Management Of Banking And Financial Services [Paperback] [Jan 01, 2017] Padmalatha Suresh & Justin Paul

Cover Page Title Page Copyright Page Contents Foreword Preface Overview Acknowledgements About the Authors Chapter 1: Managing Banking and Financial Services—Current Issues and Future Challenges THE SETTING CHANGE IS IN THE AIR….IS THE FINANCIAL SYSTEM BEING REVOLUTIONISED? Fintech1 Digital currencies2 Money – the traditional understanding E money Digital currency Assets – such as Bitcoins (see below – The Bitcoin phenomenon) The Bitcoin phenomenon Climate change and financial system3 THE GLOBAL FINANCIAL SYSTEM – AFTER THE FINANCIAL CRISIS A Rewind to the Financial Crisis of 2007–08 The Causes of the Crisis Prevalent models of banking Investment banks, Commercial banks and Universal banks – What is the difference? Macroeconomic and Financial Stability—Understanding the Linkages The Role of ‘Trust’ in Financial Stability The Role of Regulation in Ensuring Financial Stability The Objectives of Financial Regulation Financial Stability—the Over-arching Agenda for the Future THE INDIAN FINANCIAL SYSTEM—AN OVERVIEW Financial Stability in India THE INDIAN BANKING SYSTEM—AN OVERVIEW The financial institutional structure in India Who Owns the Commercial Banks in India? Public Sector Banks At the end of March 2016, there were 27 public sector banks in India, comprising of State Bank of India and its associate banks (6), and 21 nationalized banks. Private Sector Banks At the end of March 2016, there were 21 private sector banks in India. Small Finance Banks (SFB) Payments Banks Foreign Banks Indian banks operating overseas Regional Rural Banks (RRBs) The RRBs were created for rural credit delivery and to ensure financial inclusion. Their capital base is held by the central government, relevant state government and the commercial bank that ‘sponsors’ them, in the ratio of 50:15:35, respectively. Recent However, an issue that is considered to hamper performance efficiency of RRBs is the multiplicity of control—RBI is the banking regulator, while NABARD39 is the supervisor with limited supervisory powers. Non Banking Financial Institutions (NBFI) Non Banking Finance Companies (NBFC) Housing Finance Companies (HFC) Co-operative Credit Institutions Banking Models in India The Indian Financial Code (2015) The Way Forward… Technology - the game changer Chapter 2: Monetary Policy—Implications for Bank Management BASIC CONCEPTS A Macroeconomic View Money ‘Money’ is generally defined as anything that people are willing to accept in payment for goods and services or to pay off debts—in other words, money is generally an acceptable medium of exchange, usable by all, with standardized quality, durable, Money Supply Money supply is the total quantity of money in the economy. While we will look at the various measurement parameters adopted by central banks a little later, in the narrow sense, ‘money supply’ is defined as the currency in circulation in the Measuring Money Supply There are three broad measures economists use when looking at the money supply: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, Central Bank Tools to Regulate Money Supply Tool 1 : Reserve Requirements Tool 2: Bank/ Discount rate Tool 3: Open Market Operations (OMO) The Impact of OMOs on Other Tools of Monetary Policy Central Bank Signaling Through the ‘Policy Rate’ Popularity of the ‘Repo’ Rate as the Policy Rate Other Factors that Impact Monetary Base and Bank Reserves APPLICATION OF THE MONETARY POLICY TOOLS IN INDIA The Monetary Base in India Measuring Money Supply in India9 Operation of Reserve Requirements in India10 Net Demand and Time Liabilities Operation of the Bank Rate in India  Open Market Operations in India Repo Market Instruments Outside the LAF The Market Stabilization Scheme (MSS-2004) It has been designed to lend more flexibility to liquidity management. Increasing capital inflows into India has necessitated managing their impact on liquidity. However, since external capital flows could be vol MONETARY POLICY TOOLS IN SELECT COUNTRIES The United States of America13 Monetary Policy Tool 1—Reserve Requirements Reserve requirements are the portion of deposits that banks may not lend and have to keep either on hand or on deposit at a Federal Reserve Bank. Within limits specified by law, the Board of Governors has sole a Net Transaction Accounts Total transaction accounts consists of demand deposits, automatic transfer service (ATS)accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturi Monetary Policy Tool 3—Open Market Operations Open market operations (OMOs)—the purchase and sale of securities in the open market by a central bank—are a key tool used by the Federal Reserve in the implementation of monetary policy. The short-term object The Eurosystem16 Monetary Policy Tool 1—Minimum Reserve Requirements All credit institutions17 in the system are required to hold minimum reserves in separate accounts with the NCBs over a specified maintenance period (around a month). The Eurosystem pays a short-term int Reserve Coefficients Standardized Deductions Lump-Sum Allowance Monetary Policy Tool 2—Open Market Operations OMOs, coordinated by the ECB, but carried out by NCBs, take four distinct forms: Open market operations play an important role in steering interest rates, managing the liquidity situation in the market and sig Monetary Policy Tool 3—Standing Facilities The two standing facilities—a marginal lending facility and a deposit facility—offered by the Eurosystem set boundaries for overnight market rates by providing and absorbing liquidity. As their names imply, the m Other Developed and Developing Countries Demand Liabilities Demand liabilities’ include all liabilities which are payable on demand and they include: Time Liabilities Time liabilities are those which are payable otherwise than on demand and they include: Some Special Cases Other Demand and Time Liabilities (ODTL) ODTL include the following: Liabilities not to be Included for DTL/NDTL Computation The following will not form part of liabilities for the purpose of the CRR: Chapter 3: Banks’ Financial Statements PI = 1/2 (RI)2 The Net Interest Margin (NIM)—An ImportantIndicator of Banking Efficiency and Profitability The NIM, operating expenses and ‘other income’ are crucial in determining profitability of banks. The NIM indicates the margin taken by the banking sector while c Off Balance Sheet (OBS) Exposures—Contingent Liabilities of Banks in India: Earlier, we have seen the important role ‘other income’ plays in bank profitability. One of the main sources of other income is OBS. Letter of Credit A letter of credit (LC) is defined as ‘an arrangement by means of which bank acting at the request of the customer, undertakes to pay a third party a predetermined amount by a given date, according to agreed stipulations and against prese Bank Guarantee A contract of guarantee is a contract to perform the promise, or discharge the liability of a third person in the case of his default. The person who gives the guarantee is called the surety, the person in respect of whose default the guara Payment and Clearing Operations This is one of the most important fee-based services of the banking system. A cheque is the most common form of payment system used by banks. Apart from cheque, which is a paper-based payment mechanism, transfer of funds ca The following charts and table depict Banks’ performance indicators in 2014–15.18 Growth in banks’ off balance sheet (contingent) liabilities Growth in select items of Income and Expenditure of banks (Chart 2.8, page 8 of Report) Chart: More indicators of banks’ financial performance (Chart 2.9, page 8 of Report) Table: Banks’ ROA and ROE (percent) (Table 2.1, page 8 of Report) QUESTIONS ON CASE STUDY BASIC CONCEPTS Bank Liabilities Net Worth The net worth of a bank is measured by the aggregate of its share capital, reserves and surplus. In any enterprise, capital is required to absorb unexpected losses. A bank typically sustains losses when the value of its assets is eroded—leading Deposits The primary source of borrowed funds for a typical bank is ‘deposits’—predominantly raised from the public. We will see in subsequent chapters the rationale and implications of banks garnering household, corporate and government savings in order Borrowings Banks can borrow from the markets, both domestic and overseas, other institutions and banks, and from the central bank. Such borrowings, typically contribute a lower proportion to the banks’ total sources of funds. Generally, borrowings are use Bank Assets Investments Investment securities help banks in several ways. They help to meet liquidity needs, earn interest, take ­advantage of interest rate movements and are a part of the banks’ treasury functions. At the time of investment, banks must be able to de Loans and Advances This category of assets is the most important for banks because it defines their roles as financial intermediaries and impacts their profitability to a large extent. These assets also carry a high level of default risk and each asset or Fixed Assets In sharp contrast to other industrial and service sectors, banks own relatively few fixed assets. Compared to non-financial firms, banks operate with lower fixed costs and exhibit lower operating leverage. Contingent Liabilities The Income Statement Other Income As pointed out earlier, banks are increasing their earnings through fee-based services, such as fund transfers and remittances, custodial services, collections, government business, agency business, opening letters of credit, issuing letters Interest Expended This represents variable cost for the bank. However, due to the variety of borrowed sources of funds in terms of tenure, price and covenants, keeping this cost in check is a challenge for banks. Banks typically operate on narrow spreads Financial Statements of Banks Operating in India Bank Liabilities Capital Banks have to show the authorized, subscribed and paid-up capital under this head. Deposits The balance sheet of a bank operating in India will show the following classifications. Borrowings In its balance sheet, a bank operating in India would show ‘borrowings’ under two categories—borrowings in India and ‘borrowings outside India’. Other Liabilities and Provisions These categories of liabilities are typically grouped as follows. Bank Assets Cash and Balances with the RBI All cash assets of the bank are listed under this head, and this would be the most liquid part of the balance sheet. Balances with Banks and Money at Call and Short Notice Under this head, banks separately disclose the balances they hold with other banks in various deposit accounts, in and outside India. These balances are held for various purposes, including settlement Investments In times of soft interest rates, investments yield substantial incomes to banks. Loans and Advances Indian banks classify their loan assets in three ways—by nature of credit facility granted, by security arrangements and by sector. The numerical total of ‘advances’ under all three categories is the same, since the same data has been p Fixed Assets Indian banks classify ‘fixed assets’ on their balance sheets into the following categories: Other Assets These are residual assets of relatively small magnitude. Contingent Liabilities Generally, contingent liabilities are shown under the following broad heads. Income Statement of Indian Banks Income Expenses Operating expenses: These expenses are typically the overheads and other expenses necessary for a bank to function. They are categorized as follows: Provisions and contingencies: Provisions made for loan losses, taxes and diminution in the value of investments will be included under this head. Other Disclosures to be Made by Banks in India Analyzing Banks’ Financial Statements Profitability by Line of Business Chapter 4: Sources of Bank Funds Thus, the effective interest rate that the bank pays on the `50,000 FD, if the interest amounts are withdrawn every month will be 10.46 per cent (i.e., 436.04 * 12/50,000). Cash Certificates General Features This is a variation of the re-investment deposit scheme, where the maturity value will be a pre-determined lump sum. The amount of initial deposit will be the issue price of the cash certificate and will be computed based on the maturity IRA and KEOGH Plans These are long-term sources of funds for banks. They act as custodians for personal pension plans that individuals may use to defer federal income taxes on contributions and subsequent investment earnings. Both IRAs are allowed under t Federal Funds Federal funds are short-term unsecured transfers of immediately available funds between depository institutions for one business day (i.e., overnight loans). Federal funds are best suited for institutions short of reserves to meet their lega Borrowing from the Federal Reserve This is seen as a viable alternative to the Federal funds market. There are three types of loans available based on the bank’s needs. Each type of loan comes at a different price. They could take the form of: (a) adjustm Repurchase Agreements Repurchase agreements contract to sell (typically high quality and usually government securities) securities temporarily by a borrower of funds to a lender of funds with the borrower agreeing to buy back the securities at a predeterm Non-Deposit Funds These are money market liabilities purchased for relatively short time periods to adjust liquidity demands. The use of these purchased funds came into existence due to tight money periods in which deposit rate ceilings caused banks to de Negotiable CDs These were initially developed to attract large corporate deposits and savings from wealthy individuals. They are interest-bearing receipts evidencing deposit of funds in the bank for a specified time period, at a specified interest rate. H Discount Window Advances The 12 regional Federal Reserves operate discount windows29 from which banks can borrow (subject to Regulation A rules). A discount window loan must be secured by collateral acceptable to a Federal Reserve (usually US government s Eurocurrency Deposits These were originally developed in Western Europe to provide liquid funds for financial institutions to lend to one another or to customers. These are dollar-denominated deposits placed in banks outside US territory. Many Eurodollar Bankers’ Acceptances These are time drafts drawn on a bank by either an exporter or importer to finance international business transactions. The bank may discount the acceptance in the money market to (in effect) finance the transaction. Commercial Papers These are high quality short-term debt obligations (unsecured promissory notes) issued by corporations with strong credit ratings to meet the firm’s working capital needs. Banks can issue such paper through their affiliated or holding co Federal Home Loan Bank Borrowings Under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989, FHLBs can provide discount window services to banks. FHLBs function as special lending facilities for the housing finance industry. T Long-Term Non-Deposit Sources These include mortgages to fund the construction of new buildings, capital notes and debentures. Generally, the interest costs on these funds, though substantially higher than money market loans, are more stable. The Basel Committee Guidelines The BCBS has issued three documents covering money laundering issues. IAIS Guidelines This association has issued its Guidance Paper 5, ‘Anti-Money Laundering Guidance Notes for Insurance Supervisors and Insurance Entities’, which parallels the BCBS’s statement on prevention. International Organization of Securities Commissioners (IOSCO) Guidelines IOSCO in its ‘Resolution on Money Laundering’ proposes seven specific areas for security regulators in individual countries to consider while establishing requirements for firms und Rbi’s Kyc Norms36 QUESTIONS ON CASE BASIC CONCEPTS BANK LIABILITIES—DEPOSITS Protecting the Depositor—Deposit Insurance Deposit Insurance in India PRICING DEPOSIT SERVICES The Need to Price with Precision Some Commonly Used Approaches to Deposit Pricing Marginal Cost of Funds Approach New Cost of Funds Analysis Deposits and Interest Rate Risk11 BANK LIABILITIES—NON-DEPOSIT SOURCES The Funding Gap The Indian Scenario Non deposit sources of funds Some prominent money market sources of funds – banking sector securities17 a. Call, notice and term money market b. Certificate of deposit (CD) c. Repo Annexure I. contains a brief description of select non deposit sources of funds for banks in the USA. Long term borrowing by banks18 Are Non-Deposit Sources More Costly and Risky? Borrowings from the market are generally perceived to be more expensive than deposit sources. Where banks tend to rely on borrowings to fund their lending operations, they are exposed to market risks—the cost BANK DEPOSITS IN INDIA—SOME IMPORTANT LEGAL ASPECTS ‘Banking’ Defined Who is a Customer? Chapter 5: Uses of Bank Funds—The Lending Function BASIC CONCEPTS Introduction Banks’ Role as Financial Intermediaries Gains from Lending Who Needs Credit? Features of Bank Credit Types of Lending Short-Term Loans Typically, these are loans with maturities of 1 year or less. Most of these loans are granted with the primary purpose of financing working capital needs of the borrower, resulting from temporary build up of inventories and receivables. I Long-Term Loans Bank lending, which used to traditionally focus on ‘short-term’ loans, started looking at lending for periods longer than a year only from the 1930s onwards. These are called ‘term loans’ and have the following characteristics: Revolving Credits Revolving credits offer the most flexibility to borrowers. Assessed to meet the borrowers’ requirements over a period of 1 year or more, revolving credits permit drawings from the line of credit at any time, and similarly, repay the whol THE CREDIT PROCESS Constituents of the Credit Process13 The Loan Policy To ensure alignment of individual goals of credit officers to the bank’s overall goals, banks formulate ‘loan policies’. These are written documents, authorized by individual bank’s Board of Directors, that formalize and set guidelines for Business Development and Initial 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, bui Broad Steps to Credit Analysis Step 1—Building the ‘credit file’: The first step to effective credit analysis is gathering information to build the ‘credit file’. The preliminary information so obtained would throw light on the borrower’s antecedents, his credit history and track recor 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. 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 assessm Step 4—Due diligence: Bypassing due diligence can be very costly for a bank. Many loans have run into problems since bankers did not take this step seriously. This is a time-consuming activity but well worth the effort. Due diligence can include checking Step 5—Risk assessment: A key function of the credit officer is to identify and analyze the key risks associated with the proposed credit. All potential internal and external risks are to be identified and their severity assessed in terms of how these ris Step 6—Making 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 favo Credit Delivery and Administration Who takes the decision to lend? Depending on the size of the bank, the loan size and type of exposures planned, the final decision to lend may be taken by an authorized layer of the bank. Typically, banks fix ‘discretion 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 Terms and Conditions of Lending These are very important ingredients of any loan agreement. The bank derives control over the borrower’s operations and also mitigates the risks of lending through this part of the loan agreement. The terms and conditions c Events of Default Such events, when they happen, may trigger the end of the banker–borrower relationship. An illustrative list of situations that may lead to an event of default include the following: 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 either by the credit officer himself or a tea Credit Review and Monitoring This is the most important step in credit management, and one that lends value to bank financing. Banks that have succeeded in credit management, and hence reduction of credit risk, are those that have separated credit review FINANCIAL APPRAISAL FOR CREDIT DECISIONs Financial Ratio Analysis Common Size Ratio Comparisons Cash Flow Analysis FUND BASED, NON-FUND BASED AND ASSET BASEDLENDING—FEATURES AND POPULAR FORMS Fund Based Lending Loans for Working Capital Loans for Capital Expenditure and Industrial Credit Loan Syndication28 Loans for Agriculture Loans to Consumers or Retail Lending Non-fund Based Lending Asset Based Lending Loans for Infrastructure—Project Finance LOAN PRICING AND CUSTOMER PROFITABILITY ANALYSIS Step 1: Arrive at Cost of Funds Step 3: Assess Default Risk and Enforceability of Securities Step 4: Fixing the Profit Margin Some More Models of Loan Pricing Fixed Versus Floating Rates When the interest rates 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 v Hedging and Matched Funding As described above, 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 using interest The Price Leadership Model The basic model described above makes the assumption that the bank knows its costs accurately, and can estimate probability of default and recovery rate for each borrower or class of borrowers. The basic model also fails to buil 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 co Customer Profitability Analysis Periodically, or every time a borrower approaches the bank with a request for modifications in loan terms, a customer profitability analysis should be carried out by the bank. The analysis is used to evaluate whether the ne Principal Factors The Borrower/Management The Firm/Project Commercial Bank Relationships Industry Risk Modifiers Chapter 6: Banks in India—Credit Delivery and Legal Aspects of Lending MODES OF CREDIT DELIVERY Cash Credit Loan System for Delivery of Bank Credit—The Working Capital Demand Loan RBI Guidelines—Loan component and cash credit component2 Overdrafts Bills Finance Clean Bills This is a bill of exchange not supported by any documents of title to goods,6 since the seller has already delivered the goods and the documents to the buyer. Clean bills are also drawn to effect discharge of a debt or claim. Clean bills are t Documentary Bills A bill of exchange accompanied by documents of title to goods is a documentary bill. The goods have been despatched by the seller but the transfer of documents of title to goods has not yet taken place. Examples of documents of title to Supply Bills These bills do not fall in the ambit of the Negotiable Instruments Act. They are in the nature of ‘debts’ and can be assigned in favour of the bank. Precautions to be Taken While Purchasing/Discounting Bills Advances Against Bills Sent on Collection Drawee Bills In the earlier cases, the drawer of the bill, who is the seller, is financed by the bank. When the bank finances the buyer, the drawee, the buyer’s bank itself discounts the bills and sends the amount to the seller. This has the effect of fin Pricing of Loans Reset of interest rates under MCLR Interest rates on advances made in foreign currency Exemptions LEGAL ASPECTS OF LENDING What are Unsecured Loans? What are Secured Loans? Securities and Their Features Can the banker accept any asset offered by the borrower as security for the advances made? Some basic safeguards observed while accepting assets as securities would help the bank recover most of its dues in the event of defau Safeguard 1—Ensure adequate ‘margin’: For a bank, ‘margin’ signifies the difference between the market value of the security and the amount of advance granted against it. For example, if the bank has sanctioned `75 lakh as advance against a security worth Safeguard 2—Easy marketability: In case of default, the security should have wide and ready marketability, to enable the bank sell off the security and realize its dues. For example, gold or jewels held as security are more liquid since they have wider ma Safeguard 3—Documentation: The bank’s security interest is evidenced by legally valid documents that are executed by the borrower. These documents have to be periodically reviewed, especially in the case of securities for long-term loans or revolving cred What is a ‘Security’? What is ‘Right of Set Off’? The bank’s right of set off enables it to adjust the credit balance (or deposit) in one account of a customer with the debit balance (or loan) in another account of the same customer. For example, if a customer has a term depos Working Capital Finance Projected Turnover Method This method is generally used for assessing working capital finance requirements in case of borrowers whose fund-based working capital requirements are less than `2 crore. According to this method, the working capital requirement The Permissible Bank Finance Method This method is generally applied by banks to working capital limits of over `2 crore. Cash Budget Method This method is prevalently applied to borrowers with fund-based limits of over `10 crore from the banking system. Optional to all borrowers in industry, trade and service sectors, this method is preferred by borrowers in the constructi Fixing the Working Capital Credit Limit Financing Receivables Financing Capital and Non-Operating Expenditure Peer to Peer (P2P) lending – using technology for lending27 What is P2P lending? P2P- regulatory challenges Country experiences Credit Monitoring, Sickness and Rehabilitation BASIC CONCEPTS The Need for Credit Review and Monitoring Triggers of Financial Distress Financial Distress Models—The Altman’s Z-Score Some Alternate Models Predicting Financial Distress The Workout Function Credit Information companies in india 17 CIBIL and Loan Approval Other Credit Information Companies in India Debt Restructuring and rehabilitation of sick firms in India—the Workout function What is Restructuring? Criteria for Considering Restructuring Relief Measures under Restructuring Valuation of Restructured Advances Objectives of the Scheme The objectives of the scheme are: Features The features of the scheme are as follows: The Methodology The methodology is similar to the rehabilitation schemes operated for the SME sector. The CDR Structure The mechanism operates with a three-tier structure, consisting of the following: The Legal Issues The legal issues are as follows: Case Study I: India Cements Ltd Need for Restructuring When India Cements Ltd submitted a CDR proposal to the FIs at the end of 2002, it had stated that the bunching up of debt repayments over the next few years and inadequate cash flow generation was making it difficult for the company India Cements Debt Restructuring India Cements mandated HSBC Securities and Capital Markets (India) Pvt. Ltd as exclusive adviser in the restructuring process. As part of the debt-restructuring exercise, India Cements agreed to divest its entire stake in The Debt-Restructuring Proposal21 According to the debt-restructuring proposal, India Cements would use the proceeds from the sale of Visaka Cement to settle the debt in that company and then settle certain loans and interest and pressing creditors. It al Plan Under the CDR22 In a debt-restructuring plan cleared by the CDR Forum of FIs and banks, the company had committed to the following: Chapter 8 : Managing Credit Risk— An Overview BASIC CONCEPTS Expected Versus Unexpected Loss Defining Credit Risk6 Credit Risk of the Portfolio From our earlier discussions, it would be evident that managing the credit portfolio of a bank involves a higher level of risk-reward decisions than managing a portfolio of market investments. This is due to the fact that ther The Relationship Between Credit and Other Risks While loans are the largest source of credit risk and exposure to credit risk continues to be a leading source of problems, there are other sources of credit risk throughout the activities of a bank, in the Internati Cover Page Title Page Copyright Page Contents Foreword Preface Overview Acknowledgements About the Authors Chapter 1: Managing Banking and Financial Services—Current Issues and Future Challenges THE SETTING CHANGE IS IN THE AIR....IS THE FINANCIAL SYSTEM BEING REVOLUTIONISED? Fintech1 Digital currencies2 Money – the traditional understanding E money Digital currency Assets – such as Bitcoins (see below – The Bitcoin phenomenon) The Bitcoin phenomenon Climate change and financial system3 THE GLOBAL FINANCIAL SYSTEM – AFTER THE FINANCIAL CRISIS A Rewind to the Financial Crisis of 2007–08 The Causes of the Crisis Prevalent models of banking Investment banks, Commercial banks and Universal banks – What is the difference? Macroeconomic and Financial Stability—Understanding the Linkages The Role of ‘Trust’ in Financial Stability The Role of Regulation in Ensuring Financial Stability The Objectives of Financial Regulation Financial Stability—the Over-arching Agenda for the Future THE INDIAN FINANCIAL SYSTEM—AN OVERVIEW Financial Stability in India THE INDIAN BANKING SYSTEM—AN OVERVIEW The financial institutional structure in India Who Owns the Commercial Banks in India? Public Sector Banks At the end of March 2016, there were 27 public sector banks in India, comprising of State Bank of India and its associate banks (6), and 21 nationalized banks. Private Sector Banks At the end of March 2016, there were 21 private sector banks in India. Small Finance Banks (SFB) Payments Banks Foreign Banks Indian banks operating overseas Regional Rural Banks (RRBs) The RRBs were created for rural credit delivery and to ensure financial inclusion. Their capital base is held by the central government, relevant state government and the commercial bank that ‘sponsors’ them, in the ratio of 50:15:35, respectively. Recent However, an issue that is considered to hamper performance efficiency of RRBs is the multiplicity of control—RBI is the banking regulator, while NABARD39 is the supervisor with limited supervisory powers. Non Banking Financial Institutions (NBFI) Non Banking Finance Companies (NBFC) Housing Finance Companies (HFC) Co-operative Credit Institutions Banking Models in India The Indian Financial Code (2015) The Way Forward... Technology - the game changer Chapter 2: Monetary Policy—Implications for Bank Management BASIC CONCEPTS A Macroeconomic View Money ‘Money’ is generally defined as anything that people are willing to accept in payment for goods and services or to pay off debts—in other words, money is generally an acceptable medium of exchange, usable by all, with standardized quality, durable, Money Supply Money supply is the total quantity of money in the economy. While we will look at the various measurement parameters adopted by central banks a little later, in the narrow sense, ‘money supply’ is defined as the currency in circulation in the Measuring Money Supply There are three broad measures economists use when looking at the money supply: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, Central Bank Tools to Regulate Money Supply Tool 1 : Reserve Requirements Tool 2: Bank/ Discount rate Tool 3: Open Market Operations (OMO) The Impact of OMOs on Other Tools of Monetary Policy Central Bank Signaling Through the ‘Policy Rate’ Popularity of the ‘Repo’ Rate as the Policy Rate Other Factors that Impact Monetary Base and Bank Reserves APPLICATION OF THE MONETARY POLICY TOOLS IN INDIA The Monetary Base in India Measuring Money Supply in India9 Operation of Reserve Requirements in India10 Net Demand and Time Liabilities Operation of the Bank Rate in India  Open Market Operations in India Repo Market Instruments Outside the LAF The Market Stabilization Scheme (MSS-2004) It has been designed to lend more flexibility to liquidity management. Increasing capital inflows into India has necessitated managing their impact on liquidity. However, since external capital flows could be vol MONETARY POLICY TOOLS IN SELECT COUNTRIES The United States of America13 Monetary Policy Tool 1—Reserve Requirements Reserve requirements are the portion of deposits that banks may not lend and have to keep either on hand or on deposit at a Federal Reserve Bank. Within limits specified by law, the Board of Governors has sole a Net Transaction Accounts Total transaction accounts consists of demand deposits, automatic transfer service (ATS)accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible bankers acceptances, and obligations issued by affiliates maturi Monetary Policy Tool 3—Open Market Operations Open market operations (OMOs)—the purchase and sale of securities in the open market by a central bank—are a key tool used by the Federal Reserve in the implementation of monetary policy. The short-term object The Eurosystem16 Monetary Policy Tool 1—Minimum Reserve Requirements All credit institutions17 in the system are required to hold minimum reserves in separate accounts with the NCBs over a specified maintenance period (around a month). The Eurosystem pays a short-term int Reserve Coefficients Standardized Deductions Lump-Sum Allowance Monetary Policy Tool 2—Open Market Operations OMOs, coordinated by the ECB, but carried out by NCBs, take four distinct forms: Open market operations play an important role in steering interest rates, managing the liquidity situation in the market and sig Monetary Policy Tool 3—Standing Facilities The two standing facilities—a marginal lending facility and a deposit facility—offered by the Eurosystem set boundaries for overnight market rates by providing and absorbing liquidity. As their names imply, the m Other Developed and Developing Countries Demand Liabilities Demand liabilities’ include all liabilities which are payable on demand and they include: Time Liabilities Time liabilities are those which are payable otherwise than on demand and they include: Some Special Cases Other Demand and Time Liabilities (ODTL) ODTL include the following: Liabilities not to be Included for DTL/NDTL Computation The following will not form part of liabilities for the purpose of the CRR: Chapter 3: Banks’ Financial Statements PI = 1/2 (RI)2 The Net Interest Margin (NIM)—An ImportantIndicator of Banking Efficiency and Profitability The NIM, operating expenses and ‘other income’ are crucial in determining profitability of banks. The NIM indicates the margin taken by the banking sector while c Off Balance Sheet (OBS) Exposures—Contingent Liabilities of Banks in India: Earlier, we have seen the important role ‘other income’ plays in bank profitability. One of the main sources of other income is OBS. Letter of Credit A letter of credit (LC) is defined as ‘an arrangement by means of which bank acting at the request of the customer, undertakes to pay a third party a predetermined amount by a given date, according to agreed stipulations and against prese Bank Guarantee A contract of guarantee is a contract to perform the promise, or discharge the liability of a third person in the case of his default. The person who gives the guarantee is called the surety, the person in respect of whose default the guara Payment and Clearing Operations This is one of the most important fee-based services of the banking system. A cheque is the most common form of payment system used by banks. Apart from cheque, which is a paper-based payment mechanism, transfer of funds ca The following charts and table depict Banks’ performance indicators in 2014–15.18 Growth in banks’ off balance sheet (contingent) liabilities Growth in select items of Income and Expenditure of banks (Chart 2.8, page 8 of Report) Chart: More indicators of banks’ financial performance (Chart 2.9, page 8 of Report) Table: Banks’ ROA and ROE (percent) (Table 2.1, page 8 of Report) QUESTIONS ON CASE STUDY BASIC CONCEPTS Bank Liabilities Net Worth The net worth of a bank is measured by the aggregate of its share capital, reserves and surplus. In any enterprise, capital is required to absorb unexpected losses. A bank typically sustains losses when the value of its assets is eroded—leading Deposits The primary source of borrowed funds for a typical bank is ‘deposits’—predominantly raised from the public. We will see in subsequent chapters the rationale and implications of banks garnering household, corporate and government savings in order Borrowings Banks can borrow from the markets, both domestic and overseas, other institutions and banks, and from the central bank. Such borrowings, typically contribute a lower proportion to the banks’ total sources of funds. Generally, borrowings are use Bank Assets Investments Investment securities help banks in several ways. They help to meet liquidity needs, earn interest, take ­advantage of interest rate movements and are a part of the banks’ treasury functions. At the time of investment, banks must be able to de Loans and Advances This category of assets is the most important for banks because it defines their roles as financial intermediaries and impacts their profitability to a large extent. These assets also carry a high level of default risk and each asset or Fixed Assets In sharp contrast to other industrial and service sectors, banks own relatively few fixed assets. Compared to non-financial firms, banks operate with lower fixed costs and exhibit lower operating leverage. Contingent Liabilities The Income Statement Other Income As pointed out earlier, banks are increasing their earnings through fee-based services, such as fund transfers and remittances, custodial services, collections, government business, agency business, opening letters of credit, issuing letters Interest Expended This represents variable cost for the bank. However, due to the variety of borrowed sources of funds in terms of tenure, price and covenants, keeping this cost in check is a challenge for banks. Banks typically operate on narrow spreads Financial Statements of Banks Operating in India Bank Liabilities Capital Banks have to show the authorized, subscribed and paid-up capital under this head. Deposits The balance sheet of a bank operating in India will show the following classifications. Borrowings In its balance sheet, a bank operating in India would show ‘borrowings’ under two categories—borrowings in India and ‘borrowings outside India’. Other Liabilities and Provisions These categories of liabilities are typically grouped as follows. Bank Assets Cash and Balances with the RBI All cash assets of the bank are listed under this head, and this would be the most liquid part of the balance sheet. Balances with Banks and Money at Call and Short Notice Under this head, banks separately disclose the balances they hold with other banks in various deposit accounts, in and outside India. These balances are held for various purposes, including settlement Investments In times of soft interest rates, investments yield substantial incomes to banks. Loans and Advances Indian banks classify their loan assets in three ways—by nature of credit facility granted, by security arrangements and by sector. The numerical total of ‘advances’ under all three categories is the same, since the same data has been p Fixed Assets Indian banks classify ‘fixed assets’ on their balance sheets into the following categories: Other Assets These are residual assets of relatively small magnitude. Contingent Liabilities Generally, contingent liabilities are shown under the following broad heads. Income Statement of Indian Banks Income Expenses Operating expenses: These expenses are typically the overheads and other expenses necessary for a bank to function. They are categorized as follows: Provisions and contingencies: Provisions made for loan losses, taxes and diminution in the value of investments will be included under this head. Other Disclosures to be Made by Banks in India Analyzing Banks’ Financial Statements Profitability by Line of Business Chapter 4: Sources of Bank Funds Thus, the effective interest rate that the bank pays on the `50,000 FD, if the interest amounts are withdrawn every month will be 10.46 per cent (i.e., 436.04 * 12/50,000). Cash Certificates General Features This is a variation of the re-investment deposit scheme, where the maturity value will be a pre-determined lump sum. The amount of initial deposit will be the issue price of the cash certificate and will be computed based on the maturity IRA and KEOGH Plans These are long-term sources of funds for banks. They act as custodians for personal pension plans that individuals may use to defer federal income taxes on contributions and subsequent investment earnings. Both IRAs are allowed under t Federal Funds Federal funds are short-term unsecured transfers of immediately available funds between depository institutions for one business day (i.e., overnight loans). Federal funds are best suited for institutions short of reserves to meet their lega Borrowing from the Federal Reserve This is seen as a viable alternative to the Federal funds market. There are three types of loans available based on the bank’s needs. Each type of loan comes at a different price. They could take the form of: (a) adjustm Repurchase Agreements Repurchase agreements contract to sell (typically high quality and usually government securities) securities temporarily by a borrower of funds to a lender of funds with the borrower agreeing to buy back the securities at a predeterm Non-Deposit Funds These are money market liabilities purchased for relatively short time periods to adjust liquidity demands. The use of these purchased funds came into existence due to tight money periods in which deposit rate ceilings caused banks to de Negotiable CDs These were initially developed to attract large corporate deposits and savings from wealthy individuals. They are interest-bearing receipts evidencing deposit of funds in the bank for a specified time period, at a specified interest rate. H Discount Window Advances The 12 regional Federal Reserves operate discount windows29 from which banks can borrow (subject to Regulation A rules). A discount window loan must be secured by collateral acceptable to a Federal Reserve (usually US government s Eurocurrency Deposits These were originally developed in Western Europe to provide liquid funds for financial institutions to lend to one another or to customers. These are dollar-denominated deposits placed in banks outside US territory. Many Eurodollar Bankers’ Acceptances These are time drafts drawn on a bank by either an exporter or importer to finance international business transactions. The bank may discount the acceptance in the money market to (in effect) finance the transaction. Commercial Papers These are high quality short-term debt obligations (unsecured promissory notes) issued by corporations with strong credit ratings to meet the firm’s working capital needs. Banks can issue such paper through their affiliated or holding co Federal Home Loan Bank Borrowings Under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989, FHLBs can provide discount window services to banks. FHLBs function as special lending facilities for the housing finance industry. T Long-Term Non-Deposit Sources These include mortgages to fund the construction of new buildings, capital notes and debentures. Generally, the interest costs on these funds, though substantially higher than money market loans, are more stable. The Basel Committee Guidelines The BCBS has issued three documents covering money laundering issues. IAIS Guidelines This association has issued its Guidance Paper 5, ‘Anti-Money Laundering Guidance Notes for Insurance Supervisors and Insurance Entities’, which parallels the BCBS’s statement on prevention. International Organization of Securities Commissioners (IOSCO) Guidelines IOSCO in its ‘Resolution on Money Laundering’ proposes seven specific areas for security regulators in individual countries to consider while establishing requirements for firms und Rbi’s Kyc Norms36 QUESTIONS ON CASE BASIC CONCEPTS BANK LIABILITIES—DEPOSITS Protecting the Depositor—Deposit Insurance Deposit Insurance in India PRICING DEPOSIT SERVICES The Need to Price with Precision Some Commonly Used Approaches to Deposit Pricing Marginal Cost of Funds Approach New Cost of Funds Analysis Deposits and Interest Rate Risk11 BANK LIABILITIES—NON-DEPOSIT SOURCES The Funding Gap The Indian Scenario Non deposit sources of funds Some prominent money market sources of funds – banking sector securities17 a. Call, notice and term money market b. Certificate of deposit (CD) c. Repo Annexure I. contains a brief description of select non deposit sources of funds for banks in the USA. Long term borrowing by banks18 Are Non-Deposit Sources More Costly and Risky? Borrowings from the market are generally perceived to be more expensive than deposit sources. Where banks tend to rely on borrowings to fund their lending operations, they are exposed to market risks—the cost BANK DEPOSITS IN INDIA—SOME IMPORTANT LEGAL ASPECTS ‘Banking’ Defined Who is a Customer? Chapter 5: Uses of Bank Funds—The Lending Function BASIC CONCEPTS Introduction Banks’ Role as Financial Intermediaries Gains from Lending Who Needs Credit? Features of Bank Credit Types of Lending Short-Term Loans Typically, these are loans with maturities of 1 year or less. Most of these loans are granted with the primary purpose of financing working capital needs of the borrower, resulting from temporary build up of inventories and receivables. I Long-Term Loans Bank lending, which used to traditionally focus on ‘short-term’ loans, started looking at lending for periods longer than a year only from the 1930s onwards. These are called ‘term loans’ and have the following characteristics: Revolving Credits Revolving credits offer the most flexibility to borrowers. Assessed to meet the borrowers’ requirements over a period of 1 year or more, revolving credits permit drawings from the line of credit at any time, and similarly, repay the whol THE CREDIT PROCESS Constituents of the Credit Process13 The Loan Policy To ensure alignment of individual goals of credit officers to the bank’s overall goals, banks formulate ‘loan policies’. These are written documents, authorized by individual bank’s Board of Directors, that formalize and set guidelines for Business Development and Initial 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, bui Broad Steps to Credit Analysis Step 1—Building the ‘credit file’: The first step to effective credit analysis is gathering information to build the ‘credit file’. The preliminary information so obtained would throw light on the borrower’s antecedents, his credit history and track recor 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. 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 assessm Step 4—Due diligence: Bypassing due diligence can be very costly for a bank. Many loans have run into problems since bankers did not take this step seriously. This is a time-consuming activity but well worth the effort. Due diligence can include checking Step 5—Risk assessment: A key function of the credit officer is to identify and analyze the key risks associated with the proposed credit. All potential internal and external risks are to be identified and their severity assessed in terms of how these ris Step 6—Making 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 favo Credit Delivery and Administration Who takes the decision to lend? Depending on the size of the bank, the loan size and type of exposures planned, the final decision to lend may be taken by an authorized layer of the bank. Typically, banks fix ‘discretion 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 Terms and Conditions of Lending These are very important ingredients of any loan agreement. The bank derives control over the borrower’s operations and also mitigates the risks of lending through this part of the loan agreement. The terms and conditions c Events of Default Such events, when they happen, may trigger the end of the banker–borrower relationship. An illustrative list of situations that may lead to an event of default include the following: 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 either by the credit officer himself or a tea Credit Review and Monitoring This is the most important step in credit management, and one that lends value to bank financing. Banks that have succeeded in credit management, and hence reduction of credit risk, are those that have separated credit review FINANCIAL APPRAISAL FOR CREDIT DECISIONs Financial Ratio Analysis Common Size Ratio Comparisons Cash Flow Analysis FUND BASED, NON-FUND BASED AND ASSET BASEDLENDING—FEATURES AND POPULAR FORMS Fund Based Lending Loans for Working Capital Loans for Capital Expenditure and Industrial Credit Loan Syndication28 Loans for Agriculture Loans to Consumers or Retail Lending Non-fund Based Lending Asset Based Lending Loans for Infrastructure—Project Finance LOAN PRICING AND CUSTOMER PROFITABILITY ANALYSIS Step 1: Arrive at Cost of Funds Step 3: Assess Default Risk and Enforceability of Securities Step 4: Fixing the Profit Margin Some More Models of Loan Pricing Fixed Versus Floating Rates When the interest rates 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 v Hedging and Matched Funding As described above, 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 using interest The Price Leadership Model The basic model described above makes the assumption that the bank knows its costs accurately, and can estimate probability of default and recovery rate for each borrower or class of borrowers. The basic model also fails to buil 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 co Customer Profitability Analysis Periodically, or every time a borrower approaches the bank with a request for modifications in loan terms, a customer profitability analysis should be carried out by the bank. The analysis is used to evaluate whether the ne Principal Factors The Borrower/Management The Firm/Project Commercial Bank Relationships Industry Risk Modifiers Chapter 6: Banks in India—Credit Delivery and Legal Aspects of Lending MODES OF CREDIT DELIVERY Cash Credit Loan System for Delivery of Bank Credit—The Working Capital Demand Loan RBI Guidelines—Loan component and cash credit component2 Overdrafts Bills Finance Clean Bills This is a bill of exchange not supported by any documents of title to goods,6 since the seller has already delivered the goods and the documents to the buyer. Clean bills are also drawn to effect discharge of a debt or claim. Clean bills are t Documentary Bills A bill of exchange accompanied by documents of title to goods is a documentary bill. The goods have been despatched by the seller but the transfer of documents of title to goods has not yet taken place. Examples of documents of title to Supply Bills These bills do not fall in the ambit of the Negotiable Instruments Act. They are in the nature of ‘debts’ and can be assigned in favour of the bank. Precautions to be Taken While Purchasing/Discounting Bills Advances Against Bills Sent on Collection Drawee Bills In the earlier cases, the drawer of the bill, who is the seller, is financed by the bank. When the bank finances the buyer, the drawee, the buyer’s bank itself discounts the bills and sends the amount to the seller. This has the effect of fin Pricing of Loans Reset of interest rates under MCLR Interest rates on advances made in foreign currency Exemptions LEGAL ASPECTS OF LENDING What are Unsecured Loans? What are Secured Loans? Securities and Their Features Can the banker accept any asset offered by the borrower as security for the advances made? Some basic safeguards observed while accepting assets as securities would help the bank recover most of its dues in the event of defau Safeguard 1—Ensure adequate ‘margin’: For a bank, ‘margin’ signifies the difference between the market value of the security and the amount of advance granted against it. For example, if the bank has sanctioned `75 lakh as advance against a security worth Safeguard 2—Easy marketability: In case of default, the security should have wide and ready marketability, to enable the bank sell off the security and realize its dues. For example, gold or jewels held as security are more liquid since they have wider ma Safeguard 3—Documentation: The bank’s security interest is evidenced by legally valid documents that are executed by the borrower. These documents have to be periodically reviewed, especially in the case of securities for long-term loans or revolving cred What is a ‘Security’? What is ‘Right of Set Off’? The bank’s right of set off enables it to adjust the credit balance (or deposit) in one account of a customer with the debit balance (or loan) in another account of the same customer. For example, if a customer has a term depos Working Capital Finance Projected Turnover Method This method is generally used for assessing working capital finance requirements in case of borrowers whose fund-based working capital requirements are less than `2 crore. According to this method, the working capital requirement The Permissible Bank Finance Method This method is generally applied by banks to working capital limits of over `2 crore. Cash Budget Method This method is prevalently applied to borrowers with fund-based limits of over `10 crore from the banking system. Optional to all borrowers in industry, trade and service sectors, this method is preferred by borrowers in the constructi Fixing the Working Capital Credit Limit Financing Receivables Financing Capital and Non-Operating Expenditure Peer to Peer (P2P) lending – using technology for lending27 What is P2P lending? P2P- regulatory challenges Country experiences Credit Monitoring, Sickness and Rehabilitation BASIC CONCEPTS The Need for Credit Review and Monitoring Triggers of Financial Distress Financial Distress Models—The Altman’s Z-Score Some Alternate Models Predicting Financial Distress The Workout Function Credit Information companies in india 17 CIBIL and Loan Approval Other Credit Information Companies in India Debt Restructuring and rehabilitation of sick firms in India—the Workout function What is Restructuring? Criteria for Considering Restructuring Relief Measures under Restructuring Valuation of Restructured Advances Objectives of the Scheme The objectives of the scheme are: Features The features of the scheme are as follows: The Methodology The methodology is similar to the rehabilitation schemes operated for the SME sector. The CDR Structure The mechanism operates with a three-tier structure, consisting of the following: The Legal Issues The legal issues are as follows: Case Study I: India Cements Ltd Need for Restructuring When India Cements Ltd submitted a CDR proposal to the FIs at the end of 2002, it had stated that the bunching up of debt repayments over the next few years and inadequate cash flow generation was making it difficult for the company India Cements Debt Restructuring India Cements mandated HSBC Securities and Capital Markets (India) Pvt. Ltd as exclusive adviser in the restructuring process. As part of the debt-restructuring exercise, India Cements agreed to divest its entire stake in The Debt-Restructuring Proposal21 According to the debt-restructuring proposal, India Cements would use the proceeds from the sale of Visaka Cement to settle the debt in that company and then settle certain loans and interest and pressing creditors. It al Plan Under the CDR22 In a debt-restructuring plan cleared by the CDR Forum of FIs and banks, the company had committed to the following: Chapter 8 : Managing Credit Risk— An Overview BASIC CONCEPTS Expected Versus Unexpected Loss Defining Credit Risk6 Credit Risk of the Portfolio From our earlier discussions, it would be evident that managing the credit portfolio of a bank involves a higher level of risk-reward decisions than managing a portfolio of market investments. This is due to the fact that ther The Relationship Between Credit and Other Risks While loans are the largest source of credit risk and exposure to credit risk continues to be a leading source of problems, there are other sources of credit risk throughout the activities of a bank, in the Inter