Unit-3

Commercial banking & Retail Banks

-Credit Creation
-Sources and uses of funds in banks
-Emerging trends in banking
- Universal Banking
- Venture capital
- Project Financing
-General principle of bank management
-Asset management, capital adequacy management
 Commercial Banking
Definitions
1.Crowthers Definition
Bank is an institution which collects money
from those who have in spare or who are
saving it out of their income; and lend this
money out to those who require it.
All those institutions which are in the business
of banking are called financial institutions.
 Commercial Banking
2 Definition
Commercial Banks are like other financial
institutions ( eg. money lenders, indigenous
bankers, cooperative societies, agricultural and
industrial credit institutions) which are in the
business of lending and borrowing of money or
credit
Commercial Banks are the most important credit
institutions in the country in the business of
lending and borrowing of money and credit
creation.
 Functions
Functions of commercial banks-
1. Accepting deposits
2. Advancing Loans
3. Discounting Bills of exchange
4. Agency services
5. General services
 Functions
1. Accepting Deposits
i) Demand or Current Account Deposits: A
depositor can withdraw it in part or in full at any
time he likes without notice It carries no interest
Only small savings of businessmen Cheque
facilities
ii) Fixed Deposits or Time Deposits- Fixed
deposits for 15days to few years Withdrawn at
expiry of term High rate of interest A source of
investment
iii) Saving Bank Deposits small saving deposits
salaried people less rate of interest money can be
withdrawn through cheques
 Functions
9. B) Advancing Loans This is the most important means of
earnings for the banks Giving loans to businessmen But it
keeps a fine balance between deposits and loans Banks
profitability depends on this as well.
10. Two ways of advancing loans I) By allowing an over draft
facility cheques are honoured even if deposits is less facility
for businessmen only interest on overdraft amount
11. II) Loans by creating a deposit Banks give loans to
people by charging interest Bank asks for security Simply
opens an account in name of needy person and issues a
cheque book to transact Loans granted mostly for business
 Functions
3.Discounting Bills of Exchange or Hundies
If a seller sells some goods to a buyer who
does not pay in cash. But the seller draws a bill
of exchange which is signed by buyer.
There is maturity or payment period, say one
month Now the seller can give this hundy to a
bank which will give him cash against it Bank
charges interest on it till one month.
 Functions
4.Agency Services-
Collection of bills, cheques Collection of
dividends, interest, premium Purchase and
sale of shares and debentures, Payment of
insurance premiums, Acts as trustee when
nominated.
 Functions
5.General services-
Travellers cheques,
bank draft Safe vaults for valuables
Supplying trade information
Economic surveys
Projects report preparation
 Credit Creation
Credit Creation Banks create credit by creating
cheque money or deposit money which on
account of its free acceptability, circulates like
legal tender money.
This increases or decreases money in
circulation without increase or decrease in
currency or legal tender money.
 Credit Creation
Definition
Credit Creation By Banks Definition: It is the
process of creation of credit by commercial
banks. More use of DD and cheques is CC and
not cash.
Cheques and deposit money are as good as legal
tender money on account of their
acceptability by the general public .
 Credit creation
Assumptions of credit creation :
Adjusts assets balance between deposit
liability and cash reserves Cash reserve ratio
remains same
There should be sound banking system No
credit control policy of central bank Business
is normal, no severe depression
 Credit Creation Limits
Limits of credit creation
1) Amount of cash of banks. Greater is amount, larger is its
capacity for c.c.
2) Cash reserve ratio: lower is csr, higher is credit creation
capacity
3) External drain: larger is amount of money withdrawn
from bank, lower is its cc.
4)Extent of borrowing of funds by business. More c.c. when
business is prospering.
5) Supply or collateral security: larger and better is
availability of security against loan, greater is extent of C.C.
6) Banking habit of people: if people use more of cash and
less of cheque then CC is not possible. Monetary policy of
central bank: central bank can influence CC by credit
control tools
 Bank Sources of Funds
Transaction deposits
Demand deposit account (checking)
Negotiable order of withdrawal (NOW) account
1981
Requires larger minimum balance
Savings Deposits
Passbook savings
Regulation Q until 1986
 Bank Sources of Funds
Time Deposits
Certificate of deposit (CD)
No secondary market
Negotiable CD
Short-term, minimum Rs.100,000
Can trade among investors via dealer
Money Market Deposit Accounts (MMDAs)
More liquid than CDs : no specified maturity
Limited check writing
Created in 1982
 Bank Sources of Funds
Federal Funds Purchased
Short-term loans between banks
Allows banks to meet reserve requirement or
funding needs
Interest rate charged is the federal funds rate
Borrowing from the Federal Reserve Banks
Borrowing at the discount window
Discount rate
Intended for meeting temporary short-term reserve
requirement needs
Must get Fed approval
 Bank Sources of Funds
Repurchase agreements
Sale of securities by one party to another with an
agreement to repurchase the securities at a
specified date and price
Banks may sell T-bills to a corporation with
temporary excess cash (bank demand deposit)
and then buy them back later
Source of funds for a few days
Collateralized by the treasury bills
Form of paying interest on large customer
checking balances
 Bank Sources of Funds
Eurodollar borrowings
Banks outside the United States make dollar-
denominated loans
Eurodollar market is very large
Bonds issued by the bank
Like other businesses, banks issue bonds to
finance long-term fixed assets
Usually subordinated to deposits
Part of secondary regulatory capital
 Bank Sources of Funds
Bank capital
Obtained from issuing stock or retaining earnings
No obligation to pay out funds in the future
Primary vs. secondary
Must be sufficient to absorb operating losses
As of 1992: risk-based capital requirement
 Uses of Funds by Banks
Loans make up about 64 percent of bank assets,
while all securities make up about 22 percent of
assets. Cash represents 6 percent of bank
assets.
Cash and due from balances at institutions
Currency/coin provided via banks
Reserve requirements imposed by Fed
Tool for controlling the money supply
Due from Fed and vault cash count as reserves
Also hold cash and due from balances to maintain
liquidity and accommodate withdrawal requests by
depositors
 Uses of Funds by Banks
Bank Loans
Types of business loans
Working capital loans
Term loans
Purchasing fixed assets
Protective covenants
 Term loans
Informal line of credit
An agreement between a bank and a company or an individual to
provide a certain amount in loans on demand from the borrower.
The borrower is under no obligation to actually take out a loan at
any particular time, but may take part of the funds at any time
over a period of several years. This agreement is fairly common in
situations in which a business must make payroll but does not
always have the operating income to do so, especially when its
operating income is seasonal or otherwise varies from month to
month. It is also called open-end credit or a revolving line of credit
Revolving credit loan
A line of credit where the customer pays a commitment fee and is
then allowed to use the funds when they are needed. It is usually
used for operating purposes, fluctuating each month depending on
the customer's current cash flow needs.
 Uses of Funds by Banks
Bank Loans
Loan participations
Sometimes large firms seek to borrow more money
than an individual bank can provide
Lead bank
Loans supporting leveraged buyouts
Banks charge a high loan rate
Monitored by bank regulators
 Uses of Funds by Banks
Bank Loans
Collateral requirements on business loans
Increasingly accepting intangible assets
Important to service-oriented firms
Increased lending risk with service businesses--telecomm
Lender liability on business loans
Lender liability lawsuitstoxic dump under corner
business
Types of consumer loans
Installment loans
Credit cards
Real estate loans
 Uses of Funds by Banks
Investment securities (bank income and
liquidity)
Treasury securities
Government agency securities
Corporate and municipal securities
Federal funds sold
Lending funds in the federal funds market
 Uses of Funds by Banks
Repurchase agreements
Eurodollar loans
Branches of U.S. banks located outside of the U.S.
Foreign-owned banks
Fixed assets
Office buildings
Land
 Off-Balance Sheet Activities
Loan commitments
Obligation of bank to provide a specified loan
amount to a particular business upon request
Note issuance facility (NIF)
Banks earn fee income for risk assumed
Standby letters of credit (SLC)
Backs a customers obligation to a third party
Banks earn fee income
 Off-Balance Sheet Activities
Forward contracts
Agreement between a customer and bank to
exchange one currency for another on a particular
future date at a specified exchange rate
Allows customers to hedge their exchange-rate
risk
 Off-Balance Sheet Activities
Swap contracts
Two parties agree to periodically exchange
interest payments on a specified notional amount
of principal
Banks serve as intermediaries or dealer and/or
guarantor for a fee
 EMERGING TRENDS IN BANKING
Technology :-Public sector banks have been late entrants in respect
of technology, their level of technology absorption has been low.
Central Vigilance Commission (CVC) directive.
In contrast, the newer private sector banks have achieved high level
of automation and have started offering electronic banking
products including Mobile Banking to their top end customers.
Electronic banking which include ATMS,
Shared ATM networks, issue and distribution of plastic cards,
Tele-banking,
on-line submission of loan applications etc.
With the recent establishment of INFINET (Indian financial
Network) by RBI, using V-SAT technology has become possible. The
INFINET will provide inter-bank connectivity
Real Time Gross Settlement system (RTGS).
 EMERGING TRENDS IN BANKING
Financial Innovations -Technologies is credited with ending
geography as funds today flow in a seamless world. Banks
cannot perform in a competitive environment unless there
are means of mitigating various risks. Derivative
instruments like, swaps, options, futures etc., enable such
risk mitigation. As the Indian financial market moves
towards more sophistication, some of these instruments
have emerged as in the case of internet rate swaps futures
etc. It is proposed to introduce comprehensive legislation
to facilitate securitization. But there is a need for more such
instruments considering that globalization of the corporate
sector and as the Indian economy integrates with the
whole world.

 EMERGING TRENDS IN BANKING

Rationalisation of man power-In their bid to control
expenses, banks are also cutting down on tiers of
control and rationalizing their branch network by
mergers and closure wherever required.
As part of such rationalization, banks should also be
allowed to close down unviable rural branches.
Instead, the Satellite Brach concept could be used in
such areas to continue with the provision of banking
services.
Customer Relationship Management-Banks have
understood that they have to put the customer at the
center of their thinking .
 EMERGING TRENDS IN BANKING
CRM-Customer Relationship Management is the latest
buzzword.
Executive Information System (EIS) and
Decision Support System (DSS) have become faster and
more accurate through data mining.
Some of them are Customer relationship management,
field level sales force, help desk, call centres, interactive
voice response systems, interactive television and e-mail.
Retail Banking-Indian banks are going to retain banking in
big way. Retail banking which is designed to meet the
requirement of individual customer has enormous
potential and it is associated with lesser risk than corporate
banking. Banks are now for ageing into net banking,
consumer finance, housing finance, merchant banking and
insurance.
 EMERGING TRENDS IN BANKING
Transparency and Disclosure Practices-
Transparency has come to be regarded as the
golden rule for the orderly behaviour of the
financial system. It checks against under risk.
It decrease the vulnerability of markets to
sudden shift in sentiment.
It also encourages healthy competition in the
financial system. Transparency of business
operations ensures market discipline.
 EMERGING TRENDS IN BANKING
Credit to the Weaker Section-Tendency of the banks to
grant more loans to weaker section of the society has
been on the increase.
In order to grant liberal loans to small and poor people,
principle of preference to weaker section is being
pursued extensively.
This section includes, small and marginal farmers,
landless labourers, cultivators, carpenters, artsans,
small and cottage industries, beneficiaries of integrated
rural development programme, scheduled castes and
scheduled tribes and beneficiaries of differential
interest rate.
 EMERGING TRENDS IN BANKING
Conclusion:
Indian banking system will further grow in size and complexity while
acting as an important agent of
economic growth and intermingling different segments of the
financial sector. It automatically follows that the future of Indian
banking depends not only in internal dynamics unleashed by
ongoing returns but also on global trends in the financial sectors.
Indian Banking Industry has shown considerable resilience during
the return period. The second generation returns will play a crucial
role in further strengthening the system. Adoption of stringent
prudential norms and higher capital standards, better risk
management systems, adoption of internationally accepted
accounting practices and increased disclosures and transparency
will ensure the Indian Banking industry keeps pace with other
developed banking systems.
 Universal Banking -
Meaning
Universal banking is a combination of Commercial
banking .
It is a place where all financial products are
available under one roof.
So, a universal bank is a bank which offers
commercial bank functions plus other functions
such as Merchant Banking, Mutual Funds,
Factoring, Credit cards, Housing Finance, Auto
loans, Retail loans, Insurance, etc.
 Advantages of Universal Banking

The benefits or advantages of universal banking

are:-
Investors' Trust : Universal banks hold stakes
(equity shares) of many companies. These
companies can easily get other investors to invest
in their business. This is because other investors
have full confidence and faith in the Universal
banks. They know that the Universal banks will
closely watch all the activities of the companies in
which they hold a stake.
 Advantages of Universal Banking
Economics of Scale : Universal banking results
in economic efficiency. That is, it results in
lower costs, higher output and better
products and services. In India, RBI is in favour
of universal banking because it results in
economies of scale.
 Advantages of Universal Banking
Resource Utilisation : Universal banks use their
client's resources as per the client's ability to take
a risk. If the client has a high risk taking capacity
then the universal bank will advise him to make
risky investments and not safe investments.
Similarly, clients with a low risk taking capacity
are advised to make safe investments. Today,
universal banks invest their client's money in
different types of Mutual funds and also directly
into the share market. They also do equity
research. So, they can also manage their client's
portfolios (different investments) profitably.
 Advantages of Universal Banking
Profitable Diversification : Universal banks
diversify their activities. So, they can use the
same financial experts to provide different
financial services. This saves cost for the
universal bank. Even the day-to-day expenses
will be saved because all financial services are
provided under one roof, i.e. in the same
office.
 Advantages of Universal Banking
Easy Marketing : The universal banks can easily market
(sell) all their financial products and services through
their many branches. They can ask their existing clients
to buy their other products and services. This requires
less marketing efforts because of their well-established
brand name. For e.g. ICICI may ask their existing bank
account holders in all their branches, to take house
loans, insurance, to buy their Mutual funds, etc. This is
done very easily because they use one brand name
(ICICI) for all their financial products and services.

 Advantages of Universal Banking

One-stop Shopping : Universal banking offers
all financial products and services under one
roof. One-stop shopping saves a lot of time
and transaction costs. It also increases the
speed or flow of work. So, one-stop shopping
gives benefits to both banks and their clients.
 Disadvantages of Universal Banking

The limitations or disadvantages of universal

banking are:-
Different Rules and Regulations : Universal
banking offers all financial products and services
under one roof. However, all these products and
services have to follow different rules and
regulations. This creates many problems. For e.g.
Mutual Funds, Insurance, Home Loans, etc. have
to follow different sets of rules and regulations,
but they are provided by the same bank.
 Disadvantages of Universal Banking

Effect of failure on Banking System : Universal

banking is done by very large banks. If these
huge banks fail, then it will have a very big and
bad effect on the banking system and the
confidence of the public. For e.g. Recently,
Lehman Brothers a very large universal bank
failed. It had very bad effects in the USA,
Europe and even in India.
 Disadvantages of Universal Banking

Monopoly : Universal banks are very large. So,

they can easily get monopoly power in the
market. This will have many harmful effects on
the other banks and the public. This is also
harmful to economic development of the
country.
 Disadvantages of Universal Banking

Conflict of Interest : Combining commercial

and investment banking can result in conflict
of interest. That is, Commercial banking versus
Investment banking. Some banks may give
more importance to one type of banking and
give less importance to the other type of
banking. However, this does not make
commercial sense.
 Venture Capital

Definition
Money provided by investors to startup firms and
small businesses with perceived long-term
growth potential. This is a very important source
of funding for startups that do not have access to
capital markets.
It typically entails high risk for the investor, but it
has the potential for above-average returns.
 Indian Venture Capital Association
The Indian Private Equity and Venture Capital
Association was established in 1993 and is based
in New Delhi, the capital of India.
IVCA is a member based national organization
that represents Venture capital and Private
equity firms, promotes the industry within India
and throughout the world and encourages
investment in high growth companies.
It enables the development of venture capital
and private equity industry in India and to
support entrepreneurial activity and innovation.
Indian Venture Capital Association
IVCA members comprise -
Venture capital firms,
Institutional investors,
Banks, Business incubators,
Angel investor groups,
Financial advisers, Accountants,
Lawyers,
Government bodies,
Academic institutions and other service providers
to the venture capital and private equity industry.
 Project Finance
Defined by the International Project Finance Association
(IPFA) as the following:
The financing of long-term infrastructure, industrial
projects and public services based upon a non-
recourse or limited recourse financial structure where
project debt and equity used to finance the project are
paid back from the cash flow generated by the project.

In other words, project financing is a loan structure that

relies primarily on the project's cash flow for repayment,
with the project's assets, rights, and interests held as
secondary security or collateral.
 WHY PROJECT FINANCE
8. Size and cost of projectsRisk
minimizationMay be only way that enough
funds can be raised
 FEATURE

It is provided for a ring-fenced project

There is a high ratio of debt to equity
There are no guarantees
Lenders rely on the future cash flow
The main security for lenders
 ADVANTAGES
Project financing is usually chosen by project developers in
order to -
Eliminate or reduce the lenders recourse to the sponsors
Permit an off-balance sheet treatment of the debt financing
Maximize the leverage of a project
Reduce political risks affecting a project
Circumvent any restrictions or covenants binding the sponsors
under their respective financial obligations
Avoid any negative impact of a project on the credit standing
of the sponsors
Obtain better financial conditions when the credit risk of the
project is better than the credit standing of the sponsors
 DISADVANTAGES
Often takes longer to structure than
equivalent size corporate finance.
Higher transaction costs due to creation of an
independent entity .
Extensive contracting restricts managerial
decision making .
Project finance requires greater disclosure of
proprietary information and strategic deals.
Bank Management

General Principles
 Primary Concerns of the Bank
Manager
Deposit outflows must match deposit inflows.
To keep enough cash on hand, the bank manager
must engage in liquidity management.
Risk levels must be acceptably low.
To keep risk low, the bank manager must engage
in asset management by acquiring assets that
have a low rate of default and by holding a
portfolio that is well diversified.
 Primary Concerns of the Bank
Manager
Funds must be acquired at low cost.
To increase profits by acquiring funds at low cost,
the bank manager engages in liability
management.
Capital must meet regulatory standards.
To maintain and acquire capital, the bank manager
engages in capital adequacy management.
 Liquidity Management
Financial institutions face liquidity
management problems because the volume of
cash flowing in rarely matches exactly the
volume of cash flowing out.
In addition, some liabilities are payable
immediately upon demand, resulting in the
outflow of cash with little or no notice. And...
 Liquidity Management
Financial institutions are sensitive to interest
rate movements, which affect the flow of
savings they attract from the public and the
earnings from the loans and securities they
acquire.
 Liquidity Management
Liquidity managers usually meet their
institutions cash needs through two methods:
Asset management or conversion; ie., the selling
of selected assets.
Liability management; ie., the borrowing of
enough liquidity to cover a financial institutions
cash demands as they arise.
Sources and Uses of Funds Method
To estimate the financial institutions future
liquidity needs, the bank manager could use
the sources and uses of funds method.
The institutions estimated liquidity deficit or
surplus equals the estimated change in liquidity
sources minus the estimated change in liquidity
uses.
 Sources and Uses of Funds Method:
Example

Planning Estimated Change in Estimated Change in Estimated

Interval Funds Sources in Funds Uses Surplus/ Deficit

Tomorrow +$25 million +$20 million +$5 million

Next Day -$10 million +$10 million -$20 million

The bank manager could invest the $5 million surplus

overnight in order to earn interest income, and then the
next day must borrow $20 million from some other institution.
 The Structure of Funds Method
To estimate the financial institutions future
liquidity needs, the bank manager could use
the structure of funds method.
The institutions liabilities are divided into
categories based on their estimated probability of
leaving the institution. Funds are then allocated
to cover those liabilities according to the
likelihood that they will leave.
 The Structure of Funds Method:
Example
Some funds received may be hot money
that are highly sensitive to changes in interest
rates.
90% or more of these funds should be covered
with holdings of liquid assets or borrowings.
Other funds are core funds that are highly
stable.
Only 10% of these funds might be covered 10%.
 The Structure of Funds Method:
Example

Estimated liquidity need = 0.90 x (Hot money funds) + 0.10 x (Core funds)
+ Estimated new loan demand from customers

= 0.90 x ($60 million) + 0.10 x ($100 million)

+ $36 million = $100 million

The liquidity manager would want to make sure that $100

million was available in some combination of holdings of
liquid assets and borrowing capability.
 Liquidity Indicators
Liquidity indicators supply bank managers with
signs that a liquidity problem is developing. They
include:
Ratio of cash to total assets.
Ratio of hot money assets to hot money
liabilities.
Cost of borrowing for liquidity needs relative to the
cost other institutions face.
Monitoring the intentions of the banks biggest
customers.
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $20 Deposits $100

Loans $80 Bank Capital $ 10
Securities$10

Let the banks reserve requirement be 10% of deposits or $10.

Under these circumstances, an unexpected deposit outflow of

$10 presents no problems for the bank. Why?
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $10 Deposits $ 90

Loans $80 Bank Capital $ 10
Securities$10

The bank loses $10 of deposits and $10 of reserves, but since
required reserves are now 10% of $90, it still has $1 in excess reserves.

If a bank has ample reserves, a deposit outflow does not necessitate

changes in other parts of its balance sheet.
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $10 Deposits $100

Loans $90 Bank Capital $ 10
Securities$10

Let the banks reserve requirement be 10% of deposits or $10.

Under these circumstances, an unexpected deposit outflow of

$10 does present a problem for the bank. Why?
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $ 0 Deposits $ 90
Loans $90 Bank Capital $ 10
Securities$10

After the withdrawal of $10 in deposits, the bank needs $9 in

reserves, but it has none.

To eliminate the shortfall, the bank could sell assets or borrow

 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90
Loans $90 Borrowings $ 9
Securities$10 Bank Capital $ 10

If the bank borrows $9 from other banks or corporations, the bank

incurs the cost associated with the borrowing.
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90
Loans $90
Securities$ 1 Bank Capital $ 10

If the bank sells securities, the bank incurs the costs associated
with the sale. These costs include brokerage and other transactions
costs as well as the loss of future income.
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90
Loans $90 Discount Loan $ 9
Securities$10 Bank Capital $ 10

If the bank borrows from the Federal Reserve, it also incurs costs.
The bank must pay the discount rate charged on Fed loans, and
the bank risks losing its privilege of borrowing from the Fed, if it
borrows too often.
 Liquidity Management and the Role of
Reserves

Assets Liabilities

Reserves $ 9 Deposits $ 90
Loans $81
Securities$10 Bank Capital $ 10

If the bank calls or sells some loans, the bank incurs the costs
associated with the reduction of loans. This is the costliest way
of acquiring reserves.
Liquidity Management: Conclusion
Excess reserves are insurance against the costs
associated with deposit outflows.
The higher the costs associated with deposit
outflows, the more excess reserves banks will
want to hold.
 Asset Management
To maximize profits, a bank must
simultaneously seek the highest returns
possible on loans and securities, reduce risk,
and make adequate provisions for liquidity by
holding liquid assets.
 Asset Management
Four basic methods of asset management:
Find borrowers who will pay high interest rates
and are unlikely to default.
Purchase securities with high returns and low risk.
Lower risk by diversifying.
Manage the liquidity of its assets so that it can
satisfy its reserve requirements without incurring
large costs.
 Liability Management
Today, banks regularly engage in liability
management.
When a bank finds an attractive loan opportunity,
it can acquire funds by selling negotiable CDs.
If it has a reserve shortfall, it can borrow from
other banks in the federal funds markets.
Raising Funds for a Financial Institution
Factors to be considered:
The relative cost of raising funds from each
source.
The risk (volatility or dependability) of each funds
source.
The length of time (maturity) for which a source of
funds will be needed.
The size and market access of the financial
institution attempting to raise funds.
Laws and regulations that limit access to funds.
 Relative Cost Factor
The relative cost factor is important because,
other things remaining the same, a financial
institution would prefer to borrow from the
cheapest sources of funds available.
Also, if an institution is to maintain consistent
profitability, its cost of fund raising must be
kept below the returns earned on the sales of
its services.
 Pooled-Funds Approach: Example

Sources of New Funds Volume of New Interest Costs & Other

Funds Generated Expenses Incurred

Deposits $200 $20

Money Market Borrowing $ 50 $ 5
Equity Capital $ 50 $ 5

Total New Funds $300 $30

Estimated overall cost of funds for the institution is:

Pooled All Expected

Fund Raising = Fund Raising Costs = $30 = 10%
Expense Total New Funds $300
 Pooled-Funds Approach: Example

If only $250 of the $300 in funds raised can be used to invest in new loans and
investments, the estimated overall cost of funds changes.

Estimated overall cost of funds for the institution is:

Pooled All Expected

Fund Raising = Fund Raising Costs = $30 = 12%
Expense Total New Funds $250

Now the bank must earn at least 12% on its loans and other earning assets just to
cover its fund-raising costs. When it could use all the funds raised for loans and
other investments, it only needed to earn 10% to cover the fund-raising costs.
 Capital Adequacy
Functions of bank capital:
Help to prevent bank failure
Affects returns for equity holders
Required by regulatory authorities
 Capital and Bank Failure

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities

Reserves $10 Deposits $90 Reserves $10 Deposits $96

Loans $90 Bank K $10 Loans $90 Bank K $ 4

Assume that both banks write off $5 of their loan portfolio. Total
assets decline by $5, and bank capital, which equals assets minus
liabilities, also declines by $5.
 Capital and Bank Failure

High Capital Bank Low Capital Bank

Assets Liabilities Assets Liabilities

Reserves $10 Deposits $90 Reserves $10 Deposits $96

Loans $85 Bank K $ 5 Loans $85 Bank K - $ 1

After the write-off, the high capital bank still has a positive net
worth, but the low capital bank is insolvent. It does not have
sufficient assets to pay off its creditors. Regulators will now close
the bank and sell its assets.

A bank maintains bank capital to lessen the chance that it will

become insolvent.
 Bank Capital and Returns to Owners

A basic measure of bank profitability is return on assets = ROA

ROA = Net profit after taxes/assets.

This measure provides information on how efficiently a bank is

being run because it indicates how much profit is generated on
average by each dollar of assets.
 Bank Capital and Returns to Owners

Another measure of bank profitability is return on equity = ROE

ROE = Net profit after taxes/Equity capital.

This measure provides information on how much the bank is

earning on the investors equity investment.
 Bank Capital and Returns to Owners

There is a direct relationship between the return on assets and the

return on equity. This relationship is determined by the equity-
multiplier (EM). EM is the amount of assets per dollar of
equity capital.

EM = Assets/equity capital

Net profit after taxes Net profit after taxes x Assets

Equity capital Assets equity capital

ROE = ROA x EM
 Bank Capital and Returns to Owners

We can use the ROE formula to examine what happens to the return
on equity when a bank holds a smaller amount of assets per dollar
of capital. Let each bank receive a return on assets equal 1%.

ROE= ROA x EM

High Capital Bank ROE = 1% x 100/10 = 10%

Low Capital Bank ROE = 1% x 100/4 = 25%

Given the return on assets, the lower the bank capital, the higher the
return for the owners of the bank.
 Trade-off between Safety and Return
Bank capital reduces the likelihood of
bankruptcy, but it is costly because as bank
capital rises, return on equity falls.
Bank managers must determine how much
safety they are willing to trade off against the
lower return on equity.
The more uncertain the times, the larger the
amount of capital held.
 Bank Capital and Returns to Owners

Another commonly watched measure of bank performance is called

the net interest margin (NIM), the difference between interest income
and interest expenses as a percentage of total assets.

NIM = interest income - interest expenses

assets

If a bank manager has done a good job, the bank will have high
profits and low costs. This is reflected in the spread between interest
earned and interest costs.
 Off Balance-Sheet Activities
Loan sales or secondary loan participation
A contract that sells all or part of the cash stream
from a specific loan and thereby removes the loan
from the banks balance sheet.
Banks earn profits by selling loans for an amount
slightly greater than the amount of the original loan.
Institutions are willing to buy them at the high price because
of the high interest rates associated with the loans.
 Off Balance-Sheet Activities
Generation of Fee Income
Banks charge fees for specialized services such as:
Making foreign exchange trades
Servicing a mortgage-backed security by collecting
interest and principal payments and then paying them
out, and providing lines of credit.
 Banking Ombudsman
The Banking Ombudsman is a senior official
appointed by the Reserve Bank of India to redress
customer complaints against deficiency in certain
banking services.
Banking Ombudsman is a quasi judicial authority
functioning under Indias Banking Ombudsman
Scheme 2006, and the authority was created
pursuant to the a decision by the Government of
India to enable resolution of complaints of
customers of banks relating to certain services
rendered by the banks.
 Banking Ombudsman
The Banking Ombudsman Scheme was first
introduced in India in 1995, and was revised in
2002.
The current scheme became operative from 1
January 2006, and replaced and superseded
the banking Ombudsman Scheme 2002.
From 2002 until 2006, around 36,000
complaints have been dealt by the
Banking Ombudsmen.
 Banks covered under Banking
Ombudsman Scheme

All Scheduled Commercial Banks,

Regional Rural Banks and
Scheduled Primary Co-operative Banks are
covered under the Scheme.