Management of commercial bank overview

A commercial bank is a type of financial institution that provides services like accepting
deposits, making business loans, and offering basic investment products. The term
commercial bank can also refer to a bank, or a division of a large bank, which precisely
deals with deposits and loan services provided to corporations or large or middle-sized
enterprises as opposed to individual members of the public or small enterprises. For
example, Retail banking, or Merchant banks. A commercial bank can also be defined as a
financial institution that is licensed by law to accept money from different enterprises as well
as individuals and lend money to them. These banks are open to the mass and assist
individuals, institutions, and enterprises.

Basically, a commercial bank is the type of bank people tend to use regularly. They are
formulated by federal and state laws on the basis of the coordination and the services they
provide.

These banks are controlled by the Federal Reserve System. A commercial bank is licensed
to assist the following functions.

Accept deposits − Receiving money from individuals and enterprises known as depositors.

Dispense payments − Making payments according to the convenience of the depositors. For
example, honoring a check.

Collections − Bank plays as an agent to collect funds from another banks receivable to the
depositor. For example, when someone pays through check drawn on an account from a
different bank.

Invest funds − Contributing or spending money in securities for making more money. For
example, mutual funds.

Safeguard money − A bank is regarded as a safe place to store wealth including jewelry and
other assets.

Maintain savings − The money of the depositors is maintained, and the accounts are
checked and on a regular basis.

Maintain custodial accounts − These accounts are maintained under the supervision of one
person but are actually for the benefit of another person.

Lend money − Lending money to companies, depositors in case of some emergency.

Management of banking institutions.

There are many definitions of bank management. In general, bank management refers to the
process of managing the Bank’s statutory activity. Bank management is characterized by the
specific object of management - financial relations connected with banking activities and
other relations, also connected with implementation of management functions in banking.
The main objective of bank management is to build organic and optimal system of interaction
between the elements of banking mechanism with a view to profit.

Successful optimization of the "profitability-risk" ratio in a bank lending operations is largely

determined by the use of effective methods of bank management. Ability to take reasonable
risk is one of the elements of entrepreneurship culture in general and banking culture in
particular.

Reliability of the bank management is determined by the following characteristics:

● management expertise in strategic analysis, planning, policy development and

management functions;
● quality of planning;
● risk management (credit, interest rate and currency risks);
● liquidity management;
● management of human resources;
● creation of control systems: audit and internal audit , monitoring of profitability and
risks liquidity;
● unified information technology system: integrated automation of workflow,
accounting, current analysis and control, strategic planning.

All the above conditions show themselves during implementation of bank management and
its components.

Negotiable instruments

Negotiable Instruments are written contracts whose benefit could be passed on from its
original holder to a new holder. In other words, negotiable instruments are documents which
promise payment to the assignee (the person whom it is assigned to/given to) or a specified
person. These instruments are transferable signed documents which promises to pay the
bearer/holder the sum of money when demanded or at any time in the future.

As mentioned above, these instruments are transferable. The final holder takes the funds
and can use them as per his requirements. That means, once an instrument is transferred,
holder of such instrument obtains a full legal title to such instrument.

Types of Negotiable Instruments

Promissory notes
A promissory note refers to a written promise to its holder by an entity or an individual to pay
a certain sum of money by a pre-decided date. In other words, Promissory notes show the
amount which someone owes to you or you owe to someone together with the interest rate
and also the date of payment.

For example, A purchases from B INR 10,000 worth of goods. In case A is not able to pay
for the purchases in cash, or doesn’t want to do so, he could give B a promissory note. It is
A’s promise to pay B either on a specified date or on demand.
In another possibility, A might have a promissory note which is issued by C. He could
endorse this note and give it to B and clear of his dues this way. However, the seller isn’t
bound to accept the promissory note. The reputation of a buyer is of great importance to a
seller in deciding whether to accept the promissory note or not

Bill of exchange

Bills of exchange refer to a legally binding, written document which instructs a party to pay a
predetermined sum of money to the second(another) party. Some of the bills might state that
money is due on a specified date in the future, or they might state that the payment is due on
demand.

A bill of exchange is used in transactions pertaining to goods as well as services. It is signed

by a party who owes money (called the payer) and given to a party entitled to receive money
(called the payee or seller), and thus, this could be used for fulfilling the contract for
payment. However, a seller could also endorse a bill of exchange and give it to someone
else, thus passing such payment to some other party.

It is to be noted that when the bill of exchange is issued by the financial institutions, it’s
usually referred to as a bank draft. And if it is issued by an individual, it is usually referred to
as a trade draft.

A bill of exchange primarily acts as a promissory note in the international trade; the exporter
or seller, in the transaction addresses a bill of exchange to an importer or buyer. A third
party, usually the banks, is a party to several bills of exchange acting as a guarantee for
these payments. It helps in reducing any risk which is part and parcel of any transaction.

Cheques

A cheque refers to an instrument in writing which contains an unconditional order, addressed

to a banker and is signed by a person who has deposited his money with the banker. This
order, requires the banker to pay a certain sum of money on demand only to to the bearer of
cheque (person holding the cheque) or to any other person who is specifically to be paid as
per instructions given.

Cheques could be a good way of paying different kinds of bills. Although the usage of
cheques is declining over the years due to online banking.

Individuals still use cheques for paying for loans, college fees, car EMIs, etc.
Cheques are also a good way of keeping track of all the transactions on paper.
On the other side, cheques are comparatively a slow method of payment and might take
some time to be processed.

The Negotiable Instruments (Amendment) Bill, 2017

The Negotiable Instruments (Amendment) Bill, 2017 has been introduced in the Lok Sabha
earlier this year on Jan 2nd, 2018. The bill seeks for amending the existing Act. The bill
defines the promissory note, bill of exchange, and cheques. The bill also specifies the
penalties for dishonor of cheques and various other violations related to negotiable
instruments.

As per a recent circular, up to INR 10,000 along with interest at the rate of 6%-9% would
have to be paid by an individual for cheques being dishonored. The Bill also inserts a
provision for allowing the court to order for an interim compensation to people whose
cheques have bounced due to a dishonouring party (individuals/entities at fault). Such
interim compensation won’t exceed 20 percent of the total cheque value.

Working capital management

Working capital management is essentially managing Current Assets. Management of

working capital arises as a part of the process of such management.
The concept of working capital can also be explained through two angles.
(a) Value : From the value point of view, Working Capital can be defined as Gross
Working Capital or Net Working Capital.
Gross working capital refers to the firm’s investment in current assets.
Net working capital refers to the difference between current assets and current
liabilities.
A positive working capital indicates the company’s ability to pay its short-term liabilities. On
the other hand a negative working capital shows inability of an entity
to meet its short-term liabilities.
(b) Time: From the point of view of time, working capital can be divided into two
categories viz., Permanent and Fluctuating (temporary).
Permanent working capital refers to the base working capital, which is the minimum level of
investment in the current assets that is carried by the entity at all times to
carry its day to day activities.
Temporary working capital refers to that part of total working capital, which is required by an
entity in addition to the permanent working capital. It is also called
variable working capital which is used to finance the short term working capital requirements
which arises due to fluctuation in sales volume.
SIGNIFICANCE OF WORKING CAPITAL
Importance of Adequate Working Capital
Management of working capital is an essential task of the finance manager. He has to
ensure that the amount of working capital available is neither too large nor too
small for its requirements. A large amount of working capital would mean that the company
has idle funds.
Since funds have a cost, the company has to pay huge amount as interest on such funds.
If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of
working capital may lead to a situation where the firm may not be able
to meet its liabilities.The various studies conducted by the Bureau of Public Enterprises have
shown that
one of the reasons for the poor performance of public sector undertakings in our country has
been the large amount of funds locked up in working capital. This
results in over capitalization. Over capitalization implies that a company has too large funds
for its requirements, resulting in a low rate of return, a situation which
implies a less than optimal use of resources. A firm, therefore, has to be very careful in
estimating its working capital requirements.
Maintaining adequate working capital is not just important in the short-term. Sufficient
liquidity must be maintained in order to ensure the survival of the business in the long-term
as well. When businesses make investment decisions they must not only consider the
financial outlay involved with acquiring the new machine or the new building, etc., but must
also take account of the additional
current assets that are usually required with any expansion of activity. For e.g.:-
● Increased production leads to holding of additional stocks of raw materials
and work-in-progress.
● An increased sale usually means that the level of debtors will increase.
● A general increase in the firm’s scale of operations tends to imply a need for
greater levels of working capital.
A question then arises what is an optimum amount of working capital for a firm? We can say
that a firm should neither have too high an amount of working capital
nor should the same be too low. It is the job of the finance manager to estimate the
requirements of working capital carefully and determine the optimum level of
investment in working capital.

Project financing

Project Financing is a long-term, zero or limited recourse financing solution that is available
to a borrower against the rights, assets, and interests related to the concerned project.

If you are planning to start an industrial, infrastructure, or public services project and need
funds for the same, Project Financing might be the answer that you are looking for.

The repayment of this loan can be done using the cash flow generated once the project is
complete instead of the balance sheets of the sponsors. In case the borrower fails to comply
with the terms of the loan, the lender is entitled to take control of the project. Additionally,
financial companies can earn better margins if a company avails this scheme while partially
shifting the associated project risks. Therefore, this type loan scheme is highly favoured by
sponsors, companies, and lenders alike.

In order to bridge the gap between sponsors and lenders, an intermediary is formed namely
Special Purpose Vehicle (SPV). The main role of the SPV is to supervise the fund
procurement and management to ensure that the project assets do not succumb to the
aftereffects of project failure. Before a lender decides to finance a project, it is also important
that all the risks that might affect the project are identified and allocated to avoid any future
complication.
Key Features of Project Financing
Since a project deals with huge amount funds, it is important that you learn about this
structured financial scheme. Below mentioned are the key features of Project Financing:

Capital Intensive Financing Scheme: Project Financing is ideal for ventures requiring huge
amount of equity and debt, and is usually implemented in developing countries as it leads to
economic growth of the country. Being more expensive than corporate loans, this financing
scheme drives costs higher while reducing liquidity. Additionally, the projects under this plan
commonly carry Emerging Market Risk and Political Risk. To insure the project against these
risks, the project also has to pay expensive premiums.
Risk Allocation: Under this financial plan, some of the risks associated with the project is
shifted towards the lender. Therefore, sponsors prefer to avail this financing scheme since it
helps them mitigate some of the risk. On the other hand, lenders can receive better credit
margin with Project Financing.
Multiple Participants Applicable: As Project Financing often concerns a large-scale
project, it is possible to allocate numerous parties in the project to take care of its various
aspects. This helps in the seamless operation of the entire process.
Asset Ownership is Decided at the Completion of Project: The Special Purpose Vehicle
is responsible to overview the proceedings of the project while monitoring the assets related
to the project. Once the project is completed, the project ownership goes to the concerned
entity as determined by the terms of the loan.
Zero or Limited Recourse Financing Solution: Since the borrower does not have
ownership of the project until its completion, the lenders do not have to waste time or
resources evaluating the assets and credibility of the borrower. Instead, the lender can focus
on the feasibility of the project. The financial services company can opt for limited recourse
from the sponsors if it deduces that the project might not be able to generate enough cash
flow to repay the loan after completion.
Loan Repayment With Project Cash Flow: According to the terms of the loan in Project
Financing, the excess cash flow received by the project should be used to pay off the
outstanding debt received by the borrower. As the debt is gradually paid off, this will reduce
the risk exposure of financial services company.
Better Tax Treatment: If Project Financing is implemented, the project and/or the sponsors
can receive the benefit of better tax treatment. Therefore, this structured financing solution is
preferred by sponsors to receive funds for long-term projects.
Sponsor Credit Has No Impact on Project: While this long-term financing plan maximises
the leverage of a project, it also ensures that the credit standings of the sponsor has no
negative impact on the project. Due to this reason, the credit risk of the project is often better
than the credit standings of the sponsor.

Infrastructure projects

The formal definitions of infrastructure financing are not very clear. Generally, in most
countries around the world, the government issues a list of industries that are to be given
infrastructure status. The financing of projects or companies involved in these sectors is
called infrastructure financing.

However, this definition is more for the government’s internal operations. This definition is
used in order to provide tax breaks or subsidies that have been promised to the
infrastructure sector.

However, there are certain shared characteristics amongst industries that are classified as
infrastructure all over the world. Some of these characteristics have been mentioned below:

1.. Firstly, industries which are given infrastructure status are considered to be central to the
economy. This means that these industries provide the impetus for the rapid growth and
development of other industries as well. For instance, industries such as roadways and
railways enable faster movements of goods and services throughout the country. This helps
the manufacturers in the country become more competitive as compared to other countries.
The final result is an increase in exports. Other important sectors such as
telecommunications and electricity are also considered to be central to the economy and
hence have been provided infrastructure finance all over the world.
2..Secondly, since these industries are considered to be of strategic importance, too many
private sector players are not allowed to operate in them. This creates a monopolistic market
with very few players. As a result, investors are generally very keen on investing in
infrastructure opportunities. However, it also needs to be understood that since these
markets can be considered to be monopolistic, they are also highly regulated. Since there is
only a handful of suppliers, the government fixes the prices that can be charged
3..Lastly, infrastructure assets are characterized by low risk and stable cash flows. These
projects are generally built in areas where there is high demand. As a result, either the
consumers or the government are willing to pay a relatively stable cash outflow for a long
period of time.
The bottom line is that the defining feature of infrastructure financing is the sectors to which
money is being lent. The different types of loans such as overdraft, term loan, working
capital loan, etc. are generally included in the definition of infrastructure financing

Types of Infrastructure Financing

Infrastructure financing has various sub-divisions. These divisions are generally based on
the type of industry that the funds will actually be utilized in. The different types of
infrastructure financing have been listed below;

Economic: infrastructure financing can be for purely economic reasons. For instance, when
a new port is built in a country, it enables more foreign trade. These projects are generally
funded using a public-private partnership. This is because these projects have net positive
value. Hence, the value created can be shared between the government and the private
parties. Economic infrastructure projects provide benefits to the larger economy of a region
instead of providing benefits only to specific industries or people.

Social: Infrastructure funding is also given to many institutions for a social cause. For
instance, several projects are undertaken to provide clean water to the people. Similarly,
projects are undertaken to provide healthcare and education services to the people of a
region. These projects are different because they have to be undertaken regardless of the
fact that they might have a negative net present value. Hence, under other modes of
financing, these projects would be left out. However, when it comes to infrastructure
financing, the government does spend funds on these projects even though there may not
be any immediate returns. Since these projects may have a negative net present value, they
are undertaken mostly by the government.

Commercial: Commercial projects are just like economic projects. Except, these projects
provide benefits to a set of people that can be directly identified. For example, toll roads and
metro rail projects are considered to be commercial infrastructure projects. They are funded
by charging the people who utilize the services.

Non performing assets

Non-performing assets are financial assets that are not generating income for the lender or
borrower, typically due to delinquency or default on a loan. They are also referred to as
"distressed assets" or "troubled assets". Non-performing assets can include loans, bonds,
and other financial instruments, such as mortgages, commercial loans, and credit card debt.

The term is most commonly used in the banking and finance industries but can also refer to
other investments, such as real estate. The presence of non-performing assets on a lender's
balance sheet can have a negative impact on their overall financial health and ability to meet
regulatory requirements.

Types of Non-Performing Assets

1. Standard Assets
Standard assets are non-performing assets that have been due for anywhere from 90 days
to 12 months. Among non-performing assets, they are considered to be of normal risk levels.

2. Sub-Standard Assets
The non-performing assets that are due past more than twelve months are known as
sub-standard assets. In comparison to standard assets, they pose significantly higher risk
levels. Banks and financial institutions are more sceptical of borrowers with sub-standards of
non-performing assets and thus assign them with a haircut (market value reduction).

3. Doubtful Debts
Non-performing assets that are due for a minimum of 18 months period are termed doubtful
debts. Lenders have grave doubts about the intention and ability of such borrowers to repay
their debts.

4. Loss Assets
Loss assets are non-performing assets with such extended periods that lenders have given
up hope that they would be able to recover their money. They are forced to write it off as a
loss on their balance sheets

Basel 2 framework

Basel II is the second set of international banking regulations defined by the Basel
Committee on Bank Supervision (BCBS). It is an extension of the regulations for minimum
capital requirements as defined under Basel I. The Basel II framework operates under three
pillars:

The Three Pillars under Basel II

Pillar 1: Capital Adequacy Requirements

Pillar 1 improves on the policies of Basel I by taking into consideration operational risks in
addition to credit risks associated with risk-weighted assets (RWA). It requires banks to
maintain a minimum capital adequacy requirement of 8% of its RWA. Basel II also provides
banks with more informed approaches to calculate capital requirements based on credit risk,
while taking into account each type of asset’s risk profile and specific characteristics. The
two main approaches include the:
1. Standardized approach

The standardized approach is suitable for banks with a smaller volume of operations and a
simpler control structure. It involves the use of credit ratings from external credit assessment
institutions for the evaluation of the creditworthiness of a bank’s debtor.

2. Internal ratings-based approach

The internal ratings-based approach is suitable for banks engaged in more complex
operations, with more developed risk management systems. There are two IRB approaches
for calculating capital requirements for credit risk based on internal ratings:

Foundation Internal Ratings-based approach (FIRB): In FIRB, banks use their own
assessments of parameters such as the Probability of Default, while the assessment
methods of other parameters, mainly risk components such as Loss Given Default and
Exposure at Default, are determined by the supervisor.
Advanced Internal Ratings-based approach (AIRB): Under the AIRB approach, banks use
their own assessments for all risk components and other parameters.

Pillar 2: Supervisory Review

Pillar 2 was added owing to the necessity of efficient supervision and lack thereof in Basel I,
pertaining to the assessment of a bank’s internal capital adequacy. Under Pillar 2, banks are
obligated to assess the internal capital adequacy for covering all risks they can potentially
face in the course of their operations. The supervisor is responsible for ascertaining whether
the bank uses appropriate assessment approaches and covers all risks associated.

Internal Capital Adequacy Assessment Process (ICAAP): A bank must conduct periodic
internal capital adequacy assessments in accordance with their risk profile and determine a
strategy for maintaining the necessary capital level.
Supervisory Review and Evaluation Process (SREP): Supervisors are obligated to review
and evaluate the internal capital adequacy assessments and strategies of banks, as well as
their ability to monitor their compliance with the regulatory capital ratios.
Capital above the minimum level: One of the added features of the framework Basel II is the
requirement of supervisors to ensure banks maintain their capital structure above the
minimum level defined by Pillar 1.
Supervisor’s interventions: Supervisors must seek to intervene in the daily decision-making
process in order to prevent capital from falling below the minimum level.

Pillar 3: Market Discipline

Pillar 3 aims to ensure market discipline by making it mandatory to disclose relevant market
information. This is done to make sure that the users of financial information receive the
relevant information to make informed trading decisions and ensure market discipline.

Basel 3

The Basel III accord is a set of financial reforms that was developed by the Basel Committee
on Banking Supervision (BCBS), with the aim of strengthening regulation, supervision, and
risk management within the banking industry. Due to the impact of the 2008 Global Financial
Crisis on banks, Basel III was introduced to improve the banks’ ability to handle shocks from
financial stress and to strengthen their transparency and disclosure.

Key Principles of Basel III

1. Minimum Capital Requirements

The Basel III accord raised the minimum capital requirements for banks from 2% in Basel II
to 4.5% of common equity, as a percentage of the bank’s risk-weighted assets. There is also
an additional 2.5% buffer capital requirement that brings the total minimum requirement to
7%. Banks can use the buffer when faced with financial stress, but doing so can lead to even
more financial constraints when paying dividends.

As of 2015, the Tier 1 capital requirement increased from 4% in Basel II to 6% in Basel III.
The 6% includes 4.5% of Common Equity Tier 1 and an extra 1.5% of additional Tier 1
capital. The requirements were to be implemented starting in 2013, but the implementation
date has been postponed several times, and banks now have until January 1, 2022, to
implement the changes.

2. Leverage Ratio
Basel III introduced a non-risk-based leverage ratio to serve as a backstop to the risk-based
capital requirements. Banks are required to hold a leverage ratio in excess of 3%. The
non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total
consolidated assets of a bank.

To conform to the requirement, the Federal Reserve Bank of the United States fixed the
leverage ratio at 5% for insured bank holding companies, and at 6% for Systematically
Important Financial Institutions (SIFI).

3. Liquidity Requirements
Basel III introduced the usage of two liquidity ratios – the Liquidity Coverage Ratio and the
Net Stable Funding Ratio. The Liquidity Coverage Ratio requires banks to hold sufficient
highly liquid assets that can withstand a 30-day stressed funding scenario as specified by
the supervisors. The Liquidity Coverage Ratio mandate was introduced in 2015 at only 60%
of its stated requirements and is expected to increase by 10% each year till 2019 when it
takes full effect.

On the other hand, the Net Stable Funding Ratio (NSFR) requires banks to maintain stable
funding above the required amount of stable funding for a period of one year of extended
stress. The NSFR was designed to address liquidity mismatches and will start becoming
operational in 2018.

Risk rating agencies

Credit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and
their issuers, including companies and countries. These agencies assign credit risk ratings to
such entities based on quantitative and qualitative analyses. Ratings show the likelihood of a
borrower to default or repay a loan with interest.
Credit rating services use unique letter codes to depict the default risk and the financial
stability of the debt issuer. While these ratings provide risk measures for an entity, investors
get to know about its creditworthiness
. Besides corporations and nations, these ratings can be for stocks, bonds,
mortgage-backed securities
, collateralized debt obligations, and credit default swaps.