DEFINITION OF BANKS

Section 2 Banking Act 2004 of Mauritius.

Siv. D. M. Potaya writes « Une banque peut
être définie comme une entreprise qui
reçoit des fonds qui rapportent des
intérêts au public, en avance, escompte
des effets, faciliteles paiements par des
prêt’ ».
 Definition of ‘Bank’
 A simple definition that may be proposed is that ‘a bank is
an institution whose current operations consist in attracting
deposits and granting loans to the general public in return
for interests paid and charged respectively.
 Several theories have tried to explain the existence of banks
in the economy. These theories range from certain concepts
such as: monitoring commissioning, information processing,
liquidity transformation, linearization (smoothing) of
consumption and commitment method.
 Types of Banks (II)
Types
Types of
of Banks
Banks

Commercial
Commercial Central
Cooperative
Cooperative Banks
Banks Central
Banks
Banks Bank
Bank

Central
Central Public Private Foreig
Primary
Primary State
State Public Private Foreig
Coopera
Coopera
Credit
Credit tive
Cooperative
Cooperative Sector
Sector Sector
Sector nn
societies tive Banks Banks Banks Banks
societies Banks Banks Banks Banks Banks
Banks
 Examples of banking activities
 Retail banking same as commercial banking [ 22 in Mauritius as
@ 2015]
 Cooperative Banks [ The MPCB with its branches in Lallmatie
and Port- Louis] [Demise of MPCB & birth of MAUBANK.

 Credit Unions [ 29 cooperative credit unions with total assets

>Rs 20 M, granted licence under section 14E of the Banking Act
2004].
 Financial Houses not allowed to collect deposits.
 Private Banking . 2 banks : Warwyck Private Bank Ltd and
Banque Richemount Limited, which are the first stand-alone,
full-fledged private banks to be licensed in Mauritius.
 Corporate Banking & Investment Banking
Evolution of Money as legal tender
 (a) Barter system where different kinds of
goods used for exchange – axe for goat woods
for bull etc.
 Salt considered as medium of exchange in
primitive society.
 Money not a myth- it is tangible and has value
attached to it.
 Use of paper money appeared first in China.
 What is money
 (a) Money acts as a social pimp between two
people who are at different poles.
 (b) Money as a unit must be generally
acceptable and readily tradeable.
 (c) Kinds of money: (i) plastic money; (ii)
intangible money in terms of High Frequency
Trading (HFT); (III) Bitcoins as a new
monetary unit developed by Satoshi Nakmoto
in Japan.
Functions of Money (I)
 (a) Micro-economic functions:
 Unit of account (abstract)
 Common measure of value (abstract)
 Medium of exchange (concrete)
 Means of payment (concrete)
 Standard for deferred payments (abstract)
 Store of value (concrete)
Functions of Money (II)
 Macro-economic functions:
 Liquid asset
 Framework of the market allocative system
(prices)
 A causative factor in the economy
 Controller of the economy
Invention of Banking (I)
 Traced from Ancient Mesopotamia where
Royal palaces and temples provided secure
places for safe-keeping of grain and
commodities.
 Theory of banking found its root in the process
that could be termed as deposit taking and
dealing with commodities with a view to
creating and consolidating confidence among
people.
Invention of banking (II)
 Banking is aged-old phenomenon rather than a
theory. ‘Banking’ is said to be derived from the word
‘bench’. The Jewish money-changers on Lombardy, a
district in North Italy used to do their business sitting
on a bench in the market place.
 ‘Bank’ can also be traced back to the German word
‘Banck’ and Italian word ‘Banco’ which means heap of
money.
 In India the banking concept can be traced from the
Vedic periods. There were bankers known as Sheth,
Shah, Shroff or Chettiar, who were performing the
functions of banks.
 Islamic Banking Based on
Islamic beliefs & morals

●
Murabaha
●
Ijara refers to leasing
makes about 10 %
[75%]financing on allows customer to
short term basis buy assets
Century
Century Purely
PurelySharia
Sharia
Banking
Banking Law.
Law.Islamic
Islamic
Corporation
Corporation Mirofinanace
Mirofinanace
Ltd
Ltdin
in or
orGrameen
Grameen
Mauritius bank
bank
Mauritius
Islamic
Islamic
CentralShar
CentralShar Financial
iaiaBoard Financial
Boardfor
for Services
Islamic Services
Islamic Board
banks. Board based
based
banks. in
inMalaysia.
Malaysia.
●
Salam is a futures ●
Muqarada [bonds
contract Buyer pays that help the bank
at earlier date. to generate funds
Central Bank

●
Steps taken to
accommodate money
Mone supply .
Mone
tary
●

●
Sole right to issue currency
OMOs, Discount Windows,
tary
Policy Reserve Requirements.
Manager of foreign
Policy
●

exchange.

●
All deposit-taking
Sections 5
&50 Bank
institutions are
Sections 5
of
&50 Bank licensed
Mauritius
Act 2004
of
Mauritius
●
Prudential norms
Act 2004
imposed on banks.

●
Part III of the Act deals
Bankers with Capital Structure,
Bank
Bankers Reserve Account & other
[Banking
Bank financial provisions.
Act[Banking
2004] ●
Basel I-III Compliance
Act 2004] necessary
 Managing Banks
Complia
nce with
relevant
Acts +
Basel
Require
ment

Soundness
of banks

Internal
regulati
ons and
Business
related
concepts
 Profit maximization objective
 It is one of the objectives not the only
objective of banks,
 Main tool for realising the objective is
Asset –liability Management:
 Asset management ensures the
diversification of portfolio of asset classes
and caters for its low risk nature.
 Liability management is concerned with
the raising of funds at minimal costs.
 Asset-Liability
Management
Asset
Liability Management
Management
Return Risk Provision of Return
Cost of deposit
maximizati mitigatio adequate maximization in the
on on loans n liquidity interbank market minimization
Asset -liability Management

Refers to the decision making process

& requires great coordination between
available finance and investment.

Provides opportunity for

enhancement of Net Worth not
necessarily focussing on risk evasion.

Need for a combined asset and

liability duration to get an
indication of interest elasticity.

Securitization is a process of
obtaining funds directly,
which helps mitigate risks
Liability Management& Capital Adequacy
Management
 Liquidity is the capacity to generate funds in assets
and is considered as one of the main activities of the
banks.
 The Capital Adequacy Management is achieved when
worked in accordance with the Basel 2 Accord.
 The Basel 2 Accord focused on three pillars namely,
market discipline, revised supervision and Minimum
Capital requirements.
 One of the objectives of Internal Capital Adequacy
Assessment Process (ICAAP) is to find out the
economic capital required to eliminate all risks.
 ICAAP

ICAAP

Allocation of
Capital

Identificatio
Audit
n of Risks

Stress Planning of
Testing Capital
 Basel I,II &III Compliance
 The Basel Committee on Banking Supervision
[BCBS] was created as a Committee of banking
supervisory authorities of the G-10 countries.
 Basel I sets out the minimum capital
requirement of financial institutions with the
goal of minimizing credit risks.
 Banks that operate internationally are required
to maintain a minimum amount of 8% of their
capital (Tier I & Tier 2) on a percentage of
risk-weighted assets.
 Basel I,II &III Compliance [continued]
 Basel II comprises 3 Pillars.
 First Pillar deals with minimum capital
requirement.
 Second Pillar deals with supervisory
approach whose aim is to encourage
banks to develop better methods to
measure and manage the various risks.
 Third Pillar deals with disclosure
requirements and recommendations for
banks.
 Basel I,II &III Compliance [continued]

 Basel III proposed as a standard regulation for the

global banking system as a response to the recent
banking crisis. It is also divided into 3 Pillars.
 Pillar 1 is on capital reforms. Securitization
strengthens the capital treatment for certain
complex securitizations. It requires banks to
conduct more rigorous credit analyses of externally
rated securitization exposure.
 Pillar II addresses firm-wide governance and risk
management
 Pillar III revised Disclosure Requirements of Basel II
 Managing risks by banks
 The duty of banks is to identify all risks
through the activities carried out by banks
such as market environment, historical
background and business units.
 Risk can be identified through a top-down
or bottom-up approach.
 Management of Off Balance Sheet activities
essential in limiting risks. [E.g. of these
activities Futures, Options, Forwards,
hedging].
 The risks include – Market risks, Credit
Risks, Operational Risks.
 A balance2sheet
Lecture is a financial
– deals report that
with three shows the
chapters.
value of a company's assets, liabilities, and owner's
equity at aBank
specific Balance Sheet
period of time, usually at the end
of an accounting period.
 An asset is anything that can be sold for value.
 A liability is an obligation that must eventually be
paid, and, hence, it is a claim on assets.
 The owner's equity in a bank is often referred to as
bank capital, which is what is left when all assets
have been sold and all liabilities have been paid. The
relationship of the assets, liabilities, and owner's
equity of a bank is shown by the following equation:
Bank Assets = Bank Liabilities + Bank Capital
 Funds in banks
 Debt issues which is obtained from loans
and bond issues
 Companies in the form of corporate
deposits
 Interbank deposits
 Retained earnings
 General public as retail deposits.
 Interbank market – where shortage of
liquidity is met by market loans which are
extremely liquid.
 Examples of Assets of Banks
 Negotiable time drafts, bills of exchange
mainly used to fund imports, shipment
and export are liquid assets.
 Advances in the form of loans form the
primary component on the asset side.
 Investments are also a prime component
on the asset side [ comprises of securities].
 Non-deposit assets:- (a) Accrued amounts
receivable; (b) Items in suspense and
collection
 Examples of liabilities
 Notes outstanding and cash-loaded cards
in possession of banks.
 Deposits – time deposits and sight
deposits.
 Non-deposit liabilities:- (a) net derivatives;
(b) items in suspense and transmission; (c)
accrued amount payable.
 Equity Capital of banks
 Equity capital represents the ownership
interest of a company. Assets - Liabilities =
Equity capital.
 The higher the level of capital the more
the bank is secure.
 Banking risk management
 Management of risk especially in banking business
is undoubtedly one of the most important activity.
Risk management helps in boosting financial
stability and economic development.
 Risk management is carried out internally in the
bank and aims at both effectiveness and efficiency.
 Rate of return and risk are directly related.
 Behavior of a bank can be monitored by banks by
making use of CAMELS ratings.
 Risk Management differs from Risk Measurement.
 Risk measurement focuses on methods by which
risk can be quantified. The former deals with
strategy to mitigate the risk.
 Credit risk management
 The most common type of risk in the banking system.
There is a risk of not meeting obligations on due date
by counterparty
 Credit risk aims at a maximization of the rate of return
that has been risk-adjusted.
 Credit risk arises due to non-repayment of loans such
as Non-Performing Loans.
 Criticism associated with credit risk management –
size of loan is not the yardstick as there are also
aspects such as the quantity of risk and the nature of
risks. What are needed to build a more liquid and
transparent market:- Credit derivatives business
revision; expanding securitized loan and secondary
loan trading market; management of the features of
a debt fund in a more effective way.
 The lending function
 It aims at a minimization of the default risk
and the maximization of the loan value.
 The loan is priced using the formula :
RL= [(1+r / 1-d) – 1] where RL refers to
profitable loan rate, r= risk-free interest rate
and d= expected default probability.
Banks are also influenced by government
policies at a given period. The availability of
finance depends on the development policies
of government.
Loans categorised as per their risk and also as
per the nature of activities the economy of a
state dictates.
 Interest Risk Management
 Interest rate risk results when there is an
imperfection between the maturities assets and
liabilities.
 Managing interest rate risk implies to reduce the
exposure of interest rate in a bank.
 To cater for interest rate risk management, there
are two approaches for this namely the Gap
analysis and the Duration analysis.
 GAP implies the extent to which interest rate
sensitive assets and interest rate sensitive liabilities
are different over a specific time period.
 If interest rate sensitive assets are less than interest
rate liabilities, the profits generated by a bank will
decline.
 Interest Risk Management
 GAP formula: GAP = Rate –sensitive
assets – rate- sensitive liabilities. [ known
as the interest sensitivity ratio].
 Criticisms of the Gap analysis:
 The market value effect is ignored
 Intra-bucket effects are not accounted
 Pre-payment risk of a bank’s exposure is not
considered
 Spreads between the interest rates are ignored
 Interest Risk Management
 Duration analysis: implies the lifespan of the cash flow
of an asset on average. It is the weighted average of
coupon payments by considering their maturities. In the
case of zero coupon bonds, maturity equals duration.
 Duration Gap = [ DA – L/A (DL) ] where a= market
value of assets , L = market value of liabilities , D A=
duration of assets , DL= duration of liabilities and L/A=
leverage ratio.
 Criticisms of Duration analysis:
 Data requirement cause a problem
 Convexity where the relationship between changes in
equity and interest rate is linear. However, in real
transactions, there is a convex relationship.
 Durations focuses merely on re-pricing risk and ignores
interest rate risk.
 Liquid risk management
 Liquidity risk arises when the bank is not able
to meet its liabilities because the withdrawals
are higher than normal. If liquidity problems
persist, the bank will not be able to borrow
funds from the interbank market.
 A sound liquidity status in a bank is
primordial as:
 it does not allow borrowing from the Central
bank
 assets are not forced to be sold out
 it is an indication of a good management
 it can welcome any lending commitments
 Liquid risk management
 The techniques adopted for a liquidity risk
management:
 liquidity gap analysis and financing gap
 scenario analysis
 cash flow projections of daily liquidity sources
and positions
 By minimizing volatility ratio, the
liquidity position can be maintained:
VR= (VL –LA) / (TA –LA)
Where VL refers to volatile liabilities, LA =
liquid assets and TA = Total Assets
 Market risk management
 Market risk is the result of unfavorable
volatilities of market prices with respect to their
interest rate weapons, currencies, equities etc.
 Calculated as the gains or losses in a portfolio
due to a price movement at a stated probability
with a given time interval.
 Two approaches that deal with market risk
management are the Risk- Adjusted Return on
Capital and Value-at-Risk [VaR ]. The former
measures the risk obtained during each
activity. It is computed as follows:
RAROC= (Revenues – Cost – Expected losses)
/Total equity Capital
 Market risk management
 [VaR] is the maximum loss that can be
borne within a given time interval at a
stated confidence level. The assumptions
of VaR are as follows: normal distribution
of prices of the financial weapons; stable
volatility of the changes in price; statistical
un-correlation of changes in prices
 Three ways of conducting VaR:
Variance – Covariance methods
Historical methods
Simulation approaches
 Country Risk Management

 Country risk crops up when unfavorable

circumstances happen in economic, political or
social sector and they impact on a firm’s financial
interests.
 In banking, country risk is associated to a loss that
arises when cross-border lending occurs. Transfer
risk in one type of risk that encourages country
risk.
 Factors affecting country risk:
 GDP growth and inflation levels
 International reserves level
 Size and structure of a country external debt with
respect to its economy.
 Country’s access to financial markets on an
international basis
 Country Risk Management
 How to manage country risk?
(a) Monitoring of country’s conditions on a
regular basis.
(b) Country risk rating system.
(c) Effective oversight by managers – constant
study of the operations of international banks
required.
(d) Appropriate risk management policies and
procedures
 Bank regulation
 Why regulation – Sound financial system is the
prerequisite for political and social stability in a
state. Social costs of bank failure exceed private
costs.
 Bank regulations carried out by the Bank of
Mauritius Act and the Banking Act 2004.
 Briefly, the four main reasons for bank regulations
are:
 Monetary policy : The ability for credit creation
 Credit allocation : The channel of credit and
investments
 Prudential regulation : operators of payment
mechanisms, depository of private savings
 Competitions and innovations - to avoid cartels
 Types of regulation
 Systemic regulation - through the deposit
insurance arrangements and the lender-of-last-
resort functions.
 Prudential regulation - monitoring and control of
financial institutions especially to asset quality
and capital adequacy.
 Conduct of business regulation - ensures that
there is honesty, competence and fair business
practices.
 Approaches to bank supervision - Information
disclosure; Self-regulation through internal,
external audit and board audit committees;
Government bank examination; & Deposit
guarantee scheme.
 Objectives of bank supervision
 Promotion and development of a diverse
range of financial services as per the needs of
the economy
 Efficiency and security of banks
 Compliance with the laws and regulations
 Match between bank behavior and monetary
policy.
 Bank Regulation process: Minimum capital
requirements : Fit and proper personnel :
persons with criminal or bankruptcy
backgrounds should not be taken. Ownership
limits : not more than 5 per cent of total paid-
up capital of a bank.
 MONETARY CONTROL INSTRUMENTS
Definition: Monetary policy is associated with macroeconomic
policy that the central bank of a country undertakes to achieve
macroeconomic objectives like inflation, consumption, growth and
liquidity. Monetary policy of the central bank is aimed at
managing the quantity of money in order to meet the requirements
of different sectors of the economy and to increase the pace of
economic growth.
Among the main functions of the central bank include:
(i) Formulation and implementation of monetary policy; (ii)
Issuer of currency; (iii) Banker to the Government and to banks
(iv)Provider of an efficient payment, settlement and clearing
system; (v) Management of the public debt; (vi) Management
of foreign exchange reserves; (vii)Regulator and supervisor
of banks
(viii) Adviser to the Government on financial matters.
 Instruments of monetary policy
 Two types of instruments of monetary policy.
 (1) Quantitative Instruments or General Instruments –
related to the quantity or volume of money.
 (2) Qualitative Instruments of Selective Tools – not
directed towards the quality of credit or the use of the
credit. Used for discriminating between different uses
of credit.
 General tool of credit control include: Bank Rate Policy;
Open Market Operations; Variation in the Reserve
Ratios;
 Qualitative Instruments or Selective Tools include;
Fixing Margin Requirements; Consumer Credit
Regulations; Publicity; Credit Rationing; Moral
Suasion; Control Through Directives; Direct Action
 Objectives of Monetary Policy
 The following are the principal objectives of monetary
policy:
(1)Full Employment - Every government aims at
making use of existing potential to maximize output.
(2)Price Stability:- Fluctuations in prices bring
uncertainty and instability to economy.
(3)Economic Growth:- process whereby the real per
capita income of a country increases steadily.
(4)Balance of Payments:- maintaining equilibrium
in the balance of payments and assuring constant
availability of foreign exchange.
 Monetary Control Instruments
 Some conventional elements that are present in a
monetary control system:
(1)Direct controls on interest rates;

(2) Bank credit ceilings;

(3)High reserve and liquid asset requirements;

(4)Refinance facilities to direct credit to private sectors.

 Monetary Policy Committee[ Mauritius]
 Ss(54) &(55) Bank of Mauritius Act 2004 establish the
Monetary Policy Committee.
 Set up in 2007 it formulates and determines the
monetary policy to be conducted by the Bank and to
maintain price stability.
 It meets on a quarterly basis & the Governor of the
Bank is the Chairperson.
 Responsible for coordinating between monetary and
fiscal policy.
 Market-based Monetary Control
 Aims at controlling the stock of reserve money through:

(1)Open Market Operations: sale and purchase of securities in the

money market by the central bank. When prices are rising and
there is need to control them, the central bank sells securities. The
reserves of commercial banks are reduced and they are not in a
position to lend more to the business community.

Further investment is discouraged and the rise in prices is checked.

Contrariwise, when recessionary forces start in the economy, the
central bank buys securities. The reserves of commercial banks are
raised. They lend more. Investment, output, employment, income
and demand rise and fall in price is checked.
 Indirect Policy Tools
 Aiming at altering liquidity conditions they are:

 Reserve requirements ;
 secondary reserve requirement;
 cash reserve requirement, also called primary reserve
requirements;
 securities requirement ;
 BANK INSOLVENCY

Bank’s insolvency can be defined in two different

ways:- (1) its inability to pay its own debt; (2) it
cannot pay its debts when they fall due.
The question is always asked whether a bank can be

insolvent as it can print money pay its own debts

easily.
That is not so easy an answer as banks are regularly

supervised by the Central Bank in their operations.

An example of bank’s insolvency may be illustrated

as follows [see next slide].

 Causes of Bank Insolvency
 Depth and extent :percentage of the assets which are found to be
damaged exceeds 30.
 Negative net worth : a high composition of assets that are lost as
well as non performing loans both found in on-balance sheet items
and off-balance sheet items.
 No disclosure :Negative net worth and losses are common but they
are not recorded in books of the banks
 Disproportion in operational costs: Operational costs exceed
excessively the size of the business
 Deterioration of portfolio: state of the loan portfolio aggravates due
to perverse choice of borrowers characterized by high lending rates
 Increase in lending rates
 Soar in deposit rates:
 Unsound corporate culture: The corporate culture is one which
bears no match with sound banking
 Causes of Bank Insolvency
 Mismanagement: is the result of an ineffective supervision
by the bank. Mismanagement can be classified as cosmetic,
technical, desperate mismanagement as well as fraud.
 Inadequate supervision: A poor supervision leads to bank
insolvency. Supervision can be classified in the three
following ways namely; Regulatory framework;
Verification activities
 Political interference :In those banks that are owned by the
state, lending activities are influenced by several factors
such as political, social or developmental objectives
 Reserve requirements: High reserve requirements are
imposed with the view to verify inflation and make a
regulation in the monetary flows
 Implications of Bank Insolvency
 Demonetization and capital: the act of
stripping a currency unit of its status as legal
tender.
 High interest rates: Banks would be under
pressure to increase interest rate in order to
lure deposits.
 Fiscal and Monetary distortions.
 Solving bank insolvency
 Addressing the problem through regulation [no
excessive regulation required where government is
willing to encourage more capital mobility].
 Disclosure of financial information.
 Government verification required
 External auditing
 Prudential regulation through central banking and
statutory requirements: - (a) access to market
controlled; (b) capital adequacy imposed; (c. easy the
legal procedures for recovery of loans; (d) enforcement
powers to authorities or regulators; (e) purchase of new
assets.
 Bank insolvency & the Banking Act
 Part IX of the Banking Act 2004. S(65).
The central bank may appoint a conservator where it deems it
necessary in order to protect the assets of a financial institution for the
benefit of its depositors and other creditors,
The bank must have reasonable cause to believe that -
(a) the capital of the financial institution is impaired or there is a threat
of such impairment; or
(b) the financial institution has, or its directors have -
(i) engaged in practices detrimental to the interests of its depositors;
(ii) knowingly or negligently permitted its chief executive officer, any
of its other managers, officers or employees or agents to violate any
provision of the banking laws, any enactment relating to anti-money
laundering or prevention of terrorism or guidelines and instructions
issued by the central bank; or
(c) actions or violations referred to in paragraph (b)(ii) are about to
occur, or the assets of the financial institution are not sufficient to give
adequate protection to the bank’s depositors or creditors.
Part X Banking Act [voluntary liquidation]
 S 70 BA: Authorization of the Board is required to go
for voluntary liquidation. [Board of Directors of the
central bank].
 It will depend on the Board whether to a authorize or
not, based on s70 (2) of the Act.
 S72 concerns the distribution of assets where voluntary
liquidation is authorized. The rights of depositors or
other creditors is not prejudiced.
 In case of insufficient assets the Bank will appoint a
receiver to take possession of the financial institution
and commence proceeding leading to compulsory
liquidation.
Compulsory liquidation[Banking Act]
Part XI of the Act.
S(75) reads: The Board shall, notwithstanding any other
enactment, appoint any person as receiver to take
possession of a financial institution where -
(a) the capital of the financial institution is impaired or its
condition is otherwise unsound;
(b) the ratio of its capital to total assets is less than 2 per cent;
(c) the business of the financial institution is being conducted
in an unlawful, unsafe or unsound manner;
(d) the continuation of the activities of the financial
institution is detrimental to the interests of its depositors;
(e) the licence of the financial institution has been revoked
 SETTLEMENT OF CLAIMS
S(86) of the Act “ Notwithstanding any other enactment, including the
Code Civil Mauricien, claims as set out hereunder against the
general assets of a financial institution, shall be settled in the
following order of priority -
(a) necessary and reasonable costs, charges and expenses incurred by
the receiver, including his remuneration, in application of this
Part;
(b) wages and salaries of officers and employees of the financial
institution in liquidation for the 3-month period preceding the
taking possession of the financial institution;
(c) taxes, rates and deposits owed to the Government of Mauritius;
(d) savings and time deposits not exceeding in amount 100,000 rupees
per account;
(e) other deposits; (f) other liabilities.