The Commercial Loan Theory
• Originated in England during the 18th century •The theory states ; A Commercial Bank must provide short term liquidating loans to meet working capital requirements. The bank should refrain from long term loans •Logical basis of the theory Commercial bank deposits are near demand liabilities and should have short term self liquidating obligations.
The bank holds a Principle that when money is lent against self liquidating papers, it is known as Real Bills Doctrine. The doctrine had some criticisms. They were; A new loan was not granted unless the previous loan was repaid. Banks should provide loans before the maturity of the previous bills Due to Economic Condition the liquidity character of the self liquidating loans are affected.
• During Economic depression goods do not move fast through normal channels Prices fall Losses to sellers • No guarantee , even the transaction for which loan provided is genuine and whether debtor will be able to repay the debt. Another criticism was that It failed to take cognizance of the fact that the bank can ensure liquidity of its assets only when they are readily convertible into cash without any loss. Thus the Commercial loan theory was ignored because of the criticisms of the DOCRINE.
• Originated in USA in 1918 by H.G.Moulton • According to this theory, the problem of liquidity is not a problem but shifting of assets without any material loss. • Moulton specified, ‘ to attain minimum reserves, relying on maturing bills is not needed but maintaining quantity of assets which can be shifted to other banks whenever necessary
• According to this theory ; It must fulfill the attributes of immediate transferability to others without loss • In case of general liquidity crisis, bank should maintain liquidity by possessing assets which can be shifted to the Central Bank. Eligibility of Shifting of assets Soundness of assets Acceptability are distinct Thus, as development took place the Commercial Loan theory lost ground in favor of Shiftability Theory
• Blue chip securities which possess high degree of shiftability, the commercial banks were ready to buy them as a collateral security for lending purposes. • During depression, the whole industry would be in crisis. The shares and debentures of well reputed companies would fail to attract buyers and cost of shifting of assets would be high. • Blue chip Securities will also lose their shiftability character. Thus, both Commercial loan as well as Shiftability theory failed to distingish liquidity if an individual bank as well as the banking industry.
Anticipated Income Theory
• Developed in 1948 by Herbert V.Prochnov • Most striking Developments of commercial banks that took place was in participation of term lending. • The banker plans the liquidation of the term loans from anticipated earnings of the borrower. • Loan repayment schedules have to be adapted to anticipated income • Estimation of future earnings should be made.
The liability Management Theory
• It emerged in the year 1960. • This is one of the important liquidity management theory. • Says that there is no need to follow old liquidity norms like maintaining liquid assets , liquid investments etc.
Proposes many alternatives
Certificate of deposits • Is a negotiable instrument. • Maturity date. Limitations • Interest rates. • Commercial banks compete with each other for it.
Borrowing from other banks • Short term • Sensitive to market condition Limitation • Every bank mostly faces shortage
Borrowing from the central bank • Available in the form of discounting and day to day and seasonal liquidity needs. Limitations • Costlier • Restrictions
Raising of capital funds • By issue of shares • Depends on public response , dividend and growth rate. using Reserve profit
Potentiality of liability management theory in India • Inter bank participation certificate 1.with risk sharing 2.without risk sharing • RBI may not be a dependable source. • Raising capital funds is not easy.
Conclusion • This theory makes a limited contribution.
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FEATURES OF BASLE COMMITTEE - I:
MINIMUM CAPITAL REQUIREMENT
DIVIDED THE CAPITAL INTO TWO
STEPS IN COMPUTING CRAR
CLASSIFY THE ASSETS OFF BALANCE EXPOSURE RISK WEIGHTED ASSETS ARRIVE CRAR
N wB s l N rm o C p l A e u c (B s l e a e o s n a ita d q a y a e C m itte – om e ΙΙ N rm) o s
S am d en inth acco –d rin 1 6 B co m II (B B ) b u h o t o en m t e rd u g 9 6 asel m ittee C S ro g t u co su e p er o n cap ad u fram o in ju e 1 9 an a seco d n ltativ ap n ew ital eq acy ewrk n 9 9 d n rev ninjan ary2 0 th n acco restso th p isio u 0 1 e ew rd n ree illars:
• • •
M immcap req irem t in u ital u en S p iso rev p cess. u erv ry iew ro M et d lin ark iscip e.
1 M imm a ita R q ire e t . in u C p l e u mn
Primarily concerned with minimum capital requirements to cover credit risk Banks be required to measure and apply capital charges in respect of their market risks in addition to their credit risks
w h easag st th p tsin leu ifo riskw h o 1 0 . eig tag ain e resen g n rm eig t f 0 %
wu b 4categ riesfo claim o co o 2 % 0 ,1 0 an 1 0 o risk o ld e o r s n rp rate 0 ,5 % 0 % d 5 % f
• Thus besides the earlier tier i and tier ii a new category of capital tier 3 has been created. As such eligible capital to cover market risks includes equity and retained earnings • 1 Supplementary capital • 2 A third tier of capital.
S p rv o R v wo P c s u e is ry e ie f ro e s
This piller would seek to ensure that each bank has sound internal process in place to assess the adequacy of financial modelling techniques to the prescription of capital adequacy. This is to be achieved through; • Supervisors would be responsible for evaluating how well banks are assessing the capital adequacy needs relative to their risks.
The 4 basic and complimentary principles on which the piller 2 rests are;
• Assessing bank overall capital adequacy in relation to risk profile as well as strategy for maintaining capital levels • Review and evaluate internal adequacy assessment • Supervisors expect bank to operate above minimum capital ratio • Prevent capital from dipping below prudential levels
3. Market Discipline
Blostering market discipline through enhanced disclosure by banks. This is essential to ensure that market participants can better understand bank risk profile and the adequacy of their capital position
BCBS 3rd Consultative paper 2003
• • • Fully secured lending will now receive a 35% risk weighting instead of the erlier 40%. A minimum loss given defaults value 10% is propsed for retail exposures secured by mortgages Advanced and foundation internal rating based approaches are presently available for high volatility commercial real estate lending. An alternative standard operational risk approach has been developed
Management of Secondary Reserve in Commercial Banks
Nature of Secondary Reserve: Consists of the aggregate of “highly
liquid earning assets”. • Principal objective - ‘To impart adequate liquidity to funds without adversely affecting the profitability’ • Therefore assets which: yield some income + highly liquid (quickly converted into cash without any material loss).
• Three Conditions: “Shiftability, Low Risk and Yield” - Shiftability: -For quick liquidation of assets (ready market
should be there)
- Low Risk: -Asset should be free from
money rate risk (risk out of fluctuations in security price due variations in interest rates) - Contractual rate of interest would remain the
arising to same
• Market price of Fixed Interest bearing securities closely related to their maturity period • Short period securities less vulnerable to interest rates fluctuations and hence Low Risk • For the purpose of income, liquidity attribute should not be forgone • Emphasis: Liquidity- Primary Income- Secondary
Type of Assets:
• Call loans to stock brokers and commercial banks. • Short-term loans to commercial banks. • Short-term loans secured against self-liquidating assets or blue chips. • Investments in treasury bills. • Promissory notes of short period maturity. • Discounting of Usance bills eligible for rediscounting from RBI. • Short period Debentures of companies with an faultless credit standing.
Functions of Secondary Reserve:
• Principal function is to Replenish Primary Reserve. • Subsidiary function is to earn a moderate income. • Helps the banker to trade off successfully between liquidity and profitability. • “Push Button Fashion” • “Reservoir whose gates are opened or closed as the need for fund arises” • To strengthen the bank liquidity • The core of bank liquidity
• EXTERNAL FACTORS • INTERNAL FACTORS
Factors influencing the level of Secondary Reserve:
1. National Factors: - General State of Economy
# Prosperity # Recession
- Political Condition- stable - Taxation Policy- exemption=liquidity + earnings - Monetary Policy
# Rise/ Fall in minimum reserve # Liquid assets ratio & Rediscounting policy
2. Local Factors: - Character of the Local Economy
# Agriculturist # Industrialist
- Character of Local Population
# Illiterate- rumours
- Movement of Local Population # Bigger employment opportunities
# Natural Calamities
• • • • • • Deposit structure Ownerships of deposit accounts Average size of bank accounts Access to money market Nature of bank loans Maturities and diversification of investment portfolio
Management of secondary reserve in a commercial bank
1. Estimating liquidity needs for secondary reserve a) Rough method Loan-increase by 300000 to reach 1000000 Deposits-Decrease by 300000 from level of deposits 1300000. Bank would sum up excess of loans & shortfall of deposits i.e 600000(secondary reserves)
b) Statistical method • Find percentage variation in the level of loans & deposits. • Reduce percentage change into absolute figures using figures from capital, deposits, loans. • Add the net increase/subtract the net decrease in loans & deposits. • Sum up the estimated amounts of loans & deposits.
2. Estimating secondary reserve requirements for possible changes in reserve requirements.
3. Estimating secondary reserve requirements for unstable deposit accounts
Conclusion Bank should manage secondary reserve to impart adequate liquidity without adversly affecting the profitability.
III. Expansion Phase(19681984)
This phase witnessed socialization of banking sector(viewed as change agent & social control emphz.) Nationalization took place (14-1969, 61980) Birth & growth of directed lending programme Poverty alleviation & employment generating schemes Dominance of social banking over commercial banking.
1975 -Birth of RRB, 1982 –NABARD Commercial banks declined & scheduled banks shot up due to the emergence of RRBs branch expansion given importance 50,000 new branches were set up (3/4th in rural & semi urban areas)
Banking industry achieved unparallel growth but no consideration given to other issues such as support systems required for efficient services, control mechanism etc. Thus with growth came inefficiency & loss of control As lending was given to risk prone areas at concessional rate(asset quality & profitability declined)
IV. Consolidation Phase(1985-1990)
Thrust was given in consolidation of the banking sector Thus policy initiatives were taken with the objective of consolidating gains of branch expansion Branch expansion was slowed down & hardly 7000 branches were set up
Attention was paid in: - improving housekeeping, -customer services -credit management -staff productivity & profitability Steps taken to increase rate of bank deposits & lending Measures initiated to reduce structural constraints in devloping money market
90% of commercial banks were in public sector & were closely regulated There was no autonomy given for taking vital decisions: prices of asset & liability-fixed by RBI prices of services –fixed by IBA 63.5% of bank funds mopped up by CRR,SLR remaining funds directed to priority sector Thus banks ended up consolidating their losses instead of gains
V. Reformatory Phase(19912000)
The need for reform was emphasized as the country faced grave economic crisis in 1991
• Due to the crisis: - India defaulted on its international commitments - External access to commercial credit denied - International credit rating downgraded - International confidence erroded - Economy suffered from serious inflationary pressure
And thus various economic structural reformatory measure became necessary so as to improve the strength of economy & ensure against future crisis & also to ensure growth with equity For this purpose Narsimham Committee was set up
• The past four and half decades and particularly the last two and half decades witnessed cataclysmic change in the sphere of commercial banking all over the world. Indian banking system has also followed the same trend. As a matter of fact, changes here have been far more pronounced than anywhere else
Phases in Banking sector
In over six decades since independence banking system in India in has passed through distinct phases, viz., • Evolutionary phase- prior to 1948 • Foundation phase- 1948-1967 • Expansion phase- 1968-1984 • Consolidation phase- 1985-1990 • Reformatory phase- 1991-2000 • Mergers and Acquisition phase-2001 and onwards
Evolution phase (prior to 1950)
Enactment of the RBI Act 1935 gave birth to scheduled banks in India The prominent among the scheduled banks is the Allahabad Bank, which was set up in 1865 with European management while as many as twenty scheduled banks came into existence after independencetwo in the public sector and one in the private sector
The United Bank of India was formed in 1950 by the merger of four existing commercial banks the numbers of scheduled banks rise to 81. Out of 81 Indian scheduled banks, as many as 23 were either liquidated or merged into or amalgamated with other scheduled banks in 1968, leaving 58 Indian scheduled banks.
19th Century Pre- first war world Inter war- period Second World War Post- Second World War Total
No of bank’s
2 14 21 3 18 58
• It may be emphasized at this stage that banking system in India came to be recognized in the beginning of 20th century as powerful instrument to influence the pace and pattern of economic development of the country • .
• Until 1935 when RBI came into existence to play the role of Central Bank of the country and regulatory authority for the banks , Imperial Bank of India played the role of a quasi central bank
Foundation Phase 1948-1967
• The banking scenario prevalent in the country during the period 1948-1968 presented a strong focus • The emphasis of the banking system during this period was on laying the foundation for a sound banking system in the country. • phase witnessed the development of the necessary legislative framework for facilitating reorganization and consolidation of the banking system in the country
• Banking Regulation Act was passed in 1949 to conduct and control operations of the commercial banks in India • Major step taken during this period was the transformation of Imperial Bank of India into State Bank of India and a redefinition of its role in the Indian economy, • During this period number of commercial banks declined remarkably.
• Before 1968, only RBI and Associate Banks of SBI were mainly controlled by the Government. Some associates were fully owned subsidiaries of SBI and in the rest, there as a very small shareholding by individuals and the rest by RBI. •
PRIORITY SECTOR FINANCING BY COMMERCIAL BANKS IN INDIA
Priority Sector Lending Policies
OBJECTIVE Aimed at development of agriculture, small-scale industries, small traders, artisans, self-employed persons and other weak sections of society which had been ignored by the banks.
• The banks would pursue the production nexus approach instead of asset nexus approach while dispensing assistance. • Offer composite finance, it include provide term lending facilities to farmers for purchase of inputs, pesticides, for development of land etc.
• Commercial banks would provide concessional lending facilities to the priority sectors.
In order to align bank credits to the changing needs of the society the scope and definition were changed, where the following are some of measures initiated in 2003-04 • The ceiling on credit limit to farmers against pledge/hypothecation of agriculture produce was increased from Rs. 5 Lakh to Rs. 10 Lakh.
• Limit on advances for dealers in agricultural machinery was increased from 20 Lakh to 30 Lakh. • For distribution of inputs for allied activities increased to 40 lakhs from 25 Lakhs. • Investment limit in plant and machinery for 7 items belonging to sports goods was enhanced from Rs. 1 crore to Rs. 5 crore.
besides from this, • RBI was directed not to insist for any collateral security/ third party guarantees for all advances under priority sector upto Rs.25000. • no service or processing fee is to be recovered by banks in such a case. • Time schedule is given to sanction the advances.
Broad categories of priority sector for all commercial banks
1. Agriculture (direct and indirect finance) 2. Small Enterprise (direct and indirect finance) 3. Retail Trade 4.Micro credit 5.Educationa Loans 6.Housing Loans
Trends in banks advances to priority sector and Problems faced by banks in priority sector lending.
Bank advances to priority sector
700000 600000 500000 400000 a m o u n t in c r o r e 300000 200000 100000 0 Ju n -69 Ju n -91 m ach -01 m ach -06 m ach 07
Priority sector advances in different banks.
F o r e ig n b a n k s P r iv a t e s e c t o r P u b lic s e c t o r
RBI norms to improve credit delivery to priority sector.
• Only SSI units to be included in priority sector. • Banks to fix self targets for financing SME sector to achieve higher disbursement. • Banks to consider credit appraisal and rating tool (CART) risk assessment model and comprehensive rating model for risk assessment of proposals for SME. • Banks to provide credit to atleast 5 SME enterprises per year. • Banks should formulate liberal policies based on guideline of specific sectors. • Banks to adapt cluster based approach for SME financing. • Banks should start specialized SME branches to have easy access to bank credit
Problems faced by banks in priority sector lending. The main two problems are - high volume of overdues - ever increasing cost of supervision The recovery of the loans by the banks from SME sector is difficult.
• So in order to gather the resources of the bank in a better way recovery camps should be there. • If the banks have to survive successfully, the banks have to ensure proper utilization of credit and recycling of credit. Proper supervision should be there by banks. • Large scale priority sector lending have imposed additional burden to bank as they have to take care priority sector as well as other weaker sections of the society. • So something should be done so as to arrest the deterioration of profitability trend.