Question Paper

Management of Financial Institutions – II (322) : October 2003

Part D : Case Study (50 Points)
This part consists of questions with serial number 1 - 5.
Answer all questions.
Points are indicated against each question.
Do not spend more than 80 - 90 minutes on Part D.

Case Study
Read the case carefully and answer the following questions:
1. Compute the relevant ratios to evaluate the bank’s performance in the following areas.
i. Liquidity
ii. Deployment
iii. Profitability
iv. Productivity
(12 points) < Answer >
2. Comment on the performance of the bank based on the ratios computed above.
(8 points) < Answer >
3. Compute the NDTL of the bank as on 31.3.2003. Comment on the levels of CRR and
SLR maintained by the bank.
(10 points) < Answer >
4. What will be the return to the investor if the P/E ratio declines from 6 to 3.5 during
the year 2002-2003?
(8 points) < Answer >
5. Explain the various kinds of financial intermediation performed by financial
intermediaries and state its advantages.
(12 points) < Answer >
Syndicate Bank
Balance Sheet as at 31st March 2003
 (Rs. in cr.)
As on As on
Schedule
31 March 2003 31 March 2002
CAPITAL AND LIABILITIES
Capital 1 471.94 471.94
Reserves and Surplus 2 1107.64 938.44
Deposits 3 30660.55 28548.33
Borrowings 4 78.77 36.65
Other liabilities and Provisions 5 2116.53 1760.82
Total 34435.43 31756.18
ASSETS
Cash and balances with Reserve Bank of India 6 1649.98 1972.03
Balances with banks and money at call & short
notice 7 869.03 1184.80
Investments 8 13823.24 11910.60
Advances 9 16305.35 14884.66
Fixed Assets 10 343.18 338.99
Other Assets 11 1444.65 1465.10
Total 34435.43 31756.18
Contingent liabilities 12 22730.73 11884.77
Bills for collection 740.90 736.15

Profit and Loss Account for the Year Ended 31st March 2003
 (Rs. in
cr.)
As on As on
Schedule 31 March 31 March
2003 2002
I INCOME
Interest earned 13 2875.17 2882.41
Other income 14 495.08 276.04
TOTAL 3370.25 3158.45
II EXPENDITURE
Interest expended 15 1665.45 1774.87
Operating expenses 16 1086.02 1028.34
Provisions and contingencies 274.65 104.69
TOTAL 3026.12 2907.90
III PROFIT/ LOSS
Net Profit for the Year 344.13 250.55
TOTAL 344.13 250.55
IV APPROPRIATIONS
Transfer to statutory reserves 86.04 62.64
Transfer to Investment Fluctuation Reserve 93.24 41.79
Transfer to Capital Reserves 15.72 –
Redemption Reserve for Bonds 35.14 35.14
Dividend (inclusive of Dividend tax of Rs.9.07 cr,
previous year nil) 79.86 56.63
Balance carried over to Balance Sheet 34.13 54.35
TOTAL 344.13 250.55

SCHEDULE 1 : CAPITAL
(Rs. in cr.)
As on As on
31 March 2003 31 March 2002
A. Authorized Capital:
150,00,00,000 equity shares of Rs.10 each 1500.00 1500.00
B. Issued, Subscribed and Called up capital:
47,19,68,282 equity shares Equity shares of Rs.10 each
(including 346968282 shares held by Central
Government) 471.96 471.96
Less: Allotment Money due 0.02 0.02
TOTAL 471.94 471.94
SCHEDULE 2 : RESERVES AND SURPLUS
(Rs. in cr.)
 31.3.2003 31.3.2002
I Statutory Reserves
Opening Balance 231.00 168.36
Additions during the year 86.03 317.03 62.64 231.00
II Capital Reserves
Opening Balance 0.04 0.04
Additions during the year 15.72 15.76 0 0.04
III Revaluation Reserve
Opening Balance 205.90 208.08
Deductions during the year 2.33 203.57 2.18 205.90
IV Investment Fluctuation Reserve
Opening Balance 119.99 78.20
Additions during the year 93.24 41.79
Deductions during the year 0 213.23 0 119.99
V. Redemption Reserve for Bonds
Opening Balance 106.85 71.71
Additions during the year 35.14 141.99 35.14 106.85
Transfer to General Reserve
VI. Revenue and Other Reserves
Opening Balance 2.40 2.41
Add: Transfer of balance in P&L a/c 272.25 0
Less: Deductions during the year 92.72 181.93 0 2.41
VII. Balance in Profit and Loss account
Opening Balance 272.24 217.90
Less: Transfer to Revenue and other 54.35 272.25
Reserves 272.24
Additions during the year 34.13 34.13
TOTAL (I + II + III + IV + V + VI + VII) 1107.64 938.44
SCHEDULE 3 : DEPOSITS
 (Rs. in cr.)
As on As on
31 March 2003 31 March 2002
A I. Demand Deposits
(i) From banks 145.96 99.39
(ii) From others 3290.13 3213.27
II. Savings Bank Deposits 8642.75 7511.04
III. Term Deposits
(i) From banks 1545.20 2672.58
(ii) From others 17036.51 15052.05
TOTAL (I, II & III) 30660.55 28548.33
B I. Deposits of branches in India 29118.24 26616.35
II. Deposits of branches outside India 1542.31 1931.98
TOTAL (I & II) 30660.55 28548.33

SCHEDULE 4 : BORROWINGS
(Rs. in cr.)
As on
As on 31 March
31 March 2003 2002
I. Borrowings in India
(i) Reserve Bank of India 0 0
(ii) Other banks 16.13 21.32
(iii) Other institutions and agencies 14.64 15.33
TOTAL I 30.77 36.65
II. Borrowings outside India 48.00 0
TOTAL: (I & II) 78.77 36.65
Secured Borrowings included in I & II above 0 0

SCHEDULE 5 : OTHER LIABILITIES AND PROVISIONS

(Rs. in cr.)
 As on As on
31 March 31 March
2003 2002
I Bills payable 487.17 657.03
II Inter-office adjustments (net) 13.66 0
III Interest accrued 173.85 176.39
IV a. Subordinated Debt (12 yr. Maturity) 88.79 88.79
b. 7 yr. Unsecured Redeemable Bonds 170.00 170.00
(a + b Subordinate for Tier II Capital)
V. Others (including provisions) 1183.06 668.61
TOTAL (I + II + III + IV + V) 2116.53 1760.82

SCHEDULE 6 : CASH AND BALANCES WITH RESERVE BANK OF INDIA

(Rs. in cr.)
As on As on
31 March 2003 31 March 2002
I Cash on hand
(Including foreign currency notes) 147.59 149.21
II Balance with Reserve Bank of India
(i) in Current Account 1502.39 1822.82
(ii) in Other Accounts 0 0
TOTAL (I + II) 1649.98 1972.03

SCHEDULE 7 : BALANCES WITH BANKS AND MONEY AT CALL AND

SHORT NOTICE
 (Rs. in cr.)
As on As on
31 March 2003 31 March 2002
I In India
(i) Balances with banks
(a) in Current Accounts 63.70 47.22
(b) in Other Deposit Accounts 378.66 557.99
(ii) Money at call and short notice
(a) With Banks 400.00 400.04
(b) With Other Institutions – –
TOTAL: (I & II) 842.36 1005.25
II Outside India – Balances with banks
(i) in Current Accounts 21.85 16.88
(ii) in Other Deposit Accounts 4.82 162.67
TOTAL (I + II) 869.03 1184.80
SCHEDULE 8 : INVESTMENTS
 (Rs. in cr.)
As on
As on 31 March
31 March 2003 2002
I Investments in India (Gross) 13709.40 11735.11
Less: Provision for depreciation/NPA 57.22 61.06
Net Investments 13652.18 11674.05
i. Government securities 11887.26 9750.47
ii. Other approved securities 341.60 390.94
iii. Shares 116.07 93.47
iv. Debentures and Bonds 1018.70 1228.98
v. Subsidiaries and/or Joint Ventures 33.35 33.35
vi. Others
a. Units 133.52 13.30
b. Deposit with RIDF 71.10 73.26
c. Commercial Paper 50.58 90.28
TOTAL 13652.18 11674.05
II. Investments Outside India (Gross) 171.06 236.55
Less: Provision for Depreciation – –
Net Investments 171.06 236.55
Others:
Floating Rate Notes and Other Bonds 171.06 236.55
TOTAL (I + II) 13823.24 11910.60
SCHEDULE 9 : ADVANCES
 (Rs. in cr.)
As on As on
31 March 31 March
2003 2002
A. (i) Bills purchased and discounted. 583.87 333.53
(ii) Credits, overdrafts and loans repayable on demand 8556.85 8336.04
(iii) Term Loans (including short term loans) 7164.63 6215.09
TOTAL A 16305.35 14884.66
B. (i) Secured by tangible assets 11187.47 8793.86
(ii) Covered by Bank/Government Guarantees 1367.16 1171.31
(iii) Unsecured 3750.72 4919.49
TOTAL B 16305.35 14884.66
C.I. Advances in India
(i) Priority Sectors 5041.51 4101.35
(ii) Public Sector 2564.39 2511.31
(iii) Banks 300.18 83.21
(iv) Others 6006.89 5250.55
TOTAL C I 13912.97 11946.42
II Advances outside India
(i) Due from banks 1666.01 2473.29
(ii) Due from others
(a) Bills purchased and discounted 0 2.27
(b) Syndicated loans 621.37 368.33
(c) Others 105.00 94.35
TOTAL C II 2392.38 2938.24
TOTAL (C I + CII) 16305.35 14884.66
SCHEDULE 10 : FIXED ASSETS
 (Rs. in cr.)
As on As on
31 March 2003 31 March 2002
I Premises
At cost as on 31 March of the preceding year 287.33 281.33
Additions during the Year 6.79 6.86
Deductions during the Year 2.59 0.86
Add: Revaluation 0 0
Less: Depreciation to date 35.56 31.40
255.97 255.93
Add: Building under Construction 5.84 5.09
TOTAL 261.81 261.02
II Other fixed assets
(Including furniture and fixtures)
At cost as on 31 March of the preceding year 197.97 165.02
Additions during the Year 38.01 37.43
Deductions during the Year 7.05 4.49
Depreciation to date 147.56 119.99
TOTAL 81.37 77.97
TOTAL (I + II) 343.18 338.99
SCHEDULE 11 : OTHER ASSETS
(Rs. in cr.)
As on As on
31 March 2003 31 March 2002
I Inter-office adjustments (net) 0 9.65
II Interest accrued 424.01 436.47
III Tax paid in advance less provisions 25.53 27.26
IV Stationery and stamps 7.27 7.39
V Non-banking assets acquired in satisfaction of claims 0.36 0.40
VI Others 987.48 983.93
TOTAL 1444.65 1465.10
SCHEDULE 12 : CONTINGENT LIABILITIES
 (Rs. in cr.)
As on As on
31 March 31 March
2003 2002
I Claims against bank not acknowledged as debts 64.52 54.23
II Liability for partly paid investments 0.11 0.11
III Liability on account of outstanding forward exchange
contracts 20442.51 10163.51
IV Guarantees given on behalf of constituents
i) In India 1153.49 932.92
ii) Outside India 0.76 1.32
V Acceptances, endorsements and other obligations 603.14 422.46
VI Other items for which the bank is contingently liable
i) Liability on bills of exchange rediscounted 1.22 10.79
ii) Estimated amount of contracts remaining to be
executed on capital account not provided for 2.96 0.09
Others 462.02 299.34
TOTAL 22730.73 11884.77

SCHEDULE 13 : INTEREST EARNED

(Rs. in cr.)
As on As on
31 March 2003 31 March 2002
I Interest/discount on advances/bills 1533.68 1599.67
II Income on investments 1278.94 1206.75
III Interest on balances with Reserve Bank of India and
other inter-bank funds 59.44 74.41
IV Others 3.11 1.58
TOTAL 2875.17 2882.41

SCHEDULE 14 : OTHER INCOME

 (Rs. in cr.)
As on
31 March As on
2003 31 March 2002
I Commission, exchange and brokerage 109.74 103.35
II Profit/Loss on sale of investments (Net) 277.58 73.85
III Profit (– loss) on revaluation of investments (Net) –14.45 –6.86
IV Profit on sale of land, buildings and other assets (Net) –0.09 0.08
V Profit on exchange transactions (Net) 31.47 28.58
VI Miscellaneous income 90.83 77.04
TOTAL 495.08 276.04
SCHEDULE 15 : INTEREST EXPENDED
(Rs. in cr.)
As on As on
31 March 31 March
2003 2002
I Interest on deposits 1630.72 1708.11
II Interest on Reserve Bank of India/inter-bank
borrowings 1.96 2.65
III Others 32.77 64.11
TOTAL 1665.45 1774.87
SCHEDULE 16 : OPERATING EXPENSES
 (Rs. in cr.)
As on As on
31 March 2003 31 March 2002
I Payments to and provisions for employees 849.76 815.78
II Rent, taxes and lighting 64.31 58.21
III Printing & Stationery 9.03 8.01
IV Advertisement & Publicity 3.47 1.81
V Depreciation on bank's property 33.74 24.58
VI Directors' fees, allowances & expenses 0.22 0.24
VII Auditors' fees & expenses 6.77 7.96
VIIILaw charges 0.77 0.64
IX Postage, telegram, telephones, etc. 12.94 12.26
X Repairs & maintenance 12.04 9.51
XI Insurance 13.64 12.39
XII Other expenditure* 79.33 76.95
TOTAL 1086.02 1028.34
*Includes Pigmy Agents’ Commission 19.87 24.56
Other information:
In terms of the guidelines issued by the RBI, the following additional disclosures are made:
 31.03.200 31.03.2002
3
i. Shareholding
Percentage of shareholding of Government of India 73.52% 73.52%

ii. Non-Performing Assets

The Percentage of Net NPAs to Net Advances 4.29% 4.63%

iii Provisions and Contingencies

The break up of “ Provisions & Contingencies” (Rs. in Cr)
appearing in the Profit and Loss a/c is as under:
a. Provision made towards NPA 98.38 74.28
(Sufficiently covered by provisions already made
and write back)
b. Provision made for Income tax 110.00 22.50
c. Contingency provision for Standard Assets 3.48 4.06
d. Contingency provision for 90 days norms 14.75 9.82
e. Bad Debts written off 42.31 13.20
f. Others 14.79 16.12
Total 283.71 139.98
Less:
g. Excess Provision of depreciation on investments 3.84 16.32
written back
h. Write back of excess provisions 5.21 18.98
Total 9.05 35.30
Grand 274.66 104.68

iv. Tier II Capital

Amount of subordinated debts raised as Tier II capital *258.79 *258.79

v. Number of employees 26,475 27,990

* (Includes Unsecured Redeemable bonds of Rs.170 crores).

END OF PART D

Part E : Caselets (50 Points)

This part consists of questions with serial number 6 - 13.
 Answer all questions.
Points are indicated against each question.
Do not spend more than 80 - 90 minutes on Part E.

Caselet 1
Read the caselet carefully and answer the following questions:
6. Discuss the need for replacing the 1988 capital Adequacy Accord. What are the three
pillars of the new framework targeted to achieve?
(7 points) < Answer >
7. New Basel capital accord (also known as Basel II) norms contain two approaches to
measure credit risk namely (i) standardized approach and (ii) Internal Rating Based
approach. Explain these approaches.
(6 points) < Answer >
8. How the regulator can bring market discipline to protect the banking system?
(7 points) < Answer >
A key aspect of the first pillar of Basel II is the refinement of the risk weights assigned to
different assets to more accurately reflect the risks in the banking and trading book.
Market risk standards set by Basel II cover the risk in the “trading book,” and put capital
charges on foreign exchange and commodity contracts, debt and equity instruments, and
related derivative and contingent items. The committee provides some flexibility in terms of
measuring risk. Banks can use either an Internal Model or a Standard Model.
With respect to a bank’s exposure to interest rate risk, the Basel principles require that banks
hold capital that is proportionate to the risk exposure of the “banking book”. The
recommendations also stress the need for banks to disclose the level of interest rate risk and
their risk management approach. The role of supervision is important in that supervisors are
qualitative and quantitative information on derivative and securitization activities; impaired
loans and allowances for impairment by asset type; cash flows that ceased because of
deterioration; and a summary of exposures that have been restructured.
Banks were quick to react to the “regulatory tax” imposed by Basel I by engaging in activities
that exploited the divergence between the true economic risks and the measure of risks
embodied in the regulatory capital ratios. This “regulatory capital arbitrage” allowed banks to
minimize the effective capital requirements per dollar of economic risk retained by the bank.
While Basel II is quite flexible and allows banks to choose the risk management methodology
appropriate to their level of sophistication, risk measurement raises a number of difficult
questions. Even large banks using VaR models have had to face important challenges, such as
model uncertainty, parameter uncertainty, and intraday uncertainty when it comes to dealing
with trading positions. Regulators also confront difficult issues when examining bank VaR
models. How do they assess the accuracy of a bank’s internal risk model? Are the banks’
internal ratings sufficiently independent or do they merely mimic external ratings? What
standard should be used to compare such models across banks? Can banks manipulate these
ratings to lower capital charges? How are regulators to enforce the ratings or impose
sanctions based on the ratings produced by such models? These questions highlight the
difficulty of relying solely on regulation to control bank behavior, and underline the
importance of bank supervision in the new environment.
Operational risk by its very nature is hard to measure and manage. For example, estimating
loss experiences due to operational failure are difficult and usually subjective. Standard
insurance contracts meant to cover business interruptions do not provide adequate coverage,
due to lack of historical data. The need to deal with such operational risks was a reaction to
regulatory capital arbitrage. Banks, having found that activities that involved credit risk and
interest rate risk have become less profitable due to the new regulatory tax, allocated more
assets to new activities such as fee-based services and custom-tailored contracts. These
activities, because of their general complexity, involve high operational risk.
Under Basel II governments will also be affected. While the new Accord maintains the same
minimums regarding risk-weighted capital requirements, external credit assessment of
borrowers is suggested for banks that do not have their own internal system of assessment.
Thus, if credit rating agencies view the state of government finances as precarious, a low
sovereign credit rating would imply a higher capital charge. To avoid a higher capital charge
or risk lowering their own credit rating, local as well as foreign banks may reduce lending to
the government. This may in turn force governments to seek other ways of financing their
needs and pressure them to put their fiscal house in order.
Caselet 2
Read the caselet carefully and answer the following questions:
9. The article says that NPAs in India’s banks rose from Rs.37,500 crore in 1991-92 to
Rs.1,10,000 crore in 2001-02. What problems a bank will face due to NPAs.
(6points) < Answer >
10. What measures you suggest to the banks, to contain NPAs?
(6 points) < Answer >
11. How the ordinance called ‘Securitisation and Reconstruction of Financial Assets and
Enforcement of security interest ordinance 2002 is useful in recovery of NPAs?
(6 points) < Answer >
It has been known for sometime now that India’s banking system is burdened with a huge
volume of NPAs, or loans on which borrowers have defaulted on interest and amortization
payments. What is noteworthy is that much of the NPA burden was accumulated during the
years of reform. According to one estimate, NPAs in India’s banks rose from Rs. 37,500 cr at
the end of financial year 1991-92 to Rs.1,10,000 cr at the end of 2001-02. Given their
importance within the banking system, the public sector banks accounted for much of the
NPAs. At the end of financial year 2002, the accumulated NPAs of 27 public sector banks
totaled Rs. 56,000 cr.
The distribution of the NPAs was skewed in favor of big borrowers, who with 11,000
individual accounts accounted for as much as Rs. 40,000 cr of total bad debt. Among public
sector banks too high-value defaults involving 1,741 accounts exceeding Rs. 5 cr amounted
to Rs. 22,866 cr or 40% of the total. Although this concentration of bad debt among large
borrowers should have made recovery easier, the actual record of recovery has been
extremely poor. An assessment conducted by the All India Bank Officers’ Association
(AIBOA) in December 2002, indicated that less than Rs. 5,000 cr of bad debt had been
recovered during the preceding eight years.
This record of poor recovery is observed in a period when the NPA burden of the banking
system was receiving considerable attention, since as part of the ongoing financial reform
process banks were required to deal with their NPA legacy and set their books in order to
meet more stringent capital adequacy norms and rules of accounting. Bad debts were being
used to pillory the public sector banks and justify privatization, though large private players
with payments defaults were responsible for the state of the banks and it was clear that
privatization would be feasible only if these liabilities were dealt with or written off.
Among the many routes that were pursued to deal with the accumulating bad debt legacy,
there were some that received special attention. The first and most obvious route was to
restructure existing loans so as to reduce the payments burden and extend the payments
deadline faced by borrowers so that they could revive themselves. Such restructuring
involves some temporary sacrifice on the part of the banks aimed at encouraging revival of
the afflicted unit. According to one estimate, by the end of March 2002, banks had
restructured assets to the tune of Rs.7,000 cr.
The second was to set aside potential profits as provisions for bad assets. Banks have only
gone part of the way in this direction. While the cumulative provisions against loan losses of
the public sector banks worked out to 42.5% of the gross NPAs for the year ended March 31,
2002, international norms were as high as 140%.
The third was capital infusion by the government into the public sector banks. It is estimated
that until March 1999, the government had already injected Rs.20,446 cr towards
recapitalization of public sector banks (PSBs) to help them fulfil the new capital adequacy
norms. More recently, the SP Talwar and Verma committees set up by the Finance Ministry
had recommended a two-stage capitalization process for three weak banks (Indian Bank,
United Bank of India and United Commercial Bank) involving infusion of a total of Rs. 2,300
cr for shoring up their capital adequacy ratios. Similar infusion arrangements have been under
way in the case of financial institutions like the Industrial Development Bank of India and
Industrial Finance Corporation of India and the bailout of the Unit Trust of India involved
large sums of taxpayers’ money.
Finally, there are efforts to retrieve as much of these assets as possible from defaulting
clients, either by directly attaching the borrowers’ assets and liquidating them to recover dues
or by transferring NPAs to specialized asset reconstruction or asset management companies.
The National Democractic Alliance government tried to facilitate recovery through this route
by issuing an ordinance in June 2002, which was subsequently replaced by the Securitization
and Reconstruction of Financial Assets and Enforcement of Security Interest Bill passed in
November 2002.
The Ordinance and the Bill were aimed at restructuring the framework of debt work-outs in
favor of lenders and against the borrowers.
Caselet 3
Read the caselet carefully and answer the following questions:
12. Why some of the Indian banks have not evinced interest to adopt quality
management/ISO systems?
(6 points) < Answer >
13. How the implementation of Quality Management/ISO systems is beneficial to banks?
(6 points) < Answer >
Of late, banking in India seems to be taking to Quality Management. The ICICI Bank has
adopted the Six Sigma Approach—one of the sophisticated proactive techniques —for
bringing efficiency in service. Canara Bank is reported to have adopted the ISO System for
some of its branches and offices. While some of the Indian banks have adopted the ISO
system generally, such quality systems and ratings have been confined to the branches. The
major factor responsible for the neglect of quality management system in banking may be
lack of clarity about the concept of quality and its implementation.
The basic thing about Quality Management System is that it sets up customer delight as the
central point of focus for all the operations of organizations. Secondly, it provides the
framework to measure performance at the macrolevel and requires continuous improvements.
A registration system like ISO would additionally require external validation of conformity of
working of the organization and its procedures and practices to the mission, the goals and the
regulations already set out. In fact, as the ISO 9001:2001 standards declare that the quality
standards do not suggest and even imply, “uniformity in the structure of quality management
system or uniformity of documentation like ISO do not prescribe and allow for the
development of a unique customized quality system for each organization, according to its
need and purposes and appropriate to its line of business, size and structure of the
organization and scale of its operations.”
However, the process approach advocated by the ISO 2000 standards for adoption by firms
seeks to enhance customer satisfaction by meeting customer requirements. According to the
standards, the process is defined as “an activity using resources and managed to enable the
transformation of inputs into outputs”. The scope of quality management system according to
ISO 9001:2000 is “to demonstrate its ability to consistently provide a product that meets
customer and regulatory requirements”. Naturally, the international standards are generic
benchmarks.
The ISO Quality Management System is customer-centric. In fact, the standards define the
product itself as that “intended for, or required by the customer”. Such a System emphasizes
continual improvement in the processes for value maximization. It advocates the
methodology of Plan-Do-Check -Act (PDCA) for every one of the processes. The ISO 9000-
2000 is the Certification standard which specifies the minimum requirements. The ISO
9004:2000 is wider in scope and lays down requirements for the pursuit of continual
improvement in performance.
Under the 2000 ISO standards, all activities of the organization are covered. Resource
management including human resources, design and development of products, design and
development and verification, production and service provision, validation of processes of
production and service provision, control of production, service provision, identification and
traceability, measurement, analysis and improvement and provision for continuous
improvement through corrective action and preventive action are the main features of the
quality management system as envisaged in the ISO 9001:2000 standards.
The major issues involved in implementing quality management system in banks are business
process analysis, change management and automation. While the quality management
systems do not require automation of business process analysis, the mission of customer
delight makes them unavoidable. In fact, the implementation of quality systems in banks as
elsewhere in the current context would mean wholesale transformation of the organization
into a customer driven, technology-savvy and value-delivering entity. The key prerequisite for
the implementation of such systems is leadership with vision, top management commitment
and debt management of changes in processes. In view of the fact that process changes
typically affect vested interests in the organization and also isolate and attack the restrictive
practices, and redundancies and avoidable processes, the strategic decision to go in for
quality systems needs to be sustained by unambiguous commitment of the top management
and effective communication. The big benefits are going to be greater customer mind share,
market share, money share and profit share.
END OF PART E

END OF QUESTION PAPER

 Suggested Answers
Management of Financial Institutions – II (322) : October 2003
Part D : Case Study

1. i. Liquidity
(Rs. in crore)
Particulars 2002-03 2001-02
Cash 147.59 149.21
Balance with banks 442.36 605.21
Call money 400.00 400.04
Cash and balances with banks including call money 989.95 1,154.46
Demand deposits 3,436.09 3,312.66
Total deposits 30,660.5 28,548.33
5
Total assets 34,435.4 31,756.18
3
Ratios
Cash and balance with banks including call money/ 0.2881 0.3485
Demand deposits
Cash and balance with banks including call money/ Total 0.0323 0.0404
deposits
Cash and balance with banks including call money/ Total assets 0.0287 0.0364
ii. Deployment
(Rs. in crore)
Particulars 2002-03 2001-02
Credit 16,305.35 14,884.66
Investment 13,823.2 11,910.60
4
Deposits 30,660.5 28,548.33
5
Total assets 34,435.4 31,756.18
3
Ratios
Credit/Deposits 0.5318 0.5214
Investment/Deposits 0.4508 0.4172
Credit + Investment / Deposits 0.9826 0.9386
Credit + Investment / Total assets 0.8749 0.8438
iii. Profitability
(Rs. in crore)
 Particulars 2002-03 2001-02
Interest earned 2,875.17 2,882.41
Less interest expended 1,665.45 1,774.87
Net interest income (NII) 1,209.72 1,107.54
Net profit for the year 344.13 250.55
Add provisions and contingencies 274.65 104.69
Operating profit 618.78 355.24
Total assets 34,435.4 31,756.18
3
Networth (Capital + Reserves) 1,579.58 1,410.38
Ratios
Net interest margin (NIM) = NII / Total assets 0.0351 0.0349
Return on assets (ROA) = Net profit / Total assets 0.0099 0.0079
Return on equity (ROE) = Net profit / Networth 0.2178 0.1776
Operating profit / Total assets 0.0179 0.0112
iv. Productivity
(Rs. in crore)
Particulars 2002-03 2001-02
Business (Deposits + Advances) 46,965.90 43,432.99
Net profit for the year 344.13 250.55
Number of employees 26,475 27,990
Business per employee 1.77 1.55
Net profit per employee 0.0130 0.0089
< TOP >
2. Liquidity: Liquidity position of the bank decreased during the review period. There has
been a decrease in all the liquidity ratios from the previous years level. Cash and bank
balances with banks as a percentage of demand deposits has decreased from 34.85% to
28.81%. Cash and bank balances as a percentage of total deposits and total assets are also
decreased. The drop in liquidity ratios is due to the significant reduction in balances with
banks. It appears that the bank has foregone liquidity for higher profitability.
Deployment: There has been an increase in terms of deployment of funds. The credit
deposit ratio has gone up from 52.14% to 53.18%. The deployment of funds in
investment has increased substantially from 41.72% to 45.08%. All this indicates that the
bank has deployed more funds in investments than credit. Credit expansion increases the
profitability of the bank than investing funds in securities at a lower interest rate.
Profitability: The net interest margin (NIM) has improved marginally from 3.49% to
3.51%. Both operating profit and net profit have been increased during the year under
review. The bank’s operating profit has shown a handsome increase of 74.19% and the
net profit of Rs.344.13 crores represent an increase of 37.35% over the last year’s profit
level. Return on assets increased form 0.79% to 0.99% and operating profit to total assets
increased from 1.12% to 1.79%. Increase in profitability ratios indicates that the
performance of the bank is improved in the current year.
Productivity: Employee productivity in terms of business per employee has increased
from Rs.1.55 crore to Rs.1.77 crore. Net profit per employee also increased from Rs.0.89
lakhs to Rs.1.30 lakhs. Increase in productivity ratios implies that there is an overall
improvement in operational efficiency.
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3. Calculation of NDTL
 Demand and time liabilities
(Rs. in crore)
Total deposits from others 28,969.39
Bills payable 487.17
Inter-office adjustments (Net) 13.66
Interest accrued 173.85
50% of others (assumption) 591.53
Total 30,235.60 Liabilities with
banking system
Demand deposits from banks 145.96
Term deposits from banks 1,545.20
Borrowings from banks 16.13
Total 1,707.29 Assets with
banking system
Balances with banks in India 842.36
Total 842.36 NDTL =
Liabilities to others + Net Inter-Bank Liabilities (NIBL)
Where NIBL = Liabilities to banking system – Assets with banking system
Net Inter-Banking Liabilities (NIBL) = 1,707.29 – 842.36
= 864.93
NDTL = 30,235.60 + 864.93
= 31,100.53
Balance with RBI
NDTL
CRR maintained =
1,502.39
31,100.53
= = 4.83%
CRR is maintained at 4.83% as against the required level of 4.50%
SLR maintained = Cash + Government securities + Approved securities + Net balances with banks in
current accounts
= 147.59 + 11,887.26 + 341.60 + (63.70 – 145.96)
= 12,294.19
12, 294.19
31,100.53
SLR as % of NDTL =
= 39.53%
Bank is maintaining SLR at 39.53% as against 25%.

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4.
2002- 2001-
Particulars
03 2002
Profit after tax (Rs. in Crores) 344.13 250.55
Number of fully paid outstanding equity shares (in
47.194 47.194
crores)
Earning per share (in Rs.) 7.29 5.31
P/E ratio 3.5 6
Market value per share = P/E × EPS (in Rs.) 25.52 31.86
Dividend per
 share:

Rs.79.86
Dividend inclusive of Dividend Tax
crore
Rs. 9.07
Less : Dividend Tax
crore
70.79 crore Dividend per share =
70.79/47.194 = Rs.1.50
25.52 +1.50 − 31.86
31.86
Return to the investor =
= – 15.19%
If the P/E the declines from 6 to 3.5 during the year 2002-03, the investor will have a
negative return of 15.19%.
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5. Financial Intermediaries actually perform various kinds of intermediation. They are

a. Denomination Intermediation
b. Default-risk Intermediation
c. Maturity Intermediation
d. Liquidity Intermediation
e. Information Intermediation
f. Risk Pooling and Diversification (Economies of Scale and Economies of
Scope).
Denomination intermediation is a kind that occurs when small amount of savings from
individuals and others are collected and pooled so as to give loans to others.
Default-risk intermediation refers to the willingness of financial intermediaries to make
loans to risky borrowers and, at the same time, issue relatively safe and liquid securities in
order to attract loanable funds from savers who are risk averse. Generally, the borrower
from a financial intermediary is perceived to be more risky than the financial intermediary
itself.
Maturity intermediation refers to the borrowing of relatively short-term funds from
savers, who often cannot commit their funds over long periods, and making long-term
loans to borrowers who require a long-term commitment to funds.
Liquidity intermediation refers to issuing of indirect financial claims to savers that are
highly liquid while at the same time accepting relatively illiquid direct claims from
investors which may entail considerable risk of loss and high transaction cost if these
claims were converted into cash.
Information intermediation refers to the process by which financial intermediaries
substitute their skill in gathering and processing information from the financial market
place for that of the saver who neither has time nor expertise to stay abreast of market
developments nor access to relevant information about market conditions and investment
opportunities.
Intermediaries also engage in risk pooling and take advantage of Economies of Scale in
their activities. Economies of Scale refers to decreasing of costs of overall operation and
performance by virtue of large size of operations. By investing in loans and other assets
with a wide variety of risk-return characteristics, the benefits of financial diversification
are achieved, enhancing the safety of funds supplied by savers. Most small savers cannot
adequately diversify the uses they make of their limited funds among many different
types of investments; however, an intermediary can pool the funds’ contributions of many
small savers and efficiently diversify, achieving Economies of Scope, across many
 different investments, lowering risk of all savers. Economies of Scope refers to
decreasing of costs of overall operation and performance by virtue of using the same
existing resources for various complementary operations.
The advantages of Intermediation thus lie in the following:
a. Liquidity: As mentioned above, it provides the vital link between the entity which
needs funds and the entity which has funds. In a practical scenario, it is not very easy
for an individual lender to find a borrower or vice versa on mutually acceptable
terms. It is here that a financial intermediary comes into play, borrowing from all
sundry lenders (individual sources of funds) to lend to big borrowers (users of funds).
By taking care of both sides of the funds flow, financial intermediaries help provide
liquidity to the system.
b. Cost of Funds: They reduce the overall cost of funds to the borrower. With systematic
borrowing mechanism in place, the financial intermediaries play on the Economies of
Scale of Borrowing.
Financial intermediation avoids the costs that would otherwise result from
duplication of monitoring of borrowers and the management of financial distress and
defaults. Without banks, or some equivalent agent appointed collectively, we would
individually have to monitor loans to a number of borrowers and individually have to
bear the duplicated costs of default management. Though the financial intermediary
would not be helping the borrower without charging his fees yet the overall cost
would be lesser.
c. Information: It provides vital data for the corporates who have plans to obtain funds
on the cost of funds, the extent of funds that may be made available, the maturity
period and other terms that go along with lending of money. This would help
companies in planning for future operations and to ascertain the cost of funds within
the reasonable limits.
d. Risk Reduction: The lenders of funds need not be concerned with the risk profile of
the borrowers. That is, each and every individual lender of funds need not be
convinced that the ultimate user of his funds is creditworthy. It will be the duty of the
financial intermediary to take care of the risk associated with lending to corporates
and risk arising from such business will be borne by the intermediary. Looking at the
other end of the spectrum, the corporates need not take pains to convince each and
every individual lender of funds that it is worth lending to and has risk
commensurating with the return.
e. Familiarity: Last but not the least, the advantage of repeatedly borrowing is always
with the Financial Intermediaries. They know the intricacies of law, the procedures
adopted, the manner in which the documents need to be prepared, better than
individual corporates. The existence of financial intermediaries is attributed mostly to
the disproportionate amount of information available to them as compared to the
saver. The financial intermediaries are perceived to possess `assymetric information’
which will facilitate in taking better decisions on the aspect of routing money to the
investors (asymmetric information stage is a situation in which one party to a
transaction is better informed than the other). This is in fact one of the causes for
existence of a financial intermediary.
< TOP >

Part E: Caselets
Caselet 1

6. The reasons for the replacement of the Basle Norms of 1988:

Applicability of capital ratios: In the changed environment of operations, the blurring of functional and
 national divisions among the financial intermediaries, and the speed and complexity of adjustment has
raised the issue of the continued relevance of the capital ratios to this changed environment.
One-size-fits-all: The 1988 basle norms have prescribed a single CAR for all types of banks, irrespective of
their size. It has also been noted that merely maintaining the CAR at that level will not prevent bank
failures. Further, the bank regulators of most countries have not set the CAR higher than the basle norm, in
spite of their higher risk levels when compared to the developed economies.
To remove the limitations of the 1988 norms, the Basle Committee has proposed a new framework which is
based on the following three pillars:
Minimum capital requirements: In this case, the Basle Committee aims to build the minimum regulatory
capital requirements by announcing explicit risk weighting structure for different activities. This will cover
the credit risk interest rate risk, operational risk and also market risk.
Supervisory review of capital adequacy: Here, the Committee proposes to replace the on-site inspection,
off-site surveillance and external auditing by the review of internal capital adequacy assessments of banks.
Effective use of market discipline: The third pillar of the basle norm proposes to impose market discipline
through strong incentives on banks to conduct their business in a safe sound and efficient manner. It implies
that the bank will have to provide sufficient information to enable the user to assess whether the available
capital is sufficient to meet credit risk, market risk and other risk requirements.
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7. There are two approaches to measuring credit risk—a Standardized Approach and an
Internal Ratings Based Approach (IRB). The first approach is more likely to be used by
smaller and less sophisticated banks that lack the expertise to develop their own technical
models to evaluate credit risk. Such banks are expected to use external ratings-based risk
weights, consisting of separate schedules for sovereigns/central banks, commercial banks,
and the corporate sector. In contrast, the internal rating model of choice is a Value at Risk
model (VaR) that estimates how much the value of a portfolio could fall due to an
unanticipated change in market prices. Such VaR can be used to set exposure limits for
traders and to allocate capital different activities. The IRB lets banks, subject to the
approval of supervisors; develop their own credit risk models.
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8. The regulator should make greater allowance in letting market mechanisms work,
particularly when they lead to (nonsystemic) failures of institutions. The stated objective
should be to protect the banking system and not a particular institution. In a sense this is
a rejection of the “too-big-to-fail” argument and its associated moral hazard problem, and
instead favors the safety and soundness of the system.
Regulators can also further enhance the market discipline by using market channels to
fulfill the lender-of-last-resort function. This can be achieved by minimizing discount
window lending, and using open-market operations (or other indirect monetary
instruments) to inject needed liquidity into the system.
Another example of how the regulator and the market can work together to impose
discipline is seen in the US where banks maintain capital ratios well above the regulatory
minimums. The reason why this is so is quite simple. Market participants (including
rating agencies, mutual funds, etc.) look for banks to have capital above the regulatory
standards.
In other words, banks view the true capital “requirement” as being regulatory minimums plus some margin
for error. Thus, even if regulators were to raise capital requirements, banks have to increase their capital to
maintain this “market-imposed” spread.
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Caselet 2
9. NPAs do present multi-dimensional problems to banks. The chief areas which are affected by these NPAs
are:
• • Profitability: The returns expected from a loan, which becomes an NPA will be lower than the
expected returns. Sometimes the returns earned may not suffice to meet the cost of funds and/or costs
 involved in lending. This will affect the profitability of the banks.
• • Liquidity: When the cash inflows, due to the repayments of loans, are not as per the schedule,
the liquidity of the bank will be affected.
• • Capital Adequacy Requirements: Large amount of NPAs will reduce the CAR. These in turn
will restrict the business expansion plans of the bank. Further, there will also be greater need for
provisioning.
• • Mismanagement of Time and Resources: Once as asset becomes an NPA, the bank will have to
pay a closer attention to such assets so as to ensure recovery from the same, lest they become loss
assets. This involves a lot of effort and time, which adds at to the costs of the bank.
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10. Continuous monitoring is the first and foremost thing which banks need to do in order to
prevent performing assets to slip into the non-performing category. Monitoring involves
collection of the relevant information that can give an idea of the performance of the
borrower on a continuous basis. The bank should look forward to the following:
• • Financial statements;
• • Quarterly/half-yearly statements;
• • Periodic stock statements;
• • Frequency of ad hoc limits to meet the cash commitments;
• • Reflection of purchases and sales into the account;
• • Relationship with employees/customers;
• • Average delay in payment of installments;
• • Clients projections and performances etc.
If the bank monitors on these lines at regular intervals, it will be able to identify the early warning signals
for the problem loans and also the cause for the same. With this information it can take appropriate action to
stop further deterioration of the asset quality and also make recommendations to the borrower to increase
profitability.
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11. The ordinance and the bill enable secured creditors to issue without the intervention of
any court or tribunal, a 60-day notice requesting settlement of dues. If the borrower does
not comply, the secured creditor can resort to any one or a combination of the following
actions:
• • Take possession of the secured assets of the borrower, including the right to
transfer by way of lease, assignment or sale for realizing the secured asset;
• • Appoint any person to manage the secured asset; and
• • Require at any time by notice in writing, any person who has acquired any of
the secured assets from the borrower and from whom any money is due or may
become due to the borrower, to pay the secured creditor, so much of the money as is
sufficient to pay the secured debt.
All that is required is that creditors accounting for 75% or more of the secured lending
should agree to initiate recovery proceedings.
While the borrowers are allowed to seek protection from secured creditors by filing an
appeal before the Debt Recovery Tribunals (DRTs), they will also be required to deposit
with the tribunals 75% of the amount claimed by the creditors in order to prevent misuse
of appeal provisions.
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 Caselet 3
12. The other banks have not adopted QMS on an enterprise-wide scale, due to the following
reasons:
• • The Quality Management System like ISO standards is applicable mainly to
manufacturing entities and is not material for service organizations.
• • The ISO Certification is important only for international trade and does not
have relevance for domestic operations.
• • The quality system implementation and certification is an additional work
without significant benefits.
• • Quality system like the ISO increases paper work enormously.
• • Quality systems require extensive documentation of procedures and therefore,
create operational rigidities and consequential delays and deterioration in reforms.
The above-mentioned reasons, perhaps, have been responsible for the lack of sufficient
interest on the part of banks in the quality management system.
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13. It has become necessary for banks to establish and implement effective quality
management systems in view of the following benefits:
• • Setting out the processes in detail with clarity enables an organization to ensure
that the service being provided or the product being delivered is of the kind that
satisfies the customer. The touchstone of quality is a customer’s delight.
• • Quality system ensures consistency and objectivity in operations. However, it
also provides for the exercise of judgment and qualitative decision-making wherever
such processes are provided for.
• • Existence of external validation for the conformity of the organization with its
processes ensures independent review and enables timely corrections. The framework
of continuous improvement imposed on the organization by the quality system will
push the organization at various levels—right from the lowest to the highest—to
innovate and turn in measurable improvements in performance.
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