Final

Banks Funds Management
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Introduction
Finance is the hand-maid of economic growth. Institutions like Banks, which command huge financial resources, can play a crucial role in shaping the economy of a country by judiciously deploying their funds over such economic growth. Bank is often compared with the !Dam", and the money lying scattered with individuals and institutes in society to the water running its own course, without any direction. Money is collected by Banks by way of deposits, and form this fund money is turned back to the community in the form of loans. #hus, Banks act as a vital link between the savers and needy. India is still striving to transform herself into an industrially developed country based on rural and agricultural economy. #hough we are one of the most emerging nations, our economy is growing at more then $ per cent but then also we are lacking at the International level especially in the financial services. Banks have a crucial role to play, not only in achieving its objective but more significantly in determining how speedily and efficiently it is achieved. %ince with the entry of the private and the foreign banks, the needs of the nation also changing with the development in economy. &ow, the common men hope that he should get every facility from his bank. #he banking industry has developed ade'uately enough to meet the changing needs, both corporate and personal. Banks now offer wide range of services in an e(tensively varied environment. #he comple( task of managing these needs and their conse'uences re'uires that banker should be more professional than ever before.
Meaning
)tymology refers to the linguistic of a word. #he word Bank traces to the French word banque *chest+ and the Italian word banca *bench+. #he earliest known banks, temples, operated as to store wealth. #hey were among the first places where a need for money and money changers emerged. #hese early meanings capture the two basic functions the banks perform, -
-. .hest, the safekeeping or risk-control function /. Bench, the transaction function including intermediation or two-way funds rental chest, such as a gold, jewelry, cedar, or hope chest, is a place to store valuables. bank"s chest is its portfolio of assets and liabilities. the accounting lifeblood of banking earnings. bank"s chest is its portfolio of assets and liabilities. #he heart of the bank is its portfolio. Banks portfolio generates bank"s economic lifeblood is its cash flow, defined as net earnings after deducting all e(penses and provisions. 0epositors and other creditors funds are stored *invested+ for safekeeping in a bank"s portfolio of interest earnings assets loans and securities. If it helps you sleep better, think of a bank"s portfolio as safely locked away in its vault at night. Italy, banca *bench+ referred to the table, counter, or a place of business of a moneychanger. #his meaning suggests the transactions and trading functions of a modern bank. More generally, the transacting 1benches2 of modern society include the supermarket checkout counter3scanner, the platform of a convenience3lottery store, the shopping program on your cable #4 station and the Internet for ecommerce, e-trading, and e-banking. #he usual means of payment at these benches are cash, check, or credit3debit card, all means of payment supplied, but not e(clusively, by banks. Banks have benches themselves in the form of the new accounts desk, the teller"s window, the loan officer"s desk, the trading desk for securities and derivative instruments, the #M, and the Internet. In additions, bankers still make 1housecalls2 at business *wholesale, commercial, or merchant banking+ and will be 1on call2 for wealthy individuals *private banking+. #hese benches provide customers with access to bank"s safekeeping and transactions functions or, in the broadest sense, access to all kinds of deal making.
An Indian perspective
Money, declares Kautaliya in #he Arthashastra /555 years before dam %mith, father of economics, is the founder of all human activities. #he Vedas and 6autiliya"s Arthashastra bear testimony to the e(istence an efficient working of a banking system
in India early in history. #he institution of Banking is very old in our country and its origin can be traced to a time as early as 755 B... 1It may be accepted that a system of banking eminently suited to India"s ten re'uirements was in force in this country many centuries before the science of banking become as accomplished fact in India.2 French #raveller 8.B. #rvernier wrote in the seventeen century that every village in India had a money changer, called as 1Shroff,2 who, according to him, acted as a banker to make remittances of money and issue letters of e(change. 9e asserted that all the 8ews who occupied themselves with money and e(change in the empire of :rand %eigneur passed for being very sharp, but in India they would scarcely be apparent to these changers. It may be said with regard to our ancient Indian bankers that their banking operations closely resembled those of modern private bankers, inasmuch as they performed almost all operations of modern bankers. From the early 4edic period right through the time of the Moghuls and )ast India .ompany one finds evidence of their having conducted business resembling that of modern private bankers.
The Business of Banking

#he Indian banking can be broadly categori;ed into nationali;ed *government owned+, private banks and speciali;ed banking institutions. #he <eserve Bank of India acts a centrali;ed body monitoring any discrepancies and shortcoming in the system. %ince the nationali;ation of banks in -=$=, the public sector banks or the nationali;ed banks have ac'uired a place of prominence and has since then seen tremendous progress. #he need to become highly customer focused has forced the slow-moving public sector banks to adopt a fast track approach. #he unleashing of products and services through the net has galvani;ed players at all levels of the banking and financial institutions market grid to look anew at their e(isting portfolio offering. Indian banks are now 'uoting all higher valuation when compared to banks in other sian countries *vi;. 9ong 6ong, %ingapore, >hilippines etc.+ that have major problems linked to huge &on >erforming ssets *&> s+ and payment defaults. .ooperative banks are nimble footed in approach and armed with efficient branch networks focus primarily on the !high revenue" niche retail segments.
#he Indian banking has finally worked up to the competitive dynamics of the !new" Indian market and is addressing the relevant issues to take on the multifarious challenges of globali;ation. . >rivate banks have been fast on the uptake and are reorienting their strategies using the internet as a medium #he Internet has emerged as the new and challenging frontier of marketing with the conventional physical world tenets being just as applicable like in any other marketing medium. #he Indian banking has come from a long way from being a sleepy business institution to a highly proactive and dynamic entity. #his transformation has been largely brought about by the large dose of liberali;ation and economic reforms that allowed banks to e(plore new business opportunities rather than generating revenues from conventional streams *i.e. borrowing and lending+. Indian nationali;ed banks *banks owned by the government+ continue to be the major lenders in the economy due to their sheer si;e and penetrative networks which assures them high deposit mobili;ation. #he Indian banking can be broadly categori;ed into nationali;ed, private banks and speciali;ed banking institutions.
The Concept of Funds Management

ll businessmen irrespective of the si;e of business believe that success or failure of their business depends upon efficient use of funds. #his ma(im holds ground in case of banks also. #he chief e(ecutive of every business must efficiently manage the funds, direct them into profitable lines and control their use and investment. 9e must keep a constant watch to make sure not only that they are used to the best advantage, but also that no financial difficulty arises in due course. For a manager or chief e(ecutive of a bank, where money is dealt with as raw material, this proposition becomes more vital for the successful conduct of banking operation. #he problem of fund management in a bank becomes more acute and comple( because of the day-today fluctuation and movement of funds. Banks are in the business of maturity transformation. #hey lend for longer time periods as borrowers normally prefer a longer time frame. But their liabilities are typically short-term in nature as lenders normally prefer a shorter time frame
*li'uidity preference+. #his results in long-term interest rates typically e(ceeding short-term rates. 9ence, the incentive for banksA function of maturity transformation and financial intermediation is the difference between interest receipt and interest cost called interest spread. It is implicit, therefore, that banks will have a mismatched balance sheet, with liabilities greater than assets in the short-term, and with assets greater than liabilities in the medium and long-term. #hese li'uidity risk, are with respect to various time hori;ons. 9ence, the overwhelming concern of a bank is to maintain ade'uate li'uidity. Bi'uidity has been defined as the ability of an institution to replace liability run off and fund asset growth promptly and at a reasonable price. Maintenance of superfluous li'uidity will, however, impact profitability adversely. #he ability to meet both its current and potential obligations as they fall due, and achieve reasonable levels of profit margin will be the underpinning of effective fund management. #o this end, a bank has to maintain a prudent mi( of assets and liabilities in terms of 'uality return and an acceptable maturity profile. Fund management connotes all such treasury activities aimed at funding the credit and the investment operations of a bank with a view to ma(imi;ing profitability, given an acceptable level of risk and desired maturity profile of assets and liabilities articulated by the sset-Biability .ommittee * B.C+ of a bank. Cn the short-term hori;on, fund management boils down to li'uidity managementD on the long-term, it is spread management and management of asset liability profile of the bank for long-term operating viability. Ehile the objective of fund management remains the same for all banks, the fund management views and perspectives of large si;ed banks will differ from those of smaller banks. But what is Funds ManagementF Funds managers decide how to invest the huge sum of money and securities held by them. #hey use their knowledge and judgement to buy and sell shares, bonds and other assets to increase the value of their clientsA portfolios. In other words, Fund Management means to decide and manage, the sources of funds i.e. how and from where the funds should be raised and the uses of 7
funds i.e. optimally diversified the funds to get the ma(imum returns. Fund managers need self-confidence and credibility along with the courage to admit when they have made a mistake. Fund management, also known as asset or investment management, can be split into retail and institutional. <etail deals with products bought by individual investors such as investment trusts or unit trusts. Institutional fund managers work on behalf of an organisation, such an insurance or pension fund. Funds can be split between several managers to increase returns or reduce risk. Managing institutional money is seen as more prestigious. <etail funds involving smaller sums are more awkward to administer and involve greater initial costs. Funds have differing goals. %ome seek to generate regular income for investors while others focus on capital growth. %ome want relatively high-risk strategies that might make large returns, or large losses, while others are more cautious.
Funds Management Policy Guidelines

s more banks are attracting funds on a cost competitive basis, the need for properly supervised funds management policies increases. #he board of directors has ultimate responsibility for the institutional e(posure to interest rate risk and should establish overall strategic policy and adopt constraints on the level of risk assumed. good policy should generally provide for forward planning which considers the uni'ue characteristics of the bank, management goals regarding asset and liability mi(, desired earnings, and margins necessary to achieve desired earnings. Forward planning should also anticipate funding needs and the means available to meet those needs. #he policy should establish responsibility for funds management decisions and provide a mechanism for the necessary coordination between the different departments of the bank. #his responsibility may be assigned to an asset liability management committee * B.C+. In addition to establishing responsibility for planning and day-to-day funds management decisions, the policy should set forth certain guidelines. )(amples of some typical guidelines are,
i!uidity
Balance sheet ratio limits. For e(ample, a limit on total loans3total deposits and purchased funds3total assets. Bimits on the sources of funds, such as, $
- .oncentrations in funding sources. - Gse of broker3dealers. - Ma(imum use of a particular wholesale funding market. - Bimits on uses of funds. percentage limit on the relationship between anticipated funding needs and available sources. For e(ample, the ratio of primary sources3anticipated needs shall not fall below a certain percent. *>rimary sources for meeting funding needs should be defined.+ Bimits on the minimum3ma(imum average contract *not repricing dates+ maturity for different categories of liabilities. For e(ample, the average maturity of negotiable certificates of deposit shall not be less than a stated number of months.
"ate #ensitivity
Bimits on the acceptable level of earnings at risk arising from mismatches between the repricing of assets, liabilities, and off-balance sheet contracts carried on a historic cost basis. #hese limits are best e(pressed in terms of net interest income at risk. Bimits should also address the risk to earnings arising from positions that are carried on a market valuation basis. #his includes trading positions and assets held for resale. Bimits on these positions are best e(pressed in terms of the risk to market values. Bimits on earnings e(posure should consider potential adverse changes in interest rates rather than anticipated rate movements. #he magnitude of an appropriate rate movement will depend on the length of time within which a bank could realistically act to close a position. #his reaction time may vary from overnight for li'uid trading instruments, to a year or longer for illi'uid long-term positions. Banks with significant unmatched, long-term, fi(ed rate positions should evaluate and limit the severity of this e(posure.
#ources and $ses of Funds

%r.&o. %ources of Funds .apital Fund / ? 0eposits Borrowing <s. II II II %r.&o. Gses of Fund Bi'uidity Management / ? @ #C# B*<s.+ III .<<3%B< Boans dvances Investment #C# B*<s.+ II III and II II <s. II
#ources of Funds
fter initial capitali;ation, a bank has three major sources of funds for its business operations, deposits, borrowed funds, and capital increases. Eithin these three basic categories are many funding instruments whose maturities, costs, and applications in liability management vary. Biability management, in its broadest sense, is the coordination and control of all of a bankAs sources of funds so that funds are available or obtainable as needed at reasonable cost. )ffective liability management ensures that funds are available to meet reserve re'uirements and provide ade'uate li'uidity over the short term, and to satisfy loan demand and provide investment earnings over the long term. Bank funding sources management have undergone profound changes in recent years, and continued change and challenge are still on the hori;on. #he deposit structures of most banks have been altered significantly due to marked declines in traditional demand deposits and rapid increases in the volume of time deposits. #he sources of most bank funds are now interest sensitive and increasingly volatile. .ompetition for funds is intense, and effective management of a bankAs liabilities now re'uires a much more aggressive approach to attracting and keeping funds.
#he items appearing on the liability side of the balance sheet of the bank may be put in the following broad categories, 1% Capital Fund nother source of funds for the banking sector is the capital fund. In the last -5 years, the total e'uity capital raised by banks has gone up, although it is not the main source of funds for banks. Eith stricter capital ade'uacy norms and the growing loan book si;e, banks will need to infuse more capital to maintain a healthy capital ade'uacy ratio. Many of the public sector banks have reduced the government stake by raising e'uity from the market. In /55/-5?, the total amount raised by public sector banks through e'uity was appro(imately <s H.H billion. 9ence, in order to maintain a healthy capital ade'uacy ratio, going forward, and banks will embark on infusing more e'uity capital. )'uity capital is estimated to grow at . :< of /.7 per cent in the ne(t year. &% 'eposits 0eposits are the chief source of bank funds. #he funds from this source arise when depositors deposit money with the bank. #he growth in deposits depend upon various factors such as the saving habits of the people, the monetary policy of the .entral Bank, and the general economic conditions of the country. But, there are also KderivativesK deposits, i.e., the deposits accruing from the advancement of loans and the investment of funds. Banks can only lend or invest such an amount as remains in e(cess of the legal reserve re'uirements and the other reserves necessary to support liabilities. #hus, the increase or decrease in this source of funds mainly depends upon the monetary and fiscal policies. #he legal reserve re'uirements, the credit control policy, and the other monetary policies of the .entral Bank of the country greatly determine the shifts in the volume and pattern of the deposit funds. #he various factors which influence the mobili;ation of deposits are, a+ changes in the level of the moneti;ed income, b+ the spread of banking habit by e(pansion of branches into the unbanked areas, and c+ the pattern of interest rate prevailing in the country.
(% Borro)ing #he contractual obligations of the banks to the <eserve Bank of India enable them legally to get finance from the <eserve Bank. Besides the <BI, Kbanks may also borrow from the %tate Bank of India or from any other notified bank. :enerally, they borrow from the Industrial 0evelopment Bank of India, the )(port-Import Bank of India, the &ational Bank for gricultural and <ural 0evelopment and the %cheduled %tate .ooperative Banks. Include the holdings of foreign currencies and the borrowings by Indian banks and their branch adjustments with the branches abroad. #hus, the banks are free to borrow to increase their sources of funds from India and abroad according to their needs.
$ses of Funds
Bike the sources of funds, the uses of funds are broadly determined by the nature of the economy, the economic policies and a host of other factors. %ince banks are not supposed to function in a manner harmful to the interests of the depositors-the shareholders and borrowers in particular and the community in general-banks have to subject themselves to controls e(ercised by the .entral Bank of the country. #hese controls also influence the choice of banks in making use of their funds. #he statutory regulations only provide a general framework within which banks may function, and it is necessary for them to follow policies and procedures of their own in making use of funds for protecting the interests of the various parties concerned. #he e(tent to which the management of a bank succeeds in achieving this end will depend upon its ability to secure a proper balance in the pursuit of three objectives, *i+ safety, *ii+ liquidity, and *iii+ profitability. Besides, a prudent bank should also e(ercise vigilance and adaptability to the various cyclical and secular changes in the economy. #he asset side of the balance sheet of a bank comprises the following assets,
1% Cash
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From the li'uidity point of view, banks provide themselves with enough cash. Banks have the obligation to pay the demand deposits without notice and Kon demandK, for which cash is needed. 9ow much bank funds are to be kept in this portfolio depends upon several factors, which are partly legal and partly practical. Cne reason for the deep rooted interest of banks in maintaining cash is to honour the trust of the depositors that they will always be able to e(change deposits for cash. further reason for keeping cash is the functional need of providing a means of paying or clearing che'ues and their other credit obligations. 2) CRR / SLR Requirement Maintenance of <eserves is one of the major functions of the Fund Manager. #his is mainly because the <eserves are maintained on the overall financial figures of the Bank and no other department of the Bank other than Fund Management will be able to handle it effectively. Cn account of Funds Management, Funds ManagerAs active involvement in bankAs major day to day operations can manage the <eserves Maintenance more effectively than others. Ehile .<< management is directly related to the overall li'uidity position of the Bank on day to day basis, %B< Management is nothing but management of more than ?5L of the the banks. 3) Loans and Advances fter making ade'uate provisions for li'uidity, banks use their funds in making advances. #hey are obliged to serve the legitimate credit needs of the community in which they are located. Gsually, banks provide advances on the basis of the Asecurity,A which generally consists of raw materials, finished goods, securities, bills, etc. Ehen advances are based on the security of raw materials and manufactured goods, banks have to study carefully the problems of marketability, durability and price fluctuations of the articles concerned. #he risk that is involved in the transactions has to be property assessed, and the measures taken to safeguard the interests of the bank accordingly. #herefore, banks grant advances either by pledge or hypothecation of goods. In case of pledge, the goods are either under the direct physical control of the banks or in the godowns of the borrower, but in case of hypothecation goods are under the legal lien of the banks though -ssets of
they actually remains in the borrowers" possession, and, therefore, it is always accompanied by personal guarantee. Banks also grant advances against industrial assets and personal securities. 4) nvestments By investments is meant the employment of bank funds in the securities transacted at %tock )(changes or otherwise vi;., the :overnment securities, semi:overnment or trustee securities, and shares and debentures of joint stock companies. Banks can also li'uidate their investment in case there is shortage of funds to meet the credit needs, and to maintain the primary and secondary reserves. In this sense, investments have a certain element of li'uidity. #he proposition of investments and back credit keep on changing, depending upon the magnitude of bank funds and their cost. #he investment policy of banks is also influenced by the monetary policy of the .entral Bank of the country. Ehile all the instrument of the monetary policy aim at influencing the investment policy of banks, the open market operations are particularly important. #he open market operations influence the portfolios policies of banks through their effects on reserves, security prices, and the composition of the security portfolios.
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*volution of Funds Management
Bank funds management is the key to short to intermediate term decision making in todayAs dynamic and volatile banking environment. Broadly defined, funds management includes all policies and approaches designed to obtain funds from deposits and borrowings and to allocate them to loans and investments.- More specifically, the emphasis in funds management is on the funds over which management has discretionary controlMthese are primarily assets and liabilities bought and sold in impersonal financial markets, such as #reasury bills and purchased liabilities. 0iscretionary funds management primarily accepts as given those assets and funds sources based on customer relationships, such as the loan portfolios and core deposits. #hese are primary e(amples of assets and liabilities over which bank management does not, in practice, have discretionary control. #his is especially true in short decision hori;on of most approaches to funds management. Banks must stand ready to meet the legitimate credit needs of customers if they hope to maintain or increase their competitive position. #hey also have relatively large financial investment in the loan function which, in the short run, dictate that customer demands for credit be given priority in the allocation of funds. %imilarly, banks have relatively large investments in the deposits function, which generate the core deposit base which provides funds for the primary loan portfolio. 0iscretionary funds management also primarily accepts as given those sources and uses of funds which are subject to strategic management and significant regulatory constraints. Bank capital is the most important source of funds subject to these influences. <egulators generally want banks to have more capital than bankers feel is consistent in long-run profit ma(imi;ation. #he regulatory position acts constraint which must be maintained over time. %hort-run funds management is generally concerned with maintaining rather than changing the given capital position. #hus, discretionary funds management does not typically include the
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short-run management of core deposits derived from personal relationships, the shortfunding of commercial and retail loan programs, and the strategic management of the bank capital position. Funds management generally defined, is limited to the management of those assets liabilities that can be bought and sold in impersonal money capital markets without significant regard to customer relationship or major regulatory constraints. In India, Funds Management work was limited upto the maintenance of cash reserves with <BI and investments in %B< securities. But, then, <BI realises that all the banks are having e(cess amount in their .<< and %B< account. nd more or less many banks are also having idle money and as we all knowing 1 by the time alue lost its alue!2 #hen <BI issued guidelines on Banks portfolio investment, including investment in non-%B< securities, :overnment securities, 0ebentures, Bonds capital market, later on investment in 0erivatives, %waps, and others. #he scope of the Fund Management is also increased as the investment by banks is increasing and banks are entering in a commercial business of buying and selling securities. #he Fund Management activity is increased from sub department to a department and now to a separate company, for e(ample "#"#" entures Fund Management $imited! )ven at a global market many Funds Management companies are coming with the common goal of entering into foreign financial market. In .hina, Industrial and .ommercial Bank of .hina *I.B.+ and Bank of .ommunications, establishing Fund Management companies together with .hina .onstruction Bank, would chose the mode of setting up %ino-foreign joint fund management companies. mong them, industrial and .ommercial Bank of .hina, .redit %uissi First Boston *.%FB+ and .hina Ccean %hipping *:roup+ .ompany would jointly initiate I.B.As fund management company that was being brewed, while Bank of communications stated that it would co-invest a fund management company with 9ong6ong and %hanghai Banking .orporation *9%B.+ and .hina >acific Insurance .orporation *.>I.+. ll of the three banks happen to coincide in keeping a close eye on well-known international fund management companies, indicating that they are endeavored to make fund management companies the investment institutions with international standards.
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t present, .hina has established forty-si( fund management companies, thirteen of which are %ino-foreign joint ventures. #he operation of these %ino-foreign fund management companies reflects that, with yearsA e(periences in foreign markets, foreign shareholders have brought about e(cellent management e(periences and brand effects.
Approaches to Funds Management

In recent years, several items have been used to describe approaches to funds management. Cften these terms, such as balance sheet management and asset3liability management, are used in changeably with funds management. #o provide more specific differentiation between these terms, it is useful to define them consistent with their original usage and to consider them as approaches within the framework of funds management. #hus, the concept of funds management may be thought of as incorporating two major systems-oriented approaches, *-+ %Dynamic& balance sheet management'application of optimi;ing management science models to funds management in a multi-period conte(t and */+ asset(liability management'application of deterministic, computer-based financial planning models to funds management in a short-run conte(t. #hese approaches should be applied consistent with the basic objective of wealth ma(imi;ation. #wo other approaches are often associated with funds management, economic interest rate forecasting models and specific application management science models. #hese latter models are not, in of themselves, systems oriented funds management approaches. <ather, these models are designed to solve specific banking problems and3or are incorporated in more general or systems oriented funds management approaches. sset3liability management is the primary focus of bank funds management today. sset3liability management is responsible for the ac'uisition of funds *liability management+ and for their allocation *asset management+. Its basic purpose is to structure bank asset3liability portfolios which are consistent with ma(imi;ation of shareholder wealth, subject to the constraints of an uncertain world. #hese constraints include uncertainties about seasonal deposit and loan flowsD local, national, and international economic conditionsD monetary policy effects on the -7
money supply and level of interest ratesD and customer usage of lines of credit. #here are also constraints imposed by regulation and management policies. Bank asset3liability committees differ in their approaches to funds management. 9owever, the essence of asset3liability management is coordination of the interrelationships between the sources and uses of funds in short-term financial planning and decision making. It also re'uires the need for an overall view of the bank, an understanding of the assumptions that underlie decisions and awareness of the sensitivity of the desired results of the decisions to changes in these assumptions *e.g., interest rates+. #he short-to-intermediate-term results sought in asset3liability decisions should also be consistent with the objectives specified in the bankAs strategic, long-range plan. #he time hori;on for asset3liability management decisions is typically from one to si( or twelve months. #his contrasts with the even shorter time hori;on for decisions concerning legal reserve re'uirements and the longer hori;on necessary to implement major changes in the basic elements of the bankMstructure, customer base, major asset3liability components and composition, earning retention, and capital structure.
Productive Theory of Credit +Commercial, oan Theory%

4arious approaches to bank funds management have evolved over the years in response to the changing nature of banking and its environment. #he dominant theory of li'uidity management was the Kproductive theory of credit2. #his approach which focused on the asset side of the balance sheet was introduced in )nglish banking called the Kcommercial-loan theory.K #he productive theory of credit *commercial loan theory+ held that bank li'uidity was assured as long as it earning assets were composed of short-term loans li'uidated in the normal course of business. More specifically, the theory states that banks should make only Kshort-term, selfli'uidatingK loansMloans which Kgenerate their own repayment.K #hese are loans made to finance the short-tern KproductiveK *not speculative+ seasonal or temporary working capital needs of business and agriculture. <epayment for these loans is
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generated from the cash cycle of the working capital *inventory or crop+ which had been financed by the loan cash to inventory to accounts receivable to cash. Firstly, banks had to look primarily to their loan portfolios for supplemental li'uidity *beyond cash and e(cess reserves, if any+ because there was no significant alternative. #here was not a sufficient volume of short-term marketable securities which banks could ac'uire and subse'uently sell if needed for li'uidity. s a result, there was only a small volume of short-term. #he productive theory of credit had several shortcomings in providing credit and bank li'uidity needs. Its basic shortcoming as a source of li'uidity was that many of the loans were not, in fact, short-term or self-li'uidating. Boans to meet effectively longer-term needs were made on a short-term basis and routinely renewed. lso, during periods of economic stress working capital loans which would normally have been repaid from the cash cycle proved to be illi'uid. #he likelihood of these loans being illi'uid was highest during those times when banks most needed li'uidity. #hus, while widely advocated in banking circles, the productive theory of credit was, by choice or necessity, only loosely followed in practice.
Theory of #hifta-ility to the Market

Eith the rapid growth in :overnment %ecurities market. Banks evolved a future variant of asset shiftabilityMthe Ktheory of shiftability to the market.K #his broader concept of li'uidity management involved bank purchases short-term :overnment %ecurities and their sub-se'uent sales as needed for additional li'uidity. #his concept continues today as a key element of asset3liability management.
Anticipated,income Theory
0uring the -=?5s and -=@5s banks evolved the so-called Kanticipated-income theoryK of lending. #his theory states that bank may properly make longer-term loans with repayments schedule from future income. #hese scheduled repayments provide a source of li'uidity to meet bank needs. #he impetus for the anticipated loan theory was the low demand for bank credit, resultant e(cess bank li'uidity, and low bank profitability during the depression years. #he adoption of the anticipated-income
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theory encouraged banks to become more aggressive lenders by making amorti;ed loans with longer maturities. #hese loans included term loans to business *in addition to short-term working capital loans+, residential real estate loans with e(tended maturities, and consumer installment loans. #he anticipated-income theory thus provides alternatives to the theories of productive credit *longer maturities with amorti;ed repayment+ and asset shiftability *more emphasis on re payment from income than collateral+. Ehile this theory improves bank profits, it does not normally provide ade'uate li'uidity to meet seasonal or cyclical deposit withdrawals and3or loan re'uests.
Pool,of,Funds Approach
#he pool-of-funds approach gained wide acceptance in the -=?5s and -=@5s. #his approach holds that bank funds sources comprise a Kpool-of-fundsK from which asset allocations are made. It was feasible to treat bank funds sources as a pool because of their relative stability and low cost during this period. llocations from the pool are basedD first, on meeting li'uidity needs and, second, on achieving profitability objectives. In other words, funds from deposits and other sources are conceptuali;ed as pooled for prioriti;ed allocation. #he priorities for the allocation of funds from the pool are, *-+ .<< and %B<, */+ Boans, and *?+ Investments for income. Fi(ed assets are usually e(cluded from the day-to-day allocation process, having been financed from initial or subse'uent capital inflows. #)) and S$) maintenance is one of the major functions of the Fund Manager. #his is mainly because the <eserves are maintained on the overall financial figures of the Bank and no other department of the Bank other than Fund Management will be able to handle it effectively. Cn account of Funds Management, Funds ManagerAs active involvement in bankAs major day to day operations can manage the <eserves Maintenance more effectively than others. Ehile .<< management is directly related to the overall li'uidity position of the Bank on day to day basis, %B< Management is nothing but management of more than ?5L of the ssets of the banks.
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$oans represent the second priority in the allocation of funds from the asset pool. Cnce .<< and %B< needs have been provided for, funds are allocated to the primary business of banking-lending. Business loans represent the traditional type of loan among the various kinds of loans banks make. Ehile loans provide the primary source of bank revenue, they also provide li'uidity from repayments. and in the secondary markets. "n estments for income are the final priority for the allocation of funds. Ehile %B< and investments for income both included under the caption KsecuritiesK on the balance sheet they are held for different objectives. s mentioned, the primary objective of secondary reserves is li'uidity and, secondary, profitability. #he reverse is true of investments for incomeMtheir primD objective is profitability and, secondarily, li'uidity. &onetheless the maturity interest payments and sale of investments generate li'uidity. Because these securities are not e(pected to be needed for li'uidity, they may be invested more KpermanentlyK than %B< reserve securities, if deemed appropriate for income purposes. #he securities used in investment-forincome portfolios includes :ilt )dge %ecurities, Bonds of .entral and %tate :overnment, .ertificate of 0eposit and Mutual Funds #he pool-of-funds approach provided satisfactory profits as long as funds could be allocated without undue concern for the source and costs of funds. ttention could be focused on the asset side the balance sheet as long as bank deposits were predominately stable, interest-free, and grew ade'uately to meet increased lo demand. #hese conditions began to change K>ermanent *stable+ demand and savings deposits declined relative to total assets, their growth lagged the increase in loan demand, and interest sensitive deposits *at relatively high interest rates+ became significant. #he result was that banks could no longer afford to ignore the nature, cost, and volatility of funds sources in making asset decisions. #his development e(posed the primary weakness of the pool-of-funds approach-its focus on asset management to the e(clusion of the liability side of the balance sheet. lso, some loans are payable upon demand *KcallK loans+ and others may be sold through loan participate
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Asset Allocation Approach +Conversion of Funds%

#he method of Kasset allocationK *also called Kconversion of fundsK method+ gained wide acceptance as an improvement in the pool-of-funds approach. sset allocation recogni;es a number of asset3liability linkages. It is based on the premise that available funds should be allocated to assets of the type and maturity appropriate to the velocity *turnover+ of these funds. Behind this emphasis on velocity is the need to provide li'uidity to meet deposit withdrawals. Gse of the velocity prescription suggests, for e(ample, that deposits with low turnover should be allocated to relatively long-term, high-yielding assets, and vice versa. #his means that relatively e(pensive savings deposits can be invested profitably because of their low turnover rate. #his matching of liability turnover to asset maturity is facilitated by grouping the major sources of funds into four Kmini-banksK called, *-+ Kdemand *deposit+ bank,K */+ Ktime *deposit+ bank,K *?+ Ksavings *deposit+ bank,K and *@+ Kcapital funds bank.K Funds in the high turnover demand bank are allocated to .<< and %B< and loans, which are compatible with legal reserve re'uirements and the turnover of the funds in this bank. lso using the velocity of funds criterion, time-bank funds are allocated to .<< and %B<, loans, and KotherK *primarily ta( e(empt+ securitiesD savings-bank funds are allocated to .<< and %B<, mortgage loans, and KotherK securitiesD and, lastly, capital funds are assigned to fi(ed assets and KotherK securities. #he use of asset allocation results in generally improved bank profits through reduced holdings of cash assets and by increased holdings of :ilt-)dge securities. Its most obvious major shortcoming is the use of velocity to measure funds volatility. #his criterion fails to distinguish between the turnover of a given deposits and the minimum deposit balance at a given point in time. In other words, asset allocation errs in allocating funds to assets with maturities consistent to the turnover of the funds
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rather than their minimum balance. For e(ample, demand deposits may turn over many times a year their daily minimum balance may be a large proportion of the annual average balance. 9igh deposit velocity does not necessarily mean high deposit volatility. .ontrary to the principle of asset allocation, this suggests that a substantial amount of demand deposit may properly be used to support more profitable, longerterm assets rather than only short maturity loans and investment.
ia-ility Management
K$iability management,K as it later became known, evolved out of the changing banking environment. )arlier approaches to funds management met their li'uidity needs from the asset side of the balance sheet. Biability management represents a distinct break with this tradition. #he basic thrust of liability management is to purchase funds by issuing liability in the money markets to meet increased loan demand and other needs for li'uidity. Biability management thus represents a much more aggressive approach to li'uidity management than previous approaches. #he origin and development of liability management is due to strong loan demand and subse'uent pressure on bank legal reserves. :enerally, liability management considered to have begun in &ew Nork with the sale of negotiable certificates of deposit *.0s+ by &ew Nork .ity banks and by the creation of a secondary market in .0s. Biability management can provide a sound supplement to asset sources of li'uidity. mong the major sources of funds included under liability management are, *-+ <eserve Bank of India borrowingD */+ Borrowed FundD *?+ repurchase agreementsD *@+ %ale of commercial paper through bank holding companies and3or their affiliates. 9owever, as mentioned previously, the use of these sources of borrowed funds is an aggressive way of supplementing bank li'uidity needs. Ehile liability management can provide li'uidity beyond that available from asset sources, it"s continued successful use normally re'uires banks to be able to sell additional liabilities to refinance
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those that are maturing. #he major risk to a bankAs use of liability management is that money-market participants will perceive it as having grown too reliant on purchased li'uidity and without sufficient asset li'uidity to meet unforeseen cash needs. If this happens, the bankAs access to additional purchased liabilities will be drastically curtailed. #his concern has resulted in the .0s of major banks being sold at lower yields than those of smaller banksMdue to lower perceived risk. bankAs ability to sell liabilities also depends upon market conditions and its willingness to pay market rates. Banks can afford to pay increasing rates for purchased funds only if they are able to maintain an ade'uate spread between the marginal costs of these funds and the rates charged on the loans made with the funds.
.ealth Ma/imi0ation
#he basic objective of commercial banksMand other profit-seeking organi;ations for that matterMshould be wealth ma(imi;ation. Eealth ma(imi;ation is viewed from the perspective of the residual claimants on bank assets and earnings, the common stockholders. Eealth ma(imi;ation is defined as the ma(imi;ation of the present value of future cash flows accruing to the common stockholders. For a particular stockholder these cash flows can represent dividends and3or capital appreciation. Cperationally, the pursuit of wealth ma(imi;ation is constrained by the realities of an uncertain future, managementAs view of the appropriate risk3return and economic3social tradeoffs in banking, banking regulation, etc. Eealth ma(imi;ation is a function of several, often interdependent variables, including total revenue, costs of bank liabilities overhead costs, ta(es, time value of money, and stock risk premises. #hese variables are themselves influenced by, *I+ total asset */+ proportion of capital to total liabilities and capital accounts *?+ capital proportion and costs *of capital notes, preferred stock common e'uity+D *@+ e'uity shares outstanding and dividend policyD *7+ asset composition and yieldsD *$+ liability composition and costD *H+ bank cost structure *direct and indirect costs+D *J+ ta(esD
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*=+ the credit, interest rate, market and purchasing power risk associated with the bank portfolio of assets, liabilities, and capital. .hanges in any one of these factors often interact with others. For e(ample, an increase in term loans made from the proceeds of sale of #reasury bills affects the bankAs present and future cash benefits and the investorAs re'uired rate of return because of changes in the following, *-+ asset compositionD */+ average yields of loans and securities heldD *?+ certain direct costsD and *@+ credit, market and purchasing power risks of the bankAs asset portfolio. %ignificant changes of this type can also affect the marketAs perception of risk-return characteristics of the bankAs stock, i.e., the risk premium component of the marketAs re'uired rate of return for the stock. #hus, this single e(ample of a new loan and sales of securities therefore turns out not to be so simple when its implications bank portfolio risk-return behavior is traced. #ake this single case and multiply it by thousands of bank transactions of all kinds and comple(ity occurring each day into the indefinite future and one can appreciate the need for an analytical framework which attempts to guide bank decision making toward the basic objective of wealth ma(imi;ation. #raditionally, however, the myriad of bank funds decisions were made primarily on the basis of asset and, later, liability management approaches. #hese approaches were fre'uently supported trend forecasts of the key variables *e.g., core demand deposits+ and fine tuned by e(perience and judgment. 9owever, these approaches were necessarily narrow in focus and did not include of the factors and interrelationships necessary to determine systems impact of the decision made. Gnder these conditions, there was no way of estimating how closely their decisions came to ma(imi;ing shareholder wealth. &either there was any systematic way of estimating profits foregone by particular decision.
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#wo appro(imately parallel developments gave impetus to systems app caches to bank funds management. %ystems approaches are more likely to appro(imate the ma(imi;ation of shareholder wealth than are traditional approaches. Ideally, these approaches should do the following, First, with the widespread use of computers in bank operations, it became feasible to introduce management science approaches to bank funds management. %econd, with the evolution of liability management, it became necessary to introduce more comprehensive, interactive approaches to funds management. #he necessity arose from the evolution of banking from core-deposit banking to purchased-money banking. Eith this change banks became not so much deposit creators based on the e(cess reserves of core deposits as financial intermediaries involved in the buying and selling of funds. #he profitability of banks no longer depended so much on the difference between lending rates and basically fi(ed deposit rates. >rofits became more dependent on the highly variable spread between borrowing and lending rates. manner consistent with wealth ma(imi;ation. s a result, computer-based, systems approaches to bank funds management were needed to guide decision making in a
Balance #heet Management

#he application of management science *operations research+ to funds management introduced a new methodology to bank decision makingMa methodology which applies analytical techni'ues to the solution of comple(, large-scale organi;ational problems. #he objective is to provide the best possible *optimal+ solution in as certain world within the constraints of management policy regulation. #he potentially most important use of management science banking is in systems oriented approaches to Kbalance sheet management.K Balance sheet management is concerned with the coordinated management of the entire balance sheet and its inter relationships. It incorporates the concept of liability management with relevant aspects of earlier asset management approachesD balance sheet management facilitates improved overall profit plan and performance, while maintaining li'uidity, solvency and deposit safety in an uncertain world consistent with management policies and bank regulations. #he systems orientation of balance sheet management was made feasible by the use of management science techni'ues, especially linear programming.
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#he application of management science to bank funds management may be more appropriately called dynamic balance sheet management. #he word KdynamicK refers to the fact that the planning and decision making should not be made in a singleperiod conte(t. #he dynamic nature of the banking environment re'uired an assessment of the multi-period implications of todayAs forecast and decisions. #he planning hori;on must be e(tended to increased several periods. $inear programming models provide the analytical underpinnings to dynamic balance sheet management. Binear programming problems are a subclass of what are known as optimisation problems. #hese are problems that involve the ma(imisation or minimisation of a mathematical function in which the variables are subject constraints. Binear programming involves the ma(imisation *or minimisation+ of a linear function of variables which are subject linear ine'ualities. #he goal of the functionMthe objective functionMis to achieve the most efficient, feasible allocation of resources to achieve the stated economic objective. Because of the difficulties in applying concepts of wealth ma(imi;ation to the specification of an objective function, the function is usually defined in more operational terms. :enerally, the objective functions which banks attempt to ma(imi;e include discounted or undiscounted rates of return on assets, cash flows or net income. #o formulate a linear programming model for balance sheet management, the decision and forecast variables of the model must be determined. 0ecision variables are those assets and liabilities over which management can e(ercise control and for which the bank desires to determine optimal values. 0ecision variables typically include the various types of money-market assets, securities *e.g., #reasury bills+, money-market liabilities *e.g., negotiable .0s+, long-term liabilities *e.g., capital notes+, and capital *e.g., dividend policy+. Forecast variables are those over which management cannot e(ercise control or which are primarily determined by events e(ternal to the model. #hese variables typically include interest ratesD cash and due from bankD various loan and deposit categoriesD and common stock, surplus, and undivided profits.
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First and latter two points have proven to be major obstacles to effective use of these models to determine the optimal se'uence of balance sheet positions over a multiperiod planning hori;on, respect to the latter point, in recent years financial variables fluctuated widely and often une(pectedly. #he result has been errors in the forecasts re'uired in the models. #hese forecasting errors have caused a significant decline in the reliability of the me target values for asset and liability components. #hus, linear programming models have yet to attain the primary role in bank funds management that had been anticipated for them. &onetheless, management science models have proved t very helpful in assisting the decision process at less than the g level of balance sheet management. #oday, specific application models represent the most promising area for continued development and use of 'uantitative techni'ues in bank funds management. balance sheet management awaits, *-+ significant improvements in forecasting techni'ues, */+ management acceptance of these models, and *?+ their integration into the decision making process on a continuing basis. %pecific application models are not generally designed to find optimal solutions *as do linear programming models+ to goal attainment. <ather, they are typically KdeterministicK models designed to project the results of alternative decisions and forecasts according to prescribed sets of computational relationships. s suggested previously, a primary role for management science models in global
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#ources of Funds1 Capital Fund
commercial bank has usually access to three sources of funds, capital funds, deposits and borrowings. %pecifically, when a bank sells shares, accepts deposits, or borrows money, it is thereby provided with funds that enable it to ac'uire earning assets in order to grant loans and to make investments. Interest earned on these loans and investments provides the principal source of earning out of which the bank meets the operating e(penses involved in attracting and servicing deposit accounts, and in managing its loans and investments. #he residual earnings accrue to the bankAs owners. #he sources of bank funds constitute the left-hand side of a bankAs balance sheet as opposed to the right-hand side, which shows the assets that a bank owns, i.e., the uses to which it puts the available funds. Gnlike the situation in other kinds of business, the left-hand side of a bankAs balance sheet is made up overwhelmingly of liabilities, and only to a much lesser e(tent of capital funds and deposits. Indeed a closer look at the funds reveals that banks rely heavily on debt to finance the ac'uisition of assets, which, therefore, in fact, are the debts of others--the .entral :overnment, state governments, businesses and individuals. #his situation has earned for banks the reputation of being Kdealers in debts.K BankAs reliance upon each of the above-mentioned sources of funds and the e(tent of much reliance are neither incidental nor guided by the dictum Kthe more funds, the betterK. Instead, they are matter of the policy developed by the Board of 0irectors of each individual bank.
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Capital Funds
It is generally believed by bank e(ecutives and writers on banking that the ultimate financial strength of a bank lies in its capital funds. But the problem of bank capital is not 'uite that simple. It is not merely a 'uestion of Kthe more capital, the better,K but rather of Khow much capital for what reasons or purposes.K #he bank depositors may favour the ma(imum amount of capital as protection against the risks inherent in the banking business. #he bank shareholders may, from the short-range viewpoint of ma(imising profits, wish to operate with as little capital as possible in order to gain the greatest leverage in earnings from employment of deposits. #he apparent conflict of interests between the shareholders and the public is not, however, as sharp as it might appear at first sight. #he general public is interested in the higher profitability and safety of the funds of a bank, because the public e(pects the shareholders to assume all the risks. Bower profitability of a bank kills the faith of the prospective depositors and all their incentive for investing in the various deposit schemes. t the same time, it is in the interest of the shareholders to combine profitability with safety, because in the longrun only this combination will maintain and increase the return of their investment. 9ence, the significance of ade'uate capital funds cannot be gainsaid. In business, capital is broadly defined as a firmAs assets minus its liabilities or the funds invested by business owners for the operation of the business. For banks, capital includes common stock, preferred stock retailed earnings, and surplus reservesD in combination, these represent the value of the stockholdersA ownership of the bank *or ownersA e'uity+ bankAs capital base also may include long-term capital debt.
The Purposes of Bank Capital

#he most obvious purpose of bank capital *although minor in comparison with other businesses+ is that it provides funds for fi(ed-asset purchasesMbuildings, e'uipment, and other physical assetsMnecessary to conduct the bankAs business. #hese are the bankAs non-earning asset and, compared with those of other non-financial businesses, they represent only a small traction of the bankAs total assets and a comparatively small application of a bankAs total capital.
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#he major purposes of capital in banking are threefold, to insist against bank insolvency or failure by offsetting or absorbing potential losses in the value of the bankAs loans and other assetsD to protect again temporary losses of li'uidityD and to ensure public confidence in the bankAs ability to cope with shifts in economic conditions that might lead to loan losses or untimely sales of securities. .apital is also the basis again which regulators impose lending limits *particularly on the amount of funds that can be lent to an individual borrower+ and the basis again which market participants evaluate a bankAs level of profitability and. conse'uently, its investment potential. major difference between banks and other businesses is that banks operate with a much lower level of capital than non-financial businesses. 9owever, their financial leverage is considerably more than other bust-ness firms because banksA raw material is customer deposits, which boon use to make loans and invest in other assets. &evertheless, capital is the basic source of a bankAs solvency, and its ultimate purpose is to cushion Cf absorb loan losses and protect depositorsA funds. #he smaller the capital cushion, therefore, the more limited a bank will be in its lending, both in terms of the risk and the li'uidity it may assume in loans. bank with more capital has a greater cushion against loan losses and can assume higher risk, longer-term loans. In this case, earnings may be higher, but because the 'uality of earnings is lower, more capital is needed to cushion possible losses. .apital is also the basis on which bank regulators set limits on lending. #hese limits restrict the amount that can be lent to any one borrower to a certain percentage of the bankAs total capital. %uch limitations force banks to diversify their loans, thus protecting banks from concentrating funds in one or two major loans that may lead to major losses. Finally, capital is the basis for market evaluations of bank performance. >otential investors assess the return on investment available from various banks by comparing a bankAs e'uity with its net income. #he appropriate level of capital that a bank should maintain has been and will continue to be a matter of debate. lthough banks obviously must have sufficient capital to operate safely and profitably, capital ade'uacy is difficult to define because /=
it means different things to different constituenciesMnamely, the bankAs regulators, depositors, and shareholders. #o the bankAs regulators and other supervisors, ade'uate capital serves to cushion the bank against possible losses on loans and other assets, thus protecting the funds of the depositors. <eserve Bank of India and other regulators *who act in the interests of depositors and the general public+, as well as the !" #C is for ndia), are concerned that banks maintain enough capital to continue operating if troubles arise. #o bank depositors whose funds are insured by " #C, capital ade'uacy is a concern that is often left to the supervisory agencies since their funds will be fully protected if the bank should fail. Barge uninsured depositors, however, are rightfully concerned that a bank in which they deposit funds operate with ade'uate .apital. %uch depositors may analy;e their bankAs capital position carefully. Cthers large deposits, on the other hand, rely on analyses of .apital by supervisory agencies because, although their depositors more than -55,555 are uninsured, their loan obligations to the Bank often e(ceed the amount of their deposits. #he bankAs shareholders May view ade'uate capital as being that which ma(imi;es earnings on a minimum level of capital investment. Bank owners may be able to earn the same net income on a tower level of capital, whereas a higher level of capital will reduce bank profitability ratios. .arried to an e(treme, such a view would lead to great risk in bank operationsD but bank shareholders. .apital ade'uacy and capital management are comple( issues, but we can safely generali;e that most banks want to maintain ade'uate capital in order to maintain public confidence in the bankAs safety and conse'uently attract public deposits that will ensure bank growth and profitability. #hus, ade'uate capital broadly defined is that level of capital that allows a bank to assume sensible business risks in its loans and investmentsD to maintain public confidence that the bank can sustain operating losses, securities sales losses, and loan lossesD and to continue to earn a reasonable profit for its shareholders.
Methods of Increasing Capital

de'uate capital provides a bank with a base for the growth of its deposits and assets. bank with inade'uate capital is thus constrained in its ability to grow, while a bank with too much capital may find that, its growth is not as profitable as it should be.
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.apital re'uirements are varied and comple( because they are determined by a variety of regulatory agencies, including <eserve Bank of India *<BI+, %ecurity )(change Board of India *%)BI+, .entral :overnment and others. Gntil recently, suggested capital ratios varied, but the bottom line is that a bank should have enough capital to inspire public confidence in the bankAs stability, but not so much capital that stockholders are unable to earn a reasonable return on their investment. bank that wants to e(pand its business by actively seeking more deposits and loans must e(pand its capital base in order to do so. %imilarly, a bank must e(pand its capital base if economic conditions in its local business community lead to growth in the bankAs deposits and loan demand, whether or nut such growth is actively sought. Further more, a bank that seeks to attract large borrowers must meet Banking <egulation, %)BI and <BI laws that limit the ma(imum amount that can be lent to one borrower to a percentage basis of the bankAs capital. bankAs initial source of capitali;ation is the purchase of e'uity stock by the bankAs shareholders. fter this, the bankAs capital base can be increased in two basic waysM through e'uity financing, which includes profit retention and issuing additional shares, and through debt financing, which involves issuing long-term bonds and debentures.
Functions of Capital Funds

#he functions of capital funds in the commercial banking system are 'uite different from those in other types of enterprises. #he high degree of financial leverage encountered in commercial banking gives a different dimension to the functions performed by the bank capital. .apital can be e(amined from different viewpoints, vi;., those of the bank itself, its depositors, and its shareholders. #he initial function of bank capital is to provide funds for fi(ed investments, such as building, furniture, machinery, e'uipment and the supplies necessary the establish a bank as a going concern. Cnce this operational need is fulfilled, the ground is ready for the various functions of the capital to come into force. Firstly, from the depositors" point of view, the function of the capital is to provide a margin and protection to their
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claims in the event of li'uidation. )vidently, the capital plays an important role in the daily operations of a bank. In the broadest sense, it protects the depositors and other creditors by providing the security with which to take sensible business risks. In other words, the capital performs the function of a guarantee and safety against any losses arising from the lending, investing, and all other activities incidental to commercial banking. .apital, then, serves to maintain the institution as a going concern. %econdly, from the stockholdersA point of view, the function of a bankAs capital is to achieve a sufficient yield in order to meet operating costs, and to afford a fair return to its owners. Eith rare e(ceptions, the suppliers of bank capital are indeed motivated solely by the desire to own a good investment. lthough they do reali;e that the nature of business entails special obligations essential to public welfare, yet they invest in the shares of a bank for the same reasons that they choose to invest in the shares of any other business enterprise, namely, to obtain a competitive return on their funds and appreciation on their shares. Gnless this return is assured they would have no reason to continue their shareholding in the bank. #he protection function of the bank capital is considered to be of primary significance. Indeed, if a bank is to continue as a going concern, its capital funds must be ade'uate enough to create confidence among the e(isting depositors and to attract new depositors. #hus, to ensure the protection of the depositorsA interests is the main function of the capital funds. Bastly, an important function of the bank capital is that of supporting the credit risks a bank is called upon to assume in its normal lending business. #he <eserve Bank of India regulations limit the amount a bank can advance to any class of borrowers to a certain percentage of its capital. #he desire for a larger lending limit has inspired many banks to seek additional capital through mergers and amalgamations. n even more important part of the confidence a bankAs capital funds inspire is the assurance that it will be able to e(tend the credit that its community needs and to assume safety in the risks involved.
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2eed and 3olume of Capital Funds

#he ade'uacy of the capital of the commercial banks has been a major concern of the :overnment and the regulatory authorities throughout the banking history. #o make sure that banks maintain ade'uate capital, the :overnment and the regulatory authorities have to interfere to a varying e(tend in the banking affairs. #he Indian banking history is characteri;ed by a number of periods of unrestrained bank e(pansion and individual bank abuses, which led to bank failures, and losses to depositors and shareholders. In order to avoid the destabili;ing effects of bank failures, the need for regulatory intervention to supplant the judgment of the banks in matters relating to capital ade'uacy become apparent. #his intervention has taken the form of legal laws and banking regulations that establish criteria for warding off and preventing back insolvency. #hese criteria consist of certain minimum capital re'uirements for the organi;ation of a bank, and norms to ensure prudence in bank operations. #he general public being commonly not well versed in the field, the supervisorAs judgment has over the years, become especially decisive for a bankAs continued e(istence. #hus, today it is among the supervisory authorities that a bank must inspire sufficient confidence as to its ade'uacy to withstand whatever strains may be placed upon it. In a closely supervised private banking system, it is the supervisory appraisal of capital ade'uacy that determines whether and under what conditions a bank may continue to e(ist. If the capital is considered ade'uate by the e(amining supervisory authorities, it would be satisfactory for the general public too. Cbviously, an ade'uate capital position plays an important role in safeguarding public confidence in the operations of a bank. In the opinion of an eminent writer on the subject, the bank capital ade'uacy may be viewed as the most important factor in maintaining the confidence a bank must enjoy in order to continue in the business and prosper. #he essential function of the bank capital, in other words, is to keep the bank open and operating so that its earning can absorb losses, and to inspire sufficient confidence in the bank on the part of the depositors and the supervisors so that it will not be faced with costly li'uidation.
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#ources of Funds1 '*P4#IT#
cceptance of deposits and maintenance of deposit accounts is the core activity in any bank. #he very basic legal interpretation of the word AbankingK as defined in the Banking <egulation ct, -=@= means accepting deposits of money, for the purpose of lending or investment, from the public, repayable on demand or otherwise, and withdrawals by che'ue, draft, order or otherwise. Most of the funds that a bank uses for leading come from the bankAs total pool of deposits. #he many deposit instruments that this funding source comprises may be classified in a number of ways. >erhaps the clearest approach is to distinguish between retail and *holesale deposits. <etail deposits are those of the general public including consumers, small businesses, and other commercial enterprises. Eholesale deposits are those of large commercial and industrial corporations, units of government, and other financial institutions. .he'ue collection and payment services, many are keeping their demand deposit balances at minimum levels and moving the bulk of their funds into interest-earning accounts. #his is particularly true of larger retail deposits. For many banks the result has been that the bulk of the retail demand deposits are now low-balance accounts that are becoming increasingly less profitable when measured against the costs of providing transaction services. #hus, retail demand deposits play a less significant role as a source of funds as compared to the past. Cver the past /7 years, the volume of retail demand deposits as a percentage of the total deposits of insured banks has fallen roughly by half.
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evel of 'eposits
In the commercial banking system, the level of deposits is directly a function of the amount of credit e(tended by banks in the form of loans and investment. If banks did not resort to lending and investing, they would have deposits e'ual to the amount of currency left with them by depositors. #his apart, the level of deposit increases with the spread of the banking habit, as also with the steady rise in money supply. #hus, the level of deposits is governed by a host of factors, such as money supply, credit e(tension, personal savings, and growth of economic activities in country. In India, banks have made an admirable job of reaching out to the people and providing banking facilities within the reach of the common man, and thus generating deposits from every nook and corner of country. fter &ationalisation the competition between banks has been increased and then by introducing of private and foreign banks competition is on the peak of iceberg. #his trend in market capitali;ation reveals that banks, which have placed greater trust on retail banking activities have gained advantages. nd this will increase the level of deposits of banks because to ac'uire the new customers and to retain the old one the banks are planning many new innovative policies and have emerged a new concept, which includes, *lectronic Fund Transfer or, say, Anytime Any*here banking. #hrough this facility of banking, bank customers" can perform the transaction at any where through #M machine, Internet, Mobile, and others he don"t have to physically visit the bank and wit for his number. Portfolio Management on -ehalf of customers means the customer will ask bank to manage his idle money by in different securities. Eith this service the customer will get the advice of the >ortfolio Managers with no charges and also he will earn the good amount of profits. 9ere, the customer don"t have to worry about his money as he know that his money are with the e(perts who have great knoeledge and e(perience.
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Cash Management %ervice is an efficient, bench marked, technologically aided fastest way of intercity collection3 pooling3 sweeping of funds to one account or making payments at any centre of choice, or vice versa. .ash Management %ervice works on the principle of #ime value of money. Faster collection of funds ensures savings on high interest cost on borrowings, reduction of operating cycle and thereby reduction of borrowal needs, higher li'uidity, opportunity to earn from availability of surplus funds,
'eposits of 4ther Banks

0eposits that banks obtain from other banks include those of correspondent banks, foreign banks, and central banks of foreign countries. 0eposits of correspondent banks are the largest and most important category of deposits from other financial institutions. Banks maintain deposit balances with their correspondents in e(change for interbank services and transactions such as check clearing, loan participations, funds transfer, securities safekeeping and management consulting as with commercial and government accounts, compensating balances are maintained in return for services rendered. Barge banks use their correspondent relationships to borrow from smaller banks with e(cess funds or to lend to smaller banks in need of funds. %mall banks, in turn, benefit from services that they cannot undertake themselves or that can be handled with greater efficiency by larger banks. :enerally, a bank will enter into correspondent relationships with several banks depending on its needs. lthough banks are compensated for correspondent services dditional charges are determined by first n earnings credit is then estimated primarily through compensating balances, other charges may be assessed depending on the e(tent of the services provided. estimating the revenues that can be earned on the correspondentAs average compensating balance after reserve re'uirements tire met. for the deposits, and charges for services are made against the earnings credit, if service e(penses e(ceed the earnings credit, the additional charges are paid through fees.
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second source of deposits from other financial institutions includes the deposits of foreign banks and central banks of foreign countries. Foreign banks that need transaction services related to international banking may secure such services from banks by maintaining compensating deposit balances and paying service fees. 0eposits of foreign banks are a much smaller and much more limited source of funds for banks than are the deposits of correspondentsD they are held primarily by the large money center banks.
Composition of 'eposits
Banks are, on the one hand, custodians of public savings and repositories of surplus funds of people, and on the other, dispensers of funds for various purposes and different periods of time. Maintenance of ade'uate li'uidity of funds is very essential for them because they can not forecast the future needs for funds perfectly. gain, the nature of investment is related to the magnitude of li'uidity. #hus, the nature and composition of deposits can influence the performance and the achievement of the primary objectives of banks. n analysis of the composition of bank deposits is useful for an assessment of the relative rates of their growth. Moreover, their 'uantum is partly included in the data for computation of total money supply. 0eposits are classified as !demand" and !time" deposits. In the case of demand deposits, depositors can call upon the bank at any time for the e(change of deposits in notes or coins. %uch deposits are accounted for in the form of !current" accounts and !call" deposit accounts. %aving deposits assume the character of both time deposits and demand deposits. :enerally, no interest is allowed on current accounts, and in certain cases, the customer is re'uired to leave a minimum balance in his account. #he minimum amount is of a fi(ed nature, interest on which enables the bank to cover the cost of operations. call deposit is a certain sum of money deposited with the bank which can be withdrawn in entirely without any notice, and which carries a certain amount of interest and is kept for a short period. #his composition of deposits in the form of demand and time deposits has a farreaching effect on certain bank policies in determining the 'uantum of cash reserves to be deposited with <eserve Bank, for the cash ratio is different for these two types
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of deposits. #he banking theory that back finance should be Ashort termA Is based on the fact that major portions of bank deposits are subject to demand, and therefore, they can be used only for short-term purposes. #his composition is also significant for banks in determining the rates of interest to be changed on loans and advances, for interest paid on these two types of deposits differe significantly. #able @.- shows the ratio of deposits to the total liabilities of the selected banks over the period under consideration. #he deposit as a percentage of the total liabilities of the selected banks has improved steadily. #he ratio for %tate Bank of India as at the end of /55@-57 as compared with /55?-5@ stands at H=.J- per cent, for Bank of India at J/.== per cent, for IndusInd Bank at J?.=7 per cent and for 8ai 9ind .orporative Bank Btd at H-./@ per cent *as compared with H@.5? of last financial year+. It is seen that the deposits account for nearly more than J5 per cent of liabilities in all the banks, and that the deposits have grown steadily over the years.
Ta-le 561
"atio of 'eposits to Total ia-ilities %Figures in percentage& &ame of Banks /55@/55?-5@ 57 -. %tate Bank of India H=.JHJ.-? /. Bank of India J/.== J@./@ ?. IndusInd Bank J?.=7 H@./@ 4$ %ai &ind Corporative 'ank H-./@ H@.5? Ltd Source, nnual <eports of the above Banks #able @.- gives a snapshot view of the maturity pattern of the total deposits in percentage points. #he table reveals that there is a decline in the percentage of deposits in the category of ?-7 years as well as that of A7 years and above.A #he percentage of deposits in all other categories shows increase in -=JJ as compared to -=J$, e(cept in the A@=-$5 daysA category. #his shift can be attributed to the high interest rates on securities with Along maturity.A #hus, it can be concluded from the analysis of the above #able that, *a+ *b+ #here is a definite positive relationship between the interest rate structure and #his correlation is especially significant in the metropolitan and urban areas. the maturity distribution of deposits.
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*c+
#he rural savers still show a marked preference for longer-term deposits. Banks
may be able to attract more such deposits if interest rates in rural areas are suitably revised upwards for deposits of longer maturities. *d+ #he shift in deposits to the lower interest categories has marginally reduced the average rate of interest on deposits.
'eposit Mo-ili0ation
0eposits are the lifeblood of commercial banks. #hey are the mainstay of bank funds and account for about J5 per cent of bank liabilities. In fact the success of economic development depends upon the e(tent of mobili;ation of resources *both internal and e(ternal+, and the commercial banks are the heart of deposit mobili;ation. 0eposit mobili;ation is essential for banks to ensure a sound and broad-based financial structure by augumenting the credit e(pansion and thereby to realise the socio-economic objectives of the Indian economy. #hus, banks are compelled to continue a ceaseless search for new deposits, and to e(plore new deposit schemes. s such, deposit mobili;ation is a continuous process in the banking business. #he deposit mobili;ation efforts must be planned keeping in view the specific objectives and must be directed towards a specified group of potential depositors. 9ence, deposit mobili;ation efforts must be aimed at promotion of banking habits so that people may accept the negotiable instruments as a means of payment. In this conte(t, wide acceptability of bank che'ues is important. Besides, it is a 'uestion of making bank deposits more attractive than alternative forms of investment like gold and real assets. %uch aims can be achieved by opening branches in unbanked areas because the convenience of owning a bank deposit, both for making payments as well as earning interest income can be availed of only when there is a banking office which is easily accessible. #hus, deposit mobili;ation by merely opening a branch in an unbanked centre, however, is a once-for-all advantage, to continuously increase deposits in new branches. s regards attracting savings into banks as term deposits or savings deposits, interest rate offered is important consideration. But the influence of the level of interest rate should not be over emphasi;ed. fter all, investments in other forms, physical or financial do not have. #hese are fre'uent renewability, overdraft in case of need, absence of any cost of investment, absence of risk in capital depreciation etc. #he rate ?=
of interest on bank deposits is usually lower than the yield on other investments due to these reasons. It the investor is out to make highest income on his savings, then obviously, he would prefer other forms of investments. In inflationary conditions, speculative form of investment in commodities would certainly yield high return than may be pushed up. #his attitude, fortunately, is not common in majorities of small savers. #he cost and risk of investing funds in assets other bank deposits, as also the minimum si;e of investment re'uired, make bank deposits the natural and perhaps the only form of investment open to a majority of individuals.
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#ources of Fund1 Borro)ing
#he main sources of funds for commercial banks are capital funds and deposits, but very often while making allocation of these fundsD banks find themselves temporarily short of funds. Cn such occasions, they strive to increase their resources by resorting to borrowings and many banks with access to national money markets also purchase funds to enable them to e(pand their assets significantly. #he borrowed funds play a significant role in bank funds management because they offer banks an alternative means of li'uidity apart from asset li'uidation. #hey also enable banks to compete for funds to e(pand their earning assets rather than relying solely on funding from deposits. ll banks purchase or borrow funds from time to time to meet reserve deficiencies. #hese borrowing may be either from the <eserve Bank of India or other banks or from the any financial institutions set up for this purpose, such as Industrial 0evelopment Bank of India, &ational Bank for griculture and <ural 0evelopment *& B <0+, )(port and Import Bank of India *)IIM Bank+ and others. Instruments that banks use to purchase needed funds are known as money market -liabilities. #hese are liabilities that banks enter into at competitive rates. In addition to negotiable .0s and Bills, the major instruments that banks use to purchase funds are :overnment securities, repurchase agreements, and sales of commercial paper. Borrowing from .all Money Market is another source of short-term funds, but banks do not regularly use this funding source in their ongoing liability management strategies. %o to e(amine the trends of borrowing it is necessary to study the following heads, Borrowing From <eserve Bank of India Borrowing from Cther Banks Borrowing from Cther Financial institutions Borrowing from outside India @-
Borro)ings from the "eserve Bank of India

#he <eserve Bank of India *<BI+, being the A.entral BankA of the country, is empowered to regulate and control bank credit in the national interest. #he <BI has been vested with statutory powers to Krediscount eligible commercial papersK and to e(tend loans and advances against the security of Keligible documentsK. In fact, the relationship between the <eserve Bank and other banks is that of the lender who is the last resort #he borrowings from the <BI are significant in three respects. Firstly, they increase the elasticity and li'uidity of bankAs funds, and enable them to e(tend more credit. Cther banks with additional or alternative means of converting some of their assets into cash when their cash resources are adversely affected and tend to fall below the statutory minimum, or when they find it necessary or desirable to increase their cash reserves for one purpose or another. %econdly, although funds flowing from this source are KtemporaryK in character, yet they greatly influence other sources of funds, particularly the derivative deposits, via e(tension or contraction of credit by banks. #hirdly, heavy reliance of banks on this source of funds may be helpful in making the monetary control of the <BI more effective. #hus, it is evident that this source of bank funds in a useful tool both for the bank and the monetary authority, i.e., the <eserve Bank of India. 9owever, banks cannot avail of this source of funds as a matter of right. Cn the contrary, the <eserve bank may refuse to lend funds to a bank facing an actual or prospective deficiency in its reserves, or after making a short-term loan to a bank, it may observe the situation carefully, and if it finds that the bank has borrowed too often, too continuously, too much or for improper reasons, it may advise the bank to contract its loans or sell its securities in order to reduce or to retire its borrowings. nd <BI can also ask for 4oluntary or .ompulsory merger. #he statutory provisions regarding the grant of financial accommodation by the <eserve Bank of India to other banks are laid down in %ection -H of the <eserve Bank of India ct, -=?@. Gnder the ct, the bankAs credit e(tension can take the form of rediscounting eligible bills or advances against eligible securities. #he type of papers
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eligible for rediscounting by the banks with the <BI are described in the sections mentioned below, which empower the <eserve Bank to conduct various business. s per %ection -H*/9a+ the purchase, sale and rediscount of bills of e(change and promissory notes drawn on and payable in Indian and arising out of bonafide commercial or trade transactions bearing two or more good signatures, one of which shall be that of a bank or %tate .o-operatives Bank and maturing , in the case of bills of e(change and promissory notes arising out of any such transactionD relating to the e(port of goods from India, within -J5 days, and in any other case, within =5 days from the date of such purchase or rediscount e(clusive of days of grace. s per %ection -H*/6b+ the purchase, sale and rediscount of bills of e(change and promissory notes payable in India and bearing two or more good signatures, one of which shall be that of a bank or a state co-operative Bank and drawn or issued for the purpose of financing seasonal agricultural operations or the marketing of crops and maturing within fifteen months from the date of such purchase or rediscount, e(clusive of the days of grace. s per %ection -H*/9c+ the purchase, sale and rediscount of bills of e(change of promissory notes drawn and payable in India and bearing the signature of a bank, and issued or drawn for the purpose of holding or trading in securities of the .entral :overnment, or a %tate :overnment, and maturing within =5 days from the date of such purchase or rediscount, e(clusive of the days of grace. s per section -H*?+ *b+, the purchase, sale and rediscount of bills of e(change *including treasury bills drawn in or on any place in any country outside India which is a member of International Monetary Fund *IMF+ , i. ii. in the case of bills of e(change arising out of any bonafide transaction relating to e(port of goods from India, within -J5 days, and in any other case, within =5 days from the date of such purchase or rediscount.
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#he bills of e(change referred to in the above subsections should have a fi(ed maturity, not e(ceeding =5 days *-7 months in the case of agricultural and other bills, and -J5 days in the case of e(port bills+ e(cluding the days of grace, from the date of purchase or rediscount with the <eserve Bank, Moreover, a bill of e(change of promissory note must, at the time of rediscount or purchase by the <eserve Bank, have a definite currency embodied in the instrument itself. In case such an instrument is payable on demand, it must be duly converted into a Atime billA before it becomes acceptable under this section. 9owever, in view of the lack of a well-developed and property organi;ed Kbill market,K very little use has been made of the rediscount power so far. #he <BI assistance to the banking system has been made available through the alternative facilities. #he advances which are authorised under %ec. -H*@+ of the ct are repayable on demand or on the e(piry of the fi(ed period not e(ceeding =5 days *-J5 days in the case of e(port bills+. #hey are available against the following types of collateral securities, *a+ %tocks, funds and securities *other than immovable properly in which a trustee is authorised to invest trust money by any law in India3%ec. *b+ gold or silver or documents of title to the sale. *c+ %uch bills of e(change and promissory notes as are eligible for purchase or rediscount by the <eserve Bank or as are fully guaranteed as to repayment of the principal and payment of the interest by a %tate :overnment3%ec. In addition to these credit facilities available in normal times, the ct provides, during occasions of emergency, short-term loans not only against eligible security but also against such other form of security as the bank may consider sufficient %ec. -J *i+*?+. #his section empowers the <eserve Bank to make an advance to any bank, against any security acceptable to it in times of emergency which might make it necessary or e(pedient for the <eserve Bank to advance or discount directly, not withstanding the limitations imposed by conditions of eligibility.
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Borro)ing from 4ther Financial Institutions

Ehen banks e(perience shortages of funds from deposits, borrowings from the <BI, and other li'uidating sources of assets, they resort to borrowings from other banks, the character of funds from this source being purely Kshort-term.K Borrowings from other banks as a source of funds emerge from the arrangement under which banks keep deposits with other banks and use those banks as agents in various types of transactions, and also from the arrangement under which banks can obtain funds from special institutions as refinance facilities. #hese borrowings from other banks include borrowings from the %tate Bank of India, borrowings from other banks against balances with them, foreign bills discounted and the refinance available from the Industrial 0evelopment Bank of India, the &ational Bank for discussed in detail below. gricultural and <ural 0evelopment and the )(port Import Bank. #he borrowings from such sources are
Industrial 'evelopment Bank of India +I'BI%

#o augment their resources, banks have also been given the facility to approach the Industrial 0evelopment Bank of India *I0BI+ for refinancing and rediscounting assistance in respect of the term loans granted to Industrial concerns for setting up industrial projects, their e(pansion, moderni;ation, and diversification schemes. Eithin the general framework of the <efinance %cheme, the I0BI has been operating schemes of special K.apital ssistanceK for small-scale units under the small Industries 0evelopment Fund and for the units in backward areas. Moreover, ceilings have been imposed on the lending rates of banks so as to ensure that the benefit of lower rates are passed on to the beneficiaries. For operational convenience, the I0BI has adopted two procedures, vi;., utomatic <efinance %cheme * <%+ and &ormal <% is to e(pediate the disposal of <efinance %cheme *&<%+. #he objective of
applications and to reduce delay in the flow of assistance.
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"efinance from the 2ational Bank for Agriculture and "ural 'evelopment +2ABA"'%
Banks can also avail refinance in respect of the medium and long term loans advanced by them for the development of agriculture. #o stimulate the credit flow to these sectors, the 'uantum of refinance assistance to the commercial banks, the co-operative banks and the regional rural banks has been stepped up to -55 per cent of the bank loans from the present level of =5 per cent. #he limit of term loan assistance, which was hitherto up to <s. / lakhs in case of the individuals and proprietary3partnership concerns has also been raised up to <s. 7 lakhs for setting up cottage, tiny and village industries in rural areas having a population up to <s. 75,555
"efinance From the */port Import Bank +*7IM Bank%

In the field of e(port finance, the )(port and Import Bank of India provides refinance of medium-term post-shipment credits granted by the approved banks to e(porters who may be manufacturers, recognised e(port houses, or other kinds of e(porters of standing. It also provides relending facility to the banks to enable them to provide term loans to importers of the capital goods from India. It may be concluded that the funds from this source are mostly on demand basis. lthough the 'uantum of funds from this source may not be significant at all times, it has much value for the banking system. %uch borrowings are not considered a part of the legal cash reserve. #herefore, it serves the li'uidity purposes of the banks. lso, banks with funds in e(cess of their current needs can increase their deposits at other banks, thus shifting a part of the reserve to them, and increasing their lending power. #his method of operating may facilitate the geographical mobility of the bank credit to an acknowledgeable e(tent. #his source of financing also facilitates banks to grant long-term and medium-term loans to industry and agriculture. %ince funds from this source are mearly of the nature of refinance accommodation, banks" power to use them is severely limited.
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Certificate of 'eposits +C'%

nother source of finance for banks is that of .ertificate of 0eposits *.0+, which is a document of title to a time deposit. #he .0s intend to widen the range of money market. #he scheme of .ertificate of 0eposits was introduced by <BI as a step towards deregulation of interest rates on deposits. Gnder the scheme %cheduled .ommercial Banks, .o-operative Banks *e(cept Band 0evelopment Banks+ can issue .0s, for a period of not less than ? months and upto a period of not more than - year. #he Financial Institutions specifically authorised by <BI, however can issue .0s for a period not below - year and not above ? years. .0s can be issued within the period prescribed for any maturity. 0ue to the negotiable character of the .0 the same could be sold after the lock-in period thus enabling the investing bank to create li'uidity. #his instrument is useful to the corporates for parking their surplus short-term funds.
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i!uidity Management
#he nature of bankAs liabilities, together with the thin layer of e'uity on which a bank operates, renders the employment of bank funds a factor of primary significance. More specifically, the available total resources must be used in such a manner as would permit the bank to attain its two larger objectives of portfolio management, which may be described as follows, Firstly, a bankAs portfolio policies should be so designed as to enable the bank to meet the li'uidity re'uirements without e(posing itself either to embrrassment or unusual pressure. #hus, it becomes necessary to maintain the re'uired degree of li'uidity necessary to meet the e(igencies of withdrawals and loan demands. Secondly, the major part of bank liabilities is subject to withdrawal either on demand or at a very short notice. #herefore, bank portfolio policies must be guided by prudence,K i.e., bank lending and investing must be undertaken where there is almost complete assurance that the principal would be returned along with a good return. .learly, asset 'uality, and hence there are solvency considerations in the background of this objective. #o attain these two objectives, commercial banks have to aim at a certain pattern of distribution of their assets. )ffective portfolio management may, therefore, be taken to refer to a bankAs determination of what would constitute the best distribution of assets in its 'uest for li'uidity, solvency and profitability. #here is, though, a mutual conflict between li'uidity and solvency on the one hand and earning appropriate income on the other. #he nearer an asset is to cashing, the more remote it is from losses from default or manual risks. But such a highly li'uid and safe asset will yield a relatively low income. #he rate of return on assets tends to vary inversely to their degree of li'uidity and safety. In a final analysis, this conflict in the matter of employment of bank funds boils down to a conflict between li'uidity and profitability. K#he art of @J
commercial banking consists in solving this basically conflicting re'uirement, that of being safe and yet profitable.K- #he solution of this conflict rests entirely upon each bankAs management. It is a matter of individual judgement, based on e(perience and knowledge, and so no two banks would follow the same kind of practice to resolve this conflict.
2ature and Purpose of i!uidity Management

basic objective of portfolio management of a bank is the maintenance of sufficient li'uidity to meet varied demands for funds. More specifically, a bank must maintain highly li'uid assets in sufficient amount to meet deposit withdrawals as well as legitimate loan re'uests. #he maintenance of li'uidity funds against deposit demands is termed by some analysis Kdeposit li'uidityK or Kprotective li'uidityK as distinguished from Kleanding li'uidityK or K>ortfolio li'uidity,K which applies to maintenance of li'uid funds for meeting additional loan demands. Bi'uidity is a protection against the risk of losses by a bank being forced to sell or li'uidate creditworthy assets in an adverse market. In this sense, li'uidity is surely Kprotective.K In a more positive sense, li'uidity may be defined as a bankAs ability not only to meet the possible deposit withdrawals but also to provide for the legitimate credit needs of economy as well. #he li'uidity management of bank funds has two aspects , the li'uidity of the banking system as a whole, and the li'uidity of an individual bank. Ehile the transfer of deposits inter-se banks does not effect the aggregate li'uidity of the banking system, large-scale withdrawal of deposits becomes a major concern to an individual bank. bankAs liabilities largely consist of its contractual obligation to pay to the public fi(ed amounts on demand or at a very short notice. #he fact that a bank must meet its depositors" withdrawal demands as readily as possible dictates for it a certain type of li'uidity policy in the employment of its funds. In other words, the nature of bank liabilities makes it essential that the resources of a bank be managed in such a way as to provide for meeting demands for funds as they are made. #his obligation constitutes the most immediate and compelling necessity confronting the management of a bank. Indeed, if the bank fails to meet such demands, it may lose the confidence of the depositors. Ma(imum li'uidity can be attained through maintenance of all bank
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assets in the form of cash, but the impracticability of such a measures is obvious. Eith its assets entirely in cash and thus with no investment made, a bank would, nevertheless, incur costs of operation. In this case, li'uidity will be ma(imum, but profitability nil. Gnder the circumstances, the service charges for maintaining deposit accounts would become so inordinately high as to discourage customers from placing their funds with the bank. In determining a bankAs policy towards maintenance of li'uidity, the management must also consider the behavioural pattern of deposit accounts. ll deposit accounts do not e(hibit the same behavioural pattern. Indeed, owing to a number of factors, deposit accounts at any time do not necessarily move in the same direction or with the same A4elocity.K Fluctuations in individual accounts or groups of accounts may be offset by changes in other accounts or groups of accounts. For e(ample, if a particular industry suffers, so will its workers and the local merchants most of them back customers, and so the bank deposits will decline. .onversely, if an industry prospers, the bank deposits will swell. #hus, it follows that whatever the type of deposits, there will always be a likelihood of their being withdrawn at a short notice. In view of this, potential deposit withdrawals, as also demands for funds, may be classified into, K*a+ those which will surely occur, *b+ those which might but are not certain to occur, and *c+ those which are not likely to occur, under certain circumstances, could possibly occur.K #his classification of deposit withdrawals in accordance with the likelihood of their occurrences has a direct bearing upon the li'uidity of the assets of a bank. It is sufficient to say at this point that the greater the likelihood of such withdrawals, the higher must be the li'uidity of the assets employed. bankAs first step in establishing protective li'uidity re'uirements is to determine the likelihood of deposit withdrawals. %tated differently, a bank must determine the volatility of its deposits. #here are no absolute rules for determining deposit volatility. >ast e(perience and knowledge of the markets served would greatly contribute towards a better judgment, which, coupled with a systematic analysis of the deposits would serve as a guideline in the determination of the probable behaviour of the accounts, and hence of the bank li'uidity provisions against deposit withdrawals. 75
Affecting i!uidity Management

#he statutory provisions are the main factors affecting the li'uidity of banks. #here are also certain other factors which affect the li'uidity of banks. 0oubtlessly, the advances granted by the bank are the most profitable avenue of earning for a bank. 9owever, a bank cannot invest all its funds in advances, as it may not be possible for it to recall its advances to pay the depositors in a contingency. In practice, it is most unlikely that all the depositors would make a demand on a bank to invest a major portion of their deposit resources in high-yielding advances. #he confidence of the depositors in the banking system and the bank concerned also plays an important role in deciding the volume of li'uidity. For nationali;ed banks, the goodwill and confidence have not remained an important factor, because the :overnment patronage itself is a guarantee enough to generate public confidence. Moreover, the variability of the deposits also decides the 'uantum of li'uidity. If a bank is subject to wide variations in the deposit level, it must maintain high percentage of cash, because only in that way can it avoid the brokerage charges *payable on the sale of securities+ and the e(penses of fre'uent dealings with the <eserve Bank and other banks, and thus be able to ma(imi;e the profits. #he si;e and number of deposit accounts also affect the li'uidity re'uirements. Ehere a bank has relatively few depositors with large deposits, it is likely to need a larger li'uidity than a bank with numerous small accounts. #he composition of deposits and the e(tent of banking habit also greatly influence the deposit variability, and therefore, the re'uirement of li'uidity. 9ow much li'uidity a bank will seek in its asset portfolio also depends on the availability and cost of borrowings and other sources of funds, such as the li'uidation of securities, etc. If a bank is assured that it can at any time borrow any amount without bonus and at a low interest cost relative to yields on its assets, than obviously it has the re'uired minimum li'uidity. But if the availability of borrowings is uncertain, or if borrowing costs are high in comparison to yields on the bankAs assets, the bank would still need to have more li'uidity in its assets portfolio. Cn the other hand, borrowings from the <eserve Bank of India carry an onus, and sometimes they also become costlier. s far as borrowings from the Industrial gricultural and <ural 0evelopment Bank of India, the &ational Bank for
0evelopment or other financial institutions are concerned, these are availed for specific purposes, and hence cannot serve the li'uidity purpose of the banks.
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Trends in i!uidity Management in the #elected Banks

fter discussing in detail the concept of li'uidity management and other provisions affecting it, we shall now take up the li'uidity position of the selected banks during the period under study. #able $./ provides an insight into the li'uidity position of the selected banks over the years.
Ta-le 861 i!uidity Position of #elected Banks

%elected Banks %tate Bank of India Bank of India IndusInd Bank 8ai Bank 9ind .o-op .ash and Bank Balance s on ?-.?./55@ s on ?-.?./557 @,/?,-J,777 ?,J=,-@,5H/ /,/$,5?,7=H=,H5,5?/H,=?$ /,-7,H@,?5$ 7@,H/,5-5 ?5,@H= 4ariation mount >ercentage -J.57 ?@,5@,@J? -5,/=,/J7 /@,=J,5//,7@? -@.77 -?-.?@ =.-5
Money at Call and #hort 2otice

Banks besides cash reserve re'uirements need to keep funds in a short-term asset generally known as Kmoney at call and short notice.K #his asset refers to the money lent by banks to other banks and brokers in the call money markets, and is not subject to any statutory re'uirement against deposit liabilities. It is also very sensitive to the variations in the availability of funds for investment purposes, and to market conditions, such as seasonalities. #able $./ shows the behaviour of money at call and short notice, as also the ratio of this asset to the total assets. *a+le )$2 'e,aviour of -one. at Call and S,ort /otice %elected Banks %tate Bank of India Bank of India IndusInd Bank s the Near )nd /55@ mount >ercentage -?77? ?.?/ 5.H 5.55@ *in <s. crore+ *percentage to the total asset+ s the Near )nd /557 mount >ercentage -?5J@ /.J@ /?7 5./7 -
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0
$ses of Funds1 C"" 9 # " "e!uirement
Maintenance of <eserves is one of the major functions of the Fund Manager. #his is mainly because the <eserves are maintained on the overall financial figures of the Bank and no other department of the Bank other than Fund Management will be able to handle it effectively. Cn account of Funds Management, Funds ManagerAs active involvement in bankAs major day to day operations can manage the <eserves Maintenance more effectively than others. Ehile .<< management is directly related to the overall li'uidity position of the Bank on day to day basis, %B< Management is nothing but management of not more than ?5L of the ssets of the banks.
#tatutory i!uidity "atio

ccording to %ec. /@ of Banking <egulation company has to maintain in India, i. ii. in cash, or in gold or in unencumbered approved securities valued at methods of valuation specified by <BI, on daily basis, an amount not less than /7L or such other percentage not e(ceeding as specified by <BI, from time to time, of the total of its demand and time liabilities *0#B+ as on the last Friday of the second preceding fortnight. In computing the # " maintenance, i. ii. iii. any e(cess balances maintained with <BI over and above the .<< re'uirement by the Bank, the net balances in current accounts maintained by a %cheduled Bank with %BI and 3 or any other bank notified by the .entral :overnment any balances maintained by a <egional <ural Bank in call or fi(ed deposit with sponsor bank will be construed as cash maintained in India. 7? ct, -=@= states that every banking
Approved #ecurities constitutes of -+ Boans3%tocks issued by :overnment of India. #he :overnment, to meet its fiscal deficits, borrows from the market. #his is done through the Banker to the :overnment, i.e., <BI. <BI announces the issue of Boan by the :overnment. <BI specifically announces whether the security is approved for the %B< maintenance for the Banks. ny Bank can participate in the uction 3 make application and subscribe to these %tocks. #hese securities can be maintained in %ubsidiary :eneral Bedgers *%:B+ with the >ublic 0ebt Cffices at different <BI centers. Banks *holder+. /+ 0evelopment Boans issued by the state governments are also approved securities for %B< maintenance. #he periodical interest payment and redemption on due date is managed by <eserve Bank of India. #he Banks can have the. %:B facility for these securities also. ?+ Cther #rustee %ecurities *C#%+ are bonds 3 debentures issued by FIs3 >%Gs 3 :overnment *.entral and3or %tate+ bodies, interest and principal of which are guaranteed by the :overnment *.entral or %tate+ and specifically approved as security for %B< maintenance. lmost all the low coupon bonds issued by these issuers prior to reforms period were guaranteed by the :overnment and approved as %B< security. 9owever after the liberali;ation process were set in, these .orporations3institutions were permitted 3 advised to borrow at market determined rates but without guarantee of the :overnment. In selected cases the :overnment has guaranteed certain issues of these issuers. 9ence while classifying these securities for %B< maintenance, ensure that the particular issue has been guaranteed by the :overnment and specifically approved as %B< security for the .ommercial Banks. C#% are issued in physicals 3 .ertificate forms and the Banks have to maintain the custody of these securities. Mode of interest payments 3 redemption payment would be inscribed on the stock certificate. #he Banks have to follow up the same. s interest payments and redemptions are managed by <BI, the same will be credited to the current account of the respective
7@
Maintenance of # "
Following points are to be noted while maintaining %B<, -+ %B< has to be maintained on the &0#B *&0#B O :ross 0#B - Biabilities in the Banking system+ /+ &0#B as on %econd Friday of second preceding fortnight has to be taken for %B< maintenance. ?+ %B< has to be maintained on daily basis. #ill /7.-5.=H, multiple prescriptions were e(isting for the maintenance of %B< by %cheduled .ommercial Banks. 9owever, in order to rationalise and simplify the prescription of %B<, <BI vide its .ircular *0BC0 &o, B. -?H3-/.5/.55-3=H =J dt. /-.-5.=H+ announced a uniform %B< rate of /7L on their entire net demand and time liabilities which is the minimum stipulated under %ec. /@ of the Banking <egulation ct -=@=.
#u-sidiary General edger Facility

Banks and other financial Institutions can have %:B facility for operating in :overnment securities. %:B facility is similar to having depository facility in other stocks 3 securities for which Banks have to open %:B account with >ublic 0ebt Cffice at <BI. #he :overnment stocks held in its portfolio are maintained in dematerialised form. %:B account holders are to maintain .urrent ccount also with <BI. n entry in the %:B account reflects any ac'uisition or sale of stocks by the account holder and the closing balance as the amount of stock held 3 outstanding in its name. >eriodical interest payments and redemption of matured stocks are credited to the .urrent ccount of the stock owner. #o avoid settlement risk, <BI has introduced 0elivery versus >ayment *04>+ system for transactions in %:B accounts. %:B transfer forms are to be used for effecting in any transactions in the %:B account. #he %eller of the :overnment stock issues the %:B #ransfer form duly filling in the portion meant for the %eller furnishing the details of sale transactions to <BI and thereby authorises <BI to transfer specific %tock 3 security standing in its %:B account to the BuyerAs %:B account. #his %:B transfer form duly signed by the
77
authorised signatories of the %eller is issued 3 delivered to the Buyer. #he Buyer fills in the portion meant for him, furnishing the details of his buy transaction and authorises <BI to debit his .urrent ccount with the amount of consideration for the ccount. #he %:B #ransfer Form, stock and to credit the same to the %ellers .urrent
duly signed by the authorised signatories of the Buyer is lodged immediately with <BI. #ransactions are settled by <BI simultaneously. In case there is insufficient balance in %:B account of the %eller .urrent &0 3 C< in
ccount of the buyer the %:B transfer form is returned back furnishing the
reason. Bouncing back of %:B transfer form is seriously viewed by <BI and empowers them to initiate action against the Bank responsible for such %:B transfer form return. 9ence Banks have to ensure that there is sufficient balance of stock 3 security in its %:B ccount *in case of selling Bank+ and sufficient balance in .urrent account *in case of buying Bank+ before issue of %:B transfer form.
Cash "eserve "atio +C""%

ccording to %ec. @/ of <eserve Bank of India of scheduled banks to be kept with the Bank. ccordingly every bank included in %chedule II should maintain with the <eserve Bank an average daily balance, the amount of which shall not be less than @.J7L of the total of the 0emand and #ime Biabilities *0#B+ in India. <BI has been empowered to increase the said rate to such higher rate as may be specified in the notification. 9owever, as per the act, the rate shall not be more than @.J7L of the 0emand and #ime Biabilities *0#B+. .urrently the rate stipulated by <BI is @.J7L. #he method of .<< calculation for a particular fortnight, say beginning from -.-5.57 *%aturday+ to -@.-5.57 *Friday+, is worked as follows, ct, -=?@ stipulates the .ash reserves
7$
step , .alculation of &et 0emand #ime Biabilities *&0#B+ as on the preceding Friday *<eporting Friday+, -.-5./557. Find out, as on -.-5.57, #C# B BI BIBI#I)% * + of the %cheduled Bank- consisting of i+ ii+ iii+ ggregate 0eposits *0emand P #ime 0eposits+ Borrowings *other than <BI, I0BI, & B <0 and )IIM Bank+ Cther demand Q time liabilities.
0educt the Biabilities with the Banking system *deposits placed by 3 accepted from the Banks+, say *B+ from the #otal Biabilities mentioned above * + &ow, further subtract the e(empted categories *stipulated by <BI, from to time+, say *.+, consisting of, #otal of Balances outstanding as on -.-5.57 in the a. &on resident *&on repatriable+ <upee deposit b. )(change )arners Foreign .urrency 3c c. Foreign .urrency 3c *of e(porters+ d. <esident Foreign .urrency R<F.S 3c *of e(porters+ e. <F. 3c in India *by pilots of ir India+ f. Foreign .urrency *ordinary non repatriable+ 0eposit g. )scrow ccounts of Indian )(porters h. Bankers cceptance Facility i. Foreign .urrency *non resident+ 3c"s *Banks+ j. Interbank Foreign .urrency deposit k. &<) accounts and add back the net increase in F.&< *B+ item no. *i+ above over its outstanding balance #hus, the &0#B calculation as prevailing now can be put in a simple form as follows, &et 0emand Q #ime Biabilities *&0#B+ for the purpose ofA .<< O * + - *B+ - *.+ P *c+ 7H
* + #otal demand and time deposits *B+ Biabilities with the Banking system *.+ )(empted categories of liabilities *c+ Incremental F.&< *B+ deposits over the balances outstanding 6indly note that <BI may change the composition of *.+ and *c+, from time to time, depending on its Monetary >olicy. 9ence student has to update this regularly. step, Maintenance of .<< Cnce the &0#B as on-the-preceding Friday is arrived at, the Bank has to maintain an average daily balance at a rate *@.J7L as of now+ stipulated by <BI but not less than ?L of the gross 0emand and #ime Biabilities *which includes net Biabilities with the Banking system+. For */ample, s on ?5.-.=J &)# Biabilities of the Bank of which Biabilities with the Banks &et )(empted categories &0#B for .<< purposes *-?7--7-/5+ verage daily balance to be kept with <BI from ?-.-.=J to -?./.=J -55 ( @.J7L C< -?7 ( ?L <s. @.57 crores <s.@.J7 crores <s.-7 crores <s. /5 crores <s.-55 crores <s.-?7 crores
#he bank has to kept whichever is higher, in this case, the bank will keep <s. @.J7 .rores as .<< reserve with <BI.
7J
In the above e(ample, an average balance of <s.-5.7 crores has to be maintained for the -@ days in the said fortnight. %ince the re'uirement is to be met on an average basis, it is not necessary that the Bank should maintain <s.-5.7 crores on daily basis. It is enough a gross product of <s.-@H crores *ie.-5.7 ( -@+ is maintained for the fortnight as a whole. 9owever <BI has also stipulated that in the first -? days of the fortnight the balances with <BI should not be less than J7L of the average daily .<< re'uirement. 9ence in the above e(ample, while maintaining .<<, the Bank should ensure that its deposit balance with <BI does not fall below <s.J.=/7 crores on any of the first -? days in the fortnight. #his restriction is not applicable for the -@th day of the fortnight, and hence it is permitted to come below J7L, the minimum stipulation for the first -? days. #his is to enable the Bank to s'uare up the .<< position. In the referred e(ample the bank funds can said to be successful in utilising every rupee it kept with <BI. 9owever this is a hypothetical position. :enerally Banks keep an e(tra cushion so that default is avoided once the confirmed positions from all the <BI centers across the country is received. Cne of the main difficulties in the maintenance of .ash reserve re'uirements derives from not knowing what the average periodic re'uirement will be in the first 7 to H days of the maintenance period. 9ence the bank has to monitor continuously its funds flows and make corresponding adjustments to its position. :enerally weekly 3 monthly patterns reflect .orporate 3 bulk deposit inflows or regular pay roll payments. #reasury should incorporate these systematic funds flows into a planning model. If the average daily balance held at <Bi by the %cheduled Bank during any fortnight is below the minimum prescribed for .<<, such scheduled bank shall be liable to pay to the <BI penal interest at a rate of ?L above the Bank <ate on the amount by which such balance with the bank falls short of the prescribed minimum. If such default in .<< maintenance continues in the following fortnights, the penal interest will be 7L above the Bank rate. If the default continues for the third fortnight, <BI has powers toD
i. ii. iii.
punish every director, manager or secretary of the scheduled bank, who is knowingly and willfully a party to the default, with fine and to prohibit the scheduled bank from receiving any fresh deposit.
<BI has more than a do;en of centers across the country where the %cheduled .ommercial Banks, provided they have a branch at such center, can open their current account. 0ay end aggregate balances held at these centers 'ualify for .<< maintenance. Bikewise if the balances with <BI fall below the minimum of J7L on any of the first -? days of the fortnight, <BI may penalise by not paying interest on the balances held by the Bank with <BI on that day. Cnly eligible balances maintained with <BI earns interest T @L. ny e(cess .<<
*over the re'uired rate+ maintained doesnAt earn any interest for the Bank. 9ence the Bank should ensure that it maintains .<< as accurately as possible but should never default.
1
$ses of Funds1 oans and Advances
n ideal advance is !one which is granted to a reliable customer for an approved purpose in which the customer has ade'uate e(perience, safe in the knowledge that the money will be used to advantage and repayment will be made within a reasonable period from trading receipts or known maturities due on or about given dates". But today the very concept of banking has changed. Factors such as purpose of the advance viability of the proposed, and national interest are assuming greater importance than security, especially in advances to agriculture, small industries, small borrowers and e(port oriented industries. If a loan application is not viable, any amount of documentation would not make it viable. #oday, advances comprise a very large portion of bank"s total assets and form the backbone of the bank"s structure. #he strength of the bank should be judged by the soundness of its advances. In fact, a wise and prudent policy in regard to advances is considered an important factor which inspires the confidence in the depositors as well as in the prospective customers of a bank. #he process of grant of credit by banks comprises, a+ Filling in the application form by the borrowerD b+ %crutini;ing the particulars furnished by him in the applicationD c+ ssessment of his credit worthiness and the purpose for loanD recommendationD and e+ Follow-up action on the advances after they have been availed by the borrower d+ %anction of limits either by the branch agent or by higher authorities on his
#hese days, all types of business activity including trade, industry and agriculture depend on bank finance in one form or the other. Before advancing the loan, the bank should be satisfied regarding the purpose of the advance. .onsidering the large increase in the numbers of borrowers, the work of maintaining credit reports on each and every borrower has become not only laborious but also costly. But the grant of ade'uate finance is essential in the interest of both the borrower and the bank and the credit facilities should, therefore, be so arranged that the cycle of the business from the purchase of raw materials to the receipt of proceeds is not hindered for lack of finance. Ehile assessing the credit re'uirements of a borrower, the branch agents should take into consideration the borrower"s re'uirements for different types of facilities such as those against pledge, hypothecation, bills receivable, trusts receipts unsecured etc. it may also be necessary that the head office3regional office should give directions, to some e(tent, to the branch agent to interchange the limits according to re'uirements from time to time. If a constituent has been borrowing from other sources for his business purposes, the branch should endeavour to persuade him to repay such borrowings and deal e(clusively with it for all his credit re'uirements.
'ocumentation
.orrect and accurate documentation is essential to ensure absolute safety of an advance. Before an advance is granted, the guarantor should e(ecute the re'uisite letter or deed of guarantee otherwise the bank may have to lose the money if the borrower fails to repay the same. practical banker must have the knowledge about the e(ecution of the documents appropriately with appropriate authority. &ormally, banks possess a definite format for the e(ecution of the documents and this should not be allowed to deviate at any stage e(cept with the prior approval of the central office. For any advance, the documents must contain the following characteristics, a+ .orrect names of the parties, b+ 0etailed description of the security to be charged c+ <ate of interest and terms of repayment, d+ Cther conditions agreed to and the testimonium clause.
#he testimonium clause is the concluding portion of the deed which the generally reads as, 1"n *itness *hereof the said parties ha e set there respecti e hands the+ day of the month and year abo e *ritten2.
Mortgage
%ometimes a mortgage deed becomes necessary before advancing a loan. #herefore, the banker must see that mortgage of immovable property should contain the following items, a+ #he names of the borrower and the leading bank. b+ It must be very clear that the borrower is the owner of the property and has clear title to it and the property is unencumbered. c+ #he document must also contain an authority from the borrower to the bank to arrange for finance, inspection and repairs of the property as and when necessary at borrower"s cost. d+ #he mortgage deed should be attested by at least two witnesses, otherwise the document is void and not enforceable. e+ It should be registered at the office of the sub- registrar under the Indian registration ct -=5J.
Cash Credit Pledge

If a loan is granted by pledge of goods, then the banker should observe the following points in the document, a+ #he name of the borrower and the lending bank b+ #he ma(imum limit of the borrowing. c+ #he security. d+ #he rate of interest-ordinary linked to bank rate. e+ #he margin to be maintained. #his document gives the following rights to the bank, a+ #he right to verify and inspect the goods. b+ c+ ppoint godown keepers at borrowers cost. uthority to receive the monies from the insurance company in the event of a claim.
d+ #he borrower specifically agrees to the banks right to set-off against any credit balance lying in any other document in his name. e+ Cne of the clauses should be that the security is not previously encumbered and that the borrower would not create any other charge thereon during the continuance of the advance. It is also necessary that the agreement the borrower and the banker should posses the following points, a+ #he banker should have the right to demand repayment of the loan by giving a reasonable notice *normally reasonable notice period is -7 days.+ b+ #he bank will have the right to sell the security by public auction or private sale at its discretion after giving reasonable notice of the sale of the security. c+ #he document should have a 1continuing security2 clause that the cash credit management will not come to an end even if the account is in credit at any time. #he letter of pledge is not re'uired to be attested and if attested, the document would attract ad valorem stamp duty.
Cash Credit :ypothecation

#hough the document is more or less similar to that of a pledge, yet one condition stipulates that in the hypothecation agreement the lending bank may, as its discretion, take possession of the stocks from the borrower and convert the hypothecation account into a pledge account. 9owever, the bankers rarely e(ercise such a right due to many complications. ll documents must be e(ecuted in the presence of responsible banks officials. #hey should have signatures on all the pages and must avoid overwriting if the overwriting is there it should be either initialed or signed by all concerned. Eherever necessary they should be stamped sufficiently otherwise it will not be enforceable in a court of law. )very bank should maintain a register normally named as 1documents e(ecuted register2 and it should posses the following details, -
*a+ #he date, *b+ #he names of e(ecutants, *c+ #he amount3limit of advance and the nature of documents, *d+ #he entries should be signed by the bank officers in whose presence the documents are signed by the borrower should singe the entries.
easing Activity of Banks

%BI. > is the first of its kind in the country dedicated fully to merchant and leasing and assuming responsibilities of financial engineering in future. It is proposed that %BI. > would provide corporate finance services including management of capital issues and credit syndication, advisory services, including project finance, capital restructuring and portfolio management including closely held companies going public, mergers ac'uisitions, with particular reference to sick units and leasing including leasing of indigenous and imported e'uipment. #oday, banks are allowed to enter leasing activity through subsidiaries or associate companies within specified limits only after obtaining the prior approval of the <BI. #hough under the company law, the subsidiaries of the banks were permitted support by their parent undertaking, the credit authori;ation scheme of the <BI does not allow such free flow of funds from the bank to its subsidiary. authori;ation norms laid down by <BI. #he entry of banks in the leasing industry will not affect the prospects of the established leasing companies. In fact, leasing divisions, in banks should provide an additional financing window and thus improve the choices and the variety of services available to the banks clients, due to the e(pansion diversion and moderni;ation of e(isting industrial units, leasing could, in appropriate cases, be an additional or alternative mode of financing. s banking has developed and has large financial and trained manpower resources, it could be able to provide leadership to the leasing industry. #heir advent into leasing should make for greater competition, which, in turn, would tend to moderate the s far as <BI is concerned, subsidiary is noting but a separate entity and as such it should comply with the credit
somewhat high margins, which many leasing companies were able to reap so far. Further, the association of banks with other companies would bring together the financial e(pertise of the banks and the entrepreneurial skills of the private sector and there bring about a measure of standardisation of accounting methods and balance sheets of leasing companies.
Cash Credit #ystem

.ash credits are ordinarily allowed against pledge or hypothecation of goods or against personal security. If there is good turnover both in the account and in the goods there are no adverse factors, a credit limit is allowed to continue for years together. Cf course, a periodical review would be necessary. )ssentially, it is a drawing account credit granted by the bank and is operated in the same way as a current account in which an overdraft limit has sanctioned. In this connection the <BI appointed a working group in -=H= to review the system and it suggested the following,
ending #ystem
It was of the opinion that it is not possible you possible to replace cash credit system totally by any other system at present. But it suggested two major points in this direction, namely,
Peroidical "evie) 4f .orking Capital imits

periodical review of all working capital limits of <%.-5 lakhs and above must be made compulsory. #he review must be made atleast once in a year where limits are <s.-5 lakhs and over but less than <s. 75 lakhs and once in a 'uarter where limits are <s. 75 lakhs and above.
Fi/ing 4f Peak evel and 2on,Peak evel imits

#he banks should fi( limits for normal non-peak level and also for peak level. If there is no pronounced reasonal trend, peak level and normal re'uirements should be treated as identical and limits should be fi(ed on that basis.
"egulation a-out 'ra)ing of Funds

#he borrowers must indicate the re'uirements before the commencement of such 'uarter within the limits fi(ed by the banks.
Penal Interest and Free0ing 4f Account

If the borrowers do not submit the return within the prescribed time limit, then the banks are allowed to charge penal interest of one per cent per annum on the total outstandings for the period of default in the submission of 'uarterly returns. #he banks are also allowed to free;e the account3s of the borrower if default persists. In case it is a consortium should be communicated to the other bank3s concerned.
*nhancement of the .orking Capital

#he bank should advice the borrowers to enhance their working capital and this reduce their overdependence on bank credit, it is also suggest to create a cell in the chairman"s office at the central office to monitor corrective measures at operational level.
2
$ses of Funds1 Investment
KInvestments by banks include those funds that are placed in the credit instruments of enterprises, both public and private, for relatively long period of time with an objective to earn income.K It has two mutually incompatiable objectives, li'uidity of funds and income. #he investment portfolio of banks consists of :overnment securities and other domestic investments. :overnment securities include both KdomesticK and KforeignK ones. 0omestic :overnment securities are securities issued by the .entral3%tate :overnments, treasury saving deposit certificates, and postal obligations. Cther domestic investments include other trustee securities, fi(ed deposits with other bank, shares and debentures of corporate bodies, real estate, bullion, units of the Gnit #rust of India, etc. %ubstantial funds remain invested in :overnment securities partly because they are considered most li'uid, i.e., easily reali;able in cash without much capital loss, and partly because such securities serve as the basis for loans from the <eserve Bank of India at Kbank-rate.K #he nature, type and 'uantum of the investment portfolio are determined by a host of factors, vi;., the <eserve BankAs li'uidity re'uirements, the individual bankAs investment policy, the credit pressure, the general level of funds available in the bank, etc. #hese factors are individually and collectively responsible for the pattern of investment at a particular date. #he minimum statutory re'uirement ceases to be li'uid, in the sense that it cannot be utili;ed by banks in meeting their day-to-day re'uirements. In practice, banks keep at least -5 to -/ per cent more li'uid funds than the statutory re'uirement in order to meet their own li'uidity re'uirements. Most banks have arrangements with other banks, including the %tate Bank of India, through which their branches meet their re'uirements of cash by drawing against :overnment securities. )ven in the head offices, banks re'uire such accommodation against :overnment securities from the %tate Bank of India and the <eserve Bank of India.
#hus, it is seen that investments in :overnment securities are mainly influenced by li'uidity re'uirements, legal and business. Ehen banks are left with e(cess funds after meeting the credit needs and the li'uidity re'uirements, they prefer to invest these funds in such securities as may earn some income. Investments in Kother domestic securitiesK are generally held for such purposes within the investment portfolio. #he relative proportion of various types of securities is determined by the banks" policy for maintaining a balance between li'uidity, safety and profitability. Banks strive to ac'uire securities in such way that the above-stated objectives are easily fulfilled. Banks also take into consideration the Kshiftability2 character of the securities. #hus, the securities which are eligible for being placed with the <eserve Bank of India against borrowing from it may be treated as more shiftabltable. #he volume and direction of the investment portfolio depends upon the availability of bank funds, the credit needs of the economy, and the banks" policy regarding employment of funds. If the credit needs are heavy and banks are confronted with shortage of funds, they are bound to encash some of their investments and vice verse. In such a case also, banks attempt to li'uidate such investments, and to that e(tent ma(imi;e the return on the alternative uses of funds.
Changes in the 3olume and Pattern of Investments

It would be desirable to analyse, against the background of the observations made earlier, the changes in the volume and pattern of banksA investments. #hese changes can be attributed, mainly to the degree of prudence shown by the management, and their concern for li'uidity, profitability, marketability and availability of funds, etc. and the concerned statutory re'uirements. #rends in the investments of the banks have been analysed as a whole because of the data e(clusively of the banksA bring not available. #he relevant data of all the banks as a whole is presented in #able =.-.
Ta-le ;61 Investment of #cheduled Commercial Banks in India

>articulars Investment :overnment %ecurities Cther pproved -==5-=H7,5$7 @=,==J *$$.$-+ /7,5$H *??.?=+
/55?-5@
$H,H7JJ $,7@,H7J *=$.$?+ //,J?5 *?.?H+
/55@
pr. H,-?,-JJ $,=5,7@= *=$.J?+ //,$@5 *?.-H+ 0ec. $,==,$J= $,HJ,=-*=H.5?+ /5,HHJ */.=H+
%Amt! in )s! crore& /557

Mar. H,@?,5$? H,-H,H=*=$.$5+ /7,/H/ *?.@5+ pr. H,?=,55H,-$,JJ= *=H.5-+ //,--/ */.==+
%ecurities %ource, <BI Bulletins #able =.- indicates that the total investments of the scheduled commercial banks rise form <s. H7,5$7 crores in -==5-=- to <s. H@?,5$? crores at the end of March /557, thus registering a phenomenal growth of more than J55 per cent during this period. #his accelerated growth between -==- and /557 is due, among other things, to the decrease in the %tatutory Bi'uidity <atio *%B<+ to /7 per cent.
Maturity Pattern of Investments in Government #ecurities

It is a widely observed fact that most of the investments of banks are in the form of :overnment securities as a result of the li'uidity re'uirements, as also the investment policy of individual banks. Ehile investing funds in ac'uiring :overnment securities for building up secondary reserves, banks have to sacrifices some income in the interest of ensuring safety and li'uidity. #hus, every bank has to consider the maturity pattern of its investment, and to invest judiciously, because if its investment portfolio consists largely of long-term securities, it may e(pose itself e(cessively to the conse'uences of changes in interest rates. rise in interest rate causes a decline in the prices of securities, and the more distant the maturityD the greater are chances of the price decline. 9ence, not only the income but also the safety and fle(ibility of the investment portfolio are the decisive factors influencing the maturity pattern of investments in :overnment securities, two other such factors being the <BIAs monetary policy and the objectives of the banks to ma(imise earnings on investments. #able =.? presents the maturity classification of investments in :overnment securities.
Ta-le ;6&
Maturity Classification of Investments

Maturity >attern as on ?-st March /557 *0omestic Cperations+ ---@ days -7-/J days /= days Q upto ? months Cver ? months Q upto $ H,/-=.@$ -@5.-= /,7/@.-$ -H,@@/.HJ ?5$.@H -$$.7$ -,-H5.$H -,--H.?@ /,55-./? @,/=H.$H @,$=$.=/ -@,@@J.H$ /J,/5/.$/ %tate bank Cf India * mt. in crore+ Bank of India
months Cver $ months Q upto - year /,/J-.H? Cver - year Q upto ? years /=,5$7.@@ Cver ? years Q upto 7 years ?@,@-=.57 Cver 7 years ==,?$?.7= #otal -,=/,@7$.@5 %ource, nnual <eports of the particular banks.
Investment Portfolio of #elected Banks

lthough detailed information regarding the investment portfolio of all the nationali;ed banks is not available, yet an attempt is made to show *in #able =.?+ the investment portfolio of the selected nationali;ed banks as also the ratio of the :overnment and other trustee securities to the total investment.
Ta-le ;6( Investment Portfolio of #elected Banks %Amount in "555&

Banks and %elected .ategories ?-st March, /557 ?-st March, /55@
-+ #tate Bank of India a+ :overnment %ecurities b+ Cther approved securities c+ %hares d+ debentures and bonds e+ subsidiaries and3or joint ventures f+ Cthers *units 3 .>s, etc+ g+ Cutside India /+ Bank of India a+ :overnment %ecurities b+ Cther approved securities c+ %hares d+ debentures and bonds e+ subsidiaries and3or joint ventures f+ Cthers *units 3 .>s, etc+ g+ Cutside India ?+ IndusInd Bank a+ :overnment %ecurities b+ Cther approved securities c+ %hares d+ debentures and bonds e+ subsidiaries and3or joint ventures f+ Cthers *units 3 .>s, etc+ g+ Cutside India
-,H-,@/,7$,=-$ ?,H/,=7,5JH -,--,H/,JHH -?,?5,@@,75-,7/,-@,7@-,?7,H5,5/@,$@,-7,-7= -=,-@,J7,7?H J/,=J,J=? /?,55,5=H /,$-,-5,/=7 -H,/J,$-/ ?/,JJ,==/ @,JJ,-?,J5@ ?,@5,@J,=?7 /,?J,J$= /,??,/-$ --,-J,/=$ 7,555 75,@H,?=/ -
-7,HH,?J-,5-/ @,-=,@@,H$=5,-J,=H7 -7,JH,@=,@7$ -,@?,$5,?=@ -,7?,J=,5/? ?,==,/-,/5H -H,7J,?-,?@$ J$,H7,/@5 -H,J=,H?7 /,HJ,/7,J=-H,/J,$-/ ==,HJ,?@$ @,7H,==,H7/ ?,HH,5/,-$7 /,/H,7?$ --@/7/ -$@-J5/ ?--55 7-,-5,H/H -
Ta-le ;6( +Cont6% Investment Portfolio of #elected Banks %Amount in "555&

Banks and %elected .ategories @+ <ai :ind Co,op Bank td a+ :overnment %ecurities b+ shares with pe( co-op ?-st March, /557 ?,5J,?@/ -,/$/ -/,/55 -,5J,$5J ?-st March, /55@ /,/?,5H/ -,/$/ --,/55 -,H?,-/H
Bank c+ F0< with M%. Bank d+ F0< with Bank %ource, nnual <eports Cf all above Banks
34
Asset ia-ility Management
Banks are e(posed to various types of risks, vi;., Market risk, Cperational risk, .redit risk to mention a few. #hese risks play a major role in the pricing of bank products. #his resulted in the genesis of year -===. #he main motto of sset Biability Management * BM+ systems in the BM systems is to determine the market risk, which
consists of li'uidity risk, interest rate risk and foreign e(change risk. #ill the advent of the financial sector reforms in the early -==5As, the <BI did the real banking business and commercial banks were mere e(ecutors of what <BI decided.
Bank for International %ettlement *BI%+, the parent bank of central banks, is standardi;ing the practices of banks across the globe. Banks have no option but to accept the best practices, which are being gradually introduced by BI%. #he success of ssets and Biability Management, <isk Management and Basel .apital ccord introduced by BI% depends on the efficiency of the management of assets and liabilities. 9ence, these days without proper management of assets and liabilities, the survival of banks is at stake. Eith the deregulation of interest rates, the pricing has been freed, e(cept for savings bank deposits and small advances below <s. / lakhs. %uddenly the bankers, especially those who have been nurtured in such a highly regulated market, are finding it difficult to understand the nuances of the marketoriented competition and management of assets and liabilities of the balance sheet. Basel .apital ccord and corporate governance have come a long way. .apital
supply will be choked from them if they are not provided with a return over the market e(pected rate of return on their investments. #his re'uires each individual product3service line to generate a return over the market e(pected rate of return. sset Biability Management * BM+ %ystems BM is basically the art of reshaping a
bank balance sheet and income statement to achieve the desired goal - gro*th, liquidity, profitability and ser ice to the community . Banks are re'uired to cope with this pressure in a structured manner by adopting comprehensive BM practices. #he following points strengthen the reasons for implementing asset-liability management in the Indian conte(t, djusting banksA liabilities to meet loan demands, li'uidity needs and the safety re'uirements with a focus on profit and long-term operating viability. Funds management, where the focal point is to increase or decrease interest sensitive funds. 0irecting and controlling the flow, the means, the cost and the yield of consolidated funds of banks with an eye on profit and long-term viability. Management of maturities of assets and liabilities so as to cap their e(posure to interest rate risk. BM refers to the process of managing the &et Interest Margin *&IM+ within the overall risk bearing capacity of the bank.
,"M - ,et "nterest "ncome(A erage .arning Assets.
%ince ,et "nterest "ncome %,il& e'uals interest income minus interest e(penses, it can be viewed as the spread on earning assets. interest margin becomes essential. %everal banks have inade'uate and inefficient management systems that have to be altered so as to ensure that banks are sufficiently li'uid. Indian banks are now more e(posed to the vagaries of international markets, than ever before because of the removal of restrictions, especially with respect to fore( transactions. sset-liability management becomes essential as it enables a bank to maintain its e(posure to foreign currency fluctuations given the level of risk it can handle. n increasing proportion of investments by banks are being recorded on a marked-to-market basis and as such a large portion of the investment portfolio is e(posed to market risks. .ountering the adverse impact of these changes is possible only through efficient asset-liability management techni'ues. s the focus on net interest margin has increased over the years, there is an increasing possibility that the risk arising out of e(posure to interest rate volatility will be built into the capital ade'uacy norms specified by the regulatory authorities. #his, in turn, will re'uire efficient BM practices. s the basic objective of banks is to ma(imi;e income by reducing their e(posure to risk, efficient management of net
The -road o-=ectives of A M systems in -anks are1

#o control volatility of &il from changes in interest rates. Cptimi;ation of profit by ensuring acceptable balance between profitability, growth and risks. Funding of banks operation through capital planning. >roduct >ricing and introduction of new products. #o control volatility of market value of capital from market risk. .hoosing a suitable length of planning hori;on - say one, two or three months ahead. Eorking out estimates of return and risk that might result from pursuing
alternative programs. .hoosing a model that yields a stable net interest income consistently while ensuring li'uidity.
A M organi0ation -roadly consists of the follo)ing structure in -anks

Board of 0irectors Management .ommittee sset Biability .ommittee * B.C+ BM .)BB
Anal.sis of AL- S.stems in 'anks

Many banks are meeting banks in the B.C often to take decisions even though several B.C meetings regularly either BM policy agreed to conduct
on a fortnightly or monthly basis. >rivate sector banks and foreign banks are able to collect -55L data and >ublic %ector Banks *>%Bs+ are yet to collect -55L of reason for this is lack of computeri;ation in all branches. It is observed that more than 75L of the nationali;ed banks have started collecting BM data on a fortnightly basis, whereas the private sector and foreign banks are collecting the data on real-time basis. Many banks are conducting the behavioral studies of savings bank deposits and current deposits to arrive at the core and volatile proportions. Many banks are not attempting the embedded options, vi;., premature withdrawal of deposits and prepayment of advances, which reflects that the e(act effect of outflows and inflows and also rate sensitive liabilities and rate sensitive assets will not be reflected in %B% and I<% rationally, which may adversely affect the gap analysis. %ome banks are measuring both the mismatch risk and basis risk to measure the impact of &il. Many banks are measuring only mismatch risk. %ome banks are pricing deposits using BM systems, whereas in case of BM data. #he main
advances many banks are not utili;ing BM systems. Banks are in the direction of going forward towards #ransfer >ricing systems, while pricing deposits and advances. Market risk is related to the financial condition, which results from adverse movement in market prices. #his 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 conte(t, the problem is more pronounced because many financial institutions ac'uire bonds and hold them till maturity. Ehen 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.
i!uidity "isk
Bi'uidity risk is the potential inability of banks to generate ade'uate cash to cope with a decline in deposits or increase in assets. Bi'uidity or the ability to fund increases in assets and meet obligations as they become due, is crucial to the ongoing viability of any banking organi;ation. #herefore, managing li'uidity is among the most important ctivities conducted by banks. #o a large e(tent, it is an outcome of the mismatch in the maturity patterns of assets and liabilities. minimum criterion in assessing li'uidity is the ability both to meet commitments when due and to undertake new transactions when desirable. lthough the possible needs for li'uidity are manifold they can be classified under four broad heading, vi;., #he need to replace net outflows of funds whether due to withdrawal of retail deposits or to non-renewal of wholesale funds. #he need to compensate for the nonreceipt of e(pected inflow of funds, e.g., when a borrower fails to meet his commitments. #he need to find new funds when contingent liabilities become due, e.g., a sudden surge in borrowing under-automated credit facilities or e(ercising a standby line of credit by another bank. #he need to undertake new transactions when desirable, e.g., a re'uest for funds from an important client. )ach bank should have internal controls for li'uidity risk management, vi;.,
regular independent reviews and evaluation of the effectiveness of the system and wherever necessary to opt for enhancements in internal controls and the reviews should be available to supervisory authorities. )ach bank should have a mechanism for ensuring that there is an ade'uate level of disclosure of information about the bank to improve the li'uidity.
Interest "ate "isk +I""%

#oday banks face two kinds of balance sheet risksMcredit risk and interest rate risk. #hese and other risks e(pose a bankAs business to certain potential losses. #hese losses are of three types, vi;., e(pected, une(pected and stress loss. #he e(pected loss is always insurable through several hedges and, therefore, forms a part of a bankAs cost of operation. #here is the une(pected loss under adverse conditions, which cannot be predicted. It is this une(pected loss that is defined as 4alue at <isk *4a<+. #hen there is also a third type of loss, that banks may face under e(treme conditions, which occurs rarely. It is called stress loss. Market risk measures commodity, currency and interest rate risks as well. .ommodity risk is almost none(istent today for many Indian banks and currency risk is currently controlled through regulatory perception. #here remain the I<< that largely poses a problem to banksA interest income and hence profitability. It arises because banksA assets and liabilities generally have their interest rates reset at different times. .hanges in interest rates can significantly alter a bankAs &IM depending on the e(tent of mismatch between the times when asset and liability interest rates are reset. .hanges in interest rates also affect the market value of banksA e'uity. Methods of managing I<< first re'uire a bank to specify goals for either the book value or the market value of &il. In the former case, the focus will be on the current value of &il and in the latter case, the focus is on the market value of e'uity. In either case the bank has to measure the risk e(posure and formulate strategies to minimi;e or mitigate the risk. Banks mostly use the funding or maturity gap analysis model to control I<<. #hrough this gap analysis a direction and e(tent of asset-liability mismatch can be arrived at. It is computed for specified time periods and over a set-planning hori;on. #he :ap
report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturities or ne(t repricing period, whichever is earlier.
A summary of the GAP interrelationship )ith > 2il

Ta-le I Sr 0ype of ! , / ? @ 7 $ 1A/ <% O <% <%BsO <% <%BsU <% U <% <%BsV <% <%BsV <%Bs #hange in r& Increase 0ecrease Increase 0ecrease Increase 0ecrease #hange in ,et "nterest "nterest )ates %2 "ncome % 2 ,""& &o .hange &o .hange &il increases &il decreases &il decreases &il increases
#he possibilities of change in &II indicate in what direction &II will change when interest rates change. ;ero : > will be the best choice if a bank is not able to speculate interest rates fairly accurately or if its capacity to absorb risk is close to ;ero. Eith a ;ero : > a bank is fully hedged against both increase and decrease in interest rates as its &II will not change in both the cases.
'uration Gap Analysis +'GAP%

#he changes in interest rates affect banks in two ways. #he two broad perspectives of BM, i.e., short-term and long-term perspectives are given in #able II. Details Ta-le II Short'term /erspecti e $ong'term /erspecti e
#arget 4ariable <espective #ype of mismatch focus nalytical techni'ues
&et Interest Income *&II+ ccounting #actical >rof3Boss - :ap analysis - %imulation of &il - )arnings at <isk *)a<+
Market 4alue of )'uity *M4)+ )conomic %tructural Balance sheet strength - 0uration gap analysts - %imulation of M4) - 4alue at <isk W4a<+ of )'uity
Implication of 'uration Gap #he impact of changing market interest rates on a bankAs net worth is indicated in #able ?. In this way duration gap figures can be used to estimate e(pected change in the market value of e'uity for a given change in interest rates. imitations of 'uration a. 0uration basically assumes parallel shift in the yield curve. b. 0uration does not capture interest rate volatility. c. 0uration as price sensitive measure is applicable only to small changes in interest rates. d. 0uration is applicable only to option free bonds.
3alue at "isk +3a"%

s per Basel-II committee recommendations, risk identification, risk measurement and risk monitoring are three important strategies for risk mitigation in the financial sector. Gnder the Internal <ating Based *I<B+ approach of risk measurement, banks are e(pected to calculate the >robability of 0efault *>0+ on various advance portfolios based on internal ratings and given risk weights such as /5L, 75L, -55L, etc., and load the same whenever such portfolio is priced. #o calculate the >0, the 4a< model, which measures credit risk, is generally used.
*a+le &ature of 0uration .hange In Interest gap >ositive 0 X k ( <ates 0B <ise Fall <ise
#he 4a< model is Impact on Banks &et worth 0ecrease Increase Increase one the of the I<B rating and its approaches, wherein credit given to each of the borrowers migration over the
&egative 0 Y k ( Fall 0ecrease where kO*Biability - )'uity+ 3 #otal ssets
years form a part of the calculation of the .redit 4alue at <isk over a given time hori;on. #his is due to credit risk, which emanates not only from counterparty default, but also from slippage in credit 'uality. #hus, the volatility of value due to the changes in 'uality of credit needs to be estimated to calculate 4a<. In general, banks review financial statements of borrowers once in a year and allot credit ratings. But there is no e(plicit theory to guide time hori;on for risk assessment. ny risk assessment model shall normally predict relative risk than absolute risk. #he objective of any risk assessment model is to initiate risk-mitigating actions, irrespective of the time hori;ons. 9ence, any risk measurement model can be tailored to suit different time hori;ons based on the actual need. imitations of a 3a" #tudy #his study is useful only for normal operative accounts to predict their probability of default and this model does not take already defaulted customers in to account. Ehen the default probability is to be worked for a portfolio as a whole, 4a< has to be separately calculated and added to the already defaulted value. #he rating methodology should be objective and consistent for better results as this model does not directly take performance parameters of individual units into account and solely depends on their credit rating and its migration. Macrolevel changes in an industry, changes in government policies, etc., may result in distorted results. #he transition matri( does not capture enhancements3adhoc sanctions in working capital limits and additional term loans sanctioned to the same borrower within a particular credit rating. In this methodology, if the 4a< measurement is for a shorter duration
accurate.
#ecuriti0ation
%ecuriti;ation is the conversion of future cash flows into marketable securities. It is a process through which illi'uid assets are packaged, converted into tradable securities and sold to third-party investors. Asset $iability Management, Bong-term assets are replaced with cash and postsecuriti;ation reduces the tenor mismatch by which li'uidity and interest rate sensitivity of such a gap can be minimi;ed. Alternative #ource of Funding, It offers an effective and relatively 'uick alternativefunding source to originators. It enables banks to diversify their funding mi(. Balance #heet Management, Cnce the loan receivables are transferred to the %>4, i.e., the %pecial >urpose 4ehicle, they are removed from the originatorAs balance sheet. #hus, %ecuriti;ation offers an off-balance sheet-funding alternative.
"elevance of Basel II in Asset ia-ility Management of Banks

Basel ccord on capital ade'uacy aims at strengthening the financial health of banks. #he proposed ccord is in the direction of further strengthening the capital. #he prime motto of Basel-II is Kless capital for safe loans and more capital for risky loans.K It hopes to create a regulatory system that promotes stability by rewarding banks for managing risks better. #he -=JJ ccord had a Kbroad-brushK approach, i.e., one si;e fits all - focus was on a single risk. #here was no ade'uate differentiation of credit risks - there were only four risk weights - 5L, /5L, 75L and -55L. %ame risk weight for loans given to an K K company or to a corner shop.
Maturity structure of credit e(posure did not have relevance. &o recognition to credit risk mitigation techni'ues.
&o capital charge for operational risk. )conomic capital is the capital necessary to cover potential losses on the loan. )conomic capital allocation allows banks to have a better understanding of risk and better loan pricing rules. #he risk weights on investments made in >ass #hrough .ertificates *>#.s+ by financial institutions raised through housing loans securiti;ation will carry 75L in arriving at the capital re'uirement.
#he proposed &ew .apital
de'uacy Framework contains refined proposals ccord, vi;., Minimum .apital <e'uirements,
for the three pillars of the &ew
%upervisory <eview and Market 0iscipline. By introducing Internal <ating Based pproach as per Basel-II norms on all loans and advances, the status of the portfolio, i.e., its rating position will be known. If the portfolioAs rating is competitive prices. P and above the capital re'uired, its risk weighted portfolio will #his is mainly because capital re'uirement is one be at minimum. Ehen a bank wants to price such advances portfolio it can offer of the factors in arriving at the pricing of advances. hen capital re'uirement is at a minimum, the prices on advances can be charged on a competitive basis. #o strengthen the BM systems in banks, the li'uidity profiles, I<< measurements
vi;., 0uration, 4a<, %imulation models, Fore( risk measurements, etc., need to be sound. #he MI% mechanism should be strengthened and technology is to be introduced to make information available on a dynamic basis. In such a situation, as per Basel-II, the pricing of bank products can be made competitive using systems. BM
33
Cash Management
Bike blood in the human body, cash sustains a corporate body, be it a business enterprise or a commercial bank. :ood health in a human body depends to a great e(tent on the blood pressure. %imilarly, the health of good commercial enterprise depends upon good cash management. For affective cash management, it is necessary to constantly scan the spectrum of various transactions handled by the Bank and analyse them in order to e(amine whether, all funds due to the Bank have indeed been received in timeD funds paid out by the Bank on behalf of a principal in respect of agency transactions have been reimbursedD the reporting system of funds settlement in respect of various transactions are functioning smoothly and the pipeline has not been checkedD settlement of various transactions *e.g., currency, chest deposits, withdrawals, government transactions, both receipts and payments, agency or correspondent transactions transactions, under the <BI remittance facility scheme etc.+ takes place within the time stipulated or there is any delay in doing so, and the data base for reserve management drill called out from all branches in the BankAs network of offices is accurate and up- to-date. 8ust as an individual undergoes a periodical health check-up, scanning of all transactions which have a bearing on the cash position of the Bank must also be carried out at fre'uent intervals. 4iewed thus, cash has a larger meaning to banks. It not only represents notes or coin in hand but also includes !funds that are immediately available for disbursement without restrictions". In other words, apart from ready money, money which is moving towards or away from the bank becomes profoundly important. #hus, one of the important objectives of cash management in books is the harnessing or taming or cash flows in such a manner that a desired level of cash is maintained at all times, in the entire network of branches. Cne can visualise the comple(ity of the task that the stock of cash held by a Bank at a point of time as well as cash flows generated by it on any working day, is made up of a number of transactions handled by its various
brandies dotting the map of India. #he cash manager is thus like a juggler, ceaselessly at work. .ash Management in Banks is like a game played in a pyramid, with three faces and a solid base to stand on. Bike the three faces of a pyramid, cash management game too has three players with distinct perspective vi;.. Branch Bank, customer or whole Bank. #he Bank branch is our antenna in the economy and market place and the magnet which attracts cash. It is the Branch Bank which handles the money transactions of the customer and interacts with him constantly. #he business so handled at the Branch generates cash for the Bank as well as the base for its lending activities and thereby the creation of itD income and profits. #hus seen, the Branch Bank has three primary responsibilitiesM to function efficiently, generate profits and ensure that all cash generated by it on any business day becomes available to the Bank in the 'uickest possible time and is put to work in income generating assets or trading activities of the three. #he last one is crucially important as no branch bank can function in an island of its own. For instance, no Bank can retain a large 'uantum of cash all the time to meet any possible demand. #he cusumer on the other hand may have a variety of concerns, the most important of which are to ma(imise his income and profits. #he three basic postulates of 3!M! Keynes for holding cash 4i;., transaction moti e, precautionary moti e, and speculati e moti e constitute the raison d" etre for cash management in business enterprises. #he fourth motive is the profit motiveD shrewd cash managers in business houses need a lot of money for their enterprises. #hey endeavour to accelerate cash receipts, slow down cash disbursements, forecast cash receipts and disbursements, invest surplus cash profitably and safely for periods when it is not needed and constantly monitor the performance of several systems developed for this purpose. #he Bank is no different from other business enterprisesM only its business is different. It trades in money and financial services, accepts deposits, grants loans, moves money from one place to another for a charge, sometimes across the borders, fulfils statutory reserve obligations, if any, imposed by the monetary authority and
invests in securities, domestic as well as foreign. Banks operate by the principles of li'uidity, profitability and safety and endeavour to ma(imise their income, profits, network and ranking from year to year, in the same way as a customer does. #o do so, a perfect and efficient communication network, linking all branch offices to the pe( level becomes the life line, an umbilical cord as it wereD and the use of modern hardware like micro-processors, word processors, computers, copiers, magnetic ink, character readers, micro-filming e'uipments etc., provide the necessary muscle for handling the various documents and negotiable instruments and processing the information contained in them accurately and 'uickly, so that whatever is to be collected from elsewhere is entered into the system and injected into the transactions stream within the time stipulated. Ehile the employment of the forecasting models which indicate the flow of cash and the need for it at different points of time, in the days and months ahead, becomes the built-in safety measure, sending in signals of a rough ride ahead well in advance, so that corrective measures can be taken or back-up support systems can be engineered in order to preserve and protect the Bank as a going concern and enable it to stay in business. .ash movement within the BankAs network of offices as well as outside, is essentially through the transmission of messages be it from the Branch to the Bink Cffice or the Bink Cffice to the pe( Cffice or the Bank to the <eserve Bank of India, correspondent banks or other agencies. #hus, the communication made becomes a critical factor in effective cash management. Eithout communication, a Bank would be virtually lost but with an e(cellent communication infrastructure, wonders can be wrought and the pinnacle of efficiency, optimum utilisation of cash available and the ma(imisation of profits can all became objectives within our easy reach. #his is the difference which communications can make to a Bank insofar as cash management drill is concerned. For instance, the focus of the Bank branch is banking business and services and rightly soM and cash is only incidental and a tool to help the Bank branch to achieve its business goals. #hus, the cash management e(ercise at a Bank branch revolves primarily around the cash retention limit fi(ed for it.
9owever, the perspective of cash management is totally different at the whole Bank level, as it affects the Bank in the following areas, *i+ *ii+ *iii+ fulfillment of statutory reserve re'uirements, laying out the policy for credit e(pansion and setting the limit thereof, and identifying the e(ternal sources that must be drawn upon in the event of a shortfall in cash re'uirements or e(ternal avenues for deployment of surplus cash. For efficient functioning and achieving optimum utilisation of cash resources available in the system at any point of lime, it must enjoy wide discretion to take splitsecond decisions, of course based on data and above all, enjoy the total confidence of the top management within the organisation. >roblems, challenges and new opportunities created by policy changes fall within the ambit of the Money >osition Manager or #reasury or Funds Management 0epartment M the effective e(ploitation of which would influence the trends in the overall profitability of the Banks. From the foregoing, one can visualise not only the very large amounts involved in meeting reserve obligations but also the enormous significance attached to the task of collecting the BankAs 0#B base for each reserve periodD the basic data for this purpose, particularly details of aggregate deposits, inter bank deposits and credit balances on drafts. system is vital. Cne can thus easily appreciate the role which all branches in a BankAs network have to play. It is here that Banks in India today face several hurdles. #here is not only many a slip between the cup and lip but also between the lip and the sip. In this conte(t, the proposal to introduce mechanisation in the banking industry appears the most as significant and crucial decision ever taken, which, over a period of lime will alter the very face of the industry. Machines would help the banks not only to keep housekeeping up-to-date at branches, but with the help of improved communication ccounts have to be collected from all branches in the BankAs network for each reserve period. Fordoing this effectively, an efficient information
facilities enable them to transmit the 0#B data to the central point location where the #reasury or Fund Management functionaries arc centralised. .ash Management in banks is like conducting an orchestra with the various players located in different parts of the country, >roducing music, leave alone sweet and melodious tunes, in such circumstances is an almost impossible task. #his is because cash management drill is one where every branch office in a bankAs network must play its pan completely and in time, say by *a+ transmitting messages relating to the transactions handled by it, and involving settlement of funds at another centreD *b+ submitting data relating to 0emand and #ime Biabilities for purposes of reserve management drill. part from the efficacy of the communication infrastructure, the state of bookkeeping at the branch also becomes awfully important because one of the objectives of reserve management in a bank is to maintain the e(act 'uantum of cash re'uired, no more and no less and towards the ideal of 45ero e6cess reser es4. )ducation of bank branch personnel in the various facts of cash management drill thus assumes considerable significance in a Bank and a sense of urgency tooM for the failure of one branch in some remote part of the country can blow the fuse at the ape( level. %uch an e(perience has indeed been encountered by %BI and could occur in any other bank too. #his is because despite decentralisation for business needs and administrative purposes, cash management drill is one which transcends all boundaries of management control and truely envelops the Bank entirely. It is in the performance of this drill that the Bank really takes the characteristics of a one-branch Bank as it has to be performed on behalf of the whole Bank, as one individual e(erciseD although the centres where action indeed takes place could be diverse. In the year /557, %BI had more than -5555 offices in India and the transactions put through by every one of them do affect the .ash Management 0rill at the ape( level. Cne can easily comprehend the arduous nature of the task. 1Zeit ist :eld2 or 1#ime is Money2 is an old proverb. #his is very true of cash and the management of cash. #he cash in transit or in the vaults results in less income. #he
very business of banking not only involves the gathering and distribution of cash, but also its deployment in income generating assets so as to leave a surplus to banks. #he golden rule for business is profits. Banks are no e(ception. #rue in the conte(t of the several social obligations which the Banks have been called upon to discharge since -=$=, profits cannot be the sole criterion. But whatever Banks do, it can not be at the e(pense of profits for all time to come. constant slurge of red ink will choke any business, including banks. It is in this conte(t that good and effective cash management can enhance the profitability of a BankAs operations. #here is a saying that !#he worth of a thing is in what is well doe". #his is very true of .ash Management as it will bring profits to a Bank.
Bi-liography
Books
-. Funds Management in .ommercial Banks /. .ommercial Bank Financial Management ?. Bank Financial Management @. Management of Funds in Banks <BI 9.B. 4erma 8oseph F %inkey 8r
Maga0ines
-. #reasury Management /. .hattered Financial nalyst #he I.F I Gniversity >ress
"eports
-. /. ?. @. nnual <eport of %tate Bank of India nnual <eport of Bank of India nnual <eport of IndusInd Bank nnual <eport of 8ai-9ind .o-operative Bank
7. Bulletin of <BI
.e- #ites
-. www.rbi.org.in /. www.sbi.com

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Banks Funds Management

Banks Funds Management

Banks Funds Management

The Business of Banking

Banks Funds Management

The Concept of Funds Management

Banks Funds Management

Banks Funds Management

Funds Management Policy Guidelines

Banks Funds Management

Banks Funds Management

#ources and $ses of Funds

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Approaches to Funds Management

Banks Funds Management

Productive Theory of Credit +Commercial, oan Theory%

Banks Funds Management

Theory of #hifta-ility to the Market

Banks Funds Management

Banks Funds Management

Banks Funds Management

Asset Allocation Approach +Conversion of Funds%

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Balance #heet Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

The Purposes of Bank Capital

Banks Funds Management

Banks Funds Management

Methods of Increasing Capital

Banks Funds Management

Functions of Capital Funds

Banks Funds Management

Banks Funds Management

2eed and 3olume of Capital Funds

Banks Funds Management

Banks Funds Management

Banks Funds Management

'eposits of 4ther Banks

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Banks Funds Management

Borro)ings from the "eserve Bank of India

Banks Funds Management

Banks Funds Management

Banks Funds Management

Borro)ing from 4ther Financial Institutions

Industrial 'evelopment Bank of India +I'BI%

applications and to reduce delay in the flow of assistance.

Banks Funds Management

"efinance From the /port Import Bank +7IM Bank%