Banking Financial Services Management: Ms. Jebakerupa Roslin Amirtharajan St. Joseph S College of Engineering MBA

BA5008
Banking Financial Services Management
Ms. Jebakerupa Roslin Amirtharajan St. Joseph‘s College of Engineering MBA

BA5008-Banking Financial Services Management Department Of MBA 2018-2019
T HE I NDIA N B ANKING S Y STEM

An Overview
A bank is a financial institution that provides banking and other financial services to their customers. A bank is
generally understood as an institution which provides fundamental banking services such as accepting deposits and
providing loans. There are also nonbanking institutions that provide certain banking services without meeting the
legal definition of a bank. Banks are a subset of the financial services industry.
Need of the Banks
Before the establishment of banks, the financial activities were handled by money lenders and individuals. At that
time the interest rates were very high. Again there were no security of public savings and no uniformity regarding
loans. So as to overcome such problems the organized banking sector was established, which was fully regulated by
the government. The organized banking sector works within the financial system to provide loans, accept deposits
and provide other services to their customers. The following functions of the bank explain the need of the bank and
its importance:
 To provide the security to the savings of customers.
 To control the supply of money and credit
 To encourage public confidence in the working of the financial system, increase savings speedily and efficiently.
 To avoid focus of financial powers in the hands of a few individuals and institutions.
 To set equal norms and conditions (i.e. rate of interest, period of lending etc) to all types of customers.
Regulation in Indian Banking System
Banking in India originated in the 18th century. The oldest bank in existence in India is the State Bank of India, a
government-owned bank in 1806. SBI is the largest commercial bank in the country. After the independence,
Reserve Bank of India was nationalized and given wide powers. Currently, India has 96 Scheduled Commercial
Banks, 27 public sector banks, 31 private banks and 38 foreign banks.
The following are the major steps taken by the Government of India to Regulate Banking institutions in the
country:-
 1949 : Enactment of Banking Regulation Act.
 1955 : Nationalisation of State Bank of India.
 1959 : Nationalization of SBI subsidiaries.
 1961 : Insurance cover extended to deposits.
 1969 : Nationalisation of 14 major Banks.
 1971 : Creation of credit guarantee corporation.
 1975 : Creation of regional rural banks.
 1980 : Nationalisation of seven banks with deposits over 200 Crores.
India‘s first credit card, Central Card, is introduced by the Central Bank of India.
 1987 : India‘s first debit card is introduced by Citi Bank, first ATM installed in Mumbai by HSBC.
 1993 : HDFC becomes the first Indian company to receive in-principal approval for setting up a
private sector bank.
 1994 : Rupee is made convertible on the current account.
Nationalization of Indian Bank s
After independence the Government of India (GOI) adopted planned economic development for the country
(India). Accordingly, five year plans came into existence since 1951. This economic planning basically
aimed at social ownership of the means of production.
However, commercial banks were in the private sector those days. In 1950-51 there were 430 commercial
banks. The Government of India had some social objectives of planning. These commercial banks failed
helping the government in attaining these objectives. Thus, the government decided to nationalize 14 major
commercial banks on 19th July, 1969.
All commercial banks with a deposit base over Rs.50 crores were nationalized. It was considered that banks
were controlled by business houses and thus failed in catering to the credit needs of poor sections such as
St. Joseph’s College of Engineering 1
cottage industry, village industry, farmers, craft men, etc. The second dose of nationalisation came in April
1980 when banks were nationalized.
Objectives behind Nationalisation of Banks in India
The nationalisation of commercial banks took place with an aim to achieve following major objectives.
 Social Welfare: It was the need of the hour to direct the funds for the needy and required sectors of the Indian
economy. Sector such as agriculture, small and village industries were in need of funds for their expansion and
further economic development.
 Controlling Private Monopolies: Prior to nationalisation many banks were controlled by private business
houses and corporate families. It was necessary to check these monopolies in order to ensure a smooth supply of
credit to socially desirable sections.
 Expansion of Banking: In a large country like India the numbers of banks existing those days were certainly
inadequate. It was necessary to spread banking across the country. It could be done through expanding
banking network (by opening new bank branches) in the un-banked areas.
 Reducing Regional Imbalance: In a country like India where we have a urban-rural divide; it was necessary
for banks to go in the rural areas where the banking facilities were not available. In order to reduce this
regional imbalance nationalisation was justified:
 Priority Sector Lending: In India, the agriculture sector and its allied activities were the largest contributor to
the national income. Thus these were labeled as the priority sectors. But unfortunately they were deprived of
their due share in the credit. Nationalisation was urgently needed for catering funds to them.
 Developing Banking Habits: In India more than 70% population used to stay in rural areas. It was necessary to
develop the banking habit among such a large population.
CLASSIFICATION OF BANKING INDUSTRY IN INDIA
The Banking structure in India can be broadly segmented into 3 parts viz., Central Bank, Scheduled Banks & Non
Scheduled Banks. Let us decode each one of these terms so that you may have a thorough understanding of each
of these terms which will you help you in exams like SBI PO, SBI Clerk, RBI Assistant, IBPS and various other
Banking and Insurance exams.
Reserve Bank of India
Reserve Bank of India is the Central Bank of our country. It was established on 1st April 1935 under the RBI Act of
1934. It holds the apex position in the banking structure. RBI performs various developmental and promotional
functions.
It has given wide powers to supervise and control the banking structure. It occupies the pivotal position in the
monetary and banking structure of the country. In many countries central bank is known by different names.
Figure 1 Banking Structure of India

For example, Federal Reserve Bank of U.S.A, Bank of England in U.K. and Reserve Bank of India in India. Central
bank is known as a banker‘s bank. They have the authority to formulate and implement monetary and credit
policies. It is owned by the government of a country and has the monopoly power of issuing notes.
The aim of the Central Bank is not to earn profit, but to maintain price stability and to strive for economic
development with all round growth of the country.
Scheduled and Non -Scheduled banks:
A scheduled bank is a bank that is listed under the second schedule of the RBI Act, 1934. In order to be included
under this schedule of the RBI Act, banks have to fulfill certain conditions such as having a paid up capital and
reserves of at least 5 lakhs and satisfying the Reserve Bank that its affairs are not being conducted in a manner
prejudicial to the interests of its depositors. Scheduled banks are further classified into commercial and cooperative
banks. Non- scheduled banks are those which are not included in the second schedule of the RBI Act, 1934. At
present these are only three such banks in the country.
COMMERCIAL BANKS
Commercial bank is an institution that accepts deposit, makes business loans and offer related services to various
like accepting deposits and lending loans and advances to general customers and business man. These institutions
run to make profit. They cater to the financial requirements of industries and various sectors like agriculture, rural
development, etc. it is a profit making institution owned by government or private of both.
Type of Commercial
Major Shareholders Major Players
Banks
Public Sector Banks SBI, PNB, Canara Bank, Bank of Baroda, Bank of
Government of India
India, etc
Private Sector Banks ICICI Bank, HDFC Bank, Axis Bank, Kotak Mahindra
Private Individuals
Bank, Yes Bank etc.
Foreign Banks Standard Chartered Bank, Citi Bank, HSBC,
Foreign Entity
Deutsche Bank, BNP Paribas, etc.
Central Govt,
Regional Rural Banks Andhra Pradesh Grameena Vikas Bank, Uttranchal
Concerned State Govt and Sponsor Bank
Gramin Bank, Prathama Bank, etc.
in the ratio of 50 : 15 : 35
Commercial bank includes public sector, private sector, foreign banks and regional rural banks:
Public sector banks:

It includes SBI, seven (7) associate banks and nineteen (19) nationalised banks. Altogether there are 27 public sector
banks. The public sector accounts for 90 percent of total banking business in India and State Bank of India is the
largest commercial bank in terms of volume of all commercial banks.
Private sector banks:

Private sector banks are those whose equity is held by private shareholders. For example, ICICI, HDFC etc. Private
sector bank plays a major role in the development of Indian banking industry.
Foreign Sector Banks:

Foreign banks are those banks, which have their head offices abroad. CITI bank, HSBC, Standard Chartered etc. are
the examples of foreign bank in India.
Regional Rural Bank (RRB):

These are state sponsored regional rural oriented banks. They provide credit for agricultural and rural
development. The main objective of RRB is to develop rural economy. Their borrowers include small and marginal
farmers, agricultural labourers, artisans etc. NABARD holds the apex position in the agricultural and rural
development.
Co-operative Bank:
Co-operative bank was set up by passing a co-operative act in 1904. They are organised and managed on the
principal of co-operation and mutual help. The main objective of co-operative bank is to provide rural credit. The
cooperative banks in India play an important role even today in rural co-operative financing. The enactment of
Co-operative Credit Societies Act, 1904, however, gave the real impetus to the movement. The Cooperative Credit
Societies Act, 1904 was amended in 1912, with a view to broad basing it to enable organisation of non-credit
societies. Three tier structures exist in the cooperative banking:
 State cooperative bank at the apex level.
 Central cooperative banks at the district level.
 Primary cooperative banks and the base or local level.
Development banks and other financial institutions:
A development bank is a financial institution, which provides a long term funds to the industries for development
purpose. This organisation includes banks like IDBI, ICICI, IFCI etc. State level institutions like SFC‘s SIDC‘s etc. It also
includes investment institutions like UTI, LIC, and GIC etc.
F UNCTIONS O F B A NK
Important Banking Functions & Services
The functions of banks are briefly highlighted in following Diagram or Chart.
Primary Functions of Banks:

The primary functions of a bank are also known as banking functions. They are the main functions of a bank. These
primary functions of banks are explained below.
Accepting Deposits:
The bank collects deposits from the public. These deposits can be of different types, such as:-
 Saving Deposits: This type of deposits encourages saving habit among the public. The rate of interest is low. At present
it is around 4% to 6% p.a. Withdrawals of deposits are allowed subject to certain restrictions. This account is suitable to
salary and wage earners. This account can be opened in single name or in joint names.
 Fixed Deposits: Lump sum amount is deposited at one time for a specific period. Higher rate of interest is paid, which
varies with the period of deposit. Withdrawals are not allowed before the expiry of the period. Those who have surplus
funds go for fixed deposit.
 Current Deposits: This type of account is operated by businessmen. Withdrawals are freely allowed. No interest is paid.
In fact, there are service charges. The account holders can get the benefit of overdraft facility.
 Recurring Deposits: This type of account is operated by salaried persons and petty traders. A certain sum of money is
periodically deposited into the bank. Withdrawals are permitted only after the expiry of certain period. A higher rate
of interest is paid.

Granting of Loans and Advances :
The bank advances loans to the business community and other members of the public. The rate charged is higher
than what it pays on deposits. The difference in the interest rates (lending rate and the deposit rate) is its profit. The
types of bank loans and advances are:-
 Overdraft: This type of advances are given to current account holders. No separate account is maintained. All entries
are made in the current account. A certain amount is sanctioned as overdraft which can be withdrawn within a
certain period of time say three months or so. Interest is charged on actual amount withdrawn. An overdraft facility is
granted against a collateral security. It is sanctioned to businessman and firms.
 Cash Credits: The client is allowed cash credit up to a specific limit fixed in advance. It can be given to current account
holders as well as to others who do not have an account with bank. Separate cash credit account is maintained.
Interest is charged on the amount withdrawn in excess of limit. The cash credit is given against the security of tangible
assets and / or guarantees. The advance is given for a longer period and a larger amount of loan is sanctioned than
that of overdraft.
 Loans: It is normally for short term say a period of one year or medium term say a period of five years. Now-a-days,
banks do lend money for long term. Repayment of money can be in the form of installments spread over a period of
time or in a lump sum amount. Interest is charged on the actual amount sanctioned, whether withdrawn or not. The
rate of interest may be slightly lower than what is charged on overdrafts and cash credits. Loans are normally secured
against tangible assets of the company.
 Discounting of Bill of Exchange: The bank can advance money by discounting or by purchasing bills of exchange both
domestic and foreign bills. The bank pays the bill amount to the drawer or the beneficiary of the bill by deducting
usual discount charges. On maturity, the bill is presented to the drawee or acceptor of the bill and the amount is
collected.
Secondary Functions of Banks:

The bank performs a number of secondary functions, also called as non-banking functions. These important
secondary functions of banks are explained below.
Agency Functions:
The bank acts as an agent of its customers. The bank performs a number of agency functions which includes:-
 Transfer of Funds: The bank transfer funds from one branch to another or from one place to another.
 Collection of Cheques: The bank collects the money of the cheques through clearing section of its customers. The bank
also collects money of the bills of exchange.
 Periodic Payments: On standing instructions of the client, the bank makes periodic payments in respect of electricity
bills, rent, etc.
 Portfolio Management: The banks also undertakes to purchase and sell the shares and debentures on behalf of the
clients and accordingly debits or credits the account. This facility is called portfolio management.
 Periodic Collections: The bank collects salary, pension, dividend and such other periodic collections on behalf of the
client.
 Other Agency Functions: They act as trustees, executors, advisers and administrators on behalf of its clients. They act as
representatives of clients to deal with other banks and institutions.
General Utility Functions:

The bank also performs general utility functions, such as :-
 Issue of Drafts and Letter of Credits: Banks issue drafts for transferring money from one place to another. It also issues
letter of credit, especially in case of, import trade. It also issues travellers' cheques.
 Locker Facility: The bank provides a locker facility for the safe custody of valuable documents, gold ornaments and
other valuables.

 Underwriting of Shares: The bank underwrites shares and debentures through its merchant banking division.
 Dealing in Foreign Exchange: The commercial banks are allowed by RBI to deal in foreign exchange.
 Project Reports: The bank may also undertake to prepare project reports on behalf of its clients.
 Social Welfare Programmes: It undertakes social welfare programmes, such as adult literacy programmes, public
welfare campaigns, etc.
 Other Utility Functions: It acts as a referee to financial standing of customers. It collects creditworthiness information
about clients of its customers. It provides market information to its customers, etc. It provides travellers' cheque facility.
R ESERVE B A NK OF I NDIA A CT , 1934

The Central Bank of India
The Reserve Bank of India i.e RBI is the central bank of our country. It was established in the year 1935, under the
Reserve Bank of India Act, 1934. Being a central bank, RBI has control over the entire currency and banking system
in India. It acts as a banker to both the state and the central government in India. It has the exclusive right to issue
currency, notes in the country.
STRUCTURE, ORGANISATION AND GOVERNANCE
The Reserve Bank is wholly owned by the Government of India. The Central Board of Directors oversees the Reserve
Bank‘s business.
Figure 2 Structure of RBI
CENTRAL BOARD OF DIRECTORS

The Central Board has primary authority for the oversight of the Reserve Bank. It delegates specific functions
through its committees and sub-committees. Central Board includes the Governor, Deputy Governors and a few
Directors (of relevant local boards).
GOVERNORS & EXECUTIVE DIRECTORS
The Governor is the Reserve Bank‘s chief executive. The Governor supervises and directs the affairs and business of
the Reserve Bank. The management team also includes Deputy Governors and Executive Directors.
The following are the Executive Directors appointed in RBI:

1. Dr. Deepak Maohanty 2. Dr. M. D. Patra

3. Shri. Deepak Singhal 8. Shri. S. Ganesh Kumar
4. Shri. Sudarshan Sen 9. Smt. Uma Shankar
5. Shri M. Rajeshwar Rao 10. Shri A. K. Misra
6. Smt. Surekha Marandi 11. Smt. Sudha Balakrishnan – Chief Financial Officer
7. Smt. Malvika Sinha
LOCAL BOARDS
The Reserve Bank also has four Local Boards, constituted by the Central Government under the RBI Act, one each
for the Western, Eastern, Northern and Southern areas of the country, which are located in Mumbai, Kolkata, New
Delhi and Chennai. Each of these Boards has five members appointed by the Central Government for a term of
four years. These Boards represent territorial and economic interests of their respective areas, and advise the Central
Board on matters, such as, issues relating to local cooperative and indigenous banks. They also perform other
functions that the Central Board may delegate to them.
OFFICES AND BRANCHES
The Reserve Bank has a network of offices and branches through which it discharges its responsibilities. The various
units operating in the four metros (Mumbai, Kolkata, Delhi and Chennai) are known as offices, while the units
located at other cities and towns are called branches. Currently, the Reserve Bank has its offices, including branches,
at 27 locations in India. The offices and larger branches are headed by a senior officer in the rank of Chief General
Manager, designated as Regional Director while smaller branches are headed by a senior officer in the rank of
General Manager.
Over the last 75 years, as the functions of the Reserve Bank kept evolving, the work areas were allocated among
various departments. At times, the changing role of the Reserve Bank necessitated closing down of some
departments and creation of new departments. Currently, the Bank‘s Central Office, located at Mumbai, has
twenty-seven departments. (Box No.3) These departments frame policies in their respective work areas. They are
headed by senior officers in the rank of Chief General Manager.
CENTRAL OFFICE DEPARTMENTS
Markets Regulation and Research Services Support

• Department of External Supervision • Department of Economic • Customer Service • Department of
Investments and Operations • Department of Banking Analysis and Policy Department Administration and
• Financial Markets Operations and • Department of Statistics and • Department of Currency Personnel Management
Department Development Information Management Management • Department of
• Financial Stability Unit • Department of Banking • Department of Government Communication
• Internal Debt Management Supervision and Bank Accounts • Department of Expenditure
Department • Department of Non-Banking • Department of Payment and and Budgetary Control
• Monetary Policy Department Supervision Settlement Systems • Department of Information
• Foreign Exchange Technology
Department • Human Resources
• Rural Planning and Credit Development Department
Department • Inspection Department
• Urban Banks Department • Legal Department
• Premises Department
• Rajbhasha Department
• Secretary‘s Department
Figure 3 RBI Departments
Primary Authority of the Central Board

The Central Board has primary authority for the oversight of RBI. It delegates specific functions through its
committees, boards and sub-committees.
Board for Financial Supervision (BFS)
In terms of the regulations formulated by the Central Board under Section 58 of the RBI Act, the Board for
Financial Supervision (BFS) was constituted in November 1994, as a committee of the Central Board, to undertake
integrated supervision of different sectors of the financial system. Entities in this sector include banks, financial

institutions and non-banking financial companies (including Primary Dealers). The Reserve Bank Governor is the
Chairman of the BFS and the Deputy Governors are the ex officio members. One Deputy Governor, usually the
Deputy Governor in-charge of banking regulation and supervision, is nominated as the Vice-Chairperson and four
directors from the Reserve Bank‘s Central Board are nominated as members of the Board by the Governor.
The Board is required to meet normally once a month. It deliberates on various regulatory and supervisory policy
issues, including the findings of on-site supervision and off-site surveillance carried out by the supervisory
departments of the Reserve Bank and gives directions for policy formulation. The Board thus plays a critical role in
the effective discharge of the Reserve Bank‘s regulatory and supervisory responsibilities.
Audit Sub-Committee
The BFS has constituted an Audit Sub-Committee under the BFS Regulations to assist the Board in improving the
quality of the statutory audit and internal audit in banks and financial institutions. The Deputy Governor in
charge of regulation and supervision heads the sub-committee and two Directors of the Central Board are its
members.
Board for Regulation and Supervision of Payment and Settlement
Systems (BPSS)
The Board for Regulation and Supervision of Payment and Settlement Systems provides an oversight and direction
for policy initiatives on payment and settlement systems within the country. The Reserve Bank Governor is the
Chairman of the BPSS, while two Deputy Governors, three Directors of the Central Board and some permanent
invitees with domain expertise are its members.
The BPSS lays down policies for regulation and supervision of payment and settlement systems, sets standards for
existing and future systems, authorises such systems, and lays down criteria for their membership.
Subsidiaries of the RBI
The Reserve Bank has the following fully - owned subsidiaries:
Deposit Insurance and Credit Guarantee Corporation (DICGC)
With a view to integrating the functions of deposit insurance and credit guarantee, the Deposit Insurance
Corporation and Credit Guarantee Corporation of India were merged and the present Deposit Insurance and Credit
Guarantee Corporation (DICGC) came into existence on July 15, 1978. Deposit Insurance and Credit Guarantee
Corporation (DICGC), established under the DICGC Act 1961, is one of the wholly owned subsidiaries of the Reserve
Bank. The DICGC insures all deposits (such as savings, fixed, current, and recurring deposits) with eligible banks
except the following:
i. Deposits of foreign Governments;
ii. Deposits of Central/State Governments;
iii. Inter-bank deposits;
iv. Deposits of the State Land Development Banks with the State cooperative bank;
v. Any amount due on account of any deposit received outside India;
vi. Any amount, which has been specifically exempted by the corporation with the previous approval
of Reserve Bank of India.
Every eligible bank depositor is insured up to a maximum of Rs.1,00,000 (Rupees One Lakh) for both principal and
interest amount held by him.
National Housing Bank (NHB)
National Housing Bank was set up on July 9, 1988 under the National Housing Bank Act, 1987 as a wholly-owned
subsidiary of the Reserve Bank to act as an apex level institution for housing. NHB has been established to achieve,
among other things, the following objectives:
 To promote a sound, healthy, viable and cost effective housing finance system to all segments of the
population and to integrate the housing finance system with the overall financial system.
 To promote a network of dedicated housing finance institutions to adequately serve various regions and
different income groups.
 To augment resources for the sector and channelize them for housing.
 To make housing credit more affordable.
 To regulate the activities of housing finance companies based on regulatory and supervisory authority
derived under the Act.
 To encourage augmentation of supply of buildable land and also building materials for housing and to
upgrade the housing stock in the country.

 To encourage public agencies to emerge as facilitators and suppliers of serviced land for housing.
Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL)
The Reserve Bank established BRBNMPL in February 1995 as a wholly-owned subsidiary to augment the
production of bank notes in India and to enable bridging of the gap between supply and demand for bank notes in
the country. The BRBNMPL has been registered as a Public Limited Company under the Companies Act, 1956 with
its Registered and Corporate Office situated at Bengaluru. The company manages two Presses, one at Mysore in
Karnataka and the other at Salboni in West Bengal.
National Bank for Agriculture and Rural Development (NABARD)
National Bank of Agriculture and Rural Development (NABARD) is one of the subsidiaries where the majority
stake is held by the Reserve Bank. NABARD is an apex Development Bank with a mandate for facilitating credit
flow for promotion and development of agriculture, small-scale industries, cottage and village industries,
handicrafts and other rural crafts. It also has the mandate to support all other allied economic activities in rural
areas, promote integrated and sustainable rural development and secure prosperity of rural areas.
Functions Of RBI
Functions Traditional Functions of RBI Issue of Currency Notes
of RBI Banker to other Banks

Banker to Government
Exchange Rate Management
Credit Control Function
Development of the Financial System

Developmental / Development of Agriculture
Promotional Functions of Provision of Industrial Finance
Provision of Training
RBI Collection of Data
Publication of the Report
Promoter of Banking Habits
Promotion of Export through Refinance
Granting License to Banks
Supervisory Functions of
RBI Bank Inspection
Control over NBFIs
Implementation of the Deposit Insurance Scheme
Figure 4 Functions of RBI
As a central bank, the Reserve Bank has significant powers and duties to perform. For smooth and speedy progress
of the Indian Financial System, it has to perform some important tasks. Among others it includes maintaining
monetary and financial stability, to develop and maintain stable payment system, to promote and develop
financial infrastructure and to regulate or control the financial institutions. For simplification, the functions of the
Reserve Bank are classified into the traditional functions, the development functions and supervisory functions.
Traditional Functions Of RBI
Traditional functions are those functions which every central bank of each nation performs all over the world.
Basically these functions are in line with the objectives with which the bank is set up. It includes fundamental
functions of the Central Bank. They comprise the following tasks.
1. I S S U E O F C U R R E N C Y N O T E S : The RBI has the sole right or authority or monopoly of issuing currency notes except one
rupee note and coins of smaller denomination. These currency notes are legal tender issued by the RBI. Currently it is in
denominations of Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to issue and withdraw but even to
exchange these currency notes for other denominations. It issues these notes against the security of gold bullion, foreign
securities, rupee coins, exchange bills and promissory notes and government of India bonds.
2. B A N K E R T O O T H E R B A N K S : The RBI being an apex monitory institution has obligatory powers to guide, help and direct
other commercial banks in the country. The RBI can control the volumes of banks reserves and allow other banks to create

credit in that proportion. Every commercial bank has to maintain a part of their reserves with its parent's viz. the RBI.
Similarly in need or in urgency these banks approach the RBI for fund. Thus it is called as the lender of the last resort.
3. B A N K E R T O T H E G O V E R N M E N T : The RBI being the apex monitory body has to work as an agent of the central and
state governments. It performs various banking function such as to accept deposits, taxes and make payments on behalf of
the government. It works as a representative of the government even at the international level. It maintains government
accounts, provides financial advice to the government. It manages government public debts and maintains foreign
exchange reserves on behalf of the government. It provides overdraft facility to the government when it faces financial
crunch.
4. E X C H A N G E R A T E M A N A G E M E N T : It is an essential function of the RBI. In order to maintain stability in the external value
of rupee, it has to prepare domestic policies in that direction. Also it needs to prepare and implement the foreign exchange
rate policy which will help in attaining the exchange rate stability. In order to maintain the exchange rate stability it has to
bring demand and supply of the foreign currency (U.S Dollar) close to each other.
5. C R E D I T C O N T R O L F U N C T I O N : Commercial bank in the country creates credit according to the demand in the economy.
But if this credit creation is unchecked or unregulated then it leads the economy into inflationary cycles. On the other credit
creation is below the required limit then it harms the growth of the economy. As a central bank of the nation the RBI has
to look for growth with price stability. Thus it regulates the credit creation capacity of commercial banks by using various
credit control tools.
Developmental / Promotional Functions Of RBI

Along with the routine traditional functions, central banks especially in the developing country like India have to
perform numerous functions. These functions are country specific functions and can change according to the
requirements of that country. The RBI has been performing as a promoter of the financial system since its inception.
Some of the major development functions of the RBI are maintained below.
1. D E V E L O P M E N T O F T H E F I N A N C I A L S Y S T E M : The financial system comprises the financial institutions, financial markets
and financial instruments. The sound and efficient financial system is a precondition of the rapid economic development of
the nation. The RBI has encouraged establishment of main banking and non-banking institutions to cater to the credit
requirements of diverse sectors of the economy.
2. D E V E L O P M E N T O F A G R I C U L T U R E : In an agrarian economy like ours, the RBI has to provide special attention for the
credit need of agriculture and allied activities. It has successfully rendered service in this direction by increasing the flow of
credit to this sector. It has earlier the Agriculture Refinance and Development Corporation (ARDC) to look after the credit,
National Bank for Agriculture and Rural Development (NABARD) and Regional Rural Banks (RRBs).
3. P R O V I S I O N O F I N D U S T R I A L F I N A N C E : Rapid industrial growth is the key to faster economic development. In this
regard, the adequate and timely availability of credit to small, medium and large industry is very significant. In this regard
the RBI has always been instrumental in setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM
BANK etc.
4. P R O V I S I O N S O F T R A I N I N G : The RBI has always tried to provide essential training to the staff of the banking industry.
The RBI has set up the bankers' training colleges at several places. National Institute of Bank Management i.e NIBM,
Bankers Staff College i.e BSC and College of Agriculture Banking i.e CAB are few to mention.
5. C O L L E C T I O N O F D A T A : Being the apex monetary authority of the country, the RBI collects process and disseminates
statistical data on several topics. It includes interest rate, inflation, savings and investments etc. This data proves to be quite
useful for researchers and policy makers.
6. P U B L I C A T I O N O F T H E R E P O R T S : The Reserve Bank has its separate publication division. This division collects and
publishes data on several sectors of the economy. The reports and bulletins are regularly published by the RBI. It includes
RBI weekly reports, RBI Annual Report, Report on Trend and Progress of Commercial Banks India., etc. This information is
made available to the public also at cheaper rates.
7. P R O M O T I O N O F B A N K I N G H A B I T S : As an apex organization, the RBI always tries to promote the banking habits in the
country. It institutionalizes savings and takes measures for an expansion of the banking network. It has set up many
institutions such as the Deposit Insurance Corporation-1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These
organizations develop and promote banking habits among the people. During economic reforms it has taken many
initiatives for encouraging and promoting banking in India.
8. P R O M O T I O N O F E X P O R T T H R O U G H R E F I N A N C E : The RBI always tries to encourage the facilities for providing finance
for foreign trade especially exports from India. The Export-Import Bank of India (EXIM Bank India) and the Export Credit
Guarantee Corporation of India (ECGC) are supported by refinancing their lending for export purpose.
Supervisory Functions of RBI

The reserve bank also performs many supervisory functions. It has authority to regulate and administer the entire
banking and financial system. Some of its supervisory functions are given below.
1. G R A N T I N G L I C E N S E T O B A N K S : The RBI grants license to banks for carrying its business. License is also given for opening
extension counters, new branches, even to close down existing branches.
2. B A N K I N S P E C T I O N : The RBI grants license to banks working as per the directives and in a prudent manner without
undue risk. In addition to this it can ask for periodical information from banks on various components of assets and
liabilities.
3. C O N T R O L O V E R N B FI S : The Non-Bank Financial Institutions are not influenced by the working of a monitory policy.
However RBI has a right to issue directives to the NBFIs from time to time regarding their functioning. Through periodic
inspection, it can control the NBFIs.
4. I M P L E M E N T A T I O N O F T H E D E P O S I T I N S U R A N C E S C H E M E : The RBI has set up the Deposit Insurance Guarantee
Corporation in order to protect the deposits of small depositors. All bank deposits below Rs. One lakh are insured with this
corporation. The RBI work to implement the Deposit Insurance Scheme in case of a bank failure.
RBI TOOLS FOR DEVELOPING FINANCIAL SCHEME

The Reserve Bank makes use of a variety of tools and techniques to assess the build-up of systemic risks in the
economy and to provide critical inputs in this respect to its policy making departments. The tools include:
F I NA N C IA L S TR E S S I ND I C A TO R
Financial stability could be defined as a situation in which the financial sector provides critical services to the real
economy without any discontinuity. The art of managing financial stability, hence, involves not only the
identification and monitoring of the sources of risks from various segments of the financial system and pre-empting
them from snowballing into a systemic crisis, but also creating conditions for a sound financial environment in
normal times. Financial stability could encompass monitoring the following elements:
 Excessive volatility in macroeconomic variables, both global and domestic, and market trends such as interest rates,
exchange rates and asset prices;
 Build-up of leverage in financial, corporate and household sector balance sheets;
 Available systemic buffers within the financial sector, both at the institution and system levels, to withstand potential
shocks to the economy;
 Activities of unregulated nodes in the financial sector which, through their interconnectedness with the formal
regulated system, can breed systemic vulnerabilities.
S Y STE MI C L IQ U I D I TY I ND I C A TO R
Systemic liquidity in the financial system refers to the liquidity scenario in the banking sector, non-banking financial
sector, the corporate sector and prevailing foreign currency liquidity. Current needs for liquidity are also influenced
by expectations about availability of funds and their rates in future. It is preferable to go in for a multiple indicator
approach, which would be able to better capture the liquidity from a variety of dimensions. The choice of indicators
is influenced by the timely availability (at least daily) of traded data in public domain.
A Fi sc al Str ess I n di ca t or for assessing build-up of risks from the fiscal;
A N etw o rk M o d e l of the bilateral exposures in the financial system – for assessing the interconnectedness in the
system;
A Ban ki n g St abi li t y I n di ca t or for assessing risk factors having a bearing on the stability of the banking
sector; and
A series of Ban k i n g St a bi li ty Me as ur es for assessing the systemic importance of individual banks.
T HE N EGOTIABLE I NSTRUMENT A CT , 1881
Freely transferable written document
The Negotiable Instruments Act was enacted, in India, in 1881. The Act operates subject to the provisions of Sections
31 and 32 of the Reserve Bank of India Act, 1934. The effect or the consequences of these provisions are:
1. A promissory note cannot be made payable to the bearer, no matter whether it is payable on demand or after a
certain time.
2. A bill of exchange cannot be made payable to the bearer on demand though it can be made payable to the bearer
after a certain time.
3. But a cheque {though a bill of exchange} payable to bearer or demand can be drawn on a person‘s account with a
banker.
Meaning and Definition of Negotiable Instruments

According to Section 13 (a) of the Act, ―Negotiable instrument means a promissory note, bill of exchange or
cheque payable either to order or to bearer, whether the word ―order‖ or ― bearer‖ appear on the instrument or
not.‖
Thus, the term, negotiable instrument means a written document which creates a right in favour of some person
and which is freely transferable. Although the Act mentions only these three instruments (such as a promissory note,
a bill of exchange and cheque), it does not exclude the possibility of adding any other instrument which satisfies the
following two conditions of negotiability:
1. The instrument should be freely transferable (by delivery or by endorsement. and delivery) by the custom of the trade; and
2. The person who obtains it in good faith and for value should get it free from all defects, and be entitled to recover the
money of the instrument in his own name.
Characteristics of a Negotiable Instrument

A negotiable instrument has the following characteristics:
PROPERTY
The possessor of the negotiable instrument is presumed to be the owner of the property contained therein. A
negotiable instrument does not merely give possession of the instrument but right to property also. The property in
a negotiable instrument can be transferred without any formality. In the case of bearer instrument, the property
passes by mere delivery to the transferee. In the case of an order instrument, endorsement and delivery are required
for the transfer of property.
TITLE
The transferee of a negotiable instrument is known as ‗holder in due course.‘ A bona fide transferee for value is not
affected by any defect of title on the part of the transferor or of any of the previous holders of the instrument.
RIGHTS
The transferee of the negotiable instrument can sue in his own name, in case of dishonour. A negotiable instrument
can be transferred any number of times till it is at maturity. The holder of the instrument need not give notice of
transfer to the party liable on the instrument to pay.
PRESUMPTIONS
Certain presumptions apply to all negotiable instruments e.g., a presumption that consideration has been paid
under it. It is not necessary to write in a promissory note the words ‗for value received‘ or similar expressions because
the payment of consideration is presumed. The words are usually included to create additional evidence of
consideration.
PROMPT PAYMENT
A negotiable instrument enables the holder to expect prompt payment because a dishonour means the ruin of the
credit of all persons who are parties to the instrument.
Types of Negotiable Instrument
Section 13 of the Negotiable Instruments Act states that a negotiable instrument is a promissory note, bill of
exchange or a cheque payable either to order or to bearer. Negotiable instruments recognised by statute are: (i)
Promissory notes (ii) Bills of exchange (iii) Cheques. Negotiable instruments recognised by usage or custom are: (i)

Hundis (ii) Share warrants (iii) Dividend warrants (iv) Bankers draft (v) Circular notes (vi) Bearer debentures (vii)
Debentures of Bombay Port Trust (viii) Railway receipts (ix) Delivery orders.
Promissory Notes
Section 4 of the Act defines, ―A promissory note is an
instrument in writing (note being a bank-note or a
currency note) containing an unconditional undertaking,
signed by the maker, to pay a certain sum of money to or
to the order of a certain person, or to the bearer of the
instruments.‖
PARTIES TO A PROMISSORY NOTE

 Maker: He is the person who promises to pay the amount stated in the note. He is the debtor.
 Payee: He is the person to whom the amount is payable i.e. the creditor.
 Holder: He is the payee or the person to whom the note might have been indorsed.
 Indorser: When the holder transfers or indorses the instrument to anyone else, the holder becomes the ‗indorser‘.
 Indorsee: The person to whom the bill is indorsed is called an ‗indorsee‘.
Bill of Exchange
Section 5 of the Act defines, ―A bill of exchange is an instrument in writing containing an unconditional order,
signed by the maker, directing a certain
person to pay a certain sum of money only
to, or to the order of a certain person or to
the bearer of the instrument‖.
A bill of exchange, therefore, is a written
acknowledgement of the debt, written by
the creditor and accepted by the debtor.
There are usually three parties to a bill of
exchange drawer, acceptor or drawee and
payee. Drawer himself may be the payee.
PARTIES TO ‘BILL OF EXCHANGE’

 Drawer: The maker of a bill of exchange is called the ‗drawer‘.
 Drawee: The person directed to pay the money by the drawer is called the ‗drawee‘,
 Acceptor: After a drawee of a bill has signed his assent upon the bill, or if there are more parts than one, upon one of such
pares and delivered the same, or given notice of such signing to the holder or to some person on his behalf, he is called the ‗
acceptor‘.
 Payee: The person named in the instrument, to whom or to whose order the money is directed to be paid by the
instrument is called the ‗payee‘.
 The indorser and indorsee (the same as in the case of a promissory note).
 Holder: A person who is legally entitled to the possession of the negotiable instrument in his own name and to receive the
amount thereof, is called a ‗holder‘.
 Drawee in case of need: When in the bill or in any endorsement, the name of any person is given, in addition to the
drawee, to be resorted to in case of need, such a person is called ‗drawee in case of need‘.
 Acceptor for honour: In case the original drawee refuses to accept the bill or to furnish better security when demanded by
the notary, any person who is not liable on the bill, may accept it with the consent of the holder, for the honour of any
party liable on the bill. Such an acceptor is called ‗acceptor for honour‘.
Cheques
Section 6 of the Act defines ―A cheque is a bill of
exchange drawn on a specified banker, and not

expressed to be payable otherwise than on demand‖.
A cheque is bill of exchange with two more qualifications, namely,
 it is always drawn on a specified banker, and
 it is always payable on demand.
PARTIES TO ‘CHEQUE’
 Drawer. He is the person who draws the cheque, i.e., the depositor of money in the bank.
 Drawee. It is the drawer‘s banker on whom the cheque has been drawn.
 Payee. He is the person who is entitled to receive the payment of the cheque.
 The holder, indorser and indorsee (the same as in the case of a bill or note).
ENDORSEMENT
The word ‗endorsement‘ in its literal sense means, writing on the back of an instrument. But under the Negotiable
Instruments Act it means, the writing of one‘s name on the back of the instrument or any paper attached to it with
the intention of transferring the rights therein. Thus, endorsement is signing a negotiable instrument for the purpose
of negotiation. The person who effects an endorsement is called an ‗endorser‘, and the person to whom negotiable
instrument is transferred by endorsement is called the ‗endorsee‘.
Essentials 0f A Valid Endors ement
The following are the essentials of a valid endorsement:
 It must be on the instrument.
 It must be made by the maker or holder of the instrument. A stranger cannot endorse it.
 It must be signed by the endorser.
 It may be made either by the endorser merely signing his name on the instrument (it is a blank endorsement) or by any
words showing an intention to endorse or transfer the instrument to a specified person (it is an endorsement in full).
 It must be completed by delivery of the instrument. The delivery must be made by the endorser himself or by somebody on
his behalf with the intention of passing property therein.
 It must be an endorsement of the entire bill.
 If delivery is conditional, endorsement is not complete until the condition is fulfilled.
WHO MAY ENDORSE?

The payee of an instrument is the rightful person to make the first endorsement. Thereafter the instrument may be
endorsed by any person who has become the holder of the instrument. The maker or the drawer cannot endorse
the instrument but if any of them has become the holder thereof he may endorse the instrument. (Sec. 51).
The maker or drawer cannot endorse or negotiate an instrument unless he is in lawful possession of instrument or is
the holder there of. A payee or indorsee cannot endorse or negotiate unless he is the holder there of.
EFFECTS OF ENDORSEMENT
The legal effect of negotiation by endorsement and delivery is:
i. to transfer property in the instrument from the endorser to the endorsee.
ii. to vest in the latter the right of further negotiation, and
iii. a right to sue on the instrument in his own name against all the other parties (Section 50).
CANCELLATION OF ENDORSEMENT
When the holder of a negotiable instrument, without the consent of the endorser destroys or impairs the endorser‘s
remedy against prior party, the endorser is discharged from liability to the holder to the same extent as if the
instrument had been paid at maturity (Section 40).
NEGOTIATION BACK
‗Negotiation back‘ is a process under which an endorsee comes again into possession of the instrument in his own
right. Where a bill is re-endorsed to a previous endorser, he has no remedy against the intermediate parties to
whom he was previously liable though he may further negotiate the bill.

HOLDER IN DUE COURSE
Section 9 of the Act defines ‗holder in due course‘ as any person who (i) for valuable consideration, (ii) becomes the
possessor of a negotiable instrument payable to bearer or the indorsee or payee thereof, (iii) before the amount
mentioned in the document becomes payable, and (iv) without having sufficient cause to believe that any defect
existed in the title of the person from whom he derives his title. (English law does not regard payee as a holder in
due course).
Essential Qualification Of Holder In Due Course
The essential qualification of a holder in due course may, therefore, be summed up as follows:
 He must be a holder for valuable consideration. Consideration must not be void or illegal.
 He must have become a holder (possessor) before the date of maturity of the negotiable instrument.
 He must have become holder of the negotiable instrument in good faith. Good faith implies that he should not have
accepted the negotiable instrument after knowing about any defect in the title to the instrument.
 A holder in due course must take the negotiable instrument complete and regular on the face of it.
Privileges of a Holder in Due Course

Holder in due course acquiring the instrument for consideration and in good faith gets the following rights under the
Act:
i. R I G H T S I N C A S E O F I N C H O A T E I N S T R U M E N T ( S E C T I O N 2 0) : The right of a holder in due course to recover money is
not at all affected, even though the instrument was originally an inchoate stamped instrument and the transferor
completed the instrument for a sum greater than what was intended by the maker.
ii. L I A B I L I T Y O F P R I O R P A R T I E S T O H O L D E R I N D U E C O U R S E ( S E C T I O N 3 6) : ―Every prior party to a negotiable
instrument is liable thereon to a holder in due course until the instrument is duly satisfied.‖
iii. A C C E P T O R ’ S L I A B I L I T Y T O T H E H O L D E R I N D U E C O U R S E W H E N E N D O R S E M E N T F O R G E D ( S E C T I O N 4 2) : An
acceptor of bill of exchange already indorsed is not relieved from liability by reason that such indorsement to be forged
when he accepted the bill.
iv. A C C E P T O R B O U N D , A L T H O U G H B I L L D R A W N I N F I C T I T I O U S N A M E ( S E C T I O N 4 2) : An acceptor of bill of exchange
drawn in fictitious name and payable to the drawer‘s order is not by reason that such name is fictitious, relieved from
liability to any holder in due course claiming under and indorsement by the same hand as the drawer‘s signature, and
purporting to be made by the drawer.
v. N O E F F E C T O F C O N D I T I O N A L D E L I V E R Y ( S E C T I O N 4 6) : When a negotiable instrument is delivered conditionally or for
some special purpose and is negotiated to a holder in due course, it amounts to valid negotiation and he acquires good
title to it.
vi. I N S T R U M E N T M A D E W I T H O U T C O N S I D E R A T I O N ( S E C T I O N 4 3) : Under section 25 of the Indian Contract Act, ―a
contract made without consideration is void.‖ But if a negotiable instruments gets into the hands of holder in due course,
he is entitled to recover the amount on it from any of the prior parties thereof.
vii. G O O D T I T L E D E L I V E R I N G F R O M H O L D E R I N D U E C O U R S E ( S E C T I O N 5 3) : ―A holder of a negotiable instrument who
drives title from a holder in due course has the rights thereon of that holder in due course.‘
viii. B E T T E R T I T L E T H A N T H A T O F T H E T R A N S F E R O R ( S E C T I O N 5 8 ) : Although the holder of a negotiable instrument
does not get a better title than that of a transferor, the position of a holder in due course is different. He gets a better title
to the instrument notwithstanding any defect in the title of the transferor.
ix. E V E R Y H O L D E R I S A H O L D E R I N D U E C O U R S E ( S E C T I O N 1 18 ) : the law presumes that holder is a holder in due course,
although the presumption is rebuttable.
x. E S T O P P E L A G A I N S T D E N Y I N G O R I G I N A L V A L I D I T Y O F I N S T R U M E N T ( S E C T I O N 12 0) : the drawer of an instrument
and the acceptor of a bill, payable to order, cannot, in a suit thereon by a holder in course, deny the validity of the
instrument as originally made or drawn.

xi. E S T O P P E L D E N Y I N G C A P A C I T Y O F P A Y E E T O E N D O R S E E ( S E C T I O N 1 2 1) : the drawer of a promissory note for an
acceptor of a bill payable to order, cannot, in a suit thereon by a holder in due course, deny the payee‘s capacity on the
date of the instrument to endorse it.
xii. E S T O P P E L A G A I N S T D E N Y I N G S I G N A T U R E O R C A P A C I T Y O F P R I O R P A R T Y ( S E C T I O N 1 22) : No indorser of a
negotiable instrument shall, in a suit thereon by a subsequent holder, be permitted to deny the signature or capacity to
contract of any prior party to the instrument.
T HE B ANKING R EGULATION A CT , 1949

Banking Law And Regulation
The banking law as we find in India today, is the outcome of the gradual process of evolution. Before 1949, the
Indian Companies Act, 1913, contained special provisions relating to banking companies, which were felt inadequate
and were subsequently incorporated in the comprehensive legislation passed in 1949 under the name of Banking
Companies Act. 1949. Since its enforcement in 1949, this Act was suitably amended a number of times to insert new
provisions and to amend the existing ones to suit the needs of changing circumstances and to plug the loopholes in
the main legislation. The most significant amendment of the Act was effected by the Banking Laws (Amendment)
Act, 1968, which introduced ‗Social Control‘ on banks by inserting regulatory provisions of far-reaching significance.
The banking Laws (Amendment) Act, 1983 inserted a few new sections, besides amending some of the important
sections.
Main Parts Of The Act
The Banking Regulation Act, 1949, as amended up-to-date, stands divided into the following parts
Part I Preliminary (Sections 1 to 5A).
Part II Business of Banking Companies (Section 6 to 36A.
A Control over Management (Sections 36AA, and 36A).
B Prohibition of Certain Activities in relation to Banking Companies (Section 36AD)
C Acquisition of the undertakings of Banking Companies in Certain Cases (Sections 36AE to 36AJ)
Part III
Suspension of Business and Winding up of Banking Companies (Sections 36B to 45).
A Special Provisions for Speedy Disposal of Winding Proceedings (Sections 45A to 45X).
B Provisions Relating to Certain Operations of Banking Companies. (Sections 45Y to 45ZF).
Part IV Miscellaneous (Sections 46 to 55A)

Part V Main Provision as applicable to Co-operative Banks (Section 56)
It is to be noted that the main provisions relating to a banking company as a going concern are contained in Parts I,
II, IIA, IIB and IIIB. After the nationalisation of major banks the importance of Part IIC is considerably reduced.
Definition of Banking
The term ‗Banking‘ is defined as ‗accepting, for the purpose of lending or investment, or deposits of money from the
public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise‘ [Section 5(b)].
The salient features of this definition are as follows:
i. A banking company must perform both of the essential functions, viz., (a) accepting deposits, and (b) lending or
investing the same.
ii. The phrase ‗deposit of money from the public‘ is significant.
iii. The definition also specifies the time and mode of withdrawal of the deposits.
R IGHTS AND O BLIGATIONS OF A B ANKER

Following are the major rights that a banker can exercise on his customer:
RIGHT OF LIEN:
The right of a creditor (Bank) to retain goods and securities owned by the debtor bailed (as security) to the bank
until the loan due from the debtor is repaid is called the right of lien. But the banker can insist on lien only in the

absence of an agreement to the contrary. The creditor (bank) has the right to maintain the security of the debtor
but not to sell it. There are two types of lien such as:
 Particular Lien: Particular lien is one, in that the craftsman can retain those goods on which he has spent time, effort
and money until he is paid. In Particular lien the creditor doesn‘t have the right to retain all the properties of the
debtor.
 General Lien: General lien gives the banker the right to retain goods and securities delegated to him in his capacity as
a banker, in the absence of a contract contradictory to the right of lien. It extends to all goods/properties placed with
him as a banker by his customer which are not particularly identified for another purpose.
Cases in which lien cannot exercise:

1. If the goods and securities have been entrusted to the banker as a trustee or an agent.
2. If a contract exists between the banker and the customer that is contradictory with the banker‘s right of general lien.
A banker‘s lien is more than a general lien, it is an implied pledge and he has the right to sell the goods in case of
default. The right of lien is granted upon the banker by the Indian Contract Act and it helps to avoid the need of a
separate agreement. To be in a safe position the banker should take a letter of lien stating that the goods/
properties are entrusted as security for a loan at present and in future and that the banker can exercise his lien on
them. The banker can also sell the goods if the customer doesn‘t make the payment (defaults).
1. The banker can exercise the right of lien only on goods standing in the name of the borrower and not jointly with
others.
2. The banker can exercise his right of lien on securities remaining in his possession after the loan for which they were
lodged is repaid by the customer only if there is no contract to the contrary.
Exception to the Right of lien:

1. The banker cannot exercise the right of lien on valuables entrusted to the banker as a Bailee or trustee.
2. Right of lien is not applicable on documents deposited for a special purpose or with specific instruction that
the earnings are to be utilized for a specific purpose.
3. The banker‘s general lien is displaced by circumstances that show an implied agreement contradictory to
the right of general lien.
4. The banker has no right of lien on securities left with the banker negligently or unintentionally.
5. The banker doesn‘t have the right of lien on securities deposited as a trustee in respect of his personal loan.
The banker‘s right of lien extends over goods and securities handed over to him. Money deposited in the bank and
credit balance in his/her account does not fall in the category of goods and securities. Therefore the banker can use
his right of setoff as opposed to lien with regard to money deposited with him.
1. The right can be exercised only on the customer‘s property and not on joint accounts the customer.
2. The banker cannot have the right to exercise the lien when the debt has not matured.
3. The banker cannot exercise the lien when he can exercise set off.
Right of set-off
The banker has the right to set off the accounts of its customer. This enables a debtor (Bank) to set off a debt owed
to him by a creditor (customer) before the latter recovers a debt due to him from the debtor. Banks can merge two
accounts in the name of the same customer and set off the debit balance in one account with the credit balance in
the other. But the funds should belong to the customer.
The right of set-off can be exercised only if there is no agreement express or implied that is divergent to this right. It
can be exercised only after a notice is served on the customer informing the customer that the banker is going to
exercise the right of set-off. To be on the safe side bankers must take a letter of set-off from the customer
authorizing the bank to exercise the right of set-off without giving him any notice.
AUTOMATIC RIGHT OF SET OFF
Sometimes the set off will happen automatically, it depends on the situation. In automatic set off there is no need of
permission from the customer. The C A SE S I N W H IC H A U T O M A T IC S E T O F F C A N E X E R C I SE A R E A S F O L L O W S :
1. In case of the death of the customer.
2. When the customer becomes insolvent
3. If a Garnishee order is issued on the customer‘s account by court.
4. When a notice of assignment of credit balance to someone else is given by the customer to the banker.
5. When a bank receives the notice of second mortgage on the securities already charged to the bank.
CONDITIONS WHILE EXER CI SING RI GHT OF SET - OFF:
1. The accounts must be in the same name and same right. The account should be in the sole name of the
customer.
2. Funds held in trust accounts are not allowed to set off.
3. The right cannot be exercised in respect of future or contingent debts.
4. The amount of debts must be certain and measurable.
5. The banker might exercise this right at his judgment.
6. The banker has the right to exercise this right before a garnishee order is issued.
7. There should not be any agreement to the contrary.
Right of Appropriation
In the normal course of business, a banker accepts payments from customers. If the customers have more than one
account or he/she has taken more than one loan, the customer has the right to direct his banker against which debt
the payment should be appropriated/settled. If the customer does not direct the banker and there is more than one
debt outstanding in his/her name, the bank can exercise its right of appropriation and apply it in payment of any
debt. The banker can apply it against time barred debts also. Once an appropriation has been made it cannot be
reversed.
Section 59 of the Indian Contract Act states that the right of appropriation is vested in the hands of debtor. He/she
can appropriate the payment by an express intimation. Money received will first be set off against interest.
Section 60 of the Indian Contract Act states that if the debtor does not intimate or there is no circumstance of
indicating how the payment is to be used, the right of appropriation is vested in the creditor.
Section 61 of the Indian Contract Act states that where neither party makes any appropriation, the payment shall
be used in discharge of the debts in order of time. If the debts are of equal standing, the payment should be applied
in discharge of each proportionately. Any payment made by a debtor should be applied in the first instance
towards fulfilment of interest and thereafter towards principal unless there is an agreement to the contrary. If a
customer has only one account and he deposits and withdraws money from it regularly, the order in which the
credit entry will set off the debit entry is in the chronological order, this is known as Clayton‘s rule.
RIGHT TO CHARGE INTEREST
The banker has an implied right to charge interest on the advances granted to its customer. Bankers generally
charge interest monthly, quarterly or semi-annually or annually. There may be an agreement between the banker
and customer in this case the manner agreed will decide how interest is to be charged.
RIGHT TO CHARGE SERVICE CHARGES:
Banks charge customers a particular amount if their balance is below a predetermined amount, for the usage of
ATMs and withdrawals. Banks are free to charge these but the Reserve Bank of India expects banks to advise their
customers of these charges at the time of opening an account and advise them when changes are being made.
FOLLOWING ARE THE OBLIGATIONS OF A BANKER:
1. Banks have an obligation to honour the cheques drawn on it if the customer has sufficient funds in his
account. It is also obliged to honour cheques up to the overdraft limit of a customer.
2. Banker is bound to act as per the directions given by the customer. If directions are not given the banker
should act according to how he is expected to act.
3. Care should be taken to make sure that the information given is general and only facts that are evident
should be revealed.
4. Banks are obliged to maintain secrecy of their client accounts. There are times when information may be
revealed.
i. When the customer is statutorily required to do so.
ii. With express or implied permission of the customer.
iii. In common courtesy, whenever the other banks ask for details they have to provide. In this case no
specific information such as balances, etc. is given.
iv. If the bank‘s interest requires that the bank can reveal the information
v. If the disclosure is under the intention of protecting public/ national interest.
B ANKS ’ F INA NC IAL S TATEMENT

Unique features

A banks‘ financial statements are quite different from those of a firm in any other industry. In their roles as financial
intermediaries, banks have to take considerable financial risks, and their financial statements merely reflect this risk.
Following are the unique features of Bank‘s financial statement:
 Primary source of funds are short-term
 Very high financial leverage
 The proportion of fixed asset is very low
 A high proportion of bank funds is invested in loans and advances or investments.
 Change in deposit rates have great impact in cost of funds which could result in pricing problems or asset
portfolio.
 Operating leverage is relatively low due to the comparatively lower fixed cost
 The bulk of revenue is generated from interest on advances and investments
C APITAL A DEQUACY
Banks encounter various types of risks while carrying the business of financial intermediation as it is the highly
leveraged sector of an economy. Risk and uncertainties, therefore, form an integral part and parcel of banking.
Thus, risk management is the core to any banking service and hence the need for sufficient Capital Adequacy Ratio
is felt. Regulation of capital assumes significant importance so as to reduce bank failures, to promote stability, safety
and soundness of the banking system, to prevent systemic disaster and to ultimately reduce losses to the bank
depositors
Along with profitability and safety, banks also give importance to Solvency. Solvency refers to the situation where
assets are equal to or more than liabilities. A bank should select its assets in such a way that the shareholders and
depositors' interest are protected.
The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide
a stable resource to absorb any losses arising from the risks in its business.
The Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks (including foreign
banks) in India as a capital adequacy measure in line with the Capital Adequacy Norms prescribed by Basel
Committee.
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities which
published the Basel Accords i.e., rules regarding capital requirements. BCBS is a comprehensive set of reform
measures to strengthen the regulation, supervision and risk management of the banking sector. In 1988, BCBS
introduced the capital measurement system commonly referred to as Basel I. In 2004, BCBS published Basel II
guidelines which were the refined, reformed and more complex version of Basel I. While Basel I focus only on credit
risk, Basel II includes market and operational risks besides credit risks. Basel III released in December, 2010 which lay
more focus on quality, consistency and transparency of the capital base.
India adopted Basel I guidelines in 1999 while Basel II guidelines were implemented in phases by 2009.The Basel III
capital regulation has been implemented in India from April 1, 2013 in phases and will be fully implemented as on
March 31, 2018.
The Need for Minimum Capital Requirement
The capital which banks hold with themselves as required by financial regulator is known as minimum capital
requirement. Banks exposed to various types of risks while granting loans and advances to various sectors. In order
to absorb any losses which banks face from its business, it is imperative that banks should have sufficient capital. If
banks have adequate capital, then it can protect its depositors from unforeseen contingencies as well promotes the
stability and efficiency of financial systems.
Components of Capital
Capital is divided into tiers according to the characteristics/qualities of each qualifying instrument. For supervisory
purposes capital is split into two categories: Tier I and Tier II. These categories represent different instruments‘ quality
as capital. Tier I capital consists mainly of share capital and disclosed reserves and it is a bank‘s highest quality
capital because it is fully available to cover losses. Tier II capital on the other hand consists of certain reserves and
certain types of subordinated debt. The loss absorption capacity of Tier II capital is lower than that of Tier I capital.

Tier I Capital
Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital. It is also termed as
Core Capital. The elements of Tier I capital includes:
 Paid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves, if any;
 Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I capital - subject to laws
in force from time to time;
 Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital; and
 Capital reserves representing surplus arising out of sale proceeds of assets.
Tier II Capital
Capital which is second readily available to protect the unexpected losses is called as Tier-II Capital. The elements of
Tier II capital include undisclosed reserves, revaluation reserves, general provisions and loss reserves, hybrid capital
instruments, subordinated debt and investment reserve account.
Tier III Capital
This is arranged to meet part of market risk, viz. changes in interest rate, exchange rate, equity prices, commodity
prices, etc. To quantify as Tier III capital, assets must be limited to 250% of a bank‘s Tier I capital, be unsecured
subordinated and have a minimum maturity of 2 years.
Capital Adequacy Ratio (CAR)
Capital adequacy ratio is the ratio which protects banks against excess leverage, insolvency and keeps them out of
difficulty. It is defined as the ratio of banks capital in relation to its current liabilities and risk weighted assets. Risk
weighted assets is a measure of amount of banks assets, adjusted for risks. An appropriate level of capital adequacy
ensures that the bank has sufficient capital to expand its business, while at the same time its net worth is enough to
absorb any financial downturns without becoming insolvent. It is the ratio which determines banks capacity to meet
the time liabilities and other risks such as credit risk, market risk, operational risk etc. As per RBI norms, Indian SCBs
should have a CAR of 9% i.e., 1% more than stipulated Basel norms while public sector banks are emphasized to
keep this ratio at 12%. Capital adequacy ratio is defined as:
Tier I + Tier II + Tier III capital (capital funds)
CAR =
Risk Weighted Assets (RWA)
Capital Adequacy in India
The Narasimham committee endorsed the internationally accepted norms for capital adequacy standards,
developed by the Basel Committee on Banking Supervision (BCBS). BCBS initiated Basel I norms in 1988, considered
to be the first move towards risk-weighted capital adequacy norms. In 1998, NC II framed Base II in order to
overcome the limits of Base I which focus only on credit risk and excluded the other forms of risk.
Figure 5 Three Pillars of Capital Adequacy
Pillar 1- Minimum Capital Requirements

RBI requires banks in India to maintain at the minimum, a capital to risk-weighted assets ratio (CRAR) of 9 %.
Though the CRAR of 9% will have to be held continuously by banks, RBI also expects banks to operate at a capital
level well above the minimum requirements. Additionally, RBI would assess individual banks‘ risk profiles and risk
management systems. As in the Basel framework II, banks in India will maintain capital as Tier 1 and Tier 2. Banks
are encouraged to maintain, at both solo and consolidated level, a Tier 1 CRAR of at least 6 per cent. Banks which
are below this level must achieve this ratio on or before March 31, 2010. Capital funds are broadly classified as Tier I
and Tier II capital. A bank should compute its Tier 1 CRAR and Total CRAR as follows,
Eligible tier 1 capital funds
Tier 1 CRAR=
Credit RWA + Market risk RWA + Operational risk RWA
RWA- Risk Weighted Assets
Eligible total capital funds
Total CRAR=
Credit RWA + Market risk RWA + Operational risk RWA
Total Capital Funds = Tier I Capital + Tier II Capital
T HE BANKS’ OVER ALL MINIM UM CAPI TAL R EQUIREMENT WILL BE THE SUM OF :
 Capital requirement for credit risk on all credit exposures excluding items comprising trade book and
including counter party credit risk on all OTC derivatives on the basis of the risk weights,
 Capital requirement for market risks in the trading book and
 Capital requirements of operational risks.
Capital charge for Credit Risk

Banks in India currently follows the ‗Standardized Approach‘. Under this approach, ratings assigned by external
credit rating agencies will largely support the credit risk measurement. The assets/credit facilities provided by the
bank would be rated by the approved credit rating agency and risk-weighting of the assets or claim will be based
on the rating. Based on the credit ratings and the mapping process, rating is applicable to exposures on
 Foreign Sovereigns
 Foreign Banks
 Domestic Public Sector Entities
 Foreign Public Sector Entities
 Domestic Primary Dealers
 Non-Resident Primary Dealers
 Domestic Corporate Exposures
 Non-Resident Corporate Exposures
DOMESTIC CREDIT RATING AGENCIES: a) Credit Analysis and Research Limited; b) CRISIL limited; c) FITCH
India; and d) ICRA Limited.
INTERNATIONAL CREDIT RATING AGENCIES: a) Fitch; b) Moodys; and c) Standard & Poor‘s.
Capital Charge of market risk

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from
movements in market prices. The market risk positions subject to capital charge requirement are:
i) The risks pertaining to interest rate related instruments and equities in the trading book
ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and
trading books).
Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital
requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day.
Banks are also required to maintain strict risk management systems to monitor and control intra-day exposures to
market. These guidelines seek to address the issues involved in computing capital charges for interest rate related
instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and other
precious metals) in both trading and banking books.
Trading book for the purpose of capital adequacy will include:
i) Securities included under the Held for trading category
ii) Securities included under the Available for Sale category
iii) Open gold position limits
iv) Open foreign exchange position limits
v) Trading positions in derivatives, and
vi) Derivatives entered into for hedging trading book exposures.
CAPITAL CHARGE FOR OPERATIONAL RI SK

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. Legal
risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory
actions, as well as private settlements.
The New Capital Adequacy Framework outlines three methods for calculating operational risk capital charges in a
continuum of increasing sophistication and risk sensitivity:
i. The Basic Indicator Approach (BIA);
ii. The Standardised Approach (TSA); and
iii. Advanced Measurement Approaches (AMA).
Banks are encouraged to move along the spectrum of available approaches as they develop more sophisticated
operational risk measurement systems and practices.
Banks are advised to compute capital charge for operational risk under the Basic Indicator Approach as follows:
Average of [Gross Income * alpha] for each of the last three financial years, excluding years of negative or zero gross
income, where Alpha = 15 per cent
Gross income = Net profit (+) Provisions & contingencies (+) operating expenses (Schedule 16) (-) items ‗(i)‘ to ‗(vi)‘
listed below
The items are,
i. Exclude reversal during the year in respect of provisions and write-offs made during the previous year(s);
ii. Exclude income recognised from the disposal of items of movable and immovable property
iii. Exclude realised profits/losses from the sale of securities in the ―held to maturity‖ category
iv. Exclude income from legal settlements in favour of the bank
v. Exclude other extraordinary or irregular items of income and expenditure
vi. Exclude income derived from insurance activities (i.e. income derived by writing insurance policies) and insurance
claims in favour of the bank.
Pillar 2-Supervisory review

Provides key principles for supervisory review, risk management guidance and supervisory transparency and
accountability.
Pillar 3-Market discipline
Encourages market discipline by developing a set of disclosure requirements that will allow market participants to
assess key pieces of information on risk exposure, risk assessment process and capital adequacy of a bank.
D EPOSIT AND NO N - DEPOSIT SOURCES

Bank deposits are made to deposit accounts at a banking institution, such as savings accounts, checking accounts
and money market accounts. The account holder has the right to withdraw any deposited funds, as set forth in the
terms and conditions of the account. The "deposit" itself is a liability owed by the bank to the depositor (the person
or entity that made the deposit), and refers to this liability rather than to the actual funds that are deposited.
Sources of deposit
Bank deposits are differentiated by the type of deposit customer, the tenure of the deposit and its cost to the bank.
On the basis of these parameters, deposit sources are as follows,
1. Transaction accounts or Payment deposits
Payment deposits, repayable by the bank on demand from the depositor, represent one of the primary services
offered by banks. They can be bifurcated into non-interest bearing and interest bearing demand deposits. Such
deposits facilitate transfer of funds by the deposit holder to third parties, primarily through cheques and other forms
of fund transfer.
Non-interest bearing demand deposits are typically held by individuals, businesses or the government. Explicit
interest payments on these deposits are prohibited in most countries. Corporate customers prefer these accounts for
ease of operations.
Interest bearing demand deposits are preferred by individuals or certain types of organisations. Similar to the non-
interest bearing accounts, these deposits are also used for the purpose of transactions by the deposit holders and a
major portion of these deposits is likely to be volatile. They are called ‗Savings‘ accounts which carry a low rate of
interest.
2. Term Deposits
These are a form of ‗debt investment‘ for a customer, who is willing to lend money to the bank for a specified period
of time. In return, the customer receives a stream of cash flows in the form of interest. These deposits typically ay
high interest. A popular variant of large term deposits is the Certificate of deposits (CD).
Non-deposits Sources
Over the last three decades or so, banks have been increasingly turning to non-deposit funding sources or wholesale
funding sources. Non deposit funds are one which are not insured.
Funding Gap: The funding gap is calculated as the difference between current and projected
credit and deposit flows. If the difference shows the projected need for credit exceeding the expected
deposit flows, the bank has to raise additional resources either from deposit or non-deposit sources. If the
differences shows the projected credit requirements falling short of resources, the bank will have to find
profitable investment avenues for the surplus resources.
The Non-deposit sources are as follows,

1. Borrowing from Central bank
The central bank has been described as "the lender of last resort", which means that it is responsible for providing its
economy with funds when commercial banks cannot cover a supply shortage. In other words, the central bank
prevents the country's banking system from failing. However, the primary goal of central banks is to provide their
countries' currencies with price stability by controlling inflation. A central bank also acts as the regulatory authority
of a country's monetary policy and is the sole provider and printer of notes and coins in circulation.
2. Certificate of Deposits (CD)
A savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest
rate and can be issued in any denomination. CDs are generally issued by commercial banks and are insured by the
FDIC. The term of a CD generally ranges from one month to five years.
3. Foreign Funds
Foreign funds offer individual investors access to international markets. Investing abroad poses risks, but can also
help investors diversify their portfolios. It is important to recognize the difference between global funds and foreign
funds. Global funds can invest in securities from any country, including the investor's home country.
4. Commercial Papers
An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable,
inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270
days. The debt is usually issued at a discount, reflecting prevailing market interest rates.
D ESIGNING OF D EPOSIT SCHEMES

The principles underlying the concept of ‗time value of money‘ are prevalently used in designing deposit schemes.
Simply stated, the future value is the value of an investment today at some period in future, while the ‗present
value‘ is the value today of cash flow receivables at some period in future.
Recurring Deposit Scheme
Recurring deposit account is opened by those who want to save regularly for a certain period of time and earn
a higher interest rate. In recurring deposit account certain fixed amount is accepted every month for a specified
period and the total amount is repaid with interest at the end of the particular fixed period. Minimum and
Maximum deposit periods are usually 12 and 120 months, respectively.
Reinvestment Deposit Scheme
In a Reinvestment Deposit Plan, a lump sum amount is invested for a fixed period and repaid with interest on
maturity. The interest earned on the deposit is reinvested at the end of each quarter and hence, there is interest on
interest. The Minimum and Maximum deposit periods are usually 12 and 120 months, respectively, though the
period could differ among banks. The maturity amount can be calculated as follows,
Maturity Amount = Initial deposit (1+r)n
Where, r= Effective rate = (1+k/m)m -1
N= no of years
Fixed Deposit Schemes
In deposit terminology, the term Fixed Deposit refers to a savings account or certificate of deposit that pays a fixed
rate of interest until a given maturity date. Funds placed in a Fixed Deposit usually cannot be withdrawn prior to
maturity or they can perhaps only be withdrawn with advanced notice and/or by having a penalty assessed.
Depositors seeking regular income from their fixed investment would prefer this scheme.
Cash Certificates
The amount of initial deposit will be the issue price of the cash certificate and will be computed based on the
maturity amount or the face value of the cash certificate and the tenure of the deposit. The interest is re-invested
quarterly and hence, there will be interest on interest. The minimum and maximum maturity periods are generally
similar to the re-invested schemes.
P RIC ING OF D EPOSIT S ERVICES

Deposits are the primary source of funds for banks. The pricing of deposits and related services assumes great
importance in the present deregulated and highly competitive environment, where deposit rate ceilings do not exist.
Some commonly used approaches to deposit pricing:

Cost Plus Margin Deposit Pricing
The development of interest-bearing checkable deposits (particularly NOWs) offered financial managers the
opportunity to reconsider the pricing of deposit services. Unfortunately, many of the early entrants into this new
market moved aggressively to capture a major share of the customers through below-cost pricing. Customer
charges were set below the true level of operating and overhead costs associated with providing deposit services.
The result was a substantially increased rate of return to the customer, known as the implicit interest rate—the
difference between the true cost of supplying fund-raising services and the service charges actually assessed the
customer.
Deregulation has brought more frequent use of unbundled service pricing as greater competition has raised the
average real cost of a deposit for deposit-service providers. This means that deposits are usually priced separately
from other services. And each deposit service is often priced high enough to recover all or most of the cost of
providing that service, using the following cost-plus pricing formula:
Unit price charged the customer for each deposit service= Operating expense per unit of deposit service + Estimated
overhead expense allocated to the deposit service function + Planned profit margin from each service unit
Tying deposit pricing to the cost of deposit-service production, as Equation above does, has encouraged deposit
providers to match prices and costs more closely and eliminate many formerly free services. In the United States, for
example, more depositories are now levying fees for excessive withdrawals, customer balance inquiries, bounced
checks, stop-payment orders, and ATM usages, as well as raising required minimum deposit balances. The results of
these trends have generally been favorable to depository institutions, with increases in service fee income generally
outstripping losses from angry customers closing their accounts.
Conditional Pricing
Conditional pricing sets up a schedule of fees in which the customer pays a low fee or no fee if the deposit balance
remains above some minimum level, but faces a higher fee if the average balance falls below that minimum. Thus,
the customer pays a price conditional on how he or she uses the deposit. Conditional pricing techniques vary deposit
prices based on one or more of these factors:
1. The number of transactions passing through the account (e.g., number of checks written, deposits made, wire
transfers, stop-payment orders, or notices of insufficient funds issued).
2. The average balance held in the account over a designated period (usually per month).
3. The maturity of the deposit in days, weeks, or months.
The customer selects the deposit plan that results in the lowest fees possible and/or the maximum yields, given the
number of checks he or she plans to write, or charges planned to be made, the number of deposits and withdrawals
expected, and the planned average balance. Of course, the depository institution must also be acceptable to the
customer from the standpoint of safety, convenience, and service availability.
Relationship Pricing
Customers who purchase two or more services may be granted lower deposit fees compared to the fees charged
customers having only a limited relationship to the offering institution. The idea is that selling a customer multiple
services increases the customer‘s dependence on the institution and makes it harder for that customer to go
elsewhere. In theory at least, relationship pricing promotes greater customer loyalty and makes the customer less
sensitive to the prices posted on services offered by competing financial firms.
Market Penetration Deposit Pricing
This pricing strategy is typically aimed at high growth markets in which the bank is determined to garner a large
market share. Therefore, banks are tempted to offer either high interest rates, well above the market level or
charge customer fees well below the market standards. Bank managers expect that the large sources of funds and
associated loan business and investment opportunities would offset thinner spreads. Because it is usually costly for
the customer to move certain kinds of deposit such as payment accounts, the lower fees on certain deposits initially
attracted through penetration pricing which may eventually be raised to cost-recovery or profit-making level.
Upscale Target Pricing
Upscale target pricing is the use of carefully but aggressively designed deposit advertising programs and deposit
pricing schemes to appeal to customers that higher levels of income or net worth, such as business owners and
managers, doctors, lawyers and other high income households. The customers being targeted are price sensitive and
therefore could respond quickly to the price differentials.
A PPLICATION O F BA NK F U NDS
Banks have a crucial role to play in the financial system of any country. The prime objective of the financial system
is to channel surpluses arising in the economy through the activities of households, corporate houses and the
government, into the deficit units in the economy, again in the form of households, corporate houses and the
government. Hence, the main application of funds is lending.
Lending
The main function of bank is lending. Lending means granting of loan to the needed people at the rate of interest.
It adds profit to the individual bank. A bank can lend profitably only if it is able to take on and manage credit risk
that arises from the quality of the borrower and his business. The bank also has to contend with the impact of
fluctuations interest and exchange rates on profits, as well as the liquidity risk posed by mismatch in the maturities
of its liabilities and assets. Bank extends credits to different categories of borrowers for different purposes.
Features of lending:
 For a bank, good loans are its most profitable assets. And any loan is good till the borrower defaults in
repayment.
 Banks have to look for higher returns.
 Loan maturities, pricing and the methods of principal repayments all impact the timings and magnitude of
banks‘ cash inflows.
 Fluctuation in interest rates give rise to earnings volatility.
Types of Lending
Broadly, three types of lending can be identified:
1. F U N D B A SE D L E N D I N G is the most direct form of lending. It is granted as a loan or advance with an actual
outflow of cash to the borrower by the bank. In most cases, such lending is supported by prime and/or collateral
securities. Fund based advances can be further classified based on the tenure of the loans. They are
i) Short-term loans: These loans are granted with the primary purpose of financing working capital
needs of the borrower, resulting from temporary buildup of inventories and receivables. Maturity Period is 1
year or less
ii) Long-term Loans: These are called as ‗term loans‘, repayment are structured based on future cash flows
rather than on liquidation of short-term assets. Maturity period is more than one year.
iii) Revolving Credits: 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.
2. N O N F U N D B A SE D L E N D I N G , where the lending bank does not commit any physical outflow of funds. The
funds position of the lending bank remains intact. The non-funding based lending can be made in two forms:
Bank Guarantees and Letter of Credit.
3. A S SE T - B A SE D L E N D I N G is an emerging category of bank lending. In this type of lending, the bank looks
primarily or solely to the earning capacity of the asset being financed, for servicing it debt. In most cases, the
bank will have limited or no recourse the borrower.
Investments
Now a day‘s bank also participates in the activities of investment at national or international level of investment
banks. They help companies and government to raise money by issuing and selling securities in the capital markets.
They provide necessary financial guidance to its customers for effective investments in Stock and Mutual Funds.
Some banks also have specialized offices for this purpose.
I NVESTMENT A ND L ENDING F U NCT IONS

The risks involved in lending render it imperative that banks should have systems and controls that enable bank
managers to take credit decisions after objectively evaluating risk-return tradeoffs. Whether it is consumer or
commercial lending, credit decisions impact the profitability of banks, and ultimately their competitiveness and
survival in the industry. Credit decisions are by no means easy. The process of lending are as follows,
Loan Policy
To ensure alignment of individual goals of credit officer to the banks‘ overall goals, banks formulate ‗loan policies‘.
These are written documents, authorized by individual banks‘ Board of Directors, that formalize and set guidelines
for lending to be followed by decision-makers in the bank.
Business Development and Recommendations
Within the broad framework of the loan policy of the bank, and based on the bank‘s goals in building its loan asset
portfolio, credit officers seek to reinforce the relationship with existing customers, build new clientele and cross sell
non-credit services. Business development efforts for credit expansion should preferably begin with market research
and detailed credit investigation. The outcome of this research will leads to identification of potential industries and
credit products.
Credit Analysis
Modern Credit analysis uses the traditional concepts in making subjective evaluation, along with wide use of
financial ratios and risk evaluation models to determine if a borrower is creditworthy. The accent on risk evaluation
implies that the banker lends only if he is satisfied that risks are mitigated to ensure that the borrower‘s future cash
flows (and hence debt service) will not be affected.
Credit Delivery and Administration
Depending on the size of the bank, the loan size and type of exposure planned, the final decision to lend may be
taken by an authorized layer of the bank. Once a loan is approved, the officer communicates the sanction to the
borrower through formal ‗sanction letter‘ i.e. Loan Agreement.
Loan Documentation
Different types of borrowers and different types of security interests necessitate loan documentation procedures that
would be valid in a court of law. Accordingly, once the loan agreement is signed, the borrowers and guarantors
execute the loan documents. If the borrower defaults on a secured loan, the bank has the right to take possession of
the assets and liquidates them to recover its dues.
Updating the cre dit file and Periodic follow up
The credit file has to be continuously updated throughout the above process. Further, once the loan is disbursed, the
following activities have to be carried out,
i) Process loan payments and send reminders in case loan payments are received late
ii) The borrower will have to submit updates of financial performance periodically or as per the accounting
practices in force.
iii) The bank can call on the borrower at any time, even without prior intimation to ensure that the borrower‘s
activities are accordance with the bank‘s expectations.
Credit Review and Monitoring
Banks that have succeeded in credit management, and hence reduction of credit risk, are those that have
separated credit review and monitoring from credit analysis, execution and administration.
T Y PES OF L OANS
Loan refers to the act of giving money, property or other material goods to another party in exchange for future
repayment of the principal amount along with interest or other finance charges. A loan may be for a specific, one-
time amount or can be available as open-ended credit up to a specified ceiling amount. The various types of loans
are loans for working capital, loans for capital expenditure and industrial credit, loan syndication, loans for
agriculture, loans for infrastructure-project finance, loans to consumers or retain lending and Non-fund based credit.
loans for working capital
A working capital loan is a loan used by companies to cover day-to-day operational expenses. Companies are
unable to generate the revenue needed to meet expenses incurred by day-to-day business operations. In such
circumstances, companies may apply for a working capital loan. Unlike most other business loans that allow
companies to acquire capital in order to expand, a working capital loan covers only expenses incurred by existing
capital and human resources (e.g. utilities, rents, payroll, etc.). Working capital loans are generally granted only to
companies with a high credit rating, and are only meant to be used until a company can generate enough revenue
to cover its own expenses.
loans for capital expenditure and industrial credit
Financing capital investments, such as IT equipment, machinery, vehicles, buildings and the like, can be arranged in
various ways. It all depends on your company's needs and financial situation. The rule of thumb is that businesses
use bank loans for capital expenditure financing and finance operations using an overdraft facility. Experience
shows that this gives the best financing structure and provides the best protection against liquidity problems. The
only argument for financing capital expenditures with an overdraft facility is that it can reduce interest expenses as
you only pay interest when you need to draw on the facility. Generally, however, mixing capital expenditure and
working capital financing involves few advantages.
Loan Syndication
The process of involving several different banks in providing various portions of a loan. Loan syndication most often
occurs in situations where a borrower requires a large sum of capital that may either be too much for a single bank
to provide, or may be outside the scope of a bank's risk exposure levels. Thus, multiple banks will work together to
provide the borrower with the capital needed, at an appropriate rate agreed upon by all the banks.
Loans for agriculture
Agricultural loans help farmers run their farms more efficiently. It can be difficult to keep up with all of the costs
associated with running a farm, so farmers need low interest agricultural loans to help them stay afloat.
Fortunately, the government often steps in with low interest loans and other subsidies that help farmers turn a
profit. Farmers can use agricultural loans to:
Purchase farm land.
Whether you are just starting out as a farmer or wish to expand your current farm business, agricultural land loans
help you purchase the land you need to build a great farm.
Cover operating expenses.
Besides needing farm land financing, many farmers also need help covering some of the operating costs. Farm
equipment is expensive, but it's necessary to run the farm. With better equipment, you can cover more land quickly.
Help with the marketing of their product.
If they want to make a profit, then farmers need to sell the product they create. This means that they need an
effective marketing plan and money to pay for marketing costs in addition to farm land loans.
Loans for infrastructure -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. Project finance is especially attractive to the private sector because they can fund major projects off
balance sheet.
Loans to consumers or retail lending
An amount of money lent to an individual (usually on a non-secured basis) for personal, family, or household
purposes. Consumer loans are monitored by government regulatory agencies for their compliance with consumer
protection regulations such as the Truth in Lending Act. Also called consumer credit or consumer lending.
Non fund based lending
Non fund based lending, where the lending bank does not commit any physical outflow of funds. The funds position
of the lending bank remains intact. The non-funding based lending can be maid in two forms:
 Bank Guarantees
 Letter of Credit
M AJOR C OMPONENT S OF A TY PIC AL LOA N POLICY DOCUM ENT

LOAN POLICY are written documents, authorized by individual banks‘ Board of Directors that formalize and set
guidelines for lending to be followed by decision-makers in the bank. The loan policy specifies the bank‘s overall
strategy for lending, identifies loan qualities and parameters, and lays down procedures for appraising, sanctioning,
granting, documenting and reviewing loans. Following are the components of Loan Policy document.
Loan Objectives
Within the regulatory prescriptions, the loan objectives will communicate to credit officers and other decision-
makers, the bank‘s priorities among the conflicting objectives of liquidity, profitability, increasing business volumes,
and risk and asset quality.
Volume and Mix of Loans
How much of the loan portfolio is to be channeled into specific industries, sectors or geographical areas, will be
communicated in this section. It may also specify composition of the loan portfolio by size of loans, pricing of loans or
securities.
Loan Evaluation Procedures
Generally, uniform credit appraisal procedures are prescribed throughout the bank. The procedures would deal
with all issues ranging from establishing suitability of the loan to the bank‘s overall strategy and risk taking ability,
to selection of borrowers, market and project risk appraisal criteria, financial statement analysis, structuring of loan
agreements, documentation and post-sanction monitoring.
Credit Administration
Lending involves more risks than any other banking activity. Hence, banks are careful to ensure that credit decisions
are taken by experienced and knowledgeable officers, with decision-making authority as decided by the top
management or the board from time to time. The loan policy should indicate the credit sanctioning powers of the
officers at various hierarchical levels of the bank.
Credit Files
Credit files are important documented and updated material used for both decision-making and continuous
evaluation. Sometimes, the loan policy specifically mentions the mandatory format in which information in the
credit files is to be maintained.
Lending Rates
The interest charged should reflect the credit risk in a loan. The policy may also state the returns expected for each
risk group of borrowers in the bank, and specific risk limits up to which the bank can lend. It can also specify the
credit scoring system to be adopted to fix the lending rates, and circumstances under which fixed and floating rates
of interest can be charged to the borrower.
The other parameters that a loan policy may specify are,
 Type of collateral the bank can accept as security for the loans
 The extent to which the security should cover the advances made
 Nature of margins/compensating balances to be maintained by various classes of borrowers
 Limits up to which the bank can expose itself to certain sectors and borrower groups
 Credit monitoring system that would be operative after the loan is disbursed
 Credit to deposit ratios that the bank need to maintain
 Incentive schemes for loan officers
 Loan agreement and other communication practices
 Role of legal department in the bank
S TEPS INVOLVED IN C REDIT A NALY SIS S TEPS INVOLVED IN C REDIT ANALYSIS

Step 1: Building the ‘Credit file’:
The preliminary information so obtained would throw light on the borrower‘s antecedents, his credit history and
track record. If the project is a Greenfield projects, the credit officer will have to do a thorough research into various
aspects of the project, as well as into the borrower‘s financial and managerial capacity to make the project a
success. If the borrower is an existing one, seeking additional credit, the information would be readily available with
the credit officer. The credit file is an important tool box for the credit officer. The extensive information in the credit
fill will enable the credit officer to examine the borrower‘s track record in repayment, and help in forming an
opinion about the borrower‘s future repayment intention and potential.
Step 2: Project and financial appraisal:
Once the preliminary investigation is done, the internal and external factors, such as management integrity and
capability, the company‘s performance and market value and the industry characteristics are evaluated. One of
the important activities at this stage is financial analysis. As illustrative list of inputs and activities is as follows:
 Past financial statements
 Cash flow statements
 Financial risk of an entity is measured.
Step 3: Qualitative Analysis
Integrity is the most important quality that the banker looks for in a borrower, and the most difficult to measure. So
is assessment of the quality of the management team. However, lenders will have to make qualitative assessment
of the borrower on most of the criteria.

Step 4: Due diligence
Due diligence can be very costly for a bank. Many loans have run into problems since bankers did not take this step
seriously. Due diligence can include checking on the borrower‘s address, pre-approval inspections of the borrower‘s
workplace, and interviews with the borrower‘s competitors, suppliers, Customers and employees. Disclosure of
contingent liabilities by the borrower is an essential part of the due diligence.
Step 5: Risk Assessment
All Potential internal and external risks are to be identified and their severity assessed in terms of how these risks
would impact the borrower‘s future cash flows and hence the debt service capacity. The risk assessment would form
an important input for structuring the credit facility and terms of the loan agreement.
Step 6: Managing the recommendation
Finally, based on a thorough analysis of the project, the borrower and the market, and after examining the ‗fit‘ of
the credit with the ‗loan policy‘, the credit officer makes his recommendations to consider the loan favorably or
reject it outright.
C REDIT D ELIVERY AND A DM INISTRATION

Depending on the size of the bank, the loan size and type of exposure planned, the final decision to lend
may be taken by an authorized layer of the bank. Typically, banks fix ‗discretionary limits‘ – monetary
ceilings up to which personnel at each level can take credit decisions- for each layer of authority starting
from credit officers themselves to branch heads to senior and top management at the corporate office,
including the board of directors. These ‗discretionary limits‘ become larger as they move up the
organizational hierarchy.
For all decision-makers above the level of loan officers, the loan officer‘s appraisal forms the very basis of
decision-making. Hence, the loan officer‘s role in the credit decision making process is extremely critical.
Many banks create a separate channel in the hierarchy for grooming and equipping credit officers with
the essential attitude and skills for the lending functions.
Some very large banks have a centralized ‗underwriting department‘. It processes the credit request and
conveys approval ‗in principle‘, in order to cut the process and time required for a sanction through the
regular process. Once a loan is approved, the officer communicates the sanction to the borrower through
formal ‗sanction letter‘ i.e. Loan agreement.
A loan agreement is a contract between a borrower and a lender which regulates the mutual promises
made by each party. Following are the content of loan agreement.
 Nature / type of the credit facility
 Interest / discount / charges as applicable
 Repayment terms
 Stipulation regarding end use of each facility
 Additional fees as applicable
 Prime security for each credit facility
 Full descriptions of the collateral securities
 Details of personal / third party guarantees
 Terms and conditions under which the loan facilities are being granted
 Events of default and penal provision.
LOAN PRICING
Every loan has a unique risk profile, which will have to be quantified and built into the price. Proper
pricing of a loan is more complex and non- standardized than pricing of a product or service. It also
follows that, for every loan, at the minimum,
Loan price= cost of funds+ servicing costs + risk premium + desired profit margin
Steps involved in pricing of loan are shown in the following figure:
Models for loan pri cing:
Fixed versus floating rates:
When the interest rate are relatively stable and the yield curve slopes upward, banks would be willing to
lend at fixed interest rates, above the rates they pay for shorter term liabilities. In an environment where
rates are volatile, and banks have to source funds from the market at varying interest rates, they would
prefer to lend on floating rates and for shorter maturities. In effect, floating rate loans transfer the interest
rate risk from the bank to borrower. Though this appear desirable, it may result in heightened credit risk
from the bank.
Pricing floating loans:
Once the benchmark rate is determined, the bank can develop and use prime rate-based pricing models.
Sub-prime lending is resorted to only in exceptional cases. In pricing most loans, a markup over the prime
rate is stipulated. As the market-determined or bank-determined prime moves up or down, the interest
rates charged to the borrower also increase or decrease. The mark ups are based on a credit rating of the
borrower, and are modelled to take care of the risks in lending to the particular borrower.
There are two basic methods for loading the mark ups on the prime rate – through an additive method
and multiplicative method- termed ‗prime plus‘ and ‗prime times‘, respectively.
Hedging and matched funding:
Many borrowers prefer fixed rate loans. If banks have to make fixed rate loans in deference to borrower
preferences, they attempt to control loss of profits due to interest rate volatility by interest rate swaps or
futures or by match funding.
In interest rate swaps, fixed rate payments are made in return for floating rate receipts. It is also possible
to directly buy interest rate caps. With futures, it is possible to make fixed rate loans and hedge against
potential losses from higher borrowing costs in future. This can be achieved by selling futures contracts or
buying put options on futures.
In matched funding, loans are made with sources of funds with identical maturities. For example, the
bank will source a deposit of 1 year maturity to fund a loan of identical maturity and amount. In the ideal
situation, the bank can avoid interest rate risk on this transaction if there is a positive spread between the
loan price and the cost of the deposit, and the interest payments also coincide. In large banks, the transfer
pricing systems can be used flexibly for matched funding.
The price leadership model:
"price leadership" rate is important because it establishes a benchmark for many other types of loans. To
maintain an adequate business return in the price-leadership model, a banker must keep the funding
and operating costs and the risk premium as competitive as possible. Banks have devised many ways to
decrease funding and operating costs, and those strategies are beyond the scope of this article. But
determining the risk premium, which depends on the characteristics of the individual borrower and the
loan, is a different process.
Cost benefit loan pricing:
It is a practice for many banks to base their loan rates on the base reference rate, the libor or the prime
rate. Some banks have also developed sophisticated loan pricing systems that determine whether their
loan prices fully compensate for all the costs and risks involved in lending. One of these systems assesses the
costs and benefits of the pricing model using the following steps.
I. Employ sensitivity analysis to estimate the total revenue that a loan would generate under different interest
rates and charges.
II. Estimate the net loanable funds turnover.
III. Estimate the before tax yield from the loan by dividing the estimated revenue from the loans by the net
amount loanable funds utilized by the borrowers.

CUSTOMER PROFITABILITY ANALYSIS
In light of the latest onslaught of regulatory changes and increasing capital requirements, expectations for returns in
the banking business have been dramatically reduced. As a result, strategic resource management, and thus
profitability analysis, is more critical than ever. Yet, with profit margins constrained and with more waking hours
devoted to regulatory issues, where does a community bank executive find the time and money to do one more
thing?
Start with those that bring the paycheck — the customers. Those customers who actually do pay the bank, that is.
But how does a community bank build a system that determines which customers contribute to the bottom line
(and those who do not) without a major resource commitment? And if you get it done, how do you make this
information meaningful and actionable so that it has a significant impact on bank performance?
key ingredients to customer profitability
The most basic answer is revenues minus expenses. The problem arises from how much revenue you assign to your
customer as well as how much expense. Typically, the only pieces of the equation tied to the customer‘s accounts
are interest income and fees from loans, interest expense and service charges from deposits, and other non-interest
income fees from things like safety deposit boxes and trust accounts.
What is missing from the equation is the investment income from the deposits collected, the borrowing costs of the
loans lent out, and the various costs of all the activities done to service all of your customers‘ accounts.
Steps in customer Profitability Analysis
Step 1: Get O rganized
Make it a priority. How can it not be? We are talking about our customers who help us make payroll. Create a task
force with the minority being from finance. Use the accountants as an important resource for modeling support and
data input, but leadership of the effort should come from customer-facing management. Put someone in charge.
Task forces and committees are fine; however, when decisions must be made, get everyone‘s input and then make
someone responsible for making the final calls and moving on.
Step 2: Break it Down
Build the basics for income and expense. Start simple. Do not, for example, get stuck on determining the right funds
transfer method. Just pick one and get on with it. Collect account-level data. This is very important as account-level
information is the primary building block for customer profitability systems. Get as much as you can and then some,
including transaction data (type and channel) to the extent possible. Assign accounts to a relationship type that
your systems can handle (tax ID, household/CIF, if available). Again, simple and expedient is better. You can always
revisit. Assign a segment identifier to each relationship using basic segmentation schemes (i.e., general consumer,
small business, middle market commercial, affluent consumer). Save identifying ―mixed‖ relationships for later.
Compile as much demographic information (i.e. date of relationship [you may have to reach back to the first
account opened], date of birth, address/geography) in your relationship or household database as well.
Step 3: Conduct the Initial Analysis — Ad Hoc First — and Use the
Results
Use a basic database tool (Microsoft Access or even Excel can be sufficient at first, depending on the size of your
bank) to collect and analyze the data. At the account and customer level, study your customers‘ source of business,
revenues and costs. What need(s) are being met (i.e. credit, transaction, savings)? How does the customer use (or
abuse) the product (transaction type, volume, channel)? Start with creating profit tiers (using three-to-six month
smoothed relationship profit) within segment (high-profit, marginal, losers). Analyze the customer base within the
profit tiers by key driver (margin, fees, delivery cost) to help answer these questions. Identify at least three learnings
that you can apply in the short term. Assign responsibility for implementation.
Step 4: Automate the Analysis System
Wait to implement an automated profitability analysis tool until you have built the basics first and conducted the
initial analysis. Going about it in this way gets you results more quickly, enables deeper involvement in the modeling
and analysis process and therefore adds value to the end product and increases buy-in. Most core systems providers
offer a customer-profitability module or the ability to integrate with third-party software. Take your time in
evaluating the systems alternatives. Among other factors, consider ease of integration with your core system and
existing customer databases.
Step 5: Refine wit h Time
Focus on the issues that are identified by most of your team and will likely make a difference in your strategic,
tactical and customer level decision-making. Apply the 80/20 rule. Do not pursue perfection as you will not be able

to make everyone happy anyway. As the saying goes, Rome wasn‘t built in a day … on second thought who wants
Rome anyway?
Step 6: Build into Your Way of Doing Business
Use it regularly. Develop regular reporting for customer-profitability results by segment and integrate with other
customer/relationship metrics reporting (i.e. services per household, revenue by financial need) and track changes
resulting from the implementation of strategic and tactical initiatives. Integrate into strategic planning and
budgeting processes. Set customer-profitability, revenue and relationship expansion goals by segment or line of
business. Link revenue enhancement and cost management strategies to customer profitability goals, and develop
strategic and tactical initiatives to improve performance based on the analysis.
Share with your customer-contact staff. Provide selected information to the front lines but train on its uses. The
primary uses by front line staff should be to focus retention efforts on high-value customers, expand relationships
through better understanding of customer needs and behavior, and guide customers to products that better fit their
needs and how they interact with the bank.
Build in to performance management. For all levels of customer-facing staff, set team or individual goals for
customer profitability (and other customer metrics). Add to incentive systems and you will see significant results.
In the long run, nothing is more important to any business enterprise than understanding who helps us earn our
living. Non-financial businesses have known this for years. Bankers need to do this as well, no matter how big or
small and especially in the new, more challenging environment of increased regulatory burden and revenue
compression. Taking a structured approach to measuring, analyzing and using customer-profitability information is
one way to help meet the challenge.
N EED FOR CREDIT M ONIT ORING

Credit monitoring is a service that tracks your credit report on a daily basis and notifies you of any significant
changes on your report.
Credit monitoring is the process of periodically reviewing your credit reports for accuracy and changes that
could be indicative of fraudulent activity.
Credit management in a bank consists of two distinct processes. First explain the signals of borrower’s financial
sickness processes – before and after credit sanction is made. The second process is after the credit sanction is made,
and the loan is disbursed to the borrower, it is important to ensure that the principal and interest are fully
recovered.
A sound credit review process is necessary for the long-term sustenance of the bank. Once a credit is granted, it is
responsibility of the business unit, along with a credit administration support team, to ensure that the credit limit is
being operated well, credit files, financial information are updated periodically and the accounts is ‗monitored‘, to
ensure that the debt is serviced on time. An effective credit monitoring is essential to
Adherence of Loan Policy
The continuous evaluation need to be done to ensure whether the loan policy of the bank is being adhered
properly. ‗Loan policies‘ are written documents, authorized by individual banks‘ Board of Directors, that formalize
and set guidelines for credit monitoring process of the bank. The loan policy will indicate the credit sanctioning
powers of the officers at various hierarchical levels of the bank and the control measures to be taken if any
deviation occurs. Hence, the credit monitoring is essential to ensure that the loan policy is adhered.
Identify problematic accounts
The intense credit monitoring process will help us to identify problematic accounts right at the incipient stage. All
banks attach a numerical risk rating or grade to each loan. These appear somewhere in the bank credit file
documents or loan boarding information. Based on that the bank should analyse the credit worthiness or the ability
of the customer to pay back the loan frequently. This may help the bank to identify a problematic account in the
initial stage itself.
Assess the bank’s exposure to credit risk
Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in
relation to lending, trading, hedging, settlement and other financial transactions. While banks granting loans to
huge number of customers that differ in maturity and credit quality, those measures do not speak directly to risk

exposures. The magnitude of credit exposure indicates the extent to which the lender is exposed to the risk of loss in
the event of the borrower's default.
In general, a bank will seek to have greater credit exposure to its customers with the highest credit rating, and less
exposure to clients with a lower credit rating. If a customer encounters unexpected financial problems, the bank
may seek to reduce its credit exposure in order to mitigate the risk of loss arising from a potential default.
Assess the bank’s future capital requirement
Compared with other corporations, banks have a high level of indebtedness. In other words, their share of equity is
low in relation to other funding.
The standardized requirements in place for banks and other depository institutions, which determines how much
liquidity is required to be held for a certain level of assets through regulatory agencies such as the Bank for
International Settlements, Federal Deposit Insurance Corporation or Federal Reserve Board. These requirements are
put into place to ensure that these institutions are not participating or holding investments that increase the risk of
default and that they have enough capital to sustain operating losses while still honouring withdrawals.
S IGNALS OF BORRO WERS ’ FINANC IAL SICKNESS

No unit falls sick all of a sudden. It has to pass through certain stages prior to occurrence of sickness. In this respect, it
is interesting to study the behavior of sick units or borrowed accounts. As observed in banks, every borrowed
account is regular on the date of loan sanction.
Just as diseases are identified by certain symptoms, industrial sickness can be identified by the following symptoms.
These symptoms act as leading indicators of sickness, and if immediate remedial actions are not taken, the sickness
will grow to the extent that the organization will find its natural death.
 Continuous reduction in turnover.
 Piling up of inventory.
 Continuous reduction of net profit to sales ratio.
 Short term borrowings at high interest rate.
 Continuous cash losses leading to erosion of tangible net worth.
 Default in payment of interest on borrowings and default in repayment of term loan instalments.
 The ‗sundry debtors‘ as well as the ‗sundry creditors‘ keep growing and reaching a disproportionately high
level.
 Approaching the banker for temporary over draft at frequent intervals.
 High turnover of personnel, especially at senior levels.
 Change in accounting procedure with to view to window dressing.
 Delay in finalization of accounts.
F INA NC IAL DISTRESS PR EDICTIO N MODELS

Though symptoms of sickness can be observed from the leading indicators, such indicators may only suggest that the
unit is a potentially sick unit. However, it is not easy to arrive at a definite conclusion about the impending sickness
on the basis of the leading indicators of sickness. Considerable research work has been done to identify other
measurable parameters that can be used for predicting sickness. Following Models are used to predict the financial
distress:
Univariate Analysis
Univariate analysis aims to predict sickness on the basis of a single financial ratio. Though many financial ratios were
used by analysts for predicting sickness, there was no consensus as to what the most appropriate ratio is for the
prediction of sickness. Such a situation prevailed till William H. Beaver published his study on univariate analysis in
the year 1966. Beaver examined the predicative power of 30 different financial ratios by choosing a sample of 79
firms that had become sick and 79 firms that were healthy for the same period of time. The sample was so chosen
that for each failed (sick) firm, a healthy firm operating in the same industry and having comparative size was
included in the sample set. For both the set of samples of 79 firms each, Beaver examined the behaviour of 30
different financial ratios during the period of 5 years prior to the failure. The main finding of Beaver was that the
ratio that is most useful in predicting impending sickness is the ‘RATIO OF CASH FLOW TO TOTAL DEBT ‘, since this
ratio showed the minimum error in his prediction.

Multivariate Analysis
Univariate analysis examines the predictive power of individual financial ratios. The joint effect of more than one
financial ratio in predicting sickness is not studied in univariate analysis. Multivariate analysis, on the other hand,
aims to predict industrial sickness by studying the combined influence of several financial ratios.
Altman. E.I. presented his model of multivariate analysis for predicting industrial sickness in the year 1966. In his
model, Altman combined several financial ratios into a single index. He named this index as ‗Z-SCORE‘. His analysis
was based on a statistical procedure known as ‘MULTIPLE DISCRIMINATE ANALYSIS ’ (MDA). Altman studied a
sample of 33 bankrupt firms along with a paired sample of 33 non-bankrupt firms. He examined 22 financial ratios
to identify their combined influence on sickness and selected five ratios, which in his opinion jointly possess the
maximum power to predict bankruptcy.
Altman derived a discriminant function (‗Z‘) that contains five financial ratios. The discriminant function derived by
Altman is as under:
Z = 1.20x1 + 1.40x2 + 3.30x3 + 0.60x4 + 0.999x5
Where,
 Z = discriminant score
 x1 = (working capital) / (total assets)
 x2 = (retained earnings) / (total assets)
 x3 = (earnings before interest and tax) / (total assets)
 x4 = (market value of equity) / (book value of total debt)
 x5 = (sales) / (total assets)
A cut-off point for the ‗Z‘ score was determined by Altman in such a way that it minimized the overlap between
bankrupt and non-bankrupt groups. Altman found that a cut off value of 2.675 for ‗Z‘ minimized the possibility of
misclassification. Thus, as per Altman‘s analysis, firms with ‗Z‘ score less than 2.675 are prone to become bankrupt
and firms with ‗Z‘ score more than 2.675 are free from the threat of bankruptcy.
An Evaluation of Altman’s Model
Altman propounded that his sickness prediction model was highly reliable and gave a low percentage of error (of
the order of only 5%) when the data for one year before bankruptcy was employed. In other words, Altman‘s
model COULD PREDICT BANKRUPTCY ONE YEAR BEFORE THE FIRM BECOMES BANKRUPT .
The percentage of error in Altman‘s model raises from 5% to 28% when prediction is made two years prior to
bankruptcy. It further raises to 71% when the study is made four years prior to bankruptcy. Such high level of errors
in the preceding years lead one to believe that the lower percentage of error of 5% when the study is made one
year prior to bankruptcy could have been accidental. Thus, the reliability of Altman‘s model is not established
beyond doubt. Assuming that Altman‘s model works well when prediction is made one year before bankruptcy, one
year is too short a period to take any remedial action. It is like predicting that the tree would fall when the tree has
already started falling.
Another disadvantage of Altman‘s model is that it predicts only ‗bankruptcy‘. A firm becomes sick well before it
becomes bankrupt. Hence, any sickness prediction model will be of use only when it predicts the starting symptoms
of sickness so that suitable remedial measures can be taken to bring back the sick unit to life.
Dr. L.C. Gupta’s Sickness Prediction Model
Dr. L.C. Gupta made an attempt to distinguish between sick and non-sick companies on the basis of financial
ratios. He used a simple NON-PARAMETRIC TEST FOR MEASURING THE RELATIVE PREDICTING POWER OF
DIFFERENT FINANCIAL RATIOS . A mixed sample of sick and non-sick companies was made and the companies in
the sample were arranged in a single ordered sequence from the smallest to the largest, according to the financial
ratio that is tested for its predictive power. Let [profit after tax / Net worth] is a financial ratio that is to be tested
for its predictive power. The companies in the sample are arranged in increasing order of this particular ratio. Let
the sick companies be denoted by the letter ‗S‘ and the non-sick ones by the letter ‗N‘. Let us assume that 8 sick
companies and 8 non-sick companies are taken for building up the sample. When arranged in a sequential order as
stated above, the sequence may result in any pattern as shown below:
(A) S-N-S-N-S-S-N-S-N-N-S-N-S-N-S-N
(B) S-S-S-S-S-S-S-S-N-N-N-N-N-N-N-N
(C) S-S-S-S-N-N-N-N-N-N-N-N-S-S-S-S
(D) S-S-S-N-S-S-N-N-S-S-N-N-S-N-N-N
Observing the pattern of occurrence of ‗S‘ and ‗N‘ a cutoff point is chosen to separate the sick group from the non-
sick group. Companies that fall to the left of the cutoff point lie in the sick group while companies that fall to the
right of the cutoff point lie in the non-sick group. The cutoff point is so chosen that the number of misclassifications
are minimized. The ratio that showed the least percentage classification error at the earliest possible time is deemed
to have the highest predicative power. Referring to the four patterns shown above, the pattern of sequence shown
in (B) is the most accurate one since the cutoff point will be located exactly midway in the sample group and the
percentage of classification error will be zero since there are no misclassifications. Pattern shown in (C) is bound to
have a higher error since the sick companies are concentrated on both the extreme ends. Dr. L.C. Gupta used Indian
data on a sample of 41 textile companies of which 20 were sick companies and 21 were non-sick companies. He
studied the predictive power of 63 financial ratios and observed that the following two ratios have comparatively
better predictive power.
Earnings before Interest and Taxes ........&…….. Operating cash flow
Sales Sales
[Note: Operating cash flow = profit after tax + depreciation]
R EHABILITATIO N PROCES S
Industries that have gone sick have far-reaching consequences on the economy of the nation. Therefore, prevention
of sickness and rehabilitating sick projects assume greater importance. The RBI‘s current definition of a ‗sick‘ firm is
as follows,
 If any of the borrower accounts of the unit remain substandard for more than six months i.e. principal or
interest, in respect of any of its borrower accounts has remained overdue for a period exceeding 1 year.
The requirement of overdue period exceeding one year will remain unchanged even if the present
period for classification of an account as sub‐standard is reduced in due course;
 There is erosion in the net worth due to accumulated cash losses to the extent of 50 per cent of its net
worth during the previous accounting year.
 The unit has been in commercial production for at least 2 years.
BOARD OF INDUSTRIAL AND FINANCIAL RECONSTRUCTION (BIFR)
Board of industrial and Financial Reconstruction (BIFR) was established by the Central Government, under section 3
of the Sick Industrial Companies (Special provisions) Act, 1985 and it became fully operational in May, 1987.
BIFR deals with issues like revival and rehabilitation on sick companies, winding up of sick companies,
institutional finance to sick companies and amalgamation of companies etc. BIFR is a quasi-judicial
body.
The Role of BIFR as envisaged in the SICA (Sick Industrial Companies Act) is:
a. Securing the timely detection of sick and potentially sick companies.
b. Speedy determination by a group of experts of the various measures to be taken in respect of the sick
company.
c. Expeditious enforcement of such measures
BIFR has a chairman and may have a maximum of 14 members, drawn from various fields including banking,
labour, accountancy, economics etc. It functions like a court and has constituted four benches.
To rehabilitate a sick unit the BIFR follows the following broad parameters:
R E P O R T I N G T O T H E BI FR
The Board of Directors of a sick industrial company is required, by law, to report the sickness to the BIFR within 60
days of finalisation of audited accounts, for the financial year at the end of which the company has become sick.
E N Q U I R Y B Y T H E BI FR
When a case is referred to the BIFR, it is verified by the Registrar of the BIFR as to whether the facts of the case falls
within the provisions of the Sick Industrial (Special provisions) Act, 1985. Once a company has been found sick, the
BIFR may grant time to the sick company to enable it to make its net worth positive and bring the company out of
sickness, without any external financial assistance.
APPLICATION TO THE TRIBUNAL

Once a company is assessed to be a sick company, an application could be made to the Tribunal under section 254
of the 2013.

DETERM INING THE MEASURES
Act for the determination of the measures that may be adopted with respect to the revival and rehabilitation of
the identified sick company either by a secured creditor of that company or by the company itself. The application
thus made must be accompanied by audited financial statements of the company relating to the immediately
preceding financial year, a draft scheme of revival and rehabilitation of the company, and with such other
document as may be prescribed.
FIXING HEARING DATE

Subsequent to the receipt of the application, for the purpose of revival and rehabilitation, the Tribunal, not later
than seven would be required to fix a date for hearing and would be appointing an interim administrator under
Section 256 of 2013 Act to convene.
APPOINTING AN INTERIM ADMINISTRATOR

A meeting of creditors of the company in accordance with the provisions of section 257 of the 2013 Act. In certain
circumstances, the Tribunal may appoint an interim administrator as the company administrator to perform such
functions as the Tribunal may direct.
PREPARING REPORT
The administrator thus appointed would be required to prepare a report specifying the measures for revival and
rehabilitation of the identified sick industry. The measures that have been identified under the section 261 of the
2013 Act for the purpose of revival and rehabilitation of a sick company provides for the following options:
a) Financial reconstruction
b) Change in or takeover of the management
c) Amalgamation of the sick company with any other company, or another company‘s amalgamation
with the sick company
APPROVAL OF THE CREDITOR

The scheme thus prepared, will need to be approved by the secured and unsecured creditors representing three-
fourth and one-fourth of the total representation in amounts outstanding respectively, before submission to the
Tribunal for sanctioning the scheme pursuant to the requirement of section 262 of the 2013 Act.
APPROVAL OF THE TRIBUNAL

The Tribunal, after examining the scheme will give its approval with or without any modification. The scheme, thus
approved will be communicated to the sick company and the company administrator, and in the case of
amalgamation, also to any other company concerned.
FILING OF S ANCTIONED SCHEM E IF APPROVED BY CREDITOR & TRIBUN AL

The sanction accorded by the Tribunal will be construed as conclusive evidence that all the requirements of the
scheme relating to the reconstruction or amalgamation or any other measure specified therein have been complied
with. A copy of the sanctioned scheme will be filed with the ROC by the sick company within a period of 30 days
from the date of its receipt.
REVISED REP ORT IF THE SCHEM E I S NOT APPROVED BY CREDITOR & TRIBUNAL
However, if the scheme is not approved by the creditors, the company administrator shall submit a report to the
Tribunal within 15 days, and the Tribunal shall order for the winding up of the sick company. On passing of an
order, the Tribunal shall conduct the proceedings for winding up of the sick company in accordance with the
provisions of Chapter XX.
R ISK M ANAGEMENT
Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial
risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory,
reputational, operational, etc. These risks are highly interdependent and events that affect one area of risk can
have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable
importance to improve the ability to identify, measure, monitor and control the overall level of risks undertaken.

Risk Management Process
Risk management is defined as the systematic identification of potential events that prevent or obstruct attainment
of an entity objectives and taking measures to minimize the impact of those events. The risk management process
involves the following steps:
Event Identification:
In order to properly manage risks, an institution must recognize and understand risks that may arise from both
existing and new business initiatives; for example, risks inherent in lending activity include credit, liquidity, interest
rate and operational risks. Risk identification should be a continuing process, and should be understood at both the
transaction and portfolio levels.
Risk Assessment:
Once risks have been identified, they should be measured in order to determine their impact on the banking
institution‘s profitability and capital. This can be done using various techniques ranging from simple to sophisticated
models. Accurate and timely measurement of risk is essential to effective risk management systems. An institution
that does not have a risk measurement system has limited ability to control or monitor risk levels. Banking
institutions should periodically test their risk measurement tools to make sure they are accurate. Good risk
measurement systems assess the risks of both individual transactions and portfolios.
Risk Response:
Risk response is a process by which the management evaluate and adopt mitigation measures. This should also
involve assessment of costs versus benefits of the proposed measures and degree to which the response will reduce
impact and/or likelihood of risk events.
Control Activities:
Control activities are the policies and procedures in place to ensure that risk mitigation measures agreed are
implemented.
Information and Communication Activities:
Information & communication activities ensure that all staff are familiar with risks identified and mitigation
measures and plans. This helps in successful implementation of risk responses.
Monitoring:
Monitoring helps determine the effectiveness of the processes, technologies and personnel executing risk
management. To the extent, monitoring should be in-built to on-going monitoring activities, operational,
procurement and financial. Where required, separate evaluations of the risk management process could be carried
out to address any special identified problems.
Interest Rate Risk
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. The
management of Interest Rate Risk should be one of the critical components of market risk management in banks.
The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of
interest rates has, however, exposed them to the adverse impacts of interest rate risk.
The management of Interest Rate Risk should be one of the critical components of market risk management in
banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system.
Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net
Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates.
Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose
banks‘ NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market
interest rate volatility.
Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE), caused by
unexpected changes in market interest rates.
TYPE OF INTEREST RATE RISK.
Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. Accepting
this risk is a normal part of banking and can be an important source of profitability and shareholder value.
However, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base. Interest
Rate Risk can take different forms as follows:

GAP OR MI SMATCH RI SK.
A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal
amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market
interest rates.
BASIS RISK.
Market interest rates of various instruments seldom change by the same degree during a given period of time. The
risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different
magnitude is termed as basis risk.
EMBEDDED OPTION RI SK.

Significant changes in market interest rates create another source of risk to banks‘ profitability by encouraging
prepayment of cash credit/demand loans/term loans and exercise of call/put options on bonds/debentures and/or
premature withdrawal of term deposits before their stated maturities. The faster and higher the magnitude of
changes in interest rate, the greater will be the embedded option risk to the banks‘ NII.
Y IELD CURVE RI SK.

In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e.
TBs yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks use two different instruments
maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curves
would affect the NII.
PRICE RISK.
Price risk occurs when assets are sold before their stated maturities.
R EINVESTM ENT RISK .

Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment
risk.
NET INTEREST POSITION RI SK.

The size of non-paying liabilities is one of the significant factors contributing towards profitability of banks. When
banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rates adjust
downwards. Thus, banks with positive net interest positions will experience a reduction in NII as the market interest
rate declines and increases when interest rate rises. Thus, large float is a natural hedge against the variations in
interest rates.
MEASURING INTEREST RATE RISK.
Before interest rate risk could be managed, they should be identified and quantified. There are different techniques
for measurement of interest rate risk as follows:
TRADING BOOK.
The top management of banks should lay down policies with regard to volume, maximum maturity, holding
period, duration, stop loss, defeasance period, rating standards, and etc. for classifying securities in the trading book.
BANKING BOOK.
The changes in market interest rates have earnings and economic value impacts on the banks‘ banking book.
MATURITY GAP ANALYSI S.

The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes
interest rate sensitive assets, liabilities and off-balance sheet positions into a certain number of pre-defined time-
bands according to their maturity (fixed rate) or time remaining for their next repricing (floating rate).
DURATION GAP ANALYSI S.

Matching the duration of assets and liabilities, instead of matching the maturity or repricing dates is the most
effective way to protect the economic values of banks from exposure to IRR than the simple gap model.
SIM ULATION.
Many of the international banks are now using balance sheet simulation models to gauge the effect of market
interest rate variations on reported earnings/economic values over different time zones. Simulation technique
attempts to overcome the limitations of Gap and Duration approaches by computer modelling the bank‘s interest
rate sensitivity.
Liquidity Risk
Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to
efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible
funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by
increasing liabilities or converting assets, promptly and at a reasonable cost. It encompasses the potential sale of
liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a
defense mechanism from losses on fire sale of assets.
Dimension of Liquidity Risk
The liquidity risk of banks arises from funding of long-term assets by short-term liabilities, thereby making the
liabilities subject to rollover or refinancing risk. The liquidity risk in banks manifest in different dimensions:
F U N D I N G R I SK – need to replace net outflows due to unanticipated withdrawal/nonrenewal of deposits
(wholesale and retail);
T I M E R I S K - need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into
non-performing assets; and
C A L L R I SK - due to crystallization of contingent liabilities and unable to undertake profitable business
opportunities when desirable.
MEASURING LIQUIDITY RISK
Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The
key ratios, adopted across the banking system are:
a) Loans to Total Assets
b) Loans to Core Deposits
c) Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, where large
liabilities represent wholesale deposits which are market sensitive and temporary Investments are those
maturing within one year and those investments which are held in the trading book and are readily sold in the
market;
d) Purchased Funds to Total Assets, where purchased funds include the entire inter-bank and other money market
borrowings, including Certificate of Deposits and institutional deposits; and
e) Loan Losses/Net Loans.
Foreign Exchange (Forex) Risk
The risk inherent in running open foreign exchange positions have been heightened in recent years by the
pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks‘ balance sheets.
Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period
in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign
currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign
currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the
maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of
changes in premia / discounts of the currencies concerned.
In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of
risk crystallization does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot
market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the
currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of
time-lags in settlement of one currency in one centre and the settlement of another currency in another time zone.
The forex transactions with counterparties from another country also trigger sovereign or country risk.
Forex Risk Management Measures
SET APPROPRIATE LIMIT S – OPEN POSITIONS AND GAPS.
Clear-cut and well-defined division of responsibility between front, middle and back offices. The top management
should also adopt the VaR approach to measure the risk associated with exposures. Reserve Bank of India has
recently introduced two statements viz. Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for
measurement of forex risk exposures. Banks should use these statements for periodical monitoring of forex risk
exposures.

Credit Risk
While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of
serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties,
poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead
to a deterioration in the credit standing of a bank's counterparties.
Credit risk is most simply defined as the probability that a bank borrower or counter party will fail to meet
its obligations in accordance with agreed terms.
Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or
transactions. Banks should also consider the relationships between credit risk and other risks. The effective
management of credit risk is a critical component of a comprehensive approach to risk management and essential
to the long-term success of any banking organization. The goal of credit risk management is to maximize a bank's
risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. It follows that a
bank needs to manage the following:
 The risk in individual credits or transactions.
 The credit risk inherent in the entire portfolio.
 The relationships between credit risks and other risks.
Element of Credit Risk
The elements of credit risk can, therefore, be grouped in the following manner:
Credit Risk Management
A typical Credit risk management framework in a financial institution should be broadly categorized into following
main components:
BOARD AND S ENIOR MANAGEM ENT’S OVERSIGHT

It is the overall responsibility of bank‘s Board to approve bank‘s credit risk strategy and significant policies relating
to credit risk and its management which should be based on the bank‘s overall business strategy. To keep it current,
the overall strategy has to be reviewed by the board, preferably annually. The responsibilities of the
Board with regard to credit risk management should include:
a) Delineate bank‘s overall risk tolerance in relation to credit risk.
b) Ensure that bank‘s overall credit risk exposure is maintained at prudent levels and consistent with the available
capital.
c) Ensure that top management as well as individuals responsible for credit risk management possess sound
expertise and knowledge to accomplish the risk management function.
d) Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement,
monitoring and control of credit risk.
e) Ensure that appropriate plans and procedures for credit risk management are in place.
The very first purpose of bank‘s credit strategy is to determine the risk appetite of the bank. Once it is determined
the bank could develop a plan to optimize return while keeping credit risk within predetermined limits. The
bank’s credit risk strategy thus should spell out:
a) The institution‘s plan to grant credit based on various client segments and products, economic sectors,
geographical location, currency and maturity.
b) Target market within each lending segment, preferred level of diversification/concentration.
c) Pricing strategy.
It is essential that banks give due consideration to their target market while devising credit risk strategy. The credit
procedures should aim to obtain an in-depth understanding of the bank‘s clients, their credentials & their businesses
in order to fully know their customers.
The strategy should provide continuity in approach and take into account cyclic aspect of country‘s economy and
the resulting shifts in composition and quality of overall credit portfolio. While the strategy would be reviewed
periodically and amended, as deemed necessary, it should be viable in long term and through various economic
cycles.
The senior management of the bank should develop and establish credit policies and credit administration
procedures as a part of overall credit risk management framework and get those approved from board. Such
policies and procedures shall provide guidance to the staff on various types of lending including corporate, SME,
consumer, agriculture, etc. At minimum the policy should include:
a) Detailed and formalized credit evaluation/ appraisal process.
b) Credit approval authority at various hierarchy levels including authority for approving exceptions.
c) Risk identification, measurement, monitoring and control.
d) Risk acceptance criteria.
e) Credit origination and credit administration and loan documentation procedures.
f) Roles and responsibilities of units/staff involved in origination and management of credit.
g) Guidelines on management of problem loans.
In order to be effective these policies must be clear and communicated down the line. Further any significant
deviation/exception to these policies must be communicated to the top management/board and corrective
measures should be taken. It is the responsibility of senior management to ensure effective implementation of these
policies.
ORGANIZATIONAL STRUCTURE
To maintain bank‘s overall credit risk exposure within the parameters set by the board of directors, the importance
of a sound risk management structure is second to none. While the banks may choose different structures, it is
important that such structure should be commensurate with institution‘s size, complexity and diversification of its
activities. It must facilitate effective management oversight and proper execution of credit risk management and
control processes.
Each bank, depending upon its size, should constitute a Credit Risk Management Committee (CRMC), ideally
comprising of head of credit risk management Department, credit department and treasury. This committee
reporting to bank‘s risk management committee should be empowered to oversee credit risk taking activities and
overall credit risk management function. The CRMC should be mainly responsible for
a) The implementation of the credit risk policy / strategy approved by the Board.
b) Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the Board.
c) Recommend to the Board, for its approval, clear policies on standards for presentation of credit proposals,
financial covenants, rating standards and benchmarks.
d) Decide delegation of credit approving powers, prudential limits on large credit exposures, standards for loan
collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation,
pricing of loans, provisioning, regulatory/legal compliance, etc.
Further, to maintain credit discipline and to enunciate credit risk management and control process there should be
a separate function independent of loan origination function. Credit policy formulation, credit limit setting,
monitoring of credit exceptions / exposures and review /monitoring of documentation are functions that should be
performed independently of the loan origination function. For small banks where it might not be feasible to
establish such structural hierarchy, there should be adequate compensating measures to maintain credit discipline
introduce adequate checks and balances and standards to address potential conflicts of interest. Ideally, the banks
should institute a Credit Risk Management Department (CRMD). Typical functions of CRMD include:
a) To follow a holistic approach in management of risks inherent in banks portfolio and ensure the risks remain
within the boundaries established by the Board or Credit Risk Management Committee.
b) The department also ensures that business lines comply with risk parameters and prudential limits established
by the Board or CRMC.
c) Establish systems and procedures relating to risk identification, Management Information System, monitoring of
loan / investment portfolio quality and early warning. The department would work out remedial measure
when deficiencies/problems are identified.
d) The Department should undertake portfolio evaluations and conduct comprehensive studies on the
environment to test the resilience of the loan portfolio.
Notwithstanding the need for a separate or independent oversight, the front office or loan origination function
should be cognizant of credit risk, and maintain high level of credit discipline and standards in pursuit of business
opportunities.
SYSTEM S AND PROCEDURES
Credit Origination
Banks must operate within a sound and well-defined criteria for new credits as well as the expansion of existing
credits. Credits should be extended within the target markets and lending strategy of the institution. Before
allowing a credit facility, the bank must make an assessment of risk profile of the customer/transaction.
Limit setting
An important element of credit risk management is to establish exposure limits for single obligors and group of
connected obligors.
Credit Administration
Ongoing administration of the credit portfolio is an essential part of the credit process. Credit administration
function is basically a back office activity that support and control extension and maintenance of credit. A typical
credit administration unit performs following functions:
DOCUMENTATION. It is the responsibility of credit administration to ensure completeness of documentation (loan
agreements, guarantees, transfer of title of collaterals etc.) in accordance with approved terms and conditions.
Measuring credit risk

The measurement of credit risk is of vital importance in credit risk management. A number of qualitative and
quantitative techniques to measure risk inherent in credit portfolio are evolving. To start with, banks should
establish a credit risk rating framework across all type of credit activities.
Internal Risk Rating

Credit risk rating is summary indicator of a bank‘s individual credit exposure. An internal rating system categorizes
all credits into various classes on the basis of underlying credit quality. A well-structured credit rating framework is
an important tool for monitoring and controlling risk inherent in individual credits as well as in credit portfolios of a
bank or a business line. The importance of internal credit rating framework becomes more eminent due to the fact
that historically major losses to banks stemmed from default in loan portfolios.
Operational Risks
Managing operational risk is becoming an important feature of sound risk management practices in modern
financial markets in the wake of phenomenal increase in the volume of transactions, high degree of structural
changes and complex support systems. The most important type of operational risk involves breakdowns in internal
controls and corporate governance. Such breakdowns can lead to financial loss through error, fraud, or failure to
perform in a timely manner or cause the interest of the bank to be compromised.
Operational risk is defined as any risk, which is not categorized as market or credit risk, or the risk of loss
arising from various types of human or technical error.
It is also synonymous with settlement or payments risk and business interruption, administrative and legal risks.
Operational risk has some form of link between credit and market risks. An operational problem with a business
transaction could trigger a credit or market risk.
Measurement
There is no uniformity of approach in measurement of operational risk in the banking system. Besides, the existing
methods are relatively simple and experimental, although some of the international banks have made considerable
progress in developing more advanced techniques for allocating capital with regard to operational risk.
Measuring operational risk requires both estimating the probability of an operational loss event and the potential
size of the loss. It relies on risk factor that provides some indication of the likelihood of an operational loss event
occurring. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular
operational risk occurring, the magnitude (or severity) of the effect of the operational risk on business objectives
and the options available to manage and initiate actions to reduce/ mitigate operational risk. The set of risk factors
that measure risk in each business unit such as audit ratings, operational data such as volume, turnover and
complexity and data on quality of operations such as error rate or measure of business risks such as revenue
volatility, could be related to historical loss experience. Banks can also use different analytical or judgmental
techniques to arrive at an overall operational risk level. Some of the international banks have already developed
operational risk rating matrix, similar to bond credit rating. The operational risk assessment should be bank-wide
basis and it should be reviewed at regular intervals. Banks, over a period, should develop internal systems to
evaluate the risk profile and assign economic capital within the RAROC framework.
Indian banks have so far not evolved any scientific methods for quantifying operational risk. In the absence any
sophisticated models, banks could evolve simple benchmark based on an aggregate measure of business activity
such as gross revenue, fee income, operating costs, managed assets or total assets adjusted for off-balance sheet
exposures or a combination of these variables.
Risk Monitoring
The operational risk monitoring system focuses, inter alia, on operational performance measures such as volume,
turnover, settlement facts, delays and errors. It could also be incumbent to monitor operational loss directly with an
analysis of each occurrence and description of the nature and causes of the loss.

Control of Operational Risk
Internal controls and the internal audit are used as the primary means to mitigate operational risk. Banks could
also explore setting up operational risk limits, based on the measures of operational risk. The contingent processing
capabilities could also be used as a means to limit the adverse impacts of operational risk. Insurance is also an
important mitigator of some forms of operational risk. Risk education for familiarizing the complex operations at all
levels of staff can also reduce operational risk.
Policies and Procedures
Banks should have well defined policies on operational risk management. The policies and procedures should be
based on common elements across business lines or risks. The policy should address product review process, involving
business, risk management and internal control functions.
Internal Control
One of the major tools for managing operational risk is the well-established internal control system, which includes
segregation of duties, clear management reporting lines and adequate operating procedures. Most of the
operational risk events are associated with weak links in internal control systems or laxity in complying with the
existing internal control procedures.
The ideal method of identifying problem spots is the technique of self-assessment of internal control environment.
The self-assessment could be used to evaluate operational risk along with internal/external audit reports/ratings or
RBI inspection findings. Banks should endeavour for detection of operational problem spots rather than their being
pointed out by supervisors/internal or external auditors.
Along with activating internal audit systems, the Audit Committees should play greater role to ensure independent
financial and internal control functions.
The Basle Committee on Banking Supervision proposes to develop an explicit capital charge for operational risk.
Solvency Risk
The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but
a company also needs liquidity to thrive. Liquidity is a company's ability to meet its short-term obligations. A
company that is insolvent must enter bankruptcy; a company that lacks liquidity can also be forced to enter
bankruptcy even if it is solvent.
Bank solvency is defined as the ability of a financial institution to meet its short, middle and long term
financial obligations.
Solvency is also defined as the ability of a financial institution to meet its obligations in the event of cessation of
activity or liquidation. A bank is considered as solvent if the existing assets exceed or equal total liabilities. However,
if total assets are lower than current liabilities, the bank faces an insolvency risk and cannot pay its debts. This
definition implies that, at any time, the financial institution should be solvent.
R ISK MEASUREMENT PROC ESS AND M ITIGATION

Risk mitigation planning is the process of developing options and actions to enhance opportunities and reduce
threats to project objectives.
Risk mitigation implementation is the process of executing risk mitigation actions. Risk mitigation progress
monitoring includes tracking identified risks, identifying new risks, and evaluating risk process
effectiveness throughout the project.
The risk mitigation step involves development of mitigation plans
designed to manage, eliminate, or reduce risk to an acceptable level.
Once a plan is implemented, it is continually monitored to assess its
efficacy with the intent of revising the course-of-action if needed. Risk
mitigation planning, implementation, and progress monitoring are
depicted in the following figure:
Risk Mitigation Strategies

General guidelines for applying risk mitigation handling options are
shown in the following figure. These options are based on the assessed
combination of the probability of occurrence and severity of the
consequence for an identified risk. These guidelines are appropriate for
many, but not all, projects and programs.
Risk mitigation handling options include:

Assume/Accept
Acknowledge the existence of a particular risk, and make a
deliberate decision to accept it without engaging in special
efforts to control it. Approval of project or program leaders is
required.
Avoid
Adjust program requirements or constraints to eliminate or
reduce the risk. This adjustment could be accommodated by a
change in funding, schedule, or technical requirements.
Control
Implement actions to minimize the impact or likelihood of the
risk.
Transfer
Reassign organizational accountability, responsibility, and authority to another stakeholder willing to accept the
risk.
Watch/Monitor
Monitor the environment for changes that affect the nature and/or the impact of the risk.
Each of these options requires developing a plan that is implemented and monitored for effectiveness. More
information on handling options is discussed under best practices and lessons learned below.
NPA (N O N - PERFORMING A SSETS )

All those assets which don't generate regular income are known as NPA. To have a clear idea about NPAs first we
should know about the types of ass ets classifications by the bank:
Standard assets
An assets which is generating regular income to the bank.
Sub-standard assets
An asset which is overdue for a period of more than 90 days but less than 12 months.
Doubtful assets
An asset which is overdue for a period of more than 12 months.
Loss assets
Assets which are doubtful and considered as non-recoverable by bank, internal or external auditor or central bank
inspectors.
Sub-standard assets, Doubtful assets and Loss assets are NPA.
Causes of NPA
Default –
One of the main reason behind NPA is default by borrowers.
Economic conditions –
Economic condition of a region effected by natural calamities or any other reason may cause NPA.
No more proper risk management –
Speculation is one of the major reason behind default. Sometimes banks provide loans to borrowers with bad credit
history. There is high probability of default in these cases.
Mismanagement –
Often ill-minded borrowers bribe bank officials to get loans with an intention of default.
Diversion of funds –
Many times borrowers divert the borrowed funds to purposes other than mentioned in loan documents. It is very
hard to recover from these kind of borrowers.

ASSET - LIABILTY MANAGEMENT
Asset-Liability Management (ALM) is one of the important tools of risk management in commercial banks of India.
Indian banking industry is exposed to number of risk prevailed in the market such as market risk, financial risk,
interest rate risk etc. The net income of the banks is very sensitive to these factors or risk. For this purpose Reserve
bank of India (RBI), regulator of Indian banking industry evolved the tool known as ALM.
ALM-CONCEPT:
ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk of a
bank. It is the management of structure of balance sheet (liabilities and assets) in such a way that the net earnings
from interest is maximized within the overall risk-preference (present and future) of the institutions. The ALM
functions extend to liquidly risk management, management of market risk, trading risk management, funding and
capital planning and profit planning and growth projection.
The concept of ALM is of recent origin in India. It has been introduced in Indian Banking industry w. e. f. 1st April,
1999. ALM is concerned with risk management and provides a comprehensive and dynamic framework for
measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price
risks of a bank that needs to be closely integrated with the banks‘ business strategy.
Asset-liability management basically refers to the process by which an institution manages its balance sheet in order
to allow for alternative interest rate and liquidity scenarios. Banks and other financial institutions provide services
which expose them to various kinds of risks like credit risk, interest risk, and liquidity risk. Asset liability management
is an approach that provides institutions with protection that makes such risk acceptable. Asset-liability
management models enable institutions to measure and monitor risk, and provide suitable strategies for their
management.
Asset-liability management is a first step in the long-term strategic planning process. Therefore, it can be considered
as a planning function for an intermediate term. In a sense, the various aspects of balance sheet management deal
with planning as well as direction and control of the levels, changes and mixes of assets, liabilities, and capital.
SIGNIFICANCE OF ALM
 Volatility
 Product Innovations & Complexities
 Regulatory Environment
 Management Recognition
CATEGORIES OF RISK
Risk in a way can be defined as the chance or the probability of loss or damage. In the case of banks, these include
credit risk, capital risk, market risk, interest rate risk, and liquidity risk. These categories of financial risk require
focus, since financial institutions like banks do have complexities and rapid changes in their operating environments.
CREDIT RISK
The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk.
Credit risk management is an important challenge for financial institutions and failure on this front may lead to
failure of banks.
CAPITAL RISK
One of the sound aspects of the banking practice is the maintenance of adequate capital on a continuous basis.
There are attempts to bring in global norms in this field in order to bring in commonality and standardization in
international practices. Capital adequacy also focuses on the weighted average risk of lending and to that extent,
banks are in a position to realign their portfolios between more risky and less risky assets.
MARKET RISK
Market risk is related to the financial condition, which results from adverse movement in market prices. This will be
more pronounced when financial information has to be provided on a marked-to-market basis since significant
fluctuations in asset holdings could adversely affect the balance sheet of banks. In the Indian context, the problem is
accentuated because many financial institutions acquire bonds and hold it till maturity. When there is a significant
increase in the term structure of interest rates, or violent fluctuations in the rate structure, one finds substantial
erosion of the value of the securities held.
INTEREST RATE RISK
Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. It also considers
change in impact on interest income due to changes in the rate of interest. In other words, price as well as
reinvestment risks require focus. In so far as the terms for which interest rates were fixed on deposits differed from

those for which they fixed on assets, banks incurred interest rate risk i.e., they stood to make gains or losses with
every change in the level of interest rates.
LIQUIDITY RISK
Affects many Indian institutions. It is the potential inability to generate adequate cash to cope with a decline in
deposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturity patterns of assets
and liabilities.
Three Pillars of ALM
ALM INFORMATION SYSTEM
Information is the key to the ALM process. Considering the large network of branches and the lack of an adequate
system to collect information required for ALM which analyses information on the basis of residual maturity and
behavioural pattern it will take time for banks in the present state to get the requisite information. The problem of
ALM needs to be addressed by following an ABC approach i.e. analysing the behaviour of asset and liability
products in the top branches accounting for significant business and then making rational assumptions about the
way in which assets and liabilities would behave in other branches. In respect of foreign exchange, investment
portfolio and money market operations, in view of the centralised nature of the functions, it would be much easier
to collect reliable information. The data and assumptions can then be refined over time as the bank management
gain experience of conducting business within an ALM framework. The spread of computerisation will also help
banks in accessing data.
ALM ORGANIATION
The Board should have overall responsibility for management of risks and should decide the risk management
policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.
The Asset - Liability Committee (ALCO) consisting of the bank's senior management including CEO should be
responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the
bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives.
The ALM desk consisting of operating staff should be responsible for analysing, monitoring and reporting the risk
profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible
changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's
internal limits.
ALCO
The ALCO is a decision making unit responsible for balance sheet planning from risk - return perspective including
the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO,
its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank
should ensure that the bank operates within the limits / parameters set by the Board. The business issues that an
ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity
profile of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO
should review the results of and progress in implementation of the decisions made in the previous meetings. The
ALCO would also articulate the current interest rate view of the bank and base its decisions for future business
strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and
mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money
market vs capital market funding, domestic vs foreign currency funding, etc. Individual banks will have to decide
the frequency for holding their ALCO meetings.
COMPOSITION OF ALCO
The size (number of members) of ALCO would depend on the size of each institution, business mix and
organisational complexity. To ensure commitment of the Top Management, the CEO/CMD or ED should head the
Committee. The Chiefs of Investment, Credit, Funds Management / Treasury (forex and domestic), International
Banking and Economic Research can be members of the Committee. In addition the Head of the Information
Technology Division should also be an invitee for building up of MIS and related computerisation. Some banks may
even have sub-committees.
COMMITTEE OF DIRECTORS
Banks should also constitute a professional Managerial and Supervisory Committee consisting of three to four
directors which will oversee the implementation of the system and review its functioning periodically.
ALM PROCESS
R I SK P A R A M E T E R S . Define the parameters used to analyse and categorize risks, and the parameters used to
control the risk management effort.
Risk Identification. An asset or liability is termed as rate sensitive when
a. Within the time interval under consideration, there is a cash flow,
b. The interest rate resets/reprices contractually during the interval,
c. RBI changes interest rates where rates are administered and,
d. It is contractually pre-payable or withdrawal before the stated maturities.
Assets and liabilities which receive / pay interest that vary with a benchmark rate are re-priced at pre-determined
intervals and are rate sensitive at the time of re-pricing.
R I SK M E A SU R E M E NT . There are various techniques for measuring exposure of banks to interest rate risks: Trading
book, Banking Book, Maturity gap analysis, Duration gap analysis and Simulation.
R I SK M A NA G E ME N T . The process of identification, analysis and either acceptance or mitigation of uncertainty in
investment decision-making.
R I SK P O L I C I E S . All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets.
T O L E R A N C E L E V E L . The exposure of bank to interest rate risk.
M ERGERS AND D IVERSIFICATIO N OF B ANKS INTO S ECURIT IES M ARKET

Business combinations which may take the form of mergers, amalgamations and takeovers are important features
of corporate restructuring and governance. The principal factors behind the corporate restructuring activity in India
have been the policy changes that were announced in the form of economic reforms.
Merger and acquisitions are results of business strategy. While mergers are a result of the decisions of two
organizations, acquisitions are a takeover of one organization by another. A ‗forced‘ merger or a merger due to a
survival problem is normally known as an amalgamation.
Synergies of Merger:
Synergies in general is the interaction of two or more agents or forces so that their combined effect is greater than
the sum of their individual effects. In business, synergy is the cooperative interaction among groups, especially
among the acquired subsidiaries or merged parts of a corporation that creates an enhanced combined effect. The
effectiveness of synergies can be discussed on the basis of following parameters.
Financial Capabilit y
If two bank merge together that will enable them to have a strong financial and operational structure and in turn
they may supposed to be capable of greater resource/deposit mobilization.
Branch Network
Merger will help bank to increase the number of branches both in urban and rural areas.
Customer Base
The merger of bank will help the bank to acquire different type of customer base.
Tech Edge
The merger will help the bank to provide wide technical support and technology based services to the bank‘s
customers. The online banking, more number of ATMs are the example of technological support.
Priority sector advances
Commercial banks are required to lend money to people in the priority sector which includes farmers, people in
rural areas small-scale industry. When newly started private sector banks merge with established banks they can
have the advantage of priority sector advances.
Equity capital and EPS
The equity capital and swap ratio on EPS will help the bank to earn more.
Managing Human Resource
The merger will also give the banks the task of managing different type of human resource.
Managing Client Base
The merger will make the bank to design plan and schemes to attract and manage different type of client base.
This will enable the bank to gain revenue from various sources.
Managing Rural Branches
The Rural branches have rural customers and when a modern bank merges with a traditional bank this became an
additional task for them.
TYPES OF MERGER
Mergers and acquisitions in the banking sector is a common phenomenon across the world. The primary objective
behind this move is to attain growth at the strategic level in terms of size and customer base. This, in turn, increases
the credit-creation capacity of the merged bank tremendously. Small banks fearing aggressive acquisition by a
large bank sometimes enter into a merger to increase their market share and protect themselves from the possible
acquisition.
Vertical Mergers
Vertical mergers take place between firms in different stages of production / operations either as forward or
backward integration. The basic reason is to eliminate costs of searching for prices, contracting, payment collection
and advertising and may also reduce the cost of communicating and coordinating production. Both production and
inventory can be improved on account of efficient information flow within the organization.
MARKET -EXTENSION
Market extension occurs when two companies that sell the same products in different markets merge.
PRODUCT -EXTENSION
Product extension occurs when two companies that sell the different but related products in the same market
merge.
Horizontal Mergers
This type of mergers involve two firms that operate and compete in a similar kind of business. The merger is based
on the assumption that it will provide economies of scale from the larger combined unit.
Conglomerate Mergers
Conglomerate mergers are affected among firms that are in different or unrelated business activity. Firms that plan
to increase their product lines carry out these types of mergers. Firms opting for conglomerate merger control a
range of activities in various industries that require different skills in the specific managerial functions of research,
applied engineering, production, marketing and so on. These type of diversification can be achieved mainly by
external acquisition and mergers and is not generally possible through internal development. These type of mergers
are also called concentric mergers. Firms operating in different geographic locations also proceed with these types of
mergers.
PURCHASE MERGERS
Purchase mergers occurs when one company purchase other company. The purchase is made either by cash or
through the issue of some kind of debt instrument, and the sale is taxable.
CONSOLIDATION MERGERS
Consolidation mergers occur when a brand new company is formed and both companies are bought & combined
under the new entity. Tax terms are the same as those of a purchase merger.
UNDERWRITING
Underwriting is an act of guarantee by an organization for the sale of certain minimum amount of shares and
debentures issued by a Public Limited Company. According to the Companies Act, when a person agrees to take up
shares specified in the underwriting agreement, when the public or others have failed to subscribe for them, it is
called underwriting agreement.
“Underwriting is an agreement entered into before the shares are brought by the public that in the event of
the public not taking up the whole of them the underwriter will take an allotment of such part of the shares
as the public has not applied for.”
- Gerstenberg
Types of Underwritting
UNDERWRITER
The financial services intermediary who arranges for the subscription of the issue of securities, in the event of the
issue of not being taken up by the public, or who firmly guarantees capital is called ‗the underwriter‘.

Role of Underwritters
Responsibilities of Underwriters
1. An underwriter, not only has to underwrite the securities but has to subscribe within 45 days that part of
shares which remain unsubscribed by the public.
2. His understanding obligations should not exceed, at aby time, 20 times of his net worth.
3. The underwriter cannot derive any other benefit except the underwriting commission which is 5% for shares
and 2½% for debentures.
SEBI Guidelines
SEBI has issued detailed guidelines regulating underwriting as a financial service. Following are the important
guidelines:
O P T I O N A L . Underwriting has been made optional by the SEBI, for issues since October 1994. Accordingly, if an issue
has not been underwritten and the firm is not able to collect 90 percent of the amount offered to the public, the
entire amount collected would be refunded to the investors. However, the requirement of a minimum of 90 percent
subscription will not be applicable to the exclusive debt issues, provided the issuer makes adequate disclosures
about the alternative sources of finance that have been tied-up.
N U M B E R O F U N DE R W R I T E R S . The issuer will decide on the number of underwriters. For this purpose, the lead
managers must satisfy themselves about the net worth of the underwriters, and the outstanding commitments, and
disclose the same to SEBI. The underwriting agreement should be filed with the stock exchange.
R E G I ST R A T I O N . An important regulation announced by SEBI was the requirement of underwriting firms to get
themselves registered with SEBI. The registration requires the underwriters to have a minimum net worth of ` 20
lakhs.
O B L I G A T I O N S . Underwriters are required to follow scrupulously the general obligations and responsibilities,
procedures for inspection and disciplinary proceedings in case of default. The underwriting obligations, at any point
of time, should not exceed 20 times an underwriters net worth.
S U B - U N D E R W R I T I N G . As a step toward diversifying the risk, the underwriter can off-load a portion of the
obligations to other underwriters. For this purpose, underwriters can arrange for sub-underwriting on their own. In
order to ensure transparency in the operations of underwriters, an agreement is entered into with each body
corporate on whose behalf the underwriting is undertaken. The agreement stipulates details such as period within
which the underwriters shall subscribe to the issue after being asked, the precise commission payable and details of
agreements made by the underwriters for fulfilling the underwriting obligations.
U N DE R W R I T I N G C O M M I S S I O N . The payment of underwriting commission depends on the amount of obligations
devolving on the underwriter. Underwriting commission is payable by the issuer-corporation on the basis of
commission rate prescribed by the SEBI. They are maximum ceiling rate and are negotiable. No underwriting
commission is payable on amount taken up by promoters, employees, directors and their friends, and business
associates. Underwriting commission is to be paid within 15 days of finalization of allotments. However, it is payable
only when the entire portion has been subscribed.

M UTUAL F UNDS
MEANING
A mutual fund is a corporate body (trust) that attracts savings, which are then invested in money market, debt
market and capital market instruments such as shares and debentures. A mutual fund acts as a link between the
public and capital market. It is promoted by an agreement between three entities, namely sponsor, trustee and
ALM.
FUNCTION
Mutual funds raise money by selling shares of the fund to the public, much like any other type of company can sell
stock in itself to the public. Mutual funds then take the money they receive from the sale of their shares (along with
any money made from previous investments) and use it to purchase various investment vehicles, such as stocks,
bonds and money market instruments. In return for the money they give to the fund when purchasing shares,
shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most
mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund
will fluctuate daily, depending upon the performance of the securities held by the fund.
BENEFITS
Benefits of mutual funds include diversification and professional money management. Mutual funds offer choice,
liquidity, and convenience, but charge fees and often require a minimum investment. According to The Mutual
Fund Education Alliance following are the prominent benefits of Mutual Funds.
1. Professional Investment Management. By pooling the money of thousands of investors, mutual funds provide
full-time, high-level professional management that few individual investors can afford to obtain independently.
Such management can be important to achieving results in today's complex markets.
2. Diversification. Mutual funds invest in a broad range of securities. This limits investment risk by reducing the
effect of a possible decline in the value of any one security. Mutual fund shareowners can benefit from
diversification techniques usually available only to investors wealthy enough to buy significant positions in a
wide variety of securities.
3. Low Cost. If you tried to create your own diversified portfolio of 50 stocks, you'd need at least $100,000 and
you'd pay thousands of dollars in commissions to assemble your portfolio. A mutual fund lets you participate in
a diversified portfolio for as little as $1,000, and sometimes less.
4. Convenience and Flexibility. You own just one security rather than many, yet enjoy the benefits of a
diversified portfolio and a wide range of services. Fund managers decide what securities to trade, clip the bond
coupons, collect the interest payments and see that your dividends on portfolio securities are received and your
rights exercised. It's easy to purchase and redeem mutual fund shares, either directly online or with a phone call.
5. Quick, Personalized Service. Most mutual funds now offer extensive websites with a host of shareholder
services for immediate access to information about your fund account. Or a phone call puts you in touch with a
trained investment specialist at a mutual fund company who can provide information you can use to make
your own investment choices, assist you with buying and selling your mutual funds shares, and answer questions
about your mutual fund account status.
6. Ease of Investing. You may open or add to your account and conduct transactions or business with the mutual
fund by mail, telephone or bank wire. You can even arrange for automatic monthly investments by authorizing
electronic fund transfers from your checking account in any amount and on a date you choose.
7. Total Liquidity, Easy Withdrawal. You can easily redeem your shares anytime you need cash by letter,
telephone, bank wire or check, depending on the fund. Your proceeds are usually available within a day or
two.
8. Life Cycle Planning. With no-load mutual funds, you can link your investment plans to future individual and
family needs -- and make changes as your life cycles change. You can invest in growth funds for future college
tuition needs, then move to income mutual funds for retirement, and adjust your investments as your needs
change throughout your life. With no-load mutual funds, there are no commissions to pay when you change
your investments.
9. Market Cycle Planning. For investors who understand how to actively manage their portfolio, mutual fund
investments can be moved as market conditions change. You can place your funds in equities when the market
is on the upswing and move into money market mutual funds on the downswing or take any number of steps
to ensure that your investments are meeting your needs in changing market climates. A word of caution: since it
is impossible to predict what the market will do at any point in time, staying on course with a long-term,
diversified investment view is recommended for most investors.
10. Investor Information. Shareholders receive regular reports from the mutual funds, including details of
transactions on a year-to-date basis. The current net asset value of your shares (the price at which you may
purchase or redeem them) appears in the mutual fund price listings of daily newspapers. You can also obtain
pricing and performance results for the all mutual funds at this site, or it can be obtained by phone from the
mutual funds.
11. Periodic Withdrawals. If you want steady monthly income, many funds allow you to arrange for monthly
fixed checks to be sent to you, first by distributing some or all of the income and then, if necessary, by dipping
into your principal.
12. Dividend Options. You can receive all dividend payments in cash. Or you can have them reinvested in the
fund free of charge, in which case the dividends are automatically compounded. This can make a significant
contribution to your long-term investment results. With some funds you can elect to have your dividends from
income paid in cash and your capital gains distributions reinvested.
13. Automatic Direct Deposit. You can usually arrange to have regular, third-party payments -- such as Social
Security or pension checks -- deposited directly into your fund account. This puts your money to work
immediately, without waiting to clear your checking account, and it saves you from worrying about checks
being lost in the mail.
14. Recordkeeping Service. With your own portfolio of stocks and bonds, you would have to do your own
recordkeeping of purchases, sales, dividends, interest, short-term and long-term gains and losses. Mutual funds
provide confirmation of your transactions and necessary tax forms to help you keep track of your investments
and tax reporting.
15. Safekeeping. When you own shares in a mutual fund, you own securities in many companies without having
to worry about keeping stock certificates in safe deposit boxes or sending them by registered mail. You don't
even have to worry about handling the mutual fund stock certificates; the fund maintains your account on its
books and sends you periodic statements keeping track of all your transactions.
16. Retirement and College Plans. Mutual funds are well suited to Individual Retirement Accounts and most
funds offer IRA-approved prototype and master plans for individual retirement accounts (IRAs) and Keogh,
403(b), SEP-IRA and 401(k) retirement plans. Funds also make it easy to invest -- for college, children or other
long-term goals. Many offer special investment products or programs tailored specifically for investments for
children and college.
17. Online Services. The internet provides a fast, convenient way for investors to access financial information. A
host of services are available to the online investor including direct access to no-load companies.
18. Sweep Accounts. With many mutual funds, if you choose not to reinvest your stock or bond mutual funds
dividends, you can arrange to have them swept into your money market fund automatically. You get all the
advantages of both accounts with no extra effort.
19. Asset Management Accounts. These master accounts, available from many of the larger fund groups, enable
you to manage all your financial service needs under a single umbrella from unlimited check writing and
automatic bill paying to discount brokerage and credit card accounts.
20. Margin. Some mutual fund shares are marginable. You may buy them on margin or use them as collateral to
borrow money from your bank or broker. Call your fund company for details.
TYPES OF MUTUAL FUNDS
Every investor has a different investment objective. Some go for stability and opt for safer securities such as bonds or
government securities.
Those who have a higher risk appetite and yearn for higher returns may want to choose risk-bearing securities such
as equities. Hence, mutual funds come with different schemes, each with a different investment objective.
There are hundreds of mutual fund schemes to choose from. Hence, they have been categorized as mentioned
below.
FROM THE POINT OF INVESTORS:
1. O P E N - E N DE D MU T U A L F U N D : Open ended scheme consist of mutual funds which sell the units to the public.
These mutual funds can also re purchase the units. There is no fixed maturity period. IPO is open for a period of

30 days and then reopen as an open-ended scheme after a period not exceeding 30 days from the date of
closure of the IPO.
2. C L O SE - E N DE D M U T U A L F U N D : A close ended mutual fund has its mutual fund open for a fixed period and
whatever money invested form the basis for investment in various securities. These mutual fund have fixed
maturity period ranging from 2-15 years. One can invest in the scheme at the time of initial issue as it is open for
a period not exceeding 45 days.
3. G R O WT H - O R I E N T E D M U T U A L F U N D : It has an object of capital appreciation through investment in equity
shares. Normally investment is done in equity shares of such companies which have a high potential.
4. I N C O ME - O R I E N T E D F U N D : The object of this type of fund is to provide regular income to the investors so, the
mutual fund would wish to invest the public money raised in bonds, debentures and other debt related
instruments.
5. S P E C I A L I SE D M U T U A L F U N D : Here, the mutual fund will be investing the investors‘ money in a particular
industry such as steel, or petroleum so that such industries will grow rapidly.
6. D O M E ST I C MU T U A L F U ND : When the mutual fund mobilise savings from a particular geographic location like
a country or a region.
7. O F F – S H O R E MU T U A L F U N D : The object of launching offshore mutual fund is to attract foreign capital
investment in the country of the issuing company.
FROM THE POINT OF PROMOTERS:
1. S T O C K F U N D S : These are mutual funds which primarily invest in common stock, ranging from blue chip
companies such as HINDUSTAN LEVER to newly promoted companies. They can be growth oriented funds or
income oriented funds.
2. B O N D F U N D S : These are mutual funds which inversed in various types of bonds, for obtaining current income.
3. B A L A N C E D F U N D : It is combination of investment in companies‘ securities with government bonds. The
purpose is to balance the commitment of the funds.
4. I N D E X F U N D S : Here, the investment will be in those companies which forms the part of index number of the
stock exchange.
5. M O NE Y M A R K E T F U N D S : Here the mutual fund will be investing in short term securities such as treasury bills,
banks certificate of deposits and commercial paper.
6. D U A L F U N D : The close ended mutual fund units are traded in the open market and they have a specific
duration.
7. L E V E R A G E F U N D : In this mutual fund, investments are made in common stocks whose value will appreciate.
The mutual fund users will borrow in order to purchase shares and later on it is repaid from out of the sale of
the units.
8. S P E C I A L I SE D F U N D S : These are funds setup for some specialised purpose.
a. International fund
b. Global fund
c. Regional/country fund
d. Sector fund
9. T A X A T I O N F U N D S : The investors in these funds, will have exemption benefits from income tax.
10. R E A L E ST A T E F U N D S : The mutual funds invest in real estate institution such as commercial property
company, residential builder mortgage bankers. They are popular in USA and UK.
11. J U NK - B O N D F U N D S : These funds are rated low and carry risks. However, the reward comes in the form of
higher yields it is popular in UK.
I NSURANCE
Insurance means a promise of compensation for any potential future losses. It facilitates financial protection against
by reimbursing losses during crisis. There are different insurance companies that offer wide range of insurance
options and an insurance purchaser can select as per own convenience and preference.
Several insurances provide comprehensive coverage with affordable premiums. Premiums are periodical payment
and different insurers offer diverse premium options. The periodical insurance premiums are calculated according to
the total insurance amount.
Mainly insurance is used as an effective tool of risk management as quantified risks of different volumes can be
insured.

A contract (policy) in which an individual or entity receives financial protection or reimbursement against
losses from an insurance company. The company pools clients' risks to make payments more affordable for
the insured.
Mechanics of Insurance Service
Basic Principles of Insurance:

The main motive of insurance is cooperation. Insurance is defined as the equitable transfer of risk of loss from one
entity to another, in exchange for a premium. The main objective of every insurance contract is to give financial
security and protection to the insured from any future uncertainties. Insured must never ever try to misuse this safe
financial cover.
Seeking profit opportunities by reporting false occurrences violates the terms and conditions of an insurance
contract. This breaks trust, results in breaching of a contract and invites legal penalties.
An insurer must always investigate any doubtable insurance claims. It is also a duty of the insurer to accept and
approve all genuine insurance claims made, as early as possible without any further delays and annoying
hindrances. The seven principles of insurance are:
Principle of Uberrimae fidae (Utmost Good Faith).
Principle of Uberrimae fidae (a Latin phrase), or in simple English words, the Principle of Utmost Good Faith, is a
very basic and first primary principle of insurance. According to this principle, the insurance contract must be signed
by both parties (i.e insurer and insured) in an absolute good faith or belief or trust.
The person getting insured must willingly disclose and surrender to the insurer his complete true information
regarding the subject matter of insurance. The insurer's liability gets void (i.e legally revoked or cancelled) if any
facts, about the subject matter of insurance are either omitted, hidden, falsified or presented in a wrong manner by
the insured.
The principle of Uberrimae fidae applies to all types of insurance contracts.
Principle of Insurable Interest.
The principle of insurable interest states that the person getting insured must have insurable interest in the object of
insurance. A person has an insurable interest when the physical existence of the insured object gives him some gain
but its non-existence will give him a loss. In simple words, the insured person must suffer some financial loss by the
damage of the insured object.
For example: The owner of a taxicab has insurable interest in the taxicab because he is getting
income from it. But, if he sells it, he will not have an insurable interest left in that taxicab.
From above example, we can conclude that, ownership plays a very crucial role in evaluating insurable interest.
Every person has an insurable interest in his own life. A merchant has insurable interest in his business of trading.
Similarly, a creditor has insurable interest in his debtor.
Principle of Indemnity.
Indemnity means security, protection and compensation given against damage, loss or injury. According to the
principle of indemnity, an insurance contract is signed only for getting protection against unpredicted financial losses
arising due to future uncertainties. Insurance contract is not made for making profit else its sole purpose is to give
compensation in case of any damage or loss.
In an insurance contract, the amount of compensations paid is in proportion to the incurred losses. The amount of
compensations is limited to the amount assured or the actual losses, whichever is less. The compensation must not be
less or more than the actual damage. Compensation is not paid if the specified loss does not happen due to a
particular reason during a specific time period. Thus, insurance is only for giving protection against losses and not for
making profit.
However, in case of life insurance, the principle of indemnity does not apply because the value of human life cannot
be measured in terms of money.
Principle of Contribution.
Principle of Contribution is a corollary of the principle of indemnity. It applies to all contracts of indemnity, if the
insured has taken out more than one policy on the same subject matter. According to this principle, the insured can
claim the compensation only to the extent of actual loss either from all insurers or from any one insurer. If one
insurer pays full compensation then that insurer can claim proportionate claim from the other insurers.
For example: Mr. John insures his property worth `100,000 with two insurers "AIG Ltd." for
`90,000 and "MetLife Ltd." for `60,000. John's actual property destroyed is worth `60,000,
then Mr. John can claim the full loss of `60,000 either from AIG Ltd. or MetLife Ltd., or he can
claim `36,000 from AIG Ltd. and `24,000 from MetLife Ltd.
So, if the insured claims full amount of compensation from one insurer then he cannot claim the same compensation
from other insurer and make a profit. Secondly, if one insurance company pays the full compensation then it can
recover the proportionate contribution from the other insurance company.
Principle of Subrogation.
Subrogation means substituting one creditor for another. Principle of Subrogation is an extension and another
corollary of the principle of indemnity. It also applies to all contracts of indemnity.
According to the principle of subrogation, when the insured is compensated for the losses due to damage to his
insured property, then the ownership right of such property shifts to the insurer.
This principle is applicable only when the damaged property has any value after the event causing the damage.
The insurer can benefit out of subrogation rights only to the extent of the amount he has paid to the insured as
compensation.
For example: Mr. John insures his house for $ 1 million. The house is totally destroyed by the
negligence of his neighbour Mr. Tom. The insurance company shall settle the claim of Mr. John
for $ 1 million. At the same time, it can file a law suit against Mr. Tom for $ 1.2 million, the
market value of the house. If insurance company wins the case and collects $ 1.2 million from
Mr. Tom, then the insurance company will retain $ 1 million (which it has already paid to Mr.
John) plus other expenses such as court fees. The balance amount, if any will be given to Mr.
John, the insured.
Principle of Loss Minimization.

According to the Principle of Loss Minimization, insured must always try his level best to minimize the loss of his
insured property, in case of uncertain events like a fire outbreak or blast, etc. The insured must take all possible
measures and necessary steps to control and reduce the losses in such a scenario. The insured must not neglect and
behave irresponsibly during such events just because the property is insured. Hence it is a responsibility of the insured
to protect his insured property and avoid further losses.
For example: Assume, Mr. John's house is set on fire due to an electric short-circuit. In this tragic
scenario, Mr. John must try his level best to stop fire by all possible means, like first calling
nearest fire department office, asking neighbours for emergency fire extinguishers, etc. He must
not remain inactive and watch his house burning hoping, "Why should I worry? I've insured my
house."
Principle of Causa Proxima (Nearest Cause).

Principle of Causa Proxima (a Latin phrase), or in simple English words, the Principle of Proximate (i.e Nearest)
Cause, means when a loss is caused by more than one causes, the proximate or the nearest or the closest cause
should be taken into consideration to decide the liability of the insurer.
The principle states that to find out whether the insurer is liable for the loss or not, the proximate (closest) and not
the remote (farest) must be looked into.

For example: A cargo ship's base was punctured due to rats and so sea water entered and
cargo was damaged. Here there are two causes for the damage of the cargo ship - (i) The
cargo ship getting punctured beacuse of rats, and (ii) The sea water entering ship through
puncture. The risk of sea water is insured but the first cause is not. The nearest cause of damage
is sea water which is insured and therefore the insurer must pay the compensation.
However, in case of life insurance, the principle of Causa Proxima does not apply. Whatever may be the reason of
death (whether a natural death or an unnatural death) the insurer is liable to pay the amount of insurance.
Types of Insurance
The Insurance can be broadly classified as Life Insurance and General Insurance (Non-life Insurance). It is further
classified as shown in the figure:
Life Insurance
A contract in which the insurer undertakes to pay a certain sum of money to the insured, either on the expiry of a
specified period, or on the death of the insured, in consideration of payment of ‗premium‘ for a certain period of
time, is known as ‗life insurance‘. Following are some of the types of life insurance policies:
WHOLE LIFE POLICY .

An ordinary policy which runs throughout the life of the assured is known as ‗whole life policy‘. The sum assured
under this policy is payable only after the death of the assured.
ENDOWM ENT P OLICY .

The policy runs for a period as specified in the policy document. The sum assured, along with the bonuses, are
payable either on the date of maturity of the policy, or on the death of the assured, whichever occurs earlier.
ANNUITY POLICY .
Under this policy, the amount of the policy is paid in the form of annuities for a specified number of years, or till the
death of the assured.
JOINT LIFE POLICY .

When the insurance policy covers the lives of two or more persons, it is called ‗joint life policy‘.
GROUP INSURANCE POLICY.

When an insurance policy is taken out on the lives of the members of a family, or the employees of a business
concern, it is called ‗group insurance policy‘.
General Insurance
A contract whereby, upon periodic payment of a sum of money called premium, the insurer undertakes to
compensate the insured in the event of any specified loss or damage suffered by the latter, is known as ‗general
insurance‘.
FIRE INSURANCE.
Under fire insurance, the insurance company undertakes to indemnify the loss sustained by the insured party on
account of fire accidents. In order that fire claims are admitted by the insurance company, there must be an actual
fire that is accidental, and non-intentional. Some of the popular fire insurance policies are as follows:
a. Valued Policy: It is policy wherein the value of the property is agreed upon, and the insurance company
undertakes to pay the agreed value in the event of destruction of the property.
b. Average policy: A policy wherein, fire claims are paid to the insured in proportion to the actual value of
the property at the time of loss, is called ‗average policy‘. Such a clause aims at preventing under-insurance. The
amount of claims under this policy is calculated as follows:
Amount of insurance of policy X Loss assured
Amount of Claim =
Actual market value of subject matter
c. Specific policy: This is a policy wherein risk on account of fire is insured for a specific sum. The maximum
coverage under this policy shall be up to the amount of the insurance policy.
d. Floating policy: When an insurance policy covers risk pertaining to one of several kinds of goods in
different places for a single sum and for a single premium, it is called ‗floating policy‘.
e. Excess policy: In a policy, where the risk coverage is to the extent of the maximum additional amount by
which stocks may sometimes increase, it is called ‗excess policy‘.
f. Blanket policy: Where the risk pertaining to all types of assets, fixed as well as current, is covered under
one single insurance policy, it is a case of ‗blanket policy‘.
g. Comprehensive policy: A policy which covers all types of risk arising from fire, explosion, lighting,
thunderbolt, riot, civil commotion, strikes, burglary, etc. is called ‗comprehensive policy‘.
h. Consequential loss policy: Where a fire policy covers the risk arising from loss of profit owing to
interruption of business by fire, it is called a ‗consequential loss policy‘.
MARINE INSURANCE.
An insurance contract which covers the risks of loss arising from and incidental to marine adventure, is known as
‗Marine Insurance‘. Some of the important policies of marine insurance are as follows:
a. Time policy: A marine policy which covers a specified time period only.
b. Voyage policy: A marine policy that covers a specified voyage only.
c. Mixed policy: A marine policy that covers both specified time period and voyage.
d. Blanket policy: A marine policy that covers all types of risks.
e. Fleet policy: A marine policy that covers entire fleet of liners and steamers.
f. Valued policy: A marine insurance policy, wherein, the value of the subject matter is agreed upon between
the underwriter and the insured.
Health Insurance
Health insurance is, basically, a promise by an insurance company or health plan to provide or pay for health care
services in exchange for payment of premiums.
Motor Insurance
Motor insurance is a type of insurance that insures the damage to the motor vehicle and its accessories, liability for
damage to property, death of, or injury to, the assured himself or spouse and it also insures the motor vehicle
against the risk of liability for injury to, or the death of third parties caused by the driver‘s negligence.
Rural Insurance
Insurance business services that are afforded to the people in the rural areas is known as ‗rural insurance‘.
P ERFORMANCE A NA LYSIS OF B A NKS

Performance analysis in banks is carried out based on certain financial ratios. Performance analysis consists of return
analysis, risk analysis and capital adequacy analysis. The approaches for return analysis are return on equity
analysis, matrix analysis and data envelopment analysis.
Return on equity is computed multiplying return on assests with equity multiplier.
ROE ROA OM NIM NNIM ES

Net Net Non
Return on Return on Operating Earning
Equity Assets Margin Interest Interest Speed
Margin Margin
Profitability ratios including break even yield ratio, return on advances and cost of funds ratio are computed to
examine profitability performance of banks. Operating efficiency of banks is assessed by the ratio of operating
income to working funds, fund based income to operating income and fee based income to operating income.

Business efficiency is assessed by the ratio of various categories of deposits to the total deposits and deposits within
India and outside India are expected as percentage of total deposits. Employee efficiency is assessed by computing
business per employee, profit per employee, administrative expense per employee, deposits per employee and
advances per employee.
Branch efficiency is assessed through operating income per branch, net profit per branch, administrative expense
per branch, administrative expense per branch, deposits per barch and advances per branch.
Risk analysis consists of computation and analysis of credit risk, market risk, operating risk, interest rate risk and
exchange rate risk. By computing the standard deviation and beta of respective income stream for a specific
duration, we can examine operating risk. By examining the ratio of gross and net non performing assests to the
total loans and advances credit risk can be evaluated.
Liquidity risk is assessed by comparing liquid funds such as cash and government securities and cash with other
banks. Market risk is analysed by computing price risk of assets and interest rate risk.
Capital adequacy analysis is through computing capital adequacy ratio wherein Tier I and Tier II capital are related
to risk weighted assets.
CAMELS Rating System
CAMELS is a rating system developed in the US that is used by supervisory authorities to rate banks and other
financial institutions. It applies to every bank in the U.S and is also used by various financial institutions outside the
U.S. This rating system was adopted by National Credit Union Administration in 1987. In 1988, the Basel Committee
on Banking Supervision of the Bank of International Settlements (BIS) proposed the CAMELS framework for
assessing financial institutions.
Purpose:
The ratings are assigned based on the financial statements of the bank or financial
institution. This system helps the supervisory authorities to identify banks that need
maximum amount of regulatory concern. It is used to measure risk and financial stability
of a bank. It determines the banks overall conditions in the areas of financial, managerial
and operational aspects.
Score scale:
The rating system consists of a score from one to five with score one considered as best and
score five considered as the worst for each factor. Banks which obtain the score of one are
considered most stable, banks with a score of 2 or 3 are considered average and those
with 4 or 5 considered as below average and are subjected to supervisory scrutiny.
Factors for giving scores:
CAMELS is an acronym of the following factors on which ratings are given by supervisory
authorities.
C- CAPITAL ADEQUACY
Capital adequacy refers to the amount of capital the financial institutions has to hold as required by its financial
regulator. It is expressed as the Capital Adequacy ratio, which can be defined as the ratio of banks capital to risk
weighted assets. This ensures the protection of depositors and investors and financial soundness of the bank. Factors
involved in rating and assessing an institution's capital adequacy are its growth plans, economic environment,
ability to control risk, and loan and investment concentrations.
A- ASSET QUALITY
Asset quality evaluates the quality of asset/loan the bank offers. The assets of a bank include cash, government
securities, investments, real estates and interest earning loans. Assets such as loans provide returns to the financial
institutions in terms of interests and comprise a majority of banks assets carrying high risk. Asset quality deals with
quality of the loans, investments; and banks effectiveness in controlling and monitoring the credit risk. This provides
the stability of the company when faced with particular risks.
M- MANAGEMENT
Assessment of management determines ability of an institution to diagnose and react to financial stress. This
component rating is reflected by the management's capability to identify, measure, and control risks of the
institution's daily activities. It ensures safe operation of the institution with effective policies and guidelines. The
management has to address the risk related to credit, rate of interest, transactions etc.
E- EARNINGS
Ratings on earnings are based on the financial institution's ability to create returns on its assets. These returns enable
the institution to expand, retain competitiveness, and provide adequate capital. It can be measured as the return
on asset ratio. company's growth, stability, valuation allowances, net interest margin, net worth level and the
quality of the company's existing assets are assessed to rate the Earnings.
L- LIQUIDITY
To meet unexpected withdrawals from depositors without affecting the daily operations, the bank must maintain
liquid cash and assets that can be easily converted into cash. The ratio of liquid cash to asset ratio can be used as a
parameter to measure banks liquidity.
S - S ENSITIVITY
Sensitivity refers to effect on bank due to market changes. In other terms it refers to market risk. Banks sensitivity to
changes in interest rates, foreign exchange rates, changes in price of commodities, etc is measured. It primarily
evaluates the interest rate risk and sensitivity to all loans and deposits.
Camels composite rating:
The CAMELS system is also based on composite ratings on a scale of one to five based on ascending order of
supervisory concern. Each factor is assigned a weight as follows:
I NTRODUCTION TO H IGH T ECH E-B ANKING

New Information technology has taken important place in the future development of financial services, especially
banking sector transition are affected more than any other financial provider groups. Increased use of mobile
services and use of internet as a new distribution channel for banking transactions and international trading
requires more attention towards e-banking security against fraudulent activities. The development and the
increasing progress that is being experienced in the Information and Communication Technology have brought
about a lot of changes in almost all facets of life. In the Banking Industry, it has been in the form of online banking,
which is now replacing the traditional banking practice. Online banking has a lot of benefits which add value to
customers‘ satisfaction in terms of better quality of
Service offerings and at the same time enable the banks gain more competitive advantage over other competitors.
This Chapter discusses some challenges in an emerging economy.

P AY MENT SY STEM IN I NDIA
The central bank of any country is usually the driving force in the development of national payment systems. The
Reserve Bank of India as the central bank of India has been playing this developmental role and has taken several
initiatives for Safe, Secure, Sound, Efficient, Accessible and Authorised payment systems in the country. Security
threats in e-banking and RBI‘s initiatives.
The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a sub-committee of the
Central Board of the Reserve Bank of India is the highest policy making body on payment systems in the country.
The BPSS is empowered for authorising, prescribing policies and setting standards for regulating and supervising all
the payment and settlement systems in the country. The Department of Payment and Settlement Systems of the
Reserve Bank of India serves as the Secretariat to the Board and executes its directions.
In India, the payment and settlement systems are regulated by the Payment and Settlement Systems Act, 2007
(PSS Act) which was legislated in December 2007. The PSS Act as well as the Payment and Settlement System
Regulations, 2008 fRaguled thereunder came into effect from August 12, 2008. In terms of Section 4 of the PSS Act,
no person other than the Reserve Bank of India (RBI) can commence or operate a payment system in India unless
authorised by RBI. Reserve Bank has since authorised payment system operators of pre-paid payment instruments,
card schemes, cross-border in-bound money transfers, Automated Teller Machine (ATM) networks and centralised
clearing arrangements.
The Reserve Bank has taken many initiatives towards introducing and upgrading safe and efficient modes of
payment systems in the country to meet the requirements of the public at large. The dominant features of large
geographic spread of the country and the vast network of branches of the Indian banking system require the
logistics of collection and delivery of paper instruments. These aspects of the banking structure in the country have
always been kept in mind while developing the payment systems. Following are the broad classification of the
Payment System in India.
The Reserve Bank encouraged the setting up of National Payments Corporation of India (NPCI) to act as an
umbrella organisation for operating various Retail Payment Systems (RPS) in India. NPCI became functional in
early 2009. NPCI has taken over National Financial Switch (NFS) from Institute for Development and Research in
Banking Technology (IDRBT). NPCI is expected to bring greater efficiency by way of uniformity and
standardization in retail payments and expanding and extending the reach of both existing and innovative
payment products for greater customer convenience.
Paper Based Clearing
The banking sector is considered to be the back-bone of Indian economy. In India, the use of paper-based
instruments like cheques, drafts accounts for shared nearly 60% of the volume of total non-cash transactions. In
value terms, the share is presently around 11%. Since paper based payments occupy an important place in the
country, Reserve Bank had introduced Magnetic Ink Character Recognition (MICR) technology for speeding up and
bringing in efficiency in processing of cheques.
Cheque is like a written instruction to the bank asking it to pay the person‘s whose name is written on cheque the
sum of money. Cheque is just a piece of paper, to get the money it has to be cleared. The person who writes the
Cheque is called drawer and to whom it is paid is called as payee. Cheque is just a piece of paper, to get the money
it has to be cleared. Let‘s check out the steps in processing the cheque, also called as clearing.
Let‘s say Rahul gave an A/C payee cheque to Sachin. Let us see the sequence of events how Sachin gets the money
to his account:
1. Sachin deposits cheque to his bank.
2. Sachin‘s bank processes the cheque and sends a request to Rahul‘s bank for payment
3. If Rahul‘s bank has funds in his account, his bank will process the payment and release the funds to Sachin‘s
Bank
4. Sachin‘s Bank will processes the payment and credits the funds into his bank account.
Clearing process for non CTS 2010

cheques
The Payee would deposit the cheque is his/her bank. If the
payee or beneficiary of cheque has an account in the same
bank in the same city the funds are credited into his account
through internal arrangement of the bank
If the beneficiary has an account with any other bank in the
same or in any other city, then his banker would ensure that
funds are collected from the payer‘s banker through a clearing house.
A Clearing House is an association of banks that facilitates payments through cheques between different bank
branches within a city / place.
There are more than 1000 clearing houses operating all over the country facilitating cheque payments. These
clearing houses are managed by the RBI, State Bank of India and other public sector banks. To identify the paying
bank, the clearing house looks at cheque‘s routing number, MICR, the nine-digit number at the bottom of your
cheque, to the right of your account number. It identifies postal code/city and state of the origin of the cheque.
The clearing house presents paying bank with the cheque along with a payment request to drawee‘s bank, which
checks if there are sufficient funds in the account of drawer to pay money.
If the drawer‘s bank decides to pay then the clearing bank proceeds to settle the check, debiting drawer‘s bank and
crediting the payee‘s bank for the value of the check. The paying bank debits the amount from the drawer‘s
account. The clearing process is shown in following picture:
Time taken to clear the cheque: How fast the money would be deposited into Sachin‘s account depends on whether
the whether bank of Rahul and Sachin cheques are of same city. Based on this cheques are of two kinds:
 Local Cheques - These are cheques whereby the cheque issuer bank branch and the receiver bank
branch are in the same city
 Outstation Cheques - These are cheques whereby the cheque issuer bank branch and the receiver
bank branch are in different cities
All Local Cheques must be cleared on a T+1 basis. i.e., If I Deposit a local cheque into my bank account today
(irrespective of which bank the cheque is drawn or deposited) the funds must reach my account by End-Of-Day
Tomorrow. Of course, this is only if the deposit happened before the cut-off time for today. For example: Let‘s say
ICICI Bank has a cut of time of 1:00 PM. So, all cheques deposited after 1:00 PM the previous day and those
deposited before 1:00 PM today are processed in one batch and sent for payment. If you deposit your cheque after
1:00 PM, it will be processed only tomorrow and funds will be available one day after that. Outstation Cheques –
Processing of Outstation Cheques depends on location of drawee‘s bank.
 Banks in State Capitals – Max 7 days
 Banks in Major Cities – Max 10 days
 Banks in Other Locations – Max 14 days
Cheque Truncation System CTS 2010
Cheque Truncation System (CTS) or Image-based Clearing System (ICS), in India, is a project undertaken by the
Reserve Bank of India – RBI, for faster clearing of cheques. CTS is basically an online image-based cheque clearing
system where cheque images are captured at the collecting bank branch and transmitted electronically. Truncation
means, stopping the flow of the physical cheques issued by a drawer to the drawee branch. The physical instrument
is truncated at some point en-route to the drawee branch and an electronic image of the cheque is sent to the
drawee branch along with the relevant information like the MICR fields, date of presentation, presenting banks etc.
So the process now becomes:

1. In CTS, the presenting bank (or its branch) captures the data (on the MICR band) and the images of a
cheque using their Capture System (comprising of a scanner, core banking or other application.
2. The collecting bank (presenting bank) sends the data and captured images duly signed and encrypted to
the central processing location (Clearing House) for onward transmission to the paying bank (destination or
drawee bank). For the purpose of participation the presenting and drawee banks are provided with an
interface / gateway called the Clearing House Interface (CHI) that enables them to connect and transmit
data and images in a secure and safe manner to the Clearing House (CH).
3. The Clearing House processes the data, arrives at the settlement figure and routes the images and requisite
data to the drawee banks. This is called the presentation clearing. The drawee banks through their CHIs
receive the images and data from the Clearing House for payment processing. The drawee CHIs also
generate the return file for unpaid instruments.
For customers clearing process of CTS 2010 is no different from the use of traditional clearing infrastructure for
clearing paper cheques. Customers continue to use cheques as at present, except to:
1. Use image-friendly-coloured-inks while writing the cheques
2. Avoid any alterations or corrections thereon. For any change in the payee‘s name, amount in figures or in
words, fresh cheque leaves should be used by customers, as this will facilitate smooth passage through image
based clearing system.
As images of cheques (and not the physical cheques) alone need to move in CTS:
3. It is possible for the removal of the restriction of geographical jurisdiction normally associated with the paper
cheque clearing. Hence cheques would be multi-city.
4. This would result in effective reduction in the time required for payment of cheques, the associated cost of
transit and delays in processing, etc.
Cheque truncation eliminates the need to move the physical instruments across branches, except in exceptional
circumstances, thus speeding up the process of collection or realization of cheques. The Reserve Bank had
implemented CTS in the National Capital Region (NCR), New Delhi and Chennai with effect from February 1, 2008
and September 24, 2011. After migration of the entire cheque volume from MICR system to CTS, the traditional
MICR-based cheque processing has been discontinued in these two locations. Based on the advantages realised by
the stakeholders and the experienced gained from the roll-out in these centres, it was decided to operationalise CTS
across the country by Jan 1 2013.
1. Branch address with IFSC code printed top of the cheque

2. Date in dd/mm/yyyy format with boxes
3. Printers name with CTS-2010 in left side of cheque
4. A pantograph which shows VOID/COPY while taking photocopy of the cheque below the account number
5. New rupee symbol instead of bilingual format
6. ―Please sign above‖ is mentioned on bottom right of the cheque
7. Watermark ―CTS INDIA‖ to be visible cheque is held against any light.
8. Ultra Violet logo of Bank printed at upper left corner of cheque to be visible in UV lamps
Service Charges on Cheque Clearing:
1. L O C A L C H E Q U E S : The service / processing / maintenance charges levied from other member banks by the
bank managing a Clearing House are as follows –
a. MICR Cheque Processing Centres (MICR CPCs): The processing charges for the instruments
processed at MICR-CPCs shall be recovered on a monthly basis by debit to the accounts of the member
banks maintained with the bank managing the Clearing House, or by any other method, at the rate
prescribed by the Reserve Bank of India from time to time. The bank managing a MICR Cheque
Processing Centre shall not levy any other extra charges, for a service / facility relating to the clearing
process other than the rate prescribed by Reserve Bank of India towards processing charges. Currently
the charges prescribed are @ ` 2.50 per cheque (` 1/- from the presenting bank and `1.50 from the
drawee bank).
b. Cheques processed through Cheque Truncation System (CTS): Presently Cheque
Truncation System has been put in place in the National Capital Region of New Delhi and recently
launched in Chennai. The entities managing a CTS Centre shall not levy any other extra charges, for a
service / facility relating to the clearing process other than the rate prescribed by Reserve Bank of India
towards processing charges. Currently the charges prescribed are @ Rs. 1.50 per cheque (`0.50 from the
presenting bank and `1.00 from the drawee bank).
c. Other Clearing Houses: Clearing Houses other than MICR CPCs collect maintenance charges from
the member banks towards various expenses incurred for operating the clearing house. These
maintenance charges are calculated based on the actual expenditure incurred by the bank managing
the clearing house for clearing operations and the same is equally shared by all the member banks on a
no-profit basis.
d. Charges for banks managing back-up clearing centres (MICR and non-MICR
centres): Banks managing back-up clearing centres (primary or alternate) shall get themselves
compensated by the member banks of the Clearing House for the relative investment made by them
on computer hardware / software and other operating expenses on equal sharing basis. Additionally,
the back-up banks may also recover expenses incurred by them during contingencies / disruptions /
contingency drills from the member banks of the Clearing House. The expenses recovered must be
reasonable and should be approved by the President of the Clearing House.
2. C H A R G E S T O C U S T OM E R O N C H E Q U E C O L L E C T I O N S : Charges for clearing cheques, both local and outstation, are
levied by banks based on their collection policies and will be disclosed in the individual Cheque Collection Policies framed
and placed on their website.
Electronic Payments
The initiatives taken by RBI in the mid-eighties and early-nineties focused on technology-based solutions for the
improvement of the payment and settlement system infrastructure, coupled with the introduction of new payment
products by taking advantage of the technological advancements in banks. The continued increase in the volume
of cheques added pressure on the existing set-up, thus necessitating a cost-effective alternative system.
Electronic Clearing Service (ECS) Credit
The Bank introduced the ECS (Credit) scheme during the 1990s to handle bulk and repetitive payment
requirements (like salary, interest, dividend payments) of corporates and other institutions. ECS (Credit) facilitates
customer accounts to be credited on the specified value date and is presently available at all major cities in the
country.
During September 2008, the Bank launched a new service known as National Electronic Clearing Service (NECS),
at National Clearing Cell (NCC), Mumbai. NECS (Credit) facilitates multiple credits to beneficiary accounts with
destination branches across the country against a single debit of the account of the sponsor bank. The system has a
pan-India characteristic and leverages on Core Banking Solutions (CBS) of member banks, facilitating all CBS bank
branches to participate in the system, irrespective of their location across the country.
Regional ECS (RECS)
Next to NECS, RECS has been launched during the year 2009.RECS, a miniature of the NECS is confined to the
bank branches within the jurisdiction of a Regional office of RBI. Under the system, the sponsor bank will upload the
validated data through the Secured Web Server of RBI containing credit/debit instructions to the customers of CBS
enabled bank branches spread across the Jurisdiction of the Regional office of RBI. The RECS centre will process the
data, arrive at the settlement, generate destination bank wise data/reports and make available the data/reports
through secured web-server to facilitate the destination bank branches to afford credit/debit to the accounts of
beneficiaries by leveraging the CBS technology put in place by the bank. Presently RECS is available in
Ahmedabad, Bengaluru, Chennai and Kolkata
Electronic Clearing Service (ECS) Debit
The ECS (Debit) Scheme was introduced by RBI to provide a faster method of effecting periodic and repetitive
collections of utility companies. ECS (Debit) facilitates consumers / subscribers of utility companies to make routine
and repetitive payments by ‗mandating‘ bank branches to debit their accounts and pass on the money to the
companies. This tremendously minimises use of paper instruments apart from improving process efficiency and
customer satisfaction. There is no limit as to the minimum or maximum amount of payment. This is also available
across major cities in the country.
Electronic Funds Transfer (EFT)
This retail funds transfer system introduced in the late 1990s enabled an account holder of a bank to electronically
transfer funds to another account holder with any other participating bank. Available across 15 major centers in the
country, this system is no longer available for use by the general public, for whose benefit a feature-rich and more
efficient system is now in place, which is the National Electronic Funds Transfer (NEFT) system.
National Electronic Funds Transfer (NEFT) System
In November 2005, a more secure system was introduced for facilitating one-to-one funds transfer requirements of
individuals / corporates. Available across a longer time window, the NEFT system provides for batch settlements at
hourly intervals, thus enabling near real-time transfer of funds. Certain other unique features viz. accepting cash for
originating transactions, initiating transfer requests without any minimum or maximum amount limitations,
facilitating one-way transfers to Nepal, receiving confirmation of the date / time of credit to the account of the
beneficiaries, etc., are available in the system.
Real Time Gross Settlement (RTGS)System
RTGS is a funds transfer systems where transfer of money takes place from one bank to another on a "real time"
and on "gross" basis. Settlement in "real time" means payment transaction is not subjected to any waiting period.
"Gross settlement" means the transaction is settled on one to one basis without bunching or netting with any other
transaction. Once processed, payments are final and irrevocable. This was introduced in in 2004 and settles all inter-
bank payments and customer transactions above `2 lakh.
Clearing Corporation of India Limited (CCIL)
CCIL was set up in April 2001 by banks, financial institutions and primary dealers, to function as an industry service
organisation for clearing and settlement of trades in money market, government securities and foreign exchange
markets.
The Clearing Corporation plays the crucial role of a Central Counter Party (CCP) in the government securities, USD
–INR forex exchange (both spot and forward segments) and Collaterised Borrowing and Lending Obligation
(CBLO) markets. CCIL plays the role of a central counterparty whereby, the contract between buyer and seller gets
replaced by two new contracts - between CCIL and each of the two parties. This process is known as ‗Novation‘.
Through novation, the counterparty credit risk between the buyer and seller is eliminated with CCIL subsuming all
counterparty and credit risks. In order to minimize the these risks, that it exposes itself to, CCIL follows specific risk
management practices which are as per international best practices.In addition to the guaranteed settlement, CCIL
also provides non guaranteed settlement services for National Financial Switch (Inter bank ATM transactions) and
for rupee derivatives such as Interest Rate Swaps.
CCIL is also providing a reporting platform and acts as a repository for Over the Counter (OTC) products.
Other Payment Systems
Pre-paid Payment Systems
Pre-paid instruments are payment instruments that facilitate purchase of goods and services against the value
stored on these instruments. The value stored on such instruments represents the value paid for by the holders by
cash, by debit to a bank account, or by credit card. The pre-paid payment instruments can be issued in the form of
smart cards, magnetic stripe cards, internet accounts, internet wallets, mobile accounts, mobile wallets, paper
vouchers, etc.
Subsequent to the notification of the PSS Act, policy guidelines for issuance and operation of prepaid instruments in
India were issued in the public interest to regulate the issue of prepaid payment instruments in the country.
The use of pre-paid payment instruments for cross border transactions has not been permitted, except for the
payment instruments approved under Foreign Exchange Management Act,1999 (FEMA).
Mobile Banking System
Mobile phones as a medium for providing banking services have been attaining increased importance. Reserve
Bank brought out a set of operating guidelines on mobile banking for banks in October 2008, according to which
only banks which are licensed and supervised in India and have a physical presence in India are permitted to offer
mobile banking after obtaining necessary permission from Reserve Bank. The guidelines focus on systems for security
and inter-bank transfer arrangements through Reserve Bank's authorized systems. On the technology front the
objective is to enable the development of inter-operable standards so as to facilitate funds transfer from one
account to any other account in the same or any other bank on a real time basis irrespective of the mobile network
a customer has subscribed to.
ATMs / Point of Sale (POS) Terminals / Online Transactions
Presently, there are over 61,000 ATMs in India. Savings Bank customers can withdraw cash from any bank terminal
up to 5 times in a month without being charged for the same. To address the customer service issues arising out of
failed ATM transactions where the customer's account gets debited without actual disbursal of cash, the Reserve
Bank has mandated re-crediting of such failed transactions within 12 working day and mandated compensation for
delays beyond the stipulated period. Furthermore, a standardised template has been prescribed for displaying at all
ATM locations to facilitate lodging of complaints by customers.
There are over five lakh POS terminals in the country, which enable customers to make payments for purchases of
goods and services by means of credit/debit cards. To facilitate customer convenience the Bank has also permitted
cash withdrawal using debit cards issued by the banks at PoS terminals.
The PoS for accepting card payments also include online payment gateways. This facility is used for enabling online
payments for goods and services. The online payment are enabled through own payment gateways or third party
service providers clled intermediaries. In payment transactions involving intermediaries, these intermediaries act as
the initial recipient of payments and distribute the payment to merchants. In such transactions, the customers are
exposed to the uncertainty of payment as most merchants treat the payments as final on receipt from the
intermediaries. In this regard safeguard the interests of customers and to ensure that the payments made by them
using Electronic/Online Payment modes are duly accounted for by intermediaries receiving such payments,
directions were issued in November 2009. Directions require that the funds received from customers for such
transactions need to be maintained in an internal account of a bank and the intermediary should not have access
to the same.
Further, to reduce the risks arising out of the use of credit/debit cards over internet/IVR (technically referred to as
card not present (CNP) transactions), Reserve Bank mandated that all CNP transactions should be additionally
authenticated based on information not available on the card and an online alert should be sent to the cardholders
for such transactions.
National Payments Corporation of India
The Reserve Bank encouraged the setting up of National Payments Corporation of India (NPCI) to act as an
umbrella organisation for operating various Retail Payment Systems (RPS) in India. NPCI became functional in
early 2009. NPCI has taken over National Financial Switch (NFS) from Institute for Development and Research in
Banking Technology (IDRBT). NPCI is expected to bring greater efficiency by way of uniformity and
standardization in retail payments and expanding and extending the reach of both existing and innovative
payment products for greater customer convenience.
Oversight of Payment and Settlement Systems
Oversight of the payment and settlement systems is a central bank function whereby the objectives of safety and
efficiency are promoted by monitoring existing and planned systems, assessing them against these objectives and,
where necessary, inducing change. By overseeing payment and settlement systems, central banks help to maintain
systemic stability and reduce systemic risk, and to maintain public confidence in payment and settlement systems.
The Payment and Settlement Systems Act, 2007 and the Payment and Settlement Systems Regulations, 2008
framed thereunder, provide the necessary statutory backing to the Reserve Bank of India for undertaking the
Oversight function over the payment and settlement systems in the country.

E LECTRONIC B A NKING
E-banking refers to electronic banking. It is like e-business in banking industry. E-banking is also called as "Virtual
Banking" or "Online Banking".
For many people, electronic banking means 24-hour access to cash through an automated teller machine (ATM) or
Direct Deposit of pay checks into checking or savings accounts. But electronic banking involves many different types
of transactions, rights, responsibilities — and sometimes, fees.
Electronic banking is the use of computers to carry out banking transactions such as withdrawals through
cash dispensers or transfer of funds at point of sale.
E-banking involves information technology based banking. Under this I.T system, the banking services are delivered
by way of a Computer-Controlled System. This system does involve direct interface with the customers. The
customers do not have to visit the bank's premises.
The effect of technology in banking has been dramatic. Let us understand the role of technology as an enabler for
improved transaction efficiency through the categorization provided in the following figure.
The bank-to-customer relationship has changed up significantly, with open standards replacing proprietary front
ends, and many-to-many networks substituting for single-line links.
Benefits of Electronic Banking

For Banks
The benefits of electronic banking for banks are as follows:
 P R I C E - In the long run a bank can save on money by not paying for tellers or for managing branches. Plus, it's
cheaper to make transactions over the Internet.
 C U ST O M E R B A SE - the Internet allows banks to reach a whole new market- and a well off one too, because
there are no geographic boundaries with the Internet. The Internet also provides a level playing field for small
banks who want to add to their customer base.
 E F F I C I E N C Y - Banks can become more efficient than they already are by providing Internet access for their
customers. The Internet provides the bank with an almost paper less system.
 C U ST O M E R S E R V I C E A N D S A T I S F A C T IO N - Banking on the Internet not only allow the customer to have a
full range of services available to them but it also allows them some services not offered at any of the branches.
The person does not have to go to a branch where that service may or may not be offer. A person can print of
information, forms, and applications via the Internet and be able to search for information efficiently instead of
waiting in line and asking a teller. With more better and faster options a bank will surely be able to create
better customer relations and satisfaction.
 I M A G E - A bank seems more state of the art to a customer if they offer Internet access. A person may not want
to use Internet banking but having the service available gives a person the feeling that their bank is on the
cutting image.
For Customers
The benefits of electronic banking for customers are as follows
 B I L L P A Y - Bill Pay is a service offered through Internet banking that allows the customer to set up bill
payments to just about anyone. Customer can select the person or company whom he wants to make a
payment and Bill Pay will withdraw the money from his account and send the payee a paper check or an
electronic payment.
 O T H E R I M P O R T A N T F A C I L I T I E S - E- banking gives customer the control over nearly every aspect of
managing his bank accounts. Besides the Customers can, Buy and Sell Securities, Check Stock Market
Information, Check Currency Rates, Check Balances, See which checks are cleared, Transfer Money, View
Transaction History and avoid going to an actual bank. The best benefit is that Internet banking is free. At
many banks the customer doesn't have to maintain a required minimum balance. The second big benefit is
better interest rates for the customer.
T HE IMPORTANCE O F PAY MENT AND SETTLEMENT SYSTEMS

Almost all economic transactions involve some form of payment. Money, in the form of either cash or bank deposits,
is commonly the preferred means of payment for the purchase of goods and services and for the repayment of
debts. While many smaller-value payments are made with cash, larger payments usually involve the transfer of
bank deposits. Modern financial systems also involve substantial trade in financial instruments such as bonds,
equities and derivatives. Payment and settlement systems enable these transfers of deposit money and financial
instruments to take place. A developed market economy typically has various payment and settlement systems,
including large value and retail payment systems as well as securities settlement systems. Important roles may also
fall to various other institutions that provide payment and settlement services - for example, central counterparties,
large correspondent banks and custodians.
For large-value payment systems and securities settlement systems, the total value of transactions is often such that
the equivalent of annual GDP is turned over in just a few days. Interbank lending, the settlement of foreign
exchange trades and securities transfers account for the major portion of the turnover in these large-value systems.
The largest volumes of transactions are handled in the retail payment systems, such as the automated clearing
houses, card schemes and cheque clearings, which are used to pay the bulk of salaries, utility bills, taxes and
corporate invoices and to settle the range of transactions in goods and services that are necessary for a market
economy to function.
Because payment and settlement systems are essential for financial markets and the economy as a whole, central
banks have always had an intrinsic interest in their safe and efficient functioning.
E LECTRONIC P AY MENT S Y STEM

E payment is a subset of an e-commerce transaction to include electronic payment for buying and selling goods or
services offered through the Internet. Generally we think of electronic payments as referring to online transactions
on the internet, there are actually many forms of electronic payments. As technology developing, the range of
devices and processes to transact electronically continues to increase while the percentage of cash and check
transactions continues to decrease.
Current e-payment technologies depend on using traditional methods that are common to non-electronic systems.
Due to the nature of Internet, security and authenticity of payments and participants cannot be guaranteed with
technologies that are not specifically designed for electronic commerce. The following are the various type of
electronic payment system followed at present.
Real Time Gross Settlement (RTGS)
The expansion of RTGS is "Real Time Gross Settlement". It is maintained by reserve bank of India. RTGS is a money
transfer technique where transfer of money occurs from one bank to another on a ‗real time‘ and on ‗gross‘ basis.
RTGS can be described as continuous (real-time) settlement of funds transfers independently on an order by order
basis. This technique is known as fastest money transfer technique.
‗Real Time Gross Settlement (RTGS)‘ system means system which facilitates on-line real time settlement of payments
either on gross basis or through Multilateral Settlement Batches, received from the members.
The word ‗real time‘ means that transaction is executed at the time they are received, there is no waiting period.
Conversely ‗Gross settlement‘ means the settlement of fund occurs one to one basis without bunching with other
transactions. Once the money transfer take place in the book of RBI, the payment is considered as final and
irreversible.
RTGS is a large value funds transfer technique. In RTGS System the minimum value of transaction is ` 2 lakh. There
is no upper limit for transaction. Customers can use the facility of RTGS between 9 am to 4:30 pm on Monday to
Friday and 9 am to 1:30 pm on Saturdays.
National Electronic Funds Transfer (NEFT)

The expansion of NEFT is National Electronic Fund Transfer. By using this system individual, firm or corporate can
transfer the funds electronically from any bank branch to any other individual, firm or corporate having account in
other bank branch in the country.
National Electronic Fund Transfer (NEFT) is a system of transfer between two banks on net settlement basis. Which
means that each individual transfer from one account to another account is not settled or processed at that same
moment, it‘s done in batches.
This payment network is kept by RBI. NEFT system is a funds transfer technique where transfer of fund occurs from
one bank to another on a deferred net settlement basis. To provide the facility of NEFT to the customer the bank
branch has to be NEFT enabled. To perform any transaction by using NEFT, IFSC (Indian Financial System Code)
code is required. This code specifies the branch of a bank.
Some important points about NEFT are as follow:
 In NEFT the transaction can be take place between two NEFT enabled bank branches. It can also be employed
to transfer funds from or to NRE/NRO accounts in India. Remittance is not permitted to a foreign country, apart
from Nepal.
 In NEFT transactions are bunched up and executed in a bunch at specified time slot. In weekday there are 12
settlements that take place from 8 am to 7 pm, and on Saturday there are only 6 settlements that take place
from 8 am to 1 pm. If a transaction is started after a batch settlement time, it is postponed to the next batch.
 There is no lower or upper limit on the amount that can be transferred under NEFT.
 There are some charges are applied on outward transaction while inward transaction are free. This ranges from
a minimum of ` 2.50 for amounts up to ` 10,000 to a maximum of ` 25 for transfer amounts above ` 2 lakh.
NEFT versus RTGS
National Electronic Fund Transfer (NEFT) and Real Time Gross Settlement (RTGS) allow individuals, companies and
firms to transfer funds from one bank to another. You can check the RBI website for a list of NEFT and RTGS-
enabled branches of your bank. These facilities can only be used for transferring money within the country. To opt
for these, you need to fill a form providing your or the beneficiary‘s details — name, bank branch where the account
is held, the Indian Financial System Code, a unique code for identifying the branch, and the account number and
type. You have to submit a cheque while opting for this facility. You can also transfer funds through net banking.
How much can be transferred?
There is no ceiling on the minimum or maximum amount that can be transferred through NEFT. You can even
transfer ` 1. However, a minimum of ` 2 lakh must be transferred through the RTGS service. There is no cap on the
maximum amount, though. However, banks may restrict the amount you can transfer in one day. For example,
HDFC Bank allows a maximum of ` 10 lakh to be transferred in a day.

What are the charges applicable?
According to RBI, banks cannot levy any charge for inward remittances or on receipt of funds. However, it has
capped the charges on outward transfers through NEFT and RTGS. For transfers through the former, you need to
pay around ` 5-25, depending on the amount. Banks cannot charge more than ` 5 for any transfer up to ` 1 lakh, `
15 for ` 1-2 lakh and ` 25 for those above ` 2 lakh. Under RTGS, you have to pay ` 25 for ` 2-5 lakh and ` 50 for
anything above ` 5 lakh.
How are the two different?
NEFT operates on a deferred net settlement (DNS) basis and settles transactions in batches. The settlement takes
place with all transactions received till a particular cut-off time. It operates in hourly batches — there are 11
settlements from 9 am to 7 pm on weekdays and five between 9 am and 1 pm on Saturdays. Any transaction
initiated after the designated time would have to wait till the next settlement time. In RTGS, transactions are
processed continuously, all through the business hours. RBI‘s settlement time is 9 am to 4:30 pm on weekdays and 9
am to 1:30 pm on Saturdays. Banks can function within this time frame or change it. Here, transfers made are quick
and can be helpful in emergencies.
What if the amount does not get credited?
If the transaction fails, the beneficiary‘s bank must return the amount to your bank within two hours and the
transaction must be reversed. Also, the bank must transfer the amount to your account within 30 minutes of
receiving the same. The process can work quickly for RTGS. But, in case of NEFT the entire process could take an
additional three-four hours.
Electronic Clearing Services (ECS)
ECS is an electronic mode of funds transfer from one bank account to another. It can be used by institutions for
making payments such as distribution of dividend interest, salary, and pension, among others.
The Electronic Clearing Service (ECS) is an online transmission system which permits the electronic transmission of
payment information by the banks/branches to the Automated Clearing House (ACH) via a communication
network.
It can also be used to pay bills and other charges such as telephone, electricity, water or for making equated
monthly installments payments on loans as well as SIP investments. ECS can be used for both credit and debit
purposes.
How do you avail of an ECS scheme?

You need to inform your bank and provide a mandate that authorises the institution, who can then debit or credit
the payments through the bank. The mandate contains details of your bank branch and account particulars. It is
the responsibility of the institution to communicate the details of the amount being credited or debited to their
account, indicating the date of credit and other relative particulars of the payment. You will know the money has
been debited from your account through mobile alerts or messages from the bank. The ECS user can set the
maximum amount one can debit from the account, specify the purpose of debit, as well as set a validity period for
every mandate given.
What are the processing or service charges levied on the customer?
The Reserve Bank of India has deregulated the charges to be levied by sponsor banks from institutions. Destination
bank branches have been directed to afford ECS credit free of charge to the beneficiary account holders. So, it costs
you nothing.
How do you discontinue an ECS scheme?
There are two steps you have to follow to ensure appropriate closure. Firstly, the service provider, which is the
beneficiary of the payment, will have to be given a written communication in the way stipulated by them, in order
to discontinue the services. And next, the bank, which is the channel of payment, will also have to be given a written
application stating you would like to discontinue.
National Electronic Clearing Service (NECS)
NECS stands for National Electronic Clearing Service. It is an initiative launched by Reserve Bank of India, as an
improvement over the ECS –Electronic Clearing Service, currently in vogue.
ECS was launched more than two decades back, and the growth has been extraordinary. Both the ECS Credits and
Debit Products have delivered their mandates. The major drawback of the ECS is that the Sponsor Institution has to
submit the Processing Files to each Clearing House separately and also reconcile the entries Clearing House wise.
Presently, ECS system functions in a decentralized manner requiring users to prepare separate set of ECS data
centre-wise. Users are required to have tie-up with local sponsor banks for presenting ECS file to each ECS Centre.
There is no mechanism for the Sponsor Institution to centrally submit the Processing Files or to receive the Return
Files. This was hampering the growth of ECS and the transactions were at a stagnant level. To overcome the
drawbacks associated with ECS, Reserve Bank of India, decided to launch the NECS
NECS was launched on 29th September 2008 by Shri V. Leeladhar, Deputy Governor, Reserve Bank of India. He
inaugurated the National Electronic Clearing Service (NECS) at a function at the Reserve Bank's National Clearing
Centre (NCC), Mumbai.
The service aims to centralize the Electronic Clearing Service (ECS) operation and bring in uniformity and efficiency
to the system. NECS (Credit) would facilitate multiple credits to beneficiary accounts destination branch at
participating centre against a single debit of the account of a user with the sponsor bank. NECS (Debit) would
facilitate multiple debits to destination account holders against single credit to user account.
The system has a pan-India characteristic leveraging on Core Banking Solutions (CBS) of member banks. This would
facilitate all CBS bank branches to participate in the system, irrespective of their locations.
In the new set-up, users have to prepare one consolidated NECS file and submit it centrally to the NCC, Nariman
Point, Mumbai, through their sponsor banks. The sponsor banks would make use of the web-server provided for the
purpose. The web-server also has the facility to get on-line data validation so that error free data could be
uploaded for processing.
The files can be uploaded up to the cut-off time one day prior to the settlement day by sponsor banks thus bringing
down further the lead time required for processing. The returns also would get processed on the settlement day itself
thus on the third day the users would have the status of the transactions. As on date 26,000+ bank branches are
participating in NECS operations and other bank branches are expected to join in course of time.
In the first phase, the NECS (Credit) was introduced. In May 2009, more than 2 million transactions were executed
through NECS (Credit). Given the benefits offered by NECS, the need for local-ECS at various locations becomes
redundant. Accordingly, local-ECS-Credit at Mumbai has been merged with NECS-Credit. The NECS (Debit) would
be introduced subsequently, based on the experience and feedback received from member banks. As the process
flow for NECS (Debit) is different from NECS (Credit), i.e. Validation of Mandates is required for a NECS (Debit)
Transaction, the NECS (Debit), was not launched in the first phase. As Banks have seen the benefits accruing from a
NECS (Credits), they have requested Reserve Bank of India, to introduce NECS (Debit) too.
Customer Facili tation Centres for NEFT and RTGS
Some banks with internet banking facility provide this service. Once the funds are credited to the account of the
beneficiary bank, the remitting customer gets a confirmation from his bank either by an e-mail or SMS. Customer
may also contact RTGS / NEFT Customer Facilitation Centres of the banks, for tracking a transaction.

P LASTIC M ONEY
Plastic money is a term that is used predominantly in reference to the hard plastic cards we use every day in place
of actual bank notes.
Plastic money refers to the substitutions of currency at the time when a payment is taking place by using a card
normally made of plastic representing such substitutions.
Forms of Plastic Money
They can come in many different forms such as cash cards, credit cards, debit cards, pre-paid cash cards and store
cards.
 Cash Cards - A card that will allow you to withdraw money directly from your bank via an Authorised
Teller Machine (ATM) but it will not allow the holder to purchase anything directly with it.
 Credit Cards - Again this card will permit the card holder to withdraw cash from an ATM, and a credit
card will allow the user to purchase goods and services directly, but unlike a Cash Card the money is basically a
high interest loan to the card holder, although the card holder can avoid any interest charges by paying the
balance off in full each month.
 Debit Cards - This type of card will directly debit money from your bank account, and can directly be
used to purchase goods and services. While there is no official credit facility with debit cards per se, as it is linked
to the bank account the limit is the limit of what is in the account, for instance if an overdraft facility is
available then the limit will be the extent of the overdraft.
 Pre-pa id Cash Cards - As the name suggests the user will add credit to the card themselves, and will
not exceed that amount. These are usually re-useable in that they can be 'topped up' however some cards,
usually marketed as Gift Cards are not re-useable and once the credit has been spent they are disposed of.
 Store Cards - These are similar in concept to the Credit Card model, in that the idea is to purchase
something in store and be billed for it at the end of the month. These cards can be charged at a very high
interest rate and can are limited in the places they can be used, sometimes as far as only the store brand that
issued it.
C REDIT C ARDS
A credit card is a plastic card issued by a financial institution that allows its user to borrow pre-approved funds at
the point of sale in order to complete a purchase. Credit cards have higher interest rates (around 19% per year) than
most consumer loans or lines of credit. Almost every store allows for payment of goods and services through credit
cards.
Credit Card is a card issued by a financial company giving the holder an option to borrow funds, usually at
point of sale. Credit cards charge interest and are primarily used for short-term financing. Interest usually
begins one month after a purchase is made and borrowing limits are pre-set according to the individual's
credit rating.
History of Credit Cards
Many people think of credit cards as a modern day convenience, but the history of the earliest credit cards actually
dates back to the early 1900s. Today, major companies like Discover, Visa, MasterCard, and American
Express are a common sight. The concept of using credit to purchase goods and services, however, is something that
is not new. Millions of Indians currently hold some form of credit card debt. While credit cards can create more debt
for many households, they are also a convenient way to make purchases, and can serve people well in the event of
an emergency. A long time ago, people knew that the use of credit was a helpful tool for those who needed
something immediately, and the history of credit cards shows how far the industry has come.
Before major companies and banks issued actual credit cards, individual retailers, merchants, and other providers
would offer lines of credit to their customers. While the first credit card invented would not come along until the
1940s, this method of using credit is often attributed as the grandfather of credit cards. Originally, this was saved
for the oil producers in order to provide credit to shareholders and those interested in obtaining land to pursue oil,
or to retrieve and produce oil for consumption. Smaller grocers and department stores followed suit, and offered
lines of credit to customers who could prove somehow that the debt could be repaid. In most cases, collateral was
taken as a guarantee that the credit would be paid back.
The first credit card invented was dreamed up by a man named John Biggins, and was called the "Charge-It"
card. This card was created in 1946. Biggins was a banker living in Brooklyn, New York, and he came up with an
easier more direct system of credit. When a customer used the Charge-It card, a bill for that person's purchase was
also sent to his bank for review. Instead of the customer paying the merchant directly, the bank would pay them.
There were some terms even then back in the history of credit cards. For example, all purchases had to be made
locally and anyone with the Charge-It card had to be an actual customer of Biggin's bank. Regardless of these
terms, the whole process was a success.
Another early credit card was the Diners Club card, which was invented in 1949. The idea for this credit card
came about when a businessman by the name of Frank McNamara went out for an important dinner. While he
was out, he realized he had left his wallet at home and was unable to pay for the dinner. Somehow he managed to
be able to pay, but had the idea that there had to be other ways to pay for things other than cold, hard cash. Soon
he was working with his business partner and they developed the Diners Club Card, which was originally on a piece
of cardboard. Just two years later, over 20,000 people had a Diners Club Card. It was used mostly for eating and
entertainment and was known as a charge card, meaning that the balance had to be paid completely off each
month.
American Express had been in existence since the 1850s, but it was not until 1958 that the company introduced their
first credit card on a small piece of purple plastic. In all of the history of credit cards, AMEX was the first to use plastic
in their material instead of paper or cardboard. Soon, American Express had taken off and became the most widely
used credit card in the country, and could claim one million cardholders within the first five years of originating.
Today, banks and corporations across the globe issue credit cards to people, and they are perhaps the most
common form of payment in the world. Everything from airplane tickets to cosmetics and groceries can be
purchased with a credit card. The Internet has expanded the use of credit cards, making them the number one
preferred method of payment next to cash.
Types of Credit Cards
Credit cards have come to the rescue of people with hot pockets. They, nowadays, put their trust in the innovation
of credit cards where they need not carry large sums of money with them; instead simply carry a credit card which is
linked up with their bank account enabling them to make payments without batting an eye.
It is a trend, now, to make payments at a hotel, restaurant or a departmental store/ mall using a credit card.
Because of the fear of one's bank account details being swiped and stolen, more and more credit cards are made
secure so that even if a credit card is stolen, the money in one's bank account stays safe.
Today, credit cards come in multiple levels with ranging interest rates, fees and reward programs, so before you fill
out an application, it's important to know which will best suit your financial situation and lifestyle. The following is a
brief description of the most common types of credit cards available.
Standard credit cards :
This is the most commonly used. One is allowed to use money up to a certain limit. The account holder has to top up
the amount once the level of the balance goes down. An outstanding balance gets a penalty charge.
Premium Credit Card:
This has a much higher bank account and fees. Incentives are offered in this over and above that in a standard
card. Credit card holders are offered travel incentives, reward points, cask back and other rewards on the use of this
card. This is also called the Reward Credit Card. Some examples are: airlines‘ frequent flier credit card, cash back
credit card, automobile manufacturers' rewards credit card. Platinum and Gold, MasterCard and Visa card fall into
this category.
Secured Credit Card:
People without credit history or with tarnished credit can avail this card. A security deposit is required amounting to
the same as the credit limit. Revolving balance is required according to the 'buying and selling' done.
Limited Purpose Credit C ard:
There is limitation to its use and is to be used only for particular applications. This is used for establishing small
credits such as gas credits and credit at departmental stores. Minimal charges are levied.
Charge Credit Card:
This requires the card holder to make full payment of the balance every month and therefore there is no limit to
credit. Because of the spending flexibility, the card holder is expected to have a higher income level and high credit
score. Penalty is incurred if full payment of the balance is not done in time.
Specialty Credit Card:
This is used for business purposes enabling businessmen to keep their businesses transactions separately in a
convenient way. Charge cards and standard cards are available for this. Also, students enrolled in an accredited 4-
year college/university course can avail this benefit.
Prepaid Credit Card:
Here, money is loaded by the card holder on to the card. It is like a debit card except that it is not tied up with a
bank account.
The Parties to Credit Card Transaction
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and
services based on the holder's promise to pay for these goods and services. The issuer of the card creates a revolving
account and grants a line of credit to the consumer from which the user can borrow money for payment to a
merchant or as a cash advance to the user. The following are the principal players in credit card transactions:
 Cardholder: The holder of the card used to make a purchase; the consumer.
 Card-issuing bank: The financial institution or other organization that issued the credit card to the cardholder. This
bank bills the consumer for repayment and bears the risk that the card is used fraudulently. American Express and Discover
were previously the only card-issuing banks for their respective brands, but as of 2007, this is no longer the case. Cards
issued by banks to cardholders in a different country are known as offshore credit cards.
 Merchant: The individual or business accepting credit card payments for products or services sold to the cardholder.
 Acquiring bank: The financial institution accepting payment for the products or services on behalf of the merchant.
 Independent sales organization: Resellers (to merchants) of the services of the acquiring bank.
 Merchant account: This could refer to the acquiring bank or the independent sales organization, but in general is the
organization that the merchant deals with.
 Credit Card association: An association of card-issuing banks such as Discover, Visa, MasterCard, American Express, etc.
that set transaction terms for merchants, card-issuing banks, and acquiring banks.
 Transaction network: The system that implements the mechanics of the electronic transactions. May be operated by an
independent company, and one company may operate multiple networks.
 Affinity partner: Some institutions lend their names to an issuer to attract customers that have a strong relationship with
that institution, and get paid a fee or a percentage of the balance for each card issued using their name. Examples of
typical affinity partners are sports teams, universities, charities, professional organizations, and major retailers.
Settlement Process through Credit Card Netw orks

The use of a card involves an exchange of value between a consumer and a business. The card represents an offer
for payment in exchange for the merchant‘s goods or services. The sales draft itself is the cardholder‘s promise to
pay. When an acquirer accepts a draft from merchants, the bank is buying the value represented by the draft and
paying the merchant the face value of that sales draft. Collecting payment through the interchange systems is a
three-part process:
1. AUTHORISATION - AT TIME OF PURCH ASE OR PAYMENT:
Authorisation is the first step in processing a credit card. After a Cardholder enters their card details onto the
Merchant's website or Card Payment Gateway, the data is submitted to the Merchant's bank, called an Acquirer, to
request authorisation for the sale. The Acquirer then routes the request to the card-issuing bank, where it is
authorised or denied, and the Merchant is allowed to process the sale.
i. The Cardholder provides account details to the Merchant.

ii. Acquirer asks MasterCard/ Visa to determine the Issuer.

iii. MasterCard/ Visa checks card security features and sends to the Issuer for approval.
iv. Issuer approves purchase.
v. MasterCard/ Visa sends approval to the Acquirer.
vi. Acquirer sends approval the Merchant.
vii. Cardholder completes the purchase and receives confirmation of their order on screen and by email
receipt.
2. CLEARING - USUALLY WITHIN ONE DAY:
The second step in clearing, which is the process of transmitting, reconciling and, in some cases, confirming transfer
orders prior to settlement, potentially including the netting of orders and the establishment of final positions for
settlement.
i. Acquirer sends the purchase information to MasterCard/ Visa Card Network.

ii. The Card Network clearing system validates information and sends purchase information to the Issuer,
which prepares data for the Cardholder's statement.
iii. The Card Network clearing system provides reconciliation to both the Acquirer and Issuer.
3. SETTLEMENT - USUALLY WITHIN TWO DAYS:
The final stage is settlement, whereby the funds are transferred into the Merchant's account and the cardholder is
billed for the payment.
i. Issuer sends payment to the Card Network counter-party to settlement.

ii. The Card Network counter-party to settlement sends payment to the Acquirer.
iii. Acquirer pays the Merchant for the Cardholder's purchase
iv. Issuer bills the Cardholder.
Benefits of Credit Cards
Personal finance experts spend a lot of energy trying to prevent us from using credit cards - and with good reason.
Many of us abuse them and end up in debt. But, contrary to popular belief, if you can use a credit card responsibly,
you're actually much better off paying with credit than with debit. The following benefits acquire to customer form
the usage of credit cards:
 Signup Bonuses: The standard debit card offers zero rewards or very small rewards. Many credit cards,
however, offer significant rewards when used responsibly. For example, applicants with good credit can get
approved for credit cards that offer signup bonuses worth anywhere from $50 to $250 (and sometimes even
more). Other cards offer up a large number of points that can be redeemed for rewards like gift cards or air
travel.
 Cash Back: If you sign up for the right credit card, you can earn anywhere from 1-5% back on your purchases.

 Investment Rewards: Some cards, like the Fidelity Investment Rewards card, offer a higher rate of cash back;
in exchange you must deposit your cash back directly into an investment account.
 Frequent-Flyer Miles: It seems like every airline these days has at least one credit card available.
Cardholders rack up miles at a rate of one mile per dollar spent, or sometimes one mile per two dollars spent.
The price of the plane ticket you ultimately end up redeeming your miles for will determine how valuable this
credit card reward is, but many frequent flyer cards are made immensely more valuable by their mileage
signup bonuses - these are often enough to put you 50-100% of the way toward a free flight within a month or
two.
 Points: Many card rewards work on a point system where you earn up to five points per dollar spent. When
you reach a certain point threshold, you can redeem your points for gift cards at some stores. You can also use
the gift cards as gifts, making holiday and birthday shopping simpler and less expensive.
 Safety: Paying with a credit card makes it easier to avoid losses from fraud. When your debit card is used
fraudulently, the money is missing from your account instantly. Legitimate payments for which you've
scheduled online payments or mailed checks may bounce, triggering insufficient funds fees and making your
creditors unhappy. Late payments can also lower your credit score. It can take a while for the fraudulent
transactions to be reversed and the money restored to your account while the bank investigates.
 Grace Period: When you make a debit card purchase, your money is gone instantly. When you make a credit
card purchase, your money remains in your checking account until a couple of weeks later when you pay your
credit card bill. Hanging on to your money for this extra time can be helpful in two ways. First, if you pay your
credit card from a high-interest checking account and earn interest on your money during the grace period, the
extra interest will eventually add up to a meaningful amount. Second, when you always pay with a credit card,
you don't have to watch your bank account balance like crazy to make sure you stay in the black.
 Insurance: Most credit cards automatically come with a plethora of consumer protections that people don't
even realize they have, such as rental car insurance, travel insurance and product warranties that may exceed
the manufacturer's warranty.
 Universal Acceptance: Certain purchases are difficult to make with a debit card. When you want to rent a
car or stay in a hotel room, you'll almost certainly have an easier time if you have a credit card. Rental car
companies and hotels want customers to pay with credit cards because it can be easier to charge customers for
any damage they cause to a room or a car this way. So if you want to pay for one of these items with a debit
card, the company may insist on putting a hold of several hundred dollars on your account. Also, when you're
traveling in a foreign country, merchants won't always accept your debit card as payment, even when it has a
major bank logo on it.
 Building Credit: If you have no credit or are trying to improve your credit score, using a credit card
responsibly will help your credit score because credit card companies will report your payment activity to the
credit bureaus. Debit card use doesn't appear anywhere on your credit report, however, so it can't help you
build or improve your credit.
D EBIT C ARDS
Debit cards offer the convenience of a credit but work in a different way. Debit cards draw money directly from
your checking account when you make the purchase. They do this by placing a hold on the amount of the
purchase. Then the merchant sends in the transaction to their bank and it is transferred to the merchants account. It
can take a few days for this to happen, and the hold may drop off before the transaction goes through.
Debit Card is an electronic card issued by a bank which allows bank clients access to their account to
withdraw cash or pay for goods and services.
This removes the need for bank clients to go to the bank to remove cash from their account as they can now just go
to an ATM or pay electronically at merchant locations. This type of card, as a form of payment, also removes the
need for checks as the debit card immediately transfers money from the client's account to the business account.
Settlement Process through Debit Card Networks
When someone swipes a debit card through a merchant's terminal, the terminal reads the magnetic strip on the
back of the card and transmits the data to a card-processing network.

1. The cardholder pays merchant for purchase and the merchant runs the card through the terminal.
2. The terminal submits the transaction through merchant account to the acquiring bank.
3. The transaction flows through the corresponding card brand to cardholder‘s issuing bank.
4. The issuing bank verifies the card number, the transaction type, and the amount. It then reserves that amount
of the cardholder‘s credit limit for the merchant.
5. An authorization will then generate an approval code. This code is then passed back through the system and
stored within the transaction file inside the terminal.
Benefits of Debit Card
Consumers are increasingly using their debit cards for everyday purchases instead of cash and checks, because
they‘re convenient, easy to use, can be an effective budgeting tool, and provide benefits that cash and checks don‘t
offer. Following are the benefits of debit cards:
 Prepaid card: Debit card acts as a type of prepaid card. It is so, since it already has a sufficient amount of cash
balance in its holder‘s bank account. It permits to carry on the value of the transaction (i.e. purchases) to the
extent of available balance in its holder‘s bank account.
 Nominal fee: Bank issuing a debit card charges an annual fee for the issuance and maintenance of card. This
fee charged is very nominal in nature. Generally, bank charges the fee on a per annum or yearly basis. Such a
fee gets automatically debited (deducted) from the debit-cardholder‘s bank account.
 Alternative to cash: Debit card acts as an alternative mode of payment for executing various cash-related
financial transactions. It can be used for the purchases of goods and receipt of services. In its presence, there is no
need to carry a large amount of cash. Thus, it helps to avoid carrying huge amount of cash while traveling and
minimize risk of loss due to theft, damage, etc.
 Immediate transfer of funds: Debit card ensures immediate transfer of funds in the merchant‘s or dealer‘s
bank account. Such a transfer of funds takes place almost instantly at the moment of purchases of goods and
receipts of services. With its use, there is no need to visit bank‘s office premise and do a manual transfer of cash
in the merchant‘s or dealer‘s bank account.
 Instant withdrawal of cash: The debit card facilitates instant withdrawal of cash from any nearest ATM. This
helps its holder to avoid a personal visit to bank‘s office premise and wait in a long time-consuming queue. In
short, it also acts as an ATM card to meet its holder‘s cash-related needs, anytime and anywhere.
 Easy to manage: Debit card is very easy to carry, handle and manage while traveling to outstations or
overseas. Being small, thin, flat and having a negligible weight it easily fits in any pocket. It can be handled very
freely even with just two fingers. Managing it is also not a big problem. A cardholder must just take enough
care to see to it that:
 Debit card is always covered with a thick plastic cover to avoid scratching of its sensitive surface.
 It doesn‘t come in contact with contaminated water and heat.
 It doesn‘t get folded accidentally; this helps to prevent its breakage.
 It is placed safely in a convenient location which one remembers. This helps to avoid it getting misplaced
and lost due to negligence.
 Earns bonus points: Now-a-days, the competition among debit card providers (banks) is challenging. Today,
most banks offer bonus points to encourage their cardholders (customers) to make purchases using their debit
cards. Banks are able to offer such points to their cardholders as its merchants and not them who actually run
the reward program.
After every successful sale, a merchant gives the bank a small cut-off or percentage as a commission. This
commission is further shared or divided by the bank with its holder (as a reward) who did the original purchase.
Thus, in return, it finally also helps the cardholder earn bonus points on selected financial transactions executed by
him or her via a debit card.
In this cycle, all, viz., bank, merchant, and cardholder are directly benefited. Bank offers an incentive like this to
improve the sale of the products in the ordinary course of business and contribute in the economic growth.
 Gifts on redeeming points: As we have seen above, debit card helps to accumulate bonus points through a
reward program. These points can be redeemed by the cardholder (within card‘s expiration date) at any
merchant website and/or outlet that bank has already authorised. While redeeming accrued points, cardholder
gets an idea of its worthiness in terms of amount, and so he/she proceeds to claim gifts nearly equal to that
amount.
 Cash back: In a cash back, cardholder gets a percentage of the total amount spent on purchases made using
his card. In other words, when a holder use his debit card to buy something then a percentage of entire money
he spent usually in a month is credited-back to his account once every following month.
Consider for an example, a debit-cardholder spends 100 dollars three times a month on
shopping and the cash-back offer on shopping is 10 percent. In such a case, cardholder will get
back $30, which is 10% of $300 ($100 × 3) returned to his account in the coming month.
However, to avail this offer some minimal amount must be spent on some minimum number of transactions at
least once a month in a specific currency by eligible cardholders only.
For an instance, a cash back debit card provider may say in his terms as,
―To get 10% cash back you must do a minimum of three transactions in any calendar month. A minimum of $100
must be spent per transaction. All legit spending must be in US $.‖
 Free insurance coverage: Debit-cardholders also gets free insurance coverage. The bankers provide such
insurance facilities to attract new customers and to maintain their current customer strength. They provide
various types of insurances for free to their cardholders:
 Insurance on loss of debit card,
 Purchase insurance,
 Personal insurance,
 Accidental insurance,
 Travel insurance, and so on.
However, these types of insurances are given freely to cardholders depending on which type of debit card they have
possessed. The cost of insurance premium is borne by the bankers who provide debit cards to their customers.
 Miscellaneous advantages: Miscellaneous advantages of debit card are as follows:
 Debit card acts as an alternative to a traditional cheque payment.
 It helps to budget one‘s expenses and do a responsible spending of own money within account limits.
 Its holder uses his own money and not any borrowed (loaned) money. Unlike a credit card, here, no
interest is charged. Hence, its transactions are interest free.
 It is accepted internationally, by e-commerce websites, and almost everywhere by merchants who
display the logo of payment processing companies like VISA, Master Card, American Express, etc. This
ensures making successful payments anywhere in the world with ease.
 It offers optimum levels of security. This greatly minimizes the chances of fraud, misuse and theft of
money.
 Overall, it enhances the banking experience of a cardholder
E LECTRONIC M ONEY (E-M ONEY )

Electronic money (also known as e-currency, e-money, electronic cash, electronic currency, digital money, digital
cash, digital currency, cyber currency) refers to money or scrip which is only exchanged electronically. Typically, this
involves the use of computer networks, the internet and digital stored value systems. Electronic Funds Transfer (EFT)
and direct deposit are all examples of electronic money. Also, it is a collective term for financial cryptography and
technologies enabling it.
Electronic money is money which exists only in banking computer systems and is not held in any physical
form. The need for physical currency has declined as more and more citizens use electronic alternatives to
physical currency.

Electronic money is recently developed phenomenon, and its technical, legal, economic and cultural components
are not completely developed yet. In both aspects a great number of attempts are being developed and tested in
different stages, in different legislations.
Types of Electronic Money
An electronic payment is any kind of non-cash payment that doesn't involve a paper check. Methods of electronic
payments include credit cards, debit cards and the ACH (Automated Clearing House) network. The ACH system
comprises direct deposit, direct debit and electronic checks (e-checks). For all these methods of electronic payment,
there are three main types of transactions:
1. A one-time customer -to-vendor payment is commonly used when you shop online at an e-
commerce site, such as Amazon. You click on the shopping cart icon, type in your credit card information and
click on the checkout button. The site processes your credit card information and sends you an e-mail notifying
you that your payment was received. On some Web sites, you can use an e-check instead of a credit card. To
pay by e-check, you type in your account number and your bank's routing number. The vendor authorizes
payment through the customer's bank, which then either initiates an electronic funds transfer (EFT) or prints a
check and mails it to the vendor.
2. You make a recurring customer -to-vendor payment when you pay a bill through a
regularly scheduled direct debit from your checking account or an automatic charge to your credit card. This
type of payment plan is commonly offered by car insurance companies, phone companies and loan
management companies. Some long-term contracts (like those at gyms or fitness centres) require this type of
automated payment schedule.
3. To use automatic ba nk -to-vendor payment , your bank must offer a service called online bill
pay. You log on to your bank's Web site, enter the vendor's information and authorize your bank to
electronically transfer money from your account to pay your bill. In most cases, you can choose whether to do
this manually for each billing cycle or have your bills automatically paid on the same day each month.
F ORECASTING OF CASH D EMAND AT ATM S

All retail banks including leaders such as ICICI, HDFC, UTI, and SBI are competing for a larger share of the
customers‘ financial transactions. Their efforts are directed to attract and retain customers by offering them a
basket of tailor made schemes supported by a state of the art distribution system (the ATMs). The whole exercise is
helping banks to serve their customers fast and avoid human intervention totally. And for the customers, ATMs offer
hassle-free cash withdrawal. No more fighting with the bank's teller for change and fresh notes. The total cash
movement through ATMs in India is already between Millions of Rupees (local currency) every year. In future, things
are going to be even more different and challenging. The ATM has become a medium for non-cash transactions
such as payment of bills, insurance payments, printing of statements or even accessing the Internet.
The product in this chain is cash. The objective of this paper is primarily to study the information flow and the fund
flow in the supply chain of the retail banks in the country. The supply chain in retail banks needs to be more
responsive to the needs of the customers in comparison to the traditional FMCG industry. All the intermediaries in
the supply chain play an important role in making the supply chain more efficient. The various aspects involved are
the logistics involved in ATM operations, role of forecasting in retail outlets and ATMs and the parameters that are
taken into consideration, scope of network sharing, issue of having the right mix of currency denomination to be
able to satisfy the demand. The chronic problem faced in such a scenario is cash stock outs and banks are
increasingly trying to synergize their supply chain with that of the external agents (ATM vendors, outsourcing
agents, and VISA network) involved in this process.
The players in a retail bank‘s supply chain are the RBI, Corporate Branch of the Bank in the city, the Retail
Branches, the Delivery Channel Coordinators, Outsourced agents who take care of physical cash movement, ATMs
and ATM vendors.
The key elements in the supply chain are Cash flow, Information flow and IT infrastructure, Lead time of cash
replenishment, Payments and Receipts, different denominations of currencies, Geographical locations and Status of
accounts (corporate accounts, salary accounts etc).

In case of financial services and banks, it is presumed that the demand drivers for cash are those factors, which
increases the propensity of cash withdrawal (retail as well as ATMs) and cash deposits. Certain demand drivers
having substantial effect on the final level of demand are the following:
 Location of the branch / ATM.
 Number of current accounts.
 Resident accounts and their age profile (for example, some banks have a captive audience of pension holders) etc.
 Number of salary accounts.
 Seasonal factors including weekends, festivities etc.
S ECURITY THREATS IN E - BANKING A ND RBI’ S INITIAT IVES

A financial institution‘s board and management should understand the risks associated with E-banking services and
evaluate the resulting risk management costs against the potential return on investment prior to offering E-
banking services. Poor E-banking planning and investment decisions can increase a financial institution‘s strategic
risk.
Security is one of the most discussed issues around E-banking. E-banking increases security risks, potentially exposing
hitherto isolated systems to open and risky environments. Security breaches essentially fall into three categories;
breaches with serious criminal intent (fraud, theft of commercially sensitive or financial information), breaches by
‗casual hackers‘ (defacement of web sites or ‗denial of service‘ - causing web sites to crash), and flaws in systems
design and/or set up leading to security breaches (genuine users seeing / being able to transact on other users‘
accounts). All of these threats have potentially serious financial, legal and reputational implications.
The most prevalent types of Internet frauds are discussed as below:
Identity Theft
This has become a major problem with people using the Internet for cash transactions and banking services. In this
cyber-crime, a criminal accesses data about a person‘s bank account, credit cards, Social Security, debit card and
other sensitive information to siphon money or to buy things online in the victim‘s name. It can result in major
financial losses for the victim and even spoil the victim‘s credit history.
For identity theft, fraudsters make use of the personal data they have accessed via phishing, malware or another
type of social engineering.
Fraudsters can get our information in a variety of ways, and not just via the internet or our computer: they can also
request a replacement authentication code from our bank because ―we lost the old one‖. The bank sends this to our
home address, where the fraudster steals this from our mailbox. This can be especially dangerous in apartment
buildings because all the mailboxes hang next to one another and the lock is more easily broken.
Some information is more easily gained by fraudsters via social networks. This is why we should always be careful
with what our post on these sites.
Carding/ Skimming
‗Card skimming‘ is the illegal copying of information from the magnetic strip of a credit or ATM card. It is a more
direct version of a phishing scam.
The scammers try to steal your details so they can access your accounts. Once scammers have skimmed your card,
they can create a fake or ‗cloned‘ card with your details on it. The scammer is then able to run up charges on your
account.
Card skimming is also a way for scammers to steal your identity (your personal details) and use it to commit
identity fraud. By stealing your personal details and account numbers the scammer may be able to borrow money
or take out loans in your name.
Phishing
Very high is the number of phishing attacks against financial institutions, especially banks. What cyber criminals are
after are, of course, all types of sensitive information such as account credentials, transfer history etc.
A classic phishing attack consists in tricking the user into divulging personal banking data through fake emails.
Attackers direct the recipient to a replicated website looking like the real bank site and encourage them to ―login‖
or submit their information via ad hoc forms.
In a typical phishing scheme, spoofed emails lead users to visit infected websites designed to appear as legitimate
ones. The websites are designed to coax customers to divulge financial data, such as account credentials, social
security numbers and credit card numbers.

In the classic attack scheme, fraudsters send e-mails or advertisements to the victims with content that looks like
they were sent by a bank or by a credit card company. The emails request victims to click on a link to go to a
website that replicates a bank‘s website.
The malicious email could contain a link to the fake website or could include an attachment that once opened,
involves exactly the same task. Phishing attacks use social engineering techniques mixed with technical tricks to fool
the user and steal sensitive information and banking account credentials. Phishing messages usually take the form
of fake notifications from banks, providers, e-payment systems and other organizations. They request the user to
submit sensitive information such as passwords, credit card numbers and bank account details
In literature, there are several variants of phishing, many of them involve the use of malware specifically designed
to steal credentials from victims while hiding evidence of an attack.
 Email Phishing: Phishing email will direct the user to visit a website where they are asked to update
personal information, such as a password, credit card, social security, or bank account numbers, that the
legitimate organization already has.
 Pharming: Experts say it‘s one of the most difficult and advanced cyber-crime techniques, but still
possible via:
 DNS Cache Poisoning
 Hosts File Modification
Pharming is a scamming practice in which malicious code is installed on a personal computer or server,
misdirecting users to fraudulent Web sites without their knowledge or consent. Pharming has been called
"phishing without a lure."
In phishing, the perpetrator sends out legitimate-looking e-mails, appearing to come from some of the
Web's most popular sites, in an effort to obtain personal and financial information from individual
recipients. But in pharming, larger numbers of computer users can be victimized because it is not necessary
to target individuals one by one and no conscious action is required on the part of the victim. In one form of
pharming attack, code sent in an e-mail modifies local host files on a personal computer. The host files
convert URLs into the number strings that the computer uses to access Web sites. A computer with a
compromised host file will go to the fake Web site even if a user types in the correct Internet address or
clicks on an affected bookmark entry. Some spyware removal programs can correct the corruption, but it
frequently recurs unless the user changes browsing habits.
A particularly ominous pharming tactic is known as domain name system poisoning (DNS poisoning), in which
the domain name system table in a server is modified so that someone who thinks they are accessing legitimate
Web sites is actually directed toward fraudulent ones. In this method of pharming, individual personal computer
host files need not be corrupted. Instead, the problem occurs in the DNS server, which handles thousands or
millions of Internet users' requests for URLs. Victims end up at the bogus site without any visible indicator of a
discrepancy. Spyware removal programs cannot deal with this type of pharming because nothing need be
technically wrong with the end users' computers.
 Spear Phishing: Spear phishing is an email that appears to be from an individual or business that
you know. But it isn't. It's from the same criminal hackers who want your credit card and bank account
numbers, passwords, and the financial information on your PC.
 Phlash Phishing: This uses macromedia flash to build an entire website. The uses of flash is
intended to make it more difficult to determine whether or not the page is malicious, and could bypass
anti-phishing toolbars.
 Vishing: Vishing is the act of using the telephone in an attempt to scam the user into surrendering
private information that will be used for identity theft. The scammer usually pretends to be a legitimate
business, and fools the victim into thinking he or she will profit.
 Man in the Middle Attack: A man in the middle attack is one in which the attacker intercepts
messages in a public key exchange and then retransmits them, substituting his own public key for the
requested one, so that the two original parties still appear to be communicating with each other.
Man in the middle attacks are sometimes known as fire brigade attacks. The term derives from the bucket
brigade method of putting out a fire by handing buckets of water from one person to another between a
water source and the fire.
 Man in the Brows er Attack: A man in the browser attack is similar to the man in the middle
tactic, in which an attacker intercepts messages in a public key exchange. The attacker then retransmits
them, substituting bogus public keys for the requested ones. A man in the browser attack is more difficult to
prevent and disinfect, however, because instead of occurring in a public exchange, the activity takes place
between the user and the security mechanisms within that user's browser.
Money Mule
Money mules are people who serve as intermediaries for criminals and criminal organisations. Whether or not they
are aware of it, they transport fraudulently gained money to fraudsters. The use of intermediaries makes it difficult
to figure out the identity of the fraudster.
Money mules, just like fraudsters, are guilty of illegally transporting fraudulently gained money and can be
prosecuted for this.
Watering Hole
Watering hole cyber-crime is an evolution of phishing. Instead of trying to convince users to visit a certain website,
this technique involves injecting malicious code onto specific web pages, and waiting for visitors to be ―infected‖.
Exploit kits to compromise websites are available in the black market.
―Targeting a specific website is much more difficult than merely locating websites that contain a vulnerability. The
attacker has to research and probe for a weakness on the chosen website. Indeed, in watering hole attacks, the
attackers may compromise. Once compromised, the attackers periodically connect to the website to ensure that
they still have access‖

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Banking Financial Services Management

Ms. Jebakerupa Roslin Amirtharajan St. Joseph‘s College of Engineering MBA

T HE I NDIA N B ANKING S Y STEM

Figure 1 Banking Structure of India

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Public sector banks:

Private sector banks:

Foreign Sector Banks:

Regional Rural Bank (RRB):

Primary Functions of Banks:

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Secondary Functions of Banks:

General Utility Functions:

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R ESERVE B A NK OF I NDIA A CT , 1934

Figure 2 Structure of RBI

CENTRAL BOARD OF DIRECTORS

The following are the Executive Directors appointed in RBI:

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Markets Regulation and Research Services Support

Figure 3 RBI Departments

Primary Authority of the Central Board

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of RBI Banker to other Banks

Development of the Financial System

Control over NBFIs

Implementation of the Deposit Insurance Scheme

Figure 4 Functions of RBI

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Developmental / Promotional Functions Of RBI

Supervisory Functions of RBI

RBI TOOLS FOR DEVELOPING FINANCIAL SCHEME

Meaning and Definition of Negotiable Instruments

Characteristics of a Negotiable Instrument

St. Joseph’s College of Engineering 12

PARTIES TO A PROMISSORY NOTE

PARTIES TO ‘BILL OF EXCHANGE’

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WHO MAY ENDORSE?

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Privileges of a Holder in Due Course

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T HE B ANKING R EGULATION A CT , 1949

B Provisions Relating to Certain Operations of Banking Companies. (Sections 45Y to 45ZF).

Part IV Miscellaneous (Sections 46 to 55A)

R IGHTS AND O BLIGATIONS OF A B ANKER

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Cases in which lien cannot exercise:

Exception to the Right of lien:

B ANKS ’ F INA NC IAL S TATEMENT

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Pillar 1- Minimum Capital Requirements

Capital charge for Credit Risk

Capital Charge of market risk

CAPITAL CHARGE FOR OPERATIONAL RI SK

Pillar 2-Supervisory review

D EPOSIT AND NO N - DEPOSIT SOURCES

The Non-deposit sources are as follows,

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