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NBFCs DFIs Sector Sector
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(Equity,
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Debt & various
MF units,
combinations)
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• Depositories
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• Portfolio Management
• Underwritting
KEY ELEMENTS OF A WELL-FUNCTIONING FINANCIAL SYSTEM
Also, these assets would have been identified as ‘loss assets’ by the bank
or internal or external auditors or the RBI inspection but the amount
would not have been written off wholly.
PROVISIONING NORMS
Adequate provisioning has to be made for impaired loans or NPAs. Taking
into account the time lag between an account becoming doubtful of
recovery, it’s recognition as an impaired loan, the realisation the security
charged to the bank and the likely erosion over time in the value of this
security, banks should classify impaired loans into ‘sub-standard’,
‘doubtful’. And ‘loss’ assets and make provisions against these.
Loss assets should be written off or 100% provided for.
Doubtful Assets :-
• Provision of 100% to the extent the advance is not covered by the
realisable value of the security (to which the bank has a valid recourse)
• That portion of the advances covered by realisable value of the
security will provided for on the following basis.
• The standing liquidity facilities available from RBI are split into two parts.
1) Normal facility constituting about two-thirds of the limit at the bank rate.
2) Back-stop facility constituting about one-third of the limit at a variable
daily rate, which is linked to cut-off rates emerging in regular LAF
auctions. In the absence of such rates, the back-stop facility will be
linked to NSE MIBOR.
• Minimum bid size for the LAF reduced from Rs.10 cr to Rs.5 cr to
facilitate the participation from small operators.
• In order to provide quick interest rate signals, the RBI has chosen an
additional option for switching over to fixed rate repos on an overnight
basis.
• The RBI also has the option of introducing long-term repos of upto 14
days as and when required. It has introduced, a fortnightly repo auction.
REPOS
• Repo is a useful money0market instrument enabling the smooth
adjustment of short-term liquidity among varied market participants
such as banks & financial institutiions.
• Repo refers to transaction in which a participant acquires immediate
funds by selling securities and simultaneously agrees to the
repurchase of the same or similar securities after a specified time at a
specified price. In other words, it enables collateralised short-term
borrowing and lending through sale/purchase operations in debt
instruments. It is temporary sale of debt involving full transfer of
ownership of the securities. Repo is also referred to as a ready
forward transaction as it is a means of funding by selling a security
held on a spot basis and repurchasing the same on forward basis.
• REVERSE REPO :- It is exactly the opposite of repo – a party buys a
security from anther party with a commitment to sell it back to the
latter at a specified time & price. Here the transaction is repo for one
party and reverse repo for another party. Reverse repo is undertaken
to earn additional income on idle cash. In India, repo transactions are
basically fund management/SLR management devices used by
banks.
• It is also a good hedge tool because the repurchase price is locked in
at the time of the sale itself.
IMPORTANCE OF REPOS
• Repos are safer than pure call money and inter-corporate deposit
markets which are non-collteralised.
• Repos are backed by securities and are fully collateralised. Thus the
counter-party risks are minimum.
• Since repos are market-based instruments, they can be utilised by
central banks as an indirect instrument of monetary control for
absorbing or injecting short-term liquidity.
• Repos help maintain an equilibrium between demand & supply of
short-term funds. The repos market serves as an equilibrium between
the money market and securities market and provides liquidity and
depth to both the markets.
• Monetary authorities can transmit policy signals through repos to the
money market which has a significant influence on the government
securities market and foreign exchange market.
• Internationally it is a versatile and the most popular money market
instrument.
LOAN PRICING
• Interest earned by banks on loans, advances and investments is the
equivalent of revenues earned by a non-financial firm.
• The variable costs for financial product- the loan- are the cost of the
bank’s liabilities. The fixed costs include the transaction servicing
costs plus a portion of the overheads utilised for maintaining and
monitoring the account. The bank’s desired profit margin
corresponds to the profit margin inbuilt into the selling price of a
good or service.
• Therefore, Loan price= Cost of funds + servicing costs + desired
profit margin.
LOAN PRICING MODEL
• Step-I : Arrive at Cost of Funds - The objective here is to ensure
that the loan price covers variable costs. The cost of funds depends
on bank’s sources of funds- deposits or borrowings.
• Step – II : Determine Servicing Costs for the Customer :-
• Identify the full list of services used by the customer. This list would
include services related to the credit and non-credit facilities availed
by the customer. E.g. activity in the demand deposit account
maintained by the customer, usage of security custodial services,
payment related services such as transfers or letters of credit.
• Assess the cost of providing each service.
•Cost of credit services depends on the loan size and forms a major
portion of the servicing costs. They include loan administration
expenses, of which a large share is contributed by personnel,
processing or delivery costs. Most banks calculate these costs as a %
of the loan size.
• Step-III Assess Default Risk & Enforceability of Securities :-
• Based on the risk value assigned to the borrower, banks build models
to assess the probability of default, arising out of the bank’s prior
experience with borrowers having similar risk profiles. The bank then
puts a value to the enforceability and strength of the securities the
bank holds or proposes to hold for the loan.
• Assigning these probabiliities to the loan amount and interest
recoverable, the bank computes the risk premium that will fit the
borrower.
• With probability of default the expected rate would be the aggregate of-
E(r) = P(R) x r + P (D) x {R(P + P r)/P) – 1}
E(r) = Expected rate, P(R) = Probability of recovery, r = Contracted rate of
interest, P(D) = Probability of default, P = Principal amount, R =
Recovery rate in the event of default.
Step-IV Fixing the Profit Margin :-
The approach used to set the profit margin for loan transactions is to
use the ROE which is based on market expectations & shareholders’
required returns. Thus,
ROE = ROA x Equity/Assets.
FIXED VS FLOATING RATES
• When the interest rates are relatively stable and the yield curve slopes
upward, banks would be willing to lend at fixed interest rates, which are
the rates above that is paid for shorter term liabilities.
• In an environment where rates are volatile, and banks have to source
funds from the market at varying interest rates, they would prefer to
lend on floating rates and for shorter maturities. In effect, floating rate
loans transfer the interest rate risk from the bank to the borrower.
Though this appears desirable, it may result in heightened credit risk
for the bank as the rising interest rates increase the borrower’s interest
expense. If it is not met out of operating cash flows or the borrower’s
own funds, may lead to a shortfall in debt service.
• It is evident that most borrowers would prefer fixed rate loans, due to
the predictable cash flows for debt service, and allow the banks to bear
interest rate risk. If the banks want to encourage borrowers to agree for
floating rate pricing, they offer two alternatives.
• In the first alternative,banks may set the floating rate at a level below the
corresponding fixed rate. The bank charges a ‘term premium’ to cover the
risk on fixed rate loans. The size of the discount and the premium will have
to depend on the bank’s cost of funds and required rate of premium.
• In the second, banks set an interest rate cap on the floating rate loans to
limit the possible increase in interest payments. The cap may be
applicable for any interval, or for the entire maturity of the loan. The
borrower pays the negotiated floating rate till the cap is reached. The
inherent risk to banks lies in the market interest rates breaching this cap.
The floating rate structure works well when linked to a reliable benchmark
reference rate, representing the rate structure in the economy. The most
widely used reference rates are the LIBOR and the prime rate in US
markets.