Introduction to Banking BANKING REGULATION ACT 1949 - 5(b) Banking means accepting, for the purpose of lending or investment,

of deposits of money from public, repayable on demand or otherwise and withdrawable by cheque, order or otherwise. Use of the word Bank Cannot trade in goods Retail Banking What is retail banking? Augmenting lending portfolio and diversify portfolio risk Dealings of commercial banks with individual customers Both on liabilities and assets side of balance sheet L CASA, term deposit, etc. A HL, AL, EL, etc. Retail deposit products Retail Loan products Retail services Safe deposit lockers Depositor services Bancassurance Safe Custody Forex services Gold sales Wholesale Banking Business with industrial & corporate houses Corporate Banking/Commercial Banking Products: Funds based products Term Lending Working Capital finance Bill Discounting Export Credit Short term finance Non Fund based Products Bank Guarantees Collection of Bills LCs

VALUE ADDED SERVICES Cash Management Services Corporate Payroll Accounts Forex Desk Tax collection

Investment Banking Capital raising (debt, equity, convertibles) Mergers / Acquisitions Private Equity Placement Corporate Restructuring Perform Research Asset Management

Components of Bank Balance sheet Components of Liabilities 1. Capital 2. Reserves & Surplus Components under this head includes: I. Statutory Reserves II. Capital Reserves III. Investment Fluctuation Reserve IV. Revenue and Other Reserves V. Balance in Profit and Loss Account 3. Deposits This is the main source of banks funds. The deposits are classified as deposits payable on demand and time. They are reflected in balance sheet as under: I. Demand Deposits II. Savings Bank Deposits III. Term Deposits 4. Borrowings (Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions) I. Borrowings in India i) Reserve Bank of India ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside India 5. Other Liabilities & Provisions It is grouped as under: I. Bills Payable II. Inter Office Adjustments (Net) III. Interest Accrued IV. Unsecured Redeemable Bonds V. Others (including provisions) Components of Assets 1. Cash & Bank Balances with RBI I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts 2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE I. In India i) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks

b) With Other Institutions II. Outside India a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice 3. Investments A major asset item in the banks balance sheet. Reflected under 6 buckets as under: I. Investments in India in : i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares , Commercial Papers, COD & Mutual Fund Units etc.) II. Investments outside India in Subsidiaries and/or Associates abroad 4. Advances The most important assets for a bank. A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term Loans B. Particulars of Advances : i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured 5. Fixed Asset I. Premises II. Other Fixed Assets (Including furniture and fixtures) 6. Other Assets I. Interest accrued II. Tax paid in advance/tax deducted at source (Net of Provisions) III. Stationery and Stamps IV. Non-banking assets acquired in satisfaction of claims V. Deferred Tax Asset (Net) VI. Others Contingent Liability Banks obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.

Banks Profit & Loss Account A banks profit & Loss Account has the following components: I. Income: This includes Interest Income and Other Income. II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies. Components of Income 1. INTEREST EARNED I. Interest/Discount on Advances / Bills II. Income on Investments III. Interest on balances with Reserve Bank of India and other inter-bank funds IV. Others 2. OTHER INCOME I. Commission, Exchange and Brokerage II. Profit on sale of Investments (Net) III. Profit/(Loss) on Revaluation of Investments IV. Profit on sale of land, buildings and other assets (Net) V. Profit on exchange transactions (Net) VI. Income earned by way of dividends etc. from India VII. Miscellaneous Income

subsidiaries and Associates abroad/in

1. INTEREST EXPENDED I. Interest on Deposits II. Interest on Reserve Bank of India / Inter-Bank borrowings III. Others 2. OPERATING EXPENSES Payments to and Provisions for employees Rent, Taxes and Lighting Printing and Stationery Advertisement and Publicity Depreciation on Bank's property Directors' Fees, Allowances and Expenses Auditors' Fees and Expenses (including Branch Auditors) Law Charges Postages, Telegrams, Telephones etc. Repairs and Maintenance Insurance Other Expenditure

Purpose & Objective of ALM An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration. It is aimed to stabilize short-term profits, long-term earnings and long-term subsistance of the bank. Liquidity Management Banks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet. Adequacy of liquidity position for a bank Analysis of following factors throws light on a banks adequacy of liquidity position: Historical Funding requirement Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earning capacity and Present and planned capital position Funding Avenues To satisfy funding needs, a bank must perform one or a combination of the following: Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature Increase Capital funds Statement of Structural Liquidity STATEMENT OF STRUCTURAL LIQUIDITY Places all cash inflows and outflows in the maturity ladder as per residual maturity Maturing Liability: cash outflow Maturing Assets : Cash Inflow Classified in to 8 time-buckets Mismatches in the first two buckets not to exceed 20% of outflows Shows the structure as of a particular date Banks can fix higher tolerance level for other maturity buckets. ADDRESSING THE MISMATCHES Mismatches can be positive or negative Positive Mismatch: A.>L. and Negative Mismatch L.>A.

In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. For ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee. STRATEGIES To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. SUCCESS OF ALM IN BANKS : PRE - CONDITIONS Awareness for ALM in the Bank staff at all levelssupportive Management & dedicated Teams. Method of reporting data from Branches/ other Departments. (Strong MIS). Computerization-Full computerization, networking. Insight into the banking operations, economic forecasting, computerization, investment, credit. Linking up ALM to future Risk Management Strategies.

What is Risk? The uncertainties associated with risk elements impact the net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable or un-favourable. The un-favaourable impact is RISK of the business. Risk is the probability that the realised return would be different from the anticipated/expected return on investment. Risk is a measure of likelihood of a bad financial outcome. All other things being equal risk will be avoided. All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return. The Banking Book All assets & liabilities in banking book have following characteristics: 1. They are normally held until maturity 2. Accrual system of accounting is applied Since assets & liabilities are held till maturity, their mismatch may land the bank in either excess cash in-flow or shortage of cash on a particular time. This commonly known as Liquidity Risk. Due to change in interest rates, assets and liabilities are subjected to interest rate risk on their maturities/re-pricing. Further, the assets side of the banking book generates credit risk arising from defaults in payment of interest and or installments by the borrowers. IMPORTANT RISK Liquidity Risk Interest Rate Risk LIQUIDITY RISK Arising due to Over extension of credit High level of NPAs Poor asset quality Mismanagement Hot Money Non recognition of embedded option risk Reliance of few wholesale depositors Large undrawn loan commitments Lack of appropriate liquidity policy and contingent plan LIQUIDITY vs. EARNING Bank must be in a position to Balance their need for liquidity with their need for earnings More liquid assets tend to provide lower return than do less liquid assets

ASSESSING LIQUIDITY POSITION Assessing a banks liquidity position can be challenging An adequate position for one bank may not be sufficient for another bank A position considered adequate for a bank in one time period may not be so in another time It is bank specific and dynamic LIQUIDITY RISK MANIFESTATION Funding Risk Need to replace net outflows due to unanticipated withdrawal/non renewal of deposits Time Risk Need to compensate for non-receipt of expected inflows of funds performing assets turning into non-performing assets LIQUIDITY RISK Regulatory Requirements CRR / SLR Call Money Borrowings prescriptions / limits ALM Guidelines LIQUIDITY RISK - SYMPTOMS Offering higher rate of interest on deposits Delayed payment of maturity proceeds Delayed disbursement to borrowers against committed lines of credit Deteriorating asset quality Net Deposit drain Interest Rate Risk Management Interest Rate risk is the exposure of a banks financial conditions to adverse movements of interest rates. Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a banks earnings and capital base. Changes in interest rates also affect the underlying value of the banks assets, liabilities and offbalance-sheet item. Interest Rate Risk Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM). Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank. Net Interest Margin Net Interest Margin(NIM) is the difference between interest income generated by their lending and interest paid on borrowings (for example, deposits). Net interest margin is expressed as net interest income (interest earned minus interest paid on borrowed funds) as a percentage of earning assets (any asset, such as a loan, that generates interest income). Net interest margin is similar to net interest spread; net interest spread expresses the nominal average difference between borrowing and lending rates, without compensating for the fact that the amount of earning assets and borrowed funds may be different. Net interest spread is generally higher than net interest margin, as banks may need to keep a certain amount of assets in non-interest bearing assets (such as cash balances held at branches for customers or liquid reserves as determined by banking regulators).

Narasimham Committee I Also known as Committee on Financial System Reforms. Recommendations: SLR & CRR SLR to be brought down to 25% and CRR to be brought down to 3 5 %. Priority Sector Lending Target for priority sector lending to be reduced to 10% of total credit. Priority sector credit to be redefined. Subsidy in some development programs to be withdrawn Interest Rates on Govt. securities to be in line with market rates Capital Adequacy Ratio 8% by Mar 1993. Thereafter, 9%. Accounting Policies Investment Portfolio Classification of loans Income recognition Special Recovery Tribunals to be set up. Asset Reconstruction Fund to be formed to take over the bad and doubtful debts from banks Entry of private sector banks No further nationalization of banks No difference in treatment between public sector and private sector banks No bar to open banks in private sector More foreign banks should be allowed to open branches in India. Branch licensing Policy to be abolished Staff related issues Supervision of Financial Sector Dual control system (RBI and BD of MoF) Legislature Measures Amendment to Banking Companies Act Raise paid up capital and raise equity from market BR Act to be amended to effect transparency and disclosure. RRB Act 1976 to be amended to allow them to be engaged in all types of banking business.

Narasimham Committee - II Also known as Committee on Banking Sector Reforms. Recommendations: Three tier banking Two to three large Indian Banks with international character Eight to ten large national banks to take care of the needs of large / medium corporate sector Large no. of Local Area/Regional Banks to serve local trade, small industry and agriculture. Universal banking: The distinction between Development Finance Institutions and commercial banks should disappear. Paving way for Universal banking. DFI should also give working capital finance while commercial banks should term loans. Narrow Banking Mergers Government holding in banks to be reduced to 33%. CAR 9% Provision requirements General provision of 1% for standard assets. Directed credit Encompass areas like food processing, fisheries, dairy, etc. Autonomy to banks Recruitment policy Other recommendations Revamp entire banking laws, to wit, RBI Act, BR Act, etc. Setting up of ARF RBI should be regulator and maintain arms length from banks NO RBI nominee in Boards of Banks Professionalization of bank boards Thrust on technology up-gradation

BANK FOR INTERNATIONAL SETTLEMENT Bank For International Settlements - BIS An international organization fostering the cooperation of central banks and international monetary policy makers. Established in 1930, it is the oldest international financial organization, and was created to administer the transaction of monies according to the Treaty of Versailles. Among others, its main goals are to promote information sharing and to be a key center for economic research. Bank For International Settlements - BIS Essentially, the BIS is a central bank for central banks; it does not provide financial services to individuals or corporations. The BIS is located in Basel, Switzerland, and has representative offices in Mexico City and Hong Kong. BASEL ACCORD What Does Basel Accord Mean? A set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk, (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less. The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements. CAPIAL ADEQUACY RATIO The Committee on Banking Regulations and Supervisory Practices (Basel Committee) had released the guidelines on capital measures and capital standards in July 1988 which were been accepted by Central Banks in various countries including RBI. In India it has been implemented by RBI w.e.f. 1.4.92 Objectives of CAR : The fundamental objective behind the norms is to strengthen the soundness and stability of the banking system. Capital Adequacy Ratio or CAR or CRAR : It is ratio of capital fund to risk weighted assets expressed in percentage terms i.e. Minimum requirements of capital fund in India: Banks 9 % Tier I Capital should at no point of time be less than 50% of the total capital. This implies that Tier II cannot be more than 50% of the total capital. Capital fund

Capital Fund has two tiers Tier I capital include paid-up capital statutory reserves other disclosed free reserves capital reserves representing surplus arising out of sale proceeds of assets. Minus equity investments in subsidiaries, intangible assets, and losses in the current period and those brought forward from previous periods to work out the Tier I capital. Tier II capital consists of: Undisclosed reserves and cumulative perpetual preference shares: Revaluation Reserves (at a discount of 55 percent while determining their value for inclusion in Tier II capital) General Provisions and Loss Reserves up to a maximum of 1.25% of weighted risk assets: Investment fluctuation reserve not subject to 1.25% restriction Debt capital Instruments (say bonds): Subordinated debt (long term unsecured loans) Risk weighted assets Fund Based : Risk weighted assets mean fund based assets such as cash, loans, investments and other assets. Degrees of credit risk expressed as percentage weights have been assigned by RBI to each such assets. On the recommendations of Basle Committee, RBI adopted Capital on Risk Asset Ratio (CRAR) as the basis of assessment of capital adequacy. This is popularly known as CAR. Thus, now Banks with a higher risk assets profile are required to maintain a higher level of capital funds. In other words, banks which have less capital will be required to reduce those assets which carry higher risk weight. The main object for introducing the capital adequacy requirements is to strengthen the soundness and stability of the banking system in India. Under this system, the (i) Balance Sheet Assets; (ii) Non Fund Items, and (iii) Other Off Balance Sheet exposures are assigned weights, and banks are required to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of risk weighted assets and other exposures on an on going basis. MEANS and METHODS AVAILABLE TO IMPROVE CAR: Increase profits so that there are reserves can be increased Revaluation of assets Issue Tier II Bonds Go for public issue for equities Reduce assets carrying high risk weight