Professional Documents
Culture Documents
CERTIFICATE
IN
BANKING
FOREWORD
Indias abundant, high quality and cost effective services and its vast resource of
skilled software human resources have made it one of the global software
powerhouses. There has been a healthy growth in the number of Indias IT
professionals over the last decade. Many of the leading IT companies have taken
initiatives to train their technically skilled knowledge-workers with the right mix of
business and functional skills to gain competitive advantage in the international
market.
It is against this backdrop that IIBF has decided to offer a Certificate Course in
Banking to facilitate IT professionals to acquire a sound understanding of
relevant theoretical and practical concepts of banking and to enable them to
apply these principles in real life situations.
The Courseware for the subject is designed and developed with the help of
experts drawn from banking industry and practicing banking professionals and
the Institute acknowledges with gratitude the valuable services rendered by
them.
We are sure students of information technology would welcome this book. This
book may be useful to regular students of the subject as well, who are yet to
enter banking field.
Mumbai [R.Bhaskaran]
Chief Executive Officer
Page 2 of 157
CONTEN TS
II. DEPOSITS 36 55
III. LENDING 56 75
APPENDIX
Page 3 of 157
CHAPTER 1
1. OVERVIEW - FINANCIAL SYSTEM:
Financial system can be defined as the structure which manages the flow of
funds within national and/or supranational levels. It consists of institutions like
Banks, Financial Institutions, Non-Banking Financial Companies (NBFCs),
Insurance Companies, Mutual Funds, Stock Brokers, etc. World financial system
and national financial systems are complementary to each other. For
understanding what a financial system stands for, a typical national financial
system is diagrammatically illustrated hereunder (Figure 1).
It may be added here that the primary and a major component of financial system
is payments and settlements.
National Economy
Banking
systems
Prime
function
Fig.1 payment and settlement of all transactions in national economy forms a subset of financial system
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Government sector, private sector, and house hold sector hold surplus in their
hand and this comprises the national savings. National savings are held in
physical and financial assets. National savings comprises of Government sector
savings, household savings and private sector savings and is the most important
component of the financial system.
National Savings
Physical savings
Land, housing, Financial
Ornaments, savings
Paintings,
Carpets and
valuable physical
items
Fig.2 Financial savings are the largest component of financial system. For the purpose of Financial System, physical
savings are excluded.
The financial system constituents sub-serve the financial savings and payment
and settlement system in the national economy.
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Financial system comprises money markets (money market is by nature a short-
term market) and capital markets. While Money markets deal with financial
instruments with maturity of less than a year, Capital markets deal with
instruments where the maturity exceeds a year. The constituents of the financial
system broadly sub-serve these two segments. Under-noted diagram explains
these inter-linkages.
Fig 3. Short term money markets are domain of banks. Capital markets are domain
of investment banking. Central Banking Authority controls banking while Capital
Market Regulator controls Investment Bankers. Insurance Markets are in the
domain of Insurance Regulatory Authority. In U.K., FSA (Financial Services
Authority) covers all three domains.
Pension Regulatory Authority supervises all private sector pension funds which
are allowed to sell pension plans to individuals.
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To simplify, the overall financial system can be presented diagrammatically as
shown in figure:
Financial System - a Schematic Presentation
PENSIONS
1. Framing rules for
pension funds
2. Regulating all
pension funds
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Roles and Functions in Brief
Among the major Central Banks, Bank of England looks after only
monetary planning and control. The Bank Supervisory function has been
entrusted to Financial Services Authority (FSA) the super-regulator for
financial system. This came into force after the failure of Barings Bank(*).
All the other major central banks look after both functions and have the
responsibility of ensuring that the over all financial health of banks is not
impaired. This is ensured through off-site and on-site surveillance of
banks. Central Banks now classify banks in three broad categories, i.e.,
Central Banks do act as lenders of last resort to banking system, and are
responsible for ensuring an efficient payment and settlement system (refer
1.1.7., 1.1.8, 1.1.9 & 1.1.10 for other functions of Central Bank)
(*) The collapse of Britains Barings Bank in February 1995 is a classic tale of
financial risk management gone wrong. An individual trader, over the course of a
few days, brought a bank to bankruptcy, by virtue of having control over both
trading as well as risk management functions.
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1.1.2. Non-Banking Financial Companies (NBFCs)
All companies allowed to raise monies as deposits from public and lend
monies through various instruments including leasing, hire-purchase and
bill discounting etc., whose Articles of Association do not specifically
mention their core business in manufacturing, trading or service industry
come under this category of NBFCs. NBFCs cannot accept
current/savings deposits nor allow funds to be withdrawn by cheques.
Thus, they are Financial Institutions who are specifically restricted from
carrying on banking functions. NBFCs are licensed and supervised by
the Central Banking Authority and are subject to both off-site and on-site
inspections. Central Bank prescribes CRR and SLR for them and fixes
lower and upper limits for interest rates payable and chargeable by them.
No NBFC can operate without having a valid license from Central Banking
Authority.
PDs are dealers in government securities and deal both in primary and
secondary markets. Their basic responsibility is to provide two-way quotes
and act as market makers for government securities and strengthen the
government securities market.
FIs are development financial institutions which provide long term funds
for industry and agriculture. these institutions come under off-site and on-
site surveillance of Central Banking Authority. FIs raise their resources
through long-term bonds from financial system and borrowings from
international financial institutions like International Finance Corporation
(IFC), Asian Development Bank (ADB) and International Development
Association (IDA), International Bank for Reconstruction and Development
(IBRD), etc.
In India, there is a duality of control over these banks and this has resulted
in lax control over the working of these banks. Co-operative banks are
classified as short-term (agriculture) Co-operative Banks and Urban Co-
operative Banks. Urban Co-operative Banks are controlled by State
Governments and RBI, while short-term Co-operative Banks are controlled
by NABARD (National Bank for Agriculture and Rural Development) and
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State Governments. Previously, these banks had certain concessions/
exemptions in paying higher interest on deposits. But now a days, the
interest rates are deregulated. The regulatory framework for Urban Co-
operative Banks is almost similar to that of commercial banks. The short-
term co-operative structure enjoys certain concessions in capital
adequacy norms.
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1.1.10 C.R.R. / S.L.R.
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1.1.13 Brokers
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these activities have brought in technological advancements and foreign
funds in equity and debt market.
1.1.17 Custodians
1.1.18 Depositories
Mutual funds are intermediaries, who sell units to their fund subscribers.
The money received from the investors in the fund is deployed in buying
and selling securities listed in the prospectus to the scheme. Mutual funds
are formed as Asset Management Companies (AMCs). Each AMC can
launch one or more Mutual funds. Each Mutual fund will decide its rules of
operation (which securities will the mutual fund buy, what is the minimum
investment required by a potential investor in the fund, what will be the
transaction charges for investors who invest in the fund, etc.) and will seek
Regulators approval before approaching the public for subscriptions. The
mutual fund schemes are quoted on stock exchanges. One can buy and
sell through stock exchange. In many schemes, the fund itself buys and
sells its units every day on the quoted price. This provides much needed
liquidity to unit holders. Mutual funds have started the process of
disintermediation and they have competed reasonably well with banks in
weaning away deposits towards units of mutual funds.
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1.1.21 Registrars
Maintain register of share and debenture holders and process share, and
debenture allocation, when issues are subscribed. Registrars need
Regulators approval to do business.
IRDA (in India) is the Regulator for insurance business, both general and
life assurance. IRDA regulates all aspects of insurance business, including
licensing insurance companies, making regulations about conduct of
business supervising all insurance business in the country, etc.
Regulatory authority for private sector pension funds. It has licensing and
regulatory powers.
A bank can accept deposits from the public (customers or members of the
society). Such deposits of the customers can be withdrawn by cheque or
otherwise (withdrawal slip, letter and voucher) on demand, or repayable on
maturity to the customers.
The bank lends or invests the funds collected from its customers, subject
to its obligation to repay the deposits to the customers on demand or
otherwise as per the terms of the deposits. Acceptance of deposits and
lending the same are thus core functions of a bank. The above process is
known as intermediation.
Intermediation
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manage such risks. Thus banks mediate between the depositors (savers
of money) and borrowers (users of money) and earn interest spread as a
reward for risk taking and also for meeting administrative expenses and
making provision for some portions of loans that turn bad or difficult to
recover (termed as non-performing assets or NPAs). The term dis-
intermediation means the reversal of the intermediation process involved
in banking. An investment by a person in certain stocks of a company is a
direct exposure or risk taking by the investor in the particular company. In
this example of dis-intermediation, the investor may or may not get back
the capital invested in the company when he wants, as he has assumed
the risk involved in direct investment. However, in the case of deposits
with a bank, the depositor is assured of repayment of the amount of
deposit (capital with or without interest) on demand or maturity date, as
the depositor has not assumed any risk, whereas the bank, as
intermediary, has assumed the risk of lending the depositors money.
Banking Institutions
The traditional banking functions are the core functions which have been
performed by almost every bank in various countries for several decades.
These include deposit-taking, lending and remittance of funds. Modern
banking functions comprise, core banking functions, cross-border banking
and merchant banking, etc., which constitute a near-full range of banking
services in a broader sense. These specialized services have come up
during the last couple of decades to meet emerging needs of the
businesses in developed countries and later in developing countries.
These full range of banking services are offered by large banking groups
through their commercial banking branches and specialized outfits or
subsidiaries for international banking, leasing, factoring etc.
Deposit-taking
A bank accepts money from its customers (members of the public) who
may keep funds in non-interest bearing accounts (current accounts) or
interest-bearing accounts (savings, fixed deposits, recurring deposits) as
per their choice exercised at the time of opening the accounts. Deposits
constitute the largest portion of a banks funds (liabilities), along with its
own capital. Deposits may be repayable on demand (like current and
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savings accounts) or on specified maturity dates (fixed and recurring
deposits). Primarily, deposits are made for earning interest. Over and
above these, several advantages accrue to the customers by maintaining
deposit accounts with banks, e.g., safety, liquidity, transactions record and
statement of account, cheque book facility.
Lending
Funds Remittance
Banks have branch network spread in various cities/ regions/ states in the
country of their incorporation/ operations. Some banks have branches and
correspondent banks overseas as well. Banks remit funds of their
customers from one place to another in the same country or overseas
through their branches and correspondent banks by mail/
telegraphic/electronic funds transfer or by issuing bank drafts. Banks
charge commission or fee to the remitting person. Banks remittance of
funds is fast, safe, secure and cheap as compared to other modes like
post office money order, physical transfer of money, etc.
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Miscellaneous Services
In addition to the above mentioned core functions, banks also render other
services which are useful to businesses and members of the society. They
charge commission or fee on such services, which provides them with
non-interest income and augments their profits. These miscellaneous
services include safe deposit lockers, safe custody of valuables; issuance
of travellers cheques, letters of credit and guarantees; collection of out-
station cheques/ bills/ hundies; furnishing opinion reports on their
customers; Agency services for government business, correspondents;
trusteeship and executors business.
Modern banking services have evolved especially during the last, say,
three decades in USA / UK/ other developed economies and during the
last one decade in India, by the continuous up-gradation, expansion and
diversification of core banking functions, coupled with innovations of new
products/ processes for meeting emerging and new financial needs of
people and businesses. The modern banking services comprise the
traditional banking services plus new services that make an expanded
range of banking services. Furthermore, in present times, banking forms
an important segment of services sector in a countrys economy and it
would be preferable to refer banking functions as banking services in
tune with the focus on service quality. Modern banking is characterized by
certain features which may be briefly mentioned as follows:
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Universal Banking
Principles of Banking
Introduction
Some important principles that emanate from the core functions of banks
are explained below.
Liquidity Principle
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Profitability principle
The profitability principle underlines the fact that, the banking business,
like any other business, has to be profitable in order to sustain the
required growth of its business. It must also maintain sufficient liquidity
and sound financial health (solvency) to inspire public confidence as
banking business is essentially based on trust of the customers and
public. A banks profit mainly arises from the interest income which
represents the interest differential, i.e., interest spread between its
loans/investments and deposit rates. The interest earned by a bank on its
lending operations is higher than interest paid by it on its deposit
operations. Interest spread and volume of its deposits and loans
determine its total net interest income. Interest income, along with non-
interest or fee-based income (e.g. commission on letters of credit, funds
remittance; exchange on bank drafts, foreign exchange business) mainly
contributes to a banks profits.
Solvency principle
The Principle of Solvency ensures that after paying all creditors, some
balance does remain for shareholders. (This principle is closely interlinked
with pillar of capital adequacy recommended by Basel Committee for all
banks). A properly capitalized bank would always remain solvent. It
ensures that all depositors, i.e., creditors of the bank would be paid off
without any difficulty and in full, in case a bank goes into liquidation.
In United States of America (USA), the term banking was defined in one
of the earliest Acts of the Congress as follows (vide Tannans Banking
Law and Practice, 20th Edition (2002), Ch. VII, page 210):
Banks collect deposits from public by way of demand deposits and term
deposits and use these funds and their own for making loans and
advances for business and trade. Banks pay interest only on term
deposits and follow the directions issued by the regulatory authorities
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Comptroller of the Currency, Federal Reserve, and State Banking
Commissioners.
United Kingdom
Thus, a money lender who lends his own capital to others and charges
interest in course of the lending business would not qualify to be a banker
as per the British banking law, as he is not taking deposits from the public
and as also not issuing/ paying/ collecting cheques of his customers in the
course of his business.
India
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As per the above definition of banking, following are its essential or core
functions:
Structure of Banking
Introduction
Banking in its initial years evolved as family owned business but presently
all banks are either joint stock companies or statutory corporations created
by sovereign authority. Except a few statutorily created banks, joint stock
banks shares are listed on stock exchanges and are widely traded, and
ownership of banks is subject to anti trust laws in various countries. Today
banks, internationally are widely held entities and are required to maintain
high standards of corporate governance by Capital Market Regulators,
National Banking Regulators and the Basel Committee. The balance sheet
of largest banking group in the world, viz., Citi group is a trillion dollar
balance sheet, while that of small unit banks governed by state regulations
in the same country run only in hundred million dollars.
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This classification sub-serves Regulators purpose of differentiated
supervisory control on banks to ensure systemic integrity of banking
internationally.
U.S.A. has three Banking Regulators, the Federal Reserve Bank, the
State Banking Authority, and the Federal Deposit Insurance Corporation
(FDIC) in case the bank is insured. There are no banks having thousands
of branches like U.K. or India. Banks have to get state banking licence
both for setting up a bank and for opening branches. Most of the banks in
U.S.A., (reportedly more than 13,600) are unitary banks catering to niche
markets and do not have national or international ambition. Federal
Reserve Board has reportedly identified only 5-6 internationally active
banks, Citi, JP Morgan Chase, Bank of America being prominent amongst
them. There have been a slew of mergers amongst top banks thereby
creating a structure having very large international banks, a few state wise
active banks and very large number of unit banks.
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International Banking
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Running a multicurrency payment and settlement system for its
customers in diverse time zones and currency areas. Operations, risks,
and activities of an International bank are illustrated in figure 5 below.
NOSTRO
ACCOUNTS
(ACCOUNTIG,
EXPORT BILLS RECONCILIATI
ON,
PROCEEDS LIQUIDITY
RISKS)
IMPORT BILLS
PAYMENTS
ADVANCES
L/C, NON L/C LOANS
BILLS
GUARANTEE REMITTANCES
BID BOND FII
DEFERRED PAYMENT
GUARANTEE NRI
(CREDIT RISK)
VOSTRO IBRD
ACCOUNTS USAID
(COVER RISK) DFID
RUPEE DRAFT IMF
RUPEE BILLS JBIC
(COVER FOREIGN GOVT.
RISK) MARGIN RISK
Forwards, EARNING RISK
Forward rate agreements,
Interest rate swaps ,
Currency Swaps
Options
Futures
Page 24 of 157
Retail Banking
Serving very large number of customers both for raising deposits and
giving loans. A typical retail bank has a large number of savings and
term deposit accounts and concentrates on building up large portfolio
of automobile, residential mortgages, personal loans, consumer
finance, and credit card portfolio.
They have large to very large distribution channels, comprising brick
and mortar branches, ATMS, cash dispensers, internet banking,
telephone including mobile banking, and call centres.
Large volumes with individual transactions of low value imply high cost
per transaction. This is corrected by large scale use of IT to create
processing capability for very large volumes of transactions thereby
pushing down cost per transaction.
Back office is invariably set up at low cost centres to reduce cost, and
centralize all operations to enable customers to operate on their
accounts from anywhere and unfetter them from dealing with a specific
branch.
Centralized factories are set up to do cheque processing and clearing,
cheque book issue, statements issue, bank draft and bankers cheque
issue, forex sale and purchase to retail customers, documentation and
maintenance of records.
Customer acquisition and servicing is outsourced, both for deposits
and advances. While some regulators require that deposit activity is
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not outsourced, in most of countries regulators do permit outsourcing
of both activities.
Basic strategy is to minimise customers interface with banks regular
staff, and provide a technological interface including call office
interaction to do majority of customer transactions. Large retail banks
even automate activities like KYC (Know Your Customer), where staff
interaction with customer is desirable, through expert systems to avoid
human interaction to reduce cost.
Credit decisions are done through technology, by introducing credit
scoring models, thereby enabling large volumes of small credit
proposals being processed by IT systems in minimal time and at highly
reduced cost.
Account opening decisions for deposits including anti money
laundering checks and suspicious transactions reporting is handled
through middle and back offices on a centralized basis. The branches
as such are converted into pure marketing front offices.
High usage of technology diversified large number of customers each
one of them being fine-grained, reduces volatility of earnings, and
provides large margins. Retail banking provides stable resources and
low volatility on assets side.
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Activities of a typical retail banking institution are shown hereunder:
Resource- Resource
Mobilization Large volume deployment (domestic
(domestic currency) currency)
low size Personal loans
Chequing
business automobile
and financing
savings residential
accounts mortgage
Term finance
moneys credit card both
Various
own and
others, charge
savings slip purchases
schemes SME financing
Current Micro credit
deposits through NGOs
facilities Bill discounting
Float
including
receivables of
funds
SMEs
through
remittance
-s and
collections
Retail banking
high volume
low size
accounts
Back office
ATM switch
Internet site
Bank database
Wide Area Distribution
Network
WAN channels
Telephone line Brick and
Satellite based mortar
Mobile telph- branches
Ony based ATMs and cash
Linking all dispensers
Distribution Point of sales
Channels to (POS)
Central Internet
computer system. All transactions being Banking
captured on line. Phone banking
Customer becomes customer of entire and mobile Call centre attached to
bank and is not fettered to a branch. He or banking
She can do any transaction at any POS
back office and attending
Agents
ATM or branch and can settle all marketing loans all customers 24hrs/7 days
transactions through Internet banking. and deposits
Figure 6. Retail bank illustrative activities, depending upon IT capabilities variations can
be there
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WHOLESALE BANKING
Introduction
On asset side, whole-sale banks discount short term, large value buyers
and sellers credit bills in oil market. They arrange for large project finance
in conjunction with international financial institutions, arrange for large
value cross border leasing and loans for civilian aircraft. They also go in
for large ticket loans to large corporations over the medium term, the
amounts run anywhere from US $ 100 mio to $ 500 mio, over say, five
years. These banks do large value but small volume business, though the
margins are small, large volumes provide very large gross incomes. The
whole-sale banks are very selective in clientele selection. They refuse to
deal with even nationally recognized banks in case the deal size is small
or they find that the other bank cannot sustain commitments made over
the years.
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Hybrid model
Activities
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SOURCES OF FUNDS USES OF FUNDS
(LIABILITIES) (ASSETS)
Forex
IT based
front,
Wholesale derivatives,
treasury,
middle,
back
Banking ALCO,sett-
lement
office,MIS,
DSS
Structure
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President
middle-
east &
Africa
Country President
manager Canadian
U.S. subsidiary
operations Home
office &
regulato
r London
President President
Japan, Far- European
East, & subsidiary
Oceania Frankfurt
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The compliance being a host regulators concern cannot as such be
centralized.
IT function has to sub-serve local regulators concern.
In number of regulatory regimes especially in North America and
European community, I.T. systems have to be approved by regulators.
For this reason, centralization is not possible.
Control
Centralisation
For its foreign branches, the bank can centralize various functions at
CEOs level, subject to host regulators requirements being met. The bank
can centralize treasury, ALM, product development, marketing, sales, risk,
credit, inspection and audit, HRD & Corporate communications.
In USA, special statutes like PATRIOT Act (2001), Bank Secrecy Act,
Sarbenes-Oxley Act (2002), Foreign Assets Control Act, stipulate that
suspicious activity reporting have to be complied with and banks are
statutorily required to ensure that all reporting is done through
seamless IT systems without any manual intervention. It functions
especially for US operations have to be under the direct control, of
country manager US. This is an essential regulatory requirement and
cannot be centralized in home office.
Risk management systems have to be calibrated to local regulatory
concerns. In North America the product development itself is subject to
risk calibration unlike regulatory regimes elsewhere. Introduction of any
new product has to be weighed with reference to risk being taken and
precise work stages are prescribed by regulator for new product
introduction. Home office products cannot be suo-moto introduced in
US offices.
Property laws especially in regard to leasing of properties vary widely
among various countries. Hiring of property as such can not be
centralized and has to be done at foreign office level.
As Internal revenue, and social security regulations vary from country
to country pay roll can not be centralized.
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The prime item for centralization is the general ledger, day to day
balance-sheet and profit and/or loss. It is a good international practice
to centralize these basic requirements.
1.12.1 Two major trends are discernible over last decade. U.S. regulators gave a
go- bye to Glass-Steagal Act by default permitting U.S. banks, and largest
international banks are U.S. owned, to do commercial banking and
investment banking simultaneously. This gave acceleration to proprietary
trading and brought in sharp focus treasury operations. The second trend
has been disintermediation in international markets from commercial
banks to capital markets. Savers have started investing directly in capital
markets through mutual funds. Increase in strength of mutual funds and
capital markets has seriously threatened income streams of banks and
have brought in its wake, need to innovate, cut costs, and find new
businesses to generate new income streams.
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1.12.4 Basel Committee has requested all regulators to ensure that all
international banks and major national banks must ensure compliance
with the requirements laid down by Accord known as BASEL-II latest by
March 2006. This requires attention to credit risk, market risk, operational
risk, supervisory control and market discipline by way of transparency in
annual accounts and periodical publication of reviewed accounts.
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CHAPTER 2
2. DEPOSITS
INTRODUCTION
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DEPOSITS FROM DEPOSITORS PERSPECTIVE
Depositors keep their savings and salary/business funds with one or more
commercial banks because of a mix of advantages, as compared to other
avenues for deposits, e.g., non-banking finance companies, co-operative
banks, post offices, investment in shares/ debentures. Main advantages to
the customers by keeping deposits with commercial banks are as follows:
LEGAL PERSPECTIVE
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European Union (EU) DEFINITION OF DEPOSITS
Any credit balance which results from funds left in an account or from
temporary situations deriving from normal banking transactions and which
a credit institution must repay under the legal and contractual conditions
applicable, and any debt evidenced by a certificate issued by a credit
institution. Shares in United Kingdom and Irish building societies, apart
from those of a capital nature, shall be treated as deposits. It is obvious
that EU definition of deposits extends much beyond debtor creditor
relationship, and covers even funds left with a bank during temporary
situations deriving from normal banking transactions.
Single Accounts
These are deposit accounts owned by one person and titled in that
persons name only. This account category does not include deposits held
in individual retirement accounts because they are protected in a separate
category.
A customers all single accounts at the same insured bank are added
together and the total is insured up to $100,000. If a customer have a
checking account and a CD at the same insured bank and both accounts
are in clients name only, the two accounts are added together and the
total is insured up to $100,000.
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All of clients self-directed retirement accounts at the same insured bank
are added together and the total is insured up to $100,000. Naming
beneficiaries on a self-directed retirement account does not increase
insurance coverage.
Joint Accounts
These are deposit accounts owned by two or more people who have equal
rights to withdraw money from the account. Each persons share of each
joint account, with the same or different co-owners at the same insured
bank, is added together and the total is insured up to $100,000. If
customers have joint checking and savings accounts at the same insured
bank, customers portions of the two accounts are added together and
insured up to $100,000.
Example:
Living trusts also known as family trusts are formal revocable trusts
created for estate planning purposes. The owner controls the funds in the
trust during his or her lifetime. Upon the owners death, the trust generally
becomes irrevocable.
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If certain conditions are met, revocable trust accounts are insured up to
$100,000 per owner for each qualifying beneficiary.
The account title for a revocable trust account must include a term, such
as, payable on death, in trust for, living trust, family trust, or similar
language or an acronym (such as POD or ITF) to indicate the existence
of a trust relationship. In addition, for POD accounts, the beneficiaries
must be identified by name in the banks account records.
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These may be held in
under-noted ways
Single account
Self directed
retirement plans,
Joint accounts,
Revocable trust
accounts.
Commercial banks are the creators of the Money Supply through demand
deposits, time deposits, and credit creation capability through credit
multiplier. Each time a credit is given it gives rise to countervailing deposit,
which in turn is used to create credit; in sum deposits and credit grow like
a spiral and one of the major jobs of the Central Banking authority is to
ensure that this deposit and credit creating ability of banks does not go out
of control to hurt the national economy.
DEPOSIT PRODUCTS
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There are different variants in respect of maximum number of checks that
may be written per month.
Certificate of Deposits:
These are fixed deposit accounts. These are issued for a fixed face value
and zero coupon rates. As such, the initial investment is a discounted
future value at agreed percentage of return. These are, unlike other
deposits, transferable and negotiable.
Almost all banks have different minimum average deposit stipulations for
business accounts. Also, depending on the business size(s) and
requirements, most banks have different business checking account
products. No interest is paid on a business checking account.
India
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(iii) Hybrid deposits or flexi deposits combine features of demand and
term deposits. These deposits are introduced in recent times by
some banks to meet customers financial needs and convenience
and are known by different names in different banks.
Current accounts
As the name indicates, Savings bank accounts are intended for keeping
savings of individuals and small businesses for meeting their future money
needs. Interest is given by banks on these accounts with a view to
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encourage saving habit in the community. Savings accounts can be
opened by individuals, guardians (on behalf of their minor children/
wards), Karta of Hindu Undivided Family (HUF), clubs, associations,
trusts, small businesses, etc.
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Most banks provide to every savings bank account holder a pass book
wherein date-wise debit/credit transactions and credit balances are
shown as per the customers ledger account maintained by the bank.
Term Deposits
Fixed deposits are repayable on the fixed maturity date along with the
principal and agreed interest rate for the period and no operations are
allowed to the customer against the deposit, as is permitted in demand
deposits. The depositor foregoes liquidity on the deposit and the bank can
freely deploy such funds for loans/ advances and earn interest. In view of
this, banks pay higher interest rates on fixed deposits as compared to
savings bank deposits where withdrawals are permitted on demand by the
depositors, requiring banks to keep some portion of deposits always at the
disposal of the depositors. Another reason for banks paying higher rates
of interest on fixed deposits is that administrative cost in the maintenance
of these accounts is small, compared to savings bank accounts where
several transactions take place in cash, transfer or clearing and
administrative cost is higher.
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On maturity of a deposit, the principal and interest can be renewed for
another term at the prevailing new interest rate and a fresh deposit
receipt is issued to the customer evidencing a fresh contract.
Alternatively, the deposit can be paid up by obtaining the discharge of
the depositor on the reverse of the receipt.
Many banks prepay fixed deposits, at their discretion, to accommodate
customers request for meeting emergent expenses. In such cases,
interest is paid for the period actually elapsed and at rate generally1%
lower than the rate applicable to the period elapsed. Banks also may
grant overdraft/ loan against the security of their fixed deposits to meet
emergent liquidity requirements of the customers. Interest on such
facility will be 1% to 2% higher than the interest rate on the fixed
deposit.
Recurring Deposits
Flexi-deposits
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past. Banks have given their own brand names to such deposits e.g.
Quantum Deposit Scheme of ICICI Bank, Multi-Option Deposit Scheme
(MODS) of SBI.
Only one savings/ current account is opened and the term deposits
issued under the scheme are only on the banks books as no term
deposit receipts are issued to the customer. However, the term
deposits issuance and payment particulars would be reflected in the
statement of the savings/ current account for customers information/
record.
Once deposits in savings/current account cross a pre-agreed level,
such surplus amount is automatically transferred to term deposit
account of a pre-determined maturity (usually one year) in the
customers name for higher interest earning.
In the event of a shortfall in the current/savings account, the cheques
drawn on the account are honoured by automatically transferring back
the required amount to the savings/ current account from the fixed
deposit account (reverse sweep).In such a case, the term deposit is
broken and the amount of the reverse sweep earns lower interest rate
due to the pre-mature payment of that portion of the term deposit and
the balance amount of the term deposit continues to earn the original
interest rate.
Comparing the Indian and U.S. banking practice it is obvious that majority
of services in U.S. are non-interest bearing, and cost to the customer. The
table below illustrates this:
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S.No. Type of Indian deposit products US deposit products
facility
1. Non interest Current accounts in all All checking accounts and
bearing types of banks business checking accounts
in particular. Customers
have to pay for all services
including for transactions
and checkbooks.
2. Interest Savings bank interest is All interest rates are fixed by
bearing administered by regulator; banks independently of
accounts all other interest rates are regulator. Charges have to
fixed by banks. Almost no be paid by customers for
charges are levied for services received.
services rendered.
3. Money No such schemes exist in It is a common product
market India offered by almost all banks.
deposits
scheme
4. Nomination Facility exists in India for Payable on death, account
all accounts and is optional opened if it is a trust and is
voluntary.
Call deposits
Call deposits or deposit at call accounts are maintained by one bank with
another bank. These accounts may or may not fetch interest as per the
rules framed by RBI or Indian Banks Association (IBA), from time to time.
Basic requirements
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Ensuring that KYC (Know Your Customer) norms are complied with to
the banks satisfaction, before a client-bank relationship is allowed to
begin.
In United Kingdom, the deposit accounts are risk rated. They are
categorized as low risk, medium risk, and high risk. For small amount
deposit accounts, which carry very low risk, the KYC is less severe and
verification of documents to establish identity and sources of incomes
are less rigorous. For large deposit accounts, procedure is as rigorous
as in U.S.
In India KYC prescribes the same rigour for all accounts; it does not
risk rate all accounts and retains obtaining a proper introduction for all
accounts.
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Department of treasury can seize balances in the NOSTRO account
without reference to legal process. These filters also apply to all in ward
and outward remittances to and fro to an American correspondent. Failure
to comply can result in seizure of balances, launching of criminal federal
cases and stoppage of all business in U.S. for the concerned bank.
Not in order
Social security card
Passport
Check for sources of
ok
funds
Identity issued by
employer
Proceed with a/c opening
procedure
Observations
Any person who has legal capacity to enter into a contract can open a
deposit account with a bank. The person should have attained majority
age (18 years in India) and be of sound mind. On behalf of minor child, the
guardian can open a bank account. Some banks also allow deposit
accounts with limited facilities for school students who are less than 18
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years of age, with the idea of catching them young or for inculcating
saving/-banking habit among them.
Following types of legal entities can open deposit accounts with banks:
Identity verification
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adopting this procedure, access to banking services should not be denied
to general public.
Specimen signatures
A joint account is one which is opened in the names of more than one
individual and all the account holders have signed on the account opening
form. In joint accounts, mode of operation has to be authorized by all the
account holders on the account opening form itself or subsequently
revised by a letter signed by all of them. Mode of operation in joint account
of, say, two individuals, can be any of the following:
Jointly by both the account holders
Either or Survivor
Former or Survivor.
Latter or Survivor.
In joint account of A and B when both are alive, the account can be
operated:
by both A and B jointly in (a)
by A or B in (b)
by A in (c)
by B in (d)
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By the legal representative of the deceased and the survivor (it would
be better to close the account after permitting withdrawal of the
balance by the legal representative and the survivor and open fresh
account in their names).
By the survivor without obtaining legal representation for the estate of
the deceased account holder, in case of (b), (c) and (d) above. This is
the great advantage of the joint accounts with the operation by the
survivor as this obviates the problem involved in obtaining legal
representation for the deceased and the account can be operated by
the survivor without any interruption.
Nominations
The deposit account opening form contains provision for nomination which
can be made in single or even in joint accounts by the account holder(s)
by signing the declaration in the form as per the provisions of section 45-
ZA of the Banking Regulation Act, 1949 (amendment of 1983). The effect
of a valid nomination is that in the event of death of the sole depositor or
all depositors, the amount lying in the account will be returned to the
nominee without any further legal formality. The banks action in giving
money to the nominee cannot be questioned by any heirs to the
deceased, as the banks action is in pursuance of the law mentioned
above. It is note worthy that nomination per se does not bestow legal heir
ship to the nominee. It only authorizes the nominee to collect the amount
from the bank. The nominee can be questioned by the heirs as regards
the distribution of the money collected. However, the bank has nothing to
do with any such dispute as it stands discharged from its liability by giving
money to the nominee.
As a banker, one should always advise the sole account holder to make
nomination by explaining the advantage and the above provisions of law.
CLOSURE OF ACCOUNT
1) Termination by customer
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event, the bank would close the account by obtaining the unused cheques
from the customer and returning the balance in the account against the
customers acknowledgement.
2) Termination by bank
SUMMARY
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banks mainly comprise M3 or broad money that represents a major
chunk of money supply in the Indian economy.
CHAPTER 3
3. LENDING
IMPORTANCE OF LENDING
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advances. The banks earn interest spread as a reward for risk-taking.
Lending function is thus an important element of intermediary role of
banks in a financial system.
Lending function of banks is important not only for banks but also for
economic development of a country. Banks lending activities also play an
important role in determining the velocity of circulation of money in the
monetary system of a country. The importance of bank lending can be
explained as under:
iii) For the monetary system: In the process of lending (or credit
creation), banks create fresh deposits on account of the fractional
reserve system under which they are required to keep only a
specified small portion of their deposits in cash in terms of Cash
Reserve Ratio (CRR) and the remainder is lent out. The funds lent
out accrue as fresh deposits in the banking system and these
deposits are again lent out, leaving another small portion as cash or
liquidity reserves with banks. The money supply in the economy
thus increases due to the acceleration in the velocity of its
circulation (called credit creation by banks). The actual extent of
credit creation by banks would depend on the demand of credit in
the economy and also how widely the people are inclined to use
bank deposits, banking services and negotiable instruments like
cheques, bank drafts, bills of exchange, promissory notes, etc. (as
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opposed to cash transactions) as a means of settling transactions.
The extent of monetization of the economy would also determine
the velocity of circulation and credit creation by banks as the non-
monetised segment (e.g. hoarding of money, commodities/bullion,
etc.) contributes to seepages by preventing some portion of money
supply not coming back to the banking system at all or after a
prolonged period.
iv) For the society: Banks lending function indirectly helps the society
or community at large by employment and income generation which
takes place along with the growth of the economy. Further, banks
as responsive corporate citizens, invest back a portion of their
profits (which mainly comes from lending) in community welfare
projects/ activities, like beautification of parks/ gardens/ other public
places, public sanitation, environmental upgradation, support to
charitable organizations engaged in uplifting the less privileged
sections of the society. Banks also undertake loaning for poverty
alleviation programmes of the government at very low/concessional
interest rates.
Cash Reserve Ratio (CRR) is the term used by Reserve Bank of India.
The Bank of England requires all deposit taking institutions to maintain
a Cash Ratio Deposit (CRD) with it. The Federal Reserve System
requires all deposit raising banks to keep prescribed Reserve
Requirement as either cash in their vault or as balance with the
concerned Federal Reserve Bank. While RBI uses CRR to reduce or
expand availability of lending resources, the Bank of England and FRB
depend more upon Repo and OMO (open market operations) to
reduce or expand resources of member Banks.
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PRINCIPLES OF LENDING:
Banks follow basic principle of prudence in lending, as the money they are
lending belongs to their depositors and has to be repaid on demand or on
maturity as per the terms of deposits. A bank looks into three Cs of the
entrepreneur running the company. These are:
In the older paradigm, the loan to be raised was predicated to the value of
collateral. The present paradigm places emphasis on cash flows and the
loan to be raised is predicated to cash-flows and income generating
capacity of the borrowing company.
Safety principle means timely return of the funds lent by a bank. While
making a loan, a bank carefully examines the economic, commercial and
financial viability of the applicants business, the quality of its management
(integrity, honesty, willingness to repay loan, reputation in market,
business acumen, etc.) and past track record. The applicants financials
(balance sheet, profit and loss account, and funds flow statement) of the
previous years and present trend and future projections are scrutinised
critically to establish the business viability. These form the essential
processes for sanction of a loan proposal and their objective is to ensure
safety of funds lent and their timely repayment by the borrower, so that the
bank, in turn, may be able to repay money to the depositors in time.
Assets acquired out of bank loan are charged to the bank as security in
the form of mortgage over immovable property and pledge/hypothecation
of goods/ receivables of the borrower. Wherever necessary, additional
collateral securities over tangible assets and/ or third party guarantees are
also obtained by the bank. In case of default in repayment of the loan by
the borrowers, the bank can take recourse to the securities for the loan
and recover its dues of principal and interest. If the realized value of the
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securities is less than the dues and the balance amount remains unpaid
by the borrower/ guarantor, it is eventually written off by the bank out of
the provisions made for bad/ doubtful debts, thereby reducing its reserves.
Lending involves risk taking and the banks try to minimize such risk. Main
risk in lending is credit risk arising from business failure of the borrower or
default in repayment of the principal/interest by him or due to other
reasons. The credit risk is sought to be diversified by banks by avoiding
concentration of loans to a few borrowers/industries/sectors, as per
prudential norms set internally and stipulated by the regulatory authorities.
This is in keeping with the old saying : Do not put all your eggs in one
basket.
Profitability Principle:
Profit earning is necessary for any business for its sustenance and growth.
Further, the logical corollary of risk taking is profit making. Banks seek to
earn profit by charging interest higher than the interest payable by them
on their deposits. The difference between the average interest earned on
loans (yield) and paid on deposits (cost of funds) is the gross interest
spread. After deducting administrative and statutory reserves costs (by
way of provisioning for bad and doubtful loans, Statutory Liquidity
Ratio, Cash Reserve Ratio, etc.), balance portion is net spread, which
represents profit of the bank. After paying taxes, the remainder net profit
is used for paying dividend to its shareholders and the balance profit is
retained in business in the form of various reserves.
Liquidity Principle
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Banks grant loans and advances for lawful purposes as per public policy
and its own objectives. Unlawful activities include money laundering (for
terrorist activities, illegal trafficking in drugs) or for activities banned or
restricted by RBI and other regulatory and statutory authorities. Banks
must avoid loaning for unlawful or restrictive purposes. A bank may have
special knowledge and expertise of certain industries and therefore lend
mainly to the units in these segments. Every banks loan portfolio is
therefore different as per its objectives and credit policy.
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end of the production cycle. Thus working capital facilities are intended to
finance the current assets (that are often hypothecated/charged to the
lending bank) and the outstanding thereagainst are reflected as current
liabilities in the units balance sheet. These credit facilities are granted for
short term period (generally up to one year) and are thereafter renewed or
rolled over from year to year, based on fresh assessment of working
capital requirements of the unit.
The main kinds of fund based facilities (that yield largest chunk of income
to a bank by way of interest earnings) are discussed in this section,
followed by non-fund facilities (that earn fee income to the bank) in the
next section.
Cash Credit
Overdraft
Overdraft means drawings in a current account over and above the credit
balance therein. A limit for overdraft is sanctioned for specific purpose and
period. Overdraft facility may be secured (against government securities,
company shares/bonds, banks own fixed deposits, etc.) or clean
(unsecured). Drawings can be made up to the sanctioned limit and interest
is charged at agreed rate on the daily debit balances in the account.
Demand Loan
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A fixed amount is advanced to the borrower initially for specified purpose
and short period (generally up to one year). No subsequent drawals are
allowed to the borrower as the loan is one-time facility subject to periodic
or lump sum repayment along with interest applied to the account monthly
or quarterly. Once a loan is closed, another loan may be granted by
opening a fresh demand loan account and obtaining of fresh
documentation.
Bills of exchange are drawn by a seller upon the purchaser as per the credit
terms agreed. Bills can be of two types:
(a) Demand bills: These are payable on demand without any credit period
except the transit time involved in the movement of the bill of exchange and
transportation receipts (lorry or railway receipt, or airway bill or bill of lading)
from the seller to the purchaser through the banking channel. A typical
transaction would be a firm in Kanpur sending one wagon load of mustard oil
to a firm in Kolkata. It sends the railway receipt and invoice under the cover
of a demand bill through its bank to consignees bank in Kolkata. Bill covering
this transaction would be as under.
Rs. 1,623,454 Kanpur, 21/09/05
On demand Pay to Punjab National Bank a sum of Rs. One million Six
Hundred Twenty Three Thousand Four Hundred Fifty Four Only
for Value Received against our invoice number 00/0000 dated 20th
September 2005.
To,
Hari Ram and Sons, For Mangat Rai and Sons
Dharamtolla,
(a)Kolkata
Usance bill: These are payable on the expiry Partner
of the credit period normally up
to 3 months, as per different trade practices.
The seller submits the bills along with transportation receipts (railway /
lorry/air/ bill of lading) to his bank.
The bank sends the documents to the drawees through the banking
channel for presentment for payment (demand bill) or presentment for
acceptance (usance bill).
The sellers bank purchases demand bills and discounts usance bills by
crediting to the sellers account with the amount of the bills less the
interest discount and handling charges.
The advances against bills are adjusted on receipt of the proceeds of the
relative bills. In case of non-payment of the bills on the due dates,
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additional interest is charged to the seller and amount of the bill is also
recovered if it remains unpaid.
The bank ensures that bills purchased or discounted are genuine and
represent actual movement of goods from the seller to the purchasers.
Accommodation bills are the bills that are drawn without any movement of
goods from the drawer to the drawee, with a view to obtain bank finance
for non-trading purposes. Banks do not finance such bills and also take
extreme care in financing clean bills which are not accompanied by
document of title to goods and transport receipts evidencing movement of
goods.
Thirty days after acceptance please pay to Punjab National Bank a sum of
Rs. One million Six Hundred Twenty Three Thousand Four Hundred and
Fifty Four ONLY
for Value Received against our invoice no. 00/0000 dated 20th
September 2005.
To,
Hari Ram and Sons, For Mangat Rai and Sons
Dharamtolla,
Kolkata Partner
Term loans are granted for acquisition of fixed assets (land, building,
machinery and equipments) for setting up a new industrial unit, or for
financing modernization, expansion or diversification of an existing unit.
Typical features of term loans are as follows:
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Term loan is granted for medium term (generally 3 to 5 years) or long
term (over 5 years) and is repaid by the borrower from its cash
accruals (net profits after depreciation, etc.) in installments spread over
the period of the loan.
Equated monthly or quarterly installments (principal and interest) are
fixed depending on the projected cash accruals over the loan tenure.
Apart from the mortgage over the fixed assets of the unit and
guarantee of the promoters, covenants or conditions are also
stipulated by the bank for ensuring the desired financial discipline by
the borrowing unit.
In case of large sized projects (e.g. infrastructure projects) requiring a
large amount of loan for longer tenure (10 to 20 years), term loans are
granted by a group (consortium) of banks/financial Institutions. This
helps in diversification of the credit risk of lenders.
Letters of Credit
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facilities with the issuing bank which has a satisfactory record of dealings
with such customers.
Guarantees
Considerations
Each credit decision implies a risk, and can result in a loss to the Bank
depending on the probability of default. The return paid by a borrower on a
loan must weigh in
cost of funds,
operating cost for sanctioning,
maintaining,
following up of the loan,
risk taken depending upon the probability of default, and
adequate profit margin on the loan.
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Prime Rate
Each Bank calculates a prime lending rate for its prime customers. Risk
being lowest, prime rate is the finest price a bank would offer its best
customers. A borrowing customer can expect a price related to this bench
mark pricing as interest rate payable by it on amounts borrowed by it.
Probability of default being different for various customers, component of
risk will vary, and will relate interest charged to the risk carried by the
bank.
All quotes for interest rates linked to prime rate are floating interest
rates. As the prime rate is changed by the bank, the effective interest rate
for borrower changes as under:
the borrowers to quantify their liability, over the life of loan, seek fixed
interest loans.
once the interest rate is contracted, irrespective of the changes in
interest rate structure the contracted rate is payable through out the life
of loan, and
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in case of long term deflationary economies like Japan, borrowers
stand to lose to the advantage of lending banks. In other countries,
with a history of inflation the borrowers do gain.
Most banks offer both floating and fixed interest rate(s) to their
customers.
Fixed interest rates are always higher than floating interest rates in the
short run. This is done to provide a premia for IRS to convert fixed into
a floating income streams as a risk mitigation technique by banks.
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by obtaining a
supplementary letter,
agreement
Risks
Lending banks cover their risks by ensuring that their loans are properly
secured so that in case of borrowers failure to generate projected cash-
flows they can have recourse to security and recover both principal and
interest.
Guiding principle
The principle, that guides banks to decide when to secure the loan and
when to allow loans to remain unsecured, is simple and practical. The
borrowing entitys capability to repay also relates to size of its cash-flows
and the exposure the bank has taken.
Unsecured Loans
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Short term loans including bill discounting are generally allowed to remain
unsecured. The basic security in these cases is the signature of the
company. Bankers trust that for the amounts lent borrowers signature
binding it to a legal contract is good enough and there is no reason to
believe that borrower will go back on its promise to pay. It is not out of
place to mention that these loans are basically predicated to strength of
the balance sheet. Indian Oil Corporation (IOC) has been able to buy oil
from ARAMCO of Saudi Arabia without a L/C or bank guarantee for very
many years. In U.S., a number of loans given under Community
Reinvestment Act are unsecured. This is due to regulation and the
availability of Small Business Agencys guarantee for repayment. In
number of cases, in India, as per regulatory guidelines no security is taken
for small loans, loans to tiny industries and agriculture. These are small
size loans and at times carry guarantee of Guarantee Organizations.
Secured loans
Collateral security
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Equitable mortgage of all properties of owners to cover all exposures,
Directors guarantee to cover all loans to the company,
Holding companys guarantee to cover all exposures to the company,
Guarantee by Export Credit Guarantee and Small Business Guarantee
Organizations for specific contracts, business, etc.
Mortgage of third party property to cover loans given to a company,
Guarantee by government for payment of principal and interest, and
Guarantees by IFC for private sector enterprises in various countries.
The flow chart depicts the generic loan delivery value chain for wholesale
loans.
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Check exposure limit for Is it within Not complied, drop
country and industry rules? proposal
customer belongs to
Assess credit need and Appraise credit needs Recommend credit under
products three signatures and six eyes
Hand over
Convey sanction and terms to No go
and conditions to borrower accounts Stop
Obtain documentation for day to
securities, open loan day
account routine
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Value of wholesale loan
.
Wholesale loans have different values in different countries. In North
America one cannot even join as junior syndication member if contribution
is less than US $ 5 million, The Loan size starts from $ 50 million. In India,
any thing above say Rs.100 million, i.e., $ 2.5 million is treated as
wholesale. One should understand the specific market to define what is
treated as wholesale loaning in that regime.
Credit rating
Most of the banks, rate borrowing entities on the basis of their financial
statements, quality of management, industry in which they operate,
competitive environment, projected cash flows including future profitability,
and legal and economic factors affecting the company. Under Basel II,
internal credit rating has been prescribed for all international banks. Such
credit rating is used to decide about taking up the proposal and fixing price
if proposal is found to be in order. Currently in India, most of the banks,
use credit rating models which are based on past experience but not as
sophisticated as Internal Rating Based (IRB) recommended by Basel
Committee. Once this happens the capital adequacy requirement for the
loan would also be calibrated on the basis of credit rating.
Credit appraisal
Different credit appraisal techniques are used for short term and medium
and long-term loans. These are:
Short term loans are basically given to tide over short term liquidity
mismatches. The credit appraisal is either based on cash-flow
approach or projected balance sheet approach. The bank does not
finance any core capital but only gap or liquidity requirements. Major
factors to be seen are quick and current ratios, trend of profitability,
and debt equity to ensure that credit being picked up is not a potential
problem account. All these factors are examined over a time series
including projections to ensure that there is no risk to moneys being
lent.
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Medium and Long term Loans are invariably more thoroughly
examined and basic tool is projected cash flows over the life of loan,
sensitivity analysis to cash flows and whether the cash generations
would be able to service the loan. Banks insist that cash flows
generated must be at least twice as large as the servicing
requirements.
Relationship managers
All securities are to be charged to the bank before any monies are
disbursed. Documentation, stamp duty payment, and execution of
documents are taken care of by legal advisor and relationship manager
jointly. The stamp duty is paid according to local laws and must be
correctly paid to ensure enforceability of contract.
Monitoring
Banks obtain, from the borrowing units, monthly statements about cash
flows and funds generated each month and monitor cash generation and
profitability trends. Cash generation ensures that there is no liquidity
problem. The continued profitability ensures that bank will be assured to
have satisfaction of owners stake in business and it is not being run on
borrowed monies alone. The consecutive financial and other statements
are examined to ensure that borrowing entity remains on virtuous path of
growth. In case there are any slip back bank asks for corrective action
from management including enhanced security and in extreme case, can
recall loan well in time.
Nature
Retail loans are high volume low value loans. As the numbers are very
large and individual loan value is small, special sales, marketing,
processing, appraisal, accounting and credit monitoring processes are in
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vogue to keep down transaction costs, and earn/allow fair margin from this
business. As the retail loan portfolio has very large number of accounts
each of small value the portfolio is finely grained. The business as such
is less risky than wholesale loan portfolio. Keeping in with the nature of
business which is spread over:
automobile finance,
mortgages for residential properties,
personal loans and loans for purchase of consumer articles which can
come under various schemes targeting specific customers, and
SME lending including agriculture.
Customer acquisition
Most of the banks use direct sales agents to acquire customers, while they
accept direct business it is the D.S.A. who forms effective sales force. As
a risk mitigator DSA have no say in appraisal and processing of loans.
Credit scoring
Based on numerical credit rating models, which take into account trait
based factors and are based on historical data of past loans, individual
retail banks have their credit scoring templates. These are totally
computerized and the proposed customers data is fed into the template
and approval or rejection decision is taken. These credit scoring templates
are widely used for;
Automobile finance,
Mortgage loan,
Credit cards,
Personal loans.
SME
Small value agriculture loans.
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The specific work stages are as under:
Documentation is obtained and maintained at a centralized place. The
concept of maintenance of all documents at a document factory is
well established in all major retail banks.
Presigned and predated cheques are obtained for ensuring
repayments well in time. These cheques are stored, processed and
encashed through cheque processing centralized factories in most of
retail banks. In internet enabled banks customers can pay through
internet through a call centre under the control of the bank.
In case of bad debt, the banks use out side recovery agents for
recovery. The agents are paid a commission based on recoveries
made.
In view of very large number of loans, the banks do not verify security
regularly but in case of default, repossess security through agents.
This is very common in case of automobile finance. In case of
mortgages it is necessary to resort to legal process to enforce and sell
the mortgaged house or flat.
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CHAPTER 4
Major services
OPENING AN ACCOUNT
CLOSURE OF ACCOUNTS
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EVOLUTION OF SERVICING AT BANKS.
The banks traditionally were branch based institutions with large manpower,
and paper based ledgers and records. Because of size and storage of
cash and records, the banks were traditionally housed in solid looking
brick and mortar structures. This has given rise to the term Brick and
Mortar Banking. Introduction of computers in banking reduced paper
storage, and man power requirement. Subsequent technological changes
have converted banks into a virtual institutions. Some of these
developments are discussed in detail here.
Electronic banking
Communication channel can be of three types bit serial, byte serial and
parallel. For faster communication, data compressions techniques are
used. For secure transmission, data encryption techniques are used. E-
mail is used for transmission of data from one place to another with speed,
accuracy and security. Email can be used over dial-up line or a dedicated
line. The dedicated leased line connectivity can be via satellite link or
terrestrial link. VSAT networks are used across banking industry for many
on-line applications.
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banker-customer communications are fast and neat and
information service is available on 24 x 7 days basis via call
centres.
banks can also handle non-banking services for their
customers, e.g. payment of electricity/ telephone/ gas bills,
insurance premia and receipt of pension/ interest/ dividends,
etc.
ii) integrated internal accounting system: Banks book-keeping is
automated, fast and accurate. It saves time of staff for marketing
and other work after banking hours.
iii) management information system has improved, due to better data
classification and retrieval, integrated accounting system,
communication and conferencing system and inter- connectivity of
branches.
iv) cross-selling of various financial products, due to data mining and
electronic marketing channels.
cash dispensing
generating statement of account
account balance enquiry
accepting request for cheque book.
deposit of cash/ cheques etc.
issue of gift cheques/ travellers cheques
utility payments like telephone bills, electricity bills.
Round the clock banking for 365 days in a year. Only exceptions
are when they are out of order/short of cash.
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Customer can choose his own time of banking at any time or any
day of the week.
Quick and efficient service.
Response time/process is uniform and fixed for all customers as
per programme set. There is no scope for discourteous or
subjective behaviour as could happen with human interaction at
a banks counters.
Big banks have installed their own ATMs on-site and off-site. Banks
which do not have their own ATMs or which have only few ATMs and want
to have wider use of ATMs for their customers, enter into arrangements
with other banks for such usage on a mutually agreed sharing
arrangement and fee basis. Shared Payment Network System (SPNS) is
used by the participating banks, which are connected to the network by a
host computer. SPNS was in vogue in 1990s in Mumbai among
commercial banks, when the number of ATMs was limited due to high
capital cost of installing ATMs. SPNS enables one bank/ branch customer
to access another bank/ branch ATM, nearer to his residence/ office, for
putting through the permitted transactions. It also helps better utilization of
resources to a larger section of customers.
Mobile Banking
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lower capital investment, compared to a brick and mortar bank,
larger area coverage,
banker visiting customers for banking, rather than customer visiting
the bank as in the case of a conventional bank,
it also serves as a tool for marketing on special events, like
exhibitions, melas, festivals
ii) ATM on ship or airliner: This can be even lighter than an on-road
ATM and should be able to perform certain specific travel needs,
e.g. main currency exchanges relating to the destination,
acceptance of certain kinds of credit cards (global cards), debit
cards for payments/ purchases. This requires communication with
the central data base which is compatible with the navigational
system of the aircraft/ ship.
Tele-banking
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address and delivered to him/ her, against the cheque for the
amount plus service charges.
Internet banking
Internet banking is on-line banking from home or anywhere and it provides
anywhere and any time banking access to ones accounts and public
information put on its web site by the bank. It has been introduced by
most of the commercial banks in India which have fully computerized their
operations involving back-office and internal accounting system. Just as
the bank staff accesses the account of a customer on-line, the customer
can also access his/ her account on-line via internet.
A customer requires the following for Internet banking:
i) a personal computer
ii) a telephone link
iii) a modem
iv) an arrangement with one of the Internet Service Providers (ISPs),
e.g., VSNL, MTNL, TataIndicom, Sify Online, Reliance Infocomm,
etc.
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Int. TV
ATM
ho bran
me ch
kiosk
phone network
P.C.
phone
VIRTUAL BANKING
ACH is run in United States to clear both debits and credit between more
than 13000 participating institutions.
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e-commerce payments;
Federal, State and local tax payments.
Originator
Any individual, corporation or other entity that initiates entries into the
Automated Clearing House Network
Receiver
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An individual, corporation or other entity which has authorized an
Originator to initiate a credit or debit entry to a transaction account held at
an Receiving Depository Financial Institution (RDFI).
Traditionally, the funds are transferred by banks from one place to another
by mail transfer and telegraphic transfer and the latter is faster than the
former. In both kinds of transfer, banks use the postal and telegraph
department services and use certain codes to keep confidentiality and
safety in transmission of the messages. In electronic system of
communication, the transmission is much faster and safer. Several banks
have started following systems for funds transfer:
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Conduct of clearing house operations require huge expenditure by way of
premises/ equipment/ staff costs.
c) Encoder: This machine is used to write with magnetic ink details of the
cheque in the lower band. In power encoder, the data on cheques are
keyed elsewhere at branches and sent to the service branch along with
a floppy/CD containing the information. When the cheques are passed
through the power encoder, the data from the floppy are encoded on
the cheque.
The payee branches process the payments on the next day and all returns
are submitted to the clearinghouse in the next day clearing. The customer
therefore gets the credit on the third day.
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Debit Clearing System
Under this system, the utility service provider (like telephone, electricity,
gas, insurance company) obtains an authorization from the customer to
debit his specified bank account with the amount of the bills at regular
intervals. The letter of authority is submitted by the service provider to his
banker which raises a debit for the amount listed on the other bank
maintaining the clients account. Advantages of the Debit Clearing System
are:
customer is not required to keep a track of his bills for ensuring payment
before due date and need not write and cheques in payment thereof.
service provider print out bill and send it to the customer for information,
before debiting the payment in customers account.
system helps banker in saving expenses as cheques are not used for
payment of the bills.
company need not print dividend/ interest warrants. The work regarding
reconciliation of paid and outstanding amount is avoided.
investors need not deposit cheques to their bankers every time and wait
for the clearing credit. Under the Credit Clearing System, credits to the
customers account are on the fixed date.
bank saves time in processing large number of cheques/warrants
deposited by the customers in the manual system.
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transaction-by-transaction). The system handles large value, time-critical
payments.
Participants
The operators of the Real Time Gross Settlement System(RTGS) are the
Central Bank, and commercial banks, for net settlement position of banks.
Each participant of the RTGS has obligations (responsibilities) towards the
smooth operation of the RTGS. Operational procedures of the RTGS
system are clearly well defined, including roles and responsibilities of and
for the Central Bank and the other participants. Central Bank will act as
the Operator of the RTGS system that will enable participants to achieve
prompt settlement of payments by debiting and crediting their accounts
with Central Bank.
Participants in the RTGS must maintain accounts with the Central Bank
and may use the system to transfer funds to each other directly and /or
perform third party transfers for and on-behalf of their customers/account
holders. Deferred Net Settlement (DNS) obligation from clearing system
(e.g., cheques, Point-Of-Sale (POS), ATM and other cards transactions)
would also be settled over the RTGS System.
RTGS system will have a time schedule for operations within which
participants are expected to effect all transfer instructions in RTGS. These
instructions would be settled if and when participants accounts are
funded.
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settlement account monitoring
connectivity to other systems, etc
For net settlement requests for low value net settlement systems, a
participant not having sufficient funds to settle net position, could prove
a risk to the whole system. In such cases, Central Bank would provide
collateralized intraday credit facility, which would be accessed to
enable participants to make payments. The collateral must be high
quality and the amount would be determined by CBN. Any participant
that enjoys this facility must make funds available in its account to
cover the credit, not later than the close of the days business.
This module would be installed at CBN for monitoring and used as the
management tool for the RTGS.
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Participants are expected to hook up to communication network to be able
to participate in the payment system. All accesses to network and
application would be authenticated and validated.
There must exist clearly defined rules and regulations and operational
guidelines for operating the RTGS to prevent systemic risks as well
collapse of the financial sector.
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operational throughout the year 24 hours a day,
transmission of messages to any part of the word is almost
instantaneous,
about 400standardised formats are used by SWIFT for message
transmission for inter-bank transactions,
all messages are acknowledged,
Information is confidential and is protected from disclosure and
tampering,
SWIFT assumes financial liability for the accuracy and timely delivery
of all validated messages from the point these enter the network to the
point the same leave the network,
method of transmission is cost effective.
SWIFT has emerged as a need of the financial world for a fast, safe, and
universal means of transferring funds immediately. It has helped in standardizing
and automating the international payments messaging, to the great benefit of
banking community. Of late, institutions other than banks are joining SWIFT. An
illustrative list is:
TRADE FINANCE
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Trade finance implies financing of the movement of goods and services
internationally and within ones country. In all banks trade finance normally
relates to financing of foreign trade, both exports and imports. Over all domain of
trade finance covers under-noted areas:
Financial risks - arising from factors affecting cash flow and/or profits of
the operations
RISKS
---------------------------------!----------------------------------
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! !
Business Risks Financial RIsks
! !
Economic Risk Credit Risk
Systemic Risk Liquidity Risk
Country Risk Market Risk
Political Risk Price Risk
Operational Risk Interest-rate Risk
Settlement Risk Mismatch Risk
Regal & Regulatory Risk Basis Risk
Yield Curve Risk
BANK GUARANTEES
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gives advance payment to a customer and bank gives guarantee for
the amount knowing by its assessment that customer is good for the
amount. A bank in India is allowed by Regulator to give such
guarantees.
Performance Guarantee : It is for technical and managerial
competence. To illustrate, customer is asked by the government to
give guarantee that the construction of a dam given to it would be
completed in two years from the date of work order. This is a
Performance guarantee. Banks are asked to desist from entering this
type of business by the regulator.
Deferred Payment Guarantee : It is given for guaranteeing periodical
payments for goods supplied. This is akin to granting a term loan and
is permissible business for banks.
Statutory Guarantee : It is a guarantee to statutory authorities or a
court that the customer will honour his commitments when due, as per
law.
A contract between an importer and an exporter may call for payment under a
letter of credit (L/C). The L/C sets a time limit for completion and specifies which
documents are required to confirm the transactions completion.
commercial invoice,
certificate of origin,
insurance document, and
bill of lading or combined transport document.
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A letter of credit is an additional contract dealing with credit between applicant
(importer) and the issuing bank and is separate from the original contract
between buyer and seller. The bankers deal only in documents and not in goods.
If documents are in order the issuing bank will pay whether or not the goods are
of expected quality.
Types of L/C
Applicant - The party applying for the letter of credit, usually the Importer
in a transaction.
The Issuing Bank - The bank that issues the letter of credit and assumes
the obligation to make payment to the beneficiary, usually the exporter.
Terms - The requirement, including document that must be met for the
collection of the credit.
Expiry - The final date for the beneficiary to present the documents as per
the terms and conditions of the letter of credit.
These are the necessary components of any letter of credit for the credit
to become a valid, operable instrument. In addition, letters of credit come
in various forms that define their level of risk. A revocable letter of credit
allows the issuing bank (at the applicants request) to amend or cancel the
credit at any time without the approval of the exporter (beneficiary) and is
the most risky form. In contrast, an irrevocable letter of credit has terms
and conditions that cannot be amended or changed without the expressed
consent of all parties, the issuing bank, the exporter (beneficiary) and the
importer (applicant). Finally, the addition of a commitment by a bank other
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than the issuing bank to irrevocably honor the payment of the credit,
provided the exporter meets the terms and conditions of the credit, results
in a confirmed irrevocable letter of credit.
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The over all flow of documents in a L/C transaction can be depicted by
under-noted flow chart.
Exporter ships
Bank one copy of goods, gives,
L/C to Indian Bank stores copy of B/L,cert.Origin,inv
Importer for record documents, copy of oice,L/C to his
and verification L/C for future bank
reference
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Banks offer cash management services to large companies with
offices/branches at various places. In short the system works as under:
Just like receipts are swept in, payments go electronically to various centres.
It implies maintaining a Just-in-time Cash inventory in the company.
For banks having core banking solution, where all branches are interlinked
and the main database is at central computer, the process becomes much
simpler.
There is competition on the pricing and at times the CMS can be sold by
banks as a loss leader, in order to get more profitable foreign exchange and
export import business.
TREASURY SERVICES
Functions of Treasury
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treasury makes its own investment from the surplus remaining with it
after
meeting the reserve requirements for which it bears primary
responsibility,
it invests surplus in money markets,
fixed income securities, equities, and
foreign assets, subject to regulatory guidelines for taking position in
foreign currencies.
duration,
interest rate risk,
asset liability management,
gap analysis a variant of ALM, and
liquidity risk
Risk Return
Investments in money markets are less risky but so are the returns which
remain low. The treasury has to take calibrated risk to optimize income by
switching between money markets, fixed income assets, and foreign
currency assets to optimize returns. Money market investments have to be
tempered with exposure limits on every major borrowing institution,
depending upon the balance sheet and managerial capability of that
institution. The treasurys, major objective function is to optimize returns
and balance the risks without breaching exposure limits on various
borrowers and asset classes.
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Mid office : which is responsible for risk control and MIS for entire
treasury. Among other things, mid office monitors exposures, out of
market deals, and transactions where management has to be warned
about excessive risk being taken. Mid office is not internal audit, but
more risk identifie. Also, more of risk measurement and risk control
centre.
Integrated Treasury
Currency swap is the most basic and relatively safe instrument and helps
a bank to make more income than a call placement/deposit in inter-bank
market or reverse repo placement with an approved bank or Primary
Dealer. For a bank with surplus cash, a currency swap is a good source of
dollar income, which can be used for financing imports, loans to
customers, or investments abroad. But this business can be done only
when Rs. Dealer and forex dealer work in tandem.
Nature of Integration
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Generally, an integrated treasury implies vertical as well as horizontal
integration. Under the vertical integration, the forex dealing room, which is
located at International Banking Division is merged with domestic treasury.
That means both domestic and forex dealing operations, along with back
office activities are carried at the same place. Under the horizontal
integration, front office and back office are located at different places, but
combined operations are carried out with the same policies, accounting
system and technology platform.
Integration of Structure
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Structure of Integrated Treasury
Country Head
(Treasury)
Reporting Directly
To R M D
G-Securities Merchant
Non-SLR (on behalf of Settlement Merchant
activities
Call/notice/Repo customers) Custodian Reconciliation
Maintenance of trading Accounting SWIFT
CRR forward &other other documents FCNR
MM Derivatives fx related SLR Maintenance
(interest rate) derivatives
1) bank must give forex quotes both ways, i.e., for buying and selling.
These must appear online say on Bloomberg and Reuters.
2) base rate for buy and sell can be interbank rate, or to be more
competitive, interbank cross-rate offered for Rs-US$ in Singapore
market in morning and Bahrain or London in evening.
3) to do so, bank must be ready to do proprietary trading and hold
positions in its account. Policy clearance would have to be taken from
the Board.
4) based on point 2 mentioned above, bank must quote special rates for
forex transactions say, above a critical amount, to be fixed by the bank.
INSTITUTIONAL BANKING
Correspondent banks
NOSTRO ACCOUNTS
VOSTRO ACCOUNTS
Advisory services.
Banks give advisory services for debt structuring, debt raising, and
syndication for both domestic and foreign currency loans. Banks share the
risk with other banks by sharing loans and this stands them in good stead
for syndicating for debt raising especially on external commercial
borrowings.
Capital Restructuring
A company needs capital restructuring both for raising capital and debt,
when it diversifies or
when it goes sick or
when it thinks of an acquisition.
CREDIT CARDS
Let us see how a credit card is issued and used. Generally, a bank enters
into an agreement with its customer and issues the customer a credit card.
A credit card is small plastic card around 8.5 cm by 5.5 cm. It has the
name and the account number of the holder embossed on it. In addition,
the date up to which the card is valid will also be embossed and a
specimen signature panel on the reverse. The card issuer should normally
get the card holder to sign on the specimen signature panel in his
presence before parting with the credit card. A card holder is also
Charge Card
All transactions are accumulated over a period of time and total amount
charged is debited to card holders account. Cardholder is given about 10
to 15 days time to credit his account if sufficient funds do not exist in the
account.
Credit Card
Is same as charge card except that card holder may pay only 10% of
amount and gets credit to the extent of 90%.
Member Card
This is used exclusively by members of a club or a chain of hotels. Cards
can be used only for the member of a group or establishment and can be
used only in specific establishments.
Debit Card
Bank account of the card holder is straight away debited from Point-of-
Sale Terminal (POST).
Banks all over the world are regulated entities, and are subject to regulation
by Central Banking Authority. They have to comply with laws of the home and
host countries where they do business. In the previous chapters in defining bank,
its products and processes the applicable laws and regulatory guidelines have
been taken into account. Primarily it should be said that Contract Act, Negotiable
Instrument Act, Banking Regulation Act, Transfer of Property Act, Securities and
Contracts Act, etc., apply to the functions of Bank, in India. An illustrative list of
important regulations and laws that banks have to comply with on day-to-day
basis are:
reserve requirements,
exposure limits on individual and group of clients,
submission of offsite inspection data periodically to central bank,
ensuring not to take exposure on negative list circulated by Regulator,
ensure participation in specialized lending like Community
Reinvestment Act, or similar regulation or law,
implement in letter and spirit, regulations issued by Central Bank
regarding covenants binding Board of Directors for good corporate
governance,
implementation of risk management systems as directed by Regulator,
maintain capital adequacy on day to day basis,
enforce effective K.Y.C. (Know Your Customer) regime,
report all suspicious activity transactions to designated authority,
maintain an effective anti-money laundering system to ensure that
related laws are followed in letter and spirit,
if a listed company, comply with stock exchanges and periodical
reporting requirements, including reporting any market sensitive
information.
banks listed at any U.S exchange have to comply with Sarbanes Oxley
law,
provisions of labour law, Income Tax laws, and state laws having
bearing on banks business have to be complied with,
in respect of any business done through correspondent banks, banks
outside US, have to comply with Bank Secrecy Act, PATRIOT Act, and
rules of Office of Foreign Assets Control (OFAC)
filing of annual reports and periodical profit and loss statements with
regulator, stock exchange and Company Law Board as laid down by
regulation and laws, well within prescribed time limits.
provisions of Right for Information Act as applicable.
censure,
financial penalty,
cease and desist order,
suspension of business,
cancellation of banking licence, and
criminal prosecution of Principal Officers including Directors.
The Committee is normally chaired by the CEO. Its other members are the
Head of Compliance, the respective Heads of the Legal Service, Risk Control
and Internal Audit, and one senior staff member from each of the Monetary and
Economic Department and the Banking Department. The Committee may invite
at any time other members of Management or staff to discuss special topics
when necessary. The Head of Compliance acts as Secretary to the Committee.
The Committee meets minimum four times a year. Any member of the
Committee may call for an extraordinary meeting, with the prior approval of the
Head of Compliance Committee.
The Head of Compliance shall report on regular basis to his/her line manager
on compliance matters - the reports should refer to the compliance risk
assessment and testing that has taken place during the reporting period, indicate
the details of material deficiencies and/or breaches and recommend measures
to address them, and give a report on the corrective measures already taken.
Authority
To carry out its mission effectively, the Compliance Unit in the course of its
activities shall be authorised to:
Standards
The Compliance Unit shall keep abreast of sound practices in its field and
in particular take into account the recommendations of the Basel
Committee on Banking Supervision on compliance-related issues.
Best Practices
The scope and breadth of the activities of the compliance function should be
subject to periodic review by the internal audit function.
Banks should comply with applicable laws and regulations in all jurisdictions
in which they conduct business, and the organisation and structure of the
compliance function and its responsibilities should be consistent with local legal
and regulatory requirements. Banks operating say in, U.S., U.K., and India have
to comply with three regulators.
The Board should establish the Supervision Committee that will assist it in
accomplishing its supervisory functions in the following critical areas:
Risk management
Credit
Asset and liability management
Internal audit (or compliance)
Good governance practices currently require that the members of the audit
committee have the additional quality of independence.
The Bank, in organizing its functions, should strive to apply the basic
operational risk management principle of segregating responsibilities that may
present potential conflicts of interest.
Financial institutions should maintain, for at least five years, all necessary
records on transactions, both domestic or international, to enable them to comply
swiftly with information requests from the authorities.
If financial institutions suspect that funds stem from a criminal activity, the
same should be promptly reported to the appropriate authorities.
Financial institutions, their directors, officers and employees, should not, or,
where appropriate, should not be allowed to, warn their customers when
information relating to them is being reported to the competent authorities.
A KYC is thus not only customer identification but extends to find out the
sources of funds and its legal status. In practical situation, a standard KYC is run
as under:
It is worth noting that all these risks are interrelated. However, any one of
them can result in significant financial cost to banks (e.g. through the
withdrawal of funds by depositors, the termination of inter-bank facilities,
claims against the bank, investigation costs, asset seizures and freezes,
and loan losses), as well as need to divert considerable management time
and energy to resolving problems that arise.
Reputational risk poses a major threat to banks, since the nature of their
business requires maintaining the confidence of depositors, creditors and the
general marketplace. Bank should ensure that audit functions are staffed
adequately with individuals who are well-versed in KYC policies and procedures.
In addition, internal auditors should be proactive in following-up their findings and
criticisms.
Training of staff at all levels on KYC and Anti Money laundering is important.
Towards this,
Calculation of
regulatory
Capital
Risk
weighted
assets
CREDIT RISK
OPERATIONAL RISK
TRADING BOOK RISK
Credit risk is the possibility and the likely extent of default, i.e., failure to
comply with their obligation to service debt. In the case of investmens this could
be in the form of delay or default of repayments on due dates or after. Default
triggers a total or partial loss of amount lent to the counterparty
Market Risk: Market risk is the risk of possible variability in income due to
changes in the rates in the immediate period and of adverse deviations of the
mark to market value of trading portfolio during the period required to liquidate
the transactions. Market risk exists for a period of time. The holding period of
instrument is not appropriate to value market risk, since at any moment it can be
decided to liquidate the instrument or to hedge their future changes of value. The
risk is that market value may move adversely during the minimum period
required to liquidate the market transactions. This is why market risk is limited to
the liquidation period.
Some other risks which are variants of the three risks are:
Liquidity risk which implies that short term asset values are not
sufficient to match short term liabilities.
Interest Rate risk is the risk of decline of earnings due to the
movement of interest rates, more particular in respect of
asset/liabilities maturing in the short term
Foreign exchange risk is the possibility of losses due to change in
exchange rate/s. Variation in earnings is caused by the indexation of
revenues and charges to exchange rates, or of the values of assets
and liabilities denominated in foreign currencies.
Solvency risk is the risk of being unable to cover losses, generated by
all types of risks, with the available capital. Solvency risk is therefore
the risk of default of the bank.
A Banks Board should establish the supervision committees that will assist it
in accomplishing its supervisory functions in the following critical areas:
Risk management
Credit
Asset and liability management
Internal audit (or compliance)
Chairperson: MD/CEO
Vice-Chairperson: Chief Risk Officer (CRO)
Members:
DMD
Chief Finance Officer (CFO)
Chief Credit Officer (CCO)
Treasurer (TR)
Head of Branch Operations (HBO)
Head of Audit (or Compliance Officer)
The committee can call other senior officers as resource persons in the
committees discussions, from IT/MIS, personnel/ training and
development, as the case may be.)
Credit Committee :
Composition:
Chairperson: MD/CEO
Vice-Chairperson: Chief Credit Officer (CCO)
Members:
CMD
Composition:
Chairperson: MD/CEO
Vice-Chairperson: Chief Finance Officer
Members:
DMD
Chief Credit Officer
Chief Risk Officer
Treasurer
Head of Corporate Banking
Head of Retail Banking
Head of International Division
Every bank, in organizing its functions, should strive to apply the basic
operational risk management principle of segregating responsibilities that
may present potential conflicts of interest. HR, Treasury, Branch
Management and Internal Control functions should also be organized on
these lines. This is essential to avoid operational risk and better efficiency.
The core principle involves the creation of front, middle and back offices.
Operating under sound credit granting process that takes into account
lending criteria, know-your-customer (KYC) appraisal processes,
lending limits, portfolio diversification, and transacting at arms-length
basis.
A bank may develop credit scoring models that are applicable to its target
customers and product types (e.g., mortgage financing, vehicle financing, micro
credit, small and medium enterprises, agri-business, etc.). Credit scoring will
introduce an ability to conduct more meaningful and discrete assessments of
The Bank should adopt a policy to ensure that the valuation of assets
which are offered to secure loans is conducted by professionally-certified /
trained appraisers, regardless of whether they are in-house/Bank-
employed officers or third parties.
All new loans, deposit and treasury products should undergo rigorous
analysis (for interest/market, default/settlement and other operational risks).
Product manuals should be developed and approved by the Management prior to
launching these new products
OPERATIONS/TRANSACTION RISKS
Good Practices
Market risk
OVERVIEW BASEL-II
Since the introduction of Basel-I market changes have been rapid and more
risk management tools have appeared in the market.
The under-noted diagram shows the three basic pillars of BASEL-II accord.
Calculation process.
V.
II.Credit risk-the standardized approach
Operational risk.. Initially on a prescribed
III.Credit risk the internal Ratings based
basis. Later on more information will be approach.
available. IV. Credit risk Securitisation Frame work.
The committee has retained the key element of 1988 capital adequacy
accord including basic requirements for banks to hold capital
equivalent to 8% of their risk weighted assets.
Major innovation is the greater use of assessments of risk provided by
banks internal systems as inputs to capital calculations.
A detailed set of minimum requirements has been prescribed to ensure
the integrity of internal risk assessments.
National supervisor is expected to ensure compliance and overall
integrity of a banks ability to provide prudential inputs to capital
calculations.
A range of options are available to supervisors (RBI) and banks to
determine the capital requirement for credit risk and operational risk.
Regulatory Capital
Flow chart, depicting the way total risk weighted assets of a bank are to be
calculated, is given here-under
12.5 TIMES CAPITAL 12.5 TIMES CAPITAL
NEEDED FOR MARKET REQUIRED FOR
RISK OPERATIONAL RISK
SUM OF RISK
WEIGHTED ASSETS
FOR CREDIT RISK
Total risk
weighted
assets
The Basel Committee itself mentions in its recommendations that they expect
national regulators to start the processes by year 2006 and ensure that
internationally active banks follow them by 2007. National regulators are
expected to extend the coverage to nationally significant banks immediately
there-after.
CHAPTER - 6
The meaning and composition of balance sheet and profit and loss
statement is explained below.
Meaning of Accounting:
Accounting Concepts:
Dual Aspect concept : Each transaction has dual aspects i.e., debit
and credit. Every debit has a corresponding credit and vice versa.
Accounting Conventions:
Accounting Standards:
Single and Double Entry Systems are the two major systems of recording
transactions in books of accounts. A single entry system follows a receipt and
payments mode and only a Cash or Bank Book is maintained. It does not, for
example, distinguish receipts against credit sales and cash sales. It does not
recognize parties either. As such it is, at any given point of time, difficult to
comment on the financial strength of the business. On the contrary, in Double
Every business transaction has two aspects one receives benefit and
the other gives benefit. This gives rise to double entry system which
implies that every debit has a corresponding credit.
Both the aspects of transaction debit and credit sides- are recorded in
books of account.
The two-fold effect of a business transaction is recorded by debiting
one account and crediting other account at the same time.
Since both the aspects are recorded simultaneously, and they are
equal in amount, the system ensures arithmetical accuracy of the
accounts.
All business transactions are recorded systematically and the chances
of error are reduced.
It enables one to know at any time the amounts receivable/ payable
from/ to customers, expenses and income under each head of account
and the amount spent under various heads.
The system enables the accountant to prepare the annual accounts
profit and loss account and balance sheet.
The system can be implemented by any type / size of organization.
The rules of double entry system of book keeping in respect of the three
kinds of accounts are given below:
Rule for Personal accounts: Debit the receiver and credit the giver.
Rule for Real accounts: Debit what comes in and credit what goes out.
Rule for Nominal accounts: Debit the expenses or losses and credit the
income or gains.
Journal Ledger
A book of original entry. A book of final entry.
Transactions are recorded daily Posting is made simultaneously from
journal
Information about accounts is datewise Information is account-wise and
chronological
Journal shows both aspects of double It shows that aspect of journal which is
entry. ( each aspect may deal with two related to the head of a/c.
heads of accounts such as real a/c,
personal a/c or nominal a/c)
Vouchers, receipts, debit/credit notes Journal constitute basic record
form basic record
The basic documents for entry.
Petty Cash Book : A petty cash book is a subsidiary book where all petty
(small value below a defined level) cash expenses are recorded, e.g.,
conveyance, cartage etc. If these petty expenses are recorded in cash book, it
will become too bulky and unwieldy. The firms therefore appoint a petty cashier
to make all petty cash payments and record them in petty cash book.
Journal : When cash transactions are entered in cash book/ petty cash book,
all non- cash transactions are routed through Journal e.g., all opening, closing
and rectification entries are first made in journal and then posted in ledger.
FINANCIAL STATEMENTS
2004 2003
Assets
Cash resources:
Loans:
Businesses and governments 13,450 11,664
Residential mortgages 11,966 10,880
Consumer 3,252 2,702
Allowance for credit losses (349) (313)
28,319 24,933
Other:
Customers liability under acceptances 3,754 3,247
For the years ended December 31 (in millions of dollars except per share amounts)
2004 2005
Interest income:
Loans 1,396 1,375
Securities 82 103
Deposits with regulated financial institutions 69 54
1,547 1,532
Interest expense:
Deposits 617 632
Debentures 34 35
651 667
Net interest income 896 865
Credit fees 81 69
Capital market fees 110 93
Investment administration fees 60 53
Foreign exchange 68 61
Trade finance 28 26
Trading revenue 12 9
Securitization income 25 26
Other 61 27
526 443
Net interest income and non-interest revenue 1,356 1247
Non-interest expenses:
Salaries and employee benefits 423 379
It has been previously stated that the bank accounting double entry
concept follows accrual principle wherein the income and expenditure for
the year whether or not actually received / spent is accounted on an
accurual basis. For example, if a bank has to receive Rs.1,000 as interest
income for the period April to March the entire Rs.1000 is accounted as
income, though only Rs.900 might have been received. Actually, Rs.1,000
is shown as income. Rs.900 received and Rs.100 receivable. This concept
does not take into account possible defaults. As such defaults and bad
accounts are recorded as and when they occur.
The term loan is treated as NPA, if interest installment remain overdue for
more than 180 days while cash credit/overdraft account is treated as NPA,
if outstanding amounts remain over and above sanctioned limits/ drawing
power for more than 90 days.
Secured portion:
1 to 3 years- 30%
GLOSSARY
Account Payee - These are the words added to the crossing on a cheque,
which means that the cheque be collected through a banker and proceeds
deposited, only in the payees account. These words, however, do not affect the
negotiability of a cheque.
Bond Bonds are medium or long term debt instruments issued by Government
of India or State Government or Public Sector Undertakings
Bank Rate - Interest rate at which the Central bank lends to the commercial
banks
Bill re-discounting - Discounting a bill (generally by the Central Bank) that has
already been discounted by a commercial bank.
Bank Charges - This term is used for the charges levied by a bank for the
various services it renders to its customers.
Bank Draft - A bank draft is a cheque drawn by a bank on one of its own
branches or correspondents requesting the latter to pay the specified sum of
money to the person named in the draft.
Basel-II -The revised Basel Capital Accord that seeks to make the capital
adequacy requirements for banks more risk-sensitive than the original 1988
Accord.
Correspondent Bank - 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.
Current Assets - Assets which are reasonably expected to convert into cash
during the operating cycle of business, e.g., stock, debtors, cash ,etc.
Capital Reserves - A reserve created out of capital profits like share premium,
profit on revaluation of assets etc.
Cash Credit - It is a running account for drawing within a specified credit limit
sanctioned by the bank against the security of stocks (raw materials, stock-in-
process, finished goods, stores) and book debts, which are pledged/
hypothecated by the borrower
Disintermediation - The borrowing and lending of funds without the use of the
middleperson e.g., banks, brokers, etc.
Debit Card - A card that resembles a credit card but which debits a transaction
account (checking account) with the transfers occurring concurrently with the
customer's purchases.
Equity - Money invested in a company by the owners via issued share capital
and reserves.
Fixed Deposit Account - Fixed Deposits are for a fixed or specified period
chosen by the depositor and are repayable on expiry of that period.
Finished Goods Completed goods held by a business and ready for sale.
Fixed Assets - Assets that are normally purchased for long term use, e.g., car,
machinery, etc.
Hire purchase Agreement - An agreement under which the goods are let on
hire and the hirer has an option to purchase them in accordance with the terms of
the agreement.
Lien - Where the debt is due by one person to another, the creditor has the right
to hold and retain the debtors property until the debt has been settled.
Net Profit - Actual profit made by a company after taking away the variable and
fixed costs.
Nomination - Banks ask their account holders to make nominations which mean
that they should nominate persons to whom the money lying in their accounts
should go in the event of their death. Nomination can be made in account
opening form itself or on a separate form indicating the name and address of the
nominee. The account holders can change the nomination any time.
Net worth - The amount by which an individual/firms assets exceed the liabilities
Non-performing assets - Any asset that is not effectively earning any income.
Primary Dealers - Dealers who first buy securities that are issued in the market,
especially government securities.
Pension Funds- Investment firms whose main source of funds are the pensions
of salaried employees.
Profit & Loss Statement - it shows the performance concern during the relevant
period [normally, one year] showing the sources and the amount of revenue and
the expenses incurred and profit or loss made by the business.
Stock - Accumulated value of raw materials, work in progress and finished goods
held by a company at a specific time.
Trade Creditors - Suppliers the company owes money to, usually for services or
goods supplied.
Trade Debtors - Clients who owe the company money for services and goods
bought on credit.
Savings Deposit Account - Such deposit accounts are generally meant for a
class of people who want to save a small part of their income to be used in the
near future and also intend to have some income on such savings.
Standing Instructions - Such term, when used in the context of a banker and
customer relationship is meant to be an instruction given by a customer to his
Stop Payment - A customer has a legal right to give instruction to bank for
stopping payment of a cheque issued by him but before it has been presented for
payment.
Tier 1 capital- A term used to describe the capital adequacy of a bank. Tier-I
capital is core capital, which includes equity capital and disclosed reserves.
Treasury Bills- A government security with a maturity period of less than a year
Term Deposits It is a Time Deposit accepted for a fixed period carrying a fixed
rate of interest.
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ABBREVIATIONS
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Sample Questions
[Question Paper pattern]
Q 7. High volume and low size accounts with multiple distribution channels are
considered as some of the characteristic features of the following type of banking
a] Retail Banking
b] Wholesale Banking
c] International Banking
d] Universal Banking
Q 11. One essential requirement for a bank is that the deposits should be
collected by it from:
a] General Public
b] High Net Worth individuals.
c] Government Institutions.
d] Target clients and private corporations.
Q 12. The ability of a bank to meet the demand of its depositors and other
creditors in time is called:
a] Solvency
b] IT architecture and its soundness
c] Efficiency of its staff.
d] High profits in last three years.