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Definition of Banking

Banking is defined as accepting, for the purpose of lending and investments,


deposits of money from the public, repayable on demand or otherwise, and
withdrawable by cheque, draft, order or otherwise.
Over the years the nature and scope of services provided by banks have changed
and expanded. At the same time, the primary activities of the bank continue as
stated above. Bank started Lockers for keeping valuables such as Gold and other
valuable items.
Types of Banking
The banks can be categoried into different types based on the services offered to
the customer. These banks specialie in different lines of business. !ome of the most
common types of banks are"
#etail banks
$ommercial or $orporate banks
%nvestment banks
$entral banks
Retail bank is a bank that &orks &ith consumers, other&ise kno&n as 'retail
customers'. #etail banks provide basic banking services to the general public,
including"
$hecking and savings accounts
$ash (eposits
!afe deposit Lockers
(eposits and Loans
Auto loans
)nsecured and revolving loans such as credit cards
#etail banks are the banks you most often see in cities on cro&ded intersections, the
ones you probably use for your personal checking account.
A commercial or corporate bank is a bank that &orks &ith businesses.
$ommercial banks handle banking needs for large and small businesses, including"
Basic accounts such as current and cash credit accounts
Lending money for real and capital purchases
Letters of credit * Guarantees
+ayment and transaction processing
,oreign exchange
Commercial banks often function as retail banks as &ell, serving individuals along
&ith businesses.
Investment banks help organiations use investment markets. ,or example, &hen
a company &ants to raise money by issuing stocks or bonds, an investment bank
helps them through the process. %nvestment banks also consult on mergers and
ac-uisitions, among other things.
%nvestment banks primarily &ork in the investment markets and do not take
customer deposits. .o&ever, some large investment banks also serve as commercial
banks or retail banks.
Central Bank
%n every country there is one bank &hich acts as the leader of the money market,
supervising, controlling and regulating the activities of commercial banks and other
financial institutions. %t acts as a bank of issue and is in close touch &ith the
government, as banker, agent and advisor to the latter. !uch a bank is kno&n as the
central bank of the country. Bank of /ngland is the $entral Bank of )nited 0ingdom,
#eserve Bank of %ndia 1#B%2 is the central bank of %ndia.
Features of Central Bank
Aims at controlling the banking system in the country
%t has special po&ers to control and regulate the &orking of commercial banks
of the country
%t is part of the government machinery and its actions are closely coordinated
&ith those of the other departments of the government, particularly &ith the
(epartment of ,inance or the Treasury
%t is managed by the Government Officials or those connected closely &ith the
government.
Functions of the Central Bank
Bank of Issue
The central bank of a country is the sole authority that has po&ers to print and issue
money. The issue of money &as al&ays the prerogative of the government. The
government delegates the right of printing currency notes to the central bank. %n fact
the right and privilege of note issue &as al&ays associated &ith the origin and
development of central banks &hich &ere originally called as banks of issue.
Banker, Agent and Adviser to the overnment
The central banks in each country perform the functions of banker, agent and
adviser to the Government. As a banker to the government, the central bank of the
country keep the banking accounts of the government 3 both of the centre and the
states, performs the same functions as a commercial bank ordinarily does for its
customers. As a banker and agent to the government, the central bank makes and
receives payments on behalf of the government. %t helps the government &ith short3
term loans and advances to tide over temporary shortage of funds. %t also manages
public debt i.e. floats services and redeems government loans. %t advises the
government on all monetary and banking matters.
Custodian of Cash Reserves of Commercial Banks
All commercial banks keep part of their cash balances as deposits &ith the central
bank of the country, either because of convention or because of legal compulsion.
The cash deposits kept by all commercial banks &ith the central bank are kno&n as
cash reserves. They &ithdra& funds from these cash reserves during the busy
season and pay in surplus funds into them during the slack season. +art of these
cash balances are meant for che-ue clearing purposes. As all commercial banks keep
deposit accounts &ith the central bank, payment by one bank to another is a simple
book entry ad4ustment in the books of the central bank.
Custodian of Foreign Balances of the Country
The central banks in most countries maintain both gold and foreign currencies as
reserves against notes issue and to meet any adverse balance of payments &ith any
other country. Besides, it is the responsibility of central banks to maintain reserves
&ith %nternational 5onetary ,und 1%5,2. These reserves are referred to as normal
dra&ing rights and special dra&ing rights. %t is the responsibility of the central bank
of the country to maintain the rate of exchange fixed by the Government, manage
exchange control and other restrictions imposed by the state.
!ender of the !ast Resort
One of the fundamental principles of the central bank is that it 1as the banker6s bank
and as the supreme banking authority2 never refuses to accommodate any eligible
commercial bank needing funds. At certain times of the year due to seasonal
business activities or in times of intense business activities, the commercial banks
may need more funds to meet the re-uirements of their customers. %n the absence
of central banks, the commercial banks &ill be re-uired to carry substantial cash
reserves &ith themselves to meet such emergencies. Large cash reserves imply
restricted lending and reduced income by &ay of interest. %f a central bank exists, it
is easy for commercial banks to fall back on it in case of need. By lender of the last
resort, it is implied that the central bank assumes the responsibility of meeting
directly or indirectly all reasonable demands for accommodation of commercial banks
in times of difficulties and crises.
Central Clearance, "ettlement and Transfer
As the bankers6 bank, the central bank keeps the cash balances of all commercial
banks. %t is easier for member3banks to ad4ust their claims against each other in the
books of the central bank.
,or example, if AB$ Bank has a che-ue for #s.7,88893 on :;< Bank, &hich in turn,
has a che-ue for #s.7,=8893 on AB$ Bank, the easiest &ay to clear and settle the t&o
claims is for AB$ Bank to give a che-ue to :;< Bank for an amount of #s.=8893
through the account maintained &ith central Bank of the country. As a result of this
transfer, AB$ Bank6s account &ill be debited by #s. =8893, &hile :;< Bank6s account
&ill be credited by #s. =8893. There is thus no necessity for actual cash to come into
the picture at all.
Apart from economy in the use of money, much of labour and inconvenience,
associated &ith the individual system of clearance and settlement is removed. This
function is not restricted to a central bank alone> it may delegate the clearing
activities region &ise, to any leading bank in the region.
Controller of Credit
+robably the most important of all the functions performed by the central bank is
that of controlling the credit operations of commercial banks. %n modern times, bank
credit has become the most important source of money in the country, relegating
coins and currency notes to a minor position. 5oreover, it is possible for commercial
banks to expand credit and thus intensify inflationary pressure or contract credit and
thus contribute to a deflationary situation. %t is thus of great importance that there
should be some authority &hich &ill control the credit creation by commercial banks
&hich is also kno& as Bank credit. As a controller of credit, the central bank attempts
to influence and control the volume of bank credit and stabilie business conditions in
the country.
Roles #layed by Banks
#oles played by Banks are
,inancial %ntermediary
$onstituent of the payment !ystem
,inancial !ervice +rovider
Financial Intermediary
%n the economic, every business either big or small re-uires investment of money for
their business gro&th. They can not get money from society because of
$% Credit Risks 3 $redit risk refers to the risk of default by the borro&er for any
reason. %t is possible that the business does not generate sufficient income to repay
or the borro&er is not honest. This is the most serious risks any lender faces.
&% !i'uidity Risks ? The borro&er may have every intention to repay the loan and
the business may be doing &ell too. .o&ever there could be occasions &hen the
borro&er is not able to &ithdra& funds from the business &hen the lender demands
repayment.
(% Interest Rate Risk ? Another risk is due to change in the rate of interest in the
market. At the time of the transactions the borro&er may have agreed to give the
interest at the prevailing rate of, say, @A. !ubse-uently, interest may be reduced or
increased.
%ntermediation provides a business opportunity as the depositors &ill be happy to
earn interest &ith out any risks and borro&ers can get loans easily.
#ayment "ystems
Apart from intermediary other t&o uni-ue features differentiate banks from other
intermediaries like financial companies. The second part of the definition of banking
points to this feature. Banks accept BCC. deposits of money, repayable on demand
C.. and &ithdra&able by che-ueCCD. Banks are the only institutions that can accept
demand deposits or deposits repayable as and &hen demanded by the depositor. All
other financial institutions can only take fixed deposits. !econd, banks are the only
institutions on &hich a depositor can issue a che-ue to &ithdra& his deposits.
Financial "ervices
%n ancient times banks have played the roles as safe keepers, financial intermediary
and payment system constituent. As times changed, banks have provided additional
services to meet the changing needs of the people. Today banks offers more services
like selling of products of mutual funds and insurance companies, collection of utility
bill payments, sale of gold coins and many more. These activities also yield
commission income to bank.
Banking "ervices and #roducts
The services and products offered by banks can be summaried as
Role "ervices #roducts
+ayment !ystem
$onsitituent
+ayment and
#emittance
7.$he-ue
E.+ayorder 9 Bankers
$he-ue
F.(emand draft
G./lectronic ,unds Transfer
=.Harious $ards 1(ebit,
$redit..2
+ayment !ystem
$onsitituent
$ollection
7.Transfer
E.$learing
F./lectronic clearing
!ystem
G.$he-ue $ollection
=.$ash 5anagement
!ystem
I.Bill $ollection
+ayment !ystem
$onsitituent
,orex 7.,oreign /xchange
%ntermediary (eposits
7.$urrent Accounts
E.!avings Accounts
F.,ixed (eposits
G.#ecurring (eposits
%ntermediary Loans 7.#etail Loans
o .ousing 9 5ortgage
Loan
o Hehicle Loan
o +ersonal Loan
o Loan against
deposits
o $redit $ards
E.Business $redits
o Term Loan
o Jorking capital
Loan 1Overdraft,
$ash $redit2
F.Trade ,inances
o $he-ue +urchase,
Bill +urchase, Bill
(iscount, Letter of
$redit 1L$2, Bill
Kegotiation,
Guarantees
,inancial !ervices (istribution
7.5utual ,unds
E.%nsurance +roducts
F.Government Bonds
G.!tamp +aper
=.Gold $oins
,inancial !ervices $ollection
7.Taxes
E.)tility Bills
,inancial !ervices (e5at 7.(e5at !hare Account
,inancial !ervices !afe 0eeping
7.!afe (eposit Hault
E.!afe $ustody
,inancial !ervices Advisory 7.%nvestment Advice
#ayment "ystem Constituent
#ayment ) Remittance "ervices
Che'ues*
A $he-ue is a &ritten instruction issues by a customer 1dra&er2 to his bank 1dra&ee2
to pay the specified amount to the person named 1payee2 in the che-ue. The payee
can collect the amount of the che-ue in cash across the counter of the dra&ee bank
or deposit the che-ue &ith his banker for collection. %f the che-ue is crossed by
putting t&o lines on the top left corner 1BA9$ +ayeeD2, it is necessarily collected
through a bank.
+ulti City Che'ues ? As name implies the che-ues can be collected in any of the
payees branch &here the branches are interconnected 9 net &orked.
Certified Che'ue
A certified che-ue is a form of che-ue for &hich the bank verifies that sufficient
funds exist in the account to cover the che-ue, and so certifies, at the time the
che-ue is &ritten. Those funds are then set aside in the bank's internal account until
the che-ue is cashed or returned by the payee. Thus, a certified che-ue cannot
LbounceL, and, in this manner, its li-uidity is similar to cash.
#ayorder , Bankers Che'ues
The lack of certainty regarding payment of a che-ue makes it unacceptable to some
entities like government departments and institutions. A payorder or bankers
che-ues is a che-ue issued by a bank on itself. Both the dra&er and dra&ee is the
same bank, in fact same branch of the bank.
Demand Drafts*
A +ayorder is generally used for making local payments as it payable at the place
&here it is issued. Jhen payments have to be made to far a&ay places and the
payee insists on certainty of payments, (emand (rafts are used.
-lectronic Funds Transfer .-FT/
!ending or remitting money to a far a&ay place through ((s involves delay, as the
(( has to be reached to the payee through post or courier. %t is much faster for a
bank to send an electronic instruction to their branch at the payee6s center to pay
him the amount. %f the payee has an account &ith the paying bank the payment can
be made instantly.
%nstantaneous completion of the transaction cannot happen if the payer and payee
maintain their account &ith t&o different banks. %n that case the transfer or
remittance is completed through the $entral Bank.
Collection "ervices*
Transfer
Jhen a person gets a che-ue from another and deposits it &ith his bank and bank
has to BcollectD the amount to the che-ue and credit it to the account of the
depositor. %f both the payer and payee are from same bank, the collecting the
che-ue is simple as the bank can debit the account of the issuer and credit the
account of payee or depositor.
Clearing
%f the che-ue deposited by a customer is dra&n on another bank in the same city it
has to be sent to the payee bank and the amount collected. !ince all the banks in a
city &ill be getting che-ues dra&n in other banks and it is cumbersome process and
B$learing houseD is used to meet and exchange che-ues dra&n on each other.
-C" or -lectronic Clearing "ystem*
To support and enable the large number of customer credits or debits /lectronic
$learing system is used.
C+" 0 Cash +anagement "ervices " $5! is an upgraded packages of collection
and payment services. Large companies have large numbers of dealers across the
country. The dealers have to make payments on a regular basis for the goods
purchased from the company. To speed up the collection process the companies ties
up &ith the bank, &hich arranges to
+ick up che-ues from the dealers on a daily basis
Get them collected the same day through the local clearing.
#emit the total amount to the bank account of the company at its head
-uarters
+rovide information on the number and amounts of che-ues collected and
returned unpaid &ith full details of the dealers involved.
Bill Collection*
Bill refers to BBill of /xchangeD &hich is a &ritten instruction issued by the seller
1dra&er2, to the buyer 1dra&ee2, to pay a certain sum of money, to the person
named in the document 1payee2. %n short, a bill of exchange is an instrument to pay.
Jhen a bill is payable as soon as it is presented it is called a B(emondD bill. Jhen
the dra&er is permitted some time, say M8 days, to pay the bill it is called as a
B)sanceD bill.
Foreign -1change*
#emittances like clearing> transfer &ith in the country is relatively easy as the
currency involved in are the same. Jhen remittances takes place bet&een places in
t&o countries, settlement becomes a little complicated because of t&o different
currencies are involved.
!imilar to banks maintaining accounts in central bank for interbank settlement
1$learing2, bank maintains account &ith banks abroad 1Kostro Accounts2 for
facilitating foreign exchange transactions. All foreign remittances are routed through
Kostro Accounts.
Intermediary "ervices
Deposit "ervices
Banks accepts demand deposits and fixed or time deposits. (emand deposits are
repayable on demand &hile fixed deposits are repayable after the agreed upon
period or maturity. !ince demand deposits are more Bli-uidD 1available for use2 than
fixed deposit, the interest is paid on such deposits are lo& or no interest is paid at
all. Lo&er the li-uidity higher the rate of interest. .ence the longer period deposits
earn more interest.
Current Accounts , Checking Accounts
$urrent accounts are demand deposits that are primarily meant for facilitating
settlements of transactions using che-ues. Banks do not pay interest on balances in
these type of account. Generally current accounts are maintained by business
entities.
"avings Accounts
!avings accounts are also demand deposits offered for the benefit of individual &ho
&ould like to save their temporary surpluses and at the same time have li-uidity for
payments. !avings account differ from current account in follo&ing three respects.
%nterest is paid on balances in savings accounts.
The central Bank prohibits banks from opening savings accounts of business
entities.
!ome banks impose restrictions on the number of transactions from savings
accounts. Banks also monitor transactions in savings accounts and if they
found that it is used for business purpose, the account holder is instructed to
route through current account.
Fi1ed Deposit Accounts
As the name indicates, fixed deposits are accepted for fixed periods of term. They
are repayable only after the period for &hich they are deposited. Banks are entitled
to levy penalty on premature closure and some banks does &here others do not levy
any penalty from %ndividuals.
Recurring Deposit Accounts
#ecurring deposits accounts are for the benefit of those &ho &ould like to save a
fixed sum every month over a long period so that at the end of the maturity they
have reasonable large sum.
!oans
Retail !oans
#etail loans are given to individual for meeting one time re-uirements like buying
properties such as house or car, or for meeting large one time expenses. Generally
the entire amount is given to the borro&er upfront. %n some cases like buying a flat
under construction, the loan may be disbursed in installments according to the
payments to be made to the builder.
#epayments start after the entire loan is disbursed. Till then only interest is
recovered from borro&er. Loans are paid in periodical installments such as monthly
or -uarterly. %nterest is charged by banks, every month, on the balance outstanding
in the loan account.
#ersonal 2verdraft
Those &ith fixed income or salary income invariably run out of funds at certain times
and they may not &ant to touch their savings or breaking a fixed deposit as it &ould
cause loss. To manage such occasions banks offer Overdraft 1O(2 loan &here by
they can &ithdra& from their account over and above their balance for certain limit
1O( Limit2. The interest is charged for the amount utilied for those days. !uch
arrangements are usually given for one year and rene&ed every year.
O( limits may be secured or unsecured.
Credit cards
%n $redit card, the card holder gets some time to pay for the purchases or cash
&ithdra&als made. The amount up to &hich the card holder can make purchase is
called Bcredit limitD and it is fixed according to the credit &orthiness of the card
holder.
Business Credits
Term !oans
,unds re-uired for ac-uiring fixed assets are given as longterm loans &hich are
repaid in installments. The period of repayments and periodicity of installments are
fixed on the basis of estimated profits and cash generations of the company.
3orking Capital Facilities
The amount re-uired for financing current assets is called &orking capital and it &ill
be ever changing. .ence the financial assistance is provided in the follo&ing forms to
meets the &orking capital re-uirements of the company.
2verdraft
!imilar to personal overdraft, limits are given to business entities to meet the
re-uirements.
Cash Credit
The most common and popular facility for financing &orking capital re-uirements is
the cash credit. The &ithdra&ing limit is against the inventory, stocks and debtors or
book debts.
#ost "ale Finance or Trade Finance
Overdraft, $ash credit loan facilities are given to finance &orking capital
re-uirements. ,or financing the post sale re-uirements follo&ing facilities are
provided.
Che'ue #urchase ) Bill purchase
$he-ue issued by purchaser of goods, have to send for clearing or collection and this
entails delay of one to several days. Banks agree to lend the amount of the che-ue
as soon as the che-ue is deposited and the advance is recovered &hen the che-ue is
realied.
Banks also give advance against documentary bills for collection and recover the
amount &hen the dra&ee pays the amount.
Financial "ervices
Distribution
+utual Fund 4nits
%nvesting in shares is rather tricky because of volatile and no one predict the
movement of share prices. %ndividuals are best advised to take the help of
professionals for their investment.
5utual ,unds collets funds from investors and invest in shares and bonds. They have
the expertise in 4udging the companies and in taking right decisions. !ince banks
have the largest reach of customer base, 5,s seeks the help of banks to sell and
banks are happy to help as they get commission income.
Insurance #roducts
Life insurance companies have tied up &ith the banks to offer their life insurance and
saving products 1endo&ment policies, )L%+6s etc2 to individual customers of banks.
Banks also offering insurance products is called BbankassuranceD and it has been
successful business model the &orld over.
Collection of Ta1es and Bills
Banks are no& authoried to collect taxes like %ncome tax, sales taxes, excise tax,
customs duty and property taxes. The amounts collected are remitted to respective
accounts and banks.
A great convenience offered by banks is accepting payment of utility bills such as
electricity, telephone etc. %n the process, banks earns commission and also get to
maintain the accounts of the utility companies.
"afe 5eeping
"afe 5eeping 6aults ."D6/
+roviding safe keeping facility of valuables is a traditional function of banks. Banks
continue to offer the facility by providing to customers small safes. The safes are
kept in strong rooms. !afety and confidentiality are ensured by verifying the identity
of the customers before allo&ing access. Banks charge rents on annual basis.
!afe $ustody is used to accept the sealed packets of valuables. The packets are kept
in the banks safe. The customers &ere given a Bsafe custody receiptsD &hich had to
be returned to the bank &hen the customer &ants to take delivery of the packet.
Advisory "ervices
Investment Advice
The investment opportunities available today are many. ,or instance, the number of
5,s and the number of funds they offer are large. %nvestors need professional6s
assistance to select the right investments options, track the performance of 5,s and
to s&itch the investments at the opportune moments. Banks offers such assistance
to their large customers, called private banking customers.
Banking Channels
/arlier banking services &ere provided by only one channel, namely branches. Today
nearly N8A of the transactactions take place in other channels like AT5, +O! as they
are popular for follo&ing reasons.
$ustomers have access to EG hours of the day.
The cost of providing services through such channels, are much lo&er than
the cost of maintaining branches.
The non3banking channels available for customers are
AT5
+O! 1point of sale2 terminal for debit and credit cards
+hone Banking 1$all center2
%nternet Banking
5obile Banking 1!5! through 5obile +hones2.
%n AT5, customers can use additional facilities like che-ue book re-uest, che-ue
deposit in addition to cash &ithdra&al.
Risk +anagement
Banks face a number of risks in order to conduct their business, and ho& &ell these
risks are managed and understood is a key driver behind profitability, and ho& much
capital a bank is re-uired to hold. !ome of the main risks faced by banks include"
Credit risk* #isk of loss arising from a borro&er &ho does not make
payments as promised.
!i'uidity risk* #isk that a given security or asset cannot be traded -uickly
enough in the market to prevent a loss 1or make the re-uired profit2.
+arket risk* #isk that the value of a portfolio, either an investment portfolio
or a trading portfolio, &ill decrease due to the change in value of the market
risk factors.
2perational risk* risk arising from execution of a company's business
functions.
Introduction to Customer Insight
The most important asset to the success of any business is its customers. Today6s
banking customers are more demanding than ever. They &ant products and services
that are tailored to their specific needs, delivered through the channels that are most
convenient to them. %n today6s evolving marketplace, customers face a B&orld of
extremesD characteried by unprecedented complexity, intense competition and
market polariation. $ustomers are increasingly demanding relevant value
propositions that meet their individual needs and preferences and seek out those
&ho are able to provide them. #etail banking profitability is connected to the
customer insight. $ustomer %nsights &ill help and enable banks to provide superior
customer service.
3hat is Customer Insight7
The terms B'customer intelligence', 'customer insight', 'citien insight', 'customer
focus', 'customer3centric'D are often used interchangeably, &hich can be confusing. A
common definition of 'customer insight' relates to LA deep Otruth6 about the customer
based on their behavior, experiences, beliefs, needs or desires, that is relevant to
the task or issueD
$ustomer %nsight represents a deep understanding of customer needs and the
drivers of customer behavior at a level &ell beyond &hat customers are able to
articulate themselves. $ustomer %nsight leads to opportunities for creating solutions
that are tightly linked to the core drivers of human needs and behavior. (eveloping
$ustomer %nsight includes"
)nderstanding the explicitly stated or BarticulatedD needs of customers and
potential customers, but more significantly identifying their BunarticulatedD
needs.
o BArticulated Customer 8eedsD ? Keeds that are recognied and
communicated 1stated2 by customers
o B4narticulated Customer 8eedsD ? Keeds unrecognied by
customers that ? &hen recognied and satisfied ? lead to products and
services that delight them
,or many banks, understanding and meeting the needs of their customers,
particularly their most profitable customers, is critical to driving sustainable gro&th
/very bank &ould like to have a rich &ell of descriptive and predictive insight about
customers. Jith available resource, the bank could kno&, for instance,
that savings account customer 5r.A 4ust bought a ne& house and is thinking
about a home e-uity line>
that credit card holder 5r. B has a college3age daughter and seeks a student
loan from a local institution> and
that 5s.$ has had t&o unsatisfactory phone conversations regarding his
investment advisors and is thinking of s&itching to an online investment site.
Jith $ustomer %nsights, bank employees &ill be &ell informed on all aspects of the
customer so that they can -uickly respond to in-uiries, effectively sell more
products, and -uote accurate product pricing. $ustomer %nsights &ill facilitate -uick
access to detailed credit status, pricing, -uotes, orders, sales information, history
information and more. Banks &ill also gain a FI83degree vie& of the customer6s
circumstances and relations &ith the bank could better meet the customer6s needs
and save or expand the relationship. The more customer kno&ledge the banks have,
the easier it is to provide exceptional service and create ne& revenue opportunities
in existing customer base. By developing uni-ue, proprietary insights about their
customers, banks can create a more tailored and relevant banking experience &hich
sets them apart from the competition. $ustomer insight is rapidly rising up the
agenda of any organiation. %n essence, customers are the lifeline of business and
are to be handled &ith insight.
$ustomer %nsight &ill also help the banks in strategic innovation &ith the
engagement of customers in this innovation process. $ustomer %nsight is the
foundation for B$ustomer3%nspired %nnovationD.
%nnovation becomes BstrategicD &hen it is an intentional process focused on
creating breakthroughs in the value delivered to customers.
/ngaging customers as partners in the innovation process is essential for
creating breakthroughs in"
o Ke& +roduct9!ervice and category development and
o $orporate strategy development
%n practical terms, customer insight entails"
the use of data about customers to better understand their needs and
expectations
the application of this understanding in the design and delivery of services.
%nsight is not 4ust about"
$ollecting or purchasing data. (ata often exists already and only needs
synthesiing into useful forms
undertaking demographic segmentation ? it takes a broader range of data,
tools and techni-ues to generate a rich understanding of the customer
a one3off activity ? it is an ongoing 4ourney.
4nderstanding customers
Getting customer insight only via statistics may not be the &ay to go because these
track the middle of the picture and not the before and after part of the picture.
The O&hat happens after3the3sale 9 service part6 may be the biggest of challenges in
learning about the insights to customers6 thinking. This is &here customer insight
becomes so very important but is not often tracked. The only &ay this can be
tracked is for those selling the product9service need to get the feedback from their
customer1s29client1s2.
/ffective use of insight can help to"
Accelerate an enterprise3&ide vie& of customers
)nderstand and respond to customer3specific needs
!peed up customer on3boarding and drive greater retention
/nable dynamic sales, customer service, marketing, and compliance
processes
(eploy front office applications in a multi3channel environment.
deliver efficient and effective tailored services
target resources according to priorities
develop responsive services that encourage and reflect customer engagement
enhance customer service and improve satisfaction
%nform strategic3level planning and decision making, community engagement
and improvement.
(evelop appropriate products and service propositions by segmenting and
analying customer value.
#espond to customer needs by providing the best resources and responses to
representatives.
(evelop scorecards &ith appropriate ob4ectives and measurements.
Leverage data collected in risk and compliance processes to achieve
competitive advantage and #eturn on %nvestments 1#O%2.
Build virtual real3time and historic single customer and business vie&s to
empo&er enterprise integration.
.o&ever, big obstacles stand in the &ay of this idea. %n most banks, customer
information is scattered across unrelated and different databases o&ned by different
lines of business. Often banks as the result of mergers and ac-uisitions over the
yearsPhave multiple %T systems and data repositories that duplicate cross3enterprise
functions and store customer data in multiple places. This can result in an
inconsistent experience for a customer &ho deals &ith the bank using different
channels. The inability of the bank to develop a comprehensive vie& of their
customers also limits their ability to cross3sell and up3sell based on customer needs.
The insights hidden in those databases should be revealed, shared and published
across the institution, but at the same time, data must be kept strictly private and
protected. #esolving these challenges re-uires %T investment at a time &hen bank %T
budgets remain flat overall.
Amid these realities,
ho& to get customer data under controlQ
.o& to transform it from information into insightQ
Jhat do financial institutions gain from customer analytics, and
ho& should it be implementedQ
This can be achieved through the implementation of customer analytics in Banking.
Customer Analytics and Benefits
$% React 'uickly to changes in customer behavior%
BAs customers bank online, through AT5s or through mobile payments, they are
sending subtle signals about their preferences and frustrations &ith their banking
relationships. )nless the customer activities are closely monitored, banks often don6t
kno& &hat customers &ant or are unhappy &ith until it6s too late. !o some banks
use analytics soft&are to &atch to immediately spot changes in customer behavior,
generate alerts, detect service problems and use that kno&ledge to make a sale or
save a relationship.
&% Reduce customer and counterparty risk%
Analytics can help banks monitor the credit&orthiness of borro&ers and the reliability
of counterparties. %ntegrated customer databases &ill set the foundation for
customer analytics, to assess at a glance bank6s exposures to ailing counterparties
and troubled clients. %t &ill also be able to create FI83degree vie&s of clients, for
instance, gaining consolidated vie&s of a customer6s accounts in multiple cities
around the &orld, to decide &hether or not to extend more credit to that customer.
(% Reduce operational risk%
BBasel %% rules are making banks look more closely at their operational risk. An
unified data &arehouse &ith an overlay of analytics &ill reduce the operational risk
associated &ith inconsistent reporting. By eliminating redundant systems and by
improving the data -uality, the traceability can be improved. The time spent each
day on manual data management tasks &ill get reduced from several hours to less
than F8 minutes, enabling employees to focus on more important tasks.
9% Fine:tune marketing campaigns%
Analytics has long been used in retail environments to improve marketing
campaigns. Banks &ere not the first to adopt analytics for marketing, but &ithin
banks, marketing departments have been among the first to recognie the value.
Banks brought in customer analytics to test its assumptions and to create product
propensity models. ,or instance, the bank6s marketers might have an assumption
that G= percent of customers &ho open checking accounts also open savings
accounts. The marketing team inputs the numbers around each campaign, analyes
the results and ad4usts its models accordingly. 5ore recently, the bank has been
using its customer analytics platform for predictive analysis, for instance, to forecast
revenue and make sure a campaign has acceptable return on investment before it is
launched.
;% #redict the right communications channel to use for each customer%
%deally, banks &ould like to determine the best combination of price and response
rate for different customers and segments, by product. A predictive model helps
determine &hich channels are important to each customer, according to customer
preference, &hile factoring in the cost of that contact channel to the bank. %f a model
predicts that a customer &ill bring in R788 &orth of profit, and there6s a I8 percent
chance that person &ill respond to a phone call, then it might make sense to add
that person to a telemarketing campaign, even though a phone call costs t&o dollars
versus t&o cents for an e3mail.
<% -fficiently provide branches =ith lists of solid sales prospects%
Banks analye a combination of household data and product o&nership data every
month, and then supply each of its branches &ith a list of customers most likely to
sho& interest in additional bank products. ,or example, customers &ho have a direct
deposit account and credit card through the bank might be good candidates for a
debit card promotion. $ustomers &ith a checking account and mortgage are good
prospects for a home e-uity line of credit.
>% +anage debt collection% $ustomer %nsight 9 analytics help the debt
management and collection. $ustomers &ho have fallen behind in their payments
and those &ho might be having financial difficulties can be flagged. Banks also use
analytics to segment the customer portfolio into customer types so it can assign the
right type of collections effort to each case.
?% Detect credit card and online banking fraud%
Banks have long used customer insight and analytics to detect card fraud, looking for
unusual behavior that might indicate online banking fraud. ,or instance, if a
customer suddenly logs in from a different address, that could indicate foul play. %f
they6ve never used online bill pay before, and they suddenly use it, or if the
fre-uency of their payments goes up dramatically, those could also be red flags.
@% #rovide better research and reports to salespeople%
Banks use customer insight 9 analytics systems to improve the sales. Banks apply
analytics to reveal ne& insights about sales opportunities &ith its financial institution
and enterprise customers. Armed &ith this analytically derived information, sales
people can give more timely, targeted and relevant presentations to customers.
Developing customer insight
$ustomer insight is an ongoing process that evolves &ith changes to customer and
customer needs. %t should be built into everyday mechanisms for performance
management, decision making and engagement.
#eople and skills
%n practice, customer insight is often developed by an internal team ? recognied
experts &ith kno&ledge of the tools and techni-ues, access to data, and the ability to
bring the t&o together.
Insight tools, data and techni'ues $ustomer insight is as much about
organiational culture and &orking practices as it is about specific data sets and ne&
tools. .o&ever, there are a number of tools and techni-ues available to support
customer analysis.
Analytical techni-ues for understanding customers
o $ustomer !egmentation
o $ustomer 4ourney mapping
o 5arket research methods for understanding customers
o 5arket research tools
o %nternal sources and repositories of data and
o /xternal sources and data repositories
The follo&ing techni-ues can help, pull together and present customer insight to
sho& &ho the customers are, as &ell as their experiences and preferences.
Customer segmentation
!egmentation divides a target audience into groups by common characteristics and
needs. Once groups have been differentiated, councils can target and tailor resources
appropriately. !egmentation information is often combined &ith geographic
information system 1G%!2 mapping to sho& &here different customer groups live.
Customer Aourney mapping
A customer 4ourney map is a &ay to describe a customer's experiences through a life
event, intervention or interaction &ith one or several services, and the emotional
responses these provoke. $ustomer 4ourney mapping can then be used to design
service improvements that reflect the customer6s experience.
+arket research methods for understanding customers
)sing specific market research methods can help to generate information about your
customers, ho& they experience services currently, and ho& they &ould prefer to
receive them in the future.
+arket research tools
Consultation
$onsultation, or directly asking the prospective customers &hat they need, is a basic
source of insight, and is often legally re-uired. Keighborhood charters and other local
forums for agreeing priorities and delivery targets can serve as a &ay of
understanding local preferences that goes beyond formal consultation. As &ith most
tools, consultation is limited as it only reaches a small sample of the population. %t
needs to be combined &ith other sources of information to bring about true customer
insight.
Connecting =ith communities* communications toolkit
Focus groups
,ocus groups or panels are a more -ualitative form of consultation that brings
together a small number of service users to examine a particular issue or understand
detailed preferences. This can provide a rich source of information and examples to
support data analysis.
"urveys
!urveys are a form of consultation and are a useful &ay of understanding user6s
vie&s in a -uantitative &ay. !urvey data can be an especially useful input into
segmentation exercises ? for example, to understand the relative satisfaction of
different groups.
"ocial media
$ouncils are increasingly using tools such as blogs or discussion forums and social
net&orking sites like ,acebook to supplement other forms of consultation and to
engage &ith people &ho prefer to communicate online.
4sability testing and =ebsite analysis
Assessing systems and &ebsites from the customer's perspective can help identify
&here the banks are letting the customer do&n, even if they fulfill technical
re-uirements. Jebsite visitor statistics also provide a source of data about service
use and channel preference that can be fed into insight analysis.
Internal sources and repositories of data
The challenge in the large amounts of data &hich are already available is to use this
data to inform decisions.
!ocal information systems .!I"/
An L%! brings together data from various sources to form a repository of local
information for use in policy and decision3making.
Frontline and customer service staff
!taff are a key source of information on the preferences and concerns of customers.
.olding intervie&s and &orkshops &ith staff helps to capture their vie&s and
experiences.
Customer relationship management .CR+/ systems
$#5s are an increasingly common source of information about customers and their
contact &ith councils. The more services covered by the $#5 system, the more
po&erful the data source can be. The challenge, ho&ever, is to avoid duplication of
customer details.
"ervice area data
%ndividual service areas hold information and data about customers. This can include
transaction records, &hich can be combined &ith other sources of data to gain a
deeper understanding of service users.
Banks team need not necessarily gain a lot of ne& skills, but they &ill need people
to"
Analye and manipulate data
+resent and use data to inform strategy and policy
)nderstand and use market research techni-ues and methods
$ommunicate the results of customer insight analysis in a &ay that makes an
impact on the organiation.
/stablished processes are vital to collecting, analying and disseminating
information. Business processes that should be informed by customer insight
include"
service planning
business cases
/ngagement and empo&erment.
(ata and systems
Good data is the foundation of customer insight analysis. %nformation collected about
customer 9 prospective customers must be stored and shared &ithin and bet&een
organiations. (ata sets ? particularly those purchased externally ? need to be held
in one place and made available to the &hole organiation.
)nderstanding an individual customer's interactions ? a 'single customer vie&' ? is
critical to setting up a single 'clean' data source on a customer. This can then be
used to develop reliable customer analysis.
!tandard &ay to approach a customer insight pro4ect"
%dentify the ob4ectives for using insight and the related -uestion or issue.
Jork out ho& better understanding your customers &ill help you.
)ndertake an audit to establish &hat people, processes and data you already
have, the data you need and &here to get it. This includes identifying the
tools you &ill use.
(evelop a model for customer insight in your organiation and a plan for
achieving it.
)ndertake a pilot to help build skills and stimulate demand for customer
insight throughout your council.
Customer insight and data protection
Because customer insight often involves sharing and manipulating large amounts of
personal data, it is sub4ect to data protection la&s. (ata protection la&s do apply,
&here data is being shared bet&een organiations. !haring of personal information
should be supported by a sound business case and preferably accompanied by a
privacy impact assessment. This should identify the intended benefits of collecting
the data and sho& that the council has identified and addressed any risks to data
protection.
,or most customer insight purposes, as banks re-uire information about trends
&ithin the customer 9 prospective customer community ? personal data can be
anonymised keeping the aggregate level data. (ata should therefore be shared in a
&ay that minimies or avoids the use of personal identifiers.
All customer insight pro4ects should start &ith a clear sense of ho& the kno&ledge
&ill be used to make decisions.
,ollo&ing is a list of some of the principal applications in customer insight pro4ects".
%nform strategy and policy" %nformation on customers 9 prospective customer
can be used to inform decisions and to input into policy or scrutiny revie&s.
5anage performance" )nderstanding customers' needs and experiences can
help to understand &here services are performing &ell or badly.
5arket services more effectively" )nderstanding different groups of
customers makes it possible to market services more effectively, including
being able to encourage take3up of services or different channels to particular
groups.
$hange behaviours" !ocial marketing techni-ues that employ a deep
understanding of the customer to provide information, products and services
can be used to change people's behaviour.
%mprove service design" 0no&ing &hat customers &ant and need from a
service can help identify areas of &eakness and feed into the design of that
service.
%ntegrating customer information can fuel bank's gro&th. By creating a single
customer vie&, bank can enhance analysis and planning, and improve the
development and deployment of multi3channel cross3sell and retention propositions.
And measure the effectiveness of marketing, sales and service strategies.
$ustomer insight solutions can be based on soft&are, hard&are and services
combined &ith best3of3breed applications and tools from alliance partners.
Any customer insight solutions should provide complementary analytics to empo&er
multi3channel banking and successful staged core systems transformation,
integrating closely &ith risk and compliance to share corporate data.
Challenges in gaining customer insight*
The challenge &ith gaining customer insight is t&o3fold"
7. .o& can you kno& that &hat the customer says is trueQ
E. .o& can you kno& &hat the customer does &ith your product9serviceQ
The first -uestion can be partially resolved by using a variety of -ualitative and
-uantitative techni-ues 1focus groups, perceived customer value surveys2, and then
seeing ho& the responses9results LconvergeL. This is not a simple process, but it's
critical 3 especially &hen you're using that data to innovate, and not 4ust to improve
an existing process or product.
The second -uestion is partially ans&ered by transaction data, but additional &ork,
such as ethnographic study, can be absolutely critical in finding out ho& your service
or product is actually used. And, given that your LserviceL is really your entire, lust3
to3dust relationship &ith a person, you really have to understand ho& you engage
someone, ho& that engagement compares &ith other sources of engagement, and
then on&ard from there 1exploration, selection, use, retirement of the
product9service9relationship2.
)ltimately all of this data should be in service of the -uestion" Jhat is the larger goal
of the customerQ %t could be to solve a problem, to get closer to an aspiration, to
serve the ego. +eople don't buy a drill for the ability to drive a drill bit. They buy a
drill to make a hole. They &ant a hole, not a drill.
This is in part &hy this -uest for insight is especially tricky &hen &e try to innovate.
Jhy does a customer &ant a holeQ To put a scre& in. JhyQ ,or many customers" To
hang something. !o, if &e &ant to innovate, &hat &e really &ant to do is to come up
&ith something that helps people hang something. Je might be able to circumvent
having to continually improve your drill.
+ragmatically, the follo&ing can be tried"
7. ,ocus groups to determine the benefits sought by the customers.
E. (etermine the aspects of this benefit
F. (o a survey.
G. )sing factor analysis or similar techni-ue, determine &hich aspects are most
important, and &hich are truly independent of each other.
=. (o a bigger survey, using a reduced and sufficiently independent set of value
drivers.
I. !urvey Kon3$ustomer, or customers of competitors.
N. )se factor analysis again and determine ho& the customers LclumpL in their
needs.
%f you &ant to take it further, you can also ask respondents to score ho& &ell you,
and your key competitors, provide value along these value drivers. That can give you
a score relative to both the value drivers as &ell as to your competitors. #eal insight
can only happen through dialogue, and surveys aren't enough. %magine approaching
your spouse9significant other and saying, L(ear, %'d like to really understand you
more than % do, and to get feedback about &hat % might do to improve our
relationship. Jould you mind filling out this surveyQL. (eep customer insight is
usually complex and re-uires a multi3faceted approach, integrating feedback 1of
various types2, transactional data and a dash of intuition.
Conclusion
Banks can no longer think of their customers in traditional, demographic3based
segments and successfully deliver a differentiated experience. $ustomers &alk in to
the Bank &ith a specific mission, driven by fundamental, personal values and
attitudes. $ustomers &ho share the same surface characteristics may &ell have
meaningfully different needs and preferences.
(eveloping deeper insights through more sophisticated approaches to segmentation
and innovative analytical models is a key step to&ard creating a more customer3
centric banking experience. Banks need to kno& ho& their customers make
decisions, &hy they bank there, and &hat their needs and preferences.
Armed &ith these insights, banks can develop services strategies that are better
aligned to their target customers. Going for&ard, the more tailored and personalied
the experience that banks create for their customers, the greater the differentiation
from their competitors and ultimately, the greater the success.
2bAective
The ob4ective of this module is to give the reader an overvie& of the basic accounting
concepts and terms applicable to bank accounting, the various financial records
maintained by a bank and the financial statements prepared by a bank.
Financial Accounting*
3hat is accounting7
,inancial accounting involves"
)nderstanding the standard accounting principles
Applying the accounting principles &hile recording all transactions
$lassifying the recorded data under appropriate heads or accounts
!ummariing accounts into various account statements
The follo&ing diagram displays the role accounting plays as an information system
that aids business and economic decisions made by user3decision makers.
3hat is the purpose of accounting7
,inancial accounting information
.elps the o&ners, managers and external users such as investors, stock
exchanges, government authorities such as income tax officials to understand
the financial performance and position of any organiation.
.elps to understand the follo&ing aspects of any entity
o Jhether the entity has made a profit or incurred loss during the
accounting period
o Jhether the profitability of the entity is ade-uate in terms of return on
capital
o The values of entity6s assets, liabilities
Concepts of Accounting
$ash Basis
Accrual Basis
Cash Basis*
/ntity records a transaction of income &hen realied or an expense &hen incurred.
/x. #ent paid ? The transaction is recorded &hen the rent is actually paid. %f the rent
for the month of 5arch is paid in 78th of April, and a financial statement is prepared
in F7st 5arch, the rent paid for the month of 5arch &ill not be reflected in the
statement prepared as on 5arch.
Accrual Basis*
All the income and expenditure that has become due and is receivable or payable 1in
due course is recorded. Accrual based accounting is also kno&n as mercantile
system. ,or example, the rent for the month of 5arch although paid in April, &ill be
recorded as Orent payable6 in the books of account in the month of 5arch. !imilarly,
all the incomes that have become due and receivable &ill be recorded in the books of
account even if it is not recorded.
Book:5eeping #rocess
%t is important to dra& a distinction bet&een book keeping and accounting. Jhile
book keeping is the simple recording of business transactions, accounting is the use
of the information recorded to produce reports for management, share holders and
others.
Book30eeping is a part of accounting and is concerned merely &ith the recording and
keeping records of business transactions accurately and systematically in accordance
&ith certain &ell3accepted principles and rules.
All business transactions over a specified period of time are recorded and
summaried as part of book3keeping. !uch a specified period of time is called the
accounting period. This period may be month, a half3year, a full year or any length of
time. To find the profit or loss for an accounting period, only those transactions that
fall &ithin that period is taken into account.
Double -ntry "ystem for Accounting
As per this system, every transaction affects t&o or more accounts and is recorded in
t&o or more accounts. One account receives the benefit of the transaction &hile the
other gives the benefit. The t&o aspects are called debit and credit. (ebit and credit
transactions are posted to an account and the account balance is arrived at. Account
balance refers to the amount of money appearing against an account head.
Debit
An accounting entry, &hich results in either an increase in assets and expenses or a
decrease in liabilities or net&orth. %t is represented by the abbreviation B(r.D. ,or
example, Bank charges debited to a customer6s account.
,or posting the transaction, bank charges debited to a customer6s account, the
customer6s account &ill be debited &hile charges collected account &ill be credited.
Credit
An accounting entry &hich results in either an increase in liabilities and income or a
decrease in assets. %t is represented by the abbreviation B$r.D ,or example, interest
credited to a customer6s account. %nterest credited to customer6s account, the
customer6s account &ill be credited &ith the interest amount &hile interest account
&ill be debited.
Types of Accounts
Accounts can also be classified as personal accounts, real accounts and nominal
accounts.
#ersonal Accounts* are accounts of parties &ith &hom business is carried on.
These may be accounts of" Katural persons e.g. 5r. :6s Account Artificial9Legal
/ntities e.g. AB$ * $o
Accounting of #ersonal Accounts* (ebit the #eceiver $redit the Giver #eal
Accounts" are accounts of assets9properties in9&ith &hich business is carried on. /.g.
Building Account
Accounting of Real Accounts*
(ebit &hat comes into the business $redit &hat goes out of the business
8ominal Accounts* are accounts of expenses9losses a business incurs and
income9gains a business earns. /.g. #ent +aid Account
Accounting of 8ominal Accounts*
(ebit all expenses and losses $redit all incomes and gains
Assets ) !iabilities Assets Assets refer to the properties o&ned by a bank and
debts due to it from other parties that can be converted into cash.
%t can be further classified as"
Current assets* refer to temporarily held assets meant for conversion into
cash &ithin a short period of time. %ncludes $ash, %nvestments and Accounts
#eceivable.
Fi1ed Assets* refer to assets &hich are of permanent nature and are held for
use in the business and not for sale. %ncludes land and buildings, furniture
and fixtures and plant and machinery.
Intangible Assets* refer to assets that lack physical existence. %ncludes
good&ill, copyrights and patents.
!iabilities
Liabilities refer to amounts o&ed by a bank to other parties either for deposit of
money in the bank, the purchase of goods on credit or for the purchase of assets on
credit, loans borro&ed, services received on credit and shareholder money. Liabilities
can be further classified as"
Current liabilities* refer to liabilities re-uired to be repaid &ithin a short
period of time, usually one year. %ncludes (eposits taken from the public,
other banks and institutions, borro&ings in %ndia and outside from other
Banks.
!ong term !iabilities* refer to those liabilities that are repayable for a
period beyond one year. %t includes !hare $apital, #eserves * !urplus. %n
essence, all monies deposited in a bank are liabilities from the bank6s point of
vie&, &hile all forms of lending9investment by the bank are its assets.
Income ) -1penditure
Income
#efers to income earned by a business by &ay of sale of its products and services.
-1pense
/xpense, as the name suggests, refers to expenditure incurred by a business.
"uspense Accounts*
!uspense Accounts are used to store short3term funds9securities until a permanent
decision is made about their allocation. Or route entries &hen accounting entries for
certain transactions cannot be determined or &hen a mismatch of accounting entries
in an account occurs. The balance in the suspense account is subse-uently
scrutinied and suitable rectification entries are passed.
Contingent Accounts*
These are accounts that are maintained in order to monitor and keep a record of
contingent or conditional future liabilities. These transactions have no direct effect on
a bank6s position. !uch accounts are not taken into account at the time of
preparation of the Trial Balance, +rofit and Loss #eport and the Balance !heet. ,or
example, Letters of $redit opened, Guarantees issued, etc.
Trial Balance
%n double entry accounting system, for every transaction, the amount involved is
entered on the debit side of one account and the same amount is entered on the
credit side of another account. /very debit is matched by an e-uivalent credit.
Therefore, &hen the debit and credit balances in various accounts are listed and
totaled, the totals &ill tally.
Trial balance is a list of closing balances in all accounts &ith the debit and credit
balances &ritten separately. The total of debit balances must tally &ith the total of
the credit balance. Jhen the balances do not tally, it indicates there is something
error or mismatch in posting and or in calculating the balances in the account or in
totaling the t&o sides of the Trial balance.
The Chart of Account
This is a listing of all accounts based on their codes &hich ensures that the accounts
are grouped as per their type, classification, cost9profit centre3&ise and currency3
&ise defined as in the accounting system.
The hierarchy of grouping of accounts in the $hart of Accounts is highlighted by the
follo&ing example &herein the BBalance &ith BanksD is arrived at by grouping
BBalance &ith Banks in %ndiaD and BBalance &ith Banks outside %ndiaD. /ach of these
balances are arrived at by grouping BBalance held in $urrent AccountsD and BBalance
held in (eposit AccountsD"
Inter Branch Accounting
All accounting entries pertaining to transactions &hich are affected bet&een t&o
branches of the same bank are routed through the %nter Branch account. !uch
transactions could be in the nature of che-ues sent for collection, telegraphic
transfers, transfer of expenses, transfer of customer accounts and so on. lnter3
branch entries may be routed through the .ead Office9the #egional Office9directly
bet&een branches.
Inter Bank Accounting
All banks maintain accounts &ith the $entral Bank, through &hich all inter bank
transactions, are routed. !uch transactions are mainly of the follo&ing nature"
$learing Transactions
(ra&ing and $ollection Arrangements
$all 5oney and other Treasury related activities
Reporting
Types of Reports
Regulatory Reports* refer to those reports &hich a bank is re-uired to prepare in
order to fulfill the re-uirements of the $entral Bank &hich is the regulatory authority
for all banks. /xamples" !tatement of key banking indicators.
+I" Reports* refer to reports prepared by a bank for internal management
purposes. The nature and type of these reports &ould vary from bank to bank
depending on the individual re-uirements of each bank6s management.
Examples: (eposits3%nterest Accruals 9 +ayment #eport, (eposits +aid #eport,
5atured (eposits (ue #eport, )nclaimed (eposit #eport, Account Listing
Examples: Loans3 Limits !anctioned #eport, $ollaterals #eport, $redit #ating #eport,
Overdrafts #eport, Group3&ise /xposure #eport
Control Reports* refer to reports prepared by a bank for internal control purposes.
!uch reports enable the management in its decision making.
eneration of Reports
#eports are mostly generated for the follo&ing areas"
eneral !edger
This is a book of account and is a collection of the control accounts of all the
subsidiary ledgers, accounts of all assets held by the business, all liabilities of a
business, all expenses incurred and all incomes earned by a business and other
accounts like suspense accounts, contra accounts and so on.
General Ledger !ystem, as the name suggests, refers to the system by &hich a
business 1in this case a bank2 records and consolidates its day3to3day financial
transactions relating to the ac-uisition of funds and their allocation.
%t provides the business &ith a conceptual and analytical frame&ork for financial
decision making by" #ecording details of transactions pertaining to all assets,
liabilities, income and expenditure items
"ubsidiary !edgers
!eparate ledgers are maintained by a bank for different types of accounts. These
ledgers contain account3&ise details of day3to3day transaction postings. They are so
called because they are subsidiary to the main ledger that is the General Ledger, in
&hich control accounts 1totals of each subsidiary ledger2 of these ledgers are
maintained. The totals of these ledgers are tallied &ith their respective $ontrol
Accounts appearing in the General Ledger on a daily basis.
#rofit and !oss "tatement
The profit or loss is ascertained by listing the balances in all the nominal accounts,
the expenses on the debit side and income on the credit side, and finding out the net
balance. The consolidated listing of all nominal accounts is called the +rofit and Loss
account. !ince profit earned or loss incurred over a period is ascertained, the title of
+ * L a9c is &ritten as +rofit and Loss Account for the +eriod /nded
SSSS1date2SSSSS. %f the credit side 1income2 total is more, the business &ould have
made a profit and if the debit side is more it &ill indicate a loss. The balance in the
nominal account is transferred to the + * L account, &hich is also a nominal account
at the end of the year. i.e. on financial year closure.
Balance "heet Report
Jhen the + * L a9c is prepared, all the nominal account &ould have been closed and
only the real and personal accounts &ill be left. Balance in the real accounts
represents Assets of the business such as cash, furniture, computer and building.
Balance in the personal accounts represent amounts o&ed to the business by debtors
1assets2 and amount o&ed by the business to its creditors 1liabilities2. Therefore, the
balance in the real and personal account represents the assets and liabilities of the
business. The debit balance represent the assets and the credit balance the liabilities.
These balances feature in the balance sheet. The liabilities appear on the left and
assets on the right.
The parameters that need to be defined are"
Level of #eporting" Branch Level9Kodal Level9Bank 1as a &hole2 level
+eriod of #eporting
5ulti3currency classification
3ho is a Customer 7
Like %ndividual persons, government organiations like rail&ays, private limited
companies, partnership firms, companies, and trust associations clubs can o&n
assets and have legal rights and obligations. All such entities are recognied by la&
can also maintain various types of accounts &ith banks and all are customers of the
bank.
Legally recognied entities have almost same rights as individuals and can do many
of the things that individuals can do including running business for &hich they can
borro& money too. !ince legal entities are fictitious persons and do not have physical
presence, they have to exercise their rights and discharge their obligations through
the individuals &ho run them.
8eed for a Customer 7
The bank6s approach to a customer is changing drastically day by day and banks
have started seeing customers &ith more focus on relationship they establish and
maintain &ith the customer than seeing a customer &ho has a deposit or a loan
account &ith the bank. Jith this change in scenario, banks have started giving high
importance to the various types of information they gather and maintain about a
customer during the lifecycle of an account. Banks use the personal information they
gather more to give a personal touch to the relationship &ith the customer like by
sending birthday &ishes, etc.
Customer of a Bank and not a Branch
Also in earlier days customers &ere merely seen from the branch perspective, &here
the customer had an account and operated. But the present scenario is to look at a
customer from the Bank6s perspective. Jith this perspective in mind, banks have
started designing banking solutions for the customers like AT56s, %H#6s, Any&here
Banking facilities etc. These facilities provide the customer the convenience of
banking not only from their home locations but from any other locations &here the
banks have presence.
Jith this idea in mind the banks have started moving from a decentralised data
environment to a centralised data environment. The centralised data environment
makes maintenance of customer related information easier, since the information is
stored at the bank level and not at the branch level> this also results in uniformity of
data for a customer across the bank.
Types of Customers
There are E broad types of customers &e come across in banking namely, +ersonal
1%ndividual2 * $orporate.
#ersonal Customers are
Any individual &ho opens an account &ith a bank9institution
Operates the accounts for personal use
%nformation collected during account opening &ill contain personal data of the
customer
+ersonal customers may be eligible for only certain types of accounts9services
of the bank
Corporate Customers are
Any group of individuals like partnership firms, limited companies etc., &ho
opens an account &ith a bank9institution
Operates the account for business purpose
%nformation collected during account opening &ill contain business data of the
customer
$orporate customers may be eligible for most of the non3personal types of
accounts9services of the bank.
Individuals
%ndividuals can open bank accounts singly or 4ointly &ith one or more other
individuals. %n a single account only account holder can operate the account like
/n-uiring about his9her accounts 1balances, che-ue status2
(epositing cash 9 $he-ues
Jithdra&ing cash or issuing che-ue for payment to others
Transferring money from his account to another
$he-ue book re-uest, AT5 card or phone banking facility
Asking for T(! 1Tax (educted at !ource2 certificate
Account modification like including another name of person in the account and
make it as Toint account
+andate Bolder , #o=er of Attorney
A customer may authorie another person to operate the account by issuing a letter
of authority. !uch as letter of authority is called a B5andateD. The mandate holder
has all the po&ers that a customer has. Bank has to take signature and photograph
of the mandate holder along &ith the mandate.
The account holder may also issue a po&er of attorney that has the same effect as
mandate. A po&er of attorney is a registered document by &hich a person grants
certain po&ers to another person. The account holder can invoke mandate and
po&er of attorney at any time by issuing a letter to the bank.
8omination
On the death of an account holder, the nominee is entitled to claim the balance in
the account authoried by the account holder or his successor or the legal heir can
claim the balances in the account. .o&ever, he has to complete certain legal
formalities before claiming the balances in the account of the deceased account
holder. To enable their successor or legal heirs to get the balances in their account
&ithout completing any legal formalities, the account holder should make a
nomination in the account. The nominee can claim the amount after producing the
death certificate and proof of his o&n identity.
Coint Accounts
T&o or more individuals can maintain 4oint accounts &ith the banks. At the time of
opening the account the bank has to obtain clear instructions from them on ho& the
account &ill be operated.
The common operational instructions are
Both Cointly ? The account can be operated by both the account holders together
only.
Cointly or "urvivor ? Jhile the account can be operated by both the account
holders together only, on the death of any one of them, the balance becomes
payable to the survivor.
-ither or "urvivor ? Any one of the customer can operate the account. %n case of
death of a 4oint holder, the balance becomes payable to the survivor.
+inor* 3 A minor is a person &ho has not competed 7@ years of age. As per la&, a
minor can not be held responsible for not keeping his &ords. %n the circumstance,
lending money to minor is a dangerous proposition. Jhile banks do not lend to a
minor, they do open deposit accounts of minors to be operated by their guardians
&ho are expected to protect the interest of the minors.
#roprietorship Concerns
A business o&ned by one individual is kno&n as +roprietorship $oncerns. !ince only
one individual is involved he is entirely responsible for any debt of the business. This
is similar to the individual account except the legal status of the account. %n this case
the account is opened by the company name and proprietor operates the account on
behalf of the business.
#artnership Firms
The partnership act defines partnership as Bthe relation bet&een persons &ho have
agreed to share the profit of a business carried on by all or any of them on behalf of
allD. The understanding bet&een the partners are documented and recorded in a
registered document called B+artnership deedD.
Operations of a partnership account can be done by one or more partner as per the
operating instruction given by them at the time of opening the account.
Coint "tock Companies Like a firm, a company o&ned by a group of persons, but
unlike a firm, a company has a legal existence separate from that of the o&ners. The
properties of the company and not 4ointly by the o&ners, &ho are called as
shareholders, as the capital of a company is divided in to units of e-ual amount
called shares.
)nlike partners, share holders are not personally liable for the debts of the company.
The company is managed by (irectors &ho are elected by the share holders. The
(irectors, collectively constitute the Board of (irectors, &ho appoint the 5anaging
(irector &ho is responsible for the company in accordance &ith the policies approved
by the board.
T&o ma4or types of companies are
+rivate Limited $ompany
+ublic Limited $ompany
,ollo&ing documents are re-uired for bank to open the accounts
Account opening forms signed by officials &ho &ill operate the account
Latest list of (irectors
$ertified copy of resolution of the Board authoriing for account opening and
authoriing the officials to operate the account
$ertified copy of $ertificate of %ncorporation
$ertified copy of 5emorandum of Association
$ertified copy of Articles of Association
$ertified copy of the certificate of commencement of Business, in the case of
public limited companies.
Trusts
Trusts are created by persons kno&n as BauthorsD of the trust to carry on some
activities for the benefit of a person or a group of persons kno&n as BbeneficiariesD.
BTrusteesD are appointed by the author of the trust for carrying out the activities of
the trust for the benefit of the beneficiaries.
A Trust (eed is a document that specifies the ob4ectives the trust, the names of the
beneficiaries of the trust, the activities that can be carried on by the trust
The bank has to allo& operations strictly in accordance &ith the provision of the trust
deed and should not allo& the Trustees to misappropriate the funds of the trust.
"ociety and Associations
Bank accounts can be opened only for the registered societies and associations.
$ooperative societies have to be registered &ith the registrar of $ooperative
societies. The account is operated by any authoried signatory.
Clubs
$lubs may be run a business or as a non3for3profit entity. %t could be registered as
company or society or trust. The procedure to be follo&ed for opening the account of
a club and allo&ing operations &ill depend upon its constitution.
overnment departments and +unicipal Bodies Government departments 9
bodies 9 agencies can open savings accounts and current accounts provided
They do not receive any funds from government budget for their functioning.
They submit declaration that they do not receive any budget allocation.
Bank 0 Customer Relationship
The legal relationship bet&een a banker and a customer varies &ith the nature of the
services rendered by the bank. The various relationships can be summaried as
"ervice
Relationship:
Bank
Relationship:Customer
Loans $reditor (ebtor
(eposits (ebtor $reditor
+ledge of !ecurity +ledgee +ledgor
$ollection Agent +rincipal
#emittance ,iduciary Agent +rincipal
(istribution
Agent of 5,s,
Bond issuer etc
$ustomer of 5,s, Bond issuer etc
!afe (eposit
Locker
Lessor Lessee
Advisory Advisor #ecepient
3hat is a Deposit7
A (eposit can be defined as a !um of money received from a customer by a bank for
a specified period of time, on a specific rate of interest, repayable on maturity or on
demand by &ay of cash che-ue, draft or any other legal means as desired by the
customer
Types of Deposits
(eposits are classified into E categories namely (emand (eposits and Time (eposits.
Concepts in Deposits
$haracteristics of a (eposit
A typical deposit &ill have the follo&ing characteristics
$an be opened by a +ersonal or $orporate $ustomer
Jill be for a specified period of time say 7= days to = years
Jill earn interest at the agreed rate
Jill mature at the end of the agreed period
Jill be repaid to the depositor only or his authoried representatives or heirs
or nominees
A (eposit represents a liability for the bank.
Demand Deposits
(emand (eposits are repayable on demand by the customer1s2. Generally demand
deposits are &ithdra&n by the depositor by issuing a che-ue, &hich is an Binstruction
to the bank to pay the stated amount to the person named in the che-ueD.
The follo&ing are a fe& types of demand deposits.
Current Account*
$urrent accounts are primarily meant for business people &hich may be !ole
+roprietorship concerns, +artnership firms, Toint stock companies, Trusts,
Associations and individuals &ith large number of transactions. %t facilitates the
transactions using che-ues. Generally banks do not pay interest on balances in the
current account but there are fe& countries &here the banks do pay interest for
current accounts also. As no interest is paid in current accounts, there is no
restriction for number of transactions in the current account. 5inimum balance
re-uired to be maintained in current accounts are higher than savings account due to
higher transaction cost.
"avings Account*
!avings accounts are demand deposit accounts offered for the benefit of individuals
or group of individuals. !avings account differs from current accounts in three
aspects" 7. %nterest is paid on balances in savings account E. Business entities
cannot open savings account F. !ome banks impose restrictions on the number of
transactions that can be put through savings accounts on a monthly basis.
%n the vie& of the absolute li-uidity offered by demand deposits, banks pay lo&
interest 1in case of savings account2 or no interest 1in current accounts2 on such
deposits. $ost of maintaining the demand deposit accounts is high in vie& of the
large number of transactions involved. The higher transaction cost is an important
reason for payment of interest at lo&er rates or no interest on demand deposits. This
makes it a lo&3cost deposit for the banks and it is much sought after by banks.
Generally, interest is calculated on daily closing balance on such deposits and paid at
specified fre-uency 1generally half3yearly2.
Banks also prescribe certain minimum balance to be maintained in savings accounts.
Jhile some banks insist on a minimum balance at all times, others insist on an
average minimum balance during a specified period 1generally during a period of
three months2. 5inimum Balance is the amount of credit balance a customer9s is
re-uired to maintain in the !avings 9 $urrent Account at any point of time.
%f the minimum balance drops belo& the prescribed level, banks levy charges for
non3maintenance of minimum balance. !ome banks prescribe a minimum average
relationship value. i.e. combined average balance in the several savings accounts 9
fixed deposit accounts maintained by the customer.
Almost all the banks generate and send statements of accounts on periodical basis to
the customers to keep track of the transactions in their account. !ome banks used to
issue passbooks to savings account.
The follo&ing facilities are offered in savings account"
$ash deposit and &ithdra&al
$learing of local che-ues
$ollection of upcountry che-ues
/lectronic funds transfer
(ebit $ards
Access to AT5s of even other partner banks
Access to %nternet banking
Access to phone banking services
Access to mobile banking services
Any&here banking services
!tanding instructions for making regular payments
/lectronic $learing !ervices 1/$!2 facility for making regular payments like
telephone bills, other utility payments, loan repayments and also for receiving
dividends, interest and pension.
Automatic &ithdra&al of fixed deposits to meet shortage of funds in savings
account by linking fixed deposits to the savings account 1reverse s&eep from
fixed deposit to savings account2.
Types of Balances in Demand Deposits
Book Balance 3 This balance is arrived at taking into account all transactions
that have been posted to the account including cleared items and non3cleared
items.
Cleared Balance 3 This balance is arrived at after taking only the cleared
transactions.
Available Balance 3 This balance is arrived at after taking into account all
transactions including cleared items and non3cleared items. But the
&ithdra&als are not allo&ed on the un3cleared balance. Available balance &ill
also include any overdraft limits provided to the customer.
2verdraft Facility
Overdraft is a facility available to a customer provided by a bank. This is an
arrangement &ith the bank &hereby the customers can dra& from their current or
savings account a certain amount over and above the balance in their accounts.
!ince the customers are allo&ed to dra& over the balance in their account, the
facility is called an Overdraft 1O(2.
Overdrafts are of t&o types namely Temporary overdraft or permanent overdraft.
Temporary overdrafts are provided to &ell kno&n customers in times of emergency
for a shorter duration of time or for specific transactions only. +ermanent overdraft is
usually given for one year and rene&ed every year sub4ect to certain conditions. The
amount up to &hich over dra&ings are permitted is called the OO( Limit6.
The customer &ill be charged interest to the extent of amount overdra&n from the
savings9$urrent account.
O( limits may be unsecured or secured by fixed deposits or any other securities.
Jhen the fixed deposit amount is matured and if the customer is not &illing to rene&
the same, the proceeds of the fixed deposit &ill be ad4usted to&ards the overdra&n
amount in the savings9current account and the overdraft facility &ill cease to exist.
Issue of Che'ues
The account holder of a !avings or a $urrent Account could opt for che-ue book
facility &ith the bank. Once a che-ue book is issued, the customer is expected to
make all &ithdra&als from the !avings9$urrent Account through $he-ues only.
Generally, the banks issue che-ue books to the customer, free of any charges. But
under special circumstances the banks may charge a nominal amount to&ards issue
of che-ue books.
"top #ayment of Che'ues
An account holder, &ho has issued a che-ue from his account to a third party, may
for various reasons re-uest the bank not to honor the che-ue. This is called !top
+ayment of $he-ue.
The account holder &ill give the che-ue particulars like che-ue no, che-ue date,
che-ue amount and the person to &hom the che-ue is issued to the bank as
reference. The bank on receiving this instruction &ill record the che-ue details and
track the che-ue each time a che-ue comes for payment from the customer6s
account. Jhen the relevant che-ue comes for payment, the payment &ill be refused
by the bank. The bank &ill also inform both the customer and the third party to
&hom the che-ue &as issued by the customer.
Banks may charge stipulated fees from the customer for this service.
!top +ayment of che-ues could be re-uested for !avings or a $urrent
account.
Only the dra&er of the che-ue could issue !top +ayment instructions or a
person authoried to operate the account.
The dra&er of the che-ue only could revoke a che-ue under !top payment.
"tanding Instructions
A customer, &ho is re-uired to make periodic payments to satisfy various
obligations, need not make repeated &ithdra&als from the savings Account. %nstead
the customer could issue a !tanding %nstruction to the bank to make the periodic
payments to&ards his9her obligations. The bank &ill act upon the instruction, debit
the account of customer and make payments as re-uired.
The features of this facility are as belo&"
!% could be set up for specific payments9transfers like payment of #ecurring
(eposit installments on monthly basis, payment of utility bills of the
customer.
$ustomer has to specify the account number and the amount to be debited,
the beneficiary, the start date and end date of !tanding %nstruction.
The bank &ill carry out the !tanding %nstruction on the designated dates as
specified by the customer automatically till the end date or as re-uired by the
customer.
The customer as desired could revoke the !tanding %nstruction in &hich case
the bank &ill stop debiting the customer6s account.
The banks generally charge the customer for this service.
Jhen a !% is setup the customer is expected to hold sufficient balance in the
account to meet the !%, %f a !% is dishonored for &ant of funds, the banks
may treat the same as dishonor and charge the customer for the same.
Interest Accrual
The process of calculating interest amount from the last interest application day till
the next date of %nterest application is called %nterest Accrual. %n this case the
%nterest amount to be credited to the account is calculated but not yet credited.
%nterest accrual may be for debit interest or credit interest and applies to both
!avings * $urrent accounts.
Interest Application
The process of crediting the interest to the account of the customer and debiting the
General Ledger account is called %nterest Application. %nterest Application is done on
pre3determined fre-uency as decided by the bank. This process of crediting the
interest to the account of the customer is normally called as %nterest +osting.
Account "tatus
The status designated to !avings or a $urrent account, by the bank depending upon
the operation of the account is called as an Account !tatus. The different types of
account statuses are listed belo&"
Active 3 This status is assigned to an account, &hich is in continuous
operation
Inactive 3 This status is assigned to an account &ithout customer activity for
a specified period of time.
Dormant 3 This is 4ust like %nactive status, &here the account is &ithout any
customer activity for a specified period of time.
Closing 3 This status is primarily assigned &hen a customer &ishes to close
an account but has outstanding checks. $redits and deposits into the account
are not allo&ed to accounts in closing.
Closed 3 This status follo&s the closing status and after the balance in the
account becomes ero and after the expiry of the stipulated number of days
for ero balance maintenance.
FroDen ? This status restricts certain external monetary transactions from
posting to an account. This status is most commonly used &hen legal action is
taken against an account holder.
Time Deposits
These are the deposits types &hich repayable to the customer at the expiry of
contracted period of time. The follo&ing are a fe& types of Time deposits"
,ixed (eposit accounts
#ecurring (eposits
Fi1ed Deposits
As the name indicates, fixed deposits are accepted for fixed period ranging from
seven days to five years. The period may vary from country to country. They are
repayable only after the period for &hich they are deposited. %nterest on fixed
deposits is paid at regular fre-uency 1like monthly, -uarterly2 during the period of
the deposit at fixed agreed rate of interest. The interest can also be re3invested in
the fixed deposit account. %n this case, the deposit earns interest on interest and
hence called cumulative fixed deposits. (ue to lo& li-uidity, the rate at &hich
interest is paid on fixed deposits are higher than on savings deposit.
The minimum amount of deposits varies from bank to bank &ith additional deposits
in multiples of certain units 1like 78882 and depends on the nature and term of the
deposit.
Banks may or may not permit the pre3mature &ithdra&al. %n this case, interest &ill
be paid only for the period for &hich the deposit has remained &ith the bank. The
bank may also levy penalty for early &ithdra&al 9 closure. +remature encashment
&ithout any penalty is offered as an incentive to attract deposits.
To help customers tide over temporary re-uirement of funds, banks may offer loans
against fixed deposit up to @=A 1or as stipulated by the individual banks2 of the
value of deposits. The rate of interest on the loan could be 7A or EA over and
above the rate paid on deposit. On maturity, the deposit &ill be automatically
ad4usted against the deposit and only the balance, if any, &ill be repaid to the
customer.
Banks &ill also deduct tax from the interest paid on fixed deposits, either for the full
interest earnings or if the amount of interest paid to a customer exceeds certain
amount in a financial year. The tax rule may vary from country to country depending
on the rule stipulated by the country. The tax &ill be deducted at source 1T(!2. The
rate at &hich T(! is deducted also varies from country to country and from customer
to customer depending on the type of the customer. The T(! deducted have to be
paid to the tax authorities by the banks.
Bank issue a separate receipt of each fixed deposit. The fixed deposits can be
encashed or rene&ed on maturity. Automatic rene&al of fixed deposit is also
possible, incase the deposit holder places formal instruction for rene&al. On the date
of maturity, such deposits &ill be rene&ed automatically for the similar period as the
original deposit at the rate prevailing on the date of rene&al. The fixed deposit
receipt 1,(#2 has to be surrendered to the bank at the time of rene&al of
encashment. Bank may also issue duplicate ,(#, incase the ,(# is lost or misplaced.
,ixed deposits cannot be paid by cash over and above certain amount as fixed by the
bank or by la& enforcing authorities. #epayment on such deposits has to be by
che-ue in the name of the depositor or by credit to the savings or current account of
the depositor.
& in $ Account
E in 7 accounts are ,( linked savings account, &hich gives li-uidity as savings
account as &ell as higher interest rate as fixed deposit account.
The money on the savings account in excess of the stipulated amount is s&ept into a
fixed deposit 1by auto s&eep instructions2 for a particular period. This carries an
interest rate higher than the savings account interest rate. %f the money in the
savings account is insufficient to meet any debit transaction, the shortfall is
&ithdra&n from the latest fixed deposit and credited to the !B account automatically
1reverse s&eep2 for honoring the che-ue.
,eatures of E in 7 account
U Auto "=eep facility ? 5aximum returns
Balance in excess of stipulated amount is automatically transferred to a fixed
deposit 1,(2 for a period as instructed or as per the product.
The transfer 1auto s&eep2 &ill be done daily 9 &eekly depending on the bank
policy
,( formed through auto s&eep &ill carry the rate of interest prevailing on the
date of Auto s&eep.
U Reverse "=eep facility ? 5aximum li-uidity
This facility &ill give easy access to funds in ,ixed (eposit accounts
%ncase of shortfall in savings account to honor any che-ue or debit
instruction, ,ixed (eposits &ill be automatically broken to that extent of the
shortfall. The remaining balance in ,ixed (eposits &ill continue to earn higher
interest at the original rate applicable to the ,ixed (eposits.
,ixed (eposits &ill be broken in multiples of some fixed amount as stipulated
by the bank.
,or the maximum benefit of interest, they &ill be broken on Last3%n3,irst3Out
1L%,O2 basis. i.e. the fixed deposit last opened 9 created is broken first.
U Automatic Rene=al Facility
Jhen fixed deposits mature, they get automatically rene&ed &ith principal
and accrued interest for a default period 1as per the product feature2 or for a
longer period, if specified by the depositor.
All existing terms on payment of interest and premature closures as applied
to existing fixed deposits shall apply to fixed deposit linked to the savings
account.
Recurring Deposits
#ecurring deposits are for the benefit of those &ho &ould like to save a fixed sum
every month over a longer period of one to five years. %t is e-uivalent to making
fixed amount, as fixed deposit every month in such a &ay that all the fixed deposit
&ill mature on the same date. !ince it is inconvenient to issue fixed deposit receipts
on every month, the monthly deposits are accumulated in an account. %nterest paid
on recurring deposits usually at the rate applicable to fixed deposit as the deposits
cannot be &ithdra&n before the due date. ,or default in making deposit in any
month or for premature &ithdra&al, bank &ill levy penalty.
The maturity value of the recurring deposit account &ill be indicated to the depositor
assuming that the monthly installment &ill be paid regularly on the due date. %f any
installment is delayed, the interest payable in the account &ill be reduced and &ill
not be sufficient to reach the maturity value. .ence the difference in interest &ill be
deducted from the maturity value as a penalty. The rate of penalty is fixed upfront.
Tax 1T(!2 is not applicable to interest paid in #ecurring (eposit accounts.
%nterest accrual 1including catch3up accrual2 and interest payment
%nterest can be paid in any of the follo&ing modes"
by cash
by banker6s che-ue
by transfer to savings account
by transfer to GL account
by transfer to loan account
Jhen interest becomes payable, the tax on interest, if any, must be deducted from
interest and credited to tax &ithheld account and the net interest should be credited
to the interest payable account.
Interest capitalisation,compounding
$apitalising9compounding interest involves no payment of interest to the customer.
%t is credited to the Time (eposit account. This takes place at the time of maturity of
a $umulative Type of (eposit.
+aturity of time deposit
Jhen a time deposit matures, the principal and9or interest can be paid out or
rene&ed as per maturity instructions or force3rene&ed if there is a lien on it. The
principal and9or interest can be paid out by cash, by che-ue or by transfer to savings
account.
3hat is a Retail !oan 7
Banking is defined in terms of the intermediation role played by them as, accepting
deposits and lending or investing the funds is indeed the primary functions of banks.
Lending has been the largest source of income for the banks in terms of interest
income. Greater competition amongst banks, led to the banks looking to broad base
their lending activities by targeting retail customers or individuals. #etail credit
encourages economic gro&th by generating demand for products and services as
purchasing po&er of individual6s increases. #etail loans are loans given to individuals
for meeting one time re-uirements like buying tangible goods like a car 1auto loans2
or a house 15ortgage loans2 or for meeting large one time expenses like on
hospitaliation, education, marriage etc..1$onsumer loans2. ,rom Bank6s perspective,
retail credit is less risky and more profitable compared to business 9 corporate
lending.
Characteristics of Retail Credits
!mall loan sies
Large number of customers 1&ell diversified portfolio2
Target customers are normally an individual or small enterprise
!tandard product offering to simplify process and delivery
(ecentralied and -uick credit decisions ? to improve customer satisfaction
$entralied operations ? to reduce cost
#isk 5anagement at portfolio level rather than at individual account level ? to
reduce cost and manage risk more effectively.
Components of a !oan
#rincipal
This is the amount borro&ed. ,rom the point of vie& of the bank, this is the amount
of loan it gives to its customer. %t represents an asset for the bank and a liability for
the borro&er.
Interest
This is the cost the customer pays for borro&ing money from a bank. %t is computed
as a percentage of the amount borro&ed. Jhile the principal represents an asset for
the bank, interest represents income earned by the bank. %nterest is computed on
the principal outstanding in the account.
+ethods of Interest Calculation
Reducing Balance +ethod
The interest rates -uoted by banks are based on a reducing balance method. %n this
method interest is computed on the principal outstanding on a specified fre-uency
1such as daily, monthly or -uarterly2 on the principal outstanding in the account.
Therefore &hen the customer makes repayment of some portion of the loan, the
principal outstanding &ould be reduced by the amount of principal received and the
interest &ill then be computed on the reduced amount ? hence the term, reducing
balance. %n this method, the more often the interest is computed the more beneficial
it &ould be for the customer.
Flat Rate +ethod
This method of -uoting interest rates is mostly used by financial services companies.
%n this method, the interest is computed at the beginning for the entire term of the
loan. This method does not take into account the reduced principal at the end of a
repayment period, &ith the result that the interest may be substantially higher than
the amount the customer pays using the reducing balance method for the same rate
of interest.
Fees and Charges
Banks collect various fees and charges from customers for loans. Jhen the loan is
being disbursed to the customer, banks may collect a processing fee associated &ith
the loan3related paper&ork, and later they may collect other charges. These include
insurance premium to be paid by the customer to&ards insurance of the collateral,
inspection charges to be paid by the customer, service charges for certain types of
transactions, commitment fee etc. These fees and charges represent income for the
bank.
Concepts in !oans
Generally the entire amount is given to the borro&er upfront. %n some cases like
buying flat under construction, the loan may be disbursed in installments according
to the payments to be made to the builder. Generally the repayment start after the
entire loan is disbursed. Till then, only interest is recovered from the borro&er. Loans
are to be repaid in periodic installments such as monthly or -uarterly that is fixed
according to the periodicity of income of the borro&er and as per the loan product
conditions. %nterest is charged by banks, every month, on the balance outstanding in
the loan account. As the loan gets repaid, the interest burden of the borro&er comes
do&n.
#etail loans are generally recovered in /-uated 5onthly %nstallments 1/5%2. The
amount payable every month is determined by calculating the total interest payable
assuming that the installments are paid according to the schedule and dividing the
total of loan and interest amount by the number of months over &hich it has to be
paid. +art of /5% is appropriated or ad4usted to&ards interest and the balance
to&ards the principal.
Kormally, the full cost of the assets is not financed. The borro&er is re-uired to put
in a portion of the amount, &hich may vary from 78A to F8A. The amount
contributed by the borro&er is called Omargin6. 5argin is insisted upon to take care of
depreciation in value of the asset soon after it is purchased and also to increase the
commitment of the borro&er to repay the loan and protect the asset.
%f a person &ho has taken a loan for buying a car defaults in repayment, the bank
can take possession of the car and sell it to recover the loan. Jhen the bank has
recourse to a specific property or asset for recovery, the loan is said to be Osecured6
loan.
At the time of granting the loan, borro&er gives the bank the right by signing a
document to take possession and sell the asset. This activity is called Ocharge6
creation over the asset in favour of the bank.
Jhen a loan is given for consumption purpose 1consumer loan2 and no specific
security 1asset2 is available to the bank, the loan is said to be O)nsecured6 loan.
The features of retail credit are"
Types of facilities
!ecured 9 unsecured facilities
Guarantee
%nterest
Tenure
Loan to Halue ratio
Loan eligibility
$redit scoring
Kegative caution list
/-uated 5onthly %nstallments
Types of facilities*
(ifferent types of credit facilities offered to retail customers are"
!oans*
Jhen the entire amount of credit is Odisbursed6 or made available to the
customer upfront and every deposit or Ocredit6 into the account is treated as
repayment, the facility is called a loan.
A loan is a one time facility and once an amount is repaid it cannot be
&ithdra&n by the customer as it &ill be ad4usted against the amount
outstanding in the loan account.
#epayment could be after a period, in one installments could be monthly, or
-uarterly or half yearly or any other periodicity as mutually agreed bet&een
customer and the bank
2verdrafts
Overdra&ing means &ithdra&ing more than the credit balance in the current 9
savings account.
/very subse-uent credit into the current account &ill be ad4usted against the
overdra&ing to&ards payment. !uch short term over dra&ings are called
OTemporary Over (raft6 or TO(.
TO(s are expected to be repaid in about a &eek.
Banks &ill provide overdraft facility on permanent basis by setting up
permanent O( limit enabling the customer to overdra& the account up to a
limit and &hen he re-uires and to repay it according to his convenience.
Jhile every credit is ad4usted against the amount outstanding, the customer
can again &ithdra& up to the sanctioned limit 1unlike a loan account2.
.ence, &hile loan is a one time facility, an overdraft is a running or continuing
facility.
Overdraft limits are generally granted for one year and are secured by shares,
bonds, bank6s term deposits and such other financial assets.
Bank may roll over or extend the limit for another year at the end of one year
at the discretion of the bank.
"ecured , 4nsecured facilities
"ecured facilities
!ecured loans are al&ays secured by an underlying asset against &hich
funding is extended like in the case of an overdraft against shares. This is also
called asset based lending.
A specific Ocharge6 is created on the asset against &hich funding is extended.
A charge on an asset gives the lender the right to take possession of the
asset and sell it to recover the loan in case of default.
%n the case of immovable properties, i.e. land and building, the charge is
called Omortgage6
%n case of moveable assets like vehicles and goods the charge usually created
is called Ohypothecation6.
%n both the charges, the asset continues to be in the possession of the
borro&er, but in case of default, the lender can exercise his right to take
possession and dispose of the asset sub4ect to completing legal formalities,
namely, filing a case and obtaining an order from the court.
On financial assets like fixed deposits and bonds, charge is created by
marking BlienD. Lien gives the right to the lender to appropriate the deposit or
bond and ad4ust it against the loan.
%n case of shares, charge is created by marking Opledge6 in the demat
account. %n pledge, the possession of the shares passes on to the lender.
.ence the lender can straight a&ay sell the shares on default and there are
no legal formalities to be completed.
The different kinds of secured loans are"
5ortgage finance
Hehicle loans
o $ar loans
o T&o &heeler loans
o $ommercial vehicle loan
$onstruction and material handling e-uipment loans
+rofessional e-uipment loans for purchasing medical and office e-uipments
Loan against securities 1shares, bonds etc..2
Collateral
The BsecurityD charged to the bank is also called BcollateralD. The &orld collateral has
t&o meanings> 7. !ecurity given as guarantee for repayment of loan E. Additional
but subordinate Banks use the &ord collateral in both senses.
%n retail credit,D collateralD is used to refer to the security &hether primary or
additional. Jhen granting a housing loan in addition to the mortgage of the house,
the bank may take some additional security such as pledge of fixed deposit or
shares. Both the main and additional security is referred to as collateral.
%n corporate 9 business credit, the asset financed is called the primary security and
any additional security is called as collateral.
!ome banks use the &orld collateral to refer to additional security only.
4nsecured !oans
)nsecured loans do not have any underlying security and are extended purely on the
basis of credit &orthiness of the applicant.
The different kinds of unsecured loans are"
+ersonal loans
$redit $ards
uarantee
A guarantor is a person, other than the borro&er, &ho promises to pay the
loan to the lender in case of default by the borro&er.
!ome banks make the guarantor as co3borro&er &hile some others take only
a letter of guarantee.
Guarantor6s ade-uacy of his income to repay the loan in case of need &ill be
assessed by the banks before accepting a person as a guarantor.
Interest
The t&o types of rate of interest are"
,ixed rate of %nterest" %nterest &ill be charged throughout the tenure of the
loan at the rate fixed at the time of granting the loan.
,loating rate of %nterest" Jhen the rate at &hich interest is charged on a loan
varies from time to time, according to movement of interest rate, it is called a
floating rate loan. The floating rate &ill be changed according to change in the
benchmark rate.
Tenure
The period over &hich the loan has to be repaid is called the tenure of the
loan.
Tenure &ould depend upon the amount of loan and the repayment capacity of
the borro&er.
The maximum tenure permitted &ould depend upon the period over &hich the
asset financed could depreciate or reduce in value.
Tenure &ould also depend upon the age of the customer.
CapitaliDation
$apitaliation is defined as the process of satisfying unpaid interest or fees by adding
them to, and increasing, the principal balance of a loan. Any interest due from the
customer is added to the principal outstanding ? &hile this &ould not increase the
amount due from the customer, it &ould change the nature of outstanding from
interest and principal to principal only. This process of adding the interest due to the
principal and reducing the interest due to <ero is called capitaliation.
!oan to 6alue Ration .!6R/
The maximum percentage of the value of the asset that &ill be given as loan.
LH# varies according to the nature of asset and the rate at &hich the asset is
expected to depreciate.
An LH# of @=A means that the maximum loan that can be considered for
purchase of the asset is limited to @=A of the value of the asset.
!oan -ligibility
Loan eligibility is determining the maximum loan amount that can be offered
to a customer. This is determined based on the follo&ing criteria"
o $apacity to repay"
The customer should have ade-uate income to repay the loan. ,or example,
for salaried person, the persons6s disposable income is considered to assess
the repayment capacity.
Kormally, banks consider =8A of the disposable income as ade-uate to meet
the repayment obligation of the loan applied for.
The percentage may vary from bank to bank and product to product.
%ncome stream of the customer should be consistent and stable.
The income is validated by income tax returns.
o Li-uidity to repay"
The customer should be having li-uidity at the point of time &hen his
repayment is due.
!urplus 9 additional income 1if any2 is also taken into consideration for
assessing li-uidity.
The li-uidity to repay is validated by checking bank statements, nature of
business 9 profession, repayment track record etc..
Credit "coring
$redit scoring is a statistical method for predicting the credit &orthiness of
applicant for credit.
Banks are able to offer loan approvals online based on the credit scoring
methodology.
$ustomer6s relative importance is assessed on the basis of analysis of the
past loans and various other parameters.
Jeightages are assigned to each measure of the variable criteria. The
&eightage may be assigned based on the follo&ing variables"
Age of the customer
Vualification of the customer
%ncome per month
Jeightages are assigned to each variable and the total score is calculated. %f
the total score is above a cut off limit, the loan is approved else it is re4ected.
Jithout the human engagement and analysis 1done by credit appraisers2, it is
not possible to build a complete ob4ective score card for customers.
The advantages of credit scoring are"
,acilitates -uicker decision making
#anks applications according to risk involved
5inimies sub4ectivity in credit approval
$an also be used as a basis for portfolio rating
8egative , Caution !ist
This is a list of certain profile of customer segments, &hich have in past exhibited
higher tendency to default.
List of classification are hereunder"
+rofile 9 occupation of the customer ? based on the past experience and
analysis of existing portfolios, persons in certain profession &ho are kno&n to
have higher default rates may be identified in the negative list.
The location of the customer from a particular area &ho tends to default is
classified as caution or negative areas.
+ast repayment history of customer ? The list contains information about the
past borro&ings and repayment history of the customers collected from
various sources 1including credit bureaus2
-'uated +onthly Installments
The /5% is calculated by first calculating the total interest payable during the tenure
of the loan assuming that it is repaid over the period in regular installments, adding
the total interest to the principal and dividing the total amount by number of months
in &hich the loan is to be repaid.
AmortiDation
The process of splitting the /5% into principal and interest component to facilitate
crediting the interest component to the profit and loss account and the principal
component to the loan account is called BamortiationD.
#re:-+I
As the /5% is calculated on the full amount, /5% cannot be calculated till the entire
loan is disbursed. %n case of housing loan, the loan may be disbursed over a period
of time in installments, &hich depends upon the progress of construction. Though the
loan is not fully disbursed and /5% is not calculated, the borro&er has to pay interest
for the amount, &hich is already disbursed. !uch interest payments are called B+#/3
/5%D payments.
Advance -+I
Kormally, /5% payments are to be made in Oarrears6 or at the end of the month. %t is
possible to calculate /5% on the assumption that the /5% is paid at the
commencement of the month. %n that case, the first /5% &ill become payable
immediately after disbursement of loan. The first /5% taken at the commencement of
the loan is called BAdvance /5%6.
+oratorium
+ayment of /5% may commence after fe& months from the date of full disbursement
of loan. !uch repayment holiday is called B5oratoriumD. %nterest during the
moratorium may have to be paid separately as in the case of +re3/5% or may be
added to the principal and the /5% is calculated accordingly.
3hat is a +ortgage 7
This chapter introduces the various concepts related to 5ortgage. A mortgage is
defined as a loan to finance the purchase of real estate, usually &ith specified
payment periods and interest rates. The borro&er 1mortgagor2 gives the lender
1mortgagee2 a lien on the property as collateral for the loan. According to the
transfer of property act, mortgage is BTransfer of an interest in specific immovable
property for the purpose of securing the payment of money, to be advanced by &ay
of loan.D
Concepts
5ortgage is very similar to hypothecation in that both o&nership and possession
remain &ith the borro&er 1mortgagor2 and the bank 1mortgagee2 gets the right to
take possession and sell the mortgaged property after filing a suit and getting
permission of the court. (uring the subsistence of the mortgage, the borro&er
cannot sell the property &ithout the consent of the bank 1mortgagee2.
Types of mortgages*
#egistered 5ortgage
/-uitable 5ortgage
Registered +ortgage
A registered mortgage is one &hich is registered &ith the registrar of properties &ith
&hom sale 9 purchase of landed property is re-uired to be registered. The mortgage
&ill be kno&n to anyone &ho checks the property record. +roperty &ill be released
from the mortgage by filing a cancellation deed &ith #egistrar to enable him to
record the release in the property record, once the loan is repaid in full &ithout any
due. A registered mortgage is the most secured &ay of creating charge over an
immovable property.
-'uitable +ortgage
+roperty is not re-uired to be registered. The /-uitable 5ortgage in real term is
kno&n as B5ortgage by deposit of Title (eedsD. The essential characteristics of
/-uitable 5ortgage are"
Original Title deeds has to be handed over to the bank along &ith Tax receipts
and the Kon3/ncumbrance certificate obtained from registrar sho&ing the
property is free from all encumbrances.
%ntension to create mortgage" Banks &ill obtain a memorandum of deposit on
plain paper &herein the borro&er affirms the fact of deposit of title deeds &ith
the intention to create mortgage.
At places notified by the Government" The property that is mortgage may be
situation in any place, but the title deeds must be deposited only in to&n 9
cities notified by the Government for creation of /-uitable 5ortgage.
5ey #layers in the +ortgage Business
#roperty Developers 3 The people &ho build homes or develop plots of land
Borro=er ?the prospective buyer of the home or plot
Financial Institution ? The entity &hich provides the necessary finance to
the borro&er to buy the home or plot
Types of +ortgage !oans : Conventional
The follo&ing are the types of 5ortgage Loans most prevalent in the industry
,ixed #ate 5ortgage Loan
Ad4ustable #ate 5ortgage Loan 1A#52
Fi1ed Rate +ortgage !oan
,ixed #ate 5ortgage loans are those loans &here the monthly payments for interest
and principal remain fixed and does not change during the tenure of the loan.
AdAustable Rate +ortgage .AR+/ !oan
A#5 or Ad4ustable #ate 5ortgage loans also kno&n as Hariable 9 ,loating #ate
5ortgage loans. %n these types of mortgage loans, the interest rate changes from
time to time during the tenure of the loan according to some outside index. The
interest rate changes could happen based on various parameters like the change in
the base rate 1as fixed by the bank2 on &hich the loans are offered.
Categories of +ortgage !oans
5ortgage loans are available for the follo&ing purposes
+urchase of #esidential sites
+urchase of #eady built houses
+urchase of ,lats
$onstruction of houses
/xtension 9 )pgradation of existing houses
#epairs * #enovation of existing houses
+ortgage #rocess Flo=
Harious processes involved in a 5ortgage loans from the application stage to the
5ortgage Loan closure stage have been explained belo&"
Application "ubmission
Borro&er submits the completed Application to the 5ortgage $ompany along
&ith the re-uired documents and the re-uisite Application ,ee. The
documents that &ould be re-uired include
%n case of /mployed borro&ers
o +ay3slips
o Other %ncome proofs
o Tax #eturns
o Other Loan details
o Assets and Liabilities
o Bank !tatements
o The above details &ill be re-uired for the $o3borro&ers also
%n case of !elf3/mployed borro&ers
o Tax #eturns
o %ncome * /xpenditure !tatement
o Balance !heet
o Other Loan (etails
o Bank !tatements
o The above details &ill be re-uired for the $o3borro&ers also
%n case of $onstruction
o +roof of Land property in the name of the borro&er
o /stimated $ost for construction
o Kecessary approvals for $onstruction
%n case of +urchase of +roperty
o Agreement &ith the +roperty (eveloper
o !chedule of $ompletion of property
Application "crutiny
The 5ortgage $ompany verifies and validates the follo&ing"
5ortgage Loan Application
%ncome (etails of both the Borro&ers and $o3borro&ers
+roperty O&nership (ocuments
On satisfactory verification and validation of the above documents the
borro&er9s &ould be intimated of the acceptance of their application
Credit Appraisal ) Report
The 5ortgage company &ould carry out an appraisal of the loan documents
from three angles namely
,inancial Appraisal 3 &hich includes
o #epayment capacity of the borro&er and co3borro&er
o ,inancial stability of the borro&er and co3borro&er
o +revious borro&ing history of the borro&er and co3borro&er
o Herification of !alary details &ith the borro&er6s employer
o Bank account transactions
o Vuality of collateral security offered
Technical Appraisal ? &hich includes
o Halidity of Approvals for $onstruction
o $ompliance &ith local building la&s
o /stimation for construction
o $ondition of property to be financed in case of purchase
o Hisit to !ite to verify the property to be financed
o Haluation of +roperty
Legal Appraisal ? &hich includes
o $ollection of property documents 9 Title deeds
o Obtaining legal opinion about the title from la&yers
o $reation of mortgage
o Applicability of la&s like Transfer of property act, !tamp act,
#egistration Act
o Herifying succession of property, flo& of title , encumbrances if any
o +reparation of Legal !crutiny #eport
"anction of !oan
The mortgage $ompany, once satisfied that the Loan Application and related
documents are acceptable from ,inancial 9 Technical and Legal angles for providing a
loan, issues a Letter of !anction to the borro&er &ith the follo&ing details"
Loan amount offered
%nterest #ate applicable for the Loan
Term of loan
Amortiation !chedule containing the 5onthly #epayment Amount 1/5%2
#epayment conditions
Halidity of !anction
Obtaining loan acceptance letter from borro&er
Borro&er &ould be re-uired to pay Administrative 9 +rocessing ,ees at this
stage
Documentation
After the !anctioning of the loan, the 5ortgage company &ill carry out the
Loan (ocumentation +rocess. This is the stage &here the 5ortgage for the
property is created.
The indicative documents that &ould be created are as follo&s"
o (eposit of Title deeds in original
o 5ortgage Loan Agreement bet&een 5ortgage $ompany * Borro&er9s
o $ollection of +ost (ated $he-ues or (irect (ebit mandate
o Letter of guarantee
o Letter of +ledge 1in case of additional securities2
o Tripartite agreement bet&een Builder, borro&er * 5ortgage $ompany
Disbursement of !oan
On completion of the Loan (ocumentation, the 5ortgage $ompany &ould
disburse the loan amount as per the re-uest of the borro&er.
%n case of purchase of ready property, the disbursement &ould be in a single
amount.
%n case of construction of the property, the disbursement &ould be in multiple
pre3agreed installments
%n case of single disbursement, the Loan #epayment &ould start from the
next subse-uent month during &hich the disbursement is made. %n this case,
the borro&er &ould be re-uired to pay +re3/5% interest from the date of
disbursement till the last &orking day of the month.
%n case of multiple disbursements, the borro&er &ould be re-uired to pay
+re3/5% from the date of first disbursement, till the last &orking day of the
month in &hich the last disbursement &as made
!oan Repayment
On completion of the disbursement of the !anctioned Loan amount in full, the
#epayment of Loan starts. The repayment &ill normally start from the beginning of
the next month subse-uent to the month during &hich the full and final
disbursement &as made. The repayment of loan falls under t&o categories as
discussed belo&.
8ormal Repayment
Borro&er repays the loan by payment of the fixed /5% 1/-uated 5onthly
%nstallments2 as specified in the Amortiation schedule.
#epayment &ould be by &ay of either (irect (ebit mandate or +ost (ated
$he-ues provided during the sanctioning of loan.
The repayment amount &ould be uniform throughout the mortgage term,
unless there are special situations like #e3scheduling or #e3phasing of loans
#re:#ayment of !oan
Borro&er sometimes may get additional funds and may decide to prepay
either a part of the loan or the loan in full.
%n case the customer decides to prepay the loan in full, then the final loan
outstanding calculation &ould be done and the borro&er &ill be re-uired to
pay the total outstanding amount and the loan account &ould be closed. This
is called +re3closure of Loan.
%n case the customer decides to prepay only a part of the loan, then the loan
&ould be re3scheduled and a ne& loan balance and repayment schedule
&ould be calculated and the borro&er &ill start to pay the ne& /5% from the
next month on&ards.
Generally at the discretion of the 5ortgage company a nominal percentage of
the outstanding loan amount is levied as +re3$losure charges.
Re:scheduling of !oans
#e3scheduling of loans means re3ad4ustment or re3calculation of the
amortiation schedule taking into consideration any pre3payments that have
been done by the borro&er to&ards the loan account from the start of the
financial year till the date of re3scheduling to arrive at a ne& balance for the
remaining period of the loan.
#escheduling of loans &ould be done at the re-uest of the borro&er &ho
&ishes to reduce his monthly repayment installments by making part
prepayments in lump sum to&ards the loan outstanding.
#escheduling of loans &ould be done in such a &ay that after rescheduling the
entire outstanding liability at revised installment shall be paid &ithin the
unexpired term originally fixed
Re:phasing of !oans
There may be situations &here the borro&er defaults in the repayment of the
loan obligations due to genuine financial temporary difficulties and the
5ortgage $ompany may decide to re3ad4ust the loan.
The mortgage company &ill add back the unpaid installments 1dues2, overdue
interest and any other charges back to the balance of the loan and arrive at a
ne& balance. This process is called as #e3phasing of Loan.
)nder this facility all the arrears 9 overdue amounts &ill be added back to the
loan and a fresh repayment schedule 1amortiation schedule2 &ill be
determined, &herein the loan is repayable &ithin the unexpired period of the
term granted originally
Closure of !oan
Jhen the borro&er has completed all the installments of the mortgage loan
repayments as per the schedule, the loan account is said to be closed and this
is called as BKormal $losure of LoanD.
Jhen the borro&er decides to repay the loan in full before the completion of
the Term of the loan, due to availability of funds, the loan account in this
situation is also said to be closed but called as B+re3closure of LoanD.
Generally the mortgage company does not penalie the borro&er for Kormal
closure of a loan account. But in case of +re3closure of loan, the mortgage
company does levy a certain percentage as B+re3closure $hargesD.
On closure of the loan account, the 5ortgage $ompany hand over all the
original documents relating to the property to the borro&er and cancels all
liens noted on the property and notifies the re-uired authorities. The borro&er
becomes the absolute o&ner of the property henceforth.
Risks in +ortgage
Harious types of risks those are associated &ith 5ortgages. The risks can be
classified as belo&"
$redit #isk
Li-uidity risk
%nterest #ate #isk
+re3payment #isk
#egulatory #isk
/nvironment #isk
)ninsurable Loss
Credit Risks ? $redit risk refers to the risk of default by the borro&er for any
reason. %t is possible that the business does not generate sufficient income to repay
or the borro&er is not honest. This is the most serious risk any lender faces.
!i'uidity Risks ? The borro&er may have every intention to repay the loan and the
business may be doing &ell too. .o&ever there could be occasions &hen the
borro&er is not able to &ithdra& funds from the business &hen the lender demands
repayment.
Interest Rate Risk ? Another risk is due to change in the rate of interest in the
market. At the time of the transactions the borro&er may have agreed to give the
interest at the prevailing rate of, say, @A. !ubse-uently, interest may be reduced or
increased
#repayment Risk 3 +repayments can change the Account6s return because the
mortgage company may not be able to reinvest the proceeds at high interest rate as
the original mortgage loan rate.
Regulatory Risks 3 Government regulation, including oning la&s, property taxes,
fiscal, environmental or other government policies, could operate or change in a &ay
that hurts the Account and its properties. %t is also possible that the property may be
ac-uired by the government for public purposes like &idening of roads etc. in &hich
case the compensation may not be in tune &ith loan outstanding.
-nvironmental Risks 3 The Account may be liable for damage to the environment
caused by haardous substances used or found on its properties. if the Account fails
to comply &ith regulations re-uiring it to actively monitor the business activities on
its premises, the Account may have difficulty selling or renting a property or be liable
for monetary penalties.
4ninsurable !osses 3 $ertain catastrophic losses 1e.g., from earth-uakes, &ars,
terrorist acts, nuclear accidents, floods, or environmental or industrial haards or
accidents2 are uninsurable or so expensive to insure. %f a disaster that &e haven6t
insured against occurs, the Account could lose both its original investment and any
future profits from the property affected.
Types of +ortgage !oans in 4"
Jhen it comes to mortgages, there are almost as many choices as there are styles
of homes. A fe& of them are discussed belo&.
FBA !oans
,.A loans are insured by the ,ederal .ousing Administration and are often referred
to as a government mortgage. These loans re-uire lo&er do&n payments and accept
higher debt ratios than a conventional mortgage so they're good for some buyers
&ho might not other&ise -ualify.
Jhile they re-uire lo&er do&n payments, they do re-uire a minimum cash
investment of FA of the sales price. %f the do&n payment is less, the balance
goes to&ard closing costs.
An upfront Lmortgage insurance premiumL 15%+2 is re-uired 1on a F83year
loan, the 5%+ e-uals 7.=8A of the loan amount 3 EA for a 7=3year loan2, plus
an annual .=A rene&al premium for the life of the loan.
6A !oans
HA loans are available to veterans and service personnel &ho have put in the
re-uired service time in the military. They're guaranteed by the (epartment of
Heterans Affairs and, in most cases, re-uire no do&n payment.
Loan maximum may be up to 788A of the HA3established reasonable value of
the property.
A EA HA loan funding fee is re-uired although a do&n payment &ill lo&er this
fee 3 the fee is E.N=A for eligible #eserve9Kational Guard personnel.
Ko monthly mortgage insurance is re-uired.
Rural Bousing !oans
These lo&3interest3rate home loans are offered through the #ural .ousing !ervice, a
branch of the )! (epartment of Agriculture. They are specifically tailored to lo& and
moderate income persons &ho live in rural areas or small to&ns and re-uire no do&n
payment.
788A financing available &ith fixed interest rates
F83year term
)!(A Guaranty ,ee re-uired on all loans
+roperty location must meet )!(A standards
%ncome and loan amount limits apply
Affordable Bousing #rogram .AB#/ !oans
An A.+ mortgage can help lo&3to3moderate income families &ho cannot save for a
do&n payment, but pay their bills and deserve the opportunity to o&n a home.
Applicants &ill complete a take3home pre3o&nership education course in order to
make the home buying process easier to understand.
,ixed annual percentage rates
5ortgage credit insurance is not re-uired
%ncome and loan amount limits apply
.ome o&nership counseling re-uired
Fe= +ortgage !oan #roducts in 4"
Home Purchase Loan
This is a normal 5ortgage loan
%nterest #ates options could be ,ixed #ate or Ad4ustable #ate
Loan +eriod may vary from 783F8 years
Mortgage Refinance
5ortgage #efinance is the process of re3mortgaging the same property for a
lo&er rate of interest or higher period.
There are three &ays refinancing can lo&er the repayment amount.
The first is simply to refinance at a lo&er interest rate.
;ou can also change the term on your mortgage to lo&er your payment.
!&itching from a 7=3 to a F83year term can significantly lo&er your mortgage
payment. But, if long3term savings is more appealing to you, refinancing from
a F83year to a 7=3year mortgage can save you thousands of dollars over the
life of your loan.
The third &ay to lo&er your payment is by s&itching from a traditional
mortgage &ith principal and interest payments to a mortgage program that
allo&s interest only payments. .ome /-uity Loan
A .ome /-uity loan is a ne& trend of loans in the )!. )nder this scheme the
home9property o&ner borro&s a sum of money from another mortgage
company by &ay of entering into a second mortgage on the same
property9home for &hich he already has mortgage.
Jhen you get a home e-uity loan, you are borro&ing against your o&nership
stake in the house. The e-uity is the value of the house minus your mortgage
balance. A home e-uity loan uses your e-uity as collateral. %f your house is
&orth RE88,888, and you o&e R7G8,888 on the mortgage, you have RI8,888
in e-uity. A home e-uity loan &ould allo& you to borro& some or all of that
RI8,888.
;ou receive an e-uity loan as a lump sum, and repay it over a set time,
usually at a fixed rate and for the same payment each month. A home e-uity
line of credit, or ./LO$, is a type of e-uity loan that &orks like a credit card.
%t has a credit limit and a revolving balance, meaning that you can borro& up
to a certain amount, pay some or all of it back, and borro& again up to the
limit. #ates on most lines of credit vary as the prime rate moves up and
do&n.
Because they come in a lump sum, home e-uity loans generally are
recommended for one3time expenses 33 to consolidate credit card debt, pay
for a ne& roof, buy a business. /-uity lines of credit often are recommended
for recurring expenses such as education expenses, or multistage pro4ects
such as home renovations, or to hold in reserve for emergencies such as 4ob
layoffs.
A line of credit starts &ith a dra& period and ends &ith a repayment period.
(uring the dra& period, the homeo&ner can borro& against the credit line by
using a charge card or a checkbook. 5inimum monthly payments cover only
the interest during the dra& period. Jhen the repayment period starts, the
monthly payments cover interest and principal so that the balance is repaid
by the time the credit line expires. The length of the dra& and repayment
periods varies &ith the lender and sie of the credit line
3hat is Clearing 7
$learing is the process of collecting the proceeds of a che-ue, a demand draft or a
pay order deposited into an account. i.e. Jhen a che-ue 9 demand draft 9 pay order
&hich is dra&n on the other bank is deposited by the customer, it has to be sent to
the payee bank and the amount is collected and deposited to the beneficiaries 1of the
instrument2 account.
Definition of Instrument*
The Kegotiable %nstrument Act, 7@@7, defines a Kegotiable %nstrument as a
promissory note, Bill of /xchange or che-ue.
A Bill of /xchange or a +romissory Kote is an instrument in &riting containing an
unconditional order, signed by the maker, directing a certain person to pay a certain
sum of money only to, or to the order of, a certain person or to the bearer of the
instrument.
A $he-ue is a bill of exchange dra&n on a specified banker and not expressed to be
payable other&ise than on demand. A che-ue is a bill of exchange &hich is al&ays
dra&n on a banker specified therein and payable on demand.
Types of Clearing*
,ollo&ing are the different methods of clearing.
Local $learing
Kational $learing
$he-ue collection
/lectronic clearing !ystem
!ocal Clearing* %f the che-ue deposited by a customer is dra&n on another bank in
the same city it has to be sent to the payee bank and the amount collected. !ince all
the banks in a city &ill be getting che-ues dra&n in other banks and it is
cumbersome to process, B$learing houseD is used to meet and exchange che-ues
dra&n on each other. Legally, a clearing house is an association of all banks at a
centre &ith its o&n by la&s and management committee. $learing house is a place or
office, &here the representative of all the banks &ill meet and exchange che-ues
dra&n on each other. Generally, the central bank of the country or a leading bank on
behalf of the central bank of the country manages the clearing house. All the banks
at that centre &ill maintain accounts &ith the settlement bank to facilitate settlement
of the claims on each other. The payment is effected by the settlement bank by
debiting and crediting the net amount payable. This is kno&n as net settlement.
The instruments settled through clearing house are as follo&s
$he-ues
(rafts
+ay orders
Jarrants
/$! (ebits 9 $redits
%ncome Tax #efund orders
Government +ayment Orders
"ervice Center*
Typically, in a location, a bank could have more than one branch. %n such a scenario,
the bank &ill route the clearing operation through a separate branch kno&n as
service branch or a processing center and this represents bank at the clearing house.
The service branch 9 processing centre> collects instruments from all the branches of
the bank in that centre, sorts the instruments bank3&ise and presents them to the
clearing house.
+ICR Che'ues*
The clearing process varies according to the types on the instrument used. To
mechanie the process at the large centers, the central Bank has mandated that only
5%$# 15agnetic %nk $haracter #econgnition2 che-ues to be used.
.ence Banks issue che-ue, draft and other payment instruments in 5%$# format
using the special -uality paper and printing specifications. On 5%$# instruments,
there is code line at the bottom containing information printed in magnetic ink, &hich
is re-uired for mechanical processing. The code line contains the follo&ing
information
,irst six numbers indicate the $he-ue Kumber
Kext three numbers indicate city code
Kext three numbers indicate bank code
Kext three numbers indicate branch code
After some space there is a number for transaction code 1i.e. &hether the
transaction is for a saving or current account2
The magnetic portion, &hen placed under 5%$# e-uipment, allo&s for instant
readability and identification.
+ICR Che'ue Clearing #rocess Flo=
The che-ue is deposited in the branch.
All the branches send the che-ue received by them to service branch
The encoding of the che-ues are done and sorted as bundles.
The processed che-ues are sent to clearing house 1The che-ues sent to
clearing house are called BOut&ard $learing $he-uesD2
%n clearing house, bundles are sorted bank &ise.
The che-ues dra&n on each bank &ill be sent to the respective service center
1The che-ues received from the other banks are kno&n as B%n&ard $learing
$he-uesD2
The service centers of each bank sort it branch &ise and send it to the
branches for debiting the accounts of the customer. Banks &hich are fully
computeried do not send the in&ard clearing che-ues to the branches, as all
accounts can be accessed and processed in the service center itself.
The return che-ues 1due to insufficient balance, stop payment instructions2
are returned to the respective banks through clearing house.
Reasons for Dishonour of Che'ues
$he-ues 9 instruments could be dishonoured or returned by the dra&ee banks for
the follo&ing reasons
!top payment instructions has been issued for the che-ue
Account is closed
%nsufficient ,unds
#estrictions has been imposed either for posting any debits or any amount
restrictions exist for the account.
Any alteration in che-ues
+hysical damage of the che-ue
8on:+ICR che'ue clearing process
The primary difference &ith 5%$# and Kon35%$# is that &ork of sorting the che-ues
bank&ise. %n case of Kon35%$# the presenting banks have to manually sort and
consolidate bank3&ise.
Bigh 6alue Clearing
This is value added clearing service available in select cities for processing large
value che-ues on same day to facilitate the customers to use the funds immediately.
Che'ue Truncation
$he-ue truncation refers to conducting clearing operations &ith digital images of the
che-ues rather than the physical che-ues. The presenting bank, instead of sending
the physical che-ues to the clearing house &ill scan the che-ues &ith high speed
scanners and transmit the scanned images to the clearing house electronically. The
clearing house &ill in turn sort the images and transmit to each bank the images of
che-ues dra&n on them. !ince only scanned images &ill be sent, the physical
che-ues &ill remain &ith the presenting bank itself. $he-ue truncation has been
made possible by the development of imaging and communication technology.
$he-ue truncation can help to speed up clearing operations and make it more cost
effective.
8ational Clearing* $learing house handles che-ues dra&n on local branch only.
$he-ues dra&n on upcountry branches are sent by each bank to their branch at that
centre for presentation through the local clearing at that centre. The Kational
clearing is a facility offered by clearing houses to collect upcountry che-ues through
the clearing house system rather than each bank collecting such che-ues through
their branches. The central Bank has linked up the clearing houses in the large cities
to facilitate such collection &ith less time.
Che'ue Collection*
As the clearing 4urisdiction is local, a separate procedure has evolved for the
collection of che-ues dra&n on banks outside the clearing house area. %n this case,
the che-ues are sent by post for collection to the representative branch or
correspondent bank for presentation in the clearing house in the outstation centre.
Once the che-ue is realied, the proceeds are remitted to the original presenting
bank for credit to the customer account. This leads to a significant delay in the
payment of these che-ues and there is considerable uncertainty regarding the time
of realiation.
(ue to delays in collection of outstation che-ues, various alternative forms of
payments instruments are &idely used to settle outstation payments. !ome of the
payment items such as demand drafts, Bpayable at parD &arrants etc., are much
&idely in use in current day scenario. %n all these cases, &hether che-ues or drafts,
the -uestion of settlement bet&een paying bank and the collecting bank remains. %n
the case of demand drafts, the payment is usually internal to the bank and is settled
by book transfers using an internal pipe line account maintained in the bank. %n the
case of 'At par' items, a single account maintained in any branch is debited and
various paying branches are paid.
Che'ues dra=n on the bankEs upcountry branches
,or a bank &hich is fully net&orked and has a centralied database, che-ues dra&n
on any branch can be posted from any other branch. .ence, che-ues dra&n on
upcountry branches can be processed as a transfer transaction at the branch &here
the che-ue is deposited.
$he-ues dra&n on other banks at locations &here the bank has branches.
The che-ue has to be sent to the branch at the location for being presented in the
local clearing.
$he-ues dra&n on other banks at locations &here the bank does not have a branch
There are F &ays of collecting such che-ues" 7. Give the che-ue to a correspondent
bank &hich has a branch at the location. A correspondent bank is one &ith &hom the
collecting bank maintains a current account. E. Give the che-ue to a non3
correspondent bank F. !end it directly to the dra&ee bank.
-lectronic Clearing "ystem .-C"/" Let us suppose that the company has
thousands of employees &ho maintains their accounts in various banks in the city. %t
&ill be difficult for the employees if the company pays the salary by che-ue, &here in
they have to deposit and collected through local clearing. This can be avoided
through /$! &here the payer &ill give to his bank the list of payments to be made
&ith bank details to authorie him to debit their accounts. The bank in turn &ill pass
on the list to the clearing house &hich &ill distribute to amongst the banks
concerned.
There are t&o types of /$!
7. $redit /$!
E. (ebit /$!
Credit -C"* As name implies, this is used to credit the customer. ,or example the
companies that declare the dividend &arrants can use this to give credit to all its
shareholders there by reducing the cost of paying dividends. This is popular for mass
payments such as dividends, interest, salary, commission to sales agents etc.
"cheme Coverage
The !cheme shall cover transactions of the follo&ing characteristics"
Bulk payment transaction like periodic 1monthly9 -uarterly9 half3yearly9
yearly2 payments of interest9 salary9 pension9 commission9 dividend9 refund
by companies 9corporations 9government departments and such other
organiations defined as B)serD
The transactions to move from a single )ser source to a large number of
(estination Account .olders.
The credit transactions should pertain to the (estination various Bank
Branches &hich fall under the 4urisdiction of the local Bankers6 $learing
.ouse.
The credit instructions from the )ser to the (estination Account .olders
&ould be on magnetic tape9floppy 1 a form of electronic media that can be
processed on computers2 and &ould form the basis for the !ponsor Bank to
debit the )ser6s account and the (estination Banks to credit the (estination
Account .olders6 Accounts.
!uch other payment transactions involving a single debit to a )ser6s account
at one bank and multiple credits to a large number of beneficiaries at many
banks to be specified by K$$ after ascertaining the level of infrastructure
available at the !ervice95ain branches of member banks.
Debit -C"* )tility services companies such as electricity boards, telecommunication
companies or banks for loan installment collection use debit /$! for collecting the
amounts from consumers. This enables the companies to recover their dues in time
and more cost effectively. $ustomer has to give (ebit /$! mandate in the specified
form to the bank. /$! debit is also called as B(irect (ebitD
"cheme Coverage
The !cheme covers transactions of the follo&ing characteristics"
#epetitive payment collections like periodic monthly9 bimonthly9 -uarterly9
half3yearly9 yearly2 payments of telephone bills 9 electricity bills 9 loan
installments 9 insurance premium etc. by companies 9 corporations 9
government departments and such other organiations defined as L)serL.
Transactions relating to collections by a single )ser from a large number of
(estination Account .olders>
(ebit transactions should pertain to the (estination Bank Branches &hich fall
under the 4urisdiction of the local Bankers' $learing .ouses >
(ebit instructions from the )ser to the (estination Account .olders &ould be
on magnetic tape9floppy 1 a form of electronic media that can be processed
on computers 2 and &ould form the basis for the !ponsor Bank to credit the
)ser's account and the (estination Banks to debit the (estination Account
.older's Accounts>
%ndividual debit amount specified by the )ser>
!uch other payment transactions involving a single total3credit to a )ser's
account &ith sponsor bank and multiple debits to a large number of
beneficiaries at many bank branches 1$ollecting9(estination3banks2 to be
specified by local K$$ from time to time.
Introduction
This topic helps out in understanding the process of (ebt collection and monitoring.
$ollections are also best kno&n as (elin-uency management. %t is associated &ith
the recovery 9 delin-uency management of the credits 9 loans disbursed to the
customers by the banks. The repayment record of borro&ers needs to be monitored
continuously &ith regard to the payment of interest and repayment of principal.
Jhenever a borro&er defaults or is likely to default, rigorous follo&3up has to be
made for collection of the dues.
The business of a bank managing risks and its effectiveness lies in an efficient
recovery and exit strategy. The collections effort is very important in maintaining the
-uality of the credit portfolio. Timely follo& up is the key to success in collections.
The chances of recovery diminish as time passes. .ence, intense follo& up soon after
default yields greater results.
2vervie= of Collections
The loan portfolio of a bank is to be monitored continuously to identify facilities &hich
have exceeded and9or &here payment of interest 9principal is late or long over due.
The responsibility of collections department &ill start &hen an account becomes
delin-uent until it is regularied by means of payment or closed after making full
payment9charge3off.
The collection process for a credit facility offered by a bank &ill be initiated &hen the
account holder fails to meet one or more contractual payments 1installments2 on due
date and thereby turn delin-uent or &hen the customer exceed the granted limit
fixed for the overdraft facility by the bank. The ob4ective of collections department in
a bank is to minimie outstanding delin-uent receivables and thereby reduce credit
loss to the bank.
The aim of the collections process is to obtain payments promptly &hile minimiing
collections costs and &rite off cost. The collections department protects the assets of
the bank by continuous monitoring of accounts, identifying early &arning signals of
delin-uency to reduce financial losses.
Identification ) Classification of Delin'uent Accounts*
Jhen a customer fails to pay the instalment amount or minimum payment due
&ithin the payment due date, the account is termed delin-uent or in arrears.
$ollections steps can be initiated on such an account in order to regularie the
account and to protect the banks interest.
Accounts that are in arrears or in delin-uent stage are classified as overdue so that
the accounts in different stages of delin-uency can be managed more efficiently and
strategies for recovery of overdue formulated appropriately.
,or intensive follo& up overdue accounts are classified according to the period of
default and each group is called a BBucketD. As the account moves from one month
bucket to t&o months bucket, the account &ill be entrusted to another team. This
&ould ensure focus and appropriate strategy to recover the dues.
-1ample*
$onsider a customer &ho has a Loan facility &ith a Bank. The customer is expected
to make an instalment payment of R788893 every month before the F8th of $alendar
month.
%nstalment amount R788893
$urrent month August6E878
+ayment (ue (ate 1+((2 F798@9E878
%f the customer does not pay the amount, on or before F7st August E878, the Loan
account is considered to be in arrears 9 delin-uent. The account could get levied &ith
late payment charges depending on the policies existing in the bank.
On 7st !eptember E878, this account is considered 7 (+( 1one day past due2 and
collections procedures are initiated for this account.
On F8th !eptember E878, if the customer has not made payment to the account, the
account is F8 days past due and considered as F8 days delin-uent and in the F8 (+(
bucket.
%f payment is not made to the account, the account &ill continue to age and there by
move further up in the delin-uency categories 1I8 (+(, M8 (+(2.
The collection strategies associated &ith each of these buckets &ill differ based on
the procedures existing in the bank.
The different collection buckets and the days past due are listed belo&"
Days #ast Due Collection Bucket Comments
87 3 EM (ays 3 +ast (ue
F8 3 =M (ays F8 (+( (oubtful
I8 3 @M (ays I8 (+( Bad (ebts
WX M8 (ays 3 Kon +erforming Asset
Bank has to make provisions from their profits for Kon +erforming assets and this
reduces the overall profit earned by the banks.
#rocess Flo=
+onitoring of 2verlimit Accounts
%n addition loans offered to the customers, banks also offer overdraft facility to the
customer. 1The overdraft facility has been covered in detail in #etail loans and
corporate modules2. A credit limit 1i.e. the maximum cap for the credit facility to be
availed by the customer2 is assigned to the customer. The credit limit for a customer
is arrived based on the credit &orthiness of the customer, security provided by the
customer and the dra&ing po&er of the customer. The dra&ing po&er is arrived by
calculating the current value of the security 1for example the stocks of the company2
of the customer. The customer can avail of the credit facility up to the limit available.
Jhen a customer exceeds the prescribed limit, then the customer is termed as Bover
limitD. Over limit customer poses a financial risk to the bank. This type of over limit
accounts also need to be monitored till the account gets regularied.
The monitoring, regulariation of overlimit accounts are the responsibility of the
collections department.
Collection #rocess and "trategies
The collection strategies prevalent in banks can be varied depending on the policies
existing in the bank. The collection process consists of the follo&ing main activities"
A=areness Calling* A call &ill be initiated to the customer, &hen the first
payment is due from the customer. This call is to make the customer a&are of
the date of payment of his dues to the bank.
Collection Calling* A call &ill be made to the customer, to make him a&are
that he has missed the due date and re-uest him to pay the arrears at the
earliest.
Demand 8otice* %n the event of customer not responding to the telephonic
calls, a &ritten communication is sent to the customer informing the status of
the loan account.
Field Collection* The activity involves meeting the customer in person to
persuade the customer to repay the loan. A compromise deal may also be
made &ith the customer, if it is found that the financial position of the
customer has deteriorated as a result of &hich recovery of the entire dues
may not be possible.
Re:possession and disposal of hypothecated assets* As per the la&, the
hypothecated assets or the collaterals provided by the customers &ould be
taken into the possession of the bank, &hen the customer fails to make
payment of arrears and settle the loan dues.
Recovery through litigation* Jhen the sale of asset1s2 does not yield
enough to cover the outstanding balance in the loan account, bank &ill file a
la& suit for the recovery of balance dues. The follo&ing table gives flavour of
the different strategies used by banks in contacting delin-uent customers and
collecting payments from them.
Days #ast Due Collection "trategy , Actions
87 3 EM (ays Letter, !tatement message
F8 3 =M (ays
Letter, !tatement message,
+hone calls, !uspension of facility
I8 3 @M (ays
#eminder Letter, !tatement
message, #epeated phone calls
M8 3 77M (ays
Letter, !tatement message,
+hone calls, Hisit to residence9
Office
7E8 3 7GM (ays
.andled by collection agencies,
Legal notice
7=8 3 7NM (ays
.andled by collection agencies,
Legal notice, )pdate negative list
WX 7@8 days
Account charged off, .andled by
recovery agencies, Legal
+roceedings.
Collection Agent*
Once the account passes a certain level of delin-uency, the account is allocated to a
collection agency to &ork on. The customer and the loan account details are given to
the collection agency, &ho in turn &orks on these accounts on case to case basis.
The accounts are at times allocated to agencies for initiating legal proceedings. The
task of the collection agencies is to trace the defaulter and find out his exact financial
position.
Once the bank and collection agencies are convinced of the genuineness of the non3
repayment case, they enter into negotiations &ith the customer. .o&ever, if the
defaulter is hostile and does not agree to negotiations, banks hand over the case to
their recovery cell. At this stage, the loan account is closed and banks usually &rite
off the debt and take recourse to legal action. %n some cases, in case the defaulter
absconds, police help is taken. The collector is given po&er to negotiate &ith the
customer and can offer &aivers in case on one time settlement made by the
customer. The agencies are paid either on a flat rate or percentage of the amount
collected or combination of both.
3rite 2ff #olicy
Jhen an account is deemed not collectable, the account is charged off in the books
of account of the bank. The amount &ritten3off is sho&n as a loss to the bank. Banks
are re-uired to monitor cases &hich could get &ritten3off and provide for a provision
for &rite3off. But the recovery procedures &ill continue from the banks end despite
&rite3off. %n case money is recovered from the customer &ho has been &ritten3off in
the banks book, it is treated as income in the books of account of the bank.
Conclusion
The collection function is increasingly difficult to manage properly due to the gro&ing
sie, complexity of the business and collection6s labor3intensive nature. Banks use
the technology 1by implementing debt recovery 9 collection management soft&are2,
current and historical information at its disposal to formulate a plan or strategy for
optimiing its collection efforts. %n many banks, collection strategies rely on
behavioral scoring models &hich predict the likelihood of collection. Armed &ith such
information, bank managements effectively direct collection efforts &ith an emphasis
on amount at risk.
Introduction
Banks constitute the payments systems. %n the absence of banks, all transactions
have to be settled in cash &hich is not possible at all. %n addition to che-ues, there
are many &ays through &hich payments are effected. The traditional instruments,
other than che-ues used for settling payments are pay orders and demand drafts.
Gradually, electronic funds transfers are replacing these instruments. #emittances of
t&o types vi., %n&ard #emittance and Out&ard #emittance
In=ard Remittance
Jhen a customer receives a remittance 1in the form of pay order 9 demand draft 9
/lectronic remittance2 from another customer, he approaches the bank for
encashment. This is called as %n&ard remittance.
2ut=ard Remittance
Jhen a client &ishes to remit money to another and desires not to issue a che-ue
for this remittance, he approaches the bank for providing a remittance facility. !uch
remittance may be in the form of a (emand (raft, +ay Order or electronic
remittance. This is called out&ard remittance. This function is referred to as issue of
((, issue of +O, etc. as the bank issues remittance instrument.
Foreign Remittances
The in&ard9out&ard remittances may be in the form of foreign currency also like
Traveler6s $he-ues 1T$2, ,oreign ((, ,oreign TT, etc. Kostro, Hostro, and Loro
accounts are used for these purposes. !J%,T assists in efficient and fast
transmission of funds bet&een t&o countries. These are explained in B,orex
operations9/xport9%mport ,inanceD.
#arties involved in remittances
Applicant or remitter ? &ho re-uest for transfer of funds or &ho remits the
funds.
Bank ? Through &hom the funds are transferred or &ho issues the payment
instruments
Beneficiary 3 in &hose favor the instrument is dra&n, is called the beneficiary.
#ay 2rder .#2/
+ayment through $he-ues suffers from a deficiency &herein the che-ues could be
returned unpaid by the dra&ee bank for many reasons including lack of funds. A pay
order is a variant of che-ue, &here the payment is assured. This is also kno&n as
Bbanker6s che-ueD.
Features of #ay 2rder
+ay order is a che-ue issued by a bank on itself. The dra&er and dra&ee of a
pay order is the same branch of the bank. i.e. the issuing branch and the
dra&ee branch are the same.
+ay order is issued by banks after collecting the amount from the applicant.
The amount is kept in a separate account for making payment of the pay
order &hen it is presented.
+ayment of pay order cannot be stopped 1except the court order2 once it
issued, as it is issued by the bank.
%t is a source of interest free funds and commission income for the issuing
bank as the amount is kept in a separate account till it is presented for
payment.
Demand Draft
A demand draft is Ban instrument in &riting dra&n by one branch upon another
branch of the same bank. %t contains an unconditional order to pay on demand a
specified sum to a specified person or to his orderD.
(emand drafts involve movement of funds from one place to another.
(emand drafts are also che-ues issued by the banks on themselves but &ith
the difference that the issuing branch and paying branch are different.
(emand draft is a che-ue issued by one branch of a bank and made payable
at another branch of the same bank.
%t is used to settle transactions bet&een persons of t&o different places.
#arties to a Demand Draft ,ollo&ing are the important parties to a (("
Dra=er 3 One &ho dra&s the (( i.e. the %ssuing Branch
Dra=ee 3 One on &hom the (( is dra&n i.e. the branch on &hich it is dra&n
#ayee 3 One in &hose favour (( is dra&n i.e. the beneficiary
#urchaser 3 One on &hose behalf (( is issued
3hy ) 3hen a DD is re'uired The probable reason for the customer to approach
the bank for issue of (( could be one of the follo&ing"
One client of the bank &ishes to remit money to another
The client does not like to issue a $he-ue to settle this dues
The other party is in a different city
The other party does not maintain any account &ith the bank in the other $ity
or even if he maintains, the client &ishes a ((
Issue ) #ayment of a DD
Issue of Demand Draft
,ollo&ing are the various aspects associated &ith issue of (("
7. Jhen the applicant re-uests for issue of ((, the bank verifies &hether they have
their o&n branch at the place re-uested. %n some cases, even if a branch does not
exist in that place, in case (ra&ing Arrangement 1i.e. tie3up &ith some other banks2
is available on any other bank in that place, (( is issued.
E. %f more than one branch is located in the place re-uested, the (( is issued on the
nominated branch. %nstead of nominated branches, some banks issue ((s on any
branch as per customer6s preference.
F. The applicant need not be a customer of the bank for taking a ((.
G. (( can be issued either against cash or against debit to any operative account of
the applicant. .o&ever in case of issue of ((s against cash remittance, restrictions
are imposed on the maximum amount for &hich (( can be issued. .o&ever there is
no restriction on maximum amount are for issue of ((s against debit to accounts.
=. !ome banks issue ((s 1single ((2 only up to a specified amount. This is mainly to
avoid frauds. Jhen a customer re-uests for issue of (( for more than such
stipulated amount, the amount is broken into number of units and multiple ((s are
issued for each unit value.
I. (( issue attracts commission payable by the applicant. !uch commission has a
tier structure based on the amount of ((.
N. The (( is valid for a specific period 1say 7 year2 from the date of issue. The payee
can encash the (( or the purchaser can get the (( cancelled &ithin this validity
period. /lse, revalidation of (( has to be done, &hich is discussed subse-uently.
@. /very (( bears a number. This number may either be a check3digit method
number or the printed serial number of the (( itself.
M. The (( is printed, signed by authoried officials of the bank and given to the
applicant. The printing may be in a 5agnetic %nk $haracter #ecognition 15%$#2
instrument or a Kon35%$# instrument. But if the (( is dra&n on a center &here
5%$# operations9clearing system is in force, printing in a 5%$# instrument is
mandatory.
78. +articulars of name and address of the applicant, payee name, dra&ee branch,
(( number, (( amount, commission collected, etc. are maintained at issuing branch
as record.
#ayment of Demand Draft
The purchaser sends the (( to the beneficiary. %f the beneficiary has an
account &ith a branch of the same bank, he presents it to the branch. /lse,
he presents it to his bank. .is bank becomes the collecting bank in this case
and they present the (( to dra&ee bank 1branch2 for payment. !uch
presentation happens through clearing house mechanism present in that
place.
The dra&ee bank verifies &hether the (( is in order and is presented for
payment before expiry of the validity period. %f validity has expired, it is called
B!tale ((D and can not be paid unless it is revalidated by the issuing branch.
The dra&ee bank also verifies &hether any reported lost message has been
received from issuing branch for the ((. %f so, the (( is returned unpaid &ith
suitable message.
The applicant need not be a customer of the bank for taking payment of a
((. %f the (( is in order, payment is made to the client.
(( can be paid and either cash is disbursed or credit is given to any operative
account of the applicant. .o&ever in case of payment of ((s through cash,
restrictions are imposed on the maximum amount for &hich cash can be paid
against ((. .o&ever such restrictions on maximum amount are not
applicable for payment of ((s and credit to operative accounts.
Duplicate #ay order , Demand Draft
(uplicate +O 9 (( may be issued if the original is lost or mutilated.
A stamped indemnity 1an assurance from the customer that in case the bank
is put to loss due to issuing the duplicate +O 9 ((, he &ill pay the bank the
amount of loss2 &ill be obtained from the customer along &ith the re-uest
letter for issuing (uplicate +O 9 ((.
Bank may insist on guarantee from third party also incase the amount
involved is too large.
Bank &ill issue duplicate +O 9 ((, after ensuring that the original has not
been paid.
The original pay order &ill be marked as cancelled.
Cancellation of #ay order , Demand Draft
+O 9 (( can be cancelled at the re-uest of the purchase in &riting.
Amount after cancellation &ill be credited to the purchaser6s account, if it is
large.
Bank &ill also take indemnity and guarantee from the purchaser &ho is
re-uesting cancellation.
Bank &ill also ensure from the payee that the pay order 9 demand draft is not
received 9 paid.
"top payment of #ay order , Demand Draft
+ayment of +O 9 (( cannot be stopped except by the court.
Bank may refuse payment, if +O 9 (( is tampered or altered.
Revalidation of a DD
The (( is valid for a specific period from the date of issue. The payee can
encash the (( or the purchaser can get the (( cancelled &ithin this validity
period. /lse, revalidation of (( has to be done.
#evalidation is nothing but validating the (( for a further period, say F
months. 5any banks have maximum period for such revalidation e.g. one
year from the date of original expiry date, etc.
#evalidation can be done either at the re-uest of the purchaser or payee.
The fact of revalidation is done on the (( itself.
!uch ((s can be paid before the extended validity period.
#evalidation of (( attracts service charges.
!oss of a DD
%n case the (( is lost by the purchaser either during transit or other&ise, the
purchaser has to report loss of (( to the issuing bank.
Only the purchaser can report loss of (( and that too at the issuing branch
only.
%ssuing Bank &ill immediately inform the dra&ee branch and send an
B/xercise caution &hile paymentD for such ((s to the dra&ee branch.
The dra&ee branch records such losses. After noting do&n loss of ((, in case
the original (( is received for payment, dra&ee branch returns the (( &ith
the remark that the (( has been reported lost.
!ome branches charge service charges for the action taken on receiving
information regarding loss of ((.
The purchaser has t&o choices in this case. .e can either get the ((
cancelled or get a duplicate ((.
Generally no accounting entries are passed in (( account for report of loss of
((. Only collection of service charges &ill result in the entry mentioned under
B#evalidation of ((D.
Reconciliation
By issuing a ((, bank undertakes a liability to pay the amount and as such it
becomes a current liability to the bank. There are chances of the fraudulent
alteration of the instrument especially the amount portion. .ence, banks have a
reconciliation mechanism for ((s mainly for the follo&ing purposes.
To ascertain the details of outstanding ((s
To ensure that the material portion of issue of (( and payment of ((
matches.
+articulars are collected from issuing branch and also the paying branch on a
periodical basis and matching of the (( entries are done one by one. %n case of mis3
matches the issue is taken &ith the concerned branches. %n case banks have
centralied banking applications and all the branches are connected to the data3
center, automated reconciliation happens immediately during payment itself.
-lectronic Funds Transfer
/lectronic fund transfer enables the payees to get the funds instantaneously
avoiding the transit time involved in sending the instrument by post or courier
and also the time involved in the local clearing process.
As cost of mailing and cost of handling are saved, /,T is cheaper than any
other mode of remittance.
/lectronic ,unds Transfer are of the follo&ing types"
o %ntra Branch
o %nter Branch
o %nter bank
Intra branch ? Transfer of funds from one account to another in the same branch
by debiting one account and crediting another account. Both the remitter and
beneficiary are &ith the same branch of the bank.
Inter branch ? Transfer of funds from one account to another account in the
different branch. Beneficiary and remitter maintain account &ith different branches of
the bank
Inter bank ? Jhen the beneficiary and remitter maintain account &ith different
Banks, then an intermediary is re-uired to pass the funds and message electronically
from one bank to another. $entral Bank plays the role of the intermediary in
facilitating /,Ts. T&o facilities of inter3bank transfers are"
U K/,T
U #TG!
8-FT
The process of electronic funds transfer is as follo&s"
#emitter
o %nitial funds transfer through branch or internet banking
#emitter6s Bank
o $entral processing centre of the bank extract details of the payment
made from the bank systems
o +ayment file is processed in central bank6s electronic funds transfer
package.
o The file &ill be encrypted and uploaded in central bank6s site
$entral Bank
o (o&nloads funds transfer files from the remitting bank
o !orts the data beneficiary bank &ise
o )ploads the file to the beneficiary banks
o This operation &ill be performed at regular intervals in a day 1vi.,
78.F8 am > 7E.88 noon and G.88 pm2 to ensure the credit happens to
the beneficiary account on the same day.
o $entral bank debit the remitting bank6s account and credit the
beneficiary6s bank account maintained &ith them.
Beneficiary Bank
o (o&nloads /,T file from central bank site
o (ecrypts the file for processing the funds transfer to the beneficiary
o $redits the beneficiary6s account
RT"
#eal Time Gross !ettlement 1#TG!2 !ystems, has made the inter3bank funds
transfer possible on a real time basis.
%n K/,T, the funds are pooled at regular intervals and settlement is made, &hereas
in #TG!, the funds transfer happens on real time basis. i.e. one transaction per
transfer re-uest.
To reduce the load 9 net&ork traffic on such funds transfers, a limit is fixed by the
central bank, &hich ensures that the system &ill accept the funds transfer re-uest
only, if the amount is higher than the stipulated limit.
Introduction to Cards
Advancement in telecommunications and computing technologies has caused
revolutionary changes in business models. 5any businesses have been freed from
the constraints of physical space, limited &orking hours and political boundaries.
Technology has also impacted banking business in a big &ay. Banking has been freed
from the constraint of physical branches. %t is no& possible for customers to access
the accounts and &ithdra& cash any time any &here across the globe through AT5s,
&hich are linked internationally through H%!A and 5aster$ard net&orks. .o&ever,
branches continue to be most important channel for sales and delivery of banking
services and all other channels can at best support the branch channel.
Types of Cards
$ards are of different types as given belo&"
AT5 $ards
$redit $ards
(ebit $ards
+urchase $ards
+rivate Label $ards
!ecured $redit $ard
!mart $ards
AT+ Cards
AT5s or Automated Teller 5achines, as the name indicates, are meant to provide the
services that a teller at a branch provides on a EG hour basis. AT5s started out as
cash &ithdra&al machine to serve the customers any time, any &here for the
convenience of the customers. The bank also benefited as the cost of installing the
AT5 &as much lo&er than that of a branch. Gradually numbers of services are
increased in the AT5. The card is protected and the customers has to provide +%K
1+ersonal %dentification Kumber2 &hich is validated before the transactions.
Credit Cards
$redit cards are basically lines of credit that once established, depending on the
specific terms, allo& an individual to spend up to a set amount of money, &hich is
kno&n as limits and pay back these amounts either in +art or in full. This can be also
called as B+lastic 5oneyD. $redit card terms differ on annual fees, percentage rates,
payback terms and credit&orthiness restrictions. $ards can be issued &ith +rimary
and Add on cards linked to the main card, &here the limit fixed is an overall limit.
They have a validity period usually ranging from 73E years.
$redit cards are plastic cards &ith readable magnetic strips issued by a bank or a
business, &hich allo& the cardholder to purchase goods or services on credit.
$ommon credit cards include Hisa, 5aster$ard, American /xpress and (iner6s $lub.
$redit cards allo& you to make purchases up to a specified limit and then en4oy a
period of credit 3 usually up to the period varying from one month to =8 days 3
before having to settle your bill. /very time you use a credit card, you are actually
borro&ing money that is made available to you by a bank or other financial
institution. ;ou ho&ever have to repay a minimum amount each month, in &hich
case interest is charged on the balance amount, usually at a high rate. .o&ever, if
you pay the bill in full you incur no interest. This is like =8 days interest free loan.
Jhy does any bank do thatQ
%f you borro& #s.E8, 888 on personal loan at 77A.
%nterest to be paid for =8 days X #s. E8,888 Y 77A Y 1=89FI=2 X #s. F87.G8.
But, here the bank is giving you a loan &ithout interest &hen you use their credit
card. (o you astonish something is &rong some&hereQ. Jell, the concept is
explained belo& &ith a typical illustration"
7. Jhen you use your card to pay for the camera &hich you bought from !ony
Jorld, ;ou present your Bank credit card, say AB$ bank credit card 1H%!A card2 for
the payment.
E. !ony Jorld s&ipes your card on a machine provided by $itibank. .ere $itibank is
the ac-uirer bank
F. $itibank communicates &ith the card issuer i.e. AB$ Bank through H%!A Ket&ork
to check if the card is valid and has the re-uired credit limit.
G. AB$ Bank revie&s and approves 9 declines &hich is communicated back to !ony
Jorld.
=. ;ou sign a receipt 9 slip called !ales (raft given by $itibank. This is the obligation
on your part to pay the money to AB$ Bank. (ata on this receipt can be captured
electronically and transmitted.
I. At the end of day or at the end of some period !ony Jorld submits the receipt
signed by you to $itibank, &hich in return pays !ony Jorld the money. ,or the
&hole process !ony Jorld pays $itibank a fee called 5erchant (iscount. Let us say
this is IA of the sale value X IA Y E8,888 X #s. 7E88.
N. $itibank sends the receipt electronically to a Hisa data center &hich in turn sends
it to AB$ Bank.
@. AB$ Bank transfers the money to a settlement bank &hich in turn transfers the
funds to $itibank.
M. $itibank pays AB$ Bank an %nterchange ,ee of GA of the sale value X GA Y
E8,888 X #s. @88.
78. E8 to =8 days later Best Bank gets the money from you and you don6t need to
pay the interest.
!ony Jorld pays more than the interest that you should have paid for the loan that
you take. As a cardholder, you have the follo&ing benefits"
7. $onvenience of not having to carry cash.
E. $redit availability that too free of interest
.o&ever &hat benefits does !ony Jorld get for paying so much moneyQ %sn6t it more
profitable for them to take cashQ They can save as much as #s.7E88.
Jhen you don6t count the money that you are spending, you tend to buy moreZ
$ards encourage this activity &hich is called impulse purchase. %f you did not have
access to credit, you &ould not have bought the camera this month or may be not
any time soon either. By accepting cards, the merchant is actually extending you
credit at the risk of the card issuer. .e pays money to the banks to carry that risk.
!ome banks provide cash back &hen you use $redit $ard of that bank...&hy is it
so..Q
%f the sales draft that you sign at the retailer is also be from AB$ Bank 1and not from
$itibank2, they save on the %nterchange ,ee. A part of the 5erchant (iscount that
they got may be passed on to you partially as $ash back.
Also if you have noticed, AB$ Bank gives you cash back only in the next credit cycle
&hich &ill get reflected only in the next card statement. %t means they keep the cash
back money &ith themselves for I8 days before passing on a part to you. This
accrues them interest too. And that also explains &hy banks has tie up &ith petrol
pumps for example. AB$ Bank has tied up &ith an oil marketing company &here you
could re3fuel your vehicle &ithout paying the fuel surcharge of E.=A. This is because
the card issuer and the ac-uiring bank is the same and that saves interchange fees.
Debit Cards
(ebit cards are issued in con4unction &ith a business bank account, and are a
substitute for che-ues. This is similar to AT5 card and additionally these cards can
be used at any +oint of !ale 1+O!2 terminal. These cards are normally po&ered by
Hisa or 5astercard. %t differs from (ebit card in one &ay by rather than allo&ing you
a period of credit, payments are deducted almost immediately from your bank
balance. As a result, spending is limited by your available funds and only signatories
of a business account can use these cards.
#urchasing Cards
+urchasing cards are generally restricted to big businesses or public3sector bodies.
%ssued by a range of banks and companies such as Barclaycard and American
/xpress, they6re designed to cut do&n on paper&ork and the need for purchase
orders.
Charge Cards
$harge cards also allo& you a period of credit before you pay 3 but they must be
paid off in full each month. Business banks tend to make charge cards as part of
their offer to small businesses. They can be issued to as many key employees as you
choose 3 some card issuers &ill allo& you to set spending limits on employees6 cards.
#rivate !abel Cards
5erchants can issue cards that can be used only in their retail chains9outlets .,or
example !ears may release a card in association &ith any bank9net&ork that can be
used only in sear6s outlets. The advantage for the merchant in releasing such a card
is that the customer loyalty9re&ard &ith the merchant could be encouraged in the
form of discounts and special offers. The cardholder can accumulate points based on
the purchases made and these points can be later redeemed for gifts, services or
discounts. Banks issues this type of products in association &ith large retail stores or
airline companies.
"ecured Credit Card
!ecured credit cards are credit cards targeted to customers &ith poor or limited
credit histories &ho do not -ualify for a credit card. !ecured credit cards are
collateralied by cash deposits, generally a passbook savings account or certificate of
deposit. (epending upon the bank6s policy, the credit limit is =8 percent to 788
percent of the deposit amount. The bank may pay interest on the deposit account.
These programs benefit consumers by helping them either establish or reestablish a
satisfactory credit history. %f these customers perform satisfactorily, many banks &ill
BgraduateD them to an unsecured credit card.
"mart Card
$ards that can electronically store a fixed value, &hich you have prepaid .As you
make purchases, the value gets reduced by the amount of the purchase, and can be
replenished.
!mart $ards have a @ bit micro processor embedded in the card &hich stores
information about the cardholder, instead of the magnetic stripe Though costlier,
smart cards offer better security than the conventional cards &ith magnetic stripe.
Credit Card 0Concepts
H%!A, 5aster$ard * American /xpress are the three largest payment card systems in
the &orld. Hisa accounts for half of the global purchases using cards follo&ed by
5aster$ard and American express. These associations are managed by board of
directors composed of representatives on banks.
These associations are responsible for"
(eveloping and implementing operating rules
+rocessing transactions and interchange payments bet&een members.
(eveloping system3&ide innovations such as interchange technologies.
+romoting the association brand through advertising.
$oordinating ,raud $ontrol initiatives
!igning up card issuers, Ac-uirers and merchants
5ey #layers in Card Business
U %ssuer9 issuing bank" The ,inancial %nstitution that extends credit to customers
through bankcards.
U $ardholder" The customer &ho possesses the card and conducts financial
transaction using it as cash substitute.
U 5erchant" Any business establishment is a BmerchantD once an ac-uiring bank
authories them.
U Ac-uirer9 Ac-uiring processor" The ac-uirer 1the merchant9retailer6s bank2 buys
1ac-uire2 the merchant6s sales slips 1ticket2 and credit the ticket6s value to the
merchant6s account.
U %nterchange Ket&orks 1Hisa * 5aster$ard2" They provide services such as
conducting authoriations, clearing and settlement processing of transactions,
supervising the bankcard processing &ithin member banks and setting and enforcing
bankcard rules and regulation
Functions of Issuing , Ac'uiring Banks Function of an Issuing Bank
%ssue card to -ualified customers
#eceive transaction information from franchise9 settlement house.
+rovide transaction and outstanding balance information to card members
Take credit and fraud risk on card members.
Function of an Ac'uiring Bank
+rovide authoriation.
Accept transactions for credit to merchant accounts.
!ubmit transaction information to franchise9 settlement house
+rovide statements and reconciliation to merchants.
Take credit and fraud risk on merchants
Card "torage Information The details of &hat exactly the number in the credit
card mean, and &hat type of information6s are stored in the magnetic stripe are
given belo&.
The first digit in your credit3card number signifies the system"
F 3 travel9entertainment cards 1such as American /xpress and (iners $lub2
G 3 Hisa
= 3 5aster$ard
I 3 (iscover $ard
The structure of the card number varies by system. ,or example, American /xpress
card numbers start &ith FN> $arte Blanche and (iners $lub &ith F@.
American -1press 3 (igits three and four are type and currency, digits five
through 77 are the account number and digits 7E through 7G are the card
number &ithin the account and digit 7= is a check digit.
6isa 3 (igits t&o through six are the bank number, digits seven through 7E or
seven through 7= are the account number and digit 7F or 7I is a check digit.
+asterCard 3 (igits t&o and three, t&o through four, t&o through five or t&o
through six are the bank number 1depending on &hether digit t&o is a 7, E, F
or other2. The digits after the bank number up through digit 7= are the
account number, and digit 7I is a check digit.
The "tripe
The !tripe on the back of a credit card is a magnetic stripe, often called a magstripe.
The magstripe is made up of tiny iron3based magnetic particles in a plastic3like film.
/ach particle is really a tiny bar magnet about E83millionths of an inch long.
The magstripe can be L&rittenL because the tiny bar magnets can be magnetied in
either a north or !outh +ole direction. A magstripe reader can understand the
information on the three3track stripe. %f the AT5 isn't accepting your card, your
problem is probably either"
A dirty or scratched magstripe
An erased magstripe 1The most common causes for erased magstripes are
exposure to magnets, like the small ones used to hold notes and pictures on
the refrigerator, and exposure to a store's electronic article surveillance 1/A!2
tag demagnetier.2
Information on the "tripe
The card details are stored 9 encoded in magnetic strip as Track 7,E and F. /ach
track is about one3tenth of an inch &ide.
Track 7 contains $ard holder Kame , expiry date, etc
Track E contains $ard number , expiry date, service code, $HH , +HH , etc
Track three is a read9&rite track 1&hich includes an encrypted +%K, country
code, currency units and amount authoried2, but its usage is not
standardied among banks.
The information on track one is contained in t&o formats" ,ormat A333 &hich is
reserved for proprietary use of the card issuer, ,ormat B, &hich includes the
follo&ing"
!tart sentinel 3 one character
,ormat codeXLBL 3 one character 1alpha only2
+rimary account number 3 up to 7M characters
!eparator 3 one character
$ountry code 3 three characters
Kame 3 t&o to EI characters
!eparator 3 one character
/xpiration date or separator 3 four characters or one character
(iscretionary data 3 enough characters to fill out maximum record length 1NM
characters total2
/nd sentinel 3 one character
Longitudinal redundancy check 1L#$2 3 one character
L#$ is a form of computed check character.
The format for track t&o, developed by the banking industry, is as follo&s"
!tart sentinel 3 one character
+rimary account number 3 up to 7M characters
!eparator 3 one character
$ountry code 3 three characters
/xpiration date or separator 3 four characters or one character
(iscretionary data 3 enough characters to fill out maximum record length 1G8
characters total2
L#$ 3 one character
Credit Card !ife Cycle
The life cycle of card can be explained as belo&"
7. $ardholder uses the card to buy a product 9 service from the merchant
E. The transaction is captured and approved by the issuing bank
F. Bank issues statement to the customer informing the amount to be paid and the
payment due date
G. There are three possible out comes
=. $ardholder pays in full in &hich case there is no interest charged, or the
cardholder pays in part in &hich case the interest is charged and levied to the
customer during the next statement
I. $ardholder disputes the transaction in &hich case the charge back process9fraud
investigation process kicks off
N. $ardholder does not pay in &hich case the collection process kicks off. %f the
amount is not recoverable, the amount is &ritten off and the account is closed.
#2" Terminal AuthoriDation
+O! terminal transactions involve three steps"
Authoriation
$learing
!ettlement
AuthoriDation
On presentation of the card, the merchant s&ipes the card through a card reader,
&hich reads the data on the magnetic stripe and adds information that identifies the
merchant and the value of the purchase. The /lectronic data capture 1/($2 is the
soft&are at the point3of3sale 1+O!2 terminal that dials a stored telephone number
and calls an ac-uirer.
The Ac-uirer reads the message and determines the type of %nterchange Ket&orks
1Hisa, 5aster $ard2. %f the interchange net&ork is Hisa, then it dials the Hisa6s
computer, &hich checks &ith the %ssuer6s computer to verify the credit balance to
cover the purchase.
%f it founds enough credit, the issuer6s computer &ill send back a message to the
interchange net&ork 1Hisa, 5aster $ard2 authoriing the transaction. The
interchange net&ork relays the message back to the terminal at the store as &ell as
the ac-uirer.
Clearing
At the end of each business day, the merchant sends the sales transaction data &ith
a re-uest for payment to his ac-uirer, &ho in turn sends it to the interchange
net&ork 1Hisa, 5aster $ard2. The interchange computer passes the re-uest to
issuer6s computer, &hich posts the transaction to the cardholder6s account.
"ettlement
The interchange net&ork consolidates all the transaction for the day and sends the
transaction details to the ac-uirer and issuer. The issuer then sends the amount to
the interchange net&ork, &hich then posts it to the ac-uirer6s account.
Internet Credit Card AuthoriDation
$onsumer goes &eb site, chooses goods and9or services, and fills out the
merchant commerce application
$onsumer enters credit card information into a secured form that is sent over
the %nternet via #eal Time Online +rocessing soft&are 1i.e.Authorie.net2,
&hich then sends the encrypted transaction to the ac-uiring processor for
credit card authoriation
Ac-uiring processor sends transaction to card association, &hich in turn sends
the re-uest for credit card authoriation to the issuing bank
%ssuing bank accepts or declines the credit card transaction and sends
message to the card association
The card association contacts the credit card processor &ith the credit card
authoriation, and then the re-uest to deliver goods and services is given to
the merchant by &ay of the online credit card processing soft&are
5erchant sends the credit card processing company Lfulfillment notification to
permit settlementL meaning that the goods and services have been delivered
or are ready to be shipped
The capture takes place &hen the credit card authoriation information is
given to the issuing bank and the consumer's credit card is charged for goods
and services re-uested9received YY This entire process takes place in less
than ten seconds.
,inally, &hen the merchant decides to settle batch, the ac-uiring processor
finalies the credit card transaction &ith the issuing bank and they transfer
money into the merchant's bank.
Credit Card : Interest Calculation*
Billing $ycle and !tatement date" Billing cycle is the one month period, the
transactions done during the period are billed for the customer on the last day of the
billing cycle. The statement is generated and sends to the customer at the end of the
cycle and the print date is called statement date.
Total Amount Due .TAD/ and +inimum Amount Due .+AD/
The total amount of billing during the billing cycle is the TA( 1plus balance carried
from previous bill if any2. $ard issuing banks may insist only minimum amount say
78A of the TA( sub4ect to minimum amount of say #s 788 and this is called as 5A(.
#ayment Due Date ) Interest Free #eriod
Kormally the payment due date is some E8 or EE days after the statement date. The
customer has to pay either TA( or 5A( on or before the due date. %f the customer
pays TA( before the due date no interest is charged for the amount used on the
purchases.
Interest #ayment
Jhen a card holder does not pay the TA( on or before the due date, he becomes
liable to pay interest. ,or instance, if the TA( is #s E888 and the card holder pays
only #s @88, on the balance #s 7E88, interest &ill be charged from the date of
purchase. On the remaining balance the customer loses the benefit of interest free
credit period.
,urther on all fresh purchases interest &ill be charged from the date of transaction
itself. Kon +ayment of the TA( is called B#olloverD as the balance is tolled over from
one billing cycle to another billing cycle.
-1ample
Billing $ycle Oct 7I to Kov 7=
!tatement (ate Kov 7=
+ayment (ue (ate (ec N
+urchases during the billing cycle
Oct EF #s 7788
Kov 77 #s EF88
TA( #s FG88
5A( 1=A of TA(2 #s 7N8
%nterest #ate F.I=A per 5onth
+urchase after Billing $ycle
Kov 7N #s 7I=8
(ec 8F #s M@8
"cenario $*
On (ec = the customer pays #s FG88, i.e. TA(
Conse'uences
!ince customer has paid the TA( before the due date he &ill be eligible to get
interest free credit period for the transactions after Kov 7=.
"cenario &*
On (ec I the customer pays #s 7N8, the 5A( Conse'uences On the remaining
balances interest &ill be charged at F.I=A per month from the date of transactions.
,rom oct EF interest has to be paid on #s MF8 17788 less 7N82 till it is paid in
full.
,rom Kov 77 interest has to be paid on #s EF88 till it is paid in full.
On purchase after the billing cycle, interest has to be paid from the date of purchase
,rom Kov 7N, interest has to be paid on #s 7I=8 till it is paid in full
,rom (ec F, interest has to paid on #s M@8 till it is paid in full
Default
Kon payment of even the 5A( is considered as default. %t sho&s the lack of ability or
inclination of the card holder to honour his commitments. %n the event of default,
Bank initiate recovery proceedings.
$orporate banking 1also called as Jholesale Banking2 is the provision of services by
banks to the like of large corporate clients, mid3sied companies, real estate
developers and investors, international trade finance businesses, institutional
customers 1such as pension funds and government entities9agencies2, and services
offered to other banks or other financial institutions. %n essence, &holesale banking
services usually involve high value transactions. Jholesale banking contrasts &ith
retail banking, &hich is the provision of banking services to individuals.
The follo&ing topics are covered as part of $orporate Banking "
,oreign /xchange
Limits * $ollaterals
5oney 5arket
+ayments
Trade ,inance
Introduction
This module introduces the meaning of ,oreign /xchange and its importance in
cross3border monetary transactions. %t also covers some basic concepts and
terminologies used in ,oreign /xchange transactions.
3hat is Foreign -1change7
,oreign /xchange refers to changing money of one country for the money of another
country. This is necessary since the money of one country is of no value9use at the
other country 3 it cannot be used freely ? and there is no single universal currency in
&hich all settlements could be made.
$onsider these scenarios"
7. An %ndian resident is touring )!A on business commitment 3 he needs )! (ollars
for his tour> he cannot use #upees in )!A.
E. A British tourist decides to purchase an anti-ue in %ndia 3 he has to pay %ndian
#upees for the purchase> he cannot use 1!terling or Great Britain2 pounds.
F. A German firm procures 1purchases9imports2 ready made Garments &hich an
%ndian firm supplies 1!ells9/xports2 3 the %ndian firm has to be paid in %ndian #upees
and not /)#O.
G. An %ndian firm %mports Television 0it from a Tapanese firm 3 the Tapanese firm has
to be paid in Tapanese ;en and not %ndian #upees.
Thus, the process of exchanging one currency to another is called ,oreign /xchange.
8eed for foreign e1change
As enumerated in the above example, &henever there is involvement of t&o different
countries in any kind of exchange, the value needs to be paid in the currency of the
country eligible to receive funds. %n a nutshell, foreign exchange is re-uired for
cross3border transaction9trade settlement.
Foreign -1change +arket
The foreign exchange market can be defined as a market in &hich individuals,
business firms and banks buy and sell foreign currency. %t is a large, gro&ing and
li-uid financial market that operates EG hours a day. %t is not a market in the
traditional sense because there is no central trading location or BexchangeL. 5ost of
the trading is conducted by telephone or through electronic trading net&orks.
Authoried (ealers
Kot all persons or entities can deal in foreign exchange> it is governed by the
regulations of the respective country and need permission9license to transact. Those
Banks and %nstitutions &ho have been permitted to deal in ,oreign /xchange are
called Authoried (ealers 1A(2. Almost as a rule, all the banks are authoried to
entertain foreign exchange transaction.
+oney changers
Apart from A(, some firms or companies are also granted permissions to deal in
foreign exchange. They cannot entertain the entire gamut of transactions but can
undertake transaction involving purchase or sale of ,oreign $urrency and Travelers6
check only. These firms are kno&n as 5oney $hangers.
Foreign Currency
All currencies are denoted in F letter format standardied by %!O 1%nternational
!tandard Organiation2. The first t&o letters denote the country and the last letter
denotes the currency. /xception to this is /)#O, &here there is no country9currency
combination letters, but the letters denoting the common union ? /uropean )nion.
The most commonly traded currencies are )! (ollars 1)!(2, Great Britain +ounds
1GB+2, /uropean )nion $ommon $urrency 1/)#2, Tapanese ;en 1T+;2, $anadian
(ollars 1$A(2 and Australian (ollars 1A)(2. !ome other currencies are !ingapore
(ollars 1!G(2, <ealand (ollars 1K<(2, %ndian #upee 1%K#2, !audi Arabian #iyals
1!A#2, and )A/ (irhams 1A/(2.
Currency pair
An A( buys foreign currency at lo&er rates and sells at higher rates 1thereby earning
profits2. 5eaning he al&ays has t&o rates for any currency pair 3 a buying rate and a
selling rate.
A currency pair is the -uotation of the relative value of a currency unit against the
unit of another currency in the foreign exchange market. There are the t&o
currencies that make up an exchange rate. Jhen one is bought, the other is sold and
vice versa.
Base Currency and Counter Currency
,or any foreign exchange trading, currencies are -uoted in terms of a currency pair.
The first currency in the pair is the base currency and the other currency is counter
currency. ,or example, in a )!(9T+; currency pair, the )! dollar is the base
currency and T+; is the counter currency.
-1change Rate
;ou are &ell a&are that a kilogram of #ice does not cost the same as a kilogram of
silver> there is considerable difference in the cost or #ate. Like&ise, each currency
has a procurement rate different than the other. The #ate at &hich a currency is
converted into another currency is /xchange #ate. %n other &ords, the rate at &hich
one currency can be exchanged for another is an exchange rate. ,or instance, each
)! (ollar costs #s. GI.EN=8 means the rate for )!( 7 is #s. GI.EN=8, and each GB+
costs )!( 7.=ME= means the rate for GB+ 7 is e-ual to )!( 7.=ME=.
/xchange rates are generally -uoted to G decimal points and in some cases up to I
decimal points. ,or instance, )!(9%K# exchange rate is GI.7GEG. !imilarly, GB+9)!(
exchange rate is 7.=ME=F.
/xchange rates are -uoted
%n t&o methods ? direct and indirect
,or selling and buying transactions
,or different periods ? spot and for&ard
Direct and Indirect methods
$% Direct Rates
)nder this system, the exchange rate for a foreign currency is expressed in terms of
units of local currency e-ual to one unit of foreign currency.
/xample" )!( 7.88 X #s.G@.=8 &ould be a direct exchange rate for the )!( in %ndia
&% Indirect Rates
)nder this system, foreign exchange rate is -uoted as the foreign currency per unit
of the domestic currency. %n an indirect -uote, the foreign currency is a variable
amount and the domestic currency is fixed at one unit. /xample" %K# 7 X )!(
8.8E8IE &ould be the corresponding indirect -uotation in %ndia for the )!(.
An exception to the above rule is T+; 1Tapanese ;en2, in &hich the rate is -uoted per
788 )nits instead of per unit.
The system prevalent in %ndia until Aug 7MMF &as to -uote exchange rates in the
indirect method ? all -uotations used to be in terms of foreign currency units e-ual
to #s.7.88. A s&itch &as made to the direct rate system and conse-uently all
-uotations are no& in terms of rupees e-ual to a unit of foreign currency.
#urchase and "ale transactions
$% #urchase Transaction
%t is a transaction in &hich the A( buys foreign currency 1,$2 and pays 1sells2 in
e-uivalent local currency 1L$2> it converts ,$ into L$
-1ample*
a. %n&ard remittance ? )!( =888 remitted from )!A converted to %ndian #upees
1purchased2 and credited to !avings Bank Account in %ndia.
b. /xport bill paid ? An %ndian firm receives )!( 78888 from )!A &hich is converted
to %ndian #upees 1purchased2 and credited to the $urrent Account of the firm in
%ndia.
&% "ale Transaction
%t is a transaction in &hich the A( sells foreign currency by taking 1purchasing2 a
local currency.
/xample"
a. Out&ard remittance 3 #s.78888 from a !avings Bank Account in %ndia converted
to )!( 1sold2 and remitted to an Account in )!A.
b. %mport bill paid ? An %ndian firm imports machinery from )!A and pays #s.=8888
&hich is converted to )!( 1sold2 and remitted to the exporter in )!A.
One currency is bought 1procured9accepted2 and the other sold 1paid9given2. %n
other &ords, there are al&ays t&o legs to one transaction ? buying of one currency
and selling another currency.
The foreign exchange transactions result in increase9decrease of foreign currency
holding and decrease9increase in local currency holding of the entities involved.
Fore1 : Buying and "elling Rates
As mentioned earlier, there are al&ays t&o legs for the same transaction ? buying
and selling. Jhen one currency is bought, the other is sold. ,or commercial
transactions ? transactions undertaken &ith customers for settling commercial deals
like %mports, exports etc. ? rates are -uoted based on the nature of transaction.
The follo&ing are the rates -uoted for B4FI8 transactions"
$% Telegraphic Transfer .TT/ Buying Rate
This is the rate at &hich a ,oreign %n&ard remittance received by Telegraphic
Transfer is converted into #upees.
/xample" %f you are the beneficiary of a )!( remittance from )!A, Bank &ill apply
this rate to convert the )!( amount and credit to your !avings Account in rupees.
&% Bill Buying Rate
This is the rate &hich is applicable to purchase an export bill. Jhen a bill is
purchased, the e-uivalent currency of the bill value is paid to the exporter
immediately. .o&ever, the proceeds &ill be realied by the Bank after the bill is
presented on the due date.
/xample" %f you have exported machinery to )!A and your counterparty has agreed
to pay you after I8 days, you have an option to approach your Bank in %ndia
re-uesting them to purchase the bill 9 pay you the amount of bill immediately and
claim it later from the counterparty6s Bank. The Bank &ill apply this rate to convert 9
purchase the )!( bill amount and pay you in #upees. There are detailed rules
governing [purchase of export bills &hich &ill be discussed later.
(% TravelersE Che'ue .TC/ Buying Rate
This is the rate at &hich foreign currency Travelers6 che-ues deposited by the
customer is converted into #upees.
/xample" %f you hold )!( Travelers $he-ue and approach a Bank to en3cash it. The
Bank &ill apply this rate to convert the )!( T$ amount, and pay you in rupees.
9% Currency .C8/ Buying Rate
This is the rate at &hich foreign currency cash deposited by the customer is
converted into #upees.
/xample" %f you hold )!( $urrency Kotes and approach a Bank to en3cash it, the
Bank &ill apply this rate to convert )!( Kotes and pay you in #upees.
The follo&ing are the rates -uoted for "-!!I8 transactions"
$% Telegraphic Transfer .TT/ "elling Rate
This is the rate applicable &hen a customer sends an out&ard remittance through
Telegraphic Transfer for purposes other for imports.
/xample" %f you approach a Bank in %ndia to remit )!( to one of your
relatives9friends in )!A, the Bank &ill apply this rate to convert your #upees to )!(,
and send it to )!A.
&% Bill "elling Rate
This is the rate used for all transactions &hich involve handling of document by the
Bank 1payment against import2.
/xample" %f you have imported machinery from )!A and approach a Bank in %ndia to
pay your )!A counterpart in )!(, the Bank &ill apply this rate to convert your
#upees to )!( and send to )!A.
(% TravelersE Check .TC/ "elling Rate
This is the rate applicable &hen a customer buys foreign currency Travelers6 checks
from the Bank.
/xample" %f you approach a Bank in %ndia for obtaining travelers6 checks to be used
during your travel to )!A, the bank &ill apply this rate to convert your rupees to
issue you )!( T$.
9% Currency .C8/ "elling Rate
This is the rate applicable &hen a customer buys foreign currency notes from the
bank.
/xample" %f you approach a Bank in %ndia for obtaining )!( currency notes to be
used during your travel to )!A, the Bank &ill apply this rate to convert your #upees
to issue you )!( $urrency Kotes 1$K2.
Other rates &hich &ere -uoted before liberaliation of %ndian economy 17MM72, but
are no longer of much significance are ((95T buying, $he-ue Buying and ((
!elling.
"pot and For=ard Deals
A ,orex transaction concludes either immediately or after sometime. This depends on
the accrual 1actual receiving in this case2 of funds. ,or example, funds can be
received immediately as in the case of receipt of remittance from abroad, or after
sometime as in the case of realiation of export proceeds, &hich generally takes
place after the goods reach the buyer and he pays the money for the goods. %n both
the cases, exchange rates can be agreed on the date of transaction itself.
The deal 1transaction2 for &hich funds &ould be received immediately is called spot
deal and for that to be received later is called for&ard deal.
Jhy are Authoried (ealers interested to entertain foreign exchange transactionsQ
As you &ould appreciate, any trade is done to earn profits. ,or example, a &holesale
grain merchant buys rice from the farmers9middlemen at say, #s. F88.88 per
-uintal, and sells it to other retail traders at say, #s. FE=.88. #etailer in turn &ill sell
it to end users at say, #s.FG8.88. 5eaning, &holesaler makes a profit of #s. E= and
retailer earns a profit of #s.7=.88 in the transaction.
.o&ever, not al&ays does the trader earn profit> he could incur a loss as &ell, for
instance, &hen there is a bumper crop and hence reduction of rate. Taking the above
example, after having bought rice from farmers at #s.F88.88, the merchant also
exposes himself to the risk of a loss, selling it to the other retail traders at #s.EM8.88
due to sudden spurt in supply of rice in the market.
The same is applicable for buying9selling of foreign currency also. The A( buys )!(
from the other A(9customers at say, #s. GI.88 and sells it to other customer at #s.
GI.78, earning a profit of 8.78 paisa. .ere again, the A( is exposed to a loss also
that in case, if the market fluctuates adversely and he is forced to sell )!( to other
A(9customers at #s.G=.M8, he incurs a loss of 8.78 paisa.
%n a nutshell, foreign exchange transactions, &hile earning profit for the A( also
exposes them to the risk of loss from the rate difference bet&een buying and selling.
Foreign -1change : Deals and Trading
,oreign /xchange transactions bet&een entities are commonly called (eals and this
process of dealing is called Trading.
Any Trading has t&o aspects ? purchase and sale. A trader has to purchase goods
from his suppliers &hich he sells to his customers. Like&ise, the Bank purchases as
&ell as sells its commodity 1foreign currency2.
T&o points need be constantly kept in mind &hile talking for a foreign exchange
transaction.
7. The transaction is al&ays talked off from the Bank6s 1A(2 point of vie&.
E. The item referred to is the foreign currency.
Jhen &e say a purchase, &e imply that ?
7. The bank has purchased.
E. %t has purchased foreign currency.
Jhen &e say a sale, &e imply that ?
7. The bank has sold> and
E. %t has sold foreign currency.
,oreign exchange transactions can be in $urrency Kotes, Travelers $he-ues,
realiation of export proceeds 1in&ard remittance2, payment of imports 1out&ard
remittance2, Bank (eposits etc.
Bo= FG Trading takes place
Jhile A( enters into a transaction &ith his customer9client, he is &ell a&are &hether
he is going to buy or sell foreign exchange to his customer. .o&ever, the same is not
true &hile trading &ith other A( ? also called counter3party.
Jhen the counter party asks for a rate ? commonly termed -uote 3 he is not a&are if
the counter3party &ants to buy or sell. .e &ould, ho&ever, be a&are of the amount
of the transaction, since &hile asking for rate, the amount is specified. .e has to
necessarily -uote t&o rates simultaneously 3 also called t&o3&ay -uote 3 the rate at
&hich he is ready to buy and the rate at &hich he is ready to sell. This is as per
international norms9practice.
,or instance, (eutsche Bank 1(B2 &ould typically ask BVuote )!(9%K# rateD. The
rate -uoted by say, !B% &ould be, for instance, GI.7NF=9G8, meaning !B% is &illing
to buy at GI.7NF= and sell at GI.7NG8. %f the rate is agreeable, depending on
&hether (B &ants to buy or sell, he &ould say O5ine6 1meaning )!( is mine ? (B is
taking9buying from !B%2, O;ours6 1meaning )!( is yours ? (B is giving9selling to
!B%2, or OThanks6 1meaning Bthanks for the -uote> not suitable and hence not
interested either to buy or sellD2.
5ey #layers in Fore1 +arket
The follo&ing are the key players in ,orex 5arket"
$% Central Bank* The country6s central Banks play a crucial role in controlling
money supply, maintaining stability of the local currency by timely intervention in
case of volatility in ,orex 5arket 1by supplying9sucking currency to9from the
market2, regulating inflation, and also in handling Government related ,oreign
exchange transactions.
&% Commercial Banks .AD/* These engage both in the commercial transaction
based ,orex transaction 1like %mports, /xports and remittances2 and in OTrading6.
1,orex Trading refers to the transactions entered bet&een A( &ithout any underlying
$ommercial Transaction> it is done more a speculation like share markets, but &ell
defined and transparent2.
(% Bedge funds* These investment vehicles, &hich are having considerable funds,
impact the market by investing in ,orex 5arket as their strategy.
These apart, others &ho are indirectly involved in ,orex (eals 1as commonly referred
for the transactions2 are %nter3Bank Brokers 1&ho enable conclusion of transactions
by finding counter3party2, $ommercial companies 1&ho have large exposure in
foreign exchange o&ing to global business undertaken2, retail brokers 1&ho offer
dealing platforms, analysis and strategic advice2 and %nvestors and speculators 1&ho
speculate regarding market movement and invest suitably for earning profits2
"trong and 3eak Currency
Jhen the exchange rate of a currency pair moves up&ards, the base currency is said
to become strong and the counter currency &eaker.
%f )!(9%K# goes from GI.78E= to GI.78=8, )!( is said to become strong and the
%K# &eak. $onversely, if on the other hand it moves to GI.7878, then %K# is strong
and )!( is &eak.
Determination of Currency #rices
The predominant factor governing the exchange prices is the demand and supply.
Jhen the demand for currency is high, the rates for the currency &hich is sought
goes up in relation to the counter currency, and the vice3versa occurs &hen the
supply is more than demand. This apart, political stability, interest rates and inflation
are other factors &hich govern the exchange rate. Jhere the local currency is hurt
meaning the local currency becomes &eak, the $entral Bank intervenes by in4ecting
,orex into the market, and vice versa.
+aAor Currencies
The currencies &hich are in high demand globally and &idely traded in the global
market are the 5a4or $urrencies. Generally, the currencies belonging to GN $ountries
are considered the 5a4or $urrencies. They include )!( 1)!R2, $A(, GB+ 1\2, /)#
1]2 and T+; 1^2.
H#I#I
As mentioned earlier, currency rates are generally -uoted to G decimals. The last
decimal of a -uotation is a +%+. %f currency rate moves from 7.7INN to 7.7INI, the
movement is one +%+.
"pread and Commission
As mentioned earlier, the buying rate is al&ays less than selling rate. The difference
bet&een buying and selling rate is the spread 1profit2.
Apart from the exchange rate, banks load additional amount to the exchange rate
offered to customer to&ards its cost> this percentage is dependant on the nature of
transaction, and is the commission of the A(.
Fi1ed Rate
%t is the exchange rate decided, and the rate at &hich deals are done, by the $entral
Bank of the country transactions.
Floating Rate
This is the exchange rate determined by the market forces. This is based on the
demand and supply of ,orex in the market, and varies &ith the change in demand
and supply.
BID and A"5 rate
As mentioned earlier, the A( -uotes t&o3&ay rates ? the rate at &hich it buys and
sells. Buying rate is termed B%( rate and !elling rate is termed A!0 or Offered rate.
/xample"
The 5id #ate fixed by a $entral Bank for )!(9%K# is GI.=8
B%( 1Buying #ate2 -uoted by an A( for )!(9%K# is GI.G8 &hich indicate that the A(
is &illing to buy #upee against )!( _ GI.G8, thereby earning a spread 1profit2 of
8.78.
A!0 1!elling #ate2 -uoted by an A( for )!(9%K# is GI.I= &hich indicate that the A(
is &illing to sell #upee against )!( _ GI.I=, thereby earning a spread 1profit2 of
8.7=.
%n the example above, the difference bet&een buying and selling is the profit,
popularly called spread.
6alue Date
/very foreign exchange transaction involves exchanges of t&o currencies by the
counterparties to the transaction. /xample ? 5r. : receives dollars in Ke& ;ork and
pays out #upees in 5umbai. The counterparty 5r. ; pays out dollars and receives
#upees in the respective centers. The date on &hich the exchange of currencies is to
take place is the Halue (ate of the transaction.
The currencies need to change hands at the same point of time but this is not
possible because of the time differences in the t&o centers. .ence, the use of value
dates. !ince money in any currency has a time value, namely interest, the value
date of a foreign exchange transaction &ill have to be a &orking day in both the
centers &here the money transfers are to take place.
FG Dealer
+erson concluding ,orex transaction is called a dealer. .e takes position in one of the
currencies, and enters into a counter deal &hen the spread 1profit rate2 is favorable,
thereby earning profit.
FG Broker
They enable conclusion of deals by finding a matching counter deal, earning
commission for the services.
HRolloverI of Contracts
Jhen the transactions are not concluded on the due date, and is instead postponed
to a future date &ith mutual agreement of the parties involved, the contract is said
to be O#olled Over6. The rollover happens for t&o business days, and involves
payment of interest for the t&o day period.
-1tension
$ontracts &hich cannot be utilied on the due date, the contract may be extended>
the original contract is &ill be li-uidated and a ne& contract is entered. The
profit9loss arising out of the transaction is for the customers6 account.
8ostro Account
Kostro Account is the foreign currency account of an A( in the country of the
currency. An %ndia based bank &ould have )!( Account in A5/: Ke& ;ork, GB+
Account in Barclays Bank )0, /)# Account in (B ,rankfurt, and T+; account in Bank
of Tapan Tokyo. These accounts are called Kostro Accounts. These accounts are used
for settlement of ,orex transactions in the respective currency.
6ostro Account
Account of a foreign Bank held in local currency is called Hostro Account. ,or
example, $iti Bank Ke& ;ork holding a #upee Account &ith !B% in %ndia is called
Hostro Account.
The activities in these accounts are maintained in the Banks6 books> these are called
mirror accounts. The entries in the mirror accounts are matched &ith the counter
entries in the Kostro Account to ensure correctness of accounting> this process is
called reconciliation.
Correspondent Bank
This is the Bank &ith &hom business relationship exists> it is not necessary that a
bank maintains Kostro account &ith the correspondent Bank. ,or example, an %ndian
Bank holds Kostro Account &ith $hase 5anhattan Bank, Ke& ;ork, but could route
the transaction through Bank of $alifornia, !an ,rancisco.
#ayments,"ettlements
;ou &ill agree that funds pertaining to the ,orex deals need be settled> the foreign
currency amount need be transferred to the beneficiary6s Kostro Account and the
local currency amount through the locally prevalent arrangement.
Jhile the local currency is settled by transferring funds from one account to other
account maintained generally by the central bank or a bank designated by the
central bank ? funds are transferred from payer6s account to beneficiary6s account ?
through clearing or direct account to account transfer, foreign currency amounts are
settled by transferring funds from one Kostro account to another.
%n both the cases, authoriation is issued by the payer to his correspondent bank ?
central bank is the BcorrespondentD in respect of local currency settlement ? to
transfer funds from their account to the beneficiary6s account. Local currency
settlement happens by issuing $he-ues, and foreign currency settlement happens by
communicating instructions electronically.
A fe& years ago ? prior to year E887 ? settlement instructions &ere transmitted
through telex from %ndia. !ince then, messaging system developed by !J%,T ?
!ociety of Jorld&ide %nter3bank ,inancial Telecommunication ? and agreed by banks
globally are in vogue, since it affords secure, fast and cost effective means of
transmitting settlement instructions.
Banks &hich maintain Kostro Account of various banks charge for maintenance of
accounts, including for the activities happening in the account. The charges are on
per3transaction basis, and termed Kostro Activity charges.
To curtail payment of these charges, ,oreign /xchange $learing system is
operational in %ndia and in fe& other countries 1may be in different flavor2, &herein
netting of both payment and receipt of foreign currency is done, and one instruction
is transmitted for the net amount payable.
,or transaction of very huge volumes, a payment system called #TG! ? #eal Time
Gross !ettlement ? is prevalent. ,unds transferred through #TG! reach beneficiary
&ithin couple of hours. This eliminates the re-uirement of &riting che-ues and the
clearing process. This is especially helpful &hen payment is to be made beyond
clearing hours.
Dealing Room
A (ealing #oom is a place &here foreign exchange deals are entered. %t occupies an
important place in the organiation as a profit centre. %t is staffed by specially trained
personnel ? popularly kno&n as B(ealersD 3 &ho are specialied in executing foreign
exchange deals.
As you kno&, exchange rates are guided basically by the demand and supply factors.
Because of this one sees fluctuations in exchange rates in foreign exchange markets.
(ealers take advantage of such volatility in exchange rates and enter into trading
positions ? purely buying and selling ? to maximie profits.
Dealing Room 2perations 0 An overvie=
(ealing room has three sections"
7. ,ront Office" Jhere actual dealing operations take place.
E. 5iddle Office" Jhere 5%!, policies and #isk 5anagement aspects are dealt &ith
F. Back Office" Jhich takes care of tracking settlements, #econciliation, accounting
and reporting.
Jhen a deal is entered by the dealer, a deal slip is generated by him and passed on
to the back office for obtaining confirmation of deal, settlement and accounting
including arriving at the profit9loss position of the dealing room operations. 5iddle
office ensures that all the policy guidelines are duly complied and proper 5%! reports
are generated.
Direct Deals
Jith the advancement of technology, platforms &herein a forex transaction can be
concluded electronically ? on the rate display screen itself ? are available. Harious
agencies like #euters and Bloomberg, &hich updates the global events and exchange
rates on a continuous basis, offer the possibility of entering and concluding forex
transaction on the screen itself. %t also enables printing of deal slips immediately on
conclusion of deal.
Jherever deals are done over phone, facility to record the conversation is available,
to ensure that disputes if any are immediately settled by replaying the recorded
message.
Introduction
A typical Business scenario"
7. ;ou propose to be in the business of trading in commodities.
E. ;ou &ant to engage in manufacturing and selling of spare parts9components
re-uired for manufacturing TH.
F. ;ou &ant to purchase or construct a house.
G. ;ou desire to o&n a brand ne& car.
=. ;ou have invested in K!$ for tax saving purposes and in shares to earn better
returns sometime back. .o&ever, you no& re-uire funds for some family
commitment.
I. A construction company is given a contract to construct a bridge.
%n all the above circumstances, the main ingredient re-uired to achieve the desired
goal is finance.
;ou &ill agree that availability of entire -uantum of finance re-uired for the targeted
goal is extremely rare. To achieve the target, therefore, you &ould scout for source
of funds.
This is &here the banks pitch in> they offer to finance you for an agreeable return ?
or interest and fees.
!imits
%n simple &ords, the amount up to &hich the bank agrees to lend is called the Limit.
%n other &ords, it is the maximum amount of credit that a financial institution &ill
extend to a borro&er.
Before proceeding further, let us get ac-uaint ourselves &ith a fe& terms used in
lending.
Retail loans
Lending of money to individuals is #etail Lending. Loans like car loans, housing loans
etc. are called retail loans
Corporate !oans
Loans granted to business units or corporates for business purposes are called
corporate loans. Lines of $redit, Term Loans etc. are corporate loans.
Interest and +argin
Any lending attracts interest and 5argin.
The interest rate and margin percentage depends on the client including his past
performance, conduct and value of the account and his standing in the business
circle amongst others. 5argin is stipulated to ensure that the value of security is not
eroded, and is sufficient to cover the outstanding liability.
#eriod
This is the maximum timeframe &ithin &hich the loan amount is expected to be
li-uidated.
Types of !imits
Limits can be classified on the basis of funds outflo& as fund3based limit or non3fund
based limit.
Fund based limits
,und based limits involve outflo& of funds, meaning the money is lent9physically
parted by the banker. They can be generally of follo&ing types"
$% Cash Credits , 2verdrafts
This is the primary method in &hich Banks lend money against the security of
commodities and debt. %t runs like a current account except that the money that can
be &ithdra&n over and above the amount deposited in the account, up to the extent
agreed by the bank.
%t is arrangement by &hich a banker allo&s his customer to borro& money upto a
certain amount ? called limit. This is the most popular mode of borro&ing by large
commercial and industrial establishments, on account of the advantage that a
customer need not borro& entire money 1pro4ected as re-uired2 at once but can
dra& such amounts as and &hen re-uired.
Let us see ho& a Bank arrives at the limit 9 amount of credit assistance for a $ash
credit beneficiary &ith an example"
A commodity trader is engaged in business on a continuous basis. 5eaning, he needs
finance on an ongoing basis. )nder such circumstances, ho& do the banks go about
granting financial assistanceQ
The trader pro4ects 3
Annual sale #s.I88888 1+ro4ected2
+urchase value #s.G@8888 1assuming E8A profit margin2
Traders6 stake #s.7E8888 1E8A2
!hortfall #s.FI8888
,ortnight sale #s. E=888
Assume that the past performance evidences his per fortnight sale. %n such an event,
you can accept his pro4ected sale as achievable.
.o&ever, it should be noted that the entire sale does not happen in one lot> it
happens in stages ? once in a fortnight he sells goods &orth #s.E=888. %f he
normally receives payment in about 7= days from the date of sale, the total period
his funds &ould be blocked &ould be one month, in &hich period, he &ould make
total sale of #s. =8,888.
!ales #s. =8,888
+urchase #s. G8,888 1assuming E8A profit margin2
$ustomers6 stake #s. 78,888
,inancial Assistance #s. F8,888
%n other &ords, he &ould re-uire #s.F888893 as bank finance at any given point of
time for ensuring continuity of business.
2verdrafts
Loans granted against L%$ policy, Kational !avings $ertificates, and !hares 1&here
there is no availability of stocks2 is called Overdraft. (epending on the security,
margin is stipulated in this case.
-1ample*
,ace value of Kational !avings $ertificate #s.78888
5argin stipulated E8A
,inance granted #s. @888
!imilarly, margin of up to =8A could be stipulated against shares. This can also be a
one3time loan or running account.
&% Term !oans
Banks lend money in this mode, &hen the repayment is sought to be made in fixed,
pre3determined installments. This type of loan is normally given to the borro&ers for
ac-uiring long term assets 1assets &hich &ill benefit the borro&er over a long period
? exceeding at least one year2.
+urchase of plant and machinery, constructing building for factory, setting up ne&
pro4ects fall in this category. Hehicles loans, loans for purchase of consumer
durables, home loans also form a part of term loans.
Based on the period of repayment, Term Loans are further classified into ?
a. !hort term loans 1repayable &ithin E to F years2
b. 5edium term loans 1repayable &ithin = to N years2
c. Long term loans 1for tenor above N years2
Let us see ho& a Bank arrives at the limit 9 amount of credit assistance for a term
loan 1home loan2 beneficiary &ith an example"
%f you decide to purchase a flat, you re-uire finance to the extent of cost of flat. ;et
again, you need to invest a portion of money from your o&n sources, and the bank
&ill finance the rest.
Total cost of the ready to occupy flat #s.E=88888
5argin 1your stake2 #s. =88888 1E8A2
Bank finance #s.E888888
%f on the other hand, if the d&elling unit is under construction, the loan is Odisbursed6
1released2 in stages as per the &ork progress.
The above principle is also applied in various other types of loans ? like $ar loans,
loans to purchase consumer durables etc.
(% Bill Discounting
%n Bill discounting, Bank takes the bill dra&n by borro&er on his 1borro&er6s2
customer and pays him or her immediately deducting some amount as discount 9
commission. The Bank then presents the Bill to the borro&er6s customer on the due
date of the Bill and collects the total amount. %f the bill payment is delayed, the
borro&er or his customer pays pre3 determined interest to the Bank depending upon
the terms of transaction.
Let us see ho& a Bank arrives at the amount of bill discounting &ith an example"
An exporter has exported goods for )!( =8,888, the payment of &hich is due after
I8 days. The exporter maintains a fund based limit of )!( 788,888 1&hich is arrived
after thoroughly assessing his portfolio, value of security offered, collateral value and
his credit&orthiness2 &ith his bank. .e is in need of funds 9 &ants to discount the bill
and approaches his9her bank.
Total Bill amount )!( =8,888
%nterest charged by the Bank )!( E,888 1GA2
$ommission 9 $harges )!( =88
(iscounted Bill amount )!( GN,=88
The Bank assesses the bill against the purchase order and if all the terms and
conditions of the export contract are complied &ith, the Bank decides to discount the
bill.
The Bank has discounts the bill 9 credits the party &ith )!( GN,=88 &ith interest 9
commission for I8 days &orking out to be )!( E,888 plus commission 9 charges
)!( =88. The Bank claims the bill value of )!( =8,888 from the borro&er6s
customer after I8 days.
8on:fund based limits
%n this type of credit facility, the banks funds are not lent to the customer but there
is a commitment to part &ith funds in case of necessity. The Banker undertakes a
risk to pay the amounts on happening of a contingency.
They can be of the follo&ing types among other 3
7. Letter of $redit ,acility
The Banker undertakes to pay on presentation of documents of title to goods.
1/xplained in detail under BTrade ,inanceD2
E. Bank Guarantee
The Banker undertakes to discharge the liability of borro&er to third parties.
1/xplained in detail under BTrade ,inanceD2
2ther factors influencing limits
Limits are influenced by a variety of factors including your credit history and credit
rating.
Jhile credit history sho&s payment and borro&ing pattern of the borro&er, credit
rating sho&s a sub4ective assessment of the credit&orthiness based on the credit
history and assets 9 liabilities of the borro&er. These factors are a part of the
evaluation process used by Banks in setting limits.
+onitoring of limits
Limits are carefully monitored to ensure that the designated amounts are not
exceeded. Borro&ers &ith excellent credit rating and credit history are often
re&arded &ith increase in limits. .aving a high credit limit but exceeding that limit is
often vie&ed favorably among Banks. A borro&er &ho has the ability to utilie a
large amount but opts not to do it is often seen as a responsible borro&er.
"ecurity
Jhen a bank sanctions a loan, it has to secure its funds. %n other &ords, it has to
protect the funds against default.
7. %n case of limits against stocks, the stocks ? also called inventory 3 are held as
security.
E. Jhen the stock is converted into finished goods and sold, the receivables become
security.
F. Jhen the loan is sanctioned against car or flat, the car or flat, against &hich loan
is sanctioned is taken as security.
G. Jhen limit9loan is granted against permitted security, the instrument 1like K!$,
L%$ policy, shares etc.2 are taken as security.
=. %n case of construction contract, there is no physical security available.
Kevertheless, finance is needed for payment to men and machinery amongst other
things. The only security available is the receivables ? either bills raised or to be
raised ? against &hich limits are sanctioned.
The securities enumerated above are termed prime security. They are basically the
securities available, against &hich the loan is sanctioned. %t is the main security.
The terms used for obtaining security are
+ledge 1of stocks2
.ypothecation 1of vehicle2
5ortgage 1of land and building2
Guarantee 1of the business o&ner2
Collateral "ecurity
%n case of a default, the loan amount can be recovered by disposing of the
underlying security. But the amount realied may not meet the outstanding loan
amount or liability. %n other &ords loan may not be cleared by disposal of proceeds.
To obligate such an event, further securities are taken. These securities are termed
collateral securities.
$ollaterals are properties or assets that are offered to secure a loan or other credit.
$ollateral becomes sub4ect to seiure on default.
/xample"
Jhen a housing loan is sanctioned, apart from residential property, further securities
in the form of K!$ or L%$ policies may be taken by the bank.
Like&ise, in case of business loans, apart from inventory, further security like factory
premises may be taken as collateral security.
The collateral serves as protection for a lender against a borro&er's default 3 that is,
any borro&er failing to pay the principal and interest under the terms of a loan
obligation. %f a borro&er does default on a loan 1due to insolvency or other event2,
that borro&er forfeits 1gives up2 the property pledged as collateral 3 and the lender
then becomes the o&ner of the collateral.
"ecurity or Collateral +anagement
!ecurity or $ollateral 5anagement is the process of agreeing, confirming and
advising collateral transactions.
As enumerated earlier, &hen the banks lend money to the customers, sufficient
security is taken to safeguard the finance. The bank regularly assesses value of
assets to ensure that the value of assets covers their exposure. ;ou &ill agree the
value of plant and machinery, and other e-uipments, is reduced &ith usage. As
against this, the value of the value land and building generally increases &ith
passage of time.
"tock "tatement
The value of securities taken is sub4ect to fluctuation. %n the example of lending to
trader, &hile the customer &ould have stocks &orth #s. E=,888 on a particular day
1&hen he procures the same2, on a subse-uent date it could be <ero, since he &ould
have sold the stock.
)nder the circumstances, the bank has to ensure that there is no liability outstanding
in the account. 5eaning the customer has to deposit the sale proceeds in the
account. .o&ever, it is possible that the customer &ould not have received the
payment since he &ould have afforded some time 1credit period2 to the buyer before
making payment. And the customer &ould have raised an invoice for this amount. %n
&hich case bank &ould finance against the bill ? receivable ? and clear the inventory
finance.
This procedure, ho&ever, cannot happen al&ays, considering that the business is a
continuous process. A more feasible method is adopted by the banks ? they advice
the trader to submit their stock holding position ? called stock statement ? at regular
intervals.
The bank officials inspect the stock at periodic intervals to ensure that the statement
submitted is correct. The paid value of stocks is the physical holding less the stock
received on credit 1for &hich the customer has not paid2. As a prudent practice old,
and hence possibly non3disposable stock value is also reduced 1it is unrealiable
stock2.
Introduction
The money market is a component of the financial markets involved in short3term
borro&ing and lending &ith original maturities of one year or shorter time frames.
These transactions are concluded to either plug the gap in fund re-uirement or
deployment of surplus funds. %t is better kno&n as a place for large institutions and
government to manage their short3term cash needs. .o&ever, individual investors
have access to the market through a variety of different securities.
Jhile &e have given a global Overvie& on money markets in this module, for clarity
in understanding the concepts, &e have focused on the %ndian scenario &herever
re-uired. Kevertheless, the money market transactions are the same &ith locally
applicable regulations.
$onsider the follo&ing situations"
7. Jhen a customer deposits funds in Bank, a portion of the amount has to be
deposited by the Bank &ith #B% as cash to meet $## and !L# re-uirement.
To either tide over the shortfall, or to deploy surplus funds, banks trade in the
money market instruments.
E. $orporate entities are sometimes surplus of funds, &hich is probably not re-uired
immediately. As you &ill agree, these funds are idle and hence does not yield any
return.
To earn some returns by &ay of interest, these idle funds are deployed in money
market instruments.
F. Government re-uires funds for their various initiatives. An example is
development of infrastructure.
To fund the initiative, they raise short term funds from the market by trading in
money market instruments.
As can be seen from the above instances, short term monetary transactions are
entered through money market instruments.
Features of +oney +arket
5oney 5arket instruments are issued and traded by Government, ,inancial
%nstitutions and large corporations. These instruments are considered highly li-uid
1easily disposable2, extraordinarily safe, and very conservative, and hence yield lo&
returns.
5oney market investments are other&ise kno&n as cash investments because of
their short maturities and easy li-uidity.
Trading in 5oney markets are for huge volumes and only large corporations,
Government and ,inancial %nstitutions, &ho have substantial amount of surplus
funds, trade in money market instruments.
%t &ould be interesting to note that the investments in money market is on their o&n
account, and hence the investor themselves carry the risk. 1This is as against share
market &herein a broker acts on behalf of his client and earns a commission for
enabling the transaction2.
The money market interest rates are deregulated> they are determined by demand
and supply. .o&ever, these rates generally &ould be linked to some benchmark
rates
5oney market trading obligations take place in over3the3counter markets> traders
across different banks generally close their money market positions over phone or
through brokers.
8eed for +oney +arket
5oney 5arket is a market place &hich enables the various players ? Government,
,inancial %nstitutions and Large $orporations ? to borro& or lend short term funds to
earn a return. %f the above facility not &ere to be available, these institutions &ould
have not been able to deploy the funds and earn return for their idle funds. Like&ise,
short term re-uirements could also not have been met. Thus, money market enables
management of short term funds.
5oney market operations are handled by treasury department of the organiations,
&hich may either be integrated &ith ,orex operations, or &orking in unison.
2bAectives of +oney +arket
7. %t provides an e-uilibrating mechanism for productively investing short3term
surpluses and plugging short term deficits.
E. %t provides a focal point for central bank intervention for influencing li-uidity in the
economy 1as !L#, $## * #epo #ates are controlled by #B% in %ndia2
F. %t provides reasonable access to users of short3term money to meet their
re-uirements at a realistic price. 5oney market instruments
5oney market securities are essentially +romissory Kotes issued by governments,
financial institutions and large corporations. There are several different instruments
in the money market, offering different returns and different risks. .ere are the
ma4or ones 3
$% Call +oney , 8otice +oney
$all 5oney or $all deposit is the money loaned &here the borro&er has to repay the
funds &hen called on to do so by the lender.
Kotice money refers to money loaned &here the lender has to give a certain number
of days notice to the buyer to repay the funds> the notice period is agreed at the
time of contract. +articipants are permitted to lend 9 borro& for tenors ranging from
overnight to a maximum of 7G days.
&% Term +oney
Term 5oney refers to those borro&ing 9 lending transactions bet&een the inter3bank
participants &hich have tenor greater than 7G days.
(% Certificate of Deposits .CD/
A $ertificate of (eposit is a time or fixed deposit &ith a Bank. They bear a specific
maturity date, a specified interest rate and can be issued in any denomination. They
offer slightly higher return than Treasury Bills 1issued by the Government ? see item
M belo&2 because of the slightly higher default risk for a bank.
The amount of interest that you earn depends on the current interest rate scenario,
amount invested, period invested and the Bank. The main advantage of $( is their
relative safety and the ability to kno& your return ahead of time. On the other hand,
the money is locked up for the specified period and there could be penalty for
premature &ithdra&al.
9% Commercial #aper
$ommercial +aper 1$+2 is an unsecured short3term loan 9 instrument issued to
finance short3term credit needs of large institutional buyers. %t is issued at a discount
? lesser than mentioned on the instrument 3 reflecting current market interest rates.
5aturities on $+ are usually no longer than nine months, &ith maturities bet&een
one and t&o months, average.
$+ is a very safe investment because the financial situation of a company can easily
be predicted over a fe& months. Only companies &ith high credit ratings and credit
&orthiness issue $+ and subscribed by the investors.
;% BankersE Acceptance
Bankers6 Acceptance 1BA2 is a short term credit investment created by a non3
financial firm and guaranteed by a bank to make payment. They are traded at
discounts from face value in the secondary market. %t is simply a bill of exchange
dra&n by a person and accepted by a Bank. %t is a buyer6s promise to pay to the
seller a certain specified amount at certain date. The same is guaranteed by the
banker of the buyer in exchange for a claim on the goods as collateral. The person
dra&ing the bill must have a good credit rating other&ise the Banker6s Acceptance
&ill not be tradable.
,or corporations, it acts as a negotiable time draft for financing imports, exports and
other transactions in goods and is highly useful &hen the credit &orthiness of the
foreign trade party is unkno&n. One advantage of a BA is that it does not need to be
held until maturity and can be sold in the secondary markets &here investors and
institutions constantly trade BA.
/xample"
Let us assume the face value of a BA to be )!( 78888. $ommission for one year is
FA p.a. Then, the amount received by the /xporter in one year is )!( MN88.
<% -uro Dollars
/urodollars are )! dollar3denominated deposits at banks outside the )!. This market
evolved in /urope and hence the name. /uro dollars can be held any&here outside
the )!.
This /uro dollar market is relatively free of regulation because of &hich Banks
operate on narro& margin than their counterparts in the )!. /uro dollars have
maturity of less than six months. There is /uro dollar Time (eposit so also /uro
dollar $ertificate of (eposit. /uro dollar $(s are less li-uid and offer higher yields.
>% Inter Bank #articipation Certificates
%nter Bank +articipation $ertificates 1%B+$2 are short term money market
instruments to even out li-uidity &ithin the banking system. This is purely an inter
bank instrument &hereby the banks can raise money and also deploy short3term
surplus.
The ob4ective is to provide some degree of flexibility in the credit portfolio of banks
and for smooth consortium arrangements. %n the case of %B+$, the borro&ing bank
passes 9 sells on the loans and credit that it has in its book, for a temporary period,
to the lending bank.
?% CollateraliDed Borro=ing and !ending 2bligations .CB!2/
$BLO is a money market instrument developed for the benefit of entities &ho have
either been phased out from inter3bank call money market or have been given
restricted participation in terms of ceiling on call borro&ing and lending transactions
and &ho do not have access to the call money market.
%t is basically a discounted instrument available in electronic book entry form for the
maturity period ranging from one day to ninety days.
@% Treasury Bills .T:Bills/
Treasury Bills are the most marketable money market security. Their popularity is
mainly due to their simplicity. /ssentially T3Bills are a &ay for the government to
raise money from the public. T3Bills are issued by the )! Government, %ndian
government and governments of many other countries. They are short term
securities that mature in one year or less from their issue date.
T3Bills are considered to be the safest investments in the &orld because the
governments back them. They are exempt from state and local taxes in many
countries.
They are issued &ith different maturities and purchased for a price that is less than
the face value 1at a discount2. The holder gets the full par value on maturity. The
return to the investor is the difference bet&een the purchase price of the security
and &hat he gets at maturity.
/xample"
%f 5r. : buys a 7@83days T3bill at )!( MI88 and holds it till maturity, he &ill earn
)!( G88 on his investment considering the maturity value of the T3bill to be )!(
78888.
$J% +unicipal bond
A 5unicipal Bond is a bond issued by a city or other local government, or their
agencies. +otential issuers of municipal bonds include cities, counties, redevelopment
agencies, special3purpose districts, school districts, public utility districts, publicly
o&ned airports and seaports, and any other governmental entity 1or group of
governments2 belo& the state level.
$$% Federal Funds
%n the )nited !tates, federal funds are overnight borro&ings by banks to maintain
their bank reserves at the ,ederal #eserve. Banks keep reserves at ,ederal #eserve
Banks to meet their reserve re-uirements and to clear financial transactions. These
loans are usually made for one day only, that is, LovernightL. The interest rate at
&hich these deals are done is called the federal funds rate. These are much like !L#
and $## re-uirements of #B% in %ndia.
$&% Repurchase Agreements .Repo/
Those &ho deal in government securities use #epo as a form of overnight borro&ing.
%t is a form of short3term borro&ing for dealers in government securities. The dealer
sells the government securities to investors, usually on an overnight basis, and buys
them back the follo&ing day. They are short term loans ? normally for less than t&o
&eeks and fre-uently for one day ? arranged by selling securities to an investor &ith
an agreement to repurchase them at a fixed price on a fixed date.
This short3term maturity and government backing means #epo provides lenders &ith
extremely lo& risk. #epo is popular because they can virtually eliminate credit
problems.
a% Reverse Repo ? %t is the complete opposite of a #epo. %n this case, a dealer buys
G3!ecurities from an investor and then sells them back at a later date for a higher
price.
b% Term Repo ? %t is almost the same as a #epo except the term of the loan is
greater than F8 days.
#articipants in +oney +arket
+redominant participants in 5oney 5arket are"
$% overnment .Central,"tate/
The $entral and !tate Governments issue short term instruments to finance their
budget re-uirements, deficits and public sector development programs.
/xample"
The %ndian Government is an issuer of Government !ecurities 1popularly kno&n as
G3!ec.2 and Treasury Bills 1popularly kno&n as T3Bills2. The !tate Government issue
securities termed as !tate (evelopment Loans 1!(L2 to fund their budget deficit.
&% #ublic "ector 4ndertakings
+!) issue taxable and tax3free bonds to finance their &orking capital re-uirements
and long term pro4ects.
(% Banks
Banks issues $ertificate of (eposits for period ranging from N days to 7 year. Banks
also invest their surplus funds in +!) bond market and trade to take advantage of
rate volatility.
/xample"
Banks in %ndia participate in overnight 1call2 markets to manage their $ash #eserve
#atio 1$##2 commitments so also in G3!ecurities to maintain their !tatutory Li-uidity
#atio 1!L#2.
Cash Reserve Ratio .CRR/
Banks in %ndia are re-uired to hold a certain proportion of their deposits in the form
of cash. .o&ever, actually Banks do not hold these as cash &ith themselves, but
deposit such cash &ith #eserve Bank of %ndia 1#B%2 &hich is considered as e-uivalent
to holding cash &ith themselves. This minimum ratio 1that is the part of the total
deposits to be held as cash2 is stipulated by the #B% and is kno&n as the $## or
$ash #eserve #atio.
/xample"
Jhen a bank6s deposits increase by #s.788, and if the cash reserve ratio is IA, the
banks &ill have to hold additional #s. I &ith #B%. Therefore, higher the ratio 1i.e.
$##2, the lo&er is the amount that banks &ill be able to use for lending and
investment. This po&er of #B% to reduce the lend3able amount by increasing the $##
makes it an instrument in the hands of a central bank through &hich it can control
the amount that banks lend. Thus, it is a tool used by #B% to control li-uidity in the
banking system.
"tatutory !i'uidity Ratio ."!R/
!L# stands for !tatutory Li-uidity #atio. This term is used by bankers in %ndia and
indicates the minimum percentage of deposits that the bank has to maintain in form
of -uickly realiable approved securities. Thus, &e can say that it is ratio of approved
securities held vis3`3vis deposits accepted9held by the bank from the public.
$urrently, the !L# is pegged at E=A. 5eaning for every %K# 788.88 accepted as
deposit, %K# E=.88 should be held in the form of -uickly realiable approved
securities. This also enables regulating the credit gro&th in %ndia.
%n a nut shell, out of %K# 788.88 the bank accepts as deposits, %K# I.88 has to be
held as $## and %K# E=.88 should be held as !L#. %n effect, the banks &ould be able
to lend %K# IM.88 to the borro&ers.
9% #rivate "ector Companies
They issue $ommercial +apers 1$+2 and corporate debentures. $ompanies &ith cash
surplus are active investors in instruments like ,ixed (eposits, $ertificates of (eposit
and T3Bills.
;% #rovident Funds ) +utual Funds
+, invest their short term and long term surplus funds in instruments according to
their internal guidelines as to ho& much they can invest in each instrument category.
5utual ,unds invest their funds in money market and debt instruments according to
their approved investment pattern declared in each scheme.
<% eneral ) !ife Insurance Companies
G%$ have to maintain certain funds &hich have to be invested in approved
investments like G3!ec and Bonds. They also participate as lenders in this market.
L%$ invest their funds in G3!ec, Bonds or short term money markets.
>% 8on Banking Finance Companies
KB,$, as a mandate, invest their funds in debt instruments to fulfill certain
regulatory re-uirements and also to park their surplus funds.
Clearing and "ettlement
$learing and settlement is the mechanism through &hich money market instruments
are transferred and relative payments made.
Jhenever a money market instrument is traded, some means must exist for
transferring the instrument and for making payment. %n other &ords, there is a
necessity for clearing and settling the trade, tasks that are usually referred to as
operational or back3office functions.
$learing refers to processing a trade and establishing &hat the parties to the trade
o&e each other. !ettlement refers to the transfer of value9 instruments 1securities
and currency2 bet&een the parties so the trade is completed.
"teps involved in Clearing and "ettlement
The first step is to convey details of the trade from traders to the back office.
!econd, the details must be compared and matched bet&een the buyer and seller to
ensure that there is an agreement bet&een the buyer and seller regarding &hat is to
be traded and the terms thereof. ,ailure to do so might lead to delivery problems.
The participants in the money market are linked by clearing and settlement systems.
3here banks fit in
At the center of the clearing and settlement mechanism for the money market are
banks and the inter3bank payment system. Banks connect the participants in the
money market by acting in three capacities.
7. Banks act as agents for issuers of money market instruments> they therefore
perform the physical tasks of issuing and redeeming instruments in the market and
of maintaining registration records.
E. Banks act as custodians of instruments" they render their services as safe3keepers
of instruments to investors. The bank's balance sheet does not sho& like valuables
kept in a safe3deposit box, or instruments entrusted to a custodian bank, as either
assets or liabilities because they remain the property of their o&ners.
F. ,inally, and most importantly, some banks specialie in clearing. The responsibility
of clearing bank is transferring of securities from one party to another and for
transferring payment for securities.
A payment system is a system for the transfer of money. Jhat makes
it a LsystemL is that it employs cash3substitutes> traditional payment systems are
negotiable instruments such as drafts 1e.g., checks2, credit cards and other charge
cards, documentary credit 1such as L9$2 and electronic funds transfers. !ome
payment systems include credit mechanisms, but that is essentially a different
aspect of payment. +ayment systems are used in lieu of tendering cash in domestic
and international transactions and consist of a ma4or service provided by banks and
other financial institutions. This section provides more insight into the concepts of
Banking !ervices.
Introduction to #ayments
%n this module, &e look into various technology3dependant payment mechanisms
&hich have been introduced, and are becoming popular by the day globally, in the
banking system.
#ayments
+ayments are generally understood as transfer of funds from the payer to the payee.
O#ayer6 is the party making the payment
O#ayee6 is the party receiving the payment
A payment that is initiated, processed and received electronically can be termed as
an e3payment 1technology dependant payment2. $onventional payments are enabled
through cash or check &hereas electronic payments are carried out by means of
soft&are, payment cards and electronic cash.
The ma4or components of e3payment system are money transfer applications,
net&ork infrastructures, and rules * procedures governing the use of the system.
$ustomers and merchants are the ma4or actors of e3payment systems.
Technology dependant payments greatly increase efficiency by reducing transaction
costs duly enabling trade in goods and services cheaper. They may also increase the
convenience of making payments by enabling them to be made s&iftly and remotely
from various devices connected to global net&orks.
Check&$
The $heck $learing for the E7st $entury Act, commonly referred to as $heck E7, is a
federal la& 1of )!2 that enables banks to handle more checks electronically, &hich
makes check processing faster and more efficient. %t is designed to replace the old
process &hereby banks must physically move original paper checks from the bank
&here the checks are deposited to the bank that pays them, transportation that can
be inefficient and costly.
$heck E7 makes a Bsubstitute checkD 1created using an image of the check2 the legal
e-uivalent of the original paper check. )nder $heck E7, banks can electronically
transmit check images rather than physically moving the original paper checks
bet&een the receiving and paying banks.
$heck E7 applies to all types of checks" consumer, business, travelers and ).!.
Treasury.
Reason for introduction of this system
One of the many hard lessons learned from the tragic events of !eptember 77, E887,
&as the importance of developing and implementing improvements to ensure the
safety and security of the ).!. payments system.
Jith the country6s domestic air transportation system grounded for several days, a
serious &eakness in the paper3based check processing system &as exposed, creating
a potentially crippling set of circumstances. !ince physical checks could not move,
the system came to an abrupt halt, signifying the need for a rapid conversion to
electronic processing. ,urther, processing costs of physical check are increasing,
amounting to nearly t&ice that of electronic payments. A paper check is physically
handled an average of EI times during processing, adding days to the total
processing time. This also contributed to necessity for electronic processing.
$heck E7 &as designed to improve the overall efficiency of check payment
processing. ,inancial institutions and their corporate customers are already realiing
significant cost savings from float improvements, fraud detection and more efficient
processing. %maging technology is decreasing dependency on postal and
transportation systems. $heck E7 is also shortening turnaround time, improving
customer service and increasing collection rates on returned checks.
Benefits of Check&$
Operationally, financial institutions can reduce transportation costs, infrastructure
costs, hard&are maintenance, supplies and labor resources, check storage expenses,
and sorting time.
Through remote deposit, commercial businesses can also reduce check processing
time and expenses, make deposits &ithout leaving the office, and access funds
-uicker than ever before.
The Industry Benefits
/liminates the risks associated &ith physically moving billions of checks.
%mproves efficiency and ensures stability of the ).!. check payment system.
,acilitates, &ithout mandating, check truncation.
#educes the overall cost of check processing.
!treamlines the check collection and return processing.
$apitalies on existing technology.
+romotes, encourages and enables image exchange.
The Financial Institution Benefits
Accelerates settlements.
#educes the volume of physical checks.
#educes the number of times the physical check is handled.
,acilitates rapid discovery of fraud.
Allo&s for earlier or multiple transmission.
/liminates resubmits.
Lo&ers clearing fees.
#educes check float.
%mproves collections.
+romotes electronic processing of share draft returns.
Accelerates receipt and processing of check collections returns.
/nables potential increase in return check service fee income.
#educes research and ad4ustments.
The Commercial Customer Benefits
#educes the time it takes to process checks.
(eposits can be made &ithout leaving the office.
/liminates travel expenses and courier fees.
(eposits can be made daily.
5any banks have extended deposit cutoff times.
+rovides for faster access to funds.
2vervie= of Check&$ process
As &ith all checks, the $heck E7 clearing process starts &ith a person &riting an
original check. The payee then deposits the check &ith the Bank of ,irst (eposit or
BO,(, &hich &e &ill call Bank A. Bank A then stamps its endorsement onto the back
of the original check.
Let's assume that Bank A decides to BtruncateD the original check and send electronic
information about the check to Bank B> therefore, Bank A is the Btruncating bank.D
Of course, in order for this scenario to occur, Bank B must have previously agreed to
accept checks electronically from Bank A.
%n order to truncate the original check, Bank A"
captures an image of the front and back of the original check>
captures the magnetic ink character recognition 15%$#2 line data from the
original check> and
sends the image and 5%$# line data in lieu of the original check to Bank B, its
correspondent bank.
Bank B applies its endorsement electronically and transfers the check image and
5%$# line data to Bank $. Again, in order for this scenario to occur, Bank $ must
have previously agreed to accept checks electronically from Bank B.
Bank $ &ants to present the check for payment to Bank (, the paying bank.
.o&ever, Bank ( has not agreed to accept checks electronically. Accordingly, Bank $
uses the information received from Bank B to create a substitute check, and
therefore becomes the reconverting bank.
,inally, Bank $ presents the substitute check to Bank ( for payment. Bank (, the
+aying Bank, uses the 5%$# line data on the substitute check to process it 4ust like
an original check.
Bank ( may provide the substitute check to its customer, &ho &rote the original
check, in the customer6s monthly periodic statement.
!egal aspects
The bank issuing substitute checks to the customers in lieu of the original
instruments must provide a disclosure to that effect immediately.
Jhen a &rong debit is posted in the account, if the same is disputed by the customer
&ith sufficient evidence, the dispute should be immediately redressed. +ending
redressal, depending on the circumstances, the bank may need to re3credit the
check amount disputed, sub4ect to a maximum amount ceiling, ,urther, if the claim
is found to be false, the bank, immediately after recovering the amount 1&ithin EG
hours2, should inform the customer about recovery.
The main disadvantage of this system is the cost of hard&are re-uired for check
scanning9truncation, but it is more than offset over a period of time by the cost
saved in physical clearing process.
-lectronic Funds Transfer
2vervie=
The term /,T refers to the application of computer and telecommunication
technology in making or processing payments. This is the term used for the payment
system itself, rather than any specific product.
/,T can be broadly classified into &holesale and consumer payments. Jhile
&holesale payments are sieable in volume, and hence use &holesale /,T net&orks,
consumer payments are small in value, but large in number.
Direct #ayment
This is another form of electronic banking &hich is generally concluded through the
Automated $learing .ouses 1A$.2 located at the $entral Bank or their branches. %n
this system, credit9debit to9from the account is done directly &ith a one3time &ritten
authoriation. This eliminates use of AT5 cards repeatedly.
(irect credit is used predominantly for regular payments like salary and pension
payment, and direct debit for preauthoried bill payments. %n %ndia, this system is
popularly kno&n as /$! 1/lectronic $learing !ystem2.
-FT .-lectronic Funds Transfer/
This system is used to electronically move funds from one account to another in a
different bank. The account at the other bank could be of the same person or may be
third party. This system is used predominantly for values lo&er than the minimum
amount specified for other types of payment systems.
%n %ndia, the /,T &orks as under"
The remitter fills in the /,T Application form giving the particulars of the beneficiary
1city, bank, branch, beneficiary6s name, account type and account number2 and
authories the branch to remit a specified amount to the beneficiary by raising a
debit to the remitter6s account> the instructions can be given online also if the bank
provides online banking facility.
The remitting branch prepares a schedule and sends the duplicate of the /,T
application form to its !ervice branch for /,T data preparation. %f the branch is
e-uipped &ith a computer system, data preparation can be done at the branch level
in the specified format.
The !ervice branch prepares the /,T data file by using a soft&are package supplied
by #B% and transmits the same to the local #B% 1Kational $learing $ell2 to be
included for the settlement.
The #B% at the remitting centre consolidates the files received from all banks, sorts
the transactions city3&ise and prepares vouchers for debiting the remitting banks.
$ity3&ise files are transmitted to the #B% offices at the respective destination
centers.
#B% at the destination centre receives the files from the originating centers,
consolidates them and sorts them bank3&ise. Thereafter, bank3&ise remittance data
files are transmitted to banks. Bank3&ise vouchers are prepared for crediting the
receiving banks6 accounts the same day or next day.
The receiving banks at the destination centers process the remittance files
transmitted by #B% and for&ard credit reports to the destination branches for
crediting the beneficiaries6 accounts.
%t is pertinent to note that the transactions have a cut3off time> transactions
originating after cutoff time are processed the next &orking day.
Bome Banking .2nline Banking/
This facility, made available by many banks, and enabled through internet, offers a
host of facilities to the account holders. They include vie&ing account balances,
transferring funds, re-uest for demand draft, make utility payments, etc.
-lectronic Check Conversion
This facility enables converting physical checks to electronic form. The necessity and
usage is explained in detail under $heckE7.
Advantages
This /,T facility reduces processing cost and time, eliminates delay in payment and
hence resultant penalty payment, and does a&ay &ith the cumbersome process and
time of &riting9delivering the check.
Real Time ross "ettlement .RT"/
An #TG! payment system enables processing and settlement of payment
instructions bet&een banks individually and continuously throughout the day. This is
in contrast to net settlement systems 1such as paper3based clearing houses and their
more modern electronic e-uivalents2, &here payment instructions are processed
1LclearedL2 throughout the day but %nter3bank settlement 1i.e. the movement of the
funds bet&een the banks2 takes place only after&ards, typically at the end of the
day.
%n other &ords, #TG! are funds transfer systems &here transfer of money takes
place from one bank to another on a Lreal timeL and on LgrossL basis.
!ettlement in Lreal timeL means payment transaction is not sub4ected to any &aiting
period. The transactions are settled as soon as they are processed.
LGross settlementL means the transaction is settled on one to one basis &ithout
bunching or netting &ith any other transaction. Once processed, payments are final
and irrevocable.
Benefits of RT"
The attraction of the #TG! systems is that payee banks and their customers receive
funds &ith certainty, during the day, enabling them to use the funds immediately
&ithout exposing themselves to risk.
The implementation of #TG! systems by $entral Banks throughout the &orld is
driven by the goal to minimie risk in high3value electronic payment settlement
systems.
RT" in 4"A ,ederal #eserve Jire Ket&ork 1,ed&ire2 is the #eal Time Gross
!ettlement ,unds Transfer system operated by the ,ederal #eserve Banks in )!A. %n
con4unction &ith the privately held $learing .ouse %nterbank +ayments !ystem
1$.%+!2, ,ed&ire is the primary )nited !tates net&ork for large3value or time3critical
domestic and international payments, and it is designed to be highly robust and
resilient.
RT" in -urope
TA#G/TE is the #eal Time Gross !ettlement system for the /uro currency, and is
offered by the /urosystem. The participants comprise of the /uropean $entral Bank
and the Kational $entral Banks of those countries that have adopted the /uro
currency.
%t is used for the settlement of central bank operations, large3value /)#O interbank
transfers as &ell as other /)#O payments, and provides real3time financial transfers
and debt settlement at central banks &hich is immediate and irreversible.
This LelectronicL payment system is normally maintained or controlled by the $entral
Bank of a country. There is no physical exchange of money> the $entral Bank makes
ad4ustments in the electronic accounts of Bank A and Bank B. ,or example, if an
#TG! transfer is initiated from a customer of Bank A favoring customer of Bank B for
)!( 788,88893, the $entral Bank makes ad4ustments in the electronic accounts of
Bank A and Bank B, reducing )!( 788,88893 in Bank A's account and increasing in
Bank B's account by )!( 788,88893.
The #TG! system is suited for lo&3volume, high3value transactions. %t lo&ers
settlement risk, besides giving an accurate picture of an institution's account at any
point of time.
!uch systems are an alternative to systems of settling transactions at the end of the
day 3 also kno&n as the net settlement system.
%n the net settlement system, all the inter3institution transactions during the day are
accumulated. At the end of the day, the accounts of the institutions are ad4usted.
/xtending the illustration above, say another person deposits a check dra&n on Bank
B in Bank A for R=8,88893. At the end of the day, Bank A &ill have to LelectronicallyL
pay Bank B only R=8,88893 1R788,888 3 R=8,8882.
RT" in India
The #eserve Bank of %ndia 1%ndia's $entral Bank2 maintains #TG! payment net&ork
in %ndia. #TG! is very similar to /,T process, except that the system is used for large
value transaction ? %K# 7,888,888 or more in %ndia ? and the funds are settled in
pre3defined time frame. Typically, the payment has to reach the beneficiary &ithin a
maximum of t&o hours.
Both the remitting and receiving must have $ore banking in place to enter into #TG!
transactions. $ore Banking enabled banks and branches have assigned #TG! 773
character alphanumeric codes, &hich are re-uired for transactions along &ith
recipient's account number.
Trade finance is related to international trade. Jhile a seller 1the exporter2 can
re-uire the purchaser 1an importer2 to prepay for goods shipped, the purchaser
1importer2 may &ish to reduce risk by re-uiring the seller to document the goods
that have been shipped. Banks may assist by providing various forms of support. ,or
example, the importer's bank may provide a letter of credit to the exporter 1or the
exporter's bank2 providing for payment upon presentation of certain documents,
such as a bill of lading. The exporter's bank may make a loan 1by advancing funds2
to the exporter on the basis of the export contract. Other forms of trade finance can
include trade credit insurance, export factoring, forfaiting and others. %n many
countries, trade finance is often supported by -uasi3government entities kno&n as
export credit agencies that &ork &ith commercial banks and other financial
institutions. %n short, trade finance means money lent to exporters or importers This
section provides more insight into the concepts of Trade ,inance.
Introduction to Trade Finance
Trade denotes buying and selling, and ,inance in one &ord is BmoneyD. Trade
,inance is the method &hich buyers 1importers2 and sellers 1exporters2 of
commodities and goods use to finance their businesses.
%n other &ords, the money or funds necessary9involved for performing buying and
selling of various commodities is called Trade ,inance.
Trade can happen &ithin the confines of the country or across the border. The former
is termed inland Trade and the latter ,oreign Trade or %nternational Trade.
%nternational Trade happens also due to cost consideration> if the cost of goods
available locally is more than that available in the international market, trade
transactions are entered to save costs.
Any trade transaction can be broadly broken do&n into"
Movement of Goods
Movement of Documents
Movement of Funds
Banks role in trade transactions
Banks play a role in the B5ovement of (ocumentsD and B5ovement of ,undsD after
B5ovement of GoodsD has been done through a &hole range of logistics players.
;ou &ould agree that trade can happen not only bet&een kno&n parties, but also
&ith strangers> the ultimate goal of any trade is to earn profit. ,or instance, a
&holesale dealer in commodities sells it to a retailer ? &hosoever it is ? so long as he
gets the money> he &ould not attach importance to &ho the buyer is. !o also, the
retailer sells it to the consumer so long as he gets the money for goods.
Jhile the above is true for across the counter transactions, &hen the trade happens
bet&een parties unkno&n to each other, both the parties involved &ould desire to
kno& the credentials of the other before entering into any transaction. Jhile the
seller is interested in ascertaining that the money for goods sold is realied, the
buyer &ould be interested in ensuring that agreed -uality and -uantity of goods, for
&hich payment is9&ould be made, is received.
Banks involve in the trade transaction and enable receipt of goods by the buyer and
money by the seller.
I8C2T-R+"
%n international trade, the buyer and seller enter into a contract for supply of goods
by the seller at an agreed price, &hich includes all costs involved right from dispatch
of goods from seller6s place to buyer6s place 3 freight, insurance, duty etc. The
%nternational $ommercial Terms 1%K$OT/#5!2 give a clear picture of the
responsibilities of the seller3buyer in commonly used terms.
%K$OT/#5! are recognied by most countries and &ere first published by
%nternational $hamber of $ommerce 1%$$2 in 7MFI &ith subse-uent amendments.
%$$, for &hich most of the banks are members, &as formed to frame rules for
international trade, applicable throughout the &orld. All the international trade
transactions are governed by these rules framed by %$$.
There are 7F different %K$OT/#5! grouped into G different categories. Je have
restricted our study at this level to only 8G of the active terms.
$%-G3 .-1:=orks/
The obligation of the seller under this contract is to make the goods available at his
premises 9 factory. The B);/# has to bear the full cost and risk involved in bringing
the goods from the seller6s premises to the desired destination. All costs, taxes etc.
both at the seller6s country and the buyer6s country have to be borne by the B);/#.
&% F2B .Free on Board/
The seller6s obligation is to arrange to prepare the goods, pack them, place them on
the vessel as per the terms of contract and obtain a bill of lading evidencing
shipment.
(% C)F .Cost ) Freight/
The seller has to prepare, pack, transport upto the port and arrange to place the
goods on board a vessel and obtain bill of lading &ith freight paid. The buyer has to
arrange to receive the goods at the destination. .e has to arrange for insurance of
the goods during transportation.
9% CIF .Cost, Insurance ) Freight/
)nder this contract, the price -uoted by the seller includes cost of goods, freight
charges upto named destination and insurance covering the voyage. The risk in the
goods passes on to the buyer the moment they are placed on board a vessel in the
seller6s country.
$ertain variants of the above ma4or %K$O terms are less in vogue.
Documents involved in trade finance transactions
$%Bill of -1change or Draft
A bill of exchange is an instruction by the exporter 1dra&er2 to the %mporter
1dra&ee2 or the importer6s bank to make payment of the amount mentioned in it. %t
is a very important document for any financial transaction> it is negotiable and can
be produced in the court of la& as evidence of, and for recovering, dues.
A bill of exchange can be O$lean6 meaning not accompanied by any documents or
O(ocumentary6 meaning accompanying &ith commercial documents.
The tenor of the bill sho&s &hen it is due to be paid. %t is either ?
At sight ? %t is payable &hen the exporter 1dra&ee2 sees it 1on demand2.
Term or )sance ? %t is payable at the end of a fixed period. This period is usually a
specified number of days 1F8, I8, M8 etc.2 after either sight or the date of the draft
or the shipment date.
&%Commercial Invoice
A commercial invoice is a statement containing full details of the goods shipped.
%t contains ? names and addresses of the seller and buyer, details of goods shipped
1-uality, -uantity, description and value2, packing details and packing marks, price
and amount payable by the buyer, terms of trade 1,OB, $,# or $%,2, details of
freight charges, insurance premium and other charges etc.
(%"hipping Documents
This document evidences transportation of goods. %t contains ? name of the seller
and buyer, transported from and to place, number of boxes 9 cartons 9 bags.
+redominant modes of transport used ?
!R .!orry Receipt/ ? This is a receipt of goods for carriage by #oad 1Lorry2.
RR .Rail=ay Receipt/ ? This is a receipt of goods for carriage by #ail.
B! .Bill of !ading/ ? %t is a receipt given by the shipping company to the shipper
for goods accepted for carriage by sea. The most important thing to note here is that
? it also conveys title to the goods.
A3B .Air=ay Bill/ ? This is a receipt of goods from an airline company. As AJB is
only a receipt, it is not a document of title.
5ultimodal 1$ombined2 Transport (ocument ? This document lists the place of
receipt, place of delivery and the different modes of transport involved.
9%Insurance Documents .#olicy , Certificate/
This provides actionable evidence of a contract of insurance and sho&s full details of
risks covered. A marine insurance policy, for instance, provides cover against perils
of the sea and other connected risks &hich the goods are exposed to.
;% Inspection Certificate
$ertain buyers stipulate that the goods being shipped are inspected before shipment>
they could also specify agencies that should inspect the goods. These inspecting
authorities issue certificate after inspecting the goods, duly recording their
observations.
Harious internationally reputed %nspection agencies provide the %nspection services
for a nominal charge, thus building in an element of comfort in the international
transactions by assuring the importer 9 buyer that goods being shipped are as per
the standards agreed upon bet&een the importer and the exporter.
<% #acking list
This document indicates the &ay goods are packed, meaning &hether in cartons,
gunny bags etc. They also indicate the -uantity, measurement and &eights of goods
contained in each pack.
>% Certificate of 2rigin
This document evidences the country in &hich the goods exported &ere
manufactured or produced.
(epending on the nature of goods involved in the trade, other documents, &hich
could also be variants of the above, may be stipulated for submission.
+odes of International Trade
There are 8F ma4or recognied &ays of effecting payment in international trade"
Clean #ayments 1a2 Advance +ayment 1b2 Open Account
Bills for collection 1a2 (ocs against +ayment 1b2 (ocs against Acceptance
Documentary Credit .!etter of Credit/
Let us assume that $ompany : from %ndia &ants to import machinery from $ompany
; incorporated in )!A. Je shall see each of the &ays that $ompany : can pay
$ompany ; in this trade.
$% Clean #ayments
$lean +ayments are basically driven by trust. /ither the exporter sends the goods
and trusts the importer to pay once the goods have been received or the %mporter
trusts the exporter to send the goods after payment is effected.
%n $lean +ayment, all documents are handled directly by the trading parties
1importer and exporter2. The role of banks is limited to only effecting payments.
.a/ Advance payment
The exporter may re-uire that the importer should make full payment in advance for
the goods to be exported. This is possible &here the goods en4oy sellers6 market
1seller can dictate terms2. This mode of transaction is demanded by the exporter
1seller2 &hen the selling party is a &ell3kno&n and reputed company in its field. The
exporter &ould dispatch the goods after he receives the full payment from the
importer.
Advance payments are usually adopted &hen the trading parties do not yet have a
long term relationship. .ere the importer has to fully rely on the integrity of the
exporter and his capacity to execute the order in time. The entire risk of the
transaction is shouldered by the %mporter.
/xample"
$ompany : 1importer2 remits money to $ompany ; 1exporter2 and after receiving
the full payment, $ompany ; dispatches the goods to $ompany :.
.b/ 2pen Account
This situation is reverse of that for advance remittance. )nder this method, goods
are dispatched to the buyer &ho takes delivery of them &ithout making payment. %t
is agreed that he &ill make the payment to the seller at a predetermined future date
1F8, I8, M8 days after shipment etc.2. Open Account as a method of settlement is
possible &here the commodity commands buyer6s market.
.ere the exporter bears the entire risk, loses control over the goods and relies on
the integrity of the importer to receive payment. This type of a transaction
symbolies a long3term regular relationship bet&een the t&o parties. As long as the
exporter can trust the importer to make his payments on time, an Open Account
transaction is the simplest mode of doing long3term business.
/xample"
$ompany ; 1exporter2 dispatches the goods to $ompany : 1importer2 and after
receiving the goods, $ompany : remits the money to $ompany ;.
&% Bills for collection .Documentary Collection/
%n Bills sent for collection, the exporter does not part &ith the goods or the control
over the goods till he receives payment and the %mporter does not pay until he gets
the possession or control over the goods. The exporter dra&s a Bill of /xchange
1(raft2 on the importer for the good exported.
Goods are dispatched to the importer6s country but the relative documents are sent
through a bank for collection. The bank hands over the documents to the importer
only on receiving from the latter the value of the goods as advised by the /xporter.
T&o important points to be noted in (ocumentary $ollections ?
Banks involved do not give any guarantee of payment. $ollections are sub4ect to
)niform #ules of $ollections 1)#$2 framed by %$$.
There are t&o types of (ocumentary $ollection transactions" 1a2 (ocuments against
+ayment 1(9+2
Also called $ash against (ocuments 9 $ash on (elivery, (9+ means payable at sight
1on demand2. The Bank at the importer6s end hands over the documents only &hen
the importer has paid the bill. The attached instructions to the documents &ould read
? B#elease (ocuments against paymentD
The exporter, in this case, keeps control over the goods 1through the banks2 until
the importer pays.
/xample"
$ompany ; 1exporter2 ships the goods to $ompany : 1importer2 and submits the
shipping and financial documents to its bank 1+V# Bank2. +V# Bank sends the
document &ith a covering letter 1instructions2 to $ompany :6s Bank 1T0L Bank2
detailing the release of documents to $ompany : on payment.
As per the instructions of +V# Bank, T0L Bank releases the documents to $ompany :
on paying the value of the bill. $ompany : takes delivery of the goods and T0L Bank
sends the payment to +V# Bank to be credited to $ompany ;.
.b/ Documents against Acceptance .D,A/
%n (9A, the Bank at the importer6s end hands over the documents against
acceptance of a draft 1to pay on a future date as per instructions2 by the importer.
The future date is pre3defined 1F8, I8 or M8 days etc.2
.ere, the exporter allo&s credit to the importer> the period of credit is called as
B)sanceD. The importer is re-uired to make a signed promise to pay the bill at a set
date in the future. The attached instructions to the documents &ould read ? B#elease
(ocuments against AcceptanceD. The exporter, in this case, loses control over the
goods.
/xample"
$ompany ; 1exporter2 ships the goods to $ompany : 1importer2 and submits the
shipping and financial documents to its bank 1+V# Bank2. +V# Bank sends the
document &ith a covering letter 1instructions2 to $ompany :6s Bank 1T0L Bank2
detailing the release of documents to $ompany : on acceptance to pay after I8
days.
As per the instructions of +V# Bank, T0L Bank releases the documents to $ompany :
on accepting the (raft to pay the value of the bill after I8 days. $ompany : takes
delivery of the goods and makes payment after I8 days. T0L Bank sends the
payment to +V# Bank to be credited to $ompany ;.
.ere, $ompany : may or may not pay after I8 days and T0L Bank does not give any
guarantee of payment.
(% Documentary Credit .!etter of Credit/
(ocumentary $redit is an instrument of settling trade payments.
%f the seller 1exporter2 is not comfortable in sending the documents for collection,
and instead desires to have some kind of assurance of payment ? this scenario arises
&hen buyer 1importer2 is ne& ? he re-uests the seller 1exporter2 to arrange for an
undertaking from the bank to make payment &hen the documents are received. By
this, he eliminates dependence on the buyer 1importer2 for realiation of funds. The
buyer 1importer2 in turn approaches his banker to give an undertaking to pay the bill
amount. This undertaking issued by the bank on behalf of his customer to make
payment on receipt of bills, or on a future date, is called Letter of $redit 1L$2.
A letter of $redit is an irrevocable undertaking issued by the banker on behalf of
applicant 1buyer9importer2 favoring the beneficiary 1seller9exporter2 to pay a certain
sum of money against presentation of documents stipulated, and in compliance &ith
the terms and conditions stipulated therein. The decision to pay under a L$ is based
entirely on &hether the documents presented to the Bank appear on their face to be
in accordance &ith the terms and conditions of the L$. %t may be noted that banks
deal only in documents and not in goods. .o&ever, by building suitable terms in the
L$, they ensure that the underlying shipment indeed takes place.
.igh degree of involvement by banks in the L$ process builds in trust into the
transactions.
T&o important points to be noted in (ocumentary $redit ?
%t is binding on the L$ issuing Bank to pay the L$ value to the exporter provided
documents presented are in accordance &ith the terms and conditions specified in
the L$. (ocumentary $redits are sub4ect to )niform $ustoms and +ractices for
(ocumentary $redits 1)$+($2 framed by %$$.
/xample"
$ompany : 1importer2 from %ndia enters into a contract &ith $ompany ; 1exporter2
incorporated in )!A to buy machinery. $ompany : approaches his bank 1+V# Bank2
to issue an L$ favouring $ompany ;.
+V# Bank issues an %mport L$ and sends an 5T N88 !&ift message to T0L Bank
1)!A2 at exporter6s end. T0L Bank advises the L$ to $ompany ;.
As per the terms and conditions mentioned in the L$, $ompany ; packs and ships
the goods to %ndia. $ompany ; submits documents to T0L Bank &hich in turn sends
the documents to +V# Bank.
Based on the documents presented being in accordance &ith the terms and
conditions of the L$, +V# Bank releases the document to $ompany : and makes
payment to T0L Bank to be credited to $ompany ;.
.ere, it is binding on +V# Bank to make payment provided documents presented are
in accordance &ith the terms and conditions specified in the L$.
Inter Bank communication : "3IFT
The interbank communication bet&een banks9organiations is routed through !J%,T
1!ociety for Jorld&ide %nter3Bank ,inancial Telecommunication2 net&ork, &hich is a
co3operative society o&ned by its member financial institutions and head -uartered
in Belgium. %t is a secure net&ork for transmitting messages bet&een financial
institutions. The message formats are pre3defined and referred to by category
numbers called 5T numbers.
5T N88 series deals &ith (ocumentary $redits and Guarantees 1%mports2, and 5T
G88 series deals &ith (ocumentary $ollections 1/xports2. 1Other series are defined
for other purposes2. The message formats &hich are also associated &ith Trade
,inance are 5T78F 1$ustomer Transfer2 and 5TE8E 1General Bank Transfer2> they
enable trade finance related payments.
As mentioned above, individual message formats are available for specific
re-uirement under each series. One cannot &rite !J%,T instructions that do not
&ork &ith the preset messages and expect the sending bank to accept them, or the
receiving bank to respond.
#artial shipment
Goods under L$ can be shipped in full 1one lot2 or in installments or in parts
1multiple lots2. !hipment in multiple lots is termed +art3shipment.
Transshipment
Jhen goods are shipped bet&een end destinations &ith intermittent stops involving
unloading and reloading of goods, cargo is sent &ith Transshipment.
Bank uarantees
Assume that $ompany : decides to purchase manufacturing e-uipment of
considerable value, duly undertaking to make payment for e-uipment in 78 half3
yearly installments spread over a five year period. ;ou &ill agree that the supplier of
the e-uipment &ould not generally agree for that, unless somebody undertakes to
make payment of installments in case $ompany : fails to pay.
Assume that you have re-uested a contractor to construct your house. Assume
further that the contractor demands advance payment of E=A of the cost of
construction. $onsidering the value involved, you &ould not desire to part &ith such
huge amount, unless somebody undertakes to make good the advance paid, if the
contractor defaults from his obligation to construct your house.
%n both the above instances, if somebody undertakes to make good the loss arising
out of default, the supply9payment is made. And this somebody is generally a
banker.
Guarantee is an undertaking issued by the bank on behalf of its constituent, favoring
the beneficiary, to pay the underlying amount if the terms of the contract or
agreement are not honored
%n the first instance, if the installment is not paid on due date, and in the second, if
the contractor fails to construct the building to the extent of advance received, the
bank &ould compensate for the financial loss.
Jhen the payment under the contract is defaulted, the beneficiary of the guarantee
demands payment under the guarantee. This demand is referred to as invoking of
Guarantee. !oon after the guarantee is invoked, the bank is expected to make
payment of invoked amount.
.ere again, for extending facility to establish a Guarantee, prior arrangement is set
up bet&een the banker and the applicant.
-1port Finance
Pre-shipment and Post-shipment Finance
Assume that an order is received to supply 1sell2 7888 TH !ets every month.
+rocurement of such large number of TH sets involves substantial cost, &hich the
seller may not be able to invest fully from his sources. To enable seller procure and
sell TH sets, the banks lend certain percentage of total money re-uired by the seller.
This is called pre3shipment finance or inventory finance ? financial assistance
extended before transportation or shipment for building up inventory.
Again, some time &ould lapse before the cost of goods is received 1recovered2 from
the buyer. Till such time, the seller &ould be out of funds. This disables him from
procure next set of TH sets for &ant of funds. To ease the situation, the banks lend
against the sale proceeds to be received. This is called post3shipment finance or
receivable finance ? financial assistance extended after transportation or shipment
against the money to be received.
As in any other kind of loan or advance, the above finance is also eligible for interest
recovery.
Types of #re:shipment Finance
Based on the disbursement currency, +re3shipment finance can be classified into
t&o"
$% #acking Credit .!ocal Currency/ : #C!
This is the financial assistance extended for meeting the cost incurred before
shipment. This financial help is in local currency and the interest chargeable is at
rates applicable to local currency advance.
&% #re:shipment Credit .Foreign Currency/ : #CFC
This is the financial assistance for meeting the cost incurred but extended in ,oreign
$urrency. The interest charged are governed by the interest rate applicable for the
foreign currency 1L%BO#2 &hich is generally less than the local currency rates.
Types of #ost:shipment Finance
Based on the disbursement currency, +re3shipment finance can also be classified into
t&o"
Local currency advance
+ost3shipment $redit in ,oreign $urrency
+ost3shipment finance depends on the type of bill and nature of Transaction.
Purchasing a Bill (For Sight Bill
Discounting a Bill (For !sance Bill
"egotiating a Bill (For Bills under L#
,or extending either pre3shipment finance or post3shipment finance, prior
arrangement is set up bet&een the banker and the seller. The arrangement amongst
other things, specify the amount up to &hich the banker is &illing to lend, the
percentage he is &illing to share 1business o&ner needs to have stake in the
business, either already existing or stipulated> bank &ould chip3in &ith the balance
amount2, the period till &hich this arrangement &ould exist, and the interest and
other charges payable for the services.
!ondon Inter Bank 2ffered Rate .!IB2R/
L%BO# is the interest rate at &hich banks in London lend to each other. L%BO# is
considered to be the most active interest rate in the &orld and even though it is a
London3based interest rate, L%BO# is used in various markets around the &orld
including in the )!.
%n this case, it acts as a base rate to calculate interest rate to be charged on a
,oreign $urrency loan.
/xample"
$ompany : 1exporter2 from %ndia enters into a contract &ith $ompany ; 1importer2
incorporated in )!A to sell pharma goods costing )!( =8888 in M8 days. $ompany :
approaches its bank 1+V# Bank2 to avail +re3shipment $redit in ,oreign $urrency for
M8 days.
Let us assume )!( F 5onths L%BO# #ate to be G.88 A.
+V# Bank calculates the interest rate to be charged on )!( =8888 +$,$ for M8 days
&ith )!( F 5onths L%BO# as the Base #ate.
The rate of interest charged by the Bank &ill be G.88 a 8.N=A X G.N=A
8.N=A is the spread 1margin or profit2 that the Bank earns on this +$,$ loan.
Jhether the bank acts as a collecting agent or extends financial assistance, they are
entitled for a fee ? $ommission ? and interest &here financial assistance is extended.
Banking, an industry kno&n &orld&ide for predictable business practices and
measured evolution, is facing s&eeping and unprecedented change. $ustomers
demand personal service &henever and &herever they &ant, N days a &eek, EG
hours a day. Jith the competition 4ust a mouse click or a street corner a&ay, these
challengesb]Dcompounded by mega mergers, decreasing margins, regulatory
changes, and fierce competitionb]Dpresent both obstacles and opportunities.
Today, banks must adapt -uickly to survive. They must find ne& value in existing
systems and find &ays to explore ne& market opportunities. Banks also must strive
constantly to improve their service delivery and the -uality of their products and
services. Today's technology can help banks manage resources more efficiently,
open lines of collaboration, and support adaptable, integrated systems. %n doing so,
today's technology can change customer, employee, and operations experiences for
the better.
The follo&ing topics are covered as part of (elivery $hannels "
%ntroduction
Automated Teller 5achines 1AT52
+oint of !ale 1+O!2
0iosks
Ket Banking
5obile Banking
%nteractive Hoice #esponse
$all $enter
Other Banking $hannels
Click on the above links to take
The Banking %ndustry has &itnessed mammoth changes in the recent past especially
in the areas of delivery methods and business strategy both aimed at improving the
-uality and outreach of services rendered to customers besides increasing
profitability. As banks embraced the latest technology the spurt in their pace of
business &as impressive and surpassed the gro&th of some traditional banks.Let us
have a look at ho& these happened over a period of time. This section provides more
insight into the concepts of (elivery $hannels.
-volution of Delivery Channels
Traditional banking re-uires the physical presence of the customer at the branch or a
retail outlet of a bank for most transactions. The retail outlet9branch is a brick and
mortar structure re-uiring maintenance of infrastructure, branch net&orks and
developing trained personnel thus leading to high costs of operations. Jhile Banks
tried to reach out the un3banked areas by opening more retail outlets, these outlets
had a higher cost per transaction because of the overhead costs involved.
,urther traditional banking branches also had other limitations &ith respect to the
gro&ing demands of customers. ,or example, specific timings to transact business
&hich made it difficult for customers on the move &ho did not have the time to visit
a retail outlet for a transaction. These limitations and inconveniences of traditional
banking forced a group of people to think for an alternate banking delivery channel
option. The outcome &as the invention of an Automatic Teller 5achine 1AT52, the
first alternate delivery channel being operational in 7MIM.
The main advantages of alternate banking delivery channels are"
#eduction in costs and increased convenience through remote payments
Balance bet&een personalied services and emerging transactional services
%mproved outreach especially in areas &here the traditional bricks and mortar
approach is unfeasible thereby increasing financial inclusion and
%ncreased product diversification by making savings and remittance products
convenient, efficient and profitable.
Traditional banking gave &ay to Branchless banking, a distribution channel strategy
used for delivering financial services &ithout relying on bank branches. Jhile the
strategy may complement an existing bank branch net&ork for giving customers a
broader range of channels through &hich they can access financial services,
branchless banking can also be used as a separate channel strategy that entirely
forgoes bank branches.
-volution of Delivery Channels
The first modern day Automatic Teller 5achine 1AT52 &as introduced to consumers
in 7MIM by $hemical Bank, )!. This primitive AT5 supported only limited
functionality but heralded an era of changes in Banking.
!ince then the AT5 has become a strategic necessity and the main item on the
business agenda for the survival of a bank, instead of 4ust being a money
dispensing9telling facility. The drastic changes in the information technology sector in
the recent past further forced banks to move along &ith the latest technologies, lest
they lose their customer base. Banks are in a race to embrace the latest technologies
and provide the best of its services to its customers as customers are also becoming
tech savy. %t is commendable to note that even smaller banks are also in the race
&ith big Banks to establish their credentials in this area as they do not &ant to see
the flight of customers to other banks for choice of best services.
As mentioned earlier, changes in technology have made the banking services enter a
ne& era in banking i.e., reaching out to the customer and not the customer reaching
out to the bank. /volution of other delivery channels like Ket Banking, 5obile
banking, %nteractive Hoice #esponse !ystem 1%H#!2 9 +hone Banking, $all $enter,
etc has totally changed the Banking scenario &ith more and more services being
provided by the banks. Banks are increasingly trying to shift customers to transact
through automated channels for the simple reason of convenient and hassle free
banking, cost cutting efforts as &ell as cross selling of bank6s other products.
Associated Channels :Familiarising =ith some of the delivery channels
Automatic Teller +achine
%t is an electronic terminal enabling transactions on (ebit, $redit and pre3paid cards.
These cards can be either magnetic stripe cards or smart 9 chip based cards. All
transactions done in an AT5 needs a +ersonal %dentification Kumber 1+%K2.
#oint of "ale .#2"/ +achines
+oint of !ale 1also called as /lectronic (ata $apturing ?/($ machines2 is also an
electronic machine installed at merchant outlets to enable transactions using debit or
credit cards 1magnetic or smart cards2. A fe& transactions need customer +%K for
authentication of transaction. ,or example, 5aestro debit cards from 5aster$ard
%nternational.
Another term commonly used to describe +O! in Australia and Ke& <ealand is
/,T+O! i.e., /lectronic ,unds Transfer at +oint of !ale. This is the general term used
for debit, credit and charge card payments and transacting at +O!
#hone Banking .I6R"/
+hone Banking or %nteractive Hoice #esponse !ystem is an automated banking
system that guides you through a series of options to perform the re-uired banking
transactions. %t needs customer6s card details and +%K for performing the transaction.
But no physical card presence is re-uired.
+obile Banking
As the technology advanced, 5obile banking service has became the most &anted
channel for Banks * ,inancial %nstitutions to service their clients in a cost effective
&ay by leveraging the advancements in mobile communication technology. %t is also
kno&n as 53Banking, mbanking and !5! Banking.
8et Banking
%t is true that, the convenience of banking comes &hen &e talk about Ket banking or
banking at your finger tip. Online banking is not for to change your money habits.
%nstead, it uses today's computer technology to give you the option of bypassing the
time3consuming, paper3based aspects of traditional banking in order to manage your
finances more -uickly and efficiently.
5iosks .Touch points/
0iosks or touch points are also electronic device9terminal like an AT5 &here
customer can interact and do most of the banking financial and non3financial
transaction except cash transactions.
/xcept AT5, +O! and 0iosk no other channels need physical interaction of customer
card &ith devices. Or other&ise transactions in AT5, +O! and 0iosks are called as
$ard +resented transactions &here %H#!9+hone Banking 9 5obile Banking 9 $all
$enter are non3card presented transactions.
2ther Banking Channels
Banking Agents
A Banking Agent is retail or a postal outlet that processes clients6 transactions under
contract &ith a Bank9,inancial institution or a mobile net&ork operator through +O!
devices. The retail or postal outlet can conduct transactions like cash deposit,
&ithdra&al, funds transfer, payment of bills, account balance en-uiry etc. Banking
agents can be post offices, pharmacies, supermarkets, convenience stores, lottery
outlets, etc.
T6 Banking
TH Banking is a ne& concept introduced recently in %ndia &hich aims at
revolutioniing Banking by bringing it into the customer6s living room. $ustomers can
access details and information regarding all banking services even if they do not
have internet access through a !atellite (T. or (igital $able connection.
Architecture 2vervie=
A typical integrated delivery channel architecture is sho&n belo& &here all the
channels are integrated to a centralied transaction s&itching system and interfaced
to the host systems like $ore banking solutions, card management system, etc.
.o&ever, the architecture depends on the individual bank6s needs and &ill have a
different approach &hen each bank implements its delivery channel. Banks can go
&ith single delivery channel like AT5 also &here this channel only need to be
interfaced &ith .ost system9s. %f multiple channels are part of bank6s (elivery
channel strategy, the belo& diagram may find its place in Banks solution approach.
AT+:"=itch system
An AT53!&itch application is a centralied system &hich controls the operations of
the delivery channels connected to it and does a transaction validation and s&itching
to the destination systems. The transaction from delivery channel hit the !&itching
system and based on the business rules configured, it decides &hat to do &ith the
transaction received. %t stores the customer card and transaction data. !&itch
system can be interfaced to an external $ard 5anagement !ystem or it can be a part
of the !&itch system itself. !&itch system never stores the +%K of a customer in its
database instead it stores the computed +in Herification Halue 1+HH2. !&itch system
architecture has an interface layer &hich accepts the transaction details from the
channels, for&ard to its core layer for processing the transaction.
,or example, an AT5 cash &ithdra&al transaction has the follo&ing flo& in s&itching
application. 1#efer the above architecture2
7. $hannel %nterface layer 1inbound2 receives the transaction message from AT5 in
T$+%+ message format, transform the message to !&itch internal message format
and intimate the $ore layer.
E. $ore layer or the business rule engine handles the transaction received as belo&"
a.%dentify the %ssuer
b.Halidate the $ard
c.Halidate the +%K
d.Halidate the limit
%f found correct, intimate the .ost interface layer 1outbound2 to communicate to
.ost system3say for example $ore Banking !olution.
F. .ost %nterface layer 1outbound2 for&ard the message to .ost system and !&itch
system &aits 1Timer starts here2 for reply from .ost and intimate core layer after
receipt of message.
G. $ore layer does necessary system updates, and intimate channel interface layer to
communicate the AT5.
=. $hannel %nterface layer 1%nbound2 transform the message and intimate the AT5 to
dispense cash.
I. AT5 completes the transaction and intimate !&itch application by &ay of return
completion message.
The above is an example of online transaction &here .ost system is available for
communicating and responding.
There could be some scenarios &hen .ost systems &ill be do&n due to net&ork
issues, or other process like /nd3of3(ay operations, etc. %n such cases, !&itch
system &ill perform a !tand %n +rocessing. ,or this, the latest balance of customer
data or called as O+ositive Balance ,ile 1+B,26 is loaded to !&itch system at a
scheduled time intervals. Based on this limit, !&itch system &ill send a respond
message to AT5. This is called as an Ooffline transaction6. These transactions are
stored in a file called O!tore And ,or&ard 1!A,26 file in !&itch system and &hen the
.ost system become online, these transactions are routed to it for debiting the
customer accounts.
0no&n AT53!&itch application is"
7. BaseEG9BaseEGeps from A$% Jorld&ide, )!
E. +ostillion from $eltron %nternational, )0
F. Oasis3%!T from ,idelity, )!
G. !parro& from $#E systems, %reland.
An automated teller machine 1AT52, also kno&n as a $ash 5achine and by several
other names , is a computerised telecommunications device that provides the clients
of a financial institution &ith access to financial transactions in a public space &ithout
the need for a cashier, human clerk or bank teller. On most modern AT5s, the
customer is identified by inserting a plastic AT5 card &ith a magnetic stripe or a
plastic smart card &ith a chip, that contains a uni-ue card number and some security
information such as an expiration date or $HH$ 1$HH2. Authentication is provided by
the customer entering a personal identification number 1+%K2. This section provides
more insight into the concepts of AT5s.
Independent Channels
This section covers the independent delivery channels available and deployed by
various banking organiations. Let us start &ith the oldest delivery channel that is
AT5.
Automated Teller +achine .AT+/
The Automatic Teller 5achine &as the first alternate banking channel to be
introduced and is used &idely across the globe for both normal convenient banking
operations and also for cross selling of other products of the Bank.
A brief history
.istory of an automatic teller machine goes like this.
(on Jetel 1)!2 &as the co3patentee and chief conceptualist of the automatic teller
machine, an idea he thought of &hile &aiting in line at a (allas bank. At the time
17MI@2 Jetel &as the Hice +resident of +roduct +lanning at (ocutel, the company
that developed automatic baggage3handling e-uipment. The other t&o inventors
listed on the patent &ere Tom Barnes, the chief mechanical engineer and George
$hastain, the electrical engineer. %t took million dollars to develop the AT5. The
concept of the AT5 first began in 7MI@, a &orking prototype came about in 7MIM and
(ocutel &as issued a patent in 7MNF. The first &orking AT5 &as installed in a Ke&
;ork based $hemical Bank. The first voucher based cash dispensing machine &as
installed in 7MIN by Barclay's Bank in London. /xperts, ho&ever, do not consider this
an AT5. The first modern day AT5 &as introduced to consumers in 7MIM by
$hemical Bank, )!. The first %B53compatible (iebold machine is installed at a bank
in %ndianapolis in 7MN@.
Technical information*
An AT5 is an electronic device 9 terminal having mechanical devices to do the
re-uired actions on receiving instructions from source system. Kote that it is a dump
terminal only having a +$ core &ith different configurations like @8 GB .((,
Jindo&sEk9:p, 7 GB !(#A5, net&ork card, graphic cards, etc and some other
mechanical devices9part 1explained later sections2 to perform the functions. %t is
being controlled9driven by its o&n operating system soft&are 1for example K($a2
provided by the maker of the AT5s 1for example, Aptra soft&are for K$# AT5s2
&hich run on Jindo&s. %t &aits for the instructions, act up on it and complete the
instructions. %f couldn6t completed, intimate the source system, that is !&itch its
failure. .o& obedient it isZ ;es, it &orks as a 'slave' to the !&itch system. All AT5s
are net&orked, either leased lines, H!AT 1Hery !mall Aperture Terminal2 a satellite
connections, or dial3up connections through routers to the centralised !&itch
application and uses mostly T$+9%+ protocol for communication 1can be :.E= also2.
%n past years, there &ere stand3alone AT5s &here it &as attached to that particular
branch operations and controlled by local !&itch application.
Types of AT+s*
7. ,ront loading" ,it to shopping mall, lobbies, etc &here cash is loaded by opening
the currency chest from front side
E. #ear loading" )sed at Banks branches normally, &here cash is loaded from the
back side of the AT5s.
F. 5ulti3functional AT5s &ith cash 9 che-ue deposit modules
G. 5ono3functional AT5s &ith out cash9che-ue deposit module 1cash dispenser only2
or called as sleek AT5s since small in sie.
=. 0iosks 3 %nformation 0iosks &here no cash deposit9 no cash &ithdra&als functions
are allo&ed.
+anufacturers of AT+s
7. K$#
E. (ieBold
F. Jin$or
G. ,u4itsu
=. Triton, etc
Bo= an AT+ =ork*
An AT5 is simply a data terminal &ith t&o input and four output devices. Like any
other data terminal, the AT5 has to connect to, and communicate through, a host
processor. The host processor is analogous to an %nternet service provider 1%!+2 in
that it is the gate&ay through &hich all the various AT5 net&orks become available
to the cardholder 1the person &anting the cash2.
5ost host processors can support either leased3line or dial3up machines. Leased3line
machines connect directly to the host processor through a four3&ire, point3to3point,
and dedicated telephone line. (ial3up AT5s connect to the host processor through a
normal phone line using a modem and a dedicated telephone line.
Leased3line AT5s are preferred for very high3volume locations because of their thru3
put capability and dial3up AT5s are preferred for retail merchant locations &here cost
is a greater factor than thru3put. The initial cost for a dial3up machine is less than
half that for a leased3line machine. The monthly operating costs for dial3up are only
a fraction of the costs for leased3line.
The host processor may be o&ned by a bank or financial institution, or it may be
o&ned by an independent service provider. Bank3o&ned processors normally support
only bank3o&ned machines, &hereas the independent processors support merchant3
o&ned machines.
#arts , Components of an AT+
Like any other electronic device an AT5 is also driven by its electronic 9 mechanical
devices &hen it is re-uested to do so. Let us have a look at some of such
components of an AT5, its terminologies and a little technical information also.
$% +onitor* ."creen , Touch screen/
AT5 screens have different types like crt9vga9svga9tft3touch screens sie
varies bet&een 78L to 7=L screens. #ecently T,T Touch screens are &idely
used in most of the AT5s.
%ts function is for display functional menu, messages, advertisement screens,
motion pictures, etc.
&% 2ption 5eys*
These are the keys provided on the left9right side of the screens for selecting
the choice of functions by the customer. These keys are called as 'Option
0eys6 or termed as BOptkeysD.
)sed for selecting the re-uired functionality 9 menu in an AT5 by the
customer.
Technically each 'Opt0ey' is represented by an alphabet 1eg. A, B, $, (2 in
arriving at the option selected and the coding logic to be follo&ed for
executing the function opted.
(% 5ey #ad .-ncrypted 5ey, #I8 #ads/
0ey +ad contains alpha numeral keys for user inputs. After implementing the
F(/! 1(ata /ncryption !tandard2 security re-uirements, all the key pads are
no& encrypted &ith security net&ork keys.
%ts function is for customer inputs. /ntering +%K, Amount, canceling
operations, etc
9% Card Reader*
$ard #eader reads the customer data from the $ard Track data for allo&ing
the operation, flickers a glo&ing light &hen idle. There are F types of card
readers, 5otorised card reader, (ip card reader and !mart card reader.
7. 5otorised card reader" %t holds the card till the operation is
completed. Once the operation is completed card &ill be e4ected.
E. (ip $ard #eader" $ard need to be s&iped once to read and store
the information till the operation is over. Kormally in a dip card
operation only one transaction is permitted due to transaction security
reasons.
F. !mart $ard #eader" #eads the smart9 chip card for accessing the
data stored in the chip. Kote" .ybrid card readers are being used for
motorised and (ip card readers to read cards including smart cards.
%ts function is for reading the card holder's information from the card's
magnetic data area and pass information to !&itch for action.
Technically, the card contain card holder's information like Kame, card
number, expiry, cvv, etc stored in Track 7 and TrackE. The information stored
starts &ith a L>L 1semi3colon, called as 'start sentinel'2 in Track 7, thus making
the card readable in card reader.
7. %f the card data doesn't start &ith L>L card &on't be read by system.
,or eg. Track 7 of card data may have like this,
L>cG=IM7EFG88888CC.L. %f the card has lost the data, card reader
&on6t read the card.
;% Cash picker ) dispenser
$ash from the cash cassette is picked based on the dispensing logic.
%ts function is for picking the cash from cash cassettes and stacks the same
before presenting it as a bunch, move the cash through a small conveyor belt
to the presenter.
Technically, cash is picked either using ',riction method' or by 'Haccum
method'. )nder friction method currency is picked from top edge &here as
vaccum method currency is sucked out. .ence if the currency is spoiled or not
stiff, dispensing error or chances of getting additional currency may happen.
<% Cash #resenter
(evice to present the stacked 1bunch2 cash to the customer.
%ts function is for presenting the cash to the customer &ith in the time
specified 1normally 7=3F8 seconds2. %f cash is not taken out or presented &ith
in the time, cash &ill be retracted and the same for diverting to (ivert Bin.
>% Divert Bin
(ivert bin contains the currencies diverted during presentation timed out, or
due to some other technical errors.
%ts function is nothing except to hold the diverted currencies for cash tallying
purpose. !ome times this divert bin may become full, if some technical issues
are there &hile cash dispensing. %n such cases, AT5 &on6t function and go out
of service.
?% Deposit +odule*
5ostly seen in multi3functional AT5s &here cash 9 che-ue deposit can be
done. /nvelopes are to be used to drop the che-ue or cash &hile depositing
along &ith challans &ith Account Kumber.
%ts function is for accepting deposit 1cash9che-ue2 from the customer &hen
opted for '(eposit'.
Technically, &hen customer opted for '(eposit', AT5s instructs the (eposit
module slit to open, customer need to put the cover containing cash9che-ue.
AT5 3 deposit module &ill print the transaction details on top of the cover to
identify the Transaction details, &hile inserting. 1That is card number, date,
etc2.
@% Cournal,Cournal printer*
Tournal contains all the successful9failed transaction details stored. %t is an
electronic 4ournal &here all transactions happened in AT5 is stored. %t
simultaneously prints the transaction details on a paper roll also. Tournal
printer is inside the AT5 can be either dot matrix or thermal printer. Thermal
printout need special type paper rolls also.
%ts function is to print the events 9 transactions happening &hile customer
operates the AT5 in a specific message format. %t contains the transaction
data and is as e-ual as the cash scroll94ournal of a Branch since the cash paid
details are stored in AT5 Tournal. This details are stored in the +$ $ore of the
AT5s and can be retrieved 1called as 4ournal pulling2 for reconciliation of
transaction data &ith other systems. Kormally such data are stored for a
maximum period of one month in AT5s. Thereafter the records &ill be
over&ritten. .o&ever, all these transactions &ill be available in the AT53
!&itch application also.
$J% Receipt #rinters
!mall sie dot matrix 9thermal printer, printing sie configurable. #eceipts
prints normal sie of FI chars
%ts function is to prints receipts 9 statements, etc.
$$% Currency Chest*
$urrency $hest contains the currency cassettes stored in slots inside the AT5.
%ts function is to safe custody of cash, through secured locking.
$&% Currency Cassettes*
$urrency cassettes can be a minimum of E or = depends on the bank's
re-uirement loaded &ith cash &ith different denominations currencies. /ach
cassette is marked for the $urrency to be placed in the cassette. /.g.
#s.78889X or #s.=8893 , #s.78893
%ts function is to contain currencies sorted and stacked9arranged in order for
disbursement9tallying. $urrencies are placed so tightly stacked that &hen
disbursement happens, remaining currencies moved automatically so that
cash picker picks the next currency.
Technically, each cassette is configured 1using hexa decimal value method2 to
keep only one type of currency only. %f some other currency is kept in the
cassette meant for one currency, there &ill be a mismatch of disbursement
and either excess or short dispense may happen. /ach AT5 vendors need to
be )L EM7 certified for the $urrency $hest 1that is tamper 9fire proof, etc2
&ith out &hich AT5 cannot be deployed.
$(% Deposit bo1*
%t is a drop box inside AT5 &here cover containing cash9che-ue is directly
dropped in to.
%ts function is to store the $ash 9 $he-ues deposited in AT5 till operation
team picks it up for accounting.
$9% #C:Core .Computer system/*
+$ $ore is the core computer system inside the AT5, available &ith the latest
configurations.
%ts function is to drive the AT5 using the AT5 controlling soft&are loaded, for
example Aptra?K$#, and net&orked to external systems for action. The
screen 4pegs, motion pictures, executable images, etc are stored in +$3$ore
respective directory path. Jhen AT5 boots up, these images are loaded to +$
$ore memory for operations.
Technically, it drives the AT5s using the controlling soft&are.
$;% Bidden Camera
!ome of the AT5s are fitted &ith hidden camera 1for example Jincor AT52
next to the 0ey +ad.
%ts function, there is no need to explain. $apture all your actions &hile you
are at the AT5 location.
$<% "ecurity !ock*
!ecurity locks for the $urrency $hest. This can be electronic or manual or can
be both.
%ts function is to lock the currency chest, either 72 Kormal manual lever
method and lock Or E2 /lectronic key using +ass&ord, (igital numbers.
Functionalities supported
AT5 supports the follo&ing functionalities
Cash 3ithdra=al
o Fast #ash$ Jhere pre3defined amount can be selected and &ithdra&n
&ith out much key selections involved.
o "ormal #ash$ Jhere customer needs to enter the re-uired amount.
o #ash %ithdra%al can be done from savings 9 checking or current 9
credit card accounts
#I8 change* +%K change &ith in issuing bank. +%K change of another bank
card also can be done in another bank AT5, if there is a net&ork tie3up
arrangement exists.
Balance In'uiry from savings 9 checking or current account.
Deposits
o $ash deposit
o $he-ue deposit
+ini "tatements &here last five or ten transactions are printed
Fund Transfer
o From &%n accounts ? !avings to $hecking , vice versa
o 'o third part( ) designated accounts &here transfer is permitted
through net&ork tie3up arrangements.
Check Truncation &here che-ue image is captured electronically in an AT5
and the image details are sent for clearing.
6alue Added "ervices
o 5obile Top up
o )tility Bill payments like ? /lectricity, Telephone, etc
"tatement #rinting 1if supported2
Transaction Flo=
A typical Balance en-uiry transaction flo& from savings account 1(ip card AT52 is
described belo&"
7. $ustomer inserts card
E. AT5 reads the card and re-uests +%K
F. $ustomer enters +%K
G. !&itch system verifies +%K
=. AT5 displays menu options
I. $ustomer selects Balance %n-uiry option from !avings
N. !&itch system send the transaction details to .ost !ystem 1example $ore Banking
!olution2
@. .ost system responds &ith reply
M. !&itch system intimates AT5
78. AT5 displays the result.
.o&ever, +%K verification flo& can be changed based on individual bank6s
re-uirement.
+oint of sale 1+O!2 or checkout is the location &here a transaction occurs. A
LcheckoutL refers to a +O! terminal or more generally to the hard&are and soft&are
used for checkouts, the e-uivalent of an electronic cash register. A +O! terminal
manages the selling process by a salesperson accessible interface. The same system
allo&s the creation and printing of the receipt. This section provides more insight into
the concepts of +oint of !ale 1+O!2
Introduction
A +oint of !ale is an electronic device that allo&s a bank6s customers to make
payment for their purchase of goods 9 commodities 9 merchandise.
They are called +O!, as these are placed at merchant6s locations i.e. at the point of
sale and enables buyers to make payment electronically. The debit cards or credit
cards can be used for such payments. The cards are s&iped in the +O! system and
customers are asked to sign on the charge slip or vouchers to confirm the payment.
/xamples for usage of +O! are 3
Grocery stores
Gas stations
(iscount superstores
Book stores
Ticket counters
+harmacies
.otels 9 #estaurants
A Brief Bistory*
.istory sho&s that +oint of !ale systems can be traced back to year 7@N8 &hen the
idea of developing $ash #egister &as mooted by Tohn #itty in (ayton since he faced
issues in his business for improper accounting of cash. #itty finally succeeded in
inventing a $ash #egister, patented and named as B#itty6s %ncorruptible $ashierD.
%n August 7MNF %B5 announced the %B5 FI=8 and FII8 !tore !ystems that &ere, in
essence, a mainframe computer packaged as a store controller that could control
7E@ %B5 FI=F9FIIF point of sale registers. This system &as the first commercial use
of client3server technology, peer to peer communications, Local Area Ket&ork 1LAK2
simultaneous and remote initialiation. By mid37MNG, it &as installed in +athmark
!tores in Ke& Tersey and (illard's (epartment !tores.
Today6s modern3day computer driven multi3faceted point of sale system is an
enhanced version of the earlier cash register. This has got more functionality and is
integrated &ith other host of applications.
Technical , 2perations
+oint of !ale systems is an electronic device having serial ports connected through a
leased or dials up line to the .ost system for transmitting the transactions for
authoriations. %t is controlled by the soft&are provided by the +O! machine vendor
and stores the transaction data in the terminal. /ach +O! machine must follo& the
data encryption standards 1(/!2 as per H%!A 9 5aster$ard norms and data is
encrypted &ith ()0+T 1(erived )ni-ue 0ey +er Transaction2. Transactions done
through +O! machines are encrypted &ith these security keys and are transmitted to
the .ost applications.
(uring /nd3of3(ay operations, merchant transmit the consolidated transaction data
as a batch to the .ost application. The consolidated transaction amount less the
charges applicable by the .ost service provider &ill be credited to the 5erchant6s
account after processing the transaction.
,e& examples of +O! vendors are"
7. Herifone
E. .ypercom
F. Kurit, etc
#arts,Components of a #2" machine
$% #2" :-lectronic Data Capture .-DC/ Terminal*
This is a normal +O! machine unit &hich contains data card slots, thermal printers,
LAK port, Jireless modem, internal pin9key pad, internal smart card reader, L/(
display unit and rechargeable battery.
&% A all in one #2" machines have the follo=ing parts*
7. +O! computer having $+) &ith +O! soft&are loaded by the vendor.
E. T,T 5onitor &ith key display
F. Bar3$ode scanner
G. $ash dra&ers
=. Graphical customer displays
I. 0ey Boards
N. 5agnetic !tripe #eaders 15!#2
@. +%K +ads
M. #eceipt printers
Functionalities "upported*
+O! systems support the follo&ing functionalities"
7. !ale and purchase Transactions
E. +reauthoriation transaction or blocking the funds.
F. Balance in-uiry 1only debit cards2
G. Hoid transaction &here transactions are cancelled by making it voids.
=. Ad4ustments
I. Tip3ad4ust 1restaurants only2
N. #efund
@. !ettlement of transactions 1 /nd of (ay operations2
Transaction flo=
7. 5erchant 9 $ustomer s&ipes the card in +O! machine
E. 5erchant enters the transaction amount.
F. $ustomer enters +%K 1if +%K re-uired2
G. +O! system encrypts the security key and transmits the data to !&itch
application.
=. !&itch system process the transaction"
a. %dentify issuer
b. Halidate the card
c. Halidate the +%K
d. #oute the transaction to destination system
I. !&itch system &ait for the response, receives it and send back to +O!.
N. +O! receives the transaction completion message. %f successful, prints the charge
slip9voucher for the amount.
@. $ustomer signs the voucher.
0iosks or Touch points are interactive electronic terminal &here selected banking
functionalities are provided like Bill payments, ,und Transfer, Balance en-uiries, etc
but no financial transactions involving cash is allo&ed. These 0iosks can also &ork as
informative kiosks only &here product information, application forms, etc are
displayed. 0iosks are &idely installed in retail shopping areas, bank premises, and all
other visible and prominent areas. This section provides more insight into the
concepts of 0iosks.
A Brief Bistory*
Tracing back the history of a 0iosk system sho&s that the first self3service,
interactive kiosk &as developed in 7MNN at the )niversity of %llinois at )rbana3
$hampaign by a pre3med student, 5urray Lappe. The content &as created on the
+LATO computer system and accessible by plasma touch screen interface and he
named it as OThe +lato .otline6. .e created this for allo&ing students and visitors to
find movies, maps, directories, bus schedules, extracurricular activities, courses and
email student organiations
The first successful net&ork of interactive kiosk used for commercial purposes &as a
pro4ect developed by the shoe retailer ,lorsheim !hoe $o. %n 7MM7 the first
commercial kiosk &ith internet connection &as displayed at $omdex. The application
&as for locating missing children.
The first touch screen is sho&n by /lotouch at the 7M@E Jorld's ,air in 0noxville, TK,
)!A. 7M@E is also the first year that the &ord L%nternetL is used.
Technical , 2perations
Technically, kiosks are similar in appearance like an AT5, but don6t have all the
features of an AT5. 0iosks are also controlled by the centralied s&itching system
like an AT5 terminal. Like an AT5 it is also a dumb terminal &here it follo&s the
instructions from the controlling s&itch.
+arts 9 $omponents of a 0iosk contain the follo&ing"
T,T L$( 5onitor
0iosk $omputer ?$+)
5agnetic $ard #eader
5%$# $heck reader
!ignature $apture $ard
Bill acceptor
#eceipt +rinter
Additional options 3 Jeb $am, !peakers, 5icrophone, etc
Functionalities "upported*
0iosks systems support the follo&ing functionalities"
Balance /n-uiry
,und 9 Jire Transfer
Bill +ayments
!tatement printing 1if supported2
%nformation 3+roduct %nformation, etc
Application capturing
$heck processing
Transaction flo=
The flo& for balance in-uiry in a 0iosk is as follo&s"
7. $ustomer s&ipes 9 inserts the card
E. $ustomer enters +%K and select Balance %n-uiry option
F. 0iosk system encrypts the security key and transmits the data to !&itch
application.
G. !&itch system process the transaction"
a. %dentify issuer
b. Halidate the card
c. Halidate the +%K
d. #oute the transaction to destination system
=. !&itch system &ait for the response, receives it and send back to 0iosks
I. 0iosk receives the transaction completion message and displays it.
Ket Banking needs no specific introduction as every one is currently living in a &orld
of an advanced technology &here almost every thing is possible at your finger tip.
The advent of the %nternet and the popularity of personal computers presented both
an opportunity and a challenge for the banking industry. ,or years, financial
institutions have used po&erful computer net&orks to automate millions of daily
transactions> today, often the only paper record is the customer's receipt at the point
of sale. Ko& that its customers are connected to the %nternet via personal
computers, banks envision similar economic advantages by adapting those same
internal electronic processes to home use. %n Banks vie&, online banking is a
po&erful Lvalue addedL tool to attract and retain the ne& customers. This help to
eliminate the costly paper handling and teller interactions in an increasingly
competitive banking environment.
A brief history
%n 7MM8 the Jells ,argo Bank, based in $alifornia )!A, introduced the &orld's first
online banking service. %t &as not until 7MMN that a similar service &as launched in
the )0 by the Kation&ide Building !ociety. !ince the introduction of the first services
many banks have started their electronic banking services &ith access available via
personal computer, mobile phone, or an interactive Television.
5any banks no& offer %nternet based services alongside their traditional banking
facilities, &hilst other organisations have established ne& breeds of '%nternet' or
'Telenet' banks. Telenet banks are those that allo& their customers to communicate
by telephone as &ell as the %nternet. 5ost of the )0's ne& '%nternet or 'Telenet'
offerings have the backing of large and &ell kno&n financial institutions.
Technical Architecture , 2perations
%nternet banking is usually conducted through a personal computer 1+$2 that
connects to a banking Jeb site via the %nternet. ,or example, a consumer at home
accesses a financial institution's Jeb site via a modem and phone line or other
telecommunications connection, and an %nternet service provider of that individual
country, such as AT*T JorldKet in )!A, Aortal9 B!KL 9 #eliance in %ndia, etc.
%nternet banking also can be conducted via &ireless technology through +ersonal
(igital Assistants 1+(A2 or cellular 9 mobile phones.
Components of 8et Banking*
*pplication Server$ An application server is a server program in a computer
in a distributed net&ork that provides the business logic for an application
program. The application server is fre-uently vie&ed as part of a three3tier
application, consisting of a graphical user interface 1G)%2 server, an
application 1business logic2 server, and a database and transaction server.
+nternet #onnectivit($ Ket connections either LAK 9 JAK or Jireless.
Bro%sers$ A bro&ser is soft&are that provides a &ay to vie& &eb pages. The
t&o most popular &eb bro&sers are 5icrosoftd %nternet /xplorer and
Ketscaped Kavigator.
Fire%all$ A fire&all is a small program that helps protect your computer and
its contents from outsiders on the %nternet or net&ork. Jhen properly
installed, it prevents unauthorised traffic to and from your +$.
,e- Server$ Jeb servers are computers on the internet that host &ebsites,
serving pages to vie&ers upon re-uest. This service is referred to as &eb
hosting. /very &eb server has a uni-ue address so that other computers
connected to the internet kno& &here to find it on the vast net&ork. The %+
1%nternet +rotocol2 address looks something like this" IM.MF.7G7.7GI. This
address maps to a more human friendly address, such as &&&.abcbank.com
Host *pplications &here financial transactions are transmitted for
authoriation. ,or example, $ore Banking solution.
The other concepts connected &ith Ket banking are"
Digital #ertificates$ A digital certificate is an electronic %( card that helps
establish your identity &hen doing business via the %nternet. !uch certificates
can be bro&ser based 1B!oft $ertificatesD2 or embedded into a smart card
1B.ard TokenD2 and used &ith special card readers.
.ncr(ption$ %nternet Banking uses 7E@3bit encryption, one of the most
advanced technologies available for safeguarding your online banking.
/ncryption is a process that transforms sensitive information into a string of
unrecognisable characters before they are sent over the %nternet. /ncryption
helps provide a secure channel for data transmission to keep information
private bet&een the bank's computer system and your %nternet bro&ser.
Secure Sessions$ Jhen you log in to %nternet Banking you are said to be in
a Bsecure sessionD. !!L technology is used &ithin your %nternet Banking
session to encrypt information before it leaves your computer, in order to
ensure that no one else can read it. !!L or !ecure !ockets Layer is a security
protocol created by Ketscape that has become an international standard on
the %nternet for exchanging sensitive information bet&een a &ebsite and the
computer communicating &ith it, referred to as the client.
#oo/ies$ $ookies are small files stored on a computer's hard drive. $ookies
are generally harmless and are used to recognise a user so that they can
receive a more consistent experience at a particular &ebsite. $ookies can
contain information about your preferences that allo&s customisation of a site
for your use.
Functionalities supported
Ket Banking system supports the follo&ing functionalities"
Account %n-uiries3Balance, transaction history, statement, loan limit, etc.
Account Opening ? (eposits, !tanding %nstructions 9 mandate, etc.
$heck stop payments 9 check book re-uests
,und Transfer
o To o&n account
o Third party account
o (esignated account ? +ayee maintenance account &here a template is
created for regular payees. )ser can select the desired payee from the
list available.
Bill +ayments to utility providers 1)+2 &ho have a tie up &ith the bank for this
purpose. %t is applicable only after the bank has assigned an account
1!AH%KG!9$)##/KT9GL or any other type2 to the )+.
+ass&ord 9 Address $hange, etc
Other services
o !tanding %nstructions 9 5andate
o Order (emand (raft
o #e-uest issue of Letter of $redits 9 Guarantee
5essage and bulletins
+roduct %nformation
Transaction Flo=
The flo& for Account %n-uiry in is as follo&s"
$ustomer enters +%K and Account Kumbers on Ket 1client bro&ser2
!!L encrypts the +%K and data and transmits to the Jeb !erver through
,ire&all.
Jeb !erver accepts the transaction message, authenticate the !!L
encryption. %f correct, &eb server sends the re-uest to Ket banking
application.
Ket banking application authenticates the +%K and re-uests the customer data
from .ost Application. ,or example, $ore Banking !olution.
.ost system provides the customer information to Ket banking system.
Jeb !erver collects customer data and displays in customer personal
computer.
Internet Banking Risks
%nternet banking creates ne& risk control challenges for banks. ,rom a supervisory
perspective, risk is the potential that events, expected or unexpected, may have an
adverse impact on the bank6s earnings or capital. The defined nine categories of risk
for bank supervision purposes are credit, interest rate, li-uidity, price, foreign
exchange, transaction, compliance, strategic, and reputation. These categories are
not mutually exclusive and all of these risks are associated &ith %nternet banking.
.o&ever, the most vulnerable risk is security risk on transactions.
"ecurity issues in online banking
%nternet security is al&ays an issue and is regularly commented upon in the media.
The %nternet is constantly changing and undergoing development and hence it is &ise
to make sure that you are using the latest version of a &ell kno&n %nternet bro&ser.
5ost data transferred over the %nternet is normally unencrypted. This means that
anyone intercepting that data can read it. This is normally not a problem as most
internet data is not sensitive or private. To protect the secrecy of any data you
transfer over the %nternet sensitive information can be encrypted using !!L.
!!L technology means that the any data you send or receive over the %nternet is
encoded in a &ay that makes it almost impossible to read by anyone that is not
supposed to receive it. All they &ill see is a meaningless stream of data if they try to
listen in on your transactions. The effectiveness of !!L is measured in bits 1binary
digits2. The latest &eb bro&sers support 7E@3bit encryption that provides a high level
of security that should foil all but the most determined federal authorities in decoding
its contents.
As &ith all computer based security there are a number of steps you should take
yourself to protect your security details"
Kever &rite do&n your %(, pass&ord or +%K number
Kever give them to anyone else
Kever send them via email 1email is KOT secure or private2
%f given the option to set a pass&ord for your %nternet banking service, never
use an obvious pass&ord or a pass&ord that someone &ho kno&s you might
guess
Jhen you have finished &ith your %nternet banking session, al&ays close your
bro&ser so that someone else can't access your account details after you
leave your +$.
Overall if you bear these guidelines in mind, then the likelihood of you being a victim
of any %nternet fraud is extremely lo& indeed.
5obile banking 1also kno&n as 53Banking, mbanking, !5! Banking etc.2 is a term
used for performing balance checks, account transactions, payments etc. via a
mobile device such as a mobile phone or +ersonal (igital Assistant 1+(A2. 5obile
banking today is most often performed via !5! or the 5obile %nternet but can also
use special programs, called clients, do&nloaded to the mobile device. This section
provides more insight into the concepts of 5obile Banking
Introduction
!ince the inception of alternate delivery channels like the AT5 and net banking there
has been a sea of change &itnessed in the servicing of customers by offering ne&er
products and services by Banks and financial institutions. Banks &ere al&ays &aiting
for some innovative &ays to encash the opportunities for business gro&th. Then
came the mobile banking revolution.
The O5obile6 phone gives the the user the mobility to carry it any&here he &ants.
5obile phones have penetrated deep in to the mass of population. As mobile
technology advances the features and functionality improve.
The tremendous progress and achievements noticed in telecommunication sector has
sho&n far reaching results to the Banking %ndustry also. Today, &ith the support of
latest technologies and secured net&orks, customer can conduct financial and non3
financial transactions effortlessly and securely.
A brief history
!ince inception of AT5 channels in 7MIM in Banking, the customers &idely accepted
the Obanking at their convenience6 concept though it didn6t provided full fledged
banking functionalities.
Banking revolutions continued since then. Ket Banking came in mid 7MM8s &ith a
broader outlook on Oconvenient banking6 concept &here %nternet banking enabled the
customers to operate their accounts at their convenience sitting at home or office.
.o&ever, penetration of net banking in to the mass population is still in developing
stages in some of the countries due to the non3availability of personal computers and
internet connectivity every &here.
The same period sa& explosive gro&th in mobile communication penetration in
developing markets like %ndia, $hina * 0orea, etc. These factors resulted in the
rollout of 5obile Banking services channel by Banks * financial institutions by
leveraging the advancements in mobile communication technology.
Technical Architecture , 2perations
A sample of 5obile banking architecture is provided belo&.
The 5obile Banking !ervices offered by a bank can be classified based on the
originator of service as +ush or +ull.
A +ush !ervice is &hen the bank proactively sends out information about
promotional activities offered by the bank or alerts based on certain rules
setup in the system. Best example is a !tructured 5essage !ervices 1!5!2
alert &hen your account is overdra&n.
A +ull service is &hen the customer re-uests for a service or information from
the bank and the bank sends the information to the customer in the form of a
!5! message. These are t&o3&ay exchanges as banks need to take some
action for the user re-uest.
5obile banking services can also be categoried based on the nature of
service as 7. Transaction Based and E. /n-uiry Based
A re-uest for mini statement is termed as an en-uiry based service &hile a
re-uest for fund transfer is termed as a transaction based service.
Components of +obile banking system*
5obile phones &ith net facilities
+hone Banking client application ? (o&n loaded from application service
provider.
5obile Operators ? Application !ervice +roviders
JA+ gate&ay
Jeb !erver
5essage +rocessing !erver
.ost Application 1for example, $ore Banking solution2
Functionalities supported
Transactions based services
o +ull Based
,und Transfer
Bill +ayment
!top $he-ue
o +ush Based
Ko services
%n-uiry based services
o +ull Based
%n-uiries ? Balance, !tatement, check status, check book
re-uest, recent transaction history, re&ards point, etc.
o +ush Based
Alerts ? $redit, (ebit, 5inimum balance, bill payment, payment
due, large transaction, check bounce, account overdra&n, etc.
Transaction Flo=
Jhen a customer applies for the mobile banking service, the customer is registered
for the service, the account number, mobile number and the rules based on &hich
the customer &ishes to get the messages are captured.
#4"B +essages*
The &ay +)!. messages &orks is"
The rules define the kind of +)!. messages the customer re-uire and also
the threshold amounts &hich &ould trigger the messages.
Jhen the system encounters an event &hich satisfies the rule setup for a
customer, then the message is triggered.
The !ystem could use standard templates to create message and send the
message to the customer.
#4!! +essages*
The &ay +)LL messages &orks is>
The customer re-uests for information by sending an !5! containing a
service command to a pre3specified number.
Based on the key&ord9 service command, the system &ill trigger action
retrieve information form the core banking application.
)sing a standard message template send the information in the form of a
!5! to the mobile number registered by the customer.
%nteractive Hoice #esponse 1%H#2 is a technology that allo&s a computer to detect
voice and dual3tone multi3fre-uency signaling 1(T5,2 keypad inputs. %H# technology
is used extensively in telecommunication, but is also being introduced into
automobile systems for hands3free operation. $urrent deployment in automobiles
revolves around satellite navigation, audio and mobile phone systems. %n
telecommunications, %H# allo&s customers to access a companyb]es database via a
telephone keypad or by speech recognition, after &hich they can service their o&n
in-uiries by follo&ing the instructions. %H# systems can respond &ith pre3recorded or
dynamically generated audio to further direct users on ho& to proceed. %H# systems
can be used to control almost any function &here the interface can be broken do&n
into a series of simple menu choices. %n telecommunications applications, such as
customer support lines, %H# systems generally scale &ell to handle large call
volumes. This section provides more insight into the concepts of %H#
3hat is an I6R
An %nteractive Hoice #esponse 1%H#2 processes inbound phone calls, plays
recorded messages including information extracted from databases and the
internet, and potentially routes calls to either in3house service agents or
transfers the caller to an outside extension.
%t is a soft&are application that accepts a combination of voice telephone
input and touch3tone keypad selection and provides appropriate responses in
the form of voice, fax, callback, e3mail and perhaps other media.
)sing computer telephony integration 1$T%2, %H# applications can hand off a
call to a human being &ho can vie& data related to the caller at a display.
%nteractive Hoice #esponse 1%H#2 systems, &ith more advanced voice automation
technologies, are used by many financial institutions to"
.andle routine and more complex transactions using the speech3driven
technologies to give customers faster, more convenient access to a &ide
range of information, from account in-uiries and mortgage balances to stock
prices, current interest rates, special services, and even the location of AT5s
in a far3a&ay city based on their calling location.
#educe service costs.
+rovide faster and convenient banking.
Boost overall customer satisfaction
$ustomer transaction and financial data are protected by incorporating advanced
encryption and security features.
+ublic and private sector businesses of all sies are using %H# technology for sales,
marketing, customer service, collections, in-uiry and support calls to and from their
organiation.
A brief history
Tracing back the history of %H# sho&s that it began in 7MG7 &hen Bell !ystems
developed a ne& tone dialing methodology, &hen they unveiled the first telephone
that could dial area codes using (ual Tone 5ulti ,re-uency signaling technology.
%t &as bet&een the periods 7MN83@8 &hen more companies started using the %H#
systems to automate tasks in call centers, the %H# technology started changing &hen
ne& competitors entered the market.
.o&ever, the %H# systems shot into prominence, &hen call centers began to migrate
to multimedia contact centers in late M86s. $ompanies invested in Jeb3enablement
and $omputer Telephony %ntegration 1$T%2 &ith %H# systems. %H# became vital for
call centers deploying universal -ueuing and routing solutions and acted as an agent
&hich collected customer data to enable intelligent routing decisions. The
introduction of the H:5L standard also simplified the integration process bet&een
%H# systems and any back end hosts.
.istorically, %H# solutions have used pre3recorded voice prompts and menus to
present information and options to callers, and touch3tone telephone keypad entry to
gather responses. 5odern %H# solutions also enable input and responses to be
gathered via spoken &ords &ith voice recognition. Technical Architecture 9
Operations involved
$alls are BreceivedD by the %H# and the caller is directed for the next step.
The caller &ill utilie a brief series of key presses on a touch3tone phone or
&ith voice recognition> the caller may optionally speak the selections &hen
prompted.
The application &ith %H# may be connected to the organiation6s data
processing systems to provide virtually any information or operation that you
&ish to make available.
%H# applications can dra& information from databases or input data or
responses gathered from each person they contact.
They can also gather input and make decisions based on spoken &ords &ith
voice recognition technology. $omponents of %H# 9 +hone Banking"
+!TK Line" +!TK 1public s&itched telephone net&ork2 is the &orld's collection
of interconnected voice3oriented public telephone net&orks, both commercial
and government3o&ned.
+rivate Branch /xchange 1+B:2" The %H# Application is connected to a +B:. A
+B: is a telephone system &ithin an enterprise that s&itches calls bet&een
enterprise users on local lines &hile allo&ing all users to share a certain
number of external phone lines. The main purpose of a +B: is to save the
cost of re-uiring a line for each user to the telephone company's central
office.
Jeb !ervers> Jeb servers are computers on the internet that host &ebsites,
serving pages to vie&ers upon re-uest. This service is referred to as &eb
hosting.
Hoice:5L" This is an application of the /xtensible 5arkup Language :5L
&hich, &hen combined &ith voice recognition technology, enables interactive
access to the Jeb through the telephone or a voice3driven bro&ser. An
individual session &orks through a combination of voice recognition and
keypad entry. This &as created through a collaboration of AT*T, %B5, Lucent
Technologies, and 5otorola, &ho &ere each &orking on their o&n approach
but 4oined forces to create an open standard.
Functionalities supported
%n-uiry
o Account Balance ? Loan9deposit, etc
o $he-ue status
o %nformation
o #ates
#e-uests
o !tatement #e-uests
o $he-ue book re-uests
o !top payment
o Last statement
o Last five transaction
o +%K change
o Lost 9 replacement card.
Bill +ayments
,und Transfer
!tanding %nstructions
Transaction Flo=
A sample %H# call flo& is sho&n belo&.
U $ustomer dial in to %H# system
U )pon receiving an incoming phone call, the %H# phone system triggers the
services to check for an %H# script.
U The %H# client process 1%H# Application2 invokes a server process on the %H#
phone system and starts a t&o3&ay communication.
U An %H# program controls the flo& of the %H# script by prompting the caller and
re-uesting key input or directing the caller to another service, extension, or Hoice
5ail.
A call centre or call center is a centralised office used for the purpose of receiving
and transmitting a large volume of re-uests by telephone. A call centre is operated
by a company to administer incoming product support or information in-uiries from
consumers. Outgoing calls for telemarketing, clientele, product services, and debt
collection are also made. %n addition to a call centre, collective handling of letters,
faxes, live chat, and e3mails at one location is kno&n as a contact centre.
Introduction
$all $enters or $ontact $enters is one of the most spoken terms &hen &e talk about
Business +rocess Outsourcing 1B+O2 as a cost cutting measure. Both terminologies
go hand3in3hand and it has caught the &orld6s attention in the recent past due to the
various industry outsourcing deals for establishing contact or call centers out of their
countries. Outsourcing to other countries can reduce operational expenditure.
.o&ever, differences in culture and language may have some problems for
customers, &hose dissatisfaction can lead to customer complaints also.
Je have noticed the mushrooming of call centers but at the same time they have
been a lot of help to the customers of various segments, including households,
industries like banking, insurance, customer care, transportation, etc as an easy &ay
of service9solution provider. The availability of call centers round the clock, helped
the service reach out to other geographies. %n countries &ith /nglish speaking
proficiencies, like %ndia, the visibility of call centers has reached far across globe,
making it a global hub for call centers.
A brief history
.istory sho&s that, $all centres originated as a cost3cutting measure by )!
companies several decades ago, but they only really started to take off in the )0 in
the 7MN8s. The initial centres &ere in3house operations in larger organisations and
they tended to share and be formed by the same basic assumptions and drivers.
The idea of a contact center &as to"
$luster the ma4ority of telephone based contacts &ith the customer in a single
department, so that people could focus 4ust on call3related services.
Benefit out by carefully managing &ith a clear focus on to provide efficient
service and reduce the service cost.
+erhaps one of the most useful evolutions of interactive voice response has been the
ability to provide accurate and satisfying EGhr support. Jhatever the business, %H#
permits companies to help their potential customers at 4ust about any time of the
day. This not only decrease expenses, but &ill also makes it easier for administrative
professionals to take care of calls coming in at strange periods or perhaps &hen the
telephone system is overloaded.
Technical Architecture
5ost of the $all $enters follo&s the %H# system for routing the customer calls, the
same architecture and operations are applicable to call center also. The call center
process starts &hen the call is diverted to an active agent or helpdesk person to
service the client.
Functionalities supported
5ultiple vendor products are available in the market for $all centers and most of
them provide the comprehensive functionalities. !ome of the generic functionalities
supported are"
7. %H#
E. !kills based routing
F. +redictive (ialer
G. Blended inbound9outbound,
=. 788A call recording
I. /mail facility
N. $hat &hisper coaching,
@. Barge3in,
M. !kills base routing
78. #emote agent,
77. #eports 9 logs, etc
Transaction Flo=
Transaction flo& is also similar to %H# 9 +hone Banking except %H# responding back
&ith pre3recorded message.
Jhen the call is diverted to an active agent, the agent &ill provide the
information customer re-uested for. .o&ever, an active agent does not have
the privilege to execute a financial transaction on behalf of the customer.
$all center personnel can have only limited access to vie& the customer data
like transaction, charges, interest, etc and sensitive data is masked from
visibility.
$all center personal can raise a re-uest on behalf of the customer to the
customer service executives for resolving it and responding to the client.
Banking Agents
A Banking Agent is retail or a postal outlet that processes clients6 transactions under
contract &ith a Bank9,inancial institution or a mobile net&ork operator.
These agents are usually e-uipped &ith a combination of point3of3sale 1+O!2
card reader, mobile phone, barcode scanner to scan bills for bill payment
transactions, +ersonal %dentification Kumber identification number 1+%K2 pads,
and sometimes personal computers 1+$s2 that connect &ith the bank6s server
using a personal dial3up or other data connection.
$lients that transact at the agent use a magnetic stripe bank card or their
mobile phone to access their bank account or e3&allet respectively.
%dentification of customers is normally done through a +%K, but could also
involve biometrics.
Jith regard to the transaction verification, authoriation, and settlement
platform, banking agents are similar to any other remote bank channel.
Local regulation &ill determine if financial institutions are allo&ed to &ork through
retail outlets. #egulators generally determine &hat kind of, if any, financial
institutions are permitted to contract banking agents, &hat products can be offered
at the retail outlets, ho& financial institutions have to handle cash transport, 0no&
;our $ustomer re-uirements, consumer protection, and other operational areas.
Globally, these retailers and post offices are increasingly utilied as important
distribution channels for financial institutions. The points of service range from post
offices in the Outback of Australia &here clients from all banks can conduct their
transactions, to rural ,rance &here the bank $redit Agricole uses corner stores to
provide financial services, to small lottery outlets in Brail at &hich clients can
receive their social payments and access their bank accounts.
T6 Banking
TH Banking is a ne& concept introduced recently in %ndia &hich aims at
revolutioniing Banking by bringing it into the customer6s living room. $ustomers can
access details and information regarding all banking services even if they do not
have internet access through a !atellite (T. or (igital $able connection.
The follo&ing services are available through TH Banking"
,eatures9 information on the Bank6s products
/ligibility criteria for products
5andatory documents
Loan /5% $alculators9$harts
$urrent offers
%nvestment updates
%nterest3rate charts
Branch9AT5 locator
!afe Banking Tips
.o& to pay bills online
.o& to give standing instructions on one6s credit card
Toll3free number for the client to reach the Bank or to apply for a product
Advantages*
$ustomer convenience 3 banking from one6s living room
%nternet connection not re-uired
Jider reach
EGxN availability
<ero charges
,inancial risk management is the practice of creating economic value in a firm by
using financial instruments to manage exposure to risk, particularly credit risk and
market risk. Other types include ,oreign exchange, !hape, Holatility, !ector,
Li-uidity, %nflation risks, etc. !imilar to general risk management, financial risk
management re-uires identifying its sources, measuring it, and plans to address
them. ,inancial risk management can be -ualitative and -uantitative. As a
specialiation of risk management, financial risk management focuses on &hen and
ho& to hedge using financial instruments to manage costly exposures to risk. %n the
banking sector &orld&ide, the Basel Accords are generally adopted by internationally
active banks for tracking, reporting and exposing operational, credit and market
risks.
The follo&ing topics are covered as part of #isk 5anagement "
%ntroduction
Anti 5oney Laundering
Asset Liability 5anagement
Basel3%%
%,#!
!arbanes3Oxley $ompliance
Banking is all about management of risk. Banks accept risk in order to make profits.
They must balance alternative strategies in terms of their risk9 return characteristics
&ith the goal of maximiing shareholder &ealth. %n doing so, the banks recognie
that there are different types of risks and that the impact of a particular investment
strategy on shareholders depends on the impact on the total risk of the organiation.
There are several risks for the purposes of bank supervision, the important among
them being" credit, interest rate, operational, li-uidity, market, price, compliance,
strategic or business, solvency, and reputation.
Introduction
$ommercial banks are private corporations that provide payments services, financial
intermediation, and other financial services in anticipation of earning profits from
those activities. The payments system and intermediation are re-uired for economic
gro&th. Like any other for3profit corporation, their principal goal is to maximie
shareholder &ealth. Thus, decisions on lending, investing, borro&ing, pricing, adding
ne& services, dropping old services, and other activities depend on the impact on
shareholder &ealth.
!hareholder &ealth is measured by the market value of a bank6s stock and the
amount of cash dividends paid. 5arket value depends on three factors" 172 the
amount of cash flo&s that accrue to bank shareholders, 1E2 the timing of cash flo&s,
and 1F2 the risk involved in those cash flo&s. 5anagement decisions involve
evaluating the impact of various strategies on the return and the risk of those cash
flo&s.
Types of Risks
Introduction to Risk in Banks
Banks make money in one of the t&o &ays
By providing services to customers
By taking risks
The former &ay provides very less or no margin to Banks
To be in business Banks must take risk
Banks take more risk it can expect to make more profits
Greater risk also increases the danger that the bank could lose badly and be
forced out of business due to bankruptcy
Risk: Return relationship in Banks
Jhile a positive risk3return relationship is presented for profitable Banks, the
risk3return relationship is negative for profitless banks.
Theoretically, a Bank taking a relatively high risk is supposed to earn high
profits.
.o&ever, Bankruptcy costs are relatively high for a Bank maintaining higher
risk exposure.
%f Bank is internationally active, such high risk exposure could also lead to
cascading effect to other Banks and thereby might lead to country6s
insolvency.
3hat should BankEs obAective be to respond to such sensitive ambience and
still make profits7
Banks must run their operations &ith t&o goals in mind
o Generate +rofit
o !tay in Business
To achieve above, t&o goals of risk management for every Bank should be"
o (ecide Bank6s /conomic $apital
/nsure that the risk being taken is matched to the bank6s
capital
Bank6s capital is considered much enough to absorb the losses
of bad situations
o Allocate Bank6s /conomic $apital
.elp the $/O direct the limited resource of capital to the
opportunities that are expected to create maximum return &ith
the minimum return.
o #isk 5easurement and 5anagement in Banks attempts to ans&er the
follo&ing four -uestions"
.o& much could &e loseQ
$alculate the risk measure
$an &e absorb a significant loss &ithout going bankruptQ
(ecide the economic capital
%s the return high enough for us to take that riskQ
$alculate the return after considering risk
.o& can &e reduce the riskQ
)se risk mitigation techni-ues
.edge #isk
Transfer #isk
(iversify #isk
Types of Risks in Banks Broad Classification*
The risk in Banks arises mainly through the exposure taken on various assets.
Typically, the key types of risk &ithin the assets of a firm are classified as follo&s"
U Credit risk ? losses associated &ith the default 1or credit do&ngrade2 of an
obligor 1a counterparty, borro&er or debt issuer2. Also called default risk>
U +arket risk ? losses associated &ith changes in market values>
U 2perational risk ? losses associated &ith operating failures.
2ther Financial Risk Types , Terminologies*
There are other financial risk variants too &hich more or less 1directly 9 indirectly2
could be considered part of the $redit, the 5arket and or the Operational risk. These
risk variants9 terminologies are necessary to understand the topics discussed in
subse-uent sections.
Interest Rate Risk*
The risk that an investment's value &ill change due to a change in the absolute level
of interest rates, in the spread bet&een t&o rates, in the shape of the yield curve or
in any other interest rate relationship.
%nterest rate risk is the risk to earnings and capital that market rates of interest may
change unfavorably. This risk arises from differences in timing of rate changes and
the timing of credit flo&s 1repricing risk2, from changes in the shape of the yield
curve, and from option values embedded in bank products. %n essence, the market
value of a bank6s assets 1i.e., loans and securities2 &ill fall &ith increases in interest
rates. %n addition, earnings from assets, fees and the cost of borro&ed funds are
affected by changes in interest rates. Banks can reduce their interest rate risk by
hedging &ith derivative securities and by using the asset9 liability management
techni-ues.
Banks fund these assets by liabilities on &hich they pay floating rates of interest. As
deposit interest rates increase, interest income drops. The risk is managed by
matching maturities and interest basis of assets and liabilities.
!i'uidity Risk* There are three types of Li-uidity #isks ? ,unding Li-uidity #isk,
Asset Li-uidity #isk and 5arket Li-uidity #isk.
Funding Li0uidit( Ris/ is the inability of a bank to raise funds at normal cost. $ost
of funds is a critical profitability driver of a bank, but is set in part by the market6s
perception of the bank6s risk and funding policy.
*sset Li0uidit( ris/ is the risk to earnings or capital related to a bank6s ability to
meet its obligations to depositors and the needs of borro&ers by turning assets into
cash -uickly &ith minimal loss, being able to borro& funds &hen needed, and having
funds available to execute profitable securities trading activities. Given the large
amount of bank deposits that must be paid on demand or &ithin a very short period,
li-uidity risk is of crucial importance in banking.
This risk has a direct bearing on the nature of bank6s assets. .olding a pool of assets
acts as a cushion against market li-uidity as it allo&s a bank to meet obligations
&ithout recourse to external financing. %n some regulatory environments, there is a
re-uirement to hold a specific percentage of assets in cash and bank balances to
protect against short3run obligations.
Mar/et Li0uidit( Ris/ relates to problems of transaction volume in markets. %n
volatile circumstances &hen counter3parties are un&illing to trade, prices can
become very volatile and spreads &iden. %n these conditions it may be very difficult
to li-uidate assets at a fair price.
Reinvestment Risk
The risk that the proceeds from a bond &ill be reinvested at a lo&er rate than the
bond originally provided.
Call Risk
$all #isk is the risk that a bond &ill be called by its issuer. $allable bonds have call
provisions post issuance generally on one of the interest payment date. This
provision allo&s the bond issuer to purchase the bond back from the bondholders
and retire the issue before maturity date. This is usually done &ith an expectation
that interest rates &ill fall and issuer is in a position to borro& at lo&er interest rates.
$all provisions allo& the issuer to retire the old, high3rate bonds and issue ne&
bonds 9 borro& at a lo&er rate.
Default Risk
The risk that the bond's issuer &ill be unable to pay the contractual interest or
principal on the bond in a timely manner, or at all.
Currency Risk or Foreign -1change Risk
%t is the risk to earnings or capital due to changes in foreign exchange rates. %t can
arise in three &ays vi., Transaction #isk and Translation #isk and /conomic #isk.
'ransaction Ris/ is a form of market risk and relates to the movement in the value
of the financial transaction due to exchange rate movements. Transaction risk causes
cash losses.
'ranslation Ris/ is a risk of an adverse impact on the balance sheet &hen foreign
assets are translated into the home currency for reporting purposes.
.conomic Ris/ is a risk that a bank could lose business to competitors in other
countries. This is due to the exchange rate bet&een currencies is more favorable to
the foreign banks.
"overeign , Country Risk*
A collection of risks associated &ith investing in a foreign country. These risks include
political risk, exchange rate risk, economic risk, sovereign risk and transfer risk,
&hich is the risk of capital being locked up or froen by government action. $ountry
risk varies from one country to the next. !ome countries have high enough risk to
discourage much foreign investment.
Traded Credit Risk
This risk applies to derivatives that buy and sell credit contracts. ,or example, if a
bank sells a futures option, on a credit agreement expecting interest rates to fall. %f
the interest rates rise, they &ould lose a potential profit.
Inflation Risk
The risk that the rate of price increases in the economy deteriorates the returns
associated &ith the bond. This has the greatest effect on fixed bonds, &hich have a
set interest rate from inception.
+anaging Risk in Bank at +acro !evel
three keys for risk3management"
deciding the target debt rating
determining the amount of available capital
allocating risk limits to each business unit &ithin the bank
Determining the Target Debt Rating
The debt rating is a measure of the bank's credit&orthiness and corresponds
to the bank's probability of default
A high debt rating corresponds to a lo& probability of default
o ,or example, AAA3rated Bank vs. A3rated Bank
The bank's credit&orthiness is determined by
o The amount of risks a bank takes
o The amount of capital a bank hold
$apital is the difference in value bet&een the bank's assets and liabilities. %t
can be vie&ed as the current net &orth of the bank
%f the bank has a small amount of capital and takes a large amount of risk,
there is a high probability that the losses &ill be greater than the capital, and
the bank &ill go bankrupt
%f the bank &ants a high rating, it must hold a large amount of capital in
relation to its risks.
o But a bank have to pay cost for holding extra capital in hand
o ,or example, by given fixed total profit of a bank, the average profit
for per capital &ill decreases &hen the amount of capital increases
A lo& target debt rating has the advantage that the bank can take on many
risks and expect to earn a high rate of return for the shareholders.
o .o&ever, a lo& debt rating means that debt holders &ill charge higher
interest rates to lend their money to the more risky bank
To conclude, a bank has to decide a suitable debt rating for itself and then
decide the capital it has to maintain.
Determining the Amount of Available Capital
The available capital is the current value of the assets minus the current value
of the liabilities
$apital X Kominal Asset Halue3Liabilities
%f the board &ishes to increase the capital -uickly, it can do so by issuing
more bank shares
This gives the bank more cash &ithout increasing the liabilities to avoid
default.
Alternatively, the capital can be increased over several years by retaining
earnings and not paying dividends to shareholders
Allocating Risk !imits
Once the target debt rating is set and the amount of available capital has
been calculated, the bank's total risk capacity is fixed
The next -uestion is ho& to allocate the total risk capacity to the different
business units
o #etail banking, $orporate Banking>
o Activities" #etail Lending, $orporate Lending, %nvestments 3trading,
credit cards, etc.
%n doing this it must consider
o the expected return and risk from each unit
o the diversification of the risk bet&een units
o %n general, &e &ill allocate most 1not all2 of the risk capacity to the
units that are expected to make the highest returns
4nderstanding Credit, +arket and 2perational Risk in Banks
!ources of different types of risk to Bank are the assets they hold. .ence to
understand the various types of risk, it is &orth to kno& the generic assets Banks
hold.
B'he assets are composed of all the items %hich are in possession of or due
to the -an/ (from customers1 other -an/s1 Govt21 etc1 and it relies upon
these assets to meet the lia-ilities %hich it o%es to others2D
4nderstanding Credit Risk
$redit risk is the risk of loss arising from the non3payment of principal *
interest 1obligation2 by the borro&er 1obligor2 on time.
Any amount of fund lent to a borro&er is exposed to certain level of credit risk
1unless lent to someone &ho is considered default risk free2.
The price of loan or debt instrument &hich has higher credit risk is high
relative to one &ith less credit risk. Banks add a premium on risk to the price
of the asset based on the level of credit risk they are exposed to. ,or instance
a loan given to business person might be highly priced &hen compared to a
loan given to a salaried person.
%t is usually associated &ith loans and investments, but it can also arise in
connection &ith derivatives, foreign exchange, and other extensions of bank
credit.
$redit risk is the primary cause of bank failures and Bank6s success depends
on ho& &ell this risk is managed.
$redit #isk arises due to the failure of the borro&er, endorser, guarantor or
counter3party to repay a loan or to honor another financial obligation.
$oncentration #isk" Besides the risk at the account or borro&er level, &hat
impacts banks more is the high concentration of credit in select industries,
similar profiled customers and 9 or geographies. A higher concentration of
credit, e.g., to one specific industry, surely leads to a bank failure if the
industry is into recession9economic do&nturn.
To avoid $oncentration #isk, Banks should diversify the credit portfolio across
various industries, Geographies and 9 or different customer profile.
Based on diversification of credit portfolio, risk limits 1maximum exposure2 for
each Banking +roduct9Asset, %ndustries, Geographies and 9 or customer
profile should be set. Also manager should monitor that at any given point in
time these limits are not violated.
An overall limit to&ards assets &hich expose to $redit risk is decided based
on the capital bank is prepared to devote to Bank lending9investment
activities. This sets the maximum exposure that a Bank can take into assets
&ith credit risk.
4nderstanding +arket Risk
5arket risk refers to changes in the value of financial instruments or contracts
held by a Bank due to unpredictable fluctuations in prices of traded assets
and commodities as &ell as fluctuations in interest and exchange rates and
other market indices.
Loss of money due to change in the value of an instrument.
!ource of 5arket risk is !ales and Trading Group activities of the Bank.
This group deals in investment activities of Bank and takes exposure in
tradable debt and e-uity securities, and derivatives and thereby exposes Bank
to 5arket risk.
5arket #isk ,actors"
o !tock price" ,or example, in a recession period, the !*+=88 index fall
do&n, then the price of the security a bank holds &ill fall do&n as &ell.
o /xchange rate" ,or example, if a Bank holds a foreign bond and the
foreign currency depreciates.
o %nterest rate" ,or example if a Bank holds a bond and the interest rate
increases.
5arket #isk involves the changes in e-uity and commodity prices and the
follo&ing areas"
o %nterest rate #isk
o $urrency #isk
o Traded $redit #isk
o Li-uidity #isk and
o +roduct #isk
4nderstanding 2perational Risk
(efinition" BThe risk of direct or indirect losses resulting from inade-uate or
failed internal processes, people and systems or from external eventsD.
Operating risk includes fraud and the possibility of a mistake being made.
%t includes Legal risks.
Operational risk does not include strategic risk Bthe risk of a loss arising from
a poor strategic business decision.
Operational risk does not include reputation risk Bdamage to an organiation
through loss of its reputation or standingD. !ince this could be result of
operational failures as &ell as other events.
Operational risk encompasses the efficiency and effectiveness of all back3
office operations including 5%!, personnel, compliance, external and internal
frauds, la&suits, and so on.
The /nron bankruptcy case &as mainly due to Operation #isk, specifically the
lack of transparency in financial statements, biased Audit practices, etc.
Operational #isk /vent Type $ategories"
o %nternal ,raud 3 misappropriation of assets, tax evasion, intentional
mismarking of positions, bribery, etc.
o /xternal ,raud3 theft of information, hacking damage, third3party theft
and forgery
o /mployment +ractices and Jorkplace !afety 3 discrimination, &orkers
compensation, employee health and safety, etc.
o $lients, +roducts, * Business +ractice3 market manipulation, antitrust,
improper trade, product defects, fiduciary breaches, account churning,
etc.
o (amage to +hysical Assets 3 natural disasters, terrorism, vandalism,
etc.
o Business (isruption * !ystems ,ailures 3 utility disruptions, soft&are
failures, hard&are failures, etc.
o /xecution, (elivery, * +rocess 5anagement 3 data entry errors,
accounting errors, failed mandatory reporting, negligent loss of client
assets, etc.
Risk from Different Bank Assets*
The assets discussed belo& include the usually held 1and not all2 assets by Banks.
Cash
Risk Associated*
Ko risk
Due from overnment Treasury*
Risk Associated*
$ountry 9 !overeign #isk
!oans and Advances*
Associated risk*
$redit 9 (efault #isk" Kon3payment of interest and 9 or +rincipal Amount
Credit Card Receivables*
Associated risk*
$redit 9 (efault #isk" Kon3payment of interest and 9 or +rincipal Amount
Investments in "ecurities 0 "hort Term and !ong Term*
%nvestments held by Bank include many variants of (ebt and /-uity !ecurities,
ranging from different maturities 1held to maturity category2 and tradable securities.
Belo& is a list of securities &ith the associated risk.
Bonds
Bond is a (ebt !ecurity, in &hich issuer of the Bond o&es the holders a debt. Based
on Bond terms issuer is obliged to pay interest 1on given terms -uarterly9semi3
annually9yearly2 and repay the principal at a later date termed as maturity.
Types of Bonds and Risks Associated*
Fi1ed Rate Bonds*
Bonds &ith fixed interest rate paid on agreed dates throughout the life of bond. On
maturity the issuer should repay principal to the bond holder.
Associated Risk*
$redit 9 (efault #isk" Kon3payment of interest and 9 or +rincipal Amount
%nterest #ate" The risk that Bond value &ill change &ith change in the interest rates.
Also reinvestment risk and inflation risk
Kero:Coupon Bonds*
Bonds issued at discount, pay no interest but principal repaid on maturity date. The
bondholder receives full principal amount on the redemption date. ,or instance,
<ero3coupon bond valued R788 but issued at discounted price RM=. On maturity date
the Bondholder receives principal amount of R788 1not the discounted value RM=2.
Associated Risk*
$redit 9 (efault #isk" Kon3payment of interest and 9 or +rincipal Amount
%nterest #ate" The risk that Bond value &ill change &ith change in the interest rates.
Also reinvestment risk and inflation risk.
Callable Bonds* Bonds that gives issuer the right 1may or may not exercise2 to
repay the bonds on the call dates &hich is before the maturity date.
Associated Risk*
$redit 9 (efault #isk" Kon3payment of interest and 9 or +rincipal Amount
%nterest #ate" The risk that Bond value &ill change &ith change in the interest rates.
Also $all #isk, reinvestment risk and inflation risk
Floating Rate 8otes*
1,#Ks2 have a variable coupon that is linked to a reference rate of interest, such as
L%BO# or /uribor. ,or example the coupon may be defined as three month )!(
L%BO# a 8.E8A. The coupon rate is recalculated periodically, typically every one or
three months.
Associated Risk*
$redit 9 (efault #isk" Kon3payment of interest and 9 or +rincipal Amount
%nterest #ate" The risk that Bond value &ill change &ith change in the interest rates.
Also reinvestment risk and inflation risk.
-'uity "ecurities*
All the e-uity securities that are traded on organied markets like !tock /xchanges.
Associated #isk" 5arket #isk and Li-uidity #isk
Derivatives* (erivative instruments are financial instruments &hich derive their
value from the value and characteristics of one or more underlying assets. They can
be divided into exchange3traded derivatives and over3the3counter 1OT$2 derivatives.
For=ards* $ontracts to purchase or sell a specific -uantity of a financial instrument,
a commodity, or a foreign currency at a specified price determined at the outset,
&ith delivery or settlement at a specified future date. !ettlement is at maturity by
actual delivery of the item specified in the contract, or by a net cash settlement.
Associated Risk* Kone
Interest Rate "=aps* $ontracts to exchange cash flo&s as of a specified date or a
series of specified dates based on a fixed and floating interest rates. $ash flo&s from
a fixed interest rate are s&apped &ith floating interest.
Associated Risk*
%nterest rate risk that originates from changes in the floating rate. %n a plain vanilla
fixed3for3floating s&ap, the party &ho pays the floating rate benefits &hen rates fall
and vice versa.
Currency s=ap*
A currency s&ap is a foreign3exchange agreement bet&een t&o parties to exchange
aspects 1namely the principal and9or interest payments2 of a loan in one currency for
e-uivalent aspects of an e-ual in net present value loan in another currency
Associated Risk* Kone
Futures* $ontracts similar to for&ards but &ith the follo&ing differences" futures are
generic exchange3traded, &hereas for&ards are individually tailored. ,utures are
generally settled through an offsetting 1reversing2 trade, &hereas for&ards are
generally settled by delivery of the underlying item or cash settlement.
Associated risk* 5arket #isk
2ptions* $ontracts that give the purchaser the right, but not the obligation, to buy
1call option2 or sell 1put option2 a specified -uantity of a particular financial
instrument, commodity, or foreign currency, at a specified price 1strike price2, during
or at a specified period of time. These can be individually &ritten or exchange3
traded. The purchaser of the option pays the seller 1&riter2 of the option a fee
1premium2 to compensate the seller for the risk of payments under the option.
Associated risk* 5arket #isk
Bo= Banks can lose money7
Generally Blends of (ifferent #isks
Often Banks lose money from an incident that involves several forms of risk
,or instance, the $ase of Barings Bank
Kick Leeson &as a trader in the !ingapore branch of Barings Bank. .e had
seemingly generated E8A of Barings profit in 7MMG.
%n fact, he had been making losses and hiding them n a fictitious account.
1Operating #isk2
To recover the losses he tried a large, risky gamble &ith derivatives on the
KikkieEE= index. 15arket #isk2
%n 7MM=, he lost R7 billion and consumed out Baring6s capital. .e &as able to
hide the original losses because he &as in charge of both trading and
accounting in the !ingapore office. 1Operation #isk2
.e &as able to take the final gamble on Kikkie because !enior 5anagement
had no effective oversight and 9 or measurement or the risks being taken.
1lack of risk management 9 measurement9 reporting tool2
Role of Capital in Banks
B$apital represents an ideal metric for aggregating risks across both different asset
classes and across different risk types. Jhy soDQ
This section explains the significance of $apital in Banks vis3`3vis any other firm.
Banks generate revenue by taking on more exposure to their customers and by
earning appropriate return to compensate for the risk of this exposure. %n general, if
a bank takes on more risk, it can expect to earn a greater return. The trade3off,
ho&ever, is that the same bank &ill, in general, increase the possibility of facing
losses to the extent that it defaults on its debt obligations and is forced out of
business.
Banks that are managed &ell &ill attempt to maximie their returns only through risk
taking that is prudent and &ell informed.
The primary role of risk management function in a bank is to ensure that the total
risk taken across the enterprise is no greater than the bank6s ability to absorb &orst3
case losses &ithin some specified confidence interval.
$apital represents the difference bet&een the market value of bank6s assets and the
market value of its liabilities.
$apital can be vie&ed as a buffer against insolvency.
$apital ade-uacy is a measure of bank6s ability to remain a going concern under
adverse conditions.
The primary role of capital in a bank is to act as a buffer to"
Absorb large unexpected losses
+rotect depositors and other claim holders
+rovide enough confidence to external investors and rating agencies on the
financial health and viability of the firm.
A Bank6s credit rating can be seen as a measure of its capital ade-uacy and is
generally linked to a specific probability that the firm &ill enter into default over
some period of time. Bank6s &hich hold more capital are able to take on more riskier
assets than firms of similar credit rating &hich hold less capital.
3hy Banks are regulated
Before kno&ing &hat are the regulations it is necessary to kno& &hy Banks are
regulated.
3hy are Banks regulated7
The most common ob4ectives of Bank regulation are"
#rotect the publicEs savings deposited in banks %f Banks have no
regulation on ho& they could use the funds collected from +ublic as (eposits.
The Bank employee6s definitely cannot use it for their personal purpose nor
could they use it to gamble or buy &eapons>
Control the money supply Banks are expected to maintain cash and li-uid
asset reserve ratio as mandated by the ,ederal 9 $entral Bank. They cannot
simply lend all the money they have collected from various sources like
deposits, e-uity capital, borro&ings, etc. %f they are allo&ed money supply
&ould increase, interest rates &ill fall do&n thereby impacting the economy of
the country.
-nsure ade'uate supply of loans and to ensure fairness +ricing of Bank
assets is regulated. ,or instance, in %ndia, the minimum price for a loan given
by bank should be at least the prime lending rate 1+L#2. They cannot lend at
a price &hich is belo& +L#. Like&ise, interest rates offered on (eposits are
also controlled. !ome of the Banks also provide subsidied rates for certain
loans e.g., ,arm Loans, special considerations for /ducational Loans. Banks to
promote economic gro&th are mandated by ,ederal9$entral Bank to perform
certain activities.
+aintain confidence in the Financial "ystem The regulations by ,ederal
#eserve Bank ensure confidence in system.
Avoid monopoly po=ers %magine if there &ere no such regulations on &ho
can act as Bank and the (o6s and (on6ts on banking business. +eople &ith
money &ould have had their o&n terms in lending money. These issues &ere
seen in traditional Banking system and &hich lead to many regulations
imposed on Banks.
#rovide support for overnment activities
"upport special sectors of the economy The sectors like agriculture,
%mport 9 /xport business, /ducation, .ealth $are, !cientific #esearch, etc.,
are promoted by Government and have been given certain special
considerations for the &elfare of the country per se.
Impact of Bank failure is high and could fail the Financial "ystem of
country% Generally failure in one Bank could cascade to the failure of several
Banks and their by collapse the economy.
Bank Regulatory -nvironment*
Bank regulations are government regulations &hich sub4ect banks to certain
re-uirements, restrictions and guidelines.
2bAectives of bank regulation The ob4ectives of bank regulation, and the
emphasis, vary bet&een 4urisdictions. The most common ob4ectives are"
+rudential 33 to reduce the level of risk bank creditors are exposed to 1i.e. to
protect depositors2
!ystemic risk reduction 33 to reduce the risk of disruption resulting from
adverse trading conditions for banks causing multiple or ma4or bank failures
Avoid misuse of banks 33 to reduce the risk of banks being used for criminal
purposes, e.g. laundering the proceeds of crime
To protect banking confidentiality
$redit allocation 33 to direct credit to favored sectors %nstruments and
re-uirements of Banks regulation
$% Capital Re'uirement
The capital re-uirement sets a frame&ork on ho& Banks must handle their
capital in relation to their assets.
The Bank for %nternational !ettlements6 Basel $ommittee on Banking
!upervision influences each country6s $apital re-uirement.
%n 7M@@, $ommittee introduced a capital measurement system through Basel
$apital Accord 1Basel %2
The latest capital ade-uacy frame&ork is commonly kno&n as Basel %%
&% Reserve Re'uirement
The minimum reserve each Bank must hold to demand deposits and bank
notes.
Banks, &here applicable, must hold li-uid assets as per the reserve
re-uirement stipulated by the country6s ,ederal Bank.
The purpose of minimum reserve is li-uidity.
(ue to global emphasis on $apital Ade-uacy, the minimum reserve
re-uirement has lost its significance.
Only fe& countries still have such minimum reserve re-uirement for their
Banks.
(% Corporate overnance $orporate governance re-uirements are intended to
encourage the bank to be &ell managed, and is an indirect &ay of achieving other
ob4ectives.
To be a body corporate 1i.e. not an individual, a partnership, trust or other
unincorporated entity2
To be incorporated locally, and9or to be incorporated under as a particular
type of body corporate, rather than being incorporated in a foreign
4urisdiction.
To have a minimum number of directors
To have an organisational structure that includes various offices and officers,
e.g. corporate secretary, treasurer9$,O, auditor, Asset Liability 5anagement
$ommittee, +rivacy Officer etc. Also the officers for those offices may need to
be approved persons, or from an approved class of persons.
To have a constitution or articles of association that is approved, or contains
or does not contain particular clauses, e.g. clauses that enable directors to act
other than in the best interests of the company 1e.g. in the interests of a
parent company2 may not be allo&ed.
9% Financial Reporting and Disclosure Re'uirements: Banks may be re-uired
to"
+repare annual financial statements according to a financial reporting
standard, have them audited, and to register or publish them
+repare more fre-uent financial disclosures, e.g. Vuarterly (isclosure
!tatements
.ave directors of the bank attest to the accuracy of such financial disclosures
+repare and have registered prospectuses detailing the terms of securities it
issues 1e.g. deposits2, and the relevant facts that &ill enable investors to
better assess the level and type of financial risks in investing in those
securities.
;% Credit rating re'uirement*
Banks may be re-uired to obtain and maintain a current credit rating from an
approved credit rating agency, and to disclose it to investors and prospective
investors. Also, banks may be re-uired to maintain a minimum credit rating.
<% !arge e1posures restrictions*
Banks may be restricted from having imprudently large exposures to individual
counterparties or groups of connected counterparties. This may be expressed as a
proportion of the bank's assets or e-uity, and different limits may apply depending
on the security held and9or the credit rating of the counterparty.
>% Related party e1posure restrictions*
Banks may be restricted from incurring exposures to related parties such as the
bank's parent company or directors. Typically the restrictions may include"
/xposures to related parties must be in the normal course of business and on
normal terms and conditions
/xposures to related parties must be in the best interests of the bank
/xposures to related parties must be not more than limited amounts or
proportions of the bank's assets or e-uity.
Banking Regulations*
,ollo&ing Banking regulations are in place to ensure the instruments to Banking
#egulations" 5inimum $apital #e-uirement, $orporate Governance and ,inancial
#eporting and (isclosures are practiced. The belo& listed are most commonly
follo&ed regulations by internationally active Banks.
Basel %% 1originally introduced as Basel $apital Accord2
Anti35oney Laundering 1A5L2
!arbanes3Oxley Act E88E 1!O:2
Asset Liability 5anagement 1AL52
%,#! 1originally %A!B2
Anti3money laundering 1A5L2 is a term mainly used in the financial and legal
industries to describe the legal controls that re-uire financial institutions and other
regulated entities to prevent or report money laundering activities. Anti3money
laundering guidelines came into prominence globally after the !eptember 77, E887
attacks and the subse-uent enactment of the )!A +AT#%OT Act. This section
provides more insight into the concepts of A5L.
3hat is +oney !aundering 7
5oney laundering, the metaphorical Lcleaning of moneyL &ith regard to appearances
in la&, is the practice of engaging in specific financial transactions in order to conceal
the identity, source, and9or destination of money, and is a main operation of
underground economy.
%n the past, the term Lmoney launderingL &as applied only to financial transactions
related to organied crime. Today its definition is often expanded by government
regulators 1such as the )nited !tates Office of the $omptroller of the $urrency2 to
encompass any financial transaction &hich generates an asset or a value as the
result of an illegal act, &hich may involve actions such as tax evasion or false
accounting.
As a result, the illegal activity of money laundering is no& recognied as potentially
practiced by"
%ndividuals,
!mall and large businesses,
$orrupt officials,
5embers of organied crime 1such as drug dealers or the 5afia2 or of cults,
and
$orrupt states, through a complex net&ork of shell companies and trusts
based in offshore tax havens.
As per )! La&s, money laundering has been defined as Bthe movement of illicit cash
or cash e-uivalent proceeds into, out of, or through the )nited !tates 1or2 )nited
!tates ,inancial %nstitutions 1,%s2.D
Anti +oney !aundering*
Anti3money laundering is a term mainly used in the finance and legal industries to
describe the legal controls that re-uire financial institutions and other regulated
entities to prevent or report money laundering activities. Anti money3laundering
guidelines came into prominence globally after the !eptember 77, E887 attacks and
the subse-uent enactment of the )!A +atriot Act.
Today, all financial institutions globally are re-uired to monitor, investigate and
report transactions of a suspicious nature to the financial intelligence unit of the
central bank in the respective country. ,or example, a bank must perform due
diligence by having proof of a customer's identity and that the use, source and
destination of funds do not involve money laundering. )nited !tates federal la&
related to money laundering is implemented under the Bank !ecrecy Act of 7MN8 as
amended by anti3money laundering acts up to the present.
#rocess of +oney !aundering*
5oney laundering is often described as occurring in three stages"
+lacement
Layering
%ntegration
U #lacement*
#efers to the initial point of entry for funds derived from criminal activities.
%nitiated &ith placement of illegally derived funds into financial system9
1generally an institution2.
(epositing cash into a Bank account.
Large amounts are broken into smaller less conspicuous amounts
(eposit of these small amounts in different times of a single or in multiple
financial institutions.
The exchange of one currency into another>
$onversion of larger denominations into smaller denominations>
%llegal funds converted into financial instruments like money orders,
securities, etc.,
+urchase of an insurance contract
$o3mingled &ith legitimated money to divert suspicion
U !ayering*
#efers to the creation of complex net&orks of transactions &hich attempt to
obscure the link bet&een the initial entry point, and the end of the laundering
cycle.
!tarts after the illegal money is entered into financial system9institution>
,unds, securities, insurance contracts, etc., are converted or moved to other
institutions to further separate them from their criminal source>
,unds are again used to purchase other securities, insurance contracts or
other easily transferable investment instruments>
These are sold through yet another institution>
,unds could also be transferred by a form of negotiable instrument such as
check, money order or bearer bond>
,unds may be transferred electronically to other accounts in various
4urisdictions>
+ay for goods or services>
Transfer the funds to a shell corporation>
U Integration*
#efers to the return of funds to the legitimate economy for later extraction.
%nvolves the integration of funds into legitimate economy>
Accomplished through purchase of assets, such as real estate, securities or
other financial assets, or luxury goods>
U The same three stages are also seen in terrorist financing schemes, except that
stage three integration involves distribution of funds to terrorists and their
supporting organiations>
The A5L Ket&ork recommends usage of terms .ide, 5ove and %nvest instead of
+lacement, Layering and %ntegration respectively.
2ccurrence of +oney !aundering and Terrorist Financing
5oney laundering and terrorist financing can occur in any country in the
&orld>
Generally targeted to countries &ith complex financial systems>
$ountries &ith lax, ineffective, or corrupt A5L and $ombating the ,inancing of
Terrorism 1$,T2 infrastructures are likely targets for such activities>
Ko country is exempt.
A+! Regulations*
5any 4urisdictions adopt a list of specific predicate crimes for money laundering
prosecutions as a Lself laundererL 1the )0 has an Lall3crimesL regime2. %n addition,
A5L9$,T la&s typically have other offences such as Ltipping off,L L&illful blindness,L
not reporting suspicious activity, and conscious facilitation of a money
launderer9terrorist financier to move his9her monies.
The 4"A !egislation*
The 5oney Laundering $ontrol Act of 7M@I made money laundering a federal crime.
%n the )nited !tates, ,ederal la& provides 1in part2" LJhoever . . . kno&ingflyg . . .
conducts or attempts to conduct . . . a financial transaction &hich in fact involves the
proceeds of specified unla&ful activity . . . &ith the intent to promote the carrying on
of specified unla&ful activity . . . shall be sentenced to a fine of not more than
R=88,888 or t&ice the value of the property involved in the transaction, &hichever is
greater, or imprisonment for not more than t&enty years, or both.L
A5L la&s also apply to terrorist financing, including any legally obtained funds if
intended for use in planning, committing, or concealing a terrorist act.
Three key la&s lay out the basic anti3money laundering obligations of )!
,inancial %nstitutions"
o The Bank !ecrecy Act 1B!A2 of 7MN8
o The 5oney Laundering $ontrol Act of 7M@I, and
o The )! +atriot Act of E88E 1Amended to above t&o la&s2
There are similar la&s for other countries too.
The anti3money laundering la&s are designed to prevent terrorists and other
criminals from utiliing ,inancial %nstitutions to commit their crimes.
4"A #ATRI2T ACT*
The )!A +AT#%OT Act, commonly kno&n as the L+atriot ActL
An Act of the ).!. $ongress and signed into la& by +resident George J. Bush
on October EI, E887.
Title of the Act is a contrived acronym, &hich stands for )niting and
!trengthening America by +roviding Appropriate Tools #e-uired to %ntercept
and Obstruct Terrorism Act of E887.
Act dramatically reduced restrictions on la& enforcement agencies' ability to
search telephone, e3mail communications, medical, financial, and other
records>
/ased restrictions on foreign intelligence gathering &ithin the )nited !tates>
/xpanded the !ecretary of the Treasury6s authority to regulate financial
transactions, particularly those involving foreign individuals and entities> and
Broadened the discretion of la& enforcement and immigration authorities in
detaining and deporting immigrants suspected of terrorism3related acts.
/xpanded the definition of terrorism to include domestic terrorism, thus
enlarging the number of activities to &hich the )!A +AT#%OT Act6s expanded
la& enforcement po&ers could be applied.
5no= Four Customer .5FC/*
0;$ is the due diligence that financial institutions and other regulated
companies must perform to identify their clients.
Banks ascertain relevant information pertinent to doing financial business &ith
them.
0;$ is a policy implemented to conform to a customer identification program
mandated under the Bank !ecrecy Act and )!A +AT#%OT Act.
0;$ policies are becoming increasingly important globally to"
o prevent identity theft fraud,
o money laundering and
o Terrorist financing.
%n a simple form these rules may e-uate to ans&ering t&elve -uestions, but
this is the tip of the iceberg and regulators no& expect much more.
0;$ should not be thought of as a format to be filled 3 it is a process to be
undergone from the start of a customer relationship to the end.
0;$ verifies that the customer is not on any list of kno&n fraudsters,
terrorists or money launderers, such as the Office of ,oreign Assets $ontrol's
!pecially (esignated Kationals list 1O,A$ List2.
This list contains thousands of entries and is updated at least monthly.
0;$ verifies customers on the sanctions lists too.
There are lists of third party vendors that track links bet&een persons
regarded as high3risk o&ing to negative reports in the media about them or in
public records.
0;$ controls6 monitors transactions of a customer against their recorded
profile, history on the customers account1s2 and &ith peers.
Banks doing 0;$ monitoring for A5L and $T, purposes increasingly use
specialied transaction monitoring soft&are, particularly names analysis
soft&are and trend monitoring soft&are.
The generated alerts identify unusual activity &hich is then sub4ect to due
diligence or enhanced due diligence 1/((2 processes that use internal and
external sources of information on the sub4ect, including the internet.
This helps to determine &hether a transaction or activity is suspicious and
re-uires reporting to the authorities.
%n the )! !A# is filed &ith ,inancial $rimes /nforcement Ket&ork 1,in$/K2.
Like&ise in the )0 reporting to !erious Organied $rime Agency 1!O$A2.
0;$ has different connotations and the definition above is from an A5L9$,T
perspective.
0no& ;our $ustomer processes are also employed by regular companies of all sies,
for the purpose of ensuring their proposed agents, consultants or distributors anti3
bribery compliance. Banks, insurers and export credit agencies are increasingly
demanding that customers provide detailed anti3corruption due diligence
information, to verify their probity and integrity.
A+! , CFT 0 Financial Action Task Force .FATF/*
The ,inancial Action Task ,orce 1,AT,2, also kno&n by its ,rench name Groupe
d'action financihre 1GA,%2, is an intergovernmental organiation founded in 7M@M by
the GN. The purpose of the ,AT, is to develop policies to combat money laundering
and terrorist financing. The ,AT, !ecretariat is housed at the head-uarters of the
O/$( in +aris.
The ,AT, ,orty #ecommendations and !pecial #ecommendations on Terrorist
,inancing"
The primary policies issued by the ,AT, are the ,orty #ecommendations on money
laundering and the M !pecial #ecommendations 1!#2 on Terrorist ,inancing 1T,2.
Together, the ,orty #ecommendation and !pecial #ecommendations on Terrorist
,inancing set the international standard for anti3money laundering measures and
combating the financing of terrorism and terrorist acts. They set out the principles
for action and allo& countries a measure of flexibility in implementing these
principles according to their particular circumstances and constitutional frame&orks.
Both sets of ,AT, #ecommendations are intended to be implemented at the national
level through legislation and other legally binding measures.
The ,AT, issued the ,orty #ecommendations in 7MM8 and completely revised them in
7MMI and E88F. The current 1E88F2 ,orty #ecommendations re-uire states, among
other things, to"
%mplement relevant international conventions
$riminalie money laundering and enable authorities to confiscate the
proceeds of money laundering
%mplement customer due diligence 1e.g. identity verification2, record keeping
and suspicious transaction reporting re-uirements for financial institutions
and designated non3financial businesses and professions
/stablish a financial intelligence unit to receive and disseminate suspicious
transaction reports, and cooperate internationally in investigating and
prosecuting money laundering.
The ,AT, issued @ !pecial #ecommendations on Terrorist ,inancing in October E887,
follo&ing the !eptember 77 terrorist attacks in the )nited !tates. The ,AT, issued a
ninth !pecial #ecommendation on Terrorist ,inancing in October E88G.
The !pecial #ecommendations on Terrorist ,inancing broadly extend the application
of the ,orty #ecommendations to terrorist financing and introduce ne& re-uirements
relating to services such as alternative remittance, &ire transfers and cash couriers
as &ell as non3profit organisations.
Financial Intelligence 4nit .FI4/
(efinition" A central, national agency responsible for receiving 1and, as
permitted, re-uesting2, analying, and disseminating to the competent
authorities, disclosures of financial information 1i2 concerning suspected
proceeds of crime, or 1ii2 re-uired by national legislation or regulation, in
order to counter money laundering.
,AT, re-uires countries to establish an ,%), &hich has three essential
functions"
o The collector or repository of reported information,
o Analysis function and,
o ,inancial information sharing for detecting and countering money
laundering and terrorist financing.
Features of A+! "ystem*
!atisfy #egulatory #e-uirements
!uspicious Activity 5onitoring
O,A$ and Other !anction List +rocessing
0no& ;our $ustomer
$ustomer (atabase !canning
+ayment 5onitoring
Be easy to use and change
+rovide long3term cost effectiveness
5ey Components of A+! Compliance "ystem*
Challenges in A+!*
!ophisticated techni-ues used to launder money and finance terrorism add to
the complexity of these issues.
Launderers are very creative" &hen overseers detect one method to filter
such activities, the criminals soon find another. .ence scenarios built in the
system to filter suspicious activities are not good enough>
A+! 2pportunities*
!oft&are industry is developed around providing soft&are"
To analye transactions to identify transactions or
To identify patterns of transactions that may constitute illegal financial
activity.
,inancial institutions face penalties for failing to properly file reports"
$ash Transaction #eport 1$T#2
!uspicious Activity #eport 1!A#2
A serious violation could lead to heavy fines and regulatory restrictions even
to the extent of charter revocation.
These soft&are applications effectively monitor bank customer transactions on
a daily basis and using customer historical information and account profile,
provide a L&hole pictureL to the bank6s A5L compliance management.
Transaction monitoring includes cash deposits and &ithdra&als, &ire
transfers, credit card activity, che-ues 1checks2, share 1securities2 dealing
and Automated $learing .ouse 1A$.2 activity.
%n the banking terminology, these applications are kno&n as LA5L soft&areL.
%n banking, asset and liability management is the practice of managing risks that
arise due to mismatches bet&een the assets and liabilities 1debts and assets2 of the
bank. This can also be seen in insurance. Banks face several risks such as the
li-uidity risk, interest rate risk, credit risk and operational risk. Asset Liability
management 1AL52 is a strategic management tool to manage interest rate risk and
li-uidity risk faced by banks, other financial services companies and corporations.
Banks manage the risks of Asset liability mismatch by matching the assets and
liabilities according to the maturity pattern or the matching the duration, by hedging
and by securitiation. This section provides more insight into the concepts of Asset
Liability 5anagement
Introduction
AL5 process involves managing Bank6s assets and liabilities &ith the scope of
follo&ing functions.
Li-uidity #isk 5anagement
%nterest3rate risk management
,unding and capital planning
+rofit planning and gro&th pro4ection
A!+ 2rganiDation
The Bank directors have overall responsibility of managing AL5 risks and
should have risk management policy of the bank.
A committee BAsset Liability $ommittee 1AL$O2 consisting of senior
management including $/O should be set up.
An AL5 desk consisting of operating staff should be responsible of analying,
monitoring and reporting the risk profiles to the AL$O.
The AL$O is a decision making unit.
A!+ is a strategic management tool to manage t=o types of risks*
%nterest3#ate #isk" The interest3rate risk arises from the possibility that
profits &ill change if interest rates change.
,unding3Li-uidity #isk" The li-uidity risk arises from the possibility of losses
due to the bank having insufficient cash on hand to pay the obligations 19 or
to the customers2.
Both risks are due to the difference 9 mismatch bet&een Bank6s assets and
liabilities.
4nderstanding Interest:rate risk for A!+*
'he -est illustration of +nterest-rate ris/ for *LM $ !2S2 savings and
loan (S3L crisis
o !avings and loan banks" retail banks, receive retail deposits and make
retail loans
o ,or many years, interest rates &ere stable. (eposits for around GA
1floating rate2, and they lent F83year mortgages paying about @A at
fixed rates.
o Then in the 7M@8s, the ,ederal #eserve allo&ed interest rates to float.
!hort3term interest rates rose to 7IA.
o 5any deposit customers &ithdre& their funds or demanded the higher
rates.
o The rate of mortgages is fixed &ith @A, ho&ever the rate of deposits is
floating and the banks have to pay 7IA for the deposits of customers.
o This caused the banks a lot of loss and most banks &ere bankrupt.
o The cascading effect impacted entire Banking system not 4ust in )!
but also in other countries.
Some pointers from the a-ove illustration of *LM$
o The rate of deposit is floating and the rate of mortgage is fixed.
o The deposit 1loan2 is more 1less2 sensitive to interest rate.
o O#, the (eposits 1the bank6s liabilities2 are rate3sensitive and the
5ortgages 1Bank6s assets2 are rate3insensitive.
o The interest rate risk rises &hen risk sensitive liabilities 1#!L2 are not
e-ual to risk sensitive assets 1#!A2.
4nderstanding Funding:!i'uidity Risk for A!+
The funding3li-uidity risk arises from mismatches bet&een the assets and
liabilities.
This risk arises because banks generally fund themselves &ith liabilities that
have very short contractual maturity 1e.g., demand deposits such as checking
accounts2.
Banks take the money they receive from these liabilities, set aside a small
amount in cash, and invest the rest in assets that have long maturity, e.g.,
commercial loans.
%n general, customers leave most of their money in the demand deposits for a
long time, and the small amount of cash that the bank sets aside is sufficient
to meet customers' re-uests for &ithdra&als.
.o&ever, if &ithdra&als are unusually high, there is a risk that the bank
&ould not have enough cash to meet the demand.
%n such a situation, the bank's choices can be simplified into three"
o Borro& money from other banks, if they are &illing and able to supply
more cash>
o !ell some of the loans, possibly at deeply discounted prices>
o (efault to the customers, and go out of business.
This risk of defaulting or being forced to sell at a loss is called funding3
li-uidity risk or cash3crisis risk.
,unding3li-uidity risk is different from the li-uidity risk pertaining to trading
risk.
The li-uidity risk in trading arises from the possibility of the bank6s losing
money by being locked into a position that is losing value.
But in AL5, &e are concerned that the bank &ill be unable to raise enough
cash to pay its customers, or that it &ill be forced to sell 1Lcash inL2 assets at
an a&k&ard moment, incurring a significant li-uidation cost.
Basel %% is the second of the Basel Accords, &hich are recommendations on banking
la&s and regulations issued by the Basel $ommittee on Banking !upervision. The
purpose of Basel %%, &hich &as initially published in Tune E88G, is to create an
international standard that banking regulators can use &hen creating regulations
about ho& much capital banks need to put aside to guard against the types of
financial and operational risks banks face. Advocates of Basel %% believe that such an
international standard can help protect the international financial system from the
types of problems that might arise should a ma4or bank or a series of banks collapse.
%n practice, Basel %% attempts to accomplish this by setting up rigorous risk and
capital management re-uirements designed to ensure that a bank holds capital
reserves appropriate to the risk the bank exposes itself to through its lending and
investment practices. This section provides more insight into the concepts of Basel3
%%.
Background of the Basel Capital Accord
The Basel Accords refer to the banking supervision Accords 1recommendations on
banking la&s and regulations2, Basel % and Basel %% issued 1and Basel %%% under
development2 by the Basel $ommittee on Banking !upervision 1B$B!2. They are
called the Basel Accords as the B$B! maintains its secretariat at the Bank of
%nternational !ettlements in Basel, !&iterland and the committee normally meets
there.
%n 7M@@, the Basel $ommittee on Banking !upervision 1B$B!2, a group of banking
regulators from leading industrialied nations, established regulations regarding the
amount of capital banks hold against credit risk. The ma4or impetus for this Accord
&as the concern of the Governors of the G78 central banks that the capital of the
&orld's ma4or banks had become dangerously lo& after persistent erosion through
competition.
Introduction to Basel Accord
Basel3% &as original Basel Accords, &hich are recommendations on banking la&s and
regulations issued by B$B! in Tuly 7M@@.
Basel % &as motivated by t&o interacting concerns"
The risk posed to the stability of the global financial system by lo& capital
levels of internationally active banks, and
The competitive advantages accruing to banks sub4ect to lo&er capital
re-uirements. ,undamental Ob4ectives of Basel % Accord"
o !trengthening the soundness and stability of the international banking
system.
o (iminishing an existing source of competitive ine-uality among
international banks
-lements of the Basel I Accord
The Basel $ommittee released its final version of the Basel % Accord in Tuly 7M@@. The
elements of the accord &ere"
+rovided $apital Ade-uacy !tandards
$ommon frame&ork for capital measurement
Addressed only $redit risk in the Original Accord
5arket risk &as addressed later in 7MMI as amendments to original Accord
The basic approach &as"
o Assign each asset or off3balance sheet item held by a bank to one of
five risk categories
o $alculate the capital re-uired for each asset or item based on risk
&eighting, and
o Add all these amounts to produce the total minimum capital to be held
by the bank.
Basel I Capital Ratio , Cooke Ratio
1Total $apital2 9 1Jeighted $redit #isk a Jeighted 5arket #isk2 WX @A,
&herein risk &eight is flat per cent rate per asset category.
The Accord provided t=o minimum capital ratios*
Bank6s $ore $apital or Tier 7 $apital" At least GA of risk &eighted assets
Bank6s Total $apital or Tier E $apital" At least @A of risk &eighted assets
Definition of Capital in Basel I .Capital -lements/*
Tier 7 included"
o +aid )p !hare $apital 9 $ommon !tock
o (isclosed #eserves
Tier E included"
o )ndisclosed reserves
o Asset revaluation reserves
o General +rovision or Loan3loss reserves
o .ybrid 1(ebt 9 /-uity2 $apital instruments
o !ubordinated debt
Limitations and #estrictions
o Total of Tier E elements limited to a maximum of 788A of total of tier
7 elements.
o !ubordinated term debt limited to a maximum of =8A of Tier 7
elements.
o Loan3loss reserves limited to a maximum of 7.E= percentage points.
o Asset revaluation reserves that take the form of latent gains on
unrealied securities sub4ect to a discount of ==A.
Dra=backs , "hortfalls in Basel I Capital Accord
Limited guidelines for credit risk and collateral evaluation
!overeign 9 $ountry #isk &as totally ignored &hile there &ere specific cases
of country economy facing collapse.
Ko re&ard for good credit risk practices
Ko distinction bet&een high3risk and lo&3risk loan portfolios
Ko guidelines for ad4usting collateral value
Ko ad4ustments for sovereign9country risk
General tendency &as that more than re-uired capital &as set aside by Banks
impacting their +rofitability.
Ko attention to operational risk
Operational #isk" Ko standards for assessing levels of operational risk
Introduction to Basel:II
Basel %% is the second of the Basel Accords, &hich are recommendations on banking
la&s and regulations issued by B$B!. These accords &ere originally published in Tune
E88G.
#urpose of Basel II
Addressing the limitations of Basel % Accord
+rovide more risk sensitive 5inimum $apital calculation ,rame&ork
Goals of Basel %%"
To discourage the manipulation and mishandling of regulatory capital.
To re&ard banks that reduced their business risk levels by improving their
risk management systems.
Areas of !pecial Attention
$redit #isk
Operational #isk
"cope of Application of Basel:II
,rame&ork is applied on a consolidated basis to internationally active banks.
The .olding company 9 parent entity should ensure that it captures the risk of
the &hole banking group.
The frame&ork &ill also apply, on a fully consolidated basis, to all
internationally active Banks at every tier &ithin a Banking group.
%ndividual Banks under a Group9 parent Bank are ade-uately capitalied on a
stand3alone basis.
"tructure of Basel II : The Three #illars
The Basel %% regulations are structured as three pillars as given in the picture.
#illar I : +inimum Capital Re'uirements
Calculation of +inimum Capital Re'uirements
o $alculation of the total minimum capital re-uirements for $redit,
5arket and Operational #isk
o $alculated using definition of regulatory capital and risk3&eighted
assets
o Total $apital #atio must be no lo&er than @A.
o Tier E $apital is limited to 788A of Tier 7 $apital.
5aintenance of $apital for three ma4or components of risk" $redit risk, 5arket
#isk and Operational #isk
#egulatory $apital
o Tier 7 $apital as per Basel %
/-uity $apital a (isclosed #eserves from +ost Tax #etained
/arnings
,ollo&ing deductions must be made from Tier 7
Good&ill
%ncrease in e-uity capital resulting from a securitiation
exposure
%nvestments in subsidiaries engaged in banking and
financial activities &hich are not consolidated in national
systems
o Tier E $apital
Other elements, other than those included in Tier 7 capital &ill
be admitted into Tier E limited to 788A of Tier 7. The Tier E
includes"
)ndisclosed reserves
#evaluation reserves
General provisions 9 general loan loss reserves
.ybrid (ebt $apital %nstruments
o Tier F $apital
!hort3term subordinated debt covering market risk
Tier F capital &ill be limited to E=8A of a bank6s Tier 7 capital
that is re-uired to support market risks.
Risk 3eighted Assets
o Total risk &eighted assets are determined by multiplying the capital
re-uirements for market risk and operational risk 1i.e., reciprocal of
the minimum capital ratio of @A2 and adding the resulting figures to
the sum of &eighted assets for credit risks.
Calculation of Credit Risk B$B! permits Banks to calculate capital
re-uirements for credit risk by t&o approaches"
o !tandardied manner supported by external credit assessments
!tandardied Approach
o %nternal rating based approach, &hich is sub4ect to explicit approval of
the bank6s supervisor and allo&s use of internal rating6s system. The
approach has t&o versions of credit risk calculation.
,oundation ? %nternal #atings Based Approach 1,3%#B2
Advanced ? %nternal #atings Based Approach 1A3%#B2
Calculation of Credit Risk 0 "tandardiDed Approach
o #isk &eights are based on the credit rating9assessment of the assets
This is a revision of Basel % intended to make more risk
sensitive
$redit rating provided by external credit assessment institutions
1/$A%2 is used.
,or each category of rating, a #isk &eight is defined.
The risk &eights range from E8A =8 7=8A for all the assets
except for past due loans and securitied assets.
,or past due over M8 day, net of specific provisions" the
&eights range from =8A to 7=8A based on the specific
provisions made for these loans.
#isk &eights on $laims from Banks cannot be lesser than the
risk &eight given to its !overeign of incorporation.
There are thirteen categories of risk &eights defined by Basel %%
in this approach.
#isk Jeighted Assets 9 #isk Ad4usted Assets X Asset /xposure
1e.g., $laims from sovereigns2 : risk &eight. This is calculated
for each of the assets.
The total of all risk &eighted assets is considered as /xposure
at (efault and is substituted in the capital charge calculation
formula.
$apital $harge" $apital charge is a function of the follo&ing
components.
+robability of (efault 1+(2
Loss Given (efault 1LG(2
/xposure at (efault 1/A(2 and
5aturity
Calculation of Credit Risk 0 Foundation Internal Rating Based
Approach
o )nder %#B approach, sub4ect to certain minimum conditions and
disclosure re-uirements and supervisory approval for use of this
approach, banks may rely on their o&n estimate of risk components in
determining capital re-uirements for a given exposure.
o Banks must classify their banking book exposures in six broad classes
of assets" $orporate, !overeign, Bank #etail, /-uity and purchased
receivables. Also should identify = sub classes &ithin $orporate and F
sub lasses &ithin retail asset classes>
o Bank should internally create a +robability of default estimates for
each of this assets categoried. Apply the Bank calculated estimates of
+robability of default and rely on supervisory estimates for other risk
components" LG(, /A( and 5aturity.
o $alculate the capital charge based on above.
Calculation of Credit Risk 0 Advance Internal Rating Based Approach
o The only difference in this approach from the ,oundation one is Banks
create models to compute their o&n estimates for risk components"
+(, LG( and /A( and their o&n calculation of 5aturity 152 sub4ect to
meeting minimum standards.
o Apply the computed risk components to calculate the capital charge.
Calculation of +arket Risk ,or 5arket #isk the preferred approach is Halue
at #isk 1Ha#2 &hich provides the output /xpected Loss from asset exposure
to&ards 5arket risk.
Calculation of 2perational Risk
o Basel %% has given guidance to F broad methods of $apital calculation
for Operational #isk. They are"
!tandardied Approach 1T!A2
Basic %ndicator Approach 1B%A2
Advanced 5easurement Approach 1A5A2
Basic Indicator Approach 3 based on a fixed percentage 1or alpha2 of the
Bank6s annual gross income.
"tandardiDed Approach ? Basel %% identifies @ business lines and for each of
these provides Beta ,actor in percentage 1risk ad4ustment factor2 for
ad4usting the gross income to derive the capital charge. The capital charge is
obtained by multiplying gross income of each of the business lines of a bank
by a fixed percentage 1beta factor2 and summing across business lines.
Advanced +easurement Approaches ? )nder this method the regulatory
capital re-uirement &ill depend on the risk measure generated by the bank6s
internal operational risk management system. .o&ever, in order to use this
approach, the bank must demonstrate that its operational risk measure meets
a soundness standard comparable to that of %#B approach for credit risk.
Banks &ill arrive at the /xpected Loss as an output of their measurement
system.
U #illar II
!upervisory #evie& +rocess
o /nsure !ound +rocesses
o /nsure ade-uate capital at all times
o /nsure motivation for improving risk management practices
U #illar III
5arket (iscipline
o Vualitative and -uantitative disclosure of undertaken risks and risk
methodologies
Issues and Challenges*
(epending on its current risk management processes, sie, customers, portfolio, and
market, a particular bank is likely to experience varying effects of Basel %% on at least
four levels, as described belo&.
Internal Impact*
Basel %%6s focus on enhanced risk sensitivity &ill prompt an enhanced focus on
economic capital management, versus regulatory capital management, because the
Ke& Accord drives banks to measure their performance against risk factors other
than market share or expected return.
)nder Basel %, most banks &ere volume driven> Basel %% drives them to become risk3
return driven. Once banks can attribute risk to a potential transaction, product, or
process, they can ascribe a portion of economic capital to it 1based on the risk it
poses2, define an expected return on it, consider ho& best to price it, consider risk
mitigating techni-ues, and thereby decide, for example, &hether to enter a
transaction, engage in a business, or pursue an activity or process.
Customer Impact*
%mproved risk management and data flo&s should enable banks to identify target
clients, evaluate their customers in a more thorough &ay than they might have done
in the past, and determine &hether to retain certain customers.
Banks &ill need to re-uest ne& and timely information from borro&ers to perform
the internal rating assessments and the collateral evaluation that are essential to
Basel %%6s risk calculation process.
The standardied credit risk approaches re-uire external rating of most borro&ers to
be taken into account. Thus, external ratings agencies ac-uire ne& importance under
the Ke& Accord.
$ertain markets &ill remain accessible to un3rated borro&ers, but they are likely to
face premium pricing, as lenders &ould have to set aside additional capital to cover
the risks they pose. 5oreover, even un3rated borro&ers &ill find that banks are
re-uired to rate them internally.
Business Impact*
Although banks reduce their credit risk in their transactions, their operational risk
may rise. ,or example, a bank may choose to sell a securities portfolio to a special
purpose vehicle 1!+H2 or transfer credit risk via a derivatives transaction.
Jhen it does so, the bank needs to designate separate people, processes, and %T
systems to that !+H and ensure proper management of related legal issues to
mitigate risks. 5oreover, increased overall operational risk may re-uire higher
regulatory capital, &hich partly may offset savings on the credit side.
Banks may also discover that their best and9or largest customers no longer need
their services. !uch companies can access the capital markets directly ? by issuing
bonds, e-uity, or asset3backed securities ? and are as likely to do so as a bank.
#etaining such customers could become a challenge.
lobal Impact*
The banking industry6s improved risk management, enhanced information flo&s, and
related disclosures could drive parallel improvements in the stability of the financial
markets.
Ke& disclosures &ill provide regulators &ith Bearly &arningsD that banks or rating
agencies could pass on to the public and investors, potentially enhancing trust in the
financial markets.
,or the individual institution, the challenge &ill be to determine ho& to translate
internal risk management into external disclosures.
!cenario analysis of both credit and operational risk ? and to &hat extent to disclose
such analysis ? becomes increasingly important for banks in an environment in &hich
regulatory capital is aligned &ith economic risks.
Basel %%'s disclosure re-uirements are intended to allo& market participants to assess
key pieces of information on the scope of application, capital, risk exposures, risk
assessment processes, and hence the capital ade-uacy of the institution.D
!uch information has increased importance and potential value under Basel %%, in
&hich banks have ne& license to rely on internal models and ratings to determine
their capital re-uirements.
2vervie= of Basel II implementation*
#egulators in most 4urisdictions around the &orld plan to implement the ne&
Accord, but &ith &idely varying timelines and use of the varying
methodologies being restricted.
The various ).!. regulators have agreed on a final approach.
They have re-uired the %#B approach for the largest banks and the
standardied approach &ill not be available to anyone.
%n %ndia, #B% has implemented the Basel %% standardied norms on F7st 5arch
E88M and is moving to internal ratings in credit and A5A norms for
operational risks in banks.
%n response to a -uestionnaire released by the ,inancial !tability %nstitute
1,!%2, M= national regulators indicated they &ere to implement Basel %%, in
some form or another, by E87=.
The /) has already implemented the Accord via the /) $apital #e-uirements
(irectives and many /uropean banks already report their capital ade-uacy
ratios according to the ne& system. All the credit institutions adopted it by
E88@.
Australia, through its Australian +rudential #egulation Authority, implemented
the Basel %% ,rame&ork on 7 Tanuary E88@.
%nternational ,inancial #eporting !tandards 1%,#!2 are principles3based !tandards,
%nterpretations and the ,rame&ork 17M@M2 adopted by the %nternational Accounting
!tandards Board 1%A!B2. 5any of the standards forming part of %,#! are kno&n by
the older name of %nternational Accounting !tandards 1%A!2. %A! &ere issued
bet&een 7MNF and E887 by the Board of the %nternational Accounting !tandards
$ommittee 1%A!$2. On 7 April E887, the ne& %A!B took over from the %A!$ the
responsibility for setting %nternational Accounting !tandards. (uring its first meeting
the ne& Board adopted existing %A! and !%$s. The %A!B has continued to develop
standards calling the ne& standards %,#!. This section provides more insight into the
concepts of %,#!.
Introduction to IFR"
%,#! are principles3based !tandards, %nterpretations and the ,rame&ork
adopted by the %nternational Accounting !tandards Board 1%A!B2.
,rame&ork for the +reparation and +resentation of ,inancial !tatements.
Originally kno&n as %nternational Accounting !tandards 1%A!2 and &ere issued
bet&een 7MNF and E887 by %nternational Accounting !tandards $ommittee
1%A!$2.
On 7 April E887, the ne& %A!B took over the responsibility for setting
%nternational Accounting !tandards.
The ne& Board started &ith adopting existing %A! and !tanding
%nterpretations $ommittee 1!%$2.
5any of the standards forming part of %,#! are kno&n by the older name of
%nternational Accounting !tandards 1%A!2.
"tructure of IFR"*
$onsidered a Bprinciples basedD set of standards.
They establish broad rules and dictate specific treatments.
IFR" comprises*
o %,#! ? standards issued after E887
o %A! ? standards issued before E887
o %nterpretations originated from the %nternational ,inancial #eporting
%nterpretations $ommittee 1%,#%$2 ? issued after E887
o !%$ ? issued before E887
o ,rame&ork for the +reparation and +resentation of ,inancial
!tatements
Frame=ork
o ,rame&ork states basic principles of %,#!.
o %A!B and ,A!B ,rame&orks are being updated and converged.
o This 4oint conceptual frame&ork pro4ect, undertaken by the %A!B and
the )! ,A!B,aims to update and refine the existing concepts to reflect
the changes in markets, business practices and the economic
environment that have occurred in the t&o or more decades since the
concepts &ere first developed.
o %ts ob4ective is to create a sound foundation for future accounting
standards that are principles3based, internally consistent and
internationally converged.
!ist of IFR" specific to Banks
o %,#! 7 ,irst3time Adoption of %nternational ,inancial #eporting
!tandards
o %,#! N ,inancial %nstruments" (isclosures
o %,#! M ,inancial %nstruments
Brief on IFR" >
o /ffective from 7 Tanuary E88N.
o Adds certain ne& disclosures about financial instruments to those
currently re-uired by %A! FE>
o #eplaces the disclosures previously re-uired by %A! F8, and
o !upersedes all the disclosures in %A!FE to put together a ne& standard
on ,inancial %nstruments" (isclosures.
o The remaining parts of %A!FE deal only &ith ,inancial %nstruments
+resentation matters.
o The t&o main disclosures re-uired by %,#! N are"
%nformation about the significance of financial instruments
%nformation about the nature and extent of risks arising from
financial instruments
o %,#! N.FI to GE re-uires disclosure of nature and extent of $redit #isk,
Li-uidity #isk and 5arket #isk exposure of ,inancial %nstruments held.
Brief on IFR" @
o Applicable from 7 Tanuary E87F, ho&ever early adoption is permitted.
o %ntroduces ne& re-uirements for classifying and measuring financial
assets.
o Jill eventually replace %A!FM ? ,inancial %nstruments" #ecognition and
5easurement>
o #eplaces the disclosures previously re-uired by %A! F8, and
o %A!B expanding %,#!M during E878 to include ne& re-uirements for"
classifying and measuring financial liabilities>
credit risk in measurement of liabilities>
de3recognition of financial instruments>
impairment of financial assets measured at amortied cost> and
.edge accounting.
o %A!B plans to complete the replacement for %A!FM by adding above
re-uirements.
!ist of IA" specific to Banks
The list is available for reference here, ho&ever a thorough reading of each
%A! is part of only next level of this $ourse.
o %A! E= Accounting for %nvestments ? !uperseded by %A! FM and %A!
G8 effective E887
o %A! F8 (isclosures in the ,inancial !tatements of Banks and !imilar
,inancial %nstitutions ? !uperseded by %,#! N effective 7 Tanuary E88N
o %A! FE ,inancial %nstruments" +resentation ? (isclosure provisions
superseded by %,#! N effective 7 Tanuary E88N
o %A! FM ,inancial %nstruments" #ecognition and 5easurement replaced
by %,#! M effective 7 Tanuary E87F.
!ist of Bank related interpretations by IFRIC and "IC The list is
available for reference here, ho&ever a thorough reading of each
%nterpretations is part of only next level of this $ourse.
IA"(& , IFR" >*
o %A! FE 1E88F2 superseded !%$ = $lassification of ,inancial %nstruments
3 $ontingent !ettlement +rovisions
o %A! FE 1E88F2 superseded !%$ 7I !hare $apital 3 #eac-uired O&n
/-uity %nstruments 1Treasury !hares2
o %A! FE 1E88F2 superseded !%$ 7N /-uity 3 $osts of an /-uity
Transaction
o %,#%$ E 5embers' !hares in $o3operative /ntities and !imilar
%nstruments
IA" (@ , IFR" @*
o %,#%$ 7I .edge of a Ket %nvestment in a ,oreign Operation
o %,#%$ 7E !ervice $oncession Arrangements
o %,#%$ M #eassessment of /mbedded (erivatives
o %A! FM 1E88F2 superseded !%$ FF $onsolidation and /-uity 5ethod 3
+otential Hoting #ights and Allocation of O&nership %nterest
Adoption of IFR" by region
4nited "tates
Allo&ed for foreign issuers in the )! since E88N>
Target date for substantial convergence &ith %,#!s is E877> and
(ecision about possible adoption for )! $ompanies expected E877.
-uropean 4nion
U All listed /) companies have been re-uired to use %,#! since E88=.
U Approved for use only &hen a %,#! standard is endorsed by Accounting
#egulatory $ommittee 1A#$2.
U (ue to endorsement %,#! as applied in /) may differ from that used else&here.
India
U The %nstitute of $hartered Accountants of %ndia 1%$A%2 made %,#! mandatory for
financial statements for periods beginning 7 April E877 based on company net&orth9
into specific business9 listed global.
U /xisting accounting standards &ill be modified to make compatible &ith %,#!.
U #B% has stated that financial statements for Banks must be %,#! compliant
effective 7 April E877.
2ther Countries
U http"99&&&.ifrs.org9)seaaroundathea&orld9)seaaroundathea&orld.htm
IFR" Ta1onomy
%t6s the :BL# representation of %,#!, including %A! and %nterpretations issued
by the %A!B.
The %,#! Taxonomy contains tags for all %,#! disclosures.
+urpose" The %,#! ,oundation seeks to address the demand for an electronic
standard to transmit %,#! financial information.
,ormat" Taxonomies are the computer3readable Odictionaries6 of :B#L.
!tructure" Taxonomies provide :B#L tags, information about each tag, and
organies tags into a meaningful structure.
#elease9Hersion" On F8th April E878, the %,#! ,oundation released the %,#!
Taxonomy for E878.
The !arbanes3Oxley Act of E88E 1often shortened to !O:2 is legislation enacted in
response to the high3profile /nron and Jorld$om financial scandals to protect
shareholders and the general public from accounting errors and fraudulent practices
in the enterprise. The act is administered by the !ecurities and /xchange
$ommission 1!/$2, &hich sets deadlines for compliance and publishes rules on
re-uirements. !arbanes3Oxley is not a set of business practices and does not specify
ho& a business should store records> rather, it defines &hich records are to be
stored and for ho& long. The legislation not only affects the financial side of
corporations, it also affects the %T departments &hose 4ob it is to store a
corporation's electronic records. The !arbanes3Oxley Act states that all business
records, including electronic records and electronic messages, must be saved for Lnot
less than five years.L The conse-uences for non3compliance are fines, imprisonment,
or both. %T departments are increasingly faced &ith the challenge of creating and
maintaining a corporate records archive in a cost3effective fashion that satisfies the
re-uirements put forth by the legislation. This section provides more insight into the
concepts of !O:
Introduction to "2G
U !arbanes * Oxley Act is a )nited !tates federal la& enacted on Tuly F8, E88E.
U Also kno&n as the '+ublic $ompany Accounting #eform and %nvestor +rotection
Act' 1in the !enate2 and '$orporate and Auditing Accountability and #esponsibility
Act' 1in the .ouse2 and commonly called !arbanes?Oxley.
U !et ne& or enhanced standards for all ).!. public company boards, management
and public accounting firms.
U %t is named after sponsors ).!. !enator +aul !arbanes 1(35(2 and ).!.
#epresentative 5ichael G. Oxley 1#3O.2.
U The bill &as enacted as a reaction to a number of ma4or corporate and accounting
scandals including those affecting /nron, Tyco %nternational, Adelphia, +eregrine
!ystems and Jorld$om. These scandals, &hich cost investors billions of dollars &hen
the share prices of affected companies collapsed, shook public confidence in the
nation's securities markets.
U The act contains 77 titles, or sections, ranging from additional corporate board
responsibilities to criminal penalties, and re-uires the !ecurities and /xchange
$ommission 1!/$2 to implement rulings on re-uirements to comply &ith the ne&
la&.
U %t does not apply to privately held companies.
U .arvey +itt, the EIth chairman of the !ecurities and /xchange $ommission
1!/$2, led the !/$ in the adoption of doens of rules to implement the !arbanes?
Oxley Act.
U %t created a ne&, -uasi3public agency, the +ublic $ompany Accounting Oversight
Board, or +$AOB, charged &ith overseeing, regulating, inspecting and disciplining
accounting firms in their roles as auditors of public companies.
U The act also covers issues such as auditor independence, corporate governance,
internal control assessment, and enhanced financial disclosure.
-vents contributing to the adoption of "2G Act 0 A Case of -nron
Corporation*
The /nron scandal, revealed in October E887, eventually led to the
bankruptcy of the /nron $orporation and the dissolution of Arthur Andersen,
one of the five largest audit and accountancy partnerships in the &orld.
$onsidered as the biggest audit failure in the &orld history.
Billions of debt from failed deals and pro4ects &ere hidden through the use of
accounting loopholes, special purpose entities, and poor financial reporting.
$,O and other executives &ere able to mislead /nron6s Board of (irectors and
Audit committee of high risk accounting issues as &ell as pressure Andersen
to ignore the issues.
The non transparent financial statements did not clearly detail its operations
and finances &ith shareholders and analysts.
%ts complex business model stretched the limits of accounting.
The company used accounting limitations to manage earnings and modify the
Balance !heet to portray a favorable depiction of its performance.
,rom late 7MMN until its collapse, the primary motivations of /nron6s
accounting and financial transactions seem to have been to keep reported
income and cash flo& up, asset values inflated, and liabilities off the books.
The combination of these issues later led to the bankruptcy of the company.
The /nron scandal deeply influenced the development of ne& regulations to
improve the reliability of financial reporting, and increased public a&areness
about the importance of having accounting standards that sho& the financial
reality of companies and the ob4ectivity and independence of auditing firms.
One conse-uence of these events &as the passage of !arbanes?Oxley Act in
E88E, as a result of the first admissions of fraudulent behavior made by
/nron.
The act significantly raises criminal penalties for securities fraud, for
destroying, altering or fabricating records in federal investigations or any
scheme or attempt to defraud shareholders.
"ituation prior to adoption of "2G Act*
Auditor conflicts of interest* +rior to !O:, auditing firms, the primary
financial L&atchdogsL for investors, &ere self3regulated. They also performed
significant non3audit or consulting &ork for the companies they audited. 5any
of these consulting agreements &ere far more lucrative than the auditing
engagement. This presented at least the appearance of a conflict of interest.
,or example, challenging the company's accounting approach might damage
a client relationship, conceivably placing a significant consulting arrangement
at risk, damaging the auditing firm's bottom line.
Boardroom failures* Boards of (irectors, specifically Audit $ommittees, are
charged &ith establishing oversight mechanisms for financial reporting in ).!.
corporations on the behalf of investors. These scandals identified Board
members &ho either did not exercise their responsibilities or did not have the
expertise to understand the complexities of the businesses. %n many cases,
Audit $ommittee members &ere not truly independent of management.
"ecurities analystsL conflicts of interest* The roles of securities analysts,
&ho make buy and sell recommendations on company stocks and bonds, and
investment bankers, &ho help provide companies loans or handle mergers
and ac-uisitions, provide opportunities for conflicts. !imilar to the auditor
conflict, issuing a buy or sell recommendation on a stock &hile providing
lucrative investment banking services creates at least the appearance of a
conflict of interest.
Inade'uate funding of the "-C* The !/$ budget has steadily increased to
nearly double the pre3!O: level. %n one of his intervie&s, !arbanes indicated
that enforcement and rule3making are more effective post3!O:.
Banking practices* Lending to a firm sends signals to investors regarding
the firm's risk. %n the case of /nron, several ma4or banks provided large loans
to the company &ithout understanding, or &hile ignoring, the risks of the
company. %nvestors of these banks and their clients &ere hurt by such bad
loans, resulting in large settlement payments by the banks. Others
interpreted the &illingness of banks to lend money to the company as an
indication of its health and integrity, and &ere led to invest in /nron as a
result. These investors &ere hurt as &ell.
Internet bubble* %nvestors had been stung in E888 by the sharp declines in
technology stocks and to a lesser extent, by declines in the overall market.
$ertain mutual fund managers &ere alleged to have advocated the purchasing
of particular technology stocks, &hile -uietly selling them. The losses
sustained also helped create a general anger among investors.
-1ecutive compensation* !tock option and bonus practices, combined &ith
volatility in stock prices for even small earnings Lmisses,L resulted in
pressures to manage earnings. !tock options &ere not treated as
compensation expense by companies, encouraging this form of compensation.
Jith a large stock3based bonus at risk, managers &ere pressured to meet
their targets.
"2G +andates and Re'uirements for Financial Reporting
!arbanes?Oxley contains 77 titles that describe specific mandates and re-uirements
for financial reporting. /ach title consists of several sections 1!O: Act2, summaried
belo&.
7.+ublic $ompany Accounting Oversight Board 1+$AOB2
E.Auditor %ndependence
F.$orporate #esponsibility
G./nhanced ,inancial (isclosures
=.Analyst $onflicts of %nterest
I.$ommission #esources and Authority
N.!tudies and #eports
@.$orporate and $riminal ,raud Accountability
M.Jhite $ollar $rime +enalty /nhancement
78.$orporate Tax #eturns
77.$orporate ,raud Accountability
5ey #rovisions of "2G Act*
!arbanes?Oxley !ection F8E" (isclosure controls
!arbanes3Oxley !ection G87" (isclosures in periodic reports 1Off3balance
sheet items2
!arbanes?Oxley !ection G8G" Assessment of internal control
!arbanes?Oxley !ection @8E" $riminal penalties for violation of !O:
!arbanes?Oxley !ection 778N" $riminal penalties for retaliation against
&histleblo&ers
"arbanes021ley "ection 9J9* Assessment of internal control
The most contentious aspect of !O: is !ection G8G, &hich re-uires
management and the external auditor to report on the ade-uacy of the
company's internal control over financial reporting 1%$,#2.
This is the most costly aspect of the legislation for companies to implement,
as documenting and testing important financial manual and automated
controls re-uires enormous effort.
)nder !ection G8G of the Act, management is re-uired to produce an Binternal
control reportD as part of each annual /xchange Act report. !ee 7= ).!.$. i
NEIE.
The report must affirm Bthe responsibility of management for establishing and
maintaining an ade-uate internal control structure and procedures for
financial reporting.D 7= ).!.$. i NEIE1a2.
The report must also Bcontain an assessment, as of the end of the most
recent fiscal year of the $ompany, of the effectiveness of the internal control
structure and procedures of the issuer for financial reporting.D To do this,
managers are generally adopting an internal control frame&ork such as that
described in $O!O.
To help alleviate the high costs of compliance, guidance and practice have
continued to evolve.
The +ublic $ompany Accounting Oversight Board 1+$AOB2 approved Auditing
!tandard Ko. = for public accounting firms on Tuly E=, E88N.
This standard superseded Auditing !tandard Ko. E, the initial guidance
provided in E88G. The !/$ also released its interpretive guidance on Tune EN,
E88N.
%t is generally consistent &ith the +$AOB's guidance, but intended to provide
guidance for management.
Both management and the external auditor are responsible for performing
their assessment in the context of a top3do&n risk assessment, &hich
re-uires management to base both the scope of its assessment and evidence
gathered on risk.
This gives management &ider discretion in its assessment approach. These
t&o standards together re-uire management to"
o Assess both the design and operating effectiveness of selected internal
controls related to significant accounts and relevant assertions, in the
context of material misstatement risks>
o )nderstand the flo& of transactions, including %T aspects, sufficient
enough to identify points at &hich a misstatement could arise>
o /valuate company3level 1entity3level2 controls, &hich correspond to
the components of the $O!O frame&ork>
o +erform a fraud risk assessment>
o /valuate controls designed to prevent or detect fraud, including
management override of controls>
o /valuate controls over the period3end financial reporting process>
o !cale the assessment based on the sie and complexity of the
company>
o #ely on management's &ork based on factors such as competency,
ob4ectivity, and risk>
o $onclude on the ade-uacy of internal control over financial reporting.