COBK Session 2

Pradeepta Sethi
TAPMI
 Financial statements of bank
Preparation and finalization of financial statements of a bank are
governed by Banking Regulation Act 1949.
RBI devised a format for preparing balance sheet and each bank
has to follow the same format.
Section 29 - Every bank has to publish the balance sheet as on
last working day of March every year on the prescribed Form A &
profit and loss account on Form B on 3rd schedule of this Act.
Section 30 - Balance sheet is to be audited from qualified auditors.
Section 31 - Each bank is required to submit balance sheet and
auditors report within three months from the end of period.
The RBI has powers to modify and suggest certain changes in the
financial reporting format from time to time.
Item Schedule Coverage
Interest 13 I. Interest /discount on advances/bills.
earned II. Income on investments
III Interest on balances with Reserve Bank of India and other interbank funds
Other 14 I. Commission, Exchange & brokerage
Income II Net Profit on sale of Investments (net profit on sale-net loss on sale)
III. Net Profit on revaluation of investments
IV. Net Profit on sale of land, building & other assets
V. Profit (net of loss) on exchange transactions
VI. Income earned by way of dividends, etc. from subsidiaries/companies
and/or joint ventures abroad/in India
VII. Miscellaneous Income
Interest 15 I. Interest on deposits
Expended II. Interest on RBI/ Inter-Bank borrowings & III. Others
Operating 16 I. Payments to and provisions for employees II. Rent, Taxes & Lighting
Expenses III. Printing & Stationery IV. Advertisement and Publicity
V. Depreciation on Banks property, VI. Directors fees, allowances and
expenses VII. Auditors fees & expenses (including branch auditors)
VIII. Law charges IX. Legal and other expenses debited in respect of PB
Accounts, X. Postage, Telegram, Telephones, etc. XI. Repairs and
Maintenance XII. Insurance XIII. Other Expenditure
Provisions Provisions & Contingencies made for i) Income Tax ii) Other Taxes
& Contin- iii) NPAs iv) Investments v) Others
-gencies I. Transfer to Statutory Reserves II. Transfer to Capital
 Bank earnings
Principal source of banks earning
Net Interest Income (NII) = Interest income Interest expense

It accounts for at least 70% of banks income.

Net Interest Margin (NIM)

Net Interest Income / total average interest earnings assets
over the period

The net interest margin (NIM) is driven by the composition of

the balance sheet and by the interest rates applicable to the
individual asset and liability accounts.
 Why bank earnings are important?

Banks earnings provide for internal capital formation.

Healthy profits are needed to absorb loan losses and to

build adequate provisions.

A consistent earnings performance builds public confidence

in the bank - attract new investor capital.

Public confidence - is the most valuable banking asset - it

allows to minimize funding costs and provides access to the
best borrowers.
 Schedule As on (Current As on (Previous
Items
No year) in crore year) in crore
CAPITAL AND LIABILITIES:
Capital 1
Reserves & Surplus 2
Deposits 3
Borrowings 4
Other Liabilities and Provisions 5
ASSETS:
Cash and balances with R.B.I 6
Balances with banks and Money
7
at call and short notice
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
TOTAL
Contingent liabilities 12
Bills for collection
 Balance sheet
Banks sources of funds on one side (liabilities and capital)
and its use of funds (that is, its assets) on the other side.
As an accounting rule, total liabilities plus capital must equal
total assets.
Banks fund their activities by a mixture of borrowed funds
(liabilities) and their own funds (capital).
Liabilities include retail DEPOSITS from households and
firms, such as current, savings accounts, fixed deposits,
wholesale funding: borrowing funds from institutional
investors, borrow from other banks.
Assets - LOANS to households, business, lending to
wholesale market, interbank market
 Balance sheet

Capital
For PSUs
Capital owned by Central Government (major portion).
Other Indian banks
Authorized, Issued, Subscribed and Called up capital should
be given separately.
Banking Companies incorporated outside India
The amount of deposit kept with Reserve Bank of India,
under sub-section 2 of section 11 of the Banking Regulation
Act 1949.
 Balance sheet

For supervisory purposes capital is split into two categories.

Tier I Capital
Capital which is first readily available to protect the unexpected
losses.
Tier I items are deemed to be of the highest quality.
Hence it is also known as Core Capital.
It consists mainly of paid up capital, statutory reserves & capital
reserves.
 Balance sheet
Tier II Capital

Capital which is second readily available to protect the

unexpected losses.

The loss absorption capacity of Tier II capital is lower than that

of Tier I capital.

Hence, it is known as Supplementary Capital.

Tier II capital consists undisclosed reserves & paid up capital

perpetual preference shares, subordinated debt, [revaluation
reserves (at discount of 55%)- From 2016 To be included in
Tier I] & general provisions and loss reserves.
 Balance sheet
Reserve
Reserve created in terms of section 17 or any other section of Banking
Regulation Act.

Capital Reserve
That portion of a bank's profits not paid out as dividends to
shareholders.
Surplus on revaluation or sale of fixed assets should be treated as
capital reserves.
Premium on issue of share capital may be shown separately under
this head.

Revenue Reserve
Any reserve other than capital reserve, other than those separately
classified
 Funds Transfer Pricing (FTP)
Funds surplus branches - mobilize more deposits but extend
lesser amount of loan Provider of funds

Funds deficit branches - more potential for extending loans

and advances User of funds

Surplus bank branches supply to the deficit branches.

The supplier branch is compensated by way of interest

payments by the deficit branch.

The interest at which the supplier branch is compensated is

known as transfer price.
 Funds Transfer Pricing (FTP)

A transfer price is an internal rate of interest used to calculate

transfer income or cost due to an internal flow of funds in a
bank.

It is similar to actual rate of interest paid or received on a

bank product, since it concerns the same transaction balance
that the actual rate of interest does.

The interest margin is the difference between interest rate

and a transfer price, and it allows calculating the internal
interest profit on a transaction.
 Funds Transfer Pricing (FTP)

Without funds transfer pricing system

Net funds users would receive credit for interest income without
being charged for the full amount of associated interest
expense.

While net funds providers would be charged with interest

expense without being credited for the full amount of assisted
interest income.

Net funds users have the advantage because all interest

income is associated with assets and all interest expense is
associated with liabilities. So, the net users appear more
profitable than the net providers.
 Transfer Price

Transfer pricing provides an internal source of revenue to net

funds providers and an internal source of expense to net
funds users.

Transfer Price (TP) has been defined as a method to

individually measure how much each source of funding is
contributing to overall profitability.

The transfer pricing process is most often used in the

banking industry as a means of outlining the areas of
strength and weakness within the funding of the institution.
 Transfer Price

TP can be termed as an internal measurement and allocation

process that assigns a profit contribution value to funds
collected and lent or invested by the bank.

It is an important component of the profitability measurement

process, as it allocates and contributes to profitability, net
interest margin.

Traditionally, banks have viewed their branches, particularly

those with surplus deposits as the cost generators and their
loan extending branches as the profit makers.
 Transfer Price
This is done by the controlling office of the bank mainly
under the Asset-liability Management (ALM) system.
The following may help to increase profitability of a bank in
the transfer pricing process.
Proper allocation of resources to optimize revenues.
The choice of alternative investment and funding decisions.
Identify high-performing assets and investments.
Understanding of poor-performing assets and other products
Arriving at better pricing decisions.
Evaluating the performance of the treasury group &
Strengthening the budgeting process.
 Transfer Pricing Mechanism

Segregation of interest income into various segments

Transferring interest rate risk to ALM unit

Pricing funds to branches with economic benchmarks, using

economic transfer prices and other methods.

ALM unit aims to maintain interest rate risk within

prescribed limits while minimizing the cost of funds or
optimizing the return on investments.

Transferring funds between branches.

 CAMELS Approach
1980s - the US supervisory authorities, through the use of the
CAMEL rating system introduced ratings for on-site
examinations of banking institutions to classify a bank's
overall condition point in time assessment
The component of bank condition that are assesses
Capital adequacy
Assets
Management capability
Earnings
Liquidity (also called asset liability management)
Sensitivity (sensitivity to market risk, especially interest rate risk)
 CAMELS Approach

Each of the component factors is rated on a scale of 1 (best)

to 5 (worst).

A composite rating is assigned as an abridgement of the

component ratings and is taken as the prime indicator of a
banks current financial condition.

The composite rating ranges between 1 (best) and 5 (worst).

The CAMELS ratings are normally assessed every year.

 CAMELS Approach

Objective of supervision - Protection of depositors interests

and ensuring financial health of individual banks/FIs.

In 1995, S. Padmanabhan committee recommended for

Indian banks, six rating factors viz. Capital Adequacy, Asset
Quality, Management, Earnings, Liquidity, Systems and
Controls (i.e. CAMELS).

Foreign banks, five rating factors viz., Capital Adequacy,

Asset Quality, Liquidity, Compliance, Systems and Controls
(i.e. CALCS).
 CAMELS Approach
Each of the components of CAMELS is rated on a scale of 1-100 in
ascending order of performance.
The score of each CAMELS element is arrived by aggregating (by
assigning proportionate weights) the scores of various sub-
parameters that constitute the individual CAMELS parameter.
Each parameter is awarded a rating A-D (A-Good, BSatisfactory,
C-Unsatisfactory, and D-Poor).
The composite CAMELS rating is arrived by aggregating each of
the component weights.
Further the overall composite score is adjusted downwards for
poor performance in one or more components.
Rating Symbol Rating symbol indicates
A+, A, A- Good
B+, B, B- Satisfactory
C+, C, C- Unsatisfactory
D Poor

Weights of various parameters under the CAMELS/CALCS Model

CAMELS CALCS
Capital Adequacy 18 18
Asset Quality 18 18
Management 18 --
Earnings 10 --
Liquidity 18 18
Compliance -- 26
System & Control 18 20