Class 11 & 12

Class 11 & 12

Exposure Norms for Bank

Do not put all eggs in one box

Exposure – Bank has commitment (fund / non-fund / agent exposure) towards customer

ü Avoid concentration of credit (at a particular industry)

ü Individual (Telco) / Group borrower (Tata) (wrt corporate – See the exposure to a group as a whole)

NBFCs

ü Non banking financial corporations

ü Banks can give loans (lend) to NBFCs and can invest in NBFCs

ü NBFC is a financial institution

ü Supplementing the role of a bank

ü Since, many NBFCs failed in the last 10-12 years period, hence, from now on, they need capital adequacy of 12%.

ü NBFCs can’t lend at a rate above what is prescribed by RBI

ü Role –

§ Lending

§ Holding company – Hold shares of its own group company

§ Investment company – invests in shares (buys & sells)

§ Holding cum investment

§ Asset financing company – lending against Long term liabilities

§ Example – Commercial vehicle loan, leasing, financing

Grant – Consumption finance. Bank doesn’t give grant, it gives loans

Lending Method

· Consocium

§ A permanent central lender arranges for loan from many banks

§ The central bank is called the lead bank who evaluates the total loan portfolio & decides how much loan portfolio to be distributed to each participating bank & type of security to be given by the company

· Multi-banking

§ Borrower takes loans from many banks without a lead bank

· Syndication

§ Only initial arrangement of finance

Real Estate –

§ Problem with price speculation – Buy & Sell land

§ Real estate development – Township development. Banks are allowed to fund real estate development and not real estate. It should not exceed 10% of total portfolio

§ Equity investment in real estate is not more than 5%

Bridge loan – Temporary short term loan to finance long term projects

Class 9 & 10

Class 9 & 10

Retail Banking (Individual Banking) - Comparatively high transaction cost & lower risk than corporate banking (Banks hence take high risk in corporate & distribute in retail)

A person more than 182 outside India is considered as NRI

Liability segment / product

· Resident Segment

ü Demand Liabilities – Minors savings bank account

ü Time Liabilities – Education deposit, Piggy bank deposit

· Non-resident segment

ü Can hold currency in foreign denomination

ü Factors under consideration – Exchange Rate, Interest Rate, Duration of Deposit, Implication of Tax

Repatriability – With-drawl of funds at free will at any point in time

FCNR – Foreign currency non-residential deposit – Minimum 1 year to maximum of 3 years. One can maintain USD account though earning in SGD.

Now students are also considered / classified as non-residents to avail loans in foreign currency

Other banking products –

· Mutual Funds

· Insurance Sales

· Investment advice

ü Portfolio Management – Mandate given in favor of bank to transact on behalf of customer

· NRI Services

· Bill Payment Services

· Depository Services

ü Demat Account, Safe deposit vault

Why Exchange rate – For Price discovery & stability of prices

In commodities, only profit is traded (which normally pushes the prices up)

Retail Assets Group

· Product Team

ü Programs

ü Pricing

· Marketing Team

· Credit Risk Team

ü 5Cs

§ Character

§ Capacity

§ Capital

§ Collateral

§ Cash Flow

· Acquisition Team (Under-writer)

· Operation

· Collection

· RCU

ü Example – De-flagging of salary account

Class 8

Class 8

Corporate Banking = Whole-Sale Banking = Company Finance = Suits the demand of a specific customer which is corporate here

Operating cycle for a manufacturing company is more than the service company

Working Capital – Fund to finance Current asset requirement

Trade Finance –

· Domestic – Only affected by domestic interest rates

· Export Oriented – Exports are supported by reduced interest rates for lending

Bill discounting – Foreign bank giving loan to their country’s company

Buyer’s Credit – Domestic bank giving loan to foreign company

High Contingent liability attracts further Capital

Fund Based Services - Working Capital Finance

Line of Credit

1. OD (Over-Draft)

a. Can / Can’t be secured

b. Types

i. Clean OD

1. Except signed promissory note of customer

2. Example – To pay advance tax

ii. Collateralized OD

2. Cash Credit

a. Fully secured by merchandize. Stocks / goods, WIP, finished goods as security

b. Inventory can be drawn after payment to the bank

3. Bill Finance

a. Sale on credit becomes receivable. Bank gives loans on such bills which act as collaterals

b. Bill of Exchange – Unconditional order, made by drawer to pay a certain sum of money to payee in advance

Diversion

· Short term current liabilities is used to build long term asset

· Amount given for long term assets used for Working Capital requirement

Bill of exchange (BOE) – Self liquidating investment

· Demand BOE – Payable on demand

ü Clean Demand BOE. Example - Cheque

ü Documentary Demand BOE. Example – As and when amount is paid, shipping documents are handed over.

· Usance BOE – Payment takes place after sometime

ü Clean BOE – Example – Hundi (Merchant lend among themselves without documents)

ü Documentary BOE – Example

§ Delivery of documents given without payment (high credit worthiness of buyer)

§ Delivery against payment

Bill Purchase – For Demand bill

Bill Discounted – For usance bill

Other Services offered by Bank

Non Fund based facility - It is one where there is no direct immediate involvement of fund (unlike loan). Example – Letter of credit, bank guarantee.

Payment & settlement system act – RTGS can take place across border; administered by central banks. Debit and credit of bank accounts by RBI on real time basis; no refund is allowed. Must have a minimum quantum to be transferred

Example – Purchase center immediately receives money from different shops across country.

CMS (Cash Management Services) – Example – Salary Credit (where cash is required)

Channel Financing / Supplier or vendor financing – Based on creditworthiness of the firm, banks finances the vendors of the business firm. Example - P&G

Money Market Desk – Credit balance in over-draft account is passed on to buy T-bills (by banks) for 3 days to earn interest for corporate. Also, banks float commercial papers of corporate and in turn, get money for them

Employee Trust – ESOPS given to trust, who then pass on to eligible employees.

Cash Surplus Corporate – Excess cash with corporate (in OD account) are deposited in overnight deposit

Tax Collection – Banks collects tax on behalf of government

Class 7

Class 7

Basal – A place near Zurich (Swiss) – Famous for chocolates. Many Pharmaceutical industries are located in Basal.

BIS - Bank for international settlement in Basal – Set up by Central banks of G-13 countries to facilitate settlement between Central Banks and to manage surplus in the banks.

Gold can be securitized (in London & basal Market – Highest liquidity for gold) to facilitate currency

As per Indian laws, not more than 15% of country’s gold can be outside India.

Core principle of banking supervision – 1^st set of principles to monitor banking system, voluntary in nature

RAROC – Capital left after incorporating losses – Risk adjusted return on capital

Steps in RAROC –

· Risk Event

ü Probability of risk occurrence

ü Risk event drivers

· Impact

ü Probability of Impact

ü Impact Drivers

· Losses

BASAL 1 – 1988 to 1992

1. If advances made by bank is sick, implies bank is sick

2. It only considers Credit risk & Market Risk

a. Credit Risk – Looks at if advances are realizable or not

b. Market Risk – It is because of changes in interest rates (yields)

3. Risk adjusted Ratio is 8%

a. Capital > (8% max) * Risk Weighted Asset (or RWA)

b. It means bank’s own equity in risk weighted asset is maximum of 8%

Shortcomings –

Reputation Risk was not covered. Example – Lehman brothers failed as everyone invested in it because of its reputation

1996-1998 – Received feedback that Market Risk is applied only to trading book (treasury books only) and not to entire position (like foreign exchange book)

(Available Capital / RWA) *100% >= 8%

BASAL 2

Concept of Operational Risk brought in BASAL 2. Example – Barings Bank Case – Risk of Process Failure

Types of Operational Risk –

· External Risk – Example - BPO outside country

· Internal Risk – Example - Strike of unions

New definition of Regulatory Capital included

Regulatory Capital (RC) (Entry Level Capital) – In terms of law, every bank must bring in some minimum capital which should always be there. Example – INR 300 crore (1 Crore = 10 million) for any new Indian Bank.

This capital must be in government securities and should be kept with RBI (for Repo and Reverse Repo)

Economic Capital – (Regulatory Capital – Risk of Loss) – RC value changes because of risk & losses, which is economic capital (Actual value of regulatory capital)

BASAL 2

1. Minimum Capital Requirements

a. Capital is now looked as dynamic, banking considered more unstable than before. Capital will assume losses in due course of time

b. Risk weighted assets now considers market risk, credit risk and operational risk

2. Supervisory Review

a. Role of RBI / Central Bank

3. Market Discipline

Shortcomings of BASAL 2 -

· Definition of operational Risk excluded strategic risk and reputation risk in BASAL 2

· Remuneration of directors / bank employees not included in BASAL 2

BASAL 3

Total Capital / (Credit Risk + Market Risk + Ops Risk) > 8%

Every bank should have a system audit report before Board of Directors

Best Practice – Bench-mark w.r.t other banks

Statutory Auditors – Approved by regulators & appointed by banks. No auditor can provide service to a bank for more than 3 consecutive years. Auditors are free to make notes.

Long Term Audit Report - Addresses limitations of Balance sheet

Class 5 & 6

Class 5&6

CAMEL Rating

Bank publishes their CAMEL rating in their Balance Sheets

· C – Capital Adequacy

· A – Asset quality

· M – Management Quality

· E – Earnings Quality

· L – Liquidity

Capital Adequacy

· CA Ratio (CAR)

· D/E Ratio

· Advances to assets Ratio

· Securities to total investment ratio

All assets carry a risk of deterioration & the result is erosion of equity. Equity shows the firm’s ability to repay as and when the liability matures.

Earlier parameters of judging the bank’s performance – Business / Profit / Number of branches

Valuation Methods – The most conservative method is used for bank’s valuation

· Net asset Value (as on given date)

· P/E Ratio

· DCF Method (Future business earnings are discounted and not the assets)

CAR – Each of the assets carries a risk of non-realization (except cash)

Bank’s Assets (in decreasing order of liquidity)

· Cash – Zero Composite Risk

· Bank Balance – Maximum 5% risk

· Investments – Mostly in government securities as SLR & shares – 10%

ü SL R includes cash, gold, investment in unencumbered government securities

§ Unencumbered – It means Net. If as a Bank, I purchased $100 value of securities and I owe $20, then my unencumbered government security value is $80 (and not $100). It is a portion which is not mortgaged. Carry zero risk (no default risk)

ü Shares – Means for listed companies in stock market

· Advances

ü Corporate & Retail

ü 4 categories – Criterion is DPD (Days past due date)

§ Standard Asset (less than or equal to 90 days overdue installment)

§ Sub Standard Asset (More than 90 Days overdue installment but less than or equal to 90 days + 1 year overdue installment)

§ Doubtful Asset

§ Loss Asset

ü Criterions of NPA

§ Limit Expiry

§ Over-Limit

§ INS (Interest not served)

§ MAD (Minimum Amount Due)

ü Swing – Turnover for the year – Volume of money traded / generated / exchanged during the year

· PPE

· OA

· Miscellaneous Assets

***Capital should always be greater than risk weighted asset

Capital = Z = Paid up Capital + Reserves + Surplus in P&L account + Excess of reserves

Risk Weighted Asset = Y = (i = 1to N)∑ Cash * (Wi Ri) where W = Value of Asset i; R = Risk of default of Asset i.

Basal Committee says – Z > 8% (Y)

Advances to Asset Ratio = Advances / (Total Assets – Contra Items)

It shows better deployment of assets when advances increases.

0.6 = Good Deployment = (Advances / Total Assets) ……… [0.4 is SLR, CRR, WC]

General Reserve - Every bank has to transfer 20% of their profit to a reserve (called General Reserve) before dividend is declared (to protect capital of creditors). Regulators permission is needed for using general reserve.

· Forex fluctuation reserve – To cater to forex fluctuation

· Investment fluctuation reserve – Buying & Selling of Government securities

Securities (Government Bonds)to investment (Shares + Security) ratio – If high, then least risk

Asset Quality

2 Ratios

· Gross NPA / Net Advances

· Net NPA / Net Advances

Net Advances – Do not consider credit balance of OD account for calculating advances

Gross NPA – Provisions for NPA = Net NPA (Actual NPA)

Net NPA shows the ability of the bank to provide for NPA & should be justifiable with the profitability.

Quality of Management

· MV / Equity Capital

· Total Advances / Total Deposits = Credit Deposit Ratio

· Business per employee

· Profit per employee

Banks NPA may be high due to lending to priority sector. Credit guarantee corporations are formed to provide for NPA of priority sector for banks (Loans to farmers, defense personnel, students in low income group)

Earnings Quality

High spread for public sector bank = As dividend is received by the bank

Liquidity

Liquid Asset – Cash, Balances in current account with commercial bank / RBI, investment is central government securities, gold

Approved securities – Regulators approve investment in these securities for maintaining SLR requirements (may not belong to Government) like Mumbai municipal corporation bond. Here, repayment of principle and interest is guaranteed by government (state or central)

Ever Greening of Accounts – Give more time to NPAs to become standard assets or grant NPAs loans to pay off their current NPA debts

Class 4

Class 4

Why Regulators are required

· Banks have public’s money which needs to be protected. On a bank’s Balance sheet, their own capital (around 6%) is very low compared to public deposits (liabilities)

· Also, banks duty is to pay deposits as and when it is due, irrespective customer demands it or not

· Regulator creates deposit insurance agency to avoid failure of the banks

· Regulator gets hidden info form the bank (apart from Balance sheet figures)

· Creation of Money (Bank notes)

M3

· Currency in circulation (8% - 9% of Money Supply)

· Demand & time liabilities of a bank (90% of Money Supply)

· Other deposits with central bank (for international settlement)

Hence, to control money supply, control deposits. M3 is calculated on a weekly basis. Published on every Wednesday indicating position of previous Friday.

Tools of Central Bank

· Bank Rate

· Variable Cash Reserve

· Open Market Operations

· Exchange Rate Management

· Liquidity adjustment facility

· Moral suasion

Bank Rate

RBI lends to commercial banks, which covers both short term as well as long term period loans

Why Banks Fail

· Because exports get affected

· Loan payment default

Banking Regulations act – 1949

RBI Act – Controls SLR, CRR

RBI – It is a banker to the government. A cheque issued by central government is never returned. Central government’s account may not have sufficient balance due to slow tax collection. Hence, when Central government’s account has less money than cheques issued, RBI can cater to clearing of cheques via CRR / SLR deposited by banks or it will print money or will issue Treasury bill to itself.

PLR – Rate at which banks lend to AAA rated companies.

PLR + Cost of deposit + CRR Loss + Interest lost for lending to government + Profit margin of bank = New Base Rate

Hence, no bank can lend below base rate

Bankers to Banks - Banks can borrow from RBI. Transfer of bank’s funds - From Central RBI to different locations – Free of charge, maximum 3 times per week

RBI is lender of last resort – RBI can lend to individuals, but has not done it till today

RBI floats public issues (issued by Central Government)

It advices Central Government when and how much to borrow

Public Debt management – Government never borrows (issues bonds) when an IPO is coming. It may happen that IPO subscription will get affected because of government’s public issue

Vimal Jalan (Ex RBI Governer) – RBI needs to act in favor of the market

Subordinated debt – Debt (securitized, debenture) is created on the basis of underlying security

· Issued Capital >= 50% of Authorized Capital

· Paid Up Capital >= 50% of Issued Capital

Why tier 2 – To support Tier 1 Capital in order to maintain minimum level of capital adequacy

External borrowing of the bank is restricted to 15% of Tier 1 capital (More regulated)

Contingent Liability – Liability incurred as and when they arise.

Cash is certain; Profit is a matter of Opinion

Class 3

Class 3

Camel Rating

· Started after 2008 global financial crisis

· It is a US supervisory rating of bank’s overall credit condition

· Scale is from 1 to 5 (1 being strongest and 5 being weakest)

· Not released to public so as to avoid any bank runs when a bad rating is released

· Classifies around 8,000 banks in US

· Factors considered – Capital Adequacy, Asset Quality, Earnings, Liquidity

Organization of bank

Board of Directors

· They should have specific qualifications like experience in agriculture banking. In India, 50% directors of banks should be having professional background like in accounting, agriculture etc.)

· Other directors are elected in AGM (Annual General Body Meeting). RBI can nominate additional directors in bank.

· Elected Directors - Company law defines qualifications of a director. They are also shareholders of the bank. They should hold not less than 1% of shares in the bank. Normal tenure = 5 Years. Not more than 2 continuous tenure for a director

· Additional Directors – Nominated by RBI and not shareholders. They are officers of RBI. They do not offer themselves for elections. They have voting rights and can sign the Balance Sheet.

§ Right of Dissent – To be recorded in the minutes; which is against the resolution of the majority. Reason – BOD is not coordinating with additional directors properly.

§ Provision 35(A) – RBI can appoint independent director

· Effectiveness of working of BOD – RBI inspector (as additional director) comments on the working of BOD. But he can’t terminate the director. But regulators can supersede the decision of BOD. For that, they recommend that existing BOD requires diversification. Also, when additional director is appointed in a bank (an RBI officer), simply implies that banks’ performance is not satisfactory

Definition of Banking – Acceptance of deposit of money from public by cheque for investment purpose

Steps taken by RBI

1) Advisory (specific steps) in character (non-mandatory)

2) Directions are mandatory & can attract penalty (Guidance are advisory, directions are backed by laws)

3) Liquidation, Selling of shares, dissolving, mergers with other banks

4) Appointment of independent directors

In a bank, BOD meeting takes place once in a quarter. For operational decisions, committees are made to make fast decisions (like ALM committee, Credit Committee, Performance evaluation committee). BOD appoints these committees.

MD / CEO –

· Pivot of company, Chairs the meeting of BOD.

· Take cares of day to day affairs of the company.

· Available 24 X 7

Chairman of Bank –

· Honoree member, only attends the board meeting, no participation in day to day activities

· Most banks have same chairman & CEO (except ICICI and HDFC) as it facilitates management of the bank (They know management policy and can lead to growth path). SBI has same person as Chairman and MD – Mr. O.P.Bhatt

· Chairman is elected by Shareholders, but if he / she is not acceptable by regulator, then chairman’s election can be stopped by the regulator

· Chairman’s remuneration is decided / approved by the regulator (control’s chairman’s election)

· Rejection of a MD / Chairman can’t be challenged in a court of law

Moral suasion – Greatest power of the regulator, where regulator can take adverse action against the bank’s BOD. The directions are mandatory

Creeping Acquisition – Shares of the bank are widely held, no one person can have voting rights of more than 10%. If stake in shares increases from 5% (till 10%), the same information needs to be registered with the BOD. Such transfer of shares has to be done after approval of regulator. Holding of such shares is not legally transferred to the owner till the regulator approves it.

Capital of Bank

· Tier 1 Capital

ü Paid up Capital

ü Other Reserves

ü Any realization from sale of assets

ü Statutory Reserves

· Tier 2 Capital

ü Hybrid Instruments (convertible bonds)

ü Revaluation Reserves

ü Cumulative preference shares

ü Subordinated capital

Class 2

Class 2

Why & How the banking continues to exist –

1) Serving the small savers (after maintaining a minimum amount with bank)

2) Risky arbitrage (Willingness to accept risky funds – deposits on demand while issuing low risky securities to depositors)

De-regulation

***Reduction in SLR or CRR is not De-regulation. It is intensity of regulation

1. De-regulation of interest rates (like for priority sectors) – External regulation is slowly minimized. Big customers do not want to disclose their details.

2. Rising cost of funds – Spread decreasing due to intense competition. RBI allows lower SLR for some banks having liquidity crunch.

3. Repo Rate – RBI lends to banks

4. Reverse Repo – RBI borrows from banks

Trends to be taken care of

1. Technological revolution – Bank absorbs technology and upgrades staff to adapt to it. Ex – New version of Finacle (Infosys product) is given to existing users for feedback on comfort of using.

2. Globalization – Having back-up office in different countries

3. Dis-intermediation – Banks moving to provide fee-based services

4. Change of life style – Consumption & spending pattern / savings etc. has changed. People are now working in night shifts also

5. Change of lending – Investment in equity and private company securities other than Government bonds

6. Aging of staff – Max age of employees in dealing room of bank is 35 years

Indian Nationalized bank’s Disinvestment process

Earlier Days

· Government holds 100% stake in the bank

· Government sells say 40% stake and maintain 60% with them

· Premium earned here is used to reduce fiscal deficit

Now-a-days

· Bank floats additional share for public, original capital of bank is not changed

· Additional capital reduces the over-all share of government in public sector banks

· Premium is retained by banks & is used as liquid assets instead of reducing fiscal deficit

Branch Vs Bank

1) Unit Bank – Bank with only 1 branch

2) Branch Banking – It follows Brick and Mortar structure (businesses that have physical presence rather than just virtual / online; located or serving customers in a physical facility)

3) Credit Delivery Mechanism – Even distribution of banking system (bank branches)

Population Density	Name
Less than 10,000	Rural
10,000 to 100,000	Semi-urban
100,000 to 1 Million	Urban
More than 1 Million	Metropolitan

** No person should travel more than 3 kms for availing banking services

WTO stresses that every member country should allow 12 new branches of a foreign banks to be opened each year to avoid concentration of banks in just 1 country

Class 1

Banking Practices & Regulations

Class 1 - Role played by the commercial banks

1. It can create further money be lending to people

a. Money Multiplier effect – The expansion of country’s money supply that results from banks being able to lend. The higher the reserve requirement, the tighter the money supply which results in a lower multiplier effect for every dollar deposited.

2. Banks are short term financial institutions (Short term deposit acceptance). Larger short term exposure to avoid asset-liability mismatch

3. Bank Nationalization – Policies of banks are in line with government fiscal policies. Fiscal deficit of Indian government is funded by nationalized banks like SBI.

a. Banks can create money by printing currency, which leads to further inflation. Money creation is done to curb government fiscal deficit. Printing of currency also leads to currency depreciation (Mirage of high export market)

b. Hence, Central Bank should not subscribe to government securities (Direct fiscal deficit funding of government). Instead they can use measures like CRR & SLR reduction to adjust / pump liquidity in the market (which in-turn increases cash in the system, thereby improving business opportunities)

4. Offering Services to the public – Like selling of insurance, mutual funds, ATMs management, vendor management, Cash management

a. Services do not involve funds of the bank. Role of bank is like an agent for obtaining a commission – Fee based facility. (Fund based facility – Earning of bank due to difference in interest rate of loans & deposits). To cater to competition, interest margin (spread) has reduced. Hence, bank is now focusing on fee based income. Bank has now become mall of banking.

b. Deposits used to walk in earlier. Now, banks need to sell deposits

c. Bringing in psychological advantage like ULIP Plans, Minor Savings account for children

5. Intermediaries – Spread, Difference between rates of lending of loans & savings deposit rate. A credit worthy borrower can go to other institutions by sidelining e banks. For example – ADR, GDR, FCCB (equity based borrowing from foreign; ADR / GDR is normally for long term fund requirements). Hence, role of banks as intermediaries is getting challenged.

a. (100-Age of Customer) = Risk taking capacity

b. Effective Interest Rate = Nominal Interest Rate – Inflation (EIR should not be less than 3%)

c. In India, rate of inflation > Rate of savings in bank. Hence, investors (in bank’s shares) are subsidized at the cost of savers.

6. Payment System – Method by which person who pays accesses the person who receives the payment. Here, buyers and sellers are separated by different legal & financial system or may be separated by distance.

a. Banking channel is a legal channel, an organized system of exchange.

b. Layering in Money Laundering – Original source of money can’t be traced

7. Other services –

a. Insurance Sales, Portfolio management, factoring services, investment banking, mutual funds

b. Merchant banking – Loan syndication, under-writing, floating of issues

c. Management of Estate – (Beyond certain wealth, it is called estate) Banks act as lawyer & distribute the property after the death of the applicant to the necessary beneficiaries.