Bank Management

Class One

For

PGDM

Indian Institute of Management, Calcutta

By

Praloy Majumder

(For Classroom discussion only)

1
 Class One

Role of Financial System

Financial system is one of the most important inventions of the modern society. Its
primary task is to move scarce loanable funds from those who save to those who
borrow to buy goods and services and to make investments in new equipment and
facilities so that the overall economy can grow and increase the standard of living
enjoyed by the citizens. Without the financial system and the funds it supplies, each
of us would lead a much less enjoyable life.
The financial system determines both the cost of credit and how much credit will be
available to pay for the thousands of different goods and services we purchase daily.
The happening in this system has a powerful impact in the health of the overall
economy. For example, when credit becomes more costly and less available, total
spending for goods and services falls resulting in the increase in unemployment. This
will in turn reduce the growth and which will force the business houses to cut back
the production and lay off workers. In contrast, when the cost of credit declines the
loanable funds become more readily available and this will increase the total
spending in the economy. This will in turn creates more jobs and the economy
growth accelerates. In fact, the financial system is an integral part of the economy
system and we cannot be able to comprehend the economy system without knowing
the financial system.
Flows within the economic system
The basic function of any economy is to allocate scarce resources--- land, labor,
management skill and capital – to produce the goods and services needed by the
society. The economic system must combine inputs--- land, labor and management
skills, capital to produce out put in the form of goods and services. The economy
generates a flow of production in return for a flow of payments.

Flow of Production
Land & other natural
resources Goods and services sold
Flow of payments to the public.
Labor and managerial
skills

Capital equipment

2
 Figure 1.1 : The Economic System

The flows of payments and production within the economic system can be depicted
as a circular flow between producing unit (mainly business and government) and
consuming unit (principally households). In modern economy, household provides
labor, management skill, and natural resources to business firms and governments in
return for income in the form of wages and other payments. Most of the income
received by the household is spent to purchase goods and services from business
and governments. This is shown below in Fig 1.2:

Flow of expenditure for consumption and taxes

Flow of production of goods and service

Producing units
(mainly business Consuming units
firms and govt) (mainly
households)

Flow of productive services

Flow of income

Fig 1.2: Flow of income, payments and production in the economic system

3
The Evolution of Financial Transaction
All financial transactions perform at least one basic function- movement of scarce
fund from those who save and lend to those who wish to borrow and invest.
However, the transfer of funds from savers to borrowers can be accomplished in at
least three different ways . We label these methods of fund transfer as
 Direct Finance
 Semi direct Finance
 Indirect Finance
Direct Finance : In the direct finance, borrower and lender meet each other and
exchange funds in return for financial assets. One such example is the borrowing of
money from one individual to another in exchange of promissory notes ( signed by
the borrower) against money ( given by the lender) . The process is explained below
with the help of the following diagram:

Flow of funds
Borrowers Lenders
(deficit budget unit) (surplus budget unit)

Primary Securities

Fig: 1.3 Direct Finance (Direct lending gives rise to direct claims against borrowers)

Limitation of this type of finance:

 Both borrower and lender must meet each other to carry out the transaction.
So cost of searching/information is high.
 Both borrower and lender must agree to exchange exactly identical amount of
money that is difficult.
 Lender must have faith on the security issued by the borrower, which is also
difficult to achieve.
Semi direct Finance: In this type of finance , some individuals and business houses
become security brokers and dealers whose essential function is to bring surplus and
deficit budget units together, thereby reducing information costs. This is explained
below:

4
 Primary securities Primary
Borrowers Security brokers, Lenders
Securities
(deficit budget dealers and (surplus budget
unit) investment unit)
Flow of funds bankers Flow of funds

Fig 1.4 Semi direct Finance (Direct lending with the aid of market makers who assist
in the sale of direct claims against borrowers)
Semi direct finance is an improvement over the direct finance in the following
manner:
 Information cost for participants is reduced to a great extent
 The requirement of exact amount of money involved is eliminated as dealers
can split up securities and sale in smaller lots
 Both dealers and brokers help in the development of the secondary market
Still semi direct finance has limitations. The most important of them is:
 In this process also , the lender has to accept the security offered by the
borrower as an acceptable security.

Indirect Finance: The limitations of both direct and semi direct finance can be
removed in the Indirect Finance. In this form of finance, one financial intermediary
comes in between lenders and borrowers. The financial intermediaries performs the
following functions:
 The financial intermediary accepts money from the surplus budget unit in the
form of deposits. In return of the money deposited, the financial intermediary
issues secondary security. Since most of the financial intermediaries are
regulated by financial regulations in terms of financial strength, lenders are
more willing to accept this secondary security as gains the primary securities
issued by the borrower himself.
 The financial intermediary finds out the deficit budget units for giving loans
and collects money from the borrowing unit. The information and searching
cost are reduced.
The entire mechanism of indirect financing is shown below :

5
 Primary Security Secondary Security
Ultimate Financial Ultimate lenders
borrowers Intermediaries ( surplus budget
(deficit budget (banks, Financial unit)
units) Institutions)

Flow of funds Flow of funds

Fig 1.5: Indirect Finance (The financial intermediation of funds)

Financial disintermediation : In the process of financial disintermediation , the

role of financial intermediary has been eliminated and the borrowers can raise the
fund directly from the lender with the help of either public issue or private placement
of securities. This can be performed with the help of stock exchanges. Though the
financial disintermediation has been progressing rapidly in the developed and
matured financial markets like USA , UK etc, it is yet to take momentum in Indian
market. This is due to the fact that to work financial disintermediation, stock market
has to perform to the satisfaction of the lenders. Considering the maturity stage of
our stock market, it is yet a long road to go for establishing financial
disintermediation as an established procedure.

Role of bank in low income and developing economy

As we have seen that banks are one of the channels through which surplus fund
would move from savings unit to investment unit. This transfer of fund is required to
increase the national income. In case other channels are matured and developed
,even if the banking channel is not working properly , funds can move from other
channels and economy can register growth. However , in the low income and
developing economy , other channels are not developed to the extent and
accordingly the role of banks are more important than the developed economy. At
the same time , since rapid growth requires upfront capital and capital is short in the
case of developing and low income country. Under such situation , banking sector
would play the most crucial role in the overall economic growth .
Let us analyse the trend about the importance of banking system in the overall
economic growth . We have taken the following parameters for four emerging

6
economies , Vietnam, China , India and Indonesia and two developed economies
United States of America and United Kingdom. We have used data from world bank
website ( www.worldbank.org) under the following categories for the period from
2000 till 2019 except for Bank NPL data for which we have taken data from 2009
onwards and domestic credit to private sector as a % of GDP for Indonesia we have
taken data from 2009 onwards.

 Domestic credit to private sector as a % of GDP

 Domestic credit to private sector by banks as a % of GDP
 Bank NPL as a percentage to total gross loan
 Real GDP growth rate ( % p.a.)
 GDP value at current USD
From the data , we have calculated the median value of the above period of the first
4 parameters and we have taken the value of the last parameter i.e. GDP value at
current USD as on 2019. Findings are presented in the following table :

Developing Economy Developed

Economy
Vietnam China India Indonesia USA UK
Domestic 95.82% 125.04% 48.94% 36.42% 183.70% 136.47%
credit to
Private
Sector ( %
of GDP)
Domestic 95.82% 124.96% 48.94% 25.92% 52.12% 136.24%
Credit to
Private
Sector by
banks ( %
of GDP)
Banks NPL 2.28% 1.25% 5.12% 2.43% 1.85% 2.38%
to total
gross loan (
%)

7
GDP growth 6.55% 9.13% 7.23% 5.07% 2.28% 2.23%
rate ( %)
GDP at 262 14343 2875 1119 21374 2827
Current
USD (
billion) as
on 2019

Fig: 1.6 Selected macro economic parameters for developing and developed
economy
[ Source : World bank website :data.worldbank.org]
From the above table following information stand out :
 Developed economy has more domestic credit to private sector compared to
developing economy
 In USA , entities other than bank are more important in transfer of fund from
savings unit to investment unit
 China’s has been able to grow fastest among all countries mainly through
bank credit and at the same time keeping NPL lower
 Indonesia has got the lowest debt among developing economy .
For certain countries ,not only the continuous growth but speed of growth also
matters. As per statistics , India need to grow at 8% p.a. ( real GDP) continuously
for next one decade to absorb large number of people entering in the job market.
Under such situation , the question arises , would the role of the banks change under
such situation ? Besides , we are starting at double digit contraction which we never
thought of in our wildest dream even at the start of the calendar year. We also need
to analyse the role of bank during the recession phase .

Role of bank lending in faster credit growth :

We have segregated three phases of growth for three developing economies . The
fist phase of growth is the growth base when the growth would take place in small
base. We have selected this phase as the period during which GDP has grown from
USD 700 billion to USD 1000 billion. The second phase is the growth phase when the
growth would take place at a moderately elevated base. We have identified this
phase as the phase when the GDP growth would take place from USD 1000 billion to

8
USD 3000 billion. The third phase of growth would take place when GDP has to grow
at a moderately higher base . This phase has been selected as the phase when GDP
would be growing from USD 3000 billion to USD 6000 billion. For the case of China ,
we have all the three phases and for India we have phase one complete and the
phase two nearing completion. For the case of Indonesia, we have only the phase I .
We have taken the following data in these three phases to find out the influence of
bank credit to GDP growth :
 Domestic credit to private sector by bank / GDP ( %) : median value
 Time taken to go to the next phase
 GDP growth rate during this period (%) : median value

Phase I Phase II Phase III

( GDP Value from ( GDP Value from ( GDP Value from USD
USD 700 billion to USD 100 billion to 3000 billion to USD
USD 1000 billion ) USD 3000 billion ) 6000 billion )

China
Domestic credit 92.53% 111.12% 124.41%
to Private
Sector by bank
/GDP
Time taken to 3 7.1 3
reach to the
next phase (
years)
GDP growth 9.58% 10.50% 10.15%
rate
India
Domestic credit 45.63% 50.15% Yet to cross phase II
to Private
Sector by bank
/GDP
Time taken to 2.8 13
reach to the
next phase (

9
 years)

GDP growth 7.66% 6.98%

rate

Indonesia

Domestic credit 32.45% ( Yet to cross Phase Yest to Cross Phase II

to Private **37.75%) II
Sector by bank
/GDP
Time taken to 7.3
reach to the
next phase (
years)
GDP growth 5.12%
rate

Fig : 1.7 different phase of GDP growth and role of bank credit
** Domestic credit to Private Sector

It can be seen from the above that both India and China completed the Phase I more
or less in the same time frame. However India lagged behind significantly in the
Phase II growth . Indonesia struggled to cross the first phase of growth. Structural
reform , global economic situation play important roles for economic growth. The
above table and intuition definitely can not rule out the enormous importance of
bank credit during the economic growth under normal situation .

Importance of bank credit increases significantly during the time of recession and
specially when the central and state government have limited scope to provide the
necessary support in the form of appropriate stimulus. COVID 19 upended all
calculations related to GDP growth . A close look at International Monetary Fund (
IMF) )data would reveal that COVID 19 events would have chronic impact on many
economies .

10
 Cumative GDP ( in constant price ) Growth rate
2019-24
Advanced Economy
World
Emerging Market
USA
India
China

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Forecast made in Oct 20 Forecast made in Oct 19

Fig : 1.8 : Cumulative GDP ( in constant price ) Growth rate 2019-24

Forecast made in Oct 19 versus Oct 20 : Source : IMF Report

As per IMF report ( as shown above ) , India’s GDP would likely to register a
cumulative growth rate of just half the projections made last year which was more
than 40%.
The above situation clearly indicates that Indian banking system would have to
deliver unprecedented performance in next four years and this would be the most
crucial factor of the reviving the India’s GDP growth .

On this back drop , let us find out the scenario of Indian Banking for the period of
June 5th 2020 to September 11th 2020:

11
Fig : 1.9 , the deposit growth weekly basis from June 5th 2020 to September 11th
2020

12
 Fig : 1.10 , the non food credit growth weekly basis from June 5th 2020 to
September 11th 2020

It can be seen from the above that during this period , the deposit growth in the
Indian banking sector had outpaced the figures of previous years . However , the
credit growth exhibited significant negative growth compared to that of previous year
. This may be due to excessive risk aversion shown by the banks under the existing
situation. However , considering all the above factors discussed , do we have other
option other than to lend ?

Considering the role banking sector plays in the overall GDP growth in the developing
economy , this is an ominous sign. Performance of banking sector in the next two to
three years would be the determining factor of India’s future for next three decades :
not a hyperbole.

13
 Bank’s Liability and Assets

As can be seen from the above, that bank plays the role of an intermediary where
banks collects money from the depositor against issuance of its security and then it
lends to the corporate. Such system would operate as long as the bank is able to
keep its commitment to the investors. Since bank is an important financial
intermediary , the soundness of the bank is of paramount importance in the stability
of financial system. Accordingly, we need to know the basic financial structure of
bank and how it is different from normal corporate.

Let us draw a comparison of HDFC bank balance sheet and ITC Limited balance
sheet as on March 31 2020 . The liability comparison of both the entities are given
below :
HDFC Bank As on March 31 ITC Limited as on March 31, 2020 ( Rs
,2020 ( Rs crores ) crores )

% of total % of total

Equity share 548.33 0.04% Equity share 1229.22 1.63%

Capital Capital
Reserves and 170437.70 11% Reserves and 62799.94 83.47%
Surplus Surplus
Share holders 170986.03 11.17% Share holders 64029.16 85.11%
fund fund
Deposits 1147502.29 74.98% Non current 2116.79 2.81%
liability
Borrowings 144628.54 9.45% Current 9089.41 12.08%
liability and
provisions
Other liabilities 67394.40 4.40%
and provisions

Total 1359525.23 88.83% Total 11206.20 14.89%

Liabilities Liabilities

14
 Total Total
Capital Capital
and and
Liabilities 1530511.26 100.00% Liabilities 75235.36 100.00%

Fig : 1.11 Comparison of ITC Limited and HDFC Bank Limited :Balance Sheet
Liability Composition

As we see from the above that the capital structure of HDFC Bank is highly levered
compared to ITC Limited balance sheet . This is reflected in lower percentage of
equity and reserves to the total capital and liability of HDFC Bank ( 11.17%)
compared to that of ITC Limited ( 85.11%). Since we know that a highly levered
institution is highly risky entity , HDFC Bank Limited is riskier entity compared to
that of ITC Limited . This is true for all other banks . Considering the importance of
bank in the economy , at any point of time banks have to run as a going concern by
keeping its commitment to its depositors and at the same time have to work within
the risky parameters. So bank will always have to operate under strict risk
containing mechanism as prescribed by central bank of a country. When we shall
analyse the bank performance , we have to always keep this in our mind. This is the
rational behind prudential norms, exposure norms, investment valuation norms ,
capital adequacy norms, risk management and asset liability management systems
of banks.
After comparing the liability side of bank balance sheet we shall compare the asset
side of bank balance sheet :

15
 HDFC Bank As on March ITC Limited as on
31 ,2020 March 31, 2020
Rs crores % of total Rs crores % of total

Cash and 72205.12 4.72% Cash and 6843.27 9.10%

Bank with Bank
RBI
Balance with 14413.60 0.94% Investment 30630.61 40.71%
Banks
Investments 391826.66 25.60% Loans 4333.66 5.76%
Advances 993702.88 64.93% Receivable 2092.00 2.78%
Financial 1472148.26 96.19% Financial 43899.54 58.35%
Assets Assets
Fixed Asset 4431.92 0.29% Fixed Asset 23297.75 30.97%
Other Assets 53931.09 3.52% Inventories 8038.07 10.68%
Physical 58363.01 3.81% Physical 31335.82 41.65%
Assets Assets
Total 1530511.27 100.00% Total 75235.36 100.00%
Assets Assets

Fig 1.12: Comparison ITC Limited and HDFC Bank Limited Asset Composition
If we see the above , we find that majority of bank assets comprise of Financial
Assets ( 96.19%) . From the above , we see that physical asset is lower in the bank
balance sheet( 3.81%). This would be due to the reason that bank is created to
channelise fund to the productive sector. That is why banks are having restriction in
investment in Fixed assets. Banks are having significantly higher portion in the form
of investments and loans and advances. In India, Investment includes subscription
to Govt of India securities. This is being carried out due to meeting the SLR
requirement . Banks need to invest 18% of its net demand and time liabilities in the
form of SLR securities which consist of GOI securities. Government issues securities
to bridge the fiscal deficit and bank has to invest fund on this instrument in the
form of SLR securities. With the implementation of FRBM act we expect that the SLR
requirement would go down in the near future as the fiscal deficit would go down
with the implementation of FRBM act. Since during the time of crisis , the value of

16
financial asset deteriorates faster compared to that of physical asset, from asset side
composition also bank is riskier entity.

Basic principles of risk management :

As mentioned earlier , bank is riskier entity . Accordingly , bank has to operate within
proper risk management guidelines. Even though risk management is a vast subject
, we can easily find out the basic framework of risk management by understanding
the sources of risk . As mentioned that sources of risk are both from liability side and
asset side .
Liability side source of risk is arising from higher leverage. The appropriate risk
management guidelines for these are :
 Adequate capital adequacy framework : A bank has to maintain minimum
amount of capital to reduce the leverage .
 Less reliance on short term liability : A bank has to maintain proper Asset
Liability Management within next 90 days so that suddenly banks do not come
under deposit withdrawal pressure
The asset side source of risk is due to presence of financial assets . The
corresponding risk management guidelines revolve around :
 Restriction on investment in riskier securities through capital market exposure
 Marking mark to market of assets on more frequent basis by putting
restriction on Held To Maturity ceiling within overall investment
 Prudential norms on asset classification by recognising Non Performing Asset
as fast as possible and then making adequate provisions
 Reduction in concentration of exposure by having single borrower and group
exposure norms
 By keeping Liquid Asset under Liquidity Coverage Ration
Even though all the above factors are monitored by the regulators , the moral hazard
issues are very important in the financial service sector . Accordingly corporate
governance takes the center stage of risk management. Central bank must create a
robust corporate governance framework of commercial banks and this is the
precursor of any risk management of a bank.

17