EXECUTIVE SUMMARY

Funds which means a stock of money and monetary resources is always subject to change in its magnitude and composition. A continuous change in the magnitude as well as composition of funds is deemed as a flow of funds. Therefore, flow of funds can be observed in the Financial Statements. Financial Statements of any type of company consist of the Balance Sheet and the Profit & Loss Account. Balance Sheet consists of Liabilities and Assets which is also called as Sources and Uses. Balance Sheet has to be prepared according to the Schedules. There are different schedules for different companies. For example Fixed Asset schedule is 10 in Banking Company whereas it is 5 in Corporate. In other words, what is the Cost of Funds and after deploying it what are they earning from it. Are the Cost of Funds and Revenues matching or not. It is also very important to see how the banks manage liquidity. Are the banks able to satisfy the needs of the customers or not & what are the different types of risk which is associated with the funds of the banks & how much profitability they are earning from these funds. All the above concepts can be found from the Balance Sheet and Profit & Loss Account itself. Balance Sheet is
1

very

much

useful

for

the

investors,

and

even

for

the

government.

INTRODUCTION
Banks acts as vital links between the policies of the government and the various economic factors. Banks have become the most important financial intermediaries in the era of market-oriented economies by reflecting the performance of the economy as a whole. To analyze the performance of the banks, it is instructive to take a brief overview of the principal assets and liabilities as presented in the banks balance sheet and also its revenues and expenses from the income statement. The main objective in this project is to examine the balance sheet and income statement of the bank in a manner to familiarize with the sources and uses of the funds and the revenues and the expenses of the banks. A bank is a government-regulated, profit-making business that operates in competition with other banks and financial institution to serve the savings and credit needs of its customers. The primary business of banks is accepting deposits and lending money. Banks accept deposits from customers who
2

want the safety and convenience of deposit services and the opportunity to earn interest on their excess funds. Banks put their depositors funds to profitable use by lending those funds to others- to individuals for satisfying their personal needs, to businesses for satisfying their working capital needs, to state and local government units for public projects. Banks safety and profitability depend on effective management of a banks assets and liabilities. A banks total pool of funds shifts constantly as funds flow in and out of the bank. Funds management is planning and coordinating a banks sources and uses of funds over time to achieve maximum profitability and yet maintain adequate safety and liquidity consistent with banking regulations and community needs.

FUNDS AND FLOW OF FUNDS-MEANING

According to Bonneville and Dewey, funds constitute the prime importance in starting and operating any business enterprise. The most significant of all financial activities is the raising and management of funds. In the ordinary parlance, the term funds mean cash, or at least cash equivalent. In corporate statements, however, the so-called funds statement usually refers to net working capital. The word funds have different connotations for various individuals. For the layman, it usually refers to cash; for accountants and analysts, it most frequently refers to working capital---current assets less current liabilities; it may refer to all
3

the resources or to purchasing power. For others, it may refer to the net quick or current assets--- cash, temporary investments and net receivables, less current liabilities; or to net owners equity. The words funds are closely related to the normal decisionmaking process of a business, to accounting statements, the balance sheet and the income statement. It is related to a time span. Fund which means a stock of money and monetary resources is always subject to change in its magnitude and composition. A continuous change in the magnitude as well as in the nature of composition of funds is deemed as a flow of funds. Such a profile which highlights the inflows and outflows of funds is useful for the owners and lenders in order to ensure profitability and safety of their investment in the concern. The concept of Fund Flow arises from the changes that take place in the proprietors fund and the borrowed funds (liabilities) and the resources or assets held against them. These changes are an outcome of the movement of funds, which take place as a result of the operations of the business. While a change in a particular item of liability or asset can be ascertained from time to time, changes in all the items of assets and liabilities can be figured out only from balance sheets. The changes that take place in these items over a given period are reflected in the next balance sheet and so on. Flow of funds can be observed in the Financial Statement.
4

PREPARATION OF FINANCIAL STATEMENT IN BANKS

According to Section 29 of the Banking Regulation Act, 1949 banks will have to prepare the Balance Sheet and Profit & Loss Account in the format set out in the third schedule of the Act. The items that appear in the banks balance sheet and profit and loss account are shown under different schedules. Form A is the form of the balance sheet of a bank and has 12 schedules under which the various assets and liabilities are classified. Form A FORM OF BALANCE SHEET Balance Sheet of XYZ Bank Ltd. As on 31st March Particulars Schedul e No As on 31.3. Current Year CAPITAL AND LIABLITIES Capital Reserves and Surplus
6

As on 31.3. Previous Year

1 2

Deposits Borrowings Others Liabilities and Provisions

3 4 5

Total Rs ASSETS Cash and Balance with RBI Balance with Banks and Money at call and Short Notice Investments Advances Fixed Assets Other Assets 7 8 9 10 11 6

Total Rs Contingent Liabilities Bills for Collection 12

CAR (Capital Adequacy Ratio)

What is Capital Adequacy Ratio?
It is the measure of a banks financial strength expressed by the ratio of its capital (net worth and subordinated debt) to its risk-weighted credit exposure (loans). It is also called CRAR-Capital to Risk-weighted Assets Ratio. The Reserve Bank of India (RBI), currently prescribes a minimum capital of 9% of risk-weighted assets, which is higher than the internationally prescribed percentage of 8%. Most banks in India have a capital adequacy is considered safer because if its loans go bad, it can make up for its net worth.

Why do banks have to maintain CAR?

CAR is the ratio that measures a banks capacity to meet time liabilities and risks like operational risks, credit risks and other risks. Indians banks regulator, RBI, has prescribed a minimum ratio to be maintained by the banking system. This is done because the depositors are secured about their deposits and banks have a cushion for their potential losses. In the face of the financial crises seen in the last few years, maintenance of CAR is mandated by the regulatory authorities to protect the depositors.

What is risk weighting?

8

Every financial asset carries a risk. The extent of risk, however, varies. For instance, government bonds carry almost no risk while loans to government-promoted companies carry some risk. On the other hand, loans to a corporate carry 100% risk weighted as the entire loan is exposed to risk. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such asset.

How are risk weight assigned?

Different types of assets have different profiles in risk value. CAR primarily adjusts for assets that are less risky by allowing banks to discount lower-risk assets. The specifics of CAR calculation vary from country to country. In the most basic application, government debt is allowed a 0% risk weightingthat is, they are subtracted from total assets for purposes of calculating the CAR.

Characteristics of Financial Statement in Banks

A banks financial statement is quite different from those of a Firm or in any other Industry. A Simplified form of a typical Banks balance sheet would appear as follows:

Rs. in Crores Am Liability Deposit : t Asset Cash Loans & Advances Short term Medium term 65 20 : Short term Medium/Long term 25 30 Amt 3

10

Borrowings Capital & surplus

Investment

40

10

Fixed asset

10 0 100

The Characteristics of the Above Financial Structure are as follows: The Sources of Funds are primarily in short term in Nature,

payable on demand or with short term maturities. Depositors can renegotiate the term deposit rates as market Interest rates change. Financial leverage is very high, in other words, the equity

base is very low. This is risky and can lead to earnings volatility.

The proportion of fixed assets is very low. A high proportion of banks funds are invested in loans and

advances or investments, all of which are subject to interest rate volatility. Besides, when deposit rate change, the consequent impact

on the cost of funds could create problems with the pricing of portfolio of assets.
11

Operating leverage is relatively low due to comparatively

lower fixed assets

SOURCES OF FUNDS-BANKS LIABILITIES

Similar to the balance sheet of any other firm, the banks balance sheet also has assets that represent Application of Funds to generate revenue for the bank and liabilities and net worth that form the Sources of the banks funds. However, within this framework, there are significant differences in the basic composition of the assets and the liabilities and how they contribute towards the revenues and expenses of the bank.
12

The sources of the funds for the lending and investments activities constitute the Liabilities of the banks balance sheet. The various sources through which the bank raises funds for its business are broadly classified into the following:

SOURCES OF FUNDS

CAPITA

DEPOSI

OTHER LIABLITIES AND PROVISIONS

RESERV ES AND SURPLU S

BORROWING S

13

Capital
The RBI has provided guidelines for the capital requirement of the banks. The capital of the nationalized banks, which is fully contributed by the government, will also include the contributions made by the governments for participating in the World Bank projects. For banks that are incorporated outside India, and have branches in India, the capital will be the amount they bring in by way of start-up capital as prescribed by the RBI. Under this head amount of deposits kept with the RBI under section 11(2) of the banking Regulation Act, 1949 is also shown. According to this section, if the bank is not incorporated in India, it will have to maintain a deposit with the RBI either in cash or in the form of unencumbered approved securities or the party in such securities. New banks will have to be incorporated under the Indian Companies Act and have a minimum capital requirement of Rs 100 crore. Banks will have to show in their capital account the authorized, issued, subscribed and called up capital. The account will, however, be represented by the paid-up capital which will be arrived at after deducting the calls-in-arrears and adding up the paid-up value of forfeited shares to the called-up capital.

The Purposes of Bank Capital

The most obvious purpose of bank capital (although minor in comparison with other businesses) is that it provides
14

funds for fixed-asset purchases-building, equipment, and other physical assets-necessary to conduct the banks business. A major difference between banks and other businesses is that banks operate with a much lower level of capital than nonfinancial businesses. Capital is also the basis on which bank regulators set limits on lending. These limits restrict the amount that can be lent to any one borrower to a certain percentage of the banks total capital. Such limitations force banks to diversify their loans, thus protecting bank from concentrating funds in one or two major loans that may lead to major losses. Finally capital is the basis for market evaluations of bank performance.

Reserves and Surplus

The components under this item of the banks liability will include statutory reserves, capital reserves, share premium, revenue and other reserves and balance in profit and loss account. These items are discussed below:
1.

Statutory

Reserves:

Section

17

of

the

Banking

Regulation Act, 1949 which deals with the reserves fund account of the bank provides that every banking company incorporated in India shall create a reserve fund out of the balance of profit of each year as disclosed in the profit and loss account. This transfer of funds will be before any dividend is declared and the amount will be equivalent to not less than 20 percent of the profit.
15

2.

Capital Reserves: The surplus arising due to revaluation

will be considered as the capital reserve. It will not include any amount that is regarded as free for distribution through the profit and loss account. As stated earlier, if there is excess depreciation on investments and the bank intends to reverse it, then it shall be taken to capital reserve. Similarly, profit made on sale of permanent investments shall also be taken to capital reserves.
3.

Revenue and Other Reserves: All other reserves reserve fund. Excess provision for depreciation in

other than the capital; reserve will appear under this category of investments will have to be appropriated to investment fluctuation reserve account and be shown under this head. This amount will be considered as Tier-2 capital and can be utilized for the depreciation requirement on investment in securities, in the future.
4.

Share Premium: This item will show the premium on the

issue of share capital by the bank.

5.

Balance in Profit and Loss Account: The profits

remaining after the appropriations are considered under this heading.

Deposits
The equity capital and reserves of a bank form relatively a small proportion of the total liabilities. Banks are
16

highly leveraged organizations, relying mainly on debt and the chief sources of funds are the deposits that are raised. These deposits are grouped into various types depending on the purpose and the maturity. The deposits are broadly classified as deposits payable on demand and deposits accepted for a term and hence payable on a specified date. Deposits payable on demand consist of current deposits and savings deposits. However, the classification of these deposits for balance sheet purpose will be as demand deposits, savings bank deposits and term deposits. Demand Deposits: these include balances in current account and term deposits which have become due for payment but have not been paid yet. These funds represent interest-free balances. These accounts will be in the form of an operating account primarily for a business concern.
1.

Savings Deposits: these represent balances payable on

demand which is in the form of an operating account catering to non-commercial purposes such as individuals, trusts, etc.
2.

Term Deposits: Deposits that are repayable after a

specified term are included here. The minimum maturity period for which term deposits can be accepted are 15 days to 10 years and in case of deposits of Rs.15 lakhs and above this period can be relaxed in certain specific case.

17

These term deposits which can be raised from banks and others will include fixed deposit, cumulative and recurring deposits, cash certificates, certificates of deposits, annuity of deposits, deposits raised under various schemes, ordinary staff deposits, FCNR deposits, etc. The deposits under special schemes which are included here will be shown as demand deposits when they mature for repayment. All the deposits mentioned above will be classified as Those from banks and From others. The deposits from banks will include deposits from the banking system in India, co-operative banks, foreign banks which may or may not have operations in India. The balance sheet will also present the deposits segregating them into those raised by branches in India and those raised by overseas branches.

The Cost and pricing of Funding Instruments

A variety of factors influence the cost of deposits, the single most important source of bank funds. Bank funding sources have undergone profound changes in recent years, and continued change and challenge are still on the horizon. The deposit structures of most banks have been altered significantly due to marked declines in traditional demand deposits and rapid increases in the volume of time deposits. The sources of
18

most bank funds are now interest sensitive and increasingly volatile. Competition for funds is intense, and effective management of a banks liabilities now requires a much more aggressive approach to attracting and keeping funds. Bank funds managers must determine the true costs and appropriate prices of deposit accounts and must evaluate the relative costs of various short-term sources of borrowed funds.

Determining Deposit costs and prices

The changes in bank deposit structure coupled with increased competition for funds, have forced many banks to look more realistically at the true costs of obtaining funds and the adequate pricing of bank products and services to offset the total cost of funds. Recognizing the true cost of funding and recovering those costs through accurate pricing are essential to bank profitability and stability in the increasingly competitive and complex financial services industry.

Borrowings
Borrowings of the bank will be shown as those made within India and those made in the overseas markets. Borrowings in India will consist of Borrowings/ refinance obtained from the RBI, commercial banks (including co-operative banks) and other institutions and agencies like IDBI, EXIM Bank of India, NABARD etc. The borrowings made outside India will include the overseas borrowings made by the Indian branches and the borrowings of
19

the foreign branches. The amount borrowed in the money market will be shown under borrowings from other banks and other institutions depending on the lender. These borrowings will not include interoffice

transactions. Further, the funds raised by the foreign branches by way of Certificate of Deposits, notes, bonds, etc., should be segregated into deposits, borrowings, etc., based on the documentation. The secured borrowings made in the above two categories i.e. within and outside India will be shown separately under this head.

Purchased and Borrowed Funds

Purchased or borrowed funds play a significant role in bank funds management because they offer banks an alternative means of liquidity apart from assets liquidation. They also enable banks to compete for funds to expand their earning assets rather than relying solely on funding from deposits. All banks purchase or borrow funds from time to time to met reserve deficiencies, but many banks with access to national money markets also use purchased funds to enable them to expand their assets significantly.

Comparing the Costs of Borrowed Funds

Comparing the costs of funds that banks borrow or purchase is not as straightforward as cost comparisons on
20

various types of deposit instruments. Short-term borrowed funds, or money market liabilities, are liabilities that a bank incurs voluntarily to cover both expected and unexpected shortterm needs for funds. The costs of borrowing vary somewhat depending on the characteristics of the particular instrument used, but the major determinants of cost with borrowed funds are market supply and demand, as well as the efficiency of funds managers in obtaining funds.

Other Liabilities and provisions

The other liabilities of the bank are grouped into the following categories:

Bills Payable: This includes drafts, telegraphic transfers,

travelers cheques, mail transfers payable, bankers cheques and other miscellaneous items.

Interoffice Adjustments: As mentioned earlier, while

discussing the assets side of the balance sheet, the credit balance of the net interoffice adjustments will appear on the liabilities side of the banks balance sheet.

Interest Accrued: The interest accrued but not due on

deposits and borrowings is entered under this heading. Interest accrued and due is usually credited to the deposit account and hence such amounts usually do not get reflected here.
21

Others: The other liability items include the net provision

for income tax after deducting the advance payment, tax deducted at source, etc., and other taxes like interest tax. It also includes the surplus in the aggregate in provisions for bad debts account and for depreciation in securities. The contingency funds which are not disclosed as reserves but are required to be included under this head are as follows:

the proposed dividend/transfer to government, unexpired discount, outstanding charges like rent, conveyance, etc., other liabilities that do not appear under any head such as dividend.

unclaimed

Provisions and funds kept for specific purposes and certain

types of deposits like staff security deposits, margin deposits, etc., where the repayment is not free.

22

APPLICATION OF FUNDS-BANKs ASSETS

The funds mobilized by the bank, through various sources will be deployed into various assets. The assets side of a banks balance sheet consists of various items that fall into the following broad categories: Balanc APPLICATION OF FUNDS Cash and Balanc es with Reser ve es with Banks and Money at and Short Notice Call Investme
23

Other Assets Fixed

Advanc es

Within the broad classification given above, lies a variety of assets, a detailed description of which is given below:

Cash and Balances with Reserve Bank of India

All cash assets of the banks are listed under this account and it forms the most liquid account held by any bank. Cash is held by banks to cover deposit withdrawals, meet emergency expenses and handle unexpected credit demands from customers. The cash assets consist of the following:

24

1.

Cash in Hand: This asset item includes cash in hand,

including foreign currency notes and cash balances in the overseas branches of the bank. These are held on the banks premises to meet customer requests for withdrawal and loan demands at short notice.
2.

Balances with the RBI: Cash account also includes the

balances held by each bank with the RBI in order to meet the statutory Cash Reserve Requirements (CRR). Cash will also be held by banks in current account with various offices of the RBI. Cash maintained by a bank in the current chest is also reflected here as an integral part of the balances. A currency chest is an office, which is treated as a representative office of the RBI, but is actually maintained by a bank in terms of specific approval given to the bank by the RBI. Hence, cash balances with currency chest are treated as if the cash is deposited with the RBI and hence is accounted for the purpose of CRR.

Balances with Banks and Money at Call and Short Notice

Primarily, assets under this category will be shown separately as those maintained in India and abroad. The bank balances include the amount held by the bank in the current accounts and term deposit accounts, i.e. the current account
25

and other term deposit accounts, both within and outside India should be shown separately. The bank accounts within India will include all balances with banks, including co-operative banks. Likewise, the balances with banks outside India will include balances held by the domestic/foreign branches of the bank with other banks, which are located outside India. However, the balances maintained by the branches in India with their foreign branches will be considered as inter- branch balances and shall not be classified here. The other sub class of asset that appears under this category is, Money at call and Short Notice. All loans made in the interbank call money market that are repayable within 15 days notice are included here. All loans that are made outside India and which are classified as money at call and short notice in those markets will also be included. These secondary reserves (CRR and SLR from the primary reserves), which are in the form of call loans and loans payable at short notice, serve as a first line of defense when the bank needs funds to meet withdrawal requirements at short notice. The funds deployed in call market are shown separately depending on whether they are deployed in India or abroad.

Investments
A major asset item in the balance sheet of a bank is investments in various kinds of securities. Banks investments are classified into six different baskets depending upon the nature of security. These include:
26

Government Securities Approved Securities Shares Debentures and Bonds Subsidiaries and Bonds Other investments

While the above mentioned categories refer to the investments made in the domestic market, banks can also invest in the overseas markets. The overseas investments will include foreign government securities, subsidiaries and/or Joint Ventures and other investments.

Advances
The most important asset item on the banks balance sheet is advances. Advances, which represent the credit, extended by the bank to its customers, form a major part of the assets for all the banks. The assets account will be presented in the balance sheet of a bank in three different formats. In the first format, categorization will be based on the type/nature of the asset, in the second format, advances will be categorized into secured and unsecured advances and the third will consist of a categorization based on the sectorial credit disbursements. The total advances of all the three formats will be equal since the same advances are presented in different ways.
27

As in the case of investments, the balance under the advances is reflected in the balance sheet after reducing the provisions. It will be helpful to know the following to understand it better. Net Bank Credit:

1.

This

represents

the

total

credit

outstanding in the books of the bank. 2. Gross Bank credit: Net Bank Credit plus Bills Rediscounted by the bank with IDBI/SIDBI. The bank will have to make provisions depending on the level of NPAs. The figures reflected in the balance sheet are net of the provisions. It means that the figures in the balance sheet will be net bank credit less provisions. The provisions on account of NPAs are usually less than NPAs since in most of the cases the provisions are not made to the extent of 100 percent.

Type/Nature

of

Advance:

Given

below

is

the

Classification of advances based on the nature/type of the credit extended.

-

Bills purchased and discounted: The amount that is

shown against this item in the balance sheet will be discounted/ purchased by banks from the client irrespective of whether they are clean/documentary or domestic/foreign.
-

Cash

credits,

overdrafts

and

repayable

on

demand: Items under this category represent advances which

28

are repayable on demand though they may have a specific due date.
-

Term

Loans: All term loans extended by the bank

including their outstanding balances are shown here. These advances also have a specific due date, but they will not become payable on demand.

Secured/Unsecured

Advances

Based

on

the

underlying classified into the following categories:

-

Security, advances are

Secured by Tangible Assets: All advances are part of

advances, within/outside India, which is secured by tangible assets, will be considered as secured assets. Covered by Bank/Government Guarantees: Advances in India and Outside India to the extent they are covered by guarantees of Indian and Foreign government/banks and DICGC and ECGC will be included here.
-

Unsecured Advances: All advances that do not have

any security and which do not appear in the above two categories will come under this category.

Sectorial Advances: Sectorial segregation will be done

separately for advances within and outside India.

Advances in India will be classified into the following:

29

Priority sector represents advances made to sectors which

are classified as priority sectors by the RBI. Public sector advances are those advances that are made to and state government and other government

central

undertakings. Advances extended to public sectors which are eligible to be classified as priority sector should be shown under the category of priority sector and not as public sector advances. All advances made to the banking sector including the co-

operative banks will come under the head of banks. All the residual advances will appear under the head of

others. This includes non-priority advances given to the private, joint and co-operative sectors. Further, if the advances provided by the banks are on a consortium basis, the amount to be considered will be net of the share from other participating banks/institutions. Advances that are made outside India will be classified into those extended to banks and those extended to others. Advances to others will be classified as bills purchased and discounted syndicated loans and others.

Fixed Assets
Fixed assets of the bank are classified into premises and other fixed assets which include furniture and fixtures. Premises which are wholly or partly owned by the bank for
30

business/residential purpose will be shown after considering the additions or deductions made during the year and writing off the depreciation. Further, if there is any write-off on reduction of capital and revaluation of assets, then the revised figures must be shown in the subsequent balance sheets for a period of five years. All fixed assets other than premises will appear as other assets. These include furniture, fixtures and motor vehicles. Cost of the assets as given in the preceding years balance sheet will be adjusted for any additions and deductions made during the year and the write- offs due to depreciation.

Other Assets
The remainder of the items on the assets side of the banks balance sheet is categorized as other assets. The miscellaneous assets that appear here are:

Interoffice Adjustments: This shows the net position

of the interoffice accounts, domestic as well as overseas. The debit balance obtained after aggregating all the interoffice accounts will appear in this account. This will generally include items in transit and unadjusted items. If the net balance shows a credit, it will be shown on the liability side. Since 1998-99, banks are required to make 100% provision for the net debit position in their inter-branch accounts arising out of the unrecognized entries (both credit and debit) outstanding for more than 3 years as on March 31, every year.
31

Interest Accrued: Interest that can be realized in the

ordinary course will be considered. Included in this will be the interest accrued, but not due on investments and advances and interest due, but not collected on investments. Interest on advances which are in the form of loans, overdrafts and cash credit is debited to the respective accounts and hence no such amount usually gets classified here. However, interest accrued on bills purchased/discounted gets classified here. Hence, the major item under this category will be interest on investments.

Tax Paid in Advance/Tax Deducted at Source: The

amount of tax deducted at source on securities and the advance tax paid to the extent that they are not set-off against relative tax provisions will appear under this item.

Stationery and Stamps: Bulk purchase of stationery

which will be written off over a period of time will be considered under this head of account.

Non-banking Items

Assets under

Acquired account

in

Satisfaction

of

Claims:

this

include

immovable

properties/tangible assets which are acquired by the bank in satisfaction of banks claims on others.

Others: Other items primarily include claims that are in form of clearing items, unadjusted debit balances

the

representing additions to assets and deductions to liabilities and advances provided to the employees of the bank. Losses that are incurred over and above the capital, reserves and surplus
32

will also appear under this item. In respect of public sector banks, losses incurred can be set-off with capital without the prior approval of the government. Hence, all the accumulated losses are reflected under the item Other Assets irrespective of whether losses are in excess of capital or not. In all such cases it will be appropriate to reduce the accumulated losses shown on the asset side from the total of the balance sheet to arrive at working funds/earning assets/total assets. Working Funds, Earning Assets and Total Assets represent the same item and are used interchangeably. The assets and liabilities noted above will generate revenues and create expenses for the bank. Banks will thus have to balance their revenues against their expenses in such a way that there is adequate net income for them to sustain profitability in that business.

Contingent Liabilities
A Contingent liability is an off Balance sheet item. A Liability arises out of a present obligation as a result of past events. Further settlement of liability is expected to result in an outflow of resource, by way of payments to Creditors. A Contingent liability, on the other hand, is a possible obligation, which could arise depending on whether some uncertain future event occurs. It could also arise where there is

33

a present obligation, but payment is not probable or amount cannot be measured reliably. Contingent liabilities in the case of banks can generate substantial income while the going is good. A major contributor to contingent liabilities is the non- funded business that banks take such as issue of Letters of Credit, Opening Letters of Guarantee and derivatives dealing. The major risk in contingent liabilities is the

counterparty default risk. In the event of counterparty failing to honour his commitment, the liability will crystallize into a fundbased liability of the bank. Relatively higher fees for these Services offset the higher risk.

MATCHING REVENUES AND COSTS OF COMMERCIAL BANKS

A commercial bank deals in other peoples money. It gathers funds on one hand, and, deploy them on other. The problem is how to do this more effectively. For long the banks followed the Traditional Approach called Asset management. This meant putting funds, made available by the depositors to the bank, to profitable use, or, deploying them in a balanced mix of assets. The traditional approach assumes multiple pools of funds. Funds as they flow in to the bank are classified on the basis of different time structures of different sources short,
34

medium or long; and, are assigned conceptually to different pools, so as to permit matching of short sources with short uses and long sources with long uses. The traditional approach implicitly makes two further assumptions: Sources of funds are fixed and given and, The liquidity is the overriding criterion for success.

But, the general analytical approach to determination of the liquidity needs of a bank rests on the fundamental fact that changes in needs - whether short-term or long-term arise from either changes in total deposits or in total customer loans Basic underlying relationship assumed between the costs and revenues are as follows:

Costs Services

Activities

Resources

Revenues All activities need resources and have therefore

costs. But, all activities do not directly result in services. There are thus direct and indirect costs for services. A service is identified on the criterion that it satisfies the need of the customer and for which he would be willing to pay a price or a service charge, i.e. it can be a source of revenue. Services

35

rendered by a commercial bank can be classified into two categories: funds-related and non-funds-related.

Return and Cost of Funds in Banks

Return on Application of Funds
Total deployment of funds by a commercial bank during a period can be divided in to large number of components. For
36

e.g. Let us assume that deployment of funds by banks is divided into three broad categories: Deployment in statutory and non-statutory requirements of

cash and liquidity reserves and it includes investment in liquid governmental bonds or securities. Deployment in lending to nationally determined high-

priority borrowers at concessional rate of interest. Deployment in normal or competitive lending to the rest of

the borrowers at concessional and non concessional rates. Similarly, the interest earned on the total deployment of funds by a commercial bank during a period can be divided in to three broad categories: Total amount of interest earned from statutory and non-

statutory reserves of cash and liquidity reserves which includes investment in liquid governmental bonds or securities. Total amount of interest earned from lending to nationally

determined high-priority borrowers at concessional rate of interest. Total amount of interest earned from normal or competitive

lending to the rest of the borrowers at concessional and non concessional rates. The total amount of interest earned on a particular component is divided with rate of interest earned from such deployment of funds to get appropriate rate of earnings.
37

But, in order to arrive at an appropriate rate of earnings on funds deployment by a bank, it is necessary to deduct the allocated non-interest cost from out of interest revenue revenue. and add the corresponding service charges or commission recovered from the customers as non-interest

Cost of Funds in Banks

Total sources of funds by a commercial bank during a period can be divided in to large number of components. For e.g. Let us assume that sources of funds by banks are divided into three broad categories: Sources from demand deposit such as savings account

deposit, current account deposit. Sources from time deposit such as FDs, recurring account. Sources from long term borrowings, loans and advances. Similarly, the interest paid on the total sources of funds by a commercial bank during a period can be divided in to three broad categories: Interest cost to demand deposit such as savings account

deposit, current account deposit. Interest cost to time deposit such as FDs, recurring

account. Interest cost to long term borrowings, loans and advances.

38

The total amount of interest cost on a particular component is divided with rate of interest cost from such sources of funds to get rate of cost of sources of funds: But, in order to arrive at an appropriate rate of cost of sources funds by a bank, it is necessary to deduct the allocated non-interest revenue and add the non-interest cost such as manpower, administrative and other operating cost.

Cost of Loanable Funds in Banks

A part of deposits received by a bank from the public has to be deployed as cash reserves and as investment in highly liquid assets, i.e., in government and other eligible bonds and securities. The Cash Reserve Ratio and Statutory Liquidity Ratio are laid down by the Reserve Bank of India. These assets on average earn lower interest rates compared to what is on average earned on loans and advances. For working out cost of loanable funds, the loss arising out of deployment under CRR and SLR obligations. The loss is defined as the difference between the cost of funds, and rate of earnings on obligatory deployment of funds.

Cost of Funds versus Cost of Loanable Funds

The definition of cost of funds is considered to be most appropriate for all types of comparisons and decisions. Reason is based on the following:

39

1.

cost needs to be defined for the bank as a whole taking all

funds raised by the bank during the period such that total funds raised from different sources equal total funds deployed in cash, inventory and reserves, investments, loans and advances, and other assets including fixed assets; 2. all funds are assumed to flow into a common pool, no

source of funds is related to any specific use or uses of fund; 3. cost of funds needs to be calculated totally, separately and

independently of the revenues arising from deployment of funds; at no stage while measuring cost of funds they should get mixed up with each other; 4. interest cost needs to be calculated in terms of effective

rates by relating average outstanding to actual amount of interest paid, and not in terms of nominal rates; and 5. cost needs to be reckoned as total cost by adding

manpower and all other operating costs to the interest cost to arrive at the overall cost of funds to the bank; and, similarly, related service charges recovered need to be deducted.

Working Out Cost of Funds for a Bank

For working out cost of funds and earnings from funds needs a fund flow statement for a bank. This statement can be worked out on the basis of the average balance sheet. Then it can be modified and transformed into the funds flow statement. Average deposits and average borrowings can straightaway be taken as sources of funds. Similarly, average
40

cash, average balances with RBI and other banks, average loans, advances and investments can be taken as uses or deployment of funds. The difference between average capital and reserves and average fixed assets, as also the difference between average other liabilities and average other assets, can be taken as either sources or uses of funds depending on whether the difference is positive or negative. Due to averaging effect, most of the time the two sides may not exactly equal. The equality can be resorted after careful examination by plugging the difference into the sources or uses side.

The True cost of Funds for the Bank

Interest cost of raising funds and interest earned from deployment of funds need to be adjusted for non-interest cost, manpower and other operating cost. Similarly, other income received as commission, brokerage and service charges also needs to be adjusted. It was found difficult to estimate allocation of non-interest income to different components of sources and uses of funds. Major part of this income is earned through funds related activities and only a minor part emanates from ancillary services like safe-deposit lockers. A rough estimate indicated that of the total non-interest income earned by the bank is about 70% came from the borrowers, 20% from
41

current depositors, 5%from savings deposits and only 5% from ancillary services not directly related to deposits or advances.

Need to Calculate True Cost of Funds in Banks

Using the true and correct cost of funds for banks it is found that banks lose of funds deployed as cash inventory or in compliance of CRR and SLR requirements. The fact is that net earnings on these are lower than the cost of funds. If the loss has to be avoided or some profit earned, earnings rates on these items need to be raised. Therefore, the true rate of earnings from deployment in cash is CRR and SLR and the true rate of earnings from deployment in loans and advances.

Credit-Deposit Ratios of Banks

Large number of commercial banks in India today has consistently low and declining credit-deposit ratios vis--vis the rest of the banks. Improvement in credit-deposit ratio of a bank may require efforts in two areas: 1. augmenting the loanable resources of the bank on one

hand, and 2. Making efforts to step up credit on the other hand. One major reason for this is rise in the cash reserve and statutory liquidity ratios over this period.
42

Liquidity Management in Banks

Liquidity is the ease with which an individual, business firm or a financial institution can obtain cash by selling non-cash assets. Providing liquidity to the customers is one of the intermediation functions of banks. A bank is liquid if it can meet all the demands made for cash against it at precisely
43

those times when cash is demanded. Moreover whatever sources of funds bank may choose to draw upon must be available at a reasonable cost and time. Bank must maintain adequate liquidity in order to provide for declines in deposits and other liabilities, to satisfy unforeseen increases in demand for loans, and to permit increased investment in particularly desirable earning assets when such opportunities arise. Liquidity, defined in its broadest sense, is the ability to obtain needed cash quickly and at a reasonable cost. Because needs for funds may be unpredictable and uncontrollable, banks must maintain adequate liquidity to ensure that cash, or access to it, can be obtained on short notice and with little or no loss of capital. Liquidity is necessary for banks to carry out daily business transactions, to cover emergency needs for funds, to satisfy the bank customers demand for loans, and to provide flexibility in taking advantage of especially favourable investment opportunities. Fund managers must estimate and provide for liquidity needs as efficiently and cost-effectively as possible. Purposes of Liquidity Liquidity enables a bank to answer a need for funds when that need cannot be fully met by the steady growth of the banks primary sources of funds.

44

A banks deposits do not grow steadily. Deposit levels are influenced by national and local business conditions and cannot be fully controlled or predicted with accuracy. The same is true for loan demand. Uncertainty, therefore, is a key characteristic of the banking business. As a result, banks must build enough flexibility into their asset and liability portfolios so that they can handle any unexpected needs for funds. Bankers seek the highest yields possible on their investments and loans, but they must carefully consider how much risk they are willing to take to achieve that objective. They must also ensure that the bank is compensated with earnings proportionate to the risks assumed.

45

RISK ASSOCIATED WITH THE SOURCES AND USES OF FUNDS IN BANKS

As it is truly said that, income or return is closely related to risk. A bank may invest its entire fund in low-risk Government securities from which it would earn a low income of say 7%. Another bank may invest its entire fund in high risk corporate equities and real estate and earn income of say, 25%. However, the former would have safety of funds with low risk in its favour while the latter would have higher profitability along with the risk of incurring heavy losses. Thus, there is a direct correlation between risks and returns. Low risk investments are also quite liquid. They are marketable as there are many buyers for the same. On the other hand, high-risk loans are less liquid and less marketable. As such, there is a trade-off between profitability and liquidity. Banks usually carry the following basic risks:
I.

Liquidity risk: It is the risk of meeting the liquidity needs of a bank as and when they arise. It is measured as the ratio between the liquidity outflow (e.g. withdrawal of deposit, repayment of banks borrowings etc.) to liquidity inflow (e.g.
46

maturing assets, fresh deposits etc). a rough approximation of liquidity risk would be: (Short-term securities Short term borrowings)/Total Deposits. If a bank holds more of liquid assets, it would minimize liquidity risk but earn a low income.
II.

Interest rate risk: It is the risk arising out of changes in interest rates and their impact on the income of a bank and values of its assets and liabilities. The assets and the liabilities, which are sensitive to interest rate changes, are called interest sensitive. Interest rate risk can be roughly measured as the ratio of interest sensitive assets to interest sensitive liabilities. As ideal ratio is one that brings safety. If interest rate fluctuates, the bank with an interest rate risk of one would have equal to zero variation in interest income and interest cost and the net impact on profit would be zero. If the ratio is above or below one, the bank would have fluctuation in earnings, depending on how fast the interest rate on advances increases vis--vis the cost of deposits. A bank needs to take a view on interest rate movement and shuffle the portfolio at short notice.

III.

Credit risk: It is the risk arising out of default in the payment of the interest and/ or principal of the loan amount. The ratio of non-performing assets to total loan assets is a rough measure of credit risk. Credit risk is higher if the bank has more of low/medium rated loans, but the income from those loans is also correspondingly more. If a bank decides to focus
47

only

on

quality

loans

the

income

from

those

loans

is

correspondingly more. But if a bank decides to focus only on high quality loans, its interest income will shrink because of less availability of such assets and finer interest rate they attract.
IV.

Capital Risk: It is the risk that arises from diminution of capital due to losses. It measures how much the asset value may decline before the position of depositors and creditors is jeopardized. Capital adequacy is the bulwark against capital risk. A bank with a capital-to-asset ratio of 10% will be in a better position to absorb capital risk than the bank with the said ratio of 5%. Capital risk is inversely related to Equity Multiplier and to Return on Equity. Capital risk calls for higher capital while ROE and Equity Multiplier call for higher debt. Banking operations also face other risks like pre-payment risk, operation risk, reputation risk etc.

PROFITABILITY IN BANKS
Profitability is an essential objective of bank funds management. Strong profits are necessary to pay dividends stockholder and build stockholder equity, to offset loan losses, to pay ongoing operating expenses, and to expand products and services. However, bank profitability entails more than striving for immediate maximum returns; rather, it is the profitable management of the banks assets and liabilities over both the short and long term. To be profitable, a bank must show healthy
48

short-term earnings; but it must manage liquidity, risk, and earnings through recurring business cycles for long term survival. In fact, a banks location and the type of financial service needs of its market area greatly influence the level of the banks profitability. For this reason, any analysis of bank profitability must be comparative. A banks performance must be viewed in relation to records of its own past performance and to the performance of banks of similar asset size, location, and type of customer service markets. Profit is mainly the difference between the income earned and the expenditure incurred to earn the said income during the period i.e. Profit = Income Expenditure It can also be written as: Profit = Revenue Expenditure / Cost The equation can be replaced as: P=RC Where, P = profit of a bank for a period R = total revenue earned by the bank during a period C = total cost paid by the bank during a period The revenue and cost can be further bifurcated as:
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R = R1 + R2 & C = C1 + C2 Where, R1 = revenue earned by way of interest on loans, advances and investments R2 = non-interest revenue earned by way of service charges and commission on guarantees or remittances or collections from its customers C1 = cost incurred by way of interest paid out of deposits and borrowings C2 = non-interest cost paid as expenses on manpower and establishment for rendering services to customers Therefore, P = (R1 + R2) (C1 + C2) Now let us see an example of how the banks profitability gets affected because of NPAs:

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Effects of NPAs on Profitability of Banks

As we know, banks incur costs to mobilize funds and earn interest on the loans. The difference between the costs of deposits and yield on advances is a measure of the banks profits. Impairment of loans has an adverse impact on the profits, as impaired loans cease to generate income. A small degree of impairment may not affect the profit of the bank but a substantial level of NPAs results in losses. To the extent that they do not generate any income the NON Performing Assets are a drag on the net interest income of the bank. The impairment of the asset further requires provisioning at various rates in accordance with the guidelines of the RESERVE BANK OF INDIA depending on the stage of their non performance. These provisions are made out of the income generated by other performing assets thereby creating further pressure on the net interest income of the bank. NPAs are a serious strain on the profitability of banks as they cannot book income on such accounts and their funding costs and provision requirements are a charge on their profits. NPAs also carry 100% risk weightage and block capital for maintaining Capital Adequacy Ratio. To that extent this is a drain on the profitability of a bank.

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AN ILLUSTRATION
An illustration of a simple balance sheet of a typical bank is given below, which explains the effects of NPAs on bank profitability. Balance Sheet & Profit & loss Statement of XYZ Bank

(Rs. In crores)
Balance Sheet Sources(Liabilities) Share Capital Reserves Deposits Inter Bank 620 1,240 19,550 500 450 22,360 Profit and Loss Account Interest 1,260 Interest
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Uses(Assets) 1,000 7,150 10,060 4,000 150 22,360

Cash Investments Loans & Advances Bills Fixed assets

Deposits Borrowings

1,560

Income Other Income 900 2,160 Profit Tax Profit After 250 70 180

Expenses Other Expenses 350 1,910

Tax It may be observed that the Balance Sheet is healthy and the bank has made healthy profits. Assuming that the loans and advances are non performing to the extent of 20% i.e. about Rs. 2,012 crores, the interest earnings will reduce to that extent (as the interest income of Rs.1,260 crores will not be earned by the bank). In addition, the cost of carrying the NPAs like the Provisions and other expenses will add to the expenses and thus the level of profits would substantially reduce.

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CASE STUDY
An Illustration
Here, the case of a hypothetical bank, called XYZ Bank, is taken to show measures of risks and returns. The balance sheet of XYZ Bank is given below. Then shuffle the portfolios, first towards low risk and then towards higher risks, to observe their impact on returns/profits. XYZ Bank (Rs. in crores) Balance Sheet as on 31st March, xxxx Liabilities Assets Capital 1,000 Cash Balances Reserve & 6,000 Balance with Surplus banks, Money at Call Current Account Savings Deposits 30,000 30,000 and Short 15,000 20,000 Notice Investments Bills Purchased
54

6,900 15,000

Time Deposits Borrowings Total

30,000 3,000 1,00,000

Cash Credit Term Loans Fixed Assets Total

20,000 20,000 3,100 1,00,00

0 Profit and Loss Statement for the year ended 31st Income Interest Income Other Income Operating Income/profit Tax Net Income/profit XYZ Bank has total assets of Rs.1, 00,000 crores, out of which earnings assets (i.e. excluding premises and cash balances) are Rs.90, 000 crores. Among its assets, it is assumed that only cash credit loans, bills purchased and investments are affected by change in interest rate (term loans are at fixed rate of interest). Hence, its rate sensitive assets are Rs. 55,000 crores. Similarly, among its liabilities, savings deposits, time deposits and borrowings are affected by change in interest rate. Thus, its rate sensitive liabilities are Rs.63, 000 crores. Now, let us find out the various measures of returns and risks of the XYZ Bank from the above data. A. Measures of Returns :
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March, xxxx Expenses 6,950 Interest Expenses Other Expenses 6,950 1,230 400 830

3,720 2,000 5,720

1. Interest margin Earnings Assets

= (Interest Income Interest Expenses)/

= (6,950-3,720)/90,000 = 3.59% 2. Net Profit margin = Net Income/Total Income = 830/6,950 = 11.94% 3. Asset Utilization = Total Income/Total Assets = 6,950/1, 00,000 = 6.95% 4. Return on Assets = Net Income/Total Assets = 830/1, 00,000 = 0.83% 5. Equity Multiplier = Total Assets/Equity = 1, 00,000/7,000 = 14.29 6. Return on Equity = Net Income/Equity = 830/7,000 = 11.85% B. Measure of Risk 1. Liquidity Risk = Short-term securities/Deposits = 15,000/90,000 = 16.67% (Balance with banks, Money at Call and Short Notice) 2. Interest Rate Risk = Interest Sensitive Assets/Interest

Sensitive Liabilities = 55,000/63,000 = 0.87 3. Credit Risk = Medium quality loans/Total Assets = 20,000/1, 00,000 = 20%
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4. Capital Risk

= Capital/Risk assets = 7,000/7, 5000 = 9.33%

It may be mentioned here that the above parameters are only approximate measures of risk and returns adopted only for the purpose of illustration. After the measures of risks and returns of XYZ Bank are computed, it may be possible to compare the same with similar measures of peer group banks to ascertain its position in the industry and the scope for improvement on any of the said parameters. It is also possible to take into accounts the parameters prescribed by the regulatory/supervisory authorities and the parameters laid down by the banks Board of Directors/senior management, while adopting various management strategies to improve profitability.

FINDINGS OF THE STUDY

The study has given an insight into: Components of various Sources and Uses of Funds of

banks Balance Sheet. Components of Profit and Loss Account of a bank. The impact of fluctuations of rates of interest on the

Source and Uses of Funds. Importance of Revenues and Cost of funds in banks. The need for maintaining liquidity in banks. How the banks profitability gets affected.
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LIMITATIONS OF THE STUDY

As the study of specific area is restricted, and time allotted is very limited for making project. If time permits then there would be a wide scope of study on specified topic. Study/ Project on a specified topic have page

constraint. The information which is provided is not enough for in-depth study of the topic. If there would be work experience then there will be

different view of the study. Due to lack of practical knowledge there is limited

view of the project.

PRIMARY DATA
What are the sources of funds for your bank?

The sources of funds for our banks are demand deposits, term deposits, savings deposits account, current deposits account and fixed deposits. Under guidelines of RBI how much capital is required to do the banking business? Under guidelines of RBI capital required to do the banking business is rupees 100 crore.

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 What type of deposit does your bank accepts from the customer? Bank accepts deposits from customer are fixed deposits, recurring deposits, current account deposits and savings account deposits. What are the factors for the cost of deposit which is the single most important source of bank fund? Single most important source of bank fund is interest. If your bank is in need of money than what are the sources of borrowings? If bank is in need of money than the sources of borrowings are future public offer, right issue, bonds, call money and from RBI. How does your bank mobilize the funds?

Bank mobilize the funds by way of opening new branch office, developing net banking, set up ATMs and marketing the products.

Does there investment?

is

any

restriction

from

RBI

for

Yes there is restriction from RBI for investments. In what type of securities does your bank invest the money more? Our bank invests the money more in government securities, call money and treasury bills.
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 How does your bank calculate interest on loans and advances given to the customer? Our bank calculates interest on loans and advances on the based on base rate or on monthly EMIs. What are the current CRR and SLR maintain by your bank? The current CRR is 6% and SLR is 25% which is maintained by our banks. How does your bank manage liquidity for day to day expenses? Our bank manages liquidity for day to day expenses by accepting deposits from customers. Which are the risk associated with sources and application of funds? There is no risk associated sources of funds but there is risk associated with application of funds are NPAs and unsecured loans given to customers. Does NPAs affect the profitability of your bank?

Yes NPAs affects profitability of our bank. How your bank does measures the risk on loans given to customer? Bank measures the risk on loans on financial statements, profit margins, credibility of customer and repaying ability etc

CONCLUSION
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Banking industry in a large part of the world-both developed and developing has been witnessing major environmental changes during the last few decades. The changes have been witnessed in political, economic, policy and regulatory areas and have dramatically altered bank business strategies, organizational structures, and critical management areas and have related processes. The volatility of environment surrounding the banking organizations has made it clear to the banks managements that strategies and systems that were adopted earlier could no more be relied upon to provide solutions in the current environment. The volatility of environment is relevant for the banking system not only because its impacts a banks critical functions of selling various products and services at competitive prices or of raising resources. Importantly, the environment also affects individuals, corporate and institutions to which the bank sells various products and services. The environmental change may operate either on the cost/income side. While a bank has necessarily to respond to such changes, the severity of competition requires banks to be proactive, anticipate such changes and prepare themselves to face them. It is in this context that the Sources and Uses of funds of banks assume greater significance in order to maintain sustainability of its operations.

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BIBLOGRAPHY
TITLE FUNDAMENTALS OF INDIAN FINANCIAL SYSTEM MANAGEMENT OF BANKING AND FINANCIAL SERVICES BANKING LAW AND PRACTICE AUTHOR VASANT DESAI PUBLICATION HIMALAYA PUBLISHING HOUSE PERSON EDUCATION EDITION 6TH EDITION 2007 1ST EDITION 2007 21ST EDITION 2005

JUSTIN PAUL AND PADMALATHA SURESH P.N. VARSHNEY

SULTAN CHAND AND SONS

ARTICLE
SOURCE ECONOMIC TIMES TOPIC CAPITAL ADEQUACY RATIO (CAR) DATE 27TH JULY 2010

PRIMARY DATA
NAME OF THE INSTITUTION HDFC BANK NAME OF THE PERSON Mr. VIPUL SHAH DATE OF INTERVIEW 24TH September 27, 2010

COLLECTION OF ARTICLES
ECONOMIC TIMES
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MINT NEWS PAPER

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