HISTORY OF COMMERCIAL BANKING IN INDIA

Without a sound and effective banking system in India it cannot have a healthy economy. The
banking system of India should not only be hassle free but it should be able to meet new
challenges posed by the technology and any other external and internal factors.For the past
three decades India's banking system has several outstanding achievements to its credit. The
most striking is its extensive reach. It is no longer confined to only metropolitans or
cosmopolitans in India. In fact, Indian banking system has reached even to the remote corners
of the country. This is one of the main reason of India's growth process.

The government's regular policy for Indian bank since 1969 has paid rich dividends with the
nationalisation of 14 major private banks of India

Not long ago, an account holder had to wait for hours at the bank counters for getting a draft
or for withdrawing his own money. Today, he has a choice. Gone are days when the most
efficient bank transferred money from one branch to other in two days. Now it is simple as
instant messaging or dial a pizza. Money have become the order of the day.

The first bank in India, though conservative, was established in 1786. From 1786 till today,
the journey of Indian Banking System can be segregated into three distinct phases. They are
as mentioned below:

 Early phase from 1786 to 1969 of Indian Banks

 Nationalisation of Indian Banks and up to 1991 prior to Indian banking sector
Reforms.
 New phase of Indian Banking System with the advent of Indian Financial & Banking
Sector Reforms after 1991.

To make this write-up more explanatory, I prefix the scenario as Phase I, Phase II and Phase
III.

Phase I

The General Bank of India was set up in the year 1786. Next came Bank of Hindustan and
Bengal Bank. The East India Company established Bank of Bengal (1809), Bank of Bombay
(1840) and Bank of Madras (1843) as independent units and called it Presidency Banks.
These three banks were amalgamated in 1920 and Imperial Bank of India was established
which started as private shareholders banks, mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians, Punjab
National Bank Ltd. was set up in 1894 with headquarters at Lahore. Between 1906 and 1913,
Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank
of Mysore were set up. Reserve Bank of India came in 1935.

During the first phase the growth was very slow and banks also experienced periodic failures
between 1913 and 1948. There were approximately 1100 banks, mostly small. To streamline
the functioning and activities of commercial banks, the Government of India came up with
The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949
as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank of India was vested with
extensive powers for the supervision of banking in india as the Central Banking Authority.

During those days public has lesser confidence in the banks. As an aftermath deposit
mobilisation was slow. Abreast of it the savings bank facility provided by the Postal
department was comparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after independence. In
1955, it nationalised Imperial Bank of India with extensive banking facilities on a large scale
specially in rural and semi-urban areas. It formed State Bank of india to act as the principal
agent of RBI and to handle banking transactions of the Union and State Governments all over
the country.

Seven banks forming subsidiary of State Bank of India was nationalised in 1960 on 19th July,
1969, major process of nationalisation was carried out. It was the effort of the then Prime
Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in the country was
nationalised.

Second phase of nationalisation Indian Banking Sector Reform was carried out in 1980 with
seven more banks. This step brought 80% of the banking segment in India under Government
ownership.

The following are the steps taken by the Government of India to Regulate Banking
Institutions in the Country:

 1949 : Enactment of Banking Regulation Act.

 1955 : Nationalisation of State Bank of India.
 1959 : Nationalisation of SBI subsidiaries.
 1961 : Insurance cover extended to deposits.
 1969 : Nationalisation of 14 major banks.
 1971 : Creation of credit guarantee corporation.
 1975 : Creation of regional rural banks.
 1980 : Nationalisation of seven banks with deposits over 200 crore.

After the nationalisation of banks, the branches of the public sector bank India rose to
approximately 800% in deposits and advances took a huge jump by 11,000%.

Banking in the sunshine of Government ownership gave the public implicit faith and
immense confidence about the sustainability of these institutions.

Phase III

This phase has introduced many more products and facilities in the banking sector in its
reforms measure. In 1991, under the chairmanship of M Narasimham, a committee was set up
by his name which worked for the liberalisation of banking practices.

The country is flooded with foreign banks and their ATM stations. Efforts are being put to
give a satisfactory service to customers. Phone banking and net banking is introduced. The
entire system became more convenient and swift. Time is given more importance than
money.

The financial system of India has shown a great deal of resilience. It is sheltered from any
crisis triggered by any external macroeconomics shock as other East Asian Countries
suffered. This is all due to a flexible exchange rate regime, the foreign reserves are high, the
capital account is not yet fully convertible, and banks and their customers have limited
foreign exchange exposure.

Functions of Commercial Banks

The functions of a commercial banks are divided into two categories:
i) Primary functions, and
ii) Secondary functions including agency functions.

i) Primary functions:
The primary functions of a commercial bank include:
a) accepting deposits; and
b) granting loans and advances;

a) Accepting deposits
The most important activity of a commercial bank is to mobilise
deposits from the public. People who have surplus income and
savings find it convenient to deposit the amounts with banks.
Depending upon the nature of deposits, funds deposited with
bank also earn interest. Thus, deposits with the bank grow along
with the interest earned. If the rate of interest is higher, public
are motivated to deposit more funds with the bank. There is also
safety of funds deposited with the bank.

b) Grant of loans and advances

The second important function of a commercial bank is to grant
loans and advances. Such loans and advances are given to
members of the public and to the business community at a higher
rate of interest than allowed by banks on various deposit accounts.
The rate of interest charged on loans and advances varies
depending upon the purpose, period and the mode of repayment.
The difference between the rate of interest allowed on deposits
and the rate charged on the Loans is the main source of a bank’s
income.

i) Loans
A loan is granted for a specific time period. Generally,
commercial banks grant short-term loans. But term loans,
that is, loan for more than a year, may also be granted.
The borrower may withdraw the entire amount in lumpsum
or in instalments. However, interest is charged on the full
amount of loan. Loans are generally granted against the
security of certain assets. A loan may be repaid either in
lumpsum or in instalments.

ii) Advances
An advance is a credit facility provided by the bank to its
customers. It differs from loan in the sense that loans may
be granted for longer period, but advances are normally
granted for a short period of time. Further the purpose of
granting advances is to meet the day to day requirements
of business. The rate of interest charged on advances varies
from bank to bank. Interest is charged only on the amount
withdrawn and not on the sanctioned amount.

Modes of short-term financial assistance

Banks grant short-term financial assistance by way of cash credit,
overdraft and bill discounting.
a) Cash Credit
Cash credit is an arrangement whereby the bank allows the
borrower to draw amounts upto a specified limit. The amount is
credited to the account of the customer. The customer can
withdraw this amount as and when he requires. Interest is charged
on the amount actually withdrawn. Cash Credit is granted as per
agreed terms and conditions with the customers.

b) Overdraft
Overdraft is also a credit facility granted by bank. A customer
who has a current account with the bank is allowed to withdraw
more than the amount of credit balance in his account. It is a
temporary arrangement. Overdraft facility with a specified limit
is allowed either on the security of assets, or on personal security,
or both.

c) Discounting of Bills
Banks provide short-term finance by discounting bills, that is,
making payment of the amount before the due date of the bills
after deducting a certain rate of discount. The party gets the
funds without waiting for the date of maturity of the bills. In
case any bill is dishonoured on the due date, the bank can recover
the amount from the customer.
ii) Secondary functions
Besides the primary functions of accepting deposits and lending money,
banks perform a number of other functions which are called secondary
functions. These are as follows -
a) Issuing letters of credit, travellers cheques, circular notes etc.
b) Undertaking safe custody of valuables, important documents, and
securities by providing safe deposit vaults or lockers;
c) Providing customers with facilities of foreign exchange.
d) Transferring money from one place to another; and from one
branch to another branch of the bank.
e) Standing guarantee on behalf of its customers, for making
payments for purchase of goods, machinery, vehicles etc.
f) Collecting and supplying business information;
g) Issuing demand drafts and pay orders; and,
h) Providing reports on the credit worthiness of customers.

Different modes of Acceptance of Deposits

Banks receive money from the public by way of deposits. The following
types of deposits are usually received by banks:
i) Current deposit
ii) Saving deposit
iii) Fixed deposit
iv) Recurring deposit
v) Miscellaneous deposits

i) Current Deposit
Also called ‘demand deposit’, current deposit can be withdrawn by the
depositor at any time by cheques. Businessmen generally open current
accounts with banks. Current accounts do not carry any interest as the
amount deposited in these accounts is repayable on demand without
any restriction.
The Reserve bank of India prohibits payment of interest on current
accounts or on deposits upto 14 Days or less except where prior sanction
has been obtained. Banks usually charge a small amount known as
incidental charges on current deposit accounts depending on the number
of transaction.

Savings deposit/Savings Bank Accounts

Savings deposit account is meant for individuals who wish to deposit
small amounts out of their current income. It helps in safe guarding
their future and also earning interest on the savings. A saving account
can be opened with or without cheque book facility. There are
restrictions on the withdrawls from this account. Savings account holders
are also allowed to deposit cheques, drafts, dividend warrants, etc.
drawn in their favour for collection by the bank. To open a savings
account, it is necessary for the depositor to be introduced by a person
having a current or savings account with the same bank.
Fixed deposit
The term ‘Fixed deposit’ means deposit repayable after the expiry of
a specified period. Since it is repayable only after a fixed period of
time, which is to be determined at the time of opening of the account,
it is also known as time deposit. Fixed deposits are most useful for a
commercial bank. Since they are repayable only after a fixed period,
the bank may invest these funds more profitably by lending at higher
rates of interest and for relatively longer periods. The rate of interest
on fixed deposits depends upon the period of deposits. The longer the
period, the higher is the rate of interest offered. The rate of interest to
be allowed on fixed deposits is governed by rules laid down by the
Reserve Bank of India.

Recurring Deposits
Recurring Deposits are gaining wide popularity these days. Under this
type of deposit, the depositor is required to deposit a fixed amount of
money every month for a specific period of time. Each instalment may
vary from Rs.5/- to Rs.500/- or more per month and the period of
account may vary from 12 months to 10 years. After the completion of
the specified period, the customer gets back all his deposits alongwith
the cumulative interest accrued on the deposits.

Miscellaneous Deposits
Banks have introduced several deposit schemes to attract deposits from
different types of people, like Home Construction deposit scheme,
Sickness Benefit deposit scheme, Children Gift plan, Old age pension
scheme, Mini deposit scheme, etc.

Different methods of Granting Loans by Bank

The basic function of a commercial bank is to make loans and advances
out of the money which is received from the public by way of deposits.
The loans are particularly granted to businessmen and members of the
public against personal security, gold and silver and other movable and
immovable assets. Commercial bank generally lend money in the
following form:
i) Cash credit
ii) Loans
iii) Bank overdraft, and
iv) Discounting of Bills

i) Cash Credit :
A cash credit is an arrangement whereby the bank agrees to lend money
to the borrower upto a certain limit. The bank puts this amount of
money to the credit of the borrower. The borrower draws the money
as and when he needs. Interest is charged only on the amount actually
drawn and not on the amount placed to the credit of borrower’s account.
Cash credit is generally granted on a bond of credit or certain other
securities. This a very popular method of lending in our country.
ii) Loans :
A specified amount sanctioned by a bank to the customer is called a
‘loan’. It is granted for a fixed period, say six months, or a year. The
specified amount is put on the credit of the borrower’s account. He can
withdraw this amount in lump sum or can draw cheques against this
sum for any amount. Interest is charged on the full amount even if the
borrower does not utilise it. The rate of interest is lower on loans in
comparison to cash credit. A loan is generally granted against the
security of property or personal security. The loan may be repaid in
lump sum or in instalments. Every bank has its own procedure of
granting loans. Hence a bank is at liberty to grant loan depending on
its own resources.
The loan can be granted as:
a) Demand loan, or
b) Term loan

a) Demand loan
Demand loan is repayable on demand. In other words it is
repayable at short notice. The entire amount of demand loan is
disbursed at one time and the borrower has to pay interest on it.
The borrower can repay the loan either in lumpsum (one time)
or as agreed with the bank. Loans are normally granted by the
bank against tangible securities including securities like N.S.C.,
Kisan Vikas Patra, Life Insurance policies and U.T.I. certificates.

b) Term loans
Medium and long term loans are called ‘Term loans’. Term loans
are granted for more than one year and repayment of such loans
is spread over a longer period. The repayment is generally made
in suitable instalments of fixed amount. These loans are repayable
over a period of 5 years and maximum upto 15 years.
Term loan is required for the purpose of setting up of new
business activity, renovation, modernisation, expansion/extension
of existing units, purchase of plant and machinery, vehicles, land
for setting up a factory, construction of factory building or

purchase of other immovable assets. These loans are generally

secured against the mortgage of land, plant and machinery,
building and other securities. The normal rate of interest charged
for such loans is generally quite high.

iii) Bank Overdraft

Overdraft facility is more or less similar to cash credit facility. Overdraft
facility is the result of an agreement with the bank by which a current
account holder is allowed to withdraw a specified amount over and
above the credit balance in his/her account. It is a short term facility.
This facility is made available to current account holders who operate
their account through cheques. The customer is permitted to withdraw
the amount as and when he/she needs it and to repay it through deposits
in his account as and when it is convenient to him/her.
Overdraft facility is generally granted by bank on the basis of a written
request by the customer. Some times, banks also insist on either a
promissory note from the borrower or personal security to ensure safety
of funds. Interest is charged on actual amount withdrawn by the
customer. The interest rate on overdraft is higher than that of the rate
on loan.

iv) Discounting of Bills

Apart from granting cash credit, loans and overdraft, banks also grant
financial assistance to customers by discounting bills of exchange. Banks
purchase the bills at face value minus interest at current rate of interest
for the period of the bill. This is known as ‘discounting of bills’. Bills
of exchange are negotiable instruments and enable the debtors to
discharge their obligations towards their creditors. Such bills of exchange
arise out of commercial transactions both in internal trade and external
trade. By discounting these bills before they are due for a nominal
amount, the banks help the business community. Of course, the banks
recover the full amount of these bills from the persons liable to make
payment.

Agency and General Utility Services provided by

Modern Commercial Banks
You have already learnt that the primary activities of commercial banks
include acceptance of deposits from the public and lending money to
businessmen and other members of society. Besides these two main
activities, commercial banks also render a number of ancillary services.
These services supplement the main activities of the banks. They are
essentially non-banking in nature and broadly fall under two categories:
i) Agency services, and
ii) General utility services.

i) Agency Services
Agency services are those services which are rendered by commercial
banks as agents of their customers. They include :
a) Collection and payment of cheques and bills on behalf of the
customers;
b) Collection of dividends, interest and rent, etc. on behalf of
customers, if so instructed by them;
c) Purchase and sale of shares and securities on behalf of customers;
d) Payment of rent, interest, insurance premium, subscriptions etc.
on behalf of customers, if so instructed;
e) Acting as a trustee or executor;
f) Acting as agents or correspondents on behalf of customers for
other banks and financial institutions at home and abroad.
ii) General utility services
General utility services are those services which are rendered by
commercial banks not only to the customers but also to the general
public. These are available to the public on payment of a fee or charge.
They include :
a) Issuing letters of credit and travellers’ cheques;
b) Underwriting of shares, debentures, etc.;
c) Safe-keeping of valuables in safe deposit locker;
d) Underwriting loans floated by government and public bodies.
e) Supplying trade information and statistical data useful to
customers;
f) Acting as a referee regarding the financial status of customers;
g) Undertaking foreign exchange business.

What Does Securitization Mean?

The process through which an issuer creates a financial instrument by combining other
financial assets and then marketing different tiers of the repackaged instruments to investors.
The process can encompass any type of financial asset and promotes liquidity in the
marketplace.

Securitization
Mortgage-backed securities are a perfect example of securitization. By combining mortgages
into one large pool, the issuer can divide the large pool into smaller pieces based on each
individual mortgage's inherent risk of default and then sell those smaller pieces to investors.

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset
pool. Using the mortgage-backed security example, individual retail investors are able to
purchase portions of a mortgage as a type of bond. Without the securitization of mortgages,
retail investors may not be able to afford to buy into a large pool of mortgages.

Structure
Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company
looking to either raise capital, restructure debt or otherwise adjust its finances. Under
traditional corporate finance concepts, such a company would have three options to raise new
capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the
ownership and control of the company, while loan or bond financing is often prohibitively
expensive due to the credit rating of the company and the associated rise in interest rates.

The consistently revenue-generating part of the company may have a much higher credit
rating than the company as a whole. For instance, a leasing company may have provided
$10m nominal value of leases, and it will receive a cash flow over the next five years from
these. It cannot demand early repayment on the leases and so cannot get its money back early
if required. If it could sell the rights to the cash flows from the leases to someone else, it
could transform that income stream into a lump sum today (in effect, receiving today the
present value of a future cash flow). Where the originator is a bank or other organization that
must meet capital adequacy requirements, the structure is usually more complex because a
separate company is set up to buy the assets.

A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle"
or "SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of
funding the assets. Once the assets are transferred to the issuer, there is normally no recourse
to the originator. The issuer is "bankruptcy remote," meaning that if the originator goes into
bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In
order to achieve this, the governing documents of the issuer restrict its activities to only those
necessary to complete the issuance of securities.

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a
part-sale and part-financing.[10] In a sale, the originator is allowed to remove the transferred
assets from its balance sheet: in a financing, the assets are considered to remain the property
of the originator.[11] Under US accounting standards, the originator achieves a sale by being at
arm's length from the issuer, in which case the issuer is classified as a "qualifying special
purpose entity" or "qSPE".

Because of these structural issues, the originator typically needs the help of an investment
bank (the arranger) in setting up the structure of the transaction.

Issuance

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to
fund the purchase. Investors purchase the securities, either through a private offering
(targeting institutional investors) or on the open market. The performance of the securities is
then directly linked to the performance of the assets. Credit rating agencies rate the securities
which are issued in order to provide an external perspective on the liabilities being created
and help the investor make a more informed decision.

In transactions with static assets, a depositor will assemble the underlying collateral, help
structure the securities and work with the financial markets in order to sell the securities to
investors. The depositor has taken on added significance under Regulation AB. The depositor
typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or
a wholly owned subsidiary of the parent which initiates the transaction. In transactions with
managed (traded) assets, asset managers assemble the underlying collateral, help structure
the securities and work with the financial markets in order to sell the securities to investors.

Some deals may include a third-party guarantor which provides guarantees or partial
guarantees for the assets, the principal and the interest payments, for a fee.
The securities can be issued with either a fixed interest rate or a floating rate. Fixed rate ABS
set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds.
Floating rate securities may be backed by both amortizing and nonamortizing assets. In
contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down
according to a designated index such as a U.S. Treasury rate, or, more typically, the London
Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index
plus an additional fixed margin to cover the added risk

Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities generated in a

securitisation deal are "credit enhanced," meaning their credit quality is increased above that
of the originator's unsecured debt or underlying asset pool. This increases the likelihood that
the investors will receive cash flows to which they are entitled, and thus causes the securities
to have a higher credit rating than the originator. Some securitisations use external credit
enhancement provided by third parties, such as surety bonds and parental guarantees
(although this may introduce a conflict of interest).

Individual securities are often split into tranches, or categorized into varying degrees of
subordination. Each tranche has a different level of credit protection or risk exposure than
another: there is generally a senior (“A”) class of securities and one or more junior
subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The
senior classes have first claim on the cash that the SPV receives, and the more junior classes
only start receiving repayment after the more senior classes have repaid. Because of the
cascading effect between classes, this arrangement is often referred to as a cash flow
waterfall. In the event that the underlying asset pool becomes insufficient to make payments
on the securities (e.g. when loans default within a portfolio of loan claims), the loss is
absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected
until the losses exceed the entire amount of the subordinated tranches. The senior securities
are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated
classes receive a lower credit rating, signifying a higher risk.

The most junior class (often called the equity class) is the most exposed to payment risk. In
some cases, this is a special type of instrument which is retained by the originator as a
potential profit flow. In some cases the equity class receives no coupon (either fixed or
floating), but only the residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets.
This is often the case where the underlying assets are mortgages which, in essence, are repaid
every time the property is sold. Since any early repayment is passed on to this class, it means
the other investors have a more predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate "waterfalls"
because the principal and interest receipts can be easily allocated and matched. But if the
assets are income-based transactions such as rental deals it is not possible to differentiate so
easily between how much of the revenue is income and how much principal repayment. In
this case all the income is used to pay the cash flows due on the bonds as those cash flows
become due.
Credit enhancements affect credit risk by providing more or less protection to promised cash
flows for a security. Additional protection can help a security achieve a higher rating, lower
protection can help create new securities with differently desired risks, and these differential
protections can help place a security on more attractive terms.

In addition to subordination, credit may be enhanced through:

 A reserve or spread account, in which funds remaining after expenses such as

principal and interest payments, charge-offs and other fees have been paid-off are
accumulated, and can be used when SPE expenses are greater than its income.
 Third-party insurance, or guarantees of principal and interest payments on the
securities.
 Over-collateralization, usually by using finance income to pay off principal on some
securities before principal on the corresponding share of collateral is collected.
 Cash funding or a cash collateral account, generally consisting of short-term, highly
rated investments purchased either from the seller's own funds, or from funds
borrowed from third parties that can be used to make up shortfalls in promised cash
flows.
 A third-party letter of credit or corporate guarantee.
 A back-up servicer for the loans.
 Discounted receivables for the pool.

Servicing

A servicer collects payments and monitors the assets that are the crux of the structured
financial deal. The servicer can often be the originator, because the servicer needs very
similar expertise to the originator and would want to ensure that loan repayments are paid to
the Special Purpose Vehicle.

The servicer can significantly affect the cash flows to the investors because it controls the
collection policy, which influences the proceeds collected, the charge-offs and the recoveries
on the loans. Any income remaining after payments and expenses is usually accumulated to
some extent in a reserve or spread account, and any further excess is returned to the seller.
Bond rating agencies publish ratings of asset-backed securities based on the performance of
the collateral pool, the credit enhancements and the probability of default.

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-
keeper of the assets that are being held in the issuer. Even though the trustee is part of the
SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to
protect the assets and those who own the assets, typically the investors.

Repayment structures

Unlike corporate bonds, most securitisations are amortized, meaning that the principal
amount borrowed is paid back gradually over the specified term of the loan, rather than in
one lump sum at the maturity of the loan. Fully amortizing securitisations are generally
collateralized by fully amortizing assets such as home equity loans, auto loans, and student
loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The
possible rate of prepayment varies widely with the type of underlying asset pool, so many
prepayment models have been developed in an attempt to define common prepayment
activity. The PSA prepayment model is a well-known example

A controlled amortization structure is a method of providing investors with a more

predictable repayment schedule, even though the underlying assets may be nonamortizing.
After a predetermined “revolving” period, during which only interest payments are made,
these securitisations attempt to return principal to investors in a series of defined periodic
payments, usually within a year. An early amortization event is the risk of the debt being
retired early.

On the other hand, bullet or slug structures return the principal to investors in a single
payment. The most common bullet structure is called the soft bullet, meaning that the final
bullet payment is not guaranteed on the expected maturity date; however, the majority of
these securitisations are paid on time. The second type of bullet structure is the hard bullet,
which guarantees that the principal will be paid on the expected maturity date. Hard bullet
structures are less common for two reasons: investors are comfortable with soft bullet
structures, and they are reluctant to accept the lower yields of hard bullet securities in
exchange for a guarantee.

Securitisations are often structured as a sequential pay bond, paid off in a sequential manner
based on maturity. This means that the first tranche, which may have a one-year average life,
will receive all principal payments until it is retired; then the second tranche begins to receive
principal, and so forth. Pro rata bond structures pay each tranche a proportionate share of
principal throughout the life of the security.

Structural risks and misincentives

Originators (e.g. of mortgages) have less incentive towards credit quality and greater
incentive towards loan volume since they do not bear the long-term risk of the assets they
have created and may simply profit by the fees associated with origination and securitisation

Motives for securitisation

Advantages to issuer

Reduces funding costs: Through Securitisation, a company rated BB but with AAA worthy
cash flow would be able to borrow at possibly AAA rates. This is the number one reason to
securitize a cash flow and can have tremendous impacts on borrowing costs. The difference
between BB debt and AAA debt can be multiple hundreds of basis points. For example,
Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile
backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to
be rated AAA because of the strength of the underlying collateral and other credit
enhancements.

Reduces asset-liability mismatch: "Depending on the structure chosen, Securitisation can

offer perfect matched funding by eliminating funding exposure in terms of both duration and
pricing basis." Essentially, in most banks and finance companies, the liability book or the
funding is from borrowings. This often comes at a high cost. Securitisation allows such banks
and finance companies to create a self-funded asset book.
Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a
limit or range that their leverage is allowed to be. By securitizing some of their assets, which
qualifies as a sale for accounting purposes, these firms will be able to lessen the equity on
their balance sheets while maintaining the "earning power" of the asset.

Locking in profits: For a given block of business, the total profits have not yet emerged and
thus remain uncertain. Once the block has been securitized, the level of profits has now been
locked in for that company, thus the risk of profit not emerging, or the benefit of super-
profits, has now been passed on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration):

Securitisation makes it possible to transfer risks from an entity that does not want to bear it,
to one that does. Two good example of this are catastrophe bonds and Entertainment
Securitisations. Similarly, by securitizing a block of business (thereby locking in a degree of
profits), the company has effectively freed up its balance to go out and write more profitable
business.

Off balance sheet: Derivatives of many types have in the past been referred to as "off-
balance-sheet." This term implies that the use of derivatives has no balance sheet impact.
While there are differences among the various accounting standards internationally, there is a
general trend towards the requirement to record derivatives at fair value on the balance sheet.
There is also a generally accepted principle that, where derivatives are being used as a hedge
against underlying assets or liabilities, accounting adjustments are required to ensure that the
gain/loss on the hedged instrument is recognized in the income statement on a similar basis as
the underlying assets and liabilities. Certain credit derivatives products, particularly Credit
Default Swaps, now have more or less universally accepted market standard documentation.
In the case of Credit Default Swaps, this documentation has been formulated by the
International Swaps and Derivatives Association (ISDA) who have for a long time provided
documentation on how to treat such derivatives on balance sheets.

Earnings: Securitisation makes it possible to record an earnings bounce without any real
addition to the firm. When a Securitisation takes place, there often is a "true sale" that takes
place between the Originator (the parent company) and the SPE. This sale has to be for the
market value of the underlying assets for the "true sale" to stick and thus this sale is reflected
on the parent company's balance sheet, which will boost earnings for that quarter by the
amount of the sale. While not illegal in any respect, this does distort the true earnings of the
parent company.

Admissibility: Future cashflows may not get full credit in a company's accounts (life
insurance companies, for example, may not always get full credit for future surpluses in their
regulatory balance sheet), and a Securitisation effectively turns an admissible future surplus
flow into an admissible immediate cash asset.

Liquidity: Future cashflows may simply be balance sheet items which currently are not
available for spending, whereas once the book has been securitized, the cash would be
available for immediate spending or investment. This also creates a reinvestment book which
may well be at better rates.
Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this
would leave a materially worse quality of residual risk.

Costs: Securitisations are expensive due to management and system costs, legal fees,
underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs
is usually essential in Securitisations, especially if it is an atypical Securitisation.

Size limitations: Securitisations often require large scale structuring, and thus may not be
cost-efficient for small and medium transactions.

Risks: Since Securitisation is a structured transaction, it may include par structures as well as
credit enhancements that are subject to risks of impairment, such as prepayment, as well as
credit loss, especially for structures where there are some retained strips.

Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality assets: Due to the stringent
requirements for corporations (for example) to attain high ratings, there is a dearth of highly
rated entities that exist. Securitisations, however, allow for the creation of large quantities of
AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are
required to invest in only highly rated assets, have access to a larger pool of investment
options.

Portfolio diversification: Depending on the Securitisation, hedge funds as well as other

institutional investors tend to like investing in bonds created through Securitisations because
they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized are
isolated (at least in theory) from the assets of the originating entity, under Securitisation it
may be possible for the Securitisation to receive a higher credit rating than the "parent,"
because the underlying risks are different. For example, a small bank may be considered
more risky than the mortgage loans it makes to its customers; were the mortgage loans to
remain with the bank, the borrowers may effectively be paying higher interest (or, just as
likely, the bank would be paying higher interest to its creditors, and hence less profitable).
Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest

payment obligations on time. For ABS, default may occur when maintenance obligations on
the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator
of a particular security’s default risk is its credit rating. Different tranches within the ABS are
rated differently, with senior classes of most issues receiving the highest rating, and
subordinated classes receiving correspondingly lower credit ratings.

However, the credit crisis of 2007-2008 has exposed a potential flaw in the Securitisation
process - loan originators retain no residual risk for the loans they make, but collect
substantial fees on loan issuance and Securitisation, which doesn't encourage improvement of
underwriting standards.

Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject

to some degree of early amortization risk. The risk stems from specific early amortization
events or payout events that cause the security to be paid off prematurely. Typically, payout
events include insufficient payments from the underlying borrowers, insufficient excess
Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the
underlying loans above a specified level, a decrease in credit enhancements below a specific
level, and bankruptcy on the part of the sponsor or servicer.

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate
ABS move in response to changes in interest rates. Fluctuations in interest rates affect
floating rate ABS prices less than fixed rate securities, as the index against which the ABS
rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate
changes may affect the prepayment rates on underlying loans that back some types of ABS,
which can affect yields. Home equity loans tend to be the most sensitive to changes in
interest rates, while auto loans, student loans, and credit cards are generally less sensitive to
interest rates.
Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the Securitisations’
underlying assets. If the manager earns fees based on performance, there may be a temptation
to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior
note holders when the manager has a claim on the deal's excess spread.

Servicer risk: The transfer or collection of payments may be delayed or reduced if the
servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the
transaction.
Meaning of NPAs

An asset is classified as Non-performing Asset (NPA) if due in the form of principal and
interest are not paid by the borrower for a period of 180 days. However with effect from
March 2004, default status would be given to a borrower if dues are not paid for 90 days. If
any advance or credit facilities granted by banks to a borrower becomes non-performing, then
the bank will have to treat all the advances/credit facilities granted to that borrower as non-
performing without having any regard to the fact that there may still exist certain advances /
credit facilities having performing status.

Though the term NPA connotes a financial asset of a commercial bank, which has stopped
earning an expected reasonable return, it is also a reflection of the productivity of the unit,
firm, concern, industry and nation where that asset is idling. Viewed with this perspective, the
NPA is a result of an environment that prevents it from performing up to expected levels.

The definition of NPAs in Indian context is certainly more liberal with two quarters norm
being applied for classification of such assets. The RBI is moving over to one-quarter norm
from 2004 onwards

Dealing with NPAs involves two sets of policies

1. Relating to existing NPAs

2. To reduce fresh NPA generation.

As far as old NPAs are concerned, a bank can remove it on its own or sell the assets to AMCs
to clean up its balance sheet. For preventing fresh NPAs, the bank itself should adopt proper
policies.

Causes for Non Performing Assets

A strong banking sector is important for a flourishing economy. The failure of the banking
sector may have an adverse impact on other sectors. The Indian banking system, which was
operating in a closed economy, now faces the challenges of an open economy.

On one hand a protected environment ensured that banks never needed to develop
sophisticated treasury operations and Asset Liability Management skills.

On the other hand a combination of directed lending and social banking relegated
profitability and competitiveness to the background. The net result was unsustainable NPAs
and consequently a higher effective cost of banking services.

One of the main causes of NPAs into banking sector is the directed loans system under which
commercial banks are required a prescribed percentage of their credit (40%) to priority
sectors. As of today nearly 7 percent of Gross NPAs are locked up in 'hard-core' doubtful and
loss assets, accumulated over the years.

The problem India Faces is not lack of strict prudential norms but

i. The legal impediments and time consuming nature of asset disposal proposal.
ii. Postponement of problem in order to show higher earnings.
iii. Manipulation of debtors using political influence.

There are several reasons for an account becoming NPA.

* Internal factors
* External factors

Internal factors:

1. Funds borrowed for a particular purpose but not use for the said purpose.
2. Project not completed in time.
3. Poor recovery of receivables.
4. Excess capacities created on non-economic costs.
5. In-ability of the corporate to raise capital through the issue of equity or other debt
instrument from capital markets.
6. Business failures.
7. Diversion of funds for expansion\modernization\setting up new projects\ helping or
promoting sister concerns.
8. Willful defaults, siphoning of funds, fraud, disputes, management disputes, mis-
appropriation etc.,
9. Deficiencies on the part of the banks viz. in credit appraisal, monitoring and follow-ups,
delay in settlement of payments\ subsidiaries by government bodies etc.,

External factors:

1. Sluggish legal system -

Long legal tangles

Changes that had taken place in labour laws
Lack of sincere effort.
2. Scarcity of raw material, power and other resources.
3. Industrial recession.
4. Shortage of raw material, raw material\input price escalation, power shortage, industrial
recession, excess capacity, natural calamities like floods, accidents.
5. Failures, non payment\ over dues in other countries, recession in other countries,
externalization problems, adverse exchange rates etc.
6. Government policies like excise duty changes, Import duty changes etc.,

Concluding Remarks

A strong banking sector is important for a flourishing economy. The failure of the banking
sector may have an adverse impact on other sectors.

Over the years, much has been talked about NPAs and the emphasis so far has been only on
identification and quantification of NPAs rather than on ways to reduce and upgrade them.

There is also a general perception that the prescription of 40% of net bank credit to priority
sectors have led to higher NPAs, due to credit to these sectors becoming sticky. Managers of
rural and semi-urban branches generally sanction these loans. In the changed context of new
prudential norms and emphasis on quality lending and profitability, managers should make it
amply clear to potential borrowers that banks resources are scarce and these are meant to
finance viable ventures so that these are repaid on time and relevant to other needy borrowers
for improving the economic lot of maximum number of households. Hence, selection of right
borrowers, viable economic activity, adequate finance and timely disbursement, correct end
use of funds and timely recovery of loans is absolutely necessary pre conditions for
preventing or minimizing the incidence of new NPAs.
Brief History of Urban Cooperative Banks in India

The term Urban Co-operative Banks (UCBs), though not formally defined, refers to primary
cooperative banks located in urban and semi-urban areas. These banks, till 1996, were
allowed to lend money only for non-agricultural purposes. This distinction does not hold
today. These banks were traditionally centred around communities, localities work place
groups. They essentially lent to small borrowers and businesses. Today, their scope of
operations has widened considerably.

The origins of the urban cooperative banking movement in India can be traced to the close of
nineteenth century when, inspired by the success of the experiments related to the cooperative
movement in Britain and the cooperative credit movement in Germany such societies were
set up in India. Cooperative societies are based on the principles of cooperation, - mutual
help, democratic decision making and open membership. Cooperatives represented a new and
alternative approach to organisaton as against proprietary firms, partnership firms and joint
stock companies which represent the dominant form of commercial organisation.

The Beginnings

The first known mutual aid society in India was probably the ‘Anyonya Sahakari Mandali’
organised in the erstwhile princely State of Baroda in 1889 under the guidance of Vithal
Laxman also known as Bhausaheb Kavthekar. Urban co-operative credit societies, in their
formative phase came to be organised on a community basis to meet the consumption
oriented credit needs of their members. Salary earners’ societies inculcating habits of thrift
and self help played a significant role in popularising the movement, especially amongst the
middle class as well as organized labour. From its origins then to today, the thrust of UCBs,
historically, has been to mobilise savings from the middle and low income urban groups and
purvey credit to their members - many of which belonged to weaker sections.

The enactment of Cooperative Credit Societies Act, 1904, however, gave the real impetus to
the movement. The first urban cooperative credit society was registered in Canjeevaram
(Kanjivaram) in the erstwhile Madras province in October, 1904. Amongst the prominent
credit societies were the Pioneer Urban in Bombay (November 11, 1905), the No.1 Military
Accounts Mutual Help Co-operative Credit Society in Poona (January 9, 1906). Cosmos in
Poona (January 18, 1906), Gokak Urban (February 15, 1906) and Belgaum Pioneer (February
23, 1906) in the Belgaum district, the Kanakavli-Math Co-operative Credit Society and the
Varavade Weavers’ Urban Credit Society (March 13, 1906) in the South Ratnagiri (now
Sindhudurg) district. The most prominent amongst the early credit societies was the Bombay
Urban Co-operative Credit Society, sponsored by Vithaldas Thackersey and Lallubhai
Samaldas established on January 23, 1906..

The Cooperative Credit Societies Act, 1904 was amended in 1912, with a view to broad
basing it to enable organisation of non-credit societies. The Maclagan Committee of 1915
was appointed to review their performance and suggest measures for strengthening them. The
committee observed that such institutions were eminently suited to cater to the needs of the
lower and middle income strata of society and would inculcate the principles of banking
amongst the middle classes. The committee also felt that the urban cooperative credit
movement was more viable than agricultural credit societies. The recommendations of the
Committee went a long way in establishing the urban cooperative credit movement in its own
right.

In the present day context, it is of interest to recall that during the banking crisis of 1913-14,
when no fewer than 57 joint stock banks collapsed, there was a there was a flight of deposits
from joint stock banks to cooperative urban banks. Maclagan Committee chronicled this
event thus:

“As a matter of fact, the crisis had a contrary effect, and in most provinces, there was a
movement to withdraw deposits from non-cooperatives and place them in cooperative
institutions, the distinction between two classes of security being well appreciated and a
preference being given to the latter owing partly to the local character and publicity of
cooperative institutions but mainly, we think, to the connection of Government with
Cooperative movement”.

Under State Purview

The constitutional reforms which led to the passing of the Government of India Act in 1919
transferred the subject of “Cooperation” from Government of India to the Provincial
Governments. The Government of Bombay passed the first State Cooperative Societies Act
in 1925 “which not only gave the movement its size and shape but was a pace setter of
cooperative activities and stressed the basic concept of thrift, self help and mutual aid.” Other
States followed. This marked the beginning of the second phase in the history of Cooperative
Credit Institutions.

There was the general realization that urban banks have an important role to play in economic
construction. This was asserted by a host of committees. The Indian Central Banking Enquiry
Committee (1931) felt that urban banks have a duty to help the small business and middle
class people. The Mehta-Bhansali Committee (1939), recommended that those societies
which had fulfilled the criteria of banking should be allowed to work as banks and
recommended an Association for these banks. The Co-operative Planning Committee (1946)
went on record to say that urban banks have been the best agencies for small people in whom
Joint stock banks are not generally interested. The Rural Banking Enquiry Committee (1950),
impressed by the low cost of establishment and operations recommended the establishment of
such banks even in places smaller than taluka towns.

The first study of Urban Co-operative Banks was taken up by RBI in the year 1958-59. The
Report published in 1961 acknowledged the widespread and financially sound framework of
urban co-operative banks; emphasized the need to establish primary urban cooperative banks
in new centers and suggested that State Governments lend active support to their
development. In 1963, Varde Committee recommended that such banks should be organised
at all Urban Centres with a population of 1 lakh or more and not by any single community or
caste. The committee introduced the concept of minimum capital requirement and the criteria
of population for defining the urban centre where UCBs were incorporated.

Duality of Control

However, concerns regarding the professionalism of urban cooperative banks gave rise to the
view that they should be better regulated. Large cooperative banks with paid-up share capital
and reserves of Rs.1 lakh were brought under the perview of the Banking Regulation Act
1949 with effect from 1st March, 1966 and within the ambit of the Reserve Bank’s
supervision. This marked the beginning of an era of duality of control over these banks.
Banking related functions (viz. licensing, area of operations, interest rates etc.) were to be
governed by RBI and registration, management, audit and liquidation, etc. governed by State
Governments as per the provisions of respective State Acts. In 1968, UCBS were extended
the benefits of Deposit Insurance.

Towards the late 1960s there was much debate regarding the promotion of the small scale
industries. UCBs came to be seen as important players in this context. The Working Group
on Industrial Financing through Co-operative Banks, (1968 known as Damry Group)
attempted to broaden the scope of activities of urban co-operative banks by recommending
that these banks should finance the small and cottage industries. This was reiterated by the
Banking Commisssion (1969).

The Madhavdas Committee (1979) evaluated the role played by urban co-operative banks in
greater details and drew a roadmap for their future role recommending support from RBI and
Government in the establishment of such banks in backward areas and prescribing viability
standards.

The Hate Working Group (1981) desired better utilisation of banks' surplus funds and that the
percentage of the Cash Reserve Ratio (CRR) & the Statutory Liquidity Ratio (SLR) of these
banks should be brought at par with commercial banks, in a phased manner. While the
Marathe Committee (1992) redefined the viability norms and ushered in the era of
liberalization, the Madhava Rao Committee (1999) focused on consolidation, control of
sickness, better professional standards in urban co-operative banks and sought to align the
urban banking movement with commercial banks.
A feature of the urban banking movement has been its heterogeneous character and its
uneven geographical spread with most banks concentrated in the states of Gujarat, Karnataka,
Maharashtra, and Tamil Nadu. While most banks are unit banks without any branch network,
some of the large banks have established their presence in many states when at their behest
multi-state banking was allowed in 1985. Some of these banks are also Authorised Dealers in
Foreign Exchange

Recent Developments

Over the years, primary (urban) cooperative banks have registered a significant growth in
number, size and volume of business handled. As on 31st March, 2003 there were 2,104
UCBs of which 56 were scheduled banks. About 79 percent of these are located in five states,
- Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu. Recently the problems
faced by a few large UCBs have highlighted some of the difficulties these banks face and
policy endeavours are geared to consolidating and strengthening this sector and improving
governance.