Financial System

Financial System
• The mechanism to enable the smooth transfer of

funds from the savers to the users.
• The channel through which the surplus is

mobilized and routed to the deficit units.
• The main savers are the household sector and the

main users are the corporate sector and the
government sector.
1
Financial System
• The four pillars of the Financial System are -
– Savers.
– Users.
– Financial markets.
– Financial intermediaries.
• Commercial banks are one of the financial intermediaries

operating in the financial system.
• Banks mobilize deposits from the savers and lend to the

users.
2
Savings function.
Role of Financial System
- essentially mobilizing funds.
- ensuring safety, return and liquidity.
• Credit function.
- essentially deployment of funds.
- ensuring the cost, availability and the terms of borrowing.
• Policy function.
- guidelines for smooth transfer of funds.
- operating manual and rule book.
•
Commercial Banking.
The oldest, biggest and the fastest growing financial intermediaries.

The most important depositories of public savings and the most important disbursers of finance.
Banks provide various types of financial services to customers in return for payments.
• The public views the banks as safe and convenient outlet for its savings.
• It facilitates day to day transactions.
• Banks balance profitability with liquidity.
• Banks deal in other people’s money, a substantial portion of which is payable on demand. Hence liquidity management is as important as profitability management.
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Decline in Traditional banking and.
Growth of Modern banking.
Funding loans with deposits was the core business of commercial banking.
A strategy based on this core business has limited growth opportunities.
The erosion of this core business explains the decline of traditional banking.
• For many years regulations and lack of technological developments acted as shelters for commercial banks, providing a protected environment that permitted many of them to exist without diversified portfolios.
• However when the over banked system was opened to competition, the consolidation of banking industry started taking place.
• Because the environment of the Fin. System is dynamic, the traditional banking has declined and to survive, they must adapt to the changing environment.
• Many banks have expanded into other businesses such as investment banking, insurance, mutual funds, data processing and information services.
• The delivery systems of modern banking are becoming more and more electronically based (electronic banking).
• The combination of volatile interest rates, greater competition and technological advancement made interest rate and geographic restrictions obsolete.
• This resulted in the emergence of “universal banking.”
• These narrow and broad views capture the basic distinction between traditional banking and modern banking, which offers greater growth opportunities.
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Challenges to Traditional Banking
New non banking organizations enter the fray
No geographic barriers
The amazing growth of e-banking
• Further delivery channels being launched
• No scope for errors in strategy
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New Trends in Banking
Technological revolution
Disintermediation and securitization
Service proliferation
• Rising competition
• Deregulation
• Rising funding costs and shrinking spreads
• Consolidation and geographic expansion
• Globalization of banking
• Increased risk of failure and the weakness of government deposit insurance systems
• Banking is changing from a seller driven process to a buyer driven process.
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3
Commercial Banking
• The oldest, biggest and the fastest growing financial
intermediaries.
• The most important depositories of public savings and the

most important disbursers of finance.
• Banks provide various types of financial services to

customers in return for payments.
• The public views the banks as safe and convenient outlet for
its savings.
4
Commercial Banking
• It facilitates day to day transactions.
• Banks balance profitability with liquidity.
• Banks deal in other people’s money, a

substantial portion of which is payable on
demand. Hence liquidity management is
as important as profitability management.
5
Decline in Traditional banking
and Growth of modern banking
• Funding loans with deposits was the core
business of commercial banking.
• A strategy based on this core business has

limited growth opportunities.
• The erosion of this core business explains

the decline of traditional banking.
6
• For many years regulations and lack of technological
developments acted as shelters for commercial banks,
providing a protected environment that permitted
many of them to exist without diversified portfolios.
• However when the over banked system was opened to

competition, the consolidation of banking industry
started taking place.
7
• The delivery systems of modern banking are
becoming more and more electronically based
(electronic banking).
• The combination of volatile interest rates, greater

competition and technological advancement made
interest rate and geographic restrictions obsolete.
• This resulted in the emergence of “universal

banking.”
8
• These narrow and broad views capture the
basic distinction between traditional
banking and modern banking, which
offers greater growth opportunities.
9
Challenges to Traditional
banking
• New non banking organizations enter the fray
• No geographic barriers
• The amazing growth of e-banking
• Further delivery channels being launched
• No scope for errors in strategy
10
New trends in banking
• Technological revolution
• Disintermediation and securitization
• Service proliferation
• Rising competition
• Deregulation
• Rising funding costs and shrinking spreads
• Consolidation and geographic expansion
11
New trends in banking
• Globalization of banking
• Increased risk of failure and the weakness
of government deposit insurance systems
• Banking is changing from a seller driven
process to a buyer driven process.
12
Impact of Universal Banking
• Technological revolution
• Better customer service
• Automated Teller Machine
• Plastic money
• Tele banking
• Electronic Funds Transfer
• Anywhere banking
13
Challenges after Universal
Banking
• Prudential Norms
• Capital Adequacy Requirements
• Additional disclosure
• Benchmarking against International
Standards
14
Regulatory Framework
• Reserve Bank of India (RBI)
• Insurance Regulation and Development
Authority (IRDA)
• Securities and Exchange Board of India
(SEBI)
15
RBI
• Established on April 1, 1935 under the
Reserve Bank of India Act, 1934.
• Nationalized in 1948.
• Paid up capital Rs 5 crores
• Managed by a Central Board of directors.
• Four local boards of RBI are at Mumbai,
Calcutta, Delhi and Chennai
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RBI - Constitution
• Managed by a Central Board o Directors.
• Consists of The Governor, Deputy
Governors (not more than 4), appointed by
the Central Government.
• Four Directors nominated by the Central
Government, one from each of the local
Boards.
17
RBI – Constitution (Contd.)
• Ten Directors nominated by the Central
Government.
• One Government official nominated by the Central
Government.
• The local Boards consist of five members
appointed by the Central Government to represent
the territorial and economic interest and the interest
of the co-operative and indigenous banks.
18
Functions of RBI
• Role as a Central banker.
• Role as a Promoter.
• Role as a Regulator.
• While the first two are developmental roles,
the last one is disciplinary role.
19
RBI - Central Banker
• RBI transacts government business.
• RBI issues bank notes.
• RBI acts as the lender of the last resort.
20
RBI – Banker to the Government
• Acts on behalf of the Central and State
Governments.
• Accepts money on their behalf.
• Makes payments for their dues.
• Carries out exchange, remittance and other
banking operations.
• Manages the public debt.
21
RBI – Banker to the Government
(Contd.)
• Maintains the current of the central
government with a minimum balance of Rs
50 crores.
• Responsibility of raising funds for meeting
deficit.
• Issues Treasury bills and Government
securities.
22
RBI – Bank of Issue
• RBI has the sole right to issue currency notes of
various denominations.
• The Issue department of the RBI takes care of
issue, withdrawal, circulation and exchange of
currency of any denomination.
• The issue of coins is taken care of by the GOI, but
coins are circulated by RBI.
• The power of being the Bank of Issue enables RBI
to regulate and control money supply in the
country.
23
RBI – Lender of the Last Resort
• RBI meets directly or indirectly all the
reasonable demands for financial
accommodation from the commercial
banks, discount houses and other credit
institutions.
24
RBI – The Promoter
• Plays a major role in the development of the
country’s financial market place.
• To ensure that there is proper credit allocation to
the various sectors of the economy.
• To remove the imperfections present in the
financial markets by properly developing the
market place and the market players.
• To promote the economic growth by pursuing
appropriate credit and monetary policies.
25
RBI – The Promoter (Contd.)
• Key role in the establishment of various financial

institutions to serve various sectors viz., IDBI,
NABARD, EXIM bank, UTI, etc.
• Key role in the development of the financial
markets viz., the capital market, the foreign
exchange market, the credit market and the money
market.
26
RBI – The Regulator
• To control the overall credit and the price levels in
the economy.
• To maintain the value of rupee.
• To maintain sound and healthy banking system.
• To ensure effective coordination and control over
the credit through appropriate monetary and credit
policies.
• To control the activities of the commercial banks,
NBFCs and the financial institutions.
27
RBI – The Regulator (Contd.)
• Power of RBI to appoint Chairman or MD of a banking
company
• Power of RBI to control advances by banking
companies.
• Licensing of banking companies.
• Restrictions on opening of new and transfer of existing
places of business.
• Inspection
• Power of the RBI to give directions.
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• Powers of RBI to remove managerial and other
powers from office.
• Power of RBI to appoint additional directors.
• Power of RBI to act as the official liquidator.
• Power of RBI to impose penalty.
• Power of RBI to apply to the Govt. for suspension
of business by a banking company and to prepare
a scheme of reconstitution of amalgamation.
29
• Power to influence the volume of credit
through changes in Bank Rate, Open
Market Operations and variable CRR.
30
Merchant Banking
• Defined as financial intermediation that matches the
entities that need capital and those that have capital.
• Merchant banks facilitate the process of the flow of
capital in the market.
• SEBI’s definition – “ a person who is engaged in the
business of issue management either by making
arrangements regarding selling, buying or subscribing to
securities as Manager, Consultant, Advisor or rendering
corporate advisory services in relation to such issue
management.”
31
Merchant Banking Process
Securities
s
e
c
u
Issuer Merchant Banker Investor
Cash 32
Scope of Merchant Banking
Relationship with the investor.
• Plays a vital role in channelising the
financial surplus of the society into
productive investment avenues.
• Fiduciary role in relation to the investor.
• Required to exercise “due diligence” to
ensure the adequacy and appropriateness of
the disclosures made in the offer document.
33
(Contd.)
Relationship with other intermediaries.
• Leader among all the intermediaries
associated with the issue.
• Required to guide and coordinate the
activities of the Registrar to the Issue,
Bankers to the Issue, Advertising agency,
Printers, Underwriters, Brokers, etc.
34
(Contd.)
Relationship with SEBI
• Has to ensure the compliance of all the laws
and regulations governing the securities
market.
• Needs to assist the statutory authorities in
developing a regulatory framework for
orderly growth of capital markets.
35
Relationship of the Merchant
Banker
SEBI
Compliance
framework
Regulatory
Capital Returns
Issuer Merchant Banker
Market Information Protection
Investor
Guidance
Co-ordination
Intermediaries 36
Main areas of MB’s role
Role in Public Issue
• Instrument designing
• Pricing the issue
• Registration of the offer document
• Underwriting support
• Marketing of the issue
• Allotment and refund
• Listing on stock exchanges
37
Main Areas of MB’s Role
(Contd.)
Role in other areas
• Placement and distribution
• Corporate advisory services
• Project advisory services
• Loan syndication
• Venture capital and Mezzanine financing
• Mergers and Acquisitions
• Divestitures
• Takeover defense
• Financial engineering 38
Placement and Distribution
• Institutional
• Retail
39
(Contd.)
Institutional Distribution
• Represents the wholesale reach of the MB.
• Basic requirement to service this segment is the
existence of good in house research facilities to
justify the investment.
• Consists of Mutual Funds, FIIs, Banks, Domestic
and Multilateral Financial Institutions, Private
Equity Funds, Pension Funds, etc.
40
(Contd.)
Retail Distribution
• Reach depends on the networking with the
investors.
• Generally are brokers on the Stock Exchanges.
• Brokers, in turn, appoint sub brokers at various
geographical locations.
• Mainly to service the Primary and Secondary
market needs of the local investors.
• Thus a large base of captive investors is created
and maintained.
41
Distribution Network
• Equity shares • Retail and institutional
• Debt instruments • Retail and institutional
• Mutual fund products • Retail investors
• Fixed deposits • Retail investors
• Insurance products • Retail investors
• Commercial paper • Institutional investors
42
Corporate Advisory Services
• Offering customized solutions.
• Financial structuring (Leveraging).
• Study of working capital practices.
• Refinancing high cost funds with cheaper funds.
• Rehabilitation and Turnover management.
• Revival package.
• Securitisation of receivables.
• Risk management through hedging strategies.
• Deployment of short term funds.
43
Project Advisory Services
• Conceptualizing the project.
• Initial feasibility studies for viability.
• Preparation of the detailed project report.
• Project appraisal services.
44
Loan Syndication
• Analyzing the client’s cash flow patterns.
• Assisting in finalizing the loan parameters like
amount, currency, tenure, draw down, moratorium
and the amortization.
• Assisting in the loan negotiations with the lenders.
• Finalizing the loan syndication.
• Completing the loan documentation procedures.
45
Venture Capital (VC)
• VCs are basically funds providing the seed, start up and
first stage financing.
• Primarily dominated by wealthy individuals & families.
• MB needs to handle the entire deal flow.
• Identifying the VC whose investment policies match his
client.
• Assisting the VC in the due diligence.
• Assisting in the valuation of the company.
• Structuring the terms of the VC investment.
• Follow up advice.
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• Handling the divestment process.
Mezzanine Financing
• Late stage financing.
• The company is usually profitable and has a
business track record.
• The company needs fresh funds without
going for an IPO.
• Funds provided in lieu of going public later.
• Similar to bridge loan against the proceeds
of the proposed IPO.
47
Mergers and Acquisitions
• Understanding the objectives.
• Acquisition search.
• Approaching the target.
• Valuation.
• Negotiation.
• Acquisition finance.
48
Divestitures
• Involve sale of assets or business entities.
• Opportunistic, Forced or Planned.
• Developing sale strategy : negotiated or auction
• Valuation
• Drafting of offer memorandum
• Identifying the potential buyers.
• Negotiations and closing the deal.
49
Takeover Defense
• Increasing the promoter’s stake in the
company
• Comprehensive equity buy back program.
• Corporate restructuring like spin offs.
• Increasing the disclosure levels.
50
Financial Engineering
• “Financial engineering involves design,
development and implementation of
innovative financial instruments and
processes and the formulation of creative
solutions to the problems in finance.”
51
Need for Financial Engineering
• Interest rate volatility.
• Exchange rate volatility.
• Price volatility.
• Regulatory and tax changes.
• Globalization of the markets.
• Increased competition.
52
Factors driving Financial
Engineering
• Reducing transaction costs.
• Reducing agency costs.
• Leveraging tax asymmetries.
• Unbundling and reallocation of risks.
• Enhancing liquidity.
• Overcoming regulatory constraints.
• Technological advances.
53
Intermediaries in the Capital
Market
• Primary Market Intermediaries
• Merchant Bankers.
• Underwriters.
• Bankers to an Issue.
• Portfolio Managers.
• Debenture Trustees.
• Registrars to an Issue
• Share Transfer Agents.
54
Intermediaries in the Capital
Market (Contd.)
• Secondary Market Intermediaries
• Stock brokers
• Sub brokers
55
Regulatory Framework of MB
• Fund based activities – RBI
• Fee based activities – SEBI
• To avoid dual regulations on the operations
of a single entity, a MB is disallowed from
carrying on any business other than those
relating to the securities market.
56
Registration with SEBI
• Is mandatory to carry on the business of MB.
• Compliance norms
• The applicant should be a body corporate.
• The applicant should not carry on any business other than
those connected with the securities market.
• The applicant should have the necessary infrastructure.
• No related company is already registered as MB.
• The applicant should have a minimum net worth of Rs 5
crores.
• No involvement in the securities scam.
• No conviction on any offence. 57
Registration with SEBI (Contd.)
• The registration is granted for a period of 3
years.
• On expiry, MB needs to apply for renewal.
• MB is required to file half yearly returns
with SEBI.
58
Statutory Reserve Requirements
• FIs engage in the activity of financial intermediation by borrowing
and lending funds.
• This is critical in two aspects – macro level, micro level.
• At the macro level, the operations of these institutions affect the
debt capital available to the industry.
• This credit operations may lead to surplus money position or
shortfall in the same.
• While surplus situation will lead to decline in interest rates, a tight
money position will lead to rising interest rate scenario.
• The economy will like to have a well adjusted monetary position
where the demand and supply are in equilibrium.
59
Statutory Reserve
Requirements(Contd.)
• At the micro level, the operations need to ensure
profitability and adequate liquidity.
• Trade off between the profitability and liquidity.
• Excess profitability at the cost of liquidity will lead
to an enhanced level of liquidity risk affecting the
long term viability.
• Excess liquidity may affect the profitability of the
institutions, as the cost of idle funds will eat into its
profits.
• FIs prefer to follow tight liquidity position instead
of holding idle funds. 60
Need for Statutory Reserves
• Areas of concern : liquidity position and repayment ability.
• Concern in these two areas will send wrong signals in the
financial market.
• To avoid such wrong signals and to protect the interests of
the investing public, it is essential to prevent the FI from
over exposing itself.
• While the internal risk management policy ensures long
term viability by managing the risk exposure levels, the
central bank (RBI) takes steps to control the overall credits
operations of the FIs.
• One of the frequently used control measure is the reserve
requirement.
61
Statutory Reserves
• All financial institutions, which are into lending
and investment operations, need to maintain a
specified amount of reserves as cash / bank
balances with the central and other banks and
investments in approved securities.
• All such reserves that are to be maintained as a
legal requirement are referred to as Primary
Reserves.
62
Statutory Reserves (Contd.)
• In India, the legal reserve requirements fall
into the following two categories :
• Cash Reserve Ratio (CRR)
• Statutory Liquidity Ratio (SLR)
• These two measures together try to ensure
adequate liquidity and a balanced monetary
position in the system.
63
• CRR brings about the changes in the monetary
position since the reserves are in the form of cash.
• The aim of SLR is two fold :
• It provides profitability while ensuring liquidity,
since the reserves are in the form of investments n
government securities earning interest.
• The statutory investments made in approved
government securities ease the government’s
borrowing program.
64
• No standard absolute amount can be fixed.
• Percentage level to be maintained on a
common parameter.
• The common parameter is the Net Demand
and Time Liabilities (NDTL).
65
CRR
• The statute governing the CRR requires every
bank to maintain to maintain an average daily
balance with the RBI.
• CRR is to be maintained at the rate of 3% of the
NDTL.
• The minimum and maximum levels of CRR are to
be 3% and 15% respectively of the NDTL.
• CRR is varied primarily to influence the money
supply.
• The present CRR is at 4.75% since Oct, 2002 and
was reduced to this level from 11% in Aug,1998. 66
CRR (Contd.)
• CRR is to be maintained as higher of the
following two alternatives :
a) 3% of NDTL.
b) Prevailing % as announced by RBI of the
Reservable Liabilities.
• The cash reserve requirement so
computed will have a maintenance period
of a fortnight.
67
Exempted Liabilities and
Liabilities with differential CRR
• The NDTL of a bank has a few liabilities that are exempted
/ given a differential treatment for the maintenance of the
CRR.
• All inter bank liabilities are exempted from the
maintenance of the CRR.
• Some liabilities exempted / given a differential rate for
CRR maintenance are :
1) Non resident deposits
- FCNR, FCON, NRNR, NRE
68
Exempted Liabilities and
Liabilities with differential CRR
2) Other deposit schemes
- Exchange Earners Foreign Currency account
- Residential Foreign Currency account
- Packing Credit Foreign Currency account
- Escrow account by Indian Exporter
- Foreign Currency account opened by Indian Exporter
- Borrowing in foreign currency by foreign banks from HO
- Inter bank Foreign Currency deposits
69
Constituents of Cash Reserve
• The CR will be maintained by deploying funds
into certain approved assets.
• These approved assets include deposits with the
RBI and cash balances in the currency chest.
• Currency chest is a representative office of RBI
and hence cash deposited with the currency chest
is deemed to have been deposited with the RBI.
• However, the currency chest is maintained by the
bank itself.
70
Maintenance Period
• The banks should maintain the reserve for a period of
fortnight.
• The maintenance period commences from the day
immediately following the Reporting Friday.
• The banks are given the flexibility of maintaining reserves
on an average basis.
• The banks are required to maintain a minimum of 80% of
CRR requirement on a daily basis during the first 13 days.
• The last day of the maintenance period i.e. on the 14th day
of the fortnight, there is no restrictive level and the banks
can maintain any amount according to the requirement on
71
that day.
Yields and Penalties
• An yield of 4% is paid by RBI on the CRR
maintained over and above the 3% of NDTL (the
statutory limit).
• This yield is payable on a monthly basis provided
there is no default in the maintenance of the CRR.
• No yield is paid on excess reserves maintained.
• The respective bank can earn on the excess
reserves by disposing it off in the money market at
attractive rates.
• Alternately, the excess CR can be adjusted towards
SLR maintenance. 72
Yields and Penalties (Contd.)
• When the banks fail to maintain the minimum
CRR requirement during the first 13 days of the
fortnight, it will lose interest on the amount of
CRR maintained on that day.
• When the banks fail to meet the total reserve
requirement for the fortnight, it will attract a penal
interest @25% p.a on the shortfall and also lose
interest on the amount of shortfall.
• If the banks default in both the cases, both the
penalties will apply.
73
Statutory Liquidity Ratio (SLR)
• Objectives of SLR.
1) To enhance further liquidity.
2) To control money supply for credit
purpose.
3) To augment banks’ investments in
government securities.
4) To ensure solvency of banks.
74
SLR ( Contd. )
• SLR is to be maintained as higher of the following two
alternatives :
a) 3% of NDTL.
b) Prevailing % as announced by RBI of the Reservable
Liabilities.
• SLR will be at a minimum level of 25% and maximum
of 40% of the NDTL.
• The SLR requirement so computed will have a
maintenance period of a fortnight.
• The prevailing % as announced by RBI is 25%.
75
Constituents of SLR
• All banks will have to maintain SLR in the form of –
1) Cash, or
2) Gold valued at a price not exceeding the current market
price, or
3) In unencumbered approved securities valued at a price
determined, or
4) In the form of net balances in current accounts maintained
in India with the nationalized banks and RBI (excluding
the balances maintained for CRR purposes).
76
Maintenance Period
• SLR is to be maintained for a period of a fortnight.
• It will be assessed based on the NDTL of the Reporting
Friday of the preceding fortnight.
• Since the NDTL is known ahead, SLR is assessed on
actual figure.
• Unlike CRR, 100% of SLR is to be maintained on a daily
basis.
• There is no flexibility offered in the maintenance of SLR.
77
Yields and Penalties
• SLR earns a better interest than CRR mainly due to the
assets that comprise such reserves.
• The securities earn the prevalent market rates and the gold
fetches the current market price.
• Shortfall in SLR will attract a penal interest of 3% p.a.
above the Bank Rate on the shortfall on the day of default
and if the default continues for the next working day, it
will be increased to 5% p.a. above the Bank Rate on the
shortfall of all the defaulted days.
78
Asset-Liability Management
(ALM)
• ALM is concerned with strategic balance sheet
management involving the management of risks
caused by changes in the interest rates, exchange
rates and the liquidity position of the bank.
• Also covers management of credit risk and
contingency risk.
• Impact on the assets (uses of funds) and the
liabilities (sources of funds).
79
Why ALM?
• Volatility
• Product innovations
• Regulatory environment
• Enhanced awareness of top management
80
Why ALM? (Contd.)
• Volatility
1) Free and market-driven economies.
2) Globalising the operations.
3) Deregulation in the financial markets.
4) Vagaries in interest rate structures, money
supply, credit position, exchange rates and price
levels.
5) Reflects on the market value, yields/costs of the
assets/liabilities.
81
Why ALM? (Contd.)
• Product innovations.
1) Rapid innovations in the financial products.
2) Increased risk exposure.
3) For example, fixed deposit vs flexi deposit.
4) Asset liability mismatch.
5) Liquidity risk and interest rate risk
82
Why ALM? (Contd.)
• Regulatory environment.
1) Integration of domestic with international markets.
2) Measures to prevent losses arising due to market
vagaries.
3) RBI instructions on risk based capital maintenance.
4) BIS provides a framework for the banks to tackle the
market risks arising due to rate fluctuations and
excessive credit risk.
83
Why ALM? (Contd.)
• Management Recognition.
1) Awareness of the impact on the assets and
liabilities
2) Independent network for a good asset base
and credit disbursement is not sufficient.
3) Relating and linking of the asset side with
the liability side is essential.
84
Purpose of ALM
• It is not a stand-alone function, but part of the
“corporate planning strategy”.
• Macro level objective of ALM – leads to the
formulation of critical business policies, efficient
allocation of capital and designing of products with
appropriate pricing strategies.
• Micro level objectives of ALM are two-fold –
1) Aims at profitability through price matching.
2) Ensuring liquidity through maturity matching.
85
Purpose of ALM(Contd.)
• Price matching aims to maintain spreads by ensuring
that the deployment of liabilities will be at a rate
higher than the costs.
• Grouping the assets/liabilities based on their
maturing profiles ensures liquidity.
• Hence risk management approaches for ALM can
not be uni-dimensional, but to be managed
collectively.
• The purpose of ALM is, thus, to enhance the asset
quality, quantify the risks associated with assets and
liabilities and manage them.
86
Purpose of ALM(Contd.)
• Review the interest structure and compare the same to
the interest/product pricing of both assets and
liabilities.
• Examine the loan and the investment portfolio in the
light of foreign exchange risk and liquidity risk.
• Examine the probability of the credit risk and the
contingency risk that may rise due to rate fluctuations.
• Review the actual performance against the projections
made and analyze the reasons for any effect on the
spreads.
87
Target areas of ALM
• Net Interest Income (NII) : the impact of volatility in
short term profits is measured by NII.
• Market Value of Equity (MVE) : the long term profits of
the bank. It has to minimize the adverse movements in
this value. In case of unlisted banks, the MVE will be the
difference between the market value of assets and
liabilities.
• Economic Equity Ratio: the ratio of the shareholders
funds to the total assets measures the ratio of owned
funds to the total funds. This assesses the sustenance
capacity of the bank.
88
Risks in Banking
• Interest rate risk
• Foreign currency risk / currency risk
• Liquidity risk
• Credit risk
• Contingency risk
89
Risks in Banking
• Interest rate risk : when the income is sensitive to the interest
fluctuations.
• Currency risk : due to unanticipated changes in exchange rates.
• Liquidity risk : when there is a mismatch in the maturity pattern of the
assets and liabilities.
• Credit risk : the possibility of a default in the repayment obligations.
• Contingency risk : the off-balance sheet items like guarantees, L/Cs,
underwriting commitments,etc give rise to the contingency risk.
90
Approaches to risk management
• Avoidance
• Loss control
• Separation
• Combination
• Transfer
91
Approaches to risk management
(Contd.)
• Avoidance : not holding the risk bearing the asset/liability.
• Loss control : where the loss can not be avoided – eg.,insurance, introduction
of systems and procedures, internal and external audit, etc.
• Separation : spreading out the assets/liabilities. – eg., instead of having a
network in only one state, spreading the branches in many.
• Combination : not putting all eggs in one basket – multiple lending, multiple
suppliers of raw materials, well diversified portfolio.
• Transfer :
1) transfer of asset/liability – shifting to another currency.
2 )transferring the risk only – forward contract, swaps.
3)transferring the risk to a third party – insurance.
92
Risk Management Process
• Risk management is not risk avoidance, but bringing the risk
levels to manageable proportions. Process involves -
• Identification of risks.
• Quantification of the level of exposures.
• Policy formulation.
• Engineering a strategy to transform the exposures to a desired
form.
• Monitoring the risk levels and restoring them to the standards
set.
93
(Contd.)
• Identification :
1) understanding the activities originating the risks.
2) Evaluating the aspects relating to the magnitude of the risks.
3) The tenor and the implications they have on the accounting
aspects.
• Quantification of risks :
1) Measuring the risks.
2) Quantifying the consequences of the decisions taken.
3) Based on the information available and the reporting system
followed.
4) Crucial role is played by technology and MIS.
94
(Contd.)
• Policy formulation :
1) Setting the standard level of exposures to protect the
cash flows.
2) Policy is a long term framework to tackle risk.
3) Depends on the bank’s objectives and its risk tolerance
levels.
• Strategy formulation :
1) A strategy is developed to implement a policy.
2) It will be for a shorter period.
3) It will state the instruments that are to be used to
manage the risks.
95
(Contd.)
• Monitoring the risks :
1) Risk profile is not static.
2) Volatile circumstances will change the
risk levels.
3) Hence constant monitoring and follow up
strategies are required.
96
ALM Process
• The ALM Process rests on three pillars –
• ALM information systems.
- Management Information System.
- Information availability, accuracy, adequacy and expediency.
• ALM Organization.
- structure and responsibilities.
- level of top management involvement.
• ALM Process.
- Risk parameters.
- Risk identification.
- Risk measurement.
- Risk management. 97
NPA Management
• Definition of NPA.
• Income recognition.
• Classification of assets.
• Provisioning norms.
• Capital adequacy.
98
Definition of NPA
• An asset is termed as a non-performing
asset (NPA) when it ceases to yield income.
99
Classification of assets
• Standard assets.
• Sub-standard assets.
• Doubtful assets.
• Loss assets.
100
Standard assets
• This will include all loans and advances –
1) which are not NPAs on the balance sheet date ;
2) which are not perceived to default in repayment of
principal or payment of interest.
• All the above loans and advances where the terms of the
loan agreement regarding amortization (payment of
interest and principal) have been re-negotiated or
rescheduled after inception of the loan agreement should
not be classified as sub-standard, provided the loan is
fully secured and loss of interest in present value terms,
if any, is fully written or provided for.
101
Sub-standard assets
• All loans and advances which have remained as
NPAs for a period less than or equal to 12 months
will be classified as sub-standard assets.
• All the above loans and advances where the terms of
the loan agreement regarding amortization (payment
of interest and principal) have been re-negotiated or
rescheduled after inception of the loan agreement
should be classified as sub-standard.
• Such loans and advances will remain in such
category for at least 12 months of satisfactory
performance under the re-negotiated or re-scheduled
terms. 102
Doubtful assets
• Loans and advances which have remained
as NPAs for a period of 12 months.
• These loans and advances have credit
weaknesses that make collection or
liquidation in full, on the basis of current
conditions, highly questionable or
improbable.
103
Loss assets
• Loans and advances which have been
identified as “irrecoverable”, but the
amount has not been written off, wholly or
partly.
104
Provisioning norms
• On sub-standard assets : provision of 10% of the total
outstandings should be made.
• On doubtful assets :
1) 100% provision to the extent to which the advance is not
covered by the realizable value of the security to be
made.
2) Over and above the provision in (1), depending upon the
period for which the asset has remained doubtful,
provision to the extent of 20% to 50% of the secured
portion is to be made.
• On loss assets : the entire asset should be written off. If
the assets are permitted to remain in the books for any
reason, 100% of the outstandings must be provided for. 105
Capital adequacy
• Capital adequacy means having a minimum “capital”
of 8% of the “risk weighted” assets and off-balance
sheet items.
• “Capital” includes all those sources of finance which
can be relied upon as a cushion against unexpected
losses.
• Some sources of finance are more reliable and
permanent than others. Hence a distinction between
“core capital” (Tier I capital) and non-core capital (Tier
II capital).
• Capital adequacy norms provide a detailed framework
for calculating capital and the risk weighted assets. 106
Risk weightages
• Asset Risk weights(%)

• Cash and bank balances 0
(including FDs,CDs with banks)
• Investments in G secs & other 0
approved securities
• Current assets
- stock on hire (net of finance charges) 100
107
Risk weightages (Contd.)
- Inter corporate loans / deposits 100
- Loans & advances fully secured 0
- Loans to staff 0
- Other secured loans & advances 100
considered good
- Bills purchased / discounted 100
- Others to be specified 100
108
• Fixed Assets (net of depreciation)
- Assets leased out 100
- Assets for own use 100
(including premises)
- Furniture and fixtures 100
109
• Other assets
- Income tax deducted at sources 0
- Advance tax paid (net of provision) 0
- Interest due on Govt securities 0
- Others to be specified 100
110
• While assigning risk weightages to assets
which have not been specified above, it
must be noted that assets which have been
deducted from own funds to arrive at net
owned funds will have a weightage of 0
while the other assets will carry a weightage
of 100.
111
• For off-balance sheet exposures
• The first step is to determine the credit risk
exposures using conversion factors.
• The credit risk exposures are then given a risk
weightage of 100%.
• They are then added to the total of the balance
sheet risk weighted assets for the purpose of
capital adequacy.
112
• Off balance sheet conv.factor risk weights
items (%) (%)
- Gurantees 100 100
- Underwriting 50 100
- Partly paid up shares 100 100
- Lease contracts entered,
to be executed 100 100
- Bills discounted 100 100
- Other contingent liabilities
to be specified 50 100
113
Capital adequacy
• The minimum capital adequacy norm of
9% is to be maintained with Tier I & II
composite capital.
114
Management of Deposits
• Deposits form the primary raw material for a bank.
• They typically have a lower interest cost than the
other types of funds.
• They are broadly classified as Transaction
accounts and Non Transaction accounts.
• Transaction accounts cover the Current account
and the Savings account.
• Non Transaction accounts cover the Term deposits
viz., Fixed deposits, Recurring deposits and
Reinvestment scheme.
115
Management of Deposits
(Contd.)
• The Current account does not carry any rate of
interest. The Savings account offer 4% interest.
The Term deposit interest rates are announced
from time to time.
• Current account and Savings account are referred
to as Demand Deposits / Liabilities as they can be
withdrawn any time. As withdrawal of term
deposits is time bound, they are termed as Time
Deposits / Liabilities.
• Banks aim at more deposits, as they cost them less.
116
Types of Bank Deposits
• Differentiation in deposit types may arise
from the type of customer who holds the
deposit nature, tenor of the deposit, nature
and the interest factor.
• Broad classification :
- Transaction account.
- Non transaction account.
117
Types of Bank Deposits (Contd.)
• Transaction account : a deposit which
facilitates the account holder the use of a
negotiable or transferable instrument,
cheque, a written order of withdrawal, a
telephone order to transfer funds, or other
similar means of making payments and
transferring monies to third parties is known
as a transaction account. Viz., savings
account and current account. 118
• Non Transaction account : when the
deposit account does not facilitate routine
payments or transfer of funds for other
transaction purposes, it will be known as non
transaction account. Viz., term deposit
account.
119
Current account :
• these are transaction accounts offered to business
firms.
• The ease which the firm have in depositing and
withdrawing funds from this account facilitates
cash management for the firms.
• There is no requirement of advance notice to
withdraw the amount.
• Being an operating account, amount can be
withdrawn using cheque facility.
120
• The banks require the account holder to maintain a
minimum balance continuously.
• Depending on the credibility of the customers, banks
allow overdraft facility to the current account holders.
• As the account enables easy liquidity, this account does
not earn any interest.
• Although these accounts are non interest bearing liabilities
of the bank, they are not expense free as they generate
processing costs. To cover this, banks usually collect
service charges related to account activity.
121
Savings Bank account
• Non business accounts.
• Operating accounts are also necessary for individuals,
trusts, non-profit organizations.
• Fewer transactions compared to companies.
• Facilitates liquidity.
• Maintenance of minimum balance.
• Penalty for shortfall in minimum balance.
• These accounts pay interest to the accountholders.
• Interest rates as prescribed by RBI.
122
Term Deposits
• Unlike the transactional deposits, the term deposits
do not facilitate transactions.
• Deposit types based on one time deposit or over a
period of time, whether the interest is compounded
or withdrawn at regular intervals.
• Types : Fixed deposit scheme.
Reinvestment scheme.
Cash certificates.
Recurring deposit scheme. 123
Fixed Deposit :
• A lump sum is deposited for a fixed period
during which time the amount can not be
withdrawn.
• The interest is paid on a monthly/quarterly/
half yearly/annual basis.
• This provides liquidity to the depositor.
124
Reinvestment Scheme :
• A lump sum is accepted for a fixed period and
repaid with interest on maturity.
• Interest on deposit is reinvested periodically by the
bank and hence there will be interest on interest.
• The depositor can withdraw the principal and the
interest at the end of the fixed period.
• Premature withdrawal will cause loss of interest.
125
Cash Certificates
• Odd sums are accepted for a fixed period to pay
whole sums at the time of maturity.
• This deposit is a type of reinvestment deposit.
• The amount that is deposited initially will be the
issue price of the cash certificate and this will be
arrived at based on the maturity amount i.e. the
face value of the cash certificate and the tenor of
the deposit.
• The depositor chooses the face value and the tenor.
126
Recurring Deposit Scheme
• A fixed sum is deposited every month for a
fixed period.
• At the end of the period, the depositor will
be paid the total of the deposit installments
with interest.
127
Deposits for senior citizens
• Age proof above 60 years.
• Higher than the prescribed interest rate.
• Waiver of some charges.
128
Loan Management
Lending function
• The major component of the assets side of
the balance sheet are Loans and Advances.
• Lending the mainstay for banking.
• The lending function should add value to
the bank.
• Banks should essentially try to balance their
spreads and the risk levels.
129
Loan Management (Contd.)
• The need for credit arises on two counts. From the
consumers for acquiring consumer durables and from
the corporate, for manufacturing, trading and services.
• Loans can be in the form of Installment credit,
Operating credit, Receivables finance, Bill finance, etc.
• Under Installment credit, with the transfer of
ownership, the repayment can be stretched over a
period of time.
• Operating credit is in the nature of a running account
and can be operated freely within the sanctioned limit.
• Under Receivables/Bill finance, credit is extended
against book debts/debtors. 130
• Loans can be Secured or Unsecured.
• Under Secured credit, immovables are
secured by way of mortgage.
• Movables are secured by way of pledge,
hypothecation, banker’s lien.
131
Loan Policy
• The Loan Policy provides a framework for bank lending.
• The loan policy relates to the amount of credit to be
extended, the industries to be focused on, the geographic
spread, the type of credit to offer, the type proposals to
finance, the disbursal mechanism, the amount of security
& collateral, the pricing method, the repayment schedule,
the monitoring process, etc.
• The top management sets the standards for the above.
132
• Standards relate to exposure limits, credit quality of the
borrower, lending rate and the risk level.
• The set standards help better decision making at the
ground level.
• A policy document which details all these areas is the
Loan Policy of the bank.
• The issues covered in the Loan Policy will be –
Objectives of the loan, their volume and mix, evaluation
procedure, industry prospects and exposure levels, loan
administration, lending rates, etc.
133
• The Loan Policy should aim at being
contemporary.
• It should establish the credit culture of the
bank culture.
• It should be revised now and then in tune
with the times.
134
Loan Pricing
• The primary activity of the bank being lending,
the deployment should be at a rate that covers the
cost of funds and leaves a margin to the lender
after meeting the expenses.
• The margin should also cover the risks a bank is
exposed to.
• The pricing policy should aim at profitability as
well higher volumes.
135
• The main objectives of Loan Pricing are –
- Maintaining margins.
- Balancing risk - reward profile.
- Ensuring market rates.
• The margins ensure profits, the balanced
risk-reward profile ensures sustenance and
the market rate ensures the bank’s presence
in the market.
136
• Rates of interest charged by the banks could
be either fixed or floating.
• In the fixed rate loans, the fluctuations in the
interest rates will not affect the loan once the
loan agreement is signed.
• In the floating rate loans, the fluctuations are
passed on to the borrower even after the loan
agreement is signed, subject to certain
periodicity.
137
• A bench mark rate which becomes the basis
for banks to charge interest is the Prime
Lending Rate (PLR).
• For customers with greater risk, the interest
rate will be charged as a mark up on the
PLR.
• The role of pricing is not merely earning a
return. It also has the role of being used as a
tool for Risk Management.
138
Liquidity Management
• Liquidity needs arise from the cash outflows
and the withdrawals.
• Most withdrawals are predictable as they are
either contractually based or follow a well
defined pattern.
• Certain outflows are unpredictable like
maturing deposits.
• This uncertainty increases the risk of
liquidity management.
139
Liquidity Management (Contd.)
• Cash assets do not earn any income in the form of
interest and hence the entire allocation of funds is an
opportunity loss from the bank.
• Cash assets are vault cash, demand deposit balances at
central bank, demand deposit balances with FIs and
cash items in the process of collection.
• Since cash assets do not generate interest income, banks
prefer to keep the minimum cash assets in the system
without creating transactional problems.
140
• Liquidity management refers to its capacity to
acquire immediately available funds at a reasonable
price.
• A bank an acquire liquidity in three distinct ways :
- selling assets.
- new borrowings.
- new stock issues.
• Banks must be able to estimate liquidity needs
accurately and structure its portfolio to meet the
anticipated needs.
• Cash management is an important aspect in the 141
liquidity management of a bank.
• Liquidity vs. Profitability.
• Short run trade off exists between liquidity
and profitability.
• Other things remaining constant, the more
liquid a bank, the lower its return on equity
and return on assets.
• Both asset and liability liquidity contribute
to this relationship.
142
• Facts about liquidity of a bank –
- The more liquid a bank, the less profitable a
bank.
- Liquid assets earn less than illiquid assets.
- The shorter the maturity, the lower the yield.
- The highest yielding loans are loans with the
highest default or interest rate risk and are
therefore the least liquid.
143
• Asset liability is influenced by the composition
and maturity of funds viz., the ease with which a
bank can convert assets to cash with minimum
loss.
• The higher the quality of the bank’s assets, the
lower will be the rate on new liabilities issued to
meet the liquidity needs.
• Liability liquidity is measured by a bank’s ability
to obtain core deposits and funds at cost effective
rates that are diversified with respect to markets
and maturities. 144
• Asset liquidity measures the most liquid assets,
which have short maturity periods and are highly
marketable.
• Liquidity measures in general are expressed in
percentage terms as a fraction of total assets.
• The most marketable assets exhibit low default
risk, short maturities and large trading volume in
the secondary market.
145
• Liability liquidity measures the ease with which a
bank can issue new debt at reasonable cost.
• It measures a bank’s capital base and composition
of outstanding deposits and other liabilities.
• A bank’s ability to borrow from the market at
reasonable rates of interest is closely linked to the
market’s perception of its asset quality.
• Banks with high quality assets and a large capital
base can issue more debt at relatively lower rates.
146
• Liquidity, which is represented by the quality and
marketability of its assets and liabilities, exposes
the bank to liquidity risk.
• A bank generally tries to eliminate liquidity risk.
• The core activity of a bank is to attain profitability
through fund management viz., acquisition and
deployment of financial resources.
• An intricate part of the fund management is
Liquidity management.
147
• Liquidity management relates primarily to the
dependability of cash flows, both inflows and outflows
and the ability of the bank to meet maturing liabilities
and customer demands for cash within the basic pricing
policy framework.
• Liquidity risk originates from the potential inability of
the bank to generate cash to cope with the decline in
liabilities or increase in assets.
• A bank should continuously monitor its liquidity
position in the long run and on a day to day basis.
148
• Two methods to eliminate liquidity risk –
- Fundamental approach.
- Technical approach.
149
• Fundamental approach.
• Long run sustenance is the driving factor in this
approach.
• This tries to eliminate the liquidity risk in the long
run by controlling its asset liability position.
• To control the liquidity exposure through Asset
Management and Liability Management.
150
• Asset Management aims to eliminate liquidity
risk by holding near cash assets.
• When Asset management is resorted to, the
liquidity requirements are generally met from
primary and secondary reserves.
• Primary reserves are CRR and SLR reserves.
• Secondary reserves take the form of unsecured
marketable securities.
151
• Liability management focuses on the sources of
funds.
• No surplus funds are maintained, but the required
liquidity is achieved by borrowing funds when the
need arises.
• A proposal may be passed even when there is no
surplus balance since the bank intends to raise the
required funds from external sources.
152
• Technical approach.
• Technical approach focuses on the liquidity
position of the bank in the short run.
• Liquidity in the short run is primarily linked
to the cash flows arising due to the
operational transactions.
• Two methods – Working Funds approach,
Cash Flows approach.
153
• Working Funds approach concentrates on
the actual cash position and depending on the
actual position, the liquidity requirement is
assessed.
• Cash Flows approach goes a step forward
and forecasts the cash flows viz., estimates
any change in the deposits / withdrawals /
credit accommodation, etc.
154

Financial System

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Financial System

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Financial System

• The mechanism to enable the smooth transfer of

• The channel through which the surplus is

• The main savers are the household sector and the

• Commercial banks are one of the financial intermediaries

• Banks mobilize deposits from the savers and lend to the

The oldest, biggest and the fastest growing financial intermediaries.

• The most important depositories of public savings and the

• Banks provide various types of financial services to

• Banks balance profitability with liquidity.

• Banks deal in other people’s money, a

• A strategy based on this core business has

• The erosion of this core business explains

• However when the over banked system was opened to

• The combination of volatile interest rates, greater

• This resulted in the emergence of “universal

• The amazing growth of e-banking

• Further delivery channels being launched

• No scope for errors in strategy

• Key role in the establishment of various financial

3)transferring the risk to a third party – insurance.

• Asset Risk weights(%)

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