Commercial Banking System and Role of RBI

1. Mr. Arora is a Deputy Manager in a reputed commercial bank. Swaraj have recently been
appointed as an intern in the bank. As a part of his assignment, Swaraj need to learn the basic
dynamics in the banks that are required for appraising proposal for the term loans. Discuss.

Answer:

Since Swaraj joined the Bank as an intern in the Bank therefore he need to learn each and every
job assigned to him by the management. In his first assignment, Swaraj need to learn to prepare
the proposal for the term loan.

Swaraj need to understand that assessment of earning potentials and generation of cash surpluses
is very crucial in the appraisal of term loans. The unit should make enough surplus earnings after
meeting all the expenses, taxes and other necessary provisions and the same should be adequate
for servicing the loan and interest thereon within a reasonable period of time. The appraisal of
term loan broadly involves an analytical assessment of the following:

• A- Purpose, cost of project and execution.

• B - Future trends of production and sales,

• C- Estimates of costs, expenses, earning and profitability

• D -Cash flow statements during the period of the loan.

While appraising proposal for term loan, Swaraj should understand appended four fundamentals
carefully.

• 1- Technical feasibility of the project.ss

• 2- Economic viability of the project.

• 3- Financial viability of the project.

• 4- Managerial competence.

1. Technical Feasibility: Swaraj need to do the technical feasibility analysis, which is an

attempt to determine how well the technical requirements of the project can be met. This
comprises consideration of availability of infrastructural facilities, raw materials, skilled
and semiskilled labour and other utilities on the one hand, and the technology required for
the manufacturing process. Technical assessment should cover as to whether the product
mix of specified quantity and quality as projected can be manufactured and whether the
projections are achievable. The technical assessment should be made with a check on
 productivity on which depends the profitability of the unit. If deemed necessary, Swaraj
should take the help of bank’s technical officers.

2. Economic Viability: Economic viability has a bearing on the earning capacity of the project
and earnings which is directly dependent on sales. Therefore, Swaraj should access the
borrower’s projection of sales. Following points need to be considered :

a) Demand and supply position of the product and its substitutes.

b) Proposed selling price.

c) Quality of the product.

3. Financial Viability: Swaraj need to ascertain the financial viability :

• Swaraj need to see whether cost of project and means of finance as envisaged in the
project report are realistic.

• Swaraj need to see whether project is capable of profitable operations.

• Swaraj need to see whether project is capable of generating adequate surpluses for
servicing the debt and interest and can take care of future organisational development.

• He need to see whether estimates of cost of production fully cover all items of
expenditure.

• Swaraj need to see whether sources of finance are adequate.

• Swaraj need to see whether there is a reasonable basis for competitive profitable
operations.

4. Managerial Competence

• Swaraj need to check whether the performance of an industrial concern, under

competition, measures the quality of its management.

• It should be ascertained that the promoters have the desired background, experience, and
knowledge to successfully implement the project.
The data relevant for study of above aspects should be collected from the borrower by Swaraj
and analyse with the help of his senior. The data comprises the following:

1-Cost of project and means of financing.

2-Profitability projections covering revenue, cost of production/ expenditure etc.

3-Cash-flow estimates (sources and uses of funds.

4-Projected Balance Sheets (assets and liabilities)

While considering the cost of the project, the working capital requirements and means of
financing, it is necessary to know the stages of the project and ascertain the arrangements for
raising funds from time to time. Further, if all the money is not required at one time, a suitable
time schedule for disbursement of the loan amount should be drawn in consultation with the
borrower.

While examining the cost of production and profitability, the breakeven point of the project
should be worked out. This will indicate the minimum level of output as percentage of full
capacity at which losses cease & the project starts yielding profits.

Break-even point can be calculated as under:

Break-even point = Total Fixed Cost × Sales / (Sales) − (Variable Costs)

The cash flow statements giving sources and uses of funds over a period of years should be
studied by Swaraj to fix the repayment schedule according to the cash accruals for the purpose,
after providing sufficient margin of safety.

On the basis of the financial statements submitted by the borrowing concern, Swaraj & Mr. Arora
should satisfy themselves about the overall financial position of the concern.

Thus, Based upon the above points, Swaraj could be able to prepare the proposal of term loan
successfully.
2. Financial intermediaries play a vital role in the Indian financial system. Discuss any five
financial intermediaries in the financial system that helps in economic development of the
country.

Answer:

The economic growth of our country is dependent on the saving that is generated in the
economy, which gets converted to fruitful production process. This becomes an important point
in the measurement of the growth of the economy. This above method is known as the capital
formation where, it goes through three distinct stages, i.e., Saving, Finance and Investment.
Funds flow from the surplus saving to the deficit areas of the economy.

In order to enable capital formation, there is a requirement of intermediation or a system, which

will create and channelize saving, leading to capital formation. The system, which does this
function in the economy, is called the financial system.

The major financial intermediaries in the financial system are as below:

1. Commercial Banks: These are the institutions which receive money from the individuals in
form of deposit on low interest rates and lend it to the the individual and business houses for the
requirement of short-term and long-term business requirement, especially, for the purpose of
working capital. Banks collect the funds from the liability products such as saving bank account,
current account and fixed deposits. Generally, the banks borrow at a lower rate and lend at a
higher rate. They make a profit out of the difference of the rate of interest. This is known as
fund-based banking. However, now a days banks also carry out a large number of activities for
which they charge fees and make a substantial earnings.The commercial banks in India,
therefore, act as an instrument of carrying out the major funding activities of the government for
socio-economic development of the country.

Example: SBI , PNB, BOB, ICICI Bank, HDFC Bank & Axis Bank are the few examples of
commercial banks in India which deal with the general public and receive money from
individuals in form of deposit and lend them at higher rate of interest.

2. Non-Banking Financial Companies: The non-banking financial companies or NBFCs are

either fund based or into advisory business in the financial system which, like banks, take deposit
and lend money as loan, but in special ways.
Example: Some of the common NBFCs are Housing Finance Company (HFC), Equipment
Leasing Company (ELC), Loan Company (LC), Mutual Benefit Companies or Nidhis, and
Credit Rating Agencies.

3. Mutual Funds: These are the organizations which take money in small amount and invest it
in the financial market. The investors buy small units as investment and can sell these units
back . A mutual fund is set up as a trust, which has a sponsor, a trustee, an Asset Management
Company (AMC) and a custodian. Mutual funds are monitored by SEBI and through a self-
regulatory organization called Association of Mutual Fund India (AMFI). Mutual fund….Sahi
hai…….

4. Insurance Companies: Insurance is the business which covers the risk of the investors that
includes life risk and general risk. For covering the risk, the insurance companies take funds
from the individual who are covered for the risk as premium and invest in the market. In the
eventuality of the risk arising on the policyholder, the agreed upon amount for covering the risk
is paid to the policyholder. Insurance is a business in utmost good faith; hence, while the
insurance is taken, the declaration of the policyholder is taken as true. However, when the
payment is made, the risk is assessed by the company.

Example: Life Insurance Corporation of India (LIC) is the largest public sector life insurance
company in India which from its creation commanded a monopoly of soliciting and selling life
insurance in India and has created huge surpluses. Max Life Insurance Co., ICICI Prudential,
HDFC Standard life are some other life insurance company operating in Indian market. ICICI
Lombard, TATA AIG, Bajaj , Oriental Insurance, National Insurance co. are some general
insurance companies operating in Indian market.

5. Regulators: These are ornanisations which regulate the financial intermediation so that the
chances of financial fraud can be reduced. They act as protection for the investors and help in the
proper growth of the invested money. Now a days, Regulators are very active and taking
corrective action for minimising the risk for the investor.

Example: SEBI, IRDA and RBI are the regulator in the Indian financial system.

Therefore we can say that above mentioned are the main intermediaries operating in the Indian
Financial System.
3. Mr Ghanshyam has been newly appointed manager in a newly established private bank. As a
manager discuss on the following:

a. Highlight the different types of risks involved in banking business.

Answer:

Types of risks involved in banking business:

Ghanshyam need to know about the different types of risks involved in the Indian Banking
system. Few of them are appended below.

1. Interest Rate Risk: Interest rate risk is simply the risk to which a Bank is exposed because
future interest rates are uncertain. The assets and liabilities of a financial institution have
different maturity and liquidity. Financial institutions create assets and at the same time create
liabilities. These loans are invested by the financial institutions at a certain rate of interest and
similarly interest cost has to be paid to the lenders of deposit. The mismatches of interest rates of
the assets and liabilities expose to interest rate risk which would be very risky for the Bank.

2. Liquidity Risk: Liquidity risk refers to the bank’s ability to meet its cash requirement of the
depositors and borrowers. Gap analysis is the most important technique used to manage liquidity
risk. Under this method Assets and Liability are arranged according to their maturity within a
predetermined period. The gap is the difference between the maturity assets to the maturity
liabilities.

3. Foreign Exchange Rate Risk: Bank conduct business across borders, they may deal in foreign
currencies. Different countries have different currencies and different currencies have different
values. The rate of conversion i.e. the rate at which the exchange between two currencies take
place is known as exchange rate. Foreign exchange risk arises out of the fluctuation in value of
assets, liabilities, income or expenditure when unanticipated changes in exchange rates occur.

4. Credit Risk: Credit risk arises when a financial institution or Bank cannot get back the money
from loan. The main reason for credit risk for bank or financial institution is bad loans or NPAs.
To reduce the chance of defaults, banks or financial institution should do following:

a-Raise their credit standards

b-Monitor and collect information about borrowers on regular basis.

c-Guarantees and collaterals.

d-Standardised loans.

e-Setting up internal credit monitoring process, appraisal system and loan review mechanism

5. Market Risk: It refers to variability in return on investment due to market factors that affect all
investments in a similar fashion. Such factors are appended below:

a-Change the interest rate policy by government

b-Rising inflation

c-Political development, Wars, Earthquakes

d-RBI’s Change in credit policy

e-Govt. tax withdrawal of tax exemption on dividend payment by companies.

6. Operational Risk: Operational risk is the most important risk for the Banks or financial
institutions. Operational risk may result from inadequate or failed internal processes, people and
systems or from external events.

7. Solvency Risk: Solvency risk is a part of financial risk which reflects the inability of the firm
to repay its long term debts. Solvency means having enough assets in your business to cover all
the liabilities. When the value of assets is not sufficient to meet its long term obligations, this is
called solvency risk.

Above are few most important risks involved in the Banking system in India which Mr.
Ghanshyam who recently joined a private sector bank, should know for smooth and safe custody
of the invested amount in the organisation.
b. Enumerate the steps in a risk management process.

Answer:

Steps in the Risk Management Process:

Mr. Ghanshyam should know about the steps of the risk management process which are as
follows.

1. Identification: The first step in the process of managing risk is to identify potential risks.
Risks are about events that cause problems. Hence, risk identification can start with the source of
problems, or with the problem itself.

2. Assessment of Risk: Once risks have been identified, they must then be assessed as to their
potential severity of loss and to the probability of occurrence. These quantities can be either
simple to measure, in the case of the value of a lost building, or impossible to know for sure in
the case of the probability of an unlikely event occurring.

3. Mitigation of Risks: Risk control/mitigation process enables the bank to take risk prudently,
keeping in mind risk/earnings aspects and bank’s capital resources.
 a) Risk prevention: Banks are to take all measures appropriate for stopping operational
risks, which includes written policies and procedures, strong internal control system,
and business contingency & continuity plan.

b) Policies and procedures: Banks are to put in place a well-defined and laid-down
policies and procedures for accomplishing various tasks in various banking activities.

c) The framework of formal written policies and procedures is reinforced through strong
internal control system of the individual banks. Regular banking activities are closely
monitored through internal control mechanism.

Thus we can say that Mr. Ghanshyam can easily manage the risk and their consequences if he
enumerate risk management process in letter and spirit.