Financial Institutions and Market

Structure, Growth and Innovation

Chapter 8

Commercial Bank

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 contd.
Structure of Indian Banking

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Learning Objective

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Theoretical Basis of Banking Operations

 Balancing Profitability with liquidity

 Management of Reserves
 Creation of Credit
 Process of Money Creation
 The ratio of new deposits to the original increase in reserves is
called the money multi­plier or credit multiplier or deposit
multiplier. This multiplier will be equal to the reciprocal of the
required cash reserve ratio (1/CRR).

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Special Role of Banks
 Creation & Channelising credit for productive
investment
 Act of Economic support system
 Economies of Scale
 Economies of Scope
 Monetary Policy transmission mechanism
 Social welfare, Social justice and Trust

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Services Provided by Commercial
Banks
 Acceptance of deposits
 Lending money or advancing of loans
 Investment of funds
 Remittance of funds
 Dealing in foreign exchange
 Overdraft Facility
 Discounting of Bills of Exchange
 Credit Cards
 Automatic Teller Machines (ATMs) Services
 Debit cards
 Online banking
 Private banking
 Mobile banking
 Public Provident Fund Account
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Bank Financial Statements
 The balance sheet
◦ A bank’s balance sheet presents the organization’s
financial condition at a single point of time. Balance
sheets are always prepared on a particular date i.e.
usually the last day of the quarter or year.
 Income statement
◦ The income statement shows all major revenues
and expenditures, the net profit or loss for the
period, amount of dividends declared and it
measures the bank’s financial performance over a
period of time such as a quarter or year.

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Liabilities of the Commercial Bank
◦ share capital
◦ reserves and surplus
◦ Deposits
◦ Borrowings
◦ other liabilities and provisions

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Types of Bank Deposits
 Demand deposits
◦ Current deposits: These are chequable accounts,
there are no restrictions on the amount or the
number of withdrawals from these accounts and
does not carry any interest
◦ Savings deposits: cheques can be drawn, withdrawn
from an account without previous notice are
restricted
◦ Call deposits: They are accepted from fellow
bankers and are repayable on demand. These
deposits carry an interest charge
 Term deposits (Fixed deposits)
◦ They have different maturity periods on which the
rate of interest depends 11
Assets of Commercial Bank
◦ cash in hand,
◦ balances with the central bank
◦ balances with the other banks
◦ money at call and short notice
◦ balances with banks outside India
◦ investments in government and other approved
securities
◦ bank credit
◦ fixed assets
◦ other assets
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Investments, Loans and Advances
 Investments
◦ Govt. of India Securities (SLR securities)
◦ Other-approved securities (SLR securities)
◦ Non-approved securities (non-SLR securities)
 Loans and Advances
◦ Cash Credits And Overdrafts
◦ Purchase And Discounting Of Commercial Bills
◦ Demand And Term Loans

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Approaches to Bank Lending
 Liquidation Approach
◦ It looks mainly to the assets of the borrower as
security for a loan. It implies a short-term rather
than a long-term view of the borrowers' prospects
and usually involves taking a charge of his assets
 Going Concern Approach
◦ It lays greater emphasis on the borrower's ability to
repay the loan out of future cash flow rather than
his ability to offer some tangible assets as security
for the loan

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Secured Vs. Unsecured Loan
 A secured advance is a loan or an advance
made on the security of assets, whose market
value is not at any time less than the amount
of loan or advance.

 An unsecured advance is a loan or advance

not so secured (No collateral or mortgage).

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Margins
 The loan made by a bank against a given security is always
less than the value of that security. This difference is known as
a "margin".
 The extent of margin differs from security to security; the
major principles which determine it are marketability,
ascertainability of value, stability of value, and transfer­ability
of title of the security
 Certain margin requirements which are in vogue in India are:
(a) gold bullion-10 per cent; (b) gold ornaments-20 to 30 per
cent; (c) government and other trustee securi­ties-10 per cent;
(d) ordinary shares-40 to 50 per cent; (e) preference shares-25
per cent;(f) debentures-15 to 20 per cent; (g) life policies-90
per cent of surrender value; (h) commodities- 25 to 50 per
cent; (i) immovable property-50 per cent.
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Bank Performance Measures

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Bank Performance Measures Cont…

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Non-Performing Assets (NPA)
 A non-performing asset shall be a loan or an advance
where the interest and/or installment of principal
remain overdue for a period of more than 90 days in
respect of the Loan
 For agricultural loans a loan granted for short duration

crops will be treated as NPA, if the installment of

principal or interest thereon remains overdue for two
crop seasons and a loan granted for long duration crops
will be treated as NPA, if the installment of principal or
interest thereon remains overdue for one crop season

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Asset Classifications
 Standard Asset: Standard Asset is one which does not
disclose any problems and which does not carry more than
normal risk attached to the business.  Such an asset should not
be an NPA
 Sub-Standard Asset: An asset would be classified as sub-
standard  if it remained NPA  for a period less than or equal to
12 months.
 Doubtful Asset: An asset is required to be classified as
doubtful, if it has remained NPA  for more than 12 months
 Loss Asset: A loss asset is one where loss has been identified
by the bank or internal or external auditors or by the Co-
operation Department or by the Reserve Bank of India
inspection but the amount has not been written off, wholly or
partly
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Capital Base of the Banks

 As per Basle Norms Capital to Risk (weighted) Assets

Ratio (CRAR) should be at least 8 percent
 Capital is split into two categories: Tier I and Tier II.

These categories represent different instruments'

quality as capital. Tier I capital consists mainly of share
capital and disclosed reserves and it is a bank's highest
quality capital because it is fully available to cover
losses. Tier II capital on the other hand consists of
certain reserves and certain types of subordinated debt

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Retail Banking:
 Three basic characteristics:

 Multiple products (deposits, credit cards, insurance,

investments and securities)
 Multiple channels of distribution (call centre, branch,
internet and kiosk)
 Multiple customer groups (consumer, small business,
and corporate).

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 contd.

 Drivers of Retail Business in India

 economic prosperity and the consequent increase in

purchasing power

 changing consumer demographics indicate vast

potential for growth in consumption

 Technological innovations
 Decline in treasury income of the banks

 Retail loans have put comparatively less provisioning

burden on banks 24
International Banking
 It is defined as banking transactions crossing
national boundaries
 Types of International Banks

◦ Correspondent Banks
◦ Representative Office
◦ Subsidiary and Affiliate Bank
◦ Foreign Branch of a Local Bank
◦ Offshore Banking Center

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Different types of risk in International
Banking
 Country Risk
 Transfer Risk
 Credit Risk
 Currency Risk

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Other Issues in Commercial Banking
in India
 System of Cheque Clearances
 Participation Certificates and Inter-Bank

Participations
 Stockinvest Scheme
 Consortium Approach or Multiple Banking

Arrangements
 Lead Bank Scheme, Service Area Approach

and Action Plans

 Local Area Banks (LABNKs)
 Commercial Banks and Microfinance

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Factors Affecting Composition of Bank Deposits in India

 Increase in national income

 Expansion of banking facilities in new areas and for
new classes of people
 Increase of banking habit
 Increase in the relative rates of return on deposits
 Increase in deficit financing.
 Increase in bank credit.
 Inflow of deposits from Non-Resident Indians
(NRIs).
 Growth of substitutes

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NPAs in Indian Commercial Banks

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Basel Norms for Banking Supervision
(Basle-I)
 Consists of four-pillars
◦ Constituents of capital: Tier 1 capital consisting of (a) Paid-up share
capital/common stock (b) Disclosed reserves and Tier 2 capital
consisting of undisclosed reserves, Revaluation reserves, General
provisions/general loan-loss reserves, Hybrid debt capital instruments
and Subordinated term debt
◦ Risk weighting system: The risk weights include only five weights: 0,
10, 20, 50 and 100%.
◦ The target standard ratio: A target standard ratio is the ratio of capital
to weighted risk assets set at 8% (of which the core capital element has
to be at least 4%).
◦ Transitional and implementation arrangements

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Basel II

 Consists of three pillars

 Minimum capital Requirements: the banks should measure
the risk weighted assets providing the due weightage to the
three types of risks such as credit risk, market risk and
operational risk
 Supervisory Review Process: It is basically intended to
ensure that the banks should have enough capital bases to
support all the risks associated with the banks business
process.
 Market Discipline: Disclosures of a bank’s capital and risk-
taking positions are recommended to be released to the
general public
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Basel III
 The major changes Proposed in Basel III are
as follows:
 Better Capital Quality: Introduction of much stricter definition of capital. Better quality
capital means the higher loss-absorbing capacity. Greater focus on common equity.
 Capital Conservation Buffer: Banks will be required to hold a capital conservation buffer of
2.5%
 Countercyclical Buffer: The buffer will range from 0% to 2.5%, consisting of common
equity or other fully loss-absorbing capital
 Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement
for common equity, the highest form of loss-absorbing capital, has been raised under Basel III
from 2% to 4.5% of total risk-weighted assets
 Leverage Ratio: Basel III norms include a leverage ratio to serve as a safety net. A leverage
ratio is the relative amount of capital to total assets (not risk-weighted). 3% leverage ratio of
Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018
 Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be
created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to
be introduced in 2015 and 2018, respectively
 Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential
framework, systemically important banks will be expected to have loss-absorbing capability
beyond the Basel III requirements.
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Risk Management in Banking

 Includes risk identification, measurement and

assessment

 Objective is to minimize negative effects risks can

have on the financial result and capital of a bank
 Types of Banking Risk

 Credit risk  Country risk

 Market risks  Operational risk
 Liquidity risk  Legal risk
 Exposure risks  Reputational risk
 Investment risks  Strategic risk.
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Credit Risk Management

 To maximise a bank’s risk-adjusted rate of return by

maintaining credit risk exposure within acceptable
parameters

 The effective management of credit risk is a critical

component of a comprehensive approach to risk
management and essential to the long-term success

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 contd.
 Commonly used methods for Estimation of Credit Risk:

 Econometric Techniques
 Neural Network
 Optimization Models
 Rule-based or Expert Systems
 Hybrid Systems

 Major Considerations :

 The allocation of capital for credit risk

 The shape of the loss distribution
 Correlation between default risk and loss given default
 Impact of diversification between portfolios
 The internal Credit- risk Rating Framework 47
 contd.

 Essentials for an appropriate credit risk management

mechanism could include the following:

 Establishment of an appropriate Credit Risk Policy at

the Board of Directors level
 Banks should identify and manage credit risk
inherent in all products and activities.
 Senior management Support with the required MIS
 Competencies and clear accountabilities need to be
put in place.

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 contd.

BASEL II on Credit Risk

 The Basel Committee on Banking Supervision on New

Capital Adequacy Framework

 Minimum Capital Requirements

 Supervisory Review
 Market Discipline

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Market risks
 Includes :
 Interest rate risk
 Foreign exchange risk

 Interest rate risk:

 Net interest margin (NIM) of banks is a direct function
Includes:
 Re-pricing Risk
 Basis Risk Embedded
 Option Risk
 Re-investment Risk
 Yield Curve Risk
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 contd.

Measurement of Interest Rate Risk

 Most widely used techniques:

 Maturity Gap Analysis

 Duration and Modified Duration
 Simulation modeling
 Value-at-Risk
 Stock Index Approach

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 contd.
 Duration Gap Analysis (DGA

 Duration is a measure of the percentage change in the

economic value of a portfolio, that will occur consequent
to changes in interest rates

 Difference between Duration of Assets (DA) and Liabilities

(DL) is the bank’s net duration.

 DA > DL then a decline in market interest rates is likely to

increase the market value of equity
 DL > DA market value of equity increases when the
interest rate increases and it decreases in the face of decline
in interest rates
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 contd.
 Value at Risk (VaR):
 Value- at-risk indicates the potential loss of a position
/ asset over a period of time with a given level of
confidence.
 Assuming that price changes of financial instruments
are jointly normally distributed, serially independent
and have constant volatility, VaR is defined as:
VaRi = Vi*(∂V/∂P)*∂Pt
Where
Vi : market value of the position at time, i,
∂V/∂P: sensitivity of market value to changes in P (for
example interest rates)
∂Pt : change in P, of the underlying asset, over time 53
 contd.
 Interest Rate Risk: A Stock Index Approach

 Sensitivity of interest rate is observed against the

return of Bank Index

(Rs - RL)=  + (RM - RL) + €

RL = Long term risk free interest rate (Government

Bond 10-year maturity)
Rs = Return on Bank Index
RM = Return on Equity Market
‘’ indicates the sensitivity of interest rate change on
stock price of the banks. 54
Operational Risk

 Risk of loss resulting from inadequate or failed

internal processes, people and systems or from
external events

 Under Basel-II, operational risk approaches :

 Basic Indicator Approach

 Standardized Approach
 Internal Management Approach

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 contd.
 Sources of Operational Risk

 Wrong/delayed decisions and lack of accountability

 Inadequate MIS & Obsolete policies,
 Incompetency of staff and lack of proper training
 Lack of succession planning and development of second
line
 Non compliance with circulars, policies, and regulatory
requirements
 Involvement of staff in frauds and forgeries
 Failure of technological equipment
 Natural calamities and unanticipated changes
 Deterioration of bank image due to poor services, staff
behaviour, frauds, high NPAs, etc. 56
Liquidity Risk
 Inability to meet the bank’s liabilities as they become
due.

 Unable to generate cash to meet funds withdrawals,

committement credit or increase in assets.

 mismatches in the maturity pattern of assets and

liabilities.

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 contd.

 Two approaches
(I) Fundamental Approach
(II) Technical Approach

 Fundamental Approach : long run

• Asset Management
• Liability Management

 Technical Approach : short run

• Working Funds Approach
• Cash Flows Approach
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 contd.

Cash Flows Approach

• Estimate anticipated changes in deposits.

• Estimate the cash inflows by way of loan recovery
• Estimate the cash outflows by way of deposit withdrawals and
credit accommodations.
• Forecast these for the end of each period.
• Estimate the liquidity needs over the planning horizon. 59
 contd.

Techniques to quantify and manage liquidity risk

• Reserve requirements

• Liquidity ratio

• Degree of asset and liability cash flow mismatch

• Degrees of diversification of borrowing facilities and

contingent loan commitments

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