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Management of Financial Institution

Module III : Norms & Practices in the Banking Industry

I. Principles of Lending
1. Liquidity:
Liquidity is an important principle of bank lending. Bank lend for short periods only
because they lend public money which can be withdrawn at any time by depositors.
They, therefore, advance loans on the security of such assets which are easily
marketable and convertible into cash at a short notice .A bank chooses such securities in
its investment portfolio which possess sufficient liquidity. It is essential because if the
bank needs cash to meet the urgent requirements of its customers, it should be in a
position to sell some of the securities at a very short notice without disturbing their
market prices much. There are certain securities such as central, state and local
government bonds which are easily saleable without affecting their market prices. The
shares and debentures of large industrial concerns also fall in this category. But the
shares and debentures of ordinary firms are not easily marketable without bringing
down their market prices. So the banks should make investments in government
securities and shares and debentures of reputed industrial houses.

2. Safety:
The safety of funds lent is another principle of lending. Safety means that the borrower
should be able to repay the loan and interest in time at regular intervals without default.
The repayment of the loan depends upon the nature of security, the character of the
borrower, his capacity to repay and his financial standing. Like other investments, bank
investments involve risk. But the degree of risk varies with the type of security.
Securities of the central government are safer than those of the state governments and
local bodies. And the securities of state government and local bodies are safer than
those of the industrial concerns. This is because the resources of the central government
are much higher than the state and local governments and of the latter higher than the
industrial concerns. In fact, the share and debentures of industrial concerns are tied to
their earnings which may fluctuate with the business activity in the country. The bank
should also take into consideration the debt repaying ability of the governments while
investing in their securities. Political stability and peace and security are the
prerequisites for this. It is very safe to invest in the securities of a government having
large tax revenue and high borrowing capacity.

3. Diversity:
In choosing its investment portfolio, a commercial bank should follow the principle of
diversity. It should not invest its surplus funds in a particular type of security but in
different types of securities. It should choose the shares and debentures of different
types of industries situated in different regions of the country. The same principle
should be followed in the case of state governments and local bodies. Diversification
aims at minimizing risk of the investment portfolio of a bank. principle of diversity also
applies to the advancing of loans to varied types of firms, industries, businesses and
trades. A bank should follow the maxim: Do not keep all eggs in one basket. It should
spread it risks by giving loans to various trades and industries in different parts of the
country.

4. Stability:
Another important principle of a banks investment policy should be to invest in those
stocks and securities which possess a high degree of stability in their prices. The bank
cannot afford any loss on the value of its securities. It should, therefore, invest it funds
in the shares of reputed companies where the possibility of decline in their prices is
remote. Government bonds and debentures of companies carry fixed rates of interest.
Their value changes with changes in the market rate of interest. But the bank is forced
to liquidate a portion of them to meet its requirements of cash in cash of financial crisis.
Otherwise, they run to their full term of 10 years or more and changes in the market rate
of interest do not affect them much. Thus bank investments in debentures and bonds are
more stable than in the shares of companies.
5. Profitability:
This is the cardinal principle for making investment by a bank. It must earn sufficient
profits. It should, therefore, invest in such securities which was sure a fair and This is
the cardinal principle for making investment by a bank. It must earn sufficient profits. It
should, therefore, invest in such securities which was sure a fair and stable return on the
funds invested. The earning capacity of securities and shares depends upon the interest
rate and the dividend rate and the tax benefits they carry. It is largely the government
securities of the centre, state and local bodies that largely carry the exemption of their
interest from taxes. The bank should invest more in such securities rather than in the
shares of new companies which also carry tax exemption. This is because shares of new
companies are not safe investments.

II. Study of Borrowers ( pending )

Todays consumer lending environment is highly complex, driven by ever increasing


customer demands, regulatory changes, and the digital revolution that is leading to a
host of new entrants. Successful lenders need to navigate each of these challenges and
recognize that a one-size-fits-all approach to customer experience is no longer
suitable. Instead, they should develop a set of principles which can be used to build a
successful customer strategy.

Online all the way. Unsurprisingly, the majority of consumers now prefer to apply for
loans online, especially young borrowers. Since we conducted a similar survey on the
mortgage industry just two years ago, the preference for online interactions has jumped
considerably (about 30%) among survey respondents.1 While some segments still
prefer human interactions for certain parts of the process, a viable digital process is now
a must-have for lenders wishing to compete across all consumer segments and
demographics.

Reaching younger borrowers: In addition to a stronger preference for a digital


application process, younger borrowers are less satisfied with their current application
experience than other consumer segments surveyed. With other industries now typically
providing a fast, intuitive, and seamless experience, lenders need to adapt quickly or be
prepared to lose share as this segment grows to become the largest in the market.

Keep things quick and simple: Other than economic factors (for example, interest
rates and closing costs) or having an existing relationship, borrowers believe the most
important factor in choosing a lender is the speed of the process. More sophisticated
features such as automated status updates and financial literacy tools are popular but
rank lower in importance.

Mobile apps could do better: While the majority of consumers are looking for a
digitized end-to-end loan process, the mobile apps currently available on the market are
simply not providing important features that consumers say they want on their mobile
devices when they are interested in a consumer loan such as the ability to lock in rate,
compare products, or calculate affordability of payments. This represents a major
opportunity for lenders to differentiate themselves by coming to market with a user-
friendly solution that truly addresses consumers top needs.

Compete on experience as well as interest rate: Not surprisingly, interest rates are
consistently the No. 1 consideration consumers look at when choosing a lender.
However, there are still opportunities to win customers with compelling experience
featuresspeed, transparency, channels, and customer serviceeven where you are not
offering the lowest rate.

Cross-selling works: For each asset class, having an existing relationship with a lender
was seen as a key referral source for the loan in at least one-in-five cases. While
traditional marketing and referral sources remain important, the cheapest way to
generate new business may be to target customers that you are already serving.

Target the influencers: Friends and family are consistently rated as an important
referral source for all asset classes, along with key gatekeepersauto dealers, student
loan representatives, and real estate agentswho are present at the point of sale.
Lenders strategies should focus on how to win over these key influencers or at least
keep them neutral. Our research suggests social media is not an important direct referral
source (influencer) in itself but rather an outlet for customers to vent about a negative
experience.

Financial management tools can add value: Around 30% of consumers said they
have never used financial management tools or financial advice services, primarily
because they dont need, trust, or have access to them. Many of the features that
consumers said would be the most valuable to them are also relatively simple to
implementsuch as online credit score services, payment reminder tools, and budget
trackers. In some cases, it seems that lenders could provide instant additional value to
their customers with relatively little expense.
III. Balance sheet Analysis
Assets, liability and equity are the three main components of the balance sheet.
Carefully analyzed, they can tell investors a lot about a company's fundamentals.

a) Assets
There are two main types of assets: current assets and non-current assets. Current assets
are likely to be used up or converted into cash within one business cycle - usually
treated as twelve months. Three very important current asset items found on the balance
sheet are: cash, inventories and accounts receivables. Investors normally are attracted to
companies with plenty of cash on their balance sheets. After all, cash offers protection
against tough times, and it also gives companies more options for future growth.
Growing cash reserves often signal strong company performance. Indeed, it shows that
cash is accumulating so quickly that management doesn't have time to figure out how to
make use of it. A dwindling cash pile could be a sign of trouble. That said, if loads of
cash are more or less a permanent feature of the company's balance sheet, investors
need to ask why the money is not being put to use. Cash could be there because
management has run out of investment opportunities or is too short-sighted to know
what to do with the money. Inventories are finished products that haven't yet sold. As an
investor, you want to know if a company has too much money tied up in its inventory.
Companies have limited funds available to invest in inventory. To generate the cash to
pay bills and return a profit, they must sell the merchandise they have purchased from
suppliers. Inventory turnover (cost of goods sold divided by average inventory)
measures how quickly the company is moving merchandise through the warehouse to
customers. If inventory grows faster than sales, it is almost always a sign of
deteriorating fundamentals. Receivables are outstanding (uncollected bills). Analyzing
the speed at which a company collects what it's owed can tell you a lot about its
financial efficiency. If a company's collection period is growing longer, it could mean
problems ahead. The company may be letting customers stretch their credit in order to
recognize greater top-line sales and that can spell trouble later on, especially if
customers face a cash crunch. Getting money right away is preferable to waiting for it -
since some of what is owed may never get paid. The quicker a company gets its
customers to make payments, the sooner it has cash to pay for salaries, merchandise,
equipment, loans, and best of all, dividends and growth opportunities. Non-current
assets are defined as anything not classified as a current asset. This includes items that
are fixed assets, such as property, plant and equipment (PP&E). Unless the company is
in financial distress and is liquidating assets, investors need not pay too much attention
to fixed assets. Since companies are often unable to sell their fixed assets within any
reasonable amount of time they are carried on the balance sheet at cost regardless of
their actual value. As a result, it's is possible for companies to grossly inflate this
number, leaving investors with questionable and hard-to-compare asset figures.

b) Liabilities
There are current liabilities and non-current liabilities. Current liabilities are obligations
the firm must pay within a year, such as payments owing to suppliers. Non-current
liabilities, meanwhile, represent what the company owes in a year or more time.
Typically, non-current liabilities represent bank and bondholder debt. You usually want
to see a manageable amount of debt. When debt levels are falling, that's a good sign.
Generally speaking, if a company has more assets than liabilities, then it is in decent
condition. By contrast, a company with a large amount of liabilities relative to assets
ought to be examined with more diligence. Having too much debt relative to cash flows
required to pay for interest and debt repayments is one way a company can go bankrupt.
Look at the quick ratio. Subtract inventory from current assets and then divide by
current liabilities. If the ratio is 1 or higher, it says that the company has enough cash
and liquid assets to cover its short-term debt obligations.

Quick Ratio =Current Assets - Inventories


Current Liabilities

c) Equity
Equity represents what shareholders own, so it is often called shareholder's equity. As
described above, equity is equal to total assets minus total liabilities.

Equity = Total Assets Total Liabilities

The two important equity items are paid-in capital and retained earnings. Paid-in capital
is the amount of money shareholders paid for their shares when the stock was first
offered to the public. It basically represents how much money the firm received when it
sold its shares. In other words, retained earnings are a tally of the money the company
has chosen to reinvest in the business rather than pay to shareholders. Investors should
look closely at how a company puts retained capital to use and how a company
generates a return on it.

IV. Project Appraisal Criteria ( pending )


V. Prudential Norms ( Narsimham Committee Recomendation )
The main recommendations of Narasimham Committee (1991) on the Financial
(Banking) System are as follows;

(i) Statutory Liquidity Ratio (SLR) is brought down in a phased manner to 25 percent
(the minimum prescribed under the law) over a period of about five years to give banks
more funds to carry business and to curtail easy and captive finance.
(ii) The RBI should reduce Cash Reserve Ratio (CRR) from its present high level.
(iii) Directed Credit Programme i.e., credit allocation under government direction, not
by commercial judgement of banks under a free market competitive system, should be
phased out. The priority sector should be scaled down from present high level of 40
percent of aggregate credit to 10 percent. Also the priority sector should be redefined.
(iv) Interest rates to be deregulated to reflect emerging market conditions.
(v) Banks whose operations have been profitable is given permission to raise fresh
capital from the public through the capital market.
vi) Balance sheets of banks and financial institutions are made more transparent.
(vii) Set up special tribunals to help banks recover their debt speedily.
(viii) Changes be introduced in the bank structure 3-4 large banks with international
character, 8- 10 national banks with branches throughout the country, local banks
confined to specific region of the country, rural banks confined to rural areas.
(ix) Greater emphasis is laid on internal audit and internal inspection in the banks.
(x) Government should indicate that there would be no further nationalization of banks,
the new banks in the private sector should be welcome subject to normal requirements of
the RBI, branch licensing should be abolished and policy towards foreign banks should
be more liberal.
(xi) Quality of control over the banking system by the RBI and the Banking Division or
the Ministry of Finance should be ended and the RBI should be made primary agency
for regulation of banking system.
(xii) A new financial institution called the Assets Reconstruction Fund (ARF). Should be
established which would take over from banks and financial institutions a portion of
their bad and doubtful debts at a discount (based on realisable value of assets), and
subsequently follow up on the recovery of the dues owed to them from the primary
borrowers.
Follow-up Action:
(i) Statutory Liquidity Ratio (SLR) on incremental Net Domestic and Time Liabilities
(NDTL) reduced from 38.5 percent in 1991-92 to 28 percent by December 1996.
(ii) Effective Cash Reserve Ratio (CRR) on the NDTL reduced from 14 percent to 10
percent in January 1997.
(iii) In April, 1992 the RBI introduced a risk assets ratio system for banks (including
foreign banks) in India as a capital adequacy measure. Under this banks will have to
achieve a Capital to Risk Weighted Asset ratio (CRAR) of 8 percent. By March, 1996
out of 27 public sector banks 19 banks (including SBI and all its subsidiaries) have
attained 8 percent CRAR norm. In case of foreign banks, all of them have already
attained these norms.
(iv) New prudential norms for income recognition, classification of assets and
provisioning of bad debts introduced in 1992.
(v) In regard to regulated interest ratio structure: (i) considerable rationalisation has been
effected in banks lending rates with the number of concessive slabs reduced and some of
the ratio have been raised thereby reducing the element of subsidy; (ii) regulated deposit
late has been replaced by single prescription of not exceeding 13 (revised to 11 percent)
per annum for all deposit maturities of 46 days and above.

(vi) The SBI and some other nationalised banks have been allowed to seek capital
market access.
(vii) Less strong nationalised banks are being recapitalised by government through
budget provisions of Rs. 15000 crore till 1994-95.
(viii) Existing private sector banks given signal for expansion, more private sector banks
allowed to set up branches provided they confirms to the RBI guidelines.
(ix) Supervision system of the RBI is being strengthened with establishment of new
board for Financial Bank Supervision within the RBI.
(x) Banks given freedom to open new branches and upgrade extension counters on
attaining capital adequacy norms and prudential accounting standards. They are
permitted to close non-viable branches other than in rural areas.

(xi) Rapid computerization of banks being undertaken.


(xii) Agreement signed between the public sector bank and RBI to improve their
managerial and quality of performance.
(xiii) Recovery of debts due to banks and the Financial Institution Act 1993 recently
passed to facilitate quicker recovery of loans and arrears. Accordingly 6 special Debt
Recovery Tribunals were set up along with an Appellate Tribunal at Mumbai to expedite
the recovery of bank loan arrears.
(xiv) Under the Banking Ombudsmen Scheme 1995. Eleven Ombudsmen already
functioning out of a total of 15 to expedite inexpensive resolution of customers
complaints.
(xv) Ten new private banks have started functioning out of the thirteen in principle
approvals given for setting up new banks in private sector.

VI . Performance Analysis of Banks ( pending )