MBA IV Semester Institutions Management of Financial ... · Financial Markets and Institutions....

Post Raj Pokharel, M.Phil, Ph.D. Scholar, 2015 1

1

MBA IV Semester

Management of Financial Institutions

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)

Basic Highlight

• Syllabus Briefing

• References

• UNIT I: Introduction and Overview of Financial

Institutions

• Overview of Financial Institutions.

• Economic Functions Performed by Financial Institutions.

• Role of Financial Institutions in the Financial System as a whole.

• Types and Growth of Financial Institutions in Nepal.

• Structure of the Nepalese Economy and Financial

System.2

UNIT I: Introduction and Overview of Financial Institutions LH 4•Overview of Financial Institutions.

•Economic Functions Performed by Financial Institutions.

•Role of Financial Institutions in the Financial System as a whole.

•Types and Growth of Financial Institutions in Nepal.

•Structure of the Nepalese Economy and Financial System.

UNIT II: Regulatory body - Central Bank LH 3•Introduction

•Objectives

•Functions

•History of Central Banking system in Nepal

UNIT III: Banking and the Management of Financial Institutions LH 8•The Bank Balance Sheet.

•Basics of Banking.

•General Principles of Bank Management: Liquidity Management, Asset Management,

Liability Management and Capital Adequacy Management.

•Off-Balance Sheet Activities: Loan Sales, Generation of Fee Income, Trading Activities

and Risk Management Techniques.•Measuring Bank’s Performance: Bank’s Income Statement, Measures of Bank

Performance.

•Recent Trends of Bank Performance Measures in Nepal.

UNIT IV: Commercial Banking Industry and Other Depository Institutions LH 8•Definition of a Commercial Bank.

•Size, Structure and Composition of the Commercial Banking Industry.

•Technology in Commercial Banking.

•Financial Statements of Commercial Banks and Their Analyses.

•Regulation of Depository Institutions in Nepal: Balance Sheet and Off-Balance Sheet

Regulations.

•Development Banks, Finance Companies and Finance Cooperatives in Nepal: Their

Roles, Size, Structure and Compositions.

UNIT V: Management of Insurance Companies LH 6•Overview of Insurance Companies

•Fundamentals of Insurance

•Types of Insurance

•Life Insurance Companies: Meaning and Their Functions

•Types of Life Insurance Policies and Their Determination.

•Property and Liability Insurance Companies: Meaning and Their Functions

•Determining the Profitability to Property and Liability Insurance Companies.

•Regulation of Insurance Companies in Nepal.

•Existing Scenario of Insurance Industries in Nepal.


UNIT VI: Credit Risk Management in Financial Institutions LH 7•Need to Manage Risk by Financial Institutions.

•Types of Risks Incurred by Financial Institutions.

•Overview of Credit Risk Management.

•Credit Risk Analysis: Cash Flow Analysis, Ratio Analysis, Common Size

Analysis

•Credit Scoring Models

•Calculating Return on a Loan

UNIT VII: Liquidity Risk Management in Financial Institutions LH 6•Overview of Liquidity Risk Management.

•Causes of Liquidity Risk.

•Liquidity Risk and Depository Institutions: Asset Side Liquidity Risk, Liability side Liquidity Risk and Measuring bank’s Liquidity Exposure

•Liquidity Risk and Insurance Companies.

•Liquidity Risk and Mutual Funds.

UNIT VIII: Interest Rate Risk Management in Financial Institutions LH 6

•Overview of Interest Rate Risk Management.

•Methods of Interest Rate Risk Measurement and Management: Repricing

Model and Duration Model.

•Insolvency Risk Management.

References:•Anthony Saunders and Marcia Millon Cornett. (2006). Financial Markets and

Institutions. Tata McGraw Hill Publishing Company Limited, New Delhi.

•Anthony Saunders and Marcia Millon Cornett. (2003). Financial Institutions

Management: A Risk Management Approach. McGraw Hill, Irwin, USA.

•Frederic S. Mishkin and Stanley G. Eakins. (2006). Financial Markets and Institutions.

Pearson Education Inc. and Dorling Kindersley (India) Pvt. Ltd.

•L.M. Bhole. (2005). Financial Institutions and Markets: Structure, Growth and Innovations. Tata McGraw Hill Publishing Company Limited, New Delhi.

•Meir Kohn. (2005). Financial Institutions and Markets. Tata McGraw Hill Publishing

Company Limited, New Delhi.

•Ram Sharan Kharel and Dilli Ram Pokhrel. (April 2012). Does Nepal's Financial

Structure Matter for Economic Growth? NRB Working Paper. Nepal Rastra Bank

Research Department.

•Nepal Rastra Bank. (2012). Banking and Financial Statistics. NRB: Bank and Financial

Institution Regulation Department, Statistics Division.•·Banks and Financial Institutions Act, 2063 (2006).

•·Nepal Rastra Bank. Quarterly Economic Bulletin (various issues). NRB: Central

Office, Baluwatar, Kathmandu. Annual Report of NRB

•Dipak Bahadur Bhandari, Financial Institutions and Markets, Ashmita Books Publishers

& Distributors,

•Insurance Act, 1992.

•Insurance Regulation, 1993

•Insurance Board, Nepal. Annual Reports (Various Issues)

•Development of Financial Institutions in Nepal

Overview of Financial Institutions

• Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial transactions.

• a financial institution is an institution that provides financial services for its clients or members. Probably the greatest important financial service provided by financial institutions is acting as financial intermediaries. Categories of financial institutions

• Depository financial institutions

• Investment banks

• Contractual savings institutions

• Finance companies

• Unit trusts

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Nepalese Financial Institutions

• Central Bank (Chapter II in Detail):

• Commercial Banks (Chapter IV in Detail)

• Development Banks : responsible to provide loans for the

development of agriculture and industrial sectors, and also the larger scaledevelopmental lending needed to support agriculture and industrial sector

• Finance Companies : The Act … permits these companies to offer installment

credit for the purchase of vehicles, equipment, or durable household goods, for purchase or construction of residential buildings, for leasing financing, and for operating industrial, commercial or other enterprises.

• Insurance Companies : (Chapter V) All the insurance business in Nepal is

regulated by the Nepal Insurance Board. It invests in National Saving Certificate andGovernment Bonds, fixed deposits, shares and loans to insurance policyholders.

• Money Changers (Foreign Exchange Bureaus): These

exchanges are providing their services to the non- Nepali citizens in particular. At theend of every fiscal year, it is mandatory to submit an annual transaction report to theNRB by all the money-changers.

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Nepalese Financial Institutions• Postal Savings Banks : (PSB) was established in 1975 with a view to

nurture (raise) saving habits of the people residing in villages. In theinitial few years of their establishment, these banks were successful toattract small savers, to some extent. Later on, the PSBs were not able toexpand their service activities and failed to attract the small rural saversat the anticipated level.

• Employees Provident Fund: This is an autonomous body functioningunder the Employees Provident Fund Act, 1962. It mobilizes the savingscollected from employees. Total contributions and earnings under thisscheme are completely tax-free. Upon the completion of the service thecontributors or their nominees get all accumulated principal amounts plusthe interests earned.

• Citizens Investment Trust (Mutual Fund): The Citizens Investment Trust was established under the Citizens Investment Trust Act, 1990. It encourages general public to save some percentage of their income. It collects funds by operating various schemes like Employees Savings and Growth Schemes, Citizen Unit Scheme, Gratuity Fund Scheme and Investor's Account scheme. Trust invests in corporate securities, government bonds, term loans, and borrowings. 9

Economic Functions performed by FIs

1. Funds Transformation: FIs facilitates thetransfer of real economic resources from theSurplus units to deficit units.

2. Income generating productive assets: FIs openfloor to avail portfolio of securities for investmentthrough links between stock exchange and otheragents.

3. Capital formation: FIs encourages investment inhuge infrastructural sectors like: hydro-power,acquisition of plant, equipment through the fundsraised from public. 10

Economic Functions performed by FIs

4. Value of Assets: FIs provide enough scope for thecollection and transfer of funds to industries, with theconfidence of investors, they able to get adequate returnand enhance their assets (Return on assets) according totheir expectations.

5. Import and export Financial Intermediary: FIs playsignificant role as an intermediary of means of paymentthat helps to maintain the creditability of national investors.The facility of LC, IBC, Bank documents availed creditfacility to investors that has high siginificant in economy.

6. Transaction support: The facility of Debit card, Creditcard, ATMs, …. It has significant effect on monetization inthe economy.

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Role of Financial Institutions in the

Financial System as a whole

• FIs helps to accumulate small and scatteredresources which in turn discourages hoarding ofunutilized and unproductive resources.

• Investment is necessary for the economicdevelopment of a nation. FIs provides capitalneeded for the productive activities. Productiveinvestment sectors (like: agriculture, industry,trade, construction) growth has high effect due torational presence and activities of FIs.

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Role of Financial Institutions in the

Financial System as a whole

• FIs helps encouraging savers and eveninvestors. Saving and investment are the primeelements for the economic growth of a nation.

• FIs growth … tends towards employment growthopportunities …themselves and as well ascreating opportunities through the effect ofinvestment.

• …. Motivates technological innovation.

• … Overall economic activities flourish.

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Nepalese Financial System

• Modern financial system of Nepal began in 1937 with the establishment of Nepal Bank Limited as the first commercial bank of the country (was established as semi- private commercial bank under Nepal Bank Act).

• NRB was established in 1956 under NRB Act 1955 as central bank of Nepal another major step in the development of Nepalese financial system.

• NIDC in 1959 under NIDC Act 1959 --- to provide industrial credit to industries and other entrepreneurs.

• Employment Provident Fund in 1962 --- to collect provident fund of government employees.

• Co-operative bank under Co-operative bank act 1964 – to provide agricultural credit to farmers and primary cooperative societies (but could not provide well agricultural credit). As a result, the cooperative bank and the Land Reform Savings Corporation merged with ADB/N (Agricultural Devt. Bank.)

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Nepalese Financial System

• Rastriya Banijya Bank – Second commercial Bank in 1966 underRBB act 1966 (fully government-owned) --- expansion of commercialbanking services throughout the country.

• National Insurance Coorporation in 1967 and Nepal InsuranceCorporation in 1968 – to provide insurance services to Citizens.

• Securities Marketing Center in 1977, Converted to SecuritiesExchange Center in 1984, converted to NEPSE in 1992 --- todevelop capital market in Nepal.

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Types & Growth of Nepalese FIs

Ref: Banking and Financial Statistics No. 60, July 2014.


Types & Growth of Nepalese FIs

The number of commercial bank branches operating in the countryincreased to 1547 in Mid – July 2014 from 1486 in mid July 2013. Amongthe total bank branches, 49.7 percent bank branches are concentrated inthe central region followed by Eastern 18.6, Western 17.1 percent, Mid-Western 8.8 percent and Far Western 5.8 percent respectively

Structure of Nepalese Economy

• The economy remains mainly agrarian as over a third of its GDPoriginates from agriculture.

• The share of agriculture in the GDP has declined over the yearssince 1990.

• The share of industry in the GDP peaked in the mid-1990s, butdeclined thereafter because of the insurgency.

• In fact, the activities in manufacturing, construction and miningdecreased as indicated by their falling shares in the industrial GDPdue to the nationwide insurgency in the country in the post - 1995 todate.

• The rising share of services in the GDP has been at the cost of theother sectors, not because of their improvements.

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Structure of Nepalese Economy

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Nepal in the Global Economy

• Nepal is least developed (among 50 countries) as well as a landlocked(among 40 countries). It is a low income (among 53 countries) country,too.

• Nepal ranks 50th in population size (28 millions in 2006).

• It is 108th in GNI size in 2006 (among 112 economies of the world,inclusive of Macao, Nauru, Taiwan, and Tuvalu, and 110th in GDPsize.

• The country ranks 201st in nominal per capita GNI, and 185th in PPPGNI per capita in 2006.

• Among the 177 countries or economies in the world, the country stoodat 138th in the 2004 human development rank and slid down to the142nd in 2005. It ranked 112th among 117 countries in per capitawealth in 2000.

In brief, Nepal is at the bottom in development.

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The Financial System

Financial system is a mechanism that works for investors and people who want finance.

It is an interaction of various intermediaries, marketinstruments, policy makers, and various regulations to aid theflow of savings from savers to investors and managing theproper functioning of the system.

The financial system is made up of financial institutions that coordinate the actions of savers and borrowers.

Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.

• Additional….. Knowledge …. Remaining Slides…..

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Financial Intermediaries

• Financial intermediaries are financial institutions throughwhich savers can indirectly provide funds to borrowers.

Banking - NRB, Commercial banks, Co-operatives

Non-banking – Insurance Companies,

Developmental – Agricultural Development, Tourism

development, infrastructural development,

Regulatory Institutions - SEBON, NRB, insurance regulatory

and development authority,

Functions of Financial Intermediaries

Risk Sharing

1.Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation).

2.Also lower risk by helping people to diversify portfolios

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Functions of Financial Intermediaries

Adverse Selection

1. Before transaction occurs

2. Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected

Moral Hazard

1. After transaction occurs

2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back

Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits

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Functions of Financial System

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• Attributes of financial assets

• Return or yield

• Total financial compensation received from an investment expressed as a percentage of the amount invested

• Risk

• Probability that actual return on an investment will vary from the expected return



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• Liquidity

• Ability to sell an asset within reasonable time at current market prices and for reasonable transaction costs

• Time-pattern of the cash flows

• When the expected cash flows from a financial asset are to be received by the investor or lender


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The financial system facilitates portfolio restructuringThe combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows

An efficient financial systemEncourages savingsSavings flow to the most efficient usersImplements the monetary policy of governments by influencing interest ratesThe combination of assets and liabilities comprising the desired attributes of return, risk, liquidity and timing of cash flows

Global Financial System

• The global financial system is the worldwide framework of legalagreements, institutions, and both formal and informal economic actorsthat together facilitate international flows of financial capital forpurposes of investment and trade financing.

• The first modern wave of economic globalization began during theperiod of 1870–1914, marked by transportation expansion, recordlevels of migration, enhanced communications, trade expansion, andgrowth in capital transfers

• Late 19th century during the first modern wave of economicglobalization, its evolution is marked by the establishment of centralbanks, multilateral treaties, and intergovernmental organizations

• At the onset (start) of World War I, trade contracted as foreign exchangemarkets became paralyzed by money market illiquidity

• After World War II, improved exchange rate stability, fostering recordgrowth in global finance observed

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Global Financial System

• The world economy became increasingly financiallyintegrated in the 1980s and 1990s due to capital accountliberalization and financial deregulation.

• A series of financial crises in Europe, Asia, and LatinAmerica followed with contagious (infectious) effects due togreater exposure to volatile capital flows.

• The global financial crisis, which originated in the UnitedStates in 2007, quickly propagated (spread) among othernations and is recognized as the catalyst for theworldwide Great Recession.

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Methods of Moving Loanable fund from lender to borrower

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• Direct flow markets

• Users of funds obtain finance directly from savers

• Advantages

– Avoids costs of intermediation

– Increases range of securities and markets

• Disadvantages

– Matching of preferences

– Liquidity and marketability of a security

– Search and transaction costs

– Assessment of risk, especially default risk

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• Direct flow markets

• Users of funds obtain finance directly from savers

• Advantages

– Avoids costs of intermediation

– Increases range of securities and markets

• Disadvantages

– Matching of preferences

– Liquidity and marketability of a security

– Search and transaction costs

– Assessment of risk, especially default risk

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• Intermediated flow markets

• A financing arrangement involving two separate contractual agreements whereby saver provides funds to intermediary, and the intermediary provides funding to the ultimate user of funds

Advantages

• Asset transformation

• Credit risk diversification and transformation

• Liquidity transformation

• Economies of scale

• Sectorial flow of funds

• The flow of funds between business, financial institutions, government and household sectors and the rest of the world

• Influenced by fiscal and monetary policy 36


NRB

• Nepal Rastra Bank (NRB), the Central Bank of Nepal, was established in 1956 under the Nepal Rastra Bank Act, 1955, to discharge the central banking responsibilities including guiding the development of the embryonic domestic financial sector. Since inception, there has been a significant growth in both the number and the activities of the domestic financial institutions.

• To reflect this dynamic environment, the functions and objectives of the Bank have been recast by the new NRB Act of 2002, the preamble of which lays down the primary functions of the Bank as:

• to formulate necessary monetary and FOREIGN EXCHANGE policies to maintain the stability in price and consolidate the balance of payments for sustainable development of the economy of Nepal;

• to develop a secure, healthy and efficient system of payments;

• to make appropriate supervision of the banking and financial system in order to maintain its stability and foster its healthy development; and

• to further enhance the public confidence in Nepal's entire banking and financial system.

• The Bank is eminently aware that, for the achievement of the above objectives in the present dynamic environment, sustained progress and continued reform of the financial sector is of utmost importance. Continuously aware of this great responsibility, NRB is seriously pursuing various policies, strategies and actions, all of which are conveyed in the annual report on monetary policy.

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39

MBA IV Semester


Unit II

Central Bank

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)

Basic Highlight

• Syllabus Briefing

• References

UNIT II: Regulatory body - Central Bank LH 3

• Introduction

• Objectives

• Functions

• History of Central Banking system in Nepal

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Central Bank/ NRB

See: Annual Report of NRB

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NRB• the Central Bank of Nepal, was established in 1956 under the Nepal Rastra Bank

Act, 1955, to discharge the central banking responsibilities including guiding thedevelopment of the embryonic (developing) domestic financial sector. Since inception,there has been a significant growth in both the number and the activities of thedomestic financial institutions.

• To reflect this dynamic environment, the functions and objectives of the Bank havebeen recast by the new NRB Act of 2002, the preamble of which lays down theprimary functions of the Bank as:

1. to formulate necessary monetary and FOREIGN EXCHANGE policies to maintain thestability in price and consolidate the balance of payments for sustainable developmentof the economy of Nepal;

2. to develop a secure, healthy and efficient system of payments;

3. to make appropriate supervision of the banking and financial system in order tomaintain its stability and foster its healthy development; and

4. to further enhance the public confidence in Nepal's entire banking and financialsystem.

5. The Bank is eminently aware that, for the achievement of the above objectives in thepresent dynamic environment, sustained progress and continued reform of thefinancial sector is of utmost importance. Continuously aware of this greatresponsibility, NRB is seriously pursuing various policies, strategies and actions, all ofwhich are conveyed in the annual report on monetary policy.

Ref.: www.nrb.org.np/home42

Central Bank/NRB

• Central is the bank whose essential duty is to maintain stability of the monetary standard.

• A central bank is the lender of the last resort.

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Objectives of NRB

• To achieve price and balance of payments stability, manageliquidity and ensure financial stability, develop a sound paymentssystem and promote financial services.

• To formulate necessary monetary and FOREIGNEXCHANGE policies to maintain the stability in price andconsolidate the balance of payments for sustainabledevelopment of the economy of Nepal

• To develop a secure, healthy and efficient system of payments;

• To make appropriate supervision of the banking and financialsystem in order to maintain its stability and foster its healthydevelopment; and

• To further enhance the public confidence in Nepal's entirebanking and financial system. � To promote entire banking andfinancial system of the kingdom of Nepal system.

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Functions of NRB

1. Bank of Note Issue: The central bank has the sole monopoly of noteissue in almost every country. The currency notes printed and issuedby the central bank become unlimited legal tender throughout thecountry. The main advantages of giving the monopoly right of noteissue to are : (i) Brings uniformity in the monetary system of note issueand note circulation. (ii) Increases public confidence in the monetarysystem. (iii) Enables the central bank to exercise control over thecreation of credit by the commercial banks.

2. Banker, Agent and Adviser to the Government: The central bankfunctions as a banker, agent and financial adviser to the government,a) As banker to government, the central bank maintains the accountsof the central as well as state government, receives deposits from it,makes short-term advances and collects cheques and drafts depositedin the government account. b) As an Agent to the government, thecentral bank collects taxes and raises loans from the public and thusmanages public debt. c) As a financial adviser to the lent, the centralbank gives advise to the government on economic, monetary, financialand fiscal matters. Functions of a central bank 45

Functions of NRB

3. Bankers' Bank: The central bank acts as the bankers' bank in threecapacities: (a) custodian of the cash preserves of the commercialbanks; (b) as the lender of the last resort; and (c) as clearing agent.In this way, the central bank acts as a friend, philosopher and guideto the commercial banks

4. Lender of Last Resort: In case if the commercial banks are not ableto meet their financial requirements from other sources, they can, asa last resort, approach the central bank for financial accommodation.

• It increases the elasticity and liquidity of the whole credit structure of theeconomy.

• It provides financial help to the commercial banks in times of emergency.

• It enables the central bank to exercise its control over banking system ofthe country.

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Functions of NRB

5. Clearing Agent : The function of clearing house in the central bank hasthe following advantages: (i) It economies the use of cash by bankswhile settling their claims and counter-claims. (ii) It reduces thewithdrawals of cash and these enable the commercial banks to createcredit on a large scale. (iii) It keeps the central bank fully informedabout the liquidity position of the commercial banks.

6. Credit control: - The significance of the function has increased somuch that for property understanding. The central bank has acquiredthe rights and powers of controlling the entire banking. Central bankcan adopt various quantitative and qualitative methods for creditcontrol such bank rate, changes in reserve ratio selective controls,moral situation etc.

7. Collection of Data: Central banks collects statistical data regularlyrelating to economic aspects of money, credit, FOREIGN EXCHANGE,banking, economic growth etc.

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History of Central Banking System in Nepal

• In Nepal Rastra Bank that is an autonomous (sovereign) andcorporate body having perpetual succession. NRB actstates that GoN, after consultation with the Governor cangive directions to the bank as may be necessary in thenational interest.

• Central Bank has a pivotal role in the country's economicsystem in which no other organization is likely to substituteit.

• NRB is the highest monetary authority of the country.

• The bank's activities on the whole are directed towards thefinancial and economic growth of the country.

• NRB works in close collaboration with GoN so that themonetary and financial policies formulated by the bank donot contradict with plans and programs of the Govt. 48



• New NRB Act 2002 ….. states to formulate monetary andforeign exchange policies and continued reform in thefinancial sector to reflect the dynamic and vibrant economy.

• NRB started its operations with a total no. of 23 employeesincluding Governor and Chief Accountant havingdepartment like: Bank Office, Account, Currency Issue andResearch.

• With passage of time, various departments and offices atthe central and regional level were set up.

• In the initial year of operation, bank had focused onabolishing dual currency system, regulating the circulation ofNepalese currency throughout the kingdom and maintainingstability of exchange rates of Nepalese currency

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• The bank extended its activities opening number of officesand currency exchange counters in various areas like:Biratnagar, Birgunj, Siddharthnagar, Nepalgunj, Illam,Bhojpur, Dhankuta, Pokhara, Palpa, Baitadi, Doti…

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52

MBA IV Semester


UNIT III

Banking and the Management of Financial

Institutions LH 8

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)


Basic Highlight

UNIT III: Banking and the Management of Financial Institutions

LH 8

• The Bank Balance Sheet.

• Basics of Banking.

• General Principles of Bank Management: Liquidity

Management, Asset Management, Liability Management and

Capital Adequacy Management.

• Off-Balance Sheet Activities: Loan Sales, Generation of Fee

Income, Trading Activities and Risk Management Techniques.

• Measuring Bank’s Performance: Bank’s Income Statement,

Measures of Bank Performance.

• Recent Trends of Bank Performance Measures in Nepal.

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• Reference: Chapter 17 Mishkin Book

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17-55

The Bank Balance Sheet

• The Balance Sheet is a list of a bank’s assets and liabilities

• Total assets = total liabilities + capital

• A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets)

• Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers

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The Bank Balance Sheet: Liabilities (a)

• Checkable Deposits: includes all accounts that allow theowner (depositor) to write checks to third parties; examplesinclude non-interest earning checking accounts (known asDDAs—demand deposit accounts), interest earningnegotiable orders of withdrawal (NOW) accounts, andmoney-market deposit accounts (MMDAs), which typicallypay the most interest among checkable deposit accounts.

• (in Nepal: Practically Current and Saving Account)

• Checkable deposits are a bank’s lowest cost fundsbecause depositors want safety and liquidity and willaccept a lesser interest return from the bank in order toachieve such attributes


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The Bank Balance Sheet: Liabilities (b)

• Nontransaction Deposits: are the overall primarysource of bank liabilities and are accounts fromwhich the depositor cannot write checks;examples time deposits (Fixed Account in Nepal;also known as CDs or certificates of deposit)

• Nontransaction deposits are generally a bank’shighest cost funds because banks want depositswhich are more stable and predictable and will paymore to the depositors (funds suppliers) in order toachieve such attributes.

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The Bank Balance Sheet: Liabilities (c)

• Borrowings: banks obtain funds by borrowing fromthe Federal Reserve System, other banks, andcorporations; these borrowings are called: discountloans/advances (from the Fed), fed funds (from otherbanks), interbank offshore dollar deposits (from otherbanks), repurchase agreements (“repos” from otherbanks and companies), commercial paper and notes(from companies and institutional investors)

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The Bank Balance Sheet: Liabilities (d)

• Bank Capital: is the source of funds supplied bythe bank owners, either directly throughpurchase of ownership shares or indirectlythrough retention of earnings (retained earningsbeing the portion of funds which are earned as profits but

not paid out as ownership dividends)

• Since assets minus liabilities equals capital,capital is seen as protecting the liability suppliersfrom asset devaluations or write-offs (capital isalso called the balance sheet’s “shock absorber,”thus capital levels are important) 17-60

The Bank Balance Sheet


17-61

Basics of Banking

Before we explore the main role of banks—that is, asset transformation—it is helpful to understand some of the simple accounting associated with the process of banking.

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Basics of Banking

• T-account Analysis:

• Deposit of $100 cash into First National Bank

First National BankAssets Liabilities

Vault cash +$100 Checkabledeposits

+$100

17-63


Cash items inprocess ofcollection

+$100 Checkabledeposits

+$100

Basics of Banking

Conclusion: When bank receives deposits, reserves ↑ by equal

amount; when bank loses deposits, reserves ↓ by equal amount


Reserves +$100 Deposits +$100

Second National BankAssets Liabilities

Reserves -$100 Deposits -$100

• Deposit of $100 cheque

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Basics of Banking

This simple analysis gets more complicated when we add bank regulations to the picture. For example, if we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. This changes how the $100 deposit is recorded.


17-65

Basics of Banking



First National Bank Assets Liabilities

Required reserves Excess reserves

+$10 +$90

Checkable deposits

+$100

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Basics of Banking

As we can see, $10 of the deposit must remain with the bank to meeting federal regulations (NRB Regulation). Now, the bank is free to work with the $90 in its asset transformation functions. In this case, the bank loans the $90 to its customers.

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Basics of Banking



First National Bank Assets Liabilities

Required reserves Loans

+$10 +$90

Checkable deposits

+$100

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General Principles of Bank Management

1. Liquidity management

2. Asset management

• Managing credit risk

• Managing interest-rate risk

3. Liability management

4. Managing capital adequacy


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Principles of Bank Management

Liquidity ManagementReserves requirement = 10%, Excess reserves = $10 million

Assets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank Capital $10 million

Securities $10 million

Assume that the bank has ample excess reserves and that all deposits have the same required reserve ratio of 10% (the bank is required to keep 10% of its time and checkable deposits as reserves)

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Principles of Bank Management

• With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Deposit outflow of $10 millionAssets Liabilities




If a deposit outflow of $10 million occurs, the bank’s balance sheet becomes

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Liquidity Management

• With 10% reserve requirement, bank has $9 million reserve shortfall

No excess reservesAssets Liabili ties




Assume that instead of initially holding $10 million in excess reserves, the First National Bank makes additional loans of $10 million, so that it holds no excess reserves. Its initial balance sheet would then be

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• With 10% reserve requirement, bank has $9 million reserve shortfall

Deposit outflow of $10 million Assets Liabilities




When it suffers the $10 million deposit outflow, its balance sheet becomes


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1. Borrow from other banks Assets Liabilities


Loans $90 million Borrowings $9 million

Securities $10 million Bank Capital $10 million

After $10 million has been withdrawn from deposits and hencereserves, the bank has a problem: It has a reserve requirement of 10%of $90 million, or $9 million, but it has no reserves! To eliminate thisshortfall, the bank has four basic options. One is to acquire reserves tomeet a deposit outflow by borrowing them from other banks. If theFirst National Bank acquires the $9 million shortfall in reserves byborrowing it from other banks its balance sheet becomes:

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2. Sell securitiesAssets Liabilities




A second alternative is for the bank to sell some of itssecurities to help cover the deposit outflow. For example, itmight sell $9 million of its securities and deposit the proceedswith the Fed, resulting in the following balance sheet:

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3. Borrow from Fed Assets Liabilities


Loans $90 million Discount Loans $9 million

Securities $10 million Bank Capital $10 million

A third way that the bank can meet a deposit outflow is toacquire reserves by borrowing from the Fed (NRB). In ourexample, the First National Bank could leave its security andloan holdings the same and borrow $9 million in discountloans from the Fed. Its balance sheet would then be

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• Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows

4. Call in or sell off loans Assets Liabilities




Finally, a bank can acquire the $9 million of reserves to meetthe deposit outflow by reducing its loans by this amount anddepositing the $9 million it then receives with the Fed,thereby increasing its reserves by $9 million. Thistransaction changes the balance sheet as follows:

calling in loans—that is, by not renewing some loans when they come due


Asset / Liability Management

77

FI that issues liabilities of one-year maturity to finance the purchase of assets with a two-year maturity.Suppose that the FI’s liability holders, such as depositors, demand cash at the end of year 1 for their financial claims.

Asset / Liability Management

78

17-79

Asset Management

To maximize its profits, a bank mustsimultaneously seek the highest returnspossible on loans and securities, reduce risk,and make adequate provisions for liquidity byholding liquid assets. Banks try toaccomplish these three goals in four basicways.

17-80

Asset Management

• First, banks try to find borrowers who will pay highinterest rates and are unlikely to default on their loans.They seek out loan business by advertising theirborrowing rates and by approaching corporations directlyto solicit (request) loans. It is up to the bank’s loan officer todecide if potential borrowers are good credit risks whowill make interest and principal payments on time (i.e.,engage in screening to reduce the adverse selectionproblem). Typically, banks are conservative in their loanpolicies; the default rate is usually less than 1%. It isimportant, however, that banks not be so conservativethat they miss out on attractive lending opportunities thatearn high interest rates.


17-81

Asset Management

• Second, banks try to purchase securities (i.e. investment insecurities) with high returns and low risk.

• Third, in managing their assets, banks must attempt tolower risk by diversifying. They accomplish this bypurchasing many different types of assets (short- and long-term, Treasury Bills, and municipal bonds) and approvingmany types of loans to a number of customers.

• Finally, the bank must manage the liquidity of its assets sothat it can satisfy its reserve requirements without bearinghuge costs. This means that it will hold liquid securitieseven if they earn a somewhat lower return than otherassets. The bank must decide, for example, how much inexcess reserves must be held to avoid costs from a depositoutflow.

17-82

Asset Management

Summary

• Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk.

1. Get borrowers with low default risk, paying high interest rates

2. Buy securities with high return, low risk

3. Diversify

4. Manage liquidity

17-83

Liability Management

• Liability Management: managing the source of funds, from deposits, to CDs, other debt.

1. No longer primarily depend on deposits

2. When seen loan opportunities, borrow or issue CDs to acquire funds

17-84

Capital Adequacy Management

• Banks have to make decisions about the amount of capital they need to hold for three reasons.

• First, bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business.

• Second, the amount of capital affects returns for the owners (equity holders) of the bank.

• Third, a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities


17-85

How Bank Capital Helps Prevent Bank Failure

• Let’s consider twobanks with identicalbalance sheets,except that the HighCapital Bank has aratio of capital toassets of 10% whilethe Low Capital Bankhas a ratio of 4%.

Suppose that both banks get caught up real estate market,only to find that $5 million of their real estate loans becameworthless later. When these bad loans are written off (valuedat zero), the total value of assets declines by $5 million. As aconsequence, bank capital, which equals total assets minusliabilities, also declines by $5 million

How Bank Capital Helps Prevent Bank Failure

86

17-87


1. Bank capital is a cushion that prevents bank failure

2. Higher is bank capital, lower is return on equity

• ROA = Net Profits/Assets

• ROE = Net Profits/Equity Capital

• EM = Assets/Equity Capital

• ROE = ROA ×××× EM

• Capital ↑↑↑↑, EM ↓↓↓↓, ROE ↓↓↓↓17-88


3. Banks also hold capital to meet capital requirements

4. Strategies for Managing Capital

• Sell or retire stock

• Change dividends to change retained earnings

• Change asset growth


17-89

Off-Balance-Sheet Activities

A loan sale, also called a secondary loanparticipation, involves a contract that sells all orpart of the cash stream from a specific loan andthereby removes the loan from the bank’sbalance sheet. Banks earn profits by sellingloans for an amount slightly greater than theamount of the original loan. Because the highinterest rate on these loans makes themattractive, institutions are willing to buy them,even though the higher price means that theyearn a slightly lower interest rate than the originalinterest rate on the loan. 17-90


Generation of Fee Income: fees that banks receive forproviding specialized services to their customers, such asmaking foreign exchange trades on a customer’s behalf,guaranteeing debt securities such as banker’s acceptances(by which the bank promises to make interest and principalpayments if the party issuing the security cannot), andproviding backup lines of credit. Even though a guaranteedsecurity does not appear on a bank balance sheet, it stillexposes the bank to default risk: If the issuer of thesecurity defaults, the bank is left holding the bag and mustpay off the security’s owner. Backup credit lines alsoexpose the bank to risk because the bank may be forced toprovide loans when it does not have sufficient liquidity orwhen the borrower is a very poor credit risk.

17-91


1. Fee income from• Foreign exchange trades for customers

• Guarantees of debt

• Backup lines of credit

2. Financial options

3. Foreign exchange trading

4. Interest rate swaps

5. Loan sales

• All these activities involve risk

17-92

Measuring Bank Performance

• To understand how well a bank is doing, we need tostart by looking at a bank’s income statement, thedescription of the sources of income and expensesthat affect the bank’s profitability.

• Much like any business, measuring bankperformance requires a look at the incomestatement. For banks, this is separated intothree parts:

• Operating Income

• Operating Expenses

• Net Operating Income


Banks' Income Statement

17-94

Recent Trends in Bank Performance Measures in Nepal

• FIs are closely watched by their customers, regulators and by the money and capital markets.

• The performance of a bank is evaluated not only relative to the institutions' own goals but also relative to the performance of the bank's competitors.

• Mainly four dimensions of bank performance tend to be the most closely followed in Nepal:

a. The market value or stock price of a banking institution

b. The rate of return or profitability ratios of a bank.

c. The bank's risk exposure

d. The operating efficiency of the institution

17-95


a. Bank's stock price is usually the single bestindicator of how well the bank is performingbecause its shareholders must be satisfiedthey are earning a competitive return on theircapital. However banks around the worldeither do not have stockholders or have stockthat is so infrequently trade that a realisticvalue cannot be determined. This is whymany banks pay close attention to measuresvarious ratios ……

17-96


b. Profitability Ratios or Rate of Return

Profit Margin = Net Income/ Operating Income

1. Net Interest Margin (NIM) =

Net Interest Income/ Interest earning assets (or TA)

Where, Net Interest Income = Total income from interest bearing assets – Total interest cost on borrowed funds

2. Net Operating Margin =

(interest income/ earning assets)- (int. exp / Interest paying Liabilities)

3. Earning Base = (Total assets- Non earning assets)/ Total Assets

If the earnings base ratio is more then the bank will earn more profits and viceversa.


Question on GAP,NIM

Q.No. 1. Given the following information First National Bank ($ Millions)

Assets Liabilities and Equity

Rate Sensitive $200 (12%) Rate Sensitive $300 (6%)

NonRate Sensitive 400 (11%) NonRate Sensitive 300 (5%)

Non Earning 100 Equity 100

Total Assets $700 Total Liabilities and Equity $700

a. What is the GAP? Net Interest Income? Net Interest Margin? How much will net interest income change if interest rates fall by 200 basis points? Earning Base ratio ?

• The gap is $-100 ($200 - $300).

• The net interest income is ($200) (12%) + ($400) (11%) – ($300) (6%) – ($300) (5%) = $24 + $44 – $18 – $15 = $35.

• The net interest margin is $35/$600 = 5.8%.

• If interest rates change (fall) by $200 basis points, the net interest income would be ($200) (10%) + ($400) (11%) – ($300) (4%)( – ($300) (5%) = $20 + $44 - $12 – $15 = $37.

• Earning Base ratio = (700-100)/700 = 85.7%

97

C. The bank's risk exposure

Solvency (Default) Risk: Solvency ratio measure the howmuch long-term capital the owners have placed in theinstitution relative to its risk exposed assets. If aninstitution's risk assets decline in value by more than thevolume of its owner's capital (net worth), it will becomeinsolvent. Risky assets are earnings assets either subjectto credit risk or interest rate risk.

Ratio of equity capital to risk assets

= Total equity capital/total risky assets

Credit Risk: Ratio of nonperforming assets to total loans

= Nonperforming assets / Total loans

98

D. Operating Efficiency

Management response to improve efficiency

• Installing new labor saving machinery like computers,automated tellers to increase the productivity of employeesin processing transactions.

• Status of productive employees in terms of revenuegeneration, assets management and accounts handling.

Income Productivity Ratio = Net Income/ No. of Employees

Operating expense ratio = Total operating exp. / Total assets

99

[email protected]

100


101

MBA IV Semester


Unit IV

Commercial Banking Industry and Other

Depository Institutions

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)

UNIT IV: Commercial Banking Industry

and Other Depository Institutions LH 8

• Definition of a Commercial Bank.

• Size, Structure and Composition of the Commercial Banking Industry.

• Technology in Commercial Banking.

• Financial Statements of Commercial Banks and Their Analyses.

• Regulation of Depository Institutions in Nepal: Balance

Sheet and Off-Balance Sheet Regulations.

• Development Banks, Finance Companies and Finance Cooperatives in Nepal: Their Roles, Size, Structure and Compositions.

102

Commercial Bank• As the name itself signifies, are designed to accept deposit

and advance credit to commercial sector.

• These institutions are run to make a profit.

• Commercial banks are categorized under A class banks inNepal

• Commercial Banks accepts deposits from different people andorganizations. Banks allows for opening three types ofaccounts to accept deposit from customer i.e. current, savingand fixed deposit account.

• Commercial Banks provides different types of loans to peoples, organizations, business houses etc. the amount of loan given to these peoples, organizations, business houses depends upon the collateral provided.

• Commercial Banks provide letter of credit and guarantee facilities, which boost up international trade. 103

Commercial Bank

• Commercial Banks provide locker facilities to customersfor safekeeping of valuable documents and preciousarticles.

• Commercial Banks provide various card services likedebit cards, credit cards, ATM card that avoids risk incarrying money.

• Commercial Banks provide services like clearing ofcheques and performs various agencies functions liketransfer fund, pay house rent, telephone bills etc.

• Commercial banks provide easy payment and withdrawalfacility to its customers in the form of cheques and drafts.It also brings bank money in circulation. This money is inthe form of cheques, drafts, etc.

104


Size, Structure and Composition of

the Commercial Banking Industry.

105

By the end of mid – July 2014, altogether 204 banks and non- bankfinancial institutions licensed by NRB are in operation. Out of them,30 are “A” class commercial banks,

The number of commercial bank branches operating in the countryincreased to 1547 in Mid – July 2014.

The total assets of commercial banking sector reached to Rs.1477845.65 million

As of Mid – July 2014, Commercial Bank group occupied 77.9 percent of total assets/liabilities followed by Development Banks 13.6 percent, Finance Companies 5.8 percent and Micro-finance Development Bank 2.6 percent

Size, Structure and Composition of

the Commercial Banking Industry.• The composition of liabilities of commercial banks shows that,

the deposit has occupied the dominant share of 81.5 percentfollowed by others 10.1 percent, capital fund 7.3 percent andBorrowings 1.0 percent in Mid - July 2014

• The share of loans and advances to total assets remained at 60.3percent in Mid - July 2014. Similarly, share of liquid funds andinvestment to total assets registered 15.3 percent

• Commercial Banks held dominant share on the major balancesheet components of financial system. Of the total deposits Rs.1,488,834 million in Mid-July 2014, the commercial banksoccupied 81.0 percent. Similarly, development banks held 13.4percent, finance companies 4.9 percent and micro financedevelopment banks 0.7 percent.

• on the loans and advances the share of commercial banks stoodat 77.2 percent, development banks 14.0 percent, financecompanies 5.7 percent and micro finance development banks 3.1percent in Mid – July 2014. 106

Reference: Banking and Financial Statistics, Page 4 Mid-July, 2014

Technology in Commercial Banking

• Use of Software….

• Clearing House

• Central Depository System

• Use of sophisticated computers, system procedures, ERP

• ATM, Visa Card, Credit Card, Debit Card

• Mobile, E-mail, Online Payment, Online Payment Transfer

107

Financial Statements of Commercial

Banks and Their Analyses.

• Ref. Banking and Financial Statistics Mid-July, 2014, Page 21 to …….

108


Regulation of Depository Institutions in Nepal:

Balance Sheet and Off-Balance Sheet Regulations.

• Regulation is essential to safeguard the people deposit made in the commercial banks

• Regulations also prevent the commercial banks from performing undesired activities in view of the national economy.

• It also helps to prevent the bank from being suffered by the several economic problems.

• Promote efficiency of commercial bank to operate in profit.

• Ensure adequate fund to meet all cash demands

• Maintain clear and fraud free financial transactions

• Record all financial transactions as per the banking rules

Regulations under following headings:

109

a. Credit controlb. Foreign exchangec. Liquidityd. Interest rate

e. Priority sectorf. Capital adequacyg. Assets quality

Development Banks, Finance Companies and Finance Cooperatives in Nepal: Their Roles, Size, Structure and

Compositions.

110

Development Banks:

The total number of development banks decreased to 84 in Mid - July 2014Among the component of liabilities, deposit constituted 77.2 percent followed by capital fund 10.7 percent borrowing by 0.9 percent and others by 11.2 percentOn the assets side, loans and advances constituted 62.5 percent, liquid funds 26.6 percent and investment 1.9 percent

Role of Development Banks in Nepal

Industrial development bank:- The bank which is established for thedevelopment of industrial sector by providing financial, technical andadministrative and other necessary assistance is known asdevelopment bank.

· NIDC provides medium term and long term loan to the industries, against securities for the development of bank.

· It helps industrial enterprises in collecting capital by selling their shares and debenture to different persons and organization in capital market.

· It also performs general banking transaction with other national and foreign banks, specially for the benefit of the industrial undertaking.

· It organizes industrial seminar, workshop, training etc. and assist the industrial also and govt. by providing necessary suggestion and advice for the betterment of industrial sector.

111

Role of Development Banks in Nepal

Agriculture development bank (ADB)

The bank which is established for the development of agricultural The bank which is established for the development of agricultural sectors by imitating the modern system and methodology through sectors by imitating the modern system and methodology through financial, technical and administrative assistance is known as financial, technical and administrative assistance is known as ADBADB..

· Providing agricultural products.· Providing agricultural products.

· Providing loan for farm development.· Providing loan for farm development.

· Providing loan for selling agricultural products.· Providing loan for selling agricultural products.

· Providing loan to the tenants.· Providing loan to the tenants.

· Commercial function.· Commercial function.

112


Finance Companies: The history of the finance companies began withthe establishment of the Nepal Housing Development FinanceCompany Limited in 1992. In addition to the private banks, there arenumerous finance companies operating in Nepal. These institutionshave all commenced operations over the past six years since theFinance Company Act was promulgated. The Act permits thesecompanies to offer installment credit for the purchase of vehicles,equipment, or durable household goods, for purchase or constructionof residential buildings, for leasing financing, and for operatingindustrial, commercial or other enterprises

• The total number of finance companies decreased to 53 in Mid - July 2014

• The decrement in number of Finance Companies resulted the total assets/liabilities of the finance companies to shrink by 3.91 percent

• Among the total liabilities, deposits held the largest share of 66.6 percent followed by others 23.9 percent, capital fund 9.0 percent, and borrowings 0.51 percent. 113

• Micro Finance: There is abundance of organizations involved inmicrofinance in Nepal -formal and informal mainly cooperatives andNGOs. Credit cooperatives first emerged in 1956 and were registeredunder the Cooperative Act in 1959. With a view to limiting politicalintervention and to institutionalizing cooperatives, a new CooperativeAct was enacted in 1992. This Act specified that a minimum of 25persons were required to form a primary cooperative. Although around5,000 credit and multipurpose cooperatives have been registeredunder the new Act, only 35 have obtained permission from the NepalRastra Bank to undertake limited banking functions. Thenongovernmental organizations are also permitted to provide limitedbanking services in Nepal. To date, thirty NGOs have been licensed toconduct a limited banking business, of which two -Nirdhan and CSD -are Grameen replicator banks

• The total number of 'D' class rural & micro finance development banksincreased to 37 in Mid July 2014

• In Mid - July 2014, the total assets/liabilities of these banks reached toRs. 50,189 million 114

115

MBA IV Semester


Unit V

Management of Insurance Companies

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)

UNIT V: Management of Insurance

Companies LH 6

• Overview of Insurance Companies

• Fundamentals of Insurance

• Types of Insurance

• Life Insurance Companies: Meaning and Their Functions

• Types of Life Insurance Policies and Their Determination.

• Property and Liability Insurance Companies: Meaning and Their Functions

• Determining the Profitability to Property and Liability

Insurance Companies.

• Regulation of Insurance Companies in Nepal.

• Existing Scenario of Insurance Industries in Nepal.116


Overview of Insurance Companies

• Insurance companies are in the business of assuming riskon behalf of their customers in exchange for a fee, called apremium.

• Insurance companies make a profit by charging premiumsthat are sufficient to pay the expected claims to thecompany plus a profit. Why do people pay for insurancewhen they know that over the lifetime of their policy, theywill probably pay more in premiums than the expectedamount of any loss they will suffer? Because most peopleare risk-averse: They would rather pay a certaintyequivalent (the insurance premium) than accept the gamblethat they will lose their house or their car. Thus, it isbecause people are risk-averse that they prefer to buyinsurance

117

Overview of Insurance Companies

Consider how people’s lives would change if insurancewere not available. Instead of knowing that theinsurance company would help if an emergencyoccurred, everyone would have to set aside reserves.These reserves could not be invested long-term butwould have to be kept in an extremely liquid form.Furthermore, people would be constantly worried thattheir reserves would be inadequate to pay forcatastrophic events such as the loss of their house tofire, the theft of their car, or the death of the familybreadwinner. Insurance allows us the peace of mindthat a single event can have only a limited financialimpact on our lives.

118

Fundamentals of Insurance

Although there are many types of insurance and insurancecompanies, all insurance is subject to several basicprinciples.

1. There must be a relationship between the insured (theparty covered by insurance) and the beneficiary (theparty who receives the payment should a loss occur). Inaddition, the beneficiary must be someone who maysuffer potential harm. For example, you could not takeout a policy on your neighbor’s teenage driver becauseyou are unlikely to suffer harm if the teenager gets into anaccident. The reason for this rule is that insurancecompanies do not want people to buy policies as a wayof gambling.

119

Fundamentals of Insurance

2. The insured must provide full and accurate information to the insurance

company.

3. The insured is not to profit as a result of insurance coverage.

4. If a third party compensates the insured for the loss, the insurancecompany’s obligation is reduced by the amount of the compensation.

5. The loss must be quantifiable. For example, an oil company could notbuy a policy on an unexplored oil field.

6. The insurance company must be able to compute the probability of the

loss occurring.

The purpose of these principles is to maintain theintegrity of the insurance process. Without them,people may be tempted to use insurance companiesto gamble or speculate on future events.

120


Benefits of Insurance to Society

• Indemnification of loss

• Reduction of worry and fear

• Source of investment fund

• Loss prevention

• Enhancement of Credit

121

3. Categories of Insurance Business :

(1) Subject to the provisions made in the Insurance Act and Regulation, the Insurance Business to be operated by an Insurer shall be divided into the following categories :

(a) Life Insurance Business,

(b) Non-Life Insurance Business,

(c) Re-Insurance Business.

122

• Life Insurance Business :

(1) The Insurer may operate the following Insurance Business under the Life Insurance

Business:-

(a) Whole Life Insurance,

(b) Endowment Life Insurance,

(c) Term Life Insurance.

123

• Non-Life Insurance :

(1) The Insurer may operate the following Insurance Business under the Non-Life Insurance

Business :

(a) Fire Insurance,

(b) Motor Insurance,

(c) Marine Insurance,

(d) Engineering and Contractor's Risk Insurance,

(e) Aviation Insurance,

(f) Miscellaneous Insurance.124


Types of Insurance

The most common types are

• life insurance and

• property and casualty insurance.

In its simplest form, life insurance providesincome for the heirs of the deceased. Manyinsurance companies offer policies that provideretirement benefits as well as life insurance.

125

Life Insurance

• Term Life: The simplest form of life insurance is theterm insurance policy, which pays out if the insured dieswhile the policy is in force. This policy is issued for ashort period such as from 3 months to 7 years. Once thepolicy period expires, there are no residual benefits. Inaddition, the policyholder cannot borrow against thepolicy. As the insured ages, the probability of deathincreases, so the cost of the policy rises.

• Assuming that benefits are paid at the end of the year,and that the probability of dying next year for anindividual of age is pa, then the fair premium, R, paid atthe beginning of the year is:

• Fair Premium (R) = (L* Pa )/ (1+r)

126

Life Insurance

• The insurance company has a cost of moneyof 10%, the fair premium on a one year Rs.1,00,000 term life insurance policy for a 30-year old individual, whose probability ofdying over the next year is 0.133%. Calculatethe fair premimum.

Here, Cost of money (r) = 10%, Policy Amount (L) = Rs. 100,000

Probability of dying over the next year (Pa) = 0.133%

Now, Fair premium (R)= (100000*.00133)/(1+0.10) = Rs. 120.91

127

Life Insurance

• Suppose that the management of a life insurance company wants toset a competitive premium for a group of 10,000 potentialpolicyholders, each 50 years of age and each requesting a Rs.100,000 life insurance policy. Mortality tables indicate that theproportion of 50-year-old individuals expected to die in their 50th year isseven of 1000 policyholders. If this death-rate estimate is accurate forthis group of 10,000 policyholders of the company. The insurancecompany will invest any incoming premium payments by thepolicyholders at the prevailing market interest rate of 8.5%.

• Required:

• The number of deaths expected = 10,000*7/1000 = 70 deaths

• Volume of expected death benefit claims = 70 * Rs. 100,000 = Rs. 70,00,000

• Present value of expected death benefit income = Rs 70,00,000/(1+.085) = Rs. 6451612

• Estimated net premium to charge each policyholder = 6451612/10000= Rs. 645.16

128


Life Insurance

Whole Life: This policy is called cash-value or permanent orordinary or investment life insurance. Here, purchaser pays fixedannual premiums, which entitle the policyholder's beneficiariesto the value of the policy in case of death.

Endowment (gift) cum Whole Life : This plan is a combination ofEndowment Assurance and While Life Plans. It providesfinancial protection against death throughout the lifetime of thelife assured with the provision of payment of a lump sum at thematurity of the policy to the assured in case of his survival.

• Universal Life: have two parts, one for the term life insuranceand one for savings. It is a very flexible policy that allows theinsured to pay in excess of the pure premium each year. Theexcess funds can then be invested in money market instrumentsor other investments that the policyholder chooses.

129

Life Insurance

• Annuity: A life annuity is a financial contract in the form ofan insurance product according to which a seller (issuer)—a life insurance company — makes a series of futurepayments to a buyer (annuitant) in exchange for theimmediate payment of a lump sum (single-paymentannuity) or a series of regular payments (regular-payment annuity), prior to the onset of the annuity.

• The payment stream from the issuer to the annuitant hasan unknown duration based principally upon the date ofdeath of the annuitant. At this point the contract willterminate and the remainder of the fund accumulated isforfeited unless there are other annuitants or beneficiariesin the contract.

130

Life Insurance

• Health Insurance: Individual health insurance coverage isvery vulnerable to adverse selection problems. People whoknow that they are likely to become ill are the most likely toseek health insurance coverage. This causes individualhealth insurance to be very expensive. Most policies areoffered through company-sponsored programs in which thecompany pays all or part of the employee’s policypremium.

131

Property and Casualty Insurance

Property and casualty insurance protects property (houses, cars,boats, and so on) against losses due to accidents, fire, disasters,and other calamities. Marine insurance, for example, which insuresagainst the loss of a ship and its cargo, is the oldest form ofinsurance, predating even life insurance. Property and casualtypolicies tend to be short-term contracts subject to frequent renewal.

Property and casualty insurance was the earliest form of insurance.It began in the Middle Ages when merchants sent ships off toforeign ports to trade. A merchant, though willing to accept the riskthat the trading might not turn a profit, was often unwilling to acceptthe risk that the ship might sink or be captured by pirates. Toreduce such risks, merchants began to band together and insureeach other’s ships against loss. The process became moresophisticated as time went on, and insurance policies were writtenthat were then traded in the major commercial centers of the time.

132


Property and Casualty Insurance

• Property insurance can be provided in either named-perilpolicies or open-peril policies. Named-peril policies insureagainst loss only from perils that are specifically named inthe policy, whereas open-peril policies insure against allperils except those specifically excluded by the policy. Forexample, many homeowners in low-lying areas arerequired to buy flood insurance. This insurance covers onlylosses due to flooding, so it is a named-peril policy. Ahomeowner’s insurance policy, which protects the housefrom fire, hurricane, and other damage, is an example ofan open-peril policy.

133

• Reinsurance is an arrangement by which the primaryinsurere that initially writes the insurance transfers toanother insurer (called the reinsurer) part or all of thepotential losses associated with such insurance. Theprimary insurer that initially writes the business is calledceding company. The insurer that accepts part or all of theinsurance from the ceding company is called the reinsurer.

• The amount of insurance retained by the ceding companyfor its own account is called the retention limit or netretention.

• The amount of the insurance ceded to the reinsurer in turnmay reinsure part or all of the risk with another insurer.This is known as retrocession. In this case, the secondreinsurer is called a retrocessionaire.

134

Regulation of Insurance Companies in Nepal

Principles areas for regulations:

• Formation and licensing of insurers: After beingformed, insurers must be licensed to do business andalso meet requirements as per the regulation.

• Solvency Regulation: Minimum capital and surplusrequirements. An insurer must have sufficient assets tooffset its liabilities.

• Rate regulation: rate must be adequate, not excessive,and not unfairly discriminatory.

• Policy forms: is to protect public from misleading andunfair provisions.

• Consumer Protection

135

Existing Scenario of Insurance

Industries in Nepal• Rastriya Beema Sansthan (RBS) in 1968 under Company Act, 2024

and was converted into Corporation in the following year underRastriya Beema Sansthan Act, 1969

• Insurance Act, 1968 made a provision of Beema Samiti (InsuranceBoard), as a sole authority to regulate the insurance activitieswithin Nepal (as the insurance supervisory Authority)

• In 1986, a new experiment was done in Nepalese insurancescenario by licensing a joint venture insurance company to operateboth life and non life business

• In 1986, National Life and General Insurance Company Limited(Now operating life and non life business separately) was licensed as the first insurance company in the private sector with minority interest of foreign equity

• Three life insurance companies were licensed in 2001 and four in 2008

136


141

MBA IV Semester


UNIT VI

Credit Risk Management in Financial

Institutions LH 7

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)

UNIT VI: Credit Risk Management in

Financial Institutions LH 7

• Need to Manage Risk by Financial Institutions.

• Types of Risks Incurred by Financial Institutions.

• Overview of Credit Risk Management.

• Credit Risk Analysis: Cash Flow Analysis, Ratio Analysis, Common Size Analysis

• Credit Scoring Models

• Calculating Return on a Loan

142

Source: Financial Institutions and Management: A Risk Management Approach, Saunder and Cornett, Page 322,

19-144

Risks at Financial Institutions

• One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’sreturns for its owners

• Increased returns often come at the cost of increased risk, which comes in many forms:• credit risk – foreign exchange risk

• liquidity risk – country or sovereign risk

• interest rate risk – technology risk

• market risk – operational risk

• off-balance-sheet risk – insolvency risk

• One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’sreturns for its owners

• Increased returns often come at the cost of increased risk, which comes in many forms:• credit risk – foreign exchange risk

• liquidity risk – country or sovereign risk

• interest rate risk – technology risk

• market risk – operational risk

• off-balance-sheet risk – insolvency risk


19-145


• Credit risk is the risk that the promised cash flows from loans and securities held by FIsmay not be paid in full• FIs that make loans or buy bonds with long

maturities are relatively more exposed to credit risk

• a key role of FIs involves screening and monitoring loan applicants to ensure only the creditworthy receive loans

• FIs also charge interest rates commensurate with the riskiness of the borrower

19-146


• Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices• day-to-day withdrawals by liability holders are

generally predictable

• unusually large withdrawals by liability holders can create liquidity problems

• the cost of purchased and/or borrowed funds rises for FIs

• the supply of purchased or borrowed funds declines

• FIs may be forced to sell less liquid assets at “fire-sale” prices

19-147


• Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile• asset transformation involves an FI issuing secondary

securities or liabilities to fund the purchase of primary securities or assets

• if an FI’s assets are longer-term than its liabilities, it faces refinancing risk

• the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments

• if an FI’s assets are shorter-term than its liabilities, it faces reinvestment risk

• the risk that the returns on funds to be reinvested will fall below the cost of funds

19-148


• Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices• closely related to interest rate and foreign exchange risk

adds trading activity—i.e., market risk is the incremental risk incurred by an FI (in addition to interest rate or foreign exchange risk) caused by an active trading strategy

• FIs’ trading portfolios are differentiated from their investment portfolios on the basis of time horizon and liquidity

• trading assets, liabilities, and derivatives are highly liquid• investment portfolios are relatively illiquid and are usually held for longer

periods of time

• declines in traditional banking activity and income at large commercial banks have been offset by increases in trading activities and income


19-149


• Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to contingent assets and liabilities• OBS activity can increase FIs’ interest rate risk, credit risk,

and foreign exchange risk• OBS activity can also be used to hedge (i.e., reduce) FIs’

interest rate risk, credit risk, and foreign exchange risk• large commercial banks (CBs) in particular engage in OBS

activity OBS activities can affect the future shape of FIs’ balance sheets

• OBS items become on-balance-sheet items only if some future event occurs• a letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which

payment is contingent on some future event occurring, most notably default of the agent that purchases the LOC

• other examples include:– loan commitments by banks– mortgage servicing contracts by savings institutions– positions in forwards, futures, swaps, and other derivatives held by

almost all large FIs19-150


• Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies• FIs can reduce risk through domestic-foreign

activity/investment diversification

• FIs expand globally through• acquiring foreign firms or opening new branches in foreign

countries

• investing in foreign financial assets

19-151


• Country or sovereign risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments• measuring sovereign risk includes analyzing:

• the trade policy of the foreign government• the fiscal stance of the foreign government• potential government intervention in the economy• the foreign government’s monetary policy• capital flows and foreign investment• the foreign country’s current and expected inflation rates• the structure of the foreign country’s financial system

• foreign corporations may be unable to pay principal and interest even if they would desire to do so

• foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events

19-152


• Technology risk and operational risk are closely related• technology risk is the risk incurred by an FI when its

technological investments do not produce anticipated cost savings

• the major objectives of technological expansion are to allow the FI to exploit potential economies of scale and scope by:

– lowering operating costs– increasing profits– capturing new markets

• operational risk is the risk that existing technology or support systems may malfunction or break down

• the BIS defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events”


19-153


• Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities• insolvency risk is a consequence or an outcome of one

or more of the risks previously described:• interest rate, market, credit, OBS, technological, foreign exchange,

sovereign, and/or liquidity risk

• generally, the more equity capital to borrowed funds an FI has the less insolvency risk it is exposed to

• both regulators and managers focus on capital adequacy as a measure of a FI’s ability to remain solvent

Credit Risk Management

• Credit risk : is the major risk that banks are exposed toduring the normal course of lending and creditunderwriting.

• Within Basel II, there are two approaches for credit riskmeasurement: the standardized approach and the internalratings based (IRB) approach

• Due to various inherent constraints of the Nepalesebanking system, the standardized approach in its simplifiedform, Simplified Standardized Approach (SSA), has beenprescribed in the initial phase.

• (SSA): Under this approach commercial banks arerequired to assign a risk weight to their balance sheet andoff-balance sheet exposures.

154


• To earn high profits, FIs must make successful loans that are paid back in full (and so have low credit risk).

• The concepts of adverse selection and moral hazard provide aframework for understanding the principles that financialinstitution managers must follow to minimize credit risk and makesuccessful loans.

• Adverse selection in loan markets occurs because bad credit

risks (those most likely to default on their loans) are the ones whousually line up for loans; in other words, those who are mostlikely to produce an adverse outcome are the most likely to beselected. Borrowers with very risky investment projects havemuch to gain if their projects are successful, so they are the mosteager to obtain loans. Clearly, however, they are the leastdesirable borrowers because of the greater possibility that theywill be unable to pay back their loans.

155


• Moral hazard exists in loan markets becauseborrowers may have incentives to engage in activitiesthat are undesirable from the lender’s point of view. Insuch situations, it is more likely that the lender will besubjected to the hazard of default. Once borrowershave obtained a loan, they are more likely to invest inhigh-risk investment projects—projects that pay highreturns to the borrowers if successful. The high risk,however, makes it less likely that they will be able topay the loan back.

156


Credit Risk Analysis: Cash Flow Analysis,

Ratio Analysis, Common Size Analysis

• Cash Flow Analysis: Source of Fund/ Use of funds, Increase in CA, increase in CL, Purchase of Assets, Raise of Funds through equity

• Ratio Analysis: Profitability Analysis, WC Ratios, DuPoint Analysis

• Common Size Analysis

157

Credit Scoring Models

• Credit scoring models are used to calculate theprobability of default or to sort borrowers intodifferent default risk classes. The models usedata on observed economic and financial borrowercharacteristics to assist an FI manager in

(a) identifying factors of importance in explaining default risk,

(b) evaluating the relative degree of importance of thesefactors,

(c) improving the pricing of default risk,

(d) screening bad loan applicants, and

(e) more efficiently calculating the necessary reserves toprotect against future loan losses.

158


Probability Model:

Suppose the estimated linear probability model is

Z = 1.1X1 + .6X2 + .5X3 + error,

where X1 = 0.75 is the borrower's debt/equity ratio;

X2 = 0.25 is the volatility of borrower earnings; and

X3 = 0.15 is the borrower’s profit ratio.

a. What is the projected probability of repayment for the borrower?

Z = 1.1(.75) + .6(.25) + .5(.15) = 1.05%.

The expected probability of repayment is 1 - 0.0105 = 98.95%.

159


b. What is the projected probability of repayment if the debt/equity ratio is 3.5?

Z = 1.1(3.5) + .6(.25) + .5(.15) = 4.075%.

The expected probability of repayment is 1 - 0.04075 = 95.925%.

c. What is a major weakness of the linear probability model?

A major weakness of this model is that the estimated probabilities can be below 0 or above 1.0, an occurrence that does not make economic or statistical sense.

160



Linear Discriminant Models:


Cash $ 20 Accounts Payable $ 30

Accounts Receivables $ 90 Notes Payable $ 90

Inventory $ 90 Accruals $ 30

Long Term Debt $150

Plant and equipment $500 Equity $400

Total Assets $700 Total Liabilities & Equity $700

Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest payments = $40, net income = $44, the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value.

161

Credit Scoring ModelsLinear Discriminant Models:

a. What is the Altman discriminant function value for MNO, Inc.? Recall that:

Net working capital = current assets minus current liabilities.

Current assets = Cash + accounts receivable + inventories.

Current liabilities = Accounts payable + accruals + notes payable.

EBIT = Revenues - Cost of goods sold - depreciation.

Taxes = (EBIT - Interest)(tax rate).

Net income = EBIT - Interest - Taxes.

Retained earnings = Net income (1 - dividend payout ratio)

Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Assume prior retained earnings are zero.

X1 = (200 -30 -30 -90)/ 700 = .0714 X1 = Working capital/total assets (TA)

X2 = 22 / 700 = .0314 X2 = Retained earnings/TA

X3 = 140 / 700 = .20 X3 = EBIT/TA

X4 = 400 / 150 = 2.67 X4 = Market value of equity/long term debt

X5 = 500 / 700 = .7143 X5 = Sales/TA

Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104

= .0857 + .044 + .66 + 1.6 + .7143 = 3.104

162


Linear Discriminant Models:

b. Should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan?

Since the Z-score of 3.104 is greater than 1.81, ABC Inc.’s application for a capital expansion loan should be approved.

163

Calculating Return on a Loan

164

•The interest rate on the loan.•Any fees relating to the loan.•The credit risk premium on the loan

gross return on the loan k, b (compensating balances), direct fees ( of ),

loan interest rate ( BR + m ),


165

1. Calculate the promised return ( k ) on a loan if the base

rate is 13 percent, the risk premium is 2 percent, thecompensating balance requirement is 5 percent, fees are ½percent, and reserve requirements are 10 percent. (16.23%)= (0.5+13+2)/(1-0.05*(1-0.1))2. What is the expected return on this loan if the probability of default is 5 percent? (10.42%)

E(r) = p(1+ k) -1 = 0.95*(1+0.1623)-1

Where, p = probability of repayment ( p ) = 1-.05 = .95

Calculating Return on a Loan

166

167

MBA IV Semester


UNIT VII

Liquidity Management in Financial

Institutions LH 6

POST RAJ POKHAREL

M.Phil. (TU) 01/2010)

UNIT VII: Liquidity Risk Management in

Financial Institutions LH 6

• Overview of Liquidity Risk Management.

• Causes of Liquidity Risk.

• Liquidity Risk and Depository Institutions: Asset Side Liquidity Risk, Liability side Liquidity Risk and Measuring bank’s Liquidity Exposure

• Liquidity Risk and Insurance Companies.

• Liquidity Risk and Mutual Funds.

168


Overview of Liquidity Risk

Management

• Unlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs)

• At the extreme, liquidity risk can lead to insolvency

• Some FIs are more exposed to liquidity risk than others

• depository institutions (DIs) are highly exposed

• mutual funds, pension funds, and property-casualty insurers have relatively low liquidity risk

169

Overview of Liquidity Risk

Management• One type of liquidity risk arises when an FI’s liability

holders seek to withdraw their financial claims• FIs must meet the withdrawals with stored or borrowed funds

• alternately, FIs may have to sell assets to generate cash, which canbe costly if assets can only be sold at fire-sale prices

• A second type of liquidity risk arises when commitmentsmade by the FI and recorded off-the-balance-sheet areexercised by the commitment holder• unexpected loan demand can occur when off-balance-sheet loan

commitments are drawn down suddenly and in large volumes

• FIs are contractually obliged to supply funds through loancommitments immediately should they be drawn down

170

Liquidity Risk and Depository Institutions

• DIs’ balance sheets typically have• large amounts of short-term liabilities such as deposits

and other transaction accounts that must be paid out immediately if demanded by depositors

• large amounts of relatively illiquid long-term assets such as commercial loans and mortgages

• DIs know that normally only a small portion of demand deposits will be withdrawn on any given day• most demand deposits act as core deposits—i.e., they

are a stable and long-term funding source

• Deposit withdrawals are normally offset by the inflow of new deposits

171


• DI managers monitor net deposit drains—i.e., the amount by which cash withdrawals exceed additions; a net cash outflow

• DIs manage deposit drains with:

• stored liquidity

• relied on most heavily by community banks

• purchased liquidity

• relied on most heavily by the largest banks with access to the money market and other nondeposit sources of funds

172



• Purchased liquidity• allows FIs to maintain the overall size of their

balance when faced with liquidity demands

• purchased liquidity is expensive relative to stored liquidity

• purchased liquidity includes:• interbank markets for short-term loans

– fed funds

– repurchase agreements

• fixed-maturity certificates of deposits

• notes and bonds

173


• Stored liquidity• may involve the use of existing cash stores or the

sale of existing assets

• banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements

• when managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes

• Most DIs utilize a combination of stored and purchased liquidity management

174


• Loan commitments and other credit lines can cause liquidity problems

• as with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity

• If stored liquidity is used, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet

• If purchased liquidity is used, the composition of both the asset and liability sides of the balance sheet changes, and increases the size of the balance sheet 175 176

A DI with the following balance sheet (in millions) expects a net deposit drain of $15

million.

Show the DI's balance sheet if the following conditions occur.

a. The DI purchases liabilities to offset this expected drain.

b. The stored liquidity management method is used to meet the

liquidity shortfall.


Measuring Liquidity Risk Exposure

• The liquidity position of banks is measured by managers on a daily basis

• A net liquidity statement lists sources and uses of liquidity

• Ratio comparisons are used to compare a bank’s liquidity position against its competitors• loans to deposit ratio

• borrowed funds to total assets ratio

• commitments to lend to assets ratio

• Ratios are often compared to those of banks of a similar size and in the same geographic location 177


• The liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditions

where wi = the percent of each asset i in the FI’s portfolio

Pi = the price it gets if an FI liquidates asset i today i.e.Fire sale price

Pi* = the price it gets if an FI liquidates asset i under

normal market conditions

178

∑=

=N

iiii

PPw1

* )]/)([(I

A DI has the following assets in its portfolio: $20 million in cash reserves with the Fed, $20 million in T-Bills, $50 million in mortgage loans, and $10 million in fixed assets. If the assets need to be liquidated at short notice, the DI will receive only 99 percent of the fair market value of the T-Bills and 90 percent of the fair market value of the mortgage loans.Estimate the liquidity index using the above information.

Thus, and assuming that fixed assets will not be disposed on short notice:I = (20/100)(1.00/1.00) + (20/100)(0.99/1.00) + (50/100)(0.90/1.00) +(10/100)(1/1.00)= 0.848<Fixed assets can't be used as liquid index>


• The financing gap is the difference between a bank’s average loans and average (core) assets

• if the financing gap is positive, the bank must find liquidity to fund the gap

• The financing requirement is the financing gap plus a bank’s liquid assets

• a widening financing gap can be an indicator of future liquidity problems

180


Plainbank has $10 million in cash and equivalents, $30 million in

loans, and $15 in core deposits.

Cash $ 10 Core Deposit $15

Loan $30

a. Calculate the financing gap.

Financing gap = average loans – average deposits = $30 million -

$15 million = $15 million

b. What is the financing requirement?

Financing requirement = financing gap + liquid assets = $15

million + $10 million = $25 m

c. How can the financing gap be used in the day-to-day liquidity

management of the bank?


• The BIS Approach: Maturity Ladder/Scenario Analysis

• liquidity management involves assessing all cash inflows against cash outflows

• the maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervals

• daily, maturity segment, and cumulative net funding requirements are determined from the maturity ladder

• the BIS also suggests that DIs prepare for abnormal conditions using various “what if” scenarios

182

Liquidity Planning

• Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise• lowers the costs of funds by determining an optimal

funding mix

• minimizes the amount of excess reserves that a bank needs to hold

• liquidity plan components• description of managerial responsibilities

• list of fund providers most likely to withdraw funds and a pattern of fund withdrawals

• identification of the size of potential deposit and fund withdrawals over various time horizons

• internal limits on separate subsidiaries’ and branches’ borrowings as well as acceptable risk premiums to pay in each market 183

Liquidity Risk

• Major liquidity problems arise if deposit drains are abnormally large and unexpected

• Abnormal deposit drains can occur because• concerns about a bank’s solvency

• failure of another bank (i.e., the contagion (inflection)

effect)

• sudden changes in investors’ preferences regarding holding nonbank financial assets relative to bank deposits

• A bank run is a sudden and unexpected increase in deposit withdrawals from a bank

184


Liquidity Risk

• Demand deposits are first-come, first-served contracts

• The incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking system

• a bank panic is a systemic or contagious run on the deposits of the banking industry as a whole

• Regulatory mechanisms are in place to ease banks’ liquidity problems and to deter bank runs and panics

• deposit insurance

185

Liquidity Risk and Insurance

Companies

• Life insurance companies hold cash reserves and other liquid assets

• to meet policy payments

• to meet cancellation (surrender) payments

• the surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early

• to fund working capital needs which can be unpredictable

• Property-casualty (P&C) insurance companies

• the claims against P&C insurers are hard to predict

• thus, P&C insurance companies have a greater need for liquidity than life insurance companies

186

Liquidity Risk and Mutual Funds

• Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds’ assets

• However, the way MFs are valued reduces the incentive of fund shareholders to engage in bank-like runs on any given day• assets are distributed on a pro rata basis

• losses are incurred to shareholders on a proportional basis

187 188

The following is the balance sheet of an DI in millions:Assets Liabilities and EquityCash $ 2 Demand deposits $50Loans $50Plant and equipment $ 3 Equity $ 5Total $55 Total $55

The asset-liability management committee has estimated that the loans, whoseaverage interest rate is 6 percent and whose average life is 3 years, will have tobe discounted at 10 percent if they are to be sold in less than two days. If they canbe sold in 4 days, they will have to be discounted at 8 percent. If they can be soldlater than a week, the DI will receive the full market value. Loans are notamortized; that is, principal is paid at maturity.

a. What will be the price received by the DI for the loans if they have to be sold intwo days. In four days?Price of loan = PVAn=3,k=10(3) + PVn=3, k=10(50) = $45.03 if sold in two days.= Int * PVIFA k,n + M * PVIF k, n = 3*(1-1/1.1^3)/0.1+ 50/1.1^3

Price of loan = PVAn=3,k=8(3) + PVn=3, k=8(50) = $47.42 if sold in four days.

Question


189

Consider the assets (in millions) of two banks, A and B. Each bank is funded by

$120 million in deposits and $20 million in equity. Which bank has the stronger

liquidity position? Which bank probably has a higher profit?

Bank A Asset Bank B AssetsCash $10 Cash $20

Treasury securities $40 Consumer loans $30

Commercial loans $90 Commercial loans $90

Total Assets $140 Total Assets $140

Question Question

A NOW account requires a minimum balance of$750 for interest to be earned at an annual rateof 4 percent. An account holder has maintainedan average balance of $500 for the first sixmonths and $1,000 for the remaining six months.She writes an average of 60 checks per monthand pays $0.02 per check, although it costs thebank $0.05 to clear a check.

190

a. What average return does the account holder earn on the account?

Gross interest return = Explicit interest return + Implicit interest return

Interest earned by account holder $1,000 x (0.04/2) = $20.00

Implicit fee earned on checks $0.03 x 60 x 12 = $21.60

Average deposit maintained during the year ½(500) + ½(1,000) = $750.00

Average interest earned = $41.60/750 = 5.55 percent

b. What is the average return if the bank lowers the minimum balance to $400?

If the minimum balance requirement is lowered to $400, the account holder earns an extra

$500 x (0.04/2) = $10 in interest. The average interest earned = $51.60/750 = 6.88 percent.

c. What is the average return if the bank pays interest only on the amount in excess of $400? Assume that the minimum required balance is $400.

If the bank only pays interest on balances in excess of $400, the explicit interest earned = $100 x 0.02 + $600 x 0.02 = $2 + $12 = $14. The implicit fee earned on checks = $21.60, and the average interest earned = $35.60/$750 = 4.75%

191

Question Question

192

•Colonial Bank is considering a new consumer loan product.The loans will carry an interest rate of 15%, but the rateearned by Colonial Bank, after deducting operating expensesand allowed for bad debts will be 11%. Colonial bank canraise additional deposit funds at an interest rate of 9.5% butoperating costs associated with these deposits will bring theeffective interest rate to 10.5%. Colonial is required tomaintain equity equal to 5% of total assets (I.e. Colonial raisedeposit of only $95 for each $100 of loans), pays a tax rate of34%, and must earn 15% return on equity to satisfyinvestors. Is the Loan product profitable ?


•Community Federal plans to raise additional funds through the sale of oneyear certificate of deposit. The certificates will carry 9% interest, withannual compounding, and the estimated cost of attracting one $1000certificate is $20. The reserve requirement is 10%, and the reserves willearn 4%. Compute the cost of funds.

Cost of funds =

RS

IEI

d

re

−

−+

Where,Ie = dollar annual interest paid on interest-bearing depositsE = annual cost of attracting and serving accountsIr = Annual interest received on reserves, if anySd = Average value of interest bearing deposits.R = Amount of required reserves for these deposits.

Question

•Neighborhood Bank has total assets of$110 million, with$100 million coming from deposits and $10 million comingfrom equity. The interest paid on deposit funds is 6%, and thecost of attracting and administering these accounts equals1% of the average balance of deposits. The before tax costof equity is 20%. The bank is required to maintain non-interest bearing liquid assets equal to 10% of deposits.

•Compute the cost of deposits.•Compute the overall required return on funds available forinvestment.

Question

1. The following details of its deposits accounts

Account types Rs Avg Int rate (%) non-int rate (%)

Checking (demand) a/c 5000000 - 1

Now account 4000000 6 3

Saving deposit 2000000 5 4

Certificate of Deposit 1000000 8 3

Moneymarket deposit 500000 10 2

Non deposit borrowings 2500000 9 2

15000000

Required:

• What is bank's historical average interest cost ?

• What is the bank's average historical cost of funds raising ?

• What is the minimum return on the earning assets to cover the firm's funds-raising

costs ?

• If the firm's equity is Rs. 10,00,000 and the required rate on equity is 15%. At what

rate does the firm invest in earning assets ?

The funds available for investment is about 80% of total deposits.

196

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MBA IV Semester


UNIT VIII

Interest Rate Risk in Financial Institutions LH 6 POST RAJ POKHAREL

M.Phil. (TU) 01/2010)


UNIT VIII: Interest Rate Risk Management

in Financial Institutions LH 6

• Overview of Interest Rate Risk Management.

• Methods of Interest Rate Risk Measurement and Management: Repricing Model and Duration Model.

• Insolvency Risk Management.

197

Overview of Interest Rate Risk

• The asset transformation function performed by financial institutions (FIs) often exposes them to interest rate risk

• FIs use (at least) two methods to measure interest rate exposure• the repricing model ( the funding gap model) examines

the impact of interest rate changes on net interest income (NII)

• the duration model examines the impact of interest rate changes on the overall market value of an FI and thus ultimately on net worth

198

Methods of Interest Rate Risk Measurement and

Management: Repricing Model and Duration Model.

• The repricing or funding gap is the difference between those assets whose interest rates will be repriced or changed over some future period and liabilities whose interest rates will be repriced or changed over some future period

• Quarterly reporting of commercial bank assets and liabilities is detailed by maturity bucket (or bin)

• one day

• more than one day to 3 months

• more than 3 months to 6 months

• more than 6 months to 12 months

• more than 1 year to 5 years

• more than 5 years199



• The gap in each bucket or bin is measured as the difference between the rate-sensitive assets (RSAs) and the rate-sensitive liabilities (RSLs)• rate-sensitivity measures the time to repricing of

an asset or liability

• The cumulative gap (CGAP) is the sum of the individual maturity bucket gaps

• The cumulative gap effect is the relation between changes in interest rates and changes in net interest income

200




• The change in net interest income for any given bucket i (∆NIIi) is measured as:

∆NIIi = (GAPi)∆Ri = (RSAi – RSLi)∆Ri

where GAPi = the dollar size of the gap between the book

value of rate-sensitive assets and rate-sensitive

liabilities in maturity bucket i

∆Ri = the change in the level of interest rates

impacting assets and liabilities in the ith

maturity bucket

201



• A common cumulative gap of interest to commercial bank managers is the one-year repricing gap estimate:

where ∆NII is the cumulative change in net interest income from all rate-sensitive assets and liabilities that are repriced within a year given a change in interest rates ∆Ri

202

ii

ii

iRRSLRSANII ∆

−=∆ ∑∑

−

−=

−

−=

year1

day1

year1

day1



• The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change

∆NIIi = (RSAi x ∆RRSA) – (RSLi x ∆RRSL)

203

Question

204


Cash $10 Overnight Repos $170

1 month T-bills (7.05%) 75 Subordinated debt

3 month T-bills (7.25%) 75 7-year fixed rate (8.55% 150

2 year T-notes (7.50%) 50

8 year T-notes (8.96%) 100

5 year munis (floating rate)

(8.20% reset every 6 months) 25 Equity 15

Total Assets $335 Total Liabilities & Equity $335

a. What is the funding or repricing gap if the planning period is 30 days? 91

days? 2 years? Recall that cash is a noninterest-earning asset.

b. What is the impact over the next 30 days on net interest income if all interest

rates rise 50 basis points? Decrease 75 basis points?

c. The following one-year runoffs are expected: $10 million for two-year T-notes,

and $20 million for eight-year T-notes. What is the one-year repricing gap?

d. If runoffs are considered, what is the effect on net interest income at year-end

if interest rates rise 50 basis points? Decrease 75 basis points?


205

a. What is the funding or repricing gap if the planning period is 30 days? 91 days? 2 years? Recall that cash is a noninterest-earning asset.

Funding or repricing gap using a 30-day planning period = 75 - 170 = -$95 million.Funding gap using a 91-day planning period = (75 + 75) - 170 = -$20 million.

Funding gap using a two-year planning period = (75 + 75 + 50 + 25) - 170 = +$55 million.

b. What is the impact over the next 30 days on net interest income if all interest rates rise 50 basis points? Decrease 75 basis points?

Net interest income will decline by $475,000. ∆NII = FG(∆R) = -95(.005) = -$0.475m.Net interest income will increase by $712,500. ∆NII = FG(∆R) = -95(-.0075) = $0.7125m.

•The following one-year runoffs are expected: $10 million for two-year T-notes, and $20 million

for eight-year T-notes. What is the one-year repricing gap?

Funding or repricing gap over the 1-year planning period = (75 + 75 + 10 + 20 + 25) - 170 =

+$35 million.

d. If runoffs are considered, what is the effect on net interest income at year-end if interest rates

rise 50 basis points? Decrease 75 basis points?

Net interest income will increase by $175,000. ∆NII = FG(∆R) = 35(0.005) = $0.175m.Net interest income will decrease by $262,500, ∆NII = FG(∆R) = 35(-0.0075) =

-$0.2625m.

Questions

Assets $ Rate Liabilities & Equity $ Rate

Rate sensitive $3,000 10.0% Rate sensitive $2,000 8.0%

Nonrate sensitive 1,500 9.0 Nonrate sensitive 2,000 7.0

Nonearning 500 Equity 1,000

$5,000 $5,000

a. Calculate the expected net interest income at current interest rates andassuming no change in the composition of the portfolio. What is the netinterest margin?

b. Assuming that all interest rates rise by 1 percentage point, calculate the newexpected net interest income and net interest margin.

a. Net interest income = $3,000 (.10) + $1,500 (.09) – $2,000 (.08) – $2,000 (.07)

= $435 – $300 = $135

Net interest margin = $135/$4,500 = 0.03 or 3.0%

b. Net interest income = $3,000(0.11) +$1,500(0.09) – $2,000(0.09) -$2000*(.07)= $145

Net interest margin = $145/$4,500 = 0.0322 = 3.22% 206

Assets Liabilities and EquityCash $60 Demand deposits $1405-year treasury notes$60 1-year Certificates of Deposit $16030-year mortgages $200 Equity $20Total Assets $320 Total Liabilities and Equity $320

What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase or decrease in interest rates? Explain why?

MA = [0*60 + 5*60 + 200*30]/320 = 19.69 years, and ML = [0*140 + 1*160]/300 = 0.533.

Therefore the maturity gap = MGAP = 19.69 – 0.533 = 19.16 years.

Nearby bank is exposed to an increase in interest rates. If rates rise, the value of assets will decrease much more than the value of liabilities.

County Bank has the following market value balance sheet (in millions, annual rates):Assets Liabilities and EquityCash $20 Demand deposits $10015-year commercial loan @ 10% 5-year CDs @ 6% interest,interest, balloon payment $160 balloon payment $21030-year Mortgages @ 8% interest, 20-year debentures @ 7% interest $120monthly amortizing $300 Equity $50Total Assets $480 Total Liabilities & Equity $480

a. What is the maturity gap for County Bank?

b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 1 percent?

c. What will happen to the market value of the equity?

d. If interest rates increased by 2 percent, would the bank be solvent?


a. What is the maturity gap for County Bank?MA = [0*20 + 15*160 + 30*300]/480 = 23.75 years.ML = [0*100 + 5*210 + 20*120]/430 = 8.02 years.MGAP = 23.75 – 8.02 = 15.73 years.b. What will be the maturity gap if the interest rates on all assets and liabilities increase by 1

percent?If interest rates increase one percent, the value and average maturity of the assets will be:Cash = $20Commercial loans = $16*PVIFAn=15, i=11% + $160*PVIFn=15,i=11% = $148.49

Alternatively, =-D(Change in Y/1+y) = Where Duration, D = 8.12 years

Mortgages = $2.201,294*PVIFAn=360,i=9% = $273.581MA = [0*20 + 148.49*15 + 273.581*30]/(20 + 148.49 + 273.581) = 23.60 yearsThe value and average maturity of the liabilities will be:Demand deposits = $100CDs = $12.60*PVIFAn=5,i=7% + $210*PVIFn=5,i=7% = $201.39Debentures = $8.4*PVIFAn=20,i=8% + $120*PVIFn=20,i=8% = $108.22ML = [0*100 + 5*201.39 + 20*108.22]/(100 + 201.39 + 108.22) = 7.74 yearsThe maturity gap = MGAP = 23.60 – 7.74 = 15.86 years. The maturity gap increased because

the average maturity of the liabilities decreased more than the average maturity of the assets. This result occurred primarily because of the differences in the cash flow streams for the mortgages and the debentures.

c. What will happen to the market value of the equity?The market value of the assets has decreased from $480 to $442.071, or $37.929. The

market value of the liabilities has decreased from $430 to $409.61, or $20.69. Therefore the market value of the equity will decrease by $37.929 - $20.69 = $17.239, or 34.48 percent.

d. If interest rates increased by 2 percent, would the bank be solvent?The value of the assets would decrease to $409.04, and the value of the liabilities would

decrease to $391.32. Therefore the value of the equity would be $17.72. Although the bank remains solvent, nearly 65 percent of the equity has eroded because of the increase in interest rates.



• Duration measures the interest rate sensitivity ofan asset or liability’s value to small changes ininterest rates

• The duration gap is a measure of overall interestrate risk exposure for an FI

• To find the duration of the total portfolio of assets(DA) (or liabilities (DL)) for an FI• first determine the duration of each asset (or liability)

in the portfolio• then calculate the market value weighted average of

the duration of the assets (or liabilities) in the portfolio210

)1/(

security a of uemarket val in the %

RRD

+∆

∆−=



• The change in the market value of the asset portfolio for a change in interest rates is:

• Similarly, the change in the market value of the liability portfolio for a change in interest rates is:

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)1()(

R

RDAA

A

+

∆×−×=∆

)1()(

R

RDLL

L

+

∆×−×=∆



• Finally, the change in the market value of equity of a FI given a change in interest rates is determined from the basic balance sheet equation:

• By substituting and rearranging, the change in net worth is given as:

• where k is L/A = a measure of the FI’s leverage

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ELAELA ∆+∆=∆⇒+=

)1()(

R

RAkDDE

LA

+

∆××−−=∆




• The effect of interest rate changes on the market value of equity or net worth of an FI breaks down to three effects

• the leverage adjusted duration gap = (DA – kDL)

• measured in years

• reflects the duration mismatch on an FI’s balance sheet

• the larger the gap the more exposed the FI to interest rate risk

• the size of the FI

• the size of the interest rate shock

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214



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• Difficulties emerge when applying the duration model to real-world FI balance sheets• duration matching can be costly as restructuring the

balance sheet is time consuming, costly, and generally not desirable

• immunization is a dynamic problem• duration of assets and liabilities change as they approach

maturity

• the rate at which the duration of assets and liabilities change may not be the same

• duration is not accurate for large interest rate changes unless convexity is modeled into the measure

• convexity is the degree of curvature of the price-yield curve around some interest rate level

Calculation of Duration

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As a management trainee assigned to the bank’s Asset/Liability Management committee, you havebeen asked to calculate the duration of each of the following loans:

a. $20,000 principal, $4,500 payments per year for five years.b. $20,000 principal , $4,200 payments per year for five years Assume that the bank’s current

required return on these types of loans is 8%.ANSWER:a. Present Present Value

Adjusted Value of AdjustedYear Cash Flow Cash Flow Factor Cash Flow1 $4,500 $4,500 0.926 $4,1672 4,500 9,000 0.857 7,7133 4,500 13,500 0.794 10,7194 4,500 18,500 0.735 13,2305 4,500 22,500 0.681 15,322

$51,151Duration = $51,151/20,000 = 2.56 years.

b. Present Present ValueAdjusted Value of Adjusted

Year Cash Flow Cash Flow Factor Cash Flow1 $4,200 $4,200 0.926 $3,8892 4,200 8,400 0.857 7,1993 4,200 12,600 0.794 10,0044 4,200 16,800 0.735 12,3485 4,200 21,000 0.681 14,301

$47,741

Duration = $47,741/$20,000 = 2.39 years.


Question:

Suppose DA = 3 years, DL = 6 years, k = .8, and A = $100million. What is the effect on owners’ net worth if R/(1 + R) rises 1 percent? (E = $1,800,000)

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Insolvency Risk Management

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• To ensure survival, an FI manager must protect against the risk of insolvency

• The primary protection against the risk of insolvency is equity capital• capital is a source of funds

• capital is a necessary requirement for growth under existing minimum capital-to-asset ratios set by regulators

• Managers prefer low levels of capital in order to generate higher return on equity (ROE)• the moral hazard problem exacerbates this

tendency

• the result is an increased likelihood of insolvency



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• The economic meaning of capital is net worth• net worth is equal to the difference between the

market value (MV) of an FI’s assets and the market value of its liabilities

• the market value or mark-to-market value basis uses balance sheet values that reflect current rather than historical prices

• Regulatory and accounting-defined capital is based in whole or in part on historical or book values (BV)


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• The market value of capital and credit risk• declines in current and expected future cash flows on

loans lowers the MV of an FI’s assets• declines in the MVs of assets is directly charged against

the equity owners’ capital or net worth• liability holders are only hurt when asset losses exceed

equity capital levels• thus, equity capital acts as “insurance” protecting

liability holders (and guarantors such as the FDIC) against insolvency risk

• The market value of capital and interest rate risk• rising interest rates decrease the value of an FI’s assets

more than the value of the FI’s liabilities when the duration gap of the FIs balance sheet is positive

• again, losses are first charged against equity capital


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• The book value of equity capital is the difference between the BV of assets and the BV of liabilities

• the BV of equity is usually composed of the par value of equity shares, the surplus value of equity shares, and retained earnings

• the BV of equity does not equal the market value of equity

• managers can manipulate the BV of equity by

• using discretion when timing the recognition of loan losses

• selectively selling assets to inflate reported earnings (and thus capital)


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• Interest rate changes have no impact on book values of assets and liabilities• FIs can be solvent from a BV perspective, but

massively insolvent from an economic perspective

• The degree to which the BV of equity deviates from the MV of equity depends on• interest rate volatility

• examination and enforcement

• loan trading

• The discrepancy between the MV and BV of equity is measured by the market-to-book ratio



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• Arguments against using market value accounting include• it is difficult to implement

• especially so for small FIs that are not publicly traded

• it introduces an unnecessary degree of variability into reported earnings

• FIs may be less willing to accept longer-term asset exposures if they must be continually marked-to-market

• likely would interfere with FIs’ role as lenders and monitors and could lead to a “credit crunch”

Best Wishes !

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MBA IV Semester Institutions Management of Financial ... · Financial Markets and Institutions....

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