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Banking Fundamentals - Contents

Module 1: BANKING AND THE FINANCIAL SYSTEM The Financial System Financial Institutions Financial Markets Financial Instruments Financial Services Central Banking Module 2: BANKING BASICS Who is a Banks Customer? Account Opening Types of Customer Accounts Account Type & Operations The Clearing System Remittance & Payment Systems Module 3: RETAIL BANKING Retail Lending Products Electronic Banking ATMs Telephone Banking Internet Banking

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Module 4: CORPORATE BANKING

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25 26 31 31 34 37

What Constitutes Corporate Banking Corporate Credit - The Common Denominators Corporate Credit - Working Capital Delivering Working Capital - Fund based Delivering Working Capital - Non-fund based Other Corporate Related Services Module 5: TREASURY OPERATIONS Treasury Fundamentals Money market Government securities market Foreign Exchange market Dealing Functions & control of dealing

38 39 42 44 54 58

61 64 67 68 81

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Banking & the Financial System

1.

THE FINANCIAL SYSTEM

Financial system is a set of institutions, markets and instruments, which fosters savings and channels them to their efficient use. It is through the financial system that the surplus of households and businesses get transmitted to the consumers of money. Among other things, a well-developed financial system is a sine qua non for accelerated economic development. Every financial system is an aggregation of institutions, markets, instruments and services that facilitate the transfer of funds from savers to consumers. How developed and sophisticated these constituents are, determine the efficiency of the financial system. Figure 1.1 - Financial system
Financial System

Financial Institution

Financial Markets

Financial Instruments

Financial Services

1.1

Financial Institutions:

Financial institutions are business organizations like banks, mutual funds, insurance companies, building societies, etc. These specialized institutions act as mobilizers and depositories of savings and extend loans and advances to the public. Figure 1.2 - Financial Institutions
Financial Institutions

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Intermediaries Non-Intermediaries Non-banking

Regulatory

Others

Banking

Financial institutions are classified as intermediaries and non-intermediaries. As the term indicates, intermediaries intermediate between savers and investors i.e., they obtain deposits from one set of people and lend the same to another set. All banking Module 1
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Institutions are intermediaries. Many non-banking institutions like insurance companies, pension funds, credit unions, savings and loan associations, etc. are also intermediaries. While there are similarities between the functioning of banks and other financial intermediaries, there is one feature that is distinct to banks. Only banks have a role a play in the payment system of the economy. Besides, unlike other financial institutions, deposits held by banks form a part of the money supply of the countrys financial system (See Box). Non-intermediaries only do the lending and they generally do not mobilize deposits for their resources. These institutions are formed because of governmental efforts, to provide assistance for specific purposes or sectors or regions. Asian Development Bank, World Bank, Commonwealth Development Corporation, etc., are examples of such institutions? Their creation was stimulated by the fact that the credit needs of certain borrowers might not be otherwise fulfilled by the existing set of institutions. E.g. financing poverty alleviation schemes, construction of dams, setting up power stations, etc. MONEY & MONEY SUPPLY What is money? It is an essential ingredient of the world of business and trade. Its importance is due to the following: Money serves as a medium of exchange - used for payment of all goods and services. It serves as an accounting unit - as it is used for payment of goods and services, it is also a good yardstick for comparing the value of goods and service. It therefore serves as a unit of account - a common denominator that it is used to value goods and services. It is used as a store of value - money when saved provides purchasing power at a later date. Money is therefore an important cog in the wheel of trade and business. In most instances, it is supplied and controlled by the government of the land. Like all other goods, the cost of money (as reflected in the interest rate) is determined by its relative supply and demand. At present, the money in circulation in most countries is nothing but fiat money. In other words, such money has little or no intrinsic value at all (unlike the old days when gold, silver, etc. were used, which had intrinsic value). Thus a dollar bill or a rupee note is just a piece of paper. Coins may have some intrinsic value as metal, but their real value is much less than the value they depict. People accept them as money because they believe that it will give them the purchasing power (to purchase goods and services) it represents, and can be used for settlement of debt. Peoples belief in turn stems from the confidence in their government. In simple terms, money supply is the aggregation of all the fiat money that the government injects into the economy. It takes the form of currency plus deposits with banks plus deposits with other institutions and so on.

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M1

Made up of money Currency in circulation readily available with Current account people (medium of balances exchange) M2 M1 + Type of money Money market funds held as a store of wealth Savings deposits for possible spending Short term deposits later M3 M2 + Time deposits with banks Thus, all current, savings and time deposit accounts with banks form of the concerned countrys money supply. Another important function that distinguishes banks from other financial intermediaries is the fact that the former have the capacity to create deposits and credit, while others cannot. Lets see how? Credit/Deposit Creation Banks are supposed to lend deposits that they receive. But, at the same time, they cannot lend the entire amount of such deposits. They are required to keep certain percentage of their deposits as a reserve in the form of cash. This reserve is a precautionary one to ensure that at any point in time, if depositors want cash, banks would be in a position to meet their obligations without any problem. The exact quantum of such reserve requirement varies from country to country. But whatever the percentage prescription, that has a direct impact on the control of money supply and the quantum of credit that can get created. How does this happen? Let us suppose, Anupam gets a cheque for Rs.1, 00,000 as a share of his ancestral property and deposits the amount with his bank A. The bank gets a deposit of Rs.1, 00,000 and puts aside, say, 10% as reserve requirement and lends the remaining Rs.90, 000 to Badri, who has applied for a loan to purchase a computer. A 10% reserve indicates that bank A estimates that at any point in time not more than 10% of the deposits may be withdrawn by way of cash. Badri takes a pay order for Rs.90, 000 and hands it over to the computer dealer. The dealer maintains his account with bank B and deposits the amount with his bank. Bank Bs deposit is now increased by Rs.90, 000 and therefore the bank can lend upto Rs.81, 000, after keeping Rs.9, 000 as its reserve. Deposits Bank A 1,00,000 Loans Reserve Bank B 90,000 Loans Reserve 90,000 10,000 81,000 9,000

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Deposits

The above process goes on and on. With the initial amount of Rs.1, 00,000 we mentioned in the example, the deposits and the credit gets expanded in the banking system viz. 1,00,000 + 90,000 + 81,000 +. and so on, from the initial deposit of Rs. 1, 00,000. Module 1
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Of course, there are limitations to this process. The bank may not/may not be able to lend the entire 90% of all deposits received. Also, all the loan payments may not get deposited in the banking system. 1.2 Financial Markets:

A financial market is where investors come together with users of funds. It can be a place like a stock exchange or it can be a market created by way of communication (over telephone) that does not require a specific location. Financial markets contribute to our economy by taking idle or unused funds from people (individual, business, government, non-profit organization, etc.) and channeling these funds to people who use them. The users of funds generate economic activity either by consuming or by producing goods and services. Figure 1.3 - Financial Markets
Financial Markets

Organized

Unorganized

Primary Market

Capital Markets

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Secondary Market

Money Markets

The participants of the financial markets are financial institutions, agents, brokers, dealers, borrowers, lenders, savers and others who are interlinked by law, by contracts and by communication networks. Organized markets indicate that these are formed under some legal framework, are monitored in some form, the statistics of their activity is reported and is publicly available. Typical examples are stock exchanges, commodity exchanges, mortgage loan/housing loan companies, etc. In unorganized markets, there are no legal records of such business and, by and large, these markets are unregulated. Money lending by pawnbrokers, small lending/community chits carried out by individuals, etc., come under this category. Financial markets are sometimes classified as primary (direct) and secondary (indirect) markets. Module 1
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Primary markets are the ones where new financial assets are sold. Financial assets are distinguished from real assets, which are land & building, plant & machinery, house property, farmland, etc. Financial assets are generally used to raise funds for creating real assets, and run business based on real assets. A company that raises funds by issue of shares to new stockholders is raising funds in a primary market. The major players in the primary market are bankers, mutual funds, financial institutions and individual investors. Secondary markets are where old or issued financial assets are traded. Anytime a financial asset is bought or sold after its initial sale, the buyers and sellers are using the secondary market. The major players are stockbrokers, mutual funds, financial institutions and individual investors. Primary markets mobilize savings and they supply fresh and/or additional capital to business units. Secondary markets are also important because they make it easy to buy and sell financial assets and provide liquidity to investors. Otherwise, investors will be wary of getting stuck with an investment when they need money for consumption or other emergencies. For an effective primary market, therefore, a vibrant secondary market is essential. Also, trading in the secondary market provides continuous information about the value of financial assets traded. For example, by watching the price movements of a companys share, a primary market investor is given indications, as to whether the underlying business of the company is doing well or not. Financial markets are also classified as money markets and capital markets. While both perform the same function of taking the investors funds to the people who use them, the essential difference lies in the fact that, money markets deal with short-term funds, while the latter predominantly deal with long-term funds. Both the markets have their own primary and secondary markets. The participants are banks, brokers, dealers, mutual funds, etc. To sum up, three important functions of financial markets are:

a) Price discovery process - when buyers and sellers trade the assets, they determine price at which financial assets can be sold or bought at. b) Provision of liquidity by providing a mechanism for investors to sell financial assets. c) Low cost of transaction and information, as buyers / sellers are able to access each other on a collective basis and therefore individual efforts of finding a buyer / seller need not be made. This collective effort also enables a lot of information to be provided at one source or place. E.g. stock prices of all listed stocks can be known at a stock exchange. 1.3 Financial Instruments:

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A financial asset can be in the form of a claim i.e. it is a loan given to a borrower for which the lender (asset owner) is paid interest. When one puts a bank deposit or when a financial institution gives a loan to a company, it is financial asset in the form of a claim on the borrower - the bank in the former and the company in the latter case.

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This claim can also be made tradeable in secondary markets. When loans or debts are converted into a tradeable form or paper - bonds and debentures - these are called securitized assets or debts. Such assets than are tradable in secondary market. For example, a financial institution can give a loan of Rs.10 crores to a company for 10 years and recover the principal in installments while receiving interest at the preset dates. The other alternative is that, it can subscribe to 10-year bonds of the company for value of Rs.10 crores. While interest is still receivable on preset dates, the institution has the liberty to sell the bonds completely or partially from time to time, as these are tradeable in the markets. Stocks or shares are different in that and they are not claims. They represent ownership in the company to the extent of stocks held. Price of stocks is essentially driven by the performance of the company. Normally, dividends are paid on stocks, but payment of dividend is not obligatory, as is interest in the case of debt. The principal value of shares is also not repaid, but the shares can be sold to another willing buyer i.e. they are tradeable in the secondary market. The price one may get for both stocks and securitized debt may be more than the amount invested or less, depending upon the prevailing market/economic conditions. Thus stocks or shares are ownership based assets, while debentures and bonds are claim based assets. Figure 1.4 - Financial Instruments

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Financial Instruments (Claims, assets, securities) Primary Short-term Medium-term 1.

Secondary

Long-term

Financial instruments differ from each other in respect of their investment characteristics. Some examples of these characteristics are: Liquidity: Ability to convert the assets into cash at a given small price range. Investments in money market funds and shares are much more liquid than investments in real estate. Marketability: Speed and ease with which a particular product or investment may be bought or sold.

2.

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3.

Transferability: Easily transferable from one person or institution to the other like stocks, bills of exchange, etc. Transaction costs: Costs associated with buying and selling of investments e.g. brokerage paid when buying / selling shares. Risk of default: Possibility of losing the principal amount due to non-repayment by the borrower. Default can also happen in interest payments. Maturity period: The period for which a financial instrument is issued i.e. the period at the end of which the principal amount is contracted to be repaid. Call back: Instruments issued with a clause, which gives the issuer an option to repay the principal amount, with or without any premium, before its maturity, is said to have a call back option. For example, a company may issue a Rs.1000 face value 10-year bond @ 15% p.a. interest rate (also called coupon of the bond) with an option to call back the bond at the end of 3 years @ Rs.1050 and at the end of 5 years @ Rs.1000 per bond. The issuer has an option now to pay Rs.1050 per bond (premium of Rs.50) at the end of 3 years and redeem the bonds. This he would do only if the interest rates prevailing at that time are much lower, say 12% p.a. By calling back, the issuer can refinance the bond for the outstanding period at 12% p.a., saving interest cost. If the issuer does not exercise the option at the end of 3 years, it may do so at the end of 5 years. If the option is still not exercised, then the bond will run to its maturity.

4.

5.

6.

7.

8. Buy back: The holders / owners of the financial instruments in such cases are given an option by the issuer to sell the financial assets back to the issuer, usually within a specified time. The issuer may also announce the price. In the example above, the issuer instead of giving a call back option, could instead give a buy back option @ Rs.900 per bond at anytime after 3 years upto say 5 years.
9.

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Rate of return: Yield on a security till its maturity e.g. a one-year debt with face value of Rs.1000 and coupon of 15% will yield or give a return of 15% p.a. Financial Services:

1.4

Financial services basically mean services connected with money. The basic service in most cases remains, borrowing money from a set of people and lending it to another. But the borrowing and lending need to be structured or organized in such a way that it meets the varying needs of investors as well as borrowers. It also needs to keep in view the end use for which borrowers need money. Lending can therefore take the form of leasing, hire purchase, consumer finance, bill discounting, housing finance, factoring, etc. It can also be for varying periods, varying currencies, varying interest rates, varying repayment methods and so on.

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Financial services also include in their ambit services that may not involve flow of money but underlying them will be transactions that involve such flow. Examples are Letters of credit, Guarantees etc. 1.5 Importance of banks in the financial system:

In any country, banks form the core of the financial system. Although there may be a number of other institutions which do the business of lending by borrowing money, the importance of banks stand out due to their ability to move funds around the globe. All other institutions have to depend upon banks for this function. Now banks also participate in all types of financial markets and do not restrict themselves only to borrowing and lending money. As we shall see, these range from providing safe custody for articles to advising and dealing in foreign exchange, buying and selling of companies, etc. In this sense, banks pervade all types of financial services and, therefore, deal in all types of financial instruments also. 2. 2.1 CENTRAL BANKING The role and functions:

Central Bank of a country is the nerve centre of the monetary system and occupies a dominant position in the financial system. As apex banking institutions, central banks regulate, direct, monitor as well as foster their respective countrys financial system. While individual central banks may have unique and well-defined functional framework assigned to them, by and large, following are their core functions. 2.1.1 Issue and management of currency:

In most countries, it is the central bank that is vested with the power to issue currencies and coins. In the past, some of the central banks used to have backup reserve in terms of gold/convertible currencies for the currencies/coins they issued. Presently very few central banks go for a 100% asset backup for its currency issues. 2.1.2 Bankers to the Government Traditionally, it is the central banks that act as bankers to their respective Governments. In role as bankers to the Government, central banks effect payments and receive revenues on behalf of the Government. Besides, in most countries, central banks act as debt managers for the Government. Thus, it is the central bank that issues sovereign securities, taking care of their servicing and ultimate redemption. 2.1.3 Bankers Bank

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The central bank maintains accounts of all commercial banks. The statutory reserves are to be kept with the central bank. These accounts are used for inter-bank settlements and for foreign exchange transactions by commercial banks with the central bank. The central bank also acts as the lender of last resort to the commercial banks. During critical situations banks may run out of reserves and may require selling assets to meet Module 1
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their commitments. In such situations, Central Bank may come to the rescue of these banks, by providing funds so that they can overcome the immediate problem. For example, on October 19, 1987 (Black Monday), the US stock market suffered the worst one-day decline in its history with a wipe out of about 25% of the value of stocks. This forced the banks, which were holding stocks as collateral securities, to sell the stocks to avoid further loss. A large number of individuals and pension funds had invested in stocks, and a huge financial collapse looked imminent. Early next day, the Federal Reserve (Central Banking System of US) pledged to provide emergency loans to banks to obviate dumping of stocks in the market. Thus, a serious economic disaster was averted by the timely action of the countrys central bank. 2.1.4 Regulation of credit

Central Banks in some countries may direct credit/lending to certain sectors that they believe are priority from the economys point of view. E.g. In India, 40% of lending by banks need to go to what is called priority sector consisting of small-scale industries, export oriented units, etc. Central Banks may also regulate the interest rates at which the lending is to be done. They may direct the rates themselves or indicate a bandwidth within which commercial banks can charge interest from their borrowers. 2.1.5 Supervise and control commercial banks

In most countries, it is the central bank, which is responsible for the supervision and regulation of commercial banks as well as other financial institutions. Central banks often reserve the power to issue/deny license for the setting up of banks/bank branches; prescribe minimum capital stipulations to be met by commercial banks. Besides, in most countries, central banks prescribe the quantum of statutory reserve to be maintained by commercial banks. In addition, in most countries, central banks supervise the functioning of commercial banks to ensure that the latters operations are run according to the prescribed rules and regulations and in a manner not prejudicial to the interests of the depositors/financial system.

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2.1.6

Lay down and conduct monetary policy:

In most countries, central banks are responsible for laying down policies for controlling and managing money supply, inflation, interest rate, etc. Usually, central banks carry out such monetary policy making exercise in coordination with the Government. For successful monetary management, central banks use a combination of monetary instruments. Of these, the following are the most oft-used ones: Open Market Operations: Central Banks buy and sell government securities to induct liquidity or absorb liquidity (increase money supply or decrease money supply). It buys government securities and injects say, rupee / US $ supply into banking system to increase liquidity. This in turn eases the short-term interest rates. When it sells government securities, it absorbs rupee / US $ funds and releases the securities into the system. This absorbs liquidity and puts upward pressure of shortterm interest rates.
a) b) Bank Rate/Discount Rate Mechanism: Central Banks usually set a base

interest rate at which they are willing to rediscount i.e. buy commercial bills of Module 1
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exchange from the banking system. This is called the Central Bank Discount Rate. In effect, this base rate is the rate at which the banks can raise funds if necessary, and therefore becomes a base or floor for all transactions between banks and between banks and customers. An increase or decrease in the rate by the central bank indicates the direction in which it wants the interest rates to move. Reserve Requirements: We have seen that banks need to keep a reserve for liquidity purpose before they can lend money. This percentage of reserve to be kept is generally controlled by the central bank. By increasing this reserve requirement it reduces the lendable funds of the banking system, thereby tightening the money supply and providing a short-term upward pressure on interest rates. On the other hand, by reducing this reserve requirement, it increases the lendable funds of the banking system, thereby increasing money supply putting downward pressure on short-term interest rates.
c)

2.1.7

Exchange Control:

The Central Bank of a country may sometimes be assigned with the responsibility for managing foreign exchange inflows and outflows. It also may manage the value of local currency against other currencies, especially during times of market volatility. Increasing or decreasing the supply of local currency against the foreign currency concerned achieves this. The central banks may also lay down rules and regulations for foreign exchange dealing by banks, corporates, etc. The principal aim of central banks in foreign currency management is to manage the value of local currency within acceptable levels and to ensure that sufficient foreign currency balance would be available to meet import and other related external payment obligations.

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1.

WHO IS A BANKS CUSTOMER?

Normally we would describe a customer as one who uses any of the services offered by a bank. However in the way banking has evolved over the years it has taken a legal flavor. The relationship of banker and customer does not come into existence unless both parties intend to enter into it. How does this happen? If someone opens some sort of an account, - a current, savings or deposit account, then he becomes a customer of the bank. Customer signifies the relationship, in which duration is not essential. He does not need to have habitual dealings with the banker in order to rank as a customer. Just opening an account with a bank is sufficient to become a customer. 2. ACCOUNT OPENING

A bank exercises caution before opening an account and providing full banking facilities. Normally, a banker will not open an account on mere request from a stranger. Banks call for a satisfactory introduction of new customers and this is commonly obtained by asking the prospective customer to get a reference from an existing customer of the bank. But this practice, under competitive pressure is being largely done away with and other methods of verifying the bona fides are being used. An individual can produce passport, government identity card, citizenship card, driving license, etc., as proof of his/her identity. Companies can use their certificates of incorporation/tax returns and get their account opened on self introduction basis. At times an introductory letter from existing bankers is also accepted. Banks obtain an account-opening request from the customer in a detailed format where a lot of details are called for along with an undertaking from the customer that he / she will abide by the regulations of the bank. The format provides for introduction along with a specimen signature of the customer. Specimen signatures of other persons who may be authorized to operate the account are also taken at the time of opening the account. Account opening stage is considered to be an important task for the bank, where the bank is supposed to take all precautions as per the laid down guidelines. The banks internal auditors carefully scrutinize this activity, as any negligence at this stage is a potential risk for banks.

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2.1

What is this potential risk?

Account-opening formality is the starting point of the banker-customer relationship. A person with mala fide intentions can open an account with false documents and can use the same for committing frauds. A person who finds a cheque on the street or who steals it from others can open an account in the name of the cheques payee. Routing the cheque through the account, he would able to withdraw the amount that is not legally payable to him. By helping such a person to encash the cheque, even the collecting banker here abets the crime of conversion. This is the foremost risk that a banker faces while opening an account without proper introduction/background scrutiny.

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KNOW YOUR CUSTOMER (KYC) PROGRAMME Internationally, new norms are being adopted that would mandate commercial bankers to know and keep knowing their customers and their background on an on-going basis. Under KYC, banks are required to check the veracity of details furnished by customers, especially those relating to their addresses and professions. In the case of business entities opening accounts with banks, the latter are expected to verify the correct legal status of the business. KYC insists on better and more demanding documentation for each customer account. Besides, bankers are expected to keep an eagles eye on the inflows and outflows of funds in each account. Where necessary, bankers need to get curious, but at the same time without getting invasive, about the nature and pattern of dealings in the customer accounts. Any suspicious and/or unusual transactions need to be examined. This calls for carrying out a constant analysis of customer accounts and the transactions therein. The underlying motive of the KYC Programme is to ensure that banking channels are not used for money laundering and illegal stashing/movement of funds. KYC could also prove to be an effective fraud-prevention mechanism. But given the number of accounts individual banks service, falling in line with the KYC Programme in letter and spirit is going to be an onerous task. In fact, complying with the KYC Programme would necessarily call for the deployment of cutting edge technologies such as data warehousing and expert systems.

3. 3.1

TYPES OF CUSTOMER ACCOUNTS Individuals:

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A simple and most common account in a bank is that of resident individuals. Introduction to this type of account is simple and the mandate to operate the account is straightforward. Sometimes, a customer may desire that another person operate his account by giving a mandate to the bank to that effect. The powers that generally include are to operate the account in a normal way and not to overdraw the account. An account holder can nominate a person to whom, in the event of death, the payment of the balance in the account could be made. In India, nominations are available in all banks. In the case of accounts with nominations, the banker is discharged if payment is made to such nominee in the event of death of the account holder.

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3.2

Joint accounts:

Joint accounts may be run by two or more persons/entities, although most common type is that opened by two individuals. The choice to operate the account is given in the account opening form itself with various options like either or survivor, former or survivor or joint operations. The purpose of joint account is that, apart from joint operations, upon the death of one party, the balance in the account is paid to the survivor or the survivor can continue to operate the account with least formalities. 3.3 Minors: In most countries, a minor is a person under the age of 18. The law reserves a treatment for minors and provides them with only limited contractual powers. More often than not, obligations arising out of contracts would not be binding on the minors. This means, those entering into contracts with minors would find themselves on a weak wicket when it comes to enforcing the obligations on the minors. Nonetheless, there is no legal bar as such, on any bank opening accounts in the name of minors. The bank would face no legal problems so long as there is sufficient balance in the account. However, for any banker, to allow overdraft in a minors account is not in their best interest. A minor can operate an account i.e. sign cheques, etc. but the age that is considered suitable for operating a bank account depends upon the policy of the individual bank and the individual circumstances. It is usual for the banks to open minors account which is operated by the guardian i.e. father or mother of the minor. An important aspect of minors account is to note the date of birth of the minor and convert the same into a normal account on his/her attaining majority. 3.4 Partnership accounts:

Banks may or may not have separate account formats for partnership accounts and use the same formats used for individuals. But they generally examine the partnership deed to ascertain the nature of business, number of partners, their powers, etc. Bank records are suitably annotated with the names and signature of the partners who operate the account and their powers. Banks separately take a mandate signed by all the partners specifying that the partners are jointly and severally liable for any debts incurred by them to the bank. Any change in the constitution of the firm by new partners joining the firm or old partners leaving the firm or death of a partner, the bank stops the account operations and gets a fresh mandate. 3.5 Companies:

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A company is a legal person distinct from its members. Companies are commonly limited by shares and therefore the liability of the shareholders is limited. Bank account: A separate account-opening format is designed for companies. Before opening an account, the bank examines the Memorandum of Association, which contains the objects and powers of the company, and Articles of Association, which Module 2
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contains the regulations regarding the internal management of the company. Bank also insists on Certificate of Incorporation and Certificate of commencement of business. Board resolution is a must for a company to open bank accounts. Also the names of the company officials who would operate the account need to be approved by the Board. In case any money is to be lent to a company, it is the responsibility of the lending bank to verify the provisions contained in the Memorandum and Articles of Association of the concerned company. Also a separate a resolution needs to be passed by the companys board approving such borrowing. 3.6 Associations, Committees, Societies, etc.

Bank accounts need to be opened by clubs, schools, welfare association and other nontrading institutions. The important point to note is that these voluntary associations, because of its unincorporated nature, cannot be sued. Even the individual members who administer the funds cannot be personally held liable for any overdrafts with the bank. Bank account: A bank needs proper introduction to the account along with the bye-laws of the association and resolution by the members or committee of the association to open an account with the bank with operating details such as the authorized signatures, powers or amounts upto which they can sign, etc. Banks under no circumstances allow an overdraft in these accounts. 3.7 Trust accounts:

A person holding the property on trust for the benefit of someone else is known as 'trustee'. A trust is formed by a document, which the person (settlor) wishing to create the trust prepares. It describes the property, beneficiaries and the names of trustees who will deal with the property. A trust has to ensure that operations are done according to the instructions in the trust deed. Bank account: A bank is careful when opening a trust account. It studies the trust deed carefully and calls for proper introduction. A mandate signed by all the trustees is taken for opening the account. Bank also ensures that at least two trustees operate the account jointly. Trustees cannot delegate their authority to their agents. The risk in maintaining trust accounts is that, sometimes the beneficiaries may also sue the bank as a party to the breach of trust, if the trustees do not carry out the instructions in the trust deed correctly. To obviate this, the bank takes an indemnity signed by the trustees and beneficiaries protecting it from possible negative consequences of such a move. Banks also exercise great care that trust funds are not transferred to trustees individual accounts. 3.8 Executors and Administration:

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An executor is a person named in the Will to deal with the estate of the deceased, whereas the court appoints an Administrator if there is no Will or if no one is named as executor in the Will. Bank account: The executor can open an account by taking introduction in the usual manner. The bank also verifies the Will or court order for ascertaining the authority of the executor. Module 2
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Where two or more executors / administrators are to operate the account, a mandate similar to that for a joint account is obtained. The executors and administrators are empowered to delegate and therefore, they may issue power of attorney to third parties. Borrowings are possible in these accounts to meet expenses for payment of inheritance / estate tax on the deceased's estate. Banks may consider the request by taking the deceased's estate as security. 4. ACCOUNT TYPE AND OPERATIONS

4.1 Account Type Deposit taking is the earliest known operation of a bank. A deposit is defined as a sum of money paid to the bank on specific terms under which it will be repaid with or without interest. It may be repaid on demand or after a specific period of time. For banking business, borrowing money is essential for the reason that a major part of their profit is earned by employment of funds deposited with them. Deposits are generally classified into three forms:

Current Deposit: Payable on demand Savings Deposit: Payable on demand Term / Time / Fixed Deposit: Payable at a fixed future date.

4.2 Transaction Accounts

Most common of transaction accounts in a bank are current and savings account. 4.2.1 Current Account:

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Current Account is ideally suited for business or individuals who have large number of transactions to be put through the account. There are no restrictions on the number of transactions, or on cheques used by the customer. The balance standing in the customers account is repayable on demand. A customer may be even granted an overdraft i.e. he may be permitted to issue cheques up to an agreed limit, over and above the credit balance in the account. Banks provide statements to its current account customers detailing credit and debit entries in the account. Normally interest is not paid on the credit balance in the customers account. However, there are exceptions. For example, building societies in UK offer interest on current accounts. In US and in some other countries, current account is termed as checking account for the reason that the account has unlimited cheque writing privilege. A study of current account features in various countries discloses variance in the product. Some banks in UK and US offer a small interest on the credit balances in

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current accounts. Most of the banks have no limitation on issue of cheques and provide monthly statements. A sample of product variation is provided below. Statement of account with cancelled cheques during that period. Facilities to sweep the daily surplus in the current account, to a mutual fund account, to maximize the earnings on the idle funds. Follow the principles of Islamic banking i.e. the relationship between the bank and the depositor is that of a custodian and the owner. The bank uses the deposits by investing the monies in permissible activities. The Bank is responsible is in the form of a guarantor and it is compulsory to return the funds to the customer as and when it is demanded for payment. Savings Account:

4.2.2

Savings accounts are special type of deposit accounts that are intended primarily for small savers and individuals. In some banks, especially in the US, savings accounts are available for business firms also, with some conditions. Normally, stipulations on minimum balance requirements and issue of number of cheques are laid down. Passbooks are still in vogue in some countries. Savings account holders update the passbooks across the counter. In some countries like Singapore, cheque book facilities are not available for savings bank account holders. Customers do the withdrawals personally. The rate of interest is little lower than that on term deposit accounts, but the rate is fairly static. Interest is calculated on minimum balances maintained during a calendar month. Commercial banks in different countries offer savings accounts with variety of options.

Differential interest rates on savings accounts in slabs as the balance increases. In a 30 days or 60 days savings a/c, where the customer has to give 30 days or 60 days notice for withdrawals. Stepped interest rates are provided for higher balances. Multi-currency accounts with low initial deposit. Options like buying / selling foreign currencies, placing standing orders, enquiry about exchange rate and interest rate, etc. are available. Profits can be made against exchange rate spreads. Interest rate is linked to money market interest rates. Deposit Accounts

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4.3

When an amount is placed in a bank by a customer with instructions to hold it for a specific period, say 6 months, 1 year, 5 years, etc., at a given rate of interest, it is known as a deposit account. The bank gives a receipt marked not transferable and

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Banking Basics

acknowledges the amount, period and interest terms. The deposit is payable usually only on maturity and on production of the receipt duly signed by the customer. The rate of interest may be fixed for the full term, or may be variable. If variable, it is usually linked to a benchmark rate like LIBOR or London Interbank Offered Rate. The rates refixed a pre agreed intervals. The customer is not entitled to draw cheques on deposit accounts. In some countries, to withdraw a deposit account, the customer should give a notice of 7 days before withdrawal. Some deposit products are available with a stipulation that the customer should give a notice of 30 days or 60 days before withdrawal. No doubt, the interest rates are higher for these deposits. 4.3.1 Short-term and Long-term deposits:

The rules and regulations for short and long-term deposits more or less are similar. Short-term generally means, the tenor of the deposit is from 7 days to 90 days. Anything more than that is treated as term deposits or long-term deposits. There is no specific demarcation of short and long-term deposits, and the differentiation is according to the market practice prevailing in each country. Similarly, the maximum term accepted for a deposit might be 5 years in one country and it may be 7 or 10 years in another. 4.3.2 Recurring deposits:

Recurring deposits are more popular in India than in other countries. This scheme inculcates a regular habit of savings among wage earners, businessmen, housewives and students to deposit a fixed sum periodically for a particular term. The installments are supposed to be remitted on an agreed date during the calendar month. Any delay in remittance will affect the calculation of interest and therefore the banks prefer to take a standing instruction for transfer from the customers current or savings account maintained with them. Interest rates are almost equal to the rates of fixed deposits. On recurring deposits, interest is compounded quarterly. Recurring deposits if discontinued in the middle, or prematurely withdrawn, may not be eligible for interest unless the deposit completes a certain minimum period.

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Product variations are also possible. For example, a Malaysian bank offers recurring deposits for 24 months at interest rates prevailing on the savings account and also provides a bonus of 15% on the interest earned at the end of 12 months and 30% at the end of 24 months. 4.4 Product Variations:

When banks started focusing on retail and personal banking sectors to attract and improve their customer base, amidst tremendous competition, the conventional products like deposits were dissected to explore new dimensions to the products. For example, when a $20,000 is placed for 1 year @ 7% p.a. and the customer wants to withdraw in the 4th month, normal option would be to uplift the deposit. By doing so, he would be penalized on the interest rate for the entire deposit for $20,000. After utilizing the required amount i.e. $6,000, he has to open a fresh deposit for $14,000, perhaps at a different rate of interest - rate prevailing on the date of breakage of deposit. Another Module 2
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Banking Basics

option would be to pledge the deposit with the bank and raise a loan. This process is cumbersome as it involves pledge of deposit and other documentation procedures. Figure 2.1 - Cluster Deposits

$ 20,000 fixed for 1 year @ 7% p.a. In 4th month, customer withdraws $ 6,000 prematurely

$ 14,000 still enjoys interest @ 7% p.a.

$ 6,000 withdrawn

Banks innovated by allowing a deposit to be withdrawn prematurely on demand in small portions or clusters. Under this scheme, banks allow the deposits to be withdrawn in clusters (figure 2.1). Even a cheque book is issued by opening a link transaction account to the deposit. The mechanism for the above transaction will be reflected in the account as follows:

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Deposit A/c Dr. Cr. Balances Transfer Interest Trf. to SB Bal. 20,000 14,000 6,000 260 260 Transaction A/c Dr. Balances Withdrawals Trf. to FD Interest 6,000 Cr. Bal. 6,000 6,000 260 260

Amount withdrawn i.e. US $6,000 is debited to the transaction account. At the end of the day, the debit balances in transaction accounts are swept to the relative deposit accounts. The clusters are proportionately broken and the accrued interest passes on to transaction account. These transactions in practical situation are complicated and needs high degree of control to avoid drawings in excess by a customer against his outstanding deposits. Use of technology is imperative.

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Banking Basics

Examples of other variations are: Offer fixed and floating rates on fixed deposits. Automatic overdraft up to 95% of the deposits. Deposits are opened in foreign currencies and to cover a possible loss in exchange rate fluctuation, forward booking is arranged, if required by the customer. When following Islamic banking principles, instead of paying interest on deposits, a predetermined profit sharing contract is entered into between the depositors and the bank. Here the bank acts as an entrepreneur by investing the monies in permissible activities.

In India, banks offer fixed deposits, cumulative deposits (where interest gets compounded quarterly) and cash certificates. In fixed deposits, interest may be paid annually, half-yearly, quarterly or monthly, whereas in the other two deposits, interest is compounded and paid only on maturity. If deposits are prematurely withdrawn, generally a penalty is applied. 4.5 Deposit Insurance In most of the countries, deposits with banks and other recognized financial institutions are insured up to a certain amount. The banks contribute to the Insurance Fund based on their volume of deposits. In case, a contributory institution becomes insolvent, the fund pays the deposit amount to the deposit or subject to a maximum limit. In the US, most bank accounts are insured by Federal Deposit Insurance Corporation (maximum US $100,000). In UK, deposit insurance is taken care by the Deposit Protection Fund. In India, deposits are protected up to Rs.1 lakh per account by the Deposit Insurance Corporation (DIC). DIC covers only deposits held by banks. 5 THE CLEARING SYSTEM

All crossed cheques drawn on other banks have to pass through the clearing system. It is mandatory in most countries that cheques have to be physically presented to the paying banker. The fundamentals of the clearing system are similar across countries. However, the technologies used, the arrangements put in place and the procedures to be followed could vary from country to country. In India, clearing operation is the responsibility of RBI. Thus, wherever RBI has an office, it takes care of clearing. In other centres, mostly State Bank of India runs the clearinghouse. There are also a few centres where the clearing operation is conducted by a bank other than RBI or SBI. A clearinghouse, in simple words, is a meeting place for all the member banks to exchange the cheques that are drawn on each other. In figure 2.2 below, each bank sends the instruments to the clearinghouse on a bank-wise basis. Thus, Standard Chartered Grindlays (SCG) will have cheques drawn on Bank of Baroda, Canara Bank, Dena Bank, etc. Similarly, Bank of Baroda on the others and so on.

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Banking Basics

In the clearinghouse, SCG will make a claim on each bank for the amount of cheques it has presented to them (outward clearing). At the same time, all the other banks will make a claim on SCG for cheques drawn on it (inward clearing). The net balance either positive or negative - is either due to or due from SCG. Figure 2.2 - Clearing House and Member Banks
Bank of Baroda

SCG

ICLG

Canara Bank

CLEARING HOUSE Dena Bank

OCLG

Syndicate Bank

ICLG - Inward clearing (cheques drawn on bank presented by various banks) OCLG - Outward clearing (cheques drawn on various banks by the presenting bank) Wherever the volumes are heavy, the entire process illustrated above is automated. Under this, physical sorting, accounting and settlement are system-run. Irrespective of whether the clearing process is manual or automated, those banks with surplus clearing would get the money from the clearing, while banks with adverse clearing balances would be making payment within the stipulated time period. Such clearing balance adjustments are carried out through the accounts maintained by individual member banks with the bank running the clearing house. 5.1 Magnetic Ink Character Recognition (MICR):

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In all-important cities in India, clearing is done through MICR process. The relevant information is printed / encoded on the bottom of the cheques in magnetic ink (MICR Band). The code signifies the place (Mumbai, Delhi, etc.), the bank, cheque number, type of account (current, savings, dividend warrant, etc.) etc. Along with these details, the presenting banker manually using magnetic encoders types the amount of cheque. Globally MICR is used and the code details may differ from country to country e.g. it may include currency, account number, etc.

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Banking Basics

5.2

MICR Clearing: Presenting Bank - Procedure


Bank acknowledges receipt & puts crossing stamp

10 a.m-2 p.m

DAY 1

Customer deposits the cheque at the counter

Sent to clearing section

7 p.m.

Cheques, statements and floppy given to Clearing house

Sent to clearing house at the specified time

Cheques are manually encoded with the amount

Clearing house processes & provides details of cheques drawn on each bank in a floppy to

Cheques and statement details are cross verified

DRAWEE BANK

Drawee bank downloads the floppy into their system & a statement generated

Drawee bank collects the cheques statements and floppy from clearing house

8a.m.

DAY 2

Cheques are posted to issuers accounts by the system

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Excess report generated to check sufficiency of funds & simultaneously cheques physically verified for technical errors

Any cheques to be returned are included in the next outward clearing of the day

1 p.m.

11a.m

Effectively, a customer depositing a cheque on day-1 will know the fate of the cheque on the next working day evening. Generally, banks allow withdrawals on the third working day. For large value cheques amounting to more than Rs.50000, there is a facility for clearance on the same day (high-value clearing) provided the cheques are drawn on designated/specified branches, generally nearer to the clearing house. In high-value clearing, a cheque deposited within a specified time will be cleared on the same day before 4.00 p.m. 5.3 Outstation cheques: In India, for outstation cheques drawn on metros like Calcutta, Mumbai, Delhi, etc., RBI has a separate clearing system known as National Clearing. Under this, cheques are deposited with the RBI along with a statement. RBI sends the cheques to their counterpart in other metros by courier. The destination branch of RBI clears it through Module 2
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Banking Basics

local clearing and remits the proceeds electronically, which in turn is credited to the collecting bankers account in the clearinghouse. The entire process is time bound. For e.g. a cheque drawn on Mumbai and deposited in Chennai should get credit on the 5th working day from the date of deposit. In many other countries the facilities for inter-city payments are advanced, and in some cases, the cheque need not travel physically from one place to the other. 5.4 Clearing system in other countries - Some observations:

Various types of automated clearing systems are in vogue in different countries. Nonetheless, as indicated above, the processes involved in clearing are more or less similar. With latest technologies the processing time is much faster and settlement systems are more much advanced in developed countries. For example, instead of manual encoding of amount in each outgoing cheque received by tellers, a power encoder automatically encodes the cheques 6 times faster by reading the file from tellers check reader. 6. Remittance and Payment systems:

Another basic service that a bank has to be efficient at is - remittances and money transmission. The intention of the customer in depositing the amount into his account is mostly to affect a transfer either within the country or outside. It is not the deposit / lending interest rates that alone attract a customer. A good payment mechanism with speed and accuracy attracts resourceful customers. 5.1 Mechanism of remittance:

If a customer wants to make a local payment a bank pay order will serve the purpose. If it is to be remitted to other centres whether within the country or outside, a demand draft may be purchased from a bank. Urgent transfers can be effected by telegraphic transfer (TT). Figure 2.4 - The remittance process Reimbursement

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Bank TT

Customer

Beneficiary Calcutta

Bangalore

When a demand draft is issued, the customer collects it across the counter to the debit of his account. It is upto the customer to send the draft to the beneficiary to complete his

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Banking Basics

transaction. The bank will send an advice to the drawee bank for having issued the draft with full particulars. When a TT is sent, the customer gets an advice from the bank for having received his instructions. The remittance instruction will be transmitted to the destination bank by telex or other network with a secret code. The recipient bank will decode the message to check the authentication and pay the amount to the beneficiary. In both the processes, the receiving bank will honor the remitting banks instructions, as there must be some correspondent banking arrangement (see box) between them. The next step for the remitting bank is to remit the funds to the receiving bank. If both are branches of the same bank, it is done through inter-branch transfers. If it is a correspondent bank, the transfer of funds is done through a common bank, where both have an account - usually through the central bank of the country using the clearing system. Let us understand this with an example (figure 2.5). Correspondent Banking The needs of the customers are plenty and diversified. It is not possible for a bank to have branches in every nook and corner of the world or even within a country for that matter. There are some international banks having branches in important places in the world. Some banks may have good network in a particular country and some have strong presence in a region within a country. E.g. Deutsche Bank or Bank of America has international presence; State Bank of India and Central Bank of India have thousands of branches in India. If Deutsche Bank wants to issue a draft on Chandigarh; it can use State Bank of India for that purpose. If the same bank wants to issue a draft on a remote place in Kerala, Federal Bank is the suitable candidate for drawing arrangements. On the other side, if South Indian Bank wants to remit a TT to Chicago, they can seek the services of Bank of America. Such arrangements entered into by banks for facilitating services at places they are not represented is called correspondent banking arrangements. The correspondents arrangements are not entered into on a one-off basis. Each bank has a separate division to look after these requirements. Based on the frequency of requirements, mutual relations, scope for revenue generation and scope Tfor enlargement of business, the specialists of these department will sit together and design a correspondent relationship in clear terms regarding the facilities, operations and charges involved. Then it is circulated to all the branches and more particularly to the branches that are likely to utilize the relationship. Figure 2.5 - An example of the remittance process
Correspondent Bank Chase Manhattan Bank New York Debits US $ 10000 Federal Bank Alwaye

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TT for US $ 10000

Issues PO for US $ 10000 less charges

Bank of America New York 23

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Banking Basics

A customer of Federal Bank wants to remit US $10,000 to the beneficiary having an account in Bank of America, New York. Chase Manhattan is the correspondent bank for Federal Bank. Federal Bank sends a tested telex to Chase. On verifying the authenticity, Chase debits Federal Bank with US $10,000 and remits locally through CHIPS (i.e. local clearing for international payments in US) to Bank of America for credit of the beneficiary. This is somewhat a simple example. Sometimes, reimbursing bank may be different. In the above example, although Chase may be the correspondent in New York, Federal Bank may be maintaining the US$ account with Citibank in Chicago. Then another tested telex has to be sent to Citibank to cover the transactions i.e., reimburse Chase at New York. This is also called cover message or cover transaction. 5.2 Remittance networks:

SWIFT (Society for Worldwide Interbank Financial Telecommunication): SWIFT has replaced using individual telex messages for transmission of funds to a certain extent. SWIFT is a non-profit co-operative credit society organized under Belgian law. This system allows the member banks to transmit messages instantaneously by computerized telecommunication network over dedicated lines and thereby avoids delay in transmission. SWIFT handles millions of messages apart from payment instructions successfully and economically. Large Value Transfer Systems (LVTS) and link with local clearing system: In an international credit transfer, where the originators and beneficiary banks have neither a correspondent relationship nor a common correspondent, LVTS is an important link in carrying out the transmission of funds. Usually, clearing house of a country is a place where settlements between banks are done either by pay orders or by electronic messages. But in US, UK, Japan, Canada and some other countries there are dedicated networks to facilitate LVTS. Some LVTS utilize SWIFT network for exchange of domestic bank to bank payment orders. Technologically, LVTS is characterized by a communication system linking participating banks by means of dedicated lines capable of providing on-line communication in real time. Computerized LVTS are either central switch or gateway networks. A central switch system is consistent with an open access policy imposing minimum bilateral compatibility requirements between each participant and the routing is through the central computer so as to accommodate a fragmented banking system. The American CHIPS, Swiss SIC, Japans BOJ NET are based on central switch. Geographical limitations apply to this system. The banks outside the geographical area need to apply for correspondent relationship with banks within the territory. The English CHAPS and American Fedwire are based on gateway system that is more decentralized facilitating direct communication between each participant. Gateway system is more responsive to technological enhancements and is dominated by a small number of large banks. Module 2
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Banking Basics

LVTS settlement takes place on the books of the central counterparts, usually the Central Bank of the country, where all direct participants hold the account.

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Center of Learning

Retail Banking

INTRODUCTION Most banks of the world are involved in retail banking to a large extent. Retail banking involves catering to the banking and other financial needs of individuals, and in some countries, small businesses like sole proprietorship and partnership companies. It is always profitable for banks to obtain retail deposits at cheaper rates and lend them to corporates with a good margin. Although retail business has high operating costs, it is also a high margin business for the banks. The growth of non-cash wage payment methods leading to banking habit in most developed countries has broadened the consumer base and influenced the demand for additional retail financial services. Retail banking requirements vary from one age group to the other. Those who are 30-40 years old are spending and borrowing to buy houses, raise children and enjoy higher standard of living than their parents. Those little older are saving and investing for retirement. Those over 65 (in America for instance) are selling their houses and investing the proceeds to generate additional income. Obviously, age is not the only feature that can influence demand. Marital status, family structure, occupation, ethnic origin and sex all have a bearing on demand for retail services. In retail banking, deposit taking is still the most important factor in maintaining customer relationship. Severe competition has led many banks to diversify into product areas like insurance broking, stock broking, travel agencies, estate agencies and offering mutual fund facilities. The result is that, there is an increasing tendency for people to receive banking services in a fashion they receive utilities such as water, piped gas or electricity. Physical location of supplier is irrelevant to the beneficiaries, perhaps it does not matter. Having looked at the basic transaction and deposit accounts, in the previous module let us look at various other retail bank products. 1. RETAIL LENDING

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One of the main functions of a banker is accepting deposits and lending them judiciously and profitably. A good banker therefore, is expected to know its borrowers well. 1.1 1.1.1 Appraisal Methodology: Credit scoring:

Traditional method of appraisal is by looking into the purpose, credit worthiness and repaying capacity of the borrower. But when a bank is dealing with a large number of individuals, statistical method of appraisal is more popular and the main method used is called credit scoring. The system followed in credit scoring is by allocating points for various aspects of applicants life. E.g. age, occupation, how long with the present employer, nature of property occupied, etc. It is a scientific analysis of risk factors applicable to various aspects of an individual borrower. By using computer based statistical analysis, the minimum profile of a borrower who is unlikely to default is arrived at, and the corresponding credit score is kept as the hurdle score over which, lending is approved. This score may also be related to the amount being lent i.e. the score required may be higher with larger amounts. In credit scoring, the chance to reduce lending risk, by Module 3

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Retail Banking

removing subjectivity from the credit process, is high, as the computer has no personal biases. The drawback is that, in certain cases the score sheet may not divulge certain factors, as it may be out of the purview of the standard data being collected. Statistical methods go by the principle that most borrowers of a certain basic profile and above, tend not to default. As the individual amount lent is small compared to the total lending to the individuals as a class by a bank, the methodology provides for a certain percentage of default, and builds the anticipated deficit in the interest and other charges of the product. For example, a typical retail bank, say, has $100 million in retail loans. By statistical analysis, it may estimate that the bad loans may be 3% of lending. So if its normal pricing would have been say 18% p.a., it may charge 21% or 22% p.a. as interest to cover for the anticipated defaults. Retail lending rates are generally high to reflect the higher risk of default on such lending. Individual loan size in retail lending is small when compared to the total size of lending in the retail segment. Moreover these are spread over various income, cultural, wealth profiles, etc., which in turn spreads the risk over a variety of individual backgrounds. The security it has taken also varies in nature from mortgage to pledge of stocks to clean loans. This approach to lending where individual account risk is small, and the total risk is spread over large number of accounts, is called portfolio approach to lending. 1.1.2 Credit rating - Individuals

In some advanced countries, credit ratings are available for individuals also. Banks appraisal process is simplified as they obtain the ratings of individuals from these agencies and use them as a basis for evaluating loan application. Example of such agency is TRW, Fair Isaac, and Equifax, of US. 2 2.1 Products: Clean advances:

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Historically, a large portion of overdrafts to individuals is granted without the backing of any security. This is known as unsecured advance or clean advance. Clean advances may be made available in the form of overdraft or demand loans like educational loan, personal loan or consumer loan. Clean advances are generally given to customers who are confident about their integrity and credit worthiness. This facility is usually made available for the depositors / existing clients of the branch. A clean facility is normally associated with higher risk, as there is no control over the end-use of the loan and is also unsecured. Where credit scoring is used, the hurdle score will be higher. The rate of interest is therefore more for clean advances, despite lower administrative costs.

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Retail Banking

2.1.2

Personal loan against salary (Figure 3.1):

This is an unsecured loan. An employee of a reputed company approaches bank with a request for personal loan. The details are filled in the scoring sheet attaching salary certificate. Bank appraises the application and grants a limit and insists that the salary should be credited to the employees account with the bank. Equated monthly installment (EMI *) is worked out. After completing the documentation and in some cases, after obtaining post-dated cheques for the EMI, the bank releases the loan amount. Ultimately, the bank cannot attach the salary upon default of payment, but it is only a comfort. Figure 3.1 - Salary based loan
Employer Remittance of salary Loan disbursed Bank Request for loan Employee (borrower)

*EMI or Equated Monthly Installments: This is the monthly installment containing both the principal repayment element and the interest component of the loan. An employee who takes Rs.1, 00,000 loans and repays it over a period of 36 months at 10% flat interest rate will repay the loan and interest with an EMI of Rs.3611 over this period. (Table 3.1). Table 3.1 EMI Monthly 36 18% -100000 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 1-Jan-99 1-Jan-99 1-Feb-99 1-Mar-99 1-Apr-99 1-May-99 1-Jun-99 1-Jul-99 1-Aug-99 1-Sep-99 1-Oct-99 1-Nov-99 1-Dec-99 1-Jan-00 1-Feb-00 Arrears Monthly 36 10% -100000 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 Advance Monthly 36 10% -100000 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611

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Payable N Flat Rate 1-Jan-99 1-Feb-99 1-Mar-99 1-Apr-99 1-May-99 1-Jun-99 1-Jul-99 1-Aug-99 1-Sep-99 1-Oct-99 1-Nov-99 1-Dec-99 1-Jan-00 1-Feb-00 1-Mar-00

Monthly 36 18% -100000 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278

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Retail Banking 1-Apr-00 1-May-00 1-Jun-00 1-Jul-00 1-Aug-00 1-Sep-00 1-Oct-00 1-Nov-00 1-Dec-00 1-Jan-01 1-Feb-01 1-Mar-01 1-Apr-01 1-May-01 1-Jun-01 1-Jul-01 1-Aug-01 1-Sep-01 1-Oct-01 1-Nov-01 1-Dec-01 1-Jan-02 Effective Rate E / F ratio Conversion 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 19.47% 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 35.29% 1-Mar-00 1-Apr-00 1-May-00 1-Jun-00 1-Jul-00 1-Aug-00 1-Sep-00 1-Oct-00 1-Nov-00 1-Dec-00 1-Jan-01 1-Feb-01 1-Mar-01 1-Apr-01 1-May-01 1-Jun-01 1-Jul-01 1-Aug-01 1-Sep-01 1-Oct-01 1-Nov-01 1-Dec-01 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 3611 20.82% 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 4278 38.10%

2.2

Secured advances:

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1.95 1.96 (N / N + 1) * 2 F 19.46% 35.03%

2.08 2.12 (N / N - 1) * 2F 20.57% 37.03%

If the customers resources are modest in relation to the advance required, the bank may call for a security or collateral to be provided. The repayment however should come from their personal income in case of individuals or from profits, if it is a retail business. Taking security is only a form of insurance. Common assets offered as security for retail advances are stocks and shares, bonds, fixed deposits, life insurance policies, motor vehicles, consumer goods, land / house property, etc. There are five principle ways by which the security can be charged (interest of the bank in the security can be exercised through these charges), by lien, assignment, pledge, hypothecation and mortgage.

Lien is the right to retain securities / goods belonging to customer, until a debt due to the bank is paid. Lien can be exercised on deposit accounts. Assignment: is transfer of rights or benefits of a contract or a property from one party to another (bank). E.g. life insurance policy, book debts. Pledge is delivery of goods to a bank as security of payment of debt. Pledge can be applicable to stock of goods, government securities, etc.

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Retail Banking

Hypothecation is akin to pledge of an asset except that the asset is not physically handed over to the bank. E.g. vehicles, stock in trade, etc. Mortgage is transfer of interest in a specific immovable property to the bank for the purpose of obtaining a loan.

In each case, the bank does not become the absolute owner of the properties, but has rights over property until the debt is paid. 2.2.1 Lending against securities: Lending against stocks or shares and other financial assets is popular because in most developed economies investment in stocks is as common as bank deposits. Retail customers hold shares not only for the purpose of investment and income, but also for its capacity to generate a loan without much difficulty. Banks have lists of shares, its assessed value (based on market trends) and a margin upto which they can lend. Thus, if the value of shareholding at current market price is Rs.5, 00,000, at 50% margin, a limit of Rs.2, 50,000 may be set. Customer has to submit a request enclosing share certificate, blank transfer form and usual legal documentation. In case of dematerialized form of shares, the borrower has to mention in his application form the details of depository and provide power of attorney to the bank to sell the shares in case of need. The bank will request the depository to mark a lien and only upon receipt of confirmation of lien the bank will release the funds. After assessing the value of shares submitted, the bank may provide an overdraft limit to the customer in which case he / she will open a current account. The shares pledged are marked to market or revalued weekly / fortnightly / monthly and the drawing powers are changed accordingly. A loan can also be given, and in such situations the repayment schedule is fixed. Any excess drawings by the customer or when loan outstanding is higher than the drawing power worked out needs to be covered by additional lodgment of shares or regularized by cash deposits by the customer. If the debt is not repaid or regularized, or the loan installment is not paid even after usual intimations, the bank can sell the shares after informing the customer, and adjust the proceeds against the advance. Figure 3.3 - Advance against security of stocks
Borrower Lodges shares / demat particulars / power of attorney

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Market rates Limit

Electronic Communication

Bank Sets limits

Stock Exchange Publication

Varies according to market value

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2.2.2

Vehicle finance:

As the standard of living of individuals improve world over, car finance has become big business. The demand for car loans has induced the banks to arrange tie-ups with car dealers, so that the customers need not make trips to the bank and the automobile dealers separately to buy a car. The customer has to select a car and a model and inform his bank about his request. The bank will forward a proforma invoice and a car loan application form. The customer completes the form and sends a down payment of say 25% of the value. At times 100% finance may also be available. The bank arranges with the dealer for delivery. Repayment period offered is usually 3 to 5 years and monthly installments (EMI, as explained before), includes a portion of principle and interest on the loan. The rates are quoted in terms of APR in some countries. APR is the Annual Percentage Rate quoted by the lenders for the loan products, which includes fees connected to the loan. Thus, if the interest rate is 8% p.a. and the other charges work out to a certain sum, say Rs.3, 000, then the effective rate may work out to 8.3% p.a. or APR is 8.3%. Car loans are secured by hypothecation charge in favor of the bank, which gets registered with the transport authorities and at times notation is also made in the car documents. In some cases, original car documents are kept with the bank till the loan is repaid. Rights on the title of the car lies with the bank till full repayment is made. In case the customer wishes to prepay the loan, due adjustments are made in the interest and the balance amount. A point to note in car loans is that, vehicles depreciate faster, and therefore repayments should be promptly collected. Recoveries pose some problems in car finance because many borrowers tend to purchase cars beyond their repayment capacity, and later find it difficult to maintain and honor repayments. Storage of seized cars and resale of cars results in high overhead expenses for the bank and these services are generally outsourced. 2.3 Other consumer lending:

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With the boom in demand for consumer goods everywhere, people need money to acquire latest models of televisions, VCDs, washing machines, computers, refrigerators and other appliances with latest technology and features. The concept of buying goods with personal savings is gone to the extent, that even travel agents offer Travel now, pay later schemes. Some banks offer loans without getting into the hassles of invoices and sale documents and grant clean loans based on the income and financial standing of the customer. Other method of delivery of loans is to have a link with the retailer. The customer produces the invoice of purchase and the bank settles the payment to the retailer directly. The loan is repayable in predetermined installments including interest under what is called a hire purchase or installment scheme.

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Figure 3.4 - Process of loan disbursal


Applies to bank Borrower Bank Credit score, credit ratings & approval Retailer Delivery of goods Borrower

Repayment by installments

2.4

Consumer loan through credit cards:

Certain credit card organizations offer consumer loan through a fast track method. Such cardholder can walk into a selected retailers shop and pay the bill through the credit card. The bill amount is (within the upper limit of the card) debited to the cardholders account by way of EMIs over the period of the loan. The retailer is paid by credit card organization. This is the simplest way to obtain a consumer loan, but the rate of interest is high. 3. ELECTRONIC BANKING

People use banks because they need to, not because they really want to. Recent surveys show that majority of the customers (nearly 50%) visit their bank only 5 times in a given period of 3 months. Nearly 20% of them have never visited the branch during that period. Nearly 80% of the customers do not know about the bank manager. Therefore age-old custom of symbolizing the bank and bank managers to the customers is gradually disappearing. Why? Electronic banking is making inroads into banking services at a swift pace eliminating human intermediation as far as possible. Moreover customers are becoming more demanding on the level of services they seek. As a response electronic banking services like ATMs, EFTPos, telephone banking, smart cards and others have emerged one after the other at uninterrupted pace. 3.1 Automated Teller Machines (ATM):

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At present, in most of the developed countries and in many developing countries, any customer of a bank requiring cash may obtain it in one or more of the following ways: By cashing a cheque over the counter of his branch Over the counter of another bank supported by a cheque card By using a cash card (ATM card) through the teller of a branch By using cash card at a cash point in a store By using cash card in ATM outside the branch By drawing cash on credit card

ATM or cash dispenser, as it was called, is one of the most significant developments in banking and perhaps the most revolutionary in recent years. ATMs can be used for

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withdrawal and deposit of cash, deposit of cheques, requesting a latest statement of account, requesting a cheque book, balance enquiry, etc. 3.1.2 Core functions of ATM: ATMs usually provide the following services. 3.1.3 Cash withdrawal Balance enquiry Statement ordering facility Cheque book request facility Deposit (not available in shared network) Funds transfer facility Bill payment Mini statement facility Passbook updating facility (where pass book system exists) Travelers cheque dispensing (not common)

ATM operation:

Viewed from a technical perspective, an ATM is simply a safe electro-mechanical input and output system, which is itself controlled by a full electronic user interface. ATM manufacturers have taken considerable care to maximize the speed of the entire customer interaction process by making it as clear and as straightforward as feasible. ATMs are operated through a four-digit personal identification number (PIN) (see box). Some machines have an alarm that produces some kind of sound until the cash and the ATM card is removed, as some customers tend to forget to take their cards back. PIN - Personal Identification Number Four digits PIN given to customers for ATM transactions is an effective and simple way to authorize these transactions. PINs are so secret that even the staffs that operate the banks computer system do not have access to them. As soon as the customer inputs the PIN into the system, it is encrypted and therefore never occurs in the decrypted form in the system. The most obvious security hazard could be at the time of despatch of ATM cards and PINs by the bank to the customer. For this reason, plastic cards and PINs are never posted together to a customer. Either the PINs are posted a few days later or the customers are requested to collect the PIN in person at the bank. Biometrics is the other most effective authorization system that uses biological attributes to establish the bona fide of the person attempting to access the ATM. The process digitizes a thumbprint or an entire handprint and compares it with the stored record. The process may also make use of a voiceprint or it may scan the subjects retina in one or both eyes. Advantage of biometrics method is, it cannot be lost, stolen or recreated. Creation of PIN, its maintenance and management is laborious and expensive. Biometrics system is likely to overcome these difficulties and is expected to largely replace the PIN system.

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3.1.4

On and Off-line operation:

In the earlier systems, ATMs operated by banks were working on off-line basis i.e. the link between the ATM and the banks central computer was not maintained all the time but only at certain times during the day. Therefore, it was not possible to know whether the customer is having sufficient balance at the time of withdrawal. The only control that the bank could exercise is to have a daily withdrawal limit to minimize the risk. Later, the system was developed featuring a direct and simultaneous link between the ATM and the host computer. This system is known as on-line system provides for interaction with the computer on account balance, credit limit, etc. in real time. 3.1.5 ATM networks:

A banks ATM resources usually consists of a number of ATMs linked to a host computer, which instantaneously authorizes transactions. A small local bank may install just two or three ATMs in their locality whereas a larger bank may have a number of ATMs nationwide. ATMs are expensive to buy and its installation and maintenance is also costly for banks. Therefore banks are interested to share the ATMs through networks. Quite apart from cost advantages, the network provides a bank customer the facility to use ATMs all over the country and even in remote places. For example, in UK, many regional bank building societies concentrate their operations in some particular regions only. The prospect of participating in shared ATM networks gave them the chance of extending their activities geographically and also offered their customers a nationwide banking service. In India, SPSN, SWADHAN is the shared network and is promoted by Indian Banks Association (IBA). There are 29 member banks in the network including public sector and private sector banks. 3.1.6 Nature of ATMs / shared network:

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In UK, a system called LINK is the shared network of ATMs only. In US and other countries, the network includes both ATM and EFTPos. The four largest shared regional ATM networks are STAR, HONOR, NYCE and MAC. Whatever the function of shared network, the benefits are so great that it is certain to be a permanent fixture in banking services. The box below, explaining LINK network, gives an idea of the nature of these networks. The basics extend to all the other networks also.

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LINK ATM network - A case study LINK is a brand name of LINK Interchange Network Ltd. It operates its own computer systems, which provide a switching service to 26 member institutions as of 1998. The network covers nearly 15000 ATMs accessible to LINK. Links central system has 58 gigabytes of mass storage and is capable of processing 4080 transactions per minute (i.e. 68 per second). But this is by no means as powerful as that required by other major operators like VISA, but can support LINKS operations adequately. LINK has a backup for disaster recovery that can be brought into use within an hour, on contingency. LINK is developing a gateway to MasterCard, Visa and PLUS (an international ATM). LINK has a clear national identity, which is widely recognized. It has the ability to offer the customers a countrywide ATM network with minimal investment and running costs. Membership fees: A joining fee is payable on entry as member institution to the network. A fixed monthly membership is also payable along with a monthly processing fee. A transaction switching fee is payable to LINK for every transaction. Gateways: LINK is a system, which is closed in the sense that, it only provides services to member companies and their customers. All LINK members participate in the core ATM sharing services. Members have an option to link themselves to other ATM global networks and payment systems through LINKs gateway connected to MasterCard and Visa. LINK is a continuous success as it offers customers a wide range of functions and is technically reliable. Members of LINK are committed to the principle of sharing and understand the creation of a truly nationwide shared ATM network to give them a chance to compete directly with other banks. 3.2 Telephone Banking:

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Telephone banking is a convenient and time saving method of banking. Majority of important banking services can be delivered through telephone banking. The typical ranges of services available are: Balance enquiry Statement ordering Cheque book request Funds transfer between different accounts held by the customer of the bank Funds transfer to third parties (utility bills) General account queries and advice. The range of services is bound to increase with increased competition between banks. 3.2.1 Types of Tele-banking system:

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Telephone banking services require certain identification number to be keyed in to access the service, and another PIN to authorize the transaction if necessary. Where touch-tone telephone is not available or a non-routine banking transaction is to be performed, a telephone operator is made available to attend. Another method of telebanking is automated voice response technology. This involves the customer using his tone-phone to send digitized data messages to the system in order to activate a particular service. Sometimes, the customer is required to say one or a number of particular words and the system software recognize the word and the voice. The system works on a similar principle to those using tone commands. 3.2.2 Some telephone banking system use a PC that interfaces with the system and the data communication is by telephone. Call Centers: The success of telebanking system is centered on Call Centers, which is the management and operational location to which customer calls are relayed. It is here where human operator and / or operator technology is located. There has been considerable advance in the organization and automation of call centers. Typically, the call center houses a client server system that houses several hundred telephone operators / agents who keep and maintain the image of the bank as a progressive service provider. The system, in the course of the day, forwards hundreds of routine callers into an automated touch-tone or speech-enabled router, so that no human agent has to answer. With the development and sophistication of the IVR (Interactive Voice Response Systems) technology, many of the routine customer calls like account balance, cheque book issue, etc. are taken care by it, leaving the operators for more complicated requests. The system also has a customer service package running, which can be used by the operators while the telephone-based dialogue is taking place with the customer. The operator therefore interacts usually with the computer screen during the call and does the needful. CTI or Computer Telephony Integration is the more advanced technology used in call centers these days. This typically enables, Location of customer records automatically from the incoming phone call, enabling the operator to have the customers details on the screen immediately as he / she takes the call. Facility to transfer calls and customer information to the customer service system from other departments. In case of product promotions, where different response numbers have been provided based on the incoming phone number, it can detect the customer and automatically provide a screen based scripting as to what that particular enquiry could relate to. This saves time and creates customer goodwill.

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CTI is further evolving as explained in the box below. Call Center - Some latest developments The positive trends of transformation of call centers into sales points are seen in telephone banking division of some banks. Many people in Computer Telephony Integration (CTI) feel that a one-to-one marketing model is always effective in customer service. Ironically, speech recognition technologies (voice over the phone prompts it instead of through a key pad) are now cheaper and a switch over to it makes telebanking transaction even more remote to human intervention. Progressive banks strongly feel that call centers should be used as a bridge to the customer. The banks are migrating to client-focussed view from product-focussed attitude. To support a more comprehensive version of customer care, banks prefer e-mail and even video conferencing within the call center in addition to computer telephony set-ups. Software has been developed in this direction that allows the system itself to generate a series of actionable suggestions, so that the operator can quickly scan and suggest desirable alternatives to the customer. Telephone Banking - A British Banks Success Story A building society in UK, which became a bank during 1997, wanted to sell a variety of personal financial services to customers outside its traditional catchments area in South and West of England. They developed a new savings product, which made extensive use of the telephone, offering a high level of customer service, 24 hours a day all year around. The operation of the account is mainly through the telephone banking system. The system enables the operators to view all details of the customers account as soon as a call comes in, including scanned documents (cheques, correspondence, etc.) pertaining to the customer appearing on the screen. There is no need to retrieve any information from the filing cabinets. This helps the operator to see all the accounts and information pertaining to the client on a large 20 screen and offer personalized guidance and advice and at the same time cross sell the banks other products. Customers preferences can be noted on the account holders file. The notes focus on the correct way to pronounce the customers name, details of the customers interest and so on. The account holders are impressed by the speed at which their queries are answered, reflecting efficiency and high service level. It operates as a pooled system, so that there is no single personal account manager. The personal touch is delivered by the system and not by the individual operator. The product has been a great success. 3.2.3 Advantage of telephone banking:

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Telephone banking offers substantial cost savings to the bank for automating their expensive branch based operations. Banks even provide free call system from their branches with dedicated lines to encourage use of telephone banking. Bank manager as a delivery mechanism to offer a personal level of service is now available only for most important customers.

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3.3 Internet Banking: The Internet is the best-positioned delivery mechanism since the innovation of the telephone because of its power, properties and versatility as a communication system. It is not only about banks displaying information about their services on the web, but also about how many banks can use internet providing interactive services. As a payment system, the Internet is in its early stage. Considering the underlying risk in payment systems, it has to be seen how Internet is going to manage it, securely and efficiently. The background of Internet banking is the concept of home banking pioneered by Citibank connecting customers PC to the banks computer through a modem. The bank provided the special software needed for online banking to the customer. Using this program, the customer can bank off-line on the PC and complete the transaction through modem. The advent of Internet has changed everything. For banks, there is a single connection to the net instead of thousands of telephones and modems across the country. The basic minimum services that a bank can provide through Internet are account balance checking, funds transfer among accounts and electronic bill payments. Some of the sophisticated internet banks allow for loan applications, download account details to PC, trade in stocks and mutual funds, and examine deposit slips / cancelled cheques of the customer. Internet banking is not the answer to all banking needs. For cash withdrawals and cheque deposits, the customer has to go to ATM / branch. The initial public response to Internet banking cannot be termed as success. The main requirement for this service is that the user should have a PC and should have purchased Internet time. However, on-line banking has many advantages. It turns a PC into a bank branch and therefore it is easy and convenient. It is instantly accessible from anywhere by just using bankcard number and PIN. It is cost effective in the sense that it saves time and travel costs to and fro from a branch. 3.3.1 Future of Internet Banking:

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Banks are hinting at services such as downloading cash from Internet bank to customers PC. The electronic cash can be stored in electronic wallet and can be used for shopping. Future integrated banking is much like the virtual kiosk concept that calls for the integration of different delivery channels. All communication channels such as PC, Internet, telephone and ATM spot the same interface irrespective of their underlying platform. The platform in turn will communicate with the banks system and let the customer access its services from any of these devices from the airport payphone to office PC.

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Center of Learning

Corporate Banking

1.

WHAT CONSTITUTES CORPORATE BANKING?

The history of banking is inseparably linked with the history of trade and industry. England, the historical seat of banking, experienced significant changes in financial system and in corporate banking during the past three decades. Corporate banking is a collection of services by banks to Industrial and Commercial Entities (ICEs) or corporates, encompassing wide range of products and services, including facilities like cash and portfolio management. This way, all banking services rendered to ICEs and corporates should be regarded as Corporate Banking. However, there are many products / services that investment banks or investment banking arms of commercial banks offer to corporates - new issue of stocks, bonds and debentures, raising foreign currency loans, etc. It then may be thought that all investment banking activity should also be considered a part of corporate banking. The definition of corporate banking is further complicated by the rapid financial integration due to the growth of international or multinational banks that offer domestic and international services to corporates. It is difficult to standardize the pattern of corporate funding even within a country. Greater usage is being made of new techniques like securitization, factoring and leasing. Rise of international bonds and credit markets has opened up new channels in corporate financing. A profile of corporate borrowing in developed countries shows that Japan and West Germany are inclined to use bank borrowed funds for business unlike UK and US, where market based funding is more prevalent. A particularly high degree of bank closeness with corporate customers is practiced in West Germany and Japan. Given the heterogeneity of the markets which these banks serve it is difficult to analyze and define corporate banking practiced in various markets. A flavor of some services offered under the banner of Corporate Banking by some banks is provided in the box below. Even entities other than banks have also entered certain part of the corporate business. Corporate bank services rendered by banks and others Societe Generale (France)
1.

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Sogecash: Open foreign currency accounts, handle purchase and sale of foreign currencies and international transfers. Allows companies to get detailed statement of accounts all over the world.
Customer Statement Societe Generale Statement Foreign Bank

2.

Progestel Tresorerei: Monitor overall cash position in all Societe Generale group accounts.

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3.

Sogecash International Netting: Offset invoices in any currency payable to, and receivable from subsidiaries of corporate clients. Sogecash International Pooling: Centralize cash balances held by subsidiaries of corporate clients in various countries and currencies in accordance with local legislation. Sogestel: Bank - to - business electronic communication service. Transmits instructions of transfers, standing orders, etc. PC to PC on line. Equipment and Vehicle Finance: Provides hire purchase and leasing for vehicles. Also provides long-term rental and management.

4.

5.

6.

The Bank of New York (US)


1.

Asset based lending - Recapitalization: For clients with inefficient capital structures, high interest or administrative costs, the banks optimize debt structure by applying long and short-term debt instruments to suit clients needs. Debt Restructuring: Strategies and techniques like debtor-in-possession, exit financing and pre-packaged financing. Brokerage Services: Execution service offers trade execution, portfolio liquidation and transitioning, basket trading and stock repurchase. Integrated Technology Services: Offers seamless connectivity from portfolio management systems to custody and account systems, Trading Execution And Management technologies (TEAM), Electronic Trading Access Gateway (E-Tag). Cash Management Services: Funds transfer and payments, collection services, electronic commerce (clients can outsource payment processing to the bank).

2.

3.

4.

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5.

General: Information Technology companies and the post office have entered into areas like foreign exchange, money market, electronic funds transfer, information services and cash management, generating tough competition in corporate product activities. Electronic banking has provided opportunities to earn fee and commission business. Information provision and dissemination are important common elements in these new services. For our discussion, we shall therefore limit corporate banking to domestic corporate banking i.e. local banks or bank branches serving local ICE with emphasis on bank lending & ancillary banking services. 2. 2.1 CORPORATE CREDIT - THE COMMON DENOMINATORS Credit policy:

In certain circumstances, the government and the central bank of a country encourage specific developments and restrain others. In the late 1950s, the need for a loan policy for commercial banks was felt at the level of bank regulators of US and major parts of Module 4

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Europe. Their persuasion enabled bankers to gradually realize that too much discretion in lending decisions resulted in dilution of credit standards and increase of bad debts. Secondly, a lending policy enables a bank to position itself in the market and impose self-regulation. Bank of America (BOA) in 1980s is an example. Till 1979, BOA had no strategic planning and loan policy. Lending decisions were decentralized and delegation of authority to line level was high, to push profits. The virtual absence of loan policy and pressure of growth produced billions of dollars of risky loans. Bad debts jumped to 61% in 1983 and continued rising till 1986 making it a weak bank. Of course, it overcame its problems and is today regarded amongst the better banks. It, in fact, hived of its retail banking operations recently and today, its total focus is on corporate and investment banking. Banks prepare loan policy for striking a balance between returns and risks. The aim is to maximize returns while minimizing risks. Formal written credit policies are imperative for a sound credit risk management process. Such policies can provide crucial discipline to a bank's lending process, especially when the institution's standards are under assault due to intense competition for loans. They can serve to formally communicate a bank's appetite for credit risk in a manner that will support sound lending decisions, while focusing appropriate attention on those loans that diverge from approved standards. In developing and refining loan policies, some institutions specify guidance minimums for financial performance ratios for certain types of loans or borrowers (e.g. commercial real estate). Such guidance makes explicit that loans not meeting certain financial tests (based on current performance, projected future performance or both) should, in general, not be made, or alternatively should only be made under clearly specified situations. Institutions using this approach most effectively tend to avoid specifying standards for broad ranges of lending situations and instead focus on those areas of lending most vulnerable to excessive optimism, or where the institution expects loan volume to grow most significantly. Formal policies also provide lending discipline by stating clearly the type of covenants or contracts to be imposed for specific loan types. When designed and enforced properly, financial covenants can help significantly to reduce credit losses by communicating clear thresholds for financial performance and potentially triggering corrective or protective action at an early stage. Some institutions use credit scoring techniques in their small business lending in an effort to improve credit discipline while allowing heavier reliance on statistical analysis rather than detailed and costly analysis of individual loans. The policy then ensures that adequate care is taken to make balanced and careful use of credit scoring technology for small business lending. In particular, it lays down the limitations of utilizing this technology for loans or credit relationships, which are large or complex enough to warrant a formal and individualized credit analysis. The credit policy could be flexible to provide for exceptions. In such situation, it provides for approval and monitoring by appropriate levels in the management. Formal reporting requirements (MIS) are also stipulated. Module 4

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2.2

Credit appraisal:

Based on the lending policy, a bank grants advances to customers after a detailed appraisal of the customer. The first consideration is the proposition and the second, the security or collateral. The customer has to produce audited balance sheets with projected cash flows, the proposal with details of the business, the purpose and nature of advance and how it would be repaid. There is no fixed formula for lending. But there are various methods by which the bank could analyze and estimate if the business has the ability to generate sufficient funds to repay according to the terms indicated by the company. This exercise essentially involves assessing the ability of the business in achieving the projections based on past performance and the likely future scenario. The analysis tries to understand the conditions required for a loan to perform, and in communicating the vulnerabilities of the transaction to those responsible for approving loans. It provides a useful benchmark against which banks can assess the borrower's future performance. Detailed analysis of industry performance and trends can be a useful supplement to such analysis, and in some circumstances may serve, to some extent, as a substitute for detailed projections for the borrower. The projections in the credit analysis process are not only limited to describing the single most likely scenario for future events, but they characterize the kind of negative events that might impair the performance of the loan in the future. The analysis of such alternative scenarios or stress testing, generally focuses on the key determinants of the performance for the borrower and the loan, such as the level of interest rates, the rate of sales or revenue growth, or the rate at which expense reductions can be realized. It may be expensive to analyze detailed projections for smaller borrowers such as middle market firms, but these customers may collectively represent a significant portion of the institution's loan portfolio. As such, banks apply such formal analysis on a basic level, assisting the institution in identifying and managing the overall risk of its lending activities. Once the bank decides that the borrower is an acceptable risk, it conveys the terms and conditions of the advance and other credit facilities, and obtain documents from the customer to cover the security for the advance (if necessary) before release of funds or allowing the use of other credit facilities that may have been approved. 2.3 Loan or credit pricing:

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Interest, discount, commission and other fees make up the price of the credit product and are the sources of income from corporate advances. Interest rates are governed by parameters set by central banks or some market index like LIBOR in UK and the bank rate in many other countries. Banks fix their own rate, based on the central bank rate, or the rate that large banks charge for the prime - AAA rated - customers, also called prime rate. These rates are determined based on the cost of funds, management cost, minimum margin of profit and the market conditions. The prime rate considered is generally the 90-day or 180-day rates charged by large banks to their prime customers. All other customers are then Module 4

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charged by a load on the prime rate based on perceived risk, period of lending, value of customer, volume of advance, other possible business revenues, etc. The rates may be fixed or on floating basis. In fixed rate method, as the term says, the rate is the same till the repayment of the advance (or till the end of the review period when the performance of the loan is assessed and repriced if the contract provides for). Floating rates means that, the interest to be charged will be re-fixed at pre-fixed intervals according to the market. Unlike fixed rates, floating rates reduces the risk for both lenders and borrowers as the benefits of lowering or the disadvantages of higher rates are shared by both. 2.4 Securing credit:

Banks usually secure their advances by goods, document of title to goods, shares and securities, plant and machinery and immovable property. Sometimes miscellaneous securities like life policies, book debts, and guarantees from reputed individuals or institutions are also considered. We have already seen, in Module 3, the ways in which a bank could avail a security to cover an advance. 3. 3.1 CORPORATE CREDIT - WORKING CAPITAL What is working capital?

One of the important activities of a commercial bank is to finance working capital requirements of their customers and this forms a major part of the advance portfolio of a bank. Fixed capital is required for acquisition of fixed assets such as land and buildings, plant and machinery and equipment. Fixed assets constitute the basic tools or means of production. Working capital is needed for day-to-day requirements of the company. E.g. buying raw materials, holding sufficient stock, allowing credit to buyers and maintaining cash for miscellaneous expenses. Naturally, working capital is not static, but is always changing and circulating. (See fig. 4.1) The operating cycle begins when raw material is purchased. It moves to work-inprogress and after a period become finished goods. A part or entire goods may be sold in credit and the money is realized after the credit period. This process (a cycle) may take 3 months, 6 months or even 1 year depending on the type of industry. For example in the case of a monthly magazine, the working capital cycle may be 30 days. For a washing machine manufacturing company, it may be 90 days. Thus, if the expenses per day are Rs.25, 000 for the former and Rs.50, 000 for the latter, then they need to fund themselves with Rs.7, 50,000 (25,000 * 30) and Rs.45, 00,000 (50,000 * 90) before they can get the realizations from sales. Companies seek to fund this gap through working capital facilities.

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Figure 4.1 - Working Capital Cycle

E
CASH

D
Collection phase Suppliers

A
Sales & administrative exps. Wages, salaries & overheads Raw Materials

Debtors

Finished goods

Work in progress

The length of operating cycle depends on the period of holding raw material, work-inprogress and finished goods. It also depends on collection period of receivables and credit period for payables. From the balance sheet point of view, consider the following: Table 4.1

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19,000 90,000 16,000 4,000 27,000 1,56,000 Assets Land and Building Fixtures and Fittings Vehicles Debtors Stock Cash

Liabilities Capital Reserves Profit & Loss a/c Creditors Bank

50,000 34,000 26,000 12,000 33,000 1,000 1,56,000

In the above example, current assets are Rs.46, 000 (also called gross working capital) and current liabilities are Rs.31, 000. The net working capital is Rs.15, 000. 3.2 Assessment of working capital:

The lending bank, at the time of granting advance towards working capital, will assess the actual amount required. Sanction of limit is always for future requirements. Therefore, the borrower needs to project estimated level of operation and sales. The bank verifies and assesses the possibility of achieving these figures against available capacity of the unit, availability of raw material and power and also the marketability of the product.

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Banks are generally concerned about the level of inventories, level of receivables and efficiency of collection system and level of creditors. As mentioned before, the bank is approached for funding the gap between total current assets less borrowers own sources like creditors. Banks generally do not fund the entire working capital gap. Some part of this gap is required to funded by the client using their long-term sources of funds. Banks therefore use their own internal guidelines to determine what portion of the gap they can fund and this is termed the MPBF or Maximum permissible Bank Finance (for working capital purposes). 3.3 Supervision of working capital advances:

One of the effective ways of studying the health of the business is by regularly examining the profit and loss accounts and balance sheets. But frequent and periodical look into current assets / current liabilities statements may reveal the trends. E.g. The following figures in table 4.2 are the net working capital of a company for 6 months. Table 4.2 (Rs. 000) Jan Feb March April May June 67600 70900 68700 48600 54000 47600 It may be noticed that there is a considerable change between March and April. The possible reasons could be, Exceptional large losses e.g. write off of debtors. Purchase of fixed assets instead of buying raw materials or paying creditors. Diversion of funds into non-productive expense such as travel and entertainment. Mistake in calculations.

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Banks should immediately enquire the reasons from the borrower. 4. DELIVERING WORKING CAPITAL - FUND BASED

4.1 Cash credit / Overdraft: An overdraft is structured in a current account the bank agrees to allow a customer to draw over the credit balance i.e. the customer is permitted to issue cheques beyond the available credit balance up to a certain limit. Overdraft is granted only for short-term requirements of the borrower like working capital or temporary needs of funds shortfall in the business. 4.1.1 Process:

The bank assesses the working capital requirements of the customer and also the probable future cash flow pattern. A limit is fixed for the customer, say, Rs.25 lakhs, for a particular period. The customer can issue cheques, once the documentation is complete to the satisfaction of the bank. For example, the current account of a company ABC Ltd. is given below in table 4.3. Module 4
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Date 2.1.99 3.1.99 10.1.99 20.1.99 25.1.99 30.1.99 3.2.99

Particulars By cash To cheque To cheque By cheque To cheque By cash To cheque

Dr. 65,000 3,35,000 21,00,000 4,10,000

Table 4.3 Cr. Balance 10,000 10,000 Cr. 55,000 Dr. 3,90,000 Dr. 2,00,000 1,90,000 Dr. 22,90,000 Dr. 40,000 22,50,000 Dr. 26,60,000 Dr. (3rd Feb99)

Overdraft is created

Limit exceeded

On the enquiry screen, it will appear as: Current Balance: Limit: Float: Available Balance:

Rs.26, 60,000 Rs.25, 00,000 -Rs. 1,60,000 Dr.

You may notice that the account is a running account i.e. the customer can deposit and withdraw according to his convenience. The interest is calculated on the actual amount overdrawn. The account has to be operated within the agreed limit. If it exceeds, the bank may dishonor the cheque (3rd Feb99) or honor it by allowing excess. Penal interest will be charged for such excesses. 4.1.2 Features:

Overdraft may be granted clean i.e. without backing of any security or secured i.e. covered by securities like stocks, book debts, etc. Overdrafts are payable on demand and therefore the bank may request the borrower to repay the outstanding amount at any time. 4.1.3 Pricing:

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The price of overdraft is the interest rate charged by the bank. The interest rate in most of the countries depends on the central bank rate and the individual banks base rate. In UK, it is based on LIBOR (London InterBank Offered Rate). In India, it is worked on prime lending rate of individual banks. Interest rates are differentiated taking into account the size, risk and the value of the customer. Typically, the interest rates are re-fixed as 90 days or 180 days in floating rate situation. If LIBOR is the base, then the pricing may be quoted as LIBOR plus 2-percentage point or 200 basis points for a given customer. Similar practice is followed for other index based rates also - SIBOR (Singapore InterBank Offered Rate), US Prime rate, etc. 4.2 Working capital term loans (WCTL): Banks may not deliver the entire working capital requirement in the form of overdraft. A portion or a certain percentage as directed in the bank policy would be in the form of term loan. A term loan is granted for a fixed period, normally one year, for working

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capital requirements. Repayments have to be done at periodical intervals. Term Loan is not a running account. 4.2.1 Procedure:

The procedure for obtaining a working capital term loan is similar to that of an overdraft. But after granting the limit, the loan is disbursed in full to the borrower. Here the borrower does not have an option to take only a portion that it presently requires. The entire loan starts accruing interest after disbursal. In practice, the loan is taken in full to settle payment to creditors or for acquiring working capital based assets. Therefore, the need for taking it piecemeal may not arise unless, the disbursement is agreed to be made in stages. 4.2.2 Other criteria:

Sometimes, a portion of the overdraft of the customer is converted into a loan. This happens when a stagnated amount (hardcore balance) is observed in the overdraft account from which the customer is not able to come out. Ideally, an overdraft account is supposed to have a swing i.e. should move from debit to credit balances according to the cash flows in the business. If this does not happen a hard core overdraft balance develops. Banks facing such a situation, many a times, structure a larger portion as WCTL in the total working capital facility, as this ensures regular repayments, thereby preventing diversion of funds. Term loans are easier to operate when compared to other types of advances. Outstanding balances keep reducing after each repayment installment. Banks supervision is not essential on a daily basis. Therefore, the operating cost of term loans is comparatively less. 4.3 Bills discounting: When a company buys raw material for production, there are two ways of settling the payment. By cash or cheque or postpone the payment for a future date (credit). This credit sale may be done by documenting a Bill of Exchange as follows.

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Format of Bill of Exchange: (34,900) Place: Bristol Date: May 2, 1998 30 days after date, pay to order or ourselves a sum of 34,900 for value received. To General Motors Ltd. (Midland, buyer) Star Steel Industries Ltd. (Seller)

For claiming payment, the seller forwards invoice, delivery receipt and a bill of exchange (B/E) to the buyer. Bill of Exchange may be drawn at sight, if payment is to be made immediately or may be drawn for a certain period (tenor) say, 30 days, 60 days, etc. and is called usance bill. Usance bill therefore has a definite maturity date. Figure 4.2 - Bill Discounting
BUYER B

2. Draws B/E & forwards it 3. Accepts B/E

6. Pays on the due date

SELLER A

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1. Sells goods 4. Discounts 5. Receives credit

BANK

Seller A sells goods to buyer B. A would like to have the money immediately, but B would like a credit period of 30 days. In such a situation, A draws a bill of exchange on B and sends it to B who acknowledges his responsibility (acceptance). When B accepts the bill, he has closed the transaction for A. A can now take the accepted bill to his bank and in exchange get money. This process is called discounting the bill of exchange. On the due date or maturity date, B pays the bank directly. In real life situation, the transactions may not be as simple as above. The bill may pass many hands before its maturity. In working capital framework, the debtors of a company can be realized by having them accept bill of exchange and then discount it with its bankers. A part of the working capital facility may therefore be structured this way. 4.3.1 Bill market:

There is an organized sector in all developed countries to process bill discounting and deal in B/E. In UK, Acceptance Houses and Discount Houses enjoy first class reputation in the market. In New York, acceptance and discounting are performed by commercial banks and rediscounted by Federal Reserve Bank. In Germany, bills are rediscounted by Bundes Bank (Central Bank of Germany). In France, it is extended through Bank of Module 4

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France. In India, Government of India and Reserve Bank of India have taken several steps to increase bill culture in trade and finance by providing exemption of stamp duty for bills upto 90 days and providing rediscounting facility. 4.3.2 Accommodation Bills:

A B/E prepared with no genuine underlying trade transaction and, which is drawn purely for raising funds is called an accommodation bill or kites. Institutions always try to ensure that bills discounted by them are genuine bills. 4.3.3 Bills discounting process:

The customer (seller) submits the accepted bill to the bank for discounting. Bank verifies the genuiness of the transaction, sufficient stamping on the bill, date, authorized signatures of the seller (drawer) and the acceptor (buyer) and transport documents like railway receipt, lorry receipt, bill of lading, airway bill, etc. This way the bank tries to ensure that there is a genuine movement of goods and therefore a genuine transaction. If it is within the limit accorded to the customer, it processes the bill and the proceeds are paid deducting discount or interest charges. 4.3.4 Bill discounting rates:

Normally, discount or interest is charged on the bill amount from the date of discount till its maturity date. If interest is collected at the time of discounting, then interest is calculated and deducted from the bill amount. For example, when a bill for Rs.1, 00,000 for 90 days @ 13.5% is discounted, the amount to be credited will be Rs.96, 671 i.e. Rs.1, 00,000 - Rs.3,329 (interest @ 13.5% for 90 days). Interest collected upfront is called discount and the interest is said to be applied on a front-end basis as against rear-end basis. In the latter case, interest would be collected at the maturity of the bill. Obviously, rear-end rate would be higher than the front-end rate for the bank to effectively earn the same rate of return. The bank holds the bill till maturity date and presents the same to the drawee (buyer) or his banker for payment. If it is not paid, the discounting bank will generally debit their customer (seller) with the bill amount. 4.4 Commercial Paper (CP):

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CP is a fairly new instrument in the Indian money market. CP as a concept originated in US. There are some leading corporates like General Electric, which enjoyed better credit rating than some of the banks and therefore raised money by issuing such papers in tight money market conditions through sources other than banks. CP is a fairly popular instrument and exists in most developed economies like US, UK, Japan, Singapore, Hong Kong, Mexico, Canada and Australia. The rise in popularity of CP is due to its tradable and liquid nature, whereby funds could be raised from banks and other corporates even in tight money conditions. The large corporates find CPs cheaper, simpler and more flexible.

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4.4.1

What is CP?

CP is a promissory note issued by leading, reputed and highly rated corporates to raise money for short-term requirements. In India, the maximum tenor is 1 year. 4.4.2 Procedure:

The issuance of CP in the Indian context is basically in 3 stages. The company that is intending to issue CP first needs to meet the eligibility criteria set. In India, RBI which regulates issue criteria for CPs stipulates the minimum tangible networth of such company, the minimum working capital limits that the company should be enjoying from the banking system, the minimum internal rating given by the bank for the company providing working capital facilities, minimum credit rating for the CP instrument of the company, etc. Once satisfied, the company needs to get the issue rated by a SEBI registered credit rating company. It then has to select an Issuing and Paying Agent (IPA) and a dealer. The former basically acts as a trustee cum agent to the issue by holding the notes (in physical form) in safe keeping, to deliver the notes to the CP dealer (which has the mandate to place the CP with investors in the market - typically an Investment Bank), receive the proceeds and pass them to the issuer and act as an agent of the issuer when the CP is presented for payment by the holders on maturity. The CP dealer in India may most times take the entire issue upfront and then place it in the market at appropriate times. The IPA, most of the times is the principal / main banker who provides the working capital limits. Once the IPA gives the go ahead to the dealer - investment banker - it places the CP and then confirms the deal to the company and the IPA. It then informs the latter to issue the physical certificates and co-ordinates the receipt of the proceeds. The CP is tradable by endorsement in the secondary market and on maturity (maximum 1 year) it is presented to the IPA for payment. Investors in CP could be individuals, corporates, banks, unincorporated bodies, NRIs, etc. All issues of CP including rollovers are considered as fresh issues and the process needs to be repeated. 4.4.3 Maturity period:

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CPs have flexible maturity period. In US, it cannot be more than 270 days (minimum 3 days). However, 3 months is the most common maturity period in US. It varies from 7 to 364 days in UK, 30 to 365 days in Canada and upto 185 days in Australia. In India, the maturities vary from 90 to 365 days. 4.4.4 Pricing:

These are issued as discounted instruments and maturity the face value is paid. The difference between the issue price and the maturity value is the interest income to the investor and the interest cost to the issuer.

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CPs have to compete with other alternatives like bank deposits, certificate of deposits, inter-bank call money, bills rediscounting, treasury bills, etc. The pricing of CPs need to consider the interest rate for working capital loans from banks and ideally should be less than that. The CP rate also takes into account various expenses connected with the launching and issuing of CP in India including stamp duty (may not be more than 1%). Suppose the average lending rate of commercial bank is 13.5%, then a CP rate of around 10.5% may make sense. 4.4.5 Benefits:

Investors get higher yield compared to other short-term investments. CPs are liquid and buy back facilities through the dealer may also be available. For the issuer, the rates are economical because they are in direct contact with the investors. Issuers can match the exact amount and maturity requirements of investors, and therefore gets favorable exposure to variety of investors. 4.5 Factoring:

Business transactions at all levels take place partly on the basis of cash and partly on the basis of credit. The dues in sellers books are called Trade receivables or Trade debtors. The sellers may have their own internal mechanism to collect the receivables as quickly as possible or they may handover the job of collecting receivables to a specialized agency called Factor. Factoring may be defined in technical terms as an arrangement for the outright purchase by a finance company of the book debts of a supplier of goods and services (which relate to its trade customers), as such debts arise in the normal course of suppliers business. 4.5.1 History behind factoring:

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Factoring was prevalent centuries ago in Rome, where agents were employed to manage the business including collection of debts. In parts of Europe, agents were employed on commission basis that sell goods and took the responsibility for the creditworthiness of the buyers. Factoring in the modern form made its appearance in US with distinctive functions like assessing the creditworthiness, purchasing the receivables without recourse, handling insurance, packing, billing, etc.

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4.5.2

The factoring process and its role: Figure 4.3 - Process cycle

1
SUPPLIER CUSTOMER

2 6 3
FACTOR

1. Supplier makes a credit sale to their customers. 2. Supplier sells its customer a/c to the factor and notifies the customer. 3. Factor makes advance payment to the supplier after deducting the margin and discount charges. 4. Factor maintains customers account and follows up for payment. 5. Customer remits the amount due to the factor. 6. Factor makes final payment to the supplier i.e. margin amount.

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Figure 4.4 - Role of factoring
FACTORING Credit Protection

Administrative Service

Financing

The role of a factor can be summarized as follows: Factor manages trade debts of the client by maintaining sales ledger, collecting payment and other administration services. The supplier is saved of the administrative cost of bookkeeping, stationery, and postage and management time. Factor takes the risk aspect of the debt from the supplier when the arrangement is without recourse to the supplier. It provides advance to the client before maturity date. This improves the liquidity of the supplier. Securitization:

4.6

A loan receivable appearing in the balance sheet as a long-term asset would be realized over a period of time. Securitization is a process by which a loan could be sold to Module 4

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generate liquidity. To be more specific, securitization is the process by which selected pool of assets or loans of a lending institution is sold through a trust, which in turn issues securities against the backing of such assets and sells them to prospective investors. 4.6.1 Origin of Securitization:

Again, like many of the revolutionary products, securitization originated in the US when Savings & Loan Associations to save themselves from impending bankruptcy, sold loans to create liquidity. This concept revolutionized loan banking in all-important financial markets of the world. Loan market now appears like any other securities market, where it is rated and traded in the financial market freely with high liquidity. 4.6.2 Parties to securitization:

The lending institution is called the originator. The intermediary - Special Purpose Vehicle (SPV) or Trust buys assets from the originator and issues securities to investors, the third party in the process. Figure 4.5 - The process

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Lending institution Sells assets, say $100,000 SPV or Trust Investors

Assets splits into small units of $1000 and sold to investors

The originator selects the package of debts to be sold. These may be future rentals, credit card receivables, future billings of airline, hire purchase receivables, to name a few. Theoretically, any resource with predictable cash flows can be securitized. Rating is sought for the deal from the rating agencies. The loans are sold to SPV by entering into a contract thereby removing these loans from the originators balance sheet. SPV will split the pool of assets into smaller units of claims and issues certificates known as Pass Through Certificates or PTCs. When the originator receives repayments, it is passed on to SPV for distribution - hence the name pass through. The investments may be without recourse or with recourse to the originator. In case of the latter the SPV can claim the shortfall from the lending institution.

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4.6.3

Benefits:

The originator can convert his term asset into cash. By taking the loans out of balance sheet, the originator improves its capital adequacy. The SPV can structure its issue based on the types and needs of investors it is seeking. The quality of debt is good (as it is rated) and the yield could be higher than for similar maturities of other instruments. 4.7 Forfaiting:

Factoring discussed before essentially involves purchase of inland receivables. In international trade transactions, forfaiting is much a more common form of financing export-related receivables. Forfaiting is purchasing of export bills where payment is expected to be received over a longer period in installments (deferred payment exports). It is done without recourse to the exporter if the bills are accepted by the importers bank - also known as Avalling Bank. An Aval is an endorsement on the importers promissory note by the importer bank, guaranteeing the payment. Figure 4.6 - Mechanics of Forfaiting

Exporter

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C E A

Importer

Forfaiter

Avalling Bank

Exporter sells the goods to importer on deferred payment basis. Importer issues series of promissory notes undertaking to pay the exporter in installments with interest. Importer approaches its banker (Avalling bank) for adding the bank guarantee on the promissory note that the payment will be made on each maturity date. The promissory notes are now avalised. (A & B) Avalled notes are sent to the exporter (C). Avalled notes are sold at a discount to a forfaiter, usually exporters bank (D) and exporter obtains finance (E). Forfaiter may hold till maturity date and obtain payment from the importer / avalling bank, or sell it in the secondary market or sell it to a group of investors (securitization). 4.7.1 Salient features:

Unlike a factor that provides only a portion of the invoice value, forfaiter provides 100% finance. Risk is covered based on the importers country and the standing of the avalling bank. Forfaiter does not assume responsibility of sales ledger administration.

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5. 5.1

DELIVERING WORKING CAPITAL - NON-FUND BASED Letter of Credit:

In an international trade transaction, a seller wants to receive his payment promptly at his own bank after despatch of goods. A buyer wants an assurance that he pays only after the seller fulfills his obligations correctly. Also the buyer may need bank finance and assistance in dealing with complex transactions. 5.1.1 Letter of Credit (LC) comes into picture to satisfy the requirements of both the buyer and the seller. LC is an arrangement by banks for settling international commercial transactions. LC provides a form of security for the parties involved and ensures that the terms and conditions of the transaction are fulfilled. 5.1.2

LC and parties to an LC: An LC is a commitment by the buyers bank to the seller that it guarantees the payment as per the contract of sale, if the conditions stipulated in the document / letter issued by the bank (based on buyers requirements) is met by the seller. This document is called an LC or letter of credit. The buyer/importer who applies for LC is called the applicant. Issuing bank is the bank that opens LC for the importer. Advising bank is the bank to which LC is sent by the issuing ban with a request to inform seller/exporter. The bank to which the exporter presents the documents for settlement is known as settlement bank. This normally is routed through the exporters bank, if the bank settling the LC is not the exporters bank itself.

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Thus, the importer by opening an LC through its bank is providing the backing of its banker to the seller to meet the payment commitment, if the documentary proofs stipulated therein are provided. Generally these documents are invoice, proof of despatch of goods (airway bill, bill of lading), insurance documents, quality inspection certificate, etc. 5.1.3 Uniform Customs and Practice for documentary credits (UCP):

In view of the complexities of LCs and different laws prevailing in different countries, International Chamber of Commerce (ICC) has developed a code of practice for LCs, which protects the interests of all parties. This code is known as Uniform Customs and Practice for documentary credits (UCP) and is applied as international law. The publication is revised from time to time. LCs that are subject to this code should bear the clause that it has been issued under UCP. 5.1.4 Issuing a letter of credit: The buyer and the seller conclude a sale contract providing for payment by LC. The buyer instructs his bank to issue an LC. The issuing bank asks another bank in the exporters country (assuming an export sale) to advice the LC to the buyer.

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The advising bank informs the seller that LC has been issued and informs it about the terms of LC. The seller exports the goods according to the terms of LC and submits the documents to the exporters bank for negotiation. If documents are in order and in accordance with the terms of LC, the bank will pay the bill value to the seller. The negotiating bank will forward the documents to the issuing bank or its branch or correspondent bank in the exporters country itself and collect the payment. Figure 4.7 - Documentary Credit
Contract

Seller Exporter Beneficiary Letter of credit Payments

Buyer Importer Applicant

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Letter of credit Advising Bank / Negotiating Bank Issuing Bank Documents Payments

Application Payments

Documents

Documents

5.1.5

Types of LCs:

Irrevocable credit is a commitment given by the issuing bank not to revoke the LC during its currency. Revocable credit can be revoked even before the validity of the LC expires. Confirmed credit: LC may be confirmed by another bank in sellers/exporters country. Confirmation here means, a commitment by this bank to pay the exporter if the documents stipulated therein together with the LC is presented for payment within the expiry of the LC. Such confirmation may become necessary if the seller does not know enough about the issuing bank and therefore may want a bank well known for its creditworthiness in his country to confirm it. Banks between themselves, of course, have a system of having enough information to assess each others credit risk. Transferable credit: Most of the LCs are transferable i.e. the beneficiary (seller) can transfer it to a third party.

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Revolving credit is given for a specific period and/or value within which, the seller can operate it as a running account for a series of imports/exports. For time revolvers, if payment is received before the validity period of the LC, that amount can be reinstated to the LC limit, and can be used for another import/export. Similarly for value revolvers once the outstanding amount under the LC goes down below a threshold, the full amount can be reinstated. A Red clause LC is provided with a special clause authorizing the advising bank to make advance payment to the beneficiary. The negotiating bank, in such a situation, has explicit authorization from the issuing/advising bank to provide an advance. The need for presenting the stipulated documents before parting with the proceeds does not arise. 5.1.6 Documents under LCs:

Some of the important documents required under LCs are bills of exchange, invoice, packing list, weight list, certificate of origin, bill of lading/airway bill or other transport document, insurance policy, etc. What the LC actually stipulates in terms of documents in a given transaction depends upon what has been agreed between the buyer and the seller. 5.2 Co-acceptance:

Co-acceptance is a guarantee service offered in commercial trade bills (CTB) by a highly reputed bank / investment bank. These banks enhance the credit of CTBs by use of their names as an effective guarantor, undertaking that there will be no default on the bill of exchange. The acceptor bank countersigns the bill of exchange already accepted by the buyer / drawee, enhancing the credit standing of the bill. The acceptance service grew mainly for financing international commercial transactions because, the seller in most of the cases is not aware of the standing of the buyer. In UK, there exist specialist firms called Acceptance Houses. In US, banks perform this function. The accepting agencies keep updated information about credit standing of various traders at home and abroad. Banks / accepting agencies provide this service for commission and the rate depends on the risk, volume and other operational costs. 5.3 Guarantees:

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A guarantee in its generic form, can be explained as follows: A borrows money from B. C guarantees for the repayment of the loan to B. If A does not pay, C has to pay to B.

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There are three parties to the guarantee. A - Principal debtor B - Lender C - Guarantor However, the principal contract is between the lender and the guarantor. 5.3.1 Who can issue a guarantee?

Any individual or a company can give a guarantee except minors or persons of unsound mind or undischarged bankrupts. Banks, government organizations, insurance companies and specialized guarantee institutions commonly issue the guarantees. Banks can accept guarantees from third parties for advances given by them to the borrower or issue guarantees on behalf of customers for performance of certain acts by the customer under a contract. 5.3.2

Types of guarantees: In case of a specific guarantee, the guarantors liability will cease as soon as the particular advance is repaid. For instance, if Anand borrows Rs.5 lacs from ABC Bank and Sekhar gives a specific guarantee, Sekhar is not liable if the loan is repaid and a fresh loan is taken from ABC Bank again. On the otherhand, if Sekhar would have given a continuous guarantee, he is liable for the balance, irrespective of the repayments made by Anand. A guarantee may be a financial guarantee covering certain amount of loan advanced, or a performance guarantee that covers a performance like supply of goods, completion of a project, etc. Shipping guarantee is a guarantee given by a bank on behalf of its customer to a shipping company to deliver goods to the consignee (banks customer), in the absence of a bill of lading. Common purpose of issuing guarantees by banks:

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5.3.3

Banks issue guarantees to cover payment of loans taken by customers from other financial institutions. Guarantees are also issued in lieu of earnest money or customs duty, sales tax, etc. to government authorities. Performance guarantees are issued to cover export performance, turnkey projects, supply or purchase of goods, etc. 5.3.4 Invocation of guarantee:

If a loan is not repaid, and the lender wants to enforce the guarantee, the original guarantee has to be returned to the bank within the claim period giving the reason for the claim. This process is known as invocation of guarantee. If the claim is in order, the bank has to honor it even if the customer does not have sufficient funds with the bank.

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The same procedure applies to invocation of performance guarantees also, where the monetary claims are punitive in nature. 5.3.5 Other Points: Guarantees are issued on stamp paper according to the local regulations and are valid for specified periods. Banks obtain a counter-indemnity from the customer for every guarantee issued on their behalf. Non-disclosure of facts to the guarantor makes the guarantee difficult to enforce. 8. OTHER CORPORATE RELATED SERVICES

Apart from various facilities offered by banks to corporate customers, there are a few supplementary services that occupy the bank list of services. This list is increasing gradually and finds greater place in the package given to the corporates. Apart from services that save costs for clients, many are aimed directly to improve the service level like turnaround time and enhancing customers convenience. 8.1 Cash Management Services:

A corporate customer, who maintains a current account with XYZ Bank has branches, has manufacturing or sales or administrative units in the four cities. Some centres are surplus with funds, as the sales activities are high. Others are short of funds principally, as their manufacturing and administrative units are situated there (Figure 4.8). Figure 4.8 - Closing balance as on 31st July 1999 Rs.28 lacs Cr.
Delhi

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lacs Dr.
Bangalore

Rs.7 Dr.

Rs.15 lacs
Calcutta

Mumbai

Rs.39 lacs Cr. It may be noticed that at Delhi and Bangalore the company has surplus funds, whereas at Calcutta and Mumbai the accounts are overdrawn and the company may be required to pay interest on debit balances. The process of cash management service is to move all the funds to one centre - generally the place where the head office or corporate office is situated, and net the balances available in all centres. Module 4
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In the above example, the net balance at the head office, say Mumbai, would be Rs.45 lacs and the balance at the other three centres would be nil. A situation may also arise when payments may have to be made from one of the centres, say Rs.5 lacs in Calcutta. In such a situation, if the netting is not done, then Calcutta may show a debit balance of Rs.20 lacs. Cash management facilitates pooling all the balances into single account, thereby payments at all centres can be effected in time and overdrawn balances may be reduced or eliminated. The customer need not verify the balance and initiate the transfers from one centre to another. The basic range of services under cash management could be balance reporting, sending transfers or payment orders, netting of balances for intra-group settlements and pooling the group cash balances. The other feature of cash management service could be collection services, where the bank pools all the collection items at one place and employs accelerated collection process. Instead of making a whole series of payments in different currencies, the customer can make a single payment to the netting centre. Cash Management service is technologically intensive. In an international basis, this may call for currency wise pooling and netting, dealing with various payment and clearing systems across the globe, co-ordinating with a network of own branches and those of correspondent banks, etc. From a customer point of view, it may call for efficient on-line retrieval of paid items, cheque images and on-line account reconciliation. Information reporting on all the above services may have to be made available through a link to the customers computer or through the Internet. Figure 4.11 - Cash Management
UK-GBP Germany-DEM

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NETTING CENTER

France-FrF

US-$

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8.2

Other services - Employee benefit plans:

Banks offer payroll services to corporates by maintaining corporate staff accounts and by processing the payroll activities. Banks also design products for employees pension plan and other retirement plans. Many banks provide the details of plans, and the status of employee accounts directly to them, by allowing access to the banks computer system using a confidential code.

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Treasury Operations

1. 1.1

TREASURY - FUNDAMENTALS Understanding basic bank financials

1.1.1 Balance Sheet A typical structure of a balance sheet would be as follows: Table 5.1 - Balance Sheet Structure Liabilities (Sources) Capital Loans Deposits Profits Assets (Uses) Cash Investments Advances Fixed Assets

Liabilities are sources of funds for the bank. It is the amount it owes to its shareholders (capital and profits), depositors (deposits) and lenders (loans). On the other hand the sources are deployed in assets i.e. uses of funds. These assets may be in the form of

Cash Investments (in government securities - local & foreign, corporate bonds and debentures - local & foreign, stocks etc.), Advances (overdraft, bills discounted, term loans etc.) And fixed assets (land, building, computer network, etc). All these are reflected on a given date in the balance sheet. 1.1.2 Profit & Loss statement The other important statement - the Profit And Loss Account or Income Statement will have the following structure: Table 5.2 - Profit and Loss Income Investment Income Interest on advances Discount Commission Fee Income Expenditure Interest Paid Staff Cost Depreciation Other costs

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Income statement of a bank essentially shows the heads of income and expenditure. The principal sources of income are Interest on various types of lending, Capital gains, interest and / or dividend from various types of investment instruments,

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Commission and fee income on various non-fund based activities such as processing, underwriting, broking, syndication, issue of guarantee, etc. 1.2 Understanding treasury function: The broad framework from the elements of balance sheet and profit & loss can help us understand what bank treasuries are up to. The liability side: Banks raise money through various sources. Apart from banks own capital these are essentially in the form of borrowings. Some are in the form of long term and short term loans raised in the market and others are essentially deposits. The borrowings could be various maturities, currencies and interest rates. That means as and when they fall due these have to be repaid on time and in the currency that they have been contracted in. These repayments have to be made from the cash held or liquidating some of the investments or other assets. The other option is to borrow further to repay an existing obligation. Regulations prohibit the banks to borrow without any limit. The level of borrowings is related to the banks capital base and therefore the need to manage capital with relation to borrowings a bank can resort to.

The asset side:

The asset side principally consists of the various types loans/overdrafts and other type of fund based advances by the bank. The fixed assets in which it has invested to run the business. Although essential, these assets are considered non-productive. Having deployed the funds in the above two categories, if surplus funds are available then these must be deployed to earn returns which are above the cost of these funds. As in the case of borrowings, the assets also are in various currencies and of various maturities. Moreover where lines of credit are committed but not drawn (as in the case of overdrafts) the bank is not sure when the withdrawals may happen. Banks therefore have to manage the cash position in such a way that they can meet the liability related commitments as well assets/advances related commitments. Provision has also to be made for those situations where the commitment form customers on advances repayment are not met.

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The P&L side: Minimize the interest outgo or interest cost on the borrowings and maximize it on advances. Maximize fee & commission income. Maximize capital gains and interest income on investments. Optimize tax out go.

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The treasury function is to manage all of the interrelated sensitivities described above. These can be summarized in form of the six important roles described in the next section. 1.3 Role of treasury in a bank:

Broadly speaking the role of a treasury in a bank is to manage cash flow and control and reduce the risks involved. The treasury operations of a bank involve the following: 1. Asset-liability management: a. It calls for funding of assets on the best possible terms, mobilization of deposits. b. Effective utilization of surplus resources. c. Within this process mange liquidity, interest rate and future maturity profiles. d. Manage of day-to-day funding requirements. This involves both domestic and foreign currency, wholesale and retail funds, in various financial centers throughout the world. 2. Risk exposure management which calls for a. Managing credit, interest rate, liquidity, and country risk b. Also manage risks associated with foreign exchange, deposits, securities, commodities and various financial instruments including futures and options. Both these functions call for operating in various markets to raise funds, invest funds, manage maturities etc. This then calls for certain operational management.
3.

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Control and development of dealing operations in cash, forward, futures, options, interest rate, currency and other markets.

4. Control of investment portfolios and the utilization of a banks own liquid resources 5. Funding of investments in subsidiaries and affiliates. 6. Capital debt raising and loan stock administration. The organizational structure and the reporting levels for the treasury departments will have to be decided by the respective banks. The person selected to head the treasury function will have to be a top management functionary with a very thorough understanding of the operations in their myriad forms. The principal functional responsibility of the international treasury of a bank is funding of the banks investments & foreign currency business. It is well known that a banks success depends, to a large extent, up on the judicious approach to its lending and more recently in international terms, to the exposure of country and sovereign risks. It is equally important ingredient in the success formula of a banking business to have a fully coordinated treasury function and funding policy, and a management team, which is aware of the need to remain flexible in the light of changing economic, and business conditions.

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2. Money Market 2.1 Meaning and basics: Money market is a market for short-term funds, generally up to one year. The instruments used in the money market are close substitutes to money or cash itself. In this sense, these funds may also be in the form of securities that have characteristics of high liquidity (quick conversion into cash), low transaction cost and the probability of loss in value of these funds/securities is very low. 2.2 Players: The market players tend to be those who have requirement for short-term funds and those who have short-term surpluses. These are mostly institutions like banks, central banks, insurance companies, mutual funds, housing or mortgage institutions etc. The market therefore is essentially a wholesale market for money where the transaction size is large and most of them are settled on a daily basis. Central banks use the money market instruments in the open market operations to control liquidity of money or money supply, explained in the first module of this courseware. The objective is to influence the availability and cost of credit. A welldeveloped money market helps in effective implementation of monetary policy of the Central Bank / Government. 2.3 Money Market Instruments: (i) Call Money Market:

The call money market - as the name denotes is extremely short-term loans market that can be called back at the option of the lender at any point in time during the currency of the loan, which normally is for a maximum of 15 days. The need for call money market arises due to the stipulation by most central banks that a percentage of the commercial banks deposits should be maintained in a reserve account with them (in India it is called the cash reserve account based on the cash reserve ratio (CRR) stipulated by the RBI). As the deposit base keeps changing, so does the amount required to be maintained in this account. At any time some banks may have more funds than required. The banks with major operations in the important money centers (Mumbai, New York, London, Chicago, Frankfurt, Tokyo etc.) of a country generally have shortages. Banks with excess reserve funds lend to those with shortage usually on overnight transactions. This leads to an inter-bank money market. The participation these days is much greater with other players such as securities traders, non-bank finance companies, corporates etc. also taking part. The interbank call money market of the type described above is also called Federal Funds market in the US and the rate at which the transactions are done is called the Federal funds rate. Similarly, the rate at which large London banks are willing to lend money amongst them is called London Inter Bank Offered Rate or LIBOR. LIBOR can be for longer terms or maturities also and is used as a reference rate for lending to corporates and other institutions.

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(ii)

Treasury Bills Market:

Treasury bills (T-Bills) are claims on the government. These are the simplest form of borrowing by the government, generally only up to one-year term. They are issued on a discount basis i.e. instruments are issued below face value, and provide a return to the investor equal to the difference between the issue price and the face value. In India, T-Bills are issued for maturities of 14, 91 and 364 days by the auction method. The auction is announced well in advance for participation by all investors, Individuals, PDs, banks, mutual funds etc are important participants. In US, T-Bills are issued for maturities of 3 months, 6 months and one year - the first two being auctioned weekly and the last on a monthly basis. In Germany, T-Bills are issued only for open market operations and are not counted as a source of funding in that, these need to be self-liquidating and therefore at the end of the year do not remain outstanding. It uses what are called as Federal Treasury financing paper, that has maturity of one or two years and Treasury discount paper with maturities up to 2 years for raising funds. In Japan, T-Bills of two maturities, 3 and 6 months are issued. (iii) Certificates of Deposits:

A certificate of deposit (CD) is a time deposit with a bank that is negotiable i.e. sold to other investors and therefore can be traded in the secondary market. Like any other term / time deposit these are interest bearing but cannot be withdrawn before maturity. The maturity is generally for shorter term of 30 days, 90 days or 180 days, although technically these can be for longer terms. For longer term CDs the interest can be fixed or floating. For floating rate CDs generally the interest is re-fixed every six months based on LIBOR, US T-Bill or prime rate (rate at which bank lend to their AAA customers). Short term CDs of up to 6 months are extremely liquid. In the secondary market, traders quote two-way prices (sell and buy), for first class bank (high credit rating) bank CDs. The initial issue may be to the original depositor directly or through secondary market dealers. In India, 90 days CDs are popular, but serious secondary market is yet to develop. (iv) Commercial Paper:

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We have seen what CPs are, under Corporate Banking - Module 4. CPs are unsecured short-term promissory notes issued by companies of repute and are therefore backed only by the general credit standing of the issuer. They are negotiable by endorsement and delivery and therefore have a vibrant secondary market. These are issued on a discount basis like T-Bills. The issue is generally in large denominations and the issue may be through banks, investment banks, dealers or broker in the money market. Direct placement with lenders is also done. Short-term CPs of up to 90 days are most common, although these can be Module 5

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issued between 3 to 270 days in the US, 7 to 364 days in UK, 10 days to 7 years in France, 30 to 365 days in Canada, up to 185 days in Australia and from 30 to 365 days in India. The yield or return on CPs is determined by the market and is usually higher than the yield on T-Bills of the same maturity to reflect the higher credit risk. However it is lower than prime lending rate of bank and higher than bank deposit rate for the same maturity. CP issues are generally backed up by liquidity or stand by lines even if they are not required to. Rating agencies consider this important, as otherwise on maturity the repayment may become difficult. CPs are not underwritten. (v) Bankers acceptances:

A bankers acceptance starts as an order to a bank, by a banks customer, to pay a sum of money at a future date, typically within six months. It is evidenced by a bank by adding its underwriting of payment of a bill of exchange by signing the bill on the face of it and clearly indicating the place at, and the date on which it will be paid. Thus, the bank concerned assumes the responsibility for ultimate payment to the holder of the acceptance. The bill of exchange must be a term bill (time draft - American usage) payable at fixed date or future determinable date later than the date of drawing. The purpose of drawing such a bill is to obtain finance by creating an instrument (the accepted bill), which is usually readily marketable in the secondary market. The quality of the banks name in the bill determines the degree of its marketability. While most of these may be trade-related with security, clean acceptance facility may also be available. London Accepting Houses Committee, which is a consortium of lead merchant / investment banks in London provides such clean finances by setting up a line of credit for the corporate borrower. An agreed amount of revolving limit is established often with underlying trade bills acting as collateral security. The acceptances are considered safe as traders can substitute bankers credit for their own and are tradable in the secondary market like other claims on the bank. These acceptances are used widely in foreign trade where the creditworthiness of a trader is unknown to the other trading partner. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from par value. The secondary market in acceptances arises not only due to a bank accepting the bills, but also the fact that the Central Banks of many countries like the FED or Bank of England, subject to certain terms and conditions, also discount these bills held by banks. This fact therefore creates liquidity. In India, DFHI gives a two-way quote for trade bills and acceptances. (vi) REPOS and Reverses:

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Dealers in government securities use repurchase agreements also called repos or RPs as a form of short-term funding, many a times on an overnight basis, with an agreement to sell and buy back securities the next day at a slightly higher price. The

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increase in the price is the overnight interest. The dealer thus takes a one-day loan from the investor and the securities serve as collateral. Longer-term repos, generally over 30 days are called term repos. The mechanism is the same. Repos are considered safe in terms of credit risk because loans are backed by government securities. A reverse repo is the mirror image of repo. Here the dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price at a future date. To provide or absorb short-term liquidity in the market, many central banks also provide two way repo quotes for various periods. This way the excess securities with a dealer or bank can be made to earn, and on the other hand, the lenders surplus can be invested in a useful and secured manner. US has a very large repo market, while in UK it is limited. In Australia these are called buy-backs and reverse buy-backs and, are mainly used between the central bank and securities dealers. In Germany pensionsgeschaft is a repo popular with insurance companies. In Japan these are called gensaki agreements and are a major source of call money. The market is well established from overnight to six months. 3. Government Securities Market:

The government securities or bond market arises from the fact that most governments borrow domestically and many a time in markets abroad. The objective is to fund the needs of the government through borrowings as the revenue collection from various taxes levied by it does not always meet its requirement in its entirety. The domestically raised government debt and its trading in the secondary market constitute the government securities market. Government in the sense used here can denote the Central Government of a country, the state or provincial governments, city corporations and municipalities etc. In certain countries where public sector or government owned companies / organizations play a large part, as in the case till recently in India, the securities issued by these entities tend to be guaranteed by the government (for repayment of principal and interest) and are considered as government debt. These may include port authorities, electricity boards, public sector companies etc. Government debt, also called public debt, can be of short-term in nature. Generally if such debts are one year or below, they become a part of the money market. All other securitised debt of longer-term nature is included in the government bond market. The liquidity may not be as high as the money market but still is reasonably good. The deals again tend to be large size, mainly between institutions and therefore wholesale in nature. In India RBI manages the public debt and issues new loans on behalf of the Central Government and State Governments. The level of borrowing is determined by the government annual budget, but the timing, interest rate and the manner in which these loans are raised is determined by RBI, based on the state of liquidity and interest rate expectations of the market. The primary or initial issue is done by a system of auction where the RBI announces a date by which it accepts bids from various players. If the Module 5

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issue is fully subscribed or over subscribed then it allots the securities from the highest bidder downwards till the issue is exhausted. If it is under subscribed then it devolves on RBI itself and, it then lends to the government. A system of primary dealers (PDs) in the government securities market has been introduced from 1995 wherein the issues can be underwritten by them. The allotment of securities is mostly in the form of book / electronic entries and the account in which the holdings of each institution are maintained is called SGL or subsidiary ledger account. This is like a current account in government securities with RBI maintained by banks, financial institutions, mutual funds etc. When these institutions trade in the secondary market, then RBI is instructed to reduce the holding from its account, and credit the party that has bought the security - very similar to a cheque in a current account. The payment accounts are also maintained at the RBI where the credit for money / cash is given if securities are sold and, debit when securities are bought. PDs, Securities Trading Corporation of India (STCI) and Discount Finance House Of India (DFHI), provide liquidity in the secondary market by giving a two-way buy - sell quote. In other countries the basics of government debt issue remain the same except that due to a greater depth, and the fact that foreign entities also participate in a big way in these markets (specially in US, UK, Japan and German Government debt instruments), the settlement mechanisms may be much more elaborate, but the principles remain the same. 4. 4.1 (i) Foreign Exchange market

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Foreign Exchange - Basics: Definition:

Foreign exchange means different things to different people. We encounter foreign exchange when we go abroad on a tour or send money abroad to a relative, etc. These are retail transactions as compared to foreign trade transactions. In foreign trade, companies export goods, import raw material and machines, pay technology fees to their collaborators, etc. To these companies, foreign exchange is a bank deposit denominated in another currency, rather than a bank note issued of another country. A foreign exchange transaction is therefore simply an exchange of one countrys money for anothers. The foreign exchange rate is the price of one countrys money in terms of another. It may be noted here that this exchange of money is accompanied by a process of buying or selling a product, service or asset. In other words, foreign exchange transactions are a fundamental part of the international payments mechanism. Foreign exchange is the system or process of converting one national currency into another and, transferring the ownership of money from one country to another.

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(ii)

Forex market:

The foreign exchange market in the words of Gaetan Pirou, a French Economist is the co-existence between the internationalism of trade and nationalism of currencies. Worldwide trade and cross border money and capital movements resulting from financial transactions are the basis of forex dealings. It is the largest financial market in terms of turnover. The main function of the market is to provide a way of transferring purchasing power from one currency to another. The other functions of this market include provision of credit, facilitating smooth functioning of the international monetary system and forex risk management. (iii) Participants in forex markets:

The major participants in the forex markets are the large commercial banks and central banks of various countries. The former conduct business both in the interbank market and also in the retail market. They also deal with the forex brokers in the interbank markets, who act as middlemen for a fee between the banks that have complementary needs. Business and individuals also participate in the market. Here, again banks act as natural intermediary for forex transactions. The main task of the forex department of a bank is to enable its customers to convert assets held in one currency to another. (iv) Exchange rate:

The rate at which one currency is exchanged with another is known as the exchange rate. In other words, it is the price of one currency quoted in terms of another i.e. the number of units of one currency which can be exchanged for a given number of units of another currency. For example, by saying that the exchange rate of USD-INR is INR 46/-, we mean that Rs.46 can be bought with one USD. Remember when one party is buying INR it also selling USD. (v) Direct and Indirect quotes:

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The rate of exchange between the Indian Rupee and other currencies is generally specified directly i.e. in terms of number of rupees per each unit of the foreign currency. For example, in India the exchange rate between the USD and INR is INR 46.13. or 1 USD = INR 46.13. Direct rates are therefore quoted in terms of number of local currency for a given unit of foreign currency. Except for pound sterling (GBP) and Euro, forex rates for all currencies are quoted in a direct manner. In UK GBP quote is indirect i.e. number of units of foreign currency for one GBP. That is GBP1 = INR 69.52, GBP 1 = USD 1.6115 etc. (vi) Cross currency quotes:

Cross currency rates are rates arrived at between two currencies using their exchange rates with a third different currency. The exchange rate between Rupee and Pound sterling can be arrived at with the help of exchange rates between Rupee and US dollar and Pound sterling and US dollar. For example, if the exchange rate between Pound sterling and US dollar is USD 1.61 to a GBP and the US$ - INR rate is Rs.46.14, then the exchange rate between INR and Pound sterling can be arrived at as follows: Module 5

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= 46.14 x 1.61 = Rs.74.28 per GBP. In the above example one currency was quoted in a direct fashion and the other in indirect. Lets take an example of both being quoted in direct form. USD/SGD = 1.76 and USD/CHF = 1.35 then SGD/CHF = 1.35/1.76 = 0.77 and CHF/SGD = 1.76/1.35 = 1.30 (vii) Technology in forex transactions:
SGD = Singapore Dollar CHF = Swiss Francs

Foreign exchange dealing requires advanced technical equipment. The trading in forex market was largely over the telephone until April 1995, based on the screen quotations supplied by Reuters. In April 1995, Reuters introduced Dealing 2000/2, which adds automatic execution to the package creating a genuine screen based market. Other automatic systems such as Electronic Broking System (EBS) owned by the consortium of banks and MINEX in the yen market are being built. The automated trading may boost volume and reduce the cost of trading. Automated systems however threaten the oligarchy of information that was a major source of profits. But brokers remain a vital source of information for traders about the direction of the market. While computerized trading system gives a trader the best price, a broker is in touch with a large number of banks. (viii) Types of transactions:

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Forex transactions can be executed on spot or forward basis. In any forex transaction, the parties concerned enter into a contract, which specifies the details of the agreement. Cash - when foreign currency delivery is effected on the very transaction date (*Value Date = Transaction Date) Spot - where the value date for foreign currency delivery is two working days from the date of transaction. (*Value Date = Transaction Date + 2 Common Working Days) TOM - is relevant in rare cases where the value date for foreign currency delivery is the next working day. (*Value Date = Transaction Date + 1 Common Working Day) Forward - when the *value date (for foreign currency delivery) lies beyond spot. (3/7/10/15 days or one month/two months/three months/six months/one year etc. from the transaction Date) *Value date = settlement date Forward transactions are resorted to when the forex transaction is to fall at a future date. For example, a company could cover its forex requirements necessary for its future import of an equipment in advance at an exchange rate which is fixed upfront at the time of entering into the contract. The advantage is that the company can lock in the future Module 5

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requirement of funds at the present exchange rate and eliminate the risk of loss due to currency depreciation. It can thus enter into a forward contract. (ix) Nostro and Vostro Accounts: Forex transactions involve transfer of funds from one center to another. So, whenever a transaction takes place, it may not be feasible to arrange for physical transfer. Therefore, in order to facilitate the forex transactions, the authorized dealer maintains accounts in foreign currencies with its overseas branches / correspondents. Such a foreign currency account maintained by the domestic dealer / bank at a foreign center is called a Nostro account (means our account with you). Similarly, if a foreign bank in another country were to deal in Indian Rupees, it would maintain a Rupee account with a bank in India, which is designated as a Vostro Account (means your account with us). 4.2 (i) Indian scenario: Regulations:

The forex business was governed by the Foreign Exchange Regulation Act (FERA). The government has introduced a new and more comprehensive act - Foreign Exchange Management Act (FEMA) to replace the FERA with effect from 1st June 2000. FEMA is a result of liberalization policy and the rules framed under this act are simple and transparent. The object of FEMA is to facilitate external trade and payments and to promote orderly maintenance of the foreign exchange markets in India. The exchange control is administered by the Reserve Bank of India (RBI) and the Exchange Control Manual contains the regulations and procedures framed by RBI in this regard. RBI controls and regulates dealings in forex and forex securities in India, payments to persons resident outside India, export and import of currency notes, bullion or precious stones, transfer of securities to NRIs, etc.

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(ii)

Market structure:

The Indian forex market is broadly a three-tiered inter-connected market wherein the first tier consists of forex transactions between the banks and their customers, mainly exporters and importers (retail market). The second tier consists of inter-bank market where there are exchange dealings between banks themselves, conducted through forex brokers and supplemented at times by the RBI (domestic wholesale market). The third tier consists of forex dealings between banks in India and their counterparts and branches in foreign countries that have forex business to transact with India (wholesale market - international). In addition, banks also operate in international exchange markets like London, New York to cover their forex dealings with customers and other banks. (iii) Players in the Indian forex market:

Only certain commercial banks authorized by RBI can deal in foreign exchange. These authorized dealers are members of Foreign Exchange Dealers Association of India (FEDAI) and have amongst themselves a set of internal rules for conduct of business. In addition to authorized dealers, there are a group of licensed dealers called authorized money changers who are engaged in the business of buying and selling foreign currency Module 5

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notes. The major difference between an authorized dealer and a moneychanger is that moneychangers deal only in foreign currency notes, coins and travelers cheques. In simple words, money changers collect foreign exchange from exporters, importers, tourists and travelers and remit them to the authorized dealers. Similarly issue foreign currency to exporters, importers, tourists and travelers. Barring certain exceptions, the moneychangers route their transactions finally through the authorized dealers only. The market operates through forex brokers who are accredited by FEDAI. The broker is not allowed to hold positions and is expected to obtain and communicate prices to enable contracts between banks. He is only an agent between transacting parties. 4.3 Bank Foreign Exchange Department - Indian Perspective

Foreign exchange is a highly specialized business and is therefore concentrated in selected branches of the bank. The department is also known as International Division or International Banking Division or Overseas Branch and is divided into well-defined sections, each undertaking a special activity. Functions of Foreign Exchange Department: 1. 1a) Trade Finance: Export: 1b) Import: 2. Remittances: 3. Dealing: Module 5 Rate computation Maintenance of foreign currency account Forward contracts Issue of DD, TTs Payment of DD, TTs Issue and encashment of travelers cheques Sale and encashment of foreign current notes Non-resident accounts Opening of LCs Import bills Bills for collection Import loans and guarantees

Pre-shipment advances Export bills negotiation Export guarantees Advising, confirming letters of credit Bills for collection

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4.

Exchange positions cover operation.

Quotation of exchange rates:

When a bank transacts foreign exchange with its customer, it is known as merchant business and the exchange rates quoted are known as merchants rates. The transaction may be cash, spot or forward. The interbank rate on the basis of which the bank quotes its merchant rate is known as base rate. If the bank quotes the base rate to the customer, it makes no profit. 5. Exchange margin:

Banks foreign exchange deal with the customer takes place first. Based on this transaction only, the bank goes to inter-bank market to sell or acquire the foreign exchange required to cover the deal with the customer. There may be a time lapse in between, and the exchange rate in inter-bank market might have turned positive or negative for the bank. In addition, there are administrative costs involved. Therefore, banks load sufficient margin to their base rate while quoting merchant rates. In the inter-bank market, exchange rate is quoted up to four decimals in multiples of 0.0025. E.g.: USD 1 = 46.2050 SGD 1 = 25.3525 For customers, the exchange rate is quoted in two decimal places. E.g.: USD 1 = 46.21 SGD 1 = 25.35 6. Types of buying rates:

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In purchase transactions, the bank acquires foreign exchange from customers. In some transactions, the bank can acquire foreign exchange immediately and in others there will be a time gap. For example, when a bank receives a telegraphic transfer for Euro 25000, the foreign correspondent bank would already have credited the nostro account, whereas in a bill purchase transaction, realization of proceeds takes longer duration, depending upon the usance period and the transit period. Therefore, depending upon the time of realization of foreign exchange, two types of buying rates are quoted.
1.

TT buying rate: The rate is applied when the transaction does not involve any delay in realization of foreign exchange. The bank while paying DDs, TTs and foreign bill, where credit to nostro has already been provided, applies TT buying rates.

2.

Bill buying rate: In the case of a usance bill, the proceeds will be realized on the due date of the bill, which includes the transit period and the usance period of the bill. Bill buying rate is applied when foreign bills are purchased.

7.

Types of selling rates:

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When a bank sells foreign exchange, it parts with foreign currency. The sale is affected by issuing a foreign currency draft or a TT or payment of an import bill. Immediately on sale, the bank buys the requisite foreign exchange from the market and arranges credit to its nostro account with the correspondent bank. Types of selling rates quoted are:
1.

TT selling rate: Applicable to all sale transactions that do not involve handling of documents by the bank. E.g.: Issue of demand drafts, TTs, etc. Bill selling rate: It is used for sale transactions that involve handling of documents by the bank. E.g.: payment against import bills. Forward rates:

2.

4.4

In some foreign exchange transactions, delivery / acquisition of foreign currency takes place after a certain period. The transaction in which exchange of currencies takes place at a specified future date is known as forward transaction. A forward contract for delivery of one-month means, the exchange of currencies will take place after one month. Forward rate for a currency may be at par i.e. the rate is same as the spot rate. Forward rate for a currency may be at premium, if the forward rate is costlier than the spot rate. Forward rate for a currency may be at discount if the forward rate is cheaper than the spot rate. In practice, the forward rates are quoted as below: Spot: USD 1 = 46.1000 / 1100 1 month: 2000 / 2100 2 month: 3500 / 3600 i.e. spot rates with forward margins are given. The forward rates can be derived from the spot rate. 4.5. Dealing:

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Like any other trading, foreign exchange transactions consist of purchase and sale. In a purchase transaction, the bank acquires foreign currency and parts with home currency. In a sale transaction, the bank parts with foreign currency and acquires home currency. When a bank buys foreign exchange from the customer, it sells the same in the interbank market at a better rate and thus makes a profit out of the deal. The market dictates the inter-bank rate and therefore the basis of quotation of rates by the bank depends on the inter-bank rate.

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While doing purchases and sales, an exchange position is created in the banks books. If purchases exceed sales, the position is said to be overbought (long) and if sales exceed purchases, it is said to be oversold (short). To carry out this function, banks have to keep sufficient stocks of foreign exchange in the form of balances in bank accounts abroad (Nostro accounts). Since foreign exchange is a sensitive commodity and subject to wide fluctuations in price, banks would always like to keep the exchange position near zero (square). The exchange position in a currency is arrived at after netting all the purchase and sale in that currency, irrespective of the fact whether actual delivery has taken place or not. The other aspect is the actual movement in the balance in the banks account with the correspondent abroad as a result of banks purchase and sale transactions, which is known as cash position. Some examples of purchases are: 1. 2. 3. 4. 5. 6. Payment of DD, TT, Travelers cheques Purchase of bills Purchase of cheques Realization of bills Forward purchase contracts Purchase in inter-bank / international markets.

Examples of sale of foreign exchange are: 1. 2. 3. 4.

Issue of DD, TT, Travelers cheques Payment of import bills Forward sale contract Sale to inter-bank / international markets.

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All foreign exchange transactions will have an effect on exchange position and cash position. Exchange position is affected at the time of booking the contract and cash position is affected at the time of delivery of funds i.e. o o for every purchase transaction bought in exchange position, credit balance in nostro account increases - the point to note is that the timing may not coincide and for every sale transaction sold in exchange position is increased and balance in nostro account decreases. Here too the timing of the too may not coincide.

When doing a spot buy USD for example, the USD exchange position is + on the contract or transaction date but, the USD nostro will get credit only on the value date i.e. two working days from the contract date. Hence while the exchange position has been affected on contract date there is nothing happening to the cash position. On the value date the cash position will get affected and will move to +. While the exchange position enables the bank to remain square and avoid exchange risk, the cash position enables the bank to keep just adequate funds in the nostro

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account to meet its commitments without incurring interest cost (towards borrowing to meet commitment). It may be noted that steps taken to correct an imbalance in exchange position may or may not affect cash position immediately. For example, if the bank has overbought position and corrects it by selling forward, it would not affect cash position on the same day. Whereas, steps taken to correct balance in cash position would affect the exchange position. For example, to rectify overdrawn position of nostro account, the bank has to buy spot cash that would affect exchange position. 4.5.1 Cover deals:

As a consequence of the banks dealings with its customers, the bank has to purchase or sell foreign exchange in the market to cover the exchange position. This is known as cover deal and the purpose is to insure the bank against any fluctuation in the exchange rates. The bank is not only particular in covering the position but to cover it immediately i.e. to sell immediately whatever it purchases and purchase immediately whatever it sells. In other words, the bank would like to keep its exchange position squared. In the case of spot deals, the transaction is simple. If the bank has purchased USD 20,000 spot, it would endeavor to find another customer to whom it can sell spot for a similar amount. 4.5.2 Trading:

Trading refers to purchase and sale of foreign exchange in the market other than to cover banks transactions with the customers. The purpose may be to gain on the expected changes in exchange rates. In India, the scope for trading, although still subject to controls, is getting wider due to relaxation being made in the exchange control. However, the bank fixes a daylight limit and overnight limit for each currency. Daylight limit, for example, means, a bank fixes a limit of USD 5 million, then a dealer can purchase and sell USD so long as the balance outstanding at anytime during the day is not exceeding USD 5 million. Overnight limit means the extent to which the currency position can be kept open at the end of the day. Normally, the overnight limit would be much less than the daylight limit. 4.5.3 Exchange and Cash Position - Illustration:

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Transactions reported say on 1st October are as follows:


1.

2. 3. 4. 5.

Export Bill on New York for USD 50,000 purchased - payment due on 31st Dec. TT sent to London for GBP 20,000 Draft issued for GBP 1,500 TT remitted to Canada for USD 25,000 Cheque for GBP 5,000 drawn on Manchester purchased

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These transactions will result in: Exchange position: USD Bought 50,000 Sold 25,000 Exchange position: GBP Bought 5,000 Sold 20,000 1,500 Net -16,500 Net +25,000

Cash position: USD Dr. 25,000 Cr. Balance (Dr.) 25,000

Cash position: GBP

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Dr. Cr. Balance (Dr.) 16,500 20,000 1,500 5,000

4.5.4

Swap Transactions:

It may be noticed in the above example that any imbalance in exchange position or cash position has to be rectified immediately by cover operations. A swap transaction is used as a mechanism for rectifying mismatch in the cash flows between two value dates. In the above exchange position example for US dollars, if the net position of $ 25,000 is covered, it may result in cash flow mismatch i.e. export bill proceeds $ 50,000 will be received only after 3 months, whereas TT to Canada $ 25,000 has to be effected immediately. Swap is an exchange transaction in which there is a simultaneous sale and purchase of specified foreign currency for different value dates. In a swap deal, exchange position of the bank does not get altered. For example, an exporter books a forward contract for USD 50,000 for a bill drawn on New York for 60 days and his bank purchases the bill on submission of documents by the exporter. The forward contract is booked for 80 days (60 + 20 days transit). However the bill gets paid in 65 days from the date of booking the forward contract and USD 50,000 is credited to nostro account of the bank. The bank will hold this USD 50,000 idle

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for 15 days till the relative cover deal is taken up. Instead the bank can opt for a swap by effecting a ready/cash sale and buy forward for 15 days and earn a small income for the bank.
Adjustments of Funds / Funds Management Purposes of swaps Adjustments of gaps

A swap is therefore a transaction between two counter parties to buy and sell a specified foreign currency simultaneously for different maturities. The basic objective of a currency swap is to rectify the mismatch of cash flows. This may be either shortage of currency balances to meet immediate requirements or utilization of unproductive surplus balances. A swap deal should fulfill the following conditions: There should be simultaneous buying and selling of same foreign currencies of same value. The maturity periods of buying and selling should be different. Both buying and selling transactions should be between the same counter parties. The deal should be concluded with a distinct understanding between the counter parties that it is a swap deal.

For example, if Bank of Tokyo and Lloyds Bank enter into a swap deal, then Bank of Tokyo sells spot USD75, 000 and buys four months forward and Lloyds Bank buys spot and sells four months forward USD75, 000. 4.5.5 1. Need for Swap deals: Adjustment of gaps:

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Swap deals are undertaken to correct the mismatched position in cash flows. The mismatched position may arise due to various factors such as early or late deliveries under forward contract, cancellation of forward contracts, mismatch on account of cover operations, etc. E.g. a bank has the following mismatched position in GBP. (GBP In millions) Spot +1 1 month + 1.5 2 months -1 3 months +2 4 months -2 5 months - 1.5 The overall exchange position for GBP is square but there is a mismatch in cash flows. This can be corrected by the following swap deals.

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a) sell spot and buy 2 months GBP 1 mio b) sell 1 month and buy 5 months GBP 1.5 mio c) sell 3 months and buy 4 months GBP 2 mio 2. Funds Management:

Banks are interested to manage the funds in nostro account more profitably by utilizing the surplus balances judiciously and avoiding a overdrawn balance. Balances held in nostro accounts of a bank have to be commensurate with its day-to-day requirements. Surplus balances may not earn any return. The bank has to decide as to whether surplus funds should be kept as overnight deposit with the correspondent bank or undertake a swap and raise rupee resources based on the interest rates at both the centers. However, the management of banks has sufficient controls to prevent risk arising out of swaps employed for speculation. Case study: Bank A enters into a forward purchase deal for CHF 2.5 million for 2 months with its customer. It may not always be possible to cover in the inter-bank market for this large amount for the same period. At the same time, the bank cannot wait till it finds one because the rate may change adversely. To cover the exchange risk, the bank will sell spot immediately. However, for the spot sale the bank has to arrange funds in their nostro for payment. Probably, the next day, the bank will carry out a swap by buying spot and selling two months forward CHF 2.5 million to cover the cash position. Let us assume that the rates dealt by the bank on Day 1: 2 months forward purchase: Rs.28.43 Spot sale: Rs.28.08 Day 2: Spot purchase: 2 months forward sale: Day 1: ____ Day 2: .
Purchase

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Rs.27.83 Rs.28.20

2 months

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The profit or loss for the bank in the swap deal may be worked out as under: Purchases (Rs.) Forward 28.43 Spot Spot 27.83 Forward 56.26 The net gain is 2 paise per CHF for the bank. 4.6 Forex Risks: Sales (Rs.) 28.08 28.20 56.28

The Dealing Room is identified as a main profit center for a bank. It is also true that any scope for profits is associated with the risks of losing. The following are the major risks in foreign exchange dealings. (i) Open position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by the bank. (ii) Cash balance risk refers to actual balances maintained in nostro accounts at the end of each day. Any surplus balance does not earn interest, while any overdraft will incur interest payment. (iii) Maturity mismatch risk also known as liquidity risk or gap risk. This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding. As a result of this, cash flows from purchases and sales will mismatch. (iv) Credit risk arises when the failure of the counterparty to honor the contract. Limits are fixed on the aggregate outstanding commitments and separately for the amount of funds to be settled on a single day. (v) Country risk known as sovereign risk and is related to the ability and willingness of a country to service its external liabilities. (vi) Overtrading risk refers to the huge volume of transactions undertaken by a bank beyond its administrative and financial capacity. (vii) Fraud risk: Frauds may be manipulated by the dealers or operational staff in order to conceal a mistake or for personal gains. E.g. dealing for own benefit without putting them through bank accounts, undertaking unnecessary deals to pass on brokerage for a kickback, sharing benefits by quoting unduly better rates to customers, etc. (viii) Operational risk includes inadvertent mistakes in the rates, amounts, and misdirection of funds due to human errors, telecommunication mistakes.

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5.

Dealing functions and control of dealing:

Increasing volatility in both the exchange rate movements and interest rate levels have on several occasions precipitated substantial loss for several banks. This has resulted in increased attention being placed on asset / liability management and the organizations strategy to contain these exposures. It is now quite common for banks with extensive branch network to centralize the management and control of treasury divisions and dealing centers. The necessity for heightened controls, particularly to cover foreign exchange dealing operations of banks falls under the supervisory authority of the Central Bank in most countries. 5.1 Dealing room:

Bank trading rooms share common physical characteristics. All are equipped with the modern communications equipment, to keep in touch with other dealing banks, forex brokers, and corporate customers. Banks and brokers communicate their rates either through Reuters, Telerate or other similar automated media, or through telephone / telex. Although automated media is an important source of data, a dealers primary form of communication for keeping in touch with markets are direct telephone lines to brokers, banks, internal group dealing centers and other major users and suppliers of money. Most major dealing rooms have loudspeaker systems, which are fed from brokers office and facilitate an instant awareness of prices as communicated internally within those offices. Traders also subscribe to the major news services to keep current on financial and political developments that might influence exchange trading. 5.2 Back office:

Banks also maintain extensive back office support staffs to handle routine operations such as confirming exchange contracts, paying and receiving foreign currencies and general ledger accounting. These operations are generally kept separate from the trading room to assure proper management and control. 5.3 Trading policies:

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The senior management sets the basic objectives of a banks trading policy. The policy depends up on factors such as the size of the bank, the scope of its international banking commitments and, the nature of its trading activities at its foreign branches. Further the management must also decide to what extent the trading function should be aimed at providing a service for the banks customers and to what extent it should be looked up on as a profit center. This purely depends on the banks attitudes toward risk and capacity to absorb risk. 5.4 Department structure:

Every bank has its own decision-making structures. Nevertheless some generalizations can be made. A chief dealer supervises the activities of the traders and in turn reports to the senior officer in charge of the banks international asset liability management area, which normally includes foreign currency trading and Eurocurrency activities. Senior traders typically handle the most actively traded currencies, sometimes assisted by the junior traders, who might be responsible for less actively traded currency. Module 5

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Whatever the rank, actions of any trader commit the bank to potentially large sums of money. Traders give quotations to customers and other banks, approach the brokers market, arrange swaps needed to balance daily payments and receipts resulting from maturing contracts, and alert corporate clients to significant market developments. Senior traders may be authorized to take a view on potential short-term exchange rate movements and thus to establish long or short positions. Similarly they may be authorized to take a view on the potential interest rate movements and thus seek a particular maturity pattern. The chief dealer is responsible for the profit or loss of the whole operations as well as, for ensuring that deals are within the trading limits to control risks. 5.5 Trading Limits:

The establishment of limits is highly relevant to dealing staff, as thereafter they are held responsible and accountable for positions maintained. The following are considered while establishing trading limits: Each dealers maximum outright position limit is clearly defined, differentiating between intra-day (or daylight) exposure and end of day positions. Each dealers authority to operate within mis-matched limits for each dealing book, e.g., currency deposits, foreign exchange, or other portfolios, is also defined. Stop-loss or the necessity to report adverse dealing positions at a particular level of loss is clearly defined and established. Predefined bank and other counter party limits are established. Dealers undertake transaction with other market participants within approved counterparty limits and / or credit limits. Where transactions are undertaken in respect of a customer, the concerned dealer is responsible to ensure that appropriate limits are available to accommodate such business. Other forms of control over trading exposure are communicated as and when imposed. Operational Policy:

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5.6

Each bank may structure its own operational policies with regard to dealing and would broadly encompass the following: Within the authority delegated to him each dealer is solely responsible and accountable for position maintained by him. It is the responsibility of the dealer to check with the broker, jobber, bank telex backing sheets or Reuters printout, all trades undertaken during the day. Each dealer should also ensure that all

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transactions are properly recorded on dealing slips or other initial record of trade and are submitted to the operations area for further processing. The accuracy of all information recorded in the dealing slips and the legibility thereof are important factors to ensure misunderstandings do not occur in the accounting and processing areas. Dealers annotate on dealing slips, the correct rates at which the deals were concluded. Fictitious rates must not be recorded on dealing slips for any reason. Confirmations:

5.7

In the course of each business day, confirmations are produced and despatched by each principal to the other with whom trades were undertaken. If the trade involves a broker he confirms the deal with both the principals. Upon receipt, all parties verify the details with their own accounting records. It is pertinent to mention here that there is an increasing tendency within the markets for unsigned computer produced confirmations to be utilized. Although unsigned confirmations are binding, it is customary to obtain suitable indemnity from the issuing bank for errors, omissions, etc. At the end of each day each dealer verifies that all transactions have been processed correctly. This is achieved by telephone confirmation, telex backing sheets or hard copies taken from computerized dealing system. With in the context of telephone markets, the importance of confirmations and verification thereof, cannot be over-stressed. This is particularly so where forward value dates are concerned. Same day, one day and spot value transactions will frequently be settled prior to a confirmation being received. It is however necessary that confirmations to all deals are despatched immediately after the deal is concluded. Similarly immediate attention should be given to confirmations received which cannot be identified with recorded transactions. All confirmation procedures and controls are undertaken by staffs who are not connected with nor have access to the dealers or dealing room. Under no circumstances should dealers be involved in procedures relating to incoming and outgoing confirmations. 5.8 Nostro / Correspondent bank reconciliation:

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It is essential that correspondent statement of accounts in both currency and commodities are efficiently reconciled on a regular basis. Up on receipt of the statement it is first essential that items are immediately marked off against the in-house nostro record, thereby identifying large outstanding which can then be immediately investigated. 5.9 Revaluation / Mark to market:

Procedures for revaluation and / or mark to market exercises must be established with attention being focussed on where precisely the rates used for this purpose originate. The rates used for revaluation must be checked or provided independently of the dealing room. If undertaken properly revaluation will highlight any substantial underlying losses Module 5
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that have not been reported or identified. Dealers usually maintain a running position of the profits as they estimate them to be, these should be compared with the result as reflected from a revaluation of the accounting records and any significant discrepancies investigated and monitored. All accounting record must be properly and accurately maintained to ensure the accurate and timely reporting of all profit and loss figures at desired frequencies and in accordance with each banks accepted accounting policies.

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