Treasury bills, etc.• Instruments like PPF, KVP, etc. are available to savers who

wish to lend money to the government

Money Market Instruments• Call money- money borrowed/lent for a day. No collateral is

required.• Inter-bank term money- Borrowings among banks for a period

of more than 7 days• Treasury Bills- short term instruments issued by the Union

Govt. to raise money. Issued at a discount to the face value• Certificates of Deposit- Issued by banks to raise money.

Minimum value is Rs. 1 lakh, tradable in the market• CDs can be issued by banks/FIs

Financial Institutions• Includes institutions and mechanisms which

• Affect generation of savings by the community• Mobilisation of savings• Effective distribution of savings

• Institutions are banks, insurance companies, mutual funds- promote/mobilise savings

• Individual investors, industrial and trading companies- borrowers

Financial Markets

• Money Market- for short-term funds (less than a year)

• Organized (Banks)• Unorganized (money lenders, chit funds, etc.)

• Capital Market- for long-term funds• Primary Issues Market• Stock Market• Bond Market

Organized Money Market

• Call money market• Bill Market

• Treasury bills• Commercial bills

• Bank loans (short-term)• Organized money market comprises RBI,

banks (commercial and co-operative)

Call money market

• It deals with one-day loans (overnight, to be precise) called call loans or call money

• Participants are mostly banks. Also called inter-bank call money market.

• The borrowing is exclusively limited to banks, who are temporarily short of funds.

• On the lending side, besides banks with excess cash and as special cases few FIs like LIC, UTI

• All others have to keep their funds in term deposits with banks to earn interest

Bill Market• Treasury Bill market- Also called the T-Bill market

– These bills are short-term liabilities (91-day, 182-day, 364-day) of the Government of India

– They are issued at discount to the face value and at the end of maturity, the face value is paid

– The rate of discount and the corresponding issue price are determined at each auction

• Commercial Bill market- Not as developed in India as the T-Bill market

Indian Banking System• Central Bank (Reserve Bank of India)• Commercial banks• Co-operative banks• Banks can be classified as:

• Scheduled (Second Schedule of RBI Act, 1934)• Non-Scheduled

• Scheduled banks can be classified as:• Public Sector Banks • Private Sector Banks (Old and New) • Foreign Banks • Regional Rural Banks

Progress of banking in India (1)

• Nationalisation of banks in 1969: 14 banks were nationalised

• Branch expansion• Population served per branch• A rural branch office serves

Progress of banking in India (2)

• Deposit mobilisation:• 1951-1971 (20 years)- 700% or 7 times• 1971-1991 (20 years)- 3260% or 32.6 times• 1991- 2006 (11 years)- 1100% or 11 times• 2006 - 2016

• Expansion of bank credit: Growing at 20-30% thanks to rapid growth in industrial and agricultural output

• Development oriented banking: priority sector lending.

Progress of banking in India (3)

• Diversification in banking: Banking has moved from deposit and lending to

• Merchant banking and underwriting• Mutual funds• Retail banking• ATMs• Anywhere banking• Internet banking• Venture capital funds• Factoring

Financial System

The financial system or the financial sector of any country consists of (a) Specialized and non specialized Financial Institutions, (b) Organized or unorganized Financial Markets, and (c) Financial instruments and services which facilitate transfer of funds.

The main function of financial system is– the collection of savings and, – their distribution for industrial investment,– thereby stimulating the capital formation, and to, that extent, – accelerating the process of economic growth.

The process of capital formation has three activities: Savings (Resources set aside), Finance (Assembling of resources) and Investments(4 production).

Organization/ Constituents

• Financial Intermediaries1. Banks 2. NBFCs3. Mutual Funds4. Insurance Organizations

• Financial markets1. Money market2. Capital market

• Financial assets/instruments1. Primary/Direct – Equities, Debentures & others Innovatives.2. Indirect – MFs, Security receipts, securitized debt, bank deposits,

etc3. Derivatives – F & O

Financial Intermediaries• A major constituent of organization of financial system is an

array of financial intermediaries.• The financial intermediaries makes one type of contract with

lenders and other type of contract with borrowers.• As per Gurley and Shaw, the principal function of financial

intermediaries is “To purchase primary securities from ultimate borrowers and to

issue indirect debt for the portfolio of the ultimate borrowers and to issue indirect debt for the portfolio of ultimate lenders”

Primary securities are securities issued by Non-financial economic units.

Indirect securities are financial assets issued by financial intermediaries.

Financial Intermediaries

• NBFCs– AMC– Housing finance companies– Venture capital funds– Merchant banking organization– Credit rating agencies– Factoring & forfeiting– Stock broking firms– Depositories

Financial Intermediaries

Functions / Services• Convenience: divisibility & maturity• Lower risk: diversification• Expert management:• Economies scale:

Financial market• Money market

– Call market– T-bills Market– Bills Market– CP Market– Repo Market(Participants: Banks, GOI, MFs, FIs, Insurance & corporate)Capital market– Primary/New issue market– Secondary market/stock exchanges(Participants: Companies, Banks, FIs, MFs, Stock Exchange)

Financial assets

• Primary/direct securities– Equity– Debentures – Preference shares– Innovative debt instruments (Non/convertible

debenture, warrants, SPN.• Indirect securities (MFs, Security receipts)• Derivatives (F&O)

RBI• It started functioning from April 1, 1935 on the terms of RBI

Act,1934. It was a private shareholders institution till jan’1949, after which it became a state-owned institution under the RBI Act 1948.

• As the central of the country, it is the nerve of the financial and monetary system and the main regulator of the banking system.

• Main functions– It was constituted to regulate the issue of the bank notes and to keep

reserves to secure monetary stability and generally to operate the currency and credit system of the country.

– It has been gradually diversifying it business in recent times.

Functions

1. To maintain monetary stability so that the biz and economic life can deliver welfare gains.

2. To maintain financial stability and ensure sound financial institutions so that monetary stability can be safely pursued and economic units can conduct their business with confidence.

3. To maintain stable payments systems so that financial transaction can be safely and efficiently executed.

Functions 4. To promote the development of the financial infrastructure in

terms of markets and systems, and to enable it to operate efficiently, that is, to play a leading role in developing a sound financial system so that it can discharge its regulatory function efficiently.

5. To ensure that credit allocation by the financial system broadly reflects the national economic priorities and societal concerns.

6. To regulate the overall volume of the money and credit in the economy, with a view to ensuring a reasonable degree of price stability.

Role

• Note issuing Authority (15 full fedged issue offices and 2 sub-offices and 4127+ currency chests)

• Government banker.• Banker’s bank (lender of last resort)• Supervising authority.• Exchange control authority.• Promoter of the financial system, and• Regulator of money and credit (formulating

monetary policy)

Monetary policy• There are two pillars of Macroeconomic Policy- Fiscal policy and Monetary policy.• Monetary policy refers to the use of instruments within the control of the central

bank to influence the level of aggregate demand for goods and services or to influence the trends in certain sectors of the economy.

• Monetary policy operates through varying the cost and availability of credit, these producing desired changes in the assets pattern of credit institutions, primarily commercial banks.

Strategic goalsOf monetary policy•Price stability•Economic growth

Strategic intermediate Targets.•Money supply•Inflation rate•Exchange rate

Operating TargetsReserve money•Interest rates•Exchange rates•Volume of credit

Instruments-Reserve

Requirements,Bank/discount

Rate, Open marketoperations

Vital parameter that determine Liquidity & Capital formation in the economy

Monetary policy• Money supply is the total quantity of money in the economy. In narrow

sense, it is the currency in circulation in the economy plus demand deposits with banks.

• Measures of money stock: The RBI employs four measures of money stock M0, M1, M2 & M3.

• M0: currency in circulation + Banker’s deposits with RBI + other deposits with RBI. (reserve money with central bank from banks)

• M1: currency with public + Current deposit with banks + Demand liability with portion of saving deposits with banking system + other deposits with RBI.

• M2: M1 + Time liabilities portion of savings deposits + CDs issued by banks + Term deposits (upto 1 year)

• M3: M2 + Term deposits with banks (Above 1 year) + Call borrowing from non depository financial corporation..

Techniques of Regulation and Rates

Instruments of monetary policy• General (Quantitative) methods

• Bank rate• OMOs• Variable Reserve requirements (SLR & CRR)

• Selective (Qualitative) methods: It refers to regulations of credit for specific purpose or branches of economic activity. It relates to the distribution or direction of available credit supplies.

• In India such controls have been used to prevent speculative hoarding of commodities like food-grains and essential raw materials to check an undue rise in their prices.

Techniques of Regulation and Rates

• The techniques of selective credit controls used generally are in three forms:– Minimum margins for lending against specific securities,– Ceilings on the amounts of credit for certain purposes, and– Discriminatory rates of interest charged for certain types of advances.

• Credit Rationing: It involves the shortening the currency of and the limiting of the amount made available to banks so as to allocate funds among financially sound credit aspirants in accordance with a definite plan.

• Moral suasion: It involves friendly persuasion and advice so as to influence the lending policy of banks.

• Direct Action: It involves coercive measures against particular banks so as to penalize recalcitrant units of the banking units.

Regulator of money and credit

• Some of the important techniques/ instruments of monetary control that are adopted by RBI include:– Open Market Operation (OMOs)– Bank Rate– Refinance– Cash Reserve Ratio– Statutory Liquidity Ratio– Liquidity Adjustment Facility– Repo rates

Open Market Operations (OMOs)

• It refer the sale and purchase of securities of the Central and state Governments and Treasury Bills (T-bills).

• The multiple objectives of OMOs, inter-alia, are– To control the amount of and changes in bank credit and money

supply through controlling the reserve base of banks,– To make the bank rate policy more effective,– To maintain stability in the in the government securities/T-bills market– To support the government’s borrowing programme and– To smoothen the seasonal flow of funds in the bank credit market.

Open Market Operations (OMOs)

• Inspite of wide power of RBI, the OMOs is not a widely used technique of monetary control in India.

• The RBI is continuously in the market, selling Government securities on tap and buying them mostly in ‘switching operations’, it does not ordinarily purchase them against cash.

• The OMOs has helped in regulations of bank credit is two ways;– When they are conducted for switching operations, they lengthen the

maturity structure of the government securities which, in turn, has a favorable impact on monetary policy.

– The net sales of Government securities has increased over the years which has helped in regulating the flow of bank credit to the private sector.

Bank Rate• The bank rate (B/R) is the standard rate at which the

RBI buys/rediscounts bills of exchange/other eligible commercial papers.

• It is also the rate that the RBI charges on advances specified collaterals to banks.

• The interest rate on different types of accommodation from the RBI, including refinance are now linked to B/R.

• The change in B/R has been reflected in primary lending rates of banks.

Refinance• There are two refinance schemes available to banks.• Export credit refinance (ECR): It is extended to banks against

their outstanding export credit eligible for refinance.• General refinance: It is provided to surge over temporary

liquidity shortages faced by banks. It has now been replaced by a Collateralized Lending Facility (CLF) within the overall framework of liquidity adjustment facility (LAF).

• CLF is available to banks against their collateral of excess holdings of Government dated securities and T-bill over and above SLR

Cash Reserve Ratio

• It refers to the cash which banks have to maintain with the RBI, as a percentage of their demand and time liabilities.

• The objective of CRR is to ensure the safety and liquidity of bank deposits.

• The RBI is empowered to impose penal interest on banks in respect of their shortfall in the prescribed CRR.

Statutory Liquidity Ratio• It is the ratio of cash in hand (excluding CRR), balances in

current account with banks and RBI, gold and approved securities to total Demand and Time liabilities of the banks.

• The objectives of SLR can be cited as;– To restrict the expansion of bank credit,– To augment bank’s investment in Govt. securities, and– To ensure solvency of banks.

• While the CRR enables the RBI to impose primary reserves requirements; the SLR enables it to impose secondary and supplementary reserve requirements on the banking system.

Liquidity Adjustment Facility• The LAF is a new short term liquidity management

technique. • It is a flexible instrument in the hands of the RBI to

adjust or manage short-term market liquidity fluctuations on a daily basis and to help create stable or orderly conditions in the overnight/call money market.

• The LAF operations combined with OMOs and B/R changes, have become the major technique of monetary policy.

Repos• A Repo/ reverse Repo /buyback is a transaction in which

two parties agree to sell and repurchase the same security.

• The seller sells specified securities, with an agreement to repurchase the same at mutually decided future date and price.

• The same transaction is Repo from the viewpoint of seller and reverse Repo from viewpoint of buyer of securities.

• The difference between the price at which the securities are bought and sold is the lenders profit/interest earned for lending money.

Repos • Repos/reverse repos are used to

• Meet a shortfall in the cash position• Increase returns on funds held• Borrow securities to meet regulatory (SLR) requirements• By the RBI to adjust the liquidity in the financial system under LAF.

Types of Repos Interbank Repos: T-bills, all Central govt. dated securities, state govt.

securities are eligible for Repo.RBI Repos: Its repos auctions are conducted on all working days except

saturdays and are restricted to banks and Primary dealers (PDs). Types of auctions: • Discretionary price Repo auction: Multiple price bids with

volume. (till 1997)• Fixed rate Repo/uniform price auctions: Price are pre-

announced and bids are submitted with volume.

Fiscal policy• Governments use fiscal policy to influence the level of aggregate

demand in the economy, in an effort to achieve economic objectives of price stability, full employment, Income distribution, capital formation and economic growth.

• It is a part of govt. policy which is concerned with raising revenue through taxation and deciding on the level and pattern of expenditure.

• It operates through budget.– Union budget– State budget

Fiscal policy• The three possible stances of fiscal policy are neutral,

expansionary and contractionary. – A neutral stance of fiscal policy implies a balanced

economy. This results in a large tax revenue. Government spending is fully funded by Tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

– An expansionary stance of fiscal policy involves government spending exceeding Tax revenue.

– A contractionary fiscal policy occurs when government spending is lower than Tax revenue.

Fiscal policy• Pros

– Highly acceptable for developing countries– Emphasis on overall economic growth– Takes care of Revenue & Expenditure– Helps in Planning– Easy to target specific sector– For the Social Welfare

• Cons– Subject to time lags– Subject to corruption

Effects on Economy

• Government spending• Taxation

Foreign Exchange Market

• As per the, Foreign Exchange Management Act, 1999 or FEMA, foreign exchange means foreign currency and it includes:

1. All deposits, credits and balances payables in any foreign currency, and any drafts, Traveller’s cheques, Letter of credit and Bills of exchange expressed or drawn in Indian currency but payable in foreign currency.

2. Any instrument payable at the option of the drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other.

The market in which national monetary units or claims are exchanged for the foreign monetary units is known as the foreign exchange.

Foreign Exchange Market

• The foreign exchange market India is regulated by the RBI through the Exchange Control Department.

• The Authorized Dealers (Authorized by the RBI) and the accredited brokers are eligible to participate in the foreign Exchange market in India. These authorized dealers have formed an organization called Foreign Exchange Dealers Association of India (FEDAI).

• The main center of foreign exchange transactions in India is Mumbai. There are several other centers for foreign exchange transactions in the country including Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin.

• Apart from the Authorized Dealers and brokers, there are some others who are provided with the restricted rights to accept the foreign currency or travelers cheque. Among these, there are the authorized money changers, travel agents and certain hotels.

For-Ex Market

Retail Banks and money

changers

Wholesale

Inter-Bank accountBank a/c or deposits Central Bank

Direct Indirect(Through brokers)

Spot Forward (outrights & swaps)

Derivatives F&O

Foreign Exchange Market

• Retail market: It involves the exchange of bank notes, bank drafts, currency, ordinary and traveller’s cheques between private customers, tourists and banks.

• The RBI has granted two types of money changers licences. • Full-fledged money changers (Purchase and Sale transactions

with the public), • Restricted money changers (Purchase of Foreign currency

from tourists)• Wholesale market: It is primarily an inter-bank market in

which major bank trade in currencies held in different currency-denominated bank accounts

Management of Commercial Banks in India

BANKING INDUSTRY IN INDIA, CONSTITUENTS,

●The capital market size has expanded substantially since financial liberalization, the Indian financial system is dominated by financial intermediaries.

●The bank market structure in India can be classified into (a)Commercial banks, (b)Financial institutions, (c)NBFCs and (d)Co-operative credit institutions.

●The commercial bank holds the major share of the total assets of the financial intermediaries.

BANKING INDUSTRY IN INDIA, CONSTITUENTS

●Commercial Banks●Public Sector Banks●Private Sector Banks●Foreign Banks●Regional Rural Banks

Scheduled Commercial Banks (SCBs)

● As at end-March, 2016, there were 71 SCBs were operational in India. SCBs in India are categorized into the five groups based on their ownership and/or their nature of operations.

● Nationalised banks (19), SBI and associates (5), IDBI and Bharatiya Mahila bank together form the public sector banks (27) and control around 70% of the total credit and deposits businesses in India.

● Private banks are 20 out of which 13 are categorised as old private sector bank and 7 are categorised as new private banks.

● Foreign banks are present in the country either through complete branch/subsidiary route presence or through their representative offices.

● At end-June 2009, 32 foreign banks were operating in India with 293 branches.

PUBLIC SECTOR BANKS●At the end of 2009, there were 27 public sector banks in India, comprising of SBI and its associate banks and 20 nationalized banks (including IDBI).

●The public sector bank are regulated by statues of parliament and some important provisions under section 51 of banking Regulation Act, 1949.●SBI regulated by SBI act, 1955.●Subsidiary banks of SBI regulated by SBI (subsidiary Banks) Act, 1959.●Nationalized banks regulated by Banking companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980.

List of Public Sector Banks

There are 19 nationalized banks in India as follows: Allahabad Bank, Andhra Bank, Bank of Baroda, Bank of India, Bank of Maharashtra, Canara Bank, Central Bank of India, Corporation Bank, Dena Bank, Indian Bank, Indian Overseas Bank, Oriental Bank of Commerce, Punjab & Sind Bank, Punjab National Bank, Syndicate Bank, UCO Bank, Union Bank of India, United Bank of India, Vijaya Bank

PRIVATE SECTOR BANKS●In private sector banks, most of the capital is in private hands. There are two types of private sector banks in India viz. Old Private Sector Banks and New Private Sector Banks. ●There are 13 old private sector banks. There are 7 new private sector banks.

PRIVATE SECTOR BANKSOld private banks• Catholic Syrian Bank• City Union Bank • Dhanlaxmi Bank • Federal Bank • ING Vysya Bank • Jammu and Kashmir Bank • Karnataka Bank • Karur Vysya Bank • Lakshmi Vilas Bank • Nainital Bank • Ratnakar Bank • South Indian Bank • Tamilnad Mercantile Bank

New private banks• Axis Bank • Development Credit Bank (DCB

Bank Ltd) • HDFC Bank • ICICI Bank • IndusInd Bank • Kotak Mahindra Bank • Yes Bank

FOREIGN BANKS●As of December 2014, there are 43 foreign banks from 26 countries operating as branches in India and 46 banks from 22 countries operating as representative offices in India.

●Most of the foreign banks in India are niche players. RBI policy towards presence of foreign banks in India is based upon two cardinal principles viz. reciprocity and single mode of presence.

Abu Dhabi Commercial Bank Limited

American Express Banking Corporation

Antwerp Diamond Bank N.V.

Arab Bangladesh Bank Limited.

Bank Internasional Indonesia

Bank of America NA

Bank of Bahrain and Kuwait B.S.C.

Bank of Ceylon

Barclays Bank PLC

BNP Paribas

Chinatrust Commercial Bank

Citibank N.A..Credit Agricole Corporate & Investment Bank

Deutsche Bank AG

JPMorgan Chase Bank

JSC VTB BankKrung Thai Bank Public Company Limited

Mashreqbank psc

MIZUHO Corporate Bank Ltd.

Oman International Bank S.A.O.G.

Shinhan Bank

Societe Generale

Sonali Bank

Standard Chartered Bank

State Bank of Mauritius Ltd.

The Bank of Nova Scotia

The Bank of Tokyo-Mitsubishi UFJ Ltd.

The Development Bank of Singapore Ltd.The Hongkong and Shanghai Banking Corporation Ltd.

The Royal Bank of Scotland NV

UBS AG

FirstRand Bank Ltd.

Commonwealth Bank of Australia

United Overseas Bank Ltd.

REGIONAL RURAL BANKS●Regional Rural Banks were started in 1970s due to the fact that even after nationalization, there were cultural issues which made it difficult for commercial banks, even under government ownership, to lend to farmers.

●Each RRB is owned by three entities with their respective shares as follows: ●Central Government → 50% ●State government → 15% ●Sponsor bank → 35% ●They are regulated by NABARD.

Evolution of the Indian Banking Industry

● The Indian banking industry has its foundations in the 18th century, and has had a

varied evolutionary experience since then. The initial banks in India were primarily

traders’ banks engaged only in financing activities.

● The Bank of Calcutta (a precursor to the present State Bank of India) was founded on June 2,

1806, mainly to fund General Wellesley's wars against Tipu Sultan and the Marathas. It was

renamed Bank of Bengal on January 2, 1809.

● The Bank of Calcutta, and two other Presidency banks, namely, the Bank of Bombay and

the Bank of Madras were amalgamated and the reorganized banking entity was named the

Imperial Bank of India on 27 January 1921.

● Major strides towards public ownership and accountability were made with

nationalization in 1969 and 1980 which transformed the face of banking in India. .

Evolution of the Indian Banking Industry

● In the evolution of this strategic industry spanning over two centuries, immense developments have been made in terms of the regulations governing it, the ownership structure, products and services offered and the technology deployed.

● The entire evolution can be classified into four distinct phases.● Phase I- Pre-Nationalisation Phase (prior to 1955) ● Phase II- Era of Nationalisation and Consolidation (1955-1990) ● Phase III- Introduction of Indian Financial & Banking Sector Reforms

and Partial Liberalisation (1990-2004) ● Phase IV- Period of Increased Liberalisation (2004 onwards)

Lending and Borrowings of Banks

Capital & LiabilitesCommercial bank uses various categories of sources to

raise the funds. The major source of commercial bank funds are

summarized as follows: Capital- Primary and Secondary capital

1. Paid-up capital 2. Reserve fund

Deposit1. Current deposit 2. Saving deposit 3. Fixed deposit

Capital & Liabilites

Borrowings1. From central bank 2. From interbank market:

i) Interbank deposit ii) Call money market iii) Repurchase agreement

3. From international financial institution

CapitalThe bank capital represents the net worth of the bank

or its value to investors.

A bank's capital can be thought of as the margin to which creditors are covered if a bank liquidates its assets.

Loan-loss reserves or loan-loss provisions are amounts set aside by banks to allow for any loss in the value of the loans they have offered.

Capital can be classified as-1.Primary capital: Primary capital result from issuing

common or preferred stock.

2. Secondary capital : Secondary capital results from issuing subordinated notes and bonds

Deposits

• Deposits from public represent by far the most powerful source of fund to a bank, accounting for over 90% of the total.

• These deposits are key to a bank‟s potential growth.– Current Deposits– Fixed Deposits– Recurring Deposits– Saving Deposits

Borrowings

• The Central Bank will provide liquidity to the banks and other institutions when sour aces dry up.

• They may grant accommodation to scheduled banks by way of- i) Rediscounting or purchase of eligible bills; and ii) Loans and advances against certain securities

Borrowings

• Borrowing from interbank • The interbank lending market is a market in

which banks extend loans to one another for a specified.

• Such loans are made at the interbank rate (also called the overnight rate if the term of the loan is overnight). – 1. Interbank deposit sources – 2. Interbank call money – 3. Repurchase agreement

Management of funds

WHY REGULATE BANK CAPITAL?

●Two typical justifications●The risk of systematic risk.●The inability of depositors to monitor the banks.

●The liquidity will have to primarily come from the periodic liquidation of assets. But, if the assets start losing value the bank would have to turn to its capital to keep its liability commitments.

●If the capital is not augmented with fresh infusion of funds, the bank would run out of cash and face the most serious risk of all - liquidity and hence solvency risk.

WHY REGULATE BANK CAPITAL?●Conceptually, greater the (bank’s) capital funds, the greater the amount of assets that can default before the bank becomes insolvent and lower the bank’s risk.

●Thus, regulating the amount of capital that a bank should hold, though seen to constrain growth to some extent, is aimed at reducing the risks of banks expanding their ability of taking undue risks.

WHY REGULATE BANK CAPITAL?●The banking regulation ensures that depositors are given enough assurance that they will be paid in future.

●There are 3 ways to provide assurance●Adequate bank equity●Deposit insurance●Lender of last resort

●Basically, the Regulatory and Economic capital are concerned with bank’s financial strength.

CAPITAL CONCEPTS

●Regulatory capital depends on the confidence level set by the regulator.

●Economic capital can be defined as the amount of capital considered necessary by banks to absorb potential losses associated with banking risk such as – credit, market, operational and other risks.

RISK-BASED CAPITAL STANDARDS

●In early 1980s, concern about international bank’s financial health increased. It was then BCBS began thinking in terms of setting capital standards for banks.

●The international convergence of bank capital regulation began with 1988 Basel Accord I on capital standards.

●The accord was adopted as a world standard in 1990s with more than 100 countries applying the Basel framework to their banking system.

RISK-BASED CAPITAL STANDARDS

●The revised framework (Basel Accord II) issued in June 2006, included a spectrum of approaches ranging from simple to advanced from the measurement of risks,:

●Credit risks,●Market risks,●Operational risks.

CAPITAL ADEQUACY TO BANKS IN INDIA

●The Basel framework was adopted by the RBI in 1992, prescribing a higher norm of 9% on risk weighted assets for all banks.

●In accordance with the Basel II norms, the RBI required that the commercial banks in India adopt the

●Standardized approach for Credit risk●Standard approach for Market risk, and●Basic indicator approach for Operational risk

CAPITAL ADEQUACY REQUIREMENT

●In step with BIS norms and in consonance with international practice, RBI prescribed new capital norms for banking institutions in April 1992.

●BIS standards specify capital into tiers, Tier I capital and Tier II capital.

●Tier I otherwise known as ‘core capital’, consists of the most permanent and readily available resources to a bank in the event of unexpected losses.

CAPITAL ADEQUACY REQUIREMENT

●According to the norms by RBI,●Tier I capital consists:

●Paid up capital●Statutory reserves●Other free reserve, if any.

●From Tier-I capital, items such investment in subsidiaries, intangible assets and losses are deducted.

CAPITAL ADEQUACY REQUIREMENT

●Tier II capital consists:●Undisclosed reserves and cumulative. preferential debentures.●Revaluation reserves.●General provision and loss reserves.●Hybrid debt capital instruments.●Subordinated debts.●Investment fluctuation reserve, consisting of realized gains from sale of investment.

CAPITAL FUNDS OF BANKS OPERATING IN INDIA

●RBI requires banks in India to maintain at minimum, Capital to Risk-weighted Assets Ratio (CRAR) of 9%.

●Though the CRAR of 9% will have to be held continuously by banks, RBI also expects banks to operate at a capital level well above the minimum requirement.

●Within the overall minimum CRAR of 9%, banks should also maintain a Tier I CRAR of at least 6%, computed as,

Eligible Tier I capital fundsCredit RWA + Market RWA + operational risk RWA

CREDIT APPRAISAL PROCESS

Credit appraisal• Credit appraisal means an investigation or assessment

done by the bank prior before providing any loans & advances/project finance.

• The bank checks the 1. Commercial viability, 2. Financial viability3. Technical viability of the project 4. Proposed funding pattern 5. Collateral security

• Credit Appraisal is a process to ascertain the risks associated with the extension of the credit facility.

BASIC TYPES OF CREDIT1. Service credit: It is monthly payments for utilities such as

telephone, gas, electricity, and water. You often have to pay a deposit, and you may pay a late charge if your payment is not on time.

2. Installment credit: It may be described as buying on time, financing through the store or the easy payment plan. Cars, major appliances, and furniture are often purchased this way. You usually sign a contract, make a down payment, and agree to pay the balance with a specified number of equal payments called instalments. The item you purchase may be used as security for the loan.

BASIC TYPES OF CREDIT3. Loans: Loans can be for small or large amounts

and for a few days or several years. Money can be repaid in one lump sum or in several regular payments until the amount you borrowed and the finance charges are paid in full.

4. Credit cards: These are issued by individual retail stores, banks, or businesses. Using a credit card can be the equivalent of an interest-free loan--if you pay for the use of it in full at the end of each month.

CREDIT APPRAISAL PROCESSReceipt of application from applicant

|Receipt of documents

(Balance sheet, KYC papers, Different govt. registration no., MOA, AOA, and Properties

documents)|

Pre-sanction visit by bank officers|

Check for RBI defaulters list, willful defaulters list, CIBIL data, ECGC caution list, etc.

CREDIT APPRAISAL PROCESSTitle clearance reports of the properties to be obtained from empanelled

advocates|

Valuation reports of the properties to be obtained from empanelled valuer/engineers

|Preparation of financial data

|Proposal preparation

|Assessment of proposal

|

CREDIT APPRAISAL PROCESSSanction/approval of proposal by appropriate

sanctioning authority|

Documentations, agreements, mortgages|

Disbursement of loan|

Post sanction activities such as receiving stock statements, review of accounts, renew of

accounts, etc(On regular basis)

CREDIT RISK ASSESSMENTRISK: Risk is inability or unwillingness of borrower-customer or counter-party

to meet theirrepayment obligations/ honor their commitments, as per the stipulated

terms.LENDER’ TASK• Identify the risk factors, and• Mitigate the riskRISK ARISE IN CREDIT: In the business world, Risk arises out of• Deficiencies / lapses on the part of the management (Internal factor)• Uncertainties in the business environment (External factor)• Uncertainties in the industrial environment (External factor)• Weakness in the financial position (Internal factor)

CREDIT RISK ASSESSMENT

TO PUT IN ANOTHER WAY, SUCCESS FACTORS BEHIND A BUSINESS ARE

• Managerial ability• Favorable business environment• Favorable industrial environment• Adequate financial strength

CREDIT RISK ASSESSMENT (CRA) – MINIMUM SCORES / HURDLE RATES

1. The CRA models adopted by the Bank take into account all possible factors which go into appraising the risks associated with a loan. These have been categorized broadly into financial, business, industrial & management risks and are rated separately. To arrive at the overall risk rating, the factors duly weighted are aggregated & calibrated to arrive at a single point indicator of risk associated with the credit decision.

2. FINANCIAL PARAMETERS: The assessment of financial risk involves appraisal of the financial strength of the borrower based on performance & financial indicators. The overall financial risk is assessed in terms of static ratios, future prospects & risk mitigation (collateral security / financial standing).

3. INDUSTRY PARAMETERS: The following characteristics of an industry which pose varying degrees of risk are built into Bank’s CRA model:

• Competition• Industry outlook• Regulatory risk• Contemporary issues like WTO etc.

CREDIT RISK ASSESSMENT (CRA) – MINIMUM SCORES / HURDLE RATES

4. MANAGEMENT PARAMETERS: The management of an enterprise / group is rated on the following parameters:

• Integrity (corporate governance)• Track recordManagerial competence / commitment• Expertise• Structure & systems• Experience in the industry• Credibility: ability to meet sales projections• Credibility: ability to meet profit (PAT) projections• Payment record• Strategic initiatives• Length of relationship with the Bank

Asset Liability Management in Banks

Components of a Bank Balance Sheet

Banks profit and loss account

A bank’s profit & Loss Account has the following components:

I.Income: This includes Interest Income and Other Income.II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

Evolution• In the 1940s and the 1950s, there was an abundance of funds in banks in

the form of demand and savings deposits. Hence, the focus then was mainly on asset management

• But as the availability of low cost funds started to decline, liability management became the focus of bank management efforts

• In the 1980s, volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. ALM began to extend beyond the bank treasury to cover the loan and deposit functions

• Banks started to concentrate more on the management of both sides of the balance sheet

What is Asset Liability Management??

• The process by which an institution manages its balance sheet in order to allow for alternative interest rate and liquidity scenarios

• Banks and other financial institutions provide services which expose them to various kinds of risks like credit risk, interest risk, and liquidity risk

• Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management.

An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio

The parameters for stabilizing ALM system are:1. Net Interest Income (NII)2. Net Interest Margin (NIM)3. Economic Value of Equity Ratio

3 tools used by banks for ALM

ALM Information Systems Usage of Real Time information system to gather the

information about the maturity and behavior of loans and advances made by all other branches of a bank

ABC Approach : Analysing the behaviour of asset and liability products in the top

branches as they account for significant business Then making rational assumptions about the way in

which assets and liabilities would behave in other branches

The data and assumptions can then be refined over time as the bank management gain experience

The spread of computerisation will also help banks in accessing data.

ALM Organization The board should have overall responsibilities and should set the limit

for liquidity, interest rate, foreign exchange and equity price risk

The Asset - Liability Committee (ALCO) ALCO, consisting of the bank's senior management (including

CEO) should be responsible for ensuring adherence to the limits set by the Board

Is responsible for balance sheet planning from risk - return perspective including the strategic management of interest rate and liquidity risks

The role of ALCO includes product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities,

It should review the results of and progress in implementation of the decisions made in the previous meeting.

ALM Process

Categories of Risk• Risk is the chance or probability of loss or

damageCredit Risk Market Risk Operational Risk

Transaction Risk /default risk /counterparty risk

Commodity risk Process risk

Portfolio risk /Concentration risk

Interest Rate risk Infrastructure risk

Settlement risk Forex rate risk Model risk

Equity price risk Human risk

Liquidity risk

But under ALM risks that are typically managed are….

Liquidity Risk• Liquidity risk arises from funding of long term assets by short term

liabilities, thus making the liabilities subject to refinancing

Liquidity Risk Management Bank’s liquidity management is the process of generating funds to

meet contractual or relationship obligations at reasonable prices at all times

Liquidity Management is the ability of bank to ensure that its liabilities are met as they become due

Liquidity positions of bank should be measured on an ongoing basis

A standard tool for measuring and managing net funding requirements, is the use of maturity ladder and calculation of cumulative surplus or deficit of funds as selected maturity dates is adopted

Statement of Structural LiquidityAll Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:i. 1 to 14 daysii. 15 to 28 daysiii. 29 days and up to 3 monthsiv. Over 3 months and up to 6 monthsv. Over 6 months and up to 1 yearvi. Over 1 year and up to 3 yearsvii. Over 3 years and up to 5 yearsviii. Over 5 years

Statement of structural liquidity Places all cash inflows and outflows in the maturity ladder as

per residual maturity

Maturing Liability: cash outflow Maturing Assets : Cash Inflow

Classified in to 8 time buckets

Mismatches in the first two buckets not to exceed 20% of outflows Shows the structure as of a particular date

Banks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement

1-14Days15-28 Days

30 Days-3 Month

3 Mths - 6 Mths

6 Mths - 1Year

1Year - 3 Years

3 Years - 5 Years

Over 5 Years Total

Capital 200 200Liab-fixed Int 300 200 200 600 600 300 200 200 2600Liab-floating Int 350 400 350 450 500 450 450 450 3400Others 50 50 0 200 300Total outflow 700 650 550 1050 1100 750 650 1050 6500Investments 200 150 250 250 300 100 350 900 2500Loans-fixed Int 50 50 0 100 150 50 100 100 600Loans - floating 200 150 200 150 150 150 50 50 1100Loans BPLR Linked 100 150 200 500 350 500 100 100 2000Others 50 50 0 0 0 0 0 200 300Total Inflow 600 550 650 1000 950 800 600 1350 6500Gap -100 -100 100 -50 -150 50 -50 300 0Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0Gap % to Total Outflow-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57

Addressing the mismatches

• Mismatches can be positive or negative

• Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.

• 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.

Currency Risk• The increased capital flows from different nations following

deregulation have contributed to increase in the volume of transactions

• Dealing in different currencies brings opportunities as well as risk

• To prevent this banks have been setting up overnight limits and undertaking active day time trading

• Value at Risk approach to be used to measure the risk associated with forward exposures.

• Value at Risk estimates probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.

Interest Rate Risk

Interest Rate risk is the exposure of a bank’s financial conditions to adverse movements of interest rates

Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base

Changes in interest rates also affect the underlying value of the bank’s assets, liabilities and off-balance-sheet item

• Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM)

• NIM = (Interest income – Interest expense) / Earning assets

Sources of Interest Rate Risk

• Re-pricing Risk: The assets and liabilities could re-price at different dates and might be of different time period. For example, a loan on the asset side could re-price at three-monthly intervals whereas the deposit could be at a fixed interest rate or a variable rate, but re-pricing half-yearly

• Basis Risk: The assets could be based on LIBOR rates whereas the liabilities could be based on Treasury rates or a Swap market rate

• Yield Curve Risk: The changes are not always parallel but it could be a twist around a particular tenor and thereby affecting different maturities differently

• Option Risk: Exercise of options impacts the financial institutions by giving rise to premature release of funds that have to be deployed in unfavourable market conditions and loss of profit on account of foreclosure of loans that earned a good spread.

Risk Measurement TechniquesVarious techniques for measuring exposure of

banks to interest rate risks

• Maturity Gap Analysis• Duration• Simulation• Value at Risk

Maturity gap method (IRS)THREE OPTIONS:• A) Rate Sensitive Assets>Rate Sensitive

Liabilities= Positive Gap• B) Rate Sensitive Assets<Rate Sensitive Liabilities

= Negative Gap• C) Rate Sensitive Assets=Rate Sensitive Liabilities

= Zero Gap

Gap Analysis

Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates

- If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII

- conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII

The basic weakness with this model is that this method takes into account only the book value of assets and liabilities and hence ignores their market value.

Duration Analysis It basically refers to the average life of the asset or the liability

It is the weighted average time to maturity of all the preset values of cash flows

The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates

As per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero.

SimulationBasically simulation models utilize computer power to

provide what if scenarios, for example: What if:

The absolute level of interest rates shift Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad debt and prepayment levels change in different interest

rate scenarios There are changes in the funding mix e.g.: an increasing

reliance on short-term funds for balance sheet growth

This dynamic capability adds value to this method and improves the quality of information available to the management

Value at Risk (VaR) Refers to the maximum expected loss that a bank can suffer in

market value or income: Over a given time horizon, Under normal market conditions, At a given level or certainty

It enables the calculation of market risk of a portfolio for which no historical data exists. VaR serves as Information Reporting to stakeholders

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

Management of NPAs

Non Performing Assets

NPA

●An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. A ‘non-performing asset’ (NPA) was defined as a credit facility in respect of which the interest and/ or instalment of principal has remained ‘past due’ for a specified period of time. ●The specified period was reduced in a phased manner as under:Year ending March 31 Specified period1993 four quarters1994 three quarters1995 onwards two quarters

NPAs categorizes

Depending upon the record of repayment of borrowers, Banks assets or Loans are categorized into:

● Standard assets● Sub-standard assets● Doubtful assets● Loss assets

Assets categorizes

Sub-standard assets:

A sub-standard asset was one, which was classified as NPA for a period not exceeding two years. With effect from 31 March 2001, a sub-standard asset is one, which has remained NPA for a period less than or equal to 18 months.

In such cases, the current net worth of the borrower/ guarantor or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full.

Doubtful asset

● A doubtful asset was one, which remained NPA for a period exceeding two years.

● With effect from 31 March 2001, an asset is to be classified as doubtful, if it has remained NPA for a period exceeding 18 months.

● A loan classified as doubtful has all the weaknesses inherent in assets that were classified as sub-standard, with the added characteristic that the weaknesses make collection or liquidation in full, – on the basis of currently known facts, conditions and values – highly questionable and improbable.

Loss asset

● A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly.

● In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.

Preventing occurrence of New NPA

●Following measures prove useful in this regard:● Very careful selection of new borrowers based on their credit

worthiness and risk analysis.● Post sanction follow-up must be done at all levels.● All big borrowal accounts (Rs.50 Lacs) falling in the category of

‘Standard Assets’ must be reviewed on a quarterly basis and prompt action taken if any adverse feature is noted.

● Those borrowal accounts at lower-end the category of ‘Standard Assets’ deserve special attention for pro-active steps should be taken, if they show any sign of weakness.

Action points in regard to existing NPAs●The top-end list of ‘Sub-standard Assets’ has to be upgraded and make them ‘Standard Assets’ by recovering the derecognized interest of last years and current year.●All the securities charged to bank should be ‘revalued’ on a realistic basis and provision should be made strict.●In case the unsuccessful recovery, the bank has to resort legal action by going to Debt Recovery Tribunals. For a smaller loans banks may approach Lok Adalats.

Management tools

●The tools available are: ● Recovery Camps, ● Lok Adalats, ● Debt Recovery Tribunals (DRTs), ● Corporate Debt Restructuring (CDR), and● Securitization and Reconstruction of Financial

Assets through Securitization and Asset Reconstruction Companies (SCs/ ARCs).

Debt Recovery Tribunals

●The Debts Recovery Tribunals have been established by the Government of India under an Act of Parliament (Act 51 of 1993). ●The Recovery of debts due to Banks and Financial Institutions Ordinance, 1993 on 24th June 1993, the Ordinance was replaced by The Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (DRT Act) on 27th August 1993. ●Immediately Action was initiated by the Government for establishment of Recovery Tribunals and Appellate Tribunals in the country.  ●Presently, there are 29 DRTs functioning all over the country.  

Securitization

●A securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued.●This financial tool is used by financial institutions and businesses to immediately realize the value of cash-producing assets like loans, or leases or trade receivables.

Mechanism

Special Purpose Vehicle

Ancillary service provider

Obligor

Originator

Structurer/ Investment

banker

Rating Agency

Investors

Consideration forAssets purchased

Sale of assets

Issue of securities

Subscription of securities

Ori

gina

l lo

an

Interest &

principal

2. The SPV is formed with

the support of the investment banker or servicer, CRA,

other advisors

1. Originating Bank

selects the feasible

pool of assets of

securitization

3. Transaction structure

and credit enhancement

finalized

4. Assets to be securitized are

assigned to SPV, after legal

compliances.

5. The CFs to the assets- interest, principal

repayments etc-are collected by originating

bank on due dates.these amounts are paid to

SPV.

6. The SPV transmit

the collected CFsto the investors

for payment at designated

periods.

7. If defaults happens,

Originating banktakes the loss or initiates action

against the defaultersaccording to terms.

8. Finally, profit made

Is retained by theOriginator, and

The loss is Written off

or paid

Process of Securitization

Bancassurance

Banks which were meant for deposits, loans and transactions, are allowed to provide

insurance policies to people and this feature of bank is called ‘bancassurance’.

Bancassurance • As per the investigation made by Graham Morris the

opening of insurance industry to private sector participation in December1990 has led to the entry of 20 new players, with 12 in life Insurance Sector & 8 in the non-life insurance sector.

• Almost without exception these companies are seeking to utilize multiple distribution channels such as –

1) Traditional Agencies2) Bancassurance 3) Brokers & 4) Direct Marketing

Definition• The Bancassurance is the distribution of insurance products

through the bank's distribution channels.

• It is a phenomenon where in insurance products are offered through the distribution channels of the banking services.

• In the simple term of insurance there are only two parties.1) The Bank2) The Insurer &3) The customer.

Bancassurance

• The development of bancassurance in India began for following reasons:– To improve the channels through which insurance policies

are marketed.– To widen the area of working of banking sector having a

network that is spread widely.– To improve the services of insurance by creating a

competitive atmosphere among private insurance companies in the market.

Regulations

• In our country the banking & insurance sectors are regulated by two different entries.

• They are: - * Banking is fully governed by RBI & * Insurance sector is by IRDA

Guidelines given by RBI• 1. Any commercial bank will be allowed to undertake

insurance business as the agent of insurance companies & this will be on fee basis with no-risk participation.

• 2. The second guideline given by the RBI is that the joint ventures will be allowed for financial strong banks wishing to undertake insurance business with risk participation.

• 3. The third guideline is for banks which are not eligible for this joint venture option, an investment option of(1) up to 10% of the net worth of the bank or (2) Rs. 50 crores. Whichever is lower is available.

Guidelines given by IRDAThe Insurance regulatory development & Authority has given certain guidelines for the Bancassurance they are as follows: -

1) Chief Insurance Executive: Each bank that sells insurance must have a chief Insurance Executive to handle all the insurance matters & activities.

2) Mandatory Training: All the people involved in selling the insurance should under-go mandatory training at an institute determined by IRDA & pass the examination conducted by the authority.

3) Corporate agents: Commercial banks, including co-operative banks and RRBs may become corporate agents for one insurance company.

4) Banks cannot become insurance brokers.

Important Bancassurance tie-up in India

LIC: The insurance company LIC of India have tie up with the following bank for Bancassurance. (A) Corporation Bank(B) Indian Overseas Bank(C) Centurion Bank(D) Sahara District Central Co-operative bank(E) Janta Urban Co-operative bank(F) Yeotmal Mahila Sahakari Bank(G) Vijaya Bank & (H) Oriental Bank of Commerce

Important Bancassurance tie-up in India

• Birla Sun life Insurance Co. Ltd: The Birla Sun life Insurance Company has a tie-up with the following bank for the insurance purpose :-

• (a) Bank of Rajasthan(b) Andhra Bank(c) Bank of Muscat(d) Development Credit Bank(e) Dutch Bank & (f) Catholic Syrian Bank

Benefits of Bancassurance• It encourages customers of banks to purchase insurance policies and

further helps in building better relationship with the bank.

• The people who are unaware of and/or are not in reach of insurance policies can be benefitted through widely distributed banking networks and better marketing channels of banks.

• Increase in number of providers means increase in competition and hence people can expect better premium rates and better services from bancassurance as compared to traditional insurance companies.

Demerits of bancassurance• Data management of an individual customer’s identity and

contact details may result in the insurance company utilizing the details to market their products, thus compromising on data security.

• There is a possibility of conflict of interest between the other products of bank and insurance policies (like money back policy). This could confuse the customer regarding where he has to invest.