UNIT I – SOURCES &

APPLICATIONS OF FUNDS
 SOURCES OF FUND
• Banks are financial intermediaries.
• They mobilize deposits from the public mainly for the
purpose of lending and investment and to earn profits
from such operations
• Entire funds not employed in income – earning assets like
loans and investments
• A part of deposits is kept in cash and other liquid assets to
enable banker to meet its obligations towards depositors.
• Deposits are the primary sources of funds for banks
• The other sources of funds for banks are “equity and
reserves” and “borrowings”.
 SOURCES OF FUND
• A bank is a financial intermediary engaged in
purchasing and selling of funds. It is expected to
earn a reasonable return to the savers, supply
funds to investors and generate sufficient profit
margin for itself after covering the cost.
• Sources of fund
– Capital Adequacy
– Deposit
– Non – deposit sources
– Designing of deposit scheme and the pricing of deposit
services
 Capital Adequacy
• Economic Definition of a bank’s capital or
owner’s equity stake a Financial Institution (FI)
is the difference between the market values of its
assets and its liabilities.
• This is also called net worth of an FI.
• Economist – Aggregate amount of capital
required as a cushion for unexpected losses due
to risk
• Regulators – minimum capital a bank is required
to maintain as per regulatory standards
 Concept of Capital Adequacy
• It is the test of a financial business’s ability to meet its
financial obligation.
• Capital adequacy mean that a bank / financial
institution has to have enough money to conduct its
business
• Committee on Banking Regulations and Supervisory
Practices (Basel Committee) had released the guidelines
on capital measures and capital standards in July 1988,
which were been accepted by Central Banks in various
countries including RBI.
• In India, it has been implemented by RBI wrt 1.4.92.
 Objectives of CAR
Fundamental objective for holding adequate capital by
banks
• Strengthen the soundness of banks
• Stability of the banking system
• Provide a stable resource to absorb losses
• Loss absorption capacity based on the business risk
 Objectives of CAR
• Objective is to strengthen the soundness and
stability of the banking system
• CAR – It is ratio of capital fund to risk weighted
assets expressed in percentage terms.
• Minimum requirement of capital fund in India:
– Capital Adequacy Ratio = (Tier I + Tier II + Tier III
(Capital funds)) /Risk weighted assets
– As per RBI norms, Indian scheduled commercial banks
are required to maintain a CAR of 9% while Indian public
sector banks are emphasized to maintain a CAR of 12%.
– The Basel III norms stipulated a capital to risk weighted
assets of 8%.
 Capital Fund

• Capital Fund has two Tiers – I & II

• Tier I capital should at no point of time be less
than 50% of the total capital
• Tier II capital cannot be more than 50% of the
total capital
• Tier 1 capital is a bank's core capital and includes
disclosed reserves—that appears on the bank's financial
statements—and equity capital.
• Tier 2 capital is a bank's supplementary capital.
Undisclosed reserves, subordinated term debts, hybrid
financial products, and other items make up these funds.
• Tier 3 capital is inferior to I & II capital and it includes
funds that support to market risk and foreign currency
risk.
 Tier I Capital
• Tier I Capital = (paid-up capital + statutory reserves +
other disclosed free reserves + capital reserves) – (equity
investments in subsidiaries + intangible assets + current
and bought forward losses)
• Tier II Capital = Undisclosed reserves and cumulative
perpetual preference shares + revaluation reserves +
general provisions and loss reserves + investment
fluctuation reserve + hybrid debt capital instrument +
subordinated debt
 Capital Fund – Tier I
• Tier I Capital includes:
– Paid – up capital - Paid-up capital is the amount of
money a company has received from shareholders in
exchange for shares of stock
– Statutory Reserves – Profit earned year wise 20%
– Other disclosed free reserves - reserves a bank holds in
excess of required reserves for the purpose of paying
dividend, to issue bonus shares and
– Capital reserves – Profit on sale of assets
Minus
– Equity investments in subsidiaries – bank’s own
subsidiaries (mutual fund, factoring, shares) – HDFC
Bank, HDFC MF, HDFC Asset Mgt
 Capital Fund – Tier I
– Intangible assets (to create brand name ) and
– Losses in the current period and those brought
forward from previous periods, to work out the Tier I
capital
 Capital Fund – Tier II Capital
• Tier II capital consists of:
– Undisclosed reserves (confidential purpose some
reserves held which are not explicitly shown) and
cumulative perpetual preference shares
– Revaluation reserves (at a discount of 55% while
determining their value for inclusion in Tier II capital) –
(Current Mkt price – Acquisition price) * 45%
– General Provisions and Loss reserves up to a maximum
of 1.25% of weighted risk assets – From the weighted risk
assets (provision for bad debts) – 1.25%
– Investment fluctuation reserve not subject to 1.25%
restriction – SLR & other investments value keeps on
changing in securities
 Capital Fund – Tier II Capital
– Hybrid debt capital instrument (say bonds) –
combined features of both equity and debt holdings
(Tier II Preference stock & long term debts) – each has
close similarity to equity
• Hybrid debt equity instruments contain features of both
equity and debt holdings. It reduces volatility of equity
holdings and is partly secured.
• in case of liquidation or winding-up of the issuer – they are
ranked below all other debt but above equity
• Zero coupon bonds, Convertible bonds, warrants
– Subordinated debt (long term unsecured loans)
– Instruments with an initial maturity of less than 5
years should not be included as part of Tier II capital.
– Subordinated debt instruments will be limited to 50
percent of Tier I capital.
 Cumulative Preference Shares
• For example, suppose a company issues cumulative preference shares worth Rs
1,000 each, promising to pay out 10 per cent annually. In Year One, the economy is
in good financial health and pays out its dividend in full, meaning the cumulative
preferred shareholder gets Rs 100. But in Year Two, the economy slows down and
the company can only afford to pay out half the dividend, that is Rs 50. In Year
Three, the business environment worsens and the company halts dividend payment.
• The total due to the shareholder is now Rs 150 (Rs 100 for third year and balance Rs
50 from the second year). In Year Four, the economy rebounds and resumes
dividend payments. The cumulative preferred shareholder must be paid Rs 150 in
arrears, plus Year Four dividend of Rs 100. Cumulative preferred shareholders must
be paid before the company can pay a dividend to other classes of shareholders.
 Revaluation Assets

• Always asset side the cost of original acquisition price

only will be shown.
• Revaluation assets, there must be increase in price of the
asset and if revaluation required, the original price will
be revaluated.
• Say 1,00,000 – Purchase price of an asset
• Now the value is 1,75,000
• So, 75,000 is revaluation price of the asset
• Revaluation reserves is at a discount of 55% will be
calculated and included in Tier II capital
• 75,000 X .45 = 33750.
 Hybrid Security
• The most common type of hybrid security is
a convertible bond that has features of an ordinary bond
but is heavily influenced by the price movements of the
stock into which it is convertible.
 Subordinated Debt
• Suppose a company issues two bonds: Bond A and Bond B.
The company fails and is forced to liquidate its assets to pay
off debt. The money owed to Bond A holders is considered
the priority debt, so Bond B debt holders will be paid off
only after all Bond A holders are repaid. Because Bond B
was ranked second in priority, it is considered subordinated
debt. Bond A debt is considered unsubordinated debt.
• A typical example for this would be when a promoter of a
company invests money in the form of debt rather than in
the form of stock. In the case of liquidation (e.g. the
company winds up its affairs and dissolves), the promoter
would be paid just before stockholders — assuming there
are assets to distribute after all other liabilities and debts
have been paid.
 Tier III Capital
• Tier 3 capital is capital banks hold to support market risk in
their trading activities.
• Tier 3 capital must not be more than 2.5 x a bank's tier 1
capital and less than a two-year maturity.
• To qualify as tier 3 capital, assets must be limited to no more
than 2.5 x a bank's tier 1 capital, be unsecured, subordinated,
and whose original maturity is no less than two years.
• It is inferior to Tier I & II Capital
• Tier 3 capital consists of subordinated debt to cover market
risk from trading activities.
• Examples of market risk are: changes in equity prices or
commodity prices, interest rate moves or foreign exchange
fluctuations.
 Tier I , II & III Capital
• Tier I capital is a bank's core capital consisting of
shareholders' equity and retained earnings; while
• Tier II capital includes revaluation reserves, hybrid
capital instruments, and subordinated term debt.
• Tier III capital consists of Tier II capital plus short-term
subordinated loans.
 Risk Weighted Assets (RWA) – Fund
Based
• The Risk Weighted Assets (RWA) refer to the fund based
assets such as Cash, Loans, Investments and other assets.
They are the total assets owned by the Banks, however,
the value of each asset is assigned a risk weight (for
example 100% for corporate loans and 50% for mortgage
loans)
 Risk Weights

• Cash & Government bonds – 0% risk weighting

• Mortgage Loans – 50% risk weighting
• Other type of assets (Loans to customers) – 100% risk
weighting
• The degree of risk expressed % weights assigned by the Reserve
Bank of India. The following table shows the Risk weights for some
important assets assigned by RBI in an increasing order.
 How does it works
• Let’s take this example, For a AAA client, the risk weight
is 20%, which means banks have to set aside its own
capital of 1.80 for every Rs 100 loan (this means 20% of
9% of 100).
• Similarly, in case of 100% risk weight (such as capital
markets exposures) , banks have to keep aside its own
capital of Rs 9 on the loan.
Risk Weighted Assets (RWA) – Non-Funded
Items
• The Risk Weighted Assets (RWA) also refers to
• Non – funded (off the balance sheet) items –Letter of credit,
letter of guarantee and DPGL (deferred payment guarantee
letter)
• DPGL – Bank will sign guarantee letter
• Say Rs 100 given as loan to another person bank will sign
guarantee letter stating the payment will be deferred.
• For Rs.100 – 10 as Advance will be paid first month
• Second month – 10 + Int on Rs.90
• Third month – 10 + Int on Rs.80 and so on…

• From these non funded items also risk has to be allocated and
shown in the balance sheet.
 CAR - Calculation
• Calculate capital adequacy ratio, ie., total capital to risk
weighted exposures ratio for Small Bank Inc. using the
following information:

Exposure (Rs.) Risk Weight

Government Treasury held as asset 1,500,000 0%
Loans to Corporates 15,00,000 10%
Loans to Small Businesses 8,000,000 20%
Guarantees and other non – balance 6,000,000 10%
sheet exposures

• The bank’s Tier 1 capital and Tier 2 capital are

Rs.300,000 and 200,000 respectively.
• Bank’s total capital = 200,000 + 300,000 = Rs.500,000
• Risk – weighted exposures = Rs.1.5x0%+Rs.15x10%
+Rs.8x20%+Rs.6x10%=Rs.3.7 million
• Capital Adequacy Ratio = 0.5 million / 3.7 million = 14%

• According to norms, the minimum capital adequacy

ratio is 8%, since the bank has 14%, the bank is safe.
However, if the required ratio is 15% the bank might
have to face regulatory actions.
Calculate CAR
 Basel Norms
• Pre Basel period
• Basel I (1 pillar – minimum capital requirement – credit
risk)
• Basel II (3 pillars – 3 risk – credit risk, operation risk &
market risk)
 Pre Basel Period (1975 – 1988)
• From 1965 to 1981 there were about eight bank failures (or bankruptcies)
in the United States. Bank failures were particularly prominent during
the 1980s, an era that is often referred to as the “Savings and Loan crisis”
• Highly leveraged banks throughout the world were extensively, so
much that the potential for the bankruptcy of these major international
banks grew as a result of low security / capital
• To prevent this risk, the Basel committee on Banking Supervision,
comprised of central banks and supervisory authorities of 10 countries,
met in 1987 in Basel, Switzerland.
• The committee drafted a first document to set up an international
"minimum amount" of capital that banks should hold. This minimum is
a percentage of the total capital of a bank, which is also called the
minimum risk-based capital adequacy. In 1988, the Basel I Capital
Accord was created.
• The Basel Committee on Banking Supervision (BCBS) is a
committee of banking supervisory authorities that was
established by the central bank governors of the Group of Ten
countries in 1974.
• The committee expanded its membership in 2009 and then
again in 2014.
• In 2019, the BCBS comprise of 45 members from 28
Jurisdictions, consisting of Central Banks and authorities with
responsibility of banking regulation.
• It provides a forum for regular cooperation on banking
supervisory matters. Its objective is to enhance understanding
of key supervisory issues and improve the quality of banking
supervision worldwide.
• The member countries are: France, Germany, Belgium,
Italy, Japan, the Netherlands, Sweden, the United
Kingdom, the United States and Canada, with
Switzerland, Luxembourg, Spain
• It meets regularly 4 times a year.
BASEL NORMS
BASEL I – The Basel Capital Accord
BASEL I – The Basel Capital Accord
BASEL I – The Basel Capital Accord
 Credit Risk
• Credit risk is risk of loss arising from a borrower who
does not make payments as promised. This event would
be called “Default” and the person/ company/ entity
would be called “Defaulter”.
• Due to this, credit risk is also known as “Default Risk”.
BASEL II – The New Capital
Framework
BASEL II – The New Capital
Framework
 Market Risk
• Market risk is the possible losses due to movement in the
market prices. There are four standard market risk
factors viz. stock prices, interest rates, foreign exchange
rates, and commodity prices.
 Operation Risk
• Operational Risk refers to the risk of loss from inadequate
or failed internal processes, people, systems or external
events including
• Incompetent management
• Improper planning
• Staff fraud
• Noncompliance
• Programming errors
• System Failure
• Increased competition
• Deficiency in loan documentations.
• Theft & fraud
• Hacking damage, fire damage
 First Pillar – Minimum capital requirement
• Capital for credit risk - Credit risk refers to the negative
consequences associated with defaults.
– Standardized approach - the rating assigned by the
eligible external credit rating agencies, largely supports
the measure of credit risk.
– Banks rely upon the ratings assigned by the external
credit rating agencies chosen by the RBI for assigning risk
weights for capital adequacy purposes. As: a) Credit
Analysis and Research Ltd. b) CRISIL Ltd. c) FITCH Ltd.
and d) ICRA Ltd.
– International credit rating agencies : a) Fitch; b) Moody's;
and c) Standard & Poor's.

– Internal ratings based approach

 First Pillar – Minimum capital requirement

• Capital for market risk – Market risk is defined as the

risk of losses arising from movements in market prices
– Standardized approach – use risk weights provided
by the supervisor
– Value at risk (VaR) is a measure of the risk of loss for
investments. It estimates how much a set of
investments might lose (with a given probability),
given normal market conditions, in a set time period
such as a day.
• Capital for operational risk – is defined as the risk of loss
resulting from inadequate or failed internal processes, people
and systems or from external events (eg. Fraud, system failures)
– Basic indicator approach – Banks using this approach must
hold capital equal to average over the previous three years of
a fixed percentage of annual gross income
– Standardized approach – capital is computed by lines of
business using fixed percentages. For example, Corporate
finance (18%), trading & sales (18%), retail banking (12%), commercial
banking (15%), payment & settlement (18%), agency services (15%), asset
management (12%), and retail brokerage (12%) are eight standard
business lines
– Advanced measurement approach – Internal model - This
approach allows the bank to use internally generated models
to calculate their operational risk capital requirements.
Supervisory Review
 Basel I Vs Basel II
Basel I Basel II
Complexity Simple High Complexity
Approach Top down – supervisor Bottom up – Banks /
determines risk external agencies
determine risk weights
Approach to risk No risk sensitivity Increased risk sensitivity
Basel I Vs Basel II
 Basel III – Responding to 2007 - 09
Financial Crisis
• Basel III, agreed by committee in December 2010, maintains
the three pillar structure of Basel II
• Basel III intends to address shortcomings of Basel II to create
more stable banking / financial sector
• Basel III is a global framework on bank capital adequacy,
stress testing, and market liquidity risk
• It is intended to strengthen bank capital requirements by
increasing bank liquidity and decreasing bank leverage.
• The main aim of Basel III can be stated as
– Improve banks ability to absorb losses / shocks
– Improve risk management and governance
– Strengthen bank’s transparency and disclosures
 Objectives of Basel III

The Objectives of the Basel III are as follows:

•Improve the banking sector’s ability to absorb shocks
arising from financial and economic stress.
•Improve risk management and governance
•Strengthen banks’ transparency and disclosures.
 Basel III – Responding to 2007 – 09
Financial Crisis
• Major features of Basel III are
– Stricter definition of capital (what qualifies to be called
capital and what not
– More common equity (minimum 4.5% in lieu of 2%)
– More T1 capital (6% in lieu of 4%)
– Additional buffer (called capital conservation buffer) of 2.5%
of Risk weighted assets. Making total capital requirement to
go from 8% to 10.5%
– Introduces mandatory leverage ratio (T1 capital to total
asset) of 3%
– Liquidity ratio
– Systematically Important Financial Institution
 Countercyclical Capital Buffer
• A capital buffer is a mandatory capital that financial
institutions are required to hold in addition to other
minimum capital requirements.
• CCyB is the capital to be kept by a bank to meet business
cycle related risks. It is aimed to protect the banking
sector against losses from changes in economic
conditions.
• Banks may face difficulties in phases like recession when
the loan amount doesn’t return.
• To meet such situations, banks should have own
additional capital. This is an important theme of the Basel
III norms.
 Liquidity Requirements
• Being liquid or having enough cash to pay liabilities as and
when they fall due and honor other commitments, is one of
the important aspects of banking
• This vital requirement was put to severe test during and
just after financial crisis of 2007
• This is to prevent situations like “Bank Run”. A bank
run occurs when a large number of customers of a bank or
other financial institution withdraw their deposits
simultaneously over concerns of the bank's solvency.
• Basel III introduces new liquidity standard through two
liquidity ratios
– Liquidity coverage ratio (LCR)
– Net stable funding ratio (NSFR)
 Liquidity Coverage Ratios
• Banks are required to hold an amount of high-quality
liquid assets that's enough to fund cash outflows for 30
days.
• The high-quality liquid assets include only those with a
high potential to be converted easily and quickly into
cash
• In other words, the 30 day period allows banks to have a
cushion of cash in the event of a run on banks during a
financial crisis.
HQLA
• For example, let’s assume bank ABC has high-quality
liquid assets worth $55 million and $35 million in
anticipated net cash flows, over a 30-day stress period:
• The LCR is calculated by $55 million / $35 million.
• Bank ABC's LCR is 1.57, or 157%, which meets the
requirement under Basel III.
 Net Stable Funding Ratio
• The NSFR is defined as the amount of available stable
funding (ASF) via liabilities relative to the amount of
required stable funding (RSF) via assets over a one-year
period of extended stress.
• This ratio should be equal to at least 100% on an ongoing
basis.
• To ensure that banks maintain sufficient long term stable
funding (customer deposits, long term loans, equity) to
long term assets (long term customer borrowing) should
always be greater than zero
 Leverage Ratios
• The tier 1 leverage ratio measures a bank's core capital to
its total assets.
• The ratio uses tier 1 capital to judge how leveraged a
bank is in relation to its consolidated assets. Tier 1 assets
are those assets that can be easily liquidated if a bank
needs capital in the event of a financial crisis.
• The tier 1 leverage ratio measures a bank's financial
health during financial crisis to withstand shocks
• The leverage limit is at 3 %, which implies that a bank’s
total assets should not be more than 33 times the bank’s
capital
• If a bank's leverage ratio is greater than or equal to 4%, it
is considered to be well-capitalized. If its leverage ratio is
3%, the bank is considered adequately capitalized. The
bank is undercapitalized if its leverage ratio is less than
3%. If the bank's leverage ratio is less than 2%, it is
considered significantly undercapitalized.
• A ratio that can indicate a bank's ability to
maintain equity capital sufficient to pay depositors
whenever they demand their money and still have
enough funds to increase the bank's assets through
additional lending.
• Undercapitalization occurs when a company does not
have sufficient capital to conduct normal business
operations and pay creditors. This can occur when the
company is not generating enough cash flow or is unable
to access forms of financing such as debt or equity.
 Example
• For example, bank Z has tier 1 capital of $1 million and
average total consolidated assets of $16 million. Therefore,
its tier 1 leverage ratio is 6.25% ($1 million/$16 million),
and it is considered to be well-capitalized.
• On the other hand, bank Y has tier 1 capital of $2 million
and average total consolidated assets of $66.66 million.
Consequently, its leverage ratio is 3% ($2 million/$66.66
million) and bank Y is considered adequately capitalized.
• Bank X has tier 1 capital of $5 million and average total
consolidated assets of $260 million. Thus, the bank is
significantly undercapitalized because its leverage ratio is
1.92% ($5 million/$260 million).
 Systemically Important Financial
Institution
• A systemically important financial institution (SIFI)
or systemically important bank (SIB) is a bank, insurance
company, or other financial institution whose failure might
trigger a financial crisis.
• They are referred to as “too big to fail”
• To maintain a higher level of capital based on their importance in
the global financial system
• Identify global systematically important banks (G-SIBs) and
financial institution and mandating them to maintain higher level
of capital based on their importance in the global financial system
• For assessing banks – Indicator based measurement approach
was adopted
• Selected indicators are size of the bank, the lack of
readily available substitutes, infrastructure, customer
base, deposit account, loan details
• Based on these indicators scores, Basel committee
grouped G-SIBs into different categories
• The list of G-SIBs will be reviewed annually
Bucketing Approach
Bucket Score Range Minimum Additional Loss Absorbency
(common equity as a % of Risk
weighted assets)
5 (empty) D 3.5%
4 C-D 2.5%
3 B-C 2.0%
2 A-B 1.5%
1 A 1.0%
 D–SIB – Domestic Systematic
Important Banks
• The Reserve Bank of India (RBI) declared HDFC Bank
Ltd to be a domestic systemically important bank (D-
SIB). The other two such banks are State Bank of India
(SBI) and ICICI Bank Ltd.
 Sources of Bank Funds
• Two Broad categories of sources of bank funds
– Deposit sources
– Non deposit sources
• Deposit Sources
– The sources by way of which bank collects deposits
from public.
– Savings Bank Account
– Current Account
– Demand Account
– Term Deposit / Time Deposit
– Certificate of Deposit
 Deposit Products

Saving Bank Account

Current Account

Demand Deposits
Certificate of Deposit

Term Deposit / Time

Deposit
• Savings Bank Account
– To promote the habit of saving among the citizens while allowing
them to use their funds when required
– Advantage is its high liquidity and security
– Earns reasonable interest
– ROI is decided and periodically reviewed by GOI
– Opened and operated by minors provided they have completed ten
years of age
– Minimum balance varies from bank to bank
– Less in case of public sector banks and comparatively higher in case
of private banks
– Public sector banks, minimum balance to be maintained is Rs.100.
– Cheque books are issued, a minimum balance of Rs.500 has to be
maintained.
– Pension Savings Accounts, minimum balance to be maintained Rs.5
without cheque facility and Rs.250 with cheque facility.
• Current Account
– It is primarily meant for businessmen, firms, companies and public
enterprises etc., that have plentiful daily banking transactions.
– Cheque operated accounts meant neither for the purpose of
earning interest nor for the purpose of savings but only for
convenience of business hence they are non – interest bearing
accounts.
• Demand Deposit
– Refers to the funds held in deposit accounts, where the money in
the account is legally able to be withdrawn immediately upon
demand (or “at call”).
– This type of bank account allows immediate conversion of the
account balance into cash or transfer to another account
– It is different from a time deposit (also known as “Certificate of
deposit” or “term deposit”), where the funds are not legally
available for immediate withdrawal by the depositor
• Term Deposit / Time Deposit
– A deposit held at financial institution for a fixed term
– Generally for short term
– Maturity period from a month to a few years
– When a term deposit is purchased, the lender (the customer) knows
that the money can only be withdrawn after the term has ended or
by giving a predetermined umber of days notice
– Safe investment and appealing to conservative, low – risk investors
– Higher rate with term deposits compared with a demand deposit
• Certificate of Deposit / CD
– Is a time deposit, a financial product commonly offered to
consumers by banks, thrift institutions and credit unions
– CDs are similar to savings accounts in the sense that they are
insured and thus virtually risk – free, they are “money in the bank”.
 Basic Terms
• NDTL
• CRR
• SLR
• Bank run
• Bank Rate
• Base Rate
• Open Market Operations (OMO)
• Liquidity Adjustment Facility
– Repo Rate
– Reverse Repo rate
• Basis Point
 NDTL
• The Net Demand and Time Liabilities or NDTL shows
the difference between the sum of demand and time
liabilities (deposits) of a bank (with the public or the
other bank) and the deposits in the form of assets held
by the other bank.
• The net demand and time liabilities of a bank can be
calculated by using the following formula:
• Bank’s NDTL = Demand and time liabilities (deposits) – deposits
with other banks
• Suppose a bank has deposited 5000 with the other bank and its
total demand and time liabilities (including the other bank
deposit) is 10,000. Then the net demand and time liabilities
will be 5,000 (10,000-5,000).
• Time liabilities means the amount of money payable to the
client after some specific time while demand liabilities means
a money payable to the client when it is demanded by the
client.
• Demand Liabilities: Deposits that a customer can withdraw
on demand are demand liabilities. Basically, the customer can
withdraw his / her money whenever they want to do so. It
should be an on-demand basis . A customer can withdraw
from savings account and current account.
• Outstanding telegraphic transfers, Demand drafts, margins
against the letter of credit/guarantees, credit balance in cash
credit account, etc., all are paid on demand.
• Time Liabilities: Deposits that a customer only
withdraws after a specified time are time liabilities.
Fixed deposits, Recurring deposits, cash certificates,
mutual funds SIP, gold deposits are time liabilities.
• Other Demand and Time Liabilities: In short, OTDL.
These are other demand and time liabilities
(miscellaneous liabilities ) not covered in the above in
above two types of liabilities. Such as interest accrued on
deposits, unpaid dividend, suspense account balances
showing the amount due to other banks or public,
participation certificates issued to other banks, cash
collaterals, etc
 Calculation of NDTL
• DTL and other demand and time liabilities are the
liabilities that a bank has to pay to its customers.
• Bank make some deposits in other banks to receive
interest and principal amount in whole.
• Subtract deposits of a bank in another bank by the
deposits which are received by the bank as DTL
• NDTL = (Demand liability + Time Liability + ODTL) –
Deposits in other banks
• Cash Reserve Ratio is money that banks park with the RBI for free, without
receiving any interest on it.
• A CRR is calculated by a specific percentage of the bank's net demand and time
liabilities and it must be in the form of cash only.
• As per the Section 42 (1) of the Reserve Bank of India Act, 1934, the monetary
banks hold a certain proportion of their Demand and Time Liabilities (DTL)
with the central bank of a country.
• A money kept with the central bank as CRR earns no interest
• For example
• Currently, the Cash reserve ratio is 4% it means if a bank
has to put Rs 4 out of Rs100 as a CRR with the central
bank in the form of cash only.
• A commercial bank in India has a total deposit of Rs
45,00,000 and the CRR rate is 4%. So, it has to put Rs
1,80,000 as CRR with the RBI and the remaining balance
of RS 43,20,000 is used by the commercial bank for the
lending purpose of a loan, investment etc.
• CRR calculated as a percentage of each bank's net
demand and time liabilities (NDTL).
SLR
 SLR – Statutory Liquidity Ratio
• An SLR is also mandatory for the commercial banks in the
form of liquid assets it means assets which can be used to
meet the demand of depositors. An SLR is kept based on
the certain percentage of net time and demand liabilities.
• It is in the form of liquid assets like precious metals (gold)
or other approved securities, which a financial institution
must maintain as reserves other than cash.
• Statutory Liquidity Ratio is fixed by a central bank of a
country and maintained by banks in order to manage the
expansion of bank credit.
• Government securities, gold, corporate bonds of reputed
companies like Infosys, Reliance, TCS. These are “safe”
investments.
• Formula:
• SLR rate = (liquid assets / (demand + time liabilities)) ×
100%
• For example:
• Currently, An SLR rate is 19.5% so, a commercial bank
will keep Rs. 19.50 Rs out of every Rs100 deposit as SLR
with the central bank.
• A commercial bank in India has a total deposit of Rs
45,00,000 and the SLR rate is 19.5%. So, it has to put Rs
8,77,500 as SLR with the RBI and the remaining balance
of RS 36, 22,500 is used by the commercial bank.
Difference between CRR & SLR
 Bank Rate
• Bank rate is a rate at which the Reserve Bank of India (RBI)
provides the loan to commercial banks without keeping
any security. There is no agreement on repurchase that will
be drawn up or agreed upon with no collateral as well.
• Only based on this, bank’s fix up the interest rate for
customers.
• Bank rate is the rate charged by the central bank for
lending funds to commercial banks.
Bank rates influence lending rates of commercial banks.
Higher bank rate will translate to higher lending rates by
the banks. In order to curb liquidity, the central bank can
resort to raising the bank rate and vice versa.
 Base Rate

• Base rate is the minimum rate set by the Reserve Bank of

India below which banks are not allowed to lend to its
customers.
• Base rate is decided in order to enhance transparency in
the credit market and ensure that banks pass on the
lower cost of fund to their customers.
• Loan pricing will be done by adding base rate and a
suitable spread depending on the credit risk premium.
 Open Market Operations
• An Open Market Operation (OMO) is the buying and selling
of government securities in the open market.
• It is done by the central bank in a country (the RBI in India).
When the central bank wants to infuse liquidity into the
monetary system, it will buy government securities in the
open market. This way it provides commercial banks with
liquidity.
• In contrast, when it sells securities, it curbs liquidity. Thus,
the central bank indirectly controls the money supply and
influences the short-term interest rates.
• In India, after the economic reforms of 1991, the OMO has
gained more importance than the CRR (cash reserve ratio) in
adjusting liquidity.
 LAF – Liquidity Adjustment Facility

• A liquidity adjustment facility (LAF) is a tool used in

monetary policy, primarily by the Reserve Bank of India
(RBI) that allows banks to borrow money through
repurchase agreements (repos) or to make loans to the
RBI through reverse repo agreements.
• Liquidity adjustment facilities are used to aid banks in
resolving any short-term cash shortages during periods
of economic instability or from any other form of stress
caused by forces beyond their control.
Liquidity Adjustment Facility Example
• Let’s assume a bank has a short-term cash shortage due to a recession
gripping the Indian economy. The bank would use the RBI's liquidity
adjustment facility by executing a repo agreement by selling
government securities to the RBI in return for a loan with an
agreement to repurchase those securities back. For example, say the
bank needs a one-day loan for 50,000,000 Indian rupees and executes
a repo agreement at 6.25%. The bank's payable interest on the loan is
Rs. 8,561.64 (Rs. 50,000,000 x 6.25% / 365).

• Now let’s suppose the economy is expanding and a bank has excess
cash on hand. In this case, the bank would execute a reverse repo
agreement by making a loan to the RBI in exchange for government
securities, in which it agrees to repurchase those securities. For
example, the bank may have Rs.25,000,000 available to loan the RBI
and decides to execute a one-day reverse repo agreement at 6%. The
bank would receive Rs.4109.59 in interest from the RBI (Rs.25,000,000
x 6% / 365).
 Repo Rate
• Commercial banks sell securities to the central banks
with the agreement to repurchase it after a certain period
of time at a specific price. Interest that the central bank
charge on the repurchase of such securities is repo rate.
The central bank usually uses repo rate to control
inflation.
 Reverse Repo
• Reverse Repo rate is the rate at which the Reserve Bank
of India borrows funds from the commercial banks in the
country. In other words, it is the rate at which
commercial banks in India park their excess money with
Reserve Bank of India usually for a short-term. Current
Reverse Repo Rate as of February 2020 is 4.90%.
 Basis Point
• Basis points (BPS) refers to a common unit of measure
for interest rates and other percentages in finance.
 Non – Deposit Sources of Bank Funds
• NDS mean the sources by which bank collects deposits
from sources other than the public sources
• Service fees
• Cash handling charges
• Penalties
• Interest
• Money market etc.,
 Non – Deposit Sources of Bank Funds

— Borrowing on the interbank market;

— An agreement to sell securities and repurchase (or
operation «repo»);
— Consideration of bills and receipt of loans from central
banks;
— Sale of bankers’ acceptances;
— Issue of commercial paper - unsecured form of
promissory note that pays a fixed rate of interest.
— Issue of capital notes and bonds - short-term unsecured
debt generally issued by a company to pay short-term
liabilities
Non – Deposit Sources of Bank Funds
1 Interest on loans:
Banks provide various loans and advances to industries, corporates and
individuals. The interest received on these loans is their main source of
income.

2 Interest on investments:
Banks invest in various government and rated securities, and earn interest
and dividends from these investments.

3 Fees income:
Banks charge fees for performing services like syndication of loans,
accepting bills of exchange, providing safety vaults, etc. for their
customers.
Non – Deposit Sources of Bank Funds
4 Forex operations:
Banks also deal in foreign exchange and act as brokers for the same,
earning an income from these operations.
5 Commission on third party products:
Banks earn commission income by distributing insurance and mutual fund
products to their customer base.
6 Borrowing on the interbank market
7 An agreement to sell securities and repurchase
8 Issue of commercial paper - unsecured form of promissory note that
pays a fixed rate of interest
9 Issue of capital notes and bonds - short-term unsecured debt generally
issued by a company to pay short-term liabilities
10 Consideration of bills and receipt of loans from central banks
 Designing of Deposit Schemes

• First Step – Competitive Product & Analysis

• Second Step – Calculating the cost of deposit & Opinion
of the clients
• Third Step – Identification of Fixed & Variable Cost &
estimating the volume of business
• Fourth Step – Time frame in which profit will be realized
• Fifth Step – Deposit implemented & feedback
 Designing of Deposit Schemes
• First Step - Identification of all competitive products (both the
personal, and of the competitors) which offers the client more or
less the same benefits and on the other hand, in their analysis.
• Second Step - Approximate determination of the places our new
product or service will occupy in the price hierarchy, by taking
into account the special features or the advantages that can
justify its introduction.
• Third Step – which is regularly carried out simultaneously with
the second stage and not subsequently to it, is the estimation of
the sales volume that can be obtained at the chosen price level
and calculation of the afferent costs.
– Two cost categories are taken into account – fix costs (more or less) of the
service supply and variable costs of the necessary raw materials. In case of
financial services, money to which is added the planned
commercialization expenses
• Fourth Step – in the combination of the interdependent
variables of price, volume and sales expenses, so that net
profit obtained by the company to be maximised. The
calculation must take into account the time limit regarding
the materialization of the profit (if it is long period of time,
the discount principles must be applied) as well as the
possible income losses for other services, from the range of
those offered by the bank, adjacent to new product
• Fifth step is essential. If he proposition proves to be feasible,
a price is established and the product is launched on a test
market or on a general scale.
• Essential stage is controlling the effective result in
comparison to the estimations made and adopting
corrective measures by reducing the price or increasing the
sales and the intensification of the sales promotion
campaign, in case the results are not those expected.
 Pricing of Deposit Services
• Price is very important part of the marketing mix.
• Price and sales of the product are related one to another
• Main Strategies
– Cost plus profit: Sensitive strategy to costs. Institution
calculates how much the manufacturing of the
product cost it, adds a margin for he profit and
requires the clients this price.
– Cost plus pricing is a cost-based method for setting
the prices of goods and services. Under this approach,
the direct material cost, direct labor cost, and
overhead costs for a product are added up and added
to a markup percentage (to create a profit margin) in
order to derive the price of the product.
 Pricing of Deposit Services
• Cost plus Margin Deposit Pricing
• Historical cost approach
• Pooled funds approach
• Market Penetration Deposit Pricing
• Skim the cream pricing or “taking the cream“ pricing
• Conditional Pricing
• Upscale Target Pricing
• Relationship Pricing
• Marginal Cost of Funds approach
Cost Plus Margin Deposit Pricing
• Historical Cost
• Determines the bank’s cost of funds by looking at the past. It
looks at what funds the bank has raised to date and what
those funds have cost

• Pooled Funds Approach

• Determine the bank’s cost of funds by looking at the future. What
minimum Rate of Return is the bank going to have to earn on any future
loans and securities to cover the cost of all new funds raised?
• The pooled cost of funds is a method used to determine the total cost of
funds, or the expense incurred by banks and other financial institutions
(FIs) to take deposits and make loans.
• The interest rate banks charge on such loans must be greater than the
interest rate they pay to obtain the funds initially, which is called their cost
of funds.
• The pooled cost of funds is one method designed to establish if businesses
are succeeding in this goal by creating enough profits.
• Market Penetration Deposit Pricing
• The method of selling deposits that usually sets low prices and
fees initially to encourage customers to open an account and
then raises prices and fees later on

• Conditional Pricing
Schedule of fees were low if customer stayed above some
minimum balance - fees conditional on how the account was
used
Conditional pricing based on one or more of the following
factors
– The number of transactions passing through the checking
account
– The average balance held in the account during the period
– The maturity of the deposit in days, weeks, months, or years
 Conditional Pricing - Example
• Customer pays a low fee or no fee if the deposit balance
remains above a certain level, but has a higher fee if the
average balance falls below that level.
 Checking Account
• A checking account is a deposit account held at a
financial institution that allows withdrawals and
deposits.
• Checking accounts allow you to easily access your funds
in several ways. You can access your money by
withdrawing cash at an ATM or branch, writing a check,
sending an e-check, setting up an automatic transfer, or
using your debit card. Checking accounts are
typically used for day-to-day spending.
• Upscale Target Pricing
• Bank aggressively goes after high-balance, low-activity
accounts. Bank uses carefully designed advertising to
target established business owners and managers and
other high income households

• Relationship pricing
• The bank prices deposits according to the number of
services purchased or used. The customer may be granted
lower fees or have some fees waived if two or more
services are used.
• Relationship Based Pricing (RBP), as the name suggests, is
a concept in which the price a customer pays is determined
by his relationship with the bank. The pricing is based on
the customer's portfolio of products and services.
• Customers who purchase two or more services will have
lower deposit fees compared to the fees charged
customers having only a one service to the bank
• The main idea of relationship pricing is that it promotes
greater customer loyalty and makes the customer less
sensitive to the prices posted on services offered by
competing financial firms
• Skim the cream pricing or “taking the cream“ pricing
• Settlement of the prices for “taking the cream” – this
strategy may be used for products that are very new and
of high quality, it means the settlement of the price when
the product is freshly introduced on the market to “take
the cream” of the demand for that product, maximizing
the profit
 Marginal Cost of Funds approach
What deposit interest rate should the bank offer its
customers?
▫ The marginal cost of moving the deposit rate from one level to
another
▫ The marginal cost rate, expressed as a percentage of the
volume of additional funds coming into the bank
▫ Marginal cost is the additional interest earned in new deposit
money
 Application of Bank Funds
• Lending money is one of the two major activities of a
bank.
• Banks accepting deposit from public for protection and
safety and pay interest to them.
• Lend this money to earn interest on this money to public,
business firms and other institutions
• Investment Functions of a Bank
– Bank has certain instruments where they can invest money and
can help the investors as well as themselves for making
advantage in the financial markets.
– Growth of financial markets during the last 15 years has been
phenomenal
– Period is witnessed tremendous changes in the composition of
markets
• Nature of bank investments varies as per the customer
requirements:
– Money Market Instruments
– Capital Market Instruments
– Debt Market Instruments
 Money Market Instruments
• Treasury Bills
• Commercial Paper
• Certificate of Deposits
• Inter-bank Participation Certificates
• Money Market Mutual Funds
 Money Market
• Financial instruments with short term maturity upto 1 year, used as tools
for raising capital by the issuer are known as money market instruments.
• Money market instruments are securities that provide businesses, banks,
and the government with large amounts of low-cost capital for a short
time. The period is overnight, a few days, weeks, or even months, but
always less than a year.
• The main characteristic of these kinds of securities is that they can be
converted to cash with ease
• The main features are
– High Liquidity
– Secure Investment
– Fixed Returns
 Treasury Bills
• Treasury bills or T- Bills are issued by the Reserve Bank
of India on behalf of the Central Government for raising
money. They have short term maturities with highest
maturity of upto one year. Currently, T- Bills are issued
with 3 different maturity periods, which are, 91 days T-
Bills, 182 days T- Bills, 1 year T – Bills.
• T-Bills are issued at a discount to the face value. At
maturity, the investor gets the face value amount. This
difference between the initial value and face value is the
return earned by the investor. They are the safest short
term fixed income investments as they are backed by the
Government of India.
• A blue chip is stock in a corporation with a national
reputation for quality, reliability, and the ability to
operate profitably in good and bad times
 IBPC
• Interbank Participatory Certificates (IBPC) is a short term
money market instrument used by banks to meet their
short term requirements. Under this, a bank may sell a
part of any of its loan asset to another bank. Often the
seller bank receives the payment for sale in terms of
another loan asset.
• Banks troubled with capital constraints sell their “excess
baggage” of loans assets to other banks in the form of
‘Inter Bank Participation Certificate (IBPC). These IBPC
transactions are aimed to fill short-term requirements of
banks and are typically bought back by the seller bank
within three to four months, depending on the agreement.
• Reserve Bank of India has permitted foreign banks and
private sector banks to treat their investments in
interbank participatory certificate (IBPC) to treat it as
direct lending to the priority sector. A bank missing its
target for priority sector lending target will be able to
reach the target by buying IBPCs issued by the fellow
banks that have already exceeded in achieving their
regulatory targets of priority sector advances and issued
IBPCs for excess of lending under various categories of
priority sector.
• ABC is a commercial bank which has to abide by the priority sector lending
(PSL) targets set by Reserve Bank. One such PSL target is that out of the total
lending portfolio of the bank, at least 18% lending should be to the
agricultural sector. However, ABCD bank mostly has customer profile in
urban centres and as such the bank finds it difficult to meet this 18% lending
target. Let us assume that the bank expects a shortfall of 300 crore from this
target. Now there is another bank called XYZ Bank which is a Regional Rural
Bank (RRB). Being an RRB, the customer profile of XYZ Bank is mostly in rural
areas and 90% of its total lending is to the agriculture sector which is more
than the target set for this RRB by RBI. These two banks mutually enter into
an agreement under which the XYZ Bank sells 300 crore of its agricultural
loan asset to ABC Bank. In return, the ABC bank transfers 300 crore of its
non-priority sector loan asset to the XYZ Bank. For the loan asset received by
• ABC Bank (agriculture loan), it pays an interest at the rate of say
10% to the XYZ Bank. Also, the XYZ Bank pays an interest at the
rate of, say 6%, to ABC Bank for the non-priority sector loan.
The ABC Bank is able to meet its PSL target (without investing
extra into developing rural networks, exposing itself to its non-
niche sector etc) and XYZ Bank is able to make some extra profit
for the 4% difference between the interest rate of borrowing
and lending. After a few months, the ABC Bank will sell the
agriculture portfolio to XYZ Bank and buyback the non-PSL
portfolio from it. Thus there was no actual transfer of 300 crore
but a transfer of the loan portfolio for a short duration. The RBI
has given Priority Lending status to such Participatory
Certificates
 Capital Market Instruments

• Global Depository Receipts (GDR)

• American Depository Receipts (ADR)
• Book Building
• Venture Capital
• Leveraged Buy Out (LBO)
• Debentures
 GDR
• Global Depository Receipt (GDR) is an instrument in
which a company located in domestic country issues one
or more of its shares or convertibles bonds outside the
domestic country. In GDR, an overseas depository bank
i.e. bank outside the domestic territory of a company,
issues shares of the company to residents outside the
domestic country. Such shares are in the form of
depository receipt or certificate created by overseas the
depository bank.
 Depositary Receipt
• A depositary receipt (DR) is a negotiable certificate
issued by a bank representing shares in a foreign
company traded on a local stock exchange.
• The depositary receipt gives investors the opportunity
to hold shares in the equity of foreign countries and
gives them an alternative to trading on an international
market.
 GDR - Example
• A company based in USA, willing to get its stock listed
on German stock exchange can do so with the help of
GDR. The US based company shall enter into an
agreement with the German depository bank, who shall
issue shares to residents based in Germany after getting
instructions from the domestic custodian of the
company. The shares are issued after compliance of law
in both the countries.
Global Depository Receipt Mechanism
• The domestic company enters into an agreement with
the overseas depository bank for the purpose of issue of
GDR.
• The overseas depository bank then enters into a
custodian agreement with the domestic custodian of
such company.
• The domestic custodian holds the equity shares of the
company.
• On the instruction of domestic custodian, the overseas
depository bank issues shares to foreign investors.
• The whole process is carried out under strict guidelines.
• GDRs are usually denominated in U.S. dollars
 Book Building

• Book building is actually a price discovery method. In this

method, the company doesn't fix up a particular price for
the shares, but instead gives a price range, e.g. Rs 80-100.
• The process of determining the price at which an Initial
Public Offering will be offered. The book is filled with the
prices that investors indicate they are willing to pay per
share, and when the book is closed, the issue price is
determined by an underwriter by analyzing these values.
 Venture Capital
• A venture capitalist is somebody who invests in a new
business venture. They provide capital either for
expansion or a startup business.
• We refer to the money that venture capitalists invest as
‘venture capital‘ or ‘VC.
• Venture loans are start-up loans allowing businesses to
open. Lenders do not like to give out venture loans, since
the odds of a new business failing are high. They prefer
to see proof that the business will succeed or has the
backing of an entrepreneur they have done business
with before. These loans often have high interest rates
and collateral requirements to make up for the risk.
 Leverage Buyout
• A leveraged buyout (LBO) occurs when someone purchases a
company using almost entirely debt. The purchaser secures that
debt with the assets of the company they're acquiring it.
• The purchaser puts up a very small amount of equity as part of their
purchase. Typically, the ratio of an LBO purchase is 90% debt to
10% equity. That is, if the purchaser is buying a company for $100
million, they will borrow $90 million and pay $10 million from their
own cash.
• The bank will provide loan to the purchaser for the acquired
property and the bank secures its loan with the acquired property
asset. This means that the company will be responsible for making
all payments on the debt that purchaser used to buy it, and that if
the company defaults on these obligations the bank will seize its
land, inventory and other assets in lieu of payment.
• Leverage Buyout is the process of acquiring a firm in which the
investment for acquiring is made partially by equity and partially
by other debt instruments (borrowing). The acquisition of the
company or a segment of the company is funded by debt. The
assets of the acquired company are used as collateral for the
borrowed capital, sometimes with assets of the acquiring
company.
• The first being done by Tata Tea in 2000 for UK based Tetley. The
acquisition of Tetley made Tata Tea the second biggest tea
company in the world.
• Nirma, Lafarge cement Rs 9000 crore deal - LBO
 Debentures
• A company can raise funds through the issue of
debentures, which has a fixed rate of interest on it. The
debenture issued by a company is an acknowledgment
that the company has borrowed an amount of money
from the public, which it promises to repay at a future
date.
• Debenture holders are, therefore, creditors of the
company.
 Debentures
• When companies need to borrow some money to expand
themselves they take the help of debentures. There are four
different types of debentures. Debenture is used to issue the
loan by government and credit worthy companies. The loan
is issued at the fixed interest depending upon the reputation
of the companies.
• A debenture is a medium to long-term debt format that is
used by large companies to borrow money
• These debentures are for a fixed period and a fixed interest
rate that can be payable yearly or half-yearly. Debentures are
also offered to the public at large, like equity shares.
Debentures are actually the most common way for large
companies to borrow money.
 Debt Market Instruments

• Bonds
• Securitization
• Syndication
 Bonds
• A bond, also known as a fixed income security, is a debt
instrument created for the purpose of raising capital.
They are essentially loan agreements between the bond
issuer and an investor, in which the bond issuer is
obligated to pay a specified amount of money at
specified future dates.
• A bond is a fixed income instrument that represents a
loan made by an investor to a borrower (typically
corporate or governmental). Bonds are used by
companies, municipalities, states, and sovereign
governments to finance projects and operations.
 Types of Bonds
• Straight or Fixed Rate Bonds
• Callable Bonds
• Convertible Bonds
• Sinking Fund Bonds
• Currency Option Bonds
• Floating Rate Bonds
 Securitization
• Securitization refers to the process of converting debt (assets, usually illiquid
assets) into securities, which are then bought and sold in the financial
markets.
• In simple words, securitization is a process where a financial company
combines several of its assets into consolidated financial instrument or
securities
• Banks or financial institutions securitize primarily illiquid assets. One can
easily convert a liquid asset into cash, for example, gold. On the other hand,
assets that can’t be easily converted to cash are illiquid assets. Real estate is a
good example of it.
• Mortgages are valuable assets but are mostly illiquid. Mortgages are usually
backed by real estate, which again is illiquid.
• If a company has already exhausted its funds by giving loans but wants to
give more loans, then it can use securitization to raise more funds.
• First, a bank or financial institution collects thousands of mortgages into a
“pool.” Then, it divides those pool into small parts and sells them as
securities. Buyers of these securities, get the right to the interest or mortgage
payments by the homeowners. Since mortgages back these securities, they
are also called “mortgage-backed securities.”
 Syndication
• A loan syndication usually occurs when multiple banks
lend money to a borrower all at the same time and for
the same purpose.
• A loan syndication also involves multiple lenders and a
single borrower, the term is generally reserved for loans.
A loan syndication is headed by a managing bank that is
approached by the borrower to arrange credit. The
managing bank is generally responsible for negotiating
conditions and arranging the syndicate. In return, the
borrower generally pays the bank a fee.
 Lending Functions
• Banks lend money in various forms and they
lend for particularly every activity.
• Types of Lending
– Fund based
– Non – Fund Based
– Asset Based
 Fund based Funding
• Overdrafts
• Demand Loans
• Term Loans
• Cash Credit advances
• Bill finance
• Packing credit
 Demand & Term Loan
• Loan (such as an overdraft) with or without a fixed maturity date, but which
can be recalled anytime (often on a 24-hour notice) by the lender and must be
paid in full on the date of demand.
• Also called call loan or money at call.
• Term Loan
• Term loan refers to those which have a fixed tenure and it has to be repaid by
the borrower on fixed maturity date and also they have fixed repayment
schedule
 Packing Credit
• Packing credit is the most commonly used trade finance
tool by an exporter. Packing credit or pre-shipment
finance is very important to small and medium
enterprises for their financing needs.
• Packing credit is basically a loan provided to exporters
or sellers to finance the goods’ procurement before
shipment.
• At times, the packing credit is also used for financing the
working capital and meet the requirements of wages,
travel expenses, utility payments, etc for companies
listed as exporters
 Non – Fund based Lending

• Letter of Credit
• Guarantees
• Co – acceptance of bills
 Asset based Lending

• Secured Loans – is a loan in which borrower

pledges some asset as collateral (additional
security) for the loan
 Types of Loans

Types of Loans

Discounting of
Term Loans
Bills of Exchange
(Outright Loans)
(BE)

Cash Credit Overdraft

(CC) Facilities (O/D)
Classification of Loans on the basis of
Activity
Basis of
Activity

Priority Sector Commercial

Lending (Directed Lending
Credit)

Corporate Retail Loans Loans for

Loans purchase of
Automobiles /
Consumer Durable
Items
 Classification of Loans – Purpose - wise

Classification of Loans –
Purpose wise

Education Loan
Personal Loan or Student Loan

Car Loan / Auto Home Loan

Loan

Loan against Shares

 Major Components of Loan policy
Document
• List of documents most lenders will require in
order to process the mortgage application
– Information about the purchase
– Verification of Income
– Verification of your assets
– Your debts
 Pricing of Loans
• Loan Price = Cost of funds + Servicing costs + Risk
premium + Desired profit margin

• Step by step basic loan pricing model

– Step 1 – Arrive at Cost of Funds
– Step 2 – Determine the servicing costs for the
customer
– Step 3 – Assess default risk and enforceability of
securities
– Step 4 - Fixing the profit margin
 Arrive at Cost of Funds
• The objective is to ensure that the loan price covers
variable costs
• This serves as the most basic model for pricing the loan
• What is the cost of funds – It is average cost of the bank’s
sources of funds – deposits and borrowings or it is the
cost of funds that the bank requires to source to make
the loan

– Loan price = Cost of Funds + Desired profit margin

 Determining Servicing Costs for the
Customer
• Identify the full list of services used by the customer –
credit & non – credit facility
• Assess the cost of providing each service
• Multiply the unit cost with the extent to which such non-
credit services are availed.
– For example, if it is assessed by a bank that it costs Rs. 10 to make
a payment transfer, and the customer has used this service 500
times during the year, the cost for the customer works out Rs.5000
• Cost of credit services depends on the loan size and forms
a major portion of the servicing costs.
• Credit services include loan administrative expenses, of
which a large share is contributed by personnel,
processing or delivery costs.
 Assess Default risk and Enforceability
of Securities
• One of the basic methods of assessing default risk is a
credit scoring system
• The borrower whose loan is being processed is rated on
these criteria not only for deciding on sanction of the
loan, but also with a view to assigning a value to the risk
the bank would face if it lent to the borrower
 Fixing the Profit Margin
• One approach that can be used to set the margin for loan
transaction is to use the ROE as a determinant.
• ROE is generally set based on market expectations and
shareholder’s required returns
• ROE = ROA x EM
• ROA or net return on assets will be the product of ROE
and the inverse of the equity multiplier (EM)
• EM = equity / assets
 Different types of Lending Rate - Prime
Lending Rate (PLR)
• This was the oldest practice of lending rate.
• PLR (Prime Lending Rate) is the internal benchmark rate used for
setting up the interest rate on floating rate loans sanctioned by Non
Banking Financial Companies (NBFC) and Housing Finance
Companies (HFC)
• Banks were given freehand to fix their lending rate to their
customers.
• Obviously, banks taking advantage of this, use to fix high lending
rate for a borrower whose credit rating is not so trustworthy and at
the same time used to offer a discount to a borrower whose credit
rating is good.
• Hence, there was a big difference in lending rate which banks used
to offer to the borrowers.
• To avoid this parity in lending rates, RBI introduced the Base Rate
Regime or BRR.
 Fixed vs Floating Interest Rate
• The fixed interest rate on loan means repayment of loans
in fixed equal installments over the entire period of the
loan. In this case, the interest rate doesn't change with
market fluctuations.
• Floating interest rate by name implies that the rate of
interest varies with market conditions. The drawback
with floating interest rates is the uneven nature of
monthly installments.
PLR - Example
 Base Rate (BPLR)
• In the Base Rate Regime of lending rate, RBI instructed
the banks to follow certain parameters before deciding
the base rate lending rates. The lending rate at any cost
should be below this base rate

• Base Rate – Cost of Funds + Operating Expenses + Cash

Reserve Ratio + Margin

• Interest Rate – Base Rate + Spread

Base Rate Calculation
 Cash Reserve Ratio
• It is some % of the total amount of cash banks accumulated
through deposits, which banks have to deposit with RBI. The
main purpose of keeping the money with Reserve Bank is
that banks do not run out of cash to meet the payment
demands of their depositors.
• Therefore, this is nothing but the BLOCKED money which
they have to keep with RBI as a safety and statutory measure.
RBI will not give any interest on such deposited cash. This is
simply an IDLE money which banks have to keep with RBI as
a safety measure.
• RBI changes this ratio as per the economic condition. If RBI
feels that more money is required in the economy, then it
reduces the CRR and same way reverse may also be possible.
 Base Rate of Lending
• The base rate is the lending rate of banks below which
Banks were not allowed to lend. Let us say SBI’s base
rate is at 8%, then they never have to lend the money
below the 8%. Along with base rate, there is something
called as a spread. Spread is the rate of interest which is
over and above the base rate.
• If the base rate of the bank is 8% and spread is 0.5%, then
you will get the interest on the loan at 8.5%. Hence, your
loan rate is nothing but Base Rate+Spread.
• This spread depends on many things and depending on
the risk profile of the customer and the tenure of the loan
banks used to fix it.
• Before the implementation of MCLR based loans, banks
used to follow the Base Rate type system to arrive at the
interest rate of loans. During the falling interest rate,
banks used to respond very lately. Means let us say RBI
reduced the interest rate by 1%, then banks never used
to reduce it or they may do so after few months.
 Drawback of Base Rate
• The biggest drawback of Base Rate System was consideration of
“Cost of Funds”. Let us assume RBI changed the rate of interest by
1% on 1st April, 2017. Banks never tried to lower their lending rate
immediately. Because as per them, the cost of funds is HIGHER
than the current rate of interest. They used to claim that the FDs
they booked are at a higher rate and hence their cost of funding is
higher than the current RBI rate.
• Hence, they never used to act swiftly whenever there is rate
movement (especially the rate cut).
• Because banks for consideration of the cost of funds, not consider
the current FD rates or deposit rates. Instead, they used to consider
the older FD or Deposit rates.
• Also, the calculation method of cost of fund is totally different with
each individual banks (some use the average cost of funds method,
some had adopted the marginal cost of funds while others use the
blended cost of funds (liabilities) method).
• Due to all these mess up, banks used to react fastly when
there is an increase in the rate of interest. However, they
are slow in reacting or reducing the rate of interest on
their loans when there is a decrease in interest rate by
RBI.
• Also, up to January 2015, there was no such rule that
when banks should update their Base Rate. They may
retain the same base rate for a year also. But after
January 2015, RBI made it mandatory to review the Base
Rate at least once in a quarter.
 Base Rate & Marginal Cost of Funds
based lending rate (MCLR)
• Starting April 1, 2016, all floating rate loans (and select
fixed rate loans) are now linked to Marginal Cost of
Funds based Lending Rate (MCLR).
• In the past two years, RBI has cut interest rates by 150
basis points (1.5%). However, entire interest rate cut has
not been passed to the borrowers. Most banks have
passed only 60-80 basis points (0.6-0.8%) to the
customers.
• If a bank cuts base rates, the interest rate goes down not just
for new borrowers but also for old borrowers. So, not only do
you make less money from new customers, you also make
less money from the old customers.
• All loans sanctioned and credit limits renewed w.e.f 1st April
2016 will be priced based on the Marginal Cost of Funds
based Lending Rate (MCLR).
• All the existing borrowers with loans linked to Base Rate can
continue with base rate system till repayment of the loan. An
option to switch to new MCLR system will also be provided
to the existing borrowers. However, once a borrower of loan
opts for MCLR, switching back to base rate system is not
allowed.
 MCLR

• From 1st April 2016, RBI has introduced a new methodology for
calculation of the Base Rates based on marginal cost of funds rather
than average cost of funds. This new methodology is called
Marginal Cost of Funds based Lending Rate (MCLR)
• The basic difference between the previous Base Rate and the new
MCLR based rate is the change of calculation of cost of deposits
from average to marginal.
• The banks shall review and publish their MCLR every month. As
per the new methodology of MCLR, the banks must link their
lending rates with the marginal/additional cost of deposits i.e. the
rate at which they are receiving the new deposits
• So in this situation whenever RBI reduces the repo rate, banks
reduce their deposit rate and since the lending rate is linked to the
new deposit rate, they reduce the lending rate also.
• Hence, because of linking the lending rate with marginal
cost of deposits, there will be fast transmission of repo rate
into lending rate (better monetary policy transmission). It
will also help improve the transparency in the methodology
followed by banks for determining the lending rates.
• Every bank calculates its own MCLR rate based on the cost
of deposits, operational costs, reserve requirements, and
tenor premium. So MCLR is an internal benchmark.
• But the transmission of policy rates(repo), to the lending
rates of the bank has not been satisfactory because if the
reasons like
– —> reduced repo—> reduced deposit rates—> reduced deposit
rates may not be attractive to the customers/depositors. Hence,
banks may not reduce the deposit rates—> MCLR linked to deposit
rates may not reduce the lending rates
– Government offering higher interest on small savings schemes
• Hence RBI has made it mandatory for banks to link all
new floating rate personal or retail loans, and floating
rate loans to MSMEs to an external benchmark from
October 1, 2019.
• Banks can choose one of the four external benchmarks–
repo, 3-month treasury bill, 6-month treasury bill yield
or any other interest rate published by Financial
Benchmarks India Private limited.
Marginal Cost of Funds Based Lending
Rate
• MCLR is lending rate calculated based on cost of raising
new funds for the bank which include the cost of
maintaining CRR/SLR, operating costs of banks and
tenor premium.
Marginal Cost of Funds Based Lending
Rate
• MCLR (Marginal Cost of Funds Based Landing Rate)
refers to the minimum interest rate below which
financial institutions can’t lend, except in certain cases.
• For example, if the base rate of lending was 7%, certain
financial institutions used to lend their prime customers
at 7% or below. On the other hand, for ordinary
customers (borrowers), this rate of interest could have
been 10-12%.
• Current Marginal Cost of Lending Rate (MCLR) aims to:
– Bring the much-needed transparency in financial institutions while
determining their interest rates
– Pass the benefits of reduced interest rates to customers ASAP
– Ensure availability of loans to customers that is fair to both customers as
well as the lender

• Also, under MCLR, it’s mandatory for banks to declare their

overnight, 1-month, 3-month, 6-month, 1-year and 2-year
interest rates every month. Now you as a borrower, can know
the MCLR rates of banks from their websites.
Marginal Cost of Funds Based Lending
Rate (MCLR)
• MCLR = Marginal cost of funds + Operating
Expenses + Negative cash reserve ratio + Tenor
Premium
• Interest Rate = MCLR + Spread
 MCLR
• It came into effect in April 2016.
• It is a benchmark lending rate for floating-rate loans.
• This is the minimum interest rate at which commercial
banks can lend.
• This rate is based on four components—the marginal
cost of funds, negative carry on account of cash reserve
ratio, operating costs and tenor premium.
• MCLR is linked to the actual deposit rates. Hence, when
deposit rates rise, it indicates the banks are likely to hike
MCLR and lending rates are set to go up.
 Marginal Cost of Funds
• 1) Marginal Cost of Funds: This is the cost of CURRENT borrowing to
the bank. You noticed in based rate system that banks used to arrive at
the cost of the fund as per their comfort. Also, they used to consider the
existing deposits rates as if the cost of fund. However, in the case of
MCLR based loans, the last month deposit rates (current, savings, term
deposits etc) will be considered to arrive the cost of funds.
• Banks not only consider the current borrowing cost but also their margin
of profit is also included in this Marginal Cost of Funds. This is called as
the Return on Networth. The return on net worth is nothing but the
bank’s profit they want to earn from their lending business.
• You might be noticed that in the case of base rate system, the cost of
fund and margin was used to calculate separately. However, in case of
MCLR based loans, both cost of fund and margin (return on net worth)
are together are called Marginal Cost of Funds.
 Marginal Cost of Funds
• Banks borrow funds from various sources, which
include Fixed Deposits (FD), Savings accounts (FD),
Current accounts, equity (retained earnings), RBI loans
and so on. The rates of interest on these borrowings is
used for the calculation of Marginal Cost of Funds. The
Reserve Bank of India has prescribed a formula for the
calculation of MCLR, which is given below:
Negative Carry on Cash Reserve Ratio
Operating Cost & Tenor Premium /
Discount
Types of MCLR based loans
 Spread
• The next component is spread or the margin that you
pay over the bank‘s MCLR for a particular loan type of
the bank. The margin would be fixed at time of sanction
and can be changed only if there is a significant change
in customers’ credit profile. For instance, Bank A has 1
year MCLR of 9.1% and spread of 0.2 % for home loan.
The interest rate that you will be charged in this case
would be 9.3%.
• Usually, the spread is higher for unsecured loans such as
personal loans whereas for secured loans such as home loans
it will be lower.
• Example:
• Marginal Cost of funds = 7%
Negative Carry on CRR/SLR = 0.25%
Operating Cost = 1%
Premiums :
Overnight = 1.5%
Monthly = 1.25%
Quarterly = 1%
Yearly = 0.80%
• If you choose overnight , you will end up paying 9.75%
interest rate and this rate will reset everyday.
If you choose yearly, you will be paying 9.05% interest rate
and this rate will be reset every year.
Spread
Spread - Example
 Introduction to EBLR
• RBI set up a committee which is known as Janak Raj
Committee.
• The Committee recommended shifting to external
benchmark lending rate rather than banks internally
decide their benchmark. This is where the RBI acted now
and introduced all loans be under external benchmark
lending rate effective from 1st October 2019.
 External Benchmark Lending Rate /
RLLR (Repo Linked Lending Rate)
• The RBI has made it mandatory for all banks to link all
new floating rate loans (i.e. personal/retail loans, loans
to MSMEs) to an external benchmark with effect from 1st
October 2019.
• The move is aimed at faster transmission of monetary
policy rates.
• As per the committee, to judge the external benchmark lending rate,
banks are allowed to follow the below external benchmarks.
• – Reserve Bank of India policy repo rate
• – Government of India 3-Months Treasury Bill yield published by
the Financial Benchmarks India Private Ltd (FBIL)
• – Government of India 6-Months Treasury Bill yield published by
the FBIL
• – Any other benchmark market interest rate published by the FBIL.
• The banks have to calculate their lending rate based on cost of CRR,
Operational Expenses and Profit Margin. Now if banks set Repo
Rate as their external benchmark to fix the lending rate, then the
below situation will happen.
• In order to ensure transparency, standardization, and
ease of understanding of loan products by borrowers, a
bank must adopt uniform external benchmark within a
loan category; in other words, the adoption of multiple
benchmarks by the same bank is not allowed within a
loan category
 Example
• Assume that the cost of CRR, Operational Expenses and
Profit Margin is around 8%.
• Assume also that Repo Rate is 6%.
• Then the base rate for the banks to lend should be (Cost of
CRR + Operational Expenses + Profit Margin) + Repo Rate.
• Banks are free to decide the spread over the external
benchmark. However, credit risk premium may undergo
change only when borrower’s credit assessment undergoes
a substantial change, as agreed upon in the loan contract.
Further, other components of spread including operating
cost could be altered once in three years.
 Lending Rate
• PLR
• BRR – June 2010
• MCLR – April 2016
• External Benchmark Lending Rate – August 2019
 Customer Profitability Analysis
• Customer profitability is the profit which the firm makes from
serving the customers or group of customers over a period of
time. Customer profitability analysis is an important tool in
understanding which customer relationship are better than
others.
• 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 net gains from a
borrower’s transactions with the bank are in line with the bank’s
profit expectations
• The procedure involves comparing revenues generated by the
borrower with the associated costs, and ultimately with the
bank’s profit goal.
• Steps involved in analyzing customer profitability are:
– Identify all the services used by the customer- deposit
services, loans availed, payment services, services
relating to transfer of funds, custodial services and
other fee – based services
– Identify the cost of providing each service.
– The bank’s services can be classified into credit-
related and non-credit related services
– Cost estimates for non-credit related services can be
obtained by multiplying the unit cost of each service
by the corresponding activity level
• The major portion of costs is in respect of credit – related
services. The bank incurs actual cash expenses in interest
payment towards the sources of funds for the loan and the
costs for credit analysis and execution. It includes
personnel and overhead costs, including cash outgo for
sending bills for collection, processing payments,
maintaining collateral and updating documentation. It
may be computed as fixed percentage of the loan amount.
• Allocation of default risk expense
• Assess the revenues generated by the relationship with the
borrower
• Assess the fee-based income generated. Fees are generally
charged on a per service basis.
• Assess the revenue from loans