Banking term Part-2 From polaris edutech Academy

Systemically Important Financial Institutions

Definition : Systemically Important Financial Institution can be defined as some of the key banking companies, insurance companies or a financial institutions whose failure can become a threat to the existing financial system and may trigger a grave financial crisis which may have an adverse impact on the economy as a whole.

Explanation : The fact that these financial institutions are designated as systematically financial institutions can be attributed to their significant size, lack of substitutability, complexity in operations, cross-jurisdictional activities and interconnectedness. During the global financial crisis of 2008 when some of the major financial institutions came under significant pressure, the Government had to intervene to restore stability in the market and normal functioning of the financial system. In the backdrop of this financial crisis, the Basel Committee on Banking Supervision released a framework which aims to identify systemically important banks at the international level. The Financial Stability Board which coordinates between financial authorities at the international level mandated that member states need to adopt a framework which will minimize the risk within such important financial institutions.

Example : The Reserve Bank of India (RBI) in line with recommendations made by the Financial Stability Board released a framework in which it described the methodology that the Central Bank will adopt to identify such Domestic Systemically Important Banks. RBI will first assess the banks on various indicators like size and interconnectedness and then give a score on the basis of relative systemic importance. Banks having a score greater than the cut-off score will be termed as Domestic Systemically Important Banks. The RBI further added that such banks will be subject to additional regulatory and supervisory requirements.

indicators Leading and lagging

Definition : An economic indicator gives an idea about the trend of a particular macroeconomic parameter that has either happened in the past or is most likely

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to happen in the future. A Leading indicator can be defined as an indicator that points towards the trend which is most likely to sustain in the future while a lagging indicator gives an idea about the trend that has already taken place in the past.

Explanation : Leading indicators forecast the event that is likely to take place in the future while lagging indicators are all about those economic activities that have already taken in the past. Both leading indicators and lagging indicators have their own set of advantages and disadvantages. While a leading indicator is used for short term predictions and allows organizations to make necessary adjustments in accordance with the results such indicators may pose challenges in terms of data capturing and may at times have no historical data. Lagging indicators on the other hand is comparatively easy to identify and capture but does not in any way reflect the current activity levels and has no estimation or forecasting traits as such.

Example : An example of a leading indicator is the Leading Economic Index of USA which is published by the Conference Board. This indicator gauges the level of economic activity that is most likely to sustain within the U.S. economy in the short to medium term. Indicators like Gross Domestic Product, Index of Industrial Production and Consumer Price Inflation on the other hand can be taken as examples of lagging indicators.

Fixed income obligations to income ratio (FOIR)

Definition : Fixed Income obligation to income ratio (FOIR) which is also known as the debt service ratio or debt-to-income ratio is a critical aspect that banks and other financial institutions need to take into account while sanctioning a loan. This ratio is generally expressed in terms of percentage and helps to determine the loan eligibility of the borrower.


Explanation : Before lending money to the borrower, the bank tries to ascertain whether the concerned borrower has the ability to pay equated monthly instalments (EMIs) in time and repay the principal amount. To ascertain the credit worthiness of the borrower the bank looks into the personal credit history of the borrower and other financial details and calculates the FOIR. The ratio shows the proportion of the total monthly income that the borrower is using at present to pay his debt obligations. However, FOIR does not take into account statutory deductions from his monthly income which may be provident fund, professional tax and deductions for investments made for insurance or a recurring deposit. Say for example the monthly income of a borrower is Rs. 50,000 and he has a car loan of Rs. 15,000. Then the FOIR of the borrower comes out to be 15,0000/50,000×100 which is equal to 30%. A bank will prefer to give a loan to borrower whose FOIR is low. This is because if a borrower’s FOIR is high then it implies that the credit risk of the lender is also high as the disposable income available to the borrower after paying his EMIs is low. Thus the ability of the borrower to repay the loan is also low.

Example : Suppose the monthly income of an individual is Rs. 50,000 and the bank FOIR is 50%. Thus the individual can avail loans from the bank whose total EMIs is to the extent of Rs. 25,000. Now if the individual is already paying a car loan EMI of Rs. 15,000 and he wants to take a home loan as well then taking into account the above FOIR criteria the individual can avail a home loan from the bank provided that the EMI does not exceed Rs. 10,000.

Macroeconomic Vulnerability Index

Definition : Macroeconomic Vulnerability Index (MVI) is constituted by adding up the rate of inflation, Current Account Deficit and Fiscal Deficit of a country (all obtained from the latest World Economic Outlook of the International Monetary Fund). Fiscal Deficit and Current Account Deficit are measured as percentages of GDP while inflation is calculated as the year-on-year change in the relevant price index. Thus MVI together indicates three key areas where macroeconomic


imbalances are most likely to occur- fiscal management, external account and domestic prices.

Explanation : Usually it is reviewed that the index should have a level of 12- consisting of 4% inflation, 2% CAD and 6% Fiscal Deficit. Higher the level of MVI, higher is the macroeconomic imbalance and more vulnerable is the economy. The index is used to make comparison across countries and across time. In 2012-13, India witnessed a vulnerability index with a value of 22.4, comprising a 10.2% inflation rate, a Budget Deficit of 7.5% and a Current Account Deficit of 4.7% of GDP, which was well above other countries. This put the domestic economy at the top of the Fragile Five pack (India, Brazil, Indonesia, South Africa, and Turkey). In the consequent years, MVI witnessed an improvement and in 2013-14, it stood at 18.1. In 2014-15, MVI has been projected at 15.2.

Example : Change in MVI must be interpreted cautiously as increase in the index does not add to macroeconomic risk in the same way. For instance, a 2% rise in inflation with a 2% rise in CAD cannot be compared at the same level. In both cases, the MVI increases by 2, but in the latter case MVI is more risky, because it can rapidly lead to a currency crisis, while the former represents only a mild deviation from the range of inflation.

Inflation Expectations

Definition : Rate of inflation that might prevail in the future can be termed as inflation expectations. Depending on inflation expectations, the Central Bank and other market participants can set their future strategies

Explanation : Inflation expectations play a crucial role in determining the Central Bank’s policy measures. If the Central Bank expects a high level of inflation then it would prefer to raise the rate of interest and if inflation expectations remain low then the Central Bank would reduce the interest rate.To measure the inflation expectations in India, the RBI conducts inflation


expectations surveys of households of nearly 5,000 people across 16 cities. The survey helps produce both qualitative and quantitative responses on inflation expectations over the near term (three months) and long term (one year) periods. These samples are then used to calculate median and mean inflation expectations for the coming three-month and one-year periods.

Example : Inflation expectation can be used as a key parameter to determine the policy measures. It can also be used by the wage earners to determine wages. For example if the inflation expectation is high, labour force may ask for higher wages, which in turn will push up costs.

Tick Size

Definition : Tick size can be defined as the minimum price movement that is allowed on stocks and derivatives which are traded on stock exchanges. In other words, tick size is the minimum amount by which the value of a security can change.

Explanation : Tick size depends on the nature of the underlying security and the stock exchange on which the security is currently trading. Different stocks have different market prices and as a result, tick size of one stock varies from that of another. A stock with a high market price can have a higher tick size while a stock with a comparatively low market price can have a low tick size. Theoretically, tick size has a bearing on the liquidity of a security and trading volumes. A security that has low liquidity in the market has a wide bid-ask spread. In such case, a high tick size can improve the liquidity and trading of the stock as the possibility of profit making on such stock increases accordingly. However, a low tick size limits the number of orders placed on the trading platform as price points of such orders may be very close to each other. Thus trading volumes are affected and as a result, low tick size affects stocks with relatively smaller market capitalization. If the tick size varies widely across the stock exchanges, it may create room for arbitrage on a stock that is listed on more than one exchange.


Example : For example, let us consider that the tick size for a stock is Re.0.05. This implies that if the market price of the stock is Rs. 100.60, then the closest price for the next buy order or the next sell order can be placed at is Rs. 100.65 or Rs. 100.55, respectively.

Fiscal Prudence

Definition : Fiscal prudence can be defined as the manner in which the Government manages its finances. Fiscal prudence implies that the Government adheres to strict discipline in the management of its finances. However, if the Government is not fiscally prudent, then it may end up spending more than its means and thereby incur a huge debt burden and subsequently run higher levels of deficit.

Explanation : It is imperative that the Indian Government maintains fiscal prudence in the management of its finances. For that the Government may bring down its populist spending and allocate funds towards productive and developmental activities that help in the growth and development of the economy. Higher Government borrowing may lead to increased demand for funds in the bond market, which in turn will increase the cost of money, leading to a scenario of higher interest rates. High interest rates will adversely impact investments and thereby derail growth of the economy. On the other hand, if the Government borrows less, its outgo on interest payments will be less. Thus the Government will be in a position to allocate funds towards productive and developmental economic activities.

Example : The Union Minister of Finance till recently has advocated for strong fiscal prudence. The Finance Minister opined that there is a need for fiscal consolidation and the Government needs to spend within its means.

Debt Overhang

Definition : According to Paul Krugman, debt overhang can be defined as a situation in which a company or a country has inherited such high levels of debt


that the creditors themselves do not have the confidence that the concerned company or country will be able to fully repay the debt.

Explanation : Debt overhang results due to high levels of debt. It has an adverse effect on the prospects and the values of the country or the company as the case may be. This is because of the fact that there is no incentive to increase economic activity within the country or the company as the benefits of it are likely to go to the creditors rather than to its stakeholders. Thus even when there is a surge in economic activity, the concerned entity under debt overhang stands to gain little. Countries with debt overhang are thus unable to allocate asset in key areas such as education, healthcare and infrastructure. The only way by which a country can overcome the debt overhang is when the creditors decide to forgive a part of the debt or the most of it or when the country itself files for bankruptcy.

Cross – Promotion

Interactive Media

Definition : Interactive media is a method of communication widely used in present times. It is the integration of digital media including combination of electronic text, graphics, moving images, and sound, into a structured digital computerized environment which provides an alternative mode of communication. It is a method of two-way communication whereby ideas or feedbacks can be exchanged at a faster pace.

Explanation : Interactive media is used for various purposes such as training, education, information presentation, corporate presentation etc. Social networking sites are examples of interactive media as these sites allow users to share information, video, photo etc using graphics and text. It is a useful tool for business houses to interact with potential clients. Marketers use the platform of interactive media to showcase their offering to the prospective customers.

Interactive Marketing


Definition : It is an developing trend in current marketing practices, where the marketing effort has moved from traditional system to a conversation-based one. In the current scenario, companies closely track the feedback of customers in various online platforms like social networking and e-commerce sites, which in turn are used to customize product offerings for the targeted segment. The process mainly involves understanding what customers want and the products are offered accordingly.

Explanation : This form of marketing has made customer segmentation easier and has allowed the marketer to closely analyse what the customers want. The ability to react to the actions of customers and prospects are often more effective than normal marketing practice. For example, a popular website invites its registered users to write reviews on restaurants they have visited recently. They are also asked to rate the restaurant based on certain parameters like food quality, service, overall ambience etc. The restaurant management tracks such reviews regularly and alters their offerings based on the feedback received.

Jensen Alpha

Definition : Jensen's Alpha, commonly known as ‘Alpha’, is used to measure the risk-adjusted performance of a security or portfolio in relation to the expected market return.

Explanation : The Jensen Alpha formula was first used by Michael C Jensen in 1986. The ratio helps in gauging the fund manager's ability to generate additional returns over the risk-adjusted returns delivered by the corresponding benchmark index. Investors can get an idea of how much value the fund manager has added (subtracted) to (from) the fund through his stock-selection ability. Stock selection can be a combination of sound fundamental and market timing. A high value for alpha implies that the fund has performed better than expected. A positive alpha of 1 means the fund has outperformed its benchmark index by 1%. Similarly, a negative alpha of 1 signifies an underperformance of 1%. The higher the ratio, the better the risk-adjusted returns.


Jensens’ Alpha= Portfolio Return - Benchmark Portfolio ReturnWhere:Benchmark Return = Risk Free Rate of Return + Beta (Return of Market - Risk-Free Rate of Return) Source: InvestopediaInvestors usually judge a fund manager by the return he provides, never by the risk he took to provide that return. The primary idea behind is that the fund manager should never be analyzed solely on the basis of returns. The risk component associated with the investment should also be considered so to get the correct picture.

Moody’s

Definition : Moody’s, also referred to as Moody’s Corporation, is the parent company or the holding company of Moody's Investors Service and Moody's Analytics. Moody's Investors Service is a major global credit rating agency that undertakes extensive research and analysis and covers debt instrument and securities. Moody’s Analytics provides financial software and advisory services for economic analysis and financial risk management.

Explanation : Moody’s is a very essential and crucial part of global capital markets that contribute significantly in maintaining transparency, accountability and integrity in financial markets across the globe. Moody’s Investors Service tracks debt instruments that cover as much as 130 sovereign nations, 21,000 public finance issuers, 76,000 structured finance obligations and 11,000 corporate issuers in several market segments and rates them accordingly. Moody’s Investors Service allocates different ratings to debt instruments ranging from AAA to C. While AAA signifies the highest quality with the lowest level of credit risk, C indicates an instrument that is likely to default and there is a very little chance of recovery of principal or interest. Moody’s Analytics, on the other hand, offers unique tools and best practices for managing and mitigating risk by undertaking economic research, credit analysis and financial risk management.


Example : Moody's Ratings revised India's sovereign rating outlook to “positive" from "stable" as the credit rating agency expects that actions by policymakers will enhance the country's economic strength in the medium term.

Market Segmentation

Definition : Market segmentation is a process or strategy by which the entire market can be divided into various groups or small units consisting of people who have relatively similar product needs or demand characteristics.

Explanation : There are several advantages of market segmentation as it helps a company identify a particular product for a particular segment. This also helps to build its competitiveness for a particular market segment, improving its core competency. By using segmentation analysis, customer retention can be encouraged and profitability can be improved.Market segmentation can be done in various ways, some of which are discussed below:

1. Geographical segmentation: It is based on variables such as region, climate, population density and population growth. For example, woollen garments can be promoted all through the year in polar countries but in tropical countries, it can be promoted only in winter.

2. Demographic Segment: Here segmentations are done based on age, gender, family size, income, occupation, nationality, religion etc. For example, there are various mutual fund products that cater to people of different age groups. An aggressive equity scheme may appeal to young investors but aged investors may opt for a debt scheme.

3. Psychographic Segmentation: This is based on consumers’ lifestyle as well as values and beliefs. For example, a luxury club membership may appeal to those who belong to the high-income segment and need to develop network with people to boost business.

4. Behavioural Segmentation: It is based on variables such as usage rate, patterns, price sensitivity, brand loyalty etc. For example, a consumer may


prefer to use the service of a certain telecom service provider as his usage rate matches with the price offering of that particular company.

Showrooming

Definition : Showrooming is the practice of visiting retail stores to examine a product or merchandise and subsequently purchasing the same from online retailers at a cheaper rate.

Explanation : With the growing popularity of online retail shopping sites, showrooming is gaining prominence among tech-savvy consumers. A section of such consumers prefer to visit a retail shop/store to physically examine a product/merchandise they prefer to purchase. After getting a look and feel of the product, they purchase the same at a cheaper rate from online retailers. The online price may be lower compared to the retail shopping centers/stores as it involves lower overhead costs. Meanwhile, online retailers offer free shipping if the purchase exceeds a certain threshold amount. In order to combat the challenges faced by physical retailers due to showrooming, a number of retail stores are using tactics such as offering in-store pickup for online purchases, thereby avoiding shipping charges and offering select products exclusively in physical stores.

Explanation : A customer comes to know about the launch of a smart phone. He goes to a retail mobile store to get the look and feel of the product. After being satisfied with the features, he does research on the best available prices and finalises an online retail store. Accordingly, he purchases the smart phone from that online store.

Recession

Definition : Recession refers to a phase in which significant decline in economic activity is witnessed and it gets spread across the economy. It is generally considered to be less severe than depression. However, if a recession continues for a long period of time, it may lead to depression.


Explanation : Recession generally sets in just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak there is a phase of expansion. Decline in real GDP, real income, employment, industrial production, investment, consumption are some of the key attributes of recession. The effects of recession are extensive and lead to tough times for most companies due to fall in overall consumer spending. However, in order to ensure that recession does not last long, Government takes necessary actions to boost the economy. It attempts to pull the economy out of recession through its monetary and fiscal policies.

Explanation : The financial crisis of 2008 was one of the worst economic disasters which the world has witnessed and it exposed the vulnerability of major global banks. It originated in the U.S. through sub-prime crisis and gradually hit different economies across the globe.

Real GDP

Definition : Real Gross Domestic Product (GDP) can be defined as a macroeconomic indicator, which measures the value of economic output within the concerned economy. It takes into consideration the necessary adjustments for price changes due to inflation or deflation.

Explanation : GDP is the monetary value of all goods and services produced within the economy during a specific year. GDP of an economy can be expressed in real terms as well as in nominal terms. Nominal GDP or GDP at current prices can present a misleading growth picture of an economy. This is because inflationary pressures are ignored by nominal GDP, which can have a significant bearing on the performance of the economy. However, real GDP provides the real picture of actual growth of the economy. Real GDP considers a specific year as base year and calculates the growth rate of the economy in the current year with respect to that of the base year. Real GDP does not take into account taxes and subsidies in its calculation. To measure the impact of price changes on the


economy, a new indicator called GDP deflator is arrived by dividing nominal GDP by real GDP. Since real GDP is calculated by making necessary adjustments for inflation, it can be used to depict the purchasing power of an individual by dividing the real GDP by the population size.

Ponzi Scheme

Definition : Ponzi scheme is a fraudulent scheme, designed to dupe investors with the promise of very high rate of return from investments. Such schemes deliver returns to older investors by adding new ones. Ponzi schemes generally deliver promised returns to earlier investors as long as new investors invest in the scheme. When the flow of new investments dries up, such schemes collapse and as a result investors lose their money.

Explanation : Ponzi scheme derives its name from Charles Ponzi, who started an arbitrage scheme in 1920 in Boston and used the ploy of paying off early investors with the money of new investors. He promised to double investors’ money in 90 days by buying and reselling international postal-reply coupons. He mopped up over $8 million from around 30,000 investors in a span of just seven months, before the scheme busted. Various money-raising schemes use similar tactics like Ponzi. They raise money from unsuspecting investors in the name of investing in real estate, agriculture and other lines of projects and businesses. In reality, very few such businesses exist and do not generate any significant revenue. Besides offering very high returns to investors compared to banks and other regulated channels, ponzi schemes also give huge commissions to agents and field workers. Ponzi schemes flourish due to lack of awareness among investors and the greed to earn unrealistically high returns.

Explanation : Sanchaita Investments in the mid-seventies used to offer sky-high rates of around 48% returns. The fraud was detected in 1979 when many depositors complained about non-payment of dues. Subsequently, the company was wound up in early eighties. In recent times, the scam of Saradha, Rose Valley, MPS, I-Core and other ponzi schemes came into picture after they started


defaulting in making payments to depositors. The investors must stay away from such schemes which promise unrealistically high returns.

Fair Value

Definition : In accounting and economics, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset.

Explanation : Fair value is an exit price. An exit price represents expectations about the future cash inflows and outflows associated with an asset or liability from the perspective of a market participant. The most common method of determining the fair value of a bond is to calculate the present value of all expected future cash flows from the bond. To do so, one typically needs the time to maturity, the discount rate, the coupon rate and the par value. In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time.

Chit Fund

Definition : A chit fund can be defined as an arrangement where a group of people contribute money at periodic intervals in a pre-defined manner into a corpus or a kitty. Chit funds are quite popular in rural areas and tier II and tier III towns in India, mainly due to lack of financial inclusion in such areas. Owing to under-penetration of banking services in such regions, many people use chit funds to raise quick money or to meet sudden liquidity needs and even a planned expenditure.

Explanation : Under the organised route, many companies have been incorporated to run chit fund as a business and are governed by state or central laws. Apart from a number of state chit fund acts, there is a central Chit Funds Act of 1982 to govern the operations of chit funds. The office of registrar of chit funds monitors operations at the state level. Such chit funds cater to the cash


requirements of members locally. However, there are many instances of fraudulent activities by chit fund companies where the members have lost their hard-earned money.

Example : While a simple form of chit fund is run to fund the needs of members, it can get complicated if it starts getting members to fund real estate projects, plantation schemes etc. People have lost money in various ponzi schemes, multi-level marketing schemes etc and need to be cautious about the operation of a chit fund. Chit funds, that are well operated, can be an option for people who are outside the ambit of formal financial channel, but those who have access to bank accounts need not explore the risky path.


Banking term Part-2 From polaris edutech Academy

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Transcript of Banking term Part-2 From polaris edutech Academy