BA7026 Banking Financial Services Management

Unit – II – Sources and Application of Bank Funds
Ms. A. Jebakerupa Roslin, Faculty, SJCE 2015 – 2016 MBA

BA7026 – Banking Financial Services Management Unit – II – Sources and Application of Bank Funds
TABLE OF CONTENTS
CAPITAL ADEQUACY 3
BASEL COMMITTEE ON BANKING SUPERVISION 3

THE NEED FOR MINIMUM CAPITAL REQUIREMENT 4
COMPONENTS OF CAPITAL 4
CAPITAL ADEQUACY RATIO (CAR) 5
CAPITAL ADEQUACY IN INDIA 5
DEPOSIT AND NON-DEPOSIT SOURCES 9
SOURCES OF DEPOSIT 10
NON-DEPOSITS SOURCES 10
DESIGNING OF DEPOSIT SCHEMES 12
RECURRING DEPOSIT SCHEME 12

REINVESTMENT DEPOSIT SCHEME 12
FIXED DEPOSIT SCHEMES 12
CASH CERTIFICATES 13
GUIDELINES FOR OPENING A DEPOSIT ACCOUNT 13
TYPES OF DEPOSIT ACCOUNTS 14

ACCOUNT OPENING AND OPERATION OF DEPOSIT ACCOUNTS 14
INTEREST PAYMENTS 17
PRICING OF DEPOSIT SERVICES 17
COST PLUS MARGIN DEPOSIT PRICING 18

CONDITIONAL PRICING 19
RELATIONSHIP PRICING 19
MARKET PENETRATION DEPOSIT PRICING 19

UPSCALE TARGET PRICING 20
APPLICATION OF BANK FUNDS 20
LENDING 20
INVESTMENTS 21
INVESTMENT AND LENDING FUNCTIONS 21
TYPES OF LOANS 23
MAJOR COMPONENTS OF A TYPICAL LOAN POLICY DOCUMENT 25
STEPS INVOLVED IN CREDIT ANALYSIS 26
STEP 1: BUILDING THE ‘CREDIT FILE’: 26

STEP 2: PROJECT AND FINANCIAL APPRAISAL: 27
STEP 3: QUALITATIVE ANALYSIS 27
STEP 4: DUE DILIGENCE: 27
STEP 5: RISK ASSESSMENT 27
STEP 6: MANAGING THE RECOMMENDATION 28
CREDIT DELIVERY AND ADMINISTRATION 28
LOAN PRICING 29
MODELS FOR LOAN PRICING: 29
CUSTOMER PROFITABILITY ANALYSIS 31
THE STEPS IN ANALYZING CUSTOMER PROFITABILITY ANALYSIS TYPICALLY AS FOLLOWS, 31

CAPITAL ADEQUACY
Banks encounter various types of risks while carrying the business of financial intermediation as it
is the highly leveraged sector of an economy. Risk and uncertainties, therefore, form an integral
part and parcel of banking. Thus, risk management is the core to any banking service and hence
the need for sufficient Capital Adequacy Ratio is felt. Regulation of capital assumes significant
importance so as to reduce bank failures, to promote stability, safety and soundness of the
banking system, to prevent systemic disaster and to ultimately reduce losses to the bank
depositors
Along with profitability and safety, banks also give importance to Solvency. Solvency refers to the
situation where assets are equal to or more than liabilities. A bank should select its assets in such
a way that the shareholders and depositors' interest are protected.
The basic approach of capital adequacy framework is that a bank should have
sufficient capital to provide a stable resource to absorb any losses arising from
the risks in its business.
The Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks
(including foreign banks) in India as a capital adequacy measure in line with the Capital Adequacy
Norms prescribed by Basel Committee.
BASEL COMMITTEE ON BANKING SUPERVISION

The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory
authorities which published the Basel Accords i.e., rules regarding capital requirements. BCBS is a
comprehensive set of reform measures to strengthen the regulation, supervision and risk
management of the banking sector. In 1988, BCBS introduced the capital measurement system
commonly referred to as Basel I. In 2004, BCBS published Basel II guidelines which were the refined,
reformed and more complex version of Basel I. While Basel I focus only on credit risk, Basel II
includes market and operational risks besides credit risks. Basel III released in December, 2010
which lay more focus on quality, consistency and transparency of the capital base.
India adopted Basel I guidelines in 1999 while Basel II guidelines were implemented in phases by
2009.The Basel III capital regulation has been implemented in India from April 1, 2013 in phases
and will be fully implemented as on March 31, 2018.
THE NEED FOR MINIMUM CAPITAL REQUIREMENT

The capital which banks hold with themselves as required by financial regulator is known as
minimum capital requirement. Banks exposed to various types of risks while granting loans and
advances to various sectors. In order to absorb any losses which banks face from its business, it is
imperative that banks should have sufficient capital. If banks have adequate capital, then it can
protect its depositors from unforeseen contingencies as well promotes the stability and efficiency
of financial systems.
COMPONENTS OF CAPITAL
Capital is divided into tiers according to the characteristics/qualities of each qualifying instrument.
For supervisory purposes capital is split into two categories: Tier I and Tier II. These categories
represent different instruments’ quality as capital. Tier I capital consists mainly of share capital and
disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover
losses. Tier II capital on the other hand consists of certain reserves and certain types of
subordinated debt. The loss absorption capacity of Tier II capital is lower than that of Tier I capital.
TIER I CAPITAL
Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital. It
is also termed as Core Capital. The elements of Tier I capital includes:
 Paid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves, if
any;
 Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I capital
- subject to laws in force from time to time;
 Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital; and
 Capital reserves representing surplus arising out of sale proceeds of assets.
TIER II CAPITAL
Capital which is second readily available to protect the unexpected losses is called as Tier-II Capital.
The elements of Tier II capital include undisclosed reserves, revaluation reserves, general provisions
and loss reserves, hybrid capital instruments, subordinated debt and investment reserve account.
TIER III CAPITAL

This is arranged to meet part of market risk, viz. changes in interest rate, exchange rate, equity
prices, commodity prices, etc. To quantify as Tier III capital, assets must be limited to 250% of a
bank’s Tier I capital, be unsecured subordinated and have a minimum maturity of 2 years.
CAPITAL ADEQUACY RATIO (CAR)

Capital adequacy ratio is the ratio which protects banks against excess leverage, insolvency and
keeps them out of difficulty. It is defined as the ratio of banks capital in relation to its current
liabilities and risk weighted assets. Risk weighted assets is a measure of amount of banks assets,
adjusted for risks. An appropriate level of capital adequacy ensures that the bank has sufficient
capital to expand its business, while at the same time its net worth is enough to absorb any
financial downturns without becoming insolvent. It is the ratio which determines banks capacity
to meet the time liabilities and other risks such as credit risk, market risk, operational risk etc. As
per RBI norms, Indian SCBs should have a CAR of 9% i.e., 1% more than stipulated Basel norms
while public sector banks are emphasized to keep this ratio at 12%. Capital adequacy ratio is
defined as:
Tier I + Tier II + Tier III capital (capital funds)

CAR =
Risk Weighted Assets (RWA)
CAPITAL ADEQUACY IN INDIA

The NARASIMHAM COMMITTEE endorsed the internationally accepted norms for capital
adequacy standards, developed by the BASEL COMMITTEE ON BANKING SUPERVISION (BCBS).
BCBS initiated Basel I norms in 1988, considered to be the first move towards risk-weighted capital
adequacy norms. In 1998, NC II framed Base II in order to overcome the limits of Base I which focus
only on credit risk and excluded the other forms of risk.
PILLAR 1- MINIMUM CAPITAL REQUIREMENTS

RBI requires banks in India to maintain at the minimum, a 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 requirements. Additionally, RBI would
assess individual banks’ risk profiles and risk management systems. As in the Basel framework II,
banks in India will maintain capital as Tier 1 and Tier 2. Banks are encouraged to maintain, at both
solo and consolidated level, a Tier 1 CRAR of at least 6 per cent. Banks which are below this level
must achieve this ratio on or before March 31, 2010. Capital funds are broadly classified as Tier I
and Tier II capital. A bank should compute its TIER 1 CRAR and TOTAL CRAR as follows,
Eligible tier 1 capital funds

Tier 1 CRAR=
Credit RWA + Market risk RWA + Operational risk RWA
RWA- RISK WEIGHTED ASSETS

Eligible total capital funds
Total CRAR=
Credit RWA + Market risk RWA + Operational risk RWA
TOTAL CAPITAL FUNDS = Tier I Capital + Tier II Capital

THE BANKS’ OVERALL MINIMUM CAPITAL REQUIREMENT WILL BE THE SUM OF:
 Capital requirement for credit risk on all credit exposures excluding items comprising trade
book and including counter party credit risk on all OTC derivatives on the basis of the risk
weights,
 Capital requirement for market risks in the trading book and
 Capital requirements of operational risks.
CAPITAL CHARGE FOR CREDIT RISK

Banks in India currently follows the ‘Standardized Approach’. Under this approach, ratings assigned
by external credit rating agencies will largely support the credit risk measurement. The
assets/credit facilities provided by the bank would be rated by the approved credit rating agency
and risk-weighting of the assets or claim will be based on the rating. Based on the credit ratings
and the mapping process, rating is applicable to exposures on
o Foreign Sovereigns
o Foreign Banks
o Domestic Public Sector Entities
o Foreign Public Sector Entities
o Domestic Primary Dealers
o Non-Resident Primary Dealers
o Domestic Corporate Exposures
o Non-Resident Corporate Exposures
DOMESTIC CREDIT RATING AGENCIES: a) Credit Analysis and Research Limited; b) CRISIL
limited; c) FITCH India; and d) ICRA Limited.
INTERNATIONAL CREDIT RATING AGENCIES: a) Fitch; b) Moodys; and c) Standard & Poor’s.
CAPITAL CHARGE OF MARKET RISK

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions
arising from movements in market prices. The market risk positions subject to capital charge
requirement are:
i) The risks pertaining to interest rate related instruments and equities in the trading book
ii) Foreign exchange risk (including open position in precious metals) throughout the bank
(both banking and trading books).
Banks are required to manage the market risks in their books on an ongoing basis and ensure that
the capital requirements for market risks are being maintained on a continuous basis, i.e. at the
close of each business day. Banks are also required to maintain strict risk management systems to
monitor and control intra-day exposures to market. These guidelines seek to address the issues
involved in computing capital charges for interest rate related instruments in the trading book,
equities in the trading book and foreign exchange risk (including gold and other precious metals)
in both trading and banking books.
Trading book for the purpose of capital adequacy will include:
i) Securities included under the Held for trading category

ii) Securities included under the Available for Sale category
iii) Open gold position limits
iv) Open foreign exchange position limits
v) Trading positions in derivatives, and
vi) Derivatives entered into for hedging trading book exposures.
CAPITAL CHARGE FOR OPERATIONAL RISK

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events. This definition includes legal risk, but excludes
strategic and reputational risk. Legal risk includes, but is not limited to, exposure to fines,
penalties, or punitive damages resulting from supervisory actions, as well as private settlements.
The New Capital Adequacy Framework outlines three methods for calculating operational risk
capital charges in a continuum of increasing sophistication and risk sensitivity:
(i) The Basic Indicator Approach (BIA);

(ii) The Standardised Approach (TSA); and
(iii) Advanced Measurement Approaches (AMA).
Banks are encouraged to move along the spectrum of available approaches as they develop more
sophisticated operational risk measurement systems and practices.
Banks are advised to compute capital charge for operational risk under the Basic Indicator
Approach as follows:
Average of [Gross Income * alpha] for each of the last three financial years, excluding years of
negative or zero gross income, where Alpha = 15 per cent
Gross income = Net profit (+) Provisions & contingencies (+) operating expenses (Schedule 16)
(-) items ‘(i)’ to ‘(vi)’ listed below
The items are,
i) Exclude reversal during the year in respect of provisions and write-offs made during the
previous year(s);
ii) Exclude income recognised from the disposal of items of movable and immovable property
iii) Exclude realised profits/losses from the sale of securities in the “held to maturity” category
iv) Exclude income from legal settlements in favour of the bank
v) Exclude other extraordinary or irregular items of income and expenditure
vi) Exclude income derived from insurance activities (i.e. income derived by writing insurance
policies) and insurance claims in favour of the bank.
PILLAR 2-SUPERVISORY REVIEW

Provides key principles for supervisory review, risk management guidance and supervisory
transparency and accountability.
PILLAR 3-MARKET DISCIPLINE

Encourages market discipline by developing a set of disclosure requirements that will allow market
participants to assess key pieces of information on risk exposure, risk assessment process and
capital adequacy of a bank.
DEPOSIT AND NON-DEPOSIT SOURCES

Bank deposits are made to deposit accounts at a banking institution, such as savings accounts,
checking accounts and money market accounts. The account holder has the right to withdraw any
deposited funds, as set forth in the terms and conditions of the account. The "deposit" itself is a
liability owed by the bank to the depositor (the person or entity that made the deposit), and refers
to this liability rather than to the actual funds that are deposited.
SOURCES OF DEPOSIT
Bank deposits are differentiated by the type of deposit customer, the tenure of the deposit and its
cost to the bank. On the basis of these parameters, deposit sources are as follows,
1. TRANSACTION ACCOUNTS OR PAYMENT DEPOSITS

Payment deposits, repayable by the bank on demand from the depositor, represent one of the
primary services offered by banks. They can be bifurcated into non-interest bearing and interest
bearing demand deposits. Such deposits facilitate transfer of funds by the deposit holder to third
parties, primarily through cheques and other forms of fund transfer.
Non-interest bearing demand deposits are typically held by individuals, businesses or the
government. Explicit interest payments on these deposits are prohibited in most countries.
Corporate customers prefer these accounts for ease of operations.
Interest bearing demand deposits are preferred by individuals or certain types of organisations.
Similar to the non-interest bearing accounts, these deposits are also used for the purpose of
transactions by the deposit holders and a major portion of these deposits is likely to be volatile.
They are called ‘Savings’ accounts which carry a low rate of interest.
2. TERM DEPOSITS
These are a form of ‘debt investment’ for a customer, who is willing to lend money to the bank for
a specified period of time. In return, the customer receives a stream of cash flows in the form of
interest. These deposits typically ay high interest. A popular variant of large term deposits is the
Certificate of deposits (CD).
NON-DEPOSITS SOURCES
Over the last three decades or so, banks have been increasingly turning to non-deposit funding
sources or wholesale funding sources. Non deposit funds are one which are not insured.
FUNDING GAP
The funding gap is calculated as the difference between current and projected credit and deposit
flows. If the difference shows the projected need for credit exceeding the expected deposit flows,
the bank has to raise additional resources either from deposit or non-deposit sources. If the
differences shows the projected credit requirements falling short of resources, the bank will have
to find profitable investment avenues for the surplus resources.
The Non-deposit sources are as follows,
1. BORROWING FROM CENTRAL BANK

The central bank has been described as "the lender of last resort", which means that it is
responsible for providing its economy with funds when commercial banks cannot cover a supply
shortage. In other words, the central bank prevents the country's banking system from failing.
However, the primary goal of central banks is to provide their countries' currencies with price
stability by controlling inflation. A central bank also acts as the regulatory authority of a
country's monetary policy and is the sole provider and printer of notes and coins in circulation.
2. CERTIFICATE OF DEPOSITS (CD)

A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified
fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial
banks and are insured by the FDIC. The term of a CD generally ranges from one month to five years.
3. FOREIGN FUNDS
Foreign funds offer individual investors access to international markets. Investing abroad poses
risks, but can also help investors diversify their portfolios. It is important to recognize the
difference between global funds and foreign funds. Global funds can invest in securities from any
country, including the investor's home country.
4. COMMERCIAL PAPERS
An unsecured, short-term debt instrument issued by a corporation, typically for the financing of
accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper
rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing
market interest rates.
DESIGNING OF DEPOSIT SCHEMES

The principles underlying the concept of ‘time value of money’ are prevalently used in designing
deposit schemes. Simply stated, the future value is the value of an investment today at some
period in future, while the ‘present value’ is the value today of cash flow receivables at some period
in future.
RECURRING DEPOSIT SCHEME

Recurring deposit account is opened by those who want to save regularly for a certain period of
time and earn a higher interest rate. In recurring deposit account certain fixed amount is accepted
every month for a specified period and the total amount is repaid with interest at the end of the
particular fixed period. Minimum and Maximum deposit periods are usually 12 and 120 months,
respectively.
REINVESTMENT DEPOSIT SCHEME

In a Reinvestment Deposit Plan, a lump sum amount is invested for a fixed period and repaid with
interest on maturity. The interest earned on the deposit is reinvested at the end of each quarter
and hence, there is interest on interest. The Minimum and Maximum deposit periods are usually
12 and 120 months, respectively, though the period could differ among banks. The maturity
amount can be calculated as follows,
Maturity Amount = Initial deposit (1+r)n
Where, r= Effective rate = (1+k/m)m -1
N= no of years
FIXED DEPOSIT SCHEMES

In deposit terminology, the term Fixed Deposit refers to a savings account or certificate of deposit
that pays a fixed rate of interest until a given maturity date. Funds placed in a Fixed Deposit usually
cannot be withdrawn prior to maturity or they can perhaps only be withdrawn with advanced
notice and/or by having a penalty assessed. Depositors seeking regular income from their fixed
investment would prefer this scheme.
CASH CERTIFICATES
The amount of initial deposit will be the issue price of the cash certificate and will be computed
based on the maturity amount or the face value of the cash certificate and the tenure of the
deposit. The interest is re-invested quarterly and hence, there will be interest on interest. The
minimum and maximum maturity periods are generally similar to the re-invested schemes.
GUIDELINES FOR OPENING A DEPOSIT ACCOUNT

One of the important functions of the Bank is to accept deposits from the public for the purpose
of lending. In fact, depositors are the major stakeholders of the Banking System. The depositors
and their interests form the key area of the regulatory framework for banking in India and this has
been enshrined in the Banking Regulation Act, 1949.
This policy document on deposits outlines the guiding principles in respect of formulation of
various deposit products offered by the Bank and terms and conditions governing the conduct of
the account. The document recognises the rights of depositors and aims at dissemination of
information with regard to various aspects of acceptance of deposits from the members of the
public, conduct and operations of various deposits accounts, payment of interest on various
deposit accounts, closure of deposit accounts, method of disposal of deposits of deceased
depositors, etc., for the benefit of customers. It is expected that this document will impart greater
transparency in dealing with the individual customers and create awareness among customers of
their rights. The ultimate objective is that the customer will get services they are rightfully entitled
to receive without demand.
While adopting this policy, the bank reiterates its commitments to individual customers outlined
in Bankers' Fair Practice Code of Indian Banks' Association. This document is a broad framework
under which the rights of common depositors are recognized. Detailed operational instructions on
various deposit schemes and related services will be issued from time to time.
TYPES OF DEPOSIT ACCOUNTS

While various deposit products offered by the Bank are assigned different names. The deposit
products can be categorised broadly into the following types. Definition of major deposits schemes
are as under: -
1. "DEMAND DEPOSITS" means a deposit received by the Bank which is withdrawable on

demand;
2. "SAVINGS DEPOSITS" means a form of demand deposit which is subject to restrictions
as to the number of withdrawals as also the amounts of withdrawals permitted by the Bank
during any specified period;
3. "TERM DEPOSIT" means a deposit received by the Bank for a fixed period withdrawable
only after the expiry of the fixed period and include deposits such as Recurring / Double
Benefit Deposits / Short Deposits / Fixed Deposits /Monthly Income Certificate /Quarterly
Income Certificate etc.
4. NOTICE DEPOSIT means term deposit for specific period but withdrawable on giving at
least one complete banking days’ notice;
5. "CURRENT ACCOUNT" means a form of demand deposit wherefrom withdrawals are
allowed any number of times depending upon the balance in the account or up to a
particular agreed amount and will also include other deposit accounts which are neither
Savings Deposit nor Term Deposit;
ACCOUNT OPENING AND OPERATION OF DEPOSIT ACCOUNTS

The bank has to strictly follow the following guidelines whenever they are opening a new deposit
account:
1. The Bank before opening any deposit account will carry out due diligence as required under
"Know Your Customer" (KYC) guidelines issued by RBI and or such other norms or
procedures adopted by the Bank. If the decision to open an account of a prospective
depositor requires clearance at a higher level, reasons for any delay in opening of the
account will be informed to him and the final decision of the Bank will be conveyed at the
earliest to him.
2. The account opening forms and other material would be provided to the prospective
depositor by the Bank. The same will contain details of information to be furnished and
documents to be produced for verification and or for record, it is expected of the Bank
official opening the account, to explain the procedural formalities and provide necessary
clarifications sought by the prospective depositor when he approaches for opening a
deposit account.
3. For deposit products like Savings Bank Account and Current Deposit Account, the Bank
will normally stipulate certain minimum balances to be maintained as part of terms and
conditions governing operation of such accounts. Failure to maintain minimum balance in
the account will attract levy of charges as specified by the Bank from time to time. For
Saving Bank Account the Bank may also place restrictions on number of transactions, cash
withdrawals, etc., for given period. Similarly, the Bank may specify charges for issue of
cheques books, additional statement of accounts, duplicate pass book, folio charges, etc.
All such details, regarding terms and conditions for operation of the accounts and schedule
of charges for various services provided will be communicated to the prospective depositor
while opening the account.
4. The different type of deposits can be opened for the specified group of people:
a. Savings Bank Accounts can be opened for eligible person / persons and certain
organizations / agencies (as advised by Reserve Bank of India (RBI) from time to
time)
b. Current Accounts can be opened by individuals / partnership firms / Private and
Public Limited Companies / HUFs / Specified Associates / Societies / Trusts, etc.
c. Term Deposits Accounts can be opened by individuals / partnership firms / Private
and Public Limited Companies / HUFs/ Specified Associates / Societies / Trusts, etc.
5. The due diligence process, while opening a deposit account will involve satisfying about
the identity of the person, verification of address, satisfying about his occupation and
source of income. Obtaining introduction of the prospective depositor from a person
acceptable to the Bank and obtaining recent photograph of the person/s opening /
operating the account are part of due diligence process.
6. In addition to the due diligence requirements, under KYC norms the Bank is required by law
to obtain Permanent Account Number (PAN) or General Index Register (GIR) Number or
alternatively declaration in Form No. 60 or 61 as specified under the Income Tax Act / Rules.
7. Deposit accounts can be opened by an individual in his own name (status: known as
account in single name) or by more than one individual in their own names (status: known
as Joint Account). Savings Bank Account can also be opened by a minor jointly with natural
guardian or with mother as the guardian (Status: known as Minor's Account). Minors above
the age of 10 will also be allowed to open and operate saving bank account independently.
8. Operation of Joint Account - The Joint Account opened by more than one individual can be
operated by single individual or by more than one individual jointly. The mandate for
operating the account can be modified with the consent of all account holders. The Savings
Bank Account opened by minor jointly with natural guardian / guardian can be operated by
natural guardian only.
9. The joint account holders can give any of the following mandates for the disposal of
balance in the above accounts:
a. Either or Survivor: If the account is held by two individuals say, A & B, the final
balance along with interest, if applicable, will be paid to survivor on death of anyone
of the account holders.
b. Anyone or Survivor/s: If the account is held by more than two individuals say, A, B
and C, the final balance along with interest, if applicable, will be paid to the survivor
on death of any two account holders.
The above mandates will be applicable to or become operational only on or after the date
of maturity of term deposits. This mandate can be modified by the consent of all the
account holders.
10. At the request of the depositor, the Bank will register mandate / power of attorney given
by him authorizing another person to operate the account on his behalf.
11. The term deposit account holders at the time of placing their deposits can give instructions
with regard to closure of deposit account or renewal of deposit for further period on the
date of maturity. In absence of such mandate, the Bank will seek instructions from the
depositor/s as to the disposal of the deposit by sending an intimation before 15 days of
the maturity date of term deposit.
12. Nomination facility is available on all deposit accounts opened by the individuals.
Nomination is also available to a sole proprietary concern account. Nomination can be
made in favour of one individual only. Nomination so made can be cancelled or changed by
the account holder/s any time. While making nomination, cancellation or change thereof,
it is required to be witnessed by a third party. Nomination can be modified by the consent
of account holder/s. Nomination can be made in favour of a minor also.
Bank recommends that all depositors avail nomination facility. The nominee, in the event
of death of the depositor/s, would receive the balance outstanding in the account as a
trustee of legal heirs. The depositor will be informed of the advantages of the nomination
facility while opening a deposit account.
13. A statement of account will be provided by the Bank to Savings Bank as well as Current
Deposit Account Holders periodically as per terms and conditions of opening of the
account. Alternatively, the Bank may issue a Pass Book to these account holders.
14. The deposit accounts may be transferred to any other branch of the Bank at the request of
the depositor.
INTEREST PAYMENTS
The bank should follow the following guidelines for the payment of Interest to the deposit account
holders:
1. Interest shall be paid on saving account at the rate specified by Reserve Bank of India
directive from time to time. However, term deposit interest rates are decided by the Bank
within the general guidelines issued by the Reserve Bank of India from time to time.
2. In terms of Reserve Bank of India directives, interest shall be calculated at quarterly
intervals on term deposits and paid at the rate decided by the Bank depending upon the
period of deposits. In case of monthly deposit scheme, the interest shall be calculated for
the quarter and paid monthly at discounted value. The interest on term deposits is
calculated by the Bank in accordance with the formulae and conventions advised by Indian
Banks' Association.
3. The rate of interest on deposits will be prominently displayed in the branch premises.
Changes, if any, with regard to the deposit schemes and other related services shall also be
communicated upfront and shall be prominently displayed.
4. The Bank has statutory obligation to deduct tax at source if the total interest paid / payable
on all term deposits held by a person exceeds the amount specified under the Income Tax
Act. The Bank will issue a tax deduction certificate (TDS Certificate) for the amount of tax
deducted. The depositor, if entitled to exemption from TDS can submit declaration in the
prescribed format at the beginning of every financial year.
PRICING OF DEPOSIT SERVICES

Deposits are the primary source of funds for banks. The pricing of deposits and related services
assumes great importance in the present deregulated and highly competitive environment, where
deposit rate ceilings do not exist. Some commonly used approaches to deposit pricing:
 Cost Plus Margin Deposit Pricing

 Market Penetration Deposit Pricing

 Conditional Pricing
 Upscale Target Pricing
 Relationship Pricing
COST PLUS MARGIN DEPOSIT PRICING

The development of interest-bearing checkable deposits (particularly NOWs) offered financial
managers the opportunity to reconsider the pricing of deposit services. Unfortunately, many of
the early entrants into this new market moved aggressively to capture a major share of the
customers through below-cost pricing. Customer charges were set below the true level of
operating and overhead costs associated with providing deposit services. The result was a
substantially increased rate of return to the customer, known as the implicit interest rate—the
difference between the true cost of supplying fund-raising services and the service charges actually
assessed the customer.
Deregulation has brought more frequent use of unbundled service pricing as greater competition
has raised the average real cost of a deposit for deposit-service providers. This means that deposits
are usually priced separately from other services. And each deposit service is often priced high
enough to recover all or most of the cost of providing that service, using the following cost-plus
pricing formula:
UNIT PRICE CHARGED THE CUSTOMER FOR EACH DEPOSIT SERVICE= OPERATING EXPENSE
PER UNIT OF DEPOSIT SERVICE + ESTIMATED OVERHEAD EXPENSE ALLOCATED TO THE
DEPOSIT SERVICE FUNCTION + PLANNED PROFIT MARGIN FROM EACH SERVICE UNIT
Tying deposit pricing to the cost of deposit-service production, as Equation above does, has
encouraged deposit providers to match prices and costs more closely and eliminate many formerly
free services. In the United States, for example, more depositories are now levying fees for
excessive withdrawals, customer balance inquiries, bounced checks, stop-payment orders, and
ATM usages, as well as raising required minimum deposit balances. The results of these trends have
generally been favorable to depository institutions, with increases in service fee income generally
outstripping losses from angry customers closing their accounts.
CONDITIONAL PRICING
Conditional pricing sets up a schedule of fees in which the customer pays a low fee or no fee if the
deposit balance remains above some minimum level, but faces a higher fee if the average balance
falls below that minimum. Thus, the customer pays a price conditional on how he or she uses the
deposit. Conditional pricing techniques vary deposit prices based on one or more of these factors:
1. The number of transactions passing through the account (e.g., number of checks written,
deposits made, wire transfers, stop-payment orders, or notices of insufficient funds issued).
2. The average balance held in the account over a designated period (usually per month).
3. The maturity of the deposit in days, weeks, or months.
The customer selects the deposit plan that results in the lowest fees possible and/or the maximum
yields, given the number of checks he or she plans to write, or charges planned to be made, the
number of deposits and withdrawals expected, and the planned average balance. Of course, the
depository institution must also be acceptable to the customer from the standpoint of safety,
convenience, and service availability.
RELATIONSHIP PRICING
Customers who purchase two or more services may be granted lower deposit fees compared to
the fees charged customers having only a limited relationship to the offering institution. The idea
is that selling a customer multiple services increases the customer’s dependence on the institution
and makes it harder for that customer to go elsewhere. In theory at least, relationship pricing
promotes greater customer loyalty and makes the customer less sensitive to the prices posted on
services offered by competing financial firms.
MARKET PENETRATION DEPOSIT PRICING

This pricing strategy is typically aimed at high growth markets in which the bank is determined to
garner a large market share. Therefore, banks are tempted to offer either high interest rates, well
above the market level or charge customer fees well below the market standards. Bank managers
expect that the large sources of funds and associated loan business and investment opportunities
would offset thinner spreads. Because it is usually costly for the customer to move certain kinds
of deposit such as payment accounts, the lower fees on certain deposits initially attracted through
penetration pricing which may eventually be raised to cost-recovery or profit-making level.
UPSCALE TARGET PRICING

Upscale target pricing is the use of carefully but aggressively designed deposit advertising
programs and deposit pricing schemes to appeal to customers that higher levels of income or net
worth, such as business owners and managers, doctors, lawyers and other high income households.
The customers being targeted are price sensitive and therefore could respond quickly to the price
differentials.
APPLICATION OF BANK FUNDS

Banks have a crucial role to play in the financial system of any country. The prime objective of the
financial system is to channel surpluses arising in the economy through the activities of
households, corporate houses and the government, into the deficit units in the economy, again in
the form of households, corporate houses and the government. Hence, the main application of
funds is lending.
LENDING
The main function of bank is lending. Lending means granting of loan to the needed people at the
rate of interest. It adds profit to the individual bank. A bank can lend profitably only if it is able to
take on and manage credit risk that arises from the quality of the borrower and his business. The
bank also has to contend with the impact of fluctuations interest and exchange rates on profits,
as well as the liquidity risk posed by mismatch in the maturities of its liabilities and assets. Bank
extends credits to different categories of borrowers for different purposes.
FEATURES OF LENDING:
 For a bank, good loans are its most profitable assets. And any loan is good till the borrower
defaults in repayment.
 Banks have to look for higher returns.
 Loan maturities, pricing and the methods of principal repayments all impact the timings
and magnitude of banks’ cash inflows.
 Fluctuation in interest rates give rise to earnings volatility.
TYPES OF LENDING
Broadly, three types of lending can be identified:
1. FUND BASED LENDING is the most direct form of lending. It is granted as a loan or advance
with an actual outflow of cash to the borrower by the bank. In most cases, such lending is
supported by prime and/or collateral securities. Fund based advances can be further classified
based on the tenure of the loans. They are
i) Short-term loans: These loans are granted with the primary purpose of financing working
capital needs of the borrower, resulting from temporary buildup of inventories and
receivables. Maturity Period is 1 year or less
ii) Long-term Loans: These are called as ‘term loans’, repayment are structured based on future
cash flows rather than on liquidation of short-term assets. Maturity period is more than
one year.
iii) Revolving Credits: A line of credit where the customer pays a commitment fee and is then
allowed to use the funds when they are needed. It is usually used for operating purposes,
fluctuating each month depending on the customer's current cash flow needs.
2. NON FUND BASED LENDING, where the lending bank does not commit any physical outflow
of funds. The funds position of the lending bank remains intact. The non-funding based lending
can be made in two forms: Bank Guarantees and Letter of Credit.
3. ASSET-BASED LENDING is an emerging category of bank lending. In this type of lending, the
bank looks primarily or solely to the earning capacity of the asset being financed, for servicing
it debt. In most cases, the bank will have limited or no recourse the borrower.
INVESTMENTS
Now a day’s bank also participates in the activities of investment at national or international level
of investment banks. They help companies and government to raise money by issuing and selling
securities in the capital markets. They provide necessary financial guidance to its customers for
effective investments in Stock and Mutual Funds. Some banks also have specialized offices for this
purpose.
INVESTMENT AND LENDING FUNCTIONS

The risks involved in lending render it imperative that banks should have systems and controls that
enable bank managers to take credit decisions after objectively evaluating risk-return tradeoffs.
Whether it is consumer or commercial lending, credit decisions impact the profitability of banks,
and ultimately their competitiveness and survival in the industry. Credit decisions are by no means
easy. The process of lending are as follows,
1. Loan Policy: To ensure alignment of individual goals of credit officer to the banks’ overall goals,
banks formulate ‘loan policies’. These are written documents, authorized by individual banks’
Board of Directors, that formalize and set guidelines for lending to be followed by decision-
makers in the bank.
2. Business Development and Recommendations: Within the broad framework of the loan policy of
the bank, and based on the bank’s goals in building its loan asset portfolio, credit officers seek
to reinforce the relationship with existing customers, build new clientele and cross sell non-
credit services. Business development efforts for credit expansion should preferably begin with
market research and detailed credit investigation. The outcome of this research will leads to
identification of potential industries and credit products.
3. Credit Analysis: Modern Credit analysis uses the traditional concepts in making subjective
evaluation, along with wide use of financial ratios and risk evaluation models to determine if a
borrower is creditworthy. The accent on risk evaluation implies that the banker lends only if he
is satisfied that risks are mitigated to ensure that the borrower’s future cash flows (and hence
debt service) will not be affected.
4. Credit Delivery and Administration: Depending on the size of the bank, the loan size and type of
exposure planned, the final decision to lend may be taken by an authorized layer of the bank.
Once a loan is approved, the officer communicates the sanction to the borrower through
formal ‘sanction letter’ i.e. Loan Agreement.
5. Loan Documentation: Different types of borrowers and different types of security interests
necessitate loan documentation procedures that would be valid in a court of law. Accordingly,
once the loan agreement is signed, the borrowers and guarantors execute the loan documents.
If the borrower defaults on a secured loan, the bank has the right to take possession of the
assets and liquidates them to recover its dues.
6. Updating the credit file and Periodic follow up: The credit file has to be continuously updated
throughout the above process. Further, once the loan is disbursed, the following activities have
to be carried out,
I. Process loan payments and send reminders in case loan payments are received late
II. The borrower will have to submit updates of financial performance periodically or as per
the accounting practices in force.
III. The bank can call on the borrower at any time, even without prior intimation to ensure that
the borrower’s activities are accordance with the bank’s expectations.
7. Credit Review and Monitoring: Banks that have succeeded in credit management, and hence
reduction of credit risk, are those that have separated credit review and monitoring from credit
analysis, execution and administration.
TYPES OF LOANS
Loan refers to the act of giving money, property or other material goods to another party in
exchange for future repayment of the principal amount along with interest or other finance
charges. A loan may be for a specific, one-time amount or can be available as open-ended credit up
to a specified ceiling amount. The various types of loans are loans for working capital, loans for
capital expenditure and industrial credit, loan syndication, loans for agriculture, loans for
infrastructure-project finance, loans to consumers or retain lending and Non-fund based credit.
LOANS FOR WORKING CAPITAL

A working capital loan is a loan used by companies to cover day-to-day operational expenses.
Companies are unable to generate the revenue needed to meet expenses incurred by day-to-day
business operations. In such circumstances, companies may apply for a working capital loan.
Unlike most other business loans that allow companies to acquire capital in order to expand, a
working capital loan covers only expenses incurred by existing capital and human resources (e.g.
utilities, rents, payroll, etc.). Working capital loans are generally granted only to companies with a
high credit rating, and are only meant to be used until a company can generate enough revenue
to cover its own expenses.
LOANS FOR CAPITAL EXPENDITURE AND INDUSTRIAL CREDIT
Financing capital investments, such as IT equipment, machinery, vehicles, buildings and the like,
can be arranged in various ways. It all depends on your company's needs and financial situation.
The rule of thumb is that businesses use bank loans for capital expenditure financing and finance
operations using an overdraft facility. Experience shows that this gives the best financing structure
and provides the best protection against liquidity problems. The only argument for financing
capital expenditures with an overdraft facility is that it can reduce interest expenses as you only
pay interest when you need to draw on the facility. Generally, however, mixing capital expenditure
and working capital financing involves few advantages.
LOAN SYNDICATION
The process of involving several different banks in providing various portions of a loan. Loan
syndication most often occurs in situations where a borrower requires a large sum of capital that
may either be too much for a single bank to provide, or may be outside the scope of a bank's risk
exposure levels. Thus, multiple banks will work together to provide the borrower with the capital
needed, at an appropriate rate agreed upon by all the banks.
LOANS FOR AGRICULTURE
Agricultural loans help farmers run their farms more efficiently. It can be difficult to keep up with
all of the costs associated with running a farm, so farmers need low interest agricultural loans to
help them stay afloat. Fortunately, the government often steps in with low interest loans and other
subsidies that help farmers turn a profit. Farmers can use agricultural loans to:
a. Purchase farm land. Whether you are just starting out as a farmer or wish to expand your
current farm business, agricultural land loans help you purchase the land you need to build a
great farm.
b. Cover operating expenses. Besides needing farm land financing, many farmers also need help
covering some of the operating costs. Farm equipment is expensive, but it's necessary to run
the farm. With better equipment, you can cover more land quickly.
c. Help with the marketing of their product. If they want to make a profit, then farmers need to
sell the product they create. This means that they need an effective marketing plan and money
to pay for marketing costs in addition to farm land loans.
LOANS FOR INFRASTRUCTURE-PROJECT FINANCE

Defined by the International Project Finance Association (IPFA) as the following: The financing of
long-term infrastructure, industrial projects and public services based upon a non-recourse or
limited recourse financial structure where project debt and equity used to finance the project are
paid back from the cash flow generated by the project. Project finance is especially attractive to
the private sector because they can fund major projects off balance sheet.
LOANS TO CONSUMERS OR RETAIN LENDING

An amount of money lent to an individual (usually on a non-secured basis) for personal, family, or
household purposes. Consumer loans are monitored by government regulatory agencies for their
compliance with consumer protection regulations such as the Truth in Lending Act. Also called
consumer credit or consumer lending.
NON FUND BASED LENDING

Non fund based lending, where the lending bank does not commit any physical outflow of funds.
The funds position of the lending bank remains intact. The non-funding based lending can be maid
in two forms:
 Bank Guarantees
 Letter of Credit
MAJOR COMPONENTS OF A TYPICAL LOAN POLICY DOCUMENT

LOAN POLICY are written documents, authorized by individual banks’ Board of Directors that
formalize and set guidelines for lending to be followed by decision-makers in the bank. The loan
policy specifies the bank’s overall strategy for lending, identifies loan qualities and parameters, and
lays down procedures for appraising, sanctioning, granting, documenting and reviewing loans.
COMPONENTS OF LOAN POLICY

 Loan Objectives: Within the regulatory prescriptions, the loan objectives will communicate
to credit officers and other decision-makers, the bank’s priorities among the conflicting
objectives of liquidity, profitability, increasing business volumes, and risk and asset quality.
 Volume and Mix of Loans: How much of the loan portfolio is to be channeled into specific
industries, sectors or geographical areas, will be communicated in this section. It may also
specify composition of the loan portfolio by size of loans, pricing of loans or securities.
 Loan Evaluation Procedures: Generally, uniform credit appraisal procedures are prescribed
throughout the bank. The procedures would deal with all issues ranging from establishing
suitability of the loan to the bank’s overall strategy and risk taking ability, to selection of
borrowers, market and project risk appraisal criteria, financial statement analysis,
structuring of loan agreements, documentation and post-sanction monitoring.
 Credit Administration: Lending involves more risks than any other banking activity. Hence,
banks are careful to ensure that credit decisions are taken by experienced and
knowledgeable officers, with decision-making authority as decided by the top management
or the board from time to time. The loan policy should indicate the credit sanctioning
powers of the officers at various hierarchical levels of the bank.
 Credit Files: Credit files are important documented and updated material used for both
decision-making and continuous evaluation. Sometimes, the loan policy specifically
mentions the mandatory format in which information in the credit files is to be maintained.
 Lending Rates: The interest charged should reflect the credit risk in a loan. The policy may
also state the returns expected for each risk group of borrowers in the bank, and specific
risk limits up to which the bank can lend. It can also specify the credit scoring system to be
adopted to fix the lending rates, and circumstances under which fixed and floating rates of
interest can be charged to the borrower.
 The other parameters that a loan policy may specify are,
 Type of collateral the bank can accept as security for the loans
 The extent to which the security should cover the advances made
 Nature of margins/compensating balances to be maintained by various classes of
borrowers
 Limits up to which the bank can expose itself to certain sectors and borrower
groups
 Credit monitoring system that would be operative after the loan is disbursed
 Credit to deposit ratios that the bank need to maintain
 Incentive schemes for loan officers
 Loan agreement and other communication practices
 Role of legal department in the bank
STEPS INVOLVED IN CREDIT ANALYSIS

STEP 1: BUILDING THE ‘CREDIT FILE’:
The preliminary information so obtained would throw light on the borrower’s antecedents, his
credit history and track record. If the project is a Greenfield projects, the credit officer will have to
do a thorough research into various aspects of the project, as well as into the borrower’s financial
and managerial capacity to make the project a success. If the borrower is an existing one, seeking
additional credit, the information would be readily available with the credit officer. The credit file
is an important tool box for the credit officer. The extensive information in the credit fill will enable
the credit officer to examine the borrower’s track record in repayment, and help in forming an
opinion about the borrower’s future repayment intention and potential.
STEP 2: PROJECT AND FINANCIAL APPRAISAL:

Once the preliminary investigation is done, the internal and external factors, such as management
integrity and capability, the company’s performance and market value and the industry
characteristics are evaluated. One of the important activities at this stage is financial analysis. As
illustrative list of inputs and activities is as follows:
 Past financial statements

 Cash flow statements
 Financial risk of an entity is measured.
STEP 3: QUALITATIVE ANALYSIS

Integrity is the most important quality that the banker looks for in a borrower, and the most
difficult to measure. So is assessment of the quality of the management team. However, lenders
will have to make qualitative assessment of the borrower on most of the criteria.
STEP 4: DUE DILIGENCE:

Due diligence can be very costly for a bank. Many loans have run into problems since bankers did
not take this step seriously. Due diligence can include checking on the borrower’s address, pre-
approval inspections of the borrower’s workplace, and interviews with the borrower’s competitors,
suppliers, Customers and employees. Disclosure of contingent liabilities by the borrower is an
essential part of the due diligence.
STEP 5: RISK ASSESSMENT

All Potential internal and external risks are to be identified and their severity assessed in terms of
how these risks would impact the borrower’s future cash flows and hence the debt service capacity.
The risk assessment would form an important input for structuring the credit facility and terms of
the loan agreement.
STEP 6: MANAGING THE RECOMMENDATION

Finally, based on a thorough analysis of the project, the borrower and the market, and after
examining the ‘fit’ of the credit with the ‘loan policy’, the credit officer makes his recommendations
to consider the loan favorably or reject it outright.
CREDIT DELIVERY AND ADMINISTRATION

Depending on the size of the bank, the loan size and type of exposure planned, the final decision
to lend may be taken by an authorized layer of the bank. Typically, banks fix ‘discretionary limits’
– monetary ceilings up to which personnel at each level can take credit decisions- for each layer of
authority starting from credit officers themselves to branch heads to senior and top management
at the corporate office, including the Board of Directors. These ‘discretionary limits’ become larger
as they move up the organizational hierarchy.
For all decision-makers above the level of loan officers, the loan officer’s appraisal forms the very
basis of decision-making. Hence, the loan officer’s role in the credit decision making process is
extremely critical. Many banks create a separate channel in the hierarchy for grooming and
equipping credit officers with the essential attitude and skills for the lending functions.
Some very large banks have a centralized ‘underwriting department’. It processes the credit
request and conveys approval ‘in principle’, in order to cut the process and time required for a
sanction through the regular process. Once a loan is approved, the officer communicates the
sanction to the borrower through formal ‘sanction letter’ i.e. Loan Agreement.
A loan agreement is a contract between a borrower and a lender which regulates the mutual
promises made by each party. Following are the content of loan agreement.
o Nature / type of the credit facility

o Interest / discount / charges as applicable
o Repayment terms
o Stipulation regarding end use of each facility
o Additional fees as applicable
o Prime security for each credit facility
o Full descriptions of the collateral securities

o Details of personal / third party guarantees
o Terms and conditions under which the loan facilities are being granted
o Events of default and penal provision.
LOAN PRICING
Every loan has a unique risk profile, which will have to be quantified and built into the price. Proper
pricing of a loan is more complex and non- standardized than pricing of a product or service. It also
follows that, for every loan, at the minimum,
Loan Price= Cost of funds+ Servicing Costs + Risk Premium + desired profit margin
Steps involved in pricing of loan are as follows
 Step 1: Arrive at cost of funds

 Step 2: Determine the servicing costs for the customer.
 Step 3: Assess Default risk and enforceability of securities.
 Step 4: Fixing the profit margin.
MODELS FOR LOAN PRICING:

FIXED VERSUS FLOATING RATES:
When the interest rate are relatively stable and the yield curve slopes upward, banks would be
willing to lend at fixed interest rates, above the rates they pay for shorter term liabilities. In an
environment where rates are volatile, and banks have to source funds from the market at varying
interest rates, they would prefer to lend on floating rates and for shorter maturities. In effect,
floating rate loans transfer the interest rate risk from the bank to borrower. Though this appear
desirable, it may result in heightened credit risk from the bank.
PRICING FLOATING LOANS:

Once the benchmark rate is determined, the bank can develop and use prime rate-based pricing
models. Sub-prime lending is resorted to only in exceptional cases. In pricing most loans, a markup
over the prime rate is stipulated. As the market-determined or bank-determined prime moves up
or down, the interest rates charged to the borrower also increase or decrease. The mark ups are
based on a credit rating of the borrower, and are modelled to take care of the risks in lending to
the particular borrower.
There are two basic methods for loading the mark ups on the prime rate – through an additive
method and multiplicative method- termed ‘prime plus’ and ‘prime times’, respectively.
HEDGING AND MATCHED FUNDING:

Many borrowers prefer fixed rate loans. If banks have to make fixed rate loans in deference to
borrower preferences, they attempt to control loss of profits due to interest rate volatility by
interest rate swaps or futures or by match funding.
In interest rate swaps, fixed rate payments are made in return for floating rate receipts. It is also
possible to directly buy interest rate caps. With futures, it is possible to make fixed rate loans and
hedge against potential losses from higher borrowing costs in future. This can be achieved by
selling futures contracts or buying put options on futures.
In matched funding, loans are made with sources of funds with identical maturities. For example,
the bank will source a deposit of 1 year maturity to fund a loan of identical maturity and amount.
In the ideal situation, the bank can avoid interest rate risk on this transaction if there is a positive
spread between the loan price and the cost of the deposit, and the interest payments also coincide.
In large banks, the transfer pricing systems can be used flexibly for matched funding.
THE PRICE LEADERSHIP MODEL:

"Price leadership" rate is important because it establishes a benchmark for many other types of
loans. To maintain an adequate business return in the price-leadership model, a banker must keep
the funding and operating costs and the risk premium as competitive as possible. Banks have
devised many ways to decrease funding and operating costs, and those strategies are beyond the
scope of this article. But determining the risk premium, which depends on the characteristics of
the individual borrower and the loan, is a different process.
COST BENEFIT LOAN PRICING:

It is a practice for many banks to base their loan rates on the base reference rate, the LIBOR or the
Prime rate. Some banks have also developed sophisticated loan pricing systems that determine
whether their loan prices fully compensate for all the costs and risks involved in lending. One of
these systems assesses the costs and benefits of the pricing model using the following steps.
i. Employ sensitivity analysis to estimate the total revenue that a loan would generate under
different interest rates and charges.
ii. Estimate the net loanable funds turnover.
iii. Estimate the before tax yield from the loan by dividing the estimated revenue from the
loans by the net amount loanable funds utilized by the borrowers.
CUSTOMER PROFITABILITY ANALYSIS

The analysis is used to evaluate whether the net gains from a borrower’s transactions with the
bank are in line with the bank’s profit expectations. The procedure involves comparing revenues
generated by the borrower with the associated costs, and ultimately with the banks’ profit goal.
THE STEPS IN ANALYZING CUSTOMER PROFITABILITY ANALYSIS TYPICALLY

AS FOLLOWS,
Step 1: Identify all the services used by the customer- deposit services, loans availed, payment
services, services relating to transfer of funds, custodial services and other fee-based services.
Step 2: Identify the cost of providing each services. Generally, unit costs can be derived from the
bank’s cost accounting system. The bank’s service can be bifurcated into credit related and non-
credit related services.
Step 3: Cost estimates for non-credit related services can be obtained by multiplying the unit cost
of each service by the corresponding activity level.
Step 4: The major portion of costs is in respect of credit-related services. The bank incurs actual
cash expenses in interest payments towards the sources of funds for the loan, and the costs for
credit analysis and execution. The latter includes personnel and overhead costs, including cost
outgo for sending bills for collection, processing payments, maintaining collateral and updating
documentation. It may be computed as a fixed percentage of the loan amount.
Step 5: The credit-related expenses has a non-cash component- the allocation of default risk
expense. The bank’s risk rating system is used in categorizing loans in terms of their potential for
default risk, and the likely magnitude of such default. Some banks build in the default risk into the
loan price.
Step 6: Assess the revenues generated by the relationship with the borrower. The borrower could
have deposit balances with the bank, either as a depositor or by way of compensating balances.
To estimate the income from interest-bearing deposits, the bank deducts the average transactions
‘float’ and the mandatory ‘reserve requirements’ from the average deposit balances held during
the period of analysis. It then applies a ‘notational interest rate’ on the balances to estimate the
earnings potential of the customer’s deposit balances. The opportunity cost of compensating
balances varies directly with the interest rate levels, and hence, corporate borrowers do not refer
this mode of cash retention by bank.
Step 7: Assess the fee-based income generated. Fees are generally charged on a per service basis.
In the case of credit relationships, banks charge upfront fees for processing the loan application
and making funds available (regardless of whether the funds are utilized by the borrower);
commitment fees for the unutilized portion of the credit limit; and conversion fee, in case there is
a rescheduling of a loan repayment terms.
Step 8: Assess the revenue from loans.

BA7026 Banking Financial Services Management

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Unit – II – Sources and Application of Bank Funds

Ms. A. Jebakerupa Roslin, Faculty, SJCE 2015 – 2016 MBA

BASEL COMMITTEE ON BANKING SUPERVISION 3

DEPOSIT AND NON-DEPOSIT SOURCES 9

DESIGNING OF DEPOSIT SCHEMES 12

RECURRING DEPOSIT SCHEME 12

GUIDELINES FOR OPENING A DEPOSIT ACCOUNT 13

TYPES OF DEPOSIT ACCOUNTS 14

PRICING OF DEPOSIT SERVICES 17

COST PLUS MARGIN DEPOSIT PRICING 18

MARKET PENETRATION DEPOSIT PRICING 19

APPLICATION OF BANK FUNDS 20

INVESTMENT AND LENDING FUNCTIONS 21

MAJOR COMPONENTS OF A TYPICAL LOAN POLICY DOCUMENT 25

STEPS INVOLVED IN CREDIT ANALYSIS 26

STEP 1: BUILDING THE ‘CREDIT FILE’: 26

CREDIT DELIVERY AND ADMINISTRATION 28

MODELS FOR LOAN PRICING: 29

CUSTOMER PROFITABILITY ANALYSIS 31

THE STEPS IN ANALYZING CUSTOMER PROFITABILITY ANALYSIS TYPICALLY AS FOLLOWS, 31

BASEL COMMITTEE ON BANKING SUPERVISION

THE NEED FOR MINIMUM CAPITAL REQUIREMENT

 Capital reserves representing surplus arising out of sale proceeds of assets.

TIER III CAPITAL

CAPITAL ADEQUACY RATIO (CAR)

Tier I + Tier II + Tier III capital (capital funds)

CAPITAL ADEQUACY IN INDIA

PILLAR 1- MINIMUM CAPITAL REQUIREMENTS

Eligible tier 1 capital funds

RWA- RISK WEIGHTED ASSETS

TOTAL CAPITAL FUNDS = Tier I Capital + Tier II Capital

CAPITAL CHARGE FOR CREDIT RISK

CAPITAL CHARGE OF MARKET RISK

Trading book for the purpose of capital adequacy will include:

i) Securities included under the Held for trading category

CAPITAL CHARGE FOR OPERATIONAL RISK

(i) The Basic Indicator Approach (BIA);

The items are,

PILLAR 2-SUPERVISORY REVIEW

PILLAR 3-MARKET DISCIPLINE

DEPOSIT AND NON-DEPOSIT SOURCES

1. TRANSACTION ACCOUNTS OR PAYMENT DEPOSITS

The Non-deposit sources are as follows,

1. BORROWING FROM CENTRAL BANK

2. CERTIFICATE OF DEPOSITS (CD)

DESIGNING OF DEPOSIT SCHEMES

RECURRING DEPOSIT SCHEME

REINVESTMENT DEPOSIT SCHEME

Maturity Amount = Initial deposit (1+r)n

Where, r= Effective rate = (1+k/m)m -1

FIXED DEPOSIT SCHEMES

GUIDELINES FOR OPENING A DEPOSIT ACCOUNT

TYPES OF DEPOSIT ACCOUNTS

1. "DEMAND DEPOSITS" means a deposit received by the Bank which is withdrawable on

ACCOUNT OPENING AND OPERATION OF DEPOSIT ACCOUNTS

PRICING OF DEPOSIT SERVICES

 Cost Plus Margin Deposit Pricing

 Market Penetration Deposit Pricing

COST PLUS MARGIN DEPOSIT PRICING

MARKET PENETRATION DEPOSIT PRICING

UPSCALE TARGET PRICING

APPLICATION OF BANK FUNDS

 Fluctuation in interest rates give rise to earnings volatility.

INVESTMENT AND LENDING FUNCTIONS