FINANCIAL MANAGEMENT

OF BANKS

Macro Aspects of Banking

 Reserve Bank of India &
Monetary Policy
• RBI was constituted under the RBI Act,
1934 and began functioning w.e.f. 1st of
April,1935. The main objective are:
Promoting growth and maintaining price
stability.
Maintaining monetary stability.
Maintaining financial stability and ensuring
the sound health of financial institutions.
Efficient credit allocation
• Bank rate
• Bank rate to inflation
• Bank rate to prime lending rate (PLR) and
deposit rates
• Effects on demand – spending and saving
decisions
• Cash flow
• Asset prices
• Stock prices
• Exchange rates
• Tools of monetary control
 CRR
 SLR
 BR
 OMO
 Repo
Understanding Bank’s
Financial Statement
 Balance Sheet
• Sources of Funds (Bank Liabilities)
1. Net Worth
(a) Capital
(b) Reserve & Surplus = Statutory Reserve +
Capital Reserves + Share Premium + Revenue
and other Reserves + Balance in P&L Account
2. Deposits
(a) Demand Deposits
(b) Saving Deposits
© Term Deposits
1. Borrowings
2. Other Liabilities and Provisions
(a) Bills Payable
(b) Interest accrued
© Others
• Uses of Funds (Bank Assets)
1. Cash and balances with the RBI
2. Balances with banks and money at call and short
notice
3. Investments:
 Government securities
 Approved securities
 Shares
 Debentures and bonds
 Subsidiaries and / or joint ventures
 Other investments
4. Loans and advances:
(a) By nature of credit facility
(b)By security arrangements
© By sector
5. Fixed assets:
(a) Premises (including land)
(b) Other assets (including furniture and
fixtures)
© Assets on lease
6. Other assets
• Contingent Liabilities
a) claims against the bank not
acknowledged as debts
b) Liability on account of outstanding
forward exchange contracts
c) Guarantees given on behalf of outside
constituents
d) Currency swaps, interest rate swaps &
futures
 Income Statement

Sources of Income
• Interest Earned
 Interest / discount on advances/bills
 Income from investments
 Interest on balances with RBI and other
inter-bank funds
 Others
• Other Income
 Commission, exchange and brokerage
 Profit/loss on sale of investments
 Profit/loss on revaluation of investments
 Profit/loss on sale of building and other
assets
 Profit on exchange transactions
 Income earned by way of dividends
 Miscellaneous income
Sources of Expenses
• Interest Expended
 Interest on deposits
 Interest on RBI / inter-bank borrowings
 Other Interest

• Operating Expenses
 Payments to and provisions for employees
 Rent, taxes and lighting
 Printing and stationery
 Advertisement and publicity
 Depreciation on bank’s property
 Directors’ fees, allowances and expenses
 Auditors’ fees and expenses
 Law charges
 Postage, telephone, etc.
• Provisions and Contingencies
Other Disclosures to be made by Banks in
India = The banks are mandated to disclose
additional information as part of annual financial
statements as follows:
1.Capital adequacy ratio
2. Gross value of investments
3. Repo transactions
4. Non-SLR investment portfolio
5. Forward rate agreement/interest rate swap
6. Movements in NPAs
 Camels Model
• Regulators, analysts and investors have to
periodically assess the financial condition
of each bank. Banks are rated on various
parameters, based on financial and non-
financial performance.
• CAMELS is an acronym, where each letter
refers to a specific category of performance.
• CAMELS model objectives.
• Ratings are assigned for each component in
addition to the overall rating of a bank’s
financial condition. The ratings are assigned
on a scale from 1 to 5.
• Rating analysis and interpretation
CAMEL MODEL
• C - Capital Adequacy
- Capital adequacy ratio
- Debt-Equity Ratio
- Advances to Assets
- G-Secs to Total Investments
• A - Asset Quality
- Gross NPAs to Net Advances
- Net NPAs to Net Advances
- Total Investments to Total Assets
- Percentage change in Net NPAs
- Net NPAs to Total Assets

 
•  M- Management
- Profit per Branch
- Total Advances to Total Deposits
- Business per Employee
- Profit per Employee
•  E- Earning Quality
- Operating Profits to Average Working Funds
- Percentage Growth in Net Profits
- Spread
- Net Profit to Average Assets
- Interest Income to Total Income
- Non-Interest Income to Total Income
•  L- Liquidity
- Liquid Assets to Total Assets
- G-Secs to Total Assets
- Liquid Assets to Demand Deposits
- Liquid Assets to Total Deposits
• S – Sensitivity to market risk
 Key Ratios for analyzing
Financial Statements to evaluate
Bank Performance
• External factors
• Internal factors
• Ratios
 efficiency & expense control ratio
 Liquidity
 risk
 profitability
 Alternative Models for Bank
Financial Statement Analysis
• Measures based on total operating revenue
• Stock market – based performance
measures
• Customer – centric performance measures
Sources of Bank Funds

Bank Liabilities
 Deposits
• Parameters of deposits
 Maturity
 Cost of funds
 Tax implications
 Regulatory framework
 Market conditions
• Classification of deposits
 Transaction accounts or payment deposits
 Term deposits
 Pricing Deposit Services
• Need to price deposit services = The pricing
of deposits and related services assumes great
importance in the present deregulated and highly
competitive environment, where deposit rate ceiling do
not exist. However, banks have to monitor the cost of
their funding sources carefully for the following reasons:
1. Changes in cost of funds would require changes in asset
yields to maintain spreads.
2. Changes in cost of funds could alter the liability mix of
banks and expose the bank to liquidity constraints.
3. Changes in cost of funds could render the bank less
competitive in the market.
It is, therefore, imperative that banks understand how to
measure the cost of their funding sources and
accordingly price their assets in order to ensure a desired
level of profitability. This is done through a pricing
• Approaches to deposit pricing
 Market penetration deposit pricing
 Conditional pricing
 Upscale target pricing
• Deposits and interest rate risk
 Non-Deposit Sources

• Over the last three decades or so, banks have been

increasingly turning to non-deposit funding
sources (also called ‘whole sale funding’ sources).
• Funding Gap
- example
- factors in choosing among funding gap financing
options
• Are non-deposit sources more costly and risky
 Design of Deposit Schemes
• The principles underlying the concept of
‘time value of money are prevalently used
in designing deposit schemes.
 Recurring deposit scheme (RD)
 Reinvestment deposit scheme
 Fixed deposit scheme
 Cash certificates
Uses of Bank Funds

Bank Assets
 Introduction
• Bank’s role as financial intermediaries
• Gains from lending
• Features of bank credit
• Types of lending
• Short-term loans
• Long-term loans
• Revolving credits
 Credit Process
• Loan policy
1. Loan objectives
2. Volume and mix of loans
3. Loan evaluation procedures
4. Credit administration
5. Credit files
6. Lending rates
• Broad steps to credit analysis
1. Building the credit file
2. Project and financial appraisal
3. Qualitative analysis
4. Due diligence
5. Risk assessment
6. Making the recommendation
• Credit delivery and administration
(including credit review and monitoring)
 Financial Appraisal for Credit
Decision

• Financial ratio analysis

• Common size ratio comparisons
• Cash flow analysis
 Types of Loans
• 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 retail lending
• Non-fund based credit
 Loan Pricing
1. Arrive at cost of funds
2. Determine servicing costs for the
customer
3. Assess default risk and enforceability of
securities
4. Fixing the profit margin
Some more models of Loan Pricing:
• Fixed vs Floating rates
• Hedging and Matched funding
• Price leadership model
• Cost benefit loan pricing
Management of Credit Risk

Loans
 Introduction
• Expected versus Unexpected loss
• Defining credit risk
 the risk in individual credits or
transactions.
 the credit risk inherent in the entire
portfolio.
 the relationships between credit risk and
other risks.
 BASEL Committee’s Principles
of Credit Risk Management
The committee focuses on the following areas:

1. Establishing an appropriate credit risk environment;

2. Operating under a sound credit granting process;
3. Maintaining an appropriate credit administration,
measurement and monitoring process; and
4. Ensuring adequate controls over credit risk.
 Credit Risk Models
• Lenders try to diversify their credit risks,
for they know that they cannot do business
if they eliminate risks altogether. How can
lenders diversify their risk? By avoiding
‘concentration’ of credit.
• Basic model
 A simple method of estimating credit risk is to
assess the impact of NPA write-offs on the bank’s
profit.
 PBT/NPA. Here PBT is more relevant since losses
written off typically enjoy tax shields.
 (PBT/TA) / (NPA/TA)
 Interpretation
• Credit scoring model
 Credit Risk Transfers
LOAN SALES
• Syndication
• Novation
• Securitisation
The securities sold to investors are called ABS,
since they are backed by the homogeneous pool of
underlying assets. Originators of ABS usually
want to sell loans ‘without recourse’. Hence
investors usually safeguard their interests through
three mechanisms – (a) overcollateralisation, (b)
senior/subordinated structures, © credit
enhancement.
CREDIT DERIVATIVES
• CD are an effective means of protecting against
credit risk. They come in many shapes and sizes,
but all serve the same purpose. Simply stated, a
credit derivative is a security with a pay-off
linked to a credit related event, such as borrower
default, credit rating downgrades.
• Some basic credit derivative structures:
1. Loan portfolio swap
2. Total return swap
3. Credit default swap (CDS)
4. Credit risk options
5. Credit linked notes
6. Credit linked deposits / credit linked
certificates of deposit
7. Basket default swap
Treatment of Credit Risk in India
• Credit and investment exposure
• What are non-performing assets
• Prudential norms for income recognition
• Prudential norms for asset classification
• Provisioning norms
Management of Interest rate and
Liquidity Risk
Asset – Liability Management
 Introduction
• 90% of Bank A’s liabilities mature within the next 12
months. Bank A has invested 80% of these funds in
securities maturing after 5 years.
• 90% of Bank B’s liabilities mature within the next 12
months. Bank B lends 75% of these funds to various
infrastructure projects, where the repayment will start after
an initial payment holiday of 2 years.
• 80% of Bank C’s liabilities mature after 3 years and have
been borrowed at a fixed cost. Interest rates are on a
downward trend, and 80% of Bank C’s loan portfolio
consists of short-term loans to be fully repaid over the next
six months.
• Bank D has entered into dollar forward contracts at a
premium for 6 months on behalf of its importer borrowers,
who form about 60% of the bank’s loan portfolio. There is
a fall in dollar value during this period.
 Concept & Objective of ALM
• The maturity mismatches and disproportionate
changes in the level of assets and liabilities can
cause both liquidity and interest rate risk.
• ALM is an integrated strategic managerial
approach of managing of total balance sheet
dynamics having regard to its size and quality in
such a way that the net earnings from interest in
particular are maximized with the overall risk
preference of the institution.
• The focus is not on building up of deposits and
loans/assets in isolation but on net interest income
and recognizing interest rate and liquidity risks.
This is essentially a guide for survival in a
deregulated environment.
• Objective:
1. To control the volatility of net interest
income and net economic value of a bank.
2. To control liquidity risk.
3. To control volatility in target accounts,
and
4. To ensure an acceptable balance between
profitability and growth rate.
 Measuring Interest Rate Risk
• Banks use various techniques to measure the
exposure of earnings and economic value to
changes in interest rates.
• Before we examine the various approaches, we
will have to understand what determines interest
rate ‘sensitivity.’ Typically, a bank’s asset or
liability is classified as rate sensitive within a
specified time interval if
 It matures during the time interval;
 The interest rate applied to the outstanding advance changes
contractually during the interval;
 It represents an interim or partial principal payment;
 The outstanding principal can be repriced when some base rate or
index changes; and there is an expectation that the base rate or index
may change during the interval.
• Methods to measure interest rate risk
1. Traditional GAP analysis
2. Earnings sensitivity analysis (Earnings at risk)
3. Rate adjusted gap
4. Duration GAP analysis
• Managing interest rate risk – IRD
1. Swaps
2. Interest rate futures
3. Forward rate agreements
4. Interest rate options
5. Interest rate guarantees
6. Swaptions
 Liquidity Risk Management
• Sources of liquidity risk
1. Access to financial markets
2. Financial health of the bank
3. Balance sheet structure
4. Liability and asset mix
5. Timing of fund flow
6. Exposures to off-balance sheet activity
• Approach to managing liquidity in long-term
1. Asset management
2. Liability management
• Approach to managing liquidity in the short-
term
1. Projected sources and uses of funds over the planning
horizon
2. Working funds approach
3. Cash flow or funding gap report
4. Funds availability report
5. Ratio analysis
6. Historical funds flow analysis
 Capital Risk

Regulation and Adequacy

 Prudential Regulation
• Economic regulation and prudential regulation
• Prudential regulatory model calls for imposing the
regulatory capital level to maintain the health of
banks and the soundness of the financial system.
The Reserve bank of India issued prudential
norms based on the recommendations of the
Narsimham Committee report. These norms strive
to ensure that banks conduct their business
activities as prudent entities, that is, not indulging
in excessive risk taking and violating regulations
in pursuit of profit.
 BASLE Committee
• What is BASEL committee?
• BASEL Capital Accord 1988: The Basle Capital
Accord of 1988 refers to the agreement among
member countries of the Basle Committee on
Banking Supervision on a method of ensuring a
bank’s capital adequacy.
• The Basel norm of capital adequacy was
introduced in India following the
recommendations of the Narsimham Committee
(1991).
 Capital Adequacy
• Capital adequacy ratio is a measure of the
amount of a bank’s capital expressed as a
percentage of its risk-weighted assets.
• This capital framework, based on the
Basel committee proposals, prescribes two
tiers of capital for the banks:
1. Tire-I capital which can absorb losses without a bank
being required to cease trading and
2. Tier-II capital which can absorb losses in the event of a
winding-up.
• Tier-II capital should not be more than 100
percent of Tier-I capital and subordinated
debt instruments should be limited to 50
percent of Tier-I capital. Revaluation
reserve should be applied a discount of 55%
for inclusion in Tier-II capital. General
provisions/loss reserves should not exceed
1.25 percent of the total weighted risk
assets.
• Risk weight of assets.