FINANCIAL MANAGEMENT OF BANKS

Macro Aspects of Banking

Understanding Banks Financial Statement

Balance Sheet
Sources of Funds (Bank Liabilities)
1. Net Worth (a) Capital (b) Reserve & Surplus = Statutory Reserve + Capital Reserves + Share Premium + Revenue and other Reserves + Balance in P&L Account 2. Deposits (a) Demand Deposits (b) Saving Deposits Term Deposits

1. Borrowings 2. Other Liabilities and Provisions (a) Bills Payable (b) Interest accrued Others

 Uses of Funds (Bank Assets)

1. Cash and balances with the RBI 2. Balances with banks and money at call and short notice 3. Investments: Government securities Approved securities Shares Debentures and bonds Subsidiaries and / or joint ventures Other investments

4. Loans and advances: (a) By nature of credit facility (b)By security arrangements By sector 5. Fixed assets: (a) Premises (including land) (b) Other assets (including furniture and fixtures) Assets on lease 6. Other assets

 Contingent Liabilities a) claims against the bank not acknowledged as debts b) Liability on account of outstanding forward exchange contracts c) Guarantees given on behalf of outside constituents d) Currency swaps, interest rate swaps & futures

Income Statement
Sources of Income
Interest Earned Interest / discount on advances/bills Income from investments Interest on balances with RBI and other inter-bank funds Others

 Other Income Commission, exchange and brokerage Profit/loss on sale of investments Profit/loss on revaluation of investments Profit/loss on sale of building and other assets Profit on exchange transactions Income earned by way of dividends Miscellaneous income

Sources of Expenses
Interest Expended
Interest on deposits Interest on RBI / inter-bank borrowings Other Interest

Operating Expenses
Payments to and provisions for employees Rent, taxes and lighting Printing and stationery Advertisement and publicity Depreciation on banks property Directors fees, allowances and expenses Auditors fees and expenses Law charges

 Provisions and Contingencies

Other Disclosures to be made by Banks in India = The banks are mandated to disclose
additional information as part of annual financial statements as follows: 1.Capital adequacy ratio 2. Gross value of investments 3. Repo transactions 4. Non-SLR investment portfolio 5. Forward rate agreement/interest rate swap 6. Movements in NPAs

Camels Model
Regulators, analysts and investors have to periodically assess the financial condition of each bank. Banks are rated on various parameters, based on financial and nonfinancial performance. CAMELS is an acronym, where each letter refers to a specific category of performance.

 CAMELS model objectives. Ratings are assigned for each component in addition to the overall rating of a banks financial condition. The ratings are assigned on a scale from 1 to 5. Rating analysis and interpretation

CAMEL MODEL C - Capital Adequacy - Capital adequacy ratio - Debt-Equity Ratio - Advances to Assets - G-Secs to Total Investments A - Asset Quality - Gross NPAs to Net Advances - Net NPAs to Net Advances - Total Investments to Total Assets - Percentage change in Net NPAs - Net NPAs to Total Assets

 M- Management - Profit per Branch - Total Advances to Total Deposits - Business per Employee - Profit per Employee E- Earning Quality - Operating Profits to Average Working Funds - Percentage Growth in Net Profits - Spread - Net Profit to Average Assets - Interest Income to Total Income - Non-Interest Income to Total Income

 L- Liquidity - Liquid Assets to Total Assets - G-Secs to Total Assets - Liquid Assets to Demand Deposits - Liquid Assets to Total Deposits S Sensitivity to market risk

Pricing Deposit Services

Need to price deposit services = The pricing
of deposits and related services assumes great importance in the present deregulated and highly competitive environment, where deposit rate ceiling do not exist. However, banks have to monitor the cost of their funding sources carefully for the following reasons: 1. Changes in cost of funds would require changes in asset yields to maintain spreads. 2. Changes in cost of funds could alter the liability mix of banks and expose the bank to liquidity constraints. 3. Changes in cost of funds could render the bank less competitive in the market. It is, therefore, imperative that banks understand how to measure the cost of their funding sources and accordingly price their assets in order to ensure a desired level of profitability. This is done through a pricing

 Approaches to deposit pricing

Market penetration deposit pricing Conditional pricing Upscale target pricing

Deposits and interest rate risk

Management of Credit Risk

Loans

Introduction
Expected versus Unexpected loss Defining credit risk the risk in individual credits or transactions. the credit risk inherent in the entire portfolio. the relationships between credit risk and other risks.

BASEL Committees Principles of Credit Risk Management

The committee focuses on the following areas:
1. Establishing an appropriate credit risk environment; 2. Operating under a sound credit granting process; 3. Maintaining an appropriate credit administration, measurement and monitoring process; and 4. Ensuring adequate controls over credit risk.

Credit Risk Models

Lenders try to diversify their credit risks, for they know that they cannot do business if they eliminate risks altogether. How can lenders diversify their risk? By avoiding concentration of credit. Basic model
A simple method of estimating credit risk is to assess the impact of NPA write-offs on the banks profit.

 PBT/NPA. Here PBT is more relevant since losses written off typically enjoy tax shields. (PBT/TA) / (NPA/TA) Interpretation

Credit scoring model

Credit Risk Transfers

LOAN SALES Syndication Novation Securitisation The securities sold to investors are called ABS, since they are backed by the homogeneous pool of underlying assets. Originators of ABS usually want to sell loans without recourse. Hence investors usually safeguard their interests through three mechanisms (a) overcollateralisation, (b) senior/subordinated structures, credit enhancement.

CREDIT DERIVATIVES CD are an effective means of protecting against credit risk. They come in many shapes and sizes, but all serve the same purpose. Simply stated, a credit derivative is a security with a pay-off linked to a credit related event, such as borrower default, credit rating downgrades. Some basic credit derivative structures: 1. Loan portfolio swap 2. Total return swap 3. Credit default swap (CDS) 4. Credit risk options

5. Credit linked notes 6. Credit linked deposits / credit linked certificates of deposit 7. Basket default swap

Treatment of Credit Risk in India

Credit and investment exposure What are non-performing assets Prudential norms for income recognition Prudential norms for asset classification Provisioning norms

Management of Interest rate and Liquidity Risk

Asset Liability Management

Introduction
90% of Bank As liabilities mature within the next 12 months. Bank A has invested 80% of these funds in securities maturing after 5 years. 90% of Bank Bs liabilities mature within the next 12 months. Bank B lends 75% of these funds to various infrastructure projects, where the repayment will start after an initial payment holiday of 2 years. 80% of Bank Cs liabilities mature after 3 years and have been borrowed at a fixed cost. Interest rates are on a downward trend, and 80% of Bank Cs loan portfolio consists of short-term loans to be fully repaid over the next six months. Bank D has entered into dollar forward contracts at a premium for 6 months on behalf of its importer borrowers, who form about 60% of the banks loan portfolio. There is a fall in dollar value during this period.

Concept & Objective of ALM

The maturity mismatches and disproportionate changes in the level of assets and liabilities can cause both liquidity and interest rate risk. ALM is an integrated strategic managerial approach of managing of total balance sheet dynamics having regard to its size and quality in such a way that the net earnings from interest in particular are maximized with the overall risk preference of the institution. The focus is not on building up of deposits and loans/assets in isolation but on net interest income and recognizing interest rate and liquidity risks. This is essentially a guide for survival in a deregulated environment.

 Objective:
1. To control the volatility of net interest income and net economic value of a bank. 2. To control liquidity risk. 3. To control volatility in target accounts, and 4. To ensure an acceptable balance between profitability and growth rate.

Measuring Interest Rate Risk

Banks use various techniques to measure the exposure of earnings and economic value to changes in interest rates. Before we examine the various approaches, we will have to understand what determines interest rate sensitivity. Typically, a banks asset or liability is classified as rate sensitive within a specified time interval if
It matures during the time interval; The interest rate applied to the outstanding advance changes contractually during the interval; It represents an interim or partial principal payment; The outstanding principal can be repriced when some base rate or index changes; and there is an expectation that the base rate or index may change during the interval.

 1. 2. 3. 4. 1. 2. 3. 4. 5. 6.

Methods to measure interest rate risk Traditional GAP analysis Earnings sensitivity analysis (Earnings at risk) Rate adjusted gap Duration GAP analysis Managing interest rate risk IRD Swaps Interest rate futures Forward rate agreements Interest rate options Interest rate guarantees Swaptions

Liquidity Risk Management

Sources of liquidity risk
1. 2. 3. 4. 5. 6. Access to financial markets Financial health of the bank Balance sheet structure Liability and asset mix Timing of fund flow Exposures to off-balance sheet activity


1. 2.

Approach to managing liquidity in long-term

Asset management Liability management

1.

Approach to managing liquidity in the shortterm

Projected sources and uses of funds over the planning horizon Working funds approach Cash flow or funding gap report Funds availability report Ratio analysis Historical funds flow analysis

2. 3. 4. 5. 6.

Capital Risk
Regulation and Adequacy

Prudential Regulation
Economic regulation and prudential regulation Prudential regulatory model calls for imposing the regulatory capital level to maintain the health of banks and the soundness of the financial system. The Reserve bank of India issued prudential norms based on the recommendations of the Narsimham Committee report. These norms strive to ensure that banks conduct their business activities as prudent entities, that is, not indulging in excessive risk taking and violating regulations in pursuit of profit.

BASEL Committee
What is BASEL committee? BASEL Capital Accord 1988: The Basle Capital Accord of 1988 refers to the agreement among member countries of the Basle Committee on Banking Supervision on a method of ensuring a banks capital adequacy. The Basel norm of capital adequacy was introduced in India following the recommendations of the Narsimham Committee (1991).

Capital Adequacy
Capital adequacy ratio is a measure of the amount of a banks capital expressed as a percentage of its risk-weighted assets. This capital framework, based on the Basel committee proposals, prescribes two tiers of capital for the banks:
Tire-I capital which can absorb losses without a bank being required to cease trading and Tier-II capital which can absorb losses in the event of a winding-up.

1. 2.

 Tier-II capital should not be more than 100 percent of Tier-I capital and subordinated debt instruments should be limited to 50 percent of Tier-I capital. Revaluation reserve should be applied a discount of 55% for inclusion in Tier-II capital. General provisions/loss reserves should not exceed 1.25 percent of the total weighted risk assets. Risk weight of assets.