Chapter 3: Depository Institutions:

Activities and Characteristics

Definition:
Financial institutions take deposits from
savers and sanction loans to users are
known as depository institution. There
are some depository institutions those
take deposits and make direct
investment in other sectors.
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 Asset/Liability problem of
depository institutions:
Depository institutions take deposits from surplus
group by granting interest and sanction the
deposited amount to deficit group as loans and
advances by charging interest. The difference
between interest grant and interest charged is the
spread income of the institution. A depository
institution seeks to earn a positive spread between
the assets it invests and the cost of its funds. The
spread is referred to as spread income or margin.
The spread income should allow the institution to
meet operating expenses and earn a fair profit on its
capital.
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 Factors considered by depository institutions

(a) Interest rate risk: It means to change future

market interest rate that will affect ultimately the
interest rate of the institution and spread income.
(b) Liquidity concerns: Since depository institutions
take deposits from savers they are liable to meet up
the withdrawal demand of the depositors. Depositors
can place their withdrawal demand any time during
the allowable hour. There is no certainty about the
timing of withdrawal of deposited amount. Since
institutions are bound to honor the depositors
demand they will have to maintain a certain
percentage or certain amount of total deposit.
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 Commercial bank

The financial institution collects deposits from

surplus group by sanctioning interest and
sanctions the amount to deficit group as
loans and advances by charging interest for
earning profit and helping economic
development is called commercial bank. This
commercial bank is formed and administered
according to Company Act and Banking
Company Act.
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 Islamic bank
Commercial banks set their objectives and
operations based on Quranic principles where all
services comply with the religious injunctions of
islam and free from riba (The Quran Al-
Baqarah Sura 275-281), gharar and maysir are
known as Islamic bank. Profit-and-loss-sharing is
the method of resource allocation and financial
intermediation in case of all relevant banking
services instead of interest. This bank participates
in the yield resulting from the use of funds.
Depositors share in the profit of the bank
according to the predetermined ratio.
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 Islamic bank
There is thus a partnership between the
Islamic bank and its depositors as well as
between the bank and its investment clients.
The following six principles drive the activities
of Islamic banks:
i. the prohibition of predetermined loan
repayments as interest (riba);
ii. profit-and-loss-sharing is at the heart of the
Islamic banking system
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 Islamic bank
iii. making money out of money is unacceptable
and all financial activities must be asset-based;
iv. prohibition of speculative behavior;
v. only sharia approved contracts are acceptable;
vi. the sanctity of contracts i.e. transactions
should be fair, honest and just towards others
Islamic Finance in a Nutshell, Brian Kettell,
page 2-13).
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 General Bank Services

1. Individual banking: Commercial banks

provide various banking services mainly to individuals
are known as individual banking. This service
includes consumer lending, residential mortgage
lending, consumer installment loans, credit card
financing, automobile and boat financing, brokerage
services, student loans and individual-oriented
financial investment services such as personal trust.

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 General Bank Services

2. Institutional banking: Services

provided to financial and nonfinancial
corporations like insurance companies
and leasing companies. By providing
different services bank can earn
interest income and fee income.
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 General Bank Services

3. Global banking: Services provided

by banks to similar business organizations
within or outside the country are known
as global banking. It covers a broad range
of activities involving corporate financing
and capital market and foreign exchange
products and services.
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 Specific Bank Services

i) The primary operations

ii) Other types of bank services
iii) Foreign exchange services
iv) Investment services
v) Insurance services
vi) Other financial services

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 Bank funding

1. Deposits: There are several types of deposits

accepted by banks like demand/current deposits,
savings deposits and time deposits/certificates of
deposit.
2. Reserve requirements: The percentage of total
deposit amount maintained as reserve in cash and
near cash asset form in the particular bank itself and
to the central bank is called reserve requirement.
There are two types of reserves Cash reserve ratio
and statutory liquidity reserve.
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 Bank funding

3. Borrowing from central bank: Central bank provides

funds as loans to commercial banks against holding securities
and other paper assets through discount basis.
4. Other non-deposit borrowing: One commercial bank
can borrow funds from another commercial bank when it faces
severe liquidity crisis. It can also borrow funds from other
financial institutions.
5. Funds from market: A bank can raise funds from the
market by issuing different types of financial instruments. For
forming large amount of capital as a source of fund.
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 Regulation

1.Ceilings imposed on the interest rate that

can be paid on deposit accounts
2. Geographical restrictions on branch banking
3. Permissible activities for commercial banks
4. Capital requirements for commercial banks

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 Risk Weights of different asset
category

Category 1: 0% - cash, bank balance, reserves,

trading account, treasury & agency securities,
govt. reserve securities.
Category 2: 20% - due from banks, domestic
deposit institutions, repurchase agreements,
govt. sponsored agency securities, state &
municipal securities, collateralized mortgaged
obligation, municipal general obligation bonds.
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 Risk Weights of different asset
category

Category 3: 50% - municipal revenue bonds,

residential mortgages, collateralized mortgaged
obligation backed by mortgage loans, real estate family
loans.
Category 4: 100% - commercial loans & commercial
mortgages, corporate bonds, LDC loans, leases,
allowance for loan & lease loss, premises, equipments,
other investments, other assets.

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Example of capital requirements

Risk Assets Book value Product

weight (CroreTk.) (Crore Tk.)
0% Treasury securities 100 0
20% Municipal bonds 100 20
50% Residential mortgages 500 250
100% Commercial loans 300 300
Total 1000 570

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Example of capital requirements

Core capital (Tier 1) is 5% of risk

weighted assets is (570X0.05) Tk.28.5 core.
Supplementary capital (Tier 2) is also 5%
of risk weighted assets is (570X0.05)
Tk.28.5 core. The minimum total capital
requirement is 10% of total risk weighted
assets is (570X0.10) Tk.57.0 core.
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 COMPONENTS OF CORE CAPITAL
(TIER -1) CAPITAL

Paid up Capital
Non-repayable Share premium account
Statutory Reserve
General Reserve
Retained Earnings
Minority interest in Subsidiaries
Non-Cumulative irredeemable Preference Shares
Dividend Equalization Account

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COMPONENTS OF SUPPLEMENTARY
CAPITAL (TIER -2) CAPITAL

General provision maintained against

unclassified loans
Assets Revaluation Reserves
All other Preference Shares
Perpetual Subordinated debt
Exchange Equalization A/C

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Problem of capital requirements # 1
Calculate Tier-1 & Tier-2 capital

Instruments Tk. (00000)

Treasury securities 1000
Municipal bond 1500
Residential mortgage 2000
Real estate family loans 3000
Cash and bank balance 2500
Commercial loan 4500
Total 14500
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Problem of capital requirements # 2

Particulars Amount Particulars Amount

(Tk.) (Tk.)
Savings bank deposits 32500 Share capital 200000
Current deposits 12500 Statutory reserve 90000
Borrowing from other banks 40000 Profit & loss A/C balance 65000
Borrowing from central bank 10000 Share premium 10000
Bills purchased and discounted 10000 Retained earnings 25000
Cash credit, overdraft & demand Redeemable preference
loan 25000 share 142500
Term Loan 142500 Subordinated debenture 127500
General provision maintained Perpetual preferred stock 147500
against unclassified loans 127500 Minority interest 25000
Assets Revaluation Reserves 147500 Dividend equalization fund 10000
All other Preference Shares 25000 General Reserve 37500
Perpetual Subordinated debt 7500 Fixed deposits 150000
Exchange Equalization A/C 8000 3-22
 Other institutions
Savings and Loan Associations: Its an
association thats assets are mortgages, mortgage-
backed securities and treasury securities whereas
sources of funds are savings and time deposits.
Savings banks: An association is formed by
contributing fund by owners and then collecting
savings from depositors. From this fund the
association sanctions loans to potential borrowers
within or outside the association.
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 Other institutions

Credit unions: Credit unions are depository

institutions that have a common bond
requirement for membership. They are
owned by their members and their assets
are primarily small consumer loans to their
members and credit card loans.

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