BN101 Foundation Course in Banking I

FDN-BN101 Foundation Course in Banking I
Foundation Course in Banking I
Table of Contents
1 1.1 1.2 1.3 1.4 1.5 1.6
Evolution of Banking ________________________________________________ 6 What is Banking? ________________________________________________ 6 History of Banking _______________________________________________ 7 Definition of Banking _____________________________________________ 10 Services Offered by Banks _________________________________________ 12 Trends in Banking Services ________________________________________ 15 Classification of Banking Systems ___________________________________ 15
1.6.1 Central Banking System _______________________________________________ 16 1.6.2 Central Bank Structure in the US _______________________________________ 21 1.6.3 Bank of International Settlements _______________________________________ 22 1.6.4 Commercial Banking System __________________________________________ 23 1.6.5 Line of Business for a Commercial Bank _________________________________ 25 2 2.1 2.2 Introduction to Retail Banking _________________________________________ 29 Types of Deposit Accounts _________________________________________ 30 Demand Deposits ________________________________________________ 30
2.2.1 Savings Account _____________________________________________________ 30 2.2.2 NOW Account _______________________________________________________ 30 2.2.3 Money Market Account ________________________________________________ 32 2.2.4 Current Account ______________________________________________________ 32 2.3 Term Deposits __________________________________________________ 33
2.3.1 Certificate of Deposits_________________________________________________ 33 2.4 Retirement accounts _____________________________________________ 34
2.5 2.6 2.7
Insurance on Deposits ____________________________________________ 34 Withholding Tax _________________________________________________ 35 Retail Payments _________________________________________________ 36
2.7.1 Transactions in checking accounts ______________________________________ 38 2.7.2 Check ______________________________________________________________ 39 2.7.3 Physical Check Clearing Mechanism ____________________________________ 41 2.8 Private Banking or Wealth Management ______________________________ 48
2.8.1 Products in Wealth Management _______________________________________ 54 2.9 Card System____________________________________________________ 56
2.9.1 Evolution of Cards ____________________________________________________ 56 2.9.2 Types of Cards_______________________________________________________ 57 2.9.2.1 Credit Card _________________________________________________________ 57 2.9.2.2 Charge Cards _______________________________________________________ 58 2.9.2.3 Debit Cards _________________________________________________________ 59 2.9.2.4 ATM Cards _________________________________________________________ 59 2.9.2.5 Credit card cum ATM Cards ___________________________________________ 59 2.9.2.6 Debit card cum ATM Cards____________________________________________ 60 2.9.2.7 Travel Currency card cum ATM Cards __________________________________ 61 2.9.2.8 Gift Cards ___________________________________________________________ 61 2.9.2.9 Petro Cards ________________________________________________________ 62 2.9.2.10 Corporate Cards ____________________________________________________ 62 2.9.2.11 Other Private Prepaid cards __________________________________________ 64 2.9.2.12 Non-Financial Cards_________________________________________________ 64 2.10 2.11 The Participants in the Card Business ________________________________ 66 Business Models- Private Label and White Label Cards __________________ 67
3 3.1
Commercial Banking ________________________________________________ 68 Fund Based facilities _____________________________________________ 69
3.1.1 Lines of Credit _______________________________________________________ 70 3.1.2 Revolving Loans _____________________________________________________ 71 3.1.3 Term Loans _________________________________________________________ 72 3.1.4 Syndicated Loans/Club Loans __________________________________________ 73 3.1.5 Trade Finance _______________________________________________________ 74 3.1.6 Export-Import Finance ________________________________________________ 74 3.1.7 Factoring ____________________________________________________________ 76 3.1.8 Leasing _____________________________________________________________ 77 3.1.9 Bill Discounting ______________________________________________________ 77 3.2 Structuring of Loans ______________________________________________ 80
3.2.1 Fixed Rate Vs. Floating Rate ___________________________________________ 80 3.2.2 Types of Repayment __________________________________________________ 81 3.3 3.4 Concept of Default _______________________________________________ 83 Non-Fund Based Facilities _________________________________________ 84
3.4.1 Letter of Credit or Documentary Credit __________________________________ 84 3.4.2 Uniform Customs and Procedures for Documentary Credits (UCC) __________ 89 3.4.3 Types of LCs ________________________________________________________ 90 3.4.4 Guarantee ___________________________________________________________ 96 3.5 3.6 Other Non-Fund Based Products/Services____________________________100 Cash Management Services _______________________________________100
3.6.1 Collection Services ______________________________________________102 3.6.2 Payment Services _______________________________________________103 3.6.3 Benefits of CMS _________________________________________________105
3.7
Trade Finance___________________________________________________106
3.7.1 Role of Banks ___________________________________________________106 3.7.2 Services related to Import __________________________________________108 3.7.3 Services related to Export ________________________________________110 3.8 Lending Process________________________________________________111
3.8.1 Stages in a Lending Process _____________________________________113 4 4.1 Financial Statements of Banks________________________________________116 Balance Sheet _________________________________________________116
4.1.1 Assets _______________________________________________________120 4.1.2 Liabilities _____________________________________________________123 4.2 Income Statement (Report of Income)______________________________ 128
4.2.1 Interest Income ________________________________________________132 4.2.2 Interest Expenses ______________________________________________132 4.2.3 Net Interest Income ____________________________________________132 4.2.4 Loan-loss Expenses ____________________________________________133 4.2.5 Non-Interest Income____________________________________________133 4.2.6 Net Income ___________________________________________________133 4.2.7 Appropriation of Profit ___________________________________________133 4.3 Financial Reporting _____________________________________________134
In this chapter, the reader will learn about the process of evolution of banking and its contribution to growth of world commerce. The chapter will provide the rationale for banking and its supervision. A brief mention has been made of the high level segmentation of banking, which will be explored further in the next chapters. The chapter ends with the description of typical financial statements of a bank and the description of terms in a financial statement.
1 Evolution of Banking
1.1 What is banking?
Traditionally, banking is defined as the process of accepting deposits from surplus units in the economic system (lenders) with the objective of lending these funds to the deficit units in the economic system (borrowers).
A simple form of banking was practiced by the ancient temples of Egypt, Babylonia, and Greece, which loaned at high rates of interest the gold and silver deposited for safekeeping. Private banking existed by 600 B.C. and was considerably developed by the Greeks, Romans, and Byzantines. Medieval banking was dominated by the Jews and Levantines because of the strictures of the Christian Church against interest and because many other occupations were largely closed to Jews. The forerunners of modern banks were frequently chartered for a specific purpose, e.g., the Bank of Venice (1171) and the Bank of England (1694), in connection with loans to the government; the Bank of Amsterdam (1609), to receive deposits of gold and silver. Banking developed rapidly throughout the 18th and 19th centuries, accompanying the expansion of industry and trade, with each nation evolving the distinctive forms peculiar to its economic and social life. Over a period of time banking has undergone lot of changes and now banking is not restricted to only taking deposits and lending. Although deposit taking and
lending still remains the core banking activity, now banking includes services like wealth management services for ultra-rich high net worth individuals, housing finance, mergers and acquisitions advisory services, leasing, trade finance, automobile finance, education finance, and the list goes on.
The following section describes how banking has developed over all these years since its inception.
1.2
History of Banking
Banking is one of the most important services in financial sector. It also provides fuel for economic growth of a country. It offers safety and liquidity for the investors, both on short and long-term basis, offering a comparatively fair comparatively fair return for them. Banks are the principal source of credit for dealers, households, small businesses like retail traders and large business houses. Efficiency of a bank depends on its ability to satisfy its investors by offering comparatively a better interest rate to depositors and at the same time offering credit to their borrowers comparatively at cheaper interest rates. With a narrow interest rate spread (difference between borrowing and lending rate), they should make profit also. Looking into the present profile of a bank, it has grown up phenomenally offering large number of products other than the traditional functions of accepting deposits and lending funds. It is worth analyzing the historic background of evolution of banking services.
When and how did the banks appear? Linguistics (the science of language) and etymology (the study of origin of words) suggest an interesting story about the origin of banking. Both the old French word banque and the Italian word banca were used centuries ago to mean a bench or money changers table. This describes quite well what historians have observed concerning
the first bankers who lived more than 2000 years ago. They were money changers seated usually at a table or in a small shop in the commercial district aiding travelers who came to town by exchanging foreign coins for local money or discounting commercial notes1 for a fee in order to supply merchants with working capital.
During early stages, European Banks were only for safe keeping of valuables like gold, and silver as people had the fear of loss of their assets due to theft, expropriation by government or war. Merchants who collected their payments in the form of gold and silver in other countries deposited their collections in the nearest bank instead of carrying such assets and exposing themselves to the risk of piracy or storms in the sea.
During the reigns of King Henry VIII and Charles I in England, governments efforts to seize gold and silver from the public made them deposit their stock of gold and silver with goldsmith shops who in turn issued paper tokens or certificates indicating details of gold and or silver deposited with them. This certificate began to circulate as money because it was more convenient and less risky for them to carry this certificate. These goldsmiths also offered the service of valuing the gold and silver and issuing a valuation certificate. Most customers brought gold, silver or ornaments to these goldsmiths and got it examined to find out whether they were genuine or fake. Even today certain approved valuers provide this service.
The early bankers might have used their own capital for funding such activities but it was not long before the idea of attracting deposits and securing temporary loans from wealthy customers became an important source of bank funding. Loans were then made available to
Short-term unsecured promissory notes acknowledging a loan/obligation of one party against
the other.
shippers, landowners and merchants at lowest interest of 6% per annum and as high as 48% per month for riskier ventures. Most banks in early stages were of Greek origin.
Gradually, the banking industry spread outward from the classical civilization of Greek and Rome into northern and western parts of Europe. Banking industry encountered religious
protests during the Middle Ages primarily because the loan given to the poor was at higher interest rate. However, in Europe, when the Middle Ages drew to a close and the Renaissance started, bulk of deposits and loans were from wealthy customers and the religious opposition died down slowly.
Between the 15th and 17th centuries, due to the development of navigation facilities, new trade routes and cross country trade activities, nucleus of world commerce gradually shifted from Mediterranean region towards Europe and British Islands where banking became a primary leading industry.
Industrial revolution took place during the same period, which demanded a well-developed financial system. When production activities expanded at a mass scale, it required an equal quantum of expansion of global trade to absorb the output produced and new methods of trade payments and credit availability. Banks that had the competency and capacity to manage the needs, grew faster. Some of the institutions that had the fastest growth during this period were Medici Bank in Italy and Hochstetler Bank in Germany.
When colonies were established in North and South America, banking practices were revised and new practices were introduced. In the beginning of 19th Century, however, the state Many of them were simply
governments in US began chartering banking companies.
extensions of other commercial enterprises in which banking services were largely secondary to merchants sales. Developments of large professionally managed banking firms were centered in few commercial centers especially in New York. During Civil War, the federal government became a major force in US banking. Congress established office of the Comptroller of
Currency (OCC) in 1864 for the purpose of chartering national banks. This divided bank s regulatory system with both federal government and the states playing key roles in the control and supervision of banking activities, which continues even today. Barclays Bank also has a long history. It was founded by John Freame and Thomas Gould in 1690 under the name of Goldsmith Bankers. The bank was renamed as Barclays by Freame's son-in-law, James Barclay, in 1736.
1.3
Banking Definition
The word Bank has been used differently in different geographies. The regulator in the respective countries defines the scope of the functions and services the banks can offer. There are specific regulations related to the banking, which will be discussed later. As per English Common Law, a banker is defined as a person who carries on the business of Banking, which is specified as Conducting current account for the customers Paying cheques drawn on him, and Collecting cheques for his/her customers In United States any institution accepting deposits subject to withdrawal on demand such as drawing a cheque or by making an electronic withdrawal and making loans of commercial or business nature is defined as a bank. Several financial service companies and leading bank holding companies filed application for non-bank banks because they could establish these service units freely across state lines and also have an access to federal deposit insurance.
10
In 1987 Congress put a halt to further non-bank bank expansion by subjecting the parent companies of non-bank banks to the same regulatory restrictions that traditional banking organizations are subjected to. Moreover, Congress defined bank as a corporation that is a member of the Federal Deposit Insurance Corporation. By this law a banks identity depends on which government agency insures its deposits. Banks in the US are also classified as Depository Institutions whereas other non-banking financial institutions are referred to as non-depository
Depository Institutions These institutions play an important role in the development of the financial markets. These institutions play an important role in channelizing the savings in the economy. Depository institutions mainly include: Commercial Banks Savings and Loan Associations Credit Unions
Commercial Banks: These are depository institutions which are in the business of deposit taking and lending. They provide a range of products and services for individuals as well as businesses.
Savings and Loan Associations: These institutions provide savings account facilities and are also into mortgage lending. Many of them provide a range of services similar to a commercial bank.
11
Credit Unions: These are not-for-profit financial cooperatives that offer personal loans and other consumer banking services
Commercial banks, savings and loan associations and credit unions together hold a large share of the nations money stock in the form of various types of deposits and help in their transfer to effect payments. They also lend these funds directly to individuals and businesses for a variety of purposes and also lend them indirectly through investment in financial instruments.
Non-Depository Institutions These institutions perform a variety of functions other than banking. The following are the common types of non-depository institutions: Finance Companies Mutual Funds Security Firms Investment bankers, brokers and dealers Pension Funds Insurance Companies
1.4
Services Offered by Banks
The services offered by commercial banks can be broadly classified into four viz. (1) Payment System (2) Financial Intermediation and (3) Financial services (4) Ancillary Services. The Payment system is the backbone of the entire money flow in an economy .The payment system, in the olden days was basically through negotiable instruments like cheque, bill of exchange, Demand Draft and Telegraphic/Wire Transfers.
12
With evolution of technology, payment processes have changed drastically. Newer payment systems also have evolved with the advent of technology.2
Financial Intermediation: This is one of the oldest functions of the Bank. Accepting deposits from customers and then lending these funds to borrowers is the core of Financial Intermediation. This continues to be the mainstay of the Bank even in this century and will continue as long as the banking system exists.
Financial Services: Over a period, customer requirements have changed and newer services have evolved. These services include investment banking, foreign exchange business, wealth management, and investment banking. These services generate income for the commercial bank in the form of commissions etc. which is termed as Non-Fund income in accounting parlance. The services under this umbrella has also been growing at a very fast pace.
Ancillary Services: Banks have been looked upon with trust by the common man and this resulted in offering of many ancillary services which form a very minuscule of the services offered by the banks.
Typical services include safe custody of articles with the bank and safe deposit lockers. Ancillary service related to payments would be cheque pick up facility, cash payment at the doorstep referred to as door step banking.
The same will be dealt in detail in subsequent sections
13
Traditional services offered by banks Carrying out currency exchanges Discounting commercial notes and making business loans Offering savings deposits Safe keeping valuables Supporting government activities with credit by purchasing government bonds Offering checking accounts and demand deposits Offering trust services, managing financial affairs, and property of individuals and business forms for a fee
New services offered by banks Granting consumer loans Financial Advisory Services Credit and debit cards Cash management Equipment leasing Venture capital loans Insurance services Retirement plans Security brokerage and investment services Mutual funds and annuities Investment banking and merchant banking services
14
Looking into the additional services that are extended by a bank today, it is evident that beginning with a safe custodian for gold and silver, banking has moved into an era of offering all types of financial services under one unit. Service menu of banks is constantly growing, leading to a trend of banking revolution. These rapid changes may leave banks of the next generation almost unrecognizable from those of today.
1.5
Trends in Banking Services
While tracing the evolution of banking services one cannot lose sight of the following trends: Proliferation of new services and innovation of new customer friendly products Rising competition Deregulation of banking and financial markets Raising operational costs Invasion of information technology electronic funds transfer data transfers Consolidation of banking industry mergers and acquisitions Globalization of financial services Transparency in banking operations Capital adequacy to withstand credit and operational risks.
1.6
Classification of Banking Systems
Banking systems have evolved to meet the requirements that arose at different points of time in various economies and also the regulatory intervention that followed.
15
Banking can be broadly classified as:
Banking
Central Banking
Commercial Banking
1.6.1
Central Banking System
Central Banking system is a non-commercial banking system which consists of a national supervisory framework for regulation of banking and controlling money supply in the economy. The role of the central bank is totally different from that of a commercial bank. The central bank does not interact with the public directly except with the Bank. The central bank is often referred to as the Bankers Bank.
The need for a central bank is felt only when there is a banking system in place. Most central banks evolved in order to take care of actual or potential problems in the banking system. Central banking was initially practiced with the help of a large number of informal norms, conventions and self-imposed codes of conduct. These were later formalized into theory and institutionalized into laws that apply to todays central banking institutions. The first central bank, the Sveriges Riksbank, was established in Sweden in 1668; and the second was the Bank of England (BoE), set up in 1694 under a Royal Charter. Most of the bigger European central
16
banks were established in the nineteenth century, while the German Bundesbank and the U.S. Federal Reserve System in the twentieth century. Early central banks were established primarily to finance commerce, foster growth of the financial system and to bring about uniformity in issuance of currency notes.
After the First World War, the role of central banks became even more important. Their role of supervising the business of private commercial banks was extended and lender-of-the-lastresort function3 to stabilize the banking system during financial panics was strengthened. The First World War also led to the central banks increasing involvement in extending credit to their governments. In order to handle their new role as brokers for government debt, central banks were allowed to trade government paper in the open market and were entitled to develop open market policy instruments for fine-tuning of interest rates and for credit and money supply expansion. This gave rise to more discretionary powers to central banks to conduct their operations. Since 1933 in the US and shortly after the Second World War in Germany, central banks were empowered to change minimum reserve requirements, which constituted an important direct tool of monetary policy.
Central banks have evolved in accordance with the specific requirements of the economies in which they are situated and in response to the kind of demands made on them. The genesis of central banking is different between developed and developing countries. As a result, the role of central banks in developing countries of today is typically different from that of the developed country central banks when they were developing. In industrial countries this purpose centered on the need to have a lender-of-the-last-resort, in developing countries such as India, central
Central banks act as lender of last resort for banks/financial institutions that do not have any
other means of borrowing left and whose failure would adversely affect the economy
17
banks came into existence when banking was underdeveloped. In fact, the central banks were instrumental in influencing the spread of commercial bank networks in developing countries.
Regulatory Evolution The origin of banking regulation in a broad sense or the primitive form of banking regulation can be traced back to the end of the Middle Age right after the emergence of banking industry. But systematic and extensive banking regulation originated only in the mid-nineteenth century when government involvement in the national economy began to grow. Before that, banks were not regulated or little regulated, a situation often referred to as free banking or laissez faire banking.
Late Medieval Period The late medieval (late 13th century) experience of Aragon demonstrates vividly the genesis of banking regulation as a response to moral hazard following government guarantees. In some city states such as Barcelona, Valencia, and Tortosa, the economy was booming and the government had relatively abundant fiscal resources. Understanding well the importance of bank stability to the society, the kings of these cities offered guarantees to bank deposits. Government insurance caused moral hazards: irresponsibility, speculation, and lack of foresight on the part of some early bankers led to fraudulent bank failures during the last third of the thirteenth century. In response to fraudulent bankruptcies, the legislatures in Barcelona and Lerida passed the first laws governing banking in Catalonia in 1300 and 1301, respectively. The law in Barcelona provided stringent rules to punish those bankers who went bankrupt: they should be publicly denounced, not only in the streets of Barcelona but also in all the towns where they had done business. They could not open any exchange or bank thereafter, and would be imprisoned and kept on bread and water until they paid off all their creditors. The government also strengthened regulation of bank accounting system and enhanced the
18
creditors rights. The banker was declared responsible for all entries made for his/her clients, and no one, not even the king, could postpone settlement of credit beyond the set time. In Lerida, the king decreed that money changers were responsible to their creditors and that their goods could be confiscated in cases of default.
To curb problem of moral hazard as a result of deposit guarantee, the government required banks to submit a deposit as guarantee: no one would be allowed to open a bank in Catalonia without first depositing 1000 silver marks in Barcelona and Lerida and 300 marks in all other towns and cities in Catalonia. Only after the deposit was paid could the money changer place the tapestry bearing the shield of the city on his/her table, indicating that his/her office was guaranteed. Those who did not pay the fee had to leave the wooden top of their tables bare, without tapestries or other cloths, as a warning to their clients. This is in nature similar to the deposit reserve or capital adequacy requirement in contemporary banking practice, which no doubt can contribute to banking stability.
Early Nineteenth Century As the governments involvement in the national economy began to increase, the role of governments to intervene in the economic affairs as well as the fiscal and financial capacity of governments increased. The power of taxation and monetary policy equipped the governments in respective economies with ever increasing financial resources. At the same time, governments were subject to the pressure of public opinions and therefore became concerned with social welfare. In this role, governments used to bail out failing banks in order to provide a social safety net. The bailout of the Chilean Mortgage Bank is one of the earliest examples of government bailouts in the 19th century.
19
During the same period, the concept of laissez faire was made popular by Adam Smith. Laissez-faire is a French phrase meaning "let do, let go, let pass." It came to be used as a synonym for free market economics during the early and mid-19th century. It is generally understood to be a doctrine opposing economic interventionism by the state beyond that which is perceived to be necessary to maintain peace and property rights.
Laissez faire banking or free banking refers to the institutions of banking with no or little government regulation. Under this regime, there is no government control of the quantity of exchange media, no state-sponsored central bank, no legal barriers to the entry, branching, or exit of commercial banks, no government restriction on interest rates or bank asset and liability portfolios, and no government deposit guarantee.
Furthermore, the government doesnt have motivation and sufficient financial resources to ensure solvency of any bank. Contrary to what people might have imagined, free banking was not a synonym for banking panic. Individual banks did fail occasionally in the free banking era, but there did not seem to be major banking panics and crises. Some banks did fail, but usually it was not because of bankers fraudulence or recklessness. One important reason for bank failure in that period was that banks succumbed to political authority by extending loans in an inappropriate way. For example, some banks with international business in Britain lent money to British aristocracy under political pressure without daring to ask for collateral. Some British aristocrats simply defaulted on loans to escape the liability.
The Scottish experience of free banking in the 18th and 19th centuries presents a classic example of how market discipline can stabilize the banking system. In the absence of government regulation, market generates effective mechanism in disciplining b ankers behavior. Virtually all bank owners carried unlimited liabilities: all but three of Scotlands banks operated
20
with unlimited liability during the free banking era. This contributed to banking stability by removing risk-taking tendency on the part of bank owners. Bankers made very careful decisions and risk management to avoid financial risk contagion. To protect itself from any spillover effects from other banks difficulties, each bank attempted to establish a distinct brand -name identity and reputation, and held as little of other banks liabilities as possible.
Late Nineteenth and Twentieth Century Over a period of time, different economies depending upon their stage of development and the specific constraints, formulated and developed national regulatory systems. At the same time, financial liberalization was also becoming popular. To strengthen bank regulation and supervision following financial liberalization often requires the government to choose alternative regulation instruments and methods to monitor banks. Unfortunately, in reality, many countries didnt establish complementary banking regulations, and as a result suffered from financial turmoil in the wake of financial liberalization. Prominent among these were the Savings and Loans Associations Crisis in US, Chilean and Mexican Crisis, etc.
1.6.2
Central Bank Structure in US
The central bank of US is known as the Federal Reserve .Generally one country has only one central bank. However US have a very unique structure as there is a state level Fed as is depicted below. The Banks are regulated at Federal and State level depending upon the banking organizations charter type and organizational structure
21
1.6.3
Bank of International Settlements
Globalization posed new threats and challenges in terms of cross border transaction. A financial crisis no longer happened in silos .This led to a need for the central bank of one country to interact with other countries and bring a common platform for interaction and a meeting point for the various issues.
This need crystallized in the form of Bank of International Settlements (BIS) on 17 May 1930. This was set up to foster international monetary and financial cooperation and serves as a bank for central banks. Currently 56 central banks of various countries are members of the BIS. BIS is popularly known by the Basel Norms. Basel happens to be the Headquarters of BIS. All the international norms of BIS are referred to as Basel Norms worldwide. When banking systems in a number of industrial countries weakened in the late 1980s, pressure developed for harmonizing bank regulation among industrial countries, at least for large internationally-active banks in these countries. The harmonization was intended both to enhance safety by reducing the likelihood of individual failures that could spread the adverse effects across national boundaries and to provide for a more level playing field, so that banks in different countries would not benefit from any competitive advantages due to subsidies from
22
their governments, such as lower capital ratios in an environment of explicit or implicit deposit insurance or other government support. In large measure, the call for such transnational regulation reflects both the limited market discipline on banks in most countries because of the existence of actual or conjectural government guarantees and the greater difficulty in monitoring banks in non-home jurisdictions by both private stakeholders and government regulators.
This resulted in a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with active international banks. In June 1999, the Committee issued a proposal for a New Capital Adequacy Framework (Basel II) to replace the 1988 Accord. Following extensive interaction with banks and industry groups, the revised framework was issued in June 2004.
1.6.4
Commercial Banking System
Commercial banking system consists of a network of banks which provide a variety of banking services to the individuals and the businesses in the economy. The commercial banking systems may be of two types:
Commercial Banking System
Unit Banking
Branch Banking
23
Unit Banking System Unit banking involves provision of banking services by a bank in a limited local area. Sometimes, unit banks are also permitted to have branches in a limited area. The unit banks are connected through correspondent bank system which provides for the transfer of funds between unit banks. The advantage of unit banking is that it facilitates mobilization of deposits and their deployment for needs of the local community where the bank is located. Unit banking gave way to branch banking system due to the following reasons: Economic interdependence among various states Infrastructure development Growth of big business firms Mobility of population Increasing emphasis on convenience
Branch Banking System In Branch banking system the bank has a head office which controls and directs the branches located in multiple locations. The branches may be located in the same city, same state, across states, or even across countries. The head office as well as the branches is under the control of the same board.
Branch banking offers the following advantages: Facilitates the allocation of savings to their most efficient use across the nation irrespective of their origin i.e. savings may originate at different locations and may be deployed at different locations.
24
Diversifies of risk as risks are spread over an entire range of commercial assets
Leads to uniform structure of interest rates
Facilitates the penetration of best banking services to the far flung areas of the nation
A major drawback of the branch banking system is that there is excessive centralization and branches have to look up to the head office for many issues. Further, in branch banking the personnel may also get relocated to various branches during their employment with the bank and if they are from a different area or state, they may not be aware of the special problems faced by the locals/natives of that area/state. 1.6.5 Line of Business for a Commercial Bank
The banks may offer different services for different customers across geographies based on the customer need as well as the geography specific regulations. The Basel Norms categorized Lines of Business (LOB) into eight classes:
Srl. No. 1. 3. 5. 7.
Line of business Corporate finance Trading and sale Retail banking Commercial banking
Srl. No. 2. 4. 6. 8.
Line of business Payment and settlement Agency services Asset management Retail brokerage
Certain Multinational banks may have all of the above LOBs whereas certain banks may concentrate only on one or a few LOBs.
25
Corporate Finance The activities clubbed under this LOB are Mergers and acquisition, underwriting, privatizations, securitization, research, debt (government and high yield), equity, syndication, IPO, secondary private placement. This activity is also known as investment banking /merchant banking activity. Payment and Settlement The activities clubbed under this are payments and collections, fund transfer, clearing and settlement activity.
Trading and Sale The level two functions under this will be sale, marketing proprietary positions and treasury functions related to Fixed Income, equity, foreign exchange, commodities, credit ,funding ,own position securities, lending and repos, brokerage and prime brokerage Agency Services They are further sub-classified as Custody Operations, Corporate Agency and Corporate Trust Services. Escrow, Depository, securities lending (to customers) and corporate actions are covered in Custody Operations. Issuer and Paying Agents role is categorized under Corporate Agency. Corporate Trust Services include inheritance and other trustee services.
26
Retail Banking Retail banking refers to the mobilization of deposits from individuals and providing loans to individuals and small businesses. Retail banking is characterized by large volume of small value transactions. They are sub categorized under retail banking. The Private Banking services offered by the banks are also categorized under this line of Business. The services covered hereunder include private lending and deposits, banking services, trust and estates and investment advice. Interestingly the Basel norms classify the Card services under retail banking. The entire gamut of card like merchant/corporate and commercial cards, private label cards and retail cards are covered under this service.
Asset Management Asset management services include both discretionary and non-discretionary fund
management. In the US, mutual fund investment is much bigger than commercial bank deposits in terms of the relation to GDP. Commercial Banking A number of activities are clubbed under commercial banking activity. This activity is age old and traditional commercial banking comes under this. The services offered are Project Finance Real Estate Finance Export Finance Trade Finance Factoring
27
Leasing Lending Guarantees Bills of Exchange
28
In this chapter, readers will be introduced to the retail banking products, including private Banking and Retail Payment Systems. The suite of retails banking products includes Retail Liability product that encompasses various types of deposit accounts. The Asset Portfolio is not specifically discussed here as there is a separate module on Retail Assets. The Retail Payment systems have seen burgeoning volumes in the past few years and the latest electronic payment systems like ACH has been dealt in depth .The Private Banking topic discusses the various services. The Card section gives a short overview of the Credit card product and services.
2 Introduction to Retail Banking

Retail Banking is one of the biggest shock absorbers in the banking system. If one were to closely study the Banking sector, one would observe that retail bank failures seldom happen. The reason for proliferation of retail banking is twofold. The principle of spreading the eggs in multiple baskets is the core philosophy of retail. The probability of all multiple loans failing together at the same time is less than a big loan failing occasionally. On the retail liability side, the retail portfolio generates low cost deposits which mean chasing current and savings accounts.
The credit card business is also a lending business, in addition to fees generated by way of annual maintenance charges and other service charges. Private banking business is also similar to retail banking, except for the ticket size
29
2.1
Types of Deposit Accounts
A deposit account is an account at a bank that allows money to be held on behalf of the account holder. The account holder retains rights to their deposit.
Deposit accounts are of classified into two broad types: Demand Deposits Term Deposits
2.2
Demand Deposits
Demand Deposits by definition are deposits that can be withdrawn by customers on demand, while Term deposits are deposits that can be withdrawn after a specified period of time. Term deposits are also known as fixed deposit. The term fixed refers to the term of the deposit which is fixed in nature
2.2.1
Savings Account
Savings account is the most popular type of demand deposit. Savings Account provides deposit services to individuals. Banks pay a nominal interest rate (3-4% pa) on this account. The savings account can be with a cheque facility or without a cheque facility. Depending on whether it is with or without cheque facility, the minimum balance that is to be maintained in the account varies. There are restrictions on the number of withdrawals from this account.
2.2.2
NOW Account
30
The Negotiable Order of Withdrawal(NOW) is a deposit account that pays interest on which cheques may be written and is a product unique to the US .They are structured to comply with Regulation Q (one of the several regulations related to banking in US).As per this regulation interest payment is prohibited on checking accounts. Checking accounts are those accounts where the customer can draw a cheque from that specific account. NOW accounts are interest-bearing, and cheques may be written on them, but legally they are not interest-bearing checking accounts. NOW accounts are interest-bearing transaction account that combines the payable on demand feature of cheques and investment feature of savings accounts. A NOW account is functionally an interest paying checking account. The NOW account began in Massachusetts in 1974 when mutual savings banks offered interest bearing transaction accounts (NOW accounts) to compete with commercial banks. These accounts, which paid a rate of interest equivalent to that of passbook accounts, were authorized nationwide for all depository institutions by the 1980 Monetary Control Act. The NOW account is similar to a savings account globally.
Super NOWs (SNOW) These deposits offer flexible money market interest rates but accessible via cheque or preauthorized draft to pay for the goods and services. In 1986 interest rate restrictions on NOWs were relaxed. So, there is no longer any distinction between NOWs and SNOWs. SNOWs were eligible for federal deposit insurance and subject to reserve requirements.
To sum up, savings deposits have following characteristics:
31
They do not have fixed maturity. Deposits can be set up periodically to cover over-withdrawals (drawing in excess of the balance available). They provide transaction funds by means of limited cheque-writing privileges
2.2.3
Money Market Account
These accounts are known as MMA or MMDA accounts. A money market account (MMA) is a deposit account offered by a bank, which has a relatively high rate of interest and typically requires a higher minimum balance to earn interest or avoid monthly fees. The resulting investment strategy is therefore similar to, and meant to compete with, a money market fund offered by a brokerage, which is considered almost as safe as savings. In the US, an MMA is a deposit account that is considered a savings account for some purposes, but upon which cheques can typically be written, subject to certain restrictions. Like a Negotiable Order of Withdrawal account, it is structured to comply with Regulation Q, which forbids paying interest on checking accounts. Thus money market deposit accounts are accounts that bear interest and on which cheques can be written. However, due to various restrictions, they are not legally checking accounts and thus do not run afoul of Regulation Q. Since the account is not considered a transaction account, it is subject to regulations on savings accounts: only six withdrawal transactions to third parties are permitted per month, only three of which may be paid by cheques. Banks are required to discourage customers from exceeding these limits, either by imposing high fees on customers who do so, or by closing their accounts. Banks are free to impose additional restrictions (for instance: some banks limit their customers to six total transactions). ATM transactions may or may not be counted.
2.2.4
Current Account
32
This can be opened in a way similar to the savings account. There is no restriction on the number of withdrawals from this account but the bank also does not pay any interest on the balance maintained in this account. This account is known as a transaction account in the US. As per Regulation Q, Transaction account means a deposit or account from which the depositor or account holder is permitted to make transfers or withdrawals by negotiable or transferable instrument, payment order of withdrawal, telephone transfer, or other similar device for the purpose of making payments or transfers to third persons or others or from which the depositor may make third party payments at an automated teller machine ( ATM ) or a remote service unit, or other electronic device, including by debit card, but the term does not include savings deposits or accounts described in paragraph (d)(2) of this section even though such accounts permit third party transfers
2.3
Term Deposits
Term deposits, in contrast to demand deposits, are placed by customers with the depository institutions for a fixed period of time and under normal circumstances cannot be withdrawn before the maturity. They earn a fixed rate of interest. The interest computation has various permutation combinations in terms of simple interest and compound interest.
2.3.1
Certificate of Deposits
In US the Term Deposits are known as Certificate of Deposits (CD).In other geographies the Certificate of Deposit have a totally different connotation. The basic attributes of the CD Tenor (The period for which the CD is in effect): there are restrictions as per the local regulations in terms of the minimum tenor and the maximum tenor
33
Interest compounding (there are three methods of interest computation viz. Simple, Compound and discounted)
The minimum and maximum amount of subscription Auto renewal facility (in case this service is availed the CD will be automatically renewed for the same tenor as the original CD)
Premature withdrawal (certain CDs may not have the facility to withdraw before maturity period, while in certain cases they may be withdrawn before maturity on payment of certain service charges as well as sacrificing partially the interest portion)
2.4
Retirement accounts
Retirement accounts are another category of accounts with the banks. They are basically longterm deposits with a twin advantage viz. Tax Benefits and long-term savings with withdrawal restrictions. Even though these accounts are collective instruments for employers they are also available to individuals, especially the self-employed. The two popular products are the 401K accounts and the Individual Retirement Accounts (IRA).Within these products there is a further bifurcation as traditional and Roth accounts. However, retirement accounts are not FDIC insured
2.5
Insurance on Deposits
One of the most outstanding features of the deposits with banking institutions worldwide is the concept of insurance on deposits similarly to the life insurance. Deposits are insured with an insurance firm on payment of the insurance premium by the bank to the insuring agency. However, the entire deposits are not insured. There are limits per
34
customer per bank restrictions. In the event of a bank failure, the insurance firm will pay the deposit amount to the customer directly. In the US, Federal Deposit Insurance Corporation (FDIC) is the entity which insures the Bank deposits. It is an independent agency under the Federal Government created in 1933 in response to the thousands of bank failures which happened in-between 1920 and early 30s. The maximum amount of deposit insured per person per bank is $2, 50,000. The banks have to pay a premium to FDIC at periodic rests as decided by FDIC.
2.6
Withholding Tax
Taxation of deposits is also another aspect to be looked into especially in case of interest earning deposits. The local regulations define the entity from which the tax can be withheld, the amount to be withheld as well as the minimum threshold to be withheld. In case of the US, for Interest paid on deposits, there is no withholding tax for US residents.US except for salary. However US residents will have to produce the necessary Tax Identification Number. For Non-residents, withholding taxes are applicable on interest paid on deposits A minimum rate of tax may be deducted at source from savings interest payments. In the United Kingdom, tax is withheld at source unless the saver submits an R85 form (if a domestic non-tax payer) or a R105 form (if a non-resident) to claim exemption. In the Republic of Ireland, the tax is known as Deposit Interest Retention Tax or "DIRT". The commutation of withholding tax is complicated as it can vary form the type of entity to whom the Interest paid. In certain geographies the withholding taxes will have to be deducted on the interest accrued rather than interest paid.
35
2.7
Retail Payments
The transaction facilitates the transfer of money amongst individuals, corporates and merchants via paper and electronic instruments. These instruments mitigate risk of carrying cash and also ensure that money can be sent/ received across distant locations. The retail payment system is the backbone to facilitate these transfers. The instruments used are traditional paper based instruments (Cheques/Check) and electronic transfers (ECS, Credit Transfers, Debit Transfers). Payment system facilitates settlement of financial transactions. Retail payment system is used by individuals for paying their bills and receiving funds into their bank accounts.
Retail payments usually involve transactions between consumers and businesses. Although there is no definitive division between retail and wholesale payments, retail payment systems generally have higher transaction volumes and lower average dollar values than wholesale payments systems. This section provides background information on payments typically classified as retail payments. Consumers generally use retail payments in one of the following ways:
Purchase of Goods and ServicesPayment at the time the goods or services are purchased. It includes attended (i.e., traditional retailers), unattended (e.g., vending machines), and remote purchases (e.g., Internet and telephone purchases). A variety of payment instruments may be used, including cash, cheque, credit, or debit cards.
Bill PaymentPayment for previously acquired or contracted goods and services; payment may be recurring or non-recurring. Recurring bill payments include items such as
36
utility, telephone, and mortgage/rent bills. Nonrecurring bills include items such as medical bills.
P2P PaymentsPayments from one consumer to another: The vast majority of consumer-to-consumer payments are conducted with cheques and cash, with some transactions conducted using electronic P2P payment systems. For example, PayPal, Yahoo Direct, C2IT, etc. are some of the popular P2P payment systems.
Cash Withdrawals and AdvancesUse of retail payment instruments to obtain cash from merchants or automated teller machines (ATMs): For example, consumers can use a credit card to obtain a cash advance through an ATM or an ATM card to withdraw cash from an existing demand deposit or transaction account. Consumers can also use personal identification number (PIN)-based debit cards to withdraw cash at an ATM or receive cashback at some point-of-sale (POS) locations.
The checking accounts can have debit and credit transaction in an account. A debit transaction is one where the customer account is debited .E.g. of debit transactions include bank charges, cash withdrawals etc. In a credit transaction the account of the customer is credited to that account. Examples are Interest credit, Dividend credit, salary credits etc.
37
2.7.1
Transactions in checking accounts
The debit and credit transactions in checking accounts are further classified into Cash Transfer Clearing
Cash Transaction includes deposit or withdrawal of cash into the operating account. There are multiple channels through which cash can be withdrawn or deposited. The most common channel is the ATM channel followed by Branch teller. In US there are service charges for withdrawal of cash from Non ATM Channels. Cash can be withdrawn by self as well as third parties. Large cash withdrawals need to be reported to the regulator across the countries as it is one of the primary routes of money laundering. A transfer transaction refers to the transaction from one account of the bank to another account in the same bank. For e.g., Mr. A and his spouse Mrs. A have separate accounts in Bank B. Mr. A wants to give some money to his spouse and requests his bank for the same. In this scenario the bank affects a transfer to the debit of Mr. A and Credit of Mrs. A. This is an example of a customer induced transaction.
A bank induced transaction on the other hand indicates an internal transaction originated by the bank. An example would be the interest paid on a NOW account or a CD. In addition, loans and repayments are made via these bank accounts which necessitate the availability of a mechanism to transfer funds across accounts. In case of the loan repayment
38
from the checking account to the loan account within the same bank would be through a process of standing instructions and not necessarily through physical cheque A clearing transaction is a transaction between banks affected through a common third party called a clearing house /clearing corporation. This clearing activity is undertaken using the cheque mechanism.
2.7.2
Check/Cheque
Check is similar to a bill of exchange. A bill of exchange is a kind of promissory note without interest and is a written order by one person (drawer, maker, or payer) to pay another (payee) a specific sum on a specific date sometime in the future. The bank making the payment is known as the drawee bank or the paying bank. A check is a negotiable instrument and there are specific laws in specific geographies on the term and nature of the law across geographies. These laws may be called the negotiable Instruments Act/Bill of Exchange Act etc. The anatomy of the check is as follows:
Payer/Drawer
Payee
Drawee Bank
39
Depending on the type of mechanism to handle the check the local regulator can define the dimensions of the check, the type of ink to be used for printing the font size as well as the positioning of the various attributes of the check like account number, routing number etc.
Check payment system is a debit transfer system. The check payment system does not function through a single channel. When a payee receives a check, he or she deposits it in a bank. That bank then has a number of choices available to collect the check:
It is possible that the payer and payee do business with the same bank. In that case, balances are transferred on the books of that bank, and there are no inter-bank transactions. This is known as an on-us transaction, in which there is no delay in settlement. Further, processing costs are lower.
The bank of first deposit may decide to present the check directly to the bank on which the check is drawn. This occurs in situations where two banks are in close proximity and have a lot of bilateral transactions. This is known as a direct send.
The bank of first deposit may present the check to a local clearing house, an arrangement whereby a number of banks agree to meet for the purpose of presenting checks to each other and settling the net differences at the end of an agreed-upon period.
The bank of first deposit may avail itself of the services of another bank a correspondent bankto collect the check on its behalf.
40
2.7.3
Physical Check Clearing Mechanism
The technological evolution also has brought about drastic changes in which the checks have been cleared. Currently there are a number of ways a check can be cleared. They are Traditional clearing process Check Truncation (known as the Check21 in US) Automated Clearing House(ACH)
Traditional Clearing Process Scenario: Mr. John receives his salary check from Wal-Mart, his employer. Mr. John has his account with Wells Fargo while Wal-Marts banker is Citi Bank. The salary check will be drawn on Citibank and is referred to as the paying banker. Mr. Johns bank is referred to as the Collecting Bank. It is also assumed that the branches of the bank are situated in Washington DC. The diagram below depicts the typical inter-bank check clearing and settlement process through a Central Bank or Clearinghouse. The steps are as follows: Step 1: Mr. John will deposit his check with Wells Fargo Washington Branch Step2: Wells Fargo, after authenticating the check, accepts the check for payment. At the end of the day, the bank accumulates the checks received from its various customers sorts them into three categories viz. checks drawn on Wells Fargo Washington Branch, checks drawn on other branches of Wells Fargo and checks drawn on other banks. Checks drawn on other banks will be sent to the service branch of financial institution for collection whereas checks drawn on Wells Fargo will be processed at the branch itself. Step 3: The Service branch of Wells Fargo will collect the checks form the various branches across Washington and send them to the clearinghouse.
41
Step 4: At the clearinghouse, the checks are exchanged. Wells Fargo will hand over all the checks they have collected drawn upon the other members of the clearinghouse, and collect all the check drawn on the bank. Thus the check will go back to the Citibank. Step 5, 6 and 7: The Citibank will cross check the balances of Wal-Mart account and other particulars of the check. In case the check is found in order and there are sufficient balances then In case sufficient funds are not there in the Wal-Marts account in Citibank, the check is returned ,the check will physically traverse back all the way through the same route all the way back to the Johns bank i.e. Wells Fargo
Check Clearing and Settlement
Wal-Mart (Payer)
John (Payee)
Clearing House 6 Wells Fargo 4

2
Citi Bank
5 3
The physical check movement is called the clearing process. This is followed by the settlement process. The clearing house will then have to debit /credit the overall amount across banks for the checks processed.
42
In the days of non-automation the payment process was fully manual. The settlement process was followed the MICR process. The Magnetic Ink Character Recognition (MICR) automated the sorting of checks bank and branch wise as well as well as arriving at the clearing figure. Check Truncation In a traditional clearing mechanism the physical check has to move from the payee bank to the drawee bank which has the related risk associated with it. With the advent of technology the process has been improved to move the image of the check instead of the physical check itself. In the example above the Wal-Mart check deposited by John will continue to remain with Wells Fargo and only the image of the check will flow to Citibank for the purpose of processing .The remaining processes will remain the same as the traditional clearing process.
Automated clearing House (ACH) System The Automated Clearing House (ACH) Services product suite provides financial institutions with efficient, low-cost batched payment services that enable an electronic exchange of debit and credit transactions through the Automated Clearing House (ACH) network. The suite includes a wide range of easy-to-use services that conveniently and seamlessly integrate with all Federal Reserve Financial Services and offer a variety of access and connectivity options. This is an electronic batch-processing electronic payment system for small- value payments. Unlike the large-value payment systems (Fed wire4 and CHIPS5), which process only credit transfers, the ACH system processes both credit and debit transfer payments. Financial institutions participate in the ACH system as either originating depository financial institutions
4
A wholesale wire transfer system operated by the Federal Reserve System. Primarily it is used for transferring reserve account balance of depository institutions, high value domestic payments, inter-bank transfers, third party transfers and high value inter-corporate payments. 5 This is a private electronic funds transfer system operated by large private banks in New York for international movements of funds. Financial transactions like foreign/domestic trade services, international loans, syndicated loans, foreign exchange sales/purchases, etc. are done through CHIPS. Domestic EFT (Electronic Funds Transfer) payments are also done through CHIPS.
43
(ODFI) or receiving depository financial institutions (RDFI) or both. Originators and receivers are customers. The originator prepares a file of transfers, delivers it to the ODFI, and the ODFI delivers the data to the ACH operator, who then transmits the information to the RDFI, who either credits or debits the account of the receiver depending on the nature of the transaction. There are different types of transactions that can be processed in the ACH system. The transaction type is referred to as Standard Entry Codes (SEC).The type of processing depends upon the SEC. Some common Standard Entry Class (SEC) Codes: ARC Accounts Receivable Entry. A consumer check converted to a onetime ACH debit. [ CCD Corporate Cash Disbursement. Primarily used for business-tobusiness transactions. POP Point-of-Purchase. A check presented in-person to a merchant for purchase is presented as an ACH entry instead of a physical check. POS Point-of-Sale. A debit at an electronic terminal initiated by use of a plastic card. An example is using your debit card to purchase gas. PPD Prearranged Payment and Deposits. Used to credit or debit a consumer account. Popularly used for payroll direct deposits and preauthorized bill payments. RCK Represented Check Entries. A physical check that was presented but returned because of insufficient funds may be represented as an ACH entry TEL Telephone Initiated-Entry. Verbal authorization by telephone to issue an ACH entry such as checks by phone. (TEL code allowed for inbound
44
telephone orders only. NACHA disallows the use of this code for outbound telephone solicitations.) WEB Web Initiated-Entry. Electronic authorization through the Internet to create an ACH entry. XCK Destroyed Check Entry. A physical check that was destroyed because of a disaster can be presented as an ACH entry BOC- back office conversion
The three most popular SEC cods related to the merchant transaction are POP, ARC and BOC. The comparison of all the three Sec Codes is given below. For e.g. Smith walks into Carrefour Store and buys goods worth USD1000/.He can tender a check for the payment across the counter .This can be treated as a POP transaction Peter pays his Mobile bill through a check. The mobile service provider can use ARC code and process the same as an ACH Transaction.
45
POP
ARC
BOC
How it Works Checks converted at a cash Checks mailed to pay a bill Checks presented at store or register, voided and returned to or deposited into payment manned bill payment location; customer drop box converted later in the "back office" Notification Receiver notified of conversion Receiver notified of Receiver notified via sign of at
via voided check and signed conversion via notice/biller conversion receipt; must be provided opt-out insert option prior to must
each checkout/receipt be must option be
message; opt-out
payment;
provided
provided opt-out option Source Document No copy required; check returned Reproducible, to customer at register
legible Reproducible, legible image,
image, microfilm, or copy microfilm, or copy of check of check front required front required of Originator retains copy of document for two
Retention
Consumer retains voided check ODFI as long as desired
retains
copy
source document for two source
years from settlement date years from settlement date Eligibility Checks > $25,000 or containing auxiliary on-us field are ineligible for conversion receipt signed Mailed or deposited check Check considered authorization; considered notification by Originator notification required prior to payment required presentment authorization; by by Originator posted
Authorization Authorization during purchase
sign/similar receipt Presentments Three presentments allowed
46
The process flow for Smiths POP Transaction is depicted below:
The process flow for Peters ARC Transaction is depicted
47
The process flow for a BOC Transaction is depicted below:
In ACH also there is the concept of check return due to paucity of funds similar to the traditional check clearing process. Regulation E-Electronic Fund Transfer Act defines the various rules and regulations pertaining to ACH
2.8
Private Banking or Wealth Management
Wealth management is defined as a comprehensive service to optimize, protect and manage the financial well-being of an individual, family or corporation. Its basic definition covers advice on loans, investments and insurance to give a broad picture of how individuals should best deploy their financial resources. A broader picture may include tax advice, estate planning, business planning, and other financial needs. Inheritance services is also becoming part and parcel of the private banking Services.
Wealth management means taking care of the needs of clients, their families and their businesses as part of a long-term, consultative relationship. Its best conceptualized as a platform where a number of different sets of services and products are provided. Its a full -
48
service model, which can offer advice on investment management, estate planning, retirement, taxation, asset protection, cash flow, and debt management. Wealth Management is the next step in financial planning. It challenges advisors, especially those with high-net-worth clients, to bring together all aspects of a client's financial life into a single plan-from investment advice to estate planning to long-term-care insurance. The components, and the methods of approaching them, vary as widely as the number of practitioners who are moving into this area. As any professional financial planner, the wealth manager's focus is the client. His efforts are devoted to assisting clients achieve life goals through the proper management of their financial resources. While the money manager may not necessarily have background information about his client, the wealth manager will know all of this, as well as the client's goals and fears. The practice of the wealth manager is holistic and individually customized. It is holistic because there is very little about the client's global fiscal life that is not important information.
Wealth management is a broader term than Investment management. Investment management is the science of choosing investments such as stocks, bonds and derivatives and combining them in a way that respects a clients specific risk -to-reward needs. It is also frequently called money management or asset management. On the other hand, the Wealth Management process is founded on the values of the client first. What is important to the clients? What goals do they have and how do they want to accomplish them? What is their timeline for implementing these values and accomplishing these goals? Answering these questions will establish the foundation upon which the wealth manager and client work together.
49
Wealth management is an ongoing process. It involves keeping track of the needs of the clients and their changing definition of success. Constant attention should be paid to the portfolio and performance of investment should be monitored.
A wealth manager examines a clients financial situation and then suggests a combination of banking and investment services that best address his unique wealth management issues. These include:
Current lifestyle needs. The income a client needs for living, the needs of their children and short- or long-term goals.
Legacy goals: To who does the clients want to entrust his/her money and how much control doe he/she want to bestow on potential heirs?
Philanthropic pursuits. The charities a client would like to support as well as when and how he wishes to gift his/her money or assets (a decision that determines any tax benefits to the client).
Income tax considerations. The timing of stock or bonds purchases and sales might affect total tax liability, or the form in which money is gifted to others, triggers taxes due.
50
Constructing a Financial Plan There are three basic steps in establishing and maintaining any sound financial plan:
Determining clients needs or customer profiling First step is to set the financial goals before one starts working towards them. Everyone who has aspirations for the futuresuch as buying a house or saving for a child's educationneeds a detailed plan to make those dreams a reality. Effective financial planning is a process that first requires the answers to several important questions from the client:
What is the client saving money for (i.e. car, house, college education, retirement, etc.) and how much does he want to save?
What is the clients timeline for achieving these goals? What are the clients investment preferences? Does the client consider himself/herself a conservative or an aggressive investor?
Building the plan Next step is the need to choose overall investment strategy and the specific investment vehicles that will help best to achieve clients goals. A variety of investment types including stocks and bonds, life insurance and annuitiesall have a place in the overall plan. It's important to understand these options and how they can help to achieve success. Before selecting the best mix of investments for clients portfolio, the bank will seek an answer from the client to several factors so as to develop an overall investment strategy:
51
The length of time the client plans to invest the funds. The availability of emergency cash. The preferred risk level for investment choices. The client and the banks past experience investing in different financial options. The clients current income tax rate.
Ongoing management All successful financial portfolios require constant attention and monitoringas goals and needs evolve, so too should the investment mix.
Changing role of wealth manager Wealth management is becoming an extremely important part of financial services. Wealth management requires a more comprehensive relationship with a customer. Therefore, the relationship involves more trust and requires the wealth manager to be more intimately involved with customers' overall facts, financial circumstances and risk profile. It will require spending more time with each customer and their broader needs, whether those needs are for mutual funds, life insurance, annuities, asset management or long-term care. More importantly, the future will be about retirement income; creating appropriate personalized "draw-down" strategies for people who will need to live off those assets for 25 or 30 years.
Advice given by wealth manager cannot be static--it needs to be dynamic because individuals' circumstances change over time.
Because of the rapidly changing nature of the financial markets, most wealth management accounts are managed on a discretionary basis. This means that the wealth management firm
52
makes specific buy and sell decisions on behalf of clients (according to their risk-to-reward needs), while frequently informing them of portfolio decisions and performance updates. The investment manager has a fiduciary responsibility to manage clients assets prudently and according to established goals and guidelines. This fiduciary role is a legal duty to make portfolio decisions in the clients best interests.
On the other hand, in case of a non-discretionary investment authority given to the wealth manager, his/her option to acquire, manage, and dispose off the assets on behalf of the client is limited. There are controls imposed on what actions the wealth manager can or cannot take without prior approval of the client. Typically in the non-discretionary relationship, the wealth manager acts according to an investment strategy that is agreed upon by the wealth manager and the client. However, the wealth manager may not have the authority to purchase or dispose of any assets, or implement major investment decisions, without the prior review and approval of the client.
Importance of KYC in Private Banking Supervisors around the world are increasingly recognizing the importance of ensuring that their banks have adequate controls and procedures in place so that they know the customers with whom they are dealing. Know Your Customer (KYC) policies are most closely associated with the fight against money laundering. Especially as Wealth Management deals with large value transactions, KYC is more critical in this business.
Certain key elements should be included by banks in the design of KYC programmes. Such essential elements should start from the banks risk management and control procedures and should include (1) customer acceptance policy, (2) customer identification, (3) on-going
53
monitoring of high risk accounts and (4) risk management. Banks should not only establish the identity of their customers, but should also monitor account activity to determine those transactions that do not conform with the normal or expected transactions for that customer or type of account. KYC should be a core feature of banks risk management and control procedures, and be complemented by regular compliance reviews and internal audit. The intensity of KYC programmes beyond these essential elements should be tailored to the degree of risk.
All well run private banking operations have written "Know Your Customer" policies and procedures that require banking organizations to obtain identification and basic background information on their clients, describe the clients' source of wealth and lines of business, request references, handle referrals, and identify red flags and suspicious transactions.
2.8.1
Products in Wealth Management
The basis of Private banking is the diversification of asset classes. There are a number of asset classes which is available to the investors. They are also called as products The main products being offered to the wealth clients by the private banking group are: Portfolio Management Services (PMS) Mutual Funds Investment Insurance Products Equity Fixed Income instruments Artworks Commodities Real Estate
54
Private Equity
Portfolio Management Services (PMS): PMS is one of the popular products offered to wealth management clients. The bank provides advisory services to the client to better manage the portfolio of the client. The service may be discretionary or non-discretionary.
Mutual Fund Investment: The bank advises the client about investment in mutual funds. Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.
Insurance Products: This is an important financial planning product used by wealth managers. They offer various insurance policies to their clients to adequately cover the risks faced by the clients.
Equity: This is the most important asset class from the point of view of yield enhancement. Wealth managers usually advise their clients to remain invested in this asset class for a longterm. Fixed Income instruments: These are the bonds/debentures issued by corporate or by government. These are debt instruments and help the client in earning interest periodically over the life of the bond and getting back the principal at the time of maturity. Artworks: This is an emerging asset class. Art Advisory is also being most sought after. Commodities: This has become a new asset class in the last few years. Historically the volatility of the commodities has been less than the volatility of the equity. In commodities like precious metals like Gold there has been a negative co relation during certain period and has become a popular asset class.
55
Real Estate: This has become a new asset class in the last few years. Banks have either setup specific desk for the same or tied up with reputed Real Estate advisory and execution firms. The exposure to Real estate can either directly by buying the real estate or through the indirect route. In an indirect route, internationally there are funds like real estate mutual funds known as REITS. Private equity: Private Equity is an emerging asset class even for the Private Banking clients. They give an opportunity to earn higher return at higher risk.
2.9
Card System
In the retail banking landscape, the biggest volumes of transactions are perhaps managed by the Card system. 2.9.1 Evolution of Cards
The Card industry has grown phenomenally in the last two decades and has become a strong substitute for cash. This is often referred to as plastic money. However there are certain countries which have a huge parallel economy where even today a large chunk of financial transactions happen in cash. This is because a card transaction leaves back sufficient financial trail which will enable traceability of the fund flow. The Diners club and American express where the two early birds in this financial space. The same was launched in 1950s. The credit of issuing the first credit card goes to Diners club .The same was introduced in 1951. The backbone of the Card processing is the settlement mechanism. In the early days this process was a pure manual one. The burgeoning volumes as well as the technology evolution had brought drastic changes to the processing environment.
56
The diverse business needs have moved the card industry form the Credit and Debit Cards to other segments like Petro Cards, Frequent Flyer Cards, Integrated Transport system cards where in a customer using a single card can purchase a metro/railway ticket as well as bus tickets. This model is prevalent in Singapore. Business innovation has no boundaries. Even though it is too early to comment on the technical details, the ambitious UID project of the Government of India may culminate into a Smart Card. The Kisan credit Card introduced in India is a very innovative manner to support the Framers and enable straight through processing. However carrying multiple cards leads to inconvenience and days are not far off when a single card will be able to cater to multiple services similar to a mobile phone has now converged
other electronic devices like a music player, video and camera.
2.9.2
Type of Cards
Cards can be classified based on various categories like Business Usage, Issuer, Technology used etc. There can be overlaps between these classifications.
2.9.2.1 Credit Card This is one of the oldest types of cards issued since 1950s.In a credit card the card holder enjoys a credit limit which needs to be repaid in a billing cycle. There can be preset limits on the card beyond which the outstanding cannot increase. There are cards which are issued to certain category of customers where there is no preset credit limit. In terms of popularity Credit cards are the most popular.
57
The new trend in Credit card segment is the co-branded cards. For e.g., Jet Airways has tied up with Master Card to issue a Jet airways Card wherein JP Miles can be earned on spending on this card. Yatra launched a Co-branded VISA card. VISA also has launched theme cards like Womens card/Students card etc. Credit Cards can be further classified into various levels based on the credit score and the spending patterns. The lowest card is the standard, followed by Gold and the highest category is Platinum. In addition to the limits differences in the card, the facilities provided in the card as well as the charges on the card may vary.
2.9.2.2 Charge Cards Very often one will come across the terms Credit card/Charge cards. Both these words are used interchangeably by the world at large. There are conspicuous differences between a credit card and a charge card. A charge card requires the card holder to repay the balance in full at the end of each billing cycle. A credit card on the other hand allows the card holder to have a revolving balance that one can pay off over a period of time. Some cards do not have a preset credit limit giving one a limitless amount of credit. Unlike a credit card one needs a strong credit score to get the same while it is not true of the credit card. There are certain restrictions on the transaction that can be undertaken on charge cards. American Express and Diners Club Charge cards are the most popular. American Express charge cards are again classified to cater to the different strata of the society and the Platinum charge card is the most sought after .The Platinum charge card is also a status symbol among the elite
58
2.9.2.3 Debit Cards Debit Cards are of recent origin. This card evolved after the technology evolution where in the settlement was electronic. In this card the customer can spend up to the amount which is available in the account of the customer. These cards are typically linked to the operative account of the customer and validation of the balances happens prior to the spending on the card. These cards are free of credit risk (to a certain extent) from the perspective of the issuer as the issuer does not carry the default risk at all. The element of risk may be there when a merchant transaction is affected without checking the balances in the card. To overcome this certain Issuers have come out with a variant of the Debit Card which can be 100 percent online. For E.g. VISA Electron
2.9.2.4 ATM Cards ATM cards where used solely for the purpose of cash withdrawals only. In the initial stages the ATM card could be used only in the network of the Card issuer itself. I.e. if X bank issues an ATM Card the Card could have been used only in the network of that bank and nowhere else. This reduces the utility value of the card and the customer had to carry a separate card for ATM and a separate card for Debit Card. Even today one may come across this type of card in certain technologically under developed country.
2.9.2.5 Credit card cum ATM Cards Modern day credit cards offered by institutions also has the facility for the customers to withdraw cash and separate cash limits are set on the credit card for the same. This will take care of emergency cash requirements of the customer.
59
However cash withdrawal on credit cards entail service charges over and above the normal transactions.
2.9.2.6 Debit card cum ATM Cards The ATM cards can also cater to the customers need of using it as a Debit Card as well. Unlike a Credit Cum ATM Card, the overall limit be it Cash withdrawal or using the card as a debit card is restricted to the balance in the operative account to which the card is linked .In certain countries/issuers also call the debit card as Check card as it is as good as check(in the Indian context cheque) However based on the issuer there can be overdrawing to a certain extent. For example VISA has two types of cards. One is the normal VISA Debit Card and the VISA Electron. VISA electron cards cannot be overdrawn as the balances are checked online. Some merchant establishments may not accept Electron Cards Another major development in this segment is the interoperability and using the cards on a common platform. In the modern days typically a customer who has a debit cum ATM card issued by an Issuer say VISA can use this card for withdrawal of the cash from any banks ATM which is also a member of VISA. In the past if the Debit Cum ATM card was issued by Bank A, the customer had to necessarily go to the A Banks ATM only for cash withdrawal while other merchant transaction could be done with any VISA affiliated merchant. VISA is only an example there are other issuers like MASTER. There are other shared payment networks .For e.g. in India we have a network called BANCS which caters to those ATM network for Banks which are not part of the VISA and MASTER. (Earlier there was a network called Swadhan) The biggest advantage of using the Debit cum ATM cards of Global issuers like VISA and MASTER is the same card can be used to withdraw cash not only in the local currency but also
60
in foreign currency when the customer travels abroad. For e.g., the customer is an Indian and he/she has a VISA card issued by a bank in India. The customer travels to Riyadh and sees an ATM of a Saudi Arabian Bank with VISA logo on the ATM. The customer can walk into the ATM and do a cash withdrawal in SAR(Saudi Arabian Riyals).(The exchange rate and the services charges are the hidden cost in such a transaction which needs to be worked out vis--vis carrying a travel currency card).
2.9.2.7 Travel Currency card cum ATM Cards This is a new type of cards. They are cards preloaded with a specific amount. It can be issued in multiple currencies. The same card can be used as an ATM Cards. VISA and Master issue these types of cards. In the Indian context, the difference between Debit cum ATM card and Travel Currency Card are as follows: The exchange rate is locked in at the time of purchase and not across the period of spending If one is travelling to multiple countries, one may have to carry multiple travel currency cards which become a bit cumbersome. This card strictly cannot be used in India
The travel currency card becomes handy to those people who do not have a debit card .Other facility in this card is that the top up is available. Unused amount on these cards can be surrendered, if the unutilized amount is above a threshold level.
2.9.2.8 Gift Cards The concept of Gifting has undergone a sea change in modern times. Gift vouchers are being replaced with Gift Cards universally.
61
In terms of technical comparison between Gift Card and Travel currency cards is that both of them are pre-paid cards. In case of the former the same cannot be topped up once the limit is exhausted while in case of the latter the same can be topped up.
2.9.2.9 Petro Cards There are different variances of the Petro Cards. The Petro Cards in India are standalone cards and are pre-paid cards. Both BPCL and HPCL have come out with the Petro cards. However BPCL is most popular petro card. The attraction towards this card is the loyalty bonus and other discounts. The second variant of a petro card is the Co-Branded Credit Card similar to the co-branded credit cards of Airlines. For e.g. in Canada there is Citi Petro Points Master Card. The third variant of a Petro Card is linking the petro card to the Credit card. One such company which issues such a card is Petro Canada. The petro card of that company can be linked to the credit card for a consolidated view of the same
2.9.2.10 Corporate Cards All the major card issuers have launched the cards for business houses. The businesses have been classified into Small Business. Mid-size Large companies Government and Public Sector
Unfortunately the definition of the first three business classification varies from issuer to issuer. For e.g. Master Card defines a Mid-size/Medium Size business with revenue between USD 10 Mio and USD 1 Bio, while VISAs definition is revenue between USD 25 Mio and USD 500 Mio.
62
The business cards can be issued either to employees or to the organization. Certain cards can be assigned to specific departments within an organization. In case of individual, these cards are generally issued to the senior management for their travel and entertainment expenses incurred. The basic purpose of issuing such cards is for the purpose of control and convenience. Control from the perspective of spending limits, type of spending. The convenience factor is from the repayment of the spending in an effective and efficient manner. It also enables corporations to monitor the type of spending as well as patterns of spending. The corporate are wooed by the card issuers with a number of features on the card as well as other add on features. The facility to the corporate is innumerous. They have different types of cards .The business card need not necessarily be a credit card. It can also be a debit card.
VISA has the following type of Business cards for small business VISA Business Credit Card VISA Business Debit Card VISA Business Line of credit VISA Signature Business Card VISA Gift Card VISA Incentive Card
For medium and large corporate the cards can be basically classified on the spend types viz. Corporate Travel Card, Corporate Purchasing Card, Corporate Fleet card. There are integrated cards which can take care of all the four functions. The differentiator for the business cards is the frills and additional resources etc. provided by the issuer.
63
In case of growing economy to exercise better control and monitoring the business card segment is poised for growth in the days to come.
2.9.2.11 Other Private Prepaid cards The concept of prepaid cards are picking up in developing countries. In India the most popular pre-paid cards which are of multipurpose is ItzCash. It can be used to transact on mobile as well as the internet. These cards can be used for making utility payments as well. However the challenge in the private players compared to Master and Visa is the acceptability of these cards.
2.9.2.12 Non-Financial Cards The second segment of the cards which has sudden spurt in the recent times is the Nonfinancial type of cards. The typical types of cards are Frequent Flier cards issued by Airlines These cards are used for tracking the frequent flier miles accrued. These cards cannot be used for undertaking financial transactions. Basically these cards are used for awarding mileage points based on different business logic. There are grading in these cards as well. For e.g. Jet airways have JP Blue, Blue Plus, Silver, Gold and Platinum. Most of the big travel companies do offer such cards. Airlines have gone beyond mileage points only for source airlines. There is Airline code sharing arrangements wherein if one flies a partner airline, the passenger is available for Mileage points. For e.g. If one is a Jet Airways Frequent flier and flies Malaysia airlines, the
64
mileage points can be earned on the flights of Malaysia airlines. Flying: Over and above code sharing with other partner airlines, they also tie up with other partners such as hotels. The frequent flier cards are different from the co-branded credit cards issued and one must not confuse the same with the Frequent flier cards. Co-branded cards .as already mentioned above are typically credit cards issued jointly which gives special facilities to the card holders. The new concept in the travel industry is the credit card point conversion programs. This is applicable to non-co-branded cards as well. To illustrate, if a Citibank Platinum Card holder has 10000 reward points the same can be exchanged for JP Miles with jet airways. The conversion ratio varies from type of card. In case of a Platinum card 1 point on a credit card can be exchanged for 2.5 JP Miles Loyalty cards issued by Hotels This card is very similar to the frequent flier programs. The facilities offered on this card vary from hotel to hotel. Some of the most popular programs are of Starwood Preferred Guest Marriot Rewards Hilton Honors Hyatt Gold Passport
Similar to the code sharing arrangement of the airlines, the hotel programs also have a chain of hotels under their umbrella Fuel Management Cards In Canada the most popular Fuel management card is the Super Pass TM is the most popular petro cards issued by PETRO CANADA. The business logic is a Hybrid between Individual cards and corporate cards. The cards can be issued to drivers etc. for refueling etc.
65
Lot of innovation has been built into this card in terms of control like which fuel station can be used for refuel, time of refuel etc.
2.10 The Participants in the Card Business

The card industry has a number of participants in the processing. The role of each participant needs to be understood clearly before delving into the Card Dynamics. The major participants in this market can be classified as follows: Srl No Participant Name 1. Global Technology Companies 2. Card Issuers Visa, Master and Discover examples of such companies. These companies per se do not issue cards, extend credit or set rate and fees for consumers An Institution which issues the card is referred to as the card issuers. Generally Banks are the issuer. It is the issuer that extends credit and sets rates and fees for consumers. In case of 3. Acquirer An organization that collects (acquires) credit Participant Role
authorization requests from Card Accepters and provides guarantees of payment. The acquirer can also be a financial institution 4. Issuer Acquirer 5. Merchant acceptor 6. Card Holder Cum American Express cards and Discover are examples of Issuer cum Acquirer or an individual, organization, or corporation that
accepts credit cards as payment for merchandise or services Last but not the least the most Important participant in the Card business
66
7.
Independent Sales Organization (ISO)
A third-party company that provides services to merchants on behalf of the acquiring bank. These services include merchant accounts, funds processing, and account activity reporting.
2.11 Business Models- Private Label and White Label Cards

In addition to various classifications on end use of the card, cards can also be classified as private label cards and whit label cards. This classification is over and above the normal cards (there is no default name for the normal cards). Private label cards can be used only at the merchants own network. The BPCL petro card for example is a private label card as the Petro card cannot be used anywhere. White Label Card on the other hand is launched by a merchant in association with the issuer and the VISA/Master card. However it will not hold the name of the issuer. The same can be used freely like a normal credit card. For e.g. Reliance Capital can tie up with State Bank of India for a white label Visa Card. When such a card is issued, it will carry only the name of Reliance Capital and the name of State Bank of India will not feature anywhere on the card
67
This chapter discusses the Commercial Banking Business, by covering the fee and non-fee based products in the business. Cash Management and Trade Finance are introduced to the readers. The Lending Process is also discussed at a high level.
3 Commercial Banking
Wholesale banking is also known as business-to-business banking. It refers to the transactions between banks and large customer like corporates and government involving large sums of money. It also includes the transactions between banks. Project Finance Real Estate Finance Lending Trade Finance Export Finance Factoring Leasing Guarantees Bills of Exchange
The aim of Wholesale Banking is to meet requirements of corporate clients by offering a full range of banking products and services. It is not always necessary that the wholesale banking customers have only the need to manage the asset side of their balance sheet. They may have short-term investable surpluses and other service requirement like foreign exchange management as well.
68
From the Banks balance sheet perspective, the whole sale banking products are classified into two Viz. Funded Income and Non Fund Income or Fee Based income. Bank lending continues to be the mainstay of the banks and generates Funded Income.
3.1
Fund based facilities
Banking is defined as the accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawable by checks, draft, and order or otherwise."
The very definition of banking stresses the importance of lending function, when it defines banking as 'Borrowing for the purpose of lending'. Hence the basic objective of bank is presupposed to be lending.
Banks need to deploy funds borrowed from the public to be able to pay the contracted returns to the depositors. The most important source of deployment of funds and earning revenue is interest through lending. Banks act as intermediaries between the depositors and borrowers. When a bank agrees to lend money to a borrower, either against a tangible security or without a security, against a borrowers promise to repay the amount at a future date, with interest for the amount used for the period, is a form of fund based lending.
Most of the commercial credit products are in the form of loans. Loan is a comprehensive term used to refer to the various types of short, medium and long-term credit facilities made available by banks. Loan is a contractual agreement between the borrower and the lender of the funds which states the underlying terms and conditions such as loan amount, repayment period, rate of interest, penal provisions for breach of the contract, etc.
69
The fund Based lending may be via any or a combination of the following products: Lines of Credit Revolving Loans Term Loans Syndicated Loans/Club Loans Trade Finance Export-Import Finance Factoring Leasing Bills Discounting
Banks set limits for each of these product types. This limit determines the maximum amount that the borrower can borrow under the given product. The actual borrowing can therefore be different from the limit. The actual borrowing amount is called the drawing or drawdown or utilization under the product.
3.1.1
Lines of Credit
A Line of Credit allows a company to borrow up to a pre-fixed amount called the credit limit for short-term business requirements. This allows borrowers to obtain a number of loans without reapplying each time as long as the total of borrowed funds does not exceed the credit limit. The bank usually charges some amount of fee as well as interest on such borrowings. A Line of Credit can be secured or unsecured. If secured, the customer is required to offer some collateral security to cover up the borrowing. In case, the customer fails to repay, the bank may take charge of the collateral. The collateral is usually "short-term" assets, such as receivables and/or inventory.
70
It can also be by way of an overdraft where a 'credit limit' up to the amount to be lent is set in the current account. It may be a Cash Credit Account', where the bank lends against the security of stocks6 or receivables7 up to a certain limit in a form of checkable account8 allowing multiple withdrawals and deposits as per his/her business needs. The interest is payable only on the utilized amount. A company generally requires funds for the day to day activities which is called the working capital in the accounting parlance. The working capital basically would be to meet the short-term needs of liquidity of the organization. Lines of credit are typically set up for that purpose. The duration of a line of credit is generally one year and the line of credit needs to be renewed every year.
3.1.2
Revolving Loans
A Revolving Credit is firm commitment by the bank to lend up to a certain amount .Revolving credit is similar to the line of credit except for the fact that the duration of the line of credit is longer ,generally up to five years. The duration of a commitment to lend against a revolving loan is therefore longer than a Line of Credit. This commitment is subject to a loan agreement containing mutually agreeable terms and conditions. Revolving credits are to be paid in full at maturity, and the revolving credit line can be re-used again for a fresh borrowing, if required. A fee generally is charged for a Revolving Credit commitment. This is a monthly charge from 0.25% to 0.50% per annum on the average daily-unused portion of the committed amount.
6
7
Inventory of raw materials, semi-finished goods or finished goods. Money owed to the company by the customers who purchased the goods on credit. 8 A bank account on which a check may be drawn.
71
3.1.3
Term Loans
Terms loans are normally given for financing the long-term assets such as buildings, equipment, leasehold improvements, etc. Term loans are unlike Lines of Credit or Revolving Credit as its repayment does not allow the borrower an automatic right to re-borrow the unused credit limit (unused credit limit = Limit for Term Loan Drawing under the term loan). The interest rate can be either fixed or floating. If it is fixed, it remains constant for a certain time period after which re-fixing is done. For example, if the repayment period is 15 years and re-fixing is to be done after every three years, the interest rates will remain fixed for a period of 3 years and after every 3 years, the interest rate for the next three year period is determined and fixed. In case of floating rate loans, the interest rate is linked to a benchmark and the rate of interest on the loan keeps changing depending on the changes in the benchmark interest rate
The term loan can be of two types: Short-term loan Long-term loan
Short-term loan as the name suggests is given for a shorter period and the purpose of such a loan is to meet the short-term requirements of the borrower. It differs from a line of credit in that it is taken for a specific purpose and a fixed amount of money is usually borrowed for a given time period.
Long-term loans on the other hand, are loans which are taken for a longer period of time, say 5-10 years and usually the purpose is acquire some fixed asset or expansion of the existing facilities, etc. Interest is payable periodically (say at the end of each quarter). Principal
72
repayment can occur at the end of the term loan (bullet repayment) or periodically during the tenor of the term loan
3.1.4
Syndicated Loans/Club Loans
A syndicated loan/club loan is an arrangement between two or more banks to provide a term loan (either short-term or long-term) to the borrower using common loan documentation. This arrangement is usually opted for when the amount required by the borrower is huge and exceeds the exposure limits of a single bank. The lead manager/banker of the syndicate is given a mandate by the borrower, which details out the commercial as well as legal terms of credit.
In a syndicated loan, all the lenders have a common position relative to the borrower. Each lender lends only the amount it has agreed to. If any bank in the syndicate fails to fulfill its obligation, the other banks are not legally bound to make up the difference. In the event of default, banks may also take legal action against the borrower either independently or jointly as specified in the contract.
73
3.1.5
Trade Finance
Trade Finance is a very generic term which represents the purpose for which the lending is done. It can have a mix and match of the various products like lines of credit, revolving credit etc. This jargon is used to distinguish between personal and consumer loans disbursed to individual. 3.1.6 Export-Import Finance
Financing of exports and imports of goods and services is an important activity of wholesale banking. The dynamics of Export-Import Finance is similar to trade finance, the core difference being the trade finance refers to domestic trade finance, though many a times the Trade
74
Finance is used interchangeably with Export Import Finance. These loans are normally provided by the commercial banks or by the designated trade promotion bank in the country, either directly or indirectly. For example, in India, Export Import finance is provided by EXIM Bank of India. In US, its the Export Import Bank of the USA. The services provided include loan guarantees9 to help U.S. exporters obtain working capital loans to finance the raw materials used in preparing the goods to be exported, export credit insurance to cover risks of the default of a buyer in providing a payment, and medium-term and long-term financing for international buyers.
An exporter may bag an order for a manufacture of goods which may have what is called a production life cycle. The production life cycle has the following payments involved: Procurement of Raw materials Wages and salaries Establishment Expenses Inventory Holding Semi-Finished Goods Credit period for Buyers
There is a need for the exporter to finance these various components. Export finance can be classified into Pre-shipment and Post Shipment Finance. Pre-shipment finance as the name indicates is the lending to the exporter to the activities prior to shipping of the goods. Once the goods are shipped then the nature of lending gets converted to Post Shipment.
A guarantee that in the event of default by the borrower, the guaranteeing bank will repay the
loan.
75
If the exporter has availed pre-shipment finance, the same has to be liquidated by postshipment finance only, under normal circumstances. Under extraordinary circumstances, like cancellation of the export order the same can be liquidated by other means. The post shipment finance is generally disbursed by liquidating Pre- Shipment Finance. In case an exporter has not availed disbursed. any Pre-Shipment Finance a fresh Post shipment finance can be
3.1.7
Factoring
This is also known as account receivables financing. Account receivables represent the funds which are owed by the customers of a company to the company. Usually, every company has a credit policy according to which a credit period is allowed to the customers buying on credit. The customers are expected to make the payment on or before the end of the credit period. As a result, some of the companys funds remain tied up as money to be received from customers or accounts receivables. Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor, generally a bank or a banking subsidiary) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firms credit worthiness. Secondly, factoring is not a loan it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three. The three parties directly involved are: the one who sells the receivable, the debtor, and the factor. The receivable is essentially a financial asset associated with the debtors liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial
76
organization (aka the factor), to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights and risks associated with the receivables.
3.1.8
Leasing
Leasing and hire purchase is another avenue for organization to raise funds for its day to day operations. Generally leasing is related to equipments which has a short to medium life. For e.g. a company into building metro rail may have the necessity of heavy duty crane. Once the work is done they may or may not need the crane in the same location. Moreover they need not block the big amounts in buying cranes. They can lease out the crane from any specialist organization. This is an example of an operational lease. In a financial lease, the lease period is almost equal to the life of the asset. In this, it is one asset to one person at a time. Generally the banks may not do leasing activity directly instead does it through a separate subsidiary. A typical example of big ticket leasing is the leasing of aircraft by the manufacturing companies to the various airlines. In addition to the savings on capital expenditure, the lease rental paid is treated as revenue expenditure.
3.1.9
Bill Discounting
A trade transaction, involving sale of goods, is always supported by an invoice which is drawn by the seller on the buyer. This buyer can be the end user or the reseller/distributor/retailer .There is a number of documents in addition to the invoice which the seller has to submit along with the invoice. The number of documents can vary especially in International Trade. One of
77
the important documents in addition to the invoice is the bill of exchange, which is a must for both domestic and international trade. It is an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to or to the order of a specified person, or to bearer of the bill of exchange.
Parties in a bill of exchange Drawer: The person who gives the order to pay is called the drawer. Drawee: The person thereby required to pay is called the drawee. Payee: The person to whom the money is payable is called the payee. Endorsee: The person to whom a bill is transferred by endorsement is called the endorsee. Bearer: The holder (need not be the rightful holder) of a negotiable instrument Holder: The generic term holder includes any person in possession of a bill who holds it either as payee, endorsee or bearer.
A Bill of Exchange can be payable either at sight or after a given pre-specified period (called usance period) A bill of exchange is payable on demand if it is expressed so in the instrument or as per the time period expressed in the instrument In calculating the maturity of bills payable at a future time, three days, called days of grace, must be added to the nominal due date of the bill. For instance, if a bill payable one month after sight is accepted on January 1, it is payable on February 4, and not on February 1 as its tenor indicates. A bill of exchange is transferable
78
i.e. the holder of a bill of exchange (the holder receives the money on a pre-specified date from a counterparty) can transfer the bill of exchange by endorsement10 to a new holder.
In bill discounting, the bank purchases the bill from its client before the bill is due for payment (the customer endorses the bill in favor of the bank, and the bank becomes the holder of the bill). The bank credits the amount to the clients account after deducting a charge called the discount charge. The discount charge basically represents the interest on the amount given to the client from the date of purchase of the bill till the due date of the bill.
Bill discounting may be done by the bank on a with recourse basis or a without recourse basis. If it is done on with recourse basis, it implies that the bank can approach the client and ask for payment if the counterparty fails to make payment on the due date. If it is done on without recourse basis, it implies that the bank cannot approach the client in case of nonpayment on the due date.
Sample Bill of Exchange
10
The legal transfer of title of a document by signature, usually, but not necessarily, on the
reverse.
79
First of Exchange (Second Unpaid) and Second of Exchange (First Unpaid) In practice, it is not uncommon that two drafts are drawn on the drawee bank in a letter of credit (L/C) to ensure that at least one draft reaches the drawee when they are dispatched separately.
3.2
Structuring of Loans
Loans can be structured in a variety of ways depending upon the need of the borrower and the lender. The structuring is done with respect to the interest rate payable and the repayment arrangement.
3.2.1
Fixed Rate vs. Floating Rate
Loans can be fixed rate loan or floating rate loans depending upon the interest rate payable on the loans. In case of fixed rate loans, the interest rate is fixed at the time of loan origination and remains constant during the life of the loan. Such loans are preferred by the borrowers when the interest rates in the economy are expected to move up.
In case of floating rate loans, the interest rate on the loan is linked to some benchmark like LIBOR11 (London Inter-bank Offer Rate). E.g. the interest rate can be expressed as LIBOR + 1%. For example, a ten year loan can be priced at LIBOR + 1%, payable six monthly and fixed six monthly. In this example, the interest rate for the first six months is determined by the value of LIBOR + 1% at the time of disbursing the loan. The determination of the interest rate for the next six months is done at the end of the first six months. Depending upon how the LIBOR
11
This is the interest rate at which banks can borrow funds, in marketable size, from other banks
in the London interbank market.
80
changes, the interest rate on the loan will also change.
Such loans are preferred by the
borrowers when the interest rates are expected go down. This is graphically represented below:
Current Time
LIBOR + 1%
LIBOR + 1%
LIBOR + 1%
On Disbursal LIBOR = 2.23% Interest Rate = 3.23% After Six Months
LIBOR not known
LIBOR not known
Current Time
6 Months After disbursal LIBOR + 1% LIBOR + 1%
On Disbursal LIBOR = 2.23% Interest Rate = 3.23%
Libor Fixing at 3.07% Interest Rate for next 6 months = 4.07%
LIBOR not known
3.2.2
Types of Repayment
Loans can have different types of repayment arrangements also depending upon the requirements of the borrower. The common types of repayment arrangements are as follows:
Equal Periodic Installments Stepped Up Installments Bullet Repayment Deferred Repayment
81
Equal Periodic Installments This is the most common type of repayment option usually offered by banks and other financial institutions to their borrowers. In this type of repayment arrangement, the borrower is required to repay an equal amount at periodic intervals (which may be monthly, quarterly, semi-annually or annually) to the bank. This payment from the borrower goes towards meeting the payment of interest as well as the amortization of the principal outstanding.
Case: Equal Periodic Instalments
Payment = 4.39 comprising Repayment of Principal = 3.97 Payment of Interest =
Payment = 4.39 comprising Repayment of Principal = 3.99 Payment of Interest =
Other Payments from month 3 to month 23
Payment = 4.39 comprising Repayment of Principal = 4.37 Payment of Interest = 0.02
Disbursal Details 1st Month Amount Disbursed/ Lent/ Principal = 100 Interest Rate = 5% fixed Duration or Tenor of loan = 24 months
2nd Month
24 Months
As can be seen from this structure, the payments stay constant at 4.39 per month. However, as time progresses, the share of principal repayment in 4.39 increases.
Stepped Up Installments In this type of repayment arrangement, the installments payable on the loan are gradually stepped up or increased. To begin with the amount of installment is less; however, with time the amount keeps on increasing either by a constant amount or by a constant percentage. This type of repayment arrangement is preferred by borrowers who expect an increase in their income over a period of time.
Bullet Repayment
82
In this type of repayment arrangement, most of the repayment is made on the maturity of the loan (known as balloon or bullet installment)
Deferred Repayment In this type of repayment arrangement, the repayment starts only after a given period of time after disbursement. For example, the repayment may start only six months after disbursement and then continue for the entire life of the loan. The deferred repayment can be further structured as equated periodic repayment, or stepped up repayment or even a bullet repayment arrangement.
3.3
Concept of Default
All loans carry a credit risk. Credit risk may be defined as the chance of counterparty or borrower failing to fulfill its contractual obligations. When the borrower fails to repay the loan in a timely manner or does not repay at all, a default is said to have occurred. Default may be a willful default (when the borrower intentionally does not repay the loan) or a compulsive default (when some factors, internal or external to the business lead to a default). Since default may take place on every potential credit, every credit decision requires an assessment of credit risk or probability of default.
83
3.4
Non-Fund Based Facilities
The Non fund Based may take the following forms: 3.4.1 Letter of Credit or Documentary Credit
Pandian and Company is a small Garment Manufacturer operating from Tirupur, a hamlet near Coimbatore in Tamil Nadu India. John Smith is a Garment Dealer in Antwerp in Belgium. Both of them do not know each other but would like to undertake trade across the border. In such a situation they would need an intermediary like a bank who can assure Pandian and Co that once the goods are dispatched the payment will be made. More than one bank may be involved in this transaction. Pandian and Company will only trust a bank which he may know as his/her knowledge of the financial sector. His faith will be more on State bank of India compared to the Antwerp Diamond Bank, which is the bank of John Smith. This is facilitated by what is called a Letter of Credit (LC). Importer and the overseas seller while finalizing the commercial contract decide the terms of payment. Since the overseas seller is not fully aware about the financial capacity of the importer, he insists a bank must undertake the payment obligation on behalf of the buyer and payment should be made available to him immediately on dispatch of goods from his/her country. There are a number of Jargons associated with LC which needs to be understood before understanding the process. Applicant of LC-Importer in this case John Smith Beneficiary of LC-Exporter Pandian and co Importers Bank-Antwerp Diamond Bank-Issuing Bank Exporters Bank-State Bank of India-advising/confirming bank
84
L/C Definition Letter of credit is one of the mechanisms for the settlement of payment. There are two other mechanism viz. Advance Payment and collection. In the former the entire payment for the consignment is made in advance after which the consignment is dispatched while in the latter the goods are sent and the payment is sent by the exporter either on receipt of the goods or after a specific periods
Processing of establishing a Letter of Credit / Documentary Credit STAGE I On the basis of this agreement importer (Applicant) requests his/her bank (Issuing Bank) for undertaking the payment obligation on his/her behalf in favor of the overseas seller (beneficiary). To comply with the payment terms prescribed in the commercial contract for establishing a documentary credit in favor of the overseas seller, importer submits an application to his/her banker. Issuing Bank, after checking the credit status of their importer customer, establishes the documentary credit in favor of the overseas seller (beneficiary) and forwards the documentary credit to its Correspondent Bank (Advising Bank) in the Seller's country, with a request to advise the documentary credit to the Beneficiary with their authentication. Correspondent bank12 receives the documentary credit from the Issuing bank and advises the credit to the beneficiary.
12
Bank that accepts deposits of, and performs services for, another bank (called a
respondent bank); in most cases, the two banks are in different cities
85
There are two possibilities at this stage:
In case the issuing banks financial status is not acceptable to the overseas seller who is the beneficiary in the documentary credit, he may request the importer for establishing a documentary credit, which should be through a bank in the sellers country. Importer requests Issuing Bank to make suitable arrangements with a bank in the overseas seller's country for payment to the overseas seller on submission of prescribed documents. In such cases, the Issuing Bank requests a bank in the overseas sellers country or in any third country with whom they have prior arrangement, for undertaking the payment obligation on their behalf for this transaction. This bank may agree for this arrangement subject to their relationship/arrangement with the Issuing Bank. If they agree for paying the beneficiary they are known as confirming bank.
Thus, overseas seller is holding an instrument known as documentary credit by which his/her payment risk on the importer is secured. Issuing bank by extending this product to the importer facilitates the importer for conveniently managing his/her imports.
The letter of credit stipulates a number of documents to be submitted and various other conditions which needs to be strictly adhered to .A sample LC is appended
86
87
Establishing Documentary Credit
STAGE II Step 1: The beneficiary after shipping the goods presents the prescribed documents for payment to the confirming bank Step 2: On receipt of the documents, the Confirming Bank scrutinizes the documents thoroughly and if the documents are drawn in order without any discrepancy makes payment to the exporter/beneficiary of the LC. Step 3: Confirming bank dispatches the documents to the Issuing bank. Step 4: Issuing bank on receipt of documents from the confirming bank, scrutinizes the documents and reimburses the confirming bank and debits the importer. Step 5: Issuing Bank sends the documents to the importer for collection of payment Step 6: Importer makes the payment to the issuing bank
88
Negotiation of Documents under Confirmed Credit
Thus, documentary credit is one of the prominent instruments, which helps the importer to import the consignment from the overseas seller even though he does not know the seller. Under wholesale banking this is one of the products, which is aggressively marketed by commercial banks under import finance.
3.4.2
Uniform Customs and Procedures for Documentary Credits (UCC)
In cross border trade there are a number of complications and each country may take to their advantage. In order to facilitate the cross border trade there is an international body called the International Chamber of Commerce (ICC) which is a body of member countries. They undertake various self-regulating rules which govern the member countries. One such publication is the UCPDC or the UCC .This has undergone revisions at periodic interval with the changing business environment The current one in vogue is the UCC 600 which is the sixth version More than 150 countries
have agreed to issue and operate the documentary credit transactions under this set of guidelines. This is a very easy to understand standard and has 39 Articles.
89
3.4.3
Types of LCs
There are various types of letters of credit available such as:

Revocable Irrevocable Confirmed Back-to-back Standby Revolving
Revocable A revocable LC can be amended or cancelled at any time by the importer without the consent of the exporter. This option is not often used, as there is little protection for the exporter. By default all LCs are irrevocable, unless otherwise stated.
Irrevocable An irrevocable LC once issued can only be changed or cancelled with the consent of all the parties. The seller must merely comply with the terms and conditions of the LC in order to receive payment.
Confirmed LC A confirmed LC is one which has an additional confirmation from some other bank in addition to the issuing bank. The confirming bank takes on an obligation to pay even if the issuing bank defaults.
90
Back-to-Back LC The original letter of credit is used as security by the exporter to open another credit in favor of the exporter's own supplier. The bank issuing the original L/C may not necessarily be the issuing bank of the second L/C.
Standby Credit Similar to a normal letter of credit, however this differs in that it is a default instrument, whereas a normal L/C is a payment instrument. A standby credit is only called upon in the event of the applicants failure to perform.
Standby letter of credit is very similar in nature to a bank guarantee. Standby credits were first developed by banks in United States after World War II and enable domestic banks to compete with foreign banks in international business transactions. It is an alternate to guarantee bonds because of legal restrictions on banks from issuing guarantees. Japanese banks also issue Standby credits for similar reasons.
Standby credit differs from traditional letter of credit.
In a traditional credit the beneficiary is
entitled for payment once he is able to submit the documents prescribed in the credit within the stipulated time. In Standby credits the beneficiary is eligible for payment from the issuing bank when the applicant fails to perform his/her obligation.
A Letter of Credit is a simple payment mechanism. Rather than a buyer promising to pay seller, a buyer / account party (applicant) has an issuer promise to pay a seller / beneficiary: payment is expected to occur through the issuer. In contrast, the 'standby' letter of credit is merely a
91
backup.
The beneficiary makes proper demand upon the issuer only if the account party
(applicant) fails to pay or perform."
In short, standby credit is a document which: a) The Issuer, usually a bank b) At the request of its customer, applicant c) Agrees that the beneficiary will be paid
92
d) Before the credit's expiry e) Upon the beneficiary's presentment of i. Its demand for payment and ii. Any documents evidencing the applicant's non-performance or default
This gives the applicant an opportunity to specify the documents that are to be presented by the beneficiary for claiming payment. In most of the cases it will be a certificate of default of payment by the importer / applicant on due date.
This is one of the most convenient facilities preferred by the importer client and also the overseas seller. Under this arrangement, importer client can get the consignment directly from the overseas seller. Bank undertakes to pay the overseas seller only in case of default by the importer. Less number of documents is called for in this transaction.
Step 1: Goods are dispatched to the buyer [importer] directly by the seller /exporter,
Step 2: Buyer/importer fails to make the payment on due date to the seller/exporter,
Step 3: On default by the buyer, the seller/exporter presents the prescribed documents for payment to his/her [exporters] bank
Step 4: On receipt of the documents, the exporters Bank scrutinizes the documents thoroughly and if the documents are drawn in order without any discrepancy makes payment to the exporter/beneficiary of the Standby LC.
93
Step 5: Exporters bank dispatches the documents to the Issuing bank.
Step 6: Issuing bank on receipt of documents from the exporters bank, scrutinizes the documents and reimburses the exporters bank. If the documents are in order and other terms and conditions of the Standby LC are complied with.
Step 7: Issuing Bank presents the documents to the Buyer/Importer for collection of payment against the same.
Step 8: Importer makes the payment to the issuing bank
Revolving LC This type of LC allows for the L/C to be automatically reinstated under certain circumstances. It is normally used where shipments of the same goods are made to the same importer.
In a Revolving Credit the amount of drawing is re-instated and made available to the beneficiary again unto the agreed period of time on notification of payment by the applicant or merely on submission of documents. The maximum value and period up to which the Credit can be revolved is specified in the Revolving Credit. The re-instatement clause and the maximum amount of utilization under the credit are incorporated in Revolving credit.
If the importer wants to import a specified material from the overseas seller for a specified period at regular intervals, this type of credits are useful. To illustrate, an importer customer has placed an order for importing certain raw materials from Japan and the contract for import is for one year on monthly basis. Every month importer imports material worth of USD 250,000. His
94
annual consumption is USD 3,000,000.
Overseas seller insists for entering into one-year
contract and also wants the transaction to be covered under letter of credit.
Importers bank establishes a letter of credit for USD 250,000 for a validity period of 12 months. At the same time, it is also specified in the credit that this credit will be available on monthly basis, twelve times during the validity period and the total utilization under this credit should not exceed USD 3,000,000.
Under this arrangement, the importer is able to receive continuous supply of raw materials for the contracted period of one year. Instead of opening documentary credit for each transaction every month, one single credit opened at the commencement of the contract remains valid till one year. Importer saves time for opening documentary credit for 12 times. Every time when
the credit is reinstated, bank charges reinstatement charges instead of Credit opening charges.
Deferred Payment Credits When the importer client wants to import capital goods for a project and overseas seller has agreed for payment under deferred terms such as, 10% advance payment, 80% after 12 months from date of shipment and the remaining 10% after one year of successful commissioning of the equipment, the bank which offers documentary credit facility to their client, establishes a credit undertaking their payment obligation on deferred basis. Payment is not made in one
installment; it is deferred to three stages, in the above example. This product is offered to the clients who have large value of equipment imports.
95
Acceptance Credits Under this product, credit issuing banks liability comes into force only after acceptance of drafts drawn on them. The payment has to be made by the issuing bank on the due date, typically three months ahead. An Acceptance credit stipulates that bill of exchange or draft to be drawn as one of the documents and it is to be drawn on the credit-issuing bank. Credit issuing bank on receipt of the documents at their counters under their credit, examines the documents and if in order accepts the bill of exchange and communicates the due date on which they are to reimburse the sellers bank.
3.4.4
Guarantee
Bank guarantee (BG) is guarantee given by a bank for a business. Thus a bank guarantee implies a promise by the bank to repay the outstanding amount of an individual or a business if that individual/business fails to repay his/her debt. BGs are generally used as collaterals by corporates. When any business wants to enter into a financial transaction with counterparty, the counterparty may insist that a bank guarantee is put in place. Bank guarantees may be issued for domestic as well as foreign business purposes.
This is a document issued by the bank on behalf and at the request of a customer to third party for fulfillment of terms of contract as agreed between them.
96
Sample Bank Guarantee Date Issuing Banks Name & Address Re: (Counterparty's Name) Dear Sir/Madam This letter will serve as your notification that (Bank name) will irrevocably honor and guarantee payment of any check(s) written by (Customer's name) up to the amount of (Amount Guarantee) and drawn on Account Number (Customer's account number). This guarantee is for the purpose ____________________. This guarantee shall remain irrevocable throughout the event, and no stop payment will be issued. Sincerely, ___________________________________________ Bank Officer's Signature and Title
Types of Guarantees Different types of bank guarantees issued by a bank are as follows:
Tender Guarantee This is usually issued for an amount equal to between 1 and 2 percent of the contract value. It gives the beneficiary compensation for additional costs if the party submitting the tender does not take up the contract and it must be awarded to another party.
97
Performance Guarantee Normally issued for an amount equal to between 5 and 10 percent of the contact value, this guarantee assures payment to the beneficiary in the event that the contractor fails to fulfill contract obligations.
Advance Payment Guarantee This enables the beneficiary to get a refund of advance payments made in the event of default by the contractor. It is issued for the full amount of the advance payment, but may contain reduction clauses, which enable a reduction in the maximum amount upon evidence of progressive performance.
Retention Money Guarantee Most major projects call for stage payments as work progresses. Often the beneficiary retains a percentage of the payment (retention money) from the contractor, as cover for any hidden defects in the completed work. A retention money guarantee allows for immediate release of retention money to the contractor.
Facility Guarantee This is normally not trade related. Its purpose is to provide security to another bank to advance money to an individual or company. It is often used when a company does not have any credit record and wishes to expand offshore.
98
Maintenance Guarantee This ensures that the contactor does not abandon the contract after completion of the construction phase, but continues to honor any maintenance obligations as per the original agreement.
Customs Guarantee Contractors often need to import equipment temporarily to carry out a contract. Import duty would normally be payable, but the customs authorities will grant exemption if the contractor undertakes to re-export the equipment on completion of the contract. The contractor then has to provide the customs authority with this guarantee, which prevents the contractor from selling the goods in the domestic country, instead of re-exporting them.
Shipping Guarantee This enables the buyer to obtain release of the goods from the carrier, despite the bill of lading 13 being lost or delayed. When the importer wants to take delivery of the consignment under a bill of lading or any transport documents he has to produce the original transport document to the transport agency.
13
A document which is issued by the transportation carrier to the shipper acknowledging that
they have received the shipment of goods and that they have been placed on board a particular vessel which is bound for a particular destination and states the terms in which these goods received are to be carried. Separate bills of lading are issued for the inland or domestic portion of the transportation and the ocean or air transportation, or a through bill of lading can be obtained covering all modes of transporting goods to their destination.
99
At times the consignment might have landed in his/her country before the documents are received through the banking system. Shipping company will not deliver the consignment
unless the importer consignee produces original transport document. To avoid delay in clearing the goods from the shipping company without producing original transport document which is the original bill of lading importer requests his/her bank to issue a guarantee on his/her behalf in favor of the shipping company. Under this guarantee, the bank indemnifies the shipping
company for any loss that may be incurred by the shipping company in releasing the consignment to the consignee (importer) without submission of original documents.
3.5
Other Non-Fund Based Products/Services
The non-fund fee based services are also known as transaction banking services offered by banks include:
Cash Management Services Trade Finance Treasury Products
3.6
Cash Management Services
Cash is an asset with unique features. On one hand, it is an idle asset as it does not generate any returns if left alone. On the other hand, keeping too little cash may cause liquidity problems for any organization. Banks would like to hold less idle cash for the same reason. However, holding too little cash may result into:
100
Deposit runs by individuals, if they feel that it does not have enough cash for withdrawals.
Liquidity problems and increased borrowing costs.
Similarly, business organizations need to manage the cash properly for the same reasons. Cash in the context of banking does not mean physical cash, it means the cash equivalent which is the checking or the operative accounts of the customers Business organizations have receivables from and payables to various counterparties which are spread out far and wide geographically. Managing outstation collections and payments can be very time consuming and expensive.
Given this, the fundamental goal of cash management is to forecast the cash flow needs accurately and to arrange for the various sources of cash at minimum cost. Banks provide a wide range of cash management services to their customers to put them in a position of control as far as their cash needs are concerned.
Due to the extensive networking and MIS requirements, many banks may not be in a position to offer the cash management services. However, those who offer will definitely enjoy competitive advantage over others. It creates a win-win situation for both the bank as well the customer. Customers are more satisfied as their receivables are collected speedily into their accounts. Banks get access to float funds. Float is defined as the funds in the process of collection. Float arises as there is time gap between the moment a check is written and the moment the funds get credited into customers account. If a bank can monitor the float funds on a continuous basis, these can be deployed profitably by the banks treasury. In the competitive environment
101
in which the banks are operating these days, this additional return can significantly affect the bottom line of the bank.
Banks offer a wide range of cash management services (CMS) to their customers. The cash management services offered by banks can be divided into two set of services. These are: Collection Services Payment Services
As a result of developments in information technology and MIS, banks can provide these services very efficiently. These services help in providing liquidity to the client and at the same time lower the cost of funds to the banks. CMS helps in speeding up the collection process and reducing the collection time for the clients as well as help in making payments across various locations with ease.
3.6.1
Collection Services
One of the important banking activities is that of collection and payment of checks. Corporates route their funds transfer for the purpose of payment for business transactions via banks. This is so because the various parties to a business transaction for a corporate may be spread geographically and need not be in the same location. Through the CMS offering, the buyers of the customer products may deposit their checks payable to the customer at the various branches of the bank across diverse locations. If the bank does not have a branch at any location, it usually has a tie up with other banks which have branches in such locations. These banks are called as Correspondent banks and they help in collecting and realizing the checks from the buyer on behalf of the main bank.
102
The common collection services are: Check Collection Services: This service uses the extensive network of a bank either on a standalone basis or via a tie up with other banks (correspondents) to help corporate collect funds from their outstation cheques.
Overdraft: This facility is provided by banks to their business customers whereby even if adequate funds are not available in the account of the customer, the incoming checks are still cleared by the bank.
Lock-box service: In this service, the bank provides collection boxes at various locations in the city where the checks favoring the customer are collected. The box is operated by the bank and the bank gets the contents of the box removed several times during the day and deposits the checks into customers account.
Tax-collection services: Under this facility banks accept payment of income taxes, sales tax, customs duty, etc. from their customers.
3.6.2
Payment Services
Payment services are a counterpart of collection services. Payment refers to the means by which financial transactions are settled/paid. The common payment services include:
Electronic Funds Transfer (EFT): This service facilitates online transfer of funds between accounts.
103
Electronic Bill Payment and Presentation (EBPP): EBPP enables the customers to pay their bills and send invoices electronically.
Payroll services: Banks provide payroll processing facilities to the small business clients which help in reducing the fixed costs of maintaining a payroll processing department by the business.
Collection as well as payment services require an efficient payment system. An efficient payment system accelerates the flow of liquidity in the economy.
The payment system can be of divided into two types:
Retail Payment System Wholesale Payment System
Retail Payment System - This is used by individuals for paying their bills and receiving funds into their bank accounts.
Retail payment system in the United States makes extensive use of paper checks. About 50 billion checks are processed every year. However, credit card and ATM transactions are also becoming popular.
Wholesale Payment System This is used by businesses and governments for handling large value domestic and international transactions.
104
Clearing of payment instructions/ checks occurs through the check clearing/ ACH clearing mechanism described earlier (already discussed)
3.6.3
Benefits of CMS
1. Faster Realization of receivable: This is the biggest benefit of the availing the CMS facility by customers. 2. Reduction in Interest Costs: The collection services provided by banks result in receipt of funds by the customers into their account with the banks in very short period of time. This means reduced interest costs for the customer. In addition, the banks might provide funds to their customers a little later than they receive funds from the check clearing. This provides banks with zero-interest money, which brings down the average interest cost for the bank.
3. Increased Liquidity: Since funds get collected quickly, it results into enhanced liquidity for the customer.
4. Ease in Reconciliation: Customers can obtain detailed information about the instruments like checks, demand drafts, etc. collected by their bank. This results into ease in reconciliation of their books with the banks books.
5. Better Customer Service: Since CMS offers so many benefits to the customer, it translates into more satisfied customers and hence a larger customer base.
105
3.7
Trade Finance
Global markets have opened up and trade and financial services are moving freely from one country to other and banking services are becoming more responsive to such rapid changes. Inputs and accessories can be sourced from country A, assembling and manufacturing can be done in country B, Seller may be in Country C and the ultimate user or the consignee can be in country D and the financing institution can be in Country E. This has become possible today since borders are not the barriers for movement of goods or finance or manpower country to another country from one
3.7.1
Role of Banks
Banks are offering variety of products under wholesale banking to their clients, starting from assisting their client financially for importing accessories or raw materials from any country and funding their working capital requirements for their manufacturing activities and extending credit against their receivables. Under wholesale banking, banks are also offering risk management
solutions to corporate clients to mitigate credit risk protection against the default of the buyer, political risk cover for the country exposure and currency risk management against the currency exposure.
For example, if a client wants to expand his/her production capacity and enlarge his/her clients list to different countries he may require following financial solutions from the bank:
For expansion of production / manufacturing capacity the client may like to avail loan facilities to import / buy capital equipments and thus to meet modernization expenses. Credit facilities can be of medium or long-term duration and can be either in home currency
106
or in foreign currency. The bankers locally or through their correspondent banks abroad can arrange foreign currency loans at competitive international interest rates. For importing equipments or accessories, a bank can establish letter of credit or standby credit or guarantees or bankers acceptance facility in favor of the overseas suppliers. For working capital expenses to meet any export obligations, banks can sanction export credit facilities either by themselves or through any of the global credit agencies like EXIM Bank. Once manufacturing activities are over and sales start, banks can discount their clients receivables by offering receivable management solutions. Credit risk insurance is offered by insurance agencies to protect the default risk of the buyers. Instead of involving two agencies ,one for allowing credit and another agency
offering insurance for managing credit risk, the bank can offer a wholesale product like factoring or forfeiting whereby bank can allow credit facilities against the receivables and also offer credit protection i.e., insurance against the default of the overseas buyer. Besides, banks can offer buyers credit to the overseas buyers.
Ultimately, the clients are able to reduce the cost of funding by availing the cheapest trade finance from their banks and also able to manage the attendant risks by opting for appropriate risk management instruments.
Over and above the various products offered under Trade Finance Products Import Financing Documentary Collection Letter of credits Bankers Acceptance facility
107
Standby Credits [Discussed earlier in section 3.1] Guarantees
3.7.2
Services related to Import
Documentary Collection This is a product where the bank acts as a conduit between the importer and the seller, by handling the transport and related documents and releasing the documents to the importer on the availability of funds/ promises to pay the funds on a specified date.
The process for documentary collection is graphically represented below:
Step 1: Overseas seller submits the documents to the remitting bank. Step 2: Remitting bank forwards all the documents to the collecting bank. Step 3: Documents are presented to the buyer or the importer of goods. Step 4: Importer makes the payment to the collecting bank when the bank presents the documents. The importer will then receive the documents, which will entitle him to collect
108
his/her imported goods from the transport agency. The transport documents are quasi negotiable instruments. E.g. of Transport documents include Airway Bill (AWB), Bill of Lading (BOL).The importer is not entitled to the goods unless the payment has been made to the bank in case of Document against Payment (DAP) bills. In case of Usance Bill drawn by the exporter the goods will be released on the basis of accepting the bill and not necessarily the payment. Step 5: Collecting bank transfers the payment received from the importer to the remitting bank. Step 6: The Remitting Bank, when it receives the payment from the importer, transfers the amount collected to the overseas seller [who submitted the documents for collection]
Bank, which offers this collection product to its importer client, does not undertake any responsibility for payment. Bank acts as an agent for collection. Importer has an opportunity of verifying the documents and ensures that he makes payment only after the consignment has landed in his/her country. Bank acts as an intermediary and helps the importer to receive documents and the exporter to receive the payment.
Establishing Documentary Credits Establishing letter of credit on behalf of the importer is one of the fee -based businesses a bank undertakes. Under this arrangement, the importers bank undertakes the payment obligation on behalf of the importer to the overseas seller on certain conditions. Conditions are always
related to presentation of prescribed documents. When the overseas seller is not fully aware about the financial status of the importer, importers bank gives undertakes the payment obligation of the import subject to submission of prescribed documents by the overseas seller. This has been covered in the fee-based products offered by the bank
109
Bankers acceptance facility Under import financing, bank approves a line of credit to the importer. Under this arrangement the bank is prepared to accept the bill of exchange drawn by the overseas seller on them on account of their importer. When the overseas seller supplies the materials to the importer, he also agrees for this arrangement by which importers bank pays the overseas seller on the due date.
Shipment Guarantees Under wholesale banking, bank sanctions this shipping guarantee facility to the importer as one of their services. (already discussed above)
3.7.3
Services related to Export
The services offered to exporters are a mix and match of Lending and Non lending activities as mentioned below: To receive the authenticated documentary credit through his/her bank from the overseas buyer Advising of documentary credits. To get the credit confirmed thereby securing a payment undertaking from the confirming bank on behalf of the overseas buyers bank, (i.e., Issuing Bank) - Confirming of documentary credits Arranging to transfer the documentary credit, which was received in favor of his/her subsupplier enabling him to procure the inputs from his/her vendor Handling transferable credits Allowing working capital facilities assisting the exporter with credit facilities enabling the exporter to execute his/her export orders in time - Pre-shipment finance
110
Arranging to collect the payment from the overseas buyer through collection mechanism Documentary Collection
Extending receivable financing against the export documents tendered by the exporter on the overseas buyer Receivable Financing
Extending credit facilities to the overseas buyer Buyers Credits. Extending credit to overseas financial institutions for the purpose of on lending to their clients Line of Credit.
Providing credit protection (credit insurance) in case if the buyer defaults to pay the exporter. International Factoring / Forfaiting.
Lending Process
The process of lending begins even before a loan is made. It is required that the loan
officer/credit manager ensures that the loan is in agreement with the loan policy of the bank. Since it is not feasible by the board to oversee each and every loan proposal that is received by the bank and take a credit decision, usually all banks have a written loan policy. Loan policy sets out standards for exposure limits for industry/company/individuals, credit quality of the borrowers, lending rates, acceptable risk level, etc. The loan policy of a bank comprises of the following components: a. Loan Objectives b. Volume and Mix of Loans c. Loan evaluation procedures d. Loan Sanction e. Loan Administration f. Lending Rates
111
Loan Objectives This will set out the various purposes for which loans can be given by a bank. This will also specify if there are any regulatory guidelines with respect to certain objectives.
Volume and Mix of Loans This will specify the targeted composition of the loan portfolio in terms of industry exposure, region exposure, size of loans, etc. This in turn will depend on factors like size of the bank, credit requirements in the region, and the expertise available with the bank. This also sets out the risk exposure which the bank can take across industries, borrower types, countries etc.
Loan Evaluation Procedures The policy document also specifies the loan evaluation procedure to be followed by the bank. Usually, it sets out the various types of analysis like industry analysis, financial analysis of the company, management appraisal, etc. that should be undertaken while making the credit decision.
Loan Sanction This part of the loan policy document specifies the sanctioning powers of the credit officers i.e. how much amount of loan can be sanctioned by which level of credit manager in the bank.
Loan Administration Loan administration comes into picture once the loan has been sanctioned and continues till the loan is repaid. Loan policy should specify the loan administration procedures like documentation, monitoring, follow-up, etc.
Lending Rates As mentioned earlier, bank, like any other commercial enterprise has the profit motive. To ensure that lending results into profits for the bank, it is required that
112
appropriate rate of interest is charged by the bank for loans of different types. The lending rate should also reflect the risk inherent in the loan. The lending rates are dynamic and the loan policy will provide the process for identifying the right lending rates.
3.7.4
Stages in a lending process
The various stages in the lending process are as follows: Credit Appraisal Sanctioning and Structuring, the Loan Agreement Post-sanction Verification and Disbursal Credit Administration and Monitoring
Credit Appraisal The decision to sanction or reject the proposal has to be based on a careful analysis of various facts and data presented by the borrower concerning him and the proposal as assessed by the relationship manager. Such an objective and in-depth study of the information and data should convince the sanctioning authority that the money lent to the borrower for the desired purpose will be safe and it will be repaid with interest over the desired period, if the assumptions and terms and conditions on which it is sanctioned, are fulfilled. Such an in-depth study is called
the pre-sanction credit appraisal. It helps the approver to sanction the proposal
Credit appraisal focuses on: a. Borrower/Management Appraisal b. Technical Appraisal of the project c. Market Appraisal determining the viability of the project
113
d. Financial Appraisal determining the viability of the cash flows to meet the loan repayment requirements.
Sanctioning and Structuring the Loan Agreement If the credit appraisal is satisfactory and bank decides to grant a loan to the borrower, the loan agreement is structured. Loan agreements usually have the following elements: a. Type of credit facility (fund based/non-fund based) b. Term of the loan c. Method and timing of repayment d. Interest rates and fees to be paid by the borrower e. Collateral14 required f. Covenants which restrict the borrower from certain actions15 during the period of the loan
Post-sanction Verification and Disbursal If the terms and conditions of the loan agreement are acceptable to the borrower, usually a post-sanction verification is done to ensure that the funds will be deployed for the stated purpose only. This may require site visits and discussion with the management of the company. If the post-sanction verification is also positive, the bank issues a disbursal letter which entitles the borrower to take the loan amount from the bank.
14
Some asset like real estate, etc. provided as a security for a loan taken from a financial
institution.
15
For example, the loan agreement may require that the borrower should maintain debt up to a
specified limit.
114
Credit Administration and Monitoring Credit Administration is a critical element in maintaining the safety and soundness of a bank. The role of credit administration commences soon after the sanction of the credit facilities by the sanctioning committee/authority. The extent of the activities, given the wide range of responsibilities, and its organizational structure, may vary with the size and sophistication of the bank and may be specifically defined by each bank. These would normally be independent of the credit origination and approval processes. This will normally include communication of the sanction to the client/ borrower at the unit level, execution of relevant documentation, security creation and perfection, and disbursement and thereafter ensuring on-going compliance of the terms of credit, including keeping a watch over any events which may trigger default.
115
This chapter discusses the financial statements of banks and looks at the two main reports which provide information about the banks activities the Balance Sheet and the Profit and Loss statement.
4 Financial Statements of Banks

Like any other business organization, the two important financial statements of a bank are: Balance Sheet , and Income Statement However, given that banks offer different type of services than other commercial organizations, their financial statements differ from the typical financial statements of other business organizations. Let us understand what these differences are and what do the various items appearing in the financial statements of a bank mean.
4.1
Balance Sheet
Banks balance sheet or Report of Condition lists the assets, liabilities and equity cap ital (owners funds) held by or invested in the bank on any given date. Balance sheet is prepared on a particular date usually the last date of a month or quarter or year. Balance sheet captures the financial data of an institution at one point in time. It is useful to compare data for several accounting periods by which we can assess the trends in the banks financial condition.
116
In a banks balance sheet, Asset side consists of four kinds of assets. They are: a. Cash at vault and deposits held with other depository institutions (C) b. Investments in interest earning government securities (S) c. Loans and lease finances allowed to customers (L) d. Miscellaneous Assets (M)
Likewise, Liability side of a banks balance sheet has the following components: a. Deposits made by various customers (D) b. Borrowings of funds by the bank non-deposit borrowings from money and capital markets (NDB) c. Other liabilities, like acceptances made by the bank on behalf of their customers liabilities (OL) d. Equity Capital representing long-term funds that the owners have contributed to the bank (EC)
Therefore, contents of a banks balance sheet can be written as below: C + S + L + M = D + NDB + OL + EC
In short, the assets in a banks balance sheet are accumulated uses of funds and liabilities are accumulated sources of funds. Assets are made to generate income for their
stockholders, pay interest to the depositors and compensate the employees for their labor and skills. On the other hand, liabilities provide the needed capital and sources for acquiring the assets.
117
Investors, depositors and regulators are concerned about the real position of the bank. The balance sheet of a bank should disclose the required relevant information transparently.
To have more clear view on the key items appearing in a banks balance sheet, please refer the following hypothetical balance sheet of a bank:
Balance sheet of ABC Bank in the USA (Report of Conditions) as on 31st December 2010. (Amount in 000 USD) Assets (accumulated use of funds) Cash and deposits due from bank Cash 10,500 10,500
Investment securities (Liquid portion) Interest bearing bank balances Federal Funds sold 1,500 14,500
Investment securities (Income generating portion) US Treasury and agencies securities Municipal securities Other securities 14,200 14,100 4,500 48,800
Loans Consumer Real Estate Commercial 5,565 46,500 10,560
118
Agriculture Financial Institutions Total Less: Reserve for loan losses Unearned income reserves Miscellaneous Assets (building, equipments etc.) Building and other fixed assets Customers liability on acceptances Other assets Total Assets
38,500 5,600 106,725 2,450 154 104,121
5,450 1,240 3,650 10,340 173,761
Liabilities (accumulated source of funds) Deposits Demand Deposits NOWs (Negotiable Order of Withdrawals accounts) Money Market Deposit accounts Savings Accounts Time deposits Under $100,000 Over $ 100,000 22,230 50,660 135,750 25,620 10,740 20,155 6,345
Non deposit borrowings Fed funds purchased 12,150
119
Other borrowings
5,340
17,490
Other liabilities Bankers acceptance outstanding other liabilities Subordinated notes and debentures 1,240 3,500 2,220 6,960
Equity Capital Stock Surplus Retained Earnings Capital Reserve 8,250 2,120 1,120 2,071 13,561
Total liabilities
173,761
4.1.1
Assets
Cash assets The first asset item listed in the banks balance sheet is cash and deposits due from banks. This includes cash in banks vault, deposit with Federal Reserve (which is often known as primary reserves), any deposits the bank has placed with other correspondent banks (for clearing purposes and also to compensate the other bank for providing currency and coin services) and cash items in the process of collection (mainly uncollected checks). This means that these cash assets are the banks first line of defense against withdrawal of deposits and first source of funds when a customer comes in with an unexpected loan request which the bank
120
has to meet. Generally, banks strive to keep the size of this account as minimum as possible, because idle cash balances earn no interest income or little income for the bank. Bank
management should always attempt to minimize its holdings in these assets. In the above balance sheet, cash holdings are USD10, 500,000 and it is 7.73% of the total deposits.
Investment securities (Liquid Portion) Interest bearing bank balances (USD1, 500, 000), such as short-term certificates of deposits16 at other banks and federal funds sold17 (USD 14,500,000) are highly liquid, earning assets. They are generally used as part of the banks liquidity management program. Most of the smaller banks have more federal funds sold than federal funds purchased18, indicating relatively high liquidity. In the above balance sheet both these items are highly liquid and earn a certain amount of return which will help the bank for enhancing their profitability and also manage their short term liquidity.
Investment securities (Income-Generating Portion) Bonds19, notes20 and other securities held by the bank primarily for their expected rate of return or yield are known as investment securities. Frequently these are divided into taxable securities and tax-exempt securities. Taxable securities are mainly US government bonds and notes,
securities issued by various federal agencies (such as The Federal National Mortgage
16
It is a promissory note issued by a bank entitling the holder to receive back the money deposited with
interest. Withdrawal before the maturity date attracts a penalty.

17
These are the loan of excess reserves held at the Federal Reserve by one bank to another. These typically
are overnight loans although longer-term loans can be made

18 19
These are the borrowings of excess reserves held at the Federal Reserve by one bank from another. A security which entitled the holder to receive periodical interest payment and get back the principal
amount at the time of maturity. The maturity period is typically more than one year.
20
This is similar to a bond with the difference that the maturity period is not more than 3 years.
121
Association, known as Fannie Mae) and corporate bonds and notes.
Tax-exempt securities
consist primarily of state and local government (municipal) bonds. The latter generate interest income that is exempted from federal income taxes.
Loans In most of the banks balance sheets, Loan component generally account for more than 60% of the total assets. Banks Loan folio consists of Consumer Credits, Real Estate loans,
Commercial loans, Agricultural loans and the credit extended by banks to other financial institutions. In Table -1, referred above, USD10, 672, 5000 represents gross loans owed to the bank forming part of 61.4% of the total assets. . However loan losses are deducted from the gross loan figure.
Unearned income (unearned discount) USD 154,000 represents amount of income that has been deducted from a loan but has not yet been recognized as income on the income statement because it is to be distributed over the life of the loan. For example, consider a loan for a period of five years which is payable in five annual installments including interest The interest to be received on the loan will be considered as unearned income at the time the loan is disbursed. Every year when the installment is received the interest so earned will be deducted from the unearned income and the balance will be carried forward.
The amount USD2,450,000 reported as reserve for losses reflects an estimate by the bank management of probable charge-off for uncollectible /unrecoverable loans and leases on the date of balance sheet. Although the regulatory authorities have prescribed the norms in the estimation process, ultimately the bank management decides the final valuation of the reserve
122
account. Actual loan losses are deducted from reserve account and any recovery made from uncollectible loans will be added back to reserve account.
Under the current norms recommended by BASEL committee, any scheduled loan or interest dues not repaid and becomes past due for more than 90 days, is to be classified as F Loans. Once the loan is classified as Non-Performing Loan, the Bank is not allowed to record any further interest from this loan until a cash payment is actually received in.
Other assets Premises, fixed assets, equipments and capitalized leases represent an important though relatively small portion of the assets. Most of the capitalized leases for banks involve sale-andleaseback arrangements in which the bank sells the property and leases21 it back from the buyer. Terms are structured to allow the bank to maintain control over the property. These arrangements are done primarily to generate cash. Capitalized leases are recorded under assets rather than under leases, as if the bank still owns the property.
4.1.2
Liabilities
Deposits Deposits are the principal liability for any bank. It represents the financial claims held by Deposits are the main
households, business houses and governments against the bank.
sources of funds for the bank. In the event of a banks liquidation, depositors are to be paid their claims first from the sale proceeds of assets.
21
Depositors have the first priority in
This is a contractual agreement, which transfers the right to use the asset from the owner
(known as the Lessor) to the user (known as the Lessee) in return for periodical payment (Lease Rental).
123
settlement of claims. Other creditors and stock holders receive their claim from the remaining proceeds of the assets sold.
Deposits are of five major types:
a. Non-interest bearing demand deposits or regular checking accounts:
These
accounts generally permit unlimited check writing. But under Federal law passed in 1933, they cannot pay any explicit interest rate. Many banks offer to pay postage costs and other free services that yield the demand deposit customer an implicit rate of return on these deposits. b. Savings deposits: These deposits generally bear the lowest rate of interest offered to depositors by a bank but may be of any denomination. Banks may impose minimum size requirements and permit the customer to withdraw at their will. c. NOW accounts Negotiable Order of Withdrawal accounts: These can be held only by individuals and non-profit institutions and bear interest and permit checks to be written against each account in order to pay to third parties. d. MMDAs Money Market Deposit Accounts: Under this scheme, bank can offer
competitive interest rate to the depositors depending on their short-term requirements and liquidity position. This scheme offers limited check writing privileges. Minimum maturity and denomination are not prescribed under federal law; however, depository institutions reserve their right to require seven days notice before any withdrawal being made. e. Time deposits: Time deposits can be broken up into: i) deposits under USD 100,000 and ii) deposits above USD 100,000. Time deposits have a fixed maturity date on
which they are payable with a stipulated interest date. A Time Deposit may have any
124
denomination.
Deposits above USD 100,000 are large interest payable negotiable
CDs22, mostly collected from the banks high net worth customers at a competitive interest rate. These categories of deposits are mostly negotiable if issued in a
negotiable form in a well-established secondary market.
Bulks of bank deposits are held by household individuals and business firms. However, governments (local, state and federal) also hold substantial deposit accounts known as public fund deposits. Any time a local school authority sells bonds to construct a new building; proceeds of this sale of bonds will flow into its deposit account with a local bank. Similarly, when US Treasury collects taxes or sells securities to raise funds, the proceeds normally flow initially into public deposits accounts that the Treasury has established with banks across United States.
Looking into balance sheets of most banks, it can be observed that they heavily depend on their deposit folio, which is usually 70-80% of their liabilities. In Table 1 that we analyze, it can be noted that deposits constitute 78.12% of total liabilities.
22
CDs with a minimum face value of $100,000 and which can be sold in the secondary market at
any time before maturity.
125
Borrowing from Non deposit sources While deposits represent the largest portion of banks sources of funds, banks also have freedom to raise funds through miscellaneous liability accounts. This can be by Federal funds purchased and securities sold under agreement to repurchase. Borrowings can also be from
money market and transfer of funds from one institution to other financial institutions is instant through wire transfers.
Finally, other liabilities account serves as a catch-all for miscellaneous amounts owned by the bank such as deferred tax liability and obligation to pay off the investors who are holding bankers acceptances23.
Capital Account Capital account on a banks balance sheet represents the owners share of the business. This is also known as stock holders interest. Any new bank that wants to enter into a banking service starts with a minimum capital and it then borrows funds from the public to meet its operational demands. In the balance sheet under study, we can observe that the equity capital is USD 8.2 mn and it is 4.74 percent of the total assets.
Equity Reserves, Surplus and Capital Reserves are also included with Equity to arrive at the Capital Account in a banks balance sheet. Usually, retained earnings (undivided profits) that represent accumulated net income left over each year after payment of dividend forms the largest part in capital account. .
23
An order by a customer to its bank to make a certain payment at some future date, which is
accepted by the bank.
126
In some of the banks capital account, we can observe subordinated notes and debentures. In the balance sheet under Table 1, it is shown as USD 2.220 mn. These are debt securities with long-term maturities carrying a claim on the banks assets and income that comes after the claims of its depositors (subordinated to). It is a debt instrument floated by the banks and the holders claim on the bank resources has a lower priority vis--vis deposits.
Expansion of Off-Balance Sheet Banks have converted many of their customers services in recent years into fee-generating transactions that are not recorded on their balance sheets. They are known as contingent liabilities. Some of the examples of these off-balance sheet items are:
1. Standby Credit Agreements, in which a bank pledges to guarantee repaying of a customers loan borrowed from a third party. 2. Interest rate swaps, in which a bank promises to exchange interest payments on debt securities with another party. 3. Financial futures and option interest-rate contracts, in which a bank agrees to deliver or to take delivery of securities from another party at a guaranteed price. 4. Loan commitments, in which a bank pledges to lend up to a certain amount of funds until the commitment matures. 5. Foreign exchange rate contracts, in which a bank agrees to deliver or accept delivery of foreign currencies on a future date at a pre determined exchange rate.
Even though these transactions are shown as off-balance-sheet items, often they expose the bank to added risks. For example, the standby credit which guarantees the loan repayment by
127
the banks client will result in a risk exposure for the bank, if the guarantee is invoked due to default of the banks client.
4.2
Income statement (Report of Income)
Income statement of a bank indicates the amount of revenue received and expenses incurred over a specific period of time. The period can be on quarterly or half yearly or annual basis. Since Assets on the balance sheet account for the majority of revenue and liabilities generates banks expenses, Income statement has a close correlation with the balance sheet.
Principal source of banks revenue is dependent on the interest on their loans and securitie s. Other than these two items, rental income on assets and fee based income earned on their other financial services are forming significant portion of the income side of the statement. Likewise, under expenses side, interest paid on their deposits and borrowings is the major source of expenses. Apart from this, expenses include salaries, benefits paid to staff, and maintenance expenses on fixed assets
In short, Net Income = Total revenue items (-) Total expenses items.
Banks can increase their net income by using any of or all the following options: Increase the average yield on each asset Redistribute their earning assets towards those assets with higher average yields Reduce the interest expenses by going for low cost deposits or non-deposits. Shift preference towards less costly deposits and other borrowings Reducing the employees or increasing the efficiency of the staff
128
Reducing the loan losses by having an improved monitoring and efficient appraisal system Improving tax management to reduce tax liabilities
Bank management may not have absolute control on all the above options. Specifically interest payable depends on demand and supply of funds in the market operations. If the bank quotes rate of interest lower than the prevailing market rate, further deposit accretions may suffer.
Income statement of a bank will have the following major items:
Income statement for the period of (Report of Income) Financial Inflows Loan income Security income Income from cash assets Miscellaneous income Financial outflows Deposit costs Non deposit borrowing costs Salaries and wages expenses Miscellaneous expenses Tax expenses
Actual bank income statements usually have more details because each item shown above has different components. For example, loan income includes income from mortgage loans,
consumer loans and other lending activities.
For the purpose of reviewing the details of an income statement, we give below a hypothetical Income statement of a bank.
129
Income Statement of ABC Bank in the USA For the period ending December 2010 Revenue and expenses Amount In million Interest Income Interest and fees on loans Interest on investment securities Taxable securities revenue Tax exempt securities revenue Other Interest Income Total interest income Interest expenses Interest cost on deposits Interest on short-term debts Interest on long-term debts Total interest expenses Net interest income 613 181 150 944 789 1,080 376 240 37 -1,733
Provisions for loan possible losses Net interest income after provision for loan losses
355
434
Non interest income Service charges on customers 49
130
accounts Trust department income Other operating income Total non-interest income 26 99 174
Non interest expenses Wages and salaries and other 230
personal expenses Non occupancy and equipment 44
expenses Other operating expenses Total non-interest expenses Net non interest income 35 309 (135)
Income or loss before taxation Provision for income tax Net income or loss after taxes Average number of common shares of stock outstanding (actual) Income / loss per share of common stock (actual
299 49 250
50,000,000 $5
131
4.2.1
Interest Income
Interest Income generated by a bank accounts for most of the banks revenue. In the above statement we can observe that around 70 percent of the interest income is earned from loans. Interest income on investments follows the loan revenue. The relative importance of these different items fluctuates from year to year depending on the shift in interest rates, demand for loans. When the interest income is compared with non-interest revenue sources (fee based income) it is changing rapidly since fee based business is growing faster.
4.2.2
Interest expenses
Above table shows that total interest expenses is almost 74 percent of the total expenses. If the bank is not in a position to manage their liquidity position efficiently, they have to raise shortterm loans from the market at the market rates which may be costlier at times. expenses for borrowing depends on the demand and supply in the money market also. Interest
4.2.3
Net Interest Income
Most of the banks arrive at the net interest income by deducting interest expenses from interest income. This is also known as net interest margin (NIM). It totally depends on the cost of funds and the interest received on the loans. profitability. It is one of the key indicators of a banks
When the interest margin falls, bank stockholders will usually experience a
weakening in the banks bottom line and perhaps on the dividends they receive on each share they hold.
132
4.2.4
Loan-loss expenses
In case of loans that are not recoverable, bank has to make a provision from their current income. It is known as provision for possible loan losses. It is a non-cash expense, created in the books of accounts to reduce the current income to the extent of the expected loss on bad loans. When any bad loans that were previously written off is recovered, the recoveries reduce the outstanding in the loan-loss account.
4.2.5
Non-interest income
Income earned from sources other than loans and securities are called non interest income. Fees earned from offering trust services, service charges recovered on deposit accounts are classified under this group. Recently when the banks are expanding their services in selling insurance, issuing guarantees and standby credits, arranging syndicated loans their non-interest income is increasing sharply. Since interest margins are under pressure, banks are presently concentrating on these services to increase their non-interest income.
4.2.6
Net income
Net income is arrived at by deducting interest expenses and non-interest expenses from interest income and non-interest income. This will be the income earned before taxation. Federal and State incomes taxes are applied to this income figure to arrive at the banks net after tax income or loss.
4.2.7
Appropriation of profit
The net income after taxes is usually divided into two categories by the board of directors. Some of the funds may be distributed to the stockholders in the form of cash dividends and the other portion will be transferred to retained profit in order to broaden the banks capital base.
133
4.3
Financial Reporting
The formats and time periods for reporting of the Balance sheet and profit and loss statements are defined by the Central bank under whose jurisdiction the Bank is operating. In addition to the regulatory reporting, if the Bank is a joint stock company, it also has to adhere to the reporting standards as defined by the entity under which it is listed. For e.g. If a Bank is listed in NASDAQ or NYSE , the financial reporting has to happen as per the format defined by SEC and as per the accounting standard of US ,even if the Bank is operating outside US. Hence the Bank will have a financial report as per the US GAAP (Generally Accepted Accounting Principles). For balance sheet and income statement, one of the important financial reporting standards that has evolved over time relates to segment-wise reporting. In the absence of segment wise reporting, the financial results can be misleading. Many a times Treasury Income overshadows the commercial banking income and does not depict a true picture of each line of business performance Over a period of time, each country has come out with its own GAAP, leading to duplication of financial reporting and reconciliation. All GAAPs are now converging into what is known as the IFRS (International Financial Reporting Standard.) Following are the formats in which US Banks have to report their financial statements to the Federal Reserve: FR2644 effective 1st July 2009 weekly statement of Assets and Liabilities FR Y 6 Annual Report of Holding Companies FR Y 9 C Consolidated Financial Statements for Bank Holding Companies.
134

BN101 Foundation Course in Banking I

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BN101 Foundation Course in Banking I

Uploaded by

Copyright:

Available Formats

FDN-BN101 Foundation Course in Banking I

Foundation Course in Banking I

1 1.1 1.2 1.3 1.4 1.5 1.6

2.3.1 Certificate of Deposits_________________________________________________ 33 2.4 Retirement accounts _____________________________________________ 34

Foundation Course in Banking I

2.5 2.6 2.7

Insurance on Deposits ____________________________________________ 34 Withholding Tax _________________________________________________ 35 Retail Payments _________________________________________________ 36

2.8.1 Products in Wealth Management _______________________________________ 54 2.9 Card System____________________________________________________ 56

Foundation Course in Banking I

Commercial Banking ________________________________________________ 68 Fund Based facilities _____________________________________________ 69

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Short-term unsecured promissory notes acknowledging a loan/obligation of one party against

Foundation Course in Banking I

governments in US began chartering banking companies.

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Services Offered by Banks

Foundation Course in Banking I

The same will be dealt in detail in subsequent sections

Foundation Course in Banking I

Foundation Course in Banking I

Trends in Banking Services

Classification of Banking Systems

Foundation Course in Banking I

Banking can be broadly classified as:

Central Banking System

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Central Bank Structure in US

Foundation Course in Banking I

Bank of International Settlements

Foundation Course in Banking I

Commercial Banking System

Commercial Banking System

Foundation Course in Banking I

Foundation Course in Banking I

Leads to uniform structure of interest rates

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Leasing Lending Guarantees Bills of Exchange

Foundation Course in Banking I

2 Introduction to Retail Banking

Foundation Course in Banking I

Types of Deposit Accounts

Foundation Course in Banking I

To sum up, savings deposits have following characteristics:

Foundation Course in Banking I

Money Market Account

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Foundation Course in Banking I

Transactions in checking accounts

2.3.1 Certificate of Deposits_____ 33 2.4 Retirement accounts _ 34

Insurance on Deposits ____________________ 34 Withholding Tax _ 35 Retail Payments _________________________ 36

2.8.1 Products in Wealth Management _ 54 2.9 Card System______________ 56

Commercial Banking ____ 68 Fund Based facilities _ 69