MANAGEMENT OF BANKS AND FINANCIAL

SERVICES

CLASS 1 & 2

Dr. Deepak Tandon

 PART 1

MANAGING BANKING AF
FINANCIAL SERVICES –

CURRENT ISSUES AND FUTURE

CHALLENGES
 GLOBAL FINANCIAL SYSTEM – CURRENT
01
ISSUES

Global financial crisis has spared no country.

The term ‘paradigm shift’ being applied to banking as well.

Causes of Crisis
Three groups of mutually reinforcing factors were contributing to
increased ‘systemic’ risk.
1. Lower interest rates caused by worldwide macroeconomic imbalances.
2. Changing structure of financial sector and rapid pace of financial
innovation.
3. Failure to adequately regulate highly leveraged financial institutions.
 02 UNDERSTANDING THE LINKAGES

The Role of ‘Trust’ in Financial Stability

There was a massive breakdown of trust across the entire financial
system – banks, non-banks, central banks, regulators, credit rating
agencies, brokers, dealers, traders etc.

The Role of Regulation in Ensuring Financial Stability

It is of paramount importance to have robust financial regulation in each
country based on effective global standards for financial stability in
future.
 02 UNDERSTANDING THE LINKAGES

Areas requiring immediate attention:

1. Deciding which institutions and practices should be regulated.
2. Understanding procyclical practices – when there is an economy
downturn, banks become wary and tighten lending standards and pull back
liquidity.
3. Information gaps about risk and where they were distributed in the
financial system.
4. Lack of cross border information flow and co-operation among regulators
in various countries.
5. Provision of liquidity by regulators in the event of crisis.
 03 OBJECTIVES OF FINANCIAL REGULATION

Objectives of financial
regulation

Objectives of financial
Consumer Protection
regulation

Macro Micro Wholesale Retail

systemic risk systemic risk markets markets
04 TOOLS OF FINANCIAL REGULATION

Regulation
of business
entities

Regulation
Financial Regulation
of business Special tools
Tools
entities

Regulation
of business
entities
 04 TOOLS OF FINANCIAL REGULATION

According to IMF, financial regulation can be done using four broad

tools:
1. Prudential regulation typically sets out regulatory prescriptions for
maintaining capital or liquidity or credit quality. The regulation
seeks remedial action.
2. Specialized tools in the hands of central banks and other regulators
are the role of ‘lender of last resort’ (LOLR) or deposit insurance.
3. Regulation of payment and settlement systems is vital for ensuring
post trade transactions in financial contracts are managed well.
4. Business regulation aims to regulate activities of financial market
participants through regulation of trading activity and financial
market products.
 05 INDIAN FINANCIAL SYSTEM – AN OVERVIEW

The Indian financial system has two important segments:

• The financial markets
• The financial intermediaries

Indian financial system has matured since the financial reforms were
instituted. There is a reasonably sophisticated and robust system delivering
a diverse range of financial services, efficiently and profitably.

With deregulation, the operational and functional autonomy of financial

institutions has increased and so has their participation in various financial
market segments in the face of heightened international competition.
 06 CHARACTERISTICS OF FINANCIAL MARKETS

Depth of market in
Type of market Purpose Operators Typical regulator Regulator in India
India

Banks, government,
Reserve Bank of India
mutual funds, financial
(RBI) (under clause 45
Money market Short-term finance institutions, insurance Central bank Reasonably deep
(W) of RBI
companies and
Amendment Act, 2006)
corporate companies
Equity markets and its
SEBI - under SEBI
Companies, banks, related derivative
Act, 1992; Securities
financial institutions, Capital market segments are quite
Capital market Long-term finance Contracts (Regulation)
mutual funds and regulator deep and liquid, But
Act, 1956 and
exchanges corporate bond market
Depositiories Act, 1996
is quite shallow
Companies, banks and
Foreign exchange Foreign currency Quite developed and
authorised dealers Central bank RBI
market operations deep
(AD)
Government securities Short and long-term Government, banks and Well developed and
Central bank RBI
market finance primary dealers deep

Banks, financial Reasonably well

Short and long-term institutions, and non - developed, except,
Credit market Central bank RBI
finance banking financial except credit
institutions derivatives market
 REGULATORY STRUCTURE OF THE INDIAN
07
FINANCIAL SYSTEM

RBI
Board for payment and
settlement systems (BPSS)

Board for financial supervision

(BFS) SEBI

IRDA
Stock Exchanges, FIIs, stock
brokers, venture capital funds

Pension funds regulatory and

development authority
(PERDA)
08 THE COMMERCIAL BANKING SYSTEM

Public sector
banks

Regional Private
Commercial banks
rural banks sector banks

Foreign
banks
 08 THE COMMERCIAL BANKING SYSTEM

Public Sector Banks

At end of march 2009, there were 27 public sector banks in India,
comprising of SBI and its six associate banks and 20 nationalized banks
(including IDBI Bank Ltd.)

They are regulated by statutes of Parliament and some important and some
important provisions under Section 51 of the Banking Regulation Act,
1949.
 08 THE COMMERCIAL BANKING SYSTEM

Private Sector Banks

At end of march 2009, there were seven new and 15 old private sector
banks operating in India.

The broad underlying principle in permitting the private sector to own and
operate banks is to ensure that ownership and control is well diversified
and sound corporate governance principles are observed.
 08 THE COMMERCIAL BANKING SYSTEM

Foreign Banks
Foreign banks are required to invest an assigned capital of USD 25 million
upfront at the time of opening their first branch in India.

They can operate in India in one of the following three ways:

1. Through branches,
2. Through wholly owned subsidiaries and
3. Through subsidiaries with maximum aggregate foreign investment of
74 per cent in a private sector bank.
 08 THE COMMERCIAL BANKING SYSTEM

NBFCs
The ‘financial institutions’ (FIs) fall under the category of ‘non banking
financial institutions’ (NBFI)’.
The two major categories of NBFCs in India are the deposit taking (NBFC-D)
(from the public) and non deposit taking (NBFC-ND) NBFCs.

RBIs Panel for financial regulation and supervision classifies NBFCs into
another set of broad categories
1. Stand-alone NBFCs
2. NBFCs that are subsidiaries/associates/joint ventures of banking
companies
3. NBFCs and banks under the same parent company, i.e., ‘sister companies’
4. NBFCs that are subsidiaries/associates of non financial companies
08 FINANCIAL INSTITUTION STRUCTURE

All India FIs

– Exim
Bank,
NABARD,
NHB, SIDBI

Investment
Other public
Financial Institutions institutions
FIs
- LIC, GIC

State level
Fis – SFCs,
SIDCs
 ALTERNATE ORGANISATIONS FOR FINANCIAL
08
CONGLOMERATES

Financial
conglomerate –
alternate models

Holding
Universal Operating subsidiary
company
bank model model
model
 PART 2

MONETARY POLICY –

IMPLICATIONS FOR BANK

MANAGEMENT
 01 A MACROECONOMIC VIEW

The primary objective of a country’s government is to achieve economic

stability and growth.

Macroeconomic policies will target and monitor three basic indicators:

• Prices
• Employment
• Balance of payments

Fiscal policy targets two major parameters: tax receipts and government
expenditure.
 VITAL PARAMETERS THAT DETERMINE
02
LIQUIDITY AND CAPITAL FORMATION IN THE
ECONOMY

Strategic Operating targets

Instruments –
intermediate • Reserve
Strategic goals of Reserve
targets money
monetary policy requirements,
• Money • Interest rates
• Price stability bank/discount
supply • Exchange
• Economic rate, open
• Inflation rate rates
growth market
• Exchange • Volume of
operations
rate credit
 03 MONEY SUPPLY

Money Supply is the total quantity of money in the economy.

It is defined as the currency in circulation in the economy plus demand
deposits with banks.

Measuring Money Supply

There are three broad measures economists use when looking at the money
supply:
1. M1, a narrow measure of money’s function as a medium of exchange
2. M2, a broader measure that also reflects money’s function as a store of
value
3. M3, a still broader measure that covers items regarded as close substitutes
of money.
 CENTRAL BANK TOOLS TO REGULATE MONEY
04
SUPPLY

Most central banks use three primary tools to influence money supply in the
company.

1. First, the central bank determines ‘reserve requirements’

2. The second tool is the ‘discount rate’ or ‘bank rate’
3. The third, and in many cases, the most important tool of the central bank is
‘open market operations’ (OMOs).
 OPERATION AND IMPACT OF THE THREE
04
TOOLS OF MONETRAY POLICY

Expected impact on
Expected impact on Expected impact on
Central bank action monetary base/
banks money supply
money multiplier
Borrowings by banks Monetary base Money supply
Increase discount rate
decrease decreases decreases
Borrowings by banks Monetary base Money supply
Decrease discount rate
increase increases increases
Increase reserve Money multiplier Money supply
Higher leakage
requirements decreases decreases
Decrease reserve Money multiplier Money supply
Lower leakage
requirements increases increases
Monetary base Money supply
Open market purchases Injection of liquidity
increases increases
Monetary base Money supply
Open market sales Absorption of liquidity
decreases decreases
 THE IMPACT OF OMOs ON OTHER TOOLS OF
05
MONETARY POLICY

OMOs can typically be conducted in an ‘active’ or ‘passive’ manner.

Under active OMOs, the central bank aims at a predetermined quantity of
reserves, and allows the interest rates (the prices of these reserves) to fluctuate
freely.
This approach is typically used in countries where the interbank or secondary
markets are less efficient.

However, when OMOs are used as a primary policy instrument, the use of
other instruments, such as discount (bank) rate and the CRR, becomes more
selective and restricted.
 06 MONETARY RATIOS

1. The reserve ratio can be measured as = (reserves/bank’s demand

liabilities), where the bank’s reserves would be the total of the cash that
banks hold in their vaults and their deposits with the central bank, and
bank’s demand liabilities would include all deposits payable on demand
and travelers' cheques.
2. The currency ratio can be measured = (currency in the hands of the
public/bank’s demand liabilities), where the currency can also be
calculated from the central bank financial statements as the ‘monetary
base’ less ‘bank reserves’.
3. The money multiplier for ‘narrow money’ can, therefore, be measured as =
(M1 or narrow money/bank’s demand liabilities as defined in [1] above).
4. Similarly, taking into account time liabilities and other components of
‘broad money’ would enable us to calculate the money multiplier for broad
money.
 OTHER FACTORS THAT IMPACT MONETARY
07
BASE AND BANK RESERVES

The central bank can change the monetary base deliberately through any of the
tools described.

However, monetary base can also change due to other factors as well without
intervention by the central bank. Such factors could be:

1. Refinance or Discount windows.

2. Securitization.
3. Foreign exchange transactions.
4. Central Bank ‘Float’.
5. Defensive open – market operations.
 08 MEASURING MONEY SUPPLY IN INDIA

Four measures of money supply termed ‘new monetary aggregates’, are being
complied in India on the basis of banking sector’s balance sheet, in conformity
with the norms of progressive liquidity: M0 (the monetary base), M1 (narrow
money), M2 and M3 (broad money).

M0 constitutes ‘reserve money’ maintained by banks with the central banks

under the fractional reserve banking system. In specific terms, M0 is measured
as follows:

M0 = currency in circulation + bankers’ deposits with the RBI + ‘other’

deposits with the RBI.
 08 MEASURING MONEY SUPPLY IN INDIA

The concept of ‘narrow money’ is similar to that adopted by other countries

and is represented as follows:

M1 = currency with the public + demand deposits with the banking system +
‘other’ deposits with the RBI.

restated,

M1 = currency with the public + current deposits with the banking system +
demand liabilities portion of savings deposits with the banking system +
‘other’ deposits with RBI.
 08 MEASURING MONEY SUPPLY IN INDIA

The components of M2 and M3 are as follows:

M2 = M1 + time liabilities portion of savings deposits with the banking system + CDs
issued by banks + term deposits (excluding FCNR(B) deposits) with a contractual
maturity of up to and including 1 year with the banking system.

restated,

M2 = currency with the public + current deposits with the banking system + savings
deposits with the banking system + CDs issued by banks + term deposits (excluding
FCNR(B) deposits) with a contractual maturity of up to and including 1 year with the
banking system.

and,

M3 = M2 + term deposits (excluding FCNR(B) deposits) with a contractual maturity

of over 1 year with the banking system + call borrowings from non depository
financial corporations by the banking system.
 08 MEASURING MONEY SUPPLY IN INDIA

The following points need to be noted:

1. Currency with the public includes notes and coins of all denominations
in circulation, but excludes cash in hand with banks.

2. Demand deposits with the banking system implies demand deposits

with commercial and co-operative banks, but excludes interbank
deposits.

3. ‘Other deposits’ with the RBI include current deposits of foreign

central banks, financial institutions and quasi – financial institutions
operating in India, and others such as the IMF and the IBRD.
 OPERATION OF RESERVE REQUIREMENTS IN
09
INDIA

It is obvious that reserve requirements are mandatory if the liquidity in the

banking system is to be preserved, and if even a single instance of default
in repayment to depositors is to be avoided.

There are legal reserve requirements under Section 42(1) of the RBI Act,
1934, stipulating that banks maintain a CRR on their liabilities. In addition,
banks are bound under Section 24 of the Banking Regulation (BR) Act,
1949, to maintain a portion of these liabilities in cash or near cash form,
termed the statutory liquidity ratio (SLR).

CRR is maintained as cash reserves, while the SLR is maintained in liquid,

near cash instruments.
 10 NET DEMAND AN TIME LIABILITIES

Bank liabilities can be broadly classified into external and internal

liabilities. While equity, reserves and provisions are the internal liabilities,
external liabilities are those that the bank owes to outsiders. External
liabilities can be further classified into ‘liabilities to the bank system’ and
‘liabilities to others’.

NDTL is broadly those liabilities of banks in India, which have been

sourced from the ‘banking system’ and ‘others’. It is to be noted that
liabilities of overseas branches will be excluded since these branches
operate under the jurisdiction of the countries in which they are located.
 11 OPEN MARKET OPERATIONS IN INDIA

In order to tackle uncertainty in financial markets, the RBI, in the late

1990s decided to accept private placement of government securities with
the purpose of offloading them into the market through active OMOs.

This measure effectively met the large borrowing requirements of the

government, without putting pressure on interest rates and paved the way
for RBI to use the bank rate, repo rate and the reserve requirements in
conjunction with the OMOs for meeting short – term monetary policy
objectives.
 11 OPEN MARKET OPERATIONS IN INDIA

The Liquidity Adjustment Facility (LAF), introduced in 2000, operates

through repos and reverse repos to set the corridor for money market
interest rates. Both repo and reverse repo rates are fixed by the RBI, with
the spread between the two rates determined by the central bank based on
market conditions and other relevant factors.

The LAF has settled into predominantly a fixed rate overnight auction,
though repo auctions can be conducted at variable or fixed rates for
overnight or longer terms.

The move towards indirect instruments of monetary control (the CRR, e.g.,
is a direct instrument of monetary control) has provided greater flexibility
to the regulator, not only in fixing and adjusting policy rates, but also in
monitoring them on a daily basis.
 REPO MARKET INSTRUMENTS OUTSIDE THE
11
LAF

1. Collateralized borrowing and lending obligations

Under the CBLO, participants can lend and borrow funds, against security
of government securities, including treasury bills, for maturity periods
ranging from 1 to 90 days (with flexibility up to 1 year).

2. Market Repo

From 2003, non-banking financial companies, insurance companies,

housing finance companies and mutual funds could access the repo
markets, and later-on, scheduled urban co-operative banks and listed
companies with gilt accounts with scheduled commercial banks were also
permitted to transact in this market.