Principles of banking

1) Principle of Intermediation

Concept of peer to peer lending like in case of lendbox the assumption of risk is by
the lender. In case of bank it acts like an intermediatery where the risk of default is of
the bank. It also helps in mobilisation of funds and creation of credit.

2) Principles of Liquidity

The principle of liquidity is very important for the commercial bank. Liquidity refers to
the ability of an asset to convert into cash without loss within a short time.

Paying the deposited money on demand of customers is called liquidity in the sense
of banking.

A commercial bank offers two types of Deposits Demand deposits which the bank
has to repay on demand like a Savings Account and Time deposits which
the bank has to repay after the expiry of a certain periodFurther, on a daily basis,
customers withdraw as well as deposit cash. therefore, all commercial banks have to
keep a certain amount of cash in their custody to meet the cash demands of
customers.

The asset liability management department in banks, ensure that banks remain liquid
at all points of time. Asset liability management (ALM) can be defined as the
comprehensive and dynamic framework for measuring, monitoring and managing the
financial risks associated with changing interest rates, foreign exchange rates and
other factors that can affect the organisation’s liquidity. ALM relates to management
of structure of balance sheet (liabilities and assets) in such a way that the net
earning from interest is maximised within the overall risk-preference (present and
future) of the institutions. We should also look at NPA ratio of bank.

3) Principles of Profitability

Any commercial enterprise primarily tries to generate profit. A commercial bank is a

commercial enterprise as well. Hence, it tries to generate profits. The two ratios net
interest margin and return on Capital employed can determine profitability of banks.

Net Interest Margin (NIM) is a measure of the difference between the interest income
earned by a bank or other financial institution and the interest it pays out to its
lenders (for example, depositors), relative to the amount of their assets that earn
interest. It is similar to the gross margin or gross profit margin of non-banking finance
companies.

NIM is usually expressed as a percentage of what the financial institution earns on

loans in a time period and other assets minus the interest paid on borrowed funds
divided by the average amount of the assets on which it earned income in that time
period. In other words, it’s what net interest income a lender earns in percentage
terms on the average interest-earning assets in a specified period.

For example, if a bank's average interest-earning assets, which may include loans
and investment securities, stood at Rs 10,000 in a year and it earned an interest
income of Rs 600 and paid interest expense of Rs 300, the NIM would be (600 –
300) / 10,000 = 3 per cent.

Return on Capital Employed (ROCE), a profitability ratio, measures how efficiently a

company is using its capital to generate profits. The return on capital employed
metric is considered one of the best profitability ratios

ROCE = EBIT/Capital Employed

Where:
Earnings before interest and tax (EBIT) is the company’s profit, including all
expenses except interest and tax expenses.
Capital employed is the total amount of equity invested in a business. Capital
employed is commonly calculated as either total assets less current liabilities or fixed
assets plus working capital.

4) Principles of Solvency

Commercial banks must be financially sound. Further, they need to maintain a

certain required capital for running the business. Usually to check the financial
position of banks the following ratios are analysed. Capital Adequacy Ratio (CAR)
and NPA ratio.

is the ratio of a bank’s capital in relation to its risk-weighted assets and current
liabilities. It is decided by central banks and bank regulators to prevent commercial
banks from taking excess leverage and becoming insolvent in the process.

In other words, it measures how much capital does a bank has with it as a
percentage of its total credit exposure. Bank regulators enforce this ratio to ensure
credit discipline in order to protect depositors and promote stability and efficiency in
the financial system. CAR for Public Sector banks is 12% and for Private sector in
India is 9%. But government insist on maintain a high CAR.

For NPA refer to NPA Notes

5) Principles of Safety/ trust

A commercial bank accepts deposits from its customers and then invests it.
However, since it is investing the investor’s money it keeps the safety of the money
first.

he safety of funds lent is another principle of lending. Safety means that the borrower
should be able to repay the loan and interest in time at regular intervals without
default. The repayment of the loan depends upon the nature of security, the
character of the borrower, his capacity to repay and his financial standing.

Like other investments, bank investments involve risk. But the degree of risk varies

with the type of security. Securities of the central government are safer than those of

the state governments and local bodies. And the securities of state government and

local bodies are safer than those of the industrial concerns. This is because the

resources of the central government are much higher than the state and local

governments and of the latter higher than the industrial concerns.

In fact, the share and debentures of industrial concerns are tied to their earnings

which may fluctuate with the business activity in the country. The bank should also

take into consideration the debt repaying ability of the governments while investing in

their securities. Political stability and peace and security are the prerequisites for

this.

It is very safe to invest in the securities of a government having large tax revenue

and high borrowing capacity. The same is the case with the securities of a rich

municipality or local body and state government of a prosperous region. So in

making investments the bank should choose securities, shares and debentures of

such governments, local bodies and industrial concerns which satisfy the principle of

safety.