Unit-1

An overview of Indian Financial system

Financial System of any country consists of financial markets, financial intermediation and
financial instruments or financial products. This paper discusses the meaning of finance and
Indian Financial System and focus on the financial markets, financial intermediaries and
financial instruments. The brief review on various money market instruments are also covered in
this study.

INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various economic
units, broadly classified into corporate sector, government and household sector. While
performing their activities these units will be placed in a surplus/deficit/balanced budgetary
situations.

There are areas or people with surplus funds and there are those with a deficit. A financial
system or financial sector functions as an intermediary and facilitates the flow of funds from the
areas of surplus to the areas of deficit. A Financial System is a composition of various
institutions, markets, regulations and laws, practices, money manager, analysts, transactions and
claims and liabilities.

Financial System;

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities
in the economy. The financial system is concerned about money, credit and finance-the three
terms are intimately related yet are somewhat different from each other. Indian financial system
consists of financial market, financial instruments and financial intermediation. These are briefly
discussed below;

FINANCIAL MARKETS

A Financial Market can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods or
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services, a financial transaction involves creation or transfer of a financial asset. Financial Assets
or Financial Instruments represents a claim to the payment of a sum of money sometime in the
future and /or periodic payment in the form of interest or dividend.

Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid,
short-term instrument. Funds are available in this market for periods ranging from a single day
up to a year. This market is dominated mostly by government, banks and financial institutions.

Capital Market - The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.

Forex Market - The Forex market deals with the multicurrency requirements, which are met by
the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of
funds takes place in this market. This is one of the most developed and integrated market across
the globe.

Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium
and long-term loans to corporate and individuals.

Constituents of a Financial System

FINANCIAL INTERMEDIATION

Having designed the instrument, the issuer should then ensure that these financial assets reach
the ultimate investor in order to garner the requisite amount. When the borrower of funds
approaches the financial market to raise funds, mere issue of securities will not suffice.
Adequate information of the issue, issuer and the security should be passed on to take place.
There should be a proper channel within the financial system to ensure such transfer. To serve
this purpose, Financial intermediaries came into existence. Financial intermediation in the
organized sector is conducted by a widerange of institutions functioning under the overall
surveillance of the Reserve Bank of India. In the initial stages, the role of the intermediary was
mostly related to ensure transfer of funds from the lender to the borrower. This service was
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offered by banks, FIs, brokers, and dealers. However, as the financial system widened along
with the developments taking place in the financial markets, the scope of its operations also
widened. Some of the important intermediaries operating ink the financial markets include;
investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio
managers, mutual funds, financial advertisers financial consultants, primary dealers, satellite
dealers, self regulatory organizations, etc. Though the markets are different, there may be a few
intermediaries offering their services in move than one market e.g. underwriter. However, the
services offered by them vary from one market to another.

Intermediary Market Role

Secondary Market to
Stock Exchange Capital Market
securities
Corporate advisory services,
Investment Bankers Capital Market, Credit Market
Issue of securities
Capital Market, Money Subscribe to unsubscribed
Underwriters
Market portion of securities
Issue securities to the
Registrars, Depositories, investors on behalf of the
Capital Market
Custodians company and handle share
transfer activity
Primary Dealers Satellite Market making in government
Money Market
Dealers securities
Ensure exchange ink
Forex Dealers Forex Market
currencies

Context and Need for Financial sector reforms

An efficient banking system and a well-functioning capital market are essential to mobilize
savings of the households and channel them to productive uses. The high rate of saving and
productive investment are essential for economic growth. Prior to 1991 while the banking system
and the capital market had shown impressive growth in the volume of operations, they suffered
from many deficiencies with regard to their efficiency and the quality of their operations.

The weaknesses of the banking system was extensively analyzed by the committee (1991) on
financial sector reforms, headed by Narasimham. The committee found that banking system was
both over-regulated and under-regulated. Prior to 1991 system of multiple regulated interest rates
prevailed. Besides, a large proportion of bank funds was

by Government through high Statutory Liquidity Ratio (SLR) and a high Cash Reserve Ratio
(CRR). As a result, there was a decrease in resources of the banks to provide loans to the private
sector for investment.

This preemption of bank funds by Government weakened the financial health of the banking
system and forced banks to charge high interest rates on their advances to the private sector to
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meet their needs of credit for investment purposes. Further, the lack of transparency in the
accounting practice of the banks and non-application of international norms by the banks meant
that their balance sheets did not reflect their underlying financial position.

This was prominently revealed by 1992 scarcity scam triggered by Harshad Mehta. In this
situation the quality of investment portfolio of the banks deteriorated and culture of’ non-
recovery’ developed in the public sector banks which led to a severe problem of non-performing
assets (NPA) and low profitability of banks. Financial sector reforms aim at removing all these
weaknesses of the financial system.

Under these reforms, attempts have been made to make the Indian financial system more viable,
operationally efficient, more responsive and improve their allocative efficiency. Financial
reforms have been undertaken in all the three segments of the financial system, namely banking,
capital market and Government securities market.
Objectives of Reforms in the Financial Sector
The primary objective of financial sector reforms in the 1990s was to “create an efficient,
competitive and stable that could contribute in greater measure to stimulate growth”. Economic
reform process took place amidst two serious crises involving the financial sector:

The crisis involving the balance of payments that had threatened the international credibility of
the country and dragged it towards the brink of default.

The crisis involving the grave threat of insolvency threatening the banking system which had
concealed its problems for years with the aid of defective accounting policies.

Apart from the above two dilemmas, there were many deeply rooted problems of the Indian
economy in the early 1990s which were strongly related to the finance sector. Prevalent amoung
these were:

As mentioned by McKinnon and Shaw, till the early 1990s, the Indian financial sector could be
described as an example of financial repression. The sector was characterised by administered
interest rates fixed at unrealistically low levels, large pre-emption of resources by authorities and
micro regulations which direct the major flow of funds back and forth from the financial
intermediaries.

 The act of the government involving large scale pre-emption of resources from the
banking system to finance its fiscal deficit.
 More than necessary structural and micro-regulation that inhibited financial innovation
and increased transaction costs.
 Relatively inadequate level of prudential regulation in the financial sector.
 Inadequately developed debt and money markets.
 Obsolete and out-dated technological and institutional structures that lead to the
consequent inefficiency of the capital markets and the rest of the financial system.

Till the early 1990s, the Indian financial system was characterised by extensive regulations viz.
administered interest rates, weak banking structure, directed credit programmes, lack of proper
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accounting, risk management systems and lack of transparency in operations of major financial
market participants. Furthermore, this period was characterised by the restrictive entry of foreign
banks since after the nationalisation of banks in 1969 and 1980, almost 90 per cent of the
banking assets were under the control of government owned banks and financial
institutions. The financial reforms initiated in this era attempted to overcome these weaknesses
with the view of enhancing efficient allocation of resources in the Indian economy.

The Reserve Bank of India had been making efforts since 1986 to develop efficient and healthy
financial markets which were accelerated after 1991. RBI focused on the development of
financial markets especially the money market, government securities market and the forex
markets. Financial markets also benefited from close coordination between the Central
Government and the RBI as also between the other regulators.

Major financial sector reforms in last decade

The last ten years have witnessed a maturing of the country's financial markets. While many
major commercial banking and specialised investment institutions continue to be in the public
sector, private sector institutions are growing rapidly in commercial banking and asset
management business, says Abhijit Roy.

A DECADE is not a long time in the life of a nation. However, the last ten years mark a
watershed in India's economic and political development. This article attempts to take stock,
albeit briefly, of the important achievements of the financial sector reforms undertaken since
1991 by various governments.

Financial markets

The last ten years have witnessed a maturing of the country's financial markets. While many
major commercial banking and specialised investment institutions continue to be in the public
sector. Private sector institutions are growing rapidly in commercial banking and asset
management business. With the recent opening up of the insurance sector, the private sector will
start making a dent in the market.

Deregulation of the financial system and competition among financial intermediaries have led to
a gradual decline in interest rates. The task is to keep the real interest rate, that is the difference
between the nominal rate of interest and the expected rate of inflation, at a realistic level, so that
borrowers do not pay a high price, while depositors have an incentive to save. In India structural
rigidities in the form of high intermediation costs and non-performing assets have been
responsible for high real interest rates.

It may be added that deregulation has not always been successful, witness the problems faced by
a number of non-banking finance companies (NBFCs) and the poor performance of primary
markets in recent years.

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Regulators

The Government has accepted the imprortant role of regulators. The Finance Ministry continues
to formulate major policies relating to the financial sector. However, the Reserve Bank of India
has become more independent, while the Securities and Exchange Board of India and the
Insurance Regulatory and Development Authority (IRDA) have become important institutions. A
Pensions Regulatory Authority is to be set up under the IRDA. There is an opinion that a
multiplicity of regulators should be avoided and there is need for a super-regulator for the
financial services sector.

The banking system

Public sector banks (PSBs) continue to dominate the commercial banking system, controlling 80
per cent of the business. Shares of leading PSBs are already listed on the stock exchanges. The
Government proposes to reduce its equity stake in PSBs to 33 per cent. This can ultimately lead
to privatisation of PSBs.

As part of the liberalisation process, the RBI gave licences to new private sector banks. Already
restructuring of private sector banking has started with a few banks merging in order to form
stronger entities. Only a few of the existing private sector banks have the managerial capability
and financial strength to expand rapidly. The RBI has also been wary of granting banking
licences to industrial houses. Further, a number of private sector banks have been successful in
the retail and consumer segments, but are yet to deliver in important areas such as industrial
finance, retail trade, small business and agricultural finance. With foreign banks facing the
constraint of limited number of branches, the PSBs will continue to be the critical element in this
industry for some time. Hence, in order to achieve an efficient banking system, the onus is on the
Government to encourage the PSBs to be run on professional lines.

Development finance institutions

FIs's access to SLR funds reduced. Now they have to approach the capital market for debt and
equity funds.

Convertibility clause no longer obligatory for assistance to corporates sanctioned by term-

lending institutions.

Capital adequacy norms extended to financial institutions.

DFIs such as IDBI and ICICI have entered other segments of financial services such as
commercial banking, asset management and insurance through separate ventures. The move to
universal banking has started.

Non-banking finance companies

In the case of new NBFCs seeking registration with the RBI, the requirement of minimum net
owned funds, has been raised to Rs.2 crores.
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Until recently, the money market in India was narrow and circumscribed by tight regulations
over interest rates and participants. The secondary market was underdeveloped and lacked
liquidity. Several measures have been initiated and include new money market instruments,
strengthening of existing instruments and setting up of the Discount and Finance House of India
(DFHI).

The RBI conducts its sales of dated securities and treasury bills through its open market
operations (OMO) window. Primary dealers bid for these securities and also trade in them. The
DFHI is the principal agency for developing a secondary market for money market instruments
and Government of India treasury bills. The RBI has introduced a liquidity adjustment facility
(LAF) in which liquidity is injected through reverse repo auctions and liquidity is sucked out
through repo auctions.

On account of the substantial issue of government debt, the gilt- edged market occupies an
important position in the financial set- up. The Securities Trading Corporation of India (STCI),
which started operations in June 1994 has a mandate to develop the secondary market in
government securities.

Long-term debt market: The development of a long-term debt market is crucial to the financing
of infrastructure. After bringing some order to the equity market, the SEBI has now decided to
concentrate on the development of the debt market. Stamp duty is being withdrawn at the time of
dematerialisation of debt instruments in order to encourage paperless trading.

The capital market

The number of shareholders in India is estimated at 25 million. However, only an estimated two
lakh persons actively trade in stocks. There has been a dramatic improvement in the country's
stock market trading infrastructure during the last few years. Expectations are that India will be
an attractive emerging market with tremendous potential. Unfortunately, during recent times the
stock markets have been constrained by some unsavoury developments, which has led to retail
investors deserting the stock markets.

Mutual funds

The mutual funds industry is now regulated under the SEBI (Mutual Funds) Regulations, 1996
and amendments thereto. With the issuance of SEBI guidelines, the industry had a framework for
the establishment of many more players, both Indian and foreign players.

The Unit Trust of India remains easily the biggest mutual fund controlling a corpus of nearly
Rs.70,000 crores, but its share is going down. The biggest shock to the mutual fund industry
during recent times was the insecurity generated in the minds of investors regarding the US 64
scheme. With the growth in the securities markets and tax advantages granted for investment in
mutual fund units, mutual funds started becoming popular.

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The foreign owned AMCs are the ones which are now setting the pace for the industry. They are
introducing new products, setting new standards of customer service, improving disclosure
standards and experimenting with new types of distribution.

The insurance industry is the latest to be thrown open to competition from the private sector
including foreign players. Foreign companies can only enter joint ventures with Indian
companies, with participation restricted to 26 per cent of equity. It is too early to conclude
whether the erstwhile public sector monopolies will successfully be able to face up to the
competition posed by the new players, but it can be expected that the customer will gain from
improved service.

The new players will need to bring in innovative products as well as fresh ideas on marketing
and distribution, in order to improve the low per capita insurance coverage. Good regulation will,
of course, be essential.

Overall approach to reforms

The last ten years have seen major improvements in the working of various financial market
participants. The government and the regulatory authorities have followed a step-by-step
approach, not a big bang one. The entry of foreign players has assisted in the introduction of
international practices and systems. Technology developments have improved customer service.
Some gaps however remain (for example: lack of an inter-bank interest rate benchmark, an
active corporate debt market and a developed derivatives market). On the whole, the cumulative
effect of the developments since 1991 has been quite encouraging. An indication of the strength
of the reformed Indian financial system can be seen from the way India was not affected by the
Southeast Asian crisis.

Deregulation of banking system

Prudential norms introduced for income recognition, asset classification, provisioning for
delinquent loans and capital adequacy. In order to reach the stipulated capital adequacy norms,
substantial capital has been provided by the Government to PSBs.

Government pre-emption of banks' resources through statutory liquidity ratio (SLR) and cash
reserve ratio (CRR) brought down in stages.

Interest rates on deposit and lending sides almost entirely deregulated.

New private sector banks allowed to promote competition.

PSBs encouraged to approach the public to raise resources.

Recovery of debts due to banks and the Financial Institutions Act, 1993 passed, and special
recovery tribunals set up to facilitate quicker recovery of loan arrears.

Bank lending norms liberalised and a loan system to ensure better control over credit introduced.
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Banks asked to set up asset liability management (ALM) systems. RBI guidelines issued for risk
management systems in banks encompassing credit, market and operational risks.

A credit information bureau being established to identify bad risks.

Derivative products such as sforward rate agreements (FRAs) and interest rate swaps (IRSs)
introduced

Reforms around Capital Requirements

The insecurity in credit markets that began in mid-2007 clearly pointed out numerous
weaknesses in managing adequate capital by banks. Some of the major weaknesses of the global
financial system that were exposed in the crisis are discussed below.

Low core equity1 levels:

During the financial crisis it became clear that most banks were holding low levels of core
equity, meaning that in case of defaults they would fail to honor their debt. This was a big
concern for creditors and especially for banks. Raising capital for their operations became
difficult due to liquidity crunch.

Poor capital base quality

It emerged post-crisis that the banks were not only facing problems due to low levels of capital,
but there were issues around the quality, consistency, and transparency of their capital base.

Inadequate risk coverage

Some financial institutions relied too much on risk models for risk-measurement, thus losing
their perspective on the experience-based benefits of risk management. Also, the risk
calculations were generally based on single parameter, for example Value at Risk (VaR) or Tier
1 ratio.

Very high leverage ratio

Most banks had very high leverage ratios, making them “too big to fail” and posing systemic
threat to the financial system. In addition to these weaknesses, there was a clear lack of expertise
around risk and valuation methodologies, calculating transfer of funding costs and liquidity
pricing.

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 RESTRUCTURING THE FINANCIAL SECTOR :-

The 'Financial Sector Reforms' in India is, an integral part of the overall programme of economic
reforms, aimed at improving productivity and efficiency. In India, reform of the domestic
financial sector did not form part of the initial set of reforms, but events quickly moved it to
forefront. Today, financial sector restructuring, liberalisation and deregulation have become
more prominent on the reform agenda.

In any financial sector reform, the institutions immediately affected are the 'Banks', since they
typically dominate the financial systems, in the early stages of financial development. Banks are
central to providing short-term financing to the various economic entities. Banks are also
distinguishable from other financial institutions by a unique characteristic, which gives them
power to provide means of payment in non-cash transactions.

As the reform of the financial system takes its root, it is the banking system which comes to face
increasing competition from non-banks and the capital markets.

A major lesson to be learnt from the experiences of the other countries which have gone through
a programme of financial sector reform, is that, reforms are successful, only if they are
accompanied by fiscal consolidation, moderate inflation and no sharp appreciation's in the real
effective interest rate.

The problem which the financial sector reforms, ran into in the Southern cone countries were,
because of uncontrolled inflation and sharp appreciation in real exchange rate. In those Financial
Sector Reforms in India 93 circumstances, interest rate deregulation faced even more difficulties.

Also, in those countries no effective prudential guidelines had been put in place either prior to or
simultaneously with the introduction of the reforms.

On the contrary, the Indian Financial Sector Reforms has gone, hand in hand with fiscal reforms,
trade reforms and exchange rate reforms. The 3 major building blocks of the financial sector
reform in India have been ;-

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1. Removing or relaxing the external constraints;
2. Introduction of prudential norms; and
3. Institutional strengthening.

The chief merit of reform process, has been the cautions sequencing of reforms and the
consistent and the mutually reinforcing character of the various measures taken. Even as the new
prudential norms are being introduced, the capital base of the banks has been strengthened and
orgnisational improvements are being put in place.

Through these reform measures, foundation for an efficient and a well functioning banking
system is laid down. A renewed and a reinvigorated banking system can play an important role
in accelerating economic growth. Banking system is on the threshold of a second revolution. It
has, however miles to go. But the steps that are being taken, are in right direction.

MAJOR ISSUES IN FINANCIAL SECTOR REFORM.

This study, has concentrated largely on the challenges facing the 'Indian Scheduled Commercial
Banks' and changes in the environment within which they operate. While such a narrow focus
may be criticised, the justification is that, these remain the core institutions of the Indian
financial system.

The fundamental precondition for a healthy financial system is clearly in place in India, high
savings rates and low inflationary expectations. However, the role assigned to the banks has been
radically altered. From, institutional designed to channel resources to public investment and to
highly private uses, the banks are now being asked to become gobally competitive and to
develop risk assessment capacities that may have rusted. Financial reforms, which were induced
in 1991-92 based on the recommendations Financial Sector Reforms in India of the Narasimham
Committee, came as a breath of fresh air, as banks were given a chance to recover lost ground.

The path and direction are clear, it is therefore, necessary to analyse and conjecture the future of
banking, which will by typified by intense competition, as it would act as the fulcrum of all
banking activity.

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The major issues in the financial sector are:-
1. Role of banks in the new environment of LPG Package,
2. Problem of profitability and efficiency,
3. Solution towards Non-Performing Assets,
4. Recapitalisation of banks,
5. Deployment of credit in the Priority Sector,
6. Structure of interest rates,
7. Trends in Cash Reserve Ratio and Statutory Liqidity Ratio,
8. Competition among Private banks. Foreign banks, Non-Banking Financial Institutions,
Development Financial Institutions, etc.
9. Problem of merger of banks,
10. Role of public sector banks and agriculture,
11. Privatisation of public sector banks,
12. Rehabitilisation of weak banks,
13. Development of capital and money markets,
14. Concept of Universal banking,
15. Role of development financial institutions,
16. Role of Trade Unions,
17. How far reforms would help the poor in India,
18. Customers satisfaction,
19. Concept of Nan"ow banking, and
20. Future of Indian economy.etc.

The reforms in the financial system are linked to the question of reforms in the real i.e. non-
financial sectors. In the planned system, where factors of production are owned by the State, no
need for elaborate financial system was felt. Planning authorities would directly take bulk of
decisions. In a decentralised market economy, on the other hand, markets perform a co-
ordinating role.

Financial system is particularity important in mobilisation of societal savings and its efficient
deployment in different investible avenues. It also provides a payment mechanism, which is
critically important for growth in production and trade. As long as, money and financial system

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function smoothly, their importance is not realised , but a defective financial system would
adversly affect almost all other sectors.

Future agenda of reform policies

Need for greater legislative measures

It is mandatory that financial reforms are accompanied by legislative measure commensurate
with these reforms to enable further progress. These are required mainly with regard to
ownership, development of financial markets, regulatory focus, and bankruptcy
procedures. Shortcomings in benefits of reforms such as in credit delivery require changes in the
legal framework. Furthermore, it is required to concentrate in reduction of transaction costs in
economic activity and to enhance economic incentives. Increased enforceability cannot be
substituted by the increase in the severity of penalties in criminal proceedings. Lastly, in the
institutional element, there is an increasing need to clearly demarcate the roles and functions of
the owner, financial intermediary and market participant so as to “replace the joint-family
approach that is a legacy of the pre-reform framework”.

Fiscal Empowerment
Notwithstanding the existing level of fiscal deficit, which appears to be manageable, the cushion
available for meeting unforeseen circumstances is limited. This problem is acute especially in
regard to finances of states which have major structural problems and are in constant need of
fiscal support from the Central Government. Y.V. Reddy remarks that the nature of fiscal
dominance constrains the effectiveness of the monetary policy to meet unforeseen contingencies
as well as to main price stability and contain inflationary expectations.

Reforms in the real sector

Reforms in the real sector would be necessary to bring about structural changes in the Indian
economy, particularly in domestic trade. Further growth can be successfully achieved by
liberalisation of the financial and external sector.

Social obligations distribution among banks and financial institutions

It is necessary to distinguish between the contributions of a financial sector and fiscal actions in
matters relating to poverty alleviation. Social obligations should be distributed equitably among
banks and other financial intermediaries but would be difficult to achieve in the context of
emerging capital markets and an economy which is relatively open. Intermediation may have to
be multi-institutional rather than being wholly bank-centered.

Often banks, which are the foundational stones of payment systems, face problems if they are
subjected to disproportionate burdens. This needs to be looked into.- monetary and fiscal policies
in India should be focussed on what Dreze and Sen termed as “growth mediated security” while
“support lead security”. This primarily consists of direct anti-poverty interventions tackled by
fiscal and other governmental activities.

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 Overhang problems in the financial sector
The presence of ‘overhang’ problems is another element which needs to be addressed. To
exemplify the meaning of this phrase, problems such as non-performing assets of banks and
financial institutions would come within the meaning of this phrase. However, overhang issue
are contrasting in nature from flow issues. There is merit in insulating the overhang problem
from the flow issues and thereby solve the flow problem. Taking the example of the power
sector, any addition to capacities to generate without taking into account cost recovery would
add to the problem of accumulated losses. Overhang problems, apart from the financial sector,
are prevalent in public enterprises, provident fund and pension liabilities and the cooperative
sector. They have a cumulative effect on the finance sector.

Financial Inclusion
Apart from the above, several suggestions have been made in the domain of financial inclusion.
Financial inclusion is the key priority for a country like India. Below mentioned are some
initiatives taken recently for achieving this objective:

The establishment of off-site ATMs has been de-licensed.

List of banking correspondents has now been expanded to include individual petty, medical as
well as fair price shop owners and also agents of small savings schemes offered by the
Government, insurance companies, and retired teachers.

At present, the Reserve Bank is reviewing the guidelines of the priority sector lending and the
feasibility of trading in priority sector lending certificates.

A working group set up under the Reserve Bank has recommended the removal of interest rate
ceiling on loans upto Rs. 2 lakhs.

capital requirement

A capital requirement (also known as regulatory capital or capital adequacy) is the amount
of capital a bank or other financial institution has to hold as required by its financial regulator.
This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage
of risk-weighted assets. These requirements are put into place to ensure that these institutions do
not take on excess leverage and become insolvent. Capital requirements govern the ratio of
equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should
not be confused with reserve requirements, which govern the assets side of a bank's balance
sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets.

Regulations
A key part of bank regulation is to make sure that firms operating in the industry are prudently
managed. The aim is to protect the firms themselves, their customers, the government (which is
liable for the cost of deposit insurance in the event of a bank failure) and the economy, by
establishing rules to make sure that these institutions hold enough capital to ensure continuation
of a safe and efficient market and able to withstand any foreseeable problems.
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The main international effort to establish rules around capital requirements has been the Basel
Accords, published by the Basel Committee on Banking Supervision housed at the Bank for
International Settlements. This sets a framework on how banks and depository institutions must
calculate their capital. After obtaining the capital ratios, the bank capital adequacy can be
assessed and regulated. In 1988, the Committee decided to introduce a capital measurement
system commonly referred to as Basel I. In June 2004 this framework was replaced by a
significantly more complex capital adequacy framework commonly known as Basel II.
Following the financial crisis of 2007–08, Basel II was replaced by Basel III,[1] which will be
gradually phased in between 2013 and 2019.[2]
Another term commonly used in the context of the frameworks is economic capital, which can
be thought of as the capital level bank shareholders would choose in the absence of capital
regulation.

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 Unit-2

Salient provisions of banking regulation act

1. Prohibition of Trading (Sec. 8): According to Sec. 8 of the Banking Regulation Act, a
banking company cannot directly or indirectly deal in buying or selling or bartering of goods.
But it may, however, buy, sell or barter the transactions relating to bills of exchange received for
collection or negotiation.

2. Disposal of banking assets (Sec. 9): According to Sec. 9 “A banking company cannot hold
any immovable property, howsoever acquired, except for its own use, for any period exceeding
seven years from the date of acquisition thereof. The company is permitted, within the period of
seven years, to deal or trade in any such property for facilitating its disposal”.

3. Management (Sec. 10): Sec. 10 (a) states that not less than 51% of the total number of
members of the Board of Directors of a banking company shall consist of persons who have
special knowledge or practical experience in one or more of the following fields:

a) Accountancy
b) Agriculture and Rural Economy
c) Banking
d) Cooperative
e) Economics
f) Finance
g) Law
h) Small Scale Industry.

4. Requirements as to minimum paid-up capital and reserves (Sec. 11): Sec. 11 (2) of the
Banking Regulation Act, 1949, provides that no banking company shall commence or carry on
business in India, unless it has minimum paid-up capital and reserve of such aggregate value as
is noted below:

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(a) Foreign Banking Companies: In case of banking company incorporated outside India,
aggregate value of its paid-up capital and reserve shall not be less than Rs. 15 lakhs and, if it has
a place of business in Mumbai or Kolkata or in both, Rs. 20 lakhs. It must deposit and keep with
the R.B.I, either in Cash or in unencumbered approved securities.

(b) Indian Banking Companies: In case of an Indian banking company, the sum of its paid-up
capital and reserves shall not be less than the amount stated below:

(i) If it has places of business in more than one State, Rs. 5 lakhs, and if any such place of
business is in Mumbai or Kolkata or in both, Rs. 10 lakhs.

(iii) If it has all its places of business in one Stae or more of which are in Mumbai or Kolkata,
Rs. 5 lakhs plus Rs. 25,000 in respect of each place of business outside Mumbai or Kolkata? No
such banking company shall be required to have paid-up capital and reserve excluding Rs. 10
lakhs.

5. Regulation of capital and voting rights of shareholders (Sec. 12): According to Sec. 12, no
banking company can carry on business in India, unless it satisfies the following conditions:
(a) Its subscribed capital is not less than half of its authorized capital, and its paid-up capital is
not less than half of its subscribed capital.
(b) Its capital consists of ordinary shares only or ordinary or equity shares and such preference
shares as may have been issued prior to 1st April 1944.
(c) The voting right of any shareholder shall not exceed 5% of the total voting right of all the
shareholders of the company.

6. Restriction on Commission, Brokerage, Discount etc. on sale of shares (Sec.

13): According to Sec. 13, a banking company is not permitted to pay directly or indirectly by
way of commission, brokerage, discount or remuneration on issues of its shares in excess of
2½% of the paid-up value of such shares.

7. Prohibition of charges on unpaid capital (Sec. 14): A banking company cannot create any
charge upon its unpaid capital and such charges shall be void.

17
8. Restriction on Payment of Dividend (Sec. 15): According to Sec. 15, no banking company
shall pay any dividend on its shares until all its capital expenses (including preliminary expenses,
organisation expenses, share selling commission, brokerage, amount of losses incurred and other
items of expenditure not represented by tangible assets) have been completely written-off.

9. Reserve Fund/Statutory Reserve (Sec. 17): According to Sec. 17, every banking company
incorporated in India shall, before declaring a dividend, transfer a sum equal to 25% of the net
profits of each year (as disclosed by its Profit and Loss Account) to a Reserve Fund. The Central
Government may, however, on the recommendation of RBI, exempt it from this requirement for
a specified period.

10. Cash Reserve (Sec. 18): Under Sec. 18, every banking company (not being a Scheduled
Bank) shall, if Indian, maintain in India, by way of a cash reserve in Cash, with itself or in
current account with the Reserve Bank or the State Bank of India or any other bank notified by
the Central Government in this behalf, a sum equal to at least 3% of its time and demand
liabilities in India.
The Reserve Bank has the power to regulate the percentage also between 3% and 15% (in case of
Scheduled Banks). Besides the above, they are to maintain a minimum of 25% of its total time
and demand liabilities in cash, gold or unencumbered approved securities.

11. Liquidity Norms or Statutory Liquidity Ratio (SLR) (Sec. 24): According to Sec. 24 of
the Act, in addition to maintaining CRR, banking companies must maintain sufficient liquid
assets in the normal course of business. The section states that every banking company has to
maintain in cash, gold or unencumbered approved securities, an amount not less than 25% of its
demand and time liabilities in India.
This percentage may be changed by the RBI from time to time according to economic
circumstances of the country. This is in addition to the average daily balance maintained by a
bank.

12. Restrictions on Loans and Advances (Sec. 20): After the Amendment of the Act in 1968, a
bank cannot:
(i) Grant loans or advances on the security of its own shares, and
(ii) Grant or agree to grant a loan or advance to or on behalf of:
18
a) Any of its directors;
b) Any firm in which any of its directors is interested as partner, manager or guarantor;
c) Any company of which any of its directors is a director, manager, employee or guarantor, or in
which he holds substantial interest; or
d) Any individual in respect of whom any of its directors is a partner or guarantor.

13. Accounts and Audit (Sees. 29 to 34A): The above Sections of the Banking Regulation Act
deal with the accounts and audit. Every banking company, incorporated in India, at the end of a
financial year expiring after a period of 12 months as the Central Government may by
notification in the Official Gazette specify, must prepare a Balance Sheet and a Profit and Loss
Account as on the last working day of that year, or, according to the Third Schedule, or, as
circumstances permit.
.
Banking Law
Banking law is the broad term for laws that govern how banks and other financial institutions
conduct business. Banks must comply with a myriad of federal, state and even local regulations.
Lawyers perform a wide variety of functions that relate to creating, following and enforcing
regulations.

Multiple federal agencies oversee banking regulations. A bank or other financial institution
might fall under regulations of the Federal Deposit Insurance Corporation (FDIC), the Federal
Reserve System or the Office of the Comptroller of the Currency (OCC). Banks must know what
federal and state regulations they must comply with.

Why do banking laws exist?

As the American economy expanded in the 20th century, lawmakers became concerned about the
influence that banks have on the economy. When banks struggle, the effects spread to consumers
and the public as a whole. Lawmakers create banking regulations in order to ensure that banks
conduct regulations in a fair and transparent way. .

What do banking laws regulate?

Banking laws may exist in order to achieve many objectives. Some of these include:

19
 Provide transparency for consumers
 Reduce risk for banking customers
 Avoid misuse of banks for purposes like money laundering
 Allow consumers to bank with confidentiality
 Prevent other crimes
 Prioritize bank lending according to economic and social priorities
 Provide fair banking and equal opportunities for banking
 Prevent terrorism
 Create fair debt collection practices
 Make credit card agreements fair to consumers
 Prevent banks from making unfair loans to insiders like officers and principal shareholders
 Allow customers to reasonably raise disputes
 Other goals

Major banking laws

There are several major laws in the United States that regulate banking on a federal level.
Federal banking regulations often supersede state and local regulations. In total, there are
thousands of regulations, large and small, that banks need to understand and follow. Here are just
a few of the major banking regulations in the United States:

Banking Act of 1933

The Banking Act of 1933 established the Federal Deposit Insurance Corporation. The FDIC
system provides insurance for consumers in case banks fail. The maximum insurance amount has
risen over time to its current limit of $250,000. The Banking Act includes other bank regulations.

Right to Privacy Act

Also called Regulation P, the Right to Privacy Act controls how banks can use customer
information. Banks must tell consumers about their privacy policies and give them a chance to
opt out of information sharing. Banks must also report suspicious customer activity to the
government.

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Bank Secrecy Act
The Bank Secrecy Act aims to stop money laundering and tax evasion. Bank must report cash
transactions with a value of more than $10,000. They must keep records when they purchase
certain financial assets.

Community Reinvestment Act of 1977

The Community Reinvestment Act requires banks to invest their money in the areas that they
serve. They must find ways to serve low and moderate income individuals. They must also keep
public files that allow for transparency on these matters.

The Regulations That Govern Banking in India

The banking system in India is regulated by the Reserve Bank of India (RBI), through the
provisions of the Banking Regulation Act, 1949. Some important aspects of the regulations that
govern banking in this country, as well as RBI circulars that relate to banking in India, will be
explored below.
Exposure limits
Lending to a single borrower is limited to 15% of the bank’s capital funds, which may be
extended to 20% in the case of infrastructure projects. For group borrowers, lending is limited to
30% of the bank’s capital funds, with an option to extend it to 40% for infrastructure projects.
The lending limits can be extended by a further 5% with the approval of the bank's board of
directors. Lending includes both fund-based and non-fund-based exposure.

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

Banks in India are required to keep a minimum of 4% of their net demand and time
liabilities(NDTL) the form of cash with the RBI. These currently earn no interest. The CRR
needs to be maintained on a fortnightly basis, while the daily maintenance needs to be at least
95% of the required reserves. In case of default on daily maintenance, the penalty is 3% above
the bank rate applied on the number of days of default multiplied by the amount by which the
amount falls short of the prescribed level.

Over and above the CRR, a minimum of 22% and a maximum of 40% of NDTL, which is known
as the SLR, needs to be maintained in the form of gold, cash or certain approved securities. The
excess SLR holdings can be used to borrow under the Marginal Standing Facility (MSF) on an
overnight basis from the RBI. The interest charged under MSF is higher than the repo rate by
100 bps, and the amount that can be borrowed is limited to 2% of NDTL. (To learn more about

21
how interest rates are determined, particularly in the U.S., consider reading more about who
determines interest rates.)

Provisioning
Non-performing assets (NPA) are classified under 3 categories: substandard, doubtful and loss.
An asset becomes non-performing if there have been no interest or principal payments for more
than 90 days in the case of a term loan. Substandard assets are those assets with NPA status for
less than 12 months, at the end of which they are categorized as doubtful assets. A loss asset is
one for which the bank or auditor expects no repayment or recovery and is generally written off
the books.

For substandard assets, it is required that a provision of 15% of the outstanding loan amount for
secured loans and 25% of the outstanding loan amount for unsecured loans be made. For
doubtful assets, provisioning for the secured part of the loan varies from 25% of the outstanding
loan for NPAs that have been in existence for less than one year, to 40% for NPAs in existence
between one and three years, to 100% for NPA’s with a duration of more than three years, while
for the unsecured part it is 100%.

Provisioning is also required on standard assets. Provisioning for agriculture and small and
medium enterprises is 0.25% and for commercial real estate it is 1% (0.75% for housing), while
it is 0.4% for the remaining sectors. Provisioning for standard assets cannot be deducted from
gross NPA’s to arrive at net NPA’s. Additional provisioning over and above the standard
provisioning is required for loans given to companies that have unhedged foreign
exchange exposure.

Priority sector lending

The priority sector broadly consists of micro and small enterprises, and initiatives related to
agriculture, education, housing and lending to low-earning or less privileged groups (classified as
"weaker sections"). The lending target of 40% of adjusted net bank credit (ANBC) (outstanding
bank credit minus certain bills and non-SLR bonds) – or the credit equivalent amount of off-
balance-sheet exposure (sum of current credit exposure + potential future credit exposure that is
calculated using a credit conversion factor), whichever is higher – has been set for
domestic commercial banks and foreign banks with greater than 20 branches, while a target of
32% exists for foreign banks with less than 20 branches.

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The amount that is disbursed as loans to the agriculture sector should either be the credit
equivalent of off-balance-sheet exposure, or 18% of ANBC – whichever of the two figures is
higher.

Of the amount that is loaned to micro-enterprises and small businesses, 40% should be advanced
to those enterprises with equipment that has a maximum value of 200,000 rupees, and plant and
machinery valued at a maximum of half a million rupees, while 20% of the total amount lent is
to be advanced to micro-enterprises with plant and machinery ranging in value from just above
500,000 rupees to a maximum of a million rupees and equipment with a value above 200,000
rupees but not more than 250,000 rupees.

The total value of loans given to weaker sections should either be 10% of ANBC or the credit
equivalent amount of off-balance sheet exposure, whichever is higher. Weaker sections include
specific castes and tribes that have been assigned that categorization, including small farmers.
There are no specific targets for foreign banks with less than 20 branches.

New bank license norms

The new guidelines state that the groups applying for a license should have a successful track
record of at least 10 years and the bank should be operated through a non-operative financial
holding company (NOFHC) wholly owned by the promoters. The minimum paid-
upvoting equity capital has to be five billion rupees, with the NOFHC holding at least 40% of it
and gradually bringing it down to 15% over 12 years. The shares have to be listed within three
years of the start of the bank’s operations.

The foreign shareholding is limited to 49% for the first five years of its operation, after which
RBI approval would be needed to increase the stake to a maximum of 74%. The board of the
bank should have a majority of independent directors and it would have to comply with the
priority sector lending targets discussed earlier. The NOFHC and the bank are prohibited from
holding any securities issued by the promoter group and the bank is prohibited from holding any
financial securities held by the NOFHC. The new regulations also stipulate that 25% of the
branches should be opened in previously unbanked rural areas.

Willful defaulters
A willful default takes place when a loan isn’t repaid even though resources are available, or if
the money lent is used for purposes other than the designated purpose, or if a property secured
for a loan is sold off without the bank's knowledge or approval. In case a company within a

23
group defaults and the other group companies that have given guarantees fail to honor their
guarantees, the entire group can be termed as a willful defaulter.

Willful defaulters (including the directors) have no access to funding, and criminal proceedings
may be initiated against them. The RBI recently changed the regulations to include non-group
companies under the willful defaulter tag as well if they fail to honor a guarantee given to
another company outside the group.

RBI as a Central Banker

The Reserve Bank of India (RBI) is India's central banking institution, which controls
the monetary policy of the Indian rupee. It commenced its operations on 1 April 1935 in
accordance with the Reserve Bank of India Act, 1934. The original share capital was divided into
shares of 100 each fully paid, which were initially owned entirely by private
shareholders. Following India's independence on 15 August 1947, the RBI was nationalised on 1
January 1949.
The central bank of any country executes many functions such as overseeing monetary policy,
issuing currency, managing foreign exchange, working as a bank for government and as a banker
of scheduled commercial banks. It also works for overall economic growth of the country. The
preamble of the Reserve Bank of India describes its main functions as to regulate the issue of
Bank Notes and keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and credit system of the country to its advantage.
Role of RBI:
Financial Supervision
The primary objective of RBI is to undertake consolidated supervision of the financial sector
comprising commercial banks, financial institutions and non-banking finance companies.
The Board is constituted by co-opting four Directors from the Central Board as members for a
term of two years and is chaired by the governor. The deputy governors of the reserve bank are
ex-officio members. One deputy governor, usually, the deputy governor in charge of banking
regulation and supervision, is nominated as the vice-chairman of the board. The Board is
required to meet normally once every month. It considers inspection reports and other
supervisory issues placed before it by the supervisory departments.
Regulator and supervisor of the financial system
The institution is also the regulator and supervisor of the financial system and prescribes broad
parameters of banking operations within which the country's banking and financial system
functions. Its objectives are to maintain public confidence in the system, protect depositors'
interest and provide cost-effective banking services to the public. The Banking Ombudsman
Scheme has been formulated by the Reserve Bank of India (RBI) for effective addressing of
complaints by bank customers. The RBI controls the monetary supply, monitors economic
24
indicators like the gross domestic product and has to decide the design of the rupee banknotes as
well as coins.
Regulator and Supervisor of the Payment and Settlement Systems.
Payment and settlement systems play an important role in improving overall economic
efficiency. The Payment and Settlement Systems Act of 2007 (PSS Act) gives the Reserve Bank
oversight authority, including regulation and supervision, for the payment and settlement
systems in the country. In this role, the RBI focuses on the development and functioning of safe,
secure and efficient payment and settlement mechanisms.
Two payment systems National Electronic Fund Transfer (NEFT) and Real Time Gross
Settlement (RTGS) allow individuals, companies and firms to transfer funds from one bank to
another. These facilities can only be used for transferring money within the country.
NEFT operates on a deferred net settlement (DNS) basis and settles transactions in batches. The
settlement takes place for all transactions received till a particular cut-off time. It operates in
hourly batches — there are 12 settlements from 8 am to 7 pm on weekdays and SIX between 8
am and 1 pm on Saturdays.
Any transaction initiated after the designated time would have to wait till the next settlement
time. In RTGS, transactions are processed continuously, all through the business hours. RBI’s
settlement time is 9 am to 4:30 pm on weekdays and 9 am to 2:00 pm on Saturdays.
Banker and Debt Manager to Government.
Just like individuals need a bank to carry out their financial transactions effectively & efficiently,
Governments also need a bank to carry out their financial transactions. RBI serves this purpose
for the Government of India (GoI). As a banker to the GoI, RBI maintains its accounts, receive
payments into & make payments out of these accounts. RBI also helps GoI to raise money from
public via issuing bonds and government approved securities.
Managing foreign exchange.
The central bank manages to reach different goals of the Foreign Exchange Management Act,
1999. Their objective is to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.
With increasing integration of the Indian economy with the global economy arising from greater
trade and capital flows, the foreign exchange market has evolved as a key segment of the Indian
financial market and RBI has an important role to play in regulating & managing this segment.
RBI manages forex and gold reserves of the nation.
On a given day, the foreign exchange rate reflects the demand for and supply of foreign
exchange arising from trade and capital transactions. The RBI’s Financial Markets Department
(FMD) participates in the foreign exchange market by undertaking sales / purchases of foreign
currency to ease volatility in periods of excess demand for/supply of foreign currency.
Issue of currency.
Reserve bank of India is the sole body who is authorized to issue currency in India. The bank
also destroys the same when they are not fit for circulation. All the money issued by the central
bank is its monetary liability, i.e., the central bank is obliged to back the currency with assets of

25
equal value, to enhance public confidence in paper currency. The objectives are to issue bank
notes and give public adequate supply of the same, to maintain the currency and credit system of
the country to utilize it in its best advantage, and to maintain the reserves. RBI maintains the
economic structure of the country so that it can achieve the objective of price stability as well as
economic development because both objectives are diverse in themselves.
Banker's bank
Reserve Bank of India also works as a central bank where commercial banks are account holders
and can deposit money. RBI maintains banking accounts of all scheduled banks. Commercial
banks create credit. It is the duty of the RBI to control the credit through the CRR, bank rate and
open market operations. As banker's bank, the RBI facilitates the clearing of cheques between
the commercial banks and helps the inter-bank transfer of funds. It can grant financial
accommodation to schedule banks. It acts as the lender of the last resort by providing emergency
advances to the banks. It supervises the functioning of the commercial banks and takes action
against it if the need arises. The RBI also advises the banks on various matters for example
Corporate Social Responsibility.
Regulator of the Banking System
RBI has the responsibility of regulating the nation's financial system. As a regulator and
supervisor of the Indian banking system it ensures financial stability & public confidence in the
banking system. RBI uses methods like On-site inspections, off-site surveillance, scrutiny &
periodic meetings to supervise new bank licenses, setting capital requirements and regulating
interest rates in specific areas. RBI is currently focused on implementing Basel III norms.
Detection of fake currency
In order to curb the fake currency problem, RBI has launched a website to raise awareness
among masses about fake notes in the market. www.paisaboltahai.rbi.org.in provides information
about identifying fake currency.
RBI gave a press release stating that after 31 March 2014, it will completely withdraw from
circulation of all banknotes issued prior to 2005. From 1 April 2014, the public will be required
to approach banks for exchanging these notes. Banks will provide exchange facility for these
notes until further communication.
The reserve bank has also clarified that the notes issued before 2005 will continue to be legal
tender. This would mean that banks are required to exchange the notes for their customers as
well as for non-customers. From 1 July 2014, however, to exchange more than 15 pieces of `500
and `1000 notes, non-customers will have to furnish proof of identity and residence as well as
show aadhar to the bank branch in which she/he wants to exchange the notes.
This move from the reserve bank is expected to unearth black money held in cash. As the new
currency notes have added security features, they would help in curbing the menace of fake
currency.
Developmental role.
The central bank has to perform a wide range of promotional functions to support national
objectives and industries.The RBI faces a lot of inter-sectoral and local inflation-related
problems. Some of these problems are results of the dominant part of the public sector.

26
Key tools in this effort include Priority Sector Lending such as agriculture, micro and small
enterprises (MSE), housing and education. RBI work towards strengthening and supporting
small local banks and encourage banks to open branches in rural areas to include large section of
society in banking net.
Related functions
The RBI is also a banker to the government and performs merchant banking function for the
central and the state governments. It also acts as their banker. The National Housing
Bank (NHB) was established in 1988 to promote private real estate acquisition.[56] The institution
maintains banking accounts of all scheduled banks, too.
Custodian to foreign exchange
The Reserve Bank has custody of the country’s reserves of international currency, and this
enables the Reserve Bank to deal with crisis connected with adverse balance of payments
position.
Role of Development Banks

Capital Formation:

The significance of Development Finance Institutions or DFIs lies in their making available the
means to utilize savings generated in the economy, thus helping in capital formation. Capital
formation implies the diversion of the productive capacity of the economy to the making of
capital goods which increases future productive capacity.

The process of Capital Formation involves three distinct but interdependent activities, saving
financial intermediation and investment. However, poor country/economy may be, there will be
a need for institutions which allow such savings, as are currently forthcoming, to be invested
conveniently and safely and which ensure that they are channeled into the most useful purposes.
A well-developed financial structure will therefore aid in the collections and disbursements of
investible funds and thereby contribute to the capital formation of the economy. Indian capital
market although still considered to be underdeveloped has been recording impressive progress
during the post-interdependence period.

Support to the Capital Market:

The basic purpose of DFIs particularly in the context of a developing economy, is to accelerate
the pace of economic development by increasing capital formation, inducing investors and
entrepreneurs, sealing the leakages of material and human resources by careful allocation
thereof, undertaking development activities, including promotion of industrial units to fill the
gaps in the industrial structure and by ensuring that no healthy projects suffer for want of finance
and/or technical services.

Hence, the DFIs have to perform financial and development functions on finance functions,
there is a provision of adequate term finance and in development functions there include
providing of foreign currency loans, underwriting of shares and debentures of industrial
concerns, direct subscription to equity and preference share capital, guaranteeing of deferred
27
payments, conducting techno-economic surveys, market and investment research and rendering
of technical and administrative guidance to the entrepreneurs.

Rupee Loans:

Rupee loans constitute more than 90 per cent of the total assistance sanctioned and disbursed.
This speaks eloquently on DFI’s obsession with term loans to the neglect of other forms of
assistance which are equally important. Term loans unsupplemented by other forms of assistance
had naturally put the borrowers, most of whom are small entrepreneurs, on to a heavy burden of
debt-servicing. Since term finance is just one of the inputs but not everything for the
entrepreneurs, they had to search for other sources and their abortive efforts to secure other
forms of assistance led to sickness in industrial units in many cases.

Foreign Currency Loans:

Foreign currency loans are meant for setting up of new industrial projects as also for expansion,
diversification, modernization or renovation of existing units in cases where a portion of the loan
was for financing import of equipment from abroad and/or technical know-how, in special cases.

Subscription to Debentures and Guarantees:

Regarding guarantees, it is well-known that when an entrepreneur purchases some machinery or

fixed assets or capital goods on credit, the supplier usually asks him to furnish some guarantee to
ensure payment of installments by the purchaser at regular intervals. In such a case, DFIs can act
as guarantors for prompt of installments to the supplier of such machinery or capital under a
scheme called ‘Deferred Payments Guarantee’.

Assistance to Backward Areas:

Operations of DFI’s in India have been primarily guided by priorities as spelt out in the Five-
Year Plans. This is reflected in the lending portfolio and pattern of financial assistance of
development financial institutions under different schemes of financing. Institutional finance to
projects in backward areas is extended on concessional terms such as lower interest rate, longer
moratorium period, extended repayment schedule and relaxed norms in respect of promoters’
contribution and debt-equity ratio.

Such concessions are extended on a graded scale to units in industrially backward districts,
classified into the three categories of A, B and c depending upon the degree of their
backwardness. Besides, institutions have introduced schemes for extending term loans for
project/area-specific infrastructure development. Moreover, in recent years, development banks
in India have launched special programmes for intensive development of industrially least
developed areas, commonly referred to as the No-industry Districts (NID’s) which do not have
any large-scale or medium-scale industrial project. Institutions have initiated industrial potential
surveys in these areas.

28
Promotion of New Entrepreneurs:

Development banks in India have also achieved a remarkable success in creating a new class of
entrepreneurs and spreading the industrial culture to newer areas and weaker sections of the
society. Special capital and seed Capital schemes have been introduced to provide equity type of
assistance to new and technically skilled entrepreneurs who lack financial resources of their own
even to provide promoter’s contribution in view of long-term benefits to the society from the
emergence of a new class of entrepreneurs.

Development banks have been actively involved in the entrepreneurship development

programmes and in establishing a set of institutions which identify and train potential
entrepreneurs. Again, to make available a package of services encompassing preparation of
feasibility of reports, project reports, technical and management consultancy etc. at a reasonable
cost, institutions have sponsored a chain of 16 Technical Consultancy organizations covering
practically the entire country. Promotional and development functions are as important to
institutions as the financing role.

The promotional activities like carrying out industrial potential surveys, identification of
potential entrepreneurs, conducting entrepreneurship development programmes and providing
technical consultancy services have contributed in a significant manner to the process of
industrialization and effective utilization of industrial finance by industry. IDBI has created a
special technical assistance fund to support its various promotional activities.

Over the years, the scope of promotional activities has expanded to include programmes for up
gradation of skill of State level development banks and other industrial promotion agencies,
conducting special studies on important issues concerning industrial development, encouraging
voluntary agencies in implementing their programmes for the uplift of rural areas, village an
cottage industries, artisans and other weaker sections of the society.

Impact on Corporate Culture:

The project appraisal and follow-up of assisted projects by institutions through various
instruments, such as project monitoring and report of nominee directors on the Boards of
directors of assisted units, have been mutually rewarding. Through monitoring of assisted
projects, the institutions have been able to better appreciate the problems faced by industrial
units.

It also has been possible for the corporate managements to recognize the fact that interests of the
assisted units and those of institutions do not conflict but coincide. Over the years, institutions
have succeeded in infusing a sense of constructive partnership with the corporate sector.
Institutions have been going through a continuous process of learning by doing and are effecting
improvements in their systems and procedures on the basis of their cumulative experience.

29
 Relevance of development banks in economic growth

(1) Functioning as an Intermediary:

Banks act as intermediaries between the savers and investors. We have already seen that banks
prompt the people to save money by offering them a guaranteed return in the form of interest.
Thus, they bring the savings of people together and they also make loans available to those who
are in need of credit.

Thus, banks act as agents to bring the saving public and the investing public together, and thus
act as intermediaries. This is a very important function and can be performed by banks because
on the one hand, they stand guarantee to the depositors about the return of their savings end
similarly, undertake the responsibility of recovering the loaned amount; and on the other hand,·
make the money available to the borrowers.

(2) Helping Economic Development : Banks help the economic development of a country.
These banks can very well see the profitability or otherwise, of any investment in development
projects. Depending on the changes of the profitability of the project, it helps the economic
development of a country.

(3) Mobilization of Capital : The commercial banks are in a position to transfer capital from
one part of the country to another part of the country or to other countries. Thus, they impart
mobility to capital. When capital is transferred from one part of the country to another,
geographical mobility is provided. But sometimes, banks also help to provide occupational
mobility. If anyone wants to withdraw capital from one business and wants to transfer it to
another business, banks can help him to do it because they also deal in shares.

(4) Encouragement to Trade and Industry : By providing loans to traders and Industrialists,
commercial banks encourage their activities. Industrialists need working capital. Traders need
short-term accommodation for purchase of stocks. All such needs are met by bank credit.

(5) Promotion of the Habit of Thrift : Banks promote the habit of thrift among the people, by
making available to them, facilities for the safe-keeping and safe investment of their hard-earned
savings. The depositors get interest and their money, which would have remained idle, is used
for productive purposes.

(6) Channelization of Savings and Investment : Banks perform the function of channelizing
the savings into various fields of investment. The individual savers are not aware of the
opportunities of investment. Similarly, they are not in a position to decide as to which fields of
investment are safe and which are not. The commercial banks are better judges of this. Similarly,
by advancing credit or denying credit they indirectly channelize the investment of funds into
proper and productive fields of investment.

(7) Imparting Liquidity to Non-liquid Assets : Commercial banks advances loans to

borrowers against different types of securities. For example, they advance loans against the
security of gold ornaments or gold bullion. These are non-liquid assets which are transformed
into liquid resources by the commercial banks. The same is the case with other non-liquid assets.

30
(8) Creating and Dealing in Bank Money : Most of the commercial banks claim that they do
not create money but only deal in money. But this is not true because in the process of dealing in
money, they create money; and bank money is in circulation on a very large scale in modem
economies.

When a person is given a loan by a bank, normally, the person is allowed to operate a bank
account to the extent of the amount of credit given to him. The person makes his own payments
by issuing cheques. The cheques drawn on the bank are accepted in settlement of payments and
they continue to perform the functions of money. Thus, banks in the process of advancing loans,
also create money.

(9) Equitable Distribution of Funds Savings are not equitably distributed throughout the
country. Those regions which are advanced have larger funds; while the backward regions are
short of funds. Banks collect funds where they are available and provide them to the regions
where they are needed. Thus, they serve to distribute funds equitably.

(10) Influence on Rates of Interest : Banks influence the market rates of interest as they
provide loans for various terms. A higher rate for a particular type of lending induces the banks
to enter that field and the market rate then comes down: Thus, a uniform interest rate structure is
brought into existence as a result of the activities of bank.

CHARACTERISTICS OF SOURCES & USES OF FUND

There are various sources of finance such as equity, debt, debentures, retained
earnings, term loans, working capital loans, letter of credit, euro issue, venture funding
etc. These sources are useful in different situations. They are classified based on time
period, ownership and control, and their source of generation.

Sources of finance are the most explored area especially for the entrepreneurs about to
start a new business. It is perhaps the toughest part of all the efforts. There are various
sources of finance classified based on time period, ownership and control, and source of
generation of finance.

Having known that there are many alternatives of finance or capital, a company can
choose from. Choosing right source and the right mix of finance is a key challenge for
every finance manager. The process of selecting right source of finance involves in-depth
analysis of each and every source of finance. For analyzing and comparing the sources of
finance, it is required to understand all characteristics of the financing sources. There
are many characteristics on the basis of which sources of finance are classified.

On the basis of a time period, sources are classified into long term, medium term, and
short term. Ownership and control classify sources of finance into owned capital and
borrowed capital. Internal sources and external sources are the two sources of
generation of capital. All the sources of capital have different characteristics to suit
different types of requirements. Let’s understand them in a little depth.

31
ACCORDING TO TIME-PERIOD:

Sources of financing a business are classified based on the time period for which the
money is required. Time period is commonly classified into following three:

LONG TERM SOURCES OF FINANCE

Long-term financing means capital requirements for a period of more than 5 years to 10,
15, 20 years or maybe more depending on other factors. Capital expenditures in fixed
assets like plant and machinery, land and building etc of a business are funded using
long-term sources of finance. Part of working capital which permanently stays with the
business is also financed with long-term sources of finance. Long term financing sources
can be in form of any of them:

 Share Capital or Equity Shares

 Preference Capital or Preference Shares
 Retained Earnings or Internal Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes, Government, and Commercial Banks
 Venture Funding
 Asset Securitization
 International Financing by way of Euro Issue, Foreign Currency Loans, ADR,
GDR etc.

MEDIUM TERM SOURCES OF FINANCE

Medium term financing means financing for a period of 3 to 5 years. Medium term
financing is used generally for two reasons. One, when long-term capital is not available
for the time being and second, when deferred revenue expenditures like advertisements
are made which are to be written off over a period of 3 to 5 years. Medium term
financing sources can in the form of one of them:

 Preference Capital or Preference Shares

 Debenture / Bonds
 Medium Term Loans fromFinancial InstitutesGovernment, andCommercial
Banks
 Lease Finance
 Hire Purchase Finance

SHORT TERM SOURCES OF FINANCE

Short term financing means financing for a period of less than 1 year. Need for short
term finance arises to finance the current assets of a business like an inventory of raw
material and finished goods, debtors, minimum cash and bank balance etc. Short term
financing is also named as working capital financing. Short term finances are available
in the form of:
32
  Trade Credit
 Short Term Loans like Working Capital Loans from Commercial Banks
 Fixed Deposits for a period of 1 year or less
 Advances received from customers
 Creditors
 Payables
 Factoring Services
 Bill Discounting etc.

Purchase Price
Calculating the Purchase Price to acquire a target business or asset is the first step of determining
how much cash is needed and where it can be obtained. This must either be known or assumed.

Uses of Cash
Working Capital: Working capital is found in the closing balance sheet of the target company. A
successful business must have enough and ready reserves of working capital because it is the
cash on hand of a company when it needs to use it. When a company experiences a shortfall in
liquid assets, it will need cash to fund its day to day operations, to meet its current liabilities and
to continue earning more revenues. See the working capital formula here.

Fixed Assets: This is calculated by taking the Purchase Price minus the Working Capital Assets.
Fixed assets are tangible, long-term assets that take more time to be converted into cash and are
used in the production of a company’s income. They can take the form of buildings, machinery,
vehicles, land, software and computer equipment. The largest group of these is referred to
as Property Plant & Equipment (PP&E).

Fees: The fees must have their own schedule. They have to be known or assumed for the
calculation of total uses of cash. These are fees incurred during an acquisition.

Total Uses: This is the sum of the purchase price of the asset and the fees.

Sources of funds include cash farm receipts, capital asset sales, increases in liabilities, outside
equity capital infused into the business, and net non-farm cash income. The increase in total
liabilities is derived from the beginning and ending balance sheets. It is particularly important to
track the change in total liabilities from the beginning to the end of the year. If a farm borrows
more money than its reduction in short-term and long-term debt (i.e., principal payments), we
have a source of funds. Conversely, if a farm pays back more debt than it borrows, we have a use
of funds.
Uses of funds include farm cash operating expenses, capital asset purchases, decreases in total
liabilities, equity capital withdrawals, family living withdrawals, and income and self-
employment taxes.
A farm that is expanding will typically have a larger amount of capital purchases than capital
sales so capital assets are generally a use of funds rather than a source of funds. A farm that is
33
expanding would probably also have an increase in total liabilities rather than a decrease in total
liabilities. In contrast, a farm that is downsizing, perhaps in anticipation of future retirement,
would typically have relatively higher asset sales compared to asset purchases, and thus would
exhibit a decrease in total liabilities.
The five primary categories of a sources and uses of funds statement are beginning cash
balances, cash flows from operating activities, cash flows from investing activities, cash flows
from financing activities, and ending cash balances. If all cash is accounted for unlocated funds
will be zero.
If unlocated funds are not zero (either positive or negative), all cash is not accounted for. This is
often the case if family living withdrawals, and income and self-employmsent taxes are not
included in the statement.

34
 Unit – 3
Analyzing Bank Performance

This session introduces bank financial statements and provides a traditional, ratio-based
procedure for analyzing bank financial performance using historical data. It demonstrates the
interrelationship between the income statement and balance sheet and describes the risk and
return trade-off underlying management decisions. Data are provided that compare the
performance characteristics of small banks versus large banks and differentiate between high and
low performers.

3.1 THE BALANCE SHEET

A bank's balance sheet presents financial information that compares what a bank owns with what
it owes and the ownership interest of stockholders. Assets represent what a bank owns; liabilities
represent what a bank owes; and equity refers to stockholders' ownership such that:

Assets = Liabilities + Equity

The balance sheet represents a snapshot taken at a point in time. Account values indicate what a
bank owns or owes on that date. Bank regulators require that banks report balance sheet data
quarterly, so most published figures are dated at the end of March, June, September ,and
December of each year. Exhibit 2-1 presents balance sheet data for SCBS Bank, an $80million
community bank.

Bank Assets

Bank assets fall into one of four types, each with different yield and risk features.

Cash and Due from Banks

Cash and due from banks consists of vault cash, deposits held at Federal Reserve Banks (Fed),
deposits held at other financial institutions, and checks in the process of collection.

35
These accounts generally facilitate check clearing and customers' currency withdrawal sand
serve to meet legal reserve requirements. Their distinguishing feature is that they do not earn
interest, although balances at the Fed and other depository institutions can be used to obtain
correspondent banking services.

Investments

Investment securities are primarily fixed-income securities held to meet liquidity needs and earn
interest. Short-term securities have maturities less than one year and can be readily sold if a bank
needs cash and the securities are not pledged as collateral against a bank liability. In Exhibit 2-1,
SCBS Bank reports owning time deposits issued by other financial institutions, federal funds
sold and repurchase agreements (Repos) that are effectively short term investments. Long-term
securities have maturities as long as 30 years, although most banks prefer not to commit funds
out very far. Different types of securities are discussed below:

• Treasury bills, notes, and bonds are direct obligations of the U.S. Treasury. Bills are sold at a
discount where all interest is price appreciation; while notes and bonds typically carry a fixed
term and rate, and coupon interest is paid semiannually.

• Federal Agency securities are obligations of federal agencies such as the Federal Home Loan
Bank. They normally carry yields that are slightly above the yield on a comparable maturity
Treasury security because they are backed by government entities and not the government
directly. Note that government-guaranteed mortgage-backed securities are included under this
label. Actual yields earned on mortgage-backed securities often differ sharply from expected
yields due to prepayments.

• Municipal securities are obligations of state and local governments and their political
subdivisions. They come in many forms. "Bank-qualified" municipals consist of small issue
securities ($10 million a year per issuer) issued for essential public purposes. Interest income is
exempt from federal income taxes but may be subject to state income taxes. According to the
Tax Reform Act of 1986, banks can deduct 80 percent of their borrowing costs to finance
qualified municipals. Other municipals that pay tax-exempt interest are labeled "nonqualified."
Banks must take a TEFRA disallowance cost in calculating the Tax equivalent yield associated
36
with these municipals. This is usually the total cost of funds for a bank. 2013 – Interest rates
remaining low so long have made the purchase of nonqualified municipalsa good option for
some community banks.

• Other securities consist primarily of corporate and foreign bonds and various types of
mortgage-backed securities.

For reporting purposes, banks are required to designate securities either as held-to maturity,
available-for-sale, or held in a trading account. Regulators require different accounting for each
class of securities consistent with the perceived intent behind their purchase. Securities
designated as held-to-maturity are valued on the balance sheet at historical, amortized cost.
There is no financial statement impact with unrealized gains or losses when interest rates change.
Securities designated as available-for-sale are reported at current market values, with unrealized
gains and losses included as a component of capital.

Thus, when interest rates rise (fall), any decrease (increase) in the value of the securities is
balanced by a corresponding unrealized loss (gain) in equity. Trading account securities are
reported at market values on the balance sheet with unrealized gains and losses recorded in the
income statement. The objective is to provide better information to regulators, analysts, and
investors regarding the market value of securities when banks expect to sell them prior to final
maturity.

Loans

Loans represent the primary earning asset at most banks. Banks serve the needs of their
community, and extending loans to businesses and individuals allows a community bank to
grow. Loans are typically grouped into categories based on the type of borrower and use of
proceeds.

• Commercial and Industrial loans ( C& I ) c o n s i s t of loans to businesses. They appear in

many forms but are used primarily to finance working capital needs and new plant and
equipment expenditures. They may also be short-term commitments to securities dealers or
temporary loans to finance one firm's purchase of another.
37
• Real estate loans consist of property loans secured by first mortgages or interim construction
loans secured by real property.

• Consumer loans are made to individuals for a wide variety of purposes. They may be
installment loans for the purchase of cars, boats, and durable goods, or credit card loans.

• Agriculture loans represent credit extended to farmers or agribusinesses.

• International loans are essentially business loans made to foreign enterprises.

Foreign governments often guarantee them. Most Community Banks do not make international
loans.

Loans typically earn the highest yields before expenses. They also exhibit the highest risk and
default rates and cost more than securities to administer. A loan loss reserve is maintained by the
bank to cover future expected loan losses. This account is presented on the balance sheet as a
contra asset account to total loans.

Several key profitability ratios use a bank's earning assets, which equals loans plus investment
securities and other interest-earning assets.

Other Assets

Other assets are of relatively small magnitudes, representing such items as bank premises and
equipment, interest receivables, and other real estate owned. They are essentially nonearning
because they generate no interest income.

Bank Liabilities and Stockholders' Equity

Bank funding sources are classified by the type of deposit, debt claim and equity component.

The characteristics of each liability vary according to maturity, interest paid, whether the holder
can write checks against outstanding balances, and whether they are FDIC-insured.

38
Prior to the early 1980s, regulations limited the maximum interest rates that banks couldpay on
most deposits. Since 1986, interest rate restrictions have been largely removed o na l l d e p o s i
t a c c o u n t s i n c l u d i n g demand deposits. Banks now compete for deposits by paying
market rates on virtually all liabilities.

Transaction Accounts

Transaction accounts are accounts on which depositors can withdraw or transfer funds by writing
checks, debit cards, mobile banking, drafts, payment orders of withdrawal, or telephone.

The various accounts include demand deposits, NOW accounts (Interest bearing checking
accounts), automatic transfers from savings (ATS), and money market deposit accounts

(MMDAs).

• Demand deposits enable the holder to write checks against the outstanding balance.

By regulation they have an original maturity of less than seven days. Businesses now own most
demand deposits a n d t h e m a j o r i t y o f t h e s e d e p o s i t

accountsarenotinterest bearing.

• NOW accounts are interest-bearing transaction accounts where the issuing bank can pay any
rate desired. Banks often require that customers maintain some minimum balance before interest
applies and may limit the number of free checks, but terms vary among institutions. These
accounts are available to both personal and businesses.

• ATS accounts are combined savings and checking accounts where depositors can transfer
funds from an interest-bearing savings account to a demand deposit. These accounts were
initially introduced to circumvent restrictions against interest-on- checking accounts. They have
thus declined in importance over time because NOW accounts offer the same service. They still
appear, however, as sweep accounts whereby a bank can pay interest to a depositor, such as a
municipality, for all balances held in excess of some contractual minimum amount. Very rare in
banking today.
39
• MMDAs originated in December 1982 to allow banks to compete with money market. mutual
funds' share accounts, and have both savings and limited check writing features. Holders earn
market rates of interest that typically exceed rates on transaction accounts because banks do not
have to hold reserves against MMDAs. A customer can make up to six transfers per month from
the account, of which three can be by check o r d e b i t and three by telephone.

Transaction accounts are attractive funding sources because the depositors are generally not very
rate sensitive. Thus when interest rates change, customers are less likely to move their balances.
For this reason, these accounts are referred to as relationship accounts in which the customer's
primary rationale for keeping the account is convenient and personal service. These stable or
"core" deposits improve a bank's liquidity by reducing the potential for large-scale deposit losses.

Time and Savings Deposits

These deposits usually comprise most of the interest-bearing liabilities at banks.

• Regular savings are small denomination accounts with no fixed maturity and l imi t e d check-
writing capabilities.

• Time deposits pay higher interest rates, but the funds h a ve a f ixe d ma t uri t y d a t e

a n d cannot be withdrawn until this date. There are two general categories of time deposits
distinguished by whether the denomination is greater or less than $100,000,(250,000). The
features of small time deposits, or those under $100,000, are set byeach bank in terms of
maturity, interest rate, and amount of deposit. Most banks market standardized deposits so
customers are not confused. Large denomination (greater thanor equal to $100,000) deposits are
negotiable instruments that can be traded in a well established secondary market after issue.
Labeled jumbo CDs, these are treated as“hot” money by regulatory agencies due to an adage that
owners may move for just a slight higher rate at another bank.

Holders of time deposits are typically much more rate sensitive than owners of transaction
accounts. Banks must continually change the rates they pay in line with market conditions in
order to retain the bulk of these deposits. If they pay a rate on CDs slightly above market, they

40
can usually attract significant new deposits even from outside their immediate trade area. Thus
large time deposits are not viewed as stable core deposits, but are instead labeled non-core
(volatile) liabilities, or "hot money.

Other Interest-Bearing Liabilities

Banks also rely on other funding sources that can be acquired quickly. Large money center and
super-regional banks rely heavily on these funding sources, while community banks typically use
them less frequently.

• Federal funds purchased represent overnight obligations where one bank borrows/clearing
balances, such as reserves held at a Federal Reserve Bank, from other institutions. Federal funds
are primarily traded between banks to meet reserved eficiencies or offset reserve losses due to
unanticipated loan demand and deposit outflows.

• Repurchase agreements (Repos) represent the sale of securities under an agreement to

repurchase them later at a predetermined price. The maturity is negotiated, but ranges from
overnight to several weeks. This source of funds is similar to federal funds purchased, except
that the borrowing is collateralized by the security sold. Thus, the rate on a Repo is usually lower
than the rate on a comparable unsecured federal funds transaction.

• Eurodollar liabilities are similar to the jumbo CDs described earlier, except that the dollar-
denominated deposits are issued by a bank or bank subsidiary located outside theUnited States.
Eurodollars are typically issued in $1 million multiples and the holders are extremely rate
sensitive. Most Community Banks do not deal in Eurodollars.

All of these liabilities are commonly referred to as "purchased" liabilities because banks buy the
funds by paying a competitive market interest rate. They are not core deposits, but rather are also
volatile liabilities.

The Discount Window is an instrument of monetary policy (usually controlled by central banks)
that allows eligible institutions to borrow money from the central bank, usually on a short-term
basis, to meet temporary shortages of liquidity caused by internal or external disruptions. The

41
term originated with the practice of sending a bank representative to a reserve bank teller
window when a bank needed to borrow money.

The interest rate charged on such loans by a central bank is called the discount rate, base
rate ,or repo rate, and is separate and distinct from the Prime rate. It is also not the same thing as
the federal funds rate and its equivalents in other currencies, which determine the rate at which
banks lend money to each other. In recent years, the discount rate has been approximately a
percentage point above the federal funds rate. Because of this, it is a relatively unimportant
factor in the control of the money supply and is only taken advantage of at large volume during
emergencies

Subordinated Debt and Equity

Subordinated notes and debentures represent long-term securities that may meet regulatory
requirements as Tier 2 bank capital. Unlike the first $250,000 of transaction accounts and time
and savings deposits, the debt is not FDIC insured. Claims of the bondholders are also
subordinated to the claims of depositors, which means that in the event a bank fails, depositors
are paid before bondholders .

Stockholders equity represents the ownership interest in a bank. Equity component consist of
common and preferred stock outstanding at par value; surplus refers to stock proceeds in excess
of par value received when the bank issued the stock; and retained earnings represent cumulative
net income since the firm started operation minus cash dividends paid to stockholders. If a bank
designates any securities as available-for-sale, it will also report unrealized gains or losses, net of
tax on those instruments as equity.

3.2 THE INCOME STATEMENT

A bank's income statement reflects the fact that most assets and liabilities are financial.

Revenue consists primarily of interest income and interest payments on liabilities represent the
primary expense. The statement format thus starts with interest income then subtracts interest
expense. The next step is to subtract provision for loan losses, which represents management's

42
recognition that some revenues will be lost due to bad loans. The format continues by adding
noninterest income then subtracting noninterest expense and taxes to produce net income.
Exhibit 2-2 presents the income statement for SCBS Bank.

Income Statement Components

Interest Income

Interest income equals the sum of interest earned on earning assets. A statement
normallyitemizes the source of interest by type of asset. Exhibit 2-2, for example, separates
interest income into interest on loans, federal funds sold and Repos, deposits at other institutions,

Government and Agency securities, and municipal securities. All interest is fully taxable except
municipal interest, which may be exempt from federal income taxes. This tax-exempt interest
can be converted to a taxable equivalent amount by dividing by one minus the bank's tax rate.
Note that interest on loans contributes the most to interest income because loans are the bank's
dominant asset and pay the highest gross yields. In general, interest income increases when the
level of interest rates increases and/or when a bank can book more earning assets. It decreases
when loan balances decline and/or when rates fall.

Interest Expense

Interest expense equals the sum of interest paid on transaction accounts, time and savings
deposits; other purchased liabilities, and subordinated debt. Interest expense is fully tax
deductible except for the portion associated with the purchase of municipal bonds after1982. The
session on investments describes this partial deductibility and its impact.

Net Interest Income

Net interest income equals interest income minus interest expense and plays a crucial role in
determining how profitable a bank is in any period. Variations in net interest income are also
used to measure how successful a bank has been in managing its interest rate risk Provision for
Loan Losses

43
Provision for loan losses represents a deduction from income for transfers to a bank's loan loss
reserve. It is a noncash expense that indicates management's estimate of potential revenue losses
from problem loans. Increases in provisions thus lower reported net income.

Banks that understate potential losses effectively overstate net income and eventually have
toraise provisions in recognition that past income has been overstated. The income statement
reports net interest income after provision to account for estimated loan losses.

Noninterest Income

Noninterest income consists primarily of service charges, fees and commissions, me r c h a n t s

e r v i c e f e e s and gains (or losses) from securities sales. Large banks that operate securities
and foreign exchange desks also report trading account profits. Fees arise from loan
commitments, standby letters of credit, and trust department services. Since the early 1980s most
banks have concentrated on increasing noninterest income as an alternative source of earnings,
and service charges and fees have generally increased. These alternative sources primarily
include revenues derived from mortgage banking, credit card ,insurance, and electronic or
treasury banking operations. Other noninterest income is typically small unless a bank effects
some extraordinary transaction. A bank holding company that sells a mortgage banking or data
processing subsidiary might similarly report a large gain. These extraordinary or nonrecurring
transactions increase earnings on a one time basis and thus are normally excluded from profit
analyses and comparisons.

Noninterest (Overhead) Expense

Noninterest or overhead expense is composed primarily of personnel, occupancy, equipment,and

other expenses. These expenses consist of salaries and fringe benefits paid employees, rent,
depreciation, and maintenance on equipment and premises, and other operating expenses
including utilities and FDIC insurance premiums.

At most banks ,noninterest income falls far below noninterest expense. A bank's burden is the
difference ,measured as noninterest expense minus noninterest income. Improving a bank's

44
burden by raising fees and controlling unit-operating costs has been a major source of bank
profits since interest rate deregulation.

A bank's income before taxes thus equals net interest income minus provision for loan losses,
minus burden. Net income is then obtained by subtracting taxes. We can clarify these
relationships with the following definitions:

II interest income

IE interest expense

PL provision for loan losses

OI noninterest income

OE noninterest expense

T taxes

We know that NII equals net interest income (II-IE) and burden equals OE-OI. A bank's net
income (NI) can then be viewed as having four general components: net interest income,
provision for loan losses, burden and taxes.

NI = NII - PL - Burden - T

Using the income statement data for the SCBS Bank from Exhibit 2-2 yields the following
breakdown of the bank's net income:

$1,340 = $3,200-$450-($2,700-$1,700)-$410

3.3 ANALYSIS PROFITABLILTY

The return on equity (ROE) model represents a well-known approach to analyzing bank
profitability using financial ratios. The procedure combines balance sheet and income statement
figures to calculate ratios that compare performance over time and relative to peers. A peer group
consists of other banks of the same size and structure that compete in similar markets. Thus,

45
community banks are compared with other community banks competing in the same geographic
market. Each bank's Uniform Bank Performance Report

(UBPR) identifies a peer group for comparison. The UBPR data are provided by federal
regulators and are commonly used to evaluate comparative profitability and risk performance.

As a rule, ratios should be constructed using average balance sheet data calculated over the same
time period as income statement data. This eliminates distortions caused by large changes in
balance sheets just before a quarter or year ending reporting period. The following discussion
introduces key ratios, and then uses the data for SCBS Bank from Exhibits 2-1 and 2-2 as an
application.

Aggregate Profitability Ratios

Bank managers and bank analysts generally evaluate overall bank profitability in terms of return
on equity (ROE) and return on assets (ROA). When a bank consistently reports a higher than
average ROE and ROA, it is designated a high performance bank. In order to earn higher returns,
a bank must either take on above-average risk or have a competitive advantage in offering
certain products or services.

ROE =Net income/Stockholders' equity Return on equity equals net income divided by
stockholders' equity and thus measures the percentage return on stockholders' investment. The
higher the return the better, as management can pay higher dividends and support greater future
growth.

ROA =Net income/Total assets

Return on assets equals net income divided by total assets and thus measures the percentage
return per dollar of average assets held during the period. Again, the higher is ROA; the better is
the bank's profitability. ROAs vary between banks largely due to differences in net interest
income, provisions for loan losses, and burden.

ROE is tied to ROA through a bank's equity multiplier (EM), which equals total assets divided
by stockholders' equity. EM measures a bank's financial leverage, or its amount of liabilities
compared with equity. The greater are aggregate liabilities, the greater is financial leverage and
EM.

EM= Total assets/Stockholders' equity

Consider the two banks with the assets, liabilities, and equity summarized below. Both

banks have $100 million in assets, but City Bank has $90 million in liabilities and $10

million in equity, while County Bank has $95 million in liabilities and $5 million in

equity. Because County Bank has more debt, and thus greater financial leverage, its equity
46
multiplier is higher, at 20 rather than 10.

City Bank County Bank

Debt = $90 Debt = $95

Assets = $100 Assets = $100

Equity = $10 Equity = $5

EM= $100/$10 = 10 X EM= $100/$5 = 20 X

EM has a multiplier effect on a bank's profits because ROE equals ROA times EM.

ROE=ROA x EM

Thus, if a bank earns positive profits, greater debt financing produces a greater ROE. Of course,
if the bank reports a loss, greater debt financing produces a larger negative ROE. For example, if
both City Bank and County Bank earned a 1 percent ROA, their ROEs would equal 10 percent
and 20 percent, respectively. If the ROAs equaled -1 percent, the corresponding ROEs would be
- 10 percent and -20 percent.

Decomposition of ROA

A bank's ROA can be decomposed into ratios that indicate what factors contribute to higher or
lower returns. In particular, ROA equals a bank's profit margin (PM) times its asset utilization
(AU):

Where:

ROA=PM x AU

PM =Net income/Total operating income, and

AU= Total operating income/Total assets.

Net income equals total operating income minus expenses and taxes. PM thus measures a bank's
ability to control expenses and taxes. The greater is PM, the greater will be ROA because a bank
is more efficient in keeping expenses low. To determine where the efficiencies are, you can
analyze four additional ratios that compare interest expense, noninterest expense, provision for
loan losses, and taxes as a fraction of total operating income.

The lower each ratio; the better the bank has controlled that expense. If you use UBPR data,
comparable ratios are reported relative to total assets. AU measures a bank's gross yield on total
assets before expenses and taxes. This yield varies over time when interest income and
noninterest income change relative to assets, as indicated by the following decomposition.
47
AU= (interest income/total assets) + (noninterest income/total assets)

AU will increase when interest rates rise and will fall when interest rates fall, simply because
interest income tracks the level of interest rates. It will differ from peer banks when the bank
earns different average yields on various assets, when its composition of assets differs, and when
the bank has more or less total earning assets.

Noninterest income tracks changes in bank fees, service charges, and other income. The greatest
variation arises when a bank generates some nonrecurring income, such as from the sale of loans,
securities or other bank assets, or when a bank dramatically changes its fee structure and product
mix.

Net Interest Margin and the Earnings Base

Other commonly referenced ratios indicate specific factors that contribute to bank profitability.
Net interest margin (NIM) equals net interest income divided by earning assets and thus
represents the net interest return on income producing assets. A bank's earnings base (EB)
measures the fraction of assets that produce income, while noninterest expense minus noninterest
income divided by total assets reveals the bank's burden, and thus its comparative ability to
control net noninterest expense.

Efficiency Ratios

Banks typically monitor their ability to generate noninterest income versus their noninterest
expense. The most popular ratio currently used by analysts is noninterest expense divided by the
sum of net interest income and noninterest income. Typically, large banks have the lowest ratios,
but the recent trend in most banks is the sharp reduction in overhead costs or improved efficiency
over time. It is also common to compare productivity ratios, such as total assets per employee
and noninterest expense per employee.

The primary growth of noninterest income has been in the category of "other" noninterest
income, which includes merchant fees, mortgage-servicing fees, and fees associated with data
processing services, lockbox services and credit cards. Several banks have successfully lowered
noninterest expense as a fraction of revenue.

The efficiency ratio at most banks has declined since 1990s; although during the mid-2000s,
bank began building new offices and efficiency rations began to climb again. Now, we are seeing
the number of banking offices declining again and employment (labor) costs has declined as
well. The actual number of people employed has been relatively constant up to the most recent
recession and now we are seeing banks operate on fewer employees.

Finally, occupancy costs are dropping as banks have closed unprofitable branches. Dodd-Frank
is also having an effect on number of employees as banks continue to comply with all the new
regulations.

48
ANALYSIS LIQUIDITY

Banks need liquidity when they experience unanticipated deposit losses or new loan demand.
Asset liquidity refers to the ease with which the owner can convert an asset to cash with a
minimum of loss. Treasury bills are highly liquid, for example, because a holder can readily sell
the bill in the secondary market at a predictable price. Real estate is less liquid because it takes
longer to find a buyer at prevailing prices and transaction costs are higher. Liquidity risk refers to
the variation in earnings caused by a bank's inability to access cash quickly and with little price
risk. Of course, a bank can borrow to obtain cash.

Liabilities can thus provide liquidity if a bank can readily issue new debt at reasonable interest
rates. Liquidity risk measures focus on the amount of assets that can be readily sold at reasonable
prices to meet cash needs, and a bank's capacity to borrow. A bank should hold sufficient short-
term government securities, federal funds sold, or deposits at other financial institutions that are
not pledged as collateral against some bank borrowing.

Because banks do not like to sell securities at a loss, it is best if the market value of securities
exceeds book value and such securities are generally viewed as more liquid. If a bank anticipates
ever selling securities, they need to designate them as available-for- sale for reporting purposes.
A bank should also maintain quality assets and a sufficiently large equity

capital base to allow it to issue new debt (CDs and other purchased liabilities) to access cash.
Banks with few marketable securities, little or no cash, and with limited ability to issue new
liabilities operate with high liquidity risk.

Asset - Liability Management System in banks - Guidelines

Over the last few years the Indian financial markets have witnessed wide ranging changes at fast
pace. Intense competition for business involving both the assets and liabilities, together with
increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought
pressure on the management of banks to maintain a good balance among spreads, profitability
and long-term viability.

These pressures call for structured and comprehensive measures and not just ad hoc action. The
Management of banks has to base their business decisions on a dynamic and integrated risk
management system and process, driven by corporate strategy. Banks are exposed to several
major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk,
equity / commodity price risk, liquidity risk and operational risks.

2. This note lays down broad guidelines in respect of interest rate and liquidity risks management
systems in banks which form part of the Asset-Liability Management (ALM) function. The
initial focus of the ALM function would be to enforce the risk management discipline viz.
managing business after assessing the risks involved. The objective of good risk management
programmes should be that these programmes will evolve into a strategic tool for bank
management.

49
3. The ALM process rests on three pillars:

ALM information systems

=> Management Information System

=> Information availability, accuracy, adequacy and expediency

ALM organisation

=> Structure and responsibilities

=> Level of top management involvement

ALM process

=> Risk parameters

=> Risk identification

=> Risk measurement

=> Risk management

=> Risk policies and tolerance levels.

4. ALM information systems

Information is the key to the ALM process. Considering the large network of branches and the
lack of an adequate system to collect information required for ALM which analyses information
on the basis of residual maturity and behavioural pattern it will take time for banks in the present
state to get the requisite information. The problem of ALM needs to be addressed by following
an ABC approach i.e. analysing the behaviour of asset and liability products in the top branches
accounting for significant business and then making rational assumptions about the way in which
assets and liabilities would behave in other branches. In respect of foreign exchange, investment
portfolio and money market operations, in view of the centralised nature of the functions, it
would be much easier to collect reliable information. The data and assumptions can then be
refined over time as the bank management gain experience of conducting business within an
ALM framework. The spread of computerisation will also help banks in accessing data.

5. ALM organisation

5.1 a) The Board should have overall responsibility for management of risks and should decide
the risk management policy of the bank and set limits for liquidity, interest rate, foreign
exchange and equity price risks.

50
b) The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the limits set by the Board as
well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line
with the bank's budget and decided risk management objectives.

c) The ALM desk consisting of operating staff should be responsible for analysing, monitoring
and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations)
showing the effects of various possible changes in market conditions related to the balance sheet
and recommend the action needed to adhere to bank's internal limits.

5.2 The ALCO is a decision making unit responsible for balance sheet planning from risk -
return perspective including the strategic management of interest rate and liquidity risks. Each
bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be
taken by it. The business and risk management strategy of the bank should ensure that the bank
operates within the limits / parameters set by the Board.

The business issues that an ALCO would consider, inter alia, will include product pricing for
both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc.
In addition to monitoring the risk levels of the bank, the ALCO should review the results of and
progress in implementation of the decisions made in the previous meetings.

The ALCO would also articulate the current interest rate view of the bank and base its decisions
for future business strategy on this view. In respect of the funding policy, for instance, its
responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this
end, it will have to develop a view on future direction of interest rate movements and decide on a
funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs
capital market funding, domestic vs foreign currency funding, etc. Individual banks will have to
decide the frequency for holding their ALCO meetings.

5.3 Composition of ALCO

The size (number of members) of ALCO would depend on the size of each institution, business
mix and organisational complexity. To ensure commitment of the Top Management, the
CEO/CMD or ED should head the Committee. The Chiefs of Investment, Credit, Funds
Management / Treasury (forex and domestic), International Banking and Economic Research can
be members of the Committee. In addition the Head of the Information Technology Division
should also be an invitee for building up of MIS and related computerisation. Some banks may
even have sub-committees.

5.4 Committee of Directors

Banks should also constitute a professional Managerial and Supervisory Committee consisting of
three to four directors which will oversee the implementation of the system and review its
functioning periodically.

5.5 ALM process:

51
The scope of ALM function can be described as follows:

Liquidity risk management

Management of market risks

(including Interest Rate Risk)

Funding and capital planning

Profit planning and growth projection

Trading risk management

The guidelines given in this note mainly address Liquidity and Interest Rate risks.

6. Liquidity Risk Management

6.1 Measuring and managing liquidity needs are vital activities of commercial banks. By
assuring a bank's ability to meet its liabilities as they become due, liquidity management can
reduce the probability of an adverse situation developing. The importance of liquidity transcends
individual institutions, as liquidity shortfall in one institution can have repercussions on the
entire system. Bank management should measure not only the liquidity positions of banks on an
ongoing basis but also examine how liquidity requirements are likely to evolve under crisis
scenarios.

Experience shows that assets Commonly considered as liquid like Government securities and
other money market instruments could also become illiquid when the market and players are
unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches.

For measuring and managing net funding requirements, the use of a maturity ladder and
calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a
standard tool. The format of the Statement of Structural Liquidity is given in Annexure I.

6.2 The Maturity Profile as given in Appendix I could be used for measuring the future cash
flows of banks in different time buckets. The time buckets given the Statutory Reserve cycle of
14 days may be distributed as under:

i) 1 to 14 days

ii) 15 to 28 days

iii) 29 days and upto 3 months

iv) Over 3 months and upto 6 months

52
v) Over 6 months and upto 12 months

vi) Over 1 year and upto 2 years

vii) Over 2 years and upto 5 years

viii) Over 5 years

6.3 Within each time bucket there could be mismatches depending on cash inflows and outflows.
While the mismatches upto one year would be relevant since these provide early warning signals
of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-
14 days and 15-28 days. Banks, however, are expected to monitor their cumulative mismatches
(running total) across all time buckets by establishing internal prudential limits with the approval
of the Board / Management Committee.

The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash
outflows in each time bucket. If a bank in view of its asset -liability profile needs higher
tolerance level, it could operate with higher limit sanctioned by its Board / Management
Committee giving reasons on the need for such higher limit. A copy of the note approved by
Board / Management Committee may be forwarded to the Department of Banking Supervision,
RBI. The discretion to allow a higher tolerance level is intended for a temporary period, till the
system stabilises and the bank is able to restructure its asset -liability pattern.

6.4 The Statement of Structural Liquidity ( Annexure I ) may be prepared by placing all cash
inflows and outflows in the maturity ladder according to the expected timing of cash flows. A
maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would be
necessary to take into account the rupee inflows and outflows on account of forex operations
including the readily available forex resources ( FCNR (B) funds, etc) which can be deployed for
augmenting rupee resources. While determining the likely cash inflows / outflows, banks have to
make a number of assumptions according to their asset - liability profiles.

For instance, Indian banks with large branch network can (on the stability of their deposit base as
most deposits are renewed) afford to have larger tolerance levels in mismatches if their term
deposit base is quite high. While determining the tolerance levels the banks may take into
account all relevant factors based on their asset-liability base, nature of business, future strategy
etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all
necessary factors in view and further refined with experience gained in Liquidity Management.

6.5 In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a
time horizon spanning from 1-90 days, banks may estimate their short-term liquidity profiles on
the basis of business projections and other commitments. An indicative format ( Annexure III )
for estimating Short-term Dynamic Liquidity is enclosed.

7. Currency Risk

53
7.1 Floating exchange rate arrangement has brought in its wake pronounced volatility adding a
new dimension to the risk profile of banks' balance sheets. The increased capital flows across
free economies following deregulation have contributed to increase in the volume of
transactions. Large cross border flows together with the volatility has rendered the banks'
balance sheets vulnerable to exchange rate movements.

7.2 Dealing in different currencies brings opportunities as also risks. If the liabilities in one
currency exceed the level of assets in the same currency, then the currency mismatch can add
value or erode value depending upon the currency movements. The simplest way to avoid
currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. Banks
undertake operations in foreign exchange like accepting deposits, making loans and advances
and quoting prices for foreign exchange transactions. Irrespective of the strategies adopted, it
may not be possible to eliminate currency mismatches altogether. Besides, some of the
institutions may take proprietary trading positions as a conscious business strategy.

7.3 Managing Currency Risk is one more dimension of Asset- Liability Management.
Mismatched currency position besides exposing the balance sheet to movements in exchange rate
also exposes it to country risk and settlement risk. Ever since the RBI (Exchange Control
Department) introduced the concept of end of the day near square position in 1978, banks have
been setting up overnight limits and selectively undertaking active day time trading. Following
the introduction of "Guidelines for Internal Control over Foreign Exchange Business" in 1981,
maturity mismatches (gaps) are also subject to control. Following the recommendations of
Expert Group on Foreign Exchange Markets in India (Sodhani Committee) the calculation of
exchange position has been redefined and banks have been given the discretion to set up
overnight limits linked to maintenance of additional Tier I capital to the extent of 5 per cent of
open position limit.

7.4 Presently, the banks are also free to set gap limits with RBI's approval but are required to
adopt Value at Risk (VaR) approach to measure the risk associated with forward exposures. Thus
the open position limits together with the gap limits form the risk management approach to forex
operations. For monitoring such risks banks should follow the instructions contained in Circular
A.D (M. A. Series) No.52 dated December 27, 1997 issued by the Exchange Control
Department.

8. Interest Rate Risk (IRR)

8.1 The phased deregulation of interest rates and the operational flexibility given to banks in
pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk.
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's
financial condition. Changes in interest rates affect both the current earnings (earnings
perspective) as also the net worth of the bank (economic value perspective). The risk from the
earnings' perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest
Margin (NIM). In the context of poor MIS, slow pace of computerisation in banks and the
absence of total deregulation, the traditional Gap analysis is considered as a suitable method to
measure the Interest Rate Risk. It is the intention of RBI to move over to modern techniques of

54
Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk at a
later date when banks acquire sufficient expertise and sophistication in MIS. The Gap or
Mismatch risk can be measured by calculating Gaps over different time intervals as at a given
date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive
assets (including off-balance sheet positions). An asset or liability is normally classified as rate
sensitive

if:

i) within the time interval under consideration, there is a cash flow;

ii) the interest rate resets/reprices contractually during the interval;

iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, advances upto
Rs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest
rates are administered ; and

iv) it is contractually pre-payable or withdrawable before the stated maturities.

8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets and off
balance sheet positions into time buckets according to residual maturity or next repricing period,
whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All
investments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within a
specified timeframe are interest rate sensitive.

Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it
within the time horizon. This includes final principal payment and interim instalments. Certain
assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities
are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the
interest rates on term deposits are fixed during their currency, the advances portfolio of the
banking system is basically floating.

The interest rates on advances could be repriced any number of occasions, corresponding to the
changes in PLR. The

Gaps may be identified in the following time buckets:

i) upto 1 month

ii) Over one month and upto 3 months

iii) Over 3 months and upto 6 months

iv) Over 6 months and upto 12 months

v) Over 1 year and upto 3 years

55
vi) Over 3 years and upto 5 years

vii) Over 5 years

viii) Non-sensitive

The various items of rate sensitive assets and liabilities in the Balance Sheet may be classified as
explained in Appendix - II and the Reporting Format for interest rate sensitive assets and
liabilities is given in Annexure II.

8.3 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities
(RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs
whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the
institution is in a position to benefit from rising interest rates by having a positive Gap (RSA >
RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap
(RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity.

8.4 Each bank should set prudential limits on individual Gaps with the approval of the
Board/Management Committee. The prudential limits should have a bearing on the total assets,
earning assets or equity. The banks may work out earnings at risk, based on their views on
interest rate movements and fix a prudent level with the approval of the Board/Management
Committee.

8.5 RBI will also introduce capital adequacy for market risks in due course.

9. The classification of various components of assets and liabilities into different time buckets
for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in
Appendices I & II is the benchmark. Banks which are better equipped to reasonably estimate the
behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets
and liabilities on the basis of past data / empirical studies could classify them in the appropriate
time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the
ALCO / Board may be sent to the Department of Banking Supervision.

APPENDIX - I

Maturity Profile - Liquidity

Heads of Accounts Classification into time buckets

A. Outflows

1. Capital, Reserves and Surplus Over 5 years bucket.

2. Demand Deposits (Current and Savings Bank Deposits) Demand Deposits may be classified
into volatile and core portions. 25% of deposits are generally withdrawable on demand. This

56
portion may be treated as volatile. While volatile portion can be placed in the first time bucket
i.e., 1-14 days, the core portion may be placed in 1 - 2 years bucket.

3. Term Deposits Respective maturity buckets.

4. Certificates of Deposit, Borrowings and Bonds (including Sub-Ordinated Debt) Respective

maturity buckets.

5. Other Liabilities and Provisions

(i) Bills Payable (i) 1-14 days bucket.

(ii) Inter-office Adjustment (ii) As per trend analysis. Items not representing cash payables, may
be placed in over 5 years bucket.

(iii) Provisions for NPAs (iii)

a) Sub-standard a) 2-5 years bucket.

b) Doubtful and Loss b) Over 5 years bucket.

(iv) Provisions for depreciation in investments

(iv) Over 5 years bucket.

(v) Provisions for NPAs in investments (v)

a) Sub-standard a) 2-5 years bucket.

b) Doubtful and Loss b) Over 5 years bucket.

(vi) Provisions for other purposes

(vi) Respective buckets depending on the purpose.

(vii) Other Liabilities

(vii) Respective maturity buckets. Items not representing cash payables (i.e. income received in
advances etc.) may be placed in over 5 years bucket.

B. Inflows

1. Cash 1-14 days bucket

2. Balances with RBI While the excess balance over the required

57
CRR/SLR may be shown under 1-14 days bucket, the Statutory Balances may be distributed
amongst various time buckets corresponding to the maturity profile of DTL with a time-lag of 14
days.

3. Balances with other Banks

(i) Current Account (i) Non-withdrawable portion on account of stipulations of minimum

balances may be shown under 1-2 years bucket and the remaining balances may be shown under
1-14 days bucket.

(ii) Money at Call and Short Notice, Term Deposits and other placements

(ii) Respective maturity buckets.

4. Investments

(i) Approved securities

(i) Respective maturity buckets excluding the amount required to be reinvested to maintain SLR
corresponding to the DTL profile in various time buckets.

(ii) Corporate debentures and bonds, PSU bonds, CDs and CPs, Redeemable preference Shares,
Units of Mutual Funds (close ended), etc.

(ii) Respective maturity buckets. Investments

classified as NPAs should be shown under 2-5 years bucket (sub-standard) or over 5 years
bucket (doubtful and loss).

(iii) Shares / Units of Mutual Funds (open ended)

(iii) Over 5 years bucket.

(iv) Investments in Subsidiaries/Joint Ventures (iv) Over 5 years bucket.

5. Advances (Performing)

(i) Bills Purchased and Discounted (including bills under DUPN)

(i) Respective maturity buckets.

(ii) Cash Credit/Overdraft (including TOD) and Demand Loan component of Working Capital.

(ii) Banks should undertake a study of behavioural and seasonal pattern of availments based on
outstandings and the core and volatile portion should be identified. While the volatile portion

58
could be shown in the respective maturity buckets, the core portion may be shown under 1-2
years bucket.

(iii) Term Loans (iii) Interim cash flows may be shown under respective maturity buckets.

6. NPAs

(i) Sub-standard (i) 2-5 years bucket.

(ii) Doubtful and Loss (ii) Over 5 years bucket.

7. Fixed Assets Over 5 years bucket

8. Other Assets

(i) Inter-office Adjustment (i) As per trend analysis. Intangible items or

items not representing cash receivables may be shown in over 5 years bucket.

(ii) Others (ii) Respective maturity buckets. Intangible

assets and assets not representing cash receivables may be shown in over 5 years bucket.

C. Contingent Liabilities / Lines of

Credit committed / available and other

Inflows / Outflows

1. (i) Lines of Credit committed to Institutions (outflow)

(i) 1-14 days bucket.

(ii) Unavailed portion of Cash Credit / Overdraft / Demand loan component of Working Capital
limits (outflow)

(ii) Banks should undertake a study of the behavioural and seasonal pattern of potential
availments from the accounts and the amounts so arrived at may be shown under relevant
maturity buckets upto 12 months.

2. Letters of Credit / Guarantees (outflow) Historical trend analysis ought to be conducted on the
devolvements and the amounts so arrived at in respect of outstanding Letters of Credit /
Guarantees (net of margins) should be distributed amongst various time buckets.

3. Repos / Bills Rediscounted (DUPN) / Swaps INR / USD, maturing forex forward contracts
etc. (outflow / inflow) Respective maturity buckets.
59
4. Interest payable / receivable

(outflow / inflow) Respective maturity buckets.

(i) Liability on account of any other contingency may be shown under respective maturity
buckets.

(ii) All overdue liabilities may be placed in the 1-14 days bucket.

(iii) Interest and instalments from advances and investments, which are overdue for less than one
month may be placed in the 3-6 months, bucket. Further, interest and instalments due (before
classification as NPAs) may be placed in the 6-12 months bucket without the grace period of one
month if the earlier receivables remain uncollected.

D. Financing of Gap:

In case the negative gap exceeds the prudential limit of 20% of outflows, the bank may show by
way of a foot note as to how it proposes to finance the gap to bring the mismatch within the
prescribed limits. The gap can be financed from market borrowings (call / term), Bills
Rediscounting, Refinance from RBI / others, Repos and deployment of foreign currency
resources after conversion into rupees ( unswapped foreign currency funds ) etc.

APPENDIX - II

Interest Rate Sensitivity

Heads of Accounts Rate sensitivity and time bucket

Liabilities

1. Capital, Reserves and Surplus Non-sensitive.

2. Current Deposits Non-sensitive.

3. Savings Bank Deposits Sensitive to the extent of interest paying (core) portion. This may be
included in the 3-6 months bucket. The non-interest paying portion may be shown in non-
sensitive bucket.

4. Term Deposits and Certificates of Deposit Sensitive and reprices on maturity. The amounts
should be distributed to different buckets on the basis of remaining maturity. However, in case of
floating term deposits, the amounts may be shown under the time bucket when deposits
contractually become due for repricing.

5. Borrowings - Fixed Sensitive and reprices on maturity. The amounts should be distributed to
different buckets on the basis of remaining maturity.

60
6. Borrowings - Floating Sensitive and reprices when interest rate is reset.

The amounts should be distributed to the appropriate bucket which refers to the repricing date.

7. Borrowings - Zero Coupon Sensitive and reprices on maturity. The amounts should be
distributed to the respective maturity buckets.

8. Borrowings from RBI Upto 1 month bucket.

9. Refinances from other agencies.

(a) Fixed rate : As per respective maturity.

(b) Floating rate :Reprices when interest rate is reset.

10. Other Liabilities and Provisions

(i) Bills Payable (i) Non-sensitive.

(ii) Inter-office Adjustment (ii) Non-sensitive.

(iii)Provisions (iii) Non-sensitive.

(iv)Others (iv) Non-sensitive.

11. Repos/Bills Re-discounted (DUPN),

Swaps (Buy / Sell) etc. Reprices only on maturity and should be distributed to the respective
maturity buckets.

Assets

1. Cash Non - sensitive.

2. Balances with RBI Interest earning portion may be shown in 3 - 6

months bucket. The balance amount is nonsensitive.

3. Balances with other Banks

(i) Current Account (i) Non-sensitive.

(ii) Money at Call and Short Notice,

Term Deposits and other placements.

61
(ii) Sensitive on maturity. The amounts should be distributed to the respective maturity buckets.

4. Investments (Performing)

(i) Fixed Rate / Zero Coupon (i) Sensitive on maturity.

(ii) Floating Rate (ii) Sensitive at the next repricing date

5. Shares / Units of Mutual Funds Non-sensitive.

6. Advances (Performing)

(i) Bills Purchased and Discounted

(including bills under DUPN)

(i) Sensitive on maturity

(ii) Cash Credits / Overdrafts (including TODs) / Loans repayable on demand and Term Loans

(ii) Sensitive only when PLR/risk premium is changed. Of late, frequent changes in PLR have
been noticed. Thus, each bank should foresee the direction of interest rate movements and
capture the amounts in the respective maturity buckets by which time PLR would be revised.

7. NPAs (Advances and Investments) *

(i) Sub-Standard (i) 2-5 years bucket.

(ii) Doubtful and Loss (ii) Over 5 years bucket.

8. Fixed Assets Non-sensitive.

9. Other Assets.

(i) Inter-office Adjustment (i) Non-sensitive.

(ii) Others (ii) Non-sensitive.

10. Reverse Repos, Swaps (Sell/Buy) and Bills Rediscounted (DUPN) Sensitive on maturity.

11. Other products (Interest Rate)

(i) Swaps

(i) Sensitive and should be distributed under different buckets with reference to maturity.

62
(ii) Other Derivatives

(ii) Should be suitably classified as and when introduced.

63
 Unit-4

Flow of Funds Accounts: Meaning, Limitation and Importance!

The national income accounts do not tell anything about monetary or financial transactions

whereby one sector places its savings at the disposal of the other sectors of the economy by
means of loans, capital transfers, etc..

In fact, the national income accounts do not take into consideration the financial dimensions of
economic activity and they describe product accounts as if they are operated through barter. The
flow of funds accounts are meant to supplement national income and product accounts. The flow
of funds accounts were developed by Prof. Morris Copeland’ in 1952 to overcome the
weaknesses of national income accounting.

The flow of funds accounts list the sources of all funds received and the uses to which they are
put within the economy. They show the financial transactions among different sectors of the
economy and the link between saving and investment aggregates with lending and borrowing by
them.

The account for each sector reveals all the sources of funds whether from income or borrowing
and all the uses to which they are put whether for spending or lending. This way of looking at
financial transactions in their entirety has come to be known as the flow of funds approach or of
sources and uses of funds.

In the flow of funds accounts, all changes in assets are recorded as uses and all changes in
liabilities are recorded as sources. Uses of funds are increases in assets if positive or decreases in
assets if negative. They refer to capital expenditures or real investment spending which involve
the purchase of real assets.

Sources of funds are increases in liabilities or net worth or saving if positive, and repayment of
debt or dissaving if negative. Net worth is equal to a sector’s total assets minus its total
liabilities. Therefore a change in net worth equals any change in total assets less any change in
total liabilities.

Flow of Funds Matrix:

The flow of funds accounting system is presented in the form of a matrix by placing sources and
uses of funds statements of different sectors side by side. It is an interlocking self-contained
system that reveals financial relationships among all sectors of the economy.

64
For the economy as a whole, total liabilities must equal total financial assets, although for any
one sector its liabilities may not equal its financial assets. The consolidated net worth of an
economy is consequently identical to the value of its real assets. This implies that saving must
equal investment in an economy. Any single sector may save more than it invests or invest more
than it saves. But the economy-wise total of saving must equal investment.

Table 9 presents the flow of funds matrix of an economy. For simplicity, we take the flow of
funds accounts matrix of an economy divided into four sectors: households, nonfinancial
corporations, financial institutions, and the government. These institutional sectors are shown in
columns and various types of transactions in rows.

First take the columns. The household sector includes nonprofit organisations within it.
Nonfinancial corporations include savings and loan associations, mutual savings banks,
insurance companies, pension funds, mutual funds, etc. The remaining sectors are self-
explanatory. The last column showing saving and investment is a measure of domestic saving
and investment of all sectors minus the rest of the world.

Row 1 which relates to gross saving which is a source of funds for households (Rs 27 crores) and
non-financial corporation’s (Rs 17 crores), and the minus figure of Rs. 4 crores for the
government indicates a deficit in its budget.

Row 2 relates to gross investment which is a use of funds by households (Rs. 12 crores) and non-
financial corporation’s (Rs 28 crores). The last column of the table shows that saving and

65
investment are equal to Rs 40 crores each. The figures of saving and investment are supposed to
have been taken from the national income accounts of the economy.

Row 3 shows net financial investment which is the excess of saving over investment or uses over
sources of each sector. For instance, the household sector makes positive net investment of Rs 15
crores (27-12), while the non-financial corporate sector incurs negative net investment of Rs 11
crores because it makes- investment in excess of saving (17-28). The same is the case with the
government which is shown as minus Rs 4 crores. (It can also be arrived at by deducting the
figure of S of row 5 from the U figure of row 4 of each sector

Row 4 shows financial uses (net) of funds. They fear to lending. It equals the sum of the change
in each sector’s holding of financial assets which include demand deposits, government
securities, corporate securities, mortgages and net increase in foreign assets.

Thus the net financial uses of the household sector are Rs 25 crores which include Rs 7 crores of
demand deposits plus Rs 4 crores of government securities plus Rs 14 crores of corporate
securities. Similarly for the remaining sectors.

Row 5 Financial sources (net) of funds shows the liability of each sector. They refer to
borrowing. For instance, the government sector shows the acquisition of financial assets of Rs 4
crores by selling securities to the household sector.

Two important points should be noted: first, financial uses (net) and financial sources (net) of the
economy must equal. They are Rs 34 crores in our table. Second, changes in assets (uses) and
liabilities (sources) of each type of fund must total up to zero.

This is revealed by the last column of the table in relation to rows 6, 7, 8, 9 and 10. In the case of
row 10 we have taken net increase in foreign assets to be zero for the sake of convenience. If it is
a positive figure, the balance will show surplus in the international current account of the
national income accounts and a negative figure will show a deficit.

Limitations:

The flow of funds accounts are beset with a number of problems which are discussed as under:

1. The flow of funds accounts are more complicated than the national income accounts because
they involve the aggregation of a large number of sectors with their very detailed financial
transactions.

2. There is the problem of valuation of assets. Many assets, claims and obligations have no fixed
value. It, therefore, becomes difficult to have their correct valuation.

3. The problem of inclusion of non-reproducible real assets arises in the flow of funds accounts.
Economists have not been able to decide as to the type of reproducible assets which may be
included in flow of funds accounts.

66
4. Similarly, economists have failed to decide about the inclusion of human wealth in flow of
funds accounts.

Despite these problems, the flow of funds accounts supplements the national income accounts
and help in understanding social accounts of an economy.

Importance:

The flow of funds accounts present a comprehensive and systematic analysis of the financial
transactions of the economy.

As such, they are useful in a number of ways:

1. The flow of funds accounts is superior to the national income accounts. Even though the latter
are fairly comprehensive, yet they do not reveal the financial transactions of the economy which
the flow of funds accounts do.

2. They provide a useful framework for studying the behaviour of individual financial
institutions of the economy.

3. According of Prof. Goldsmith, they bring “the various financial activities of an economy into
explicit statistical relationships with one another and with data on the nonfinancial activities that
generate income and production.”

4. They trace the financial flows that interact with and influence the real saving-investment
process. They record the various financial transactions underlying saving and investment.

5. They are essential raw materials for any comprehensive analysis of capital market behaviour.
They help to identify the role of financial institutions in the generation of income, saving and
expenditure, and the influence of economic activity on financial markets.

6. The flow of funds accounts show how the government finances its deficit and surplus budget
and acquires financial assets.

7. They also show the results of transactions in government and corporate securities,, net
increase in deposits and foreign assets in the economy.

8. The flow of funds accounts help in analysing the impact of monetary policies on the economy
as to whether they bring stability or instability or economic fluctuations.

Valuation of Management
In finance, valuation is the process of determining the present value (PV) of an asset. Valuations
can be done on assets (for example, investments in marketable securities such
as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on
67
liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such
as investment analysis, capital budgeting, merger and acquisition transactions, financial
reporting, taxable events to determine the proper tax liability, and in litigation.[1]
Valuation of financial assets is done generally using one or more of the following approaches[2];
but see also, Outline of finance #Valuation:

1. Absolute value models ("Intrinsic valuation") that determine the present value of an
asset's expected future cash flows. These models take two general forms: multi-period
models such as discounted cash flow models, or single-period models such as
the Gordon model (which, in fact, often "telescope" the former). These models rely on
mathematics rather than price observation. See #Discounted cash flow valuation.
2. Relative value models determine value based on the observation of market prices of
'comparable' assets, relative to a common variable like earnings, cashflows, book value
or sales. This result, will often be used to complement / assess the intrinsic valuation.
See #Relative valuation.
3. Option pricing models, in this context, are used to value specific balance-sheet items, or
the asset itself, when these have option-like characteristics. Examples of the first type
are warrants, employee stock options, and investments with embedded options such
as callable bonds; the second type are usually real options. The most common option
pricing models employed here are the Black–Scholes-Merton models and lattice models.
This approach is sometimes referred to as contingent claim valuation, in that the value
will be contingent on some other asset; see #Contingent claim valuation.
Common terms for the value of an asset or liability are market value, fair value, and intrinsic
value. The meanings of these terms differ. For instance, when an analyst believes a stock's
intrinsic value is greater (less) than its market price, an analyst makes a "buy" ("sell")
recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and
vary among analysts.
The International Valuation Standards include definitions for common bases of value and
generally accepted practice procedures for valuing assets of all types.

Usage
In finance, valuation analysis is required for many reasons including tax
assessment, wills and estates, divorce settlements, business analysis, and
basic bookkeeping and accounting. Since the value of things fluctuates over time, valuations are
as of a specific date like the end of the accounting quarter or year. They may alternatively
be mark-to-market estimates of the current value of assets or liabilities as of this minute or this
day for the purposes of managing portfolios and associated financial risk (for example, within
large financial firms including investment banks and stockbrokers).
Some balance sheet items are much easier to value than others. Publicly traded stocks and bonds
have prices that are quoted frequently and readily available. Other assets are harder to value. For
instance, private firms that have no frequently quoted price. Additionally, financial instruments
that have prices that are partly dependent on theoretical models of one kind or another are
difficult to value. For example, options are generally valued using the Black–Scholes model
while the liabilities of life assurance firms are valued using the theory of present value.
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Intangible business assets, like goodwill and intellectual property, are open to a wide range of
value interpretations.
It is possible and conventional for financial professionals to make their own estimates of the
valuations of assets or liabilities that they are interested in. Their calculations are of various
kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-
cash-flow and present value calculations, and analyses of bonds that focus on credit ratings,
assessments of default risk, risk premia, and levels of real interest rates. All of these approaches
may be thought of as creating estimates of value that compete for credibility with the prevailing
share or bond prices, where applicable, and may or may not result in buying or selling by market
participants. Where the valuation is for the purpose of a merger or acquisition the respective
businesses make available further detailed financial information, usually on the completion of
a non-disclosure agreement.
It is important to note that valuation requires judgment and assumptions:

 There are different circumstances and purposes to value an asset (e.g., distressed firm, tax
purposes, mergers and acquisitions, financial reporting). Such differences can lead to
different valuation methods or different interpretations of the method results
 All valuation models and methods have limitations (e.g., degree of complexity, relevance of
observations, mathematical form)
 Model inputs can vary significantly because of necessary judgment and differing
assumptions
Users of valuations benefit when key information, assumptions, and limitations are disclosed to
them. Then they can weigh the degree of reliability of the result and make their decision.

Business valuation
Businesses or fractional interests in businesses may be valued for various purposes such
as mergers and acquisitions, sale of securities, and taxable events. An accurate valuation
of privately owned companies largely depends on the reliability of the firm's historic financial
information. Public company financial statements are audited by Certified Public
Accountants (USA), Chartered Certified Accountants (ACCA) or Chartered Accountants (UK
and Canada) and overseen by a government regulator. Alternatively, private firms do not have
government oversight—unless operating in a regulated industry—and are usually not required to
have their financial statements audited. Moreover, managers of private firms often prepare their
financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public
firms tend to want higher profits to increase their stock price. Therefore, a firm's historic
financial information may not be accurate and can lead to over- and undervaluation. In an
acquisition, a buyer often performs due diligence to verify the seller's information.
Financial statements prepared in accordance with generally accepted accounting
principles (GAAP) show many assets based on their historic costs rather than at their current
market values. For instance, a firm's balance sheet will usually show the value of land it owns at
what the firm paid for it rather than at its current market value. But under GAAP requirements, a
firm must show the fair values (which usually approximates market value) of some types of
assets such as financial instruments that are held for sale rather than at their original cost. When a
firm is required to show some of its assets at fair value, some call this process "mark-to-market".
69
But reporting asset values on financial statements at fair values gives managers ample
opportunity to slant asset values upward to artificially increase profits and their stock prices.
Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk
of manager bias, equity investors and creditors prefer to know the market values of a firm's
assets—rather than their historical costs—because current values give them better information to
make decisions.
There are commonly three pillars to valuing business entities: comparable company analyses,
discounted cash flow analysis, and precedent transaction analysis.
Discounted cash flow method
This method estimates the value of an asset based on its expected future cash flows, which are
discounted to the present (i.e., the present value). This concept of discounting future money is
commonly known as the time value of money. For instance, an asset that matures and pays $1 in
one year is worth less than $1 today. The size of the discount is based on an opportunity cost of
capital and it is expressed as a percentage or discount rate.
In finance theory, the amount of the opportunity cost is based on a relation between the risk and
return of some sort of investment. Classic economic theory maintains that people are rational and
averse to risk. They, therefore, need an incentive to accept risk. The incentive in finance comes
in the form of higher expected returns after buying a risky asset. In other words, the more risky
the investment, the more return investors want from that investment.
Using the same example as above, assume the first investment opportunity is a government bond
that will pay interest of 5% per year and the principal and interest payments are guaranteed by
the government. Alternatively, the second investment opportunity is a bond issued by small
company and that bond also pays annual interest of 5%.
If given a choice between the two bonds, virtually all investors would buy the government bond
rather than the small-firm bond because the first is less risky while paying the same interest rate
as the riskier second bond. In this case, an investor has no incentive to buy the riskier second
bond. Furthermore, in order to attract capital from investors, the small firm issuing the second
bond must pay an interest rate higher than 5% that the government bond pays.
Otherwise, no investor is likely to buy that bond and, therefore, the firm will be unable to raise
capital. But by offering to pay an interest rate more than 5% the firm gives investors an incentive
to buy a riskier bond.
For a valuation using the discounted cash flow method, one first estimates the future cash flows
from the investment and then estimates a reasonable discount rate after considering the riskiness
of those cash flows and interest rates in the capital markets. Next, one makes a calculation to
compute the present value of the future cash flows.

Guideline companies method

This method determines the value of a firm by observing the prices of similar companies (called
"guideline companies") that sold in the market. Those sales could be shares of stock or sales of
entire firms. The observed prices serve as valuation benchmarks. From the prices, one
calculates price multiples such as the price-to-earnings or price-to-book ratios—one or more of

70
which used to value the firm. For example, the average price-to-earnings multiple of the
guideline companies is applied to the subject firm's earnings to estimate its value.
Many price multiples can be calculated. Most are based on a financial statement element such as
a firm's earnings (price-to-earnings) or book value (price-to-book value) but multiples can be
based on other factors such as price-per-subscriber.
Net asset value method
The third-most common method of estimating the value of a company looks to
the assets and liabilities of the business. At a minimum, a solvent company could shut down
operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a
floor value for the company. This method is known as the net asset value or cost method. In
general the discounted cash flows of a well-performing company exceed this floor value. Some
companies, however, are worth more "dead than alive", like weakly performing companies that
own many tangible assets.
This method can also be used to value heterogeneous portfolios of investments, as well
as nonprofits, for which discounted cash flow analysis is not relevant. The valuation premise
normally used is that of an orderly liquidation of the assets, although some valuation scenarios
(e.g., purchase price allocation) imply an "in-use" valuation such as depreciated replacement cost
new.
An alternative approach to the net asset value method is the excess earnings method. This
method was first described in ARM34,[further explanation needed] and later refined by the U.S. Internal
Revenue Service's Revenue Ruling 68-609. The excess earnings method has the appraiser
identify the value of tangible assets, estimate an appropriate return on those tangible assets, and
subtract that return from the total return for the business, leaving the "excess" return, which is
presumed to come from the intangible assets. An appropriate capitalization rate is applied to the
excess return, resulting in the value of those intangible assets. That value is added to the value of
the tangible assets and any non-operating assets, and the total is the value estimate for the
business as a whole.

Specialised cases
In the below cases, depending on context, Real options valuation techniques are also sometimes
employed, if not preferred; for further discussion here see Business valuation #Option pricing
approaches, Corporate finance #Valuing flexibility.
Valuation of a suffering company
When valuing "distressed securities", in many cases the company in question is valued using real
options analysis - see Business valuation #Option pricing approaches. This value serves to
complement (or sometimes replace) the more standard techniques. When these latter are applied,
various adjustments are typically made to the valuation result; this would be true whether
market-, income-, or asset-based. These adjustments would consider

 Lack of marketability discount of shares

 Control premium or lack of control discount
 Excess or restricted cash

71
 Other non-operating assets and liabilities
 Above- or below-market leases
 Excess salaries in the case of private companies
The financial statements here are similarly recast, including adjustments to working capital,
deferred capital expenditures, cost of goods sold, Non-recurring professional fees and costs, and
certain non-operating income/expense items[3]
Valuation of a startup company
Startup companies such as Uber, which was valued at $50 billion in early 2015, are
assigned post-money valuations based on the price at which their most recent investor put money
into the company. The price reflects what investors, for the most part venture capital firms, are
willing to pay for a share of the firm. They are not listed on any stock market, nor is the
valuation based on their assets or profits, but on their potential for success, growth, and
eventually, possible profits.[4] Many startup companies use internal growth factors to show their
potential growth which may attribute to their valuation. The professional investors who fund
startups are experts, but hardly infallible.
Valuation of intangible asset
Valuation models can be used to value intangible assets such as for patent valuation, but also
in copyrights, software, trade secrets, and customer relationships. Since few sales of
benchmark intangible assets can ever be observed, one often values these sorts of assets
using either a present value model or estimating the costs to recreate it. Regardless of the
method, the process is often time-consuming and costly.
Valuations of intangible assets are often necessary for financial reporting and intellectual
property transactions.
Stock markets give indirectly an estimate of a corporation's intangible asset value. It can be
reckoned as the difference between its market capitalisation and its book value (by including
only hard assets in it)

SLR and CRR Management

Statutory liquidity ratio

Statutory liquidity ratio (SLR) is the Indian government term for the reserve requirement that
the commercial banks in India are required to maintain in the form of cash, gold reserves,
government approved securities before providing credit to the customers. Statutory liquidity ratio
is determined by Reserve Bank of India maintained by banks in order to control the expansion of
bank credit.
The SLR is determined by a percentage of total demand and time liabilities. Time liabilities refer
to the liabilities which the commercial banks are liable to pay to the customers after a certain
period mutually agreed upon, and demand liabilities are such deposits of the customers which are
payable on demand. An example of time liability is a six month fixed deposit which is not

72
payable on demand but only after six months. An example of demand liability is a deposit
maintained in a saving account or current account that is payable on demand through a
withdrawal form such as a cheque.
The SLR is commonly used to control inflation and fuel growth, by increasing or decreasing it
respectively. This counter acts by decreasing or increasing the money supply in the system
respectively. Indian banks’ holdings of government securities are now close to the statutory
minimum that banks are required to hold to comply with existing regulation. When measured in
rupees, such holdings decreased for the first time in a little less than 40 years (since the
nationalisation of banks in 1969) in 2005–06. Currently[when?] it is 19.5 percent.

Usage
SLR is used by bankers and indicates the minimum percentage of deposits that the bank has to
maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of
cash and some other approved liability (deposits). It regulates the credit growth in India.
The liabilities that the banks are liable to pay within one month's time, due to completion of
maturity period, are also considered as time liabilities. The maximum limit of SLR is 40% and
minimum limit of SLR is 0 In India, Reserve Bank of India always determines the percentage of
SLR.
There are some statutory requirements for temporarily placing the money in government bonds.
Following this requirement, Reserve Bank of India fixes the level of SLR. However, as most
banks currently keep an SLR higher than required (>26%) due to lack of credible lending
options, near term reductions are unlikely to increase liquidity and are more symbolic.[1][2]
The SLR is fixed for a number of reasons. The chief driving force is increasing or decreasing
liquidity which can result in a desired outcome. A few uses of mandating SLR are:

 Controlling the expansion of bank credit. By changing the level of SLR, the Reserve Bank of
India can increase or decrease bank credit expansion.
 Ensuring the solvency of commercial banks
 By reducing the level of SLR, the RBI can increase liquidity with the commercial banks,
resulting in increased investment. This is done to fuel growth and demand.
 Compelling the commercial banks to invest in government securities like government bonds
If any Indian bank fails to maintain the required level of the statutory liquidity ratio, then it
becomes liable to pay penalty to Reserve Bank of India. The defaulter bank pays penal interest at
the rate of 3% per annum above the bank rate, on the shortfall amount for that particular day.
However, according to the Circular released by the Department of Banking Operations and
Development, Reserve Bank of India, if the defaulter bank continues to default on the next
working day, then the rate of penal interest can be increased to 5% per annum above the bank
rate. This restriction is imposed by RBI on banks to make funds available to customers on
demand as soon as possible. Gold and government securities (or gilts) are included along with
cash because they are highly liquid and safe assets.

73
The RBI can increase the SLR to control inflation, suck liquidity in the market, to tighten the
measure to safeguard the customers' money. Decrease in SLR rate is done to encourage growth.
In a growing economy banks would like to invest in stock market, not in government securities
or gold as the latter would yield less returns. One more reason is long term government securities
(or any bond) are sensitive to interest rate changes. However, in an emerging economy, interest
rate change is a common activity.

Value and formula

The quantum is specified as some percentage of the total demand and time liabilities ( i.e. the
liabilities of the bank which are payable on demand anytime, and those liabilities which are
accruing in one months time due to maturity) of a bank.
SLR rate = (liquid assets / (demand + time liabilities)) × 100%
This percentage is fixed by the Reserve Bank of India. The maximum limit for the SLR was 40%
in India.[when?][3] Following the amendment of the Banking regulation Act (1949) in January
2017, the floor rate of 20.75% for SLR was removed. Presently,[when?] the SLR is 19.5%.
.
Cash Reserve Ratio ( CRR )

Cash Reserve Ratio (CRR) is the share of a bank’s total deposit that is mandated by the Reserve
Bank of India (RBI) to be maintained with the latter in the form liquid cash.
1. Objectives of Cash Reserve Ratio
In order to determine the base rate, the Cash Reserve Ratio acts as one of the reference rates.
Base rate means the minimum lending rate which is determined by the Reserve Bank of India
(RBI) and no bank is allowed to lend funds below this rate. This rate is fixed to ensure
transparency with respect to borrowing and lending in the credit market. The Base Rate also
helps the banks to cut down on their cost of lending so as to be able to extend affordable loans.
Apart from this, there is two main objective existence of cash reserve ratio:
1. Cash reserve ratio ensures that a part of the bank’s deposit is with the Central Bank and is
hence, safe
2. The second and a very important reason is for the purpose of combating inflation. To keep the
liquidity in check, the RBI resorts to increasing and decreasing the Cash Reserve Ratio
2. How does Cash Reserve Ratio work?
When the RBI decides to increase the Cash Reserve Ratio, the amount of money that is available
with the banks reduces. This is the RBI’s way of controlling the excess supply of money. The
cash balance that is to be maintained by scheduled banks with the RBI should not be less than
4% of the total NDTL, which is the Net Demand and Time Liabilities. This is done on a
fortnightly basis.
NDTL refers to the total demand and time liabilities (deposits) that is held by the banks of public
and with other banks. Demand deposits consist of all liabilities which the bank needs to pay on
74
demand like current deposits, demand drafts, balances in overdue fixed deposits and demand
liabilities portion of savings bank deposits.
Time deposits consist of deposits that need to repay on maturity and where the depositor can’t
withdraw money immediately; instead, he is required to wait a certain time period to access the
funds. It includes fixed deposits, time liabilities portion of savings bank deposits and staff
security deposits. The liabilities of a bank include call money market borrowings, certificate of
deposits and investment in deposits other banks.
In short, higher the Cash Reserve Ratio, lesser is the amount of money available to banks for
lending and investing.

3. How does CRR affect the economy

Cash Reserve Ratio (CRR) is one of the components of the monetary policy of the RBI which is
used to regulate the money supply, level of inflation and liquidity in the country. The higher the
CRR, the lower is the liquidity with the banks and vice-versa.
During high levels of inflation, attempts are made to reduce the money supply in the economy.
For this, RBI increases the CRR, sucking the loanable funds available with the banks. This, in
turn, slows down investment and reduces the supply of money in the economy. As a result, the
growth of the economy is negatively impacted. However, this also helps bring down inflation.
On the other hand, when the RBI needs to pump funds into the system, it lowers CRR which
increases the loanable funds with the banks. The banks thus extend a large number of loans to
the businesses and industry for different investment purposes. It also increases the overall supply
of money in the economy. This ultimately boosts the growth rate of the economy.

help you choose b

4. Difference between CRR & SLR

Both CRR & SLR are the components of the monetary policy. However, there are a few
differences between them. The following table gives a glimpse into the dissimilarities:

Statutory Liquidity Ratio (SLR) Cash Reserve Ratio (CRR)

In case of SLR, banks are asked to have reserves of The CRR requires banks to have only
liquid assets which include both cash and gold. cash reserves with the RBI

Banks earn returns on money parked as SLR Banks don't earn returns on money

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Statutory Liquidity Ratio (SLR) Cash Reserve Ratio (CRR)

parked as CRR

SLR is used to control the bank's leverage for credit The Central Bank controls the liquidity in
expansion. the Banking system with CRR.

In case of SLR, the securities are kept with the banks In CRR, the cash reserve is maintained by
themselves which they need to maintain in the form of the banks with the Reserve Bank of India.
liquid assets.

5. Why is Cash Reserve Ratio changed regularly?

In accordance with the RBI guidelines, every bank is decreed to maintain a ratio of their total
deposits that can also be held with currency chests. This is considered to be the same as it is kept
with the RBI. This ratio can be changed by the RBI from time to time in regular intervals. When
this ratio is changed, it impacts the economy.
For banks, profits are made by lending. In pursuit of this goal, banks may lend out to the max to
make higher profits and have very less cash with them. In such a scenario, if there is an
unexpected rush by the customers to withdraw their deposits, the banks will not be in a position
to meet all the repayment needs. Therefore, CRR is vital to ensure that there is always a certain
fraction of all the deposits in every bank, kept safe with them. RBI curbs these issues with the
help of the CRR.
While ensuring liquidity against deposits is the prime function of the CRR, it has an equally
important role in the control of the rates in the economy. The RBI controls the short-term
volatility in the interest rates by the amount of liquidity allowed in the system. Too much
availability of cash leads to the fall in rates while the scarcity of it leads to a sudden rise in rates,
both of which are unhealthy for the economy.
Thus, as a depositor, it is good for you to know of the CRR prevailing in the market that ensures
that regardless of the performance of the bank, a certain percentage of your cash is safe with the
RBI.

6. Current Repo Rate and its impact

Apart from CRR, there are others metrics used by RBI to regulate the economy. RBI keeps
changing the repo rate and reverse repo rate according to changing macroeconomic factors.
Whenever RBI modifies the rates, it impacts every sector of the economy; although in different
ways. Some segments gain as a result of the rate hike while others may suffer losses. Looking at
the built up of inflationary pressures, RBI recently hiked the repo rate by 25 basis points to
6.25% and the reverse repo rate to 6%.
76
 In some instances, big loans like home loans might be impacted due to a change in the reverse
repo rates. If the RBI cuts the repo rate, it need not necessarily mean that the home loan EMIs
would get lesser or the interest rates would get reduced as well. The lending bank also needs to
reduce its ‘Base Lending’ rate for the EMIs to decrease. Home loan rates or fixed rate consumer
loans aren’t impacted by RBI’s rate cut. The rate of interest is fixed with respect to fixed loans.

Credit Risk Management

Credit risk is defined as the possibility of losses associated with diminution in the credit quality
of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to
inability or unwillingness of a customer or counterparty to meet commitments in relation to
lending, trading, settlement and other financial transactions. Alternatively, losses result from
reduction in portfolio value arising from actual or perceived deterioration in credit quality.
Credit risk emanates from a bank’s dealings with an individual, corporate, bank, financial
institution or a sovereign. Credit risk may take the following forms:

 in the case of direct lending: principal/and or interest amount may not be repaid;
 in the case of guarantees or letters of credit: funds may not be forthcoming from the constituents
upon crystallization of the liability;
 in the case of treasury operations: the payment or series of payments due from the counter parties
under the respective contracts may not be forthcoming or ceases;
 in the case of securities trading businesses: funds/ securities settlement may not be effected;
 in the case of cross-border exposure: the availability and free transfer of foreign currency funds
may either cease or restrictions may be imposed by the sovereign.

In this backdrop, it is imperative that banks have a robust credit risk management system which
is sensitive and responsive to these factors. The effective management of credit risk is a critical
component of comprehensive risk management and is essential for the long term success of any
banking organisation. Credit risk management encompasses identification, measurement,
monitoring and control of the credit risk exposures.

RBI Guidelines on credit risk Management

The Reserve Bank of India (RBI) will issue comprehensive guidelines on credit-risk
management for commercial banks soon. This will enable banks to improve their existing risk
management framework. Sources close to the development told The Financial Express that the
final guidelines will come in a fortnight’s time.
It is also pointed out that there will not be any time-frame for banks for adhering to the norms on
credit-risk management. “This cannot be done overnight, and banks can do this at their own
pace,” the sources aid.

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Earlier, the apex bank had prepared a guidance note in this regard in September last and
forwarded it to all commercial banks for a detailed study. The RBI had also sought comments
from banks. The guidance note was prepared by a working group comprising senior officials
from banks and financial institutions (FIs). After reviewing the comments from banks, final
guidelines have now been prepared.
The RBI guidelines are likely to ask banks to develop a separate credit-risk management strategy
which should spell out its credit appetite and the acceptable level of risk-reward trade off at both
the micro and macro levels.

Banks should have a system of checks and balances in place and bank officials dealing with
credit would be accountable for managing risk and, in conjunction with credit-risk management
framework, for establishing and maintaining appropriate risk limits and risk management
procedures for their businesses. The RBI is also of the view that banks should have a consistent
approach toward early recognition, classification of problem and remedial actions. Banks are
also to maintain a diversified risk assets in line with the capital desired to support such a
portfolio.

Credit-risk is defined as the possibility that a borrower or counter-party will fail to meet its
obligations in accordance with agreed terms. Thus, the risk arises from the bank’s dealing with
or lending to a corporate, individual, another bank or an FI.
Credit-risk management will enable banks to identify, assess, manage risk proactively. The RBI
reiterated that amidst the changing financial environment, in the backdrop of the globalisation
and liberalisation, there should be a proper credit-risk management policy in place, in sync with
the international best practices.

The central bank may also ask banks to constitute a high level credit-risk management committee
to deal with the issues relating to credit policies and procedures of the bank.
The committee will be powered to formulate clear policies on standards for presentation of credit
proposals, financial covenants, rating standards and benchmark, delegation of credit approving
powers, prudential limits on large credit exposures amongst others.

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 Credit Risk Management:

In a bank, an effective credit risk management framework would comprise of the following
distinct building blocks:

a. Policy and Strategy

b. Organisational Structure
c. Operations/ Systems

1.4 Policy and Strategy

The Board of Directors of each bank shall be responsible for approving and periodically
reviewing the credit risk strategy and significant credit risk policies.

1 Credit Risk Policy

 Every bank should have a credit risk policy document approved by the Board. The document
should include risk identification, risk measurement, risk grading/ aggregation techniques,
reporting and risk control/ mitigation techniques, documentation, legal issues and management
of problem loans.
 Credit risk policies should also define target markets, risk acceptance criteria, credit approval
authority, credit origination/ maintenance procedures and guidelines for portfolio management.
 The credit risk policies approved by the Board should be communicated to branches/controlling
offices. All dealing officials should clearly understand the bank’s approach for credit sanction
and should be held accountable for complying with established policies and procedures.
 Senior management of a bank shall be responsible for implementing the credit risk policy
approved by the Board.

Credit process

 Banks should establish proactive credit risk management practices like annual / half yearly
industry studies and individual obligor reviews, periodic credit calls that are documented,
periodic visits of plant and business site, and at least quarterly management reviews of troubled
exposures/weak credits.
 Banks should have a system of checks and balances in place for extension of credit viz.:

 Separation of credit risk management from credit sanction

 Multiple credit approvers making financial sanction subject to approvals at various stages viz.
credit ratings, risk approvals, credit approval grid, etc.
 An independent audit and risk review function.

 The level of authority required to approve credit will increase as amounts and transaction risks
increase and as risk ratings worsen.
 Every obligor and facility must be assigned a risk rating.
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 Mechanism to price facilities depending on the risk grading of the customer, and to attribute
accurately the associated risk weightings to the facilities.
 Banks should ensure that there are consistent standards for the origination, documentation and
maintenance for extensions of credit.
 Banks should have a consistent approach towards early problem recognition, the classification of
problem exposures, and remedial action.
 Banks should maintain a diversified portfolio of risk assets; have a system to conduct regular
analysis of the portfolio and to ensure ongoing control of risk concentrations.
 Credit risk limits include, obligor limits and concentration limits by industry or geography. The
Boards should authorize efficient and effective credit approval processes for operating within the
approval limits.
 In order to ensure transparency of risks taken, it is the responsibility of banks to accurately,
completely and in a timely fashion, report the comprehensive set of credit risk data into the
independent risk system.
 Banks should have systems and procedures for monitoring financial performance of customers
and for controlling outstanding within limits.
 A conservative policy for provisioning in respect of non-performing advances may be adopted.
 Successful credit management requires experience, judgement and commitment to technical
development. Banks should have a clear, well-documented scheme of delegation of powers for
credit sanction.

Banks must have a Management Information System (MIS), which should enable them to
manage and measure the credit risk inherent in all on- and off-balance sheet activities. The MIS
should provide adequate information on the composition of the credit portfolio, including
identification of any concentration of risk. Banks should price their loans according to the risk
profile of the borrower and the risks associated with the loans.

Characteristics of different types of loans

10 Characteristics of a bank loan that makes it different from other types of loans are;

1. Parties.
2. Amount of loan.
3. Ultimate decision.
4. Mode of the loan.
5. Nature of distribution.
6. The process of disbursement.
7. Security.
8. Loan price.
9. Periodicity’ of bank loan.
10. Repayment of loan.

1. Parties

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There are two parties involved in the loan transactions. One is the bank and the other is the loan
applicant.

The applicant will apply for loans to the bank and bank will accept the application. Bank can
reject the application if found financially not viable.

2. Amount of Loan

The loan amount may very-small, medium or large.

There might be the difference between the applied amount and the sanctioned amount on the
basis of the quality and capacity of the borrower and the purpose for which applied.

3. Ultimate Decision

Banks’ decision is final in the case of loan application.

That is bank can fully sanction, partially sanction or may totally reject the loan application after
considering the goodwill of the clients, its own fund and other issues related with
creditworthiness.

4. Mode of Loan

Generally, loans are given in cash.

But in exceptional cases, the same may be provided in kind, such as raw materials, machinery,
and other inputs etc.

5. Nature of Distribution

Generally, banks disburse loan in installment basis.

But when the bank is convinced, it may disburse the whole amount of sanctioned amount at a
time.

6. Process of Disbursement

Banks often disburse their loan against the existing current account of the client. If the client is
new, the bank asks the person to open a current account.

The bank provides the sanctioned loan through that account.

7. Security

Generally, loans are provided against collateral.

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But the sometimes small amount of loans can be sanctioned on the basis of personal guarantee.

8. Loan Price

Banks never sanction loan without interest. But interest rate can vary on the basis of types of
loan or track records of the clients.

9. Periodicity’ of Bank Loan

Depending on types’ of the loan, goodwill of the clients and purpose, the periodicity of the loans
can vary.

The loan may be sanctioned for immediate use, short-term, and mid-term or long-term basis.

10. Repayment of Loan

Loans are repaid on an installment basis or it may be a one-shot arrangement.

In preparing the loan repayment schedule, banks generally, focus on the possible cash flow
stream of the clients’ projects.

At a glance, these are the characteristics of bank loans generally that are seen in case of every’
commercial bank.
A credit risk is the risk of default on a debt that may arise from a borrower failing to make
required payments .In the first resort, the risk is that of the lender and includes
lost principal and interest, disruption to cash flows, and increased collection costs. The loss may
be complete or partial. In an efficient market, higher levels of credit risk will be associated with
higher borrowing costs .Because of this, measures of borrowing costs such as yield spreads can
be used to infer credit risk levels based on assessments by market participants.
Losses can arise in a number of circumstances, for example:

 A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit,
or other loan.
 A company is unable to repay asset-secured fixed or floating charge debt.
 A business or consumer does not pay a trade invoice when due.
 A business does not pay an employee's earned wages when due.
 A business or government bond issuer does not make a payment on a coupon or principal
payment when due.
 An insolvent insurance company does not pay a policy obligation.
 An insolvent bank won't return funds to a depositor.
 A government grants bankruptcy protection to an insolvent consumer or business.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage
insurance, or seek security over some assets of the borrower or a guarantee from a third party.
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The lender can also take out insurance against the risk or on-sell the debt to another company. In
general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay
on the debt. Credit risk mainly arises when borrowers are unable to pay due willingly or
unwillingly.

Assessing credit risk

Significant resources and sophisticated programs are used to analyze and manage risk. Some
companies run a credit risk department whose job is to assess the financial health of their
customers, and extend credit (or not) accordingly. They may use in-house programs to advise on
avoiding, reducing and transferring risk. They also use third party provided intelligence.
Companies like Standard & Poor's, Moody's, Fitch Ratings, DBRS, Dun and Bradstreet, Bureau
van Dijk and Rapid Ratings International provide such information for a fee.
For large companies with liquidly traded corporate bonds or Credit Default Swaps, bond yield
spreads and credit default swap spreads indicate market participants assessments of credit risk
and may be used as a reference point to price loans or trigger collateral calls.
Most lenders employ their own models (credit scorecards) to rank potential and existing
customers according to risk, and then apply appropriate strategies. With products such as
unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers
and vice versa.With revolving products such as credit cards and overdrafts, risk is controlled
through the setting of credit limits. Some products also require collateral, usually an asset that is
pledged to secure the repayment of the loan.
Credit scoring models also form part of the framework used by banks or lending institutions to
grant credit to clients. For corporate and commercial borrowers, these models generally have
qualitative and quantitative sections outlining various aspects of the risk including, but not
limited to, operating experience, management expertise, asset quality, and leverage and liquidity
ratios, respectively. Once this information has been fully reviewed by credit officers and credit
committees, the lender provides the funds subject to the terms and conditions presented within
the contract (as outlined above).
Sovereign risk
Sovereign credit risk is the risk of a government being unwilling or unable to meet its loan
obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in
the late-2000s global recession. The existence of such risk means that creditors should take a
two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly
one should consider the sovereign risk quality of the country and then consider the firm's credit
quality.
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:

 Debt service ratio

 Import ratio
 Investment ratio
 Variance of export revenue
 Domestic money supply growth

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The probability of rescheduling is an increasing function of debt service ratio, import ratio,
variance of export revenue and domestic money supply growth.[17] The likelihood of
rescheduling is a decreasing function of investment ratio due to future economic productivity
gains. Debt rescheduling likelihood can increase if the investment ratio rises as the foreign
country could become less dependent on its external creditors and so be less concerned about
receiving credit from these countries/investors.
Counterparty risk
A counterparty risk, also known as a default risk, is a risk that a counterparty will not pay as
obligated on a bond, derivative, insurance policy, or other contract.Financial institutions or other
transaction counterparties may hedge or take out credit insurance or, particularly in the context
of derivatives, require the posting of collateral. Offsetting counterparty risk is not always
possible, e.g. because of temporary liquidity issues or longer term systemic reasons.
Counterparty risk increases due to positively correlated risk factors. Accounting for correlation
between portfolio risk factors and counterparty default in risk management methodology is not
trivial.

Key components of credit risk rating systems

One of the most popular tools to monitor credit risk is a standardized risk rating system. A credit
risk rating system provides banks and credit unions the opportunity to grade transactions in their
commercial loan portfolio by level of risk. CEIS Review, a New York-based bank consulting
firm, recently published an article on these systems in their newsletter, The CEIS Quarterly. The
article cites a lack of specific requirements and standard models for credit risk rating systems.
The only requirement from regulators is assigning transactions, when appropriate, to four
criticized categories: special mention, substandard, doubtful and loss.

Because there is no standard model, each institution is allowed to customize a risk rating system
to fit its own needs. However, each institution should pay special attention to the level of detail
included in its model. According to CEIS, the “number of grade levels will primarily depend on
the breadth of the spectrum of risk embedded in the portfolio, and where within that range it lies
both in dollar terms and in terms of number of transactions and/or clients.” Finding the right
balance between having insightful information and avoiding unnecessary complexities is key.

In 2001, the OCC published the Comptroller’s Handbook on Rating Credit Risk, which
highlighted the expectations of credit risk rating systems:

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1. The system should be integrated into the bank’s overall portfolio risk management.
2. The board of directors should approve the credit risk rating system.
3. All credit exposures should be rated.
4. The risk rating system should assign an adequate number of ratings.
5. Risk ratings must be accurate and timely.
6. The criteria for assigning each rating should be clear and precisely defined using objective and
subjective factors.
7. Ratings should reflect the risks posed by both the borrower’s expected performance and the
transaction’s structure.
8. The risk rating system should be dynamic.
9. The risk rating process should be independently validated.
10. Banks should determine through backtesting whether the assumptions are valid.
11. The rating assigned to a credit should be well supported and documented in the credit file.

With these expectations in mind, CEIS highlighted a nine-grade system often used by banks:

• Grades one and two (the top grades) are generally reserved for “cash collateralized transactions,
claims on the federal government, transactions secured by marketable financial instruments,
federally guaranteed portions of SBA loans and loans to investment grade entities.”
• Grades three through five (pass credits) are usually split into low, medium and high risk
transactions. In most cases, the majority of the bank’s portfolio will be in this category.
• Grades six through nine (problem credits) incorporate the four criticized categories: special
mention, substandard, doubtful and loss.

Further enhancements to the rating system can be made, including the use of a watch list for
potentially problematic credits and/or the use of split ratings when some portions of a loan are
secured/guaranteed but the rest is not. According to CEIS, some banks even differentiate
between borrower risk and transaction risk by rating them separately. Others use a rating matrix
where different risk criteria are scored separately, applied a certain weight and then averaged to
obtain the score. Regardless of the system used, consistency is critical.

The main purpose of a credit risk rating system is to “measure and manage the risk contained in
individual credit transactions.” This allows institutions to generate a risk profile of the entire
portfolio, which can then be tracked and measured over time to analyze changes in risk. Banks
also use the rating system to calculate reserves, as the ability to segment their portfolio based
upon risk is critical to making ALLL calculations.
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Learn how to books loans faster while managing risk.

sAnother benefit is the ability to standardize pricing. A weighted average price can be calculated
for each grade, and then used as a reference point when pricing future transactions. This helps
ensure consistency and adequate returns on the risk being incurred.

For more credit risk rating system best practices, access the full article by CEIS. To learn about
how to build the proper culture around it, access this archived webinar: The Real Price of Risk.

Download the free eBook Commercial Risk Ratings Considerations to learn best practices for
building your risk rating system.

Credit Pricing

Risk-based pricing in the credit market refers to the offering of different interest rates and loan
terms to different consumers based on their creditworthiness. Risk-based pricing looks at factors
such as a consumer’s credit score, adverse credit history (if any), employment status and income.
It does not consider factors such as race, color, national origin, religion, gender, marital status or
age which is not allowed based on the Equal Credit Opportunity Act. In 2011 the U.S. instituted
a new federal risk-based pricing rule which requires lenders to provide borrowers with a risk-
based pricing notice in certain situations.

Many banks and credit unions have adopted sophisticated risk-management practices, and their
board of directors has to play an active role in ensuring that risks are well understood in
overseeing risk exposure. Credit risk refers to the potential for a loss if a borrower or a
counterparty to the transaction fails to meet its obligations as they fall due. Credit risk remains
the most important risk that banks and credit unions have to monitor. Even so, many institutions
are still failing to price their loans using credit risk as a major factor.

When pricing a loan, financial institutions can choose to use a single-factor approach, like risk
rating, or they can choose a more sophisticated multi-factor approach that combines risk rating
with either quality of collateral or loan-to-value. While most institutions start with a single-factor
risk rating approach, it is recommended that lenders advance to multi-factor pricing to improve
accuracy and profitability.

Ensure consistency in your credit analysis and documentation.

1. Risk Rating

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One method for pricing a loan is to assign a risk rating to quantify risk of default. If the
prospective loan is booked, this same methodology can be used throughout the life of the loan to
accurately and concisely describe the risk of the loan. This is often a favorable method of pricing
credit risk because each institution establishes a risk rating system that is reflective of the level of
complexity of their borrowers and loan types. For example, banks and credit unions who are
lending to borrowers with complex relationships will need a risk rating system that incorporates
multiple factors such as guarantors, real estate, percent ownership, etc. Institutions should ensure
risk ratings are dynamic and timely, have an adequate number of factors and that the criteria for
each risk rating are well defined. Basing a loan pricing model on a robust and customized risk
rating system will lead to a more accurate and profitable lending at an institution.

2. Risk Rating and Quality of Collateral

Collateral provides incentives for the borrower to avoid default and can help reduce the loss to
the institution if the borrower defaults on a loan. However, not all collateral is created equally:
marketability of the asset, sales costs and access to collateral all affect value. Quality of
collateral is normally assessed based on the recovery factor, which is the ratio of value of the
collateral after subtracting liquidation expenses to the current stated value of the collateral. For
example, real estate may have a recovery ratio of 60 percent due to high selling expenses while
stocks and bonds may have a recovery ratio of 90 percent because they are easily converted to
cash.

One way to price that risk into the loan is using probability of default/loss given default
(PD/LGD) metrics to measure both risk rating and collateral. Probability of Default (PD) gives
the average percentage of obligors that default in a rating grade in the course of one year. Loss
Given Default (LGD) measures the expected loss, net of any recoveries, should a borrower
default, and it’s expressed as a percentage of the exposure.

A PD/LGD can be complicated to calculate, but if the analysis is included in the loan pricing
model, it will more accurately capture and account for the institution’s exposure.

3. Risk Rating and Loan-to-Value

Accounting for risk rating and loan-to-value (LTV) is another recommended methodology for
pricing credit risk. The loan-to-value ratio compares the total loan amount to the value of the

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property or asset used as underlying collateral. For example if the requested loan amount is
$800,000 and the property appraises for $1,000,000 then the LTV is 80 percent. Since the
appraisal has a significant impact on the LTV, financial institutions must ensure they have a
strong appraisal process in place. Here are three components of a quality appraisal:

1. Appraisal should have been updated within the last year

2. The appraisal should be performed by a credible and trustworthy source

3. Appropriate discount rates should be applied to the financials

Each financial institution has its own loan-to- value benchmarks, which are driven by both the
bank’s goals and current loan portfolio concentrations. As a general rule of thumb: as the LTV
increases, the risk profile of the loan increases, which calls for a higher interest rate. LTV can be
used in conjunction with risk rating to incorporate other factors such as guarantors, probability of
default or additional collateral, which may increase or decrease the final price of the loan

Exposure Norms

As a prudential measure aimed at better risk management and avoidance of concentration of

credit risks, the Reserve Bank of India has advised the banks to fix limits on their exposure to
specific industry or sectors and has prescribed regulatory limits on banks’ exposure to individual
and group borrowers in India. In addition, banks are also required to observe certain statutory
and regulatory exposure limits in respect of advances against / investments in shares, convertible
debentures /bonds, units of equity-oriented mutual funds and all exposures to Venture Capital
Funds (VCFs). Banks should comply with the following guidelines relating to exposure norms.

Credit Exposures to Individual/Group Borrowers

Ceilings

The exposure ceiling limits would be 15 percent of capital funds in case of a single borrower and
40 percent of capital funds in the case of a borrower group. The capital funds for the purpose will
comprise of Tier I and Tier II capital as defined under capital adequacy standards (please also
refer to paragraph 2.1.3.5 of this Master Circular).

Credit exposure to a single borrower may exceed the exposure norm of 15 percent of the bank's
capital funds by an additional 5 percent (i.e. up to 20 percent) provided the additional credit
exposure is on account of extension of credit to infrastructure projects. Credit exposure to

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borrowers belonging to a group may exceed the exposure norm of 40 percent of the bank's
capital funds by an additional 10 percent (i.e., up to 50 percent), provided the additional credit
exposure is on account of extension of credit to infrastructure projects.

In addition to the exposure permitted under paragraphs 2.1.1.1 and 2.1.1.2 above, banks may, in
exceptional circumstances, with the approval of their Boards, consider enhancement of the
exposure to a borrower (single as well as group) up to a further 5 percent of capital funds subject
to the borrower consenting to the banks making appropriate disclosures in their Annual Reports.

With effect from May 29, 2008, the exposure limit in respect of single borrower has been raised
to twenty five percent of the capital funds, only in respect of Oil Companies who have been
issued Oil Bonds (which do not have SLR status) by Government of India. In addition to this,
banks may in exceptional circumstances, as hitherto, in terms of paragraph of the Master
Circular, consider enhancement of the exposure to the Oil Companies up to a further 5 percent of
capital funds.

Parameters of Financing by Banks & FIs

Capital adequacy:

Adherence to capital adequacy requirements as per Basel III regulatory norms The adequacy of
Common Equity Tier I (CET 1), Tier I and Total Capital Ratio as required under the Basel III
framework is a key input in CRISIL’s assessment of the capital adequacy of a bank/FI. A material
cushion over the minimum capital requirement should enable the bank to better support future
credit growth.

Size of capital The absolute size of capital imparts flexibility to a bank/FI to withstand shocks.
Therefore, a bank/FI with high absolute capital is viewed favourably.

Sustainability of capital ratios and flexibility to raise Tier I and hybrid capital A bank/FI can
enhance its Tier I capital base either through internal accrual or by raising fresh equity or hybrid
capital. CRISIL, therefore, evaluates the rated entity’s ability to access the capital markets to
meet its Tier I capital needs and its ability to service the increased capital base. The ability of a
bank/FI to support the increased asset base through earnings is an important parameter in
assessing the sustainability of its capital adequacy. An entity that is able to sustain asset growth
through internal accrual without impairing capital adequacy is viewed favourably. Other factors
considered when assessing the sustainability of capital ratios are dividend policy, likely capital
commitments to subsidiaries, shareholding in subsidiaries and the ability to dilute stake in them.

Growth plans CRISIL also factors in the growth plans of the bank/FI when analysing capital
adequacy. Capital adequacy (even if at high levels) would be regarded unsustainable if an entity
pursues a high-growth strategy. Also, segments where incremental growth is targeted would
require varying levels of capital.

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Resource-raising ability

Size of deposit base A large deposit base provides stability to a bank’s resources position by
diversifying the depositor base and ensuring a continuous, stable source of funds.

Diversity in deposit base and the geographical spread The diversity of the deposit base in terms
of number of small deposits, geographical spread and optimal rural/urban mix lends stability to
the resource position of a bank. The number of branches and their geographical spread lend
diversity to its deposit base. Thus, a bank with a large number of branches spread all over India
and with an optimal rural/urban mix is viewed favourably.

Deposit mix A bank’s deposit mix has an impact on its cost of deposits. A high proportion of
current and savings deposits leads to a low-cost resource base. CRISIL also analyses the trends
in deposit mix to form an opinion on future stability and costs. The proportion of wholesale or
bulk deposit is assessed to form a view on stability and cost of borrowing.

Growth in deposits Accretion to deposits (especially low-cost retail deposits) is the main source
of funding asset growth and managing liquidity risks in banks. CRISIL compares a bank’s
growth in deposits with industry trends to make relative judgments on the cost of deposits.

Cost of deposits Cost of deposits is a function of a bank’s deposit mix, its region of operations
and ability to attract deposits at lower rates. Banks with low-cost resources not only benefit from
higher profitability but also have greater flexibility to increase deposit rates in order to maintain
their resource positions. CRISIL analyses the all-inclusive funding cost of a bank. This factors in
the operating cost involved in mobilising deposits and the negative carry incurred due to the
mandatory statutory liquidity ratio (SLR) and cash reserve ratio (CRR) norms.

Asset quality

Geographical diversity and diversity across industries Geographical diversity of asset base
and diversity across industries, along with single-risk concentration limits, are important inputs
in determining the asset quality of banks/FIs. Regional banks with limited operations and branch
network have lesser flexibility to diversify their advances portfolio than banks with a national
presence, and are thus susceptible to adverse economic conditions in a particular region. Industry
exposure and single-risk concentration is monitored by the RBI through exposure guidelines.
However, some banks/FIs show a high degree of exposure to certain industries, leaving
themselves vulnerable to downturns in those industries. To ascertain credit concentration,
CRISIL reviews the rated entity’s largest exposures.

Client profile of the corporate asset portfolio The credit quality of a bank/FI’s corporate
portfolio (funded as well as non-funded) is an important input in analysing asset quality. CRISIL
analyses the profile of the top 100 or 200 corporate exposures in the asset portfolio of a bank to
make a judgment on portfolio quality. CRISIL also analysis banks’ exposure to various sectors
across economic cycles. The ability of a bank/FI to attract clients with a better credit quality is an
important indicator of its own future credit quality. The size (of capital) of a financial sector
entity lends considerable flexibility in attracting clients with a better credit quality, given its
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ability to take on large exposures on its balance sheet. Also, a bank/FI’s ability to attract and
retain good quality clients by providing value-added services would enhance asset quality in
future.

Quality of non-industrial lending Banks in India are obliged to lend a portion of their funds to
the priority sector that primarily includes agriculture and small-scale industries. To that extent,
FIs are better placed than banks because they do not have any such obligations. CRISIL analyses
the credit quality of the non-industrial portfolio in judging the overall asset quality of a bank.
The credit quality of the asset portfolio is also indicated by segment-wise non-performing asset
(NPA) levels in the portfolio, which reveals the performance in each segment. This helps gauge a
bank’s relative strength in each loan segment. In recent times, banks and FIs have begun to
sharpen focus on retail consumer loans – primarily vehicle and housing loans. CRISIL looks at
the quality of retail consumer credit growth, and the underwriting standards and recovery
mechanisms to arrive at the asset quality implications of the retail foray

Growth in advances High growth rates in the financial sector engender risks associated with the
establishment of collection systems, tracking of asset quality, and lack of seasoning in loan
portfolios. CRISIL closely analyses the pattern and nature of such growth, studying entities with
higher growth rates more carefully to look at the nature of the growth, the reasons for it and its
implications on asset quality. An entity that has grown by attracting good quality clients would
be viewed more favourably than one that has grown just by increasing geographical presence or
diluting credit criteria.

Management and systems evaluation

Goals and strategies A bank/FI’s future goals and strategies are evaluated to form a view on its
management’s vision. The ability to adapt to the changing environment and manage credit and
market risks, especially in a scenario of increasing deregulation of the financial markets, assumes
critical importance. CRISIL also has extensive discussions with managements regarding their
policy on diversification, asset growth, maintenance of capital, provisioning, and liquidity levels.

Systems and monitoring CRISIL studies systems for credit appraisal and for managing and
controlling credit and market risks at a portfolio level. Significant emphasis is laid on the
analysis of risk monitoring systems and the periodicity and quality of monitoring. Most Indian
banks face the challenge of enhancing coverage and quality of their information systems and
reporting. The degree of acceptance of new systems and procedures, data monitoring systems
and the extent of digitalisation and interconnectivity between branches within a bank are given
significant importance. The level of computerisation is gauged on the basis of the extent of
business covered by computerisation of branches, and of the money market and foreign exchange
desks. CRISIL attaches significance to operating systems for data capture and MIS reporting. A
balance sheet that has a large volume of transactions pending reconciliation reflects lack of
adequate operating systems and is viewed negatively. Expenses made on technology during the
recent period and the strategy of using technology effectively as a delivery platform to reduce
costs and improve service levels are also assessed.

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Appetite for risk CRISIL also analyses the management’s attitude towards risk and growth. An
analysis of the strength of systems and processes put in place by the management to strengthen
structures within a bank/FI are also undertaken to assess the management risk appetite. A high-
risk propensity typically reflects in higher earnings volatility in both fund-based and fee-based
businesses. A management with a higher propensity to take on risks is viewed cautiously.

Earnings potential

Level of earnings The level of earnings as measured by the net profitability margin (NPM)
provides the bank/FI with a cushion for its debt servicing and also increases its ability to cover
its asset risk. NPM is a function of interest spreads, expense levels, and fee-based income earned.
The level of earnings is looked at in conjunction with risk appetite. Purely from the viewpoint of
size, absolute profit levels are also germane to the earnings profile. Earnings can be significantly
affected due to volatility in interest rates. Thus, the trend in profitability at gross profit levels
over the past years is examined to form a view on the sustainability of earnings. The various
elements leading to profitability, such as interest spreads, fee levels, expense levels and
provisioning levels are also analysed to form a view on profitability trends and the sustainability
of profits.

Diversity of income sources Diversity of income sources is an important input in analysing the
stability of earnings. Diversity in fund-based income is achieved by focusing on different
borrower segments such as industries, trade and retail. Banks also diversify their income streams
through non-interest, or fee, income such as guarantees, cash management facility, service
charges from retail customers and trading income. Fee income provides a cushion to
profitability, especially in times of pressure on interest spreads. CRISIL also views the
composition of interest revenue streams when analysing the earnings position. Those relying on
short-term, non-repetitive income sources such as bill financing and trading income are viewed
less favourably than those with long-term credit relationships with companies through cash credit
or term loan exposures. The composition of non-interest income is also analysed when
evaluating earnings. This includes income from trading activities, which tends to be volatile. A
closer analysis of the composition of revenue streams helps form an opinion on the sustainability
of earnings.

Efficiency measures CRISIL looks at the level and trend of operating expenses and degree of
automation. Salary expenses and total noninterest expenses as a proportion of average assets is
used to benchmark efficiencies.

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 Unit-5

Concept of Insurance:

Insurance is a means of protection from financial loss. It is a form of risk management,

primarily used to hedge against the risk of a contingent or uncertain loss.

An entity which provides insurance is known as an insurer, insurance company, insurance carrier
or underwriter. A person or entity who buys insurance is known as an insured or as a
policyholder. The insurance transaction involves the insured assuming a guaranteed and known
relatively small loss in the form of payment to the insurer in exchange for the insurer's promise
to compensate the insured in the event of a covered loss. The loss may or may not be financial,
but it must be reducible to financial terms, and usually involves something in which the insured
has an insurable interest established by ownership, possession, or preexisting relationship.

The insured receives a contract, called the insurance policy, which details the conditions and
circumstances under which the insurer will compensate the insured. The amount of money
charged by the insurer to the insured for the coverage set forth in the insurance policy is called
the premium. If the insured experiences a loss which is potentially covered by the insurance
policy, the insured submits a claim to the insurer for processing by a claims adjuster. The insurer
may hedge its own risk by taking out reinsurance, whereby another insurance company agrees to
carry some of the risk, especially if the primary insurer deems the risk too large for it to carry.

Life insurance (or life assurance, especially in the Commonwealth of Nations) is a contract
between an insurance policy holder and an insurer or assurer, where the insurer promises to pay a
designated beneficiary a sum of money (the benefit) in exchange for a premium, upon the death
of an insured person (often the policy holder). Depending on the contract, other events such
as terminal illness or critical illness can also trigger payment. The policy holder typically pays a
premium, either regularly or as one lump sum. Other expenses, such as funeral expenses, can
also be included in the benefits.

Life policies are legal contracts and the terms of the contract describe the limitations of the
insured events. Specific exclusions are often written into the contract to limit the liability of the
insurer; common examples are claims relating to suicide, fraud, war, riot, and civil commotion.

Life-based contracts tend to fall into two major categories:

 Protection policies – designed to provide a benefit, typically a lump sum payment, in the
event of a specified occurrence. A common form—more common in years past—of a
protection policy design is term insurance.
 Investment policies – the main objective of these policies is to facilitate the growth of capital
by regular or single premiums. Common forms (in the U.S.) are whole life, universal life,
and variable life policies.

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Parties to contract

The person responsible for making payments for a policy is the policy owner, while the insured
is the person whose death will trigger payment of the death benefit. The owner and insured may
or may not be the same person. For example, if Joe buys a policy on his own life, he is both the
owner and the insured. But if Jane, his wife, buys a policy on Joe's life, she is the owner and he is
the insured. The policy owner is the guarantor and he will be the person to pay for the policy.
The insured is a participant in the contract, but not necessarily a party to the contract.

The beneficiary receives policy proceeds upon the insured person's death. The owner designates
the beneficiary, but the beneficiary is not a party to the policy. The owner can change the
beneficiary unless the policy has an irrevocable beneficiary designation. If a policy has an
irrevocable beneficiary, any beneficiary changes, policy assignments, or cash value borrowing
would require the agreement of the original beneficiary.

Contract terms

Special exclusions may apply, such as suicide clauses, whereby the policy becomes null and void
if the insured commits suicide within a specified time (usually two years after the purchase date;
some states provide a statutory one-year suicide clause). Any misrepresentations by the insured
on the application may also be grounds for nullification. Most US states specify a maximum
contestability period, often no more than two years. Only if the insured dies within this period
will the insurer have a legal right to contest the claim on the basis of misrepresentation and
request additional information before deciding whether to pay or deny the claim.

The face amount of the policy is the initial amount that the policy will pay at the death of the
insured or when the policy matures, although the actual death benefit can provide for greater or
lesser than the face amount. The policy matures when the insured dies or reaches a specified age
(such as 100 years old).

Costs, insurability, and underwriting

The insurance company calculates the policy prices (premiums) at a level sufficient to fund
claims, cover administrative costs, and provide a profit. The cost of insurance is determined
using mortality tables calculated by actuaries. Mortality tables are statistically based tables
showing expected annual mortality rates of people at different ages. Put simply, people are more
likely to die as they get older and the mortality tables enable the insurance companies to
calculate the risk and increase premiums with age accordingly. Such estimates can be important
in taxation regulation.

In the 1980s and 1990s, the SOA 1975–80 Basic Select & Ultimate tables were the typical
reference points, while the 2001 VBT and 2001 CSO tables were published more recently. As
well as the basic parameters of age and gender, the newer tables include separate mortality tables
for smokers and non-smokers, and the CSO tables include separate tables for preferred classes

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The mortality tables provide a baseline for the cost of insurance, but the health and family
history of the individual applicant is also taken into account (except in the case of Group
policies). This investigation and resulting evaluation is termed underwriting. Health and lifestyle
questions are asked, with certain responses possibly meriting further investigation. Specific
factors that may be considered by underwriters include:

 Personal medical history

 Family medical history
 Driving record
 Height and weight matrix, otherwise known as BMI (Body Mass Index)

Based on the above and additional factors, applicants will be placed into one of several classes of
health ratings which will determine the premium paid in exchange for insurance at that particular
carrier.

Life insurance companies in the United States support the Medical Information Bureau
(MIB) which is a clearing house of information on persons who have applied for life insurance
with participating companies in the last seven years. As part of the application, the insurer often
requires the applicant's permission to obtain information from their physicians.

Automated Life Underwriting is a technology solution which is designed to perform all or some
of the screening functions traditionally completed by underwriters, and thus seeks to reduce the
work effort, time and/or data necessary to underwrite a life insurance application. These systems
allow point of sale distribution and can shorten the time frame for issuance from weeks or even
months to hours or minutes, depending on the amount of insurance being purchased.

The mortality of underwritten persons rises much more quickly than the general population. At
the end of 10 years, the mortality of that 25-year-old, non-smoking male is 0.66/1000/year.
Consequently, in a group of one thousand 25-year-old males with a $100,000 policy, all of
average health, a life insurance company would have to collect approximately $50 a year from
each participant to cover the relatively few expected claims. (0.35 to 0.66 expected deaths in
each year × $100,000 payout per death = $35 per policy.) Other costs, such as administrative and
sales expenses, also need to be considered when setting the premiums. A 10-year policy for a 25-
year-old non-smoking male with preferred medical history may get offers as low as $90 per year
for a $100,000 policy in the competitive US life insurance market.

Most of the revenue received by insurance companies consists of premiums, but revenue from
investing the premiums forms an important source of profit for most life insurance
companies. Group Insurance policies are an exception to this.

In the United States, life insurance companies are never legally required to provide coverage to
everyone, with the exception of Civil Rights Act compliance requirements. Insurance companies
alone determine insurability, and some people are deemed uninsurable. The policy can be
declined or rated (increasing the premium amount to compensate for the higher risk), and the
amount of the premium will be proportional to the face value of the policy.

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Many companies separate applicants into four general categories. These categories are preferred
best, preferred, standard, and tobacco. Preferred best is reserved only for the healthiest
individuals in the general population. This may mean, that the proposed insured has no adverse
medical history, is not under medication, and has no family history of early-
onset cancer, diabetes, or other conditions. Preferred means that the proposed insured is currently
under medication and has a family history of particular illnesses. Most people are in the standard
category.

Death proceeds

Upon the insured's death, the insurer requires acceptable proof of death before it pays the claim.
If the insured's death is suspicious and the policy amount is large, the insurer may investigate the
circumstances surrounding the death before deciding whether it has an obligation to pay the
claim.

Payment from the policy may be as a lump sum or as an annuity, which is paid in regular
installments for either a specified period or for the beneficiary's lifetime.[22]

Non-life insurance premia written in 2005

General insurance or non-life insurance policies, including automobile and homeowners

policies, provide payments depending on the loss from a particular financial event. General
insurance is typically defined as any insurance that is not determined to be life insurance. It is
called property and casualty insurance in the United States and Canada and non-life
insurance in Continental Europe.

In the United Kingdom, insurance is broadly divided into three areas: personal lines, commercial
lines and London market.

The London market insures large commercial risks such as supermarkets, football players and
other very specific risks. It consists of a number of insurers, reinsurers, P&I Clubs, brokers and
other companies that are typically physically located in the City of London. Lloyd's of London is
a big participant in this market.[1] The London market also participates in personal lines and
commercial lines, domestic and foreign, through reinsurance.

Commercial lines products are usually designed for relatively small legal entities. These would
include workers' compensation (employers liability), public liability, product liability,
commercial fleet and other general insurance products sold in a relatively standard fashion to
many organisations. There are many companies that supply comprehensive commercial
insurance packages for a wide range of different industries, including shops, restaurants and
hotels.

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Personal lines products are designed to be sold in large quantities. This would
include autos (private car), homeowners (household), pet insurance, creditor insurance and
others.

ACORD, which is the insurance industry global standards organization, has standards for
personal and commercial lines and has been working with the Australian General Insurers to
develop those XML standards, standard applications for insurance, and certificates of currency.

Types of general insurance

General insurance can be categorised in to following:

 Motor Insurance: Motor Insurance can be divided into two groups, two and four wheeled
vehicle insurance.
 Health Insurance: Common types of health insurance includes: individual health insurance,
family floater health insurance, comprehensive health insurance and critical illness
insurance.
 Travel Insurance: Travel insurance can be broadly grouped into: individual travel policy,
family travel policy, student travel insurance, and senior citizen health insurance.
 Home Insurance: Home insurance protects a house and its contents.
 Marine Insurance: Marine cargo insurance covers goods, freight, cargo, and other interests
against loss or damage during transit by rail, road, sea and/or air.
 Commercial Insurance: Commercial insurance encompasses solutions for all sectors of the
industry arising out of business operations.

Reinsurance

Reinsurance is insurance that is purchased by an insurance company. In the classic case,

reinsurance allows insurance companies to remain solvent after major claims events, such as
major disasters like hurricanes and wildfires. In addition to its basic role in risk management,
reinsurance is sometimes used for tax mitigation and other reasons. The company that purchases
the reinsurance policy is called a "ceding company" or "cedent" or "cedant" under most
arrangements. The company issuing the reinsurance policy is referred simply as the "reinsurer".

A company that purchases reinsurance pays a premium to the reinsurance company, who in
exchange would pay a share of the claims incurred by the purchasing company. The reinsurer
may be either a specialist reinsurance company, which only undertakes reinsurance business, or
another insurance company. Insurance companies that sell reinsurance refer to the business as
'assumed reinsurance'.

There are two basic methods of reinsurance:

1. Facultative Reinsurance, which is negotiated separately for each insurance policy that is
reinsured. Facultative reinsurance is normally purchased by ceding companies for
individual risks not covered, or insufficiently covered, by their reinsurance treaties, for

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 amounts in excess of the monetary limits of their reinsurance treaties and for unusual
risks. Underwriting expenses, and in particular personnel costs, are higher for such
business because each risk is individually underwritten and administered. However, as
they can separately evaluate each risk reinsured, the reinsurer's underwriter can price the
contract more accurately to reflect the risks involved. Ultimately, a facultative certificate
is issued by the reinsurance company to the ceding company reinsuring that one policy.
2. Treaty Reinsurance means that the ceding company and the reinsurer negotiate and
execute a reinsurance contract under which the reinsurer covers the specified share of
all the insurance policies issued by the ceding company which come within the scope of
that contract. The reinsurance contract may oblige the reinsurer to accept reinsurance of
all contracts within the scope (known as "obligatory" reinsurance), or it may allow the
insurer to choose which risks it wants to cede, with the reinsurer obliged to accept such
risks (known as "facultative-obligatory" or "fac oblig" reinsurance).

There are two main types of treaty reinsurance, proportional and non-proportional, which are
detailed below. Under proportional reinsurance, the reinsurer's share of the risk is defined for
each separate policy, while under non-proportional reinsurance the reinsurer's liability is based
on the aggregate claims incurred by the ceding office. In the past 30 years there has been a major
shift from proportional to non-proportional reinsurance in the property and casualty fields.

Insurance sector reforms

In 1993, Malhotra Committee headed by former Finance Secretary and RBI Governor R.N. Malhotra was
formed to evaluate the Indian insurance industry and recommend its future direction.

The Malhotra committee was set up with the objective of complementing the reforms initiated in the financial
sector. The reforms were aimed at "creating a more efficient and competitive financial system suitable for the
requirements of the economy keeping in mind the structural changes currently underway and recognizing that
insurance is an important part of the overall financial system where it was necessary to address the need for
similar reforms…"

In 1994, the committee submitted the report and some of the key recommendations included:

1) Structure

 Government stake in the insurance Companies to be brought down to 50%.

 Government should take over the holdings of GIC and its subsidiaries so that these subsidiaries can act
as independent corporations.
 All the insurance companies should be given greater freedom to operate.

2) Competition

 Private Companies with a minimum paid up capital of Rs.1bn should be allowed to enter the industry.

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  No Company should deal in both Life and General Insurance through a single entity.
 Foreign companies may be allowed to enter the industry in collaboration with the domestic companies.
 Postal Life Insurance should be allowed to operate in the rural market.
 Only One State Level Life Insurance Company should be allowed to operate in each state.

3) Regulatory Body

 The Insurance Act should be changed.

 An Insurance Regulatory body should be set up.
 Controller of Insurance (Currently a part from the Finance Ministry) should be made independent.

4) Investments

 Mandatory Investments of LIC Life Fund in government securities to be reduced from 75% to 50%.
 GIC and its subsidiaries are not to hold more than 5% in any company (There current holdings to be
brought down to this level over a period of time).

5) Customer Service

 LIC should pay interest on delays in payments beyond 30 days.

 Insurance companies must be encouraged to set up unit linked pension plans.
 Computerisation of operations and updating of technology to be carried out in the insurance industry
The committee emphasized that in order to improve the customer services and increase the coverage
of the insurance industry should be opened up to competition.

But at the same time, the committee felt the need to exercise caution as any failure on the part of new players
could ruin the public confidence in the industry. Hence, it was decided to allow competition in a limited way
by stipulating the minimum capital requirement of Rs.100 crores. The committee felt the need to provide
greater autonomy to insurance companies in order to improve their performance and enable them to act as
independent companies with economic motives. For this purpose, it had proposed setting up an independent
regulatory body.

MAJOR POLICY CHANGES

Insurance sector has been opened up for competition from Indian private insurance companies with the
enactment of Insurance Regulatory and Development Authority Act, 1999 (IRDA Act). As per the provisions
of IRDA Act, 1999, Insurance Regulatory and Development Authority (IRDA) was established on 19th April
2000 to protect the interests of holder of insurance policy and to regulate, promote and ensure orderly growth
of the insurance industry. IRDA Act 1999 paved the way for the entry of private players into the insurance
market which was hitherto the exclusive privilege of public sector insurance companies/ corporations. Under
the new dispensation Indian insurance companies in private sector were permitted to operate in India with the
following conditions:

 Company is formed and registered under the Companies Act, 1956;

 The aggregate holdings of equity shares by a foreign company, either by itself or through its
subsidiary companies or its nominees, do not exceed 26%, paid up equity capital of such Indian
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 insurance company;
 The company's sole purpose is to carry on life insurance business or general insurance business or
reinsurance business.
 The minimum paid up equity capital for life or general insurance business is Rs.100 crores.
 The minimum paid up equity capital for carrying on reinsurance business has been prescribed as
Rs.200 crores.

The Authority has notified 27 Regulations on various issues which include Registration of Insurers,
Regulation on insurance agents, Solvency Margin, Re-insurance, Obligation of Insurers to Rural and Social
sector, Investment and Accounting Procedure, Protection of policy holders' interest etc. Applications were
invited by the Authority with effect from 15th August, 2000 for issue of the Certificate of Registration to both
life and non-life insurers. The Authority has its Head Quarter at Hyderabad.

Insurance companies:

IRDA has so far granted registration to 12 private life insurance companies and 9 general
insurance companies. If the existing public sector insurance companies are included, there are
currently 13 insurance companies in the life side and 13 companies operating in general
insurance business. General Insurance Corporation has been approved as the "Indian reinsurer"
for underwriting only reinsurance business. Particulars of the life insurance companies and
general insurance companies including their web address is given below:

LIFE INSURERS Websites

Public Sector
Life Insurance Corporation of India www.licindia.com
Private Sector
Allianz Bajaj Life Insurance Company Limited www.allianzbajaj.co.in
Birla Sun-Life Insurance Company Limited www.birlasunlife.com
HDFC Standard Life Insurance Co. Limited www.hdfcinsurance.com
ICICI Prudential Life Insurance Co. Limited www.iciciprulife.com
ING Vysya Life Insurance Company Limited www.ingvysayalife.com
Max New York Life Insurance Co. Limited www.maxnewyorklife.com
MetLife Insurance Company Limited www.metlife.com
Om Kotak Mahindra Life Insurance Co. Ltd. www.omkotakmahnidra.com
SBI Life Insurance Company Limited www.sbilife.co.in
TATA AIG Life Insurance Company Limited www.tata-aig.com
AMP Sanmar Assurance Company Limited www.ampsanmar.com
Dabur CGU Life Insurance Co. Pvt. Limited www.avivaindia.com
GENERAL INSURERS
Public Sector
National Insurance Company Limited www.nationalinsuranceindia.com
New India Assurance Company Limited www.niacl.com
Oriental Insurance Company Limited www.orientalinsurance.nic.in

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United India Insurance Company Limited www.uiic.co.in
Private Sector
Bajaj Allianz General Insurance Co. Limited www.bajajallianz.co.in
ICICI Lombard General Insurance Co. Ltd. www.icicilombard.com
IFFCO-Tokio General Insurance Co. Ltd. www.itgi.co.in
Reliance General Insurance Co. Limited www.ril.com
Royal Sundaram Alliance Insurance Co. Ltd. www.royalsun.com
TATA AIG General Insurance Co. Limited www.tata-aig.com
Cholamandalam General Insurance Co. Ltd. www.cholainsurance.com
Export Credit Guarantee Corporation www.ecgcindia.com
HDFC Chubb General Insurance Co. Ltd.
REINSURER
General Insurance Corporation of India www.gicindia.com

Liberalization of the insurance

Comprehensive regulation of the insurance business in India has been insurance legislation and
enforcement, in 1983. It is advice directly, research, etc. But registration, the controller of
insurance in force in order to liquidate the insurance company almost consequent nationalization
of the insurance business, the regulatory functions were taken, regulatory powerful, supervision
and strong from the controller of insurance, insurance attributable to the company itself apart An
attempt was made to create a. The Indian government RNMalhotra examine the structure of the
insurance industry, to recommend changes to enhance the competitiveness to keep in view the
structural change, it is more efficient and governor yuan, by the Reserve Bank of India, high-
power committee in 1993 other parts of the country's financial system was set up meeting.

Malhotra is the Commission's recommendations

The committee has submitted a report in January 1994 has been recommended that can be
private insurance companies, government enterprises to co-exist with companies like GIC and
LIC. This recommendation, such as the need for a much larger scale of the mobilization of funds
from the economy for much larger scale mobilization of the deeper insurance fund, from the
economic and infrastructure development, depending on several factors in the economy such had
been prompted. Liberalization of insurance sector is driven by the need for year to tap the large
reserve of savings in the economy at least partially. Commission's recommendations were as
follows.

GIC to increase the capital base of LIC and Rs is. Are sold to the general public in the
reservation for 200 rupees, its employees, and the remaining half is held by government
private sector, will be granted to enter the insurance industry paid a minimum capital of Rs. 100
rupees.

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Foreign insurance, you can partner in India India Company, to be allowed to enter by floating a
joint venture company preferred.

steps are initiated in order to set a strong and effective insurance regulation in the form of an
autonomous statutory board on the lines of SEBI.

You can allow a limited number of sectors of the private sector o. However, the company is not
allowed in the sector at all. However, are not allowed to operate in both the (life or non-life)
insurance line of office who is Advisory Committee on tariff (TAC) is delinked form the GIC
was functioning as a body independent of sculpture under the supervision of insurance required
by regulatory authorities.

All insurance companies are treated on an equal footing, which is determined by the provisions
of the Insurance Law. Special providence of God, not specified in the Government Companies.
Before allowing the private sector to sector, Setting consists of strong and effective regulatory
agency with an independent source of funding for.

Competition to the government sector:

The government even when the company issues a diverse range of insurance products, private as
well as effective techniques to sell the product side, and distribution channel is the privatization
of insurance sector has in terms of customer service a variety of open the door to innovations in
business methods have now in the face of competition in insurance companies is possible
transaction.

Insurance company of a new era has begun in a more cost-effective way to new concepts and
business transactions. The idea is to respond to the largest business lest the cost is clear. Over
time, the old norms, and then expand by setting the branch seems to be popular with companies
lost government slowly.

In technology seem to be catching up fast as an alternative to meet the rural social sector which
is the hub and spoke arrangements insurance. Together with self-help groups (SHGs) participants
and NGO, these are doing most of the sale of rural and social sector policies.

The main challenge is from the commercial banks have a vast network of branches. In this
respect, LIC has signed a contract with Industrial Bank of cartoon-based infrastructure to
leverage for mutual benefit with the monolith insurance to get the 27 shares strategic percent,
Bank Ltd., the project to mention here that it has decided to give up is important. We are
promoting a life insurance company. Bank, you will receive a commission policy to act as an
agent of the enterprise for future LIC, which are sold through its branches. LIC with its network
of branches near the office in 2100, you can Bank Co., Ltd. to establish a center expansion. The
ATM or branch in its facilities. I had to implement a cash-flow management system for effective
corporate bank of LIC.

102
Law IRDA, 1999

Preamble of the 1999 Act IRDA is ", for that is incidental thereto or matters in order to adjust in
order to protect the interests of holders of insurance, to promote orderly growth of the insurance
industry, to ensure, that are attached to it Read the law in order to provide the establishment of
the authority.

Section 25, Advisory Committee on insurance that will be configured, members. Section 26 of
25 or more must be configured without offers are provided to make regulations in consultation
with the Advisory Committee on the insurance institution are composed of law that this is, the
rule, Act. Section 29, first of Certain Provisions of the Insurance Act, 1938 in such a way
specified in the schedule carried out under there to carry this purpose seeking the amendment.
IRDA, in order to effectively empower, promote regulations, to ensure the orderly growth of
insurance industry, the revision of the insurance law is inevitable.

Act 1972, section 30 & 31seek to GIC in 1956 and amended law LIC.

Impact of liberalization

State-owned insurance company, but have a good work by extending the volume of business the
opening of insurance sector to private players, it was necessary in the context of liberalization of
the financial sector. Semi-public goods industry infrastructure and traditional banks, airlines,
telecommunications, and such power if you have a significant presence of private sector, the
continued state monopoly provision of insurance, excuse As mentioned earlier there was a, and
therefore, the privatization of insurance has been made. You have to be seen in the form of its
effect would be to create a variety of opportunities and challenges.

Opportunity

A. Privatization has abolished the monopoly of Life Insurance Corporation of India if the
insurance. It may help to cover a wide range of risk of life insurance in general insurance.

1) It allows you to introduce a new range of products

2)It also will improve the diversity of insurance products and prices will lead to excellent
customer service.
3) Entry of new players will speed up the expansion of both life and general insurance. It will
increase the value of insurance penetration and density measurement.
4) Entry of private players, to ensure the mobilization of funds available for the purpose of
infrastructure development.
5) In order to allow commercial banks to the insurance business, will help to mobilize funds
from the rural areas the availability of the huge branches of the bank.
6)Not the most important, it will be created in the field of insurance is a tremendous opportunity
for employment burning problem of today's issue of the day there is at least.

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Current scenario

After the opening of private insurance, private companies, including leading a variety of joint
venture has entered the field of business of both life and non life insurance. Tata - AIG, Birla
Sun Life, HDFC Standard Life Insurance, Reliance General Insurance, Royal Sundaram Alliance
Insurance, Bajaj Auto Alliance, Tokyo property and casualty insurance IFFCO, life insurance
INA Vysya, life insurance SBI, Dabur CJU and life insurance Max New York Life. SBI Life
Insurance has launched a Young Sanjeevan Sanjeevan three products, and Sukhjeevan, it has
sold 320 policies under the plan so far already.

TIPULATING stiff exposure norms, the Insurance Regulatory and Development Authority
(IRDA) has said that investments by an insurance company cannot exceed more that 10 per cent
of the total subscribed share capital, free reserves, debentures and bonds o f the investee
company or 10 per cent of the insurer's total assets in case of non-life insurance companies and
10 per cent of the controlled funds in case of life insurers, whichever is lower.

The IRDA's revised investment regulations have also said that for the public sector insurance
companies, the investment exposure cannot at any point exceed 20 per cent of the subscribed
share capital, debentures and bonds of the investee company or five per cent of controlled funds
of the life insurer or 10 per cent of the general insurer's total assets.

Within the above exposure limit, the authority has said that the investment in equity instruments,
including preference shares, investment in equity convertible part of debentures should not
exceed 50 per cent of the overall exposure ceiling. A similar 5 0 per cent exposure norm limit
would also apply to investments in immovable property.

IRDA has also barred insurance companies from investing more than five per cent in aggregate
of its controlled funds in case of life insurance and five per cent of aggregate assets in case of
non-life insurers in the group companies controlled by the pro moters of the insurance venture.
The concept of `group' would be determined on the basis of the MRTP Act, the regulations have
said.

Specifying limits for the entire group to which the investee company belongs, IRDA has said that
the exposure of an insurance company at any point of time should not exceed 10 per cent of the
aggregate subscribed share capital, free reserves and debentur es of all the groups companies in
which investments are made or are proposed to be made by the insurer or 10 per cent of the total
assets in case of non-life insurers and 10 per cent of the controlled funds in case of life insurers.

However, the authority has said that the 10 per cent limit set can be raised to 15 per cent with the
specific approval of the authority.

A similar 50 per cent sub-limit within this category has been set for investments in equity and
equity-related instruments within the above limit and for investments in immovable property.

IRDA has said that an insurance company would be required to set up an investment committee
consisting of a minimum of two non-executive directors of the insurers, the principal officer,
104
chiefs of finance and investment divisions and the appointed actuar y, where an actuary is
employed.

The insurance companies have also been directed to draw up an annual investment policy, which
has to be approved by the board of directors. The policy would be implemented by the
Investment Committee.

Mumbai: The Reserve Bank of India (RBI) on Friday unveiled draft norms for entry of banks
into insurance broking, which would allow commercial banks to offer policies sold by multiple
insurers, besides those of their own insurance subsidiaries.
The norms, if they come into force, would permit banks to undertake insurance broking
departmentally after seeking the specific prior approval of the banking regulator. The move is
aimed at enabling banks “to leverage their branch network for increasing insurance penetration”,
RBI said.

Entry norms for insurance sectors

Finance minister , in his February budget Has announced that banks would be permitted to act as
insurance brokers. In August, the insurance regulator allowed banks to act as brokers and sell
products of more than one insurer to increase the penetration of the sector across the country.
norms, there is no capital requirement for insurance broking business, but the business of the
insurance broker will have to be carried out in such a manner that not more than 50% of the
premium emanates from any one client. Going by the Insurance Regulatory and Development
Authority

In the draft norms, RBI said the final approvals for banks to undertake broking business will
factor in the regulatory and supervisory comfort on various aspects of banks’ functioning, such
as corporate governance, risk management and the arrangements proposed for insurance
brokerage and so on.

However, banks offering insurance broking services shall not enter into any arrangement for
corporate agency or insurance referral business to avoid any conflict of interest, the central bank
said. Approvals granted for insurance broking will be initially for three years and will be
reviewed after that.

RBI has given time till 31 December for feedback from stakeholders on the draft norms.

Currently, banks like State Bank of India and ICICI Bank Ltd, among others, distribute insurance
products of their own subsidiaries under the so-called bancassurance channel. Under the agency
model, they cannot sell products of other insurance companies. However, once they decide to
become a broker, they can sell products of multiple insurance companies.

“The business will demand them to act as corporate agents and not brokers,” said Abizer
Diwanji, a partner and head of financial services at global consulting firm EY.

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Detailing the draft norms, RBI said banks that want to offer insurance broking should have a
comprehensive board-approved policy. They should also have a net worth of not less than Rs.500
crore and capital adequacy—a measure of financial strength expressed as the ratio of capital to
risk-weighed assets—of not less than 10%.
The aspirants should not have non-performing assets equivalent to more than 3% of their loans
and should have made profits for the last three consecutive years.

Experts said banks engaged in the insurance business through joint venture subsidiaries are likely
to choose to remain corporate agents if indeed the draft norms take final shape.

The draft norms stipulate that banks should have a standardized system of assessing the needs of
the customer across all branches offering insurance broking services, besides having a robust
internal grievance redressal mechanism in place to resolve issues related to services offered.

The draft rules also emphasises transparency of operations. “In order to ensure transparency,
banks should disclose to the customers, details of remuneration (in any form) received from
various insurance companies for the broking business,” RBI said.

“The details of fees/brokerage received in respect of insurance broking business undertaken by

them should also be disclosed in the ‘notes to accounts’ to their balance sheet,” it added.

Investment Management Policies

An insurer’s investment policy shall establish the principal parameters within which the insurer
should manage its investment activities. The policy should be sufficiently supported to ensure
effective management, particularly in respect of situations where the risk is considered to be
high.
 Guideline on Investment Management
 In light of the investment strategy developed by the insurer, the investment policy shall
address the following elements, at a minimum:
 Insurer’s risk appetite and tolerance levels;
 types and characteristics of the investments;
 expected returns and the purpose of the investments, such as liquidity, matching,
pledging of collateral, hedging and trading;
 investment concentration limits;
 investments decision criteria, standards and other parameters;
 processes relating to intra-group management of investment activities;
 procedures for analyzing and evaluating investments when deciding to make an
investment and when carrying out a transaction; and
 monitoring and control of investments.
 accountability for all investment transactions; and
 investment authorization criteria and limits.
 asset liability matching.

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 EXPOSURE NORMS

STIPULATING stiff exposure norms, the Insurance Regulatory and

Development Authority (IRDA) has said that investments by an insurance
company cannot exceed more that 10 per cent of the total subscribed share
capital, free reserves, debentures and bonds o f the investee company or 10
per cent of the insurer's total assets in case of non-life insurance companies
and 10 per cent of the controlled funds in case of life insurers, whichever is
lower.

The IRDA's revised investment regulations have also said that for the public
sector insurance companies, the investment exposure cannot at any point
exceed 20 per cent of the subscribed share capital, debentures and bonds of
the investee company or five per cent of controlled funds of the life insurer
or 10 per cent of the general insurer's total assets.

Within the above exposure limit, the authority has said that the investment
in equity instruments, including preference shares, investment in equity
convertible part of debentures should not exceed 50 per cent of the overall
exposure ceiling. A similar 5 0 per cent exposure norm limit would also apply
to investments in immovable property.

IRDA has also barred insurance companies from investing more than five per
cent in aggregate of its controlled funds in case of life insurance and five per
cent of aggregate assets in case of non-life insurers in the group companies
controlled by the pro moters of the insurance venture. The concept of
`group' would be determined on the basis of the MRTP Act, the regulations
have said.

Specifying limits for the entire group to which the investee company
belongs, IRDA has said that the exposure of an insurance company at any
point of time should not exceed 10 per cent of the aggregate subscribed
share capital, free reserves and debentur es of all the groups companies in
which investments are made or are proposed to be made by the insurer or
10 per cent of the total assets in case of non-life insurers and 10 per cent of
the controlled funds in case of life insurers.

However, the authority has said that the 10 per cent limit set can be raised
to 15 per cent with the specific approval of the authority.

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A similar 50 per cent sub-limit within this category has been set for
investments in equity and equity-related instruments within the above limit
and for investments in immovable property.

IRDA has said that an insurance company would be required to set up an

investment committee consisting of a minimum of two non-executive
directors of the insurers, the principal officer, chiefs of finance and
investment divisions and the appointed actuar y, where an actuary is
employed.

The insurance companies have also been directed to draw up an annual

investment policy, which has to be approved by the board of directors. The
policy would be implemented by the Investment Committee.

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