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Financial Framework
The Financial system consists of:
Markets (Stock Markets, Bond Markets,) Market Players (Banks, NBFIs)
Instruments (Stocks, Bonds etc) Regulators (RBI, SEBI etc)
Banks
The term ‘bank’ is used generically to refer to any financial institution that is licensed to accept deposits that are repayable on demand, and lend money.
Services offered by a bank to a corporate are:
Loans: Banks provide short and long-term funds to businesses. Cash Deposits: Corporates deposit surplus funds in a bank.
Foreign exchange transactions: Banks act as authorized dealers to facilitate foreign exchange transactions.
Advisory Services: Banks provide financial advisory services such as valuations, issue management, mergers & acquisitions, etc. to corporates.
Trade and commerce: Banks play the role of the trusted intermediary between parties involved in trade and facilitate trade and commerce.
NBFCs
‘NBFC’ stands for ‘Non Banking Financial Company’. An NBFC broadly carries out lending and investment functions. Only few permitted NBFCs can accept deposits.
The three key differences between a bank and NBFC are:
1. An NBFC cannot accept deposits which are repayable on demand. Some can accept fixed-term deposits. 2. Any deposits accepted by NBFCs (these will be of fixed maturity as explained above) are not insured 3. Only banks can participate in the payment system; hence NBFCs cannot issue cheque books to their
customers.
Categories of Banks in India
Scheduled banks: Banks which have deposits > INR 200 crore are ‘Scheduled Banks’.
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Banking Structure in India:
Public sector Banks: PSBs are those where the government holds a majority (>50%) ownership.
Private Banks: Private banks, are banks owned by private (i.e. non-government) Indian entities such as corporates
and individuals.
Foreign Banks: Foreign Banks are those owned by multi national/non-Indian entities.
Regional Rural Banks: RRBs are also banks with a Government ownership. The idea was to create banks which
will focus on the rural areas and serve the under banked sector. A scheduled commercial bank acts as a sponsor of an RRB.
Urban Co-operative Banks: Co-operative banks are formed by a group of members. Traditionally the thrust of
UCBs has been, to mobilize savings from the middle and low income urban groups and ensure credit to their members - many of which belong to the weaker section.
State Co-operative Banks: SCBs are set up with state government partnership to help agricultural and rural
development.
The Central Bank
The ‘Central Bank’ (CB) of any country is the banker’s bank. It acts as a regulator for other banks, while providing various facilities to facilitate their functioning. It also acts as the government’s bank. The Federal Reserve is the Central Bank of the United States, while the Reserve Bank of India (RBI) is the Central Bank in India.
National Housing Bank: National Housing Bank, a wholly owned subsidiary of RBI, governs the functioning of all
housing finance companies.
Capital adequacy ratio-Basel accord/norms
The Basel Accord is a global regulation controlling the amount of risk that banks face. The norms defined the amount of capital (owners’ funds – i.e. money invested by owners, plus profits) a bank or NBFC must maintain, based on the risks it takes. This is called the Capital Adequacy Ratio (CAR). The higher the risk a bank takes, the higher capital it must maintain.
Risks covered by Basel norms are:
Credit risk: Risk of loss a bank faces while lending.
Operational risk: Risk of loss a bank faces during regular operations.
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Reserve Requirements
Reserve requirements are a certain percentage of deposits taken which are to be maintained with the RBI. Reserve requirements in India are of two types:
1) Cash Reserve Ratio: A certain percentage of all deposits must be placed with the RBI in the form of cash. CRR defines this percentage.
2) Statutory Liquid Ratio: A certain percentage of all deposits must be used to purchase Government securities. SLR defines this percentage.
Key Concepts for Banks & NBFCs
1) Net Owned Funds: Essentially NOF is Owners’ Equity – i.e., money belonging to the owners. Net Owned Funds = Owners‟ Equity – Losses
2) Capital to Risk Weighted Assets Ratio (CRAR): CRAR gives the ratio of owners’ money as a
percentage of risk weighted assets (loans).
3) Ways of charging interest:
a) Flat rate method: Charging interest on constant principal. That is, if a loan of Rs. 1 lakh is given, interest is always calculated on Rs. 1 lakh, even if Rs. 5000 is repaid each month.
b) Reducing balance rate method: Charging interest on outstanding principal – i.e. any repaid principal is deducted from the outstanding amount and interest is only charged on unpaid principal.
4) Methods of securing a loan with collateral:
a) Pledge: When a borrower ‘pledges’ an asset and borrows against it, she loses the right to use it. This means usually that, the asset will lie with the lender.
b) Hypothecation: ‘Hypothecating’ an asset gives the owner the right to use it, and the lender the right to seize and sell it in case of default.
c) Mortgage: Mortgage is used whenever the asset used as collateral, is immovable property. d) Lien: A lien means, the claim of the lender on any asset used to secure the loan.
5) NPA and Provisioning: An NPA is a ‘Non Performing Asset’. Lenders must ‘provision’ for NPAs, which
means they must keep aside a certain portion of their income to provide for the losses against these NPAs. For a bank, a loan becomes an NPA after 90 days overdue; for an NBFC, after 180 days.
6) Priority Sector Lending: For all domestic commercial banks, 40% of their lending must be to the priority
sector defined by the RBI.
The priority sector includes:
•
Agriculture•
Small enterprises•
Self Help Groups•
Micro Credit•
Educational Loans•
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Banking Business
The primary function of a bank is to collect funds (deposits) at a lower interest rate and lend them out at a higher interest rate. A bank makes money via ‘Net Interest Income’.
Net Interest Income (NII) = Interest Earned on Loans – Interest Paid on Deposits
However, a sizeable portion of income comes from fee charged on various services such as Demand drafts
Advisory services to corporate, Trading income,
Commission via selling other (non-bank) financial products like insurance and mutual funds.
Cost of Funds for a Bank
It is critical for a bank to keep close track of the cost of the money it is borrowing. It has thousands of deposits, each of different tenors (tenures/maturity) and with different interest rates. It can work out its lending rate, only if it knows the cost of the money it has borrowed.
Weighted Average Cost of Capital (WACC)
We can find the cost of funds using the concept of Weighted Average Cost of Capital. It can be calculated as shown below.
Rate Weight Weighted cost
Savings A/cs 3 % 0.45 1.35 Fixed deposits 7% 0.25 1.75
Current A/cs 0% 0.3 0
WACC = 3.1 %
Spread
The difference between the average deposit rate and the average lending rate is called the ‘spread’.
Spread = Average Lending Rate – Average Deposit Rate
In India, banks typically work on spreads of 3-5%. So, if SBI says its spread is 3%, it means that the difference between its average deposit rates and lending rates is 3%.
Difference between Spread and NII
NII is the income earned (difference of the actual interest earned and paid) by the bank in absolute terms. Spread is the difference between the interest rates.
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Structure of a Bank
Banks are structured based on what specific businesses they focus on. For example, if its two-wheeler loans business is large, it may have a separate business unit (department) just for this product. If not, there maybe a unit catering jointly to two wheeler loans, loans against securities, etc.
Described below is a generic overview of what a large bank would look like.
Broadly, a bank’s divisions can be categorized for easier understanding, into:
1. Line Functions - Business units which are a key part of banking operations, are called ‘Line Functions’ –
and are customer facing or part of the ‘Front Office’. This means they are interacting with the customer. These include the sales functions, the channels and each specific group of offerings like retail banking, corporate banking, etc. as shown.
2. Back Office & Support Functions - The second category also comprises key line functions, but these are
‘back office’ or operations. They support the front office. These include all operations such as account opening, loan documentation processing; also risk management, payments, new product development and Asset & Liability Management or ALM.
3. Staff Functions - The third set is the ‘staff’ functions – they are not key banking or line functions, and
would be there in any large organization. These are functions like Human Resources, IT, Legal, Finance & Control, etc.
Let us know about each section in brief.
Channels: Systems/Infrastructure which enables a customer to access the bank’s services. Sales & Marketing: Division managing sales of all the products of the bank.
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Retail Banking: Division which handles banking requirements of domestic individuals and small businesses –
proprietorships and partnerships.
NRI Banking: Specific to India – handles banking requirements of NRIs. This can be clubbed in the Retail Banking
Division.
Rural/Agricultural Banking: Division seen mainly in Public Sector Banks (PSBs) in India, as they must, by
mandate, cater to the needs of this sector.
SME Banking: Small and Medium Enterprises division. Sometimes also included under Corporate Banking – depends
on the bank.
Corporate/Wholesale Banking: Division which handles the banking needs of corporates only.
Pvt. Banking & WM: Managing the investment needs of wealthy individuals, called High Networth Individuals
(HNIs).
Investment Banking: A specialized division that caters to the niche requirements of corporates. For example,
Mergers and Acquisitions advisory (M&A).
Financial Markets & Treasury: Trading division of the bank. This could be proprietary (for their own books) or on
the behalf of clients.
Product Development: Designs new product offerings based on market requirements.
Operations: Entire set of processes to enable banking services. Can be divided into Operations for each division or
merged for economies of scale.
Risk Management: Handles credit, market, operational, liquidity risks for the bank – can be segregated for each
division.
Payments/Remittances: Handles all the payments processing. Large operational area, hence separate division. ALM: Manages a bank's balance sheet to minimize interest rate and liquidity risk.
HR: Manages Human Resources function such as recruitment, training etc. Legal & Compliance: Ensures compliance to regulatory requirements. IT: Managing the technology required for the various processes. Audit: Internal function, ensuring processes are within guidelines.
Finance & Control: Preparing the financial statements, budgeting, forecasting & internal reporting of the bank.
Let’s look at the channels in detail.
Channels
Banking channels refer to the means by which customers access a bank’s products and services. Typical channels offered by banks include:
1. Branch Banking
Branch banking refers to a physical location where a bank offers a wide array of services to its customers. It involves large investment in infrastructure and employees.
Branch banking is the most popular channel and also the most expensive channel for a bank. Functions of a branch - The functions of a branch are illustrated below. They can be divided into:
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a) Front-office or customer interfacing functions - The front office or customers facing functions arethose of the teller, customer service and sales staff. Often, as shown, one person can have dual
responsibilities: A teller can also answer customer queries or a customer service staff can use his interaction time to sell a bank product.
b) Back office or operations - The typical back office operations are payments, check book processing, loan processing etc. These operations are usually centralized in a region. Hence for large banks, operations within each branch are minimal.
2. ATMs
An Automated Teller Machine (ATM) is a computerized device that provides the customers of a bank easy access to transactions, without the need for a branch.
ATMs can be just cash dispensers or evolved facilities offering facilities such as: Balance Enquiry Statement of Accounts Cash Withdrawal Cash deposit Check deposit Check cashing Funds transfer Bill Payment Currency Exchange Loan Application Investment Advice MF, Insurance sales Electronic Purse loading Ticketing
3. Internet Banking
Internet Banking refers to the ability to access banking services/products via the internet. It is one of the cheapest channels for a bank.
Typical Internet Banking offerings include:
Static information about the bank’s offerings, application forms Specific account information: Statements, Alerts,
Ability to change/edit account information
Stop payments, cheque book requests/other instructions
Payment transactions to other accounts within and external to the bank Bill Payments
4. Phone Banking
Call centers enable customers to access services as described below:
Enquiries about Loans and Deposits - Check your account balance, enquire the last five transaction details,
make general foreign exchange rates enquiry etc.
Transactions - Request for a cheque book or account statement, transfer funds between accounts (same
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5. Mobile Banking
Banking using a mobile phone network can use either SMS or WAP technology. Interactions can be classified as either transactions or enquiries; as also if they are bank initiated (‘Push’) or Customer initiated (‘Pull’), as shown in the table below.
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Retail Banking
Retail banking is a division that handles banking requirements of individuals and small businesses. The retail bank acts as a key channel to collect deposit funds, which are in turn used to generate profits for the bank.
The retail bank broadly offers two categories of products: Liability (Deposit) Products
Asset (Loan) Products
Liability Products
A deposit is a contract between the bank and the customer. The bank must repay the deposit per the terms of the contract. Hence deposits are liabilities for the bank. Bank deposits are insured. Some deposit accounts pay interest. In India, RBI mandates four basic types of domestic deposit accounts:
a) Savings Accounts: These accounts are meant for individuals. The key features of a savings account are:
Users Meant only for individuals.
Withdrawal frequency
There is some restriction on the number of times a customer may withdraw or deposit funds.
Interest rate
It pays interest. Currently (Oct 2011), RBI has deregulated the savings rate. The interest is calculated on the daily balance in the account. The interest is credited to the accounts on a quarterly or longer rests.
b) Current Accounts: The key features of a current account are:
Users
They are held mainly by businesses. Legally speaking, they can also be opened by individuals, but unless they have a large (say, more than a hundred per month) number of transactions, they’d be better off with a savings account which pays them interest.
Withdrawal frequency These are accounts primarily meant for transacting, and hence have no restrictions on
the number of transactions.
Interest rate Banks do not pay any interest on current accounts, though RBI allows Urban
Co-operative Banks to pay some interest if they wish.
c) Term/Time/Fixed Deposits: These are deposits with a fixed maturity, hence also called Fixed Deposits (FDs).The key features of a fixed deposit are:
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Users Either an individual or a business.
Withdrawal frequency The customer cannotadd to, or withdraw from, this deposit till maturity – i.e., transactions are not allowedon an FD.
Interest rate FDs earn higher interest than savings deposits, and banks are free to fix the interest rates.
As there are no transactions, FD accounts do not come with means of withdrawal, such as cheque books or ATM cards.
Recurring Deposits - These are a fixed deposit variant. The only difference being that, the customer has the
flexibility to deposit the amount in installments.
Users Meant only for individuals.
Withdrawal frequency No withdrawals are allowed. One can, however avail a loan against the deposit.
Interest rate Depends on the maturity period. It earns a compounded rate of interest.
d) Public Provident Fund Accounts: These are accounts meant for retirement savings. In India, they are fully tax exempt – you pay no tax on the principal or interest earned.
They currently earn a tax free interest rate of 8.7% p.a., compounded annually.
Combination Accounts
Apart from the above, banks also offer some combination structures. They are:
1. Book the FD in small „pieces‟: Here the F.D is booked as multiple FDs of small equal amounts. Hence a customer can withdraw or break these small amounts without disturbing the other parts of the FD. 2. Loan against the F.D: This is actually a loan – an OverDraft (OD) - against the security/collateral of your
FD.
Banks charge a higher interest rate on loans against F.D. If the customer doesn’t repay the loan, the FD (on which there is a ‘lien’) is seized to repay both principal and interest.
3. Savings/Transaction Account with F.D: The customer is offered the option of having surplus money in a savings account /Current account moved automatically into an FD, thereby earning higher interest. In case an amount more than what’s there in the savings account is needed, the linked FD is broken and money ‘swept’ back into the savings account. These are typically called ‘Sweep-in/Sweep-out’ accounts or an ‘Auto Sweep’ facility.
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NRI Banking
There is a separate category of accounts for NRIs. If a bank has a large NRI deposit base, they may have a separate business division for NRI deposits.
An NRI can hold only any one of the following three types of NR (Non Resident) accounts.
Non Resident Ordinary (NRO)
Account
Non Resident External (NRE) Account
Foreign Currency Non Resident (FCNR)
Account Deposit Currency Foreign Currency/INR Foreign Currency Foreign Currency
Withdrawal Currency INR INR Foreign Currency – but no interim withdrawals
Currency Risk for
Customer No Yes No
Repatriable
No limit on interest amount. Principal capped
at USD 1 Mn. Principal and interest Principal and interest
Liability Processes
The liability process is as follows:
a) Account Opening: An account can be opened only after various checks like identity, source of funds etc. are done.
b) Relationship Management: Relationship management involves ongoing interaction with the customer in order to service any requests.
c) Operations/Servicing: The operations around the lifecycle of a deposit are reasonably complex and
large. They involve interest accrual, statements, any modifications to the customer details (such as
address, phone number etc), managing transactions and closure.
d) Monitoring: With countries coming together to fight terrorism via tracking and blocking terrorist and illegal funds, banks have the additional responsibility of monitoring the transactions of deposit accounts.
Liability Account Status
The status of any account can be classified as follows:
a) Active Account - An active account is a normally functioning one.
b) Dormant Account - If an account has seen no transaction in the last 12 months, it is declared as inactive
account. And if there is no activity in the account for two years, then the account is classified as ‘dormant‟ account‟. A dormant account needs special monitoring.
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Asset Products
Asset products can be categorized based on certain parameters. They are: 1) Basis Security – There are two types of products under this category
a) Secured Loans: Loans in which an item of value is collateral for its repayment.
b) Unsecured Loans: Unsecured loans do not involve the pledge of collateral. Assurance of repayment is the borrower’s promise to repay the loan.
2) Basis Repayment – The following products are offered based on repayment
a) Single Payment Loan - The borrower repays the loan in one lump sum with the single-payment plan. b) Installment Payment Loan - Borrowers repay loans over a period of time at periodic intervals (for
example, monthly, quarterly, or semiannually). 3) Basis Disbursal
a) Open Ended Loan - Also called a revolving loan or an overdraft (OD), borrowers are assigned a limit
or ‘line of credit’upto which they can borrow. They can repay and borrow again upto the limit, hence the term ‘revolving’.
b) Close Ended Loan - A lender extends a specific amount of funds to a borrower, after which no
additional advances can be made, even if the borrower makes payments on the loan.
4) Basis Interest Rate - Interest rates on the loan can be fixed-i.e., the rate remains the same for the period of the loan, or floating (adjustable)– i.e., the rate floats, tied to a benchmark interest rate.
Typical Loan Products
The typical loan products offered by a retail bank are: Home Loans
Loans against Property Vehicle Loans
Loans Against Fixed Deposits Credit Cards
Personal Loans Education Loans
Asset Processes/Roles
Irrespective of the type of loan, the retail lending process typically follows the following stages:
a. Origination: Informing the prospective applicant about the features of the loan, collecting the completed application and required additional documentation and verifying the collected information, are all parts of this stage of the loan process.
b. Underwriting/credit appraisal: The bank evaluates the prospective borrower and decides how risky s/he is.
c. Documentation: The documents required for closing the loan – such as title papers of any collateral – are collected and verified.
d. Loan Closing: All parties to the loan sign the contract.
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f. Servicing: The loan does not end with disbursal. The principal and interest repayments need to becollected in a timely manner. Also the servicing function has to ensure that the title and value of the collateral remains secure.
g. Collections and recovery: In case the borrower delays payment, the process of collections starts. If there is no payment on a loan for more than 90 days, it is classified as a ‘Non Performing Asset’ or NPA. If a loan shows no signs of repayment after that, then the process of recovery – seizing any collateral and recovering the loan amount – starts.
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Corporate Banking
Corporate banking is the name given to the different banking services which companies need for their day to day operations. It is also called wholesale banking.
Structure of Corporate Banking Division A typical Corporate Banking structure looks like this:
The relationship chain manages the customer relationship. This can be called the front office. They interact with the customers and understand their requirements.
The credit chain, on the other hand, rarely meets the customer. Their role is to evaluate the credit requirements of the company, as presented by the relationship chain, and evaluate them.
Product management is responsible for customizing the banking products and services to suit customer needs.
Transaction banking is often separated from the relationship chain & the credit chain and can be an individual business unit called TBG (Transaction Banking Group). TBG is responsible for ensuring product and service delivery to the customers.
Products and Services
The types of credit products and services offered can be classified as follows: 1. Fund Based Facilities – Line of credit
These are products in which a bank is ‘out of funds’ by lending money to its customers – hence, they are loan
products. The earning of the bank for such facilities is mainly interest income.
2. Non – Fund Based Facilities:
Here, the bank primarily stands guarantee for its customer. Examples of non-fund based facilities are ‘letters of credit’ and ‘guarantees’. They are called non-fund facilities as they do not involve actual lending of funds.
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Both fund-based and non fund-based facilities can be classified on the basis of:1. Purpose 2. Maturity
3. Revolving or one-off 4. Security
To understand the various facilities, we will use the funded and non funded classification.
Funded facilities:
Working Capital Loans • Overdraft Facility • Cash Credit Facility
• Working Capital Demand Loans (WCDL) Long-term Loans
Trade Finance
• Pre-shipment Loans • Post-shipment Loans
Non Funded facilities:
Trade Products
• Intermediaries • Letter of Credit (LC) • Bank Guarantee
Cash Management Services (CMS)
Working Capital Loans: Banks provide various forms of loans to meet the daily requirements of businesses. These
are generally for a short term (up to 1 year).
Overdraft Facility: An overdraft facility or OD is a revolving credit facility that allows a borrower to
overdraw funds beyond the available balance, up to an agreed limit, from her account.
Cash Credit Facility: As in an OD, the business can withdraw up to the sanctioned limit when needed,
paying interest only on the amount withdrawn and for the period withdrawn. This is a facility against collateral of receivables and inventory of the business. The limit is typically 60-70% of the value of the collateral. The buffer (30-40%) which the bank keeps on the value of the asset is called the ‘margin’.
Working Capital Demand Loans (WCDL): Working Capital Demand Loan (WCDL) is, in essence, a short
term revolving loan facility given for the working capital requirement of the company.
Long Term Loans: Banks provide secured or unsecured long term loans to corporations – these could be to finance
expansions, buy real estate or machinery etc.
Trade Finance: Corporate banking provides services to facilitate international trade. These include loans to the
seller, to bridge his funding requirements till he/she gets payment from the buyer. These can be both pre-shipment and post-shipment loans.
Bill Discounting: It serves to provide liquidity to an exporter. This is done by advancing him/her a portion of the face value of a trade bill drawn by the exporter. The bill must have been accepted by the buyer, and then endorsed to the bank.
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Trade Products
Intermediaries: Banks also act as intermediaries for documents and funds flow in an international trade
transaction. This is because transfer through banking channels is far more secure, than if the buyer were to send money directly to the seller, or the seller trying to send documents directly to the buyer.
Letter of Credit: The Letter of Credit (LC) allows the buyer and seller to contract a trusted intermediary (a bank),
that will guarantee full payment to the seller provided he has shipped the goods and complied with the terms of the agreement.
Bank Guarantee (BG): A Bank Guarantee (BG) is an instrument by which the issuing bank guarantees the
satisfactory performance of a contract, or of the non-happening of an event (such as an event of default), to the beneficiary. It can be a financial or performance guarantee.
Cash Management Services (CMS): CMS involves no credit risk for the bank. The bank provides a pure
administrative service for the corporate by managing the company’s receipts and payments across the country. Hence, credit evaluation (that is, evaluating whether or not to grant a credit limit for the company) is not relevant here.
Credit Evaluation: Before granting a facility/loan, the bank must follow a stringent credit evaluation process, to
determine whether or not to give the loan to the company. This function analyses the ‘credibility’ of an organization.
The credit process involves a qualitative and quantitative appraisal of the client. Qualitative analysis includes analysis of:
Promoter’s reputation Industry outlook Past track record
Extent of competition etc.
Quantitative analysis includes comparing the financials over a period of time to evaluate performance.
SME Banking
An SME – Small and Medium Enterprise – is also a corporate. So the facilities offered are similar. The most popular products a bank provides to an SME are working capital products. They are:
Cash Credit: As described earlier, this is an overdraft facility which is secured by a business’ inventory and receivables.
A bank will offer 60-70% of the value of the collateral as a cash credit facility. While the receivables & inventory should be revalued periodically, usually a bank will do this once a year.
Overdraft (OD) Facility: This is an unsecured line of credit. The bank will allow the SME to overdraw their current account upto a certain limit. Interest is charged only on the overdrawn amount for the period it is overdrawn.
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Specialized Divisions and Support Functions
Specialized Divisions
Let’s look at the specialized divisions of a bank.
1. Investment Banking
The traditional function of a bank was to accept deposits and lend money. But, as the needs of corporates became more complex, a separate division got carved out of the corporate bank to cater to these niche requirements of customers. This was called the investment banking division.
Its functions can be broadly classified as follows:
a) Mergers and acquisitions – Investment Banks assist in negotiating and structuring a merger between two companies. If, for example, a company wants to buy another firm, then an investment bank will help finalize the purchase price, structure the deal, and generally ensure a smooth transaction.
b) Loan Syndication - In case, a company wishes to raise a large sum of money, the investment bank can help arrange funds from a group of banks. ‘Syndicate’ means group and this process of funding is called loan syndication.
c) Issue Management - This is also called Merchant Banking. In case a company wishes to raise money directly from the public by issuing shares or bonds, the investment bank will advise and facilitate the entire process. This involves determining the price, the regulatory formalities to be complied with, and to ensure the investor gets the shares, and the company the money.
d) Private Equity (PE) & Venture Capital (VC)- Some other services that fall within the gamut of
investment banking are Private Equity and Venture Capital. This involves investing in the equity of operating companies that are not publicly traded on stock exchange. Private equity or Venture Capitalists take an equity stake and assist the management in the overall direction of the business.
e) Underwriting:
The investment bank also provides underwriting services. An underwriter guarantees that the capital issue will be subscribed to the extent of his underwritten amount.
2. Financial Markets/Treasury
The treasury division facilitates transactions in the currency and fixed income(bond) markets, for their own books, or on behalf of corporate customers.
Companies can buy or sell foreign currency through the bank for their import or export requirements.
Banks route orders to markets and maintain the information regarding positions and prices for such trades. They also facilitate the process of settlement.
3. Private Banking/Wealth Management
Private banking involves personalized services such as money management, financial advice, and investment services for ‘High Net worth Individuals (HNIs)’.
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Traditional Banking Services –
Personalised check books Separate counters Banking at your doorstep Instant wire transfers
Advisory Services – These are divided into
a) Investment Management & Advice: A client relationship manager understands the client’s liquidity,
capital and investment needs. Advisory services can relate to investments, tax planning, real estate management and art advisory.
The investment advice can be of two types:
Self-Directed or Non-discretionary - This is investment advisory in which the bank offers investment recommendations based on the Client’s approval. The client may choose to ignore this. Discretionary - In this case, the bank’s portfolio managers make investment decisions on behalf of
the customer.
b) Liquidity Management: This involves management of a Client’s liquidity (cash etc) needs through
short-term credit facilities, flexible cash management services etc. An exclusive cash management service with "sweep" facility is a Private Banking feature.
Private banking clients typically demand higher returns on their investment, and as a result banks offering these services are heavily dependent on efficient systems and processes to achieve this.
Private Banking – Workflow
The high-level process flow for private banking is shown below.
The front office manages the client interaction and trade execution part. He gets inputs from the middle office in terms of investment research reports. The back office handles the processing and settlement of the transactions. This includes sending regular statements, payment messages, to the client etc.
Certain activities are outsourced to the service providers such as safe custody of securities, tax processing etc.
4. Rural & Agricultural Banking
A bank’s involvement in rural banking can be to take deposits and lend money. However, the branch network required to access rural areas vs. the typical deposit amounts gathered, make it an unviable proposition for private sector banks.
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An important vehicle for funding in rural areas tends to be microfinance which can be retail (to SHGs) or wholesale (to Micro Finance Institutions who then lend the money to SHGs).Broadly, credit or funding can be focused on three parts of the agricultural chain described below:
The risks a bank faces specific to agricultural lending are the risk of crop failure and drop in crop prices, as both will impact repayment.
Support Functions
Below are some of functions that encompass the whole bank, and are not restricted to a specific division.
a) Sales & Marketing: The sales function is largest for the Retail Bank (offerings for individuals). The sales staff
can be divided by product. Banks and NBFCs achieve their sales for Retail Banking through:
External/outsourced agencies: These are called Direct Sales Agencies (DSAs) or Direct Marketing Agencies (DMAs). They are paid a commission on every sale. Other outsourcing agencies are tele-marketing and direct mailing agencies.
Internal sales staff: Every interaction with the bank is seen as an opportunity to sell its services. Hence branch staff and relationship managers often cross sell various products and services of the bank.
b) Asset Liability Management (ALM): For a business, timings of the returns from the asset, must match the
due date of the liability. A basic aspect of financial planning encompasses such matching activities of cash flows and is given the generic label: Asset and Liability Management or, in short, ALM.
Asset Liability Management consists of managing this interest rate risk to within acceptable limits. ALM also manages liquidity risk for the organization; that is, the bank must always have sufficient funds to service their depositors.
FARMERS &
FARMER COLLECTIVES INPUT: SUPPLIERS
Suppliers of: Seeds, Fertilisers, farming equipment PURCHASERS Agriprocessors, Wholesalers, Agri Businesses Working Capital Financing Dealer financing Guarantees Working capital funding
Short term and long term loans
Warehouse financing • Individual loans against
crops
• For Land development • Mechanisation • Poultry, piggery, dairy
farming support • Warehousing financing • Funding of fertiliser
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c) Human Resource Management: As the name suggests, this deals with managing the employees of the bank.
This includes recruitment, training, evaluation, compensation and any issues of conflict amongst the employees.
d) Legal and Compliance: This deals with any regulatory requirements of the bank. Any lawsuits will be handled
by the legal department. Any new client contracts or legal agreements will also be drawn up and vetted by this division.
e) Finance and Control: This manages the internal and external reporting requirements for the bank. This is
where the financial statements of the organization are prepared and reported. This department is closely associated with the senior management of the organization.
f) Audit: This manages the internal audit requirements for the bank. It is an independent division that evaluates
the control systems within the organisation.
g) Technology: This is responsible for managing the existing technology platform of the bank. They also design
any new systems and processes that are required to provide the bank with a competitive edge. A lot of this activity could be outsourced to IT companies as well, in which case managing the technology vendors would also be a role of the technology division.
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NBFCs
Introduction
Non Banking Finance Companies (NBFCs) are financial institutions that provide services, similar to banks, but they do not hold a banking license. The main difference is that NBFCs cannot accept deposits repayable on demand.
Classification of NBFCs
NBFCs have been classified into three types:
1. Asset Finance Company (AFC): An AFC is an NBFC, whose principal business is the financing of physical
assets.
This includes financing of automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments and general purpose industrial machines.
An AFC may be either
1. Giving loans to businesses for purchasing the physical assets – tractors, machinery etc. 2. Leasing these assets to businesses.
Examples of AFCs are Infrastructure Finance Limited, Diganta Finance etc.
2. Investment Company (IC): This is an NBFC whose primary business is purchase and sale of securities
(financial instruments, such as stocks and bonds).
A mutual fund would come under this category. Examples of an Investment Company (IC) are Motilal Oswal, UTI Mutual Fund etc.
3. Loan Company (LC): Loan Company (LC) means any NBFC whose principal business is that of providing finance,
by giving loans or advances. It does not include leasing or hire purchase. Example of a Loan Company (LC) is Tata Capital Limited.
NBFCs can be further classified into those taking deposits or those not taking deposits. Only those NBFCs can take deposits, that
a) Hold a valid certificate of registration with authorization to accept public deposits. b) Have minimum stipulated Net Owned Funds (NOF – i.e. owners’ funds)
c) Comply with RBI directions such as investing part of the funds in liquid assets, maintain reserves, rating etc. issued by the bank.
How do NBFCs Access Funds?
NBFCs cannot access CASA funds, they can only access fixed deposits which are the most expensive among all deposits. Also, not all NBFCs can access deposits – there are regulations governing which can, and which cannot. Their cost of funds, and hence lending rate, is typically higher than a bank’s. People borrow from NBFCs because their lending norms are not as strict as a bank’s. However, their default rates are therefore also generally higher.
NBFC Business Offerings
NBFCs focus primarily on the areas which banks do not service, or service sparingly. Deposits (for some), lending, leasing and hire purchase are key activities. Business offerings of an NBFC are:
1. Deposits: Customers deposit with NBFCs because they pay rates higher than those of banks. They can accept public deposits which are of fixed maturity. The minimum maturity period is 12 months and the maximum 60 months.
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2. Leasing & Hire Purchase: An asset finance company, mainly derives revenues from financing assets such as equipment, vehicles, etc.In a Lease transaction two parties are involved:
a) Lessor: The person who pays rent for land or property from a lessor. b) Lessee: The person who rents land or property to a lessee.
The ownership of the asset rests with the asset finance company. The AFC earns lease rentals, which comprise finance or hiring charge and recovery of the ‘used up’ value of the leased asset.
In hire purchase the ownership of the asset is transferred to the hirer at the end of the HP period.
3. Lending: NBFCs tend to take on higher risk than a bank. They are not constrained by the priority sector lending requirement which banks have.
4. Investment Services:
NBFCs offer a wide range of investment services such as:
Merchant Banking and Underwriting - Investment Banking functions where a business that wishes to raise capital is provided various services.
Stock Broking - Trading on behalf of customers.
Asset Management - Managing clients’ funds. Mutual Funds, Pension Funds, Private Equity Funds all offer these services.
Venture Capital & Private Equity - Equity capital to start-up companies; and private (not public) equity capital for other businesses.
Custodial services - Settlement of securities transactions.
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Payment Systems: An Introduction
Any non-cash payment system consists of four parties: 1. The payer, who’s making the payment 2. The payee, who’s receiving the payment 3. The payer’s bank
4. The payee’s bank
Only banks can participate in the payment system. Hence the payment system concerns itself with the payer’s and payee’s banks. They in turn interact with the payer and payee respectively.
The two banks can exchange the funds either directly or through an intermediary called a Clearing House (CH) or Clearing Agency (explained later).
Let’s now understand what a non-cash payment looks like. It consists of two components:
1. The Payment Instruction: The payment instruction, where a message is transmitted between the two banks.
2. Transfer of Funds: Transfer of funds between the two bankscan happen either along with, or later than, the payment instruction.
Concepts and Terms:
Let us look at some concepts and terms used in the world of payments.
Clearing: This is the process of defining payment obligations between banks within a payment system – that is,
which bank owes what to whom.
Clearing House (CH): The banks could either exchange messages and funds with each other, or through a central
intermediary.
One central agency keeping track of the payment instructions and fund exchanges between banks means that, each bank only needs to interact with one entity – the Clearing House (CH).
Functions of a clearing house: Record
Reconcile Calculate Send information
Settlement: Once the payment obligation has been defined, then the bank has to exchange funds, or settle the
obligation.
Settlement Bank: Settlement happens via debit/credit of accounts which banks hold with a settlement bank.
Each of these banks can hold a settlement account with a third bank, designated for this purpose as the ‘settlement bank’.
Correspondent Bank/Correspondent: A correspondent bank is one which acts as a representative of another
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Nostro Account: It is a bank’s foreign currency account with any other bank. This means, „our account with them‟.
Vostro Account: This is how a correspondent bank refers to another bank’s foreign currency account with it. It
means ‘their account with us’.
On-Us: This term is used within a bank, when the payment transaction it receives, is drawn on it. That is, payer and
payee belong to the same bank.
Off-Us: In case the payer and payee belong to different banks, the transaction is called ‘Off-Us’ or a ‘transit
item/clearing item’.
Float: Advantage to the payer/payer’s bank because of delay in the payment system, as he enjoys the usage of the
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Payment Systems – Process and Methods
Layers within the payment system
Various layers within the payment system are:
Central Bank of the country: The Settlement Bank - most often, the RBI– ensures that payments get
settled between various banks.
Clearing house: The Clearing house in turn, sends data to the settlement bank.
Service branches: Each bank in turn, will have one service branch which interacts with the clearing house. Member banks: Exchange of funds between the individuals and businesses takes place via their banks,
who are members of the payment system.
Households/Firms: The largest users of the system – households/individuals and businesses.
Steps in a payment system
There are 2 steps in payment systems:
1. Clearing: It is the process of classifying which bank owes what to whom. 2. Settlement: It involves settling obligations via exchange of funds.
Settlement can be of two types.
Deferred Net Settlement systems: Refers to settlement between banks by netting off what they owe
each other. Since netting can only happen once some transactions have occurred, there is always a lag between clearing and settlement.
Hence netsettlement systems are also called Deferred Net Settlement or DNSsystems/methods.
Real Time Gross Settlement (RTGS) systems: RTGS systems enable settlement of each transaction, at
the same time as the payment instruction. These are typically used for large value payments, and are not feasible for small value retail payments.
DNS is feasible for large volume, lower value payments and RTGS is great for high value, time critical payments.
Categorization of Payment Methods
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Paper based payments
Cheques: A cheque is a payment instrument in a specified format, using which, the payer instructs (or ‘draws on’) his bank to allow a debit from his account.
Demand drafts: Similar to a cheque except that a cheque, is payable finally by the payer (‘drawer’, in cheque terminology) who holds an account with the paying bank, while a draft is payable by the paying bank itself.
Card based payments
Debit cards: Plastic card which one can swipe to give electronic instruction to bank to debit his account and transfer funds to recipient.
Credit cards: Plastic card which one can swipe to give electronic instruction to bank to transfer funds to recipient but without debiting his account for a specified period.
Electronic payments
Electronic Clearing Service (ECS): The Electronic Clearing Service clears and settles mainly bulk, repeated electronic payments. In this one time authorization, your account may be debited periodically. National Electronic Funds Transfer (NEFT): NEFT is useful for one time electronic payments. Real Time Gross Settlement (RTGS): RTGS is usedif one wants to make a one time transaction
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Risk Management in Banks and NBFCs
Risk is the probability of financial loss. It’s not a certainty. This is important, in order to measure and manage risk. Risks can arise both from causes internal to a business (such as employee fraud) or externally from the
environment - causes not directly related to operations (e.g. exchange rate risk for IT companies). The key then, is to be aware and take steps to manage risks.
Risk Management Process
Risk management is a three stage process and is shown below: 1. Identify the risk
2. Measure the risk
3. Implement risk management measures
Risk Management in Financial Institutions
Risk Management for financial institutions like banks has large significance, as there are a lot of parties/processes dependent on them.
If a bank fails, hundreds of thousands of depositors money is at stake; the entire chunk of payments which is due to be paid to other banks via the deferred net settlement process, is at stake – hence other banks are affected; this bank will have borrowed from other FIs – they in turn will have problems paying back their obligations.
Typical Causes of Financial Crises
The root causes of financial crises have been classified as follows:
Asset (Loan) Quality
Asset-Liability Mismatch: Banks and financial institutions have assets and liabilities of different
maturities. This exposes them to Interest Rate Risk and Liquidity Risk.
Fraud: Poor risk management processes have also resulted in frauds in large institutions.
Let’s discuss the risk management process in detail.
Identifying Risk
The first step in the risk management process is to identify the sources of risk.Credit Risk, Market Risk and Operational Risk encompass over 90% of the risk faced by financial institutions today.
Market Risk - Risk of loss due to price movements in any market the institution is trading in, such as
currency, stocks, bonds, commodities etc.
Credit Risk - Risk of loan default
Operational Risk - Risk of incurring losses due to manual errors, fraud or system failure.
Liquidity Risk - Risk of not having liquid funds when needed. Liquidity risk exists typically in emerging
markets.
Let us now map each of these risks more specifically to each division of a bank/financial institution to make it more relevant.
Current Account and Savings Account (CASA) - Liquidity Risk: The institution should have enough
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Loans – Credit Risk: The institution should ensure that loans given are recoverable from the parties and
there are minimum defaults.
Cheque Clearing – Operational Risk: The institution should ensure that the clearing process takes place
smoothly without any manual errors. Else they would be exposed to operational losses.
Letter of Credit – Credit Risk: As the institution is providing a guarantee, they are exposed to default risk,
similar to loans.
Cash Management Service (CMS) – Operational Risk: Here again, as this activity is operation intensive,
the institution is exposed loss due to system failure, manual errors etc.
Trading – Market Risk & Operational Risk: As this involves the front office activity of trading in market
variables such as stocks and bonds and the back office activity.
Underwriting – Market Risk: As the institution agrees to buy unsubscribed amount in case of public issues
and issuance of other financial instruments.
Asset Liability Management – Market Risk & Liquidity Risk: Both loans and deposits are subjected to
market risk and liquidity risk.
Measuring Risk
The next stage in risk management process is to measure the risk. We all know that risk can be defined as probability of occurrence and deviation from expectation.
There are a number of other risk parameters such as ‘Duration’ – used for bonds, ‘Beta’- used for equities, ‘Factor sensitivity’ - used for currencies etc.
Let us discuss briefly about a comprehensive measure of risk called ‘Value at Risk (VaR)’.
Value at Risk (VaR)
VaR is an attempt to provide a single number summarizing the total risk in a portfolio of financial assets. It has become widely used by corporate treasurers and fund managers as well as by financial institutions.
Some of the impetus for the use of VaR has also come from the regulators. Regulators now require all banks to calculate VaR. They use VaR in determining the capital a bank is required to keep, to reflect the risks it is bearing.
Remember, risk measures are statistical estimates which can never be made with 100% confidence. The full statement of VaR therefore reads as follows “We are X% confident that we will not lose more
than V rupees over the next N days.”
There are various methodologies for computing VaR. Variance -Covariance Methodology
o J.P Morgan's Risk Metrics
o FEDAI methodology for currencies in India Simulation Methodology
o Historical Simulation (using past data) o Monte Carlo (using random sampling)
Basel Norms for Capital Adequacy
The Bank for International Settlements (BIS) is an international organization that fosters international monetary and financial cooperation, and serves as a bank for central banks of various countries.
The Basel Committee on Banking Supervision was formed in order to secure standardization across the global banking industry, to limit risks faced by the banking system.
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Basel I norms defined the minimum capital required to be maintained by internationally active banks. This capital required, was linked directly to the risk faced by them in their operations.The norms established a standard of risk weights applied to different classes. So, riskier lending (such as unsecured loans to borrowers of doubtful credit history) attracted higher risk weights, and hence, higher capital requirements.
The risk weights suggested to banks were as follows:
Lending to your own branch – 0%
Lending to another bank – 20%
Lending to a corporate of certain credibility – 50%
Lending to other entities – 100%
Basel – II Framework
The Basel- II Accord later came up with a comprehensive framework covering credit, market and operational risk as well.
The amount of capital to be maintained would be directly proportional to the risks taken in each category.
Basel III – The Latest
The financial crisis of 2008 made the Basel committee review and come up with more stringent norms. One of the main outcomes of Basel III is a significant rise in the banking industry’s capital requirements.
It increased the minimum capital requirement for RWA to 10.5% from 8%.
It also increased the weightage of core capital (Tier I) against RWA.
It introduced measures for better management of liquidity risk within banks.
Banking Laws and Regulatory Compliances:
Banking Laws
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1. Negotiable Instruments (N.I) Act: The N.I Act covers the rules around transactions of negotiableinstruments. Negotiable instruments are payment instruments which are transferrable from one party to
another.
Example: promissory note, bill of exchange
A Promissory Note is a note written by a borrower, promising to pay back the sum borrowed. Bill of exchange is an instrument used in business transactions. A seller will prepare a bill saying
‘Pay (seller or whoever is to be paid) the payment amount’, and send it to the buyer.
2. UCPDC: It stands for Uniform Customs and Practices for Documentary Credits. A Letter of Credit (LC) is also called a documentary credit. As trade finance is across countries, there have to be uniform practices followed globally. Hence, the International Chamber of Commerce (ICC) has issued this set of regulations governing international trade. It’s commonly called ‘UCP’ and as the current version is called 600, the ‘UCP 600’.
3. SARFAESI Act: SARFAESI stands for Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act. This Act covers the rights a lender has over the collateral, when a secured loan defaults.
‘Reconstruction’ of an asset, is banker-speak for reworking the terms of a loan to ensure that the money is repaid.
The SARFAESI Act in case of default, covers features such as:
a) Securitization: Issuing securities – financial instruments – against the recovered assets. It can be done only by specific registered entities called an asset reconstruction company or securitization company.
b) Guidelines for Asset Reconstruction: It covers how a defaulting business should be managed or controlled to ensure repayment. Payments can be rescheduled, and secured collateral
repossessed.
c) No court intervention needed: One of the main features of this Act is, the lender can take over the collateral without court intervention, which was not possible earlier.
Regulatory Compliance
Regulatory compliance means, ensuring that the bank is functioning within the regulatory requirements laid down by the regulator-the Central Bank. The compliance requirements for a bank are:
1. Reserve Requirements: These requirements define how much of every deposit must be deposited with the RBI.
Currently, 4% of every deposit must be deposited with the RBI under the Cash Reserve Ratio (CRR). And 22.5% of every deposit must be invested in defined Government securities, under the Statutory Liquidity Ratio (SLR).
NBFCs have only SLR requirements, no CRR. This protects the bank/finance company (FC) against liquidity risk and the customer against default risk.
2. Know Your Customer (KYC) & Anti Money Laundering (AML): These compliance requirements come from the Prevention of Money Laundering Act (PMLA). KYC and AML norms have been implemented the world over post 9/11.
KYC procedures enable banks to know/understand their customers and their financial dealings better, which in turn help them manage their risks prudently. Here the entire focus is on gathering sufficient information on a customer’s profile, and monitoring his transactions on an ongoing basis for ‘suspicious’ (unusual) activity.
A bank has hundreds of thousands of customers. The effort involved in actually monitoring every transaction is huge. The steps involved in monitoring transactions are:
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1. Customer Identification Procedure: to gather adequate information about a customer and his/herfinancial behavior. The key elements are, to collect and verify proof of identity and address (for individuals), categorise the customer into different risk profiles and review risk categorization regularly. 2. Monitoring Of Transactions: To make monitoring of transactions easy the customers are classified
into low, medium and high risk customers. Once customers are categorized, their account profiles are developed.
3. Reporting: As per RBI regulations, all cash transactions greater than INR 1 million must be reported via what’s called a Cash Transaction Report (CTR). Further, any suspicious transactions also need to be reported.
